In its regulatory reform proposals,President Barack Obama's administration recommended that the Securities and Exchange Commission study the use of mandatory arbitration clauses in investor contracts. Those clauses require investors to take all disputes with their advisors to FINRA arbitration rather than the court system and the Administration wants to know whether investors are being harmed by this exclusion. It also asked the agency to consider whether changes to arbitration are needed. The subsequent Investor Protection Act of 2009 expressly gives the SEC the authority to restrict the use of mandatory arbitration clauses.
The SEC had not announced any review of the system by press time, however, the House of Representatives is considering a bill that would go further than the Administration's recommendations. That bill would outlaw the use of mandatory arbitration clauses in all consumer disputes, including those between brokers and investors. The Arbitration Fairness Act of 2009 was introduced by Rep. Hank Johnson (D-Ga.) in February. A similar bill failed two years ago, but the current regulatory fervor may provide a more receptive response this time around.
Is Arbitration So Unfair?
FINRA's most recent arbitration statistics show that there have been 3,168 new cases filed between January and the end of May this year. That represents an 85% increase from the same period last year. Observers say it is common to see a spike in cases in a market downturn. Following the tech stock bubble burst, there were 6,915 cases filed in 2001, a 24% increase from the year before. On the other hand, in 2007, before the current meltdown took hold, there were only 3,238 cases filed for the whole year.
The debate about the fairness of the FINRA arbitration system generates passionate responses on both sides. In 2007, Wake Forest University assistant finance Prof. Edward O'Neal and claimant's attorney Daniel Solin, released a study that looked at all arbitration awards rendered by the National Association of Securities Dealers and the New York Stock Exchange regulatory arm (FINRA's predecessors) between 1994 and 2004. O'Neal and Solin concluded that investors bringing a claim could only expect to recover 20% of the amount they sought.
The statistic appears damning but there were plenty of industry types crying foul when the study was released. The Securities Industry and Financial Markets Association (SIFMA), the main industry lobby group, denounced the study as "fundamentally flawed" because it didn't consider the large number of cases that are settled before arbitration. (Those awards aren't disclosed).
Moreover, the low rate of recovery is misleading because attorneys typically ask for more than their client is actually entitled to, says Mark Astarita, a partner at Beam & Astarita, who represents brokers in arbitrations. "The concept is that if you don't ask for it you won't get it. You ask for everything that you are possibly entitled to," he says.
Still, investor-advocates maintain that investors are entitled to their day in court if they so choose. In a statement supporting the House bill, Fred Joseph, president of the North American Securities Administrators Association, the state securities regulators group, said: "NASAA believes that this 'take-it-or-leave-it' clause in brokerage contracts is inherently unfair to investors...As long as securities arbitration remains mandatory, investors will continue to face a system that is not fair and transparent to all."
What's the Alternative?
Prior to the 1987 Supreme Court decision in Shearson/American Express Inc. v. McMahon, which upheld the legality of mandatory arbitration clauses, investors with a complaint against a broker were able to decide whether to take their claim to arbitration or to court. However brokerage firms weren't afforded the same choice. They basically had to abide by the investor's wishes.
If mandatory arbitration were to be abolished, some investor-advocates support a return to the old system that would give investors a choice. "We would like to see that sort of arbitration agreement," says Brian Smiley, partner at Atlanta-based Smiley, Bishop & Porter and president of the Public Investors Arbitration Bar Association (PIABA). "Brokerages operate as regulated entities. As a condition of that regulation they should be required to offer certain remedies." Smiley adds that the unequal bargaining position of investors and brokerage firms means that the firms should not be given the same choice.