Document ID: SEC-2020-1928-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2020-12-04T05:00Z

[Federal Register Volume 85, Number 234 (Friday, December 4, 2020)]
[Notices]
[Pages 78540-78569]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2020-26594]

[[Page 78539]]

Vol. 85

Friday,

No. 234

December 4, 2020

Part III

Securities and Exchange Commission

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Self-Regulatory Organizations; Financial Industry Regulatory Authority, 
Inc.; Notice of Filing of a Proposed Rule Change To Adopt FINRA Rule 
4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for 
Regulating Activities Under Rule 4111); Notice

  Federal Register / Vol. 85 , No. 234 / Friday, December 4, 2020 / 
Notices  

[[Page 78540]]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-90527; File No. SR-FINRA-2020-041]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of a Proposed Rule Change To Adopt 
FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561 
(Procedures for Regulating Activities Under Rule 4111)

November 27, 2020.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on November 16, 2020, the Financial Industry Regulatory Authority, Inc. 
(``FINRA'') filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') the proposed rule change as described in Items I, 
II, and III below, which Items have been prepared by FINRA. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing to (1) adopt FINRA Rule 4111 (Restricted Firm 
Obligations) to require member firms that are identified as 
``Restricted Firms'' to maintain a deposit in a segregated account from 
which withdrawals would be restricted, adhere to specified conditions 
or restrictions, or comply with a combination of such obligations; and 
(2) adopt a new FINRA Rule 9561 (Procedures for Regulating Activities 
Under Rule 4111), and amend FINRA Rule 9559 (Hearing Procedures for 
Expedited Proceedings Under the Rule 9550 Series), to create a new 
expedited proceeding to implement proposed Rule 4111.\3\ In addition, 
FINRA proposes to adopt Capital Acquisition Broker (``CAB'') Rule 412 
(Restricted Firm Obligations), to clarify that member firms that have 
elected to be treated as CABs would be subject to proposed FINRA Rule 
4111, and to amend Funding Portal Rule 900(a) (Application of FINRA 
Rule 9000 Series (Code of Procedure) to Funding Portals), to clarify 
that funding portals would not be subject to proposed FINRA Rule 9561.
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    \3\ This reflects a different numbering than was originally 
proposed. See Regulatory Notice 19-17 (proposing to number the 
proposed new expedited proceeding rule as Rule ``9559'' and to 
renumber current Rule 9559 as Rule ``9560'').
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    The text of the proposed rule change is available on FINRA's 
website at http://www.finra.org, at the principal office of FINRA and 
at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
Background
    FINRA has been engaged in an ongoing effort to enhance its programs 
to address the risks that can be posed to investors and the broader 
market by individual brokers and member firms that have a history of 
misconduct. As part of these efforts, FINRA is proposing to adopt Rule 
4111, which would impose obligations on member firms that have 
significantly higher levels of risk-related disclosures than similarly 
sized peers. FINRA would preliminarily identify these member firms by 
using numeric, threshold-based criteria and several additional steps 
that would guard against misidentification. The obligations could 
include requiring a member firm to maintain a specific deposit amount, 
with cash or qualified securities, in a segregated account at a bank or 
clearing firm, from which the member firm could make withdrawals only 
with FINRA's approval. The obligations also could include conditions or 
restrictions on the operations and activities of the member firm and 
its associated persons that relate to, and are designed to address the 
concerns indicated by, the preliminary identification criteria and 
protect investors and the public interest. FINRA also is proposing to 
adopt FINRA Rule 9561, and amend FINRA Rule 9559, to create a new 
expedited proceeding to implement proposed Rule 4111.
    FINRA has a number of tools to deter and remedy misconduct by 
member firms and the individuals they hire, including review of 
membership applications, focused examinations, risk monitoring and 
disciplinary actions. These tools have been effective in identifying 
and addressing a range of misconduct by individuals and member firms, 
and FINRA has continued to strengthen them. In recent years, for 
example, FINRA has enhanced its key investor protection rules and 
examination programs, expanded its risk-based monitoring of brokers and 
member firms, and deployed new technologies designed to make its 
regulatory efforts more effective and efficient.\4\
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    \4\ For example, in October 2018, FINRA announced plans to 
consolidate its Examination and Risk Monitoring Programs, 
integrating three separate programs into a single, unified program 
to drive more effective oversight and greater consistency, eliminate 
duplication and create a single point of accountability for the 
examination of member firms. The consolidation brings those programs 
under a single framework designed to better direct and align 
examination resources to the risk profile and complexity of member 
firms. FINRA is conducting its examinations under this unified 
program in 2020.
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    These efforts have strengthened protections for investors and the 
markets, but persistent compliance issues continue to arise in some 
FINRA member firms, which are a top focus of FINRA regulatory programs. 
While historically small in number, such firms generally do not carry 
out their supervisory obligations to ensure compliance with applicable 
securities laws and regulations and FINRA rules, and they act in ways 
that could harm their customers and erode trust in the brokerage 
industry. Recent academic studies, for example, find that some firms 
persistently employ brokers who engage in misconduct, and that 
misconduct can be concentrated at these firms. These studies also 
provide evidence that the past disciplinary and other regulatory events 
associated with a firm or individual can be predictive of similar 
future events.\5\ While these firms may eventually be forced out of the 
industry through FINRA action or otherwise, these patterns indicate a 
persistent, if limited, population of

[[Page 78541]]

firms with a history of misconduct that may not be acting appropriately 
as a first line of defense to prevent customer harm by their brokers.
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    \5\ For example, in 2015 FINRA's Office of the Chief Economist 
(``OCE'') published a study that examined the predictability of 
disciplinary and other disclosure events associated with investor 
harm based on past similar events. The OCE study showed that past 
disclosure events, including regulatory actions, customer 
arbitrations and litigations of brokers, have significant power to 
predict future investor harm. See Hammad Qureshi & Jonathan Sokobin, 
Do Investors Have Valuable Information About Brokers? (OCE Working 
Paper, Aug. 2015). A subsequent academic research paper presented 
evidence that suggests a higher rate of new disciplinary and other 
disclosure events is highly correlated with past disciplinary and 
other disclosure events, as far back as nine years prior. See Mark 
Egan, Gregor Matvos, & Amit Seru, The Market for Financial Adviser 
Misconduct, J. Pol. Econ. 127, no. 1 (Feb. 2019): 233-295.
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    Such firms expose investors to real risk. For example, FINRA has 
identified certain firms that have a concentration of associated 
persons with a history of misconduct, and some of these firms 
consistently hire such individuals and fail to reasonably supervise 
their activities. These firms generally have a retail business engaging 
in cold calling to make recommendations of securities, often to 
vulnerable customers. FINRA has also identified groups of individual 
brokers who move from one firm of concern to another firm of concern. 
Such firms and their associated persons often have substantial numbers 
of disclosures on their records. In such situations, FINRA closely 
examines the firms' and brokers' conduct, and where appropriate, FINRA 
will bring enforcement actions to bar or suspend the firms and 
individuals involved.
    However, individuals and firms with a history of misconduct can 
pose a particular challenge for FINRA's existing examination and 
enforcement programs. In particular, examinations can identify 
compliance failures--or imminent failures--and prescribe remedies to be 
taken, but examiners are not empowered to require a firm to change or 
limit its business operations in a particular manner without an 
enforcement action. While these constraints on the examination process 
protect firms from potentially arbitrary or overly onerous examination 
findings, an individual or firm with a history of misconduct can take 
advantage of these limits to simply continue activities that pose risk 
of harm to investors until they result in an enforcement action.
    Enforcement actions in turn can only be brought after a rule has 
been violated and any resulting customer harm has already occurred. In 
addition, these proceedings can take significant time to develop, 
prosecute and conclude, during which time the individual or firm is 
able to continue misconduct, with significant risks of additional harm 
to customers and investors. Parties with serious compliance issues 
often will litigate enforcement actions brought by FINRA, which 
potentially involves a hearing and multiple rounds of appeals, 
forestalling the imposition of disciplinary sanctions for an extended 
period. For example, an enforcement proceeding could involve a hearing 
before a Hearing Panel, numerous motions, an appeal to the National 
Adjudicatory Council (``NAC''), and a further appeal to the SEC. 
Moreover, even when a FINRA Hearing Panel imposes a significant 
sanction, the sanction is stayed during appeal to the NAC, many 
sanctions are automatically stayed on appeal to the SEC, and they 
potentially can be stayed during appeal to the courts. And when all 
appeals are exhausted, the firm may have withdrawn its FINRA membership 
and shifted its business to another member or other type of financial 
firm, limiting FINRA's jurisdiction and avoiding the sanction, 
including making restitution to customers.
    Temporary cease and desist proceedings, while useful, do not always 
provide an effective remedy for potential ongoing harm to investors 
during the enforcement process.\6\ Temporary cease and desist 
proceedings are available only in narrowly defined circumstances. 
Moreover, initiation by FINRA of a temporary cease and desist action 
does not necessarily enable more rapid intervention, because FINRA must 
be prepared to file the underlying disciplinary complaint at the same 
time.
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    \6\ See FINRA Rule 9800 Series (Temporary and Permanent Cease 
and Desist Orders).
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    In addition, by the time sanctions are imposed, as noted above, the 
firm may have exited the industry, thereby limiting FINRA's 
jurisdiction over the misconduct. In such circumstance, the firm may 
also fail to pay arbitration awards owed to claimants, leaving 
investors uncompensated and diminishing confidence in the securities 
markets.
    Therefore, FINRA is strengthening its tools to respond to firms and 
brokers with a significant history of misconduct, and the firms that 
employ those brokers, several of which are described below.
Additional Steps Undertaken by FINRA
    To address these problems, FINRA has undertaken the following:
    [rtarr8] Published Regulatory Notice 18-15, which rearticulates the 
obligation of member firms to implement heightened supervisory 
procedures tailored to the associated persons with a history of 
misconduct;
    [rtarr8] Proposed rule amendments that would require a member firm 
to conduct with FINRA a materiality consultation before allowing 
persons with a history of misconduct to become owners, control persons, 
principals or registered persons of a member firm; authorize the 
imposition in a disciplinary proceeding of conditions and restrictions 
on the activities of a respondent member firm or respondent broker that 
are reasonably necessary for the purpose of preventing customer harm, 
and require a respondent broker's member firm to adopt heightened 
supervisory procedures for such broker, when a disciplinary matter is 
appealed to the NAC or called for NAC review; require firms that apply 
to continue associating with a statutorily disqualified person to 
include in that application an interim plan of heightened supervision 
that would be effective throughout the application process; and allow 
the disclosure through FINRA BrokerCheck of the status of a member firm 
as a ``taping firm'' under FINRA Rule 3170 (Tape Recording of 
Registered Persons by Certain Firms); \7\
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    \7\ See Securities Exchange Act Release No. 88600 (April 8, 
2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No. 
SR-FINRA-2020-011); see also Regulatory Notice 18-16 (April 2018).
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    [rtarr8] Published Regulatory Notice 18-17, which announced 
revisions to the FINRA Sanction Guidelines;
    [rtarr8] Raised fees for statutory disqualification applications; 
\8\ and
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    \8\ See Securities Exchange Act Release No. 83181 (May 7, 2018), 
83 FR 22107 (May 11, 2018) (Notice of Filing and Immediate 
Effectiveness of File No. SR-FINRA-2018-018).
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    [rtarr8] Revised the qualification examination waiver guidelines to 
permit FINRA to more broadly consider past misconduct when considering 
examination waiver requests.\9\
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    \9\ See Regulatory Notice 18-16 (April 2018).
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    While these efforts should help mitigate the risks posed by 
individual brokers with a history of misconduct, challenges remain 
where a member firm itself has a concentration of such brokers--in some 
cases because the firm seeks out such brokers--or otherwise has a 
history of substantial compliance failures.
Proposed Rule 4111 (Restricted Firm Obligations)
    FINRA is proposing to adopt Rule 4111 (Restricted Firm 
Obligations), a new rule that would use numeric thresholds based on 
firm-level and individual-level disclosure events and impose a 
Restricted Deposit Requirement on member firms that present a high 
degree of risk to the investing public. FINRA believes that the direct 
financial impact of a restricted deposit is most likely to change such 
member firms' behavior--and therefore protect investors. An added 
benefit of this proposal would be to preserve member firm funds for 
payment of arbitration awards against them and their associated 
persons. The proposal would consider ``Covered Pending Arbitration 
Claims'' \10\ and

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unpaid arbitration awards \11\ in determining the size of a Restricted 
Firm's ``Restricted Deposit Requirement.'' \12\ The proposal also would 
establish presumptions that, when assessing an application by a member 
firm or former member firm that was previously designated as a 
Restricted Firm for withdrawal from a Restricted Deposit Account,\13\ 
the Department of Member Regulation (``Department'') shall: (i) Deny an 
application for withdrawal if the member firm, the member firm's 
Associated Persons who are owners or control persons, or the former 
member firm have any Covered Pending Arbitration Claims or unpaid 
arbitration awards, or if the member firm's Associated Persons have any 
Covered Pending Arbitration Claims or unpaid arbitration awards 
relating to arbitrations outstanding that involved conduct or alleged 
conduct that occurred while associated with the member firm; but (ii) 
approve a former member firm's application for withdrawal when that 
former member firm commits in the manner specified by the Department to 
use the amount it seeks to withdraw from its Restricted Deposit to pay 
the former member firm's specified unpaid arbitration awards.
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    \10\ The term ``Covered Pending Arbitration Claim'' is defined 
in proposed Rule 4111(i)(2) to mean, for purposes of Rule 4111, an 
investment-related, consumer initiated claim filed against the 
member or its associated persons in any arbitration forum that is 
unresolved; and whose claim amount (individually or, if there is 
more than one claim, in the aggregate) exceeds the member's excess 
net capital. The claim amount includes claimed compensatory loss 
amounts only, not requests for pain and suffering, punitive damages 
or attorney's fees, and shall be the maximum amount for which the 
member or associated person, as applicable, is potentially liable 
regardless of whether the claim was brought against additional 
persons or the associated person reasonably expects to be 
indemnified, share liability or otherwise lawfully avoid being held 
responsible for all or part of such maximum amount. This term 
conforms, in relevant part, to the definition of Covered Pending 
Arbitration Claim in Rule 1011(c). See Securities Exchange Act 
Release No. 88482 (March 26, 2020), 85 FR 18299 (April 1, 2020) 
(Order Approving File No. SR-FINRA-2019-030).
    \11\ For purposes of this Form 19b-4, ``unpaid arbitration 
awards'' also includes unpaid settlements related to arbitrations.
    \12\ The term ``Restricted Deposit Requirement'' is defined in 
proposed Rule 4111(i)(15).
    \13\ See proposed Rule 4111(i)(14) (proposed definition of 
``Restricted Deposit Account'').
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    The proposed rule would create a multi-step process for FINRA's 
determination of whether a member firm raises investor-protection 
concerns substantial enough to require that it be subject to additional 
obligations. Those obligations could include a requirement to maintain 
a deposit of cash or qualified securities in an account from which 
withdrawals would be restricted, or conditions or restrictions on the 
member firm's operations that are necessary or appropriate for the 
protection of investors and in the public interest. The proposed rule 
would give each affected member firm several ways to affect outcomes, 
including a one-time opportunity to reduce staffing so as to no longer 
trigger the preliminary identification criteria and numeric thresholds. 
The firm also could explain to the Department why it should not be 
subject to a Restricted Deposit Requirement or propose alternatives, 
and the firm could challenge a Department determination by requesting a 
hearing before a Hearing Officer in an expedited proceeding.
    The proposed multi-step process includes numerous features designed 
to narrowly focus the new obligations on the firms most of concern. As 
the flow chart in Exhibit 2d reflects, this process is akin to a 
``funnel.'' The top of the funnel applies to the range of member firms 
with the most disclosures, with a narrowing in the middle of the 
potential member firms that may be subject to additional obligations, 
and the bottom of the funnel reflecting the smaller number of member 
firms that are determined to present high risks to the investing 
public.
[rtarr8] General (Proposed Rule 4111(a))
    Proposed Rule 4111(a) would require a member designated as a 
Restricted Firm to establish a Restricted Deposit Account and maintain 
in that account deposits of cash or qualified securities with an 
aggregate value that is not less than the member's Restricted Deposit 
Requirement, except in certain identified situations, and be subject to 
conditions or restrictions on the member's operations as determined by 
the Department to be necessary or appropriate for the protection of 
investors and in the public interest.
[rtarr8] Annual Calculation by FINRA of the Preliminary Criteria for 
Identification (Proposed Rule 4111(b))
    The multi-step process would begin with an annual calculation. As 
explained more below, proposed Rule 4111(b) would require the 
Department to calculate annually (on a calendar-year basis) the 
``Preliminary Identification Metrics'' \14\ to determine whether a 
member firm meets the ``Preliminary Criteria for Identification.'' \15\ 
A key driver of that is whether a member firm's ``Preliminary 
Identification Metrics'' meet quantitative, risk-based ``Preliminary 
Identification Metrics Thresholds.'' \16\
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    \14\ See proposed Rule 4111(i)(10) (definition of ``Preliminary 
Identification Metrics'').
    \15\ See proposed Rule 4111(i)(9) (definition of ``Preliminary 
Criteria for Identification'').
    \16\ See proposed Rule 4111(i)(11) (definition of ``Preliminary 
Identification Metrics Thresholds'').
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    Several principles guided FINRA's development of the proposed 
Preliminary Criteria for Identification and the proposed Preliminary 
Identification Metrics Thresholds. The criteria and thresholds are 
intended to be replicable and transparent to FINRA and affected member 
firms; employ the most complete and accurate data available to FINRA; 
be objective; account for different firm sizes and business profiles; 
and target the sales-practice concerns that are motivating the 
proposal. These criteria are intended to identify member firms that 
present a high risk but avoid imposing obligations on member firms 
whose risk profile and activities do not warrant such obligations.
    Using these guiding principles, FINRA is proposing numeric 
thresholds based on six categories of events or conditions, nearly all 
of which are based on information disclosed through the Uniform 
Registration Forms.\17\ The six categories, collectively defined as the 
``Disclosure Event and Expelled Firm Association Categories,'' \18\ 
are:
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    \17\ One of the event categories, Member Firm Adjudicated 
Events, includes events that are derived from customer arbitrations 
filed with FINRA's dispute resolution forum.
    \18\ See proposed Rule 4111(i)(4).
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    1. Registered Person Adjudicated Events; \19\
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    \19\ ``Registered Person Adjudicated Events,'' defined in 
proposed Rule 4111(i)(4)(A), means any one of the following events 
that are reportable on the registered person's Uniform Registration 
Forms: (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; (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 in which the registered person was a named party or 
was a ``subject of'' the customer arbitration settlement, civil 
litigation settlement or a settlement prior to a customer 
arbitration or civil litigation; (iii) a final investment-related 
civil judicial matter that resulted in a finding, sanction or order; 
(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; or (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.
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    2. Registered Person Pending Events; \20\
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    \20\ ``Registered Person Pending Events,'' defined in proposed 
Rule 4111(i)(4)(B), means any one of the following events associated 
with the registered person that are reportable on the registered 
person's Uniform Registration Forms: (i) A pending investment-
related civil judicial matter; (ii) a pending investigation by a 
regulatory authority; (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; or (iv) a pending criminal charge 
associated with any felony or any reportable misdemeanor. Registered 
Person Pending Events does not include pending arbitrations, pending 
civil litigations, or consumer-initiated complaints that are 
reportable on the registered person's Uniform Registration Forms.

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    3. Registered Person Termination and Internal Review Events; \21\
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    \21\ ``Registered Person Termination and Internal Review 
Events,'' defined in proposed Rule 4111(i)(4)(C), means any one of 
the following events associated with the registered person at a 
previous member firm that are reportable on the registered person's 
Uniform Registration Forms: (i) A termination in which the 
registered person voluntarily resigned, was discharged or was 
permitted to resign from a previous member after allegations; or 
(ii) a pending or closed internal review by a previous member. FINRA 
has revised this definition, from the version proposed in Regulatory 
Notice 19-17 (May 2019), to clarify that termination and internal 
review disclosures concerning a person whom a member firm terminated 
would not impact that member firm's own Registered Person 
Termination and Internal Review Metric; rather, they would only 
impact the metrics of member firms that subsequently register the 
terminated individual.
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    4. Member Firm Adjudicated Events; \22\
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    \22\ ``Member Firm Adjudicated Events,'' defined in proposed 
Rule 4111(i)(4)(D), means any one of the following events that are 
reportable on the member firm's Uniform Registration Forms or based 
on customer arbitrations filed with FINRA's dispute resolution 
forum: (i) A final investment-related, consumer-initiated customer 
arbitration award in which the member was a named party; (ii) a 
final investment-related civil judicial matter that resulted in a 
finding, sanction or order; (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; or (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.
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    5. Member Firm Pending Events; \23\ and
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    \23\ ``Member Firm Pending Events,'' defined in proposed Rule 
4111(i)(4)(E), means any one of the same kinds of events as the 
``Registered Person Pending Events,'' but that are reportable on the 
member firm's Uniform Registration Forms.
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    6. Registered Persons Associated with Previously Expelled Firms 
(also referred to as the Expelled Firm Association category).\24\
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    \24\ ``Registered Persons Associated with Previously Expelled 
Firms,'' defined in proposed Rule 4111(i)(4)(F), means any 
``Registered Person In-Scope'' who 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'' 
(i.e., the prior five years from the ``Evaluation Date,'' which is 
the annual date as of which the Department calculates the 
Preliminary Identification Metrics). See proposed Rule 4111(i)(5), 
(6), and (13) (proposed definitions of ``Evaluation Date,'' 
``Evaluation Period,'' and ``Registered Persons In-Scope''). This 
proposed definition is narrower than the definition proposed in 
Regulatory Notice 19-17.
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    To calculate whether a member firm meets the Preliminary Criteria 
for Identification, the Department would first compute the Preliminary 
Identification Metrics for each of the Disclosure Event and Expelled 
Firm Association Categories. Each category's Preliminary Identification 
Metric computation would start with a calculation of the sum of the 
pertinent disclosure events or, for the Expelled Firm Association 
category, the sum of the Registered Persons Associated with Previously 
Expelled Firms. For the adjudicated disclosure-event based categories, 
the counts would include disclosure events that were resolved during 
the prior five years from the date of the calculation. For the pending 
events categories and pending internal reviews, the counts would 
include disclosure events that are pending as of the date of the 
calculation. In addition, for the three Registered Person disclosure-
event based categories, the counts would include disclosure events 
across all Registered Persons In-Scope, which is defined to include 
persons registered with the member firm for one or more days within the 
one year prior to the calculation date.\25\
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    \25\ See proposed Rule 4111(i)(13).
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    Each of those six sums would then be standardized to determine the 
member's six Preliminary Identification Metrics. For the five 
``Registered Person and Member Firm Events'' categories (Categories 1-5 
above),\26\ the proposed Preliminary Identification Metrics are in the 
form of an average number of events per registered broker, calculated 
by taking each category's sum and dividing it by the number of 
Registered Persons In-Scope. The sixth Preliminary Identification 
Metric--the proposed Expelled Firm Association Metric--is in the form 
of a percentage concentration at the member firm of Registered Persons 
Associated with Previously Expelled Firms. This concentration is 
calculated by taking the number of Registered Persons Associated with 
Previously Expelled Firms and dividing it by the number of Registered 
Persons In-Scope.
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    \26\ See proposed Rule 4111(i)(12) (definition of Registered 
Person and Member Firm Events).
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    A firm's six Preliminary Identification Metrics are used to 
determine if the member firm meets the Preliminary Criteria for 
Identification. To meet the Preliminary Criteria for Identification, a 
member firm would need to meet the Preliminary Identification Metrics 
Thresholds, set forth in proposed Rule 4111(i)(11), for two or more of 
the appropriate metrics listed above for its size and, if it does, one 
of these metrics must be for adjudicated events or the Expelled Firm 
Association Metric, and the firm must have two or more Registered 
Person and Member Firm Events (i.e., events in categories besides the 
Registered Persons Associated with Previously Expelled Firms 
category).\27\ This involves analyzing the extent to which the 
Preliminary Identification Metrics meet the specified numeric 
Preliminary Identification Metrics Thresholds and meet additional 
conditions intended to prevent a member firm from becoming potentially 
subject to additional obligations solely as a result of pending matters 
or a single event or condition.\28\ Specifically, the Department would:
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    \27\ Including an Expelled Firm Association Metric in the 
Preliminary Criteria for Identification is similar to how FINRA Rule 
3170 (Tape Recording of Registered Persons by Certain Firms) imposes 
recording requirements on firms with specific percentages of 
registered persons who were previously associated with disciplined 
firms.
    \28\ The purpose of ensuring that a firm does not meet the 
Preliminary Criteria for Identification solely because of pending 
matters is because FINRA recognizes that pending matters include 
disclosure events that may remain unresolved or that may 
subsequently be dismissed or concluded with no adverse action. As 
explained in more detail in the Economic Impact Assessment, FINRA 
also evaluated the impact of including and excluding pending matters 
from the Preliminary Criteria for Identification. Based on this 
evaluation, FINRA has included pending matters in the proposed 
criteria because they are critical to identifying firms that pose 
greater risks to their customers.
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     First, pursuant to proposed Rules 4111(b) and (i)(9)(A), 
evaluate whether two or more of the member firm's Preliminary 
Identification Metrics are equal to or more than the corresponding 
Preliminary Identification Metrics Thresholds for the member firm's 
size, and whether at least one of those Preliminary Identification 
Metrics is the Registered Person Adjudicated Event Metric, the Member 
Firm Adjudicated Event Metric, or the Expelled Firm Association Metric; 
and
     second, pursuant to proposed Rules 4111(b) and (i)(9)(B), 
evaluate whether the member firm has two or more Registered Person or 
Member Firm Events (i.e., two or more events from Categories 1-5 
above).
    If all of these conditions are met, the member firm would meet the 
Preliminary Criteria for Identification.
    Each specific numeric threshold in the Preliminary Identification 
Metrics Thresholds grid in proposed Rule 4111(i)(11) is a number which 
represents outliers with respect to peers for the type of events in the 
category (i.e., the firm is at the far tail of the respective 
category's distribution), which is intended to preliminarily

[[Page 78544]]

identify member firms that present significantly higher risk than a 
large percentage of the membership. In addition, there are numeric 
thresholds for seven different firm sizes, to ensure that each member 
firm is compared only to its similarly sized peers.\29\ As explained 
more below in the Economic Impact Assessment, based on recent history 
FINRA expects that its annual calculations will identify between 45-80 
member firms that meet the Preliminary Criteria for Identification.\30\
---------------------------------------------------------------------------

    \29\ Because FINRA has narrowed the definition of Registered 
Persons Associated with Previously Expelled Firms from the version 
that was originally proposed in Regulatory Notice 19-17, FINRA also 
has revised the Expelled Firm Association Metric Thresholds.
    \30\ Due to the revisions in the Preliminary Criteria for 
Identification, discussed above, and the inclusion of the year 2019 
in the review period, this estimate and other corresponding 
estimates in the Economic Impact Assessment have changed from the 
ones in Regulatory Notice 19-17.
---------------------------------------------------------------------------

    The following three examples demonstrate--in practical terms--the 
point at which a member firm's Preliminary Identification Metrics would 
meet the Preliminary Identification Metrics Thresholds in proposed Rule 
4111(i)(11):

------------------------------------------------------------------------
                                   Preliminary
                                 identification     Practical equivalent
                               metrics thresholds
------------------------------------------------------------------------
Example 1 (member firm size   The Preliminary       For a member firm
 between 1-4 registered        Identification        with four
 persons).                     Metrics Threshold     Registered Persons
                               for the Registered    In-Scope as of the
                               Person Adjudicated    Evaluation Date,
                               Event Metric, for a   the member would
                               member firm that      meet the
                               has between one and   Preliminary
                               four Registered       Identification
                               Persons In-Scope as   Metrics Threshold
                               of the Evaluation     for the Registered
                               Date,\31\ is 0.50     Person Adjudicated
                               (or 0.50 events per   Event Metric if the
                               Registered Broker     sum of its four
                               In-Scope).            Registered Persons
                                                     In-Scope's
                                                     Adjudicated Events,
                                                     which reached a
                                                     resolution over the
                                                     five years before
                                                     the Evaluation
                                                     Date, was two or
                                                     more.
                                                    (4 Registered
                                                     Persons In-Scope) *
                                                     (0.50 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Registered
                                                     Person Adjudicated
                                                     Event Metric) = (2
                                                     Adjudicated Events)
Example 2 (member firm size   The Preliminary       For a member firm
 between 20-50 registered      Identification        with 50 Registered
 persons).                     Metrics Threshold     Persons In-Scope as
                               for the Member Firm   of the Evaluation
                               Adjudicated Event     Date, the member
                               Metric, for a         firm would meet the
                               member firm that      Preliminary
                               has between 20-50     Identification
                               Registered Persons    Metrics Threshold
                               In-Scope as of the    for the Member Firm
                               Evaluation Date, is   Adjudicated Event
                               0.20 (or 0.20         Metric if the sum
                               events per            of the member
                               Registered Broker     firm's Adjudicated
                               In-Scope).            Events, which
                                                     reached a
                                                     resolution over the
                                                     five years before
                                                     the Evaluation
                                                     Date, was ten or
                                                     more.
                                                    (50 Registered
                                                     Persons In-Scope) *
                                                     (0.20 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Member Firm
                                                     Adjudicated Event
                                                     Metric) = (10
                                                     Adjudicated Events)
Example 3 (member firm size   The Preliminary       For a member firm
 between 51-150 registered     Identification        with 100 Registered
 persons).                     Metrics Threshold     Persons In-Scope as
                               for the Expelled      of the Evaluation
                               Firm Association      Date, the member
                               Metric, for a         firm would meet the
                               member firm that      Preliminary
                               has between 51-150    Identification
                               Registered Persons    Metrics Threshold
                               In-Scope as of the    for the Expelled
                               Evaluation Date, is   Firm Association
                               0.03 (or a 3%         Metric if the sum
                               concentration         of its Registered
                               level).               Persons Associated
                                                     with Previously
                                                     Expelled Firms was
                                                     three or more.
                                                    (100 Registered
                                                     Persons In-Scope) *
                                                     (0.03 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Expelled
                                                     Firm Association
                                                     Metric) = (Three
                                                     Registered Persons
                                                     Associated with
                                                     Previously Expelled
                                                     Firms)
------------------------------------------------------------------------

    In a comment to Regulatory Notice 19-17, SIFMA requested more 
clarity around when the annual Evaluation Date would be. FINRA would 
announce the first Evaluation Date no less than 120 calendar days 
before the first Evaluation Date. Subsequent Evaluation Dates would be 
on the same month and day each year, except when that date falls on a 
Saturday, Sunday or federal holiday, in which case the Evaluation Date 
would be on the next business day.
---------------------------------------------------------------------------

    \31\ The ``Evaluation Date'' is defined in proposed Rule 
4111(i)(5) to mean the date, each calendar year, as of which the 
Department calculates the Preliminary Identification Metrics to 
determine if the member firm meets the Preliminary Criteria for 
Identification.
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    FINRA has conducted a thorough analysis of the proposed criteria 
and thresholds to ensure that the proposed Preliminary Criteria for 
Identification preliminarily identify the types of member firms that 
are motivating this rule proposal.\32\ As explained below, however, the 
proposed rule involves several additional steps to guard against the 
risk of misidentification.
---------------------------------------------------------------------------

    \32\ OCE has tested the Preliminary Criteria for Identification, 
including the Preliminary Identification Metrics Thresholds, in 
several ways. For example, OCE has compared the firms captured by 
the proposed criteria to the firms that have recently been expelled 
or that have unpaid arbitration awards. OCE also has consulted with 
Department staff and examiners about whether, based on their 
experience, the criteria identifies firms that appear to present 
high risks to investors.
---------------------------------------------------------------------------

[rtarr8] Initial Department Evaluation (Proposed Rule 4111(c)(1))
    For each member firm that meets the Preliminary Criteria for 
Identification, the Department would conduct, pursuant to proposed Rule 
4111(c)(1), an initial internal evaluation to determine whether the 
member firm does not warrant further review under Rule 4111. In doing 
so, the Department would review whether it has information to conclude 
that the computation of the member firm's Preliminary Identification 
Metrics included disclosure events or 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. For example, the Department may have 
information that the computation included disclosure events that were 
not sales-practice related, were duplicative (involving the same 
customer and the same matter), or mostly involved compliance concerns 
best addressed by a different regulatory response by FINRA. The 
Department would evaluate the events to determine, among other things, 
whether they

[[Page 78545]]

indicated risks to investors or market integrity, rather than, for 
instance, repeated violations of procedural rules.
    The Department would also consider whether the member firm has 
addressed the concerns signaled by the disclosure events or conditions 
or altered its business operations, including staffing reductions, such 
that the threshold calculation no longer reflects the member firm's 
current risk profile. Essentially, the purpose of the Department's 
initial evaluation is to determine whether it is aware of information 
that would show that the member firm--despite having met the 
Preliminary Criteria for Identification--does not pose a high degree of 
risk.
    Pursuant to proposed Rule 4111(c)(3), if the Department determines, 
after this initial evaluation, that the member firm does not warrant 
further review, the Department would conclude that year's Rule 4111 
process for the member firm and would not seek that year to impose any 
obligations on it. If, however, the Department determines that the 
member firm does warrant further review, the Rule 4111 process would 
continue.
[rtarr8] One-Time Opportunity To Reduce Staffing Levels (Proposed Rule 
4111(c)(2))
    If the Department determines, after its initial evaluation, that a 
member firm warrants further review under proposed Rule 4111, such 
member firm--if it would be meeting the Preliminary Criteria for 
Identification for the first time--would have a one-time opportunity to 
reduce its staffing levels to no longer meet these criteria, within 30 
business days after being informed by the Department. The member firm 
would be required to demonstrate the staff reduction to the Department 
by identifying the terminated individuals. The proposed rule would 
prohibit the member firm from rehiring any persons terminated pursuant 
to this option, in any capacity, for one year. A member firm that has 
reduced staffing levels at this stage may not use that staff-reduction 
opportunity again.
    If the Department determines that the member firm's reduction of 
staffing levels results in its no longer meeting the Preliminary 
Criteria for Identification, the Department would close out that year's 
Rule 4111 process for the member firm and would not seek that year to 
impose any obligations on that firm. If, on the other hand, the 
Department determines that the member firm still meets the Preliminary 
Criteria for Identification even after its staff reductions, or if the 
member firm elects not to use its one-time opportunity to reduce 
staffing levels, the Department would proceed to determine the firm's 
maximum Restricted Deposit Requirement, and the member firm would 
proceed to a ``Consultation'' with the Department.
[rtarr8] FINRA's Determination of a Maximum Restricted Deposit 
Requirement (Proposed Rule 4111(i)(15))
    For members that warrant further review after being deemed to meet 
the Preliminary Criteria for Identification and after the initial 
Department evaluation, the Department would then determine the member's 
maximum ``Restricted Deposit Requirement.''
    The Department would tailor the member firm's maximum Restricted 
Deposit Requirement amount to its size, operations and financial 
conditions. As provided in proposed Rule 4111(i)(15), the Department 
would consider the nature of the member 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'' or unpaid 
arbitration awards.\33\ Based on a consideration of these factors, the 
Department would determine a maximum Restricted Deposit Requirement for 
the member firm that would be consistent with the objectives of the 
rule, but not significantly undermine the continued financial stability 
and operational capability of the member firm as an ongoing enterprise 
over the next 12 months. FINRA's intent is that the maximum Restricted 
Deposit Requirement should be significant enough to change the member 
firm's behavior but not so burdensome that it would force the member 
firm out of business solely by virtue of the imposed deposit 
requirement.
---------------------------------------------------------------------------

    \33\ The proposed factors that the Department would consider 
when determining a maximum Restricted Deposit Requirement have been 
revised from the ones proposed in Regulatory Notice 19-17. Some of 
the revisions are to ensure that proposed Rule 4111(i)(15) describes 
more accurately the factors that would be relevant to a 
determination of the maximum Restricted Deposit Requirement. In this 
regard, the ``annual revenues'' and ``net capital requirements'' 
factors proposed in Regulatory Notice 19-17 have been modified to 
``revenues'' and ``net capital,'' and ``assets,'' ``expenses,'' and 
``liabilities'' have been added as factors. Another revision 
clarifies that the Covered Pending Arbitration Claims and unpaid 
arbitration awards factors include claims and awards against the 
firm and its Associated Persons. The Department's consideration of 
claims and awards against the firm's Associated Persons would focus 
on claims and awards against Associated Persons who are owners or 
control persons and on claims and awards relating to arbitrations 
that involved conduct or alleged conduct that occurred while 
associated with the member firm. The revised proposed definition 
also adds the member firm's ``insurance coverage for customer 
arbitration awards or settlements'' as a factor. FINRA believes 
that, if Restricted Firms were able to procure errors and omissions 
policies, or other kinds of insurance coverage, for some or all of 
the kinds of arbitration claims that customers typically bring, that 
could warrant a reduced Restricted Deposit Requirement and would be 
behavior to encourage.
---------------------------------------------------------------------------

[rtarr8] Consultation (Proposed Rule 4111(d))
    If the Department determines, after the process discussed above, 
that a member firm warrants further Rule 4111 review, the Department 
would consult with the member firm, pursuant to proposed Rule 4111(d). 
This Consultation will give the member 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.
    In the Consultation, there would be two rebuttable presumptions: 
That the member firm should be designated as a Restricted Firm; and 
that it should be subject to the maximum Restricted Deposit 
Requirement. The member firm would bear the burden of overcoming those 
presumptions.
    Proposed Rule 4111(d)(1) governs how a member may overcome these 
two presumptions. First, a member may overcome the presumption that it 
should be designated as a Restricted Firm by clearly demonstrating that 
the Department's calculation that the member meets the Preliminary 
Criteria for Identification is inaccurate because, among other things, 
it included events, in the six categories described above, 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. Second, a member firm may overcome the presumption 
that it should be subject to the maximum Restricted Deposit Requirement 
by clearly demonstrating to the Department that the member firm would 
face significant undue financial hardship if it were required to 
maintain the maximum Restricted Deposit Requirement and that a lesser 
deposit requirement would satisfy the objectives of Rule 4111 and be 
consistent with the protection of investors and the public interest; or 
that other conditions and restrictions on the operations and activities 
of the member firm and its associated persons would address the

[[Page 78546]]

concerns indicated by the thresholds and protect investors and the 
public interest.
    Proposed Rule 4111(d)(2) governs how the Department would schedule 
and provide notice of the Consultation. In a change from the proposal 
in Regulatory Notice 19-17, the Department would provide the written 
letter required by the rule at least seven days prior to the 
Consultation, and would establish a process whereby the member can 
request a postponement for good cause shown. These changes, which are 
in response to a comment on Regulatory Notice 19-17, are intended to 
ensure that the firms have sufficient time to prepare for the 
Consultation and to enhance the procedural protections.
    Proposed Rule 4111(d)(3) provides guidance on what the Department 
would consider during the Consultation when evaluating whether a member 
firm should be designated as a Restricted Firm and subject to a 
Restricted Deposit Requirement. This provision also provides member 
firms with guidance on how to attempt to overcome the two rebuttable 
presumptions. For example, proposed Rule 4111(d)(3) requires that the 
Department consider:
     Information provided by the member firm during any 
meetings as part of the Consultation;
     relevant information or documents, if any, submitted by 
the member firm, in the manner and form prescribed by the Department, 
as would be necessary or appropriate for the Department to review the 
computation of the Preliminary Criteria for Identification;
     any plan submitted by the member firm, in the manner and 
form prescribed by the Department, proposing in detail the specific 
conditions or restrictions that the member firm seeks to have the 
Department consider;
     such other information or documents as the Department may 
reasonably request from the member firm related to the evaluation; and
     any other information the Department deems necessary or 
appropriate to evaluate the matter.
    To the extent a member firm seeks to claim undue financial 
hardship, it would be the member firm's burden to support that with 
documents and information.
[rtarr8] Department Decision and Notice (Proposed Rule 4111(e)); No 
Stays
    After the Consultation, proposed Rule 4111(e) would require that 
the Department render a Department decision. Under proposed Rule 
4111(e)(1), there are three paths that decision might take:
     If the Department determines that the member firm has 
rebutted the presumption that it should be designated as a Restricted 
Firm, the Department's decision would state that the member firm will 
not be designated that year as a Restricted Firm.
     If the Department determines that the member firm has not 
rebutted the presumption that it should be designated as a Restricted 
Firm or the presumption that it must maintain the maximum Restricted 
Deposit Requirement, the Department's decision would designate the 
member firm as a Restricted Firm and require the member firm to 
promptly establish a Restricted Deposit Account, deposit and maintain 
in that account the maximum Restricted Deposit Requirement, and 
implement and maintain specified conditions or restrictions, as 
necessary or appropriate, on the operations and activities of the 
member firm and its associated persons that relate to, and are designed 
to address the concerns indicated by, the Preliminary Criteria for 
Identification and protect investors and the public interest.
     If the Department determines that the member firm has not 
rebutted the presumption that it should be designated as a Restricted 
Firm but has rebutted the presumption that it must maintain the maximum 
Restricted Deposit Requirement, the Department's decision would 
designate the member firm as a Restricted Firm; would impose no 
Restricted Deposit Requirement on the member firm, or would require the 
member firm to promptly establish a Restricted Deposit Account, deposit 
and maintain in that account a Restricted Deposit Requirement in such 
dollar amount less than the maximum Restricted Deposit Requirement as 
the Department deems necessary or appropriate; and would require the 
member firm to implement and maintain specified conditions or 
restrictions, as necessary or appropriate, on the operations and 
activities of the member firm and its associated persons that relate 
to, and are designed to address the concerns indicated by, the 
Preliminary Criteria for Identification and protect investors and the 
public interest.
    Pursuant to proposed Rule 4111(e)(2), the Department would provide 
a written notice of its decision to the member firm, pursuant to 
proposed Rule 9561 and no later than 30 days from the latest scheduling 
letter provided to the member firm under proposed Rule 4111(d)(2), that 
states the obligations to be imposed on the member firm, if any, and 
the ability of the member firm to request a hearing with the Office of 
Hearing Officers in an expedited proceeding, as further described 
below.
    Proposed Rule 4111(e)(2) would provide that a request for a hearing 
would not stay the effectiveness of the Department's decision. However, 
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.\34\ This has one exception: A member firm that is re-
designated as a Restricted Firm and is already subject to a previously 
imposed Restricted Deposit Requirement would be required to maintain 
the full amount of its Restricted Deposit Requirement until the Office 
of Hearing Officers or the NAC issues its final written decision in the 
expedited proceeding.
---------------------------------------------------------------------------

    \34\ In Regulatory Notice 19-17 (May 2019), FINRA originally 
proposed that the member firm would be required, upon requesting a 
hearing, to deposit the lesser of 50% of the Restricted Deposit 
Requirement or 25% of the firm's average excess net capital during 
the prior calendar year. FINRA has revised this provision because, 
although the no-stay provisions are a fundamental part of how the 
proposed rule would protect investors, FINRA believes that this 
aspect of the no-stay provisions could be less burdensome than 
originally proposed and still achieve its intended purpose.
---------------------------------------------------------------------------

    Considering the nature of the firms identified as Restricted Firms 
and the risks they present, the immediate effectiveness of the 
Department's decision will help protect investors during the pendency 
of the expedited proceeding. Moreover, FINRA believes that the no-stay 
provision is consistent with fairness principles, because obligations 
would be imposed only after firms are preliminarily identified, from 
among their firm-size peer group, by transparent criteria and a process 
that involves an initial evaluation and a consultation with the firm.
[rtarr8] Continuation or Termination of Restricted Firm Obligations 
(Proposed Rule 4111(f))
    The proposed Restricted Firm Obligations Rule would require FINRA 
to determine annually whether each member firm is, or continues to be, 
a Restricted Firm and whether the member firm should be subject to any 
obligations. For this reason, proposed Rule 4111(f) contains provisions 
that set forth how any obligations that were imposed during the Rule 
4111 process in one year are continued or terminated

[[Page 78547]]

in that same year and in subsequent years.
    Proposed Rule 4111(f)(1), titled ``Currently Designated Restricted 
Firms,'' establishes constraints on a member firm's ability to seek to 
modify or terminate, directly or indirectly, any obligations imposed 
pursuant to Rule 4111. Because the Restricted Firm Obligations Rule 
would entail annual reviews by the Department to determine whether a 
member firm is a Restricted Firm that should be subject to obligations, 
a Restricted Firm could seek each year to terminate or modify any 
obligations that continue to be imposed. For this reason, proposed Rule 
4111 does not authorize a Restricted Firm to seek, outside of the 
Consultation process and any ensuing expedited proceedings after a 
Department decision, a separate interim termination or modification of 
any obligations imposed. Rather, proposed Rule 4111(f)(1) provides that 
a member firm that has been designated as a Restricted Firm will not be 
permitted to withdraw all or any portion of its Restricted Deposit 
Requirement, or seek to terminate or modify any deposit requirement, 
conditions, or restrictions that have been imposed on it, without the 
prior written consent of the Department. In a change from the proposal 
in Regulatory Notice 19-17, there would be a presumption that the 
Department shall deny an application by a member firm or former member 
firm that is currently designated as a Restricted Firm to withdraw all 
or any portion of its Restricted Deposit Requirement.\35\
---------------------------------------------------------------------------

    \35\ This revision, and additional revisions to proposed Rule 
4111(f)(3) discussed below, are intended to make more clear the 
process that would guide the Department's assessment of applications 
for withdrawal from a Restricted Deposit Requirement.
---------------------------------------------------------------------------

    Proposed Rule 4111(f)(2), titled ``Re-Designation as a Restricted 
Firm,'' addresses the scenario when the Department determines in one 
year that a member firm is a Restricted Firm, and in the following year 
determines that the member firm still meets the Preliminary Criteria 
for Identification. In that instance, the Department would re-designate 
the member firm as a Restricted Firm, and the obligations previously 
imposed on the member firm would continue unchanged, unless either the 
member firm or the Department requests, within seven days of the 
Department's decision to re-designate the member firm as a Restricted 
Firm, a Consultation.\36\ If a Consultation is requested, the 
obligations previously imposed would continue unchanged unless and 
until the Department modifies or terminates them after the 
Consultation. In addition, in the Consultation process, a presumption 
would apply that any previously imposed Restricted Deposit Requirement, 
conditions or restrictions would remain effective and unchanged, absent 
a showing by the party seeking changes that they are no longer 
necessary or appropriate for the protection of investors or in the 
public interest. At the end of the Consultation, the Department would 
be required to provide written notice of its determination to the 
member firm, no later than 30 days from the date of the latest 
scheduling letter provided to the member firm under Rule 4111(d)(2).
---------------------------------------------------------------------------

    \36\ The seven-day period to request a Consultation is a 
revision from the proposal in Regulatory Notice 19-17 (May 2019), 
which proposed a 30-day period.
---------------------------------------------------------------------------

    Proposed Rule 4111(f)(3), titled ``Previously Designated Restricted 
Firms,'' addresses the scenario where the Department determines in one 
year that a member firm is a Restricted Firm, but in the following 
year(s) determines that the member firm or former member firm \37\ 
either does not meet the Preliminary Criteria for Identification or 
should not be designated as a Restricted Firm. In that case, the member 
firm or former member firm would no longer be subject to any 
obligations previously imposed under proposed Rule 4111. There would be 
one exception: A former Restricted Firm would not be permitted to 
withdraw any portion of its Restricted Deposit Requirement without 
submitting an application and obtaining the Department's prior written 
consent for the withdrawal. Such an application would be required to 
include, among other things set forth in proposed Rule 4111(f)(3)(A), 
evidence as to whether the firm, its Associated Persons, or the former 
member firm have Covered Pending Arbitration Claims or any unpaid 
arbitration awards outstanding.
---------------------------------------------------------------------------

    \37\ See proposed Rule 4111(i)(7) (definition of ``Former 
Member'').
---------------------------------------------------------------------------

    The Department would determine whether to authorize a withdrawal, 
in part or in whole. Proposed Rule 4111(f)(3)(B)(i) would establish a 
presumption that the Department shall approve an application for 
withdrawal if the member firm, its Associated Persons, or the former 
member firm have no Covered Pending Arbitration Claims or unpaid 
arbitration awards. Proposed Rule 4111(f)(3)(B)(ii) would establish 
presumptions that the Department shall: (a) Deny an application for 
withdrawal if the member firm, the member firm's Associated Persons who 
are owners or control persons, or the former member have any ``Covered 
Pending Arbitration Claims,'' unpaid arbitration awards, or if the 
member's Associated Persons have any ``Covered Pending Arbitration 
Claims'' or unpaid arbitration awards relating to arbitrations that 
involved conduct or alleged conduct that occurred while associated with 
the member; but (b) approve an application by a former member for 
withdrawal if the former member commits in the manner specified by the 
Department to use the amount it seeks to withdraw from its Restricted 
Deposit to pay the former member's specified unpaid arbitration 
awards.\38\ The Department would be required to issue, pursuant to 
proposed Rule 9561, a notice of its decision on an application to 
withdraw from the Restricted Deposit Account within 30 days from the 
date the application is received by the Department.
---------------------------------------------------------------------------

    \38\ The presumptions in proposed Rule 4111(f)(3)(B) have been 
modified from what was proposed in Regulatory Notice 19-17. In 
addition, in clarifying changes from Regulatory Notice 19-17, 
proposed Rule 4111(f)(3) expressly provides that the Covered Pending 
Arbitration Claims and unpaid arbitration awards of a member firm's 
``Associated Persons'' are pertinent to an application for a 
withdrawal from the Restricted Deposit Requirement.
---------------------------------------------------------------------------

[rtarr8] Restricted Deposit Account (Proposed Rule 4111(i)(14))
    If a Department decision requires a member firm to establish a 
Restricted Deposit Account, proposed Rule 4111(i)(14) would govern this 
account. The underlying policy for the proposed account requirements is 
that, to make a deposit requirement effective in creating appropriate 
incentives to member firms that pose higher risks to change their 
behavior, the member firm must be restricted from withdrawing any of 
the required deposit amount, even if it terminates its FINRA 
membership.
    The proposed rule would require that the Restricted Deposit Account 
be established, in the name of the member firm, at a bank or the member 
firm's clearing firm. The account must be subject to an agreement in 
which the bank or the clearing firm agrees: Not to permit withdrawals 
from the account absent FINRA's prior written consent; to keep the 
account separate from any other accounts maintained by the member firm 
with the bank or clearing firm; that the cash or qualified securities 
on deposit will not be used directly or indirectly as security for a 
loan to the member firm by the bank or the clearing firm, and will not 
be subject to any set-off, right, charge, security interest, lien, or 
claim of any kind in favor of the bank, clearing firm or any person 
claiming through the bank or clearing

[[Page 78548]]

firm; that if the member firm becomes a former member, the Restricted 
Deposit Requirement in the account must be maintained, and withdrawals 
will not be permitted without FINRA's prior written consent; that FINRA 
is a third-party beneficiary to the agreement; and that the agreement 
may not be amended without FINRA's prior written consent. In addition, 
the account could not be subject to any right, charge, security 
interest, lien, or claim of any kind granted by the member.\39\
---------------------------------------------------------------------------

    \39\ In the event of a liquidation of a Restricted Firm, funds 
or securities on deposit in the Restricted Deposit Account would be 
additional financial resources available for the Restricted Firm's 
trustee to distribute to those with claims against the Restricted 
Firm.
---------------------------------------------------------------------------

[rtarr8] Books and Records (Proposed Rule 4111(g))
    Proposed Rule 4111(g) would establish new requirements to maintain 
books and records that evidence the member firm's compliance with the 
Restricted Firm Obligations Rule and any Restricted Deposit Requirement 
or other conditions or restrictions imposed under that rule. In 
addition, the proposed books and records provision would specifically 
require a member firm subject to a Restricted Deposit Requirement to 
provide to the Department, upon its request, records that demonstrate 
the member firm's compliance with that requirement.
[rtarr8] Notice of Failure To Comply (Proposed Rule 4111(h))
    FINRA also is proposing a requirement to address the situation when 
a member firm fails to comply with the obligations imposed pursuant to 
proposed Rule 4111. Under proposed Rule 4111(h), FINRA would be 
authorized to issue a notice pursuant to proposed Rule 9561 directing a 
member firm that is not in compliance with its Restricted Deposit 
Requirement, or with any conditions or restrictions imposed under Rule 
4111, to suspend all or a portion of its business.
[rtarr8] Definitions (Proposed Rule 4111(i))
    A complete list of defined terms used in proposed Rule 4111 appears 
in proposed Rule 4111(i).\40\
---------------------------------------------------------------------------

    \40\ See Exhibit 5.
---------------------------------------------------------------------------

[rtarr8] Net Capital Treatment of the Deposits in the Restricted 
Deposit Account (Proposed Rule 4111.01)
    Proposed Supplementary Material .01 would clarify that because of 
the restrictions on withdrawals from a Restricted Deposit Account, 
deposits in such an account cannot be readily converted to cash and 
therefore shall be deducted in determining the member's net capital 
under Exchange Act Rule 15c3-1 \41\ and FINRA Rule 4110.
---------------------------------------------------------------------------

    \41\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

[rtarr8] Compliance With Continuing Membership Application Rule 
(Proposed Rule 4111.02--Compliance with Rule 1017)
    Proposed Supplementary Material .02 would clarify that nothing in 
proposed Rule 4111 would alter a member firm's obligations under Rule 
1017 (Application for Approval of Change in Ownership, Control, or 
Business Operations). A member firm subject to proposed Rule 4111 would 
need to continue complying with the requirements of Rule 1017 and 
submit continuing membership applications as necessary.
[rtarr8] Examples of Conditions and Restrictions (Proposed Rule 
4111.03)
    In a change from Regulatory Notice 19-17, FINRA is proposing to 
add, in supplementary material to proposed Rule 4111, a non-exhaustive 
list of examples of conditions and restrictions that the Department 
could impose on Restricted Firms. FINRA believes that providing these 
examples will provide clarity about the Department's authority to 
impose conditions and restrictions without restricting the Department's 
flexibility to react and respond to different sources of risk. The non-
exhaustive list of examples of conditions and restrictions includes: 
(1) Limitations on business expansions, mergers, consolidations or 
changes in control; (2) filing all advertising with FINRA's Department 
of Advertising Regulation; (3) imposing requirements on establishing 
and supervising offices; (4) requiring a compliance audit by a 
qualified, independent third party; (5) limiting business lines or 
product types offered; (6) limiting the opening of new customer 
accounts; (7) limiting approvals of registered persons entering into 
borrowing or lending arrangements with their customers; (8) 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 (9) 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.
[rtarr8] Planned Review of Proposed Rule 4111
    FINRA plans to conduct a review of proposed Rule 4111 after gaining 
sufficient experience under proposed Rule 4111. Among other things, 
FINRA would review whether the Preliminary Identification Metrics 
Thresholds remain targeted and effective at identifying member firms 
that pose higher risks.
Proposed Amendments to the Rule 9550 Series To Establish a New 
Expedited Proceeding To Implement the Requirements of Proposed Rule 
4111
    FINRA is proposing to establish a new expedited proceeding in 
proposed Rule 9561 (Procedures for Regulating Activities Under Rule 
4111) that would allow member firms to request a prompt review of the 
Department's determinations under the Restricted Firm Obligations Rule 
and grant a right to challenge any of the ``Rule 4111 Requirements,'' 
including any Restricted Deposit Requirements, imposed.\42\ The new 
expedited proceeding would govern how the Department provides notice of 
its determinations and afford affected member firms the right to seek a 
Hearing Officer's review of those determinations. The proposed 
expedited proceeding is similar in nature to FINRA's other expedited 
proceedings.
---------------------------------------------------------------------------

    \42\ Proposed Rule 9561(a)(1) would define the ``Rule 4111 
Requirements'' to mean the requirements, conditions, or restrictions 
imposed by a Department determination under proposed Rule 4111.
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[rtarr8] Notices Under Proposed Rule 4111 (Proposed Rule 9561(a))
    Proposed Rule 9561(a) would establish an expedited proceeding for 
the Department's determinations under proposed Rule 4111 to designate a 
member firm as a Restricted Firm and impose obligations on the member; 
and to deny a member's request to access all or part of its Restricted 
Deposit Requirement.
    Proposed Rule 9561(a) would require the Department to serve a 
notice that provides its determination and the specific grounds and 
factual basis for the Department's action; states when the action will 
take effect; informs the member firm that it may file, pursuant to Rule 
9559, a request for a hearing in an expedited proceeding within seven 
days after service of the notice; and explains the Hearing Officer's 
authority. The proposed rule also would provide that, if a member firm 
does not request a hearing, the notice of the Department's

[[Page 78549]]

determination will constitute final FINRA action.
    Proposed Rule 9561(a) also would provide that any of the Rule 4111 
Requirements imposed in a notice issued under proposed Rule 9561(a) are 
immediately effective. In general, a request for a hearing would not 
stay those requirements. There would be one partial exception: When a 
member firm requests review of a Department determination under 
proposed Rule 4111 that imposes a Restricted Deposit Requirement on the 
member for the first time, the member firm would be required to 
deposit, while the expedited proceeding was pending, the lesser of 25% 
of its Restricted Deposit Requirement or 25% of its average excess net 
capital over the prior year.
[rtarr8] Notice for Failure To Comply With the Proposed Rule 4111 
Requirements (Proposed Rule 9561(b))
    Proposed Rule 9561(b) would establish an expedited proceeding to 
address a member firm's failure to comply with any requirements imposed 
pursuant to proposed Rule 4111.
    Proposed Rule 9561(b) would authorize the Department, after 
receiving authorization from FINRA's chief executive officer (``CEO''), 
or such other executive officer as the CEO may designate, to serve a 
notice stating that the member firm's failure to comply with the Rule 
4111 Requirements, within seven days of service of the notice, will 
result in a suspension or cancellation of membership. The proposed rule 
would require that the notice identify the requirements with which the 
member firm is alleged to have not complied; include a statement of 
facts specifying the alleged failure; state when the action will take 
effect; explain what the member firm must do to avoid the suspension or 
cancellation; inform the member firm that it may file, pursuant to Rule 
9559, a request for a hearing in an expedited proceeding within seven 
days after service of the notice; and explain the Hearing Officer's 
authority. The proposed rule also would provide that, if a member firm 
does not request a hearing, the suspension or cancellation will become 
effective seven days after service of the notice.
    Proposed Rule 9561(b) also would provide that a member firm could 
file a request seeking termination of a suspension imposed pursuant to 
the rule, on the ground of full compliance with the notice or decision. 
The proposed rule would authorize the head of the Department to grant 
relief for good cause shown.
[rtarr8] Hearings (Proposed Amendments to the Hearing Procedures Rule)
    If a member firm requests a hearing under proposed Rule 9561, the 
hearing would be subject to Rule 9559 (Hearing Procedures for Expedited 
Proceedings Under the Rule 9550 Series). FINRA is proposing several 
amendments to Rule 9559 that would be specific to hearings requested 
pursuant to proposed Rule 9561.
    Hearings in expedited proceedings under proposed Rule 9561 would 
have processes that are similar to the hearings in most of FINRA's 
other expedited proceedings--including requirements for the parties' 
exchange of documents and exhibits, the time for conducting the 
hearing, evidence, the record of the hearing, the record of the 
proceeding, failures to appear, the timing and contents of the Hearing 
Officer's decision, the Hearing Officer's authority, and the authority 
of the NAC to call an expedited proceeding for review--and FINRA is 
proposing amendments to the Rule 9559 provisions that govern these 
processes to adapt them for expedited proceedings under proposed Rule 
9561. A few features of the proposed amendments to Rule 9559 warrant 
emphasis or guidance.
 Hearing Officer's Authority (Proposed Amended Rule 9559(d) and 
(n))
    Hearings in expedited proceedings under proposed Rule 9561 would be 
presided over by a Hearing Officer. The Hearing Officer's authority 
would differ depending on whether the hearing is in an action brought 
under proposed Rule 9561(a) (Notices Under Rule 4111) or 9561(b) 
(Notice for Failure to Comply with the Rule 4111 Requirements).
    Proposed amended Rule 9559(n)(6) would provide that the Hearing 
Officer, in actions brought under proposed Rule 9561(a), may approve or 
withdraw any and all of the Rule 4111 Requirements, or remand the 
matter to the Department, but may not modify any of the Rule 4111 
Requirements, or impose any other requirements or obligations available 
under proposed Rule 4111.
    Proposed amended Rule 9559(n)(6) would authorize the Hearing 
Officer, in failure-to-comply actions under proposed Rule 9561(b), to 
approve or withdraw the suspension or cancellation of membership, and 
impose any other fitting sanction. Authorizing a Hearing Officer to 
impose any other fitting sanction is intended to provide a Hearing 
Officer with authority that is appropriate for responding to situations 
involving member firms that repeatedly fail to comply with an effective 
FINRA action under proposed Rule 4111.
 Timing Requirements
    The proposed amendments to the Hearing Procedures Rule are intended 
to give member firms a prompt process for challenging a Department 
decision under proposed Rule 4111. Proposed amended Rule 9559(f) would 
require that a hearing in actions under proposed Rule 9561(a) be held 
within 30 days, and that a hearing in failure-to-comply actions under 
proposed Rule 9561(b) be held within 14 days, after the member firm 
requests a hearing.\43\
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    \43\ Proposed amendments to Rule 9559 contain other related 
timing requirements for proceedings pursuant to proposed Rule 9561.
---------------------------------------------------------------------------

    Proposed amended Rule 9559(o) would require the Hearing Officer, in 
all actions pursuant to proposed Rule 9561, to prepare a proposed 
written decision, and provide it to the NAC's Review Subcommittee, 
within 60 days of the date of the close of the hearing. Pursuant to 
Rule 9559(q), the Review Subcommittee could call the proceeding for 
review within 21 days after receipt of the proposed decision. As in 
most expedited proceedings, the timing of FINRA's final decision would 
then depend on whether or not the Review Subcommittee calls the matter 
for review.\44\
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    \44\ See FINRA Rule 9559(q).
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 Contents of the Decision
    Proposed amended Rule 9559(p) would govern the contents of the 
Hearing Officer's decision. The proposed amendments would broaden Rule 
9559(p)(6) to account for the kinds of obligations that could be 
imposed under proposed Rule 4111. Rule 9559(p) would otherwise remain 
the same. For example, Rule 9559(p) would continue to require that the 
Hearing Officer's decision include a statement setting forth the 
findings of fact with respect to any act or practice the respondent was 
alleged to have committed or omitted or any condition specified in the 
notice, the Hearing Officer's conclusions regarding the condition 
specified in the notice, and a statement in support of the disposition 
of the principal issues raised in the proceeding.
    Additional guidance may be helpful, considering the different kinds 
of issues that may arise in an expedited proceeding pursuant to 
proposed Rule 9561. For example, in a request for a hearing of a 
Department determination that imposes a Restricted Deposit Requirement 
or other obligations under Rule 4111, the principal issues raised may 
include whether: (1) The member

[[Page 78550]]

firm should not be designated a Restricted Firm; (2) the Department 
incorrectly included disclosure events when calculating whether the 
member firm meets the Preliminary Criteria for Identification; (3) a 
Restricted Deposit Requirement would impose an undue financial burden 
on the member firm; or (4) the obligations imposed are inconsistent 
with the standards set forth in proposed Rule 4111(e). In a request for 
a hearing of a Department determination that denies a request to 
withdraw amounts from a Restricted Deposit Account, the principal 
issues raised may include whether the member firm or its Associated 
Persons have Covered Pending Arbitration Claims or unpaid arbitration 
awards and the nature of those claims or awards.
 No Collateral Attacks on Underlying Disclosure Events
    In expedited proceedings pursuant to proposed Rule 9561(a) to 
review a Department determination under the Restricted Firm Obligations 
Rule, a member firm may sometimes seek to demonstrate that the 
Department included incorrectly disclosure events when calculating 
whether the member firm meets the Preliminary Criteria for 
Identification. When the member firm does so, however, it would not be 
permitted to collaterally attack the underlying merits of those final 
actions. An expedited proceeding under proposed Rule 9561 would not be 
the forum for attempting to re-litigate past final actions.\45\
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    \45\ Attempts to collaterally attack final matters are also 
precluded in other FINRA proceedings. Cf. Dep't of Enforcement v. 
Amundsen, Complaint No. 2010021916601, 2012 FINRA Discip. LEXIS 54, 
at *21-24 (FINRA NAC Sept. 20, 2012) (rejecting respondent's attempt 
to collaterally attack a judgment that was required to be disclosed 
on Form U4), aff'd, Exchange Act Release No. 69406, 2013 SEC LEXIS 
1148 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C. Cir. 2014); 
Membership Continuance Application of Member Firm, Application No. 
20060058633, 2007 FINRA Discip. LEXIS 31, at *51 (July 2007) 
(holding, in a membership proceeding, that a firm may not address 
its and its FINOP's past disciplinary history by collaterally 
attacking those past violations) (citing BFG Sec., Inc., 55 SEC. 
276, 279 n.5 (2001)); Jan Biesiadecki, 53 SEC. 182, 185 (1997) 
(describing, in eligibility proceedings, FINRA's long-standing 
policy of prohibiting collateral attacks on underlying disqualifying 
events).
---------------------------------------------------------------------------

    If the Commission approves the proposed rule change, FINRA will 
announce the effective date of the proposed rule change in a Regulatory 
Notice to be published no later than 60 days following Commission 
approval. The effective date will be no later than 60 days following 
publication of the Regulatory Notice announcing Commission 
approval.\46\
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    \46\ FINRA notes that the proposed rule change would impact all 
member firms, including member firms that have elected to be treated 
as capital acquisition brokers (``CABs''), given that the CAB rule 
set incorporates the FINRA Rule 9550 Series by reference. In 
addition, FINRA is proposing to adopt CAB Rule 412, to reflect that 
a CAB would be subject to Rule 4111.
     The proposed rule change would not impact, however, member 
firms that are funding portals. At this time, regulatory experience 
with funding portals is still at an early stage. The permissible 
business activities of funding portals are limited and, as such, it 
is not clear that funding portals present the corresponding risks 
that FINRA is seeking to address in the broker-dealer space. 
Moreover, developing relevant metrics and thresholds for funding 
portals would require a separate effort and analysis because, unlike 
broker-dealers, the Uniform Registration Forms do not apply to 
funding portals and their associated persons. Accordingly, FINRA is 
proposing to amend Funding Portal Rule 900(a) to add proposed Rule 
9561 as a rule to which funding portal members would not be subject.
---------------------------------------------------------------------------

2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\47\ which requires, among 
other things, that FINRA rules must be designed to prevent fraudulent 
and manipulative acts and practices, to promote just and equitable 
principles of trade, and, in general, to protect investors and the 
public interest. The proposed rule change is designed to protect 
investors and the public interest by strengthening the tools available 
to FINRA to address the risks posed by member firms with a significant 
history of misconduct, including firms at which individuals with a 
significant history of misconduct concentrate. The proposed rule would 
create strong measures of deterrence while a firm is designated as a 
Restricted Firm, limiting the potential for harm to the public. It also 
should create incentives for firms to change behaviors and activities, 
either to avoid being designated as a Restricted Firm or lose an 
existing Restricted Firm designation, to mitigate FINRA's concerns.
---------------------------------------------------------------------------

    \47\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change will result in 
any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act.
    FINRA has undertaken an economic impact assessment, as set forth 
below, to analyze the regulatory need for the proposed rulemaking, its 
potential economic impacts, including anticipated benefits and costs, 
and the alternatives FINRA considered in assessing how to best meet its 
regulatory objectives.
Economic Impact Assessment
1. Regulatory Need
    FINRA uses a number of measures to deter and discipline misconduct 
by firms and brokers, and continually strives to strengthen its 
oversight of the brokers and firms it regulates. These measures span 
across several FINRA programs, including review of new and continuing 
membership applications, risk monitoring of broker and firm activity, 
cycle and cause examinations, and enforcement and disciplinary actions.
    As part of its efforts to monitor and deter misconduct, FINRA has 
adopted rules that impose supervisory obligations on firms to ensure 
they are appropriately supervising their brokers' activities. These 
rules require each firm to establish, maintain and enforce written 
procedures to supervise the types of business in which it engages and 
the activities of its associated persons that are reasonably designed 
to achieve compliance with applicable securities laws and regulations, 
and FINRA rules. Under this regulatory framework, FINRA also provides 
guidance to ensure consistency in interpretation of the rules and to 
further strengthen compliance across firms. As such, all firms play an 
important role in ensuring effective compliance with applicable 
securities laws and FINRA rules to prevent misconduct. This is 
consistent with the incentives of economic agents.\48\
---------------------------------------------------------------------------

    \48\ See, e.g., Roland Strausz, Delegation of Monitoring in a 
Principal-Agent Relationship, Rev. Econ. Stud. 64(3):337-57 (July 
1997). The paper shows that in a standard principal-agent framework, 
the delegation of monitoring by the principal (e.g., a regulator) to 
the agent (e.g., a firm) can be economically efficient for both 
parties.
---------------------------------------------------------------------------

    Nonetheless, some firms do not effectively carry out these 
supervisory obligations to ensure compliance and they act in ways that 
could harm their customers--sometimes substantially. For example, 
recent academic studies find that some firms persistently employ 
brokers who engage in misconduct, and that misconduct can be 
concentrated at these firms. These studies also provide evidence of 
predictability of future disciplinary and other regulatory-related 
events for brokers and firms with a history of past similar events.\49\ 
These patterns suggest that some firms may not be acting appropriately 
as a first line of defense to prevent customer harm. Further, some 
firms may take advantage of the fair-process protections afforded to 
them under the federal securities

[[Page 78551]]

laws and FINRA rules to forestall timely and appropriate regulatory 
actions, thereby limiting FINRA's ability to curb misconduct promptly. 
Without additional protections, the risk of potential customer harm may 
continue to exist at firms that fail to effectively carry out their 
supervisory obligations or are associated with a significant number of 
regulatory-related events. Further, even where harmed investors obtain 
arbitration awards, harm followed by recompense typically comes with 
some economic costs to customers and brokers, and firms may still fail 
to pay those awards. Unpaid arbitration awards harm successful customer 
claimants and may diminish investors' confidence in the arbitration 
process.\50\
---------------------------------------------------------------------------

    \49\ See supra note 5.
    \50\ Investors may also file claims in courts or other dispute 
resolution forums. Successful claimants in these forums may face 
similar challenges associated with collecting awards or judgments.
---------------------------------------------------------------------------

    To mitigate these risks, FINRA seeks additional authority to impose 
obligations on firms that pose these types of greater risk to their 
customers. The proposed Restricted Firm Obligations Rule would identify 
firms based upon a concentration of significant firm and broker events 
on their disclosure records that meet the proposed criteria and 
specified thresholds. Under the proposal, FINRA seeks to impose 
obligations on the operations and activities of the member and its 
associated persons that are necessary or appropriate to address the 
concerns indicated by the Preliminary Criteria for Identification and 
protect investors and the public interest.
2. Economic Baseline
    The economic baseline used to evaluate the economic impacts of the 
proposed rules is the current regulatory framework, including FINRA 
rules relating to supervision, the membership application process, 
statutory disqualification proceedings and disciplinary proceedings 
that provide rules to deter and discipline misconduct by firms and 
brokers. This baseline serves as the primary point of comparison for 
assessing economic impacts of the proposed rules, including incremental 
benefits and costs.
    The proposals are intended to apply to firms that pose far greater 
risks to their customers than other firms. One identifier of these 
types of firms is that they and their brokers generally have 
substantially more regulatory-related events on their records than do 
their peers.\51\ Consistent with this, the proposed Restricted Firm 
Obligations Rule would specifically apply to firms that have far more 
Registered Person and Member Firm Events, or far higher concentrations 
of Registered Persons Associated with Previously Expelled Firms, 
compared to their peers.\52\ Based on staff analysis of all firms 
registered with FINRA between 2013 and 2019, firms that would have met 
the Preliminary Criteria for Identification had on average four to nine 
times more Registered Person and Member Firm Events than peer firms at 
the time of identification. Specifically, the number of events per 
firm, for firms that would have met the Preliminary Criteria for 
Identification, ranged, on average, from 25-52 events during the 
Evaluation Period, compared to 4-5 events per firm for firms that would 
not have met the Preliminary Criteria for Identification. The median 
number of events per firm, for the firms that would have met the 
Preliminary Criteria for Identification, ranged from approximately 9-18 
events, compared to zero events among other firms that would not have 
met the Preliminary Criteria for Identification.
---------------------------------------------------------------------------

    \51\ As discussed above, recent studies provide evidence of 
predictability of future regulatory-related events for brokers and 
firms with a history of past regulatory-related events. As a result, 
brokers and firms with a history of past regulatory-related events 
pose greater risk of future harm to their customers than other 
brokers and firms.
    \52\ For example, for each of the six Preliminary Identification 
Metrics, the Preliminary Identification Metrics Threshold was chosen 
to capture one to five percent of the firms with the highest number 
of events per registered broker or the highest concentrations of 
Registered Persons Associated with Previously Expelled Firms, in 
respective firm-size categories.
---------------------------------------------------------------------------

    Although disciplinary and regulatory-related events are one of the 
identifiers for firms posing higher risk, FINRA recognizes that firms 
posing higher risks do not always manifest themselves with greater 
disclosures on their records. These firms may be newer, have recently 
made changes in management, staff or approach, or simply may be more 
effective in avoiding regulatory marks.
3. Economic Impacts
a. Proposed Restricted Firm Obligations Rule
    To estimate the number and types of firms that would meet the 
Preliminary Criteria for Identification, FINRA analyzed the categories 
of events and conditions associated with the proposed criteria for all 
firms during the 2013-2019 review period. For each year, FINRA 
determined the approximate number of firms that would have met the 
proposed criteria. The number of firms that would have met the proposed 
criteria during the review period serves as a reasonable estimate for 
the number of firms that would have been directly impacted by this 
proposal had it been in place at the time. This analysis indicates that 
there were 45-80 such firms at the end of each year during the review 
period, as shown in Exhibit 3a. These firms represent 1.3-2.0% of all 
firms registered with FINRA in any year during the review period. The 
population of firms identified by the proposed criteria reflects the 
distribution of firm size in the full population of registered firms. 
Approximately 88-94% of these firms were small, 4-12% were mid-size and 
0-3% were large at the end of each year during the review period, as 
shown in Exhibit 3b.\53\
---------------------------------------------------------------------------

    \53\ FINRA defines a small firm as a member with at least one 
and no more than 150 registered persons, a mid-size firm as a member 
with at least 151 and no more than 499 registered persons, and a 
large firm as a member with 500 or more registered persons. See 
FINRA By-Laws, Article I.
---------------------------------------------------------------------------

    FINRA notes that the number of firms that would have met the 
proposed criteria during the review period have declined (by 
approximately 44%) from 80 firms in 2013 to 45 firms in 2019. This 
decline is associated with an overall decrease in the number of 
Registered Person and Member Firm Events and the number of firms 
associated with these events.\54\ Specifically, the Registered Person 
and Member Firm Events have declined by 24% and the number of firms 
with one or more of these events has declined by 22% during the review 
period. However, the average number of events per firm identified by 
the proposed criteria has increased, suggesting that there may be an 
increase in concentration of events across a smaller set of firms that 
may pose greater risks to their customers. For example, the average 
number of Registered Person and Member Firm Events for the firms 
identified by the criteria has increased by 94% from 24 events per firm 
in 2013 to 47 events per firm in 2019. These trends over the 2013-2019 
review period suggest that while many firms continue to improve their 
regulatory records over time, a small proportion of firms may continue 
to further engage in activities that pose greater risks to their 
customers, which the proposed rule is intended to address.
---------------------------------------------------------------------------

    \54\ FINRA notes that part of the decline in the number of 
events and the firms that would have met the proposed criteria may 
be associated with an approximately 15% decline in the overall 
number of registered firms during the 2013-2019 review period.
---------------------------------------------------------------------------

    In developing the proposed Preliminary Criteria for Identification, 
FINRA paid significant attention to the impact of possible 
misidentification of firms, specifically, the economic trade-off 
between including firms that are less

[[Page 78552]]

likely to subsequently pose risk of harm to customers, and not 
including firms that are more likely to subsequently pose risk of harm 
to customers. There are costs associated with both types of 
misidentifications.\55\ The proposed criteria, including the proposed 
numerical thresholds, aim to balance these economic trade-offs 
associated with over- and under-identification.\56\ Further protection 
against misidentification would be provided by the proposed initial 
Department evaluation and the Consultation process.
---------------------------------------------------------------------------

    \55\ For example, subjecting firms that are less likely to pose 
a risk to customers to the proposed Restricted Deposit Requirement 
or other obligations would impose additional and unwarranted costs 
on these firms, their brokers and their customers.
    \56\ In order to evaluate the effectiveness of the proposed 
criteria at identifying firms that pose greater risks, FINRA 
examined the overlap between the firms that would have met the 
Preliminary Criteria for Identification each year during the review 
period and the firms that were subsequently expelled, associated 
with unpaid awards, or identified by Department staff as suitable 
candidates for additional obligations. Finally, as discussed below, 
FINRA also examined disclosure events associated with firms that 
would have met the Preliminary Criteria for Identification each year 
during the review period, subsequent to meeting the criteria, to 
assess the extent of risk posed by these firms.
---------------------------------------------------------------------------

[rtarr8] Anticipated Benefits
    The proposal's primary benefit would be to reduce the risk and 
associated costs of possible future customer harm. This benefit would 
arise directly from additional restrictions placed on firms identified 
as Restricted Firms and resulting expected increased scrutiny by these 
firms on their brokers. Further, this benefit would also accrue 
indirectly from improvements in the compliance culture, both by firms 
that meet the proposed criteria and by firms that do not. For example, 
the proposal may create incentives for firms that meet the Preliminary 
Criteria for Identification to change activities and behaviors, to 
mitigate the Department's concerns. Similarly, the proposal may have a 
deterrent effect on firms that do not meet the Preliminary Criteria for 
Identification, particularly firms that may be close to meeting the 
proposed criteria. These firms may change behavior and enhance their 
compliance culture in ways that better protect their customers.
    The proposal also may help address unpaid arbitration awards. Under 
the proposed rule, the Department may require a Restricted Firm to 
maintain a restricted deposit at a bank or a clearing firm that agrees 
not to permit withdrawals absent FINRA's approval. The amount of the 
Restricted Deposit Requirement would take into consideration, among 
other factors, the amount of any Covered Pending Arbitration Claims and 
unpaid arbitration awards against the member firm or its Associated 
Persons. Moreover, the proposed rule would have presumptions that the 
Department would: (a) Deny an application by a member firm or former 
member firm that was previously designated as a Restricted Firm for a 
withdrawal from the Restricted Deposit if the member firm, its 
Associated Persons who are owners or control persons, or the former 
member firm have any Covered Pending Arbitration Claims or unpaid 
arbitration awards, or if the member firm's Associated Persons have any 
Covered Pending Arbitration Claims or unpaid arbitration awards 
relating to arbitrations that involved conduct or alleged conduct that 
occurred while associated with the member firm; but (b) approve a 
former member firm's application for withdrawal if the former member 
firm commits in the manner specified by the Department to use the 
amount it seeks to withdraw from its Restricted Deposit to pay the 
former member firm's specified unpaid arbitration awards. Accordingly, 
the proposed rule could potentially create incentives for firms to pay 
unpaid arbitration awards against the firm or its Associated Persons, 
thereby alleviating, to some extent, harm to successful claimants and 
enhancing investor confidence in the arbitration process.\57\
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    \57\ Further, as discussed above, the Department would consider 
a member firm's and its Associated Persons' unpaid arbitration 
awards as one of the factors in determining the amount of the 
Restricted Deposit Requirement. As a result, there would be 
additional incentives to pay unpaid arbitration awards.
---------------------------------------------------------------------------

    To scope these potential benefits and assess the potential risk 
posed by firms that would meet the proposed Preliminary Criteria for 
Identification, FINRA evaluated the extent to which firms that would 
have met the criteria during 2013-2017 \58\ (had the criteria existed) 
and their brokers were associated with ``new'' Registered Person and 
Member Firm Events after having met the proposed criteria. These 
``new'' events correspond to events that were identified or occurred 
after the firm's identification, and do not include events that were 
pending at the time of identification and subsequently resolved in the 
years after identification. As shown in Exhibit 3c, FINRA estimates 
that there were 77 firms that would have met the Preliminary Criteria 
for Identification in 2013. These firms were associated with 1,552 
``new'' Registered Person and Member Firm Events that occurred after 
their identification, between 2014 and 2019. Exhibit 3c similarly shows 
the number of events associated with firms that would have met the 
Preliminary Criteria for Identification in 2014, 2015, 2016 and 2017. 
Across 2013-2017, there were 180 unique firms \59\ that would have met 
the proposed Preliminary Criteria for Identification, and these firms 
were associated with a total of 2,995 Registered Person and Member Firm 
Events that occurred in the years after they met the proposed 
criteria.\60\
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    \58\ This analysis examines firms that would have met the 
Preliminary Criteria for Identification from 2013 until 2017 
(instead of the 2013-2019 review period) to allow sufficient time 
for the ``new'' events to resolve in the post-identification period.
    \59\ Certain firms would have met the criteria in multiple years 
during the review period. The 180 firms discussed in the text 
correspond to the unique number of firms that would have met the 
criteria in one or more years during the review period.
    \60\ Specifically, FINRA examined and counted all Registered 
Person and Member Firm Events that occurred any time after the firms 
were identified until December 31, 2019.
---------------------------------------------------------------------------

    Exhibit 3c also shows the number of Registered Person and Member 
Firm Events for these firms compared to other firms. Specifically, 
FINRA calculated a factor which represents a multiple for the average 
number of events (on a per registered person basis) for firms that 
would have met the Preliminary Criteria for Identification relative to 
other firms of the same size that would not have met the Preliminary 
Criteria for Identification. For example, as shown in Exhibit 3c, the 
factor of 6.1x for 2013 indicates that firms meeting the Preliminary 
Criteria for Identification in 2013 had 6.1 times more new disclosure 
events (per registered person) in the years after identification (2014-
2019) than other firms of the same size registered in 2013 that would 
not have met the Preliminary Criteria for Identification. Overall, this 
analysis demonstrates that firms that would have met the Preliminary 
Criteria for Identification during the 2013-2017 period had on average 
approximately 6-20 times more new disclosure events after their 
identification than other firms in the industry during the same period 
that would not have met the Preliminary Criteria for Identification.
[rtarr8] Anticipated Costs
    The anticipated costs of this proposal would fall primarily upon 
firms that meet the Preliminary Criteria for Identification and that 
the Department deems to warrant further review after its initial 
evaluation. Although FINRA would perform the annual calculation and 
conduct an internal evaluation, firms may choose to expend effort to 
monitor whether they would meet the

[[Page 78553]]

Preliminary Criteria for Identification, and incur associated costs, at 
their own discretion. To the extent that a firm deemed to warrant 
further review under proposed Rule 4111 chooses to seek to rebut the 
presumption that it is a Restricted Firm subject to the maximum 
Restricted Deposit Requirement, it would incur costs associated with 
collecting and providing information to FINRA. For example, these firms 
may provide information on any disclosure events that may be 
duplicative or not sales-practice related. These firms may also provide 
information on any undue significant financial hardship that would 
result from a maximum Restricted Deposit Requirement. Likewise, a firm 
availing itself of the one-time staffing reduction opportunity incurs 
the separation costs, along with the potential for lost future 
revenues.
    In addition, firms subject to a Restricted Deposit Requirement or 
other obligations would incur costs associated with these additional 
obligations. These would include, for example, costs associated with 
setting up the Restricted Deposit Account and ongoing compliance costs 
associated with maintaining the account. Further, as a result of 
restrictions on the use of cash or qualified securities in the deposit 
account or other restrictions on the firm's activities, the firm may 
lose economic opportunities, and its customers may lose the benefits 
associated with the provision of these services.
    Similarly, a firm required to apply heightened supervision to its 
brokers would incur implementation and ongoing costs associated with 
its heightened supervision plan.\61\ Firms that meet the Preliminary 
Criteria for Identification also may incur costs associated with 
enhancing their compliance culture, including possibly terminating 
registered persons with a significant number of disclosure events--
through exercising the one-time staffing reduction option under 
proposed Rule 4111 or otherwise--and reassigning the responsibilities 
of these individuals to other registered persons. Finally, there may be 
indirect costs, including greater difficulty or increased cost 
associated with maintaining a clearing arrangement, loss of trading 
partners, or similar impairments where third parties can determine that 
a firm meets the proposed Preliminary Criteria for Identification or 
has been deemed to be a Restricted Firm.
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    \61\ These costs would likely vary significantly across firms. 
Costs would depend on the specific obligations imposed specific to 
the firm and its business model. In addition, costs could escalate 
if a heightened supervision plan applied to brokers that serve as 
principals, executive managers, owners, or in other senior 
capacities. Such plans may entail reassignments of responsibilities, 
restructuring within senior management and leadership, and more 
complex oversight and governance approaches.
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    Firms that do not meet the proposed Preliminary Criteria for 
Identification, particularly ones that understand they are close to 
meeting the proposed criteria, also may incur costs associated with 
enhancing their compliance culture or making other changes in order to 
avoid meeting the proposed criteria in the future. These costs may 
include terminating registered persons with disciplinary records, 
replacing them with existing or new hires, enhancing compliance 
policies and procedures, and improving supervision of registered 
persons. Finally, registered persons with significant number of 
disciplinary or other disclosure events on their records may find it 
difficult to retain employment, or get employed by new firms, 
particularly where those firms and their associated registered persons 
already have disciplinary records. Similarly, firms meeting the 
proposed criteria or those close to meeting the proposed criteria may 
find it difficult to hire registered persons with disclosure events. 
FINRA notes, however, that the anticipated economic impacts on firms 
hiring and registered persons seeking employment would likely be 
limited to a small proportion of registered persons and member 
firms.\62\
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    \62\ For example, during the 2013 to 2019 review period, only 
one to two percent of the registered persons had any qualifying 
events in their regulatory records, which represents the most 
conservative estimate of the set of registered persons who might be 
impacted by the proposed rule. Further, the vast majority of member 
firms, approximately 98%, would likely be able to employ most of the 
individuals seeking employment in the industry--including ones who 
have some disclosures--without coming close to meeting the 
Preliminary Criteria for Identification.
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[rtarr8] Other Economic Impacts
    FINRA also has considered the possibility that, in some cases, this 
proposal may impose restrictions on brokers' and firms' activities that 
are less likely to subsequently harm their customers. In such cases, 
these brokers and firms may lose economic opportunities or find it 
difficult to retain brokers or customers. FINRA believes that the 
proposal mitigates such risks by requiring an initial layer of 
Departmental review, and providing affected firms an opportunity to 
engage in a Consultation with the Department and request a review of 
the Department's determination in an expedited proceeding.
    FINRA also considered that some firms may consider not reporting, 
underreporting, or failing to file timely, required disclosures on 
Uniform Registration Forms in an effort to avoid costs associated with 
the proposals. However, this potential impact is mitigated because many 
events are reported by regulators or in separate public notices by 
third parties and, as a result, FINRA can monitor for these unreported 
events. Further, failing to timely update Uniform Registration Forms is 
a violation of FINRA rules and can result in fines and penalties, 
thereby serving as a deterrent for underreporting, misreporting and 
failing to file timely required disclosures.
    Considering that the proposed criteria are based on a firm's 
experience relative to its similarly sized peers, FINRA does not 
believe that the proposed criteria impose costs on competition between 
firms of different sizes. Further, because FINRA would perform the 
annual calculation to determine the firms that meet the Preliminary 
Criteria for Identification, the costs a firm incurs to monitor its 
status in relation to the proposed criteria would be discretionary and 
not likely create any competitive disadvantage based on firm size. 
Although the proposed rule would not impose these monitoring costs, 
FINRA would provide transparency around how the Preliminary Criteria 
for Identification are calculated and appropriate guidance to assist 
firms seeking to monitor their status. Similarly, FINRA does not 
anticipate that the proposed Restricted Firm Obligations Rule, 
including the Restricted Deposit Requirement or any required conditions 
and restrictions, would create competitive disadvantages across firms 
of different sizes. This is, in part, because FINRA would consider the 
number of offices and registered persons, among other factors, when 
determining the appropriate maximum Restricted Deposit Requirement or 
any conditions and restrictions, to ensure that the obligations are 
appropriately tailored to the firm's business model but do not 
significantly undermine the continued financial stability and 
operational capability of the firm as an ongoing enterprise over the 
ensuing 12 months.
    As discussed above, FINRA would exercise some discretion in 
determining the maximum Restricted Deposit Requirement and tailor it to 
the size, operations and financial conditions of the firm, among other 
factors. This approach is intended to align with FINRA's objective to 
have the specific financial obligation be significant enough to change 
a Restricted Firm's

[[Page 78554]]

behavior but not so burdensome that it would indirectly force it out of 
business. In determining the specific maximum Restricted Deposit 
Requirement, FINRA would consider a range of factors, including 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'' or unpaid arbitration awards. In developing the 
proposal, FINRA considered the possibility of having a transparent 
formula, based on some of these factors, to determine a maximum 
Restricted Deposit Requirement. However, as discussed in more detail 
below, given the range of relevant factors and differences in firms' 
business models, operations, and financial conditions, FINRA decided 
not to propose a uniform, formulaic approach across all firms.
    In developing the proposal, FINRA also considered the possibility 
that the size of the maximum Restricted Deposit Requirement may be too 
burdensome for the firms, and could undermine their financial stability 
and operational capability. FINRA believes that these risks are 
mitigated by providing affected firms an opportunity to engage in a 
Consultation process with FINRA and propose a lesser Restricted Deposit 
Requirement or restrictions or conditions on their operations. Further, 
as discussed above, Restricted Firms would have the opportunity to 
request a review of the Department's determination in an expedited 
proceeding.
b. Proposed Expedited Proceeding Rule
    When FINRA imposes obligations on a firm pursuant to the proposed 
Restricted Firm Obligations Rule, the firm may experience significant 
limitations to its business activities and incur direct and indirect 
costs associated with the obligations imposed. The proposed Expedited 
Proceeding Rule would, in general, require that these obligations apply 
immediately, even during the pendency of any appeal.
    The proposed rule would be associated with investor protection 
benefits through the impact of the no-stay provision in proposed Rule 
9561(a)(4). Under the proposal, obligations imposed by the Department 
would be effective immediately, except that a firm that is subject to a 
Restricted Deposit Requirement under proposed Rule 4111 and requests a 
hearing would be required to make only a partial deposit while the 
hearing is pending. This would reduce the risk of investor harm during 
the pendency of a hearing. Similarly, the no-stay provision may limit 
hearing requests by firms that seek to use them only as a way to 
forestall FINRA obligations.
    The benefit of the proposed rule accruing to firms would be to 
permit firms to appeal FINRA's determinations (both to request prompt 
review of obligations imposed or of determinations for failure to 
comply) in an expedited proceeding, thereby reducing undue costs where 
firms may have been misidentified or where the obligations imposed are 
not necessary or appropriate to address the concerns indicated by the 
Preliminary Criteria for Identification and protect investors and the 
public interest. For example, the proposed rule is anticipated to 
reduce any undue costs by the proceeding's expedited nature. Similarly, 
the proposed rule's time deadlines may also reduce the costs of the 
proceedings, in certain cases.
    The costs would be borne by firms that choose to seek review via 
the proposed expedited proceeding, and these costs can be measured 
relative to a standard proceeding. These firms would incur costs 
associated with provisions and procedures specific to this proposed 
rule, including the provision that the obligations imposed would not be 
stayed.\63\ This would include the obligations imposed under the 
proposed rule, including the Restricted Deposit Requirement, and the 
requirement that the firm, upon the Department's request, provide 
evidence of its compliance with these obligations. However, the extent 
of the costs associated with the Restricted Deposit Requirement would 
be mitigated by the expedited nature of the proceeding and by the 
provision that would require a firm, during the pendency of an 
expedited hearing process, to maintain only a partial deposit 
requirement.
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    \63\ The effect of the no-stay provision is that imposed 
obligations would apply immediately, even during the pendency of any 
hearing request. As a result, the no-stay provision would impose 
direct costs on misidentified firms or firms for which the 
obligations imposed are not necessary or appropriate.
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    As with the other proposals, FINRA does not anticipate that the 
proposed rule would have differential competitive effects based on firm 
size or other criteria. The costs and benefits are anticipated to apply 
to all firms that request a hearing in an expedited proceeding.
4. Alternatives Considered
    FINRA recognizes that the design and implementation of the rule 
proposals may impose direct and indirect costs on a variety of 
stakeholders, including firms, brokers, regulators, investors and the 
public. Accordingly, in developing its rule proposals, FINRA seeks to 
identify ways to enhance the efficiency and effectiveness of the 
proposed rules while maintaining their regulatory objectives. For 
example, FINRA considered several alternatives to addressing the risks 
posed by firms and their brokers that have a history of misconduct, 
including alternative approaches and alternative specifications to the 
numeric threshold based-approach and the Restricted Deposit 
Requirement.
a. Alternative to the Proposed Numeric Threshold-Based Approach
    In addition to the proposed approach based on numeric thresholds, 
FINRA considered an approach similar to the Investment Industry 
Regulatory Organization of Canada's (IIROC) ``terms and conditions'' 
rule, IIROC Consolidated Rule 9208, that would allow FINRA to identify 
a limited number of firms with significant compliance failures and 
impose on them appropriate terms and conditions to ensure their 
continuing compliance with the securities laws, the rules thereunder, 
and FINRA rules.\64\ FINRA considered and evaluated the economic 
impacts of such a terms and conditions rule relative to proposed Rule 
4111.
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    \64\ IIROC Consolidated Rule 9208 permits IIROC to impose terms 
and conditions on an IIROC Dealer Member's membership when IIROC 
considers these terms and conditions appropriate to ensure the 
member's continuing compliance with IIROC requirements.
---------------------------------------------------------------------------

    Compared to proposed Rule 4111, a terms and conditions rule would 
provide FINRA with greater flexibility in identifying firms that should 
be subject to additional obligations. This greater flexibility could 
help better target its application and reduce misidentification by 
allowing FINRA to leverage non-public information, including regulatory 
insights collected as part of its monitoring and examination programs, 
in identifying firms that pose the greatest risk. Further, under a 
terms and conditions rule, FINRA could quickly update its 
identification of firms based on emerging risk patterns, to ensure that 
the rule continues to be effective at addressing firms that presently 
pose the greatest risk. This flexibility could

[[Page 78555]]

mitigate the risk that the criteria and thresholds in proposed Rule 
4111 no longer identify the appropriate firms.
    Further, as discussed above, the identification criteria in 
proposed Rule 4111 may not identify all the firms that pose material 
risk to their customers, such as firms that may act to stay just below 
the proposed criteria and thresholds by any means, including 
misreporting or underreporting disclosure events. The absence of a set 
identification criteria in a terms and conditions rule would make it 
more difficult for firms to evade the identification criteria and thus 
could provide greater investor protections.+
    At the same time, a terms and conditions rule may have certain 
disadvantages relative to proposed Rule 4111. For example, a benefit of 
proposed Rule 4111 is the deterrent effect it may have on firms that do 
not meet the proposed Preliminary Criteria for Identification, 
particularly firms that may be close to meeting the criteria. These 
firms may change behavior and enhance their compliance culture in ways 
that could better protect their customers. By comparison, under a terms 
and conditions rule, in the absence of transparent criteria, firms 
would have to assess FINRA's view of the significance of repeated exam 
findings to determine whether to change their conduct to avoid 
potential terms and conditions.
    Although FINRA has considered, and will continue to explore, this 
alternative, it is not proposing a terms and conditions rule at this 
time.
b. Alternative Specifications for the Proposed Numeric Threshold-Based 
Approach
    FINRA also considered several alternatives to the numerical 
thresholds and conditions for the Preliminary Criteria for 
Identification. In determining the proposed criteria, FINRA focused 
significant attention on the economic trade-off between incorrect 
identification of firms that may not subsequently pose risk of harm to 
their customers, and not including firms that may subsequently pose 
risk of harm to customers. FINRA also considered three key factors: (1) 
The different categories of reported disclosure events and metrics, 
including the Expelled Firm Association Metric; (2) the counting 
criteria for the number of reported events or conditions; and (3) the 
time period over which the events or conditions are counted. FINRA 
considered several alternatives for each of these three factors.
[rtarr8] Alternatives Associated With the Categories of Disclosure 
Events and Metrics
    In determining the different types of disclosure events, FINRA 
considered all categories of disclosure events reported on the Uniform 
Registration Forms, including the financial disclosures. FINRA decided 
to exclude financial disclosures because while financial events, such 
as bankruptcies, civil bonds, or judgments and liens, may be of 
interest to investors in evaluating whether or not to engage a broker 
or a firm, these types of events by themselves are not evidence of 
customer harm.
    In developing the Preliminary Criteria for Identification, FINRA 
also considered whether pending criminal, internal review, judicial and 
regulatory events should be excluded from the threshold test. Pending 
matters are often associated with an emerging pattern of customer harm 
and capture timely information of potential ongoing or recent 
misconduct. However, pending matters may include pending regulatory 
investigations and criminal proceedings that do not result in a 
finding.\65\ FINRA evaluated the impact of eliminating pending matters 
from the Preliminary Criteria for Identification. Specifically, FINRA 
identified the firms that would no longer meet the proposed criteria 
(had the criteria existed) during the evaluation period if pending-
events categories were eliminated from the criteria, and examined the 
extent to which such firms were associated with ``new'' Registered 
Person and Member Firm Events. As shown in Exhibit 3d, FINRA estimates 
that these firms had on average approximately 8.0-13.1 times more new 
disclosure events than other firms in the industry during the same 
period that would not have met the Preliminary Criteria for 
Identification.\66\ Accordingly, based on this review and other 
validations, FINRA decided to include pending matters in the proposed 
criteria because they are critical to identifying firms that pose 
greater risks to their customers.
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    \65\ As discussed in more detail below, several commenters 
expressed concerns about including pending and un-adjudicated events 
in the Preliminary Criteria for Identification. Commenters suggested 
that pending events are often associated with frivolous cases and 
that many pending regulatory investigations and criminal proceedings 
are discontinued without action.
    \66\ In assessing the impact of removing pending events from the 
Preliminary Criteria for Identification and restricting the criteria 
solely to final events, FINRA also examined the number of firms that 
would have met or exceeded at least one Preliminary Identification 
Metrics Threshold in the Registered Person Adjudicated Events, 
Member Firm Adjudicated Events, or Registered Persons Associated 
with Expelled Firms categories, during the relevant period. This 
analysis showed that the number of firms identified by this 
alternative criteria would increase from 45-80 firms to 131-196 
firms, each year, during the review period. Similarly, FINRA 
estimates the number of firms that would have met or exceeded at 
least two thresholds within these categories to be 32-57 firms, each 
year, during the review period.
---------------------------------------------------------------------------

    As with other categories, the proposed Preliminary Identification 
Metrics Thresholds for the relevant Preliminary Identification Metrics, 
including the Registered Person Pending Event Metric and the Member 
Firm Pending Event Metric, are intended to capture firms that are on 
the far tail of the distributions. Thus, firms meeting these thresholds 
have far more pending matters on their records than other firms in the 
industry that do not meet these thresholds. Nonetheless, FINRA 
recognizes that pending matters include disclosure events that may 
remain unresolved or that may subsequently be dismissed or concluded 
with no adverse action because they lack merit or suitable 
evidence.\67\ In order to ensure that a firm does not meet the 
Preliminary Criteria for Identification solely because of pending 
matters, FINRA has proposed the conditions that, to meet the criteria, 
the firm must meet or exceed at least two of the six Preliminary 
Identification Metrics Thresholds, and at least one of the thresholds 
for the Registered Person Adjudicated Event Metric, Member Firm 
Adjudicated Event Metric, or Expelled Firm Association Metric.
---------------------------------------------------------------------------

    \67\ For example, customers may file complaints that are false 
or erroneous and such complaints may subsequently be withdrawn by 
the customers or get dismissed by arbitrators or judges.
---------------------------------------------------------------------------

    In developing the Preliminary Criteria for Identification, FINRA 
also considered alternatives to the Expelled Firm Association Metric. 
For example, in Regulatory Notice 19-17, FINRA initially proposed the 
metric to be based on all registered persons who were previously 
associated with one or more previously expelled firms, at any time in 
their career and irrespective of their duration of association at the 
previously expelled firm. FINRA subsequently narrowed the Expelled Firm 
Association Metric by only including registered persons who were 
registered with a previously expelled firm within the prior five years 
(i.e., whose registration with a previously expelled firm terminated 
during the prior five years) and who were registered with the expelled 
firm for at least one year. FINRA selected this formulation to analyze 
because the five-year lookback is consistent with the lookback periods 
for the other proposed metrics in the proposal and, based on staff 
experience,

[[Page 78556]]

FINRA believes that individuals who are more recently associated with 
previously expelled firms (e.g., in the last five years) and have 
longer tenures at expelled firms (e.g., a year or more, instead of a 
shorter employment duration) generally pose higher risk than other 
individuals.
    In developing the proposal, FINRA conducted several validations on 
the firms meeting the criteria, including the proposed Expelled Firm 
Association Metric, by reviewing the extent to which firms identified 
during 2013-2017 (had the criteria existed) were subsequently expelled, 
associated with unpaid awards, or identified by the Department as 
suitable candidates for additional obligations. As discussed above, 
FINRA also evaluated the extent to which firms that would have met the 
criteria during 2013-2017 (had the criteria existed) and their brokers 
were associated with ``new'' Registered Person and Member Firm Events 
after having met the criteria. As shown in Exhibit 3c, FINRA estimates 
that the identified firms had on average approximately 6.1-19.9 times 
more new disclosure events after their identification than other firms 
in the industry during the same period that would not have met the 
Preliminary Criteria for Identification. Based on staff review and 
validations, FINRA believes that the proposed Expelled Firm Association 
Metric preserves the usefulness of the Preliminary Criteria for 
Identification (as originally proposed in Regulatory Notice 19-17) and 
continues to identify firms that pose greater risks to their customers.
[rtarr8] Alternatives Associated With the Counting Criteria for the 
Proposed Criteria and Metrics
    FINRA considered a range of alternative counting criteria for the 
Preliminary Criteria for Identification. For example, FINRA considered 
whether the Preliminary Criteria for Identification should be based on 
firms meeting two or more Preliminary Identification Metrics 
Thresholds, or whether the number of required thresholds should be 
decreased or increased. Decreasing the number of required thresholds 
from two to one would increase the number of firms that would have met 
the Preliminary Criteria for Identification during the review period 
from 45-80 firms to 155-217 firms, each year. Alternatively, increasing 
the number of required thresholds from two to three would decrease the 
number of firms that would have met the Preliminary Criteria for 
Identification from 45-80 firms to 11-20 firms, each year. FINRA 
reviewed the list of firms identified under these alternative counting 
criteria and examined the extent to which they included firms that were 
subsequently expelled, associated with unpaid awards, or identified by 
the Department as suitable candidates for additional obligations. FINRA 
also paid particular attention to firms that would have been identified 
by these alternative criteria but subsequently were not associated with 
high-risk activity, as well as firms that would not have been 
identified by these alternatives that were associated with high-risk 
events. Based on this review, FINRA believes that the proposed 
approach--meeting two or more of the Preliminary Identification Metrics 
Thresholds--more appropriately balances these trade-offs between 
misidentifications than the alternative criteria.
[rtarr8] Alternatives Associated With the Time Period Over Which the 
Metrics Are Calculated
    The proposed Preliminary Identification Metrics are based on two 
different time periods over which different categories of events and 
conditions are counted (``lookback periods''). Pending events, 
including the Registered Person Pending Events and the Member Firm 
Pending Events categories, are counted in the Preliminary 
Identification Metrics only if they are pending as of the Evaluation 
Date. Adjudicated events, including the Registered Person Adjudicated 
Events and the Member Firm Adjudicated Events categories, and 
Registered Persons Associated with Previously Expelled Firms are 
counted in the Preliminary Identification Metrics over a five-year 
lookback period.\68\
---------------------------------------------------------------------------

    \68\ Registered Persons In-Scope include all persons registered 
with the firm for one or more days within the one year prior to the 
Evaluation Date.
---------------------------------------------------------------------------

    In developing the proposal, FINRA considered alternative criteria 
for the time period over which the disclosure events or conditions are 
counted. For example, FINRA considered whether adjudicated events 
should be counted over the individual's or firm's entire reporting 
period or counted over a more recent period. Based on its experience, 
FINRA believes that more recent events (e.g., events occurring in the 
last five years) generally pose a higher level of possible future risk 
to customers than other events. Further, counting events over an 
individual's or firm's entire reporting period would imply that brokers 
and firms would always be included in the Preliminary Identification 
Metrics for adjudicated events, even if they subsequently worked 
without being associated with any future adjudicated events. 
Accordingly, FINRA decided to include adjudicated events only in the 
more recent period (i.e., a five-year period).\69\
---------------------------------------------------------------------------

    \69\ This also is consistent with the time period used for 
counting ``specified risk events'' in SR-FINRA-2020-011.
---------------------------------------------------------------------------

    Similarly, FINRA also considered alternative limits on the time 
periods over which components of the Expelled Firm Association Metric 
would be calculated. For example, FINRA considered alternative metrics 
based on only firms that have been expelled within three to five years 
prior to the Evaluation Date. Further, FINRA considered alternatives 
where the individual broker's association with the previously expelled 
firm was within a five-year window around the firm's expulsion. In 
evaluating these alternatives, FINRA recalculated the underlying 
thresholds to capture firms that are on the far tail of the 
distribution for these alternative metrics.\70\ As with other 
alternatives, FINRA conducted several validations on alternative 
specifications of time periods for calculating the Expelled Firm 
Association Metric. These validations included reviewing the extent to 
which firms identified by alternative specifications of the proposed 
criteria were associated with ``new'' events after identification, 
subsequently expelled or associated with unpaid awards, or were 
identified by the Department as suitable candidates for additional 
obligations. Based on these validations, FINRA selected the proposed 
five-year period for calculating the Expelled Firm Association Metric 
as the alternative specifications did not result in any material change 
to the proposed criteria's ability to identify firms that pose greater 
risk of customer harm.\71\
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    \70\ These alternatives would have identified approximately the 
same number of firms as meeting the Preliminary Criteria for 
Identification, during the review period.
    \71\ For example, as discussed above, FINRA estimates that the 
firms identified by the proposed criteria (based on a five-year 
period for calculating the Expelled Firm Association Metric) had on 
average approximately 6.1-19.9 times more new disclosure events 
after their identification than other firms in the industry during 
the same period that would not have met the proposed criteria.
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c. Alternatives to the Restricted Deposit Requirement
    In developing the proposal, FINRA considered alternative approaches 
to the Restricted Deposit Requirement. For example, FINRA considered 
increasing the capital requirements on identified firms, in lieu of the 
Restricted Deposit Requirement. A net capital approach would provide 
the identified firms

[[Page 78557]]

greater flexibility and control over the assets. These firms would be 
able to use the assets for cash flow and operating expenses. As a 
result, an additional net capital charge would be associated with lower 
direct and indirect costs to these firms. However, there are several 
drawbacks with respect to economic incentives and anticipated impacts 
to relying upon a net capital approach as a tool for addressing the 
risks posed by firms with a significant history of misconduct. For 
example, the firm assets that would be maintained pursuant to an 
increased net capital requirement would not be deposited into a 
separate restricted account and may be fungible with other firm assets. 
As a result, these assets could be withdrawn by the identified firms at 
any time and these firms could employ the capital during the pendency 
of the restriction period. This suggests that the deterrent effect of 
an increased net capital approach would be much lower on a dollar-for-
dollar basis than the proposed Restricted Deposit Requirement. An 
increased net capital approach also may not be sufficiently impactful 
in providing incentives to change firm behavior if a Restricted Firm 
already maintains substantial excess net capital. Further, considering 
that the identified firms could withdraw their assets at any time under 
a net capital approach, FINRA would not be able to ensure that any 
funds would be available for satisfying unpaid arbitration awards. In 
light of these considerations, FINRA decided to propose a Restricted 
Deposit Requirement approach, rather than changes to the capital 
requirements on identified firms.
    FINRA also considered whether the Restricted Deposit Requirement 
amount should be based on a formula or include a cap in order to 
provide greater transparency to the member firms. To assess the 
feasibility of a strict formula or cap in setting the Restricted 
Deposit Requirement, FINRA assessed the financial condition of the 
firms that would have been identified by the Preliminary Criteria for 
Identification in 2019 (if the criteria had existed) and found 
significant variation across firms. These variations existed even 
across firms within the same size category. For example, FINRA found 
that the highest firm's revenues were approximately 1,750 times that of 
the firm with the lowest revenue when standardized by the number of 
registered persons at the firm. Within firm size categories, the 
corresponding difference in revenues per registered person was as high 
as over 80 times. Similarly, there was significant variation in the 
reported cash and ownership equity across these firms. The highest 
firm's excess net capital was over 3,500 times that of the firm with 
the lowest excess net capital (standardized per registered person).\72\ 
The firm reporting the highest ownership equity was over 2,300 times 
that of the lowest firm's ownership equity (standardized per registered 
person). Further, firms' awards and settlements appear to be unrelated 
to their financial condition. For example, FINRA estimates that over 
20% of the identified firms with high awards and settlement amounts 
have low or medium revenues (on a per registered person basis) or high 
revenues and low or medium awards and settlement amounts.\73\ Thus 
there appears to be no consistent relationship between firm size, and 
basic metrics of the financial condition of the firm, and potential 
obligations to harmed customers. Given these significant variations in 
quantitative factors and the qualitative nature of some of the factors 
for consideration (e.g., concerns raised during FINRA exams), FINRA 
decided to maintain the Department's discretion for determining the 
Restricted Deposit Requirement, instead of proposing a formula or a 
cap. Additionally, FINRA believes that if the proposal were to include 
a precise formula, it may undermine the effectiveness of the rule by 
providing an opportunity for firms to take actions to minimize the 
expected restricted deposit.
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    \72\ See Exhibit 3e, which reflects the firms that would have 
met the Preliminary Criteria for Identification in 2019, had the 
criteria existed.
    \73\ For purposes of this Form 19b-4, ``high'' arbitration 
awards, settlement amounts and revenues means the top tercile (above 
66th percentile) of these awards, settlements and revenues among 
firms that would have met the proposed criteria, and ``medium'' and 
``low'' arbitration awards, settlement amounts and revenues means 
the middle tercile (33rd-66th percentile) and bottom tercile (below 
the 33rd percentile). See Exhibit 3f, which reflects the firms 
meeting the Preliminary Criteria for Identification in 2019.
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C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in Regulatory 
Notice 19-17 (May 2019). Thirty-two comments were received in response 
to the Regulatory Notice.\74\ Exhibit 2a is a copy of the Regulatory 
Notice. Exhibit 2b is a list of commenters. Exhibit 2c contains copies 
of the comment letters received in response to the Regulatory Notice. 
Of the 32 comment letters received, 11 were generally in favor of the 
proposed rule change, and 18 were generally opposed.
---------------------------------------------------------------------------

    \74\ All references to commenters are to the comment letters as 
listed in Exhibit 2b.
---------------------------------------------------------------------------

    FINRA has considered the comments received. In light of some of 
those comments, FINRA has made some modifications to the proposal. The 
comments and FINRA's responses are set forth in detail below.
1. General Support for the Proposal
    Several commenters expressed general support for the proposed rule 
changes in Regulatory Notice 19-17.\75\ For example, NASAA commended 
FINRA's attempt to strategically identify, and more strongly regulate, 
the limited number of member firms with histories of regulatory 
noncompliance, and stated that the proposal should increase investor 
protection while imposing minimal burdens on the brokerage industry. 
Massachusetts called the proposal a positive step toward protecting 
investors from the riskiest corners of the brokerage industry, and 
asserted that the proposal rightly places the burden of investor 
protection on the firms that hire bad brokers and ensures that 
investors have meaningful recourse when harmed. CAI likewise expressed 
support for how the proposal would enhance customer protection by 
imposing additional obligations on a targeted group of firms. SIFMA 
supported how the proposal fits into FINRA's continuing efforts to help 
ensure that arbitration claims, awards, and settlements are paid in 
full. Cetera supported both the concept and manner in which FINRA has 
approached this effort. Cambridge agreed that an objective data 
assessment coupled with a comprehensive and transparent review of that 
data--which is the general structure of the proposed Restricted Firm 
Obligations Rule--will aid FINRA in identifying those high risk member 
firms and registered persons contemplated by this proposal.
---------------------------------------------------------------------------

    \75\ CAI, Cambridge, Cetera, FSI, Massachusetts, MIRC, NASAA, 
PIABA, PIRC, SIFMA, St. John's SOL. Supportive commenters also 
suggested ways in which the proposal could be modified or enhanced, 
which are discussed in more detail below.
---------------------------------------------------------------------------

2. General Opposition to the Proposal
    Several commenters generally opposed proposed Rule 4111, on a 
variety of grounds. For example, several commenters wrote that the 
proposal would disproportionately affect small firms or reflected an 
attempt to put small firms out of business.\76\ PIRC, however, 
characterized industry

[[Page 78558]]

objections that the proposed rule would disproportionately affect small 
firms as unwarranted noting that the rule accounts for different firm 
sizes in its threshold calculations. Each specific numeric threshold in 
the Preliminary Identification Metrics Thresholds grid (proposed Rule 
4111(i)(11)) represents an outlier with respect to similarly sized 
peers. Moreover, the process of determining a Restricted Deposit 
Requirement would require the Department to consider several factors 
that relate to firm size and a parameter directly influenced by firm 
size.\77\ Thus, while the revised proposal includes several 
modifications that will lessen some of the original proposal's burdens 
on all firms, the modifications are not specific to small firms.
---------------------------------------------------------------------------

    \76\ Brooklight, Colorado FSC, Dempsey, FSI, IBN, Joseph Stone, 
Luxor, McNally, Moss & Gilmore, Westpark.
    \77\ See proposed Rule 4111(i)(15)(A) (including as factors, 
inter alia, the ``nature of the firm's operations and activities'' 
and ``the number of offices and registered persons,'' and requiring 
that the Department determine a maximum Restricted Deposit 
Requirement that ``would not significantly undermine the continued 
financial stability and operational capability of the firm as an 
ongoing enterprise over the next 12 months'').
---------------------------------------------------------------------------

    Some commenters generally opposed the proposal on the basis of its 
potential adverse impacts on individuals.\78\ For example, some 
commenters contended that many terminated individuals would have to 
uproot their lives and be unable to find a new broker-dealer.\79\ 
Brooklight commented that innocent representatives who associated with 
a firm expelled for firm-level issues would be marked with a ``scarlet 
letter'' that could end their careers. Westpark commented that the 
proposed rule would make it financially untenable for small firms to 
employ brokers with certain levels of disclosures, essentially making 
them unemployable. HLBS commented that the proposed rule will allow 
FINRA to grossly intrude on member firms' recruiting and termination 
decisions. Some commenters expressed concern that the proposal would 
unfairly affect some persons who previously worked at disciplined firms 
and persons with any regulatory incidents regardless of their 
intent.\80\
---------------------------------------------------------------------------

    \78\ Brooklight, Dempsey, Joseph Stone, Westpark.
    \79\ Dempsey, Joseph Stone.
    \80\ Brooklight, Dempsey, Joseph Stone.
---------------------------------------------------------------------------

    FINRA notes, however, that between 2013 and 2019, only one to two 
percent of registered persons in any year had any qualifying events in 
their regulatory records, which represents the most conservative 
estimate of the set of brokers who might be associated with the 
proposed rule. Further, approximately 98% of member firms would be able 
to employ individuals seeking employment in the industry--including 
ones who have some disclosures and ones who were terminated by 
Restricted Firms--without meeting the Preliminary Criteria for 
Identification. Moreover, under a separately proposed rule, a member 
firm could register an individual who has only one ``specified risk 
event'' in their record without having to request a materiality 
consultation.\81\
---------------------------------------------------------------------------

    \81\ See Securities Exchange Act Release No. 88600 (April 8, 
2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No. 
SR-FINRA-2020-011).
---------------------------------------------------------------------------

    For these reasons, FINRA is not proposing to revise proposed Rule 
4111 to address these comments, except to narrow the scope of the 
Expelled Firm Association Metric. FINRA recognizes that proposed Rule 
4111 could result in some firms declining to employ persons who have 
associated with a firm that has been expelled, even when it would not 
cause the firm to meet the Preliminary Criteria for Identification. 
FINRA does not believe this concern--which is similar to how some firms 
may respond to FINRA's ``Taping Rule'' \82\--warrants removing the 
Expelled Firm Association Metric from the Preliminary Criteria for 
Identification. Nevertheless, as explained more below, FINRA has 
narrowed the Expelled Firm Association Metric, to narrow its impact on 
individuals.
---------------------------------------------------------------------------

    \82\ See Rule 3170 (Tape Recording of Registered Persons by 
Certain Firms). The Taping Rule provides, in general, that a firm is 
a ``taping firm'' when specified percentages of its registered 
persons have been associated with one or more ``disciplined firms'' 
in a registered capacity within the last three years.
---------------------------------------------------------------------------

    Westpark commented that the proposal is inconsistent with Section 
15(b)(6) of the Exchange Act, which requires that FINRA rules not be 
designed to permit unfair discrimination between brokers or dealers, 
and Section 15A(b)(9) of the Exchange Act, which requires that FINRA 
rules not impose any burden on competition not necessary or appropriate 
in furtherance of the Exchange Act. Proposed Rule 4111, however, will 
allow FINRA to impose obligations only on the limited number of member 
firms that pose substantially higher risks to investors compared to 
their similarly sized peers, and only after a multi-step process that 
has numerous procedural protections, for the purpose of protecting 
investors and the public interest. Therefore, FINRA believes the 
proposal is an appropriate means of protecting investors and the public 
interest, and is not unfair.\83\
---------------------------------------------------------------------------

    \83\ See Securities Exchange Act Release No. 17371 (December 12, 
1980), 45 FR 83707 (December 19, 1980) (Order Approving File No. SR-
NASD-78-3) (explaining that disparate treatment of differently 
situated parties is not necessarily either fair or unfair).
---------------------------------------------------------------------------

    Several commenters predicted that, for a variety of reasons, the 
proposal will not achieve its intended goals \84\ or commented that the 
proposal is insufficient.\85\ For example: (1) Some question the 
underlying premise of using disclosure data to predict future customer 
harm; \86\ (2) Rockfleet suggested that when a Restricted Deposit 
Requirement would essentially shut a firm down, the firm would likely 
terminate its membership and ``leav[e] FINRA in exactly the position it 
is seeking to avoid''; (3) Joseph Stone commented that firms that 
dilute their concentration of brokers that meet the threshold criteria 
can still pose risks, and that the proposal will ``force firm 
management to push quality and compliant representatives out of their 
firms''; (4) Luxor commented that there is no evidence to prove that 
the proposal will cure the problem it is intended to solve; (5) 
Massachusetts wrote that the annual calculation is predictable and may 
provide an incentive for firms to comply only enough to remain just 
below the triggering thresholds; (6) Cambridge predicted that member 
firms without significant retained earnings would be given exceptions 
to the Restricted Deposit Requirement; (7) Network 1 wrote ``[t]here 
will always be `bad' brokers''; and (8) ASA commented that certain 
aspects of the proposal ``do not go far enough to remove the most 
egregious actors from our industry'' and would ``marginally increase 
the financial obligations of bad actor firms and allow [them] to 
continue their abuse of Main Street investors.''
---------------------------------------------------------------------------

    \84\ ASA, Dempsey, Joseph Stone, Luxor, PIABA, Rockfleet, 
Worden.
    \85\ ASA, Better Markets.
    \86\ Cetera, Dempsey, Luxor.
---------------------------------------------------------------------------

    The primary goal of the proposed rule change is to incentivize 
members with a significant history of misconduct relative to their 
peers to change behavior, and FINRA believes that the proposed rule 
change is reasonably designed to achieve that goal. The way the 
proposal identifies the affected firms is consistent with recent 
academic studies that analyzed correlations between disclosure data and 
risks to investors. The proposed rule change creates substantial, 
ongoing incentives for the firms that present the highest levels of 
risk to change behavior, and gives FINRA an important new tool to 
respond to those firms that continue to present outlier-level risks to 
investors. FINRA also believes that the most effective measure to 
incentivize such

[[Page 78559]]

firms to change behavior is a financial restriction--including the mere 
potential for a financial restriction.
    Several commenters state that the proposal's impacts are too broad 
to address the risks posed. For example, Brooklight expressed that 
instead of impacting just a ``few bad actors,'' the proposal imposes 
increased regulatory burdens on ``every single member'' and could 
``sweep in wholly innocent firms.'' HLBS commented that the proposed 
rule would impose punishment based only on the mere suspicion of 
misconduct. Rockfleet commented that the burdens would be unwarranted, 
because unpaid arbitration awards are ``not a widespread industry 
issue,'' and the proposal would unfairly capture firms that only employ 
a single individual with numerous disclosure events. Sichenzia 
commented that reducing unpaid arbitration awards is better achieved 
through less onerous means. FSI expressed concern that the proposal 
does not provide adequate safeguards to protect against 
misidentification.
    FINRA believes, however, that the proposed rule change is 
reasonably designed to impact a relatively small number of firms posing 
outlier-level risks. The proposed Rule 4111 ``funnel'' process has 
numerous safeguards designed to protect against misidentification. 
Furthermore, although the proposal would have ancillary benefits for 
addressing unpaid arbitration awards, the proposal's primary purpose is 
to create incentives for members that pose outlier-level risks to 
change behavior.
    Luxor commented that the proposal is inconsistent with the usual 
``causal relationship inherent in any regulatory schema'' where 
misconduct precedes the sanctions imposed. Proposed Rule 4111, however, 
is similar to other kinds of rules and regulations that impose 
requirements and restrictions based on a firm's circumstances. For 
example, FINRA's membership rules permit FINRA to impose restrictions 
on new member applicants that are reasonably designed to address 
specific concerns, including--besides disciplinary concerns--financial, 
operational, supervisory, investor protection, or other regulatory 
concerns.\87\ As another example, Exchange Act Rule 15c3-1,\88\ the Net 
Capital Rule, imposes different minimum net capital requirements based 
on the types of securities business the broker-dealer conducts. 
Moreover, the obligations that FINRA may impose pursuant to Rule 4111 
are not ``sanctions'' for violations; rather, they are obligations that 
relate directly to firm profiles that pose substantially more risk to 
investors than the profiles of the vast majority of other member firms 
of similar sizes.
---------------------------------------------------------------------------

    \87\ See Rule 1014(c)(2) (describing granting of applications 
for new membership subject to restrictions).
    \88\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    Some commenters opposed the proposal on the ground that it is 
unnecessary. For example, Rockfleet commented that FINRA's membership 
program and examinations should be sufficient to deal with firms that 
have a poor supervisory structure and compliance culture. Likewise, 
Network 1 wrote that FINRA's enforcement program is a practical 
solution for addressing ``bad brokers.'' As explained above, however, 
while FINRA has a number of tools for identifying and addressing a 
range of misconduct by individuals and firms, and has strengthened 
these protections for investors and the markets, persistent compliance 
issues continue to arise in some member firms. Proposed Rule 4111 
reflects FINRA's belief that more can be done to protect investors from 
firms with a significant history of misconduct.
    Notwithstanding that FINRA has generally retained the proposal as 
it was originally proposed, FINRA appreciates the concerns raised by 
the commenters about the potential impacts and effectiveness of 
proposed Rule 4111. If approved, FINRA plans to review proposed Rule 
4111 after gaining sufficient experience under the rule, at which time 
it will assess the rule's ongoing effectiveness and efficiency.
3. Concerns That the Proposal Gives FINRA Too Much Discretion, and 
Requests for Increased Transparency
    Several commenters contended that, in numerous respects, the 
proposal gives FINRA too much discretion.\89\ Commenters pointed to how 
the proposal gives the Department discretion to decide: (1) In the 
initial Department evaluation stage, which firms require further 
review; (2) the maximum and actual Restricted Deposit Requirement; and 
(3) the types of conditions or restrictions that may be imposed.\90\ 
Some commenters further requested that the proposal provide more 
transparency on how FINRA would exercise its discretion. For example, 
Sichenzia suggested which kinds of disclosure events FINRA should 
eliminate from consideration during the initial Department evaluation, 
and some commenters requested that FINRA clarify how the Department 
would calculate a Restricted Deposit Requirement \91\ and what kinds of 
conditions or restrictions could be imposed.\92\ Some commenters 
recommended specific conditions and restrictions that FINRA should 
impose.\93\
---------------------------------------------------------------------------

    \89\ CAI, Cambridge, FSI, Sichenzia, Westpark.
    \90\ CAI, Cambridge, FSI, Rockfleet, Sichenzia, Westpark, 
Whitehall.
    \91\ CAI, Westpark, Whitehall.
    \92\ FSI, Massachusetts, NASAA, PIRC, St. John's SOL.
    \93\ Massachusetts, MIRC, NASAA, St. John's SOL.
---------------------------------------------------------------------------

    FINRA believes that the proposal contains numerous steps that are 
objective and do not involve the use of discretion or that limit or 
focus FINRA's discretion. FINRA notes that the annual calculation--the 
first and most significant step that identifies member firms that are 
subject to the proposed rule--does not involve the use of discretion. 
The annual calculation uses objective, transparent criteria to identify 
outlier firms with the most significant history of misconduct relative 
to their peers (based on a review of the criteria as if it existed 
today, the number of member firms would be between 45-80 firms). 
Following the annual calculation, the Department would conduct an 
evaluation to review whether it has information that a member firm's 
calculation included disclosure events or 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, whether the member has already 
addressed the concerns signaled by the disclosure events or conditions, 
or whether the member firm has altered its business operations such 
that the calculation no longer reflects the member firm's current risk 
profile. During the Consultation, the Department would evaluate whether 
the member firm has demonstrated that the calculation included 
disclosure events that should not have been included (because they are 
duplicative or not sales-practice related). When the Department 
considers whether a member firm should be subject to the maximum 
Restricted Deposit Requirement, it will evaluate whether the maximum 
amount would impose an undue financial hardship and whether a lesser 
amount, or conditions and restrictions, would satisfy the objectives of 
the rule and be consistent with the protection of investors and the 
public interest. The ability to request a Hearing Officer's review also 
would protect against overreaching.

[[Page 78560]]

    To ensure that the member firms identified as Restricted Firms are 
of the type motivating this proposal and incentivize Restricted Firms 
to reduce the risks posed to investors, however, the Department will 
need some degree of flexibility to identify, react and respond to 
different sources of risk. For this reason, the revised proposal 
retains the ability of the Department to make internal assessments 
during the evaluation and Consultation, including ones concerning the 
amount of the Restricted Deposit Requirement and the conditions and 
restrictions that may be imposed, to appropriately address the concerns 
indicated by the Preliminary Criteria for Identification.
    Nevertheless, FINRA agrees with commenters' request for additional 
clarity regarding the conditions and restrictions that could be imposed 
under the proposed rule.\94\ For this reason, the revised proposal 
provides a non-exhaustive list of conditions and restrictions that 
could be imposed on Restricted Firms. Moreover, the proposed rule's 
descriptions of the Department's tasks and discretion are broad enough 
to allow FINRA to provide further guidance as it gains experience 
implementing the rule. For example, FINRA could provide additional 
guidance if it learns of categories of disclosure events that could be 
described as not consistent with the purpose of the Preliminary 
Criteria for Identification or not reflective of a firm posing a high 
degree of risk. FINRA also could provide further guidance on the kinds 
of conditions and restrictions that might be warranted in different 
contexts.
---------------------------------------------------------------------------

    \94\ See, e.g., FSI, NASAA, PIRC.
---------------------------------------------------------------------------

4. Comments Concerning the Preliminary Criteria for Identification
    Numerous commenters suggested alternatives to several aspects of 
the Preliminary Criteria for Identification. Some suggested narrower 
criteria, including, for example, requests to: (1) Exclude criminal 
events in which the registered person pled nolo contendere; \95\ (2) 
exclude or narrow criteria based on final regulatory actions; \96\ (3) 
remove or narrow criteria based on pending events or unadjudicated 
events; \97\ (4) remove or modify the criteria based on terminations or 
internal reviews; \98\ (5) remove or substantially narrow the Expelled 
Firm Association Metric; \99\ (6) increase the $15,000 threshold for 
settlements \100\ and establish a minimum threshold for awards and 
judgments; \101\ (7) decrease the lookback period; \102\ (8) 
distinguish between events by recidivist and non-recidivist brokers; 
\103\ (9) exclude all matters that are not sales-practice or 
investment-related \104\ or that do not involve customer harm; \105\ 
(10) address or remove ``nuisance arbitrations . . . settled without 
admission of guilt'' and ``disclosure events . . . filed by a 
compensated non-attorney representative''; \106\ (11) narrow the term 
``Registered Persons In-Scope'' to exclude persons who were registered 
with a member firm for only one day and include only those who have 
been employed with a member firm for at least 180 days; \107\ (12) 
reconsider the inclusion in the criteria of settlements of arbitrations 
and regulatory actions,\108\ disclosure events against persons who were 
named due to their position within a chain of supervision,\109\ and 
``allegation-driven'' disclosures; \110\ and (13) account for 
widespread product or market collapse that could result in a high 
number of new disclosure events.\111\
---------------------------------------------------------------------------

    \95\ Westpark.
    \96\ Moss & Gilmore, Westpark.
    \97\ AdvisorLaw, Cambridge, Cetera, HLBS, Joseph Stone, Luxor, 
Moss & Gilmore, Westpark, Worden.
    \98\ Cambridge, Cetera, Westpark. Two of these commenters 
cautioned that including termination and internal review events 
could discourage firms from conducting internal reviews and filing 
appropriate termination disclosures on the Uniform Registration 
Forms, thereby reducing internal compliance procedures and 
potentially leading to underreporting of such events. Cetera, 
Westpark.
    \99\ Cambridge, Cetera, Joseph Stone, Luxor, Network 1, 
Sichenzia, Westpark.
    \100\ Cambridge, Joseph Stone, Luxor.
    \101\ Cambridge.
    \102\ Westpark.
    \103\ Sichenzia.
    \104\ Cambridge.
    \105\ Westpark.
    \106\ Luxor, Moss & Gilmore, Sichenzia.
    \107\ Westpark.
    \108\ HLBS, Moss & Gilmore, Westpark.
    \109\ Cambridge, Westpark.
    \110\ Worden.
    \111\ Cambridge.
---------------------------------------------------------------------------

    Some commenters suggested broader criteria, including requests to: 
(1) Lower the dollar threshold for settlements; \112\ (2) increase the 
lookback period; \113\ (3) include financial disclosures like 
judgments, liens, bankruptcies and compromises; \114\ (4) include non-
investment related civil matters that involve dishonesty, deceit, or 
reckless or intentional wrongdoing; \115\ (5) include internal reviews 
by other member firms; \116\ (6) include a category based on specific 
products sold by the member firm; \117\ and (7) include expunged 
Registered Person Adjudicated Events.\118\
---------------------------------------------------------------------------

    \112\ Better Markets.
    \113\ Better Markets.
    \114\ Massachusetts, NASAA.
    \115\ Massachusetts.
    \116\ Massachusetts.
    \117\ MIRC, PIABA.
    \118\ NASAA.
---------------------------------------------------------------------------

    Two commenters criticized or questioned how the metrics thresholds 
were based on firm size.\119\
---------------------------------------------------------------------------

    \119\ Rockfleet, Worden.
---------------------------------------------------------------------------

    In response to the comments about the proposed criteria's 
underlying categories and metrics, FINRA made two modifications to the 
proposal in Regulatory Notice 19-17. First, as explained above, the 
revised proposal uses a narrower definition of Registered Persons 
Associated with Previously Expelled Firms. Instead of an unlimited 
lookback over a registered person's entire career and no limitations 
based on the duration of the person's registration with the expelled 
firm as originally proposed in Regulatory Notice 19-17, the revised 
proposal would include only those registered persons who were 
registered with a previously expelled firm for at least one year and 
within the five years prior to the date the Preliminary Criteria for 
Identification are calculated. Persons' previous registrations with 
expelled firms (i.e., beyond the five-year lookback) would not be 
counted in this category or towards an employing member firm's Expelled 
Firm Association Metric. Moreover, FINRA believes using a five-year 
lookback would be consistent with the lookback periods for the other 
metrics.\120\
---------------------------------------------------------------------------

    \120\ FINRA analyzed whether the revised Expelled Firm 
Association Metric still preserves its usefulness, and FINRA 
determined that it does, as explained in the Economic Impact 
Assessment.
---------------------------------------------------------------------------

    Second, FINRA believes that the comments about the termination and 
internal review events demonstrated a need for clarification of the 
relevant metric. The revised proposal would make clear that termination 
and internal review disclosures concerning a person that a member firm 
terminated would not impact that member firm's own Registered Person 
Termination and Internal Review Metric; rather, those disclosures would 
only impact the metrics of member firms that subsequently register the 
terminated individual.
    Otherwise, FINRA has decided to retain the rest of the Preliminary 
Criteria for Identification as originally proposed in Regulatory Notice 
19-17. Many of the commenters' other proposed alternative definitions 
and criteria comments concern issues that FINRA already considered and 
addressed in the economic assessment in Regulatory Notice 19-17, and 
the comments have not persuaded FINRA that any changes would be more 
efficient or effective at addressing the potential for future

[[Page 78561]]

customer harm presented. As FINRA explained in Regulatory Notice 19-17, 
the primary benefit of the proposed rule change would be to reduce the 
risk and associated costs of possible future customer harm by member 
firms that meet the proposed criteria, by applying additional 
restrictions on firms identified as Restricted Firms and by the 
increased scrutiny that will likely result by these firms on their 
brokers. In developing this proposal, one of the guiding principles was 
to provide transparency regarding the proposal's application, so that 
firms could largely identify with available data the specific set of 
disclosure events that would count towards the proposed criteria and 
whether the firm had the potential to be designated as a Restricted 
Firm. This is why--unlike many of the alternatives suggested by 
commenters--FINRA's proposal is based on events disclosed on the 
Uniform Registration Forms, which are generally available to firms and 
FINRA.
    Several commenters expressed concern over how the Preliminary 
Criteria for Identification relies on data in the Uniform Registration 
Forms.\121\ Several commenters contended that there are underlying 
problems with the information disclosed through the Uniform 
Registration Forms, stemming primarily from the allegation-based 
disclosures that must be made and frivolous arbitrations.\122\ One 
commenter pointed to the number of expungements as evidence of the 
unreliability of the disclosure data.\123\ NASAA, PIABA, and some law 
school clinics raised a concern from a different perspective, writing 
that expungements are granted too frequently and will cause the annual 
calculation of the Preliminary Criteria for Identification to not 
identify all firms that pose the highest risks.\124\ Relatedly, several 
commenters suggested that the proposed Preliminary Criteria for 
Identification highlights problems with expungements, including that 
the proposal will incentivize even more expungement requests,\125\ that 
FINRA should simultaneously pursue meaningful expungement reform,\126\ 
or that FINRA should make it easier to expunge certain customer dispute 
information because Uniform Registration Form disclosures would now 
carry greater weight.\127\ Some commenters predicted that the proposal 
will create perverse incentives to avoid making required disclosures on 
the Uniform Registration Forms.\128\
---------------------------------------------------------------------------

    \121\ AdvisorLaw, Cambridge, Moss & Gilmore, Worden.
    \122\ AdvisorLaw, Cambridge, Moss & Gilmore, Worden.
    \123\ AdvisorLaw.
    \124\ MIRC, NASAA, PIABA, PIRC.
    \125\ MIRC, NASAA, PIABA, PIRC.
    \126\ NASAA, PIABA.
    \127\ Cambridge.
    \128\ Cetera, PIRC, St. John's SOL.
---------------------------------------------------------------------------

    FINRA believes, however, that the data reported on the Uniform 
Registration Forms is reliable enough on which to base proposed Rule 
4111. FINRA rules require firms and individuals to make accurate 
disclosures, and they could be subject to disciplinary action and 
possible disqualification if they fail to do so. Regulators are the 
source of disclosures on Form U6. FINRA's Department of Credentialing, 
Registration, Education and Disclosure conducts a public records review 
to verify the completeness and accuracy of criminal disclosure 
reporting. And although some commenters take issue with some of the 
specific events that must be disclosed on the Uniform Registration 
Forms, the SEC has taken the position that ``essentially all of the 
information that is reportable on the Form U4 is material.'' \129\
---------------------------------------------------------------------------

    \129\ Joseph S. Amundsen, Exchange Act Release No. 69406, 2013 
SEC LEXIS 1148, at *41 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C. 
Cir. 2014).
---------------------------------------------------------------------------

    FINRA recognizes that the number of expungement requests may 
increase as a result of this proposal. However, the existing regulatory 
framework and FINRA rules are designed to ensure that expungements are 
granted only after a neutral adjudicator (arbitrator or judge) 
concludes that expungement is appropriate. Furthermore, OCE has tested 
the proposed thresholds in several ways using the existing Central 
Registration Depository (``CRD'') data, including comparing the firms 
captured by the proposed thresholds to the firms that have recently 
been expelled, that have unpaid arbitration awards, that Department 
staff has identified as high risk for sales practice and fraud based on 
the Department's own risk-based analysis, and that subsequently had 
additional disclosures after identification. Moreover, FINRA is 
actively engaged in efforts to address concerns with the current system 
of arbitration-based expungement of customer allegations from brokers' 
records.\130\ FINRA's planned review of proposed Rule 4111 would 
necessarily account for any future amendments to the expungement 
process and any associated impact on the underlying data in CRD. 
Accordingly, FINRA does not believe that the proposal would directly 
result in inappropriate expungements being granted or appropriate 
expungements being not granted, or that it would undermine the quality 
of the underlying CRD information used for the proposed metrics.
---------------------------------------------------------------------------

    \130\ FINRA recently filed a proposed rule change that would 
amend the Codes of Arbitration Procedure for Customer and Industry 
Disputes (``Codes'') to modify the current process relating to 
requests to expunge customer dispute information. The proposed rule 
change would amend the Codes to: (1) Impose requirements on 
expungement requests filed either during an investment-related, 
customer-initiated arbitration or separate from a customer-initiated 
arbitration (``straight-in requests''); (2) establish a roster of 
arbitrators with enhanced training and experience from which a 
three-person panel would be randomly selected to decide straight-in 
requests; (3) establish procedural requirements for expungement 
hearings; and (4) codify and update the best practices of the Notice 
to Arbitrators and Parties on Expanded Expungement Guidance that 
arbitrators and parties must follow. See Securities Exchange Act 
Release No. 90000 (September 25, 2020), 85 FR 62142 (October 1, 
2020) (Notice of Filing of File No. SR-FINRA-2020-030); Notice to 
Arbitrators and Parties on Expanded Expungement Guidance, available 
at https://www.finra.org/arbitration-andmediation/notice-arbitrators-and-parties-expanded-expungement-guidance). In addition, 
FINRA recently amended the Codes to apply minimum fees to requests 
to expunge customer dispute information. See Securities Exchange Act 
Release No. 88945 (May 26, 2020), 85 FR 33212 (June 1, 2020) (Order 
Approving Filing of File No. SR-FINRA-2020-005); Regulatory Notice 
20-25 (July 2020).
---------------------------------------------------------------------------

5. Annual Calculation of the Preliminary Criteria for Identification
    Massachusetts contends that calculations of the Preliminary 
Criteria for Identification should occur more than annually. FINRA 
appreciates this suggestion, but believes that it should gain 
experience with an annual requirement before considering whether to 
conduct more frequent reviews.
    SIFMA requested that the proposal provide more transparency around 
the variables for the annual calculation of the Preliminary Criteria 
for Identification, so that firms can have the same ability as FINRA to 
calculate whether they meet the thresholds. For example, SIFMA 
explained that firms will need specific information about the 
Evaluation Date to make the calculations on their own.
    FINRA agrees that additional clarity should be provided regarding 
the timing of the calculation. Proposed Rule 4111 is intended to be 
transparent enough so that member firms can understand whether they are 
at risk of being subject to additional obligations, and member firms 
will need to know the exact Evaluation Date to do their own 
calculations. FINRA would announce in a Regulatory Notice the first 
Evaluation Date no less than 120 days before the first Evaluation Date. 
FINRA also would announce that subsequent Evaluation

[[Page 78562]]

Dates would be on the same month and day each year, except when that 
date falls on a Saturday, Sunday, or federal holiday, in which case the 
Evaluation Date would be on the next business day.
    Some commenters requested that FINRA provide member firms with 
assistance in determining if they meet the Preliminary Criteria for 
Identification. For example, CAI requested clarification on whether 
FINRA would provide advance notice to firms that meet or come close to 
meeting the Preliminary Criteria for Identification. Cambridge wrote 
that FINRA should notify firms in advance that they meet the criteria 
and publish a list of expelled firms. SIFMA requested that FINRA 
provide an electronic worksheet, available year round.
    FINRA does not currently plan to provide member firms with advance 
notice about whether they would meet, or are close to meeting, the 
Preliminary Criteria for Identification, because the calculation under 
the proposal would occur annually, not on a rolling basis, and 
calculating the events included in the Preliminary Criteria for 
Identification based on an earlier date may lead to different results. 
Moreover, the proposed rule is designed to be transparent enough to 
allow member firms to perform their own calculations. FINRA agrees, 
however, that additional guidance and resources could facilitate member 
firms' independent calculations, and FINRA will explore ways to provide 
helpful resources. For example, this could include mapping the 
Disclosure Event and Expelled Firm Association Categories to the 
relevant disclosure questions on the Uniform Registration Forms. It 
also could include making available, year round, a worksheet that 
member firms could populate with the number of Registered Persons In-
Scope, the number of disclosure events in each category, and the number 
of Registered Persons Associated with Previously Expelled Firms to 
generate information about whether the member firm meets or is close to 
meeting the Preliminary Criteria for Identification.\131\ FINRA also 
would consider making available to member firms a list of expelled 
firms, if that information is burdensome for member firms to obtain on 
their own.
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    \131\ Such a year-round worksheet could be a tool for member 
firms to monitor their status in relation to the Preliminary 
Criteria for Identification, but not a determinate one. Whether a 
member firm will meet the criteria could only be definitively 
established on the annual Evaluation Date.
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6. One-Time Staffing Reduction
    Several comments addressed the proposal's one-time staffing 
reduction opportunity. PIRC expressed support for the one-time staffing 
reduction opportunity, commenting that it will have the benefit of 
lowering the number of representatives who have repeatedly harmed 
investors. Joseph Stone commented that member firms should have several 
opportunities to reduce staff, not just one. Westpark stated that the 
one-time opportunity should renew after three years. HLBS called the 
staffing reduction opportunity the proposal's ``most alarming and 
punitive measure,'' because member firms would ``conduct a mass 
termination not because of an independent business decision but because 
. . . failing to do so . . . would essentially result in financial 
ruin.''
    FINRA has retained the one-time staffing reduction opportunity as 
originally proposed. The one-time staffing reduction opportunity is 
intended to provide another procedural protection for member firms, 
because it would give a firm that meets the Preliminary Criteria for 
Identification one opportunity to reduce staff so as to fall below the 
criteria's thresholds. It has been designed as only a single 
opportunity to deter member firms from resurrecting a high-risk 
business model after a staff reduction. Moreover, FINRA does not agree 
with HLBS's assertion that the proposed staffing reduction opportunity 
removes member firms' independence to make business decisions. FINRA 
believes that a member firm that meets the Preliminary Criteria for 
Identification, possibly inadvertently, in one year should have the 
choice of whether to exercise the staffing reduction option. 
Furthermore, a firm that chooses to exercise the staffing reduction 
option would have the independence to decide how to proceed going 
forward, with the knowledge that it has once met the Preliminary 
Criteria for Identification, that the preliminary criteria are fully 
transparent, and that it would not have another opportunity to reduce 
staff to avoid a review under Rule 4111.
    Better Markets stated that the staffing reduction opportunity needs 
to better protect investors, by prohibiting other high-risk firms from 
hiring terminated persons, prohibiting any firms from hiring the 
terminated persons for one year, or requiring that staff reductions 
commence with brokers with the highest number of disclosure events or 
with frequent and severe violations. FINRA is already pursuing, 
however, a separate proposal that would require a member firm to 
request a materiality consultation with FINRA staff when a person who 
has one final criminal matter or two ``specified risk events'' seeks to 
become an owner, control person, principal or registered person of the 
member.\132\ That related proposal would potentially impact persons 
terminated pursuant to the staffing reduction opportunity.
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    \132\ See Securities Exchange Act Release No. 88600 (April 8, 
2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No. 
SR-FINRA-2020-011).
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7. Consultation
    Westpark commented that proposed Rule 4111 does not give firms 
enough time to prepare for the Consultation. Because the proposed rule 
sets tight deadlines for the Department's decision, FINRA agrees that 
the proposed deadlines for the Consultation would also be tight. For 
this reason, FINRA has revised proposed Rule 4111(d)(2) to require that 
the letter scheduling the Consultation provide at least seven days' 
notice of the Consultation date, and also give the member firm the 
opportunity to request a postponement of the Consultation for good 
cause shown. Postponements would not exceed 30 days unless the member 
firm establishes the reasons a longer postponement is necessary.
    Other comments about the Consultation did not prompt FINRA to make 
revisions. For example, FSI commented that the Consultation should be 
an opportunity for FINRA to work collaboratively with the identified 
firm. FINRA believes the Consultation is already intended to give 
member firms an opportunity to meet with FINRA and demonstrate why the 
calculation of the Preliminary Criteria for Identification should not 
include certain events or provide a rationale as to why the firm should 
not be required to maintain the maximum Restricted Deposit Requirement. 
As such, FINRA does not believe further revisions are necessary.
    Chiu and Luxor wrote that although proposed Rule 4111 would allow 
members during the Consultation to request a waiver of the maximum 
Restricted Deposit Requirement for financial hardship reasons, member 
firms will not do so because it would deter recruitment and cause 
brokers to leave. Allowing member firms to demonstrate undue financial 
hardship, however, is consistent with the intent of the Restricted 
Deposit Requirement that it not significantly undermine the member 
firm's continued financial stability and operational capability as an 
ongoing enterprise over the next 12 months. Moreover, FINRA anticipates

[[Page 78563]]

that member firms subject to the requirement will not be deterred from 
asserting that a Restricted Deposit Requirement would cause an undue 
financial hardship, given that such arguments could lead to a reduced 
Restricted Deposit Requirement or no deposit requirement at all. 
Moreover, the proposal would not make public any such assertions by a 
member firm.
    In a comment related to the Consultation, FSI commented that firms 
should not shoulder the risk of misidentification, and that FINRA 
should have to demonstrate its reasons for continuing the review 
process for firms preliminarily identified as high risk. Proposed Rule 
4111 only places burdens of proof on the small number of firms that 
meet the Preliminary Criteria for Identification and that the 
Department determines, after conducting its initial evaluation, 
warrants further review. Each of these firms would have the opportunity 
to overcome the presumption that it should be designated as a 
Restricted Firm and subject to the maximum Restricted Deposit 
Requirement. Under the proposed rule, the affected firms would initiate 
this process because they would be in the best position to provide the 
relevant information. For example, proposed Rule 4111(d)(1)(A) would 
provide that a member firm may overcome the presumption that it should 
be designated as a Restricted Firm by clearly demonstrating that the 
Department's calculation included events 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 
member firm, not Department staff, is in the best position to provide 
that kind of information about the disclosure data. Likewise, the 
member firm would be in the best position to demonstrate, pursuant to 
proposed Rule 4111(d)(1)(B), that it would face undue financial 
hardship if it were required to maintain the maximum Restricted Deposit 
Requirement.
8. Restricted Deposit Requirement
    FINRA also received general comments concerning the proposed 
Restricted Deposit Requirement concept. Some commenters were generally 
opposed to the proposed requirement. Their reasons include: (1) A 
deposit requirement may trigger unintended consequences which result in 
harm to the investing public; \133\ (2) a deposit requirement may lead 
to competitive disadvantages, because members without significant 
retained earnings may receive exceptions, while members with greater 
working capital would not; \134\ (3) the only members likely to be able 
to satisfy a deposit requirement would be ones that do not anticipate 
being subject to the rule; \135\ (4) a deposit requirement would 
``result[ ] in cash flow problems, increased borrowing, and layoffs'' 
\136\ and a ``devastating economic impact'' on the broker-dealer and 
its employees, customers, vendors, and counterparties; \137\ (5) 
restricted funds could be better used for other purposes; \138\ (6) 
there is little evidence why restricted deposits are necessary; \139\ 
(7) requiring ``up front financing of uninsured claims, many of which 
are specious, would have negative net capital implications''; \140\ (8) 
any assertion that unpaid arbitration awards is rampant and justifies 
the deposit requirement is false; \141\ (9) a deposit requirement would 
put small firms out of business and result in less choice for 
investors; \142\ and (10) many members do not have sufficient cash to 
hold as restricted deposits.\143\
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    \133\ Cambridge.
    \134\ Cambridge.
    \135\ Cambridge.
    \136\ Westpark.
    \137\ Rockfleet.
    \138\ Chiu.
    \139\ Brooklight.
    \140\ Moss & Gilmore.
    \141\ Moss & Gilmore.
    \142\ Chiu, IBN, Whitehall. Whitehall also wrote that the 
proposal entails ``FINRA . . . demanding funds for itself'' and 
``using [members] as bank accounts to expand'' FINRA's activities. 
Nothing in the proposal, however, results in FINRA receiving any 
assets from firms. At all times, a Restricted Firm would continue to 
own the assets that it maintains in a Restricted Deposit Account.
    \143\ Whitehall.
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    Other commenters were generally supportive of the Restricted 
Deposit Requirement concept. PIRC said that Restricted Deposit 
Requirements should help deter misconduct and also help FINRA ``rein in 
Restricted Firms that shut down and reconstitute themselves in an 
attempt to avoid paying settlements and awards.'' SIFMA opined that the 
proposal ``appropriately embraces the `front-end' approach'' to 
addressing unpaid awards by ``seeking to identify those small number of 
firms with an extensive history of misconduct and/or relevant 
disclosure events, and as appropriate, requiring [them] to set aside 
cash deposits or qualified securities that could be applied to . . . 
unpaid awards.''
    FINRA's proposal continues to provide that the Department could 
impose a Restricted Deposit Requirement on Restricted Firms. FINRA 
believes that a financial requirement is the measure most likely to 
motivate Restricted Firms to change behavior. As such, the Restricted 
Deposit Requirement is an essential feature of the proposal to protect 
investors, with the possible secondary benefit of helping to address 
the issue of unpaid arbitration awards. Moreover, the proposal attempts 
to counteract firms' preemptively withdrawing capital by instructing 
the Department to consider several financial factors--not just net 
capital--when determining a Restricted Deposit Requirement. In 
addition, FINRA believes the implications of a Restricted Deposit 
Requirement on a member firm's net capital levels--that a member firm 
would have to deduct deposits in Restricted Deposit Accounts in 
determining the firm's net capital \144\--is one reason why the 
proposal would incentivize member firms to avoid becoming Restricted 
Firms, not a reason to abandon the Restricted Deposit Requirement 
concept. Finally, the proposal contemplates that the Restricted Deposit 
Requirement should correlate to the financial realities at the member 
firm, and allows the firm to attempt to demonstrate that it would 
impose undue financial burdens.\145\
---------------------------------------------------------------------------

    \144\ See proposed Rule 4111.01.
    \145\ Westpark commented that proposed Rule 4111 is inconsistent 
with Section 15A(b)(5) of the Exchange Act, which requires that 
FINRA's rules ``provide for the equitable allocation of reasonable 
dues, fees, and other charges among members.'' The proposed 
Restricted Deposit Requirement, however, is not a due, fee or 
charge. Assets that a member maintains in a Restricted Deposit 
Account would remain the member's assets; they would not be provided 
to, used by, or owned by FINRA.
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9. Calculating a Restricted Deposit Requirement
    FINRA received several comments about the Department's 
determination of a Restricted Deposit Requirement. CAI expressed 
support for some of the proposed factors that the Department would 
consider when calculating the Restricted Deposit Requirement. In 
addition, CAI endorsed the proposed limitation in proposed Rule 
4111(i)(15) that the maximum Restricted Deposit Requirement be an 
amount that would not significantly undermine the continued financial 
stability and operational capability of the firm as an ongoing 
enterprise over the next 12 months.
    Several commenters expressed concerns about the proposed factors 
that the Department would consider when calculating the Restricted 
Deposit Requirement. For example, Sichenzia called the factors 
``arbitrary''; some commenters opposed the inclusion of, or requested 
modifications to, the

[[Page 78564]]

``Covered Pending Arbitration Claims'' factor; \146\ Network 1 
commented that the Restricted Deposit Requirement should not consider 
``bona fide nuisance claims brought in arbitration''; Cambridge 
objected to the ``gross revenues'' factor, on the grounds that that 
factor would not contemplate the firm's contractual obligations for 
which the revenues have already been allocated; and Moss & Gilmore 
objected to considering ``concerns raised during FINRA exams'' on the 
grounds that ``novice examiners . . . [often] conduct the front-line 
examinations.'' \147\
---------------------------------------------------------------------------

    \146\ Moss & Gilmore, Network 1, Sichenzia, Westpark.
    \147\ Moss & Gilmore.
---------------------------------------------------------------------------

    Some commenters believed that the list of factors should be 
expanded. For example, two commenters requested that FINRA account for 
instances in which the firm has insurance coverage for arbitration 
claims.\148\ MIRC commented that the Covered Pending Arbitration Claims 
factor should be expanded to include other kinds of pending claims that 
could lead to unpaid awards, not just ones limited to the arbitration 
setting. PIABA requested that the Restricted Deposit Requirement 
calculation also take into account the nature and extent of harm that 
the Restricted Firm has done in the past.
---------------------------------------------------------------------------

    \148\ Network 1, Sichenzia.
---------------------------------------------------------------------------

    As explained above, FINRA has made several revisions to the factors 
that the Department would consider when determining a maximum 
Restricted Deposit Requirement. The ``annual revenues'' and ``net 
capital requirements'' factors proposed in Regulatory Notice 19-17 have 
been modified to ``revenues'' and ``net capital,'' and ``assets,'' 
``expenses,'' and ``liabilities'' have been added as factors. In 
addition, FINRA has clarified that unpaid arbitration awards against a 
member firm's Associated Persons is one relevant factor. FINRA believes 
this modified and expanded list of factors would lead to a more 
complete consideration of the firm's financial situation.
    FINRA has retained the other proposed factors, however, because 
they appropriately and accurately describe the factors, financial and 
otherwise, that would be most relevant to the Department when 
calculating a Restricted Deposit Requirement. This includes the Covered 
Pending Arbitration Claims factor. Because one purpose of the 
Restricted Deposit Requirement is to preserve some of a Restricted 
Firm's assets for potential payment of arbitration awards, FINRA 
believes that purpose is served by allowing the Department to consider 
Covered Pending Arbitration Claims when determining a Restricted 
Deposit Requirement. At the same time, the revised proposed rule also 
adds as a factor the member's ``insurance coverage for customer 
arbitration awards or settlements.'' FINRA believes that if Restricted 
Firms were able to procure errors and omissions insurance policies or 
other kinds of insurance coverage for some or all of the kinds of 
claims that customers typically bring in arbitrations, at meaningful 
coverage amounts, that could warrant a reduced Restricted Deposit 
Requirement and would be behavior to encourage.
    Two commenters contended that because potential liabilities 
relating to pending arbitrations must be accrued on financial 
statements, a Restricted Deposit Requirement that is based in part on 
Covered Pending Arbitration Claims (which would be a non-allowable 
asset) would ``double[ ] the net capital impact.'' \149\ While there 
would not usually be a double impact--accruals of contingent 
liabilities based on pending arbitrations usually reflect only a small 
percentage of the potential liability--a member firm's net capital 
level could be impacted by a Restricted Deposit Requirement based in 
part on Covered Pending Arbitration Claims and a member firm's accruals 
of potential liabilities stemming from the same pending arbitration 
claims. For this reason, the Department's consideration of Covered 
Pending Arbitration Claims could take into account whether any 
liability accruals for those same claims warrant a reduction in the 
Restricted Deposit Requirement. It should be noted, however, that the 
purposes of accruing a liability on a financial statement are different 
from the purposes of the proposed Rule 4111 requirement to deposit 
money in a Restricted Firm's segregated, restricted account.
---------------------------------------------------------------------------

    \149\ Network 1, Rockfleet.
---------------------------------------------------------------------------

    In addition to comments about the specific factors that the 
Department would consider, some commenters requested that the proposal 
describe with more specificity how the Restricted Deposit Requirement 
would be calculated or establish caps. CAI, for example, requested that 
FINRA develop specific limitations such as caps and a formula that 
focuses on the correlation between revenues that may give rise to 
unpaid arbitration awards (e.g., penny stock sales) and unpaid 
arbitration award amounts. FSI suggested that FINRA use published 
guidelines to provide transparency. Westpark suggested that the 
proposal should cap the Restricted Deposit Requirement at a specified 
percentage of required net capital amounts or a percentage of average 
net income over a three-year lookback period. Whitehall asked whether 
FINRA would have a formula for calculating the Restricted Deposit 
Requirement. MIRC suggested that FINRA should impose Restricted Deposit 
Requirements that are sufficient to meet all unpaid awards and pending 
claims related to products and product types.
    FINRA has not proposed a uniform formulaic approach for calculating 
the Restricted Deposit Requirement because of the range of relevant 
factors and differences in member firms' business models, operations, 
and financial conditions. In addition, although formulas do provide 
objective, transparent methodologies, here they would allow member 
firms the opportunity to manipulate their revenue numbers during the 
calculation periods. For these reasons, FINRA has retained the factor-
based, principles-based approach to determining a Restricted Deposit 
Amount.
10. Impact on Unpaid Arbitration Awards
    PIABA contended that the proposal will not solve the issue of 
unpaid arbitration awards, because there is no indication that the 
Restricted Deposit Requirements will be sufficient to cover anticipated 
arbitration awards. Relatedly, several commenters requested that the 
proposal also provide more clarity on how the Restricted Deposit 
Requirement could be used to pay investor claims.\150\
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    \150\ MIRC, PIABA, PIRC.

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[[Page 78565]]

    With respect to the relationship between proposed Rule 4111 and 
unpaid arbitration awards, FINRA notes that FINRA rules currently 
prohibit member firms or registered representatives who do not pay 
arbitration awards in a timely manner from continuing to engage in the 
securities business under FINRA's jurisdiction.\151\ As to proposed 
Rule 4111, it was designed to address a broader range of investor 
protection concerns posed by firms and individuals with a significant 
history of misconduct, including but not limited to unpaid arbitration 
awards. The Rule would apply to firms who, based on statistical 
analysis of their prior disclosure events, are substantially more 
likely than their peers to subsequently have a range of additional 
events indicating various types of harm or potential harm to investors.
---------------------------------------------------------------------------

    \151\ See FINRA Rule 9554. Under FINRA rules, unless a 
respondent has specified defenses to non-payment, the respondent 
must pay a monetary award within 30 days of receipt. See FINRA Rule 
12904(j). In addition, firms with unpaid awards cannot re-register 
with FINRA and individuals cannot register as representatives of any 
member firm, without paying or discharging the outstanding award.
---------------------------------------------------------------------------

    Nevertheless, FINRA believes proposed Rule 4111 may have important 
ancillary effects in addressing unpaid customer arbitration awards. In 
particular, the Rule may deter behavior that could otherwise result in 
unpaid arbitration awards, by incentivizing firms to reduce their risk 
profile and violative conduct in order to avoid being deemed a 
Restricted Firm and becoming subject to the Restricted Deposit 
Requirement (or other conditions or restrictions). In addition, firms 
may be incentivized to obtain insurance coverage for potential 
arbitration awards, because such coverage would be taken into account 
in determining any Restricted Deposit Requirement. Moreover, and as 
explained above, the proposed rule includes several presumptions, 
applicable to the Department's assessment of an application by a firm 
previously designated as a Restricted Firm for a withdrawal from a 
Restricted Deposit, that would further incentivize the payment of 
arbitration awards.
    FINRA has made several revisions to proposed Rule 4111(f) to make 
more clear the process that would guide the Department's evaluation of 
a request for a withdrawal from a Restricted Deposit Account. As 
explained above, these include several presumptions of approval or 
denial that set forth how Covered Pending Arbitration Claims or unpaid 
arbitration awards would impact the Department's evaluation. The 
presumptions of denial that would apply when a Restricted Firm or 
previously designated Restricted Firm applies for a withdrawal from a 
Restricted Deposit would still apply when the firm seeks to use the 
funds to satisfy unpaid arbitration awards; unless the presumption of 
denial can be overcome, those firms would generally need to satisfy 
unpaid arbitration awards using funds other than those in a Restricted 
Deposit Account.\152\ There would be a separate presumption that a 
request by a former member firm previously designated as a Restricted 
Firm to access its Restricted Deposit would be approved when it commits 
in the manner specified by the Department to use the amount it seeks to 
withdraw from its Restricted Deposit to pay the former member's 
specified unpaid arbitration awards.
---------------------------------------------------------------------------

    \152\ See proposed Rule 4111(f)(1) and (f)(3)(B)(ii)(a).
---------------------------------------------------------------------------

    PIABA also raised the concern that thinly capitalized firms would 
have smaller Restricted Deposit Requirements. A member's thin 
capitalization at the time of the Consultation, however, would be only 
one factor of many that the Department would consider when determining 
a Restricted Deposit Requirement, and would not necessarily result in a 
lower requirement.
11. Custodians of the Restricted Deposit Account
    Some commenters expressed concern about how proposed Rule 4111 
would require the Restricted Deposit Account to be maintained with a 
bank or clearing firm. Rockfleet predicted that it will be unlikely 
that banks or clearing firms will create new policies and procedures 
for the small amount of Restricted Deposit Accounts that would result 
from the proposal. SIFMA commented that a number of clearing firms 
believe it would be problematic to custody a Restricted Deposit Account 
``given the clearing firm's unique role in the relationship between an 
introducing broker and its clients,'' and how the proposed rule would 
impose additional duties and responsibilities that are not now part of 
clearing firms' systems and procedures. SIFMA also stated that custody 
by a clearing firm of the Restricted Deposit Requirement likely would 
not provide FINRA with the level of transparency that FINRA would want.
    The revised proposal retains the option for Restricted Firms to 
establish Restricted Deposit Accounts with clearing firms. FINRA 
believes that member firms have an existing relationship with their 
clearing firms and should be permitted to establish the Restricted 
Deposit Account with them if the parties choose. Nothing in the 
proposal requires clearing firms to establish Restricted Deposit 
Accounts. Where a clearing firm is unwilling or unable to establish 
these accounts, the proposal would permit Restricted Firms to establish 
such accounts at banks.
    SIFMA also commented that the proposal should be revised to 
expressly allow trust companies to maintain the accounts. FINRA 
believes that the original proposal includes many trust companies and 
so gives members sufficient options and flexibility.
12. Comments Concerning Proposed Expedited Proceedings
    As originally proposed in Regulatory Notice 19-17, proposed Rule 
9561(a) would have provided that any of the Rule 4111 Requirements 
imposed in a notice issued under proposed Rule 9561(a) would be 
immediately effective; that, in general, a request for a hearing would 
not stay those requirements; and that, if a member firm requests a 
hearing of a Department determination that imposes a Restricted Deposit 
Requirement for the first time, the member firm would be required to 
deposit, while the expedited proceeding was pending, the lesser of 
either 50% of its Restricted Deposit Requirement or 25% of its average 
excess net capital during the prior calendar year. Westpark commented 
that the expedited proceedings would not be meaningful because 
obligations would not be stayed. Luxor commented that the requirement 
to deposit a percentage of the Restricted Deposit Requirement would be 
``devastating.''

[[Page 78566]]

    In general, FINRA has retained the no-stay provisions as originally 
proposed. FINRA believes that the proposed no-stay provisions are a 
fundamental part of how the proposed rules would protect investors. 
Requiring Restricted Firms to comply with obligations imposed during 
the short pendency of an expedited proceeding would afford more 
immediate protections to investors from firms that pose outlier-level 
risks. Moreover, requiring immediate compliance with the Department's 
decision would be similar to other situations in which firms and 
individuals posing substantial risks must abide by FINRA decisions 
before underlying proceedings are resolved, such as when disciplinary 
respondents must abide by temporary cease and desist orders before an 
underlying disciplinary proceeding is complete or comply with FINRA-
imposed bars while an SEC appeal is pending. Nonetheless, FINRA 
believes that one aspect of the proposed no-stay provisions could be 
less burdensome without compromising its intended purpose. Accordingly, 
FINRA has revised the proposed rules to lower the proposed partial-
deposit requirement to the lesser of 25% of the Restricted Deposit 
Requirement or 25% of the firm's average excess net capital during the 
prior calendar year.
    Cetera commented that the hearings should be conducted by a Hearing 
Panel that includes two industry members and one Hearing Officer, 
because Hearing Officers are viewed as ``not as objective.'' FINRA has 
retained, however, the proposal to have Hearing Officers preside over 
the new expedited proceedings. Hearing Officers preside over several 
kinds of proceedings.\153\ And here, FINRA believes the need for swift 
proceedings as a result of the proposed no-stay provisions and to 
protect investors works in favor of the efficiency of Hearing Officer-
only proceedings. Moreover, FINRA believes there are additional 
protections for the firms in the proposal, given that the Hearing 
Officer's authority will be circumscribed and that the NAC's Review 
Subcommittee will have the right to call the proceeding for review.
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    \153\ See FINRA Rule 9559(d) (providing that Hearing Officers 
preside over, and act as the sole adjudicator for, proceedings 
initiated under Rules 9553 (failures to pay FINRA dues, fees and 
other charges), 9554 (failures to comply with arbitration awards or 
related settlements or orders of restitution or settlements 
providing for restitution), and 9556(h) (subsequent proceedings for 
failures to comply with temporary or permanent cease and desist 
orders)).
---------------------------------------------------------------------------

    Cetera commented that the proposed rule would require hearings to 
be held in expedited proceedings in an unreasonably short time after 
the firm receives notice of its Restricted Firm status. FINRA believes, 
however, that the proposed rule offers reasonable time limits and an 
opportunity to seek extensions. Under proposed Rules 9561(a)(5) and 
9559(f)(5), a member would be required to request a hearing within 
seven days after service of a notice of a determination that a firm is 
a Restricted Firm, and a hearing would be required to be held within 30 
days after the member files that hearing request. In addition, under an 
existing provision in Rule 9559, the Hearing Officer could extend the 
time limits for holding the hearing for good cause shown or with the 
consent of all the parties.
    PIABA commented that under proposed Rule 9561(b), which would 
establish an expedited proceeding to address a member firm's failure to 
comply with any requirements imposed pursuant to proposed Rule 4111, 
FINRA should be required to immediately suspend a non-compliant firm 
and should not have the discretion not to act. Although FINRA expects 
that non-compliant Restricted Firms would be a high priority for the 
Department of Enforcement, the revised proposal retains FINRA's 
prosecutorial discretion to ensure that FINRA can use its best 
judgments about how to deploy its limited resources.
    Rockfleet commented that the proposed Rule 9561(b) expedited 
proceeding is counterintuitive, because canceling a Restricted Firm's 
membership would result in FINRA losing any control over the firm. 
FINRA respectfully disagrees and believes that proposed Rule 4111 must 
provide a tool for FINRA to compel the immediate compliance with 
obligations that have been imposed pursuant to the rule.
12. Procedural Protections
    Several commenters contended that the proposal is an attempt to 
impose the equivalent of sanctions while avoiding the fair-process 
requirements that would be present in a disciplinary proceeding, and to 
ban persons who are not statutorily disqualified.\154\ The proposed 
Rule 4111 process, however, is neither a disciplinary nor an 
eligibility proceeding, and the obligations that could be imposed 
pursuant to proposed Rule 4111 would not be sanctions imposed for 
violations. Furthermore, FINRA believes the proposal gives affected 
member firms substantial procedural protections. These include 
providing notice that a member has met the Preliminary Criteria for 
Identification and of the maximum Restricted Deposit Requirement; a 
one-time staffing reduction opportunity for firms that meet the 
Preliminary Criteria for Identification for the first time; a 
Consultation, which will allow affected firms to attempt to show why 
they should not be deemed Restricted Firms or be subject to the maximum 
Restricted Deposit Requirement; and the right to seek an expedited 
hearing before a Hearing Officer.\155\ These procedural protections are 
in addition to the Preliminary Criteria for Identification, which would 
be fully transparent and enable firms to monitor whether they are at 
risk of meeting the threshold criteria.
---------------------------------------------------------------------------

    \154\ Brooklight, Luxor, Network 1, Rockfleet, Westpark.
    \155\ The right to have a Hearing Officer's decision reviewed by 
the SEC would be governed by Section 19 of the Exchange Act.
---------------------------------------------------------------------------

    Moreover, the proposal is neither intended nor designed to expel 
member firms and persons that are not statutorily disqualified. In this 
regard, FINRA notes that the rule text contains express language that 
the Department determine a maximum Restricted Deposit Requirement that 
``would not significantly undermine the continued financial stability 
and operational capability of the firm as an ongoing enterprise over 
the next 12 months,'' and also contemplates situations in which 
Restricted Firms remain member firms for years. Furthermore, persons 
terminated pursuant to the Rule 4111 staffing reduction opportunity 
would be permitted to seek employment with any other member firm and 
allowed to apply to re-associate with the Restricted Firm after one 
year.\156\
---------------------------------------------------------------------------

    \156\ Some commenters (Network 1, Westpark) asserted that the 
proposed rule change would be unconstitutional, for a variety of 
reasons. FINRA, however, is not a state actor.
---------------------------------------------------------------------------

13. Unintended Consequences
    Rockfleet expressed concern that clearing firms will terminate 
clearing agreements for firms deemed to be Restricted Firms, and that 
firms using tri-party clearing agreements could be impacted through no 
fault of their own. CAI raised a concern that being deemed as a 
Restricted Firm could have ramifications for firms that are parties to 
selling agreements. FINRA appreciates that proposed Rule 4111 may have 
potential unintended consequences, and plans to examine issues like 
those when FINRA reviews proposed Rule 4111 after gaining sufficient 
experience under the rule.
14. Public Disclosure Issues
    Several commenters addressed whether there should be public 
disclosure of a firm's status as a

[[Page 78567]]

Restricted Firm. Some opposed any disclosure at all, warning that 
disclosure could adversely impact the affected firms, and would make it 
more likely the firm would fail.\157\ Several commenters, particularly 
regulators and public advocacy groups, argue that FINRA should disclose 
the names of Restricted Firms to the public or, at least, to other 
regulators or clearing firms.\158\
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    \157\ Cetera, FSI.
    \158\ Better Markets, Massachusetts, NASAA, SIFMA, St. John's 
SOL.
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    FINRA believes the aim of the proposal is to address the risks 
posed by Restricted Firms by imposing appropriate restrictions on them 
and, at the same time, providing them with opportunities and incentives 
to remedy the underlying concerns (e.g., the one-time staff reduction, 
the opportunity to roll off the Restricted Firms list). Because 
requiring FINRA to publicly disclose a firm's Restricted Firm status 
may potentially interfere with those purposes, FINRA is not proposing 
to require the public disclosure of a firm's status as a Restricted 
Firm at this time. FINRA believes that it is necessary to gain 
meaningful experience with the proposed rule to evaluate the impact of 
creating an affirmative disclosure program.\159\
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    \159\ It should be noted that information about a firm's status 
as a Restricted Firm, and any restricted deposit it must maintain, 
could become publicly available through existing sources or 
processes. Such disclosures could occur, for example, through Form 
BD, Form CRS, or financial statements, or when a Hearing Officer's 
decision in an expedited proceeding is published pursuant to FINRA's 
publicity rule.
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15. Economic Impact Assessment
    Rockfleet commented that the proposal appears to be reverse 
engineered to target firms that FINRA has already chosen. As discussed 
above, the proposed Preliminary Criteria for Identification are based 
on metrics that are replicable and transparent to FINRA and the 
affected member firms, and are intended to identify firms that pose far 
greater risks to their customers than other firms. One identifier of 
these types of firms is that they and their brokers generally have 
substantially more Registered Person and Member Firm Events compared to 
their peers. This is consistent with a growing academic literature that 
provides evidence on past disciplinary and other regulatory events 
associated with a firm or individual being predictive of similar future 
events.\160\ These patterns indicate a persistent, albeit limited, 
population of firms with a history of misconduct that may not be acting 
appropriately as a first line of defense to prevent customer harm by 
their brokers. Accordingly, the proposed rule is intended to strengthen 
FINRA's toolkit to respond to these firms and brokers with a 
significant history of misconduct based on a proposed criteria that 
relies on regulatory and other disclosure events, similar to those used 
in the literature.
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    \160\ See supra note 5.
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    FINRA also conducted several validations on the firms meeting the 
criteria, by reviewing the extent to which firms identified were 
subsequently expelled, associated with unpaid awards, or were 
associated with ``new'' Registered Person and Member Firm Events. For 
example, these validations showed that the identified firms had on 
average approximately 6.1-19.9 times more new disclosure events after 
their identification than other firms in the industry during the same 
period that would not have met the Preliminary Criteria for 
Identification. This suggests that the proposed criteria is effective 
in identifying firms that may be associated with additional events 
after identification, which is consistent with the literature's finding 
on regulatory events being predictive of similar future events.
    Better Markets commented that the Economic Impact Assessment did 
not quantify the harm to investors when firms with a significant 
history of misconduct are permitted to continue engaging with 
investors. The proposed rule is intended to place additional 
restrictions on identified firms and increase scrutiny by these firms 
on their brokers. As a result, FINRA anticipates that the proposed rule 
will reduce the risk and associated costs of possible future customer 
harm and lead to improvements in the compliance culture, relative to 
the economic baseline of the current regulatory framework. The proposed 
rule is intended to create incentives for firms and brokers to limit or 
end practices that result in customer harm and provide increasing 
restrictions on those that choose not to alter their activities. 
Nonetheless, it is difficult to predict or quantify, before the 
proposed rule is implemented, the extent to which firms may continue to 
engage in harmful activities despite any additional restrictions 
imposed. However, FINRA plans to review the proposed rule after gaining 
sufficient experience with it, at which time FINRA will assess the 
rule's ongoing effectiveness and efficiency.
    Westpark wrote that FINRA should analyze how many brokers who are 
currently licensed and in good standing would become ``unemployable'' 
if the proposed rule were approved. FINRA's Economic Impact Assessment 
of the proposed rule includes the economic impacts on firms hiring and 
registered persons seeking employment. For example, as discussed above, 
FINRA estimates that during the 2013-2019 review period only one to two 
percent of the registered persons had any qualifying events in their 
regulatory records. Accordingly, 98%-99% of the registered persons 
(with no qualifying events) should have no adverse economic impacts 
associated with their employment opportunities. Further, the vast 
majority of member firms, approximately 98%, would likely be able to 
employ most of the individuals seeking employment in the industry--
including ones who have some disclosures--without coming close to 
meeting the Preliminary Criteria for Identification. Accordingly, FINRA 
believes that these anticipated economic impacts would likely be 
limited to a small proportion of registered persons and member firms, 
particularly in cases where registered persons with disclosures are 
seeking employment at firms at or near the Preliminary Criteria for 
Identification.
    Westpark commented that FINRA should back-test the impact of the 
proposed rule to cover a period that was not a bull market. The 
economic impact assessment evaluated the proposed criteria over the 
2013-2019 period. Because of the criteria's 5-year lookback period for 
adjudicated events, the evaluation included events that reached a 
resolution between 2009 and 2019, which includes the period of the 
global financial crisis.
16. Suggested Alternatives or Additional Measures
    Several comments suggested alternatives to proposed Rule 4111. For 
example, several commenters suggested that FINRA improve how it uses 
its existing rules and programs. For example, Network 1 commented that 
FINRA's enforcement program is already a practical solution for 
addressing ``bad brokers.'' Brooklight suggested that FINRA try to 
solve for any gaps in its enforcement authority and processes that 
prevent FINRA from dealing with the ``few bad actors'' motivating the 
proposal. ASA wrote that FINRA should pursue the expulsion of firms 
that do not carry out their supervisory obligations and act in ways 
that harm customers, and impose immediate lifetime bans on those who 
engage in certain egregious acts, such as theft of customer funds. ASA 
further commented that FINRA ``has an obligation to penalize and, if 
necessary, revoke the licenses of bad actors,'' and

[[Page 78568]]

that ``[i]f FINRA believes it lacks the authority or the tools 
necessary to stop the most egregious abuses, . . . then it should work 
with the . . . SEC, Congress and the industry to correct the problem.'' 
Joseph Stone commented that FINRA should continue focusing on firms' 
supervisory systems.
    As explained above, FINRA has a number of current programs through 
which it strives to prevent and deter misconduct by member firms and 
the individuals they hire. These tools have been effective in 
identifying and addressing a range of misconduct by individuals and 
firms, and FINRA has continued to strengthen them. Despite FINRA's 
efforts, however, persistent compliance issues continue to arise in 
some member firms, as explained above. Thus, while FINRA continues to 
explore whether additional enhancements to existing programs, including 
relevant statutory or regulatory changes,\161\ would help FINRA target 
firms or individuals that engage in serious misconduct with greater 
speed and effectiveness, FINRA believes there remains a strong need to 
equip FINRA with authority to address more proactively the current 
risks posed by the limited population of firms with a significant 
history of misconduct.
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    \161\ The Exchange Act includes fair procedure requirements for 
various SRO actions, including the disciplining of members and 
persons associated with members, and sets out the types of 
misconduct that presumptively exclude brokers from engaging in the 
securities business (identified as statutory disqualifications or 
``SDs''). The Exchange Act and SEC rules thereunder also establish a 
framework within which FINRA evaluates whether to allow individuals 
who are the subject of a statutory disqualification. In addition, 
FINRA's review of many SD applications is governed by the standards 
set forth in Paul Edward Van Dusen, 47 SEC. 668 (1981), and Arthur 
H. Ross, 50 SEC. 1082 (1992). These standards provide that, in 
situations where an individual's misconduct has already been 
addressed by the SEC or FINRA, and certain sanctions have been 
imposed for such misconduct, FINRA should not consider the 
individual's misconduct when it evaluates an SD application.
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    Some commenters proposed that, instead of a Restricted Deposit 
Requirement, FINRA should impose insurance or performance bond 
requirements,\162\ create a national investor recovery pool funded from 
fines that FINRA receives \163\ or a restitution fund,\164\ or impose 
additional capital requirements on identified firms.\165\ FINRA 
believes these alternatives present challenges and is continuing to 
propose a Restricted Firm Obligations Rule that would authorize the 
imposition of Restricted Deposit Requirements.
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    \162\ Brooklight, Cetera, Rockfleet.
    \163\ PIRC.
    \164\ Sichenzia.
    \165\ ASA.
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    Some commenters proposed other alternatives for FINRA's 
consideration. Chiu wrote that FINRA should instead focus attention on 
investor education and encouraged the creation of more tools like the 
Senior Helpline. Colorado FSC recommended that FINRA assign 
``disciplinary training and behavior restructuring'' to address 
disclosure related issues. FINRA does not believe, however, that the 
suggested alternatives would be as effective as the proposed Restricted 
Firm Obligations Rule at addressing firms with a significant history of 
misconduct and encouraging such firms to modify their behavior and risk 
profile.
    Several commenters proposed steps that FINRA should take in 
addition to the proposal. These included: (1) Requiring firms to 
provide BrokerCheck reports to customers; \166\ (2) expelling firms 
that are Restricted Firms for two consecutive years; \167\ (3) ``de-
licensing'' all current brokers who worked at such firms when they were 
initially designated as Restricted Firms; \168\ (4) disclosing more 
information on BrokerCheck, such as the percentage of brokers at a firm 
with disclosures and the average number of brokers' and firm's 
disclosures,\169\ or which brokers have a demonstrable pattern of 
violating the law; \170\ and (5) explaining to investors the methods 
that ``recidivist'' firms employ.\171\ Several commenters also 
suggested that FINRA give more consideration to proposing a rule like 
Investment Industry Regulatory Organization of Canada (IIROC) 
Consolidated Rule 9208, which is a terms and conditions rule.\172\
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    \166\ PIRC.
    \167\ Better Markets.
    \168\ Better Markets.
    \169\ St. John's SOL.
    \170\ Better Markets.
    \171\ Better Markets.
    \172\ Better Markets, Brooklight, Cambridge, Cetera, Luxor, 
Massachusetts, MIRC, PIRC.
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    FINRA appreciates receiving suggestions on additional steps it 
might take to address firms with a significant history of misconduct, 
and FINRA will continue to explore ways to address firms with a 
significant history of misconduct. As FINRA explained in Regulatory 
Notice 19-17, this includes continuing to consider whether to propose a 
terms and conditions rule. FINRA notes, however, that some of Better 
Markets' suggestions essentially request that FINRA broaden the 
statutory definition of disqualified persons, which is not within 
FINRA's jurisdiction to do.\173\
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    \173\ See 15 U.S.C. 78c(a)(39) (defining ``statutory 
disqualification'').
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17. Miscellaneous Comments Outside the Scope of the Proposal
    Some commenters raised concerns regarding issues that are not 
directly related to the proposal, such as whether barring ``rogue 
brokers'' or firms is effective,\174\ whether the Uniform Registration 
Forms should request disclosure of unsubstantiated allegations or 
unadjudicated alleged rule violations,\175\ and whether FINRA Hearing 
Officers are impartial.\176\ FINRA believes, however, that these 
comments are outside the scope of the proposal.
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    \174\ Chiu.
    \175\ AdvisorLaw.
    \176\ Moss & Gilmore.
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III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2020-041 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.
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    \177\ 17 CFR 200.30-3(a)(12).

All submissions should refer to File Number SR-FINRA-2020-041. This 
file number should be included on the subject line if email is used. To 
help the

[[Page 78569]]

Commission process and review your comments more efficiently, please 
use only one method. The Commission will post all comments on the 
Commission's internet website (http://www.sec.gov/rules/sro.shtml). 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for website viewing and printing in 
the Commission's Public Reference Room, 100 F Street NE, Washington, DC 
20549, on official business days between the hours of 10:00 a.m. and 
3:00 p.m. Copies of such filing also will be available for inspection 
and copying at the principal office of FINRA. All comments received 
will be posted without change. Persons submitting comments are 
cautioned that we do not redact or edit personal identifying 
information from comment submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-FINRA-2020-041 and should be submitted 
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on or before December 28, 2020.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\177\
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    \177\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-26594 Filed 12-3-20; 8:45 am]
BILLING CODE 8011-01-P