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Arbitration of Securities Cases Arbitration Is Here to Stay A common complaint of federal and state judges is that they no longer get to try many cases. Of the many reasons for this, the rising incidence of binding arbitration is near the top of the list. For example, arbitration has conspicuously displaced litigation as the primary means by which securities disputes are resolved on their merits. Long before arbitration became common in other areas of the law, it was a fact of life in the highly regulated securities industry, for both customer and employment cases. Lawyers often complain that arbitration is an unfamiliar, even terrifying process, which encroaches upon the right of trial by jury. This article seeks to dispel the myths and to familiarize the reader with the arbitration process as it works in securities cases. Arbitration is not so foreign to our basic sense of jurisprudence that a lawyer should fear it when considering taking on a securities case. Since arbitration of securities cases is here to stay, a lawyer’s continued ignorance of it is perilous. Securities Arbitration Is a Creature of Contract, Enforceable by Federal LawWhy are some cases arbitrated rather than litigated? No case is referred to arbitration unless there is a written, signed agreement between the parties specifically providing forarbitration. In the securities industry, arbitration agreements are usually included as standard provisions in the written agreements by which a customer opens an account with a brokerage firm or investment adviser.1 They typically cover any claim that a customer might make for losses arising from investments made in an account. In order to provide services to its customers, a securities brokerage firm must purchase and sell securities on national exchanges. Because this activity involves interstate commerce, courts have universally held that arbitration agreements with securities firms are governed by the Federal Arbitration Act (“FAA”).2 Because of the FAA’s applicability, the Texas Arbitration Act is preempted to the extent that it conflicts with the FAA.3 However, because the FAA is enforceable in both state and federal courts, state courts are often called upon to enforce arbitration agreements under the FAA.4 In the event a suit is filed in court on behalf of a customer whose securities account agreement contains an arbitration provision, it is virtually certain the brokerage firm or investment adviser will obtain an order from that court, compelling arbitration. When a case is subject to arbitration under either the federal or the Texas Act, trial proceedings are stayed pending the completion of arbitration.5 By this statutoryframework, the merits of such a case are decided in arbitration, and a court keeps a hands-off posture during that process. Is Arbitration Fair?The sponsoring organization for arbitration of securities cases is a quasi-public agency now known as “FINRA.”6 It has promulgated a detailed Code of Arbitration Procedure that sets out the ground rules for securities arbitrations.7 Despite the misconception that arbitration is an inscrutable process, the Code has much in common with the federal and Texas rules of civil procedure — save for the obvious difference that it concerns an adjudicative process presided over by arbitrators, rather than by a judge or jury. Persons wishing to become arbitrators for FINRA must meet rigorous qualifications and successfully complete a training course that emphasizes the need for arbitrators to provide a scrupulously fair forum for investor complaints. Since it is usually an investor’s sole remedy, FINRA’s arbitration program is subject to extensive oversight by the SEC, and ultimately by Congress. Although some attorneys and members of the public who are unfamiliar with arbitration still characterize it as a whitewash for the sins of the securities industry, the facts prove otherwise. In 2008, approximately 74 percent of customer claimant cases resulted, through settlements or final awards, in recovery for the investor.8 Myth v. Reality: Arbitration Compared to Litigation:Myth: Judges always know what the law is and apply it impartially. A judge is more likely to “get it right” than an arbitrator. Myth: Since there is no jury, arbitration promotes a private system of justice that does not reflect the values of the community. Arbitration is structurally unfair to consumers. Myth: Arbitration is second-class. A trial in state or federal court is the real thing. Reality: No arbitrator will ever ask you –or your opponent – for a campaign contribution. Reality: Most securities arbitrators are capable, highly responsible citizens of their communities – exactly the types of persons that both plaintiff and defense counsel would be unlikely to strike from a jury panel. Reality: Arbitration as a forum allows advocates to seek a just resolution of cases, with a greater opportunity to argue for a fair result, regardless of legal technicalities. Arbitrators can “split the baby.” Courts usually cannot. Reality: As long as cases are decided by human beings (judges, jurors, or arbitrators), the decision-making process will be imperfect. Get used to it! Types of Securities Arbitration CasesThis article deals primarily with customer (investor)cases, in which monetary damages are sought against a brokerage firm or investment adviser who selected or recommended loss-generating investments. However, other types of cases that arise in the securities industry are also frequently arbitrated, especially post-employment cases filed by terminated brokers (usually involving claims for compensation or deferred compensation, and possibly non-competition or non-solicitation issues); and “clearing” disputes between a financial planner/investment adviser and the broker-dealer through whom trades are cleared on a stock exchange. Typical Fact Patterns, Claims, and Defenses in Customer CasesTypical fact patterns: (a) Unsuitability, failure to tailor investment recommendations to the needs of the client; (b) failure to diversify the portfolio between equities, bonds, cash; (c) failure to disclose material facts or risks; (d) churning/excessive trading;9 (e) unauthorized trading; or failure to execute orders timely or at the best price; (f) faulty tax advice, resulting in greater tax liability for the investor; (g) undisclosed compensation arrangement motivating broker to push unsuitable securities; (h) brokerage firm’s failure to supervise broker; (i) market manipulation (thinly capitalized “penny stocks”); (j) “Ponzi scheme:” theft or diversion of invested funds.10 Typical claims: Claims for fraud, negligent misrepresentation, and breach of fiduciary duty are commonly asserted. Federal statutes often relied upon in securities arbitrations include the Securities Act of 1933, 15 U.S.C. §77, and the Securities Exchange Act of 1934, 15 U.S.C. §78 (and SEC Rule 10b-5). Possibly applicable Texas statutes include the Texas Securities Act (“Blue Sky Law”), TEX. REV. CIV. STAT. §581-33; the Texas fraud statute, TEX. BUS. & COMM. CODE §27.01; and the Texas Deceptive Trade Practices Act, TEX. BUS. & COMM. CODE §§17.41 - 17.63.11 Typical defenses: (a) No causation, market losses beyond the control of the investment professional; (b) due diligence; reasonable basis to believe in the suitability of a recommended investment, especially published reports; (c) broker or investment adviser did not control investment decisions; (d) customer did not rely on broker for recommendations but only to execute trades; (e) limitations/eligibility;12 (f) ratification: i. e., customer received account statements, never complained or sought to rescind any transaction; (g) customer was financially sophisticated, especially if there is a prior history of speculative investments or investments of the same type on which the current claim is based; (h) customer understood risks inherent in investing in the stock market;13 (h) customer’s failure to mitigate damages; (i) faulty damage model, selecting losing transactions only while not allowing credit for transactions that were profitable for the investor. Composition of FINRA Arbitration PanelsAll arbitrators who hear FINRA cases are neutrals, certified by FINRA after required training and examination. For customer cases where the amount in controversy exceeds $100,000, FINRA convenes a panel of three arbitrators (two “public” arbitrators and one “industry” arbitrator) (FINRA Code §§ 12401 (c) and 12402.). Cases in which less than $25,000 is in controversy are subject to “simplified arbitration” before one (public) arbitrator (FINRA Code §12401(a)); and for cases involving claims ranging between $25,000 and $100,000, the parties may elect to have either one arbitrator or a panel of three arbitrators. (FINRA Code §12401(b)). In contrast to random assignment of a trial judge to hear a court case, parties in securities arbitration exercise substantial control over the process of selecting who will ultimately decide the merits of the case. For three-arbitrator panels, FINRA sends out to both sides a strike/ranking list of proposed chairperson (public arbitrator) and proposed public and industry panelists. The lists include extensive biographical profiles on the prospective arbitrators recapping their employment history and dealings with brokerage firms, and a listing of prior final awards in FINRA/NASD cases on which the prospective arbitrator has served. (The complete final award for each such case can be pulled up from the FINRA website—a veritable gold mine of information for an attorney in striking and ranking prospective arbitrators for a case.) FINRA composes a three-arbitrator panel by compiling the results after both sides’ peremptory striking of unacceptable prospective panelists on the list, and numerical preference ranking of the ones not stricken by either side. Arbitrators who are selected for a panel must then specifically disclose any relationships with parties, counsel, or witnesses in the case, and are subject to being stricken from the panel on the basis of such disclosures (FINRA Code §§ 12409 and 12410). The opinion often voiced by inexperienced counsel—that arbitrators are biased in favor of the securities industry—is not one shared by most attorneys experienced in handling such cases, including those who represent claimants. The striking/ranking process, the heightened level of disclosure of potential conflicts that is required of arbitrators and prospective arbitrators, and the frequent willingness of an industry arbitrator to come down hard on broker misconduct (because an errant broker is a “rotten apple” in the industry’s barrel)—all contribute toward leveling the playing field. DiscoveryDiscovery in FINRA arbitration is intended to be more streamlined than in litigation. “Paper” discovery—production of documents and providing certain discoverable information in writing—is not that much different from litigation. The FINRA Discovery Guide makes certain enumerated documents presumptively discoverable in customer cases, and production of additional documents may also be requested. The FINRA Code also allows for service and answering of written Requests for Information (FINRA Code §12507(a)(1).) Requests for information are similar to interrogatories. But the scope of information that can be sought by requests for information is considerably narrower than that for interrogatories. The major difference in discovery with FINRA arbitration vis-a-vis litigation is that oral depositions are not allowed, unless the panel, on motion and pre-hearing conference, allows otherwise (per FINRA Code §12510), or if the parties agree to conduct depositions (which is unusual, except in large, complex cases). If a discovery dispute arises, it is usually resolved in a telephonic pre-hearing conference conducted by the chairperson of the panel. The FINRA Code requires parties to exchange witness lists and documents to be used as exhibits in the case-in-chief 20 days before the final hearing date (FINRA Code §12504). Expert WitnessesUse of expert witnesses in securities arbitrations has become a growth industry. Many financial planners and other investment professionals, including retired ones, actively seek out such engagements. Subject matters on which experts might offer opinions in customer cases include: (a) suitability of the investment recommendations for the client’s risk profile; (b) whether the portfolio was adequately diversified; (c) whether the sales practices at issue met applicable legal and ethical standards; (d) adequacy of a firm’s supervision over a broker; (e) interpretations of arcane statutes for which the expert is uniquely qualified to opine (especially statutes and regulations re: tax treatment of investment transactions); (f) calculation of monetary damages; or refuting the damage calculation urged by the opposing side. Final Hearing, Award and Post-AwardExcept for the obvious difference that a FINRA arbitration takes place in a rented conference room before a panel of arbitrators, rather than in a courtroom before judge and jury, the final hearing is conducted much like a court trial. FINRA has the power to subpoena witnesses in the industry, and their documents (FINRA Code §§12512 and 12513). Hearings are tape-recorded. A party may have a court reporter present to take down the proceedings at that party’s expense, or the arbitrators may order the taped record to be transcribed (FINRA Code §12606). Opening statements are usually made. Witnesses testify under oath, and exhibits are offered for admission just as in a trial. Evidentiary objections are resolved by the chairperson. Panelists may question witnesses and usually do. Closing arguments are usually made. The panel may ask for post-hearing briefs to be submitted, especially if the case presents novel legal issues. The panel’s decision on the merits, usually issued within 30 days of the close of the hearing (FINRA Code§12904(d)), is made in a written final award, signed by the panelists (one of whom may dissent). FINRA maintains a database of all final awards. The final award must make some provision for assessing costs, and may include an award of attorney’s fees for a successful claimant. A brokerage firm or registered representative in the industry must pay any monetary award within 30 days of issuance, per FINRA Code §12904(i), or suffer regulatory penalties, including possible loss of licensing and/or referral to SEC for enforcement or penalty proceedings. In cases of serious misconduct, the panel’s award mayrefer the broker or firm to FINRA for disciplinary charges. Where the customer’s case is found to lack any merit, and under certain other limited circumstances, expungement of the case from the broker’s record in the industry may be recommended by the panel, but must be confirmed by a court of competent jurisdiction to be effective (FINRA Code §12805, and Rule 2130). 14 Under both the Federal and Texas Arbitration Acts, a court may enter judgment confirming an arbitration award, on application of a party to the award.15 Such judgment is then enforceable as any other court judgment. Both Acts also provide for possible motions to a court to vacate or modify an arbitration award.16 However, the grounds for doing so are extremely limited, requiring a more rigorous showing than mere error of law or fact.17 Mark C. Watler is of counsel at Ross, Banks, May, Cron & Cavin, P.C. He has represented investors, brokers and brokerage firms in securities cases, and has also served as a neutral arbitrator and mediator. Watler is Board Certified in Civil Trial Law and is a frequent CLE speaker on securities arbitration. Endnotes1. The account agreement by which a customer opens a securities account at a brokerage firm is almost always a non-negotiated, form document. Even if it can be characterized as a contract of adhesion, the Texas Supreme Court has held that neither adhesion contracts nor arbitration agreements contained within them are per seunconscionable. In re: U. S. Home Corp., 236 S.W.3d 761 (Tex. 2007). 2. Citigroup Global Markets, Inc. v. Brown, 261 S.W.3d 394, 399 (Tex. App.—Houston [14th Dist.] 2008, no pet.); UBS Fin. Servs. v. Branton, 241 S.W.3d 179, 183 (Tex. App.—Fort Worth 2007, orig. proceeding); In re Raymond James & Assocs., Inc., 196 S.W.3d 311, 321 (Tex. App.-Houston [1st Dist.] 2006, orig. proceeding); In re Merrill Lynch, Pierce, Fenner & Smith, Inc., 195 S.W.3d 807, 812-13 (Tex. App.—Dallas 2006, orig. proceeding); Merrill Lynch Trust Co. FSB v. Alaniz, 159 S.W.3d 162, 166-67 (Tex. App.—Corpus Christi 2004, no pet.); In re MONY Sec. Corp., 83 S.W.3d 279, 282-83 (Tex. App.—Corpus Christi 2002, orig. proceeding). 3.In re Merrill Lynch, Pierce, Fenner & Smith, Inc., 195 S.W.3d 807, 812-13 (Tex. App.—Dallas 2006, orig. proceeding); Wachovia Sec., LLC v. Emery, 186 S.W.3d 107, 111 (Tex. App.—Houston [1st Dist.] 2005, no pet.). 4. Solis v. Evins, 951 S.W.2d 44, 48 (Tex. App.—Corpus Christi 1997, orig. proceeding). 5. The mandatory stay of trial proceedings pending the completion of arbitration is found in the Federal Act at 9 U.S.C. §3, and in the Texas Act at TEX. CIV. PRAC. & REM. CODE §171.025. 6. “FINRA” is the “Financial Industry Regulatory Authority.” It was formed in 2007 by merging the NASD– Office of Dispute Resolution with the New York Stock Exchange Board of Arbitration. Its website is www.finra.org/ArbitrationMediation/index.htm 7. Actually, there are two FINRA Codes of Arbitration Procedure. One governs customer cases, the other “industry” (employment) cases. 8. See FINRA “Dispute Resolution Statistics,” available on-line from the FINRA website. 9. In the typical situation, the relationship between broker and investor is not deemed to be a fiduciary relationship. However, there may be particular facts in a case to support the theory that a fiduciary relationship existed and was breached by the broker, especially where the customer is financially unsophisticated, elderly, incapacitated, etc. 10. It is typical for claimant’s counsel to seek, in addition to recovery of claimant’s monetary damages, an award of claimant’s reasonable attorney’s fees, so that the claimant is made whole for losses– i.e. claimant would have an uncompensated loss if he recovered only account losses, but then had to pay attorney’s fees out-of-pocket. 11. See this author’s article: The Applicability of the Texas Deceptive Trade Practices Act toSecurities Cases, Texas Bar Journal (June 2001, Vol. 64, pp. 542- 554). 12. The FINRA Code of Arbitration Procedure provides for a six-year period of “eligibility” for filing of claims, while also providing that such shall not be construed as extending any applicable period of limitations under state or federal law. (FINRA Code §12206(a) and (c)). FINRA recently amended its Code to make it more difficult for a brokerage firm to obtain dismissal of a case on its merits through a dispositive motion (the functional equivalent of a motion for summary judgment in litigation) without a full evidentiary hearing. (FINRA Code §12206(b)). 13. The prior and subsequent investment history of the claimant usually becomes an important issue in the case. 14. Expungement can only be recommended after the panel follows strict procedural guidelines set out in FINRA Code §12805. It is not routinely available, so as to safeguard the integrity and accuracy of a broker’s public record concerning customer complaints. 15. 9 U.S.C. §9; and TEX. CIV. PRAC. & REM. CODE. §171.087. 16. 9 U.S.C. §§ 10, 11, and 12; and TEX. CIV. PRAC. & REM. CODE §§171.088 and 171.091. 17. See Citigroup Global Markets, Inc. v. Bacon, 562 F. 3d 349 (5th Cir. 2009) (“manifest disregard of the law” not a grounds for court to vacate arbitration award under Federal Arbitration Act); Callahan & Associates v. Orangefield Indep. School Dist., 92 S.W.3d 841 (Tex. 2002).
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