The Securities and Exchange Commission approved a Financial Industry Regulatory Authority rule late last week designed to rein in broker-dealers with a history of sales abuses by forcing them to set aside money in an account that could be used only to pay regulatory arbitration awards and regulatory penalties.

The new rule grants Finra the authority to impose financial reserve requirements on broker-dealers that present the greatest risk to investors. Only Finra will be able to authorize withdrawals from the reserve account.

“Kudos to Finra and the SEC for finally curtailing high-risk brokers and firms from ‘cockaroaching,’ an industry term that means firms get into a lot of trouble, then shut down to avoid paying arbitration awards and restitution before starting back up under another name,” Adam Gana, a NYC-based securities arbitration attorney and professor at New York Law School told Financial Advisor magazine.

Gana said in his two decades of representing aggrieved investors, “We have won many arbitration awards only to see the firm shutter its doors to avoid paying investors. It’s devastating to clients. Now there will actually be money for arbitration awards. The new rule tells firms shape up or ship out,” he added. 

The SEC said the new rule “will address the risks that can be posed to investors by broker-dealers and their associated persons with a history of misconduct. The proposal would impose new obligations on broker-dealers with significantly higher levels of risk-related disclosures (including, notably, sales-practice related disclosure events) than other similarly sized peers based on numeric, threshold-based criteria.”

At least some of the damages that are awarded to aggrieved investors in 30% of arbitration awards are currently unpaid, according to Finra.

Specifically, the rule uses numeric thresholds based on six conditions including pending and adjudicated disclosure events for registered individuals or firms, terminations and affiliating with registered persons from previously expelled firms to determine if a firm should be categorized as restricted.

Finra will determine what a restricted firm’s deposit requirement should be based on the firm’s size, operations and financial conditions.

As both Finra and the SEC have said, a small percentage of firms cause the most harm to investors. Just 1.3% of all member firms met the preliminary criteria for designation as a restricted firm as of 2019, according to Finra data. That includes just 1.3% of small firms, 2.5% of midsize firms and 0% of large firms.

As a requirement of the rule, Finra will assess member firms each year to see whether they should be designated or redesignated as a restricted firm.

Firms that are designated as high risk will have a onetime opportunity to fire high-risk advisors within 30 days of receiving notification, which will allow them to fall below the numeric threshold for a financial reserve. Firms will not be allowed to rehire any person it fires in the process for at least one year. During the evaluation process, member firms can make the case that they should not be considered for restriction and financial reserve requirements.

A member firm can overcome the presumption that it should be designated as restricted “by clearly demonstrating that the department’s calculation is inaccurate because, among other things, it considered events that should not have been included,” according to the rule.

A firm may also 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 … 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,” the rule states.

Finra told the SEC last July that it also plans to propose an amendment that would require firms to disclose their restricted status on BrokerCheck.

The SEC also greenlighted Finra’s ability to share its list of restricted firms with state regulators.

The rule is slated to go into effect 180 days after Finra issues a regulatory notice to members announcing the SEC’s approval.