SEC Approves FINRA’s New Definitions Of Public and Non-Public Arbitrators

3/18/2015

On February 26, 2015, the Securities and Exchange Commission (“SEC”) approved changes to the Financial Industry Regulatory Authority’s (“FINRA”) Code of Arbitration Procedure for both customer and industry disputes that entirely overhauls the current definitions of “public” and “non-public” arbitrators – changes that will affect both investors and financial institutions in arbitration and which will ultimately result in a substantial reduction in the number of public arbitrators on FINRA’s arbitrator roster. The changes to Rule 12100 of the Code of Arbitration Procedure for Customer Disputes are intended to promote neutrality of arbitrator classifications through the use of “bright-line” rules governing the requisite qualifications and prohibitions for who may qualify or subsequently be reclassified as a “public” arbitrator(1). These changes, which include the elimination of a “cooling-off” period that had previously allowed certain non-public arbitrators to be later reclassified as public arbitrators, will have significant ramifications for practitioners going forward. The revised Rule 12100 will take effect upon FINRA’s specification of an effective date in a published Regulatory Notice announcing the changes, and will likely apply to all active cases in which the arbitrator selection process has not yet commenced.

Whether a prospective FINRA arbitrator is classified as “public” or “non-public” is based largely on several factors, including their current or previous experience in, or providing services to, the financial industry. This classification has become increasingly important not only as FINRA arbitrations have gained steam in recent years, but also because public arbitrators make up the majority (and sometimes entirety) of the standard three-person panel(2). Under the previous Rule 12100, individuals with previous financial industry experience or affiliations were initially classified as a non-public arbitrator but permitted to be reclassified as a public arbitrator after various “cooling off” periods following the termination of the pertinent affiliation. For example, individuals with previous financial industry experience could later be classified as a public arbitrator after a five-year period following their employment, while attorneys and other professionals who represented or provided services to parties in FINRA disputes could serve as a public arbitrator after a similar two-year cooling off period. Additionally, employees of banks or other financial institutions effecting securities transactions or overseeing or monitoring those employees’’ compliance with securities laws could often become a public arbitrator immediately after ending their affiliation.

Notable Changes

Rule 12100(p)(1) would eliminate the five-year cooling off period for arbitrators with previous financial industry experience or affiliations by permanently classifying that individual as a non-public arbitrator. The new rule would also expand the categories of applicable financial industry professionals to include individuals associated with or registered through a mutual fund, hedge fund, or investment adviser. Finally, a new provision specifies that the change would be applicable to any entity “organized under or registered pursuant to the Securities Exchange Act of 1934, Investment Company Act of 1940, or the Investment Advisers Act of 1940” was designed to encapsulate future industry positions that might arise in the future.

Rule 12100(p)(2) makes similar changes to rules governing attorneys, accountants, and other professionals who previously devoted 20% of more of their professional work in the immediately-preceding two-year period to serving financial industry entities and/or employees. The rule increases the “cooling-off” period to five years from two years, and also permanently disqualifies any professionals from serving as public arbitrators if they provided at least 15 calendar years of service to financial industry entities and/or employees.

Perhaps in a nod to criticism from industry lobbying groups, FINRA also proposed changes to the classification of attorneys and other professionals that devoted at least 20% of their time to providing services to investors in customer and employment disputes. While these individuals were classified as public arbitrators under the previous rule, the new Rule 12100(p)(3) would reclassify those persons as non-public arbitrators who could only become reclassified as a public arbitrator following a five-year period in which they devoted less than 20% of their professional work to serving customer parties. Additionally, like the revised Rule 12100(p)(2), an individual that provided services for 15 calendar years or more over the course of his or her career would be permanently disqualified from ever being classified as a public arbitrator.

Rule 12100(p)(4) also changes the way that former employees of certain financial institutions are classified. Previously, FINRA classified as non-public arbitrators those employees of banks or other financial institutions that currently (a) effected transactions in securities, or (b) supervised or monitored those employees’ compliance with securities and commodities laws. Upon terminating their affiliation, FINRA allowed the immediate reclassification of a former employee as a public arbitrator. The new rule introduces a five-year “look-back period,” which would extend the restrictions to individuals serving as covered employees within the past five calendar years. Additionally, those employees could obtain reclassification as a public arbitrator after a five-year “cooling off” period. Finally, any potential reclassification would not be available to any employees who provided those services for 15 years or more.

Ramifications Of Changes

While the changes focus on combatting inherent bias in the classification of arbitrators, many have voiced concerns that FINRA may not have adequately anticipated the potential consequences. Indeed, it has been pointed out that FINRA declined to perform any cost-benefit analysis prior to proposed implementation of the revisions, and the SEC noted that FINRA had committed to do so only after approval of the proposal.

Many of the concerns revolve around what a significant reduction in FINRA’s public arbitration roster might portend. For example, some worry that a diminution in the availability of public arbitrators for the thousands of cases handled annually by FINRA could potentially result in delays and increase case disposition timeframes. As one commenter noted to FINRA, statistics have shown that parties have elected to proceed with an all-public panel approximately in approximately 75% of eligible arbitrations. Additionally, some have wondered how the decrease – which is pegged to be as high as 25% of FINRA’s current public arbitrator roster – might affect the arbitration process in the event of another market crash that spurs a sharp increase in arbitration filings. While FINRA acknowledged the concerns about the likely reduction in the public arbitrator roster, it indicated that it intended to address these concerns through an “aggressive” campaign focused on the recruitment and retention of public arbitrators. For example, it disclosed that it had received almost 200 applications from Puerto Rico residents interested in serving as a public arbitrator.

After reviewing the revisions and accompanying comment submissions, the SEC approved the proposed rule change and found that the “proposal would enhance the perception of the entire FINRA arbitration forum.” Whether or not these predictions are ultimately accurate, one thing will not change – the arbitrator selection process will remain a crucial component of customer arbitrations.

Jordan D. Maglich is an associate at Wiand Guerra King where he focuses his practice on securities and business litigation, securities arbitration, and white collar defense. You can contact Jordan at jmaglich@wiandlaw.com or 813-347-5100.

[1]  All references to Rule 12100 refer to the newly revised rule.  While this article addresses changes to the Customer Code, the same changes were made to the corresponding rule in the Code of Arbitration Procedure for Industry Code.

[2]  For claims of $100,000 or more, a three-person arbitration panel is standard.  Additionally, under FINRA’s recent all-public panel initiative, either party has the ability to request that the arbitrator panel be composed of all public arbitrators.  Recent FINRA statistics suggest that the parties’ use of this option has exceeded FINRA’s expectations.