Recently, the Financial Industry Regulatory Authority Inc. published a proposal to impose restrictions on firms with a significant history of misconduct.
Finra wants to label firms with high numbers of disclosures and with a history of employing brokers with high numbers of disclosures as "restricted firms." Once they are so labeled, they must deposit funds into restricted accounts, which can only be accessed with Finra's permission.
Finra has been increasing its focus on recidivist brokers. For 2019, the regulator made examining brokers with "problematic regulatory histories" a regulatory priority. Last year, it issued a notice focused on "high-risk brokers." In the notice, Finra proposed several rule amendments focused on
brokers posing the highest risk.
Academic studies show that some firms persistently hire brokers who engage in misconduct, thereby concentrating misconduct at those firms.
Finra's own study found that past disciplinary action can be predictive of future misconduct. If it knows where misconduct is most likely to occur, and can predict which brokers are most likely to engage in misconduct,
Finra can and should proactively protect investors from these firms and brokers. The current proposal should help protect investors from these bad actors.
First, by labeling the firm as restricted, Finra is signaling to the marketplace that there may be some concerns about the firm. While the label is a bit of a misnomer — the only restriction which will be placed on the firm is its ability to access certain funds — it's a start. Perhaps Finra should just label them "high-risk firms" instead.
Second, Finra is increasing the cost of regulatory misconduct and the practice of hiring recidivist brokers. A firm will be considered restricted if it or its brokers have a greater number of regulatory related disclosures than its peer group. If implemented appropriately, this should have the practical effect of making it too costly for bad actors to remain in the business, thereby hopefully pricing the worst of worst out of the industry.
Third, Finra is beginning to address the
problem of unpaid awards. The regulator has said it will look at whether a firm has any pending arbitration claims involving customers, or any unpaid awards when determining the amount the firm must deposit into its restricted fund.
One of the permissible uses for the restricted funds will be to pay customer arbitration awards. To be sure, this is a small drop in the bucket and will not solve the unpaid award issue by itself, but it is a start. In the end, more than these restricted funds are needed as it is unlikely that a firm's restricted fund will be large enough to make a significant dent in that problem.
Finra stated that it is concerned about taxing firms out of the business. To balance its approach, the regulators will ensure that the fund amount will not "significantly undermine the continued financial stability and operational capability" of the firm.
However, the capitalization requirements for firms are negligible. Focusing on financial stability and operational capability encourages gamesmanship, incentivizing firms to keep cash low in order to minimize any restriction on the use of funds. In other words, firms can ensure they are "too poor to fail." Moreover, if allowed to game the system, bad actors will be able to continue to do business as usual.
More still needs to be done to protect investors. Even though firms provide advice about investors' retirement and life savings, there is little protection for investors if the advice is bad, or even fraudulent.
In the event of a product failure, or concentrated misconduct, firms simply cannot make investors whole and a restricted fund will not last long enough to pay a string of arbitration awards resulting from the misconduct. Troubled firms will remain more likely to shut down, leaving investors with no recourse, with the key people simply moving on to new firms.
Finra must do more to ensure that firms, and those in charge of the firms, are held accountable when their brokers go astray. While this proposal is a welcome step in the right direction, until Finra defines "accountability" to mean protecting investors and making them whole, investors will not be fully protected.
Christine Lazaro is the president of the Public Investors Arbitration Bar Association. She is a professor of clinical legal education and the director of the Securities Arbitration Clinic at St. John's University School of Law.
