Financial Advisor (August 4, 2021) - The Financial Industry Regulatory Authority’s rule to require risky broker-dealers to set aside funds in reserve to pay arbitration awards and other regulatory penalties is a first step, but it has gaps due to the grandfathering of outstanding unpaid awards and the fact that so many disciplinary events are expunged from firms’ records, the president of the Public Investors Advocate Bar Association said.
The new rule, which the Securities and Exchange Commission has greenlighted, grants Finra the authority to impose reserve account obligations on firms with significantly higher levels of risk-related disclosures—such as sales-practice related events—than their similarly sized peers. These firms will now be classified as “restricted firms,” Finra said.
The new rule is an important step forward for Finra, but there are still gaps in the regulation that will leave investors holding the bag for risky broker-dealer behavior, David Meyer, founding partner of the law firm Meyer Wilson Co. and president of the PIABA, said in an interview.
First, the regulation does not require existing outstanding arbitration awards to be paid, only future awards, Meyer noted. “While the proposed rule allows Finra to consider outstanding unpaid arbitration awards and settlements as criteria when designating a firm as a restricted firm, the rule fails to establish a remedy, such as requiring these outstanding debts to be paid by the firm prior to depositing funds into a Restricted Deposit Account to cover future obligations, which could preclude the need to consider such criteria in the first place,” he said.
Another gap in the rule’s investor protection is created by the practice of expungement, which allows firms and brokers to request that their regulatory disclosures and arbitration awards be erased from their record. If the events aren’t in their regulatory record, they won’t be considered by Finra when deciding which firms are risky or how much money a restricted firm must put into their reserve account, Meyer said.
At least some of the damages that are awarded to aggrieved investors in 30% of arbitration awards are currently unpaid, according to Finra.
Expungements of customer disputes “are granted all too frequently, and in violation of Finra’s attempts to ensure expungement is an extraordinary remedy, rather than the norm as it exists today. This creates serious concerns regarding the efficacy of Finra’s ability to discern whether a firm should be restricted, because member firms and its brokers can sanitize their records,” Meyer said.
As a result, Finra’s Rule 4111 underscores “the ongoing problem related to the pervasive nature of expungement of customer disputes. To the extent the threshold analysis to determine ‘restricted’ status reviews a member firm’s disclosure history, Finra can only review the disclosures that exist in the record,” Meyer said.
There are many positives about the rule, he noted. Above all else, it should make firms that hire rogue brokers be much more careful about their practices. “The firms that previously welcomed, and then failed to supervise, brokers with long rap sheets may think twice about those hires because it will be a less profitable gamble for them. This will help eliminate the cracks that bad brokers can squeeze themselves into in the industry,” Meyer said.
Ridding the industry of these serial offenders “is critically important to address the risks posed by firms and brokers with significant histories of misconduct. The recidivism numbers are clear—those firms and brokers Finra is designating as high risk are likely to continue accruing disclosure events so long as they are in operation. With Finra holding a magnifying glass to their misconduct and demanding financial consequences, we are hopeful that the industry will be rid of them,” Meyer said.
Finra will determine a restricted firm’s deposit requirement based on the firm’s size, operations and financial conditions.
Just 1.3% of all member firms met the preliminary criteria for designation as a restricted firm as of 2019, according to Finra data. That includes just 1.3% of small firms, 2.5% of mid-size firms and 0% of large firms.
As a requirement of the rule, Finra will assess member firms each year to see whether they should be designated or redesignated as a restricted firm.
Firms that are designated as high risk will have a one-time opportunity to fire high-risk advisors within 30 days of receiving notification, which will allow them to fall below the numeric threshold for a financial reserve. Firms will not be allowed to rehire any person it fires in the process for at least one year. During the evaluation process, member firms can make the case that they should not be considered for restriction and financial reserve requirements.
Finra told the SEC last July that it also plans to propose an amendment that would require firms to disclose their restricted status on BrokerCheck. The rule is slated to go into effect 180 days after Finra issues a Regulatory Notice to Members announcing the SEC’s approval.