[co-author: Jessmine Lee]

The new rule establishes criteria for firms to elect “non-branch” designation for a private residence where an associated person engages in specified supervisory activities.

On January 23, 2024, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 24-02 (Reg. Notice 24-02), announcing guidance and effective dates on two recently approved supplementary materials under FINRA Rule 3110:

1. FINRA Rule 3110.19, enabling firms to treat a private residence (a Residential Supervisory Location, or RSL) where an associated person engages in specified supervisory activities as a non-branch location, subject to safeguards and limitations; and
2. FINRA Rule 3110.18, establishing a voluntary, three-year remote inspections pilot program (Pilot Program).

The Notice further announced that certain COVID-19-related temporary relief measures pertaining to updates of office information on Forms U4 and BR, as set forth in Regulatory Notice 20-08 (Reg. Notice 20-08) would end on May 31, 2024.

Background

FINRA Rule 3110, FINRA’s Supervision Rule, imposes various supervisory obligations on member firms, including the obligation to “establish and maintain a system, including written procedures, to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.” As part of these obligations, firms must register and designate each location meeting the “branch office” or “office of supervisory jurisdiction” (OSJ) definitions in Rule 3110(f). Firms are required to internally designate, but not register, any “non-branch location.”

Finally, firms must inspect all OSJs, branch offices, and non-branch locations in accordance with the frequencies laid out under Rule 3110(c). Notably, Rule 3110(c) states that every OSJ and any branch office that supervises a non-branch location must be inspected at least annually and other branch offices and non-branch offices must be inspected at least every three years.

One exception to the requirement to designate a location as a branch office or OSJ is Rule 3110(f)’s longstanding residential exclusion. That exclusion permits treating an associated person’s primary residence as a non-branch location, subject to certain conditions. One of those conditions is that the location not be “responsible for supervising the activities of persons associated with the member at one or more non-branch locations.”

Historically, the rule’s structure has restricted a supervisor who works from home from having their home designated as a non-branch office. The rule has required such a supervisor’s residence to be designated as a branch office or OSJ.

This has led to at least two undesirable consequences for firms in connection with such arrangements:

1. Such location counts towards the firm’s maximum branch office allowance in its membership agreement.
2. Such location is subject to an annual inspection requirement.

To mitigate the heightened pandemic-related impacts of these consequences, FINRA implimented temporary relief through Reg. Notice 20-08. The relief permitted increased usage of teleworking arrangements, enabled greater flexability on inspections, and suspended the requirement to submit Form BR applications for newly opened temporary office locations and related Form U4 employment address information.

However, the recent fundamental shifts in workforce expectations have created concerns, which FINRA acknowledged in Regulatory Notice 21-44 (Reg. Notice 21-44). As some of these arrangements become permanent under the “new normal,” expiration of this temporary relief would cause many member firms to exceed the safe harbor thresholds for office count expansions. Firms would then be forced to submit continuing membership applications (Form CMA) for FINRA’s approval and face significantly increasing inspection burdens. The new rules were designed to modernize Rule 3110 and provide more permanent relief to mitigate such concerns.

Reduced Inspection Frequency for RSLs

FINRA Rule 3110.19, effective June 1, 2024, will permit firms to elect to designate an associated person’s private residence where certain supervisory activities are conducted to be considered a “non-branch” location of the associated person’s firm, or an RSL. Like other forms of non-branch locations, RSLs will be subject to inspections on a regular periodic schedule (presumed to be at least every three years) instead of the annual inspections currently required for OSJs.

However, to elect RSL designation, the firm and the relevant associated person at each prospective RSL must meet specified conditions and eligibility requirements.

Criteria for RSL Eligibility

FINRA Rule 3110.19 provides both conditions for designation as an RSL, as well as member firm and location ineligibility criteria.

There are 10 eligibility conditions for designation as an RSL:

1. Only one associated person (or multiple associated persons who are immediate family members and reside at that location) conducts business at the location.
2. The location is not held out to the public as an office.
3. The associated person does not meet with customers at the location.
4. Any sales activity at the location is in compliance with FINRA Rule 3110(f)(2)(A)(ii) or (iii).
5. Neither customer funds nor securities are handled at the location.
6. The associated person is assigned to a designated branch office, which is reflected on all communications to the public by the associated person.
7. The associated person’s correspondence and communications with the public are supervised by the firm.
8. The associated person’s electronic communications are made through the firm’s system.
9. The firm has a recordkeeping system that satisfies applicable securities law and regulations, FINRA rules, and firm’s rules; the records are not stored or electronically maintained at the location; and the firm has prompt access to records.
10. The firm must determine that its surveillance and technology tools are appropriate to supervise the risks presented by each RSL.

Conversely, firms are ineligible to designate a location as an RSL if the firm is currently designated as a Restricted Firm (under FINRA Rule 4111) or a Taping Firm (under FINRA Rule 3170). A firm is also ineligible if it receives a notice from FINRA pursuant to Capital Compliance (under FINRA Rule 9557), Regulatory Notification and Business Curtailment (under FINRA Rule 4120), or Regulation of Activities of Section 15C Members Experiencing Financial and/or Operational Difficulties (under FINRA Rule 4130), unless FINRA has otherwise permitted the activities in writing.

Further, firms are ineligible if they are or become suspended from FINRA, are currently undergoing or are required to undergo a review under FINRA Rule 1017(a)(7) for the associated person at the location, or have been found within the last three years to have violated office inspection requirements (under FINRA Rule 3110(c)). Firms which have only been FINRA members for less than 12 months (based on the date in the Central Registration Depository) are also ineligible.

Locations are ineligible for RSL designation if the associated person at the location has less than one year of direct supervisory experience with the firm or an affiliate or subsidiary of the firm that is a registered broker-dealer or investment adviser. This ineligibility applies if the associated person is functioning temporarily as a principal without yet having passed a principal-level exam pursuant to the allowance under FINRA Rule 1210.04.

A location is also ineligible if the associated person is subject to a mandatory heightened supervisory plan under the Securities and Exchange Commission (SEC), FINRA, or a state regulatory agency, is statutorily disqualified (unless approved), or had an event in the prior three years that required a “yes” response to certain questions on the Form U4. Lastly, a location is ineligible if the associated person at the location has been notified in writing that the person is subject to an investigation or proceeding by the SEC, a self-regulatory organization, or a state securities commission (with the exception of the earlier of: (1) the member’s receipt of written notification that the investigation has concluded without further action; or (2) one year from the date of the last communication from the regulator relating to the investigation).

Obligations Related to RSL Election

RSL List

Firms that elect to designate private residences as RSLs will be required to provide FINRA with a current list of their RSLs by the 15th day of the first month of each quarter, beginning October 15, 2024. The October 15, 2024, lists must reflect the locations firms have designated as RSLs for the period between June 1, 2024, and September 30, 2024. RSL lists will be submitted through FINRA Gateway. FINRA has indicated forthcoming additional guidance on RSL designations, including the operational process to submit the list to FINRA.

Risk Assessment

The firm must also develop a reasonable risk-based approach to designating a private residence as an RSL and document a risk assessment for the associated person prior to designating a location as an RSL. The assessment must document the factors considered, including whether the associated person at the location is now subject to:

• customer complaints;
• heightened supervision;
• any failure to comply with the firm’s written supervisory procedures;
• any recordkeeping violation; and
• regulatory communications indicating failure to reasonably supervise another person.

The firm must take into account any high-risk activities at the location or a higher-risk associated person at the location. The firm’s supervisory system must consider any “red flags” (indicators of irregularities or misconduct) when designating a location as an RSL.

Key Takeaways

All firms should carefully consider the potential impacts from the cessation on May 31, 2024, of the Reg. Notice 20-08 temporary relief with regard to Form U4 and BR filing requirements, as well as potential Form CMA triggers as a result of increased office counts. Furthermore, member firms seeking to mitigate such impacts by taking advantage of the new RSL rule will need to:

• develop new RSL-specific policies and procedures addressing the new requirements;
• assess supervisory processes and controls to determine whether the firm has the appropriate surveillance and technology tools to enable compliance; and
• begin identifying eligible associated persons and conducting risk assessments accordingly before the designation of RSLs.

Firms should also consider Rule 3110.19 in conjunction with the newly adopted Rule 3110.18. Rule 3110.18 establishes the Pilot Program, a voluntary three-year program that permits eligible member firms to fulfill their obligations under Rule 3110(c)(1) with respect to inspection of qualified branch offices, including OSJs and RSLs, remotely. Under Rule 3110.18(i), a firm must affirmatively elect to participate in the Pilot Program through an “opt-in notice.”

Open enrollment for Pilot Year 1 is between June 1, 2024, and June 26, 2024. Additional requirements, conditions, and eligibility criteria apply for the Pilot Program.