Financial advisors could face a lot more dings on their permanent records in coming months. Clients get litigation-happy when the bottom drops out of the market, and this time around is no exception, with arbitration case filings up 71 percent year-to-date through July versus last year. But now, the rules of recording claims have also changed, making it a lot easier for arbiration claims to make it onto a rep's U4 and into the CRD system. Basically, within 30 days of receiving a client arbitration claim or civil lawsuit, brokerage firms must now decide whether the advisor named in that document is likely to have committed the offense that the customer claims he did. If so, the firm must put it on the advisor's record, regardless of whether the case has been arbitrated or settled yet.
“The FINRA amendments are very significant,” says Jacob Zamansky, founder of Zamansky & Associates, a law firm specializing in securities fraud and financial services arbitration and litigation. “I think you're going to see a more significant increase in broker's records being marked than we've seen before — particularly in product cases. Firms are going to make sure that they comply with the FINRA rules by over marking even if it is a firm issue,” he says. But Zamansky thinks that this could also lead to more complaints against firms by brokers, especially now, when the market is finally starting to turn, and many advisors are trying to rebuild their businesses. Marks on an advisor's record aren't going to help him win investor trust and confidence in this environment, especially considering all of the high-profile financial frauds that have been uncovered in the past year.
Of course, the FINRA amendments do serve a purpose — ideally they will help weed out bad brokers sooner, before they can do a lot of damage to individual investors or to the industry's reputation. Under the current system, rogue brokers with repeated client arbitration claims can escape without any marks on their records. That's because, historically, claimant's attorneys have filed their claims against the big brokerage firms with the deep pockets — rather than against financial advisors with their handfuls of millions — in order to obtain greater settlements. Claimant's counsel often intentionally excluded the advisor's name from the list of defendants, using this as leverage to force the firm to make a settlement — whether the customer felt the advisor was to blame or not. The firms would often agree to settle so that their advisors would not get permanent marks on their records, because having advisors with marked up records is not so great for business. No settlement? Then the attorney would make the advisor a defendant in the case. Under the prior Financial Industry Regulatory Authority (FINRA) rules, as soon as an advisor becomes a defendant/respondent in a customer dispute, the complaint must go on his U4, or permanent record.
Under the new rules (Regulatory Notice 09-23), which took effect in May, firms must now report arbitration claims they believe have merit regardless of whether the advisor is named a respondent or defendant in the case. He has only to be named in the body of the complaint, or not at all. This determination must be made in “good faith,” after the firm has investigated the relevant circumstances.
Firms and trade groups representing financial advisors complain that this perverts the judicial system — an advisor's reputation can be sullied before the allegations against him have been adjudicated or settled. They are particularly worried that the new rules will result in a lot more frivolous complaints landing on advisors' permanent records. Because of the 30-day deadline, even if the claimant later amends the filing to remove the advisor's name prior to settlement, the complaint is already in the CRD and can only be removed through expungement. In other words, the advisor would be presumed guilty until proven innocent. “For those people who file frivolous lawsuits against financial advisors and firms, the bad news is that they'll unfortunately be disclosed on the U4 and U5,” says John Bowman, a complaint & regulatory officer at Raymond James Financial Services. Year-to-date through July, 45 percent of arbitraton claims were settled directly, 5 percent were settled via mediton and just 25 percent actually made it to arbitration. Another 16 percent were withdrawn.
Victoria Bach-Fink, CEO and CFO of independent b/d Wall Street Financial Group based in Rochester, NY, agrees that frivolous complaints could become a major challenge under the new rules. “Anybody can put a complaint in writing. Just because someone is named in a document, all of a sudden, now they have a ‘yes’ on their U4,” she says, referring to the section of the CRD that indicates whether an advisor has customer complaints on his record.
Bach-Fink and others say FINRA's new rules will end up sweeping too many good advisors into their widened net. Bach-Fink contends that FINRA should have structured the reporting requirement so that complaints would only land on an advisor's permanent record if there were specific criteria indicating the advisor was engaged in repetitive bad behavior — for instance, if he or she had three or more complaints with the same allegations within a year-long period. To Bach-Fink's point, this would go some way toward weeding out the baseless one-off complaints from litigation-happy clients.
But ultimately, the system is set up to record allegations and not convictions anyway, according to Bowman. “A lot of times, when you read the statement of claim, while the FA's name may be absent in the legal titling of the statement of claim, as you read the body of the complaint, you'll see that FA's name all through there, ‘I spoke to the FA, he said this, and I actually ended up getting this.’” Bowman says the firm often has to explain to FAs that the U4 documents allegations not crimes. “Sometimes an FA will want to make a whole case to you and tell you, ‘but I didn't do this,’ and that is not the question being asked. It's about allegations and, unfortunately, the allegations can be totally false, but in this regulatory system, you're kind of guilty until proven innocent later on.”
In Good Faith
One question some firms and attorneys are asking is, how will firms decide whether an advisor is guilty, or not? Many executives complain that the standards for determining whether an arbitration or civil litigation should be reported against a rep are too vague — what exactly constitutes a “good faith determination” is not very clear. The result could be inconsistent or incorrect reporting, plus a greater administrative burden and increased litigation exposure. “It is also hurting the broker/dealer,” says Bach-Fink. They need to disclose client complaints, because if they don't, FINRA will cite them, she says. But on the other hand, if they fall afoul of the “good faith determination” and get a little sloppy, the advisor may litigate.
Counsel at one of the major firms says there are a number of gray areas. For instance, when there is a “failure to supervise,” should marks go on the records of advisors and managers both? Another place where it could get murky is determining the onus when an advisor is part of a partnership. If both advisors received compensation as a result of the alleged violation, but one of the advisors did not directly participate, what happens to the non-participating advisor's U4? Lastly, for an advisor who inherits a book of clients from another advisor, if legacy investments in those accounts blow up, is the new advisor partially responsible? And to what extent?
“Everyone is living up to the rules but the firms don't want to make a disclosure that is not required because then they face claims by the broker,” says Tracy DeWald, General Counsel at independent b/d Securities America. “So the firms are caught between a rock and a hard place, and the plaintiff lawyers don't really care. They've learned if you don't name the rep it is easier to settle, so the plaintiff lawyers were happy to play along with the game: ‘I'll just name the firm, but in my complaint I will allege some pretty horrendous, egregious conduct by the advisor and the advisor's U4 stays clean.’”
While some firms are concerned about FINRA's murky wording, Bowman says making FINRA's “good faith determination,” should be fairly easy, and really comes down to determining whether the actions under question were the responsibility of the broker or the firm. Of course, this “good faith determination” gives firms a certain amount of leverage over the broker, and could allow them to influence the outcomes of arbitration cases. For example, they could threaten to put customer complaints on an advisor's record in order to get his or her cooperation.
Many attorneys who defend advisors in arbitration cases say the new rule should not apply to advisors where an entire product class went bad, such as auction rate securities (ARS) or structured products. In such cases, according to these attorneys, it is the responsibility of the firm to make sure brokers understand the products they're selling. “In these mass product cases, the argument by brokers is that it is not appropriate for them to be named where it is really a firm product issue,” Zamansky says. Lately, ARS and derivatives are hot targets. FINRA began tracking cases involving derivatives and ARS back in January 2008, and since then more cases have been brought involving these investments than any other investments except for mutual funds and common stocks.
New Game, Same Old Game
Some claimant attorneys think they have found a way around the new rules that may keep advisors' records safe: They are simply leaving advisors' names out of their complaints entirely. It's hard to know yet whether the strategy will go over in settlements with firms or in front of arbitrators. David Robbins, partner at Kaufmann Gildin Robbins & Oppenheim, who has been practicing as a securities attorney representing customers and brokers for 30 years, says that he did just that in a recent Auction Rate Securities (ARS) claim. I would “never in a million years name the broker,” says Robbins. “We don't even put his name in the document. I mean you cannot tell from the claim who the heck the broker is.” In the past, he would have named the broker in the complaint without naming him as a defendant. But because of the new rule, Robbins decided to just refer to him as “the broker,” to “make it really hard for someone to report his name. I'll see if it works.” Robbins' claim is still pending.
Bill Singer, securities attorney and Registered Rep. columnist, says this is happening a lot already at firms like Lehman Brothers, Bear Stearns, and Merrill Lynch — former employees are not getting named in the claim. Claimant's council knows that in many cases the brokers are bankrupt and more importantly they would rather have the broker cooperate. “I am finding a lot of claimant's counsel are purposely not naming the individual broker because they don't necessarily want to antagonize a now hostile witness to the b/d,” says Singer. “They also are being careful about naming managers, whether it is regional, back office or branch managers, because many of them have seen their income destroyed and they are hoping that rather than support the firm, they will say, ‘We were pressured into doing this.’ More often than not, these folks are upset or pissed off at their former employer and their testimony could make all the difference between winning or losing the case.”
But counsel at one wirehouse said that naming a particular advisor “Mr. X” on a claim wouldn't stop most firms from recording complaints on the advisors' U4. The firms know which advisors work with which clients and are still going to be held responsible for disclosures by regulators.
Reps In The Fray
FINRA is taking other measures as well in a wider regulatory push to make registered reps' complaint histories more transparent to regulators and the public. Another set of amendments will require the disclosure of smaller, older complaints, also called “historic complaints,” if certain conditions are met. Under earlier rules, historic complaints were any complaints on an advisor's U4 or U5 that were over two years old but had not been settled or adjudicated, or any complaints, arbitrations or litigations that had been settled for less than $10,000. Under the changes to the rule, historic complaints include anything settled for under $15,000. Moreover, historic complaints must now be reported if the most recent complaint arbitration or litigation on an advisors' record is less than ten years old and there are at least three counts on the advisors' record, including regulatory actions, customer complaints, arbitrations, litigations or historic complaints.
“I think the thing to the advisor is that they now have this mark on their U4, and with the new expungement restriction, the ability to clean those up, just becomes more difficult,” says Securities America's Tracy DeWald.
FINRA has also made recent amendments requiring firms to answer additional questions on forms U4 and U5 regarding whether an advisor's violations of SEC and Commodity Futures Trading Commission (CFTC) regulations were “willful.” As a result regulators will now be able to query the CRD system to identify individuals who have committed such willful violations, which can disqualify them from the industry. Furthermore, the SEC recently approved FINRA Rule 1010, which makes it easier for firms to file amendments to U4s without obtaining the advisor's manual signature.
While the ink is still drying on all of these rule amendments, they present a new battle ground for attorneys, reps and their firms in the handling of customer claims.
