30
For Advisor Use Only
January/February
2014
constitutes selling away. This is a serious violation of Rule
3040 and firm policy and one that can result in the advisor’s
immediate termination from Commonwealth for cause.
What if the advisor hasn’t received or doesn’t expect
to receive selling compensation?
Advisors often believe
that, if they did not receive a commission associated with
their participation in a private securities transaction, they
could not have violated Rule 3040. “Selling compensation,”
however, has a much broader definition.
The rule states that selling compensation shall mean “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, though not limited to,
commissions; finder’s fees; securities or rights to acquire
securities; rights of participation in profits, tax benefits,
or dissolution proceeds as a general partner or otherwise;
or expense reimbursements.”
In addition, FINRA has consistently held that an
advisor’s receipt of “anything of value” equates to selling
compensation under Rule 3040. According to FINRA,
an existing client relationship between an advisor and an
investor automatically constitutes selling compensation
because the relationship itself is something of value. In
other words, if the transaction in question involves an
existing client of the advisor or Commonwealth, it is
automatically assumed that the advisor has received
selling compensation, whether or not he or she receives
compensation tied specifically to the private securities
transaction in question.
If Commonwealth’s Investment Research staff has
reviewed a product’s performance and portfolio
makeup, why can’t the advisor relay that information
to the client and provide a recommendation?
Broker/dealers are required to perform due diligence on
a security prior to permitting any associated person to
make a recommendation to an investor or prospective
investor about the security. Due diligence involves more
than reviewing performance and portfolio makeup from
third-party sources.
When our Investment Research team performs due
diligence on a nontraded product, it conducts a thorough
background investigation of the key people at the sponsor
company. It also requires the product sponsor to complete
a due diligence questionnaire, which Commonwealth
reviews initially and on an ongoing basis. In addition,
Commonwealth reviews offering materials and other legal
documents, financial books and records, investment
methodology, custodians and escrow agents, use of
proceeds, existence and adequacy of insurance coverage,
past disciplinary history, and more. Moreover, the
process typically includes an on-site visit.
Further, there can be potential conflicts of interest that
may not appear on the surface. For example, the advisor
could recommend selling a security and receive no apparent
compensation. But since there is a reasonable likelihood
that the proceeds generated from the sale would be used
to purchase securities or provide advisory services for which
the advisor would likely receive compensation, an underlying
potential for compensation-based conflict exists.
If a member firm were to approve participation in a
private securities transaction, is there a books-and-records
requirement?
Yes, as discussed above, Rule 3040 requires
any advisor’s participation in a private securities transaction
for compensation to be recorded in the books and records
of the advisor’s broker/dealer. In addition, the firm must
Compliance & Regulation
