Thursday, October 22, 2020
With the comment period closing today, the SEC will consider a FINRA proposal to make some relatively minor changes to how the current process for expunging public records works. In my comment letter, I explained that changes simply don't do anywhere near enough to address the core problem underlying the current, fundamentally broken expungement process. In essence, the Proposal’s expungement process improperly relies on an adversarial system to surface information relevant to whether customer dispute information should be expunged. This adversarial system fails to function in any reliable way because expungement hearings generally proceed as one-sided affairs which are functionally ex parte proceedings. In these functionally ex parte proceedings, arguments and evidence submitted by brokers seeking expungement never receive any real scrutiny by anyone well-situated to carefully consider these expungement requests. When arbitrators recommend expungement, courts—which are generally precluded from closely reviewing the underlying arbitration absent the rarest of circumstances—then confirm the arbitration awards. Judicial review under these circumstances provides no meaningful check on this process and only serves as a dubious veneer.
To help the Commission see that these expungement hearings often have little resemblance to the sort of adversarial proceeding one would expect in arbitration, I pointed out that in expungement-only arbitrations, law firms often sue their own clients to obtain expungements for brokers employed by their brokerage firm clients. State ethics rules generally prohibit lawyers from suing their own clients unless all clients involved specifically consent to the conflict. And even then, the ethics rules prohibit a lawyer from representing both the claimant and the respondent at the same time in an adversarial proceeding. (But that hasn't prevented it from happening within the FINRA arbitration forum. One arbitration award reveals that a lawyer represented both the claimant and the respondent in the same proceeding.) As a practical matter, clients are only likely consent to being sued by their own lawyers when lawsuit somehow benefits them.
Expungement-only or "straight-in" arbitrations deviate from how we ordinarily expect adversarial proceedings to go. Consider a typical fact pattern. A customer loses a large amount of money after following a broker's investment advice. The customer, believing that the commission-compensated broker gave unsuitable advice, complains about it or files an arbitration claim against the brokerage firm. The brokerage firm may even settle the suit for a significant amount of money. The rough allegations in the complaint and any settlement amount or arbitration outcome go into a public database so that other investors and regulators can know that another investor complained and whether any settlement ensued.
Later, the broker decides to seek an expungement. The broker will file an arbitration claim against the brokerage and allege that the customer's claim was "false," that the broker had nothing to do with the complaint, or that the complaint was simply factually impossible. In essence, the broker files an arbitration calling the customer a liar and names the brokerage employer as the respondent. Together, the broker and the brokerage will select the arbitrator who will hear the case. Each of them may strike up to four arbitrators off the ten arbitrator list FINRA provides and rank the remaining arbitrators. If they cooperate, they can effectively control which arbitrator will be selected to hear the case. (Surprise, arbitrators who grant expungements hear many, many expungement cases.).
Under current FINRA guidance, the parties will send the customer some kind of notice about the expungement proceeding and letting the customer know that the customer can participate if they want, but that they have no obligation at all to participate. This will be the first time the customer might learn that his former financial adviser has called him or her a liar. My review of some of these letters left me with the distinct impression that the lawyers drafting these notice letters would prefer it if customers didn't participate. (Surprise, customers only participate in about 1 out of 7 expungement hearings). The letter often does not plainly state that the broker plans to convince an arbitrator that the customer is a liar. It doesn't say anything outright false, but figuring out that the broker will call the customer a liar generally takes some reading. After all, most people would not know that they were being called liars if they received a letter saying that "a broker has filed an arbitration proceeding under the industry arbitration code and now seeks to modify or remove certain information from the Central Registration Depository pursuant to FINRA Rule 2080."
The new changes will make some difference, but it's mostly just nibbling around the edges. FINRA won't allow the parties to strike and rank arbitrators for expungement hearings any more. It will require the broker to actually show the arbitrator the letter it used to notify the customer. It'll require a majority vote by a three-arbitrator panel. It'll put some time limits in place so that brokers can't wait years and years before seeking an expungement. It'll make some other changes.
But there are many things the proposal won't do. It won't address common customer barriers to participation. It won't provide a lengthy notice period so customers can figure out what is going on and get legal help. It won't even guarantee customers can receive all of the documents filed in these arbitrations. It won't make it clear that these proceedings are really ex-parte proceedings and that all advocates must be held to higher standards in them. It won't change the system in any truly significant way. It burdens the customer with protecting the public record at the customer's expense.
Ultimately, what this does is simply continue the problem. It will likely allow FINRA to politely kick the can down the road for another five years and say that it has made changes in response to criticism and that it will continue to monitor the process and make further changes if they become necessary. Fixing this problem has not been an urgent priority. FINRA's proposals were filed about a month ago after taking a lengthy period to digest the comments FINRA received after putting out a notice in 2017.
As it stands, we know that the current expungement system is not set up in a way that is likely to surface information necessary for an arbitrator to make an informed recommendation on expungement. These changes do not significantly alter that reality. You should not trust BrokerCheck alone when looking up a financial professional. You'll need to also check the arbitration award database to see if there have been expungements. Even then, you won't learn everything you should have been able to see. But at least you'll know that you should be more cautious. After all, one study found that brokers receiving expungements were more than three times as likely to engage in future misconduct as the average broker.