# Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of a Proposed Rule Change To Adopt FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111) > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-26594 ## Record - **Collection:** Federal Register - **Document type:** Notice - **Published:** December 4, 2020 - **Citation:** 85 FR 78540 ## Text SECURITIES AND EXCHANGE COMMISSION [Release No. 34-90527; File No. SR-FINRA-2020-041] Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of a Proposed Rule Change To Adopt FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111) November 27, 2020. Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) 1 and Rule 19b-4 thereunder, 2 notice is hereby given that on November 16, 2020, the Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by FINRA. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons. 1 15 U.S.C. 78s(b)(1). 2 17 CFR 240.19b-4. I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change FINRA is proposing to (1) adopt FINRA Rule 4111 (Restricted Firm Obligations) to require member firms that are identified as “Restricted Firms” to maintain a deposit in a segregated account from which withdrawals would be restricted, adhere to specified conditions or restrictions, or comply with a combination of such obligations; and (2) adopt a new FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111), and amend FINRA Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series), to create a new expedited proceeding to implement proposed Rule 4111. 3 In addition, FINRA proposes to adopt Capital Acquisition Broker (“CAB”) Rule 412 (Restricted Firm Obligations), to clarify that member firms that have elected to be treated as CABs would be subject to proposed FINRA Rule 4111, and to amend Funding Portal Rule 900(a) (Application of FINRA Rule 9000 Series (Code of Procedure) to Funding Portals), to clarify that funding portals would not be subject to proposed FINRA Rule 9561. 3 This reflects a different numbering than was originally proposed. See Regulatory Notice 19-17 (proposing to number the proposed new expedited proceeding rule as Rule “9559” and to renumber current Rule 9559 as Rule “9560”). The text of the proposed rule change is available on FINRA's website at http://www.finra.org, at the principal office of FINRA and at the Commission's Public Reference Room. II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change In its filing with the Commission, FINRA included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. FINRA has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements. A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change 1. Purpose Background FINRA has been engaged in an ongoing effort to enhance 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 these efforts, FINRA is proposing to adopt Rule 4111, which would impose obligations on member firms that have significantly higher levels of risk-related disclosures than similarly sized peers. FINRA would preliminarily identify these member firms by using numeric, threshold-based criteria and several additional steps that would guard against misidentification. The obligations could include requiring a member firm to maintain a specific deposit amount, with cash or qualified securities, in a segregated account at a bank or clearing firm, from which the member firm could make withdrawals only with FINRA's approval. The obligations also could include conditions or restrictions 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 identification criteria and protect investors and the public interest. FINRA also is proposing to adopt FINRA Rule 9561, and amend FINRA Rule 9559, to create a new expedited proceeding to implement proposed Rule 4111. FINRA has a number of tools to deter and remedy misconduct by member firms and the individuals they hire, including review of membership applications, focused examinations, risk monitoring and disciplinary actions. These tools have been effective in identifying and addressing a range of misconduct by individuals and member firms, and FINRA has continued to strengthen them. In recent years, for example, FINRA has enhanced its key investor protection rules and examination programs, expanded its risk-based monitoring of brokers and member firms, and deployed new technologies designed to make its regulatory efforts more effective and efficient. 4 4 For example, in October 2018, FINRA announced plans to consolidate its Examination and Risk Monitoring Programs, integrating three separate programs into a single, unified program to drive more effective oversight and greater consistency, eliminate duplication and create a single point of accountability for the examination of member firms. The consolidation brings those programs under a single framework designed to better direct and align examination resources to the risk profile and complexity of member firms. FINRA is conducting its examinations under this unified program in 2020. These efforts have strengthened protections for investors and the markets, but persistent compliance issues continue to arise in some FINRA member firms, which are a top focus of FINRA regulatory programs. While historically small in number, such firms generally do not carry out their supervisory obligations to ensure compliance with applicable securities laws and regulations and FINRA rules, and they act in ways that could harm their customers and erode trust in the brokerage industry. Recent academic studies, for example, find that some firms persistently employ brokers who engage in misconduct, and that misconduct can be concentrated at these firms. These studies also provide evidence that the past disciplinary and other regulatory events associated with a firm or individual can be predictive of similar future events. 5 While these firms may eventually be forced out of the industry through FINRA action or otherwise, these patterns indicate a persistent, if limited, population of firms with a history of misconduct that may not be acting appropriately as a first line of defense to prevent customer harm by their brokers. 5 For example, in 2015 FINRA's Office of the Chief Economist (“OCE”) published a study that examined the predictability of disciplinary and other disclosure events associated with investor harm based on past similar events. The OCE study showed that past disclosure events, including regulatory actions, customer arbitrations and litigations of brokers, have significant power to predict future investor harm. See Hammad Qureshi & Jonathan Sokobin, Do Investors Have Valuable Information About Brokers? (OCE Working Paper, Aug. 2015). A subsequent academic research paper presented evidence that suggests a higher rate of new disciplinary and other disclosure events is highly correlated with past disciplinary and other disclosure events, as far back as nine years prior. See Mark Egan, Gregor Matvos, & Amit Seru, The Market for Financial Adviser Misconduct, J. Pol. Econ. 127, no. 1 (Feb. 2019): 233-295. Such firms expose investors to real risk. For example, FINRA has identified certain firms that have a concentration of associated persons with a history of misconduct, and some of these firms consistently hire such individuals and fail to reasonably supervise their activities. These firms generally have a retail business engaging in cold calling to make recommendations of securities, often to vulnerable customers. FINRA has also identified groups of individual brokers who move from one firm of concern to another firm of concern. Such firms and their associated persons often have substantial numbers of disclosures on their records. In such situations, FINRA closely examines the firms' and brokers' conduct, and where appropriate, FINRA will bring enforcement actions to bar or suspend the firms and individuals involved. However, individuals and firms with a history of misconduct can pose a particular challenge for FINRA's existing examination and enforcement programs. In particular, examinations can identify compliance failures—or imminent failures—and prescribe remedies to be taken, but examiners are not empowered to require a firm to change or limit its business operations in a particular manner without an enforcement action. While these constraints on the examination process protect firms from potentially arbitrary or overly onerous examination findings, an individual or firm with a history of misconduct can take advantage of these limits to simply continue activities that pose risk of harm to investors until they result in an enforcement action. Enforcement actions in turn can only be brought after a rule has been violated and any resulting customer harm has already occurred. In addition, these proceedings can take significant time to develop, prosecute and conclude, during which time the individual or firm is able to continue misconduct, with significant risks of additional harm to customers and investors. Parties with serious compliance issues often will litigate enforcement actions brought by FINRA, which potentially involves a hearing and multiple rounds of appeals, forestalling the imposition of disciplinary sanctions for an extended period. For example, an enforcement proceeding could involve a hearing before a Hearing Panel, numerous motions, an appeal to the National Adjudicatory Council (“NAC”), and a further appeal to the SEC. Moreover, even when a FINRA Hearing Panel imposes a significant sanction, the sanction is stayed during appeal to the NAC, many sanctions are automatically stayed on appeal to the SEC, and they potentially can be stayed during appeal to the courts. And when all appeals are exhausted, the firm may have withdrawn its FINRA membership and shifted its business to another member or other type of financial firm, limiting FINRA's jurisdiction and avoiding the sanction, including making restitution to customers. Temporary cease and desist proceedings, while useful, do not always provide an effective remedy for potential ongoing harm to investors during the enforcement process. 6 Temporary cease and desist proceedings are available only in narrowly defined circumstances. Moreover, initiation by FINRA of a temporary cease and desist action does not necessarily enable more rapid intervention, because FINRA must be prepared to file the underlying disciplinary complaint at the same time. 6 See FINRA Rule 9800 Series (Temporary and Permanent Cease and Desist Orders). In addition, by the time sanctions are imposed, as noted above, the firm may have exited the industry, thereby limiting FINRA's jurisdiction over the misconduct. In such circumstance, the firm may also fail to pay arbitration awards owed to claimants, leaving investors uncompensated and diminishing confidence in the securities markets. Therefore, FINRA is strengthening its tools to respond to firms and brokers with a significant history of misconduct, and the firms that employ those brokers, several of which are described below. Additional Steps Undertaken by FINRA To address these problems, FINRA has undertaken the following: ➢ Published Regulatory Notice 18-15, which rearticulates the obligation of member firms to implement heightened supervisory procedures tailored to the associated persons with a history of misconduct; ➢ Proposed rule amendments that would require a member firm to conduct with FINRA a materiality consultation before allowing persons with a history of misconduct to become owners, control persons, principals or registered persons of a member firm; authorize the imposition in a disciplinary proceeding of conditions and restrictions on the activities of a respondent member firm or respondent broker that are reasonably necessary for the purpose of preventing customer harm, and require a respondent broker's member firm to adopt heightened supervisory procedures for such broker, when a disciplinary matter is appealed to the NAC or called for NAC review; require firms that apply to continue associating with a statutorily disqualified person to include in that application an interim plan of heightened supervision that would be effective throughout the application process; and allow the disclosure through FINRA BrokerCheck of the status of a member firm as a “taping firm” under FINRA Rule 3170 (Tape Recording of Registered Persons by Certain Firms); 7 7 See Securities Exchange Act Release No. 88600 (April 8, 2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No. SR-FINRA-2020-011); see also Regulatory Notice 18-16 (April 2018). ➢ Published Regulatory Notice 18-17, which announced revisions to the FINRA Sanction Guidelines; ➢ Raised fees for statutory disqualification applications; 8 and 8 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). ➢ Revised the qualification examination waiver guidelines to permit FINRA to more broadly consider past misconduct when considering examination waiver requests. 9 9 See Regulatory Notice 18-16 (April 2018). While these efforts should help mitigate the risks posed by individual brokers with a history of misconduct, challenges remain where a member firm itself has a concentration of such brokers—in some cases because the firm seeks out such brokers—or otherwise has a history of substantial compliance failures. Proposed Rule 4111 (Restricted Firm Obligations) FINRA is proposing to adopt Rule 4111 (Restricted Firm Obligations), a new rule that would use numeric thresholds based on firm-level and individual-level disclosure events and impose a Restricted Deposit Requirement on member firms that present a high degree of risk to the investing public. FINRA believes that the direct financial impact of a restricted deposit is most likely to change such member firms' behavior—and therefore protect investors. An added benefit of this proposal would be to preserve member firm funds for payment of arbitration awards against them and their associated persons. The proposal would consider “Covered Pending Arbitration Claims” 10 and unpaid arbitration awards 11 in determining the size of a Restricted Firm's “Restricted Deposit Requirement.” 12 The proposal also would establish presumptions that, when assessing an application by a member firm or former member firm that was previously designated as a Restricted Firm for withdrawal from a Restricted Deposit Account, 13 the Department of Member Regulation (“Department”) shall: (i) 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 firm have any Covered Pending Arbitration Claims or unpaid arbitration awards, or if the member firm's Associated Persons have any Covered Pending Arbitration Claims or unpaid arbitration awards relating to arbitrations outstanding that involved conduct or alleged conduct that occurred while associated with the member firm; but (ii) approve a former member firm's application for withdrawal when that former member firm 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 firm's specified unpaid arbitration awards. 10 The term “Covered Pending Arbitration Claim” is defined in proposed 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). See Securities Exchange Act Release No. 88482 (March 26, 2020), 85 FR 18299 (April 1, 2020) (Order Approving File No. SR-FINRA-2019-030). 11 For purposes of this Form 19b-4, “unpaid arbitration awards” also includes unpaid settlements related to arbitrations. 12 The term “Restricted Deposit Requirement” is defined in proposed Rule 4111(i)(15). 13 See proposed Rule 4111(i)(14) (proposed definition of “Restricted Deposit Account”). The proposed rule would create a multi-step process for FINRA's determination of whether a member firm raises investor-protection concerns substantial enough to require that it be subject to additional obligations. Those obligations could include a requirement to maintain a deposit of cash or qualified securities in an account from which withdrawals would be restricted, or conditions or restrictions on the member firm's operations that are necessary or appropriate for the protection of investors and in the public interest. The proposed rule would give each affected member firm several ways to affect outcomes, including a one-time opportunity to reduce staffing so as to no longer trigger the preliminary identification criteria and numeric thresholds. The firm also could explain to the Department why it should not be subject to a Restricted Deposit Requirement or propose alternatives, and the firm could challenge a Department determination by requesting a hearing before a Hearing Officer in an expedited proceeding. The proposed multi-step process includes numerous features designed to narrowly focus the new obligations on the firms most of concern. As the flow chart in Exhibit 2d reflects, this 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. ➢ General (Proposed Rule 4111(a)) Proposed Rule 4111(a) would require a member designated as a Restricted Firm to establish a Restricted Deposit Account and maintain in that account deposits of cash or qualified securities with an aggregate value that is not less than the member's Restricted Deposit Requirement, except in certain identified situations, and be subject to conditions or restrictions on the member's operations as determined by the Department to be necessary or appropriate for the protection of investors and in the public interest. ➢ Annual Calculation by FINRA of the Preliminary Criteria for Identification (Proposed Rule 4111(b)) The multi-step process would begin with an annual calculation. As explained more below, proposed Rule 4111(b) would require the Department to calculate annually (on a calendar-year basis) the “Preliminary Identification Metrics” 14 to determine whether a member firm meets the “Preliminary Criteria for Identification.” 15 A key driver of that is whether a member firm's “Preliminary Identification Metrics” meet quantitative, risk-based “Preliminary Identification Metrics Thresholds.” 16 14 See proposed Rule 4111(i)(10) (definition of “Preliminary Identification Metrics”). 15 See proposed Rule 4111(i)(9) (definition of “Preliminary Criteria for Identification”). 16 See proposed Rule 4111(i)(11) (definition of “Preliminary Identification Metrics Thresholds”). Several principles guided FINRA's development of the proposed Preliminary Criteria for Identification and the proposed 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 are motivating the proposal. 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. Using these guiding principles, FINRA is proposing numeric thresholds based on six categories of events or conditions, nearly all of which are based on information disclosed through the Uniform Registration Forms. 17 The six categories, collectively defined as the “Disclosure Event and Expelled Firm Association Categories,” 18 are: 17 One of the event categories, Member Firm Adjudicated Events, includes events that are derived from customer arbitrations filed with FINRA's dispute resolution forum. 18 See proposed Rule 4111(i)(4). 1. Registered Person Adjudicated Events; 19 19 “Registered Person Adjudicated Events,” defined in proposed 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. 2. Registered Person Pending Events; 20 20 “Registered Person Pending Events,” defined in proposed 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. 3. Registered Person Termination and Internal Review Events; 21 21 “Registered Person Termination and Internal Review Events,” defined in proposed 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. FINRA has revised this definition, from the version proposed in Regulatory Notice 19-17 (May 2019), to clarify that termination and internal review disclosures concerning a person whom a member firm terminated would not impact that member firm's own Registered Person Termination and Internal Review Metric; rather, they would only impact the metrics of member firms that subsequently register the terminated individual. 4. Member Firm Adjudicated Events; 22 22 “Member Firm Adjudicated Events,” defined in proposed 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. 5. Member Firm Pending Events; 23 and 23 “Member Firm Pending Events,” defined in proposed Rule 4111(i)(4)(E), means any one of the same kinds of events as the “Registered Person Pending Events,” but that are reportable on the member firm's Uniform Registration Forms. 6. Registered Persons Associated with Previously Expelled Firms (also referred to as the Expelled Firm Association category). 24 24 “Registered Persons Associated with Previously Expelled Firms,” defined in proposed 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). See proposed Rule 4111(i)(5), (6), and (13) (proposed definitions of “Evaluation Date,” “Evaluation Period,” and “Registered Persons In-Scope”). This proposed definition is narrower than the definition proposed in Regulatory Notice 19-17. To calculate whether a member firm meets the Preliminary Criteria for Identification, the Department would first compute the Preliminary Identification Metrics for each of the Disclosure Event and Expelled Firm Association Categories. Each category's Preliminary Identification Metric computation would start with a calculation of the sum of the pertinent disclosure events or, for the Expelled Firm Association category, the sum of the Registered Persons Associated with Previously Expelled Firms. For the adjudicated disclosure-event based categories, the counts would include disclosure events that were resolved during the prior five years from the date of the calculation. For the pending events categories and pending internal reviews, the counts would include disclosure events that are pending as of the date of the calculation. In addition, for the three Registered Person disclosure-event based categories, the counts would 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 calculation date. 25 25 See proposed Rule 4111(i)(13). Each of those six sums would then be standardized to determine the member's six Preliminary Identification Metrics. For the five “Registered Person and Member Firm Events” categories (Categories 1-5 above), 26 the proposed Preliminary Identification Metrics are in the form of an average number of events per registered broker, calculated by taking each category's sum and dividing it by the number of Registered Persons In-Scope. The sixth Preliminary Identification Metric—the proposed 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 See proposed Rule 4111(i)(12) (definition of Registered Person and Member Firm Events). A firm's six Preliminary Identification Metrics are used to determine if the member firm meets the Preliminary Criteria for Identification. To meet the Preliminary Criteria for Identification, a member firm would need to meet the Preliminary Identification Metrics Thresholds, set forth in proposed Rule 4111(i)(11), for two or more of the appropriate metrics listed above for its size and, if it does, one of these metrics must be for adjudicated events or the Expelled Firm Association Metric, and the firm must have two or more Registered Person and Member Firm Events ( i.e., events in categories besides the Registered Persons Associated with Previously Expelled Firms category). 27 This involves analyzing the extent to which the Preliminary Identification Metrics meet the specified numeric Preliminary Identification Metrics Thresholds 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. 28 Specifically, the Department would: 27 Including an Expelled Firm Association Metric in the Preliminary Criteria for Identification is similar to how FINRA Rule 3170 (Tape Recording of Registered Persons by Certain Firms) imposes recording requirements on firms with specific percentages of registered persons who were previously associated with disciplined firms. 28 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. As explained in more detail in the Economic Impact Assessment, FINRA also evaluated the impact of including and excluding pending matters from the Preliminary Criteria for Identification. Based on this evaluation, FINRA has included pending matters in the proposed criteria because they are critical to identifying firms that pose greater risks to their customers. • First, pursuant to proposed Rules 4111(b) and (i)(9)(A), evaluate whether 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 whether 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; and • second, pursuant to proposed Rules 4111(b) and (i)(9)(B), evaluate whether the member firm has two or more Registered Person or Member Firm Events ( i.e., two or more events from Categories 1-5 above). If all of these conditions are met, the member firm would meet the Preliminary Criteria for Identification. Each specific numeric threshold in the Preliminary Identification Metrics Thresholds grid in proposed Rule 4111(i)(11) is a number which represents outliers with respect to peers for the type of events 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. In addition, there are numeric thresholds for seven different firm sizes, to ensure that each member firm is compared only to its similarly sized peers. 29 As explained more below in the Economic Impact Assessment, based on recent history FINRA expects that its annual calculations will identify between 45-80 member firms that meet the Preliminary Criteria for Identification. 30 29 Because FINRA has narrowed the definition of Registered Persons Associated with Previously Expelled Firms from the version that was originally proposed in Regulatory Notice 19-17, FINRA also has revised the Expelled Firm Association Metric Thresholds. 30 Due to the revisions in the Preliminary Criteria for Identification, discussed above, and the inclusion of the year 2019 in the review period, this estimate and other corresponding estimates in the Economic Impact Assessment have changed from the ones in Regulatory Notice 19-17. The following three examples demonstrate—in practical terms—the point at which a member firm's Preliminary Identification Metrics would meet the Preliminary Identification Metrics Thresholds in proposed Rule 4111(i)(11): Preliminary identification metrics thresholds Practical equivalent Example 1 (member firm size between 1-4 registered persons) 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, 31 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 would 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) 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 would 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) 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% concentration level) For a member firm with 100 Registered Persons In-Scope as of the Evaluation Date, the member firm would 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) In a comment to Regulatory Notice 19-17, SIFMA requested more clarity around when the annual Evaluation Date would be. FINRA would announce the first Evaluation Date no less than 120 calendar days before the first Evaluation Date. Subsequent Evaluation Dates would be on the same month and day each year, except when that date falls on a Saturday, Sunday or federal holiday, in which case the Evaluation Date would be on the next business day. 31 The “Evaluation Date” is defined in proposed Rule 4111(i)(5) to mean the date, each calendar year, as of which the Department calculates the Preliminary Identification Metrics to determine if the member firm meets the Preliminary Criteria for Identification. FINRA has conducted a thorough analysis of the proposed criteria and thresholds to ensure that the proposed Preliminary Criteria for Identification preliminarily identify the types of member firms that are motivating this rule proposal. 32 As explained below, however, the proposed rule involves several additional steps to guard against the risk of misidentification. 32 OCE has tested the Preliminary Criteria for Identification, including the Preliminary Identification Metrics Thresholds, in several ways. For example, OCE has compared the firms captured by the proposed criteria to the firms that have recently been expelled or that have unpaid arbitration awards. OCE also has consulted with Department staff and examiners about whether, based on their experience, the criteria identifies firms that appear to present high risks to investors. ➢ Initial Department Evaluation (Proposed Rule 4111(c)(1)) For each member firm that meets the Preliminary Criteria for Identification, the Department would conduct, pursuant to proposed 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 would review whether it has information to conclude that the computation of the member firm's Preliminary Identification Metrics included disclosure events or other conditions that should not have been included because they 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. The Department would 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 would also consider whether the member firm has addressed the concerns signaled by the disclosure events or conditions or altered its business operations, including staffing reductions, 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 proposed Rule 4111(c)(3), if the Department determines, after this initial evaluation, that the member firm does not warrant further review, the Department would 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 (Proposed Rule 4111(c)(2)) If the Department determines, after its initial evaluation, that a member firm warrants further review under proposed Rule 4111, such member firm—if it would be meeting the Preliminary Criteria for Identification for the first time—would 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. The member firm would be required to demonstrate the staff reduction to the Department by identifying the terminated individuals. The proposed rule would prohibit the member firm from rehiring any persons terminated pursuant to this option, in any capacity, for one year. A member firm that has reduced staffing levels at this stage may not use that staff-reduction opportunity again. If the Department determines that the member firm's reduction of staffing levels results in its no longer meeting the Preliminary Criteria for Identification, the Department would close out that year's Rule 4111 process for the member firm and would not seek that year to impose any obligations on that 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, or if the member firm elects not to use its one-time opportunity to reduce staffing levels, the Department would proceed to determine the firm's maximum Restricted Deposit Requirement, and the member firm would proceed to a “Consultation” with the Department. ➢ FINRA's Determination of a Maximum Restricted Deposit Requirement (Proposed Rule 4111(i)(15)) For members that warrant further review after being deemed to meet the Preliminary Criteria for Identification and after the initial Department evaluation, the Department would then determine the member's maximum “Restricted Deposit Requirement.” The Department would tailor the member firm's maximum Restricted Deposit Requirement amount to its size, operations and financial conditions. As provided in proposed Rule 4111(i)(15), the Department would 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. 33 Based on a consideration of these factors, the Department would determine a maximum Restricted Deposit Requirement for the member firm that would be consistent with the objectives of the rule, but 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 so burdensome that it would force the member firm out of business solely by virtue of the imposed deposit requirement. 33 The proposed factors that the Department would consider when determining a maximum Restricted Deposit Requirement have been revised from the ones proposed in Regulatory Notice 19-17. Some of the revisions are to ensure that proposed Rule 4111(i)(15) describes more accurately the factors that would be relevant to a determination of the maximum Restricted Deposit Requirement. In this regard, the “annual revenues” and “net capital requirements” factors proposed in Regulatory Notice 19-17 have been modified to “revenues” and “net capital,” and “assets,” “expenses,” and “liabilities” have been added as factors. Another revision clarifies that the Covered Pending Arbitration Claims and unpaid arbitration awards factors include claims and awards against the firm and its Associated Persons. 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. The revised proposed definition also adds the member firm's “insurance coverage for customer arbitration awards or settlements” as a factor. FINRA believes that, if Restricted Firms were able to procure errors and omissions policies, or other kinds of insurance coverage, for some or all of the kinds of arbitration claims that customers typically bring, that could warrant a reduced Restricted Deposit Requirement and would be behavior to encourage. ➢ Consultation (Proposed Rule 4111(d)) If the Department determines, after the process discussed above, that a member firm warrants further Rule 4111 review, the Department would consult with the member firm, pursuant to proposed Rule 4111(d). This Consultation will give the member firm 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. In the Consultation, there would be two rebuttable presumptions: 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 would bear the burden of overcoming those presumptions. Proposed Rule 4111(d)(1) governs how a member may overcome these two presumptions. First, a member 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 to the Department that the member firm would face significant undue financial hardship if it were required to maintain 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. Proposed Rule 4111(d)(2) governs how the Department would schedule and provide notice of the Consultation. In a change from the proposal in Regulatory Notice 19-17, the Department would provide the written letter required by the rule at least seven days prior to the Consultation, and would establish a process whereby the member can request a postponement for good cause shown. These changes, which are in response to a comment on Regulatory Notice 19-17, are intended to ensure that the firms have sufficient time to prepare for the Consultation and to enhance the procedural protections. Proposed Rule 4111(d)(3) provides guidance on what the Department would 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. For example, proposed 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 would 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 would be the member firm's burden to support that with documents and information. ➢ Department Decision and Notice (Proposed Rule 4111(e)); No Stays After the Consultation, proposed Rule 4111(e) would require that the Department render a Department decision. Under proposed 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 would 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 maintain the maximum Restricted Deposit Requirement, the Department's decision would designate the member firm as a Restricted Firm and require the member firm to promptly establish a Restricted Deposit Account, deposit and maintain in that account the maximum Restricted Deposit Requirement, and 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 must maintain the maximum Restricted Deposit Requirement, the Department's decision would designate the member firm as a Restricted Firm; would impose no Restricted Deposit Requirement on the member firm, or would require the member firm to promptly establish a Restricted Deposit Account, deposit and maintain 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 would 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. Pursuant to proposed Rule 4111(e)(2), the Department would provide a written notice of its decision to the member firm, pursuant to proposed Rule 9561 and no later than 30 days from the latest scheduling letter provided to the member firm under proposed 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, as further described below. Proposed Rule 4111(e)(2) would provide that a request for a hearing would 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 would only be required to maintain in a Restricted Deposit Account the lesser of 25% of its Restricted Deposit Requirement or 25% of its average excess net capital during the prior calendar year, until the Office of Hearing Officers or the NAC issues its final written decision in the expedited proceeding. 34 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 would be required to maintain the full amount of its Restricted Deposit Requirement until the Office of Hearing Officers or the NAC issues its final written decision in the expedited proceeding. 34 In Regulatory Notice 19-17 (May 2019), FINRA originally proposed that the member firm would be required, upon requesting a hearing, to deposit the lesser of 50% of the Restricted Deposit Requirement or 25% of the firm's average excess net capital during the prior calendar year. FINRA has revised this provision because, although the no-stay provisions are a fundamental part of how the proposed rule would protect investors, FINRA believes that this aspect of the no-stay provisions could be less burdensome than originally proposed and still achieve its intended purpose. Considering the nature of the firms identified as Restricted Firms and the risks they present, the immediate effectiveness of the Department's decision will help protect investors during the pendency of the expedited proceeding. Moreover, FINRA believes that the no-stay provision is consistent with fairness principles, because obligations would be imposed only after firms are preliminarily identified, from among their firm-size peer group, by transparent criteria and a process that involves an initial evaluation and a consultation with the firm. ➢ Continuation or Termination of Restricted Firm Obligations (Proposed Rule 4111(f)) The proposed Restricted Firm Obligations Rule would require FINRA to determine annually whether each member firm is, or continues to be, a Restricted Firm and whether the member firm should be subject to any obligations. For this reason, proposed 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. Proposed 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 the Restricted Firm Obligations Rule would 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 could seek each year to terminate or modify any obligations that continue to be imposed. For this reason, proposed 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, proposed Rule 4111(f)(1) provides that a member firm that has been designated as a 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. In a change from the proposal in Regulatory Notice 19-17, there would be a presumption that the Department shall deny an application by a member firm or former member firm that is currently designated as a Restricted Firm to withdraw all or any portion of its Restricted Deposit Requirement. 35 35 This revision, and additional revisions to proposed Rule 4111(f)(3) discussed below, are intended to make more clear the process that would guide the Department's assessment of applications for withdrawal from a Restricted Deposit Requirement. Proposed 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 would re-designate the member firm as a Restricted Firm, and the obligations previously imposed on the member firm would continue unchanged, unless either the member firm or the Department requests, within seven days of the Department's decision to re-designate the member firm as a Restricted Firm, a Consultation. 36 If a Consultation is requested, the obligations previously imposed would continue unchanged unless and until the Department modifies or terminates them after the Consultation. In addition, in the Consultation process, a presumption would apply that any previously imposed Restricted Deposit Requirement, conditions or restrictions would 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. At the end of the Consultation, the Department would be required to provide written notice of its determination to the member firm, no later than 30 days from the date of the latest scheduling letter provided to the member firm under Rule 4111(d)(2). 36 The seven-day period to request a Consultation is a revision from the proposal in Regulatory Notice 19-17 (May 2019), which proposed a 30-day period. Proposed 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 firm 37 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 would no longer be subject to any obligations previously imposed under proposed Rule 4111. There would be one exception: A former Restricted Firm would 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 would be required to include, among other things set forth in proposed 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. 37 See proposed Rule 4111(i)(7) (definition of “Former Member”). The Department would determine whether to authorize a withdrawal, in part or in whole. Proposed Rule 4111(f)(3)(B)(i) would establish 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. Proposed Rule 4111(f)(3)(B)(ii) would establish 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,” 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. 38 The Department would be required to issue, pursuant to proposed 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. 38 The presumptions in proposed Rule 4111(f)(3)(B) have been modified from what was proposed in Regulatory Notice 19-17. In addition, in clarifying changes from Regulatory Notice 19-17, proposed Rule 4111(f)(3) expressly provides that the Covered Pending Arbitration Claims and unpaid arbitration awards of a member firm's “Associated Persons” are pertinent to an application for a withdrawal from the Restricted Deposit Requirement. ➢ Restricted Deposit Account (Proposed Rule 4111(i)(14)) If a Department decision requires a member firm to establish a Restricted Deposit Account, proposed Rule 4111(i)(14) would govern this account. The underlying policy for the proposed 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. The proposed rule would require 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 Restricted Deposit Requirement in the account must be maintained, 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 account could not be subject to any right, charge, security interest, lien, or claim of any kind granted by the member. 39 39 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 for the Restricted Firm's trustee to distribute to those with claims against the Restricted Firm. ➢ Books and Records (Proposed Rule 4111(g)) Proposed Rule 4111(g) would establish new requirements to maintain books and records that evidence the member firm's compliance with the Restricted Firm Obligations Rule and any Restricted Deposit Requirement or other conditions or restrictions imposed under that rule. In addition, the proposed books and records provision would specifically require 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 (Proposed Rule 4111(h)) FINRA also is proposing a requirement to address the situation when a member firm fails to comply with the obligations imposed pursuant to proposed Rule 4111. Under proposed Rule 4111(h), FINRA would be authorized to issue a notice pursuant to proposed Rule 9561 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. ➢ Definitions (Proposed Rule 4111(i)) A complete list of defined terms used in proposed Rule 4111 appears in proposed Rule 4111(i). 40 40 See Exhibit 5. ➢ Net Capital Treatment of the Deposits in the Restricted Deposit Account (Proposed Rule 4111.01) Proposed Supplementary Material .01 would clarify 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 15c3-1 41 and FINRA Rule 4110. 41 17 CFR 240.15c3-1. ➢ Compliance With Continuing Membership Application Rule (Proposed Rule 4111.02—Compliance with Rule 1017) Proposed Supplementary Material .02 would clarify that nothing in proposed Rule 4111 would alter a member firm's obligations under Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations). A member firm subject to proposed Rule 4111 would need to continue complying with the requirements of Rule 1017 and submit continuing membership applications as necessary. ➢ Examples of Conditions and Restrictions (Proposed Rule 4111.03) In a change from Regulatory Notice 19-17, FINRA is proposing to add, in supplementary material to proposed Rule 4111, a non-exhaustive list of examples of conditions and restrictions that the Department could impose on Restricted Firms. FINRA believes that providing these examples will 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. The non-exhaustive list of examples of conditions and restrictions includes: (1) Limitations on business expansions, mergers, consolidations or changes in control; (2) filing all advertising with FINRA's Department of Advertising Regulation; (3) imposing requirements on establishing and supervising offices; (4) requiring a compliance audit by a qualified, independent third party; (5) limiting business lines or product types offered; (6) limiting the opening of new customer accounts; (7) limiting approvals of registered persons entering into borrowing or lending arrangements with their customers; (8) requiring the member to impose specific conditions or limitations on, or to prohibit, registered persons' outside business activities of which the member has received notice pursuant to Rule 3270; and (9) requiring the member to prohibit or, as part of its supervision of approved private securities transactions for compensation under Rule 3280 or otherwise, impose specific conditions on associated persons' participation in private securities transactions of which the member has received notice pursuant to Rule 3280. ➢ Planned Review of Proposed Rule 4111 FINRA plans to conduct a review of proposed Rule 4111 after gaining sufficient experience under proposed Rule 4111. Among other things, FINRA would review whether the Preliminary Identification Metrics Thresholds remain targeted and effective at identifying member firms that pose higher risks. Proposed Amendments to the Rule 9550 Series To Establish a New Expedited Proceeding To Implement the Requirements of Proposed Rule 4111 FINRA is proposing to establish a new expedited proceeding in proposed Rule 9561 (Procedures for Regulating Activities Under Rule 4111) that would allow member firms to request a prompt review of the Department's determinations under the Restricted Firm Obligations Rule and grant a right to challenge any of the “Rule 4111 Requirements,” including any Restricted Deposit Requirements, imposed. 42 The new expedited proceeding would govern how the Department provides notice of its determinations and afford affected member firms the right to seek a Hearing Officer's review of those determinations. The proposed expedited proceeding is similar in nature to FINRA's other expedited proceedings. 42 Proposed Rule 9561(a)(1) would define the “Rule 4111 Requirements” to mean the requirements, conditions, or restrictions imposed by a Department determination under proposed Rule 4111. ➢ Notices Under Proposed Rule 4111 (Proposed Rule 9561(a)) Proposed Rule 9561(a) would establish an expedited proceeding for the Department's determinations under proposed 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. Proposed Rule 9561(a) would require 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. The proposed rule also would provide that, if a member firm does not request a hearing, the notice of the Department's determination will constitute final FINRA action. Proposed Rule 9561(a) also would provide that any of the Rule 4111 Requirements imposed in a notice issued under proposed Rule 9561(a) are immediately effective. In general, a request for a hearing would not stay those requirements. There would be one partial exception: When a member firm requests review of a Department determination under proposed Rule 4111 that imposes a Restricted Deposit Requirement on the member for the first time, the member firm would be required to deposit, while the expedited proceeding was pending, the lesser of 25% of its Restricted Deposit Requirement or 25% of its average excess net capital over the prior year. ➢ Notice for Failure To Comply With the Proposed Rule 4111 Requirements (Proposed Rule 9561(b)) Proposed Rule 9561(b) would establish an expedited proceeding to address a member firm's failure to comply with any requirements imposed pursuant to proposed Rule 4111. Proposed Rule 9561(b) would authorize 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. The proposed rule would require 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. The proposed rule also would provide that, if a member firm does not request a hearing, the suspension or cancellation will become effective seven days after service of the notice. Proposed Rule 9561(b) also would provide that a member firm could file a request seeking termination of a suspension imposed pursuant to the rule, on the ground of full compliance with the notice or decision. The proposed rule would authorize the head of the Department to grant relief for good cause shown. ➢ Hearings (Proposed Amendments to the Hearing Procedures Rule) If a member firm requests a hearing under proposed Rule 9561, the hearing would be subject to Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series). FINRA is proposing several amendments to Rule 9559 that would be specific to hearings requested pursuant to proposed Rule 9561. Hearings in expedited proceedings under proposed Rule 9561 would have processes that are similar to the hearings in most of FINRA's other expedited proceedings—including requirements for the parties' exchange of documents and exhibits, the time for conducting the hearing, evidence, the record of the hearing, the record of the proceeding, failures to appear, the timing and contents of the Hearing Officer's decision, the Hearing Officer's authority, and the authority of the NAC to call an expedited proceeding for review—and FINRA is proposing amendments to the Rule 9559 provisions that govern these processes to adapt them for expedited proceedings under proposed Rule 9561. A few features of the proposed amendments to Rule 9559 warrant emphasis or guidance. • Hearing Officer's Authority (Proposed Amended Rule 9559(d) and (n)) Hearings in expedited proceedings under proposed Rule 9561 would be presided over by a Hearing Officer. The Hearing Officer's authority would differ depending on whether the hearing is in an action brought under proposed Rule 9561(a) (Notices Under Rule 4111) or 9561(b) (Notice for Failure to Comply with the Rule 4111 Requirements). Proposed amended Rule 9559(n)(6) would provide that the Hearing Officer, in actions brought under proposed Rule 9561(a), may approve or withdraw any and all of the Rule 4111 Requirements, or remand the matter to the Department, but may not modify any of the Rule 4111 Requirements, or impose any other requirements or obligations available under proposed Rule 4111. Proposed amended Rule 9559(n)(6) would authorize the Hearing Officer, in failure-to-comply actions under proposed Rule 9561(b), to approve or withdraw the suspension or cancellation of membership, and impose any other fitting sanction. Authorizing a Hearing Officer to impose any other fitting sanction is intended to provide a Hearing Officer with authority that is appropriate for responding to situations involving member firms that repeatedly fail to comply with an effective FINRA action under proposed Rule 4111. • Timing Requirements The proposed amendments to the Hearing Procedures Rule are intended to give member firms a prompt process for challenging a Department decision under proposed Rule 4111. Proposed amended Rule 9559(f) would require that a hearing in actions under proposed Rule 9561(a) be held within 30 days, and that a hearing in failure-to-comply actions under proposed Rule 9561(b) be held within 14 days, after the member firm requests a hearing. 43 43 Proposed amendments to Rule 9559 contain other related timing requirements for proceedings pursuant to proposed Rule 9561. Proposed amended Rule 9559(o) would require the Hearing Officer, in all actions pursuant to proposed Rule 9561, to prepare a proposed written decision, and provide it to the NAC's Review Subcommittee, within 60 days of the date of the close of the hearing. Pursuant to Rule 9559(q), the Review Subcommittee could call the proceeding for review within 21 days after receipt of the proposed decision. As in most expedited proceedings, the timing of FINRA's final decision would then depend on whether or not the Review Subcommittee calls the matter for review. 44 44 See FINRA Rule 9559(q). • Contents of the Decision Proposed amended Rule 9559(p) would govern the contents of the Hearing Officer's decision. The proposed amendments would broaden Rule 9559(p)(6) to account for the kinds of obligations that could be imposed under proposed Rule 4111. Rule 9559(p) would otherwise remain the same. For example, Rule 9559(p) would continue to require that the Hearing Officer's decision include a statement setting forth the findings of fact with respect to any act or practice the respondent was alleged to have committed or omitted or any condition specified in the notice, the Hearing Officer's conclusions regarding the condition specified in the notice, and a statement in support of the disposition of the principal issues raised in the proceeding. Additional guidance may be helpful, considering the different kinds of issues that may arise in an expedited proceeding pursuant to proposed Rule 9561. For example, in a request for a hearing of a Department determination that imposes a Restricted Deposit Requirement or other obligations under Rule 4111, the principal issues raised may include whether: (1) The member firm should not be designated a Restricted Firm; (2) the Department incorrectly included disclosure events when calculating whether the member firm meets the Preliminary Criteria for Identification; (3) a Restricted Deposit Requirement would impose an undue financial burden on the member firm; or (4) the obligations imposed are inconsistent with the standards set forth in proposed Rule 4111(e). In a request for a hearing of a Department determination that denies a request to withdraw amounts from a Restricted Deposit Account, the principal issues raised may include whether the member firm or its Associated Persons have Covered Pending Arbitration Claims or unpaid arbitration awards and the nature of those claims or awards. • No Collateral Attacks on Underlying Disclosure Events In expedited proceedings pursuant to proposed Rule 9561(a) to review a Department determination under the Restricted Firm Obligations Rule, 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 would not be permitted to collaterally attack the underlying merits of those final actions. An expedited proceeding under proposed Rule 9561 would not be the forum for attempting to re-litigate past final actions. 45 45 Attempts to collaterally attack final matters are also precluded in other FINRA proceedings. Cf. Dep't of Enforcement v. Amundsen, Complaint No. 2010021916601, 2012 FINRA Discip. LEXIS 54, at *21-24 (FINRA NAC Sept. 20, 2012) (rejecting respondent's attempt to collaterally attack a judgment that was required to be disclosed on Form U4), aff'd, Exchange Act Release No. 69406, 2013 SEC LEXIS 1148 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C. Cir. 2014); Membership Continuance Application of Member Firm, Application No. 20060058633, 2007 FINRA Discip. LEXIS 31, at *51 (July 2007) (holding, in a membership proceeding, that a firm may not address its and its FINOP's past disciplinary history by collaterally attacking those past violations) (citing BFG Sec., Inc., 55 SEC. 276, 279 n.5 (2001)); Jan Biesiadecki, 53 SEC. 182, 185 (1997) (describing, in eligibility proceedings, FINRA's long-standing policy of prohibiting collateral attacks on underlying disqualifying events). If the Commission approves the proposed rule change, FINRA will announce the effective date of the proposed rule change in a Regulatory Notice to be published no later than 60 days following Commission approval. The effective date will be no later than 60 days following publication of the Regulatory Notice announcing Commission approval. 46 46 FINRA notes that the proposed rule change would impact all member firms, including member firms that have elected to be treated as capital acquisition brokers (“CABs”), given that the CAB rule set incorporates the FINRA Rule 9550 Series by reference. In addition, FINRA is proposing to adopt CAB Rule 412, to reflect that a CAB would be subject to Rule 4111. The proposed rule change would not impact, however, member firms that are funding portals. At this time, regulatory experience with funding portals is still at an early stage. The permissible business activities of funding portals are limited and, as such, it is not clear that funding portals present the corresponding risks that FINRA is seeking to address in the broker-dealer space. Moreover, developing relevant metrics and thresholds for funding portals would require a separate effort and analysis because, unlike broker-dealers, the Uniform Registration Forms do not apply to funding portals and their associated persons. Accordingly, FINRA is proposing to amend Funding Portal Rule 900(a) to add proposed Rule 9561 as a rule to which funding portal members would not be subject. 2. Statutory Basis FINRA believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) of the Act, 47 which requires, among other things, that FINRA rules must be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest. The proposed rule change is designed to protect investors and the public interest by strengthening the tools available to FINRA to address the risks posed by member firms with a significant history of misconduct, including firms at which individuals with a significant history of misconduct concentrate. The proposed rule would create strong measures of deterrence while a firm is designated as a Restricted Firm, limiting the potential for harm to the public. It also should create incentives for firms to change behaviors and activities, either to avoid being designated as a Restricted Firm or lose an existing Restricted Firm designation, to mitigate FINRA's concerns. 47 15 U.S.C. 78 o -3(b)(6). B. Self-Regulatory Organization's Statement on Burden on Competition FINRA does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act. FINRA has undertaken an economic impact assessment, as set forth below, to analyze the regulatory need for the proposed rulemaking, its potential economic impacts, including anticipated benefits and costs, and the alternatives FINRA considered in assessing how to best meet its regulatory objectives. Economic Impact Assessment 1. Regulatory Need FINRA uses a number of measures to deter and discipline misconduct by firms and brokers, and continually strives to strengthen its oversight of the brokers and firms it regulates. These measures span across several FINRA programs, including review of new and continuing membership applications, risk monitoring of broker and firm activity, cycle and cause examinations, and enforcement and disciplinary actions. As part of its efforts to monitor and deter misconduct, FINRA has adopted rules that impose supervisory obligations on firms to ensure they are appropriately supervising their brokers' activities. These rules require each firm to establish, maintain and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and FINRA rules. Under this regulatory framework, FINRA also provides guidance to ensure consistency in interpretation of the rules and to further strengthen compliance across firms. As such, all firms play an important role in ensuring effective compliance with applicable securities laws and FINRA rules to prevent misconduct. This is consistent with the incentives of economic agents. 48 48 See, e.g., Roland Strausz, Delegation of Monitoring in a Principal-Agent Relationship, Rev. Econ. Stud. 64(3):337-57 (July 1997). The paper shows that in a standard principal-agent framework, the delegation of monitoring by the principal ( e.g., a regulator) to the agent ( e.g., a firm) can be economically efficient for both parties. Nonetheless, some firms do not effectively carry out these supervisory obligations to ensure compliance and they act in ways that could harm their customers—sometimes substantially. For example, recent academic studies find that some firms persistently employ brokers who engage in misconduct, and that misconduct can be concentrated at these firms. These studies also provide evidence of predictability of future disciplinary and other regulatory-related events for brokers and firms with a history of past similar events. 49 These patterns suggest that some firms may not be acting appropriately as a first line of defense to prevent customer harm. Further, some firms may take advantage of the fair-process protections afforded to them under the federal securities laws and FINRA rules to forestall timely and appropriate regulatory actions, thereby limiting FINRA's ability to curb misconduct promptly. Without additional protections, the risk of potential customer harm may continue to exist at firms that fail to effectively carry out their supervisory obligations or are associated with a significant number of regulatory-related events. Further, even where harmed investors obtain arbitration awards, harm followed by recompense typically comes with some economic costs to customers and brokers, and firms may still fail to pay those awards. Unpaid arbitration awards harm successful customer claimants and may diminish investors' confidence in the arbitration process. 50 49 See supra note 5. 50 Investors may also file claims in courts or other dispute resolution forums. Successful claimants in these forums may face similar challenges associated with collecting awards or judgments. To mitigate these risks, FINRA seeks additional authority to impose obligations on firms that pose these types of greater risk to their customers. The proposed Restricted Firm Obligations Rule would identify firms based upon a concentration of significant firm and broker events on their disclosure records that meet the proposed criteria and specified thresholds. Under the proposal, FINRA seeks to impose obligations on the operations and activities of the member and its associated persons that are necessary or appropriate to address the concerns indicated by the Preliminary Criteria for Identification and protect investors and the public interest. 2. Economic Baseline The economic baseline used to evaluate the economic impacts of the proposed rules is the current regulatory framework, including FINRA rules relating to supervision, the membership application process, statutory disqualification proceedings and disciplinary proceedings that provide rules to deter and discipline misconduct by firms and brokers. This baseline serves as the primary point of comparison for assessing economic impacts of the proposed rules, including incremental benefits and costs. The proposals are intended to apply to firms that pose far greater risks to their customers than other firms. One identifier of these types of firms is that they and their brokers generally have substantially more regulatory-related events on their records than do their peers. 51 Consistent with this, the proposed Restricted Firm Obligations Rule would specifically apply to firms that have far more Registered Person and Member Firm Events, or far higher concentrations of Registered Persons Associated with Previously Expelled Firms, compared to their peers. 52 Based on staff analysis of all firms registered with FINRA between 2013 and 2019, firms that would have met the Preliminary Criteria for Identification had on average four to nine times more Registered Person and Member Firm Events than peer firms at the time of identification. Specifically, the number of events per firm, for firms that would have met the Preliminary Criteria for Identification, ranged, on average, from 25-52 events during the Evaluation Period, compared to 4-5 events per firm for firms that would not have met the Preliminary Criteria for Identification. The median number of events per firm, for the firms that would have met the Preliminary Criteria for Identification, ranged from approximately 9-18 events, compared to zero events among other firms that would not have met the Preliminary Criteria for Identification. 51 As discussed above, recent studies provide evidence of predictability of future regulatory-related events for brokers and firms with a history of past regulatory-related events. As a result, brokers and firms with a history of past regulatory-related events pose greater risk of future harm to their customers than other brokers and firms. 52 For example, for each of the six Preliminary Identification Metrics, the Preliminary Identification Metrics Threshold was chosen to capture one to five percent of the firms with the highest number of events per registered broker or the highest concentrations of Registered Persons Associated with Previously Expelled Firms, in respective firm-size categories. Although disciplinary and regulatory-related events are one of the identifiers for firms posing higher risk, FINRA recognizes that firms posing higher risks do not always manifest themselves with greater disclosures on their records. These firms may be newer, have recently made changes in management, staff or approach, or simply may be more effective in avoiding regulatory marks. 3. Economic Impacts a. Proposed Restricted Firm Obligations Rule To estimate the number and types of firms that would meet the Preliminary Criteria for Identification, FINRA analyzed the categories of events and conditions associated with the proposed criteria for all firms during the 2013-2019 review period. For each year, FINRA determined the approximate number of firms that would have met the proposed criteria. The number of firms that would have met the proposed criteria during the review period serves as a reasonable estimate for the number of firms that would have been directly impacted by this proposal had it been in place at the time. This analysis indicates that there were 45-80 such firms at the end of each year during the review period, as shown in Exhibit 3a. These firms represent 1.3-2.0% of all firms registered with FINRA in any year during the review period. The population of firms identified by the proposed criteria reflects the distribution of firm size in the full population of registered firms. Approximately 88-94% of these firms were small, 4-12% were mid-size and 0-3% were large at the end of each year during the review period, as shown in Exhibit 3b. 53 53 FINRA defines a small firm as a member with at least one and no more than 150 registered persons, a mid-size firm as a member with at least 151 and no more than 499 registered persons, and a large firm as a member with 500 or more registered persons. See FINRA By-Laws, Article I. FINRA notes that the number of firms that would have met the proposed criteria during the review period have declined (by approximately 44%) from 80 firms in 2013 to 45 firms in 2019. This decline is associated with an overall decrease in the number of Registered Person and Member Firm Events and the number of firms associated with these events. 54 Specifically, the Registered Person and Member Firm Events have declined by 24% and the number of firms with one or more of these events has declined by 22% during the review period. However, the average number of events per firm identified by the proposed criteria has increased, suggesting that there may be an increase in concentration of events across a smaller set of firms that may pose greater risks to their customers. For example, the average number of Registered Person and Member Firm Events for the firms identified by the criteria has increased by 94% from 24 events per firm in 2013 to 47 events per firm in 2019. These trends over the 2013-2019 review period suggest that while many firms continue to improve their regulatory records over time, a small proportion of firms may continue to further engage in activities that pose greater risks to their customers, which the proposed rule is intended to address. 54 FINRA notes that part of the decline in the number of events and the firms that would have met the proposed criteria may be associated with an approximately 15% decline in the overall number of registered firms during the 2013-2019 review period. In developing the proposed Preliminary Criteria for Identification, FINRA paid significant attention to the impact of possible misidentification of firms, specifically, the economic trade-off between including firms that are less likely to subsequently pose risk of harm to customers, and not including firms that are more likely to subsequently pose risk of harm to customers. There are costs associated with both types of misidentifications. 55 The proposed criteria, including the proposed numerical thresholds, aim to balance these economic trade-offs associated with over- and under-identification. 56 Further protection against misidentification would be provided by the proposed initial Department evaluation and the Consultation process. 55 For example, subjecting firms that are less likely to pose a risk to customers to the proposed Restricted Deposit Requirement or other obligations would impose additional and unwarranted costs on these firms, their brokers and their customers. 56 In order to evaluate the effectiveness of the proposed criteria at identifying firms that pose greater risks, FINRA examined the overlap between the firms that would have met the Preliminary Criteria for Identification each year during the review period and the firms that were subsequently expelled, associated with unpaid awards, or identified by Department staff as suitable candidates for additional obligations. Finally, as discussed below, FINRA also examined disclosure events associated with firms that would have met the Preliminary Criteria for Identification each year during the review period, subsequent to meeting the criteria, to assess the extent of risk posed by these firms. ➢ Anticipated Benefits The proposal's primary benefit would be to reduce the risk and associated costs of possible future customer harm. This benefit would arise directly from additional restrictions placed on firms identified as Restricted Firms and resulting expected increased scrutiny by these firms on their brokers. Further, this benefit would also accrue indirectly from improvements in the compliance culture, both by firms that meet the proposed criteria and by firms that do not. For example, the proposal may create incentives for firms that meet the Preliminary Criteria for Identification to change activities and behaviors, to mitigate the Department's concerns. Similarly, the proposal may have a deterrent effect on firms that do not meet the Preliminary Criteria for Identification, particularly firms that may be close to meeting the proposed criteria. These firms may change behavior and enhance their compliance culture in ways that better protect their customers. The proposal also may help address unpaid arbitration awards. Under the proposed rule, the Department may require a Restricted Firm to maintain a restricted deposit at a bank or a clearing firm that agrees not to permit withdrawals absent FINRA's approval. The amount of the Restricted Deposit Requirement would take into consideration, among other factors, the amount of any Covered Pending Arbitration Claims and unpaid arbitration awards against the member firm or its Associated Persons. Moreover, the proposed rule would have presumptions that the Department would: (a) Deny an application by a member firm or former member firm that was previously designated as a Restricted Firm for a withdrawal from the Restricted Deposit if the member firm, its Associated Persons who are owners or control persons, or the former member firm have any Covered Pending Arbitration Claims or unpaid arbitration awards, or if the member firm'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 firm; but (b) approve a former member firm's application for withdrawal if the former member firm 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 firm's specified unpaid arbitration awards. Accordingly, the proposed rule could potentially create incentives for firms to pay unpaid arbitration awards against the firm or its Associated Persons, thereby alleviating, to some extent, harm to successful claimants and enhancing investor confidence in the arbitration process. 57 57 Further, as discussed above, the Department would consider a member firm's and its Associated Persons' unpaid arbitration awards as one of the factors in determining the amount of the Restricted Deposit Requirement. As a result, there would be additional incentives to pay unpaid arbitration awards. To scope these potential benefits and assess the potential risk posed by firms that would meet the proposed Preliminary Criteria for Identification, FINRA evaluated the extent to which firms that would have met the criteria during 2013-2017 58 (had the criteria existed) and their brokers were associated with “new” Registered Person and Member Firm Events after having met the proposed criteria. These “new” events correspond to events that were identified or occurred after the firm's identification, and do not include events that were pending at the time of identification and subsequently resolved in the years after identification. As shown in Exhibit 3c, FINRA estimates that there were 77 firms that would have met the Preliminary Criteria for Identification in 2013. These firms were associated with 1,552 “new” Registered Person and Member Firm Events that occurred after their identification, between 2014 and 2019. Exhibit 3c similarly shows the number of events associated with firms that would have met the Preliminary Criteria for Identification in 2014, 2015, 2016 and 2017. Across 2013-2017, there were 180 unique firms 59 that would have met the proposed Preliminary Criteria for Identification, and these firms were associated with a total of 2,995 Registered Person and Member Firm Events that occurred in the years after they met the proposed criteria. 60 58 This analysis examines firms that would have met the Preliminary Criteria for Identification from 2013 until 2017 (instead of the 2013-2019 review period) to allow sufficient time for the “new” events to resolve in the post-identification period. 59 Certain firms would have met the criteria in multiple years during the review period. The 180 firms discussed in the text correspond to the unique number of firms that would have met the criteria in one or more years during the review period. 60 Specifically, FINRA examined and counted all Registered Person and Member Firm Events that occurred any time after the firms were identified until December 31, 2019. Exhibit 3c also shows the number of Registered Person and Member Firm Events for these firms compared to other firms. Specifically, FINRA calculated a factor which represents a multiple for the average number of events (on a per registered person basis) for firms that would have met the Preliminary Criteria for Identification relative to other firms of the same size that would not have met the Preliminary Criteria for Identification. For example, as shown in Exhibit 3c, the factor of 6.1x for 2013 indicates that firms meeting the Preliminary Criteria for Identification in 2013 had 6.1 times more new disclosure events (per registered person) in the years after identification (2014-2019) than other firms of the same size registered in 2013 that would not have met the Preliminary Criteria for Identification. Overall, this analysis demonstrates that firms that would have met the Preliminary Criteria for Identification during the 2013-2017 period had on average approximately 6-20 times more new disclosure events after their identification than other firms in the industry during the same period that would not have met the Preliminary Criteria for Identification. ➢ Anticipated Costs The anticipated costs of this proposal would fall primarily upon firms that meet the Preliminary Criteria for Identification and that the Department deems to warrant further review after its initial evaluation. Although FINRA would perform the annual calculation and conduct an internal evaluation, firms may choose to expend effort to monitor whether they would meet the Preliminary Criteria for Identification, and incur associated costs, at their own discretion. To the extent that a firm deemed to warrant further review under proposed Rule 4111 chooses to seek to rebut the presumption that it is a Restricted Firm subject to the maximum Restricted Deposit Requirement, it would incur costs associated with collecting and providing information to FINRA. For example, these firms may provide information on any disclosure events that may be duplicative or not sales-practice related. These firms may also provide information on any undue significant financial hardship that would result from a maximum Restricted Deposit Requirement. Likewise, a firm availing itself of the one-time staffing reduction opportunity incurs the separation costs, along with the potential for lost future revenues. In addition, firms subject to a Restricted Deposit Requirement or other obligations would incur costs associated with these additional obligations. These would include, for example, costs associated with setting up the Restricted Deposit Account and ongoing compliance costs associated with maintaining the account. Further, as a result of restrictions on the use of cash or qualified securities in the deposit account or other restrictions on the firm's activities, the firm may lose economic opportunities, and its customers may lose the benefits associated with the provision of these services. Similarly, a firm required to apply heightened supervision to its brokers would incur implementation and ongoing costs associated with its heightened supervision plan. 61 Firms that meet the Preliminary Criteria for Identification also may incur costs associated with enhancing their compliance culture, including possibly terminating registered persons with a significant number of disclosure events—through exercising the one-time staffing reduction option under proposed Rule 4111 or otherwise—and reassigning the responsibilities of these individuals to other registered persons. Finally, there may be indirect costs, including greater difficulty or increased cost associated with maintaining a clearing arrangement, loss of trading partners, or similar impairments where third parties can determine that a firm meets the proposed Preliminary Criteria for Identification or has been deemed to be a Restricted Firm. 61 These costs would likely vary significantly across firms. Costs would depend on the specific obligations imposed specific to the firm and its business model. In addition, costs could escalate if a heightened supervision plan applied to brokers that serve as principals, executive managers, owners, or in other senior capacities. Such plans may entail reassignments of responsibilities, restructuring within senior management and leadership, and more complex oversight and governance approaches. Firms that do not meet the proposed Preliminary Criteria for Identification, particularly ones that understand they are close to meeting the proposed criteria, also may incur costs associated with enhancing their compliance culture or making other changes in order to avoid meeting the proposed criteria in the future. These costs may include terminating registered persons with disciplinary records, replacing them with existing or new hires, enhancing compliance policies and procedures, and improving supervision of registered persons. Finally, registered persons with significant number of disciplinary or other disclosure events on their records may find it difficult to retain employment, or get employed by new firms, particularly where those firms and their associated registered persons already have disciplinary records. Similarly, firms meeting the proposed criteria or those close to meeting the proposed criteria may find it difficult to hire registered persons with disclosure events. FINRA notes, however, that the anticipated economic impacts on firms hiring and registered persons seeking employment would likely be limited to a small proportion of registered persons and member firms. 62 62 For example, during the 2013 to 2019 review period, only one to two percent of the registered persons had any qualifying events in their regulatory records, which represents the most conservative estimate of the set of registered persons who might be impacted by the proposed rule. Further, the vast majority of member firms, approximately 98%, would likely be able to employ most of the individuals seeking employment in the industry—including ones who have some disclosures—without coming close to meeting the Preliminary Criteria for Identification. ➢ Other Economic Impacts FINRA also has considered the possibility that, in some cases, this proposal may impose restrictions on brokers' and firms' activities that are less likely to subsequently harm their customers. In such cases, these brokers and firms may lose economic opportunities or find it difficult to retain brokers or customers. FINRA believes that the proposal mitigates such risks by requiring an initial layer of Departmental review, and providing affected firms an opportunity to engage in a Consultation with the Department and request a review of the Department's determination in an expedited proceeding. FINRA also considered that some firms may consider not reporting, underreporting, or failing to file timely, required disclosures on Uniform Registration Forms in an effort to avoid costs associated with the proposals. However, this potential impact is mitigated because many events are reported by regulators or in separate public notices by third parties and, as a result, FINRA can monitor for these unreported events. Further, failing to timely update Uniform Registration Forms is a violation of FINRA rules and can result in fines and penalties, thereby serving as a deterrent for underreporting, misreporting and failing to file timely required disclosures. Considering that the proposed criteria are based on a firm's experience relative to its similarly sized peers, FINRA does not believe that the proposed criteria impose costs on competition between firms of different sizes. Further, because FINRA would perform the annual calculation to determine the firms that meet the Preliminary Criteria for Identification, the costs a firm incurs to monitor its status in relation to the proposed criteria would be discretionary and not likely create any competitive disadvantage based on firm size. Although the proposed rule would not impose these monitoring costs, FINRA would provide transparency around how the Preliminary Criteria for Identification are calculated and appropriate guidance to assist firms seeking to monitor their status. Similarly, FINRA does not anticipate that the proposed Restricted Firm Obligations Rule, including the Restricted Deposit Requirement or any required conditions and restrictions, would create competitive disadvantages across firms of different sizes. This is, in part, because FINRA would consider the number of offices and registered persons, among other factors, when determining the appropriate maximum Restricted Deposit Requirement or any conditions and restrictions, to ensure that the obligations are appropriately tailored to the firm's business model but do not significantly undermine the continued financial stability and operational capability of the firm as an ongoing enterprise over the ensuing 12 months. As discussed above, FINRA would exercise some discretion in determining the maximum Restricted Deposit Requirement and tailor it to the size, operations and financial conditions of the firm, among other factors. This approach is intended to align with FINRA's objective to have the specific financial obligation be significant enough to change a Restricted Firm's behavior but not so burdensome that it would indirectly force it out of business. In determining the specific maximum Restricted Deposit Requirement, FINRA would consider a range of factors, including the nature of the 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. In developing the proposal, FINRA considered the possibility of having a transparent formula, based on some of these factors, to determine a maximum Restricted Deposit Requirement. However, as discussed in more detail below, given the range of relevant factors and differences in firms' business models, operations, and financial conditions, FINRA decided not to propose a uniform, formulaic approach across all firms. In developing the proposal, FINRA also considered the possibility that the size of the maximum Restricted Deposit Requirement may be too burdensome for the firms, and could undermine their financial stability and operational capability. FINRA believes that these risks are mitigated by providing affected firms an opportunity to engage in a Consultation process with FINRA and propose a lesser Restricted Deposit Requirement or restrictions or conditions on their operations. Further, as discussed above, Restricted Firms would have the opportunity to request a review of the Department's determination in an expedited proceeding. b. Proposed Expedited Proceeding Rule When FINRA imposes obligations on a firm pursuant to the proposed Restricted Firm Obligations Rule, the firm may experience significant limitations to its business activities and incur direct and indirect costs associated with the obligations imposed. The proposed Expedited Proceeding Rule would, in general, require that these obligations apply immediately, even during the pendency of any appeal. The proposed rule would be associated with investor protection benefits through the impact of the no-stay provision in proposed Rule 9561(a)(4). Under the proposal, obligations imposed by the Department would be effective immediately, except that a firm that is subject to a Restricted Deposit Requirement under proposed Rule 4111 and requests a hearing would be required to make only a partial deposit while the hearing is pending. This would reduce the risk of investor harm during the pendency of a hearing. Similarly, the no-stay provision may limit hearing requests by firms that seek to use them only as a way to forestall FINRA obligations. The benefit of the proposed rule accruing to firms would be to permit firms to appeal FINRA's determinations (both to request prompt review of obligations imposed or of determinations for failure to comply) in an expedited proceeding, thereby reducing undue costs where firms may have been misidentified or where the obligations imposed are not necessary or appropriate to address the concerns indicated by the Preliminary Criteria for Identification and protect investors and the public interest. For example, the proposed rule is anticipated to reduce any undue costs by the proceeding's expedited nature. Similarly, the proposed rule's time deadlines may also reduce the costs of the proceedings, in certain cases. The costs would be borne by firms that choose to seek review via the proposed expedited proceeding, and these costs can be measured relative to a standard proceeding. These firms would incur costs associated with provisions and procedures specific to this proposed rule, including the provision that the obligations imposed would not be stayed. 63 This would include the obligations imposed under the proposed rule, including the Restricted Deposit Requirement, and the requirement that the firm, upon the Department's request, provide evidence of its compliance with these obligations. However, the extent of the costs associated with the Restricted Deposit Requirement would be mitigated by the expedited nature of the proceeding and by the provision that would require a firm, during the pendency of an expedited hearing process, to maintain only a partial deposit requirement. 63 The effect of the no-stay provision is that imposed obligations would apply immediately, even during the pendency of any hearing request. As a result, the no-stay provision would impose direct costs on misidentified firms or firms for which the obligations imposed are not necessary or appropriate. As with the other proposals, FINRA does not anticipate that the proposed rule would have differential competitive effects based on firm size or other criteria. The costs and benefits are anticipated to apply to all firms that request a hearing in an expedited proceeding. 4. Alternatives Considered FINRA recognizes that the design and implementation of the rule proposals may impose direct and indirect costs on a variety of stakeholders, including firms, brokers, regulators, investors and the public. Accordingly, in developing its rule proposals, FINRA seeks to identify ways to enhance the efficiency and effectiveness of the proposed rules while maintaining their regulatory objectives. For example, FINRA considered several alternatives to addressing the risks posed by firms and their brokers that have a history of misconduct, including alternative approaches and alternative specifications to the numeric threshold based-approach and the Restricted Deposit Requirement. a. Alternative to the Proposed Numeric Threshold-Based Approach In addition to the proposed approach based on numeric thresholds, FINRA considered an approach similar to the Investment Industry Regulatory Organization of Canada's (IIROC) “terms and conditions” rule, IIROC Consolidated Rule 9208, that would allow FINRA to identify a limited number of firms with significant compliance failures and impose on them appropriate terms and conditions to ensure their continuing compliance with the securities laws, the rules thereunder, and FINRA rules. 64 FINRA considered and evaluated the economic impacts of such a terms and conditions rule relative to proposed Rule 4111. 64 IIROC Consolidated Rule 9208 permits IIROC to impose terms and conditions on an IIROC Dealer Member's membership when IIROC considers these terms and conditions appropriate to ensure the member's continuing compliance with IIROC requirements. Compared to proposed Rule 4111, a terms and conditions rule would provide FINRA with greater flexibility in identifying firms that should be subject to additional obligations. This greater flexibility could help better target its application and reduce misidentification by allowing FINRA to leverage non-public information, including regulatory insights collected as part of its monitoring and examination programs, in identifying firms that pose the greatest risk. Further, under a terms and conditions rule, FINRA could quickly update its identification of firms based on emerging risk patterns, to ensure that the rule continues to be effective at addressing firms that presently pose the greatest risk. This flexibility could mitigate the risk that the criteria and thresholds in proposed Rule 4111 no longer identify the appropriate firms. Further, as discussed above, the identification criteria in proposed Rule 4111 may not identify all the firms that pose material risk to their customers, such as firms that may act to stay just below the proposed criteria and thresholds by any means, including misreporting or underreporting disclosure events. The absence of a set identification criteria in a terms and conditions rule would make it more difficult for firms to evade the identification criteria and thus could provide greater investor protections.+ At the same time, a terms and conditions rule may have certain disadvantages relative to proposed Rule 4111. For example, a benefit of proposed Rule 4111 is the deterrent effect it may have on firms that do not meet the proposed Preliminary Criteria for Identification, particularly firms that may be close to meeting the criteria. These firms may change behavior and enhance their compliance culture in ways that could better protect their customers. By comparison, under a terms and conditions rule, in the absence of transparent criteria, firms would have to assess FINRA's view of the significance of repeated exam findings to determine whether to change their conduct to avoid potential terms and conditions. Although FINRA has considered, and will continue to explore, this alternative, it is not proposing a terms and conditions rule at this time. b. Alternative Specifications for the Proposed Numeric Threshold-Based Approach FINRA also considered several alternatives to the numerical thresholds and conditions for the Preliminary Criteria for Identification. In determining the proposed criteria, FINRA focused significant attention on the economic trade-off between incorrect identification of firms that may not subsequently pose risk of harm to their customers, and not including firms that may subsequently pose risk of harm to customers. FINRA also considered three key factors: (1) The different categories of reported disclosure events and metrics, including the Expelled Firm Association Metric; (2) the counting criteria for the number of reported events or conditions; and (3) the time period over which the events or conditions are counted. FINRA considered several alternatives for each of these three factors. ➢ Alternatives Associated With the Categories of Disclosure Events and Metrics In determining the different types of disclosure events, FINRA considered all categories of disclosure events reported on the Uniform Registration Forms, including the financial disclosures. FINRA decided to exclude financial disclosures because while financial events, such as bankruptcies, civil bonds, or judgments and liens, may be of interest to investors in evaluating whether or not to engage a broker or a firm, these types of events by themselves are not evidence of customer harm. In developing the Preliminary Criteria for Identification, FINRA also considered whether pending criminal, internal review, judicial and regulatory events should be excluded from the threshold test. Pending matters are often associated with an emerging pattern of customer harm and capture timely information of potential ongoing or recent misconduct. However, pending matters may include pending regulatory investigations and criminal proceedings that do not result in a finding. 65 FINRA evaluated the impact of eliminating pending matters from the Preliminary Criteria for Identification. Specifically, FINRA identified the firms that would no longer meet the proposed criteria (had the criteria existed) during the evaluation period if pending-events categories were eliminated from the criteria, and examined the extent to which such firms were associated with “new” Registered Person and Member Firm Events. As shown in Exhibit 3d, FINRA estimates that these firms had on average approximately 8.0-13.1 times more new disclosure events than other firms in the industry during the same period that would not have met the Preliminary Criteria for Identification. 66 Accordingly, based on this review and other validations, FINRA decided to include pending matters in the proposed criteria because they are critical to identifying firms that pose greater risks to their customers. 65 As discussed in more detail below, several commenters expressed concerns about including pending and un-adjudicated events in the Preliminary Criteria for Identification. Commenters suggested that pending events are often associated with frivolous cases and that many pending regulatory investigations and criminal proceedings are discontinued without action. 66 In assessing the impact of removing pending events from the Preliminary Criteria for Identification and restricting the criteria solely to final events, FINRA also examined the number of firms that would have met or exceeded at least one Preliminary Identification Metrics Threshold in the Registered Person Adjudicated Events, Member Firm Adjudicated Events, or Registered Persons Associated with Expelled Firms categories, during the relevant p [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-26594. Public record. Not legal advice.