Document ID: SEC-2019-1980-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2019-12-30T05:00Z

[Federal Register Volume 84, Number 249 (Monday, December 30, 2019)]
[Notices]
[Pages 72088-72101]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-28021]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-87810; File No. SR-FINRA-2019-030]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of a Proposed Rule Change To Amend 
the Membership Application Program (``MAP'') Rules To Address the Issue 
of Pending Arbitration Claims

December 20, 2019.
    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 December 13, 2019, 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 substantially 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 amend the Membership Application Program 
(``MAP'') rules to help further address the issue of pending 
arbitration claims, as well as arbitration awards and settlement 
agreements related to arbitrations that have not been paid in full in 
accordance with their terms.\3\ Specifically, the proposed rule change 
would: (1) Amend Rule 1014 (Department Decision) to: (a) Create a 
rebuttable presumption that an application for new membership should be 
denied if the applicant or its associated persons are subject to a 
pending arbitration claim, and (b) permit an applicant to overcome a 
presumption of denial by demonstrating its ability to satisfy an unpaid 
arbitration award, other adjudicated customer award, unpaid arbitration 
settlement or pending arbitration claim; (2) adopt a new requirement 
for a member, that is not otherwise required to submit an application 
for continuing membership for a specified change in ownership, control 
or business operations, including business expansion, to seek a 
materiality consultation if the member or its associated persons have a 
defined ``covered pending arbitration claim,'' unpaid arbitration 
award, or an unpaid arbitration settlement; (3) amend Rule 1017 
(Application for Approval of Change in Ownership, Control, or Business 
Operations) to require a member to demonstrate its ability to satisfy 
an unpaid arbitration award or unpaid settlement related to an 
arbitration before effecting the proposed change thereunder; (4) amend 
Rule 1013 (New Member Application and Interview) and Rule 1017 to 
require an applicant to provide prompt written notification of any 
pending arbitration claim that is filed, awarded, settled or becomes 
unpaid before a decision on an application constituting final action on 
FINRA is served on the applicant; and (5) make other non-substantive 
and technical changes in the specified MAP rules due to the proposed 
amendments.\4\
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    \3\ Effective May 8, 2019, FINRA adopted the NASD Rule 1010 
Series (Membership Proceedings), among other rules, in the 
consolidated FINRA rulebook, without substantive change. The MAP 
rules now reside under the FINRA Rule 1000 Series (Member 
Application and Associated Person Registration) as FINRA Rules 1011 
through 1019. See Securities Exchange Act Release No. 85589 (April 
10, 2019), 84 FR 15646 (April 16, 2019) (Notice of Filing and 
Immediate Effectiveness of File No. SR-FINRA-2019-009). For purposes 
of this filing, all references to the MAP rules are to the FINRA 
Rule 1000 Series. The proposed rule change would also update cross-
references and make other non-substantive, technical changes, and 
make corresponding changes to the Forms NMA and CMA. FINRA is 
separately developing changes to the MAP rules in connection with 
the retrospective review of this rule set. See Regulatory Notice 18-
23 (July 2018) (``Notice 18-23'') (requesting comment on a proposal 
regarding the MAP rules).
    \4\ For example, the proposed rule change would require the 
renumbering of some paragraphs in Rules 1011 and 1014 and the 
updating of cross-references.
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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
    The MAP rules govern the way in which FINRA reviews a new 
membership application (``NMA'') and a continuing membership 
application (``CMA'').\5\ These rules require an applicant to 
demonstrate its ability to comply with applicable securities laws and 
FINRA rules, including observing high standards of commercial honor and 
just and equitable principles of trade. FINRA evaluates an applicant's 
financial, operational, supervisory and compliance systems to ensure 
that the applicant meets the standards set forth in the MAP rules. 
Among other factors, the MAP rules require FINRA to consider whether 
persons associated with an applicant have material disciplinary actions 
taken against them by industry authorities, customer complaints, 
adverse arbitrations, pending arbitration claims, unpaid arbitration 
awards, pending or unadjudicated matters, civil actions, remedial 
actions imposed or other industry-related matters that could pose a 
threat to public investors.\6\
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    \5\ Unless otherwise specified, the term ``application'' refers 
to either an NMA (or Form NMA) or CMA (or Form CMA), depending on 
context.
    \6\ See generally Rules 1014(a)(3) and 1014(a)(10).
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    FINRA is proposing to amend the MAP rules in several ways. First, 
FINRA is proposing to amend one standard for admission and the 
corresponding factors therein relating to the presumption to deny an 
application for new or continuing membership. Second, FINRA is 
proposing to clarify the various ways in which an applicant for new or 
continuing membership may demonstrate its ability to satisfy an unpaid 
arbitration award, other adjudicated customer award, unpaid arbitration 
settlement, or a pending arbitration claim during the application 
review process, and to preclude an applicant from effecting any 
contemplated change in ownership, control or business operations until 
such demonstration is made and FINRA approves the application. Third, 
FINRA

[[Page 72089]]

is proposing to mandate a member firm to seek a materiality 
consultation in two situations in which specified pending arbitration 
claims, unpaid arbitration awards, or unpaid arbitration settlements 
are involved. Finally, FINRA is proposing to require an applicant for 
new or continuing membership to notify FINRA of any pending arbitration 
claim that is filed, awarded, settled or becomes unpaid before FINRA 
renders a decision on the application.
    FINRA believes that these proposed amendments to select portions of 
the MAP rules would enable FINRA to take a stronger approach to 
addressing the issue of pending arbitration claims, as well as 
arbitration awards and settlement agreements related to arbitrations 
that have not been paid in full in accordance with their terms, in 
connection with the application review process. In addition, the 
proposed amendments would enable FINRA to consider the adequacy of the 
supervision of individuals with pending arbitration claims. As 
described below, the proposed amendments are intended to address 
concerns regarding situations where: (1) A FINRA member firm hires 
individuals with pending arbitration claims, where there are concerns 
about the payment of those claims should they go to award or result in 
a settlement, and concerns about the supervision of those individuals; 
and (2) a member firm with substantial arbitration claims seeks to 
avoid payment of the claims should they go to award or result in a 
settlement by shifting its assets, which are typically customer 
accounts, or its managers and owners, to another firm and closing down.
    The proposed rule change would impact members that have elected to 
be treated as capital acquisition brokers (``CABs'') and are subject to 
CAB rules. CAB Rules 111 through 118 incorporate by reference several 
MAP rules, including Rules 1011, 1013, 1014 and 1017.\7\ The proposed 
amendments would make conforming changes to CAB Rules 111 through 118, 
as applicable.
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    \7\ See generally CAB Rule 111 (Membership Proceedings) 
(referencing Rule 1011), CAB Rule 112 (New Member Application and 
Interview) (referencing Rule 1013), CAB Rule 113 (Department 
Decision) (referencing Rule 1014), and CAB Rule 116 (Application for 
Approval of Change in Ownership, Control, or Business Operations) 
(referencing Rule 1017).
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Proposed Rule Change
A. Rule 1014(a)(3)--Compliance with Industry Rules, Regulations, and 
Laws
    Rule 1014(a) sets forth 14 standards for admission FINRA must 
consider in determining whether to approve an application. Currently, 
Rule 1014(a)(3) (``Standard 3'') requires FINRA to determine whether an 
applicant for new or continuing membership and its associated persons 
``are capable of complying with'' the federal securities laws, the 
rules and regulations thereunder, and FINRA rules. Standard 3 sets 
forth six factors that FINRA must consider in making that 
determination.\8\ One factor, set forth under Rule 1014(a)(3)(B), 
requires FINRA to consider whether an applicant's or its associated 
person's record reflects a sales practice event, a pending arbitration, 
or a pending private civil action. Another factor appears under Rule 
1014(a)(3)(C) and requires FINRA to consider, among other regulatory 
history, whether an applicant, its control persons, principals, 
registered representatives, other associated persons, any lender of 
five percent or more of the applicant's net capital, and any other 
member with respect to which these persons were a controlling person or 
a five percent lender of its net capital, is subject to unpaid 
arbitration awards, other adjudicated customer awards, or unpaid 
arbitration settlements.
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    \8\ See Rule 1014(a)(3)(A)-(F).
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    Further, under Rule 1014(b)(1), where an applicant or its 
associated person is subject to certain regulatory history enumerated 
in Standard 3, ``a presumption exists that the application should be 
denied.'' \9\ Rule 1014(a)(3)(C) is one of several factors that trigger 
the presumption. The existence of such an event ``[raises] a question 
of capacity to comply with the federal securities laws and the rules of 
[FINRA],'' which should result in a rebuttable presumption to deny the 
application.\10\ However, the existence of a record of a pending 
arbitration, as set forth in Rule 1014(a)(3)(B), is currently not among 
the enumerated factors that trigger the presumption to deny an 
application.
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    \9\ See also Rule 1017(h)(1), which pertains to CMAs and 
contains language identical to Rule 1014(b)(1). FINRA would make 
conforming changes to Rule 1017(h)(1).
    \10\ See Notice to Members 04-10 (February 2004).
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1. Rebuttable Presumption to Deny an NMA (Proposed Rule 1014(b)(1))
    FINRA is concerned about prospective applicants for new membership 
hiring principals and registered persons with pending arbitration 
claims without having to demonstrate how those claims would be paid if 
they go to award or result in a settlement. In addition, FINRA is 
concerned about a new member's supervision of such individuals who may 
have a history of noncompliance. Accordingly, FINRA is proposing to 
amend Rule 1014(b)(1) to specify that a presumption of denial would 
exist if a new member applicant or its associated persons are the 
subject of a pending arbitration claim. Creating a presumption of 
denial in connection with a pending arbitration claim for an NMA would 
shift the burden to the new member applicant to demonstrate how its 
pending arbitration claims would be paid should they go to award or 
result in a settlement. In addition, the proposed amendment would 
spotlight the firm's supervision of individuals with pending 
arbitration claims. This presumption of denial for a pending 
arbitration claim would not apply to an existing member firm filing a 
CMA. Instead, consistent with today's practice, FINRA would continue to 
consider whether an applicant's or its associated persons are the 
subject of a pending arbitration claim in determining whether the 
applicant for continuing membership is ``capable of complying with'' 
applicable federal securities laws and FINRA rules.\11\
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    \11\ For purposes of determining whether an applicant meets 
Standard 3, FINRA's consideration of an applicant's or associated 
person's pending arbitration claim would be separated from Rule 
1014(a)(3)(B) and moved to proposed Rule 1014(a)(3)(E).
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2. Evidence of Ability To Satisfy Unpaid Arbitration Awards, Other 
Adjudicated Customer Awards, Unpaid Arbitration Settlements, or for New 
Member Applications, Pending Arbitration Claims (Proposed IM-1014-1)
    Proposed IM-1014-1 would provide that an applicant may demonstrate 
its ability to satisfy an unpaid arbitration award, other adjudicated 
customer award, unpaid arbitration settlement or a pending arbitration 
claim, through an escrow agreement, insurance coverage, a clearing 
deposit, a guarantee, a reserve fund, or the retention of proceeds from 
an asset transfer, or such other forms of documentation that FINRA may 
determine to be acceptable.\12\ In addition, under the proposed 
interpretive material, an applicant may

[[Page 72090]]

provide a written opinion of an independent, reputable U.S. licensed 
counsel knowledgeable in the area as to the value of the arbitration 
claims (which might be zero). Proposed IM-1014-1 would also provide 
that to overcome the presumption to deny the application, the applicant 
must guarantee that any funds used to evidence the applicant's ability 
to satisfy any awards, settlements, or claims will be used for that 
purpose. Any demonstration by an applicant of its ability to satisfy 
these outstanding obligations would be subject to a reasonableness 
assessment by FINRA.
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    \12\ FINRA expects to make conforming amendments to Forms NMA 
and CMA. FINRA notes that Form CMA currently instructs the applicant 
to provide supporting documentation to show that such applicant is 
able to meet Standard 3. Specifically, if the CMA involves a 
transfer of assets with no corresponding transfer of associated 
liabilities, and there are pending arbitration claims or closed or 
settled arbitration matters, Form CMA requires the applicant to 
provide a written ``Arbitration Plan,'' explaining, among other 
things, how the applicant will handle the arbitrations and awards 
that may result. An applicant may show that it has a reserve fund or 
will retain the proceeds of the asset transfer to satisfy the award. 
See Form CMA, Standard 3, Question 2.d. (within the section titled, 
``Provide supporting documents'').
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B. Materiality Consultation
    A member is required to file a CMA when it plans to undergo an 
event specified under Rule 1017 (e.g., acquisition or transfer of the 
member's assets, or a business expansion). In some cases, a change 
contemplated by a firm may not clearly fall within one of the events 
described in Rule 1017, and so before taking steps to prepare a CMA, a 
member has the option of seeking guidance, or a materiality 
consultation, from FINRA on whether such proposed event would require a 
CMA.\13\ The materiality consultation process is voluntary, and FINRA 
has published guidelines about this process on FINRA.org.\14\ A request 
for a materiality consultation, for which there is no fee, is a written 
request from a member firm for FINRA's determination on whether a 
contemplated change in business operations or activities is material 
and would therefore require a CMA or whether the contemplated change 
can fit within the framework of the firm's current activities and 
structure without the need to file a CMA for FINRA's approval. The 
characterization of a contemplated change as material depends on an 
assessment of all the relevant facts and circumstances, including, 
among others, the nature of the contemplated change, the effect the 
contemplated change may have on the firm's capital, the qualifications 
and experience of the firm's personnel, and the degree to which the 
firm's existing financial, operational, supervisory and compliance 
systems can accommodate the contemplated change.\15\ Through this 
consultation, FINRA may communicate with the member to obtain further 
documents and information regarding the contemplated change and its 
anticipated impact on the member. Where FINRA determines that a 
contemplated change is material, FINRA will instruct the member to file 
a CMA if it intends to proceed with such change. Ultimately, the member 
is responsible for compliance with Rule 1017. If FINRA determines 
during the materiality consultation that the contemplated business 
change is material, then the member potentially could be subject to 
disciplinary action for failure to file a CMA under Rule 1017.\16\
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    \13\ See IM-1011-1 (stating, ``[f]or any expansion beyond these 
[safe harbor] limits, a member should contact its district office 
prior to implementing the change to determine whether the proposed 
expansion requires an application under Rule 1017.''); see also 
Notice to Members 00-73 (October 2000) (``Notice 00-73'') (stating, 
whether, based upon all the facts and circumstances, a change and 
expansion that falls outside of the safe harbor provisions are 
material, ``[a] member may, but is not required to, contact the 
District Office to obtain guidance on this issue.'').
    \14\ See The Materiality Consultation Process for Continuing 
Membership Applications, https://www.finra.org/rules-guidance/guidance/materiality-consultation-process.
    \15\ See Notice 00-73.
    \16\ See Notice 00-73.
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    To help further incentivize payment of arbitration awards and 
settlements, FINRA is proposing to preclude a member from effecting 
specified changes in ownership, control, or business operations, 
including business expansions involving a ``covered pending arbitration 
claim'' (as defined under proposed Rule 1011(c)), unpaid arbitration 
award, or unpaid settlement related to an arbitration without first 
seeking a materiality consultation from FINRA as described below.\17\
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    \17\ In a separate proposal, FINRA is proposing to mandate 
materiality consultations under other circumstances. See Notice 18-
23 (seeking comment on a proposal to the MAP rules that would, among 
other things, codify the materiality consultation process and 
mandate a consultation under specified circumstances such as where 
an applicant seeks to engage in, for the first time, retail foreign 
currency exchange activities, variable life settlement sales to 
retail customers, options activities, or municipal securities 
activities).
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1. Mandatory Materiality Consultation for Business Expansion To Add One 
or More Associated Persons Involved in Sales (Proposed IM-1011-2 and 
Proposed Rules 1011(c)(1) and 1017(a)(6)(B))
    Rule 1017 specifies the changes in a member's ownership, control, 
or business operations that require a CMA and FINRA's approval.\18\ 
Among the events that require a CMA are a ``material change in business 
operations,'' which is defined to include, but is not limited to: (1) 
Removing or modifying a membership agreement restriction; (2) market 
making, underwriting or acting as a dealer for the first time; and (3) 
adding business activities that require a higher minimum net capital 
under SEA Rule 15c3-1.\19\ In addition, a CMA is required for business 
expansions to increase the number of associated persons involved in 
sales, offices, or markets made that are a material change in business 
operations.\20\ However, IM-1011-1 (Safe Harbor for Business 
Expansions) creates a safe harbor for incremental increases in these 
three categories of business expansions that will be presumed not to be 
material. Under this safe harbor provision, a member, subject to 
specified conditions and thresholds, may undergo such business 
expansions without filing a CMA.\21\
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    \18\ See Rule 1017(a). The events that require a member to file 
a CMA for approval before effecting the proposed event are: (1) a 
merger of the member with another member, unless both members are 
members of the New York Stock Exchange, Inc. (``NYSE'') or the 
surviving entity will continue to be a member of the NYSE; (2) a 
direct or indirect acquisition by the member of another member, 
unless the acquiring member is a member of the NYSE; (3) direct or 
indirect acquisitions or transfers of 25 percent or more in the 
aggregate of the member's assets or any asset, business or line of 
operation that generates revenues composing 25 percent or more in 
the aggregate of the member's earnings measured on a rolling 36-
month basis, unless both the seller and acquirer are members of the 
NYSE; (4) a change in the equity ownership or partnership capital of 
the member that results in one person or entity directly or 
indirectly owning or controlling 25 percent or more of the equity or 
partnership capital; or (5) a material change in business operations 
as defined in Rule 1011(k).
    \19\ See Rule 1011(k).
    \20\ See Rule 1017(b)(2)(C) (stating, ``If the application 
requests approval of an increase in Associated Persons involved in 
sales, offices, or markets made, the application shall set forth the 
increases in such areas during the preceding 12 months.'').
    \21\ The safe harbor is unavailable to a member that has a 
membership agreement that contains a specific restriction as to one 
or more of the three areas of expansion or to a member that has a 
``disciplinary history'' as defined in IM-1011-1.
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    FINRA is concerned that the changes in a member firm's ownership, 
control, or business operations as currently described in Rule 1017, 
and the availability of the safe harbor for a business expansion to 
increase the number of associated persons involved in sales could allow 
a member to, for example, hire principals and registered 
representatives with substantial pending arbitration claims without 
giving consideration to how the firm would supervise such individual or 
the potential financial impact on the firm if the individual, while 
employed at the hiring firm, engages in additional potential misconduct 
that results in a customer arbitration. Accordingly, FINRA is proposing 
to add new interpretive material, IM-1011-2 (Business Expansions and 
Covered Pending Arbitration Claims), to provide that if a member is 
contemplating to add one or more associated persons involved in sales 
and one or more of those associated persons has a ``covered

[[Page 72091]]

pending arbitration claim'' (as that term is defined under proposed 
Rule 1011(c)(1)), an unpaid arbitration award or an unpaid settlement 
related to an arbitration, and the member is not otherwise required to 
file a CMA, the member may not effect the contemplated business 
expansion unless the member complies with the requirements in proposed 
Rule 1017(a)(6)(B).
    Proposed Rule 1017(a)(6)(B) would require a member firm to file a 
CMA for approval of the business expansion described in proposed IM-
1011-2 unless the member first submits a written request to FINRA 
seeking a materiality consultation for the contemplated business 
expansion. The written request must address the issues that are central 
to the materiality consultation. As part of the materiality 
consultation, FINRA would consider the written request and other 
information or documents the member provides to determine in the public 
interest and the protection of investors that either: (1) The member is 
not required to file a CMA in accordance with Rule 1017 and may effect 
the contemplated business expansion; or (2) the member is required to 
file a CMA in accordance with Rule 1017 and the member may not effect 
the contemplated business expansion unless FINRA approves the CMA.
    A materiality consultation for this type of business expansion 
would allow FINRA to, among other things, assess the nature of the 
anticipated activities of the principals and registered representatives 
with arbitration claims, unpaid arbitration awards or arbitration 
settlements; the impact on the firm's supervisory and compliance 
structure, personnel and finances; and any other impact on investor 
protection raised by adding such individuals. If FINRA determines that 
a member must file a CMA, it would be subject to the application review 
process set forth under the MAP rules, including a review of any record 
of a pending arbitration claim and the presumption of denial with 
respect to any unpaid arbitration awards, other adjudicated customer 
awards, or unpaid arbitration settlements.
    For purposes of a business expansion to add one or more associated 
persons involved in sales, FINRA is proposing to define, under proposed 
Rule 1011(c)(1), a ``covered pending arbitration claim'' as: (1) An 
investment-related, consumer-initiated claim filed against the 
associated person in any arbitration forum that is unresolved; and (2) 
whose claim amount (individually or, if there is more than one claim, 
in the aggregate) exceeds the hiring member's excess net capital. For 
purposes of this definition, the claim would include only claimed 
compensatory loss amounts, not requests for pain and suffering, 
punitive damages or attorney's fees, and shall be the maximum amount 
for which the associated person 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.
    FINRA believes that the definition of a ``covered pending 
arbitration claim'' for purposes of a business expansion as described 
in proposed IM-1011-2 and proposed Rule 1017(a)(6)(B) is appropriate 
because if an individual has substantial arbitration claims, those 
claims could be an indication that the individual may engage in future 
potential misconduct that could result in additional arbitration 
claims.\22\ Under such circumstances, if the customer names the hiring 
member firm in any such additional arbitration claims, FINRA is 
concerned whether a hiring member firm with low excess net capital 
would be able to satisfy any obligation that may result from the 
arbitration claims including a customer award or settlement. By 
requiring a materiality consultation if a member firm is contemplating 
hiring an individual with a ``covered pending arbitration claim,'' 
FINRA would be able to assess, among other things, the adequacy of any 
supervisory plan the member firm has in place for the individual. In 
addition, the materiality consultation would allow FINRA to discuss 
with the member firm the potential impact on its finances if the member 
firm hires the individual and the individual engages in future 
potential misconduct while employed at the member firm that results in 
an arbitration claim against the member firm.
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    \22\ Recent academic studies provide evidence that the past 
disciplinary and other regulatory events associated with a firm or 
individual can be predictive of similar future events. See Hammad 
Qureshi and Jonathan Sokobin, Do Investors Have Valuable Information 
About Brokers? (FINRA Office of the Chief Economist Working Paper, 
August 2015). See also Mark Egan, Gregor Matvos, and Amit Seru, The 
Market for Financial Adviser Misconduct, J. Pol. Econ. 127, No. 1 
(February 2019): 233-295.
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    If the SEC approves the proposed rule change, FINRA will reassess 
the definition of ``covered pending arbitration claim'' for purposes of 
proposed IM-1011-2 and proposed Rule 1017(a)(6)(B) after FINRA has had 
experience with the application of the rule to determine its impact and 
if the definition requires modification. In addition, FINRA invites 
comment on the proposed definition.
2. Mandatory Materiality Consultation for Any Acquisition or Transfer 
of Member's Assets (Proposed Rule 1017(a)(6)(A) and Proposed Rule 
1011(c)(2))
    Rule 1017(a) requires a member to file a CMA for direct or indirect 
acquisitions or transfers of 25 percent or more in the aggregate of the 
member's assets or any asset, business or line of operation that 
generates revenues composing 25 percent or more in the aggregate of the 
member's earnings measured on a rolling 36-month basis, unless both the 
seller and acquirer are NYSE members.\23\
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    \23\ See supra note 18.
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    FINRA is concerned that this 25 percent threshold could permit a 
firm with pending arbitration claims that ultimately produce awards or 
settlements to avoid satisfying those awards or settlements by 
transferring assets without encumbrance and then closing down. 
Accordingly, FINRA is proposing to amend Rule 1017(a) to add new 
subparagraph (6)(A) to provide that if a member is contemplating any 
direct or indirect acquisition or transfer of a member's assets or any 
asset, business or line of operation where the transferring member or 
an associated person of the transferring member has a covered pending 
arbitration claim (as that term is defined under proposed Rule 
1011(c)(2)), an unpaid arbitration award or an unpaid settlement 
related to an arbitration, and the member is not otherwise required to 
file a CMA, the member may not effect the contemplated transaction 
unless the member first submits a written request to FINRA seeking a 
materiality consultation for the contemplated acquisition or transfer. 
Similar to proposed subparagraph (6)(B) in Rule 1017(a), the written 
request must address the issues that are central to the materiality 
consultation. As part of the materiality consultation, FINRA would 
consider the written request and other information or documents 
provided by the member to determine in the public interest and the 
protection of investors that either: (1) The member is not required to 
file a CMA in accordance with Rule 1017 and may effect the contemplated 
acquisition or transfer; or (2) the member is required to file a CMA in 
accordance with Rule 1017 and the member may not effect the 
contemplated business acquisition or transfer unless FINRA approves the 
CMA.

[[Page 72092]]

    During the course of this consultation, FINRA would consider, among 
other relevant facts and circumstances, whether the contemplated 
acquisition or transfer could result in non-payment of an arbitration 
claim should it go to award or result in a settlement, or the continued 
non-payment of such arbitration award or settlement. If FINRA 
determines that a member must file a CMA, it would be subject to the 
application review process set forth under the MAP rules, including a 
review of any record of a pending arbitration claim and the presumption 
of denial with respect to any unpaid arbitration awards, other 
adjudicated customer awards or unpaid arbitration settlements.
    For purposes of this proposed amendment, FINRA is proposing to 
define, under proposed Rule 1011(c)(2), a ``covered pending arbitration 
claim'' as: (1) An investment-related, consumer-initiated claim filed 
against the transferring member or its associated persons in any 
arbitration forum that is unresolved; and (2) whose claim amount 
(individually or, if there is more than one claim, in the aggregate) 
exceeds the transferring member's excess net capital. For purposes of 
this definition, the claim amount would include only claimed 
compensatory loss amounts, not requests for pain and suffering, 
punitive damages or attorney's fees, and shall be the maximum amount 
for which the associated person 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.
    FINRA believes that the definition of a ``covered pending 
arbitration claim'' for purposes of a direct or indirect acquisition or 
transfer as described in proposed Rule 1017(a)(6)(A) is an appropriate 
measure because a member with substantial arbitration claims that is 
seeking to transfer its assets could be an indication of attempts to 
insulate itself from responsibility for the payment of pending 
arbitration claims, unpaid arbitration awards, or unpaid arbitration 
settlements particularly when there is no corresponding transfer of 
liabilities. Under such circumstances, FINRA is concerned whether a 
transferring member firm with low excess net capital would be able to 
satisfy any obligation that may result from the arbitration claims, 
including a customer award or settlement. By requiring a materiality 
consultation where a member firm is contemplating any direct or 
indirect acquisition or transfer involving a ``covered pending 
arbitration claim,'' FINRA would be able to assess, among other things, 
the adequacy of any plan the member firm has in place to satisfy 
pending arbitration claims, unpaid arbitration awards, or unpaid 
arbitration settlements.
    As noted above, FINRA invites comment on the proposed definition 
and if the SEC approves the proposed rule change, FINRA will reassess 
the definition of ``covered pending arbitration claim'' for purposes of 
proposed Rule 1017(a)(6)(A) after FINRA has had experience with the 
application of the rule to determine its impact and if the definition 
requires modification.
C. Other Proposed Amendments
1. Notification of Changes
    Rule 1013(a) sets forth a detailed list of items that must be 
submitted with an NMA.\24\ Rule 1017(b) sets forth the documents or 
information required to accompany a CMA, depending on the nature of the 
CMA. FINRA is proposing to amend Rules 1013 and 1017 to add new 
paragraphs that would appear as proposed Rules 1013(c) and 1017(h), to 
require an applicant to provide prompt notification, in writing, of any 
pending arbitration claim involving the applicant or its associated 
persons that is filed, awarded, settled or becomes unpaid before a 
decision on the application constituting final action of FINRA is 
served on the applicant.\25\ Thus, any such unpaid arbitration award, 
other adjudicated customer award, unpaid arbitration settlement, or 
pending arbitration claim (for a new member applicant only) that comes 
to light in this manner during the application review process would 
result in FINRA being able to presumptively deny the application under 
the applicable factors set forth in Standard 3 and the ability of the 
applicant to overcome such presumption by demonstrating its ability to 
satisfy the obligation, as discussed above.
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    \24\ The list of items set forth under Rule 1013(a) includes, 
among other things, documentation of disciplinary history and 
certain regulatory, civil, and criminal actions, arbitrations, and 
customer complaints for the applicant and its associated persons.
    \25\ FINRA expects to make conforming changes to Forms NMA and 
CMA, but notes that Form CMA currently requires the applicant 
seeking approval of an asset transfer to promptly update the 
information provided regarding arbitration claims. Such update 
should include new arbitrations filed, settlements made and awards 
granted against the applicant. See Form CMA, Standard 3, Question 
4.b.
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2. Timing and Conditions for Effecting Change Under Rule 1017
    Rule 1017(c) describes the timing and conditions for effecting a 
change under Rule 1017.\26\ Rule 1017(c)(1) requires a member to file a 
CMA for approval of a change in ownership or control at least 30 days 
before the change is expected to occur. While a member may effect the 
change prior to the conclusion of FINRA's review of the CMA, FINRA may 
place interim restrictions on the member based upon the standards in 
Rule 1014 pending a final determination.\27\ Under Rule 1017(c)(2), a 
member may file a CMA to remove or modify a membership agreement 
restriction at any time, but any such existing restriction shall remain 
in effect during the pendency of the proceeding. Finally, Rule 
1017(c)(3) permits a member to file a CMA for approval of a material 
change in business operations at any time, but the member may not 
effect such change until the conclusion of the proceeding, unless FINRA 
and the member otherwise agree.
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    \26\ In a separate proposal, FINRA is considering whether to 
eliminate the timing considerations for filing a CMA depending upon 
the type of contemplated change or event to require that any change 
specified under Rule 1017 should not be permitted until such time as 
the CMA has been approved by FINRA. See Notice 18-23 (seeking 
comment on a proposal to the MAP rules that would, among other 
things, delete Rule 1017(c) in its entirety).
    \27\ Interim restrictions are meant for the protection of 
investors and ordinarily would not prevent a transaction from moving 
forward. However, there may be some instances where the protection 
of investors will require that interim restrictions will prohibit or 
delay a transaction from closing. See Notice to Members 02-54 
(August 2002).
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    FINRA is proposing to amend Rule 1017(c) by adding new subparagraph 
(4) to provide that, notwithstanding the existing timing and conditions 
for effecting a change as described under Rule 1017(c)(1) through (3), 
where a member or an associated person has an unpaid arbitration award 
or unpaid settlement related to an arbitration at the time of filing a 
CMA, the member may not effect such change until demonstrating that it 
has the ability to satisfy such obligations in accordance with Rule 
1014 and proposed IM-1014-1, as discussed above, and obtaining approval 
of the CMA.\28\
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    \28\ FINRA expects to make conforming changes to Forms NMA and 
CMA. FINRA notes that where an applicant is seeking FINRA's approval 
of a CMA to transfer assets with no corresponding transfer of 
associated liabilities, and there is an unpaid arbitration award, 
Form CMA currently requires the applicant to provide proof that the 
award was satisfied in full and in the case of an unpaid award, the 
applicant must pay the award in full before closing the transaction. 
See Form CMA, Standard 3, Question 2.a. (within the section titled, 
``Provide supporting documents'').

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[[Page 72093]]

    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 120 days following 
publication of the Regulatory Notice announcing Commission approval of 
the proposed rule change.
2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the 
provisions of Section 15A(b)(6) of the Act,\29\ 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. FINRA believes that the proposed rule change will 
allow FINRA to better take into account the issue of pending 
arbitration claims, as well as arbitration awards and settlement 
agreements related to arbitrations that have not been paid in full in 
accordance with their terms, in connection with the NMA or CMA 
processes. FINRA believes that the proposed amendments will strengthen 
FINRA's ability to consider the adequacy of the supervision of 
individuals with pending arbitration claims and, therefore, who may 
have a history of noncompliance, and how a member firm will address the 
payment of an existing or potential arbitration claim should it go to 
award or result in a settlement. In addition, FINRA believes that the 
proposed amendments will give FINRA the authority to carefully assess, 
at an earlier stage of a member's contemplated business transaction or 
expansion, the relevant facts and circumstances surrounding pending 
arbitration claims.
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    \29\ 15 U.S.C. 78o-3(b)(6).
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    Among other things, the proposed amendments will help address 
concerns regarding situations where: (1) A FINRA member firm hires 
individuals with pending arbitration claims, where there are concerns 
about the payment of those claims should they go to award or result in 
a settlement, and the adequacy of the supervision of those individuals; 
and (2) a member firm with substantial arbitration claims seeks to 
avoid payment of the claims should they go to award or result in a 
settlement by shifting its assets, which are typically customer 
accounts, or its managers and owners, to another firm and closing down.

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.
1. Economic Impact Assessment
    FINRA has undertaken an economic impact assessment, as set forth 
below, to analyze the regulatory need for the proposed rule change, its 
potential economic impacts, including anticipated costs, benefits, and 
distributional and competitive effects, relative to the current 
baseline, and the alternatives FINRA considered in assessing how best 
to meet its regulatory objectives.
2. Regulatory Need
    The MAP rules are intended to promote investor protection by 
applying uniform standards for admission and by reviewing changes to 
ownership, control, or business operations. While the current MAP rules 
give FINRA the ability to review pending arbitration claims, unpaid 
arbitration awards, and unpaid arbitration settlements in determining 
whether to grant or deny an application, the proposed amendments would 
strengthen the MAP rules when claimants may need additional 
protections. Currently, claimants may be at risk if the individuals or 
firms responsible actively maneuver to avoid payment of awards (e.g., 
by joining or transferring assets to a different member firm).\30\
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    \30\ FINRA identified five customer arbitration claims that (a) 
closed between 2015 and 2017 and resulted in an award that went 
unpaid and (b) the associated persons responsible for the unpaid 
awards transitioned from one member firm to another while the claim 
was pending. The total amount of unpaid awards relating to the five 
customer claims was $2.5 million. Three of the four associated 
persons relating to the unpaid awards were suspended or barred from 
the industry by FINRA. The fourth associated person declared 
bankruptcy but was no longer registered as a broker.
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3. Economic Baseline
    The economic baseline for the proposed amendments is the current 
set of MAP rules and related guidance, and FINRA practices. The current 
rules include unpaid arbitration awards and settlements, but not 
pending arbitration claims, in the presumption of denial; the 
definition of a material change in business operations and the 
availability of a safe harbor for some business expansions; and the 
requirements for a member firm to file a CMA relating to asset 
acquisitions or transfers. The proposed amendments would affect 
prospective and existing member firms, and associated persons. The 
proposed amendments would also affect the current and future customers 
of prospective and existing member firms including those that have 
brought or may bring claims against member firms and associated 
persons.
A. NMAs
    In order to get a better understanding of the potential scope of 
the proposed amendments, FINRA reviewed 317 NMAs that it received from 
January 2015 through December 2017.\31\ Among these applications, FINRA 
identified few new member applicants or their associated persons as 
having a pending arbitration claim at the time of FINRA's receipt of 
the NMA.\32\ Among the 317 NMAs, FINRA identified 13 NMAs (or four 
percent) where the new member applicant or its associated persons had a 
pending arbitration claim at the time of receipt of the 
application.\33\ Under the proposed amendments, FINRA could have 
presumptively denied these NMAs. FINRA also identified one NMA as 
relating to a customer claim that resulted in an award that went 
unpaid.\34\
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    \31\ These NMAs were either approved in whole or with 
restrictions, denied, withdrawn, rejected, or lapsed.
    \32\ The statistics on pending arbitration claims in this 
discussion relate only to claims in the arbitration forum 
administered by FINRA. The proposed amendments also would apply to 
claims in other venues. Information describing claims in other 
arbitration forums, however, is generally not available. FINRA's 
estimates of the number of firms that may be impacted by the 
proposed amendments are therefore likely lower than the true number. 
Further, FINRA is not able to estimate the total amount of monetary 
compensation claimants received from the arbitration cases discussed 
because information that identifies the settlement amount relating 
to a particular case is not available.
    \33\ Among these 13 NMAs, there were seven pending customer 
arbitration claims filed against associated persons prior to FINRA's 
receipt of the application, and among these seven customer claims, 
three resulted in a settlement, one closed by hearing, and three 
were withdrawn. The total amount of compensatory damages sought by 
customers was over $1.9 million (including the claims that resulted 
in a settlement). In the case closed by hearing, the customer was 
awarded compensatory damages of approximately $76,000.
    \34\ The firm withdrew the NMA. The customer arbitration claim 
resulted in an award prior to FINRA's receipt of the NMA. The amount 
of the damages that went unpaid is approximately $250,000. The 
associated person who failed to pay the awarded damages has been 
suspended by FINRA.
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B. CMAs
    FINRA also reviewed 1,051 CMAs that it received from January 2015 
through December 2017.\35\ This sample of CMAs only provides a 
potential indication of the member firms that

[[Page 72094]]

could be impacted by the proposed amendments. A member firm may elect 
to proceed with effecting a change in business operations because it 
independently determines, without seeking guidance from FINRA through a 
materiality consultation, that such contemplated change falls within 
the safe harbor parameters or that such transaction does not represent 
a material change in business operations that would require a CMA. In 
these cases, a member firm is not obligated to proactively notify FINRA 
of the independent determination.\36\ Thus, the number of member firms 
that potentially may be subject to the proposed amendments, including 
those that effect an increase in the number of associated persons 
involved in sales under the safe harbor or effect some other change in 
business operations that is, in the member firm's view, not material, 
may be different than the member firms that filed a CMA and are part of 
the sample.
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    \35\ The CMAs were either approved in whole or with 
restrictions, denied, withdrawn, rejected, or lapsed.
    \36\ Under IM-1011-1, a firm would remain obligated to keep 
records of increases in personnel, offices, and markets made to 
determine whether they are within the safe harbor.
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    Of the 1,051 CMAs, 65 involved the hiring of associated persons. 
FINRA identified four of the 65 CMAs where the associated person being 
hired had a pending customer arbitration claim. Under the proposed 
amendments, the pending customer arbitration claims for all four of the 
CMAs would have been considered covered pending arbitration claims.\37\ 
An additional 154 of the 1,051 CMAs were identified as relating to 
asset acquisitions (17) or transfers (137). FINRA identified 44 CMAs 
(29 percent of 154) where the transferring member or an associated 
person of the transferring member had a pending customer arbitration 
claim at the time of the filing.\38\ Under the proposed amendments, the 
pending customer arbitration claims for 25 of the 44 CMAs would have 
been considered covered pending arbitration claims. FINRA also 
identified five of the CMAs as relating to six customer claims that 
resulted in an award that went unpaid.\39\
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    \37\ From January 2015 to December 2017, among all member firms, 
480 associated persons were hired with a pending arbitration claim 
at the time of hiring. These pending claims would have been 
considered ``covered pending arbitration claims'' under the proposed 
amendments for 186 of the associated persons (39 percent of 480) and 
would not have been considered covered pending arbitration claims 
for the remaining 294 associated persons (or 61 percent of 480). 
FINRA does not know how many of the associated persons were involved 
in sales. This estimate, therefore, provides an upper bound for the 
number of materiality consultations member firms would have been 
required to seek under the proposed amendments. See supra note 30 
for a discussion of the unpaid awards relating to associated persons 
who transitioned from one member firm to another while the claim was 
pending.
    \38\ Thirty-four of the CMAs were approved, and 10 were 
withdrawn or not substantially completed and therefore rejected. 
There were 300 pending customer arbitration claims as of the receipt 
of the CMAs. The pending claims included claims made against the 
applicant or its associated persons. Of the 300 pending arbitration 
claims, 184 resulted in a settlement, 48 closed by hearing or on the 
papers, 52 closed by other means including 32 that were withdrawn, 
and 16 remained open. Customers requested a total of $311.3 million 
in compensatory relief (including the claims that resulted in a 
settlement); and in the claims resulting in an arbitration award in 
favor of customers, customers were awarded approximately $9.9 
million in compensatory damages.
    \39\ Three of the CMAs were withdrawn, and two were approved. 
Three of the six customer claims were closed prior to the filing of 
the CMA, whereas the other three were still pending. For the two 
approved CMAs, the cases which resulted in an unpaid customer award 
closed at least one year after the decision was served. Five of the 
six customer awards went unpaid by a member firm, whereas the other 
went unpaid by an associated person. The total amount of damages 
that went unpaid is approximately $3.4 million. The member firms 
have either cancelled their membership or were expelled by FINRA, 
and the associated person has been suspended by FINRA.
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4. Economic Impact
    FINRA believes that the proposed amendments to the MAP rules would 
enhance the review of applications by strengthening the MAP rules in 
relation to pending arbitration claims and unpaid arbitration awards 
and settlements.
    The proposed amendments would benefit claimants and potential 
claimants by decreasing the risk that firms are avoiding the payment of 
awards or settlements by transferring their assets, including capital 
and customer accounts, to another firm. Firms can shift their assets to 
another firm by starting a new firm, or by selling or transferring 
assets to an existing firm. A decrease in the ability of firms to avoid 
satisfying their arbitration awards or settlements in this manner may 
result in a higher likelihood that they are paid in full in accordance 
with their terms. The proposed amendments could also benefit the 
current and future customers of new member applicants and member firms 
that seek a materiality consultation by increasing FINRA's ability to 
assess, among other things, the adequacy of the supervisory plan the 
member firm has in place for the associated persons who may have a 
history of non-compliance.
A. Rebuttable Presumption To Deny an NMA
    Proposed Rule 1014(b)(1) would specify that a presumption of denial 
would exist if a new member applicant or its associated persons are 
subject to a pending arbitration claim. By establishing a presumption 
of denial, the proposed rule change would shift the burden to the new 
member applicant to demonstrate how pending arbitration claims would be 
paid if they go to an award. Proposed Rule 1014(b)(1) would impose both 
direct and indirect costs on new member applicants.
    New member applicants with pending arbitration claims would incur 
direct costs. The costs include the time and expense of firm staff and 
outside experts to demonstrate the ability to satisfy the claims. The 
costs would be in addition to the costs new member applicants incur to 
demonstrate their ability to meet the 14 standards for admission under 
Rule 1014(a). In addition, new member applicants and their associated 
persons may incur the opportunity costs associated with setting aside 
funds that may otherwise be used for new business. A new member 
applicant may incur more opportunity costs than is necessary if it sets 
aside more capital than the actual amount of the award.
    New member applicants may also incur indirect costs if the rebuttal 
process delays the applicant's ability to begin earning revenues or 
otherwise negatively impacts the business. The magnitude of these costs 
is related to the ability of the new member applicant and FINRA to 
adequately gauge the likelihood and size of an award or settlement. 
However, as noted above, FINRA estimates that few associated persons 
related to new member applicants will have pending arbitration claims 
at the time of the filing.\40\ The majority of new member applicants 
are therefore unlikely to be affected by the proposed amendments.
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    \40\ See supra note 33 and accompanying text.
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B. Materiality Consultations
    The proposed amendments would also mandate a member firm to seek a 
materiality consultation for specified business changes--hiring an 
associated person involved in sales, or any direct or indirect 
acquisition or transfer of assets--where the member firm or associated 
person, as applicable, has an unpaid arbitration award or settlement 
related to an arbitration, or a defined covered pending arbitration 
claim, unless the member firm is otherwise required to file a CMA. 
FINRA believes that an unpaid arbitration award or settlement poses a 
severe risk to claimants that would warrant a materiality consultation 
under any circumstances. FINRA also believes that the proposed 
definition of a covered pending arbitration claim, which

[[Page 72095]]

focuses on investment-related, consumer-initiated claims (individually 
or, if there is more than one claim, in the aggregate) that exceed the 
excess net capital of the transferring or hiring member firm (as 
applicable), represents an objective benchmark that would provide FINRA 
the opportunity to review the specified business changes to assess 
whether they may adversely affect former, current or future customers 
in a material way.
    For a member firm transferring assets, FINRA believes that the 
relative size of covered pending arbitration claims may signal that the 
firm may be attempting to avoid the payment of awards or settlements by 
transferring assets, including capital and customer accounts, to 
another firm. For member firms adding one or more associated persons 
involved in sales, the relative size of the covered pending arbitration 
claims may foreshadow future potential misconduct by such individuals 
that could result in additional arbitration claims.\41\ Under such 
circumstances, if the customer names the hiring member firm in any such 
additional arbitration claims, FINRA is concerned whether a hiring 
member firm with low excess net capital would be able to satisfy any 
obligation that may result from the arbitration claims, including a 
customer award or settlement.
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    \41\ See supra note 22.
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    Member firms that would be required to seek a materiality 
consultation would incur direct costs. Similar to the additional direct 
costs associated with NMAs, the costs may include the time and expense 
of firm staff and outside experts to provide information and documents 
that demonstrate the ability to satisfy the unpaid awards or 
settlements, or covered pending arbitration claims. Member firms that 
would be required to seek a materiality consultation and their 
associated persons may also incur the opportunity costs associated with 
setting aside funds that may otherwise be used for new business.
    Member firms that seek a materiality consultation may also incur 
costs relating to a delay in effecting the contemplated expansion or 
transaction. A delay may negatively impact the value of the expansion 
or transaction and may lead to a loss of business opportunities. Given 
the experience of FINRA, this delay is anticipated to be small as the 
time for a materiality consultation has recently averaged 12 days; this 
time period, however, may lengthen depending on the complexity of the 
contemplated expansion or transaction.
    Business activities that decrease the amount of excess net capital 
available may increase the likelihood that member firms would be 
required to seek a materiality consultation. In response, member firms 
may constrain business activities to maintain a level of excess net 
capital in order to demonstrate their ability to pay pending 
arbitration claims (or pay unpaid awards or settlements) in the event a 
materiality consultation is required. As described in the Economic 
Baseline, a number of CMAs relate to the hiring of an associated person 
with a covered pending arbitration claim or the acquisition or transfer 
of a member's assets where the transferring member or an associated 
person of the transferring member had a covered pending arbitration 
claim.\42\
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    \42\ See the discussion in the Economic Baseline. Customers may 
have an incentive to file an arbitration claim for the sole purpose 
of disrupting a contemplated transaction. This incentive could 
increase the number of member firms that would be required to seek a 
materiality consultation and potentially file a CMA and incur the 
associated costs. FINRA has no reasonable basis on which to predict 
the frequency of this occurring if the proposed amendments are 
adopted. SIFMA suggested that the definition of a covered pending 
arbitration claim should be limited to claims filed prior to the 
public announcement of the contemplated transaction. FINRA would 
review customer claims as part of a materiality consultation and 
consider the facts and circumstances of the case as well as its 
timing. The potential disruption to contemplated transactions from 
these claims, therefore, is expected to be limited.
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    FINRA may require member firms that seek a materiality consultation 
to file a CMA. FINRA would then consider whether the member firm meets 
each of the 14 standards under Rule 1014. These members would therefore 
incur costs in addition to the costs to seek a materiality 
consultation. This includes the fees associated with a CMA, time of 
firm staff, and submission of additional documentation. The filing of a 
CMA would also cause an additional delay to effectuate the contemplated 
expansion or transaction. This may cause member firms, associated 
persons and the customers of member firms to lose the benefits 
associated with the business opportunities. A determination that a CMA 
must be filed, however, would indicate that the risks to claimants, and 
therefore the potential benefits of a closer examination, are high. An 
examination may include the regulatory history of a member to determine 
whether it is able to satisfy any pending arbitration claims should 
they go to award, as well as the adequacy of any supervisory plan for 
an individual with a pending arbitration claim that the firm is 
contemplating hiring.\43\ If the actual risks to claimants are low 
(e.g., the amount settled or eventually awarded is a small percentage 
of the amount claimed), then the greater costs to member firms to file 
a CMA would not also result in a similar increase in customer 
protections.
---------------------------------------------------------------------------

    \43\ Individuals with pending arbitration claims may engage in 
future potential misconduct that could result in additional 
arbitration claims, including claims that name the hiring member. 
See supra note 22.
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    The proposed amendments are not designed to impose disproportionate 
costs based on firm size. Instead, the costs the proposed amendments 
would impose are dependent on the compensatory loss amounts of pending 
customer arbitration claims, or the presence of an unpaid arbitration 
award or an unpaid settlement related to an arbitration, and the 
financial capacity of the member firm. In addition, the costs member 
firms may incur to seek a materiality consultation (and potentially 
file a CMA) as a result of the proposed amendments, including any 
burden on competition, are borne at their discretion, in their decision 
to hire or acquire or transfer the member's assets. Member firms would 
incur the additional costs if they choose to hire an associated person 
involved in sales who has a covered pending arbitration claim, or where 
the transferring member or an associated person of the transferring 
member has a covered pending arbitration claim.
    The member firms that would be required to seek a materiality 
consultation (and potentially file a CMA) as a result of the proposed 
amendments may range in size.\44\ For example, as described in the 
Economic Baseline, FINRA identified four member firms that filed a CMA 
relating to the hiring of an associated person with a covered pending 
arbitration claim. All four member firms were small.\45\ Similarly, 
FINRA identified 25 CMAs as relating to the asset acquisitions or 
transfers of 26 member firms where the transferring members had covered 
pending customer arbitration claims. Among the 26 transferring members, 
13 members were small, nine members

[[Page 72096]]

were mid-size, and four members were large.\46\
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    \44\ The definition of firm size is based on Article I of the 
FINRA By-Laws. A firm is defined as ``small'' if it has at least one 
and no more than 150 registered persons, ``mid-size'' if it has at 
least 151 and no more than 499 registered persons, and ``large'' if 
it has 500 or more registered persons.
    \45\ During the sample period and among all member firms, FINRA 
also identified 186 associated persons who were hired with a covered 
pending arbitration claim at the time of the hiring. See supra note 
37. The percentage of small member firms that hired the 186 
associated persons (90 percent) is similar to the proportion of 
small member firms industry-wide as of year-end 2017 (90 percent). 
See 2018 FINRA Industry Snapshot, https://www.finra.org/sites/default/files/2018_finra_industry_snapshot.pdf.
    \46\ As a result of the safe harbor provision, the member firms 
that would have been subject to the proposed amendments during the 
sample period may be different than the member firms that filed a 
CMA. The number and composition of member firms that would have been 
required to file a materiality consultation under the proposed rule 
change is therefore not known.
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    An associated person, as a respondent to a pending claim, may also 
incur costs as a result of the proposed amendments. New member 
applicants and existing member firms may be less likely to hire 
associated persons with a pending claim in order to avoid the costs 
associated with the proposed amendments. An associated person, as a 
respondent to a pending claim, may therefore experience fewer career 
opportunities within the brokerage industry.
C. Other Proposed Amendments
    Two other proposed amendments would have additional economic 
effects. First, the proposed amendments would require applicants to 
provide prompt notification of a pending arbitration claim that is 
filed, awarded, settled, or becomes unpaid before a decision on the 
application is served. These notifications would further improve the 
ability of FINRA to oversee and review the pending arbitrations of 
applicants to ensure that arbitration awards and settlements are paid 
in full in accordance with their terms. Applicants that provide 
notification would incur additional costs including the time of firm 
staff and the expense to submit additional documentation.
    A number of the applicants for new membership or member firms that 
filed a CMA during the sample period would have been required to 
promptly notify FINRA of changes to pending arbitration claims. FINRA 
identified 13 of the 317 NMAs (or four percent) from January 2015 
through December 2017 as having changes in the status of a pending 
arbitration claim involving the applicant or its associated persons 
before a decision constituting final action was served on the applicant 
(or the application was otherwise withdrawn),\47\ and 156 of the 1,051 
CMAs (or 15 percent) as also having similar changes to the status of a 
pending arbitration claim.\48\
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    \47\ The arbitration claims consisted of 11 customer claims and 
one intra-industry claim. Among the 11 customer claims, three 
resulted in a settlement, three closed by hearing, four were 
withdrawn, and one remained open. The total amount of compensatory 
damages sought by customers was $5.8 million (including the cases 
closed by settlement). In the cases closed by hearing, the customers 
were awarded compensatory damages of approximately $146,000. None of 
the awarded damages went unpaid.
    \48\ The arbitration claims consisted of 913 customer claims of 
which 497 resulted in a settlement, 184 closed by hearing or on the 
papers, 174 were closed by other means including 95 that were 
withdrawn, and 58 remained open. The total amount of compensatory 
damages sought by customers was $856.0 million. In the cases closed 
by hearing or on the papers, the customer was awarded compensatory 
damages of approximately $20.5 million. Two of the customer cases 
resulted in an award that went unpaid. One of the cases is referred 
to above in the discussion in the Economic Baseline. The other case 
relates to two associated persons who left the applicant before a 
decision constituting final action was served. The amount of the 
awarded damages that went unpaid is approximately $70,000. The 
associated persons who failed to pay the awarded damages have been 
suspended or barred by FINRA. The CMA was approved with 
restrictions. For applicants with changes to a pending arbitration 
claim before a decision constituting final action was served (or the 
application was otherwise withdrawn), the median number of changes 
is two.
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    Second, the proposed amendments would clarify the manner in which 
an applicant may demonstrate its ability to satisfy pending arbitration 
claims or unpaid arbitration awards or settlements. The clarification 
would improve the efficiency of the MAP process by increasing the 
ability of applicants to anticipate the information necessary to 
demonstrate their ability to satisfy outstanding obligations, and 
reduce the need for applicants to submit additional information after 
the initial filing.
5. Alternatives Considered
    FINRA considered a range of suggestions in developing the proposed 
amendments as set forth in Regulatory Notice 18-06. The proposed 
amendments reflect the changes that FINRA believes at this time to be 
the most appropriate for the reasons discussed herein.
    An alternative to the proposed amendments includes a rebuttable 
presumption of denial for a CMA if the applicant or its associated 
persons are the subject of a pending arbitration claim. This 
alternative would increase the costs to member firms that file a CMA, 
including member firms that initially sought a materiality consultation 
under the proposed amendments. Member firms may incur costs to 
demonstrate their ability to satisfy the claims. This includes the 
opportunity costs associated with setting aside funds that may 
otherwise be used for other business opportunities.
    A presumption of denial would reduce the risks associated with 
firms avoiding the payment of claims should they go to award. As part 
of a materiality consultation, however, FINRA would examine the 
regulatory history of a member firm to determine whether it is able to 
satisfy pending arbitration claims should they go to award, as well as 
the adequacy of any supervisory plan for an individual with a pending 
arbitration claim that the firm is contemplating hiring.\49\ The 
additional protections from extending a presumption of denial for 
pending arbitration claims to CMAs, therefore, may not justify the 
additional costs to member firms.\50\
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    \49\ See supra note 22.
    \50\ Several commenters suggested alternatives to the proposed 
amendments that would require a presumption of denial when pending 
arbitration claims exceed certain thresholds. See GSU, PIABA, and 
UNLV. Although member firms with pending arbitration claims that 
exceed the thresholds may be at higher risk of nonpayment, FINRA 
believes that it would still be able to adequately assess these 
firms' ability to pay the claims should they go to award without the 
presumption of denial.
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    Other alternatives to the proposed amendments include expanding or 
narrowing the conditions for member firms to seek a materiality 
consultation or file a CMA.\51\ Expanding (narrowing) the requirements 
for member firms to seek a materiality consultation or to file a CMA 
may decrease (increase) the ability of firms to avoid satisfying their 
outstanding obligations by transferring their assets to another firm. 
By expanding (narrowing) the requirements, however, additional (fewer) 
member firms would incur the associated costs. FINRA believes that the 
requirements under the proposed amendments for member firms to seek a 
materiality consultation provide for the additional investor 
protections but minimize the costs when the risk of members not 
satisfying their outstanding obligations is low.
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    \51\ For example, commenters suggested expanding the requirement 
to seek materiality consultations for business expansions. 
Suggestions include omitting the qualifying term ``involved in 
sales'' (NASAA) and expanding to principals, control persons, or 
officers (GSU). Another commenter, however, suggested excluding 
business expansions from the requirement to seek a materiality 
consultation if the expansion is in connection with another 
corporate event such as a merger, acquisition, or asset transfer 
(FSI). Commenters also suggested narrowing the requirement to seek 
materiality consultations for asset acquisitions or transfers. 
Suggestions include permitting smaller acquisitions or transfers to 
proceed without a materiality consultation (GSU) or excluding 
covered pending arbitration claims altogether (FSI).
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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 18-06 (February 2018) (``Notice''). FINRA received nine comment 
letters in response to the

[[Page 72097]]

Notice. A copy of the Notice is attached as Exhibit [sic] 2a. A list of 
the comment letters received in response to the Notice is attached as 
Exhibit [sic] 2b.\52\ Copies of the comment letters received in 
response to the Notice are attached as Exhibit [sic] 2c.
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    \52\ All references to commenters are to the comment letters as 
listed in Exhibit [sic] 2b.
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    Eight commenters supported the proposal as set forth in the Notice 
either absolutely or with some qualifications.\53\ One commenter raised 
concerns outside the scope of the Notice.\54\ A summary of the comments 
and FINRA's responses are discussed below.\55\
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    \53\ See Colorado, Cornell, GSU, FSI, NASAA, PIABA, SIFMA, and 
UNLV.
    \54\ See IBN.
    \55\ Comments that speak to the economic impacts of the proposed 
rule change are addressed in Item B above.
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1. Rebuttable Presumption to Deny an NMA
    FINRA is proposing to amend Standard 3 to create a rebuttable 
presumption to deny an NMA where the applicant or its associated person 
is subject to a pending arbitration claim. Three commenters expressly 
supported the proposed amendment.\56\ No commenters opposed this 
proposed amendment.
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    \56\ See SIFMA, Cornell, and GSU.
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2. Rebuttable Presumption to Deny a CMA
    In the Notice, FINRA requested comment on whether the presumption 
of denial in connection with a pending arbitration claim should be 
applied to a CMA as well. Six commenters responded with three 
expressing opposition to this approach.\57\ In general, these three 
commenters noted that a CMA already requires an applicant to provide 
information pertaining to pending arbitration claims and how an 
applicant will handle the arbitrations and the awards that may result. 
NASAA further expressed the belief that creating a presumption to deny 
a CMA may disincentivize a firm from taking on potential liability 
through an acquisition, which could result in more unpaid arbitration 
awards.
---------------------------------------------------------------------------

    \57\ See Cornell, NASAA, and SIFMA.
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    The other three commenters supported extending the presumption to 
deny an application with pending arbitration claims to a CMA but 
recommended various conditions on when the presumption should 
apply.\58\
---------------------------------------------------------------------------

    \58\ See GSU, PIABA, and UNLV.
---------------------------------------------------------------------------

    GSU recommended that the presumption to deny a CMA should be 
triggered when the applicant or its associated person has a pending 
arbitration claim or unpaid settlement for an amount exceeding $15,000, 
contending that such dollar limit would provide some balance to the 
proposed rule change by tying the presumption to CMAs with claims that 
are required to be reported to FINRA. PIABA recommended that two 
preconditions for the presumption to deny a CMA should apply--one for 
the associated person and the other for the member firm. With respect 
to the associated person, PIABA stated that the presumption to deny a 
CMA should be triggered when more than five claims are pending against 
any control person, principal, registered representative, or other 
associated person of the member, as such number of claims may signal 
problems within the member and may be an indicator of potential future 
investor harm. If the member can overcome the presumptive denial of a 
CMA, and it still desires to hire or continue the employment of 
individuals with five or more pending arbitration claims, PIABA 
recommended that those individuals with such claims pending against 
them should be subject to heightened supervision and not be permitted 
to serve in a supervisory capacity until all pending arbitration claims 
against them have in fact been resolved, and the corresponding awards 
or settlements, if any, have been paid in full. PIABA further stated 
that following the conclusion of such proceedings, the decision related 
to an individual's supervision or supervisory capacity should rest with 
the member, and recommended that FINRA's rules should be modified to 
ensure that such individual is not permitted to move from one firm to 
another without regard to problems that occurred at the former firm.
    As for the member firm, PIABA stated that the presumption should be 
applied based upon the aggregate amount of damages pleaded in all 
pending arbitration claims, taking the nature and quality of those 
claims into account, compared to the value of cash assets and insurance 
held by the member firm. If this ratio indicates a substantial risk of 
insolvency or presents the inability to pay all pending legitimate 
claims in full, then the presumption should apply. PIABA further stated 
that FINRA should be permitted to look beyond the damages described in 
a statement of claim, and discuss the issues related to damages 
directly with investors, their representative and FINRA members and 
their counsel, in confidential sessions, prior to applying a 
presumptive CMA denial. UNLV recommended that the presumption apply to 
a CMA where there is a covered pending arbitration claim.
    The existence of a specified regulatory history currently 
enumerated under Standard 3 that triggers the presumption to deny an 
application is intended to encourage compliance with unpaid arbitration 
awards, other unpaid adjudicated customer awards and unpaid arbitration 
settlements, and their existence raise the question of an applicant's 
capacity to comply with applicable securities laws and regulations, and 
with applicable FINRA rules.\59\ Standard 3, as proposed, would not 
diminish FINRA's ability to assess whether the applicant and its 
associated persons are able to meet this standard. FINRA would continue 
to consider an applicant's or its associated person's pending 
arbitration claims, among other regulatory history, in determining 
whether an applicant for continuing membership is ``capable of 
complying with'' the federal securities laws and FINRA rules. 
Accordingly, while FINRA appreciates the commenters' recommendations, 
FINRA has determined, at this time, not to apply the presumption of 
denial for pending arbitration claims to a CMA.
---------------------------------------------------------------------------

    \59\ See Rule 1014(a)(3)(C) (providing, in part, that a 
presumption of denial applies if the applicant, its control persons, 
principals, registered representatives, other associated persons, 
any lender of five percent or more of the applicant's net capital, 
and any other member with respect to which these persons were a 
control person or a five percent lender of its net capital is 
subject to unpaid arbitration awards, other adjudicated customer 
awards or unpaid arbitration settlements).
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3. Evidence of Ability to Satisfy Unpaid Arbitration Awards, Other 
Adjudicated Customer Awards, Unpaid Arbitration Settlements, or Pending 
Arbitration Claims
A. Types of Evidence
    Proposed IM-1014-1 would provide that an applicant may demonstrate, 
in a variety of ways, that it has the financial resources to satisfy an 
unpaid arbitration award, other adjudicated customer award, unpaid 
arbitration settlement, or a pending arbitration claim. Some examples 
include an escrow agreement, insurance coverage, a clearing deposit, a 
guarantee, a reserve fund, or the retention of proceeds from an asset 
transfer.
    With the exception of SIFMA, none of the commenters expressed views 
on the types of documentation an applicant may present to evidence the 
ability to satisfy an award, settlement or claim. SIFMA expressed 
concern about proposed IM-1014-1 requiring an

[[Page 72098]]

applicant to show proof of insurance coverage, asserting that having 
insurance coverage does not necessarily correspond to having the 
ability to pay the award, settlement or claim. FINRA notes that the 
supporting documentation listed in the proposed interpretive material 
are examples of what an applicant may produce to FINRA to evidence the 
ability to satisfy the award, settlement or claim, and is not intended 
to be an exhaustive list by which a member can show its financial 
resources.\60\
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    \60\ FINRA notes that similar examples appear in other FINRA 
rules. See, e.g., Section 4(i)(3) of Schedule A to the FINRA By-Laws 
(describing the circumstances under which a CMA for an acquisition 
or transfer of 25 percent or more of the member's assets may qualify 
for a fee waiver where the applicant can demonstrate in the CMA the 
ability to satisfy in full any unpaid customer-related claim (e.g., 
sufficient capital or escrow funds, proof of adequate insurance for 
customer related claims)). Form CMA also includes various examples. 
See supra note 12.
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B. Guarantee
    In the Notice, FINRA requested comment on whether an applicant, if 
it designates a clearing deposit or the proceeds from an asset transfer 
for purposes of showing the ability to satisfy a pending arbitration 
claim, should be required to provide some form of guarantee that such 
funds will be used to satisfy the award, settlement or claim. Three 
commenters expressed their general support for a guarantee,\61\ with 
two of these commenters making additional recommendations.\62\
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    \61\ See NASAA, PIABA, and UNLV.
    \62\ See NASAA and PIABA.
---------------------------------------------------------------------------

    Emphasizing the need to secure funds or to prevent them from being 
depleted for other purposes, PIABA recommended that applicants hold the 
funds in an escrow account with clear instructions to the third party 
escrow agent (unaffiliated with the member firm) to disburse the funds 
under specified circumstances.\63\ PIABA also suggested strict 
penalties in the event of a breach of that guarantee, such as the 
immediate suspension of a member's broker-dealer license. NASAA noted 
that circumstances sometimes change during the pendency of a planned 
business transaction and that an applicant may need to reallocate the 
prior designated funds. To account for potentially changing business 
circumstances and given the fungibility of money, NASAA stated that an 
applicant should not be duty bound to satisfy an arbitration award or 
settlement from the funds they may have initially identified. Instead, 
FINRA's rules should allow an applicant the flexibility to amend its 
application and designate a different source of available funds to 
satisfy pending claims or unpaid arbitration awards or settlements if 
necessary.
---------------------------------------------------------------------------

    \63\ PIABA's other recommendation was to have the guarantee 
secured by a lien in favor of FINRA or the investor.
---------------------------------------------------------------------------

    In light of the comments received, FINRA has modified proposed IM-
1014-1 to provide that to overcome the presumption to deny the 
application, the applicant must guarantee that any funds used to 
evidence the applicant's ability to satisfy any awards, settlements, or 
claims, will be used for that purpose. As proposed, IM-1014-1 would not 
preclude an applicant from designating a different source of funds to 
satisfy an award, settlement or claim, provided the source of funds is 
acceptable to FINRA. Moreover, Section 1(c) of Article IV of the FINRA 
By-Laws already requires an applicant to keep its application current 
by submitting supplementary amendments as necessary.\64\ A change in 
source of available funds to satisfy pending arbitration claims or 
unpaid arbitration awards or settlements would require the application 
to be updated in accordance with the FINRA By-Laws.
---------------------------------------------------------------------------

    \64\ See Section 1(c) of Article IV of the FINRA By-Laws.
---------------------------------------------------------------------------

C. Valuation of Claim Through Independent Legal Counsel
    Proposed IM-1014-1 would also permit an applicant to provide a 
written opinion of an independent, reputable U.S. licensed counsel 
knowledgeable as to the value of the arbitration claim in an effort to 
lend support to the applicant's ability to demonstrate that it has the 
financial resources to satisfy the claim, award or settlement. Two 
commenters suggested that the proposed provision should not require 
that counsel be ``independent.'' \65\ FSI stated that a firm should be 
able to rely on the opinion of in-house counsel as such counsel would 
be more familiar with the firm and its risk profile, adding that 
obtaining an opinion from external legal counsel could be costly and 
would not increase the regulatory value of the opinion offered. NASAA 
stated that it did not believe that the expert opinion necessarily 
needed to be from an ``independent'' source and instead, FINRA should 
have the authority to assess the veracity and reasonableness of an 
offered expert opinion on a case-by-case basis and to require such 
qualifications and degree of independence from the applicant as FINRA 
reasonably believes warranted in each instance. In addition, NASAA 
recommended that proposed IM-1014-1 should compel an applicant to 
obtain a written opinion of a legal or financial expert to support the 
applicant's assertion that it can satisfy an unpaid award or settlement 
obligation it intends to assume, rather than giving the applicant the 
discretion to provide such opinion.
---------------------------------------------------------------------------

    \65\ See FSI and NASAA.
---------------------------------------------------------------------------

    FINRA believes that it would be appropriate and consistent with 
current FINRA Rules to provide a member with the option to derive 
support for the valuation of an arbitration claim through a legal 
opinion from an independent, reputable U.S. licensed counsel 
knowledgeable as to the value of such arbitration claim.\66\
---------------------------------------------------------------------------

    \66\ See, e.g., FINRA Rule 2040 (Payments to Unregistered 
Persons) (providing in supplementary material that a member, if 
uncertain about whether an unregistered person may be required to be 
registered under SEA Section 15(a), can derive support from the 
member's determination by, among other things, a legal opinion from 
independent, reputable U.S. licensed counsel knowledgeable in the 
area).
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4. Materiality Consultations
A. The Process
    Proposed IM-1011-2 and proposed Rule 1017(a)(6) would require a 
member to seek a materiality consultation under specified 
circumstances. FSI, while not expressly opposed to the underlying 
concept of mandating materiality consultations, stated that the 
proposed rules do not set forth clear parameters around the process, 
such as the time in which FINRA must issue a decision and the remedy a 
member firm has if it does not agree with FINRA's decision on the 
materiality consultation. FINRA notes that the materiality consultation 
process is well established, and a description of the process and the 
information that should be included in a request for a materiality 
consultation, among other information, is detailed on FINRA.org.\67\ In 
addition, FINRA notes that if this proposed rule change is approved by 
the Commission, FINRA will update the materiality consultation process 
as detailed on its website as necessary.
---------------------------------------------------------------------------

    \67\ See supra note 14 and accompanying text.
---------------------------------------------------------------------------

B. Mandatory Materiality Consultation for Business Expansion To Add One 
or More Associated Persons Involved in Sales With Covered Pending 
Arbitration Claims
    As set forth in the Notice, proposed IM-1011-2 would require a 
member to seek a materiality consultation before effecting a business 
expansion that would involve adding one or more associated persons 
involved in sales with a covered pending arbitration claim, unpaid 
arbitration award, or unpaid settlement related to an

[[Page 72099]]

arbitration.\68\ Thus, a member would not be permitted to effect the 
contemplated business expansion until FINRA determined whether or not a 
CMA would be required for such contemplated business expansion.
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    \68\ FINRA notes that the term, ``associated person involved in 
sales'' as used in proposed IM-1011-2 and proposed Rule 
1017(a)(6)(B) is derived from the safe harbor provision under IM-
1011-1.
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    Four commenters expressed support for this proposed 
requirement,\69\ with some commenters suggesting modifications. For 
example, NASAA recommended omitting the qualifying term ``involved in 
sales'' so that the proposed rule would apply to any associated person, 
irrespective of the nature of his or her employment at the member firm, 
who is subject to a claim, award or settlement, explaining that firms 
may assign an associated person with pending claims or unpaid awards to 
administrative, non-sales roles in order to circumvent a materiality 
consultation. GSU suggested that proposed IM-1011-2 should be expanded 
to apply to principals, control persons or officers as occasionally, 
associated persons from problematic firms may move on to become 
officers at larger firms.\70\ If a materiality consultation results in 
the requirement to file a CMA, Cornell recommended that proposed IM-
1011-2 should require the member to file the CMA within a specified 
timeframe (e.g., 30 days after FINRA's finding of materiality).\71\
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    \69\ See SIFMA, NASAA, GSU, and Cornell.
    \70\ FINRA notes that the proposed amendments relating to 
requiring a materiality consultation for asset acquisitions or 
transfers would apply to principals, control persons or officers 
with covered pending arbitration claims, unpaid arbitration awards, 
or unpaid arbitration settlements moving between firms.
    \71\ FINRA does not believe that it is necessary to require the 
applicant to file the CMA within a specified time period because if 
a CMA is required, the applicant would not be able to effect the 
transaction without FINRA's approval of the CMA and, therefore, 
FINRA believes the applicant would be incentivized to file the CMA 
for approval as soon as possible.
---------------------------------------------------------------------------

    FSI raised a concern that proposed IM-1011-2 could require a member 
to undergo a materiality consultation to add a single registered person 
with a pending arbitration claim. FSI recommended that proposed IM-
1011-2 should exclude such a business expansion when adding associated 
persons involved in sales to a member's roster if done in connection 
with another corporate event such as a merger, acquisition, asset 
transfer or some other business expansion. FSI also recommended that 
the proposed rule exclude pending arbitration claims, explaining that a 
member should not be potentially compelled to undergo an application 
review process so that FINRA can assess the member's decision to hire 
one registered person with a pending arbitration claim, particularly 
when the claim is unsubstantiated. FSI noted that the proposed 
provision would have a negative impact on a member's recruiting efforts 
by overreaching into a member's routine hiring decisions.
    As noted above, proposed IM-1011-2 is intended to address 
situations in which a member wants to hire an associated person who 
engages in sales with the public and has a covered pending arbitration 
claim, unpaid arbitration award, or unpaid settlement related to an 
arbitration and, therefore, may have a history of noncompliance. In the 
Notice, proposed IM-1011-2 also included a description of the possible 
outcomes of FINRA's determination on a materiality consultation; that 
is, either a member firm would not be required to file a CMA in 
accordance with Rule 1017 and may effect the contemplated business 
expansion or the member must file a CMA in accordance with Rule 1017 
and would not be permitted to effect the contemplated business 
expansion without FINRA's approval of the CMA.
    For clarity, FINRA has modified the language in proposed IM-1011-2 
in two ways. First, proposed IM-1011-2 expressly states that the safe 
harbor for business expansions in IM-1011-1 is not available if a 
member firm is seeking to add one or more associated persons involved 
in sales with a covered pending arbitration claim (as defined in 
proposed Rule 1011(c)(1)), unpaid arbitration award, or unpaid 
settlement related to an arbitration. Second, proposed IM-1011-2, as 
modified, directs member firms to proposed Rule 1017(a)(6)(B) under 
which the description of the possible outcomes of FINRA's determination 
on a materiality consultation now resides. Proposed IM-1011-2, as 
modified, and proposed Rule 1017(a)(6)(B) are intended to clarify that 
a member firm, before it considers hiring one or more associated 
persons involved in sales with a covered pending arbitration claim (as 
defined in proposed Rule 1011(c)(1)), unpaid arbitration award, or 
unpaid settlement related to an arbitration, must first seek a 
materiality consultation from FINRA.
    Requiring a materiality consultation in this situation would give 
FINRA the opportunity to assess, among other things, the adequacy of 
any supervisory plan the member firm has in place for the individual, 
and to discuss with the member firm the potential impact on its 
finances if the member firm hires the individual and the individual 
engages in future potential misconduct while employed at the member 
firm that results in an arbitration claim against the member firm. 
FINRA notes that, in general, materiality consultations are not lengthy 
processes, taking on average 12 days.
    In addition, FINRA notes that with respect to pending arbitration 
claims, a materiality consultation would only be required if those 
claims individually or in the aggregate are substantial, i.e., exceed 
the hiring firm's excess net capital. As described above, mandating a 
materiality consultation where a member is seeking to increase the 
number of associated persons involved in sales with covered pending 
arbitration claims, unpaid arbitration awards or unpaid settlements is 
to provide FINRA the opportunity to assess the relevant facts and 
circumstances of hiring such individuals and the impact, if any, on the 
member's supervisory and compliance structure, among other 
considerations.
C. Mandatory Materiality Consultation for Any Acquisition or Transfer 
of Member's Assets (Proposed Rule 1017(a)(6)(A))
    Proposed Rule 1017(a)(6)(A) would require a member to seek a 
materiality consultation before effecting any direct or indirect 
acquisition or transfer of a member's assets or any asset, business or 
line of operation where the transferring member or an associated person 
of the transferring member has a covered pending arbitration claim, 
unpaid arbitration award, or unpaid settlement related to an 
arbitration.\72\ The proposed rule would require a member to wait for 
FINRA's determination on whether or not a CMA would be required for the 
contemplated acquisition or transfer.
---------------------------------------------------------------------------

    \72\ In the Notice, this provision previously appeared as 
proposed paragraph (a)(4) in Rule 1017. The proposed rule change 
would renumber this provision as paragraph (a)(6)(A) in Rule 1017.
---------------------------------------------------------------------------

    Several commenters supported proposed Rule 1017(a)(6)(A) either 
unequivocally or with a minor qualification.\73\ GSU expressed its 
support for the proposed provision insofar as it would prevent a member 
from acquiring or transferring a large amount of assets without first 
undergoing a materiality consultation in situations involving covered 
pending arbitration claims, unpaid arbitration awards or settlements, 
but recommended that smaller acquisitions or transfers involving such 
claims, awards or settlements should be

[[Page 72100]]

permitted to proceed without a materiality consultation or CMA. 
Specifically, GSU recommended that FINRA should set a threshold of 10 
percent, explaining that this threshold would allow the ``occasional 
transfer'' of customer accounts from one firm to another, but not allow 
an associated person to move a ``meaningful percentage of his accounts 
to another firm.''
---------------------------------------------------------------------------

    \73\ See, e.g., Cornell, GSU, NASAA, and SIFMA.
---------------------------------------------------------------------------

    FSI stated that proposed Rule 1017(a)(6)(A) should exclude covered 
pending arbitration claims, noting that asset transfers that do not 
require a CMA under the current MAP rules should not be required to 
undergo a materiality consultation solely because the member or its 
associated person has a pending arbitration claim. FSI stated that 
proposed Rule 1017(a)(6)(A) could be interpreted as requiring a member 
that transfers any asset, no matter how immaterial, to undergo a 
materiality consultation and then potentially, a CMA, where the member 
or any of its associated persons may be subject to unsubstantiated, 
pending, investor arbitration claims.
    While FINRA appreciates the commenters' recommendation and 
concerns, FINRA has determined not to modify the proposal. As noted 
above, FINRA believes that the definition of a covered pending 
arbitration claim is sufficiently narrowly tailored to limit the extent 
to which a member would have to seek a materiality consultation, but 
would also capture those transactions that could result in investors 
not being paid should the claims go to award.
    In the Notice, FINRA requested comment on whether proposed Rule 
1017(a)(6)(A) should be limited to asset acquisitions or transfers 
involving a principal, control person or officer who has a covered 
pending arbitration claim, unpaid arbitration award, or unpaid 
arbitration settlement. Two commenters responded, opposing such 
limitation because it may provide an opportunity for circumvention.\74\ 
NASAA stated that narrowing the scope of the proposed provision could 
allow a member to make staffing changes by temporarily shifting its 
principals, control persons or officers into administrative or other 
positions that fall outside the proposed provision. PIABA stated that a 
member's solvency may be jeopardized by an associated person who is not 
a principal, control person or officer, but who may be engaged in 
selling away activities or ``running a large scheme'' without the 
member's knowledge.
---------------------------------------------------------------------------

    \74\ See NASAA and PIABA.
---------------------------------------------------------------------------

    FINRA has determined not to limit proposed Rule 1017(a)(6)(A) to 
asset acquisitions or transfers involving principals, control persons 
or officers. FINRA believes that to help further address the issue of 
unpaid arbitration awards, the proposal should apply more broadly.
D. Definition of ``Covered Pending Arbitration Claim''
    The Notice defined the term ``covered pending arbitration claim'' 
for business expansions, and asset acquisitions and transfers as: (1) 
An investment-related, consumer-initiated claim filed against the 
associated person (for business expansions), or filed against the 
transferring member or its associated persons (for asset acquisitions 
and transfers) that is unresolved; and (2) whose claim amount 
(individually or, if there is more than one claim, in the aggregate) 
exceeds the member's excess net capital. Under both circumstances, the 
definition provided that such claim amount would include only claimed 
compensatory loss amounts, not requests for pain and suffering, 
punitive damages or attorney's fees.
    Two commenters discussed this definition.\75\ FSI stated that the 
nexus between an associated person's pending arbitration claim and a 
firm's excess net capital is unclear as the firm at which the 
misconduct occurred would be the one to cover the claim, not the firm 
that is obligated to file the materiality consultation. NASAA 
recommended that the definition should expressly state that it includes 
all investment-related arbitration claims filed in any arbitration 
forum (e.g., FINRA arbitration forum, a private alternative dispute 
resolution forum) or judicial (state or federal) forum). In addition, 
NASAA stated that the ``claim amount'' was unclear as to its treatment 
of pending claims for which there may be joint liability between more 
than one person or for which an associated person reasonably expects to 
be indemnified, explaining that pending claims with joint liability 
should be assessed to each respondent maximally, as if no other person 
could be potentially liable.
---------------------------------------------------------------------------

    \75\ See FSI and NASAA.
---------------------------------------------------------------------------

    In response to comments, FINRA has modified the definition to 
clarify that a covered pending arbitration claim would include those 
filed in any arbitration forum, and that a pending claim with joint 
liability would be assessed to each respondent, as if no other person 
could be potentially liable. In addition, FINRA emphasizes that the 
definition would be applied only for purposes of determining whether a 
materiality consultation would be required or not. The term is not 
intended to speak to whether the member would be responsible for 
satisfying the covered pending arbitration claim.
    In the Notice, FINRA requested comment on whether the definition of 
``covered pending arbitration claim'' should be limited to claims filed 
prior to a specified time period or event such as a public announcement 
of the contemplated transaction. Two commenters addressed this 
question.\76\ SIFMA stated that the definition should include only 
those pending arbitration claims filed prior to public announcement of 
the contemplated transaction. PIABA stated that the definition should 
be broad and not be limited to claims filed prior to a specific date, 
but if a date is specified, then FINRA should require that any funds 
received in consideration for the transaction be frozen or subject to a 
lien in favor of the investor, pending the resolution of all pending 
arbitration claims filed within a certain period following the 
transaction closing.
---------------------------------------------------------------------------

    \76\ See PIABA and SIFMA.
---------------------------------------------------------------------------

    FINRA has determined not to limit the proposed definition to only 
those claims filed prior to a specified date. At this time, FINRA 
believes that the definition of a covered pending arbitration claim is 
sufficiently narrowly tailored without adding a time limitation 
relating to when the arbitration claims are filed.
5. Written Notification of Any Pending Arbitration Claim That Is Filed, 
Awarded, Settled or Becomes Unpaid Before Final Action Is Served on 
Applicant
    FINRA is proposing to add a new provision to the application review 
process to require an applicant to provide prompt notification, in 
writing, of any pending arbitration claim that is filed, awarded, 
settled or becomes unpaid before a decision constituting final action 
of FINRA is served on the applicant. Two commenters expressed their 
views on proposed Rules 1013(c) and 1017(h).\77\
---------------------------------------------------------------------------

    \77\ See Cornell and NASAA.
---------------------------------------------------------------------------

    Cornell noted that the proposed provisions would enhance FINRA's 
ability to monitor when pending arbitration claims are filed or when 
awards become unpaid during the application review process. NASAA 
recommended moving the language from proposed Rule 1013(c) to Rule 
1013(a)(1)(H), which currently provides that an NMA must include

[[Page 72101]]

documentation of disciplinary history and certain regulatory, civil, 
and criminal actions, arbitrations, and customer complaints for the 
applicant and its associated persons, unless such history has been 
reported to the Central Registration Depository (CRD[supreg]). At this 
time, FINRA intends to retain the language as a standalone provision 
under proposed Rule 1013(c) to maintain clear parity with the language 
appearing under proposed Rule 1017(h). However, FINRA will consider 
NASAA's recommendation in connection with its separate proposal to 
substantially restructure the MAP rules.\78\
---------------------------------------------------------------------------

    \78\ See Notice 18-23.
---------------------------------------------------------------------------

6. Other Comments
    UNLV recommended that FINRA consider proposing a rule to protect 
investors when FINRA members try to convert themselves into another 
area of the securities industry while facing covered pending 
arbitration claims or outstanding unpaid arbitration awards. IBN 
expressed the view that ``[a]rbitration has nothing to do with the law 
it is about feelings[,]'' suggesting that there needs to be two sets of 
rulebooks, one for small firms and the other for large firms. While 
FINRA acknowledges the commenters' concerns, their recommendations are 
beyond the scope of this proposed rulemaking and, therefore, FINRA has 
not addressed them here.

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-2019-030 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.

All submissions should refer to File Number SR-FINRA-2019-030. This 
file number should be included on the subject line if email is used. To 
help the 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-2019-030 and should be submitted 
on or before January 21, 2020.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\79\
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    \79\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2019-28021 Filed 12-27-19; 8:45 am]
BILLING CODE 8011-01-P