Effect of Recent New York City Amendments May Limit Brokers and Advisers in Conducting Credit and Background Checks on Potential Employees

The New York City Council recently passed two amendments to the New York City Human Rights Law that are likely to substantially affect the manner in which firms in New York City may evaluate the qualifications and background of potential new employees. The Stop Credit Discrimination in Employment Act (SCDEA) mandates that, as of September 3, 2015, employers may not conduct credit checks on potential new employees. The Fair Chance Act (FCA) requires that, beginning October 27, 2015, employers may not conduct a criminal background check or examine a potential employee’s arrest or conviction record until after they have given the potential employee a conditional employment offer.

This Dechert OnPoint focuses on the application of these laws to SEC-registered investment advisers and broker-dealers that are subject to the laws of New York City.

Overview of the SCDEA and FCA

The SCDEA generally makes it unlawful for employers to request or use a potential employee’s credit history when the employer makes hiring or other employment determinations.¹ The SCDEA applies to both potential and existing employees in any context in which an employment determination is made.² Thus, the SCDEA prohibits an employer from taking into consideration credit history – including, without limitation: credit reports; credit scores; and other information regarding a person’s credit, bankruptcies, judgments or liens – in hiring, promotion and firing decisions.³ Even a request by an employer to review such information prior to a conditional offer of employment is potentially a violation of the SCDEA. Only under certain narrow and specified circumstances, which are further discussed below, may an employer conduct a check on a potential employee’s credit history.

The FCA prohibits employees from reviewing certain information prior to a conditional offer of employment. The FCA makes it unlawful for employers to request or to use a criminal background check, or a person’s arrest or conviction record, when making employment determinations. Unlike the SCDEA, firms can request and use criminal background information after a conditional offer for employment has been made, provided that certain procedural steps are followed. As discussed further below, the FCA also includes specific exceptions to its broad prohibitions.

Broker-Dealer Recommendations

Despite these new requirements for employers, broker-dealers are likely to be exempt from the SCDEA’s and FCA’s requirements in certain instances. Both acts contain a specific exception for broker-dealer employers that are regulated by the Financial Industry Regulatory Authority (FINRA). Accordingly, credit checks are allowed if they are mandated by state or federal law, by regulation, or by a self-regulatory organization (SRO) as defined in Section 3(a)(26) of the Securities Exchange Act of 1934.⁴

FINRA Rule 3110(e), which was approved by the Securities and Exchange Commission (SEC) and became effective on July 1, 2015, requires each FINRA member firm to investigate the “good character, business reputation, qualifications and experience” of an applicant before registering the person with FINRA. FINRA Rule 3110(e) also mandates that each FINRA member firm implement written procedures to permit them to verify the accuracy and completeness of information contained in a potential employee’s Form U4 (Uniform Application for Securities Industry Registration or Transfer) no later than 30 calendar days after it is filed with FINRA. At a minimum, the procedures require a search of reasonably available public records to verify the accuracy and completeness of the Form U4 information. Therefore, Form U4 requires applicants to make specific disclosures about their criminal history, regulatory action history, civil judicial and litigation history, and personal financial history (including bankruptcies). Because Rule 3110(e) and Form U4 were promulgated by FINRA in its capacity as an SRO, broker-dealers in New York City can qualify for an exception from the SCDEA, and may conduct the credit checks required by FINRA that would otherwise be prohibited by the SCDEA.

However, broker-dealers should be mindful to not go beyond the credit checks or due diligence inquiries that are explicitly required by FINRA, because only those that are explicitly required are exempt from the SCDEA’s ban. For example, broker-dealers are required to investigate and verify Form U4 information of potential employees by running database searches for lawsuits, liens, garnishments, etc. to look for items that were incorrectly disclosed or omitted from Form U4 required information. However, such a search must be limited to the confines of Form U4 or other SRO requirements and cannot be used as a mechanism to conduct a general search of everything related to a potential employee’s credit background. In addition, it must be limited to those requirements in Form U4 or other SRO requirements that are specifically mandated as a pre-condition to employment with the broker-dealer and not merely those that are required to be disclosed.⁵ As discussed below, the SCDEA is interpreted strictly and only those employees who are specifically covered by FINRA rules will be covered by the SCDEA exception. The SCDEA does not provide a blanket exemption to all employees of broker-dealers, and only exempts those where there is a specific legal or SRO requirement to conduct a credit check.

Investment Adviser Recommendations

Unlike broker-dealers, investment advisers are not governed by an SRO, and there is no federal law that mandates background credit checks for employees of SEC-registered investment advisers.⁶ Other than requirements to disclose in an investment adviser’s Form ADV, information as to convictions, certain pending proceedings, or bankruptcies, there is no federal requirement that mandates a criminal background check on an investment adviser. Therefore, SEC-registered investment advisers likely will not be able to rely on the type of exemption that broker-dealers can generally use for both the SCDEA and FCA.

Nonetheless, there are various provisions in the SCDEA and FCA that may allow investment advisers to conduct credit or background checks on potential employees in certain circumstances. The SCDEA provides for several exceptions, some of which may be applicable to investment advisers. As the SCDEA notes, credit checks can be permitted for certain positions, such as: (i) positions that are non-clerical and involve “having regular access to trade secrets, intelligence information or national security information;” (ii) positions that require “having signatory authority over third party funds or assets valued at $10,000 or more” or that involve “a fiduciary responsibility to the employer with the authority to enter financial agreements valued at $10,000 or more on behalf of the employer;” or (iii) positions that involve “regular duties that allow the employee to modify digital security systems established to prevent the unauthorized use of the employer’s or client’s networks or databases.” Therefore, if an investment adviser can show that one of the above exceptions applies to the hiring of a potential employee, the SCDEA’s requirements may not be applicable.

The New York City authorities have indicated that they will construe any exceptions narrowly. In its enforcement guidance (Guidance), the New York City Commission on Human Rights (NYC Commission) has stated that it will interpret the SCDEA broadly, noting that the City Council intended for the SCDEA to “be the strongest bill of its type in the country prohibiting discriminatory employment credit checks."⁷ Moreover, the term “trade secrets” is defined narrowly and will need to be carefully examined by an investment adviser to determine whether the particular exception can be met.⁸ For example, it may be applicable to investment advisers with regard to employees that will have access to information, such as investment opportunities or proprietary models. The Guidance notes, however, that trade secrets do not include “general proprietary company information such as handbooks and policies” or “access to or the use of client, customer, or mailing lists.”⁹ Trade secrets also do not include information that is regularly collected in the course of business or regularly used by entry-level and non-salaried employees, or their supervisors or managers. Investment advisers should therefore distinguish within their firm between different types of employment roles to determine which, if any, would require their employees to have regular access to “trade secrets.”

Separately, an employer could perform such checks if the potential employee will work in a position that involves signatory authority over third-party funds or assets that are valued at $10,000 or more, or if the employee will have a fiduciary responsibility that allows him/her to enter into financial agreements that are valued at $10,000 or more. The Guidance notes, however, that the latter prong does not apply to the entire staff of a finance department, but is intended to cover (among others) Chief Financial Officers and Chief Operating Officers.

Background checks are also permitted on the potential employees who are expected to work with digital security systems that are designed to prevent the unauthorized use of the firm’s or its clients’ networks or databases. The SCDEA allows firms to conduct credit checks in these situations, but limits the scope of this exception. As stated in the Guidance, the exception applies to the Chief Technology Officer or a senior information technology executive, but not to persons that generally access computer systems or networks available to employees.

Employers that claim an exemption must maintain records sufficient to show that the position falls under one of the enumerated exemptions included in the SCDEA, and should inform applicants or employees of the applicable exemption. Employers should also keep such records for a period of five years from the date that the exemption is used.¹⁰

Additional Considerations

In making determinations as to whether an exemption applies, employees should be mindful of the limitations on the scope of any such exemption. Related guidance from the NYC Commission notes that “Employers will be held liable even if they are honestly mistaken about whether or not an exemption applies.”¹¹ Therefore, employers should take care to examine whether an exception applies to a particular situation.

Moreover, the SCDEA applies to part-time workers, undocumented workers, interns, many independent contractors, and probationary workers.¹² As long as the employer has four or more employees, compliance with the SCDEA is required.¹³

The SCDEA is focused solely on credit history information. The Guidance states that employers may research potential employees’ background and experience, evaluate their resumes and references, and conduct online searches to obtain information.

Fair Chance Act

The FCA prohibits firms in New York City from engaging in criminal background checks or examining a potential employee’s arrest or conviction history prior to an employment offer. The FCA notes that “it shall be an unlawful discriminatory practice for any employer, employment agency or agent thereof to […] [m]ake any inquiry or statement related to the pending arrest or criminal conviction record of any person who is in the process of applying for employment with such employer or agent thereof until after such employer or agent thereof has extended a conditional offer of employment to the applicant.”¹⁴

These prohibitions apply to application questions, interview questions, and online searches of public records or databases regarding an individual’s criminal background. The FCA notes that “any inquiry” includes any question communicated to an applicant, as well as any searches of publicly available records or consumer reports that are conducted for the purpose of obtaining an applicant’s criminal background information.¹⁵ This includes questions by broker-dealers related to an applicant's background that are not specifically required by Form U4 or other SRO requirement and includes questions in Form ADV for investment advisers. Once a conditional offer of employment has been extended, an employer is permitted to review a person’s criminal background information.

Similar to the SCDEA, the FCA also provides exceptions where the inquiries are required by law or mandated by an SRO.¹⁶ However, the FCA does not provide many of the other exceptions that the SCDEA permits with respect to (among others) trade secrets, signatory authority, or digital security systems. In addition, the FCA does not provide an exception for SEC-registered investment advisers that are required to disclose felony convictions or charges against their employees, or those of an advisory affiliate.¹⁷ Because the obligations regarding investment advisers as to prior convictions are disclosure-oriented and do not prohibit the employee from being employed by the investment adviser, investment advisers do not qualify for this exception under the FCA. As such, whereas Form U4 contains specific requirements that mandate criminal background checks for employment purposes, Form ADV does not; it only asks questions for disclosure, and not employment, purposes, which would not be exempted from the requirements of the FCA.

Employers may need to change their procedures to implement certain notification protocols if background checks are conducted after a conditional offer of employment has been made. If the employer decides to take adverse action after extending an offer of employment, the employer must:

1. inform the potential employee of the employer’s actions;
2. review the degree to which an arrest or conviction history applies to the particular position;
3. give the potential employee a copy of the analysis and any supporting documentation;
4. and keep the position open to allow the applicant to respond.¹⁸
    

Significantly, as part of taking potential adverse action after extending a conditional offer of employment, the employer must follow the standard set forth in Article 23-A of the New York Corrections Law.¹⁹ Section 12-A of the Article states that an application may be acted upon adversely only if “(1) there is a direct relationship between one or more of the previous criminal offenses and the specific license or employment sought or held by the individual; or (2) the issuance or continuation of the employment would involve an unreasonable risk to property or to the safety or welfare of specific individuals or the general public.” In determining what constitutes an “unreasonable risk,” Section 753 of the New York Corrections Law details multiple factors that should be considered with respect to previous criminal convictions.²⁰ This analysis, however, needs to be conducted with respect to each potential employee on an individual basis, and can only occur after the conditional offer of employment has been extended.²¹

Dual Registrants

An entity that is regulated as both a broker-dealer and an investment adviser would be exempt from these requirements to the extent that the exemption arises from the entity’s role in either capacity. As such, as long as it can show that certain employment actions are exempt because of the entity’s function as a broker-dealer or because it meets one of the other exceptions, the entity can still conduct credit or criminal background checks prior to providing a conditional employment offer.

Violations

Under the SCDEA and FCA, employees and potential employees may assert claims that include, but are not limited to, back and front pay, and compensatory and punitive damages.²² In addition, the NYC Commission can pursue claims under the SCDEA and can apply civil penalties of up to $125,000 for violations, or up to $250,000 for violations that arise from willful, wanton or malicious conduct.²³

Conclusion

The SCDEA and FCA provide additional limitations on the employment practices of financial services firms, including broker-dealers and investment advisers. The SRO exemption may exclude broker-dealers and dually registered broker-dealer/investment advisers from many of the requirements. However, the question of whether any other exemptions apply necessarily entails a fact-specific analysis that depends on the nature of the employment of the potential employee.