Securities Regulation and Litigation Lawyer & Attorney : OverRegd Blog : Lindquist & Vennum Law Firm, Minneapolis and Denver

The North American Securities Administrators Association will be holding a public forum on securities industry arbitration, on June 24 in New York City. 

NASAA, which is the organization of heads of securities departments from each of the American states and territories, as well as the Canadian provinces and Mexico, has long perceived industry securities arbitration as unfair to investors.  The organization has advocated for substantial changes in the arbitration system, including abolition of mandatory arbitration.

NASAA's position on securities arbitration is abundantly clear in the title of the upcoming forum:  Arbitration is Broken:  How Can it be Fixed?  According to NASAA, the forum "will feature a panel of legal and regulatory experts, academics, and consumer advocates who will address the manner in which arbitrations are conducted; whether the selection, qualification, and composition of arbitration panels is fair; and whether the arbitration process should be an option, not a requirement, for investors. Panelists also will discuss the Arbitration Fairness Act of 2007 and current research exploring consumer views on securities arbitration."

Registration for the forum is free, on a first-come-first served basis.  Registration details are on NASAA's website.

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There’s a timely article up at Bloomberg regarding the ongoing back and forth between the securities industry and claimants’ bar regard the fairness of mandatory industry arbitration. The article cites the recent survey on claimant perceptions of arbitration fairness commissioned by the Securities Industry Conference on Arbitration ("SICA"), and conducted by the Investor Rights Clinic at Pace University Law School.

The SICA survey, together with a to-be-expected rebuttal piece from SIFMA, point out the sharp differences in perception regarding whether the current arbitration system is fundamentally biased toward firms. The SICA survey pointed to, for example, the declining numbers of hearings ending in awards, as well as the increasing number of early settlements. Does this show that the system is increasingly stacked against investors? Does it indicate, rather, that firms identify meritorious cases and settle, rather than defend through a hearing? Can any generalizations be drawn about the large number of industry and public arbitrators, other than that every lawyer and firm in this area – whether on the claimant or defense side – has had both fair results and real head-scratchers.

One thing is clear: both investors’ groups and state regulators will continue to push FINRA to make its arbitration forum more investor-friendly – or to eliminate mandatory arbitration entirely.

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In December 2003, the SEC approved NASD Conduct Rule 2130, ending the moratorium on expungement that had been in effect since January 19, 1999. Under Rule 2130, the Financial Industry Regulatory Authority (FINRA) will not oppose expungement relief in a court confirmation process if the arbitrator makes an affirmative finding that:

1. The claim, allegation, or information is factually impossible or clearly erroneous;
2. The registered person was not involved in the alleged investment-related sales practice violation, forgery, theft, misappropriation, or conversion of funds; or 
3. The claim, allegation, or information is false.

The rule was designed to meet the varying and often competing interests of the regulators, the brokerage community, and investors.

Last week the Public Investors Arbitration Bar Association (PIABA) urged the SEC and FINRA to prohibit arbitrators from recommending the expungement of customer dispute information from the Central Registration Depository (CRD). According to PIABA president  Steven B. Caruso, review of more than 200 stipulated or settled customer awards issued in 2006 revealed that in 71% of the stipulated arbitration awards, arbitrators recommended the expungement “without any indication of an evidentiary hearing having been held.” Caruso asserted that critical information investors need to know is being “improperly concealed.”

But must an arbitrator conduct an evidentiary hearing to be able to make an affirmative finding that the claims and allegations are false or clearly erroneous, or that the registered person was not even involved in the alleged wrongdoing? Can’t such an affirmative finding often be determined simply based on the pleadings, the often exhaustive exhibits attached thereto, or the terms of the settlement agreement? Compelling arbitrators to conduct evidentiary hearings before ever recommending expungement will increase arbitration costs, reduce the number of settlements, and force the parties to reach a settlement on the amount of cooperation claimants will give during the evidentiary hearing.

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Investors frequently pursue “selling away” claims against brokerage firms, alleging that the brokerage firm is somehow responsible for the actions of its registered representative, even if the firm was not aware of the broker’s activities, and did not profit from them. In most cases, brokerage firms vigorously defend against such claims, and in my experience, Courts and NASD Panels justifiably scrutinize such claims with a great deal of skepticism. 

But occasionally such claims are successful. And a recent case demonstrates once again that a claimant who obtains an award in an NASD arbitration almost always will be successful resisting any attempt by the brokerage firm to vacate the award.

In Walnut Street Securities, Inc. v. Bonnie Lisk, 2007 WL 2094902 (M.D. N.C. 2007), 18 investors purchased unregistered securities of a fraudulent investment called ETS Payphones, Inc. But the investors did not purchase these securities through Walnut Securities or its registered representative. Rather, they purchased the securities from a separate corporation owned by the representative and her daughter. 

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Check out this article from the Sunday edition of the New York Times which examines potential flaws in the process in which arbitrators disclose their conflicts in securities arbitrations. The story focuses on a couple who lost $48 million of their $60 million stock portfolio, which they had invested primarily in Level 3 Communications and WorldCom. The couple sued their broker for allegedly failing to diversify their portfolio.

Although, at first glance, the case seems like another run-of-the-mill securities case in the wake of the tech bubble burst (albeit an expensive one), the interesting fact is that four days before the arbitration hearing was to scheduled to begin, plaintiffs’ counsel discovered that the chair of the arbitration panel had a significant conflict-of-interest. It turns out the chair’s firm represented  the broker on numerous occasions in the past 5 years. The NASD removed the chair and indefinitely postponed the hearing date until a new chair could be appointed.

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NASD arbitration securities practitioners beware - you are no longer dealing with the "old" NASD Code of Arbitration Procedure.  Effective April 16, 2007, NASD arbitration proceedings initiated after this date will be governed by a new Code of Arbitration Procedure - and there are plenty of new provisions and changes to learn.  Everything from deadlines to motion practice and even the powers of the Director of Arbitration have been altered, codified, or clarified.

To aid parties and counsel in understanding the plethora of changes, the NASD has posted a detailed chart comparing new and old provisions of the Arbitration Codes relating to customer disputes, which even breakdowns and separates the substantive from more stylistic changes.

The NASD has posted on-line the 165-page chart discussing the changes at  www.nasd.com/web/groups/rules_regs/documents/rule_filing/nasdw_018366.pdf

Obviously, it is much too early to determine what, if any, impact the changes will have on NASD arbitration proceedings. But given the substance and number of changes made, NASD arbitration practice will undoubtedly evolve to keep pace.

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If a private litigant or its counsel were to lose critical documents in a lawsuit, or fail to take reasonable steps to preserve such documents, they would have to defend against charges of “spoliation of evidence” and face potential sanctions ranging from fines to adverse evidentiary presumptions, or even the entry of a default verdict. What happens when the NASD loses all the evidence submitted at an NASD arbitration proceeding and the tapes of the hearing? Not much.

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Go and catch a falling star,

Get with child a mandrake root,

Tell me where all past years are,

Or who cleft the devil's foot,

Teach me to hear mermaids singing,

Or to keep off envy's stinging,

And find what wind serves to advance an honest mind.

                                          John Donne

Like the person “true and fair” that John Donne seeks in his “Song”, successful motions to vacate arbitration awards are rare. When they are successful, they invariably are based on arbitrator bias. Indeed, given the informalities and lack of review inherent in the arbitration process, if the parties cannot trust that the neutral deciding the case is “true and fair,” the entire process seems fundamentally unfair. The Fifth Circuit Court of Appeals affirmed this fundamental policy in Positive Software Solutions, Inc. v. New Century Mortgage Corp. , No. 04-11432 (11th Cir. January 11, 2006). In that case, the sole arbitrator in a AAA arbitration failed to disclose that he and his law firm had acted as co-counsel with the counsel for the successful arbitration party in patent litigation that lasted 7 years. The losing party discovered this fact after the arbitration by conducting a computer investigation of the arbitrator. (It is unclear why this investigation was not conducted beforehand, and why there were no consequences for the failure to do so before the arbitration.) The Court determined that the failure to disclose these facts might create a reasonable impression of the arbitrator’s partiality. Thus, the Court vacated the award based on Section 10(a)(2) of the Federal Arbitration Act for “evident partiality.”

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According to a recent New York Times article, an average NASD arbitration, which is promoted as a quicker alternative to litigating in state or federal court, now takes 14.3 months to resolve. Even more troubling are the alleged conflicts of interest, which, according to the article, exemplify growing criticisms that the NASD is not doing enough to ensure that its arbitration panels are unbiased.

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At the March 21, 2006 breakout session at the SIA Compliance and Litigation conference involving arbitration, Linda Fienberg, NASD, discussed two changes to NASD arbitration rules of special interest to the industry. The first rule -- "the explained award rule" -- will require arbitrators to provide explanation or rationale for their awards. This rule change stems from concerns raised by investor advocate groups, who wanted more clarity for investors regarding arbitration results. Feinberg indicated that the NASD received around 200 comment letters to the proposed Rule, mostly from industry representatives expressing concerns that the new Rule will result in higher costs and confusion as to what is expected of arbitrators. Fienberg said that while the NASD does plan to go ahead with the Rule, language in the final Rule will stress that explained Awards will not be of precedential value and are to be used only for the information of the parties. She also said that the NASD will provide examples as to the level of detail in Awards intended by the new Rule, stressing that Awards will not need to address each and every cause of action set forth in the Statement of Claim.

Feinberg also informed conference participants that the NASD will soon be filing a revised version of the non-party subpoena Rule. Under the revised Rule, only arbitrators - not attorneys - can issue subpoenas. Also, the revised Rule requires a party receiving subpoenaed records to notify the other parties within five days of receipt of documents. Attendees expressed concern with the proposed revisions, noting that subpoenaed records from brokerage firms are often the only records received of customers' trading histories. Industry members fear that requiring arbitrators to sign subpoenas will result in delay and, perhaps, an inability to obtain documents where inexperienced arbitrators do not understand the importance of brokerage account records. Fienberg said that the NASD will provide an opportunity to comment on the proposed changes to this Rule.

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