The Time for Change in Securities Arbitration Has Come: The Unfolding Story of How the Financial Industry Regulatory Authority’s Arbitration System Is Failing Investors
By Amy Radon, Public Justice Goldberg, Waters & Kraus Fellow
If you’ve ever hired a securities firm to provide you with financial planning advice or investment services, chances are you have had to sign a pre-dispute, binding, mandatory arbitration clause that requires you to arbitrate any dispute that you might have with the firm or its associates. What you might not know is that, in most cases, you’ve also agreed to have an “industry arbitrator” – that is, someone who has been employed by a securities firm in the past five years – to decide your case, and that in some cases, you’ve waived your right to bring a class action against the firm. The securities industry has long touted its arbitration system as fair to investors and an efficient means of resolving disputes between securities firms and their customers, but recent developments in the past two years have shown that the opposite may be true.
The most prominent securities arbitration forum is that run by the Financial Industry Regulatory Authority (“FINRA”). FINRA is a private corporation that is the largest independent regulator for securities firms in the U.S., and oversees nearly 4,800 brokerage firms, 172,000 branch offices, and approximately 646,000 registered securities representatives. FINRA Arbitration & Mediation, “What is Dispute Resolution.”
FINRA members may compel their customers to arbitrate any claim they may have against the firm in FINRA’s own arbitral forum, so long as the arbitration clause appears in writing and designates FINRA’s Code of Arbitration to govern the proceedings. FINRA Arbitration Code § 12200.
FINRA securities firms over the past ten years have jumped at the opportunity to compel their customers to arbitrate their claims in the FINRA arbitral forum. With anywhere between 3,000 to just under 9,000 arbitrations filed every year, FINRA’s arbitral forum has now become the largest securities arbitration forum in the world. FINRA Arbitration & Mediation, “What is Dispute Resolution.” But are investors happy with the system? The answer, unsurprisingly, is a resounding “no.”
As explained in greater detail below, a 2008 study by the Securities Industry Conference on Arbitration (“SICA”) reveals that investors are fed up with having to arbitrate their claims against securities firms in a forum that they view as biased, expensive, and unfair. The reasons for this collective dissatisfaction with what is supposed to be a neutral arbitral forum likely include the following: FINRA requires at least one securities industry insider to serve on every arbitration panel; investors don’t receive any explanation for why a panel ruled the way it did; the arbitrators need not comply with state ethics laws that govern all other non-securities arbitrations; and finally, investors more often than not lose. Add to these problems a recent federal district court case holding that, under certain circumstances, FINRA members can ban their customers from bringing or joining in a class action, and the result is an urgent need for investor protection. Public Justice, through its Mandatory Arbitration Abuse Prevention Project, is acutely aware of the ways in which a corporate defendant can exculpate itself from liability to its customers by inserting unfair provisions – like class action bans – into its arbitration clauses. FINRA – an organization committed to regulating securities firms and protecting investors – shouldn’t stand for this in the securities industry, and neither should the courts.
The SICA Study
To its credit, FINRA funded a study in 2008 conducted by SICA that documents the results of a one-time mailed survey to individual investors who initiated arbitrations with either the National Association of Securities Dealers (“NASD”) or New York Stock Exchange (“NYSE”). (On July 30, 2007, the NASD and the NYSE, including each organization’s respective arbitration forums, consolidated to form FINRA. For the most part, the rules governing the arbitration processes did not change during or after the consolidation, so the findings in the SICA study are relevant here.) According to the SICA study, nearly half of the investors who participated in the survey believed that their arbitration panel was biased; 52 percent would not recommend arbitration to others; 71 percent were dissatisfied with the outcome of their arbitration; and 49 percent stated that the arbitration process was too expensive. Jill Gross and Barbara Black, Perceptions of Fairness of Securities Arbitration: An Empirical Study, Report to the Securities Industry Conference on Arbitration (Feb. 2008). Moreover, an astounding 75 percent of investors who compared the arbitration process to civil litigation indicated that arbitration was “very unfair” or “somewhat unfair.” Id.
FINRA’s Industry Arbitrators
The SICA study reveals that the “most negative customer reactions” involved arbitrator impartiality. Jill Gross and Barbara Black, When Perception Changes Reality: An Empirical Study of Investors’ Views of the Fairness of Securities Arbitration, 2008 J. Disp. Resol. 349, 385 (2008). The truth is, investors should have great cause for concern regarding whether their panel of FINRA arbitrators is neutral, given FINRA’s requirement that at least one industry professional serve on every three-person arbitration panel. FINRA Arbitration Code §§ 12400-12402 require that at least one panel member in every arbitration be a “non-public arbitrator,” which means, among other things, that the arbitrator has been “associated with or registered through, a broker or a dealer” within the past five years. FINRA Code § 12100. Brian Smiley, President of the Public Investors Arbitration Bar Association, notes the problem with this requirement: “Look at it this way, if it was a medical malpractice case and one-third of the jurors were doctors, it would intuitively strike you as unfair. There is a concern that some industry arbitrators – and I emphasize that some are very decent and capable – tend to favor the industry.” On Wall Street Editorial Staff, Five Questions with Brian Smiley, On Wall Street (Oct. 1, 2009). Especially in recent years, when brokerage firms have been consolidating at a record pace, any industry arbitrator could sometime in the future be employed by a firm involved in the arbitration. At a minimum, investors should have the choice to exclude these industry arbitrators from their panel, and instead have their cases heard solely by “public” arbitrators who are not connected to the securities industry.
Unexplained Arbitration Awards
Another reason for investor dissatisfaction with the FINRA arbitration forum is that the investors – win or lose – never receive any explanation of why their panel of arbitrators ruled the way they did. The SICA study found that 55 percent of the investors surveyed expressed frustration at the fact that FINRA arbitrators issue awards without providing any analysis or reasoning. See Jill Gross and Barbara Black, When Perception Changes Reality: An Empirical Study of Investors’ Views of the Fairness of Securities Arbitration, 2008 J. Disp. Resol. at 386. To its credit, FINRA publishes the results of arbitration awards on its website for any member of the public to access, which is more than can be said of other arbitral forums that operate in complete secrecy. See FINRA Arbitration Awards Online, available at http://finraawardsonline.finra.org/ Nonetheless, FINRA arbitrators are not required to explain why they ruled the way they did, or provide any authority or analysis whatsoever for their decisions. See Review of the Secs. Arbitration Sys.: Hearing before the U.S. H. Subcomm. on Capital Markets, Ins. and Gov’t Sponsored Enterprises, 109th Cong. 13-14 (Mar. 17, 2005).
Interestingly, FINRA proposed a rule two years ago that would require arbitrators to issue an explanation for the award if the customer requests it. See Jill Gross and Barbara Black, When Perception Changes Reality: An Empirical Study of Investors’ Views of the Fairness of Securities Arbitration, 2008 J. Disp. Resol. at 387. However, no action has been taken on that rule, and it remains to be seen if it will ever be adopted.
Lax Ethical Standards
Perhaps another reason why investors are dissatisfied with the FINRA system is that FINRA arbitrators need only comply with FINRA’s own ethical rules contained in its Code of Arbitration – not the more stringent ethical standards that some states have adopted for all other arbitrators. For example, California ethics standards provide for mandatory and automatic disqualification of an arbitrator from arbitrating a dispute if that arbitrator fails to make a required disclosure and one of the parties to the dispute serves a timely notice of disqualification. See Ethics Standards for Neutral Arbitrators in Contractual Arbitration (“Cal. Standard”), Cal. Rules of Court, Div. VI, § 10(a)(1). In contrast, FINRA’s Code provides that, even if the arbitrator fails to make a required disclosure and one of the parties serves a timely notice of disqualification, it’s in the discretion of the Director of FINRA Arbitration to either keep the arbitrator on or remove him or her from arbitrating the dispute. FINRA Code § 12410. Likewise, California’s list of required disclosures that an arbitrator must make to the parties is much more stringent than the disclosures required by FINRA. For example, California requires that arbitrators disclose whether their spouses ever served on a bar committee with an associate of a party’s lawyer, even if the associate is not involved in the case, and also requires disclosure of “[a]ny other professional relationship . . . that the arbitrator or a member of the arbitrator’s immediate family has or has had with a party or lawyer for a party.” Cal. Standard 7(d). The FINRA Code doesn’t require either of these disclosures.
Both the Ninth Circuit and the California Supreme Court have held that the NASD Arbitration Code, which was the predecessor to the FINRA Code and is equivalent to the FINRA Code in all material respects, preempts California’s more-stringent ethics standards. See Credit Suisse First Boston Corp. v. Grunwald, 400 F.3d 1119 (9th Cir. 2005); Jevne v. Superior Court, 111 P.3d 954 (Cal. 2005). One would think that, because FINRA is a private self-regulatory organization, its rules would not be considered “Laws of the United States” capable of having preemptive effect over California ethics standards, but the Ninth Circuit and the California Supreme Court reached the opposite conclusion. These courts found that, because the Securities and Exchange Commission (“SEC”) exerts substantial control over NASD’s (now FINRA’s) rule-making authority, SEC’s approval of an NASD rule “is an expression of federal policy” that, under certain circumstances, will have preemptive effect. Jevne, 111 P.3d at 953. In particular, when the NASD overhauled its arbitration procedures in 1989, NASD was required to file its proposed procedures with the SEC along with a policy statement justifying the basis and purpose of each proposed change, and then the SEC was required to provide public notice of the proposed changes to the arbitration procedures and an opportunity for public comment before the SEC would approve of the changes. In short, it is now the case that rules adopted by FINRA and approved of by the SEC may preempt state laws that either conflict with the FINRA rule, or in some other way “stand as an obstacle” to the objectives of FINRA and the SEC.
With respect to California’s ethics requirements for arbitrators, both the Ninth Circuit and the California Supreme Court held that the NASD rules preempt California law. These courts found that California’s disqualification rules conflicted with NASD’s disqualification rules, because the former provides for mandatory disqualification under certain circumstances, while the latter grants discretion to the NASD Director of Arbitration to ultimately decide whether an arbitrator should be disqualified. Likewise, the court held that California’s disclosure rules were preempted because they “stand as an obstacle to the accomplishment and execution of the full purposes and objectives” of the NASD arbitration procedures, even though it would be entirely possible for an NASD arbitrator to satisfy both sets of disclosure requirements. To reach this holding, the Ninth Circuit deferred to the SEC’s amicus brief, where the SEC stated that enforcement of California’s more stringent disclosure requirements would, among other things, disrupt national uniformity, increase NASD’s administrative costs, and may deter otherwise well-qualified individuals from serving as NASD arbitrators. Id. at 1136 (noting that the SEC is “in a unique position to evaluate whether application of the California Ethics Standards to NASD arbitrations would frustrate the objectives of the Exchange Act”). The result is that, if you arbitrate a claim in the FINRA forum, your arbitrator isn’t held to the same ethical standards as other arbitrators in your state. It’s no wonder that the vast majority of investors view the FINRA arbitral forum as unfair.
Investors Lose
Finally, investors are dissatisfied with FINRA arbitration because, more often than not, they lose – and the rate at which they lose has been increasing in recent years. For example, a study conducted by the Securities Arbitration Commentator found that customer win rates declined from 53 percent in 2001 to 43 percent in 2005. Years in Review, 2007 SEC Arb. Commentator 1, 3 (Feb. 2007). Other commentators have found that brokers are more likely to prevail on counterclaims against their customers, and that repeat players have a significant advantage over the individual customer. Richard Voytas, Empirical Evidence of Worsening Conditions for Investor in Securities Arbitration, 2002 SEC Arb. Commentator 7 (June 2002). This is unsurprising, given that FINRA arbitrators need not provide explanations for their awards, so the repeat defendant securities firm can reap the benefits of experience by arbitrating the same claim over and over, perfecting any defense or counterclaim, while the individual investor can’t learn from those who lost or prevailed before him or her.
Class Actions Against FINRA Members: the Diminishing Silver-Lining?
Perhaps the one aspect of FINRA arbitration that investors could be happy about was FINRA’s long-standing rule that FINRA members could not compel arbitration of their customer’s class claims, as the FINRA Code of Arbitration provides that “[c]lass action claims may not be arbitrated under the Code.” FINRA Code § 12204. Thus, according to FINRA’s arbitration rules, any investor was free to pursue his or her class claims against any FINRA member in court. However, this “silver lining” of the FINRA arbitration system may be diminishing, as a federal district court in Minnesota just last month held that, depending on the type of service the FINRA member provides, it may or may not be subject to FINRA’s Code of Arbitration, and therefore may or may not be able to ban its customers from bringing or participating in a class action at all. This is an extremely troubling development, and is one that will hopefully be the last straw in a long line of investor complaints about the fairness of the FINRA arbitration system.
The case is Bakas v. Ameriprise Financial Services, Inc., 2009 WL 2877974 (D. Minn. Sept. 3, 2009). Plaintiff Anastasia Bakas sued Defendant Ameriprise Financial Services on behalf of herself and a putative class of thousands of Ameriprise customers, asserting four causes of action: (1) breach of contract; (2) violation of the Minnesota Consumer Fraud Act; (3) violation of the Investment Advisers Act of 1940; and (4) a claim for injunctive relief. The average claim for each class member was $500.
Bakas signed an agreement with Ameriprise in June 2005 where Ameriprise was to provide her with an initial financial plan, as well as annually updated plans. However, Bakas alleged that she never received a financial plan from Ameriprise or an annual update, despite being charged for them. In 2006 and 2007, on the anniversaries of the signing of her initial contract with Ameriprise, Bakas signed additional contracts containing essentially the same terms – including an arbitration clause. The arbitration clause required arbitration of “[a]ny controversy or claim arising out of or relating to this contract or the breach thereof,” and also included a class action ban.
Ameriprise moved to compel Bakas to arbitration, which Bakas opposed, arguing that, as a member of FINRA, Ameriprise was bound to follow FINRA’s Code of Arbitration and therefore could not compel arbitration of her class claims. In an interesting move, Ameriprise argued that there exists a distinction between its activities as a broker-dealer on the one hand, for which it is subject to FINRA’s authority, and its activities as an investment adviser on the other, for which it is not subject to FINRA’s authority. Thus, the argument goes, because Ameriprise was acting only as an investment adviser with respect to Bakas – and not a broker/dealer – it need not follow FINRA’s rules, including the rules that govern arbitrations between FINRA members and their customers.
The court found Ameriprise’s argument persuasive and held that Ameriprise, in this instance, wasn’t bound by the FINRA Code of Arbitration, and therefore could compel Bakas to arbitrate her claims and enforce its class action ban against Bakas. It remains to be seen what FINRA will think of one of its members skirting around the rules by essentially denying its FINRA membership in circumstances where it happens to be acting outside of its broker/dealer capacity. It also remains to be seen whether other courts will buy into the broker-dealer/investment adviser distinction, although one Eighth Circuit case suggests that the Bakas decision may garner some support in the future. See Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770 (8th Cir. 2001) (“We do not believe that the NASD Rules were meant to apply to every sort of financial service an NASD member might provide, regardless of how remote that service might be from the investing or brokerage activities, which the NASD oversees.”). Regardless, it seems inherently unfair to investors that a securities firm, which openly advertises itself as a FINRA Member, need not actually comply with the many rules that FINRA imposes on its members to protect investors. Ameriprise states on the home page of its website and on its service agreements with its customers that it is a FINRA Member, see http://www.ameriprise.com/default-home.asp (“Member FINRA and SIPC”), and also appears on FINRA’s own “List of Members,” see http://www.finra.org/AboutFINRA/MemberFirms/ListOfMembers/ . Ameriprise’s customers should expect that, by virtue of its membership in FINRA, Ameriprise actually abides by FINRA’s rules, including those governing arbitration of investor disputes. According to the Bakas decision, however, this is not the case.
Conclusion
Is the Bakas decision the push FINRA needs to revamp its arbitration rules to provide investors with adequate protections against securities firms when a dispute arises between the two? Probably not. Even in the face of the SICA study, FINRA responded only to state, “We will continue to search for ways to improve the dispute resolution process, educate investors and implement changes that will further enhance the process.” Justin Kelly, Study Shows Mixed Views on Fairness of Securities Arbitration, 63 Disp. Resol. J. 9 (Oct. 2008). However, at a recent hearing of the House Financial Services Committee on capital markets regulatory reform, FINRA Chairman and CEO Richard Ketchum testified that FINRA would not object if mandatory arbitration was prohibited. Carol E. Curtis, State Regulators to Congress: End Mandatory Arbitration, Securities Industry News (Oct. 6, 2009). FINRA also recently announced the expansion of a “pilot program” where investors in certain types of cases, against a handful of firms that have agreed to participate in the program, can select an arbitration panel with three public arbitrators, and need not select one industry arbitrator. FINRA News Release, “FINRA to Expand Program Evaluating All-Public Arbitration Panels” (Oct. 5, 2009). While these are small steps toward a system that adequately protects the interests of investors, what cannot stand is FINRA members imposing arbitration clauses on their customers that prohibit their customers from bringing or participating in a class action when that is the customers’ only effective means of seeking redress for crimes committed by the firm.
Public Justice’s work in fighting unfair arbitration clauses in the consumer context has exposed that, in many cases, class action bans act as a “get out of jail free” card for the corporate defendant, and the same holds true when investors who have small-value, but complex claims against a securities firm are prevented from aggregating their class claims. Hopefully the Bakas decision will be an anomaly, but if it’s not, and FINRA does not take any action to clarify that its members are subject to FINRA’s rules no matter what hat they wear, then challenges to securities firms’ unfair arbitration clauses – especially those that effectively exculpate the firm from liability to its customers by banning class actions – must be brought through litigation to protect investors.
about the author
Amy Radon is the Goldberg, Waters & Kraus Fellow at Public Justice, where she practices in the firm’s Access to Justice, civil rights, and consumer rights litigation areas.