Financial Advisor IQ (December 14, 2018) – A persistent problem in the broker-dealer industry – unpaid awards in customer arbitration disputes – was a hot topic at the SEC Investor Advisory Committee meeting in Washington, D.C. Thursday.

Richard Berry, director of Finra’s Office of Dispute Resolution, said the self-regulator is fully committed to reducing unpaid awards in customer arbitration cases, but it needs the support of policymakers and other stakeholders to find a solution to this problem.

Several potential solutions are on the table, including a proposed bill from Sen. Elizabeth Warren (D-Mass.) requiring Finra to set up a relief fund for unpaid awards funded by fines; a proposal from Finra for a relief fund that’s funded by additional fees charged to member firms or individuals or to dip into an existing brokerage industry fund; mandated insurance coverage for member firms; and increased net capital requirements.

Berry said unpaid awards made up around 2% of the nearly 13,000 customer cases closed between 2012 and 2016. But when looking just at the smaller subset of cases where arbitrators awarded damages to customers, “about a third” of the awards were unpaid, he said.

SEC Commissioner Kara Stein said 27% of cases where damages were awarded were unpaid in 2016, which amounted to $14 million in unrecovered damages.

A relief fund could cost up to $120 per broker.

“Protection should mean that an investor can recover losses because of the broker’s misconduct,” said Christine Lazaro, president of the Public Investors Arbitration Bar Association. “An unpaid award is worthless to an investor who just lost his life savings.”

In cases where the broker-dealer firms shut down, “there is no hope for recovery” for the harmed investors, Lazaro said.

Berry said Finra has taken “numerous steps” to address unpaid awards, including suspending brokers and firms from the broker-dealer industry for non-payment of awards.

However, Berry said he isn’t aware of any federal provision that prevents those suspended for non-payment of arbitration awards from operating in other financial services industries.

Berry said Finra has also identified other approaches that would require rulemaking and legislation to help customers recover monetary damages. These include:

• Requiring firms to raise or maintain additional capital to cover unpaid awards or carry insurance coverage for this purpose;
• Amending the disclosure requirement regarding unpaid awards by firms;
• Including unpaid awards among the reasons for disqualifying firms or individuals from the industry;
• Preventing the use of bankruptcy as a reason for an unpaid award;
• Creating a new fund administered by Finra to cover unpaid awards; and
• Including the unpaid awards in the responsibilities of the Securities Investor Protection Corporation coverage.

Piaba’s Lazaro believes a fund administered by Finra would be the best solution because “it ensures the money is there” and under the auspices of the organization that has oversight over the broker-dealer industry.

Lazaro suggested the fund size should be based on the trailing five-year average of unpaid awards, which currently stands at “around $40 million per year.”

That would roughly translate to a relief fund charge of around $23 to $120 per broker, depending on whether the total unpaid awards in a given year are on the high or low end of the past five years’ range, she said.

But that amount could be adjusted based on Finra’s risk assessment of member firms so a firm that’s more likely to incur unpaid awards would be charged more than others, according to Lazaro.

Berry said a relief fund that’s funded by new fees “makes more sense” because “fine money is going to investor protection already.” Finra has said its fines are used for regulatory support or capital initiatives.

Robin Traxler, deputy general counsel of the Financial Services Institute, proposed a different solution, which is to ban brokers and firms from working in the financial services industry in any capacity if they don’t pay arbitration awards. FSI members are independent broker-dealer firms and independent financial advisors.

“We feel that the potential consequences to the bad actor are a truly significant deterrent to engaging in reckless or fraudulent behavior to begin with,” Traxler said.

“It directly impacts the bad actor and protects investors from working with the bad actor in another capacity. In addition, this solution does not punish honest actors by placing unnecessary costs and burdens on them,” she added.

Traxler said several of the proposed solutions – including the proposed bill from Senator Warren, mandated insurance coverage and increased net capital requirements – “each come with likely unintended consequences that will not only fail to address the issue but could in fact exacerbate it.”

Senator Warren’s bill – the Compensation for Cheated Investors Act (S. 2499) – would require Finra to establish a relief fund for unpaid awards funded by fines the self-regulator collects from errant member firms.

Traxler said FSI believes the mere existence of a relief fund would encourage bad actors to act recklessly, knowing they can defraud investors but not have to pay the consequences beyond losing their Finra registration.

The relief fund would also encourage arbitration panelists to award damages to investors whether justified or not, out of a sense of wanting to make the investor whole and knowing that the firm or financial advisor will not have to pay out of their pocket, she added.

FSI also has similar concerns about the proposed solution to require financial advisors to carry Errors & Omissions insurance to cover arbitration awards.

Any such coverage would be extremely expensive and unlikely to cover many situations that result in unpaid awards, such as outright fraud, according to Traxler.

“While the cost may seem negligible to large firms, small firms and independent financial advisors who own and operate their own businesses will certainly feel the pinch of having to obtain expensive coverage,” she said. “It is hard to make a strong case for requiring this output of money and effort because 2% of Finra arbitration claims go unpaid.”

Meanwhile, increasing net capital requirements would essentially put small firms that currently have only a $5,000 net capital requirement out of business, according to Traxler.

The SEC’s Investment Advisory Committee advises the Commission on regulatory priorities, the regulation of securities products, trading strategies, fee structures, the effectiveness of disclosure, and initiatives to protect investor interests and to promote investor confidence and the integrity of the securities marketplace.