Jonathan Henschen, founder of the recruiting firm Henschen & Associates, recently tried to place an advisor client at a broker/dealer. But the candidate had two FINRA disclosures on his record. One related to a customer complaint around sales of his b/d’s auction rate securities, and the firm had paid the fine. The second was a decade-old complaint related to the rep’s sale of a variable annuity, which resulted in a fine of under $10,000.
“Normally this would be a nonevent at most broker/dealers, but this firm surprisingly passed on pursuing the prospect,” Henschen said. “If someone with a largely uneventful compliance history is getting rejected, there are many advisors with more recent and greater frequency of disclosures that may not be able to find a home at all, being forced to go RIA and/or do fixed insurance only.”
Until recently, registered reps with only a few disclosures on their records could easily find a home at a broker/dealer to hang their license. But those days may be coming to an end, due to the Financial Industry Regulatory Authority’s Rule 4111, which went into effect Jan. 1, 2022.
FINRA’s new rule requires broker/dealers that the regulator determines pose the greatest risk to investors to set aside funds in a dedicated account to meet future FINRA fines, including potential unpaid arbitration awards.
Firms are deemed “restricted” based on numeric thresholds across six conditions. Those include pending and adjudicated disclosure events for registered individuals or firms, as well as terminations and affiliations with registered persons from previously expelled firms.
In July, the regulator gave each firm access to its own Rule 4111 report, and those that are on the preliminary list are in the “funnel” process, according to a FINRA spokesman. That includes a deeper scrutiny to determine whether some disclosures should not have been included in the regulator’s calculations. Firms also have a 30-day period to fire high-risk advisors in order to bring their risk number below the numeric threshold. They’ll then go through a consultation with regulators before a decision is made.
FINRA does not specify how much restricted firms will need to set aside, but it will depend on 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, unpaid arbitration awards or unpaid settlements related to arbitrations."
Firms will be reviewed on an annual basis, and their restricted status may soon be made public. FINRA filed a proposal with the Securities and Exchange to release this information on BrokerCheck. The SEC has until Sept. 15 to decide.
Broker/dealers don’t want to end up on FINRA’s list, especially one that would be made public, so many are taking steps to avoid it, say recruiters and compliance officers. Many firms are becoming more reluctant to bring on advisors with even relatively minor compliance disclosures, while others are encouraging expungements, although FINRA is cracking down here as well. Some say it’s pushing smaller firms to consolidate or sell to larger ones.
“To stay off the FINRA Leper List, many of the broker/dealers with higher concentrations of problematic advisors may be forced to shed many of them to bring down levels to industry averages,” Henschen said. “We will look back in 2-3 years and see the coming months as the ‘Great FINRA Purge.’ 41-11 will only amplify the advisor shortage and cause a further decline in the number of broker dealers.”
The numbers of FINRA registered reps and b/ds have been on the decline since 2006. Just in the last year, from 2020 to 2021, the number of b/ds declined 1%, and the number of reps dropped about 0.8%.
The Impact to Smaller Firms
According to data released by FINRA, just 1.3% of all member firms met the preliminary criteria for identification on the restricted firm list as of 2019. But smaller b/ds, in particular, may be at a disadvantage. FINRA identified 45 member firms for the list in 2019, 40 of which were small b/ds with no more than 150 reps. Five were midsize firms, and there were no large b/ds.
Jennifer Szaro, chief compliance officer of XML Financial Group and XML Securities and a member of FINRA’s small firm advisory committee, said Rule 4111 has been an area of concern raised by her peers on the committee. One fear is that good firms get swept up into the rule. Being on the restricted list can have damaging effects, she said, not just from a regulatory standpoint, but also with clearing firms and other vendors the b/ds work with.
“We want to make sure that it's really handled for the firms that it's intended to, and the activity that it's intended to address, and not for good firms to get caught up into that and really have such negative consequences and ramifications,” Szaro said. “I think it will affect hiring decisions because if you were to hire people with certain checkpoints that would increase your matrix, that's a consideration. So I think you're going to see people scrutinizing anyone with records or their past history.”
Firms are also concerned that the standards to stay off the list get revised ever upward as firms on the restricted list close or consolidate.
“Is that going to reset the matrix? In which case that's problematic,” Szaro said. “You're always going to have someone in the class getting the lowest score. That doesn't mean they should be moved out of the industry. I think that's something for the industry to keep our eyes on to make sure that it's not exceeding the authority or exceeding the intent of it.”
Dochtor Kennedy, president and founder of AdvisorLaw, a law firm that represents advisors and wealth managers, said most smaller firms can’t afford to put the extra money aside, so they’ll be significantly affected. These firms will have to weigh their options between mass firings or possibly merging with another b/d. When deciding which reps to terminate, they’ll likely weigh the number of disclosures versus the rep’s profitability to the firm, he said.
“The deeper they are in the danger zone, the more people that they're actually going to have to get rid of and the more it's going to impact them,” he said. “And I think it's going to be very meaningful for those smaller firms. I think it might lead to consolidation, not in the proactive way, but more so in the, ‘Well, we don't have a choice now. We don't have enough of the profit to continue.’ They get a great deal and roll them into something else like a little bit cleaner shop where the impact of those disclosures is heavily diluted.”
Henschen says the rule may have motivated the recent merger between National Securities to merge with B. Riley.
“National Securities is likely to fall under Rule 4111 or at best close to being under it,” Henschen said. “If they meld the two firms together (B. Riley with good compliance and National with poor compliance), the blending would raise their rankings on the different criteria gauged to an improved status for the National side.”
A spokesperson for B. Riley did not respond to a request for comment by press time.
The Impact on Recruiting
Both Kennedy and recruiters say they’ve seen firsthand that broker/dealers are tightening up their recruiting practices in the last year, more heavily scrutinizing the brokers they bring on.
“We had folks come to us and say, ‘I was in conversations with these three places. Everything was going great. But two of them shied away because of the two or three customer complaints or the customer complaints and the U5, I have.’ And that has to be driven somewhat by the fact that they're being measured based on public disclosures per rep,” Kennedy said.
Kennedy expects a lot of reps will be on the market looking for a new home, and that will have a downward impact on recruiting packages and payouts, particularly to advisors with disclosures, since these reps will no longer have as much bargaining power. Larger firms may be able to afford to bring on some of these reps without affecting their restricted status. But they’ll likely just offer them smaller deals.
“Some folks will end up finding a new way to make a living, but those who stay in the industry, it's not going to be as rosy because they're going to get cut down a few notches,” he said.
Recruiters argue that not all disclosures are created equal, and that there are nuances involved in any situation.
Jodie Papike, president of Cross-Search, a third-party recruiting firm, said she works with a number of quality advisors with minor blemishes, caught up in accusations or client complaints that don’t reflect the whole story.
“A customer complaint could come out of anyone feeling any certain way about an advisor, and it does not mean that the advisor did something wrong,” she said.
She gave an example of a recent advisor who had a pending customer complaint about a 6% market loss, when most everyone else is losing between 15% to 25%.
“The problem in our industry is that not only are you looked at as guilty until you’re proven innocent, but even when you’re proven innocent—sometimes firms decide to settle on things just because they don’t want to go through the time and expense of fighting something. You may still be viewed as guilty of doing something, just because a firm settled something, for example, but you may not have done anything wrong,” she said.
Papike argues the new mandate is another example of FINRA getting heavy-handed and making things more difficult for broker/dealers to operate.
“Take a midize firm that was doing a good job, has quality advisors. They could take on an advisor that maybe had a ding or two because they understood the other side of the story and they trust an advisor. Or maybe they’re going to get the advisor in a better situation,” she said.
“But now because the regulators are making these sweeping regulations that just put an advisor in a box.
Henschen said there are lot of things on reps’ records that are frivolous, such as complaints that were dismissed or no action taken.
“Those things should roll off a record,” he said. “You can sue anyone, but do you have a leg to stand on? You can do a customer complaint on any rep, but anything that goes on there, it goes on their record, and you have to pay $15,000 or so to get that expunged off their record.”
Sander Ressler, managing director of Essential Edge Compliance Outsourcing Services, said he’s seen an uptick in the number of cases where he’s brought in as an expert witness on U5 disputes, the form that’s filed when an individual leaves a broker/dealer. For the first seven to eight years of his expert witness practice, he did zero U5 cases; in the last year and half, he’s done a dozen.
“I can easily extrapolate that the reason I’m being hired as an expert witness in those cases is because more people are challenging their U4 disclosure and trying to get them expunged to clean up their record,” Ressler said.
Ressler said he’s typically brought in to help a rep get this disclosure modified, rather than expunged.
“Sometimes I would say that the reporting could be a bit retaliatory,” he said. “And where it’s retaliatory, I can come in and say, ‘You know, while there’s a genuine issue here, I would have reported it this way, which would have much less effect on his career than the way the firm reported it.’”
“They’re trying to present the best face to the regulators and to the public as they can through the available means. And I’m not sure for a long time they really cared, because the regulators weren’t really targeting people with a large number of complaints. And clients don’t really use BrokerCheck. So it wasn’t an imperative to spend $5,000 to $10,000 on a lawyer to clean up your record.”
To be sure, XML’s Szaro says broker/dealers will have the opportunity to talk to FINRA about the nuances of those disclosures during the internal evaluation phase, before the final determination. And firms have an opportunity now to see where they stand through FINRA Gateway.
“The industry said, ‘Look, you can't just go by data. There's always more to the story.’ So a conversation needs to be had and firms clearly understand all of the metrics before a firm is ever placed as a restricted firm identified as such because that in essence could kill their business. So I believe they did bake that into the process.”