Thursday, January 14, 2021
We have some significant developments in the law for expungement hearings. As a quick refresher for those that don't follow this corner of securities law closely, the process for deciding whether or not to remove customer dispute information from a broker's record is unreliable, poorly designed, and seemingly emboldens brokers to commit more misconduct. One study found that "with prior expungements are 3.3 times as likely to engage in new misconduct as the average broker."
Many of the problems flow from how brokers procure expungements. Often they simply file an arbitration against their employer. (Notably, the employer benefits if its broker/sales agent has red flags and past misconduct removed from regulatory and public databases.) At some point, they notify the customer about the arbitration and their right to participate, but non-party customers have little incentive or ability to meaningfully participate--and usually don't participate. Arbitrators, hearing no reason not to grant the expungement from the parties overwhelmingly recommend expungement. The broker then notifies FINRA and has the arbitration award "confirmed" by a state court. As I wrote in my comment letter, "judicial review under these circumstances provides no meaningful check on this process and only serves as a dubious veneer." Under the law, courts confirming arbitration awards do not meaningfully review these awards--they simply confirm them absent certain, statutorily-defined problems with the award.
In October, I wrote about a proposal to change some of the rules for brokers seeking to expunge customer dispute information from their records and linked to my own extensive comment letter on the proposal which drew heavily from a law review article explaining how the system fails to surface relevant information because many hearings are not adversarial. (The SEC also received comments from Arbitrator Julius Z. Frager, PIABA, NASAA, AdvisorLaw, Pace Law School's Securities Clinic, St. John's Securities Clinic, and Steven Caruso.) At the time, I explained that the proposal would do much to change the fundamental dynamic and would leave many problems in place:
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.
After the comment period, FINRA extended the time for SEC action on the proposal before providing a response to comments and an amended proposal, addressing some of the problems I highlighted. The amended proposal meaningfully engages with the comments and makes some real improvements. Although I didn't get everything I wanted, I'm glad that the amendment addresses some of the most egregious flaws in the current system. I have my thoughts on FINRA's response after the jump.
Expanded Duty of Candor
In my original letter, I asked FINRA to recognize that "straight-in" or "expungement-only" arbitrations lacked any real adversarial character and impose an expanded duty of candor on the advocates appearing in these matters because they are functionally ex parte hearings. Although it characterized the hearings as "potentially non-adversarial," FINRA recognized the problem and stated that it had made two changes to mitigate the risk, disabling parties from being able to rank and strike arbitrators in these matters and codifying arbitrators' power to request any material they deem relevant from parties. FINRA declined to impose an expanded duty of candor because it is "a legal ethics principle that is applicable to attorneys pursuant to individual state Rules of Professional Conduct that FINRA does not regulate. In addition, FINRA does not believe that it would be practical or appropriate to impose this legal-ethics principle on non-attorney associated persons."
It's doubtful that FINRA lacks the ability to regulate the conduct of advocates appearing within its forum. That being said, state bar associations may be the next step for trying to get real reform. The changes to the selection process and the codification of arbitrators powers will do some limited good. They still won't change the underlying dynamics and I strongly doubt that they will increase the likelihood that these functionally ex parte proceedings will reliably surface information weighing against an expungement request.
In my comment letter, I urged the SEC to recognize or require FINRA to create some financial incentive for customers to participate in these hearings. As it stands, the actual parties to most straight-in expungement requests have strong incentives to push for expungements while investors have little reason to hire a lawyer to protect the public record. Wronged customers already know who swindled them, they have little need to keep the information in a public database. In response, FINRA indicated that it did "not favor creating special incentive awards for participation in expungement hearings, as doing so would be inconsistent with FINRA’s neutral administration of the arbitration forum."
The difficulty with FINRA's position is that it places the burden to defend the public record on customers who are not even parties to the arbitration. Very few will hire lawyers to assist with mounting any effective defense. Absent some sort of public defender/investor advocate model, the SEC can't have any confidence that this "neutral" system will surface information from customers relevant to whether or not to recommend expungement. The SEC may have the power to require more.
In my letter, I explained that the current expungement system often left investors without access to documents filed in the proceeding. I suggested that the rules could be improved by requiring brokers to provide customers with all of the documents filed in the proceeding. FINRA partially agreed:
Edwards suggested that the associated person also be required to disclose all documents filed in the proceeding to the customer, including a copy of the answer. Edwards also suggested that the notice be sent on the same day that the broker files the request and recommended giving customers 90 days from the notice to secure counsel and prepare a response.
FINRA agrees that a customer should receive notice of the expungement request as soon as practicable. FINRA also believes that customers would benefit from a copy of the answer in addition to the statement of claim. Accordingly, FINRA has determined to amend proposed Rule 13805(b)(1) to require that the associated person serve the customers with the statement of claim within 10 days of filing the statement of claim with FINRA and any answer within 10 days of filing each answer with FINRA. FINRA does not believe that it would be appropriate to mandate the disclosure of all other documents filed in the proceeding. After receiving the statement of claim or any answers, the customer would be able to determine whether to participate and respond. Where the customer does not actively participate in the expungement request, or the matter also involves issues unrelated to expungement, imposing the additional requirement of providing all other documents filed in the proceeding in all circumstances could be unnecessarily burdensome on the associated person.
This change to the notice requirement is significant. In many instances, brokers have filed their claim and wait until a few weeks before the hearing to notify the customers. This delayed notice may entirely prevent customers from participating. Consider a retiree taking a month in France or to visit with their children. If an odd notice arrives at their home, the customer may never see it until after the hearing concludes.
Although giving investors better notice and access to more documents is certainly an improvement, the SEC should require FINRA to allow customers to readily access materials filed in the arbitration. FINRA maintains an electronic filing system, its "DR Portal." If it would be too much of a burden for brokers to deliver everything they file, perhaps FINRA should simply allow customers to access the DR Portal as non-parties. This would allow customers to have access to all the documents filed.
Participation in Scheduling Conferences
One of the problems with requiring non-parties to protect the public's interest at their own time and expense is that they generally lack access to the procedural tools available to parties. FINRA took my suggestion that investors be allowed to participate in scheduling conferences:
The Proposal provides that the Director shall notify all customers whose customer arbitrations, civil litigations, and customer complaints gave rise to the customer dispute information that is the subject of the expungement request of the time, date and place of the expungement hearing. Edwards recommended that customers be allowed to participate in all initial scheduling decisions and to communicate with the panel on these scheduling matters.
FINRA agrees that customers should be provided with information that would enable them to participate in prehearing conferences relating to straight-in requests. Accordingly, FINRA has determined to amend proposed Rule 13805(b)(2) to provide that the Director will notify these customers of the time, date and place of any prehearing conferences using the customers’ current address provided by the party seeking expungement. FINRA has also determined to amend proposed Rule 13805(c)(3)(A) to clarify that the customer is entitled to appear at prehearing conferences. FINRA will continue to consider customer participation in expungement hearings, including ways to further encourage customer participation.
Actual Standards for Expungement
In my comment letter, I argued that FINRA should include some actual evidentiary standard for arbitrators to use when deciding whether or not to recommend expungement. FINRA's letter summarized my view, PIABA's view, and FINRA's rationale for declining to create any evidentiary standard:
Two commenters suggested requiring arbitrators to apply additional standards when considering expungement requests. Edwards suggested that the required standard of proof to obtain an expungement recommendation should be “at least clear and convincing evidence” because the “absence of guidance” creates “confusion and inconsistent application of the” Rule 2080 standards, and because of the generally nonadversarial nature of straight-in requests. PIABA recommended that the panel should be required to find “no investor protection or regulatory value” before recommending expungement because arbitrators may misapply the existing Rule 2080 standards.
Consistent with the requirements under the Codes today, the Proposal would require that to recommend expungement of customer dispute information, the arbitrator or panel must make an affirmative finding that (i) the claim, allegation or information is factually impossible or clearly erroneous; (ii) the associated person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (iii) the claim, allegation or information is false. At this time, FINRA does not believe that adding a “clear and convincing evidence” standard only for expungement decisions would aid arbitrator decision-making.34 As stated above, FINRA seeks to balance the competing interests in the expungement process, including in providing a fair process and ensuring that information about associated persons that is available to investors is accurate. In addition, as stated in the Proposal, FINRA is concerned that codifying a “no investor protection or regulatory value” standard could create confusion and the potential for inconsistent results among different arbitrators.
FINRA believes that the overall Proposal, including, for example, the provisions that require additional training and qualifications for arbitrators on the special arbitrator roster, should help ensure that the existing standards are applied appropriately. Accordingly, FINRA has determined not to revise the Proposal to require arbitrators to apply a “clear and convincing evidence” or “no investor protection or regulatory value” standard before recommending expungement."
As it stands, FINRA's decision to not create an evidentiary standard means that many arbitrators will continue to apply a simple preponderance of the evidence standard. Under this standard, when a broker appears and calls the investor a liar, the arbitrator will probably recommend expungement because customers usually do not appear and the arbitrator never receives any other evidence.
Sadly, the lack of any evidentiary standard will create more inconsistent results--something FINRA ostensibly desires to avoid. Without guidance on the standard, arbitrators will have to come up with their own. Some may stay with a preponderance standard, but others won't. Different standards will inevitably lead to inconsistent results.
If you're interested in this issue and want to comment on it, the deadline is January 19th.