The broker regulator takes another step towards ruling RIAs by making its arbitration process open to them

December 7, 2012 — 4:52 AM UTC by Guest Columnist Patrick Burns


Brooke’s Note: For us laymen, the whole FINRA-as-SRO issue is confoundingly confusing at times and certainly requires more space on the old mental hard drive than we’d prefer to allocate. It is with this thought in mind that I pay great thanks to Pat Burns for bringing his lawyerly lobes — and intellectual courage — to bear on the latest FINRA move. He follows able legal brain trusts like Ron Rhoades and Brian Hamburger who have done some of this heavy lifting in the past on related issues for RIABiz.

Linda Fienberg, president of FINRA Dispute Resolution, and chief hearing officer, has stated that FINRA is opening its arbitration system to RIAs and mentioned that there are already three cases involving RIAs in FINRA’s system. This marks a major step in FINRA’s attempt to regulate RIAs, and should be watched carefully by advisors who fear falling under FINRA’s jurisdiction.

The policy change was disclosed on Oct. 18 at the Public Investors Arbitration Bar Association meeting in Austin, Texas, and though Fienberg attributes the policy to “a lot of requests from attorneys” for investors and RIAs alike, FINRA, a self-regulatory organization for member brokerage firms and exchange markets, has been campaigning vigorously to assume that role for RIAs. Fienberg has said the arbitration move was unrelated to that effort. See: Brian Hamburger hammers the FINRA SRO proposal in a letter.

Even though FINRA acknowledges on its website that it can’t enforce awards against non-members and/or their employees, Fienberg’s announcement raises numerous questions about whether FINRA has the authority to handle such arbitrations, considering FINRA’s own guidelines.

The guidelines divide FINRA cases between two codes: a customer code, which “governs arbitrations between investors and brokers and/or brokerage firms” and an industry code, which “governs arbitrations between or among industry parties only.” There has been no update to either code to include RIAs. Nor has there been an announcement of any regulatory notice to include such an amendment, or any pilot program whereby FINRA can test out RIA arbitration.

Based on the current limitations of FINRA’s arbitration process for RIAs, it is hard to comprehend why any plaintiff’s attorney would suggest that clients submit to such an ambiguous process. See: “Why Bachus’ SRO-that-must-not-be-named would prove a tyrant to RIAs.”

An unfair process?

By opening the door for RIAs to have their arbitration cases held before a FINRA arbitration panel, it seems that FINRA has taken another step in its quest to become the SRO for RIAs. FINRA presently administers the Investment Adviser Registration Depository for RIA filings. The added capacity to hear arbitration cases helps build momentum to argue that if an SRO does regulate RIAs, FINRA would be naturally suited for the role. See: An in-depth analysis of FINRA’s attempted takeover of RIAs and why the group should be disbanded, Part 2.

The FINRA arbitration process has been widely criticized for years as being unfair to brokerage firms’ clients. A study by Edward S. O’Neal, Ph.D. and Daniel R. Solin of more than 14,000 cases over the course of a decade found that FINRA awarded investors, on average, only 12% of their claims when bringing major brokerage firms to arbitration. And it is not unreasonable to think the same could eventually be true for advisory clients. It is interesting to note that currently, there have not been any RIAs lobbying for FINRA to open its arbitration process to them and/or their advisory clients.

Solin, an attorney representing investors against broker misconduct, testified before Congress on his findings, warning about the dangers of industry-administered arbitration by SROs, calling it “a system that takes away two fundamental rights of American citizens: access to the courtroom and trial by a jury of their peers. This is a system that has neither the appearance nor the reality of impartiality, since it requires that a victim of misconduct must submit his or her claim to a tribunal administered by the very industry that he or she is suing.”

Inherent conflict

The qualifications of FINRA arbitrators and their selection processes have been called into question numerous times. David P. Meyer, an investment fraud attorney, reported in August that, up until last year, “investors involved in a dispute of more than $100,000 were required to have at least one industry-affiliated arbitrator on their three-person panel. This requirement was often — rightly — perceived as having the potential to introduce a significant conflict of interest into the process.”

Meyer goes on to say that “when FINRA introduced a pilot program in 2010 that allowed investors to choose all-public arbitration panels instead … investors were awarded damages in a higher percentage of cases than any other year over the past six years … The number of multimillion-dollar awards also increased that year.” If these numbers are correct, then FINRA’s reliance on industry arbitrators for the majority of its history may have cost investors countless awards in damages.

And that’s just the inherent conflict of interest by profession. There are also numerous cases of conflicts of interest and successful disqualification challenges to arbitrators serving on FINRA arbitration panels that have taken place over the years. FINRA has not always been successful in policing the system and cleaning up these problems.

Hopeful signs

Perhaps the best argument against FINRA’s overreach to regulate RIAs was stated in an open letter to Congress from the Project on Government Oversight, a non-partisan, non-profit group that wrote to the House Financial Services committee this May. “FINRA’s regulatory effectiveness is undermined by its inherent conflicts of interest, its lack of transparency and accountability, its lobbying expenditures and its executive compensation packages, among other issues,” stated the letter. “Instead of delegating additional authority to private self-regulatory groups, Congress should reduce the SEC’s current reliance on FINRA and other SROs, work to improve FINRA’s transparency and accountability policies and provide sufficient funding to the SEC to ensure that it is able to carry out its important regulatory duties on its own.” See: An in-depth analysis of FINRA’s attempted takeover of RIAs and why the group should be disbanded, Part 2.

And POGO couldn’t be more right. But is FINRA’s increased role with respect to RIAs inevitable? See: “Is See: Is FINRA oversight a fait accompli? It’s starting to feel that way...”

The Investment Adviser Oversight Act of 2012, introduced by Rep. Spencer Bachus (R-Ala.), chairman of the House Financial Services Committee, and Rep. Carolyn McCarthy (D-N.Y.), would allow for FINRA’s oversight of RIAs, but it was met with a much divided, partisan response. The bill was vehemently opposed by the House panel’s ranking Democrat, Rep. Barney Frank of Massachusetts, who referred to FINRA’s business model as “inherently dubious,” and Rep. Maxine Waters (D-Calif.), who proposed a countermeasure that would augment the SEC’s resources so it could regulate RIAs. The Bachus-McCarthy bill died in Congress this year but is likely to be reintroduced in 2013. See: “RIAs flood Capitol Hill with protests against a SRO-FINRA future on the day of the Bachus Bill hearing.”


Moreover, President Obama recently designated Elisse Walter as the new chairwoman of the Securities and Exchange Commission, a selection that has been met with great concern by RIAs, who are worried she will quickly push for FINRA to be the SRO for RIAs. As designated chairwoman, Walter may serve as head of the agency until late 2013. See: Obama makes 'really unfortunate’ appointment of Elisse Walter as new SEC chairman. Ms. Walter, has worked as senior executive vice president for FINRA, and could help shift advisor oversight from the SEC to a SRO. David Tittsworth, executive director/executive vice president of the Investment Adviser Association, noted that “[Ms. Walter] has been an outspoken advocate favoring an SRO for investment advisers and expressed disappointment that Dodd-Frank did not include SRO provisions. She also filed a separate statement when the SEC staff issued its Dodd-Frank Section 914 report in January 2011 and essentially argued that the report did not list [enough of the] benefits of an SRO. She also has expressed strong support for 'harmonizing’ broker-dealer and investment adviser rules, including a 'harmonized’ fiduciary standard.” See: Nine threats to the RIA business and how they can be avoided.

So, while further financial industry regulation seems unavoidable, there are hopeful signs for RIAs. Particularly of note is the election to the Senate of Massachusetts’ Elizabeth Warren, architect of the Consumer Financial Protection Bureau. Warren campaigned on a strongly anti-Wall Street (big firm) platform, which may mean that she could be a friend to the RIA community. She is likely to be asked to sit on the Senate Banking Committee. FINRA’s desire to become the new SRO — and perhaps at some point the mandatory arbitration forum — for RIAs are open issues and ones that will be hotly debated as we head into 2013. See: “How Time magazine’s “Sheriff” article about Mary Schapiro, Sheila Blair and Elizabeth Warren misses the mark.” See: New York conference: SIFMA wants members to be like RIAs — minus the same rules of accountability.

Patrick J. Burns Jr. is the managing attorney with theThe Law Offices of Patrick J. Burns, Jr., P.C., a securities law firm dedicated to assisting industry members with their legal needs. He is also the president and founder of “Advanced Regulatory Compliance Inc.”: Additionally, Mr. Burns is a member of the California, New York and New Jersey bars. He received his J.D. degree from Southwestern University School of Law in Los Angeles and bachelor’s in business administration from Pace University’s Lubin School of Business in Pleasantville, N.Y. Mr. Burns began his professional career with a New Jersey-based law firm and then worked in a legal/compliance capacity for several financial services firms located in New York and Los Angeles. During his financial services career, he acquired numerous FINRA and insurance licenses. Mr. Burns is a frequent industry speaker on breakaway-broker matters, investment advisory compliance and general regulatory issues.

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