As early as this summer, brokerages with spotty histories will find their tarnished records a matter of public record, through a black mark showing they've been placed on regulators' naughty list.
The Securities and Exchange Commission on Feb. 3 approved a rule allowing a "restricted firm" designation to be affixed to broker-dealers that have run afoul of regulators too many times. These scarlet letter-type marks will show up in a prominent place whenever a retail investor or other person searches for a firm in the Financial Industry Regulatory Authority's
FINRA, the broker-dealer industry's self-regulator, first gained the ability in January 2022 to place the restricted label on firms, but the black marks stayed out of the public eye. The designation means that brokerages have to put money into a special fund to pay off any arbitration awards they might face in the future. Such firms can also be subject to more frequent regulatory examinations.
Early on, the main goal of the warning label was to prevent dodgy firms from folding up to avoid paying damages and fines. So the names of listed firms weren't released. But industry watchdogs have complained ever since the rule's adoption that the public deserves to know exactly which companies have been flagged. Now, with the black marks on track to become public as soon as this summer, investors can find out.
Andrew Hartnett, the president of the North American Securities Administrators Association, a trade group of state regulators, wrote in a
"Investors deserve to know whether they are doing business with, or are about to do business with, a firm that poses a heightened risk of misconduct," Hartnett wrote. "Releasing a firm's status as a Restricted Firm on BrokerCheck would serve as a clear, simple, and warranted notice to investors to think carefully before doing business with these firms and their associated persons."
A FINRA spokesman declined to say how many of its more than 3,400 members are now under the restricted designation.
FINRA already allows for public shaming of brokerages that are subject to its so-called taping rule, which requires brokers who have run afoul of regulations to record all of their discussions with clients. In BrokerCheck, firms under that restriction show up with this warning: "This firm is subject to
The treatment for restricted firms will be almost exactly the same. Besides protecting investors, regulators also want to give brokerages incentives "to change behaviors and activities, either to avoid being designated or re-designated as a Restricted Firm."
Critics of FINRA's public scarlet letter plan contend it amounts to overkill. Francis Skinner, the chief legal counsel at broker-dealer Coastal Equities, wrote to the SEC that many firms already on the nonpublic restricted list are likely on the brink of insolvency owing to their obligation to set aside arbitration funds. Tagging them publicly, he said, will only make it harder to work with clients and retain and recruit talented employees.
"Attracting 'good' employees and sales persons should be in furtherance of FINRA's goal, but this Rule will serve only to defeat that goal by labeling Restricted Firms as 'bad' firms, which will certainly hinder their recruiting efforts," Skinner wrote. "In short, it is illogical to adopt a rule when the stated but speculative public policy to be advanced is outweighed by the harm it will cause to Restricted Firms and its personnel."
But Hugh Berkson, the president of the Public Investors Advocate Bar Association, said that brokerages marked by regulators for special scrutiny should also be identified to the public.
His concern, he said, has more to do with the money that restricted firms have to set aside to pay arbitration awards. Berkson said there is no standardized mechanism for injured investors to recover that money. And how, he asked, can small firms possibly set aside enough to pay future damages and fines without going out of business?
"Remaining in business is part of the idea behind this rule," Berkson said. "We aren't saying that you're so bad that you will no longer be able to operate."
FINRA's decisions on which brokerages belong on the restricted list are made using a two-step examination process that gets underway in June.
Being added to the list involves a complicated system that attempts to take into account a firm's and its employees' past misdeeds and its size and whether there has been a persistent pattern of misbehavior. FINRA regulators start by looking how many times a given firm has been the subject of customer complaints, regulatory arbitrations and criminal and civil charges. Firms can also get flagged if they have unsavory employees who have come over from brokerages that have been banned from the industry, have a lot of complaints on their records or have been fired by previous employers.
Next, regulators next look at a brokerage's headcount and use a formula to determine if the firm's record makes it an outlier among companies of a similar size. Firms with 50 registered brokers, for instance, will come in for special scrutiny if they've been the subject of 10 or more regulatory actions in the past five years. For brokerages with only four registered brokers, it's two or more actions.
FINRA then tries to weed out disclosures that "are not reflective of a firm posing a high degree of risk." The watchdog gives more weight to business practices that put investors or market integrity at risk rather than to violations of procedural rules. Firms also get a one-time chance to avoid being put on the restricted list through a staff reduction — essentially by firing employees with the worst records.
If, after all that, a firm ends up on the naughty list, it has to start placing money to cover any future arbitration awards against it. The amount to be set aside is once again calculated using another formula, one that looks at things like a brokerage's revenues, commissions, assets, liabilities, expenses and net capital. Firms on the list get a chance every year to argue before regulators that they've reformed themselves and should be removed.
