You can be sure there won’t be any official celebration or anything, but the new year brings an important anniversary to the securities industry: It’s been 20 years since the Supreme Court ruled that retail brokerage clients could be forced to go to arbitration rather than sue in a court of their choosing. The court’s ruling in the Shearson/American Express Inc. v. McMahon case in 1987 provided the legal underpinnings for a system that was supposed to help investors air out their disputes with securities firms in an equitable forum, one that had the benefits of a courtroom but few of the drawbacks. It was to be a fair, fast and relatively cheap way to adjudicate disputes before an impartial panel.
Twenty years later, the arbitration system is neither fair, cheap nor swift, say lawyers on both sides of the table (albeit for different reasons). On top of all this, arbitration results are final and can be somewhat mysterious: No explanation of how the panel came by its binding conclusion is necessary. Not surprisingly, most of those involved—except perhaps the firms—would like to see the system overhauled. A House Subcommittee on Financial Services hearing was held on the subject on March 17, 2005. In the hearing, William Galvin, the crusading Secretary of the Commonwealth of Massachusetts (as such, the state’s chief securities regulator), pressed for change, calling the present arbitration system “fundamentally flawed and stacked against the individual investors.” Alas, that hearing was held on the same day as the Major League Baseball steroid hearing; the finance meeting lasted a little more than an hour and was adjourned. It hasn’t met on the matter since. (Incidentally, brokers fighting their firms don’t think much of the arbitration system either.)
Currently, there is a major rewrite of the NASD’s procedural code. The firms don’t like two of the rules proposed, saying they are biased against them. Now that the NASD and the NYSE are to merge, it is likely a dead letter, anyway. Linda Fienberg, president of NASD Dispute Resolution, which would absorb the NYSE regulatory body when the two are merged, said she plans to set up a task force to examine differences in the arbitration procedures at both organizations.
Here are three problems that lawyers who struggle with the arbitration system say they confront on a routine basis. For the most part, the lawyers for customers and those who represent the industry have radically different views on how to fix the system. But there’s some surprising common ground.
Problem No. 1: It’s the arbitrators themselves. The people who come together to form the three-person panel that decide the disputes are the main problem, according to many lawyers on both sides. They are either biased or incompetent—or both.
Each panel is composed of two “public” representatives and one “industry” representative; the plaintiffs’ lawyers uniformly say the industry panelist must go. “Get rid of the industry arbitrator,” says Steven Caruso, a lawyer in New York and the incoming president of the Public Investors Arbitration Bar Association (PIABA), the lobbying group for lawyers who represent customers. “There’s no viable reason to have an industry arbitrator on every panel. If you have a personal injury claim and you take that claim to a jury, there’s no requirement that a claims adjuster be on that jury.” Caruso and other customer lawyers often make comparisons to the courtroom. Trouble is, they lost that fight 20 years ago.
Last year, the NASD tightened the rules on public arbitrators, disqualifying people with direct family relationships to people employed by the industry, such as sons and daughters and husbands and wives. “Twenty years ago, your husband could have been a branch manager and you would not have been considered to have been in the industry,” says Matthew Farley of Drinker Biddle & Reath, who has represented the brokerage industry in arbitrations for decades. Farley says he’s fed up with a pool of public arbitrators composed mainly of retired schoolteachers and guidance counselors, who are clueless about investing and who he believes are biased against Wall Street.
In fact, PIABA hired a consultant to recruit people to serve as public arbitrators—a development discussed at PIABA’s annual meeting in Tucson, Ariz., last October. Corporate lawyers say PIABA is just trying to lard the arbitration pool with artists, teachers and others biased against Wall Street—and paid a rumored $50,000 for the consultant’s services. Caruso confirmed that PIABA had hired the consultant, but declined to discuss the fee. “We felt that the arbitration pool in many areas of the country is very thin,” he says. And PIABA is merely catching up with the firms’ lobby group, the Securities Industry and Financial Markets Association, which, he says, solicits defense attorneys to be public arbitrators. “They have people working the process, and they always have. That’s why you see so many brokerage industry people serving on these panels.”
Meanwhile, customer and defense lawyers both complain that “industry” members of the panel need to have more expertise. “You get so many guys whose industry connection is selling variable annuities out of the trunk of their Buick,” says Farley. “If that is the sum total of your industry expertise, you are not going to be much help.”
Lastly, there’s the crazy-quilt means by which arbitrators are “chosen” by the parties, a process known as “list selection.” Each side gets a list of 10 “public” arbitrators, and five “industry” arbitrators. After some research, mainly done by consulting data on history of decisions compiled by the Securities Arbitration Commentator, each side ranks their preferences and the average of those top choices form a potential panel. Ideally, three people with the lowest combined score would be selected for the panel. But each side can also strike as many names from the list as they want, and more often than not, there aren’t three arbitrators standing after that process is completed. At that point, names are drawn at random from the NASD’s computer, and the parties are stuck with those people. Too often, it’s the same few arbitrators the computer offers up, critics say.
Solution? The NASD has proposed a change to address complaints about the competence of arbitrators and the list-selection process. But the pool of arbitrators themselves seems to be the problem, and no one seems to be recommending a way of getting better people involved in the process. For now, it may be best for an independent government agency, such as the Government Accountability Office, to audit the qualifications and disclosures of the men and women who currently serve on the roster.
Problem No. 2: Arbitrations have taken on the worst aspects of litigation in the courtroom. In the 1970s and through the early 1980s, Farley recalls, arbitrations generally began at around 4:15 in the afternoon and were concluded by 6:30 or 7 that evening. “Because people came prepared to get a resolution done,” he says. That era is long gone. Farley hasn’t done a one-day arbitration hearing in more than a decade.
Among claimants’ lawyers, what they call discovery abuse ranks at the very top of their lists of gripes. A 1999 revision of the arbitration code provides a list of documents that are presumed relevant and the parties are supposed to turn those over automatically, but defendants prefer to wage a fight over discovery first. “They give you absolutely nothing,” says Hugh Berkson of Hermann Cahn & Schneider. Among the basic pieces of evidence are an investor’s account-opening documents. In one recent case, Berkson says, the defense sent the investor his own monthly statements. “That was it,” Berkson says.
In July 2004, NASD brought an enforcement action against three firms (Citigroup, Merrill Lynch and Morgan Stanley), fining them each $250,000 for failing to comply with their discovery obligations in 20 arbitration cases between 2002 and 2004. NASD also ordered the firms to implement written procedures designed to ensure that future discovery violations that lead to sanctions are elevated to senior officers for review and appropriate corrective action. “They spend more on an office party for a branch,” says PIABA’s Caruso. And just before this past Christmas, the NASD charged Morgan Stanley with “routinely failing to provide emails to claimants in arbitration proceedings as well as to regulators, and with falsely claiming that millions of emails it possessed had been lost in the Sept. 11, 2001, terrorist attacks on the World Trade Center in New York, where its email servers were housed.” The NASD alleged that this took place in “numerous proceedings from October 2001 through March 2005.”
Another ploy used by brokerage firms, claimants’ lawyers say is, to subpoena third parties for an investor’s mortgage records, bank records, other brokerage accounts, in an effort to show that the claimant was not a naïve customer duped by his trader, but a sophisticated investor. (Heeding complaints from PIABA, the NASD has given arbitrators power to issue subpoenas.) Theodore Eppenstein, of Eppenstein & Eppenstein, who argued the McMahons’ case back in 1987, says a current arbitration case he is handling could be prolonged by a year or more as the parties argue over what is admissible and who should pay for the costs of photocopying the evidence.
Of course, corporate defense lawyers say the claimants’ bar has also been known to twist the discovery game to further its ends. “Claimants’ lawyers have figured out that sweeping discovery requests can lead to settlements that might not have otherwise happened,” says Timothy Burke, a lawyer with the Boston office of Bingham McCutcheon. Some discovery requests are so massive and costly that brokerages firms prefer to settle. Then there are some claimants’ lawyers who seek records from a broker’s other customer accounts, not only to establish a pattern of his trading, but also to troll for new clients, Burke says.
Arbitration proceedings do not follow the same rules as courtrooms; they are supposed to apply principles of “equity” rather than the strict, technical pleading requirements of claims argued in a courtroom. It is standard practice in a courtroom to bring a motion to dismiss the plaintiff’s claim. Those motions used to be rare in arbitrations but they are now commonplace. “The general counsels of these companies are advocating that their lawyers make a minimum of three motions to dismiss in every case,” says Eppenstein.
Solutions? Abuse of motions to dismiss has been a hot topic for years, but it hasn’t been tackled, yet, despite some past rule-change proposals. Litigants tend to respond to the threat of penalty, so sanctions may be the way to address problems of arbitration lawyers behaving like courtroom lawyers. A good first step, though, would be for the SEC to finally adopt some of the rule changes it has been sitting on—a prospect that seems all the more unlikely now that the two regulators have a deal to merge.
Problem No. 3: Time and money. The turnaround time from the filing of a complaint to a hearing decision has been inching upward, from 15.1 months in 1996 to 16.7 months in 2006. The cost has been increasing, too. The arbitrators in NASD proceedings charge $1,200 per four-hour session, and a full day costs $2,500, a cost usually split by both parties. NASD’s Fienberg has also noted a recent increase in the number of hearings, attributing the trend to an increased tendency of defendants to litigate, rather than settle. (See table.)
The NASD’s proposed merger with the Big Board would all but kill a NYSE proposal from last August, which would have streamlined the arbitration process by having a single arbitrator decide cases with alleged damages under $200,000. “The NYSE really only has the larger firms,” Fienberg says, suggesting that the rule would not make sense for many of the 4,000 small firms in its membership. And work on the merger would definitely shelve the NASD’s initial inquiries into expanding its arbitration forum to customers and registered investment advisors (RIAs) who are not registered as broker/dealers (about 80 percent of RIAs are dually registered). Currently, the NASD has no jurisdiction over those disputes, which either land in court or in some other arbitration forum, depending on the customer’s agreement.
Solution? Perhaps there isn’t any way to stop the lawsuit juggernaut. We live in a litigious society. In the 20 years since the McMahon case was decided, there has been an explosion in lawsuits. Twenty years after the Supreme Court passed the arbitration ball to the regulators in the McMahon case, those regulators are in a curious spot. They are balancing the various gripes on every side, while defending the validity of the system. Perhaps it’s time to examine the most radical solution of all: To pass this arbitration system from the member-owned regulators to an independent group to make it an obviously fairer forum. After all, mandatory arbitration clauses can be found in many contracts, from the construction industry to employment agreements. If you have a credit card, chances are you are bound to settle whatever dispute you have with the bank that issued it by arbitration. But unlike the brokerage industry, where arbitrations are conducted in an industry-owned forum, such as the NASD, these arbitrations are farmed out to another organization, such as the American Arbitration Association or JAMS/Endispute, a mediation and arbitration service that is manned, primarily, by former judges.
“The sad thing is, industry-sponsored arbitration is the only game in town,” said Galvin, the Massachusetts securities regulator, at that Capitol Hill hearing back in March 2005. Perhaps it’s time to find another field on which to play the arbitration game.
|Total hearing sessions*||2,879||3,387||3,543||7,095|
|Sessions for longest single case*||43||94||36||108|
|Average hearing length (in sessions)||3.5||4.8||4.1||6.1|
|Average Forum Fees+||$4,200||$5,760||$4,920||$7,320|
|*Each session is four hours long. |
+Based on $1,200 charge per four-hour hearing session, NASD’s fee for cases alleging $500,000 or more in damages.