Skip navigation

The Fight Is On

When a client opens a brokerage account, he agrees that he won't sue you, the registered rep, in a court of law. In opening the account, the client agrees to take his complaint through an arbitration system controlled by the securities industry. In many cases, the client may not have read the fine print, and may have no idea he is signing away his right to go to court. Is that fair? For years, plaintiffs'

When a client opens a brokerage account, he agrees that he won't sue you, the registered rep, in a court of law. In opening the account, the client agrees to take his complaint through an arbitration system controlled by the securities industry. In many cases, the client may not have read the fine print, and may have no idea he is signing away his right to go to court. Is that fair?

For years, plaintiffs' lawyers and other consumer groups have been arguing just that: It's not right. Finally, after 20 years of complaining that fell on deaf ears, Congress is considering legislation that would kill mandatory arbitration. Specifically, Congress has before it a bill that would void any pre-dispute agreement to arbitration in any employment, franchise or consumer dispute (essentially nullifying the practice in all consumer affairs, from credit cards to brokerage accounts). If it passes, the law could give investors the option of going to court to dispute alleged problems — from unsuitable investments to churning — against brokers and broker/dealers.

Normally, you'd just assume this assault on arbitration was dead in the water. (A similar fate befell a challenge in 1988.) Not with the Democrats in control of Congress. The bill, lobbied hard for by trial lawyers (who contributed $2.8 million in the 2006 campaign cycle, 95 percent of it to Democrats) and others, may actually have more than a passing chance. In mid-July, Sen. Russell Feingold, D-Wis., and Rep. Hank Johnson, D-Ga., introduced The Arbitration Fairness Act of 2007, a bill that came after a lobbying effort by a broad coalition of consumer groups, including the Consumer Federation of America, the National Employment Lawyers Association, Public Citizen (founded by Ralph Nader), as well as the largest and most powerful trial lawyers lobbying group in the country, the American Association of Justice (formerly known as the American Trial Lawyers Association). This group of trial lawyers ranks fifth among the all-time top organizations that contribute money to members of Congress — more than the Teamsters or Goldman Sachs, according to the Center for Responsive Politics, a Washington, D.C.-based nonprofit that tracks political spending. The AAJ has donated $27,117,606 since CJR began tracking the numbers in 1989.

The groups have targeted the fine print in consumer contracts, such as credit-card agreements, where consumers agree (probably without realizing it) to seek dispute resolutions via arbitration. A September 2007 report by Public Citizen analyzed more than 19,000 credit-card arbitration cases in California, and found that arbitrators ruled for corporations about 95 percent of the time. The legislation would also reach brokerage accounts, which have contained a mandatory clause in every brokerage account since the United States Supreme Court green-lighted — by a narrow margin — the constitutionality of arbitration in securities contracts in Shearson/American Express Inc. v. McMahon, a 5-4 ruling that came down in June 1987.

Theodore G. Eppenstein of New York's Eppenstein & Eppenstein, who argued — and lost — the McMahon case on behalf of investors, was one of nine witnesses on October 25 to testify about The Arbitration Fairness Act before the House Subcommittee on Commercial and Administrative Law. Eppenstein told the panel that a “crisis existed today” in the arbitration system run by FINRA, the successor to the NASD. “For sure, arbitration has served the securities industry well these past 20 years, where public scrutiny of all kinds of brokerage evils are hidden behind arbitration's closed doors, and the firms' pocketbooks are sheltered from a jury's wrath,” he said.

In his testimony, Eppenstein flagged the long list of problems that investors' lawyers have been citing for years. “Securities arbitration has not been the fair, fast and economical path to recovery it has been reputed to be,” he said. The litany of complaints: higher fees, lack of disclosure of potential conflicts of interest in the pool of available arbitrators, more costly preliminary hearings, motions, mammoth discovery requests — all imparting the cost of litigation without the benefits of a jury trial — and the presence of an industry member from the brokerage industry on the three-person arbitration panel that, he contends, stacks the deck against the retail investor.

Eppenstein brought with him the statistics he believes proves the case that mandatory arbitration has resulted in a steady and inexorable path of lower recoveries in investor complaints in the 20 years since McMahon was decided:

  • A 1992 study of arbitration awards by the U.S. Government Accountability Office showed that investors got a favorable result 60 percent of the time for cases heard before the NASD and NYSE, and that winners recovered 61 percent of their losses.

  • Arbs Work, Say Brokerages

    In 1996, The Securities Arbitration Commentator, a trade publication, published a survey of 10,000 awards issued from 1989 to 1995, and found a “steady downward” trend in the win rate for cases in which customers prevailed.

  • A 2000 GAO report surveyed awards from 1992 to 1998, and found that investors won about 51 percent of the time; dollar recoveries for investors who won also dipped, from 61 percent to 51 percent of the amount they had claimed.

  • The NASD's own statistics show that from 2002 to 2006, the customer win rate dropped from 53 to 42 percent.

Eppenstein also cited a study released in June by Edward S. O'Neal, a consultant, and Daniel R. Solin, a lawyer for customers, based on 14,000 awards from 1995 to 2004. They examined recovery rates, calculated by multiplying the average win rate by the average amount won by investors (see table at right); recoveries reached a high of 38 cents on the dollar in 1998, but dropped to a low of 22 cents on the dollar by 2004. “It just shows the slippery slope downward, and it doesn't look like it's going to stop,” Eppenstein said in an interview with Registered Rep. “And we haven't had any big reform of the system to make this better or fairer for the investors.”

Of course, the brokerage firms have a very different take on arbitration, and are lending their own voice to the debate. On the eve of the October 25 hearing before Congress, the Securities Industry Financial Markets Association (SIFMA), Wall Street's largest lobbying group, released a white paper on the mandatory arbitration system. Among its key findings:

  • Arbitrations were 40 percent faster than civil litigation during the 12-month period ending August 2007, concluding in an average of 13.7 months for arbitration, versus 22.2 months in civil litigation filed in federal court.

  • Arbitration claims are heard on the merits 20 percent of the time, while litigation goes to trial before a judge or jury about 1.5 percent of the time.

  • In 2006, investors recovered money through an award or settlement 66 percent of the time.

  • A review of 2005 and 2006 arbitration cases found that the presence of an industry arbitrator has “no material impact on customer wins.”

In an October conference call with reporters, Marc Lackritz, SIFMA's president, said that arbitration has “proven time and time again to be fairer, faster and cheaper for investors than other alternatives such as litigation.” He attributed complaints about the system to the plaintiffs' lawyers at the Public Investors Arbitration Bar Association, which, he said, “has always been wonderful about touting” the inevitable case or two in which the result “doesn't make sense.” But he added: “There's a lot of errant nonsense out there about this system.”

Inevitably a reporter asked a question: If the arbitration system is working so well, and investors are so happy with it, why not give them the choice to opt for it, rather than forcing it on them? Lackritz says a choice would create a two-track system, one that would serve “wealthy investors,” and another for “everyone else.” Such a duel system, he said, would be “incredibly expensive,” and “impose a huge transaction cost on the industry.”

In calculating the 66-percent recovery rate for investors, SIFMA included cases in which customers settled their claims, even though settlements are confidential. Calling himself a “recovering lawyer,” Lackritz pointed out: “I know that when plaintiffs settle cases, they settle cases for amounts that they think are reasonable.”

At the hearing, Rep. Chris Cannon, R-Utah, the committee's ranking Republican, issued an opening statement suggesting that trial lawyers, among the largest contributors to the Democratic party, would be the primary winners if the legislation were to pass: “So how will it benefit consumers, the little guy, the working man, to take arbitration off of the table? …Would the only ones guaranteed to benefit be the trial lawyers? I'll venture a ‘yes.’ Common sense and the laws of economics suggest that if this bill were to pass, trial lawyers would be the largest beneficiaries.”

Unlike many other witnesses at the hearing who advocated dismantling arbitration altogether in favor of going to court, Eppenstein did not assert that arbitrations be eliminated for brokerage cases. He proposed that investors have the choice between arbitration and going to court, and predicted that for many of the small claims (those alleging $25,000 or less), investors would chose the arbitration route. But he also warned that the arbitration system, now run by FINRA, which is owned by the securities industry, must be handed off to an independent group to insure fairness. “It has got to be outside the industry, with new rules. And we can't have an industry person as a required arbitrator,” he says.

Some defense lawyers believe the plaintiffs' bar ought to be careful about what it wishes for, because many a claim that makes it to a hearing before arbitrators would not make it past a motion to dismiss in a court of law. “A lot of claims that are heard on the merits in arbitration would not get past the pleadings stage in court,” says Michael G. Shannon, a lawyer with the New York office of Thelen Reid Brown Raysman & Steiner who has handled more than 250 securities arbitration proceedings. “The costs are going to go up for everyone,” he says. Shannon, for one, is also skeptical about the numbers that show lower recovery rates. “I have seen many cases where the dollars claimed were unrealistic. Not every case is a great case,” he says.

While SIFMA says the Arbitration Fairness Act would “nullify” mandatory arbitration in brokerage cases, PIABA is not so sure. Steven B. Caruso, who has just wrapped up his term as PIABA's president, wants the bill to be clear that it applies to securities cases. “There's nothing in there that says securities. That's an open question — at least in our minds — and it needs to be clarified,” he says.

Hide comments


  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.