From Ulmer’s Broker-Dealer Law Corner Blog
By Alan M. Wolper
Reading Reg Notice 19-17 makes me think of the legal arguments that I’ve recently read regarding whether a president can be found guilty of obstructing justice if the actions in question were taken out in the open, for everyone to see. Here, FINRA’s proposed power grab is simply outrageous, but, you got to give them credit, it is certainly being done right out there for everyone to see. It doesn’t make it right, however, no more so than tweets designed to intimidate witnesses or steer DOJ investigations.
This is a long, sometimes boring Reg Notice. I wonder if, perhaps, FINRA didn’t deliberately publish a 43-page bear of a document, burdened with charts and 53 footnotes, with the specific intent of dissuading people from reading the whole thing, and figuring out what it’s all about. Lucky you, though, as I read it for you. And, frankly, if you harbor any degree of affinity for concepts like due process or presumption of innocence, you would undoubtedly be appalled by the time you finish it.
The notice addresses FINRA’s recently contrived concerns about “high-risk” firms. According to FINRA, there are certain firms that “have a history of misconduct” with “persistent compliance issues.” According to FINRA, academic studies statistically prove that these firms – which are called “Restricted Firms” here – are more likely than other firms to have disciplinary issues going forward. While FINRA claims that such firms have been “a top focus of FINRA regulatory programs,” it nevertheless complains that its “existing examination and enforcement programs” are inadequate to address the threat that these firms present. So, FINRA is offering a solution.
Before I get to that, let me first revisit what continues to remain a sore point for me. FINRA’s public stance is to express its dismay, even outrage, that these firms with relatively extensive regulatory histories still manage to exist, notwithstanding everything that FINRA has thrown at them from its already considerable arsenal of regulatory weapons. What FINRA has steadfastly refused to concede, however, is that the fact these supposedly terrible firms, firms that FINRA insists manifest a statistically proven likelihood of continuing misbehavior, have not yet been expelled from the industry is either (1) FINRA’s fault, or (2) because expulsion wasn’t necessary. How, after all, does a BD get a regulatory history? When it is named as a respondent in a disciplinary action. Who brings those actions? FINRA. Who decides what charges to file? FINRA. Who decides what sanctions to impose? FINRA. If FINRA has not been able to bring a disciplinary action against a “high-risk” firm that included charges or resulted in findings sufficient to result in the BD getting kicked out of the industry, it can only mean one of two things: either FINRA didn’t do its job, or, equally possible, the firm simply didn’t deserve to be expelled. With the current proposal, however, FINRA urges readers to conclude that these firms continue to operate, like cockroaches after the nuclear apocalypse, not because FINRA hasn’t been tough enough, and not because the evidence wasn’t there to justify an expulsion, but, rather, because FINRA’s existing regulatory tools are somehow inadequate. I just don’t buy that.
Ok, let’s get to the proposal. As I have previously complained about, the starting point for this proposal is FINRA’s need to define what a “high-risk” or “Restricted” firm is. No such definition exists, of course, so FINRA has to conjure one up. To do this, FINRA suggests a multi-step process, I suppose designed to give some impression of fairness, but which, ultimately, boils down to this: a firm is “high-risk” simply because FINRA says it is.
What FINRA proposes to do is create a quantitative standard for each firm, comprised of six bad facts about the firm and the firm’s registered persons. You give the firm a point for each bad fact – “adjudicated”and “pending events” for both the firm and its reps, plus terminations and internal reviews of reps – add them up and divide by the number of reps at the firm, yielding the “average number of events per registered broker.” Then, you take the number of reps at the firm who came from a “previously expelled firm,” divide that by the total number of reps, resulting in a percentage concentration.
Armed with these data, FINRA will then numerically compare the firm to its peers, based on size. (FINRA proposes seven size categories, “to ensure that each member firm is compared only to its similarly sized peers.”) While there are some nuances to that comparison, essentially, if the firm sticks out from the pack in a bad way, based solely on this quantitative analysis, it is deemed, at least preliminarily, to fall within the new rule.
But, it wouldn’t be fair to label a firm bad based solely on numbers, right? So, the next step in the process is that FINRA then conducts an “initial internal evaluation.” The stated purpose of this evaluation is “to determine whether [FINRA] is aware of information that would show that the member – despite having met the Preliminary Criteria for Identification – does not pose a high degree of risk.” In other words…based on FINRA’s subjective consideration of the data – data that FINRA compiled pursuant to its own criteria – FINRA could step in and tell, um FINRA, that the firm ought not to have been branded as high risk. I have got to tell you, based on my historical dealings with FINRA, I am not putting a whole lot of faith in the reasonableness of any decision that FINRA might be called upon to make at this step of the process, i.e., to second-guess its own preliminary decision.
Ok, so let’s assume that FINRA doesn’t talk itself out of characterizing a firm as high-risk. The next step is that FINRA will give the firm a chance to terminate as many of its reps as necessary to reduce the bad points it accumulated in step one, the points that resulted in the firm being identified in the first place. It’s a lot like the deal already in place under the existing “Taping Rule,” when a BD hires enough reps who came from expelled firms to be forced to tape record all of its reps’ phone conversations. It’s a one-time deal, and the firm would also have to agree not to rehire any reps it fires for a year.
As gruesome as this sounds so far, the next step is even worse, and, by FINRA’s own admission, the most punitive. If a firm is still deemed high-risk at this point, FINRA will then turn its attention to calculating a number meant to represent the most money and securities that it could possibly require the firm to deposit in an account, assets which the firm cannot touch without FINRA’s approval, indeed, even if the firm goes out of business. In short, FINRA proposes to make these firms deposit a whole bunch of money in an account with one essential purpose: to satisfy customer arbitrations. (Did PIABA write this rule??)
FINRA knows this will sting, and, frankly, it couldn’t care less. Indeed, it wants it to sting. FINRA admits that its “intent is that the maximum Restricted Deposit Requirement should be significant enough to change the member’s behavior but not so burdensome that it would force the member out of business solely by virtue of the imposed deposit requirement.” How nice. How magnanimous of FINRA! How industrious and clever! To be able to determine the “maximum” – its word, not mine – amount that it can require a firm to pony up as ransom, in effect, without having to declare bankruptcy. I eagerly look forward to the comments this is going to generate. And I hope that some focus on the use of the word “solely,” which leaves FINRA all kinds of running room to trample the rights of its member firms.
In its next passing effort to demonstrate a modicum of fairness, FINRA proposes to include in the process as the next step a “consultation,” that is, an opportunity for an affected firm to rebut two presumptions, that it should branded a restricted firm, and that it should be subject to the maximum deposit. Once again, the result of this lies completely within FINRA’s sole and subjective determination.
Finally, if all other steps to get FINRA to change its mind have failed, the firm may request an expedited hearing before a FINRA Hearing Officer – the same group of folks who administer Enforcement actions – to challenge FINRA’s conclusions.
I realize that this all sounds pretty crazy. But, consider this: it is actually better than an alternative that FINRA admits it’s still mulling over, and that is what it calls a “terms and conditions” approach. FINRA indicates that it could easily be convinced that this approach, which is presently employed by IIROC, the Investment Industry Regulatory Organization of Canada, and clearly something that FINRA is jealous of, would work best to address firms that “typically have substantial and unaddressed compliance failures over multiple examination cycles that put investors or market integrity at risk.” Under the “terms and conditions” regime, the regulator simply gets to decide that a firm is a problem, and unilaterally impose terms and conditions on the firm if it wants to continue to operate. According to IIROC (at least as FINRA describes it), it utilizes this approach when “there are outstanding compliance issues that clearly require regulatory action, but that may be best addressed through an enforcement hearing.” On reflection, I think FINRA goes to the trouble of describing “terms and conditions” as a scare tactic, to make the ridiculous “Restricted Firm” approach sound reasonable by comparison.
In conclusion, I have read this horror show of a Notice several times, and I am still left asking, exactly what situation cannot be addressed adequately through the Enforcement program? The Enforcement scheme is hardly perfect, but at least there some deference is – by rule – paid to due process. A respondent is deemed innocent until proven guilty, and FINRA bears the burden of proof. The respondent may continue to operate despite the charges being outstanding. No deposit, of any size, has to be made as a condition of continued operations. The bottom line is that FINRA never adequately explains why its existing procedures can’t do the trick. And the reason for that is that it can’t.
FINRA’s real problem is that it simply doesn’t like having to jump through the procedural hoops that presently exist, hoops that provide safeguards to respondents. FINRA doesn’t like to have to prove its allegations. Just consider this whining, found early on in the Reg Notice: “Parties with serious compliance issues often will litigate enforcement actions brought by FINRA, which potentially involves a hearing and multiple rounds of appeals, thereby effectively forestalling the imposition of disciplinary sanctions for an extended period.” Gee, wouldn’t it be easier if we can forego the complaint, the hearing, the evidence, and jump right to sanctions? THAT, my friends, is what FINRA is proposing here.
 Because any cash in such an account could not be readily accessed, the proposed rule requires that such deposits be deducted when determining net capital!
 The terms and conditions can be appealed, but, notably, they are NOT stayed during the pendency of the appeal.