Tuesday, October 8, 2013

FINRA May Require Brokers to Carry Arbitration Insurance

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

When investors suffer damages at the hands of brokers, they often turn to FINRA arbitration rather than suing in state or federal court. FINRA arbitrations are designed to "assist in the resolution of monetary and business disputes between and among investors, brokerage firms and individual brokers," and sometimes result in a monetary award.  However, one problem with FINRA awards is that some brokers are unable to pay, especially brokers with small under-capitalized firms who ran fraudulent schemes that harmed many investors.

The Wall Street Journal is reporting that FINRA may soon require brokers to obtain arbitration insurance to cover awards even in the event of insolvency.  The reason is clear:  many arbitration awards go unpaid, and many brokers would be unable to pay if hit with an award:
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, according to an analysis by SNL Financial for the Journal. 
Finra said $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.
In the short term, arbitration insurance may lead to higher costs for brokers, which may be passed on to investors as higher fees.  The Securities Investor Protection Corporation (SIPC) does not cover most arbitration awards, according to the Journal article.

However, in the long run, requiring arbitration insurance may even have preventative effects on the brokerage industry.  If a particular broker had a history of arbitration awards or suspicious activity, the insurance companies may charge that broker higher premiums, effectively penalizing careless or unethical practices.  This may also prevent a practice known as 'cockroaching,' whereby brokers from failed firms find their way to other firms with similarly unscrupulous practices.

It remains to be seen whether FINRA will implement these plans, and if they do, how much protection will be required.  As always, we recommend using FINRA's BrokerCheck system to check the professional background of particular brokers.

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