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Fair or Foul: Arbitration at 20

3/30/2007

Dow Jones Newswires

By Jaime Levy Pessin

A Dow Jones Newswires Column

NEW YORK (Dow Jones)–One aspect of mandatory arbitration for brokerage customers that is a flash point for criticism is the industry arbitrator.

Arbitration hearing panels are made up of three people: two public arbitrators, who are supposed to be unaffiliated with the brokerage industry, and one industry arbitrator, whose role is to provide context about industry norms.

Investors’ advocates say the industry arbitrator has undue influence and an inherent conflict of interest, which combine to create at least the perception of bias. Those who represent brokers and firms argue that industry arbitrators give useful background to panelists who may otherwise have no sense of what’s normal in the industry.

After getting the go-ahead from the Supreme Court in 1987, brokerage houses now require their customers to sign agreements saying they will resolve any disputes with the firm via arbitration. Because customers can’t take their claims elsewhere, questions of fairness and efficiency become magnified.

The debate over the industry arbitrator might come to a head soon. State regulators and some lawmakers are considering the merit of the industry arbitrator and the system’s overall fairness – especially in light of the upcoming consolidation of the NASD and New York Stock Exchange Regulation, which will create a single arbitration venue.

“Not only are you locked into arbitration, you’re locked into arbitration at one forum,” said Massachusetts Secretary of State William Galvin. “A number of investors, regardless of (political) party, feel the system is shortchanging them. An industry arbitrator as such, by definition, is just not fair to people.”

Context Givers

For years, investors’ advocates complained that even public arbitrators had recent ties to the industry. Now, public arbitrators have to be at least five years removed from the securities business, and cannot have spent “a substantial part of a career” in the industry, even if it was a long time ago. The NASD has a pending rule that would further limit the financial ties an arbitrator’s employer can have with the securities industry.

While investor advocates say these changes are improvements, some argue that the fundamental problem – the industry arbitrator – still exists.

The industry arbitrator shares information with other panelists behind the scenes. “You have an expert who gives his opinion in a dark hole,” said Phil Aidikoff, an investors’ lawyer, noting that there’s no chance for cross-examination.

The context an industry arbitrator provides may lead other panelists to accept bad industry practices as normal and therefore acceptable, said Dan Solin, a lawyer and investment advisor. “The industry arbitrator will say ‘I never did that either. It’s not fair to hold them to that standard,'” he said.

Others argue that by providing some context, industry arbitrators eliminate the need to use expert witnesses in most cases. “If you had to start from scratch with a judge and jury, you’d have to spend a lot of time explaining how things work,” said Robert Keenan, a principal at St. Bernard Financial Services, who recently succeeded in defending an arbitration claim against one of his brokers.

Michael Neft, a branch manager at Oppenheimer & Co. who is an industry arbitrator, said he’s “been told by other arbitrators that they appreciate my input…. They look to me for interpretation of compliance and industry rules.”  He says his vote is “usually in the majority.” The NASD has said that the vast majority of hearing panel decisions are unanimous.

A 2005 study of alleged bias by the Securities Arbitration Commentator, a Maplewood, N.J. newsletter that tracks awards, was inconclusive. The study found that in 2003, small-claim arbitration hearings that didn’t require industry panelists had a 58% win rate for customers. That result was higher than the 51% win rate in full panels hearing larger awards. Still, the newsletter found “very little to suggest that the non-public arbitrator plays a less neutral role than his or her public counterparts.”

But investors’ advocates say they see bias.

“Anybody who’s tried as many cases as I have and didn’t see a perceived bias by many industry arbitrators is kidding themselves,” Aidikoff said. When “the broker’s on the ropes,” Aidikoff said, industry arbitrators might jump in to help: “‘Didn’t you mean (something else)?'”

John Mark, a former NASD arbitrator, recalled a legitimate case in which the industry arbitrator came into the hearing saying: “‘This is the same B.S. it always is. This guy deserves nothing.'”

Industry representatives say they just don’t see bias.

“I’ve had any number of cases where after the fact I find out the industry person was advocating for money,” said arbitrator Paul Matecki, senior vice president and general counsel at Raymond James Financial Inc. (RJF), referring to cases against his firm.

Where some argue that industry arbitrators don’t want to give the industry a bad name by handing investors big wins, public arbitrator Terry Peppard says industry arbitrators want to come down hard on rogue brokers and companies.

“Industry members of a panel are embarrassed when they learn what some cowboy has done to the reputation of their calling,” he said.

Merger Fallout

The pending merger of the NASD with NYSE Regulation has state regulators and lawmakers especially keen on examining the system’s essential fairness. Over time, NYSE’s forum has become less popular with investors; in 2006, just 187 cases involving customers were filed at the NYSE, down from 1,010 in 2002.  Still, with the consolidation, just one forum will remain.

“Without another forum with a different view, you lose that advantage of having different ways in which things are done,” said Rick Ryder, editor of the Securities Arbitration Commentator.

Ryder said the NASD has been responsive to demands for change from both sides.  Even so, with just one forum “it becomes much more likely NASD will develop the attitude of… ‘If you don’t like it, there’s no place else to go,'” Ryder said.

The NASD’s Linda Fienberg, who will head arbitration at the new self-regulatory body, said she is confident the consolidated forum “will continue to serve the interest of the investing public,” and that she will review rules from NYSE arbitration and integrate those that will “further enhance the fairness for all investors.”

The North American Securities Administrators Association has included securities arbitration on its legislative agenda this year. And the House Financial Services Committee, led by Rep. Barney Frank, D-Mass., will examine “the balance, fairness, and efficiency of the current arbitration system,” according to its oversight plan.

Although Frank’s staff could not say when the issue would come up, Galvin, of Massachusetts, said the congressman “has very ambitious plans” for investigations and oversight hearings. “I think this is a very high priority for him,” Galvin said.

“We’re driving more and more people into the risk marketplace,” Galvin said, referring to retirement plans, education plans and all the other investment choices that have emerged as traditional pensions die out. “If this is the only forum people have, it has to be fair.


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