These rules affect four main areas and are designed to: (1) bolster the authority of Hearing Officers to impose restrictions on respondent firms and brokers during the pendency of an appeal; (2) require member firms to adopt heightened supervisory procedures for statutorily disqualified representatives during an eligibility request; (3) enhance BrokerCheck disclosures; and (4) take steps described in amended Rule 1017 when a natural person that has, in the prior five years, one or more “final criminal matters” or two or more “specified risk events” seeks to become an owner, control person, principal or registered person of the member firm. Amended Rule 1017 will require a member firm in those circumstances to submit a written request to FINRA’s Department of Member Regulation (“Member Regulation”), through the Membership Application Program (“MAP”), seeking a materiality consultation and, if the materiality consultation is denied, file a continuing membership application (“CMA”) for approval by Member Regulation. This client alert will focus on the new CMA requirement, followed by a discussion of the other rule changes.
The CMA Process and Materiality Consultations
FINRA’s Membership Application Rule 1014(a) establishes the standards for admission as a FINRA member. Rule 1014(a)(3) requires an applicant to demonstrate that it and its associated persons are capable of complying with federal securities laws and FINRA rules, including observing high standards of commercial honor and just and equitable principles of trade. FINRA states that, when evaluating the Rule 1014(a)(3) standard, it takes into consideration, among other things, “whether persons associated with an applicant are the subject of disciplinary actions taken against them by industry authorities, criminal actions, civil actions, arbitrations, customer complaints, remedial actions or other industry-related matters that could pose a threat to public investors.”
Under new Rule 1017(a)(7), when a final criminal matter or two or more specified risk events exist on the record of a natural person seeking to become an owner, control person, principal or registered person of a member, the member will be required to first submit a written request to Member Regulation seeking a materiality consultation (sometimes known as a “Mat Con”) to determine whether the contemplated activity is material to the member’s business and, if FINRA is unable to conclude that the event is not material, to file a CMA. The written request for a materiality consultation must include a description of the issues central to the materiality consultation and any additional documentation relevant to the consultation.
Upon filing a materiality consultation, FINRA will consider the written request and other information provided by the member and make a determination whether the member is required to file a Form CMA.
FINRA notes in the rule proposal that the “characterization of a proposed change as material depends on an assessment of all the relevant facts and circumstances.” FINRA’s MAP group will consider, among other things, “whether the events are customer-related; whether the events represent discrete actions or are based on the same underlying conduct; the anticipated activities of the person; the disciplinary history, experience and background of the proposed supervisor, if applicable; the disciplinary history, supervisory practices, standards, systems and internal controls of the member firm and whether they are reasonably designed to achieve compliance with applicable securities laws and regulations and FINRA rules; whether the member firm employs or intends to employ in any capacity multiple persons with one or more ‘final criminal matters’ or two or more ‘specified risk events’ in the prior five years; and any other investor protection concern raised by seeking to make the person an owner, control person, principal or registered person of the member firm.”
The CMA filing process of Rule 1017(a)(7) will not apply, however, when the member is required to file a Statutory Disqualification (“SD”) Application or written request for relief pursuant to Rule 9522 for approval of the same contemplated association. SD Applications are required to register an individual with disciplinary history that rises to the level of a statutory disqualification, as defined in Section 3(a)(39) of the Securities Exchange Act of 1934. In order to prevent redundant determinations by FINRA, if the member files an SD Application for the natural person, neither a CMA nor materiality consultation is required.
The concept of mandatory materiality consultations is new. In the past, materiality consultations concerning whether some change is material to the member’s business were voluntary. In other contexts, FINRA recognizes three different types of materiality determination: the reasoned determination by the member, ideally reflected in a written record, that the change is not material; a written request to FINRA for a materiality consultation resulting in a determination of no materiality, and a determination by the member or FINRA that a change is material. FINRA introduced a new category of mandatory materiality consultation in September 2020, with the addition of FINRA Rule 1017(a)(6), which mandates materiality consultations if a member is contemplating adding one or more associated persons involved in sales with a “covered pending arbitration claim,” an unpaid arbitration award or an unpaid settlement related to an arbitration, or any direct or indirect acquisition or transfer of a member’s assets or any asset, business or line of operation where the transferring member or an associated person of the transferring member has a covered pending arbitration claim, an unpaid arbitration award or an unpaid settlement related to an arbitration, and the member is not otherwise required to file a CMA (for example, where there is a material change in control pursuant to Rule 1017(a)(4)).
New definitions have been added to Rule 1011, which apply to Rules 1014 and 1017, including definitions of “financial criminal matters” and “specified risk events.” Rule 1011(h) defines final criminal matter to mean a criminal matter that resulted in a conviction, guilty plea or plea of nolo contendere (no contest) by a person that is disclosed, or is required to be disclosed, on the applicable uniform registration forms, including Form BD and Forms U4, U5 and U6. The definition of specified risk event contains a longer list of events. The key concept is that it is an investment-related judgement or settlement with a monetary penalty that meets or exceeds $15,000, or a matter where the sanction involved a bar, expulsion, suspension or comparable resolution.
Summary of Other Changes
- Rule 9200 Series (Disciplinary Proceedings) and the 9300 Series (Review of Disciplinary Proceeding by National Adjudicatory Council and FINRA Board; Application for SEC Review): will allow a Hearing Officer to impose conditions or restrictions on the activities of a respondent member firm or respondent broker, and require a respondent broker’s member firm to adopt heightened supervisory procedures for such broker, when a disciplinary matter is appealed to the National Adjudicatory Council (“NAC”) or called for NAC review.
- Rule 9520 Series (Eligibility Proceedings): will require member firms to adopt heightened supervisory procedures for statutorily disqualified brokers during the period a statutory disqualification eligibility request is under review by FINRA.
- Rule 8312 (FINRA BrokerCheck Disclosure): will allow the disclosure through the BrokerCheck website of the status of a member firm as a “taping firm” under FINRA Rule 3170 (Tape Recording of Registered Persons by Certain Firms). Previously, the rule required FINRA to release information about whether a firm was a taping firm, but only in response to telephonic inquiries via the BrokerCheck toll-free telephone listing
Key Points and Observations
These new requirements enhance the need for due diligence of prospective associated persons and firms should be mindful of the disciplinary history of any new individuals associating with the firm in any of the specified capacities. Firms should balance the potential benefits against the costs of undertaking the CMA process when considering bringing on an individual with disciplinary history covered by the rule. Because Rule 1017(a)(7) allows some room to decide when to apply for the materiality consultation, firms may want to consider engaging in the materiality consultation prior to making any firm commitment to prospective employees, control persons, or owners to first determine whether such an association would be deemed material and require a CMA. On this basis, firms could make informed decisions about the costs and compliance requirements of associating with a given individual.
Firms involved in M&A transactions involving the acquisition of less than 25% of a member should be particularly mindful of this new requirement. The new Rule 1017(a)(7), unlike 1017(a)(4), does not carve out a 25% de-minimis threshold when a member firm seeks to sell a small stake in the firm to an individual or entity with disciplinary history covered by the rule. FINRA has not provided guidance as to what percentage of ownership, in a materiality consultation, would trigger the need for a CMA. In such cases, the association could ultimately be deemed immaterial depending on the percentage of ownership, but the firm would need to seek the materiality consultation to obtain a determination.
Currently, firms with a “disciplinary history” as defined by IM-1011-1 are not eligible to use the safe harbor contained in that provision for business expansions. However, the safe harbor did not prevent firms from onboarding representatives with disciplinary history if the firm itself did not have disciplinary history . Rule 1017(a)(7), as amended, provides that the safe harbor for business expansions in IM-1011-1 will not be available to the member firm when a materiality consultation is required under Rule 1017(a)(7).
Firms may wish to consult this flowchart in order to navigate the multiple alternative steps necessary to reach a final conclusion. We would be happy to discuss this new process with you.
The changes to the CMA process and new definitions of final criminal matter and specified risk event add new layers of regulatory oversight when firms seek to associate with individuals who have a record of disciplinary history, and could potentially prevent such an association depending on the outcome of FINRA’s CMA review. In addition, the rules enhance FINRA’s ability to impose conditions or restrictions on the activities of a respondent member firm or respondent broker after an initial hearing and require heightened supervision of such individuals both during an appeal and during statutory disqualification eligibility requests. Firms should be aware of these new requirements as they navigate the hearing and appeal process and consider associating with persons covered by the rule.
Christopher Grobbel was a contributing author to this alert.