For Arbitration Award Payment, Insurance is No Easy Fix

by Nicholas Kulik

Hedging against catastrophic occurrences through products such as life, car and home owners insurance have been staples for years. But what about “errors and omissions” insurance for broker-dealers? In response to a growing problem of brokerage firms going bankrupt after losing securities arbitration cases, the FINRA (Financial Industry Regulatory Authority), Wall Street’s industry-funded regulator, is floating the idea of requiring brokerages to carry insurance for the payment of arbitration awards to investors.

A total of $51 million of arbitration awards were granted in 2011, or 11% of total awards, have not been paid due to many small brokerage firms closing up shop after they could not afford awards levied against them. This insurance requirement could allow customers to recoup some of their losses that would otherwise go unpaid.

Sounds like a great idea, right? 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. These may include allegations of fraud and problems stemming from risky investments. Additionally, many insurance underwriters may not want to cover small brokerages, which they often view as high-risk. Other issues FINRA will have to consider in developing an insurance mandate includes how much coverage to require firms to buy and the effect of this directive on the financial industry as a whole.

Even if requiring insurance is not the solution, lawyers for investors and consumer advocates have no shortage of alternative proposals. The following are four more possible solutions to FINRA’s problem of unpaid awards and the hurdles experts say regulators would have to overcome to make them viable.

S.E.C. (Securities Exchange Commission) regulation calls for all brokerages to keep funds on hand to pay liabilities known as net capital requirements. However, this can be as little as $5,000. At a recent conference of securities lawyers, the question was posed, “Why don’t we just hike up that amount?” Several problems arise from this potential plan. First, changes in SEC regulation could take years to implement, leaving harmed investors waiting in the meantime. Second, even a substantial requirement of $500,000 could still leave investors stranded when they win arbitration awards exceeding that amount.

If individual brokers cannot afford awards, why not require all 630,000 brokers under FINRA governance to contribute annual dues to a newly created recovery fund? The dues would not be steep and could create around $126 million annually to cover potential unpaid awards. Problems may arise despite the funds size, by encouraging small firms to pursue risky investments and then close up shop when things go south knowing investors can recover from the fund.

If creating a new fund is not ideal, FINRA could look to an organization that exists with a large sustainable fund already in place. The Securities Investor Protection Corporation is a non-profit organization that provides insurance coverage in cases where brokerages close and customers’ assets go missing. SIPC, which is funded by the brokerage industry, accumulates annual interest of $1.6 billion which could potentially be enough to pay such unpaid awards. Issues arise with this reform measure because the proposal would likely be tied up in Washington D.C. for years with debate of the dangers of making the good actors cover the bad actors.

For more information, see Arbitration Award Insurance