Two years ago, when it was just an ugly rule proposal, I blogged about FINRA’s intent to modify its MAP rules to “Incentivize Payment of Arbitration Awards.” Sadly, FINRA once again showed it spinelessness by pushing these rule amendments through, ignoring the concerns of its own member firms. They are now not just rule proposals, but actual rules that become effective in September. It is worth revisiting this transparent display by FINRA to curry favor with PIABA.
The new rules are outlined in Reg Notice 20-15. I will review each of the principal components.
The first one is a little weird. As you are likely aware, the MAP rules spell out pretty specifically when a BD must file a CMA to seek permission from FINRA to effect a “material change” in its business. If a change is not material, then the firm can simply plow forward, without the need for the CMA. Well, the new rule changes that. According to the amendments, even when a firm is NOT required to file a CMA, it nevertheless cannot proceed to add RRs if one or more of them has a “‘covered pending arbitration claim,’ an unpaid arbitration award or an unpaid settlement related to an arbitration” without first “seek[ing] a materiality consultation for the contemplated business expansion.” That is super interesting, especially since on the very same page of the Reg Notice, FINRA states that the “materiality consultation process is voluntary.” As Inspector Clouseau famously said about the priceless Steinway piano he wrecked, not anymore. Under this circumstance, at least, now MatCons are mandatory.
Putting aside that odd development, in my earlier blog I questioned why an individual RR’s arbitration, whether pending or concluded, should become the BD’s problem. I know from my publisher that FINRA reads this blog, so perhaps that’s why it attempted to address that concern in the Reg Notice. Unfortunately, FINRA’s reasoning is pretty flimsy and, frankly, a bit of a subterfuge. Basically, what FINRA says boils down to this: if a BD is allowed to add RRs with “substantial pending arbitration claims” without having to undertake a MatCon and potentially file a CMA, it would “allow a member to, for example, hire principals and registered representatives without giving consideration to how the firm will supervise such individual or the potential financial impact on the firm if the individual, while employed at the hiring firm, engages in additional potential misconduct that results in a customer arbitration involving the firm.” Holy cow! Are there enough what-ifs built into this analysis?
Worse, this flimsy attempt to justify the new requirement by citing supposed supervisory concerns absolutely ignores the true underlying reason for the amendments, which is all about money, to pacify PIABA and its complaint that arbitration awards sometimes do not get paid. The simple fact is that there are other FINRA rules that already dictate the diligence that a BD must conduct when it wants to hire someone, and that diligence most certainly includes a close look at pending and concluded customer arbitrations. It is bothersome that FINRA has conjured up this bogus excuse for the rule amendment, a supposed supervisory issue, rather than simply admitting its true goal of discouraging firms from hiring RRs with disclosed customer arbitrations.
The second component of the new rule also changes the existing CMA framework. Under the current rule, a firm is only required to file a CMA if it transfers 25% percent or more of its assets or line of operation that generates revenues composing 25% percent or more of its earnings. Transfers of less than 25% do not require FINRA approval. Again, not anymore. The new rule requires that any such transfer, no matter how insignificant, go through the MatCon process “where the transferring member or an associated person of the transferring member has a ‘covered pending arbitration claim,’ an unpaid arbitration award or an unpaid settlement related to an arbitration.”
You know, perhaps I could get behind this if we were to restrict the analysis only to unpaid awards or settlements. But FINRA doesn’t stop there. It includes pending claims. That is, claims that are unadjudicated, claims in which the respondent is presumed innocent, claims in which the complaining customer has the burden of proof, claims that history teaches are too often specious. This is not just ridiculous, it runs counter to existing authority that allows member firms not to take financial cognizance of frivolous claims.
What do I mean by that? Well, the new rule describes what it takes to overcome the rebuttable presumption that being involved in a customer arbitration precludes a firm from filing a successful CMA, or new firm from getting approved, and, in short, in FINRA’s eyes, it’s all about the Benjamins. If you have enough money, maybe you’re ok. But that is clearly NOT how the SEC looks at customer claims. In a 1988 letter to the NASD, the SEC – the owner of the net capital rule, mind you – offered this guidance regarding what a BD must do from a net cap standpoint when it is sued (but which is also applicable when a BD is named as a respondent in an arbitration):
A broker-dealer that is the subject of a lawsuit that could have a material impact on its net capital must obtain an opinion of outside counsel regarding the potential effect of such a suit on the firm’s financial condition. Absent such opinion, the item must be considered, at a minimum, a contingent liability, and be included in the calculation of aggregate indebtedness that is required by SEA Rule 15c3-1(c)(1).
As you can see, if a customer claim is so bogus that a lawyer is willing to opine that the claim lacks merit, the SEC doesn’t require the claim to be cranked into the net capital computation, even as a contingent liability. But here, under the new MAP rules, FINRA is saying something very different. FINRA is saying that regardless of the merits (or lack thereof) of a customer arbitration, a firm that wants to transfer even a tiny percentage of its assets is first required to demonstrate to FINRA that it has the financial wherewithal to satisfy an adverse award, no matter how ridiculously unlikely that outcome may be. That is, simply, wrong.
But first, what does FINRA take into consideration when it comes to the ability to satisfy an award? Under new IM-1014-1, that financial wherewithal includes “an escrow agreement, insurance coverage, a clearing deposit, a guarantee, a reserve fund or the retention of proceeds from an asset transfer.” But, the IM goes even further, stating that “[t]o overcome the presumption to deny the application, the Applicant must guarantee that any funds used to evidence the Applicant’s ability to satisfy any awards, settlements or claims will be used for that purpose.” So, not enough just to show FINRA you’ve got the money; you’ve got to “guarantee” that you won’t spend it on anything else but the satisfaction of an adverse award, no matter how long it may take for the arbitration to play out. That could be a long time to keep funds tied up just to make FINRA happy.
Interestingly, FINRA does state in that same accompanying IM to the new rule that in connection with the effort to prove to FINRA you’ve got the money to pay an adverse award, you “may provide a written opinion of an independent, reputable U.S. licensed counsel knowledgeable as to the value of such arbitration claims.” Sort of sounds like the SEC interpretation, but it is actually very different. In the SEC interpretation, the opinion of counsel on the merits of the claim alone, without any accompanying financial disclosures, establishes that there is no net capital impact. In this new FINRA rule, however, the opinion of counsel is not, by itself, dispositive as to anything, as the application still requires the financial showing. So what purpose, then, does the opinion have, if the merits of the claim are irrelevant to FINRA? I really can’t tell. Also worth thinking about: who is going to be the arbiter of whether the attorney who offers the opinion is “independent,” “reputable,” and “knowledgeable?” Presumably that is, um, FINRA, right? As always in these things, FINRA is judge, jury and executioner. And what does FINRA mean by “independent?” If I am hired by a BD to defend an arbitration, am I independent? Or does this mean, because I am already the advocate for the BD, that the firm must engage a second counsel, to provide the optional opinion?
There is a lot going on with these rule amendments, and none of it good for BDs. All so FINRA can tell Congress, and PIABA, of course, how hard it is working to help make sure customers can collect their arbitration awards, no matter the cost to its own member firms.
 Consider this: the definition of a “covered arbitration claim” is “[a]n investment-related, consumer initiated claim filed against the Associated Person in any arbitration forum that is unresolved; and whose claim amount (individually or, if there is more than one claim, in the aggregate) exceeds the hiring member’s excess net capital.” What does the hiring BD’s net capital have to do with anything? The BD is not named in the arbitration, and is not even potentially responsible to pay the award if the claimant manages to prevail. So what difference could it possibly make if the claim exceeds the firm’s net capital?