Ensuring arbitration awards make it to investors

It Is long past time for Finra to address the problem of unpaid arbitration awards to clients of failed financial firms.The issue has been smoldering since at least 2000, when a Government Accountability Office report said the industry needed to address the problem. Meanwhile, thousands of customers have been harmed by firms’ failure to pay such awards.
In 2013 alone, 14% of awards, totaling $62 million, went unpaid, and some industry observers think that could be the tip of the iceberg as clients might not bother to make claims when they are aware the company is likely to go out of business.

NEWPORT COAST CLOSURE

This is an issue Robert W. Cook, the new Financial Industry Regulatory Authority Inc. CEO, can tackle without taking a listening tour, as he’s spoken of doing. And if he could successfully install a solution, he could add credibility to Finra’s arbitration system for settling disputes.

(Related read: Advisers want Finra to focus on the ‘bad guys’ and leave the rest alone)

The issue was brought to the fore again this summer by the closure of Newport Coast Securities, which, owing more than $220,000 to customers, sold its assets to another broker-dealer. There is great uncertainty about whether those clients will get their money.
There should be no doubt. Customers who have been awarded money in arbitration hearings should be first in line to receive any remaining assets — or proceeds from the sale of assets — from a failing firm.
Finra must stop stalling and actively seek a solution, of which there are three obvious possibilities.
One, Finra could establish an industry-wide insurance pool to which all firms would be required to contribute, which would be used to pay the awards that individual firms are unable to pay.
Two, all firms could be required to carry an amount of insurance commensurate with the client dollars they oversee.
Three, the firms could be required to have more capital backing them, and perhaps pass financial stress tests to continue in business.
The first two of these are the most practical, with a Finra-sponsored industry-wide insurance pool the simplest to implement.
The insurance premium could be based on the number of clients and the dollars advised. The premium could also be adjusted based on the disciplinary record of the firm and its brokers, thus punishing firms that have the greatest number of arbitration awards against them. That would serve to reduce the danger of moral hazard — the tendency for the availability of insurance to encourage poor behavior — and perhaps drive the bad guys out of the business.
The second option, requiring each individual firm to carry a certain level of insurance, would impose higher costs on bad actors, as insurance companies would demand higher premiums to offset the added risk. This also might drive the bad firms, or at least the bad brokers and advisers, out of the business.

A FACT OF LIFE

The industry won’t like any of these solutions because they will all cost money and reduce earnings, but too bad. If you own a car, you need auto insurance to indemnify anyone who is hurt by your driving. The banking industry is required to contribute to the Federal Deposit Insurance Corp.; ditto the savings banks which must contribute to the Federal Savings and Loan Insurance Corp. Companies that sponsor pension plans must pay an annual premium to the Pension Benefit Guarantee Corp.
Insurance to protect the public is a fact of life and a cost of doing business in most industries, so the financial services industry has no right to an exemption. If a firm does not have the financial resources to contribute to insuring the public against bad actors in its ranks, then it should not be in business.
The issue has attracted the attention of Sen. Elizabeth Warren, an implacable defender against what she sees as misbehavior in the financial industry. If Finra does not soon address the problem of unpaid awards, Sen. Warren, or the Consumer Financial Protection Bureau, will likely take action — and the industry probably won’t like their solutions.

(Related read: Why financial advisers hate Elizabeth Warren)