Well, Memorial Day is just past us, so we all know what that means: it’s time for FINRA to conduct its first annual assessment of its member firms to determine whether they should be branded a “Restricted” firm under new Rule 4111, with all the benefits and privileges appurtenant thereto. Given that it’s pretty clear that FINRA’s goal in identifying Restricted firms is to make it so expensive and onerous for them to remain in business that they choose, instead, simply to close down, it behooves every member to understand completely the pretty complex processes baked into the rule. I am going to try to make it understandable, in six easy steps.
But, understand this: there are plenty of places in the application of the rule where FINRA gets to wield unfettered discretion, so while certain aspects of the rule deal with objective criteria, other parts are simply left to FINRA staff to do whatever they want – but governed by whatever due process is supposedly supplied by an expedited appeal process.
First things first, Step One: we start with the Evaluation Date, which was yesterday. This is “the date . . . as of which the Department calculates the Preliminary Identification Metrics to determine if the member meets the Preliminary Criteria for Identification.” Starting with that date, FINRA looks back five years, which constitutes the Evaluation Period, to determine if the firm and, more importantly, persons associated with the firm display any of the six broad categories of misbehavior identified in the Rule:
- Registered Person Adjudicated Event
- Registered Person Pending Event
- Registered Person Termination and Internal Review Event
- Member Firm Adjudicated Event
- Member Firm Pending Event
- Expelled Firm Association
Within each of these categories are more specific events, which will be tallied up by FINRA. You need to know what they are.
Registered Person Adjudicated Event. These events are comprised of some actual arbitration or litigation in which an RR was named (or not named, but where the RR was, nevertheless, the “subject” of the case) and the RR actually lost or settled the case. There are five possible ways for such an event to arise:
- Under 4111(i)(4)(A)(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.”
- Under 4111(i)(4)(A)(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”
- Under 4111(i)(4)(A)(iii): “a final investment-related civil judicial matter that resulted in a finding, sanction or order”
- Under 4111(i)(4)(A)(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”
- Under 4111(i)(4)(A)(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”
Registered Person Pending Event. These are basically the same as the Adjudicated Events, except they’re not adjudicated and final, rather, they’re just pending. There are four such events:
- Under 4111(i)(4)(B)(i): “a pending investment-related civil judicial matter”
- Under 4111(i)(4)(B)(ii): “a pending investigation by a regulatory authority”
- Under 4111(i)(4)(B)(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”
- 4111(i)(4)(B)(iv): “a pending criminal charge associated with any felony or any reportable misdemeanor”
Registered Person Termination and Internal Review Event. There are only two of these, and they relate to the circumstances under which an RR left a prior BD:
- Under 4111(i)(4)(C)(i): “a termination in which the registered person voluntarily resigned, was discharged or was permitted to resign from a previous member after allegations”
- Under 4111(i)(4)(C)(ii): “a pending or closed internal review by a previous member”
Member Firm Adjudicated Event. These events are the equivalent of the Registered Person Adjudicated Events, except the firm, rather than the RR, managed to lose the arbitration or litigation. Note, however, that unlike RRs, FINRA does not include settlements in this metric. Not sure why. There are four such events:
- Under 4111(i)(4)(D)(i): “a final investment-related, consumer-initiated customer arbitration award in which the member was a named party”
- Under 4111(i)(4)(D)(ii): “a final investment-related civil judicial matter that resulted in a finding, sanction or order”
- Under 4111(i)(4)(D)(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”
- 4111(i)(4)(D)(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”
Member Firm Pending Event. Again, as the term suggests, these are the BD equivalent of the Register Person Pending Events. There are three of them:
- Under 4111(i)(4)(E)(i): “a pending investment-related civil judicial matter”
- Under 4111(i)(4)(E)(ii): “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”
- Under 4111(i)(4)(E)(iii): “a pending criminal charge associated with any felony or any reportable misdemeanor”
Expelled Firm Association. This one is kind of the oddball in the bunch, as it has nothing whatsoever to do with any disclosures by the RR or the firm. In other words, even RRs with perfectly clean Forms U-4 can trigger this metric (which, again, raises at least the whiff of unfairness). Under 4111(i)(4)(F), it is driven strictly by two criteria: (1) Has the firm registered for at least one day during the five-year Evaluation Period someone who (2) 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.”
Got all that? Remember this is just Step One. So, FINRA will look at each of these six categories and add up each firm’s score. It’s like golf: you want the lowest possible score. If your score does not exceed the thresholds that FINRA has conjured up for your size firm (because it has broken its membership down into seven size groups, ranging from the smallest – 1 – 4 RRs – to the largest – 500+), you win! But, sadly, if your score exceeds the threshold, you advance to Step Two, the Initial Department Evaluation, which is a scary step.
Why is this evaluation scary? Because it represents one of the black holes in the Rule, i.e., where behind the scenes and employing criteria that are not articulated anywhere, FINRA staff decide whether they can disregard their own math and deem a BD worthy of getting kicked out of the 4111 machine notwithstanding the fact that its preliminary score exceeded FINRA’s threshold. As FINRA put it in a webinar it presented recently, in Step Two, the Staff “will review the events and the risk profile of the firm to determine if the firm should not be subject to further review under the rule.” According to the Rule itself, the purpose of Step Two is for the Staff to determine whether
the member does not warrant further review under this Rule because the Department has information to conclude that the computation of the member’s Preliminary Identification Metrics included disclosure events (and 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. The Department shall also consider whether the member has addressed the concerns signaled by the disclosure events or conditions or altered its business operations such that the Preliminary Criteria for Identification calculation no longer reflects the member’s current risk profile.
I am not really sure what any of that means. And given that this is the first time that FINRA is embarking on this endeavor, it would seem that they’re making it up as they go. I mean, just consider the phrase “high degree of risk.” What is that? How does it differ, whether quantitatively or qualitatively, from a normal “degree of risk,” which, apparently, is not serious enough for a firm to remain in the 4111 process.
Step Three is for any firm unfortunate to have metrics that exceed the established numerical threshold in Step One and which was deemed too much of a risk in the secret Department Evaluation in Step Two. For such firms, Step Three is the chance to terminate enough RRs whose disclosures and employment history constitute Events in the Step One computation to bring the firm’s overall total down to the point that the thresholds are no longer met. Kind of like the process that firms can utilize if they trigger the Taping Rule. Firms that avail themselves of this reduction in force can only use it once, must do it quickly – within 30 days – and cannot rehire anyone terminated for a year. But, the upside is that a firm that does this will have successfully extricated itself from the 4111 machine.
To participate in Step Four means that the firm either could not or would choose to reduce its staff in Step Three, and so keeps moving down the conveyor belt. If you find yourself here, you are in awfully dangerous territory. And that’s because under the Rule, you are presumed to be a Restricted Firm, and it is your burden to overcome that presumption.
But what does it mean to be a Restricted Firm? That’s where the teeth in the Rule are, because it means that FINRA has the right to require the BD to make a Restricted Deposit, i.e., a cash deposit, and to impose a whole bunch of restrictions and conditions. The Restricted Deposit is explicitly NOT deemed to be an allowable asset for a firm’s net capital computation, so it has to be in addition to any other cash that a firm has lying about that is used to satisfy its net capital requirement. How much money are we talking about? It’s anyone’s guess, as this is yet another part of the Rule that FINRA handles behind the scene, in private, away from scrutiny. I can tell you that the Rule defines the Restricted Deposit as a sum of money
determined by the Department taking into consideration 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, unpaid arbitration awards or unpaid settlements related to arbitrations.
The Rule goes on to provide that the Restricted Deposit is designed to “be consistent with the objectives of this Rule, but would not significantly undermine the continued financial stability and operational capability of the firm as an ongoing enterprise over the next 12 months.” Again, not sure what this means. Taking these words at face value, it seems that FINRA can make a firm deposit so much money that it “undermines” the firm’s “continued financial stability,” but not enough money to “significantly undermine” such financial stability. What’s the difference? Well, that’s a secret.
Making matters worse for firms that find themselves at this Step is that the Rule presumes that FINRA will impose the Maximum Restricted Deposit, which I guess is the most money possible before it would “significantly undermine” a firm’s financial stability.
Firms at Step Four bear the burden of rebutting this presumption. The mechanism for doing so comes in the form of a Consultation. According to the Rule, there are basically two ways to go about attempting to rebut the presumption. The first is simply demonstrating that FINRA’s computation is mathematically wrong. Or, as the Rule puts it, “demonstrating that the Department’s calculation that the member meets the Preliminary Criteria for Identification included events in the Disclosure Event and Expelled Firm Association Categories 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.”
The other approach is less precise, as it doesn’t involve the math, but, rather, FINRA’s opinion about the firm. When you read this list of things that the Rule says you can supply to FINRA to try to rebut the presumption, you will see just how loosy-goosy this is:
- information provided by the member during any meetings as part of the Consultation;
- a plan, if any, submitted by the member, in the manner and form prescribed by the Department, proposing in detail the specific conditions or restrictions that the member seeks to have the Department consider;
- such other information or documents as the Department may reasonably request in its discretion from the member related to the evaluation; and
- any other information the Department deems necessary or appropriate to evaluate the matter.
Anyway, in theory, the Consultation could result in FINRA concluding that, gee, they were all wrong, and offer their apologies for even suggesting that a firm should be deemed to be Restricted. Just how successful BDs will actually be remains to be seen, of course.
If a firm reaches Step Five, it means it was not successful in changing anyone’s mind, because Step Five is the issuance of a Notice by FINRA that the firm has, in fact, been determined to be a Restricted Firm. As well, the Notice will recite the amount of the Restricted Deposit. That Deposit must then be made within 15 days, absent a showing of good cause to delay it.
In addition, the Notice can include the requirement that the firm “implement and maintain specified conditions or restrictions.” Like what? According to the Supplementary Material to the Rule, these include, but are not limited to:
- limitations on business expansions, mergers, consolidations or changes in control;
- filing all advertising with FINRA’s Department of Advertising Regulation;
- imposing requirements on establishing and supervising offices;
- requiring a compliance audit by a qualified, independent third party;
- limiting business lines or product types offered;
- limiting the opening of new customer accounts;
- limiting approvals of registered persons entering into borrowing or lending arrangements with their customers;
- 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
- 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.
As you can see, these restrictions can be severe; indeed, they might have a much greater impact on a firm’s operations than the Restricted Deposit Requirement. And note that a failure to abide by any of these restrictions or conditions allows FINRA to suspend or cancel a firm’s membership on seven-day notice under new Rule 9561 (subject to a firm’s ability to stay that by requesting a hearing).
The final step is Step Six, an expedited review – by FINRA’s Office of Hearing Officers – of the determination that a firm is Restricted. BDs have seven days from the Notice to request the hearing, and that request “must set forth with specificity the basis for eliminating any Rule 4111 Requirements.” If such a request is made, the good news is that the firm need not make the entire Restricted Deposit; rather, it is only required to deposit “the lesser of 25 percent of its Restricted Deposit Requirement or 25 percent of its average excess net capital during the prior calendar year.” Quite the bargain! But, any restrictions or conditions imposed remain in place pending the outcome of the review.
As I stated at the outset, it seems to me that FINRA deliberately drafted this rule so that it is so harsh no member firm in its right mind would ever dare to take the process to the end. Rather, I believe the hope and expectation of the drafters is that firms that would become Restricted Firms will either take advantage of the opportunity to fire a whole bunch of RRs, to avoid becoming Restricted, or simply reconsider their business model. I am not saying that this is right, or fair. I believe the computation that underlies the Rule accords way too much weight to pending matters – for reasons I’ve outlined above – and on settled arbitrations – which are typically settled not necessarily because the claims have merit, but because it’s faster, cheaper and easier than fighting them.
The Rule reminds me of the frustration I felt over 20 years ago, when I was the Director of NASD’s Atlanta District Office. People often complained to me at the time about the fact that this firm or that firm was somehow still in business, notwithstanding its spotty reputation. My response was always the same: bring me the evidence to support a case to expel the firm, and I will back that effort with all the power my position provided me. But, absent such evidence, then stop your whining. Here, with Rule 4111, FINRA wants to skip the hard part of actually developing cases supported by real evidence, and then bringing and winning those cases. FINRA wants, instead, to achieve back-door expulsions simply making it too expensive for firms to choose to remain members. That doesn’t strike me as the right, or fair, way of cleaning up the industry.
 I mean, objective in the sense that there are numerical thresholds actually contained in the rule that supposedly represent the cut-off between being an ok firm and a firm that might need to be Restricted. It bears noting, however, that FINRA simply invented these thresholds. So, in a sense, even these objective criteria embody a great deal of subjectivity.
 I will refrain from commenting about the seeming unfairness of holding pending events against firms, given that “pending events” mean the allegations are unproven, that the RR is presumed to be innocent, and the plaintiff/claimant/prosecutor bears the burden of proof. You already know how I feel about that.
 According to the FAQs it published, FINRA stated that “there are numeric thresholds for seven different firm sizes to ensure that each member firm is compared only to its similarly sized peers.” In other words, FINRA is looking, theoretically, only for outliers.