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SEC raises red flag over Finra enforcement referral rule

Jun 3, 2014 @ 12:37 pm

By Mark Schoeff Jr.

Finra, SEC, arbitration, enforcement, investors
+ Zoom
(Bloomberg News)

Citing concerns over investor protection, the Securities and Exchange Commission is taking a closer look at a Finra proposal that would allow arbitrators to alert Finra to broad investor threats in the middle of disputes they are hearing.

In a May 27 notice published in the Federal Register, the SEC said that the Finra proposal could harm investors if a mid-case referral is used as grounds to request the recusal of an arbitrator or challenge an arbitration award.

In the same notice, the SEC indicated that it would “institute proceedings” on the Finra proposal, a move that the SEC must make in order to give itself more time to consider a rule proposal from a self-regulatory organization, such as Finra.

The step does not indicate that the SEC has reached a conclusion about the rule. But it does mean that it has enough concerns to request more public comment.

“Institution of such proceedings appears appropriate at this time in view of the legal and policy issues raised by the proposal,” the SEC stated in the Federal Register notice.

The SEC also instituted proceedings recently on a Finra proposal involving the pricing of shares in real estate investment trusts.

One of the reasons that the SEC is slowing down the arbitration proposal is because it wants public input on a partial amendment Finra recently filed. It would require that recusal requests be made within three days of arbitration parties being informed about a referral rather than reserving the right for later in the proceedings.

Protections included in the rule would “minimize delays, costs and administrative procedures” and reduce the chances that a finding of arbitrator bias could overturn an arbitration decision, according to Finra.

“Finra believes the current proposal could save a substantial number of other investors from incurring losses, the benefit of which, on balance, outweighs the risk of potential increased costs for an individual investor,” Finra stated in a May 19 regulatory notice.

The SEC is requesting comment on the amended Finra proposal by June 26. It asked respondents to address potential adverse affects on retail investors and whether Finra should notify case participants about a referral.

George Friedman, who was director of Finra arbitration from 1998-2013, said that arbitrators should have the flexibility to contact Finra the moment that they hear of something that could harm investors. Under current rules, they must complete the case.

“I don’t see how investors would be protected if arbitrators are told to wait to the end no matter how egregious the threat to the investing public might be,” Mr. Friedman said.

The rule was first proposed in 2010 in the wake of the multibillion-dollar investor rip-off perpetrated by Bernard Madoff. It would give arbitrators more latitude to inform Finra about potential wide-ranging investor threats discovered in arbitration hearings.

But if referrals are made during a case, it could give participants leverage to delay the proceedings or try to overturn awards, according to comment letters on the proposal.

Mr. Friedman hopes that the SEC will end up with the same result as Finra — allowing mid-case referrals. He said that Finra needs as many ways as possible to detect investor threats.

“Finra can't be 99% effective,” Mr. Friedman said. “One event can cause massive destruction. Look at Madoff.”

The SEC must approve all Finra rule proposals. Typically, SEC staff makes such decisions under delegated authority from the five SEC commissioners.

Correction: An earlier version of this story stated that when the SEC institutes proceedings on a rule, it means that the rule will be voted on by the full five-member commission. Although the commission has the option of taking up a rule itself under proceedings, the staff usually decides under delegated authority.

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