SEC Approves Finra’s Deposit Requirement Rule for High-Risk Firms
Past is prologue for firms and brokers who have engaged in misconduct, according to the Financial Industry Regulatory Authority’s new rule, which the Securities and Exchange Commission approved on July 30.
Those requirements include establishing segregated accounts with funds earmarked to pay customers’ pending arbitration claims or unpaid arbitration awards and abide by other restrictions.
Finra proposed Rule 4111, initially in 2019, based on research that shows “past disciplinary history and other regulatory events associated with a firm or individual can be predictive of future events,” the SEC states in its order.
“This proposal is designed to address persistent compliance issues that arise at some FINRA member firms that generally do not carry out their supervisory obligations to achieve compliance with applicable securities laws and regulations and FINRA rules, and act in ways
that could harm their customers and erode confidence in the brokerage industry,” the SEC said in its approval.
It is also aimed at giving Finra the ability to take proactive action against firms before more problems arise since without Rule 4111, the regulator can only bring enforcement actions and seek restitution only after a rule has been violated and the customer harm has already occurred, the SEC’s approval notes. Investor advocates and some members of Congress have raised concerns for years about the issue of arbitration awards that go unpaid to harmed investors when a firm goes out of business.
The new rule represents a victory lap for the academic researchers–Mark Egan at Harvard Business School, Gregor Matvos at the University of Texas at Austin, and Amit Seru at Stanford University–who conducted a 2018-amended study demonstrating brokers with a history of misconduct are five times more likely to be repeat offenders.
“This subset of firms appears to be more tolerant of misconduct,” Egan wrote in an email. “Advisers at these firms with elevated rates of misconduct are more likely to engage in future misconduct and are more likely to maintain employment after engaging in misconduct.”
Even so, broker-dealers and brokers previously engaged in misconduct will often uncover ways to avoid the regulators’ grasp, Brad Bennett, the former chief of enforcement at Finra, predicted.
“I suspect the true outlaw operators will adapt their business model to be sure they stay under whatever thresholds are necessary to trigger this rule,” Bennett said. “While it is a noble effort, I suspect that its practical effect on bad actors will be less than Finra hopes.”
In its 2018 proposal, Finra said it 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.
A Finra spokesperson did not immediately return a request for comment about how many firms it estimates could qualify for restricted status.
Under the new rule, Finra will conduct an annual analysis of each of its member firms to determine which, based on their and their brokers’ disciplinary records, should be required to have the segregated accounts and comply with the other restrictions.
The high-risk designated firms will have the opportunity during a new type of expedited proceeding to challenge Finra’s categorization and a one-time opportunity to voluntarily reduce their broker workforce to avoid the segregated account requirement and other restrictions, the SEC order states.
Rule 4111 follows the same pre-emptive regulatory approach as Finra’s Rule 3170, commonly referred as the taping rule, which became effective in 2014, and requires firms that employ a large number of high-risk brokers from expelled firms to record all phone conversations between brokers and existing as well as potential customers.