So…What is FINRA Arbitration?

We have written before about the fact that if you open a securities account with almost any broker-dealer, you have, perhaps unknowingly, waived your right to sue your broker in a court of law and have contracted to settle any dispute you may have by arbitration.  So what is mandatory pre-dispute securities arbitration?  Let’s start with a historical perspective.

The History of Securities Arbitration.       Perhaps the best place to start is the 7th Amendment to the United States Constitution (part of the Bill of Rights) passed by Congress on September 25, 1789 and ratified on December 15, 1791.  The 7th Amendment preserves a right to a civil jury trial in suits brought under the common law provided the amount in controversy exceeds twenty dollars.  The 7th Amendment applies only to federal courts, however over 75% of the states ratified the Amendment as state law.  Section 7 of the Kentucky’s Constitution, likewise provides that “trial by jury shall be held sacred, and the right thereof shall remain inviolate …”  So both federal law and most state’s laws preserve the common law right to a civil jury trial.  Even with these Constitutional provisions, since the beginning of stock and bond trading in the United States, voluntary arbitration has be utilized in the securities industry as a means to resolve disputes.

In 1925, Congress enacted the Federal Arbitration Act (“FAA”) which declared pre-dispute arbitration agreements in contracts involving commerce as “valid, irrevocable and enforceable”.  FAA, 9 U.S.C. §2.  The pre-dispute arbitration clause was then fortified and protected by federal law.

Then in 1933 and 1934, in wake of the financial markets debacle and the Great Depression, Congress passed the Securities Act (of 1933) and the Securities Exchange Act (of 1934).  These laws seem to conflict with the FAA because they contain anti-waiver provisions which provide that any condition, stipulation, or provision waiving compliance with any provision of either Act is void.  The Supreme Court held that the anti-waiver provisions in the Securities Act made pre-dispute arbitration clauses unenforceable and cases involving securities law violation proceeded in court.  At that time, the federal securities laws trumped the FAA.  That changed in 1987.

In 1987, the Supreme Court decided Shearson/American Express, Inc. v. McMahon holding that claims brought under of the Securities Exchange Act (Rule 10b-5) were arbitrable.  Two years later, in Rodriguez de Quijas v. Shearson/American Express, Inc., the Court held that claims arising under the Securities Act of 1933 also were arbitrable.  That opened the flood gates for mandatory securities arbitration and the proliferation of pre-dispute arbitration agreements embedded in the account opening documents of virtually every securities broker-dealer.

The vast majority of securities arbitrations are conducted in a forum sponsored by FINRA (Financial Industry Regulatory Association), a securities industry regulator and “trade association” populated by the broker-dealers which constitute its membership.  FINRA reports that there were 3,456 arbitrations filed in 2017.  In the first quarter of 2018, there have been 1,152 arbitrations filed.  Of those, customers filed 60% of the cases and the other 40% are intra-industry disputes.

Arbitration is often confused with mediation, but they are very different.  In a mediation, the parties with the assistance of an unbiased mediator, try to reach a settlement which is acceptable to both parties.  If both parties do not agree to the terms, then no settlement is reached.  In arbitration, both sides try the controversy to a single arbitrator (generally smaller cases) or to a panel of three arbitrators.  The arbitrator(s) listen to the testimony presented by the parties, review evidence admitted into the record, listen to the arguments of counsel and then issues a final, binding ruling in the form of an Award.  A final hearing in FINRA Arbitration is similar to a trial, with some key differences set out in the FINRA Code of Arbitration Procedure.

Initiating an Arbitration.    The party initiating an arbitration is called the Claimant.  The Claimant begins the process by paying a filing fee to FINRA and submitting a Statement of Claims which sets out the facts and law upon which Claimant seeks redress.  The amount of the filing fee paid by a Claimant in a customer case depends on the size of the case, ranging from $50 for arbitrations seeking damages of less than $1,000 to $2,250 for arbitrations seeking over $5 Million in damages.  In addition to filing fees, the parties also are charged hearing session fees which range from $100-$3,000 a day so the arbitrators can be paid for their time and effort.  Arbitration seems to be and can be an expensive undertaking, especially when one considers that it cost $115 to file a civil case in Kentucky to be decided by a judge; and the parties don’t have to pay the judge’s salary.

An arbitration may be initiated by a single person, a business entity, a married couple or multiple parties who have factually similar claims.  The claims, i.e., causes of action, most often alleged by Claimants in FINRA arbitrations are breach of fiduciary duty, negligence, suitability, misrepresentations/omissions of material facts under the state (Blue Sky) and federal securities laws (Rule 10b-5), failure to supervise and fraud.  We have initiated all of these types of claims and others including elder abuse, unauthorized trading, churning and excessive markups and markdowns of bonds or other fixed-income investments.

After the Statement of Claims is filed, FINRA serves it on the Respondents who then have 60 days to file an Answer. Respondents may file a counterclaim alleging causes of action against the Claimant, a crossclaim against another named Respondent, or a third-party claim against a non-party. In years past, Respondents routinely filed motions to dismiss the arbitration claims.  However, FINRA has put a stop to these abusive tactics by a rule change which limits motions to dismiss to situations where the claims are ineligible for arbitration –  that is more than six years has elapsed from the occurrence or event giving rise to the claim.  FINRA Rule 12206.

Picking the Arbitrators.       The process for picking arbitrators proceeds like this.  FINRA provides the parties with three lists of arbitrators and provides each side with a limited number of strikes.  If any party strikes an arbitrator, he or she will not serve on the case.  Two of the three lists of arbitrators are populated by “public” arbitrators.  Public arbitrators are people who have not worked in the securities industry for a number of years or lawyers who routinely represent clients in securities industry disputes.  The third list of arbitrators are “non-public” or industry arbitrators with close ties to the securities industry.   A party may elect to have the dispute decided by an “all-public” panel by striking all of the industry arbitrators from the lists of potential arbitrators.  Many seasoned securities arbitration practitioners routinely strike all the industry arbitrators for fear of an industry bias.

Since the arbitrators that hear your case are the judge and jury, it is important to research all of the potential arbitrators and review their past awards history.  We have seen arbitrators who have sat on a dozen or more cases, but not one time decided in a Claimant’s favor.  That calls for a strike.  Once you determined your strikes – those arbitrators you cannot have on your case – you must rank the remaining potential arbitrators with one being your favorite, two being your second favorite, and so on.  Once both sides have submitted their respective strikes and rankings, a panel is selected from the remaining arbitrators ranked highest by the parties.  You now have the panel of three arbitrators to decide your case (or a single arbitrator in smaller cases).

Initial Pre-hearing Conference.      Shortly after the arbitrators are assigned, your matter is scheduled for a telephonic initial pre-hearing conference.  The purpose of this conference call is to schedule the final hearing dates, set forth discovery deadlines and discuss any issues which may be unique to that particular arbitration.  The final hearing may be as short as one day or as long as several weeks or even months in multi-Claimant or otherwise complex arbitrations.   The final hearing dates will likely be set several months or even a year from the initial pre-hearing conference, which allows the parties ample time to complete the limited discovery available in arbitration.

Discovery in Arbitration.     Discovery is a process in litigation where a party obtains documents, facts and information about the case from another party to prepare for the final hearing.  Discovery in FINRA Arbitration is limited primarily to an exchange of documents and names of witnesses.  There are generally no depositions in arbitration, except in rare circumstances, i.e. to preserve the testimony of dying witness or one who is unable to testify at the final hearing.  Unlike court, in arbitration the first time a lawyer examines an adverse witness or party is at the final hearing.  Some would characterize arbitration as trial by ambush.  Also, unlike a court proceeding, interrogatories and requests for admissions are not among the tools available to litigants in arbitration.  Since the only information a Claimant will (perhaps) obtain from the Respondent brokerage firm are “documents”, it is imperative that Claimant’s counsel know the types of records which brokerage firms are required to maintain and the significance of those documents.  If a party does not seek specific records from the firm, the firm will produce standard account related documents such as account statements, confirmations, account opening documentation and correspondence, the same documents that many Claimants already have.

Even a skilled securities counsel’s request for key, often internal, documentation from the broker-dealer, does not guarantee they will be produced.  Brokerage firms frequently object to producing multitudes of documents, even those which FINRA have deemed “presumptively discoverable”.  When this occurs, Claimants have to file a motion to compel and argue to the panel or chairperson why the documents are important and why the Respondent should produce them.  After hearing arguments of counsel on the motion to compel, the panel or chairperson issues a decision which may grant or deny the requested discovery.

Discovery is a two-way street.  Claimants must produce documents to the Respondents as well.  Claimants have to produce any and all documents that they received from the firm, several years of tax returns, statements of accounts maintained at other firms and correspondence and notes received from or sent to the Respondent.  If a party refuses to produce documents in the arbitration, the arbitrators can levy various penalties against the non-compliant party, including monetary sanctions and claim dismissal.

Other than routine motions to compel and now less routine motions to dismiss, there is not “motion practice” as there is in a court of law.  Motion practice is important in court as it tends to narrow the issues for trial.  Again, arbitration, with its limited discovery and motion practice, is trial by ambush!

The 20-day Exchange.          The next key moment in the life of a securities arbitration is the 20-day exchange.  As its name indicates, 20 days prior to the beginning of the final hearing, parties must exchange their list of witness and any documents that they intend to introduce at the hearing which were not previously exchanged in discovery.  The only “new” information generally gleaned at the 20-day exchange is the identity of the opposing party’s expert witness(es).  If the expert intends to introduce a report, like an account profit and loss report, then the expert reports are exchanged 20-days prior to the hearing, if not exchanged earlier.

If the parties decide that the arbitrators may benefit from a pre-hearing brief on some unique legal positions or the parties’ view of the facts and law controlling the case, such briefs are often exchanged at the 20 day.  The parties are generally free to extend deadlines, so sometimes the 20-day exchange becomes a ten day or seven day exchange.  By this time, basically all of the cards are on the table, so cases oftentimes settle on or near the final exchange date.

The Final Hearing.   The final hearing is arbitration’s version of a trial.  However, a final hearing is conducted far differently than a trial.  First of all, though often cited by litigants and occasionally arbitrators, neither the federal or state rules of evidence apply in FINRA arbitration. Moreover, there is no courtroom, which electronic devices to submit documentary evidence to the witnesses and arbitrators.  Rather attorneys cart around several copies of documentary evidence in three-ring binders and the hearings (in Kentucky) take place in a hotel conference room.

Similar to court, the Claimant carries the burden of proving their case.  Claimants must call witnesses, introduce evidence through those witnesses and present arguments of counsel to support their position. Respondents have the opportunity to cross examine all of the witnesses called by Claimants and they may introduce their own documents and evidence through Claimants’ witnesses.

After preliminary greetings administrative announcements, the final hearing begins with opening statements.  Claimants’ counsel makes the first opening statement to try to persuade the arbitrators to the rightness of Claimants’ position.  Respondent’s counsel then makes an opening statement saying Respondents have done nothing wrong, or Claimant has suffered no damages or whatever other argument best supports their position.

In the “normal” customer case involving one Claimant, the fact witnesses would include, although not necessarily in this order, the Claimant, the registered representative who serviced the account and perhaps his or her supervisor.  In most cases, Claimants employ and call an expert witness to offer expert opinions concerning Respondent’s liability and the damages suffered by Claimant.  A Claimant’s expert witness may be an accountant, PhD mathematician or a retired industry professional who can offer opinions on industry practices and procedures, and how the Respondent in your case breached or failed in its duties owed to you.

After the Claimant presents all of his witnesses and evidence, he “rests”.  At this point, Respondents generally make an oral motion to dismiss arguing that Claimant has failed to meet his burden of proof.  The attorneys argue their respective positions to the arbitrators and the arbitrators confer and announce their decision.  If they dismiss the claim, it is over.  If they deny the motion to dismiss, then it is Respondents turn to put on its case in chief.

Respondents may recall Claimants’ witnesses or call additional fact witnesses.  Inevitably they will call one or more expert witnesses to rebut Claimant’s expert and argue about what a great job the firm and its registered representative did on Claimant’s account.  They may opine that the Claimants suffered no damages, or in the event there are damages, that Respondents did not cause Claimant’s damages and thus should not be held liable for them. They will likely testify about a report the expert created, which may be hundreds of pages long.  After the Respondents complete their presentation of the evidence, it is time for closing arguments.

Claimants may defer his or her closing argument until after Respondents’ closing.  Many Claimants elect to do this noting the primacy and recency effects of memory.  We tend to recall best what we hear first and last.  Claimant was heard first on day one of the hearing when Claimant’s counsel made the opening argument (primacy effect); and by deferring will be heard last when he makes his closing argument (recency effect).  After closing arguments, the parties and lawyers pack up and return to home.  Depending on the time of day, the arbitrators may begin their deliberations.

The Award,    The award is akin to a judgment in a civil court case.  It is issued and signed by the arbitrators who presided at the final hearing.  So, you completed your final hearing two weeks ago and still no word. Be patient; it sometimes takes a month to receive the arbitrators’ award.  When your attorney gets the award, usually by an unannounced facsimile, it will state (hopefully) an amount of money that the Respondent owes to the Claimant.  If Claimant asked for attorney’s fees, interest and costs (we almost always do as that is what most state’s securities laws provide), the arbitrators may award Claimants additional money for attorney’s fees, pre-award and post-award interest and/or costs, including expert witness fees.  On the other hand, the award may (hopefully not) dismiss all of Claimants claims and award no damages.  In those rare cases where a counterclaim has been lodged, the award would decide that as well and could award damages against the Claimant to the Respondents.

What will probably not be in the award is any reasoning or basis for the arbitrators’ decision.  On a three-arbitrator case, the prevailing party must convince two of the three arbitrators.  However, unanimous decisions are by far the most common type of award.  The award will clearly state who wins and who loses, but there is rarely any discussion of how or why the arbitrators reached the decision.

The Arbitrators’ award also determines who pays the hearing session or forum fees.  On a typical quarter million dollar customer case with three arbitrators which lasts, let’s say, four full days, the hearing session fees would be $9,000.  There are two hearing sessions in a full day of hearing (the morning and afternoon sessions) and FINRA charges $1,125 per session on a $250,000 case.  In four full days of hearing there are eight hearing sessions.  $1,125 times eight sessions equals $9,000.  The arbitrators decide who pays for the hearing session by assessing the fees 100% to one party or splitting the hearing session fees between two or more parties.  Again, there will be no basis disclosed for the assessment of forum fees.

So there you have it, securities arbitration in a nutshell.  If you suspect misconduct on the part of your investment professional, call us for a free confidential consultation.