Financial Advisor (November 8, 2021) - Groups representing investor attorneys are throwing their support behind a proposal rule that would allow state securities regulators to expel or suspend financial professionals and their firms who don’t pay arbitration awards to the investors they defrauded.
The proposed rule from the North American Securities Regulators Association (NASAA) would give regulators the authority to punish and even take the license of any financial professional or firm that has unpaid arbitration awards or regulatory fines.
Both the Public Investors Advocate Bar Association (PIABA) and the St. John’s University School of Law Securities Arbitration Clinic wrote comment letters supporting the first-of-its-kind proposal, which NASAA President Melanie Senter Lubin said at a press conference last week the organization plans to pass by membership vote by the end of the year.
Nearly one out of four dollars awarded to investors in 2020 went unpaid, even as many brokerage firms’ profits grew to record levels, according to a report by the PIABA.
“In 2019 alone, over $19 million of awards went unpaid. This represents nearly 20% of all monetary damages awarded that year,” said Christine Lazaro, St. John’s clinic director and professor of clinical legal education.
The clinic agrees that the proposal is “significant because they create clear repercussions for investment advisors who have not paid arbitration awards” and would prevent bad actors from simply moving to the advisor world to escape enforcement, Lazaro said.
Since the Financial Industry Regulatory Authority does not have authority over advisors "states must have clear authority to discipline investment advisors who do not comply with arbitration awards,” she added.
The rule allows state regulators to consider a broker or rep’s failure to pay in connection with their investment advisor licensing. This “may help eliminate regulatory arbitrage as Finra-regulated individuals shift to the advisory side of the industry,” Lazaro said.
“This is critical since investment advisors would no longer be incentivized to leave a brokerage firm because they have unpaid arbitration awards against them and transition to an RIA with a new title and clean slate,” said Lazaro, who said the rules should be tightened up to ensure they apply to registered investment advisor firms and that they have to disclose such awards to state regulators and investors.
Lazaro said that while the rule is a “noble effort” and would stop bad brokers and reps from committing further crimes, a fund to pay existing defrauded investors who won in arbitration and can’t collect should be established.
PIABA President Michael Edmiston said the trade group for plaintiff attorneys supports the proposed rules “because they would allow the state regulators to suspend or expel a financial professional or firm if they fail to pay an arbitration award or otherwise attempt to avoid payment of any client or customer-initiated arbitration.”
The PIABA has called for the establishment of a fund to pay stiffed investors twice before. “While the proposed rules are undoubtedly a positive step and important tool for regulators, PIABA repeats its longstanding call to NASAA and the securities industry to institute an Investor Recovery Fund: The most effective solution to address the serious unpaid arbitration issue,” Edmiston said.
While the rules may incentivize brokers and reps to carry errors and omissions insurance, the best protection for investor recovery is the establishment of a fund, he argued. Schwab instituted an E&O policy requirement on its 13,000 advisors, but only Oregon requires firms and advisors to carry such insurance, which is imperfect at best, Edmiston said.
While insurance will typically address standard negligence claims, PIABA members have found that policies are rife with exemptions for a variety of things common in securities disputes. For example, particular novel products, options, private placements, insurance products and fraud claims can be excluded from insurance coverage, he said.
E&O policy design can also be problematic, allowing defense counsel to be paid first and in full while the investor who wins their claim will not be paid, he added. “A repeat bad actor may quickly deplete a million-dollar coverage policy within a coverage period. ... While insurance coverage is desirable, its inherent limitations can lead to an uneven administration of justice and further undermine investors’ confidence in dispute resolution and the securities industry at large."