Removing Bad Actors and Preventing Unpaid Arbitration Awards

As advisors know, one of the fundamental requirements for success in our industry is the ability to earn and maintain the trust of clients, who rely on firms and advisors to help them achieve their financial goals. That trust is something that can only be built over time as advisors show a consistent dedication to putting clients’ needs first and helping them progress toward their objectives.

Bad actors in our industry damage honest advisors’ ability to build that vital trust with clients. Just as bad, the persistent problem of unpaid arbitration awards causes a black eye for all firms and advisors by undermining the system that has been established to help clients recover when a bad actor has caused them financial harm.

The result is that hard-working Main Street Americans lose out on unbiased, professional financial advice, while trustworthy advisors must work that much harder to prove their integrity to wary clients. Removing bad actors from the industry and preventing unpaid arbitration awards would uphold the industry’s reputation and protect advisory firm clients.

FSI is firmly focused on this issue as we work to advance the interests of honest firms and advisors across the country.

Last December, FSI Senior Vice President and Deputy General Counsel Robin Traxler spoke on this issue before the Securities and Exchange Commission’s Investor Advisory Committee.

She discussed the potential unintended consequences of three proposals — given that FINRA data indicates only 2% of all claims filed in the FINRA Dispute Resolution forum go unpaid — and suggested solutions to rectify the problem without inadvertently causing harm.


Unintended Consequences

Relief Fund: The first proposal Traxler addressed was Senator Elizabeth Warren’s bill S. 2499, which would require FINRA to establish a relief fund “to provide investors with the full value of unpaid arbitration awards issued against brokerage firms or brokers regulated by the Authority.” While well intended, Traxler explained, Warren’s proposal would have two unintended consequences.

The first is that the proposal would lead to potential bad actors in the industry becoming even more reckless with investors, since a relief fund would compensate clients when bad actors do not pay. Secondly, it would lead to arbitration panelists awarding damages to investors whether or not those awards are justified, since the firm or advisor would not have to pay the award themselves.

E&O Insurance: Traxler also addressed a second proposal, which would require advisors to carry Errors and Omissions insurance to cover arbitration award payments, based on the argument that insurance is a relatively inexpensive way to ensure that investors are made whole. Traxler pointed out several flaws in this logic, as well.

First, such insurance would in fact be too expensive for many small firms and independent advisors running their own businesses. Furthermore, insurance companies do not cover fraudulent acts, and would be highly unlikely to underwrite policies that encourage reckless behavior among policyholders. The end result would be an unfair financial burden on good advisors that would not accomplish its stated goal.

Increased Capital: A third proposal under consideration is to hike net capital requirements for small firms that now have a $5,000 requirement. Supporters say putting more money aside would prevent firms from claiming that paying a large arbitration award would put them out of business, and instead the capital cushion would obligate firms to pay the arbitration award. Traxler refuted this view with simple math.

FINRA data shows that the median unpaid arbitration award is nearly $200,000, which implies that an effective net capital requirement would have to increase to at least that level. Many small firms do not have an extra $200,000 in cash to set aside. Such a net capital requirement would effectively force those firms to shut down.

As Traxler rightly emphasized, a viable proposal should not involve putting good advisors out of business because they do not have enough money to pay for the misdeeds of bad actors.


Effectively Targeting Bad Actors

As Traxler points out, the real issue is the bad actors whose reckless and at times intentional behavior causes unpaid arbitration awards. As an alternative to the approaches above, she points to an existing FINRA proposal that would expand the definition of “statutory disqualification” under the Exchange Act to include individuals who have unpaid arbitration awards against them as well as firms and individuals who fail to pay awards – even if the award was discharged through bankruptcy.

Traxler says that, rather than stopping with FINRA, such disqualification should extend to the SEC and to state-level securities and insurance regulators. This would prevent bad actors who fail to pay arbitration awards from closing their current businesses, then re-opening as investment advisory or insurance practitioners – and would permanently disqualify them from the entire financial services industry.

The prospect of total, industry-wide disqualification for anyone with unpaid arbitration awards would dissuade many potential bad actors from doing harm to begin with – potentially negating the need for arbitration in those instances, without forcing honest advisors and firms to pay burdensome additional costs.

FSI strongly believes that this solution would be a major step toward solving the problem of bad actors and unpaid arbitration awards, while also protecting investors and bolstering the reputation of the independent financial advice industry.

We will continue to work with regulators and legislators to address this crucial problem, and we look forward to keeping you informed of our progress.

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