Rule 4111: FINRA Punishes Advisors with Checkered Past

On September 28, FINRA adopted its previously proposed Rule 4111 — Restricted Firm Obligations. The Rule applies to broker-dealers with a history of misconduct or those with a concentration of reps with such histories. 

FINRA will use its own criteria to determine whether to designate a firm as “restricted.” Once a firm is slapped with the restricted label, it will be required to fulfill FINRA-specified obligations:

  • The firm must deposit cash or qualified securities (in an amount determined by and at the sole discretion of FINRA) in a segregated, restricted account. 
  • The firm must adhere to and comply with conditions, restrictions, or both.

Restricted firms will be able to challenge the designation, and they’ll have a single chance to avoid Rule 4111 obligations by voluntarily terminating any reps with a disclosure history. Once designated as restricted, firms will have six months to make the changes required to lift the label and free themselves from its obligations.

Segregated Accounts

The funds that firms are obligated to hold in the segregated account are intended to be used toward litigation, should the firm close, and for paying settlements to customers. Firms’ ability to withdraw funds in segregated accounts will be restricted, and all withdrawals will be subject to FINRA approval.

While it does not appear that FINRA will supply a tool for calculating deposit amounts, the segregated cash or securities must be sufficient to cover all pending arbitration claims and unpaid arbitration awards for the firm and its associated persons. The amount will be tailored based on the size, operations, and financial conditions of the firm itself. Put bluntly — it will be a hefty deposit. FINRA capped the deposit amount at one which merely would not cause the firm to be insolvent within the year.

Do you have a meritless disclosure on your BrokerCheck, IAPD, or CRD record? Give us a call today at (303) 952-4025, or contact us for a complimentary consultation.

Which Firms Will Qualify As Restricted?

Six categories of calculations will be used to determine whether a firm qualifies for restricted status. First, the total firm and rep disclosures on Forms BD, U4, U5, and U6 are calculated. Disclosures, such as customer disputes, terminations (especially from expelled firms), pending disputes, and regulatory, criminal, and civil judgments, all factor into the scoring mechanism. Next, FINRA assigns weight to the various factors, based on the size of the firm. If the resulting number exceeds a threshold, FINRA may “preliminarily identify” that particular firm as one that should be restricted.

While FINRA may be implying that all firms will be subject to the Rule, data contradicts that claim and reveals that the rule is squarely aimed at small firms with less than 150 reps.

Based on hypothetical test runs by FINRA Itself, it was found that:

  • Each year, FINRA will investigate up to 80 firms or about 2% of the industry.
  • Of those, small firms (<150 reps) constitute about 91%, and mid-sized firms (151-500 reps) constitute about 8%.

FINRA Forces Firms To Terminate

Upon being identified as possibly restricted, firms must take corrective action. The broker-dealer will face a binary option. It must either (1) accept the maximum Restricted Deposit Requirement (RDR), or (2) conduct a mass layoff of advisors with disclosures and hope to fall below the numeric thresholds. If a firm does not fall below the threshold after its one-time chance to reduce its workforce, the firm will have to institute the RDR. 

Do you have a meritless disclosure on your BrokerCheck, IAPD, or CRD record? Give us a call today at (303) 952-4025, or contact us for a complimentary consultation.

So what’s the worst part for advisors? The firms have a free pass from FINRA to terminate you! 

AdvisorLaw has found that firms have attempted to “weaponize” Form U5 in the vast majority of U5 terminations. Upon being terminated, reps receive a public disclosure by the firm on BrokerCheck, and many times, the firm will call the rep’s clients, speaking of serious wrongdoing by the rep, in an attempt to keep the investor and jettison the rep.

With Rule 4111 in place, it will be awfully difficult for an advisor to claim wrongful termination, because FINRA essentially forced the firm to terminate them. An action that might otherwise have been seen as weaponized thereby becomes viewed as thoughtful, pragmatic, and a necessary decision for the greater good.

Advisors with small firms who have several disclosures should remain alert. Only firm officers will be privy to whether the company is being “preliminarily investigated” by FINRA, and a firm in the crosshairs will endeavor to hold any type of regulatory investigation close to the vest. Firm officers will face the “choice” of whether to hand over a large sum to FINRA, which the firm cannot access, or identify as many reps with the most disclosures as possible, terminate them, and retain as many clients as they can. That’s how risk gets transferred from broker-dealers to financial advisors. 

New Rules 9561 and 9559 accompany Rule 4111 to facilitate its implementation, and all become effective on January 1, 2022. Additionally, FINRA will propose amendments to its Rule 8312, FINRA BrokerCheck Disclosure, to ensure the publication of a firm’s restricted status. Restricted firms’ reputations will be marred, and they will face greater obstacles when attempting to recruit. Even reps with clean records who are registered with such BDs will likely be negatively affected by both their association with the restricted firm and its reduced resources.

Similarly, the reason that most firms bring on advisors with disclosures in the first place is that those individuals are high producers. With firms’ options limited to either terminating those reps or funding a restricted account, broker-dealers could suffer as a result of large assets moving away from the firm with terminated reps.

Do you have a meritless disclosure on your BrokerCheck, IAPD, or CRD record? Give us a call today at (303) 952-4025, or contact us for a complimentary consultation.

The Takeaway

FINRA purports that the financial impact of restricted deposits will likely change firms’ behavior and thereby protect investors. Others anticipate that there will be fewer representatives who are unethical and less hiring of such reps by BDs. However, it appears that being labeled as restricted will be the kiss of death for most firms and will likely cost the financial services industry a significant portion of its representatives. Further, FINRA has the ability to expand what’s considered problematic to include more and more events from an advisor’s past. In other words, an event that does not count against you today could very well count toward a firm’s restricted status in the future. 

AdvisorLaw has succeeded in expunging more disclosures for advisors over the last five years than the rest of the industry, combined. Contact us for a complimentary consultation today!

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