The Financial Industry Regulatory Association encourages investors to check on the professional backgrounds of brokers by using its BrokerCheck system.
The database discloses a host of disciplinary information about registered reps, and "should be the first resource investors turn to when choosing whether to do business with a particular broker or brokerage firm," FINRA officials say. The regulator has even been running advertisements encouraging investors to use the system.
But BrokerCheck suffers from a serious flaw. There's a little-known loophole in disclosure rules that allows brokers to avoid reporting some arbitrations filed by their clients. How? If a broker is not personally named in an arbitration complaint, and that complaint is filed directly with FINRA, the rep does not have to report it.
No one knows exactly how many cases like this come in under the radar, but it apparently happens all the time, according to industry observers.
The plaintiff's bar acknowledges that leaving brokers out of lawsuits is a common tactic. Since increasing the number of defendants just translates into more lawyers and more complications — and since the securities firms with their deep pockets end up paying anyway — why bring a broker into it?
"If [my case is] against a wirehouse firm, I will never name the individual rep as a respondent," said Robert Banks of the Banks Law Office PC in Portland, Ore., a former president of the Public Investors Arbitration Bar Association of Norman, Okla.
When asked about the loophole, FINRA spokesman Herb Perone declined to comment.
"We fully support disclosure as prescribed by the rules," said Ben Veghte, a spokesman for the Securities Industry and Financial Markets Association. Mr. Veghte, however, declined to comment about whether SIFMA supports eliminating the reporting loophole.
As a result of the loophole, some potentially serious wrongdoing never appears on a broker's record.
Take a recent case handled by Steven Caruso, a partner in New York with Maddox Hargett & Caruso PC of Indianapolis, against Merrill Lynch & Co. Inc. Mr. Caruso, also a former PIABA president, sued for unsuitable investments, negligence, misrepresentation and material omissions, without naming the broker.
Last fall, a FINRA arbitration panel awarded his client $3.3 million.
(InvestmentNews, Nov. 19).
But the incident isn't on the broker's record, Mr. Caruso said. He or she never had to report it.
As a general matter, "even if I haven't named the broker, [by filing an arbitration claim] I've clearly asserted misconduct and it's mind-boggling [that the broker] doesn't report it," Mr. Caruso said.
Merrill Lynch has said the client didn't suffer losses from trading at Merrill, but instead suffered from declines in stocks that were transferred in.
In another case, Mr. Caruso said he sued a firm after one of its brokers allegedly converted funds.
But again, the broker never disclosed it.
Ironically, even broker advocates — who say that the reporting of unproven allegations is unfair, if not unconstitutional — generally don't argue against disclosing adverse arbitrations decisions.
State regulators have been trying to close the reporting loophole, and FINRA, to its credit, has for several years been working to change the U-4 and U-5 reporting forms to fix the problem. Those proposed changes were close to being finalized more than a year ago, and word at that time was that a proposal was imminent. But that effort has since stalled.
The finger-pointing begins the minute the delay comes into conversation.
State regulators say FINRA has been sidetracked by NYSE merger-related work.
Meanwhile, various plaintiff's attorneys complain that both FINRA and the Securities and Exchange Commission have been slow to act on a number of rule proposals and reforms.
Industry observers, meanwhile, declined to speculate as to whether the powers that be in the industry have killed the effort to close the loophole.
But "it's astounding" that regulators haven't acted yet, Mr. Caruso said.
Meanwhile, FINRA has taken action on a related issue involving expungements.
The regulator announced last month that it would propose a rule tightening up on the expungement-approval process by requiring arbitrators to document why an expungement was granted. The same day, The New York Times ran a story on the issue, warning readers that because some information is removed, BrokerCheck "does not tell the whole story."
That might be an understatement.
The reporting loophole probably produces more holes in Broker-Check than expungements do, Mr. Banks said.
"I probably name the broker less than 25% of the time," he said. In other words, in 75% of his cases the broker remains unscathed.
By contrast, according to FINRA data reported by The New York Times, 8% to 9% of customer arbitrations heard over the past two years ended with information being expunged from the brokers' disciplinary histories. Last year, ex-pungements were granted in about 300 cases in all.
Unlike unreported arbitrations, expunged information at least gets some oversight.
When brokers seek to have an arbitrator-ordered expungement confirmed in court (which they must do with customer complaints), regulators are notified and have the opportunity to oppose it. But no one sees cases that pass through the reporting loophole, unless the case is decided in arbitration. Even then, it will only appear on a firm's record, not the broker's record.
To add insult to injury, there exists yet another loophole in the public reporting system.
Even though broker-dealers report customer settlements of more than $25,000 to regulators, the self-regulatory organizations never make that information public, so the public can't see a pattern of investor complaints at a firm.
Observers say when customers have a legitimate case, firms often settle rather than risk a bigger arbitration award and its attendant publicity.
"The party that should ensure disclosure is FINRA," said Larry Schultz, partner at Driggers Schultz & Herbst PC in Troy, Mich., and current PIABA president. "They are the SRO [that] trumpets itself as providing investor protection."
Dan Jamieson can be reached at [email protected].
