A Few Things About AAA Arbitration of RIA (and Other) Claims

At a recent webinar, representatives of the American Arbitration Association ("AAA") provided several comments about the arbitration process as applied to claims involving registered investment advisors ("RIAs"):

Do the consumer or commercial AAA Rules apply?

Where the operative arbitration clause determines the applicable rules, that controls.  Otherwise, AAA's case team reviews the claim to determine whether the claim falls under the consumer or commercial rules.  On motion, the appointed arbitrator may also be asked to review which rules apply.

What's the number one difference between the Rules from the consumer perspective?

The AAA identified the fee structure as a primary difference between commercial and consumer AAA rules. The fees for consumer cases are much easier on the wallet; fees are capped at $2,500 per hearing day. The consumer's filing fee is $225 and no other fee is charged to the consumer. Under the commercial rules, AAA fees are charged at the arbitrators' standard hourly rates.

How are arbitrators assigned under the Commercial Rules?

• The strike-and-rank method.
• AAA will provide the parties with a link to arbitrators and they can then pick from the list. The parties may also limit the list based on the parties' requests regarding arbitrator fees or qualifications.
• AAA will discuss with the parties desired arbitrator qualifications, often industry experts are desired
• AAA will look at the contract and assess arbitrator qualifications best suited for the case. 

How are arbitrators assigned under the Consumer Rules?

• the arbitrator is directly appointed by AAA, the parties are provided the selected arbitrator's resume and allowed to object
• the parties may also agree to a panel of three; selection via strike-and-rank method (the AAA charge is $250 for five names)

What if the arbitration clause is unclear about the size/composition of an arbitration panel?

AAA will make a judgment regarding the size and composition of an arbitration panel upfront. Where there is an ambiguity in the arbitration clause, AAA will first seek agreement from the parties.  If there is no agreement, AAA will make judgment.  AAA generally will take into account that multi-arbitrator proceedings are much more expensive (in AAA's experience 5x more costly) and slower (on average requiring months of additional time).

How are conflicts vetted?  

AAA arbitrators are instructed to disclose, disclose, disclose; if in doubt, disclose.  

The parties can also request enhanced arbitrator selection, which makes particular sense on high-stakes cases. This typically involves getting on a ZOOM call and have a discussion with the arbitrators and pose questions related to any conflict-of-interest questions or concerns.

A party may make a bias or similar serious challenge to an arbitrator to AAA's Administrative Review Council.  The Council hears about 300 challenges per year.  The challenges result in a "yea" or nay" decision, not an explained decision about whether an arbitrator should stay or be removed.

What if a party wishes to object to hearing location, even where that is defined by agreement?

The AAA will make an initial determination, and a request can be made for review by AAA's Administrative Review Council.  The arbitrator can also be asked to make a ruling.

Registered Investment Advisor Claims and American Arbitration Association (AAA)

The American Arbitration Association (AAA) handles a great number of financial disputes. At a recent seminar, AAA shared some data:

• the AAA case load has risen rather sharply, a 19% rise in claimsin 2022 as compared to the prior year;
• The primary claim types driving that increase are: lender debtor, banking services, partnerships;
• 90% of cases are decided in favor of one side or the other--in general they do not see claims resolved on a "split the baby" basis;
• the usual time frame from filing to award is 6-9 months, of course there are outliers; 
• 65% of cases settle;
• case decisions are generally non-public, with exception of employment, labor, and some international case types (searchable in Westlaw);
• arbitration awards are not disclosed to securities regulators; and
• the AAA does not track win/loss ratio with particular arbitrators.

2022 Revisions to American Arbitration Association Rules

The American Arbitration Association (AAA) has updated its Commercial Arbitration Rules and Mediation Procedures, effective September 1, 2022.  Per AAA’s announcement the changes reflect the input of a wide range of AAA stakeholders, and “standardize important longstanding AAA practices—confidentiality, consideration of consolidation/joinder motions, and civility—as well as revise rules to further promote efficiency, reflect advances in technology, and include where appropriate discussions regarding cybersecurity.”

The AAA highlights five key changes:

1. Consolidation: AAA’s first-ever commercial rule for the consolidation of existing arbitrations or the joinder of additional parties.  New Rule R-8 now explicitly allows a party to file a request to consolidate and establishes a procedure for acting on such requests.
2. Confidentiality: Captures the long-standing requirements of the Code of Ethics for Arbitrators by including a commitment to the confidentiality of arbitration in the Rules, pursuant to new Rule 45(a).  Rule 45(b) specifically permits arbitrators to issue confidentiality orders.
3. Conduct of parties and their representatives: Specifically incorporates into the Rules the AAA’s expectations of civility and professionalism of all participants in arbitrations.
4. Providing arbitrators with the authority to interpret awards: Allows the arbitrator to explain the award (and correct clerical, typographical, or computational errors) on a party’s motion, per an update to Rule R-52.
5. The importance of cybersecurity, privacy, and data protection: Reflects the weight that the AAA places on cybersecurity and recommends that data protection be discussed in the preliminary hearing.

The revised rules include a number of other important changes.  The upper limit dollar threshold for the application of the Expedited Procedures rises from $75,000 to $100,000 and, similarly, the lower limit for application of Large, Complex Commercial Disputes Procedures doubles from $500,000 to $1 million.  Rule R-34 establishes procedures for dispositive motions and Expedited Procedure E-5 prohibits them absent good cause shown and arbitrator permission. Other rule amendments expressly authorize and promote use of videoconferencing. 

These are all welcome changes to promote AAA's goal of an "orderly, economical, and expeditious" procedure for the determination of disputes.  The amended rules can be found here. 

Attorneys' Fees under the Uniform Securities Act

Because of the expense of litigation (and arbitration), a common question is whether attorneys' fees are available to the prevailing party.  Yes, but only in connection with some claims and don't bank on it.

Under the Uniform Securities Act, which has been adopted in four New England States, the answer is yes, although recovery of attorneys' fees is permissive, not mandatory.  Maine and New Hampshire adopted the current version of the Act.  Massachusetts and Rhode Island adopted the original Act but have not adopted the current version.  Both the current and prior versions of the Act provide for recovery of attorneys' fees in connection with certain civil claims by the seller, purchaser, and in several other situations.

Update on Securities Arbitration Administered by FINRA

This is by no means verbatim, but presents the highlights of a town hall meeting with Rick Berry, Director of FINRA’s Arbitration Services and Manly Ray, Director of FINRA Arbitration’s Southeast Regional Office and the head of FINRA’s Mediation program, and Sam Edwards, President of the Public Investors Arbitration Association.

Has FINRA seen a spike in cases as a result of stock market volatility and the economic downturn?  Not yet.  FINRA expects a 3-6 month lag, or possibly longer as a result of delays caused by the COVID-19 situation.  So far in 2020, customer case filings are down 7%.

How fast are expedited cases moving?  They are moving as fast as allowed by the Code.  FINRA is considering changes to the Code to speed up cases for claimants over age 75 or with very serious medical conditions.

Has the mix of securities at issue in arbitration changed?  Yes.  In 2020, claims related to common stock, private equity, REITs are the top three claim types, followed by bonds and bond funds.  In recent prior years the top cases by volume were bond and bond fund cases.  The number of cases that go to hearing as a percentage of total cases continues to trend lower, perhaps driven by pre-hearing settlement of many bond cases.

Updated on commitment to diversity?  Of the new arbitrators added to the list in 2019, 39% were women, 19% were African-American, and 3% were Asian.  Many newer arbitrators are younger.  Mediator diversity is also improving.

What portal improvements are in the works?   FINRA is working toward offering a real-time fee display.  FINRA is working toward more clear and frequent invoicing.  FINRA will also move toward electronic expense, billing, and invoicing.  TAll arbitrator selection, including short lists, will be through the portal sometime next year.

Any progress toward reforming the expungement process?  Last week the SEC approved a new filing fee for expungement, $1575 fee.  The FINRA Board approved in Fall, 2019 a special roster of arbitrators to handle expungement cases.  They will have enhanced training and a certain amount of experience will be required.  Comments from SEC are pending.  FINRA is moving toward codifying Expanded Expungement Guidance, which currently describes the best practices arbitrators should follow when deciding expungement requests.

What's going on with unpaid arbitration awards?  FINRA has done three things to attack the issue of unpaid awards.  First, stopping bad conduct from taking place on the front end--targeting firms with significant history of misconduct.  Second, rule changes would give investor claimants more options in pursuing claims against firms/brokers that become inactive at any stage of the case; to withdraw a claim and go to court or to amend claims.  The proposal is meant to provide more flexibility in proceedings against defunct or inactive parties.  Third, the Membership Application Program (MAP) incentivizes the timely payment of arbitration awards and prevents an individual from switching firms, or a firm from using asset transfers or similar transactions to avoid payment of arbitration awards.  FINRA continues to weigh other options.

When will insurance information be discoverable?  The issue remains under study at FINRA, and there is no set deadline to update Code to require discovery of insurance information.  This will require further action by the FINRA Board. 

How successful has the simplified arbitration process been?  The rule became effective September 17, 2018.  It has not been a big success.  As of June 1, 2020, 66 cases have been administered under this rule.  11 of 66 cases were closed by award; 1 case awarded damages.  FINRA is considering moving to video as a default or at least making video optional.

FINRA Response to COVID-19.

Aside from in-person hearings and mediation, FINRA continues to move forward with remote hearings and electronic filings as normal.  The schedule and pace of cases has not slipped, with one exception ... FINRA postponed all hearings through July 31.  FINRA has also offered to waive hearing postponement fees through September 4, 2020.   By joint agreement, hearings can be conducted via Zoom.  The same is true for mediation (with added incentive of reduced fee mediation).

In customer cases, FINRA arbitrators have heard 18 contested motions by Zoom (in all cases 28 motions have been heard).  No customer cases have been heard in their entirety by Zoom; one case had a final hearing date by Zoom but the vast majority of the case was presented in-person.  One industry case was heard stem-to stern by Zoom.  The Zoom recording (audio only-not video) will be the official hearing record.

FINRA has been encouraging Zoom mediation.  FINRA's reduced fee mediation program has been working well since May 6.  Fee is $100/hr split by the parites.  FINRA waives all filing and administrative fees.  To date only 4 cases have opted in, but 20 or so are scheduled.  Some mediators use a mix of Zoom and telephone.

FINRA staff will host and facilitate Zoom hearings.  FINRA has substantial familiarity with Zoom and has been using it for several years. 

Arbitrators are presenting best practices for use of Zoom in "The Neutral Corner."  FINRA is finalizing a Zoom Guide for Arbitrators, and recording three instructional videos (3-5 minutes each): introduction to Zoom, technical instructions, and Zoom etiquette.  

For practitioners who prefer a remote hearing platform other than Zoom, the parties can file a motion with the panel and propose an alternative.  FINRA has thoroughly vetted Zoom and that is the default, but FINRA has not ruled out using other platforms if preferred by the parties or ordered by an arbitration panel.

The future of in-person hearings is revisited on an ongoing basis.  The lodestar is public health and safety.  FINRA is considering geographic differentiation; moving forward with in-person hearings in some locations, but not others.  FINRA is also considering venues that would accommodate social distancing.  It is considering whether to require masks at hearings and other changes when in-person hearings begin.

Maine Securities Administrator Warns of COVID-19-Related Fraudulent Investment Schemes

In an April 3, 2020 warning urging investors to be on guard against an anticipated surge of COVID-19 fraudulent investment schemes, the Maine Securities Administrator cautions that scammers will be targeting investors, capitalizing on the double whammey of the recent economic downturn and anxiety about the virus.   

Of special concern are get rich quick schemes specifically tied to the threat of COVID-19.  "Bad actors can be expected to develop schemes that falsely purport to raise capital for companies manufacturing surgical masks and gowns, producing ventilators and other medical equipment, distributing small-molecule drugs and other preventative pharmaceuticals, or manufacturing vaccines and miracle cures."  

Also flagged by the Securities Administrator as areas of likely abuse:

• Private placements and off-market securities. Scammers will take advantage of concerns with the regulated securities market to promote off-market private deals. These schemes will continue to pose a threat to retail investors because private securities transactions are not subject to review by federal or state regulators. 

• Gold, silver and other commodities. Scammers may also take advantage of the decline in the public securities markets by selling fraudulent investments in gold, silver and other commodities that are not tied to the stock market. These assets may also be attractive because they are often promoted as safe or guaranteed as hedging against inflation and mitigating systematic risks. However, scammers may conceal hidden fees and mark-ups, and the illiquidity of the assets may prevent retail investors from selling the assets for fair market value. 

• Recovery schemes. Retail investors should be wary of buy-low sell-high recovery schemes. For example, scammers will begin promoting investments tied to oil and gas, encouraging investors to purchase working or direct interests now so they can recognize significant gains after the price of oil recovers. Scammers will also begin selling equity at a discount, promising the value of the investments will significantly increase when the markets strengthen. 

• Replacement and swap schemes. Investors should be wary of any unlicensed person encouraging them to liquidate their investments and use the proceeds to invest in more stable, more profitable products. Investors may pay considerable fees when liquidating the investments, and the new products often fail to provide the promised stability or profitability. Advisors may need to be registered before promoting these transactions and legally required to disclose hidden fees, mark-ups and other costs.

• Real estate schemes. Real estate investments may prove appealing because the real estate market has been strong and low interest rates have been increasing the demand for housing. Scammers often promote these schemes as safe and secure, claiming real estate can be sold and the proceeds can be used to cover any losses. However, real estate investments present significant risks, and changes to the economy and the real estate market may negatively impact the performance of the products.

As reported in the Portland Press Herald, scammers are also using email "phishing" and other techniques to get access to investors' computers and steal stimulus relief checks.

Any investor targeted by suspicious activity is encouraged to contact the Maine Office of Securities at https://www.investors.maine.gov , by calling 1-877-624-8551 or writing to the Maine Office of Securities, 121 SHS, Augusta, Maine 04333-0121.

Maine Joins Other States by Requiring Mandatory Reporting of Suspected Financial Exploitation

To enhance prompt reporting of financial exploitation to state securities regulators and adult protective services, on April 2, 2019 Maine joined 25 other states by enacting the Act to Protect Vulnerable Adults from Financial Exploitation, Public Law 2019 Ch. 17.  The Act makes broker-dealers and others mandatory reporters of suspected financial exploitation of seniors and vulnerable adults. 

The Act is intended to combat financial exploitation of elderly and disabled persons, a not infrequent occurrence.  According to one reputable source as many as 20% of adults over the age of 65 have been victimized by financial fraud, and only one in 44 cases of financial abuse is ever reported.  The Maine law is largely identical to a model act developed by the North American Securities Administrators Association (NASAA), an organization of state securities administrators dedicated to protecting senior investors from financial exploitation. 

The Act contains five key elements:

• mandatory reporting to a state securities regulator and state adult protective services agency when a qualified individual has a reasonable belief that financial exploitation--generally, wrongful or unauthorized use of money--of an eligible adult has been attempted or has occurred;
• authorized disclosure only to third parties in instances where an eligible adult has previously designated the third party to whom disclosure may be made;
• authority for broker-dealers and investment advisers to delay disbursing funds from an eligible adult's account if there is a reasonable belief that a disbursement would result in financial exploitation;
• immunity from liability for reporting of suspected financial abuse and for delayed disbursements; and
• mandatory cooperation with requests for information by state investigators in cases of suspected financial abuse (any records provided under this clause are exempt from state public records law).

The Act applies to any "eligible adult," which is defined as persons age 65 or older or who are protected under adult protective services law.  The mandatory reporting requirement applies to any agent, investment adviser representative or individual who serves in a supervisory, compliance or legal capacity for a broker-dealer or investment adviser.  According to NASAA, the "reasonable belief" standard for making a report "is intended to be both a subjective and objective standard – i.e., a qualified individual must have a subjective belief in the existence of the financial exploitation, and this belief must be objectively reasonable."

The Act will force broker-dealers to make tough calls about whether to make a report.  Broker-dealers may perceive reporting as having the potential to alienate a customer or a customer's family, who may react negatively to a report and ensuing investigation.  Although a mandatory reporter is immune from liability, that does not mean that a customer (or customer's family) is obligated to continue to do business with a broker-dealer who (in the family's view) instigated an unjustified investigation.  Many customers will, however, recognize that reporting is ultimately for their own benefit.

How well is the Act working?  The Maine Office of Securities has not made public any statistics on the number of reports, the outcome of reports, or other activity related to the Act.   Nor has it pursued any enforcement action for failure to report.   The focus of Maine regulators is on educating the regulated community about this obligation, so far.

Unpaid Arbitration Awards: An Unabated Problem

Earlier posts highlighted a long-recognized problem in the securities industry: investors who've proven that they were harmed by bad actors  all too often wind up recovering little or nothing even after winning a legal claim.

An analysis of arbitration awards a few years ago revealed that about 25%, nearly $1 out of every $4 awarded to customers in arbitration went unpaid.  There are solutions to the problem, like requiring insurance (as is required to register an automobile), requiring that broker-dealers maintain higher minimum capital reserves, or establishing a fund that could be used to pay arbitration awards against broker-dealers who can't or won't pay, as described here.  Have these or other solutions been implemented?  No, although they remain under consideration.

And the problem remains prevalent.  The industry faces a "fresh wave" of unpaid arbitration awards, according to reporting by Bruce Kelly in Investment News.  He reports, "From 2013 to 2017, brokers and firms failed to pay $167 million in arbitration awards to customers that FINRA hearing panels had approved."  A $1 million award made in Maine not long ago remains unpaid.  That's quite a bit of money, especially considering that it represents awards obtained after a legal proceeding and the vast majority, in some instances, of investors' retirement savings. 

This a a problem in need of a solution.  At stake is not just the well-being of customers who have been defrauded and face dire personal financial and lifestyle consequences, or the injustice of leaving customers without any real-world remedy in all too many instances.  The industry needs to weigh the risk of seriously undermining consumer confidence, which could have much broader implications for the health of financial markets.

Expungement: A Seriously Flawed Process?

In 2017, this blog featured a post examining the standard applied to requests by brokers to cleanse (erase) their public records of customer complaints, a process called "expungement," here.  A recently released (October 2019) study by the investor protection foundation run by the Public Investors Arbitration Bar Association (PIABA) reports that the process is “broken” as a result of being “systematically gamed, exploited and abused” by brokers and brokerage firms. 

Among the problems found, according to PIABA's study are sham cases seeking nominal damages ($1.00) resulting in lower costs and fewer arbitrators, and brokerage firms which almost never (only 2% of the time) oppose brokers' requests for expungement.  Investors only rarely appear to oppose expungement requests, and may not even get notice of expungement hearings.  The result is that the dice are loaded in favor of expungement, with the result that investor complaints, including those that may be settled for a significant payment, never see the light of day.  

Are meritless claims against brokers made by investors?  Without question.  Should brokers be able to unilaterally wipe the slate clean, leaving the appearance that no claim had ever been filed in the first place?  That is a much tougher to justify--especially if the system for vetting such requests lacks sufficient safeguards to ensure that they are granted only in extraordinary cases where the request is truly justified.

Lessons From "Arbitration Nation:" an Empirical Study of 40,000+ Consumer Arbitrations

A recent study identifies a problem -- "we know little about what actually happens in" arbitration -- and offers a solution: find out what happened in more than 40,000 consumer arbitrations administered by four major arbitration forums over the course of six years.

In the study, "Arbitration Nation: Data from Four Providers," Professors Andra Cann Chandrasekher and David Horton analyzed "40,775 consumer, employment, and medical malpractice arbitrations filed between 2010 and 2016 in four major arbitration administrators: the AAA, Judicial Arbitration and Mediation Services (JAMS), ADR Services, Inc., and the Kaiser Health Care Office of Independent Administration (Kaiser)."

Important conclusions:

• consumer arbitration is relatively fast and affordable, with corporate defendants paying the lion's share of the costs;
• although the U.S. Supreme Court has repeatedly and emphatically enforced mandatory arbitration clauses in recent years, the uptick in the volume of arbitration "has been modest;"
• plaintiffs who represent themselves in arbitration rarely win (they only prevail in 10% of employment cases)--"pro se plaintiffs struggle mightily" (but do they fare any better in court?  -- the authors don't comment) and
• arbitration favors repeat players (what I'll call frequent flyers) on both sides--arbitration favors frequent flyer corporate defendants but also frequent flyer plaintiffs' law firms.

To encourage more lawyers to take relatively small value cases to arbitration and thus (presumably) weed out cases without merit and improve outcomes for plaintiffs who have cases with merit, the authors propose "that state lawmakers create rewards for plaintiffs’ lawyers to arbitrate. Specifically, jurisdictions should create a statutory 'arbitration multiplier': an extra bounty for winning a case in arbitration." Intriguing.  And, not likely to be preempted.

What about securities arbitration?  Alas, the authors' study did not include data on FINRA arbitrations.  That is in part because the study relied on data on consumer arbitrations made public as required by Section 1281.96 of the California Code of Civil Procedure--a law that does not cover FINRA.  

New Maine Restrictions on Non-Compete Agreements; Bans Restrictive Employment Agreements

A new Maine law will make it more difficult for Maine employers to enforce non-compete agreements, an issue of particular interest in the securities industry where non-competition agreements often have been used to deter brokers from changing jobs. In enacting the new legislation, Maine joins other New England states, including Rhode Island, Massachusetts, and New Hampshire, which also have new laws on the books limiting the enforceability of non-compete agreements.

On June 28, 2019, Governor Mills signed LD 733 (“An Act to Promote Keeping Workers in Maine”) into law. Under the new law, a noncompete agreement is defined as a contract or contract provision that prohibits an employee or prospective employee from working in the same or a similar profession or in a specified geographic area for a certain period of time following termination of employment.

The new law applies to noncompete agreements entered into or renewed after September 18, 2019.

The new law makes clear that noncompete agreements are “contrary to public policy” and enforceable only to the extent that they are reasonable and are no broader than necessary to protect one or more of the following legitimate business interests of the employer: the employer’s trade secrets, the employer’s confidential information that does not qualify as a trade secret, or the employer’s goodwill. A noncompete agreement may be presumed necessary if the legitimate business interest cannot be adequately protected through an alternative restrictive covenant, including but not limited to a nonsolicitation agreement or a nondisclosure or confidentiality agreement. 

Further, the new law prohibits an employer from requiring or entering into a noncompete agreement with an employee earning wages at or below 400% of the federal poverty level. 

If an employer requires a noncompete agreement for a position of employment, the employer must disclose that requirement in any advertisement for that position, and an employer must provide an employee or prospective employee with a copy of a noncompete agreement at least three business days before requiring that employee or prospective employee to sign the agreement. 

The terms of a noncompete agreement (except for a noncompete agreement with a physician) are not in effect until after an employee has been employed with the employer for at least one year or a period of six months from the date the agreement was signed, whichever is later. 

The law is enforceable as civil violation subject to a fine of $5,000 or more. The Department of Labor is responsible for enforcement of the law. 

LD 733 also addresses “Restrictive employment agreements,” defined as an agreement: (a) between two or more employers, including through a franchise agreement or a contractor and subcontractor agreement; and (b) prohibits or restricts one employer from soliciting or hiring another employer's employees or former employees. With respect to such agreements, an employer may not enter into a restrictive employment agreement or enforce or threaten to enforce a restrictive employment agreement. An employer that does so commits a civil violation subject to a fine of $5,000 or more. The Department of Labor is also responsible for enforcement of this section.

Investing in Private Companies: Opportunities Abound, But So Do Risks

More retail investors than ever are investing in private companies, but doing so can be "high-risk" and "more opaque" and private companies tend to be a magnet for fraud, according to the Wall Street Journal.  "More opaque" means "more secretive"--subject to lesser regulatory oversight and fewer obligations to disclose to the public how their business is performing.  Also problematic is that it can be hard to sell investments in private companies, which means that buying private companies can "tie up your money for a long time."  Sometimes, selling an investment in a private company can be subject to penalties or fees, which may not have been disclosed or understood when the investment was first made.  Investments in private companies are sometimes referred to as "private placements" and include stock and limited partnerships.

Also of concern is that tens of billions of dollars a year in securities in private companies are being sold by securities firms with a checkered past, including investor complaints and other red flags suggesting potential misconduct, according to the Journal.  Investments in private companies also tend to pay higher commissions, creating an incentive for securities professionals to overlook or justify risk in return for a larger commission.  The result is that investors facing the special risks associated with private securities are too often receiving recommendations from registered representatives at securities firms less prepared (or willing) to provide suitable recommendations and to aggressively supervise securities professionals making recommendations to buy private securities. 

Private placement memoranda and sales materials given to investors sometimes contain inaccurate statements. In addition, some materials omit information necessary to make informed investment decisions, and some firms fail to conduct an adequate investigation of the issuer to determine if the private placements were suitable for their customers, according to the Financial Industry Regulatory Authority. 

The Journal also reports that the Securities and Exchange Commission is planning to increase the number of people allowed to buy private companies, even though that population has "already grown 10-fold since the 1980s."   An investor typically must be "accredited" to buy stock in private companies, which requires an annual income of more than $200,000 ($300,000 with a spouse) or a net worth of more than $1 million (excluding the investor's primary residence).  But those thresholds were set more than 30 years ago in 1982.  "If the limits had been adjusted to keep pace with inflation, an accredited investor would now need an annual income of about $515,000--more than double the actual $200,000 limit--and a net worth of more than $2.5 million," according to the Journal.

To put it bluntly, $200,000 isn't the same income it used to be.  Nor does a net worth of $1 million automatically put someone in a position to make speculative investments.  A few years ago the Commission provided these examples of people who would generally be considered "accredited" investors:

• A single working parent of three children with an annual salary of $205,000, and likely with a home mortgage to pay;
• A recent widow who inherited $1 million, but is not earning a separate income; and
• A senior retiree who has accumulated over $1 million in his or her retirement account and needs that money for the retirement years.

Other "accredited" investors include people who have suffered catastrophic injuries and received payments as a result of personal injury claims.  But, such persons should not be assumed to have the "financial sophistication and/or investment experience to be able to assess whether any particular investment is appropriate for them," according to the Commission. 

Of course, "each year, companies raise billions of dollars selling securities in non-public offerings that are exempt from registration under the federal securities laws. These offerings . . . can be a key source of capital for American businesses, especially small or start-up companies."  But for retail investors who receive recommendations to invest in private companies, consult the Financial Industry Regulatory Authority's list of tips and cautions before buying--the gist of which is look very, very carefully before leaping.

Public Investors Bar Association Report: Draft Reforms to FINRA Supervision Rules Leave Investors Vulnerable

In a report titled, FINRA’s Attempt to Gut Investor Protections: Proposed Reforms to FINRA Supervision Rules, Public Investors Arbitration Bar Association (PIABA) argues, “FINRA is currently contemplating the evisceration of crucial protections that have been in place for decades to safeguard investors against investment schemes by brokerage firms’ registered representatives, including ‘selling away’ schemes. If FINRA’s proposed changes are approved, there will likely be more investment scams perpetrated by registered representatives. If these proposals are adopted, brokerage firms will no longer be held primarily responsible for identifying and stopping rogue brokers.” 

FINRA is currently contemplating changes to FINRA Rules 3270 and 3280 as outlined in FINRA Regulatory Notice 18-08. Both rules impose broad supervisory responsibilities and obligations for registered representatives and member firms with respect to outside business activities and private securities transactions. FINRA Regulatory Notice 18-08 proposes to exempt member firms from supervising:

• Investment-related activities at third‐party investment advisor firms;
• Investment-related activities at member affiliates, including IAs, banks, and insurance companies;
• Non‐investment–related work and outside business activities; and
• Personal investments

According to PIABA, outside business activities manifest themselves in a variety of schemes and fraudulent activity every year, including but not limited to, fraudulent private placements, Ponzi schemes, and investment frauds perpetrated through third-party IAs established by the registered representative. According to PIABA, “A common modus operandi in these schemes is for a registered representative to establish a solo or small IA firm and perpetrate the fraud through outside business activities in an effort to avoid member supervision.” 

FINRA proposed Rule 3290 narrows and reduces member firms’ supervisory obligations and, according to PIABA, results in unacceptable adverse consequences, including:

• Dramatically weakening long-standing supervisory obligations;
• Creating glaring supervisory deficiencies;
• Encouraging de facto violations of federal securities laws;
• Generating inconsistencies with other FINRA rules and regulatory guidance;
• Producing perverse incentives for registered representatives and members; and
• Leaving investors with inadequate protection

According to Financial Advisor Magazine, the comment period for the FINRA proposal is closed. “Now all eyes are on FINRA to see what they’ll do and if they’ll put investor protection interests first and let this horrific rule die,” says Andrew Stoltman, current President and member of the Board of Directors for PIABA.

FINRA Arbitration Requirements Take Priority over Forum Selection Clause

The Third Circuit Court of Appeals recently ruled that Bear Stearns must comply with the Financial Industry Regulatory Authority (FINRA) rules that require arbitration of a customer’s claims despite the existence of a forum selection clause. That ruling, in Reading Health System v. Bear Stearns & Co., n/k/a J.P. Morgan Securities, LLC, involved a broker-dealer agreement between Bear Stearns (now J.P. Morgan Securities) and Reading Health System regarding offerings of certain securities by Reading Health through which J.P. Morgan Securities served as broker-dealer and underwriter. The agreement provided that any actions and proceedings arising out of the agreement or the underlying transactions had to be filed in the U.S. District Court for the Southern District of New York. However, FINRA Rule 12200 generally requires FINRA members to arbitrate disputes with customers at the customers’ request if arbitration is required by written agreement or requested by a customer.

Reading Health filed a Statement of Claim with FINRA, alleging that J.P. Morgan Securities engaged in improper conduct in conjunction with the offerings. J.P. Morgan Securities refused to participate in FINRA arbitration. It cited the forum selection clause in its agreement with Reading Health. In response, Reading Health filed a declaratory judgment action to address the arbitration issue. 

The U.S. District Court ordered J.P. Morgan Securities to arbitrate. On appeal, the Third Circuit affirmed. The court found J.P. Morgan Securities’ argument unpersuasive that, in agreeing to the forum selection clauses included in the broker-dealer agreements, Reading Health waived the right to FINRA arbitration under Rule 12200. The Third Circuit found that the forum selection clause, which did not refer to arbitration, lacked the specificity to support a finding of waiver. Although waiver of FINRA Rule 12200 might be found under different facts, the assertion of waiver would need to be supported by explicit language waiving the specific right to FINRA arbitration. 

The court found that Reading Health System had not waived its right to compel Bear Stearns to arbitrate under FINRA’s rules. 

The deadline to file a writ of certiorari to the U.S. Supreme Court in this case is 90 days from the entry of judgment on August 7, 2018. This ruling widens a circuit split. The Second and Ninth Circuits have enforced forum selection clauses, while the Fourth Circuit has held that the FINRA Rule requires arbitration even in the face of a forum selection clause.

FINRA Issues Guidance on Heightened Supervision for Persons with a History of Past Misconduct

To reiterate the supervisory obligations of FINRA member firms regarding associated persons with a history of past misconduct that may pose a risk to investors, FINRA recently published Regulatory Notice 18-15.

FINRA Rule 3110 (Supervision) requires member firms to establish and maintain systems to supervise activities of associated persons to comply with applicable securities laws and FINRA rules. Member firms have a fundamental obligation to implement a supervisory system that is tailored to the member firm’s business and addresses the activities of all its associated persons.

Notice 18-15 highlights particular instances where heightened supervision of an associated person may be appropriate. Firms are encouraged to adopt the practices that are outlined in Notice 18-15 to strengthen their supervisory procedures. Notice 18-15 is one of several FINRA initiatives focused on associated persons with a history of past misconduct that pose a risk to investors and the firms that employ them. These initiatives are designed to strengthen oversight through guidance, rule changes, and surveillance programs.

In Notice 18-15, FINRA instructs that a firm should routinely evaluate its supervisory procedures to ensure they are appropriately tailored for each associated person and consider, among other things, the person’s activities and history of industry and regulatory-related incidents. When an associated person of the firm has a history of industry or regulatory-related incidents, the firm must determine whether its standard supervisory and educational programs are adequate to address the issues such person’s history raises or whether the firm should develop tailored heightened supervisory procedures to address such issues. The failure to assess the adequacy of its supervisory procedures in light of an associated person’s history of industry or regulatory-related incidents will be closely evaluated in determining whether the firm itself should be subject to disciplinary action for a failure to supervise should that person be the subject of a future industry or regulatory related incident.

In short, firms can’t rely on ordinary garden variety supervisory processes and procedures when a broker has a pattern of misconduct. 

Blockchain, Digital Currencies, and Securities Regulation

As with any new investment product or asset class, cryptocurrencies and related blockchain technology have been the subject of a great deal of investor interest and regulatory activity, particularly as bad actors have exploited public interest to peddle unsuitable investments or--even worse--perpetrate frauds.

A blockchain is a public, distributed ledger that is replicated and hosted on numerous computers, creating thousands of identical digital copies that give the system credibility and oversight needed to create a secure public list of an asset.  That list can describe things such as identification, contracts, or cryptocurrencies--scarce, virtual assets represented on a blockchain.  The most well-known cryptocurrency is Bitcoin.  Other popular cryptocurrencies include Dash, Monero, Litecoin, Ethereum, and Ripple.  Blockchain technology is also sometimes referred to as distributed ledger technology (DLT) or distributed database technology. 

For regulatory purposes, federal agencies categorize cryptocurrency in different ways.  To the Internal Revenue Services it is property.  To the Commodity Futures Trading Commission it is a commodity.  The Securities and Exchange Commission says that cryptocurrency tokens can be a security. 

Many securities rules administered by the SEC and the Financial Industry Regulatory Authority (FINRA) are implicated by crytocurrency, as FINRA made clear in its report, "Distributed Ledger Technology: Implications of Blockchain for the Securities Industry" (March 2018)  For example,

• a DLT application that seeks to alter clearing arrangements or serve as a source of recordkeeping by broker-dealers may implicate FINRA’s rules related to carrying agreements and books and records requirements;
• DLT may have implications for trade and order reporting requirements to the extent it seeks to alter the equity or debt trading process; and
• FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer (suitability), supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT applications are being used or tested within the equity, debt and derivative markets.

Unsurprisingly, investors have been attracted to blockchain related investments.  A new fundraising vehicle, the initial coin offering (ICO)--also called a "token generation event" or "initial token offering"--allows accredited investors (those with a net worth of more than $1 million) to bankroll the creation of a blockchain in exchange for payment cryptocurrency "coins" or tokens."  In 2017, more than 200 ICOs raised more than $4 billion.  The size and nature of ICOs vary greatly.

The SEC issued an Investor Alert: Public Companies Making ICO-Related Claims (August 2017) warning "about potential scams involving stock of companies claiming to be related to, or asserting they are engaging in [ICOs]"  According to the SEC, "Fraudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams.  These frauds include 'pump-and-dump' and market manipulation schemes involving publicly traded companies that claim to provide exposure to these new technologies." 

The North American Securities Administrators Association advises investors considering putting money into an ICO to exercise "extreme caution" in its "Informed Investor Advisory: Initial Coin Offerings" (April 2018) as follows:

• ICOs are very risky and are not suitable for many investors;
• Use extreme caution when dealing with promoters who claim their ICO offering is exempt from securities registration yet do not ask about your income, net worth or level of investing sophistication; and
• ask whether the “coins” or “tokens” are considered securities and whether the offering itself has been registered with appropriate securities regulators. 

State regulators, like the SEC, have engaged in active ongoing enforcement activity, including regulators in Texas, North Carolina, New Jersey, and Massachusetts.  Hey, let's be careful out there.

FINRA to Investors: Beware of "Regulator" Impostor Scams

The Financial Industry Regulatory Authority (FINRA) recently issued an Investor Alert, warning investors to beware of financial scammers posing as regulators.

Gerri Walsh, FINRA’s Senior Vice President for Investor Education warns, “Financial fraudsters go to great lengths to appear legitimate, making it difficult for investors to recognize their ruses.” “That’s why we are telling investors flat out that FINRA does not guarantee investments, and our officers play no role in facilitating investment opportunities. We want people to know that and to understand how they can verify who the real FINRA is.” 

Financial fraudsters have gone so far in recent times as to use FINRA’s name and logo in correspondence—and a fake signature from FINRA President and Chief Executive Officer Robert W. Cook—to create the impression that FINRA provided guarantees related to an investment opportunity that was, in fact, an advance-fee scam. 

One common fraudulent scheme involves luring investors into sending money to cover administrative or regulatory charges associated with a buyback of shares of stock that are generally worthless or underperforming. Once investors send the money, they never see it—or any money promised from the stock buyback—again. Sometimes, the con artists will ask for additional money or simply disappear. 

On other occasions, fraudsters send e-mails to unsuspecting individuals, purporting to originate from FINRA’s CEO, notifying potential victims that “approval has been granted for the release and payment of your outstanding inheritance fund.” The victim would be asked to fly to another country—outside of the jurisdiction of any U.S. regulator or law enforcement officer—to claim the “inheritance.” The victim is asked to provide personal information, including a copy of their passport—a common tactic used in phishing scams. 

To avoid losing money in these types of scams, FINRA advises investors to hang up on suspected fraudulent callers and delete e-mails from these individuals. Walsh adds, “If you’re unsure whether an investment solicitation is legitimate, do your own independent search for the official number for the government agency, office, or employee, and call to confirm its authenticity.” 

If an investor is suspicious about an offer or thinks the claims might be exaggerated or misleading, FINRA offers a Scam Meter tool to help investors assess whether an opportunity is too good to be true. FINRA also developed a Risk Meter, which determines if an investor shares characteristics and behavior traits that have been shown to make some individuals particularly vulnerable to investment fraud.

FINRA Proposes Special Procedure for Simplified Cases

The Financial Industry Regulatory Authority (FINRA) proposes to amend the Code of Arbitration Procedure for Customer Disputes and the Code of Arbitration Procedure for Industry Disputes to include a Special Proceeding for Simplified Arbitration. FINRA claims involving $50,000 or less would benefit by having an additional, intermediate form of adjudication that would provide the chance to argue cases before an arbitrator in a shorter, limited telephone hearing format. The Special Proceeding would be limited to two hearing sessions. 

The highlights: 

• A Special Proceeding would be held by telephone unless the parties agree to another method of appearance 
• The claimants, collectively, would be limited to two hours to present their case and 1⁄2 hour for any rebuttal and closing statement, exclusive of questions from the arbitrator and responses to such questions 
• The respondents, collectively, would be limited to two hours to present their case and 1⁄2 hour for any rebuttal and closing statement, exclusive of questions from the arbitrator and responses to such questions 
• Notwithstanding the above-mentioned conditions, the arbitrator would have the discretion to cede his or her allotted time to the parties; in no event could a Special Proceeding exceed two hearing sessions, exclusive of prehearing conferences 
• The parties would not be permitted to question the opposing parties’witnesses 
• A customer could not call an opposing party, a current or former associated person of a member party, or a current or former employee of a member party as a witness, and members and associated persons could not call a customer of a member party as a witness 

FINRA believes the proposed rule change would provide parties with claims of $50,000 or less with an additional, cost-effective hearing option for resolving disputes and limit the potential costs of a hearing and provide parties with the opportunity to present their case without cross-examination from their opponents.

The ability to present their case without cross-examination may benefit those who would otherwise be intimidated by a direct confrontation. FINRA believes that the broader role of arbitrators for a Special Proceeding in asking questions of the parties would serve a similar function to cross-examination, effectively charging the arbitrator with clarifying issues, and asking questions necessary to assess witness credibility.

FINRA 2018 Regulatory and Exam Priorities Released

The Financial Industry Regulatory Authority (FINRA) recently released its 2018 Regulatory and Examination Priorities Letter (the “Priorities Letter”), highlighting topics FINRA will focus on in 2018.

FINRA regulates brokerage firms doing business with the public in the United States. FINRA writes rules; examines for and enforces compliance with FINRA rules and federal securities laws; registers broker-dealer personnel and offers them education and training; and informs the investing public. FINRA provides surveillance and other regulatory services for equities and options markets, as well as trade reporting and other industry utilities. FINRA also administers a dispute resolution forum for investors and brokerage firms and their registered employees. 

Some of the key topics identified in the Priorities Letter as areas of focus in 2018 are fraud, high-risk firms and brokers, operational and financial risks—including technology governance and cybersecurity—and market regulation. Other areas of priority in 2018 include: 

 

• Sales practice risks, including recommendations of complex products to unsophisticated, vulnerable investors 
• Protection of customer assets and the accuracy of firms’ financial data 
• Market integrity, including best execution, manipulation across markets and products, and fixed income data integrity 

In the Priorities Letter, FINRA CEO Robert Cook wrote, “The coming year will bring both continuity and change in FINRA’s programs. . . . The continuity comes, first and foremost, in our unwavering commitment to our mission: protecting investors and promoting market integrity in a manner that facilitates vibrant capital markets. Change will come in how we accomplish that mission.” 

FINRA flags the following significant new rules that are currently scheduled to become applicable in 2018. 

• Financial Exploitation of Specified Adults – FINRA Rule 2165 will become effective February 5, 2018. The rule permits members to place temporary holds on disbursements of funds or securities from the accounts of specified customers where there is a reasonable belief of financial exploitation of these customers. 
• Amendments to FINRA Rule 4512 (Customer Account Information) – An amendment to FINRA Rule 4512 requires members to make reasonable efforts to obtain the name of and contact information for a trusted contact person for a non-institutional customer’s account. The amendment will become effective February 5, 2018. 
• Amendments to FINRA Rule 2232 (Customer Confirmations) – The amended FINRA Rule 2232 requires a member to disclose the amount of mark-up or mark-down it applies to trades with retail customers in corporate or agency debt securities if the member also executes offsetting principal trades in the same security on the same trading day. The amended rule also requires members to disclose two additional items on all retail customer confirmations for corporate and agency debt security trades: (1) a reference, and a hyperlink if the confirmation is electronic, to a web page hosted by FINRA that contains publicly available trading data for the specific security that was traded, and (2) the execution time of the transaction, expressed to the second. These amendments are scheduled to become effective on May 14, 2018. 
• Margin Requirements for Covered Agency Transactions (Amendments to FINRA Rule 4210) – FINRA’s new margin requirements for Covered Agency Transactions are slated to become effective June 25, 2018. Covered Agency Transactions include (1) To Be Announced (TBA) transactions, inclusive of adjustable rate mortgage (ARM) transactions; (2) Specified Pool Transactions; and (3) transactions in Collateralized Mortgage Obligations (CMOs), issued in conformity with a program of an agency or Government-Sponsored Enterprise (GSE), with forward settlement dates. Members are reminded that the risk limit determination requirements under the amendments to Rule 4210 became effective on December 15, 2016.

FINRA Proposes Amendments to the Codes of Arbitration Procedure Regarding Requests to Expunge Customer Dispute Information

Through Financial Industry Regulatory Authority (FINRA) Regulatory Notice 17-42, FINRA proposes establishing a roster of arbitrators with certain training, backgrounds, or experience to handle requests to expunge customer dispute information. These arbitrators would decide expungement requests where the underlying customer-initiated arbitration is not resolved on the merits (e.g., settled) or the associated person files a separate claim requesting expungement of customer dispute information.

FINRA also proposes additional changes to the expungement process, such as changes to the timeframe in which an associated person can seek expungement of the customer dispute information, as well as unanimous consent of a three-person panel of arbitrators to grant expungement.

This is one piece of a larger series of initiatives FINRA is considering related to the expungement process. Comments are requested. The comment period expires February 5, 2018.