As FINRA prepares to implement a new rule that takes aim at firms with a “significant history of misconduct,” lawyers, investor groups and others within the industry are only cautiously optimistic about its potential for success.
Investor groups say they would like to see Rule 4111 force compliance rather than set up incentives for brokers to stop behaving badly. Lawyers applaud its provision that calls for setting aside capital to pay out awards and other claims. And industry leaders say there are concerns over allowing pending matters to determine if a firm should be slapped with a “restricted” label.
Under the rule, FINRA will evaluate its 3,400 broker-dealers starting June 1 each year, to decide which should be categorized as restricted. The annual process will be based on the number of risk-related disclosures a firm has compared to other firms of similar size. FINRA said the restriction of a firm will be based in large part on publicly available information on BrokerCheck.
Then on July 1, FINRA will begin determining which broker-dealers meet the criteria for being categorized as restricted.
If a firm is restricted, it will have to deposit money in a restricted deposit account, the size of which will be partly based on the amount of unpaid arbitration awards and other claims it faces. The money will be used to pay those claims.
Furman Alexander Ford, who once jumped his fence to avoid federal agents, will head back to trial in May for a separate criminal case involving Medicare fraud.
A firm that is labeled restricted has the right to appeal to FINRA and may also move to correct the situation through a “one-time staff reduction,” the rule states, meaning dismissal of the brokers found to have engaged in misconduct. FINRA said the rule is designed to serve as an incentive for firms to rid themselves of or not hire brokers with histories of misconduct who jump from firm to firm.
The restricted designation will be made public on BrokerCheck.
Firms will be evaluated annually, allowing restricted firms to make modifications to the practices and seek to remove the label and other obligations FINRA imposes.
Lawyers, investor groups and the industry are encouraged by the rule but see some potential pitfalls.
Kevin Galbraith, owner of The Galbraith Law Firm in Manhattan, called it “a good start. I am encouraged after many years of watching firms get away with murder, hiring people who shouldn’t be working in the industry. Firms who have been slapped on the wrist — a $10,000 fine here and there — are going to have to account for what they have done and the culture they have allowed to flourish or even promote, a culture of non-compliance.”
The issue of when the information actually will be available to the investing public, however, causes some concern for Michael Edmiston, president of the Public Investor Advocate Bar Association and an attorney in the Law Offices of Jonathan W. Evans & Associates in Studio City, California.
“The initial finding isn’t being made public until some time later. During that window, a customer could be vulnerable,” he said, referring to the fact that evaluations take place only once each year.
Edmiston stressed PIABA’s support for the rule, however.
“It is an effort systemwide to stop the behavior of troubled brokers jumping from firm to firm when the heat gets too hot or a firm is shut down, so they scurry to the next firm,” Edmiston said.
He said this behavior often leads to arbitration awards that are never paid by firms that wind up going out of business.
Net new assets soared in 2021, even though the firm's pandemic-related pause in hiring and training overhaul has trimmed its force of brokers.
“But I am anxious to see how FINRA implements the rule,” he said, “and the effect that a restricted firm label will have on public investor perceptions of the firm.”
FINRA spokesman Ray Pellecchia said the new rule will hopefully pressure firms to pay arbitration awards because the amount of unpaid awards is used, in part, to arrive at the amount of the restricted deposit requirement.
Mark Quinn, director of regulatory affairs at Cetera Financial Group in El Segundo, California, also said that while he is supportive of rooting out rogue brokers and the firms that employ them, he is concerned about a label being slapped onto a firm before it’s found guilty of misconduct.
“The criteria include reportable events, where you are a party to a suit or someone files an arbitration proceeding against you or a regulatory investigation is going on, but that doesn’t mean much,” Quinn said. “You have to be careful about including things that have not been concluded. Just because someone sues me doesn’t mean I’m wrong.”
FINRA said while pending events are included, studies show that, unlike with investments, past performance can be a predictor of future results.
“The criteria are intended to identify member firms that present a greater risk of future harm to their customers than other firms and is consistent with studies that provide evidence of predictability of future regulatory-related events for brokers and firms with a history of past regulatory-related events,” Pellecchia wrote in an email.
In a Dec. 28, 2020, letter, David P. Meyer, who was then the president of PIABA, wrote that the then-under-proposal rule sought to incentivize compliant behavior rather than enforce compliance.
“You do want to incentivize,” now-president Edmiston said. “That’s a positive form of regulation. Then you encourage the firm to supervise itself. It can then keep more capital as working capital rather than having to use it to pay for bad broker behavior down the road.”
He also stressed the need for follow-up enforcement after the restricted designation.
“I want FINRA paying much closer attention to these firms, analyzing broker behavior, supervisors, executives, as well as looking at the firm’s activity. What products are they selling to the investing public?” Edmiston said.
He said the sale of complex, risky private products — such as promissory notes or private placements — should be factored into FINRA’s analysis.
And the sooner that restricted label can be slapped on, the better, Edmiston said.
“The investor benefits from having that determination, and it incentivizes the firm to do the one-time staff reduction and not hire troubled brokers. The sooner you fix the problem, the less investor harm down the road,” he said.
Galbraith said not only will the additional scrutiny help investors, the financial penalty will as well, especially when it comes to the payment of arbitration awards to investors.
“The existence of more capital and more liquidity serves an important purpose for investors,” he said. “If we win a million-dollar award, I won’t have to worry if the award will bankrupt the company and I’ll end up in a line of creditors, or I get a call from the firm a month before the arbitration hearing where they plead poverty and ask to just pay my client $100,000 now.”
Such awards are the result of disputes, and Edmiston argues that FINRA’s expungement process works against Rule 4111 by wiping out disputes that should be considered when a firm is being evaluated for restricted status.
“Expungements should only be granted in the most extraordinary circumstances,” he said. “Right now, the expungement rate is 90% granted.”
Even if expunged, Edmiston said, they are still available for FINRA to use in its calculations, and should be.
Galbraith said he does not view expungements as a significant impediment to thorough evaluation of a firm.
“Grounds for expungement are limited,” he said. “The broker must prove that the customer complaint was fake or misleading or was clearly erroneous.”
He pointed out that the customer can participate in the proceeding, be represented by a lawyer and cross-examine witnesses.
Quinn voiced concerns that the rule may disproportionately impact smaller firms.
“If the issue is how many complaints there have been in relation to the number of advisors, larger firms are not going to be subject to this,” he said. “But to put a small firm in the position of ‘if you have one bad event, you get dragged down to FINRA and have to put up a bunch of additional capital,’ it seems draconian.
“A bunch of arbitrations could arise out of one circumstance,” he added, “and then you ask the firm to put up $1 million in additional capital. It’s a death sentence.”
