A Wrinkle in the Arbitration of Broker Promissory Notes

Little did Laura Facsina know that when she joined Morgan Stanley (MS) in 2009 as a financial adviser (FA) she would battle, not only the wirehouse for gender discrimination, but MS’s right to arbitrate the matter.

After bringing suit in court against MS, Ms. Facsina received a forgivable loan settlement of $280,000. But, a FINRA panel subsequently ordered that she repay a $419,000 promissory note, which was upheld in district court. The panel’s ruling is now before the 6^th Circuit U.S. Court of Appeals, where Facsina is claiming there is a crucial jurisdictional issue negating FINRA’s determination.

According to the suit, it was not Morgan Stanley Smith Barney (MSSB) that owned the note, but rather its non-FINRA member subsidiary Morgan Stanley Smith Barney FA Notes Holdings. As such, Facsina argues, FINRA had no standing to entertain the arbitration, as only members may compel use of the forum by associated persons and clients.

“Moreover, Facsina’s settlement states that unless approved by all parties, no portion of the agreement – including the promissory note – is assignable. Facsina never gave consent for the note to be assigned to MSSB FA Notes Holding.”[i] This, she claims, is just one example of an on-going deceptive practice in which the true holders of promissory notes have been hidden, with significant consequences for hundreds of brokers.

Citing the research of a former MS employee turned whistleblower, website Think Advisor in its article “Ex-Morgan Advisor, in Unusual Move, Takes FINRA Arb Case to Federal Court,” found that between June 2009 and August 2015, of the 382 cases against advisors, only 12 were won by (ex-)employees and 330 by the company. Of those, MSSB FA Notes Holdings were believed to hold 160 of the notes.

These promissory notes are the overwhelming majority issue heard by FINRA’s arbitration panels. Notably, the panels also serve as the basis counterclaims in defamation and tortious interference claims brought by FAs. Food for thought…

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[i] Ex-Morgan Advisor, in Unusual Move, Takes FINRA Arb Case to Federal Court (2015 November 24). Retrieved from http://www.thinkadvisor.com/2015/11/24/ex-morgan-advisor-in-unusual-move-takes-finra-arb?page_all=1

Who has the Right to Enforce Your Promissory Note?

A customary practice in the securities industry is for financial advisors to receive a transition bonus above and beyond an advisor’s standard commission compensation upon joining to a new firm. The bonus amount is usually determined using a certain percentage or multiplier of the advisor’s trailing 12-month production. These are usually referred to as “promissory notes” or Employee Forgivable Loans (“EFL”). Promissory notes are often used to solicit new employees/contractors from another brokerage firm. However, this “incentive” is usually cloaked with many restrictions. Typically these loans are forgiven by the firm on a monthly or annual basis but the advisor has to commit to the firm for a specified number of years or be required to pay the balance back to the firm should the advisor leave before the end of the term. 

Brokerage firms can enforce promissory notes through FINRA arbitration. Promissory note cases are one of the most common types of arbitration and the brokerage firms experience a high success rate with these cases. These proceedings are governed, in part, by FINRA Rule 13806 if the only claim brought by the Member is breach of the promissory note. This rule allows the appointment of one public arbitrator unless the broker rep. files a counterclaim requesting monetary damages in an amount greater than $100,000.  If the “associated person” does not file an answer, simplified discovery procedures apply and the single arbitrator would render an Award based on the pleadings and other materials submitted by the parties. However, normal discovery procedures would apply if the broker rep. does file an answer. Thus, if a broker wants to make use of common defenses to promissory note cases and obtain full discovery on these issues, the broker should ensure that he or she timely files an Answer.    

  

A recent trend with promissory notes is that the advisor’s employer does not actually own the Note. Sometimes this entity holding the note upon default is a non-FINRA member company, such as a subsidiary of the broker-dealer or holding company set up specifically to hold promissory notes. Many believe the practice of dumping promissory notes into a subsidiary is to circumvent the SEC requirement that brokerage firms hold a significant amount of capital (one dollar for each dollar lent) to protect against loan losses.  By segregating promissory notes into a separate entity, firms likely can retain much less to meet its capital requirements. 

Because a non-FINRA member firm may ultimately attempt to enforce the promissory note, questions arise as to how an entity can use FINRA arbitration to pursue claims against an agent.  The Note likely contains a FINRA arbitration clause but this may create questions of the enforceability of the arbitration clause. Furthermore, non-FINRA member entities cannot take advantage of FINRA’s expedited proceedings for promissory notes under Rule 13806 as this rule only applies to “a member's claim that an associated person failed to pay money owed on a promissory note.”

However, in order to make use of the simplified proceedings under Rule 13806, some member-firms have started a practice of sending a demand letter to the broker requesting full payment be made to the broker-dealer, rather that the entity that actually owns the note.  Broker-dealers have also attempted to simply add the Note-holder as a party to the 13806 proceedings. Reps should immediately question the broker-dealer’s standing to pursue collection or arbitration, the use of Rule 13806 to govern the arbitration, and potentially consider raising a challenge to a non-FINRA member firm attempting to enforce its right through FINRA arbitration. 

If you have recently received a demand letter seeking collection of a promissory note or are party to an arbitration, you may wish contact the attorneys at Cosgrove Law Group, LLC for legal representation.

FINRA ISSUES PROPOSAL EXPANDING POOL OF ARBITRATORS QUALIFIED TO HEAR INDUSTRY PROMISSORY NOTE DISPUTES

An exciting blog this will not be. But alas, some of the most routine rule changes carry the potential of consequences worthy of consideration. Most of you readers know that broker-dealers frequently loan funds to their agents in exchange for a promissory note. These loans and notes are frequently exchanged as part of a broker-dealer's retention incentive program. You may also know that many are the times that the incentives prove insufficient and the broker-dealer ends up suing its former agent for repayment. Indeed, at least one major broker-dealer in St. Louis has an entire division of its legal department dedicated to litigating such matters.

SR-FINRA-2011-05, if approved after public comment, will expand the roster of FINRA arbitrators eligible to hear such matters by removing the current statutory discrimination claim qualification requirement. By doing so, it is likely that a more diverse field of arbitrators will begin hearing these cases. Whether that is a positive development for agents or broker-dealers is yet to be seen. Promissory note cases can be particularly difficult to defend, particularly if they are below the threshold for the expedited FINRA procedures. Valid and meritorious affirmative defenses, particularly those based in equity, are already difficult to develop and present with the restricted discovery available in FINRA arbitrations. Defending the case without any discovery or even a hearing is an even greater challenge. But while SR-FINRA-2011-005 will not remove this current barrier to the full development of equitable affirmative defenses, it may bring a fresh set of eyes to the legal debate surrounding the enforceability of promissory notes. That prospect alone is worthy of the entire industry's support of the proposed amendment to Rule 13806.

Click here if you would like to review the entire rule proposal, including FINRA's “Statement of Purpose” for the proposed rule change. Click here for the SEC's subsequent proposal in the Federal Register.

BROKER BEWARE

Brokers and Investment Advisors facing demands for repayment of training fees, retention bonuses, or promissory notes should bite the bullet and retain legal counsel. While their new current employer may be willing to offer unofficial advice or moral support, it is rarely willing to assign its legal department to your defense. No surprise, as its legal department is probably busy sending similar demands out to its former account executives or representatives.

The truth of the matter is that, despite demand letters that inaccurately portray your indebtedness as an unassailable fundamental truth, there are frequently either legal or equitable defenses to your former employer’s demand for money. And even if you owe and should therefore remit some funds, the broker frequently owes less than the total being demanded. Few like to hire attorneys, and even less like to pay for them. But you might actually have a legal right to save yourself some hard-earned cash in the long run—even after paying for that damn lawyer.