SEC Approves FINRA Rule Permitting Mid-Case Referrals

By Patricia Uceda, Fall 2014 Graduate Research Assistant

LAW_IACThe SEC approved a rule change to Rule 12104 of the Code of Arbitration Procedure for Customer Disputes and Rule 13104 to the Code of Arbitration Procedure, both entitled “Effect of Arbitration on FINRA Regulatory Activities” broadening the authority of arbitrators to make referrals during an arbitration proceeding. The previous rules only permitted such referrals when a case concludes.

The approved rule change permits an arbitrator to make mid-case referrals if he or she becomes aware of any matter or conduct that the arbitrator has reason to believe poses a serious threat, whether ongoing or imminent, that is likely to harm investors unless immediate action is taken. If an arbitrator makes a mid-case referral, it must be disclosed to the parties and a party is permitted to request recusal of the referring arbitrator within three days of being notified of the referral. The new rule further provides that the arbitrator should wait until the case concludes to make a referral if he or she believes that investor protection would not be materially compromised by the delay.

FINRA filed an early version of the proposed rule change in July of 2010; however it made a few changes and published the current version for comment in the Federal Register on February 12, 2014. The SEC received twelve comment letters, including one from the GSU Investor Advocacy Clinic.  Our Clinic expressed concern that an individual investor’s proceeding would be delayed or adversely impacted by the potential for recusal of the referring arbitrator, and that mid-case referrals would lead to increased costs and time delays. In addition, if a referring arbitrator refused to recuse herself and held in favor of the investor, the investor would risk having to defend against an expensive and time-consuming motion to vacate the arbitrator’s award.

In response to concerns raised in comments, FINRA filed a partial amendment to the proposed rule on May 19, 2014 stating that the subject of the referral must request recusal of an arbitrator, if at all, within three days of being notified of the referral. This amendment was intended to prevent a party from receiving notice of the mid-case referral and reserving the right to strategically request recusal when it would best benefit them.

The SEC instituted proceedings to determine whether to approve or disapprove of the proposed rule. They requested additional comments to help them make a decision, and received nine, including one from our Clinic. We noted that FINRA’s partial amendment did not ameliorate our earlier concerns because it does not change the fact that recusal would result in increased costs and time delays that could adversely harm small investors. Additionally we stated that FINRA’s Central Review Group, which already analyzes all the documents filed with FINRA dispute resolution for fraudulent securities activities, was in a better position to refer matters to the Enforcement division than the arbitrator.

In response, FINRA declined to further amend their proposed rule. While FINRA acknowledged that it could not eliminate all potential costs or delays to individual investor claimants, there are a number of ways that the costs will be minimized. For example, a hearing panel can allocate increased costs to the respondent, and FINRA will absorb some of the arbitrator replacement costs. In addition, FINRA will provide training for arbitrators on the mid-case referral rule and how it should be applied, so that it is only used in serious cases of imminent harm to investors. They also did not agree with concerns that mid-case referrals resulting in recusal requests that were not granted would lead to increased motions to vacate awards for arbitrator bias, pointing out that courts have found that an arbitrator’s denial of a recusal request does not provide the required bias grounds to vacate an arbitrator award.

As to the Central Review Group, FINRA stated that the enforcement procedures conducted by the CRG prior to an arbitration hearing was not an effective substitute for arbitrator action taken during a hearing based on the evidence presented. Ultimately, FINRA concluded that while there may be a negative impact on individual investor claimants, the additional protection to public investors outweighs the potential increased costs to an individual investor party. The rule change will help FINRA detect serious threats to investors at an earlier stage, and help prevent financial harm to the general public.

The SEC agreed, finding that this rule change was consistent with the Securities Exchange Act which requires that FINRA rules be designed to prevent fraudulent acts and practices, promote just and equitable principles of trade, and protect investors and the public interest. In response to concerns that mid-case referrals would disrupt or delay arbitration proceedings, the SEC stated that FINRA would gather statistics and report to the SEC for one year after the rule change goes into effect on the number of cases in which a mid-case referral is made, as well as the effects of that referral. From there, they will determine if further action is necessary.

Filing comment letters is an important function of our Clinic. FINRA is required to file with the SEC proposed rules, and they always solicit comments on the proposals from the public by publishing the rule in the Federal Register for 21 days. By providing feedback we are able to promote our Clinic’s goal of protecting investors by representing the voice of the individual investor in the rulemaking process.