Thursday, December 20, 2018
The SEC Investor Advisory Committee met last week and considered how to respond to the unpaid arbitration awards problem. This is an issue I've written about before. As more outside attention has focused on the issue, FINRA has begun releasing statistics on how many arbitration awards go unpaid. In 2017, about $25 million in awards went unpaid--amounting to roughly a third of the awards and a quarter of the total damages won.
The Investor Advisory Committee heard from an informed panel, taking statements from Christine Lazaro, President of the Public Investors Arbitration Bar Association (PIABA) and professor at St. John's School of Law, Jill Gross, a professor at Pace Law School, Richard Berry, the head of FINRA's dispute resolution group, and Robin Traxler, from the Financial Services Institute (also known as FSI). There is also pending legislation on this issue from Senator Warren with Senator Kennedy on board as a bipartisan co-sponsor.
The issue matters for retirement savers swindled by bad brokers. Professor Lazaro provided the committee with the stories of wronged investors, including the problem facing one retired couple:
Take for example the Sheas. The couple has been together for over 40 years. Mr. Shea started out with a dairy route in southern Illinois. After saving for about a decade, the couple purchased a dairy farm, which they operated for the next twenty years. Although they have given up the dairy part of the farm, they continue to grow crops. As you can imagine, the life of a farmer is not an easy one. The Sheas saved their money over time, and eventually accumulated about $1.5 million. As they approached retirement, they considered what to do with their life savings. Their broker, with the firm Windsor Street Capital, aggressively pursued the Sheas, eventually convincing them to invest with him. Within one year, the Sheas lost a significant portion of their savings. The broker traded their account for his own benefit, something commonly called churning. His trading resulted in annualized turnovers of between 10 and 38, far in excess of what would be considered reasonable (which is typically something between 0 on the low side and 6 on the extreme high side). Earlier this year, the Sheas were awarded over $1.3 million in compensatory damages, and $3 million in punitive damages after the arbitration hearing. Although the Sheas lost so much of their life savings, and the arbitration panel agreed that the firm engaged in misconduct, the Sheas have not recovered from the firm. And it is unlikely they will as the firm has shut down.
Stories like the Sheas are all too common. Although the unpaid award statistics do not look good, the true scope of the problem is likely worse because most investors will not file an arbitration if the brokerage firm has already shut down. Imagine that there were five different dairy farmer families all in the same situation. The first one to file may generate the unpaid award. The remaining four may decide not to spend what little they have left pursing an arbitration against an uncollectable brokerage.
My view is that FINRA should bear some financial responsibility for unpaid arbitration awards because it is a self-regulatory entity. The theory behind self-regulation holds that the industry has an incentive to police itself and can do so more efficiently than traditional government. Having the industry internalize the costs of wrongful behavior creates an incentive to more effectively self-police. When arbitration awards go unpaid, the industry does not bear the costs of misconduct and lacks the right incentive to devote optimal resources to policing misconduct from its members.
This doesn't mean that the industry should be required to pony up every penny for all awards. I'd feel comfortable putting some appropriate cap or limit on the amount and type of damages the industry could be liable for in the interest of financial stability. It wouldn't make sense to hold the industry liable for a trillion dollars if one rogue arbitration panel awarded that amount.
Consider it from a different angle. To some degree, FINRA has to sell its members on the need for enforcement and oversight resources. After all, these members have a significant voice on FINRA's board and directly elect many of its members. Even some of the appointed "public" representatives also serve on the boards of directors for other financial institutions that are FINRA members or have FINRA members as subsidiaries. If these members end up, collectively, on the hook for misbehavior from the industry's bad apples, it creates an incentive to devote more resources to identifying and addressing problems at an earlier stage before they go on and cause problems for investors. Without that incentive, larger players with better compliance programs may not care overmuch about misconduct happening elsewhere.
It's wonderful to see the SEC's Investor Advisory Committee focused on this issue. Hopefully we'll see a recommendation from them soon.
*Disclosure: I'm on PIABA's board of directors. I do not speak for the organization and write this in my personal capacity.