Brokerage firms that hire brokers with a checkered disciplinary history who may pose an outsized risk to investors could face fresh financial burdens under a new rule that FINRA is proposing.
The regulator is calling for comments on its latest investor-protection proposal, which would require brokers designated as risky to pay into a fund that FINRA would oversee. The money would be held in reserve for paying out potential arbitration awards.
"The member firms that could be subject to these obligations, while small in number, present heightened risk of harm to investors and their activities may undermine confidence in the securities markets as a whole," FINRA says in its
Those firms, FINRA says, "generally do not carry out their supervisory obligations to ensure compliance with applicable securities laws and regulations and FINRA rules, and they often act in ways that harm their customers and erode trust in the brokerage industry."
The organization is accepting comments on the plan through July 1.
A roundup of planners and brokers who drew regulatory scrutiny for alleged misconduct.
The goal of the regulation is twofold, FINRA explains. The penalties and heightened compliance burden would incentivize firms not to associate with recidivist brokers with lengthy disciplinary records. At the same time, it would address the acknowledged problem of unpaid arbitration awards.
FINRA is positioning its latest proposal as building on steps it has taken to address the risks posed by firms with histories of misconduct, including targeted examinations and ongoing risk monitoring. Under the ongoing initiative on high-risk brokers, FINRA has issued a series of regulatory notices proposing new restrictions and sanctions for firms that continue to employ brokers with long histories of misconduct.
Still, the regulator acknowledges, "persistent compliance issues continue to arise in some FINRA member firms." It cites research identifying a pattern in a small percentage of firms of hiring brokers with bad track records, and then failing to supervise them adequately. Moreover, studies have indicated that "past disciplinary and other regulatory events associated with a firm or individual can be predictive of similar future events."
"Such firms expose investors to real risk," FINRA says. "These firms generally have a retail business with vulnerable customers and engage in cold calling to make recommendations of securities."
There were 20 small firms with at least 30 disclosures on their record over the prior five years, 10 midsize firms with 45 or more disclosures in the same period, and five large firms with 750 or more disclosures.
FINRA stresses that these problem firms are a small minority of the brokerage population. Still, some appear to serve as a magnet for recidivist brokers, many of whom cycle through the same troubled shops, which rack up a disproportionate number of disciplinary citations among their ranks. At the end of last year, FINRA says there were 20 small firms with at least 30 disclosures on their record over the prior five years, 10 midsize firms with 45 or more disclosures in the same period, and five large firms with 750 or more disclosures.
Still, FINRA notes that even when it identifies these firms, examiners can point out their compliance issues, but cannot compel them to make changes. When enforcement prepares to punish a firm for misconduct, the customer harm has already taken place. Recouping lost money after the fact is famously challenging.
‘Peer group’ approach
FINRA is now exploring a preemptive approach, where firms most likely to engage in misconduct would be identified as those with a disproportionately high number of risk-related disclosures compared with other comparably sized and structured firms in their "peer group."
The result would be the Restricted Firm Obligations rules, where firms that met a number of minimum thresholds used to identify risk would be subject to heightened scrutiny and, potentially, the requirement to set aside money in a dedicated account from which they could only make withdrawals with FINRA's permission.
"FINRA believes that a restricted deposit is most likely to change such members' behavior — and therefore protect investors — through its direct financial impact," FINRA says.
Firms would be able to shed the restricted designation by severing ties with the problematic brokers, and FINRA is envisioning a process through which they could challenge the increased oversight. FINRA estimates that the rule would apply to only around 2% of the firms it regulates, and the overwhelming majority of those would be small brokerages.
FINRA says it is also considering — but not yet proposing — a rule that would allow it to set the terms and conditions of the operations for the most problematic firms, modeled after a similar regulation in Canada.
