Michael Carroll, Executive Editor, Albany Government Law Review Member
“McGinn, Smith invested nearly all of [Mr.] Steinkirchner’s life savings into a high-risk investment fund . . . ‘It virtually destroyed his retirement plan’ . . . ‘He had to go back to work.”
McGinn, Smith, a once prominent investment firm in Albany, New York, has been accused by the Securities and Exchange Commission (“SEC”) of “running a $136 million [Ponzi] scheme that funneled cash from hundreds of investors into a sex-themed cruise line operation and other highly speculative businesses while funding a lavish lifestyle for [the] company[‘s] founders.” According to the SEC, the alleged Ponzi scheme primarily concerned McGinn, Smith’s sale of private placement securities to over 900 different investors. The SEC’s complaint alleges that the private placements carried “a high-degree of risk” due to the fact that these securities were unregulated and illiquid. McGinn, Smith allegedly sold these products to investors by promising high rates of return (in some cases 13%) while reassuring the clients that the investments were safe. The SEC’s complaint states that at least one investor claimed that he was “steered . . . away from investing in blue chip stocks like General Electric as too risky, and [was] told . . . that the Fund private placements were safer investments.”
Since the beginning of 2010, and prior to the SEC lawsuit, several former McGinn, Smith customers were awarded damages in arbitration actions against the investment firm. In fact, the author of this article worked on a successful arbitration action filed against McGinn, Smith while serving as a Law Intern in Albany Law School’s Securities Arbitration Clinic. Additionally, as of April 2010, former customers of McGinn, Smith have been awarded over $3 million in damages by arbitrators, and one attorney practicing in the Albany area claims to be handling 10 more arbitration actions against the firm. For these aggrieved customers, there is a risk that they may never recover their losses. Currently, McGinn, Smith is in receivership, and the first report of the receiver calls into question whether the firm’s assets will be sufficient to cover its liabilities. Potentially, this could leave investors from the Capital District (and elsewhere) with no chance of recovery.
Unfortunately, this is not a unique circumstance. In 2001, an estimated 33% of securities arbitration awards throughout the United States “were not fully paid.” In 2004, this rate was cut in half, as 15% of awards were unpaid. Today, after the recent financial market collapse, it is safe to assume that defrauded investors will continue to face the prospect of never receiving arbitration awards from their fraudulent or out-of-business brokers. This paper will briefly explain the securities arbitration process, analyze why unpaid awards should be reduced or eradicated, and evaluate two proposed solutions for resolving the issue of unpaid awards.
What is Securities Arbitration?
After the United States Supreme Court’s decision in Shearson/American Express v. McMahon in 1987, arbitration has been the primary forum used to “resolve disputes between individual investors and broker-dealer firms.” FINRA, an organization created in 2007, oversees the securities arbitration process. Customers of brokerage firms “typically . . . initiate arbitration proceedings. . . . [And] the majority of claims . . . involve disputes related to brokers’ sales practices.” One claim that customers typically assert against their brokers involves allegations that the broker recommended “unsuitable investments.” Before making a recommendation to buy, sell, or hold a security, a broker must “have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts.” These facts include the customer’s financial status, tax status, and investment objectives.
Another claim that customers bring against their brokers is called “churning.” A broker can churn a client’s account by engaging in “excessive trading.” This excessive trading generates greater commission payments, and therefore, greater income for the broker. If a customer brings an unsuitability or churning claim (among others) against a broker, the dispute is heard before “[o]ne or three arbitrators.” The number of arbitrators is determined by the amount of money damages the claimant is seeking. The arbitration “panel’s decision is final and [it] is only reviewable under limited, statutorily enumerated circumstances.” If the arbitrators issue an award, it “must be paid within thirty days . . . unless an appeal is sought.”
Why Should Unpaid Awards be Reduced or Eradicated?
According to FINRA, “over 80 percent of all unpaid awards involve a firm or individual that is no longer in business.” For customers who win arbitration awards against “insolvent or vagabond brokers,” their chance of recovery is “hopeless.” There are several reasons for trying to reduce or eradicate the number of unpaid awards that result from the securities arbitration process. First, if an arbitration award goes unpaid, individual investors are forced to pay for the mistakes of financial regulators who failed to properly supervise brokers. This amounts to “unfair burden-shifting” because customers should not have to pay for a regulator’s inability to identify “broker-dealer delinquency.” Second, reducing the amount of unpaid awards would “contribute to the restoration of trust in the markets shaken by . . . [the financial collapse] and Wall Street scandals.” This trust could lead to greater confidence in the U.S. market and “foster increased public participation in shareholding, which benefits the securities industry.” Third, non-payment of arbitration awards undermines the securities arbitration process. Permitting unpaid awards “constitutes a waste of [FINRA] resources” and fundamentally harms investors seeking justice.
How to Remedy Unpaid Awards
Strong policy reasons exist for remedying the non-payment of arbitration awards. One solution for reducing unpaid awards involves creating a fund administered by FINRA that would compensate investors. This “FINRA fund” could be financed with “charges on investor transactions, fees on broker-dealers, or funds obtained from [FINRA] money penalties.” Critics of this solution claim that it will increase costs to brokers and customers “in the aggregate” and should be rejected. However, under current protocol, “the costs of unpaid awards are currently borne by an unfortunate few investors.” As stated previously, this “misplaced burden . . . has the potential to erode investor confidence in the capital markets” because any individual investor could suffer a catastrophic loss without any chance of recovery. These costs can be dispersed throughout the industry as a whole by implementing a “FINRA fund.” This fund could remove the burden placed on “randomly-chosen investors” who currently bear the costs of failed regulatory oversight.
A second solution advocated by legal scholars includes expanding the coverage of the Securities Investor Protection Corporation (“SIPC”) to compensate investors for unpaid awards. The SIPC currently addresses claims for “securities and cash held in a customer’s account at the time a broker-dealer fails. . . . [T]hese claims [are protected] in amounts of up to $500,000.” However, the SIPC does not cover “customer losses resulting from fraud, misrepresentation, [or] churning . . . [and the] SIPC does not cover unpaid arbitration awards.” Critics of this solution have argued that increasing the coverage of SIPC would deplete the SIPC fund and eventually pass greater costs onto broker-dealers and customers. Conversely, securities lawyer William Shepherd noted that the brokerage industry makes over $100 billion in annual revenues, and stated that “‘if but one percent of these revenues went to insure its members’ conduct, more than $1 billion would be available to compensate those harmed by wrongdoing.’” It has also been argued that the SIPC is the organization best equipped to handle unpaid awards because the purpose of the organization is to “‘restore investor confidence in the capital markets,’” and the SIPC has experience dealing with broker-dealer failures and liquidations.
The SEC’s case against McGinn, Smith demonstrates that Ponzi schemes and financial frauds may not only be limited to Wall Street. It is an indisputable fact that arbitrators have found McGinn, Smith liable for compensatory damages in their dealings with certain investors. If these awards continue to go unpaid, residents of the Capital District will unfortunately bear the cost of regulatory failure. The two solutions proposed in this paper seek to illuminate this issue and foster debate on how to resolve the problem of unpaid securities arbitration awards.
 Larry Rulison, Albany Firm is Paying Price: Arbitrators Award Millions in Payments to Clients of Dormant McGinn, Smith, Times Union, Apr. 27, 2010, available at http://www.timesunion.com/AspStories/story.asp?storyID=925523&category=ALBANY&BCCode=&newsdate=4/27/2010&TextPage=1.
 Larry Rulison, McGinn, Smith Complaint: SEC Accuses Albany Brokerage of Running $136 Million Scheme, Times Union, Apr. 21, 2010, available at http://www.timesunion.com/ASPStories/Story.asp?StoryID=923587&TextPage=1.
 Complaint at 2, SEC v. McGinn, Smith & Co., No. 1:10-cv-457 (N.D.N.Y. filed Apr. 20, 2010), available at http://www.sec.gov/litigation/complaints/2010/comp-pr2010-62.pdf.
 Id. at 10, 17.
 Id. at 15, 22.
 Id. at 12.
 Rulison, supra note 1.
Andrew L. Kaufman, The First Judge Cardozo: Albert, Father of Benjamin, 11 J.L. & Religion 271, 305 n.141 (1995) (“A receivership proceeding involves the appointment by a court of a ‘receiver’ who takes custody of the assets of a debtor in order to preserve them for, and divide them among, its creditors.”).
 First Report of the Receiver at 4–5, SEC v. McGinn, Smith & Co., No. 1:10-cv-457 (N.D.N.Y. filed June 4, 2010), available at http://www.mcginnsmithreceiver.com/reports/No49.pdf.
 Per Jebsen, How to Fix Unpaid Arbitration Awards, 26 Pace L. Rev. 183, 186 (2005).
 Id. at 187.
 482 U.S. 220 (1987).
 Marilyn Blumberg Cane & Marc J. Greenspon, Securities Arbitration: Bankrupt, Bothered & Bewildered, 7 Stan. J.L. Bus. & Fin. 131, 134 (2002); Barbara Black & Jill I. Gross, Making It Up As They Go Along: The Role of Law in Securities Arbitration, 23 Cardozo L. Rev. 991, 991 (2002).
 Cane & Greenspon, supra note 15, at 135.
 NASD Manual Rule § 2310(a), available at http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=4315&element_id=3638&highlight=2310%28a%29#r4315.
 Id. § 2310(b).
 Id. § IM-2310-2(b)(2), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=3640.
 Cane & Greenspon, supra note 15, at 134.
 Id. at 134–35.
 Id. at 135.
 FINRA: Arbitration Case Flow, http://www.finra.org/ArbitrationMediation/Parties/ArbitrationProcess/ArbitrationCaseFlow/ (last visited July 25, 2010).
 Cane & Greenspon, supra note 15, at 138.
 Jebsen, supra note 12, at 195.
 Id. at 194.
 Id. at 193.
 Id. at 200.
 Id. at 201.
 Id. at 202.
 Id. at 219.
 Id. at 220.
 Cane & Greenspon, supra note 15, at 138.
 Id. at 140.
 Jebsen, supra note 12, at 224 (quoting Secs. Investor Prot. Corp. v. Barbour, 421 U.S. 412, 415 (1975)).