On July 30, 2021, the Securities and Exchange Commission (SEC) approved the Financial Industry Regulatory Authority’s (FINRA) rule proposal aimed at cracking down on brokerages with a history of misconduct. FINRA, the self-regulator that oversees all broker-dealers in the U.S., is tasked with protecting investor interests as well as the overall integrity of the securities market. Creating a heightened scrutiny standard in light of historical egregious examples of broker bad behavior, fraud, and client harm, the SEC considers brokerages with a track record of misconduct and/or a high concentration of bad actors on their payroll to be a higher risk to investors than their more compliant counterparts.
In an effort to stem the rising tide of improper conduct amongst repeat offender firms, FINRA’s new Rule 4111 is set to “impose new obligations on broker-dealers with significantly higher levels of risk-related disclosures (including, notably, sales-practice related disclosure events) than other similarly sized peers based on numeric, threshold-based criteria.” In its proposal, FINRA cited study findings showing that certain brokerage firms were routinely employing brokers with histories of misconduct. The studies also indicated that firms associated with disciplinary actions or bad actors in the past were likely to engage in future bad practices as well.
The new rule will require firms with significant records of wrongdoing—also referred to as “Restricted Firms”—to contribute cash or qualified securities to a separate, FINRA-controlled bank account. The money in this “Restricted Deposit Account” can only be accessed with FINRA’s consent and can be used to pay down pending arbitration claims or outstanding arbitration awards related to instances of misconduct. The new rule also gives FINRA leeway to place conditions or restrictions on a Restricted Firm’s business operations if deemed necessary. These measures allow FINRA to act in a preventative capacity, reigning in brokers before they cause further investor harm as opposed to only bringing enforcement action after the fact. This will also provide a pool of potential recovery funds in the more severe cases where the unlawful actions compromise the firm’s continued operations or result in the revocation of licenses.
However, FINRA is also adopting measures that will allow Restricted Firms to challenge their restricted designation or to argue for alternative disciplinary action. Restricted Firms will also be allowed a one-time opportunity to avoid disciplinary obligations by terminating employees who have records of misconduct in order to unmeet the threshold criteria. These safe harbor provisions are arguably incentivizing firms to keep a close eye over their operations and take appropriate action against bad actors or recidivist brokers.
FINRA currently does not publicly share firms’ restricted statuses with investors or other state securities regulators but is considering doing so in the future. While the agency’s goal is to protect public investors from harm, it also wants to incentivize firms to change behavior and remedy regulatory issues—a goal that could be counteracted by revealing a restricted status. The agency stated that it “recognized the potential value to investors of public disclosure of a member’s status as a Restricted Firm and intends to consider employing it and other approaches during its planned review of Rule 4111 after it has gained ‘sufficient experience with the rule.’” Rule 4111 is set to go into effect in January 2022, with firms’ restricted statuses subject to annual review by FINRA.
If you have any further questions regarding broker-dealers and regulatory compliance, please contact James Heavey.