It’s no secret that small broker-dealers are struggling to keep their doors open as technology, compliance and legal costs continue to increase, especially as they prepare to put weighty new regulations such as the Department of Labor’s fiduciary rule into place.
Indeed, the decline of the broker-dealer industry continues. According to the Financial Industry Regulatory Authority Inc., 3,901 broker-dealers were open for business in August; that’s a drop of 13% from 2011, when 4,456 firms were opens; and a decrease of 20% from 2008, when Finra counted 4,895 firms under its scrutiny.
With hundreds of firm shutting down in recent years, the issue of unpaid arbitration awards to investors becomes more pressing than ever. When small firms close and have yet to pay arbitration awards, investors are often out of luck and get nothing despite winning their cases. The vast majority of these cases are overseen by Finra’s Dispute Resolution forum.
Take the case of Newport Coast Securities Inc., a small broker-dealer with 109 registered reps thatshut down over the summer. The firm sold its assets — namely select brokers and their books of business — to another broker-dealer.
Newport Coast was plagued with advisers hauling around banged-up compliance histories. An InvestmentNews review of the firm’s employment roster in July showed that a large portion of brokers, 63%, had at least one compliance mark, known as a “disclosure event,” on its Finra BrokerCheck reports .
That was far above the industry norm. According to Finra, just 12% of the 640,000 registered reps, executives and back office employees of securities firms have one or more disclosure events on their records.
And according to its profile on BrokerCheck, Newport Coast “cannot meet the financial liabilities shown” and its “total amount owed to customers, from pending and awarded arbitrations, is $220,628.”
Under the current system, it looks like those Newport Coast clients may be out of luck.
“How can you sell the firm’s assets for cash when investors still have outstanding arbitration claims against it?” asked Scott Silver, a plaintiff’s attorney who said he has a handful of complaints against Newport Coast charging that its brokers churned customer accounts in 2013 and 2014.
“Finra has to approve mergers, such as Newport Coast’s,” Mr. Silver said. “So why isn’t Finra questioning the purchase price and how those funds will be used to satisfy the liabilities of Newport Coast, i.e., the customer complaints?”
Attorneys like Mr. Silver obviously have a vested interest in this issue since they generally work on contingency fees. If the award is not paid, they don’t get paid.
Representatives for Newport Coast couldn’t be reached directly for comment, but Joseph Mangiapane, one of the minority owners of Rubicon Financial Inc., the parent company of Newport Coast, left a voice mail saying, “There’s insurance, and everything is covered up and through the time a company goes out.”
Philip Aidikoff, a plaintiff’s attorney, said that while many broker-dealers do carry insurance for investor claims, limits on insurance can be low and insurance doesn’t cover all types of claims.
How bad is the problem? According to a report issued by a Finra Dispute Resolution task force last year, Finra in 2013 issued arbitration awards in 539 investor cases, of which 75 were not paid. The amount of unpaid damages in these cases totaled $62.1 million.
“This has been going on for a long time and that number — $62.1 million in unpaid damages — is really just the tip of the iceberg,” said Mr. Aidikoff, who served on the task force. “It’s an interesting number, but is not representative of the true harm to investors, and there’s no way of knowing what that could be. What about all the claims investors don’t make because it’s common knowledge that the firm is going out of business?”
“Finra remains very concerned with awards to investors that go unpaid,” said spokeswoman Michelle Ong. “This is a complex issue and Finra is looking at it in a fuller context, examining root causes like sufficiency of firm capital and other relevant aspects of this issue,” said Ms. Ong. She said Finra could not comment about Newport Coast.
That’s all well and good, but Finra has been aware of this issue for a long time and has made very little progress resolving it. In 2000 — 16 years ago — the U.S. Government Accountability Office issued a report that said that the industry needed to address the problem of unpaid arbitration awards.
In 2013, a Finra senior executive told the Wall Street Journal it was considering requiring brokerage firms to carry insurance to cover the payment of arbitration awards to investors. A year later, a Finra spokeswoman told Reuters no such thing would happen, insurance would be too costly.
Most recently, industry talk has floated the idea of establishing a fund for unpaid arbitration awards. But if the past is any indication of where this proposal is going, such chatter is pure gossamer.
Finra has a brand new CEO, Robert Cook. If he wants to make his mark for retail investors, he should immediately start working to fix this open sore on the securities industry.