FINRA Statutory Disqualifications and the MC-400 Process

Under the Securities Exchange Commission’s authority FINRA promulgates rules of its own as a self regulatory organization (“SRO”). Pursuant to FINRA’s By-Laws (and the By-Laws of the NASD and the NYSE before it) a person may be disqualified from membership. A person disqualified from membership would be prohibited from participation in the securities industry. In July 2007 FINRA adopted a revised version of the NASD’s definition of disqualification contained in its By-Laws such that any person subject to a statutory disqualification under the Securities Exchange Act Section 3(a)(39) also is subject to disqualification under FINRA’s By-Laws.

Prior to the amendment, the NASD’s By-Laws listed some, but not all, of the grounds for statutory disqualification contained in Exchange Act Section 3(a)(39). However, after the amendment to the NASD’s then existing By-Laws, FINRA’s By-Laws provided that: “A person is subject to a ‘disqualification’ with respect to membership, or association with a member, if such person is subject to any ‘statutory disqualification’ as such term is defined in Section 3(a)(39) of the [Securities Exchange Act of 1934].”

The revised definition of disqualification incorporated three additional categories of statutory disqualification which previously did not exist. One of those additional categories of disqualification comes from the Sarbanes-Oxley Act. Section 604 of the Sarbanes-Oxley Act expanded the definition of statutory disqualification under the Securities Exchange Act of 1934 by creating Exchange Act Section 15(b)(4)(H) and then incorporating it into Exchange Act Section 3(a)(39). As a result of this change, statutory disqualification under Exchange Act Section 15(b)(4)(H) includes a person that:

is subject to any final order of a State securities commission (or any agency or officer performing like functions), State authority that supervises or examines banks, savings associations, or credit unions, State insurance commission (or any agency or office performing like functions), an appropriate Federal banking agency (as defined in section 3 of the Federal Deposit Insurance Act (12 U.S.C. 1813(q))), or the National Credit Union Administration, that --

1. bars such person from association with an entity regulated by such commission, authority, agency, or officer, or from engaging in the business of securities, insurance, banking, savings association activities, or credit union activities; or

2. constitutes a final order based on violations of any laws or regulations that prohibit fraudulent, manipulative, or deceptive conduct.

This revised definition of statutory disqualification became effective as of July 2007. The effect of the revised definition would have been the immediate disqualification of a large number of individuals subject to the new categories of disqualification. In order to remain in the securities industry, these individuals would have had to utilize the then existing NASD eligibility proceedings for persons subject to disqualification; i.e. NASD Rule 9520.

In order to avoid this result, the NASD requested that the Securities Exchange Commission Staff not recommend enforcement action to the Commission under Exchange Act Section 15A(g)(2) or Rule 19h-1(a) for those persons subject to the new definition of disqualification until the NASD could update and improve its eligibility proceedings to address the changes to the definition of statutory disqualification. As a result, the SEC, by Chief Counsel Catherine McGuire, issued a No Action Letter on July 27, 2007, informing the NASD that it would not seek enforcement against the individuals subject to the new categories of statutory disqualification if NASD did not file notice with the Commission for enforcement between the time the amended By-Laws containing the revised definition of statutory disqualification became effective and the effective date of the revised eligibility procedures. This would mean that those persons subject to the revised definition could continue membership in FINRA without going through the application process for eligibility pending the adoption of the revised eligibility procedures.

In April 2009, FINRA released Regulatory Notice 09-19 which set forth the amendments to FINRA Rule 9520 Series to become effective June 15, 2009. The revised FINRA Rule 9520 Series established procedures applicable to firms and associated persons subject to the additional statutory disqualifications as a result of the adoption of the revised definition of disqualification. Under this new construct of the Rule 9520 Series, individuals subject to one of the additional categories of disqualification would need to seek FINRA’s approval to enter or remain in the securities industry by way of an application with FINRA’s Department of Registration and Disclosure (“RAD”) only under certain circumstances. The need to file an application depends on 1) the type of disqualification; 2) the date of the disqualification; and 3) whether the firm or individual was seeking admission, readmission or continuance in the securities industry.

There are likely four different ways that a member of FINRA would know that they are required to file an application with RAD as a result of the application of revised Rule 9520 Series to an order of a state securities commission. First, Regulatory Notice 09-19 states that as of June 15, 2009, FINRA began reviewing its records to identify persons that met any of the additional conditions that would require the filing of an application under the revised Rule 9520 Series. In what manner FINRA has undertaken this review is unknown. Second, an individual could identify on their own that they are subject to an existing order which would require an application with RAD.

Third, if someone is seeking to transfer their registration to a new broker-dealer, then any existing state orders which would require an application with RAD as a result of the revised Rule 9520 Series would be disclosed by the CRD (the central licensing and registration system for the U.S. securities industry and its regulators) when it is reviewed by FINRA. Fourth, if an individual is subject to a new order of a state regulator, then an alert is sent out to all other state regulators as well as FINRA through the CRD. Whether FINRA reviews each alert it receives in order to decide to take action against an individual subject to an order of a state securities commission is unknown.

For those subject to a statutory disqualification arising from orders specified in Exchange Act Section 15(b)(4)(H)(i) and Exchange Act Section 15(b)(4)(H)(ii), find below an outline of the circumstances under which the person must file an application with RAD under FINRA’s revised Rule 9520 Series:

A. If the person is seeking admission or re-admission to the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i), then the person must file an application unless the order imposing a bar on the person is time-limited and the time period is expired. However, if the bar is related to Fraudulent, Manipulative or Deceptive (“FMD”) conduct, then the person must submit an application under the circumstances described in section I.B.

2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then the person must submit an application unless:

i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions) and the sanctions are no longer in effect; or

ii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), the sanctions are no longer in effect, and the order was entered 10 or more years ago.

B. If the person was, as of March 17, 2009, a member of, or an associated person of a member of FINRA or another SRO, and was subject to a statutory disqualification as of that same date and is seeking to continue in the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i); and
i. the bar is no longer in effect and is not related to FMD conduct, then no application is required.

ii. the bar is still in effect and is not related to FMD conduct then no application is required unless there is a “triggering event” - which occurs when the person subject to the statutory disqualification either changes employers or the member firm makes an application for the registration of such person as a principal pursuant to FINRA rules.

iii. the bar is still in effect and is related to FMD conduct, then an application is required.

2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then an application is required unless:

i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are no longer in effect; or

ii. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are still in effect, in which event an application is required only if there is a triggering event; or

iii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), and the sanctions are no longer in effect, and the order was entered 10 or more years ago. However, if the order was issued less than 10 years ago, then an application is required if there is a triggering event.

C. If the person was, as of March 17, 2009, a member of, or an associated person of a member of FINRA or another SRO, and is subject to a statutory disqualification that arose after March 17, 2009, and is seeking to continue in the industry; and

1. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(i), then the person must file an application unless the order imposing a bar on the person is time-limited and the time period is expired. However, if the bar is related to FMD conduct, then the person must submit an application under the circumstances described in section III.B.

2. the person is subject to an order under Exchange Act Section 15(b)(4)(H)(ii), then an application is required unless:

i. the sanctions do not involve licensing or registration revocation or suspension (or analogous sanctions) and the sanctions are no longer in effect; or

ii. the sanctions do involve licensing or registration revocation or suspension (or analogous sanctions), the sanctions are no longer in effect, and the order was entered 10 or more years ago.

Some more recent articles touching upon this process include: “Stockbroker's DUI Puts Career in the FINRA Ditch” by Bill Singer, “Bankrupt Stockbroker Winds Up Statutorily Disqualified” by Bill Singer, “U-4 Omissions and Statutory Disqualification:Much Ado About Nothing” by Alan Wolper. Do not hesitate to call us if you or your broker-dealer need assistance with a potential MC-400 application.

Hey Brokers--Think Before You Sign the State Consent Order

A state regulator has threatened to bring an enforcement action against you for unsuitability relative to the sale of an annuity and barely exceeding the expected churn ratio in an elderly client's brokerage account. Your sister's younger brother is a top-notch commercial litigator with the biggest law firm in town (“Hot Shot”). He comes to your rescue and goes toe-to-toe with your state regulator. To your disbelief, all you must do to extract yourself from the ugliness is sign a Consent Order requiring you to disgorge commissions and pay a modest fine. Unbeknownst to you (and Hot Shot), you become statutorily disqualified from practicing in the industry for 10 years as the instant the Commissioner accepts and signs the Order.

The following are just a few critical excerpts from FINRA's website regarding industry disqualification and eligibility requirements and proceedings:

“Eligibility Requirements - Article III, Section 3 of FINRA's By-Laws provides that no member shall be continued in membership if it becomes subject to disqualification; and that no person shall be associated with a member, continue to be associated with a member, or transfer association to another member if such person is or becomes subject to disqualification. FINRA's authority to deny the registration and/or membership of disqualified persons or members is set forth in Section 15A(g)(2) of the Securities Exchange Act of 1934. Disqualification Defined - FINRA amended its By-Laws on July 30, 2007 to incorporate the definition of "disqualification" as set forth in Section 3(a)(39) of the Exchange Act.”

Section 604 of the Sarbanes-Oxley Act expanded the definition of statutory disqualification in Section 3(a)(9) of the Securities Exchange Act of 1934 by both creating and incorporating Exchange Act Section 15(b)(4)(H) so as to include persons subject to a Final Order of a state securities commission if the Order is based upon the violation of a statute or regulation that prohibits fraudulent, manipulative, and deceptive conduct. Because the list of disqualifying events prior to this expansion fell within the ambit of the obvious—such as convictions, bars, expulsions, and revocations—many members of the industry as well as the legal community remain dangerously unaware of the implications of the final state order. So, for example, while you may have neither “denied or admitted” a state enforcement section's allegations, and unsuitability is likely more a matter of negligence than deception, the Consent Order implicitly admitting you were engaged in churning could very well qualify the Final Consent Order as one based upon deceptive conduct.

No one is going to try to revoke anything from you after the Consent Order is issued. You just automatically revoked it yourself by operation of Federal Law. Once your member firm files the appropriate U-4 disclosure regarding the Consent Order, or the state enters it in to the CRD system, FINRA RAD will fax a letter to your Chief Compliance Officer politely informing your firm that it can file an MC-400 Application or “immediately terminate its association with [you].” Your firm will then have to decide if you are worth it, and you might have to hire an attorney other than Hot Shot.

One final word of caution--and I have seen this too many times--the disqualifying Final Order provision is not limited to Orders issued by your home state or even by a state in which you are registered. So don't blow off a Show-Cause Order from Alaska just because you don't have any clients there. When you default and Alaska issues a Final Order against you for something you didn't even do—you will be in the very unsavory position of having to “unring” that bell or persuade your firm to “sponsor” you through FINRA's Membership Continuation process.

“Article III, Section 3(d) of FINRA's By-Laws permits a disqualified person or member to request permission to enter or remain in the securities industry. Procedural Rules 9520-27 set forth procedures for a member to sponsor the proposed association of a person subject to disqualification or for a member to obtain approval to remain a member notwithstanding the existence of a disqualification. These actions are referred to as "Eligibility Proceedings."

Generally speaking, a person who is subject to disqualification may not associate with a FINRA member in any capacity unless and until approved in an Eligibility Proceeding. If a person is currently associated with a FINRA member at the time the disqualifying event occurs, however, the person may be permitted to continue to work in certain circumstances, provided the employer member promptly files a written application seeking permission to continue the employment in an Eligibility Proceeding. A member subject to disqualification also may be allowed to remain a member, in certain circumstances, pending the outcome of an Eligibility Proceeding, provided the member promptly files an application requesting approval of its continued membership.

Once it becomes aware of a statutory disqualifying event (related to the member or a disqualified person), the member is obligated to report the event to FINRA. In the case of a disqualified person, the Firm must either file a Form U5 if it wishes to terminate the individual's association or file a Form MC-400 application if a member wishes to sponsor the association of a disqualified person. The member should file any MC-400 application when it amends the Form U4 and it must amend the Form U4 within 10 days of learning of a statutory disqualifying event (see Art. 5, Sec. 2(c) of the FINRA By-Laws). The MC-400 application requests information about the terms and conditions of the proposed employment, with special emphasis on the proposed supervision to be accorded the disqualified person.”

FINRA SD12003 is just one of the many cautionary tales I could tell. The broker in that case purchased three (3) collateralized debt obligations his firm promoted through an auction rate securities market that his firm sponsored for a municipal client in Massachusetts in 2006. The broker entered into a Consent Order with the Massachusetts Securities Division in 2008 in which he agreed to pay a modest fine and be suspended for six (6) months. Mr. Broker returned to work with a new firm in August of 2008 after Massachusetts allowed him to re-register with the state. Everything went just swimmingly until presumably a year later, his firm received “the letter” from FINRA. According to FINRA Registration and Disclosure, Mr. Broker was out of the game when the state Consent Order was entered by the Director of the Massachusetts Securities Division.

Mr. Broker's new firm filed the MC-400 application in January of 2010. FINRA's Member Regulation staff opposed the application. A hearing was held before the National Adjudicatory Council¹ 18 months later, in September 2011. The National Adjudicatory Council (“NAC”) issued its opinion in favor of Mr. Broker the next year. Get the picture? So--consult with an attorney trained in state and FINRA disciplinary matters before you sign a state consent order.² Do not rely solely upon your brother-in-law or even your firm's compliance department. Same goes for you compliance officers!

1  These are fairly uncommon and very serious. I represented an applicant in one and we prevailed.

2  David Cosgrove is the former Commissioner of Securities and has represented brokers in MC-400 proceedings since 2007. He represents brokers and broker-Dealers throughout the United States.