The following is part of an occasional series on specific rules and regulations governing financial professions. This article will analyze FINRA Rule 3280, which governs (and limits) private securities transactions by persons associated with a FINRA member (“associated persons” or “representatives”). In general, the rule forbids representatives from participating in private securities transactions unless they have given their firm prior written notice. Further, if the representative could earn selling compensation from the transaction, Rule 3280 also requires the firm’s prior approval. The sections below will discuss the rule’s purpose, and the standards for demonstrating the representative participated in the transaction, the transaction involved a “security,” and the prior written notice was adequate.
THE RULE
Rule 3280 – Private Securities Transactions of an Associated Person
(a) No associated person shall participate in any manner in a private securities transaction except in accordance with the requirements of this rule.
(b) Prior to participating in any private securities transaction, an associated person shall provide written notice to the member with which he is associated describing in detail the proposed transaction and the person’s proposed role therein and stating whether he has received or may receive selling compensation.
(c) Transactions for Compensation
- In the case of a transaction in which an associated person has received or may receive selling compensation, a member which has received notice pursuant to paragraph (b) shall advise the associated person in writing stating whether the member:
A. Approves the person’s participation in the proposed transaction; or
B. Disapproves the person’s participation in the proposed transaction.
- If the member approves a person’s participation in a transaction pursuant to paragraph (c)(1), the transaction shall be recorded on the books and records of the member and the member shall supervise the person’s participation in the transaction as if the transaction were executed on behalf of the member.
- If the member disapproves a person’s participation pursuant to paragraph (c)(1), the person shall not participate in the transaction in any manner, directly or indirectly.
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(e) Definitions
For purposes of this Rule, the following terms shall have the stated meanings:
“Private securities transaction” shall mean any securities transaction outside the regular course or scope of an associated person’s employment with a member, including, though not limited to, new offerings of securities which are not registered with the Commission, provided however that transactions subject to the notification requirements of Rule 3210, transactions among immediate family members (as defined in FINRA Rule 5130), for which no associated person receives any selling compensation, and personal transactions in investment company and variable annuity securities, shall be excluded.
THE RULE’S PURPOSE
Rule 3280 applies to both purchases and sales of securities.[1] The rule is considered fundamental to a representative’s duty to customers and his or her firm.[2] Like Rule 3270, Rule 3280 aims to protect investors and firms through increased oversight. Investors benefit because, with the rule’s disclosure provisions, firms can supervise sales undertaken by associated persons outside the scope of their employment.[3] Conversely, when a representative violates the rule’s notice provision, this “deprives investors of firm oversight and due diligence – benefits they have the right to expect.”[4] In short, the protection is lost.
The disclosure provisions protect firms, as they can be subject to liability for their representatives’ conduct, even if outside the scope of their employment. With timely and proper notice, however, firms can supervise or limit their representatives outside sales.[5] This gives them a measure of control over their risk.
PARTICIPATION
To further Rule 3280’s goal of expansive disclosure, regulatory adjudicators (“adjudicators”)[6] have defined “participation” broadly.[7] Indeed, the rule covers not only representatives who make a sale, but those who participate “in any manner.”[8]
Still, this broad definition is not unlimited. At minimum, “participation” requires that the representative took specific actions to effectuate a particular transaction, and there was a “reasonably close factual nexus” between the participatory conduct and the specific securities transaction.[9] More specifically, conduct deemed “participation” exhibits at least some combination of the following three traits: (1) the representative recommended or marketed the investment to customers; (2) the representative assisted with the mechanics of the transaction[10]; and (3) the representative was compensated for his or her role in the transaction.[11]
Recommending or marketing the investment
A representative’s marketing activities can stem from a direct relationship with the investment’s promoters. Here, the representative would seek out potential investors and introduce them to the promoters. Adjudicators are more likely to find participation if the customer would not have learned of the investment without the representative’s intervention.[12]
In the less direct cases, representatives will recommend the investment, usually to a client, friend, or family member. This can encompass different types of pitches. Some adjudicators have found participation where the representative tells the customers that he or she plans to invest.[13] Here, the endorsement is implicit, but strong, given that the customer may view the representative as an expert on the subject.
Other times, the representative vouches for the transaction. This can be through hyping the promoters or through hyping the opportunity itself.[14] The latter case is not necessarily limited to the transaction’s benefits in and of themselves. That is, representatives have been deemed participants when they touted the investment as a fit for a client’s specific needs. For example, in Akindemowo, the representative told his client she needed to make an outside investment because it fit her “window of opportunity.”[15] Similarly, in Gluckman, the representative advised his client that an outside investment offered the right circumstance to use funds from his recent home refinancing.[16]
Nonetheless, 3280 does not target a representative who does “nothing more than refer a customer to another investment opportunity.”[17] So merely introducing customers and promoters does not, by itself, equal participation. Rather, there must be some link between the introductions and the specific transaction.[18] Consider Browne, where an SEC panel found no such link. There, the NASD alleged that two representatives – Browne and Calandro – participated in stock offerings by their client, e2 Communications.[19] Their alleged participation consisted of introducing e2 to various business contacts and commenting to certain family and friends about e2’s offerings. These people later purchased stock in one or both of the offerings.[20]
First, the panel ruled that the introductions did not equal participation because they did not relate to a specific offering.[21] Mostly, this was a product of time – as in, the introductions happened well before e2’s stock offerings.[22] It was not until several months later that e2 began arranging its first (of two) offerings. In the panel’s view, this bolstered Browne and Calandro’s claim that the introductions were for general business purposes, untethered to any specific investment opportunity.[23] The panel held that there was not a strong enough “factual nexus” between the introductions and the stock purchases at issue.[24]
Second, Browne and Calando mentioned e2’s offering to various family and friends who later purchased e2 stock.[25] The panel found these were no more than referrals.[26] Indeed, each time, the discussion of e2 was limited, and the representative did not try to convince the other person to invest.[27] The most either did was help exchange contact information between e2 and some eventual stock purchasers. But each time, the purchaser asked for e2’s information or learned about the offering independent of the representatives.[28] These actions did not match those supporting “participation” in other cases, as Browne and Calandro were not trying to recruit investors or sell them on e2’s potential. So again, the panel did not find that these actions turned the representatives into participants.[29]
Engaging in the mechanics of the transaction
Adjudicators have deemed representatives participants when they perform necessary functions in a transaction. For example, in Gluckman, the representative connected two customers with the investment’s promoter – the understanding being they wanted to invest. He also took a central role in drafting the customers’ investment agreements, including typing the agreements and proposing specific language.[30] In Goldsworthy, the representative assisted with the sale of promissory notes to twelve of his customers. Specifically, he signed the investment agreements, coordinated sale of the notes, and collected proceeds from the sale.[31] In White, the representative urged his mother to invest in a company. This meant accompanying his mother when she visited the company and discussing the company’s merits with her. When his mother invested, the representative also provided the bank information for transmittal of the cashier’s check.[32]
Here, it is difficult to set the boundary between participation and non-participation. In the above cases, the representatives took on meaningful roles in the transactions. Conversely, in cases that rejected participation, almost none of the undisclosed conduct involved the transaction’s mechanics.[33]
Receiving compensation for his or her role in the transaction
For the most part, this trait is self-explanatory. Representatives who receive compensation for their role in a transaction also become participants.[34] That said, the compensation still must be tied to the transaction in question. Again, Browne is instructive. There, e2 granted the representatives stock after its second offering closed.[35] Browne and Calandro were not expecting the shares and did not pay for them.[36] The panel determined the shares were not linked to any specific transaction. Rather, they could have been rewards for Browne and Calandro’s general support of e2.[37] So this did not weigh toward making either representative a participant.[38]
A TRANSACTION INVOLVING SECURITIES
For Rule 3280 to apply, the transaction in question must involve a security.[39] This determination overlaps with my previous articles on the definition of a security. And adjudicators use the same principles – sometimes, the same cases – to address this question in the 3280 context.[40]
Adjudicators apply the definition of “security” provided in the Securities Act of 1933 and the Securities Exchange Act of 1934 (collectively, the “Securities Acts”):[41]
any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, . . . investment contract, voting-trust certificate, . . . any interest or instrument commonly known as a security, or any certificate of interest or participation in, . . . or right to subscribe to or purchase, any of the foregoing.[42]
In a given case, the issue becomes whether the instrument in question fits one of these categories. So courts have crafted tests to help define some forms of securities and, thus, judge whether that fit exists. The two most common tests are the “family resemblance test,” for “notes,” and the “Howey Test,” for “investment contracts.”
If the instrument qualifies as a security under either of these tests, the adjudicator will continue analyzing whether the respondent engaged in a “private securities transaction.” But if the adjudicator rules the other way, the analysis stops, and the representative cannot be found liable for a 3280 violation.
Notes
To determine whether a financial instrument qualifies as a “note” under the Acts, courts use the family resemblance test (or the “Test”).[43]
The Test helps distinguish between “notes issued in an investment context (which are ‘securities’) from notes issued in a commercial or consumer context (which are not).”[44] Mechanically, it proceeds in two stages, each meant to determine whether the note in question resembles a non-security. First, the note is presumed a security unless it bears a strong resemblance to one of the categories of non-securities enumerated in Exchange Nat’l Bank of Chicago v. Touche Ross & Co., (544 F.2d 1126, 1137 (2d Cir.1976)):
(1) A note delivered in consumer financing; (2) A note secured by a mortgage on a home; (3) A short-term note secured by a lien on a small business or some of its assets; (4) A note evidencing a ‘character’ loan to a bank customer; (5) Short-term notes secured by an assignment of accounts receivable, (6) A note which simply formalizes an open-account debt incurred in the ordinary course of business (particularly if, as in the case of the customer of a broker, it is collateralized), and (7) Notes evidencing loans by commercial banks for current operations.[45]
Second, if there is not a strong resemblance to the enumerated items, the court or adjudicator will consider whether a new category of non-security should be added.[46]
Both inquiries rely on the same four factors: (1) The buyer’s or seller’s motivation for the transaction in question; (2) The plan for distributing the note; (3) The public’s reasonable expectation as to whether the note is a security; and (4) Whether another regulatory scheme safeguards the transaction or note.[47] The eventual result depends not on the note’s form or label, but the “economic reality” of the transaction.
Over the years, courts have added two quirks to the Test. First, while technically, the Test is meant to determine whether the instrument resembles a non-security, most courts have framed it as determining whether the instrument resembles a security.[48] Second, because the Test’s two inquiries rely on the same four factors, in effect, they “collapse into a single inquiry.”[49]
In their application of the Test, adjudicators have shown no material difference from most federal courts.[50] (Federal courts’ application is discussed here).
Investment Contracts
As the U.S. Supreme Court established in the 1946 case, SEC v. Howey, an “investment contract” encompasses any “scheme [involving] an investment of money in a common enterprise with profits to come solely from the efforts of others.”[51] Functionally, this definition breaks down into four elements: (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profits, and (4) profits derived solely from the efforts of others.[52] These form the Howey Test.[53]
Adjudicators have applied the Howey Test to conclude certain transactions qualified as investment contracts.[54] The most common scenario is where a representative persuades clients to contribute money to a fund, which the fund’s manager then invests.[55] If the manager’s investment strategy is successful, the fund will generate profit for those who contributed to it. Through the lens of the Howey Test, the clients would have invested money in a common enterprise (the fund) with profits expected through the efforts of another (the fund’s manager).[56] So the transaction would be an investment contract.
For more on application of the Howey Test, look here and here.
CONTENT AND QUALITY OF DISCLOSURE
Regarding the substance of disclosure, the plain language of Rule 3280 provides more guidance than Rule 3270. Both rules require prior disclosure in writing. But 3280 adds three requirements as to the content of disclosure. Here, the disclosure must include (1) a detailed description of the transaction, (2) an explanation of the associated person’s role in it, and (3) a statement of whether the associated person will be receiving selling compensation.[57] Further, if the associated person is receiving selling compensation, the rule requires him or her to obtain firm approval before engaging in the transaction.[58]
It is uncommon for a case to turn on the notice’s level of detail or its explanation of the associated person’s role in the transaction. So guidance on these subjects is limited. That said, “at a minimum,” the notice should identify the investor and the amount of money involved in the transaction.[59]
The third requirement – whether the associated person “received or may receive selling compensation” – has generated more discussion. FINRA defines “selling compensation” as “any compensation paid directly or indirectly from whatever source in connection with or as a result of the purchase or sale of a security, including, but not limited to, commissions and finders fees.”[60] This is interpreted broadly – in effect, preventing representatives from devising creative arrangements to mask compensation that, in reality, is “selling compensation.”[61]
Rule 3280 requires written notice and firm approval for any transactions that involve selling compensation. Based on the rule’s plain language, the approval goes beyond the steps required for transactions without selling compensation.[62] That is, Section 3280(b) demands that all written notices state whether the representative “has received or may receive selling compensation.” Section 3280(c) then outlines an approval process, which it only applies to transactions with selling compensation. There is no equivalent section for approval of transactions without selling compensation. So taking the rule as a whole, the most logical conclusion would be that its drafters meant to establish approval as a condition only for transactions with selling compensation.
Terry Brennan represents financial professionals – including FINRA associated persons – in a wide variety of matters. For more information, see the “Practice Areas” section of this website.
[1] Dep’t of Enforcement v. Friedman, No. 2005000835801, 2010 FINRA Discip. LEXIS 10, at 9 (NAC July 26, 2010)
[2] Blair C. Mielke and Frederick W. Shultz, SEC Exchange Act Release No. 75981, at 17 (September 24, 2015)
[3] Dep’t of Enforcement v. White, No. 2012033128703, 2015 FINRA Discip. LEXIS 48, at 26 (OHO June 30, 2015); See Dep’t of Enforcement v. Mathieson, No. 2014040876001, 2016 FINRA Discip. 9, at 6 (OHO December 16, 2016)
[4] Mielke, SEC Exchange Act Release, at 17
[5] Joseph J. Vastano, SEC Exchange Act Release No. 50219, at 4 (August 19, 2004); Dep’t of Enforcement v. Akindemowo, No. 2011029619301, 2015 FINRA Discip. LEXIS 58, at 16 (NAC December 29, 2015)(Also noting that, in this case, disclosure from Akindemowo would have allowed firm to “intervene”); White, 2015 FINRA Discip. LEXIS at 26; See Mark H. Love, SEC Exchange Act Release No. 49248, at 5 (February 13, 2004)
[6] In this context, “adjudicator” encompasses any disciplinary or judicial decisionmaker within a government agency, like the SEC, or a self-regulatory organization, like FINRA or the NASD. It covers single judges and panels.
[7] Love, SEC Exchange Act Release, at 4; Akindemowo, 2015 FINRA Discip. LEXIS 58, at 16; White, 2015 FINRA Discip. LEXIS at 26
[8] Stephen J. Gluckman, SEC Exchange Act Release No. 41628, at 5 (July 20, 1999)
[9] James W. Browne and Kevin Calandro, SEC Exchange Act Release No. 58916, at 4 (November 7, 2008)
[10] Love, SEC Exchange Act Release, at *4 (Holding that a representative violates 3280 when he or she “becomes involved in a customer’s investment choice through a specific recommendation and by facilitating the mechanics of transactions”)
[11] See e.g., Gluckman, SEC Exchange Act Release, at 5; See Browne, SEC Exchange Act Release, at 10-11 (Collecting cases)
[12] See Love, SEC Exchange Act Release, at 4-5; See Browne, SEC Exchange Act Release, at 10-11
[13] Love, SEC Exchange Act Release, at 4-5
[14] Love, SEC Exchange Act Release, at 4-5; FINRA Dept. of Enforcement v. Miller, No. 2012034393801, 2018 FINRA Discip. LEXIS 13, 12 (NAC May 23, 2018); See Mathieson, 2016 FINRA Discip., at 7
[15] Akindemowo, 2015 FINRA Discip. LEXIS, at 11
[16] Gluckman, SEC Exchange Act Release, at 2
[17] Browne, SEC Exchange Act Release, at 1; Love, SEC Exchange Act Release, at 5-6
[18] Browne, SEC Exchange Act Release, at 11-12
[19] Id. at 3-5
[20] Id.
[21] Id. at 11-12
[22] Id. at 12
[23] Id.
[24] Id. at 11-12
[25] Id. at 4-5
[26] Id. at 13
[27] Id. at 13-15
[28] Id.
[30] Gluckman, SEC Exchange Act Release, at 4
[31] John P. Goldsworthy, SEC Exchange Act Release No. 45926, at 7 (May 15, 2002)
[32] White, 2015 FINRA Discip. LEXIS at 26
[33] See generally, Browne, SEC Exchange Act Release
[34] See e.g., Gluckman, SEC Exchange Act Release, at 4; See Browne, SEC Exchange Act Release, at 10-11 (Collecting cases)
[35] Id. at 7
[36] Id.
[37] Id. at 14
[38] Id.
[39] See Mielke, SEC Exchange Act Release, at 12; See Dep’t of Enforcement v. Abbondante, C10020090, 2005 NASD Discip. LEXIS 43, at 7 (NAC April 5, 2005)
[40] FINRA Dept. of Enforcement v. Miller, No. 2012034393801, 2018 FINRA Discip. LEXIS 13, 10-11 (NAC May 23, 2018); Mielke, SEC Exchange Act Release, at 12; Abbondante, 2005 NASD Discip. LEXIS 43, at 7
[41] Miller, 2018 FINRA Discip. LEXIS 13, 10-11; Mielke, SEC Exchange Act Release, at 12; Abbondante, 2005 NASD Discip. LEXIS 43, at 7
[42] 15 U.S.C. § 78c(a)(10); 15 U.S.C. § 77b(a)(1)
[43] Miller, 2018 FINRA Discip. LEXIS at 10-11
[44] Thompson, 732 F. 3d at 1158, quoting Reves, 494 U.S. at 63
[45] FINRA Dept. of Enforcement v. Miller, No. 2012034393801, 2018 FINRA Discip. LEXIS 13, 10, n. 10 (NAC May 23, 2018), citing Reves, 494 U.S. at 66-67
[46] Id.
[47] Id.
[48] SEC v. Wallenbrock, 313 F.3d 532, 537 (9th Cir 2002) (Adopting Supreme Court framing)
[49] Thompson, 732 F. 3d at 1160, quoting Wallenbrock, 313 F.3d at 537
[50] See e.g., Miller, 2018 FINRA Discip. LEXIS at *10-11
[51] SEC v. WJ Howey Co., 328 US 293, 301 (1946)
[52] See e.g., SG, Ltd., 265 F.3d at 46; Foxfield Villa Associates v. Robben, 967 F.3d 1082, 1090 (10th Cir. 2020)
[53] Mielke, SEC Exchange Act Release, at 12; Abbondante, 2005 NASD Discip. LEXIS 43, at *7; Kenny Akindemowo, SEC Exchange Act Release No. 79007, at 6-7; See Warfield v. Alaniz, 569 F.3d 1015, 1020, n. 6 (9th Cir. 2009); See also Great Rivers Coop. of Se. Iowa v. Farmland Industries, 198 F.3d 685, 700 (8th Cir. 1999)
[54] Mielke, SEC Exchange Act Release, at 12-13; Akindemowo, SEC Exchange Act Release, at 6-7
[55] See e.g., Mielke, SEC Exchange Act Release, at 12-13; Akindemowo, SEC Exchange Act Release, at 6-7
[56] Id.
[57] See FINRA Rule 3280(a)-(b)
[58] See FINRA Rule 3280(c)
[59] Dep’t of Enforcement v. Dinh Hartley, C01010009, 2003 NASD Discip. 49, at 9 (NAC December 3, 2003)
[60] White, 2015 FINRA Discip. LEXIS at 26
[61] See Mielke, SEC Exchange Act Release, at 14-15
[62] Miller, 2018 FINRA Discip. LEXIS, at 10
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