Arbitration is arguably the most efficient way for public customers to resolve a dispute that they may have with their stockbroker. I have personally been a participant in a great many more securities industry arbitrations than most people.
But the arbitrations themselves have become suspect. Too many customers who have clearly been defrauded by their stockbrokers are walking away uncompensated and shaking their heads. A brief case study will illustrate the point.
I located only 35 awards in the FINRA Arbitration Awards database concerning securities issued by a company called DBSI. DBSI was a national real estate syndicator that filed for bankruptcy protection in 2008 and was shown to have been operating as a Ponzi scheme.
I chose DBSI claims for three reasons:
First, the Examiner working for the DBSI’s Bankruptcy Trustee filed a comprehensive report detailing how DBSI had operated as a Ponzi scheme from at least 2004 at which time DBSI was already insolvent. Like any classic Ponzi scheme, DBSI was using funds collected from new investors to pay obligations to prior investors.
Second, virtually every private placement offering that DBSI made after 2004 (approx. $800 million in total) contained an un-audited balance sheet that stated, falsely, that the company was actually solvent. This was important because with each offering the company was taking on financial obligations to the investors, mostly lease payments for the buildings that it was syndicating.
Third, brokerage industry standards require the firms that sell private placements to verify the information that they are handing out in the private placement memorandums s (PPMs). Verifying DBSI’s claim that it was solvent when it was not would not have been possible. Logic and experience suggest that the approximately 100 brokerage firms that sold DBSI securities failed to conduct a reasonable due diligence investigation if they conducted any investigation at all.
So, we have an independent report filed with the Bankruptcy Court that would seem to establish that investors were given false financial information about DBSI at the time the brokerage firms sold the DBSI securities to them. The principal of DBSI was also convicted of fraud, on basically the same facts, at his criminal trial.
We also have aggrieved investors who begin the FINRA arbitration process knowing that the investment that their stockbroker had sold to them was a Ponzi scheme. The public investors should have a reasonable expectation that a securities industry arbitration panel would find that selling interests in a Ponzi scheme to be beneath industry standards and be willing to award the investors adequate compensation.
So how did the complaining investors actually fare?
Of the 35 awards involving DBSI securities that I could locate in the FINRA Arbitration Awards database, the results were as follows:
In 8 of those claims the brokerage firm had either filed for bankruptcy protection or defaulted and failed to appear at the hearing. In two of these claims the brokerage firm was not a named party presumably because it had gone out of business. A substantial number of the brokerage firms that sold DBSI securities did exactly that. Had they not, I would think that there would have been a lot more claims.
The arbitrators made awards in several of these “defaulted” claims where the customers were able to prove up their claim and establish their damages. There is no indication that the defaulting firms actually paid anything to these customers. A brokerage firm that will not defend a claim will generally not pay the award.
In FINRA statistics these count as a win for investors because an award was made, even though the customers did not actually receive compensation for their losses. FINRA does not require its member firms who sell these private placements to have either adequate net capital or adequate insurance. FINRA does not take any steps to enforce an award against the principals of a firm who sell Ponzi schemes and then close up shop.
In 10 of the 15 claims where the brokerage firm was present and represented by counsel the arbitrators dismissed the claim or awarded the investors nothing. One has to wonder why these 10 panels of arbitrators could not be convinced that selling a Ponzi scheme to public customers was conduct for which the customers should be compensated.
In the 5 fully adjudicated claims where the arbitrators did make an award in the customers’ favor, in only one did the panel order the offending DBSI investment rescinded and the customers fully compensated. The rest of the awards were for much less than the amount that the firms’ customers had invested.
In one of the adjudicated claims the panel dismissed the claim for one DBSI investment and made a small award on a second. Both of these offerings contained fraudulent financial information about DBSI. What could these arbitrators have been thinking?
Twelve of the claims brought by customers seeking compensation for DBSI losses were settled for undisclosed amounts. Pre-hearing settlements are often based upon each party’s evaluation of what might be their worst result if the claim is given to the arbitrators to decide. The fact that only one panel deemed it appropriate to rescind the DBSI transactions and fully compensate the customers would certainly impact the brokerage firms’ idea of what might be the worst result that they might suffer if they did not settle.
When you boil this down to the fact that in only one claim in 35 did the customer get all or a substantial award from the FINRA arbitration panel when all were clearly defrauded, it does give one pause to consider than something may just not be right.
Perhaps it might help to look at the expungement phase of some of these hearings. Claims like these are routinely expunged from the record of the individual registered representatives when the claims settle.
After a settlement, the arbitrators conduct a live or telephonic hearing to determine if the claim should be wiped from the representative’s record. The claimants and their representatives do not usually appear at this hearing, nor should they need to appear. Left alone with the arbitrators some industry firms may be taking advantage.
In more than one claim the expungement order noted that the claim (for selling a Ponzi scheme to a public customer) was factually impossible. In others, the panel held that the offering materials (which contained fraudulent financial information) were within industry standards or that the due diligence (which, if done correctly could not have verified that DBSI was solvent as it claimed to be) was adequate and also within industry standards. I personally refuse to believe that industry standards have fallen that low.
These findings by the panels are often supported by “experts” whom the brokerage firms bring to the expungement hearings to educate the panels without cross-examination. If an arbitrator hears this recitation of “industry standards” from an expert or two provided by the industry over several cases, many apparently start to believe it.
It is certainly logical to assume that after many claims involving DBSI and several other large Ponzi schemes that were sold to public customers in the last market cycle (Medical Capital, Provident Royalties, etc.) the arbitrator pool around the country may have been tainted by the patently false “opinions” of these industry “experts”. Arbitrators get no training in securities law or industry standards from FINRA.
Securities industry arbitration has always been considered to be efficient because it costs less than state court litigation. The cost of the forum should be irrelevant if the customers cannot realistically expect to obtain a reasonable recovery of their losses in cases like this. I cannot fathom that a series of 35 juries sitting in civil courts around the country would come up this many defense victories. If I am right then clearly there must be some defect in the FINRA arbitration system.
As importantly, the lack of compensation awarded to these aggrieved investors in FINRA arbitration forums re-enforces a business model where a broker/dealer can be inadequately funded, carry no insurance, affirmatively flaunt the rules, conduct inadequate due diligence and sell millions of dollars of fraudulent investments to thousands of investors. Once exposed, the principals can simply close up shop and open up across the street under a new broker/ dealer and start over.
Either way, if FINRA intends to advocate its forum as fair and equitable to the public investors, it should take steps to see that it really is.