Jeffrey Hymen

Associate Editor

Loyola University Chicago School of Law, JD 2023

For several years, the Financial Industry Regulatory Authority (FINRA) has sought to increase oversight of brokers who have a history of misconduct as well as the firms that hire these brokers. In an effort to disincentivize the recruitment of high-risk brokers, the Securities and Exchange Commission (SEC) recently approved FINRA’s proposed Rule 4111, which subjects “restricted firms” to additional capital obligations and hiring restrictions. Specifically, FINRA Rule 4111 targets brokerage firms that have exceeded thresholds of risk-related or investor-harming disclosures compared to similarly sized peers. The new rule, which will go into effect in 2022, is designed to provide FINRA with greater authority to proactively address the risks posed to investors by rogue brokerage firms.

How does FINRA Rule 4111 impact the brokerage industry?

FINRA Rule 4111, Restricted Firm Obligations, sets standards to determine whether or not to classify a brokerage firm as a “restricted firm”. The new rule enables FINRA to levy new obligations on brokerage firms with substantially higher levels of risk-related disclosures compared to peer firms. Specifically, FINRA is targeting firms with “significantly higher levels” of internal disciplinary problems including sales practice violations and due diligence failures in the broker hiring process. FINRA annually will utilize a multi-step process to determine whether a firm elicits investor protection risks substantial enough to warrant a designation as a “Restricted Firm”, which may subject the firm to a “Restricted Deposit Requirement.” Pursuant to the deposit requirement, FINRA Rule 4111 requires high-risk firms to deposit cash or qualified securities in a restricted account, which will be overseen by FINRA. High-risk firms are prohibited from withdrawing cash or securities without FINRA’s consent. Additionally, the deposited funds may be utilized to cover arbitration awards or settlements.

To determine whether a brokerage firm classifies as a “Restricted Firm”, FINRA will conduct an annual review by calculating which firms exceed numeric thresholds of firm-level and individual-level disclosure events. The annual review will enable FINRA to distinguish member firms with a substantially higher level of risk-related disclosures in comparison to similarly sized peers. Nevertheless, member firms will receive a one-time opportunity to avoid the additional obligations either by voluntarily reducing its workforce or by petitioning the Department of Member Supervision about why the firm should not receive a “Restricted Firm” designation. Broker-dealers identified as a “Restricted Firm” will have thirty days to terminate high-risk brokers in order to fall below FINRA’s numeric threshold. Further, brokerage firms would be prohibited from rehiring these brokers for at least one year. The new rule also permits FINRA to preemptively address brokerage firms that pose heightened risk to investors. Prior to FINRA Rule 4111, the regulator was authorized to file enforcement actions or seek restitution only after a rule violation had occurred or an investor was harmed. However, the newly adopted rule enables FINRA to apply the “Restricted Firm” designation and enforce the “Restricted Deposit Requirement” in an effort to proactively protect investors.

Why did FINRA adopt Rule 4111?

In 2020, one out of three clients who prevailed in FINRA arbitration cases did not receive their award payment. Based on FINRA’s publicly available 2020 arbitration awards, at least nineteen client awards worth $5 million were not paid out, according to the Public Investors Advocate Bar Association (PIABA). Furthermore, the report indicated that 29.7 percent of client arbitration awards went unpaid in 2020 compared to 26.9 percent in 2019. FINRA’s new rule serves to disincentivize the hiring of brokers who possess a lengthy disclosure history; however, FINRA Rule 4111 addresses industry-wide concerns regarding client arbitration awards that are unpaid by high-risk or undercapitalized brokerage firms. The new rule targets broker-dealers who surpass numeric thresholds of firm-level and individual-level disclosures because these disclosures often indicate that client harm has resulted in arbitration. In other words, FINRA Rule 4111 scrutinizes firms that are more likely to become involved in future arbitration or have a propensity to not pay arbitration awards.

Does FINRA Rule 4111 go far enough?

Pursuant to the new rule, FINRA will annually review whether broker-dealers have racked up a sufficient number of disclosures in order to warrant a “Restricted Firm” designation. However, FINRA can only analyze disclosure histories that exist on record, which restricts FINRA from reviewing disclosures that have been expunged. According to a 2013 PIABA study, expungement was granted in nearly 97 percent of cases between May 2009 and December 2011. In essence, FINRA will face an uphill battle with determining whether or not a broker-dealer’s disclosure history is an accurate measure in applying the “Restricted Firm” classification. While FINRA’s adoption of Rule 4111 is a step in the right direction, brokers and member firms may seek to counter the spirit of the rule by aggressively pursuing expungement in an effort to present a clean disclosure history.