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

Reuters

By Suzanne Barlyn

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

The Financial Industry Regulatory Authority, Wall Street'sindustry-funded regulator, is looking into the measure becauseof a growing problem: brokerages that lose securitiesarbitration cases against investors and then close up shop,leaving those investors unable to collect.

A total of $51 million of arbitration awards granted in2011, or 11 percent of the total awards, have not been paid,according to FINRA. The figure marks a 4 percent increase from2009 and 2010. Many of the problems involve small brokerages.

A U.S. Securities and Exchange Commission regulationrequires all brokerages to keep funds on hand, known as netcapital, to pay arbitration awards and other obligations. Butthat can be as little as $5,000 at some small firms - not enoughto 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 andomissions" insurance to cover those awards, first reported lastSaturday 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 "intendsto evaluate this entire area to determine if steps should betaken," a spokeswoman said.

While insurance may provide some financial relief toinvestors who may otherwise be out of luck, the policies canalso be riddled with exceptions and coverage limitations, saylawyers and insurance professionals.

What's more, many insurance underwriters may not want tocover small brokerages, which they often view as high-risk. Firms, at the very least, would have to cough up expensivepremium payments - anywhere from $15,000 to $50,000 annually for$1 million of coverage - a basic amount - at a firm with up to100 brokers, say insurance professionals.

"Simply mandating that there be errors and omissionsinsurance doesn't necessarily mean you're going to have coveragefor the claim," said Shane Hansen, a lawyer in Grand Rapids,Michigan, who advises firms on regulatory issues. A policy, hesaid, is only as good as its fine print.

EXCLUSIONS, EXCLUSIONS

Jenice Malecki, a New York-based lawyer, is still trying tocollect nearly $1 million for a Pennsylvania couple who won anarbitration 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, DavidL. Smith and Timothy McGinn, defrauded hundreds of investors outof $80 million by pushing sham investments in a security alarmfinancing company. Both were later convicted of securities fraudin a related criminal case and sentenced to prison in August.

The case is one type of scenario for harmed investors thaterrors and omissions coverage likely cannot salvage. That isbecause the policies generally exclude fraud and otherintentional misconduct, say lawyers. The investors may recoversome money through forfeiture proceedings against the duo, butthat is far from certain, Malecki said.

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

An insurance requirement for brokerages, however, could pushinvestors' lawyers to rethink their strategies by dropping anyreference to fraud, said Richard Slavin, a lawyer in Westport,Connecticut, who represents brokerages. Instead, lawyers wouldlikely build their cases around the argument that the brokeragewas negligent, or failed to care for the investor properly, hesaid.

Nonetheless, policies may also exclude coverage for problemsstemming from certain types of risky investments, such asprivately issued, unregistered securities, say lawyers andinsurance professionals.

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

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

Laws in several states allow the investor to pursue theinsurance company directly while bankruptcy is pending, but thatwill not always work either, said Andrea Dobin, a bankruptcylawyer in West Orange, New Jersey. For example, an insurer maydeny coverage if the brokerage failed to notify it of aninvestor's claim before closing its doors, Dobin said.

RISKY BUSINESS

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

"The insurance markets recognize that a lot of problemshappen at smaller firms," said Vento. Insurers who are willingto consider coverage of small firms are "very selective," saidVento, whose firm handles some small company policies through asubsidiary.

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

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