The Expert's Examiner


LOTS OF COMMENTS, MOSTLY SPLIT ALONG PARTY LINES, ON FINRA RULEMAKING PROPOSAL TO PROTECT AGAINST AT-RISK FIRMS AND UNPAID ARBITRATION AWARDS. SOME SURPRISES, THOUGH.
October 6, 2019

The comment period closed July 1st on FINRA’s Regulatory Notice seeking comments on rule changes aimed at better protecting investors from unpaid awards involving firms with significant regulatory histories. The thirty letters were mostly split along party lines, but some interesting alliances have emerged. We reported in SAA 2019-18 (May 8) that FINRA had issued a Regulatory Notice seeking comments on rule changes aimed at better protecting investors from firms with significant regulatory histories. Specifically, the Authority on May 2 announced publication of Regulatory Notice 19-17, FINRA Requests Comment on Proposed New Rule 4111 (Restricted Firm Obligations) Imposing Additional Obligations on Firms with a Significant History of Misconduct: “As part of FINRA’s ongoing initiatives to protect investors from misconduct, FINRA is requesting comment on proposed new Rule 4111 (Restricted Firm Obligations) that would impose tailored obligations, including possible financial requirements, on designated member firms that cross specified numeric disclosure-event thresholds.” A core thrust was unpaid arbitration awards. About thirty comments were posted on the Authority’s Website as of the comment period’s close on July 1 (ed: click on the announcement's “Comments” tab). We present below some representative institutional comments grouped by views. Footnotes have been omitted.

Generally Supportive But More Should Be Done
For the most part, investor advocacy groups and regulators support the proposal, but urge that more be done to protect investors from unpaid awards. Industry groups and commenters were more divided, some looking more to the burdens on competition among smaller firms, while others approached the proposition from an individual responsibility perspective. SIFMA generally supports the proposed changes.

NASAA: “NASAA commends FINRA’s attempt to strategically identify, and more strongly regulate, the limited number of FINRA member firms with histories of regulatory noncompliance. The Proposal represents another step in FINRA’s recent multi-pronged effort to protect investors from the bad behavior of certain high-risk firms – an effort NASAA supports.” The group suggests several improvements, however, such as: “Proposed Rule 4111 would provide FINRA with authority to require Restricted Firms to maintain a Restricted Deposit Account and ‘be subject to such conditions or restrictions on the member’s operations, as FINRA determines’ …. The Proposal is silent, though, on what such conditions or restrictions might entail. We encourage FINRA to provide greater guidance on this point and, in particular, to identify conditions or restrictions that generally may be appropriate.”

Public Investors Arbitration Bar AssociationPresident Christine Lazaro and Executive VP Samuel B. Edwards write: “We applaud all steps that regulators take in furtherance of those goals, but the problem that high-risk firms and high-risk brokers create is enormous. While we generally support the rules for what they will do to strengthen the regulation and compliance of high-risk firms and brokers, with the noted exceptions below, Rules 4111 and 9559 will not cure the long-standing unpaid arbitration award issue and we are concerned it is misleading to those interested in the unpaid arbitration award issue to suggest otherwise.”

SIFMA: “The issue of unpaid awards cannot be solved on the ‘back-end’ as a matter of post-award collection because at that point the money is already gone. Rather, the issue needs to be addressed on the ‘front-end’ – before an arbitration arises by ensuring that the firm maintains adequate resources to satisfy it. The Proposal appropriately embraces the ‘front-end’ approach by seeking to identify those small number of firms with an extensive history of misconduct and/or relevant disclosure events, and as appropriate, requiring those firms to set aside cash deposits or qualified securities that could be applied to pay the firm’s or its representatives’ unpaid awards. SIFMA supports this approach.” The group also suggests further clarifications and improvements.

Law School Investor Protection Clinics: Three clinics, John Jay Legal Services, Inc., University of Miami School of Law, and St. John’s University School of Law, filed predominantly supportive letters that suggest further improvements. For example, the St. John’s clinic writes: “The Clinic believes that more stringent conditions should be adopted to ensure firms deemed to be ‘high-risk’ are not harming investors. Under the proposal, FINRA contemplates that ‘additional conditions or restrictions’ may be imposed on high risk firms, however, there are no specific additional conditions or restrictions set forth in the proposal. At a minimum, firms that are under the purview of the rule should be subject to heightened supervision obligations. Such a requirement would be beneficial and a step towards increased investor protection. The Clinic also urges FINRA to include language in the proposed rule that would incentivize firms to maintain appropriate capital and operating account levels.”

Not Fair, Especially to Smaller Firms
Industry parties and the lawyers who represent them were, for the most part, opposed to the proposal as being unfair to smaller firms. The lone surprise was a State regulator sharing that view.

Better Markets: This group is “a non-profit, nonpartisan, and independent organization founded in the wake of the 2008 financial crisis to promote the public interest in the financial markets, support the financial reform of Wall Street, and make our financial system work for all Americans again.” A key point? “There are multiple, peer-reviewed studies showing the disproportionate harm that firms that specialize in bad brokers inflict on investors. As released, the Proposal fails to even remotely solve this fundamental challenge. Instead of appropriately working to rid its membership ranks of firms that attract and pay brokers who have indisputable records of repeat misconduct and investor abuses, this Notice tinkers on the margins by essentially making it slightly costlier for firms to hire or retain brokers with checkered pasts by slightly raising the firm’s regulatory cost.”

Colorado Financial Service Corporation: “We believe the underlying basis for the Proposed Rule does not apply to the majority of member firms and it would place an undue financial and economic burden on smaller member firms that are operating in an honorable and respectable manner, who have chosen to onboard enough representatives with disclosures, enough to pass the obligation thresholds.”

(*While an intriguing idea, we worry that subjective capital levels based on some regulatory scorecard give FINRA unrestricted power over small firms. We're reminded of Chief Justice Marshall's words: "The power to tax is the power to destroy." We agree with the commenters who want more detail. Why not take a case history like Stratton-Oakmont and illustrate how capital contributions would have assured payments to customers as they obtained awards and judgments against the firm. When one starts to think about dealing with a continuum like that, the concept gets a lot more complex. **Staff will analyze the comments, make changes, and then likely seek Board approval to do a 19b rule filing with the SEC.) (SAC Ref. No. 2019-26-03)