FINRA filed with the SEC on April 14, 2014 its proposal to adopt FINRA Rule 2081 to prohibit member firms and associated persons from conditioning the settlement of disputes on a customer's agreement to consent to, or not oppose, expungement of the dispute information from the Central Registration Depository ("CRD"). The proposal stems from issues arising from the construction and application of FINRA Rule 2080 (formerly NASD Rule 2130).(I)
Background and Purpose of Rule 2080
In the U.S. securities industry, the CRD is the system for the licensing and registration of brokers. The system housing administrative and disciplinary information about registered personnel, including customer complaints, arbitration claims, and court filings along with the resulting arbitration awards or court judgments. (II) Regulators use CRD information in connection with their licensing and regulatory activities. Investment firms use CRD information when making hiring decisions. And through BrokerCheck®, the investing public uses CRD information to choose honest and competent brokers.
Brokers seeking to have customer dispute information erased from the CRD system must seek expungement pursuant to Rule 2080. (III) The Rule provides that firms and associated persons seeking expungement of customer dispute information from the CRD system must - while naming FINRA as a party - obtain a court order either directing expungement or confirming an arbitration award containing expungement relief. FINRA may waive the obligation to name it as a party if it determines that the expungement relief is based on an affirmative judicial or arbitral finding that: (1) the claim, allegation or information is factually impossible or clearly erroneous; (2) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (3) the claim, allegation or information is false. (IV) FINRA may also waive the obligation to name it if: (1) the expungement relief and accompanying findings are meritorious; and (2) the expungement would have no material adverse effect on investor protection, the integrity of the CRD system, or regulatory requirements. (V) These standards are used not only in determining whether to name FINRA as a party; they also are used in the event of a settlement where the broker or firm requests the arbitration panel order expungement. (VI)
FINRA describes the role of the expungement process as "an extraordinary remedy that should be granted only under appropriate circumstances... [as] when it has no meaningful investor protection or regulatory value. (VII) Because expunged information is permanently deleted (VIII), expungement is a drastic remedy to be used sparingly where justice requires.
FINRA has taken many steps to ensure the integrity of this process. (IX) Yet despite the safeguards, from an unforeseen gap in the law a widespread practice has emerged of firms and associated persons conditioning settlement agreements on their obtaining expungement relief. Many settlements include a provision that the customer must consent to, or not oppose, the broker's request for expungement relief. Customers typically agree to these provisions because they are concerned that objecting to the provision may jeopardize the settlement. Without the customer's appearance at the hearing, the arbitration panel only hears the broker's side of the story, and the expungement requests are routinely granted. (X)
The net effect of this practice is the removal from the CRD system of information that helps protect investors - essentially fostering continued patterns of unencumbered wrongdoing. Among cases resolved by stipulated awards or settlements, expungement was granted 89 percent of the time from January 1, 2007 to mid-May 2009 and 96.9 percent of the time from mid-May 2009 to December 2011. (XI) These numbers are far from the "extraordinary remedy" the drafters of Rule 2080 intended.
Rule 2081 would prohibit member firms and associated persons from conditioning the settlement of a dispute with a customer on, or to otherwise compensate the customer for, the customer's agreement to consent to, or not to oppose, the member's or associated person's request to expunge such customer dispute information from the CRD. (XII) Such agreements are prohibited even if the customer offers not to oppose expungement as part of negotiating a settlement agreement. (XIII) If adopted, these additions should ensure the legal chasm is properly sealed.
The proposed rule change aligns with the spirit of § 15A(b)(6) of the Securities and Exchange Act of 1934 (XIV), which requires that FINRA rules be designed to "prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest." (XV) Regulators, member firms, and the investing public rely on CRD information in licensing, hiring, and investing, respectively. Thus, it is essential to investor protection that the CRD system houses complete and accurate dispute information. (XVI)
Some critics of the proposed Rule question whether the proposal would result in a reduction in the size of settlement offers. (XVII) Industry representatives have also posited that the change could reduce the number of customer disputes that will settle, thereby increasing the costs to all parties involved. (XVIII) For instance, since some firms may choose not to settle because a customer may oppose an expungement request regardless of the outcome of the underlying dispute, they might as well proceed to arbitration. (XIX) FINRA, however, expects such impacts to be negligible because some firms that already prohibit the use of expungement conditions in their settlement agreements have not witnessed any material impact to their ability to reach settlements. (XX)
The practice of conditioning settlements on expungement consent runs afoul of the goal of investor protection. The proposed rule change would help guarantee that expungement relief is based solely on the facts of the underlying customer dispute rather than deft negotiating and form settlement offers. Rule 2081 is appropriately narrowly tailored to its purpose of quelling the influx of expungement grants to unworthy participants, and it should be adopted.
(I) Securities Exchange Act Release No. 48933 (December 16, 2003), 68 FR 74667 (December 24, 2003) (Order Approving File No. SR-NASD-2002-168).
(II) See Notice to Members (''NTM'') 04-16 (March 2004).
(III) See Securities Exchange Act Release No. 48933, supra n1.
(IV) FINRA Rule 2080.
(V) FINRA Rule 2080 (Formerly NASD Rule 2130) Frequently Asked Questions, http://www.finra.org/Industry/Compliance/Registration/CRD/FilingGuidance/P005224
(VII) See Notice to Arbitrators and Parties on Expanded Expungement Guidance, http://www.finra.org/ArbitrationAndMediation/Arbitration/SpecialProcedures/Expungement/index.htm.
(IX) See FINRA Rule 12805 (requiring arbitrators to review settlement terms and indicate Rule 2080 grounds for expungement, inter alia). See also FINRA Rule 13805.
(X) See PIABA Expungement Study, available at http://piaba.org/system/files/pdfs/PIABA%20Expungement%20Study.pdf.
(XI) PIABA Expungement Study, available at http://piaba.org/system/files/pdfs/PIABA%20Expungement%20Study.pdf. These periods were based on revised disclosure requirements FINRA implemented in May 2009 requiring registered persons to disclose whether they were the subjects of litigation but not named as defendants/respondents.
(XII) SEC Release No: 34-71959; File No. SR-FINRA-2014-020, Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of a Proposed Rule Change to Adopt FINRA Rule 2081 (Prohibited Conditions Relating to Expungement of Customer Dispute Information).
(XIV) 15 U.S.C. 78o-3(b)(6).
(XV) SEC Release, supra n11.