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On July 22, 2014, the Securities and Exchange Commission (“SEC”) published an order approving a rule change proposed by the Financial Industry Regulatory Authority (“FINRA”), which significantly restricts the ability of the securities industry to remove information about customer complaints from permanent records through a process known as “expungement.”  SEC Release No. 34-72649.  New FINRA Rule 2081 prohibits financial advisors and brokerage firms from conditioning settlement of a customer claim upon an agreement by the customer to consent to (or not oppose) expungement of the claim from the permanent records maintained by the Central Registration Depository (“CRD”).  In approving the rule change, the SEC concluded that “[b]oth regulators and the investing public are disadvantaged when factual information is removed from the CRD.”  SEC Release No. 34-72649, p. 14.

 

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In the wake of the unprecedented scandals that rocked the financial world over the past few years, many commentators, politicians, and members of the media began pointing the finger of blame at regulators who were thought to be “asleep at the switch.”  In response to growing criticism, regulators have become more proactive in fostering investor confidence and transparency in the financial markets, and new FINRA Rule 2081 was forged within this industry climate.  Indeed, the SEC questioned whether FINRA’s expungement rules were strict enough and encouraged FINRA to:

 

conduct a comprehensive review of its expungement rules and procedures to determine whether additional rulemaking is necessary or appropriate to assure that expungement in fact is treated as an extraordinary remedy that is permitted only where the information to be expunged has no meaningful investor protection or regulatory value.


SEC Release No. 34-72649, p. 14.


Despite the SEC’s clear disfavor of the expungement process, one of the possible side effects of Rule 2081’s prohibition of negotiated expungements is that settlements of FINRA Arbitration claims may become more challenging.


The Brokerage Firm/Financial Advisor Relationship


Undoubtedly, this new FINRA expungement rule will cast long-lasting ripple effects throughout the securities industry, including changes to the dynamic between brokerage firms and their financial advisors.  Costs associated with defending FINRA Arbitration claims have steadily increased for brokerage firms in recent years, particularly with the more prevalent use of expert witnesses, electronic discovery, motion practice, etc.  As a result, brokerage firms will sometimes choose to make calculated business decisions about settling customer claims, particularly where the reasonable value of the claim is expected to be less than the anticipated defense costs and where other case-specific factors militate in favor of settlement.


However, if the brokerage firm is footing the bill for the defense costs, the financial advisor who is implicated in the customer complaint is generally more concerned with the deleterious effects of a customer complaint appearing on his or her CRD report than on the costs of defense.  Among other things, the existence of a customer complaint on a CRD report may make it more difficult for the financial advisor to (a) become registered in a new jurisdiction, (b) become employed with a new firm, (c) obtain errors and omissions insurance, and (d) garner new clients, particularly in the era of the publicly available information on FINRA’s online BrokerCheck system.


The divergent interests of the brokerage firm and the financial advisor may, at times, create friction between the two during settlement negotiations with a customer.  Prior to the advent of Rule 2081, this friction was often quelled through conditioning settlement upon an agreement by the customer to consent to an expungement of the complaint from the financial advisor’s CRD report.  In other words, the negotiated expungement served as both an important bargaining chip during settlement negotiations and a way to appease the financial advisor.  Through its prohibition of negotiated expungements, Rule 2081 is expected to add more heat to this friction between financial advisors and their employing brokerage firms and may lead to the unintended consequences of making settlement less likely.


The Insurance Carrier/Financial Advisor Relationship


Rule 2081 may also engender greater tension between insurance carriers and the financial advisors that they insure.  Financial advisors often carry professional liability insurance, typically described as “errors and omissions” (“E&O”) insurance, to insure against claims brought by customers for a variety of alleged wrongdoings arising out of their professional relationship.  As with the brokerage firm/financial advisor relationship, a customer complaint may, in certain circumstances, create conflicting interests between the insurance carrier and the insured financial advisor.


The specific language of the E&O insurance policy will determine whether the ultimate decision to settle a claim rests with the carrier or the financial advisor.  Some insurance policies include what are commonly referred to as “consent to settle” clauses whereby, in general, settlement of a claim requires consent from the insured who may not unreasonably withhold such consent.


Like the brokerage firms, insurance carriers often undergo an internal cost/benefit analysis when evaluating a FINRA Arbitration claim and may be more inclined to settle where the perceived value of the claim is less than the expected costs to defend the claim and where other factors suggest settlement is the prudent course of action.  Financial advisors, however, may become less agreeable to settlement of a customer complaint in light of Rule 2081’s bar of negotiated expungements.  Instead, the financial advisor may believe the only means of vindication would be through a favorable award after a full arbitration hearing.  As a result, some financial advisors may decide to withhold consent to settle customer claims, which may spawn coverage disputes between the insured financial advisor and the carrier.

Additionally, the filing of a customer claim against a financial advisor may negatively impact the underwriting of future insurance policies for the financial advisor.  In other words, more customer claims will likely equate to higher insurance premiums or an inability to get insurance for the financial advisor.  In light of this reality, financial advisors may be more willing to defend customer claims through final arbitration hearings instead of settlement in order to clear themselves of any suspicions of wrongdoing.


Conclusion


By removing the negotiated expungement from the hands of the litigants through the enactment of Rule 2081, the SEC and FINRA may have created an additional obstacle to settlement.  Nevertheless, in this period of regulatory fervor, many commentators, regulators, and attorneys believe that this practical trade-off is worthwhile to provide the investing public and regulators with a more complete, uncensored picture of the financial advisors and the customer complaints lodged against them.

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