CLIENT NEWSFLASH

FINRA Proposes Rule on the
Use of Third-Party Service Providers

April 12 , 2011

After many years of negotiations with the SEC staff, FINRA recently proposed for comment Rule 3190 to clarify the scope of the obligations and supervisory responsibility of member firms for functions outsourced to third-party service providers.  The rule would reiterate current restrictions on all member firm’s outsourcing arrangements while also applying new and heightened obligations to clearing and carrying firms.  In addition, the proposed rule explicitly treats affiliates like any other third-party provider and requires notice to FINRA of outsourcing arrangements.  The comment period expires on May 13, 2011.

Obligations and Supervisory Responsibilities Regarding Outsourcing Arrangements

The requirements in proposed FINRA Rule 3190 applicable to all member firm’s arrangements with third-party service providers largely codify and align with prior FINRA guidance in this area (most notably NASD Notice to Members 05-48).  These include:

  • No Delegation of Ultimate Compliance with Applicable Laws and Rules: A firm’s delegation of a function or activity related to a firm’s business as a regulated broker-dealer to a third-party (including a corporate affiliate) does not relieve the firm of ultimate responsibility for compliance with applicable requirements.  Moreover, a firm may not delegate its responsibilities, or control over, any activities performed by the third-party service provider.  Although it is not clear from the text of FINRA’s proposal, it is unlikely that FINRA intended to allow outsourcing of control of general supervisory or compliance functions.
  • Due Diligence:  Each firm must establish and maintain a supervisory system and written procedures for any functions performed by a service provider that are reasonably designed to comply with applicable requirements.  Such procedures would include an initial consideration and an ongoing due diligence analysis by the firm of the vendor to determine (i) that such vendor is capable of performing the outsourced function and (ii) if the firm can achieve compliance with applicable requirements with respect to any outsourced functions.

  • Exceptions:  The rule would not apply to ministerial activities, nor would it restrict activities performed under a carrying agreement approved under FINRA Rule 4311.

Heightened Restrictions on Clearing or Carrying Firms

Proposed FINRA Rule 3190 would impose heightened restrictions and obligations on clearing or carrying members, on the rationale that there is increased risk due to such firms’ roles in protecting customer funds and securities. 

  • Activities that Must be Performed by Associated Person:  The proposed rule would limit enumerated activities to an appropriately registered associated person subject to the direct control and supervision of the clearing or carrying firm.  Such specified activities include the movement of customer proprietary cash or securities; preparation of net capital reserve formula computations; and the adoption or execution of compliance or risk management systems, subject to limited exceptions for ministerial activities.

  • Additional Supervisory Procedures: A clearing or carrying firm would be required to adopt additional procedures to oversee third-party service providers to ensure the firm could take prompt corrective action if needed to ensure compliance with applicable requirements, and to require the firm to approve the use of sub-contracting by the third-party vendor.
  • Notification Requirements:  The proposed rule imposes new notification requirements of a clearing or carrying firm’s outsourcing arrangements.  Within 30 days of entering into an outsourcing arrangement, a clearing or carrying firm would be required to provide to FINRA specified information (e.g. function to be performed, description of affiliation, identity and regulator of the vendor).  Clearing or carrying firms would need to notify FINRA of all existing outsourcing arrangements within three months of the effective date of the rule.  In the proposal, FINRA suggests that (while not required by the proposed rule) a clearing or carrying firm may seek FINRA’s review prior to entering into an arrangement with a third-party provider.

The proposal would need to be filed with and approved by the SEC prior to becoming effective.

Click here for the proposed rule.

     

 

 

If you have questions regarding this newsflash, please contact any of the lawyers listed below or your regular Davis Polk contact.

Robert L.D. Colby202 962 7121robert.colby@davispolk.com
Annette L. Nazareth 202 962 7075 annette.nazareth@davispolk.com
Lanny A. Schwartz212 450 4174lanny.schwartz@davispolk.com
Gerard Citera 212 450 4881 gerard.citera@davispolk.com
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