Financial Advisor IQ (March 5, 2019) - Industry organization Finra is looking into all potential solutions to solving the long-time problem of unpaid arbitration awards.
“Everything’s on the table,” says Richard Berry, New York-based director of Finra’s Office of Dispute Resolution, which administers the self-regulator’s independent arbitration and mediation forum.
Berry says Finra is continuing to hold meetings with various stakeholder groups to come up with a solution.
“A lot of those items … would require either congressional [approval] or other participants to be involved,” Berry says. “Finra can’t do this alone.”
Several potential solutions are on the table, including a proposed bill from Sen. Elizabeth Warren (D-Mass.) that would require Finra to set up a relief fund for unpaid awards funded by fines; a proposal from Finra for a relief fund that would be funded by additional fees charged to member firms or individuals or by dipping into an existing brokerage industry fund; mandated insurance coverage for member firms; and increased net capital requirements.
Unpaid awards made up an average of 2% of the 12,306 customer cases closed from 2013 to 2017, according to Finra data.
However, when looking just at the smaller subset of cases where arbitrators awarded damages to customers, an average of around 28% of the awards were unpaid in that five-year period.
In dollar terms, $167 million out of the $653 million in customer arbitration awards were unpaid in that five-year period, or around 26% of the total.
“We have to make sure that we have a wide variety of people to help solve the problem, so we are continuing those stakeholder meetings,” Berry says. “We are fully committed to reducing the incidence of unpaid awards and judgments in the financial services industry, and we’re still working to make that reduction happen.”
Berry says Finra is also working on ways to prevent having unpaid arbitration awards. Finra believes fixing the problem at the root cause – the brokers who harm investors – would reduce the incidence of unpaid arbitration awards, according to Berry.
“We want to tackle the problem from every angle,” Berry says.
“We want to make sure that we stop those high-risk brokers, those high-risk firms from getting in the door in the first place. We want to make sure that we get them out if they are in, and that we get them out as quickly as we can,” he adds.
Last year Finra issued Regulatory Notice 18-15 to reiterate the supervisory obligations of member firms regarding associated persons with a history of past misconduct that may pose a risk to investors. Finra also issued Regulatory Notice 18-16 seeking comment on proposed rule amendments that would impose additional restrictions on member firms that employ brokers with a history of significant past misconduct.
Also last year, Finra proposed amendments to its Membership Application Program rules that aim to create more incentives for the timely payment of arbitration awards by stopping individuals from switching firms or preventing firms from using asset transfers to avoid paying arbitration awards.
The changes to the rules would authorize Finra to deny a new membership application from a firm if the applicant or its associated persons are subject to pending arbitration claims. The changes won’t let Finra deny a continuing membership application from a firm that’s already a member, but it could subject that firm to restrictions, such as not hiring more associated persons with pending unpaid arbitration awards.
Christine Lazaro, president of the Public Investors Arbitration Bar Association, has said she 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.
At an SEC Investor Advisory Committee meeting in December, 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.
“The idea of a fund … there are different ways that could happen,” Berry says. “It is very complex.”
Finra must consider the pros and cons of creating a fund for unpaid arbitration awards, as well as the potential ramifications of such a fund, according to Berry.
“As you can imagine, one of the things we heard at the stakeholder meetings is you’ve got to be careful of regulatory arbitrage,” Berry says. “In other words, if you just target the broker-dealer area, but ignore other financial services industries – like investment advisors or other parts of the financial services industry – you could have people move away from the broker-dealer model to a less-regulated model where a fund doesn’t exist.”
Finra must also think about potential unintended consequences or perceptions that could arise because of an unpaid arbitration award fund, according to Berry.
“When we had our stakeholder meetings, it was clear that people worried about some unintended consequences of some of these things,” Berry says. “You have to worry that people will think there is a conflict of interest.”
For example, if an unpaid arbitration award fund is funded using Finra fines, “people will think ‘Oh, they’re raising my fines to pay for unpaid awards,’” Berry says.
“Or there could be a perception that Finra has a vested interest in limiting awards because we may have to end up paying for them later,” he adds, stressing the complexity of the problem.