FINRA Arbitration- Where Winning Is Not Everything

The Public Investors Arbitration Bar Association (PIABA) has issued a troubling report to the effect that customers who receive monetary awards in FINRA arbitration forums frequently cannot collect.

Using data from 2013, PIABA demonstrated that more than $62 million in awards made to public customers by FINRA arbitrators in that year went unpaid. That amounts to 1 out of 3 cases where investors went through the arbitration process and won, or nearly $1 of every $4 awarded to investors in all of the arbitration hearings that took place that year.

This is a problem that has been ongoing for many years. FINRA has done little over that time to keep track of unpaid awards and has been reluctant to take any remedial steps. In theory, an award made to a customer by a FINRA panel is due within 30 days. After that it becomes a charge against the firm’s net capital and may lead to disciplinary charges and the firm’s expulsion from FINRA. The latter, of course, hinders collection rather than helping it.

Obviously it is the larger awards rather than the smaller ones that do not get paid. Just as obviously, if the customer dealt with one of the larger firms such as, Merrill Lynch, Morgan Stanley or Charles Schwab, even a large arbitration award is rarely going to be a problem.

Because it is the smaller firms that often opt to go out of business rather than pay a substantial award, PIABA has offered a number of potential solutions including an increase in the minimum requirement for net capital, mandatory liability insurance, broadened SIPC coverage and an industry-wide pool to cover unpaid awards.

I cannot see Merrill Lynch and the larger firms agreeing to fund a pool to cover customers at other firms that they would just as soon have as their own.  And just to be clear, most error and omissions policies carried by FINRA firms specifically exclude actions based upon fraud.

The $62 million in unpaid awards for 2013 is skewed by a single $19 million award that went unpaid and which illustrates the actual problem. The firm that did not pay the award, Western Financial Planning (WFP) actually had insurance, just not enough for its business model.

WFP did not decide to close up shop after the large arbitration award or because of it. It was put out of business by the SEC. A receiver was appointed and assets were managed and sold. Not enough was recovered to pay general creditors like the recipients of the arbitration awards (there were more than a few).

The record does however reflect that WFP sold private placements almost exclusively. Several of the private placements were large Ponzi schemes that resulted in billions of dollars of customer losses causing dozens of small FINRA member firms to close their doors. The only reason that these Ponzi schemes were sold to anyone is that the FINRA firms who sold them did not even attempt to conduct legitimate due diligence investigations to detect the fraud.

Years ago I worked for a law firm that was preparing both public and private real estate offerings. We carried professional liability insurance. The cost was scaled to the dollar amount of offerings that we prepared each year. The more money raised by offerings we prepared, the greater amount of coverage we needed and the premium we were charged went up.

The insurance company sent a representative to our offices. He handed out a multi-page detailed list of documents. “We hope you never have to call upon us to defend you”, he said, “but if you do, this is list of documents about the issue that we would hope to find in your files.” Anyone who thinks that a due diligence investigation is anything other than a way for the issuers, lawyers and brokers to CYA does not understand it.

FINRA has a realistic requirement for due diligence investigations of private offerings that requires member firms to independently verify all of the representations being given to investors.  I had several due diligence officers from smaller firms on the witness stand after the 2008 real estate crash. Almost all just took what the issuer was telling them as gospel. None conducted an independent investigation. You could rarely find a title report or title insurance in their files. None had attended the closing for the property where adjustments are frequently made.

The next crash will assuredly result in arbitrations based upon losses from oil and gas private placements. Where the argument can be made that an office building is an office building, due diligence in the oil and gas industry is very different.

Over the years, I worked on offerings for shallow oil wells in Pennsylvania, deep wells in West Texas, gas wells in Louisiana and at least one shale oil project in Colorado. The due diligence investigation required to verify the facts can differ project by project and state by state. One of the few things that they have in common is they can require multiple experts to conduct an adequate investigation which can obviously run up the cost.

The chance of a small FINRA firm doing an adequate due diligence investigation of an oil and gas offering is slim. I am available as a consulting expert witness for both arbitrations and class actions and I expect that I will be busy.

The problem of unpaid arbitration awards is very much centered in the Reg. D private offering market. It is from investments in the Reg. D market that customers take the huge losses that are the subject of many FINRA arbitrations. Many of the largest Ponzi schemes are sold through private offerings for no other reason than crooks do not want government scrutiny on their offerings.

These offerings are most often sold to retail customers by small firms that specialize in private offerings because the commission on each sale may be many times what it would be on a sale of a similar dollar amount of British Petroleum or ExxonMobil. A broker selling $1 million worth of private placements might take home as much as $90,000 in commissions.

In a registered offering, due diligence is performed by the lead underwriter on behalf of the other firms in the selling group. The issuer pays the lead underwriter for the due diligence process up front before the issue comes to market. In the Reg. D market, each member of the selling group frequently performs their own due diligence and is reimbursed after the fact based upon a fixed percentage of the monies that each firm raises.

This business model where the firms do not get paid for due diligence if they reject the offering and then only get paid based upon how much of an offering that they sell is at the root of the problem. For a large firm doing registered offerings due diligence is a profit center with positive cash flow. For small firms in the Reg. D market it can be an out of pocket cost with questionable reimbursement. Therein lays the problem and the solution.

FINRA might consider requiring a lead underwriter for all Reg. D offerings that mimics the investment banking function for registered offerings. As this is a potentially very profitable enterprise, it is reasonable to believe that some firms would be happy to step up. These firms and only these firms would need enhanced insurance coverage which would be folded into their cost of operations and reflected in the fees that they charge the issuers.

Asking each of the small firms selling Reg. D offerings to purchase insurance against offering statement fraud and adding to the cost of what is already an unprofitable part of their business is not going to gain traction at FINRA. A way to shift the risk profitably to a well compensated lead underwriter might do the trick.

The benefit of loss avoidance in the financial markets which is certainly part of FINRA’s charter should take precedence over insuring recovery costs for the few people who deal with the wrong firms.  It should surprise no one that many people in the brokerage industry do not particularly care for lawyers who make their livings filing customer arbitration claims. The PIABA study, while important, is not likely to stir the industry into action.

Arbitration claims based upon the sale of these offerings to unsuitable customers will still occur, but the aggregate losses will be far less and the number of Ponzi schemes foisted upon the public will likely be dramatically reduced. That is good for everyone.

I do have sympathy for the frustration suffered by the PIABA lawyers but the issue of collection is not limited to securities claims or arbitrations. Thousands of people are injured every year by uninsured drunk drivers .I would argue that it would be easier to substantially reduce the number of Ponzi schemes offered through FINRA firms than getting all the drunk drivers off the road.

 

 

 

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