On May 2, 2019, FINRA proposed new rules to designate “high-risk” firms and strengthen its ability to impose additional obligations on those firms.[1]

  • Proposed Rule 4111 would authorize FINRA to designate “Restricted Firms” based on the number of event disclosures made by the firm and its registered persons. Restricted Firms would be subject to limitations on their operations and could be required to maintain restricted deposits that could only be withdrawn with FINRA’s consent.
  • Proposed Rule 9559 would create an expedited appeals process, including a process for challenging a designation as a Restricted Firm and any obligations imposed.

FINRA expects that only a small number of large firms (500 or more registered representatives) would be affected by the proposed rules, and that only zero to two would have been impacted in any given year had the rules been effective from 2013-2018.[2]

Early signals from FINRA about this rulemaking generated concern that the standards would be overly subjective, leading to uncertainty in application.  We believe, however, that the proposed rules on balance reflect a reasonable, and largely objective, approach given FINRA’s stated goal to “impose tailored obligations” on those firms that “present heightened risk of harm to investors.”[3]

Operation of the Proposed Rules

Under the proposed rules, FINRA would identify and designate Restricted Firms through an annual process containing six primary steps:

  1. Preliminary Criteria Calculation: The Department of Member Supervision (the “Department”) would calculate annually whether a firm meets the preliminary criteria for identification as a Restricted Firm. Generally, the calculation takes the total of certain event disclosures of the firm and its registered persons on the Uniform Registration Forms (Forms BD, U4, U5, and U6), and measures that total against numeric thresholds set by FINRA.  There are numeric thresholds for each of six categories of disclosures,[4] and each disclosure category has a numeric threshold for seven different firm sizes.[5]  A firm would receive a preliminary designation as a Restricted Firm if (1) it meets or exceeds the numeric thresholds in two or more of the disclosure categories, and at least one of those categories is a category involving adjudicated events or association with expelled firms; and (2) the member had two or more events during the past five years in any of the five categories not involving association with expelled firms.[6]
  2. Evaluation: The Department would then evaluate a firm meeting the preliminary criteria to determine whether there is information showing that the firm does not pose a high degree of risk, such as where the relevant disclosure events were not sales-practice related, were duplicative (involving the same customer and the same matter), or “mostly involved compliance concerns best addressed by a different regulatory response.”[7] FINRA would also consider whether the member has addressed the concerns signaled by the disclosure events, including staffing reductions, such that the preliminary calculation no longer reflects the current risk.
  3. One-Time Opportunity to Reduce Staffing: Firms who have not previously met the preliminary criteria would have an opportunity to reduce their staffing levels (presumably by terminating employees with the relevant disclosure events) to no longer meet these criteria, within 30 business days after notification by FINRA.[8] This mechanism to avoid designation as a Restricted Firm would only be available to a firm once.
  4. Restricted Deposit: FINRA would then determine a maximum restricted deposit amount tailored to the firm’s size, operations, and financial conditions, which could not be withdrawn without FINRA’s prior consent.[9] FINRA has stated that it intends the deposit to be significant enough to change the member’s behavior but not so burdensome that it would force the member out of business.
  5. Consultation: In consultation with FINRA and after being given notice, the firm would have the opportunity to rebut two presumptions—that the member should be designated as a Restricted Firm and that it should be subject to the maximum restricted deposit requirement.[10] Notably, FINRA has contemplated that a member can rebut the restricted deposit presumption by proposing “conditions or restrictions” on its operations that would address the concerns identified by the preliminary criteria.[11]
  6. Decision and Consequences: After consultation, the Department would make a determination, including whether to designate the firm as a Restricted Firm and what, if any, specific limitations to impose. Under proposed Rule 9559, firms may appeal adverse decisions through an expedited process.  Notably, that expedited process would result in final FINRA action, which can then be appealed to the SEC and then to federal court in the event of an adverse decision.

Key Takeaways

  • Firms appear to have more meaningful opportunities to consult with FINRA about restricted deposits than about the preliminary designation as a Restricted Firm. In particular, the proposed rules specify only one path for overcoming the Restricted Firm presumption—that FINRA was overinclusive in totaling the number of event disclosures.  By contrast, a firm could show that it should not be subject to a maximum restricted deposit by demonstrating financial hardship, that a lesser deposit amount would satisfy FINRA’s objectives, or by proposing conditions on its operations that would address the relevant risk concerns.
  • We do not expect that the proposed rules will significantly impact strategy considerations for regulatory settlements because virtually all settlements will be counted as disclosure events under the proposed rules. Accordingly, we expect that commenters’ attention may focus more on the numeric thresholds underlying the Restricted Firm calculation.
  • Comments to the proposed rules from members and industry groups will be important in evaluating whether FINRA’s proposed disclosure thresholds are reasonable and as narrowly tailored as FINRA estimated.  As a result, firms should check back in after July 1, 2019, when comments are due.

[1] FINRA, Regulatory Notice 19-17 (May 2, 2019) (“Regulatory Notice”) at 1.

[2] See Regulatory Notice at 7, 9, Attachment D.

[3] Regulatory Notice at 1.

[4] These disclosures broadly include regulatory investigations and criminal matters and “investment-related” arbitrations and civil matters, concluded within the past five years, and pending disclosure events in certain instances.  The disclosure categories are: (i) Registered Person Adjudicated Events, (ii) Registered Person Pending Events, (iii) Registered Person Termination and Internal Review Events, (iv) Member Firm Adjudicated Events, (v) Member Firm Pending Events, and (vi) Registered Persons Associated with Previously Expelled Firms.

[5] The proposed rules provide 42 different numeric thresholds.  See Regulatory Notice, Attachment A, Proposed Rule 4111 (the “Proposed Rule”) at 17 (Rule 4111(i)(11)).

[6] See Proposed Rule at 15‑16 (Rule 4111(i)(9)).

[7] See Regulatory Notice at 11.

[8] The Proposed Rule would prohibit the member from rehiring any persons terminated pursuant to this option, in any capacity, for one year.  See Proposed Rule at 2‑3 (Rule 4111(c)(2)).

[9] In particular, FINRA would also consider the member’s operations and activities, annual revenues, commissions, net capital requirements, the number of offices and registered persons, the nature of the disclosure events, the amount of certain arbitration claims or awards, and any concerns raised during FINRA exams.  See Regulatory Notice at 12.  FINRA has provided examples to show how it might exercise its discretion to determine the restricted deposit amount.  Regulatory Notice, Attachment C.

[10] See Regulatory Notice at 13.

[11] See Proposed Rule at 4‑5 (Rule 4111(d)(1)).