October 10, 2013 / 8:19 PM / 6 years ago

COMPLY-FINRA arbitration awards go unpaid, insurance no easy fix

Oct 10 (Reuters) - Wall Street’s watchdog is floating the idea of requiring brokerages to carry insurance for the payment of arbitration awards to investors. Developing such a plan, however, could be tricky.

The Financial Industry Regulatory Authority, Wall Street’s industry-funded regulator, is looking into the measure because of a growing problem: brokerages that lose securities arbitration cases against investors and then close up shop, leaving those investors unable to collect.

A total of $51 million of arbitration awards granted in 2011, or 11 percent of the total awards, have not been paid, according to FINRA. The figure marks a 4 percent increase from 2009 and 2010. Many of the problems involve small brokerages.

A U.S. Securities and Exchange Commission regulation requires all brokerages to keep funds on hand, known as net capital, to pay arbitration awards and other obligations. But that can be as little as $5,000 at some small firms - not enough to cover even the tiniest awards, say lawyers.

FINRA suspends firms that do not pay arbitration awards, leading some to close and even file for bankruptcy protection. That is often when investors owed money get stuck.

The notion of requiring that brokerages carry “errors and omissions” insurance to cover those awards, first reported last Saturday by the Wall Street Journal, is already stirring debate. It is unclear what other options may be available to FINRA, which is concerned about unpaid arbitration awards and “intends to evaluate this entire area to determine if steps should be taken,” a spokeswoman said.

While insurance may provide some financial relief to investors who may otherwise be out of luck, the policies can also be riddled with exceptions and coverage limitations, say lawyers and insurance professionals.

What’s more, many insurance underwriters may not want to cover small brokerages, which they often view as high-risk. Firms, at the very least, would have to cough up expensive premium payments - anywhere from $15,000 to $50,000 annually for $1 million of coverage - a basic amount - at a firm with up to 100 brokers, say insurance professionals.

“Simply mandating that there be errors and omissions insurance doesn’t necessarily mean you’re going to have coverage for the claim,” said Shane Hansen, a lawyer in Grand Rapids, Michigan, who advises firms on regulatory issues. A policy, he said, is only as good as its fine print.


Jenice Malecki, a New York-based lawyer, is still trying to collect nearly $1 million for a Pennsylvania couple who won an arbitration case against a small brokerage in late 2009.

But the brokerage, McGinn Smith & Co, in Albany, New York, shuttered after the SEC alleged in 2010 that its owners, David L. Smith and Timothy McGinn, defrauded hundreds of investors out of $80 million by pushing sham investments in a security alarm financing company. Both were later convicted of securities fraud in a related criminal case and sentenced to prison in August.

The case is one type of scenario for harmed investors that errors and omissions coverage likely cannot salvage. That is because the policies generally exclude fraud and other intentional misconduct, say lawyers. The investors may recover some money through forfeiture proceedings against the duo, but that is far from certain, Malecki said.

Other arbitration cases may involve less extreme conduct, but often nonetheless allege civil fraud - another type of intentional misconduct. While not criminal, it is also typically excluded from insurance coverage, say lawyers.

An insurance requirement for brokerages, however, could push investors’ lawyers to rethink their strategies by dropping any reference to fraud, said Richard Slavin, a lawyer in Westport, Connecticut, who represents brokerages. Instead, lawyers would likely build their cases around the argument that the brokerage was negligent, or failed to care for the investor properly, he said.

Nonetheless, policies may also exclude coverage for problems stemming from certain types of risky investments, such as privately issued, unregistered securities, say lawyers and insurance professionals.

Other issues FINRA will have to consider in developing an insurance mandate include how much coverage to require firms to buy and how to determine whether they are keeping up with their premium payments, said G. Philip Rutledge, a lawyer in Lemoyne, Pennsylvania, who advises financial services firms on regulatory issues.

Investors who are owed money from arbitrations may then face another set of legal problems if the insured brokerage files for bankruptcy. The insurance proceeds could, in some jurisdictions, be dumped into a larger pot to help pay off other types of claims against the firm.

Laws in several states allow the investor to pursue the insurance company directly while bankruptcy is pending, but that will not always work either, said Andrea Dobin, a bankruptcy lawyer in West Orange, New Jersey. For example, an insurer may deny coverage if the brokerage failed to notify it of an investor’s claim before closing its doors, Dobin said.


Obtaining any coverage at all could be another problem for small brokerages, which are typically viewed as a high-risk, said Frank Vento, head of the investment management practice for Marsh Inc, a global insurance broker and unit of Marsh & McLennan Cos. (Marsh sells insurance to brokerages through a FINRA referral program and pays FINRA a fee to belong).

“The insurance markets recognize that a lot of problems happen at smaller firms,” said Vento. Insurers who are willing to consider coverage of small firms are “very selective,” said Vento, whose firm handles some small company policies through a subsidiary.

Nonetheless, a regulatory requirement to buy coverage would create a bigger market in that niche for insurers and could spur some companies to develop new types of policies, Vento said.

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