FINRA arbitration rules too shareholder friendly and may encourage spurious claims
When the National Association of Securities Dealers (NASD) and NYSE Regulation merged into the Financial Industry Regulatory Authority (FINRA), the idea was to simplify regulation by creating a single set of rules. The result, however, may be the opposite: some of the new rules governing customer dispute arbitrations are raising the eyebrows – and irritation levels – of brokers who see some of the changes as overly favoring investors.
FINRA has an arbitration program for disputes between customers and their brokers that is considered important to the industry. In fact, arbitration is widely supported by the government and most regulators as a measure to avoid costly damages disputes. Most securities dealers have contracts that mandate FINRA arbitration if a customer has a complaint that cannot be directly resolved. According to FINRA spokesperson Brendan Intindola, changes in rules have generally been ‘to maintain and increase the fairness and efficiency of arbitration.’
Ralph De Martino, chair of the securities regulation and compliance practice at Cozen O’Connor, shares this view. ‘Some of the changes that took place were merely the consolidation and revision of the rules generally and didn’t reflect significant changes,’ he points out.
While some brokers think the rules are skewed too heavily toward customers, some dealers and their lawyers are welcoming the changes. Earlier this year, for example, the SEC approved increasing the threshold for single arbitrator cases to $100,000.
‘That will cut costs and streamline the process,’ asserts Scott Holcombe, general counsel at broker and investment banking firm JP Turner. ‘Some of the moves FINRA has made have been designed to improve efficiency and reduce costs, and I think those moves are certainly laudable.’
Shutting the door on dismissal
Other rules are proving somewhat less endearing to brokers and their representatives. One that is turning out to be particularly contentious is the new rule relating to the handling of motions to dismiss, which was initially passed last year and took effect during 2009.
‘It was previously the case in NASD arbitration that you could file a motion to dismiss or for summary judgment at any point,’ De Martino says. Now, even if the broker thinks the customer’s claim is baseless, it cannot present a motion to dismiss until the actual hearing on the matter, unless the broker can show the matter has been settled or the statute of limitations has passed on the claim.
‘The recent changes to the motion to dismiss rules in the FINRA dispute resolution process were designed to prevent respondents – whether member firms or brokers – from delaying the process and increasing the expense in the hope that a disgruntled investor would either run out of money or run out of steam and agree to settle the case for a smaller amount,’ explains Ivan Knauer, a former senior SEC enforcement attorney and partner at Pepper Hamilton focusing on securities-related defense work.
What troubles brokers and defense lawyers about the rule change is that, they claim, it tips the economic dynamics strongly in the direction of claimants, particularly when the amount in question is $50,000 or less.
Not worth the effort
‘If a claimant files a clearly baseless claim, the respondents have no choice but to go through the whole process of discovery, preparing for the hearing and even having the hearing, before filing that motion,’ says De Martino. ‘From a settlement and negotiation perspective, that’s an expensive process.’
To mount a defense against a claim for $50,000, costs could run between $35,000 and $40,000 on the low end, and as high as $75,000. That amount becomes a sunk cost, and the broker faces the possibility of losing the case, adding another $50,000 on top of it. Many experts feel this disproportionate cost could lead to undue pressure for brokers to settle claims, particularly once investors realize this disparity exists and begin to manipulate the situation. In turn, the fear is that this will lead to an increase in spurious cases as claimants realize it is often cheaper for dealers to settle than it is for them to fight.
‘Say someone claimed $25,000,’ De Martino explains. ‘If the lawyer is being a good adviser, he’s going to say, Let’s settle for $10,000 now.’ In the past, some brokers have fought every single claim on principle, holding that immediately settling any case would only make them targets for more investor lawsuits. But when a major defense tool is taken out of their hands, the approach may suddenly become far more expensive in total.
According to FINRA, the organization saw 4,982 arbitration cases filed in 2008, and 2,403 filed from January through April 2009. Of the cases that went to arbitration last year, customers were awarded damages 42 percent of the time. In 2008 almost three quarters of the cases resulted in monetary or non-monetary recovery for investors through settlements or awards. In 2009, through April, 47 percent of cases resulted in damages being awarded to the investor. Not the best odds to bet on.
‘My experience was that, before the meltdown in the market in the last year, if a dispositive motion wasn’t generated, the arbitration panel’s general response was to split the baby, so dispositive motions were very important,’ De Martino says. ‘If you could claim a legal basis for why the claim shouldn’t go forward, the process was down.’
The economics change in larger claims because the stakes are larger and the size of a settlement is more likely to outweigh the defense costs.
Resetting the clock
A second change that is causing some consternation is one regarding the so-called tolling rule on the statute of limitations, which, in effect, discounts the time taken to conduct arbitration from the time limit.
‘The rules used to say, We’re bound by applicable law,’ explains Holcombe. If a state did not provide for tolling that statute of limitations, then the arbitration process would count against that time limit. If an arbitration process – which, according to Holcombe, can last anything from a few months to a year – happened to run to completion, the claimant would not be able to bring an action in court. But now all arbitrations toll the applicable statute of limitations, potentially leaving a dealer open to action for a longer period of time.
Another rule that may potentially prove troubling to individual brokers has been proposed. Arbitration has traditionally been the method of choice in handling disputes between a registered securities dealer and a brokerage firm. The representative panels in such cases have been largely staffed with former members of the securities industry, under the assumption that people unfamiliar with the industry might misunderstand the issues at question. Under the proposed rules, brokerages could, through a technical maneuver, forbid the use of all so-called public arbitrators that don’t have industry affiliation.
The concern, of course, is that the public arbitrators would tend to favor the securities companies at the expense of the individual dealers.
