Terra Extraneus

In Raymond James Financial v Bishop, the United States Court of Appeals for the 4th Circuit affirmed a district court judgment vacating an arbitration award. While the 4th Circuit opinion depicted the arbitration award as “incoherent,” the 4th Circuit’s opinion was little better. However, that the 4th Circuit was willing to act as it did seems to be yet another harbinger of death for arbitration.

This particular arbitration award was issued by a FINRA arbitration panel in 2006 and Raymond James moved to vacate it in 2007. Thus, because this was a case involving only industry members and associated persons, at that time we should be right that the panel was an industry panel. The 4th Circuit, however, does not address it. That would matter because that would likely mean there was no lawyer on the panel, or only a lawyer that had never practiced. Without a lawyer to guide them, an industry panel would not likely be able to draft anything satisfying to a federal court.

The composition of the panel would be important to know because the trial court, the federal district court, remanded the arbitration award to the FINRA arbitration panel for clarification. The 4th Circuit opinion is unclear whether the award was a standard award or whether it contained any reasons for decision. But, it seems almost certain the award did not contain any findings of fact or conclusions of law. Thus, a remand for clarification was not likely to garner clarity. The 4th Circuit opinion does not address whether the panel was asked by anyone to enter formal findings of fact and law or whether the panel refused.

While the 4th Circuit noted that the arbitration panel did not have a duty to clarify the award, most arbitration panels would not refuse to respond to a remand from a federal court. An industry panel might not realize that the better response would have been a polite refusal to clarify a standard award, because a standard award does not contain findings of fact or conclusions of law. Indeed, two letters of clarification later, the federal court was still depicting the arbitration award as “inscrutable.” The federal trial court did not seem to like the arbitration panel’s description of the legal basis for the award. The federal trial court also did not find any articulation of the causal link between the liability finding and the damages awarded. How could the federal expect to find either in the brief comments of an industry panel that likely did not include a lawyer and in the absence of formal findings of fact and law?

It should also be noted that the authorities relied upon by the 4th Circuit were often from the era of Wilco v Swan, and not from the era beginning with Shearson/American Express, Inc. v McMahon. In other words, much of this opinion comes from the era when courts expressed disdain for arbitration.

The 4th Circuit, however, by holding a standard FINRA award to a review standard that a jury verdict form could never meet, clearly expressed its hostility to arbitration, a court emotion that was supposed to be obsolete.

No Comments

One of the things that will hamper if not ultimately destroy the utility of arbitration is that the largest non-securities self-regulatory arbitration forum, the American Arbitration Association, has begun to behave more like a scion of capitalism than a non-profit organization advocating reform. This has been brought about by several changes in AAA policy.

The first change began when AAA started viewing its continuing education of arbitrators as a profit or income center. In out of the way places like Oklahoma, the AAA soon had no local arbitrators because the number of AAA cases in Oklahoma did not provide enough arbitrator employment to offset the high cost of AAA continuing education fees.

The next change came about when AAA stopped viewing service as an arbitrator as public service and began promoting it as just another form of hourly consulting practice. Hourly rates for most AAA arbitrators rocketed from the rates associated with non-profit work to the highest commercial hourly rates, typically for legal work, offered in a region. Also, this fit in with the first change because the charges for continuing education of arbitrators could then be justified to arbitrators allowed to charge, if not encouraged to charge, their highest hourly rates.

Thus, in out of the way places like Oklahoma, where AAA has no office, and probably has never had an office, and now has to local panel of arbitrators, arbitrators must be imported. The result is that the travel costs are now a significant cost burden on the arbitration.

The result of all of this is that to hear a relatively routine commercial dispute in Oklahoma, the AAA will want to bill and collect $100,000 in fees and expenses for itself, the fees of a trio of arbitrators, and their travel costs. Even with any resources the AAA can muster as a non-profit forum, the AAA can only moderate the fees and expenses to the $75,000 range.

These fees and expenses, of course, are sought by the AAA for routine commercial disputes. This means that claims with a risk of recovery as high as 30% or 40% (the likelihood of a zero or an award less than the expenses) should not be brought in the AAA. Because handicapping outcomes in jury trials, arbitrations, and horse races bear so much uncertainty, AAA claims probably cannot be handled on a reduced hourly, partial contingency or full contingency basis. They cannot be handled on a contingency basis in which counsel advances the AAA fees and expenses. Clients that cannot pay $40,000 to $50,000 for arbitrator expenses and bear the risk of loss, too, have to stay out of AAA. Clients that, in addition to the arbitrator fees and expenses, must also pay the costs of full blown court-type discovery many of these panels authorize (depositions, document production, expert witness fees) will quickly be frozen out of the system. Indeed, it may be that the AAA, in seeking its own economic goals, has decided that B2B litigation, where the commercial entities can afford to spend hundreds of thousands of dollars on dispute resolution, are its “market” of choice.

The original premise of the US Supreme Court in authorizing mandatory arbitration clauses, came about when Wilko v Swan, 346 US 427 (1953) was overruled in a triad of cases that included Rodriguez de Quijas v Shearson / American Express, Inc., 490 US 477 (1989). The premise was that the safeguards available in modern arbitration now permitted deference to arbitration as a dispute resolution method outside of court process.

It might be better for parties to challenge in court mandatory arbitration clauses in some circumstances. For example, a mandatory arbitration clause in an older contract that mandated AAA as a forum could not have anticipated the $100,000 arbitration model that is now prevalent. Indeed, the $100,000 arbitration model for any but the largest commercial entities, might be unconscionable. In any event, the $100,000 arbitration model has ended the chief advantage in arbitration, cost-efficiency.

No Comments

Associated persons (a/k/a “financial advisors,” stockbrokers, etc.) should be wary of FINRA’s new Rule 13806 which provides for a single arbitrator in promissory note cases. While the single arbitrator may be fine for default cases, where the associated persons plans to make no defense and files no answer, rarely are single arbitrators desirable in contentious employment cases of any kind. Invariably, single arbitrators rarely have the courage on their own to do more than do a Solomon - like “split the baby” Award. Worse, too often, the single arbitrator is so aligned with the industry that even public policies designed to protect ALL employees are simply disregarded. FINRA tried to avoid the latter by restricting single arbitrator choices to panelists qualified to hear discrimination cases. However, anyone caught in this system should be wary until the system statiscally verifies its lack of imbalance in favor of the industry.

No Comments

The new FINRA statistics are always fascinating. While filings are up for 2008, “82%” FINRA says, that is an 82% increase over the fourth lowest number of new case filings since 1994. The lowest since 1994 was in 2007 at 3,238. FINRA is estimating new case filings in 2009 will eventually reach 7,750, even though as of June the new filings had not reached 4,000. Thus, FINRA is predicting for 2009 the fourth highest number of new case filings since 1994.

Why did the number of new case filing in 2007 drop so drastically? Was it because of strong market performance? Was it because of upgraded and determined compliance by the securities broker dealers? Was it because the legal community decided to leave these types of cases to specialists? Was it because the legal community thought that the system was rigged (i.e., the controversy over industry panel members and other disputes) and stopped filing cases?

We have heard anecdotal reports, and seen some news media reports, suggesting that all of these might be true, or might be the perception of at least some participants. If these, in whole or in part, are true, or perceived as true, then FINRA’s projection of new case filings for 2009 may be too high.

No Comments

How did Bernie Madoff, the hands-down all-time winner of the title “world’s greatest thief,” get away for so many years with bilking so many investors out of so many billions of dollars?

Madoff awaits sentencing after pleading guilty to 11 felony counts in a Ponzi scheme by which he swindled investors out of $65 billion. Inmate 61727-054 has settled into his new home: a 7½ x 8-foot cinder block cell at the Metropolitan Correction Center in New York City.

How could Madoff get away with such a massive fraud for so long? Don’t we have regulatory mechanisms in place to protect investors against crooked brokers and investment advisors? Yes we do — sort of. If the Bernie Madoff super-con has provoked your ire, how do you react when you learn that one of the people entrusted with preventing such skullduggery was – wait for it – Bernie Madoff. Keep reading.

The Securities and Exchange Commission is the agency charged with enforcing federal securities laws. The SEC was established in 1934 in response to the 1929 crash and the Great Depression that followed. The SEC makes sure that public companies disclose information that investors have a right to know. It also brings enforcement actions against brokers, dealers and advisors who violate securities laws.

However, to a great extent, the SEC allows the securities industry to regulate itself. Come again? That’s right, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves.

FINRA (the Financial Industry Regulatory Authority) is the self-regulatory organization entrusted by the SEC with making sure that its member brokerage firms and their registered reps follow the law. FINRA can initiate disciplinary actions against its erring members, and also, unhappy customers may file complaints with FINRA against their brokers, which are resolved through arbitration.

By the way, if you have never heard of FINRA, you probably have heard of its predecessor: the National Association of Securities Dealers (NASD). In 2007, the NASD became FINRA and took over enforcement of all major U.S. stock exchanges. So how well does FINRA do at keeping its own members in the financial sector in line? That is, how is FINRA doing besides failing to uncover the biggest swindle in the history of the industry?

According to the Wall Street Journal, in 2008 FINRA levied fines against financial firms totaling $40 million. $40 million? That’s a miniscule sum compared to the trillions being managed by the 5,000 brokerage firms, 173,000 branch offices and 659,000 registered reps that FINRA oversees.

In addition, customers filed about 5,000 arbitration cases with FINRA in 2008. The most common complaints were breach of fiduciary duty, misrepresentation, breach of contract and negligence. However, less than 500 arbitrations in 2008 survived the process all the way to an actual hearing and decision, and less than half of them (42%) resulted in an award for the claimant. About 2,000 more cases were settled or mediated.

To the securities industry, a few million dollars in fines and a couple of hundred arbitration awards is the equivalent of an occasional “traffic ticket.” The industry merely budgets these minor inconveniences as part of the cost of doing business.

And how does Madoff figure into this discussion? Well, believe it or not, Madoff is a former chairman of the NASD’s board of directors, a former member of the NASD board of governors, and a former chairman of Nasdaq, the stock exchange the NASD regulated. In other words, to put it in the simplest possible terms, while Madoff was stealing billions of dollars from unwitting investors, he was also serving as one of the top officials entrusted with making sure brokers didn’t get away with such things. Wall Street, we have a problem.

Dallas money manager Gary D. Halbert writes: “How could regulators have missed this one? Oddly, Madoff appears to have operated below the radar screens of the SEC and various other regulatory agencies for many years. Perhaps this was because of Madoff’s very high Wall Street profile and his service as co-founder, board chairman and governor of the NASDAQ for several years in the late 1980s and early 1990s.”

Halbert continues:

The SEC said it conducted two inquiries [including a 2007 examination] of Madoff in the last several years and did not find major problems. … I find this baffling! My company, Halbert Wealth Management, is a Registered Investment Advisor with the SEC. We have been through a routine examination by the SEC. Our broker-dealer firm, ProFutures Financial Group, has been through multiple routine examinations by the NASD, and more recently FINRA … I can tell you that these routine regulatory examinations – at least among smaller firms like mine – are rigorous. They typically have 2-3 examiners in our offices for up to two weeks at a time looking at all of our books … If my company was running a Ponzi Scheme, or stealing customer monies, I feel confident that the regulators would have caught us upon the next regularly scheduled examination. … Frankly, I have NO CLUE how the SEC failed to discover Madoff’s giant Ponzi Scheme in its various examinations.

Halbert’s observation underscores a frequent criticism of SEC and FINRA enforcement: that the agencies go after small fish to keep up appearances, while failing to uncover large-scale wrongdoing perpetrated by the major players. Madoff was one of the biggest, and he went undetected for years.

As I said, under our current system, our first line of defense to protect investors against dishonest brokers and broker-dealers is for the brokers to regulate themselves. That means that in the case of Bernie Madoff, we have been trusting history’s all-time greatest thief to keep himself honest. That’s not working. New SEC chief Mary Schapiro says a crackdown is coming. “The world has changed dramatically in the last year,” Schapiro recently told Congress. “There will be no sacred cows.”

Given recent headlines, tough talk is to be expected. Tough action is another matter. We’ll believe it when we see it.

No Comments

There is an old saw that compares lawsuits to two men armed with knives circling each other in a dark room, not knowing whether they can ever put the knives down. During the raiding wars (a/k/a recruitment wars) of the last twenty-five years, the major wirehouses, broker dealers, and investment banks tried to defend their market share by making it difficult or impossible for stock brokers (a/k/a registered representatives, financial advisors, financial consultants)(“FCs”) to change jobs, even though they are mere at will employees.

One of the most aggressive and effective firms at defending its turf when stock brokers tried to change jobs and take their books of business with them was Merrill Lynch. Other firms were more vicious about it, and turned to forfeiture programs designed to put thousands if not millions of dollars of earned compensation at risk just for changing jobs, so Merrill Lynch was by far not the worst with which to deal.

Finally, however, the Courts began to wise up to the fact that, no matter what high sounding moral or legal issues might be used to justify the raiding wars and the TROs and emergency hearings they spawned, what was really at stake was the book of business, market share and business income. That led Merrill Lynch to develop the Protocol for Recruiting Brokers. About sixty broker dealers have signed up and Bank of America, Merrill’s new owner, just joined in the last couple of weeks.

However, during the recruitment drives of 2008, we are seeing the same contracts containing the same clauses that were used to obtain TROs and put the FCs on the beach since time immemorial. Also, no house will agree to insert any language deferring to the Protocol for Recruiting Brokers.

The houses all say the same thing about their refusal to incorporate the Protocol for Recruiting Brokers. Because any house can resign from the Protocols at any time, no house wants to make its employees third party beneficiaries of an agreement others might not keep. The men in the dark room carrying knives are still circling.

In these turbulent times when recruitment and job flight are at all time highs for FCs, it will be interesting to see if the houses panic over market share and withdraw from the Protocols. It will be interesting to see if courts have the sanity to impose the Protocols as an industry standard with or without signatories. A few courts have done so. See, Merrill Lynch v Brennan (D. Ohio 2007) (hat tip to the Firth Law Firm in Roanoke); Citigroup Global Markets, Inc. v Griffin, slip op. (District Court of Suffolk, No. 08-0022, 2008)(hat tip Social Law Library Research Portal at socialaw.com).

Courts should be reminded that historically courts have historically found these cases interesting for awhile and then later rued the day they let them flourish.

Petitioner’s [Smith Barney] protestations to the contrary notwithstanding, the Court does not foresee any cataclysmic repercussions for Smith Barney that cannot adequately be addressed by monetary damages which are easily calculable from the requisite documentation.

Smith Barney, Inc. v. Anthony Cappiello, Supreme Court, County of New York, No. 603445/98, July 20, 1998, Slip Op. at 3.

No Comments

The State Bar of Texas, I guess, will publish absolutely anything. In this instance, the State Bar of Texas published a pamphlet, called it a book, and stuck in a CD to try and justify the nice cover.

Arbitration Road Map, A Guide to Clauses Procedures, and Hearings, Austin 2007, is divided into two parts. Part 1, all 38 pages of it, supposedly deals with general arbitration considerations and Part 2, all 37 pages of it, deals primarily with international arbitration. The third part of the book, pages 78 – 110, contains the appendices, which include sample arbitration clauses. The CD contains the text of the book and is searchable, but the paucity of the book is not improved on the CD.

The book contains a few good points about arbitration law and procedure, but nothing a first year associate could not gather in a day from a standing start. There is little commentary from the practitioners that are named as the authors that would be considered substantive advice from experienced arbitration counsel. I would have expected experienced Texas arbitration counsel commentators to at least be able to tell some good anecdotes, even if they were unable or unwilling to give advice about how to handle the various steps in arbitration proceedings.

While a novice or student faced with an arbitration might find a useful item or two about the arbitration process, experienced arbitration counsel would find this volume a waste of time. Further, there are simply better “road maps” and “guides” and even casebooks already available that do not insult the intelligence of the reader. It is almost as if this book was really the outline for a future book, and was shipped to the printer by mistake.

No Comments

Most people that engaged a financial advisor employed by a FINRA (formerly NASD) broker-dealer and all registered representatives signed something containing a mandatory arbitration clause. FINRA announced that for 2007, new arbitration case filings dropped to their lowest level since 1992. That is a staggering concession.

While some political forces have been trying literally forever to abolish or curtail arbitration, arbitration itself may be doing what political power could not do.

I have been handling securities industry arbitrations since 1988 and I have represented broker-dealers, registered representatives, and customers, although few of the latter, and I thought 2007 was a busy year. It seems, however, it was less busy than I realized.

The three years of lesser activity at FINRA Dispute Resolution, 1992, 1998 and 2006, averaged 4,644 case filings annually. 2007 was 70% of that average; 30% below the average of the lowest filing years prior to 2007.

It will be interesting to see if the industry credits one or more allegations of: good returns of 2007, good compliance initiatives, or something else. Could it be that the legal community has figured it out and has revised upward the criteria for case selection to offset the fact that it is a high risk forum?

No Comments

I saw an article in Investment News a day or so ago on this topic but after reading the article, could not tell what new event had led to the story. But, it led me to consider that even with a Democratic Congress in its infancy, there have already been bills submitted which would essentially abolish mandatory arbitration. So, the debate over whether FINRA should abolish the practice of mandating one industry arbitrator on each panel of arbitrators is again cutting edge. (FINRA, the Financial Industry Regulatory Authority, is the organization that resulted from the merger of the National Association of Securities Dealers, Inc. and the New York Stock Exchange, Inc.’s regulatory arm.)

The article by Dan Jamieson of Investment News contained the claim that industry arbitrators were the “good guys” because they were harder on industry “ne’er do wells” than public arbitrators.

Sometimes that is true and sometimes it is not.

FINRA provides to litigants a database that contains all of the decisions of every arbitrator proposed for an arbitration. Counsel can study the past decisions of an arbitrator and, if there are enough of them, can also develop a model of the arbitrators’ decision making proclivities that is sometimes predictive. For example, if an arbitrator has never awarded any money, or never an amount seemingly reflective of the claims, after sitting on several panels, it should be pretty clear that they are not likely to do it. Counsel for the aggrieved customer or aggrieved employee should not count on a break through with that arbitrator.

Many lawyers select arbitrators based solely on their respect for the arbitrator. While that is a good criteria, it should not be the only one. The mathematics of past decisions should be equal to or greater than subjective impressions. Half a dozen decisions is usually enough to gauge a prospective arbitrator, but a dozen is much better. Simple math tricks can also help: weighting types of cases, weighting the quality of counsel that have appeared in those past cases, weighting the awards, and dropping highs and lows. The passage of time should be considered; decisions more than a decade old may not truly reflect that an arbitrator has matured or ripened.

Arbitrators that have developed a decisional history that omits monetary awards are more often than not former branch managers. It is not hard to decipher the cause. Branch managers are historically front line cannon fodder for the wirehouses and appear at arbitrations as the company representative. They would not be sitting there, sometimes with their own career or future prospects on the line, if not for a customer or that disgruntled employee. At the very least, if there is an award by the panel, it usually comes off the bottom line of their office, and more directly, out of their bonus. It leaves an impression that is usually indelible. Even after many years of retirement, most former branch managers cannot strike that feeling of déjà vu. While most former or retired branch managers that are experienced arbitrators will deny that their bitter moments in arbitrations of long ago do not impact them in the here and now, their published voting pattern usually reveals something else.

Some of the most respected arbitrators are often the first struck from a prospective panel by students of their decisional histories. What would improve the standing of industry arbitrators is more stringent disclosures, including things such as the number of times the industry arbitrator has testified, the number of times they have acted as a company designee in litigation and arbitration, and clearer disclosures about whether they have ever suffered a professional or monetary set back because of an arbitrated claim. The current system of disclosures needs a tune up and bolt tightening.

No Comments

California courts have been narrowing the enforceability of arbitration agreements in adhesion contracts, especially in employment contracts used by employers with numerous at will employees.

The problem is caused because of the inability of the average employee in the United States, or anywhere, to read the foregoing sentence and understand words like “adhesion,” and even words like “at will” and “arbitration.” Employees that go to work for employers of numerous employees often have employment handbooks or sign employment documents, like applications, that contain arbitration clauses. However, from now on, in California, if the employment documents contain a clause purporting to strip the employee of the right to bring a class action, the clause is void. Further, no arbitration clause that depends upon a prohibition of a class action can trump the right to bring a class action. Lisa Murphy v Check ‘N Go of California, Inc., Cal. App., A114442, October 17, 2007. To read this decision, you can find it here.
This opinion is one of a numerous series of cases that have defined the substantive or procedural unconscionability of arbitration clauses.

No Comments