The Mysterious Case of the Unpaid Arbitration Awards

So Berkson asked FINRA for additional information: specifically, how many different firms and persons were involved in those 75 unpaid awards, the size of each unpaid award and the total amount paid in claims to customers in 2013.

FINRA responded that the requested data wasn't available, and that it would take "several months" to determine if the requested data would be provided. "FINRA's refusal to provide the data, either to the task force or the author, is puzzling," Berkson wrote, "given its professed interest in promoting transparency in the arbitration process."

Undeterred, the intrepid team at the PIABA combed the reports it received from FINRA for every award issued in 2013, finding the following: For that year, there were 225 awards of some damages to investors, totaling $256.7 million. That means the 75 unpaid awards cited in the task force report represent 33.3%; and the $62.1 million they didn't receive represents 24.2% of the total.

No Firm, No Award

In case you're thinking that all these deadbeat BDs and brokers are the kind of smaller firms that savvy investors should know to avoid in the first place, Berksen's report makes an example of a much larger firm, one that hits all too close to home for the financial planning community: Securities America.

In 2010, with some 1,900 reps and more than $53 billion in client AUM, Securities America was the fifth largest independent BD in the country. According to Berkson, "its year-end net capital was $1.9 million." Yet by the following year, $400 million of private placements sold by Securities America reps were in default and the firm "faced actions brought by various state regulators and individual investors," wrote Berkson.

"In March 2011, three weeks after reporting it had nearly eight times the required net capital," he continued, Securities America's CFO at the time, Kelly Windorski, testified in open court that if a "settlement was not approved, the firm would go out of business soon, due to defense costs and arbitration awards. […] Facing hundreds of millions of dollars of liability to investors, Securities America bargained from a position of weakness: Take $X or we'll file for bankruptcy."

Berkson noted that the "problem, of course, is not limited to independent brokerage firms. The financial meltdown of 2008 saw established and well-respected firms Bear Stearns and Lehman Brothers collapse. When a brokerage firm shuts down, for whatever reason, the likelihood that any arbitration awards against the firm will be paid is slim if not entirely non-existent."

The horror in this story is that such a large portion of FINRA arbitration awards to investors go unpaid. The 2013 figures (courtesy of Berkson and the PIABA) are troubling enough, yet the GAO's figures tell us that things can be much worse.

The mystery is why the SEC, Congress and the public let this situation continue. In his paper, Berkson offers four potential solutions to the problem: expanding SIPC; increasing BD net capital; buying default insurance; or creating a National Recovery Pool. He favors the latter as the least costly and most workable.

Despite Berkson's charge that this is a problem the industry must fix, to my mind, the actual solution is far less important than who creates and oversees it. FINRA's record on the matter would seem to rule it out, and I'm not sure the SEC would be much better. Perhaps an entity outside the securities industry, such as the PIABA, might actually get some results.

But until a workable solution is found, these figures throw the whole system of securities arbitration into question. "The arbitration award is meaningless if the broker or brokerage firm does not have the resources to pay the award," wrote Berkson. "Unfortunately, this is an all too common problem, and has been for quite some time."

— Read "Is FINRA the Fox Guarding the Henhouse?" on ThinkAdvisor.