As has been pointed out in the trade press in recent years, there have been numerous instances of broker-dealers going out of business for a number of reasons, not the least of which is being on the wrong end of an arbitration award. For small broker-dealers, an adverse arbitration award can be a devastating event. If not fully covered by insurance, it can mean the end of the broker-dealer. Since the SEC’s Net Capital Rule requires that broker-dealers book the entire amount of an adverse arbitration award upon receipt, an award in excess of that firm’s net capital requires the FINOP to direct the cessation of securities business except for liquidating transactions, and even those may only be effected by customers directly with the clearing firm. In a circumstance like this, the broker-dealer will likely want to wind down the business and transfer the brokers and accounts to another firm as quickly as possible. Sometimes a broker-dealer in this circumstance will attempt to sell its assets (and in terms of customer accounts and brokers, while not technically assets, they certainly represent valuable relationships). This is called a FINRA BD asset acquisition.
FINRA has addressed scenarios such as this in NASD Notice to Members 04-10. In the Notice, FINRA (NASD at the time) points out that firms in this circumstance must file an application under Rule 1017 and must gain approval prior to effecting this type of transaction – one it calls an “Asset Transfer” or a FINRA BD asset acquisition. FINRA expressed concern about this practice because – remember FINRA’s mission is investor protection – it wants to ensure that customers who have arbitration awards against a broker-dealer are given priority in any sale or liquidation transaction. In the Notice, NASD said, “NASD has encountered several instances where the effect of a member attempting to restructure by transferring assets is to insulate the member and its owners from responsibility for payment of pending or unpaid arbitrations. In some cases, the member will transfer its assets without a corresponding transfer of its liabilities.”
In circumstances in which a broker-dealer is closing, it is possible to gain approval from FINRA, whether or not there is a payment for the assets being transferred. However, FINRA’s Rule 1017 process must be followed and FINRA satisfied that customer claims will be dealt with in as fair a manner as is possible under the circumstances. This is a critical aspect of the FINRA BD asset acquisition and is discussed more in this article about FINRA Arbitration Plans. 
Generally, this type of application is filed under Rule 1017(a)(3). The provision states that a Continuation of Membership Application, or CMA, must be filed in any instance in which there are, “direct or indirect acquisitions or transfers of 25% or more in the aggregate of the member’s assets or any asset, business or line of operations that generates revenues comprising 25% or more in the aggregate of the member’s earnings measured on a rolling 36-month basis, unless both the seller and acquirer are members of the New York Stock Exchange, Inc.”
UPDATE: See discussion of FINRA Notice 20-15 below. Note that while Rule 1017(a)(3) is still in effect, FINRA has amended its rules to require that if a member is contemplating any acquisition (even under the 25% threshold above) and the transferring member or an associated person of the transferring member has a “covered pending arbitration claim” an unpaid arbitration award or settlement, the member must file a materiality consultation prior to proceeding, again, even if under the 25% threshold that existed previously. Similarly, a member may not expand its business using the FINRA safe harbor for business expansion if that expansion includes one or more associated persons involved in sales who have a “covered pending arbitration claim” an unpaid arbitration award or settlement. Instead, it must first file a materiality consultation.
Don’t Have 180 Days for a FINRA BD Asset Acquisition CMA?
A FINRA BD asset acquisition application often is filed in urgent circumstances. Because the firm has ceased operations, the client services are limited. Firms often want to effect a mass transfer of representatives of the closed firm to a new firm. The new firm may also need to file a Rule 1017 application. Also, as is often the case in these scenarios, the broker-dealers involved will want to effect a block transfer of customer accounts using a negative consent letter. All of these scenarios require precise compliance with the numerous rules that are triggered. Further, there can be significant operational considerations. In some instances, FINRA BD asset acquisition applications can be processed in an expedited manner. There is the possibility of using the FINRA fast track membership application process.
UPDATE: On September 14, 2020, as outlined in FINRA Notice 20-15, FINRA has amended its Membership Application Program rules to create further incentives for the timely payment of arbitration awards. The existing MAP rules (FINRA Rule 1014) already required that FINRA consider whether the applicant and its associated persons have any material disciplinary actions taken against them by industry authorities, customer complaints, arbitrations, civil actions, etc. The amended rules include the following key changes:
- FINRA now requires firms to seek Materiality Consultations when engaging in certain changes involving ownership, control, or business operations, including business expansions when an unpaid arbitration award or settlement exists;
- There is a rebuttable presumption to deny a new member application that involves a pending arbitration claim against that applicant or its associated persons;
- To overcome a presumption of denial due to unpaid arbitration claims or settlements, an applicant must demonstrate its ability to satisfy the awards settlements or claims and guarantee that any funds used to evidence ability to pay will used for that purpose; and
- An applicant must notify FINRA of any arbitration claim involving the applicant or its associated persons that is filed, settled, awarded, or becomes unpaid before FINRA renders the decision on the application.
If your firm is experiencing circumstances like these, or if you desire to effect a FINRA BD asset acquisition contact a FINRA CMA expert who knows how to navigate these complex requirements in an expedited manner. Mitch Atkins, FINRA’s former Senior Vice President and Regional Director has extensive experience with the FINRA CMA process and particularly with asset transfers and broker-dealer acquisitions under Rule 1017(a)(3).
Contact Mitch Atkins, Principal, FirstMark Regulatory Solutions at 561-948-6511.
