By Matt Applebaum, Michael Weissmann and Elizabeth Marino
Bingham McCutchen LLP
Expungement is the process by which a registered representative gets his slate wiped clean of a customer complaint. Controversy over the expungement process is not new. In rule changes and related guidance since the 1990s, the Financial Industry Regulatory Authority (“FINRA”) has sought to allay persistent claims that expungement is too readily available, with not enough oversight. On the other hand, FINRA also recently proposed rules to provide an express expungement procedure for registered representatives who are not named in an arbitration, but whose industry records must nonetheless reflect that they are the subject of a customer claim.
Pressure on FINRA to further modify the expungement process has increased over the past year, especially following a study issued by the Public Investors Arbitration Bar Association (“PIABA”) in October 2013, which claimed that expungement rates in settled cases were “alarmingly high.” Some have alleged that registered representatives may “buy a clean record” by conditioning a settlement on a claimant’s agreement not to oppose expungement. As discussed below, in the wake of the PIABA study and the political interest it generated, FINRA has already made significant changes to the expungement process and has made clear that more are coming. In this article, we review the current rules governing expungement, the recent PIABA study and its impact, and the changes that are afoot.
Expungement of an action/complaint from a representative’s record is usually a three step process. First, the representative must convince an arbitration panel to enter an award ordering expungement. To do that the representative must meet one of the three grounds for granting expungement set out in FINRA Rule 2080: (A) the claim, allegation or information is factually impossible or clearly erroneous; (B) the registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation or conversion of funds; or (C) the claim, allegation or information is false. Second, the award must be confirmed by a court in the jurisdiction in which the arbitration occurred. Third, the award and the judgment confirming the award are sent to the Central Registration Depository (“CRD”) to have the matter removed from the representative’s record.
The process is governed by two FINRA rules: Rule 12805 of the Code of Arbitration Procedure for Customer Disputes and FINRA Rule 2080 (discussed above). Rule 12805 -- which became effective in 2008 -- addresses the first part of the process: the responsibilities of the arbitration panel hearing a request for expungement. The Rule requires a panel to “[h]old a recorded hearing session (by telephone or in person) regarding the appropriateness of expungement.” In a case that has gone to hearing on the merits, a panel will consider a request for expungement as part of its deliberations on the merits of a claimant’s damage claims.
If, however, a case has been resolved before a final hearing on the merits -- usually by settlement -- the panel must still hold a recorded hearing on the record to evaluate a representative’s expungement request, including “review[ing] settlement documents and consider[ing] the amount of payments made to any party and any other terms and conditions of a settlement.” A representative seeking expungement after a settlement must, therefore, be prepared to present testimony to the panel and to have the panel consider the terms of the settlement, including the size of the settlement payment relative to the claim and whether the representative has participated in the settlement.
In these instances it is common for FINRA to agree, upon request of a party, to keep the arbitration panel intact following the settlement for purposes of holding a hearing limited to the issue of the representative’s expungement request. Indeed, it is currently common in the settlement of a case for the parties to acknowledge that the representative plans to seek expungement and to agree that the claimant’s claims may be dismissed without discharging the panel to allow it to hear the expungement request. In some instances claimants have also agreed in the settlement to not object to the request, a practice that, as discussed below, FINRA now proposes to prohibit.
The process of having an expungement request heard by a panel is easily accomplished when a representative is named in the matter since he or she has standing to ask FINRA to retain the panel and to appear before the panel. The process becomes more complicated when the party seeking expungement is not a named party (e.g., an unnamed supervisor where a customer claims there was a failure to supervise), especially when he or she is no longer associated with the respondent firm that is defending the arbitration. FINRA’s rules do not establish a process by which such an individual may seek expungement (although FINRA has proposed one, as discussed below). FINRA has, however, advised these individuals to file a FINRA arbitration in which they name as respondent the customer whose claims they seek to expunge -- an uncomfortable approach to be sure -- with the sole request that the panel grant expungement.
Rule 12805 instructs the panel that if it grants expungement, it must “[i]ndicate in the arbitration award which of the Rule 2080 grounds for expungement serve(s) as the basis for its expungement order and provide a brief written explanation of the reason(s) for its finding that one or more Rule 2080 grounds for expungement applies to the facts of the case.” When a panel orders expungement, it is most often based on the finding that “the claim, allegation or information is factually impossible or clearly erroneous,” or “the claim, allegation or information is false.” If a panel has determined expungement is proper it will issue an award with appropriate findings and an order that the matter be expunged from the representative’s record.
The next step of the process is to have the award confirmed by a court. Rule 2080 requires a party confirming an award ordering expungement to “name FINRA as an additional party and serve FINRA with all appropriate documents.” FINRA may, however, waive this requirement if it finds that the expungement award is based on one of three required findings noted above (i.e., that the panel made a proper finding) or in “extraordinary circumstances” that the “expungement relief and accompanying findings on which it is based are meritorious; and . . . the expungement would have no material adverse effect on investor protection, the integrity of the CRD system or regulatory requirements.” A party that has been granted expungement by a panel may apply to FINRA for a determination as to whether it agrees to waive being named in the confirmation proceeding. If the panel has made an appropriate finding as required by Rule 2080, FINRA routinely waives being named. Once FINRA has made its intentions known, the representative can ask a court to confirm the arbitration award.
The final step in the process is to file the award and the court’s judgment confirming the award with CRD to have the matter removed from the representative’s record.
Proposed In re Expungement Proceedings
Prior to the PIABA Study -- before FINRA was under fire for allowing too many expungement requests -- FINRA requested comment on “new rules that would permit persons who are the ‘subject of’ allegations of sales practice violations made in arbitration claims, but who are not named as parties to the arbitration (unnamed persons), to seek expungement relief by initiating In re Expungement proceedings at the conclusion of the underlying customer-initiated arbitration case.” FINRA was concerned that registered persons lacked an adequate remedy to clear their records when, although not a named party in an arbitration, they had to disclose a complaint on their Forms U4 and/or U5 because they were mentioned in a statement of claim or could reasonably be identified as a person involved in alleged sales practice violations.
The proposed rules would provide unnamed persons with a procedure to obtain expungement, however, it would still be a fairly onerous process. Under the proposal, unnamed persons would receive a notification from FINRA when his or her firm notifies CRD of an alleged sales practice violation by the unnamed person in a customer-initiated arbitration proceeding. The unnamed person could submit a “Notice of Intent to File” to FINRA if he is considering pursuing expungement relief. After the applicable customer arbitration case has concluded, FINRA would notify the unnamed person, who could then initiate an In re Expungement arbitration proceeding by filing a statement of claim and an In re Submission Agreement with FINRA. Alternatively, the respondent to the underlying arbitration could request expungement relief on behalf of the unnamed persons or could request a stipulated award, among other things.
After considering the comments received in response to the In re Expungement proposal, the FINRA Board of Governors authorized FINRA to file a modified proposal with the SEC, but, likely due to the more recent increased scrutiny regarding expungement proceedings, FINRA has not yet done so.
The PIABA Study and Political Fallout
PIABA released its “Expungement Study” on October 16, 2013. Most notably, the study found that, with respect to settled cases in which expungement was requested, it was granted in 89% of the cases for the period January 1, 2007 through May 17, 2009 and 96.9% of the cases for the period May 18, 2009 through December 31, 2011. The PIABA study also found that from 2007 through 2011, expungement was granted in over 60% of the cases in which respondents prevailed after a hearing on the merits and in which expungement was requested.
According to PIABA, the rate of expungements in settled cases is “alarmingly high,” and shows that arbitrators have not treated expungement as the “extraordinary remedy” that FINRA and the SEC intended, and that respondents are improperly “bargaining” for expungement as a condition of settlement despite FINRA’s efforts to prevent such conduct. PIABA recommended rule changes that would make it a violation of FINRA Rule 2010 (Standards of Commercial Honor and Principles of Trade) for respondents, as part of settlement, to negotiate for a claimant to agree to (or to not oppose) expungement relief. Other recommendations include requiring both FINRA and state securities regulators to review all requests for expungement as well as any settlement agreements in the underlying cases, and enabling them to appear at a hearing to oppose a motion for expungement when appropriate.
PIABA’s study has important limitations. For example, notwithstanding the participation of PIABA’s own members in many arbitration cases, the study does not purport to identify any actual case in which an expungement was allegedly unwarranted under the standards of FINRA Rule 2080. Instead, the study relies entirely on statistical data. But when PIABA claims that expungement rates are “high,” it does not say relative to what benchmark, or what rate would be appropriate. In addition, the expungement rates highlighted in the study reflect, by definition, cases in which the respondents invested the effort and resources to seek expungement -- a small minority of cases. Parties are most likely to seek expungement (and risk an adverse finding by the Panel) when they have a good faith basis for doing so under FINRA Rule 2080, and it is therefore not necessarily surprising to find that expungement relief is granted in most of these cases.
Most fundamentally, the PIABA study simply presumes that mere unproven allegations are generally credible and that expunging them gives investors “a woefully incomplete picture” of a broker’s industry record. PIABA does not consider the possibility that most expungements, in settled cases and otherwise, reflect an arbitration panel’s well-founded view that a claim is factually impossible or false.
FINRA reacted quickly to the PIABA study. On October 26, 2013, FINRA issued a “Notice to Arbitrators and Parties on Expanded Expungement Guidance.” Among other things, the notice emphasizes the “extraordinary nature” of expungement relief; discusses the “unique, distinct” role of arbitrators in ensuring that CRD information is “accurate and meaningful”; and pointedly states that arbitrators “should inquire and fully consider whether a party conditioned a settlement of the arbitration” upon an agreement not to oppose expungement. The notice also states that arbitrators should review a current copy of the representative’s BrokerCheck report when considering whether expungement is appropriate, implying that a broker’s previous disclosures are somehow relevant to whether the matter at hand should be expunged.
The PIABA study also prompted a response from Capitol Hill. Letters to FINRA from Senator Markey on October 25, 2013 and from Senators Reed and Grassley on December 16, 2013 cited the PIABA findings and echoed the concern that settled matters were being expunged to the detriment of investor protection. The Reed-Grassley letter requested FINRA to respond to each of PIABA’s recommendations.
In its responses to these letters, FINRA reaffirmed its position that “while expungement of customer dispute information is an extraordinary measure, it is nevertheless appropriate in limited circumstances,” and outlined the procedures and governing standards already in place under FINRA Rules 12805 and 2080. FINRA also pointed out that, as noted above, the PIABA findings focus only on the small percentage of cases in which respondents actually sought expungement.
FINRA Accepts Key PIABA Conclusions and Moves to Change the Rules
Ultimately, however, FINRA accepted PIABA’s key finding regarding settled cases, stating that it is “extremely concerned over the inordinately high percentage of expungement relief granted by arbitrators in settled cases.” Averring that conditioning settlements on non-opposition to expungement “may interfere with the arbitrators’ ability to independently determine the appropriateness of expungement and make the requisite affirmative finding,” FINRA also agreed to one of PIABA’s recommendations, a rule change that would “prohibit the practice of conditioning settlements on an investor’s agreement not to oppose expungement.” On February 13, 2014, the FINRA Board of Governors authorized FINRA to file such a proposal with the SEC. Specifically, the proposed rule “would prohibit firms and associated persons from conditioning or seeking to condition settlement of a dispute with a customer on, or otherwise compensating the customer for, the customer’s agreement to consent to, or not to oppose, the firm’s or associated person’s request to expunge the customer dispute information from FINRA’s [CRD] system.” It remains to be seen whether such a prohibition will have any practical impact as it is difficult to predict whether a customer who has settled an arbitration would take the time, effort and counsel fees to oppose an expungement request or to appear at an expungement hearing.
FINRA’s response to Reed/Grassley also outlined additional measures FINRA is taking and has recently taken. These measures, largely consonant with PIABA’s recommendations, include “completely revamp[ing]” arbitration expungement training, and “urging” arbitrators to review a broker’s record for any prior customer complaints or regulatory matters. FINRA does not clarify how prior matters bear on the expungement of a particular matter. This new emphasis on past disclosures risks turning expungement hearings into a “trial within a trial” on collateral matters, and worse, could unfairly prejudice brokers by suggesting to panels that past disclosures serve as a ground to deny expungement.
FINRA did not, however, accept PIABA’s recommendation that FINRA and state regulators be provided the right to appear at arbitration hearings to oppose expungement relief. FINRA asserts that it would be problematic to permit non-parties to participate in private arbitration hearings, and could threaten “the ability of FINRA Dispute Resolution to operate a neutral arbitration forum.”
Finally, on a more general note, FINRA states that it is “currently engaged in a comprehensive review of its expungement rules and procedures,” making clear that more change is to come.
 A widely-noted New York Times article in June 2013 aired concerns by claimants’ attorneys concerning the expungement process, see Susan Antilla, A Rise In Requests From Brokers To Wipe the Slate Clean, N.Y. Times, June 10, 2013, available at http://dealbook.nytimes.com/2013/06/10/a-rise-in-requests-from-brokers-to-wipe-the-slate-clean/?_r=0., and FINRA’s Director of Arbitration stated that FINRA is “looking at the issues raised by investors concerning settlement negotiations when an expungement request is involved,” Dan Jamieson, New FINRA Rules Could Help Brokers Clear Records in Certain Cases, Investment News, Aug. 8, 2013, available at http://www.investmentnews.com/article/20130808/FREE/130809919.
 Rule 13805 of the Code of Arbitration Procedure for Industry Disputes sets forth the same process for industry disputes.
 In 2004, FINRA cautioned firms that it is a rule violation to procure “exculpatory affidavits” from customers as part of settlement negotiations when the firm “knows or should know” that the affidavits are “false or misleading.” See FINRA, Notice to Members 04-43 (June 2004).
 See FINRA, Regulatory Notice 12-18: Expungement Procedures (April 2012); see also Bingham McCutchen LLP, Legal Alert: FINRA Seeks Comment on Proposed “In re Expungement Rule” Applicable to Unnamed Parties in Arbitration Proceedings (Apr. 16, 2012).
 See FINRA, Update: FINRA Board of Governors Meeting (Dec. 7, 2012), available at http://www.finra.org/Industry/Regulation/Guidance/CommunicationstoFirms/P197425.
 Before May 18, 2009, associated persons that were not named as respondents in a customer arbitration did not need to report that arbitration. As of May 18, 2009, “unnamed” representatives are required to report arbitrations of which they are a “subject.” PIABA acknowledges that the increase in expungement requests after May 18, 2009 is attributable at least in part to this rule change.
 According to FINRA, the number of arbitrator-originated expungements during the period reviewed by PIABA is 850, less than 5% of the 17,635 arbitration proceedings initiated by customers during the same period.
 Letter from Richard Ketchum, Chairman and CEO, FINRA, to Senator Jack Reed and Senator Charles E. Grassley, United States Senate (Jan. 6, 2014) [hereinafter Ketchum Letter]; see also Letter from Richard Ketchum to Senator Markey (Nov. 13, 2013).
 Ketchum Letter, supra note 8, at 3
 See Ketchum Letter, supra note 8, at 5.
 See FINRA, Update: FINRA Board of Governors Meeting (Feb. 13, 2014), available at http://www.finra.org/Industry/Regulation/Guidance/CommunicationstoFirms/P445719