Yesterday, the New York Times ran an article on its online page questioning the fairness of securities arbitration. The author of the article, Gretchen Morgenson, was particularly concerned with the process used in selecting the members of the arbitration panel. According to Morgenson, “The problem is that the potential arbitrators are trusted to volunteer their own possible conflicts of interest.” (Gretchen Morgenson, When Arbitrators Are Their Own Judges, nytimes.online, August 12, 2007).
Wall Street Firms require their clients to sign contracts with mandatory arbitration clauses. This means that if a conflict arises between the customer and the brokerage house, the dispute will be resolved in arbitration, and not a court of law. The Financial Industry Regulatory Authority (FINRA) is the organization that oversees almost all securities arbitration disputes involving customers. FINRA requires a three-member arbitration panel to hear the case. One panel member represents the brokerage industry, and the other two allegedly represent the public. The three arbitrators act as judge and jury.
Both sides are provided a list of candidates for the three-member arbitration panel. Although they are allowed to strike people from the list for possible bias, conflicts and so forth, the process is not foolproof. Potential arbitrators are supposed to disclose conflicts they may have in the so-called arbitrator disclosure report. But, for some reason, potential arbitrators frequently do not provide sufficient disclosure.
Morgenson explains the problem as follows:
For investor advocates, the potential for conflicts among arbitrators ranks high on the list of arbitration problems. They say that requiring arbitrators to volunteer their conflicts with little policing of those disclosures is an honor system that can lead to abuse.
Morgenson provides a real-life example of a retired couple that lost $48 million–their retirement–because the broker put all their money in just two volatile telecommunications companies. The broker worked for Piper Jaffray. The victims brought an arbitration against Piper Jaffray. One of the arbitrators selected–in fact, the chairman of the three-member panel–failed to disclose significant conflicts of interest. The chairman of the panel was an attorney who worked at a law firm who had previously represented Piper Jaffray in two different law suits, and had provided legal services to Piper Jaffray relating to public offerings. The arbitrator in question, Mark F. Marshall of Davenport, Evans, Hurwitz & Smith in Sioux Falls, S.D., did not explain why he chose not to disclose this important information. (Gretchen Morgenson, When Arbitrators Are Their Own Judges, nytimes.online, August 12, 2007).