Jury of Their Peers
On Wall Street
Under a new FINRA pilot program starting this month, customers who bring arbitration claims against the firms of their financial advisors will be able to choose to have their cases heard by a panel of three of their peers, a switch from the current norm of two public panelists and one industry arbitrator.
The new program is aimed at quelling rising criticism that having even a single industry panelist unfairly biases the arbitration process against investors. Surprisingly, though, the new plan seems to have sparked opposition on both sides of the equation: Those in favor of empaneling the industry arbitrator are predictably against this new idea, but even longtime critics of the industry-panelist concept-including the Public Investors Arbitration Bar Association (PIABA) and the state regulators who belong to the North American Securities Administrators Association (NASAA)-have shown little enthusiasm for the plan. Both sides say the new system will take too long, and will likely produce inconclusive results. And attorneys who defend financial advisors, of course, worry the new rule will have long-term negative implications for their clients.
But FINRA says the goal here is to provide options. The two-year program will take 40 cases from the five major wirehouse firms-Merrill Lynch, Citi Global Wealth Management, UBS, Wachovia Securities, Morgan Stanley-plus 10 from Charles Schwab each year. In each case, the investor will choose whether or not to include an industry arbitrator as one of the panelists. “This pilot will give investors greater choice when selecting an arbitration panel,” says FINRA Chief Executive Mary Schapiro. “Additionally, [we’ll] see if a change in the way arbitration panels are selected is a better way to serve and protect the interests of investors.”
FINRA will compare the results against existing metrics, such as the percentage of cases that settle before award, the length of the hearings, use of expert witnesses and the end results of the cases.
Executives at both PIABA and NASAA say the effort to address the issue is long overdue. Both believe that a mandatory industry panelist is inherently unfair and biased against the investor. “The basic problem is the industry arbitrator has a conflict of interest, and a built-in bias: an inclination to support the industry position,” says attorney Larry Schultz of Driggers, Schultz & Herbst in Troy, Mich., and president of PIABA.
Pete Michaels, a Boston-based attorney who represents advisors, argues that the accusations of bias against industry arbitrators are flawed. Sure, he says, with two public arbitrators and one industry arbitrator, it’s always two against one-but in number only. “It is false that the industry arbitrator is rigged for the industry. I sit as an industry arbitrator and I am incredibly skeptical of registered reps’ claims. If you have one person [who always sided] for the industry and two for the clients, the registered reps would lose every single case. And that’s not what happens. That’s the fault of their logic.”
But Schultz and other investors’ attorneys contend that bias becomes a growing concern in the face of industrywide scandals.
“It’s even more of a problem where we’re seeing systemic fraud-auction-rate securities being the most recent example-because firms are dealing in the same types of products and the same type of misrepresentation,” Schultz says. “The arbitrator who works for a firm selling a lot of variable annuities is going to have a hard time sitting on a variable annuity case,” he says.
FINRA tacitly recognized this conflict, Schultz adds, when the regulator finally decided to ban from cases involving auction-rate securities any industry arbitrator whose firm had ever handled those products. That effectively eliminated arbitrators who worked for any major wirehouse. As far back as May, PIABA had objected to industry arbitrators sitting on these cases, but, Schultz recalls, FINRA had refused to step in, saying that its rules prevented any remedial action. But after a series of settlements in cases brought against the industry by state regulators, including New York State Attorney General Andrew Cuomo, FINRA changed its position.
Expertise: Helpful or a Hindrance?
But PIABA and NASAA don’t simply want industry arbitrators pulled from the most high-profile system wide cases as well as the pilot program. Both groups say they’d rather see FINRA simply propose a new rule to the Securities and Exchange Commission to eliminate the industry arbitrator from the panels altogether.
Another contention is that the fluid employment market-and the takeovers of Dean Witter, Prudential Securities, A.G. Edwards, Paine Webber and Bear Stearns-opens another door to industry arbitrators’ bias. “Yesterday’s A.G. Edwards branch manager is today’s Wachovia employee,” says Brian Smiley, the incoming PIABA president and partner at Smiley Bishop & Porter in Atlanta. “That has to put pressure on industry arbitrators sitting in judgment of firms that could well be their future employer.” He adds that there are many industry arbitrators to whom he doesn’t object. His real concern, he says, is the industry panelist’s mandatory presence. Finally, PIABA and other critics object on the grounds that even though industry arbitrators work in the business, they are not necessarily experts in the issue at hand.
“FINRA materials say the industry [panelists] are there to provide expertise on policies and procedures and standards of conduct of the securities industry. But you never know what they’re telling the other arbitrators-whether it’s right, wrong, or indifferent,” says Stephen Caruso, PIABA’s past president and a partner at Maddox Hargett & Caruso in New York. That leads to the potential for bias or improprieties, he says. He and Smiley each say that an arbitration case is supposed to rise and fall on proof that the parties submit to the arbitrators. But that can often be undermined behind closed doors by an industry arbitrator who may or may not know the law.
“Having the industry arbitrator give his or her own views of what the case is about denies me of the opportunity to present my own proof and my own case. They sometimes disregard what I present,” Caruso says. “What if you get a bozo industry arbitrator who says, ‘This is how they do it at my firm [and we] sell auction-rate securities the same way.’ It may or may not be true. You don’t get a chance to sit down with an industry arbitrator to get their views on industry practices. I could do a two-week hearing on industry practices and general mispractices and all my proof and theories could be negated by an improper or misguided industry arbitrator, which I’ll never know about.”
Smiley agrees, adding that if an industry arbitrator negated his expert witness, he wouldn’t have the chance to cross-examine the arbitrator to find out the basis for the opinion, including the possibility that the arbitrator is simply defending a practice from which his or her firm profits.
Michaels scoffs at the notion that industry arbitrators might be more of a hindrance than a help to the public arbitrators. He’s seen a retired firefighter and the owner of a printing franchise sit cheek-by-jowl with attorneys and professors. “You need an industry person to tell them what’s going on; and some of these cases are very complex. They don’t get training on how to be a securities arbitrator; they get mechanical training on how to read the script [to investors] and are told not to talk in the bathroom. They’re not trained in the industry. They don’t know what options are, or short sales. So you need the industry person to explain the intricacies of the industry to the laypeople.”
Caruso dismisses this argument, noting that juries in murder trials are made up of ordinary citizens. “In a capital case with life-and-death stakes, there’s no requirement that there be expertise on that jury. If we can entrust people’s lives to everyday people, it defies common sense that in the securities arena some expertise is needed.”
Michaels fears the ultimate result will be “a dumbing-down” of arbitration panels, which “will adversely impact the ability of investment professionals to get a fair hearing.” True or not, the two sides are divided about whether the industry arbitrator should be explaining securities law in the first place. “My job is to explain the facts of the case to them, not to educate them on the securities industry,” Michaels says. But the PIABA attorneys say they’d rather lay out everything for the public arbitrators, without any help from the industry arbitrator.
Schultz says the pilot program is flawed because the industry can “rig the results.” Wirehouses are likely to settle the cases in which the customer has a good chance of winning and will only take the cases they feel confident about to arbitration. “That way, they can show that the panel without industry arbitrators ruled against investors in a large number of cases,” Schultz says, adding that he expects far fewer than 400 decisions, with the vast majority of cases settling.
Michaels also thinks the plan is ill-advised because of the length of time and the unlikelihood of a clear outcome. “This is a knee-jerk reaction by FINRA to a lot of external pressure and not very well thought out. At best it’s not going to be fair to anybody. If people think the system is broken, this won’t help. It’s going to complicate things.” Highly technical cases, he says, will require extra days to explain complex issues to a panel of laypeople. That, he says, “costs more money and clogs up the system.” One key benefit of arbitration is that it’s supposed to allow investors with relatively small claims to be heard. The alternative is a court of law, where attorney fees can cost $30,000, and cases can get thrown out.
“FINRA’s wacky pilot project doesn’t seem to me to suit anybody’s interest,” Michaels says. “It’s not going to make people [who are] unhappy with arbitration happy either. If you want to get rid of arbitration, get rid of it and we’ll all go to court. But in 10 years, you’ll come back and say ‘That’s not fair for investors either.”
Both sides agree that the two-year pilot will likely take far longer to play out. In fact, Schultz says it may be five years before we see a resolution: two years’ worth of cases will take three years to wind through the system, plus two more years for the SEC to deliberate over FINRA’s rule proposal.
Decisions All Over the Place
Schultz and other observers say it’s difficult to cite specific cases in which the industry arbitrator swung the decision against the investor. It’s impossible to know what was said behind closed doors.
But, incoming PIABA president Smiley and Philip M. Aidikoff, a leading investors’ attorney in Beverly Hills, Calif., say that suspiciously low judgments for clients can be red flags of an industry arbitrator using undue influence. Smiley says that many awards appear to be the product of compromise. One arbitrator may feel the investor is entitled to full damages, while the industry member may not see anything worthy of condemnation or any recovery at all. “That’s when the third arbitrator plays Solomon and splits the difference,” Smiley says. “That may explain the fairly low recovery rates when people win and they don’t win much.”
According to a survey of 3,000 investors who have been through arbitration, more than 62% believed the process was unfair, 60% had an unfavorable view of arbitration and 70% were dissatisfied with the outcome. Schultz notes the results were hardly surprising, since more than half of the investors who took their cases to arbitration received a zero award. Plus, based on another PIABA study of awards made in 2006, those who do recover are awarded an average of just over 10% of the amount claimed-which may not even offset the fees arbitrators sometimes assess that can run into several thousands of dollars.
One attorney, who requested to speak off the record because of fear of damaging his client’s case with arbitrators, recalls a case in which the client was awarded $100. This same attorney, who has served as a public arbitrator, reports that industry arbitrators can sometimes become apologists for industrywide abuses to his fellow panelists. “The industry member will say, ‘This just isn’t that unusual. Sure, the regulators believe in this, but they don’t live in the real world.'”
Aidikoff gives examples of seemingly random awards and fee assessments. He note that in court, the winning party never pays costs. In one case filed in May 2001, the claimant asked for $2.6 million in damages and received $2.1 million. The client paid out $2,200 in fees but was reimbursed $1,200. In a case filed in October 2005, a client seeking damages of $202,000 was awarded $60,000, but had to split the costs with the broker, each paying $6,300 in forum fees to FINRA. (Aidikoff says that it was not FINRA that levied that fee, but the arbitration panel.) In another case, filed in December 2002, the claimant had asked for $518,000; the panel awarded $334,000, but assessed the entire forum fee against the broker, a sum of $29,700. “It’s all over the place,” Aidikoff says. “You win and you have to pay on some and not on others? It’s completely on the panel. Gee, if there weren’t an industry member on these panels, do you really think a winning claimant would be assessed forum fees?”