United States: Bankruptcy: An Opportunity To Settle FINRA Member - Employee Disputes

Last year, a U.S. bankruptcy court held that a bankruptcy trustee could settle a Financial ‎Industry Regulatory Authority ("FINRA") suit against a broker-dealer by its former employee ‎seeking damages and expungement of alleged false and defamatory FINRA Form U-5 ‎termination disclosure language, over the objection of the former employee-debtor.2  Once a ‎bankruptcy case is filed by a former employee, the claims become property of the bankruptcy ‎estate. In chapter 7 liquidation and in some chapter 11 reorganization cases, a trustee is ‎appointed, providing the broker-dealer with an opportunity to settle the claims with the trustee ‎and obtain a full release, usually for payment of a relatively small amount.‎


Clark was terminated by his broker-dealer ("BD") after it received and investigated ‎customer allegations that he placed unauthorized trades in their accounts.3‎ ‎ The BD reported that ‎reason for termination in a Form U-5 Termination Notice filed with the Central Registration ‎Depository, as required by law. 15 U.S.C. § 78s(d)(1) (mandatory filing requirement); Article V, ‎Section 3 of FINRA's By-Laws; FINRA Regulatory Notice 10-39. The information was ‎included on the registered representative's public BrokerCheck Report, and he contended it was ‎essentially a death knell for his career.4‎ ‎ Clark commenced a FINRA arbitration proceeding ‎against the BD, alleging wrongful termination and defamation and requesting a substantial award ‎of alleged actual damages, punitive damages, and expungement of his Form U-5 (the "FINRA ‎Action"). Two years after his termination, and while the FINRA Action was pending, Clark filed ‎for bankruptcy.

Clark did not initially list his FINRA Action as an asset in his bankruptcy case, or notify ‎the bankruptcy trustee, the BD or FINRA of the bankruptcy. He received a discharge and his ‎bankruptcy case was closed. The BD learned of the bankruptcy and informed the debtor's ‎counsel of its intent to dismiss the FINRA Action because of the bankruptcy non-disclosure. ‎The debtor then moved to reopen his bankruptcy, and the bankruptcy trustee hired his ‎contingency fee counsel to pursue the FINRA Action for the bankruptcy estate. The BD and the ‎trustee agreed to settle for a fraction of the claimed amount, enough to pay the fees of the trustee ‎and his counsel and enable a distribution to the creditors. The debtor objected, arguing that (1) ‎his "claim" for expungement was personal and not property of his bankruptcy estate, (2) only ‎FINRA had authority to adjudicate and approve settlement of expungment claims, (3) the ‎settlement was unfair, and (4) he had an exemption claim to part of the settlement payment in ‎any event.


The bankruptcy court held that expungement of a Form U-5 is not an independent claim ‎but a remedy, like an injunction or damages, for wrongful termination and defamation claims. ‎While no previous authority had expressly so held, the court cited numerous arbitration rulings ‎the BD had provided where expungement was repeatedly sought as a remedy to a claim, along ‎with citing FINRA Rules and notices referring to expungement as a remedy to be granted only ‎when certain grounds for such relief are present.5 ‎ The court also noted that the debtor's ‎Statement of Claim initiating the FINRA Action alleged wrongful termination and defamation, ‎and requested Form U-5 expungement in his prayer for relief, not as an independent claim.‎


‎Once a bankruptcy case is filed, all of the debtor's legal and equitable interests, including ‎causes of action arising from prepetition events, are property of the bankruptcy estate. Multiple ‎authorities cited by the court and the BD have held that a debtor's monetary and non-economic ‎claims for wrongful termination, defamation, and disputes over job promotion and job benefits ‎are included in property of the estate.6 ‎ In chapter 7 liquidation cases and in some chapter 11 ‎reorganization cases, a bankruptcy trustee is appointed and takes control of the litigation and ‎other assets. Until and unless exempted out or abandoned out of a bankruptcy estate, the trustee ‎has authority to dispose of all such causes of action, including by settlement.

The debtor in Clark argued that actions involving a debtor's professional license are not ‎property of the bankruptcy estate.7 ‎As the court noted, the cases cited by the debtor hold that a ‎non-transferrable professional license is not property of the estate, but neither the bankruptcy ‎trustee nor the BD were taking away his license. They were merely settling a cause of action ‎which might have an impact on the debtor's ability to procure future employment.‎8


The debtor argued that the bankruptcy court could not approve the trustee-BD settlement ‎agreement because he said FINRA has "exclusive jurisdiction" over all claims and remedies ‎relating to expungement of the Form U-5, including the claims asserted in the FINRA Action.9 ‎ ‎He claimed that FINRA would have to be joined as a party to the settlement agreement, citing ‎FINRA Rule 2080. However, the joinder requirement in Rule 2080 was not triggered by the ‎settlement because the bankruptcy court was not being asked to order the expungement of ‎FINRA records.‎

FINRA requires that most disputes between a member broker-dealer and its employee ‎that arise out of those parties' business activities be arbitrated under FINRA's Code of ‎Arbitration for Industry Disputes. See FINRA Rule 13200(a). But FINRA Rules do not ‎preclude parties from agreeing to mediate and/or settle a dispute in lieu of initiating or continuing ‎an arbitration proceeding. See, e.g., FINRA Uniform Forms Guide, p. 2 (encouraging potential ‎claimants to consider mediation before initiating arbitration or court litigation, and noting that the ‎claimant may submit the claim to FINRA for arbitration if the parties do not fully settle their ‎claims). Even after a FINRA arbitration is initiated, it can be settled without FINRA's ‎participation pursuant to FINRA Rule 13701. FINRA "must" dismiss the FINRA Action with ‎prejudice if requested by the parties. FINRA Rule 13700(a). Only if settlement of the FINRA ‎Action includes the affirmative expungement of the Form U-5 is FINRA's approval required. ‎See FINRA Rules 13805, 2080. The Clark settlement between the bankruptcy trustee and BD, ‎including a provision requiring dismissal of the FINRA Action with prejudice, was accordingly ‎entirely consistent with the FINRA Rules. Nothing in the FINRA Rules prohibited or imposed ‎any special conditions or restrictions on the parties' decision to settle or the bankruptcy court's ‎authority and discretion to approve the settlement under Bankruptcy Rule 9019(a).‎


When a bankruptcy court considers approval of a settlement, it evaluates: (a) the ‎probability of success in the litigation; (b) the difficulties, if any, to be encountered in collection; ‎‎(c) the complexity of the litigation involved, and the expense, inconvenience and delay ‎necessarily attending it; and (d) the paramount interest of the creditors and deference to their ‎reasonable views on the settlement.‎10 The court reviews the underlying issues to determine only ‎whether the settlement falls below the lowest point in the zone of reasonableness. The BD ‎explained some of its defenses to the FINRA Action, and the court concluded that the trustee's ‎possible success in light of such defenses was less certain and immediate than the settlement.11‎ ‎The litigation would also be complex, lengthy and expensive, which supported settlement.‎12

In the Clark case, as in many bankruptcy cases, the court recognized that the settlement ‎might not be in the best interest of the debtor. But the interests of creditors are paramount in ‎bankruptcy, and the settlement enabled them to receive a distribution from the trustee.‎13


The Clark debtor argued that the BD's settlement with the bankruptcy trustee was ‎effectively a lost wages payment, in which he was entitled to claim an exemption.14‎ The BD ‎responded that it was settling to avoid paying professional fees and costs and incurring the ‎burden on its personnel to litigate the dispute, not paying wages to the debtor. It also cited ‎authority for the point that a debtor who fails to list lawsuit claims in his bankruptcy schedules, ‎like the Clark debtor, is judicially estopped from benefiting from the claim.15‎ However, it left ‎the allocation of settlement proceeds to the bankruptcy trustee, and the trustee agreed to transfer ‎a small portion of the settlement proceeds to the debtor on account of his exemption claim.‎16


Whenever a claimant in a FINRA arbitration becomes a bankruptcy debtor, he cedes ‎authority over the claim to the bankruptcy trustee. Settlement of a million-dollar claim for ‎nuisance value becomes possible. In many cases where the debtor hides his claim from the ‎trustee by failing to include it on bankruptcy schedules, whether or not the debtor receives a ‎discharge, that claim may be subject to dismissal without even the need to settle with the ‎trustee.‎17‎ It is easy, and worthwhile, to check a national database of bankruptcy cases to ‎determine whether a claimant has filed a bankruptcy case, or become a debtor after an ‎involuntary bankruptcy petition was filed, after alleged causes of action arose.‎18


1 Susan Freeman is a partner in the bankruptcy practice group and Jay Simpson and Ed Barkel are partners in the ‎Securities Litigation practice group at Lewis Roca Rothgerber LLP, Phoenix, AZ. ‎

2 In re Jimmy W. Clark, U.S. Bankr. D. Ariz. No. 2:11-bk-12833-CGC ("Clark Case"), Docket 60, April 24, 2012 (the ‎‎"Order"). ‎

3‎ Order n. 4.‎

4 ‎ Id.‎

5 ‎ Order at 3, 4; see also Statement in Response to Debtor's Objection and in Support of Trustee's Application to ‎Compromise Arbitration Claim, Clark Case Docket 51 ("BD Response").‎

6‎ Order at 5; BD Response at 6-8, 10-12.‎

7‎ Debtor's Reply to [BD's] Statement in Response to Debtor's Objection to Trustee's Application to Compromise ‎Arbitration Claim ("Debtor's Reply"), Clark Case Docket 58 at 2, 3.‎

8‎ Order at 5-6.‎

9‎ Debtor's Objection to Trustee's Application to Compromise Arbitration Claim ("Debtor's Objection"), Clark Case ‎Docket 43 at 3-4.‎

10‎ Order at 6.‎

11‎ BD Response at 19-23; Order at 7.‎

12‎ Order at 7.‎

13 ‎ Order at 8.‎

14‎ Debtor's Objection at 4-5.‎

15‎ Hamilton v. State Farm Fire & Cas. Co., 270 F.3d 778, 782 (9th Cir. 2001). ‎

16‎ Trustee's Response to Debtor's Objection to Trustee's Application to Compromise Arbitration Claim, Clark Case ‎Docket 54 at 1-2.‎

17‎ See Hamilton, n. 14 above.‎

18 A search may be done on a nationwide or single state basis to determine if a person or entity has filed a ‎bankruptcy case or if an involuntary petition has been filed through PACER, Public Access to Court Electronic ‎Records. It requires registration, and there is a $ .10 per page charge for each document viewed.

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