Thread by @BenPEdwards, On some big developments in expungement rules--a strange corner of securites law. [...]

On some big developments in expungement rules--a strange corner of securites law.

Today's blog post summarizes much of it, but a thread may help as well.

https://lawprofessors.typepad.com/business_law/2021/01/new-developments-in-expungement-rules.html

Here, you may be wondering, what is he talking about?

Stockbrokers (they often call themselves financial advisers now) operate in a complex regulatory system. For decades, complaints about them and arbitrations filed against them have been collected into a database-the CRD.

FINRA's BrokerCheck system draws on data from the CRD. You absolutely should use BrokerCheck as a first step to research any financial adviser.

https://brokercheck.finra.org/

Don't assume that it'll give you the entire story. Much information has been purged from the database.

This happens through the expungement process. Most expungements start with an arbitration filing in FINRA's arbitration forum. In many instances, the broker files against his current or former employer, alleging that complaints against him are false.

One thing to notice here, the broker and the employer have aligned interests. The broker wants to get the red flags off his record. The employer also wants those red flags gone because it makes it easier for the broker to keep making money for the employer by selling products.

For years, the person who previously complained might find out about the arbitration mere weeks before the hearing. FINRA told arbitrators to have the broker or broker's lawyer send the complaining customer a notice.

Unsurprisingly, with short notice few investors showed up.

It's also worth noticing that investors who have complained about being swindled don't have any real personal incentive to fight expungements. They already know who swindled them and they won't forget.

The overwhelming bulk of these expungement hearings never face any opposition. The @PIABAFoundation released a report examining over a thousand expungement hearings and finding that the investors only contested expungement in about 13% of the cases:
https://piabafoundation.org/wp-content/uploads/2019/10/Expungement-Study-101519-FINAL-VERSION.pdf

I've also published a law review article on the problem. It's called Adversarial Failure and available here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3622730

The big problem is that this adversarial system is making determinations without any reason to believe that arbitrators actually get good info.

Most of the time, the arbitrators never even hear from the people who made the complaints. Despite that, they declare them to be false and recommend expungement. FINRA allows them to purge the information once they get the arbitration award confirmed by a court.

Now, you might think that a court will somehow review these in some meaningful way, but you'd be very, very wrong. Under the Federal Arbitration Act, judges have to confirm these arbitration awards unless very particular criteria are met.

The awards simply get confirmed. Objections almost never get filed because the only people to know about the court filing to confirm are the parties to the arbitration--and they all want the expungement to be granted.

Why should we care though?

All of this information getting ripped out of the system is really important. It has strong predictive value for predicting future misconduct. One study found that brokers who win expungements are 3.3x as likely to harm future investors as the average broker. That's insane.

In 2017 FINRA announced that it was studying the issue and asked for comments. Then, it waited three years before proposing some relatively minor tweaks to the process--leaving the core of this broken system unchanged.

https://www.sec.gov/rules/sro/finra/2020/34-90000.pdf

As someone who has studied this issue, I saw that this wouldn't do nearly enough to fix the problem and filed a big comment letter on the proposal.

https://www.sec.gov/comments/sr-finra-2020-030/srfinra2020030-7893494-224270.pdf

I had some success, FINRA's response agreed with some of the points I made, even though they didn't think they needed to fundamentally change the system.

https://www.finra.org/sites/default/files/2020-12/SR-FINRA-2020-030-response-to-comments.pdf

The changes they agreed to mostly relate to actually letting investors see the documents the parties (brokers and industry firms) have filed in the arbitration.

As it stood with the initial proposal, non-party customers wouldn't even be able to participate in scheduling conferences, leaving brokers free to schedule an expungement hearing where they would call you a liar on your birthday, anniversary, or vacation

Despite these changes, the system remains totally broken and incoherent. We shouldn't be using arbitration to address this issue.

Still, it's a hard thing for FINRA to deal with. It oversees the CRD database and it gets complaints from all sides about this.

Brokers want some way to challenge complaints they believe to be false or fundamentally unfair. The system, as set up, tilts the odds overwhelmingly in their favor. The @PIABAFoundation study found that brokers have been winning expungements over 80% of cases in recent years.

This is a big problem. State regulators use the CRD database to oversee their markets. Imagine if your local police got multiple complaints about a fraudster. We'd expect them to keep watch on that person. Expungement allows the broker to erase those complaint's from memory.

This is also a problem for the SEC and FINRA. They recently approved new rules for high-risk brokers with a history of misconduct.

https://www.sec.gov/rules/sro/finra/2020/34-90635.pdf

These oversight rules for high-risk brokers depend on data in the CRD database to actually identify high-risk brokers.

Expungement now leaves the SEC and FINRA blind.

It also blinds state regulators and other investors.

Ultimately, the entire expungement system is a giant mess. We need to scrap it and start over.

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