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  • 2019

    • 19-24 FINRA Encourages Firms to Notify FINRA if They Engage in Activities Related to Digital Assets

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      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Trading
      Training
      Key Topics

      Blockchain
      Cryptocurrencies
      Definition of "Security"
      Digital Assets
      Distributed Ledger Technology
      Initial Coin Offerings
      Virtual Coin
      Virtual Token
      Referenced Rules & Notices

      FINRA Rule 1017
      FINRA Rule 3210
      FINRA Rule 3270
      FINRA Rule 3280
      Notice to Members 00-73
      Regulation ATS
      Regulatory Notice 09-46
      Regulatory Notice 18-20
      Section 2(a)(1) of the Securities Act of 1933
      Section 3(a)(10) of the Securities Exchange Act of 1934

      Summary

      Last year, FINRA took several steps to engage with members regarding their current and planned activities relating to digital assets. These efforts included the issuance of Regulatory Notice 18-20, which encouraged firms to keep their Regulatory Coordinator informed if the firm, or its associated persons or affiliates, engaged, or intended to engage, in activities related to digital assets, including digital assets that are non-securities.1 Regulatory Notice 18-20 requested that firms provide these updates to Regulatory Coordinators until July 31, 2019. FINRA appreciates members' cooperation over the past year and is encouraging firms to continue keeping their Regulatory Coordinators abreast of their activities related to digital assets until July 31, 2020.

      Questions concerning this Notice may be directed to:

      •   Kosha Dalal, Associate Vice President & Associate General Counsel, Office of General Counsel (OGC), at (202) 728-6903 or by email at kosha.dalal@finra.org;
      •   Racquel Russell, Associate General Counsel, OGC, at (202) 728-8363 or by email at racquel.russell@finra.org; or
      •   Cara Bain, Assistant General Counsel, OGC, at (202) 728-8852 or by email at cara.bain@finra.org.

      Background & Discussion

      In 2018, FINRA undertook a multifaceted outreach initiative to engage with member firms regarding current and planned activities relating to digital assets, such as cryptocurrencies and other virtual coins and tokens.2 FINRA requested that communication be ongoing and asked that, until July 31, 2019, each member keep its Regulatory Coordinator informed of new activities or plans regarding digital assets, including cryptocurrencies and other virtual coins and tokens (whether or not they meet the definition of "security" for the purposes of the federal securities laws and FINRA rules).3 FINRA greatly appreciates the ongoing cooperation and outreach from members over the past year.

      As securities regulators continue to provide guidance to members regarding the unique regulatory challenges presented by digital assets—e.g., Joint Statement on Broker-Dealer Custody of Digital Asset Securities—FINRA believes it is important to keep the lines of communication with members open on this important topic.4 As a result, FINRA is issuing this Notice to encourage each firm to continue to keep FINRA up to date on the firm's new and planned activities relating to digital assets not previously disclosed.

      As was the case under Regulatory Notice 18-20, FINRA asks that each firm promptly notify its Regulatory Coordinator if it, or its associated persons (including activities under Rules 3270 and 3280),5 or affiliates, currently engages, or intends to engage, in any activities related to digital assets.6 As a reminder, the types of activities of interest to FINRA if undertaken (or planned) by a member, its associated persons or affiliates, include, but are not limited to:

      •   purchases, sales or executions of transactions in digital assets;
      •   purchases, sales or executions of transactions in a pooled fund investing in digital assets;
      •   creation of, management of, or provision of advisory services for, a pooled fund related to digital assets;
      •   purchases, sales or executions of transactions in derivatives (e.g., futures, options) tied to digital assets;
      •   participation in an initial or secondary offering of digital assets (e.g., ICO, pre-ICO);
      •   creation or management of a platform for the secondary trading of digital assets;
      •   custody or similar arrangement of digital assets;7
      •   acceptance of cryptocurrencies (e.g., bitcoin) from customers;
      •   mining of cryptocurrencies;
      •   recommend, solicit or accept orders in cryptocurrencies and other virtual coins and tokens;
      •   display indications of interest or quotations in cryptocurrencies and other virtual coins and tokens;
      •   provide or facilitate clearance and settlement services for cryptocurrencies and other virtual coins and tokens; or
      •   recording cryptocurrencies and other virtual coins and tokens using distributed ledger technology or any other use of blockchain technology.8

      Until July 31, 2020, FINRA encourages firms to promptly notify their Regulatory Coordinator in writing (including email) of these activities. If a firm already has submitted a continuing membership application (CMA)9 regarding its involvement in activities related to digital assets, or has otherwise provided this information to FINRA, additional notice is not requested unless a change has occurred.


      1. See See Regulatory Notice 18-20 (FINRA Encourages Firms to Notify FINRA if They Engage in Activities Related to Digital Assets) (July 6, 2018).

      2. For purposes of this Notice, the term "digital asset" refers to cryptocurrencies and other virtual coins and tokens (including virtual coins and tokens offered in an initial coin offering (ICO) or pre-ICO), and any other asset that consists of, or is represented by, records in a blockchain or distributed ledger (including any securities, commodities, software, contracts, accounts, rights, intangible property, personal property, real estate or other assets that are "tokenized," "virtualized" or otherwise represented by records in a blockchain or distributed ledger).

      3. Firms that engage in activities related to digital assets, whether or not they are securities, are reminded to consider all applicable FINRA rules and federal and state laws, rules and regulations. In addition, digital assets that meet the definition of an "investment contract" under Section 2(a) (1) of the Securities Act of 1933 or under Section 3(a)(10) of the Securities Exchange Act of 1934 are "securities" governed by the federal securities laws and FINRA rules, irrespective of whether or not they are labeled as "securities." On April 3, 2019, the Strategic Hub for Innovation and Financial Technology of the Commission published a framework for analyzing whether a digital asset has the characteristics of an "investment contract" and whether offers and sales of a digital asset are securities transactions. See Strategic Hub for Innovation and Financial Technology of the Securities and Exchange Commission, Framework for "Investment Contract" Analysis of Digital Assets (April 3, 2019) (Framework). See also Securities Exchange Act Release No. 81207 (July 25, 2017), Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.

      4. See, e.g., Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities, Division of Trading and Markets, U.S. Securities and Exchange Commission and Office of General Counsel, Financial Industry Regulatory Authority, (July 8, 2019) (Joint Statement).

      5. FINRA continues to be interested in learning how firms handle notifications regarding participation in activities related to digital assets, such as cryptocurrencies and other virtual coins and tokens. See FINRA Rule 3270 (Outside Business Activities of Registered Persons) and Rule 3280 (Private Securities Transactions of an Associated Person). FINRA is not requesting notification or information regarding passive investments and activities of associated persons that are subject to the requirements of Rule 3210 (Accounts at Other Broker-Dealers and Financial Institutions).

      6. This notification is separate from any existing regulatory obligations under FINRA rules that may apply to a firm regarding its involvement in activities relating to digital assets (e.g., trade reporting transactions in digital assets that meet the definition of a "security" or filing a new member application or continuing member application). This notification also is separate from any other regulatory obligations that may apply to a firm regarding its involvement in activities relating to digital assets, such as submitting Form ATS filings as required, including notifications of "material changes" under Regulation ATS, such as changes to the types of securities traded on a platform. See Securities Exchange Act Release No. 40760 (December 8, 1998), 63 FR 70845, 70922 (December 22, 1998) (Regulation ATS adopting release) (including changes to "the operating platform, the types of securities traded, or the types of subscribers" as examples of "material changes" that must be filed under Rule 301(b)(2) of Regulation ATS); see also Regulatory Notice 09-46 (August 2009) (reminding alternative trading systems of the need to submit to FINRA duplicate copies of any filing required by Rule 301(b)(2) of Regulation ATS).

      7. See Joint Statement (stating that "[t]he specific circumstances where a broker-dealer could custody digital asset securities in a manner that the Staffs believe would comply with the Customer Protection Rule remain under discussion, and the Staffs stand ready to continue to engage with entities pursuing this line of business.").

      8. Cryptocurrencies and other virtual coins and tokens use distributed ledger technology, most commonly known as "blockchain," as the primary protocol for exchanging, storing and verifying information.

      9. A material change in a firm's business operations also requires the submission and approval of a CMA. See, e.g., Joint Statement, note 7 and accompanying text. For factors to consider in determining materiality, see Notice to Members 00-73 (SEC Approves Amendments to NASD Membership Rules). See also FINRA Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations).

    • 19-23 FINRA Supplements Prior Guidance on Credit for Extraordinary Cooperation

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      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Extraordinary Cooperation Referenced Rules & Notices

      FINRA Rule 4530
      FINRA Rule 8210
      FINRA Rule 8313
      Regulatory Notice 08–70
      Regulatory Notice 11–32
      Regulatory Notice 19–04
      Sanction Guidelines

      Summary

      FINRA is issuing this Notice to restate and supplement prior guidance regarding the circumstances under which a firm or individual may influence the outcome of an investigation by demonstrating extraordinary cooperation. This Notice incorporates FINRA's prior guidance and provides clarification and additional information about how FINRA assesses whether a potential respondent's cooperation is "extraordinary" and distinct from the level of cooperation expected of all member firms and their associated persons.

      Questions concerning this Notice should be directed to:

      •   Lara Thyagarajan, Senior Vice President & Counsel to the Head of Enforcement, at (212) 858–4176 or Lara.Thyagarajan@finra.org; and
      •   Megan Davis, Senior Counsel, Enforcement, at (646) 315–7336 or Megan.Davis@finra.org.

      Background & Discussion

      FINRA recognizes extraordinary cooperation by respondents when making its enforcement determinations. In 2008, FINRA published Regulatory Notice 08–70 to apprise industry participants of the factors FINRA considers in determining whether and how to award credit for extraordinary cooperation in a FINRA investigation. FINRA noted that the types of extraordinary cooperation by a firm or individual that could result in credit can be categorized as follows: (1) self-reporting before regulators are aware of the issue; (2) extraordinary steps to correct deficient procedures and systems; (3) extraordinary remediation to customers; and (4) providing substantial assistance to FINRA's investigation. The guidance set forth in Regulatory Notice 08–70 is restated and incorporated into this Notice.

      Subsequent changes to FINRA's rules, including the adoption of FINRA Rule 4530(b) — which requires member firms to report internal conclusions of violations of certain laws, rules, regulations or standards of conduct — may have created uncertainty around the continued impact that self-reporting may have on a potential respondent's ability to receive credit for extraordinary cooperation. In addition, other FINRA rules and policies — such as FINRA Rule 8210 and FINRA's Sanction Guidelines — expect certain levels of cooperation in every case.

      To provide further clarity on the differences between required cooperation and extraordinary efforts, and in response to comments from the industry requesting further transparency,1 FINRA is issuing this Notice, which incorporates its prior guidance and provides additional information regarding the circumstances under which credit for extraordinary cooperation will be awarded and the nature of credit available. In doing so, FINRA hopes to incentivize firms and associated persons to voluntarily and proactively assist FINRA. This, in turn, will aid FINRA in meeting its objectives of investor protection and market integrity by quickly identifying and remediating misconduct.

      What Is Extraordinary Cooperation?

      FINRA's Sanction Guidelines state, "Sanctions in disciplinary proceedings are intended to be remedial and to prevent the recurrence of misconduct."2 While disciplinary actions are an important tool that FINRA uses to achieve the goals of remediation and prevention, actions taken by member firms and associated persons are also an important part of that effort. Action by member firms and associated persons that demonstrates their commitment to remediating past misconduct and preventing recurrence is essential to furthering FINRA's mission of investor protection and market integrity.

      Therefore, FINRA always considers factors such as corrective measures and payment of restitution in assessing whether a disciplinary action is necessary, and, if so, what sanctions are appropriate. FINRA's Sanction Guidelines direct Enforcement to consider whether a respondent:

      i. accepted responsibility for and acknowledged the misconduct prior to detection and intervention by the firm or a regulator;3
      ii. voluntarily employed subsequent corrective measures, prior to detection or intervention by the firm or by a regulator, to revise general and/or specific procedures to avoid recurrence of the misconduct;4
      iii. voluntarily and reasonably attempted, prior to detection and intervention by a regulator, to pay restitution or otherwise remedy the misconduct;5 and
      iv. provided substantial assistance to FINRA in its examination and/or investigation of the underlying misconduct.6

      FINRA has and will continue to look to these factors when assessing sanctions in disciplinary matters.7 For example, Enforcement may recommend a sanction that is on the low end of the specified range in the Sanction Guidelines based on the presence of these mitigating factors. In certain circumstances, Enforcement also may determine to forgo recommending formal disciplinary action entirely.

      Enforcement may recommend a sanction that is well below the range set forth in the Sanction Guidelines or comparable precedents when respondents have voluntarily provided such material assistance to FINRA in its investigation, or effected such expedient and effective remediation, that FINRA deems these steps to constitute "extraordinary cooperation" beyond what it requires of any member firm or associated person. Member firms and associated persons who take proactive and voluntary steps well beyond those required under FINRA rules materially assist FINRA in meeting its goals of investor protection and market integrity. To recognize and incentivize such conduct, FINRA weighs these mitigating factors so heavily that the outcome of the matter is materially different than it would have been absent the respondent's extraordinary conduct.

      In several matters in recent years, FINRA has granted substantial credit to firms based on their extraordinary cooperation:

      •   Beginning in 2015 through 2018, FINRA ordered a number of firms to pay more than $75 million in restitution, including interest, to affected customers for failing to waive mutual fund sales charges for certain charitable and retirement accounts. FINRA did not impose fines in those matters based on the firms' extraordinary cooperation. Firms initiated, prior to detection or intervention by a regulator, investigations to identify whether the misconduct existed; promptly established a plan of remediation for affected customers; promptly self-reported the conduct to FINRA; promptly took action and remedial steps to correct the violative conduct; and employed subsequent corrective measures, prior to detection or intervention by a regulator, to revise their procedures to avoid recurrence of the misconduct.
      •   In September 2017, FINRA ordered a respondent firm to pay approximately $9.8 million in restitution to customers who were affected by the firm's failure to establish and maintain a supervisory system reasonably designed to detect and prevent unsuitable short-term trading of unit investment trusts. While FINRA fined the firm $3.25 million, this reflected substantial credit for the firm's extraordinary cooperation and remediation to customers. The firm initiated, prior to intervention by a regulator, a firm-wide investigation to identify the scope of potentially unsuitable trades, which included the interview of a substantial number of firm personnel and the retention of an outside consultant to conduct a statistical analysis; identified harmed customers and established a plan to provide remediation; and provided substantial assistance to FINRA in its investigation.
      •   In October 2018, FINRA sanctioned a firm for failures to supervise firm functions it outsourced to a vendor. FINRA did not impose a fine, acknowledging, among other things, the firm's self-report, which extended beyond its obligation to self-report pursuant to FINRA Rule 4530; the extraordinary steps the firm took to remediate, including weekly meetings with the vendor's CEO and COO, hiring two full-time employees to implement controls, and assigning a dedicated manager to oversee the vendor; changing its billing structure to avoid similar issues; and conducting a comprehensive review of all its wealth management accounts to identify impacted investors, whom it voluntarily paid $4.6 million in restitution.

      FINRA resolved these matters in consideration of the factors set forth in both the Sanction Guidelines and Regulatory Notice 08–70, including a consideration of both the timeliness and quality of the respondents' corrective measures and cooperation. FINRA believes these cases are good examples of its existing policy. Although the impact of extraordinary cooperation depended upon the facts and circumstances of each particular case, these matters demonstrate, among other things, that the receipt of substantial credit depended on corrective measures and cooperation aimed at broadly and quickly remediating harm.

      Most recently, in January 2019, FINRA announced in Regulatory Notice 19–04 its 529 Plan Share Class Initiative, encouraging firms to review their supervision of 529 plan sales. FINRA described common supervisory issues it had observed concerning share class recommendations and stated that it would recommend settlements with no fines for firms that choose to review their supervisory systems and procedures, self-report supervisory violations, and provide FINRA with a plan to remediate harmed customers. This initiative was announced to promote firms' compliance with the rules governing 529 plan recommendations, to promptly remedy violations, and to return money to harmed investors as quickly and efficiently as possible.

      As in these prior matters, FINRA will continue to consider the factors that are set forth in the Sanction Guidelines and Regulatory Notice 08–70 when determining whether credit will be given for extraordinary cooperation. Those factors are reiterated below, with additional guidance regarding how they impact FINRA's decision making:

      1. Providing Credit for Steps Taken to Correct Deficient Procedures and Systems

      When a firm identifies a problem involving deficient supervisory systems, procedures and controls, the firm must take corrective steps to fully remediate the problem. In considering whether to provide substantial credit for extraordinary cooperation, FINRA will consider whether a firm's steps to correct deficient systems and procedures go beyond these baseline requirements. Examples of corrective steps that may result in credit for extraordinary cooperation include:

      •   Engaging or conducting an independent audit or investigation that is thorough and far-reaching in scope beyond the immediate issue, with an eye toward identifying and remediating all related misconduct that may have occurred.
      •   Hiring independent consultants to ensure the adoption and implementation of improved supervisory systems, procedures and controls.
      •   Where the root cause of a violation relates to organizational weaknesses such as where a firm dedicated inadequate staff to the supervision of a particular business line, making organizational changes by, for example, creating new supervisory positions, adjusting reporting lines or, if necessary, removing or disciplining responsible individuals, including those in supervisory roles (although personnel changes are not necessarily required to achieve extraordinary cooperation).

      FINRA will consider whether the firm took these or other corrective steps promptly following its discovery of the misconduct, prioritizing the remediation of any deficiencies. Additionally, FINRA will consider whether the firm maintained an open dialogue with FINRA staff regarding improvements to supervisory systems, procedures and controls, and provided FINRA with ready access and information to evaluate whether new systems, procedures and controls are reasonable.

      FINRA staff will also consider the breadth of a firm's remediation. For example, if a firm identifies deficient procedures that affect a particular department or product line, the firm must review and correct the identified procedures. In contrast, FINRA may consider the firm's responses "extraordinary" when the firm conducts a broader assessment, which goes beyond the scope of the original investigation, and looks for and remediates similar deficiencies in procedures that govern other aspects of its business.

      Although FINRA will, consistent with the Sanction Guidelines, take into consideration the timing of steps taken to correct deficient systems or procedures when deciding whether to award credit,8 FINRA recognizes that there is some tension between expecting firms to report misconduct promptly and, at the same time, giving priority to corrective measures that a firm takes prior to detection by FINRA or other regulators (e.g., prior to any self-report). For that reason, and in order to encourage the timely self-reporting of misconduct, FINRA will consider, in appropriate circumstances, giving credit for corrective measures taken promptly after a firm reports the misconduct.
      2. Providing Credit for Restitution to Customers

      FINRA's overarching mission is to protect investors and promote vibrant markets. As FINRA has previously stated, when a member firm or registered representative engages in misconduct, restitution for harmed customers is our highest priority. Therefore, if a respondent's misconduct has caused customer harm, it will be difficult for that respondent to obtain credit for extraordinary cooperation without making complete and timely restitution to injured customers.

      The Sanction Guidelines recognize the importance of prompt restitution and treat as a mitigating factor for sanctions purposes the fact that a firm or associated person voluntarily paid restitution prior to detection or intervention by a regulator.9 Because FINRA expects firms and associated persons to make full restitution to injured customers10 in all cases, the mere payment of restitution will not result in credit for extraordinary cooperation. Rather, as with other corrective measures, FINRA will consider whether a firm or associated person has proactively and voluntarily taken extraordinary steps to ensure that restitution is paid as quickly as possible, in a manner that ensures all harmed customers are made whole.

      This is particularly relevant in matters involving widespread, systemic failures, where identifying injured customers and calculating each individual's losses can be complex and time consuming. For example, where a firm's failure to supervise compliance with its suitability obligations has resulted in customer losses, it could review the recommendations made in each of its customer's accounts, calculate individual losses resulting from the failure to comply with the suitability duty, and pay restitution to the customers who were harmed. This complex process can take significant time. An extraordinary step, in contrast, could be one that significantly accelerates the process in order to return money to investors sooner. For example, implementing a methodology to efficiently identify customers for restitution, such as a statistical approach, could meaningfully reduce the time it would take for investors to receive restitution. Similarly, taking steps to accelerate a trade-by-trade review (such as dedicating staff members, hiring temporary help, paying for overtime, or re-prioritizing other projects) may constitute extraordinary efforts.

      When assessing whether a respondent has exceeded expectations regarding restitution, FINRA will consider whether the respondent is proactive about identifying and proposing an expeditious methodology, and willing to engage in a dialogue with FINRA and other regulators about the appropriate way to identify the pool of affected customers and to calculate the amount of restitution to pay back customers as swiftly as possible. Even where restitution is paid after FINRA becomes aware of the misconduct (for example, if the firm reports the misconduct within 30 days of discovery as required by Rule 4530), FINRA will consider whether to award credit when the restitution remediated all potential harm and was paid promptly at the initiative of the firm, prior to any order by FINRA or another regulator.
      3. Self-Reporting of Violations

      One reason for this updated guidance is to clarify how FINRA considers self-reporting in light of the adoption of Rule 4530. Rule 4530 replaced NASD Rule 3070 in February 2011 and, in subsection (b), unlike its predecessor, requires member firms to self-report internal conclusions regarding violations of certain laws, rules, regulations or standards of conduct. Although self-reporting of such internal conclusions was already required for NYSE member firms under NYSE Rule 351(a)(1), FINRA Rule 4530(b) represented a significant change for many firms.

      As noted previously in the Rule 4530 Frequently Asked Questions, to be considered "extraordinary cooperation," self-reporting must, at a minimum, "go significantly beyond" what is required to comply with regulatory obligations.11 Credit will not be awarded to firms merely for complying with their reporting obligations under Rule 4530. Nor will firms and associated persons be given credit for merely complying with their obligations to provide information or testimony in response to regulatory requests made pursuant to Rule 8210. If, however, a firm self-reports misconduct that does not fall within the reporting requirements of Rule 4530, then self-reporting will be considered in determining whether to award credit.

      In matters where a self-report is required pursuant to Rule 4530, FINRA will consider whether the firm self-reports information beyond that which is required by the rule. For example, a firm exceeds its regulatory obligation when it proactively and voluntarily asks to meet with FINRA staff, provides summaries of key facts, and identifies and explains key documents. This type of substantial assistance is further described below.

      FINRA also will consider whether the firm proactively detected the misconduct through compliance, audits or other surveillance, as opposed to identifying the misconduct only after receiving notice from customers, counterparties or regulators. FINRA also will consider whether the firm made diligent efforts to identify and inform FINRA of the relevant facts as soon as it discovered the issue, and kept FINRA updated as it learned new facts through continuing investigation.

      Finally, FINRA will consider whether the firm reported the misconduct to the public and other regulators, as appropriate. FINRA also may consider the level of the firm's cooperation with other regulators and, if appropriate, law enforcement bodies, particularly in matters where multiple agencies are investigating the misconduct.12
      4. Providing Substantial Assistance to FINRA Investigations In addition to the above factors, FINRA also will consider giving credit to firms or associated persons for providing substantial assistance to FINRA in its investigation of the underlying misconduct.13 In assessing whether firms have provided substantial assistance, FINRA will consider the degree of assistance that might be expected given a firm's size and resources, as well as the scope of the misconduct within the organization and the steps taken to address systemic deficiencies; there is no one-size-fits-all approach to the steps that FINRA would consider substantial assistance. Credit is potentially available to any firm or individual that cooperates substantially, including the largest broker-dealers and single-employee firms.

      To constitute substantial assistance, industry participants should fully inform FINRA about the potential misconduct — including all relevant issues, products, markets and industry participants — in ways that go far beyond merely responding to requests made under Rule 8210. For example, substantial assistance deserving of credit might include:

      •   volunteering relevant information that the firm believes would be helpful even if FINRA did not directly request the specific documents or information;
      •   providing analysis of trading or other activity that assists FINRA in understanding the conduct at issue;
      •   volunteering facts related to the involvement of particular parties who may have committed violations;
      •   providing demonstrations of trading or other systems at issue;
      •   after identifying misconduct by an individual employee, conducting a thorough and expeditious review of the employee's misconduct and promptly sharing the findings with FINRA;
      •   volunteering relevant industry knowledge to help FINRA quickly assimilate information about a complex product or practice. Examples could include providing information about the considerations or issues that affect an industry-wide common practice;
      •   providing detailed summaries or chronologies of relevant events prior to receiving a Rule 8210 or other regulatory request;
      •   voluntarily assisting FINRA in obtaining effective access to firm offices, records or computer systems prior to receiving a Rule 8210 or other regulatory request;
      •   identifying witnesses who possess relevant information, including witnesses over whom FINRA lacks jurisdiction, and making those witnesses available for interviews; and
      •   conducting a thorough and independent audit or investigation, using counsel or consultants where appropriate, and fully disclosing the findings to FINRA.14

      What Type of Credit Will Be Given in Return for Extraordinary Cooperation?

      When FINRA determines that a firm should be given credit for extraordinary cooperation, that credit may take many forms. For example, where a problem has been fully remediated, FINRA often concludes that no enforcement action is warranted and closes an investigation with no further action or with a Cautionary Action Letter.

      In other cases, FINRA might determine that an enforcement action is appropriate to remedy or prevent harm, even where a firm has provided extraordinary cooperation. In those matters, FINRA may provide credit by reducing the sanctions imposed. When credit is given in the form of a reduced fine, the reduction normally will be substantial. Indeed, in appropriate cases, as illustrated in several of the examples above, FINRA may consider imposing formal discipline without any fine. FINRA also may give credit by declining to require an undertaking. For example, FINRA may forego requiring a firm to hire an independent consultant where, although a systemic deficiency is in an extended period of remediation, the firm is taking other extraordinary steps to address the problem.

      How Does FINRA Plan To Be More Transparent About Credit for Extraordinary Cooperation?

      In each case where the applicable principal considerations and the factors set forth in this Regulatory Notice result in a respondent receiving credit for extraordinary cooperation, FINRA will include in the Letter of Acceptance, Waiver and Consent (AWC) memorializing the settlement a new section titled, "Credit for Extraordinary Cooperation." FINRA will describe the factors that resulted in credit being given, as well as the type of credit.

      In order to provide more useful guidance to the industry, FINRA will take additional steps to distribute information about instances when it has deemed cooperation to be extraordinary, in ways that are more accessible and easier to identify. For example, FINRA occasionally issues press releases in connection with individual cases to highlight matters deemed worthy of public attention.15 In press releases, FINRA will note factors that led the respondent to receive credit, as well as the type of credit. Similarly, when FINRA proceeds without formal action in connection with an investigation, traditionally FINRA has not made public a statement regarding the action. Going forward, when FINRA gives credit for extraordinary cooperation that results in FINRA electing to proceed without formal action, FINRA will determine, on a case-by-case basis, whether it would be useful to provide additional transparency regarding the factors that led to FINRA's decision and, when appropriate, publish information about those individual cases. Unless the firm or associated person gives permission to be named, FINRA will preserve their anonymity by describing the respondents' extraordinary cooperation at a sufficiently high level to shield their identities.

      FINRA also seeks to provide clear guidance on the difference between matters characterized by extraordinary cooperation, and matters in which the respondent's conduct did not exceed its regulatory obligations but sanctions determinations were materially affected by other considerations. As described above, FINRA always considers factors such as corrective measures and payment of restitution in assessing whether a disciplinary action is necessary and what sanctions are appropriate. For example, the Principal Considerations in the Sanction Guidelines include "Whether the respondent voluntarily and reasonably attempted, prior to detection and intervention, to pay restitution or otherwise remedy the misconduct." Accordingly, Enforcement may consider a firm's voluntary payment of restitution to be mitigating and recommend a sanction on the low end of the specified range in the Sanction Guidelines. In contrast, Enforcement may consider it "extraordinary" if a firm takes significant steps to effect speedy restitution, such as re-prioritizing other projects or developing a rules-based approach to accelerate the process. Under those circumstances, FINRA may consider these additional steps so extraordinary that it recommends a sanction well below the Sanction Guidelines or other similar cases.

      At other times, the presence of aggravating factors may materially affect the sanction determination. For example, even if a respondent remediates the problem and makes restitution as expected, FINRA may recommend a more severe sanction due to aggravating factors in the matter, such as prior disciplinary history;16 the nature of the underlying misconduct, including whether the misconduct was intentional or reckless,17 involved numerous acts or a pattern of misconduct, and continued over an extended period of time;18 the nature and extent of injury to the investing public, a member firm and other market participants;19 whether the respondent profited from the misconduct;20 and whether the respondent engaged in the misconduct notwithstanding prior warnings from FINRA, another regulator or a supervisor.21

      In general, the factual findings set forth in an AWC should always include any facts that were considered as aggravating or mitigating for sanctions purposes. However, where appropriate an AWC may also include a new section titled, "Sanctions Considerations." In that section, FINRA may identify mitigating or aggravating factors (such as those discussed in the relevant Principal Considerations from the Sanction Guidelines) that affected FINRA's sanction determination.

      Can Individuals Also Receive Credit for Extraordinary Cooperation?

      Credit for extraordinary corrective measures and cooperation is available to individuals as well as firms. FINRA believes many of the principles discussed above may apply equally to individuals. For example, although individuals may not be able to correct deficient firm procedures and systems, they may still self-report misconduct, provide substantial assistance during an investigation, and pay restitution to customers with appropriate notice to and involvement by a member firm. However, the presence of aggravating factors may weigh against credit for extraordinary cooperation, and certain aggravating factors are more likely to be present in cases involving individuals, such as intentional or reckless misconduct,22 attempts to conceal misconduct from a member firm,23 and misconduct notwithstanding prior warnings from a supervisor.24

      In evaluating whether to give credit to an individual, FINRA also will consider the same four general factors outlined in the SEC's policy regarding cooperation by individuals: (1) the assistance provided by the individual; (2) the importance of the underlying matter in which the individual cooperated; (3) the societal interest in holding the individual accountable for his or her misconduct; and (4) the appropriateness of credit based upon the profile of the cooperating individual.25


      1. See May 8, 2017, letter from the Securities Industry and Financial Markets Association to FINRA in response to Special Notice — Engagement Initiative (Mar. 21, 2017), at 8 (urging FINRA to, among other things, "publicize when good credit is given").

      2. Sanction Guidelines (March 2019 version), at 3.

      3. Principal Consideration No. 2.

      4. Principal Consideration No. 3.

      5. Principal Consideration No. 4.

      6. Principal Consideration No. 12.

      7. As was the case with Regulatory Notice 08–70, this Notice is intended to provide the industry with additional guidance concerning the factors that FINRA considers in assessing whether formal discipline is warranted and, if so, the appropriate sanctions in the context of settlement discussions prior to initiation of a disciplinary proceeding. Nothing herein is intended to alter the Sanction Guidelines, FINRA rules or other applicable requirements.

      8. See Principal Consideration No. 3 (treating as a mitigating factor corrective measures taken "prior to detection or intervention" by a regulator).

      9. Principal Consideration No. 4.

      10. FINRA reminds associated persons that paying restitution or otherwise settling a customer complaint without notice to the firm is a violation of FINRA Rule 2010, and can result in sanctions of up to two years or, in egregious cases, a bar. Sanction Guidelines, at 34.

      11. Regulatory Notice 11–32, A6.

      12. Cf. General Principles Applicable to All Sanction Determinations, No. 7 (directing adjudicators to consider, where appropriate, sanctions previously imposed by other regulators for the same conduct).

      13. Principal Consideration No. 12.

      17. Principal Consideration No. 13.

      18. Principal Consideration Nos. 8, 9.

      19. Principal Consideration No. 11.

      20. Principal Consideration No. 16.

      21. Principal Consideration No. 14.

      22. Principal Consideration No. 13.

      23. Principal Consideration No. 10.

      24. Principal Consideration No. 14.

      25. SEC Policy Statement Concerning Cooperation by Individuals in its Investigations and Related Enforcement Actions, Release No. 34–61340, 17 CFR Part 202 (Jan. 19, 2010).

    • 19-22 FINRA Requests Comment on a Proposal to Publish ATS Volume Data for Corporate Bonds and Agency Debt Securities on FINRA's Website; Comment Period Expires: September 7, 2019 [PDF]

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      GASB Accounting Support Fee

      Regulatory Notice
      Notice Type

      Request for Comment
      Suggested Routing

      Compliance
      Fixed Income
      Legal
      Operations
      Senior Management
      Systems
      Trading
      Key Topics

      Alternative Trading Systems
      Fixed Income
      TRACE-Eligible Security
      Transparency
      Referenced Rules

      FINRA Rule 6110
      FINRA Rule 6610
      FINRA Rule 6710
      FINRA Rule 6720
      FINRA Rule 6730
      FINRA Rule 6732
      FINRA Rule 6750

      Summary

      FINRA requests comment on a proposal to expand the alternative trading system (ATS) volume data that it publishes on its website to include information on transactions in corporate bonds and agency debt securities that occur within an ATS and are reported to FINRA's Trade Reporting and Compliance Engine (TRACE).

      Questions regarding this Notice should be directed to the:

      •   Chris Stone, Vice President, Transparency Services, at (202) 728-8457 or chris.stone@finra.org;
      •   Patrick Geraghty, Vice President, Market Regulation, at (240) 386-4973 or patrick.geraghty@finra.org;
      •   Racquel Russell, Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8363 or racquel.russell@finra.org; or
      •   Robert McNamee, Assistant General Counsel, OGC, at (202) 728-8012 or robert.mcnamee@finra.org.

      Action Requested

      FINRA encourages all interested parties to comment on the proposal. Comments must be received by September 7, 2019.

      Comments must be submitted through one of the following methods:

      •   Emailing comments to pubcom@finra.org; or
      •   Mailing comments in hard copy to:

      Jennifer Piorko Mitchell
      Office of the Corporate Secretary
      FINRA
      1735 K Street, NW
      Washington, DC 20006-1506

      To help FINRA process comments more efficiently, persons should use only one method to comment on the proposal.

      Important Notes: The only comments that FINRA will consider are those submitted pursuant to the methods described above. All comments received in response to this Notice will be made available to the public on the FINRA website. Generally, FINRA will post comments as they are received.1

      Before becoming effective, the proposed rule change must be filed with the Securities and Exchange Commission (SEC) pursuant to Section 19(b) of the SEA.2

      Background & Discussion

      To improve market transparency relating to trading occurring on ATSs, in June 2014, FINRA began publishing individual ATS volume information for equity securities on its website.3 In its proposed rule change relating to ATS data publication, FINRA stated that it intended "periodically to assess the reporting and publication of information to consider whether modifications to the scope of securities covered, the delay between the activity and publication, or the frequency of publication of the information are appropriate."4 FINRA also stated that it would not publish data for TRACE-Eligible Securities5 until FINRA "had the opportunity to evaluate the data…and the differences between the existing trade reporting regimes applicable to equity and debt securities."6 Since that time, FINRA has been evaluating ATS data and believes it is now appropriate to include individual ATS volume data for certain TRACE-Eligible Securities.

      Accordingly, FINRA is soliciting comment on a proposal to publish volume and trade count information for corporate and agency debt securities,7 categorized by individual security (i.e., CUSIP) and ATS, in a format similar to that currently published for equity securities.8 The published data would include both the total number of transactions and aggregate dollar volume traded for transactions in a particular corporate bond or agency debt security executed within the ATS and reported to FINRA during the aggregation period. The ATS data would be aggregated on a monthly basis and published with a three-month delay (e.g., aggregate ATS data for the month of February 2019 would be published in June 2019).9 FINRA would not charge for the aggregated ATS fixed income data, which would be published on FINRA's website.

      While FINRA recognizes that there are other significant fixed income electronic trading platforms that are not ATSs, for example, request-for-quote (RFQ) platforms, FINRA believes it is appropriate at this time to take a phased and measured approach, as was done with equity securities. Specifically, the proposal would initially be limited to ATSs, which currently are identifiable in TRACE by a unique market participant identifier (MPID) pursuant to Rule 6720(c) (Alternative Trading Systems). FINRA also believes it is appropriate initially to limit fixed income ATS data publication to corporate and agency debt securities because these product types account for the majority of publicly identified ATS activity in TRACE-Eligible Securities.10 FINRA may consider including additional asset classes in published ATS volume data in the future; e.g., transactions involving Securitized Products.11

      Similar to the approach with the publication of ATS equity volume, FINRA proposes initially to require that each ATS self-report to FINRA its aggregate weekly volume information and number of trades, by security, in corporate and agency debt securities that are TRACE-Eligible Securities. Self-reporting by ATSs would occur on a security-by-security basis within seven business days after the end of each week. FINRA would then publish the data as described above. As with the ATS equity volume data, FINRA staff intends to compare the self-reported ATS volume data with the transaction information firms report to TRACE to verify the accuracy of volume and trade counts.12 Once FINRA is comfortable with relying on trade reporting data to calculate the volume, it would eliminate the self-reporting requirement and would derive the published data directly from the transaction information reported to TRACE.

      FINRA proposes that the published data would reflect: (1) sale trades and related volume reported by the ATS;13 and (2) the sell-side of trades and related volume between member subscribers where the ATS is identified on the trade report pursuant to Rule 6730(c)(13)14 (i.e., an exempt ATS).15 FINRA believes this approach would help ensure that the published trade counts and corresponding volume information do not reflect multi-leg or dually reported transactions more than once.

      Economic Impact Assessment

      FINRA has undertaken an economic impact assessment, as set forth below, to analyze the regulatory need for the proposed rule change and its potential economic impacts, including anticipated costs and benefits.

      Regulatory Need

      FINRA is proposing to publish volume and trade count information for corporate and agency debt securities, with the intent to improve market transparency relating to trading in these instruments on ATSs. As mentioned above, FINRA makes similar information for equity securities available to the public, and has received support from the industry on its transparency initiatives in the equity markets.16

      Economic Baseline

      Pursuant to FINRA Rule 6720(c) (Alternative Trading Systems), since February 2, 2015, TRACE participants that operate an ATS have been required to use a separate MPID to report all transactions that are executed within the ATS to TRACE. Also, since 2016, disseminated TRACE transactions contain a new identifier to indicate when the reporting party or contra-party is an ATS or when a trade is executed on an ATS.17 Therefore, market participants can today observe real-time whether a party to a disseminated transaction is a dealer, non-member affiliate of a member, customer or an ATS.

      However, real-time dissemination does not disclose the identity of the ATSs, as all ATSs are identified using a generic ATS reporting party and contra-party type and an ATS flag. Hence, market participants currently lack a relevant component in evaluating the historical location of liquidity in individual corporate bond and agency debt issues.

      To assess the current structure of the market, FINRA analyzed a sample of corporate bond and agency debt transactions reported to TRACE between August 2016 and November 2018. In the sample period, there were, on average, 923,511 trades in a month for corporate bonds and 32,474 trades in a month for agency debt, corresponding to an average monthly dollar volume of approximately $427 billion and $66 billion, respectively. Trades in corporate bonds occurred on 16 unique ATSs and trades in agency debt securities occurred on nine unique ATSs. While ATS trades accounted for between 25 percent and 30 percent of total transactions in all corporate bonds, for agency debt securities, such statistic increased from approximately 18 percent in the beginning of the sample period to over 30 percent in the last quarter of 2018.

      There were, on average, 20,566 and 3,001 unique corporate bond and agency debt CUSIPs, respectively, that traded in a given month during the sample period. Approximately 59 percent of the corporate bond and 54 percent of the agency debt CUSIPs that traded in a given month traded on at least one ATS. In the sample of bonds that traded on at least one ATS, a corporate bond traded, on average, on 2.43 ATSs in a given month, whereas the same figure was 1.52 for an agency debt security.

      Approximately 98 percent of the trading activity on ATSs occurred against brokerdealers, whereas the remaining were against other market participants; i.e., customers or non-member affiliates of broker-dealers. An ATS had, on average, 63 broker-dealer counterparties in a month in corporate bonds and 31 broker-dealer counterparties in agency debt.

      Economic Impacts

      The current proposal would expand the benefits of FINRA's ATS transparency program to market participants by providing transparency on monthly aggregate trading on ATSs in corporate bond and agency debt securities. The additional information may help broker-dealers and their customers in assessing where liquidity is concentrated, and may mitigate some of the search costs associated with seeking a counterparty to a trade. Economic theory suggests that reduced search costs would be associated with fewer lost opportunities to trade. Similarly, such information may inform routing decisions and may help achieve a better execution, such as by providing a better price or a faster execution.

      As noted above, the proposed rule change initially imposes a new weekly reporting obligation on ATSs. FINRA expects that ATSs impacted by this proposal should already maintain this information pursuant to Regulation ATS. Because of the existing recordkeeping obligations in Regulation ATS, FINRA does not believe that the weekly reporting requirements in the proposed rule change will impose significant costs on firms or will require firms to expend significant resources.

      As discussed above, once FINRA eliminates the self-reporting requirement and starts deriving the published data directly from the transaction data, the proposal to publish aggregate ATS trade counts and volume data would not impose any additional reporting requirements on firms, and as a result would impose no direct costs on firms. Some ATSs may choose to incur costs to verify the information FINRA publishes (e.g., trade counts), but these costs are not anticipated to be material and would be incurred only at the discretion of the ATS.

      In developing this proposal, FINRA considered the potential impacts on competition, both among firms and ATSs. Specifically, FINRA considered the potential that market participants could reverse engineer the aggregated trade counts and volume data. Such data could potentially be analyzed to infer whether there was a single counterparty to an ATS trade in a given CUSIP, in a given month, on an ATS. In such a case, it may be possible for a participant to take advantage of such information when the same counterparty tries to take a position on the opposite side of the trade. However, the publication would be subject to a three month delay, which could mitigate such potential impact.

      The analysis of the trade data between August 2016 and November 2018 indicated that, in the sample period, aggregate monthly trade counts and volume data at the CUSIP and ATS level would include trading activity of, at the median, two (one) broker-dealers in corporate (agency) TRACE-eligible securities on a given ATS. Over the sample period, 38 percent (66 percent) of the transactions in the monthly reports would be associated with a single broker-dealer, assuming no de minimis threshold on the number of parties to transactions on an ATS.

      However, in the sample period, 50 percent of those broker-dealers would have trading activity with at least one other counterparty (for corporate bonds), whereas the same figure is only 19 percent for the broker-dealers in agencies, in a given CUSIP. Furthermore, CUSIPs that traded on at least one ATS in a given month, traded, on average, four to ten times more than CUSIPs that did not trade on at least one ATS. This finding implies that the proposed ATS reports would contain trade information for relatively more liquid securities where reverse engineering of trading patterns would be potentially less likely. Therefore, the proposed ATS reports are not likely to be useful in estimating the trading strategies or complete inventories of broker-dealers.

      FINRA also considered the direct competitive effects on ATSs that may potentially arise from disseminating the proposed trade data. To the extent that this information is not already observed by market participants, ATS subscribers who discover that trading had been concentrated–due to relatively higher liquidity or other reasons–in a single ATS or a few ATSs in a given CUSIP may choose to send orders exclusively to those ATSs. As a result, other ATSs that have relatively smaller trading volume may lose some market share in that CUSIP. Similarly, new ATSs may potentially find it harder to enter the market due to the heightened barriers to entry caused by the disclosure of information regarding concentration of trading in certain ATSs.

      Alternatives Considered

      FINRA will consider alternatives based on the feedback to the proposal.

      Request for Comment

      FINRA seeks comments on the proposal outlined above regarding publication of fixed income ATS volume information. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. In addition to general comments, FINRA specifically requests comments on the following questions:

      •  Would expansion of individual ATS volume data to include information on corporate and agency debt securities provide valuable information to the marketplace?
      •  What, if any, benefits would commenters anticipate if FINRA were to begin publishing ATS volume data for corporate and agency debt instruments on its website?
      •  What, if any, concerns, including potential information leakage and reverse engineering concerns, would commenters have if FINRA were to begin publishing this ATS volume data on its website?
      •  Are there any potential competitive advantages or disadvantages to attributing corporate and agency debt transaction volume by ATS?
      •  Could the proposed publication of ATS corporate and agency debt volume data create barriers to entry for new ATSs, and if so, please describe?
      •  Should FINRA consider a de minimis activity threshold under which an ATS would not be identified in the published reports with respect to a security or would be aggregated with the volume of other ATSs, and, if so, what would be an appropriate threshold?
      •  FINRA proposes that the ATS volume and trade count data would reflect the sell-side of trades reported by an ATS and the sell side of inter-dealer trades where the ATS is identified on the trade report pursuant to Rule 6730(c)(13). Do commenters agree that this approach is the most appropriate? If not, what other approach would be more appropriate and why
      •  FINRA proposes to publish volume and trade count data by ATS and CUSIP for corporate and agency debt securities on a monthly aggregation schedule with a three-month delay. Do commenters agree with this approach?
      •  Is there an alternative schedule that might be more appropriate than monthly aggregation, and, if so, why?
      •  Is there an alternative delay period that might be more appropriate than three months, and, if so, why?
      •  Should aggregation periods or publication delays differ for corporates versus agencies, and, if so, why?
      •  Are there other types of tiering of the aggregation period or publication delays, based on volume, number of trades or some other factor, FINRA should consider? If so, what are they and why?
      •  Should FINRA consider groupings other than by CUSIP, such as by investment rating (e.g., investment grade rated and high yield categories by trade size), or some other factor?
      •  FINRA proposes initially to limit publication of ATS data to corporates and agencies. FINRA intends in the future to reconsider the appropriateness of including other types of disseminated TRACE-Eligible Securities.
      •  Do commenters agree with this approach? Would commenters suggest that FINRA include any different assets classes for initial publication, and, if so, why?
      •  What, if any, issues do commenters anticipate if FINRA were to expand publication of fixed income ATS volume data to include other asset classes in the future, such as Securitized Products?
      •  How would commenters like to see corporate and agency debt ATS volume data displayed; e.g., what categories or groupings of data would be most helpful?
      •  FINRA proposes to limit the current fixed income publication initiative to data on transactions that occur within an ATS. However, as noted above, FINRA is aware that there are other types of fixed income electronic trading platforms that are not ATSs. Should FINRA consider broadening the scope of the website publication initiative to include transactions on other fixed income trading mechanisms, such as RFQ platforms? If so, what types of platforms should be included, why, and how should they and/or the transactions executed on those platforms be defined and identified?
      •  Are there any other issues specific to the fixed income markets that FINRA should consider in connection with publishing aggregate ATS corporate and agency debt volume data?

      1. FINRA will not edit personal identifying information, such as names or email addresses, from submissions. Persons should submit only information that they wish to make publicly available. See NTM 03-73 (November 2003) (NASD Announces Online Availability of Comments) for more information.

      2.See Section 19 of the Securities Exchange Act of 1934 (SEA) and rules thereunder. After a proposed rule change is filed with the SEC, the proposed rule change generally is published for public comment in the Federal Register. Certain limited types of proposed rule changes, however, take effect upon filing with the SEC. See SEA Section 19(b)(3) and SEA Rule 19b-4.

      3. See OTC Transparency Data [https://otctransparency.finra.org/otctransparency/Agreement](for the best experience, please view this site using the latest version of Chrome, Firefox, Safari or Internet Explorer).

      4. See Securities Exchange Act Release No. 70676 (October 11, 2013), 78 FR 62862 (October 22, 2013) (Notice of Filing of File No. SR-FINRA-2013-042).

      5. Rule 6710(a) generally defines a "TRACE-Eligible Security" as a debt security that is United States ("U.S.") dollar-denominated and is: (1) issued by a U.S. or foreign private issuer, and, if a "restricted security" as defined in Securities Act Rule 144(a) (3), sold pursuant to Securities Act Rule 144A; (2) issued or guaranteed by an Agency as defined in Rule 6710(k) or a Government-Sponsored Enterprise as defined in Rule 6710(n); or (3) a U.S. Treasury Security as defined in Rule 6710(p). "TRACE-Eligible Security" does not include a debt security that is issued by a foreign sovereign or a Money Market Instrument as defined in Rule 6710(o).

      6. See Securities Exchange Act Release No. 70676 (October 11, 2013), 78 FR 62862 (October 22, 2013) (Notice of Filing of File No. SR-FINRA-2013-042).

      7. See The published ATS data would include the CUSIPs that are disseminated as part of FINRA's Corporate Bond Data Set and Agency Data Set.

      8. See OTC Transparency Data [https://otctransparency.finra.org/otctransparency/Agreement] (for the best experience, please view this site using the latest version of Chrome, Firefox, Safari or Internet Explorer).

      9. See By contrast, ATS data for equity securities is aggregated on a weekly basis and publication delays vary from two weeks for Tier 1 NMS stocks to four weeks for OTC equities. See Rules 6110 and 6610.

      10.FINRA would not include within the published ATS data any information on transactions in corporate or agency debt securities that FINRA does not disseminate pursuant to Rule 6750.

      11."Securitized Product" generally includes a security collateralized by any type of financial asset, such as a loan, a lease, a mortgage, or a secured or unsecured receivable, and includes but is not limited to an asset-backed security as defined in SEA Section 3(a)(79)(A), a synthetic asset-backed security, and any residual tranche or interest of any such security, which tranche or interest is a debt security for purposes of Rule 6710(a) and the Rule 6700 Series.

      12. See Securities Exchange Act Release No. 70676 (October 11, 2013), 78 FR 62862, 62865 (October 22, 2013) (Notice of Filing of File No. SR-FINRA-2013-042); Securities Exchange Act Release No. 76931 (January 8, 2016), 81 FR 4076 (January 25, 2016) (Notice of Filing and Immediate Effectiveness of File No. SR-FINRA-2016-002).

      13. Where the ATS is a reporting party and stands in between a trade on its platform (either between two members or between a member and a non-member), the published data will reflect only the ATS sale in connection with the overall transaction.

      14. Rule 6730(c)(13) requires that, where a member is reporting a transaction that occurred on an exempt ATS (pursuant to an exemption granted under Rule 6732), the member must include the ATS's separate MPID. FINRA would not require exempt ATSs that currently report trade data on a monthly basis under Rule 6732 to separately self-report volume and trade count data for exempt transactions.

      15. The published data would not include the buy-side of any member subscriber trades, or the sell-side of trades by a member subscriber against an ATS.

      16. See Letters in connection with File No. SRFINRA-2015-020 from Kerry Baker Relf, Head of Content Acquisition and Rights Management, Americas, Thomson Reuters, to Brett J. Fields, Secretary, SEC, dated July 20, 2015; and Theodore R. Lazo, Managing Director and Associate General Counsel, Securities Industry and Financial Markets Association, to Brett J. Fields, Secretary, SEC, dated July 30, 2015.

      17. See Securities Exchange Act Release No. 77404 (March 18, 2016), 81 FR 05770 (March 24, 2016) (Notice of Filing and Immediate Effectiveness of File No. SR-FINRA-2016-011).

    • 19-21 Margin Requirements for Exchange-Traded Notes

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      Discovery in FINRA Arbitration

      Regulatory Notice
      Notice Type

      Guidance
      Referenced Rules & Notices

      Regulatory Notice 09-53
      Rule 4210
      Suggested Routing

      Compliance
      Institutional
      Legal
      Margin
      Operations
      Registered Representatives
      Risk
      Senior Management
      Systems
      Trading
      Key Topics

      Exchange-Traded Notes
      Portfolio Margin
      Strategy-Based Margin

      Summary

      Pursuant to FINRA Rule 4210(f)(8)(A), FINRA is establishing higher strategy-based margin requirements for exchange-traded notes (ETNs) and options on ETNs in light of the complex nature of these products. The new requirements for initial and maintenance margin are detailed below.

      In addition, FINRA is clarifying that ETNs and options on ETNs are not eligible for portfolio margining under FINRA Rule 4210(g).

      If these measures would result in undue hardship to a firm or its customers, the firm may submit a written request to FINRA for additional time to comply with this Notice.

      Questions concerning this Notice should be directed to:

      •   Adam Rodriguez, Director, Credit Regulation, at (646) 315-8572 or adam.rodriguez@finra.org;
      •   Joseph David, Principal Specialist, at (646) 315-8444 or joseph.david@finra.org; or
      •   Kathryn Moore, Associate General Counsel, Office of General Counsel, at (202) 728-8200 or kathryn.moore@finra.org.

      Background & Discussion

      An ETN is an unsecured obligation of its issuer, typically a bank or other financial institution. However, ETNs are different from typical corporate bonds as, among other things, they do not pay interest and pay principal based on the performance of a reference index or benchmark. For this reason, an investment in an ETN can have a return similar to an investment in an exchange-traded fund (ETF) that is designed to track the performance of the index or benchmark referenced by the ETN.

      Though these products are also structured products that trade on an exchange, they differ in a few respects. For example, ETFs are generally equity products: an investor in an ETF, which is typically a registered investment company, owns shares of a fund, which represents an ownership interest in an underlying portfolio of assets. In contrast, as noted above, ETNs are unsecured debt, typically of a financial institution. Unlike ETFs, ETNs do not reflect ownership of an underlying portfolio of assets, and this feature exposes holders of an ETN to the creditworthiness of the issuer in addition to the risk of the reference index or benchmark. ETNs may also have "knock-out" features or give their issuers early redemption rights, which can cause the return on an ETN investment to further diverge from the return on an investment in an ETF that tracks the same index.1

      Increase in Strategy-Based Margin

      The maintenance margin requirements on all "margin securities," which include debt securities, are generally set by FINRA Rule 4210(c). The rule requires strategy-based accounts to maintain equity equal to 25% of the current market value of all margin securities long in the account, and the greater of 5% of the principal amount or 30% of the current market value of debt securities short in the account.

      As an exception to this general rule, reduced margin requirements for investment grade debt securities,2 listed non-equity securities3 and "other margin eligible non-equity securities"4 are set out in Rule 4210(e)(2)(C).5 Although ETNs may technically qualify for these reduced margin requirements (because they are listed on national securities exchanges and their issuers are generally rated investment-grade), they have materially different risk profiles than typical debt securities. Typical debt securities expose investors to issuer credit risk and a greater or lesser degree of interest rate risk, while ETN investors are exposed to issuer credit risk and also the risk of the reference index or benchmark. Because of the significance of the reference index or benchmark risk to an ETN position, FINRA believes that the exceptions provided by Rule 4210(e)(2)(C) should not apply to ETN positions in strategy-based accounts.

      Pursuant to FINRA Rule 4210(f)(8)(A),6 FINRA is excluding ETNs from the exceptions available for positions in ordinary investment grade debt securities, listed non-equity securities and "other margin eligible non-equity securities," and establishing for them:

      •  an initial and maintenance margin requirement of 25% of the current market value for ETNs held long in an account, and 30% of the current market value for ETNs held short; and
      •  an initial and maintenance margin requirement on listed options on ETNs of 20% of the underlying current market value of the ETN, and a minimum margin requirement of 10% of the underlying current market value of the ETN, in each case for purposes of the listed options and warrants requirements chart in Rule 4210(f)(2)(E)(i).7

      Further, similar to the approach taken in Regulatory Notice 09-53 with respect to leveraged ETFs, FINRA is increasing the margin requirements (including day trading requirements) for leveraged ETNs and their associated uncovered options by a factor commensurate with their leverage.8 The margin requirement on a leveraged ETN held long in an account is capped at 100% of its value; however, no such cap applies for a leveraged ETN held short.

      Portfolio Margin Treatment

      As an alternative to the strategy-based margin requirements specified in FINRA Rule 4210(c)-(f), FINRA Rule 4210(g) permits members to margin certain products according to a prescribed portfolio margin methodology that is based on the Options Clearing Corporation's (OCC) Theoretical Intermarket Margining System (TIMS) model.9 Portfolio margin is a risk-based margin methodology that was created to align margin requirements for equity securities with the overall risk of the portfolio. Portfolio margin usually results in lower margin requirements on hedged positions than strategy-based margin rules would impose on such hedged positions.

      ETNs and options on ETNs historically have been included in the TIMS file provided by the OCC, and as a result some firms have provided portfolio margin treatment to ETNs and options on ETNs when such products have been included in customer portfolio margin accounts. However, ETNs are not on the list of products that are eligible to be included in portfolio margin as provided in FINRA Rule 4210(g)(6).10 Therefore, firms may not apply the portfolio margin requirements provided by the TIMS model for positions in ETNs and options on ETNs held in portfolio margin accounts.11

      Effective on August 16, 2019, the OCC will be removing all ETNs and related options that are currently in the TIMS file.12

      Hardship Extension

      If the foregoing measures would result in undue hardship to a firm or its customers, the firm may submit a written request to FINRA for additional time to comply with this Notice. Such requests must include an explanation of the specific circumstances leading to the request and must be received by FINRA no later than July 26, 2019. Requests regarding margin may be directed to Adam Rodriguez or Joe David at the contact information stated at the top of this Notice.


      1. See, e.g., SEC Investor Bulletin, Exchange Traded Notes (ETNs) and FINRA Investor Alert, Exchange-Traded Notes–Avoid Unpleasant Surprises.

      2. Rule 4210(a)(10) defines "investment grade debt securities" as "any debt securities … if at the time of the extension of credit the issue, the issuer or guarantor, or any other outstanding obligation of the issuer or guarantor ranked junior to or on a parity with the issue or the guarantee is assigned a rating (implicitly or explicitly) in one of the top four rating categories by at least one nationally recognized statistical rating organization."

      3. Rule 4210(a)(15) defines "listed non-equity securities" as "any non-equity securities that: (A) are listed on a national securities exchange; or (B) have unlisted trading privileges on a national securities exchange."

      4. Rule 4210(a)(16) limits the term "other margin eligible non-equity securities" to:

      A. Any debt securities not traded on a national securities exchange meeting all of the following requirements:
      i. At the time of the original issue, a principal amount of not less than $25 million of the issue was outstanding;
      ii. The issue was registered under Section 5 of the Securities Act and the issuer either files periodic reports pursuant to Section 13(a) or 15(d) of the Exchange Act or is an insurance company which meets all of the conditions specified in Section 12(g)(2)(G) of the Exchange Act; and
      iii. At the time of the extensions of credit, the creditor has a reasonable basis for believing that the issuer is not in default on interest or principal payments; or
      B. Any private pass-through securities (not guaranteed by any agency of the U.S. government) meeting all of the following requirements:
      i. An aggregate principal amount of not less than $25 million (which may be issued in series) was issued pursuant to a registration statement filed with the SEC under Section 5 of the Securities Act;
      ii. Current reports relating to the issue have been filed with the SEC; and
      iii. At the time of the credit extension, the creditor has a reasonable basis for believing that mortgage interest, principal payments and other distributions are being passed through as required and that the servicing agent is meeting its material obligations under the terms of the offering.

      5. The reduced requirements are 10% of the current market value of investment grade debt securities long or short in the accounts and the greater of 20% of the current market value or 7% of the principal amount of any other listed non-equity securities or other margin eligible non-equity securities long or short in the account.

      6. FINRA Rule 4210(f)(8)(A) authorizes FINRA to prescribe higher initial and maintenance margin requirements, and such other terms and conditions as FINRA deems appropriate relating to such requirements, whenever it determines that market conditions so warrant. This provision has been used to raise or clarify the margin requirements for several products. See, e.g., Regulatory Notice 10-53 (exempted securities mutual funds and exempted securities ETFs), Regulatory Notice 09-53 (non-traditional ETFs) and Regulatory Notice 08-08 (certain auction rate securities).

      7. The listed option margin requirements in Rule 4210(f)(2)(E) do not contemplate listed options on debt securities other than U.S. treasury and GNMA obligations. The initial and maintenance requirements we are prescribing for listed options on ETNs are a 5% over the requirements for OTC options on listed non-equity securities under Rule 4210(f)(2)(E)(iii) and are equal to the initial and maintenance margin requirements on listed options on stock and convertible corporate debt securities.

      8. See Regulatory Notice 09-53 (August 2009) detailing increased margin requirements for leveraged ETFs and associated uncovered options.

      9. FINRA Rule 4210(g)(3) requires that theoretical pricing models must be approved by the Securities and Exchange Commission (SEC). The OCC's TIMS model is the only model so approved.

      10. The eligible products listed in FINRA Rule 4210(g) (6)(B) consist of: (1) a margin equity security (including a foreign equity security and option on a foreign equity security, provided the foreign equity security is deemed to have a "ready market" under SEA Rule 15c3-1 or a "no-action" position issued thereunder, and a control or restricted security, provided the security has met the requirements in a manner consistent with Securities Act Rule 144 or an SEC "no-action" position issued thereunder, sufficient enough to permit the sale of the security, upon exercise or assignment of any listed option or unlisted derivative written or held against it, without restriction); (2) a listed option on an equity security or index of equity securities; (3) a security futures product; (4) an unlisted derivative on an equity security or index of equity securities; (5) a warrant on an equity security or index of equity securities; and (6) a related instrument as defined in paragraph (g)(2)(D) of FINRA Rule 4210.

      11. Consistent with FINRA Rule 4210(g)(7)(D), positions on ETNs and options on ETNs may be retained in portfolio margin accounts so long as the strategy-based requirement, as specified in this Notice, is applied.

      12. See OCC Information Memo #45304: ETN Removal from Customer Portfolio Margin Theoretical Output File [file:///C:/Users/u6078323/Downloads/45304.pdf].

    • 19-20 SEC Approves Amendments to Arbitration Codes to Expand Time for Non-Parties to Respond to Arbitration Subpoenas and Orders of Appearance of Witnesses or Production of Documents; Effective Date: July 1, 2019

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      Discovery in FINRA Arbitration

      Regulatory Notice
      Notice Type

      Rule Amendment
      Referenced Rules & Notices

      FINRA Rule 12512
      FINRA Rule 12513
      FINRA Rule 13512
      FINRA Rule 13513
      Suggested Routing

      Compliance
      Legal
      Registered Representatives
      Key Topics

      Arbitration
      Codes of Arbitration Procedure
      Discovery
      Dispute Resolution
      Orders to Appear or to Produce Documents
      Subpoenas

      Summary

      The Securities and Exchange Commission (SEC) approved1 amendments to FINRA's customer and industry arbitration rules to expand time for nonparties to respond to arbitration subpoenas and orders of appearance of witnesses or production of documents. The amendments also make related changes to enhance the discovery process for forum users.

      The amendments are effective for cases filed on or after July 1, 2019.

      Questions concerning this Notice should be directed to:

      •   Leslie Leutwiler, Associate Director, Office of Dispute Resolution, at (212) 858-4136 or leslie.leutwiler@finra.org; or
      •   Kristine Vo, Principal Counsel, Office of General Counsel, at (212) 858-4106 or kristine.vo@finra.org.

      Background & Discussion

      Under the Codes of Arbitration Procedure for Customer and Industry Disputes (Codes), parties exchange documents and information to prepare for arbitration through the discovery process.2 Parties who seek discovery from a non-party may request the panel to issue an order of appearance of witnesses or production of documents if the non-party is subject to FINRA's jurisdiction as an associated person or member firm.3 The Codes also authorize arbitrators to issue a subpoena if the non-party is not subject to FINRA's jurisdiction.4 If the panel decides to issue the order or subpoena, FINRA will transmit the signed order or subpoena to the moving party to serve on the non-party.5 If a non-party receiving an order or a subpoena objects to the scope or propriety of the order or subpoena, the non-party may file written objections through the Director of the Office of Dispute Resolution (Director).6

      FINRA amended the Codes to extend the response time for non-parties to object to an order or subpoena from 10 calendar days of service to 15 calendar days of receipt of the order or subpoena. Receipt of overnight mail service, overnight delivery service, hand delivery, email or facsimile is accomplished on the date of delivery. With each of these methods of service, parties will be able to determine the date of delivery. The amendments exclude first-class mail as an option to serve documents on the non-party and as an option for the non-party to file the objection to the scope or propriety of the order or subpoena. Finally, the amendments codify the current practice that the Director send, at the same time, objections and responses to the panel after the reply date has elapsed, unless otherwise directed by the panel.

      Effective Date

      The amendments are effective for cases filed on or after July 1, 2019


      1. See Securities Exchange Act Release No. 85781 (May 6, 2019), 84 Federal Register 91 (May 10, 2019) (Order Approving File No. SR-FINRA-2019-004).

      2. The Codes require parties to cooperate with each other and exchange documents or information to expedite the arbitration. See FINRA Rules 12505 and 13505.

      3. See FINRA Rules 12513 and 13513.

      4. See FINRA Rules 12512 and 13512.

      5. See FINRA Rules 12512 and 12513. See also FINRA Rules 13512 and 13513.

      6. See id.


      Attachment A

      Customer Code

      12512. Subpoenas

      (a)–(c) No change.
      (d) If the arbitrator issues a subpoena, the party that requested the subpoena must serve the subpoena on all parties and, if applicable, on any non-party receiving the subpoena. The party must serve the subpoena on the non-party by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile.
      (e) If a non-party receiving a subpoena objects to the scope or propriety of the subpoena, the non-party may, within [10] 15 calendar days of [service] receipt of the subpoena, file written objections with the Director and the requesting party. The non-party may file the objection by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile. The Director shall forward a copy of the written objections to [the arbitrator and] all other parties. The party that requested the subpoena may respond to the objections within 10 calendar days of receipt of the objections. The party must serve the response on the non-party and all other parties and file proof of service with the Director pursuant to Rule 12300(c)(5). The Director will send, at the same time, objections and responses to the panel after the reply date has elapsed, unless otherwise directed by the panel. After considering all objections, the arbitrator responsible for issuing the subpoena shall rule promptly on the objections.
      (f)–(g) No change.

      * * * * *

      12513. Authority of Panel to Direct Appearances of Associated Person Witnesses and Production of Documents Without Subpoenas

      (a)–(c) No change.
      (d) If the arbitrator issues an order, the party that requested the order must serve the order on all parties and, if applicable, on any non-party receiving the order. The party must serve the order on the non-party[.] by overnight mail service, overnight delivery service, hand delivery, email or facsimile.
      (e) If a non-party receiving an order objects to the scope or propriety of the order, the non-party may, within [10] 15 calendar days of [service] receipt of the order, file written objections with the Director and the requesting party. The non-party may file the objection by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile. The Director shall forward a copy of the written objections to [the arbitrator and] all other parties. The party that requested the order may respond to the objections within 10 calendar days of receipt of the objections. The party must serve the response on the non-party and all other parties and file proof of service with the Director pursuant to Rule 12300(c)(5). The Director will send, at the same time, objections and responses to the panel after the reply date has elapsed, unless otherwise directed by the panel. After considering all objections, the arbitrator responsible for issuing the order shall rule promptly on the objections.
      (f)–(g) No change.

      * * * * *

      Industry Code

      13512. Subpoenas

      (a)–(c) No change.
      (d) If the arbitrator issues a subpoena, the party that requested the subpoena must serve the subpoena on all parties and, if applicable, on any non-party receiving the subpoena. The party must serve the subpoena on the non-party by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile.
      (e) If a non-party receiving a subpoena objects to the scope or propriety of the subpoena, the non-party may, within [10] 15 calendar days of [service] receipt of the subpoena, file written objections with the Director and the requesting party. The non-party may file the objection by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile. The Director shall forward a copy of the written objections to [the arbitrator and] all other parties. The party that requested the subpoena may respond to the objections within 10 calendar days of receipt of the objections. The party must serve the response on the non-party and all other parties and file proof of service with the Director pursuant to Rule 13300(c)(4). The Director will send, at the same time, objections and responses to the panel after the reply date has elapsed, unless otherwise directed by the panel. After considering all objections, the arbitrator responsible for issuing the subpoena shall rule promptly on the objections.
      (f)–(g) No change.

      * * * * *

      13513. Authority of Panel to Direct Appearances of Associated Person Witnesses and Production of Documents Without Subpoenas

      (a)–(c) No change.
      (d) If the arbitrator issues an order, the party that requested the order must serve the order on all parties and, if applicable, on any non-party receiving the order. The party must serve the order on the non-party by [first-class mail] overnight mail service, overnight delivery service, hand delivery, email or facsimile.
      (e) If a non-party receiving an order objects to the scope or propriety of the order, the non-party may, within [10] 15 calendar days of [service] receipt of the order, file written objections with the Director and the requesting party. The non-party may file the objection by [first-class mail,] overnight mail service, overnight delivery service, hand delivery, email or facsimile. The Director shall forward a copy of the written objections to [the arbitrator and] all other parties. The party that requested the order may respond to the objections within 10 calendar days of receipt of the objections. The party must serve the response on the non-party and all other parties and file proof of service with the Director pursuant to Rule 13300(c)(4). The Director will send, at the same time, objections and responses to the panel after the reply date has elapsed, unless otherwise directed by the panel. After considering all objections, the arbitrator responsible for issuing the order shall rule promptly on the objections.
      (f)–(g) No change.

    • 19-19 FINRA Reminds Firms to Register for CAT Reporting by June 27, 2019

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      Consolidated Audit Trail

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Systems
      Trading
      Key Topics

      Consolidated Audit Trail (CAT)
      FINRA CAT
      NMS Securities
      OTC Equity Securities
      Referenced Rules & Notices

      Securities Exchange Act Rule 613

      Summary

      FINRA is issuing this Notice to remind firms they must register with FINRA CAT, LLC (FINRA CAT) for reporting to the Consolidated Audit Trail (CAT). CAT registration commenced on March 18, 2019, and will run through June 27, 2019. All Industry Members, as defined under the CAT NMS Plan, that will have a CAT reporting obligation must register during this window.

      All questions regarding CAT registration should be directed to the FINRA CAT Helpdesk at (888) 696-3348 or help@finracat.com.

      Background & Discussion

      On March 19, 2019, the CAT NMS Plan participants presented the timelines and documentation for Industry Members to register with FINRA CAT1 for reporting to the CAT. The registration form, which must be submitted online, and related information can be found at www.catnmsplan.com/registration/.

      Industry Members that must register for the CAT include any:

      •   member of FINRA or a national securities exchange that handles orders or quotes in NMS stocks, OTC equity securities or exchange listed options; and
      •   third-party CAT reporting agent that is or will be authorized to submit data to the CAT on behalf of an Industry Member.

      The CAT rules do not provide for any firms to be excluded or exempted from the CAT reporting obligation.

      For Equities (Phase 2a), Industry Member testing (file submission and data integrity) is scheduled to commence in December 2019, with go-live in April 2020. For Options (Phase 2b), Industry Member testing (file submission and data integrity) is scheduled to start as early as December 2019, with go-live in May 2020.2

      All questions should be directed to the FINRA CAT Helpdesk via phone at (888) 696-3348 or email at help@finracat.com.


      Endnotes

      1 In February 2019, the CAT NMS Plan participants announced they had selected FINRA as the plan processor to perform the CAT processing functions required by SEC Rule 613 and as set forth in the CAT NMS Plan. FINRA created a subsidiary, FINRA CAT, to carry out its obligations as plan processor. As a subsidiary of FINRA, FINRA CAT is part of the registered securities association; however, it is separate and distinct from the other FINRA entities

      2 See www.catnmsplan.com/wp-content/ uploads/2019/03/CAT_Industry_Call_03192019_ Presentation.pdf

    • 19-18 FINRA Provides Guidance to Firms Regarding Suspicious Activity Monitoring and Reporting Obligations

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      Anti-Money Laundering (AML) Program

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Key Topics

      Anti-Money Laundering
      Compliance Programs
      Referenced Rules & Notices

      Bank Secrecy Act
      FINRA Rule 3310
      Notice to Members 02-21

      Summary

      FINRA is issuing this Notice to provide guidance to member firms regarding suspicious activity monitoring and reporting obligations under FINRA Rule 3310 (Anti-Money Laundering Compliance Program).

      Questions concerning this Notice should be directed to:

      •   Victoria Crane, Associate General Counsel, Office of General Counsel, at (202) 728-8104 or victoria.crane@finra.org; or
      •   Blake Snyder, Senior Director, Member Regulation, at (561) 443-8051 or blake.snyder@finra.org.

      Background and Discussion

      FINRA Rule 3310 (Anti-Money Laundering Compliance Program) requires each member firm to develop and implement a written anti-money laundering (AML) program reasonably designed to achieve and monitor the firm's compliance with the requirements of the Bank Secrecy Act (BSA),1 and the implementing regulations promulgated thereunder by the Department of the Treasury (Treasury).

      FINRA Rule 3310(a) requires firms to "[e]stablish and implement policies and procedures that can be reasonably expected to detect and cause the reporting of transactions required under [the BSA] and the implementing regulation thereunder." The BSA authorizes Treasury to require that financial institutions file suspicious activity reports (SARs).2

      Under Treasury's SAR rule,3 a broker-dealer must report a transaction to the Financial Crimes Enforcement Network (FinCEN) if it is conducted or attempted by, at or through a broker-dealer, it involves or aggregates funds or other assets of at least $5,000, and the broker-dealer knows, suspects or has reason to suspect that the transaction (or a pattern of transactions of which the transaction is a part):

      •   involves funds derived from illegal activity or is intended or conducted in order to hide or disguise funds or assets derived from illegal activity (including, without limitation, the ownership, nature, source, location or control of such funds or assets) as part of a plan to violate or evade any federal law or regulation or to avoid any transaction reporting requirement under federal law or regulation;
      •   is designed, whether through structuring or other means, to evade any regulations promulgated under the BSA;
      •   has no business or apparent lawful purpose or is not the sort in which the particular customer would normally be expected to engage, and the broker-dealer knows of no reasonable explanation for the transaction after examining the available facts, including the background and possible purpose of the transaction; or
      •   involves use of the broker-dealer to facilitate criminal activity.4

      Broker-dealers must report the suspicious activity by completing a SAR and filing it in accordance with the requirements of Treasury's SAR rule.5 Broker-dealers must maintain a copy of any SAR filed and supporting documentation for a period of five years from the date of filing the SAR.6 FinCEN has provided guidance7 to the industry advising that if the activity that was the subject of a SAR filing continues, firms should review any continuing activity at least every 90 days to consider whether a continuing activity SAR filing is warranted, with the filing deadline being 120 days after the date of the previously related SAR filing.

      In situations that require immediate attention, such as terrorist financing or ongoing money laundering schemes, broker-dealers must immediately notify by telephone an appropriate law enforcement authority in addition to filing timely a SAR. The firm may call FinCEN's Hotline at (866) 556-3974.

      Money Laundering Red Flags

      FINRA published a list of "money laundering red flags" in Notice to Members 02-21 (NTM 02-21). Since NTM 02-21 was published, guidance detailing additional red flags that may be applicable to the securities industry have been published by a number of U.S. government agencies and international organizations.8 FINRA is issuing this Notice to provide examples of these additional money laundering red flags for firms to consider incorporating into their AML programs, as may be appropriate in implementing a risk-based approach to BSA/AML compliance. This could include, as applicable, incorporation into policies and procedures relating to suspicious activity monitoring or suspicious activity investigation and SAR reporting. Upon detection of red flags through monitoring, firms should consider whether additional investigation, customer due diligence measures or a SAR filing may be warranted.

      The following is not an exhaustive list and does not guarantee compliance with AML program requirements or provide a safe harbor from regulatory responsibility. Further, it is important to note that a red flag is not necessarily indicative of suspicious activity, and that not every item identified in this Notice will be relevant for every broker-dealer, every customer relationship or every business activity.

      Firms should also be aware of emerging areas of risk, such as risks associated with activity in digital assets. Regardless of whether such assets are securities, BSA/AML requirements, including SAR filing requirements apply, and firms should thus consider the relevant risks, monitor for suspicious activity and, as applicable, report any such activity.

      This Notice is intended to assist broker-dealers in complying with their existing obligations under BSA/AML requirements and does not create any new requirements or expectations. In addition, this Notice incorporates the red flags listed in NTM 02-21 so that firms can refer to this Notice only for examples of potential red flags.

      I. Potential Red Flags in Customer Due Diligence and Interactions With Customers

      1. The customer provides the firm with unusual or suspicious identification documents that cannot be readily verified or are inconsistent with other statements or documents that the customer has provided. Or, the customer provides information that is inconsistent with other available information about the customer. This indicator may apply to account openings and to interaction subsequent to account opening.
      2. The customer is reluctant or refuses to provide the firm with complete customer due diligence information as required by the firm's procedures, which may include information regarding the nature and purpose of the customer's business, prior financial relationships, anticipated account activity, business location and, if applicable, the entity's officers and directors.
      3. The customer refuses to identify a legitimate source of funds or information is false, misleading or substantially incorrect.
      4. The customer is domiciled in, doing business in or regularly transacting with counterparties in a jurisdiction that is known as a bank secrecy haven, tax shelter, high-risk geographic location (e.g., known as a narcotics producing jurisdiction, known to have ineffective AML/Combating the Financing of Terrorism systems) or conflict zone, including those with an established threat of terrorism.
      5. The customer has difficulty describing the nature of his or her business or lacks general knowledge of his or her industry.
      6. The customer has no discernable reason for using the firm's service or the firm's location (e.g., the customer lacks roots to the local community or has gone out of his or her way to use the firm).
      7. The customer has been rejected or has had its relationship terminated as a customer by other financial services firms.
      8. The customer's legal or mailing address is associated with multiple other accounts or businesses that do not appear related.
      9. The customer appears to be acting as an agent for an undisclosed principal, but is reluctant to provide information.
      10. The customer is a trust, shell company or private investment company that is reluctant to provide information on controlling parties and underlying beneficiaries.
      11. The customer is publicly known or known to the firm to have criminal, civil or regulatory proceedings against him or her for crime, corruption or misuse of public funds, or is known to associate with such persons. Sources for this information could include news items, the Internet or commercial database searches.
      12. The customer's background is questionable or differs from expectations based on business activities.
      13. The customer maintains multiple accounts, or maintains accounts in the names of family members or corporate entities, with no apparent business or other purpose.
      14. An account is opened by a politically exposed person (PEP),9 particularly in conjunction with one or more additional risk factors, such as the account being opened by a shell company10 beneficially owned or controlled by the PEP, the PEP is from a country which has been identified by FATF as having strategic AML regime deficiencies, or the PEP is from a country known to have a high level of corruption.
      15. An account is opened by a non-profit organization that provides services in geographic locations known to be at higher risk for being an active terrorist threat.11
      16. An account is opened in the name of a legal entity that is involved in the activities of an association, organization or foundation whose aims are related to the claims or demands of a known terrorist entity.12
      17. An account is opened for a purported stock loan company, which may hold the restricted securities of corporate insiders who have pledged the securities as collateral for, and then defaulted on, purported loans, after which the securities are sold on an unregistered basis.
      18. An account is opened in the name of a foreign financial institution, such as an offshore bank or broker-dealer, that sells shares of stock on an unregistered basis on behalf of customers.
      19. An account is opened for a foreign financial institution that is affiliated with a U.S. broker-dealer, bypassing its U.S. affiliate, for no apparent business purpose. An apparent business purpose could include access to products or services the U.S. affiliate does not provide.

      II. Potential Red Flags in Deposits of Securities

      1. A customer opens a new account and deposits physical certificates, or delivers in shares electronically, representing a large block of thinly traded or low-priced securities.
      2. A customer has a pattern of depositing physical share certificates, or a pattern of delivering in shares electronically, immediately selling the shares and then wiring, or otherwise transferring out the proceeds of the sale(s).
      3. A customer deposits into an account physical share certificates or electronically deposits or transfers shares that:
      •   were recently issued or represent a large percentage of the float for the security;
      •   reference a company or customer name that has been changed or that does not match the name on the account;
      •   were issued by a shell company;
      •   were issued by a company that has no apparent business, revenues or products;
      •   were issued by a company whose SEC filings are not current, are incomplete, or nonexistent;
      •   were issued by a company that has been through several recent name changes or business combinations or recapitalizations;
      •   were issued by a company that has been the subject of a prior trading suspension; or
      •   were issued by a company whose officers or insiders have a history of regulatory or criminal violations, or are associated with multiple low-priced stock issuers.
      4. The lack of a restrictive legend on deposited shares seems inconsistent with the date the customer acquired the securities, the nature of the transaction in which the securities were acquired, the history of the stock or the volume of shares trading.
      5. A customer with limited or no other assets at the firm receives an electronic transfer or journal transfer of large amounts of low-priced, non-exchange-listed securities.
      6. The customer's explanation or documents purporting to evidence how the customer acquired the shares does not make sense or changes upon questioning by the firm or other parties. Such documents could include questionable legal opinions or securities purchase agreements.
      7. The customer deposits physical securities or delivers in shares electronically, and within a short time-frame, requests to journal the shares into multiple accounts that do not appear to be related, or to sell or otherwise transfer ownership of the shares.
      8. Seemingly unrelated clients open accounts on or at about the same time, deposit the same low-priced security and subsequently liquidate the security in a manner that suggests coordination.

      III. Potential Red Flags in Securities Trading13

      1. The customer, for no apparent reason or in conjunction with other "red flags," engages in transactions involving certain types of securities, such as penny stocks, Regulation "S" stocks and bearer bonds, which although legitimate, have been used in connection with fraudulent schemes and money laundering activity. (Such transactions may warrant further due diligence to ensure the legitimacy of the customer's activity.)
      2. There is a sudden spike in investor demand for, coupled with a rising price in, a thinly traded or low-priced security.
      3. The customer's activity represents a significant proportion of the daily trading volume in a thinly traded or low-priced security.
      4. A customer buys and sells securities with no discernable purpose or circumstances that appear unusual.
      5. Individuals known throughout the industry to be stock promoters sell securities through the broker-dealer.
      6. A customer accumulates stock in small increments throughout the trading day to increase price.
      7. A customer engages in pre-arranged or other non-competitive securities trading, including wash or cross trades, with no apparent business purpose.
      8. A customer attempts to influence the closing price of a stock by executing purchase or sale orders at or near the close of the market.
      9. A customer engages in transactions suspected to be associated with cyber breaches of customer accounts, including potentially unauthorized disbursements of funds or trades.
      10. A customer engages in a frequent pattern of placing orders on one side of the market, usually inside the existing National Best Bid or Offer (NBBO), followed by the customer entering orders on the other side of the market that execute against other market participants that joined the market at the improved NBBO (activity indicative of "spoofing").
      11. A customer engages in a frequent pattern of placing multiple limit orders on one side of the market at various price levels, followed by the customer entering orders on the opposite side of the market that are executed and the customer cancelling the original limit orders (activity indicative of "layering").
      12. Two or more unrelated customer accounts at the firm trade an illiquid or lowpriced security suddenly and simultaneously.
      13. The customer makes a large purchase or sale of a security, or option on a security, shortly before news or a significant announcement is issued that affects the price of the security.
      14. The customer is known to have friends or family who work at or for the securities issuer, which may be a red flag for potential insider trading or unlawful sales of unregistered securities.
      15. The customer's purchase of a security does not correspond to the customer's investment profile or history of transactions (e.g., the customer may never have invested in equity securities or may have never invested in a given industry, but does so at an opportune time) and there is no reasonable explanation for the change.
      16. The account is using a master/sub structure, which enables trading anonymity with respect to the sub-accounts' activity, and engages in trading activity that raises red flags, such as the liquidation of microcap issuers or potentially manipulative trading activity.
      17. The firm receives regulatory inquiries or grand jury or other subpoenas concerning the firm's customers' trading.
      18. The customer engages in a pattern of transactions in securities indicating the customer is using securities to engage in currency conversion. For example, the customer delivers in and subsequently liquidates American Depository Receipts (ADRs) or dual currency bonds for U.S. dollar proceeds, where the securities were originally purchased in a different currency.
      19. The customer engages in mirror trades or transactions involving securities used for currency conversions, potentially through the use of offsetting trades.
      20. The customer appears to buy or sell securities based on advanced knowledge of pending customer orders.

      IV. Potential Red Flags in Money Movements

      1. The customer attempts or makes frequent or large deposits of currency, insists on dealing only in cash equivalents, or asks for exemptions from the firm's policies and procedures relating to the deposit of cash and cash equivalents.
      2. The customer "structures" deposits, withdrawals or purchases of monetary instruments below a certain amount to avoid reporting or recordkeeping requirements, and may state directly that they are trying to avoid triggering a reporting obligation or to evade taxing authorities.
      3. The customer seemingly breaks funds transfers into smaller transfers to avoid raising attention to a larger funds transfer. The smaller funds transfers do not appear to be based on payroll cycles, retirement needs, or other legitimate regular deposit and withdrawal strategies.
      4. The customer's account shows numerous currency, money order (particularly sequentially numbered money orders) or cashier's check transactions aggregating to significant sums without any apparent business or lawful purpose.
      5. The customer frequently changes bank account details or information for redemption proceeds, in particular when followed by redemption requests.
      6. The customer makes a funds deposit followed by an immediate request that the money be wired out or transferred to a third party, or to another firm, without any apparent business purpose.
      7. Wire transfers are made in small amounts in an apparent effort to avoid triggering identification or reporting requirements.
      8. Incoming payments are made by third-party checks or checks with multiple endorsements.
      9. Outgoing checks to third parties coincide with, or are close in time to, incoming checks from other third parties.
      10. Payments are made by third party check or money transfer from a source that has no apparent connection to the customer.
      11. Wire transfers are made to or from financial secrecy havens, tax havens, highrisk geographic locations or conflict zones, including those with an established presence of terrorism.
      12. Wire transfers originate from jurisdictions that have been highlighted in relation to black market peso exchange activities.
      13. The customer engages in transactions involving foreign currency exchanges that are followed within a short time by wire transfers to locations of specific concern (e.g., countries designated by national authorities, such as FATF, as non-cooperative countries and territories).
      14. The parties to the transaction (e.g., originator or beneficiary) are from countries that are known to support terrorist activities and organizations.
      15. Wire transfers or payments are made to or from unrelated third parties (foreign or domestic), or where the name or account number of the beneficiary or remitter has not been supplied.
      16. There is wire transfer activity that is unexplained, repetitive, unusually large, shows unusual patterns or has no apparent business purpose.
      17. The securities account is used for payments or outgoing wire transfers with little or no securities activities (i.e., account appears to be used as a depository account or a conduit for transfers, which may be purported to be for business operating needs).
      18. Funds are transferred to financial or depository institutions other than those from which the funds were initially received, specifically when different countries are involved.
      19. The customer engages in excessive journal entries of funds between related or unrelated accounts without any apparent business purpose.
      20. The customer uses a personal/individual account for business purposes or vice versa.
      21. A foreign import business with U.S. accounts receives payments from outside the area of its customer base.
      22. There are frequent transactions involving round or whole dollar amounts purported to involve payments for goods or services.
      23. Upon request, a customer is unable or unwilling to produce appropriate documentation (e.g., invoices) to support a transaction, or documentation appears doctored or fake (e.g., documents contain significant discrepancies between the descriptions on the transport document or bill of lading, the invoice, or other documents such as the certificate of origin or packing list).
      24. The customer requests that certain payments be routed through nostro14 or correspondent accounts held by the financial intermediary instead of its own accounts, for no apparent business purpose.
      25. Funds are transferred into an account and are subsequently transferred out of the account in the same or nearly the same amounts, especially when the origin and destination locations are high-risk jurisdictions.
      26. A dormant account suddenly becomes active without a plausible explanation (e.g., large deposits that are suddenly wired out).
      27. Nonprofit or charitable organizations engage in financial transactions for which there appears to be no logical economic purpose or in which there appears to be no link between the stated activity of the organization and the other parties in the transaction.
      28. There is unusually frequent domestic and international automated teller machine (ATM) activity.
      29. A person customarily uses the ATM to make several deposits into a brokerage account below a specified BSA/AML reporting threshold.
      30. Many small, incoming wire transfers or deposits are made using checks and money orders that are almost immediately withdrawn or wired out in a manner inconsistent with the customer's business or history; the checks or money orders may reference in a memo section "investment" or "for purchase of stock." This may be an indicator of a Ponzi scheme or potential funneling activity.
      31. Wire transfer activity, when viewed over a period of time, reveals suspicious or unusual patterns, which could include round dollar, repetitive transactions or circuitous money movements.

      V. Potential Red Flags in Insurance Products

      1. The customer cancels an insurance contract and directs that the funds be sent to a third party.
      2. The customer deposits an insurance annuity check from a cancelled policy and immediately requests a withdrawal or transfer of funds.
      3. The customer cancels an annuity product within the free-look period. This could be a red flag if accompanied with suspicious indicators, such as purchasing the annuity with several sequentially numbered money orders or having a history of cancelling annuity products during the free-look period.
      4. The customer opens and closes accounts with one insurance company, then reopens a new account shortly thereafter with the same insurance company, each time with new ownership information.
      5. The customer purchases an insurance product with no concern for the investment objective or performance.

      VI. Other Potential Red Flags

      1. The customer is reluctant to provide information needed to file reports to proceed with the transaction.
      2. The customer exhibits unusual concern with the firm's compliance with government reporting requirements and the firm's AML policies.
      3. The customer tries to persuade an employee not to file required reports or not to maintain the required records.
      4. Notifications received from the broker-dealer's clearing firm that the clearing firm had identified potentially suspicious activity in customer accounts. Such notifications can take the form of alerts or other concern regarding negative news, money movements or activity involving certain securities.
      5. Law enforcement has issued subpoenas or freeze letters regarding a customer or account at the securities firm.
      6. The customer makes high-value transactions not commensurate with the customer's known income or financial resources.
      7. The customer wishes to engage in transactions that lack business sense or an apparent investment strategy, or are inconsistent with the customer's stated business strategy.
      8. The stated business, occupation or financial resources of the customer are not commensurate with the type or level of activity of the customer.
      9. The customer engages in transactions that show the customer is acting on behalf of third parties with no apparent business or lawful purpose.
      10. The customer engages in transactions that show a sudden change inconsistent with normal activities of the customer.
      11. Securities transactions are unwound before maturity, absent volatile market conditions or other logical or apparent reason.
      12. The customer does not exhibit a concern with the cost of the transaction or fees (e.g., surrender fees, or higher than necessary commissions).
      13. A borrower defaults on a cash-secured loan or any loan that is secured by assets that are readily convertible into currency.
      14. There is an unusual use of trust funds in business transactions or other financial activity.

      1. 31 U.S.C. 5311, et seq.

      2. See 31 U.S.C. 5318(g).

      3. See 31 CFR 1023.320.

      4. See 31 CFR 1023.320(a)(2).

      5. See 31 CFR 1023.320.

      6. See 31 CFR 1023.320(d).

      7. See FinCEN SAR Activity Review Issue 21 [https://www.fincen.gov/sites/default/files/shared/sar_tti_21.pdf] (May 2012).

      8. See, e.g, Financial Action Task Force (FATF), Guidance for a Risk-Based Approach for the Securities Sector [http://www.fatf-gafi.org/media/fatf/documents/recommendations/pdfs/RBA-Securities-Sector.pdf], October 2018; FATF, Money Laundering and Terrorist Financing in the Securities Sector [http://www.fatf-gafi.org/media/fatf/documents/reports/ML%20and%20TF%20in%20the%20Securities%20Sector.pdf], October 2009; FATF, Guidance for Financial Institutions in Detecting Terrorist Financing [http://www.fatf-gafi.org/media/fatf/documents/Guidance%20for%20financial%20institutions%20in%20detecting%20terrorist%20financing.pdf], April 2002; FATF Report, Laundering the Proceeds of Corruption [http://www.fatf-gafi.org/media/fatf/documents/reports/Laundering%20the%20Proceeds%20of%20Corruption.pdf], July 2011; FATF Report, Risk of Terrorist Abuse in Non-Profit Organisations [http://www.fatf-gafi.org/media/fatf/documents/reports/Risk-of-terrorist-abuse-in-non-profit-organisations.pdf], June 2014; FinCEN Advisory FIN2010-A001: Advisory to Financial Institutions on Filing Suspicious Activity Reports regarding Trade Based Money Laundering [https://www.fincen.gov/resources/advisories/fincen-advisory-fin-2010-a001], February 2010; U.S. Department of State, Money Laundering Methods, Trends and Typologies [https://www.state.gov/j/inl/rls/nrcrpt/2003/vol2/html/29910.htm], March 2004; Securities and Exchange Commission (SEC) National Exam Risk Alert on Master/Sub-accounts [https://www.sec.gov/about/offices/ocie/riskalert-mastersubaccounts.pdf], September 2011; SEC National Exam Risk Alert on Broker-Dealer Controls Regarding Customer Sales of Microcap Securities [https://www.sec.gov/about/offices/ocie/broker-dealer-controls-microcap-securities.pdf], October 2014; and SEC Responses to Frequently Asked Questions about a BrokerDealer's Duties When Relying on the Securities Act Section 4(a)(4) Exemption to Execute Customer Orders [https://www.sec.gov/divisions/marketreg/faq-broker-dealer-duty-section4.htm], October 2014. See also Regulatory Notices 09-05 (January 2009) and 10-18 (April 2010); and Federal Financial Institutions Examination Council Bank Secrecy Act/Anti-Money Laundering, Money Laundering and Terrorist Financing "Red Flags." [https://www.ffiec.gov/%5C/bsa_aml_infobase/pages_manual/OLM_106.htm]

      9. A "Politically Exposed Person" is defined by FATF as an individual who is or has been entrusted with a prominent public function, for example, Heads of State or of government, senior politicians, senior government, judicial or military officials, senior executives of state-owned corporations, or important political party officials. See FATF Guidance, Politically Exposed Persons [http://www.fatf-gafi.org/media/fatf/documents/recommendations/Guidance-PEP-Rec12-22.pdf], June 2013.

      10. A "shell company" is an issuer of securities for which a registration statement has been filed with the SEC that has: (1) no or nominal operations; and (2) either: (i) no or nominal assets; (ii) assets consisting solely of cash and cash equivalents; or (iii) assets consisting of any amount of cash or cash equivalents and nominal other assets. See 17 CFR 230.504.

      11. The FATF Report on Risk of Terrorist Abuse in Non-Profit Organisations [file:///C:/Users/HemansD/AppData/Local/Microsoft/Windows/INetCache/Content.Outlook/ZRK9N9QO/Risk%20of%20Terrorist%20Abuse%20in%20Non-Profit%20Organizsations] (FATF Report), June 2014, defines "terrorist threat" as: A person or group of people, object or activity, with the potential to cause harm. Threat is contingent on actors that possess both the capability and intent to do harm.

      12. The FATF Report defines "terrorist entity" as a terrorist and/or terrorist organization identified as a supporter of terrorism by national or international sanctions lists, or assessed by a jurisdiction as active in terrorist activity. See id.

      13. These red flags could also be indicative of securities law violations.

      14. Nostro accounts are accounts that a financial institution holds in a foreign currency in another bank, typically in order to facilitate foreign exchange transactions.

    • 19-17 FINRA Requests Comment on Proposed New Rule 4111 (Restricted Firm Obligations) Imposing Additional Obligations on Firms with a Significant History of Misconduct

      Protecting Investors from Misconduct

      Regulatory Notice
      Notice Type

      Request for Comment
      Referenced Rules & Notices

      FINRA Rule 3110
      FINRA Rule 4110
      FINRA Rule 9559
      Regulatory Notice 18-06
      Regulatory Notice 18-15
      Regulatory Notice 18-16
      Regulatory Notice 18-17
      Suggested Routing

      Compliance
      Legal
      Operations
      Registered Representatives
      Risk
      Senior Management
      Key Topics

      Expedited Proceedings
      Restricted Deposit and other Obligations

      Summary

      As part of FINRA's ongoing initiatives to protect investors from misconduct, FINRA is requesting comment on proposed new Rule 4111 (Restricted Firm Obligations) that would impose tailored obligations, including possible financial requirements, on designated member firms that cross specified numeric disclosure-event thresholds. These thresholds were developed through a thorough analysis and are based on the number of events at similarly sized peers. The member firms that could be subject to these obligations, while small in number, present heightened risk of harm to investors and their activities may undermine confidence in the securities markets as a whole. The proposal would further promote investor protection and market integrity and give FINRA another tool to incentivize member firms to comply with regulatory requirements and to pay arbitration awards.

      FINRA is requesting comment on:

      1. proposed new Rule 4111 (Restricted Firm Obligations), which would authorize FINRA to require "Restricted Firms," identified by a multi-step process involving threshold calculations, to make deposits of cash or qualified securities that could not be withdrawn without FINRA's prior written consent, adhere to other conditions or restrictions on the member's operations that are necessary or appropriate for the protection of investors and in the public interest, or be subject to some combination of those obligations; and
      2. proposed new Rule 9559 (Procedures for Regulating Activities Under Rule 4111) (new Rule 9559) and amendments to existing Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series) to be renumbered as Rule 9560 (Rule 9560 or the Hearing Procedures Rule) to create an expedited proceeding that allows a prompt review of the determinations under the Restricted Firm Obligations Rule and grants a member a right to challenge any obligations imposed.1

      The proposed rule text is available in Attachment A. A flow chart describing proposed Rule 4111 is available in Attachment B. A chart presenting examples of restricted deposit requirements is available as Attachment C. The attachments referenced in the Economic Impact Assessment are available in Attachment D (Attachments D-1, D-2 and D-3).

      Questions concerning this Notice should be directed to:

      •   Kosha Dalal, Associate Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-6903 or Kosha.Dalal@finra.org; or
      •   Michael Garawski, Associate General Counsel, OGC, at (202) 728-8835 or Michael.Garawski@finra.org.

      Questions concerning the Economic Impact Assessment in this Notice should be directed to:

      •   Jonathan Sokobin, Senior Vice President and Chief Economist, Office of the Chief Economist (OCE), at (202) 728-8248 or Jonathan.Sokobin@finra.org; or
      •   Hammad Qureshi, Senior Economist, OCE, at (202) 728-8150 or Hammad.Qureshi@finra.org.

      Action Requested

      FINRA encourages all interested parties to comment. Comments must be received by July 1, 2019.

      Comments must be submitted through one of the following methods:

      •   Emailing comments to pubcom@finra.org; or
      •   Mailing comments in hard copy to:

      Jennifer Piorko Mitchell
      Office of the Corporate Secretary
      FINRA
      1735 K Street, NW
      Washington, DC 20006-1506

      To help FINRA process comments more efficiently, persons should use only one method to comment.

      Important Notes: All comments received in response to this Notice will be made available to the public on the FINRA website. In general, FINRA will post comments as they are received.2

      Before becoming effective, the proposed rule change must be filed with and approved by the Securities and Exchange Commission (SEC or Commission) pursuant to Section 19(b) of the Securities Exchange Act of 1934 (SEA or Exchange Act).3

      Background & Discussion

      FINRA has been engaged in an ongoing effort to enhance its programs to address the risks that can be posed to investors and the broader market by individual brokers and member firms that have a history of misconduct. FINRA has a number of tools to deter and remedy misconduct by member firms and the individuals they hire, including review of membership applications, focused examinations, risk monitoring and disciplinary actions. These tools have been effective in identifying and addressing a range of misconduct by individuals and firms, and FINRA has continued to strengthen them. In recent years, for example, we have enhanced our key investor protection rules and examination programs, expanded our risk-based monitoring of brokers and firms and deployed new technologies designed to make our regulatory efforts more effective and efficient.4

      While these efforts have strengthened protections for investors and the markets, persistent compliance issues continue to arise in some FINRA member firms. While historically small in number and a top focus of FINRA regulatory programs, such firms generally do not carry out their supervisory obligations to ensure compliance with applicable securities laws and regulations and FINRA rules, and they often act in ways that harm their customers and erode trust in the brokerage industry. Recent academic studies, for example, find that some firms persistently employ brokers who engage in misconduct, and that misconduct can be concentrated at these firms. These studies also provide evidence that the past disciplinary and other regulatory events associated with a firm or individual can be predictive of similar future events.5 While these firms may eventually be forced out of the industry through FINRA action or otherwise, these patterns indicate a persistent, if limited, population of firms with a history of misconduct that may not be acting appropriately as a first line of defense to prevent customer harm by their brokers.

      Such firms expose investors to real risk. For example, FINRA has identified certain firms that have a concentration of individuals with a history of misconduct, and some of these firms consistently hire such individuals and fail to reasonably supervise their activities. These firms generally have a retail business with vulnerable customers and engage in cold calling to make recommendations of securities. FINRA has also identified groups of individual brokers who move from one firm of concern to another firm of concern. In addition, certain firms, along with their representatives, have substantial numbers of disclosures on their records. For example, as of year-end 2018, there were 20 small firms (i.e., firms with no more than 150 registered persons) with 30 or more disclosure events over the prior five years, 10 mid-size firms (i.e., firms with between 151 and 499 registered persons) with 45 or more disclosure events over the prior five years, and five large firms (i.e., firms with 500 or more registered persons) with 750 or more disclosure events over the prior five years.6 In such situations, FINRA closely examines the firms' and brokers' conduct, and where appropriate, FINRA will bring enforcement actions to bar or suspend the firms and individuals involved.

      However, individuals and firms with a history of misconduct can pose a particular challenge for FINRA's existing examination and enforcement programs. In particular, examinations can identify compliance failures—or imminent failures—and prescribe remedies to be taken, but examiners are not empowered to require a firm to change or limit its business operations in a particular manner. While these constraints on the examination process protect firms from potentially arbitrary or overly onerous examination findings, an individual or firm with a history of misconduct can take advantage of these limits to simply continue ongoing activities that harm or pose risk of harm to investors until they result in an enforcement action.

      Enforcement actions in turn can only be brought after a rule has been violated—and any resulting customer harm has already occurred. In addition, these proceedings can take significant time to develop, prosecute and conclude, during which time the individual or firm is able to continue misconduct, perpetuating significant risks of additional harm to customers and investors. Parties with serious compliance issues often will litigate enforcement actions brought by FINRA, which potentially involves a hearing and multiple rounds of appeals, thereby effectively forestalling the imposition of disciplinary sanctions for an extended period. For example, an enforcement proceeding could involve a hearing before a Hearing Panel, numerous motions, an appeal to the National Adjudicatory Council (NAC), and a further appeal to the SEC. Moreover, even when a FINRA Hearing Panel imposes a significant sanction, the firm can forestall its effectiveness through the appeals process, because sanctions are stayed during appeals to the NAC and potentially the SEC. And when all appeals are exhausted, the firm may have withdrawn its FINRA membership, limiting FINRA's jurisdiction and eliminating the leverage that FINRA has to incent the firm to comply with the sanction, including making restitution to customers.

      Temporary cease and desist proceedings do not always provide an effective remedy for potential ongoing harm to investors during the enforcement process.7 Temporary cease and desist proceedings are available only in narrowly defined circumstances. Moreover, initiation by FINRA of a temporary cease and desist action does not necessarily enable more rapid intervention, because FINRA must be prepared to file the underlying disciplinary complaint at the same time.

      In addition, by the time intervention is practical, as noted above, the firm may have exited the industry, thereby limiting FINRA's jurisdiction over the misconduct. In such circumstance, the firm may also fail to pay arbitration awards in favor of harmed investors, preventing their recovery and potentially diminishing confidence in the arbitration process.

      A typical example of these challenges would be a firm that hires representatives with numerous disclosure events, has a poor supervisory structure and compliance culture, consistently engages in aggressive sales practices to retail customers relating to unregistered penny stocks, private placements or illiquid securities, and affirmatively seeks to stall the imposition of disciplinary sanctions. In FINRA's experience, such a firm may attempt to prolong FINRA's examination and investigation efforts by failing to provide full and timely responses to FINRA's requests for information. This lack of cooperation requires FINRA to increase regulatory pressure to gain cooperation and seek other sources for information, delaying FINRA's investigative efforts.

      When FINRA is ready to pursue enforcement action against such a firm, a temporary cease and desist order may not be available (since many circumstances are not within the scope of that authority) or may not enable more rapid intervention (since the disciplinary complaint must be ready to be filed at the same time). While a disciplinary proceeding will be commenced as soon as possible (with or without a temporary cease and desist proceeding), the firm can further prolong the disciplinary action by litigating through the stages described above.

      In light of these considerations, FINRA has undertaken an initiative to better address the issues created by individuals and firms with a history of misconduct. The initial focus of this initiative has been to strengthen the controls by FINRA and firms over the risks posed by individuals with a history of misconduct, including:

      •   Regulatory Notice 18-15 (Heightened Supervision), which reiterates the existing obligation of member firms to implement for such individuals tailored heightened supervisory procedures under Rule 3110;
      •   Regulatory Notice 18-16 (FINRA Requests Comment on FINRA Rule Amendments Relating to High-Risk Brokers and the Firms That Employ Them), which seeks comment on proposed rule amendments that, among other things, would impose additional restrictions on member firms that employ brokers with a history of specified misconduct events by requiring the filing with FINRA of a materiality consultation when such individuals seek to become owners, control persons, principals or registered persons of a firm; authorize Hearing Panels and Hearing Officers to impose conditions and restrictions on a respondent in a disciplinary proceeding that are reasonably necessary for the purpose of preventing customer harm during that respondent's appeal of a disciplinary decision; and require firms that apply to continue associating with a statutorily disqualified person to include in that application an interim plan of heightened supervision that would be effective throughout the application process; and
      •   Regulatory Notice 18-17 (FINRA Revises the Sanction Guidelines), which announced revisions to the FINRA Sanction Guidelines.

      In addition, FINRA raised fees for statutory disqualification applications,8 and it revised the qualification examination waiver guidelines to more broadly consider past misconduct when considering examination waiver requests.9

      While these efforts should help mitigate the risks posed by individual brokers with a history of misconduct, challenges remain where a member firm itself has a concentration of such brokers without adequate supervision—in some cases because the firm seeks out such brokers—or otherwise has a history of substantial compliance failures.

      As a result, FINRA is proposing to adopt Rule 4111, which would impose obligations on members that have significantly higher levels of risk-related disclosures than similarly sized peers. FINRA would preliminarily identify these members by using numeric, threshold-based criteria and several additional steps that would guard against misidentification. The obligations could include requiring a member to maintain a specific deposit amount, with cash or qualified securities, in a segregated account at a bank or clearing firm, from which the member could make withdrawals only with FINRA's approval. This proposal also aims to preserve firm funds for payment of arbitration awards against them. The proposal would achieve this both through how a member's "covered pending arbitration claims" and unpaid arbitration awards could impact the size of its restricted deposit requirement, and a presumption that a member would continue to maintain a restricted deposit if it has any "covered pending arbitration claims" or unpaid arbitration awards.10

      FINRA also considered proposing a "terms and conditions" rule similar to Investment Industry Regulatory Organization of Canada (IIROC) Consolidated Rule 9208, which permits IIROC, in an effort to strategically target the most problematic firms, to exercise discretion to identify firms and develop appropriate terms and conditions on their operations.11 Although FINRA is still considering such a rule, it is not proposing it at this time.

      Proposed Amendments

      1. Proposed Rule 4111 (Restricted Firm Obligations)

      FINRA is proposing to adopt Rule 4111 (Restricted Firm Obligations), a new rule that would use numeric-based thresholds based on firm-level and individual-level disclosure events or conditions disclosed on the Uniform Registration Forms12 and, subject to an internal Department of Member Supervision (Department) review and member firm consultation process, presumptively impose a "Restricted Deposit Requirement" on members that present a high degree of risk to the investing public. FINRA believes that a restricted deposit is most likely to change such members' behavior—and therefore protect investors—through its direct financial impact.
      •   General/Multi-Step Process for Identifying "Restricted Firms" (Proposed Rule 4111(a))

      The proposed rule would create a multi-step process to guide FINRA's determination of whether a member raises investor-protection concerns substantial enough to require that it be subject to additional obligations. Those obligations could include a requirement to maintain a deposit of cash or qualified securities in an account from which withdrawals would be restricted, or conditions or restrictions on the member's operations that are necessary or appropriate for the protection of investors and in the public interest.13 The proposed rule would give each affected member firm several ways to affect outcomes, including a one-time opportunity to reduce staffing so as to no longer trigger the preliminary identification criteria and numeric thresholds, a consultation with the Department at which the member could explain why it should not be subject to a Restricted Deposit Requirement or propose alternatives, and the right to challenge a Department determination by requesting a hearing before a Hearing Officer in an expedited proceeding.

      The proposed multi-step process includes numerous features designed to focus the obligations on the small number of firms motivating this rule proposal. As the attached flow chart reflects (Attachment B), this process is akin to a "funnel." The top of the funnel applies to a limited set of firms with numerous disclosures, with a narrowing in the middle of the potential member firms that may be subject to additional obligations, and the bottom of the funnel reflecting the small number of member firms that present high risks to the investing public.
      •   Annual Calculation by FINRA of Preliminary Criteria for Identification (Proposed Rule 4111(b))

      The multi-step process would begin with an annual calculation. As explained more below, the Department would calculate annually a member firm's "Preliminary Identification Metrics" to determine if it meets the "Preliminary Criteria for Identification." A key driver of that is whether a firm's "Preliminary Identification Metrics" meet quantitative, risk-based "Preliminary Identification Metrics Thresholds."14

      Several principles guide the Preliminary Criteria for Identification and the Preliminary Identification Metrics Thresholds. The criteria and thresholds are intended to be replicable and transparent to FINRA and affected member firms; employ the most complete and accurate data available to FINRA; are objective; account for different firm sizes and business profiles; and target the sales-practice concerns that are motivating the proposal. FINRA also has sought to develop criteria and thresholds that identify members that present a high risk but limit improperly imposing obligations on firms whose risk profile and activities do not warrant such obligations.

      Using these guiding principles, FINRA is proposing numeric thresholds based on six categories of events or conditions, nearly all of which are based on information disclosed through the Uniform Registration Forms.15 The six categories are:
      1. Registered Person Adjudicated Events;16
      2. Registered Person Pending Events;17
      3. Registered Person Termination and Internal Review Events;18
      4. Member Firm Adjudicated Events;19
      5. Member Firm Pending Events;20 and
      6. Registered Persons Associated with Previously Expelled Firms (also referred to as the Expelled Firm Association category).21
      To calculate whether a member meets the Preliminary Criteria for Identification, which is defined in proposed Rule 4111(i)(9), the Department would first compute the Preliminary Identification Metrics for each category, which are set forth in proposed Rule 4111(i)(10). Each category's Preliminary Identification Metric computation would start with a calculation of the sum of the pertinent disclosure events or, for the Expelled Firm Association category, the sum of the Registered Persons Associated with Previously Expelled Firms. For the adjudicated disclosure-event based categories, the counts would include disclosure events that reached a resolution during the prior five years from the date of the calculation. For the pending-events categories and pending internal reviews, the counts would include disclosure events that are pending as of the date of the calculation. In addition, for the three Registered Person disclosure-event based categories, the counts would include disclosure events across all "Registered Persons In-Scope," defined in proposed Rule 4111(i)(13) as persons registered with the member firm for one or more days within the one year prior to the calculation date.

      Each of those six sums would then be standardized to determine the member's six Preliminary Identification Metrics. For the five Registered Person and Member Firm event categories (Categories 1–5 above), the proposed Preliminary Identification Metrics are in the form of an average number of events per registered broker, calculated by taking each category's sum and dividing it by the number of Registered Persons In-Scope. For the Registered Persons Associated with Expelled Firms category (Category 6), the proposed Preliminary Identification Metric is in the form of a percentage concentration at the member of registered persons who, at any time in their career, were associated with previously expelled firms. This concentration is calculated by taking the number of Registered Persons Associated with Previously Expelled Firms and dividing it by the number of Registered Persons In-Scope.

      A firm's six Preliminary Identification Metrics are used to determine if the member firm meets the Preliminary Criteria for Identification. To meet the Preliminary Criteria for Identification, a firm would need to meet the Preliminary Identification Metrics Thresholds, set forth in proposed Rule 4111(i)(11), for two or more of the appropriate categories listed above for its size and, if it does, one of these categories must be for adjudicated events and the firm must have two or more events (in categories besides the Expelled Firm Association category). This involves analyzing the extent to which the Preliminary Identification Metrics meet the specified numeric Preliminary Identification Metrics Thresholds and meet additional conditions intended to prevent a member from becoming potentially subject to additional obligations solely as a result of pending matters or a single event or condition. Specifically, the Department would:
      •   first, pursuant to proposed Rule 4111(b) and (i)(9)(A), evaluate whether two or more of the member firm's Preliminary Identification Metrics are equal to or more than the corresponding Preliminary Identification Metrics Thresholds for the member firm's size,22 and whether at least one of those Preliminary Identification Metrics is the Registered Person Adjudicated Event Metric, the Member Firm Adjudicated Event Metric, or the Expelled Firm Association Metric; and
      •   second, pursuant to proposed Rule 4111(b) and (i)(9)(B), evaluate whether the member firm has two or more Registered Person or Member Firm Events (i.e., two or more events from Categories 1–5 above).23
      If all these conditions are met, the member would meet the Preliminary Criteria for Identification.

      Each specific numeric threshold in the Preliminary Identification Metrics Thresholds grid in proposed Rule 4111(i)(11) is a number which represents outliers with respect to peers for the type of events in the category (i.e., the firm is at the far tail of the respective category's distribution), which is intended to preliminarily identify member firms that present significantly higher risk than a large percentage of the membership. In addition, there are numeric thresholds for seven different firm sizes, to ensure that each member firm is compared only to its similarly sized peers. As explained more below in the Economic Impact Assessment, based on recent history FINRA expects that its annual calculations will identify between 60–98 member firms that meet the Preliminary Criteria for Identification.

      The following three examples demonstrate—in practical terms—the point at which a member firm's Preliminary Identification Metrics would meet the Preliminary Identification Metrics Thresholds in proposed Rule 4111(i)(11):

        Preliminary Identification Metrics Thresholds Practical Equivalent
      Example 1 (member firm size between 1–4 registered persons) The Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric, for a member that has between one and four Registered Persons In-Scope as of the Evaluation Date,24 is 0.50 (or 0.50 events per Registered Broker In-Scope). For a member with four Registered Persons In-Scope as of the Evaluation Date, the member would meet the Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric if the sum of its four Registered Persons In-Scope's Adjudicated Events, which reached a resolution over the five years before the Evaluation Date, was two or more.

      (4 Registered Persons In-Scope) * (0.50 Preliminary Identification Metrics Threshold for the Registered Person Adjudicated Event Metric) = (2 Adjudicated Events)
      Example 2 (member firm size between 20–50 registered persons) The Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric, for a member that has between 20–50 Registered Persons In-Scope as of the Evaluation Date, is 0.20 (or 0.20 events per Registered Broker In-Scope). For a member with 50 Registered Persons In-Scope as of the Evaluation Date, the member would meet the Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric if the sum of the member's Adjudicated Events, which reached a resolution over the five years before the Evaluation Date, was ten or more.

      (50 Registered Persons In-Scope) * (0.20 Preliminary Identification Metrics Threshold for the Member Firm Adjudicated Event Metric) = (10 Adjudicated Events)
      Example 3 (member firm size between 51–150 registered persons) The Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric, for a member that has between 51–150 Registered Persons In-Scope as of the Evaluation Date, is 0.25 (or a 25% concentration level). For a member with 100 Registered Persons In-Scope as of the Evaluation Date, the member would meet the Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric if the sum of its Registered Persons Associated with Previously Expelled Firms was 25 or more.

      (100 Registered Persons In-Scope) * (0.25 Preliminary Identification Metrics Threshold for the Expelled Firm Association Metric) = (25 Registered Persons Associated with Previously Expelled Firms)


      FINRA has conducted a thorough analysis of the proposed criteria and thresholds to ensure that the proposed Preliminary Criteria for Identification preliminarily identify the member firms that are motivating this rule proposal.25 As explained below, however, the proposed rule involves several additional steps to guard against the risk of misidentification.
      •   Initial Department Evaluation (Proposed Rule 4111(c)(1))

      For each member firm that meets the Preliminary Criteria for Identification, the Department would conduct, pursuant to proposed Rule 4111(c)(1), an initial internal evaluation to determine whether the member does not warrant further review under Rule 4111. In doing so, the Department would review whether it has information to conclude that the computation of the member's Preliminary Identification Metrics included disclosure events or other conditions that should not have been included because they are not consistent with the purpose of the Preliminary Criteria for Identification and are not reflective of a firm posing a high degree of risk. For example, the Department may have information that the computation included disclosure events that were not sales-practice related, were duplicative (involving the same customer and the same matter), or mostly involved compliance concerns best addressed by a different regulatory response by FINRA. As another example, the Department may have information that the Expelled Firm Association Metric calculation included registered persons who had associated with previously expelled firms only for a brief amount of time. The Department would also consider whether the member has addressed the concerns signaled by the disclosure events or conditions or altered its business operations, including staffing reductions, such that the threshold calculation no longer reflects the member's current risk profile. Essentially, the purpose of the Department's initial evaluation is to determine whether it is aware of information that would show that the member—despite having met the Preliminary Criteria for Identification—does not pose a high degree of risk.

      If the Department determines, after this initial evaluation, that the member does not warrant further review, the Department would conclude that year's Rule 4111 process for the member and would not seek that year to impose any obligations on the member. If, however, the Department determines that the member does warrant further review, the Rule 4111 process would continue.
      •   One-Time Opportunity to Reduce Staffing Levels (Proposed Rule 4111(c)(2))

      If the Department determines, after its initial evaluation, that a member that meets the Preliminary Criteria for Identification warrants further review under Rule 4111, such member—if it would be meeting the Preliminary Criteria for Identification for the first time—would have a one-time opportunity to reduce its staffing levels to no longer meet these criteria, within 30 business days after being informed by the Department. The member would be required to demonstrate the staff reduction to the Department by identifying the terminated individuals. The proposed rule would prohibit the member from rehiring any persons terminated pursuant to this option, in any capacity, for one year. A member that has reduced staffing levels at this stage may not use that staff-reduction opportunity again.

      If the Department determines that the member firm's reduction of staffing levels results in its no longer meeting the Preliminary Criteria for Identification, the Department would close out that year's Rule 4111 process for the member and would not seek that year to impose any obligations on that member. If, on the other hand, the Department determines that the member still meets the Preliminary Criteria for Identification even after its staff reductions, or if the member elects not to use its one-time opportunity to reduce staffing levels, the Department would proceed to determine the member's maximum Restricted Deposit Requirement, and the member would proceed to a Consultation with the Department.
      •   FINRA's Determination of a Maximum Restricted Deposit Requirement (Proposed Rule 4111(i)(15))

      For members that warrant further review after being deemed to meet the Preliminary Criteria for Identification and after the initial Department evaluation, the Department would then determine the member's maximum "Restricted Deposit Requirement."

      The Department would tailor the member's maximum Restricted Deposit Requirement amount to its size, operations and financial conditions. As provided in proposed Rule 4111(i)(15), the Department would consider the nature of the member's operations and activities, annual revenues, commissions, net capital requirements, the number of offices and registered persons, the nature of the disclosure events counted in the numeric thresholds, the amount of any "covered pending arbitration claims" or unpaid arbitration awards, and concerns raised during FINRA exams.26 Based on a consideration of these factors, the Department would determine a maximum Restricted Deposit Requirement for the member that would be consistent with the objectives of the rule, but not significantly undermine the continued financial stability and operational capability of the member as an ongoing enterprise over the next 12 months. FINRA's intent is that the maximum Restricted Deposit Requirement should be significant enough to change the member's behavior but not so burdensome that it would force the member out of business solely by virtue of the imposed deposit requirement.

      To provide increased transparency, Attachment C contains several examples that are intended to demonstrate how, in different scenarios, the Department might exercise its discretion in determining a maximum Restricted Deposit Requirement. Nothing in the examples is intended to suggest that the Department will follow specific formulas in determining a maximum Restricted Deposit Requirement or the weight that any specific circumstances carry. FINRA welcomes comments on alternative ways of calculating the Restricted Deposit Requirement that would be more predictable while remaining impactful but avoiding disproportionate effects on different types of firms.
      •   Consultation (Proposed Rule 4111(d))

      As explained above, if the Department determines, after initially calculating that a member firm meets the Preliminary Criteria for Identification, conducting its internal evaluation, and affording the one-time opportunity to reduce staffing levels (if available), that a member warrants further Rule 4111 review, the Department would consult with the member, pursuant to proposed Rule 4111(d). This Consultation will give the member an opportunity to demonstrate why it does not meet the Preliminary Criteria for Identification, why it should not be designated as a Restricted Firm, and why it should not be subject to the maximum Restricted Deposit Requirement.

      In the Consultation, there would be two rebuttable presumptions: that the member should be designated as a Restricted Firm; and that it should be subject to the maximum Restricted Deposit Requirement. The member would bear the burden of overcoming those presumptions.

      Proposed Rule 4111(d)(1) governs how a member may overcome these two presumptions. Proposed Rule 4111(d)(1)(A) provides that a member may overcome the presumption that it should be designated as a Restricted Firm by clearly demonstrating that the Department's calculation that the member meets the Preliminary Criteria for Identification is inaccurate because, among other things, it included events, in the six categories described above, that should not have been included because, for example, they are duplicative, involving the same customer and the same matter, or are not sales-practice related. Proposed Rule 4111(d)(1)(B) provides that a member may overcome the presumption that it should be subject to the maximum Restricted Deposit Requirement by clearly demonstrating to the Department that the member would face significant undue financial hardship if it were required to maintain the maximum Restricted Deposit Requirement and that a lesser deposit requirement would satisfy the objectives of Rule 4111 and be consistent with the protection of investors and the public interest; or that other conditions and restrictions on the operations and activities of the member and its associated persons would address the concerns indicated by the thresholds and protect investors and the public interest.

      Proposed Rule 4111(d)(2) governs how the Department would schedule and provide notice of the Consultation.

      Proposed Rule 4111(d)(3) provides guidance on what the Department would consider during the Consultation, when evaluating whether a member should be designated as a Restricted Firm and subject to a Restricted Deposit Requirement. This provision also provides members with guidance on how to attempt to overcome the two rebuttable presumptions. For example, proposed Rule 4111(d)(3) requires that the Department consider information provided by the member during any meetings as part of the Consultation; relevant information or documents, if any, submitted by the member, in the manner and form prescribed by the Department, as would be necessary or appropriate for the Department to review the computation of the Preliminary Criteria for Identification; a plan, if any, submitted by the member, in the manner and form prescribed by the Department, proposing in detail the specific conditions or restrictions that the member seeks to have the Department consider; such other information or documents as the Department may reasonably request from the member related to the evaluation; and information provided by the member during any meetings as part of the Consultation. To the extent a member seeks to claim undue financial hardship, it would be the member's burden to support that with documents and information.
      •   Department Decision (Proposed Rule 4111(e)); No Stays

      After the Consultation, proposed Rule 4111(e) would require that the Department render a Department decision. Under proposed Rule 4111(e)(1), there are three paths that decision might take:
      •   If the Department determines that the member has rebutted the presumption that it should be designated as a Restricted Firm, the Department's decision would be required to state that the member will not be designated that year as a Restricted Firm.
      •   If the Department determines that the member has not rebutted the presumption that it should be designated as a Restricted Firm or the presumption that it must maintain the maximum Restricted Deposit Requirement, the Department's decision would designate the member as a Restricted Firm and require the member to promptly establish a Restricted Deposit Account, deposit and maintain in that account the maximum Restricted Deposit Requirement, and implement and maintain specified conditions or restrictions, as necessary or appropriate, on the operations and activities of the member and its associated persons that relate to, and are designed to address the concerns indicated by, the Preliminary Criteria for Identification and protect investors and the public interest.
      •   If the Department determines that the member has not rebutted the presumption that it should be designated as a Restricted Firm but has rebutted the presumption that it must maintain the maximum Restricted Deposit Requirement, the Department's decision would designate the member as a Restricted Firm; would impose no Restricted Deposit Requirement on the member or require the member to promptly establish a Restricted Deposit Account, deposit and maintain in that account a Restricted Deposit Requirement in such dollar amount less than the maximum Restricted Deposit Requirement as the Department deems necessary or appropriate; and would require the member to implement and maintain specified conditions or restrictions, as necessary or appropriate, on the operations and activities of the member and its associated persons that relate to, and are designed to address the concerns indicated by, the Preliminary Criteria for Identification and protect investors and the public interest.
      Pursuant to proposed Rule 4111(e)(2), the Department would be required to provide a written notice of its determination to the member, pursuant to proposed new Rule 9559,27 no later than 30 days from the date of the letter that scheduled the Consultation. Where the Department decision imposes a Restricted Deposit Requirement or other conditions or restrictions, it also would inform the member of its ability to request a hearing with the Office of Hearing Officers in an expedited proceeding, as further described below.

      Proposed Rule 4111(e)(2) would provide that a request for a hearing would not stay the effectiveness of the Department's determination. However, upon requesting a hearing of a Department determination that imposes a Restricted Deposit Requirement, the member would only be required to maintain in a Restricted Deposit Account the lesser of 50% of its Restricted Deposit Requirement or 25% of its average excess net capital during the prior calendar year, until the Office of Hearing Officers or the National Adjudicatory Council (NAC) issues its final written order in the expedited proceeding. This has one exception: a member that is re-designated as a Restricted Firm and is already subject to a previously imposed Restricted Deposit Requirement would be required to maintain the full amount of its Restricted Deposit Requirement until the Office of Hearing Officers or the NAC issues its final written order in the expedited proceeding.
      •   Continuation or Termination of Restricted Firm Obligations (Proposed Rule 4111(f))

      The proposed Restricted Firm Obligations Rule would require FINRA to evaluate annually whether each member is, or continues to be, a Restricted Firm and whether the member should be subject to any obligations. For this reason, proposed Rule 4111(f) contains provisions that set forth how any obligations that were imposed during the Rule 4111 process in one year are continued or terminated in that same year and in subsequent years.

      Proposed Rule 4111(f)(1), titled "Currently Designated Restricted Firms," establishes constraints on a member's ability to seek to modify or terminate, directly or indirectly, any obligations imposed pursuant to Rule 4111. Because the Restricted Firm Obligations Rule would entail annual reviews by the Department to determine whether a member is a Restricted Firm that should be subject to obligations, a Restricted Firm would have an annual opportunity to seek the termination or modification of any obligations that continue to be imposed. For this reason, proposed Rule 4111 does not authorize a Restricted Firm to seek, outside of the Consultation process and any ensuing expedited proceedings after a Department decision, an interim termination or modification of any obligations imposed. Rather, proposed Rule 4111(f)(1) provides that a member that has been designated as a Restricted Firm will not be permitted to withdraw all or any portion of its Restricted Deposit Requirement, or seek to terminate or modify any deposit requirement, conditions, or restrictions that have been imposed on it, without the prior written consent of the Department.

      Proposed Rule 4111(f)(2), titled "Re-Designation as a Restricted Firm," addresses the scenario when the Department determines in one year that a member is a Restricted Firm, and in the following year determines that the member still meets the Preliminary Criteria for Identification. In that instance, the Department would re-designate the member as a Restricted Firm, and the obligations previously imposed on the member would remain effective and unchanged, unless either the member or the Department requests, within 30 days of the Department's decision to re-designate the member as a Restricted Firm, a Consultation. If a Consultation is requested, the obligations previously imposed would remain effective and unchanged unless and until the Department modifies or terminates them after the Consultation. In addition, in the Consultation process, a presumption would apply that any previously imposed Restricted Deposit Requirement, conditions or restrictions would remain effective and unchanged, absent a showing by the party seeking changes that they are no longer necessary or appropriate for the protection of investors or in the public interest. At the end of the Consultation, the Department would be required to provide written notice of its determination to the member, no later than 30 days from the date of the letter provided to the member under Rule 4111(d)(2) that schedules the Consultation.

      Proposed Rule 4111(f)(3), titled "Previously Designated Restricted Firms," addresses the scenario where the Department determines in one year that a member is a Restricted Firm, but in the following years determines that the member either does not meet the Preliminary Criteria for Identification or should not be designated as a Restricted Firm. In that case, the member would no longer be subject to any obligations previously imposed under proposed Rule 4111. There would be one exception: a former Restricted Firm would not be permitted to withdraw any portion of its Restricted Deposit Requirement without submitting an application and obtaining the Department's prior written consent for the withdrawal. Such an application would be required to include, among other things set forth in proposed Rule 4111(f)(3), evidence as to whether the member has "covered pending arbitration claims" or any unpaid arbitration awards outstanding against the member. The Department would determine whether to authorize a withdrawal, in part or in whole, but there would be a presumption that the member would be required to continue to maintain its Restricted Deposit Requirement if it has any "covered pending arbitration claims" or any unpaid arbitration awards. The Department would be required to issue a notice of its decision on an application to withdraw from the Restricted Deposit Account, pursuant to proposed new Rule 9559, within 30 days from the date the application is received.
      •   Restricted Deposit Account (Proposed Rule 4111(i)(14))

      If a Department decision requires a member to establish a Restricted Deposit Account, proposed Rule 4111(i)(14) would govern this account. The underlying policy for the proposed account requirements is that, to make a deposit requirement effective in creating appropriate incentives to members that pose higher risks to change their behavior, the member must be restricted from withdrawing any of the required deposit amount, even if it terminates its FINRA membership.

      The proposed rule would require that the Restricted Deposit Account be established, in the name of the member, at a bank or the member's clearing firm. The account must be subject to an agreement in which the bank or the clearing firm agrees: not to permit withdrawals from the account absent FINRA's prior written consent; to keep the account separate from any other accounts maintained by the member with the bank or clearing firm; that the cash or qualified securities on deposit will not be used directly or indirectly as security for a loan to the member by the bank or the clearing firm, and will not be subject to any set-off, right, charge, security interest, lien, or claim of any kind in favor of the bank, clearing firm or any person claiming through the bank or clearing firm; that if the member becomes a former member, the Restricted Deposit Requirement in the account must be maintained, and withdrawals will not be permitted without FINRA's prior written consent; that FINRA is a third-party beneficiary to the agreement; and that the agreement may not be amended without FINRA's prior written consent. In addition, the account could not be subject to any right, charge, security interest, lien, or claim of any kind granted by the member.

      These account restrictions would impact how a Restricted Firm calculates its net capital levels. As explained in proposed Rule 4111.01, a deposit in the Restricted Deposit Account would be an asset of the member firm that could not readily be converted into cash, due to the restrictions on accessing it. Accordingly, the member would be required to deduct deposits in the Restricted Deposit Account when determining its net capital under Exchange Act Rule 15c3-1 and FINRA Rule 4110.
      •   Books and Records (Proposed Rule 4111(g))

      Proposed Rule 4111(g) would establish new requirements to maintain books and records that evidence the member's compliance with the Restricted Firm Obligations Rule and any Restricted Deposit Requirement or other conditions or restrictions imposed under that rule. In addition, the proposed books and records provision would specifically require a member subject to a Restricted Deposit Requirement to provide to the Department, upon its request, records that demonstrate the member's compliance with that requirement.
      •   Notice of Failure to Comply (Proposed Rule 4111(h))

      FINRA also is proposing a requirement to address the situation when a member fails to comply with the obligations imposed. Under proposed Rule 4111(h), FINRA would be authorized to issue a notice pursuant to proposed new Rule 9559 directing a member that is not in compliance with its Restricted Deposit Requirement, or with any conditions or restrictions imposed under Rule 4111, to suspend all or a portion of its business.
      •   Definitions (Proposed Rule 4111(i))

      The above description of proposed Rule 4111 introduces many of the terms that would be defined by Rule 4111. A complete list of defined terms used in the proposed rule appears in proposed Rule 4111(i).
      •   Compliance with Continuing Membership Application Rule (Proposed Rule 4111.02-Compliance with Rule 1017)

      Proposed Supplementary Material .02 would clarify that nothing in the proposed rule would alter a member's obligations under Rule 1017 (Application for Approval of Change in Ownership, Control, or Business Operations). A member firm subject to proposed Rule 4111 would need to continue complying with the requirements of Rule 1017 and submit continuing membership applications as necessary.
      •   Periodic Review of Preliminary Identification Metrics Thresholds

      FINRA would review the Preliminary Identification Metrics Thresholds on a periodic basis, to consider whether the thresholds remain targeted and effective at identifying firms that pose higher risks.
      2. Proposed Amendments to the Rule 9550 Series to Establish a New Expedited Proceeding to Implement the Requirements of Proposed Rule 4111

      FINRA is proposing to establish a new expedited proceeding in the Rule 9550 Series (Expedited Proceedings), specifically proposed new Rule 9559 (Procedures for Regulating Activities Under Rule 4111), that would allow member firms to request a prompt review of the Department's determinations under the Restricted Firm Obligations Rule and grant a right to challenge any of the "Rule 4111 Requirements," including any Restricted Deposit Requirements, imposed.28 The new expedited proceeding would govern how the Department provides notice of its determinations and afford affected member firms the right to seek a Hearing Officer's review of those determinations.
      •   Notices Under Proposed Rule 4111 (Proposed New Rule 9559(a))

      Proposed new Rule 9559(a) would establish an expedited proceeding for the Department's determinations under proposed Rule 4111 to designate a member as a Restricted Firm and impose obligations on the member; and to deny a member's request to access all or part of its Restricted Deposit Requirement.

      Proposed new Rule 9559(a) would require the Department to serve a notice that provides its determination and the specific grounds and factual basis for the Department's action; states when the action will take effect; informs the member that it may file, pursuant to Rule 9560, a request for a hearing in an expedited proceeding within seven days after service of the notice; and explains the Hearing Officer's authority. The proposed rule also would provide that, if a member does not request a hearing, the notice of the Department's determination will constitute final FINRA action.

      Proposed new Rule 9559(a) also would provide that any of the Rule 4111 Requirements imposed in a notice issued under proposed new Rule 9559(a) are immediately effective. In general, a request for a hearing would not stay those requirements. There would be one partial exception: when a member requests review of a Department determination under proposed Rule 4111 that imposes a Restricted Deposit Requirement on the member for the first time, the member would be required to deposit, while the expedited proceeding was pending, the lesser of 50% of its Restricted Deposit Requirement or 25% of its average excess net capital over the prior year.
      •   Notice for Failure to Comply with the Proposed Rule 4111 Requirements (Proposed New Rule 9559(b))

      Proposed new Rule 9559(b) would establish an expedited proceeding to address a member's failure to comply with any requirements imposed pursuant to proposed Rule 4111.

      Proposed new Rule 9559(b) would authorize the Department, after receiving authorization from FINRA's CEO, or such other executive officer as the CEO may designate, to serve a notice stating that the member's failure to comply with the Rule 4111 Requirements, within seven days of service of the notice, will result in a suspension or cancellation of membership. The proposed rule would require that the notice identify the requirements with which the member is alleged to have not complied; include a statement of facts specifying the alleged failure; state when the action will take effect; explain what the member must do to avoid the suspension or cancellation; inform the member that it may file, pursuant to Rule 9560, a request for a hearing in an expedited proceeding within seven days after service of the notice; and explain the Hearing Officer's authority. The proposed rule also would provide that, if a member does not request a hearing, the suspension or cancellation will become effective seven days after service of the notice.

      Proposed new Rule 9559(b) also would provide that a member could file a request seeking termination of a suspension imposed pursuant to the rule, on the ground of full compliance with the notice or decision. The proposed rule would authorize the head of the Department to grant relief for good cause shown.
      •   Hearings (Proposed Amendments to the Hearing Procedures Rule)29

      If a member requests a hearing under proposed new Rule 9559, the hearing would be subject to Rule 9560 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series). FINRA is proposing several amendments to Rule 9560 that would be specific to hearings requested pursuant to proposed new Rule 9559.

      Hearings in expedited proceedings under proposed new Rule 9559 would have processes that are similar to the hearings in most of FINRA's other expedited proceedings—including requirements for the parties' exchange of documents and exhibits, the time for conducting the hearing, evidence, the record of the hearing, the record of the proceeding, failures to appear, the timing and contents of the Hearing Officer's decision, the Hearing Officer's authority, and the authority of the NAC to call an expedited proceeding for review—and FINRA is proposing amendments to the Rule 9560 provisions that govern these processes to adapt them for expedited proceedings under proposed new Rule 9559. A few features of the proposed amendments to Rule 9560 warrant emphasis or guidance:
      •   Hearing Officer's Authority (Proposed Amended Rule 9560(d) and (n))

      Hearings in expedited proceedings under proposed new Rule 9559 would be presided over by a Hearing Officer. The Hearing Officer's authority would differ depending on whether the hearing is in an action brought under proposed new Rule 9559(a) (Notices Under Rule 4111) or 9559(b) (Notice for Failure to Comply with the Rule 4111 Requirements):
      •   Proposed amended Rule 9560(n)(6) would provide that the Hearing Officer, in actions brought under proposed new Rule 9559(a), may approve or withdraw any and all of the Rule 4111 Requirements, or remand the matter to the Department, but may not modify any of the Rule 4111 Requirements, or impose any other requirements or obligations available under proposed Rule 4111.
      •   Proposed amended Rule 9560(n)(6) would authorize the Hearing Officer, in failure-to-comply actions under proposed new Rule 9559(b), to approve or withdraw the suspension or cancellation of membership, and impose any other fitting sanction. Authorizing a Hearing Officer to impose any other fitting sanction is intended to provide a Hearing Officer with authority that is appropriate for responding to situations involving firms that repeatedly fail to comply with an effective FINRA action under proposed Rule 4111.
      •   Timing Requirements

      The proposed amendments to the Hearing Procedures Rule are intended to give members a prompt process for challenging a Department decision under proposed Rule 4111. Proposed amended Rule 9560(f) would require that a hearing in actions under proposed new Rule 9559(a) be held within 30 days, and that a hearing in failure-to-comply actions under proposed new Rule 9559(b) be held within 14 days, after the member requests a hearing.30

      Proposed amended Rule 9560(o) would require the Hearing Officer, in all actions pursuant to proposed new Rule 9559, to prepare a proposed written decision, and provide it to the NAC's Review Subcommittee, within 60 days of the date of the close of the hearing. Pursuant to Rule 9560(q), the Review Subcommittee could call the proceeding for review within 21 days after receipt of the proposed decision. As in most expedited proceedings, the timing of FINRA's final decision would then depend on whether or not the Review Subcommittee calls the matter for review.31
      •   Contents of the Decision

      Proposed amended Rule 9560(p) governs the contents of the Hearing Officer's decision. The proposed amendments would broaden Rule 9560(p)(6) to account for the kinds of obligations that could be imposed under proposed Rule 4111. Rule 9560(p) would otherwise remain the same. For example, Rule 9560(p) would continue to require that the Hearing Officer's decision include a statement setting forth the findings of fact with respect to any act or practice the respondent was alleged to have committed or omitted or any condition specified in the notice, the Hearing Officer's conclusions regarding the condition specified in the notice, and a statement in support of the disposition of the principal issues raised in the proceeding.

      Additional guidance may be helpful, considering the different kinds of issues that may arise in an expedited proceeding pursuant to proposed new Rule 9559. For example, in a request for a hearing of a Department determination that imposes a Restricted Deposit Requirement or other obligations under Rule 4111, the principal issues raised may include whether: (1) the member firm should not be designated a Restricted Firm; (2) the Department incorrectly included disclosure events when calculating whether the member meets the Preliminary Criteria for Identification; (3) a Restricted Deposit Requirement would impose an undue financial burden on the member; or (4) the obligations imposed are inconsistent with the standards set forth in proposed Rule 4111(e). In a request for a hearing of a Department determination that denies a request to withdraw amounts from a Restricted Deposit Account, the principal issues raised may include whether the member firm has covered pending arbitration claims or unpaid arbitration awards.
      •   No Collateral Attacks on Underlying Disclosure Events

      In expedited proceedings pursuant to proposed new Rule 9559(a) to review a Department determination under the Restricted Firm Obligations Rule, a member firm may sometimes seek to demonstrate that the Department included incorrectly disclosure events when calculating whether the member meets the Preliminary Criteria for Identification. When the member does so, however, it would not be permitted to collaterally attack the underlying merits of those final actions. An expedited proceeding under proposed new Rule 9559 would not be the forum for attempting to re-litigate past final actions.32

      Additional Approach Considered

      FINRA also has considered a "terms and conditions" rule, but is not proposing such a rule at this time. As further discussed below in the Economic Impact Assessment, the numeric threshold-based approach in Rule 4111 has benefits and limitations. Because the rule would provide transparent, objective criteria based on public disclosure events, it would allow firms to understand clearly how they could become subject to the rule. On the other hand, the numeric-based criteria and thresholds may not identify all firms that raise the concerns motivating this proposal; firms may minimally change behavior simply to stay below established criteria and thresholds; firms may attempt to underreport required disclosures on Uniform Registration Forms; and the numerous steps that guard against misidentifications will affect how quickly FINRA can intervene.

      Because of these limitations, FINRA also has considered an additional option for addressing firms with a history of misconduct that may pose a risk to investors. A key objective in developing possible approaches was to strengthen FINRA's ability to take earlier, effective intervention. The firms motivating FINRA action in this area typically have substantial and unaddressed compliance failures over multiple examination cycles that put investors or market integrity at risk. These serious compliance failures may be prolonged by firms while FINRA works to build a case of violations of specific securities requirements, which often requires obtaining the willing cooperation of customers. To meet this challenge, FINRA has considered another option that would permit FINRA to address prolonged noncompliance by the small number of firms whose activities present heightened risk of harm to investors and that may undermine confidence in the securities markets as a whole.

      Specifically, FINRA has considered a proposal that would be similar to the IIROC's "terms and conditions" rule. Under this rule, IIROC may impose terms and conditions on an IIROC Dealer Member's membership when IIROC considers these terms and conditions appropriate to ensure the member's continuing compliance with IIROC requirements. IIROC has indicated that it will use this authority against its dealers that fail to address significant compliance findings or that fail to demonstrate a commitment to the development of a strong compliance culture, and primarily to address situations in which there are outstanding compliance issues that clearly require regulatory action, but that may not be best addressed through an enforcement proceeding.33 IIROC's imposition of terms and conditions may be challenged by requesting a hearing panel review and a further appeal to provincial authorities, but the terms and conditions do not appear to be stayed during an appeal.

      Compared to proposed Rule 4111, the regulatory benefits of a "terms and conditions" rule approach could arise from greater flexibility in identifying firms of concern, which may not trigger Rule 4111's thresholds, and quicker intervention to ensure compliance. Such an approach could also help mitigate the under- and over-inclusive concerns of the threshold-based criteria approach, and it could help fill the gap where a firm might not otherwise meet the numeric thresholds of proposed Rule 4111 but still has a history of serious noncompliance that poses a high degree of risk to investors or the markets. It also could allow for the imposition of tailored limitations and controls on firms and their brokers who might otherwise endanger customers, while motivating changes in the practices, activities and culture of firms seeking to terminate any terms and conditions imposed.

      This approach could empower FINRA—outside of the continuing membership application process, the enforcement process and the proposed new Restricted Firm Obligations Rule—to require that a member abide by identified terms and conditions to incent its compliance with the federal securities laws and FINRA rules. Possible terms and conditions could include operational, conduct, financial, or sales practice obligations; limitations on business expansions; or other obligations on the business of the member or its associated persons.

      Under this "terms and conditions" approach, the circumstances in which FINRA could intervene would be limited to when a member has repeatedly and significantly demonstrated a lack of compliance with the securities laws, the rules thereunder, or FINRA rules in specific ways that threaten investors or market integrity, and has not acted promptly to resolve the noncompliant condition. To ensure that the authority could be used in only the most serious circumstances, the imposition of terms and conditions would require the prior approval of FINRA's Chief Executive Officer or other executive officer not in FINRA's Departments of Member Supervision or Enforcement. In addition, a firm could be given an opportunity to request a prompt review of any terms and conditions imposed through an expedited proceeding process.

      Although FINRA has closely considered, and will continue to further explore, this option, it is not proposing a terms and conditions approach at this time pending consideration of proposed Rule 4111.

      Economic Impact Assessment

      1. Regulatory Need

      FINRA uses a number of measures to deter and discipline misconduct by firms and brokers, and continually strives to strengthen its oversight of the brokers and firms it regulates. These measures span across several FINRA programs, including review of new and continuing membership applications, risk monitoring of broker and firm activity, cycle and cause examinations, and enforcement and disciplinary actions.

      As part of its efforts to monitor and deter misconduct, FINRA has adopted rules that impose supervisory obligations on firms to ensure they are appropriately supervising their brokers' activities. These rules require each firm to establish, maintain and enforce written procedures to supervise the types of business in which it engages and the activities of its associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and FINRA rules. Under this regulatory framework, FINRA also provides guidance to ensure consistency in interpretation of the rules and to further strengthen compliance across firms. As such, all firms play an important role in ensuring effective compliance with applicable securities laws and FINRA rules to prevent misconduct. This is consistent with the incentives of economic agents.34

      Nonetheless, some firms do not effectively carry out these supervisory obligations to ensure compliance and they act in ways that could harm their customers—sometimes substantially. For example, recent academic studies find that some firms persistently employ brokers who engage in misconduct, and that misconduct can be concentrated at these firms. These studies also provide evidence of predictability of future disciplinary and other regulatory-related events for brokers and firms with a history of past similar events.35 These patterns suggest that some firms may not be acting appropriately as a first line of defense to prevent customer harm. Further, some firms may take advantage of the fair-process protections afforded to them under the federal securities laws and FINRA rules to forestall timely and appropriate regulatory actions, thereby limiting FINRA's ability to curb misconduct promptly. Without additional protections, the risk of potential customer harm may continue to exist at firms that fail to effectively carry out their supervisory obligations or are associated with a significant number of regulatory-related events. Further, even where harmed investors obtain arbitration awards, brokers and firms may still fail to pay those awards. Unpaid arbitration awards harm successful customer claimants and may diminish investors' confidence in the arbitration process.36

      To mitigate these risks, FINRA seeks additional authority to impose obligations on firms that pose these types of greater risk to their customers. The proposed Restricted Firm Obligations Rule would identify firms based upon a concentration of significant firm and broker events on their disclosure records that meet the proposed criteria and specified thresholds. Under the proposal, FINRA seeks the authority to impose obligations on firms that are necessary or appropriate.
      2. Economic Baseline

      The economic baseline used to evaluate the economic impacts of the proposed rules is the current regulatory framework, including FINRA rules relating to supervision, the membership application process, statutory disqualification proceedings and disciplinary proceedings that provide rules to deter and discipline misconduct by firms and brokers. This baseline serves as the primary point of comparison for assessing economic impacts of the proposed rules, including incremental benefits and costs.

      The proposals are intended to apply to firms that pose greater risks to their customers than other firms. One identifier of these types of firms is that they and their brokers generally have substantially more regulatory-related events on their records than do their peers.37 Consistent with this, the proposed Restricted Firm Obligations Rule would specifically apply to firms that have far more Registered Person and Member Firm Events, or far higher concentrations of Registered Persons Associated with Previously Expelled Firms, compared to their peers.38 Based on staff analysis of all firms registered with FINRA between 2013 and 2018, firms that would have met the Preliminary Criteria for Identification had on average 4–8 times more Registered Person and Member Firm Events than peer firms at the time of identification. Specifically, the number of events per firm, for firms that would have met the Preliminary Criteria for Identification, ranged, on average, from 26–42 events during the Evaluation Period, compared to 5–7 events per firm for other firms. The median number of events per firm, for the firms that would have met the Preliminary Criteria for Identification, ranged from approximately 10–17 events, compared to 0 events amongst other firms.

      Although disciplinary and regulatory-related events are one of the identifiers for firms posing higher risk, FINRA recognizes that firms posing higher risks do not always manifest themselves with greater disclosures on their records. These firms may be newer, have recently made changes in management, staff or approach, or simply may be more effective in avoiding regulatory marks.
      3. Economic Impacts
      A. Proposed Restricted Firm Obligations Rule

      To estimate the number and types of firms that would meet the Preliminary Criteria for Identification, FINRA analyzed the categories of events and conditions associated with the proposed criteria for all firms during the 2013–2018 review period. For each year, FINRA determined the approximate number of firms that would have met the proposed criteria. The number of firms that would have met the proposed criteria during the review period serves as a reasonable estimate for the number of firms that would have been directly impacted by this proposal had it been in place at the time. This analysis indicates that there were 60–98 such firms at the end of each year during the review period, as shown in Attachment D-1. These firms represent 1.6–2.4% of all firms registered with FINRA in any year during the review period. The population of firms identified by the proposed criteria reflects the distribution of firm size in the full population of registered firms. Approximately 90–94% percent of these firms were small, 4–10% percent were mid-sized and 0–2% percent were large at the end of each year during the review period, as shown in Attachment D-2.39

      In developing the proposed Preliminary Criteria for Identification, FINRA paid significant attention to the impact of possible misidentification of firms; specifically, the economic trade-off between including firms that are less likely to subsequently pose risk of harm to customers, and not including firms that are more likely to subsequently pose risk of harm to customers. There are costs associated with both types of misidentifications.40 The proposed criteria, including the proposed numerical thresholds, aim to balance these economic trade-offs associated with over- and under-identification.41 Further protection to misidentification would be provided by the proposed initial Department evaluation and the Consultation process.
      •   Anticipated Benefits

      The proposal's primary benefit would be to reduce the risk and associated costs of possible future customer harm. This benefit would arise directly from additional restrictions placed on firms identified as Restricted Firms and increased scrutiny by these firms on their brokers. Further, this benefit would also accrue indirectly from improvements in the compliance culture, both by firms that meet the proposed criteria and by firms that do not. For example, the proposal may create incentives for firms that meet the Preliminary Criteria for Identification to change activities and behaviors, to mitigate the Department's concerns. Similarly, the proposal may have a deterrent effect on firms that do not meet the Preliminary Criteria for Identification, particularly firms that may be close to meeting the proposed criteria. These firms may change behavior and enhance their compliance culture in ways that better protect their customers.

      The proposal also may help address unpaid arbitration awards associated with firms identified as Restricted Firms under the proposal. Under the proposed rule, the Department may require a Restricted Firm to maintain a restricted deposit at a bank or a clearing firm that agrees not to permit withdrawals absent FINRA's approval. Moreover, the proposed rule would have a presumption that the Restricted Firm maintain the deposit if it has any covered pending arbitration claims or unpaid arbitration awards. Accordingly, the proposed rule could potentially create incentives for firms to pay unpaid arbitration awards, thereby alleviating, to some extent, harm to successful claimants and enhancing investor confidence in the arbitration process.42

      To scope these potential benefits and assess the potential risk posed by firms that would meet the proposed Preliminary Criteria for Identification, FINRA evaluated the extent to which firms that would have met the criteria during 2013–201643 (had the criteria existed) and their brokers were associated with "new" Registered Person and Member Firm Events after having met the proposed criteria. These "new" events correspond to events that were identified or occurred after the firm's identification, and do not include events that were pending at the time of identification and subsequently resolved in the years after identification. As shown in Attachment D-3, FINRA estimates that there were 89 firms that would have met the Preliminary Criteria for Identification in 2013. These firms were associated with 1,859 "new" Registered Person and Member Firm Events that occurred after their identification, between 2014 and 2018. Attachment D-3 similarly shows the number of events associated with firms that would have met the Preliminary Criteria for Identification in 2014, 2015 and 2016. Across 2013–2016, there were 183 unique firms44 that would have met the proposed Preliminary Criteria for Identification, and these firms were associated with a total of 2,793 Registered Person and Member Firm Events that occurred in the years after they met the proposed criteria.45

      Attachment D-3 also shows the number of Registered Person and Member Firm Events for these firms compared to other firms. Specifically, FINRA calculated a factor which represents a multiple for the average number of events (on a per registered person basis) for firms that would have met the Preliminary Criteria for Identification relative to other firms of the same size. For example, as shown in Attachment D-3, the factor of 6.3x for 2013 indicates that firms meeting the Preliminary Criteria for Identification in 2013 had 6.3 times more new disclosure events (per registered person) in the years after identification (2014–2018) than other firms of the same size registered in 2013. Overall, this analysis demonstrates that firms that would have met the Preliminary Criteria for Identification during the review period had on average approximately 6–9 times more new disclosure events after their identification than other firms in the industry during the same period.
      •   Anticipated Costs

      The anticipated costs of this proposal would fall primarily upon firms that meet the Preliminary Criteria for Identification and that the Department deems to warrant further review after its initial evaluation. Although FINRA would perform the annual calculation and conduct an internal evaluation, firms may choose to expend effort to determine if they would meet the Preliminary Criteria for Identification, and incur associated costs, at their own discretion. To the extent that a firm deemed to warrant further review under proposed Rule 4111 chooses to rebut the presumption that it is a Restricted Firm subject to the maximum Restricted Deposit Requirement, it would incur costs associated with collecting and providing information to FINRA. For example, these firms may provide information on any disclosure events that may be duplicative or not sales-practice related. These firms may also provide information on any undue financial hardship that would result from a Restricted Deposit Requirement. Likewise, a firm availing itself of the one-time staffing reduction opportunity incurs the separation costs, along with the potential for lost future revenues.

      In addition, firms subject to a Restricted Deposit Requirement or other obligations would incur costs associated with these additional obligations. These would include, for example, costs associated with setting up the Restricted Deposit Account and ongoing compliance costs associated with maintaining the account. Further, as a result of restrictions on the use of cash or qualified securities in the deposit account or other restrictions on the firm's activities, the firm may lose economic opportunities, and its customers may lose the benefits associated with the provision of these services.

      Similarly, a firm required to apply heightened supervision to its brokers would incur implementation and ongoing costs associated with its heightened supervision plan.46 Firms that meet the Preliminary Criteria for Identification also may incur costs associated with enhancing their compliance culture, including possibly terminating registered persons with significant number of disclosure events—through exercising the one-time staffing reduction option under proposed Rule 4111 or otherwise—and reassigning the responsibilities of these individuals to other registered persons. Finally, there may be indirect costs, including greater difficulty or increased cost associated with maintaining a clearing arrangement, loss of trading partners, or similar impairments where third parties can determine that a firm meets the proposed Preliminary Criteria for Identification or has been deemed to be a Restricted Firm.

      Firms that do not meet the proposed Preliminary Criteria for Identification, particularly ones that understand they are close to meeting the proposed criteria, also may incur costs associated with enhancing their compliance culture to avoid meeting the proposed criteria. These costs may include terminating registered persons with disciplinary records, replacing them with existing or new hires, enhancing compliance policies and procedures, and improving supervision of registered persons. Finally, registered persons with significant number of disciplinary or other disclosure events on their records may find it difficult to retain employment, or get employed by new firms.
      •   Other Economic Impacts

      FINRA also has considered the possibility that, in some cases, this proposal may impose restrictions on brokers' and firms' activities that are less likely to subsequently harm their customers. In such cases, these brokers and firms may lose economic opportunities or find it difficult to retain brokers or customers. FINRA believes that the proposal mitigates such risks by requiring an initial layer of Departmental review, and providing affected firms an opportunity to engage in a Consultation with the Department and request a review of FINRA's determination in an expedited proceeding. FINRA recognizes that some firms may elect to terminate the registrations of certain brokers with disclosure events, and these brokers may find it difficult to get employed by other firms.

      FINRA also considered that some firms may consider not reporting, underreporting, or failing to file timely, required disclosures on Uniform Registration Forms in an effort to avoid costs associated with the proposals. However, this potential impact is mitigated because many events are reported by regulators or in separate public notices by third parties and, as a result, FINRA can monitor for these unreported events. Further, failing to update timely Uniform Registration Forms is a violation of FINRA rules and can result in fines and penalties, thereby serving as a deterrent for underreporting or misreporting.

      Considering that the proposed criteria are based on a firm's experience relative to its similarly sized peers, FINRA does not believe that the proposed criteria impose costs on competition between firms of different sizes. Further, because FINRA would perform the annual calculation to determine the firms that meet the Preliminary Criteria for Identification, the costs a firm incurs to monitor its status in relation to the proposed criteria would be discretionary and not likely create any competitive disadvantage based on firm size. Although the proposed rule would not impose these monitoring costs, FINRA would provide transparency around how the Preliminary Identification Metrics are calculated and appropriate guidance to assist firms seeking to determine their status. Similarly, FINRA does not anticipate that the proposed Restricted Firm Obligations Rule, including the Restricted Deposit Requirement or any required conditions and restrictions, would create competitive disadvantages across firms of different sizes. This is, in part, because FINRA would consider firm size, among other factors, when determining the appropriate maximum Restricted Deposit Requirement or any conditions and restrictions, to ensure that the obligations are appropriately tailored to the firms' business models but do not significantly undermine the continued financial stability and operational capability of the firm as an ongoing enterprise over the ensuing 12 months.

      As discussed above, FINRA would exercise some discretion in determining the maximum Restricted Deposit Requirement and tailor it to the size, operations and financial conditions of the firm. This approach is intended to align with FINRA's objective to have the specific financial obligation be significant enough to change a Restricted Firm's behavior but not so burdensome that it would indirectly force it out of business. In determining the specific maximum Restricted Deposit Requirement, FINRA would consider a range of factors, including the nature of the firm's operations and activities, annual revenues, commissions, net capital requirements, the number of offices and registered persons, the nature of the disclosure events counted in the numeric threshold, the amount of any "covered pending arbitration claims" or unpaid arbitration awards, and concerns raised during FINRA exams. In developing the proposal, FINRA considered the possibility of having a transparent formula, based on some of these factors, to determine a maximum Restricted Deposit Requirement. However, given the range of relevant factors and differences in firms' business models, operations, and financial conditions, FINRA decided not to propose a uniform, formulaic approach across all firms. Nonetheless, FINRA recognizes that in the absence of a transparent formulaic approach, firms that meet the Preliminary Criteria for Identification may overestimate or underestimate the maximum Required Deposit Requirement and incur associated costs.47 Accordingly, FINRA seeks comment on alternative approaches that could be used to determine the maximum Restricted Deposit Requirement, and why these alternatives may be more efficient and effective than the proposed rule.

      In developing the proposal, FINRA also considered the possibility that the size of the maximum Restricted Deposit Requirement may be too burdensome for the firms, and could undermine their financial stability and operational capability. FINRA believes that these risks are mitigated by providing affected firms an opportunity to engage in a Consultation process with FINRA and propose a lesser Restricted Deposit Requirement or restrictions or conditions on their operations. Further, as discussed above, Restricted Firms would have the opportunity to request a review of FINRA's determination in an expedited proceeding.
      B. Proposed Expedited Proceeding Rule

      When FINRA imposes obligations on a firm pursuant to the proposed Restricted Firm Obligations Rule, the firm may experience significant limitations to its business activities and incur direct and indirect costs associated with the obligations imposed. The proposed Expedited Proceeding Rule would, in general, require that these obligations apply immediately, even during the pendency of any appeal.

      The proposed rule would be associated with investor protection benefits through the impact of the no-stay provision (proposed new Rule 9559(a)(4)). Under the proposal, obligations imposed by FINRA would be effective immediately, except that a firm subject to a Restricted Deposit Requirement under proposed Rule 4111 would be required to make a partial deposit while the matter is pending review. This would reduce the risk of investor harm during the pendency of a hearing requested by the firm. Similarly, the no-stay provision may limit hearing requests by firms that seek to use them only as a way to forestall FINRA obligations.

      The benefit of the proposed rule accruing to firms would be to permit firms to appeal FINRA's determinations (both to request prompt review of obligations imposed or of determinations for failure to comply) in an expedited proceeding, thereby reducing undue costs where firms may have been misidentified. For example, the proposed rule is anticipated to reduce the costs associated with obligations imposed on misidentified firms by the proceeding's expedited nature. Similarly, the proposed rule's time deadlines may also reduce the costs of the proceedings, in certain cases.

      The costs would be borne by firms that choose to seek review via the proposed expedited proceeding, and these costs can be measured relative to a standard proceeding. These firms would incur costs associated with provisions and procedures specific to this proposed rule, including the provision that the obligations imposed would not be stayed.48 This would include the obligations imposed under the proposed rule, including the Restricted Deposit Requirement, and the requirement that the firm, upon the Department's request, provide evidence of its compliance with these obligations. However, the extent of the costs associated with the Restricted Deposit are mitigated by the expedited nature of the proceeding and by the provision that would require a firm, during an expedited hearing process, to maintain only a partial deposit requirement.

      As with the other proposals, FINRA does not anticipate that the proposed rule would have differential competitive effects based on firm size or other criteria. The costs and benefits are anticipated to apply to all firms that request an expedited hearing.
      4. Alternatives Considered

      FINRA recognizes that the design and implementation of the rule proposals may impose direct and indirect costs on a variety of stakeholders, including firms, brokers, regulators, investors and the public. Accordingly, in developing its rule proposals, FINRA seeks to identify ways to enhance the efficiency and effectiveness of the proposals while maintaining their regulatory objectives. FINRA seeks comment on potential alternatives to the proposed amendments in this Notice and why these alternatives may be more efficient or effective at addressing broker and firm misconduct than the proposed amendments.

      In developing this proposal, FINRA considered several alternatives to addressing the risks posed by firms and their brokers that have a history of misconduct, including an alternative to the proposed numeric threshold-based approach and alternative specifications to the proposed numeric threshold based-approach.
      A. Alternative to the Proposed Numeric Threshold-Based Approach

      In addition to the proposed approach based on numeric thresholds, FINRA considered an approach similar to IIROC's "terms and conditions" rule that would allow FINRA to identify a limited number of firms with significant compliance failures and impose on them appropriate terms and conditions to ensure their continuing compliance with the securities laws, the rules thereunder, and FINRA rules. FINRA considered and evaluated the economic impacts of such a Terms and Conditions rule relative to proposed Rule 4111.

      Compared to proposed Rule 4111, a Terms and Conditions rule would provide FINRA with greater flexibility in identifying firms that should be subject to additional obligations. This greater flexibility could help better target its application and reduce misidentification by allowing FINRA to leverage non-public information, including regulatory insights collected as part of its monitoring and examination programs, in identifying firms that pose the greatest risk. Further, under a Terms and Conditions rule, FINRA could quickly update its identification of firms based on emerging risk patterns, to ensure that the rule continues to be effective at addressing firms that presently pose the greatest risk. This flexibility could mitigate the risk that the criteria and thresholds in proposed Rule 4111 no longer identify the appropriate firms.

      Further, as discussed above, the identification criteria in proposed Rule 4111 may not identify all the firms that pose material risk to their customers, such as firms that may act to stay just below the proposed criteria and thresholds by any means, including misreporting or underreporting disclosure events. The absence of a set identification criteria in a Terms and Conditions rule would make it more difficult for firms to evade the identification criteria and thus could provide greater investor protections.

      A Terms and Conditions rule also may have certain disadvantages relative to proposed Rule 4111. For example, a benefit of proposed Rule 4111 is the deterrent effect it may have on firms that do not meet the proposed Preliminary Criteria for Identification, particularly firms that may be close to meeting the criteria. These firms may change behavior and enhance their compliance culture in ways that could better protect their customers. By comparison, under a Terms and Conditions rule, in the absence of transparent criteria, firms must assess FINRA's view of the significance of repeated exam findings to determine whether to change their conduct to avoid potential terms and conditions.

      Although FINRA has considered, and will continue to explore this alternative, it is not proposing a terms and conditions approach at this time.
      B. Alternative Specifications for the Proposed Numeric Threshold-Based Approach

      FINRA also considered several alternatives to the numerical thresholds and conditions for the Preliminary Criteria for Identification. In determining the proposed criteria, FINRA focused significant attention on the economic trade-off between incorrect identification of firms that may not subsequently pose risk of harm to their customers, and not including firms that may subsequently pose risk of harm to customers but do not meet the proposed thresholds. FINRA also considered three key factors: (1) the different categories of reported disclosure events and metrics; (2) the counting criteria for the number of reported events or conditions; and (3) the time period over which the events or conditions are counted. FINRA considered several alternatives for each of these three factors.
      •   Alternatives Associated with the Categories of Disclosure Events and Metrics

      In determining the different types of disclosure events, FINRA considered all categories of disclosure events reported on the Uniform Registration Forms, including the financial disclosures. FINRA decided to exclude financial disclosures because while financial events, such as bankruptcies, civil bonds, or judgments and liens, may be of interest to investors in evaluating whether or not to engage a broker or a firm, these types of events by themselves are not evidence of customer harm.

      In developing the Preliminary Criteria for Identification, FINRA also considered whether pending criminal, internal review, judicial and regulatory events should be excluded from the threshold test. FINRA decided to include these pending events because they often are associated with an emerging pattern of customer harm and capture timely information of potential ongoing or recent misconduct. Further, as with other categories, the proposed Preliminary Identification Metrics Thresholds for the relevant Preliminary Identification Metrics, including the Registered Person Pending Event Metric and the Member Firm Pending Event Metric, are intended to capture firms that are on the far tail of the distributions. Thus, firms meeting these thresholds have far more pending matters on their records than other firms in the industry. Nonetheless, FINRA recognizes that pending matters include disclosure events that may remain unresolved or that may subsequently be dismissed or concluded with no adverse action because they lack merit or suitable evidence.49 In order to ensure that a firm does not meet the Preliminary Criteria for Identification solely because of pending matters, FINRA has proposed the conditions that, to meet the criteria, the firm must meet or exceed at least two of the six Preliminary Identification Metrics Thresholds, and at least one of the thresholds for the Registered Person Adjudicated Event Metric, Member Firm Adjudicated Event Metric, or Expelled Firm Association Metric.50
      •   Alternatives Associated with the Counting Criteria for the Proposed Criteria and Metrics

      FINRA considered a range of alternative counting criteria for the Preliminary Criteria for Identification. For example, FINRA considered whether the Preliminary Criteria for Identification should be based on firms meeting two or more Preliminary Identification Metrics Thresholds, or whether the number of required thresholds should be decreased or increased. Decreasing the number of required thresholds from two to one would increase the number of firms that would have met the Preliminary Criteria for Identification during the review period from 60–98 firms to 150–220 firms, each year. Alternatively, increasing the number of required thresholds from two to three decreases the number of firms that would have met the Preliminary Criteria for Identification from 60–98 to 15–35, each year. FINRA reviewed the list of firms identified under these alternative counting criteria and examined the extent to which they included firms that were subsequently expelled, associated with unpaid awards, or identified as suitable candidates for additional obligations by the Department. FINRA also paid particular attention to firms that would have been identified by these alternative criteria but subsequently were not associated with high-risk activity, as well as firms that would not have been identified by these alternatives that were associated with high-risk events. Based on this review, FINRA believes that the proposed approach—meeting two or more of the Preliminary Identification Metrics Thresholds—more appropriately balances these trade-offs between misidentifications than the alternative criteria.
      •   Alternatives Associated with the Time Period over which the Metrics Are Calculated

      The proposed Preliminary Identification Metrics are based on three different time periods over which different categories of events and conditions are counted (look-back periods). Pending events, including the Registered Person Pending Events and the Member Firm Pending Events categories, are counted in the Preliminary Identification Metrics only if they are pending as of the Evaluation Date. Adjudicated events, including the Registered Person Adjudicated Events and the Member Firm Adjudicated Events categories, are counted in the Preliminary Identification Metrics over a five-year look-back period. The Expelled Firm Association Metric does not have a limit on the look-back period, and is based on the association of Registered Persons In-Scope with a previously expelled firm at any time in their career.51

      In developing the proposal, FINRA considered alternative criteria for the time period over which the disclosure events or conditions are counted. For example, FINRA considered whether adjudicated events should be counted over the individual's or firm's entire reporting period or counted over a more recent period. Based on its experience, FINRA believes that events that are more recent (e.g., events occurring in the last five years) generally pose a higher level of possible future risk to customers than other events. Further, counting events over an individual's or firm's entire reporting period would imply that brokers and firms would always be included in the Preliminary Identification Metrics for adjudicated events, even if they subsequently worked without being associated with any future adjudicated events. Accordingly, FINRA decided to include adjudicated events only in the more recent period (i.e., a five-year period).52

      Similarly, FINRA also considered whether there should be limits on the time period over which the Expelled Firm Association Metric is calculated. For example, FINRA considered alternative metrics that would only be based on firm expulsions over the last three to five years. Further, FINRA considered alternatives where the individual broker's association with the previously expelled firm was within a five-year window around the firm's expulsion. In evaluating these alternatives, FINRA recalculated the underlying thresholds to capture firms that are on the far tail of the distribution for these alternative metrics.53 As with other alternatives, FINRA evaluated these alternatives by paying particular attention to the economic trade-offs of misidentifications, including over- and under-identification of firms. Based on this evaluation, FINRA determined that the Expelled Firm Association Metric proposed in this Notice better accounts for these economic trade-offs. Nonetheless, FINRA specifically seeks comments on alternatives FINRA should consider for the Expelled Firm Association Metric and why these alternatives may be more effective and efficient for identifying the firms that this proposal seeks to address.

      Request for Comment

      FINRA requests comment on all aspects of the proposal. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. FINRA specifically requests comment concerning the following issues.

      General

      1. Are there alternative ways to address members that pose a high degree of risk that should be considered? What are the alternative approaches that FINRA should consider?
      2. Are there any material economic impacts, including costs and benefits, to investors, issuers and firms that are associated specifically with the proposal? If so:
      c. What are these economic impacts and what are their primary sources?
      d. To what extent would these economic impacts differ by business attributes, such as size of the firm or differences in business models?
      e. What would be the magnitude of these impacts, including costs and benefits?
      3. Are there any expected economic impacts associated with the proposal not discussed in this Notice? What are they and what are the estimates of those impacts?

      Proposed Rule 4111

      4. As discussed above, the framework in proposed Rule 4111 for identifying members that pose a high degree of risk is based on identifying members with significantly more reportable events than their peers, based upon six proposed categories of events and conditions.
      a. Does this appear to be a reasonable approach for identifying members that could be subject to additional obligations? Are there other approaches FINRA should consider?
      b. Do the seven firm-size categories in proposed Rule 4111(i)(11) appropriately group firms of similar sizes? Should FINRA consider additional size categories or consider combining certain size categories?
      c. The framework is based on six different categories of events and conditions. Each of these categories is based on a combination of disclosure events. Do these categories appropriately combine similar types of disclosure events? Should FINRA consider additional disclosure categories or consider aggregating or disaggregating certain categories?
      d. FINRA anticipates that the distributions of the six categories of events and conditions would change over time. Should FINRA consider updating the Preliminary Identification Metrics Thresholds periodically, to ensure that they continue to identify members that are significantly different than their peers? If so, how frequently should FINRA consider updating the thresholds?
      5. As discussed above, when developing proposed Rule 4111, FINRA considered several numerical and categorical thresholds for identifying member firms that could potentially be subject to a Restricted Deposit Requirement and other obligations. In determining the proposed metrics and thresholds, FINRA paid significant attention to the economic trade-offs associated with misidentifications, including both over- and under-identification of member firms. FINRA seeks comments on the proposed numerical thresholds and metrics, including the following key factors associated with developing the metrics: (a) the different categories of reported disclosure events and conditions; (b) the counting criteria for the metrics; and (c) the time period over which the metrics are calculated. Specifically, FINRA seeks comment on whether alternative inputs for any of these factors should be considered, and why these alternatives may better identify firms that pose greater risks to their investors.
      6. Should FINRA consider alternative thresholds or look-back periods for the Expelled Firm Association Metric? What factors or conditions should FINRA consider when developing a metric with respect to expelled firm association?
      7. Proposed Rule 4111 includes several processes, including qualitative reviews and consultations, to minimize potential sources of misidentifications. These processes may aid in the identification of the members motivating this proposal, but may also delay the imposition of obligations on them. Are there alternative processes that should be considered?
      8. Proposed Rule 4111 is premised on a notion that the most effective tool to change the behavior of a member firm that presents a high degree of risk is a financial restriction. The proposal, however, affords members that meet the Preliminary Criteria for Identification the opportunity to advocate for a lower Restricted Deposit Requirement or for conditions and restrictions as alternatives to a Restricted Deposit Requirement. Are there better ways to create a potential financial restriction that serves as an effective incentive to change firm behavior?
      9. Proposed Rule 4111 would restrict a member firm from withdrawing any amount from the Restricted Deposit Account, even if it terminates its FINRA membership. However, the proposed Restricted Deposit Account would not be bankruptcy remote and could be used to satisfy claims in a bankruptcy proceeding. Should FINRA consider ways to structure the Restricted Deposit Account so that it is bankruptcy remote or preferentially available to customer claims in the event of a bankruptcy? If so, how should FINRA structure the Restricted Deposit Account, and what conditions and priorities should FINRA consider placing on claims in the event of a bankruptcy?
      10. Proposed Rule 4111 would allow a member firm that meets the Preliminary Criteria for Identification, and that the Department determines warrants further review under Rule 4111, to present why certain disclosure events should not be counted. For example, a member could maintain that disclosure events should not be included in the annual calculation because they involved the same person and the same event or were non-sales-practice related. Are there other characteristics of disclosure events that should lead to not including those events in the calculation of whether the member firm meets the Preliminary Criteria for Identification?
      11. Proposed Rule 4111 uses a principles-based approach for determining a maximum Restricted Deposit Requirement.
      a. FINRA intends to take several factors into account in determining the maximum Restricted Deposit Requirement, including the nature of the member's operations and activities, annual revenues, commissions, net capital requirements, the number of offices and registered persons, the nature of the disclosure events counted in the numeric thresholds, the amount of covered pending arbitration claims or unpaid arbitration awards, and concerns raised during FINRA examinations. Are there other factors FINRA should consider in making this determination? What are those factors, and how should FINRA account for them?
      b. Should FINRA instead consider a formula-based approach(es)? If so, what would be an appropriate formula-based approach that results in a meaningful Restricted Deposit Requirement? How would the formula-based approach account for differences in firms' business models, financial conditions, or other factors discussed above?
      12. Should there be a cap on the maximum Restricted Deposit Requirement? If so, what should the cap be? Should it be expressed as a specific dollar amount? As a number derived from a firm-specific figure, such as a percentage of the member's gross revenues? Or something else?
      13. Apart from having to comply with a Restricted Deposit Requirement or other obligations, are there collateral consequences that could result from being designated as a Restricted Firm, even if FINRA does not publicly disclose that designation? If so, what are those collateral consequences?
      14. This Notice explains that FINRA would review the Preliminary Identification Metrics Thresholds in proposed Rule 4111 on a periodic basis, to consider whether the thresholds remain targeted and effective at identifying member firms that pose higher risks. How frequently should FINRA conduct those periodic reviews?

      Proposed New Rule 9559 and Proposed Amended Rule 9560

      15. Hearings in expedited proceedings under proposed new Rule 9559 would be presided over by a Hearing Officer. By requiring the appointment of a Hearing Officer instead of a Hearing Panel, FINRA intends to create efficiencies, considering the number of potential expedited proceedings that could result from the proposed rule and the substantial amount of time and resources that the Office of Hearing Officers could expend in identifying Hearing Panelists. However, there would be potential benefits to having a Hearing Panel preside over the proceedings, especially due to the industry experience that Hearing Panelists may have. Should FINRA consider requiring that a Hearing Panel be appointed in proceedings under proposed new Rule 9559? Would the benefits of appointing Hearing Panelists outweigh the costs?

      Additional Approaches Considered

      16. Should FINRA consider a rule proposal that would provide it discretion to identify firms that pose significant concerns and impose tailored terms and conditions on a firm, similar to the IIROC's "terms and conditions" rule? If so, should FINRA consider adopting both proposed Rule 4111 and a "terms and conditions" rule, or just one of these kinds of rules? What would be the costs and consequences to member firms of a "terms and conditions" rule, and what kinds of limitations should be placed on such a rule?
      17. FINRA's authority to seek temporary cease and desist orders is limited to alleged violations of specific Exchange Act provisions, specific Exchange Act rules, and specific FINRA rules. It is also limited to circumstances in which the alleged violative conduct is likely to result in significant dissipation or conversion of assets or other significant harm to investors prior to the completion of the underlying disciplinary proceeding.54 Should FINRA consider expanding its authority to seek temporary cease and desist orders?

      In addition to comments responsive to these questions, FINRA invites comment on any other aspects of the rules that commenters wish to address. FINRA further requests any data or evidence in support of comments. While the purpose of this Notice is to obtain input as to whether or not the current rules are effective and efficient, FINRA also welcomes specific suggestions as to how the rules should be changed.


      1. The proposed new rule establishing expedited proceeding procedures for regulating activities under proposed Rule 4111 would be new Rule 9559 (Procedures for Regulating Activities Under Rule 4111); current Rule 9559 (Hearing Procedures for Expedited Proceedings Under the Rule 9550 Series) would be renumbered as Rule 9560. References in this Notice to "new Rule 9559" are to the proposed new rule; references to "Rule 9560" or "the Hearing Procedures Rule" are to current Rule 9559.

      2. Persons submitting comments are cautioned that FINRA does not redact or edit personal identifying information, such as names or email addresses, from comment submissions. Persons should submit only information that they wish to make publicly available. See Notice to Members 03-73 (Online Availability of Comments) (November 2003) for more information.

      3. See SEA Section 19 and rules thereunder. After a proposed rule change is filed with the SEC, the proposed rule change generally is published for public comment in the Federal Register. Certain limited types of proposed rule changes take effect upon filing with the SEC. See SEA Section 19(b)(3) and SEA Rule 19b-4.

      4. For example, in October 2018, FINRA announced plans to consolidate its Examination and Risk Monitoring Programs, integrating three separate programs into a single, unified program to drive more effective oversight and greater consistency, eliminate duplication and create a single point of accountability for the examination of firms. That effort is well underway, and FINRA expects the consolidation will bring those programs under a single framework designed to better direct and align examination resources to the risk profile and complexity of member firms.

      5. For example, in 2015 FINRA's Office of the Chief Economist (OCE) published a study that examined the predictability of disciplinary and other disclosure events associated with investor harm based on past similar events. The OCE study showed that past disclosure events, including regulatory actions, customer arbitrations and litigations of brokers, have significant power to predict future investor harm. See Hammad Qureshi & Jonathan Sokobin, Do Investors Have Valuable Information About Brokers? (FINRA Office of the Chief Economist Working Paper, Aug. 2015). A subsequent academic research paper presented evidence that suggests a higher rate of new disciplinary and other disclosure events is highly correlated with past disciplinary and other disclosure events, as far back as nine years prior. See Mark Egan, Gregor Matvos, & Amit Seru, The Market for Financial Adviser Misconduct, J. Pol. Econ. 127, no. 1 (Feb. 2019): 233–295.

      6. The number of disclosure events correspond to the number of Registered Person and Member Firm Events (defined in proposed Rule 4111(i)(12)) during the Evaluation Period (defined in proposed Rule 4111(i)(6)), as of December 31, 2018. As per the Evaluation Period definition, all final events are counted over the prior five years, and all pending events are counted if they were pending as of December 31, 2018.

      7. See FINRA Rule 9800 Series (Temporary and Permanent Cease and Desist Orders).

      8. See Securities Exchange Act Release No. 83181 (May 7, 2018), 83 FR 22107 (May 11, 2018) (Notice of Filing and Immediate Effectiveness of File No. SR-FINRA-2018-018).

      9. See Regulatory Notice 18-16.

      10. The term "covered pending arbitration claim" is defined in proposed Rule 4111(i)(2) to mean an investment-related, consumer initiated claim filed against the member or its associated persons that is unresolved; and whose claim amount (individually or, if there is more than one claim, in the aggregate) exceeds the member's excess net capital. The claim amount includes claimed compensatory loss amounts only, not requests for pain and suffering, punitive damages or attorney's fees. This term also is proposed in Regulatory Notice 18-06 (February 2018). FINRA anticipates that the term would be amended in proposed Rule 4111(i)(2) to conform to any final definition adopted under the proposal in Regulatory Notice 18-06. For purposes of this Notice, the term "unpaid arbitration awards" also includes unpaid settlements related to arbitrations.

      11. See IIROC Consolidated Rule 9208.

      12. "Uniform Registration Forms" mean Forms BD, U4, U5 and U6.

      13. See proposed Rule 4111(a) and (d).

      14. This part of the Notice uses many terms that are defined in proposed Rule 4111(i). The terms used have the meanings as defined in proposed Rule 4111(i).

      15. See supra note 12. One of the event categories, Member Firm Adjudicated Events, includes events that are derived from customer arbitrations filed with FINRA's dispute resolution forum.

      16. "Registered Person Adjudicated Events," defined in proposed Rule 4111(i)(4)(A), means any one of the following events that are reportable on the registered person's Uniform Registration Forms: (i) a final investment-related, consumer-initiated customer arbitration award or civil judgment against the registered person in which the registered person was a named party, or was a "subject of" the customer arbitration award or civil judgment; (ii) a final investment-related, consumer-initiated customer arbitration settlement, civil litigation settlement or a settlement prior to a customer arbitration or civil litigation for a dollar amount at or above $15,000 in which the registered person was a named party or was a "subject of" the customer arbitration settlement, civil judgment settlement or a settlement prior to a customer arbitration or civil litigation; (iii) a final investment-related civil judicial matter that resulted in a finding, sanction or order; (iv) a final regulatory action that resulted in a finding, sanction or order, and was brought by the SEC or Commodity Futures Trading Commission (CFTC), other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority, or a self-regulatory organization; or (v) a criminal matter in which the registered person was convicted of or pled guilty or nolo contendere (no contest) in a domestic, foreign, or military court to any felony or any reportable misdemeanor.

      17. "Registered Person Pending Events," defined in proposed Rule 4111(i)(4)(B), means any one of the following events associated with the registered person that are reportable on the registered person's Uniform Registration Forms: (i) a pending investment-related civil judicial matter; (ii) a pending investigation by a regulatory authority; (iii) a pending regulatory action that was brought by the SEC or CFTC, other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority, or a self-regulatory organization; or (iv) a pending criminal charge associated with any felony or any reportable misdemeanor. Registered Person Pending Events does not include pending arbitrations, pending civil litigations, or consumer-initiated complaints that are reportable on the registered person's Uniform Registration Forms.

      18. "Registered Person Termination and Internal Review Events," defined in proposed Rule 4111(i)(4)(C), means any one of the following events associated with the registered person that are reportable on the registered person's Uniform Registration Forms: (i) a termination in which the registered person voluntarily resigned, was discharged or was permitted to resign after allegations; or (ii) a pending or closed internal review by the member.

      19. "Member Firm Adjudicated Events," defined in proposed Rule 4111(i)(4)(D), means any of the following events that are reportable on the member firm's Uniform Registration Forms, or are based on customer arbitrations filed with FINRA's dispute resolution forum: (i) a final investment-related, consumer-initiated customer arbitration award in which the member was a named party; (ii) a final investment-related civil judicial matter that resulted in a finding, sanction or order; (iii) a final regulatory action that resulted in a finding, sanction or order, and was brought by the SEC or CFTC, other federal regulatory agency, a state regulatory agency, a foreign financial regulatory authority, or a self-regulatory organization; or (iv) a criminal matter in which the member was convicted of or pled guilty or nolo contendere (no contest) in a domestic, foreign, or military court to any felony or any reportable misdemeanor.

      20. "Member Firm Pending Events," defined in proposed Rule 4111(i)(4)(E), means any one of the same kinds of events as the "Registered Person Pending Events," but that are reportable on the member firm's Uniform Registration Forms.

      21. "Registered Persons Associated with Previously Expelled Firms," defined in proposed Rule 4111(i)(4)(F), means any registered person registered for one or more days within the year prior to the "Evaluation Date" (i.e., the annual date as of which the Department calculates the Preliminary Identification Metrics) with the member, and who was associated with one or more previously expelled firms (at any time in his/her career).

      22. For each of the six Preliminary Identification Metrics, proposed Rule 4111(i)(11) establishes numeric thresholds for seven different firm sizes. Firm sizes are based on the number of registered persons, and range from members that have 1–4 registered persons to members that have 500 or more registered persons. Thus, the proposal establishes 42 different numeric thresholds.

      23. "Registered Person and Member Firm Events," a term defined in proposed Rule 4111(i)(12), means the sum of events in the following five categories: (i) Registered Person Adjudicated Events; (ii) Registered Person Pending Events; (iii) Registered Person Termination and Internal Review Events; (iv) Member Firm Adjudicated Events; and (v) Member Firm Pending Events.

      24. The "Evaluation Date" is defined in proposed Rule 4111(i)(5) to mean the date, each calendar year, as of which the Department calculates the Preliminary Identification Metrics to determine if the member firm meets the Preliminary Criteria for Identification.

      25. OCE has tested the Preliminary Criteria for Identification, including the Preliminary Identification Metrics Thresholds, in several ways. For example, OCE has compared the firms captured by the proposed criteria to the firms that have recently been expelled or that have unpaid arbitration awards. OCE also has consulted with Member Supervision staff and examiners about whether, based on their experience, the criteria identifies firms that appear to present high risks to investors.

      26. See supra note 10, for an explanation of references in this Notice to the term "unpaid arbitration awards."

      27. See supra note 1, for explanations of references in this Notice to "new Rule 9559" and references to "Rule 9560" or the "Hearing Procedures Rule."

      28. Proposed new Rule 9559(a)(1) would define the "Rule 4111 Requirements" to mean the requirements, conditions, or restrictions imposed by a Department determination under proposed Rule 4111.

      29. See supra note 1, for explanations of references in this Notice to "new Rule 9559" and references to "Rule 9560" or the "Hearing Procedures Rule."

      30. Proposed amended Rule 9560 contains other related timing requirements for proceedings pursuant to proposed new Rule 9559.

      31. See FINRA Rule 9560(q).

      32. Attempts to collaterally attack final matters are also precluded in other FINRA proceedings. Cf. Dep't of Enforcement v. Amundsen, Complaint No. 2010021916601, 2012 FINRA Discip. LEXIS 54, at *21–24 (FINRA NAC Sept. 20, 2012) (rejecting respondent's attempt to collaterally attack a judgment that was required to be disclosed on Form U4), aff'd, Exchange Act Release No. 69406, 2013 SEC LEXIS 1148 (Apr. 18, 2013), aff'd, 575 F. App'x 1 (D.C. Cir. 2014); Membership Continuance Application of Member Firm, Application No. 20060058633, 2007 FINRA Discip. LEXIS 31, at *51 (July 2007) (holding, in a membership proceeding, that a firm may not address its and its FINOP's past disciplinary history by collaterally attacking those past violations) (citing BFG Sec., Inc., 55 S.E.C. 276, 279 n.5 (2001)); Jan Biesiadecki, 53 S.E.C. 182, 185 (1997) (describing, in eligibility proceedings, FINRA's long-standing policy of prohibiting collateral attacks on underlying disqualifying events).

      33. See IIROC Consolidated Rule 9208; see also IIROC Notice 17-0010, at pp. 2, 14 (Jan. 12, 2017) (IIROC Compliance Priorities), available at www.iiroc.ca/Documents/2017/2461049c-03b1-4bfa-ba16-2ac05bd59ab4_en.pdf.

      34. See, e.g., Roland Strausz, Delegation of Monitoring in a Principal-Agent Relationship, Rev. Econ. Stud. 64(3):337–57 (July 1997). The paper shows that in a standard principal-agent framework, the delegation of monitoring by the principal (e.g., a regulator) to the agent (e.g., a firm) can be economically efficient for both parties.

      35. See supra note 5.

      36. Investors may also file claims in courts or other dispute resolution forums. Successful claimants in these forums may face similar challenges associated with collecting awards or judgments.

      37. As discussed above, recent studies provide evidence of predictability of future regulatory-related events for brokers and firms with a history of past regulatory-related events. As a result, brokers and firms with a history of past regulatory-related events pose greater risk of future harm to their customers than other brokers and firms.

      38. For example, for each of the six Preliminary Identification Metrics, the Preliminary Identification Metrics Threshold was chosen to capture 1%–5% of the firms with the highest number of events per registered broker or the highest concentrations of Registered Persons Associated with Previously Expelled Firms, in respective firm-size categories.

      39. FINRA defines a small firm as a member with at least one and no more than 150 registered persons, a mid-size firm as a member with at least 151 and no more than 499 registered persons, and a large firm as a member with 500 or more registered persons. See FINRA By-Laws, Article I.

      40. For example, subjecting firms that are less likely to pose a risk to customers to the proposed Restricted Deposit Requirement or other obligations would impose additional and unwarranted costs on these firms, their brokers and their customers.

      41. In order to evaluate the effectiveness of the proposed criteria at identifying firms that pose greater risks, FINRA examined the overlap between the firms that would have met the Preliminary Criteria for Identification each year during the review period and the firms that were subsequently expelled, associated with unpaid awards, or identified by Department staff as suitable candidates for additional obligations. Finally, as discussed below, FINRA also examined disclosure events associated with firms that would have met the Preliminary Criteria for Identification each year during the review period, subsequent to meeting the criteria, to assess the extent of risk posed by these firms.

      42. Further, as discussed above, the Department would consider unpaid awards as one of the factors in determining the amount of the Restricted Deposit Requirement. As a result, Restricted Firms would have additional incentives to pay unpaid arbitration awards.

      43. This analysis examines firms that would have met the Preliminary Criteria for Identification from 2013 until 2016, to allow sufficient time for the "new" events to resolve in the post-identification period.

      44. Certain firms would have met the criteria in multiple years during the review period. The 183 firms discussed in the text correspond to the unique number of firms that would have met the criteria in one or more years during the review period.

      45. Specifically, FINRA examined and counted all Registered Person and Member Firm Events that occurred any time after the firms were identified until March 15, 2019.

      46. These costs would likely vary significantly across firms. Costs would depend on the specific obligations imposed specific to the firm and its business model. In addition, costs could escalate if a heightened supervision plan applied to brokers that serve as principals, executive managers, owners or in other senior capacities. Such plans may entail re-assignments of responsibilities, restructuring within senior management and leadership, and more complex oversight and governance approaches.

      47. For example, firms may, conservatively, overestimate the amount of the required deposit, and withhold the use of additional funds, thereby losing out on economic opportunities associated with these excess funds, until FINRA informs these firms of their actual maximum Restricted Deposit Requirement.

      48. The effect of the no-stay provision is that imposed obligations would apply immediately, even during the pendency of any hearing request. As a result, the no-stay provision would impose direct costs on misidentified firms.

      49. For example, customers may file complaints that are false or erroneous and such complaints may subsequently be withdrawn by the customers or get dismissed by arbitrators or judges.

      50. In order to assess the impact of removing pending events from the Preliminary Criteria for Identification and restricting the criteria solely to final events, FINRA examined the number of firms that would have met or exceeded at least one Preliminary Identification Metrics Threshold in the Registered Person Adjudicated Events, Member Firm Adjudicated Events, or Registered Persons Associated with Expelled Firms categories, during the relevant period. This analysis showed that the number of firms identified by this alternative criteria would increase from 60–98 firms to 150–220 firms, each year, during the review period. Similarly, FINRA estimates the number of firms that would have met or exceeded at least two thresholds within these categories to be 50–75 firms, each year, during the review period.

      51. Registered Persons In-Scope include all persons registered with the firm for one or more days within the one year prior to the Evaluation Date.

      52. This is consistent with the time period used for counting "specified risk events" in Regulatory Notice 18-16.

      53. These alternatives would have identified approximately the same number of firms as meeting the Preliminary Criteria for Identification, during the review period.

      54. See FINRA Rules 9810(a), 9840(a).

      • Attachment A

        Download the document in PDF format.

      • Attachment B

        Download the document in PDF format.

      • Attachment C

        Download the document in PDF format.

      • Attachment D

        Download the document in PDF format.

    • 19-16 SEC Approves Amendments to FINRA Rule 4570; Effective Date: August 19, 2019 [PDF]

      Please click here to view the full PDF pending the publication of the HTML version as soon as possible.

    • 19-15 FINRA Publishes Consolidated Criteria to Designate Firms for Mandatory Participation in FINRA's Business Continuity/Disaster Recovery Testing [PDF]

      Please click here to view the full PDF pending the publication of the HTML version as soon as possible.

    • 19-14 2019 GASB Accounting Support Fee to Fund the Governmental Accounting Standards Board

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      GASB Accounting Support Fee

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Government Securities
      Institutional
      Legal
      Municipal
      Operations
      Senior Management
      Systems
      Trading
      Key Topics

      Financial Accounting Foundation
      GASB Accounting Support Fee
      Governmental Accounting Standards Board
      Municipal Securities Transactions
      Referenced Rules & Notices

      Dodd-Frank Act Section 978
      FINRA By-Laws, Schedule A
      Regulatory Notice 12-15
      Regulatory Notice 13-17
      Regulatory Notice 14-17
      Regulatory Notice 15-12
      Regulatory Notice 16-16
      Regulatory Notice 17-10
      Regulatory Notice 18-12
      Securities Act Section 19(g)

      Summary

      In February 2012, pursuant to an SEC order, FINRA established an accounting support fee (GASB Accounting Support Fee) to adequately fund the annual budget of the Governmental Accounting Standards Board (GASB). The GASB Accounting Support Fee is collected on a quarterly basis from member firms that report trades to the Municipal Securities Rulemaking Board (MSRB). Each member firm's assessment is based on its portion of the total par value of municipal securities transactions reported by all FINRA member firms to the MSRB during the previous quarter. FINRA will assess and collect a total of $8,935,500 to adequately fund GASB's annual budget by collecting $2,233,875 from its member firms each calendar quarter beginning in April 2019.

      Questions regarding this Notice should be directed to the:

      •   Finance Department at (240) 386-5910; or
      •   Office of General Counsel at (202) 728-8071.

      Background & Discussion

      Pursuant to Section 14 of Schedule A to FINRA's By-Laws, which was adopted in response to the SEC's 2011 order under Section 19(g) of the Securities Act of 1933 (Securities Act),1 FINRA assesses a reasonable annual accounting support fee to adequately fund the annual budget of GASB.2 The GASB Accounting Support Fee is assessed on a quarterly basis and is based on member firms' municipal securities trading volume reported to the MSRB during the previous calendar quarter.

      Each quarter, FINRA collects one-fourth of the annual GASB Accounting Support Fee from its member firms. A firm's quarterly assessment reflects its portion of the total par value of municipal securities transactions reported to the MSRB by all FINRA members in the previous calendar quarter. To exclude firms with de minimis transactions in municipal securities in a given quarter from being assessed the fee, firms with a quarterly assessment of less than $25 are not charged the fee for that quarter, and any amounts originally assessed to those firms are reallocated among the firms with an assessment that quarter of $25 or more. Firms that do not engage in reportable municipal securities transactions during a particular calendar quarter are not subject to the GASB Accounting Support Fee for that quarter.

      For 2019, GASB's annual budget expenses of $10,452,300 will be partially funded from $1,516,800 of excess reserves of the Financial Accounting Foundation. As a result, the recoverable annual budgeted expense for purposes of the GASB Accounting Support Fee is $8,935,500;3 therefore, FINRA will collect $2,233,875 from its member firms each quarter beginning in April 2019.4

      Because some firms may seek to pass the GASB Accounting Support Fee onto customers engaged in municipal securities transactions, FINRA will continue to provide an estimated fee rate (per $1,000 par value) based on the GASB recoverable annual budgeted expenses reported to FINRA for that year, as well as historical municipal security trade reporting volumes so that firms will have a basis on which to establish a fee. Based on reported municipal trading activity by FINRA member firms in 2018 and the 2019 GASB budget, FINRA estimates that the GASB Accounting Support Fee for 2019 will be between $0.0024 and $0.0030 per $1,000 par value.

      Firms are reminded that if they choose to pass along the fee, they must ensure any such fees are properly disclosed, including (if applicable) that the fee is an estimate and that the firm ultimately may pay more or less than the fee charged to the customer. In addition, any disclosure used by a firm cannot be misleading and must conform to FINRA rules, including just and equitable principles of trade, as well as any applicable MSRB rules.


      1. Securities Exchange Act Release No. 64462 (May 11, 2011), 76 FR 28247 (May 16, 2011). Section 19(g) of the Securities Act, as added by Section 978 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), gave the SEC the authority to require a national securities association to establish a reasonable annual accounting support fee to adequately fund the annual budget of GASB and to draft the rules and procedures necessary to equitably assess the fee on the association's members. See 15 U.S.C. 77s(g); Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

      2. See Securities Exchange Act Release No. 66454 (February 23, 2012), 77 FR 12340 (February 29, 2012); see also Regulatory Notice 18-12 (April 17, 2018); Regulatory Notice 17-10 (March 2017); Regulatory Notice 16-16 (May 2016); Regulatory Notice 15-12 (April 2015); Regulatory Notice 14-17 (April 2014); Regulatory Notice 13-17 (April 2013); Regulatory Notice 12-15 (February 2012). In accordance with Section 19(g)(5)(B) of the Securities Act, collection of the GASB Accounting Support Fee shall not be construed to provide the SEC or FINRA direct or indirect oversight of the budget or technical agenda of GASB, or to affect the setting of generally accepted accounting principles by GASB. See 15 U.S.C. 77s(g)(5)(B).

      3. For purposes of the GASB Accounting Support Fee, the annual budget of GASB is the annual budget reviewed and approved according to the internal procedures of the Financial Accounting Foundation (FAF). See 15 U.S.C. 77s(g)(2). GASB's 2019 budget includes an administrative fee to FINRA of $30,000 that is intended to cover FINRA's costs associated with calculating, assessing, and collecting the GASB Accounting Support Fee. The amount of the administrative fee is reviewed and evaluated each year by FINRA and the FAF in light of FINRA's experience in assessing and collecting the GASB Accounting Support Fee and the actual costs incurred by FINRA.

      4. The invoice firms received in January 2019 covers the fourth quarter of GASB's 2018 budget and is based on the amounts set forth in Regulatory Notice 18-12. As required by Section 19(g) of the Securities Act, any GASB Accounting Support Fees collected by FINRA are remitted to the FAF and used to support the efforts of the GASB to establish standards of financial accounting and reporting applicable to state and local governments. See 15 U.S.C. 77s(g)(1), (3). Section 19(g)(4) of the Securities Act prohibits FINRA from collecting GASB Accounting Support Fees for a fiscal year in excess of GASB's recoverable annual budgeted expenses. See 15 U.S.C. 77s(g)(4).

    • 19-13 SEC Approves Amendments to FINRA Rule 4512 to Permit the Use of Electronic Signatures for Discretionary Accounts; Effective Date: May 6, 2019

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      Account Authorization Records

      Regulatory Notice
      Notice Type

      Rule Amendment
      Referenced Rules & Notices

      E-Sign Act
      FINRA Rule 4512
      SEA Rule 17a-3
      SEA Rule 17a-4
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Key Topics

      Account Authorization
      Discretionary Authority
      Electronic Signatures
      Recordkeeping

      Summary

      The Securities and Exchange Commission (SEC) approved a proposed rule change to amend FINRA Rule 4512 (Customer Account Information) to permit the use of electronic signatures for discretionary accounts and to clarify the scope of the rule.1 These changes become effective on May 6, 2019.

      The text of the amended rule is set forth in Attachment A.

      Questions concerning this Notice should be directed to:

      •   Afshin Atabaki, Associate General Counsel, Office of General Counsel, at (202) 728-8902 or Afshin.Atabaki@finra.org.

      Background and Discussion

      For discretionary accounts, FINRA Rule 4512(a)(3) currently requires member firms to maintain a record of the dated, manual (or "wet") signature of each named, natural person authorized to exercise discretion in such accounts. To comply with the current requirement, most firms print a paper copy of the account record and require that the authorized individual physically sign it. They then convert the paper record to an electronic record for retention on electronic storage media consistent with Rule 17a-4(f) under the Securities Exchange Act of 1934 (SEA).

      Given technological advances relating to electronic signatures, including authentication and security, FINRA has amended Rule 4512(a)(3) to permit the use of electronic signatures. The rule change is consistent with the Electronic Signatures in Global and National Commerce Act (E-Sign Act), which facilitates the use of electronic signatures. The rule change is also consistent with the requirements of SEA Rule 17a-3(a)(17)(ii) relating to discretionary accounts,2 which does not prescribe the type of signature that must be obtained from an authorized individual. While FINRA Rule 4512(a)(3) would continue to require member firms to obtain the signature of the authorized individual, it would provide firms the option of obtaining either a manual or an electronic signature.

      For purposes of compliance with amended Rule 4512(a)(3), a valid electronic signature would be any electronic mark that clearly identifies the signatory and is otherwise in compliance with the E-Sign Act, the guidance issued by the SEC relating to the E-Sign Act,3 and the guidance provided by FINRA staff through interpretive letters.4

      FINRA has also amended Rule 4512(a)(3) to clarify that the rule is limited to discretionary accounts maintained by member firms for which associated persons of such firms are authorized to exercise discretion. Specifically, the amended rule provides that for a discretionary account maintained by a member firm, the firm must maintain a record of the dated signature of each named, associated person of the firm authorized to exercise discretion in the account. This change will eliminate any potential confusion regarding the scope of the rule and aid members' compliance efforts.


      1. See Securities Exchange Act Release No. 85282 (March 11, 2019), 84 FR 9573 (March 15, 2019) (Order Approving File No. SR-FINRA-2018-040).

      2. 17 CFR 240.17a-3(a)(17)(ii).

      3. See Securities Exchange Act Release No. 44238 (May 1, 2001), 66 FR 22916 (May 7, 2001) (Commission Guidance to Broker-Dealers on the Use of Electronic Storage Media Under the Electronic Signatures in Global and National Commerce Act of 2000 with Respect to Rule 17a-4(f)).

      4. See, e.g., Letter from Nancy Libin, NASD, to Jeffrey W. Kilduff, O'Melveny & Myers, LLP, dated July 5, 2001, www.finra.org/industry/ interpretive-letters/july-5-2001-1200am.


      Attachment A

      Below is the amended rule text. New language is underlined; deletions are in brackets.

      * * * * *

      4500. BOOKS, RECORDS AND REPORTS

      * * * * *

      4512. Customer Account Information

      (a) Each member shall maintain the following information:
      (1) through (2) No Change.
      (3) for discretionary accounts maintained by a member, in addition to compliance with subparagraph (1) and, to the extent applicable, subparagraph (2) above, and NASD Rule 2510(b), the member shall maintain a record of the dated, [manual] signature of each named, [natural] associated person of the member authorized to exercise discretion in the account. This recordkeeping requirement shall not apply to investment discretion granted by a customer as to the price at which or the time to execute an order given by a customer for the purchase or sale of a definite dollar amount or quantity of a specified security. Nothing in this Rule shall be construed as allowing members to maintain discretionary accounts or exercise discretion in such accounts except to the extent permitted under the federal securities laws.
      (b) through (c) No Change.

      • • • Supplementary Material: --------------

      .01 through .06 No Change.

      * * * * *

    • 19-12 FINRA Requests Comment on a Proposed Pilot Program to Study Recommended Changes to Corporate Bond Block Trade Dissemination; Comment Period Expires: June 11, 2019

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      Trade Reporting and Compliance Engine (TRACE)

      Regulatory Notice
      Notice Type

      Request for Comment
      Referenced Rules & Notices

      Notice to Member 06-01
      Notice to Members 03-73
      Notice to Member 03-12
      Notice to Members 01-18
      Regulatory Notice 17-23
      Regulatory Notice 13-35
      Rule 6710
      Rule 6730
      Rule 6750
      SEC Rule 144A
      Suggested Routing

      Compliance
      Fixed Income
      Legal
      Operations
      Research
      Systems
      Trading
      Training
      Key Topics

      ETFs
      Fixed Income
      TRACE
      TRACE-Eligible Security
      TRACE Transaction Data
      Trade Reporting

      Summary

      FINRA requests comment on a proposed pilot program to study changes to corporate bond block trade dissemination based on recommendations of the Securities and Exchange Commission's (SEC) Fixed Income Market Structure Advisory Committee (FIMSAC or Committee). Specifically, the proposed pilot is designed to study two primary changes recommended by the FIMSAC: an increase to the current dissemination caps for corporate bond trades, and delayed dissemination of any information about trades above the proposed dissemination caps for 48 hours. The proposed pilot incorporates these primary elements of the FIMSAC Recommendation and other features, including a control group, designed to support a meaningful analysis of the pilot's impact.

      Questions concerning this Notice should be directed to:

      •   Shawn O'Donoghue, Economist, Office of the Chief Economist (OCE), at (202) 728-8273 or shawn.odonoghue@finra.org; or Yue Tang, Economist, OCE, at (202) 728-8237 or yue.tang@finra.org; or
      •   Alex Ellenberg, Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8152 or alexander.ellenberg@finra.org.

      Action Requested

      FINRA encourages all interested parties to comment on the proposal. Comments must be received by June 11, 2019.

      Comments must be submitted through one of the following methods:

      •   Emailing comments to pubcom@finra.org; or
      •   Mailing comments in hard copy to:

      Marcia E. Asquith
      Office of the Corporate Secretary
      FINRA
      1735 K Street, NW
      Washington, DC 20006-1506

      To help FINRA process comments more efficiently, persons should use only one method to comment on the proposal.

      Important Notes: The only comments that FINRA will consider are those submitted pursuant to the methods described above. All comments received in response to this Notice will be made available to the public on the FINRA website. Generally, FINRA will post comments as they are received.1

      Before becoming effective, the proposed rule change must be filed with the SEC pursuant to Section 19(b) of the Securities Exchange Act (SEA).2

      Background and Discussion

      FINRA's Trade Reporting and Compliance Engine (TRACE) provides information to investors and other market participants about secondary market trades in corporate bonds and other debt securities. Currently, TRACE disseminates information to the marketplace about corporate bond trades, including trade price and size, immediately upon receipt. FINRA launched TRACE in 2002 following an SEC staff review of the U.S. debt markets and a corresponding call for FINRA "to develop systems to receive and redistribute [corporate bond] transaction prices on an immediate basis."3 As FINRA noted at the time, it had worked closely with the SEC, the dealer community and other market participants "to ensure that TRACE maximizes transparency, while optimizing liquidity."4

      To promote transparency without negatively impacting liquidity, FINRA adopted a measured, phased approach to corporate bond trade dissemination that began in 2002 with the most actively traded and liquid bonds.5 In 2003, FINRA phased in dissemination for transactions in smaller investment grade (IG) issues,6 and in 2005 FINRA expanded dissemination for non-investment grade (non-IG) corporate bonds, with delayed dissemination for certain non-IG trades.7 Beginning in 2006, all over-the-counter (OTC) secondary market trades in corporate bonds were disseminated immediately upon receipt, except for trades executed pursuant to SEC Rule 144A.8 FINRA began immediate dissemination for trades in corporate bonds executed pursuant to SEC Rule 144A in 2014.9

      FINRA also leverages academic study to evaluate the impact of TRACE in support of its mission. FINRA performs and publishes economic analysis of TRACE impacts10 and it provides substantial support for independent research.11 Academic research generally has found that liquidity conditions proxied by aggregate activity have improved or have not deteriorated with the introduction of TRACE transparency. However, some market participants have raised concerns about difficulty executing block-size trades in recent years, and some have pointed to metrics or questions they feel are not fully addressed in the academic research, including turnover (aggregate trading activity as a fraction of total bonds outstanding) and the concept of unexecuted trades.

      The FIMSAC was empaneled by the SEC in 2017 "to provide the Commission with diverse perspectives on the structure and operations of the U.S. fixed income markets, as well as advice and recommendations on matters related to fixed income market structure."12 In particular, the FIMSAC has been asked to help the Commission ensure that regulation of the fixed income markets is designed "to meet the needs of retail investors, as well as companies and state and local governments."13

      The state of bond market liquidity was the first issue taken up by the FIMSAC. Discussion at the first FIMSAC meeting cited a number of factors that may be impacting current liquidity conditions and the ability to execute block trades, including technology-driven changes to fixed income market structure and the regulation of bank capital.14 The FIMSAC discussion also identified the perceived dealer cost of TRACE's immediate post-trade transparency as an area to study further. Following on this discussion, at the second FIMSAC meeting the Committee introduced a recommendation for a pilot to study specific changes to FINRA's current post-trade transparency protocols for block-size trades in corporate bonds.15 The FIMSAC Recommendation includes two primary elements: an increase to the current trade size dissemination caps for large corporate bond trades, and a 48-hour dissemination delay for trades above the caps. While a majority of the FIMSAC ultimately approved the Recommendation, several members questioned aspects of the recommended pilot and raised concerns, which are discussed in more detail below.

      The proposed pilot described in this Notice, developed in consultation with SEC staff, incorporates the two primary elements of the FIMSAC Recommendation. It also includes elements designed to produce pilot data that can be measured against a baseline, so that the pilot's effect can be assessed in relation to FINRA's core regulatory objectives of market integrity and investor protection.

      Below, this Notice discusses:

      •   the current protocols for TRACE dissemination of corporate bond trades;
      •   research concerning the impact of TRACE dissemination;
      •   the FIMSAC Recommendation for a pilot;
      •   comments on the FIMSAC Recommendation;
      •   a description of FINRA's proposed pilot;
      •   an analysis of the pilot's expected economic impacts; and
      •   questions for comment on FINRA's pilot proposal.

      As noted throughout, FINRA encourages comment on all aspects of a potential pilot, including the need for a pilot, the potential impact of a pilot, the proposed pilot design, the economic impact assessment and possible alternatives to a pilot.

      Current TRACE Dissemination Protocols

      Today, all OTC secondary market trades in TRACE-eligible16 corporate bonds must be reported to FINRA as soon as practicable, but no later than within 15 minutes of the time of execution.17 FINRA then publicly disseminates information about these trades immediately upon receipt.18

      FINRA currently applies dissemination caps to large-size trades in corporate bonds—i.e., trades that exceed $5 million for IG corporate bonds, and $1 million for non-IG corporate bonds.19 For trades at or below the caps, FINRA disseminates the security identifier, whether the trade was between dealers, or between a dealer and a customer or affiliate, whether the FINRA member involved in the trade bought or sold the security, and the price and full size of the trade. For trades above the dissemination caps, FINRA disseminates all of the same information, but with the size of the trade capped as "5MM+" (for IG) and "1MM+" (for non-IG). The full, uncapped size of trades above the caps is later published as part of an historical dataset six months after the calendar quarter in which they are reported.20

      Research Concerning the Impact of TRACE Dissemination

      Most of the empirical literature on corporate fixed income trading occurred after transaction prices became publicly available through TRACE beginning in 2002. The initial studies of transparency in the corporate bond market are summarized below. These studies used complementary methods and generally reached similar conclusions: that improved post-trade transparency is associated with lower transaction costs and price dispersion and not associated with greater trading volume for actively traded, recently issued and IG bonds.

      Goldstein, Hotchkiss and Sirri (2007) studied a set of BBB-rated bonds, phased into price dissemination in April 2003. In coordination with FINRA, the release of data was structured as a randomized experiment with a control group. They created a stratified sample of bonds to be disseminated along with controls of non-disseminated bonds. They reported that transaction costs on newly transparent bonds declined relative to bonds that experienced no transparency change, except for very large trades. They also reported that transaction costs declined as trade sizes increased, and did not demonstrate further decline on average for sizes above 1,000 bonds. One measure of transaction costs that FINRA's proposed pilot will use is the dealer round-trip measure that is defined in Goldstein, Hotchkiss and Sirri (2007).

      Edwards, Harris and Piwowar (2007) also studied the impact of transparency on transactions costs. The authors employed a design that compared the experience of a set of bonds for which trades were disseminated through TRACE to another set that had not yet been made transparent. By comparing the two sets of bonds before and after the introduction of public dissemination, they were able to isolate the impacts of transparency directly. This type of analysis is referred to as a "difference-in-difference" methodology in the academic literature. Looking at data for the period between January 2003 and January 2005, they found that dissemination was associated with lower trading costs for corporate bonds with larger issue size, better credit quality, more recently issued bonds and bonds closer to maturity. The empirical methodology for this proposed pilot is informed by Edwards, Harris and Piwowar (2007), as it examines the impact of a dissemination delay by comparing trading behavior before versus after its implementation, and uses the same measure of transaction costs. Another closely related paper by Bessembinder, Maxwell and Venkataraman (2006) used insurance company transaction data before July 2002 to find that improved information in disseminated bonds improved market quality for non-disseminated bonds. This study also showed a reduction in institutional trading costs around the initiation of TRACE reporting in July 2002.

      In more recent papers, academics have studied a variety of questions that are related to transparency using TRACE corporate bond data. Harris (2015) found that the lack of a consolidated quote system in bond markets limits the ability of retail and smaller institutional investors to observe best available prices. A consequence of this opacity is that brokers may arrange trades at prices inferior to those readily available. Bao, O'Hara and Zhou (2018) and Bessembinder, Jacobsen, Maxwell and Venkataraman (2018) found empirical evidence that the Volcker Rule reduced the willingness of dealers to commit capital to market making. Financial institutions also attribute some of their decline in capital commitment to fixed income trading to the greater capital costs associated with higher bank capital requirements. This decline is attributable to bank-affiliated dealers, as non-bank dealers have increased their capital commitment. Schultz (2017) and Choi and Huh (2017) found that there has been a greater move to riskless principal trading away from trading that would be intermediated by dealers relying on dealer inventory. Jacobsen and Venkataraman (2018) examined the impact of post-trade reporting of Rule 144A corporate bond transactions. They found that TRACE dissemination had no measureable impact on turnover or dealers' participation in interdealer trades, facilitation of block transactions or willingness to hold inventory. Small dealers increased market share and reduced the cost advantage of large dealers.

      Dick-Nielsen and Rossi (2016) found that hedge funds and buy-side traders fill the void created by reduced bank involvement in market making, and concluded that this change is associated with less immediacy and demands greater customer patience. In addition, another study finds that mutual funds are an important source of liquidity supply when other investors sell bonds (Wang, Zhang and Zhang 2018). Furthermore, Anand, Jotikasthira and Venkataraman (2018) found that some bond mutual funds exhibit a persistent trading style that provides liquidity by absorbing dealer inventory positions. Cici, Gibson and Merrick (2011) focused on the dispersion of month-end valuations placed on identical bonds by different mutual funds when calculating net asset value (NAV). They found that this bond price dispersion declined over their sample period, and may be related to improved transparency in the corporate bond market from TRACE.

      FIMSAC Recommendation for Block Pilot

      At the second FIMSAC meeting on April 9, 2018, the FIMSAC's Transparency Subcommittee introduced a Preliminary Recommendation for a Pilot Program to Study the Market Implications of Changing the Reporting Regime for Block-Size Trades in Corporate Bonds. At the same meeting, the FIMSAC modified and approved the Recommendation by a vote of 15 to four.21

      The FIMSAC Recommendation includes two primary elements. First, it would increase the current dissemination caps from $5 million to $10 million for IG corporate bonds, and from $1 million to $5 million for non-IG corporate bonds.22 This would result in the dissemination of additional size information for trades between the current and proposed caps. Second, the Recommendation would delay dissemination of any information about trades above the proposed $10 and $5 million caps for at least 48 hours.23 This would result in no price or size transparency for these trades during the dissemination delay period. After 48 hours, the trade price and capped size of the trade would be disseminated and the full size of the capped trade would be published three months after the calendar quarter in which the capped trade was reported to FINRA, rather than the current six-month delay.

      The following example illustrates where the Recommendation would decrease price transparency. Today, for an IG trade with a size of $11 million par value, FINRA disseminates immediately upon receipt the price of the trade, and a capped trade size ($5MM+). Under the Recommendation, for the same trade, no information about the trade would be disseminated for 48 hours. After 48 hours, the trade's time of execution, the price of the trade and a capped trade size ($10MM+) would be disseminated. A second example illustrates where the Recommendation would increase size transparency, with no change to price transparency. Today, for an IG trade with a size of $6 million par value, FINRA disseminates immediately upon receipt the price of the trade, and a capped trade size ($5MM+). Under the Recommendation, for the same trade, FINRA would disseminate immediately upon receipt the price of the trade and the full, uncapped trade size.

      The FIMSAC included data tables in its Recommendation that help estimate the impact of the recommended changes. Between 2013 and 2017, there was an average of 350 trades per day above the proposed $10 million cap for IG corporate bonds. These are the trades in IG corporate bonds for which no information would be disseminated for at least 48 hours (different from today, where there is immediate dissemination of price and other trade information but with the size capped). As noted in the FIMSAC Recommendation, these trades represented 1.2% of the total number of trades and 32.6% of total par value traded. Similarly, there was an average of 545 daily trades in non-IG corporate bonds above the proposed $5 million cap that would be subject to the dissemination delay and withheld for 48 hours. These trades represented 3.2% of the total number of trades and 40.8% of total par value traded.

      For pilot design, the FIMSAC Recommendation proposed that the new dissemination protocols apply to all trades in TRACE-eligible corporate bonds for a period of one year, subject to an early termination mechanism linked to market quality indicators. The FIMSAC Recommendation did not contemplate a control group. It also identified a list of proposed measurement criteria that contemplate the evaluation of, in relation to the current dissemination protocols, average daily trading volume of capped and uncapped trades, the number of capped and uncapped trades, the proportion of volume in block trades, the price impact of block trades, transaction cost analysis, and changes in dealer capital, inventory and behavior.

      The FIMSAC Recommendation did not include written supporting rationale. During discussion at the April 9th meeting, the Recommendation was framed as exploring the balance between transparency, which was said to promote efficient markets through lower search costs and greater price competition, and too much transparency, which was said could impair liquidity and market quality in certain market segments if it increases risk in the provision of capital or the likelihood of market impact.24 As explained by the chair of the Transparency Subcommittee, the Recommendation was based on a "general consensus . . . within the [Transparency Subcommittee] and also through outreach to other market participants that maybe the corporate bond market—restraints in the corporate bond market, especially for larger blocks, wasn't working as it should and was perhaps being hindered by some of the TRACE reporting requirements."25

      Proponents of the Recommendation stated at the meeting that that a dissemination delay could help encourage dealers to provide more block liquidity. One panelist at the meeting stated that dealers "have a very asymmetric risk profile when [they] bid or offer a block of securities to a client," and he offered data to show declining trade size between 2007 and 2017.26 The same panelist further noted that a two-day dissemination delay would allow his firm to recycle 50% of block trade risk, while today it recycles 30% of block trade risk on T+0 (the date of the block trade). Proponents also discussed the ways they believed the Recommendation would benefit institutional investors, the people those institutions represent and individual investors.27

      Others, however, raised questions during the meeting about the Recommendation.One member of the FIMSAC and the Transparency Subcommittee strongly urged the inclusion of a control group in the study design.28 Another FIMSAC member asked whether the Recommendation's increase in size transparency was a sufficient balance against the complete reduction in transparency for block-size trades during the dissemination delay.29 Other points of discussion included the impact of reduced price transparency on investors,30 and potential pilot gaming or manipulation by dealers.31

      Comments on FIMSAC Recommendation

      Nine comments have been submitted to date on the FIMSAC Recommendation.32 Four commenters expressed support for the Recommendation, while five opposed it. Commenters generally addressed the need for the block pilot advanced by the FIMSAC Recommendation, the potential impact of the pilot and pilot design.

      Comments on the Need for the Pilot

      Commenters that supported the FIMSAC Recommendation generally felt the pilot was needed based on their view of market conditions for block-size trades in corporate bonds. SIFMA stated that "block size transactions have become substantially more difficult to execute and counterparties are more frequently choosing to break up blocks into smaller transactions or delay transactions to avoid market frictions." SIFMA's statement is based on the observation of its members that there has been a "decline in the proportion of block trades to total volume during a period associated with an increase in the average and median size of corporate bond new issues."33

      JPMorgan Chase also commented that "[p]roviders of liquidity accept heightened risk when transacting in block trades, and these trades are immediately disclosed to the market with masked trade sizes." According to JPMorgan Chase, "as a result of this immediate disclosure, broker dealers now prefer smaller trade sizes on average, particularly for less liquid and lower rated bonds" and adjust their pricing to reflect the cost of immediate post-trade transparency.34 Similarly, Eaton Vance stated that "[f]inding block trade size liquidity in the market is often difficult," and that "[t]he quick publication of all post-trade prices is a significant cause of this difficulty."35 Eaton Vance explained that immediate TRACE dissemination of trades reduces dealers' incentives to provide block-size liquidity because immediate post-trade transparency "lowers transaction costs for market participants, but imposes costs on the Market Makers who give up valuable information on trade details without having received any pre-trade benefit."

      In contrast, three FIMSAC members jointly submitted a comment letter that disagreed with the Recommendation and questioned the FIMSAC's justification for the pilot. In the Harris Letter, these FIMSAC members took issue with the argument that immediate trade dissemination—in place currently—imposes material additional costs on dealers that need to be addressed.36 According to the Harris Letter, despite dealer concerns about being "front run" after printing large trades, it is not likely that other traders will sell ahead of the block dealer either because they would not want to sell a bond they've chosen to own, or because it is expensive to sell bonds short. The Harris Letter further stated that, "in comparison to equity markets, the price moves associated with fundamental information in the bond markets—especially for IG bonds—are small so that the profits associated with front running are not likely large." To the extent dealers encounter significant price impact when engaging in block trades, the Harris Letter contended that dealers "can reduce that impact by selling slowly," and that market structure should not "favor large traders to the detriment of smaller traders."

      The Harris Letter also pointed to alternative explanations—besides TRACE post-trade transparency—to explain changes to large dealer inventory and capital commitment.37 Specifically, the Harris Letter cited as primary factors the growth of electronic trading and competition with traditional dealers from new liquidity-providing proprietary trading firms, and post-financial crisis bank regulation that has affected the willingness or ability of bank-affiliated dealers to commit capital. In addition, the Harris Letter noted as secondary factors a decrease in bond volatility because of low interest rates and substantial economic growth.

      Comments on the Potential Impact of the Pilot

      JPMorgan Chase supported the FIMSAC Recommendation on the grounds that "the recommended pilot would provide a data-driven approach to consider regulatory changes and calibrate a well-tailored transparency regime."38 According to JPMorgan Chase, "[t] ransparency is important to the price discovery process, but the risk of mis-calibration is significant, with the potential to undermine the overall functioning of the market." SIFMA similarly stated that "[t]he pilot recalibration recommended by the SEC FIMSAC offers an opportunity to better balance both transparency and liquidity objectives to promote health and robust markets."39 Eaton Vance supported the Recommendation because it believes the pilot "will encourage market participants to target larger trade sizes in order to take advantage of the forty-eight hour dissemination delay," and "produce more liquidity in block size trades" as a result.40

      On the other hand, several commenters expressed concern about the potential impacts of the pilot. The Harris Letter observed that "[s]ubstantial empirical evidence has shown that public dissemination of TRACE trade reports has saved public investors about $1B/ year."41 The Harris Letter contended that, by reducing price transparency during the 48-hour dissemination delay, "[t]he proposed change will transfer power and thus wealth from receiving investors, who are typically smaller investors, to dealers and the large block initiating traders."42 The Harris Letter further stated that that such a transfer "is inefficient as dealers undoubtedly would capture some or even much of the benefit of knowing the block trade prices," and it questioned the value of the Recommendation's proposal to increase size transparency by raising dissemination caps. In addition, the Harris Letter expressed concern that delayed dissemination of block-size trades could mislead the market about supply and demand conditions, with particular impacts on smaller dealers. The Harris Letter offered the following example: "if a dealer crosses $20 million in bonds from one seller to four buyers each buying $5 million on a riskless-principal basis, under the recommended proposal, FINRA would delay dissemination of the $20 million dealer buy report but would immediately disseminate reports [for] each of the $5M dealer sales. The immediately disseminated reports would give the appearance of surplus buying demand and the possibility that one or more dealers have been left short facilitating this customer demand."43

      Similarly, The Credit Roundtable, an organization of institutional fixed income managers, objected to the Recommendation's proposed 48-hour dissemination delay, which it believed would create information asymmetry that would ultimately benefit "broker/ dealers, very large institutional investors, and high frequency leveraged players at the expense of other participants in the corporate bond market."44 Vanguard also objected to the significant reduction in price transparency that would be caused by a 48-hour dissemination delay. Vanguard expressed concern that imposing a dissemination delay on a third of recorded market volume "could have a meaningful negative impact on daily price discovery and execution costs while advantaging a segment of market participants over others."45 Vanguard further observed that "[b]y bifurcating the market into those with access to information and those without, [the FIMSAC Recommendation] may even create additional barriers to entry for newer or smaller market participants, and further entrench those with the largest market positions."46

      Separately, two Exchange Traded Fund (ETF) market makers expressed concerns that the Recommendation would diminish price transparency in the corporate bond markets and degrade the market for overlying ETFs and other related derivatives. Jane Street stated that a 48-hour dissemination delay "would introduce a material amount of information asymmetry and adverse selection to the corporate bond market."47 As a result, Jane Street noted it would need to adjust its behavior when trading with a block liquidity provider because of the risk the block liquidity provider has information about large block trades it executed that have not yet been disseminated to the market. Specifically, Jane Street stated it would be forced to widen its quotes for corporate bond ETFs, and "that wider spreads in ETFs would impose significant costs on ETF end-users, who are in substantial part retail investors."48 Flow Traders offered similar observations about ETF spreads and also pointed to other derivative products, like total return swaps, credit default swaps and the credit default swap index, that would become more difficult to price because of the information asymmetry that would be created by the Recommendation.49 Vanguard also stated that diminished price transparency would create pricing challenges for market makers who create and redeem ETFs, which would translate into higher costs for ETF investors.50

      Comments on Pilot Design

      Several commenters provided specific feedback on particular elements of the FIMSAC's recommended pilot design. JPMorgan Chase suggested that the non-IG dissemination cap should be raised to $3 million, as originally proposed in the FIMSAC Preliminary Recommendation, instead of $5 million, as proposed in the final FIMSAC Recommendation.51 With respect to the FIMSAC Recommendation's proposed measurement criteria for the pilot, JPMorgan Chase stated that the objective criteria concerning trading activity should be measured separately for bonds with large and small outstanding values to compare impact across issue sizes. JPMorgan Chase further suggested that, to the extent price impact or transaction cost analysis are studied, the calculation methodology should be better defined. And JPMorgan Chase questioned whether the proposed measurement criteria concerning changes in dealer capital and inventory, or changes in dealer behavior, should be included at all, because they could be influenced by other factors outside the pilot and therefore misleading.

      The Harris Letter proposed to change the pilot design altogether. The Harris Letter recommended a decrease in the dissemination caps, from $5 million to $2.5 million for IG, and from $1 million to $750,000 for non-IG.52 The Harris Letter stated that the decrease "would protect the dealers by further hiding the full sizes of the blocks that they have purchased and must distribute," but "the receiving investors would still know the actual trade prices." To offset its proposed decrease in size transparency, the Harris Letter recommended publishing the full size of IG trades between $1 and $10 million, and non-IG trades between $750,000 and $2.5 million, two market days after they occur, and publishing the full size of larger IG and non-IG trades four market days after they occur.

      Vanguard expressed concern that if the FIMSAC Recommendation were to proceed without a control group, the study would result in "data that is open to misinterpretation." Vanguard specifically noted that volume alone is not an appropriate measure of success in fixed income markets and urged more comprehensive data study before the implementation of a pilot. In addition, Vanguard stated that the proposed thresholds for delayed dissemination in the FIMSAC Recommendation—i.e., the proposed increased dissemination caps of $10 million for IG corporate bonds and $5 million for non-IG corporate bonds—are "far too low" and "could lead to gaming and data distortions that would impair the credibility of the results."53

      Description of FINRA's Proposed Pilot

      FINRA is soliciting comment on a proposed modified pilot design based on careful study of the FIMSAC Recommendation and associated comment letters, and after consultation with SEC staff. FINRA's modifications are intended to allow for a more meaningful study of the pilot's impacts on market integrity and investor protection, including large investors who trade in block sizes, smaller investors who do not, and investors in derivative or other related markets.

      Proposed Pilot Design

      As discussed in this Notice, the FIMSAC Recommendation essentially combines two different proposed changes to the current transparency framework. First, it proposes to increase the number of trade reports that would report the full size of the transaction, which effectively increases size transparency for those trades. And second, it proposes a complete dissemination delay for trade reports above the new dissemination cap size, which effectively reduces price (and other information) transparency for those trades. Because the FIMSAC Recommendation includes elements designed both to increase and decrease transparency for different size trades, FINRA's primary challenge is to design a pilot that can reasonably assess the impact of the different changes proposed, and the trade-off between them, without imposing unnecessary costs and disruptions to markets and market participants.

      The proposed pilot would last for a duration of one year. As the FIMSAC recommended, and based on consultation with SEC staff, the pilot would be subject to early termination if market quality indicators demonstrate a significant disruption. The pilot would include non-convertible, callable and non-callable TRACE-eligible corporate debt securities, except for bonds issued by religious organizations or for religious purposes (e.g., church bonds), and equity-linked notes. New issues would be included in the pilot the first day after they begin trading in the secondary market. There would be three pilot study groups and one control group. The three test groups are:

      •   Test Group 1, which would study a 48-hour dissemination delay with no change to the current dissemination caps. In other words, for bonds in this test group, TRACE would apply a 48-hour dissemination delay to trades above $5 million in IG corporate bonds, and trades above $1 million in non-IG corporate bonds.
      •   Test Group 2, which would study increased dissemination caps with no change to the current dissemination timeframes. In other words, for bonds in this test group, TRACE would increase dissemination caps to $10 million for IG corporate bond trades and $5 million for non-IG corporate bonds trades, without applying a 48-hour dissemination delay.
      •   Test Group 3, which would study both a 48-hour dissemination delay and increased dissemination caps. In other words, for bonds in this test group, TRACE would apply a 48-hour dissemination delay to trades above $10 million in IG corporate bonds, and trades above $5 million in non-IG corporate bonds.

      Similar to the SEC's approach to test and control group creation for its recently adopted Transaction Fee Pilot, FINRA proposes to implement stratified sampling for this pilot in a manner that permits comparison between each test group and the control group.54 Pilot bonds would be stratified along the characteristics of bond issue size, age of bond issue, bond rating and 144A status.

      FINRA would use these variables to create categories, or buckets, of bonds. Bonds in each of the buckets will be randomly assigned before the start of the pilot to the four pilot groups (three test and one control), with Test Groups 1, 2 and 3 each containing one-third of the bonds randomized to the control group.

      These stratification variables are proposed because they have been identified as capturing differences in liquidity among corporate bonds (Bessembinder, Jacobsen, Maxwell and Venkataraman 2018). For example, investors may trade larger offerings more than smaller ones simply because they are more liquid at the issuance date due to their size. Alternatively, larger offerings are usually issued by large issuers. Large issuers, in turn, may have better informational environments, thereby reducing the cost of acquiring information about the issuer. This may make the bonds more liquid. Similarly, younger bonds could be more liquid than older ones because the time to maturity is greater for a given transaction cost. Should investors believe that credit ratings truly proxy for credit worthiness, they may prefer to transact in corporate bonds with higher ratings. Different credit ratings may also attract different type of traders which could affect their liquidity. Lastly, corporate bonds subject to Rule 144A may trade differently than non-144A corporate bonds.55

      FINRA further proposes to rotate pilot bonds halfway through the pilot. After 126 days of trading—there are approximately 252 trading days per year—bonds that are initially randomized to one of the test groups would be rotated to the control group, and the bonds initially in the control group would be divided equally into the three test groups. The sole exceptions to the rotation approach would be bonds that are newly issued close to the rotation date, or bonds that default during the pilot. New issues that trade fewer than 50 total trading days before rotation occurs on the 126th day of the pilot would not be moved from the test or control group to which they were initially randomized, and bonds that default would not be moved from the test or control group to which they were initially randomized. Rotation of the bonds between test and control group is intended to address concerns that test and control assignment could impose unfair costs and burdens.56

      FINRA understands that a potential consequence of the proposed rotation is that market participants may have different expectations about the impact of delayed dissemination or an increase in cap size for test and control group bonds at the pilot's start than at the time when rotation occurs. As a result, the evidence generated from the first half of the pilot may differ from that of the second half. If so, interpretation may be more difficult because of potential differences that may arise from latent differences in bond assignment to a given test group as market participants update expectations from learning. However, if market participants quickly understand the impact of a change in transparency, then bonds initially randomized to a given Test Group in the first 126-day period are likely to be affected in a similar manner by the same change in transparency when bonds in the control group are randomized to the same Test Group in the second 126-day period. The list of existing CUSIPs assigned to each Group will be publicly posted before the proposed pilot begins and before rotation. In addition, the list of assigned CUSIPs will be updated throughout the term of the pilot as new issues are assigned to pilot groups.

      Methodology

      This section provides a high-level description of the proposed criteria for evaluating the impact of the pilot.

      The primary method proposed to evaluate the impacts associated with the pilot is a "difference-in-difference" method used by academics to identify changes in transparency on corporate bond trading from the implementation of TRACE. The benefit of employing this method is that it is generally accepted as an effective way to assess changes in transparency for corporate bonds and it permits a comparison of the pilot's findings to earlier studies. There are two types of comparisons that are made in this difference-indifference pilot design. The first comparison is the effect of a change in transparency on a given outcome variable by comparing the outcome variable's average change over time for a Test Group versus its control group. For example, one may examine the difference in average transaction costs between bonds in Test Group 1, which would be subject to a dissemination delay, versus those in the control group, which would not be subject to a dissemination delay. The second comparison is the effect of a change in transparency on a given outcome variable by comparing the outcome variable's average change over time for one Test Group versus another Test Group. For example, one may examine the difference in average transaction costs between bonds in Test Group 1, which would be subject to a dissemination delay, versus those in Test Group 2, which would be subject to increased dissemination caps.

      By construction, Test Group 1 reduces transparency by introducing a dissemination delay. The identification strategy is to compare the effect of the dissemination delay on outcome measures, such as aggregate trading volume including the amount attributable to institutional and non-institutional sized trades, transaction costs and market participation for bonds in Test Group 1 versus the control group and bonds in Test Group 1 versus Test Group 2 or 3.

      Test Group 2 potentially improves size transparency, with no change to price transparency, by increasing the dissemination cap, thereby increasing the number of bond trades subject to uncapped dissemination, without imposing any dissemination delay. This identification strategy compares bonds in Test Group 1 versus the control group and bonds in Test Group 2 versus Test Group 1 or 3.

      Test Group 3 combines these two primary elements of the FIMSAC Recommendation. By construction, it potentially mitigates the reduction in transparency relative to Test Group 1 by increasing the dissemination caps, thereby increasing the number of bond trades subject to real-time, uncapped dissemination and reducing the number of trades that are subject to a dissemination delay. At the same time, Test Group 3 reduces transparency relative to Test Group 2 by introducing a dissemination delay for the size capped trades. This identification strategy compares the effect of the dissemination delay with increased cap size to the control group in addition to the other two test groups. Test Group 3 permits a comparison of the joint effect of the dissemination delay or increased cap size relative to trades affected by a lower threshold for a delayed dissemination alone in Test Group 157 or an increased cap alone in Test Group 2.

      The proposed pilot tests delayed dissemination versus a new trade size dissemination cap. Such a design permits those evaluating the pilot to discriminate between the relative impacts of each of those changes and assess the trade-off between the two elements. In this framework, for example, the public would be able to assess directly how any benefits arising from increasing the trade size dissemination cap offsets any costs associated with delaying any dissemination of larger sized trade reports. Without this framework, such a comparison would likely be extremely uncertain.

      In order to best provide this comparability, the proposed pilot would extend the trade delay beyond the FIMSAC Recommendation to the current trade size dissemination caps in one of the test groups for the duration of the pilot. The FIMSAC Recommendation does not provide evidence for the basis of the thresholds recommended. If those thresholds best reflect the trade-off between investor protection and well-functioning markets, extending the reporting delay to more trades may impose greater costs than intended by the FIMSAC.

      FINRA considered alternatives that would potentially avoid these costs. One option considered was to limit the dissemination delay in Test Group 1 to the FIMSAC recommended thresholds of $10 and $5 million respectively for IG and non-IG bonds, without increasing the dissemination caps for Test Group 1. In other words, under this alternative construction for Test Group 1, for an IG bond in Test Group 1, a trade with a size of $6 million par value would not be subject to the 48-hour dissemination delay and would be disseminated immediately according to current dissemination caps with a capped size of $5MM+. For the same IG bond under this alternative construction for Test Group 1, a trade with a size of $11 million par value would be subject to the 48-hour dissemination delay and would be disseminated after the delay according to current dissemination caps with a capped size of $5MM+. FINRA recognizes that such an alternative construction would conflate the impact of both the delay and the change in the dissemination caps. Accordingly, FINRA believes this alternative would be more likely to provide evidence that is harder to interpret. FINRA asks commenters to consider the importance of design and how it can affect the ability of FINRA, the SEC and the public to evaluate the outcome of the pilot in their comments.

      Outcome Measure and Research Questions

      As FIMSAC's proposed pilot is a test of a joint hypothesis, FINRA suggests that the optimal experimental design is a direct test of the delay in the dissemination of block trades, an increase in the cap size and a dissemination delay combined with an increased cap size to determine whether dealers will provide increased liquidity for block trades. To this end, FINRA solicits comments on whether this proposed pilot can provide reliable answers to the following research questions organized by type of measure, and if so, how these questions would be measured empirically.

      1. Trade-based

      Is either a dissemination delay or a delay with increased cap associated with changes in aggregate trading activity?

      In particular, does a decrease in transparency:
      1. increase trading activity;
      2. increase liquidity58;
      3. decrease time between transactions; or
      4. decrease uncertainty/error in prices?
      2. Blocks and block activity

      Are there differences in block trading between groups at the threshold where the dissemination is delayed or the dissemination is delayed with increased cap?

      In particular, does a decrease in transparency:
      1. increase the frequency or size of block trades;
      2. decrease liquidity in block trades; or
      3. increase the time between block trades?
      3. Trading costs

      Is either a dissemination delay or a delay with increased cap associated with changes in trading costs for investors?

      In particular, does a decrease in transparency:
      1. decrease transaction costs (e.g., dealer roundtrip costs); or
      2. decrease costs from adverse selection (i.e., price impact)?
      4. Dealer behavior

      Is either a dissemination delay or a delay with increased cap associated with changes in dealer behavior?

      In particular, does a decrease in transparency:
      1. increase market making (measured as volume or inventory) of large broker-dealers that are active in blocks;
      2. benefit large broker-dealers that are active in blocks at expense of less informed ones in trades when block traders have an information advantage after the block executes but before that transaction is disseminated; or
      3. increase the probability of gaming by dealers, for example, altering their trading pattern to selectively release prices or make information more asymmetric?
      5. Dealer compensation

      Is either a dissemination delay or a delay with increased cap associated with changes in dealer compensation?

      In particular, does a decrease in transparency:
      1. increase the likelihood of principal activity relative to agency trades;
      2. increase markups;
      3. decrease the size of dealer networks; or
      4. increase profitability of larger dealers at center of the dealer network?
      6. Buy side behavior

      Is either a dissemination delay or a delay with increased cap associated with increased adverse selection for less informed institutional investors?

      In particular, does a decrease in transparency benefit more informed institutional investors at expense of less informed institutional investors?
      7. ETFs, mutual funds and derivative markets

      Bond ETFs and bond mutual funds derive their value from an underlying basket of corporate bonds. Efficient pricing of these derivative baskets and their individual securities requires up-to-date information on the pricing of holdings. Is either a dissemination delay or delay with increased cap associated with more pricing errors in ETFs, mutual funds or derivatives? Are these delays associated with profitable trading strategies for these instruments by market participants that trade blocks of securities that underlie the instruments and are subject to delayed dissemination?

      In particular, does a decrease in transparency:
      1. decrease the accuracy of average ETF and mutual fund pricing;
      2. increase the information content in ETFs and mutual funds associated with more informed market participants relative to others; or
      3. increase profitable trading of derivatives by dealers that trade blocks in corporate bonds?

      Economic Impact Assessment

      FINRA developed the pilot proposal described in this Notice based on the FIMSAC Recommendation. The discussion below presents a framework to evaluate the potential economic impacts of the specific changes recommended by the FIMSAC. However, as discussed throughout the Notice, there are different views on the need for and potential impact of studying these changes as a pilot. As the SEC has discussed, pilot studies may be particularly useful to inform policy decisions where there is not sufficient empirical evidence otherwise available. For example, when the SEC adopted the Transaction Fee Pilot, it explained the pilot was needed because available data was too limited to permit researchers to isolate and study the contested policy issue in question—specifically, the impact of transaction fees on order routing behavior, execution quality and market quality. Accordingly, the SEC stated that the Transaction Fee Pilot was uniquely capable of generating the empirical evidence to inform regulatory decisions.59 The SEC further noted that better informed regulatory decisions generally are more likely to result in regulatory approaches that better balance costs and benefits relative to regulatory decisions based on less precise information.60

      The SEC also recognized that pilots may impose costs and can face limitations that may impact pilot design. The SEC noted that pilots can be unpredictable and may face the limitation that market participants may adjust their behavior differently for a pilot than for a rule change.61 In addition, while the pilot described in this Notice may impose less compliance cost because it does not require any change to the way market participants report trades to TRACE, the pilot likely will impose some costs on market participants to remain aware of the dissemination protocols associated with the bonds in each pilot group. This is in addition to the costs discussed below concerning the changes that would be implemented by the pilot.

      FINRA includes questions below and encourages comments on the need for and potential impacts of studying the recommended changes with a pilot, including whether the current data is sufficient or insufficient to inform the policy questions raised by the FIMSAC Recommendation, whether the proposed pilot's benefits outweigh the costs, and whether other methods or data sets should be considered rather than a pilot to measure impacts or "lost opportunities" to trade.

      Economic Baseline

      The current regime of post-trade transparency was created with the introduction of TRACE in 2002. Since then, as noted above, numerous studies examined the impact of TRACE post-trade transparency on the liquidity and competitiveness of the U.S. corporate bond market. The current market conditions inform the economic baseline and are the result of these impacts. The studies of the impacts serve as reference in evaluating the effect(s) of the pilot.

      Several papers examined the impact of transparency on realized bid-ask spread, which is considered either as a proxy for liquidity or the transaction cost of a customer roundtrip (completing a buy and sell of a corporate bond). These papers concluded that the increased transparency associated with TRACE transaction reporting is generally associated with a substantial decline in investors' trading costs and the cost reduction is greater for smaller trade sizes, potentially accruing to retail investors.62 Researchers also found reductions in intraday price dispersion, which could translate into reductions in trading costs.63 Some studies found that trading volume in the dealer market had remained the same or decreased with the introduction of TRACE; a possible explanation was that TRACE might have helped trading volume shift to the electronic platform.64 Other studies examined the impact on dealer competition and found evidence of increased competitiveness of small dealers.65 Finally, another study found improved valuation precision of mutual funds holdings in the presence of increased TRACE transparency.66

      This section briefly describes the market for corporate bonds as captured by the TRACE dataset, focusing on the sample of transactions in pilot eligible corporate instruments reported to TRACE in calendar year 2018. Pilot-eligible securities are defined as non-convertible, callable and non-callable TRACE-eligible corporate debt securities, including 144A bonds (and excluding religious institution bonds and equity linked notes).

      Table 1 presents secondary market trading statistics of corporate bonds grouped by the bond characteristics used for stratification in the pilot. In particular, it shows the number of CUSIPs, total par value traded and mean par value per trade in calendar year 2018.67 TRACE data indicates that 32,408 bonds were traded in 12.4 million transactions during calendar year 2018. During that same period the total par value traded was $7.0 trillion, and the average par value per trade was $561.4 thousand.

      Table 2 describes the mean number of trades and par value traded by CUSIP and per day in calendar year 2018. The average bond was traded 384 times with a total traded par value per CUSIP of $215.3 million in 2018. An average of 49,524 trades representing $27.8 billion in par value exchanged hands per day. Larger issues were traded more frequently and typically in larger trade size.

      Table 3 reports the number of issues, trades, total and mean par value traded per day by rating and trade size for all corporate bonds in the year 2018. The table indicates that there were significantly more trades in smaller size than in larger institutional sizes, yet this is not true for the total dollar par value traded. For example, there were 31,628 trades of less than $1 million per day for investment grade bonds, but only 403 trades of larger than $10 million. Yet the total par value traded in less than one million dollar trades is $2.8 billion, compared to $6.3 billion for trades larger than $10 million.

      Figure 1 presents the number of new issuances per year by type, grade and size for each year from 2009 to 2018. The period post-2009 shows a strong secular growth in new corporate bond issuance. The issuance of non-IG, non-144A and smaller issue size (size less than $500 million) corporate bonds increased 536% from 2009 to 2018. The issuance of IG, non-144A corporate bonds increased for all issue sizes.

      Figure 2 presents the par value of new issuances per year by type, grade and size for each year from 2009 to 2018. For non-144A and non-IG issues, issuances of less than $500 million increased 48.3%, $500 million to $1 billion increased 39.8%, while larger than $1 billion decreased 21.6%. For non-144A and IG issues, issuances of less than $500 million increased 2.4%, $500 million to $1 billion increased 92.9%, while larger than $1 billion increased 24.5%.

      Figure 3 shows secondary market trading of corporate bonds in TRACE from 2013 to 2018.68 The sample reflects the set of corporate bonds proposed to be included in the pilot. To account for the difference in total bonds outstanding across years, annual traded dollar par value is standardized by the total dollar par value of outstanding bonds as of June 30th of the corresponding year.

      Figure 3–1 indicates that there has been some time series variation in IG bond turnover, but the aggregate difference over the period is very small ranging from 0.608 in 2013 to 0.602 in 2018. There appears to be at least some secular growth in the turnover from smallest and largest trade size groupings. Figure 3–2 represents the share that each trade size group represents as a fraction of all trading activity. In this view, the share of trades in IG bonds less than $1 million increased from 13.4% in 2013 to 15.0% in 2018. The share of trades larger than $10 million increased from 32.1% in 2013 to 33.8% in 2018.

      For non-IG bonds, Figure 3-3 shows that total turnover increased from 76.4% in 2013 to 94.2% in 2018. Turnover is generally increasing for smaller trade sizes. Figure 3–4 shows that the share of trades less than $1 million increased from 11.2% in 2013 to 14.6% in 2018. The share of trades larger than $10 million decreased from 20.0% in 2013 to 17.6% in 2018.

      Economic Impacts

      A discussion of the anticipated economic impacts, including costs and benefits associated with each pilot test group, is presented below. Based on the sample population affected by the pilot, approximately 3% and 18% of trades and 56% and 85% of par volume in investment grade and non-investment grade bonds may be candidates subject to delayed dissemination at some point during the pilot. Similarly, based on the sample population affected by the pilot, approximately 2% and 15% of trades and 22% and 45% of par volume in investment grade and non-investment grade bonds may be candidates potentially affected by the pilot cap size change. These estimates do not account for changes in behavior in response to the pilot.

      Test Group 1: 48-hour Dissemination Delay with No Change to Dissemination Caps

      Potential Benefits

      The primary goal of the FIMSAC Recommendation is to test whether delayed dissemination of reported transactions can increase liquidity in blocks, without imposing significant indirect and direct costs on market participants and investors. The FIMSAC Recommendation and supporting comments cite observational evidence that finding block-size liquidity in the current market (i.e., the baseline) may be difficult because of the relatively quick publication of post-trade prices. Although TRACE post-trade transparency lowers transaction costs for market participants, proponents of the dissemination delay believe that post-trade transparency may impose costs on dealers and other liquidity providers by making public valuable trade information. When larger trades are publicly disseminated, dealers with recently acquired blocks may be more vulnerable to adverse price movements from traders who are aware of these recent executions. This may cause larger trades to incur greater costs for dealers, which could reduce the incentive for them to provide liquidity in blocks or require them to receive greater compensation for providing block liquidity.

      Under this rationale, providing a delay in dissemination for larger trade sizes could be associated with greater provision of liquidity to those seeking to conduct larger trades. Delayed dissemination of large trades could provide dealers with more time to offset positions. During the delayed dissemination, dealer positions may be less vulnerable to price movements that negatively impact profits, because other traders have less information on these recent large trades. Consequently, existing dealers of large trade sizes may trade larger trade sizes more frequently, further increase the size of larger trades, or offer more attractively priced quotes. The benefits from the dissemination delay may disproportionately accrue to dealers who trade larger sizes, if transaction prices convey information about bond quality or future prices that are no longer shared.

      Institutional investors may also benefit, as they may trade faster or more frequently because dealers might find counterparties faster or carry more inventory. In addition, institutional investors might save time and effort in contacting dealers for quoted prices, as more dealers may be willing to provide aggressively priced bid-ask quotes or trade in larger size. If liquidity in larger trade sizes improves for particular bonds and these bonds are a close substitute for bonds that are typically more costly to trade, then institutional investors may benefit from substituting a more liquid bond for a less liquid one.

      This benefit may be limited to the extent block-size trades are not relatively more difficult to execute in the current market, as suggested in certain of the baseline data discussed above.

      Potential Costs

      Dealers and institutional investors that regularly transact in these larger block sizes would have more non-public information during the dissemination delay than in the absence of the pilot. This may give them an even greater competitive advantage during that 48-hour dissemination delay window relative to market participants who do not typically trade these larger blocks. Back, Liu and Tequia (2018) theoretically showed that disclosure of transaction prices conveys information on the security's quality and reduces dealer's rents when trading inventory in the secondary market. Consequently, the reduction in transparency could potentially reduce information content of prices and could increase dealers' rents. Dealers and institutional investors that trade larger sizes may profit from this informational advantage on trade prices at the expense of dealers and investors that do not larger block sizes.

      This economic rent is a cost imposed by Test Group 1 from the perspective of market participants not regularly transacting in blocks subject to the 48-hour dissemination delay. Smaller brokers that do not regularly trade blocks benefitting from the 48-hour dissemination delay may be more likely to provide less attractively priced quotes, thereby increasing trading costs, or reduce the size at a given quoted price. Under this scenario, retail traders may find increased costs and lower returns from participating in the corporate bond market. Furthermore, some institutional investors and less active dealers may need to contact more dealers, thereby increasing search costs.

      Delayed reporting of large trades could increase price uncertainty to less informed traders, thereby potentially reducing liquidity in corporate bonds. Delayed block price reporting exposes buy and sell side participants to additional risk, as they may be transacting at prices inferior to those that they would have accepted had dissemination of block trades not been delayed. Limited information on large transactions is particularly problematic during periods of market stress when the benefit of timely pricing information is large. It may also introduce misleading information to the market about supply and demand conditions, with particular impacts on smaller dealers, as noted in the Harris Letter.

      An implicit assumption of the FIMSAC Recommendation is that an increase in the size or frequency of block trades or improved ability for dealers to manage inventory risk associated with block trades will improve fixed income market quality. In addition to the informational advantages that might accrue to dealers participating in block trades discussed above, the ability of those dealers to reduce their inventory risk exposures more quickly or more easily where they take on large positions may effectively represent a risk transfer between those dealers and the ultimate holders of the securities. The aggregate efficiency of the transfer depends, in part, if the resultant prices reflect the risk transfer and on whether the dealer or the ultimate customer represents the most efficient holder of the risk.

      Authorized participants (APs) are important to the creation and redemption process for exchange-traded funds (ETFs). These market participants have the exclusive right to change the supply of ETF shares on the market. When they identify a shortage of ETF shares in the market, they create more shares by buying the underlying corporate bonds. Conversely, when there's an excess supply of ETF shares on the market, they reduce the number of ETF shares by selling the underlying corporate bonds. Price transparency helps ensure that APs and other market makers engaged in deposit and redemption transactions continue to participate in the markets. As their trades facilitate liquidity transfer, they tend to stabilize prices. This creation and redemption mechanism keeps the share price of an ETF aligned with its underlying NAV.

      The impact of delayed reporting may well have an amplified effect on securities deriving their value from corporate bonds. The impact could lead to less efficient pricing of index-based products, such as ETFs, and derivatives, such as total return and credit default swaps. If the pilot makes it more difficult to mark-to-market the relevant securities, market participants, who do not trade blocks benefitting from delayed reporting dissemination, may be more likely to use stale prices for operational and accounting purposes. For example, ETFs and mutual funds may incorrectly estimate net asset value with greater probability. In addition, market makers that do not trade these blocks may not be able to confidently assess the price at which the basket of bonds and bonds should trade. Consequently, market makers may provide less attractively priced quotes or be less willing to take on inventory. Such an outcome could suppress innovation, such as electronification of the corporate bond market.

      There is a potential for spillover effects in demand and liquidity for bonds that trade less frequently, because these instruments are typically priced using matrix pricing or other relative valuation methods. In this view, decreasing certainty about the primary instrument could lead to greater market uncertainty about securities whose value is assigned on a relative basis, whether or not those bonds are likely to trade in block size.

      Test Group 2: Increased Dissemination Caps with No Dissemination Delay

      Potential Benefits

      The incremental increase in size transparency is limited to observing the actual size on trades between $1 million and $5 million for non-IG and between $5 million and $10 million for IG corporate bonds. There is no change in price transparency in Test Group 2 relative to the baseline. If transaction costs are decreasing in trade size (as found by Edwards, Harris and Piwowar (2007)) and the differences in trade size within this group are economically important, then the increased transparency with respect to size may help some investors better interpret the price for trades. This would potentially improve price formation for these bonds and for ETFs and other derivatives that contain bonds that are frequently traded in the size between $1 and $5 million and between $1 and $10 million for non-IG and IG corporate bonds.

      Potential Costs

      If the optimal size trade for some institutional investors is between $1 and $5 million and $5 and $10 million for non-IG and IG corporate bonds, then a change in the dissemination caps could impose costs, such as price impact, on these institutional investors or on overall market efficiency.

      If these same investors choose to trade in a size above the new $5 and $10 million cap thresholds, then delayed reporting of large trades may encourage traders to trade blocks with qualifying size rather than the typical smaller blocks or blocks broken into smaller pieces. This could decrease price and size transparency, which may distort incentives to trade slowly and responsibly.

      Test Group 3: 48-Hour Dissemination Delay and Increased Dissemination Caps

      Potential Benefits and Costs

      Test Group 3 has the same potential benefits that are described above for Test Group 1 and 2. These benefits are not outlined again for the purpose of brevity.

      However, the increase in dissemination caps limits the costs and benefits to Test Group 1 to only those trades executed at sizes above the increased trade dissemination caps of Test Group 2. This is anticipated to mitigate the informational advantage accruing to dealers and institutional investors who trade blocks created by the 48-hour dissemination delay that is evaluated in Test Group 1.

      Alternatives Considered

      As discussed above, FINRA considered but is not proposing to design the pilot without a control group, as the FIMSAC recommended.

      Also discussed above, FINRA considered alternate specification of Test Group 1 to limit its application to only those trades with reported size at or above the new dissemination cap recommended by the FIMSAC.

      In addition, consistent with another part of the FIMSAC proposal, FINRA considered disseminating the actual trade size of capped transactions three months instead of six months after the end of the calendar quarter in which they are reported. The rationale for not proposing this modification is: (1) its impact on block size trades in corporate bonds would be difficult to evaluate given the pilot's proposed duration is one year, and (2) it would add additional complexity to the pilot.

      Finally, FINRA considered a number of alternatives in the specification of the pilot, including the set of bonds eligible for the pilot, the characteristics necessary for control in the stratified assignment to test groups and the appropriate length of time for the pilot. FINRA requests comments on these topics.

      Request for Comment

      FINRA requests comment on all aspects of the proposal. FINRA requests that commenters provide empirical data or other factual support for their comments wherever possible. FINRA specifically requests comment concerning the following questions:

      Comments on the Need for the Pilot

      1. Is there a need for this pilot? What evidence can you provide to support this conclusion?
      2. Is the objective of the pilot clearly defined?

      Comments on the Potential Impact of the Pilot

      1. What potential impacts of the pilot does this proposal fail to consider or inadequately describe?
      2. Are there particular risks, economic or otherwise, inherent in a pilot that reduces transparency that already exists in the marketplace?
      3. One suggested need for the pilot is that block size transactions have become substantially more difficult to execute and may result in breaking the block into smaller transactions. To the extent blocks have in fact become more difficult to trade, is this a valid concern? Do potential delays in block size trades and related strategies to execute those block trades, such as more smaller-size trades, lead to a more accurate and appropriate risk transfer? Would delays in dissemination improperly mask the risk of block-size trades to the individual firm and instead shift such risk to other market participants or the overall market?
      4. FINRA cannot directly measure the impact on "lost opportunities," particularly to asset managers. How would this negatively impact the success of the pilot? What other measure or data sets should FINRA consider in order to measure "lost opportunities" to trade?
      5. Are there ways market participants can alter their behavior during the course of the pilot to affect its outcome? What are other similar negative impacts or concerns that could occur as a result of the pilot? What changes can FINRA make to the pilot design to limit or mitigate the impact of such "gaming"?

      Comments on Pilot Design

      1. Is the pilot adequately designed with respect to its objective?
      2. Are Test Groups 1, 2 and 3 and the control group clearly defined?
      3. What should the test groups be?
      4. Is it appropriate to have a market-wide pilot or should it be limited to a small number of CUSIPs?
      5. Should other types of securities, aside from corporate bonds, be included in the pilot?
      6. Should the corporate bond CUSIPs in Test Groups 1, 2 and 3 switch with those in the control group with respect to the three treatments, which are the dissemination delay, dissemination cap, dissemination cap and delay?
      7. Should all of the CUSIPs in each test group be published or should some or all not be made known?
      8. Should the pilot include a control group?
      9. Should the test groups be designed such that the impact is limited to the thresholds identified in the FIMSAC Recommendation? Is it appropriate to expand the test in the way proposed in the pilot design here?
      10. Does the pilot propose to use the most appropriate outcome measures? If not, which ones are preferable and why?
      11. Is the proposed methodology of examining pilot data appropriate?
      12. Are the dimensions on which the corporate bonds are sorted (size of issue, age of issue, rating and 144A versus non-144A categories) appropriate? If not, which additional dimensions should be included (e.g. inclusion status with respect to an index or ETF, maturity, standardized versus complex, degree of substitutability for other CUSIPs, mean frequency of trading in prior year, etc.)?
      13. Are there other methods that could be used to determine the control and test groups? For example, should the corporate bonds be assigned to the control group and test groups by a more random approach—such as based on the last digit of the CUSIP for each bond, instead of assigning bonds to groups based on the stratification characteristics like those discussed above (size of issue, age of issue, rating and 144A status)?
      14. How should FINRA seek to measure the impact of the pilot on assets that derive their value from corporate bonds, such as ETFs and mutual funds?
      15. Should the pilot's duration be increased to two years to better incorporate trading in illiquid corporate bonds?
      16. Is there a risk that traders can easily substitute CUSIPs in a test group for ones in the control group? If so, to what extent might this happen and on which dimensions (e.g. CUSIP from the same issuer, CUSIP from a different issuer having the same maturity and age)?
      17. Are there additional research questions that should be addressed?
      18. Are there other changes to the pilot that should be considered to better study the impact of dissemination (i.e., transparency) on the corporate bond market?
      19. Should the dissemination delay or caps only apply to trades on which a broker-dealer makes a capital commitment?
      20. Will market participants and other users of the TRACE data need to make any system changes as a result of the pilot? For example, will pricing, compliance or other systems, including systems used to determine or supervise prevailing market price for fair pricing and calculating mark-ups for retail and other customers, need to be updated to reflect delayed dissemination of certain trades? If so, how long will those changes take to implement and what would be the estimated costs associated with such changes?
      21. Should new issues be randomized to test groups or the control group while controlling for the issuer?

      Comments on the Economic Impact Assessment

      1. Does the economic baseline accurately describe current trading of TRACE-reportable corporate bonds?
      2. What will be the overall impact of the pilot on liquidity, trade size, competition among dealers or competition among issuers?
      3. With respect to the 48-hour dissemination delay (i.e., Test Group 1), have its benefits or costs be adequately described?
      a. Will the 48-hour dissemination delay improve liquidity for those trade sizes affected? If so, would transaction costs decline, or trade sizes or dealer inventory increase? Would buy-side firms need to contact fewer dealers for quotes?
      b. Would traders that do not typically trade the sizes affected by the dissemination delay be negatively affected by the informational asymmetry? If so, how?
      c. Would delayed reporting have an amplified effect on securities deriving their value from corporate bonds leading to ineffective pricing of index-based products, such as ETFs, and derivatives, such as total return and credit default swaps?
      d. Would the reduced price transparency caused by the 48-hour dissemination delay have particular impacts on retail investors, for example, by reducing the market information used to determine prevailing market price for fair pricing and to calculate mark-ups?
      4. With respect to the increased dissemination caps (i.e., Test Group 2), have its benefits or costs been adequately described?
      a. Would the increase in the reporting cap size mitigate the informational advantage accruing to dealers and institutional investors who trade blocks created by the 48-hour dissemination delay? If so, would smaller dealers step in and begin providing quotes for trades having benefited from the increased reporting cap?
      b. If trade sizes do increase in response to the increase in the reporting cap size, are traders more likely to trade blocks with qualifying size rather than the typical smaller blocks or blocks broken into smaller pieces?
      5. With respect to the increase of the reporting cap size and the 48-hour dissemination delay (i.e., Test Group 3), have its benefits and costs relative to Test Group 1 or 2 been adequately described?
      6. The comparison of Test Group 3 and Test Group 1 is confounded by the increase in the threshold for the dissemination delay. Should FINRA consider the alternative construction for Test Group 1 discussed above, where Test Group 1 would maintain the current size dissemination cap while implementing a delay threshold consistent with the threshold in Test Group 3? Would such an alternative construction for Test Group 1 provide a cleaner test of the impact of the dissemination delay? Would such an alternative construction for Test Group 1 create complications that affect the implementation of the pilot?
      7. What impact would the dissemination delay or cap have on broker-dealer routing to or trades occurring on alternative trading systems or on electronic trading innovations? Are these impacts different from those experienced by those transacting OTC?
      8. Will the dissemination delay or cap create opportunities for market manipulation, and if so, what specific behaviors should either be measured or guarded against?
      9. The current assignment of CUSIPs to Test and control groups does not control for the issuer's identity. If CUSIPs are not normally distributed by issuer across control and a particular Test Group or across Test Groups, will there be difficulty interpreting the empirical results? If so, how?
      10. Would assignment of an issuer to a particular Test Group change competition between issuers? If so, how?
      11. What will the impact on competition be between issuers when some issuers' bonds are in the Test Groups versus the control group?
      12. Will the dissemination delay or cap have an impact on competition among dealers? Are dealers who trade larger blocks sizes likely to benefit at the expense of dealers who do not make such trades? If so, how will the dealer network be affected?
      13. Will the dissemination delay discourage institutional investors who do not trade larger block sizes from trading with those dealers who do trade larger block sizes? Alternatively, will the dissemination delay encourage institutional investors who do trade larger block sizes to selectively trade with those dealers who do not trade larger block sizes?

      Comments on Alternatives to Consider

      1. Should FINRA consider other potential designs, for example, as described in the Harris Letter? If so, what designs should be considered and how do they improve over the design described here?
      2. Should FINRA consider an alternate reporting design for the dissemination delay test group whereby brokers could report capped trades up to 48 hours after transaction and FINRA would disseminate the trade report when received? Under what conditions would brokers report capped trades earlier than the maximum delay permitted under the pilot? What are the costs and benefits associated with this approach?
      3. Should FINRA consider an alternate design that would study, in place of delayed dissemination, suppression of the buy/sell indicator for block-size trades in corporate bonds? As noted above, FINRA currently disseminates this indicator, among other information, for corporate bond trades. However, for trades in Asset-Backed Securities (ABS), FINRA suppresses the buy/sell indicator (and information about contra party type) to balance concerns about transparency and liquidity in the ABS market, which is generally smaller and more institutional than the corporate bond market. What are the costs and benefits associated with an alternative approach that would study ABS-like dissemination protocols for block-size trades in corporate bonds?
      4. Can the goals of the pilot be achieved through other means, such as study of currently available data or supplemented with other specific data requests?
      5. As discussed above, certain baseline data suggests that block-size trades in IG bonds have not become more difficult to execute. Does the current data support an alternative approach that would limit the study of delayed dissemination to non-IG bonds? What are the costs and benefits associated with such an alternative approach?

      1. Persons submitting comments are cautioned that FINRA does not redact or edit personal identifying information, such as names or email addresses, from comment submissions. Persons should submit only information that they wish to make publicly available. See Notice to Members 03-73 (November 2003) (NASD Announces Online Availability of Comments) for more information.

      2. See Section 19 of the Securities Exchange Act of 1934 (SEA) and rules thereunder. After a proposed rule change is filed with the SEC, the proposed rule change generally is published for public comment in the Federal Register. Certain limited types of proposed rule changes, however, take effect upon filing with the SEC. See SEA Section 19(b)(3) and SEA Rule 19b-4.

      3. See Securities Exchange Act Release No. 43873 (January 23, 2001), 66 FR 8131 (January 29, 2001) (Order Approving File No. SR-NASD-99-65) (citing a speech by SEC Chairman Levitt, September 9, 1998, at Media Studies Center, New York, NY).

      4. See NASD Press Release: NASD Launches TRACE Bond Trade Data System (July 1, 2002).

      5. See Notice to Members 01-18 (March 2001).

      6. See Notice to Members 03-12 (February 2003).

      7. See Notice to Members 06-01 (January 2006) (describing the categories of non-IG trades that were subject to delayed dissemination, specifically, newly issued securities rated BBB or lower, and non-IG transactions greater than $1 million).

      8. See id.

      9. See Regulatory Notice 13-35 (October 2013).

      10. See FINRA Office of the Chief Economist Research Note: Analysis of Corporate Bond Liquidity (2015).

      11. See FINRA catalogue of TRACE Independent Academic Studies, available at www.finra.org/industry/trace/trace-independent-academic-studies.

      12. See Securities Exchange Act Release No. 81958 (October 26, 2017), 82 FR 50460 (October 31, 2017) (Notice of Federal Advisory Committee Establishment for the Fixed Income Market Structure Advisory Committee).

      13. See SEC Press Release 2017-209, SEC Announces the Formation and First Members of Fixed Income Market Structure Advisory Committee (November 9, 2017), available at www.sec.gov/news/press-release/2017-209; see also Opening Remarks of Chairman Jay Clayton at the Inaugural Meeting of the Fixed Income Market Structure Advisory Committee (January 11, 2018), available at www.sec.gov/news/public-statement/opening-remarks-inaugural-meeting-fixed-income-market-structure-advisory (emphasizing the "long term interests of retail investors").

      14. See Transcript of FIMSAC Meeting (January 11, 2018), available at www.sec.gov/spotlight/fixed-income-advisory-committee/fimsa-011118-transcript.txt.

      15. See Recommendation for a Pilot Program to Study the Market Implications of Changing the Reporting Regime for Block-Size Trades in Corporate Bonds (April 9, 2018), available at www.sec.gov/spotlight/fixed-income-advisory-committee/fimsac-block-trade-recommendation.pdf ("FIMSAC Recommendation").

      16. Rule 6710 generally defines a "TRACE-Eligible Security" as: (1) a debt security that is U.S. dollar-denominated and issued by a U.S. or foreign private issuer (and, if a "restricted security" as defined in Securities Act Rule 144(a)(3), sold pursuant to Securities Act Rule 144A); or (2) a debt security that is U.S. dollar-denominated and issued or guaranteed by an "Agency" as defined in Rule 6710(k) or a "Government-Sponsored Enterprise" as defined in Rule 6710(n).

      17. Rule 6730 (Transaction Reporting) describes members' TRACE reporting obligations.

      18. See Rule 6750 (Dissemination of Transaction Information).

      19. See, e.g., Securities Exchange Act Release No. 71607 (February 24, 2014), 79 FR 11481 (February 28, 2014 (Order Approving File No. SR-FINRA-2013-046) at 11483 n. 30 (describing the IG and non-IG dissemination caps). FINRA notes that bonds without ratings are generally treated as non-IG for current TRACE dissemination purposes. See Rule 6710(i) (stating that "if a TRACE-Eligible Security is unrated, FINRA may classify the TRACE-Eligible Security as a Non-Investment Grade security").

      20. See Regulatory Notice 17-23 (July 2017).

      21. See Transcript of FIMSAC Meeting (April 9, 2018), available at www.sec.gov/spotlight/fixed-income-advisory-committee/fimsa-040918transcript.txt ("April 9th FIMSAC Transcript").

      22. The FIMSAC Transparency Subcommittee's preliminary recommendation proposed to increase the dissemination cap for non-IG corporate bonds from $1 million to $3 million; during discussion at the FIMSAC meeting, the recommended new dissemination cap for non-IG corporate bonds was increased from $3 million to $5 million.

      23. This document refers generally to a 48-hour dissemination delay for shorthand. However, as the FIMSAC Recommendation noted, the dissemination delay is at least 48 hours, because trades reported after normal TRACE hours will be disseminated more than 48 hours after execution time. In addition, FINRA believes the FIMSAC Recommendation intended that the 48-hour delay would not include any hours from days on which TRACE was not open, such as weekends and holidays.

      24. See April 9th FIMSAC Transcript at pg. 13–14 (opening remarks of Brett Redfearn, Director, Division of Trading and Markets).

      25. See id. at pg. 25.

      26. See id. at pg. 38–41.

      27. See id. at pg. 43–46.

      28. See id. at pg. 32–35.

      29. See id. at pg. 50–55.

      30. See id. at pg. 76–78.

      31. See id. at pg. 64.

      32. See Letter from Kenneth E. Bentsen, Jr., President & CEO, Securities Industry and Financial Markets Association, to Chairman Jay Clayton, SEC, and Robert Cook, President & CEO, FINRA (July 6, 2018) ("SIFMA Letter"); Letter from Matt Berger, Global Head of Fixed Income and Commodities, Jane Street Capital, LLC, to Brent J. Fields, Federal Advisory Committee Management Officer and Secretary, SEC (May 16, 2018) ("Jane Street Letter"); Letter from Wouter Buitenhuis, Flow Traders U.S. LLC, to Federal Advisory Committee Management Officer and Secretary, SEC (July 5, 2018) ("Flow Traders Letter"); Letter from Gregory Davis, Chief Investment Officer, Vanguard, to Brent Fields, Secretary, SEC (January 2, 2019) ("Vanguard Letter"); Letter from Larry Harris, Fred V. Keenan Chair in Finance, USC Marshall School of Business, Kumar Venkataraman, James M. Collins Chair in Finance, Southern Methodist University, and Elisse Walter, Former Chairman, SEC, to Brent J. Fields, Federal Advisory Committee Management Officer and Secretary, SEC (August 21, 2018) ("Harris Letter"); Letter from Michael O'Brien, Head of Global Income Trading, Eaton Vance Management, to Brent J. Fields, Federal Advisory Committee Management Officer and Secretary, SEC, and Robert Cook, President & CEO, FINRA (September 24, 2018) ("Eaton Vance Letter"); Letter from Sandra E O'Connor, Chief Regulatory Affairs Officer, JPMorgan Chase & Co., to SEC and FINRA (June 29, 2018) ("JPMorgan Chase Letter"); Letter from Cathy Scott, Director, Fixed Income Forum on behalf of The Credit Roundtable, to Brent Fields, Secretary, SEC, and SEC Complaint Center (November 27, 2018) ("Credit Roundtable Letter"); and Letter from Jed Stevenson, Senior Managing Director, Wellington Management Company LLP, to Brent J. Fields, Federal Advisory Committee Management Officer and Secretary, SEC, and Robert Cook, President & CEO, FINRA (February 4, 2019) ("Wellington Management Letter"). These comments were submitted to the FIMSAC comment file (File No. 265-30), available at www.sec.gov/comments/265-30/265-30.htm.

      33. See SIFMA Letter at 2.

      34. See JPMorgan Chase Letter at 3. Wellington Management offered a similar observation, stating that "[o]ur experience in trading both investment grade and high yield bonds suggests that the immediate [TRACE] dissemination could result in broker-dealers preferring smaller trade sizes." See Wellington Management Letter at 1.

      35. See Eaton Vance Letter at 2.

      36. See Harris Letter at 2–3.

      37. See Harris Letter at 5.

      38. See JPMorgan Chase Letter at 3.

      39. See SIFMA Letter at 2.

      40. See Eaton Vance Letter at 2. Similarly, Wellington Management stated its expectation that the pilot "will allow for improved market liquidity, as broker-dealers will have 48 hours to find purchasers who are willing to purchase the subject securities at prices that are not artificially reduced by the expectation of an eager seller." See Wellington Management Letter at 2.

      41. See Harris Letter at 4.

      42. See id. at 2.

      43. See Harris Letter at 3.

      44. See The Credit Roundtable Letter at 2. Although The Credit Roundtable opposed the 48-hour dissemination delay proposed in the FIMSAC Recommendation, it supported the Recommendation's proposal to increase the IG dissemination cap from $5 million to $10 million and the non-IG dissemination cap from $1 million to $5 million. See The Credit Roundtable Letter at 1.

      45. See Vanguard Letter at 2.

      46. See id.

      47. See Jane Street Letter at 2–3.

      48. Jane Street further stated that the information asymmetry that would be created by the FIMSAC Recommendation would make market participants less willing to provide liquidity on "all-to-all" trading platforms, stifling the growth of such trading platforms. See Jane Street Letter at 2.

      49. See Flow Traders Letter at 3–4.

      50. See Vanguard Letter at 2.

      51. See JPMorgan Chase Letter at 4–6.

      52. See Harris Letter at 4.

      53. See Vanguard Letter at 3.

      54. See Securities Exchange Act Release No. 84875 (December 19, 2018), 84 FR 5202, 5215 (February 20, 2019) (Transaction Fee Pilot Adopting Release).

      55. The manner in which bonds are stratified by 144A type in this proposed pilot is consistent with the peer reviewed academic literature (Bessembinder, Jacobsen, Maxwell and Venkataraman 2018).

      56. See April 9th FIMSAC Transcript at pg. 30–31 (expressing concern about picking "winners and losers, both in terms of issuers, in terms bonds owned by asset managers, bonds owned by individuals and bonds owned on dealer balance sheets").

      57. FINRA notes that the comparison between Test Group 1 and 3 involves two changes because the delayed dissemination in Test Group 3 would occur at a higher trade size threshold and Test Group 3 includes an increase in the dissemination cap. An alternative construction considered for Test Group 1 is discussed below.

      58. Liquidity is the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset's price.

      59. See Transaction Fee Pilot Adopting Release, 84 FR at 5244.

      60. See id. at 5259.

      61. See id. at 5266.

      62. Bessembinder, Maxwell and Venkataraman (2006), Edwards, Harris and Piwowar (2007) and Goldstein, Hotchkiss and Sirri (2007) found that TRACE reduced transaction costs for investors. The latter two papers also found the reduction in cost is greater for smaller size trades. Jacobsen and Venkataraman (2018) found reduced trading cost in 144A corporate bonds. On the other hand, Goldstein, Hotchkiss and Sirri (2007) found that the reduction in bid-ask spread was limited to certain type of bonds and less frequently traded bonds and very large trades showed no significant reduction in bid-ask spread.

      63. See Goldstein and Hotchkiss (2007) and Asquith, Covert and Pathak (2013).

      64. Goldstein, Hotchkiss and Sirri (2007) and Asquith, Covert and Pathak (2013) did not find that TRACE increased trading activity. Indeed, Asquith, Covert and Pathak (2013) found that TRACE reduced trading activity for high-yield (i.e., non-IG) bonds. Bessembinder and Maxwell (2008) offered a possible explanation of the reduced trading activity in the dealer market. The paper noted the dramatic increase in corporate bond trading volume on the electronic platform that followed the introduction of TRACE and that TRACE might have improved the viability of the electronic market. Bessembinder and Maxwell (2008) noted that while investors had benefited from the increased transparency through reduced trading cost, bond dealers had experienced reductions in employment and compensation. Market participants found it more difficult to trade large size orders as dealers were reluctant to carry inventory.

      65. Bessembinder, Maxwell and Venkataraman (2006) found the concentration ratio of trades completed by the largest 12 dealers decreased. Jacobsen and Venkataraman (2018) found small dealers gained market share and closed the trading cost advantage enjoyed by large dealers. Similar effects also have been observed in other markets. For example, Schultz and Song (2017) found trading costs fell for institutional investors and less active dealers received better prices in their trades with more active dealers in the To Be Announced mortgage-backed securities market.

      66. Cici, Gibson and Merrick (2011) found that TRACE contributed to the general decline in the valuation dispersion of bonds across mutual funds.

      67. For the purposes of the economic baseline, consistent with Rule 6710, IG includes bonds in the four highest generic rating categories (AAA, AA, A, BBB). Non-IG includes bonds rated in lower credit categories (BB, B, CCC, CC, C, C, NA/NR).

      68. The trend of block size trades are similar across issue sizes. Larger issue sizes attract more block trades. The graphs are available upon request.

    • 19-11 FINRA Announces Update of the Interpretations of Financial and Operational Rules

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      SEC Financial Responsibility Rules

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Finance
      Legal
      Operations
      Regulatory Reporting
      Senior Management
      Key Topics

      Backstop Agreements
      Net Capital
      Open Contractual Commitments
      Referenced Rules & Notices

      Regulatory Notice 08-56
      Regulatory Notice 13-44
      Regulatory Notice 14-06
      Regulatory Notice 14-12
      Regulatory Notice 14-25
      Regulatory Notice 14-38
      Regulatory Notice 15-25
      Regulatory Notice 18-03
      Regulatory Notice 18-42
      SEA Rule 15c3-1

      Summary

      FINRA is making available an update to the Interpretations of Financial and Operational Rules that the staff of the SEC's Division of Trading and Markets (SEC staff) has communicated to FINRA staff. The update relates to Securities Exchange Act (SEA) Rule 15c3-1(c)(2)(viii) (Open Contractual Commitments).

      Questions concerning this Notice should be directed to:

      •   Yui Chan, Senior Director, Risk Oversight and Operational Regulation (ROOR), at (646) 315-8426 or Yui.Chan@finra.org; or
      •   Ann Duguid, Senior Director, ROOR, at (646) 315-7260 or Ann.Duguid@finra.org.

      Background & Discussion

      FINRA is updating the Interpretations of Financial and Operational Rules to add the following new interpretation:

      •   SEA Rule 15c3-1(c)(2)(viii)(C)/06 (Underwriting Backstop Agreement). This interpretation relates to the conditions under which an underwriting backstop agreement in a firm commitment underwriting would not give rise to an open contractual commitment charge.

      This interpretation update is available in portable digital format (PDF) on FINRA's Interpretations of Financial and Operational Rules [http://www.finra.org/industry/interpretationsfor] page.

      Further, SEC staff continues to communicate and issue written and oral interpretations of the financial responsibility and reporting rules. FINRA has previously updated the Interpretations of Financial and Operational Rules on its website in Regulatory Notices 08-56, 13-44, 14-06, 14-12, 14-25, 14-38, 15-25, 18-03 and 18-42.

      FINRA member firms and others that maintain a hardcopy version of the Interpretations of Financial and Operational Rules may replace the existing page in their hardcopy version by printing the accompanying updated page. The filing instruction for the new page is as follows:

      SEA Rule Remove Old Page Add New Page
      15c3-1 654 654

    • 19-10 FINRA Provides Guidance on Customer Communications Related to Departing Registered Representatives

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      Customer Communications

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Registered Representatives
      Senior Management
      Key Topics

      Customer Accounts
      Customer Communications
      Registered Representative Departures
      Referenced Rules & Notices

      FINRA Rule 2210

      Executive Summary

      This Notice addresses the responsibilities of member firms when communicating with customers about departing registered representatives.

      Questions regarding this Notice should be directed to:

      •   Philip Shaikun, Vice President and Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8451 or Philip.Shaikun@finra.org; and
      •   Jeanette Wingler, Associate General Counsel, OGC, at (202) 728-8013 or jeanette.wingler@finra.org.

      Background and Discussion

      FINRA has consistently sought to ensure that customers can make a timely and informed choice about where to maintain their assets when their registered representative (i.e., a person registered with the member who has direct contact with customers in the conduct of the member's securities sales) leaves a member firm. Accordingly, FINRA expects that:

      1. in the event of a registered representative's departure, the member firm should promptly and clearly communicate to affected customers how their accounts will continue to be serviced; and
      2. the firm should provide customers with timely and complete answers, if known, when the customer asks questions about a departing registered representative.

      Registered Representative Departures

      Registered representatives move with some frequency between member firms and across financial firms under various regulatory jurisdictions, such as investment advisory firms and insurance companies. In addition, registered representatives may leave the financial industry entirely. A registered representative's departure may prompt customer questions about the departing representative and the status of their accounts following the departure.

      FINRA recognizes that member firms' different business models give rise to different approaches to managing the customer relationship, and that the expectations regarding a member firm's handling of a departing registered representative will vary accordingly. For instance, the departure of a registered representative who works closely with customers in a one-on-one relationship will likely be handled differently than the departure of a registered representative in a customer advisory center model or a group service model. While member firms have flexibility in reassigning customer accounts and communicating with customers about the reassignments, they should provide timely and complete answers, if known, to all customer questions resulting from a departing representative, so that customers may make informed decisions about their accounts.

      Communications with Customers

      Customers should not experience an interruption in service as a result of a registered representative's departure. FINRA understands that decisions about the reassignment of customer accounts, if applicable, are typically made promptly following the departure of a registered representative. In the event of a registered representative's departure, FINRA expects that the member firm will have policies and procedures reasonably designed to assure that the customers serviced by that registered representative are aware of how the customers' account will be serviced at the member firm, including how and to whom the customer may direct questions and trade instructions following the representative's departure and, if and when assigned, the representative to whom the customer is now assigned at the member firm.

      In addition, a member firm should communicate clearly, and without obfuscation, when asked questions by customers about the departing registered representative. Consistent with privacy and other legal requirements, these communications may include, when asked by a customer:

      1. clarifying that the customer has the choice to retain his or her assets at the current firm and be serviced by the newly assigned registered representative or a different registered representative or transfer the assets to another firm; and
      2. provided that the registered representative has consented to disclosure of his or her contact information to customers, providing reasonable contact information, such as phone number, email address or mailing address, of the departing representative.

      FINRA would not expect a member firm to seek to obtain the departing registered representative's contact information if not known by those responsible for reassigning and continuing to service the account (e.g., the branch supervisor responsible for reassigning the customer account or newly assigned registered representative) at the time of a customer's question. As with all communications with customers, information provided by the member firm about the departing registered representative must be fair, balanced and not misleading.

    • 19-09 FINRA Reminds Firms of Their Obligations Under SEC Rule 15c2-11(a)(4)

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      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Registered Representatives
      Systems Trading Training
      Key Topics

      Foreign Private Issuers
      Form 211
      OTC Equity Securities
      Quoting
      Trading
      Referenced Rules & Notices

      FINRA Rule 6432
      Securities Exchange Act Rule 12g3-2(b)
      Securities Exchange Act Rule 15c2-11

      OTC Quotations in Foreign Private Issues

      Summary

      In consultation with the staff of the Securities and Exchange Commission (SEC staff), FINRA is issuing this Notice to remind firms of their obligations under Securities Exchange Act (SEA) Rule 15c2-11 and FINRA Rule 6432 (Compliance with the Information Requirements of Rule 15c2-11) regarding quotations in the securities of foreign private issuers that rely on SEA Rule 12g3-2(b). Specifically, we are reminding firms that Rule 15c2-11(a)(4) requires that they make paragraph (a)(4) information reasonably available upon request to any person expressing an interest in a transaction involving the security, such as by providing the requesting person with appropriate instructions regarding how to obtain the information electronically. Firms cannot comply with this requirement by directing customers to an issuer's website if, by its terms, the website restricts access by U.S. persons to the paragraph (a)(4) information.

      Questions regarding this Notice should be directed to:

      •   Yvonne Huber, Vice President, Market Regulation (MR), at (240) 386-5034 or yvonne.huber@finra.org;
      •   Sewall Lee, Director, MR, at (240) 386-6054 or sewall.lee@finra.org; or
      •   for legal and interpretive questions, Racquel Russell, Associate General Counsel, Office of General Counsel, at (202) 728-8363 or racquel.russell@finra.org.

      Background and Discussion

      Rule 15c2-111 generally prohibits a broker-dealer from publishing (or submitting for publication) a quotation2 in an unlisted security on a quotation medium3 unless it has obtained and reviewed current information about the issuer. The specific information required under Rule 15c2-11 differs depending upon the circumstances surrounding the issuer and security to be quoted. A broker-dealer must have a reasonable basis for believing that the information, when considered along with any supplemental information, is accurate and from a reliable source.

      With respect to quotations in the security of a foreign private issuer, paragraph (a)(4) of Rule 15c2-11 requires a broker-dealer to review and make reasonably available upon request the information the issuer published pursuant to Rule 12g3-2(b) since the beginning of its last fiscal year.4 The broker-dealer can make paragraph (a)(4) information available by providing instructions to investors on how to obtain the information electronically, such as from the issuer's website.5 However, some foreign private issuers may prohibit persons not domiciled in their jurisdiction from accessing paragraph (a)(4) information. For example, the issuer's website may require the investor to confirm or attest they are a resident of, or domiciled in, the non-U.S. jurisdiction prior to being permitted to access the page that contains the paragraph (a)(4) information. SEC staff has advised that paragraph (a)(4) information on such a website would not be considered "reasonably available" to U.S. persons and, therefore, may not be used by a broker-dealer to fulfill its obligations under Rule 15c2-11(a)(4). Similarly, firms cannot rely on a website that restricts access by U.S. persons to the paragraph (a)(4) information to comply with FINRA Rule 6432.6


      1. 17 CFR 240.15c2-11(a).

      2. Rule 15c2-11(e)(3) provides that, except as otherwise specified in Rule 15c2-11, the term "quotation" means "any bid or offer at a specified price with respect to a security, or any indication of interest by a broker or dealer in receiving bids or offers from others for a security, or any indication by a broker or dealer that he wishes to advertise his general interest in buying or selling a particular security." See 17 CFR 240.15c2-11(e)(3).

      3. Rule 15c2-11(e)(1) provides that the term "quotation medium" means any "'interdealer quotation system' or any publication or electronic communications network or other device which is used by brokers or dealers to make known to others their interest in transactions in any security, including offers to buy or sell at a stated price or otherwise, or invitations of offers to buy or sell." See 17 CFR 240.15c2-11(e)(1). Rule 15c2-11(e)(2) provides that the term "interdealer quotation system" means "any system of general circulation to brokers or dealers which regularly disseminates quotations of identified brokers or dealers." 17 CFR 240.15c2-11(e)(2).

      4. See 17 CFR 240.15c2-11(a)(4); see also 17 CFR 240.12g3-2.

      5. See Securities Exchange Act Release No. 58465 (Exemption From Registration Under Section 12(G) of the Securities Exchange Act of 1934 for Foreign Private Issuers).

      6. To demonstrate compliance with Rule 15c2-11, FINRA Rule 6432 requires, among other things, that firms submit a Form 211 to FINRA prior to initiating or resuming a quotation in a nonexchange-listed security. In the case of a Form 211 for a foreign private issuer under Rule 15c2-11(a)(4), Form 211 requires that firms provide the: (i) foreign exchange(s) on which the subject class of securities is listed that, either singly or together with the trading of the same class of the issuer's securities in another foreign jurisdiction, constitutes the primary trading market for the securities; (ii) the symbol(s) of the security(ies) that trade on the foreign exchange(s); and (iii) the location of the internet website or electronic information delivery system that the firm would provide upon request to any person to direct them to the information that the issuer published electronically pursuant to Rule 12g3-2(b). FINRA is advising firms that, with respect to item (iii) above, a firm may not provide a website address on a Form 211 where U.S. persons are restricted from accessing the paragraph (a)(4) information.

    • 19-08 Guidance on FOCUS Reporting for Operating Leases

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      FOCUS Reporting

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Finance
      Legal
      Operations
      Registered Representatives
      Systems Trading Training
      Key Topics

      FOCUS Reporting
      Referenced Rules & Notices

      SEA Rule 15c3-1
      SEA Rule 17a-5
      Form X-17A-5

      Summary

      In October 2018, the staff of the SEC Division of Trading and Markets (the SEC staff) issued no-action relief1 (the no-action relief letter) regarding the treatment of operating leases under SEA Rule 15c3-1 (Rule 15c3-1) in connection with the Financial Accounting Standards Board's (FASB) Accounting Standards Update for Leases (the Lease Accounting Update).2 Based on discussions with the SEC staff, and in response to member inquiries, FINRA is issuing this Notice to provide guidance to members for reporting lease assets and lease liabilities on their FOCUS reports.3

      Members should apply the guidance in this Notice going forward when preparing their FOCUS reports. Members are not required to refile any FOCUS reports that they have already submitted to comply with this guidance.

      Questions concerning this Notice should be directed to:

      •  Yui Chan, Senior Director, Risk Oversight & Operational Regulation (ROOR), at (646) 315-8426 or Yui.Chan@finra.org;
      •  Ann Duguid, Senior Director, ROOR, at (646) 315-7260 or Ann.Duguid@finra.org; or
      •  Anthony Vinci, Director, ROOR, at (646)315-8335 or Anthony.Vinci@finra.org.

      Background & Discussion

      SEC Staff's No-Action Relief

      The FASB's Lease Accounting Update introduced changes to the treatment of operating leases by requiring that a lessee must include on its balance sheet an asset and liability arising from an operating lease.4 However, in the no-action relief letter, the SEC staff noted that under paragraph (c)(2)(iv) of Rule 15c3-1,5 the operating lease asset would be a non-allowable asset for purposes of determining net worth. As such, absent relief, a broker-dealer lessee would need to deduct the operating lease asset from its net worth when computing net capital. Further, the SEC staff noted that a broker-dealer lessee using the aggregate indebtedness standard under Rule 15c3-1 to determine its minimum net capital requirement would be required to include the operating lease liability in its aggregate indebtedness calculation.

      In the no-action relief letter, the SEC staff stated that it will not recommend enforcement action to the Commission under Rule 15c3-1 in the following circumstances:

      •  if a broker-dealer computing net capital adds back an operating lease asset to the extent of the associated operating lease liability. The SEC staff stated that a broker-dealer cannot add back an operating lease asset to offset an operating lease liability unless the asset and the liability arise from the same operating lease and the amount of the asset as to each lease may not exceed the liability arising from that lease;
      •  if a broker-dealer determining its minimum net capital requirement using the aggregate indebtedness standard does not include in its aggregate indebtedness an operating lease liability to the extent of the associated operating lease asset. The SEC staff stated that if the value of the operating lease liability exceeds the associated operating lease asset, the amount by which the lease liability exceeds the lease asset must be included in the broker-dealer's aggregate indebtedness.

      FOCUS Reporting Guidance

      To assist members in their FOCUS reporting obligations, and in response to member inquiries, FINRA is providing the following guidance to members for reporting lease assets and lease liabilities on their FOCUS reports based on discussions with the SEC staff.

      To Report the Operating Lease Asset on FOCUS Report Part II, Part IIA and Part II CSE

      •  Members should report the operating lease asset on the line "Property, furniture, equipment, leasehold improvements and rights under lease agreements" as follows:

      •  report the portion of the asset to be added back in Box 490 (under the "Allowable" column);

      •  report any non-allowable portion of the asset in Box 680 (under the "Non-Allowable" column).

      To Report the Operating Lease Liability…

      …On FOCUS Report Part II
      •  Members should report the operating lease liability on the line "Accounts payable and accrued liabilities and expenses – F. Other" as follows:

      •  report the portion that is not an aggregate indebtedness liability in Box 1380 (under the "Non-A.I. Liabilities" column);

      •  report the portion that is an aggregate indebtedness liability in Box 1200 (under the "A.I. Liabilities" column).
      …On FOCUS Report Part IIA
      •  Members should report the operating lease liability on the line "Accounts payable, accrued liabilities, expenses and other" as follows:
      •  report the portion that is not an aggregate indebtedness liability in Box 1385 (under the "Non-A.I. Liabilities" column);
      •  report the portion that is an aggregate indebtedness liability in Box 1205 (under the "A.I. Liabilities" column).
      …On FOCUS Report Part II CSE
      •  Members should report the operating lease liability on the line "Accounts payable and accrued liabilities and expenses – F. Other" in Box 1680.

      As noted above, members should apply the guidance in this Notice going forward when preparing their FOCUS reports. Members are not required to refile any FOCUS reports that they have already submitted to comply with this guidance.


      1. See letter from Michael A. Macchiaroli, Associate Director, Division of Trading and Markets, SEC, to Securities Industry and Financial Markets Association (SIFMA) (October 23, 2018), available on the SEC website [https://www.sec.gov/divisions/marketreg/mr-noaction/2018/sifma-treatment-of-operating-leases-15c3-1.pdf].

      2. See FASB ASU No. 2016-02, Leases (Topic 842) (February 2016), available on the [https://www.fasb.org/jsp/FASB/Document_C/DocumentPage?cid=1176167901010&acceptedDisclaimer=true] FASB website. For broker-dealers generally, the Lease Accounting Update is effective for fiscal years beginning after December 15, 2018.

      3. "FOCUS" stands for Financial and Operational Combined Uniform Single. Pursuant to SEA Rule 17a-5, members are required to file with FINRA, through the eFOCUS System, reports concerning their financial and operational status using SEC Form X-17A-5 (referred to as the FOCUS Report). Members must submit their FOCUS Reports electronically through the eFOCUS System via the FINRA Firm Gateway.

      4. The SEC staff noted that, under U. S. generally accepted accounting principles (GAAP) prior to the effectiveness of the Lease Accounting Update, a lessee was not required to record an asset or liability on its balance sheet with respect to an operating lease.

      5. Paragraph (c)(2)(iv) generally requires broker-dealers to deduct fixed assets and assets which cannot be readily converted into cash from their net worth for purposes of computing net capital.

    • 19-07 FINRA Revises Indexed Amounts for Monetary Sanctions in the Sanction Guidelines; Effective Immediately

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      Sanction Guidelines

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Legal
      Registered Representatives
      Senior Management
      Key Topics

      FINRA Sanction Guidelines
      Referenced Rules & Notices

      Regulatory Notice 15-15

      Summary

      FINRA has revised the Sanction Guidelines to reflect the effects of inflation, per a policy established in May 2015.

      The revised Sanction Guidelines are effective immediately and available on FINRA's website [HTML version].

      Questions concerning this Notice should be directed to Megan Rauch, Associate General Counsel, Office of General Counsel, at (202) 728-8863.

      Background & Discussion

      FINRA's Sanction Guidelines familiarize FINRA firms with some of the typical securities industry rule violations that occur and the range of disciplinary sanctions that may result from those rule violations. The goal of the Sanction Guidelines is to assist FINRA's adjudicators in determining the appropriate sanctions in disciplinary proceedings.

      In May 2015, the National Adjudicatory Council (NAC) announced a policy of indexing the high-end of the monetary sanctions for each sanction guideline in the Sanction Guidelines to the Consumer Price Index.1 In addition, the NAC established that FINRA would index the sanction guidelines every three years, rounding the fine amounts to the nearest $1,000. In this adjustment to the fine amounts, the high-end of the monetary sanctions increases by 5.86 percent, before rounding. The low-end of the monetary sanction ranges in the Sanction Guidelines remains the same.


      1. See Regulatory Notice 15-15 (The National Adjudicatory Council (NAC) Revises the Sanction Guidelines Related to Misrepresentations and Suitability).

    • 19-06 FINRA Requests Comment on the Effectiveness and Efficiency of Its Rule on Business Continuity Plans and Emergency Contact Information; Comment Period Expires: April 26, 2019

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      Retrospective Rule Review

      Regulatory Notice
      Notice Type

      Request for Comment
      Suggested Routing

      Compliance
      Legal
      Operations
      Senior Management
      Systems
      Key Topics

      Business Continuity Plans
      Cybersecurity
      Emergency Contact Information
      Referenced Rules & Notices

      FINRA Rule 4370
      NTM 04-37
      Regulatory Notice 09-59
      Regulatory Notice 09-60

      Summary

      FINRA is conducting a retrospective review of Rule 4370 (Business Continuity Plans and Emergency Contact Information), FINRA's emergency preparedness rule, to assess its effectiveness and efficiency. This Notice outlines the general retrospective rule review process and seeks responses to several questions related to firms' experiences with this specific rule.

      Questions regarding this Notice should be directed to:

      •   Jeanette Wingler, Associate General Counsel, Office of General Counsel (OGC), at (202) 728-8013 or Jeanette.Wingler@finra.org;
      •   Sarah Kwak, Assistant General Counsel, OGC, at (202) 728-8471 or Sarah.Kwak@finra.org;
      •   Lori Walsh, Deputy Chief Economist, Office of the Chief Economist (OCE), at (202) 728-8323 or Lori.Walsh@finra.org; or
      •   Meghan Burns, Associate Principal Analyst, OCE, at (202) 728-8062 or Meghan.Burns@finra.org.

      Action Requested

      FINRA encourages all interested parties to comment. Comments must be received by April 26, 2019.

      Comments must be submitted through one of the following methods:

      •   Emailing comments to pubcom@finra.org; or
      •   Mailing comments in hard copy to:

      Jennifer Piorko Mitchell
      Office of the Corporate Secretary
      FINRA
      1735 K Street, NW
      Washington, DC 20006-1506

      To help FINRA process comments more efficiently, persons should use only one method to comment.

      Important Notes: All comments received in response to this Notice will be made available to the public on the FINRA website. In general, FINRA will post comments as they are received.1

      Background & Discussion

      FINRA believes that it is appropriate, after a reasonable period of time, to look back at its significant rulemaking to determine whether a FINRA rule or rule set2 is meeting its intended investor-protection objectives by reasonably efficient means. FINRA further believes that a retrospective review should include a review not only of the substance and application of a rule or rule set, but also FINRA's processes to administer the rules. FINRA conducts retrospective rule reviews on an ongoing basis to ensure that its rules remain relevant and appropriately designed to achieve their objectives, particularly in light of environmental, industry and market changes.

      In conducting the review of Rule 4370, FINRA staff will follow a similar process to previous retrospective rule reviews. In general, the review process consists of an assessment and action phase. During the assessment phase, FINRA will evaluate the efficacy and efficiency of the rule or rule set as currently implemented, including FINRA's internal administrative processes. FINRA will seek input from affected parties and experts, including its advisory committees, subject-matter experts inside and outside of the organization, and other stakeholders, including industry members, investors, interested groups and the public. FINRA staff will assess issues including the existence of duplicative, inconsistent or ineffective regulatory obligations; whether market or other conditions have changed to suggest there are ways to improve the efficiency or effectiveness of a regulatory obligation without loss of investor protections; and potential gaps in the regulatory framework.

      Upon completion of this assessment, FINRA staff will consider appropriate next steps, which may include some or all of the following: modifications to the rule, updated or additional guidance, administrative changes or technology improvements, or additional research or information gathering.

      The action phase will then follow. To the extent action involves modification of rules, FINRA will separately engage in its usual rulemaking process to propose amendments to the rules based on the findings. This process will include input from FINRA's advisory committees and an opportunity for comment on specific proposed revisions in a Regulatory Notice or rule filing with the SEC, or both.

      Request for Comment

      Rule 4370 is the successor rule to NASD Rules 3510 (Business Continuity Plans) and 3520 (Emergency Contact Information).3 After the events of September 11, 2001, FINRA closely studied the securities markets and industry's recovery capability to assess whether any regulatory action would be needed to assure swift recovery in the event of any future significant business disruptions. As a result of that study, FINRA (then NASD) adopted in 2004 NASD Rules 3510 and 3520 to help ensure that member firms would be able to continue their business operations in the event of such disruptions. In 2009, FINRA adopted those rules, without substantive change, as Rule 4370 in the consolidated FINRA rulebook.4

      Rule 4370 requires a member firm to create, maintain, annually review and update upon any material change a written business continuity plan identifying procedures relating to an emergency or significant business disruption. While each member firm needs to conduct its own risk analysis to determine where critical impact points and exposures exist within the firm and with its counterparties and suppliers, significant business disruptions for purposes of business continuity planning may include, among other things, natural disasters, pandemics, terrorist attacks and cyber events.5 In addition, member firms that heavily leverage technology for their business systems and infrastructure may have an increased risk of significant business disruptions associated with cyber events and technology-related disruptions.

      Each member firm has flexibility to tailor the business continuity plan to the size and needs of its business, provided that the plan addresses the enumerated minimum elements to the extent applicable and necessary to the firm. The rule also requires each member firm to disclose (at a minimum, in writing at account opening, by posting on its website, and by mailing upon request) to its customers how the business continuity plan addresses the possibility of a future significant business disruption and how the member firm plans to respond to events of varying scope.

      In addition, Rule 4370 requires each member firm to provide (and promptly update upon any material change) to FINRA prescribed emergency contact information for the member firm. This requirement is intended to ensure that FINRA has a reliable means of contacting each member firm in the event of an emergency. The rule requires the member firm to designate two associated persons as emergency contact persons, at least one of whom is a member of senior management and a registered principal of that firm. If a member firm designates a second emergency contact person who is not a registered principal, the rule requires the person to be a member of senior management who has knowledge of the member firm's business. For a member firm with only one associated person (e.g., a sole proprietorship), the second emergency contact person may be an individual, either registered with another firm or nonregistered, who has knowledge of the member firm's business operations, such as the firm's attorney, accountant or clearing firm contact.

      FINRA seeks answers to the following questions with respect to these rules:

      1. Has the rule effectively addressed the problem(s) it was intended to mitigate? To what extent has the original purposes of and need for the rule been affected by subsequent changes to the risk environment, the markets, the delivery of financial services, the applicable regulatory framework or other considerations? Are there alternative ways to achieve the goals of the rule that FINRA should consider?
      2. What has been your experience with implementation of the rule, including any ambiguities in the rule or challenges to comply with it?
      3. What have been the economic impacts, including costs and benefits, of creating, maintaining or updating a business continuity plan? To what extent do the costs and benefits have a disproportionate impact on firms based on size and business model? Has the rule led to any negative unintended consequences?
      4. Can FINRA make the rule, guidance or attendant administrative processes more efficient and effective?
      5. Have you ever needed to activate your BCP and if so, was it effective? Please describe the circumstances that led to the activation of your BCP.
      6. How do you determine what may constitute a significant business disruption? To what extent do you address specific types of significant business disruptions in your BCP (e.g., cyber events, terrorist attacks, pandemics or natural disasters)?
      7. What other rules, if any, conflict with or get in the way of business continuity planning?
      8. To what degree does your business or BCP rely on vendors or other external providers? Would the rule be more effective if it addressed expectations around additional diligence into vendor resiliency?

      In addition to comments responsive to these questions, FINRA invites comment on any other aspects of the rule that commenters wish to address. FINRA further requests any data or evidence in support of comments. While the purpose of this Notice is to obtain input as to whether or not the current rule is effective and efficient, FINRA also welcomes specific suggestions as to how the rule should be changed. As discussed above, FINRA will separately consider during the action phase specific changes to the rules.


      1. Persons submitting comments are cautioned that FINRA does not redact or edit personal identifying information, such as names or email addresses, from comment submissions. Persons should submit only information that they wish to make publicly available. See Notice to Members 03-73 (November 2003) (Online Availability of Comments) for more information.

      2. A rule set is a group of rules identified by FINRA staff to contain a similar subject, characteristics or objectives.

      3. See Exchange Act Release No. 49537 (Apr. 7, 2004), 69 Fed. Reg. 19586 (Apr. 13, 2004) (SEC Notice of Order Approving File No. SR-NASD-2002-108). See also Notice to Members 04-37 (May 2004).

      4. See Exchange Act Release No. 60534 (Aug. 19, 2009), 74 FR 44410 (Aug. 28, 2009) (Order Granting Accelerated Approval of Proposed Rule Change, as Modified by Amendment No. 1; File No. SR-FINRA-2009-036) (approving the adoption, without material change, of NASD Rule 3510 (Business Continuity Plans) and NASD Rule 3520 (Emergency Contact Information) as FINRA Rule 4370). See also Regulatory Notice 09-60 (Oct. 2009).

      5. See, e.g., Regulatory Notice 09-59 (Oct. 2009) and FINRA's Small Firm Business Continuity Plan Template [http://www.finra.org/industry/small-firm-business-continuity-plan-template]. See also FINRA's Business Continuity Planning FAQ 16 [http://www.finra.org/industry/faq-business-continuity-planning-faq].

    • 19-05 FINRA Extends Effective Date of Margin Requirements for Covered Agency Transactions; New Effective Date: March 25, 2020

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      Covered Agency Transactions

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Margin Department
      Operations
      Regulatory Reporting
      Risk Management
      Senior Management
      Key Topics

      Covered Agency Transactions
      Margin
      Referenced Rules & Notices

      FINRA Rule 4210
      Regulatory Notice 16-31
      Regulatory Notice 17-28
      Regulatory Notice 18-18

      Summary

      In June 2016, the SEC approved1 FINRA's rule change (referred to as the "rule change") amending FINRA Rule 4210 to establish margin requirements for Covered Agency Transactions.2 FINRA is extending, to March 25, 2020, the effective date of the requirements pursuant to the rule change that otherwise would have become effective on March 25, 2019.3

      Questions regarding this Notice should be directed to:

      •    Kris Dailey, Vice President, Risk Oversight & Operational Regulation (ROOR), at (646) 315-8434 or Kris.Dailey@finra.org;
      •    Adam Rodriguez, Director, Credit Regulation, ROOR, at (646) 315-8572 or Adam.Rodriguez@finra.org; or
      •    Adam Arkel, Associate General Counsel, Office of General Counsel, at (202) 728-6961 or Adam.Arkel@finra.org.

      Background & Discussion

      In June 2016, the SEC approved4 FINRA's rule change amending FINRA Rule 4210 to establish margin requirements for Covered Agency Transactions. FINRA issued Regulatory Notice 16-31 in August 2016 to announce the SEC's approval of the rule change and the effective dates of the new requirements. FINRA announced that the risk limit determination requirements as set forth in paragraphs (e)(2)(F), (e)(2)(G) and (e)(2)(H) of Rule 4210, and Supplementary Material .05 of Rule 4210, each as respectively amended or established by the rule change (collectively referred to as the "risk limit determination requirements") would become effective on December 15, 2016.

      In May 2018, FINRA issued Regulatory Notice 18-18 to announce the extension of the implementation date for all other requirements pursuant to the rule change—broadly, the substantive margin requirements for Covered Agency Transactions—to March 25, 2019.5

      In extending the implementation date of the margin requirements for Covered Agency Transactions, FINRA noted that FINRA is considering whether any revisions to the requirements are appropriate. FINRA's consideration of potential revisions is ongoing.

      FINRA is issuing this Notice to announce that FINRA is extending by an additional year, until March 25, 2020, the effective date of the margin requirements that otherwise would have become effective on March 25, 2019. Members should note that the risk limit determination requirements became effective on December 15, 2016, and are not affected by this Notice.


      1. See Securities Exchange Act Release No. 78081 (June 15, 2016), 81 FR 40364 (June 21, 2016) (Notice of Filing of Amendment No. 3 and Order Granting Accelerated Approval to a Proposed Rule Change To Amend FINRA Rule 4210 (Margin Requirements) To Establish Margin Requirements for the TBA Market, as Modified by Amendment Nos. 1, 2, and 3; File No. SR-FINRA-2015-036); see also Regulatory Notice 16-31 (August 2016) (announcing the SEC's approval of the rule change).

      2. Covered Agency Transactions include (1) To Be Announced (TBA) transactions, inclusive of adjustable rate mortgage (ARM) transactions, (2) Specified Pool Transactions and (3) transactions in Collateralized Mortgage Obligations (CMOs), issued in conformity with a program of an agency or Government-Sponsored Enterprise (GSE), with forward settlement dates, as defined more fully in paragraph (e)(2)(H)(i)c. of FINRA Rule 4210.

      3. See Securities Exchange Act Release No. 85083 (February 8, 2019) (Notice of Filing and Immediate Effectiveness of a Proposed Rule Change To Extend the Implementation Date of Certain Amendments to FINRA Rule 4210 Approved Pursuant to SR-FINRA-2015-036; File No. SR-FINRA-2019-005) (extending, until March 25, 2020, the implementation date of the amendments to FINRA Rule 4210 pursuant to SR-FINRA-2015-036, other than the amendments pursuant to SR-FINRA-2015-036 that were implemented on December 15, 2016).

      4. See note 1.

      5. See Securities Exchange Act Release No. 83155 (May 2, 2018), 83 FR 20889 (May 8, 2018) (Notice of Filing and Immediate Effectiveness of a Proposed Rule Change To Extend the Implementation Date of Certain Amendments to Rule 4210 Approved Pursuant to SR-FINRA-2015-036; File No. SR-FINRA-2018-017). FINRA previously extended the implementation date of the amendments, other than the amendments relating to the risk limit determination requirements, in September 2017. See Regulatory Notice 17-28.

    • 19-04 FINRA's 529 Plan Share Class Initiative Encourages Firms to Self-Report Potential Violations

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      529 Plans

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Legal
      Registered Representatives
      Senior Management
      Key Topics

      529 Plans
      Share Classes
      Suitability
      Supervision
      Referenced Rules & Notices

      MSRB Rule G-19
      MSRB Rule G-27

      Summary

      Over the past several years, FINRA has found that some firms have failed to reasonably supervise brokers' recommendations of multi-share class products.1 FINRA has raised concerns specifically regarding firms' supervision of share-class recommendations to customers of 529 savings plans ("529 plans").2

      FINRA is launching a 529 Plan Share Class Initiative to promote firms' compliance with the rules governing 529 plan recommendations, to promptly remedy potential supervisory and suitability violations related to recommendations that customers of 529 plans buy share classes that are inconsistent with the accounts' investment objectives, and to return money to harmed investors as quickly and efficiently as possible. As described in this Notice, to encourage voluntary reporting under this initiative, FINRA's Department of Enforcement (Enforcement) will recommend that FINRA accept favorable settlement terms for firms that self-report these potential violations and provide FINRA with a detailed remediation plan.3

      Questions concerning this Notice should be directed to:

      •    Christopher Kelly, Senior Vice President, Enforcement, at (732) 596-2082; or
      •    Christopher Burky, Senior Director, Enforcement, at (312) 899-4348.

      Background & Discussion

      529 plans are tax-advantaged municipal securities that are designed to encourage saving for the future educational expenses of a designated beneficiary. Because 529 plans are municipal securities, the sale of 529 plans are governed by the rules of the Municipal Securities Rulemaking Board (MSRB).4 MSRB Rule G-19 (Suitability of Recommendations and Transactions) requires, in part, that firms and brokers that sell municipal securities have a reasonable basis to believe that a recommended transaction is suitable in light of the customer's investment profile. MSRB Rule G-27 (Supervision) requires firms to establish and maintain a supervisory system that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable MSRB rules.5

      Shares of 529 plans are commonly sold in different classes with differing fee structures.6 Class A shares typically impose a front-end sales charge but charge lower annual fees compared to other classes.7 Class C shares typically impose no front-end sales charge but impose higher annual fees than Class A shares. These classes have a differing cost impact depending on the length of time the customer holds the securities. The MSRB has stated that information known about the designated beneficiary generally would be relevant in weighing the investment objectives of the customer, including information regarding the age of the beneficiary and the number of years until the funds will be needed to pay qualified education expenses of the beneficiary.8 Further, the MSRB has stated that information regarding the designated beneficiary should be treated as information relating to the customer's investment objective for purposes of Rule G-19. 9

      Similarly, in the mutual fund context, FINRA has repeatedly cautioned that firms must supervise recommendations to purchase higher-expense share classes, particularly when an investor is seeking a long-term investment.10 With regard to Class C share sales, for example, FINRA has cautioned that customers should be informed "of the potential long- term effect of the higher ongoing sales charges" associated with holding Class C shares, and that firms should "maintain written records of [such] discussions in their files."11

      Effective in January 2018, amendments to the Internal Revenue Code expanded the use of 529 plans for tuition for grades K-12, subject to certain limitations. While 529 plan distributions were tax-free when used to pay for qualified higher education expenses (i.e., expenses incurred at or around the time the beneficiary is college-aged, typically 18 years or older), now, in addition, up to $10,000 per year in 529 plan withdrawals would be tax-free if used for elementary or secondary educational expenses (e.g., expenses incurred when the beneficiary is as young as four or five years old). These additional considerations underscore the importance of recommending a share class that is tailored to the unique circumstances and needs of the customer, as well as the importance of supervising such recommendations.

      FINRA is concerned that because of the unique features of 529 plans, some member firms may not provide adequate supervision. For example, 529 plan transactional data, including account asset levels, may not be available in the systems that firms use to monitor other types of transactions. This initiative is intended to encourage firms to assess their supervisory systems and procedures governing 529 plan share-class recommendations, to identify and remediate any defects, and to compensate any investors harmed by supervisory failures.

      The 529 Plan Share Class Initiative

      Who should consider self-reporting?

      Firms are encouraged to review their supervisory systems and procedures governing 529 plan share-class recommendations and self-report to FINRA areas where their supervision may not have been reasonable.12 Potential areas of concern include the failure to:

      •   provide training regarding the costs and benefits of different 529 plan share classes;
      •   understand and assess the different costs of share classes for individual transactions;
      •   receive or review data reflecting 529 plan share classes sold; and
      •   review share-class information, including potential breakpoint discounts or sales charge waivers, when reviewing the suitability of 529 plan recommendations.

      Firms that identify and self-report issues with 529 plan share-class supervision should also assess and self-report the potential impact of such supervisory failures. Firms may choose to assess the potential impact by conducting a customer-specific analysis, reviewing each customer's investment objectives and investment horizon, and assessing whether the firm recommended a suitable share class for that customer given his or her facts and circumstances. Alternatively, firms may choose to assess the potential impact of supervisory failures using a statistical approach to identify categories of 529 plan customers invested in share classes that are not economically advantageous if held for the accounts' expected investment horizon. For example, in many plans that offer both A and C share classes, the aggregate costs of a C share tend to exceed the aggregate costs of an A share after approximately six to seven years. Therefore, when assets are expected to be invested for more than six to seven years (for example, in a 529 plan purchased for the future college expenses of a beneficiary younger than 12), an A share might be the more cost-effective choice. Thus, firms could consider identifying 529 plan customers who invested in Class C shares for the future college expenses of beneficiaries younger than 12.13 FINRA will work with firms that prefer to develop different statistical models as a more effective way to assess potential impact.

      When and what firms should self-report?14

      To be eligible for the 529 Plan Share Class Initiative, firms must self-report by providing written notification to FINRA Enforcement by 12:00 a.m. E.T. on April 1, 2019. Notification can be made by email to 529Initiative@finra.org or by mail to 529 Plan Initiative, FINRA, Department of Enforcement, Brookfield Place, 200 Liberty Street, New York, New York 10281. A firm that has timely self-reported must, by May 3, 2019,15 confirm its eligibility for the 529 Plan Share Class Initiative by submitting all of the following information for the period of January 2013 through June 2018 (the "disclosure period").

      i. A list of the 529 plans sold by the firm, including the 529 plan name and the dates the firm offered each 529 plan.
      ii. The total aggregate principal amount invested in each 529 plan sold by the firm during the disclosure period.
      iii. A description of the firm's supervisory systems and procedures relating to 529 plan sales during the disclosure period.
      iv. A description of the changes to the firm's supervisory systems and procedures that the firm has implemented or will implement in order to strengthen compliance with its supervisory obligations. To the extent the firm identifies changes that have not yet been implemented, the firm should identify the individual supervisor at the firm who is responsible for the implementation.
      v. The firm's assessment of potential impact on customers of supervision weaknesses, including a description of the firm's methodology for assessing impact on customers and a description of the firm's proposal to make restitution payments to harmed customers.
      vi. Any other information the firm believes would assist Enforcement in understanding the firm's assessment of an account's expected investment horizon, the suitability of the firm's recommendations, or the reasonableness of the firm's supervisory system regarding share class recommendations.

      Standardized Settlement Terms

      To the extent that a firm meets the requirements of the 529 Plan Share Class Initiative, and Enforcement decides to recommend a formal enforcement action based on the facts disclosed by the firm through the 529 Initiative and any other relevant information, Enforcement will recommend that FINRA accept a settlement that includes restitution for the impact on affected customers16 and a censure, but no fine.17 Recommended settlements also will include either an acknowledgement that the firm has voluntarily taken corrective actions or undertakings to do so. Enforcement anticipates that settlements entered into pursuant to this 529 Initiative will include charges under MSRB Rule G-27 (Supervision). Settlements under this rule would not result in a firm's "statutory disqualification" as that term is defined in Section 3(a)(39) of the Securities Exchange Act of 1934.

      No Assurances for Firms That Do Not Self-Report

      In 2019, FINRA's Member Supervision and Enforcement departments will continue to examine and investigate firms' supervision of share-class recommendations to customers of 529 plans. If a firm does not self-report under the 529 Initiative but FINRA later identifies supervisory failures by that firm, any resulting disciplinary action likely will result in the recommendation of sanctions beyond those described under the initiative.18

      No Assurances Offered With Respect to Individual Liability

      The 529 Plan Share Class Initiative covers only member firms. Enforcement provides no assurance that individuals associated with these firms will be offered similar terms if they sold 529 plans to customers in violation of MSRB rules, or violated any securities laws. Enforcement may recommend enforcement action against such individuals and may seek sanctions beyond those resulting from the initiative. Assessing whether to recommend enforcement action against an individual necessarily involves a case-by-case assessment of specific facts and circumstances.


      1 See 2017 Report on FINRA Examination Findings [http://www.finra.org/industry/2017-report-exam-findings], at 7 (Dec. 2017).

      2 FINRA's 2016 Regulatory and Examination Priorities Letter [http://www.finra.org/industry/2016-regulatory-and-examination-priorities-letter], at 7 (Jan. 2016). A 529 plan is structured as a trust. The trust is divided into investment options and those investment options then may invest in mutual funds. A customer purchases units in the trust. Most 529 plans offer different "unit" class pricing options similar to the share class pricing offered by open-end mutual funds. For purposes of this initiative, the terms "unit class" and "share class" are used interchangeably.

      3 FINRA settlements must be accepted by Enforcement prior to submission to the Office of Disciplinary Affairs (ODA) or the National Adjudicatory Council (NAC) Review Subcommittee. The NAC, or ODA on behalf of the NAC, must then approve the Letter of Acceptance Waiver and Consent (AWC) before it becomes final.

      4 FINRA is responsible for examining FINRA members that are municipal securities dealers or municipal advisors and for enforcing MSRB rules.

      5 In addition, MSRB Rule G-17 (Conduct of Municipal Securities and Municipal Advisory Activities) requires that firms and their associated persons deal fairly with all persons and not engage in any deceptive, dishonest, or unfair practice. See Interpretation on Customer Obligations Related to Marketing of 529 College Savings Plans (Aug. 7, 2006) ("[D]ealers must ensure that they do not engage in transactions primarily designed to increase commission revenues in a manner that is unfair to customers under Rule G-17.").

      6 Direct-sold 529 plans, versus broker-sold 529 plans, may have different share-class fee structures.

      7 Breakpoint discounts typically cause the front-end sales charge to decrease as the amount invested increases.

      8 See Interpretation on Customer Obligations Related to Marketing of 529 College Savings Plans (Aug. 7, 2006).

      9 Id.

      10 See Notices to Members 94-16 (March 1994) and 95-80 (Sept. 1995).

      11 NASD Regulatory & Compliance Alert (Summer 2000), at 15.

      12 Firms that already have been contacted by Enforcement as of the date of this announcement regarding potential violations related to 529 plan share class sales are not required to self-report under the initiative. Firms that are subject to pending examinations by FINRA are eligible to self- report under the initiative.

      13 Importantly, a recommendation that a customer purchase 529 plan Class C shares for an account with a beneficiary age 12 or younger is not per se unsuitable. There may be circumstances in which the recommendation of higher-expense Class C shares is suitable in light of the customer's facts and circumstances.

      14 Self-reporting under the initiative does not replace firms' obligations to determine whether to self- report under FINRA Rule 4530. However, a firm's reporting obligation under Rule 4530 is triggered only if the firm concludes that it violated any securities-, insurance-, commodities-, financial- or investment-related laws, rules, regulations or standards of conduct of any domestic or foreign regulatory body or self-regulatory organization. Further, for purposes of FINRA Rule 4530(b), only those violations that meet the reporting threshold under FINRA Rule 4530.01 are required to be reported. With respect to violations by a firm, FINRA Rule 4530.01 requires the firm to report only conduct that has widespread or potential widespread impact to the firm, its customers or the markets, or conduct that arises from a material failure of the firm's systems, policies or practices involving numerous customers, multiple errors or significant dollar amounts. If the firm concludes (or reasonably should have concluded) that such a violation has occurred, it is obligated to report pursuant to FINRA Rule 4530(b). However, under the 529 Plan Share Class Initiative, FINRA is asking member firms to self-report any areas of concern regarding the reasonableness of their supervisory policies and procedures.

      15 Enforcement may grant an extension of time to submit the required information. To obtain an extension, member firms must email requests to 529Initiative@finra.org at least two days before the deadline.

      16 Enforcement will confer with the firm on an acceptable methodology for calculating restitution. The relevant time periods under any settlement, including the period for calculating any restitution, may differ from the disclosure period.

      17 Alternatively, Enforcement may, based on the particular facts and circumstances presented, determine that formal action is not appropriate and instead resolve the matter informally or with no further action. FINRA also will consider whether widespread violations are best addressed through the issuance of additional regulatory guidance.

      18 Assessing whether to recommend enforcement action necessarily involves a case-by-case assessment of specific facts and circumstances.

    • 19-03 FINRA Reminds ATS Subscribers and ATSs of the April 13, 2019, Effective Date for Disaggregated Transaction Reporting

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      TRACE Reporting of U.S. Treasury Securities

      Regulatory Notice
      Notice Type

      Guidance
      Suggested Routing

      Compliance
      Fixed Income
      Legal
      Trading
      Key Topics

      TRACE-Eligible Securities
      Trade Reporting
      00U.S. Treasury Securities
      Referenced Rules

      FINRA Rule 6730

      Summary

      FINRA is reminding firms that, after April 12, 2019, member subscribers on an alternative trading system (ATS) and ATSs will be required to report to TRACE each transaction in U.S. Treasury securities executed in trading sessions on an ATS on a disaggregated basis.

      Questions regarding this Notice should be directed to:

      •  Joseph Schwetz, Senior Director, Market Regulation (MR), at (240) 386-6170 or by email at joseph.schwetz@finra.org;
      •  Russell Kemp, Associate Director, MR, at (240) 386-5081 or by email at russell.kemp@finra.org; or
      •  for legal and interpretive questions, Racquel Russell, Associate General Counsel, Office of General Counsel, at (202) 728-8363 or by email at racquel.russell@finra.org.

      Background and Discussion

      On July 10, 2017, members began reporting transactions in U.S. Treasury securities to TRACE.1 In advance of the July 10 implementation date, members expressed concerns regarding their ability to accurately report transactions in U.S. Treasury securities that were executed on an ATS in discrete trading sessions (sometimes referred to as "work-up sessions"). These concerns arose because trades executed in trading sessions may involve more than one market participant (on one or both sides of the market), and the ATS usually confirms resulting executions through an aggregated trade message sent by the ATS to its subscribers (e.g., a single message aggregating all orders executed for each subscriber in a security during the session). The ATS and member subscribers use these aggregated trade messages for TRACE trade reporting purposes.2 Because Rule 6730 requires members to report separately each individual trade that occurs in a trading session, members expressed a need for additional time to complete the systems changes necessary to disaggregate trade reporting by the July 10, 2017, effective date for reporting transactions in U.S. Treasury securities to TRACE.

      To assist members in their compliance efforts, on June 23, 2017, FINRA filed a proposal to, on a temporary basis, adopt Supplementary Material .06 to Rule 6730 (Temporary Exception for Aggregate Transaction Reporting of U.S. Treasury Securities Executed in ATS Trading Sessions) to permit members to report trades that occurred in U.S. Treasury securities executed within discrete ATS trading sessions on an aggregate, rather than individual, basis.3 The relief granted afforded members flexibility concerning the number of transactions reported and the price reported, as well as the time of execution reported to TRACE.4

      The relief provided by Rule 6730.06 originally was scheduled to expire on July 10, 2018. However, members requested additional time to complete necessary systems changes and testing to comply with Rule 6730. Therefore, on April 16, 2018, FINRA provided a onetime, nine-month extension to permit aggregated trade reporting to continue through April 12, 2019, while member ATSs performed the development work necessary to report individual execution information, including the development of an additional data feed to deliver execution-level information to subscribers and vendors.5 FINRA also understood that member subscribers required additional time to update their systems to consume the new execution information to be provided by the ATSs and to systematically incorporate this information in their TRACE reporting to FINRA. In the filing, FINRA stated that it expects that necessary testing of the new functionality will commence well in advance of the extended date of April 12, 2019, but at a minimum, no later than January 12, 2019.

      In its 2017 filing, FINRA also provided an example of how trade reporting for transactions executed in a work-up session will need to change for both subscribers and ATSs after the end of the exception.6 For ease of reference, the example is provided as Attachment A to this Notice and FINRA encourages firms to review the example as they update their systems.

      FINRA is reminding members — both ATS subscribers and ATSs — of these deadlines. After April 12, 2019, member ATSs and member ATS subscribers will be required to comply with Rule 6730 by separately reporting each individual trade that occurs during a trading session, as well as the actual time and price at which each individual trade is executed.


      1 See Securities Exchange Act Release No. 79116 (October 18, 2016), 81 FR 73167 (October 24, 2016) (Notice of Filing of Amendment No. 1 and Order Granting Accelerated Approval of File No. SR-FINRA-2016-027). See also Regulatory Notice 16-39 (October 2016).

      2 For additional information on the types of trading sessions that may occur on ATSs and on the operation of the exception in varying trade reporting scenarios, see Securities Exchange Act Release No. 81018 (June 26, 2017), 82 FR 29956 (June 30, 2017) (Notice of Filing and Immediate Effectiveness of File No. SR-FINRA-2017-023).

      3 Id.

      4 Specifically, the exception provided that ATSs and member subscribers are permitted to report transactions in U.S. Treasury securities executed within discrete trading sessions by submitting a transaction report reflecting the aggregate amount of a U.S. Treasury security purchased (sold) to another party during a single trading session at the average price of such transactions, with the time of execution communicated by the ATS, irrespective of the number of trades in the trading session. Id.

      5 See Securities Exchange Act Release No. 83098 (April 24, 2018), 83 FR 18866 (April 30, 2018) (Notice of Filing and Immediate Effectiveness of a Proposed Rule Change To Extend the Temporary Exception That Permits Aggregate Reporting for Certain ATS Transactions in U.S. Treasury Securities).

      6 See supra note 2.


      Attachment A

      Example of required trade reporting by ATSs and subscribers of transactions executed in a work-up session after April 12, 2019

      Assume that the following events occur in an ATS trading session:

      Trade No.
      Time
      Subscriber
      Buy/Sell
      Amount (in millions)
      11:34:02.000 Subscriber A Sell $25
      1 11:34:03.155 Subscriber B Buy $10
      2 11:34:03.483 Subscriber C Buy $15
      11:34:04.003 Subscriber D Sell $10
      3 11:34:05.002 Subscriber E Buy $5
      4 11:34:05.877 Subscriber B Buy $5
      11:34:07.877
      Trading Session Closes

      At the end of the trading session, the ATS provides each subscriber with an aggregate trade message indicating the subscriber's aggregate activity during the trading session (including, for example, an aggregate size and average price). The trade messages contain a single time of execution (e.g., the time the trading session closed), rather than the actual time at which each respective trade was executed during the trading session. The temporary exception permits the subscriber and ATS to use the aggregate size and average price information contained in the trade message for purposes of TRACE reporting. The temporary exception also permits all parties to use the time of execution contained in the ATS's trade message, rather than the actual time the parties executed the individual transactions.

      After April 12, 2019, members must comply with existing TRACE reporting requirements in Rule 6730 and must submit trade reports for the following transactions executed in a trading session, including the actual price and time of execution for each trade:

      Trade No.
      TRACE Reports
      Quantity (in millions)
      Time of Execution
      1 Subscriber A sell to ATS
      ATS buy from Subscriber A
      ATS sell to Subscriber B
      Subscriber B buy from ATS
      $10
      $10
      $10
      $10
      11:34:03.155
      11:34:03.155
      11:34:03.155
      11:34:03.155
      2 Subscriber A sell to ATS
      ATS buy from Subscriber A
      ATS sell to Subscriber C
      Subscriber C buy from ATS
      $15
      $15
      $15
      $15
      11:34:03.483
      11:34:03.483
      11:34:03.483
      11:34:03.483
      3 Subscriber D sell to ATS
      ATS buy from Subscriber D
      ATS sell to Subscriber E
      Subscriber E buy from ATS
      $5
      $5
      $5
      $5
      11:34:05.002
      11:34:05.002
      11:34:05.002
      11:34:05.002
      4 Subscriber D sell to ATS
      ATS buy from Subscriber D
      ATS sell to Subscriber B
      Subscriber B buy from ATS
      $5
      $5
      $5
      $5
      11:34:05.877
      11:34:05.877
      11:34:05.877
      11:34:05.877

    • 19-02 FINRA Updates Supplemental Statement of Income; Implementation Date: The updated SSOI applies beginning with all SSOI filings that report on the period January 1 through March 31, 2019, and are due by April 26, 2019.

      View PDF

      Supplemental FOCUS Information

      Regulatory Notice
      Notice Type

      Guidance
      Referenced Rules & Notices

      FINRA Rule 4524
      Regulatory Notice 12-11
      Regulatory Notice 18-38
      Suggested Routing

      Compliance
      Finance
      Legal
      Operations
      Regulatory Reporting
      Senior Management
      Key Topics

      FOCUS Reporting
      Supplemental Statement of Income

      Summary

      FINRA is updating the Supplemental Statement of Income (SSOI) to conform with amendments adopted by the SEC1 that simplify and update certain of the FOCUS reporting requirements for broker-dealers.2 Pursuant to Rule 4524, the SSOI must be filed by all FINRA members as a supplement to the FOCUS Report3 within 20 business days after the end of each calendar quarter.4 FINRA is making available the updated SSOI instructions and form, as well as a resource that illustrates the SSOI form updates.

      The updated SSOI applies beginning with all SSOI filings that report on the period January 1 through March 31, 2019, and are due by April 26, 2019.

      Questions concerning this Notice should be directed to:

      •   Yui Chan, Senior Director, Risk Oversight and Operational Regulation (ROOR), at (646) 315-8426 or Yui.Chan@finra.org;
      •   Ann Duguid, Senior Director, ROOR, at (646) 315-7260 or Ann.Duguid@finra.org; or
      •   Anthony Vinci, Director, ROOR, at (646) 315-8335 or Anthony.Vinci@finra.org.

      Background & Discussion

      On August 17, 2018, the SEC adopted amendments that simplify and update, among other rules and forms, certain of the FOCUS reporting requirements for brokers and dealers and make changes to the annual audit requirements.5 As previously announced in Regulatory Notice 18-38, FINRA has updated the eFOCUS forms to reflect the SEC's FOCUS Report amendments. Further, to assist members in their financial reporting obligations, FINRA is updating the SSOI instructions and form to conform with the SEC's amendments:

      The following resource illustrates the SSOI form updates:

      The updated eFOCUS forms are available on Firm Gateway. The updated SSOI form will be available on Firm Gateway beginning February 8, 2019. Requests for technical assistance with the eFOCUS and SSOI forms may be directed to the FINRA Gateway Call Center at (800) 321-6273.

      As noted above, the updated SSOI applies beginning with all SSOI filings that report on the period January 1 through March 31, 2019, and are due by April 26, 2019.


      1 See Exchange Act Release No. 83875 (August 17, 2018), 83 FR 50148 (October 4, 2018) (Final Rule: Disclosure Update and Simplification) (the SEC's Adopting Release). FINRA issued Regulatory Notice 18-38 to announce updates to the FINRA eFOCUS System designed to correspond with the new FOCUS requirements and to inform members of the effective date of the new requirements pursuant to specified relief granted by the staff of the SEC Division of Trading and Markets. See also letter from Michael A. Macchiaroli, Associate Director, Division of Trading and Markets, SEC, to Ann Duguid, Senior Director, FINRA, dated October 29, 2018.

      2 See Exchange Act Release No. 84855 (December 19, 2018), 83 FR 66828 (December 27, 2018) (Notice of Filing and Immediate Effectiveness of a Proposed Rule Change to Make Technical Revisions and One Minor Correction to the Supplemental Statement of Income Required to be Filed Pursuant to FINRA Rule 4524 (Supplemental FOCUS Information); File No. SR-FINRA-2018-041).

      3 Members must submit their FOCUS Reports and SSOIs electronically through the eFOCUS System via the FINRA Firm Gateway.

      4 FINRA Rule 4524 (Supplemental FOCUS Information) requires each member, as FINRA shall designate, to file such additional financial or operational schedules or reports as FINRA may deem necessary or appropriate for the protection of investors or in the public interest as a supplement to filing FOCUS reports. FINRA implemented the SSOI pursuant to Rule 4524 in 2012. See Regulatory Notice 12-11 (Supplemental FOCUS Information) (February 2012) (announcing the SEC's approval of Rule 4524 and the SSOI).

      5 See note 1. See also, for example, the SEC's Adopting Release at 83 FR 50179, 50182 and 50183.

    • 19-01 Final Statements for Broker-Dealers, Investment Adviser Firms, Agents and Investment Adviser Representatives, and Branches; Payment Deadline: January 21, 2019

      View PDF

      BD and IA Renewals for 2019

      Regulatory Notice
      Notice Type

      Renewals


      Suggested Routing

      Compliance
      Legal
      Operations
      Registration
      Senior Management
      Key Topics

      IARD™
      Registration
      Renewals
      Web CRD®

      Summary

      FINRA is issuing this Notice to help firms review, reconcile and respond to their Final Statements in E-Bill as well as view the reports that are currently available in Web CRD/IARD for the annual registration renewal process. The payment deadline is January 21, 2019.

      Please direct questions concerning this Notice to the FINRA Call Center at (301) 869-6699.

      Background & Discussion

      Final Statements

      On January 2, 2019, Final Statements became available for viewing and printing in E-Bill. These statements reflect the final status of broker-dealer, registered representative, investment adviser firm, investment adviser representative, and branch registrations and/or notice filings as of December 31, 2018. Any adjustments in fees owed because of registration terminations, approvals, IA firm registrations, reporting status or notice filings subsequent to the Preliminary Statement are included in this final reconciled statement. Renewal reports are available in Web CRD/IARD for request, print and/or download.

      If the amount assessed on the Final Statement is greater than the amount assessed on the Preliminary Statement, the additional renewal fees are due by January 21, 2019. If the amount assessed on the Final Statement is less than the amount assessed on the Preliminary Statement, FINRA has issued a credit to the firm's Flex-Funding Account.

      The Final Statements include the following fees (if applicable):

      •   Web CRD/IARD system processing fees;
      •   FINRA branch office and branch processing fees;
      •   participating Self-Regulatory Organization (SRO) maintenance fees, if applicable;
      •   state broker-dealer firm, branch and agent (AG) renewal fees, if applicable;
      •   state investment adviser firm, branch and investment adviser representative (RA) renewal fees, if applicable; and
      •   FINRA annual statutory disqualification fees for registered individuals.

      Renewal Payment

      Web CRD/IARD issues a refund if a firm owes less for registrations at year-end than what was reflected on the Preliminary Statement. FINRA transferred overpayments to firms' Flex-Funding Accounts on January 2, 2019. Firms that have a credit balance in their FlexFunding Accounts may submit a refund request [http://www.finra.org/industry/e-bill-user-guide#Refunds] through E-Bill or leave the funds in their account to pay for other future fees.

      If the Final Statement reflects an amount due, FINRA must receive payment no later than January 21, 2019. Firms may pay electronically through E-Bill, send a wire transfer or mail a check; however, FINRA highly recommends that firms remit funds via E-Bill. Firms are encouraged to check their Renewal Statements to confirm FINRA has received payment and that the firm's Renewal Statement balance is paid in full.

      Electronic Payment via E-Bill

      Firms may submit electronic payments to fund their Renewal Accounts through E-Bill [http://www.finra.org/industry/finra-e-bill]. FINRA does not charge for using E-Bill; however, firms should verify if their banks charge additional fees. Firms must enroll to use E-Bill.

      Please Note: Firm users with the proper entitlement may transfer funds from their Flex-Funding Account to their Renewal Account or transfer funds between affiliated firms at any time by using E-Bill. For further details, please refer to the E-Bill User Guide [http://www.finra.org/industry/e-bill-user-guide].

      ACH/Wire Transfer and Check Payments

      Wire transfer and check payments are deposited into a firm's Flex-Funding Account. Beginning January 21, 2019, if sufficient funds are available, FINRA will systematically transfer funds from Flex-Funding Accounts to Renewal Accounts. A systematic transfer will only occur if the entire outstanding renewal amount is available in the firm's FlexFunding Account. Firms that intend to transfer funds to their Renewal Accounts using E-Bill should do so before January 21.

      ACH/Wire Transfer

      To initiate a wire or ACH transfer, instruct your firm's bank to contact Bank of America and provide your bank with the following information:

      Wire ABA Number: 026009593

      ACH ABA Number: 054001204

      Beneficiary: FINRA

      FINRA Account: 226005684771

      Reference Number: Firm CRD number

      Inform your bank to credit funds to the FINRA bank account and to only use your firm's CRD number as a reference. Record the confirmation number of the wire transfer provided by your bank.

      If you send your wire transfer by 2 p.m., ET, your firm may confirm receipt the next business day by reviewing your Flex-Funding Account online or calling the FINRA Gateway Call Center at (301) 869-6699. Wire payments received after 2 p.m., ET, should be available in two business days. Please note that while wire transfers are received by FINRA on the same day they are initiated, ACH bank transfers typically take several days longer to be received by FINRA.

      Checks

      Checks should be made payable to FINRA and your firm's CRD number should be written on the check memo line. Processing of check payments may take up to two business days. Please account for mail delivery and payment processing time when sending payment. Write the address on an envelope exactly as noted in this Notice:

      U.S. Mail Overnight or Express Delivery
      FINRA
      P.O. Box 418911
      Boston, MA 02241-8911

      Note: This box will not accept courier or
      overnight deliveries.
      Bank of America Lockbox Services
      FINRA 418911
      MA5-527-02-07
      2 Morrissey Blvd.
      Dorchester, MA 02125

      Provide the following phone number, if
      required: (800) 376-2703

      Renewal Reports

      Renewal reports include all individual registrations renewed for 2019; however, they do not include registrations that were "pending approval" or "deficient" at year-end. Firms should examine their reports carefully to ensure that all registration approvals are correct. FINRA also suggests that firms include these reports in firms' permanent records.

      •   Firm Renewal Report — lists individuals included in the Renewal Program and includes billing codes (if the firm provided them). See the new Firm Renewal Report Guide [http://www.finra.org/industry/firm-renewal-report-guide] for more information.
      •   Branches Renewal Report — lists each branch registered with FINRA and/or with any other regulator that renews branches through Web CRD/IARD and for which the firm is being assessed a fee.
      •   Approved AG Reg Without FINRA Approval Report — contains all individuals who are not registered with FINRA, but are registered with one or more jurisdictions. Firms should request this report as soon as possible to determine if they need to request any FINRA registrations or terminate jurisdiction registrations.

      Discrepancies

      If your firm believes there are discrepancies on your Final Statement, report them in writing directly to FINRA by January 21, 2019. Along with your letter describing the discrepancy, please include a copy of your Final Statement and any supporting documentation to:

      FINRA
      Registration & Disclosure — Regulatory Services & Operations
      9509 Key West Avenue
      Rockville, MD 20850

      If you have questions regarding renewal discrepancies, please call FINRA at (240) 386-4182.