From the Blog

FINLAW: Pitfall to the Unwary — Mandatory Arbitration and the Unanticipated FINRA Enforcement Action

We hear frequent complaints about FINRA arbitrations.  The arbitration is unfair to one party or another, that there are insufficient procedures to dismiss frivolous cases, or that the arbitrators do not spell out the factual or legal basis for their decision.  While each of these may be a legitimate complaint, unwary litigants who are also FINRA Members or Associated Persons may be surprised when the mandatory arbitration before FINRA leads to a FINRA Enforcement action.

A top FINRA priority is to protect investors and market integrity.  This is accomplished by initiating Enforcement disciplinary actions against firms or their associated persons for violations of FINRA Rules and the federal securities laws.  FINRA has the authority to fine, suspend, bar or expel broker-dealers and registered-representatives from the industry.  FINRA treats its mandatory arbitration proceedings as fertile soil to learn about misconduct and bring enforcement actions.  Here are some of the ways an arbitration can result in a FINRA enforcement action:

  • Members and associated persons who fail to comply with an order of an arbitration panel may be referred by an arbitrator for possible disciplinary action. Discipline can include suspensions, fines and termination of FINRA membership or registration.
  • FINRA staff reviews arbitration filings for potential violations. The FINRA arbitration department often refers to Member Regulation or Enforcement arbitration complaints alleging troubling conduct.
  • Arbitrators are encouraged to make referrals if they believe that the evidence or other information they learn during an arbitration indicates misconduct.  Arbitrators are provided a Disciplinary Referral Form setting forth the types of information that is beneficial to an investigation.  In 2008, a FINRA enforcement attorney even wrote a paper instructing FINRA arbitrators on how to best make an enforcement referral advocating that referrals include as many details as possible, including key testimony or exhibits that establish wrongdoing.  Each Arbitrator has sole discretion whether to make a referral.  The referrals generally occur after the arbitration proceeding is concluded.
  • If an arbitrator hears evidence of serious wrongdoing and has reason to believe the conduct poses a serious threat to investors that is ongoing or imminent, a referral is permitted to be made during the arbitration proceeding. Each Arbitrator has sole discretion to make the disciplinary referral.  Moreover, when an arbitrator does makes a referral mid-arbitration, this does not necessarily mean that arbitrator has a conflict of interest or must be recused.  Rather, FINRA does not view a disciplinary referral as a factor indicating bias because the arbitrator identified the wrongful conduct while observing the arbitration proceeding.  Thus, an arbitrator’s referral does not necessarily mean recusal, and the arbitrator will still help decide the case.
  • Under FINRA Rule 9554, if an award is issued against a member or its associated person, the failure to pay that award within 30-days will result in a FINRA action to revoke your registration. This rule permits an enforcement proceeding with expedited suspension procedures.  In a customer dispute proceeding, the inability to pay the award to the customer is not a defense.   Rather, the only defenses available when requesting a disciplinary hearing is full payment, an installment payment agreement or other settlement agreed to between the parties, a timely motion to vacate the award which motion has not yet been denied, or that an associated person has filed a petition in bankruptcy.

What should you do when an arbitration is filed that contains unfavorable facts that may result in regulatory action?  FINRA data mines arbitrations to identify enforcement cases.  Each arbitrator is empowered in an appropriate case to make a mid-arbitration referral, thus raising a possibility that a broker-dealer or associated person will litigate the remainder of the arbitration while managing an Enforcement investigation.  In these circumstances, the facts of the arbitration, and existence of the Enforcement action, will spill over into the other proceeding.  The referring arbitrator may remain to decide the arbitration, unless he or she determines to recuse himself.  The Enforcement investigation likely will dig much deeper into the facts than the arbitration, covering issues involving other unrelated customers or a broker-dealer’s possible supervisory failings. While there are lots of reasons to seek another arbitration forum rather than FINRA, any effort to limit a customer’s (or associated person’s) right to FINRA arbitration by forum selecting is a violation of FINRA rules.

Defense counsel needs to be mindful of these issues and should seriously consider settling early, preferably before the filing of the arbitration, in cases where there are highly problematic facts.  It can be dangerous to simply deny customer allegations and force the customer prove his or her FINRA arbitration case.  Defense counsel should carefully assess whether there is a real danger of a FINRA enforcement action when determining the appropriate arbitration strategy.


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