A Corrupt Arbitration Process That Hurts Investors

Today’s column is a going to be a bit technical, but stick with it. It’s about litigation and gaming the system. No, we’re not discussing Volkswagen’s diesel deception. Instead, we are going to look at the way some organizations seek advantages when it comes to adjudicating disputes.

In the world of investing, this comes up often. The Financial Industry Regulatory Authority (Finra) is the brokerage world’s self-regulating organization. It has run an arbitration division for a long time. More recently, the Securities and Exchange Commission expanded its ownin-house adjudication forum.

The SEC situation came to broader attention courtesy of a Wall Street Journal article last October. The story noted that the agency prevailed much more often in cases heard by SEC-appointed administrative law judges than in those that went to federal court:

The agency’s win rate in recent years is considerably higher in front of its administrative law judges than it is in jury trials. In the 12 months through September, the SEC won all six contested administrative hearings where verdicts were issued, but only 61%—11 out of 18—federal-court trials, according to previously unpublished figures.

There has been a similar winning rate in previous years. The agency won nine of 10 contested administrative proceedings in the 12-month period through September 2013 and seven out of seven in the 12 months through September 2012, according to SEC data. The SEC won 75% and 67%, respectively, of its trials in federal court in those years.

Part of this shift traces to the Dodd-Frank Act, which authorized more use of administrative law judges. The idea was to streamline the adjudication process on the theory that administrative hearings are faster and cheaper than traditional trials.


The problem is that it creates a home-field advantage for prosecutors. It isn’t so much the penalties but the proceedings themselves that are at issue. Defendants claim they have more extensive rights to take witness testimony and collect evidence in federal trials than an administrative proceeding. Last year, Jordan Peixoto, accused of insider trading, appealed his administrative trial, claiming an abridgment of his “constitutional rights to due process and equal protection under the law.” The case was dropped, though for different reasons.

American jurisprudence is replete with structural devices to avoid litigation. The reality is the vast majority of disputes are resolved without going to trial. Typically, there is a party claiming some kind of damage, and the threat of litigation and its potential costs forces some manner of rational calculus on all of the parties.

A small number of claims don’t lend themselves to easily resolution. Sometimes facts are in dispute, the law is unsettled or there are advantages to delay. Occasionally, one of the parties isn’t rational. The result is that some cases do go to trial.

I have personal experience with this. Decades ago in my earlier career as a lawyer, I ran mediation and arbitration cases. I worked with retired federal and state judges, who were used by litigants to hash out faster, cheaper and arguably fairer settlements than might otherwise have been reached through the courts.

The key however was that “alternative dispute resolution,” as the process was known, was strictly voluntary. When both sides realized they were at an impasse, and the costs of delay were high, all parties came to the table to find a palatable solution. No one gave up the right to go to court.

This isn’t the case, though, in Finra arbitrations. Anyone who works on Wall Street or invests through a brokerage firm has signed an agreement to settle any dispute through mandatory arbitration. There is no alternative. If you want a job at a brokerage firm, or if you want a brokerage account, you are placed in an arbitration straitjacket. Unfortunately, our business-friendly Supreme Court has upheld the use of mandatory-arbitration agreements.

Forget for a moment that these agreements require you to sign away your right to go to court to resolve a dispute.  What’s more troubling is the how the process is slanted in favor of those who work for the financial industry, which in turn runs Finra. This conflict of interest tells you almost all you need to know about Finra-sponsored arbitration. Some of the abuses that have been documented over the years are mind-boggling.

To its credit, the SEC has responded to complaints from the defendant’s bar, and is overhauling its in-house tribunal process. This is a small but positive step. Whether it goes far enough has yet to be determined.  One thing you probably can count on: No similar change at Finra.

Americans have a fundamental right to a trial for both criminal and civil offenses, and no one should be required to surrender it to get a job or conduct business. We should be very skeptical of methods that limit or deny people the right to defend themselves or seek redress.

Oh, and one last thing: The Supreme Court should undo its mistake.

Published as: A Legal System That Works for Wall Street




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  1. DeDude commented on Sep 25

    Interesting differences in the headline here and on Bloomberg.

  2. willid3 commented on Sep 25

    while the industry is different, the root cause is the same. its the self regulation scam that has been sold to all that its cheaper so it must be better which turns out to be a scam in that its all predicated on being cheap, not fair, or effective., courts tend to be expensive and try to be fair. but business doesnt like that cause if they get caught gaming their business or gasp breaking it, they get their hands slapped. but if they can control the process (arbitration or testing) they can save money, and get their way with no one the wiser

  3. DSS10 commented on Sep 25

    Finra is trying to reach NAR levels of credibility….

  4. cbatchelor commented on Sep 25

    Meanwhile, in the world of sports (from which we get the word “sportsmanship”):

    Switzerland announced a criminal investigation today (Sept 25) focused on Sepp Blatter, the FIFA leader already a target of U.S. investigations of corruption in world soccer’s governing body. One issue, the Swiss said, was his awarding to the Caribbean Football Union the rights to two World Cups for $600,000, which another official, Jack Warner, then licensed for up to $20 million.

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