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FINRA's new plans for firms with bad regulatory histories

Steven Lofchie, Cadwalader Wickersham & Taft, Partner, New York, 19 November 2020


The US Financial Regulatory Authority wishes to promulgate a new Rule 4111 (entitled "Restricted Firm Obligations") to make certain broker-dealers do more.

It intends to call these firms "restricted firms" and classifies them as firms that are risky for investors to use. It is also proposing to adopt the Capital Acquisition Broker Rule 412 in order to make it clear that all capital acquisition brokers ought to be subject to FINRA Rule 4111.

[Editor's note: FINRA sends each proposal for a new rule to the Securities and Exchange Commission, its superior regulator, which then reviews it to determine whether it is consistent with the Securities Exchange Act 1934. The SEC's staff may call for changes or amendments. If all goes well, the SEC publishes the rule for comment in the Federal Register. In general, the comment period is open for 21 days after publication. If the SEC then approves the final rule, it places an official announcement in the Federal Register. Later on, FINRA issues a Regulatory Notice that announces the rule's effective date.]

FINRA wants to target "member firms that have significantly higher levels of risk-related disclosures than similarly-sized peers" through a variety of quantitative tests based on the "conduct histories" of persons associated with them (i.e. (i) firms with a concentration of brokers that have a history of misconduct and (ii) broker-dealers with a history of significant compliance failures).

The proposed Rule 4111 seeks to subject each restricted firm to a "Restricted Deposit Requirement," obliging it to keep a deposit in a segregated account to ensure that funds are available for arbitration awards that relate to conduct at that firm. The rule is meant to lay down criteria to govern the approval of withdrawals from a "Restricted Deposit Account" and to forbid the firm in question to have any pending arbitration claims or unpaid arbitration awards.

The draft rule does not propose to impose any cap on the amount of the deposit requirement, nor is there to be any formula for setting that requirement. Instead, when it fixes the amount of a firm's maximum Restricted Deposit Requirement, FINRA has said that it wants to "take into consideration" the types of business that the firm does, its annual revenues, its net capital requirements, the misdeeds that caused the firm to become a Restricted Firm, and events such as "concerns raised during FINRA exams."

FINRA notes that the deposit amount should not be so high as to "significantly undermine" the firm's financial stability and capacity to operate. FINRA adds that it might subject a Restricted Firm to other obligations which might include limits on the types of business that it can do.

FINRA has proposed to make FINRA Rule 9561 to implement the new "Restricted Firm Obligations." This seeks to establish a process for expedited proceedings to ensure the timely review of a determination by FINRA's Department of Member Regulation on the application of Rule 4111.

Furthermore, FINRA is proposing to amend FINRA Rule 9559 so as to (i) outline the authority of a hearing officer with regard to Restricted Firm Obligations, (ii) provide timing requirements for hearings relating to Restricted Firms and (iii) bar a Restricted Firm from challenging the merits of the negative events that FINRA used to determine its status as a Restricted Firm.

Comments on the proposal must be submitted within 21 days after publication in the Federal Register.

The merits of the proposals

FINRA states that it has empirical evidence to prove that an employee who has been the subject of a "negative conduct finding" in the past is much more likely than an employee with a clean record to be subject of such a finding in the future. This accords with common sense as well.

In spite of the apparent benefits of the proposed rule, it is reasonable to ask whether it may be unduly arbitrary. For example, brokerage employees are tainted for having worked at firms with conduct-related problems, even though they have done nothing wrong themselves; this is also a feature of the existing FINRA Rule 3170 (the "Taping Rule").

Furthermore, the draft rule proposes to give FINRA total discretion to set the amount of the deposit. The supposed limitation on FINRA's authority - that the amount of the deposit should not threaten the firm's viability - seems absurd. If the firm is likely to be a substantial risk to investors, the deposit requirement should not be reduced on the basis of the firm having so little capital that the deposit amount threatens its viability. More generally speaking, any deposit amount is likely to materially reduce a firm's return on equity, inherently making the firm less viable. A deposit requirement that is based on a clear numeric formula - perhaps the sum of all arbitration awards against the firm's employees over a prescribed period - would seem fairer and would eliminate the need for the fiction that the deposit would not threaten the firm's existence.

* Steven Lofchie can be reached at Steven.Lofchie@cwt.com

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