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.”


Clinic Students Submit Comment Letter on Proposed FINRA Rule Change

On September 8, 2016, the Investor Rights Clinic (“IRC”) submitted a comment letter to the Securities and Exchange Commission (“SEC”) to share its opinion regarding a proposed change to FINRA Rule 2232. The proposed rule change would require broker-dealers to disclose mark-up and/or mark-down pricing information on retail customer confirmations for certain fixed-income securities when that broker-dealer executes the customer’s order using its proprietary account and then executes an offsetting sale or purchase in the same trading day.

When customers buy or sell certain fixed-income securities, such as bonds, brokerage firms sometimes buy or sell the security from their own proprietary account and charge the customer a mark-up or a mark-down.  A mark-up occurs when a broker-dealer sells a customer a fixed-income security at a price above the prevailing market price. A mark-down occurs when a broker-dealer buys a fixed-income security from a customer below the prevailing market price. Broker-dealers can then either purchase additional securities to cover what it has sold out of its proprietary account or sell the securities it bought from customers out of its proprietary account and pocket the mark-up or mark-down difference from the prevailing market price.

The IRC supports the proposed rule change because the new disclosure requirements would help many of the IRC’s clients who are retired or near retirement age and look to fixed-income securities to meet their investment goals and objectives.  Many investors are unaware that the actual market price of the security may be different than the amount they pay or receive. This lack of information has led to some customers paying more for trades in fixed-income securities than other similar customer trades.  The proposed rule change would protect the interests of those who need that protection the most – the less sophisticated investors who invest in fixed-income securities but may not have the level of trading expertise required to investigate undisclosed mark-up or mark-down pricing schemes.  Theoretically, investors could use a sophisticated trade statistics database such as the Trade Reporting and Compliance Engine (“TRACE”). However, this platform requires a level of trading knowledge far beyond that of the average retail investor.  The IRC believes average retail investors should not be at a disadvantage solely because they cannot utilize a complex online database such as TRACE.

Requiring firms to disclose the true cost of fixed-income securities transactions will further the objectives of the SEC because this rule change would protect the average retail investor from being adversely affected in these types of trades. Furthermore, consumers would be armed with the knowledge needed to select broker-dealers whose services will not impose undue costs on investors.






Investor Rights Clinic Weighs In On Proposed Rules Regarding the Financial Exploitation of Seniors

By Neda Ghomeshi

On November 30, 2015, the Investor Rights Clinic (IRC) submitted a comment letter to FINRA in regard to Regulatory Notice 15-37. The Regulatory Notice sought comments on proposed rules to address the financial exploitation of seniors and other vulnerable adults. The notice proposed amendments to Rule 4512, Customer Account Information, which would require firms to obtain the name of and contact information for a trusted contact person for a customer’s account. The IRC fully supported those amendments; however, its comment letter focused on FINRA’s proposed rule, Rule 2165, Financial Exploitation of Specified Adults. Rule 2165 would permit qualified persons of firms to place temporary holds on disbursement of funds or securities from the accounts of specified adults where there is a reasonable belief of financial exploitation of those customers. The proposed rule does not create an obligation to place a hold on funds or securities where financial exploitation may be occurring. In its letter, the IRC supported FINRA’s efforts to protect seniors and vulnerable adults; however, the IRC encouraged FINRA to mandate the rule as opposed to its current permissive language.

To support its position, the IRC provided FINRA with alarming statistics. For example, approximately 10,000 people will turn 65 every day for the next 15 years. Also, an estimated one million elders lose over $2.9 billion each year due to financial abuse. As a non-profit legal organization dedicated to protecting investors, particularly elderly investors, the IRC passionately advocated for a mandatory reporting process for any reasonable belief of financial exploitation of an elder.

More specifically, the IRC referenced the 21 states and the District of Columbia that require financial institutions to adhere to reporting requirements. The IRC explained that adding a mandatory reporting obligation to the proposed rule would provide uniform protection for the most vulnerable of the nation’s investors. Furthermore, it would promote the interest of investor protection and ensure protection for seniors who are being financially exploited.

FINRA will evaluate the comments submitted by the public and, if it makes any material changes to its proposed rules, may issue revised rules for additional comments. Otherwise, FINRA will submit the proposed rules to the SEC for review and the SEC’s comment process.

The Investor Rights Clinic Sends FINRA Dispute Resolution Task Force Letter Proposing Changes to Benefit Small Claim Investors

FINRA provides the largest forum for the resolution of disputes between investors and their brokers. Indeed, because nearly all brokerage firms in the U.S. have included a pre-dispute arbitration provision in the agreements with their customers, individuals really have no choice but to pursue their claims in arbitration. In an effort to improve the transparency, impartiality and efficiency of the forum for all participants, FINRA formed a 13-member arbitration Task Force to solicit information and comments from all interested parties with the view towards making recommendations to FINRA’s advisory committee, the National Arbitration and Mediation Committee. [July 17, 2014 FINRA Press Release, at: ]

Of particular concern to the Investor Rights Clinic (IRC) is the arbitration process governing small claims, specifically, matters with losses under $50,000. Those matters are generally handled under FINRA’s Simplified Arbitration process, which is anything but simple. However, investors with losses in this range frequently cannot find legal representation due to the size of the claim. Unless they have access to one of a handful of law school clinics, such as the IRC, they are faced with the choice of either pursuing their claim in an unknown and complicated forum, or forgoing their claim altogether.

As such, on May 13, 2015, the IRC submitted a detailed, 10-page-letter (FINRA Task Force Letter (2015)) to the Task Force, outlining a number of issues and suggestions regarding the small arbitration claims process. As the IRC explained in its letter, the IRC routinely deals with claims under $50,000, and its clients and callers requesting assistance “regularly share information about the particular difficulties they face in understanding whether they have a claim in the first place and, if so, how to navigate FINRA’s Dispute Resolution process.”

The recommendations the IRC made to the Task Force include, among other things:

• Establishing a short simplified arbitration guide (in English and Spanish) with filing forms that investors can complete, at their option;

• Providing for telephonic hearings for all small claims at the customer’s option (the only choice for investors today is to proceed entirely on paper submissions or ask for a full blown, in-person hearing);

• Establishing a dedicated roster of small claim arbitrators specially trained in dealing with unrepresented investors;

• In larger cases, giving the customer the choice of a hearing where they reside at the time the claim is filed (since many have moved or relocated since the transactions at issue); and

• Recommending additional, sustained funding to the law school clinics that, like the IRC, provide critical assistance to investors at no charge.

The Task Force should complete its work by the end of this year. Even if all of the proposals are not ultimately adopted by FINRA, the IRC appreciated the opportunity to speak on behalf investors with small claims. The IRC student interns who drafted the recommendation are: Thomas Hospod (’15), Alexandra Levenson (’15), Jessica Neer (’16) and David Tanner (’15).

Proposed FINRA Rule Change to Shift Professionals without Ties to Securities Industry into “Non-public” Arbitrator Pool

By Sunny Desai

In a proposed FINRA rule change, persons who worked in the financial industry for any duration during their careers would always be classified as non-public arbitrators, as well as persons who represent investors or the financial industry as a significant part of their business. This would mean removing certain attorneys, accountants, and other professionals from the public arbitrator classification and into the non-public arbitrator classification. As such, the Public Investors Arbitration Bar Association (PIABA) is not as highly enthusiastic about the proposed rule change.

The proposed change, that would essentially shift attorneys and other professionals without ties to the securities industry into the non-public arbitrator pool, will “harm the integrity of the arbitration process” according to PIABA. PIABA takes issue with the fact that the proposed rule change would prevent attorneys and other professionals who service investors in securities disputes, from serving as public arbitrators.

Currently, a non-public arbitrator is one who is associated with the financial industry, either by being registered through a broker or dealer, spending a substantial amount of his/her career engaging in the securities industry, or working in a financial institution with securities and commodities, etc. A public arbitrator is one who is not an investment advisor and is not engaged in securities or commodities. As of now, attorneys and accountants who service investors would be classified as public arbitrators, but this proposed rule change would re-classify those individuals as non-public arbitrators.

PIABA’s letter to the Securities and Exchange Commission (SEC) asserts that the categorization of a proposed arbitrator as public and/or non-public has always focused on the nature and extent of the individual’s relationship to the financial industry. This was borne solely out of the perceived bias on the part of the industry and in the interest of protecting the investing public.

How would this proposed rule change help investors in the arbitration process? According to PIABA, it simply wouldn’t. As stated in PIABA’s letter to the SEC, “placing arbitrators with no ties to the securities industry into the non-public pool makes no logical sense and would harm the integrity of the arbitration process because parties would not have accurate disclosure information to rely on in selecting arbitration panels.” Under FINRA’s proposed rule change, arbitrators with no ties to the securities industry would be mistakenly believed to have ties to the securities industry, as they would be categorized as non-public arbitrators.

According to PIABA, this would hurt and undermine FINRA’s own stated goal of arbitrator neutrality. With investor confidence already shaken, how can investors have faith in arbitration if the parties do not have accurate disclosure information when selecting arbitration panels?

FINRA May Collect Massive Amounts of Confidential Customer Data in the Future

By Tanner Forman

FINRA has proposed the creation of a new form of market regulation known as the Comprehensive Automated Risk Data System (“CARDS”).  If the system is created, FINRA would be allowed to mine massive amounts of client data from investment firms in hopes of using that data to better protect investors and to detect and fight risks that could cripple firms and the market.  A FINRA regulatory notice published in December of 2013 provides, “the CARDS system would download customer trade data from clearing firms and analyze it to identify churning, pump-and-dump schemes, excessive markups and mutual fund switching.”  FINRA believes that the system would help it deter both investment firms and brokers from engaging in questionable behavior.

However, not everyone shares FINRA’s same enthusiasm for the CARDS system.  The brokerage industry is hoping to convince FINRA that the system would cause too many privacy concerns.  What the brokerage industry isn’t saying is that the industry is opposed to the system because the increased oversight could uncover broker misconduct and could harm the investment firms’ overall profits.

Some investors are also opposed to the creation of the CARDS system because of the system’s apparent resemblance to the data collection process of the National Security Administration.  In particular, investors are concerned with the idea of FINRA possessing large amounts of sensitive data.  If there was a breach in the security of the database, a hacker could have access to highly confidential customer financial information, including holdings and transactions.  Unauthorized access to that information could cause serious damage to individual customers and to the overall confidence in the stock market.

At this point, CARDS is only a concept and not a formal rule proposal.  FINRA solicited comments on the CARDS system with the deadline to comment expiring on March 21, 2013.  It will be interesting to see whether FINRA creates the CARDS system and whether the system’s higher risk will lead to higher returns in regard to market regulation.

FINRA BrokerCheck: Will New Expungement Guidelines Help or Hurt the Securities Industry?

by Sean McCleary

Despite seemingly rigid rules on granting expungements, arbitrators have been allowing them far too often.  In fact, in mid-October, FINRA sent out a notice to its arbitrators, reiterating the guidelines for granting an expungement, which it considers to be an “extraordinary remedy.” Essentially, expungements cleanse any settlement information from a broker’s record on the Central Registration Depository (“CRD”).  BrokerCheck is the investor resource that allows investors to access certain information from the CRD—specifically, whether there were any past claims against a broker.  Expungements can carry significant implications because it reduces the transparency that potential investors need.

Until recently, FINRA Rules did not expressly prohibit members from conditioning settlements on expungement.  However, on February 13, 2014, FINRA’s Board of Governors moved to file Rule 2081 with the SEC, which will bar broker-dealers from trying to condition customer dispute settlements on the customers not opposing an expungement request.  In settlement negotiations, customers are probably not cognizant of an expungement’s implications—after all, the investor is getting some money back and he probably does not plan on using the broker in the future.  With Rule 2081, brokers will find it considerably harder to sanitize their BrokerCheck report from a past settlement claim.  Further, this will ensure that future investors can more accurately assess the quality and integrity of a broker.

On the other hand, settlements are a significant part of resolving FINRA claims in a timely manner.  If more FINRA claims reached arbitration, then the average FINRA claim would take substantially longer to adjudicate.  Ultimately, Rule 2081 could dissuade broker-dealers from settlement prior to arbitration because they may want to take their chances in arbitration.

Should FINRA Expand the Fiduciary Duties of Brokers to Include the Duty of Loyalty?

By Kent Crocker

FINRA recently issued a report on observations made while analyzing brokerage firms that suggests a broker’s accountability and compensation may need to be altered in order to protect the “best interests” of customers. More specifically, FINRA recently modified the suitability rule when it added more duty of care elements, but is now raising the possibility of implementing the duty of loyalty standard. Holding a broker to the duty of loyalty standard may help prevent conflicts of interest, which often arise from how the broker is compensated. For instance, a broker can be compensated more favorably based on what investments he sells to customers. The broker could also be under the direction of the firm to sell only certain investments to customers in cases where the firm is motivated to generate the revenue from investments that more favorably compensate the firm.

Implementing a duty of care standard helps guide brokers in a few respects. The duty of care standard creates the requirement that the broker be well-informed in the investment a customer is being placed in. If the broker breaches the duty of care, then the broker can be found liable for negligence and entitle the customer to damages. Under this rationale, it is quite obvious why FINRA decided to include the duty of care in the suitability standard, as brokers should be aware of the consequences of not finding the correct investment for each customer. However, the duty of care standard draws into question the compensation platforms that some brokerage firms may use and suggests that caps should be placed on the amount of fees a broker or brokerage firm is allowed to receive or charge. The logic behind this rationale is simple: Brokers and firms are motivated and driven to make a profit, which can create a conflict of interest where the customer’s “best interests” are not considered to the extent FINRA would like.

FINRA is now hinting at implementing the duty of loyalty in order to offset the amount of influence profit and compensation can have on both the firm and broker’s decision making process. Again, the manner in which brokers and firms are compensated would have to be altered in order for the amount of claims being brought to decrease. However, if the duty of loyalty were to be enacted, then it would run contrary to how the duty of loyalty is applied in corporate settings. For instance, a board of director for a corporation has the fiduciary duty of loyalty to always make decisions that are in the best interests of the corporation. Here, the brokers and firms would have a duty of loyalty to the client’s best interests and would be prevented from making decisions based on the best interests of the firm.

In order to help firms and brokers evolve towards a greater concern for the “best interests” of the customer, FINRA and the Securities and Exchange Commission (“SEC”) could tighten the standards for brokers and firms by intensifying the fiduciary duties owed to clients. In the view of the regulators, the financial industry is often driven by sales and profits, which suggests the motivation behind the duty of loyalty discussion. FINRA and the SEC are regulating the industry to ensure the rights of investors are protected, but overregulation can be just as devastating in the opposite respect. Unsurprisingly, many in the financial industry do not want brokers to be subject to a duty of loyalty by FINRA, the SEC, or any other regulatory agency. It will be interesting to see how far regulation can go. The duty of loyalty appears reasonable on its face, but its application in the current compensation structure for firms and brokers may prove difficult.

Broker Recruiting Practices Revealed: Firms May Soon Have to Disclose Bonus Packages

By Bernadette Sadeek

If firms want to recruit high-producing brokers, they may soon be required to disclose their bonus incentive packages to customers. On September 19, 2013, the Financial Industry Regulatory Authority (FINRA) Board of Directors approved a proposal to require disclosures of conflicts of interest relating to recruitment compensation packages incentivizing brokers to move to a new firm. The proposal is now being considered by the Securities and Exchange Commission (SEC) for final review and approval. The SEC staff may request changes or amendments to the rule proposal.

There are two main components of the proposed rule. The first is a disclosure requirement, obligating “recruiting firm[s] to make important disclosures to a registered representative’s former customer who is contacted about following the representative to the recruiting firm or who decides to transfer assets to the new firm.” Firms would have to disclose any upfront payments (e.g. guaranteed bonuses and loans) and potential future payments (e.g. compensation contingent upon satisfying performance criteria or special payments not ordinarily provided to similarly situated representatives) and the basis for receiving the potential future payments. The disclosure would be required if the broker’s compensation package exceeds $100,001. However, the amount of compensation would only be required to be divulged in ranges, i.e. $100,000–$500,000, not the precise dollar amount. Lastly, because switching firms could be costly to investors, firms would also have to disclose the costs that would “accrue if a customer decides to transfer assets to a new firm” as well as the fact that “certain assets may not be transferrable.”

FINRA states that the purpose for requiring these disclosures is to allow the customer to make an informed decision about the implications of following the broker to the new firm. Many firms offer significant financial incentives to recruit brokers to join their firms and to transfer their book of business to the new firm. A typical compensation package is paid upfront to the broker in the form of a 10-year forgivable loan. The compensation package is usually based on the broker’s 12-month gross production or revenue produced in fees and commissions during the past year at the broker’s old firm. Other factors that may influence a broker’s bonus package include the firm from which the broker is transferring, the broker’s book of business, and the broker’s years of service and experience. The offer is typically an irresistible financial package, sometimes reaching up to several million dollars and exceeding three times a broker’s annual production. At some firms, the compensation package will include a combination of a forgivable loan and an annual bonus that equals the annual installment due on the loan at the time the loan payment is due. As part of this package, each year, the broker is expected to meet or exceed a sales goal in order to be “forgiven” for a portion of the loan.  If the broker fails to meet the sales goal, the broker is obligated to pay installments on the loan, plus interest.  Consequently, brokers may feel pressured to sell securities as high levels, or worse, engage in conduct that may violate obligations to investors (i.e. recommending unsuitable investment products or churning customer accounts), in order to generate enough fees and commissions to meet the firm’s expectations.

Meanwhile, an unassuming customer would be completely oblivious that this arrangement creates a significant conflict of interest. While the broker is bound by the duty to recommend and operate in the customers’ best interest, the bonus packages incentivize brokers to generate more costs to the customer. Therefore, the disclosures are intended to provide transparency and to protect customers from the conflict that arises when the customer follows the broker to a new firm. Customers would be able to make a fully informed decision to follow the broker to a new firm and understand the costs and other implications associated with transferring his or her account.

The second component of the proposed rule is a reporting obligation—requiring a “recruiting firm to report to FINRA when a representative is expected to receive [either] an increase in total compensation over the prior year of 25 percent or $100,000, whichever is greater, in connection with the transfer to that firm.” FINRA would use this information to compile an industry-wide risk-based examination of compensation packages as it relates to sales abuses.

Some firms who oppose the rule warn the proposed rule is anti-competitive in nature because it would limit compensation and discourage brokers from seeking new employment at another firm. However, the problem of broker sales abuse due to pressures associated with the recruiting practices of the industry has persisted for many years. This proposed rule is a step towards preventing such abuses relating to conflicts of interests between firms, brokers, and their customers.

To view a short video detailing this report, please see the FINRA Regulation Guidance Video

Joint Proposed Rule Filing by FINRA and SEC Hoping for More Transparency

by Brian Heit

The Financial Industry Regulatory Authority (“FINRA”) has filed with the Securities Exchange Commission (“SEC”) proposed rule changes that are intended to facilitate greater consumer and industry access to disciplinary and other relevant information.

Under the current disciplinary complaints and disciplinary decisions rule, FINRA releases information to the public regarding disciplinary decisions. However, the disciplinary information available is limited by the publicity threshold under this rule. The proposed rule would remove the restrictions and allow FINRA to release a public copy of the information with respect to any disciplinary complaint or disciplinary decisions issued by FINRA.

FINRA believes the changes would provide valuable guidance and information to members, associated persons, regulators, and investors.  More specifically, FINRA explained the releasing of a public copy as opposed to “information” would “serve to deter and prevent future misconduct and … improve the overall business standard in the securities industry.”  The rule allows investors to consider firms’ and representatives’ disciplinary track record when deciding whether to engage in business with them. Also, firms may use the information as a resource to educate their associated persons with compliance matters and highlight potential violations.

Furthermore, FINRA asserts that this will better align its publication standards with the practices of the SEC and other regulators, which will help avoid confusion between those looking to regulators for information. Although this proposed rule change requires more transparency regarding disciplinary actions, FINRA believes the rule is fair to members because any complaint that is dismissed or withdrawn will be accompanied by the order.  In addition, in certain circumstances and at FINRA’s discretion, it may find the potential harm to a firm outweighs any investor protection benefit, and will choose to not release information.

Whether this proposed rule serves as a regulatory trend is yet to be determined. The possible expansion of FINRA’s regulatory scheme, coupled with the complexity of political and public considerations, may require changes in brokerage-firms business choices.