The idea of mandating that brokerage firms carry arbitration insurance is on the table for consideration by the Financial Industry Regulatory Authority (FINRA). As reported by the Wall Street Journal last week, the problem of brokerage firms shutting down without paying awards or other legal claims owed to investors has been an ongoing issue for FINRA for some time now.
“We’re going to evaluate the whole area and see if there are additional steps we can take,” said Susan Axelrod, FINRA’s executive vice president of regulatory operations, in the Wall Street Journal story.
As noted in the Wall Street Journal article, “the financial cushion at some brokerage firms is so thin that just one arbitration award could put them out of business. More than 940 firms disclosed net capital of less than $50,000 in their most recent financial reports as of July 1.”
In 2011, FINRA says that $51 million of arbitration awards granted in 2011 haven’t been paid, or 11% of the total awards. The percentage is up from 4% in 2009 and 2010.
Adding to the problem is the fact that many brokers at firms that go out of business often continue working in the financial industry. Meanwhile, investors are left with nowhere to turn and no help by state regulators when they try to collect their awards.
Some state securities regulators support the idea of requiring brokerage firms to have arbitration insurance.
The Securities and Exchange Commission, which oversees FINRA, requires smaller brokerage firms to have net capital of at least $5,000 or a level related to the firm’s debts, if higher. The net capital rules are in place to ensure that brokerage firms can return investors’ assets if the firm fails.
Still, those rules don’t do much good for investors who lose money because of alleged broker misconduct and are unable to get their arbitration awards because the firm has shuttered its business.
FINRA’s Axelrod said in the Wall Street Journal article that regulator will consider whether brokerage firms should be required to have “errors and omissions” insurance, which can cover claims for negligence or misconduct by the brokers.
Case in point: Provident Royalties LLC. In 2009, the SEC charged the firm and its three owners of operating a $485 million Ponzi scheme. Earlier this year, the executives pleaded guilty to criminal charges related to the fraud.
FINRA has since taken disciplinary action against several brokerage firms and brokers for allegedly selling Provident Royalties’ private placements without conducting their proper due diligence. More than $150 million was sold by firms that have closed and appear to have no insurance or other means to pay investors.