FINRA proposes to tighten rules for brokers with history of misconduct

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Financial Services Alert

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Earlier this month, the Financial Industry Regulatory Authority (FINRA) submitted a rule filing to the Securities and Exchange Commission (SEC or Commission) proposing several changes to FINRA’s rules in an effort to address the risks posed by brokers whom FINRA views as having a significant history of misconduct and the firms that employ them.  FINRA first proposed the changes in Regulatory Notice 18-16 (April 30, 2018), and its current proposal reflects comments received in response to that notice. 

In the current rule filing, FINRA proposes to amend its:

  • eligibility proceedings rules to require member firms to adopt heightened supervisory procedures for statutorily disqualified brokers while a statutory disqualification eligibility request is under review by FINRA
  • membership rules to require a member firm to submit a written request to FINRA’s Membership Application Group (MAP Group) for a materiality consultation, and approval of a continuing membership application (CMA) if required, when a natural person who seeks to become an owner, control person, principal, or registered person of the member firm has one or more “final criminal matters” or two or more “specified risk events” in the last five years that do not rise to the level of a statutory disqualification
  • disciplinary rules to allow a Hearing Officer to impose conditions or restrictions on the activities of a respondent member firm or respondent broker, and require a respondent broker’s member firm to adopt heightened supervisory procedures for such broker, when a disciplinary matter is appealed to the National Adjudicatory Council (NAC) or called for NAC review and during the pendency of any subsequent reviews and
  • disclosure rules to provide for BrokerCheck disclosure of the status of a member firm as a “taping firm” under FINRA Rule 3170 (the Taping Rule). 

FINRA provided detailed information about the potential impact of the rule changes by analyzing data from 2013 to 2018 (the review period) and assessing the effect the proposed rules would have had if they had been in place during that time, which we describe below.  The proposal, if approved, may impact broker-dealer hiring and retention decisions and who can invest in or otherwise control a broker-dealer.  Comments on the proposal are due May 5.

Proposed changes to eligibility proceedings

FINRA’s eligibility proceedings are set forth in the Rule 9520 Series of the FINRA Rules.  These rules require a member firm to file an application if it wishes to associate with an individual subject to a statutory disqualification (SD application).  Statutory disqualifications include certain types of criminal convictions (or guilty or no contest pleas) within the last ten years and certain civil and regulatory actions relating to serious misconduct that disqualify an individual from association with a broker-dealer under Section 3(a)(39) of the Securities Exchange Act of 1934 as amended.  FINRA takes into account a variety of factors in determining whether to approve an SD application, including the nature and gravity of the disqualifying event; the length of time that has elapsed since it occurred and any intervening misconduct;  the regulatory history of the disqualified individual, the firm, and the individual(s) who will act as supervisors; the potential for future regulatory problems; the nature of the proposed securities-related activities of the individual; and the proposed plan of heightened supervision that would be in place if the SD application were approved. 

Although FINRA generally will not approve an SD application lacking an acceptable proposed plan of heightened supervision, FINRA Rules currently do not require the applying member firm to place the statutorily disqualified person under any form of interim heightened supervision while the SD application is pending.  Under the proposed rule change, however, rather than waiting for the SD application to be approved before a heightened supervision plan is put in place, FINRA proposes to require a member firm that files an SD application to include an interim plan of heightened supervision that would apply during the pendency of the SD application, which according to FINRA takes about 15 months on average to process. 

FINRA also provided statistics that illuminate the frequency and success of SD applications.  During the review period, there were 80 SD applications filed by 71 firms for 79 individuals, or on average about 13 applications were filed by 12 firms each year.  About 65 percent were filed by small firms, 12 percent by mid-size firms, and 23 percent by large firms.  Approximately 12.5 percent of the SD applications were approved, 14 percent were pending during the review period, and the remainder were denied, withdrawn, or no longer required by operation of law.  If the proposal is approved, firms availing themselves of the SD application process would need to have the interim plan of heightened supervision in place potentially for up to 15 months or more, even though data indicates that the chance of ultimate success in getting the SD application approved may be relatively low.

Proposed changes to CMA process

If the event does not rise to the level of a statutory disqualification, consultation with FINRA still may be necessary before associating an individual who would be a registered person, principal, control person, or owner.  FINRA proposes to require a member firm to submit a written request to the MAP Group for a materiality consultation when a natural person seeks to become an owner, control person, principal, or registered person of the broker-dealer and such person has one or more “final criminal matters” or two or more “specified risk events” in the prior five years.  If FINRA determines during the materiality consultation that associating with the contemplated individual would be material, then the member firm would be required to file a CMA.  This proposal is a significant departure from current practice. 

A “final criminal matter” would be defined to mean a final criminal matter that resulted in a conviction of, or guilty plea or no contest by, a person disclosed on the applicable Uniform Registration Forms (ie, Forms U4, U5, and U6).  A “specified risk event” would be defined to mean any one of the following events disclosed on a Uniform Registration Form:

(1) a final investment-related, consumer-initiated customer arbitration award or civil judgment against the person for a dollar amount at or above $15,000 in which the person was a named party

(2) a final investment-related, consumer-initiated customer arbitration settlement or civil litigation settlement for a dollar amount at or above $15,000 in which the person was a named party

(3) a final investment-related civil action where (A) the total monetary sanctions (which includes civil and administrative penalties or fines, disgorgement, monetary penalties other than fines, or restitution) were ordered for a dollar amount at or above $15,000, or (B) the sanction against the person was a bar, expulsion, revocation, or suspension and

(4) a final regulatory action where (A) the total monetary sanctions were ordered for a dollar amount at or above $15,000, or (B) the sanction against the person was a bar (permanent or temporary), expulsion, rescission, revocation, or suspension from associating with a member.

Firms employing or proposing to associate individuals with such disclosure also would no longer be eligible to avail themselves of the safe harbor for business expansions under IM-1011-1, which provides an exception from the CMA requirement for firms that add limited numbers of persons, offices, or markets made within a 12-month period.  Although firms with certain types of disciplinary history are prohibited from using the safe harbor, to date that prohibition has not included individual misconduct. 

Currently, the issue of individual misconduct falling short of a statutory disqualification is evaluated as part of the CMA process, which is generally triggered by certain significant events, including a new direct or indirect 25 percent owner of the broker-dealer, mergers or certain assets sales, or a material change in the broker-dealer’s operations.  To approve a CMA, FINRA must be able to find, among other things, that the applicant and all of its associated persons are capable of complying with the federal securities laws and rules and FINRA rules, including observing high standards of commercial honor and just and equitable principles of trade.  In determining whether this standard is met, FINRA rules require the MAP Group to consider an array of misconduct much broader than the definitions of “final criminal matters” or “specified risk events.”  In particular, the MAP Group must consider whether:

(A) a state or federal authority or self-regulatory organization (SRO) has taken permanent or temporary adverse action with respect to a registration or licensing determination regarding the applicant or an associated person

(B) an applicant’s or associated person’s record reflects a sales practice event, a pending arbitration, or a pending private civil action

(C) an applicant or associated person is the subject of a pending, adjudicated, or settled regulatory action or investigation by the SEC, the Commodity Futures Trading Commission, a federal, state, or foreign regulatory agency, or an SRO; an adjudicated, or settled investment-related private civil action for damages or an injunction; or a criminal action (other than a minor traffic violation) that is pending, adjudicated, or that has resulted in a guilty or no contest plea or an applicant, its control persons, principals, registered representatives, other associated persons, any lender of 5 percent or more of the applicant’s net capital, and any other member with respect to which any such person was a control person or a 5 percent lender of its net capital is subject to unpaid arbitration awards, other adjudicated customer awards, or unpaid arbitration settlements

(D) an associated person was terminated for cause or permitted to resign after an investigation of an alleged violation of a federal or state securities law or rule, an SRO rule, or industry standard of conduct

(E) a state or federal authority or SRO has imposed a remedial action, such as special training, continuing education requirements, or heightened supervision, on an associated person and

(F) a state or federal authority or SRO has provided information indicating that the applicant or an associated person otherwise poses a threat to public investors.

The existence of any of the above events, other than (B), creates a rebuttable presumption that the CMA should be denied.  An applicant may overcome the presumption by demonstrating that it can meet each of the standards for admission found in FINRA Rule 1014(a), notwithstanding the existence of any such event.  FINRA has broad discretion to determine whether an applicant and its associated persons can comply with applicable law, and in the event of an adverse decision, an applicant’s only recourse is to appeal.

The net effect of the proposal is to significantly expand the triggering events for filing a materiality consultation and/or CMA and accelerate consideration of the issue of disciplinary history to an earlier point in the application process.  As to the former, FINRA’s analysis of data from the review period indicates that 110-215 individuals per year would have met the criteria for seeking a materiality consultation if the proposed rules been in place, although the number of such individuals also declined over the review period. 

With respect to the risk of recidivism, FINRA noted that from 2013 to 2016, there were 635 brokers who would have met the proposal’s criteria, and during the remainder of the review period, they were associated with 93 events that met such criteria.  FINRA did not disclose how many of the 635 brokers actually were recidivists, but assuming that a separate broker committed each one of the 93 events, then it appears that more than 85 percent were not recidivists.  FINRA acknowledged that certain aspects of its proposal would be both under- and over-inclusive in effectively targeting recidivists. 

While FINRA notes that the materiality consultation process can be completed in 8-10 days, our own observation is that in the past, it has more typically taken 30-60 days.  The proposal does not include a deadline for FINRA action on the material consultation.

Proposed changes to disciplinary proceedings

FINRA proposes amendments to the Series 9200 and 9300 Series to bolster investor protection during the pendency of appeals from Hearing Officer or Hearing Panel decisions in litigated cases by permitting Hearing Officers to impose conditions and restrictions on respondents that are reasonably necessary for the purpose of preventing customer harm.  We note that only a small percentage of FINRA disciplinary actions are litigated and fewer still are appealed.  (By way of comparison, FINRA filed 854 new disciplinary actions in 2019 and 921 in 2018, while the Office of Hearing Officers issued about 20 decisions in 2019 and 25 decisions in 2018.)  During the review period, there were about 20 appeals from Hearing Panels to the NAC per year, with 5 percent filed by firms, 80 percent by brokers, and 15 percent jointly; according to FINRA, appeals to the NAC take on average about 15 months to complete.

Under FINRA’s current rules, all sanctions are generally stayed during the pendency of an appeal.  This is consistent with the SEC’s Rules of Practice related to initial decisions rendered by the agency’s Administrative Law Judges.  Sanctions imposed by an initial decision of an SEC’s ALJ do not become effective until that decision becomes final.  If a respondent appeals, the sanctions imposed by the initial decision do not take effect until the SEC decides the appeal and renders a final decision. 

Both FINRA and the SEC have cease-and-desist authority.  FINRA’s authority is set forth in the Rule 9800 Series and sets a significantly higher threshold compared to the proposal.  For a temporary cease-and-desist order, the Hearing Panel must issue a decision finding that FINRA’s Department of Enforcement (Enforcement) has made a showing of a likelihood of success on the merits and that the alleged violative conduct or continuation thereof is likely to result in significant dissipation or conversion of assets or other significant harm to investors prior to the completion of the underlying disciplinary proceeding.  For a permanent cease-and-desist order, the Hearing Panel must find by a preponderance of the evidence that the alleged violation has occurred and that the violative conduct or continuation thereof is likely to result in significant market disruption or other significant harm to investors.  This authority appears to be rarely used.

While the SEC’s Rules of Practice allow for certain temporary cease-and-desist orders and suspension in very limited circumstances, those rules do not contemplate that the SEC’s Division of Enforcement may seek to make sanctions imposed by an initial decision effective during the course of the respondent’s appeal in every case.   Temporary cease-and-desist orders and suspensions in SEC administrative proceedings are the exception, not the rule, and arise from exigent circumstances.  The SEC’s rules related to temporary orders and suspensions are found in the SEC’s Rules of Practice 500 et seq.  Generally, the SEC’s Division of Enforcement (Division) must outline in its application what violations are at issue for each respondent and the nature of temporary relief sought against each respondent, including whether the respondent would be required to take action to prevent the dissipation or conversion of assets.  If the Division has not already commenced a proceeding for a permanent cease-and-desist order, it must do so at the time of the application for a temporary cease-and-desist order.  The standard for the Division to obtain a temporary cease-and desist-order is high.  Under SEC Rule of Practice 512(a), a temporary cease-and-desist order may only issue if the Commission determines that the alleged violation or threatened violation is likely to result in significant dissipation or conversion of assets, significant harm to investors or substantial harm to the public interest, including but not limited to, losses to the Securities Investor Protection Corporation, prior to the completion of proceedings on the permanent cease-and-desist order.  The SEC’s rules contemplate that this process occurs prior to any Initial Decision.   As discussed below, FINRA’s proposed rule changes are much different.

Under the FINRA proposal, within 10 days after service of a notice of appeal from, or the notice of a call for NAC review of, a disciplinary decision of a Hearing Officer or Hearing Panel, Enforcement could file a motion for the imposition of conditions or restrictions on the activities of a respondent that are reasonably necessary for the purpose of preventing customer harm.  The motion must specify the conditions and restrictions that are sought to be imposed and explain why they are necessary.

The Hearing Officer who participated in the underlying disciplinary proceeding would have jurisdiction to rule on the motion, notwithstanding the appeal or call for NAC review.  FINRA asserts that the Hearing Officer’s knowledge about the factual background and the violations, gained through presiding over the disciplinary proceeding, would make the Hearing Officer well-qualified to evaluate the potential for customer harm and expeditiously tailor conditions and restrictions to minimize that potential harm.  This is a change from the proposal in Regulatory Notice 18-16, which would have vested such authority in the full Hearing Panel; FINRA believes that empowering the Hearing Officer with this authority will allow orders placing conditions or restrictions to be imposed more expeditiously. 

A respondent would have the right to file an opposition or other response to the motion within 10 days after service of the motion and would be required to explain why no conditions or restrictions should be imposed, or specify alternative conditions and restrictions and explain why they are reasonably necessary for the purpose of preventing customer harm.  The Hearing Officer generally would decide the motion on the papers and without oral argument and be required to issue a ruling no later than 20 days after any opposition or permitted reply is filed. 

If the Hearing Officer grants a motion for conditions or restrictions, its order must describe the activities that the respondent must refrain from taking and any conditions imposed.  The conditions and restrictions imposed should target the misconduct demonstrated in the disciplinary proceeding and be tailored to the specific risks posed by the member firm or broker. Conditions or restrictions could include, for example, prohibiting a member firm or broker from offering private placements in cases of misrepresentations and omissions made to customers, or prohibiting penny stock liquidations in cases involving violations of the penny stock rules. A condition could also include posting a bond to cover harm to customers before the sanction imposed becomes final or precluding a broker from acting in a specified capacity. FINRA believes authorizing Hearing Officers to impose conditions or restrictions during pending appeals or reviews would allow FINRA to target the demonstrated bad conduct of a respondent during the pendency of the appeal or review and add an interim layer of investor protection while the disciplinary proceeding remains pending.

The proposal would establish an expedited process for review of these orders. Specifically, within 10 days of service of the order, a respondent could file a motion with the NAC’s Review Subcommittee to modify or remove any or all of the conditions or restrictions.  The respondent would have the burden to show that the conditions or restrictions are not reasonably necessary to prevent customer harm. Enforcement could file an opposition or other reply within five days.  The Review Subcommittee generally would decide the motion based on the papers and without oral argument no later than 30 days after the filing of the opposition. The Review Subcommittee could approve, modify, or remove any and all of the conditions or restrictions. The filing of a motion would stay the effectiveness of the conditions and restrictions ordered by the Hearing Officer until the Review Subcommittee ruled.  Any conditions or restrictions imposed by the Review Subcommittee would remain in effect until there was a final FINRA disciplinary action and all appeals were exhausted.

The proposal also would establish requirements during an appeal or NAC review proceeding for member firms to establish mandatory heightened supervision plans for disciplined respondents. Specifically, when a Hearing Panel or Hearing Officer disciplinary decision finding that a respondent violated a statute or rule provision is appealed or called for NAC review, the proposal would require any member with which the respondent is associated to adopt a written plan of heightened supervision of the respondent.  The plan of heightened supervision would be required to be signed by the designated principal and to include an acknowledgement that the principal is responsible for implementing and maintaining the plan. The plan would remain in place until there is a final disciplinary action and all appeals are exhausted. Under the proposal, if a firm adopted a mandatory heightened supervision plan before any conditions or restrictions were imposed via a motion by Enforcement for interim conditions or restrictions, then the firm’s plan would have to be modified to take into account such conditions or restrictions once imposed.

FINRA also proposes other conforming changes to its disciplinary rules.  The additional compliance burdens associated with the interim conditions and restrictions and heightened supervisory plans may discourage broker-dealers from continuing to associate with those brokers who choose to exercise their rights to appeal Hearing Panel decisions.

Proposed changes to disclosure of firms subject to taping rule

FINRA Rule 8312(b) currently requires that FINRA release information about whether a member firm is subject to the Taping Rule, but only in response to telephonic inquiries. The Taping Rule requires members to establish, enforce, and maintain special written supervisory procedures, including the tape recording of conversations, when they have hired more than a specified percentage of brokers from certain firms that have been expelled or that have had their registrations revoked for violations of sales practice rules (disciplined firms).  Under the proposal, the status of a firm as a taping firm would be disclosed with its online BrokerCheck report.  Over the last three years, there have been six disciplined firms, and currently only one firm is subject to the Taping Rule. 

In summary, the proposed rules represent a significant departure from current practice and may impact broker-dealer hiring and retention decisions with respect to individuals subject to the rule and limit who is eligible to invest in or otherwise control a broker-dealer.  If you have any questions regarding this alert, please contact one of the authors, your DLA Piper relationship partner, or a member of the DLA Piper Financial Services team.

This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.