example, FINRA considered several alternatives to addressing the risks
posed by firms and their brokers that have a history of misconduct,
including alternative approaches and alternative specifications to the
numeric threshold based-approach and the Restricted Deposit
Requirement.
a. Alternative to the Proposed Numeric Threshold-Based Approach
    In addition to the proposed approach based on numeric thresholds,
FINRA considered an approach similar to the Investment Industry
Regulatory Organization of Canada's (IIROC) ``terms and conditions''
rule, IIROC Consolidated Rule 9208, that would allow FINRA to identify
a limited number of firms with significant compliance failures and
impose on them appropriate terms and conditions to ensure their
continuing compliance with the securities laws, the rules thereunder,
and FINRA rules.\64\ FINRA considered and evaluated the economic
impacts of such a terms and conditions rule relative to proposed Rule
4111.
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    \64\ IIROC Consolidated Rule 9208 permits IIROC to impose terms
and conditions on an IIROC Dealer Member's membership when IIROC
considers these terms and conditions appropriate to ensure the
member's continuing compliance with IIROC requirements.
---------------------------------------------------------------------------

    Compared to proposed Rule 4111, a terms and conditions rule would
provide FINRA with greater flexibility in identifying firms that should
be subject to additional obligations. This greater flexibility could
help better target its application and reduce misidentification by
allowing FINRA to leverage non-public information, including regulatory
insights collected as part of its monitoring and examination programs,
in identifying firms that pose the greatest risk. Further, under a
terms and conditions rule, FINRA could quickly update its
identification of firms based on emerging risk patterns, to ensure that
the rule continues to be effective at addressing firms that presently
pose the greatest risk. This flexibility could

mitigate the risk that the criteria and thresholds in proposed Rule
4111 no longer identify the appropriate firms.
    Further, as discussed above, the identification criteria in
proposed Rule 4111 may not identify all the firms that pose material
risk to their customers, such as firms that may act to stay just below
the proposed criteria and thresholds by any means, including
misreporting or underreporting disclosure events. The absence of a set
identification criteria in a terms and conditions rule would make it
more difficult for firms to evade the identification criteria and thus
could provide greater investor protections.+
    At the same time, a terms and conditions rule may have certain
disadvantages relative to proposed Rule 4111. For example, a benefit of
proposed Rule 4111 is the deterrent effect it may have on firms that do
not meet the proposed Preliminary Criteria for Identification,
particularly firms that may be close to meeting the criteria. These
firms may change behavior and enhance their compliance culture in ways
that could better protect their customers. By comparison, under a terms
and conditions rule, in the absence of transparent criteria, firms
would have to assess FINRA's view of the significance of repeated exam
findings to determine whether to change their conduct to avoid
potential terms and conditions.
    Although FINRA has considered, and will continue to explore, this
alternative, it is not proposing a terms and conditions rule at this
time.
b. Alternative Specifications for the Proposed Numeric Threshold-Based
Approach
    FINRA also considered several alternatives to the numerical
thresholds and conditions for the Preliminary Criteria for
Identification. In determining the proposed criteria, FINRA focused
significant attention on the economic trade-off between incorrect
identification of firms that may not subsequently pose risk of harm to
their customers, and not including firms that may subsequently pose
risk of harm to customers. FINRA also considered three key factors: (1)
The different categories of reported disclosure events and metrics,
including the Expelled Firm Association Metric; (2) the counting
criteria for the number of reported events or conditions; and (3) the
time period over which the events or conditions are counted. FINRA
considered several alternatives for each of these three factors.
[rtarr8] Alternatives Associated With the Categories of Disclosure
Events and Metrics
    In determining the different types of disclosure events, FINRA
considered all categories of disclosure events reported on the Uniform
Registration Forms, including the financial disclosures. FINRA decided
to exclude financial disclosures because while financial events, such
as bankruptcies, civil bonds, or judgments and liens, may be of
interest to investors in evaluating whether or not to engage a broker
or a firm, these types of events by themselves are not evidence of
customer harm.
    In developing the Preliminary Criteria for Identification, FINRA
also considered whether pending criminal, internal review, judicial and
regulatory events should be excluded from the threshold test. Pending
matters are often associated with an emerging pattern of customer harm
and capture timely information of potential ongoing or recent
misconduct. However, pending matters may include pending regulatory
investigations and criminal proceedings that do not result in a
finding.\65\ FINRA evaluated the impact of eliminating pending matters
from the Preliminary Criteria for Identification. Specifically, FINRA
identified the firms that would no longer meet the proposed criteria
(had the criteria existed) during the evaluation period if pending-
events categories were eliminated from the criteria, and examined the
extent to which such firms were associated with ``new'' Registered
Person and Member Firm Events. As shown in Exhibit 3d, FINRA estimates
that these firms had on average approximately 8.0-13.1 times more new
disclosure events than other firms in the industry during the same
period that would not have met the Preliminary Criteria for
Identification.\66\ Accordingly, based on this review and other
validations, FINRA decided to include pending matters in the proposed
criteria because they are critical to identifying firms that pose
greater risks to their customers.
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    \65\ As discussed in more detail below, several commenters
expressed concerns about including pending and un-adjudicated events
in the Preliminary Criteria for Identification. Commenters suggested
that pending events are often associated with frivolous cases and
that many pending regulatory investigations and criminal proceedings
are discontinued without action.
    \66\ In assessing the impact of removing pending events from the
Preliminary Criteria for Identification and restricting the criteria
solely to final events, FINRA also examined the number of firms that
would have met or exceeded at least one Preliminary Identification
Metrics Threshold in the Registered Person Adjudicated Events,
Member Firm Adjudicated Events, or Registered Persons Associated
with Expelled Firms categories, during the relevant period. This
analysis showed that the number of firms identified by this
alternative criteria would increase from 45-80 firms to 131-196
firms, each year, during the review period. Similarly, FINRA
estimates the number of firms that would have met or exceeded at
least two thresholds within these categories to be 32-57 firms, each
year, during the review period.
---------------------------------------------------------------------------

    As with other categories, the proposed Preliminary Identification
Metrics Thresholds for the relevant Preliminary Identification Metrics,
including the Registered Person Pending Event Metric and the Member
Firm Pending Event Metric, are intended to capture firms that are on
the far tail of the distributions. Thus, firms meeting these thresholds
have far more pending matters on their records than other firms in the
industry that do not meet these thresholds. Nonetheless, FINRA
recognizes that pending matters include disclosure events that may
remain unresolved or that may subsequently be dismissed or concluded
with no adverse action because they lack merit or suitable
evidence.\67\ In order to ensure that a firm does not meet the
Preliminary Criteria for Identification solely because of pending
matters, FINRA has proposed the conditions that, to meet the criteria,
the firm must meet or exceed at least two of the six Preliminary
Identification Metrics Thresholds, and at least one of the thresholds
for the Registered Person Adjudicated Event Metric, Member Firm
Adjudicated Event Metric, or Expelled Firm Association Metric.
---------------------------------------------------------------------------

    \67\ For example, customers may file complaints that are false
or erroneous and such complaints may subsequently be withdrawn by
the customers or get dismissed by arbitrators or judges.
---------------------------------------------------------------------------

    In developing the Preliminary Criteria for Identification, FINRA
also considered alternatives to the Expelled Firm Association Metric.
For example, in Regulatory Notice 19-17, FINRA initially proposed the
metric to be based on all registered persons who were previously
associated with one or more previously expelled firms, at any time in
their career and irrespective of their duration of association at the
previously expelled firm. FINRA subsequently narrowed the Expelled Firm
Association Metric by only including registered persons who were
registered with a previously expelled firm within the prior five years
(i.e., whose registration with a previously expelled firm terminated
during the prior five years) and who were registered with the expelled
firm for at least one year. FINRA selected this formulation to analyze
because the five-year lookback is consistent with the lookback periods
for the other proposed metrics in the proposal and, based on staff
experience,

FINRA believes that individuals who are more recently associated with
previously expelled firms (e.g., in the last five years) and have
longer tenures at expelled firms (e.g., a year or more, instead of a
shorter employment duration) generally pose higher risk than other
individuals.
    In developing the proposal, FINRA conducted several validations on
the firms meeting the criteria, including the proposed Expelled Firm
Association Metric, by reviewing the extent to which firms identified
during 2013-2017 (had the criteria existed) were subsequently expelled,
associated with unpaid awards, or identified by the Department as
suitable candidates for additional obligations. As discussed above,
FINRA also evaluated the extent to which firms that would have met the
criteria during 2013-2017 (had the criteria existed) and their brokers
were associated with ``new'' Registered Person and Member Firm Events
after having met the criteria. As shown in Exhibit 3c, FINRA estimates
that the identified firms had on average approximately 6.1-19.9 times
more new disclosure events after their identification than other firms
in the industry during the same period that would not have met the
Preliminary Criteria for Identification. Based on staff review and
validations, FINRA believes that the proposed Expelled Firm Association
Metric preserves the usefulness of the Preliminary Criteria for
Identification (as originally proposed in Regulatory Notice 19-17) and
continues to identify firms that pose greater risks to their customers.
[rtarr8] Alternatives Associated With the Counting Criteria for the
Proposed Criteria and Metrics
    FINRA considered a range of alternative counting criteria for the
Preliminary Criteria for Identification. For example, FINRA considered
whether the Preliminary Criteria for Identification should be based on
firms meeting two or more Preliminary Identification Metrics
Thresholds, or whether the number of required thresholds should be
decreased or increased. Decreasing the number of required thresholds
from two to one would increase the number of firms that would have met
the Preliminary Criteria for Identification during the review period
from 45-80 firms to 155-217 firms, each year. Alternatively, increasing
the number of required thresholds from two to three would decrease the
number of firms that would have met the Preliminary Criteria for
Identification from 45-80 firms to 11-20 firms, each year. FINRA
reviewed the list of firms identified under these alternative counting
criteria and examined the extent to which they included firms that were
subsequently expelled, associated with unpaid awards, or identified by
the Department as suitable candidates for additional obligations. FINRA
also paid particular attention to firms that would have been identified
by these alternative criteria but subsequently were not associated with
high-risk activity, as well as firms that would not have been
identified by these alternatives that were associated with high-risk
events. Based on this review, FINRA believes that the proposed
approach--meeting two or more of the Preliminary Identification Metrics
Thresholds--more appropriately balances these trade-offs between
misidentifications than the alternative criteria.
[rtarr8] Alternatives Associated With the Time Period Over Which the
Metrics Are Calculated
    The proposed Preliminary Identification Metrics are based on two
different time periods over which different categories of events and
conditions are counted (``lookback periods''). Pending events,
including the Registered Person Pending Events and the Member Firm
Pending Events categories, are counted in the Preliminary
Identification Metrics only if they are pending as of the Evaluation
Date. Adjudicated events, including the Registered Person Adjudicated
Events and the Member Firm Adjudicated Events categories, and
Registered Persons Associated with Previously Expelled Firms are
counted in the Preliminary Identification Metrics over a five-year
lookback period.\68\
---------------------------------------------------------------------------

    \68\ Registered Persons In-Scope include all persons registered
with the firm for one or more days within the one year prior to the
Evaluation Date.
---------------------------------------------------------------------------

    In developing the proposal, FINRA considered alternative criteria
for the time period over which the disclosure events or conditions are
counted. For example, FINRA 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 (e.g., events occurring in the
last five years) generally pose a higher level of possible future risk
to customers than other events. Further, counting events over an
individual's or firm's entire reporting period would imply that brokers
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.
Accordingly, FINRA decided to include adjudicated events only in the
more recent period (i.e., a five-year period).\69\
---------------------------------------------------------------------------

    \69\ This also is consistent with the time period used for
counting ``specified risk events'' in SR-FINRA-2020-011.
---------------------------------------------------------------------------

    Similarly, FINRA also considered alternative limits on the time
periods over which components of the Expelled Firm Association Metric
would be calculated. For example, FINRA considered alternative metrics
based on only firms that have been expelled within three to five years
prior to the Evaluation Date. Further, FINRA considered alternatives
where the individual broker's association with the previously expelled
firm was within a five-year window around the firm's expulsion. In
evaluating these alternatives, FINRA recalculated the underlying
thresholds to capture firms that are on the far tail of the
distribution for these alternative metrics.\70\ As with other
alternatives, FINRA conducted several validations on alternative
specifications of time periods for calculating the Expelled Firm
Association Metric. These validations included reviewing the extent to
which firms identified by alternative specifications of the proposed
criteria were associated with ``new'' events after identification,
subsequently expelled or associated with unpaid awards, or were
identified by the Department as suitable candidates for additional
obligations. Based on these validations, FINRA selected the proposed
five-year period for calculating the Expelled Firm Association Metric
as the alternative specifications did not result in any material change
to the proposed criteria's ability to identify firms that pose greater
risk of customer harm.\71\
---------------------------------------------------------------------------

    \70\ These alternatives would have identified approximately the
same number of firms as meeting the Preliminary Criteria for
Identification, during the review period.
    \71\ For example, as discussed above, FINRA estimates that the
firms identified by the proposed criteria (based on a five-year
period for calculating the Expelled Firm Association Metric) had on
average approximately 6.1-19.9 times more new disclosure events
after their identification than other firms in the industry during
the same period that would not have met the proposed criteria.
---------------------------------------------------------------------------

c. Alternatives to the Restricted Deposit Requirement
    In developing the proposal, FINRA considered alternative approaches
to the Restricted Deposit Requirement. For example, FINRA considered
increasing the capital requirements on identified firms, in lieu of the
Restricted Deposit Requirement. A net capital approach would provide
the identified firms

greater flexibility and control over the assets. These firms would be
able to use the assets for cash flow and operating expenses. As a
result, an additional net capital charge would be associated with lower
direct and indirect costs to these firms. However, there are several
drawbacks with respect to economic incentives and anticipated impacts
to relying upon a net capital approach as a tool for addressing the
risks posed by firms with a significant history of misconduct. For
example, the firm assets that would be maintained pursuant to an
increased net capital requirement would not be deposited into a
separate restricted account and may be fungible with other firm assets.
As a result, these assets could be withdrawn by the identified firms at
any time and these firms could employ the capital during the pendency
of the restriction period. This suggests that the deterrent effect of
an increased net capital approach would be much lower on a dollar-for-
dollar basis than the proposed Restricted Deposit Requirement. An
increased net capital approach also may not be sufficiently impactful
in providing incentives to change firm behavior if a Restricted Firm
already maintains substantial excess net capital. Further, considering
that the identified firms could withdraw their assets at any time under
a net capital approach, FINRA would not be able to ensure that any
funds would be available for satisfying unpaid arbitration awards. In
light of these considerations, FINRA decided to propose a Restricted
Deposit Requirement approach, rather than changes to the capital
requirements on identified firms.
    FINRA also considered whether the Restricted Deposit Requirement
amount should be based on a formula or include a cap in order to
provide greater transparency to the member firms. To assess the
feasibility of a strict formula or cap in setting the Restricted
Deposit Requirement, FINRA assessed the financial condition of the
firms that would have been identified by the Preliminary Criteria for
Identification in 2019 (if the criteria had existed) and found
significant variation across firms. These variations existed even
across firms within the same size category. For example, FINRA found
that the highest firm's revenues were approximately 1,750 times that of
the firm with the lowest revenue when standardized by the number of
registered persons at the firm. Within firm size categories, the
corresponding difference in revenues per registered person was as high
as over 80 times. Similarly, there was significant variation in the
reported cash and ownership equity across these firms. The highest
firm's excess net capital was over 3,500 times that of the firm with
the lowest excess net capital (standardized per registered person).\72\
The firm reporting the highest ownership equity was over 2,300 times
that of the lowest firm's ownership equity (standardized per registered
person). Further, firms' awards and settlements appear to be unrelated
to their financial condition. For example, FINRA estimates that over
20% of the identified firms with high awards and settlement amounts
have low or medium revenues (on a per registered person basis) or high
revenues and low or medium awards and settlement amounts.\73\ Thus
there appears to be no consistent relationship between firm size, and
basic metrics of the financial condition of the firm, and potential
obligations to harmed customers. Given these significant variations in
quantitative factors and the qualitative nature of some of the factors
for consideration (e.g., concerns raised during FINRA exams), FINRA
decided to maintain the Department's discretion for determining the
Restricted Deposit Requirement, instead of proposing a formula or a
cap. Additionally, FINRA believes that if the proposal were to include
a precise formula, it may undermine the effectiveness of the rule by
providing an opportunity for firms to take actions to minimize the
expected restricted deposit.
---------------------------------------------------------------------------

    \72\ See Exhibit 3e, which reflects the firms that would have
met the Preliminary Criteria for Identification in 2019, had the
criteria existed.
    \73\ For purposes of this Form 19b-4, ``high'' arbitration
awards, settlement amounts and revenues means the top tercile (above
66th percentile) of these awards, settlements and revenues among
firms that would have met the proposed criteria, and ``medium'' and
``low'' arbitration awards, settlement amounts and revenues means
the middle tercile (33rd-66th percentile) and bottom tercile (below
the 33rd percentile). See Exhibit 3f, which reflects the firms
meeting the Preliminary Criteria for Identification in 2019.
---------------------------------------------------------------------------

C. Self-Regulatory Organization's Statement on Comments on the Proposed
Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in Regulatory
Notice 19-17 (May 2019). Thirty-two comments were received in response
to the Regulatory Notice.\74\ Exhibit 2a is a copy of the Regulatory
Notice. Exhibit 2b is a list of commenters. Exhibit 2c contains copies
of the comment letters received in response to the Regulatory Notice.
Of the 32 comment letters received, 11 were generally in favor of the
proposed rule change, and 18 were generally opposed.
---------------------------------------------------------------------------

    \74\ All references to commenters are to the comment letters as
listed in Exhibit 2b.
---------------------------------------------------------------------------

    FINRA has considered the comments received. In light of some of
those comments, FINRA has made some modifications to the proposal. The
comments and FINRA's responses are set forth in detail below.
1. General Support for the Proposal
    Several commenters expressed general support for the proposed rule
changes in Regulatory Notice 19-17.\75\ For example, NASAA commended
FINRA's attempt to strategically identify, and more strongly regulate,
the limited number of member firms with histories of regulatory
noncompliance, and stated that the proposal should increase investor
protection while imposing minimal burdens on the brokerage industry.
Massachusetts called the proposal a positive step toward protecting
investors from the riskiest corners of the brokerage industry, and
asserted that the proposal rightly places the burden of investor
protection on the firms that hire bad brokers and ensures that
investors have meaningful recourse when harmed. CAI likewise expressed
support for how the proposal would enhance customer protection by
imposing additional obligations on a targeted group of firms. SIFMA
supported how the proposal fits into FINRA's continuing efforts to help
ensure that arbitration claims, awards, and settlements are paid in
full. Cetera supported both the concept and manner in which FINRA has
approached this effort. Cambridge agreed that an objective data
assessment coupled with a comprehensive and transparent review of that
data--which is the general structure of the proposed Restricted Firm
Obligations Rule--will aid FINRA in identifying those high risk member
firms and registered persons contemplated by this proposal.
---------------------------------------------------------------------------

    \75\ CAI, Cambridge, Cetera, FSI, Massachusetts, MIRC, NASAA,
PIABA, PIRC, SIFMA, St. John's SOL. Supportive commenters also
suggested ways in which the proposal could be modified or enhanced,
which are discussed in more detail below.
---------------------------------------------------------------------------

2. General Opposition to the Proposal
    Several commenters generally opposed proposed Rule 4111, on a
variety of grounds. For example, several commenters wrote that the
proposal would disproportionately affect small firms or reflected an
attempt to put small firms out of business.\76\ PIRC, however,
characterized industry

objections that the proposed rule would disproportionately affect small
firms as unwarranted noting that the rule accounts for different firm
sizes in its threshold calculations. Each specific numeric threshold in
the Preliminary Identification Metrics Thresholds grid (proposed Rule
4111(i)(11)) represents an outlier with respect to similarly sized
peers. Moreover, the process of determining a Restricted Deposit
Requirement would require the Department to consider several factors
that relate to firm size and a parameter directly influenced by firm
size.\77\ Thus, while the revised proposal includes several
modifications that will lessen some of the original proposal's burdens
on all firms, the modifications are not specific to small firms.
---------------------------------------------------------------------------

    \76\ Brooklight, Colorado FSC, Dempsey, FSI, IBN, Joseph Stone,
Luxor, McNally, Moss & Gilmore, Westpark.
    \77\ See proposed Rule 4111(i)(15)(A) (including as factors,
inter alia, the ``nature of the firm's operations and activities''
and ``the number of offices and registered persons,'' and requiring
that the Department determine a maximum Restricted Deposit
Requirement that ``would not significantly undermine the continued
financial stability and operational capability of the firm as an
ongoing enterprise over the next 12 months'').
---------------------------------------------------------------------------

    Some commenters generally opposed the proposal on the basis of its
potential adverse impacts on individuals.\78\ For example, some
commenters contended that many terminated individuals would have to
uproot their lives and be unable to find a new broker-dealer.\79\
Brooklight commented that innocent representatives who associated with
a firm expelled for firm-level issues would be marked with a ``scarlet
letter'' that could end their careers. Westpark commented that the
proposed rule would make it financially untenable for small firms to
employ brokers with certain levels of disclosures, essentially making
them unemployable. HLBS commented that the proposed rule will allow
FINRA to grossly intrude on member firms' recruiting and termination
decisions. Some commenters expressed concern that the proposal would
unfairly affect some persons who previously worked at disciplined firms
and persons with any regulatory incidents regardless of their
intent.\80\
---------------------------------------------------------------------------

    \78\ Brooklight, Dempsey, Joseph Stone, Westpark.
    \79\ Dempsey, Joseph Stone.
    \80\ Brooklight, Dempsey, Joseph Stone.
---------------------------------------------------------------------------

    FINRA notes, however, that between 2013 and 2019, only one to two
percent of registered persons in any year had any qualifying events in
their regulatory records, which represents the most conservative
estimate of the set of brokers who might be associated with the
proposed rule. Further, approximately 98% of member firms would be able
to employ individuals seeking employment in the industry--including
ones who have some disclosures and ones who were terminated by
Restricted Firms--without meeting the Preliminary Criteria for
Identification. Moreover, under a separately proposed rule, a member
firm could register an individual who has only one ``specified risk
event'' in their record without having to request a materiality
consultation.\81\
---------------------------------------------------------------------------

    \81\ See Securities Exchange Act Release No. 88600 (April 8,
2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No.
SR-FINRA-2020-011).
---------------------------------------------------------------------------

    For these reasons, FINRA is not proposing to revise proposed Rule
4111 to address these comments, except to narrow the scope of the
Expelled Firm Association Metric. FINRA recognizes that proposed Rule
4111 could result in some firms declining to employ persons who have
associated with a firm that has been expelled, even when it would not
cause the firm to meet the Preliminary Criteria for Identification.
FINRA does not believe this concern--which is similar to how some firms
may respond to FINRA's ``Taping Rule'' \82\--warrants removing the
Expelled Firm Association Metric from the Preliminary Criteria for
Identification. Nevertheless, as explained more below, FINRA has
narrowed the Expelled Firm Association Metric, to narrow its impact on
individuals.
---------------------------------------------------------------------------

    \82\ See Rule 3170 (Tape Recording of Registered Persons by
Certain Firms). The Taping Rule provides, in general, that a firm is
a ``taping firm'' when specified percentages of its registered
persons have been associated with one or more ``disciplined firms''
in a registered capacity within the last three years.
---------------------------------------------------------------------------

    Westpark commented that the proposal is inconsistent with Section
15(b)(6) of the Exchange Act, which requires that FINRA rules not be
designed to permit unfair discrimination between brokers or dealers,
and Section 15A(b)(9) of the Exchange Act, which requires that FINRA
rules not impose any burden on competition not necessary or appropriate
in furtherance of the Exchange Act. Proposed Rule 4111, however, will
allow FINRA to impose obligations only on the limited number of member
firms that pose substantially higher risks to investors compared to
their similarly sized peers, and only after a multi-step process that
has numerous procedural protections, for the purpose of protecting
investors and the public interest. Therefore, FINRA believes the
proposal is an appropriate means of protecting investors and the public
interest, and is not unfair.\83\
---------------------------------------------------------------------------

    \83\ See Securities Exchange Act Release No. 17371 (December 12,
1980), 45 FR 83707 (December 19, 1980) (Order Approving File No. SR-
NASD-78-3) (explaining that disparate treatment of differently
situated parties is not necessarily either fair or unfair).
---------------------------------------------------------------------------

    Several commenters predicted that, for a variety of reasons, the
proposal will not achieve its intended goals \84\ or commented that the
proposal is insufficient.\85\ For example: (1) Some question the
underlying premise of using disclosure data to predict future customer
harm; \86\ (2) Rockfleet suggested that when a Restricted Deposit
Requirement would essentially shut a firm down, the firm would likely
terminate its membership and ``leav[e] FINRA in exactly the position it
is seeking to avoid''; (3) Joseph Stone commented that firms that
dilute their concentration of brokers that meet the threshold criteria
can still pose risks, and that the proposal will ``force firm
management to push quality and compliant representatives out of their
firms''; (4) Luxor commented that there is no evidence to prove that
the proposal will cure the problem it is intended to solve; (5)
Massachusetts wrote that the annual calculation is predictable and may
provide an incentive for firms to comply only enough to remain just
below the triggering thresholds; (6) Cambridge predicted that member
firms without significant retained earnings would be given exceptions
to the Restricted Deposit Requirement; (7) Network 1 wrote ``[t]here
will always be `bad' brokers''; and (8) ASA commented that certain
aspects of the proposal ``do not go far enough to remove the most
egregious actors from our industry'' and would ``marginally increase
the financial obligations of bad actor firms and allow [them] to
continue their abuse of Main Street investors.''
---------------------------------------------------------------------------

    \84\ ASA, Dempsey, Joseph Stone, Luxor, PIABA, Rockfleet,
Worden.
    \85\ ASA, Better Markets.
    \86\ Cetera, Dempsey, Luxor.
---------------------------------------------------------------------------

    The primary goal of the proposed rule change is to incentivize
members with a significant history of misconduct relative to their
peers to change behavior, and FINRA believes that the proposed rule
change is reasonably designed to achieve that goal. The way the
proposal identifies the affected firms is consistent with recent
academic studies that analyzed correlations between disclosure data and
risks to investors. The proposed rule change creates substantial,
ongoing incentives for the firms that present the highest levels of
risk to change behavior, and gives FINRA an important new tool to
respond to those firms that continue to present outlier-level risks to
investors. FINRA also believes that the most effective measure to
incentivize such

firms to change behavior is a financial restriction--including the mere
potential for a financial restriction.
    Several commenters state that the proposal's impacts are too broad
to address the risks posed. For example, Brooklight expressed that
instead of impacting just a ``few bad actors,'' the proposal imposes
increased regulatory burdens on ``every single member'' and could
``sweep in wholly innocent firms.'' HLBS commented that the proposed
rule would impose punishment based only on the mere suspicion of
misconduct. Rockfleet commented that the burdens would be unwarranted,
because unpaid arbitration awards are ``not a widespread industry
issue,'' and the proposal would unfairly capture firms that only employ
a single individual with numerous disclosure events. Sichenzia
commented that reducing unpaid arbitration awards is better achieved
through less onerous means. FSI expressed concern that the proposal
does not provide adequate safeguards to protect against
misidentification.
    FINRA believes, however, that the proposed rule change is
reasonably designed to impact a relatively small number of firms posing
outlier-level risks. The proposed Rule 4111 ``funnel'' process has
numerous safeguards designed to protect against misidentification.
Furthermore, 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.
    Luxor commented that the proposal is inconsistent with the usual
``causal relationship inherent in any regulatory schema'' where
misconduct precedes the sanctions imposed. Proposed Rule 4111, however,
is similar to other kinds of rules and regulations that impose
requirements and restrictions based on a firm's circumstances. For
example, FINRA's membership rules permit FINRA to impose restrictions
on new member applicants that are reasonably designed to address
specific concerns, including--besides disciplinary concerns--financial,
operational, supervisory, investor protection, or other regulatory
concerns.\87\ As another example, Exchange Act Rule 15c3-1,\88\ the Net
Capital Rule, imposes different minimum net capital requirements based
on the types of securities business the broker-dealer conducts.
Moreover, the obligations that FINRA may impose pursuant to Rule 4111
are not ``sanctions'' for violations; rather, they are obligations that
relate directly to firm profiles that pose substantially more risk to
investors than the profiles of the vast majority of other member firms
of similar sizes.
---------------------------------------------------------------------------

    \87\ See Rule 1014(c)(2) (describing granting of applications
for new membership subject to restrictions).
    \88\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

    Some commenters opposed the proposal on the ground that it is
unnecessary. For example, Rockfleet commented that FINRA's membership
program and examinations should be sufficient to deal with firms that
have a poor supervisory structure and compliance culture. Likewise,
Network 1 wrote that FINRA's enforcement program is a practical
solution for addressing ``bad brokers.'' As explained above, however,
while FINRA has a number of tools for identifying and addressing a
range of misconduct by individuals and firms, and has strengthened
these protections for investors and the markets, persistent compliance
issues continue to arise in some member firms. Proposed Rule 4111
reflects FINRA's belief that more can be done to protect investors from
firms with a significant history of misconduct.
    Notwithstanding that FINRA has generally retained the proposal as
it was originally proposed, FINRA appreciates the concerns raised by
the commenters about the potential impacts and effectiveness of
proposed Rule 4111. If approved, FINRA plans to review proposed Rule
4111 after gaining sufficient experience under the rule, at which time
it will assess the rule's ongoing effectiveness and efficiency.
3. Concerns That the Proposal Gives FINRA Too Much Discretion, and
Requests for Increased Transparency
    Several commenters contended that, in numerous respects, the
proposal gives FINRA too much discretion.\89\ Commenters pointed to how
the proposal gives the Department discretion to decide: (1) In the
initial Department evaluation stage, which firms require further
review; (2) the maximum and actual Restricted Deposit Requirement; and
(3) the types of conditions or restrictions that may be imposed.\90\
Some commenters further requested that the proposal provide more
transparency on how FINRA would exercise its discretion. For example,
Sichenzia suggested which kinds of disclosure events FINRA should
eliminate from consideration during the initial Department evaluation,
and some commenters requested that FINRA clarify how the Department
would calculate a Restricted Deposit Requirement \91\ and what kinds of
conditions or restrictions could be imposed.\92\ Some commenters
recommended specific conditions and restrictions that FINRA should
impose.\93\
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    \89\ CAI, Cambridge, FSI, Sichenzia, Westpark.
    \90\ CAI, Cambridge, FSI, Rockfleet, Sichenzia, Westpark,
Whitehall.
    \91\ CAI, Westpark, Whitehall.
    \92\ FSI, Massachusetts, NASAA, PIRC, St. John's SOL.
    \93\ Massachusetts, MIRC, NASAA, St. John's SOL.
---------------------------------------------------------------------------

    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. FINRA notes that the annual calculation--the
first and most significant step that identifies member firms that are
subject to the proposed rule--does not involve the use of discretion.
The annual calculation uses objective, transparent criteria to identify
outlier firms with the most significant history of misconduct relative
to their peers (based on a review of the criteria as if it existed
today, the number of member firms would be between 45-80 firms).
Following the annual calculation, the Department would conduct an
evaluation to review whether it has information that a member firm's
calculation included disclosure events or conditions that should not
have been included because they are not consistent with the purpose of
the Preliminary Criteria for Identification and are not reflective of a
firm posing a high degree of risk, whether the member has already
addressed the concerns signaled by the disclosure events or conditions,
or whether the member firm has altered its business operations such
that the calculation no longer reflects the member firm's current risk
profile. During the Consultation, the Department would evaluate whether
the member firm has demonstrated that the calculation included
disclosure events that should not have been included (because they are
duplicative or not sales-practice related). When the Department
considers whether a member firm should be subject to the maximum
Restricted Deposit Requirement, it will evaluate whether the maximum
amount would impose an undue financial hardship and whether a lesser
amount, or conditions and restrictions, would satisfy the objectives of
the rule and be consistent with the protection of investors and the
public interest. The ability to request a Hearing Officer's review also
would protect against overreaching.

    To ensure that the member firms identified as Restricted Firms are
of the type motivating this proposal and incentivize Restricted Firms
to reduce the risks posed to investors, however, the Department will
need some degree of flexibility to identify, react and respond to
different sources of risk. For this reason, the revised proposal
retains the ability of the Department to make internal assessments
during the evaluation and Consultation, including ones concerning the
amount of the Restricted Deposit Requirement and the conditions and
restrictions that may be imposed, to appropriately address the concerns
indicated by the Preliminary Criteria for Identification.
    Nevertheless, FINRA agrees with commenters' request for additional
clarity regarding the conditions and restrictions that could be imposed
under the proposed rule.\94\ For this reason, the revised proposal
provides a non-exhaustive list of conditions and restrictions that
could be imposed on Restricted Firms. Moreover, the proposed rule's
descriptions of the Department's tasks and discretion are broad enough
to allow FINRA to provide further guidance as it gains experience
implementing the rule. For example, FINRA could provide additional
guidance if it learns of categories of disclosure events that could be
described as not consistent with the purpose of the Preliminary
Criteria for Identification or not reflective of a firm posing a high
degree of risk. FINRA also could provide further guidance on the kinds
of conditions and restrictions that might be warranted in different
contexts.
---------------------------------------------------------------------------

    \94\ See, e.g., FSI, NASAA, PIRC.
---------------------------------------------------------------------------

4. Comments Concerning the Preliminary Criteria for Identification
    Numerous commenters suggested alternatives to several aspects of
the Preliminary Criteria for Identification. Some suggested narrower
criteria, including, for example, requests to: (1) Exclude criminal
events in which the registered person pled nolo contendere; \95\ (2)
exclude or narrow criteria based on final regulatory actions; \96\ (3)
remove or narrow criteria based on pending events or unadjudicated
events; \97\ (4) remove or modify the criteria based on terminations or
internal reviews; \98\ (5) remove or substantially narrow the Expelled
Firm Association Metric; \99\ (6) increase the $15,000 threshold for
settlements \100\ and establish a minimum threshold for awards and
judgments; \101\ (7) decrease the lookback period; \102\ (8)
distinguish between events by recidivist and non-recidivist brokers;
\103\ (9) exclude all matters that are not sales-practice or
investment-related \104\ or that do not involve customer harm; \105\
(10) address or remove ``nuisance arbitrations . . . settled without
admission of guilt'' and ``disclosure events . . . filed by a
compensated non-attorney representative''; \106\ (11) narrow the term
``Registered Persons In-Scope'' to exclude persons who were registered
with a member firm for only one day and include only those who have
been employed with a member firm for at least 180 days; \107\ (12)
reconsider the inclusion in the criteria of settlements of arbitrations
and regulatory actions,\108\ disclosure events against persons who were
named due to their position within a chain of supervision,\109\ and
``allegation-driven'' disclosures; \110\ and (13) account for
widespread product or market collapse that could result in a high
number of new disclosure events.\111\
---------------------------------------------------------------------------

    \95\ Westpark.
    \96\ Moss & Gilmore, Westpark.
    \97\ AdvisorLaw, Cambridge, Cetera, HLBS, Joseph Stone, Luxor,
Moss & Gilmore, Westpark, Worden.
    \98\ Cambridge, Cetera, Westpark. Two of these commenters
cautioned that including termination and internal review events
could discourage firms from conducting internal reviews and filing
appropriate termination disclosures on the Uniform Registration
Forms, thereby reducing internal compliance procedures and
potentially leading to underreporting of such events. Cetera,
Westpark.
    \99\ Cambridge, Cetera, Joseph Stone, Luxor, Network 1,
Sichenzia, Westpark.
    \100\ Cambridge, Joseph Stone, Luxor.
    \101\ Cambridge.
    \102\ Westpark.
    \103\ Sichenzia.
    \104\ Cambridge.
    \105\ Westpark.
    \106\ Luxor, Moss & Gilmore, Sichenzia.
    \107\ Westpark.
    \108\ HLBS, Moss & Gilmore, Westpark.
    \109\ Cambridge, Westpark.
    \110\ Worden.
    \111\ Cambridge.
---------------------------------------------------------------------------

    Some commenters suggested broader criteria, including requests to:
(1) Lower the dollar threshold for settlements; \112\ (2) increase the
lookback period; \113\ (3) include financial disclosures like
judgments, liens, bankruptcies and compromises; \114\ (4) include non-
investment related civil matters that involve dishonesty, deceit, or
reckless or intentional wrongdoing; \115\ (5) include internal reviews
by other member firms; \116\ (6) include a category based on specific
products sold by the member firm; \117\ and (7) include expunged
Registered Person Adjudicated Events.\118\
---------------------------------------------------------------------------

    \112\ Better Markets.
    \113\ Better Markets.
    \114\ Massachusetts, NASAA.
    \115\ Massachusetts.
    \116\ Massachusetts.
    \117\ MIRC, PIABA.
    \118\ NASAA.
---------------------------------------------------------------------------

    Two commenters criticized or questioned how the metrics thresholds
were based on firm size.\119\
---------------------------------------------------------------------------

    \119\ Rockfleet, Worden.
---------------------------------------------------------------------------

    In response to the comments about the proposed criteria's
underlying categories and metrics, FINRA made two modifications to the
proposal in Regulatory Notice 19-17. First, as explained above, the
revised proposal uses a narrower definition of Registered Persons
Associated with Previously Expelled Firms. Instead of an unlimited
lookback over a registered person's entire career and no limitations
based on the duration of the person's registration with the expelled
firm as originally proposed in Regulatory Notice 19-17, the revised
proposal would include only those registered persons who were
registered with a previously expelled firm for at least one year and
within the five years prior to the date the Preliminary Criteria for
Identification are calculated. Persons' previous registrations with
expelled firms (i.e., beyond the five-year lookback) would not be
counted in this category or towards an employing member firm's Expelled
Firm Association Metric. Moreover, FINRA believes using a five-year
lookback would be consistent with the lookback periods for the other
metrics.\120\
---------------------------------------------------------------------------

    \120\ FINRA analyzed whether the revised Expelled Firm
Association Metric still preserves its usefulness, and FINRA
determined that it does, as explained in the Economic Impact
Assessment.
---------------------------------------------------------------------------

    Second, FINRA believes that the comments about the termination and
internal review events demonstrated a need for clarification of the
relevant metric. The revised proposal would make clear that termination
and internal review disclosures concerning a person that a member firm
terminated would not impact that member firm's own Registered Person
Termination and Internal Review Metric; rather, those disclosures would
only impact the metrics of member firms that subsequently register the
terminated individual.
    Otherwise, FINRA has decided to retain the rest of the Preliminary
Criteria for Identification as originally proposed in Regulatory Notice
19-17. Many of the commenters' other proposed alternative definitions
and criteria comments concern issues that FINRA already considered and
addressed in the economic assessment in Regulatory Notice 19-17, and
the comments have not persuaded FINRA that any changes would be more
efficient or effective at addressing the potential for future

customer harm presented. As FINRA explained in Regulatory Notice 19-17,
the primary benefit of the proposed rule change would be to reduce the
risk and associated costs of possible future customer harm by member
firms that meet the proposed criteria, by applying additional
restrictions on firms identified as Restricted Firms and by the
increased scrutiny that will likely result by these firms on their
brokers. In developing this proposal, one of the guiding principles was
to provide transparency regarding the proposal's application, so 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. This is why--unlike many of the alternatives suggested by
commenters--FINRA's proposal is based on events disclosed on the
Uniform Registration Forms, which are generally available to firms and
FINRA.
    Several commenters expressed concern over how the Preliminary
Criteria for Identification relies on data in the Uniform Registration
Forms.\121\ Several commenters contended that there are underlying
problems with the information disclosed through the Uniform
Registration Forms, stemming primarily from the allegation-based
disclosures that must be made and frivolous arbitrations.\122\ One
commenter pointed to the number of expungements as evidence of the
unreliability of the disclosure data.\123\ NASAA, PIABA, and some law
school clinics raised a concern from a different perspective, writing
that expungements are granted too frequently and will cause the annual
calculation of the Preliminary Criteria for Identification to not
identify all firms that pose the highest risks.\124\ Relatedly, several
commenters suggested that the proposed Preliminary Criteria for
Identification highlights problems with expungements, including that
the proposal will incentivize even more expungement requests,\125\ that
FINRA should simultaneously pursue meaningful expungement reform,\126\
or that FINRA should make it easier to expunge certain customer dispute
information because Uniform Registration Form disclosures would now
carry greater weight.\127\ Some commenters predicted that the proposal
will create perverse incentives to avoid making required disclosures on
the Uniform Registration Forms.\128\
---------------------------------------------------------------------------

    \121\ AdvisorLaw, Cambridge, Moss & Gilmore, Worden.
    \122\ AdvisorLaw, Cambridge, Moss & Gilmore, Worden.
    \123\ AdvisorLaw.
    \124\ MIRC, NASAA, PIABA, PIRC.
    \125\ MIRC, NASAA, PIABA, PIRC.
    \126\ NASAA, PIABA.
    \127\ Cambridge.
    \128\ Cetera, PIRC, St. John's SOL.
---------------------------------------------------------------------------

    FINRA believes, however, that the data reported on the Uniform
Registration Forms is reliable enough on which to base proposed Rule
4111. FINRA rules require firms and individuals to make accurate
disclosures, and they could be subject to disciplinary action and
possible disqualification if they fail to do so. Regulators are the
source of disclosures on Form U6. FINRA's Department of Credentialing,
Registration, Education and Disclosure conducts a public records review
to verify the completeness and accuracy of criminal disclosure
reporting. And although some commenters take issue with some of the
specific events that must be disclosed on the Uniform Registration
Forms, the SEC has taken the position that ``essentially all of the
information that is reportable on the Form U4 is material.'' \129\
---------------------------------------------------------------------------

    \129\ Joseph S. Amundsen, Exchange Act Release No. 69406, 2013
SEC LEXIS 1148, at *41 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C.
Cir. 2014).
---------------------------------------------------------------------------

    FINRA recognizes that the number of expungement requests may
increase as a result of this proposal. However, the existing regulatory
framework and FINRA rules are designed to ensure that expungements are
granted only after a neutral adjudicator (arbitrator or judge)
concludes that expungement is appropriate. Furthermore, OCE has tested
the proposed thresholds in several ways using the existing Central
Registration Depository (``CRD'') data, including comparing the firms
captured by the proposed thresholds to the firms that have recently
been expelled, that have unpaid arbitration awards, that Department
staff has identified as high risk for sales practice and fraud based on
the Department's own risk-based analysis, and that subsequently had
additional disclosures after identification. Moreover, FINRA is
actively engaged in efforts to address concerns with the current system
of arbitration-based expungement of customer allegations from brokers'
records.\130\ FINRA's planned review of proposed Rule 4111 would
necessarily account for any future amendments to the expungement
process and any associated impact on the underlying data in CRD.
Accordingly, FINRA does not believe that the proposal would directly
result in inappropriate expungements being granted or appropriate
expungements being not granted, or that it would undermine the quality
of the underlying CRD information used for the proposed metrics.
---------------------------------------------------------------------------

    \130\ FINRA recently filed a proposed rule change that would
amend the Codes of Arbitration Procedure for Customer and Industry
Disputes (``Codes'') to modify the current process relating to
requests to expunge customer dispute information. The proposed rule
change would amend the Codes to: (1) Impose requirements on
expungement requests filed either during an investment-related,
customer-initiated arbitration or separate from a customer-initiated
arbitration (``straight-in requests''); (2) establish a roster of
arbitrators with enhanced training and experience from which a
three-person panel would be randomly selected to decide straight-in
requests; (3) establish procedural requirements for expungement
hearings; and (4) codify and update the best practices of the Notice
to Arbitrators and Parties on Expanded Expungement Guidance that
arbitrators and parties must follow. See Securities Exchange Act
Release No. 90000 (September 25, 2020), 85 FR 62142 (October 1,
2020) (Notice of Filing of File No. SR-FINRA-2020-030); Notice to
Arbitrators and Parties on Expanded Expungement Guidance, available
at https://www.finra.org/arbitration-andmediation/notice-arbitrators-and-parties-expanded-expungement-guidance). In addition,
FINRA recently amended the Codes to apply minimum fees to requests
to expunge customer dispute information. See Securities Exchange Act
Release No. 88945 (May 26, 2020), 85 FR 33212 (June 1, 2020) (Order
Approving Filing of File No. SR-FINRA-2020-005); Regulatory Notice
20-25 (July 2020).
---------------------------------------------------------------------------

5. Annual Calculation of the Preliminary Criteria for Identification
    Massachusetts contends that calculations of the Preliminary
Criteria for Identification should occur more than annually. FINRA
appreciates this suggestion, but believes that it should gain
experience with an annual requirement before considering whether to
conduct more frequent reviews.
    SIFMA requested that the proposal provide more transparency around
the variables for the annual calculation of the Preliminary Criteria
for Identification, so that firms can have the same ability as FINRA to
calculate whether they meet the thresholds. For example, SIFMA
explained that firms will need specific information about the
Evaluation Date to make the calculations on their own.
    FINRA agrees that additional clarity should be provided regarding
the timing of the calculation. Proposed Rule 4111 is intended to be
transparent enough so that member firms can understand whether they are
at risk of being subject to additional obligations, and member firms
will need to know the exact Evaluation Date to do their own
calculations. FINRA would announce in a Regulatory Notice the first
Evaluation Date no less than 120 days before the first Evaluation Date.
FINRA also would announce that subsequent Evaluation

Dates would be on the same month and day each year, except when that
date falls on a Saturday, Sunday, or federal holiday, in which case the
Evaluation Date would be on the next business day.
    Some commenters requested that FINRA provide member firms with
assistance in determining if they meet the Preliminary Criteria for
Identification. For example, CAI requested clarification on whether
FINRA would provide advance notice to firms that meet or come close to
meeting the Preliminary Criteria for Identification. Cambridge wrote
that FINRA should notify firms in advance that they meet the criteria
and publish a list of expelled firms. SIFMA requested that FINRA
provide an electronic worksheet, available year round.
    FINRA does not currently plan to provide member firms with advance
notice about whether they would meet, or are close to meeting, the
Preliminary Criteria for Identification, because the calculation under
the proposal would occur annually, not on a rolling basis, and
calculating the events included in the Preliminary Criteria for
Identification based on an earlier date may lead to different results.
Moreover, the proposed rule is designed to be transparent enough to
allow member firms to perform their own calculations. FINRA agrees,
however, that additional guidance and resources could facilitate member
firms' independent calculations, and FINRA will explore ways to provide
helpful resources. For example, this could include mapping the
Disclosure Event and Expelled Firm Association Categories to the
relevant disclosure questions on the Uniform Registration Forms. It
also could include making available, year round, a worksheet that
member firms could populate with the number of Registered Persons In-
Scope, the number of disclosure events in each category, and the number
of Registered Persons Associated with Previously Expelled Firms to
generate information about whether the member firm meets or is close to
meeting the Preliminary Criteria for Identification.\131\ FINRA also
would consider making available to member firms a list of expelled
firms, if that information is burdensome for member firms to obtain on
their own.
---------------------------------------------------------------------------

    \131\ Such a year-round worksheet could be a tool for member
firms to monitor their status in relation to the Preliminary
Criteria for Identification, but not a determinate one. Whether a
member firm will meet the criteria could only be definitively
established on the annual Evaluation Date.
---------------------------------------------------------------------------

6. One-Time Staffing Reduction
    Several comments addressed the proposal's one-time staffing
reduction opportunity. PIRC expressed support for the one-time staffing
reduction opportunity, commenting that it will have the benefit of
lowering the number of representatives who have repeatedly harmed
investors. Joseph Stone commented that member firms should have several
opportunities to reduce staff, not just one. Westpark stated that the
one-time opportunity should renew after three years. HLBS called the
staffing reduction opportunity the proposal's ``most alarming and
punitive measure,'' because member firms would ``conduct a mass
termination not because of an independent business decision but because
. . . failing to do so . . . would essentially result in financial
ruin.''
    FINRA has retained the one-time staffing reduction opportunity as
originally proposed. The one-time staffing reduction opportunity is
intended to provide another procedural protection for member firms,
because it would give a firm that meets the Preliminary Criteria for
Identification one opportunity to reduce staff so as to fall below the
criteria's thresholds. It has been designed as only a single
opportunity to deter member firms from resurrecting a high-risk
business model after a staff reduction. Moreover, FINRA does not agree
with HLBS's assertion that the proposed staffing reduction opportunity
removes member firms' independence to make business decisions. FINRA
believes that a member firm that meets the Preliminary Criteria for
Identification, possibly inadvertently, in one year should have the
choice of whether to exercise the staffing reduction option.
Furthermore, a firm that chooses to exercise the staffing reduction
option would have the independence to decide how to proceed going
forward, with the knowledge that it has once met the Preliminary
Criteria for Identification, that the preliminary criteria are fully
transparent, and that it would not have another opportunity to reduce
staff to avoid a review under Rule 4111.
    Better Markets stated that the staffing reduction opportunity needs
to better protect investors, by prohibiting other high-risk firms from
hiring terminated persons, prohibiting any firms from hiring the
terminated persons for one year, or requiring that staff reductions
commence with brokers with the highest number of disclosure events or
with frequent and severe violations. FINRA is already pursuing,
however, a separate proposal that would require a member firm to
request a materiality consultation with FINRA staff when a person who
has one final criminal matter or two ``specified risk events'' seeks to
become an owner, control person, principal or registered person of the
member.\132\ That related proposal would potentially impact persons
terminated pursuant to the staffing reduction opportunity.
---------------------------------------------------------------------------

    \132\ See Securities Exchange Act Release No. 88600 (April 8,
2020), 85 FR 20745 (April 14, 2020) (Notice of Filing of File No.
SR-FINRA-2020-011).
---------------------------------------------------------------------------

7. Consultation
    Westpark commented that proposed Rule 4111 does not give firms
enough time to prepare for the Consultation. Because the proposed rule
sets tight deadlines for the Department's decision, FINRA agrees that
the proposed deadlines for the Consultation would also be tight. For
this reason, FINRA has revised proposed Rule 4111(d)(2) to require that
the letter scheduling the Consultation provide at least seven days'
notice of the Consultation date, and also give the member firm the
opportunity to request a postponement of the Consultation for good
cause shown. Postponements would not exceed 30 days unless the member
firm establishes the reasons a longer postponement is necessary.
    Other comments about the Consultation did not prompt FINRA to make
revisions. For example, FSI commented that the Consultation should be
an opportunity for FINRA to work collaboratively with the identified
firm. FINRA believes the Consultation is already intended to give
member firms an opportunity to meet with FINRA and demonstrate why the
calculation of the Preliminary Criteria for Identification should not
include certain events or provide a rationale as to why the firm should
not be required to maintain the maximum Restricted Deposit Requirement.
As such, FINRA does not believe further revisions are necessary.
    Chiu and Luxor wrote that although proposed Rule 4111 would allow
members during the Consultation to request a waiver of the maximum
Restricted Deposit Requirement for financial hardship reasons, member
firms will not do so because it would deter recruitment and cause
brokers to leave. Allowing member firms to demonstrate undue financial
hardship, however, is consistent with the intent of the Restricted
Deposit Requirement that it not significantly undermine the member
firm's continued financial stability and operational capability as an
ongoing enterprise over the next 12 months. Moreover, FINRA anticipates

that member firms subject to the requirement will not be deterred from
asserting that a Restricted Deposit Requirement would cause an undue
financial hardship, given that such arguments could lead to a reduced
Restricted Deposit Requirement or no deposit requirement at all.
Moreover, the proposal would not make public any such assertions by a
member firm.
    In a comment related to the Consultation, FSI commented that firms
should not shoulder the risk of misidentification, and that FINRA
should have to demonstrate its reasons for continuing the review
process for firms preliminarily identified as high risk. Proposed Rule
4111 only places burdens of proof on the small number of firms that
meet the Preliminary Criteria for Identification and that the
Department determines, after conducting its initial evaluation,
warrants further review. Each of these firms would have the opportunity
to overcome the presumption that it should be designated as a
Restricted Firm and subject to the maximum Restricted Deposit
Requirement. Under the proposed rule, the affected firms would initiate
this process because they would be in the best position to provide the
relevant information. For example, proposed Rule 4111(d)(1)(A) would
provide that a member firm may overcome the presumption that it should
be designated as a Restricted Firm by clearly demonstrating that the
Department's calculation included events that should not have been
included because, for example, they are duplicative, involving the same
customer and the same matter, or are not sales practice related. The
member firm, not Department staff, is in the best position to provide
that kind of information about the disclosure data. Likewise, the
member firm would be in the best position to demonstrate, pursuant to
proposed Rule 4111(d)(1)(B), that it would face undue financial
hardship if it were required to maintain the maximum Restricted Deposit
Requirement.
8. Restricted Deposit Requirement
    FINRA also received general comments concerning the proposed
Restricted Deposit Requirement concept. Some commenters were generally
opposed to the proposed requirement. Their reasons include: (1) A
deposit requirement may trigger unintended consequences which result in
harm to the investing public; \133\ (2) a deposit requirement may lead
to competitive disadvantages, because members without significant
retained earnings may receive exceptions, while members with greater
working capital would not; \134\ (3) the only members likely to be able
to satisfy a deposit requirement would be ones that do not anticipate
being subject to the rule; \135\ (4) a deposit requirement would
``result[ ] in cash flow problems, increased borrowing, and layoffs''
\136\ and a ``devastating economic impact'' on the broker-dealer and
its employees, customers, vendors, and counterparties; \137\ (5)
restricted funds could be better used for other purposes; \138\ (6)
there is little evidence why restricted deposits are necessary; \139\
(7) requiring ``up front financing of uninsured claims, many of which
are specious, would have negative net capital implications''; \140\ (8)
any assertion that unpaid arbitration awards is rampant and justifies
the deposit requirement is false; \141\ (9) a deposit requirement would
put small firms out of business and result in less choice for
investors; \142\ and (10) many members do not have sufficient cash to
hold as restricted deposits.\143\
---------------------------------------------------------------------------

    \133\ Cambridge.
    \134\ Cambridge.
    \135\ Cambridge.
    \136\ Westpark.
    \137\ Rockfleet.
    \138\ Chiu.
    \139\ Brooklight.
    \140\ Moss & Gilmore.
    \141\ Moss & Gilmore.
    \142\ Chiu, IBN, Whitehall. Whitehall also wrote that the
proposal entails ``FINRA . . . demanding funds for itself'' and
``using [members] as bank accounts to expand'' FINRA's activities.
Nothing in the proposal, however, results in FINRA receiving any
assets from firms. At all times, a Restricted Firm would continue to
own the assets that it maintains in a Restricted Deposit Account.
    \143\ Whitehall.
---------------------------------------------------------------------------

    Other commenters were generally supportive of the Restricted
Deposit Requirement concept. PIRC said that Restricted Deposit
Requirements should help deter misconduct and also help FINRA ``rein in
Restricted Firms that shut down and reconstitute themselves in an
attempt to avoid paying settlements and awards.'' SIFMA opined that the
proposal ``appropriately embraces the `front-end' approach'' to
addressing unpaid awards by ``seeking to identify those small number of
firms with an extensive history of misconduct and/or relevant
disclosure events, and as appropriate, requiring [them] to set aside
cash deposits or qualified securities that could be applied to . . .
unpaid awards.''
    FINRA's proposal continues to provide that the Department could
impose a Restricted Deposit Requirement on Restricted Firms. FINRA
believes that a financial requirement is the measure most likely to
motivate Restricted Firms to change behavior. As such, the Restricted
Deposit Requirement is an essential feature of the proposal to protect
investors, with the possible secondary benefit of helping to address
the issue of unpaid arbitration awards. Moreover, the proposal attempts
to counteract firms' preemptively withdrawing capital by instructing
the Department to consider several financial factors--not just net
capital--when determining a Restricted Deposit Requirement. In
addition, FINRA believes the implications of a Restricted Deposit
Requirement on a member firm's net capital levels--that a member firm
would have to deduct deposits in Restricted Deposit Accounts in
determining the firm's net capital \144\--is one reason why the
proposal would incentivize member firms to avoid becoming Restricted
Firms, not a reason to abandon the Restricted Deposit Requirement
concept. Finally, the proposal contemplates that the Restricted Deposit
Requirement should correlate to the financial realities at the member
firm, and allows the firm to attempt to demonstrate that it would
impose undue financial burdens.\145\
---------------------------------------------------------------------------

    \144\ See proposed Rule 4111.01.
    \145\ Westpark commented that proposed Rule 4111 is inconsistent
with Section 15A(b)(5) of the Exchange Act, which requires that
FINRA's rules ``provide for the equitable allocation of reasonable
dues, fees, and other charges among members.'' The proposed
Restricted Deposit Requirement, however, is not a due, fee or
charge. Assets that a member maintains in a Restricted Deposit
Account would remain the member's assets; they would not be provided
to, used by, or owned by FINRA.
---------------------------------------------------------------------------

9. Calculating a Restricted Deposit Requirement
    FINRA received several comments about the Department's
determination of a Restricted Deposit Requirement. CAI expressed
support for some of the proposed factors that the Department would
consider when calculating the Restricted Deposit Requirement. In
addition, CAI endorsed the proposed limitation in proposed Rule
4111(i)(15) that the maximum Restricted Deposit Requirement be an
amount that would not significantly undermine the continued financial
stability and operational capability of the firm as an ongoing
enterprise over the next 12 months.
    Several commenters expressed concerns about the proposed factors
that the Department would consider when calculating the Restricted
Deposit Requirement. For example, Sichenzia called the factors
``arbitrary''; some commenters opposed the inclusion of, or requested
modifications to, the

``Covered Pending Arbitration Claims'' factor; \146\ Network 1
commented that the Restricted Deposit Requirement should not consider
``bona fide nuisance claims brought in arbitration''; Cambridge
objected to the ``gross revenues'' factor, on the grounds that that
factor would not contemplate the firm's contractual obligations for
which the revenues have already been allocated; and Moss & Gilmore
objected to considering ``concerns raised during FINRA exams'' on the
grounds that ``novice examiners . . . [often] conduct the front-line
examinations.'' \147\
---------------------------------------------------------------------------

    \146\ Moss & Gilmore, Network 1, Sichenzia, Westpark.
    \147\ Moss & Gilmore.
---------------------------------------------------------------------------

    Some commenters believed that the list of factors should be
expanded. For example, two commenters requested that FINRA account for
instances in which the firm has insurance coverage for arbitration
claims.\148\ MIRC commented that the Covered Pending Arbitration Claims
factor should be expanded to include other kinds of pending claims that
could lead to unpaid awards, not just ones limited to the arbitration
setting. PIABA requested that the Restricted Deposit Requirement
calculation also take into account the nature and extent of harm that
the Restricted Firm has done in the past.
---------------------------------------------------------------------------

    \148\ Network 1, Sichenzia.
---------------------------------------------------------------------------

    As explained above, FINRA has made several revisions to the factors
that the Department would consider when determining a maximum
Restricted Deposit Requirement. The ``annual revenues'' and ``net
capital requirements'' factors proposed in Regulatory Notice 19-17 have
been modified to ``revenues'' and ``net capital,'' and ``assets,''
``expenses,'' and ``liabilities'' have been added as factors. In
addition, FINRA has clarified that unpaid arbitration awards against a
member firm's Associated Persons is one relevant factor. FINRA believes
this modified and expanded list of factors would lead to a more
complete consideration of the firm's financial situation.
    FINRA has retained the other proposed factors, however, because
they appropriately and accurately describe the factors, financial and
otherwise, that would be most relevant to the Department when
calculating a Restricted Deposit Requirement. This includes the Covered
Pending Arbitration Claims factor. Because one purpose of the
Restricted Deposit Requirement is to preserve some of a Restricted
Firm's assets for potential payment of arbitration awards, FINRA
believes that purpose is served by allowing the Department to consider
Covered Pending Arbitration Claims when determining a Restricted
Deposit Requirement. At the same time, the revised proposed rule also
adds as a factor the member's ``insurance coverage for customer
arbitration awards or settlements.'' FINRA believes that if Restricted
Firms were able to procure errors and omissions insurance policies or
other kinds of insurance coverage for some or all of the kinds of
claims that customers typically bring in arbitrations, at meaningful
coverage amounts, that could warrant a reduced Restricted Deposit
Requirement and would be behavior to encourage.
    Two commenters contended that because potential liabilities
relating to pending arbitrations must be accrued on financial
statements, a Restricted Deposit Requirement that is based in part on
Covered Pending Arbitration Claims (which would be a non-allowable
asset) would ``double[ ] the net capital impact.'' \149\ While there
would not usually be a double impact--accruals of contingent
liabilities based on pending arbitrations usually reflect only a small
percentage of the potential liability--a member firm's net capital
level could be impacted by a Restricted Deposit Requirement based in
part on Covered Pending Arbitration Claims and a member firm's accruals
of potential liabilities stemming from the same pending arbitration
claims. For this reason, the Department's consideration of Covered
Pending Arbitration Claims could take into account whether any
liability accruals for those same claims warrant a reduction in the
Restricted Deposit Requirement. It should be noted, however, that the
purposes of accruing a liability on a financial statement are different
from the purposes of the proposed Rule 4111 requirement to deposit
money in a Restricted Firm's segregated, restricted account.
---------------------------------------------------------------------------

    \149\ Network 1, Rockfleet.
---------------------------------------------------------------------------

    In addition to comments about the specific factors that the
Department would consider, some commenters requested that the proposal
describe with more specificity how the Restricted Deposit Requirement
would be calculated or establish caps. CAI, for example, requested that
FINRA develop specific limitations such as caps and a formula that
focuses on the correlation between revenues that may give rise to
unpaid arbitration awards (e.g., penny stock sales) and unpaid
arbitration award amounts. FSI suggested that FINRA use published
guidelines to provide transparency. Westpark suggested that the
proposal should cap the Restricted Deposit Requirement at a specified
percentage of required net capital amounts or a percentage of average
net income over a three-year lookback period. Whitehall asked whether
FINRA would have a formula for calculating the Restricted Deposit
Requirement. MIRC suggested that FINRA should impose Restricted Deposit
Requirements that are sufficient to meet all unpaid awards and pending
claims related to products and product types.
    FINRA has not proposed a uniform formulaic approach for calculating
the Restricted Deposit Requirement because of the range of relevant
factors and differences in member firms' business models, operations,
and financial conditions. In addition, although formulas do provide
objective, transparent methodologies, here they would allow member
firms the opportunity to manipulate their revenue numbers during the
calculation periods. For these reasons, FINRA has retained the factor-
based, principles-based approach to determining a Restricted Deposit
Amount.
10. Impact on Unpaid Arbitration Awards
    PIABA contended that the proposal will not solve the issue of
unpaid arbitration awards, because there is no indication that the
Restricted Deposit Requirements will be sufficient to cover anticipated
arbitration awards. Relatedly, several commenters requested that the
proposal also provide more clarity on how the Restricted Deposit
Requirement could be used to pay investor claims.\150\
---------------------------------------------------------------------------

    \150\ MIRC, PIABA, PIRC.

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

    With respect to the relationship between proposed Rule 4111 and
unpaid arbitration awards, FINRA notes that FINRA 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.\151\ As to proposed
Rule 4111, it was designed to address a broader range of investor
protection concerns posed by firms and individuals with a significant
history of misconduct, including but not limited to unpaid arbitration
awards. The Rule would apply to firms who, 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.
---------------------------------------------------------------------------

    \151\ See FINRA Rule 9554. Under FINRA rules, unless a
respondent has specified defenses to non-payment, the respondent
must pay a monetary award within 30 days of receipt. See FINRA Rule
12904(j). In addition, firms with unpaid awards cannot re-register
with FINRA and individuals cannot register as representatives of any
member firm, without paying or discharging the outstanding award.
---------------------------------------------------------------------------

    Nevertheless, FINRA believes proposed Rule 4111 may have important
ancillary effects in addressing unpaid customer arbitration awards. In
particular, the Rule may deter behavior that could otherwise result in
unpaid arbitration awards, by incentivizing firms to reduce their risk
profile and violative conduct in order to avoid being deemed a
Restricted Firm and becoming subject to the Restricted Deposit
Requirement (or other conditions or restrictions). In addition, firms
may be incentivized to obtain insurance coverage for potential
arbitration awards, because such coverage would be taken into account
in determining any Restricted Deposit Requirement. Moreover, and as
explained above, the proposed rule includes several presumptions,
applicable to the Department's assessment of an application by a firm
previously designated as a Restricted Firm for a withdrawal from a
Restricted Deposit, that would further incentivize the payment of
arbitration awards.
    FINRA has made several revisions to proposed Rule 4111(f) to make
more clear the process that would guide the Department's evaluation of
a request for a withdrawal from a Restricted Deposit Account. As
explained above, these include several presumptions of approval or
denial that set forth how Covered Pending Arbitration Claims or unpaid
arbitration awards would impact the Department's evaluation. The
presumptions of denial that would apply when a Restricted Firm or
previously designated Restricted Firm applies for a withdrawal from a
Restricted Deposit would still apply when the firm seeks to use the
funds to satisfy unpaid arbitration awards; unless the presumption of
denial can be overcome, those firms would generally need to satisfy
unpaid arbitration awards using funds other than those in a Restricted
Deposit Account.\152\ There would be a separate presumption that a
request by a former member firm previously designated as a Restricted
Firm to access its Restricted Deposit would be approved when it 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.
---------------------------------------------------------------------------

    \152\ See proposed Rule 4111(f)(1) and (f)(3)(B)(ii)(a).
---------------------------------------------------------------------------

    PIABA also raised the concern that thinly capitalized firms would
have smaller Restricted Deposit Requirements. A member's thin
capitalization at the time of the Consultation, however, would be only
one factor of many that the Department would consider when determining
a Restricted Deposit Requirement, and would not necessarily result in a
lower requirement.
11. Custodians of the Restricted Deposit Account
    Some commenters expressed concern about how proposed Rule 4111
would require the Restricted Deposit Account to be maintained with a
bank or clearing firm. Rockfleet predicted that it will be unlikely
that banks or clearing firms will create new policies and procedures
for the small amount of Restricted Deposit Accounts that would result
from the proposal. SIFMA commented that a number of clearing firms
believe it would be problematic to custody a Restricted Deposit Account
``given the clearing firm's unique role in the relationship between an
introducing broker and its clients,'' and how the proposed rule would
impose additional duties and responsibilities that are not now part of
clearing firms' systems and procedures. SIFMA also stated that custody
by a clearing firm of the Restricted Deposit Requirement likely would
not provide FINRA with the level of transparency that FINRA would want.
    The revised proposal retains the option for Restricted Firms to
establish Restricted Deposit Accounts with clearing firms. FINRA
believes that member firms have an existing relationship with their
clearing firms and should be permitted to establish the Restricted
Deposit Account with them if the parties choose. Nothing in the
proposal requires clearing firms to establish Restricted Deposit
Accounts. Where a clearing firm is unwilling or unable to establish
these accounts, the proposal would permit Restricted Firms to establish
such accounts at banks.
    SIFMA also commented that the proposal should be revised to
expressly allow trust companies to maintain the accounts. FINRA
believes that the original proposal includes many trust companies and
so gives members sufficient options and flexibility.
12. Comments Concerning Proposed Expedited Proceedings
    As originally proposed in Regulatory Notice 19-17, proposed Rule
9561(a) would have provided that any of the Rule 4111 Requirements
imposed in a notice issued under proposed Rule 9561(a) would be
immediately effective; that, in general, a request for a hearing would
not stay those requirements; and that, if a member firm requests a
hearing of a Department determination that imposes a Restricted Deposit
Requirement for the first time, the member firm would be required to
deposit, while the expedited proceeding was pending, the lesser of
either 50% of its Restricted Deposit Requirement or 25% of its average
excess net capital during the prior calendar year. Westpark commented
that the expedited proceedings would not be meaningful because
obligations would not be stayed. Luxor commented that the requirement
to deposit a percentage of the Restricted Deposit Requirement would be
``devastating.''

    In general, FINRA has retained the no-stay provisions as originally
proposed. FINRA believes that the proposed no-stay provisions are a
fundamental part of how the proposed rules would protect investors.
Requiring Restricted Firms to comply with obligations imposed during
the short pendency of an expedited proceeding would afford more
immediate protections to investors from firms that pose outlier-level
risks. Moreover, requiring immediate compliance with the Department's
decision would be similar to other situations in which firms and
individuals posing substantial risks must abide by FINRA decisions
before underlying proceedings are resolved, such as when disciplinary
respondents must abide by temporary cease and desist orders before an
underlying disciplinary proceeding is complete or comply with FINRA-
imposed bars while an SEC appeal is pending. Nonetheless, FINRA
believes that one aspect of the proposed no-stay provisions could be
less burdensome without compromising its intended purpose. Accordingly,
FINRA has revised the proposed rules to lower the proposed partial-
deposit requirement to the lesser of 25% of the Restricted Deposit
Requirement or 25% of the firm's average excess net capital during the
prior calendar year.
    Cetera commented that the hearings should be conducted by a Hearing
Panel that includes two industry members and one Hearing Officer,
because Hearing Officers are viewed as ``not as objective.'' FINRA has
retained, however, the proposal to have Hearing Officers preside over
the new expedited proceedings. Hearing Officers preside over several
kinds of proceedings.\153\ And here, FINRA believes the need for swift
proceedings as a result of the proposed no-stay provisions and to
protect investors works in favor of the efficiency of Hearing Officer-
only proceedings. Moreover, FINRA believes there are additional
protections for the firms in the proposal, given that the Hearing
Officer's authority will be circumscribed and that the NAC's Review
Subcommittee will have the right to call the proceeding for review.
---------------------------------------------------------------------------

    \153\ See FINRA Rule 9559(d) (providing that Hearing Officers
preside over, and act as the sole adjudicator for, proceedings
initiated under Rules 9553 (failures to pay FINRA dues, fees and
other charges), 9554 (failures to comply with arbitration awards or
related settlements or orders of restitution or settlements
providing for restitution), and 9556(h) (subsequent proceedings for
failures to comply with temporary or permanent cease and desist
orders)).
---------------------------------------------------------------------------

    Cetera commented that the proposed rule would require hearings to
be held in expedited proceedings in an unreasonably short time after
the firm receives notice of its Restricted Firm status. FINRA believes,
however, that the proposed rule offers reasonable time limits and an
opportunity to seek extensions. Under proposed Rules 9561(a)(5) and
9559(f)(5), a member would be required to request a hearing within
seven days after service of a notice of a determination that a firm is
a Restricted Firm, and a hearing would be required to be held within 30
days after the member files that hearing request. In addition, under an
existing provision in Rule 9559, the Hearing Officer could extend the
time limits for holding the hearing for good cause shown or with the
consent of all the parties.
    PIABA commented that under proposed Rule 9561(b), which would
establish an expedited proceeding to address a member firm's failure to
comply with any requirements imposed pursuant to proposed Rule 4111,
FINRA should be required to immediately suspend a non-compliant firm
and should not have the discretion not to act. Although FINRA expects
that non-compliant Restricted Firms would be a high priority for the
Department of Enforcement, the revised proposal retains FINRA's
prosecutorial discretion to ensure that FINRA can use its best
judgments about how to deploy its limited resources.
    Rockfleet commented that the proposed Rule 9561(b) expedited
proceeding is counterintuitive, because canceling a Restricted Firm's
membership would result in FINRA losing any control over the firm.
FINRA respectfully disagrees and believes that proposed Rule 4111 must
provide a tool for FINRA to compel the immediate compliance with
obligations that have been imposed pursuant to the rule.
12. Procedural Protections
    Several commenters contended that the proposal is an attempt to
impose the equivalent of sanctions while avoiding the fair-process
requirements that would be present in a disciplinary proceeding, and to
ban persons who are not statutorily disqualified.\154\ The proposed
Rule 4111 process, however, is neither a disciplinary nor an
eligibility proceeding, and the obligations that could be imposed
pursuant to proposed Rule 4111 would not be sanctions imposed for
violations. Furthermore, FINRA believes the proposal gives affected
member firms substantial procedural protections. These include
providing notice that a member has met the Preliminary Criteria for
Identification and of the maximum Restricted Deposit Requirement; a
one-time staffing reduction opportunity for firms that meet the
Preliminary Criteria for Identification for the first time; a
Consultation, which will allow affected firms to attempt to show why
they should not be deemed Restricted Firms or be subject to the maximum
Restricted Deposit Requirement; and the right to seek an expedited
hearing before a Hearing Officer.\155\ These procedural protections are
in addition to the Preliminary Criteria for Identification, which would
be fully transparent and enable firms to monitor whether they are at
risk of meeting the threshold criteria.
---------------------------------------------------------------------------

    \154\ Brooklight, Luxor, Network 1, Rockfleet, Westpark.
    \155\ The right to have a Hearing Officer's decision reviewed by
the SEC would be governed by Section 19 of the Exchange Act.
---------------------------------------------------------------------------

    Moreover, the proposal is neither intended nor designed to expel
member firms and persons that are not statutorily disqualified. In this
regard, FINRA notes that the rule text contains express language that
the Department determine a maximum Restricted Deposit Requirement that
``would not significantly undermine the continued financial stability
and operational capability of the firm as an ongoing enterprise over
the next 12 months,'' and also contemplates situations in which
Restricted Firms remain member firms for years. Furthermore, persons
terminated pursuant to the Rule 4111 staffing reduction opportunity
would be permitted to seek employment with any other member firm and
allowed to apply to re-associate with the Restricted Firm after one
year.\156\
---------------------------------------------------------------------------

    \156\ Some commenters (Network 1, Westpark) asserted that the
proposed rule change would be unconstitutional, for a variety of
reasons. FINRA, however, is not a state actor.
---------------------------------------------------------------------------

13. Unintended Consequences
    Rockfleet expressed concern that clearing firms will terminate
clearing agreements for firms deemed to be Restricted Firms, and that
firms using tri-party clearing agreements could be impacted through no
fault of their own. CAI raised a concern that being deemed as a
Restricted Firm could have ramifications for firms that are parties to
selling agreements. FINRA appreciates that proposed Rule 4111 may have
potential unintended consequences, and plans to examine issues like
those when FINRA reviews proposed Rule 4111 after gaining sufficient
experience under the rule.
14. Public Disclosure Issues
    Several commenters addressed whether there should be public
disclosure of a firm's status as a

Restricted Firm. Some opposed any disclosure at all, warning that
disclosure could adversely impact the affected firms, and would make it
more likely the firm would fail.\157\ Several commenters, particularly
regulators and public advocacy groups, argue that FINRA should disclose
the names of Restricted Firms to the public or, at least, to other
regulators or clearing firms.\158\
---------------------------------------------------------------------------

    \157\ Cetera, FSI.
    \158\ Better Markets, Massachusetts, NASAA, SIFMA, St. John's
SOL.
---------------------------------------------------------------------------

    FINRA believes the aim of the proposal is to address the risks
posed by Restricted Firms by imposing appropriate restrictions on them
and, at the same time, providing them with opportunities and incentives
to remedy the underlying concerns (e.g., the one-time staff reduction,
the opportunity to roll off the Restricted Firms list). Because
requiring FINRA to publicly disclose a firm's Restricted Firm status
may potentially interfere with those purposes, FINRA is not proposing
to require the public disclosure of a firm's status as a Restricted
Firm at this time. FINRA believes that it is necessary to gain
meaningful experience with the proposed rule to evaluate the impact of
creating an affirmative disclosure program.\159\
---------------------------------------------------------------------------

    \159\ It should be noted that information about a firm's status
as a Restricted Firm, and any restricted deposit it must maintain,
could become publicly available through existing sources or
processes. Such disclosures could occur, for example, 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.
---------------------------------------------------------------------------

15. Economic Impact Assessment
    Rockfleet commented that the proposal appears to be reverse
engineered to target firms that FINRA has already chosen. As discussed
above, the proposed Preliminary Criteria for Identification are based
on metrics that are replicable and transparent to FINRA and the
affected member firms, and are intended to identify firms that pose far
greater risks to their customers than other firms. One identifier of
these types of firms is that they and their brokers generally have
substantially more Registered Person and Member Firm Events compared to
their peers. This is consistent with a growing academic literature that
provides evidence on past disciplinary and other regulatory events
associated with a firm or individual being predictive of similar future
events.\160\ These patterns indicate a persistent, albeit 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 by
their brokers. Accordingly, the proposed rule is intended to strengthen
FINRA's toolkit to respond to these firms and brokers with a
significant history of misconduct based on a proposed criteria that
relies on regulatory and other disclosure events, similar to those used
in the literature.
---------------------------------------------------------------------------

    \160\ See supra note 5.
---------------------------------------------------------------------------

    FINRA also conducted several validations on the firms meeting the
criteria, by reviewing the extent to which firms identified were
subsequently expelled, associated with unpaid awards, or were
associated with ``new'' Registered Person and Member Firm Events. For
example, these validations showed that the identified firms had on
average approximately 6.1-19.9 times more new disclosure events after
their identification than other firms in the industry during the same
period that would not have met the Preliminary Criteria for
Identification. This suggests that the proposed criteria is effective
in identifying firms that may be associated with additional events
after identification, which is consistent with the literature's finding
on regulatory events being predictive of similar future events.
    Better Markets commented that the Economic Impact Assessment did
not quantify the harm to investors when firms with a significant
history of misconduct are permitted to continue engaging with
investors. The proposed rule is intended to place additional
restrictions on identified firms and increase scrutiny by these firms
on their brokers. As a result, FINRA anticipates that the proposed rule
will reduce the risk and associated costs of possible future customer
harm and lead to improvements in the compliance culture, relative to
the economic baseline of the current regulatory framework. The proposed
rule is intended to create incentives for firms and brokers to limit or
end practices that result in customer harm and provide increasing
restrictions on those that choose not to alter their activities.
Nonetheless, it is difficult to predict or quantify, before the
proposed rule is implemented, the extent to which firms may continue to
engage in harmful activities despite any additional restrictions
imposed. However, FINRA plans to review the proposed rule after gaining
sufficient experience with it, at which time FINRA will assess the
rule's ongoing effectiveness and efficiency.
    Westpark wrote that FINRA should analyze how many brokers who are
currently licensed and in good standing would become ``unemployable''
if the proposed rule were approved. FINRA's Economic Impact Assessment
of the proposed rule includes the economic impacts on firms hiring and
registered persons seeking employment. For example, as discussed above,
FINRA estimates that during the 2013-2019 review period only one to two
percent of the registered persons had any qualifying events in their
regulatory records. Accordingly, 98%-99% of the registered persons
(with no qualifying events) should have no adverse economic impacts
associated with their employment opportunities. Further, the vast
majority of member firms, approximately 98%, would likely be able to
employ most of the individuals seeking employment in the industry--
including ones who have some disclosures--without coming close to
meeting the Preliminary Criteria for Identification. Accordingly, FINRA
believes that these anticipated economic impacts would likely be
limited to a small proportion of registered persons and member firms,
particularly in cases where registered persons with disclosures are
seeking employment at firms at or near the Preliminary Criteria for
Identification.
    Westpark commented that FINRA should back-test the impact of the
proposed rule to cover a period that was not a bull market. The
economic impact assessment evaluated the proposed criteria over the
2013-2019 period. Because of the criteria's 5-year lookback period for
adjudicated events, the evaluation included events that reached a
resolution between 2009 and 2019, which includes the period of the
global financial crisis.
16. Suggested Alternatives or Additional Measures
    Several comments suggested alternatives to proposed Rule 4111. For
example, several commenters suggested that FINRA improve how it uses
its existing rules and programs. For example, Network 1 commented that
FINRA's enforcement program is already a practical solution for
addressing ``bad brokers.'' Brooklight suggested that FINRA try to
solve for any gaps in its enforcement authority and processes that
prevent FINRA from dealing with the ``few bad actors'' motivating the
proposal. ASA wrote that FINRA should pursue the expulsion of firms
that do not carry out their supervisory obligations and act in ways
that harm customers, and impose immediate lifetime bans on those who
engage in certain egregious acts, such as theft of customer funds. ASA
further commented that FINRA ``has an obligation to penalize and, if
necessary, revoke the licenses of bad actors,'' and

that ``[i]f FINRA believes it lacks the authority or the tools
necessary to stop the most egregious abuses, . . . then it should work
with the . . . SEC, Congress and the industry to correct the problem.''
Joseph Stone commented that FINRA should continue focusing on firms'
supervisory systems.
    As explained above, FINRA has a number of current programs through
which it strives to prevent and deter misconduct by member firms and
the individuals they hire. These tools have been effective in
identifying and addressing a range of misconduct by individuals and
firms, and FINRA has continued to strengthen them. Despite FINRA's
efforts, however, persistent compliance issues continue to arise in
some member firms, as explained above. Thus, while FINRA continues to
explore whether additional enhancements to existing programs, including
relevant statutory or regulatory changes,\161\ would help FINRA target
firms or individuals that engage in serious misconduct with greater
speed and effectiveness, FINRA believes there remains a strong need to
equip FINRA with authority to address more proactively the current
risks posed by the limited population of firms with a significant
history of misconduct.
---------------------------------------------------------------------------

    \161\ The Exchange Act includes fair procedure requirements for
various SRO actions, including the disciplining of members and
persons associated with members, and sets out the types of
misconduct that presumptively exclude brokers from engaging in the
securities business (identified as statutory disqualifications or
``SDs''). The Exchange Act and SEC rules thereunder also establish a
framework within which FINRA evaluates whether to allow individuals
who are the subject of a statutory disqualification. In addition,
FINRA's review of many SD applications is governed by the standards
set forth in Paul Edward Van Dusen, 47 SEC. 668 (1981), and Arthur
H. Ross, 50 SEC. 1082 (1992). These standards provide that, in
situations where an individual's misconduct has already been
addressed by the SEC or FINRA, and certain sanctions have been
imposed for such misconduct, FINRA should not consider the
individual's misconduct when it evaluates an SD application.
---------------------------------------------------------------------------

    Some commenters proposed that, instead of a Restricted Deposit
Requirement, FINRA should impose insurance or performance bond
requirements,\162\ create a national investor recovery pool funded from
fines that FINRA receives \163\ or a restitution fund,\164\ or impose
additional capital requirements on identified firms.\165\ FINRA
believes these alternatives present challenges and is continuing to
propose a Restricted Firm Obligations Rule that would authorize the
imposition of Restricted Deposit Requirements.
---------------------------------------------------------------------------

    \162\ Brooklight, Cetera, Rockfleet.
    \163\ PIRC.
    \164\ Sichenzia.
    \165\ ASA.
---------------------------------------------------------------------------

    Some commenters proposed other alternatives for FINRA's
consideration. Chiu wrote that FINRA should instead focus attention on
investor education and encouraged the creation of more tools like the
Senior Helpline. Colorado FSC recommended that FINRA assign
``disciplinary training and behavior restructuring'' to address
disclosure related issues. FINRA does not believe, however, that the
suggested alternatives would be as effective as the proposed Restricted
Firm Obligations Rule at addressing firms with a significant history of
misconduct and encouraging such firms to modify their behavior and risk
profile.
    Several commenters proposed steps that FINRA should take in
addition to the proposal. These included: (1) Requiring firms to
provide BrokerCheck reports to customers; \166\ (2) expelling firms
that are Restricted Firms for two consecutive years; \167\ (3) ``de-
licensing'' all current brokers who worked at such firms when they were
initially designated as Restricted Firms; \168\ (4) disclosing more
information on BrokerCheck, such as the percentage of brokers at a firm
with disclosures and the average number of brokers' and firm's
disclosures,\169\ or which brokers have a demonstrable pattern of
violating the law; \170\ and (5) explaining to investors the methods
that ``recidivist'' firms employ.\171\ Several commenters also
suggested that FINRA give more consideration to proposing a rule like
Investment Industry Regulatory Organization of Canada (IIROC)
Consolidated Rule 9208, which is a terms and conditions rule.\172\
---------------------------------------------------------------------------

    \166\ PIRC.
    \167\ Better Markets.
    \168\ Better Markets.
    \169\ St. John's SOL.
    \170\ Better Markets.
    \171\ Better Markets.
    \172\ Better Markets, Brooklight, Cambridge, Cetera, Luxor,
Massachusetts, MIRC, PIRC.
---------------------------------------------------------------------------

    FINRA appreciates receiving suggestions on additional steps it
might take to address firms with a significant history of misconduct,
and FINRA will continue to explore ways to address firms with a
significant history of misconduct. As FINRA explained in Regulatory
Notice 19-17, this includes continuing to consider whether to propose a
terms and conditions rule. FINRA notes, however, that some of Better
Markets' suggestions essentially request that FINRA broaden the
statutory definition of disqualified persons, which is not within
FINRA's jurisdiction to do.\173\
---------------------------------------------------------------------------

    \173\ See 15 U.S.C. 78c(a)(39) (defining ``statutory
disqualification'').
---------------------------------------------------------------------------

17. Miscellaneous Comments Outside the Scope of the Proposal
    Some commenters raised concerns regarding issues that are not
directly related to the proposal, such as whether barring ``rogue
brokers'' or firms is effective,\174\ whether the Uniform Registration
Forms should request disclosure of unsubstantiated allegations or
unadjudicated alleged rule violations,\175\ and whether FINRA Hearing
Officers are impartial.\176\ FINRA believes, however, that these
comments are outside the scope of the proposal.
---------------------------------------------------------------------------

    \174\ Chiu.
    \175\ AdvisorLaw.
    \176\ Moss & Gilmore.
---------------------------------------------------------------------------

III. Date of Effectiveness of the Proposed Rule Change and Timing for
Commission Action

    Within 45 days of the date of publication of this notice in the
Federal Register or within such longer period (i) as the Commission may
designate up to 90 days of such date if it finds such longer period to
be appropriate and publishes its reasons for so finding or (ii) as to
which the self-regulatory organization consents, the Commission will:
    (A) By order approve or disapprove such proposed rule change, or
    (B) institute proceedings to determine whether the proposed rule
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views and
arguments concerning the foregoing, including whether the proposed rule
change is consistent with the Act. Comments may be submitted by any of
the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to<EMAIL_ADDRESS>Please include
File Number SR-FINRA-2020-041 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.
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    \177\ 17 CFR 200.30-3(a)(12).

All submissions should refer to File Number SR-FINRA-2020-041. This
file number should be included on the subject line if email is used. To
help the

Commission process and review your comments more efficiently, please
use only one method. The Commission will post all comments on the
Commission's internet website (http://www.sec.gov/rules/sro.shtml).
Copies of the submission, all subsequent amendments, all written
statements with respect to the proposed rule change that are filed with
the Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for website viewing and printing in
the Commission's Public Reference Room, 100 F Street NE, Washington, DC
20549, on official business days between the hours of 10:00 a.m. and
3:00 p.m. Copies of such filing also will be available for inspection
and copying at the principal office of FINRA. All comments received
will be posted without change. Persons submitting comments are
cautioned that we do not redact or edit personal identifying
information from comment submissions. You should submit only
information that you wish to make available publicly. All submissions
should refer to File Number SR-FINRA-2020-041 and should be submitted
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on or before December 28, 2020.

    For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\177\
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    \177\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Assistant Secretary.
[FR Doc. 2020-26594 Filed 12-3-20; 8:45 am]
BILLING CODE 8011-01-P