FINRA Regulatory Notice 18-22 (Discovery of Insurance Information in Arbitration)
23 August 2019
To: Director, E&O Division for Broker-Dealer Coverage (or equivalent)
Re: FINRA Regulatory Notice 18-22
Discovery of Insurance Information in Arbitration
In July 2018, FINRA issued Regulatory Notice 18-22 (Discovery of Insurance Information in Arbitration) where FINRA requested comment on proposed amendments to its Arbitration Discovery Guide that would require the production of a broker-dealer’s insurance information in the FINRA arbitration forum. The comment period for this set of rule amendments closed on September 24, 2018 and FINRA received 112 individual comment letters. The vast majority of comment letters supporting the proposal came from PIABA, a bar association whose members represent investors in disputes with the securities industry. FINRA’s small broker-dealer members and Associations were principally in opposition to 18-22. It is worth noting that one small firm comment letter was signed by 77 small firms opposing 18-22.
In the 18-22 rule amendment proposal, FINRA seeks to amend the FINRA Arbitration Discovery Guide’s (the Guide) Firm/Associated Persons Document Production List to require firms and associated persons to produce documents concerning third-party insurance coverage in a customer arbitration proceeding.
By way of background, the Guide supplements the discovery rules contained in the FINRA Code of Arbitration Procedure for Customer Disputes (Customer Code). It includes an introduction that describes the discovery process generally and explains how arbitrators should apply the Guide in arbitration proceedings. The introduction is followed by two Document Production Lists, one for firms and associated persons and one for customers, which enumerate the documents that are presumptively discoverable in customer cases. As presumptively discoverable, parties do not have to expressly request the documents. FINRA expects the parties to exchange the documents without arbitrator intervention. The Guide only applies to customer arbitration proceedings, not to intra-industry cases.
In Notice 18-22, FINRA seeks to add a new Production List Item requiring the production of information relating to insurance policies obtained through third-party carriers; this Item would not require production of documents relating to self-insurance. Specifically, the Item would require firms and associated persons, upon request, to produce documents sufficient to provide details concerning the coverage and limits of any insurance policy regarding a named party under which any third-party insurance carrier might be liable to satisfy in whole or in part an award issued by an arbitrator in the subject arbitration proceeding or to indemnify or reimburse a party for payments made to satisfy an award.
Quoting further from the FINRA Notice, practitioners who represent customers at the forum have told FINRA staff that insurance information is important during settlement discussions, especially with firms for which the ability to pay a potential award may be uncertain. These customer representatives believe that having knowledge of possible insurance, if any, would make them better able to advise their clients and determine a litigation strategy. Practitioners who represent the industry have raised concerns about insurance information being presumptively discoverable because of the potential for an opposing party to leak the information to the arbitrators, which would be prejudicial to a firm or associated person. They caution that disclosing the existence of a policy could be misleading because insurance policies often contain exclusions and limits that might preclude payment to a customer. They also believe that FINRA should not require firms to produce insurance information automatically in every case because it may not be relevant if the ability to pay a potential award is not an issue in the case.
Proponents of 18-22, principally practitioners who earn their living representing customers, support the proposal because, as stated in the Economic Analysis of the proposal, “the benefits of the proposed amendments accrue primarily to claimants in arbitration cases. Insurance information can provide valuable information to a claimant when determining a litigation strategy. By receiving details of the existence and scope of any third-party insurance coverage, a customer can decide whether to amend the statement of claim to fit within the coverage. Insurance information can be particularly important during settlement discussions when the ability of a firm or an associated person to pay an award is otherwise less certain. For example, when the insurance coverage of a firm or an associated person is not known and their ability to pay an award is less certain, then a customer may have difficulty determining whether to settle a claim and for what amount. In this instance, a customer may be more likely to settle a claim for a lesser amount to ensure some monetary compensation for damages. The discovery information, therefore, could increase the ability of customers to determine a litigation strategy to maximize the monetary compensation they could expect to receive.”
Additionally, FINRA believes that the proposed amendments would increase the consistency and efficiency of the arbitration forum and that customers would seek an arbitrator’s order for production in fewer cases and, therefore, reduce the forum fees associated with the requests.
Opponents to 18-22, principally the small firm community that are the primary focus of this proposal, point out that, as a general matter, insurance policies and coverage have no relevance or probative value to the issue of liability or the appropriate amount of damages in any case. As SIFMA says in their comment letter, they are merely an internal risk transfer mechanism purchased by the firm. As the Notice correctly points out, insurance information is generally only useful for purposes that have nothing to do with the merits of the case itself. It is neither the arbitration forum’s nor the arbitrator’s function to assist a plaintiff to maximize the plaintiff’s compensation anymore than it is to minimize the defendant’s liability.
The FINRA Notice identifies two such purposes: to allow a claimant to assess a respondent’s ability to pay the highest possible settlement amount or prospective arbitration award; and to allow a claimant to amend his or her claim to fit within the insurance coverage. The latter practice is questionable at best and abusive at worst, certainly from an insurance company’s perspective, particularly where the actual facts of the case become distorted or lost in the exercise of reframing objective reality to meet the requirements of an insurance policy. Moreover, opponents of 18-22 assert that the existence of potentially applicable insurance coverage is not probative of issues of liability on the part of respondent, even if the adequacy of the capitalization of the respondent to satisfy an award may be at issue.
The argument for adoption of this proposed amendment rests squarely, as expressed in a dozen or more plaintiff attorney comment letters, on the fact that disclosure of liability insurance coverage has been part of the Federal Rules of Civil Procedure for decades and, as such, should be further mandated in the FINRA Code. There is however a significant and meaningful problem with that argument and as there is a notable lack of correlation between the federal court system and FINRA Arbitration, the latter being the mandated forum for member firms and their associated persons.
Small business owners/operators point out it is an indisputable fact that FINRA members and associated persons do not enjoy the same Constitutional protections that other defendants have under the federal rules of civil procedure and federal rules of evidence found in the federal court system. For instance, the protections for defendants of litigation to have a case decided by a jury of their peers, the bifurcation of court proceedings dealing with liability and sanctions (v. liability and sanctions heard in ONE proceeding at FINRA), the ability to subpoena witnesses and documents in court (which we cannot do in a FINRA arbitration unless the parties to be subpoenaed are associated with a FINRA member), or to have the ability to exclude evidence traditionally believed to be unreliable, such as hearsay. None of these federal protections are afforded to FINRA member firms or their associated persons. Also, the right to move cases from FINRA Arbitration to federal courts is impermissible for FINRA member firms and/or their associated persons.
Further, unlike the federal court system, FINRA does not have an appeal process through which a party may challenge an award. Consequently, all awards rendered under the FINRA Codes are final and are not subject to review or appeal, except under very limited circumstances; the bottom line is FINRA does not hear appeals on arbitration awards. In small firms’ collective experience, it takes a virtual act of Congress to have an arbitration award appeal granted. Keeping in mind, too, that even clear mistakes of law or fact will not necessarily justify an arbitration award being reviewed. This is the significance of the term “binding” in binding arbitration and is the basis for the concern for small firm rights, specifically if a small firm is dealing with a less than reputable plaintiff attorney who initiates meritless actions and files vexatious litigation that is so costly and harmful to small businesses.
Finally, instead of heavily weighing civil procedure rules in consideration of amending the requirements of the Discovery Checklist, FINRA should consider the American Arbitration Association (“AAA”) rules as a more informative resource of typicality in arbitration proceedings. In an arbitration proceeding under AAA rules, the parties determine which documents will be discoverable by mutual agreement, however, those documents must bear directly on the determination (of liability) being sought. AAA rules state that “the parties may offer such evidence as is relevant and material to the dispute and shall produce such evidence as the arbitrator may deem necessary to an understanding and determination of the dispute.” The AAA’s rules requiring discovery of only that which is relevant to the determination of the matter conform with the purpose of arbitration, which is to focus on the issue of liability, not on a party’s ability to cover the cost of an award. Requiring production of insurance documents adds to the complexity of arbitration and is contradictory to its purpose.
Given this background on FINRA’s rule amendment proposal, as well as a brief summary of the “for” and “against” positions, we would like to ask the following if 18-22 passes:
1. Are E&O policy premium increases based on the interest rate environment and, if not, what are E&O premium increases based on?
2. The majority of E&O claims settle prior to arbitration. PIABA is pushing for insurance policy information to be disclosed in order to maximize their settlements, which will result in their earning more money in fees. As an E&O carrier, if 18-22 is enacted would you anticipate the dollar amount of settlements to increase?
3. As an E&O carrier in the broker-dealer space, would your company anticipate a rising policy premium environment should third-party E&O insurance coverage become presumptively discoverable?
4. As a provider of third-party E&O insurance to broker-dealers, do you support FINRA’s rule proposal to require the presumptive discovery of E&O coverage in all third-party insured arbitration actions? If not, please tell us why.
5. Small firms are concerned that current E&O carriers, which are few to begin with, will exit the broker-dealer space if 18-22 is enacted thus creating a hard market for E&O coverage. Do you see this as a potential outcome?
We appreciate your time and consideration of this issue and look forward to hearing your position on this matter. Please feel free to contact Paige Pierce directly if you have any questions:
Paige W. Pierce
[The undersigned have been financial industry leaders for the past 25 years including having chaired FINRA’s Small Firm Advisory Committee, served multiple times on FINRA’s National Adjudicatory Council and are serving on the FINRA Board of Governors. This letter represents our personal views and not that of any regulatory agency or committee.]
Paige W. Pierce
Encl FINRA Notice 18-22