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Regulatory Notice 21-34

FINRA Adopts Rules to Address Firms With a Significant History of Misconduct

Effective Date: January 1, 2022

Summary

FINRA has adopted new rules to address firms with a significant history of misconduct.1 New Rule 4111 (Restricted Firm Obligations) requires member firms that are identified as “Restricted Firms” to deposit cash or qualified securities in a segregated, restricted account; adhere to specified conditions or restrictions; or comply with a combination of such obligations. New Rule 9561 (Procedures for Regulating Activities Under Rule 4111) and amendments to Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series) establish a new expedited proceeding to implement Rule 4111.

The new rules and rule amendments become effective on January 1, 2022.

The rule text is available in Attachment A. A flow chart of the Rule 4111 process is available in Attachment B.

Questions concerning this Notice should be directed to:

  • Kosha Dalal, Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-6903 or by email; or
  • Michael Garawski, Associate General Counsel, OGC, at (202) 728-8835 or by email

Background and Discussion

FINRA uses a combination of tools to reduce the risk of harm to investors from member firms and the brokers they hire that have a history of misconduct. These tools include assessments of applications member firms file to retain or employ an individual subject to a statutory disqualification, reviews of membership and continuing membership applications, disclosure of brokers’ regulatory backgrounds, supervision requirements, focused examinations, risk monitoring and disciplinary actions.

For several years, FINRA has been enhancing its programs to address the risks that can be posed to investors and the broader market by individual brokers and member firms that have a history of misconduct. As part of this initiative, FINRA has:

  • published Regulatory Notice 18-15 (Heightened Supervision), which reiterates the existing obligation of member firms to implement for such individuals tailored heightened supervisory procedures under Rule 3110 (Supervision);
  • published Regulatory Notice 18-17 (FINRA Revises the Sanction Guidelines), which announced revisions to the FINRA Sanction Guidelines;
  • raised fees for statutory disqualification applications;2
  • revised the qualification examination waiver guidelines to permit FINRA to more broadly consider past misconduct when considering examination waiver requests;3 and
  • adopted rules concerning brokers with a significant history of misconduct.4

New Rule 4111

Rule 4111 addresses risks from broker-dealers with a significant history of misconduct, including firms with a high concentration of individuals with a significant history of misconduct. The rule allows FINRA to impose new obligations on broker-dealers with significantly higher levels of risk-related disclosures than other similarly sized peers, based on numeric, threshold-based criteria. The obligations that can be imposed include a requirement to deposit cash or qualified securities in a segregated, restricted account, and other conditions and restrictions that are necessary or appropriate for the protection of investors and in the public interest. FINRA believes that the direct financial impact of a restricted deposit is likely to change such member firms’ behavior—and therefore protect investors.

As explained in detail below, Rule 4111 establishes a multi-step, annual process through which FINRA will determine whether a member firm raises investor protection concerns substantial enough to require that it be designated (or re-designated) as a “Restricted Firm” and subject to additional obligations, including a “Restricted Deposit Requirement.” The multi-step process includes numerous features designed to narrowly focus the new obligations on the firms most of concern. Each year’s process will begin with a calculation of which firms meet numeric thresholds based on firm-level and individual-level disclosure events to identify member firms with a significantly higher level of risk-related disclosures as compared to similarly sized peers. The process also gives each member firm that is preliminarily identified by these numeric criteria several ways to affect outcomes during subsequent steps in the process. These include a one-time opportunity to avoid the imposition of obligations by voluntarily reducing its workforce; an opportunity to explain to the Department of Member Supervision (Department) why the firm should not be designated as a Restricted Firm or be subject to a Restricted Deposit Requirement or to propose alternatives that would still accomplish FINRA’s goal of protecting investors; and the opportunity to request a hearing before a FINRA Hearing Officer in an expedited proceeding to challenge a Department determination.

As the attached flow chart reflects (Attachment B), the Rule 4111 process is akin to a “funnel.” The top of the funnel applies to the range of member firms with the most disclosures, with a narrowing in the middle of the potential member firms that may be subject to additional obligations, and the bottom of the funnel reflecting the smaller number of member firms that are determined to present high risks to the investing public.

An added benefit of Rule 4111 will be important ancillary effects in addressing unpaid arbitration awards. The rule is intended to incentivize firms to improve their practices to avoid being deemed a Restricted Firm in the first place. In addition, the new rule will consider, among other factors, “Covered Pending Arbitration Claims”5 and unpaid arbitration awards6 in determining the size of a Restricted Firm’s Restricted Deposit Requirement.7 The new rule also includes a number of presumptions that apply in the Department’s assessment of an application by a previously designated Restricted Firm to make a withdrawal from its Restricted Deposit that would further incentivize the payment of arbitration awards.8    

Explanations of the specific provisions in Rule 4111 are provided below.

General (Rule 4111(a))

Rule 4111(a) requires a member designated as a Restricted Firm to establish a “Restricted Deposit Account”9 and deposit in that account cash or qualified securities with an aggregate value that is not less than the member firm’s Restricted Deposit Requirement, except in certain identified situations. Restricted Firms also could be subject to conditions or restrictions on the member firm’s operations as determined by the Department to be necessary or appropriate for the protection of investors and in the public interest, in addition or in alternative to a Restricted Deposit Requirement.

Annual Calculation by FINRA of the Preliminary Criteria for Identification (Rule 4111(b))

The annual multi-step Rule 4111 process will begin with a calculation. As explained below, Rule 4111(b) requires the Department to calculate annually a member firm’s “Preliminary Identification Metrics”10 to determine whether the firm meets the “Preliminary Criteria for Identification.”11 A key driver of that is whether a member firm’s Preliminary Identification Metrics meet quantitative, risk-based “Preliminary Identification Metrics Thresholds.”12

Several principles guided FINRA’s development of the Preliminary Criteria for Identification and the Preliminary Identification Metrics Thresholds. The criteria and thresholds are intended to be replicable and transparent to FINRA and affected member firms, employ the most complete and accurate data available to FINRA, be objective, account for different firm sizes and business profiles and target the sales-practice concerns that motivated the new rule. These criteria are intended to identify member firms that present a high risk, but avoid imposing obligations on member firms whose risk profile and activities do not warrant such obligations.

To calculate whether a member firm meets the Preliminary Criteria for Identification, the Department will first compute the Preliminary Identification Metrics for each of six categories of events or conditions, collectively defined as the “Disclosure Event and Expelled Firm Association Categories.”13 These six categories are all based on events or conditions disclosed through the Uniform Registration Forms,14  with the exception of one event category (Member Firm Adjudicated Events), which also includes events that are derived from customer arbitrations filed with FINRA’s dispute resolution forum. The six categories are:

  1. Registered Person Adjudicated Events;15
  2. Registered Person Pending Events;16
  3. Registered Person Termination and Internal Review Events;17
  4. Member Firm Adjudicated Events;18
  5. Member Firm Pending Events;19 and
  6. Registered Persons Associated with Previously Expelled Firms (also referred to as the Expelled Firm Association category).20

To calculate each of the six categories’ Preliminary Identification Metrics, FINRA first will add the number of pertinent disclosure events or, for the Expelled Firm Association category, the number of the Registered Persons Associated with Previously Expelled Firms. For the adjudicated-events categories, the counts will include disclosure events that were resolved during the prior five years from the Evaluation Date.21 For the pending-events categories and pending internal reviews, the counts will include disclosure events that are pending as of the Evaluation Date.22 In addition, for the three Registered Person disclosure-event based categories, the counts will include disclosure events across all “Registered Persons In-Scope,” which is defined to include persons registered with the member firm for one or more days within the one year prior to the Evaluation Date.23

Each of those six sums will then be standardized to determine the member firm’s six Preliminary Identification Metrics. For the five “Registered Person and Member Firm Events” categories (Categories 1-5 above),24 the Preliminary Identification Metrics are in the form of an average number of events per Registered Persons In-Scope, calculated by taking each category’s sum and dividing it by the number of Registered Persons In-Scope.25 The sixth Preliminary Identification Metric—the Expelled Firm Association Metric—is in the form of a percentage concentration at the member firm of Registered Persons Associated with Previously Expelled Firms. This concentration is calculated by taking the number of Registered Persons Associated with Previously Expelled Firms and dividing it by the number of Registered Persons In-Scope.26

A firm’s six Preliminary Identification Metrics will then be used to determine if the member firm meets the Preliminary Criteria for Identification. This involves analyzing the extent to which the member firm’s Preliminary Identification Metrics meet the specified numeric Preliminary Identification Metrics Thresholds in Rule 4111(i)(11) and meet additional conditions intended to prevent a member firm from becoming potentially subject to additional obligations solely as a result of pending matters or a single event or condition.27 Each specific numeric threshold in the Preliminary Identification Metrics Thresholds grid in Rule 4111(i)(11) is a number which represents outliers with respect to similarly sized peers for the type of events or conditions in the category (i.e., the firm is at the far tail of the respective category’s distribution), which is intended to preliminarily identify member firms that present significantly higher risk than a large percentage of the membership. There are numeric thresholds for seven different firm sizes (ranging from firms with 1-4 Registered Persons In-Scope to 500 or more Registered Persons In-Scope) to ensure that each member firm is compared only to its similarly sized peers.

Specifically, a member firm will meet the Preliminary Criteria for Identification if:

  • two or more of the member firm’s Preliminary Identification Metrics are equal to or more than the corresponding Preliminary Identification Metrics Thresholds for the member firm’s size, and at least one of those Preliminary Identification Metrics is the Registered Person Adjudicated Event Metric, the Member Firm Adjudicated Event Metric, or the Expelled Firm Association Metric;28 and
  • the member firm has two or more Registered Person or Member Firm Events (i.e., two or more events from Categories 1-5 above) during the Evaluation Period.29

The following three examples demonstrate—in practical terms—the point at which a member firm’s Preliminary Identification Metrics for different categories will meet the Preliminary Identification Metrics Thresholds:

  Preliminary Identification Metrics Thresholds Practical Equivalent

Example 1 (member firm size between 1-4 Registered Persons In-Scope)

The Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric, for a member firm that has between one and four Registered Persons In-Scope as of the Evaluation Date, is 0.50 (or 0.50 events per Registered Broker In-Scope).

For a member firm with four Registered Persons In-Scope as of the Evaluation Date, the member will meet the Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric if the sum of its four Registered Persons In-Scope’s Adjudicated Events, which reached a resolution over the five years before the Evaluation Date, was two or more.

(4 Registered Persons In-Scope) * (0.50 Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric) = (2 Adjudicated Events)

Example 2 (member firm size between 20-50 Registered Persons In-Scope)

The Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric, for a member firm that has between 20-50 Registered Persons In-Scope as of the Evaluation Date, is 0.20 (or 0.20 events per Registered Broker In-Scope).

For a member firm with 50 Registered Persons In-Scope as of the Evaluation Date, the member firm will meet the Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric if the sum of the member firm’s Adjudicated Events, which reached a resolution over the five years before the Evaluation Date, was ten or more.

(50 Registered Persons In-Scope) * (0.20 Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric) = (10 Adjudicated Events)

Example 3 (member firm size between 51-150 Registered Persons In-Scope)

The Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric, for a member firm that has between 51-150 Registered Persons In-Scope as of the Evaluation Date, is 0.03 (or a 3 percent concentration level).

For a member firm with 100 Registered Persons In-Scope as of the Evaluation Date, the member firm will meet the Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric if the sum of its Registered Persons Associated with Previously Expelled Firms was three or more.

(100 Registered Persons In-Scope) * (0.03 Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric) = (Three Registered Persons Associated with Previously Expelled Firms)

The annual “Evaluation Date” will establish the date as of which all specified events that are reportable on the Uniform Registration Forms, or otherwise included in Rule 4111, would be included in the annual calculation of the Preliminary Criteria for Identification, not the date as of when the events that are reported would be counted. For example, if a relevant final regulatory action against a registered person occurs just prior to the Evaluation Date but is reported on Form U4 after the Evaluation Date, the annual Preliminary Criteria for Identification calculation would include that disclosure event. Furthermore, the Evaluation Date is not the date when FINRA would actually perform the annual calculation of the Preliminary Criteria for Identification. Rather, FINRA plans to actually perform the annual calculation at least 30 days after the Evaluation Date, to account for the time between when relevant disclosure events occurred and when firms must report those events on the Uniform Registration Forms.

In a separate Regulatory Notice, FINRA will announce the first Evaluation Date no less than 120 calendar days before the first Evaluation Date. FINRA expects that the first Evaluation Date will be mid-year 2022. FINRA further expects that subsequent Evaluation Dates will be on the same month and day each year, whether that date certain falls on a business day, weekend or a holiday. However, FINRA will evaluate whether future adjustments of the annual Evaluation Date are warranted and would announce any changes in such date sufficiently in advance.      

Before the first Evaluation Date and FINRA’s first performing of the annual calculation, FINRA will need to develop new systems and processes to implement Rule 4111. These systems and processes will include, for example, internal systems for FINRA’s annual calculations of the Preliminary Criteria for Identification (and the underlying Preliminary Identification Metrics) and systems that facilitate FINRA’s Rule 4111 operations. While the development of such technology will require time and resources, FINRA expects that these new systems and processes will add significant value long term by allowing the large volumes of data required to run the annual calculations to be evaluated and analyzed efficiently.

In addition, FINRA will provide several external resources to assist firms. FINRA will maintain on its website a chart that maps the Registered Person and Member Firm Events categories (Categories 1-5 above) to the relevant disclosure questions and fields on the Uniform Registration Forms. FINRA also plans to publish on its website, and keep updated, a list of firms that have been expelled.

Based on feedback from member firms, FINRA also expects to provide a non-determinative calculation (an “early indicator calculation”) of the Preliminary Criteria for Identification that will give firms an indication of where they stand as of a specific date in advance of the Evaluation Date. This early indicator calculation would be for informational purposes only to provide firms a signal, and a firm’s status as of the Evaluation Date could change significantly based on subsequent activities at the firm. The early indicator calculations will indicate only whether a firm would meet the Preliminary Criteria for Identification and what a firm’s six Preliminary Identification Metrics would be were the annual Rule 4111 calculation to be run as of the specific date used in the early indicator calculation. The results of the early indicator calculations could be used by member firms to monitor their status in relation to the Preliminary Criteria for Identification, including how close a firm’s Preliminary Identification Metrics are in relation to the relevant Preliminary Identification Metrics Thresholds, at that specific point in time. As the necessary technology systems are built and tested, FINRA will announce in advance the date it will make available to firms the early indicator calculation and the process and manner by which firms can gain access to their own early indicator calculation.

Initial Department Evaluation (Rule 4111(c)(1))

Following the annual calculation, for each member firm that meets the Preliminary Criteria for Identification as of the Evaluation Date, the Department will conduct, pursuant to Rule 4111(c)(1), an initial internal evaluation to determine whether the member firm does not warrant further review under Rule 4111. In doing so, the Department will review whether the computation of the member firm’s Preliminary Identification Metrics included disclosure events or other conditions that are not consistent with the purpose of the Preliminary Criteria for Identification and are not reflective of a firm posing a high degree of risk. For example, the Department may have information that the computation included disclosure events that 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 by FINRA (e.g., enforcement actions, more frequent examination cycles, temporary cease and desist orders). The Department will evaluate the events to determine, among other things, whether they indicated risks to investors or market integrity, rather than, for instance, repeated violations of procedural rules.

The Department will also consider whether the member firm has addressed the concerns signaled by the disclosure events or conditions, or altered its business operations such that the threshold calculation no longer reflects the member firm’s current risk profile. Essentially, the purpose of the Department’s initial evaluation is to determine whether it is aware of information that would show that the member firm—despite having met the Preliminary Criteria for Identification—does not pose a high degree of risk.

Pursuant to Rule 4111(c)(3), if the Department determines, after this initial evaluation, that the member firm does not warrant further review, the Department will conclude that year’s Rule 4111 process for the member firm and would not seek that year to impose any obligations on it. If, however, the Department determines that the member firm does warrant further review, the Rule 4111 process would continue.

One-Time Opportunity to Reduce Staffing Levels (Rule 4111(c)(2))

If the Department determines, after its initial evaluation, that a member firm warrants further review under Rule 4111, such member firm—if it has met the Preliminary Criteria for Identification for the first time—will have a one-time opportunity to reduce its staffing levels to no longer meet these criteria, within 30 business days after being informed by the Department that it met the Preliminary Criteria for Identification. The member firm will be required to demonstrate the staff reduction to the Department by identifying the terminated individuals. Rule 4111(c)(2) will prohibit the member firm from rehiring any persons terminated pursuant to this option, in any capacity, for one year.

If the member reduces its staffing levels, and the Department determines that the member firm no longer meets the Preliminary Criteria for Identification, the Department will close out that year’s Rule 4111 process for the member firm. If, on the other hand, the Department determines that the member firm still meets the Preliminary Criteria for Identification even after its staff reductions, the Department will proceed to determine the firm’s maximum Restricted Deposit Requirement, and the member firm will proceed to a “Consultation” with the Department.

FINRA’s Determination of a Maximum Restricted Deposit Requirement (Rule 4111(i)(15))

The Department would tailor the member firm’s maximum Restricted Deposit Requirement amount to its size, operations and financial conditions. As provided in Rule 4111(i)(15), the Department will consider the nature of the member firm’s operations and activities, revenues, commissions, assets, liabilities, expenses, net capital, the number of offices and registered persons, the nature of the disclosure events counted in the numeric thresholds, insurance coverage for customer arbitration awards or settlements, concerns raised during FINRA exams and the amount of any of the firm’s or its Associated Persons’ “Covered Pending Arbitration Claims” or unpaid arbitration awards.30 Based on a consideration of these factors, the Department will determine a maximum Restricted Deposit Requirement for the member firm that is consistent with the objectives of the rule, but that does not significantly undermine the continued financial stability and operational capability of the member firm as an ongoing enterprise over the next 12 months. FINRA’s intent is that the maximum Restricted Deposit Requirement should be significant enough to change the member firm’s behavior but not force the member firm out of business solely by virtue of the imposed deposit requirement.31

Consultation (Rule 4111(d))

During the Consultation, the member firm will have an opportunity to demonstrate why it does not meet the Preliminary Criteria for Identification, why it should not be designated as a Restricted Firm and why it should not be subject to the maximum Restricted Deposit Requirement. There will be two rebuttable presumptions in a Consultation: That the member firm should be designated as a Restricted Firm; and that it should be subject to the maximum Restricted Deposit Requirement. The member firm will bear the burden of overcoming those presumptions.

Rule 4111(d)(1) governs how a member firm may overcome these two presumptions. First, a member firm may overcome the presumption that it should be designated as a Restricted Firm by clearly demonstrating that the Department’s calculation that the member meets the Preliminary Criteria for Identification is inaccurate because, among other things, it included events, in the six categories described above, that should not have been included because, for example, they are duplicative, involving the same customer and the same matter, or are not sales-practice related. Second, a member firm may overcome the presumption that it should be subject to the maximum Restricted Deposit Requirement by clearly demonstrating that the member firm would face significant undue financial hardship if it were subject to the maximum Restricted Deposit Requirement and that a lesser deposit requirement would satisfy the objectives of Rule 4111 and be consistent with the protection of investors and the public interest; or that other conditions and restrictions on the operations and activities of the member firm and its associated persons would address the concerns indicated by the thresholds and protect investors and the public interest.

Rule 4111(d)(2) governs how the Department will schedule and provide notice of the Consultation, and also governs requests for postponements of the Consultation.

Rule 4111(d)(3) provides guidance on what the Department will consider during the Consultation when evaluating whether a member firm should be designated as a Restricted Firm and subject to a Restricted Deposit Requirement. This provision also provides member firms with guidance on how to attempt to overcome the two rebuttable presumptions. Specifically, Rule 4111(d)(3) requires that the Department consider:

  • information provided by the member firm during any meetings as part of the Consultation;
  • relevant information or documents, if any, submitted by the member firm, in the manner and form prescribed by the Department, as shall be necessary or appropriate for the Department to review the computation of the Preliminary Criteria for Identification;
  • any plan submitted by the member firm, in the manner and form prescribed by the Department, proposing in detail the specific conditions or restrictions that the member firm seeks to have the Department consider;
  • such other information or documents as the Department may reasonably request from the member firm related to the evaluation; and
  • any other information the Department deems necessary or appropriate to evaluate the matter.

To the extent a member firm seeks to claim undue financial hardship, it is the member firm’s burden to support that with documents and information.

Department Decision and Notice (Rule 4111(e)); No Stays

Rule 4111(e) requires that, after the Consultation, the Department render a Department decision. Under Rule 4111(e)(1), there are three paths that decision might take:

  • If the Department determines that the member firm has rebutted the presumption that it should be designated as a Restricted Firm, the Department’s decision will state that the member firm will not be designated that year as a Restricted Firm.
  • If the Department determines that the member firm has not rebutted the presumption that it should be designated as a Restricted Firm or the presumption that it must be subject to the maximum Restricted Deposit Requirement, the Department’s decision will:
    • designate the member firm as a Restricted Firm; and
    • require the member firm to promptly establish a Restricted Deposit Account and deposit in that account the maximum Restricted Deposit Requirement; and
    • require the member firm to implement and maintain specified conditions or restrictions, as necessary or appropriate, on the operations and activities of the member firm and its associated persons that relate to, and are designed to address the concerns indicated by, the Preliminary Criteria for Identification and protect investors and the public interest.
  • If the Department determines that the member firm has not rebutted the presumption that it should be designated as a Restricted Firm but has rebutted the presumption that it shall be subject to the maximum Restricted Deposit Requirement, the Department’s decision will:
    • designate the member firm as a Restricted Firm;
    • impose no Restricted Deposit Requirement on the member firm, or will require the member firm to promptly establish a Restricted Deposit Account, deposit in that account a Restricted Deposit Requirement in such dollar amount less than the maximum Restricted Deposit Requirement as the Department deems necessary or appropriate; and
    • require the member firm to implement and maintain specified conditions or restrictions, as necessary or appropriate, on the operations and activities of the member firm and its associated persons that relate to, and are designed to address the concerns indicated by, the Preliminary Criteria for Identification and protect investors and the public interest.32

Rule 4111(e)(2) provides that the Department will issue a written notice of its decision to the member firm, pursuant to new Rule 9561 and no later than 30 days from the latest letter provided to the member firm under Rule 4111(d)(2), that states the obligations to be imposed on the member firm, if any, and the ability of the member firm to request a hearing with the Office of Hearing Officers in an expedited proceeding.33

Rule 4111(e)(2) provides that a request for a hearing will not stay the effectiveness of the Department’s decision. However, upon requesting a hearing of a Department decision that imposes a Restricted Deposit Requirement, the member firm will only be required to deposit in a Restricted Deposit Account the lesser of 25 percent of its Restricted Deposit Requirement or 25 percent of its average excess net capital during the prior calendar year, until the Office of Hearing Officers or the National Adjudicatory Council (NAC) issues its final written decision in the expedited proceeding. This has one exception: A member firm that is re-designated as a Restricted Firm and is already subject to a previously imposed Restricted Deposit Requirement will be required to keep in the Restricted Deposit Account the assets then on deposit therein until the Office of Hearing Officers or the NAC issues a written decision in the expedited proceeding.

Continuation or Termination of Restricted Firm Obligations (Rule 4111(f))

Rule 4111(f) contains provisions that set forth how any obligations that were imposed during the Rule 4111 process in one year are continued or terminated in that same year and in subsequent years.

Rule 4111(f)(1), titled “Currently Designated Restricted Firms,” establishes constraints on a member firm’s ability to seek to modify or terminate, directly or indirectly, any obligations imposed pursuant to Rule 4111. Because Rule 4111 will entail annual reviews by the Department to determine whether a member firm is a Restricted Firm that should be subject to obligations, a Restricted Firm will be able to seek each year to terminate or modify any obligations that continue to be imposed. For this reason, Rule 4111 does not authorize a Restricted Firm to seek, outside of the Consultation process and any ensuing expedited proceedings after a Department decision, a separate interim termination or modification of any obligations imposed. Rather, Rule 4111(f)(1) provides that a currently designated Restricted Firm will not be permitted to withdraw all or any portion of its Restricted Deposit Requirement, or seek to terminate or modify any deposit requirement, conditions or restrictions that have been imposed on it, without the prior written consent of the Department. Rule 4111(f)(1) also provides that there shall be a presumption that the Department shall deny an application by a currently designated Restricted Firm to withdraw all or any portion of its Restricted Deposit Requirement.

Rule 4111(f)(2), titled “Re-Designation as a Restricted Firm,” addresses the scenario when the Department determines in one year that a member firm is a Restricted Firm, and in the following year determines that the member firm still meets the Preliminary Criteria for Identification. In that instance, the Department will provide a written letter to the member firm stating that it shall be re-designated as a Restricted Firm, and that the obligations previously imposed on the member firm shall remain effective and unchanged, unless either the member firm or the Department requests a Consultation in writing within seven days of the Department’s letter. If a Consultation is requested, the obligations previously imposed will continue unchanged unless and until the Department modifies or terminates them after the Consultation. In addition, in the Consultation process, a presumption will apply that any previously imposed Restricted Deposit Requirement, conditions or restrictions will remain effective and unchanged absent a showing by the party seeking changes that they are no longer necessary or appropriate for the protection of investors or in the public interest. If a Consultation is not requested, the firm shall be subject to Rule 4111(f)(1) (the provision that governs “currently designated Restricted Firms”).

Rule 4111(f)(2) further provides that when FINRA re-designates a member as a Restricted Firm and the member is subject to a Restricted Deposit Requirement, the member shall promptly after such re-designation (or, in the case where a hearing is requested pursuant to Rule 9561, promptly after the Office of Hearing Officers or the NAC issues a written decision under Rule 9559) deposit additional cash or qualified securities in the member’s Restricted Deposit Account to the extent necessary to cause the aggregate value of the cash and qualified securities in the member’s Restricted Deposit Account to be not less than its re-designated Restricted Deposit Requirement.  

Rule 4111(f)(3), titled “Previously Designated Restricted Firms,” addresses the scenario where the Department determines in one year that a member firm is a Restricted Firm, but in the following year(s) determines that the member firm or former member firm34 either does not meet the Preliminary Criteria for Identification or should not be designated as a Restricted Firm. In that case, the member firm or former member firm will no longer be subject to any obligations previously imposed under Rule 4111.

There is one exception: A former Restricted Firm will not be permitted to withdraw any portion of its Restricted Deposit Requirement without submitting an application and obtaining the Department’s prior written consent for the withdrawal. Such an application will be required to include, among other things set forth in Rule 4111(f)(3)(A), evidence as to whether the firm, its Associated Persons, or the former member firm have Covered Pending Arbitration Claims or any unpaid arbitration awards outstanding. The Department will determine whether to authorize a withdrawal, in part or in whole, and several presumptions will apply. Rule 4111(f)(3)(B)(i) establishes a presumption that the Department shall approve an application for withdrawal if the member firm, its Associated Persons, or the former member firm have no Covered Pending Arbitration Claims or unpaid arbitration awards. Rule 4111(f)(3)(B)(ii) establishes presumptions that the Department shall: (a) Deny an application for withdrawal if the member firm, the member firm’s Associated Persons who are owners or control persons, or the former member have any Covered Pending Arbitration Claims or unpaid arbitration awards, or if the member’s Associated Persons have any Covered Pending Arbitration Claims or unpaid arbitration awards relating to arbitrations that involved conduct or alleged conduct that occurred while associated with the member; but (b) approve an application by a former member for withdrawal if the former member commits in the manner specified by the Department to use the amount it seeks to withdraw from its Restricted Deposit to pay the former member’s specified unpaid arbitration awards. The Department will be required to issue, pursuant to Rule 9561, a notice of its decision on an application to withdraw from the Restricted Deposit Account within 30 days from the date the application is received by the Department.35

Restricted Deposit Account (Rule 4111(i)(14))

If a Department decision requires a member firm to establish a Restricted Deposit Account, Rule 4111(i)(14) will govern this account. The underlying policy for the account requirements is that, to make a deposit requirement effective in creating appropriate incentives to member firms that pose higher risks to change their behavior, the member firm must be restricted from withdrawing any of the required deposit amount, even if it terminates its FINRA membership.

Rule 4111(i)(14) requires that the Restricted Deposit Account be established in the name of the member firm, at a bank or the member firm’s clearing firm. The account must be subject to an agreement in which the bank or the clearing firm agrees:

  • not to permit withdrawals from the account absent FINRA’s prior written consent;
  • to keep the account separate from any other accounts maintained by the member firm with the bank or clearing firm;
  • that the cash or qualified securities on deposit will not be used directly or indirectly as security for a loan to the member firm by the bank or the clearing firm, and will not be subject to any set-off, right, charge, security interest, lien, or claim of any kind in favor of the bank, clearing firm or any person claiming through the bank or clearing firm;
  • that if the member firm becomes a former member, the assets deposited in the Restricted Deposit Account to satisfy the Restricted Deposit Requirement shall be kept in the Restricted Deposit Account, and withdrawals will not be permitted without FINRA’s prior written consent;
  • that FINRA is a third-party beneficiary to the agreement; and
  • that the agreement may not be amended without FINRA’s prior written consent.

In addition, the Restricted Deposit Account may not be subject to any right, charge, security interest, lien, or claim of any kind granted by the member.36

Books and Records (Rule 4111(g))

Rule 4111(g) establishes requirements to maintain books and records that evidence the member firm’s compliance with Rule 4111 and any Restricted Deposit Requirement or other conditions or restrictions imposed under that rule. In addition, the books and records provision specifically requires a member firm subject to a Restricted Deposit Requirement to provide to the Department, upon its request, records that demonstrate the member firm’s compliance with that requirement.

Notice of Failure to Comply (Rule 4111(h))

Under Rule 4111(h), FINRA will be authorized to issue a notice pursuant to Rule 9561(b) directing a member firm that is not in compliance with its Restricted Deposit Requirement, or with any conditions or restrictions imposed under Rule 4111, to suspend all or a portion of its business.

Net Capital Treatment of the Deposits in the Restricted Deposit Account (Rule 4111.01)

Supplementary Material .01 provides that, because of the restrictions on withdrawals from a Restricted Deposit Account, deposits in such an account cannot be readily converted to cash and therefore shall be deducted in determining the member’s net capital under Exchange Act Rule 15c3-137 and FINRA Rule 4110.

Compliance With Continuing Membership Application Rule (Rule 4111.02—Compliance with Rule 1017)

Supplementary Material .02 provides that nothing in Rule 4111 shall be construed as altering a member firm’s obligations under Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations). A member firm subject to Rule 4111 will need to continue complying with the requirements of Rule 1017 and submit continuing membership applications as necessary.

Examples of Conditions and Restrictions (Rule 4111.03)

Supplementary Material .03 provides a non-exhaustive list of examples of conditions and restrictions that the Department could impose on Restricted Firms. This non-exhaustive list is intended to provide clarity about the Department’s authority to impose conditions and restrictions without restricting the Department’s flexibility to react and respond to different sources of risk.

New Rule 9561 and Amendments to Rule 9559

Rule 9561 establishes a new expedited proceeding that will: (1) allow member firms to request a prompt review of the Department’s determinations under Rule 4111 and challenge any of the “Rule 4111 Requirements”38 imposed, including any Restricted Deposit Requirements; and (2) address a member firm’s failure to comply with any requirements imposed under Rule 4111.

Notices Under Rule 4111 (Rule 9561(a))

Rule 9561(a) establishes an expedited proceeding for the Department’s determinations under Rule 4111 to designate a member firm as a Restricted Firm and impose obligations on the member; and to deny a member’s request to access all or part of its Restricted Deposit Requirement. Rule 9561(a) requires the Department to serve a notice that provides its determination and the specific grounds and factual basis for the Department’s action; states when the action will take effect; informs the member firm that it may file, pursuant to Rule 9559, a request for a hearing in an expedited proceeding within seven days after service of the notice; and explains the Hearing Officer’s authority.39 The rule also provides that, if a member firm does not request a hearing, the notice of the Department’s determination will constitute final FINRA action.40

In general, a request for a hearing will not stay any of the Rule 4111 Requirements imposed in the Department’s decision, which would be immediately effective.41 There would be one exception: When a member firm requests review of a Department determination under Rule 4111 that imposes a Restricted Deposit Requirement on the member for the first time, the member firm will be required to deposit, while the expedited proceeding is pending, the lesser of 25 percent of its Restricted Deposit Requirement or 25 percent of its average excess net capital over the prior year.42 As explained above, however, this exception would not be available for a member firm that has been re-designated as a Restricted Firm, and is already subject to a previously imposed Restricted Deposit Requirement; in that instance, the firm would need to keep the assets on deposit in the Restricted Deposit Account until the Office of Hearing Officers or NAC issues a written decision.43

Notice for Failure to Comply with the Rule 4111 Requirements (Rule 9561(b))

Rule 9561(b) authorizes the Department, after receiving authorization from FINRA’s chief executive officer (CEO), or such other executive officer as the CEO may designate, to serve a notice stating that the member firm’s failure to comply with the Rule 4111 Requirements, within seven days of service of the notice, will result in a suspension or cancellation of membership.44 The rule requires that the notice identify the requirements with which the member firm is alleged to have not complied; include a statement of facts specifying the alleged failure; state when the action will take effect; explain what the member firm must do to avoid the suspension or cancellation; inform the member firm that it may file, pursuant to Rule 9559, a request for a hearing in an expedited proceeding within seven days after service of the notice; and explain the Hearing Officer’s authority.45 The rule provides that the suspension or cancellation referenced in a notice shall become effective seven days after service of the notice unless stayed by a request for a hearing.46 The rule also provides that a member firm may file a request seeking termination of a suspension imposed pursuant to the rule, on the ground of full compliance with the notice or decision, and authorizes the head of the Department to grant relief for good cause shown.47

Hearings (Amendments to Rule 9559)

If a member firm requests a hearing under Rule 9561, the hearing will be subject to Rule 9559. Several amendments to Rule 9559 have been approved that are specific to hearings requested pursuant to Rule 9561. These include, among others, amendments to Rule 9559(d) and (n) to establish the authority of the Hearing Officer; amendments to Rule 9559(f) to set out timing requirements for hearings conducted under Rule 9561(a) and (b); and amendments to Rule 9559(p)(6) to account for the obligations that may be imposed under Rule 4111 within the content requirements of any decision issued by a Hearing Officer under the Rule 9550 Series.48

Endnotes


1  See Securities Exchange Act Release No. 92525 (July 30, 2021), 86 FR 42925 (August 5, 2021) (Order Approving File No. SR-FINRA-2020-041, as Modified by Amendment Nos. 1 and 2) (Approval Order).

2  See Securities Exchange Act Release No. 83181 (May 7, 2018), 83 FR 22107 (May 11, 2018) (Notice of Filing and Immediate Effectiveness of File No. SR-FINRA-2018-018).

3  See Regulatory Notice 18-16 (April 2018).

4  See Regulatory Notice 21-09 (March 2021).

5   The term “Covered Pending Arbitration Claim” is defined in Rule 4111(i)(2) to mean, for purposes of Rule 4111, an investment-related, consumer initiated claim filed against the member or its associated persons in any arbitration forum that is unresolved; and whose claim amount (individually or, if there is more than one claim, in the aggregate) exceeds the member’s excess net capital. The claim amount includes claimed compensatory loss amounts only, not requests for pain and suffering, punitive damages or attorney’s fees, and shall be the maximum amount for which the member or associated person, as applicable, is potentially liable regardless of whether the claim was brought against additional persons or the associated person reasonably expects to be indemnified, share liability or otherwise lawfully avoid being held responsible for all or part of such maximum amount. This term conforms, in relevant part, to the definition of Covered Pending Arbitration Claim in Rule 1011(c).

6  For purposes of this Regulatory Notice, “unpaid arbitration awards” also includes unpaid settlements related to arbitrations.

7  “Restricted Deposit Requirement” is defined in Rule 4111(i)(15) and is further described below.

8  FINRA also has recently amended its Membership Application Program rules to create further incentives for the timely payment of arbitration awards by preventing an individual from switching firms, or a firm from using asset transfers or similar transactions, to avoid payment of arbitration awards. See Regulatory Notice 20-15 (May 2020).

9  “Restricted Deposit Account” is defined in Rule 4111(i)(14) and is further described below.

10   See Rule 4111(i)(10) (definition of “Preliminary Identification Metrics”).

11  See Rule 4111(i)(9) (definition of “Preliminary Criteria for Identification”).

12  See Rule 4111(i)(11) (definition of “Preliminary Identification Metrics Thresholds”).

13  See Rule 4111(i)(4) (defining “Disclosure Event and Expelled Firm Association Categories”).

14  See Rule 4111(i)(17) (defining “Uniform Registration Forms”).

15  “Registered Person Adjudicated Events,” defined in Rule 4111(i)(4)(A), means any one of the following events that are reportable on the registered person’s Uniform Registration Forms: (i) A final investment-related, consumer-initiated customer arbitration award or civil judgment against the registered person in which the registered person was a named party, or was a “subject of” the customer arbitration award or civil judgment; (ii) a final investment-related, consumer-initiated customer arbitration settlement, civil litigation settlement or a settlement prior to a customer arbitration or civil litigation for a dollar amount at or above $15,000 in which the registered person was a named party or was a “subject of” the customer arbitration settlement, civil litigation settlement or a settlement prior to a customer arbitration or civil litigation; (iii) a final investment-related civil judicial matter that resulted in a finding, sanction or order; (iv) a final regulatory action that resulted in a finding, sanction or order, and was brought by the SEC or Commodity Futures Trading Commission (CFTC), other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority or a self-regulatory organization; or (v) a criminal matter in which the registered person was convicted of or pled guilty or nolo contendere (no contest) in a domestic, foreign or military court to any felony or any reportable misdemeanor.

16  “Registered Person Pending Events,” defined in Rule 4111(i)(4)(B), means any one of the following events associated with the registered person that are reportable on the registered person’s Uniform Registration Forms: (i) A pending investment-related civil judicial matter; (ii) a pending investigation by a regulatory authority; (iii) a pending regulatory action that was brought by the SEC or CFTC, other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority or a self-regulatory organization; or (iv) a pending criminal charge associated with any felony or any reportable misdemeanor. Registered Person Pending Events does not include pending arbitrations, pending civil litigations or consumer-initiated complaints that are reportable on the registered person’s Uniform Registration Forms.

17  “Registered Person Termination and Internal Review Events,” defined in Rule 4111(i)(4)(C), means any one of the following events associated with the registered person at a previous member firm that are reportable on the registered person’s Uniform Registration Forms: (i) A termination in which the registered person voluntarily resigned, was discharged or was permitted to resign from a previous member after allegations; or (ii) a pending or closed internal review by a previous member. Under this definition, the included termination and internal review disclosures concerning a person whom a member firm terminated will not impact that member firm’s own Registered Person Termination and Internal Review Event Metric; rather, they will impact only the metrics of member firms that subsequently register the terminated individual.

18  “Member Firm Adjudicated Events,” defined in Rule 4111(i)(4)(D), means any one of the following events that are reportable on the member firm’s Uniform Registration Forms or based on customer arbitrations filed with FINRA’s dispute resolution forum: (i) A final investment-related, consumer-initiated customer arbitration award in which the member was a named party; (ii) a final investment-related civil judicial matter that resulted in a finding, sanction or order; (iii) a final regulatory action that resulted in a finding, sanction or order, and was brought by the SEC or CFTC, other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority or a self-regulatory organization; or (iv) a criminal matter in which the member was convicted of or pled guilty or nolo contendere (no contest) in a domestic, foreign or military court to any felony or any reportable misdemeanor. As FINRA previously explained, Rule 4111(i)(4)(D)(i) is intended to capture all BrokerCheck disclosures of arbitration awards against firms. See FINRA Response to Comments, at p. 8, SR-FINRA-2020-041 (March 4, 2021), available at https://www.finra.org/sites/default/files/2021-03/sr-finra-2020-041-response-to-comments.pdf.

19  “Member Firm Pending Events,” defined in Rule 4111(i)(4)(E), means any one of the following events that are reportable on the member firm’s Uniform Registration Forms: (i) a pending investment-related civil judicial matter; (ii) a pending regulatory action that was brought by the SEC or CFTC, other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority or a self-regulatory organization; or (iii) a pending criminal charge associated with any felony or any reportable misdemeanor.

20  “Registered Persons Associated with Previously Expelled Firms,” defined in Rule 4111(i)(4)(F), means any “Registered Person In-Scope” who was registered for at least one year with a previously expelled firm and whose registration with the previously expelled firm terminated during the “Evaluation Period” (i.e., the prior five years from the “Evaluation Date,” which is the annual date as of which the Department calculates the Preliminary Identification Metrics to determine if the member firm meets the Preliminary Criteria for Identification). See Rule 4111(i)(5), (6), and (13) (definitions of “Evaluation Date,” “Evaluation Period,” and “Registered Persons In-Scope”).

21  See Rule 4111(i)(10)(A), (C) and (D); Rule 4111(i)(6) (definition of “Evaluation Period”).

22  See Rule 4111(i)(10)(B), (C) and (E); Rule 4111(i)(6) (definition of “Evaluation Period”).  

23  See Rule 4111(i)(10)(A), (B) and (C); Rule 4111(i)(13) (definition of “Registered Persons In-Scope”).

24  See Rule 4111(i)(12) (definition of “Registered Person and Member Firm Events”).

25  See Rule 4111(i)(10)(A)-(E).

26  See Rule 4111(i)(10)(F).

27  The purpose of ensuring that a firm does not meet the Preliminary Criteria for Identification solely because of pending matters is because FINRA recognizes that pending matters include disclosure events that may remain unresolved or that may subsequently be dismissed or concluded with no adverse action.

28  See Rule 4111(b) and (i)(9)(A).

29  See Rule 4111(b) and (i)(9)(B).

30  The Department’s consideration of claims and awards against the firm’s Associated Persons would focus on claims and awards against Associated Persons who are owners or control persons and on claims and awards relating to arbitrations that involved conduct or alleged conduct that occurred while associated with the member firm. See Securities Exchange Act Release No. 90527 (November 27, 2020), 85 FR 78540, 78545 n.33 (December 4, 2020) (Notice of Filing of File No. SR-FINRA-2020-041) (Filing).

31  The term “maximum” is used to indicate that a firm’s maximum Restricted Deposit Requirement will be the figure FINRA declares to the firm is the highest deposit requirement to which it may be subject during that year’s Rule 4111 process. See Approval Order, 86 FR 42925, 42930 n.88.

32  A Restricted Deposit Requirement will require the member firm to promptly deposit in a Restricted Deposit Account cash or qualified securities with an aggregate value that is not less than the firm’s Restricted Deposit Requirement, but will not require the firm to make additional deposits in order to maintain continuously the original value of the qualified securities in its Restricted Deposit Account, if such qualified securities have declined in value. Likewise, if the aggregate value of the assets deposited by a member firm to comply with its Restricted Deposit Requirement increases above the firm’s Restricted Deposit Requirement, that would not be a basis for the firm to request a withdrawal from its Restricted Deposit Account. See Partial Amendment No. 2, at p. 4, SR-FINRA-2020-041 (July 20, 2021) (Partial Amendment No. 2). As described below, there are additional requirements in Rule 4111(f)(2) that apply when FINRA re-designates a member firm as a Restricted Firm and the member is subject to a Restricted Deposit Requirement.  

33   As FINRA has previously explained, FINRA plans to file with the SEC a proposed amendment to Rule 8312 (FINRA BrokerCheck Disclosure) to release on BrokerCheck information as to whether a particular member firm or former member firm is designated as a Restricted Firm pursuant to Rules 4111 and 9561. See FINRA Response to Comments, at p. 3, SR-FINRA-2020-041 (July 20, 2021), available at https://www.finra.org/sites/default/files/2021-07/SR-FINRA-2020-041-response-to-comments.pdf. In addition, in Rule 9561 expedited proceedings, FINRA shall release to the public a copy of, and information with respect to, any decision issued pursuant to Rule 9559 that constitutes final FINRA action. See Rule 8313(a)(3).     

34   See Rule 4111(i)(7) (definition of “Former Member”).                                                                                                                

35   See Rule 4111(f)(3)(B).

36   As FINRA has explained, funds or securities on deposit in a Restricted Firm’s Restricted Deposit Account are not held with respect to any particular claim, or class of claimants, against the Restricted Firm. In the event of a liquidation of a Restricted Firm, funds or securities on deposit in the Restricted Deposit Account would be additional financial resources available to satisfy claims against the Restricted Firm. See Partial Amendment No. 2, at 4 n.6.

37   See 17 CFR 240.15c3-1.

38   See Rule 9561(a)(1) (defining the “Rule 4111 Requirements” to mean the requirements, conditions, or restrictions imposed by a Department determination under Rule 4111).

39   See Rule 9561(a)(1), (2), (3) and (5).

40   See Rule 9561(a)(6).

41   See Rule 9561(a)(4).

42   See Rule 9561(a)(4).

43   See Rule 4111(e)(2).

44   See Rule 9561(b)(1), (2).

45   See Rule 9561(b)(3) and (5).

46   See Rule 9561(b)(4) and (6).

47   See Rule 9561(b)(7).

48   Amendments also have been approved to Rule 9559(b) (computation of time), (c) (stays), (e) (consolidation of severance of proceedings), (g) (notice of hearing), (h) (transmission of documents) and (o) (timing of decision). Additionally, in expedited proceedings pursuant to Rule 9561(a) to review a Department determination under Rule 4111, a member firm may sometimes seek to demonstrate that the Department included incorrectly disclosure events when calculating whether the member firm meets the Preliminary Criteria for Identification. When the member firm does so, however, it will not be permitted to collaterally attack the underlying merits of those final actions. See Filing, 85 FR 78540, 78550 & n.45; see also Approval Order, 86 FR 42925, 42932 n.115.