Shortly, I hope to get around to drafting a blog post about FINRA’s latest demonstration of abasement to PIABA and claimants’ counsel everywhere, namely new Rule 4111. But, that rule is such a monstrosity that it will take a little time to parse, and a lot of work to get the post shorter than ten pages.  Plus, my eyes roll so much every time I read the rule that I get dizzy and can’t type very well, which makes it hard to see the keyboard. For now, just enjoy the clever title of the piece-to-come: The 411 On Rule 4111.

With that said, there IS ample time today to discuss one of the central tenets of FINRA’s shiny new rule: do everything possible to ensure that any customer who files an arbitration – and, of course, the lawyer representing that customer on a contingency basis – gets paid. And note that I have chosen my words here quite carefully. I deliberately did not say “any customer who files an arbitration and then takes the case to a hearing and wins.” Nor did I say “any customer who files an arbitration and then enters into a settlement agreement that calls for installment payments over a period of time.” No, I said any customer who simply files an arbitration. Period. Regardless of the merits. For the simple fact is that FINRA – not Dispute Resolution, which, to its credit, doesn’t care who wins or loses, as long as the process is fair, but, rather, Member Supervision – will not rest until it is able to show the SEC, and, likely, Congress, all the things it is doing to address arbitration awards that do not get paid because the firm just goes out of business.

Let’s just take a minute here to discuss something important, yet widely overlooked: the size of the universe of cases at issue. From the amount of attention that FINRA devotes to the subject (which is only slightly less than PIABA), one would think that unpaid arbitration awards are rampant, affecting huge numbers of complaining customers. Not surprisingly, the actual number is really quite modest, by anyone’s definition. This is evident from FINRA’s own statistics, published here. According to the most recent data, from calendar year 2020, there were 2,145 arbitration cases closed in total that year. Of that total, 193 were closed as a result of an award following an evidentiary hearing. (As everyone knows, the overwhelming majority of arbitrations are closed due to settlement.) Of those 193, only 62 resulted in damages being awarded to the claimant. And, of those 62, only 23 had damages that were not paid. Of course, that is not particularly surprising when you consider that of those 23 cases, 17 of them were not even contested by the respondent(s). And what is the principal reason a firm would not contest an arbitration? Because it is inactive, and has no money to pay for a defense, let alone pay the award.[1]

So, when you get to the bottom of things, you can see that there were a whopping six cases in 2020 where a respondent actually appeared and defended itself in an arbitration, lost, and then failed to pay the award. Not exactly the mountain of cases that FINRA, or PIABA, make it out to be.

Yet, as I said, FINRA sure acts like this is a massive problem. And it makes no effort to keep secret its efforts to address it. In Reg Notice 21-34, which attempts to describe how Rule 4111 works and why FINRA created it, FINRA flat out admits that a primary motivation for the rule is unpaid arbitration awards: “An added benefit of Rule 4111” – and let’s stop right there to insert sarcastic laughter, as that certainly suggests that there are any benefits to the rule – “will be important ancillary effects in addressing unpaid arbitration awards.” If that was all there was to it, it would be bad enough. I mean, as FINRA’s statistics amply demonstrate, the supposed issue concerning unpaid arbitration awards doesn’t amount to much. Six cases, big whoop.

But, sadly, that is NOT all there is to it. FINRA’s fixation goes beyond simply “addressing unpaid arbitration awards.” No, FINRA not only wants the customers in those six cases to get paid, it wants any customer who files an arbitration to get paid. As I said above, regardless of the merits, regardless of the facts, regardless of, well, anything besides the mere fact that the Statement of Claim was filed.

Here’s what I’m talking about. Consider that one factor in FINRA’s convoluted process of deciding under Rule 4111 whether a BD should be characterized as a “Restricted Firm,” i.e., one that may have to pay a big, fat deposit just for the privilege of remaining a member, is not just unpaid arbitration awards – which should result in a firm’s being summarily suspended anyway – but, as well, “Covered Pending Arbitration Claims.”

Under Rule 4111, a “Covered Pending Arbitration Claim” is an “investment-related, consumer initiated claim filed against the member or its associated persons 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 member’s excess net capital.” The emphasis on “unresolved” is mine, to highlight the fact that FINRA is so focused on the six unpaid arbitration awards following contested hearings in 2020 that it is willing to make broker-dealers make huge deposits to address unadjudicated claims, i.e., claims that are pending and unresolved, which are altogether different than claims that have resulted in an award. That is really staggering, as it demonstrates that FINRA has completely lost sight of some basic, but important things.

Principally, FINRA appears to have forgotten (or maybe it just doesn’t care) that in arbitration, as in court, it is the claimant who bears the burden of proof. Respondents in arbitrations, like defendants in court, are presumed to be innocent. It is up to the claimant to prove otherwise. And, frankly (and statistically), claimants aren’t very good at that. As noted above, FINRA Dispute Resolution’s 2020 statistics reveal that claimants only win 32% of the time they go to hearing. Over two-thirds of the time they go to hearing, their claims are dismissed and they recover nothing. And that’s not because respondents’ counsel are such geniuses; it’s because a lot of these claims are silly and baseless. Indeed, on occasion, a hearing panel is willing to call out a claimant (and/or claimant’s counsel) for bringing a meritless claim by awarding attorneys’ fees to the prevailing respondent.[2] FINRA, however, disregards all of this. As far as FINRA appears to be concerned, if a claimant simply files an arbitration Statement of Claim, it is presumptively valid, not the other way around, as the law and due process demand. And that is not just troubling, it’s frightening.

The same phenomenon manifests itself in connection with CMAs. Reg Notice 20-15 is all about changes FINRA made to its Membership Application Program, or MAP, rules in 2020. As with the promulgation of Rule 4111, FINRA represented that these edits were designed to reflect FINRA’s “effort to help further address the issue of customer recovery of unpaid arbitration awards.” But, just like Rule 4111, FINRA did not stop at unpaid arbitration awards. Just like Rule 4111, FINRA also baked into MAP’s consideration of a CMA a review of – you guessed it – “Covered Pending Arbitration Claims.” Indeed, it appears that Rule 4111 borrowed the definition for that awkward term from Rule 1011(c)(2), which reads the same as Rule 4111: “[a]n investment-related, consumer initiated claim filed against the transferring member or its Associated Persons in any arbitration forum that is unresolved.”

So, what this means is this, according to Reg Notice 20-15: “FINRA is concerned about prospective applicants for new membership hiring principals and registered persons with pending arbitration claims without having to demonstrate how those claims will be paid if they go to award or result in a settlement.” In other words, if you want to hire someone with a pending arbitration, you are required to show FINRA that you have the money to pay that claim IF it goes to hearing and claimant beats the odds and wins, or IF the case settles. Irrespective of its merits, irrespective of the facts, irrespective of the fact that it is the claimant’s burden of proof, irrespective of FINRA’s own statistics that show most arbitrations are without merit. And how much money will you need to show FINRA you’ve got? Well, that’s anyone’s guess, as it is entirely up to FINRA, which doesn’t publish a formula. Basically, it boils down to the more money, the better, and unless you can show you have enough money to pay 100% of the amount demanded in the Statement of Claim – despite the fact such figures are often grossly inflated – FINRA may very well conclude it’s not enough.

In sum, then, in its zeal to appease PIABA, and maybe Congress, by showing all the clever steps it is taking to address unpaid arbitration awards, FINRA has gone waaaay further than it needed to go by legislating language into at least two rules that it has the right to hold against member firms the mere existence of pending arbitrations. Ironically, even though the SEC approved the rules, this is well beyond anything the SEC itself does itself. Just consider the net capital rule, perhaps the granddaddy of customer protection rules. Remember that the net capital rule is an SEC rule, not a FINRA rule. In an interpretation that’s been around for over 30 years, the SEC has stated that a broker-dealer need not book even a contingent liability in its net capital computation to account for a pending lawsuit – and this reasoning has been extended to cover arbitrations – if it obtains an “opinion of outside counsel regarding the potential effect of such a suit on the firm’s financial condition.” In other words, from a net capital perspective, unlike FINRA, the SEC cares a lot about the merits, or lack of merits, of an arbitration. If a claim is so void of a factual or legal basis that a lawyer is willing to offer an opinion on that subject, the SEC says the amount of that claim need not be accounted for in the net capital computation. And if it’s not necessary to include it in the net capital computation, then, logically, there are no customer protection issues implicated.

As explained above (at length, sorry), FINRA has taken the opposite tack. In FINRA’s world, even utterly baseless claims have to be accounted for; for FINRA, all that matters is that they’re pending. That is not how this system is supposed to work.

[1] To its further credit, FINRA Dispute Resolution understands the problems a claimant faces when arbitrating against an inactive firm, but correctly notes that such claimants are fully advised by Dispute Resolution of the situation, and are given the chance to do something else, like go to court. When they don’t, and continue to pursue the arbitration and end up with a worthless award, well, that’s pretty much on them. As FINRA puts it, “FINRA also informs the customer that awards against such firms or associated persons have a much higher incidence of non-payment and that FINRA has limited disciplinary authority over inactive firms or associated persons that fail to pay arbitration awards. Thus, the customer knows before pursuing the claim in arbitration that collection of an award may be more difficult. . . . Accordingly, claims against inactive firms and brokers proceed in arbitration only at the customer’s option.

[2] You want proof? Look at this award we obtained a month or two ago on behalf of a BD client. While Claimant ultimately dismissed his case voluntarily (presumably for the lack of supporting evidence), that only came after we pressured him to do so. In recognition of that, the arbitrator granted my client’s motion for its attorneys’ fees “as sanctions for . . . [claimant] continuing to pursue the claim after it was apparent there were no reasonable grounds for doing so.”

Not too long ago, I wrote a piece complaining about (among other things) the fact that the potential arbitrators that FINRA rolled out to the parties in a particular arbitration I was handling skewed juuuuuuust a bit towards the older end of the age spectrum; indeed, the average age of the ten potential chairpersons was 75.3 (and seven of the ten were, in fact, 75 or older).  I have nothing against these guys, or any old person.  My point was simply that when it comes to diversity, FINRA arbitration panels are conspicuously old, white, and male.

Anyway…as I was catching up on recent FINRA publications, I ran across Reg Notice 22-09, “FINRA Requests Comment on a Proposed Rule to Accelerate Arbitration Proceedings for Seriously Ill or Elderly Parties.”  As the title suggests, FINRA is considering conjuring up some new procedural rules to increase the likelihood that an elderly or infirm claimant can “participate meaningfully in a FINRA arbitration” by shortening a bunch of the deadlines, theoretically resulting in a final evidentiary hearing that happens sooner than under the current rules.

Putting aside the questions whether this is a good or bad idea, I simply cannot help but relish the irony in the juxtaposition of my recent blog post and some of things that FINRA says in this Reg Notice about old people.

According to FINRA’s proposal, any claimant who is 75 or older can take advantage of the expedited procedures.  While FINRA takes great pains not simply to declare that anyone who’s 75 is necessarily at death’s doorstep, it is quite clear that FINRA does have grave concerns about these septuagenarians.  Citing published mortality tables, FINRA posits that “[p]arties who are 75 or older are significantly more likely to become unable to participate in a hearing after a claim is filed than those who are 65 or older, as demonstrated by published rates of adverse health conditions and mortality.”  In other words, once you hit 75, given your “relatively higher average mortality rates,” you have a statistically greater chance of not living long enough, or not staying cogent enough, from the day you file your Statement of Claim through the hearing to be able to participate in it.  Morbid stuff, to be sure.

So, you can see where I’m going with this.  If FINRA is so concerned about the ability of claimants who are 75 and older to participate in the hearing, I can’t help but wonder why FINRA apparently has zero qualms about populating its arbitration panels with candidates with the exact same demographics.  I mean, it simply has to cut both ways, right?  If hitting 75 means, statistically speaking, that you’ve entered some strange and dangerous territory that renders into question your ability to keep your wits about you, not to mention simply surviving the rigors of being cross-examined by smart ass lawyers like me, then logic dictates that the same concerns apply to arbitrators, no?  Seems to me that FINRA cannot have it both ways.  It should, therefore, take a hard look at its roster of arbitrators to figure out who is still up to the task of handling an arbitration hearing.

FINRA recently published a “Discussion Paper” on expungement of customer dispute information in which it outlines its plans going forward on revising the expungement process.  Expungement_Discussion_Paper.pdf ( (Let me just start by applauding FINRA for trying hard to get this right.  The current patchwork of expungement rules and guidance could use some improvements, and there are no easy answers – although I’ll provide some ideas at the end of this post.)

The upshot of the Discussion Paper is that FINRA is contemplating dual paths: (1) in the short term, revising and resubmitting some of its proposed rule changes that it withdrew from the SEC’s consideration back in May 2021, and (2) in the long term, creating an administrative process where FINRA or state regulators make expungement decisions, which would replace the current system of seeking expungement in arbitration.  Let’s discuss.

As some of you may recall, FINRA published many proposed changes to the expungement process in Reg Notice 17-42, all the way back in 2017.  After several rounds of comments, FINRA submitted those changes to the SEC, only to withdraw them in May 2021.  That withdrawal occurred after PIABA (a trade group that works to protect investors) released a study and commentary where it argued expungement is granted too frequently and the proposed rule changes wouldn’t do enough to fix the system.  The SEC also apparently had some concerns about at least one part of the proposed changes – the Special Roster Proposal.  The Special Roster Proposal is exactly what it sounds like – a proposal to appoint arbitrators in expungement cases from a “special roster” of arbitrators who have been specifically trained by FINRA to handle expungement hearings.

The SEC’s concerns about the Special Roster Proposal haven’t been publicly discussed – yet.  We will know soon enough because the Discussion Paper states that FINRA intends to continue pursuing approval of the Special Roster Proposal in some modified format that addresses the SEC’s concerns.

Let me just do a little speculating here as to what I think one concern might be: the Special Roster Proposal may result in appointing arbitrators who do not appear neutral.  Traditionally, arbitrators are neutral triers of fact, just like judges and juries.  The idea that arbitrators are supposed to be neutral is so fundamental to the arbitration process that one of the few bases for vacating an arbitration award is if an arbitrator demonstrated “evident partiality.” 9 U.S.C. § 10.  The Special Roster Proposal included enhanced expungement training for the arbitrators on the roster regarding how to handle an expungement case and the actions they should take to ensure the customer’s side of the story is told, even if the customer does not participate.

This stems from FINRA attempting to correct the problem that most customers do not show up to participate in expungement hearings, so arbitrators might hear only one side of the story.  The Special Roster Proposal would specifically authorize these specially trained expungement arbitrators to request documentary, testimonial, and other evidence they deem relevant to the deciding the claim.  It almost deputizes the arbitrators to act as representatives of the customers.

When you combine these three aspects of the Special Roster Proposal (enhanced training from FINRA plus appointment by FINRA plus authorization to investigate evidence that might rebut the expungement request), you can start to see how an argument could be made that these arbitrators might be less than neutral.  That could set up a decent argument to vacate any expungement request that gets denied.

I believe this concern that the Special Roster Proposal might destroy arbitrators’ appearance of impartiality is precisely the reason that FINRA is now suggesting it may attempt to create a new “administrative process” where FINRA and or state regulators decide expungement requests, rather than arbitrators.  The Discussion Paper acknowledges that redesigning the expungement process altogether will take substantial time, but it is now something it is seriously considering as a way to fix “problems” with the current process.  The main “problem,” of course, is that FINRA believes too many expungements are being filed and are being granted by arbitrators who are not seeing both sides of the story because customers chose not to participate in expungement hearings.

But will designing some kind of administrative proceeding where FINRA or the state regulators decide what to expunge really going to solve that problem?  It may make it more difficult for registered reps to obtain expungement, but it won’t do anything to encourage customers to participate in the hearings.  It also seems a little circular to have FINRA / state regulators deciding what must be disclosed in the first place, and then having those same institutions deciding what may be expunged.  One winner in this situation might be broker-dealers who are often named in expungement arbitrations – and assessed large processing fees – even though they are not being accused of doing anything wrong and may choose not even to participate in the hearing.  I’m sure they would be happy to be removed from the expungement process altogether since they are required to report customer complaints regardless of their accuracy or merit.

To be clear, the Discussion Paper states that this is just the beginning of the discussion on these issues, and FINRA invites a dialogue on many questions it raises in the Discussion Paper.  Here are some of my own ideas about revising the expungement process that may be more impactful than simply creating a special “administrative proceeding” or using specialized arbitrators to hear expungement cases.

  • Reduce the number of items being disclosed. This is not as controversial as it sounds. Just hear me out.  Footnote 1 of the Discussion Paper acknowledges that FINRA makes public more information about its registered reps than is available for insurance agents, bankers, doctors, lawyers, and accountants.  If regulators are concerned about the number of expungements taking place, we need to examine WHY they are happening.  This is a situation where we know the egg definitely came before the chicken.  What do I mean? The Discussion Paper acknowledges that changes in 2009 to a registered reps’ U4/U5 reporting requirements led to an increase in number of customer disputes being reported – and in a number of expungements being sought.  The Discussion Paper also acknowledges that broker-dealers must report customer complaints even if they believe the allegations are “untrue, inaccurate or malicious.”  That’s sort of the problem.  If the goal of the CRD/BrokerCheck system is to maintain a record of “accurate” and “meaningful” information, as the Discussion Paper suggests, it seems contrary to that goal to require every little complaint to be disclosed, regardless of merit, and then sort it out later.  Even if a completely erroneous complaint is expunged, it is still likely to remain on the broker’s BrokerCheck for the 9 to 12 months it takes to go through the expungement hearing and confirm it in court.  That means the current system is perpetuating the publication of erroneous or inaccurate information until it can be expunged. That seems contrary to the goal of true and accurate reporting.

Instead of shooting first and asking questions later, maybe it should be the other way around.  What if the rules simply worked like this:

  • If an FC/BD loses an arbitration, it is reported.
  • If an FC/BD wins an arbitration, it is not reported. They’ve already had a trier of fact decide the claim was meritless, so why require an additional expungement hearing? This change may have the benefit of encouraging FCs/BDs to go to a hearing more often.
  • If a customer withdraws a complaint without receiving compensation, it is not reported.
  • If a customer complains (but does not file an arbitration or lawsuit), and the BD denies the complaint, it is not reported.
  • If an FC/BD settles a complaint, it is NOT reported unless it is (a) over a certain dollar amount, AND (b) a regulator takes some action with regard to the complaint. This one is obviously where the bulk of complaints fall.  Currently, settled complaints must be reported if they are over a certain dollar amount.  But just because a complaint is settled does not mean it had merit.  Cases often settle because it is simply cheaper than funding litigation.  Settlement by itself shouldn’t warrant a disclosure.  Instead, maybe a settled complaint should only be reported if a regulator takes some formal action.  FCs/BDs often receive exam inquiries from FINRA or other regulators after they get wind of a customer complaint.  The regulators then gather info and decide if they want to take action.  This is already occurring.  Regulators are already assessing these customer complaints.  If they decide to take further action by filing a Complaint or seeking a settlement with the FC/BD, then it should be reported.  But if a regulator looks at a customer complaint that has settled and decides not to take any action, perhaps that suggests the complaint had no merit and should not be reported.  The benefit of this method, from FINRA’s view, is that FINRA would ultimately be the one holding the keys to the castle – which seems to be what it wants.  Instead of having FINRA decide what disclosures should be removed in an expungement administrative hearing, why not have FINRA decide which complaints should be disclosed in the first place, based on their examination findings?  After all, if FINRA examiners decide the complaint doesn’t warrant any formal action, is it really something the public needs to know about?
  • Give customers a financial incentive to participate in expungements. It seems that the biggest issue FINRA is trying to tackle with current expungement arbitrations is that the complaining customers do not participate, so the arbitrators only hear one side of the story.  But customers have no incentive to participate.  Occasionally, those who are truly disgruntled write an angry letter or show up to testify against the expungement.  But that is rare. If customers had an incentive for participating, they might be more apt to do so. The best incentive is cold hard cash. Again, hear me out.  I’m not talking about paying someone to give favorable testimony (although if that seems offensive to you, you should know it happens every day with expert witnesses).  I am talking about telling customers who have already filed an arbitration and already paid a filing fee, “I know your case settled, but the broker is seeking expungement, so if you would tell your side of the story at the expungement hearing, we will give you back $____ of your filing fee.”  In small cases, the filing fees are pretty low – as low as $50. But most claims of any decent size have a filing fee of $1,000 or more.  Part of it could be set aside for this purpose. Or, FINRA could just tack on a refundable expungement fee when the customer files the arbitration.  Let’s say it’s an additional $1,000 fee.  If the customer settles, maybe give the broker six months to seek expungement.  If the broker doesn’t seek expungement, the customer gets the expungement fee back.  If the broker does seek expungement, the customer only gets the fee back if he/she submits a written statement or testifies at the expungement hearing.  This could be implemented in the current arbitration expungement process or in a new administrative proceeding process that FINRA designs.  This doesn’t work so well when the disclosure is simply a complaint that does not result in filing an arbitration or lawsuit.  But should that really be disclosable anyway?



Thanks to Chris for not only making the personal sacrifice of traveling from frigid Chicago to sunny Florida to attend the SIFMA Compliance and Legal conference last week, but for providing these helpful comments about the sessions he attended. – Alan


I attended the four-day SIFMA Compliance and Legal seminar last week, and there were a bunch of interesting soundbites from regulators that folks might find interesting.  The challenge at these conferences is always separating the chaff from the wheat.  There’s still plenty of responses that begin by stating, “Without going into the details on that,” and “That will be addressed more by the next panel.”  And, as is tradition, they saved some of the best panels for the last day.  By that time, some common themes were emerging across many of the panels.  Here’s a recap of some of the highlights.

Regulation Best Interest.  Every time a question on this topic was addressed to a FINRA staff member, it was met with the same tepid response: “that’s the SEC’s rule, and we are going to let them run with it.  If people have questions about it, we can help you engage in a dialogue with the SEC to get some clarity.  But it’s their rule.”  Every. Single. Time.  If there isn’t an internal memo floating around that talks about how to answer Reg BI questions, I would be shocked.  You can’t help but sympathize with FINRA a little.  Suitability was one of FINRA’s bread and butter concepts for decades.  They were the go-to source for suitability questions – including numerous rule revisions, Reg Notices, and FAQs.  Now that Reg BI has all but taken over, it makes sense that FINRA wants to give the SEC its space to call the shots on interpreting Reg BI.  The problem, however, is that FINRA still needs to enforce the rule, don’t they? One of the more entertaining – and candid, in a good way – FINRA staff members who spoke at a breakout session actually said, “we are not leading the charge on this with enforcement cases.” I was so shocked I wrote it down verbatim.  FINRA is certainly taking a look at Reg BI and Form CRS issues in their exams. They also have created guidance like the Reg BI checklist.  So, while FINRA might not be leading the charge, they are certainly following close behind.  SEC Commissioner Pierce, on the other hand, fully acknowledged that Reg BI will be shaped by how the SEC chooses to enforce it.

Bringing brokers back to the industry.  A few folks from FINRA mentioned they were pleased that Reg Notice 21-41 extended the time period – from two years to five years – for inactive advisors to rejoin the industry without having to retake exams.  FINRA President/CEO Robert Cook mentioned that he hoped this would help bring people back to the industry who may have left due to “life events.”  Mr. Cook really seemed excited about the change, at one point reminding the audience that advisors who are already out of the industry can still take advantage of the change, but they just need to “opt in.”  It is no secret that FINRA’s members have been declining for years.  We’ve blogged about it.  In fact, one of the other panels at the seminar also acknowledged that many advisors have been leaving the broker-dealer side of business that is under FINRA’s jurisdiction and moving to the registered investment advisor side regulated by the states and the SEC.  Perhaps FINRA has decided that it would benefit investors if they have more advisors to choose from.

CCO Liability.  This topic arose a few times because of the recent Reg Notice 22-10 that assures CCOs that “FINRA will not bring an action against a CCO under Rule 3110 for failure to supervise except when the firm conferred upon the CCO supervisory responsibilities and the CCO then failed to discharge those responsibilities in a reasonable manner.”  FINRA CEO Robert Cook acknowledged compliance personnel have a tough role, but hoped that the new Reg Notice would “give them comfort” because there is lots of room within the rules to operate safely.  Jessica Hopper, Executive Vice President and Head of Enforcement at FINRA, directly addressed the compliance personnel in the room by saying “we heard you,” and she reassured them that “it is not open season on CCOs.”  According to Ms. Hopper, most CCO liability cases are ones where the CCO is “dual-hatted” as CCO and either CEO, branch manager, or has been assigned some specific supervisory responsibility.  She also reminded folks that the standards at issue in these types of cases are ones of “reasonableness,” not perfection.  She did, however, point out that BDs should not try to use Reg Notice 22-10 as a shield to hide behind by calling something “compliance” rather than “supervision.”  Fair enough.

Crypto.  A lot was said about crypto at the conference, too much to go into detail here (to quote many of the SIFMA speakers).  Some of the more interesting comments came from SEC Commissioner Hester Peirce (who, it should be mentioned, is a republican appointee operating under a democratically appointed Chair).  She suggested the SEC hasn’t gone about this the right way by pursuing enforcement actions before they fully understand the technology.  She is in favor of slowing down and thinking about how calling something a security might impact it later down the line.  She even suggested allowing small scale experimentation with various rules and regulations might help “figure it out” now before crypto gets even bigger.  In fact, slowing down was a theme of her entire session.  For instance, she reiterated her disagreement with the SEC’s new policy that reduces the comment period for new rule proposals from 60 days to 30.  In her view, she would rather have a more robust and careful dialogue regarding a rule proposal, rather than acting too quickly.  Other speakers indicated that many broker-dealers are currently hesitant to sell crypto because they fear they will be accused of a Section V violation for selling unregistered securities.  So what do they do? Set up an affiliate entity to sell crypto instead. Hmmmm.

SEC sanctions / admissions.  The head of the SEC’s Division of Enforcement, Gurbir Grewal, provided some useful insight into the calculation of sanctions and the use of admissions with settling defendants.  Mr. Grewal indicated that most settlements will still use language that the defendant neither admits nor denies the allegations.  But, he warned that when the SEC does seek admissions in a settlement, they are signaling that they are willing to litigate that case to the end.  He basically said, “when we put admissions on the table, we won’t take them off.”  Melanie Lubin, the President of NASAA, added that admissions are beneficial to help customers recover their losses in civil litigation.  That’s an important point to keep in mind – an admission in a settlement with a regulator may start a feeding frenzy among plaintiffs’ lawyers who use the admission to find investors and convince them they have personally been harmed.  Both Mr. Grewal and Ms. Lubin shared another tip with regards to sanctions: when a defendant brings them a list of “comparable” cases that settled in order to try to negotiate a similar sanction, that often backfires.  Why? Because when a defendant shows them a list of other cases with lesser sanctions, that can indicate to the regulators that those lesser punishments are not having the desired deterrent effect, so they may need to ratchet up the sanctions to send a message.  Yikes!

Use of Personal Communication Devices.  Several panels briefly touched on the topic of advisors using personal communication devices (i.e., cell phones, text messages) to communicate with clients.  The message on this issue was pretty clear: the same old rules apply regarding communications with the public, supervision, and books/records (2210, 3110, 4511).  But BDs must apply those rules to current behaviors and technology.  (Specific guidance exists on these issues as well: Reg Notice 17-18, 11-39).  Folks from FINRA and the SEC explained that most firms have policies regarding the use of personal devices to communicate with customers, but the problem is they fail to adequately implement those policies.  And the policies may need to be updated for current real world behavior.  The current sentiment is that having a policy stating you prohibit use of personal devises (and since you have banned personal devices, you don’t need to supervise them) is inadequate in 2022.  Everyone is going to use a personal device from time to time, either intentionally or inadvertently, so you had better figure out how to address it.

Complex Products.  This was a hot topic because of the recent publication of Reg Notice 22-08 which “reminds” members of their obligations regarding complex products and options.  Folks from FINRA described options as the “mother” of all complex products.  And yet, FINRA staff also reported that option trading in 2021 was up 30% from 2020, and was up 100% from 2019.  If that’s true, did the investing public suddenly get a lot smarter? Maybe.  Or are we going to see a run of options-related customer arbitrations / enforcement actions filed in the coming years?  Also maybe.  Chris Kelly, Senior Vice President and Deputy Head of Enforcement, said there are two problems.  First, brokers often don’t understand the complex options spread transactions they are recommending, so they have no reasonable basis for recommending them.  Second, “options approval bots” for self-directed accounts cause problems where investors who might not qualify for options trading at first then decide to go back, reapply, and check different boxes that will get them approved.  That should raise red flags that BDs investigate – and sometimes don’t.  There was some suggestion that even though these are self-directed accounts, there needs to be stricter protocols in place to potentially protect the customers from themselves. For instance, risk disclosures for options accounts may need to be amplified, even for self-directed accounts where an investors might not fully appreciate what they are getting themselves into.  But, it is interesting to note that one of the other panel members got Chris Kelly to agree that “most” customers are knowledgeable and know what they are doing (generally speaking, not when it comes to options).  I wish I had that on video!

Acquiring Customers Through Social Media.  The topic of using “finfluencers” to gain customers was raised a few times, but disappointingly, not much was said about it.  The message was a familiar one: same old rules, new application.  FINRA staff said that tons of new client accounts were opened during the Covid pandemic, largely as a result of influencers on social media networks hyping certain platforms and firms.  Chris Kelly admitted this issue appears in the exam stages right now, but there are no enforcement cases yet.  Some important questions they are exploring are ones that you would expect: What’s the relationship between the BD and the influencer? Is the BD paying the influencer? Is the BD supervising the influencer? What about reviewing the communications? You can see how classic compensation and communications rules might come into play here. Stay tuned.

Senior Investors.   This issue is highly topical given the recent Reg Notices 22-05 and 22-09. FINRA staff discussed that the goal of Reg Notice 22-05 was to provide BDs additional time to freeze (and protect) monies of elderly clients suspected of being defrauded – and to encourage more freezes.  They have not see firms placing many holds on accounts, which they suspect is out of fear that they would face litigation.  FINRA hoped that Reg Notice 22-05 would give BDs further comfort that they have a “safe harbor” if they freeze senior investors’ accounts in certain situations.  This helps protect investors, but also BDs.  If a BD is threatened with litigation for freezing an account, it can point to the Reg Notice and related rules to argue they were acting within their rights – and hopefully avoid liability (while at the same time stopping the investor’s assets from getting taken by a scam-artist or manipulative family member).  In order to detect potential fraud against senior investors, one broker-dealer on the panel described how they use various algorithms with 75 data points to analyze changes in client behavior that might indicate they are being manipulated by an external fraudster or family member.  They compare the customer’s withdrawals for the past three months compared to the past three years, looking at items such as new recipients getting cash from the account, amounts being withdrawn in round numbers, etc.  They also look at the number of client contacts and the length of those contacts to determine of someone may be working behind the scenes to manipulate the senior investor and steal the investor’s assets.

The Upshot.  Overall, it was good to hear from some high profile regulators about what to expect in the coming year.  FINRA had a good showing and a presence on many panels, which people appreciated.  And even though there are always some competing views expressed at seminars like this, EVERYONE was in agreement that it was good to be able to share these views in-person once again.


Let me say at the outset that I, myself, am an old (by most people’s definition, anyway), white man.  So, selfishly, I’ve got nothing against old, white men.  But, the fact is that FINRA arbitration panels are disproportionately populated by such guys.  And I am not sure that’s a good thing for the arbitral process.  Astute readers will recall a post from a couple of weeks ago in which I made the argument that if the parties to FINRA arbitrations do not perceive the process to be fair, then the whole system has to be judged to be a failure.  I suppose I am making the same point here.

Last week, my partner, Heidi VonderHeide, and I did a webinar[1] on what we were each thinking about FINRA here in early 2022.  One point I made was the oversized presence that old, white men have in the rolls of potential arbitrators.  In case after case, I was seeing the same thing, for better or for worse.

Yesterday, hot off of that pronouncement, I began the arbitrator ranking process for a new customer case that I am defending.  This process is relatively standardized: I look at who the potential arbitrator is, what they do (and have done) for a living, any prior awards, of course, and anything else I can dig up about them (from the internet, as well as from other lawyers who may have previously had cases with the same person).  Gender, race and age are simply demographic facts that are noted for each person.[2]  For me, the only one of the three that will cause me to automatically strike someone is age.  I simply will not – unless the alternatives are seriously worse, somehow – rank an 85-year old to be considered for chair in a case that I know will be tenaciously litigated.  I know the amount of energy and attention that is required from the chair in such cases, and, candidly, I don’t trust someone of that age to be able to do it well.  (I did an arbitration in New York about 20 years ago, with two super-old panelists, one of whom was the chair.  It is still the only case I ever handled in my career where two members of the hearing panel – yes, the two old guys – fell asleep at the same time.  One sleeper on the panel?  Well, that happens all the time; indeed, it is annoying but unsurprising.  But two?  At that point, it becomes a joke — the punchline to which is: drop a big stack of books on the floor, create a very loud noise, and pretend it was an accident.)

Anyway, there I was, ranking the potential chairperson.  I guess I can safely say chairman here, as all ten candidates were men.  As well, all ten were white (as best I can tell).  Finally, all ten were old.  How old?  Here are their ages:  64 (the baby in the group), 70, 72, 75, 75, 77, 77, 78, 80 and 85.  Average age = 75.3.  I don’t know what the average age of all FINRA arbitrators is, but it has to skew to “older,” in light of FINRA statistics that reveal that 71% of all FINRA arbitrators are age 61 and older.  (By the way, all ten of my chair candidates are lawyers, so there’s no diversity in occupation, either, although I admit I do prefer a lawyer to serve as chair.)

So, there you have it, my webinar thesis, if you will, embodied in a real case.  Utter lack of diversity.  Which is, at a minimum, ironic, given this statement on FINRA’s website by Rick Berry, the genuinely nice guy who runs FINRA Dispute Resolution:

It’s vitally important that our pool of arbitrators reflects the varied backgrounds of the parties who use the FINRA arbitration forum. We have bolstered our recruitment efforts, both in terms of increasing the numbers and diversity – in age, gender, race, and occupation – and continue working toward this goal.

I agree with Rick that arbitrators should be diverse.  Ultimately, it’s an issue of fairness, and there’s nothing more important than that.  And on this point, I am joining a chorus of voices already out there.  My friends at Bressler said last year, “Ensuring a diverse arbitration panel is crucial to improved decision-making through diversity of thought and approach. Different backgrounds bring different perspectives, which will ultimately lead to a more inclusive process.”

The then-president of PIABA – a group with which I hardly ever see eye-to-eye – wrote in 2014 that, “There is no question that having a pool of arbitrators with diverse backgrounds and experiences will result in improved decision making.”

Last year, the Washington Law Review published an article that asked, “How can an investor expect a fair consideration if it is both true that the industry controls the dispute resolution system and consumer investors who are not white males over the age of sixty are unlikely to see arbitrators with backgrounds like their own?”

There are tons more, all saying the same thing.  The point here is pretty obvious: as this particular pool of arbitrators amply demonstrates, given the complete lack of diversity in the ten chair candidates’ “age, gender, race, and occupation,” Rick Berry has not reached the point where he can begin to curtail his recruitment efforts.  So, go, Rick, go!



[1] It was part of a larger series of webinars offered by Ulmer, all of which are now available on demand.

[2] Gender and race are pretty easy to divine, but age takes a bit of a reasoned guess.  Here’s how I do it: I know how old I am, and when I graduated from college.  By comparing the year in which a potential arbitrator graduated college to my own graduation year, I can back into his or her current age pretty accurately.

Let’s talk about commissions today.  Or, as they are sometimes referred to, transaction based compensation.  Specifically, who can receive commissions.  Actually, that’s not phrased correctly.  The correct phrasing of this issue, courtesy of FINRA Rule 2040, would be: to whom a broker-dealer may legally pay commissions?  According to that rule, BDs can only pay commissions to a registered BD or to registered persons.[1]  Seems straightforward enough, but, in reality, it causes all kinds of problems.  Indeed, in any given week, you are bound to see some action taken by FINRA, or the SEC, that centers on the improper payment of commissions to someone.

Let’s start with a common scenario that still manages to cause problems:  there is a registered person (typically a principal, but not necessarily) who owns and runs his own branch office, where a bunch of other people work, some registered, like the RRs, and some unregistered, like, say, the receptionist.  He operates the branch through some legal entity that he’s created, like an LLC.  The LLC pays everyone at the end of the month.  The sole source of the money that the LLC uses to pay everyone comes is a check from the BD for all the commissions earned at the branch that month.  The LLC then cuts checks to everyone for their share of the commissions (in the case of the RRs), or for their monthly salary (in the case of the receptionist).

Here’s the deal:  the BD cannot pay the commissions directly to the LLC.  Why?  Because the LLC is not registered.  Accordingly, the BD has to pay the commissions to the registered person who owns the LLC.  If it doesn’t, then it will find itself named as a respondent in a disciplinary action, such as this AWC from a few years ago.  I think most everyone understands this, and abides by this general principle.

The problem with this scenario is that it suggests that as long as a broker-dealer makes the initial commission payment to a registered person, it doesn’t matter to the broker-dealer what that person then does with the money.  Take the above example, where the BD properly pays commissions to the registered owner of the branch, who then uses that money to pay all the expenses of his branch office.  Including salaries to the unregistered receptionist.  Assuming that the commission payment represents the sole source of revenue for that branch, it is rather clear that the unregistered receptionist – not to mention the landlord, the utility company, the delivery guy who brings in the pizza for the monthly meeting – is, in fact, being paid money that came from commissions.  But, it seems that no one has any problem with this, given how common this arrangement is, and that’s fair.

But it’s not that easy, however.  The fact is, there is a lot of guidance from the SEC[2] that makes it clear that what happens after the initial payment of commissions to a registered person does, in fact, matter.  Like this 20-year old no-action letter (or, more accurately, denial of a no-action request).  In that case, the SEC declined to provide no-action relief to a BD that made this proposal:

  1. The BD would pay commissions directly to nine RRs (all owners of an entity they created for administrative reasons);
  2. The nine RRs would then deposit their commission checks into their respective personal accounts;
  3. The nine RRs would then write their own checks to their co-owned entity;
  4. The entity would deduct things like overhead, payroll taxes, etc., for of the nine RRs; and, finally,
  5. The entity would cut the checks, sans the deductions back to the nine RRs.

What do you mean the SEC rejected this proposal?  After all, the BD paid the commissions directly to the RRs, not their unregistered entity.  Isn’t that exactly what 2420 requires?  I concede that there was more to the SEC’s analysis than this.  I also concede that the SEC has granted no-action relief in “employee leasing” situations.  The point, however, is this, and it’s simple:  if you are a BD, you cannot blithely ignore what your RRs do with their commission payments, simply because you were clever enough to have been aware of Rule 2420 and ensured that all commission payments were made directly to registered persons.

I’ll give you one more scenario to think about, something even more baffling.  Let’s take the same owner of the branch I talked about earlier, same branch, same facts, but with one big difference: let’s presume that this guy is not the sole owner of the LLC under which he runs his branch.  Instead, let’s presume that the he is only a co-owner, and the other co-owner is not registered.  Let’s also presume that the unregistered co-owner has ZERO role in the operation of the branch; his sole function is to cash the check that he receives each month representing his share of the profits earned at the branch.  Is this ok under 2420?

Before I answer, consider this:  at the firm level, it is perfectly fine for an unregistered person to serve as a “passive” owner.  As long as you are not involved in the day-to-day management of the BD, you can own some or all of the BD – and be entitled to its profits – without having to register in any capacity.  (Granted, FINRA will push back hard to confirm that the ownership is truly “passive,” but it’s hardly impossible to make this showing.)

Given this, it would certainly seem that the answer to the question I posed two paragraphs ago must be “yes,” right?  I mean, if passive ownership is ok at the firm level, then it must also be ok at the branch level.  That’s just simple logic.

Well, shame on you for thinking logic applies when it comes to FINRA.  The fact is, I have had a FINRA examiner tell me, in this exact circumstance, that it was a 2040 violation for the registered co-owner of the branch to share profits with the unregistered, passive co-owner of the branch.  I pushed back – hard – and enough time has transpired since then with no follow-up that I can only presume that the issue has died on the vine (or the examiner quit FINRA and the exam got forgotten – not an unheard of story).

But, it goes to show you, again, the lesson of today’s post: as a BD, your job doesn’t end when you have ensured that commissions are paid directly to registered people.  No, you have to go further, you need to ask enough questions so you understand what those people are doing with that money.  If they simply deposit it into their personal checking account, and use it to pay their household expenses, no one is going to claim you’ve violated 2040 because the rep’s spouse wrote a check off of that account to pay the mortgage.  But…if the rep gives his commission check to an entity he created to run the operations of his branch office, you had better, at a minimum, be aware of that, and, even better, have a memo in your file reflecting your reasoned conclusion why this did not implicate Rule 2420.

[1] FINRA, of course, only has jurisdiction over BDs and individuals associated with a BD.  If someone is paid commissions but is not properly registered, while FINRA may properly take issue with the BD payor, FINRA has no standing to do anything to the unregistered recipient because it does not have jurisdiction over that person/entity.  But, because the receipt of transaction based compensation is deemed to be a hallmark of acting as a broker-dealer (not necessarily a dispositive fact, but pretty damn telling), this means that the unregistered recipient may find him/herself in hot water with the SEC, for acting as an unregistered BD.

[2] Again, the reason this guidance comes from the SEC, not FINRA, is that it is the SEC that dictates the circumstances under which an entity needs to be registered as a BD.

There are certain topics that broker-dealers have been encountering for decades, yet continue unnecessarily to wrestle with due to the absence of clear guidance from the regulators.  I have written about one such topic before, and that’s the fuzzy line between most outside business activities, which RRs are obliged (at a minimum) by rule to disclose – but which BDs are not obligated to supervise – and outside business activities that are comprised of investment advisor activity done away from the firm – which BDs may, or may not, have to supervise.  Unfortunately, I am compelled to revisit this unpleasant territory.

In my last blog about this, dating back almost exactly a year ago, I highlighted an AWC that Cetera entered into with FINRA because for a seven-year period it “failed to establish, maintain and enforce a supervisory system and written supervisory procedures reasonably designed to supervise certain private securities transactions conducted by their dually-registered representatives (DRRs) at unaffiliated or ‘outside’ registered investments advisors (RIAs).”  The problem, I wrote, was principally due to FINRA’s 25-year refusal to provide clear guidance to its members on when, exactly, those transactions cross the line from being OBAs – not requiring supervision by the BD – to private securities transactions – which do.

Well, sadly, nothing has changed.  FINRA’s guidance on the subject – which still dates back to Notice to Members 94-44 and 96-33 – is as murky and unhelpful as ever.  And the rule that FINRA proposed back in 2018 to clear this whole thing up, proposed Rule 3290, remains in rulemaking purgatory on life support.  This has real-life consequences to FINRA member firms.  Cetera is living proof of that.  But, now, here’s another one.

Last week, the State of Massachusetts (one of my favorite tunes by the Dropkick Murphys, by the way; indeed, it’s the ringtone on my phone) filed a complaint against Purshe Kaplan Sterling Investments, a broker-dealer, alleging that the firm failed to supervise certain transactions that some of its people – who were dually registered as RRs with PKS and as IARs with Harvest Wealth Management, an unaffiliated Registered Investment advisor – effected through Harvest for their advisory customers.  The complaint identifies thousands of trades involving leveraged ETFs.  As avid readers are undoubtedly already aware, FINRA has provided guidance that such securities “typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.”  Unfortunately, according to the complaint, “[a]s a result of [PKS’s] neglect, Massachusetts investors – often holding leveraged ETF positions for periods in excess of one-year – experienced significant losses.”

But I am not here to talk about leveraged ETFs.  All I will say about them is that to me, the key is FINRA’s use of the word “typically,” meaning not universally, meaning that in some instances, perhaps many instances, it would not be unsuitable to hold a leveraged ETF for longer than one trading session.  What I am here to talk about, again, is the fact that FINRA’s continuing refusal to provide clear, concrete guidance to its member firms regarding exactly when they have a duty and when there is no duty to supervise transactions by dually registered RR/IARs effected away from the BDs is still resulting in such firms finding themselves the subject of enforcement actions.

What did PKS do wrong?  Allegedly, it failed to supervise trades that is dually registered salespeople were making at Harvest.  Specifically,

  • From 2017 through 2019 PKS did not review any of these transactions at Harvest
  • PKS failed to have in place “any policies and procedures requiring it to conduct risk-based account reviews regarding its DRAs investment advisory clients in 2017 and 2018.
  • Although PKS amended its policies and procedures in April 2019 to conduct risk-based reviews of DRA transactions at third-party investment advisory firms, it failed to conduct any review of transactions executed at Harvest in 2019.
  • In 2020, PKS only conducted one review of transactions executed by Harvest DRAs.

These are precisely the sort of trades that, had FINRA actually adopted proposed Rule 3290, would NOT have been subject to supervision by PKS.  And would that have mattered?  Would that have presented any real threat to investors residing in Massachusetts?  Theoretically not, because Harvest, an RIA, with a fiduciary duty to its customers – a duty that is higher and greater (somehow) than either the suitability standard governing recommendations or the “best interest” standard baked into Reg BI – already had its own obligation to supervise those trades.  The SEC and the State of Massachusetts have the necessary jurisdiction to bring an Enforcement action against Harvest if it fails to meets its supervisory obligations; what is gained, therefore, by requiring PKS also to supervise the same trades that Harvest is already supervising?

But, because of FINRA’s lack of action, the massive gray area at the OBA/PST border continues to exist.  In its complaint, the State alleges that “PKS was on notice of its regulatory requirements to supervise private securities transactions of its DRAs . . . .”  Respectfully, I have to disagree.  Or at least argue that the allegation should be qualified to recite that PKS was “on very weak and confusing notice” of its regulatory obligations here.  And that is utterly FINRA’s fault.  There is no reason for this complete overlap in supervisory obligations by both the RIA and the BD; yet, FINRA allows it to exist, knowing that its members are paying the price.

Here is a very interesting piece from Chris about the fact that some customers who file arbitrations may come to learn the hard way that even when their attorney takes the case on a continency fee basis, they still have real skin the game.  I also want to be clear: while the award that serves as the centerpiece for this post reflects that I was counsel for the prevailing respondent, it was, in fact, Chris’s case, so all the kudos belong to him. – Alan


While the FINRA arbitration system certainly is not perfect – just see Alan’s troubling blog from last week regarding the Motion to Vacate that was granted by a Judge in Atlanta – we like to think that when cases go to hearing and all the facts come to bear, the system usually produces correct results (not all of the time, obviously).  But, the problem is the vast majority of cases never go to hearing, so investors and their attorneys are able to get away with saying anything they want when they file their claims.  In fact, the most frequent question I field from brokers is this: how can an investor get away with filing a Statement of Claim that contains so many false statements?

FINRA purposefully makes it easy to initiate an arbitration – so that the average main street investor can seek to recover losses and keep industry professionals in check without having to expend much effort.  But that’s sort of the problem.  It’s almost too easy to file an arbitration.  Filing fees are modest – less than $1,000 if you allege damages under $100,000, and only $2,000 if you allege damages up to $5,000,000.  So there is relatively little stopping an investor from making an inflated claim for damages, hoping such a large number scares a broker-dealer into inflating its settlement check.  And there are plenty of attorneys out there who will gladly file a case for no cost and will only take a third, or so, of anything recovered.  Many of them have pre-drafted Statements of Claim containing standard allegations about suitability and failure to disclose risks that they spend no more than an hour tweaking before they file them.  And that’s where the real problem lies.

Unlike in court, where an attorney signing a Complaint affirms that to the best of his/her knowledge the allegations have evidentiary support and are not being made for purposes of harassment (Federal Rule of Civil Procedure 11 and the equivalent in state rules), no such rule applies to the filing of FINRA arbitrations.  As a result, attorneys can spend very little time investigating the merits of his client’s potential claims and can file a document containing blatantly untrue statements without any fear of repercussions.  Attorneys can get away with this because they know from historical statistics most arbitrations will settle, so the veracity of their statements will never be tested in front of an arbitration Panel.  According to FINRA’s numbers from 2012-2016, only 18% of arbitrations actually go to a final hearing.  That means customers and their attorneys can say whatever they want in the Statement of Claim and most of the time will never have to put their money where their mouth is.

This creates a “heads-I-win, tails-you-lose” scenario.  An investor who takes risk on an investment and makes money is happy (although sometimes you see the rare gem of a case where an investor actually makes money but complains that if they had been invested differently they would have made even more money in the bull market).  But if the investor loses money, he or she simply files an arbitration hoping to recover something from the broker-dealer in a settlement.  After all, something is better than nothing, and I believe many investors are convinced by attorneys that there’s no downside to filing the claim.  In fact, I am convinced that some attorneys actually promise investors that they will never have to go to hearing and they should just file a claim to see how much the broker-dealer is willing to pay in settlement to make the case go away (rather than spending tens of thousands of dollars to defend a 12-18 month long arbitration).

This can be immensely frustrating for broker-dealers and their registered reps, who have a hard time fathoming that some customers (not all) can get away with making demonstrably false statements in their complaint.  They feel like they have little recourse except seeking to expunge the disclosures that end up on their CRD and BrokerCheck records after the complaint is filed.

The silver lining for broker-dealers, and the harsh reality for investors who might have been talked into filing an arbitration by a zealous attorney, is that investors do, in fact, face some very real monetary risks for filing meritless arbitrations: being charged with paying all the hearing fees and the respondent’s attorneys’ fees as monetary sanctions.

Let’s start with the latter of these, which reared its head in a recent arbitration award in a case we handed for a broker-dealer we will call Infinity.[1]  An investor filed an arbitration against Infinity, even though he never had an account or any relationship with Infinity.  The Statement of Claim made blatantly incorrect statements such as: the customer bought an investment from Infinity (he actually bought it at another BD); Infinity failed to advise him to sell the investment (he never had an account with Infinity, nor was he Infinity’s customer); and Infinity earned high commissions from the customer relationship (since he was never Infinity’s customer, Infinity never made a dime from him).

The Statement of Claim also referred to the investment as a REIT, when it wasn’t.  The arbitrator denied our Rule 12504 Motion to Dismiss in order to give Claimant an opportunity to conduct discovery to ferret out any possible connection he may have had to Infinity.  After forcing us to conduct months of discovery, the facts – which were clearly not vetted prior to filing the claim – remained unchanged.  After Infinity signaled it would not settle the case and was preparing to refile its Motion to Dismiss, Claimant voluntarily dismissed his claims, and did so with prejudice.

Since Infinity had been forced to waste thousands of dollars to defend a claim brought by someone who wasn’t even its customer, Infinity filed a Motion for Attorneys’ Fees and Costs after the claims were voluntarily dismissed.  We argued that under the laws of the States of Washington and Nevada (where the customer was located), this litigation was “frivolous” and Infinity was entitled to recover its attorneys’ fees.[2]  All states have similar statutes, some of which are more generous than others.  They all essentially say the same thing: a prevailing party may recover its attorneys’ fees when the court finds that a claim was brought or maintained without reasonable grounds or to harass the prevailing party.  The Nevada Code is particularly pointed and states that “it is the intent of the Legislature that the court award attorney’s fees pursuant to this paragraph … in all appropriate situations to punish for and deter frivolous or vexatious claims and defenses because such claims and defenses overburden limited judicial resources, hinder the timely resolution of meritorious claims and increase the costs of engaging in business and providing professional services to the public.”[3]

Needless to say, we really believed our case warranted recovery of attorneys’ fees under these frivolous litigation statutes.  More importantly, the Arbitrator agreed, and instructed Claimant to pay Infinity some, but not all, of its attorneys’ fees.  To be clear, this is not an everyday occurrence.  But it is a very real risk that every investor faces when filing an arbitration – and probably one they are never warned about when they think they will just try to squeeze a quick settlement out of a broker-dealer.

A much more common occurrence is for an arbitration panel to charge an investor with paying the hearing fees incurred in an arbitration.  Every time the arbitration panel holds a hearing session, for either a pre-hearing conference or the evidentiary hearing, FINRA charges the parties a fee between $600 and $1,575 per session.  Under FINRA Rule 12902, an arbitration panel can allocate these fees to any party it chooses, and the losing party is often charged with footing the bill.  Even when a case never goes to hearing, if a respondent files a couple of motions on pre-hearing issues such as discovery, the Panel could charge all of those hearing session fees to the investors.  Sometimes these can really add up, especially when a case goes to hearing.

For instance, Wells Fargo recently defeated claims brought by customers seeking $5,000,000 in damages in an American Arbitration Association arbitration (not FINRA).  The Panel in that case (AAA No. 01-20-0015-7450, as reported by Capital Forensics in its weekly Arb Reporter) issued an award requiring the Claimants to bear responsibility for “the compensation and expenses of the arbitrators totaling $195,233.28.”  Interestingly, the award states that the Claimants voluntarily dismissed their claims against two Wells Fargo affiliates, but the Panel still required Claimants to reimburse those two affiliates for the portion of fees and expenses those affiliates incurred in the arbitration.

In other words, in both of these cases, if the investors thought they would file an arbitration and could always just dismiss it, “no harm no foul,” they were sorely mistaken.  Perhaps it is just coincidence that two separate arbitration panels instructed two different sets of Claimants to reimburse defendants thousands of dollars in expenses even after the Claimants decided to voluntarily dismiss their claims.  But the message should be clear: filing an arbitration claim may be every investor’s right, but it also comes with real risks.  Counsel and their clients should make sure they have done their homework prior to filing a claim, and should strap together something more than a cookie cutter complaint to file.  On the flip side, if a broker-dealer is faced with a truly frivolous claim, there can be some potential silver-lining to fighting it – with the right set of facts and the right panel.

[1] Infinity gave us permission to discuss its case on this blog.

[2] Revised Code of Washington 4.84.185 and Nevada Revised Statutes 18.010(2)(b).

[3] There are other bases for awarding a respondent its attorneys’ fees even if the arbitration panel does not find the claim to be frivolous.  For example, a contract may exist that states the prevailing party is entitled to his/her attorneys’ fees, or if both the Claimant and Respondent request fees in their pleadings then the Panel may award them to either party – even if the claims are not so meritless that they are considered frivolous.

Motions to vacate an adverse arbitration award are rarely granted by courts.  Indeed, that should come as no surprise to anyone inasmuch as the awards rendered at the conclusion of the arbitral process are explicitly designed to be “final.”  As a matter of both federal and state law, there are very, very few available bases on which a court may overturn an award rendered by an arbitration panel.  (In some jurisdictions, lawyers can be – and have been – sanctioned for filing a motion to vacate without a sound basis for it.)  As everyone who participates in arbitrations understands (except, perhaps, clients on the losing end of arbitrations), even errors of law and errors of fact committed by an arbitration panel are not grounds for vacatur.  By comparison, adverse decisions issued by a court can be appealed pretty much for any reason one is capable of conjuring up, even silly ones.

Last week, however, a Superior Court Judge in Fulton County, Georgia – my old stomping grounds – actually granted a motion to vacate that a customer filed after losing a FINRA arbitration he had brought against Wells Fargo Advisors.  What makes the Order remarkable is not that it was granted, a rarity, as I said, but why it was granted.

In fact, the Judge identified five separate reasons to vacate the award.  I will not focus on all of them; you can read them for yourself, and it’s not very pretty.  Rather, I want to focus on the most troubling, and the one that should cause anyone who appears in FINRA’s arbitration forum to have questions about the fairness of the process.  Namely, the Judge found that FINRA’s administration of the arbitrator selection process was not fair, and it wasn’t fair because it wasn’t, as advertised, neutral.

Here is the pertinent part of the story in a nutshell, according to the Judge’s Order:

  • As in any customer arbitration, FINRA supplied both parties the same list of potential arbitrators, who together comprise the “pool.”
  • From that list, the parties each strike the potential arbitrators they don’t want to sit on the panel – and that can be for any reason whatsoever – and rank the remaining candidates in order of preference. That is the so-called “Neutral List Selection System” identified in Rule 12400, namely, “a computer system that generates, on a random basis, lists of arbitrators from FINRA’s rosters of arbitrators.”  Emphasis on random.
  • In the case at hand, however, an extra step was inserted: when counsel for WFA got the list, he noticed that it included a potential arbitrator who he was not expecting to see.
  • The reason the lawyer was not expecting to see this person is that, apparently, he had had the same arbitrator on the panel in a prior case (one not involving WFA), and claimed that the arbitrator “harbored personal bias” against him based on how that prior case had been conducted.  Following that, WFA’s lawyer entered into an “agreement” with FINRA that none of the three members of the arbitration panel in that prior case would ever be included in any lists in any subsequent cases in which the lawyer participated.[1] Accordingly, prior to submitting his rankings, WFA’s lawyer requested that FINRA strike this one arbitrator from the list and replaced with someone else, since it violated the terms of his agreement with FINRA.
  • Although claimant objected, FINRA did remove the arbitrator and replaced him in the pool with someone else.

The Judge did not approve of this, at all, and the words she used to express her view on the subject say it perfectly:  “Permitting one lawyer to secretly red line the neutral list makes the list anything but neutral, and calls into question the entire fairness of the arbitral forum.”

It has been reported, following the publication of this Order, that FINRA flat-out denied the existence of any supposed agreement with the lawyer to exclude certain potential arbitrators from lists he is provided.  One article I read includes this quote from a FINRA spokesperson: “There has never been any agreement between Finra Dispute Resolution Services and [the] attorney . . . regarding appointment of arbitrators.  Any assertions to that effect are false.”  The spokesperson went on to say that FINRA has “reviewed all cases involving [the attorney] . . . and none of the three arbitrators in question was excluded or removed from ranking lists prior to sending the lists to the parties.”

Frankly, I do not know how to account for the 180° difference between what the FINRA spokesperson said – i.e., what agreement? – and what the lawyer represented to Fulton County Judge in a legal brief – “It was made clear to me verbally [by FINRA] that none of the . . . arbitrators [from the prior case] would have the opportunity to serve on any one of my cases given the horrific circumstances surrounding the underlying case.”  All I know is that these cannot both be true.  I also know that I am damn careful when I make representations to a judge that what I am saying is true, and demonstrably so.  I think it’s fair to say that any competent lawyer is similarly careful.

There is nothing in the Order that suggests that WFA was aware of any of these supposed shenanigans.  And I expect that WFA will appeal (with different counsel, no doubt).  But, for now, the Order stands, and FINRA (among others), for now, looks awfully bad.

And that is a problem for everyone who participates in FINRA arbitrations.  Win or lose, but particularly when I lose, I have to be able to look my client in the eye and say, well, at least you got a fair shot.  Arbitrations are not perfect, but neither are jury trials.  But, as long as the process is fair, then the imperfections are annoyances, at best, but not grounds to throw the whole system away.  But what this case presents is not some silly annoyance that makes for a good war story; it goes to the heart of the arbitral process, that is, to its fairness.  If, in fact, FINRA played games here with the arbitrator lists pursuant to some secret agreement with one of the lawyers, then there should be hell to pay.  And Senator Elizabeth Warren would be justified in ensuring that something be done to FINRA.

[1] It should be noted that in the prior case, i.e., the one that supposedly caused the arbitrator to develop his “personal bias” against the lawyer, the lawyer filed a motion to vacate the adverse arbitration award, claiming his client had lost as a result of that supposed bias.  The motion to vacate was denied, however. which raises questions, of course, about the legitimacy of the claim of bias.