A US federal appeals court has just sent brokerages and their customers a somber message — a ruling by the Financial Industry Regulatory Authority’s arbitration panel is absolute regardless of its validity.
The Fourth Circuit Court of Appeals in a 2-1 decision earlier this month ended a five-year dispute between Interactive Brokers and three former clients by deciding that the Greenwich, Connecticut-based on-line brokerage must abide by a 2018 verdict by FINRA’s arbitration panel to pay the clients about US$1 million in compensation for their financial losses when the firm liquidated their accounts during the market downturn in August 2015.
The Fourth Circuit Court of Appeals, which overturned a lower court’s decision supporting Interactive Brokers, disputed the lower court’s stance that the FINRA arbitration panel acted in “manifest disregard for the law” when it didn’t clearly explain the rationale for its figure. The arbitration panel based its award on the value of the accounts held by Rohit Saroop, Preya Saroop, and George Sofis on August 19, 2015 before their investment adviser began trading risky short-term futures options. When the market tanked and the accounts lost 80 percent of their values, Interactive Brokers liquidated their portfolio margin accounts in a matter of 30 minutes resulting in the investors owing the brokerage firm US$384,000 in borrowed funds. A lower federal court– the US District Court for the Eastern District of Virginia — had revoked the arbitration panel’s decision and the investors appealed that decision to the Fourth Circuit Court.
At the core of the battle between Interactive Brokers and its former customers is whether investors have their right to sue their brokerages for damages based on violating FINRA’s rules. The regulation in question is FINRA’s Rule 4210 which explicitly prohibits trades of high-risk securities in portfolio margin accounts. FINRA’s arbitration panel which initially awarded damages apparently thought investors could sue for damages related to violations of FINRA rules, but the Virginia district court disagreed. The majority opinion of the Fourth Circuit Court of Appeals in favor of Interactive Brokers never addressed the issue, but made it clear that federal courts shouldn’t dispute FINRA arbitration decisions. The fact that the Saroops and Sofis signed an agreement with Interactive Brokers that the firm would not be held liable for financial losses in the event of a market downturn didn’t matter. Nor did the fact that as sophisticated investors, the Saroops and Sofis agreed to high-risk trading strategies and must have acknowledged Interactive Brokers’ auto-liquidation terms for portfolio margin accounts when they created their accounts. The Saroops and Sofis could have sued their investment adviser Vikas Brar for their losses, but his firm was reportedly out of cash and their only alternative was to sue Interactive Brokers, the firm with deep pockets.
Here are the facts that no one disputes: The Saroops and Sofis opened their accounts with Interactive Brokers in 2012 and hired Vikas Brar, an investment adviser with Brar Capital, unrelated to Interactive Brokers, to trade on their behalf using naked shorting and margin trading strategies. The high-risk strategies worked well until August 20, 2015, when Brar sold hundreds of naked call options for VXX (iPath S&P 500 VIX Short Term Futures) and the market spiked in volatility. Selling naked call options is always a gamble. If the market remains stable investors make money, but if the market takes a downturn, investors will lose money. On August 24, 2015, the largest one-day market decline in history occurred.
Because Brar traded on behalf of the Saroops and Softis through their portfolio margin accounts with Interactive Brokers, if the value of their accounts fell too much, they could owe Interactive Brokers. The Saroops had switched from a Regulation T margin account to a portfolio margin account in January 2015 and Sofis did so in July 2015. A portfolio margin accounts relies on an algorithm to determine how much money an investor can borrow from its brokerage, whereas Regulation T allows an investor to borrow only 50 percent of the value of its account. As a rule of thumb, portfolio margin accounts permit investors to borrow far more money than they could using Regulation T accounts. When the value of Saroops and Sofis’ accounts plunged, a “margin deficiency” occurred which meant that the value of the accounts fell below the amount needed by Interactive Brokers to maintain a portfolio margin account. Therefore, Interactive Brokers immediately closed out the accounts based on the terms of the investors’ agreements with the brokerage firm.
The Saroops and Sofis sued Interactive Brokers in 2015 on numerous charges which amounted to blaming the brokerage firm for their financial losses citing in part its “unreasonable” auto-liquidation policy. The brokerage firm, which insisted that market volatility was the reason for the losses, countersued for damages of US$384,000 on the basis it was owed that amount of money after liquidating the Saroops and Sofis’ accounts. As is required policy in disputes between customers and brokerages, the matter went before a FINRA arbitration panel and in early 2017 the panel decided that Interactive Brokers owed the Saroops and Softs about US$$1.5 million. Interactive Brokers appealed that ruling to the US District Court for the Eastern District of Virginia whose judge sent back the ruling to the FINRA arbitration panel asking for an explanation of how the panel came up with the “baffling” US$1.5 million figure. Either FINRA’s arbitration panel disregarded the law or made a mistake, the judge said. The same arbitration panel in 2018 returned with a new US$1 million figure, but the district court judge was still not satisfied with its limited explanation of how it calculated the amount and said it was invalid because it appeared to be based strictly on Interactive Broker’s violating FINRA’s Rule 4210. Therefore, he ruled, the panel disregarded the law which prohibits an investor from suing FINRA for damages based on the investor violating FINRA’s rules.
The Saroops and Sofis appealed the Virginia district court’s decision to reject the modified compensation ruling to the Fourth Circuit Court of Appeals, which in mid-August 2020 voted against Interactive Brokers. In a majority decision, the federal appeals court said that the Virginia district court was mistaken in refusing to accept the FINRA arbitration panel’s modified award. The reason had nothing to do with the merits of the case, but whether FINRA’s arbitration process was legit. “Without appropriate deference to arbitrators, the costs of vindicating rights dramatically increase, threatening to foreclose yet another avenue of relief for ordinary consumers who routinely enter contracts with mandatory arbitration provisions,” wrote the court in explaining the majority decision. The one judge who dissented with the majority decision agreed with the Virginia district court’s ruling that the FINRA arbitration panel should never have applied a random date to determine compensation when it did not know whether the investors’ accounts had any profits or losses before August 20, 2015. The judge reprimanded FINRA’s arbitration panel for not following the law in doing its homework in asking for more documentation when it came to allocating a figure for damages.
While some investor advocacy groups and law schools which filed briefs in favor of the three investors are likely breathing a sigh of relief at the federal court’s decision, other attorneys caution there is no cause for celebration. Investors could easily be on the losing end when decisions are poorly crafted by FINRA’s arbitration panel. “The Fourth Circuit imbues FINRA rules with a private right of action that upends decades of jurisprudence,” warns Bill Singer, a New York-based attorney specializing in broker-dealer regulation and a critic of FINRA’s arbitration rulings. “Federal courts should not be forced to base a decision to vacate or confirm an arbitration award in the absence of compelling content and context set forth in the arbitration forum’s award. Similarly there is no private right of action for the violation of FINA rules, so how does a FINRA Arbitration Panel render an award that seems to be predicated upon a finding of a violation of FINRA rules and how does a federal court overlook that glaring error?”
Singer hopes Interactive Brokers appeals the federal appeals court’s ruling to the Supreme Court so the highest court can ultimately decide whether FINRA should be allowed to continue with its policy of requiring arbitration in investor disputes or whether investors can be allowed to sue brokerages in state courts. “Investors are forced to rely on FINRA arbitration and in this case the panel’s decision was seriously flawed,” he says. “The fact that the Fourth Circuit Court of Appeals did not judge the case on its merits, but rubber-stamped the arbitration panel’s decision is an injustice to both brokerages and investors.”
FINRA says that from 2014 through 2019, 22,476 cases were opened and 22,464 cases were closed. Appeals for decisions made by FINRA’s arbitration panels must go through federal courts and federal courts must also approve of any damages awarded by FINRA arbitration panels to investors so they can be paid. FINRA does not keep records of how many decisions of arbitration panels have been appealed and of those how many have been reversed. A spokesperson for Interactive Brokers says the brokerage firm is weighing its options as it disagrees with the Fourth Circuit’s decision and it believes the Virginia district court’s opinion should have been affirmed.