A surprise ruling from the Securities and Exchange Commission will start to put brokerages and investment professionals from the securities industry in the hot seat as the agency seeks to increase protections for consumers. Dating back to 2019, the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC) have attempted to impose stricter regulation guidelines on investment advisors and the firms that employ them to crack down on firms with a history of regulatory disclosure issues. In an attempt to provide more consumer protections in the securities industry, the SEC passed FINRA’s proposed Rule 4111 which establishes monetary punishments for firms and their advisors if FINRA designates them as a risk to the investing public.
Misconduct in the financial securities industry includes violations of securities laws and regulations, criminal or civil litigations, client arbitrations, and other forms of financial harm. If it was found that a firm had a long history of misconduct, Rule 4111 mandates that the firm put cash or qualified security assets into a Restricted Deposit Requirement (RDR) fund that will be used as an insurance policy to cover the costs of pending and unpaid regulatory issues, such as arbitration awards. In 2019, nearly 30% of cases (totaling $19 million) that were awarded damages from firms went unpaid and nearly 35% (totaling $31 million) went unpaid in 2018, according to FINRA. The average balance of an unpaid consumer arbitration in 2019 was just south of $500,000 and stretched well north or $700,000 in 2018.
Firms that are seen as a red flag, or in other words, are a risk to the investing public, would be subject to these mandates. The size of the disciplinary deposit would be determined based on the severity of the misconduct, how many disclosures are held by the firm and the individuals involved, while also considering the size of the firm. With that said however, FINRA will not assess financial penalties that would put a firm at risk of becoming insolvent. To determine whether these financial firms should be designated as a risk or not, FINRA intends on analyzing the companies each year to determine the proper course of action. When FINRA designates a firm as restricted, those firms will have the ability to appeal these decisions made by FINRA, but outside of the appeals process, FINRA obtains sole discretion when it comes to assessing the disciplinary actions for red flag firms and the monetary penalties required to be deposited.
To address the restricted firm designation, these firms can release advisors that are high-risk to potentially mitigate their RDR penalty. While assessing monetary penalties and putting firms—particularly smaller firms—in the hot seat to unload advisors with records of financial misconduct is a step in the right direction, experts have pointed out that this kind of regulatory action does not go far enough to solve the industry-wide problem. Even if a firm were to fire a risky advisor, it doesn’t preclude that individual from being rehired by another firm, nor does it address advisors from other firms who may have slipped under the radar that also have a history of misconduct in the securities industry.
Opponents of the newly adopted rule argued that FINRA is targeting smaller firms and the forced removal of staff could ultimately lead to legal challenges and other complications. Firms that are faced with a restricted designation from FINRA will have only two choices according to legal experts in the field. The first option is to simply accept the penalty for having advisors with regulatory issues working for the company and pay the RDR, or the firm can release the advisors who have a history of misconduct. Legal experts believe that this ties the hands of smaller investment firms.
While opponents to the new rule raise a legitimate concern about the impact this will have on smaller investment firms, the importance of Rule 4111 is to establish credibility in the securities industry and crack down on rogue brokers while also identifying them to the public. For years, industry professionals and regulators have warned about red flags in the industry and brokers with a history of regulatory issues moving from throughout the industry. These include recidivist brokers who slip under the radar and are high-risk for consumers in the investment industry. In a joint public statement, SEC Commissioners Allison Herren Lee and Caroline A. Crenshaw stated, “A firm’s high-risk status is important information and will help investors make informed choices about the firms they select.” They also said that they are pleased to have FINRA “disclose the identities of high-risk firms to the public.”
Establishing consumer protections in an industry that is known for putting investors at risk is a step in the right direction but there is certainly more that the financial industry can do to protect investors. Despite the benefits of Rule 4111, the objections raised by investment firms and some legal experts about how the new regulations will impact the business of small firms speaks volumes to whom the industry is more concerned about representing. Investors young and old can utilize FINRAs online Broker Check to determine if their broker and investment firm are a risk to their investments by checking their regulatory disclosures. While retirees can utilize these tools there are no protections in the securities industry to protect nest eggs from the market risk and fees of Wall Street that threaten the retirement security of millions of investors every day.