KEY TAKEAWAYS

  • While typically there is a relatively small portion of FINRA customer cases that proceed to an award of damages, approximately one out of every four damage awards goes unpaid.
  • FINRA has proposed changes to its application and membership-review procedures in an effort to encourage payment of arbitration awards and settlements; the comment period remains open until April 9, 2018.
  • While FINRA’s proposed changes are likely more favorable to firms than the alternative proposal of a common, industry-funded “pool,” the effectiveness of FINRA’s proposals on curbing unpaid awards and settlements is unclear.

The Financial Industry Regulatory Authority, or “FINRA,” operates the country’s largest arbitration forum for investment- and securities-related disputes. FINRA typically adjudicates approximately 2,500 cases brought by customers against their firms and/or investment advisors every year.

THE PROBLEM BY THE NUMBERS

On February 8, 2018, FINRA announced that in FINRA arbitrations, more than one out of every four awards of damages goes unpaid. In 2016, for instance, there were 2,457 “customer” cases brought to a close; of those, 1,741 (71%) settled, and 158 (6%) ultimately resulted in an award of damages to the customer. Of those 158 damage awards, 44 (28%) were unpaid. So, while 44 unpaid damage awards may seem insignificant (less than 2%) in comparison to the number of cases closed, the number of unpaid awards represents a significant portion of cases proceeding through hearing and ultimately resulting in an award of damages. The figure below illustrates the statistics from 2012-2016.

FINRA reported various observations related to the unpaid damages awards, noting that approximately half of the unpaid awards resulted from FINRA’s equivalent of default judgments, when respondents fail to appear and contest the claimant’s case. Additionally, most unpaid awards were assessed against firms and associated persons who are inactive (barred, terminated, suspended from FINRA, etc.), and a sizeable number of unpaid damages awards were assessed against firms that were smaller in size.

POSSIBLE SOLUTIONS

On the same day FINRA released statistics related to unpaid arbitration awards, FINRA also issued a Regulatory Notice 18-06, in which it proposed various changes to its rules in an effort to ameliorate the unpaid awards. The comment period for the proposed changes extends until April 9, 2018. Most notably, the proposed rules would add steps to FINRA’s procedures for New Member Applications (“NMAs”) and Continuing Member Applications (“CMAs”).

Currently, when a firm wishes to register with FINRA as a new member or continue its registration with FINRA on a regular basis (or after undergoing some kind of organizational or operational change), the firm must file its NMA or CMA. FINRA reviews the application according to various factors laid out in NASD Rule 1014(a). Rule 1014(a)(3)(C) currently provides that FINRA will presumptively deny an application if the applicant has an unpaid arbitration award or an unpaid arbitration settlement against it. FINRA’s proposals would make a few marginal changes, including the following:

  1. Create a presumptive denial of NMAs by applicants with a “covered pending arbitration claim”FINRA’s proposed amendment would add a new ground to Rule 1014(a), creating a presumptive denial of new (but not continuing) member applications: the existence of a “covered pending arbitration claim.” Determining whether a pending claim is “covered” involves comparing the aggregate of all of a claimant’s requests for compensatory damages, punitive damages, pain and suffering, etc., asserted against a firm in a given case against the respondent firm’s excess net worth. If the claim’s value exceeds the firm’s excess net worth, the claim qualifies as a “covered pending arbitration claim,” and thus creates a presumption that the member’s application will be denied. To overcome the presumptive denial, a new applicant would have to show its ability to pay the pending claim, including via insurance coverage, an escrow agreement, or other mechanisms that would satisfy FINRA.
  2. Additional scrutiny for firms seeking to expand to associate with individuals with covered pending claims, unpaid arbitration awards, or unpaid arbitration settlementsIf a firm wishes to associate with an individual who is subject to a covered pending arbitration claim or has assessed against them an unpaid arbitration award or settlement, the firm will have to seek out and satisfy a “materiality consultation.” The materiality consultation is a mechanism by which firms undergoing certain changes consult with FINRA to determine whether a change is substantial enough to necessitate the filing of a CMA. Currently, materiality consultations and CMAs are not required in every instance a firm wishes to associate with an individual with a covered pending or unpaid award or settlement. Under the proposed rule, a firm would have to seek out a materiality consultation, and either satisfy the consultation such that FINRA determines a CMA is not necessary, or else go through the process of seeking approval of the CMA. In determining whether to require a CMA and grant an application, FINRA will consider the firm’s net worth and ability to supervise the prospective associated person.
  3. Additional scrutiny for firms seeking to transfer assets when the firm has covered pending claims or unpaid arbitration awards or settlementsThe proposed rule would likewise require a materiality consultation (and, if needed, CMAs) for firms seeking to transfer assets when the firm has a covered pending or unpaid award or settlement. The current rule requires a CMA only if the firm is seeking to transfer at least 25% of its assets or business operations comprising 25% of the firm’s earnings, but this allows firms to seek to evade paying arbitration awards and settlements without the scrutiny of a CMA.

REACTIONS TO THE STATISTICS AND PROPOSED RULES

Some commentators, especially attorneys who typically represent claimants in FINRA arbitrations, have advocated creating a member-funded pool for unpaid awards. Members of the industry, on the other hand, note that such an approach would tax responsible firms with the burden of covering other firms’ unpaid awards, and would likely result in passing along higher costs to customers.

FINRA’s proposed rules would likely impact only a small minority of members. For instance, FINRA noted that of the 246 NMAs covering 2015 and 2016, only 7 (less than 3%) involved firms with pending arbitration claims at the time of filing. Further, other changes would likely incur only the marginal costs of extra procedures (i.e., paying for a materiality consultation, and, if warranted, a CMA). Still, given that such a large portion of unpaid damages awards were against respondents who did not have active FINRA memberships, it remains unclear how effective the proposed changes to the NMA and CMA process would be in reducing unpaid damages awards and settlements to customers.