On May 2, 2019, FINRA proposed new Rules that would impose financial and other obligations on member firms with significant levels of risk-related disclosures as compared to similarly sized firms. See Regulatory Notice 19-17, available at http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-19-17.pdf.
Under the new Rules, FINRA would perform an annual calculation of each firm based on six categories of firm-level and individual-level disclosure events. Firms that exceed pre-determined thresholds would be deemed “Restricted Firms” and subject to a review process that could result in the firm being required to deposit funds in a restricted account and comply with other conditions specific to the firm’s suspect areas of operation. Based on historical data, FINRA expects between 60 and 98 member firms to qualify as “Restricted Firms” each year.
The proposal is primarily contained in proposed Rule 4111, which sets forth the structure of the annual review process. The process begins with FINRA’s annual calculation of the following six categories:
- Registered Person Adjudicated Events
- Registered Person Pending Events
- Registered Person Termination and Internal Review Events
- Member Firm Adjudicated Events
- Member Firm Pending Events
- Registered Persons Associated with Expelled Firms
While FINRA provides a complex definition for what qualifies as an “event” under each category, the definitions generally mirror the requirements for whether an event is reportable on the firm or registered person’s CRD.
The proposed Rule also provides a grid of numeric thresholds for each of these categories based on seven different firm sizes. If a firm meets or exceeds the thresholds applicable to its size for two or more categories, FINRA may determine that the firm qualifies as a Restricted Firm. A firm’s maximum number of disclosure events can be calculated by multiplying the total number of registered persons by the applicable decimal in the chart below. For example, in the “Registered Person Adjudicated Event” category, a firm with 400 registered persons will reach the threshold if its registered persons have 60 or more combined disclosure events (400 x 0.15 = 60) during the evaluation period.
The look-back period for these events varies by category. While the “pending event” categories must actually be pending at the time of FINRA’s review, the “adjudicated event” categories include events that concluded in the five years preceding FINRA’s review. The “Registered Person Termination and Internal Review Events” category includes events adjudicated over the previous five years as well as those pending at the time of FINRA’s review. For the “Registered Persons Associated with Expelled Firms” category, FINRA will count any person who was registered with the firm over the prior year who has ever been associated with a firm that was expelled.
After the calculation and identification process, FINRA will conduct a subjective evaluation of each Restricted Firm to determine whether further review is warranted. If, for example, a firm has already altered its business practices to address the perceived concerns, or the metric threshold was reached with disclosure events that were not sales practice related, FINRA may decide that the firm does not pose a high degree of risk and close its review with no further action. In addition, first-time Restricted Firm designees will have a one-time opportunity to terminate problematic brokers to bring themselves below the metric thresholds and out of further review.
If FINRA determines that a Restricted Firm warrants further review, the firm will typically undergo a consultation with FINRA. Prior to the consultation, FINRA will determine the firm’s maximum “Restricted Deposit Requirement” tailored to the firm’s size, operations and activities, financial conditions, nature of its disclosure events, and other aggravating and mitigating factors. There is no specific formula for calculating a firm’s maximum Restricted Deposit Requirement. Instead, FINRA states that the amount should be high enough to incentivize a firm to change its business practices while not being so burdensome as to significantly undermine its financial stability.
During the consultation with FINRA, the firm will have the burden to overcome presumptions that: (1) it should be designated as a Restricted Firm and (2) it should be required to maintain the maximum Restricted Deposit Requirement. The consultation may involve a series of meetings, document requests by FINRA, and submission of relevant information or documents by the member firm.
Within 30 days of the initial consultation notice, FINRA will render its decision as to whether the firm will be designated a Restricted Firm and, if so, the amount of its Restricted Deposit Requirement. The Restricted Firm must promptly establish an account, deposit the required amount, and maintain it over the next year. FINRA may also require the member to implement and maintain specific conditions or restrictions, as it deems necessary, on suspect operations and activities of the Restricted Firm.
The proposed Rule also requires FINRA to evaluate a Restricted Firm’s status on an annual basis. Thus, firms will have an opportunity each year to seek modification or termination of the obligations imposed by FINRA.
Finally, FINRA proposed adoption of new Rule 9559 and amendments to renumbered Rule 9560, which establish and govern the process through which firms may contest findings made pursuant to proposed Rule 4111.
Interested parties may submit comments on the proposed Rules by July 1, 2019.