The Dodd-Frank Wall Street Reform and Consumer Protections Act ("Dodd-Frank Act") is intended to spawn regulations that will significant alter the arbitration landscape for investors who are victims of securities fraud. Currently, securities firms uniformly require investors to sign mandatory arbitration agreements when opening a brokerage account, a result of the U.S. Supreme Court's 1987 decision in Shearson/American Express v. McMahon that firms were entitled to mandate that all investor disputes be resolved through arbitration. The vast majority of securities disputes between investors and brokers are arbitrated through the dispute resolution forum maintained by the Financial Industry Regulatory Authority ("FINRA").
1. Securities Arbitrations Involve $1 Billion Per Year in Investment Losses
Securities arbitrations involve, collectively, enormous sums of money. Between 2001 and 2009, aggrieved investors filed, on average, nearly 6,500 arbitration claims per year against brokerage firms. According to an in-depth analysis of investor arbitration proceedings sponsored by the Securities Industry Conference on Arbitration, more than 65 percent of the investor arbitration claims that were studied sought damages in excess of $100,000. Thus, at any given time, FINRA is responsible for ensuring the fair adjudication of claims for alleged investment fraud responsible for losses exceeding one billion dollars. It is, accordingly, no surprise that investors as well as industry participants have a vested interest in the significant changes to the rules governing these disputes that will be ushered in by the Dodd-Frank Act.
2. The Rules Governing Securities Arbitrations Disadvantage Investors
The stated goals of the existing securities arbitration framework are to streamline and make more accessible the dispute resolution process. To be sure, the arbitral forum in its present state offers concrete benefits to investors and industry participants alike. For example, statements of claim need not satisfy the pleading requirements applied to complaints filed in court, and respondents are precluded, with limited exception, from filing motions to dismiss. Additionally, the rules of evidence which govern courtroom trials do not apply to FINRA arbitrations, thereby allowing the parties greater flexibility to present information they believe relevant to their case. Moreover, arbitration awards constitute a final resolution of the dispute, as the bases to appeal the arbitrators' decision are severely restricted by federal and state statutes.
The benefits, however, come at significant monetary and strategic costs which are disproportionately borne by members of the investing public. For example, the cost of bringing a FINRA arbitration proceeding can be prohibitively expensive to an investor compared to the relatively well-funded brokerage firm. In a claim seeking more than $100,000 in damages, an investor faces fees of thousands of dollars regardless of the outcome -- significantly more than the cost of filing a lawsuit. Investors also face substantial costs of retaining expert witnesses to testify on issues of liability and/or damages, whereas respondent brokerage firms often rely on the testimony of employees rather than outside experts to provide such evidence.
Investors face extremely limited ability to obtain discovery in arbitration, which poses a great disadvantage against brokerage firms that have far superior understanding of their inner workings and have unilateral access to all employees who can explain to respondents' attorneys how and why certain actions were taken.
Perhaps the most controversial aspect of FINRA arbitration procedures is the existence of the "industry" member on the three-arbitrator panels for all cases seeking damages in excess of $25,000. The vast majority of FINRA investor disputes are decided by a panel that includes one arbitrator who has significant ties to the securities industry in addition to two "public" arbitrators. Investor advocates strenuously object to the perceived unfairness of the "industry" arbitrator deciding these claims while securities organizations dispute the presence of any resulting pro-industry bias.
3. The Inequities of the Current Arbitration System Have Advsersely Impacted Investors
The impact of such disparate burdens on investors in arbitration is subject to much debate. It is indisputable, however, that as arbitrations have become more expensive, time consuming and dependent on courtroom-style litigation tactics, the success rate for investors has declined. Between 1997 and 1999, investors won between 56 percent and 59 percent of arbitration claims that proceeded to a hearing. Ten years later, investors are faring far worse; between 2007 and 2009, claimants won between 37 percent and 45 percent of hearings. Even these figures inflate the true success rate for claimants because FINRA records any award in an investors favor, regardless of amount, as a "win." For example, as reflected in the SICA report on securities arbitration, 5.3 percent of the investor "wins" it studied returned an award to the claimant of less than 1 percent of the amount claimed to have been lost.
4. Dodd-Frank Should Level The Playing Field for Investors in Arbitration
The Dodd-Frank Act is poised to level the playing field to litigate disputes with brokers. It gives the SEC broad authority to prohibit or limit the use of mandatory arbitration agreements, and to design a dispute resolution mechanism that satisfies the demands of investors for more fairness as well as the desire of industry participants to arbitrate rather than litigate in court.
The SEC should not prohibit arbitrations. The procedure does provide benefits to all parties that are not available in a court of law. Investors, however, should be given a meaningful and voluntary opportunity to choose arbitration. The arbitration option cannot exist without revisions to the rules in order to assuage investors' legitimate concerns regarding fairness. If substantive reforms addressing such inequities are enacted, investors should be more willing to exercise their choice to arbitrate disputes rather than go to court. Indeed, even though the SEC has yet to act, Dodd-Frank has already ushered in a significant benefit to investors in arbitration. On October 26, 2010, FINRA filed with the SEC a proposed rule change to permit investors with claims of more than $100,000 to select three member arbitration panels that do not include the contentious "industry" arbitrator.
While the elimination of the "industry" arbitrator is a substantive step toward fairness, the SEC will have to consider additional measures to reverse the existing bias against investors to make arbitration a viable alternative. Such changes should allow investors greater access before an arbitration hearing to evidence in the exclusive possession of respondent, should prevent well-documented discovery abuses by brokerage firms in arbitration, and should establish burdens of proof to end the need for expensive expert witnesses who are more appropriate to a courtroom trial than an arbitration hearing.
The investment fraud lawyers at Block & Landsman concentrate their practice in the area of securities arbitration and securities litigation.
