Business & Corporate

The Business & Corporate Law Section's monthly article.

FINRA Stock Broker Expungement – A flawed system of unavoidable conflict between investor, broker, and broker-dealer

When an investor files a complaint against his or her stock broker and/or broker-dealer, the broker-dealer must disclose the allegations made in the complaint on the underlying stock broker’s Central Registration Depository (“CRD”) record.  These disclosures almost always become publicly available via FINRA’s BrokerCheck system—an online database that provides information about current and former FINRA registered brokers and brokerage firms. 1  Indeed, such disclosures pose a significant obstacle to a stock broker’s ability to maintain existing clients and acquire new ones.  And expunging these publicly available disclosures is not an easy task. 

Typically, investor complaints are made before the Financial Industry Regulatory Authority (FINRA), the arbitration forum that manages substantially all investor complaints filed against stock brokers and/or broker-dealers. 2  Parties to FINRA arbitration proceedings agree to be bound its jurisdiction, rules, and the arbitrators’ decision on the outcome of the underlying arbitration.

FINRA rules provide the standard that a stock broker must use to obtain expungement of a customer complaint from his or her CRD record.  That standard, codified under FINRA rule 2080, allows an arbitration panel to recommend stock broker expungement where he or she can show one of the following:

  1. The claim or allegation is factually impossible or clearly erroneous,
  2. The broker was not involved in the alleged investment related sales practice violation, or
  3. The claim or allegation is false.3

FINRA rule 2080 also provides an “alternative standard” that allows expungement where the arbitration panel finds the following:

  1. The expungement relief and accompanying findings on which it is based are meritorious; and
  2. The expungement would have no material adverse effect on investor protection, the integrity of the CRD system or regulatory requirements.4

If the arbitration panel enters an expungement award, the award must then be confirmed in a court of competent jurisdiction.  Once the award is confirmed, FINRA will formally remove it from the stock broker’s CRD record.

Juxtaposed to the nuanced standards a broker must meet to obtain an arbitration award recommending expungement, are the broad standards the broker-dealer must apply when determining whether or not it should report an allegation of a “sales practice violation” on a broker’s CRD record. 

A broker-dealer’s reporting obligations are outlined in FINRA Regulatory Notice 09-23 ("RN 09-23").  In sum, these reporting obligations make it easier than ever for a stock broker to obtain a disclosure on his or her CRD record.  RN 09-23 contemplates three general instances where a broker-dealer must report an allegation of a “sales practice violation” on a stock broker’s CRD record. 

First, the broker-dealer must disclose where the broker is a named party to the investor complaint.  Second, the broker-dealer must disclose where the broker is mentioned in the body of the complaint (even if he or she is not a named party to the action).  Third, a broker-dealer must disclose where it makes its own "good faith determination" that the  "sales practice violation" "involved" the underlying broker - even if the "alleged sales practice violation" neither names nor mentions the broker. (See RN 09-23 n. 6, 7)

The disconnect between FINRA’s expungement standard and its standards with respect to a broker-dealer’s obligation to report allegations of sales practice violations has created a significant conflict between the claimant investor, broker, and broker-dealer.  On one hand, the broker-dealer (particularly where the broker is neither named nor mentioned in the investor complaint) has almost unlimited discretion to determine whether a broker is "involved" enough with the allegations made in the investor complaint to constitute amending his or her CRD record.  And the risk of fines and regulatory scrutiny encourages the broker-dealers to err on the side of over-reporting rather than under-reporting such allegations at the underlying broker(s) expense.

On the other hand, the underlying broker (particularly where he or she is neither named nor mentioned in the complaint) has no input over the strategy in litigating the investor complaint because he or she is not a named party.  Similarly, he or she has no say in any settlement discussions.  Nevertheless, the litigation has a direct effect on his or her CRD record.  

Like most litigation, the vast majority of FINRA arbitrations settle.  Unless the broker moves for expungement immediately following settlement (for which broker-dealers are rarely willing to pay) the matter “closes” and the arbitration panel is released.  Once FINRA “closes” the matter, the only way a broker can obtain expungement is to file an entirely new action before FINRA and select and educate an entirely new arbitration panel.

In short, the current system has given stock brokers a “raw deal” and FINRA has taken notice.  In April 2012, it issued Regulatory Notice 12-18 (“RN 12-18”), which asked for comment on a series of new rules that endeavor to give stock brokers the opportunity to file an “In Re Expungement” action.  Summarily, RN 12-18 and the rules it contemplates give brokers 180 days from receiving notice that his or her CRD record was tarnished to bring such an action for expungement.  It remains to be seen whether these proposed rules will be retroactive.  Moreover, the proposed rules are not entirely clear as to the scope of discovery that will be made available to qualifying brokers.  But until these new rules take effect, stock brokers are stuck with the current system, which makes it extremely difficult for an individual broker to find a cost-effective avenue to expungement.

May 20th CLE: Annual Securities Law Update

For more information on this and other topics, please join the Business & Corporate Law Section and New Lawyer Division for their CLE on May 20, 2013, from 12 – 1:15 p.m. at the SDCBA Conference Center at 401 West A Street, Suite 120, San Diego, CA 92101.  Please click here to register online.

--Patrick R. Mahoney, Esq.

**This article is intended for informational purposes only and does not constitute legal advice. Any views expressed are those of the author only and not of the SDCBA or its Business & Corporate Law Section.**

3 See FINRA rule 2080 (b)(1)

4 See FINRA rule 2080 (b)(2)