Defense Digest, Vol. 27, No. 5, December 2021

A ‘Significant History of Misconduct’ Means ‘Risky Business’

Key Points:

  • FINRA enacts a new rule with the stated goal of protecting investors from brokerage firms and brokers with a history of misconduct.
  • New Rule 4111 creates a rebuttable presumption that such firms will be designated as a “Restricted Firm.”
  • The presumption can be potentially overcome after a consultation with FINRA Department of Member Regulation.
  • If the presumption is not overcome, the Restricted Firm must abide by additional fiscal and other obligations imposed by FINRA.

The Financial Industry Regulatory Authority (FINRA) has adopted new procedures to address brokerage firms with a “significant history of misconduct.” For several years, FINRA has been enhancing its programs to address the risks that can be posed to investors by individual brokers and member firms that have a history of reported misconduct. 

What is misconduct? FINRA member firms are required to disclose adjudicated and pending events involving either customer complaints, customer arbitrations, or regulatory matters of both the firm and its registered representatives. New FINRA Rule 4111, to become effective January 1, 2022, imposes new obligations on broker dealers with significantly higher levels of risk-related disclosures than other similarly-sized peer firms. The level of risk is based upon numeric, threshold-based criteria. FINRA Rule 4111 establishes a multi-step annual process through which FINRA will determine whether a member firm raises investor protection concerns substantial enough to require that it be designated as a “Restricted Firm.” If so, the firm is then subject to numerous additional obligations. On an annual basis, FINRA will review all of its member firms in order to determine which may be determined to be a Restricted Firm. FINRA will utilize numeric thresholds in several categories of events and conditions of broker and firm disclosures; the size of the firm relative to the above-referenced matter the number of disclosures; and look back periods to prior years. 

After this review, if the review of the firm does not present “Preliminary Criteria for Identification,” there are no obligations placed upon the firm and there is no further review. However, if there is a finding of Preliminary Criteria for Identification, FINRA will scrutinize events in the risk profile of the firm to determine if it should be subject to further review under the new Rule. If further review is required, FINRA allows the firm the option to terminate brokers with a history of misconduct in order to reduce its staffing levels to come below the numeric thresholds set by FINRA. 

If the firm chooses not to terminate the brokers, FINRA will require the firm to deposit cash or qualified securities in a segregated, restricted account, and it will impose other conditions and restrictions that are deemed necessary and appropriate for the protection of investors and in the public interest. FINRA believes that the financial impact of a restricted deposit is likely to change such member firms’ behavior and, therefore, protect investors.

Provisions of the Rule allow the member firm to explain why it should not be designated as a Restricted Firm or be subject to a restricted deposit requirement. In addition, the firm is allowed to propose alternatives that would accomplish FINRA’s goal of protecting investors. The Rule also allows the firm to request a hearing before a FINRA hearing officer in an expedited proceeding to challenge termination. 

Another stated goal of Rule 4111 is to address the problem of unpaid arbitration awards. The rule is intended to incentivize firms to improve their practices to avoid being named as a Restricted Firm. To ensure that arbitration awards against the firm are paid, it may make a withdrawal from its mandatory deposit to reduce the number of unpaid arbitration awards.

Pursuant to Rule 4111, FINRA Department of Member Regulation (Department) will not act unilaterally, but it will conduct a consultation with the firm to determine if it should be designated as a Restricted Firm. There is a rebuttable presumption that the firm will be designated as such and subject to the maximum restricted deposit amount, unless the firm can provide information to overcome the presumption. If the firm overcomes the presumption, then it is not designated as a Restricted Firm. If it does not overcome the presumption and accepts the designation as a Restricted Firm, it must abide by any and all obligations imposed by FINRA. There is also an appeals process whereby the firm can request a hearing on the determination. During the appeal, there is no stay of imposed obligations and the restricted deposit must remain in place. 

It is anticipated that the designation as a Restricted Firm will need to be placed on FINRA’s publicly available BrokerCheck website. This requirement has not yet been made part of the rule, but it is likely that it will be required. 

In conclusion, a Restricted Firm will be permitted to continue its business operations, but it will be subject to financial and other requirements imposed by FINRA and will likely be required to publicly disclose such designation. 

*James is a shareholder in our Pittsburgh, Pennsylvania, office. He can be reached at 412.803.1180 or jamcgovern@mdwcg.com

 

Defense Digest, Vol. 27, No. 5, December 2021 is prepared by Marshall Dennehey Warner Coleman & Goggin to provide information on recent legal developments of interest to our readers. This publication is not intended to provide legal advice for a specific situation or to create an attorney-client relationship. ATTORNEY ADVERTISING pursuant to New York RPC 7.1. © 2021 Marshall Dennehey Warner Coleman & Goggin. All Rights Reserved. This article may not be reprinted without the express written permission of our firm. For reprints, contact tamontemuro@mdwcg.com.