FINRA Proposed Rule 4111 Could Mean Major Changes for Some Firms and Big Problems for Some Brokers
So, what is the 411 on Rule 4111? In FINRA’s ongoing quest to protect the public from member firms with a history of misconduct, FINRA has proposed Rule 4111 (Restricted Firm Obligations) and several complementary proposals to address firms with what it categorizes as a significant history of misconduct.[1] The proposed rule seeks to “impose obligations on member firms that have significantly higher levels of risk-related disclosures than similarly sized peers.”[2] To accomplish this FINRA is creating a metrics based system that would allegedly identify high risk firms (a Restricted Firm) using a “numeric, threshold-based criteria and several additional steps that would guard against misidentification.”[3] Once identified, these Restricted Firms would be subject to additional obligations which could include holding a specific deposit amount in a segregated account from which the Restricted Firm could only make withdrawals upon the approval of FINRA (the Restricted Deposit Requirement).[4]
The Preliminary Criteria for Identification as a Restricted Firm
FINRA proposes to evaluate firms on an annual basis using Preliminary Identification Metrics.[5] The Preliminary Identification Metrics are “based on six categories of events or conditions, nearly all of which are based on information disclosed through the Uniform Registration Forms” such as a Form U4 or Form U5.[6] The events or conditions are: “1. Registered Person Adjudicated Events; 2. Registered Person Pending Events; 3. Registered Person Termination and Internal Review Events; 4. Member Firm Adjudicated Events; 5. Member Firm Pending Events; and 6. Registered Persons Associated with Previously Expelled Firms (also referred to as the Expelled Firm Association category).”[7] Each category is subject to specific rules and criteria for calculation, and the metrics are applied in the form of “an average number of events per registered broker.”[8] Ultimately, if the final calculated metric meets the Preliminary Criteria for Identification,[9] the firm will be subject to additional review and the Restricted Deposit Requirement.[10]
Preventing Misidentification
To guard against the risk of misidentification, a firm meeting the Preliminary Criteria for Identification undergoes an Initial Department Evaluation.[11] In the Initial Department Evaluation, the Department reviews the member firm’s Preliminary Identification Metrics giving greater weight to any potential risk to investors or market integrity event and less weight to violations of procedural rules.[12] If the Department believes the firm meets the Preliminary Criteria for Identification, further review is warranted and the Rule 4111 process continues.
The Option to Terminate Brokers with Disclosures
The next stage of the Rule 4111 process allows a firm, meeting the Preliminary Criteria for Identification for the first time, a “one-time opportunity to reduce its staffing levels to no longer meet these criteria.”[13] Essentially, the firm is given an ultimatum – terminate brokers with higher point totals or subject the firm to the enhanced obligations of Rule 4111. This is the one and only opportunity for firms to reduce staffing pursuant to this option.[14] At this stage in the process, firms will likely be under intense pressure to terminate brokers with a disclosure history to avoid being labeled as a Restricted Firm and subjected to the additional obligations of that designation.
The Consultation
If a firm successfully reduces staff and no longer meets the Preliminary Criteria for Identification, the yearly review process ends. Firms that do not use this one-time option, or otherwise fail to avoid the Preliminary Criteria for Identification, would continue to a “Consultation” with the Department to (1) determine the firm’s maximum Restricted Deposit Requirement;[15] and (2) give the 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.”[16] If, in the Consultation, the firm takes the opportunity to argue against classification as a Restricted Firm, it must overcome two rebuttable presumptions: (1) the firm should be designated as a Restricted Firm; and (2) the firm should be subject to the maximum Restricted Deposit Requirement.[17] After Consultation, the Department will render a decision.
Request for Hearing
If the firm does not accept the Department’s determination, the firm may request a separate hearing.[18] The firm’s request for a hearing would not stay the effectiveness of the Department’s decision.[19] However, subject to the exception of a previously imposed Restricted Deposit Requirement, “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.”[20] FINRA believes this no stay provision strikes a balance by providing prompt investor protection while allowing firms to request a hearing to quickly review the imposition of any obligations imposed.[21]
Current Status of the Purposed Rule
It remains to be seen if proposed Rule 4111 will be approved by the SEC. On December 4, 2020, the proposed rule was published for comment in the Federal Register and as of March 4, 2021, the SEC has implemented proceedings to determine the fate of the proposed rule.[22] If implemented, firms meeting the Preliminary Criteria for Identification will be faced with tough choices and individual brokers with past disclosures, especially those at smaller firms, may need to carefully evaluate their firm’s position in advance of the proposed rule. If you need assistance understanding whether or how Rule 4111 may apply to you, do not wait to consult a securities attorney. Shustak Reynolds and Partners regularly advises brokers and firms on the impact of FINRA rules. To discuss your situation, contact us for a confidential initial consultation. We can help you take necessary steps to protect yourself and your livelihood.
Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes.
We represent many broker-dealers, registered representatives, investment advisors, investors, and businesses.
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[1] Proposed Rule Change to Address Firms with a Significant History of Misconduct, FINRA, https://www.finra.org/rules-guidance/rule-filings/sr-finra-2020-041
[2] Text of the Proposed Rule Change, FINRA, 4, (Nov. 2020), https://www.finra.org/sites/default/files/2020-11/SR-FINRA-2020-041.pdf
[3] Id.
[4] Id.
[5] Id. at 13.
[6] Id. at 14-16.
[7] Id.
[8] Id. at 17.
[9] “The term ‘Preliminary Criteria for Identification’ means meeting the following conditions: (A) Two or more of the member's Preliminary Identification Metrics are equal to or more than the corresponding Preliminary Identification Metrics Thresholds, and at least one of these metrics is among the following metrics: (i) Registered Person Adjudicated Event Metric; (ii) Member Firm Adjudicated Event Metric; and (iii) Expelled Firm Association Metric; and (B) The member has two or more Registered Person and Member Firm Events during the Evaluation Period.” Id. at 576-77.
[10] Id. at 19.
[11] Id. at 21-22.
[12] Id. at 22.
[13] Id. at 23.
[14] Id.
[15] Id. at 24.
[16] Id. at 26.
[17] Id.
[18] Id. at 29-30.
[19] Id. at 30.
[20] Id.
[21] Id. at 61.
[22] Release No. 34-91258; File No. SR-FINRA-2020-041, Securities and Exchange Commission, 1-2, (Mar. 2021), https://www.sec.gov/rules/sro/finra/2021/34-91258.pdf.
