A FINRA Rule Requiring Deposits for High-Risk Firms Is Approved by the SEC

The Securities and Exchange Commission (SEC) on July 30 approved a new rule by the FINRA or Financial Industry Regulatory Authority that applies to firms and brokers who have engaged in misconduct. With this approved new rule, it is a must that investment advisor must be equipped with knowledge of FINRA, SEC or even RIA compliance services.

In January 2022, Finra’s Rule 4111, which is scheduled to become effective in a few months, will allow broker-dealers that the SEC deems high-risk to be exempt from compliance requirements if they exceed certain thresholds of disclosures that harm investors, the SEC has stated.

In addition, these requirements include setting up segregated accounts destined for paying arbitration claims pending or outstanding from customers, as well as adhering to other restrictions.

According to the SEC’s order, FINRA proposed Rule 4111 in 2019, citing research that suggests “past disciplinary events or other regulatory actions associated with an individual or a firm can predict future actions.”

“This proposal is designed to address persistent compliance issues that arise at some FINRA member firms that generally do not carry out their supervisory obligations to achieve compliance with applicable securities laws and regulations and FINRA rules, and act in ways that could harm their customers and erode confidence in the brokerage industry,” the SEC said in its approval.

Also, the SEC notes that Rule 4111 gives FINRA the ability to act proactively by engaging in enforcement actions in advance of more problems arising, since without it it can only pursue restitution and enforcement after rules have been violated and harm to customers has already occurred. Arbitration awards that go unpaid to harmed investors when firms go out of business have been a topic of concern for years among investor advocates and members of Congress. 

Researchers Gregor Matvos at the University of Texas at Austin, Mark Egan at Harvard Business School, and Amit Seru at Stanford University have been considered winners, thanks to their study, which found that brokers with a misconduct history were five times more likely to engage in the same misconduct.

Egan wrote in an email that firms in this subset appear to be more tolerant of misconduct. He added that there is a higher likelihood, among advisers of these firms with high levels of misconduct, that they will commit another misconduct act and that they will maintain employment after engaging in misconduct.” But Brad Bennett, who served as FINRA’s chief enforcement officer for nearly six years, predicted that broker-dealers and brokers formerly guilty of misconduct would often find ways to escape the regulator’s grasp.

Bennett believes that true outlaw operators will change their business models to avoid happening under the thresholds needed to trigger this rule. He even added that while FINRA’s initiative is a noble one, it’s not likely to have the impact it hopes on bad actors.

FINRA’s 2018 proposal has identified 20 small firms with 150 or fewer employees that disclosed 30 or more times in the previous five years, ten mid-size firms with 45 disclosures in the previous five years, and five large companies with more than 500 employees that disclosed at least 750 times. When asked how many firms could potentially qualify for restricted status, a FINRA spokesperson did not respond immediately. 

With the new regulation, FINRA will analyze all of its member firms every year to determine if segregated accounts must be maintained and other requirements must be met based on their and their brokers’ disciplinary records.

Through an expedited proceeding, high-risk designated firms will have a chance to challenge FINRA’s categorization before a single disciplinary hearing, as well as a chance to reduce their broker workforce for disciplinary purposes, SEC rules state.

According to Rule 4111, firms employing large numbers of high-risk brokers from expelled brokerage firms must record and archive all phone conversations between those brokers and their client, similar to FINRA Rule 3170, which became effective in 2014. At MAH Advising, we can assist you with RIA compliance services in similar to this one, thus, contact us today.

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