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The SEC has approved an omnibus rule filing strengthening investor protection from at-risk firms and brokers. Addressing unpaid Awards is a major focus.

Readers may recall that we reported in SAA 2019-18 (May 8) that FINRA had issued a Regulatory Notice seeking comments on rule changes aimed at better protecting investors from firms with significant regulatory histories. Specifically, the Authority in May 2019 announced publication of Regulatory Notice 19-17FINRA Requests Comment on Proposed New Rule 4111 (Restricted Firm Obligations) Imposing Additional Obligations on Firms with a Significant History of Misconduct. The description: “As part of FINRA’s ongoing initiatives to protect investors from misconduct, FINRA is requesting comment on proposed new Rule 4111 (Restricted Firm Obligations) that would impose tailored obligations, including possible financial requirements, on designated member firms that cross specified numeric disclosure-event thresholds.” A core thrust was unpaid arbitration awards.

Comments to Original Proposal

We analyzed in SAA 2019-26 (Jul. 10) the 32 comment letters received  by the July 1, 2019, deadline, which were mostly split along party lines (but with some interesting alliances). For the most part, investor advocacy groups and regulators supported the proposal, but urged that more be done to protect investors from unpaid awards. Industry groups and commenters were more divided, with some looking more to the burdens on competition among smaller firms, while others approached the proposition from an individual responsibility perspective. SIFMA generally supported the proposed changes.

The Rulemaking Proposal Filed with SEC

We said in #2019-26 that: “staff will analyze the comments, make changes, and then likely seek Board approval to do a 19b rule filing with the SEC.” As reported in SAA 2020-44 (Nov. 25), that transpired in November 2020 when FINRA announced that it had filed SR-FINRA-2020-041Proposed Rule Change to Address Firms with a Significant History of Misconduct. The announcement echoed the Regulatory Notice’s statement of purpose, with more details: “(1) adopt FINRA Rule 4111 (Restricted Firm Obligations) to require member firms that are identified as ‘Restricted Firms’ to maintain a deposit in a segregated account from which withdrawals would be restricted, adhere to specified conditions or restrictions, or comply with a combination of such obligations; and (2) adopt a new FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111), 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. In addition, FINRA proposes to adopt Capital Acquisition Broker (‘CAB’) Rule 412 (Restricted Firm Obligations), to clarify that member firms that have elected to be treated as CABs would be subject to proposed FINRA Rule 4111, and 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.”

SEC Approves the Rule: Addressing Unpaid Awards a Major Objective

The Commission approved the rule on July 30 (Release No. 34-92525). Although arbitration or unpaid Awards were not referenced in the title or description, both feature prominently in the rule filing’s text and the Approval Order. In fact, the term “arbitration” or its derivatives appear 123 times in the Approval Order; “unpaid arbitration award” 37 times. There are numerous passages defining one of the proposal’s purposes as addressing unpaid arbitration Awards, for example: “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. 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” (footnotes omitted). And the FINRA response to comments dated March 4, 2021 says: “As an initial matter, although the proposal would have ancillary benefits for addressing unpaid arbitration awards, the proposal’s primary purpose is to create incentives for members that pose outlier-level risks to change behavior” (footnote omitted).

Commissioner Statements

In a relatively rare move, Commissioners Caroline A. Crenshaw and Allison Herren Lee issued a July 30 Statement lauding the approval: “Today, the Commission approved FINRA’s proposed rule change to, among other things, impose additional obligations on FINRA member firms with a significant history of misconduct, as well as those firms that employ individual brokers with such histories (collectively ‘high risk firms’). We appreciate FINRA’s attention to these high risk firms because they raise important investor protection concerns. We were pleased to see FINRA’s commitment to working with state securities regulators to share information regarding these firms. We are also pleased that FINRA’s Board recently approved a plan for a separate filing to disclose the identities of high risk firms to the public, which it expects to file promptly. A firm’s high-risk status is important information and will help investors make informed choices about the firms they select. We intend to monitor this important investor protection issue and will evaluate whether additional steps may be needed to address recidivist firms and brokers” (footnotes omitted).

(ed: *Next in the regulatory process is FINRA’s issuance of a Regulatory Notice setting the effective date 180 days thereafter. **FINRA has taken several steps to address unpaid Awards. For example, the Authority now publishes detailed statistics on the subject.)

This post first appeared on the Securities Arbitration Alert blog.  The blog’s editor-in-chief is George H. Friedman, Chairman of the Board of Directors for Arbitartion Resolution Services, Inc.

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