FINRA's Restricted Firm Rule: Two SEC Commissioners Toast the Sinking of the Titanic

August 2, 2021

At first blush, it's nothing more than a published statement under the signatures of SEC Commissioners Allison Herren Lee and Caroline A. Crenshaw. SEC Commissioners publish many statements during a given year. Sometimes they criticize a particular action by the Commission, sometimes they voice their support, and other times, well, you know, the spirits moves them to comment and they do. Rather than spin the Commissioners' Statement, let me publish it verbatim:

Today, the Commission approved FINRA's proposed rule change to, among other things, impose additional obligations on FINRA member firms with a significant history of misconduct, as well as those firms that employ individual brokers with such histories (collectively "high risk firms").[1]  We appreciate FINRA's attention to these high risk firms because they raise important investor protection concerns.  We were pleased to see FINRA's commitment to working with state securities regulators to share information regarding these firms.[2]  We are also pleased that FINRA's Board recently approved a plan for a separate filing to disclose the identities of high risk firms to the public, which it expects to file promptly.[3]  A firm's high-risk status is important information and will help investors make informed choices about the firms they select.  We intend to monitor this important investor protection issue and will evaluate whether additional steps may be needed to address recidivist firms and brokers. 

= = = = =
[1]  See Securities Exchange Act Release No. 92525 (July 30, 2021) (order approving SR-FINRA-2020-041).

[2]  See Letter from Michael Garawski, Associate General Counsel, FINRA, to Vanessa A. Countryman, Secretary, Commission, dated July 20, 2021, at 3.

[3]  See id. at 2-3.

The Restricted Firm Release

Prompting the Commissioners' Statement is this SEC Release: Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving a Proposed Rule Change, as Modified by Amendment No. 1 and Amendment No. 2, to Adopt FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111)
(Release No. 34-92525; File No. SR-FINRA-2020-041 / July 30, 2021) (herein the "Restricted Firm Release") 

As set forth in the "Introduction" to the 75-page Restricted Firm Release [Ed: footnotes omitted]:

On November 16, 2020, Financial Industry Regulatory Authority, Inc. ("FINRA") filed with the Securities and Exchange Commission ("SEC" or "Commission"), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 19b-4 thereunder,  a proposed rule change to amend FINRA's rules to help further address the issue of associated persons with a significant history of misconduct and the broker-dealers that employ them. 

at Page 1 of the Restricted Firm Release

As more fully explained in the "Background" portion of the Restricted Firm Release [Ed: footnotes omitted]:

FINRA's proposed rule change would adopt a new Rule 4111 to address the risks that can be posed to investors by broker-dealers and their associated persons with a history of misconduct. The proposal would impose new obligations on broker-dealers with significantly higher levels of risk-related disclosures (including, notably, sales-practice related disclosure events) than other similarly sized peers based on numeric, threshold-based criteria.  

Specifically, FINRA is proposing to adopt FINRA Rule 4111 (Restricted Firm Obligations) to require member firms that are identified as "Restricted Firms" to deposit cash or qualified securities in a segregated account, adhere to specified conditions or restrictions, or comply with a combination of such obligations. FINRA is also proposing to adopt FINRA Rule 9561 (Procedures for Regulating Activities) and amend FINRA Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series), to create a new expedited proceeding to implement proposed Rule 4111. In particular, the proposed rule change would establish a process to give a Restricted Firm an opportunity to challenge the designation and the resulting obligations of that designation, as well as give the firm a one-time opportunity to avoid the imposition of obligations by voluntarily reducing its workforce.

The proposed rule change is designed to protect investors and the public interest by strengthening tools available to FINRA to address the risks posed by member firms with a significant history of misconduct, including firms with a high concentration of individuals with a significant history of misconduct. The proposed rule should create incentives for firms to change behaviors and activities, either to avoid being designated as a Restricted Firm or lose an existing Restricted Firm designation, to mitigate FINRA's concerns.

This proposal is designed to address persistent compliance issues that arise at some FINRA member firms that generally do not carry out their supervisory obligations to achieve compliance with applicable securities laws and regulations and FINRA rules, and act in ways that could harm their customers and erode confidence in the brokerage industry. According to FINRA, recent academic studies have found that some firms persistently employ registered representatives who engage in misconduct, and that misconduct can be concentrated at these firms. FINRA states that these studies also provide evidence that the past disciplinary history and other regulatory events associated with a firm or individual can be predictive of future events. While these firms may eventually be forced out of the industry through FINRA action or otherwise, FINRA observed that these compliance issues include a persistent, if limited, population of firms with a history of misconduct that may not be acting appropriately as a first line of defense to prevent customer harm.

at Pages 3 - 5 of the Restricted Firm Release

Bill Singer's Wall Street Reform Advocacy

My record of advocating Wall Street Reform is a matter of public record, and my decades of hectoring Wall Street's regulators to think outside the box and to adopt a more pre-emptive protocol is well documented. See, for example, "Wall Street Critic Bill Singer Revisits His 2009 Reform Proposals" (Broke Blog / April 22, 2016) As I noted in part in my 2009 musings at

Wall Street Point System

Way back in 1996, I suggested in a Dow Jones News Service article, "Lawyer Proposes Disciplinary Point System for Brokers," that Wall Street implement a "point system" whereby stockbrokers would be rated on a scale similar to that used in many states for wayward motorists. For each class of infraction, a Financial Service Professional would earn X points. If an FSP accumulates a given number of points within a defined period of time, certain sanctions would automatically be imposed; e.g., he or she would be required to take remedial classes or he'd have his license suspended or registration revoked.

Coming up with the point system and the grid indicating what earns what may be daunting, but it's not rocket science, and I am confident it can be accomplished. Given that we utilize such a system for drivers in all states, it's not as if my proposal is a radical solution. I'm sure if you gave me an empty room and let me pick some regulators, public investor advocates and industry advocates, we would be able to propose a fair system.

Note that I am not suggesting this point system in lieu of the extensive enforcement and disciplinary rules already on the books of federal, state and self-regulators. I propose that we augment that enforcement and disciplinary system by creating a more simplified early warning system. Moreover, I am urging the implementation of the point system so investors will have an easy means of determining the caliber of the firm and FSP they are dealing with.

In addition to using the point system to better notify customers of the compliance history of their potential broker-dealer (BD) and servicing FSP, I would also use the points to create an additional revenue stream to enhance regulation. For each accumulated point during a 24-month period, a broker-dealer and an FSP should be required to pay a given annual assessment into a fund with its primary purpose as source of a guaranty of an financial award rendered in arbitration or court to any defrauded investor, provided that the prevailing investor demonstrates the inability to collect any compensatory awards against a broker-dealer or FSP.

An indirect benefit of the annual fees per point would be to provide a financial disincentive for a BD to hire or retain FSPs with voluminous points, as such points add to the financial burden upon the BD's own point score.

I would then mandate that the 24-month industry average point score for all similarly situated firms and FSPs be calculated monthly. I would require that such industry averages be prominently posted on the uniform account documents I proposed above, and that the current score for the servicing financial services firm and the FSP be displayed alongside.

I can't think of any data that would be more dramatic on a daily trade confirmation or account statement, than, say, the presentation of a regulatory point system with 0 indicating no issues and 100 indicating disaster. Imagine the impact on a consumer of the stark disclosure that the average firm's regulatory point rating for the past 24 months is 21 on scale of 100, and the average FSP's rating is 32 on a scale of 100, but your broker-dealer's number is 87 and your FSP's is 92. What could be simpler and more effective? 

For extra measure, I would require immediately adjacent to the point system disclosure the display of the direct phone number and e-mail address for the compliance officer overseeing your servicing FSP, along with the direct phone number and e-mail address for all state and federal regulators overseeing your servicing broker-dealer and FSP.

Note that I first proposed the above point-system proposal in 1996, some 25 years ago. With all due respect to Commissioners Lee and Crenshaw, both of whom I admire and respect, you should not be pleased by FINRA's belated and fairly tepid reforms. So-called "high risk firms" did not spring up last night. Given that the Commissioners' Statement asserts that they "will evaluate whether additional steps may be needed to address recidivist firms and brokers," they too acknowledge that recidivism is indicative of a history of misconduct rather than something new. Frankly, recidivist misconduct has plagued Wall Street for as long as that street has existed. Moreover, FINRA's (and its predecessor the NASD's) rulebook have never lacked the authorization to go after high risk firms or employees. The failure is inbred into the very concept of self regulation. 

SEC Chair Levitt's 1996 Condemnation

As former SEC Chair Arthur Levitt so famously noted in "Statement by Chairman Arthur Levitt / U.S. Securities and Exchange Commission Press Conference Regarding the NASD / Washington, DC / August 8, 1996"

Our securities markets operate under a "self-regulatory" system.  Markets serve an important public interest, and deserve public oversight; but markets are also innovative and fast-moving, and easily stifled by the heavy hand of government. 

So Congress arrived at a formula in which the industry polices itself, with SEC oversight. This keeps us out of most day-to-day affairs, and allows us to keep our hands off, but our eyes open.  And on those rare occasions when self-regulation goes off track, the SEC must act in the public interest.

This is one of those occasions.  

I will state it simply and up front. We have found a widespread course of conduct among market makers to coordinate their quotes. Investors paid too much, and received too little , when they bought and sold stock on Nasdaq. New traders were, as a matter of course, trained in this fashion. Over time, this practice became the expected standard. In some instances, those who did not comply were harassed and penalized, even if they had acted in the best interest of investors. 

This culture of collaboration subverted the price mechanism and curtailed competition. It raised the cost of capital and undermined market efficiency. It hurt investors and damaged the reputation of Nasdaq. 

Where was the NASD, the cop on the Nasdaq beat? 

The NASD was not blind to these practices in the marketplace. It simply looked the other way. 

As the issue of the pricing convention was brought to the attention of the NASD, as the press and others raised it with increasing frequency, the NASD sounded no alarm; it conducted no investigation. 

Nor was the pricing convention the only unacceptable practice. The NASD failed to ensure the accuracy and fairness of quotation and transaction information -- the backbone of securities trading. It failed to apply certain rules to its members, and selectively enforced rules against others. The NASD allowed the interests of large marketmaking firms to have undue influence over the conduct of its affairs and the regulation of its market. 

The evidence -- gathered from hundreds of witnesses, thousands of hours of tapes, and more than a million pages of documents -- shows that the NASD did not fulfill its most basic responsibilities -- and I quote from its charter: to promote just and equitable principles of trade for the protection of investors. On the contrary, American investors were hurt -- large and small, sophisticated and inexperienced, institutional and individual -- all were hurt by these practices. 

Nor has the SEC emerged unscathed. To the extent these practices took place on our watch, we should have acted sooner. We, as well as the NASD, need to be faster and more vigilant, to assure that the public interest is protected. . . .

I would urge Commissioners Lee and Crenshaw to re-visit Chair Levitt's remarks, which retain their potency and relevancy some 25 years later. Self regulation has failed in the past. I submit that it is an ongoing failure. I believe that the "culture of collaboration" that subverted the markets over a quarter of a century ago was never fully eradicated. That culture exists but is now more concentrated, more powerful. Just as NASD failed by allowing the "interests of large marketmaking firms to have undue influence over the conduct of its affairs and the regulation of its market," I believe that in 2021, FINRA continues to protect the interests of its Large Member Firms to the disadvantage of smaller firms, the industry's employees, and the investing public. By pretending otherwise, the SEC does not emerge unscathed and takes on the role of a collaborator itself.

Nothing Wrong But Nothing Right

What then is the problem with the Restricted Firm Rule?  For starters, nothing. In theory, the Rule is spot-on and sensible. I want you to re-read those first two sentences in this paragraph. I want to ensure that you don't misunderstand my criticism here and that you don't set me up as a strawman or punching bag. The issue is not with FINRA's Restricted Firm Rule per se -- the issue is with how the Rule will be applied and implemented.  

For decades, NASD and then FINRA have cozied up to the once-powerful market makers and, more recently, to what was once called a "wirehouse" but is now purportedly a "financial services company." Call it what you want. We're talking about a cluster of economic power and a consolidation of political influence that commands the waves to stop. And at FINRA, those waves do, indeed, stop. 

My expectation -- my fear -- is that FINRA will not fully apply the Restricted Firm Rule but will only focus on the usual suspects: The heirs to the sordid traditions of boiler-rooms and pennystock hustlers. What will not blip on FINRA's Restricted Firm radar are its Large Member Firms -- the newfangled financial services companies. No, those firms will never be deemed to to have a qualifying "history of misconduct." 

Deus Ex Machina

Those who sit in the cushy C-Suites at FINRA's Large Member Firms are rarely the subject of any FINRA regulatory Complaint in contradistinction to the smaller firms and their management/owners. Similarly, as we have seen time and time again, when Large Member Firms run afoul of the laws and the industry's rules, well, you know, gee, how nice, they get credit from FINRA and the SEC for "self reporting." Moreover, when the regulatory investigations conclude and the settlements are finalized, the Large Member Firms always get credit for extending so-called "extraordinary cooperation" to the investigating staff. Brings a tear to your eyes, no? Ultimately, whenever a Large Member Firm goes astray, its core regulatory misconduct becomes detached from the hands, hearts, and minds of any human being and is magically transformed into some institutional failure devoid of any named human being's efforts -- other than for the sacrificial lambs who are always offered up to the regulators by the larger firms. For small firms, there is no deus ex machina concession. At small firms, everyone is a crook, a fraudster, a scamster, and any cooperation afforded to Staff is never quite extraordinary. 

The Federal Reserve's 2018 Sanctions of Wells Fargo

Consider Wells Fargo's recent history of engaging in horrific consumer abuse that was so outrageous as to prompt the Federal Reserve Board to impose historic sanctions on the company in 2018;  see, "Historic Federal Reserve Restrictions On Wells Fargo" ( Blog /  February 5, 2018) In case you forgot how the Fed lambasted Wells Fargo, here's a bit of the spirit:

Responding to recent and widespread consumer abuses and other compliance breakdowns by Wells Fargo, the Federal Reserve Board on Friday announced that it would restrict the growth of the firm until it sufficiently improves its governance and controls. Concurrently with the Board's action, Wells Fargo will replace three current board members by April and a fourth board member by the end of the year.  You think that FINRA will deem Wells Fargo a Restricted Firm? Don't hold your breath! As to FINRA's complicity in fostering compromised regulation, the regulator could easily deflect my criticism by showing me the C-Suiters at Wells Fargo who FINRA suspended and fined for their roles in the abuses cited in the Federal Reserve action or in FINRA's 2020 variable annuity AWC. 

The Maximum Restricted Deposit Requirement

As to the Maximum Restricted Deposit Requirement contemplated by the Restricted Firm Rule, that pretty much underscores my argument as to why the "fix" is in when it comes to FINRA's proposal. For a large, multinational, publicly-traded financial services firm, such a deposit will likely prove of no consequence. The funds are not coming out of the Chief Executive Officer's or the Chair's personal pockets. The funds are going to come out of the pockets of public investors. As to small firms, such a restriction will more likely hit 'em where it hurts.  Smaller, mom-and-pop firms feel pain. There will be no pain felt at a large institution because financial services firms do not feel anything.

Small Firm Demise

Ultimately, look at the numbers. FINRA's Small Member Firms have dramatically dwindled over the years.  As set forth on Page 12 of the "2021 FINRA Industry Snapshot" at , in 2016 there were 3,462 Small Member Firms but by 2020, there were 3,079 (an 11% loss in four years) -- and the report does not calculate the likely 2021 devastation of the Covid pandemic. As I have long argued and will persist, NASD and now FINRA have socially engineered small firms out of the industry. This goal has been furthered by rising compliance costs, one-size-fits-all regulation, and the overall decline in the profitability of the FINRA broker-dealer model, which is heavily dependent upon commissions and market making fees. Further, FINRA's lackluster Board of Governors remains complicit in this effort because those who promised to speak out, do not; and those who should speak out, keep their silence.

I do not lament the likely demise of the FINRA broker-dealer model. In large part, the broker-dealer construct is victim of changing investors preferences and financial realities. We have seen the demise of mutual funds as their assets are migrated into ETFs. We witnessed a similar migration in assets from mainstay FINRA brokerage firms into registered investment advisers. As part of those ongoing trends, we also see investors growing disenchanted with so-called full-service firms and becoming enamored with online/app-based competitors. What will remain behind, what will struggle for relevancy and power at FINRA, will be a distillate of large financial services complexes, where banks will be affiliated with brokerage firms and affiliated with insurance firms and affiliated with RIAs and affiliated with fintech and -- well, you know, the now-discredited financial superstore will have one more blaze in the sky before it too fizzles out.  

So -- if SEC Commissioners Lee and Crenshaw want to raise a glass to toast FINRA's proposed Restricted Firm Rule, have at it. Last round in the Titanic's Bar. 

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