Does FINRA Disclose Enough on High-Risk Firms?

By Brandon Greenberg

As of January 2017, FINRA had expelled about 130 firms due to misconduct including securities fraud, churning, unsuitable recommendations, records falsification, and misuse of funds. In most cases, however, the executives and brokers at these banned firms remain free to continue working at other firms. Shouldn’t investors know which brokerage firms employ the most fraudsters?

In June 2017, Reuters published a data-driven article alleging that investors are being prevented from learning which brokerage firms have an unusually high concentration of brokers flagged for violations, customer complaints, and many other “red flag” events that FINRA requires to be publicly disclosed. Reuters looked at bulk data culled by Columbia University Law’s Datalab researchers, who wrote code extracting it from FINRA’s BrokerCheck—a tool that permits users to search the backgrounds of individual financial advisors. Because this data only covered the years between 2000 and 2015, after identifying 48 firms where at least 30% of brokers had at least one red flag (out of the 12 most serious of the 23 total incidents FINRA requires to be disclosed), Reuters staff manually updated the data by using BrokerCheck to include broker disclosures at these firms through early 2017.

The twelve red flags that Reuters focused on included customer disputes involving allegations of broker sales practice violations that either (1) resulted in an arbitration award or civil judgment, or (2) were settled at some cost to the firm and/or, whether or not wrongdoing was admitted. Other flags included regulatory violations, unsatisfied judgments or liens, post-allegation employee terminations, bankruptcy and other financial problems, and both civil and criminal adjudications. While investors are free to research individual brokers on BrokerCheck, FINRA does not provide bulk data about firms with high concentrations of flagged brokers to the public.

FINRA officials argue that it is not illegal to hire possibly problematic brokers, and that many of these disclosures do not automatically equate to broker misconduct, such as when firms pay clients to settle complaints without admitting wrongdoing. The self-regulatory organization rests its “unwillingness to name names” on concerns of “fairness and due process,” as CEO Robert Cook recently said. When pressed for details about this issue during a Reuters interview, FINRA’s executive VP of regulatory operations Susan Axelrod “declined to comment on any specific firm identified by Reuters…and would not directly address why the regulator will not publicly name the firms it identified as high-risk.” “Let’s just say those are not new names to us,” Axelrod said. She also explained that FINRA already has an experienced unit of examiners and managers dedicated to monitoring high-risk firms, although she would not elaborate on the resources or functions of this unit.

The fact remains that the 48 problem firms identified by Reuters employ 4,600 brokers who manage billions of dollars in investor capital. Publicly, FINRA prides itself on providing “unparalleled transparency” to investors. And yet, it remains an industry-financed organization operating outside of public financing and records laws. In fact, Brian Kovack, president of Kovack Securities, Inc.—one of the high-risk firms Reuters identified—actually serves on FINRA’s 24-member Board of Governors, which some might argue is a conflict of interest on this issue. About one in three (34%) out of the 388 brokers at Kovack’s firm have been flagged. Regrettably, however, zero percent of its customers are able to learn this troubling fact from FINRA’s BrokerCheck tool.

FINRA Cracks Down on Unpaid Awards

By Daniel Guernsey

On July 18, 2017, the FINRA Board of Governors authorized FINRA to publish a Regulatory Notice soliciting comment on proposed amendments to FINRA’s Membership Application Program rules relating to member’s hiring brokers with a history of misconduct and members’ unpaid arbitration awards.

The first issue the board discussed was related to broker conduct. When a member seeks to add a broker to its firm, FINRA Rule IM-1011-1 states that the member must submit a Rule 1017 application. When determining whether a broker’s Rule 1017 application gets approved, FINRA may take into account whether “[a] . . . [broker] is the subject of a pending, adjudicated, or settled regulatory action or investigation by the Commission. . . .”

However, Rule IM-1011-1 has safe harbor provisions. For example, if a member has 1–10 brokers, it may acquire up to 10 brokers per year without having to file a Rule 1017 application for each broker. These safe harbor provisions could allow brokers who have committed securities violations to join firms and not have to file a Rule 1017 application.

FINRA’s recent board meeting proposed that even if a member is otherwise not required to file a Rule 1017 application with FINRA when acquiring a new broker, “if the member seeks to add a broker with certain specified risk events to the firm,” the member will have to file a Rule 1017 application. These risk events include prior securities violations. This proposal would remove the loophole created by the safe harbor provisions in Rule IM-1011-1.

Secondly, the board discussed members who have unpaid arbitration awards. Similar to safe harbors for adding brokers, Rule IM-1011-1 provides a safe harbor for firms looking to expand. For example, if a member has 1–5 offices, it may acquire 3 more offices per year without filing a Rule 1017 application. Therefore, if a member has an unpaid arbitration award, it may still expand without filing with FINRA if it is within the safe harbor provisions.

In its recent meeting, the FINRA Board of Governors proposed that if a member is seeking “a business expansion or asset transfer and the member. . . has a substantial level of pending arbitration claims, an unpaid arbitration award or an unpaid settlement related to an arbitration[,] . . .  the safe harbor in IM-1011-1 for business expansions would not be available.” This proposal would not allow members to get away with expanding without scrutiny if they have any of the issues mentioned.

These proposals can help solve what FINRA’s executive vice president of regulatory operations, Susan Axelrod, calls “cockroaching.” “Cockroaching” refers to a practice where brokers who have committed securities violations move to risky, usually smaller sized, firms. These smaller firms then close and the risky brokers jump to the next firm. If these small firms are adding brokers within the safe harbor provisions of Rule IM-1011-1, they will not have to file a Rule 1017 application for the added broker, which could allow these risky brokers to slip through the cracks. This new proposal would remove the safe harbor of Rule IM-1011-1 for brokers that have committed securities violations and thus hopefully reduce the “cockroaching.”