[Federal Register Volume 86, Number 148 (Thursday, August 5, 2021)]
[Notices]
[Pages 42925-42944]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2021-16671]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-92525; File No. SR-FINRA-2020-04]


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)

July 30, 2021.

I. Introduction

    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'') \1\ and Rule 19b-4 
thereunder,\2\ 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. The 
proposed rule change was published for comment in the Federal Register 
on December 4, 2020.\3\ On January 12, 2021, FINRA consented to extend 
until March 4, 2021, the time period in which the Commission must 
approve the proposed rule change, disapprove the proposed rule change, 
or institute proceedings to determine whether to approve or disapprove 
the proposed rule change.\4\ On March 4, 2021, FINRA responded to the 
comment letters received in response to the Notice.\5\ On March 4, 
2021, the Commission filed an order instituting proceedings to 
determine whether to approve or disapprove the proposed rule change.\6\ 
On May 7, 2021, FINRA consented to an extension of the time period in 
which the Commission must approve or disapprove the proposed rule 
change to July 30, 2021.\7\ On May 14, 2021, FINRA filed an amendment 
to the proposed rule change (``Amendment No. 1'').\8\ On July 20, 2021, 
FINRA filed

[[Page 42926]]

a second amendment to the proposed rule change (``Amendment No. 
2''),\9\ as well as a second response to the comment letters received 
in response to the Notice.\10\ This order approves the proposed rule 
change, as modified by Amendment No. 1 and Amendment No. 2.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Exchange Act Release No. 90527 (Nov. 27, 2020), 85 FR 
78540 (Dec. 4, 2020) (File No. SR-FINRA-2020-041) (``Notice'').
    \4\ See letter from Michael Garawski, Associate General Counsel, 
OGC Regulatory Practice and Policy, FINRA, to Daniel Fisher, Branch 
Chief, Division of Trading and Markets, Commission, dated January 
12, 2021. This letter is available at https://www.finra.org/sites/default/files/2021-01/SR-FINRA-2020-041-Extension1.pdf.
    \5\ See letter from Michael Garawski, Associate General Counsel, 
Office of General Counsel, FINRA, to Vanessa Countryman, Secretary, 
Commission, dated March 4, 2021 (``FINRA March 4 Letter''). The 
FINRA March 4 Letter is available at https://www.sec.gov/comments/sr-finra-2020-041/srfinra2020041-8445557-229759.pdf.
    \6\ See Exchange Act Release No. 91258 (Mar. 4, 2021), 86 FR 
13780 (Mar. 10, 2021) (File No. SR-FINRA-2020-041) (``Order 
Instituting Proceedings''). The Order Instituting Proceedings is 
available at https://www.sec.gov/rules/sro/finra/2021/34-91258.pdf.
    \7\ See letter from Michael Garawski, Associate General Counsel, 
Office of General Counsel, FINRA, to Daniel Fisher, Branch Chief, 
Division of Trading and Markets, Commission, dated May 7, 2021. This 
letter is available at https://www.finra.org/sites/default/files/2021-05/sr-finra-2020-041-extension2.pdf.
    \8\ Amendment No. 1 is available at https://www.finra.org/sites/default/files/2021-05/sr-finra-2020-041-amendment1.pdf. FINRA has 
made a technical correction to the definition of ``Member Firm 
Pending Events'' in proposed Rule 4111(i)(4)(E). In the initial 
filing of the proposed rule change, proposed Rule 4111(i)(4)(E)(ii) 
included ``a pending investigation by a regulatory authority'' 
reportable on the member's Uniform Registration Forms as among the 
Member Firm Pending Events. The Uniform Registration Forms, however, 
do not contain disclosure questions or Disclosure Reporting Pages 
(``DRP'') fields about pending investigations by a regulatory 
authority concerning firms. Amendment No. 1 proposes deleting ``a 
pending investigation by a regulatory authority'' from the proposed 
definition of Member Firm Pending Events. Because Amendment No. 1 to 
the proposed rule change is technical in nature and does not 
materially alter the substance of the proposed rule change or raise 
any novel regulatory issues, it is not subject to notice and 
comment.
    \9\ Amendment No. 2 is available at https://www.finra.org/sites/default/files/2021-07/SR-FINRA-2020-041-Amendment2.pdf. In the 
initial filing of the proposed rule change, proposed Rule 4111 
included several references to the requirement that a Restricted 
Firm (defined below) ``maintain'' a deposit in a segregated account. 
Amendment No. 2 proposes several changes to, among other things, 
eliminate the word ``maintain'' from proposed Rule 4111 and clarify 
that a firm is not required to deposit additional funds or qualified 
securities where the initial deposit consists of qualified 
securities that have declined in value, nor is it permitted to 
withdraw any such funds or securities merely because the value of 
such qualified securities increased in value. It further clarifies 
that if FINRA thereafter re-designates a firm as a Restricted Firm 
in the following year, such firm would be required to deposit 
additional cash or qualified securities if necessary, at the 
appropriate time during that process, to meet the required deposit 
amount. Because Amendment No. 2 to the proposed rule change is 
technical in nature and does not materially alter the substance of 
the proposed rule change or raise any novel regulatory issues, it is 
not subject to notice and comment.
    \10\ See letter from Michael Garawski, Associate General 
Counsel, Office of General Counsel, FINRA, to Vanessa Countryman, 
Secretary, Commission, dated July 20, 2021 (``FINRA July 20 
Letter''). The FINRA July 20 Letter is available at https://www.sec.gov/comments/sr-finra-2020-041/srfinra2020041-9083092-246591.pdf.
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II. Description of the Proposed Rule Change

Background

    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.\11\ 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.\12\
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    \11\ As discussed more fully below, the proposed rule change 
would apply to firms who, based on statistical analysis of their 
prior disclosure events, including regulatory actions, customer 
arbitrations and litigations of brokers, are substantially more 
likely than similarly-sized peers to subsequently have a range of 
additional events indicating various types of harm or potential harm 
to investors. See Notice at 78565.
    \12\ As described below, such ``risk-related disclosures'' 
encompass those items included within the ``Preliminary 
Identification Metrics'' found in proposed Rule 4111(i)(10). Higher 
levels of risk-related disclosures are hereinafter referred to as 
``outlier-level disclosure events'' or ``outlier-level risks.''
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    Specifically, FINRA is proposing to adopt FINRA Rule 4111 
(Restricted Firm Obligations) to require member firms that are 
identified as ``Restricted Firms'' \13\ to deposit cash or qualified 
securities in a segregated account, adhere to specified conditions or 
restrictions, or comply with a combination of such obligations.\14\ 
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.\15\ 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.\16\
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    \13\ As described more fully below, a ``Restricted Firm'' is a 
firm identified through the proposed multi-step process to have a 
significantly higher level of risk-related disclosures than 
similarly sized peers and determined by FINRA to pose a high degree 
of risk to the investing public. See discussion infra Proposed Rule 
4111 (Restricted Firm Obligations).
    \14\ See Notice at 78540.
    \15\ See Notice at 78542-78550. The proposed rule change would 
cover Capital Acquisition Brokers (``CABs''). FINRA is proposing to 
adopt CAB Rule 412 (Restricted Firm Obligations), to clarify that 
the member firms that have elected to be treated as CABs would be 
subject to proposed FINRA Rule 4111. The proposed rule change would 
not cover funding portals. According to FINRA, given its limited 
regulatory experience with funding portals, it is not clear that 
funding portals present the corresponding risks that FINRA is 
seeking to address with respect to broker-dealers. See Notice at 
78550 note 46. Moreover, developing relevant metrics and thresholds 
for funding portals would require a separate effort and analysis 
because, unlike broker-dealers, the Uniform Registration Forms do 
not apply to funding portals and their associated persons. 
Accordingly, FINRA is proposing to amend Funding Portal Rule 900(a) 
(Application of FINRA Rule 9000 Series (Code of Procedure) to 
Funding Portals), to clarify that funding portals would not be 
subject to proposed FINRA Rule 9561. See Notice at 78550 note 46.
    \16\ See Notice at 78542.
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    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.\17\ 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.\18\
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    \17\ Id. at 78540.
    \18\ Id. at 78550.
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    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.\19\ 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.\20\ 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.\21\ 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.\22\
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    \19\ Id. at 78550-51.
    \20\ See Notice at 78540 note 5 (In particular, FINRA cited to 
Hammad Qureshi & Jonathan Sokobin, Do Investors Have Valuable 
Information About Brokers? (OCE Working Paper, Aug. 2015) (a study 
showing that past disclosure events, including regulatory actions, 
customer arbitrations and litigations of registered representatives, 
have significant power to predict future investor harm) and Mark 
Egan, Gregor Matvos & Amit Seru, The Market for Financial Adviser 
Misconduct, J. Pol. Econ. 127, no. 1 (Feb. 2019), 233-295 
(presenting evidence suggesting a higher rate of new disciplinary 
and other disclosure events is highly correlated with past 
disciplinary and other disclosure events that occurred in the 
previous nine years)).
    \21\ Id. at 78540.
    \22\ Id. at 78540-41.
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    FINRA states that such firms expose investors to real risk.\23\ For 
example, FINRA states that it has identified certain firms that have a 
concentration of associated persons with a history of misconduct, and 
some of these firms consistently hire such individuals and fail to 
reasonably supervise their activities.\24\ FINRA has found that these 
firms generally have a retail business engaging in cold calling 
investors to make recommendations of securities, often to vulnerable 
customers.\25\ FINRA has also identified groups of individual 
representatives who move from one firm of concern to another firm of 
concern.\26\

[[Page 42927]]

FINRA observed that such firms and their associated persons often have 
substantial numbers of reportable events on their Uniform Registration 
Forms.\27\ In such situations, FINRA closely examines the firms' and 
registered representatives' conduct, and where appropriate, FINRA will 
bring enforcement actions to bar or suspend the firms and individuals 
involved.\28\
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    \23\ Id. at 78541.
    \24\ Id.
    \25\ Id.
    \26\ Id.
    \27\ Id.
    \28\ Id.
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    However, FINRA states that individuals and firms with a history of 
misconduct can pose a particular challenge for FINRA's existing 
examination and enforcement programs.\29\ Specifically, examinations 
can identify compliance failures--or imminent failures--and prescribe 
remedies to be taken, but examiners are not empowered to require a firm 
to change or limit its business operations in a particular manner 
without an enforcement action.\30\ While these constraints on the 
examination process protect firms from potentially arbitrary or overly 
onerous examination findings, an individual or firm with a history of 
misconduct can take advantage of these limits to continue activities 
that pose risk of harm to investors until they result in an enforcement 
action.\31\
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    \29\ Id.
    \30\ Id.
    \31\ Id.
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    FINRA states that enforcement actions in turn can only be brought 
after a rule has been violated and any resulting customer harm has 
already occurred.\32\ In addition, these proceedings can take 
significant time to develop, prosecute and conclude, during which time 
the individual or firm is able to continue misconduct, with significant 
risks of additional harm to investors.\33\ Parties with serious 
compliance issues often will litigate enforcement actions brought by 
FINRA, which may involve a hearing and multiple rounds of appeals, 
forestalling the imposition of disciplinary sanctions for an extended 
period.\34\ For example, an enforcement proceeding could involve a 
hearing before a Hearing Panel, numerous motions, an appeal to the 
National Adjudicatory Council (``NAC''), and a further appeal to the 
Commission.\35\ Moreover, even when a FINRA Hearing Panel imposes a 
significant sanction, the sanction is stayed during appeal to the 
NAC.\36\ Many sanctions are also automatically stayed on appeal to the 
Commission, and can be stayed during an appeal to the courts.\37\ And 
when all appeals are exhausted, the firm may have withdrawn its FINRA 
membership and shifted its business to another member or other type of 
financial firm, limiting FINRA's jurisdiction and avoiding the 
sanction, including making restitution to customers.\38\ In such 
circumstances, the firm may also fail to pay arbitration awards owed to 
claimants, leaving investors uncompensated and diminishing confidence 
in the securities markets.\39\
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    \32\ Id.
    \33\ Id.
    \34\ Id.
    \35\ Id.
    \36\ Id.
    \37\ Id.
    \38\ Id. FINRA also states that temporary cease and desist 
proceedings can, but do not always, provide an effective remedy for 
potential ongoing harm to investors during the enforcement process. 
FINRA explains that it does not always permit rapid intervention 
because FINRA must be prepared to file the underlying disciplinary 
complaint at the same time it seeks a cease and desist order. See 
Notice at 78541. Moreover, temporary cease and desist proceedings 
are available only in narrowly defined circumstances. See FINRA Rule 
9800 Series (Temporary and Permanent Cease and Desist Orders).
    \39\ See Notice at 78541.
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Proposed Rule 4111 (Restricted Firm Obligations)

    Proposed Rule 4111 would establish numeric thresholds based on 
firm-level and individual-level disclosure events to identify member 
firms with a significantly higher level of risk-related disclosures as 
compared to similarly sized peers.\40\ Following a multi-step process 
of evaluating a member firm, FINRA's Department of Member Regulation 
(``Department'') would be permitted to impose on member firms it 
determines pose a high risk to the investing public (i.e., a 
``Restricted Firm'') a ``Restricted Deposit Requirement,'' \41\ 
conditions or restrictions on the member firm's operations that are 
necessary or appropriate to protect investors and the public interest, 
or both.\42\
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    \40\ Id.
    \41\ See proposed Rule 4111(i)(15) (defining ``Restricted 
Deposit Requirement'').
    \42\ See Notice at 78542.
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    According to FINRA, the proposed multi-step process includes 
features that narrowly focus the proposed obligations on the firms of 
most concern.\43\ FINRA describes this process as a ``funnel.'' \44\ 
The top of the funnel applies to the range of member firms with the 
most disclosures, with a narrowing in the middle of the potential 
member firms that may be subject to additional obligations, and the 
bottom of the funnel reflecting the smaller number of member firms that 
FINRA determines present high risks to the investing public.\45\
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    \43\ Id.
    \44\ Id.
    \45\ See Exhibit 2d to the text of FINRA's proposed rule change 
for a diagram of the ``funnel,'' available at https://www.finra.org/sites/default/files/2020-11/SR-FINRA-2020-041.pdf at p. 553.
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    FINRA would conduct the process annually for each member firm, 
determining whether it should be designated (or re-designated) as a 
Restricted Firm and whether any such Restricted Firm should be subject 
to any obligations.\46\ Each member firm that is preliminarily 
identified based on its firm-level and individual-level disclosure 
events would have several ways to affect outcomes during subsequent 
steps in the evaluative process, including a one-time opportunity to 
terminate registered representatives with relevant disclosure events so 
as to no longer trigger the numeric thresholds.\47\ The member firm 
would also be able to explain to the Department why it should not be 
subject to a Restricted Deposit Requirement, or propose alternatives 
that would still accomplish FINRA's goal of protecting investors, and 
could request a hearing before a FINRA Hearing Officer in an expedited 
proceeding to challenge a Department determination.\48\
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    \46\ See Notice at 78542.
    \47\ Id.
    \48\ Id.
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    The rule would subject the Department to certain presumptions when 
it assesses a previously designated Restricted Firm's application for 
withdrawal from its Restricted Deposit Account.\49\ Specifically, the 
Department would be required to: (1) Deny an application for withdrawal 
if the member firm, the member firm's associated persons who are owners 
or control persons, or the former member firm have any Covered Pending 
Arbitration Claims \50\ or unpaid arbitration awards, or if the member 
firm's associated persons have any Covered Pending Arbitration Claims 
or unpaid arbitration awards relating to arbitrations that involved 
conduct or alleged conduct that occurred while the person was 
associated with the member firm; but (2) approve the application of a 
Former Member \51\ when that Former

[[Page 42928]]

Member commits in the manner specified by the Department to use the 
amount it withdraws to pay down its specified unpaid arbitration 
awards.\52\
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    \49\ See proposed Rule 4111(i)(14) (defining ``Restricted 
Deposit Account'').
    \50\ See proposed Rule 4111(i)(2) (defining Covered Pending 
Arbitration Claim as an investment-related, consumer-initiated claim 
filed against the member or its associated persons in any 
arbitration forum that is unresolved; and whose claim amount 
(individually or, if there is more than one claim, in the aggregate) 
exceeds the member's excess net capital).
    \51\ See proposed Rule 4111(i)(7) would define ``Former Member'' 
as an entity that has withdrawn or resigned its FINRA membership, or 
that has had its membership cancelled or revoked. However, proposed 
rule 9561.01 would include former members as members for purposes of 
the proposed rule changes. To the extent a Restricted Member 
withdraws its membership applications with specified unpaid 
arbitration awards, the conditions for releasing funds from the 
restricted deposit would encourage the firm to use the released 
funds to pay those awards. See also Notice at 78542.
    \52\ See Notice at 78547.
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General (Proposed Rule 4111(a))
    Under the proposal, any member firm that is designated by the 
Department as a Restricted Firm would be required to establish a 
Restricted Deposit Account \53\ and deposit cash or qualified 
securities with an aggregate value that is not less than the member 
firm's Restricted Deposit Requirement, except in certain identified 
situations.\54\ Restricted Firms could also be subject to conditions or 
restrictions on their operations,\55\ as determined by the Department 
to be necessary or appropriate to protect investors and the public 
interest in addition or in the alternative to a Restricted Deposit 
Requirement.\56\
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    \53\ See proposed Rule 4111(i)(14) (defining ``Restricted 
Deposit Account''). Proposed Rule 4111(i)(14) would require that any 
Restricted Deposit Account be in the name of the member firm at a 
bank or at the member firm's clearing firm. The account would need 
to be subject to an agreement in which the bank or the clearing firm 
agrees: Not to permit withdrawals from the account absent FINRA's 
prior written consent; to keep the account separate from any other 
accounts maintained by the member firm with the bank or clearing 
firm; that the cash or qualified securities on deposit will not be 
used directly or indirectly as security for a loan to the member 
firm by the bank or the clearing firm, and will not be subject to 
any set-off, right, charge, security interest, lien, or claim of any 
kind in favor of the bank, clearing firm or any person claiming 
through the bank or clearing firm; that if the member firm becomes a 
Former Member, the assets deposited in the Restricted Deposit 
Account to satisfy the Restricted Deposit Requirement shall be kept 
in the Restricted Deposit Account, and withdrawals will not be 
permitted without FINRA's prior written consent; that FINRA is a 
third-party beneficiary to the agreement; and that the agreement may 
not be amended without FINRA's prior written consent. In addition, 
the account could not be subject to any right, charge, security 
interest, lien, or claim of any kind granted by the member. See 
Notice at 78547-8. In the event of a liquidation of a Restricted 
Firm, funds or securities on deposit in the Restricted Deposit 
Account would be additional financial resources available for the 
Restricted Firm's trustee to distribute to those with claims against 
the Restricted Firm. However, such funds and securities on deposit 
in the Restricted Deposit Account would not be held with respect to 
any particular claim, or class of claimants, against such firm. See 
Notice at 78548 note 39.
    \54\ See Notice at 78542.
    \55\ FINRA has also proposed adopting Supplementary Material .03 
to proposed Rule 4111 to provide member firms with a non-exhaustive 
list of examples of conditions and restrictions that the Department 
could impose on Restricted Firms. See Notice at 78458.
    \56\ Id.
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Annual Calculation by FINRA of the Preliminary Criteria for 
Identification (Proposed Rule 4111(b))
    FINRA will announce for all member firms the date of the first 
annual evaluation (``Evaluation Date'') no less than 120 calendar days 
prior to the first Evaluation Date.\57\ Subsequent Evaluation Dates 
would be on the same month and day each year, whether that date certain 
falls on a business day, a weekend day, or a holiday.\58\
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    \57\ Id.
    \58\ See FINRA March 4 Letter at 5-6.
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    The Department would begin each member firm's annual Rule 4111 
review process by calculating specified ``Preliminary Identification 
Metrics'' for each firm for each of six categories of events or 
conditions, collectively defined as the ``Disclosure Event and Expelled 
Firm Association Categories.'' \59\ FINRA would use a formula to 
identify whether a firm has exceeded certain established 
thresholds,\60\ based on the firm's size,\61\ for each of these six 
categories of events or conditions.\62\ The six categories are: (1) 
Registered Person Adjudicated Events; \63\ (2) Registered Person 
Pending Events; \64\ (3) Registered Person Termination and Internal 
Review Events; \65\ (4) Member Firm Adjudicated Events; \66\ (5) Member 
Firm Pending

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Events; \67\ and (6) Registered Persons Associated with Previously 
Expelled Firms (also referred to as the Expelled Firm Association 
category).\68\ Based on this calculation, the Department would 
determine whether the particular member firm meets the ``Preliminary 
Criteria for Identification.'' \69\
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    \59\ See proposed Rule 4111(i)(4) (defining ``Disclosure Event 
and Expelled Firm Association Categories''). The Disclosure Event 
and Expelled Firm Association Categories are all based on events or 
conditions disclosed through the Uniform Registration Forms with the 
exception of one event category (Member Firm Adjudicated Events), 
which includes events that are derived from customer arbitrations 
filed with FINRA's dispute resolution forum. See Notice at 78542 
note 17.
    \60\ See proposed Rule 4111(i)(11) (defining ``Preliminary 
Identification Metrics Thresholds'').
    \61\ Specifically, member firms will be divided into seven size 
categories, ranging from firms with 1-4 Registered Persons In-Scope 
to 500 or more Registered Persons In-Scope. See Notice at 78544. The 
term ``Registered Persons In-Scope'' means all persons registered 
with the firm for one or more days within the one year prior to the 
Evaluation Date. See proposed Rule 4111(i)(13).
    \62\ See Notice at 78543. As detailed further below, in each of 
these six categories, FINRA would identify all of the firm's events 
or conditions within that category. The total number of these events 
or conditions in each category will then be divided by the number of 
Registered Persons In-Scope to identify the per capita number of 
events or conditions that the firm has, to enable comparison against 
similarly sized firms. This per capita number of events or 
conditions in each category will then be used to determine whether 
or not the firm has met or exceeded the threshold for that category, 
as set out below. Id.
    \63\ ``Registered Person Adjudicated Events,'' defined in 
proposed Rule 4111(i)(4)(A), means any one of the following events 
that are reportable on the registered person's Uniform Registration 
Forms: (1) A final investment-related, consumer-initiated customer 
arbitration award or civil judgment against the registered person in 
which the registered person was a named party, or was a subject of 
the customer arbitration award or civil judgment; (2) a final 
investment-related, consumer-initiated customer arbitration 
settlement, civil litigation settlement or a settlement prior to a 
customer arbitration or civil litigation for a dollar amount at or 
above $15,000 in which the registered person was a named party or 
was a subject of the customer arbitration settlement, civil 
litigation settlement or a settlement prior to a customer 
arbitration or civil litigation; (3) a final investment-related 
civil judicial matter that resulted in a finding, sanction or order; 
(4) a final regulatory action that resulted in a finding, sanction 
or order, and was brought by the Commission or Commodity Futures 
Trading Commission (``CFTC''), other federal regulatory agency, a 
state regulatory agency, a foreign financial regulatory authority, 
or a self-regulatory organization; or (5) a criminal matter in which 
the registered person was convicted of or pled guilty or nolo 
contendere (no contest) in a domestic, foreign, or military court to 
any felony or any reportable misdemeanor.
    \64\ ``Registered Person Pending Events,'' defined in proposed 
Rule 4111(i)(4)(B), means any one of the following events associated 
with the registered person that are reportable on the registered 
person's Uniform Registration Forms: (1) A pending investment-
related civil judicial matter; (2) a pending investigation by a 
regulatory authority; (3) a pending regulatory action that was 
brought by the Commission or CFTC, other federal regulatory agency, 
a state regulatory agency, a foreign financial regulatory authority, 
or a self-regulatory organization; or (4) a pending criminal charge 
associated with any felony or any reportable misdemeanor. Registered 
Person Pending Events does not include pending arbitrations, pending 
civil litigations, or consumer-initiated complaints that are 
reportable on the registered person's Uniform Registration Forms.
    \65\ ``Registered Person Termination and Internal Review 
Events,'' defined in proposed Rule 4111(i)(4)(C), means any one of 
the following events associated with the registered person at a 
previous member firm that are reportable on the registered person's 
Uniform Registration Forms: (1) A termination in which the 
registered person voluntarily resigned, was discharged or was 
permitted to resign from a previous member after allegations; or (2) 
a pending or closed internal review by a previous member. FINRA has 
revised this definition, from the version proposed in Regulatory 
Notice 19-17 (May 2019), to clarify that termination and internal 
review disclosures concerning a person whom a member firm terminated 
would not impact that member firm's own Registered Person 
Termination and Internal Review Metric; rather, they would only 
impact the metrics of member firms that subsequently register the 
terminated individual.
    \66\ ``Member Firm Adjudicated Events,'' defined in proposed 
Rule 4111(i)(4)(D), means any one of the following events that are 
reportable on the member firm's Uniform Registration Forms or based 
on customer arbitrations filed with FINRA's dispute resolution 
forum: (1) A final investment-related, consumer-initiated customer 
arbitration award in which the member was a named party; (2) a final 
investment-related civil judicial matter that resulted in a finding, 
sanction or order; (3) a final regulatory action that resulted in a 
finding, sanction or order, and was brought by the Commission or 
CFTC, other federal regulatory agency, a state regulatory agency, a 
foreign financial regulatory authority, or a self-regulatory 
organization; or (4) a criminal matter in which the member was 
convicted of or pled guilty or nolo contendere (no contest) in a 
domestic, foreign, or military court to any felony or any reportable 
misdemeanor.
    \67\ ``Member Firm Pending Events,'' defined in proposed Rule 
4111(i)(4)(E), means any one of the same kinds of events as the 
``Registered Person Pending Events,'' but that are reportable on the 
member firm's Uniform Registration Forms.
    \68\ ``Registered Persons Associated with Previously Expelled 
Firms,'' defined in proposed Rule 4111(i)(4)(F), means any 
``Registered Person In-Scope'' who was registered for at least one 
year with a previously expelled firm and whose registration with the 
previously expelled firm terminated during the ``Evaluation Period'' 
(i.e., the prior five years from the ``Evaluation Date,'' which 
would be the annual date as of which the Department calculates the 
Preliminary Identification Metrics). See proposed Rule 4111(i)(5), 
(6), and (13) (proposed definitions of ``Evaluation Date,'' 
``Evaluation Period,'' and ``Registered Persons In-Scope''). This 
proposed definition is narrower than the definition proposed in 
Regulatory Notice 19-17, which would have captured any registered 
person registered for one or more days within the year prior to the 
Evaluation Date with the firm, and who was associated with one or 
more previously expelled firms at any time in his/her career. 
Including an Expelled Firm Association Metric in the Preliminary 
Criteria for Identification is similar to how FINRA Rule 3170 (Tape 
Recording of Registered Persons by Certain Firms) imposes recording 
requirements on firms with specific percentages of registered 
persons who were previously associated with disciplined firms.
    \69\ See proposed Rule 4111(i)(9) (defining ``Preliminary 
Criteria for Identification'').
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    Several principles guided FINRA's development of the proposed 
Preliminary Criteria for Identification and the proposed Preliminary 
Identification Metrics Thresholds.\70\ The criteria and thresholds are 
intended to be replicable and transparent to FINRA and affected member 
firms; employ the most complete and accurate data available to FINRA; 
be objective; account for different firm sizes and business profiles; 
and target the sales practice concerns that arise when firms appear to 
systemically perpetuate harm on investors leading up to and at the 
point-of-sale of securities products, that are motivating the 
proposal.\71\ These criteria are intended to identify member firms that 
present a high risk but avoid imposing obligations on member firms 
whose risk profile and activities do not warrant such obligations.\72\
---------------------------------------------------------------------------

    \70\ See Notice at 78542.
    \71\ Id.
    \72\ Id.
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    To calculate each of the six categories' Preliminary Identification 
Metrics, FINRA would first add the number of pertinent disclosure 
events.\73\ To calculate the Expelled Firm Association category, FINRA 
would count the number of Registered Persons Associated with Previously 
Expelled Firms.\74\ For purposes of these calculations: (1) Adjudicated 
disclosure events would include only those that were resolved during 
the prior five years from the date of the calculation; (2) pending 
events and pending internal reviews would include disclosure events 
that are pending as of the date of the calculation; and (3) Registered 
Person disclosure events (i.e., disclosure events of all persons 
registered with the member firm for one or more days within the one 
year prior to the calculation date, that is, Registered Persons In-
Scope).\75\ The sum for each of the six categories would then be run 
through a standardization process to determine the member's six 
Preliminary Identification Metrics, wherein the raw numbers of a firm's 
relevant events in each category would be divided by the number of 
Registered Persons In-Scope at the firm, to enable more accurate, per 
person comparisons with other member firms.\76\
---------------------------------------------------------------------------

    \73\ Id. at 78543.
    \74\ Id.
    \75\ See proposed Rule 4111(i)(13).
    \76\ See Notice at 78543. For the five ``Registered Person and 
Member Firm Events'' categories (Categories 1-5 above),\76\ the 
proposed standardized Preliminary Identification Metrics would be 
derived by dividing the sum of events from each category by the 
number of Registered Persons In-Scope to identify the average number 
of events per registered representative. For the Expelled Firm 
Association category (Category 6 above), the proposed Preliminary 
Identification Metric would be standardized by taking the number of 
Registered Persons Associated with Previously Expelled Firms and 
dividing it by the number of Registered Persons In-Scope to 
determine the percentage of the member firm's registered 
representatives who meet the Registered Persons Associated with 
Previously Expelled Firms definition. See also proposed Rule 
4111(i)(12) (defining ``Registered Person'' and ``Member Firm 
Events'').
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    A firm's six Preliminary Identification Metrics would be used to 
determine if the member firm meets the Preliminary Criteria for 
Identification. FINRA believes that the Preliminary Identification 
Metrics Thresholds in proposed Rule 4111(i)(11) represent member firms 
that present significantly higher risk than a large percentage of their 
similarly sized peers for the type of events in the category. There are 
numeric thresholds for seven different firm sizes, to provide that each 
member firm would be compared only to its similarly sized peers.\77\
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    \77\ Because FINRA has narrowed the definition of Registered 
Persons Associated with Previously Expelled Firms from the version 
that was originally proposed in Regulatory Notice 19-17, FINRA also 
has revised the Expelled Firm Association Metric Thresholds. See 
Notice at 78544 note 29.
---------------------------------------------------------------------------

    To meet the Preliminary Criteria for Identification, a member firm 
would need to meet: (1) Two or more of the Preliminary Identification 
Metrics Thresholds set forth in proposed Rule 4111(i)(11), at least one 
of which must be the Registered Person Adjudicated Event Metric, the 
Member Firm Adjudicated Event Metric, or the Expelled Firm Association 
Metric, and (2) two or more Registered Person and Member Firm Events 
(i.e., two or more events from Categories 1-5 above).\78\ If these 
conditions are met, the member firm would meet the Preliminary Criteria 
for Identification.\79\
---------------------------------------------------------------------------

    \78\ See Notice at 78543.
    \79\ Id.
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Initial Department Evaluation (Proposed Rule 4111(c)(1))
    The Department would then evaluate whether a member firm that has 
met the Preliminary Criteria for Identification warrants further review 
under Rule 4111.\80\ FINRA's evaluation would include consideration of: 
Whether non-high-risk disclosure events or other conditions should not 
have been included within the initial calculation of the firm's 
Preliminary Identification Metric computations (e.g., events that were 
not sales-practice related, duplicative events involving the same 
customer and the same matter, or events involving compliance concerns 
best addressed by a different regulatory response by FINRA (e.g., 
enforcement actions; more frequent examination cycles; temporary cease 
and desist orders)); \81\ whether the disclosure events pose risks to 
investors or market integrity, as opposed to violations of procedural 
rules; \82\ and whether the member firm has already addressed the 
concerns signaled by the disclosure events or conditions, or has 
altered its business operations such that the threshold calculation no 
longer reflects the firm's current risk profile.\83\ The Department 
would then either determine that further review would be necessary and 
continue the Rule 4111 process, or, if the Department concluded that no 
further review would be warranted, close out that member firm's Rule 
4111 process for the year without imposing any restrictions or 
obligations.\84\
---------------------------------------------------------------------------

    \80\ See Notice at 78544.
    \81\ Id.
    \82\ Id. at 78544-45.
    \83\ Id. at 78545.
    \84\ Id.
---------------------------------------------------------------------------

One-Time Opportunity To Reduce Staffing Levels (Proposed Rule 
4111(c)(2))
    If the Department determines that a member firm warrants further 
review under Rule 4111, and such member firm would be meeting the 
Preliminary Criteria for Identification for the first time, the member 
firm would have a

[[Page 42930]]

one-time opportunity to reduce its staffing levels to avoid meeting the 
Preliminary Criteria for Identification, within 30 business days after 
being informed by the Department that it met the Preliminary Criteria 
for Identification.\85\ The member firm would need to identify the 
terminated individuals to the Department and would be prohibited from 
rehiring any of those terminated persons, in any capacity, for one 
year.\86\
---------------------------------------------------------------------------

    \85\ Id. at 78544.
    \86\ Id.
---------------------------------------------------------------------------

    If the member firm reduces its staffing levels, and the Department 
then determines that the member firm no longer meets the Preliminary 
Criteria for Identification, the Department would close out the firm's 
Rule 4111 process for the year without seeking to impose any 
restrictions or obligations on the firm. However, if the Department 
determines that the member firm still meets the Preliminary Criteria 
for Identification (or if the member firm did not opt to reduce 
staffing levels) the Department would determine the firm's maximum 
Restricted Deposit Requirement, and the member firm would proceed to a 
``Consultation'' with the Department.\87\
---------------------------------------------------------------------------

    \87\ Id. at 78545.
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Determination of a Maximum Restricted Deposit Requirement (Proposed 
Rule 4111(i)(15))
    For firms still meeting the Preliminary Criteria for 
Identification, the Department would then determine the firm's maximum 
Restricted Deposit Requirement,\88\ and the member firm would then 
proceed to a ``Consultation'' with the Department.\89\ The Department 
would seek to tailor a firm's maximum Restricted Deposit Requirement 
amount to its size, operations and financial conditions, and determine 
the member firm's maximum Restricted Deposit Requirement consistent 
with the objectives of the rule, while not significantly undermining 
the firm's continued financial stability and operational capability as 
an ongoing enterprise over the next 12 months.\90\
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    \88\ The term ``maximum'' is used to indicate that a firm's 
maximum Restricted Deposit Requirement will be the figure FINRA 
declares to the firm is the highest deposit requirement it may be 
subject to during that year's Rule 4111 process. As discussed below, 
firms could then seek to demonstrate to FINRA why a lower deposit 
requirement would be more appropriate during the Consultation. See 
FINRA March 4 Letter supra note 5.
    \89\ See Notice at 78545.
    \90\ Id. The proposed factors that the Department would consider 
when determining a maximum Restricted Deposit Requirement include 
revenues, net capital, assets, expenses, and liabilities, the firm's 
operations and activities, number of registered persons, the nature 
of the disclosure events included in the numeric thresholds, 
insurance coverage for customer arbitration awards or settlements 
concerns raised during FINRA exams, and the amount of any of the 
firm's or its associated persons' ``Covered Pending Arbitration 
Claims'' or unpaid arbitration awards. See proposed FINRA Rule 
4111(i)(15)(A).
---------------------------------------------------------------------------

Consultation (Proposed Rule 4111(d))
    During the Consultation, the Department would give the member firm 
an opportunity to demonstrate why it does not meet the Preliminary 
Criteria for Identification, why it should not be designated as a 
Restricted Firm, and why it should not be subject to the maximum 
Restricted Deposit Requirement.\91\ A member firm may overcome the 
presumption that it should be designated as a Restricted Firm by 
``clearly demonstrating that the Department's calculation is 
inaccurate'' because, among other things, it considered events that 
should not have been included.\92\ A member firm also may overcome the 
presumption that it should be subject to the maximum Restricted Deposit 
Requirement by clearly demonstrating that such an amount would cause 
significant undue financial hardship, and that a lesser deposit 
requirement would satisfy the objectives of Rule 4111; or that other 
operational conditions and restrictions on the member and its 
associated persons would sufficiently protect investors and the public 
interest.\93\ To the extent a member firm seeks to claim undue 
financial hardship, it would bear the burden of supporting that claim 
with documents and information.\94\
---------------------------------------------------------------------------

    \91\ See Notice at 78545.
    \92\ Id. These would include, for example, events that are 
duplicative, involving the same customer and the same matter, or are 
not sales-practice related. Id.
    \93\ Id. Proposed Rule 4111(d)(3) provides guidance to member 
firms on what information the Department would consider during the 
Consultation, and guidance on how to attempt to overcome the two 
rebuttable presumptions (that the member firm should be designated 
as a Restricted Firm, and that it should be subject to the maximum 
Restricted Deposit Requirement). See Notice at 78546.
    \94\ See Notice at 78545.
---------------------------------------------------------------------------

Department Decision and Notice (Proposed Rule 4111(e)); No Stays
    After the Consultation, the Department would be required to render 
a decision, pursuant to one of three paths: (1) If the Department 
determines that the member firm has rebutted the presumption that it 
should be designated a Restricted Firm, the Department would not 
designate the firm as a Restricted Firm that year; (2) if the 
Department determines that the member firm has not rebutted the 
presumption that it should be designated as a Restricted Firm, but has 
rebutted the presumption that it shall be subject to the maximum 
Restricted Deposit Requirement, the Department would designate the 
member firm as a Restricted Firm, but would: (a) Either impose no 
Restricted Deposit Requirement on the member firm, or require it to 
promptly establish a Restricted Deposit Account, and deposit in that 
account a lower Restricted Deposit Requirement in such dollar amount as 
the Department deems necessary or appropriate; and (b) require the 
member firm to implement and maintain specified conditions or 
restrictions on the operations and activities of the member firm and 
its associated persons, as necessary or appropriate, to address the 
concerns identified by the Department, and protect investors and the 
public interest; or (3) if the Department determines that the member 
firm has rebutted neither presumption, the Department would designate 
the member firm as a Restricted Firm, require it to promptly establish 
a Restricted Deposit Account, deposit in that account the maximum 
Restricted Deposit Requirement, and implement and maintain specified 
conditions or restrictions on the firm's operations and activities, and 
those of its associated persons, as necessary or appropriate to address 
the concerns identified by the Department, and protect investors and 
the public interest.\95\ Pursuant to proposed Rule 4111(e)(2), the 
Department would provide the member firm with written notice of its 
decision no later than 30 days from the date of FINRA's letter 
scheduling the Consultation, stating any conditions or restrictions to 
be imposed, and the ability of the member firm to request a hearing 
with the Office of Hearing Officers in an expedited proceeding.\96\
---------------------------------------------------------------------------

    \95\ See Notice at 78546.
    \96\ Id. As noted below, any request for a hearing would not 
stay the effectiveness of the Department's decision, but, unless 
that firm was already operating as a Restricted Firm based on a 
prior year's Department decision, it would temporarily lower the 
necessary Required Deposit Requirement for that member firm until 
the Office of Hearing Officers, or the NAC issues a final written 
decision. See proposed FINRA Rule 4111(e)(2). If the firm was 
already operating as a Restricted Firm based on a prior year's 
Department decision, it would be required to keep in the Restricted 
Deposit Account the assets then on deposit therein until the Office 
of Hearing Officers or the NAC issues its final written decision in 
the expedited proceeding. Id.
---------------------------------------------------------------------------

Continuation or Termination of Restricted Firm Obligations (Proposed 
Rule 4111(f))
    Proposed Rule 4111(f) would set forth the circumstances under which 
any obligations (including any Restricted Deposit Requirement, 
conditions, or

[[Page 42931]]

restrictions) that were imposed during the Rule 4111 process in one 
year are continued or terminated in that same year and in subsequent 
years. Pursuant to proposed Rule 4111(f)(1), a currently designated 
Restricted Firm would not be able to withdraw all or any portion of its 
Restricted Deposit Requirement, or seek to terminate or modify any 
Restricted Deposit Requirement, conditions, or restrictions that have 
been imposed pursuant to this Rule, without the prior written consent 
of the Department. Restricted Firms would only be permitted to seek to 
withdraw a portion of its Restricted Deposit Requirement, or terminate 
or modify any required deposit, conditions, or restrictions that have 
been imposed, during their annual Consultation, and any ensuing 
expedited proceedings after a Department decision; no interim 
termination or modification of any obligations would be permitted.\97\
---------------------------------------------------------------------------

    \97\ See Notice at 78547. FINRA has indicated that there will be 
a presumption that the Department shall deny an application by a 
member firm or former member firm that is currently designated as a 
Restricted Firm to withdraw all or any portion of its Restricted 
Deposit Requirement.; see also FINRA proposed Rule 4111(f)(3).
---------------------------------------------------------------------------

    Where the Department determines in one year that a member firm is a 
Restricted Firm, but in the following year(s) determines that the 
member firm or former member firm \98\ either does not meet the 
Preliminary Criteria for Identification or should not be designated as 
a Restricted Firm, the member firm or former member firm would no 
longer be subject to any obligations previously imposed under proposed 
Rule 4111.\99\ There would be one exception from this removal of 
previously imposed obligations in the case of the Restricted Deposit 
Requirement: A former Restricted Firm would not be permitted to 
withdraw any portion of its Restricted Deposit Requirement without 
submitting an application in the manner specified under Rule 
4111(f)(3)(A), and obtaining the Department's prior written consent for 
the withdrawal.\100\ The rule would establish presumptions for the 
Department's approval, or disapproval, of a withdrawal application. 
Specifically, the Department would approve an application for 
withdrawal if the member firm, its associated persons, or the former 
member firm have no Covered Pending Arbitration Claims or unpaid 
arbitration awards.\101\ In addition, the Department would approve an 
application by a former member for withdrawal if the former member 
commits in the manner specified by the Department to use the amount it 
seeks to withdraw from its Restricted Deposit to pay the former 
member's specified unpaid arbitration awards.\102\ By contrast, the 
Department would deny an application for withdrawal if: (1) The member 
firm, the member firm's associated persons who are owners or control 
persons, or the former member have any Covered Pending Arbitration 
Claims or unpaid arbitration awards, or (2) any of the member's 
associated persons have any Covered Pending Arbitration Claims or 
unpaid arbitration awards relating to arbitrations that involved 
conduct or alleged conduct that occurred while associated with the 
member.\103\
---------------------------------------------------------------------------

    \98\ See Notice at 78547; see also definition of ``Former 
Member'' in proposed Rule 4111(i)(7).
    \99\ See Notice at 78547.
    \100\ Id. Proposed Rule 4111(f)(3) would require a member's 
application requesting permission to withdraw any portion of its 
Restricted Deposit Requirement to include, among other things: (1) 
Evidence that there are no Covered Pending Arbitration Claims, 
unpaid arbitration awards or unpaid settlements relating to 
arbitrations outstanding against the member, the member's Associated 
Persons or the Former Member, or (2) a detailed description of any 
existing Covered Pending Arbitration Claims, unpaid arbitration 
awards or unpaid settlements relating to arbitrations outstanding. 
The Department would be required to issue a notice of its decision 
within 30 days from the date it receives the relevant application.; 
see also FINRA proposed Rule 9561.
    \101\ See Notice at 78547.
    \102\ Id.; see also proposed Rule 4111(f)(3) provides that the 
Covered Pending Arbitration Claims and unpaid arbitration awards of 
a member firm's associated persons are pertinent to an application 
for a withdrawal from the Restricted Deposit Requirement. In 
particular, the conditions for releasing funds from the restricted 
deposit include the former member having no specified unpaid 
arbitration awards. See supra note 51 and accompanying text.
    \103\ See Notice at 78547; see also FINRA proposed Rule 
4111(f)(3)(B).
---------------------------------------------------------------------------

Books and Records (Proposed Rule 4111(g))
    Member firms would also be obligated to maintain books and records 
that evidence their compliance with Rule 4111 and any Restricted 
Deposit Requirement or other conditions or restrictions imposed under 
that rule, which the member firm would also need to provide to the 
Department upon request.\104\
---------------------------------------------------------------------------

    \104\ See Notice at 78547.
---------------------------------------------------------------------------

Proposed Rule 9561 (Procedures for Regulating Activities Under Rule 
4111) and Amendments to Rule 9559 To Implement the Requirements of 
Proposed Rule 4111

    Rule 9561 would establish new expedited proceedings that would: (1) 
Provide an opportunity to challenge any requirements the Department has 
imposed, including any Restricted Deposit Requirements, by requesting a 
prompt review of the Department's decision in the Rule 4111 process; 
\105\ and (2) address a member firm's failure to comply with any 
requirements imposed under Rule 4111.\106\
---------------------------------------------------------------------------

    \105\ Proposed Rule 9561(a)(1) would define the ``Rule 4111 
Requirements'' to mean the requirements, conditions, or restrictions 
imposed by a Department determination under proposed Rule 4111. See 
Notice at 78548.
    \106\ See Notice at 78549.
---------------------------------------------------------------------------

Notices Under Proposed Rule 4111 (Proposed Rule 9561(a))
    Under new Rule 9561(a)(1), the Department would serve to the member 
firm a notice of the Department's decision following the Rule 4111 
process that: (1) Provides the specific grounds and factual basis for 
the Department's action; (2) states when the action would take effect; 
(3) informs the member firm that it may, within seven days after 
service of the notice, request a hearing in an expedited proceeding; 
and (4) explains the Hearing Officer's authority.\107\ The proposed 
rule change would also provide that, if a member firm does not request 
a hearing, the decision would constitute final FINRA action.\108\
---------------------------------------------------------------------------

    \107\ Id.
    \108\ Id. at 78548-49.
---------------------------------------------------------------------------

    In general, a request for a hearing would not stay any of the Rule 
4111 Requirements imposed in the Department's decision, which would be 
immediately effective.\109\ There is one exception: When a member firm 
requests review of a Department determination to impose a Restricted 
Deposit Requirement on the member, the firm would be required to 
deposit the lesser of 25% of its Restricted Deposit Requirement or 25% 
of its average excess net capital over the prior year, while the 
expedited proceeding is pending.\110\ This exception would not be 
available for a member firm that has been re-designated as a Restricted 
Firm, and is already subject to a previously imposed Restricted Deposit 
Requirement, which it would need to keep the assets on deposit in the 
Restricted Deposit account until the Office of Hearing Officers or NAC 
issues a written decision.\111\
---------------------------------------------------------------------------

    \109\ Id. at 78549.
    \110\ Id.
    \111\ See FINRA Rule 4111(e)(2), as modified by Amendment No. 2.
---------------------------------------------------------------------------

Notice for Failure To Comply With the Proposed Rule 4111 Requirements 
(Proposed Rule 9561(b))
    If a member firm fails to comply with any of the requirements 
imposed on it under Rule 4111, the Department would be authorized to 
serve a notice pursuant to proposed Rule 9561 stating that the member 
firm's continued failure to

[[Page 42932]]

comply within seven days of service of the notice would result in a 
suspension or cancellation of membership.\112\ The notice would need 
to: (1) Identify the requirements with which the member firm is alleged 
to have not complied; (2) specify the facts involved in the alleged 
failure; state when the action will take effect; (3) explain what the 
member firm would be required to do to avoid the suspension or 
cancellation; (4) inform the member firm that it may file a request for 
a hearing in an expedited proceeding within seven days after service of 
the notice under Rule 9559; and (5) explain the Hearing Officer's 
authority.\113\ If a member firm does not request a hearing, the 
suspension or cancellation would become effective seven days after 
service of the notice.\114\
---------------------------------------------------------------------------

    \112\ See FINRA Rule 4111(b)(1)-(2).
    \113\ See FINRA Rule 4111(b)(3).
    \114\ See FINRA Rule 4111(b)(6). After a suspension has been 
imposed, a member firm may file a request under Rule 9561(b) to 
terminate the suspension on the ground of full compliance with the 
notice or decision, and the head of the Department will be permitted 
to grant relief for good cause shown. See Notice at 78549.
---------------------------------------------------------------------------

Hearings (Proposed Amendments to the Hearing Procedures Rule)
    If a member firm requests a hearing under proposed Rule 9561, the 
hearing would be subject to Rule 9559 (Hearing Procedures for Expedited 
Proceedings Under the Rule 9550 Series). FINRA is also adopting several 
amendments to Rule 9559 specific to hearings requested pursuant to new 
Rule 9561.\115\
---------------------------------------------------------------------------

    \115\ See Notice at 78549. Specifically, FINRA is: (1) Amending 
Rule 9559(d) and (n) to establish the authority of a Hearing Officer 
in expedited proceedings under Rule 9561; (2) amending Rule 9559(f) 
to set out timing requirements for hearings conducted under Rule 
9561(a) and (b); and (3) amending Rule 9559(p)(6) to account for the 
obligations that may be imposed under new Rule 4111 within the 
content requirements of any decision issued by a Hearing Officer 
under the Rule 9550 Series. See amended Rules 9559(d), (f), (n), and 
(p)(6). Additionally, during expedited proceedings conducted under 
new Rule 9561(a) to review a Department determination under proposed 
Rule 4111, a member firm would be permitted to seek to demonstrate 
that the Department incorrectly included disclosure events when 
calculating whether the member firm meets the Preliminary Criteria 
for Identification. However, the member firm would not be permitted 
to argue the underlying merits of the final actions underlying the 
disclosure events. See Notice at 78550.
---------------------------------------------------------------------------

Effective Date

    The effective date will be 180 days after the Regulatory Notice 
announcing this Commission approval.\116\
---------------------------------------------------------------------------

    \116\ See FINRA March 4 Letter at 4. FINRA set a 180-day 
timeline for the effective date based on comments requesting that 
FINRA provide additional resources to facilitate member firms' 
compliance with proposed Rule 4111. FINRA stated, however, that 
while it intends to develop and provide additional tools to member 
firms, such tools may not be determinative, because ``whether a 
member firm will meet the Preliminary Criteria for Identification 
could only be definitely established as of the annual Evaluation 
Date.'' Id.
---------------------------------------------------------------------------

III. Discussion and Commission Findings

    After careful review of the proposed rule change, as modified by 
Amendment No. 1 and Amendment No. 2, the comment letters, and FINRA's 
responses to the comments, the Commission finds that the proposed rule 
change, as modified by Amendment No. 1 and Amendment No. 2, is 
consistent with the requirements of the Exchange Act and the rules and 
regulations thereunder that are applicable to a national securities 
association.\117\ Specifically, the Commission finds that the proposed 
rule change is consistent with Section 15A(b)(6) of the Exchange Act, 
which requires, among other things, that FINRA rules 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.\118\
---------------------------------------------------------------------------

    \117\ In approving this rule change, the Commission has 
considered the rule's impact on efficiency, competition, and capital 
formation. See 15 U.S.C. 78c(f).
    \118\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

Proposed Rule 4111 (Restricted Firm Obligations)

    The proposal to establish a process in new Rule 4111 to identify 
member firms that present a high degree of risk to the investing 
public, based on numeric thresholds of firm-level and individual-level 
disclosure events, and then impose a Restricted Deposit Requirement, 
conditions or restrictions on the member firm's operations, or both, 
will help protect investors and encourage such member firms to change 
their behavior. FINRA has designed the proposed rule change to 
establish an annual, multi-step process to determine whether a member 
firm raises investor protection concerns substantial enough to require 
the imposition of additional obligations,\119\ while allowing 
identified firms several means of challenging FINRA's decisions and 
affecting the ultimate outcome.\120\ The annual review process, and the 
ability to impose added obligations on firms presenting a significantly 
higher degree of risk to investors, should encourage firms to alter 
their behavior, ultimately to the benefit and protection of investors.
---------------------------------------------------------------------------

    \119\ FINRA believes that the proposal contains numerous steps 
that are objective and do not involve the use of discretion or that 
limit or focus FINRA's discretion. For example, the annual 
calculation that identifies member firms that are subject to the 
proposed rule would use objective, transparent criteria to identify 
outlier firms with the most significant history of misconduct 
relative to their peers. See Notice at 78559.
    \120\ For example, during the Consultation, the Department would 
evaluate whether the member firm has demonstrated that the annual 
calculation included disclosure events that should not have been 
included (because they are duplicative or not sales-practice 
related). Id.
---------------------------------------------------------------------------

    One commenter expressed general support for the proposal, without 
calling for any amendments.\121\ Three commenters expressed general 
support for the proposal, while also suggesting changes to the proposal 
to ease firms' compliance burdens, and to help achieve the intended 
purpose of both incentivizing improved behavior from member firms and 
better protecting investors.\122\ Finally, three other commenters 
expressed general opposition to the proposal.\123\
---------------------------------------------------------------------------

    \121\ See Letter from Ruben Huertero, Legal Intern, and 
Christine Lazaro, Director of the Securities Arbitration Clinic and 
Professor of Clinical Legal Education, St. John's University School 
of Law, dated December 28, 2020 (The Clinic indicating its support 
for the adoption of Rule 4111 requiring member firms with a high 
degree of risk towards the investing public to be subject to a 
deposit from which withdrawals would be restricted).
    \122\ See Letter from Kevin M. Carroll, Managing Director and 
Associate General Counsel, Securities Industry and Financial Markets 
Association, dated December 28, 2020 (``SIFMA Letter'') (SIFMA was 
supportive of the proposal ``to the extent it has the ancillary 
effect of incentivizing firms and their associated persons to comply 
with their regulatory obligations and to pay their arbitration 
awards.''); Letter from David P. Meyer, President, Public Investors 
Advocate Bar Association, dated December 28, 2020 (``PIABA Letter'') 
(PIABA indicated it supports the proposal ``in general'' and is ``a 
firm supporter of FINRA's efforts to enhance its programs to address 
the risks posed to investors by individual brokers and member firms 
that have a history of misconduct.''); letter from Lisa Hopkins, 
President, General Counsel and Senior Deputy Commissioner of 
Securities, West Virginia, North American Securities Administrators 
Association, Inc., dated December 28, 2020 (``NASAA Letter'') (NASAA 
``commends the Commission and FINRA for expanding controls over 
high-risk firms'' and indicated the proposal has the potential to 
``better protect investors from high-risk firms, which is a goal 
that NASAA supports.'').
    \123\ See Letter from Lev Bagramian, Senior Securities Policy 
Advisor, and Michael J, Hughes, Program & Research Assistant, Better 
Markets, dated December 28, 2020 (``Better Markets Letter'') (Better 
Markets indicated that the proposal is ``better than doing nothing, 
[but] it is nonetheless grossly insufficient.''); Letter from Andrew 
R. Harvin, Doyle, Restrepo, Harvin & Robbins, L.L.P., dated December 
21, 2020 (``Harvin Letter'') (Harvin indicated that the proposal is 
a ``rule proposal looking for a problem.''); Letter from Richard J. 
Carlesco Jr., CEO, IBN Financial Services, Inc., dated December 15, 
2020 (``IBN Letter'') (IBN indicated that the proposal is just one 
of a ``throng of new regulations that are burying small firms.'').
---------------------------------------------------------------------------

Disclosure of Restricted Firms
    Three commenters advocated for some form of public disclosure of 
Restricted Firms identified by FINRA during the Rule 4111 process.\124\ 
Two of those commenters expressed concerns that withholding publication 
of this information would limit investors'

[[Page 42933]]

ability to make informed decisions when selecting a brokerage 
firm.\125\ One argued that ``at a minimum, FINRA must prominently 
publicize the names of the firms that have been twice-designated as 
high-risk'' and those of newly formed firms where at least 20% of the 
associated persons were affiliated previously with twice-designated 
high-risk firms.\126\ One commenter also criticized the lack of 
required disclosure on Form BD or Form CRS, noting that firms are 
unlikely to make such disclosures voluntarily.\127\ The other commenter 
asserted that, ``at a minimum, the names of Restricted Firms should be 
provided to state securities regulators'' to assist such authorities 
with regulatory oversight and risk analyses of the firms.\128\ This 
commenter stated that the lack of disclosure to state securities 
regulators was particularly concerning, because it could ``skew an 
examiner's review of the firm's compliance with net capital 
requirements due to the restricted funds not being readily available to 
meet creditor's calls or liquidity requirements.'' \129\
---------------------------------------------------------------------------

    \124\ See PIABA Letter; Better Markets Letter; and NASAA Letter.
    \125\ See PIABA Letter at 3-4; Better Markets Letter at 17-18.
    \126\ See Better Markets Letter at 18. The Commission finds that 
this suggestion is also beyond the scope of the proposed rule 
change.
    \127\ See NASAA Letter at 5.
    \128\ Id. at 4.
    \129\ Id.
---------------------------------------------------------------------------

    In its initial response, FINRA pointed out that the purpose of 
proposed Rule 4111 is to address the risks posed by Restricted Firms 
through appropriate operational restrictions, while giving them 
opportunities and an incentive to remedy those risks, but that it 
intends to explore how it can appropriately share identified risks 
presented by certain firms with both the public and state securities 
regulators, while remaining consistent with the purpose of proposed 
Rule 4111.\130\ FINRA stated that the proposed rule change is designed 
to incentivize members that pose outlier-level risks, when compared to 
all similarly sized firms by headcount, to change behavior and could 
have an ancillary benefits for addressing unpaid arbitration 
awards.\131\ FINRA expressed concern that publicly disclosing a firm's 
Restricted Firm status may potentially interfere with those 
purposes.\132\ However, FINRA recognized the potential value to 
investors of public disclosure of a member's status as a Restricted 
Firm and intends to consider employing it and other approaches during 
its planned review of Rule 4111 after it has gained ``sufficient 
experience with the rule.'' \133\
---------------------------------------------------------------------------

    \130\ See FINRA March 4 Letter at 16-17 (listing the one-time 
staff reduction as an example of a means to get removed from the 
Restricted Firms list).
    \131\ Id. at 12.
    \132\ Id. at 16.
    \133\ Id. at 17. FINRA believes that information about a firm's 
status as a Restricted Firm, and any restricted deposit it is 
subject to, could become publicly available through existing sources 
or processes, such as through Form BD, Form CRS, or financial 
statements, or when a Hearing Officer's decision in an expedited 
proceeding is published pursuant to FINRA's publicity rule. See 
Notice at 78567 note 159.
---------------------------------------------------------------------------

    In further consideration of the matter, FINRA filed a second 
response to comments, wherein it indicated that the FINRA Board of 
Governors has authorized the filing of proposed amendments to Rule 8312 
(FINRA BrokerCheck Disclosure) that would require FINRA to identify on 
BrokerCheck those member firms or former member firms that are 
designated as Restricted Firms pursuant to proposed Rules 4111 and 
9561.\134\ FINRA indicated that public disclosure on BrokerCheck of 
those firms that it designates as a Restricted Firm should ``help 
investors make informed choices about the member firms with which they 
do business.'' \135\ FINRA stated that if the Commission approves the 
proposed rule change, FINRA would promptly thereafter file with the 
Commission the proposed amendments to Rule 8312.\136\ Additionally, 
FINRA committed to working with individual state securities regulators 
to share relevant information concerning whether firms that operate 
within their jurisdictions have been designated as Restricted Firms, 
along with information pertaining to the obligations that it has 
imposed on such firms pursuant to proposed Rules 4111 and 9561.\137\
---------------------------------------------------------------------------

    \134\ See FINRA July 20 Letter.
    \135\ Id. at 3.
    \136\ See FINRA July 20 Letter.
    \137\ Id.
---------------------------------------------------------------------------

    The Commission finds that the incentives it provides to encourage 
firms' remediation of high-risk behaviors would be an important step in 
furtherance of the protection of investors from broker-dealers with 
risk profiles indicative of potential future harm. The Commission finds 
that the proposed rule change is reasonable and is designed to enhance 
investor protection by incentivizing broker-dealers and brokers that 
pose higher risks to investors to change their behavior. For these 
reasons, the Commission finds the proposed rule change as presented is 
consistent with Section 15A(b)(6) of the Act in that it is in the 
public interest. The Commission further supports FINRA's commitment to 
working with individual state securities regulators to share relevant 
information and observes its commitment to further consider public 
disclosure of a firm's designation as a Restricted Firm by filing 
proposed amendments to Rule 8312 that would require FINRA to identify 
on BrokerCheck those member firms or former member firms that are 
designated as Restricted Firms pursuant to proposed Rules 4111 and 
9561.
Resources To Assist Member Firms With Compliance
    Two commenters advocated for greater clarity on how firms can 
independently replicate FINRA's calculation of the Preliminary 
Identification Metrics, due to the burdens firms may face in complying 
with proposed Rule 4111.\138\ One suggested that FINRA commit to: (1) 
Providing resources that ``map the Disclosure Event and Expelled Firm 
Association Categories to the relevant questions on Uniform 
Registration Forms''; (2) giving firms a worksheet to track their 
status based on disclosure events and previous firm associations of 
their Registered Persons In-Scope; and (3) providing firms with a list 
of all expelled firms.\139\ The other commenter suggested FINRA should 
advise each member firm ``in writing annually what its six Preliminary 
Identification Metrics are,'' and pointed out that without further 
assistance from FINRA, firms would need to review each of their 
registered representative's BrokerCheck reports to track the Registered 
Persons Associated With Previously Expelled Firms metric.\140\ FINRA 
indicated that it appreciates the potential compliance burdens, and 
understands the need and expressed its commitment to provide more 
guidance and resources.\141\ Further, FINRA indicated it will explore 
the feasibility of providing each member firm with notice of its status 
with respect to the Preliminary Criteria for Identification, including 
whether such notice would be useful for firms if calculated at any 
point other than on their annual Evaluation Date.\142\ As noted above, 
due to these concerns and the need to develop resources to assist firms 
with compliance, FINRA has extended the effective date for the proposed 
rule change to no later than 180 days after publication of a

[[Page 42934]]

Regulatory Notice announcing this Commission approval.\143\
---------------------------------------------------------------------------

    \138\ See SIFMA Letter; Harvin Letter.
    \139\ See SIFMA Letter at 2.
    \140\ See Harvin Letter at 1-3.
    \141\ See FINRA March 4 Letter at 4.
    \142\ Id.
    \143\ Id.
---------------------------------------------------------------------------

    Providing firms with increased clarity as to how the Preliminary 
Identification Metrics apply to their own situation would further 
assist in FINRA's goal to incentivize better behaviors from firms. The 
Commission thus supports FINRA's decision to extend the effective date 
of proposed Rule 4111 to develop certain compliance tools, and would 
encourage FINRA to provide resources and guidance for firms as is 
feasible.
Preliminary Criteria for Identification
    Three commenters expressed various concerns regarding the scope of 
events included in the proposed Preliminary Criteria for 
Identification.\144\
---------------------------------------------------------------------------

    \144\ See Harvin Letter; Better Markets Letter; and PIABA 
Letter.
---------------------------------------------------------------------------

    One commenter urged FINRA to amend the Preliminary Identification 
Metrics to use ``more stringent criteria in identifying high risk 
firms,'' including (1) expanding the look-back review period for 
disclosure events from five to ten years; (2) decreasing the settlement 
size threshold for investment-related, consumer-initiated customer 
arbitration awards and civil judgments from $15,000 to $5,000; and (3) 
expanding the scope of disclosure events to cover events that are 
harmful to investors, even where not consumer-initiated.\145\
---------------------------------------------------------------------------

    \145\ See Better Markets Letter at 16.
---------------------------------------------------------------------------

    FINRA responded that it already considered these alternative 
definitions and criteria among many others. For instance, FINRA stated 
that it considered whether adjudicated events should be counted over 
the individual's or firm's entire reporting period or counted over a 
more recent period. Based on its experience, FINRA believes that more 
recent events (i.e., events occurring in the last five years) generally 
pose a higher level of possible future risk to customers than other 
events. Further, FINRA believes that counting events over an 
individual's or firm's entire reporting period would imply that 
associated persons and firms would always be included in the 
Preliminary Identification Metrics for adjudicated events, even if they 
subsequently worked without being associated with any future 
adjudicated events.\146\
---------------------------------------------------------------------------

    \146\ See Notice at 78556.
---------------------------------------------------------------------------

    Similarly, FINRA's use of the $15,000 settlement threshold is 
consistent with its approach in the High Risk Broker Approval Order. In 
that filing, FINRA established metrics based, in part, on complaints 
that led to an award against a broker or settled above a de minimis 
threshold of $15,000 because it wanted to ``focus its analysis on 
outcomes that are more likely associated with material customer harm.'' 
\147\ FINRA also stated that the $15,000 mark represents the current 
CRD settlement threshold for reporting customer complaints on Uniform 
Registration Forms.\148\ Thus, by lowering the threshold to $5,000, 
FINRA ``would not have useful information . . . from which to make its 
objective analysis,'' because the additional events that would be 
captured by this change from the proposed rule would not be 
reportable.\149\
---------------------------------------------------------------------------

    \147\ See High Risk Broker Approval Order at 81547.
    \148\ Id.
    \149\ Id.
---------------------------------------------------------------------------

    Finally, FINRA also disputed the assessment that the proposed rule 
is ``limited to only events that are `consumer-initiated,' '' as 
disclosure events are only qualified by the term ``consumer-initiated'' 
in the proposal where that distinction is made in disclosure questions 
in the Uniform Registration Forms.\150\
---------------------------------------------------------------------------

    \150\ See FINRA March 4 Letter at 10; see also proposed Rule 
4111(i)(4), including, among other things, criminal matters, 
regulatory actions, and terminations as disclosure events.
---------------------------------------------------------------------------

    The Commission finds that the standards proposed by FINRA are 
reasonable and are designed to better enable FINRA to initially 
identify firms for potential designation as a Restricted Firm through 
objective criteria--one of FINRA's stated goals in initially proposing 
the rule.\151\ Further, this approach conforms to another of FINRA's 
``guiding principles'' in developing the proposal, to provide member 
firms with transparency regarding how proposed Rule 4111 would operate, 
such that firms ``could largely identify with available data the 
specific set of disclosure events that would count towards the proposed 
criteria and whether the firm had the potential to be designated as a 
Restricted Firm.'' \152\ In addition, the proposed disclosure events 
covered by the proposed rule would not be limited to customer initiated 
events but would include, among other things, criminal matters, 
regulatory actions, and terminations.\153\ FINRA's proposed definition 
of disclosure events would capture the types of activities FINRA 
believes are indicative of future investor protection concerns. For 
these reasons, the Commission finds FINRA's approach is designed to 
protect investors and the public interest.
---------------------------------------------------------------------------

    \151\ See Notice at 78542.
    \152\ Id. at 78561. FINRA also stated that this desire to 
provide transparency is why it based proposed Rule 4111 on ``events 
disclosed on the Uniform Registration Forms, which are generally 
available to firms and FINRA.'' As noted above, FINRA remains aware 
that even though these data would be available to firms by accessing 
the BrokerCheck reports of each of their registered representatives, 
FINRA could ease firms' compliance burdens by providing additional 
tools. With this in mind, FINRA has committed to providing firms 
with additional guidance and resources to help facilitate member 
firms' independent calculations, and has extended the effective date 
following the Commission's approval in order to have sufficient time 
for development of such resources. See FINRA March 4 Letter at 4.
    \153\ See FINRA March 4 Letter at 10.
---------------------------------------------------------------------------

    With respect to expanding the five-year lookback, the same 
commenter objected to FINRA's proposed rule change establishing a 
maximum look-back period for the Registered Persons Associated with 
Previously Expelled Firms metric at five years, asserting it was based 
on ``overblown'' concerns that an unlimited look-back period would 
discourage firms from hiring registered representatives who may not 
themselves have violated any rules, thus resulting in unfair 
punishment.\154\ Alternatively, the commenter suggested that this 
lookback period be extended to ten years.\155\
---------------------------------------------------------------------------

    \154\ See Better Markets Letter at 10.
    \155\ Id. at 16.
---------------------------------------------------------------------------

    In response, FINRA explained that it avoided proposing an unlimited 
lookback period over a registered person's entire career and added a 
five-year look back to be consistent with the lookback periods for the 
other proposed metrics.\156\ FINRA further reasoned that it added the 
requirement that the individual was registered at the now-expelled firm 
for a year or more because, in its experience, registered persons with 
more recent associations and longer tenures with expelled firms 
``generally pose higher risk than other individuals.'' \157\ Finally, 
FINRA stated that it believes the Expelled Firm Association Metric and 
Expelled Firm Association Metrics Thresholds ``appropriately serve[] 
the goal of preliminarily identifying firms that present a higher 
risk.'' \158\ To help ensure the Expelled Firm Association Metric 
continues to serve its intended purposes, FINRA indicated it examined 
the Expelled Firm Association Metric and related thresholds and 
validated that they continue to serve the intended purpose of 
identifying firms posing a greater risk to customers.\159\
---------------------------------------------------------------------------

    \156\ See FINRA March 4 Letter at 11; see also Notice at 78560.
    \157\ See FINRA March 4 Letter at 11.
    \158\ Id. at 10.
    \159\ Id. at 11-12.
---------------------------------------------------------------------------

    The Commission finds that FINRA has reasonably tailored its 
proposal and its related thresholds to identify those firms that 
present such a risk. In

[[Page 42935]]

particular, the Commission finds FINRA's conclusion reasonable that a 
registered representative's association with an expelled firm that is 
more recent, and/or longer-term is more likely to pose a higher risk 
than those relationships that are further removed, or of a shorter-
duration. The Commission encourages FINRA to regularly reassess the 
appropriateness of the related metrics and thresholds for identifying 
firms to help ensure these definitions accurately identify the highest 
risk firms.\160\ For these reasons, the Commission finds FINRA's 
approach to identify firms that may pose a higher risk to investors is 
designed to protect investors and the public interest.
---------------------------------------------------------------------------

    \160\ If FINRA proposes to amend these rules in the future, 
FINRA would be required to file the proposed rule change with the 
Commission along with a concise general statement of the basis and 
purpose of the proposed rule change. The Commission would then 
publish a notice in connection with the proposed rule change in the 
Federal Register and post it on its public website to give 
interested persons an opportunity to comment on the proposed rule 
change. See Exchange Act Section 19(b)(1) and Rule 19b-4 promulgated 
thereunder.
---------------------------------------------------------------------------

    Finally, one commenter suggested that the proposed Preliminary 
Criteria for Identification Metrics could be improved by considering 
the nature and extent to which certain securities are sold by firms. In 
particular, this commenter expressed concern that ``high-risk firms 
will often focus a large percentage of their business on selling, for 
example, non-publicly traded investment products.'' \161\ In the event 
that such a product fails, these firms' investors can be left without 
recourse if a firm collapses.\162\ FINRA responded that the proposed 
Preliminary Criteria for Identification are intended to be 
``replicable, objective and transparent,'' and are thus ``almost 
entirely based on disclosures on the Uniform Registration Forms'' that 
do not distinguish disclosures associated with product failures from 
any other disclosures made by the firm.\163\ However, FINRA indicated 
it could account for the types of securities sold by a firm (including 
``product failures'') when making its initial determination in the Rule 
4111 process, or through the Consultation.\164\ Further, FINRA stated 
that proposed Rule 4111(i)(15) requires that any determination of a 
Restricted Firm's Restricted Deposit Requirement would be required to 
consider, among other items, ``the nature of the firm's operations and 
activities.'' \165\
---------------------------------------------------------------------------

    \161\ See PIABA Letter at 6.
    \162\ Id.
    \163\ See FINRA March 4 Letter at 9; see also supra note 66 
(noting that one of the event categories, Member Firm Adjudicated 
Events, includes events that are derived from customer arbitrations 
filed with FINRA's dispute resolution forum).
    \164\ Id.
    \165\ Id.; see also 4111(i)(15).
---------------------------------------------------------------------------

    As previously noted, the Commission supports FINRA setting 
Preliminary Criteria for Identification in as transparent, replicable, 
and objective a manner as possible by reference to the Uniform 
Registration Forms. While the comment focuses on securities that may be 
riskier for investors, such as non-publicly traded securities, FINRA 
has demonstrated that the proposed ``funnel'' process affords the 
opportunity for FINRA to account for the types of securities sold by a 
firm. While not included in the Preliminary Criteria for Identification 
Metrics that serve as the threshold analysis, FINRA can identify and 
consider a firm's propensity to offer riskier securities during the 
Consultation process and in setting a Restricted Deposit Requirement 
and imposing appropriate conditions and restrictions on such a firm. 
For these reasons, the Commission finds FINRA's approach is designed to 
protect investors and the public interest.
    One commenter suggested that proposed Rule 4111 should directly 
reference the ``specific disclosure questions or items'' in the Uniform 
Registration Forms that align to the Preliminary Criteria for 
Identification, rather than using alternative language for the 
definitions of each of the rule's categories.\166\ FINRA responded that 
the definitions of the six categories of the Preliminary Criteria for 
Identification capture disclosures from multiple Uniform Registration 
Forms.\167\ As such, FINRA believes that listing each of the questions 
from each such relevant form would ``be more confusing in the rule text 
and could lead to ongoing amendments to the definition as the [Uniform 
Registration Forms] are amended.'' \168\ Instead, FINRA has elected to 
use substantive descriptions of the included disclosure events in 
proposed Rule 4111 with a ``plain-English approach'' that summarizes 
and describes disclosure events from the Uniform Registration Forms to 
make the definitions easier to read, understand, and use.\169\ FINRA 
also stated that this approach is consistent with a related filing that 
was recently approved by the Commission (SR-FINRA-2020-011), where it 
elected not to include questions from the Uniform Registration Forms to 
avoid confusion and the need for ongoing amendments to the proposed 
rule change when these forms are revised in the future.\170\ Although 
FINRA did not take this commenter's suggestion, it stated it is 
considering providing guidance that would map the Registered Person and 
Member Firm events to the relevant disclosure questions on the Uniform 
Registration Forms to help firms self-monitor their metrics.\171\
---------------------------------------------------------------------------

    \166\ See Harvin Letter at 2.
    \167\ See FINRA March 4 Letter at 7.
    \168\ Id.
    \169\ Id. at 8.
    \170\ Id. at 7-8.
    \171\ Id. at 8.
---------------------------------------------------------------------------

    The same commenter stated that while the proposed definition of 
``Member Firm Adjudicated Events'' includes ``[a] final investment-
related, consumer-initiated customer arbitration award in which the 
member was a named party,'' \172\ publicly available summary 
information on arbitration awards found on BrokerCheck and Arbitration 
Awards Online do not identify awards as ``investment-related'' or 
``consumer-initiated.'' \173\ FINRA agreed that additional clarity is 
warranted, and confirmed that this prong of the Member Firm Adjudicated 
Events definition is ``intended to capture all BrokerCheck disclosures 
of arbitration awards against firms,'' but stopped short of amending 
the rule text to make direct references to BrokerCheck. Due to the 
concerns over the potential for added confusion noted above, FINRA 
stated it was not appropriate to make such amendment in light of its 
plain-English approach.\174\
---------------------------------------------------------------------------

    \172\ See proposed Rule 4111(i)(4)(D)(i).
    \173\ See Harvin Letter at 2.
    \174\ See FINRA March 4 Letter at 8.
---------------------------------------------------------------------------

    The Commission finds that FINRA's choice to provide a ``plain-
English'' approach is reasonable and designed to provide clarity 
regarding what events would and would not be included in the 
Preliminary Identification Metrics. For these reasons, the Commission 
finds FINRA's approach is designed to protect investors and the public 
interest.
    The same commenter also raised a question about the definition of 
Member Firm Pending Events, and whether there is a distinction between 
a ``pending investigation by a regulatory authority'' and a ``pending 
regulatory action that was brought by the SEC or CFTC, other federal 
regulatory agency, a state regulatory agency, a foreign financial 
regulatory authority, or a self-regulatory organization.'' While Forms 
U4 and U5 require disclosure of pending ``investigations,'' the 
commenter observed that Form U6 refers to a matter as an action and 
does not mention ``investigation.'' \175\ FINRA stated that the 
proposed inclusion of ``pending investigations by a regulatory 
authority''

[[Page 42936]]

within the Member Firm Pending Events definition was intended to 
parallel a similar provision in the proposed Registered Person Pending 
Events definition.\176\ However, FINRA stated that, from a technical 
perspective, ``Form BD contains no disclosure questions or DRP fields 
about pending investigations by a regulatory authority concerning 
firms.'' \177\ As a result, FINRA filed Amendment No. 1 to make a 
technical correction to the definition of Member Firm Pending Events in 
proposed Rule 4111(i)(4)(E) by deleting ``a pending investigation by a 
regulatory authority'' reportable on the member's Uniform Registration 
Forms, as the relevant forms contain no such disclosure question or DRP 
fields.
---------------------------------------------------------------------------

    \175\ See Harvin Letter at 2; see also proposed Rule 
4111(i)(4)(E)(ii) and (iii).
    \176\ See FINRA March 4 Letter at 9; see also proposed Rule 
4111(i)(4)(B)(ii).
    \177\ See FINRA March 4 Letter at 9.
---------------------------------------------------------------------------

One-Time Opportunity To Reduce Staffing Levels
    Two commenters urged FINRA to add further conditions to the one-
time staff reduction option afforded to those firms identified the 
first time the Rule 4111 process is used.\178\ One commenter asked 
FINRA to require that any terminations would need to begin with those 
persons with the highest number of disclosure events or those that 
``pose the greatest risk to investors,'' and that in all circumstances, 
firms should be prohibited from retaining certain persons ``due to 
their position within the firm or the amount of revenue they 
generate.'' \179\ The other commenter criticized the allowance of a 
one-time staff reduction as incentivizing member firms to merely 
``discharge `low hanging fruit' and continue business as usual,'' 
rather than effectively monitor and supervise their registered 
representatives.\180\
---------------------------------------------------------------------------

    \178\ See Better Markets Letter; PIABA Letter.
    \179\ See Better Markets Letter at 17.
    \180\ See PIABA Letter at 7.
---------------------------------------------------------------------------

    FINRA responded that it agrees with the investor protection 
objectives of these two comments, but that the proposed rule change 
achieves these objectives.\181\ For instance, FINRA believes that firms 
would have a strong incentive to use the staff-reduction option to 
avoid being subject to a Restricted Deposit Requirement or other 
conditions and restrictions for a significant period of time, and to 
use this option they would need to terminate representatives who have 
the kinds of disclosures captured by the rule and in sufficient numbers 
that cause the firm to fall below the stated thresholds.\182\ FINRA 
also stated that prohibiting the firm from rehiring any terminated 
employees for one-year prevents a firm from evading the objectives of 
the proposed rule change since any member firm that seeks to hire such 
persons would need to also consider and comply with FINRA Rule 9522 
(Initiation of Eligibility Proceeding; Member Regulation Consideration) 
to the extent that any such persons are subject to a ``statutory 
disqualification'' as defined in Section 3(a)(39) of the Exchange 
Act.\183\ Additionally, FINRA stated that since a firm would not be 
able to use the staff-reduction option a second time, it would deter 
firms from thereafter hiring individuals with a record of disciplinary 
issues after a staff reduction and incentivize those firms to improve 
compliance going forward to avoid a Restricted Firm designation in the 
future.\184\
---------------------------------------------------------------------------

    \181\ See FINRA March 4 Letter at 21.
    \182\ Id. at 21-22.
    \183\ Id. at 22 note 60.
    \184\ Id. at 22; see also Notice at 78562.
---------------------------------------------------------------------------

    The Commission finds that the one-time staff reduction option, 
along with a one-year restriction on rehiring by the firm from which 
those employees were terminated, as proposed, is a reasonable means to 
materially reduce the current risk to investors and to incentivize 
firms to improve compliance over a longer-term period to avoid both a 
Restricted Firm designation the first time they meet the Preliminary 
Criteria for Identification, and also being re-identified in a 
subsequent Rule 4111 evaluation. For these reasons, the Commission 
finds that FINRA's approach is designed to protect investors and the 
public interest.
    One of the commenters also called on FINRA to amend the proposal to 
prohibit those employees who are laid off during the Consultation 
process from being ``hired by other firms for at least one year, and 
never by another high-risk firm.'' \185\ While FINRA stated that a 
separate rulemaking (amending FINRA Rule 1017), recently approved by 
the Commission, may also help deter firms from hiring recidivist 
registered representatives recently fired by other firms,\186\ the 
commenter argued this rule change is insufficient, as it ``does not 
prohibit the hiring [of such terminated employees], but merely requires 
that the hiring firm impose an additional supervisory regime over 
troublesome brokers.'' \187\
---------------------------------------------------------------------------

    \185\ See Better Markets Letter at 16-17. In its letter, Better 
Markets also suggested--as an alternative to their suggestion that 
FINRA adopt an order for the employees to be terminated--that FINRA 
could require would be that firms ``terminate or lay-off those 
brokers who would have had a harmful combination of frequent and 
severe violations of FINRA and SEC rules that have a direct impact 
on investors.'' Better Markets Letter at 16.
    \186\ See Exchange Act Release No. 90635 (Dec. 10, 2020), 85 FR 
81540 (Dec. 16, 2020) (File No. FINRA-2020-011) (``High Risk Broker 
Approval Order''). Pursuant to FINRA Rule 1017, any broker-dealer 
seeking to add a natural person who: (1) Has, in the prior five 
years, one or more final criminal matters or two or more specified 
risk events and (2) seeks to become an owner, control person, 
principal, or registered person of the member must submit a written 
request seeking a materiality consultation for the contemplated 
activity so that FINRA can determine whether a the firm must file a 
continuing member application.
    \187\ See Better Markets Letter at 17.
---------------------------------------------------------------------------

    FINRA disagreed, noting that under the approved changes to Rule 
1017(a)(7), member firms must submit a written request to FINRA seeking 
a materiality consultation whenever a person ``seeks to become an 
owner, control person, principal or registered person of the member'' 
who has one ``final criminal matter'' or two ``specified risk events'' 
within the past five years.\188\ During this materiality assessment, 
the Department may then require the firm make a Form CMA filing \189\--
and obtain FINRA's approval thereafter--before such person may be 
hired.\190\ Further, FINRA stated that one of the examples provided in 
proposed Rule 4111.03 of the conditions and restrictions the Department 
may impose on a Restricted Firm is ``limitations on business 
expansions,'' which FINRA has indicated ``could include limitations on 
the kinds of persons that a Restricted Firm may hire.'' \191\ 
Separately, FINRA also stated that the Commission recently approved 
rule changes that will potentially impact employees terminated under 
proposed Rule 4111(c)(2) when seeking to join another firm.\192\
---------------------------------------------------------------------------

    \188\ See FINRA March 4 Letter at 22-23.
    \189\ Prior to making certain changes to its ownership, control, 
or business operations, a FINRA member firm must file a Form 
Continuing Membership Application or ``Form CMA,'' and obtain 
FINRA's pre-approval to do so. See FINRA Rule 1017(a) (Application 
for Approval of Change in Ownership, Control, or Business 
Operations).
    \190\ See FINRA March 4 Letter at 22-23.
    \191\ Id. at 23; see proposed Rule 4111.03(1), which sets out 
that FINRA may impose ``limitations on business expansions, mergers, 
consolidations, or changes in control,'' among the examples of 
potential conditions or restrictions that may be placed on 
Restricted Firms.
    \192\ See FINRA March 4 Letter at 22; see also High Risk Broker 
Approval Order at 81544-45.
---------------------------------------------------------------------------

    The Commission finds that the incentives created by the one-time 
staff reduction option, as proposed, reasonably align with FINRA's 
stated purpose to incentivize firms to reduce their risk profile and 
improve their compliance. For these reasons, the Commission finds 
FINRA's approach is designed to protect investors and the public 
interest. While the Commission recognizes that FINRA's recent 
amendments to the materiality

[[Page 42937]]

consultation process noted above, could provide an additional layer of 
deterrence to firms' hiring of recidivist representatives terminated by 
other firms, it finds that the critique of previously approved Rule 
1017(a)(7) is beyond the subject matter of this proposed rule change 
and therefore is beyond the scope of this filing.
Calls To Expel Restricted Firms That Fail To Improve
    One commenter argued that proposed Rule 4111 should be amended so 
that if a firm is designated a Restricted Firm in one year, and does 
not improve to avoid re-designation in either of the next two years, 
FINRA should ``expel the firm, and de-license and bar all current 
brokers who were employed by the firm at the time of initial 
designation.'' \193\ Further, this commenter argued the expulsion order 
``should not be appealable and should take immediate effect.'' \194\ 
FINRA responded that this request would essentially broaden the 
statutory definition of ``disqualified persons,'' ``which is not within 
FINRA's jurisdiction to do.'' \195\ Additionally, FINRA asserted that 
the call for expulsion without a right to appeal would be 
``inconsistent with the fair procedure requirements in Section 
15A(b)(8) of the Securities Exchange Act of 1934.'' \196\
---------------------------------------------------------------------------

    \193\ See Better Markets Letter at 19.
    \194\ Id. Better Markets argued that the rationale for this 
remedy is that firms that have been twice-designated, but not 
significantly improved their compliance culture have ``prove[d] that 
they are irredeemable, and they do not deserve to be permitted to 
serve, or more likely, harm any additional investors.'' Id.
    \195\ See FINRA March 4 Letter at 26.
    \196\ Id. at 26-27; see also Exchange Act Section 15A(b)(8) 
(Requiring that FINRA's rules, in general, ``provide a fair 
procedure for the disciplining of members and persons associated 
with members, the denial of membership to any person seeking 
membership therein, the barring of any person from becoming 
associated with a member thereof, and the prohibition or limitation 
by the association of any person with respect to access to services 
offered by the association or a member thereof.'').
---------------------------------------------------------------------------

    The Commission agrees with FINRA that the expulsion of a firm 
without right to appeal the decision would be inconsistent with the 
fair disciplinary procedures that member firms are to be afforded 
pursuant to Section 15A(b)(8). Moreover, the Commission finds that 
proposed Rule 4111 adopts a reasonable set of conditions and 
restrictions on firms with outlier-level disclosure events, and 
incentivizes such firms to improve their behavior for the protection of 
the investing public. Still, the Commission encourages FINRA to, after 
gaining sufficient experience post-effectiveness, to review whether 
proposed Rule 4111 is adequately meeting its intended goals or if 
further amendments would be appropriate.\197\ For these reasons, the 
Commission does not believe that it is necessary to address whether, as 
FINRA states, the commenter's proposal would impermissibly broaden the 
definition of ``statutory disqualification'' under the Exchange Act.
---------------------------------------------------------------------------

    \197\ FINRA plans to conduct a review of the effectiveness of 
proposed Rule 4111 after gaining sufficient experience with its 
operation. See Notice at 78548. Among other things, FINRA would 
review whether the Preliminary Identification Metrics Thresholds are 
sufficiently targeted and effective at identifying member firms that 
pose higher risks. Id.
---------------------------------------------------------------------------

Concerns About the Definition of ``Covered Pending Arbitration Claim'' 
and the Restricted Deposit Account
    Two commenters expressed concerns regarding the proposed definition 
of a ``Covered Pending Arbitration Claim.'' \198\ One commenter argued 
that adopting a definition to only cover claims if they exceed a firm's 
excess net capital ``improperly excludes claims that are less than a 
firm's excess net capital yet may still remain unpaid by the firm.'' 
\199\ In response, FINRA stated that the term ``Covered Pending 
Arbitration Claim'' excludes final arbitration matters that have 
resulted in either an award or settlement, and that ``regardless of a 
firm's excess net capital, if a final arbitration award or settlement 
is unpaid, that would be a factor for FINRA to consider when 
determining a Restricted Deposit Requirement and reviewing a firm's 
request for a withdrawal from a Restricted Deposit.'' \200\ The same 
commenter also argued that because FINRA will assess each firm based on 
a fixed point in time, this definition will enable firms to 
``manipulate whether an arbitration claim is covered simply by 
adjusting its excess net capital while FINRA is determining the 
Restricted Deposit Requirement.'' \201\ FINRA responded that although 
its assessment of a firm will occur on a fixed date, proposed Rule 
4111(i)(15) would require the Department to review a firm's financial 
factors, including its net capital levels ``for relevant periods,'' 
enabling the Department to detect material changes in a firm's net 
capital levels during or in anticipation of a possible review under 
Rule 4111 and to ``take into account attempts by a firm to manipulate 
financial-related factors.'' \202\
---------------------------------------------------------------------------

    \198\ See PIABA Letter; Harvin Letter. As noted above, proposed 
Rule 4111(i)(2) defines Covered Pending Arbitration Claim as an 
investment-related, consumer-initiated claim filed against the 
member or its associated persons in any arbitration forum that is 
unresolved; and whose claim amount (individually or, if there is 
more than one claim, in the aggregate) exceeds the member's excess 
net capital.
    \199\ See PIABA Letter at 7.
    \200\ See FINRA March 4 Letter at 23. FINRA also stated that 
other of its rules ``currently prohibit member firms or registered 
representatives who do not pay arbitration awards in a timely manner 
from continuing to engage in the securities business under FINRA's 
jurisdiction.'' Id. at 23 note 65; see also proposed Rule 4111(f) 
and (i)(15).
    \201\ See PIABA Letter at 7.
    \202\ See FINRA March 4 Letter at 24.
---------------------------------------------------------------------------

    The Commission finds that it is reasonable to exclude final 
arbitration matters that have resulted in an award or settlement from a 
definition designed to capture only pending claims. Further, the 
Commission agrees that proposed Rule 4111 has provided a mechanism for 
FINRA to account for such unpaid arbitration awards or settlements 
resulting from a final arbitration in crafting a Restricted Firm's 
Restricted Deposit Requirement, and in evaluating any request to 
withdraw funds from its Restricted Deposit Account. The Commission also 
finds that the design of proposed Rule 4111, which would require FINRA 
to evaluate each firm's financial factors across ``relevant periods,'' 
should be allow FINRA to detect potential manipulation of a firm's net 
capital amounts. For these reasons, the Commission finds FINRA's 
approach is designed to protect investors and the public interest.
    Another commenter asserted that the term ``claim amount'' should be 
removed from the definition of a ``Covered Pending Arbitration Claim,'' 
arguing there is no support for the proposition that the ``claim 
amount'' stated in an arbitration claim has ``any basis in reality.'' 
\203\ Instead, this commenter suggested that the definition of 
``Covered Pending Arbitration Claim'' be revised to refer to the 
accounting standards pertaining to loss contingencies as adopted by the 
Financial Accounting Standards Board, so as to account for the 
probability that a pending arbitration claim results in a loss, and 
whether that potential loss can be reasonably estimated.\204\
---------------------------------------------------------------------------

    \203\ See Harvin Letter at 3; see also Notice at 78541 note 10 
(FINRA has stated that the ``claim amount'' only includes claimed 
compensatory loss amounts and not those for pain and suffering, 
punitive damages or attorney's fees. The claim amount shall be the 
maximum amount that the member or 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.).
    \204\ Id. at 5. Specifically, Harvin pointed to Financial 
Accounting Standards Board (FASB) Accounting Standards Codification 
(ASC) Topic 450-20 (Loss Contingencies), ASC 450-20-25 
(Recognition), ASC 450-20-25-2, ASC-450-20 (Glossary), and ASC 450-
20-55-13. Id. at 3-5.

---------------------------------------------------------------------------

[[Page 42938]]

    FINRA responded that it is necessary that all Covered Pending 
Arbitration Claims be considered within the requirements, because based 
on its experience, firms do not necessarily recognize a ``loss 
contingency'' for such a claim before concluding a proceeding.\205\ 
FINRA also indicated it believes that proposed Rule 4111(i)(15) ``is 
already flexible enough to address'' the commenter's concerns regarding 
loss contingencies.\206\ Finally, FINRA clarified that while the 
commenter seemed to ``presume [ ] that the Restricted Deposit 
Requirement amount would establish a floor based on the amount of the 
firm's Covered Pending Arbitration Claims,'' the amount of such claims 
will serve merely as one factor, among many others, considered when 
FINRA crafts a firm's Restricted Deposit Requirement.\207\
---------------------------------------------------------------------------

    \205\ See FINRA March 4 Letter at 24.
    \206\ Id. FINRA also stated that, in this regard, firms would 
not be precluded during the Consultation from asserting that the 
Covered Pending Arbitration Claims factor should be evaluated by the 
Department ``in relation to the probability that those pending 
claims would evolve into actual liabilities and that the size of 
such actual liabilities would be less than the stated amount of the 
claims.''
    \207\ Id. See supra note 90 (detailing a series of proposed 
factors the Department would consider when determining a Restricted 
Firm's maximum Restricted Deposit Requirement).
---------------------------------------------------------------------------

    The Commission finds it is reasonable for FINRA to retain the term 
``claim amount'' within the proposed definition of a Covered Pending 
Arbitration Claim. To operationalize Rule 4111, FINRA will need to be 
able to utilize consistent metrics that provide for comparable data 
across firms of similar sizes. The Commission agrees that the lack of 
consistency in firms recognizing ``loss contingencies'' for pending 
claims would undermine the usefulness of such figures in making initial 
identifications of those firms with outlier-level disclosure events 
relative to similarly sized peers. Further, the Commission agrees that 
proposed Rule 4111, and specifically the proposed definition of a 
Restricted Deposit Requirement, provides flexibility to enable FINRA to 
account for loss contingencies when thereafter determining an 
appropriate deposit requirement for Restricted Firms. Finally, pursuant 
to proposed Rule 4111(d), a firm would have an opportunity to 
demonstrate that it should not be required to be subject to the maximum 
Restricted Deposit Requirement by arguing that that certain Covered 
Pending Arbitration Claims were improperly considered in determining 
its restricted status.\208\ For these reasons, the Commission finds 
FINRA's approach is designed to protect investors and the public 
interest.
---------------------------------------------------------------------------

    \208\ See Notice at 78545.
---------------------------------------------------------------------------

Concerns About the Calculation of a Firm's Maximum Restricted Deposit 
Requirement
    One commenter stated that as one of the purposes of proposed Rule 
4111 is to ``give FINRA another tool to incentivize member firms to . . 
. pay arbitration awards,'' imposing a Restricted Deposit Requirement 
on any firm that lacks Covered Pending Arbitration Claims or other 
unpaid arbitration awards would be unnecessary and that calculation of 
the Restricted Deposit in these circumstances would be arbitrary.\209\ 
FINRA disagreed, asserting that the primary purpose of proposed Rule 
4111 is to incentivize member firms with outlier-level risks to change 
their behavior, and therefore confirmed that under the proposal the 
Department could impose a Restricted Deposit Requirement on a 
Restricted Firm regardless of whether it has any unpaid arbitration 
awards or Covered Pending Arbitration Claims.\210\
---------------------------------------------------------------------------

    \209\ See Harvin Letter at 5-7.
    \210\ See FINRA March 4 Letter at 13; see also Notice at 78541 
(stating FINRA believes that the ``direct financial impact of a 
restricted deposit is most likely to change [a] member firms' 
behavior--and therefore protect investors.'').
---------------------------------------------------------------------------

    The same commenter criticized FINRA's failure to include in 
proposed Rule 4111(i)(15) the ``average total revenue paid out in the 
past five years in arbitration and customer settlements and 
litigation'' as a factor for determining a firm's maximum Restricted 
Deposit Requirement.\211\ According to the commenter, the ``average 
total revenue paid'' would represent a more accurate metric than the 
average amount of arbitration and customer settlements paid because the 
latter is not indicative of a firm having difficulty paying arbitration 
awards. FINRA questioned the commenter's assumption, stating that even 
if a Restricted Firm has a recent history of paying arbitration awards 
and settlements, it does not mean that a Restricted Deposit Requirement 
would not be an appropriate step to address the risks such firm poses 
to investors.\212\ FINRA responded that in general, it believes the 
factors included in the rule are both specific enough to be relevant 
for the Department in determining a firm's maximum Restricted Deposit 
Requirement, and also flexible enough to allow the Department to weigh 
those factors against all relevant facts and circumstances for a given 
firm.\213\ Moreover, the Consultation process would provide an 
opportunity for a firm to present why the maximum Restricted Deposit 
Requirement amount does not properly account for any particular factor 
in the rule, including by presenting the firm's average total revenue 
paid out in the past five years in arbitration and customer settlements 
and litigation.\214\
---------------------------------------------------------------------------

    \211\ See Harvin Letter at 7.
    \212\ See FINRA March 4 Letter at 14.
    \213\ Id. at 13.
    \214\ Id. at 13-14; see also Notice at 78545-46.
---------------------------------------------------------------------------

    The Commission finds that the proposed rule change to enable FINRA 
to impose a Restricted Deposit Requirement on Restricted Firms is a 
reasonable component of proposed Rule 4111 and is reasonably designed 
to address the proposed rule's goal of improving member firm behavior 
for the protection of the investing public. Even where a firm lacks 
Covered Pending Arbitration Claims or other unpaid arbitration awards, 
the imposition of a Restricted Deposit Requirement is a reasonable 
means of accomplishing the proposal's primary purpose. Moreover, the 
Commission agrees that the flexibility afforded by proposed Rule 
4111(i)(15) should enable FINRA to account for such factors as the 
``average total revenue paid out in the past five years in arbitration 
and customer settlements and litigation'' when determining the 
appropriate deposit requirement for a firm.
    Further, the Commission disagrees with the assertion that the 
calculation of a firm's Restricted Deposit Requirement would be 
arbitrary. FINRA has laid out numerous factors in proposed Rule 
4111(i)(15) to discern an appropriate maximum Restricted Deposit 
Requirement for Restricted Firms that will incentivize improved 
behavior without undermining that firm's financial stability. Moreover, 
the proposed rule's Consultation process provides firms an opportunity 
to discuss the imposition of a lower Restricted Deposit 
Requirement.\215\ As FINRA has stated, the Consultation process is 
designed to specifically account for the disparities in risk presented 
by each firm initially identified through the Preliminary 
Identification Criteria, and to thereafter enable the Department to 
craft a Restricted Firm's Restricted Deposit Requirement in light of 
discussions with that firm, and to account for that firm's ``unique 
characteristics.'' Further, FINRA stated it will ``tailor the member 
firm's maximum Restricted Deposit Requirement amount to its size, 
operations and financial conditions . . .

[[Page 42939]]

[to] be consistent with the objectives of the rule, but [without] 
significantly undermin[ing] the continued financial stability and 
operational capability of the member firm as an ongoing enterprise over 
the next 12 months'' \216\ The Commission finds this process is a 
reasonable means of establishing an appropriate Restricted Deposit 
Requirement for individual Restricted Firms that affords those firms 
with sufficient opportunity to affect the outcome of FINRA's 
determination. For these reasons, the Commission finds FINRA's approach 
is designed to protect investors and the public interest.
---------------------------------------------------------------------------

    \215\ See Notice at 78545.
    \216\ Id.
---------------------------------------------------------------------------

Unpaid Arbitration Awards and Settlements
    One commenter asserted that proposed Rule 4111 does not explicitly 
address unpaid arbitration awards and settlements.\217\ In particular, 
this commenter criticized proposed Rule 4111's failure to require or 
incentivize Restricted Firms to pay unpaid arbitration awards and 
settlements in connection with imposing a Restricted Deposit 
Requirement.\218\
---------------------------------------------------------------------------

    \217\ See PIABA Letter at 3.
    \218\ Id. at 4.
---------------------------------------------------------------------------

    FINRA responded that firms are already required to pay unpaid 
arbitration awards and settlements, and that any Restricted Deposit 
Requirement will serve only as an additional, mandatory obligation--
with each requirement serving an ``important, but different, regulatory 
purpose.'' \219\ FINRA also stated it currently suspends member firms 
and their registered representatives from membership or association 
where they do not timely pay arbitration awards, and that proposed Rule 
4111 is designed to address investor protection concerns beyond unpaid 
awards.\220\ Further, FINRA stated it believes that proposed Rule 4111 
``may have important ancillary effects in addressing unpaid customer 
arbitration awards.'' \221\
---------------------------------------------------------------------------

    \219\ See FINRA March 4 Letter at 18.
    \220\ Id. Specifically, FINRA indicated that proposed Rule 4111 
would cover those firms that, ``based on statistical analysis of 
their prior disclosure events, are substantially more likely than 
their peers to subsequently have a range of additional events 
indicating various types of harm or potential harm to investors.'' 
See Notice at 78565.
    \221\ Id. In particular, FINRA thinks that proposed Rule 4111 
may incentivize firms to reduce their risk profile and scope of 
violative conduct to avoid being deemed a Restricted Firm in the 
first place. FINRA further believes that proposed Rule 4111 may also 
incentivize firms to obtain insurance for potential arbitration 
awards because the proposed rule would account for this type of 
insurance coverage in determining any firm's Restricted Deposit 
Requirement. See Rule 4111(i)(15)(A) and the discussion about 
FINRA's determination of a Maximum Restricted Deposit Requirement, 
supra note 90. Finally, FINRA argued that proposed Rule 4111 
includes a number of presumptions as to the Department's assessment 
of any previously designated Restricted Firm's application to 
withdraw from its Restricted Deposit, ``that would further 
incentivize the payment of arbitration awards.''
---------------------------------------------------------------------------

    The same commenter asserted that as unpaid and anticipated 
arbitration awards are part of the proposed criteria used to determine 
whether a firm should be designated as a Restricted Firm, and 
thereafter, to determine its maximum Restricted Deposit Requirement, it 
is ``axiomatic'' that the maximum deposit FINRA ultimately imposes 
should ``at the very least'' cover such awards.\222\ However, the 
commenter also stated that proposed Rule 4111, in limiting what FINRA 
may require in the way of a restricted deposit to avoid ``significantly 
undermin[ing] the continued financial stability and operational 
capability of the member as an ongoing enterprise over the next 12 
months,'' may result in more thinly capitalized firms not being subject 
to a Restricted Deposit Requirement sufficient to cover all outstanding 
arbitration awards and settlements, ``let alone `Covered Pending 
Arbitration Claims.''' \223\
---------------------------------------------------------------------------

    \222\ See PIABA Letter at 3.
    \223\ Id.
---------------------------------------------------------------------------

    In response, FINRA stated that a key reason why FINRA proposed a 
factor-based approach to determining a Restricted Deposit Requirement 
rather than a formulaic one is because it is less susceptible 
manipulation by firms.\224\ Accordingly, nothing in proposed Rule 4111 
would establish a floor for the amount of a Restricted Deposit 
Requirement.\225\ Nevertheless, FINRA reiterated that proposed Rule 
4111 would ``not absolve firms from paying unpaid arbitration awards,'' 
and that a member's ``thin capitalization at the time of the 
Consultation would be only one factor'' that the Department considers 
during that firm's Consultation process, and would ``not necessarily 
result in a lower'' Restricted Deposit Requirement.\226\
---------------------------------------------------------------------------

    \224\ See FINRA March 4 Letter at 19.
    \225\ Id.
    \226\ Id.
---------------------------------------------------------------------------

    Finally, this commenter also suggested that proposed Rule 4111 
should be amended to address how those investors owed unpaid 
arbitration awards might access funds from a Restricted Firm's 
restricted deposits to pay themselves.\227\ FINRA responded that 
although it understands the purpose of the request, proposed Rule 4111 
is intended to ``address the risks posed to investors by individual 
brokers and member firms that have a history of misconduct,'' and while 
the rule has features to incentivize payment of unpaid arbitration 
awards, ``it is not intended to alter how aggrieved investors currently 
may collect on an arbitration award.'' \228\
---------------------------------------------------------------------------

    \227\ See PIABA Letter at 4. In particular, PIABA indicated that 
proposed Rule 4111 should address how an investor may access funds 
from a firm's restricted deposit in the case of Former Members ``if 
the former firm refuses to apply for a withdrawal, or if no one from 
the former firm is available to make such a request on behalf of the 
investor.'' Id.
    \228\ See FINRA March 4 Letter at 19-20.
---------------------------------------------------------------------------

    The Commission finds it is reasonable for FINRA to adopt the 
Restricted Deposit Requirement as a separate obligation, distinct from 
a Restricted Firm's existing obligations on member firms to satisfy 
unpaid arbitration awards. As FINRA stated, its rules already include 
comprehensive obligations on member firms that owe unpaid arbitration 
awards, and impose significant penalties on those firms that fail to do 
so.\229\ The Commission thus finds that structuring proposed Rule 
4111's Restricted Deposit Requirement to instead primarily address 
investor protection concerns more broadly, with the possibility of 
reducing the number of unpaid customer arbitration awards as a 
potential ancillary benefit, is reasonable. Moreover, the Commission 
finds that FINRA's proposed use of the Consultation process--taking a 
fulsome view of a firm's capitalization, including the potential effect 
of any unpaid arbitration awards--when determining its Restricted 
Deposit Requirement, provides a reasonable safeguard for evaluating the 
application of the proposed rule to thinly capitalized firms. This 
approach should enable FINRA to both further the intended goal of 
proposed Rule 4111 to incentivize better behavior from firms without 
undermining their financial stability, while also taking into account 
their pre-existing obligations to satisfy unpaid arbitration awards. 
Finally, as the Restricted Deposit Requirement is intended to provide 
an obligation on Restricted Firms distinct from their pre-existing 
obligations to satisfy unpaid arbitration awards, the Commission finds 
the issue of collecting unpaid arbitration awards by investors is 
beyond the subject matter of this proposed rule change and therefore, 
is beyond the scope of this filing.
---------------------------------------------------------------------------

    \229\ See Notice at 78565 note 151 and accompanying text; see 
also FINRA March 4 Letter at 7 note 15 and accompanying text.
---------------------------------------------------------------------------

    Another commenter stated that FINRA's data on unpaid arbitration 
awards do not justify its establishment of ``an elaborate system of 
additional

[[Page 42940]]

regulation to address the issue.'' \230\ In response, FINRA stated that 
addressing the issue of unpaid arbitration awards was not the primary 
purpose of the proposed rule change. Specifically, FINRA stated that 
the proposed rule change's primary purpose is ``to create incentives 
for members that pose outlier-level risks to change behavior.'' \231\ 
At the same time, FINRA believes that the proposed rule change ``may 
have important ancillary effects in addressing unpaid customer 
arbitration awards [including deterring] behavior that could otherwise 
result in unpaid arbitration awards by incentivizing firms to reduce 
their risk profile and violative conduct to avoid being deemed a 
Restricted Firm and becoming subject to a Restricted Deposit 
Requirement or other conditions or restrictions for a year or more.'' 
\232\ FINRA stated that it has ``long been concerned about non-payment 
of arbitration awards'' \233\ and hopes to continue the dialogue about 
``addressing the challenges of customer recovery across the financial 
services industry.'' \234\
---------------------------------------------------------------------------

    \230\ See Harvin Letter at 5.
    \231\ See FINRA March 4 Letter at 12.
    \232\ Id.
    \233\ See FINRA March 4 Letter at 18 note 52 (citing FINRA, 
Discussion Paper--FINRA Perspectives on Customer Recovery, at pp. 1, 
19 (Feb. 8, 2018), available at https://www.finra.org/sites/default/files/finra_perspectives_on_customer_recovery.pdf).
    \234\ Id.
---------------------------------------------------------------------------

    FINRA has clarified that the primary purpose of the proposed rule 
change is to incentivize better behavior from firms without undermining 
their financial stability. While the Restricted Deposit Requirement may 
also reduce the number of unpaid customer arbitration awards as a 
potential ancillary benefit, the Commission finds that the issue of 
collecting unpaid arbitration awards by investors is beyond the subject 
matter of this proposed rule change and therefore, is beyond the scope 
of this filing.
Expungement Concerns and Undercounting Arbitrations
    One commenter expressed concern about the ``pervasive nature of 
expungement of customer disputes'' and how that might undermine FINRA's 
ability to determine whether a firm should be deemed a Restricted Firm 
under proposed Rule 4111.\235\ This commenter asserted that FINRA's 
inability to review the ``full breadth of relevant disclosures'' due to 
certain events being expunged from the record will likely lead to it 
overlooking recidivist firms and registered representatives that should 
be designated as Restricted Firms.\236\ As a result, the commenter 
argued that proposed Rule 4111 incentivizes member firms and registered 
representatives to ``sanitize their records'' by pursuing expungement 
of customer complaints.\237\
---------------------------------------------------------------------------

    \235\ See PIABA Letter at 4-5.
    \236\ Id. at 4.
    \237\ Id.
---------------------------------------------------------------------------

    FINRA responded that its rules require accurate disclosures of 
member firms and individuals, who are ``subject to disciplinary action 
and possible disqualification if they fail to do so.'' \238\ Further, 
FINRA stated that even if expungement requests rise due to proposed 
Rule 4111, that does not mean that there will be a corresponding 
increase in expungements that are granted, as such approvals may only 
be provided ``after a court of competent jurisdiction has entered an 
order directing expungement or confirming an arbitration award 
containing expungement relief.'' \239\ FINRA also explained in its 
Response that its Office of the Chief Economist has tested the proposed 
thresholds under proposed Rule 4111 based on existing CRD data,\240\ 
and believes that the existing CRD data and proposed criteria using 
these data are ``effective at identifying firms that pose greater risks 
to customers.'' \241\ Finally, FINRA also pointed out that although 
proposed Rule 4111 is not intended to address the expungement process, 
it has undertaken a prior separate rulemaking to ``substantially 
strengthen'' this process.\242\
---------------------------------------------------------------------------

    \238\ See FINRA March 4 Letter at 20. FINRA also stated that the 
source of disclosures on Form U6 are regulators, and that FINRA's 
Department of Credentialing, Registration, Education and Disclosure 
``conducts a public records review to verify the completeness and 
accuracy of criminal disclosure reporting.'' Id. (citing Notice at 
79561).
    \239\ Id.
    \240\ Specifically, FINRA asserted it believes the use of 
existing CRD data in conjunction with the criteria proposed under 
the proposed rule effectively identifies higher risk firms. FINRA 
bases this assertion on its comparison of firms captured by the 
proposed thresholds to the firms that had recently been expelled, 
that had unpaid arbitration awards, that Department staff had 
identified as high risk for sales practice and fraud based on its 
own risk-based analysis, and that subsequently had additional 
disclosures after FINRA had made these preliminary identifications. 
See FINRA March 4 Letter at 20-21.
    \241\ Id.
    \242\ Id.; see Exchange Act Release No. 90000 (Sep. 25, 2020), 
85 FR 62142 (Oct. 1, 2020) (FINRA No. SR-FINRA-2020-030). FINRA 
temporarily withdrew this rule filing from Commission consideration 
so that they can further consider whether modifications to the 
filing are appropriate. See FINRA Statement on Temporary Withdrawal 
of Specialized Arbitrator Roster Rule Filing (May 28, 2021).
---------------------------------------------------------------------------

    Given that the proposed rule change does not affect FINRA's 
expungement process, the Commission finds recommendations to amend it 
are outside the scope of the proposed rule change.
The Restricted Deposit Requirement and a Member Firm's Net Capital 
Requirement
    One commenter argued that, although proposed Rule 4111 requires 
deposits in the Restricted Deposit Account to be deducted when 
determining a member firm's net capital under Exchange Act Rule 15c3-1 
and FINRA Rule 4110 (Capital Compliance), the actual effect of the rule 
is to require additional net capital of the firm.\243\ This commenter 
argued that, under Rule 4110(a), FINRA may already prescribe greater 
net capital or net worth requirements on carrying or clearing members, 
which the commenter stated would appear to provide FINRA ``ample 
authority'' to address the issue of unpaid customer arbitration 
awards.\244\ FINRA responded by noting that proposed Rule 4111's 
primary purpose is incentivizing member firms to engage in less risky 
behaviors, and the extent to which the rule change addresses unpaid 
arbitration awards, this is merely an ancillary benefit.\245\ Further, 
FINRA stated that it had considered the alternative of applying 
increased capital requirements on Restricted Firms, but determined this 
approach would be accompanied by ``several drawbacks with respect to 
economic incentives and anticipated impacts.'' \246\
---------------------------------------------------------------------------

    \243\ See Harvin Letter at 7.
    \244\ Id.
    \245\ See FINRA March 4 Letter at 12.
    \246\ Id.; see also Notice at 78556-57. FINRA stated that 
maintaining the firm's assets under an increased net capital 
requirement would not be isolated to a restricted account and thus 
``may be fungible with other firm assets,'' potentially resulting in 
such assets being withdrawn and used by the firm during the 
restricted period. Thus, FINRA determined that such an approach 
would likely provide a much lower deterrent effect on firms than the 
Restricted Deposit Requirement under proposed Rule 4111. Similarly, 
FINRA believes that using an increased net capital requirement, 
rather than the Restricted Deposit Requirement, may not sufficiently 
incentivize behavioral changes from those Restricted Firms that 
already were carrying substantial excess net capital.). See Notice 
at 78557.
---------------------------------------------------------------------------

    The Commission finds the use of a separate and distinct deposit 
requirement is reasonable and designed to accomplish the separate 
purpose of incentivizing Restricted Firms to engage in less risky 
behaviors. The Commission anticipates that FINRA members will include 
in their decision-making the possibility of having their funds held in 
an account with significant withdrawal restrictions when making certain 
business determinations, which should reduce their propensity to engage 
in

[[Page 42941]]

risky behaviors that are not in their customers' interests. For these 
reasons, the Commission finds FINRA's approach is designed to protect 
investors and the public interest.
Potential Harm to Small Firms
    One commenter asserted that proposed Rule 4111 will have unintended 
consequences for small firms including ``increased costs to defend and 
reporting.'' \247\ FINRA responded that, although some reporting and 
defense costs may increase for a limited number of firms, this will 
impact firms of all sizes, and it does not believe proposed Rule 4111 
imposes either disproportionate costs or impacts on small firms.\248\ 
These costs could include, for example, when a firm seeks to rebut the 
presumption that it is a Restricted Firm, which would involve added 
costs to collect and provide information to FINRA, and when a firm 
seeks review through the expedited proceeding proposed in Rule 
9561.\249\ FINRA further indicated that proposed Rule 4111 is designed 
to impact a limited number of firms that pose significantly higher risk 
compared to similarly sized peers--across all firm sizes.\250\ The 
proposed ``funnel'' process proposed by FINRA includes subsequent 
review and a Consultation process provides safeguards designed to 
protect firms of all sizes against misidentification.\251\ Finally, 
FINRA reiterated that the rule requires FINRA to consider a firm's 
size, among other things, when it determines to impose a Restricted 
Deposit Requirement or other conditions or restrictions, and thus 
should not have a disproportionate impact on small firms.\252\
---------------------------------------------------------------------------

    \247\ See IBN Letter.
    \248\ See FINRA March 4 Letter at 5.
    \249\ Id.
    \250\ Id.
    \251\ Id.
    \252\ Id.
---------------------------------------------------------------------------

    In raising concerns about the impact on small firms, this commenter 
also provided a partial list of purported disclosure events applicable 
to the commenter's firm, including that seven of the firm's 70 
representatives were previously at now-expelled firms ``during their 
career.'' \253\ FINRA stated that the list of disclosure events 
included in this commenter's letter were broader than those covered by 
the Preliminary Criteria for Identification, and could not determine 
whether they would be captured by the proposed criteria without more 
information.\254\ For example, in reference to the individuals who had 
been at an expelled firm ``during their careers,'' FINRA stated that 
the Registered Persons Associated with Previously Expelled Firms 
category only covers a narrow scope of those registered representatives 
who were registered with an expelled firm for at least one year and 
whose registration with the previously expelled firm terminated during 
the Evaluation Period.\255\
---------------------------------------------------------------------------

    \253\ See IBN Letter.
    \254\ See FINRA March 4 Letter at 6.
    \255\ Id. The Registered Persons Associated with Previously 
Expelled Firms category only includes any Registered Person In-Scope 
who was registered with the previously expelled firm (1) for at 
least one year; and (2) ``whose registration with the previously 
expelled firm terminated during the Evaluation Period'' (limiting 
this to the prior five years from the current firm's Evaluation 
Date). See FINRA Rule 4111(i)(4)(F). The same commenter also 
referenced a registered representative with a ``financial 
disclosure'' related to ``medical losses'' and expressed concerns 
about pending arbitrations. See IBN Letter. FINRA reiterated that 
neither a registered person's ``financial disclosures'' (e.g., the 
compromises with creditors, bankruptcy petitions, bond-related 
questions, unsatisfied judgments, and unsatisfied liens found in 
Form U4, Questions 14K, 14L, and 14M), nor pending arbitrations and 
written consumer-initiated complaints like those disclosed under 
Form U4 Question 14I are counted in the Preliminary Criteria for 
Identification. See FINRA March 4 Letter at 6-7. Only those ``awards 
and settlements in specified investment-related, consumer initiated 
arbitrations and complaints'' are counted within the Preliminary 
Criteria for Identification. See FINRA March 4 Letter at 7.
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    The Commission finds that the proposal, which is designed to 
identify a limited number of firms with a significantly higher level of 
risk related disclosures than similarly situated peers with thresholds 
tailored to seven different firm sizes, takes a reasonable approach to 
identifying firms that pose the greatest risk to investors, without 
being unduly burdensome towards smaller firms. Further, FINRA's 
commitment to tailoring any Restricted Deposit Requirement or other 
conditions or restrictions it imposes on any firm it designates as a 
Restricted Firm in a manner that accounts for the firm's size and 
financial condition should help tailor the application of proposed Rule 
4111 to the unique risks presented by particular firms. Finally, 
pursuant to proposed Rule 4111(d), a firm would have an opportunity to 
demonstrate that it should not be required to be subject to the maximum 
Restricted Deposit Requirement by arguing that that certain disclosures 
were improperly considered in determining its restricted status. For 
these reasons, the Commission finds FINRA's approach is designed to 
protect investors and the public interest.
Restricted Deposit Subject to Swings in Value
    One commenter asserted that proposed Rule 4111 fails to address 
fluctuations in the valuation of ``qualified securities'' that a 
Restricted Firm may deposit into its Restricted Deposit Account as 
opposed to depositing cash.\256\ The commenter argued that as there is 
no guarantee that securities used for this purpose will retain 
sufficient value until they are redeemed to pay the firm's outstanding 
debt, and proposed Rule 4111 lacks a ``mechanism . . . to ensure the 
Restricted Deposit Account maintains sufficient value between FINRA 
reviews,'' the proposal should be amended to require account 
replenishment as necessary.\257\
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    \256\ See PIABA Letter at 7.
    \257\ Id.
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    FINRA has stated that proposed Rule 4111(a) only permits a 
Restricted Firm to satisfy its Restricted Deposit Requirement with ``a 
security issued by the United States or a security in respect of which 
the principal and interest are guaranteed by the United States.'' \258\ 
FINRA believes such securities possess a sufficiently stable value such 
that any post-deposit price fluctuation would not affect the financial 
impact of their use to satisfy the Restricted Deposit Requirement, nor 
the resulting incentive for the Restricted Firm to reform.\259\ 
Nevertheless, FINRA filed Amendment No. 2 to clarify that the proposed 
rule change would not require a Restricted Firm to make additional 
deposits in order to maintain continuously the original value of 
qualified securities in its Restricted Deposit Account, if such 
qualified securities have declined in value.\260\ Likewise, FINRA 
clarified that, if the aggregate value of the assets deposited by a 
member firm increases above the firm's Restricted Deposit Requirement, 
that would not be a basis for the firm to request a withdrawal from its 
Restricted Deposit Account. Rather, if a firm is re-designated as 
Restricted Firm in the following year, it would need to deposit 
additional cash or qualified securities if needed to meet the 
Restricted Deposit Requirement at that time.\261\
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    \258\ See FINRA March 4 Letter at 15.
    \259\ Id.
    \260\ See Amendment No. 2 at 4.
    \261\ Id. See also Rule 4111(f)(2), as modified by Amendment No. 
2. The firm would be required to make any necessary additional 
deposit promptly at the time of re-designation, or where a hearing 
is requested pursuant to Proposed Rule 9561, promptly after the 
Office of Hearing Officers or the NAC issues a written decision 
under Rule 9559. Id.
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    The Commission finds that FINRA's determination to not require a 
Restricted Firm to replenish a Restricted Deposit Account to address 
fluctuations in the value of qualified securities is reasonable. 
Securities included within the ``qualified securities'' definition,

[[Page 42942]]

including U.S. Treasury Securities, serve as a benchmark for stability 
and liquidity within U.S. securities markets. Thus, the Commission 
expects that any change in value of these securities should be 
relatively minimal during the year between any Restricted Firm 
designation made by FINRA, and a firm's next annual Rule 4111 
evaluation--wherein any re-designation of the firm as a Restricted Firm 
would require the firm to again satisfy any Restricted Deposit 
Requirement then imposed by FINRA. For these reasons, the Commission 
finds FINRA's approach is designed to protect investors and the public 
interest.
Additional Conditions and Restrictions Imposed on Restricted Firms
    One commenter stated that proposed Rule 4111.03 would unnecessarily 
limit FINRA's options for conditioning or restricting the operation 
high-risk firms.\262\ Specifically, the commenter stated that by 
promulgating an illustrative list of conditions and restrictions that 
could be imposed on Restricted Firms proposed Rule 4111 would not give 
FINRA the necessary flexibility to impose obligations on such 
firms.\263\ Instead, this commenter proposed that FINRA should 
explicitly amend its proposal to make clear that it does not cede any 
authority to take ``punitive'' action against firms that violate 
FINRA's rules and the rights of their customers.\264\
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    \262\ See Better Markets Letter at 20.
    \263\ Id. See Notice at 78548, providing in Supplementary 
Material .03 to proposed Rule 4111, Examples of Conditions and 
Restrictions that FINRA may impose on Restricted Firms other than a 
Restricted Deposit Requirement.
    \264\ See Better Markets Letter at 20.
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    FINRA does not take the view that proposed Rule 4111 provides 
either an express or implied limit on the scope of conditions and 
restrictions that FINRA could impose on Restricted Firms.\265\ Further, 
FINRA disagrees with the suggestion that ``punitive'' conditions and 
restrictions would be imposed, and in fact has pointed to proposed Rule 
4111(e) as allowing the Department to impose those conditions and 
restrictions on the ``operations and activities of the member and its 
associated persons that are necessary or appropriate to address the 
concerns indicated by the Preliminary Criteria for Identification and 
protect investors and the public interest.'' \266\ However, FINRA 
acknowledged the concerns raised by the commenter of the need to act, 
when appropriate, to protect investors from predatory firms, and 
indicated it ``fully intends to continue using its existing authority 
to take action against predatory firms that violate FINRA's rules and 
the rights of customers.'' \267\ Further, FINRA does not view anything 
in proposed Rule 4111 to limit FINRA's authority to bring disciplinary 
action against firms and registered representatives for violations and 
``impose remedial sanctions for violations, including expulsions and 
bars where appropriate.'' \268\
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    \265\ See FINRA March 4 Letter at 15.
    \266\ Id. at 15-16.
    \267\ Id. at 16.
    \268\ Id. FINRA also stated that it is separately proposing the 
adoption of Rule 9561(b) to permit it to bring expedited proceedings 
against any firm that fails to comply with any of the Rule 4111 
requirements--and also to seek the imposition of a suspension or 
cancellation of that firm's membership. Id.
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    The Commission agrees with FINRA's assessment that proposed Rule 
4111 provides no express or implied limitation on the scope of 
conditions or restrictions that it may impose as necessary or 
appropriate to protect investors and the public interest, or both, 
without seeking to undermine the viability of such firms' ongoing 
operations. Additionally, the Commission agrees with FINRA's assessment 
that nothing in proposed Rule 4111 limits its authority to impose 
remedial sanctions--including expulsions and bars where appropriate--
through separate disciplinary actions against firms and registered 
representatives for violations of FINRA rules. For these reasons, the 
Commission finds FINRA's approach is designed to protect investors and 
the public interest.
FINRA Should Impose Specific ``Terms and Conditions'' on Restricted 
Firms That Circumvent Conditions and Restrictions Imposed by FINRA 
Under Proposed Rule 4111, or Fail to Significantly Improve Compliance
    One commenter argued that FINRA should add to proposed Rule 4111 
the general authority to impose ``terms and conditions'' on firms that 
demonstrate ``significant compliance failures'' to prevent any 
``gaming'' of the Preliminary Identification Metric Thresholds.\269\ In 
particular, this commenter expressed support for FINRA using this 
authority regarding those firms that ``either circumvent the 
obligations and restrictions placed upon them by proposed Rule 4111 . . 
. or otherwise refuse to significantly improve their compliance 
culture.'' \270\ FINRA responded that although it is not adopting a 
``terms and conditions'' approach currently, it will explore doing so 
in the future to address any compliance issues.\271\ While FINRA 
recognized that a terms and conditions rule would make it more 
difficult for firms to evade the identification criteria, FINRA 
believed that proposed Rule 4111 may offer a better deterrent effect 
for firms to change their behavior, particularly those firms that may 
be close to meeting such criteria.\272\ For Restricted Firms that evade 
compliance with the conditions and restrictions imposed on them, FINRA 
stated that proposed Rule 9561(b) would permit it to ``bring an 
expedited proceeding against a member that fails to comply with any 
Rule 4111 Requirements'' that could result in the suspension or 
cancellation of the firm's membership.\273\ Further, FINRA asserted 
that proposed Rule 4111 already has been designed with features that 
will make it more difficult to manipulate their Preliminary 
Identification Metrics, but that it appreciates the support for any 
further efforts it adopts to curtail such behavior.\274\
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    \269\ See Better Markets Letter at 19-20. Better Markets further 
indicated that, to prevent the gaming of Preliminary Identification 
Metric Thresholds, it will support ``any reasonable and appropriate 
amendments or future proposals that will allow FINRA to address 
firms with substantial compliance issues that cannot be captured by 
the proposed numerical framework.'' See Better Markets Letter at 19-
20. As part of the proposal, FINRA considered an approach similar to 
the Investment Industry Regulatory Organization of Canada's 
(``IIROC'') ``terms and conditions'' rule to identify a limited 
number of firms with significant compliance failures using non-
public information from FINRA's examination and monitoring process 
and impose appropriate terms and conditions to encourage these 
firms' increased compliance. However, it elected not to propose a 
terms and conditions rule at this time. See Notice at 78554-55 
(referencing IIROC Consolidated Rule 9208).
    \270\ See Better Markets Letter at 5.
    \271\ See FINRA March 4 Letter at 27. FINRA stated that it had 
already explained one possible alternative approach it has 
considered is to adopt an approach similar to the ``terms and 
conditions'' rule used by IIROC, under IIROC Consolidated Rule 9208. 
See Notice at 78554.
    \272\ See Notice at 78554-55.
    \273\ Id.
    \274\ See FINRA March 4 Letter at 27-28. FINRA stated that 
particular aspects of proposed Rule 4111 that are designed to 
curtail efforts by firms to game their Preliminary Identification 
Metrics include: (1) Defining ``Registered Persons In-Scope'' under 
proposed Rule 4111(i)(13) to cover all persons registered with the 
firm for one or more days within the year prior to the Evaluation 
Date, undercutting any effort to manipulate the outcome by reducing 
staff immediately before FINRA's annual calculation of that firm's 
Preliminary Criteria for Identification; and (2) performing the 
annual calculation of a firm's Preliminary Criteria for 
Identification at least 30-45 days after the Evaluation Date, ``to 
account for the lag time between when relevant disclosure events 
occurred and when they are required to be reported on the Uniform 
Registration Forms'' to prevent any attempt by a firm to delay 
Uniform Registration Form submissions to manipulate annual metrics. 
Id.
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    The Commission finds the proposal provides for reasonable measures 
to

[[Page 42943]]

prevent firms from manipulating their Preliminary Identification 
Metrics, particularly by adopting checks within proposed Rule 4111 to 
impede any efforts to distort FINRA's initial calculations of a firm's 
metrics as of the Evaluation Date. For these reasons, the Commission 
finds FINRA's approach is designed to protect investors and the public 
interest.
Economic Impact Analysis
    One commenter suggested that although proposed Rule 4111 may 
increase investor protection above the status quo, FINRA should conduct 
a ``full economic assessment'' that not only compares proposed Rule 
4111 against the ``baseline scenario where FINRA takes no action to 
monitor or control predatory wolf-pack firms,'' but also compares 
proposed Rule 4111 against an alternative scenario that ``assumes the 
improvements offered'' by the commenter.\275\ FINRA rejected the 
suggestion, as it believes that its current economic impact analysis 
``thoroughly addresses'' how proposed Rule 4111 addresses the current 
regulatory need better than reasonable alternatives,\276\ and is also 
``consistent with the framework for FINRA's approach to economic impact 
assessments in proposed rulemakings.'' \277\ FINRA asserted that the 
appropriate economic baseline, and the one that it used to evaluate the 
economic impacts of proposed Rule 4111, is the ``current regulatory 
framework,'' which includes numerous provisions related to FINRA's 
current supervision and oversight of member firms.\278\ FINRA argued 
that it has already conducted a thorough economic impact analysis of 
proposed Rule 4111, and assessed the potential impacts by examining the 
number of firms that would have met the Preliminary Criteria for 
Identification between 2013-2017, and the number of ``new'' Registered 
Person and Member Firm Events in the 2014-2019 period.\279\ FINRA 
believes this assessment provided the ``appropriate information about 
the economic baseline and effectiveness of the proposed rule in 
identifying firms that may be associated with additional events after 
identification.'' \280\
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    \275\ See Better Markets Letter at 13. As discussed more fully 
above, the Commission considered this commenter's recommended 
alternatives and has concluded that the proposed rule change 
represents a reasonable approach to identifying firms that pose the 
greatest risk to investors and imposing obligations on those firms 
to encourage them to change their behavior.
    \276\ See FINRA March 4 Letter at 26. For example, FINRA 
indicated that it ``considered several alternative specifications to 
the numeric threshold based-approach, including alternative 
categories of reported disclosure events and metrics, alternative 
counting criteria for the number of reported events or conditions, 
and alternative time periods over which the events or conditions are 
counted.'' See FINRA March 4 Letter at 26 note 70.
    \277\ Id. See Framework Regarding FINRA's Approach to Economic 
Impact Assessment for Proposed Rulemaking (Sept. 2013), available at 
https://www.finra.org/sites/default/files/Economic%20Impact%20Assessment_0_0.pdf.
    \278\ See FINRA March 4 Letter at 25. Specifically, FINRA 
highlighted its rules pertaining to FINRA supervision, the 
membership application process, proceedings for statutory 
disqualification and other disciplinary proceedings as to firms and 
registered representatives, along with FINRA's current ``risk 
monitoring and focused examination programs . . . designed to 
monitor and address the risks posed by high-risk firms and high-risk 
brokers.'' Id.
    \279\ Id. FINRA indicated that economic analysis ``demonstrated 
that for firms that would have met the Preliminary Criteria for 
Identification in the years 2013-2017, those firms were associated 
with 2,995 `new' Registered Person and Member Firm Events in the 
Post-Identification Period . . . [and] also demonstrated that such 
firms had between 6.1 and 19.9 times more ``new'' disclosure events 
(per registered person) in the years after identification than other 
firms registered during the 2013-2017 period.'' See FINRA March 4 
Letter at 25-26.
    \280\ See FINRA March 4 Letter at 26.
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    The Commission finds it is both reasonable and appropriate for 
FINRA to assess the hypothetical results of proposed Rule 4111 using 
the current regulatory framework as its economic baseline. Doing so 
enables FINRA to determine the potential impact of the proposal based 
on existing, recent market data. As any modification of the existing 
regulatory framework will lead to a response in the market and changes 
in firm behavior, it is appropriate for FINRA to compare the 
hypothetical impacts of proposed Rule 4111 against this pre-existing, 
recent market data.
    In sum, the Commission finds that proposed Rule 4111 would provide 
an important new tool to FINRA in identifying and imposing conditions 
or restrictions on those member firms with outlier-level disclosure 
events relative to their similarly sized peers. In addition, the 
Commission finds that proposed Rule 4111 takes a reasonable and 
appropriate approach to incentivizing better behavior from such firms 
for the protection of investors and the public interest. Further, the 
Commission finds that the proposed Rule 4111 process provides firms 
with ample opportunity to affect the ultimate outcome of FINRA's 
decisions, including an extensive Consultation process--that will 
provide member firms who would be initially identified by FINRA with 
opportunities to demonstrate why they should not actually be designated 
as a Restricted Firm, or thereafter why they should not be subject to 
the maximum Restricted Deposit Requirement or other operational 
conditions or restrictions--along with avenues to seek further review 
if necessary. Moreover, by establishing different thresholds for 
identification across seven different firm sizes, proposed Rule 4111 
should help reduce the possibility that the rule becomes overly 
burdensome on any group of firms based solely on their size or 
resources.
    Accordingly, the Commission finds proposed Rule 4111 is reasonably 
designed to protect investors by helping incentivize compliant behavior 
from those firms exhibiting higher levels of disclosure events, while 
effectively tailoring the review process to mitigate the burdens on 
member firms throughout that process. The Commission further supports 
FINRA's commitment to working with individual state securities 
regulators to share relevant information and observes its commitment to 
further consider public disclosure of a firm's designation as a 
Restricted Firm by filing proposed amendments to Rule 8312 that would 
require FINRA to identify on BrokerCheck those member firms or former 
member firms that are designated as Restricted Firms pursuant to 
proposed Rules 4111 and 9561.

Proposed Rule 9561 (Procedures for Regulating Activities Under Rule 
4111) and Amendments to Rule 9559 To Implement the Requirements of 
Proposed Rule 4111

    The proposal to adopt new Rule 9561 and to amend Rule 9559 to 
establish new, expedited proceedings to enable firms to challenge any 
requirements imposed by the Department under the Rule 4111 process will 
help provide for both the fair administration of Rule 4111, and faster 
remediation of instances of non-compliance. Proposed new Rule 9561 is 
designed to afford firms with an opportunity to address such matters 
through timely notice of FINRA's decision to impose obligations, or 
determination that a firm is failing to comply with such obligations, 
and the ability to thereafter request a hearing regarding such a 
decision or determination. Correspondingly, the proposed amendments to 
Rule 9559 would assist in the administration of such requested 
hearings.
    One commenter suggested that the expedited proceeding rule be 
amended to include a requirement ``that each member firm be given 
notice of the Preliminary Identification Metrics.'' \281\ FINRA 
declined this suggestion, asserting that the purpose of the proposed 
rule, ``is to establish procedures for when the Department determines, 
after the Rule 4111 process,

[[Page 42944]]

that a firm is a Restricted Firm and seeks to impose requirements, 
conditions, or restrictions on the Restricted Firm.'' \282\ Further, 
FINRA asserted that the proposed expedited proceeding rule is not 
intended to provide any notice of the Preliminary Identification 
Metrics to firms other than those few that are deemed to be Restricted 
Firms.\283\ FINRA believes that the commenter may have instead been 
suggesting that it provide each firm with notice of its own Preliminary 
Identification Metrics under proposed Rule 4111, and indicated that if 
this is the case, FINRA reiterates its commitment to providing firms 
with compliance tools for the Rule 4111 process.\284\
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    \281\ See Harvin Letter at 1.
    \282\ See FINRA March 4 Letter at 25.
    \283\ Id.
    \284\ Id. See supra note 152 (addressing FINRA's commitment to 
providing additional guidance and resources to member firms to 
assist in satisfying their compliance burdens under the proposed 
rule).
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    The expedited proceedings process proposed by FINRA will help 
afford firms with fair procedures to contest such decisions and 
determinations. The Commission also agrees with FINRA that disclosure 
of the Preliminary Identification Metrics to member firms does not fall 
within the purpose of the expedited proceedings rule.\285\ Accordingly, 
the Commission finds that the proposed new Rule 9561 and proposed 
amendments to existing Rule 9559 will help facilitate the effective 
administration of proposed new Rule 4111, while providing a fair appeal 
and review process for firms seeking to challenge FINRA's decisions and 
determinations thereunder. For these reasons, the Commission finds 
FINRA's approach is designed to protect investors and the public 
interest.
---------------------------------------------------------------------------

    \285\ Separate comments addressing whether FINRA should 
otherwise disclose to firms their Preliminary Identification Metrics 
across all six categories is discussed above in ``Resources to 
assist Member Firms with Compliance.''
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    However, the Commission also supports and encourages FINRA's 
willingness to regularly reassess the performance of the Rule 4111 
process in practice to continue to identify what further measures, if 
any, are necessary and appropriate to guard against such manipulation 
by firms.

IV. Conclusion

    It is therefore ordered pursuant to Section 19(b)(2) of the 
Exchange Act \286\ that the proposed rule change (SR-FINRA-2020-041), 
as modified by Amendment No. 1 and Amendment No. 2, be, and hereby is, 
approved.
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    \286\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\287\
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    \287\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2021-16671 Filed 8-4-21; 8:45 am]
BILLING CODE 8011-01-P


