Whether you are a registered representative looking to become a registered principal, or are currently functioning as a registered principal, it is important to keep the communication requirements of the Financial Industry Regulatory Authority (FINRA - formerly the NASD) at the forefront of your mind. While not all communications with the public must be filed with FINRA, they must be kept in accordance with FINRA recordkeeping requirements contained in NASD Rule 2211 - Institutional Sales Material and Correspondence.
Among other items, Rule 2211 was established to provide a clear definition of recordkeeping requirements for institutional investor sales literature. Disregarding this rule could result in the loss of your license. Read on to make sure you and this rule are working together.
Who Is an Institutional Investor?
Rule 2211 defines an institutional investor as any:
- Entity described in Rule 3110(c)(4) such as a bank, savings and loan association, insurance company or registered investment company; an investment advisor registered either with the Securities and Exchange Commission (SEC) under Section 203 of the Investment Advisors Act of 1940 or with a state securities commission (or any agency or office performing like functions); or any other entity (whether a natural person, corporation, partnership, trust, or otherwise) with total assets of at least $50 million;
- A governmental entity or subdivision thereof;
- An employee benefit plan that meets the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and has at least 100 participants, but does not include any participant of such a plan;
- A qualified plan, as defined in Section 3(a)(12)(C), which is any entity that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities; is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such issuer's total assets (excluding government securities and cash items) on an unconsolidated basis; that has at least 100 participants, but does not include any participant of such a plan;
- A FINRA member or registered associated person of such a member; or
- A person acting solely on behalf of any such institutional investor
Other Situations Covered
Rule 2211 also covers situations where the preparing member firm may be in non-compliance if it had prior knowledge (or it can be reasonably assumed) that a piece of sales literature will be shown to non-institutional audiences. This could happen if a registered representative shows institutional sales literature to a company's executive board or senior management. In these instances, the registered representative has a duty to discuss the intended audience with the individuals who prepare the sales literature.
If the registered principal knows that the sales literature will likely fall into the hands of non-institutional audiences, he or she can include additional explanations, including "legalese to plain English" translations to ensure transparency amidst a sea of required disclosures.
Registered Principal Approval and Recordkeeping
NASD Rule 2211 provides registered principals with a set of standards to objectively review communications. One of the most common areas of noncompliance is a lack of documentation to substantiate proprietary and third-party claims. For example, investment managers often make claims about the market or a specific product. These claims are largely derived from quantitative sources (i.e., Morningstar, Ibbotson, etc.) and can be easily documented.
However, many investment managers also use quantitative data, which could include experience-based inferences about specific products and/or the market, which can result in communications that contain unsubstantiated/unwarranted claims in the eyes of the regulators.
In cases where the investment manager has made an unsubstantiated/unwarranted claim, the registered principal must determine whether the investment manager's experience is reasonable, given the markets and the particular product, as well as clearly disclose the investment manager's inferences as professional opinions - not necessarily statements of fact.
Reviewing Institutional Sales Literature
NASD Rule 2211 states that most of the standards and guidelines require a significant level of internal controls to ensure compliance. In general, each member firm must establish written procedures about the use of proprietary and third-party data, which would include limitations on distribution to certain institutional investors. The procedures must be in written form, and communicated (i.e., internal training) to each registered representative. In addition, member firms must maintain sufficient documentation to substantiate the efficiency of internal controls.
Recordkeeping for Institutional Sales Literature
NASD Rule 2211 also states that members must maintain all institutional sales material in a file for a period of three years from the date of last use. The file must include the name of the person who prepared each item of institutional sales material. The file must also contain information concerning the source of any statistical table, chart, graph or other illustration used by the member in communications with the public.
Does FINRA Have a Recordkeeping Form?
There is no standard FINRA recordkeeping form. Each member firm must create a custom form that allows registered principals to account for each specific review and recordkeeping requirement including the intended audience, dates of use, quantities in distribution and how/when regulatory comments have been incorporated. The forms are typically used by members of the marketing and communications department, but they are also used by individual brokers and wirehouses.
Regulatory Audits: Showcasing Your Firm's Stellar Internal Controls
The primary purpose of recordkeeping forms is to help the regulators (FINRA, SEC, state insurance and municipal boards, etc.) facilitate an effective communications audit with member firms. And because most individual investor sales literature is filed with regulatory authorities, much of the audit will typically be spent reviewing institutional sales literature - particularly communications between mutual-fund companies and the registered representatives selling their products.
The regulators want to see what kinds of promotions mutual-fund companies are presenting to brokers, especially communications that promote increased commissions and exaggerated or unwarranted claims about product features and benefits; including recommendations on suitability and selling practices. They also want to see proprietary data collection and analysis methodologies to ensure that sales literature is fair and balanced and is devoid of "cherry-picking" product performance.
Maintaining a Clean Record with Regulators
As a registered principal, your primary goal is to maintain a spotless record with regulators. You can maintain a clean record with the FINRA by keeping one question at the forefront of your mind: "Would you be willing to stand in front of an FINRA or SEC panel and put your license on the line, stating that the communication you approved was thoroughly reviewed and maintained?" If you have had doubts during the initial review, or during subsequent spot checks, make it a top priority to resolve those doubts.
The Bottom Line
The recordkeeping and review requirements require a heightened sense of diligence from registered principals. As you become more experienced, you will discover your own "Zen-like" approach to dealing with frequent pressures from aggressive sales personnel - those who liberally develop communications on their own, and expect overnight approval because they want to present the communication to an institutional client in the morning. Sometimes this means you'll have to decide which firing squad you'd rather face - your employer or the regulators.
For more reading on this subject, see the FINRA's member notices "Disclosure of Fees and Expenses in Mutual Fund Performance Sales Material" (April 2007) and "Principal Pre-Use Approval of Certain Member Correspondence Sent to 25 or More Existing Retail Customers within a 30 Calendar-Day Period" (December 2006).