SEC May End Brokerage Mandatory Arbitrations

October 2010

A little-known provision within the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 contains a provision that could dramatically impact how security investment disputes are resolved between brokers and their customers. The Securities and Exchange Commission (SEC) now has the power to remove mandatory arbitration language that is currently part of all client-broker agreements. These mandatory arbitrations are conducted by the Financial Industry Regulatory Authority (FINRA).

The U.S. Supreme Court confirmed the lawfulness of mandatory arbitrations in Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987). Currently, brokerage customers must submit to mandatory arbitration through FINRA because of requirements contained in the account opening documents. For the typical (and even not-so-typical) investor, customers have no choice regarding arbitration because the practice is industry-wide, and no broker will ordinarily waive the arbitration provision. Under a possible rule change, investors could still use arbitration; they would simply not be required to use arbitration.

Unlike numerous of other sections in Dodd-Frank that require the SEC to study an issue before making changes, this provision allows the SEC to introduce a new rule immediately. Specifically, SEC. 921, entitled “AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION” amends both Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 780), and Section 205 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-5) by including the following:

AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.-The Commission, by rule, may prohibit, or impose conditions or limitations on the use of agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.

FINRA arbitrations have been widely criticized by investor groups and consumer advocates. The investment industry wins approximately 70% of all arbitrations FINRA conducts. In those rare disputes that are not conducted by FINRA, investors/plaintiffs have fared better.

Of course, the securities industry contends that the poor investor showing occurs because the plaintiffs’ claims are usually weak. However, investor advocates counter that poor claimant results are at least partially caused by the current FINRA requirement that, for claims over $100,000, a three-person arbitration panel serves, and one of these arbitrators must be an industry representative. FINRA states the industry representative is intended to educate the other arbitrators about industry conditions. However, in a court system, a plaintiff would never consider allowing the defendant to have its representatives make up a third of the jury, regardless of how smart those defendant representatives were.

During the last two years, FINRA ran a limited pilot program with 14 brokerage firms that gave investors the option of NOT having an industry representative on the arbitration panel. The pilot was extended for a third year. As of September 28, 2010, approximately 560 cases were part of this program. According to FINRA, investors given an option chose to have their case heard by an all-public panel 60% of the time. At the end of the first two years, 23 cases reached a verdict without a settlement. Not surprisingly, investors fared considerably better in cases without an industry representative on the panel. FINRA contends that the sample size is too small to reach any reliable conclusion regarding the result difference. However, if FINRA were open to changing this conclusion, our firm would run the statistical tests for FINRA for free. The statistical tests would show that having an industry expert on the panel is statistically significant in terms of whether the plaintiff or the defendant won.

Regardless of FINRA’s stubborn refusal to acknowledge that industry experts affect the panel results, FINRA is obviously concerned about a continued public outcry that might encourage the SEC to eliminate FINRA’s arbitration monopoly based on the new Dodd-Frank law. Accordingly, on September 28, 2010, FINRA proposed to the SEC that the requirement for an industry representative be eliminated.

FINRA, and practically every broker that FINRA regulates, contend that FINRA’s monopoly on dispute resolution is in consumers’ best interests. If consumers believed this, FINRA would not need to lobby for the status quo, since consumers would continue to use FINRA’s dispute forum. The fact that FINRA and the brokerage community need to sell the arbitration advantages so hard is perhaps the best indication that they are wrong.

Expect considerable lobbying from both sides of the issue, both before the SEC proposes a change under Dodd-Frank Section 921, and during whatever formal rulemaking process the SEC proposes. Stated otherwise, don’t expect to take to court your dispute against your broker for a long while.

Fulcrum Inquiry analyzes damages in litigation and arbitration, and performs forensic accountings and business valuations.