PIABA Bar Journal, Spring 2005 (Vol. 12, # 1)

"Survey Says - SRO Arbitration Unfair"

By Mark A. Tepper     Investment Fraud Attorney

Introduction -- the Theory

Securities arbitration is not a level playing field. During recent hearings in the United States House of Representatives on the fairness of SRO (fn. 1) arbitration, Representative Barney Frank put the issue in perspective when he asked: if SRO arbitration is fair, why must it be mandatory?
(fn. 2).

How can securities arbitration be fair when SRO's instruct their arbitrators that they need not follow the law (fn. 3) and that they can frustrate judicial review by not writing reasons for their awards? (fn. 4). This type of instruction encourages lawlessness in arbitration by replacing the objectivity of law with the bias and prejudice of individual arbitrators who are not accountable for their reckless conduct.

Such instruction is an example of institutional bias which compromises the integrity of SRO arbitration. As SRO's encourage arbitrators to dish out their own brand of frontier justice, Claimants are being denied their full measure of damages as provided by statute.

The deck is stacked against customers in their arbitrations with brokerage firms. The securities industry has a ringer on every three arbitrator panel the industry arbitrator. (fn. 5). Imagine a state criminal court saying that a policeman must be on every criminal jury to explain police work to the other jurors. There are constitutional protections against that in court. But not so for victims of investment fraud who are expected to fight Goliath with one foot in a bear trap.

NASD and NYSE representatives told Congress that their arbitration programs are fair. NASD cited statistics that 55% of arbitration panels find for the Claimant. (fn. 6). NASD did not disclose the amount recovered in these "favorable" awards which tells a different story.

Arbitration Survey (fn. 7)

Florida has enacted the Florida Investor Protection Act reflecting a public policy to protect Floridians from investment fraud. To achieve its purpose of protecting Floridians and deterring fraud, by defeating all visionary schemes, the Act must be liberally interpreted and vigilantly enforced. (fn. 8). The purpose of this Survey was to investigate whether Florida arbitrators were enforcing the statutory rights provided to investment fraud victims by the Florida Investor Protection Act ("517").

Methodology

When this Survey began on May 12, 2005, there were more than 10,000 awards in the Westlaw arbitration award data base ("FSEC-ARB"). We searched for all arbitration awards where the Claimant requested relief pursuant to 517, in arbitrations between a customer and member and/or associated person, ("517" & "customer"), which narrowed the amount of awards to 605. One-hundred thirty-three of the 605 were stipulated awards, which we eliminated, leaving 472
awards decided by arbitrators.

Arbitrators ruled in favor of the Claimant and awarded damages in only 207 of the 472 arbitration awards. In other words, Claimants had a losing percentage of 56% or a "favorable" percentage of 44% on statutory claims.

Among the 207 "favorable" awards, 154 were decided by three-arbitrator panels; the remaining 53 by a single arbitrator, (154+53=207).

In 53 of these 207 "favorable" awards, or 25.6%, the Arbitrators found a breach of fiduciary duty and/or other violation, but did not find a violation of the 517 Statute. Of these 53 awards, 50 were decided by three-arbitrator panels which includes an industry arbitrator; by comparison, a single arbitrator decided the other 3.

In 53 of the 154 arbitrations decided by three arbitrators, which includes an industry arbitrator, 34.4% of the panels found a breach of fiduciary duty, but did not make a statutory 517 finding.
In 3 of the 53 arbitrations decided by a single arbitrator, only 5.7%, made a finding of breach of fiduciary duty but failed to make a 517 finding. See Table.

 Florida Arbitrations Awarding Damages

 Finding

 3-Arbitrators

 1-Arbitrator

Total 

 517 violation

 101

 50

151

 B/F Duty; no 517

 53

 3

56 

Total 

154 

 53

 207

The Similarities between 517 and Breach of Fiduciary Duty

In customer-broker disputes, breach of fiduciary duty and 517 are premised on strikingly similar facts. Under Florida common law, a broker owes its customers the following fiduciary duties, among others:

1. The duty to recommend [investments] only after studying
it sufficiently to become informed as to its nature, price,
and financial prognosis;

2. The duty to perform the customer's orders promptly in a
manner best suited to serve the customer's interests;

3. The duty to inform the customer of the risks involved in
purchasing or selling a particular security;

4. The duty to refrain from self-dealing . . . ;

5. The duty not to misrepresent any material fact to the
transaction; and

6. The duty to transact business only after receiving approval
from the customer. (fn. 9).

Under Florida law, breach of fiduciary duty is more difficult to prove than a violation of 517. Proof of breach of fiduciary duty requires evidence that the breach directly or proximately caused the damages. (fn. 10). By comparison, proof of loss causation and reliance are not required to prove a violation of 517. (fn. 11). Neither breach of fiduciary duty nor a violation of 517 requires proof of scienter. (fn. 12).

Florida Statute 517 makes it a violation for a brokerage firm and/or its associated person, in connection with the purchase, sale or rendering of any investment advice, directly or indirectly, to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact. (fn. 13). Thus, under the Florida Statute, failure to perform any one of these fiduciary duties by a broker would establish a violation of 517. (fn. 14). Logic dictates that an arbitrator cannot find a breach of fiduciary duty by a broker without finding a violation of 517.

The Florida Investor Protection Act, in sections 517.211(3)-(6), specifies the legal remedy for a violation of the anti-fraud provisions of the Act ("statutory damages") which includes attorney's fees. When a violation is found, Florida and federal courts agree that statutory damages are "automatic" and "mandatory." (fn. 16). The Florida statute does not provide for any discretion. (fn. 17). 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 survey shows that a significant percentage of arbitrators are not giving the facts their full legal effect, refusing to apply the Florida Statute even when the facts compel such a finding.
This arbitrary and capricious conduct makes a mockery of the Statute and deprives investment fraud victims of their full statutory damages.

Survey's Significance Eliminate the Industry Arbitrator

The Survey identifies a serious problem with the fairness and integrity of SRO arbitration the presence of an industry arbitrator dramatically increases the probability that the arbitration panel will not enforce the Florida Investor Protection Act.

In favorable single-arbitrator cases, where there is no industry arbitrator, the arbitrators overwhelmingly (50 / 53, 94%) found a violation of 517. However, in three-arbitrator panel cases, which must include an industry arbitrator, the panels enforced the Florida Investor Protection Act in only two out of every three cases (101 / 154, 66%).

The NASD Code of Arbitration mandates that every dispute in excess of $50,000 must be decided by a three-arbitrator panel, including one industry arbitrator. (fn. 18). For disputes decided by a single arbitrator, NASD Rules provide that the arbitrator list will contain only public arbitrators. (fn. 19).

How can SRO arbitration be fair, if the SRO's mandate arbitration before an industry arbitrator? The difference between public and industry decisions is clear-cut only one in twenty (1/20, 5%) public arbitrators refused to enforce 517, while one in three (1/3, 34%) panels with an industry arbitrator did not enforce 517.

The presence of an industry arbitrator leads to disparate treatment of defrauded investors, which conflicts with due process.

Arbitrators' Obligation to Follow Statutory Law

In its Arbitrator's Manual, SICA (fn. 20) mis-informs arbitrators that they are not required to follow statutory law. SICA's mis-information conflicts with the interpretation of the United States Supreme Court as well as the Securities and Exchange Commission ("SEC"). The United States Supreme Court approved securities arbitration of statutory claims predicated on the stated expectation that arbitrators will enforce statutory rights. (fn. 21).

SICA's mis-interpretation is responsible for the common mis-perception that arbitrators are not required to follow statutory law. 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. 22). In its Amicus Brief in Shearson/American Express, Inc. v. McMahon, (fn. 23) urging the Court to overrule Wilko, the SEC recognized the arbitrators would be required to follow the law. (fn 24). This requirement became one of the linchpins 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. 25).

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. 26).

This Survey shows that panels with an industry arbitrator are not applying the Statute as required. The above referenced Supreme Court decisions make clear that, when dealing with statutory claims at least, arbitrators do have an obligation to follow the statute. This is important because the claimants in these Survey cases sought damages under the Florida Investor Protection Act. These provisions were developed to discourage improper practices in the securities markets during the 1920's. Today, we are seeing the same types of abuse by the brokerage industry. The securities statutes need to be strictly enforced to curb these current
abuses.

We have been unsuccessful in locating an explanation why the SEC permits the SRO's to distribute SICA's Arbitrator's Manual containing provocative mis-information to its arbitrators. According to the SEC, ninety-percent (90%) of arbitration cases received at the SROs in 1997 were filed at the NASD. (fn. 27). "[A]lmost all (98%) of 1997 arbitration cases were filed at the NASD and the NYSE." (fn 28).

Conclusion

Witnesses who testified on March 17, 2005 before the House Committee on Financial Services made it clear that practitioners who represented customers have a different perspective on the fairness of SRO arbitration than the NASD and NYSE. NASD and NYSE believe that their arbitration programs are fair.

NASD is a monopoly, by its own admission, as well as by the SEC statistics referenced above. NASD tells its arbitrator applicants that "[w]e handle more than 90% of all securities claims filed involving customers of brokerage firms . . . ." (fn. 29).

Monopolies, as business models, are notoriously poor providers of services. Monopolies have little incentive to improve service because demand has no alternative. There needs to be consumer choice, if there is going to be meaningful competition leading to meaningful reform.

SRO's must be made to compete with the AAA, (fn. 30) other arbitration forums as well as the courts for its arbitration services. With the advent of competition, market forces will compel reform by leaving investment fraud victims free to choose the fairest and most efficient forum, leading to better arbitration services.

Elimination of the industry arbitrator from three arbitrator panels is an essential reform for removing the appearance of partiality in SRO arbitration. The AAA uses three arbitrator panels in customer disputes with brokerage firms which do not include an industry arbitrator.

This Survey shows that industry arbitrators have a chilling effect on arbitrators' willingness to enforce Florida's Investor Protection Act. It is hard to imagine that a victim of investment fraud would voluntarily agree to have an industry arbitrator on a panel considering his or her dispute with a brokerage firm, which explains why SRO arbitration is mandatory. Industry arbitrators serve no necessary function.

The securities industry has a rule that requires brokerage firms to arbitrate customer claims before an SRO whether or not the customer and brokerage firm signed an arbitration agreement. (fn. 31). Expanding that rule will go a long way to resolving the unfairness of SRO arbitration. An SRO rule that requires brokerage firms to accept its customer's choice to proceed in SRO arbitration or an alternate arbitration forum or in the courts will provide the choice and competition needed to achieve the objective of fair and efficient resolution of customer disputes with brokerage firms.

___________________________________________________________

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

2. Congressman Frank made his comment, on March 17, 2005, during hearings before the House Committee on Financial Services.

3. Arbitrators are "not strictly bound by case precedent or statutory law." SICA, The Arbitrator's Manual, January 2001 ed., at 32, a publication of the Securities Industry Conference on Arbitration.

4. "In NASD training sessions, arbitrators are taught that 'awards that do not contain the panel's reasons are more appropriate. . . .' Written opinions, they are told, are burdensome, time-consuming, and invitations to judicial review not to mention that arbitrators may not even be competent to write them properly." Rosenberg v. Merrill Lynch, 995 F.Supp. 190, 198 (D. Mass. 1998).

5. SRO rules mandate that every three arbitrator panel include an industry arbitrator. NASD rules require that the panel include an industry arbitrator for customer disputes with brokerage firms, in excess of $50,000. NASD Rule 10308. NYSE rules require an industry arbitrator on the panel when the customer claim exceeds $25,000. NYSE Rule 607.

6. Testimony of Linda D. Feinberg, President, NASD Dispute Resolution, before the
Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Committee on Financial Services, United States House of Representatives, March 17, 2005.

7. Special thanks to Evan S. Shenkin who conducted this Survey.

8. Arthur Young & Co. v. Mariner Corporation, 630 So.2d 1199, 1203 (Fla. App. 4th Dist. 1994); Merrill Lynch v. Byrne, 320 So.2d 436, 441 (Fla. App. 3d Dist. 1975).

9. Ward v. Atlantic Security Bank, 777 So.2d 1144, 1147 (Fla. 3d DCA 2001). The Ward Court specifically did not limit the duties owed to a customer.

10. Csordas v. Smith Barney, 1992 WL 426460 (Fla. Cir. Ct.).

11. E.F. Hutton v. Rousseff, 537 So.2d 978, 981 (Fla. 1989); Waters v. International Precious Metals, 172 FRD 479, 495 (S.D. Fla. 1996).

12. Merrill Lynch v. Byrne, 320 So.2d 436, 440 (Fla. App. 3rd Dist. 1975).

13. Fla. Stat. 517.301; Ward v. Atlantic Security Bank, 777 So.2d 1144, 1147 (Fla. 3d DCA 2001)("Unlike its federal counterpart, a securities fraud claim under section 517.301 may also be brought for fraud 'in connection with the rendering of any investment advice'").

14. See Gochnauer v A.G. Edwards, 810 F.2d 1042 (11th Cir. 1987). The Eleventh Circuit held that Gochnauer proved a breach of fiduciary duty, but not a 517 violation, based on plaintiff's failure to prove reliance causation. Based on the Florida Supreme Court's decision in Rousseff, the Waters Court held that reliance is not a required element under 517.

15. Of course, not all breaches of fiduciary duty will constitute violations, such as in the context of the duties majority shareholders owe minority shareholders. However, among those cited by Florida Courts as the duties owed by brokers to their customers, each likely would.

16. 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).

17. "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).

18. NASD Rule 10308(b)(1)(B).

19. NASD Rule 10308(b)(1)(A). The single, public arbitrator may request to have the claim decided by a three-arbitrator panel if the amount is less than $25,000. For claims between $25,000 and $50,000, a party in its initial filing or the assigned arbitrator may request a three-arbitrator panel.

20. SICA stands for "Securities Industry Conference on Arbitration."

21. 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).

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

23. McMahon, supra.

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

25. McMahon, supra. at 232.

26. 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).

27. United State Securities & Exchange Commission, Division of Market Regulation, Oversight of Self-Regulatory Organization Arbitration (Audit 289), August 24, 1999, p. 1.

28. Id.

29. See cover letter sent to prospective arbitrators by NASD's Neutral Relations Supervisor.

30. "AAA" stands for American Arbitration Association.

31. NASD Rule 10301; NYSE Rule 600.