[Federal Register Volume 85, Number 234 (Friday, December 4, 2020)]
[Notices]
[Pages 78540-78569]
[FR Doc No: 2020-26594]

Vol. 85

Friday,

No. 234

December 4, 2020

Part III

Securities and Exchange Commission

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Self-Regulatory Organizations; Financial Industry Regulatory Authority,
Inc.; Notice of Filing of a Proposed Rule Change To Adopt FINRA Rule
4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for
Regulating Activities Under Rule 4111); Notice

Federal Register / Vol. 85 , No. 234 / Friday, December 4, 2020 /
Notices

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-90527; File No. SR-FINRA-2020-041]

Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Notice of Filing of a Proposed Rule Change To Adopt
FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561
(Procedures for Regulating Activities Under Rule 4111)

November 27, 2020.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that
on November 16, 2020, the Financial Industry Regulatory Authority, Inc.
(``FINRA'') filed with the Securities and Exchange Commission (``SEC''
or ``Commission'') the proposed rule change as described in Items I,
II, and III below, which Items have been prepared by FINRA. The
Commission is publishing this notice to solicit comments on the
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance
of the Proposed Rule Change

    FINRA is proposing to (1) adopt FINRA Rule 4111 (Restricted Firm
Obligations) to require member firms that are identified as
``Restricted Firms'' to maintain a deposit in a segregated account from
which withdrawals would be restricted, adhere to specified conditions
or restrictions, or comply with a combination of such obligations; and
(2) adopt a new FINRA Rule 9561 (Procedures for Regulating Activities
Under Rule 4111), and amend FINRA Rule 9559 (Hearing Procedures for
Expedited Proceedings Under the Rule 9550 Series), to create a new
expedited proceeding to implement proposed Rule 4111.\3\ In addition,
FINRA proposes to adopt Capital Acquisition Broker (``CAB'') Rule 412
(Restricted Firm Obligations), to clarify that member firms that have
elected to be treated as CABs would be subject to proposed FINRA Rule
4111, and to amend Funding Portal Rule 900(a) (Application of FINRA
Rule 9000 Series (Code of Procedure) to Funding Portals), to clarify
that funding portals would not be subject to proposed FINRA Rule 9561.
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    \3\ This reflects a different numbering than was originally
proposed. See Regulatory Notice 19-17 (proposing to number the
proposed new expedited proceeding rule as Rule ``9559'' and to
renumber current Rule 9559 as Rule ``9560'').
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    The text of the proposed rule change is available on FINRA's
website at http://www.finra.org, at the principal office of FINRA and
at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements
concerning the purpose of and basis for the proposed rule change and
discussed any comments it received on the proposed rule change. The
text of these statements may be examined at the places specified in
Item IV below. FINRA has prepared summaries, set forth in sections A,
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and
Statutory Basis for, the Proposed Rule Change

1. Purpose
Background
    FINRA has been engaged in an ongoing effort to enhance its programs
to address the risks that can be posed to investors and the broader
market by individual brokers and member firms that have a history of
misconduct. As part of these efforts, FINRA is proposing to adopt Rule
4111, which would impose obligations on member firms that have
significantly higher levels of risk-related disclosures than similarly
sized peers. FINRA would preliminarily identify these member firms by
using numeric, threshold-based criteria and several additional steps
that would guard against misidentification. The obligations could
include requiring a member firm to maintain a specific deposit amount,
with cash or qualified securities, in a segregated account at a bank or
clearing firm, from which the member firm could make withdrawals only
with FINRA's approval. The obligations also could include conditions or
restrictions on the operations and activities of the member firm and
its associated persons that relate to, and are designed to address the
concerns indicated by, the preliminary identification criteria and
protect investors and the public interest. FINRA also is proposing to
adopt FINRA Rule 9561, and amend FINRA Rule 9559, to create a new
expedited proceeding to implement proposed Rule 4111.
    FINRA has a number of tools to deter and remedy misconduct by
member firms and the individuals they hire, including review of
membership applications, focused examinations, risk monitoring and
disciplinary actions. These tools have been effective in identifying
and addressing a range of misconduct by individuals and member firms,
and FINRA has continued to strengthen them. In recent years, for
example, FINRA has enhanced its key investor protection rules and
examination programs, expanded its risk-based monitoring of brokers and
member firms, and deployed new technologies designed to make its
regulatory efforts more effective and efficient.\4\
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    \4\ For example, in October 2018, FINRA announced plans to
consolidate its Examination and Risk Monitoring Programs,
integrating three separate programs into a single, unified program
to drive more effective oversight and greater consistency, eliminate
duplication and create a single point of accountability for the
examination of member firms. The consolidation brings those programs
under a single framework designed to better direct and align
examination resources to the risk profile and complexity of member
firms. FINRA is conducting its examinations under this unified
program in 2020.
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    These efforts have strengthened protections for investors and the
markets, but persistent compliance issues continue to arise in some
FINRA member firms, which are a top focus of FINRA regulatory programs.
While historically small in number, such firms generally do not carry
out their supervisory obligations to ensure compliance with applicable
securities laws and regulations and FINRA rules, and they act in ways
that could harm their customers and erode trust in the brokerage
industry. Recent academic studies, for example, find that some firms
persistently employ brokers who engage in misconduct, and that
misconduct can be concentrated at these firms. These studies also
provide evidence that the past disciplinary and other regulatory events
associated with a firm or individual can be predictive of similar
future events.\5\ While these firms may eventually be forced out of the
industry through FINRA action or otherwise, these patterns indicate a
persistent, if limited, population of

firms with a history of misconduct that may not be acting appropriately
as a first line of defense to prevent customer harm by their brokers.
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    \5\ For example, in 2015 FINRA's Office of the Chief Economist
(``OCE'') published a study that examined the predictability of
disciplinary and other disclosure events associated with investor
harm based on past similar events. The OCE study showed that past
disclosure events, including regulatory actions, customer
arbitrations and litigations of brokers, have significant power to
predict future investor harm. See Hammad Qureshi & Jonathan Sokobin,
Do Investors Have Valuable Information About Brokers? (OCE Working
Paper, Aug. 2015). A subsequent academic research paper presented
evidence that suggests a higher rate of new disciplinary and other
disclosure events is highly correlated with past disciplinary and
other disclosure events, as far back as nine years prior. See Mark
Egan, Gregor Matvos, & Amit Seru, The Market for Financial Adviser
Misconduct, J. Pol. Econ. 127, no. 1 (Feb. 2019): 233-295.
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    Such firms expose investors to real risk. For example, FINRA has
identified certain firms that have a concentration of associated
persons with a history of misconduct, and some of these firms
consistently hire such individuals and fail to reasonably supervise
their activities. These firms generally have a retail business engaging
in cold calling to make recommendations of securities, often to
vulnerable customers. FINRA has also identified groups of individual
brokers who move from one firm of concern to another firm of concern.
Such firms and their associated persons often have substantial numbers
of disclosures on their records. In such situations, FINRA closely
examines the firms' and brokers' conduct, and where appropriate, FINRA
will bring enforcement actions to bar or suspend the firms and
individuals involved.
    However, individuals and firms with a history of misconduct can
pose a particular challenge for FINRA's existing examination and
enforcement programs. In particular, examinations can identify
compliance failures--or imminent failures--and prescribe remedies to be
taken, but examiners are not empowered to require a firm to change or
limit its business operations in a particular manner without an
enforcement action. While these constraints on the examination process
protect firms from potentially arbitrary or overly onerous examination
findings, an individual or firm with a history of misconduct can take
advantage of these limits to simply continue activities that pose risk
of harm to investors until they result in an enforcement action.
    Enforcement actions in turn can only be brought after a rule has
been violated and any resulting customer harm has already occurred. In
addition, these proceedings can take significant time to develop,
prosecute and conclude, during which time the individual or firm is
able to continue misconduct, with significant risks of additional harm
to customers and investors. Parties with serious compliance issues
often will litigate enforcement actions brought by FINRA, which
potentially involves a hearing and multiple rounds of appeals,
forestalling the imposition of disciplinary sanctions for an extended
period. For example, an enforcement proceeding could involve a hearing
before a Hearing Panel, numerous motions, an appeal to the National
Adjudicatory Council (``NAC''), and a further appeal to the SEC.
Moreover, even when a FINRA Hearing Panel imposes a significant
sanction, the sanction is stayed during appeal to the NAC, many
sanctions are automatically stayed on appeal to the SEC, and they
potentially can be stayed during appeal to the courts. And when all
appeals are exhausted, the firm may have withdrawn its FINRA membership
and shifted its business to another member or other type of financial
firm, limiting FINRA's jurisdiction and avoiding the sanction,
including making restitution to customers.
    Temporary cease and desist proceedings, while useful, do not always
provide an effective remedy for potential ongoing harm to investors
during the enforcement process.\6\ Temporary cease and desist
proceedings are available only in narrowly defined circumstances.
Moreover, initiation by FINRA of a temporary cease and desist action
does not necessarily enable more rapid intervention, because FINRA must
be prepared to file the underlying disciplinary complaint at the same
time.
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    \6\ See FINRA Rule 9800 Series (Temporary and Permanent Cease
and Desist Orders).
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    In addition, by the time sanctions are imposed, as noted above, the
firm may have exited the industry, thereby limiting FINRA's
jurisdiction over the misconduct. In such circumstance, the firm may
also fail to pay arbitration awards owed to claimants, leaving
investors uncompensated and diminishing confidence in the securities
markets.
    Therefore, FINRA is strengthening its tools to respond to firms and
brokers with a significant history of misconduct, and the firms that
employ those brokers, several of which are described below.
Additional Steps Undertaken by FINRA
    To address these problems, FINRA has undertaken the following:
    [rtarr8] Published Regulatory Notice 18-15, which rearticulates the
obligation of member firms to implement heightened supervisory
procedures tailored to the associated persons with a history of
misconduct;
    [rtarr8] Proposed rule amendments that would require a member firm
to conduct with FINRA a materiality consultation before allowing
persons with a history of misconduct to become owners, control persons,
principals or registered persons of a member firm; authorize the
imposition in a disciplinary proceeding of conditions and restrictions
on the activities of a respondent member firm or respondent broker that
are reasonably necessary for the purpose of preventing customer harm,
and require a respondent broker's member firm to adopt heightened
supervisory procedures for such broker, when a disciplinary matter is
appealed to the NAC or called for NAC review; require firms that apply
to continue associating with a statutorily disqualified person to
include in that application an interim plan of heightened supervision
that would be effective throughout the application process; and allow
the disclosure through FINRA BrokerCheck of the status of a member firm
as a ``taping firm'' under FINRA Rule 3170 (Tape Recording of
Registered Persons by Certain Firms); \7\
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    \7\ 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); see also Regulatory Notice 18-16 (April 2018).
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    [rtarr8] Published Regulatory Notice 18-17, which announced
revisions to the FINRA Sanction Guidelines;
    [rtarr8] Raised fees for statutory disqualification applications;
\8\ and
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    \8\ See Securities Exchange Act Release No. 83181 (May 7, 2018),
83 FR 22107 (May 11, 2018) (Notice of Filing and Immediate
Effectiveness of File No. SR-FINRA-2018-018).
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    [rtarr8] Revised the qualification examination waiver guidelines to
permit FINRA to more broadly consider past misconduct when considering
examination waiver requests.\9\
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    \9\ See Regulatory Notice 18-16 (April 2018).
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    While these efforts should help mitigate the risks posed by
individual brokers with a history of misconduct, challenges remain
where a member firm itself has a concentration of such brokers--in some
cases because the firm seeks out such brokers--or otherwise has a
history of substantial compliance failures.
Proposed Rule 4111 (Restricted Firm Obligations)
    FINRA is proposing to adopt Rule 4111 (Restricted Firm
Obligations), a new rule that would use numeric thresholds based on
firm-level and individual-level disclosure events and impose a
Restricted Deposit Requirement on member firms that present a high
degree of risk to the investing public. FINRA believes that the direct
financial impact of a restricted deposit is most likely to change such
member firms' behavior--and therefore protect investors. An added
benefit of this proposal would be to preserve member firm funds for
payment of arbitration awards against them and their associated
persons. The proposal would consider ``Covered Pending Arbitration
Claims'' \10\ and

unpaid arbitration awards \11\ in determining the size of a Restricted
Firm's ``Restricted Deposit Requirement.'' \12\ The proposal also would
establish presumptions that, when assessing an application by a member
firm or former member firm that was previously designated as a
Restricted Firm for withdrawal from a Restricted Deposit Account,\13\
the Department of Member Regulation (``Department'') shall: (i) Deny an
application for withdrawal if the member firm, the member firm's
Associated Persons who are owners or control persons, or the former
member firm have any Covered Pending Arbitration Claims or unpaid
arbitration awards, or if the member firm's Associated Persons have any
Covered Pending Arbitration Claims or unpaid arbitration awards
relating to arbitrations outstanding that involved conduct or alleged
conduct that occurred while associated with the member firm; but (ii)
approve a former member firm's application for withdrawal when that
former member firm 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 firm's specified unpaid arbitration awards.
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    \10\ The term ``Covered Pending Arbitration Claim'' is defined
in proposed Rule 4111(i)(2) to mean, for purposes of Rule 4111, an
investment-related, consumer initiated claim filed against the
member or its associated persons in any arbitration forum that is
unresolved; and whose claim amount (individually or, if there is
more than one claim, in the aggregate) exceeds the member's excess
net capital. The claim amount includes claimed compensatory loss
amounts only, not requests for pain and suffering, punitive damages
or attorney's fees, and shall be the maximum amount for which the
member or associated person, as applicable, is potentially liable
regardless of whether the claim was brought against additional
persons or the associated person reasonably expects to be
indemnified, share liability or otherwise lawfully avoid being held
responsible for all or part of such maximum amount. This term
conforms, in relevant part, to the definition of Covered Pending
Arbitration Claim in Rule 1011(c). See Securities Exchange Act
Release No. 88482 (March 26, 2020), 85 FR 18299 (April 1, 2020)
(Order Approving File No. SR-FINRA-2019-030).
    \11\ For purposes of this Form 19b-4, ``unpaid arbitration
awards'' also includes unpaid settlements related to arbitrations.
    \12\ The term ``Restricted Deposit Requirement'' is defined in
proposed Rule 4111(i)(15).
    \13\ See proposed Rule 4111(i)(14) (proposed definition of
``Restricted Deposit Account'').
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    The proposed rule would create a multi-step process for FINRA's
determination of whether a member firm raises investor-protection
concerns substantial enough to require that it be subject to additional
obligations. Those obligations could include a requirement to maintain
a deposit of cash or qualified securities in an account from which
withdrawals would be restricted, or conditions or restrictions on the
member firm's operations that are necessary or appropriate for the
protection of investors and in the public interest. The proposed rule
would give each affected member firm several ways to affect outcomes,
including a one-time opportunity to reduce staffing so as to no longer
trigger the preliminary identification criteria and numeric thresholds.
The firm also could explain to the Department why it should not be
subject to a Restricted Deposit Requirement or propose alternatives,
and the firm could challenge a Department determination by requesting a
hearing before a Hearing Officer in an expedited proceeding.
    The proposed multi-step process includes numerous features designed
to narrowly focus the new obligations on the firms most of concern. As
the flow chart in Exhibit 2d reflects, this process is akin to a
``funnel.'' The top of the funnel applies to the range of member firms
with the most disclosures, with a narrowing in the middle of the
potential member firms that may be subject to additional obligations,
and the bottom of the funnel reflecting the smaller number of member
firms that are determined to present high risks to the investing
public.
[rtarr8] General (Proposed Rule 4111(a))
    Proposed Rule 4111(a) would require a member designated as a
Restricted Firm to establish a Restricted Deposit Account and maintain
in that account deposits of cash or qualified securities with an
aggregate value that is not less than the member's Restricted Deposit
Requirement, except in certain identified situations, and be subject to
conditions or restrictions on the member's operations as determined by
the Department to be necessary or appropriate for the protection of
investors and in the public interest.
[rtarr8] Annual Calculation by FINRA of the Preliminary Criteria for
Identification (Proposed Rule 4111(b))
    The multi-step process would begin with an annual calculation. As
explained more below, proposed Rule 4111(b) would require the
Department to calculate annually (on a calendar-year basis) the
``Preliminary Identification Metrics'' \14\ to determine whether a
member firm meets the ``Preliminary Criteria for Identification.'' \15\
A key driver of that is whether a member firm's ``Preliminary
Identification Metrics'' meet quantitative, risk-based ``Preliminary
Identification Metrics Thresholds.'' \16\
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    \14\ See proposed Rule 4111(i)(10) (definition of ``Preliminary
Identification Metrics'').
    \15\ See proposed Rule 4111(i)(9) (definition of ``Preliminary
Criteria for Identification'').
    \16\ See proposed Rule 4111(i)(11) (definition of ``Preliminary
Identification Metrics Thresholds'').
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    Several principles guided FINRA's development of the proposed
Preliminary Criteria for Identification and the proposed Preliminary
Identification Metrics Thresholds. The criteria and thresholds are
intended to be replicable and transparent to FINRA and affected member
firms; employ the most complete and accurate data available to FINRA;
be objective; account for different firm sizes and business profiles;
and target the sales-practice concerns that are motivating the
proposal. These criteria are intended to identify member firms that
present a high risk but avoid imposing obligations on member firms
whose risk profile and activities do not warrant such obligations.
    Using these guiding principles, FINRA is proposing numeric
thresholds based on six categories of events or conditions, nearly all
of which are based on information disclosed through the Uniform
Registration Forms.\17\ The six categories, collectively defined as the
``Disclosure Event and Expelled Firm Association Categories,'' \18\
are:
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    \17\ One of the event categories, Member Firm Adjudicated
Events, includes events that are derived from customer arbitrations
filed with FINRA's dispute resolution forum.
    \18\ See proposed Rule 4111(i)(4).
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    1. Registered Person Adjudicated Events; \19\
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    \19\ ``Registered Person Adjudicated Events,'' defined in
proposed Rule 4111(i)(4)(A), means any one of the following events
that are reportable on the registered person's Uniform Registration
Forms: (i) A final investment-related, consumer-initiated customer
arbitration award or civil judgment against the registered person in
which the registered person was a named party, or was a ``subject
of'' the customer arbitration award or civil judgment; (ii) a final
investment-related, consumer-initiated customer arbitration
settlement, civil litigation settlement or a settlement prior to a
customer arbitration or civil litigation for a dollar amount at or
above $15,000 in which the registered person was a named party or
was a ``subject of'' the customer arbitration settlement, civil
litigation settlement or a settlement prior to a customer
arbitration or civil litigation; (iii) a final investment-related
civil judicial matter that resulted in a finding, sanction or order;
(iv) a final regulatory action that resulted in a finding, sanction
or order, and was brought by the SEC or Commodity Futures Trading
Commission (``CFTC''), other federal regulatory agency, a state
regulatory agency, a foreign financial regulatory authority, or a
self-regulatory organization; or (v) a criminal matter in which the
registered person was convicted of or pled guilty or nolo contendere
(no contest) in a domestic, foreign, or military court to any felony
or any reportable misdemeanor.
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    2. Registered Person Pending Events; \20\
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    \20\ ``Registered Person Pending Events,'' defined in proposed
Rule 4111(i)(4)(B), means any one of the following events associated
with the registered person that are reportable on the registered
person's Uniform Registration Forms: (i) A pending investment-
related civil judicial matter; (ii) a pending investigation by a
regulatory authority; (iii) a pending regulatory action that was
brought by the SEC or CFTC, other federal regulatory agency, a state
regulatory agency, a foreign financial regulatory authority, or a
self-regulatory organization; or (iv) a pending criminal charge
associated with any felony or any reportable misdemeanor. Registered
Person Pending Events does not include pending arbitrations, pending
civil litigations, or consumer-initiated complaints that are
reportable on the registered person's Uniform Registration Forms.

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    3. Registered Person Termination and Internal Review Events; \21\
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    \21\ ``Registered Person Termination and Internal Review
Events,'' defined in proposed Rule 4111(i)(4)(C), means any one of
the following events associated with the registered person at a
previous member firm that are reportable on the registered person's
Uniform Registration Forms: (i) A termination in which the
registered person voluntarily resigned, was discharged or was
permitted to resign from a previous member after allegations; or
(ii) a pending or closed internal review by a previous member. FINRA
has revised this definition, from the version proposed in Regulatory
Notice 19-17 (May 2019), to clarify that termination and internal
review disclosures concerning a person whom a member firm terminated
would not impact that member firm's own Registered Person
Termination and Internal Review Metric; rather, they would only
impact the metrics of member firms that subsequently register the
terminated individual.
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    4. Member Firm Adjudicated Events; \22\
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    \22\ ``Member Firm Adjudicated Events,'' defined in proposed
Rule 4111(i)(4)(D), means any one of the following events that are
reportable on the member firm's Uniform Registration Forms or based
on customer arbitrations filed with FINRA's dispute resolution
forum: (i) A final investment-related, consumer-initiated customer
arbitration award in which the member was a named party; (ii) a
final investment-related civil judicial matter that resulted in a
finding, sanction or order; (iii) a final regulatory action that
resulted in a finding, sanction or order, and was brought by the SEC
or CFTC, other federal regulatory agency, a state regulatory agency,
a foreign financial regulatory authority, or a self-regulatory
organization; or (iv) a criminal matter in which the member was
convicted of or pled guilty or nolo contendere (no contest) in a
domestic, foreign, or military court to any felony or any reportable
misdemeanor.
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    5. Member Firm Pending Events; \23\ and
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    \23\ ``Member Firm Pending Events,'' defined in proposed Rule
4111(i)(4)(E), means any one of the same kinds of events as the
``Registered Person Pending Events,'' but that are reportable on the
member firm's Uniform Registration Forms.
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    6. Registered Persons Associated with Previously Expelled Firms
(also referred to as the Expelled Firm Association category).\24\
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    \24\ ``Registered Persons Associated with Previously Expelled
Firms,'' defined in proposed Rule 4111(i)(4)(F), means any
``Registered Person In-Scope'' who was registered for at least one
year with a previously expelled firm and whose registration with the
previously expelled firm terminated during the ``Evaluation Period''
(i.e., the prior five years from the ``Evaluation Date,'' which is
the annual date as of which the Department calculates the
Preliminary Identification Metrics). See proposed Rule 4111(i)(5),
(6), and (13) (proposed definitions of ``Evaluation Date,''
``Evaluation Period,'' and ``Registered Persons In-Scope''). This
proposed definition is narrower than the definition proposed in
Regulatory Notice 19-17.
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    To calculate whether a member firm meets the Preliminary Criteria
for Identification, the Department would first compute the Preliminary
Identification Metrics for each of the Disclosure Event and Expelled
Firm Association Categories. Each category's Preliminary Identification
Metric computation would start with a calculation of the sum of the
pertinent disclosure events or, for the Expelled Firm Association
category, the sum of the Registered Persons Associated with Previously
Expelled Firms. For the adjudicated disclosure-event based categories,
the counts would include disclosure events that were resolved during
the prior five years from the date of the calculation. For the pending
events categories and pending internal reviews, the counts would
include disclosure events that are pending as of the date of the
calculation. In addition, for the three Registered Person disclosure-
event based categories, the counts would include disclosure events
across all Registered Persons In-Scope, which is defined to include
persons registered with the member firm for one or more days within the
one year prior to the calculation date.\25\
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    \25\ See proposed Rule 4111(i)(13).
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    Each of those six sums would then be standardized to determine the
member's six Preliminary Identification Metrics. For the five
``Registered Person and Member Firm Events'' categories (Categories 1-5
above),\26\ the proposed Preliminary Identification Metrics are in the
form of an average number of events per registered broker, calculated
by taking each category's sum and dividing it by the number of
Registered Persons In-Scope. The sixth Preliminary Identification
Metric--the proposed Expelled Firm Association Metric--is in the form
of a percentage concentration at the member firm of Registered Persons
Associated with Previously Expelled Firms. This concentration is
calculated by taking the number of Registered Persons Associated with
Previously Expelled Firms and dividing it by the number of Registered
Persons In-Scope.
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    \26\ See proposed Rule 4111(i)(12) (definition of Registered
Person and Member Firm Events).
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    A firm's six Preliminary Identification Metrics are used to
determine if the member firm meets the Preliminary Criteria for
Identification. To meet the Preliminary Criteria for Identification, a
member firm would need to meet the Preliminary Identification Metrics
Thresholds, set forth in proposed Rule 4111(i)(11), for two or more of
the appropriate metrics listed above for its size and, if it does, one
of these metrics must be for adjudicated events or the Expelled Firm
Association Metric, and the firm must have two or more Registered
Person and Member Firm Events (i.e., events in categories besides the
Registered Persons Associated with Previously Expelled Firms
category).\27\ This involves analyzing the extent to which the
Preliminary Identification Metrics meet the specified numeric
Preliminary Identification Metrics Thresholds and meet additional
conditions intended to prevent a member firm from becoming potentially
subject to additional obligations solely as a result of pending matters
or a single event or condition.\28\ Specifically, the Department would:
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    \27\ Including an Expelled Firm Association Metric in the
Preliminary Criteria for Identification is similar to how FINRA Rule
3170 (Tape Recording of Registered Persons by Certain Firms) imposes
recording requirements on firms with specific percentages of
registered persons who were previously associated with disciplined
firms.
    \28\ The purpose of ensuring that a firm does not meet the
Preliminary Criteria for Identification solely because of pending
matters is because FINRA recognizes that pending matters include
disclosure events that may remain unresolved or that may
subsequently be dismissed or concluded with no adverse action. As
explained in more detail in the Economic Impact Assessment, FINRA
also evaluated the impact of including and excluding pending matters
from the Preliminary Criteria for Identification. Based on this
evaluation, FINRA has included pending matters in the proposed
criteria because they are critical to identifying firms that pose
greater risks to their customers.
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     First, pursuant to proposed Rules 4111(b) and (i)(9)(A),
evaluate whether two or more of the member firm's Preliminary
Identification Metrics are equal to or more than the corresponding
Preliminary Identification Metrics Thresholds for the member firm's
size, and whether at least one of those Preliminary Identification
Metrics is the Registered Person Adjudicated Event Metric, the Member
Firm Adjudicated Event Metric, or the Expelled Firm Association Metric;
and
     second, pursuant to proposed Rules 4111(b) and (i)(9)(B),
evaluate whether the member firm has two or more Registered Person or
Member Firm Events (i.e., two or more events from Categories 1-5
above).
    If all of these conditions are met, the member firm would meet the
Preliminary Criteria for Identification.
    Each specific numeric threshold in the Preliminary Identification
Metrics Thresholds grid in proposed Rule 4111(i)(11) is a number which
represents outliers with respect to peers for the type of events in the
category (i.e., the firm is at the far tail of the respective
category's distribution), which is intended to preliminarily

identify member firms that present significantly higher risk than a
large percentage of the membership. In addition, there are numeric
thresholds for seven different firm sizes, to ensure that each member
firm is compared only to its similarly sized peers.\29\ As explained
more below in the Economic Impact Assessment, based on recent history
FINRA expects that its annual calculations will identify between 45-80
member firms that meet the Preliminary Criteria for Identification.\30\
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    \29\ Because FINRA has narrowed the definition of Registered
Persons Associated with Previously Expelled Firms from the version
that was originally proposed in Regulatory Notice 19-17, FINRA also
has revised the Expelled Firm Association Metric Thresholds.
    \30\ Due to the revisions in the Preliminary Criteria for
Identification, discussed above, and the inclusion of the year 2019
in the review period, this estimate and other corresponding
estimates in the Economic Impact Assessment have changed from the
ones in Regulatory Notice 19-17.
---------------------------------------------------------------------------

    The following three examples demonstrate--in practical terms--the
point at which a member firm's Preliminary Identification Metrics would
meet the Preliminary Identification Metrics Thresholds in proposed Rule
4111(i)(11):

------------------------------------------------------------------------
                                   Preliminary
                                 identification     Practical equivalent
                               metrics thresholds
------------------------------------------------------------------------
Example 1 (member firm size   The Preliminary       For a member firm
 between 1-4 registered        Identification        with four
 persons).                     Metrics Threshold     Registered Persons
                               for the Registered    In-Scope as of the
                               Person Adjudicated    Evaluation Date,
                               Event Metric, for a   the member would
                               member firm that      meet the
                               has between one and   Preliminary
                               four Registered       Identification
                               Persons In-Scope as   Metrics Threshold
                               of the Evaluation     for the Registered
                               Date,\31\ is 0.50     Person Adjudicated
                               (or 0.50 events per   Event Metric if the
                               Registered Broker     sum of its four
                               In-Scope).            Registered Persons
                                                     In-Scope's
                                                     Adjudicated Events,
                                                     which reached a
                                                     resolution over the
                                                     five years before
                                                     the Evaluation
                                                     Date, was two or
                                                     more.
                                                    (4 Registered
                                                     Persons In-Scope) *
                                                     (0.50 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Registered
                                                     Person Adjudicated
                                                     Event Metric) = (2
                                                     Adjudicated Events)
Example 2 (member firm size   The Preliminary       For a member firm
 between 20-50 registered      Identification        with 50 Registered
 persons).                     Metrics Threshold     Persons In-Scope as
                               for the Member Firm   of the Evaluation
                               Adjudicated Event     Date, the member
                               Metric, for a         firm would meet the
                               member firm that      Preliminary
                               has between 20-50     Identification
                               Registered Persons    Metrics Threshold
                               In-Scope as of the    for the Member Firm
                               Evaluation Date, is   Adjudicated Event
                               0.20 (or 0.20         Metric if the sum
                               events per            of the member
                               Registered Broker     firm's Adjudicated
                               In-Scope).            Events, which
                                                     reached a
                                                     resolution over the
                                                     five years before
                                                     the Evaluation
                                                     Date, was ten or
                                                     more.
                                                    (50 Registered
                                                     Persons In-Scope) *
                                                     (0.20 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Member Firm
                                                     Adjudicated Event
                                                     Metric) = (10
                                                     Adjudicated Events)
Example 3 (member firm size   The Preliminary       For a member firm
 between 51-150 registered     Identification        with 100 Registered
 persons).                     Metrics Threshold     Persons In-Scope as
                               for the Expelled      of the Evaluation
                               Firm Association      Date, the member
                               Metric, for a         firm would meet the
                               member firm that      Preliminary
                               has between 51-150    Identification
                               Registered Persons    Metrics Threshold
                               In-Scope as of the    for the Expelled
                               Evaluation Date, is   Firm Association
                               0.03 (or a 3%         Metric if the sum
                               concentration         of its Registered
                               level).               Persons Associated
                                                     with Previously
                                                     Expelled Firms was
                                                     three or more.
                                                    (100 Registered
                                                     Persons In-Scope) *
                                                     (0.03 Preliminary
                                                     Identification
                                                     Metrics Threshold
                                                     for the Expelled
                                                     Firm Association
                                                     Metric) = (Three
                                                     Registered Persons
                                                     Associated with
                                                     Previously Expelled
                                                     Firms)
------------------------------------------------------------------------

    In a comment to Regulatory Notice 19-17, SIFMA requested more
clarity around when the annual Evaluation Date would be. FINRA would
announce the first Evaluation Date no less than 120 calendar days
before the first Evaluation Date. 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.
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    \31\ The ``Evaluation Date'' is defined in proposed Rule
4111(i)(5) to mean the date, each calendar year, as of which the
Department calculates the Preliminary Identification Metrics to
determine if the member firm meets the Preliminary Criteria for
Identification.
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    FINRA has conducted a thorough analysis of the proposed criteria
and thresholds to ensure that the proposed Preliminary Criteria for
Identification preliminarily identify the types of member firms that
are motivating this rule proposal.\32\ As explained below, however, the
proposed rule involves several additional steps to guard against the
risk of misidentification.
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    \32\ OCE has tested the Preliminary Criteria for Identification,
including the Preliminary Identification Metrics Thresholds, in
several ways. For example, OCE has compared the firms captured by
the proposed criteria to the firms that have recently been expelled
or that have unpaid arbitration awards. OCE also has consulted with
Department staff and examiners about whether, based on their
experience, the criteria identifies firms that appear to present
high risks to investors.
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[rtarr8] Initial Department Evaluation (Proposed Rule 4111(c)(1))
    For each member firm that meets the Preliminary Criteria for
Identification, the Department would conduct, pursuant to proposed Rule
4111(c)(1), an initial internal evaluation to determine whether the
member firm does not warrant further review under Rule 4111. In doing
so, the Department would review whether it has information to conclude
that the computation of the member firm's Preliminary Identification
Metrics included disclosure events or other 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. For example, the Department may have
information that the computation included disclosure events that were
not sales-practice related, were duplicative (involving the same
customer and the same matter), or mostly involved compliance concerns
best addressed by a different regulatory response by FINRA. The
Department would evaluate the events to determine, among other things,
whether they

indicated risks to investors or market integrity, rather than, for
instance, repeated violations of procedural rules.
    The Department would also consider whether the member firm has
addressed the concerns signaled by the disclosure events or conditions
or altered its business operations, including staffing reductions, such
that the threshold calculation no longer reflects the member firm's
current risk profile. Essentially, the purpose of the Department's
initial evaluation is to determine whether it is aware of information
that would show that the member firm--despite having met the
Preliminary Criteria for Identification--does not pose a high degree of
risk.
    Pursuant to proposed Rule 4111(c)(3), if the Department determines,
after this initial evaluation, that the member firm does not warrant
further review, the Department would conclude that year's Rule 4111
process for the member firm and would not seek that year to impose any
obligations on it. If, however, the Department determines that the
member firm does warrant further review, the Rule 4111 process would
continue.
[rtarr8] One-Time Opportunity To Reduce Staffing Levels (Proposed Rule
4111(c)(2))
    If the Department determines, after its initial evaluation, that a
member firm warrants further review under proposed Rule 4111, such
member firm--if it would be meeting the Preliminary Criteria for
Identification for the first time--would have a one-time opportunity to
reduce its staffing levels to no longer meet these criteria, within 30
business days after being informed by the Department. The member firm
would be required to demonstrate the staff reduction to the Department
by identifying the terminated individuals. The proposed rule would
prohibit the member firm from rehiring any persons terminated pursuant
to this option, in any capacity, for one year. A member firm that has
reduced staffing levels at this stage may not use that staff-reduction
opportunity again.
    If the Department determines that the member firm's reduction of
staffing levels results in its no longer meeting the Preliminary
Criteria for Identification, the Department would close out that year's
Rule 4111 process for the member firm and would not seek that year to
impose any obligations on that firm. If, on the other hand, the
Department determines that the member firm still meets the Preliminary
Criteria for Identification even after its staff reductions, or if the
member firm elects not to use its one-time opportunity to reduce
staffing levels, the Department would proceed to determine the firm's
maximum Restricted Deposit Requirement, and the member firm would
proceed to a ``Consultation'' with the Department.
[rtarr8] FINRA's Determination of a Maximum Restricted Deposit
Requirement (Proposed Rule 4111(i)(15))
    For members that warrant further review after being deemed to meet
the Preliminary Criteria for Identification and after the initial
Department evaluation, the Department would then determine the member's
maximum ``Restricted Deposit Requirement.''
    The Department would tailor the member firm's maximum Restricted
Deposit Requirement amount to its size, operations and financial
conditions. As provided in proposed Rule 4111(i)(15), the Department
would consider the nature of the member firm's operations and
activities, revenues, commissions, assets, liabilities, expenses, net
capital, the number of offices and registered persons, the nature of
the disclosure events counted in the numeric thresholds, insurance
coverage for customer arbitration awards or settlements, concerns
raised during FINRA exams, and the amount of any of the firm's or its
Associated Persons' ``Covered Pending Arbitration Claims'' or unpaid
arbitration awards.\33\ Based on a consideration of these factors, the
Department would determine a maximum Restricted Deposit Requirement for
the member firm that would be consistent with the objectives of the
rule, but not significantly undermine the continued financial stability
and operational capability of the member firm as an ongoing enterprise
over the next 12 months. FINRA's intent is that the maximum Restricted
Deposit Requirement should be significant enough to change the member
firm's behavior but not so burdensome that it would force the member
firm out of business solely by virtue of the imposed deposit
requirement.
---------------------------------------------------------------------------

    \33\ The proposed factors that the Department would consider
when determining a maximum Restricted Deposit Requirement have been
revised from the ones proposed in Regulatory Notice 19-17. Some of
the revisions are to ensure that proposed Rule 4111(i)(15) describes
more accurately the factors that would be relevant to a
determination of the maximum Restricted Deposit Requirement. In this
regard, 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. Another revision
clarifies that the Covered Pending Arbitration Claims and unpaid
arbitration awards factors include claims and awards against the
firm and its Associated Persons. The Department's consideration of
claims and awards against the firm's Associated Persons would focus
on claims and awards against Associated Persons who are owners or
control persons and on claims and awards relating to arbitrations
that involved conduct or alleged conduct that occurred while
associated with the member firm. The revised proposed definition
also adds the member firm's ``insurance coverage for customer
arbitration awards or settlements'' as a factor. FINRA believes
that, if Restricted Firms were able to procure errors and omissions
policies, or other kinds of insurance coverage, for some or all of
the kinds of arbitration claims that customers typically bring, that
could warrant a reduced Restricted Deposit Requirement and would be
behavior to encourage.
---------------------------------------------------------------------------

[rtarr8] Consultation (Proposed Rule 4111(d))
    If the Department determines, after the process discussed above,
that a member firm warrants further Rule 4111 review, the Department
would consult with the member firm, pursuant to proposed Rule 4111(d).
This Consultation will give the member firm an opportunity to
demonstrate why it does not meet the Preliminary Criteria for
Identification, why it should not be designated as a Restricted Firm,
and why it should not be subject to the maximum Restricted Deposit
Requirement.
    In the Consultation, there would be two rebuttable presumptions:
That the member firm should be designated as a Restricted Firm; and
that it should be subject to the maximum Restricted Deposit
Requirement. The member firm would bear the burden of overcoming those
presumptions.
    Proposed Rule 4111(d)(1) governs how a member may overcome these
two presumptions. First, a member may overcome the presumption that it
should be designated as a Restricted Firm by clearly demonstrating that
the Department's calculation that the member meets the Preliminary
Criteria for Identification is inaccurate because, among other things,
it included events, in the six categories described above, 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. Second, a member firm may overcome the presumption
that it should be subject to the maximum Restricted Deposit Requirement
by clearly demonstrating to the Department that the member firm would
face significant undue financial hardship if it were required to
maintain the maximum Restricted Deposit Requirement and that a lesser
deposit requirement would satisfy the objectives of Rule 4111 and be
consistent with the protection of investors and the public interest; or
that other conditions and restrictions on the operations and activities
of the member firm and its associated persons would address the

concerns indicated by the thresholds and protect investors and the
public interest.
    Proposed Rule 4111(d)(2) governs how the Department would schedule
and provide notice of the Consultation. In a change from the proposal
in Regulatory Notice 19-17, the Department would provide the written
letter required by the rule at least seven days prior to the
Consultation, and would establish a process whereby the member can
request a postponement for good cause shown. These changes, which are
in response to a comment on Regulatory Notice 19-17, are intended to
ensure that the firms have sufficient time to prepare for the
Consultation and to enhance the procedural protections.
    Proposed Rule 4111(d)(3) provides guidance on what the Department
would consider during the Consultation when evaluating whether a member
firm should be designated as a Restricted Firm and subject to a
Restricted Deposit Requirement. This provision also provides member
firms with guidance on how to attempt to overcome the two rebuttable
presumptions. For example, proposed Rule 4111(d)(3) requires that the
Department consider:
     Information provided by the member firm during any
meetings as part of the Consultation;
     relevant information or documents, if any, submitted by
the member firm, in the manner and form prescribed by the Department,
as would be necessary or appropriate for the Department to review the
computation of the Preliminary Criteria for Identification;
     any plan submitted by the member firm, in the manner and
form prescribed by the Department, proposing in detail the specific
conditions or restrictions that the member firm seeks to have the
Department consider;
     such other information or documents as the Department may
reasonably request from the member firm related to the evaluation; and
     any other information the Department deems necessary or
appropriate to evaluate the matter.
    To the extent a member firm seeks to claim undue financial
hardship, it would be the member firm's burden to support that with
documents and information.
[rtarr8] Department Decision and Notice (Proposed Rule 4111(e)); No
Stays
    After the Consultation, proposed Rule 4111(e) would require that
the Department render a Department decision. Under proposed Rule
4111(e)(1), there are three paths that decision might take:
     If the Department determines that the member firm has
rebutted the presumption that it should be designated as a Restricted
Firm, the Department's decision would state that the member firm will
not be designated that year as a Restricted Firm.
     If the Department determines that the member firm has not
rebutted the presumption that it should be designated as a Restricted
Firm or the presumption that it must maintain the maximum Restricted
Deposit Requirement, the Department's decision would designate the
member firm as a Restricted Firm and require the member firm to
promptly establish a Restricted Deposit Account, deposit and maintain
in that account the maximum Restricted Deposit Requirement, and
implement and maintain specified conditions or restrictions, as
necessary or appropriate, on the operations and activities of the
member firm and its associated persons that relate to, and are designed
to address the concerns indicated by, the Preliminary Criteria for
Identification and protect investors and the public interest.
     If the Department determines that the member firm has not
rebutted the presumption that it should be designated as a Restricted
Firm but has rebutted the presumption that it must maintain the maximum
Restricted Deposit Requirement, the Department's decision would
designate the member firm as a Restricted Firm; would impose no
Restricted Deposit Requirement on the member firm, or would require the
member firm to promptly establish a Restricted Deposit Account, deposit
and maintain in that account a Restricted Deposit Requirement in such
dollar amount less than the maximum Restricted Deposit Requirement as
the Department deems necessary or appropriate; and would require the
member firm to implement and maintain specified conditions or
restrictions, as necessary or appropriate, on the operations and
activities of the member firm and its associated persons that relate
to, and are designed to address the concerns indicated by, the
Preliminary Criteria for Identification and protect investors and the
public interest.
    Pursuant to proposed Rule 4111(e)(2), the Department would provide
a written notice of its decision to the member firm, pursuant to
proposed Rule 9561 and no later than 30 days from the latest scheduling
letter provided to the member firm under proposed Rule 4111(d)(2), that
states the obligations to be imposed on the member firm, if any, and
the ability of the member firm to request a hearing with the Office of
Hearing Officers in an expedited proceeding, as further described
below.
    Proposed Rule 4111(e)(2) would provide that a request for a hearing
would not stay the effectiveness of the Department's decision. However,
upon requesting a hearing of a Department decision that imposes a
Restricted Deposit Requirement, the member firm would only be required
to maintain in a Restricted Deposit Account the lesser of 25% of its
Restricted Deposit Requirement or 25% of its average excess net capital
during the prior calendar year, until the Office of Hearing Officers or
the NAC issues its final written decision in the expedited
proceeding.\34\ This has one exception: A member firm that is re-
designated as a Restricted Firm and is already subject to a previously
imposed Restricted Deposit Requirement would be required to maintain
the full amount of its Restricted Deposit Requirement until the Office
of Hearing Officers or the NAC issues its final written decision in the
expedited proceeding.
---------------------------------------------------------------------------

    \34\ In Regulatory Notice 19-17 (May 2019), FINRA originally
proposed that the member firm would be required, upon requesting a
hearing, to deposit the lesser of 50% of the Restricted Deposit
Requirement or 25% of the firm's average excess net capital during
the prior calendar year. FINRA has revised this provision because,
although the no-stay provisions are a fundamental part of how the
proposed rule would protect investors, FINRA believes that this
aspect of the no-stay provisions could be less burdensome than
originally proposed and still achieve its intended purpose.
---------------------------------------------------------------------------

    Considering the nature of the firms identified as Restricted Firms
and the risks they present, the immediate effectiveness of the
Department's decision will help protect investors during the pendency
of the expedited proceeding. Moreover, FINRA believes that the no-stay
provision is consistent with fairness principles, because obligations
would be imposed only after firms are preliminarily identified, from
among their firm-size peer group, by transparent criteria and a process
that involves an initial evaluation and a consultation with the firm.
[rtarr8] Continuation or Termination of Restricted Firm Obligations
(Proposed Rule 4111(f))
    The proposed Restricted Firm Obligations Rule would require FINRA
to determine annually whether each member firm is, or continues to be,
a Restricted Firm and whether the member firm should be subject to any
obligations. For this reason, proposed Rule 4111(f) contains provisions
that set forth how any obligations that were imposed during the Rule
4111 process in one year are continued or terminated

in that same year and in subsequent years.
    Proposed Rule 4111(f)(1), titled ``Currently Designated Restricted
Firms,'' establishes constraints on a member firm's ability to seek to
modify or terminate, directly or indirectly, any obligations imposed
pursuant to Rule 4111. Because the Restricted Firm Obligations Rule
would entail annual reviews by the Department to determine whether a
member firm is a Restricted Firm that should be subject to obligations,
a Restricted Firm could seek each year to terminate or modify any
obligations that continue to be imposed. For this reason, proposed Rule
4111 does not authorize a Restricted Firm to seek, outside of the
Consultation process and any ensuing expedited proceedings after a
Department decision, a separate interim termination or modification of
any obligations imposed. Rather, proposed Rule 4111(f)(1) provides that
a member firm that has been designated as a Restricted Firm will not be
permitted to withdraw all or any portion of its Restricted Deposit
Requirement, or seek to terminate or modify any deposit requirement,
conditions, or restrictions that have been imposed on it, without the
prior written consent of the Department. In a change from the proposal
in Regulatory Notice 19-17, there would be a presumption that the
Department shall deny an application by a member firm or former member
firm that is currently designated as a Restricted Firm to withdraw all
or any portion of its Restricted Deposit Requirement.\35\
---------------------------------------------------------------------------

    \35\ This revision, and additional revisions to proposed Rule
4111(f)(3) discussed below, are intended to make more clear the
process that would guide the Department's assessment of applications
for withdrawal from a Restricted Deposit Requirement.
---------------------------------------------------------------------------

    Proposed Rule 4111(f)(2), titled ``Re-Designation as a Restricted
Firm,'' addresses the scenario when the Department determines in one
year that a member firm is a Restricted Firm, and in the following year
determines that the member firm still meets the Preliminary Criteria
for Identification. In that instance, the Department would re-designate
the member firm as a Restricted Firm, and the obligations previously
imposed on the member firm would continue unchanged, unless either the
member firm or the Department requests, within seven days of the
Department's decision to re-designate the member firm as a Restricted
Firm, a Consultation.\36\ If a Consultation is requested, the
obligations previously imposed would continue unchanged unless and
until the Department modifies or terminates them after the
Consultation. In addition, in the Consultation process, a presumption
would apply that any previously imposed Restricted Deposit Requirement,
conditions or restrictions would remain effective and unchanged, absent
a showing by the party seeking changes that they are no longer
necessary or appropriate for the protection of investors or in the
public interest. At the end of the Consultation, the Department would
be required to provide written notice of its determination to the
member firm, no later than 30 days from the date of the latest
scheduling letter provided to the member firm under Rule 4111(d)(2).
---------------------------------------------------------------------------

    \36\ The seven-day period to request a Consultation is a
revision from the proposal in Regulatory Notice 19-17 (May 2019),
which proposed a 30-day period.
---------------------------------------------------------------------------

    Proposed Rule 4111(f)(3), titled ``Previously Designated Restricted
Firms,'' addresses the scenario where the Department determines in one
year that a member firm is a Restricted Firm, but in the following
year(s) determines that the member firm or former member firm \37\
either does not meet the Preliminary Criteria for Identification or
should not be designated as a Restricted Firm. In that case, the member
firm or former member firm would no longer be subject to any
obligations previously imposed under proposed Rule 4111. There would be
one exception: A former Restricted Firm would not be permitted to
withdraw any portion of its Restricted Deposit Requirement without
submitting an application and obtaining the Department's prior written
consent for the withdrawal. Such an application would be required to
include, among other things set forth in proposed Rule 4111(f)(3)(A),
evidence as to whether the firm, its Associated Persons, or the former
member firm have Covered Pending Arbitration Claims or any unpaid
arbitration awards outstanding.
---------------------------------------------------------------------------

    \37\ See proposed Rule 4111(i)(7) (definition of ``Former
Member'').
---------------------------------------------------------------------------

    The Department would determine whether to authorize a withdrawal,
in part or in whole. Proposed Rule 4111(f)(3)(B)(i) would establish a
presumption that the Department shall approve an application for
withdrawal if the member firm, its Associated Persons, or the former
member firm have no Covered Pending Arbitration Claims or unpaid
arbitration awards. Proposed Rule 4111(f)(3)(B)(ii) would establish
presumptions that the Department shall: (a) Deny an application for
withdrawal if the member firm, the member firm's Associated Persons who
are owners or control persons, or the former member have any ``Covered
Pending Arbitration Claims,'' unpaid arbitration awards, or if the
member's Associated Persons have any ``Covered Pending Arbitration
Claims'' or unpaid arbitration awards relating to arbitrations that
involved conduct or alleged conduct that occurred while associated with
the member; but (b) approve an application by a former member for
withdrawal if the former member commits in the manner specified by the
Department to use the amount it seeks to withdraw from its Restricted
Deposit to pay the former member's specified unpaid arbitration
awards.\38\ The Department would be required to issue, pursuant to
proposed Rule 9561, a notice of its decision on an application to
withdraw from the Restricted Deposit Account within 30 days from the
date the application is received by the Department.
---------------------------------------------------------------------------

    \38\ The presumptions in proposed Rule 4111(f)(3)(B) have been
modified from what was proposed in Regulatory Notice 19-17. In
addition, in clarifying changes from Regulatory Notice 19-17,
proposed Rule 4111(f)(3) expressly provides that the Covered Pending
Arbitration Claims and unpaid arbitration awards of a member firm's
``Associated Persons'' are pertinent to an application for a
withdrawal from the Restricted Deposit Requirement.
---------------------------------------------------------------------------

[rtarr8] Restricted Deposit Account (Proposed Rule 4111(i)(14))
    If a Department decision requires a member firm to establish a
Restricted Deposit Account, proposed Rule 4111(i)(14) would govern this
account. The underlying policy for the proposed account requirements is
that, to make a deposit requirement effective in creating appropriate
incentives to member firms that pose higher risks to change their
behavior, the member firm must be restricted from withdrawing any of
the required deposit amount, even if it terminates its FINRA
membership.
    The proposed rule would require that the Restricted Deposit Account
be established, in the name of the member firm, at a bank or the member
firm's clearing firm. The account must be subject to an agreement in
which the bank or the clearing firm agrees: Not to permit withdrawals
from the account absent FINRA's prior written consent; to keep the
account separate from any other accounts maintained by the member firm
with the bank or clearing firm; that the cash or qualified securities
on deposit will not be used directly or indirectly as security for a
loan to the member firm by the bank or the clearing firm, and will not
be subject to any set-off, right, charge, security interest, lien, or
claim of any kind in favor of the bank, clearing firm or any person
claiming through the bank or clearing

firm; that if the member firm becomes a former member, the Restricted
Deposit Requirement in the account must be maintained, and withdrawals
will not be permitted without FINRA's prior written consent; that FINRA
is a third-party beneficiary to the agreement; and that the agreement
may not be amended without FINRA's prior written consent. In addition,
the account could not be subject to any right, charge, security
interest, lien, or claim of any kind granted by the member.\39\
---------------------------------------------------------------------------

    \39\ In the event of a liquidation of a Restricted Firm, funds
or securities on deposit in the Restricted Deposit Account would be
additional financial resources available for the Restricted Firm's
trustee to distribute to those with claims against the Restricted
Firm.
---------------------------------------------------------------------------

[rtarr8] Books and Records (Proposed Rule 4111(g))
    Proposed Rule 4111(g) would establish new requirements to maintain
books and records that evidence the member firm's compliance with the
Restricted Firm Obligations Rule and any Restricted Deposit Requirement
or other conditions or restrictions imposed under that rule. In
addition, the proposed books and records provision would specifically
require a member firm subject to a Restricted Deposit Requirement to
provide to the Department, upon its request, records that demonstrate
the member firm's compliance with that requirement.
[rtarr8] Notice of Failure To Comply (Proposed Rule 4111(h))
    FINRA also is proposing a requirement to address the situation when
a member firm fails to comply with the obligations imposed pursuant to
proposed Rule 4111. Under proposed Rule 4111(h), FINRA would be
authorized to issue a notice pursuant to proposed Rule 9561 directing a
member firm that is not in compliance with its Restricted Deposit
Requirement, or with any conditions or restrictions imposed under Rule
4111, to suspend all or a portion of its business.
[rtarr8] Definitions (Proposed Rule 4111(i))
    A complete list of defined terms used in proposed Rule 4111 appears
in proposed Rule 4111(i).\40\
---------------------------------------------------------------------------

    \40\ See Exhibit 5.
---------------------------------------------------------------------------

[rtarr8] Net Capital Treatment of the Deposits in the Restricted
Deposit Account (Proposed Rule 4111.01)
    Proposed Supplementary Material .01 would clarify that because of
the restrictions on withdrawals from a Restricted Deposit Account,
deposits in such an account cannot be readily converted to cash and
therefore shall be deducted in determining the member's net capital
under Exchange Act Rule 15c3-1 \41\ and FINRA Rule 4110.
---------------------------------------------------------------------------

    \41\ 17 CFR 240.15c3-1.
---------------------------------------------------------------------------

[rtarr8] Compliance With Continuing Membership Application Rule
(Proposed Rule 4111.02--Compliance with Rule 1017)
    Proposed Supplementary Material .02 would clarify that nothing in
proposed Rule 4111 would alter a member firm's obligations under Rule
1017 (Application for Approval of Change in Ownership, Control, or
Business Operations). A member firm subject to proposed Rule 4111 would
need to continue complying with the requirements of Rule 1017 and
submit continuing membership applications as necessary.
[rtarr8] Examples of Conditions and Restrictions (Proposed Rule
4111.03)
    In a change from Regulatory Notice 19-17, FINRA is proposing to
add, in supplementary material to proposed Rule 4111, a non-exhaustive
list of examples of conditions and restrictions that the Department
could impose on Restricted Firms. FINRA believes that providing these
examples will provide clarity about the Department's authority to
impose conditions and restrictions without restricting the Department's
flexibility to react and respond to different sources of risk. The non-
exhaustive list of examples of conditions and restrictions includes:
(1) Limitations on business expansions, mergers, consolidations or
changes in control; (2) filing all advertising with FINRA's Department
of Advertising Regulation; (3) imposing requirements on establishing
and supervising offices; (4) requiring a compliance audit by a
qualified, independent third party; (5) limiting business lines or
product types offered; (6) limiting the opening of new customer
accounts; (7) limiting approvals of registered persons entering into
borrowing or lending arrangements with their customers; (8) requiring
the member to impose specific conditions or limitations on, or to
prohibit, registered persons' outside business activities of which the
member has received notice pursuant to Rule 3270; and (9) requiring the
member to prohibit or, as part of its supervision of approved private
securities transactions for compensation under Rule 3280 or otherwise,
impose specific conditions on associated persons' participation in
private securities transactions of which the member has received notice
pursuant to Rule 3280.
[rtarr8] Planned Review of Proposed Rule 4111
    FINRA plans to conduct a review of proposed Rule 4111 after gaining
sufficient experience under proposed Rule 4111. Among other things,
FINRA would review whether the Preliminary Identification Metrics
Thresholds remain targeted and effective at identifying member firms
that pose higher risks.
Proposed Amendments to the Rule 9550 Series To Establish a New
Expedited Proceeding To Implement the Requirements of Proposed Rule
4111
    FINRA is proposing to establish a new expedited proceeding in
proposed Rule 9561 (Procedures for Regulating Activities Under Rule
4111) that would allow member firms to request a prompt review of the
Department's determinations under the Restricted Firm Obligations Rule
and grant a right to challenge any of the ``Rule 4111 Requirements,''
including any Restricted Deposit Requirements, imposed.\42\ The new
expedited proceeding would govern how the Department provides notice of
its determinations and afford affected member firms the right to seek a
Hearing Officer's review of those determinations. The proposed
expedited proceeding is similar in nature to FINRA's other expedited
proceedings.
---------------------------------------------------------------------------

    \42\ Proposed Rule 9561(a)(1) would define the ``Rule 4111
Requirements'' to mean the requirements, conditions, or restrictions
imposed by a Department determination under proposed Rule 4111.
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[rtarr8] Notices Under Proposed Rule 4111 (Proposed Rule 9561(a))
    Proposed Rule 9561(a) would establish an expedited proceeding for
the Department's determinations under proposed Rule 4111 to designate a
member firm as a Restricted Firm and impose obligations on the member;
and to deny a member's request to access all or part of its Restricted
Deposit Requirement.
    Proposed Rule 9561(a) would require the Department to serve a
notice that provides its determination and the specific grounds and
factual basis for the Department's action; states when the action will
take effect; informs the member firm that it may file, pursuant to Rule
9559, a request for a hearing in an expedited proceeding within seven
days after service of the notice; and explains the Hearing Officer's
authority. The proposed rule also would provide that, if a member firm
does not request a hearing, the notice of the Department's

determination will constitute final FINRA action.
    Proposed Rule 9561(a) also would provide that any of the Rule 4111
Requirements imposed in a notice issued under proposed Rule 9561(a) are
immediately effective. In general, a request for a hearing would not
stay those requirements. There would be one partial exception: When a
member firm requests review of a Department determination under
proposed Rule 4111 that imposes a Restricted Deposit Requirement on the
member for the first time, the member firm would be required to
deposit, while the expedited proceeding was pending, the lesser of 25%
of its Restricted Deposit Requirement or 25% of its average excess net
capital over the prior year.
[rtarr8] Notice for Failure To Comply With the Proposed Rule 4111
Requirements (Proposed Rule 9561(b))
    Proposed Rule 9561(b) would establish an expedited proceeding to
address a member firm's failure to comply with any requirements imposed
pursuant to proposed Rule 4111.
    Proposed Rule 9561(b) would authorize the Department, after
receiving authorization from FINRA's chief executive officer (``CEO''),
or such other executive officer as the CEO may designate, to serve a
notice stating that the member firm's failure to comply with the Rule
4111 Requirements, within seven days of service of the notice, will
result in a suspension or cancellation of membership. The proposed rule
would require that the notice identify the requirements with which the
member firm is alleged to have not complied; include a statement of
facts specifying the alleged failure; state when the action will take
effect; explain what the member firm must do to avoid the suspension or
cancellation; inform the member firm that it may file, pursuant to Rule
9559, a request for a hearing in an expedited proceeding within seven
days after service of the notice; and explain the Hearing Officer's
authority. The proposed rule also would provide that, if a member firm
does not request a hearing, the suspension or cancellation will become
effective seven days after service of the notice.
    Proposed Rule 9561(b) also would provide that a member firm could
file a request seeking termination of a suspension imposed pursuant to
the rule, on the ground of full compliance with the notice or decision.
The proposed rule would authorize the head of the Department to grant
relief for good cause shown.
[rtarr8] Hearings (Proposed Amendments to the Hearing Procedures Rule)
    If a member firm requests a hearing under proposed Rule 9561, the
hearing would be subject to Rule 9559 (Hearing Procedures for Expedited
Proceedings Under the Rule 9550 Series). FINRA is proposing several
amendments to Rule 9559 that would be specific to hearings requested
pursuant to proposed Rule 9561.
    Hearings in expedited proceedings under proposed Rule 9561 would
have processes that are similar to the hearings in most of FINRA's
other expedited proceedings--including requirements for the parties'
exchange of documents and exhibits, the time for conducting the
hearing, evidence, the record of the hearing, the record of the
proceeding, failures to appear, the timing and contents of the Hearing
Officer's decision, the Hearing Officer's authority, and the authority
of the NAC to call an expedited proceeding for review--and FINRA is
proposing amendments to the Rule 9559 provisions that govern these
processes to adapt them for expedited proceedings under proposed Rule
9561. A few features of the proposed amendments to Rule 9559 warrant
emphasis or guidance.
 Hearing Officer's Authority (Proposed Amended Rule 9559(d) and
(n))
    Hearings in expedited proceedings under proposed Rule 9561 would be
presided over by a Hearing Officer. The Hearing Officer's authority
would differ depending on whether the hearing is in an action brought
under proposed Rule 9561(a) (Notices Under Rule 4111) or 9561(b)
(Notice for Failure to Comply with the Rule 4111 Requirements).
    Proposed amended Rule 9559(n)(6) would provide that the Hearing
Officer, in actions brought under proposed Rule 9561(a), may approve or
withdraw any and all of the Rule 4111 Requirements, or remand the
matter to the Department, but may not modify any of the Rule 4111
Requirements, or impose any other requirements or obligations available
under proposed Rule 4111.
    Proposed amended Rule 9559(n)(6) would authorize the Hearing
Officer, in failure-to-comply actions under proposed Rule 9561(b), to
approve or withdraw the suspension or cancellation of membership, and
impose any other fitting sanction. Authorizing a Hearing Officer to
impose any other fitting sanction is intended to provide a Hearing
Officer with authority that is appropriate for responding to situations
involving member firms that repeatedly fail to comply with an effective
FINRA action under proposed Rule 4111.
 Timing Requirements
    The proposed amendments to the Hearing Procedures Rule are intended
to give member firms a prompt process for challenging a Department
decision under proposed Rule 4111. Proposed amended Rule 9559(f) would
require that a hearing in actions under proposed Rule 9561(a) be held
within 30 days, and that a hearing in failure-to-comply actions under
proposed Rule 9561(b) be held within 14 days, after the member firm
requests a hearing.\43\
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    \43\ Proposed amendments to Rule 9559 contain other related
timing requirements for proceedings pursuant to proposed Rule 9561.
---------------------------------------------------------------------------

    Proposed amended Rule 9559(o) would require the Hearing Officer, in
all actions pursuant to proposed Rule 9561, to prepare a proposed
written decision, and provide it to the NAC's Review Subcommittee,
within 60 days of the date of the close of the hearing. Pursuant to
Rule 9559(q), the Review Subcommittee could call the proceeding for
review within 21 days after receipt of the proposed decision. As in
most expedited proceedings, the timing of FINRA's final decision would
then depend on whether or not the Review Subcommittee calls the matter
for review.\44\
---------------------------------------------------------------------------

    \44\ See FINRA Rule 9559(q).
---------------------------------------------------------------------------

 Contents of the Decision
    Proposed amended Rule 9559(p) would govern the contents of the
Hearing Officer's decision. The proposed amendments would broaden Rule
9559(p)(6) to account for the kinds of obligations that could be
imposed under proposed Rule 4111. Rule 9559(p) would otherwise remain
the same. For example, Rule 9559(p) would continue to require that the
Hearing Officer's decision include a statement setting forth the
findings of fact with respect to any act or practice the respondent was
alleged to have committed or omitted or any condition specified in the
notice, the Hearing Officer's conclusions regarding the condition
specified in the notice, and a statement in support of the disposition
of the principal issues raised in the proceeding.
    Additional guidance may be helpful, considering the different kinds
of issues that may arise in an expedited proceeding pursuant to
proposed Rule 9561. For example, in a request for a hearing of a
Department determination that imposes a Restricted Deposit Requirement
or other obligations under Rule 4111, the principal issues raised may
include whether: (1) The member

firm should not be designated a Restricted Firm; (2) the Department
incorrectly included disclosure events when calculating whether the
member firm meets the Preliminary Criteria for Identification; (3) a
Restricted Deposit Requirement would impose an undue financial burden
on the member firm; or (4) the obligations imposed are inconsistent
with the standards set forth in proposed Rule 4111(e). In a request for
a hearing of a Department determination that denies a request to
withdraw amounts from a Restricted Deposit Account, the principal
issues raised may include whether the member firm or its Associated
Persons have Covered Pending Arbitration Claims or unpaid arbitration
awards and the nature of those claims or awards.
 No Collateral Attacks on Underlying Disclosure Events
    In expedited proceedings pursuant to proposed Rule 9561(a) to
review a Department determination under the Restricted Firm Obligations
Rule, a member firm may sometimes seek to demonstrate that the
Department included incorrectly disclosure events when calculating
whether the member firm meets the Preliminary Criteria for
Identification. When the member firm does so, however, it would not be
permitted to collaterally attack the underlying merits of those final
actions. An expedited proceeding under proposed Rule 9561 would not be
the forum for attempting to re-litigate past final actions.\45\
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    \45\ Attempts to collaterally attack final matters are also
precluded in other FINRA proceedings. Cf. Dep't of Enforcement v.
Amundsen, Complaint No.<PHONE_NUMBER>601, 2012 FINRA Discip. LEXIS 54,
at *21-24 (FINRA NAC Sept. 20, 2012) (rejecting respondent's attempt
to collaterally attack a judgment that was required to be disclosed
on Form U4), aff'd, Exchange Act Release No. 69406, 2013 SEC LEXIS
1148 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C. Cir. 2014);
Membership Continuance Application of Member Firm, Application No.
20060058633, 2007 FINRA Discip. LEXIS 31, at *51 (July 2007)
(holding, in a membership proceeding, that a firm may not address
its and its FINOP's past disciplinary history by collaterally
attacking those past violations) (citing BFG Sec., Inc., 55 SEC.
276, 279 n.5 (2001)); Jan Biesiadecki, 53 SEC. 182, 185 (1997)
(describing, in eligibility proceedings, FINRA's long-standing
policy of prohibiting collateral attacks on underlying disqualifying
events).
---------------------------------------------------------------------------

    If the Commission approves the proposed rule change, FINRA will
announce the effective date of the proposed rule change in a Regulatory
Notice to be published no later than 60 days following Commission
approval. The effective date will be no later than 60 days following
publication of the Regulatory Notice announcing Commission
approval.\46\
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    \46\ FINRA notes that the proposed rule change would impact all
member firms, including member firms that have elected to be treated
as capital acquisition brokers (``CABs''), given that the CAB rule
set incorporates the FINRA Rule 9550 Series by reference. In
addition, FINRA is proposing to adopt CAB Rule 412, to reflect that
a CAB would be subject to Rule 4111.
     The proposed rule change would not impact, however, member
firms that are funding portals. At this time, regulatory experience
with funding portals is still at an early stage. The permissible
business activities of funding portals are limited and, as such, it
is not clear that funding portals present the corresponding risks
that FINRA is seeking to address in the broker-dealer space.
Moreover, developing relevant metrics and thresholds for funding
portals would require a separate effort and analysis because, unlike
broker-dealers, the Uniform Registration Forms do not apply to
funding portals and their associated persons. Accordingly, FINRA is
proposing to amend Funding Portal Rule 900(a) to add proposed Rule
9561 as a rule to which funding portal members would not be subject.
---------------------------------------------------------------------------

2. Statutory Basis
    FINRA believes that the proposed rule change is consistent with the
provisions of Section 15A(b)(6) of the Act,\47\ which requires, among
other things, that FINRA rules must be designed to prevent fraudulent
and manipulative acts and practices, to promote just and equitable
principles of trade, and, in general, to protect investors and the
public interest. The proposed rule change is designed to protect
investors and the public interest by strengthening the tools available
to FINRA to address the risks posed by member firms with a significant
history of misconduct, including firms at which individuals with a
significant history of misconduct concentrate. The proposed rule would
create strong measures of deterrence while a firm is designated as a
Restricted Firm, limiting the potential for harm to the public. It also
should create incentives for firms to change behaviors and activities,
either to avoid being designated as a Restricted Firm or lose an
existing Restricted Firm designation, to mitigate FINRA's concerns.
---------------------------------------------------------------------------

    \47\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change will result in
any burden on competition that is not necessary or appropriate in
furtherance of the purposes of the Act.
    FINRA has undertaken an economic impact assessment, as set forth
below, to analyze the regulatory need for the proposed rulemaking, its
potential economic impacts, including anticipated benefits and costs,
and the alternatives FINRA considered in assessing how to best meet its
regulatory objectives.
Economic Impact Assessment
1. Regulatory Need
    FINRA uses a number of measures to deter and discipline misconduct
by firms and brokers, and continually strives to strengthen its
oversight of the brokers and firms it regulates. These measures span
across several FINRA programs, including review of new and continuing
membership applications, risk monitoring of broker and firm activity,
cycle and cause examinations, and enforcement and disciplinary actions.
    As part of its efforts to monitor and deter misconduct, FINRA has
adopted rules that impose supervisory obligations on firms to ensure
they are appropriately supervising their brokers' activities. These
rules require each firm to establish, maintain and enforce written
procedures to supervise the types of business in which it engages and
the activities of its associated persons that are reasonably designed
to achieve compliance with applicable securities laws and regulations,
and FINRA rules. Under this regulatory framework, FINRA also provides
guidance to ensure consistency in interpretation of the rules and to
further strengthen compliance across firms. As such, all firms play an
important role in ensuring effective compliance with applicable
securities laws and FINRA rules to prevent misconduct. This is
consistent with the incentives of economic agents.\48\
---------------------------------------------------------------------------

    \48\ See, e.g., Roland Strausz, Delegation of Monitoring in a
Principal-Agent Relationship, Rev. Econ. Stud. 64(3):337-57 (July
1997). The paper shows that in a standard principal-agent framework,
the delegation of monitoring by the principal (e.g., a regulator) to
the agent (e.g., a firm) can be economically efficient for both
parties.
---------------------------------------------------------------------------

    Nonetheless, some firms do not effectively carry out these
supervisory obligations to ensure compliance and they act in ways that
could harm their customers--sometimes substantially. For example,
recent academic studies find that some firms persistently employ
brokers who engage in misconduct, and that misconduct can be
concentrated at these firms. These studies also provide evidence of
predictability of future disciplinary and other regulatory-related
events for brokers and firms with a history of past similar events.\49\
These patterns suggest that some firms may not be acting appropriately
as a first line of defense to prevent customer harm. Further, some
firms may take advantage of the fair-process protections afforded to
them under the federal securities

laws and FINRA rules to forestall timely and appropriate regulatory
actions, thereby limiting FINRA's ability to curb misconduct promptly.
Without additional protections, the risk of potential customer harm may
continue to exist at firms that fail to effectively carry out their
supervisory obligations or are associated with a significant number of
regulatory-related events. Further, even where harmed investors obtain
arbitration awards, harm followed by recompense typically comes with
some economic costs to customers and brokers, and firms may still fail
to pay those awards. Unpaid arbitration awards harm successful customer
claimants and may diminish investors' confidence in the arbitration
process.\50\
---------------------------------------------------------------------------

    \49\ See supra note 5.
    \50\ Investors may also file claims in courts or other dispute
resolution forums. Successful claimants in these forums may face
similar challenges associated with collecting awards or judgments.
---------------------------------------------------------------------------

    To mitigate these risks, FINRA seeks additional authority to impose
obligations on firms that pose these types of greater risk to their
customers. The proposed Restricted Firm Obligations Rule would identify
firms based upon a concentration of significant firm and broker events
on their disclosure records that meet the proposed criteria and
specified thresholds. Under the proposal, FINRA seeks to impose
obligations on the operations and activities of the member and its
associated persons that are necessary or appropriate to address the
concerns indicated by the Preliminary Criteria for Identification and
protect investors and the public interest.
2. Economic Baseline
    The economic baseline used to evaluate the economic impacts of the
proposed rules is the current regulatory framework, including FINRA
rules relating to supervision, the membership application process,
statutory disqualification proceedings and disciplinary proceedings
that provide rules to deter and discipline misconduct by firms and
brokers. This baseline serves as the primary point of comparison for
assessing economic impacts of the proposed rules, including incremental
benefits and costs.
    The proposals are intended to apply to 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 regulatory-related events on their records than do
their peers.\51\ Consistent with this, the proposed Restricted Firm
Obligations Rule would specifically apply to firms that have far more
Registered Person and Member Firm Events, or far higher concentrations
of Registered Persons Associated with Previously Expelled Firms,
compared to their peers.\52\ Based on staff analysis of all firms
registered with FINRA between 2013 and 2019, firms that would have met
the Preliminary Criteria for Identification had on average four to nine
times more Registered Person and Member Firm Events than peer firms at
the time of identification. Specifically, the number of events per
firm, for firms that would have met the Preliminary Criteria for
Identification, ranged, on average, from 25-52 events during the
Evaluation Period, compared to 4-5 events per firm for firms that would
not have met the Preliminary Criteria for Identification. The median
number of events per firm, for the firms that would have met the
Preliminary Criteria for Identification, ranged from approximately 9-18
events, compared to zero events among other firms that would not have
met the Preliminary Criteria for Identification.
---------------------------------------------------------------------------

    \51\ As discussed above, recent studies provide evidence of
predictability of future regulatory-related events for brokers and
firms with a history of past regulatory-related events. As a result,
brokers and firms with a history of past regulatory-related events
pose greater risk of future harm to their customers than other
brokers and firms.
    \52\ For example, for each of the six Preliminary Identification
Metrics, the Preliminary Identification Metrics Threshold was chosen
to capture one to five percent of the firms with the highest number
of events per registered broker or the highest concentrations of
Registered Persons Associated with Previously Expelled Firms, in
respective firm-size categories.
---------------------------------------------------------------------------

    Although disciplinary and regulatory-related events are one of the
identifiers for firms posing higher risk, FINRA recognizes that firms
posing higher risks do not always manifest themselves with greater
disclosures on their records. These firms may be newer, have recently
made changes in management, staff or approach, or simply may be more
effective in avoiding regulatory marks.
3. Economic Impacts
a. Proposed Restricted Firm Obligations Rule
    To estimate the number and types of firms that would meet the
Preliminary Criteria for Identification, FINRA analyzed the categories
of events and conditions associated with the proposed criteria for all
firms during the 2013-2019 review period. For each year, FINRA
determined the approximate number of firms that would have met the
proposed criteria. The number of firms that would have met the proposed
criteria during the review period serves as a reasonable estimate for
the number of firms that would have been directly impacted by this
proposal had it been in place at the time. This analysis indicates that
there were 45-80 such firms at the end of each year during the review
period, as shown in Exhibit 3a. These firms represent 1.3-2.0% of all
firms registered with FINRA in any year during the review period. The
population of firms identified by the proposed criteria reflects the
distribution of firm size in the full population of registered firms.
Approximately 88-94% of these firms were small, 4-12% were mid-size and
0-3% were large at the end of each year during the review period, as
shown in Exhibit 3b.\53\
---------------------------------------------------------------------------

    \53\ FINRA defines a small firm as a member with at least one
and no more than 150 registered persons, a mid-size firm as a member
with at least 151 and no more than 499 registered persons, and a
large firm as a member with 500 or more registered persons. See
FINRA By-Laws, Article I.
---------------------------------------------------------------------------

    FINRA notes that the number of firms that would have met the
proposed criteria during the review period have declined (by
approximately 44%) from 80 firms in 2013 to 45 firms in 2019. This
decline is associated with an overall decrease in the number of
Registered Person and Member Firm Events and the number of firms
associated with these events.\54\ Specifically, the Registered Person
and Member Firm Events have declined by 24% and the number of firms
with one or more of these events has declined by 22% during the review
period. However, the average number of events per firm identified by
the proposed criteria has increased, suggesting that there may be an
increase in concentration of events across a smaller set of firms that
may pose greater risks to their customers. For example, the average
number of Registered Person and Member Firm Events for the firms
identified by the criteria has increased by 94% from 24 events per firm
in 2013 to 47 events per firm in 2019. These trends over the 2013-2019
review period suggest that while many firms continue to improve their
regulatory records over time, a small proportion of firms may continue
to further engage in activities that pose greater risks to their
customers, which the proposed rule is intended to address.
---------------------------------------------------------------------------

    \54\ FINRA notes that part of the decline in the number of
events and the firms that would have met the proposed criteria may
be associated with an approximately 15% decline in the overall
number of registered firms during the 2013-2019 review period.
---------------------------------------------------------------------------

    In developing the proposed Preliminary Criteria for Identification,
FINRA paid significant attention to the impact of possible
misidentification of firms, specifically, the economic trade-off
between including firms that are less

likely to subsequently pose risk of harm to customers, and not
including firms that are more likely to subsequently pose risk of harm
to customers. There are costs associated with both types of
misidentifications.\55\ The proposed criteria, including the proposed
numerical thresholds, aim to balance these economic trade-offs
associated with over- and under-identification.\56\ Further protection
against misidentification would be provided by the proposed initial
Department evaluation and the Consultation process.
---------------------------------------------------------------------------

    \55\ For example, subjecting firms that are less likely to pose
a risk to customers to the proposed Restricted Deposit Requirement
or other obligations would impose additional and unwarranted costs
on these firms, their brokers and their customers.
    \56\ In order to evaluate the effectiveness of the proposed
criteria at identifying firms that pose greater risks, FINRA
examined the overlap between the firms that would have met the
Preliminary Criteria for Identification each year during the review
period and the firms that were subsequently expelled, associated
with unpaid awards, or identified by Department staff as suitable
candidates for additional obligations. Finally, as discussed below,
FINRA also examined disclosure events associated with firms that
would have met the Preliminary Criteria for Identification each year
during the review period, subsequent to meeting the criteria, to
assess the extent of risk posed by these firms.
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[rtarr8] Anticipated Benefits
    The proposal's primary benefit would be to reduce the risk and
associated costs of possible future customer harm. This benefit would
arise directly from additional restrictions placed on firms identified
as Restricted Firms and resulting expected increased scrutiny by these
firms on their brokers. Further, this benefit would also accrue
indirectly from improvements in the compliance culture, both by firms
that meet the proposed criteria and by firms that do not. For example,
the proposal may create incentives for firms that meet the Preliminary
Criteria for Identification to change activities and behaviors, to
mitigate the Department's concerns. Similarly, the proposal may have a
deterrent effect on firms that do not meet the Preliminary Criteria for
Identification, particularly firms that may be close to meeting the
proposed criteria. These firms may change behavior and enhance their
compliance culture in ways that better protect their customers.
    The proposal also may help address unpaid arbitration awards. Under
the proposed rule, the Department may require a Restricted Firm to
maintain a restricted deposit at a bank or a clearing firm that agrees
not to permit withdrawals absent FINRA's approval. The amount of the
Restricted Deposit Requirement would take into consideration, among
other factors, the amount of any Covered Pending Arbitration Claims and
unpaid arbitration awards against the member firm or its Associated
Persons. Moreover, the proposed rule would have presumptions that the
Department would: (a) Deny an application by a member firm or former
member firm that was previously designated as a Restricted Firm for a
withdrawal from the Restricted Deposit if the member firm, its
Associated Persons who are owners or control persons, or the former
member firm have any Covered Pending Arbitration Claims or unpaid
arbitration awards, or if the member firm's Associated Persons have any
Covered Pending Arbitration Claims or unpaid arbitration awards
relating to arbitrations that involved conduct or alleged conduct that
occurred while associated with the member firm; but (b) approve a
former member firm's application for withdrawal if the former member
firm 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 firm's specified unpaid arbitration awards. Accordingly,
the proposed rule could potentially create incentives for firms to pay
unpaid arbitration awards against the firm or its Associated Persons,
thereby alleviating, to some extent, harm to successful claimants and
enhancing investor confidence in the arbitration process.\57\
---------------------------------------------------------------------------

    \57\ Further, as discussed above, the Department would consider
a member firm's and its Associated Persons' unpaid arbitration
awards as one of the factors in determining the amount of the
Restricted Deposit Requirement. As a result, there would be
additional incentives to pay unpaid arbitration awards.
---------------------------------------------------------------------------

    To scope these potential benefits and assess the potential risk
posed by firms that would meet the proposed Preliminary Criteria for
Identification, FINRA evaluated the extent to which firms that would
have met the criteria during 2013-2017 \58\ (had the criteria existed)
and their brokers were associated with ``new'' Registered Person and
Member Firm Events after having met the proposed criteria. These
``new'' events correspond to events that were identified or occurred
after the firm's identification, and do not include events that were
pending at the time of identification and subsequently resolved in the
years after identification. As shown in Exhibit 3c, FINRA estimates
that there were 77 firms that would have met the Preliminary Criteria
for Identification in 2013. These firms were associated with 1,552
``new'' Registered Person and Member Firm Events that occurred after
their identification, between 2014 and 2019. Exhibit 3c similarly shows
the number of events associated with firms that would have met the
Preliminary Criteria for Identification in 2014, 2015, 2016 and 2017.
Across 2013-2017, there were 180 unique firms \59\ that would have met
the proposed Preliminary Criteria for Identification, and these firms
were associated with a total of 2,995 Registered Person and Member Firm
Events that occurred in the years after they met the proposed
criteria.\60\
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    \58\ This analysis examines firms that would have met the
Preliminary Criteria for Identification from 2013 until 2017
(instead of the 2013-2019 review period) to allow sufficient time
for the ``new'' events to resolve in the post-identification period.
    \59\ Certain firms would have met the criteria in multiple years
during the review period. The 180 firms discussed in the text
correspond to the unique number of firms that would have met the
criteria in one or more years during the review period.
    \60\ Specifically, FINRA examined and counted all Registered
Person and Member Firm Events that occurred any time after the firms
were identified until December 31, 2019.
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    Exhibit 3c also shows the number of Registered Person and Member
Firm Events for these firms compared to other firms. Specifically,
FINRA calculated a factor which represents a multiple for the average
number of events (on a per registered person basis) for firms that
would have met the Preliminary Criteria for Identification relative to
other firms of the same size that would not have met the Preliminary
Criteria for Identification. For example, as shown in Exhibit 3c, the
factor of 6.1x for 2013 indicates that firms meeting the Preliminary
Criteria for Identification in 2013 had 6.1 times more new disclosure
events (per registered person) in the years after identification (2014-
2019) than other firms of the same size registered in 2013 that would
not have met the Preliminary Criteria for Identification. Overall, this
analysis demonstrates that firms that would have met the Preliminary
Criteria for Identification during the 2013-2017 period had on average
approximately 6-20 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.
[rtarr8] Anticipated Costs
    The anticipated costs of this proposal would fall primarily upon
firms that meet the Preliminary Criteria for Identification and that
the Department deems to warrant further review after its initial
evaluation. Although FINRA would perform the annual calculation and
conduct an internal evaluation, firms may choose to expend effort to
monitor whether they would meet the

Preliminary Criteria for Identification, and incur associated costs, at
their own discretion. To the extent that a firm deemed to warrant
further review under proposed Rule 4111 chooses to seek to rebut the
presumption that it is a Restricted Firm subject to the maximum
Restricted Deposit Requirement, it would incur costs associated with
collecting and providing information to FINRA. For example, these firms
may provide information on any disclosure events that may be
duplicative or not sales-practice related. These firms may also provide
information on any undue significant financial hardship that would
result from a maximum Restricted Deposit Requirement. Likewise, a firm
availing itself of the one-time staffing reduction opportunity incurs
the separation costs, along with the potential for lost future
revenues.
    In addition, firms subject to a Restricted Deposit Requirement or
other obligations would incur costs associated with these additional
obligations. These would include, for example, costs associated with
setting up the Restricted Deposit Account and ongoing compliance costs
associated with maintaining the account. Further, as a result of
restrictions on the use of cash or qualified securities in the deposit
account or other restrictions on the firm's activities, the firm may
lose economic opportunities, and its customers may lose the benefits
associated with the provision of these services.
    Similarly, a firm required to apply heightened supervision to its
brokers would incur implementation and ongoing costs associated with
its heightened supervision plan.\61\ Firms that meet the Preliminary
Criteria for Identification also may incur costs associated with
enhancing their compliance culture, including possibly terminating
registered persons with a significant number of disclosure events--
through exercising the one-time staffing reduction option under
proposed Rule 4111 or otherwise--and reassigning the responsibilities
of these individuals to other registered persons. Finally, there may be
indirect costs, including greater difficulty or increased cost
associated with maintaining a clearing arrangement, loss of trading
partners, or similar impairments where third parties can determine that
a firm meets the proposed Preliminary Criteria for Identification or
has been deemed to be a Restricted Firm.
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    \61\ These costs would likely vary significantly across firms.
Costs would depend on the specific obligations imposed specific to
the firm and its business model. In addition, costs could escalate
if a heightened supervision plan applied to brokers that serve as
principals, executive managers, owners, or in other senior
capacities. Such plans may entail reassignments of responsibilities,
restructuring within senior management and leadership, and more
complex oversight and governance approaches.
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    Firms that do not meet the proposed Preliminary Criteria for
Identification, particularly ones that understand they are close to
meeting the proposed criteria, also may incur costs associated with
enhancing their compliance culture or making other changes in order to
avoid meeting the proposed criteria in the future. These costs may
include terminating registered persons with disciplinary records,
replacing them with existing or new hires, enhancing compliance
policies and procedures, and improving supervision of registered
persons. Finally, registered persons with significant number of
disciplinary or other disclosure events on their records may find it
difficult to retain employment, or get employed by new firms,
particularly where those firms and their associated registered persons
already have disciplinary records. Similarly, firms meeting the
proposed criteria or those close to meeting the proposed criteria may
find it difficult to hire registered persons with disclosure events.
FINRA notes, however, that the anticipated economic impacts on firms
hiring and registered persons seeking employment would likely be
limited to a small proportion of registered persons and member
firms.\62\
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    \62\ For example, during the 2013 to 2019 review period, only
one to two percent of the registered persons had any qualifying
events in their regulatory records, which represents the most
conservative estimate of the set of registered persons who might be
impacted by the proposed rule. 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.
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[rtarr8] Other Economic Impacts
    FINRA also has considered the possibility that, in some cases, this
proposal may impose restrictions on brokers' and firms' activities that
are less likely to subsequently harm their customers. In such cases,
these brokers and firms may lose economic opportunities or find it
difficult to retain brokers or customers. FINRA believes that the
proposal mitigates such risks by requiring an initial layer of
Departmental review, and providing affected firms an opportunity to
engage in a Consultation with the Department and request a review of
the Department's determination in an expedited proceeding.
    FINRA also considered that some firms may consider not reporting,
underreporting, or failing to file timely, required disclosures on
Uniform Registration Forms in an effort to avoid costs associated with
the proposals. However, this potential impact is mitigated because many
events are reported by regulators or in separate public notices by
third parties and, as a result, FINRA can monitor for these unreported
events. Further, failing to timely update Uniform Registration Forms is
a violation of FINRA rules and can result in fines and penalties,
thereby serving as a deterrent for underreporting, misreporting and
failing to file timely required disclosures.
    Considering that the proposed criteria are based on a firm's
experience relative to its similarly sized peers, FINRA does not
believe that the proposed criteria impose costs on competition between
firms of different sizes. Further, because FINRA would perform the
annual calculation to determine the firms that meet the Preliminary
Criteria for Identification, the costs a firm incurs to monitor its
status in relation to the proposed criteria would be discretionary and
not likely create any competitive disadvantage based on firm size.
Although the proposed rule would not impose these monitoring costs,
FINRA would provide transparency around how the Preliminary Criteria
for Identification are calculated and appropriate guidance to assist
firms seeking to monitor their status. Similarly, FINRA does not
anticipate that the proposed Restricted Firm Obligations Rule,
including the Restricted Deposit Requirement or any required conditions
and restrictions, would create competitive disadvantages across firms
of different sizes. This is, in part, because FINRA would consider the
number of offices and registered persons, among other factors, when
determining the appropriate maximum Restricted Deposit Requirement or
any conditions and restrictions, to ensure that the obligations are
appropriately tailored to the firm's business model but do not
significantly undermine the continued financial stability and
operational capability of the firm as an ongoing enterprise over the
ensuing 12 months.
    As discussed above, FINRA would exercise some discretion in
determining the maximum Restricted Deposit Requirement and tailor it to
the size, operations and financial conditions of the firm, among other
factors. This approach is intended to align with FINRA's objective to
have the specific financial obligation be significant enough to change
a Restricted Firm's

behavior but not so burdensome that it would indirectly force it out of
business. In determining the specific maximum Restricted Deposit
Requirement, FINRA would consider a range of factors, including the
nature of the firm's operations and activities, revenues, commissions,
assets, liabilities, expenses, net capital, the number of offices and
registered persons, the nature of the disclosure events counted in the
numeric thresholds, insurance coverage for customer arbitration awards
or settlements, concerns raised during FINRA exams, and the amount of
any of the firm's or its Associated Persons' ``Covered Pending
Arbitration Claims'' or unpaid arbitration awards. In developing the
proposal, FINRA considered the possibility of having a transparent
formula, based on some of these factors, to determine a maximum
Restricted Deposit Requirement. However, as discussed in more detail
below, given the range of relevant factors and differences in firms'
business models, operations, and financial conditions, FINRA decided
not to propose a uniform, formulaic approach across all firms.
    In developing the proposal, FINRA also considered the possibility
that the size of the maximum Restricted Deposit Requirement may be too
burdensome for the firms, and could undermine their financial stability
and operational capability. FINRA believes that these risks are
mitigated by providing affected firms an opportunity to engage in a
Consultation process with FINRA and propose a lesser Restricted Deposit
Requirement or restrictions or conditions on their operations. Further,
as discussed above, Restricted Firms would have the opportunity to
request a review of the Department's determination in an expedited
proceeding.
b. Proposed Expedited Proceeding Rule
    When FINRA imposes obligations on a firm pursuant to the proposed
Restricted Firm Obligations Rule, the firm may experience significant
limitations to its business activities and incur direct and indirect
costs associated with the obligations imposed. The proposed Expedited
Proceeding Rule would, in general, require that these obligations apply
immediately, even during the pendency of any appeal.
    The proposed rule would be associated with investor protection
benefits through the impact of the no-stay provision in proposed Rule
9561(a)(4). Under the proposal, obligations imposed by the Department
would be effective immediately, except that a firm that is subject to a
Restricted Deposit Requirement under proposed Rule 4111 and requests a
hearing would be required to make only a partial deposit while the
hearing is pending. This would reduce the risk of investor harm during
the pendency of a hearing. Similarly, the no-stay provision may limit
hearing requests by firms that seek to use them only as a way to
forestall FINRA obligations.
    The benefit of the proposed rule accruing to firms would be to
permit firms to appeal FINRA's determinations (both to request prompt
review of obligations imposed or of determinations for failure to
comply) in an expedited proceeding, thereby reducing undue costs where
firms may have been misidentified or where the obligations imposed are
not necessary or appropriate to address the concerns indicated by the
Preliminary Criteria for Identification and protect investors and the
public interest. For example, the proposed rule is anticipated to
reduce any undue costs by the proceeding's expedited nature. Similarly,
the proposed rule's time deadlines may also reduce the costs of the
proceedings, in certain cases.
    The costs would be borne by firms that choose to seek review via
the proposed expedited proceeding, and these costs can be measured
relative to a standard proceeding. These firms would incur costs
associated with provisions and procedures specific to this proposed
rule, including the provision that the obligations imposed would not be
stayed.\63\ This would include the obligations imposed under the
proposed rule, including the Restricted Deposit Requirement, and the
requirement that the firm, upon the Department's request, provide
evidence of its compliance with these obligations. However, the extent
of the costs associated with the Restricted Deposit Requirement would
be mitigated by the expedited nature of the proceeding and by the
provision that would require a firm, during the pendency of an
expedited hearing process, to maintain only a partial deposit
requirement.
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    \63\ The effect of the no-stay provision is that imposed
obligations would apply immediately, even during the pendency of any
hearing request. As a result, the no-stay provision would impose
direct costs on misidentified firms or firms for which the
obligations imposed are not necessary or appropriate.
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    As with the other proposals, FINRA does not anticipate that the
proposed rule would have differential competitive effects based on firm
size or other criteria. The costs and benefits are anticipated to apply
to all firms that request a hearing in an expedited proceeding.
4. Alternatives Considered
    FINRA recognizes that the design and implementation of the rule
proposals may impose direct and indirect costs on a variety of
stakeholders, including firms, brokers, regulators, investors and the
public. Accordingly, in developing its rule proposals, FINRA seeks to
identify ways to enhance the efficiency and effectiveness of the
proposed rules while maintaining their regulatory objectives. For