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Regulation and Compliance > Federal Regulation > FINRA

The Mysterious Case of the Unpaid Arbitration Awards

By Bob Clark

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I’m not a big fan of horror stories — the daily news is usually horrific enough for me — so give me a good murder mystery every time. Occasionally, I’ll come across a mystery that’s so compelling, it more than makes up for any horrors revealed in the story.

I recently came across one such story by a most unlikely author: securities attorney Hugh Berkson, president of the Public Investors Arbitration Bar Association (PIABA), in his recently released paper, “Unpaid Arbitration Awards: A Problem the Industry Created — A Problem the Industry Must Fix.”

Recently, I’ve written a few stories for ThinkAdvisor.com about FINRA’s mandatory arbitration system for investor claims against brokers and BDs. (See “Is FINRA the Fox Guarding the Henhouse?” Feb. 1; “Broker Arb Lessons From Animal House and Brian Hamburger,” Feb. 23; and “If Broker Arbitration Is Good for Investors, Why Is it Mandatory?” March 2.) Those stories are about, respectively, the lack of transparency in FINRA investor arbitration proceedings; whether a 40% or so win rate for investors who receive “some money” in arbitration is an indication of a problem; and whether arbitration needs to be mandatory.

While those issues may be troubling enough on their own, Berkson takes the FINRA arbitration story to another level. As a mystery writer, he does leave a bit to be desired: for instance, revealing the denouement in the title. Yet the strength of Berkson’s tale lies not in the surprise at the end but in the magnitude of the facts revealed throughout. For instance (spoiler alert), based on data provided by FINRA, the PIABA calculated that in 2013, a third of the arbitration awards won by brokerage customers went unpaid by the BDs or brokers involved.

All good stories have an antagonist, and in this one, outgoing FINRA chairman Richard Ketchem auditioned for the part. On March 3, during his testimony before the Senate Banking Subcommittee on Insurance, Securities and Investments, Sen. Elizabeth Warren asked him, should there “be more regulations so that people get paid?” Ketchum responded: “Something should be done about it; I do believe that we want to work with the SEC on this.”

After the hearing, he told ThinkAdvisor.com’s Melanie Waddell that “FINRA is ‘actively’ looking at regulatory measures in this area, which could come out in proposal form before he leaves this year as head of the self-regulator.” (See “FINRA Mulls Crackdown on Arb Award Deadbeats,” ThinkAdvisor.com, March 3.)

Sound pretty good? FINRA on the case? One might think so until you read Berkson’s report. It seems that back in 2000, the General Accounting Office, frustrated by failure on the part of the National Association of Securities Dealers (FINRA’s old name) to take action on unpaid investor awards, decided to do its own research.

“The results of the initial GAO survey were surprising,” wrote Berkson. “The GAO estimated that 64% of NASD awards were unpaid in 1998. While that percentage is shockingly high, the dollar figures were staggering. GAO estimated that unpaid awards totaled $129 million, or 80% of the [total] $161 million awarded in 1998.”

Considering that the NASD was aware of the GAO’s finding in 2000, that puts a different light on Ketchum’s intentions to “look into it” before he departs. So does the fact that according to Berkson, the FINRA Dispute Resolution Task Force Final Report, released last December, noted that “FINRA issued arbitration awards in 539 customer cases in 2013, with 75 of those awards going unpaid, for a total of $62.1 million.”

The task force report states: “FINRA advised the task force that it has implemented a number of changes to its arbitration program to address the problem of unpaid awards […]. When an investor files an arbitration claim, FINRA alerts the investor if the respondent firm or associated person is no longer in business. Thus, investors know before pursuing the claim in arbitration that collection of an award may be more difficult.”

Did you get that? Just three months ago, FINRA advised its own task force that it already has the problem under control — it simply tells aggrieved investors ahead of time when they stand virtually no chance of collecting anything from the broker or BD involved so they won’t waste their time filing a claim. Problem solved. (Frankly, I’m surprised FINRA doesn’t tell that to all investors who file claims. Think of how much money they’d save their member BDs.) The task force, basking in the glow of a job well done, made no further recommendations on the matter.

Berkson and the folks at the PIABA felt the information supplied in the task force report was incomplete and took pains to offer a clearer picture. “Unfortunately, the task force report does not contain information sufficient to put the unpaid award problem into context,” he explained.

So Berkson asked FINRA for additional information: specifically, how many different firms and persons were involved in those 75 unpaid awards, the size of each unpaid award and the total amount paid in claims to customers in 2013.

FINRA responded that the requested data wasn’t available, and that it would take “several months” to determine if the requested data would be provided. “FINRA’s refusal to provide the data, either to the task force or the author, is puzzling,” Berkson wrote, “given its professed interest in promoting transparency in the arbitration process.”

Undeterred, the intrepid team at the PIABA combed the reports it received from FINRA for every award issued in 2013, finding the following: For that year, there were 225 awards of some damages to investors, totaling $256.7 million. That means the 75 unpaid awards cited in the task force report represent 33.3%; and the $62.1 million they didn’t receive represents 24.2% of the total.

No Firm, No Award

In case you’re thinking that all these deadbeat BDs and brokers are the kind of smaller firms that savvy investors should know to avoid in the first place, Berksen’s report makes an example of a much larger firm, one that hits all too close to home for the financial planning community: Securities America.

In 2010, with some 1,900 reps and more than $53 billion in client AUM, Securities America was the fifth largest independent BD in the country. According to Berkson, “its year-end net capital was $1.9 million.” Yet by the following year, $400 million of private placements sold by Securities America reps were in default and the firm “faced actions brought by various state regulators and individual investors,” wrote Berkson.

“In March 2011, three weeks after reporting it had nearly eight times the required net capital,” he continued, Securities America’s CFO at the time, Kelly Windorski, testified in open court that if a “settlement was not approved, the firm would go out of business soon, due to defense costs and arbitration awards. […] Facing hundreds of millions of dollars of liability to investors, Securities America bargained from a position of weakness: Take $X or we’ll file for bankruptcy.”

Berkson noted that the “problem, of course, is not limited to independent brokerage firms. The financial meltdown of 2008 saw established and well-respected firms Bear Stearns and Lehman Brothers collapse. When a brokerage firm shuts down, for whatever reason, the likelihood that any arbitration awards against the firm will be paid is slim if not entirely non-existent.”

The horror in this story is that such a large portion of FINRA arbitration awards to investors go unpaid. The 2013 figures (courtesy of Berkson and the PIABA) are troubling enough, yet the GAO’s figures tell us that things can be much worse.

The mystery is why the SEC, Congress and the public let this situation continue. In his paper, Berkson offers four potential solutions to the problem: expanding SIPC; increasing BD net capital; buying default insurance; or creating a National Recovery Pool. He favors the latter as the least costly and most workable.

Despite Berkson’s charge that this is a problem the industry must fix, to my mind, the actual solution is far less important than who creates and oversees it. FINRA’s record on the matter would seem to rule it out, and I’m not sure the SEC would be much better. Perhaps an entity outside the securities industry, such as the PIABA, might actually get some results.

But until a workable solution is found, these figures throw the whole system of securities arbitration into question. “The arbitration award is meaningless if the broker or brokerage firm does not have the resources to pay the award,” wrote Berkson. “Unfortunately, this is an all too common problem, and has been for quite some time.”

— Read “Is FINRA the Fox Guarding the Henhouse?” on ThinkAdvisor.

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