In Disputes With Wall Street, Investors Face 'Rough Justice'

Investor complaints spiked in 2009, but investors can't sue their broker.

Jan. 27, 2010— -- As a veteran securities lawyer representing individual investors who say they were wronged by brokerage firms, Howard Rosenfield has seen his share of horror stories over the past 25 years.

There was the case a few years ago involving a disabled man whose broker placed half his entire inheritance in a single technology stock. The stock, JDS Uniphase, tanked monumentally, wiping his client out.

When it came time to seek some legal recourse, the client had one option: mandatory industry arbitration. A three-person panel of arbitrators who were paid by the industry to hear the case ultimately found that the broker in question did nothing wrong. Rosenfield's client was awarded nothing.

"It's Wall Street's system," Rosenfield added. "And it can be rough justice."

Complaints against brokers, which are on the rise again in the wake of financial turmoil, are not heard in civil court; instead, they are handled exclusively through the dispute resolution arm of the Financial Industry Regulatory Authority (FINRA), the brokerage industry's self-regulatory organization created in 2007.

FINRA's forerunner, the National Association of Securities Dealers (NASD), was set up more than seven decades ago specifically by the broker-dealer industry to police itself, and settle disputes. Mandatory arbitration has been the norm since 1987, when a Supreme Court ruling upheld the securities industry's position that customer agreements were sufficient means to prevent any cases from ever going to court.

According to securities lawyers who have handled hundreds of such cases, investors often overlook the fact that when they formally establish a brokerage account -- which requires signing the customer agreement -- they voluntarily stipulate to settle all disputes via an industry-run arbitration process.

But this may soon change.

A Push for Arbitration Reform

Among the myriad of financial industry reforms currently being debated on Capitol Hill are some specific proposals, coming from the House, Senate and the Obama administration, which would prohibit or restrict mandatory arbitration, giving investors, finally, at least the option to take their brokers to court.

Rosenfield, who once sued FINRA, has been outspoken in calling for the need to reform the way Wall Street metes out justice. In the end, he stressed, the issue boils down to choice.

"It's time to end mandatory arbitration," the Farmington, Conn.-based lawyer said. "Give investors the right to decide if they want to go to a regular court, or to arbitration."

Jonathan Kord Lageman, another veteran New York securities lawyer, was more blunt: "FINRA arbitration is a sham."

Last year, FINRA logged 7,137 cases, up 43 percent from 2008. Three-fourths of the cases involved complaints made by individual investors; the rest of the cases were "intra-industry" disputes, such as a brokerage employee alleging unfair treatment by his employer.

The bulk of investor cases (or around three-fourths of them) are settled before ever going to a formal arbitration proceeding. Lageman and Rosenfield both stressed that most cases are settled primarily because securities lawyers know to avoid formal FINRA arbitration if at all possible.

Historically, going back decades, the securities industry used to prevail in roughly 60 percent of cases, according to the industry's own past studies. But in more recent years, that percentage has fallen. Of the 304 investor cases last year that went to arbitration, a slight majority, 55 percent, concluded with a decision favoring the industry. The industry win rate has come down from 58 percent in 2008, and 63 percent in 2007.

Stacked Deck?

Linda Fienberg, the president of FINRA Dispute Resolution, declined to be interviewed for this story. A FINRA spokesman pointed out that when counting claims that were settled, complainants in 2009 won some form of award in 70 percent of cases.

Most commonly, investor cases involve allegations of negligence, misrepresentation or instances of assets being placed by brokers in unsuitable investments -- like when a senior citizen is placed inappropriately in an aggressive, high-risk growth fund that pays the broker a high commission fee.

Cases of account "churning" -- excessive trading by brokers to generate commissions -- were common in the 1990s, but not as prevalent nowadays, lawyers said.

FINRA picks its arbitrators from a pool of about 6,000 professional arbitrators nationwide who are paid up to $475 per day. Many are retirees.

Disputes involving sums of money exceeding $100,000, if not settled, go before a three-person panel. Two of three panelists need to agree for a decision to become final. FINRA insists the majority of cases, some 98 percent, are resolved with unanimous decisions. Cases involving less than $100,000 (about one-third of claims) are heard by just a single public arbitrator.

Critics of FINRA, including some former professional arbitrators who have sat on panels, insist that the system is not set up with investors' best interests in mind.

"I've seen a disturbing amount of examples where it appears that attempts were made to fix cases," claimed one former arbitrator who requested anonymity, fearing a professional backlash from FINRA. "In general, their system is conflicted. If you don't vote in favor the industry, you don't get assigned any more cases, it's as simple as that."

The arbitrator, who no longer sits on panels, described several specific instances when he said FINRA assigned a new, hand-picked "replacement" panelist at the 11th hour, usually for some ambiguous reason.

"When I would see that, it usually involved a big case, and a major firm – and it also meant the investor was in for a tough time," the arbitrator said.

John Mark, a former NASD arbitrator, recalled being removed from a panel several years ago for "geographic reasons" after he objected to what he described as an unabashed bias shown a fellow panelist who had been a last-minute replacement.

"This guy was clearly trying to rig the case, and I wouldn't go along with it," Mark told

The episode eventually made the Wall Street Journal and drew the attention of Massachusetts Secretary of State William Galvin, who has repeatedly said that industry arbitration was unfair, at one point calling it "an industry sponsored damage-containment and control program masquerading as juridical proceeding."

Last year, Galvin testified before the House Financial Services Committee, urging arbitration reform.

State regulators such as Galvin are now among those leading the charge for an end to mandatory arbitration.

A 2008 study done by researchers at the University of Cincinnati on behalf of the Securities Industry Committee on Arbitration surveyed around 3,000 investors who had participated in industry-run securities arbitration. Some 62 percent said they thought the arbitration process was unfair; 70 percent were dissatisfied with the outcome. Nearly half of the respondents felt their panel was biased.

At the time the study was released, Bryan Lantagne, director of the Massachusetts Securities Division and chair of NASAA's Arbitration Project Group, said that the "study's results are disturbing, and support what state regulators have been hearing from investors in their states -- investors believe that the arbitration forum they are forced to participate in is rigged against them."

A separate study done by attorney Daniel Solin and finance professor Edward O'Neal studied approximately 14,000 cases between 1995 and 2004 and found that on average investors recovered between 22 percent and 38 percent of the monetary claims sought. For claims of more than $250,000 and involving the largest 20 firms, the recovery rate dropped to only about 12 percent of the amount claimed.

Changing Perception

FINRA has taken steps to make the system at least appear fair and not biased toward the industry.

Three-person arbitration panels can only have one person from the financial industry, either a direct practitioner or a lawyer for the industry. This type of arbitrator is known as a "non-public" arbitrator. The other two panelists need to be "public" arbitrators, or, ostensibly, not from the industry. However, public arbitrators can sometimes be retirees who at one time or another once worked in the industry.

Lawyers who deal with FINRA say outright deck stacking is far less of a problem than the generally wide latitude given to panelists to find reasons to rule in favor of the industry members who, while putting their own interests ahead of clients, never technically breach any codes of conduct. The burden of proof in an arbitration case, in other words, is much harder for investors than it would be if they were to pursue claim in a regular civil court where a broker defendant is held to a higher fiduciary standard, and thus shoulders more of the burden of disproving the claim.

"Imagine having a defective tire that caused an accident and then being forced to have your claim decided by the national association of tire dealers -- I tell my clients that's the level of fairness they can expect," said Rosenfield, who added that he avoids panels at all costs and almost always tries for a settlement.

Two years ago, FINRA introduced a pilot program that allowed claimants to use panels consisting of all purely public arbitrators, and later expanded it. In most cases, though, claimants still chose to have a non public, or industry person, hear the case. So even though the option for an all public panel is available, most lawyers recommend the traditional panel mix, undermining claims that FINRA can stack the deck.

Industry expertise can be useful, Rosenfield said.

"You have industry people whose expertise works in favor of the investor, and then you just have plain old shills or hired guns," he explained.

Fed up with what he called the brokerage industry's tendency to put its interests ahead of investors -- without ever being held accountable in a court of law as a fiduciary -- industry member Knut Rostad last year formed the Committee for the Fiduciary Standard in Washington, D.C. The steering committee has been meeting with regulators hoping to raise the level of industry accountability.

"Most investors don't realize that brokers, who nowadays usually go by impressive sounding titles such as financial consultant, are not legal fiduciaries," explained Rostad, a compliance officer at Rembert Pendleton Jackson, a Falls Church, Va.-based investment adviser

"Up until eight months ago, every part of Wall Street unanimously opposed the fiduciary standard for brokers," he added. "Now there has been a shift to where some in the industry are open to the idea."

Harold Evansky, president of Miami-based financial planning firm Evanksky & Katz and who years ago served as an NASD arbitrator, insisted that the system he observed was always "very fair."

But Evanksy, also a member of the Committee for the Fiduciary Standard, added that the rules governing broker conduct allow for behaviors that while technically not actionable violations, are, nevertheless, not in the client's best interests.

"I can tell you that I have been involved in cases which I felt concluded fairly, but not equitably," he said. "The standards of expected conduct in a broker arbitration case are lower than the fiduciary standards used in regular court."

FINRA President: Agreements Are Clear

Mary Schapiro, the former head of FINRA and who now heads the SEC, said earlier this month in testimony before the Financial Crisis Inquiry Commission that she supports bringing the fiduciary standard to all aspects of financial services, including brokers.

Brokers who find themselves fighting a claim in an arbitration case have no burden to prove that they acted in the client's best interest, only that rules were followed; the client has to prove that the broker did something wrong. In cases involving a breach of fiduciary responsibility, the burden is on the investment adviser to show that he or she followed a prudent process, according to Rostad.

Included in the many components to major, sweeping financial reforms being proposed in the House and Senate, and by the Obama administration, are measures that would prohibit or restrict the longstanding brokerage industry practice of mandatory, pre-dispute arbitration, giving clients who want it the right to pursue claims in a regular court of law.

FINRA rules do not require investors to arbitrate disputes with their brokerage firm. Similarly, the rules do not require firms to include a pre-dispute arbitration section in customer agreement, although this is a standard industry practice.

In Congressional testimony last year, FINRA president Richard Ketchum explained that "this is a matter of contract between firms and their customers. To protect investors, however, we do require firms to clearly and conspicuously state the nature and implications of the pre-dispute arbitration agreement."

The Obama administration has proposed, as part of its regulatory reform plan, which includes proposed Investor Protection Act, that Congress authorize the SEC to restrict or prohibit mandatory arbitration agreements. Measures that would end mandatory arbitration are included in financial reforms passed in the House, and in the Senate, where reform legislation has not yet passed. The Comptroller General is also studying arbitration reform.

In his prepared testimony last year, Ketchum said: "FINRA has long maintained that a determination about whether mandatory arbitration agreements should be allowable is a decision best made by Congress and the SEC. Our view is that Congressional or SEC action is necessary in light of Supreme Court precedent that upholds the ability of firms to contract in this way with customers. As such, we do not object to the Administration's proposal."