In the wake of the Dodd-Frank Financial Reform Act of 2010 the SEC is considering whether to impose a fiduciary — or other heightened — duty on stockbrokers and whether to allow mandatory pre-dispute arbitration clauses to remain in account opening documents. More than 20 years of protecting investors, both at the SEC and in private practice, convinces me that, unless the SEC does away with mandatory arbitration, any change in the stockbroker’s duty will be meaningless.
I have represented investors in security arbitration cases since I left the Enforcement Division of the SEC in 1996. I know the arguments in favor of arbitration— faster and less expensive. I also know the drawbacks — playing on the industry’s home turf, no meaningful appellate rights, very limited discovery, and no written discussion of how the arbitrators reach their decisions. For purposes of this article, the last drawback is the most significant.
No explanation
Getting the notice of an arbitration award in the mail is almost always a frustrating experience, even when you win. You get a result, but you never get an explanation. What you most want is an assessment of your case, an explanation for what evidence the panel found important, which evidence it accepted or rejected and why, and how the panel calculated any damages awarded. What you receive instead is a document that is important to your client and your opponent, but absolutely meaningless to anyone else.
If the SEC’s goal in changing the stockbroker’s duty is to change stockbroker behavior, there must be a mechanism for review of that behavior, someone to tell the industry whether a broker’s conduct measured up to the heightened standard. The current arbitration system cannot do that. A simple number, whether it be a zero or eight figures, cannot explain to the industry how certain conduct fell short, or explain to investors why certain claims are not meritorious. As a guide for changing stockbroker behavior industry-wide, therefore, arbitration is useless.
If customers are free to take their cases to court, a change in the stockbroker’s duty can do some good. If the public can see how a broker’s conduct translated into a decision from a judge or jury, other brokers can conform their conduct to make future violations less likely.
If the broker believes the jury reached the wrong conclusion he can appeal the case. In that event, the appellate court will issue a written opinion that will serve as a guide to all future litigants. That helps both the industry and the investing public.
“Sour grapes” cases
A clear standard as articulated in published judicial opinions would result in fewer frivolous claims. I reject more than 90% of the prospective investor cases that I review. Most often its because the client appears to have what I call a “sour grapes” case; he or she understood the risk involved in investing, but would rather not accept the consequences when the market turns south.
No doubt, I am not the last lawyer that some of those clients consult. Once a body of law develops — it has been stunted for twenty years now — appellate decisions will guide the decisions that claimants’ lawyers make about whether to accept representation.Transparency is a concept that we can all rally around. We can fight over whether Dodd-Frank did all it might have done in the area of derivatives trading. We can disagree over whether granting shareholders greater proxy rights is a good idea. But, where are the advocates for less transparency?
In the due diligence reports I write for clients of Investor’s Watchdog, I always mention any lack of transparency and underscore it as a major red flag for investment fraud. And yet, currently, we are supposed to have faith in a securities arbitration system that robs the investing public of transparency.
Arbitration also robs the participants of the right to just resolution of the dispute. Because arbitration decisions are not explained and because there are no meaningful appellate rights, panels issue unjust awards and the parties have to live with the injustice. That’s not the way things ought to be.
Our Founding Fathers thought this matter important enough to preserve the right to a judge and jury in civil cases in the Seventh Amendment to the Constitution. For roughly 210 years between the ratification of the Constitution and the wholesale move to mandatory arbitration, the civil justice system worked in disputes between stockbrokers and their customers.
Scrap the system
For the past twenty years — a period during which reckless conduct by the securities and banking industries created a crisis that nearly destroyed our economy — we have experimented with a system that provides no transparency. Now is the time to scrap it, especially if the industry must adapt quickly to a change in the duty that brokers owe their customers.
Pat Huddleston was an Enforcement Branch Chief in the SEC, leading a team of Enforcement Attorneys in nationwide investigations of cases involving insider trading, brokerage firm misconduct, and scams of every stripe. Since returning to private law practice he has represented investors in securities litigation and arbitration. He currently serves as court-appointed receiver in SEC fraud cases, cleaning up the mess left in the wake of the collapse of those scams and working to recover assets for defrauded investors. In 2006, Pat founded Investor’s Watchdog, LLC, a due diligence company that conducts fraud prevention investigations for pension funds, endowments, family offices, and individual investors. He blogs on investment scams and investor protection issues every weekday at investorswatchblog.com. You can also follow him on Twitter where his handle is @scamdemic.
Ron A. Rhoades, JD, CFP added: (Saturday 10.2.10 10:39a.m. PST)
In my view, arbitration has several potential benefits, which should be preserved. For example, it is often less costly to plaintiffs to bring claims in arbitration. This enables investors suffering smaller damage amounts access to legal counsel.
From the RIA’s perspective, arbitration prevents many frivilous claims from being filed. Since, as suggested in the article, an investment adviser’s reputation means EVERYTHING, wise plaintiff’s counsel could utilize the THREAT of a lawsuit to extort a settlement from an RIA firm. Legal counsel knows that, especially in smaller communities, media coverage of filed civil complaints occurs often, with little or no chance for rebuttal by the defendant.
(I would comment further, however, that reputational risk is much greater for smaller RIA firms, than for wirehouse-affiliated RIA firms. Reputation is easily “restored” by those firms who conduct massive marketing campaigns. Behaviorial biases, such as recency, permit such repair.)
Nevertheless, I concur with Mr. Huddleston that there there are problems with arbitration. Chief among these is that, for BDs, arbitration occurs under FINRA. Regardless of any changes FINRA undertakes to its arbitration rules, where the industry controls the arbitration process it will always be viewed by individual investors as “unfair.” And this perception serves to undermine the essential trust investors must possess to participate in our capital markets more fully.
Another key problem with FINRA arbitration includes lack of required findings of fact and conclusions of law, and the publication of same, by arbitration panels. This has resulted, most noticeably, in a lack of development of fiduciary law, as applied to investment advisory activities. Published decisions would also lead to meaningful rights of appeal, as the record can be reviewed by a court.
Hence, I submit, that the solution which should be attempted by the SEC is not to abolish arbitration, but to fix the problems which exist in the current structure. Remove arbitration so that it is conducted by independent arbitration forums (such as AAA). Require such forums, and the arbitration panels, to provide written findings of fact and conclusions of law. Provide a central repository for these written arbitration decisions, for research and review purposes. And clearly delineate the right of appeal from arbitration decisions, and the standard of review.