December 19, 2001

Starting Your Own NASD Broker-Dealer:  First you take three steps, then another four steps, but watch out for that last one --- it's a doozy!

By Bill Singer,Esq. and Sheryl Anne Zuckerman, Esq.

Have the events of September 11, 2001, made you re-think your career?  Has your employer announced cut-backs and layoffs?  Have you finally arrived at the conclusion that it's time you opened your own NASD broker-dealer and became your own boss?  

Over the years, many registered persons have pondered this version of the American dream…but more so now than ever in these uncertain and crazy times. But there's a catch . . . and it's not Catch 22 but Catch 3030.  As it is currently written, NASD Conduct Rule 3030 states:

3030. Outside Business Activities of an Associated Person

EXPLORING THE POSSIBILITIES

You're presently working for XYZ Broker-Dealer.  Word is out that the company may either be closing, firing 30% of its salesforce, or selling to ABC Broker-Dealer (and you don't like that outfit).  You and a few colleagues spoke one evening and agreed that it may make sense to explore the possibility of opening  your own firm --- just in case.  You investigate the process and learn that you could file a Form BD and initiate the registration of the new firm through the NASD --- however,  you don't actually need to open the company immediately.  In fact, if the market turns around and XYZ stabilizes, maybe, just maybe, you could let the registration lapse. 

So, now you're in a quandary: should you go ahead, submit the paperwork, engage in the six months of filing and waiting, and then "shelve" the entire project if you change your mind, or, should you simply wait until you are certain you want to open your own firm (but then be faced with something like a six-month delay)?

MUST YOU DISCLOSE YOUR PLANS IN ADVANCE?

Then one of your friends raises a troubling question.  You don't really want XYZ to know that you're pursuing opening your own firm.  After all, if they find out they may assume that rather than the Form BD providing you with some insurance, your real intention is to leave and compete.  And if your employer gets wind of what you're up to, well, it may simply be expedient to fire you next and keep someone more loyal.

Now what exactly are your obligations under NASD Conduct Rule 3030?  If you and each of your colleagues deposited $5,000 in a newly opened corporate bank account and used those funds to pay attorney's/accountant's fees and the costs of filing the Form BD, is that activity beyond a "passive investment?" If you merely file the Form BD application, absent more, are you receiving "compensation."  Does the act of establishing a broker-dealer constitute being "employed by" by that entity? And these questions are critical, because a "yes" answer means you have to provide your employer with "written notice."  Of course, once your employer learns about your plans, you may well be out on the street.

This issue of whether Rule 3030 is triggered within the context of applying for and/or receiving approval to operate a BD appears likely to recur with some frequency in upcoming months. Additionally, it's not just a concern for the registered persons seeking to start their own BDs, but it also raises reporting questions on behalf of the current employer --- if I find out that they're engaged in the outside business activity of creating a new BD without notifying me, isn't that a reportable violation of Rule 3030?

Notwithstanding the sense that there's nothing new under the sun in securities industry regulation -- we seemed to have set foot on undiscovered land. Consequently, Singer Frumento LLP recently posed this issue to the NASDR Office of the General Counsel ("OGC") for some definitive interpretive guidance regarding Rule 3030's application. Sure enough, even the Staff conceded that there was no clear-cut, readily apparent interpretation of this Rule.  Please read the verbatim letter sent by us to NASDR, and the regulator's subsequent response.

LETTER FROM SINGER FRUMENTO LLP TO NASDR

September 24, 2001

Sarah Williams, Esq.
NASD Regulation, Inc. 
Office of the General Counsel 
1735 K Street NW 
Washington, D.C. 20006

Re: Request for Interpretive Guidance Regarding the Application of NASD Rule 3030 

Dear Ms. Williams: 

In recent months we have all watched with much concern as the economy has slowed and the market has substantially declined. Unfortunately, the unprecedented attack on the World Trade Center that has so devastated every aspect of our lives has now, not surprisingly, wreaked havoc on the market. Businesses are shaky and layoffs mount daily. Understandably then, many registered persons are concerned for their futures and several, although currently employed, have contacted this law firm about setting up their own broker-dealer ("BD"). Their reasons are generally twofold: 

Some registered persons anticipate being laid off (or their employing BD will terminate business) and, in order to safeguard their future, have decided to start their own BD. This segment of clients understand that it will be some months before their BD application is approved by SEC and NASD, and even longer until they are operational. Consequently, these registered person do not intend to resign from their jobs at this point in time.

Another group of registered persons have long intended to open their own firm and, but for recent events, would be aggressively pursuing a new member application. However, given the personal tragedies that have impacted many BDs these past few weeks, some of these applicants have temporarily deferred their plans to resign from their current employer and open their own firm. Thus, a typical scenario would be as follows: XYZ BD currently employs RR Doe. While still working for XYZ, RR Doe submits an application seeking approval to open NEW BD (with RR Doe being one of the principals of the firm). During this nascent stage, no business is being conducted at NEW BD and RR Doe currently receives no compensation from the new firm. Additionally, at this stage RR Doe is not engaged in any activity that is in actual conflict or competition with XYZ BD. Given that NEW BD has not commenced a securities business, RR Doe does not believe that the mere application for and subsequent approval of NEW BD places her current BD employer at any regulatory or arbitration risk. 

Still, after reviewing the NASD's Conduct Rules, RR Doe finds herself in somewhat of a dilemma. NASD Rule 3030: "Outside Business Activities of an Associated Person," states in pertinent part that 

[n]o person associated with a member in any registered capacity shall be employed by, or accept compensation from, any other person as a result of any business activity, other than a passive investment, outside the scope of his relationship with his employer firm, unless [s/he] has provided prompt written notice to the member. Such notice shall be in the form required by the member. [emphasis added] 

NASD Notice to Members--88-5 (Request for Comments on Proposed NASD Rule of Fair Practice Regarding Outside Business Activities), states that the purpose of NASD Rule 3030 is 

[T]o inform member firms of the nature and extent of the outside activities of their principals, associated persons, and employees so the firms can more effectively carry out the supervisory responsibilities mandated by the NASD Rules of Fair Practice and the federal securities laws. 

Although the rule appears on its face to be straight forward, nowhere in the Association's rules, regulations, Notices to Members or Interpretive Letters has there been any definition of "employed by." Does the mere affiliation of RR Doe as a founding principal of NEW BD constitute employment? If NEW BD does not commence a securities business, did NASD Rule 3030 intend to deem RR Doe an employee, such that notice of the outside activity is due? Additionally, if several associated persons decide to start a BD, and two are registered as principals and two solely enter into consulting agreements as independent contractors, are the latter contractors deemed "employed" within the ambit of 3030? Additionally, the rule references "accept[ance of] compensation from " any person. Even assuming an associated person of a BD submits an application for his or her own BD, absent any compensation, must that individual notify the current employer pursuant to Rule 3030? It remains unclear as to whether the rule contemplates notice arising out of any activity, whether presently compensated or not, or is actually limited to those activities where some compensation is accepted. For purposes of this Interpretive Letter we concede that the raising of capital for a BD would likely trigger the notice/approval requirements of the private securities transaction provisions of NASD Rule 3040. 

This scenario of when Rule 3030 is triggered within the context of applying for and/or receiving approval to operate a BD appears likely to recur with some frequency in upcoming months. Attached for your reference is a redacted opinion letter from another law firm, which opines that certain facts discussed herein do not trigger any notice requirement. However, there being no previous ruling on this issue, we believe that it would be imprudent to advise any BD or broker on this issue before seeking the Staff's insight and interpretation.

Please do not hesitate to contact me if you have any questions or require additional information. Thank you in advance for your assistance in this matter. I look forward to your response. 

Very truly yours, 

SINGER FRUMENTO LLP 

By: Sheryl Anne Zuckerman, Esq. 
Bill Singer, Regulatory Partner 

REDACTED OPINION LETTER FROM OUTSIDE COUNSEL

Re: OUTSIDE BUSINESS ACTIVITIES

You have requested that we summarize in writing the advice we have previously given you, and which you have relied upon, regarding your obligation to provide notice to your present employer as to your participation in ABC/BD ("Company") pursuant to NASD Rules 3030 and 3040. 

Based upon our understanding of the following:

i) you and your associates have formed the Company; 
ii) the Company is in the process of registering as a broker/dealer by filing a new member application pursuant to NASD Rule 1013; 
iii) the Company is not currently engaged in any business activity; 
iv) you are a Member of, but are neither employed by nor receiving compensation from, the Company; and 
v) you are an associated, person as to your current employer; we have advised you as follows: 

Specifically as to Rule 3030, which regulates outside business activities of associated persons: 

This Rule requires prompt, written notice to your employer of any unrelated employment or compensation you receive arising from any business activity other than your employment. As the Company is not engaged in any business activity, and you are not employed by, receiving compensation from or engaged in a business activity by virtue of your association with the Company, notice is not required. Prior to any such business activity or compensation commencing, written notice must be given to your employer without delay.

Specifically as to Rule 3040, which regulates private securities activities of associated persons: 

This Rule requires advance notice to your employer of your involvement in any nonpublic securities offering. The Company has not offered or issued any securities to anyone other than its founders (including you): If, and when, a private offering of securities is contemplated, then a written, detailed description of the proposed transaction must be provided to your employer prior to your involvement. Until such time, no notice is required or appropriate.

We arrived at these conclusions based upon the facts and information you provided and the underlying purpose of both rules, which is to prevent employees, while employed, from simultaneously serving two masters without disclosing that fact. As long as the Company remains inactive and you are not employed, compensated or aiding in the issuance of securities on its behalf, you are not engaged in an activity which obligates you to provide notice to your employer, pursuant to either NASD Rule 3030 or 3040.

LETTER FROM NASDR TO SINGER FRUMENTO LLP

December 6, 2001 

Singer Frumento LLP 
Sheryl Anne Zuckerman, Esq. 
40 Exchange Place 
20th Floor 
New York, NY 10025 

Re: NASD Rule 3030 

Dear Ms. Zuckerman: 

I am responding to your letter dated September 24, 2001 in which you seek advice on whether a registered person who is associated with a member firm would violate NASD Rule 3030: Outside Business Activities of an Associated Person by filing a membership application with the NASD to form a new broker/dealer without providing prompt written notice to his or her firm about such activity. 

Background 

According to your letter, your firm has been approached on numerous occasions by both member firms and associated persons seeking advice regarding the scope of NASD Rule 3030 in the circumstance where an associated person currently employed by a member firm forms a new company and files a membership application with the NASD pursuant to NASD Rule 1013. You state that in light of the recent tragedies of September 11, 2001 and their impact on the economy and the securities markets, this issue has greater significance because many registered persons who are concerned about their employing member firm terminating business, or anticipate being laid off, have contacted your law firm about setting up their own broker/dealers. 

You provide the following as a typical scenario:

XYZ BD currently employs RR Doe. While still working for XYZ, RR Doe submits an application seeking approval to open NEW BD (with RR Doe filing a Form U?4 as an associated person and principal of the new firm). During this nascent stage, no business is being conducted at NEW BD and RR Doe currently receives no compensation from the new firm. Additionally, at this stage RR Doe is not engaged in activity that is in actual conflict or competition with XYZ BD. Given that NEW BD has not commenced a securities business, RR Doe does not believe the mere application for and subsequent approval of NEW BD places her current BD employer at any regulatory or arbitration risk. 

In addition, you state that for purposes of this interpretive letter, you acknowledge that the raising of capital for a broker/dealer would likely trigger the notice/approval requirements of the private securities transaction provisions of NASD Rule 3040 --- Private Securities Transactions of an Associated Person.

Response 

NASD Rule 3030 provides that no associated person of a member shall be employed by, or accept compensation from, any other person as a result of any business activity (other than passive investment) outside the scope of his/her relationship with his/her employer firm, unless prompt written notice is provided to the member. NASD Notice to Members 88-5 (Request for Comments on Proposed NASD Rule of Fair Practice Regarding Outside Business Activities) indicates that the stated purpose of this rule is to enable member firms to receive prior notification of all outside business activities of their associated persons so that members can exercise appropriate supervision over the activities of their associated persons. 

Under the facts as you have described them in your letter, the staff believes that the notice requirements of NASD Rule 3030 are not triggered when, in an effort to apply for membership as a new broker/dealer, an associated person takes the following steps: (1) forms a company, (2) files an application on behalf of the company to become a member in accordance with NASD Rule 1013; and (3) files a Form U-4 with NASD designating such associated person as a principal of such company, provided, however, the associated person does not (1) accept any compensation from such company or other person (other than compensation received from the current member firm with which he or she is associated); (2) engage in any securities or investment banking activity on behalf of such company, (3) raise capital for such company, (4) solicit customers for such company, or (5) generally engage in any business activity on behalf of such company. 

During our phone conversations, you noted that the new membership application process requires RR Doe to file a Form U-4 as an associated person and principal of the applicant broker/dealer, and that the Central Registration Depository ("CRD") system discloses the filing of this Form U-4 (i.e., the associated person's current member firm could search the individual's records and see the filing of the second Form U-4). You raised some concern that this disclosure could have a potentially negative impact on RR Doe. Staff of the Office of General Counsel is discussing your concerns with staff in the CRD Department, as well as with staff in the Department of Member Regulation responsible for the membership application program. 

I hope this letter responds to your inquiry. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Directors of NASD Regulation. This letter responds only to the issues that you have raised based on the facts as you have described them, and does not address any other rule or interpretation of the NASD, or all the possible regulatory and legal issues involved. 

Sincerely, 

Kosha K, Dalal
Assistant General Counsel 

Cc: Emily Gordon, Director NASDR, Member Regulation/Regulation Policy 

Richard Pullano, Director NASDR, CRD/Membership-Policy and Guideline 

Catherine Shine, Senior Vice president and Director NASDR, District 10 

ANALYSIS

In essence, NASDR is now promulgating a three-point and a five-point test to determine whether Rule 3030 is triggered.  

THE MERE ACT STANDARD

The three-point test creates what I will call the "mere act" standard; i.e., the "mere act" of forming an entity or filing any forms attendant to the broker-dealer start-up process (e.g., Form BD, Form U-4).  Such mere acts, absent more, do not trigger the Rule 3030 reporting process.

However, NASDR promulgates a second five-point test, which directly modifies the mere act standard. This secondary guideline focuses on any associated persons involved with a nascent BD and precludes them from

1. accepting compensation other than from their current member firm;

2. engaging in securities/IB activity on behalf of the new BD;

3. raising capital for the new BD

4. soliciting customers for the new BD, or 

5. generally engaging in any business activity on behalf of the new BD.

Points 1 through 4 are fairly straight forward and comport with somewhat standard practices (particularly Rule 3040's prohibitions against private securities transactions).  Point 5 is troubling because in some sense it goes to the heart of the matter, yet delicately sidesteps the controversy.

ANY BUSINESS ACTIVITY

Assume that you've filed your Form BD for the registration of a new broker-dealer --- in fact you've even submitted Forms U-4 for several associated persons.  If you retain a real estate agent to look for possible space, is that a business activity on behalf of the new BD?  If you initiate discussions with a potential clearing firm, is that a covered activity?  The permutations of such questions could go on forever.  Suffice it to say that the NASDR's letter leaves a significant, unresolved issue:  what is business activity on behalf of the new BD? NASDR has pointedly prohibited securities/IB activity, yet subsequently adds, almost as an afterthought, conducts defined as "generally" engaging in business activity.  Generally as opposed to what . . . specifically?  And what differentiates generally engaging in business activity from engaging in securities/IB activity?  And, finally, assuming there's an outright prohibition on engaging in securities, Investment Banking, or business activity, then why not simply prohibit any business-related activity on behalf of the new BD?  What's missing is a working definition of "business activity."

Overall, the letter is helpful in that it is the first pronouncement on a ticklish issue --- we have three specific exempted acts and four clearly understandable covered acts.  But that last general business activity caveat remains a puzzle.  Proceed with caution.