U.S. Legislators Seek to End Mandatory Arbitration for Consumers

The securities industry has adopted mandatory arbitration as the de facto method of resolving disputes against broker-dealers and their registered representatives.   Brokerage firm account agreements universally require clients to waive their rights to file lawsuits in court and instead arbitrate their claims before the Dispute Resolution division of the Financial Industry Regulatory Authority (“FINRA”).   

While recent improvements to FINRA procedures have made the arbitration process more even-handed than it historically had been, investors are still required to forego a variety of benefits of litigating in court that are unavailable in arbitration.   Although arbitration is appropriate for some investors’ disputes, its limitations on discovery and testimony of witnesses not subject to FINRA’s jurisdiction can significantly hinder an investor’s ability to prove a respondent’s liability.

Recently, Senator Al Franken (D-MN) and Representative Hank Johnson (D-GA) introduced bills in the U.S. Senate and the U.S. House of Representatives, respectively, seeking passage of the Arbitration Fairness Act.  The proposed law would eliminate mandatory arbitration in consumer contracts, and instead make the alternative dispute resolution forum available to investors and other consumers as an optional alternative to filing a lawsuit.   While the bills face a long and challenging process to becoming law, their introduction reflects recent efforts to expand the rights of investors to litigate disputes in a fair and efficient manner.  In fact, the more fair FINRA’s dispute resolution procedures become, the more likely that investors would opt for arbitration even if given the choice of going to court.

Investors who have disputes against their financial advisers should contact the securities litigation attorneys at Block & Landsman for a confidential and free consultation.

FINRA Rules Inch Toward Holding Brokers Fully Accountable to their Customers

Later this year, the Financial Industry Regulatory Authority ("FINRA") will put in effect new rules of conduct that narrow the gap between brokers' duties and investors' expectations of their brokers' responsibility.

Many investors would be surprised to learn that licensed brokers generally do not owe a duty to act in the best interests of their customers. Instead, the duty of a broker to a customer with a non-discretionary account has been much more limited: only to recommend investments that are suitable in light of their client's objectives, financial needs and circumstances. This is true even where customers place exclusive reliance on their brokers and always follow their recommendations.

The Securities and Exchange Commission has approved new FINRA Rule 2111, an updated version of the old NASD Rule 2310 (Suitability) requires brokers and their firms to "have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based o n the information obtained through the reasonable diligence of the member or associated person to ascertain the customer's investment profile."

FINRA's new Rule 2111 expands a broker's responsibility toward the customer. While not reaching the level of requiring brokers to act in their customers' best interests, the new standard is an improvement in the protection of investors because it will explicitly cover situations that industry members have historically opposed. Specifically, the new suitability standard will no longer apply only to recommendations concerning the purchase or sale of a security. Rather, it now applies also to the recommendation of investment strategies. Additionally, the new rule directly applies the suitability standard to a broker's recommendation to hold a security, rather than just to purchase or sell a security. This expansion nullifies years of denials by brokers and their firms that a recommendation to "hold" a security constitutes actionable behavior. It recognizes the reality that investors sometimes refrain from executing a transaction on the advice and recommendation of their adviser.

The rule further explains the three primary suitability obligations of a broker. First, a broker must make a reasonable-basis suitability determination, based on reasonable diligence, that the recommendation is suitable for at least some investors. What constitutes "reasonable diligence," however, is undefined, and depends on a variety of factors such as the complexity, the risks and the rewards associated with the security or the investment strategy. Second, assuming the recommendation is suitable for at least some investors, a broker must then make a customer-specific suitability determination to ensure that the recommendation is suitable for a particular customer based on his or her investment profile. Finally, where brokers exercise actual or de factor control over a customer's account, they must have a reasonable basis for believing that a series of recommended transactions, even if individually suitable, are not collectively unsuitable for the customer. Factors relevant to this determination are turnover ratio, cost-equity ratio and the existence of short-term trading.

The new rule is undoubtedly an improvement over the former suitability rule, and will benefit investors in their interactions with their brokers, and in customer arbitration claims where their brokers have violated the rules. The benefits of the revisions, however, are mitigated by the new rule's limitations. For example, the rule leaves much ambiguity regarding the precise contours of a broker's obligations. Additionally  the duty is only triggered by a "recommendation" of the broker, as opposed to an adviser acting under a fiduciary duty, who in required in all respects to provide guidance in the client's best interests. While the regulatory trends appear to favor protecting investors, much work still needs to be done, and investors must remain vigilant to ensure their advisers are recommending securities and investment strategies that are appropriate for their purposes.

Securities Arbitration: Who Shot J.R. Down?

The need for the Financial Industry Regulatory Authority ("FINRA"), which oversees securities arbitration hearings, to revise its arbitrator disclosure procedures is under a spotlight because of a FINRA arbitration case brought by actor Larry Hagman, star of the 1980s program "Dallas," against Citigroup.

On October 6, 2010, Hagman won an $11 million arbitration case against Citigroup Global Markets for the actions of a Smith Barney broker. Hagman and his wife claimed that the broker breached her fiduciary duty by creating an unsuitable portfolio of securities and improperly selling them a life insurance policy that had annual premiums of $168,000. The Hagmans' arbitration victory was thorough. The panel of arbitrators awarded them $1.1 million in compensatory damages, $10 million in punitive damages payable to a charity of the Hagmans' choice, and attorneys' fees of nearly $460,000.

Citigroup filed a petition to vacate the award in a California court. Arbitration awards cannot easily be appealed, and the vast majority of petitions to vacate are denied because the grounds to overturn an award are severely limited.

The Hagmans were not so fortunate. On February 9, 2011, a judge vacated the award because one of the arbitrators did not disclose a potential conflict of interest involving his own lawsuit against a business partner who had allegedly breached his fiduciary duty resulting in substantial losses to the arbitrator's retirement funds. Under FINRA rules, arbitrators must disclose whether they were involved in a dispute involving the same subject matter with the prior five years. Purportedly, the arbitrator's own case did not involve the securities industry, and did not involve asset allocation, which was at the heart of the Hagmans' case. Thus, it appears the arbitrator did not believe his case fell within the FINRA disclosure requirements. The judge disagreed, ruled that the arbitrator should have disclosed his prior dispute, and vacated the award.

This dispute highlights a glaring failure in FINRA's arbitration process. All arbitration parties, both investors and brokerage firms alike, devote significant time, energy and resources in claims that often involve large sums of money. They necessarily rely on FINRA to ensure that the arbitrators selected for their cases are free from any actual or potential conflicts of interest that may color their view of a dispute. FINRA must make more detailed and thoughtful inquiries into potential arbitrators' backgrounds to ensure the absence of disqualifying factors. FINRA must also clearly and fully disclose the arbitrators' backgrounds to avoid a losing party petitioning a court to nullify a hard fought award. Only when FINRA corrects these deficiencies will parties have confidence in the finality of the arbitration process.

Victory for Investors - Securities Arbitration Now Offers All-Public Arbitrators

In a long-sought victory for investors, the Securities and Exchange Commission ("SEC") has approved a proposal by the Financial Industry Regulatory Authority ("FINRA") that arbitration panels, which decide investor claims of broker misconduct, no longer are required to include an arbitrator who is a member of the financial industry. For the first time since the U.S. Supreme Court allowed brokerage firms to require investors to arbitrate disputes, investors will have a choice of selecting an all-public arbitration panel.

For years, investors and their advocates have complained that the presence of an industry arbitrator on panels creates an unfair bias in favor of the industry members who are accused of wrongfully causing investment losses. Brokerage firms have long resisted any changes to the use of the industry, or non-public, arbitrators who, the firms claim, are better able to understand the standards that they are required to follow.

Although some disputes may be appropriate for selection of an industry arbitrator, investors will now be permitted to choose the the make-up of the arbitrators who will decide their cases.

As a result, the playing field is becoming even for investors who pursue arbitration claims for investment fraud.

FINRA Arbitration Statistics - Closing the Book on 2010

The Financial Industry Regulatory Authority ("FINRA"), which provides the arbitration mechanism for resolving securities disputes involving investment fraud, has published its 2010 arbitration statistics. The results show a gradual, very gradual, trend that may be favoring investors.

Investors filed 5,680 arbitration cases in 2010. Although this number is twenty percent less than the number of arbitration cases filed in 2009, it is the second largest annual figure in the past five years, representing a general increase in the number of investors who are claiming losses due to broker misconduct. The majority of cases filed in 2010 involved claims for breach of fiduciary duty and misrepresentations involving common stock and mutual funds, although a significant number of cases involved annuities and bonds as well.

2010 did not just usher in an increased number of new arbitrations. A large number of cases (6,241) were closed during that year as well, which is a result of the increased filings in 2009 following the near collapse of the financial markets in the Fall of 2008. These statistics follow a general pattern regarding an uptick of arbitration activity following major market downswings, although these figures did not quite reach the record number of cases filed on the heels of the tech bubble burst early in the decade.

Of the cases closed in 2010, 22% were resolved by hearing or decided just on the submission of documents, and 62% were settled through mediation or through direct discussions between the parties. This is fairly consistent with method of case resolution seen in prior years.

Notably, 47% of all customer cases decided by arbitration resulted in an award of damages in favor of the investor. This statistic requires a significant asterisk: it includes the award of any dollar amount in favor of the customer, regardless of how little it is compared to the amount of the claimed losses. Even with that qualification, the 2010 results confirm that the percentage of victories for investors is gradually trending upward; in 2007, only 37% of customer claims received an award in favor of the investor. Indications remain, however, that arbitration presents significant undue challenges to investors by failing to provide a level playing field.

Arbitration statistics over the next two years will shed light on the impact of important changes that FINRA is implementing to its arbitration procedures. Among the most significant changes is the elimination of the industry arbitrator for claims involving more than $100,000. Additional improvements, such as making arbitration voluntary rather than mandatory, are likely in the wake of SEC action pursuant to the requirements of the recently enacted Dodd-Frank Act. Whether such changes impact the results of arbitration hearing is a question that investors and industry members will closely watch.

If you believe your investment losses may have been caused by fraud or broker misconduct, call the investment fraud lawyers at Block & Landsman for a confidential consultation. Please visit our website for more information.