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The Decline of FINRA Membership and the Litigation Implications

Posted by Jack Duval

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Feb 7, 2020 8:52:25 AM

In the six years ending in 2018, the number of broker-dealers ("BDs") shrank by 13.5 percent.  Over the same period, the number of SEC Registered Investment Advisor ("RIA") firms increased by 19.7 percent.[1]

Chart 1: FINRA Broker-Dealer and SEC Registered Investment Advisor Firms[2]

FINRA Broker-Dealer and SEC Registered Investment Advisory Firms - Fiduciary Duties

I expect these trends to continue, if not accelerate.

Firms and/or brokers shifting from BDs to RIAs reflect the trends in the market and what business models are sustainable.  The business model based on generating commissions from transactions in customer accounts is losing to the business model of asset management fees based on the amount of assets in the client's account.  This trend has been in place for well over a decade.

At the same time, both of these business models are under attack by the index investing trend.  However, the RIA model is less subject to declines from indexing because an RIA firm can charge the same fees whether it invests in index funds or actively management funds.

Indeed, many RIA firms are disintermediating asset managers by using index ETFs that the RIA selects.

Something that is hidden in the data in Chart 1, above, is that most BDs are dually registered (meaning they are also RIA firms) so they are acting as fiduciaries for a significant percentage of clients.  This, as will be examined below, is showing up in FINRA arbitration statistics, and has important implications for securities litigations, in-house counsel, and compliance and supervisory implementation.

Changing Trends in Securities Litigation

The decline in the number of broker dealers and the increase in the number of RIA firms would suggest that securities arbitrations will shift from being primarily suitability driven to being primarily fiduciary duty driven.

The shift from BDs to RIAs will also entail a shift in securities arbitrations from being overwhelmingly heard in FINRA forums to those of AAA, JAMS, and other forums.

This will have a number of impacts on attorneys and their clients.

Obviously, the fiduciary standard is much higher than the suitability standard.  (I have written about fiduciary duties extensively here.)  This will benefit claimants and make respondent's cases harder to defend.

For respondents, one offsetting factor could be the fact that BD cases with breach of fiduciary duty claims will be heard in FINRA forums.  FINRA arbitrators who have years of experience hearing suitability claims may not fully appreciate the difference between the suitability and fiduciary standards, even when it is explained to them.

If the cases are in AAA or JAMS forums, the costs will almost certainly be higher than at FINRA.  This comparatively higher cost may be well worth it for claimants (not that they have a choice in most instances) because many AAA and JAMS arbitrators are former judges (and if not, almost always attorneys) who are well versed in the weight and import of fiduciary duties.

Trends in FINRA Arbitration Claim Types

FINRA publishes statistics on arbitration case filings and has broken out customer case filings (that is, excluding cases between member firms) since 2013.

The trends in types of controversy are indicative of the falling number of BDs and rising number of RIA firms and RIA services provided by dually registered BDs.

Table 1:  FINRA Arbitration Claims by Type of Controversy[3]

FINRA Breach of Fiduciary Duty Table

Table 1, above, shows that Breach of Fiduciary Duty claims now comprise 86.9 percent of all customer cases filed, up from 75.9 percent in 2013.  Suitability claims have risen even more, to 66.9 percent in 2019 up from 52 percent in 2013.[4] 

Importantly, these types of claims are not exclusive of one another, and in my experience, almost all Breach of Fiduciary Duty claims will also have a Suitability claim attached.

Trends in FINRA Arbitration Resolutions

It would appear that the increasing number of Breach of Fiduciary Duty claims (and the higher hurdle to defending them) is showing up in FINRA arbitration settlements.

Table 2:  FINRA Arbitration Case Settlements[5]

FINRA Arbitration Settlements Table - Fiduciary Duties

Indeed, in 2019 69.4 percent of arbitrations settled, up from 58.9 percent in 2013.[6]

The correlation between the 17.8 percent rise in settlements and the 14.5 percent rise in Breach of Fiduciary Duty Claims over the same period can be seen clearly in Chart 2, below.

Chart 2:  FINRA Breach of Fiduciary Duty Claims and Case Settlements[7]

FINRA Breach of Fiduciary Duty claims and Case Settlements chart

The Long-Term Effects of a Shift from BDs to RIAs

While the number of FINRA Arbitration claims has fallen to the 3,400 to 4,000 per year range during the post-GFC bull market,[8] the types of claims have shifted, with a notable rise in Breach of Fiduciary Duty claims.

Breach of Fiduciary Duty claims must be prosecuted and defended differently than suitability cases.  As I have written about here and here, the difference is profound.  In short, the defenses to suitability claims will generally fail if a fiduciary standard is operative.

 

The increase of Breach of Fiduciary Duty claims and the shift from BDs to RIAs, are trends that are almost certain to continue, if not accelerate.  They require changes in all aspects of BD compliance, supervision, education and training, and business structure.  BDs doing fiduciary business must be built to do that type of business.  That structure is fundamentally different from the old BD brokerage/suitability structure.

 

For BDs doing an increasing amount of RIA business, being a FINRA member firm will become less and less attractive as their brokerage revenue declines and FINRA membership becomes a source of expensive regulatory oversight.

 

Needless to say, with Breach of Fiduciary Duty claims comprising nearly 87 percent of Customer claims, securities litigators should be honing their chops on fiduciary duty case construction and prosecution.

__________

Notes:

[1]      Investment Advisor Association; “2018 Evolution Revolution: A Profile of the Investment Adviser Profession”; 38.  Available at: https://higherlogicdownload.s3.amazonaws.com/INVESTMENTADVISER/aa03843e-7981-46b2-aa49-c572f2ddb7e8/UploadedImages/resources/Evolution_Revolution_2018_v7.pdf;  Accessed January 30, 2020.

[2]      Id.

[3]      FINRA Dispute Resolution Statistics;  Available at: https://www.finra.org/arbitration-mediation/dispute-resolution-statistics;  Accessed December 31, 2019.

[4]      Id.  I have excluded the other types of controversy for this analysis.

[5]      Id.  “Settled via Mediation” means cases settled with a FINRA mediator.  In the vast majority of instances, “Direct Settlement by Parties” involves a mediation with a third-party, non-FINRA mediator.

[6]      Id.

[7]      Id.

[8]      Id.

 

To learn more about fiduciary expert Jack Duval, click here.

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Topics: supervision, Investment Suitability, Securities Exchange Commission, fiduciary duties, Breach of Fiduciary Duty Claims

   

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