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Bates Research  |  07-27-17

FINRA President and CEO Sets Forth Comprehensive Bad Actor Initiative


This is the second installment in our ongoing look at FINRA’s efforts to address high risk brokers, also referred to by FINRA as “bad actors.”  As described in a previous Bates news item,  FINRA’s Board of Governors recently approved a set of proposals to identify high risk brokers and enhance tools for disciplinary actions, examinations and ongoing surveillance.

In a speech before the Georgetown Center for Financial Markets and Policy, FINRA’s President and CEO Robert Cook set forth the self-regulatory agency’s comprehensive approach to existing and developing programs and practices to protect investors and markets from bad actors. In his speech, Mr. Cook expounded on the agency’s operational experience, provided supporting data for its actions, and delved into the rationale that gave rise to those proposals. The approved proposals and numerous recent initiatives are intended to supplement and augment the regulatory practices and operations currently in place.

Mr. Cook explained that the developing regulatory framework is influenced by the FINRA360 initiative. That multi-year initiative has been described as an “exercise, focused on creating an organization that is committed to continuous improvement.” The Georgetown speech painted a picture of FINRA as an organization with the analytic tools, a deepening pool of relevant data, and the necessary leadership focus to tackle the issue of bad actors. Mr. Cook explained that bad actors challenge the integrity and trust critical to the success of the financial services industry in general, and the broker-dealer marketplace in particular. Because FINRA represents a part of the larger regulatory framework, it will be necessary to coordinate with the SEC and other federal and state regulators to combat the problem, he said.

The FINRA Approach to Bad Actors: An All-Out Effort

Mr. Cook defined FINRA’s comprehensive approach to dealing with bad actors in terms of process. His speech covered the cycle of a broker-dealer’s engagement with regulators: from licensing and registration to monitoring,  examination and finally enforcement, including discipline and restitution. He shared that these processes have “matured” over time and that each intersection in the cycle provides an opportunity to identify problems and to serve as a “basis for action against many bad actors, including firms and brokers.”

Beyond cycle events, Mr. Cook noted additional tools FINRA uses which contribute to the overall effort to address this issue, such as extensive investor education, trading surveillance in the equity and fixed income markets, and the use of risk-based methodologies “to allocate [the agency’s] finite monitoring and examination resources in ways that will best protect investors.” That said, Mr. Cook’s central thesis is that the answer to the bad actor problem is to “further augment these long-standing regulatory programs” by “initiat[ing] more targeted efforts to better identify and supervise those firms and individual brokers who may pose the greatest risk of harm to investors.”

FINRA: Focused On Risk

FINRA is making a significant effort to enhance the identification and subsequent targeting of high-risk firms. Mr. Cook described the development of a “risk hierarchy” that would “help calibrate” monitoring and examination efforts around any particular firm. As he shared, FINRA focuses on certain key risks including “sales practices, fraud and deception, and the protection of client assets.” The impact of this effort is significant; it affects “whether the firm itself should be considered high risk” and, “how frequently” the firm will be examined. The initiative also extends to the branch office examination program to better determine which firms and which network of branches may present the greatest risk. Mr. Cook reported that of the firms assessed, “more than 40 percent are no longer FINRA members, in many cases because of regulatory action.” Other firms have responded to their high risk designation by taking remedial steps to address the concerns leading to that designation.

Regarding individuals, FINRA initiatives involve the use of risk models that take into account “a range of quantitative [through BrokerCheck] and qualitative information regarding [the background of] a particular broker.” The information used is derived from regulatory reports by firms and brokers, the examination program, “employment histories, past associations with problematic firms, customer complaints, and any history of informal actions levied by FINRA.” The ability to collate this information allows FINRA to assess “an individual’s background more closely, focusing on aggravating factors such as patterns of behavior, conflicts of interest, and links to previously disciplined individuals.”

Striking the Right Balance: Ensuring Due Process

While lauding the success of this approach–almost 120 brokers have been barred, and 420 individuals are no longer registered with a member firm as a result–Mr. Cook expressed concern regarding allegations of FINRA overreach. These concerns, for example, led to the decision not to publish the names of high-risk firms and brokers and also the protection of information related to internal risk assessment. He went out of his way to convey this balance:

“On the one hand, I share the desire to be aggressive in this space and to address recidivist misconduct promptly—and we need to make sure we are doing all we can. On the other hand, like other regulators, FINRA does not—and should not—have unfettered discretion. Formal action to bar or suspend a broker requires satisfying procedural safeguards established by federal law and FINRA rules to prevent enforcement overreach by regulators (including FINRA) and to protect the rights of brokers to engage in business unless proven guilty of serious misconduct.”

Having said that, Mr. Cook then 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.”

An Appeal to FINRA Members

In a broad appeal to member firms, Mr. Cook asked that they play their part in ensuring the integrity of the market. He called on firms to review their hiring practices, monitor their brokers, improve their supervisory systems, and investigate red flags. He reinforced the priorities laid out in his 2017 exam priorities letter, suggesting that FINRA will pay close attention to their conduct on these issues and promising additional guidance in the future to help them. And he concluded with a plea to the industry to work together “to reduce the risk of misconduct and ensure that investors can have confidence in their investment professionals.”

Where is FINRA Heading?

Taken in context, the new proposals approved by the Board last month, including: (i) requiring brokerage firms to adopt heightened supervisory procedures for individuals while a disciplinary case is pending appeal; (ii) expanding the sanction guidelines to enable adjudicators to consider more severe sanctions when an individual's disciplinary history includes additional types of past misconduct; and (iii) allowing hearing panels to restrict the activities of firms and individuals while a disciplinary matter is on appeal, represent a focused extension of the current regulatory framework. Operational improvements described by Mr. Cook, such as strengthening analytics, improving the risk models and better leveraging data also fit into the expressed FINRA360 goal of continuous improvement. How the industry reacts to Mr. Cook’s initiatives will be revealed in submitted comments to FINRA’s latest proposals. Bates will continue to keep you apprised.

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