Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Instituting Proceedings To Determine Whether To Approve or Disapprove the Proposed Rule Change To Adopt FINRA Rule 4111 (Restricted Firm Obligations) and FINRA Rule 9561 (Procedures for Regulating Activities Under Rule 4111)

I. Introduction

On November 16, 2020, the Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“Commission”) the proposed rule change SR-FINRA-2020-041 pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 19b-4 thereunder to address the risks that can be posed to investors and the broader market by broker-dealers that have a history of misconduct. The proposed rule change was published for public comment in the Federal Register on December 4, 2020. On January 12, 2021, FINRA consented to extend, until March 4, 2021, the time period in which the Commission must approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether to approve or disapprove the proposed rule change. The Commission is publishing this order pursuant to Section 19(b)(2)(B) of the Exchange Act to institute proceedings to determine whether to approve or disapprove the proposed rule change.

II. Description of the Proposed Rule Change

The proposed rule change would: (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 with withdrawals requiring FINRA's approval, adhere to specified conditions or restrictions, or comply with a combination of such obligations; and (2) adopt 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.

Proposed Rule 4111 (Restricted Firm Obligations)

Proposed Rule 4111 would establish numeric thresholds based on firm-level and individual-level disclosure events to identify member firms with a significantly higher level of risk-related disclosures as compared to similarly-sized peers. Following a multi-step process of evaluating a member firm, FINRA's Department of Member Regulation (“Department”) would be permitted to impose on member firms it determines pose a high risk to the investing public a “Restricted Deposit Requirement,” conditions or restrictions on the member firm's operations that are necessary or appropriate to protect investors and the public interest, or both.

FINRA would conduct the process annually for each member firm, determining whether it should be designated (or re-designated) as a Restricted Firm and whether it should be subject to any obligations. Each member firm that is preliminarily identified based on its firm-level and individual-level disclosure events would have several ways to affect outcomes during subsequent steps in the evaluative process, including a one-time opportunity to terminate registered representatives with relevant disclosure events so as to no longer trigger the numeric thresholds. The member firm would also be able to explain to the Department why it should not be subject to a Restricted Deposit Requirement or propose alternatives that would still accomplish FINRA's goal of protecting investors, and could request a hearing before a FINRA Hearing Officer in an expedited proceeding to challenge a Department determination.

General (Proposed Rule 4111(a))

Under the proposal, any member firm that is designated by the Department as a Restricted Firm would be required to establish a Restricted Deposit Account and maintain within that account deposits of cash or qualified securities with an aggregate value that is not less than the member firm's Restricted Deposit Requirement, except in certain identified situations. Restricted Firms could also be subject to conditions or restrictions on their operations, as determined by the Department to be necessary or appropriate to protect investors and the public interest.

Annual Calculation by FINRA of the Preliminary Criteria for Identification (Proposed Rule 4111(b))

The Department would begin a member firm's Rule 4111 review process by calculating specified “Preliminary Identification Metrics” for that firm across six categories of events or conditions, collectively defined as the “Disclosure Event and Expelled Firm Association Categories.” These six categories include risk events, covering adjudicated and pending actions against firms and their registered representatives, along with metrics addressing registered representatives' termination and internal review history, and their association with former member firms that were previously expelled by FINRA. FINRA would use a formula to identify whether the firm has exceeded certain established thresholds, set based on the firm's size, across the six categories, starting by determining 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 as of the calculation date. Based on this calculation, the Department would determine whether the particular member firm meets the “Preliminary Criteria for Identification.” FINRA has indicated that it developed the criteria and thresholds for identification with the intent to be replicable and transparent to both 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 sales practice concerns.

Initial Department Evaluation (Proposed Rule 4111(c)(1))

The Department would then evaluate whether a member firm that has met the Preliminary Criteria for Identification warrants further review under Rule 4111. This would include consideration of: Whether non-high-risk disclosure events or other conditions should not have been included within the initial calculation of the firm's Preliminary Identification Metric computations (e.g., because, for example, they were not sales-practice related, or include duplicative events involving the same customer and the same matter, or events involving compliance concerns best addressed by a different regulatory response by FINRA); whether the disclosure events pose risks to investors or market integrity, as opposed to violations of procedural rules; and whether the member firm has already addressed the concerns signaled by the disclosure events or conditions, or has altered its business operations such that the threshold calculation no longer reflects the firm's current risk profile. The Department would then either determine that further review is necessary and continue the Rule 4111 process, or, if the Department concluded that no further review is warranted, close out that member firm's Rule 4111 process for the year without imposing any restrictions or obligations.

FINRA originally stated that it would conduct this annual evaluation on the same month and day each year where that date was a business day, and that if that date were a weekend date or federal holiday, the evaluation would shift to the next business day. FINRA has since stated that it would announce the date of the first annual evaluation (“Evaluation Date”) no less than 120 calendar days prior to the first Evaluation Date. Subsequent Evaluation Dates would be on the same month and day each year, whether that date certain falls on a business day, a weekend day, or a holiday.

One-Time Opportunity To Reduce Staffing Levels (Proposed Rule 4111(c)(2))

If the Department determines that a member firm warrants further review under Rule 4111, and such member firm is meeting the Preliminary Criteria for Identification for the first time, the member firm 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 need to identify the terminated individuals to the Department, and would be prohibited from rehiring any of those terminated persons, in any capacity, for one year.

Determination of a Maximum Restricted Deposit Requirement (Proposed Rule 4111(i)(15))

For firms still meeting the Preliminary Criteria for Identification, the Department would then determine the firm's maximum Restricted Deposit Requirement, and the member firm would proceed to a “Consultation” with the Department. FINRA states that the Department would seek to tailor a firm's maximum Restricted Deposit Requirement amount to its size, operations and financial conditions, and determine the member firm's maximum Restricted Deposit Requirement consistent with the objectives of the rule, while not significantly undermining the firm's continued financial stability and operational capability as an ongoing enterprise over the next 12 months.

Consultation (Proposed Rule 4111(d))

During the Consultation, the Department would 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.

A member firm may overcome the presumption that it should be designated as a Restricted Firm by clearly demonstrating that the Department's calculation is inaccurate because, among other things, it considered events that should not have been included. A member firm also may overcome the presumption that it should be subject to the maximum Restricted Deposit Requirement by clearly demonstrating that such an amount would cause significant undue financial hardship, and that a lesser deposit requirement would satisfy the objectives of Rule 4111 to impose obligations on those firms identified as presenting a higher risk to investors; or that other operational conditions and restrictions on the member and its associated persons would sufficiently protect investors and the public interest. To the extent a member firm seeks to claim undue financial hardship, it would bear the burden of supporting that claim with documents and information.

Department Decision and Notice (Proposed Rule 4111(e)); No Stays

After the Consultation, the Department would be required to render a decision, pursuant to one of three paths: (1) If the Department determines that the member firm has rebutted the presumption that it should be designated a Restricted Firm, the Department would not designate the firm as a Restricted Firm that year; (2) 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 would designate the member firm as a Restricted Firm, but would either impose no Restricted Deposit Requirement on the member firm, or require it to promptly establish a Restricted Deposit Account, and deposit and maintain in that account a lower Restricted Deposit Requirement in such dollar amount as the Department deems necessary or appropriate; and would require the member firm to implement and maintain specified conditions or restrictions on the operations and activities of the member firm and its associated persons, as necessary or appropriate, to address the concerns identified by the Department, and protect investors and the public interest; or (3) if the Department determines that the member firm has rebutted neither presumption, the Department would designate the member firm as a Restricted Firm, require it 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 on the firm's operations and activities, and those of its associated persons, as necessary or appropriate to address the concerns identified by the Department and protect investors and the public interest. The Department would provide the member firm with written notice of its decision no later than 30 days from its latest scheduling letter provided to the member firm, stating any obligations to be imposed, and the ability of it to request a hearing with the Office of Hearing Officers in an expedited proceeding.

Continuation or Termination of Restricted Firm Obligations (Proposed Rule 4111(f))

During the Department's annual Rule 4111 review, a Restricted Firm could seek to terminate or modify any obligations that continue to be imposed. Restricted Firms would only be permitted to seek this result during their annual Consultation, and any ensuing expedited proceedings after a Department decision; no interim termination or modification of any obligations would be permitted. A Restricted Firm would not be permitted to withdraw any portion of its Restricted Deposit Requirement, or to seek to terminate or modify any other conditions or obligations that have been imposed, without the prior written consent of the Department.

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 either does not meet the Preliminary Criteria for Identification or should not be designated as a Restricted Firm, 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 in the manner specified under Rule 4111(f)(3)(A), and obtaining the Department's prior written consent for the withdrawal.

In this situation, the Department would be subject to a presumption that it 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. The rule would also 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 or 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.

Books and Records (Proposed Rule 4111(g))

Member firms would also be obligated to maintain books and records that evidence its compliance with Rule 4111 and any Restricted Deposit Requirement or other conditions or restrictions imposed under that rule, that the member firm would need to provide to the Department upon request.

Planned Review of Proposed Rule 4111

FINRA has indicated it intends to conduct a review of proposed Rule 4111 after gaining sufficient experience under Rule 4111 following its effective date. FINRA has indicated that it expects to review, among other items, whether the Preliminary Identification Metrics Thresholds remain targeted and effective at identifying member firms that pose higher risks.

Proposed Rule 9561 (Procedures for Regulating Activities Under Rule 4111) and Amendments to Rule 9559 To Implement the Requirements of Proposed Rule 4111

FINRA is proposing Rule 9561 to establish new expedited proceedings that would: (a) Provide member firms an opportunity to challenge any requirements the Department has imposed, including any Restricted Deposit Requirements, by requesting a prompt review of the Department's decision in the Rule 4111 process; and (b) address a member firm's failure to comply with any requirements imposed under Rule 4111.

Notices Under Proposed Rule 4111 (Proposed Rule 9561(a))

Under proposed Rule 9561(a)(1), the Department would be obligated to serve a notice of its decision following the Rule 4111 process that provides 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 request a hearing in an expedited proceeding within seven days after service of the notice; and explains the Hearing Officer's authority. The proposed rule would also provide that, if a member firm does not request a hearing, the decision will constitute final FINRA action.

Any of the Rule 4111 Requirements imposed in the Department's decision would be immediately effective. In general, a request for a hearing would not stay those requirements. There would be one exception: When a member firm requests review of a Department determination to impose a Restricted Deposit Requirement on the member, the firm would be required to deposit the lesser of 25% of its Restricted Deposit Requirement or 25% of its average excess net capital over the prior year, while the expedited proceeding was pending. This exception would not be available for a member firm that has been re-designated as a Restricted Firm, and is already subject to a previously imposed Restricted Deposit Requirement, which it will need to maintain in full until the Office of Hearing Officers or NAC issues a written decision.

Notice for Failure To Comply With the Proposed Rule 4111 Requirements (Proposed Rule 9561(b))

After receiving authorization from FINRA's chief executive officer (“CEO”), or such other executive officer as the CEO may designate, the Department would be authorized 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. Proposed Rule 9561(b) would establish an expedited proceeding to review the Department's decision to issue a suspension or cancellation notice to a member firm for its failure to comply with requirements of Rule 4111. If a member firm does not request a hearing, the suspension or cancellation will become effective seven days after service of the notice.

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.

Effective Date

If the proposed rule is approved by the Commission, FINRA has indicated it will announce an effective date for the proposed rule in a Regulatory Notice to be published no later than 60 days following the Commission approval. FINRA originally stated that the effective date would be no later than 60 days following publication of the Regulatory Notice announcing Commission approval. However, FINRA has since extended the timeline of the effective date to 180 days after the Regulatory Notice announcing Commission approval.

III. Proceedings To Determine Whether To Approve or Disapprove File No. SR-FINRA-2020-041 and Grounds for Disapproval Under Consideration

The Commission is instituting proceedings to further consider the proposed rule change and the issues raised by commenters.

Specifically, the Commission is providing notice of the following grounds for possible disapproval under consideration:

• Whether FINRA has demonstrated how its proposed rule change is consistent with Section 15A(b)(6) of the Exchange Act, 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.

Under the Commission's Rules of Practice, the “burden to demonstrate that a proposed rule change is consistent with the [Exchange Act] and the rules and regulations issued thereunder . . . is on the [SRO] that proposed the rule change.” The description of a proposed rule change, its purpose and operation, its effect, and a legal analysis of its consistency with applicable requirements must all be sufficiently detailed and specific to support an affirmative Commission finding, and any failure of an SRO to provide this information may result in the Commission not having a sufficient basis to make an affirmative finding that a proposed rule change is consistent with the Exchange Act and the applicable rules and regulations.

For the reasons discussed above, the Commission believes it is appropriate to institute proceedings pursuant to Section 19(b)(2)(B) of the Exchange Act to allow for additional consideration of the issues raised by the proposed rule change as it determines whether the proposed rule change should be approved or disapproved.

IV. Request for Written Comments

The Commission requests that interested persons provide written submissions of their views, data, and arguments with respect to the issues identified above, as well as any other concerns they may have with the proposed rule change. In particular, the Commission invites the written views of interested persons concerning whether the proposed rule change is consistent with the Exchange Act and the rules thereunder.

Although there do not appear to be any issues relevant to approval or disapproval that would be facilitated by an oral presentation of views, data, and arguments, the Commission will consider, pursuant to Rule 19b-4, any request for an opportunity to make an oral presentation.

Interested persons are invited to submit written data, views, and arguments regarding whether the proposed rule change should be approved or disapproved by March 24, 2021. Any person who wishes to file a rebuttal to any other person's submission must file that rebuttal by March 31, 2021. Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form ( http://www.sec.gov/rules/sro.shtml ); or
• Send an email to rule-comments@sec.gov. Please include File No. SR-FINRA-2020-041 on the subject line.

Paper Comments

• Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File No. SR-FINRA-2020-041. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website ( http://www.sec.gov/rules/sro.shtml ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change, that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10:00 a.m. and 3:00 p.m. Copies of such filing also will be available for inspection and copying at the principal office of FINRA.

All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

All submissions should refer to File No. SR-FINRA-2020-041 and should be submitted on or before March 24, 2021. If comments are received, any rebuttal comments should be submitted on or before March 31, 2021.