The Financial Industry Regulatory Authority, the self-regulating watchdog of brokerages, opened a new front on rogue brokers last month when it scored the SEC’s blessing to weed out “high risk firms” where advisors cheat investors.
If FINRA’s analysis of recent history is a guide, “high risk” would exclusively mean small and mid-sized brokerages.
By contrast, Wall Street’s powerhouses, including Bank of America’s Merrill Lynch, LPL Financial, Raymond James and Ameriprise Financial, would be unlikely to acquire a scarlet letter under FINRA’s new rule.
Either way, the investing public wouldn’t immediately know. And loopholes in its new rule can allow firms flagged early on to eventually avoid the label entirely.
Inching toward disclosure
Industry-funded FINRA, whose primary mission is to protect investors, initially didn’t propose disclosing the names of “high risk” firms to the public. After backlash from critics, it wrote in a July 20 letter to the SEC that it would ask the Commission to approve its separate effort to enter a red-letter “restricted firm” status for brokerages deemed “high risk” on their BrokerCheck profiles.
Wall Street’s self-regulator has long been criticized for not doing enough to detect and discipline recidivist brokers who pile up securities-law violations and complaints from investors. FINRA perennially battles sketchy salesmen who peddle variable annuities and private or unregistered securities to elderly or unsophisticated consumers without proper disclosures or required regard for their risk tolerance. Not just smaller firms are offenders: Convicted swindler Bernie Madoff, a fiduciary advisor and former vice chairman of the National Association of Securities Dealers (NASD), FINRA’s precursor, ran a $65 billion Ponzi scheme before being busted in 2008.
Under FINRA’s new rule, called 4111, the watchdog will scrutinize the more than 3,400 firms it regulates and their 624,000 brokers each year for signs of bad behavior, including cold-calling vulnerable customers and disciplinary and legal actions. Brokerages branded a “restricted firm” can be forced to set aside money to pay restitution to swindled investors and potentially be on track toward expulsion.
FINRA says its new rule will “address the risks of firms with a significant history of misconduct, including firms with a high concentration of individuals with a significant history of misconduct.” Alma Angotti, a partner at consulting firm Guidehouse, says the rule will help weed out bad actors, because FINRA’s lengthy examination and disciplinary processes mean it takes time to rein in offenders and examiners can’t force a rogue firm to change.
“Now they can restrict business before enforcement action,” says Angotti, a former senior enforcement official at FINRA, the SEC and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN).
But critics say the rule falls short of protecting investors amid a steep rise in consumer complaints against advisors and brokerages.
“This is a cumbersome, vague and inherently weak way to get at the problem of incorrigible brokers,” says Stephen Hall, the legal director and securities specialist at Better Markets, a nonprofit that pushes for consumer protection on Wall Street. The SEC said in a July 30 statement about the rule that the agency “will evaluate whether additional steps may be needed to address recidivist firms and brokers.”
A nongovernmental entity, FINRA is overseen by the SEC, the government’s regulator of securities markets, including broker-dealers that sell securities and registered investment advisory (RIA) firms. The Wall Street watchdog tracks both brokers and independent investment advisors through its BrokerCheck system. Brokers, who work on commission, are required to act in a client’s best interest, a lower standard than the fiduciary rule that governs independent advisors, who operate on a fee basis.
FINRA is routinely faulted by critics for not disclosing more information about the brokerages it sanctions. The self regulator barred or suspended fewer brokers in 2020 than in the prior four years. Likewise, the number of firms it suspended or expelled was a fraction, sometimes tiny, of the numbers over 2016–2018.
FINRA’s new rule comes amid evidence that advisors can behave badly. A 2016 academic study of pure brokers and their cousins, advisors at hybrid broker-dealer/RIA firms, found that 7% of all advisors have misconduct records. The study also found that more than one in seven financial advisors at Oppenheimer & Co., Wells Fargo Advisors Financial Network and First Allied Securities, all large brokerages, had engaged in past misconduct. At Goldman Sachs and Morgan Stanley, the study said, the ratio was less than one in one hundred.
What’s more, the study said, one in three advisors with misconduct records are repeat offenders and five times as likely to engage in new misconduct as the average clean advisor. California, Florida and Arizona were deemed hotspots for bad brokers.
The Wall Street Journal, which has reported extensively in prior years on FINRA’s shortcomings, found in 2014 that unbeknownst to the watchdog, at least 38,400 brokers that year had regulatory or financial red flags that appeared only on state records. Of those, at least 19,000 had spotless BrokerCheck records.
Mark Egan, a Harvard Business School professor and one of the authors of the 2016 study, says that bad brokers are roughly evenly split between Wall Street wirehouses and hybrid RIAs with broker-dealer services.
But regardless of where they work, misconduct records can be erased from BrokerCheck.
“FINRA is looking at the regulatory record, but with expungements, a lot of bad brokers are getting their records clean,” says securities lawyer David Meyer, a director and officer at the Public Investors’ Arbitration Bar Association (PIABA), which represents investors in securities arbitrations. “A lot of bad brokers are having their records expunged, so FINRA’s not going to get a complete picture” with the new rule.
Shift to focus on firms, not individuals
The watchdog’s “high risk firms” initiative appears to mark a sea change away from focusing on individual bad brokers toward scrutinizing the firms they work for. Recidivist salesmen often bounce from one brokerage to another, a job-hopping move known in the industry as “cockroaching.” A 2021 academic study found that “wandering financial advisors” with records of misconduct “disproportionately” end up working as salesmen under highly-fragmented state insurance laws, where they can go undetected.
FINRA argues that the threat of the scarlet-letter “high risk” label will “incentivize” bad brokers to clean up their acts. Under the rule, tarred brokerages can be required to set aside cash or securities in a segregated account to pay investors should the firm be found to have cheated investors.
“I predict this will be the death blow for small broker-dealers,” securities lawyer Max Schatzow of law firm Stark & Stark tweeted earlier this month. “New FINRA Rule 4111 is intended to identify bad BDs and publicly shame them. Make them keep money in escrow. Hope is to incentivize better behavior. Lolz. You ever spend time on Broker Check???”
But if the “restricted firm” label isn’t immediately public, is the incentive there? “A firm’s restricted status should be publicized and readily available to the public,” Better Markets’ Hall says. What if a brokerage trips the “high risk” threshold but avoids the label? FINRA’s July 20 letter doesn’t say that the watchdog would tell investors or state regulators.
Under the rule, FINRA will scrutinize member firms annually by conducting a proprietary statistical analysis of their prior disclosure events over the past five years, including regulatory actions, customer arbitrations and lawsuits involving brokers. Through a process it calls “the funnel,” the watchdog will use a formula, with six categories, to identify whether a firm has exceeded certain thresholds, based on the firm’s size, for each of the six categories of events or conditions.
The categories cover brokers who:
- Have been disciplined by a regulator, court or arbitration panel.
- Have “pending events” filed against them in a civil court for an investment-related matter, by any regulator or by a criminal court.
- Have been terminated after an internal review by their employer uncovered fraud, securities or investment infractions or violations of industry-conduct standards.
- Have been registered with a brokerage for at least one year that was expelled by FINRA in the past five years.
On the firm level, the remaining two categories cover brokerages that have been through or are undergoing adjudication, and that have “pending events.”
The rule appears to have loopholes. For brokers and brokerages, “pending events” don’t include pending arbitrations, pending civil litigations or customer complaints that are reportable on Uniform Registration Forms. Settlements ordered through arbitration or civil courts that aren’t at least $15,000 are also excluded.
By not including smaller awards in the metrics and not forcing payment of unpaid judgments, some in the millions of dollars, FINRA is missing the boat, PIABA’s Meyer says. “Maybe 1% of firms would qualify as restricted, but we’ve got 25—30% of arbitration awards that go unpaid. This rule does nothing to solve the problem.”
The road to ‘restricted’ status
Firms that trip an unspecified numeric threshold based on FINRA’s score of the six factors would start down a trail of options to avoid being labeled a “Restricted Firm.”
A brokerage with the new black mark can challenge the unflattering designation or make it disappear altogether by firing employees, even honest ones — a move that can let it avoid crossing one metric that ranks firms against their peers according to size. Brokerages can’t rehire the terminated employees for at least one year. Firms forced to pony up a deposit can argue that it should be reduced if it would cause “significant undue financial hardship.”
“The rule is a convoluted data-crunching process which has a quantitative quality on the front end, but it very quickly gets lost in vague standards and subjective judgments,” says Better Markets’ Hall. The main squishy area: the rule’s focus on firms with what FINRA calls “outlier-level risks” that tip it into the “high risk” threshold. “I’m still trying to figure it out,” Hall says.
A FINRA spokesperson referred all questions to the nearly 600 pages of the new rule.
Mid-sized brokerages most at risk
It sounds dramatic. But Wall Street’s largest brokerages, including Fidelity Investments, JPMorgan Securities, Charles Schwab and Morgan Stanley’s E-trade, may be unlikely to get tarnished by the new rule, which was first proposed in 2019. Meanwhile, smaller and mid-sized firms may be more likely to fall in FINRA’s crosshairs. “It’s signaling to the smaller firms,” says Brian Rubin, the head of Eversheds Sutherland’s SEC, FINRA and state securities enforcement practice.
One line of thinking may be that larger firms typically have more robust internal controls and monitoring compared to smaller firms. At big firms, “the likelihood of a rogue broker escaping the due diligence checks is relatively lower,” says Ken Joseph, the head of Kroll’s Americas financial services compliance and regulation practice. Angotti says that big firms “tend to be more conservative in who they hire.”
But larger brokerages aren’t without blemishes. A 2016 study by the Securities Litigation & Consulting Group, a firm in Fairfax, Virginia, that provides expert witnesses for cheated investors, ranked brokerages with at least 400 advisors by their “investor harm rate,” with Oppenheimer & Co, UBS Financial Services and First Allied Securities each scoring above 10%.
“Look at Merrill Lynch,” wrote securities lawyer Alan Wolper in 2019, the year FINRA first proposed its rule. “Its BrokerCheck report shows that it has managed to garner 1,434 disclosures, 559 of which are “Regulatory Events,” five “Civil Events” and 870 arbitrations.” Wolper is a former regional director at FINRA’s pre-2007 predecessor NASD.
FINRA’s ‘high risk’ data
The tale of two brokerage worlds under the new FINRA rule emerges in the watchdog’s analysis of seven years of data through 2019 that it crunched under its new vetting process.
Over 2017 through 2019, no large brokerages, meaning those with 500 or more registered brokers, would have met the “preliminary” criteria that could lead them to eventually be labeled “high risk.”
Only one large brokerage would have raised an early red flag over 2014 through 2016 in FINRA’s new system. In 2013, the watchdog’s first year of analysis using its new criteria, only two large firms would have tripped into the “high risk” threshold.
By contrast, mid-sized brokerages with 151 to 499 registered brokers are the most likely to be labeled “high risk.” Five out of 198 mid-sized firms, or 2.5%, would have met the preliminary criteria in 2019. In 2018, the percentage was 3.6%, the peak of the period FINRA cited.
Small brokerages are the second most likely to garner the new red-flag label. Some 40 firms out of the 3,156 that FINRA oversees, or 1.3% tripped their threshold in 2019. In 2014, the peak, the trip rate was 2%.
Those statistics may not square entirely with academic data. “At some firms, more than 15% of advisors have a past record of misconduct,” says Egan, whose research shows that recidivist brokers are five times as likely to engage in new misconduct as the average financial advisor. But he adds, “this is true across firms of all sizes.”
Critics insist the rule doesn’t go nearly far enough in threatening firms that engage in abusive tactics, and that miscreants should have a much shorter plank to walk.
“Wolf pack firms love to hire incorrigible brokers and prey on seniors,” says Better Markets’ Hall. “FINRA could say, ‘we’re going to expel these firms’, not just rearrange the furniture.”