November 17, 2020

FINRA Proposes Additional Obligations for Firms with a History of Misconduct

Steven Lofchie Commentary by Steven Lofchie

FINRA proposed the adoption of new FINRA Rule 4111 ("Restricted Firm Obligations") that would impose additional requirements on broker-dealers that are deemed to pose a significant risk to investors ("Restricted Firms"). Additionally, FINRA proposed the adoption of the Capital Acquisition Broker Rule 412 in order to clarify that all capital acquisition brokers would be subject to FINRA Rule 4111.

FINRA stated that it would identify "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 the firm (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). Under proposed Rule 4111, Restricted Firms would be subject to a "Restricted Deposit Requirement" that would oblige the firm to keep a deposit in a segregated account in order to ensure that there would be funds available for arbitration awards relating to conduct at the firm. Proposed Rule 4111 would create criteria for the approval of withdrawals from a "Restricted Deposit Account," including the requirement that a firm not have any pending arbitration claims or unpaid arbitration awards.

The proposed rule does not impose any cap on the amount of the deposit requirement, nor is there any formula for the setting of the deposit requirement. Rather, in tailoring a member firm's maximum Restricted Deposit Requirement amount, FINRA said it will take "into consideration" the types of business the firm does, the firm's annual revenues, its net capital requirements, the violations that caused the firm to become a Restricted Firm, and events such as "concerns raised during FINRA exams." FINRA noted that the deposit amount should not be so high as to "significantly undermine" the continued financial stability and operational capability of the firm. FINRA added that a Restricted Firm could be made subject to other obligations, including, for example, limits on the types of business that the firm did.

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

Further, FINRA proposed amendments to FINRA Rule 9559 that would (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) disallow a Restricted Firm from challenging the merits of the negative events that were 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.


FINRA stated that it has substantial empirical evidence to demonstrate 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 question whether the rule may be unduly arbitrary. For example, brokerage employees are tainted for having worked at a firm with conduct problems, even though no finding was made against the employee; this is also a feature of existing FINRA Rule 3170 (the "Taping Rule").

Further, under the proposed rule, FINRA would have total discretion to set the required deposit amount. 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, 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 was 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.

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