Finra Proposes Deposit Requirement for Rogue Firms
In a far-reaching extension of its effort to rein in broker-dealers that pose high risks to investors, the Financial Industry Regulatory Authority on Thursday proposed a rule that could require firms to set up segregated bank accounts that the regulator would control.
Rule 4111 would “impose obligations on members that have significantly higher levels of risk-related disclosures than similarly sized peers” in a dual attempt to modify their hiring of bad brokers and to ensure they have money to pay arbitration awards assessed against them, the self-regulatory group said.
Finra is accepting comments on the rule through July 1.
Finra in recent years has enhanced examination programs and risk-monitoring programs to identify rogue brokers and firms that employ them, but said it needs more severe measures to weed out those with persistent compliance issues. Consumer-protection advocates and some members of Congress also have petitioned regulators to ameliorate the problem of unpaid arbitration awards.
“These firms generally have a retail business with vulnerable customers and engage in cold calling to make recommendations of securities,” the rule proposal says. “Finra has also identified groups of individual brokers who move from one firm of concern to another firm of concern. In addition, certain firms, along with their representatives, have substantial numbers of disclosures on their records.”
Firms presenting “a high degree of risk to the investing public” could be required to deposit cash or qualified securities with a bank or clearing firm that could be withdrawn only with Finra’s approval and that cannot be used toward meeting capital requirements, the proposal said. The deposit proposal is aimed, in part, at keeping them from leaving the industry to escape the regulator’s jurisdiction.
“Finra believes that a restricted deposit is most likely to change such members’ behavior—and therefore protect investors—through its direct financial impact,” the rule proposal said. “Finra’s intent is that the maximum Restricted Deposit Requirement should be significant enough to change the member’s behavior but not so burdensome that it would force the member out of business solely by virtue of the imposed deposit requirement.”
Barbara Roper, director of investor protection at the Consumer Federation of America, lauded the proposal’s potential deterrence effect.
“It creates strong disincentive to hire individuals with problematic track records,” she said. “We’ll see what the impact is, but I think it’s an appropriate place to start.”
Brad Bennett, a former chief of enforcement at Finra, said the industry is likely to question the regulator’s ability to accurately identify which firms would be subject to the deposit requirements, but applauded the rule as a “strong step” to modify behavior.
The universe of firms posing serious harm to investors is relatively small but enduring, the rule proposal said, despite its enforcement efforts to bar or suspend miscreant firms and individuals.
As of year-end 2018, Finra identified 20 small firms employing 150 or fewer registered persons that had 30 or more disclosure events over the prior five years, ten mid-size firms with 45 such disclosures in the same period, and five large firms with 500 or more registered persons that had 750 or more disclosure events. The rule proposes numeric disclosure-event thresholds as the chief method for identifying rogue firms.
Firms required to set up the deposit accounts would have a one-time opportunity to fire personnel in order to meet compliance thresholds, and also could challenge the determination of their high-risk status as “restricted firms” by Finra’s enforcement division.
But even firms that come off the restricted list would not be able to withdraw anything from their accounts without Finra’s written consent.
“[T]here would be a presumption that the member would be required to continue to maintain its Restricted Deposit Requirement if it has any ‘covered pending arbitration claims’ or any unpaid arbitration awards,” the rule proposal says.
As with all Finra rule proposals, Rule 4111 would require approval by the Securities and Exchange Commission.