All jobs have their perks: Starbucks baristas get free coffee, movie critics get advanced screenings, rockstars get groupies. The securities brokers of a NASD-licensed trading firm, however, get one of the most exclusive (and potentially lucrative) perks around: access to financial products that the SEC allows only accredited individual investors and other FINRA members to trade.
Each NASD brokerage firm has its own trading strategies and expects its brokers to sell the products that reflect these strategies. Yet, outside of work, brokers are allowed to buy and sell other FINRA-restricted products, so long as they adhere to the prescribed NASD & NYSE guidelines for such "Private Securities Transactions."
Definition
A "Private Securities Transaction", as defined by the NASD, is the sale of a security by a broker working for a NASD-licensed firm wherein a) the security is not recognized by the employer or typically sold by the broker, b) the broker receives outside compensation for the transaction, or c) both.
The SEC, the NASD and FINRA
On October 24, 1929, the world's largest stock exchange---the New York Stock Exchange (NYSE)---began the devastating month-long downturn known as "The Great Crash of 1929." This violent implosion of market capitalization increased the economy's existing downward momentum and triggered other events that ultimately resulted in the Great Depression.
To prevent against future market crashes, federal lawmakers passed The Securities Acts of 1933 & 1934. These acts required that, in order for a security to by sold in public exchanges, potential investors must be provided with extensive information regarding its finances and operation. The U.S. Securities and Exchange Commission (SEC) was created to enforce these regulations and pass new ones if need be.
However, the SEC was primarily created to secure the integrity of public markets (that is, stock exchanges). With private securities (known collectively as the "Over-The-Counter" (OTC) market), the products were often one-of-a-kind and transactions were too de-centralized to fit into any single reporting template. Therefore, the Maloney Act of 1938 allowed private securities dealers to self-govern, leading to the formation of the National Association of Securities Dealers (NASD) in 1939. The NASD, through the authority of the SEC, wrote its own regulations of OTC transactions and acted as arbitrator between clients and NASD-licensed firms. Meanwhile, in the public markets, the SEC transferred many of its day-to-day regulation enforcement responsibilities to the NYSE.
Finally, in 2007, NYSE's enforcement department and the NASD were combined into a single entity: the Financial Industry Regulatory Authority (FINRA).
NASD Rule 3040
FINRA (formerly NASD) is pretty strict about who is allowed to trade private securities on the OTC market because it helps keep the confidence men and other criminal enterprises out of the industry. However, brokers employed by NASD-licensed firms aren't subjected to the same rigorous vetting process, and are thus merely "associates" (as opposed to licensees). Because of this distinction, brokers can only promote, sell and trade a particular security if their firm allows them to.
So, if a broker finds a new security offer that is still unregistered with FINRA (such as, private limited partnerships, preferred stock, promissory notes (basically IOUs that list principal, interest and a repayment promise) and real estate) and wants to sell it to one of his clients, NASD Rule 3040 says he has to first submit a written proposal to his boss, detailing what's being sold, who it's being sold to, what his involvement is with the seller and what, if any, compensation he'll be getting for brokering the transaction. The broker's boss must then not only agree to the transaction, but oversee it as well, before it can go through.
In fact, if a broker is offered outside compensation for selling any security (whether it's registered or unregistered), it automatically qualifies as a "Private Securities Transaction" and he must submit a written proposal to his boss before executing it.
Selling Away
If the transaction doesn't follow Rule 3040, it stops being a "Private Securities Transaction" and becomes a crime called "Selling Away." And then you get fired and go to prison.
Selling Away is a slippery slope. For most people, it's just a way to save paper work. For others, however, it opens the door to multi-million dollar confidence scheme, using the legitimate, NASD-licensed company as a front.
Just as a hypothetical example, assume you are a charming securities broker who's early successes won you lots of wealthy referrals. The year is 1997 and the dot-com bubble is booming; people with throw money at anything with a URL. Without Rule 3040, you could, using the credibility of your firm, offer clients the chance to get in on the "ground floor" of an undiscovered (and non-existent) software start-up, calling it the next "Microsoft," but only if they promise to keep quiet (that is, don't mention it to your boss). If they agree, their money gets wired to a dummy bank account, you give them a worthless piece of paper and either live it up until you get caught or disappear to some remote island paradise. Yet, back in America, your clients could sue your former employers (despite their innocence) for tens of millions.
Legitimate Uses of Private Securities Transactions
If you're a small business owner trying to expand operations or an entrepreneur trying to start a business, selling debt or an LLC membership through a Private Securities Transaction lets you raise the capital you need without having to spend the time and money involved in registering with the SEC and preparing an Initial Public Offering (IPO).
