FINRA Arbitration – Why Customers Lose

There are a number of commentators, including some consumer groups, who believe that FINRA arbitration is inherently unfair to public investors.  I have heard these commentators refer to FINRA arbitration as a “kangaroo court” where investors do not get a fair hearing because arbitrators are biased.  Evidence of that bias has never been presented.

Surprisingly, some of the most fervent critics are lawyers who regularly practice in these forums.  I can only wonder if they voice their concerns or make a written disclosure when they are asking new clients to engage their services for arbitration at FINRA.

For many years, both parties were required to state on the record at the end of the hearing that they had been afforded an opportunity to fairly present their evidence to the panel. It was rare when someone on either side of the table refused to state that they had.  I think that I refused once in 40 years practicing before FINRA arbitrators and their predecessors.

Much of the “evidence” of bias and unfairness is based upon statistical research.  The researchers start with the mythical assumption that customers should win at least one half of the claims that are brought. That assumption has no basis in fact and belies the fact these claims are far easier to defend than to prosecute.

I was a pretty good defense attorney when I was representing firms for the first 15 years of my career. I learned a lot more about how to defend a brokerage firm from the defense lawyers with whom I tangled during the last 25 years representing customers.  The brokerage firms are almost always well represented and the critics of FINRA arbitration should give some credit to the defense where it is due.

Investors are generally better educated and more aware than average consumers.  A claim against a stockbroker is not the same as a claim against a drunk driver.  Investors usually know that the stock market goes up and down and that they can lose money every time that they invest.

“I lost money” or “I lost more money than I thought I would” may not be the basis for a claim without some affirmative bad act by the broker.  To be successful in a claim the customer may have to prove that the broker or brokerage firm did something out of the bounds of appropriate conduct and that the losses are a direct result of that conduct.

Many of the claims at FINRA involve its “suitability” rule.  The rule requires brokers to ascertain whether the customer understands the risk of loss from a particular investment or strategy, whether they want to take that risk and whether or not they can comfortably afford to take the loss should it occur.

A customer who claims at the hearing to be a conservative investor but who checked the box that they would still be comfortable if the account value declined by 20% is going to have a hard time convincing the panel that they were truly conservative. A 20% decline in account value is not a conservative loss.

Likewise, a conservative investor who follows the broker’s recommendation to invest in stocks is not conservative because there is no such thing as a conservative stock or portfolio of stocks.  Truly conservative investors buy bonds because they want to conserve their account value.

The brokerage industry collects information on a new account form and sends out monthly statements as a way of protecting itself, not the customer.  Customers who do not read the account application form, check the boxes even if the boxes do not set forth what they really want or who sign the forms with some items left blank have only themselves to blame.

Customers receive account statements every month but many never read them or claim at the hearing that they could not understand them but never asked for help.  With statements that are delivered on -line or through e-mail the brokerage firm will have a record of when the statement was sent, when it was opened and in some cases how long the customer spent on-line reading it.

When you get an account statement and do not complain about the transactions or positions in your account the firm will assert a legal defense called “ratification and waiver”.  Once the customer is notified and identifies a problem, they cannot just wait and see what happens next.  Invariably, the losses may get worse.

It is not unfair for a defense attorney to ask the customer a question like “Your account declined in value for 6 months, you knew it because you read the monthly statements and you did not complain about it. Why should the panel now believe that these losses were unacceptable to you?”

In many cases the response will be: “I spoke with the broker and he told me to stay the course and the account value will come back.”  Of course, the broker cannot know what the market will do in the future.

The legal term for this is “assumption of risk” which is what the customer is doing. Once informed that the investments have lost value, the customer is assuming the risk that the account may decline further by not demanding the broker sell the investments that they are now telling the arbitration panel were unsuitable because they were too risky.

Some claims assert that the broker committed fraud. This is frequently the case where the customer bought a private placement, such as a non-traded REIT, and all of the facts that should have been disclosed were not. Where the true facts could have been ascertained with a reasonable amount of due diligence, the brokerage firm is usually liable.

But to succeed on a claim of fraud, the customer must show that the loss was caused by the fraud.  This is not always easy to do.  A customer who was suitable for a real estate fund was not always awarded compensation for their loss.  This became evident after the real estate market collapsed in 2009.

In the case of a non-traded REIT that committed fraud by failing to disclose the operator’s many lawsuits, it could still be shown that the fund collapsed because the properties it owned suffered from high vacancy rates.  Defense attorneys will argue, often successfully, that the customer would have suffered the same loss if the broker had sold him any one of a dozen other REITS that the firm was offering which did not misstate the facts about the operator’s history.

Consider that a stockbroker is a trained salesperson who can usually look the arbitrators in the eye and tell a convincing story. They usually testify well and seem to always remember all the pertinent facts that will discredit the customer’s case. Customers, on the other hand, are often not as good on the witness stand.

All of this would be equally true if these cases are brought in court. Judges and juries are far from perfect and can be biased or worse, they just miss the point.  That is less likely to happen where one of the arbitrators is a representative of the securities industry like a retired branch office manager. A good branch manager who has been listening to stockbrokers for years can often ferret out the truth.

The essential difference is that aggrieved investors can wait years to get a jury trial and spend thousands of dollars on pre-trial motions and depositions before they get there.  Arbitration is quick and inexpensive.  The customer’s counsel usually does better if they understand the transaction from the industry point of view.

Finally, there is a tendency by some lawyers to try to prove too much. In a court case, a lawyer will plead all the alternative ways the court might find the defendant liable to his client.  I never recommend doing thatin an arbitration. Too often, there is a lot of testimony about things that arbitrators do not care about.

A customer in arbitration will always do better by telling the arbitrators “I would not have lost this money if the broker had acted appropriately.”  Arbitrators are fact-finders. Stick with the facts.

I am a fan of FINRA arbitration. Over the years I participated in more claims than most other attorneys.  If I thought FINRA arbitration was biased against the customer to the extent that I could not win, I would have stayed on the defense side of the table.

Any lawyer who frequents courthouses will tell you that there are judges that they do not like for one reason or another.  None would think to argue that the entire system is rigged.  The lawyers who complain about FINRA arbitration should do something else. If you cannot make FINRA arbitration  work, leave it to the lawyers who can.

 

 

 

 

 

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