In May, the U.S. Financial Industry Regulatory Authority (“FINRA”) Board of Governors approved a set of proposals as part of FINRA’s “ongoing initiative to strengthen controls on brokers with a history of significant past misconduct and to ensure greater accountability for firms that choose to employ high-risk brokers.” In a speech before the Georgetown University McDonough School of Business, FINRA’s President and CEO Robert Cook explained that these “bad actors” challenge the fundamental trust that investors and other market participants place in the financial system.

Mr. Cook emphasized that FINRA, as the self-regulatory organization for approximately 3,800 securities firms and more than 630,000 individuals, is responsible for protecting investors from bad actors who seek to evade regulatory requirements and harm investors for their own personal gain. He discussed the newly approved proposals and numerous recent initiatives that serve FINRA’s mission of protecting investors and market integrity.

FINRA’s new requirements

On January 4, 2017, Mr. Cook issued FINRA’s Annual Regulatory and Examinations Priority Letter [PDF] which contained a commitment that FINRA will “devote particular attention to firms’ hiring and monitoring of high-risk and recidivist brokers.” FINRA took a significant step towards making good on this commitment when the Board of Governors approved the set of proposals designed to identify these brokers and enhance tools for disciplinary action, enhanced examinations, and ongoing surveillance. The proposals include:

  1. amending sanctions guidelines to allow adjudicators to consider more severe sanctions when an individual’s disciplinary history includes past misconduct;
  2. amending eligibility rules to toughen requirements for firms hiring high-risk brokers;
  3. amending rules on disciplinary proceedings to include the use of hearing panels, in certain circumstances, in order to restrict the activities of firms and individuals while a disciplinary matter is on appeal;
  4. rearticulating firms’ heightened obligations over high-risk brokers under existing supervision rules including heightened supervisory procedures for brokers in cases where a statutory disqualification request is under review, or the broker is appealing a hearing panel decision;
  5. amending FINRA by-laws to raise the statutory disqualification eligibility application fee for individuals, and enact a new fee for firms to reflect the additional time it takes staff to screen applications;
  6. amending disclosure rules for firms subject to existing requirements in cases where the firm has a specified percentage of registered representatives who were formerly employed by disciplined firms; and
  7. revising the guidelines for reviewing requests of a waiver from FINRA exam requirements to allow for broad consideration of past misconduct of an individual, including arbitration awards and settlements.

FINRA’s focus on risk

In the last few years FINRA has initiated more targeted efforts to better identify and supervise firms and individual brokers who may post the greatest risk of harm to investors – or “high-risk” firms and brokers. Mr. Cook described that a key objective of this targeted program is to ensure that FINRA is using risk based methodology to allocate finite monitoring and examination resources in ways that best protect investors.

Mr. Cook noted that FINRA represents only a part of the larger regulatory framework for the financial industry and therefore it will be necessary for FINRA to coordinate with the SEC and other federal and state regulators to combat the problem.

Mr. Cook described the development of a “risk hierarchy” for firms that would help calibrate “monitoring and examination efforts to the particular firm.” FINRA will focus on key risks such as “sales practices, fraud and deception, and the protection of client assets.” The assessment of risks associated with key personnel is an important element of weighing whether the firm itself should be considered high risk. The risk hierarchy assessment will inform both what FINRA looks for in a particular firm, but also “how frequently” FINRA examines that firm.

With respect to individual brokers, Mr. Cook described the risk model that FINRA has developed that takes into account information derived from a variety of sources, including “regulatory reports from firms and brokers, [FINRA’s] examination program, employment histories, past associations with problematic firms, customer complaints, and any history of informal actions levied by FINRA.” Using the output of this model, FINRA will review an individual’s background more closely, focusing on “aggravating factors such as patterns of behaviour, conflicts of interest, and links to previously disciplined individuals.”

When a firm or individual is identified as high-risk, FINRA begins heightened monitoring and scrutiny. Mr. Cook reported that of the firms assessed as higher risk in the last five years, “more than 40 percent are no longer FINRA members, in many cases because of regulatory action.” In other cases, the firm has taken steps to address FINRA’s concerns, such as by making changes or improvements in personnel, operations, and/or the quality of their supervisory controls, and FINRA has downgraded their risk level. FINRA has also “barred approximately 120 individuals who were identified as high-risk brokers, and more than 420 such individuals are no longer registered with a member firm.”

Mr. Cook announced a goal to “improve our identification efforts and double the number of examinations we conduct in the program this year as compared to 2016.”

FINRA’s appeal to the industry

In a broad appeal to the industry, Mr. Cook asked that firms do their part in ensuring the integrity of the market. He reinforced the priorities laid out in FINRA’s 2017 regulatory and examinations priority letter, suggesting that FINRA will play close attention to issues such as a firm’s hiring practices, monitoring of brokers, improvement of supervisory systems and investigation of red flags. Mr. Cook promised that additional guidance will be issued in the future to help firms with these issues. He concluded that it is “imperative that broker-dealers continue to work with us to reduce the risk of misconduct and ensure that investors can have confidence in their investment professionals.”

By proposing to give wider latitude to adjudicators to impose tougher sanctions, raising fees and firm obligations, and enhancing disclosure, FINRA is extending the current regulatory framework, which will have costs and consequences for brokers and firms. The industry’s response to FINRA’s initiatives will be revealed in submitted comments to FINRA’s latest proposals.

Implications for Canadian industry

Given Canada’s proximity to the United States, and the interconnectedness of our capital markets with our southern neighbour, regulatory trends and directions inevitably influence those in Canada. Canada’s national self-regulatory organization, the Investment Industry Regulatory Organization of Canada (“IIROC”), has already been urged by their overseeing Canadian securities regulators to enhance its oversight efforts. We will watch how the impact these trends have on IIROC, if any.