Why broker-dealers and financial advisers should be required to carry insurance

Finra does not require its members to carry insurance, which lets big risks to investors materialize.

Federal law requires commercial truckers to carry insurance. If a reckless driver smashes your car, you can look to the driver’s insurance policy for recovery. This insurance requirement costs money, of course, and reduces trucking profits. It also forces frequently ticketed drivers off the road. Insuring them becomes too costly as the insurance company demands more cash to cover their risk. This is good. No one wants a sloppy driver on the highway with 80,000 pounds behind them.

Insurance helps keep the roads safe. So why not also require the broker-dealer firms and financial advisers that move capital through the economy to carry insurance? Their recklessness causes catastrophes, too. If a commission-hungry financial adviser puts your mother’s pension into a Ponzi scheme, an insurance policy should provide the possibility of recovery. Without it, an investor may face a wrecked future, unable to pay for medical bills or a quality assisted-living facility. Of course, insurance comes with costs. Requiring brokerage firms to bear the costs of bad behavior would force some sloppy financial advisers or brokerage firms out of business if insurance for their particular operation proved too costly. But this would be a benefit, not a bug, of an insurance requirement.

Unsurprisingly, the Financial Industry Regulatory Authority Inc. — the organization of brokerage firms that regulates brokerage firms — does not require its members to carry insurance because certain firms may be uninsurable. This allows Finra’s member firms to collect profits right up until big risks materialize. It’s like leaving a high-risk driver on the road. And wrecks happen regularly. When one of Finra’s firms goes under, its employees often scatter to other firms. Think of cockroaches when the lights come on. This is nothing new. Jordan Belfort, the infamous “Wolf of Wall Street,” explained that he had former employees set up other firms to enable this “cockroaching.”

Brokerage blowups happen regularly and often leave investors without recourse. One recent study by the Public Investors Arbitration Bar Association found that one of every three arbitration awards issued against Finra’s brokerage firms goes unpaid. In 2013, this amounted to $62.1 million. And because most lawyers will not waste time or money bringing cases against uncollectable defendants, this number vastly understates the harm borne by investors. Lack of insurance also allows firms to settle complaints on the cheap. Simply by threatening to declare bankruptcy, some Finra firms force claimants to accept a pittance. Yet investors have little choice.

Defenders of the status quo argue that self-serving attorneys simply invented this unpaid awards problem to enrich themselves. They point out that other defendants such as dry cleaners and candy stores also become insolvent, and no one believes a national insurance scheme should be put in place for them. But Finra’s firms are nothing like dry cleaners or candy stores. A ruined shirt or wardrobe can be replaced. For most of us, replacing a ruined retirement is beyond reach.

Finra’s failure to protect investors has broader consequences, too. If people lose confidence in the integrity and stability of Finra’s member firms, they might hoard their cash and not invest. Finra’s own task force has pointed out that unpaid awards “diminish investor confidence and reflect poorly on the securities industry and Finra.” This loss of confidence hurts the economy. If Finra fails to provide adequate protection, investors facing increased risks will become less willing to invest. While difficult to quantify, any reduction in the amount of investor capital flowing to business opportunities inhibits economic growth. Increases to the cost of capital make it more difficult for growing businesses to raise the capital they need.

Senator Elizabeth Warren chastised Finra CEO Richard Ketchum for these unpaid awards in a recent hearing, asking whether there should “be more regulations so that people get paid?” He conceded that “something should be done about it” but failed to offer any solution. Because a compensation scheme would transfer funds from Finra members to their victims, it seems unlikely that Finra will require its members to contribute anytime soon.

The industry may also be slow to act because creating an insurance scheme or a compensation fund will bring to the light the full scope of the damage inflicted. Today, many wronged investors subsist on Social Security checks because the brokers who lost their retirements have skipped town. Forcing the industry to create a real compensation system may be the only way to unveil the true extent of the harm. An insurance system will also do much by allowing the market to police brokerage behavior.

Benjamin P. Edwards is assistant professor of law at Barry University School of Law. Follow him on Twitter @benpedwards.