PIABA Bar Journal, Winter 2006 (Vol. 13, #4)

SRO Arbitration -- is it Fair to Investors?

by Mark A. Tepper

Florida Securities Fraud Attorney
                                
    
The debate rages is mandatory NASD arbitration fair to both sides of customer   broker disputes or is there an industry bias? NASD and NYSE representatives told Congress that their arbitration programs are fair (fn. 1).  NASD cited statistics that 55% of arbitration panels find for the Claimant (fn. 2).  Despite this assertion, NASD published alarming figures on its website that customer win rates in NASD arbitration declined from 54% to 43% during the period 2001-2005 (fn. 3). 
                                
Congressman Barney Frank commented if SRO (fn. 4) arbitration is fair, why does it have to be mandatory? (fn. 5).  The answer is because it is not fair, demonstrating a marked bias against investors.  Consequently, the securities industry wants arbitration to be mandatory and enforces its intention by inserting a pre-dispute arbitration clause in its form customer agreements and its employment contracts with brokers.
 
The benchmark for fairness in NASD arbitration is the one adopted by the United States Supreme Court whether statutory rights are being enforced.  The United States Supreme Court approved securities arbitration of statutory claims predicated on the stated expectation that arbitrators will enforce statutory rights (fn. 6).   The problem of arbitrators not following the law
was one of the bases for the Supreme Court's rejection of mandatory securities arbitration in Wilko v. Swan (fn. 7).  

In its Amicus Brief in Shearson/American Express, Inc. v. McMahon (fn.8), urging the Court to overrule Wilko, the SEC  recognized that arbitrators would be required to follow the law (fn. 9).  This requirement became one of the lynchpins of the McMahon decision as the Court said:

          Finally, we have indicated that there is no reason to
          assume at the outset that arbitrators will not follow
          the law; although judicial scrutiny of arbitration
          awards necessarily is limited, such review is
          sufficient to insure that the arbitrators comply with
          the requirements of the statutes. (fn. 10).
     Subsequently, the Supreme Court in Gilmer said:

          [B]y agreeing to arbitrate a statutory claim, a party
          does not forgo the substantive rights afforded by the
          statute; it only submits to their resolution in an
          arbitral, rather than judicial, forum. (fn. 11).

This survey adopted the Supreme Court's benchmark for measuring the fairness of SRO arbitration.  The Supreme Court did not want to assume that arbitrators would not follow the law.
         

Arbitration Survey

Florida has enacted the Florida Investor Protection Act, Chapter 517, ("517") reflecting a public policy to protect Floridians from investment fraud. To achieve its purpose of protecting investors and deterring fraud by defeating all visionary schemes, 517 must be liberally interpreted and vigilantly enforced. (fn. 12).

The purpose of this Survey of Arbitration Awards was to investigate whether Florida arbitrators were enforcing the statutory rights provided to investment fraud victims by 517.

Arbitrators are Not Enforcing the 517 Statute

This survey found that arbitrators are not enforcing the 517 Statute, replacing the objectivity of law with the bias and prejudice of individual arbitrators who are not accountable for their irresponsible conduct.  Like the infamous 19th Century Judge Roy Bean, the arbitrators dish out their own brand of frontier justice, denying Claimants their full measure of damages as provided by the 517 Statute.  If the arbitration process is mandatory and unfair to defrauded investors, then it violates due process and is unconstitutional.

Methodology

The survey covers Florida Arbitration Awards from January 1, 2000 through May 23, 2006 (fn. 13).  Research associates(fn. 14) compiled a data base of the Florida Arbitration Awards where either one or three arbitrators decided the outcome in favor of an investor (i.e. excluding stipulated awards, settlements and cases in which the investor lost)(fn. 15).  A violation of Chapter 517 was alleged in more than 95% of the 399 awards that were used in the survey(fn. 16).  See Table 1 (fn. 17).

Table 1 examines the performance of enforcing 517 by single, public non-industry arbitrators ("public arbitrator") and three arbitrator panels (two public arbitrators, one industry arbitrator) (fn. 18).  Table 1 also compares the two to measure the impact of industry arbitrators on the enforcement of 517.

Table 1 shows that neither single, public arbitrators nor three arbitrator panels enforced 517.  Public arbitrators enforced the 517 statute 68.4% of the time while three arbitrator panels only enforced the 517 statute 47.5% of the time.  See Table 1.

Under 517 there is a very low standard of proof necessary to prove a violation.  Any transaction or practice that would operate as a fraud or deceit on a person, including, unsuitability (fn. 19) negligent misrepresentations or omissions and a breach of fiduciary duty, is a violation of 517(fn. 20), as is any violation of an NASD or NYSE rule (fn. 21).  The law is well settled that evidence of scienter(fn. 22) (proof of intent), causation(fn. 23) and reliance(fn. 24) are not necessary to
recover under 517.

Table 1 reveals 179 awards where, although alleged, a 517 violation was not found (31 awards for single, public arbitrators and 148 for three arbitrator panels).  The survey investigated each of those awards to determine whether a 517 finding was deserved based on the reason stated in the award.  In 82% of the three arbitrator panel awards (122 of 148), where 517 was alleged but not given, a 517 award should have been granted because the arbitrators found an equal or higher level of culpability than required for a 517 recovery ("deserved").  Table 3.

In the remaining 26 three arbitrator panel cases, an award was made without any indication of the reason.  30 of the single arbitrator awards had no reason cited for the award.  As a practical matter, when 517 is alleged and an award is given, there is a high probability that 517 is deserved because of the low standard of proof for 517.

Table 2 reveals that three arbitrator panels, in addition to failing to make a 517 finding, appear to be unaware of the standard of proof required for a 517 finding.  Table 2 also reveals that in most cases where 517 was alleged and an award was made, a 517 finding was deserved.

Table 3 examines Florida Arbitration Awards where 517 was alleged and deserved but was not awarded (fn. 25).  Analysis of the 122 three arbitrator awards where a reason was indicated, table 3 reveals that three arbitrator panels were not enforcing the 517 Statute 47.7% of the time.
              

Chapter 517
                   
The Florida Investor Protection Act, in sections 517.211(3)-(6), specifies the legal remedy for a violation of the consumer protection provisions of 517 ("statutory damages") which includes rescission or rescissionary damages (fn. 26) and ttorney's fees (fn. 27).  517 victims are ". . . entitled to full rescissionary damages for any sale in violation of the 517 statute regardless of whether the buyer happened to profit from other sales. . . ." (fn. 28).  The Kane Court reasoned that netting or offsetting was contrary to the 517 statute because it ". . . could serve as a license for broker-dealers to defraud their customers with impunity up to the point where losses equaled prior gains."(fn. 29).

When a 517 violation is found, Florida and federal courts agree that statutory damages are "automatic" and "mandatory." (fn. 30).  The Florida 517 Statute does not provide for any discretion (fn. 31).  It is not left to Judges, =
juries or arbitrators to fashion a remedy.  Florida has a public policy that each victim of securities fraud be treated the same. 
         
The prevailing party under 517 is also entitled to attorney's fees unless it would be unjust (fn. 32).  Florida law is well settled that it is a just result for Arbitration Claimants to recover their attorney's fees made necessary by Arbitration Respondents' violation of the consumer protection provisions of 517 (fn. 33).

The survey shows that a significant percentage of arbitrators are not giving the facts their full legal effect by failing to apply the Florida 517 Statute even when the facts compel such a finding.  It is apparent SRO arbitrators are not enforcing the 517 Statute.  This noted failure to follow the law, as warned by the Supreme Court in Wilko(fn. 34),  makes mandatory
arbitration unfair.  It deprives investment fraud victims of their full measure of statutory damages, victimizing them a second time. 
         

Conclusion              

The staggering percentage of times that arbitrators are not enforcing the 517 Statute is appalling, leading to the inescapable conclusion that SRO arbitration is unfair to investors and biased in favor of the industry.  Since SRO arbitration is unfair, it should not be mandatory.  The better practice is the NASD rule which provides for SRO arbitration of designated disputes "upon the demand of the customer." (fn. 35).  If pre-dispute arbitration clauses in customer agreements are prohibited as an unfair practice, the better rule would become effective.

The mandatory presence of a securities industry affiliated arbitrator on every three arbitrator panel is not a level playing field.  It creates the appearance of impropriety as well as the likelihood that the 517 Statute will not be enforced.  Industry arbitrators should be excluded from participation in customer disputes with an industry member unless the customer agrees to have an industry arbitrator. 

Why arbitrators fail to enforce 517 remains a mystery.  Nonetheless, the dramatic failure of panels with an industry arbitrator to enforce 517 leaves no doubt that SRO arbitration should not be mandatory.

_________________________________________________________________________________________________________________________

1.  Testimony of Linda D. Feinberg, President, NASD Dispute Resolution and testimony of Karen Kupersmith, Director of arbitration, NYSE, before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Committee on Financial Services, United States House of Representatives, March 17, 2005.
  
2.  Testimony of Linda D. Feinberg, footnote 1.

3.  www.nasd.com/ArbitrationMediation/NASDDisputeResolution/Statistics/index.htm

4.  “SRO” means “self-regulatory organization” which includes the National Association of Securities Dealers, Inc. (“NASD”) and the New York Stock Exchange (“NYSE”).

5.  Congressman Barney Frank made his comment, on March 17, 2005, during hearings before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Committee on Financial Services, United States House of Representatives.

6.  Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 232 (1987)(“. . . [W]e have concluded that the streamlined procedures of arbitration do not entail any consequential restriction on substantive rights).

7.  Wilko v. Swan, 346 U.S. 427 (1953).

8.  McMahon, supra.

9.  SEC Amicus Curiae Brief, p.20, McMahon, supra.  

10. McMahon, supra. at 232.

11. Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20, 26 (1991), quoting Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 628 (1985).

12. Arthur Young & Co. v. Mariner Corporation, 630 So. 2d 1199, 1203 (Fla. App. 4th Dist. 1994); Merrill Lynch v. Byrne, 320 So. 2d 436, 440 (Fla. App. 3d Dist. 1975).

13. The source for the arbitration award data used in this survey was Thompson West (Westlaw) Securities Arbitration Awards Database (fsec-arb).

14. Special thanks to Karen Lager, Barry Haimo and Evan Shenkin who gathered the data, compiled the data base, and conducted this Survey.  This will acknowledge the valuable contribution of Sean Kelly and Professor Edward O’Neal who reviewed this survey and confirmed its statistical significance.

15. Cases where investors lost were irrelevant to this survey because they shed no light on the central question: “How often is a Chapter 517 finding deserved as a matter of law, but not given?”

16. The 19 cases where Chapter 517 was not alleged were excluded as insignificant.

17. Special thanks to Scot Bernstein, Esq. and Barry Haimo for their valuable contributions in creating Tables 1-3.

18. NASD Code of Arbitration Procedure 10332, Schedule of Fees for Customer Disputes, calls for a single public arbitrator in claims valued up to $25,000 and for claims greater than $25,000 panels with three arbitrators are used.

19. Newsom v. Dean Witter Reynolds, Inc., 558 So.2d 1076, 1077 (Fla. App. 1s=
t Dist. 1990).

20. See Fla. Stat. §§ 517.301 & 517.211(2).

21. Fla. Adm. Code section 69W-600.013 (p)1 and 2.

22. Merrill Lynch v. Byrne, 320 So. 2d 436, 440 (Fla. App. 3rd Dist. 1975) cited with approval Silverberg v. PaineWebber, 710 F.2d 678,690-91 (11th Cir. 1983.

23. E.F. Hutton & Co., Inc. v. Rousseff, 537 So.2d 978, 981 (Fla. 1989).

24. Waters v. International Precious Metals Corporation, 172 F.R.D. 479, 496 (S.D. Fla. 1990).

25. A number of awards were made with no reason indicated.  For purposes of Table 3 those awards were not considered.

26. Kane v. Shearson Lehman Hutton, 916 F.2d 643, 646 (11th Cir. 1990)(“The remedy specified [in the statute] is rescission, or rescissionary damages, if the defrauded purchaser has already disposed of the securities.”). 

27. Fla. Stat. § 517.211(6).

28. Kane, supra. at 647.

29. Id. supra. at 646.

30. A violation of the consumer protection provisions of the Florida Investor Protection Act, section 517.301, “automatically triggers” a damage award under the “mandatory damages provision of Fla. Stat. §517.211, . . . .”   Ainsworth v. Skurnick, 960 F.2d 939 (11th Cir. 1992).  “. . . [D]amages are automatic in accordance with the provisions of section 517.211.”  Skurnick v. Ainsworth, 591 So. 2d 904, 906 (Fla. 1991). 

31. “Indeed, as the Florida courts have held, ‘[b]ecause . . . section 517.211 contains an express civil liability provision, Florida courts need fashion no court-made civil right.  They need only follow the clear language of the statute.’” Hutton v Rousseff, 537 So. 2d 978, 981 (Fla. 1989).

32. Fla. Stat. §517.211(6).

33. Kirshner v.Interfirst Capital Corp., 732 So. 2d 482, 484 (Fla. App. 5th Dist. 1999) cited with approval in Moser v. Baron Chase, 783 So. 2d 231, 234 (Fla. 2001)(“It would be an empty victory for Kirchner to have prevailed in obtaining redress from her broker who violated the consumer protection provisions of the securities law if she now had to use her recovered investment to pay the fees to her lawyer made necessary by defendant's violation of its statutory duty.”).

34. Wilko,supra.

35. NASD Code of Arbitration 10301.