FINRA Arbitrator Troubled by Rep's Advance Collection of Asset Management Fees

June 10, 2020

Where there's smoke, there's fire. Unless there isn't any fire but only smoke. And thus we have the conundrum of today's featured FINRA Arbitration Decision. Did a rep double-bill his clients for asset management fees? Maybe. Maybe not. One thing that's for sure, no such proof was presented at the hearing. Should the unanswered questions prompt FINRA the regulator to intrude into FINRA the arbitration forum? Would your answer change if you knew that the rep won a dismissal of the claims? Our publisher Bill Singer, Esq. doesn't have an answer. See what you think.

Case In Point

In a Financial Industry Regulatory Authority Arbitration Statement of Claim filed by FINRA member firm FSC Securities in January 2020, the firm asserted unjust enrichment and breach of fiduciary duty. In the Matter of the Arbitration Between FSC Securities Corporation, Claimant, v. David Hergert, Respondent (FINRA Arbitration Decision 20-00211)
As set forth in the FINRA Arbitration Decision:

[T]he causes of action relate to Claimant's allegation that Respondent billed his clients in advance for quarterly asset management fees for the entirety of the second quarter of 2013 and collected and retained the fees, despite his employment with Claimant ceasing just after the commencement of that quarter. Claimant further alleges that it returned the fees to the customers and that it believes Respondent billed and collected the fees again when he went to a new firm but has not reimbursed Claimant for its expenditure. 

Duplicate Fees

In its Statement of Claim, FSC sought up to $33,380 in compensatory damages, which allegedly consisted of "all duplicate asset management fees collected and wrongly retained by Respondent for the second quarter of 2013." Further, Claimant sought interest, costs, expenses, and fees of at least $2,100.

SIDE BAR: Let's do a quick recap of the allegations to make sure that we're all on the same page.
    1. Hergert allegedly billed his clients in advance for their Q2 2013 asset management fees;
    2. Hergert left FSC shortly after the onset of Q2;
    3. Hergert collected and retained the Q2 fees from his clients;
    4. FSC returned the Q2 fees to Hergert's clients;
    5. FSC "believes" tha Hergert billed and collected Q2 fees from his client at his new employer; and
    6. Hergert did not reimburse FSC for the refunded Q2 fees.
Out of Time. No Standing.

Respondent associated person Hergert generally denied the allegation and asserted various affirmative defenses. Pointedly, Respondent argued that Summary Judgment be granted on the grounds that Claimant's claims were "time barred and/or that Claimant has no standing to bring said claims, or, alternatively, that there be a finding that the claims made are without merit . . ."

Respondent Hergert filed a Motion to Dismiss citing FINRA Code of Arbitration Procedure Rule 13206: Time Limits and FINRA Code of Arbitration Procedure Rule 13504: Motions to Dismiss; and a Motion for Summary Judgment under FINRA Code of Arbitration Procedure Rule 13503: Motions. Respondent FSC opposed the motions. 

Dismissed Without Prejudice

The sole FINRA Arbitrator Jude A. Smith granted without prejudice Claimant Hergert's Motion to Dismiss and offered the following rationale:

Claimant's claim is time-barred under Rule 13206(a) of the Code, which requires disputes to be submitted to arbitration within six years of the occurrence or event giving rise to the claim. Claimant has admitted that it is time-barred from pursuing a direct claim against Respondent. 

The Arbitrator found persuasive, and accepted as fact, the first three paragraphs of Claimant's "Background and Circumstances of Claim" in the Statement of Claim. Respondent quit his job with Claimant immediately upon being paid in advance for services to his clients for the second quarter of 2013. His payment was deducted from his clients' accounts. As Respondent was aware the funds were withdrawn in advance from his clients' accounts, he would be implicitly aware he was being paid for work he had not yet accomplished and would never perform. The Arbitrator is of the opinion that this is unethical and that any broker would be aware of such. It is the Arbitrator's opinion that this violated FINRA Rule 2150(a) as an improper use of client funds. 

Claimant brings forward a troubling claim that the clients who followed Respondent, after receiving timely reimbursements from Claimant, may have been billed again once they were situated at Respondent's new firm. However, Claimant is only able to theorize that such a client exists and would require an order for discovery of another brokerage house's client records. Even should such clients be identified, any related claims would be barred by the six year limitation on filing a claim in arbitration. Accordingly, in this context, the Arbitrator does not find Claimant's use of the 'discovery rule' to be persuasive. 

To allow the arbitration to proceed into a potentially expensive and lengthy discovery process and a multi-day hearing with potentially non-local witnesses and experts, defeats the purpose of arbitration which is to provide a faster and less expensive venue than litigation. To proceed would be an exercise in futility when no claim could be presented which was not barred by time limitations. Claimant's argument regarding Rule 13504(a)(1) of the Code was well taken, however a Motion to Dismiss regarding time limitations is quite specifically an exception to the doctrine disfavoring motions to dismiss prior to the conclusion of a party's case in chief. 

As time limits have passed for Claimant's claims, the Motion to Dismiss is granted.

Bill Singer's Comment

My compliments to Arbitrator Smith for publishing a thoughtful rationale that succinctly explains his bases for dismissing Claimant FSC's claims. No -- this is not a comfortable decision and it certainly contains unsettling fact. We feel Arbitrator Smith's struggle when we come upon this:

[A]s Respondent was aware the funds were withdrawn in advance from his clients' accounts, he would be implicitly aware he was being paid for work he had not yet accomplished and would never perform. The Arbitrator is of the opinion that this is unethical and that any broker would be aware of such. It is the Arbitrator's opinion that this violated FINRA Rule 2150(a) as an improper use of client funds.

As set forth in FINRA Rule 2150: Improper Use of Customers' Securities or Funds; Prohibition Against Guarantees and Sharing in Accounts:

(a) Improper Use
No member or person associated with a member shall make improper use of a customer's securities or funds. .

Arbitrator Smith acknowledges that Claimant FSC raised a "troubling claim" by alleging that Respondent Hergert may have essentially double-billed his clients for Q2 2013 asset management services at FSC and also at his next employer. The first billing allegedly constituted charges for services that Hergert "would never perform" at FSC.  At the FINRA arbitration hearing, FSC failed to present any proof of any follow-on, second Q2 2013 billing by Hergert of the customers at the next employer. Moreover, FSC refunded the fees collected by Hergert while in its employ, so the customers never wound up out-of-pocket for two fees. Notwithstanding the troubling nature of the allegations about double-billed fees, Arbitrator Smith makes it clear that "Claimant is only able to theorize that such a client exists and would require an order for discovery of another brokerage house's client records."

The road to the left is based upon a theory that argues that Hergert may have double-billed clients but no proof of such misconduct was presented by FSC. 

The road to the right is closed to all travelers who have been on the road for six years or longer. 

Arbitrator Smith notes that the cited FSC advances for services were paid to Hergert in the Q2 2013, and, accordingly, FINRA's Six Year Eligibility Rule should preclude any claims as of the January 2020 date when Claimant FSC had filed its Statement of Claim against Hergert. How come FSC waited nearly 7 years to file its Statement of Claim against Hergert? Now there's a question that we all wish was answered in the FINRA Arbitrtation Decision.

Having come to the proverbial fork in the road, Arbitrator Smith declined to walk down either path and dismissed FSC's claims. 

There is no indication in the FINRA Arbitration Decision that FINRA Arbitrator Smith undertook a regulatory referral to FINRA. FINRA Code of Arbitration Procedure for Customer Disputes Rule 12104 (which tracks FINRA Code of Arbitration Procedure for Industry Disputes Rule 13104), provides that:

Rule 12104. Effect of Arbitration on FINRA Regulatory Activities; Arbitrator Referral During or at Conclusion of Case

(a) Submitting a dispute to arbitration under the Code does not limit or preclude any right, action or determination by FINRA that it would otherwise be authorized to adopt, administer or enforce.

(b) During the pendency of an arbitration, any arbitrator may refer to the Director any matter or conduct that has come to the arbitrator's attention during a hearing, which 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. Arbitrators should not make referrals during the pendency of an arbitration based solely on allegations in the statement of claim, counterclaim, cross claim, or third party claim. If a case is nearing completion, the arbitrator should wait until the case concludes to make the referral if, in the arbitrator's judgment, investor protection will not be materially compromised by this delay.

(c) If any arbitrator refers a matter or conduct for investigation under paragraph (b) of this rule, the Director will disclose the act of making the referral to the parties. A party may request that the referring arbitrator(s) recuse themselves, as provided in the Code, no later than three days after the Director notifies the parties of the referral. If a party does not make the recusal request within the prescribed timeframe, the party forfeits the right to request recusal of the referring arbitrator(s).

(d) The Director will evaluate the arbitrator referral to determine whether to transmit it to other divisions of FINRA. Only the Director shall have the authority to act under this paragraph (d).

(e) At the conclusion of an arbitration, any arbitrator may refer to FINRA for investigation any matter or conduct that has come to the arbitrator's attention during and in connection with the arbitration, either from the record of the proceeding or from material or communications related to the arbitration, which the arbitrator has reason to believe may constitute a violation of the rules of FINRA, the federal securities laws, or other applicable rules or laws.

As provided in (e) above, Smith could have referred Hergert's conduct to FINRA for regulatory investigation but the Rule requires that an Arbitrator should first form a state of mind whereby he "has reason to believe" that the cited conduct "may constitute a violation." Smith's commentary suggests that he does not have a reasonable belief that Hergert engaged in any misconduct; however, he sure as hell is troubled by some aspects of the record. 

What happens at this point -- and what is best per public policy?

Should FINRA-the-regulator monitor FINRA arbitration decisions and pursue a regulatory investigation solely predicated upon the the musings of sitting arbitrators? 

From a public policy perspective, is it constructive or destructive for FINRA to undertake a regulatory investigation based upon the adjudication of a dispute before its arbitration forum absent a referral from an arbitrator? Wouldn't such intrusive regulatory action violate the confidential nature of arbitration subject to the dictates of a private contract? 

Solely based upon the facts in Hergert, I am not prepared to answer the questions above. I don't have an answer that satisfies many nuances that I'm thinking about. I'm not sure whether FINRA should inject itself, uninvited, into investigating allegations in a private arbitration. I'm not sure why FINRA wouldn't regularly monitor its arbitration decisions (and a host of other forums) for leads on potential misconduct. Perhaps I'm at that stage where I'm forming an opinion. Perhaps I will never be able to come up with a satisfactory answer. While I'm pondering the mysteries of Wall Street, feel free to reach your own conclusions.