I. General
A. Nearly all brokerage firms require retail clients to sign an agreement to have all disputes between them decided in arbitration rather than court.
B. About 25 years ago, in Shearson/Am. Express, Inc. v. McMahon, 402 U.S. 220 (1987), the U.S. Supreme Court upheld the validity of arbitration clauses which require clients to arbitrate any disputes they have with their stock brokerage firms or individual brokers. These clauses are included in nearly all new account agreements between brokerage firms and clients. As a result, there are virtually no viable legal challenges to an arbitration clause signed by a legally competent adult. Section 921 of the Dodd-Frank Act amended the Securities Exchange Act of 1934 to provide that the SEC may limit or prohibit the use of mandatory arbitration clauses by brokerage firms. However, these clauses are still deemed enforceable, which the SEC is considering what action to take. Investor advocates are pushing hard to ban mandatory arbitration, while still allowing arbitration at the election of the customer.
C. Arbitrators now hear most disputes (other than class actions) between brokerages and clients and among industry members. Almost all arbitrations are conducted by the Financial Industry Regulatory Authority (“FINRA”). FINRA’s arbitrations are conducted under the Code of Arbitration Procedure (“CAP”). These procedural rules are reviewed and approved by the SEC.
II. Advantages and Disadvantages of Arbitration
A. Advantages – Arbitrations are usually resolved within a year versus much longer in court. Costs in arbitration are less than court, and appeals are much more limited. Cases are heard on the merits. Dismissals of claims on motions are almost nonexistent. Arbitrators are free to apply concepts of equity and fairness, as opposed to following technicalities.
B. Disadvantages – There is a wide-spread perception that the arbitration system is stacked against customers. Some people have expressed concern that many arbitrators are reluctant to mete out large awards against big brokerage firms or to issue strong discovery rulings.
III. Selection of Arbitrators
A. The Rules
1. Arbitrators are appointed to the roster by FINRA, but they do not work for FINRA.
a. Candidates must fill out lengthy applications. To qualify, a candidate must have at least five years of full-time business or professional experience and two years of college-level credits.
b. FINRA requires candidates to submit to a thorough background check and to attend and pay for a basic arbitrator training course ($125). There are continuing education courses which are provided by FINRA, mostly on-line and free.
c. There are three categories of arbitrators:
i. Public—they are not affiliated with the securities industry; but there are holes that allow people who, for example, are living on their pension from a brokerage to be deemed public;
ii. Chair Qualified—these are public arbitrators who have additional training to act as chairperson at the hearing; and
iii. Non-Public—these are individuals who are, or were recently, associated, directly or indirectly, with the brokerage industry.
2. The number of arbitrators assigned to a case is based on the size of the claim (CAP §12401):
| Size of Claim | Number of Arbitrators |
| $25,000 or less | One |
| Over $25,000 to $100,000 | One, unless parties agree to three |
| Over $100,000 | Three, unless parties agree to fewer |
3. Under CAP §12403, arbitrators for three arbitrator cases are selected as follows:
a. Step 1—FINRA’s computer system randomly generates a list of ten (10) arbitrators from each category (Public, Chair, and Non-Public) who are available to serve in the location in which the case will be heard (generally the major city in the state of customer’s residence);
b. Step 2—biographical forms for the arbitrators and lists of their prior awards are sent to parties about thirty (30) days after the answer is due;
c. Step 3—twenty (20) days later, each separately represented party may strike up to four (4) names from each list; the remaining arbitrators are ranked in order of preference by the parties; the rankings and strikes are sent to FINRA (but not to opposing party); and
d. Step 4—FINRA compares the lists submitted by the parties and assigns the highest ranked remaining arbitrators to the case, if they will serve. Before appointing arbitrators to a specific case, FINRA notifies them of the nature of the dispute and the identity of the parties. The arbitrators must then disclose any facts that could indicate bias, including relationships with parties, counsel or witnesses. This information is conveyed to the parties. CAP §12405. If there are no arbitrators left in a given category who can or will serve, FINRA goes back to the computer for a randomly selected replacement arbitrator.
4. Under an important rule which was enacted in 2011 at the urging of investors, parties can elect not to have a non-public member (i.e., an industry member) on the panel. CAP §12403(d).
5. After an arbitrator is appointed, parties can move to have him or her withdraw or be removed for good cause (bias, partiality, etc.). CAP §12406, 12407.
IV. Pleadings, Discovery, Filing Fees, and Deadlines
A. The Statement of Claim (“SOC”) should specify “the relevant facts and remedies” and include supporting documents. CAP §12303. FINRA serves the SOC on the respondent.
B. Filing fees are based on the size of the claim. They range from $50 to $1,800 (for claims over $1 million). CAP §12900(a).
C. Answers are to be filed forty-five (45) days after service of the SOC. The answer may include counterclaims, cross-claims or third-party claims. CAP §12303.
D. After arbitrators are appointed, an Initial Pre-Hearing Conference (“IPHC”) is held for the arbitrators and counsel to set deadlines and formally accept the arbitrators. CAP §12500(d). The date for the hearing on the merits is usually set at the IPHC. That hearing generally occurs within a year of the IPHC. This may seem like a long time, but it is much faster than court.
E. Prehearing motions to dismiss are severely limited. Under CAP §12504, the arbitrators cannot act on such a motion unless the non-moving party previously released the claim in dispute in a signed settlement agreement or release, or the moving party was not associated with the account, security or conduct at issue.
F. Limited discovery is allowed, with an emphasis on document production. Unless the parties agree otherwise, the parties must produce certain documents set forth on the FINRA Discovery Guide which are presumed to be discoverable in all customer cases. CAP §12506.
1. Among the documents that customers must produce are: federal income tax returns for three years prior to the first transaction at issue through and including the date of filing of the SOC; account statements from accounts other than that at issue; notes; correspondence; telephonic records and correspondence; recordings; and other complaints about securities matters.
2. Brokerage firms must produce documents concerning the customer’s risk tolerance, income, net worth, and investment objective; notes; correspondence; research materials; and relevant compliance manuals.
3. Parties can serve additional document requests which go beyond what is on the mandatory lists. These must be answered in sixty (60) days. CAP §12507.
4. Subpoenas may be issued by the arbitrators. CAP §12512.
5. Depositions are “strongly discouraged,” but may be allowed to preserve testimony of ill witnesses, to accommodate essential witnesses who can’t attend the hearing, to expedite large or complex cases, or if the panel thinks extraordinary circumstances exist. CAP §12510.
6. Standard interrogatories are not allowed, but very limited “requests for information” which seek data like names of persons may be utilized. They cannot require narrative answers or fact finding. CAP §12507(a)(i).
7. If a party is dissatisfied with discovery responses (or lack thereof), they may file a motion to compel discovery. CAP §12509.
8. Sanctions for discovery abuse can include awarding a party attorneys’ fees and dismissal of claims and defenses. CAP §12511.
G. At least twenty (20) calendar days before the first scheduled hearing on the merits, parties must serve documents which they intend to present at the hearing (that they have not already produced) and identify the witnesses they intend to use. CAP §12514. Under CAP §12514(e), parties may not present witnesses or documents not previously identified unless the arbitrators find good cause. The arbitrators can subpoena third parties to testify at the hearing. They can also, without use of subpoena, direct the appearance of witnesses who are associated with the securities industry. CAP §12513.
V. The Arbitration Hearing
A. Hearing Procedure
1. Format is similar to a non-jury trial, but less formal.
a. Conduct of hearing is court-like (i.e., witnesses are sworn, there is direct and cross examination, documentary evidence is introduced, expert witnesses can be used, counsel give openings and closings).
b. The chairperson runs the hearing, but has no greater vote on any issue than the other arbitrators.
c. Arbitrators can ask questions of parties and witnesses.
d. Formal rules of evidence do not apply (CAP §12604), so “hearsay” evidence is usually allowed “for what it is worth.” Multiple objections to evidence are frowned upon.
e. After closing arguments, parties and counsel leave the room. The arbitrators usually decide the case at that time. Their written decision is called the award.
f. The award is usually sent to parties in about thirty (30) days. Arbitrators are not required to give explanations for their rulings; however, a small number of arbitrators may do so anyway.
VI. How Arbitrators Decide Cases
A. M. Domke, Domke on Commercial Arbitration §25:01 (rev. ed. 1984):
It is true that the arbitrator is not obliged to follow formal rules as they prevail in court procedures; rules of evidence, burdens of proof, and other court devices are relaxed when arbitrators face such issues. While arbitrators are not supposed to disregard the law, they may disregard the strict and traditional rules of law. It is often said that the parties do not expect the arbitrators to make their decisions according to rules but rather, especially when the arbitrators are not lawyers, on the basis of their experience, knowledge of the customs of the trade and fair and good sense for equitable relief.
B. Arbitrators give substantial weight to FINRA and New York Stock Exchange (“NYSE”) rules which set industry standard of care and are usually part of an investor’s contract with brokerage. See, Miley v. Oppenheimer & Co., 637 F.2d 318, 333 (5th Cir. 1981); Mihara v. Dean Witter & Co., 619 F.2d 814, 824 (9th Cir. 1980). These rules also create liability for such generalized forms of misconduct as failure to adhere to high standards of commercial honor and just and equitable principles of trade. FINRA Conduct Rule 2110; NYSE Rule 401. Statutes and case law may be relied upon, but arbitrators can decide on equitable grounds, regardless of technical legal defenses.
C. Arbitrators can grant any relief that a court can. This may include attorneys’ fees to prevailing parties and punitive damages, though these remedies are rarely issued.
D. Arbitration awards are decided by majority vote. Once entered, awards are seldom reversed. The Federal Arbitration Act, 9 U.S.C. §10, sets narrow grounds for reversal of awards (fraud, evident partiality, corruption, unreasonable refusal to grant postponement or hear evidence, arbitrators exceed powers). Courts will not vacate for a mere difference of opinion as to how the relevant law or facts should have been interpreted. Counsel may be sanctioned by courts for filing non-meritorious motions to vacate arbitration awards.
VII. Common Claims Between Customers and Brokerages
A. Breach of Fiduciary Duty/Negligence
1. Theory
a. Brokers are fiduciaries of their clients, and owe them duties of loyalty, good faith and competence. Gochnauer v. A.G. Edwards & Sons, 810 F.2d 1042 (11th Cir. 1987); Holmes v. Grubman, 286 Ga. 636, 691 S.E.2d 196 (2010). When a broker hangs out his shingle, he implicitly represents to the public that he will deal fairly with customers. This is commonly referred to as the “shingle theory.” Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir.), cert. denied, 321 U.S. 786 (1943).
b. Even jurisdictions that do not recognize per se a fiduciary duty for non-discretionary accounts, tend to recognize that certain specific duties exist for the benefit of clients, including:
i. the duty to recommend a stock only after studying it sufficiently to become informed as to its nature, price and financial prognosis;
ii. the duty to carry out the customer’s orders promptly and in a manner best suited to serve the customer’s interests;
iii. the duty to inform the customer of the risks involved in purchasing or selling a particular security;
iv. the duty to refrain from self-dealing;
v. the duty not to misrepresent any material fact to the transaction; and
vi. the duty to transact business only after obtaining prior authorization (Gochnauer, 810 F.2d at 1049).
2. According to the U.S. Supreme Court, securities professionals “[owe] a duty of honesty and fair dealing towards … clients.” Bateman Eichler Hill Richards, Inc. v. Berner, 472 U.S. 299, 314 (1985).
3. As professionals, a broker has the duty to “exercise such care, skill, prudence, diligence and judgment as might reasonably be expected of people in his calling.” Poser, Broker-Dealer Law & Regulation, §16.03 [A] [1] (4th ed. 2007). Failure to do this is negligence.
B. Suitability Cases
1. Theory—broker has the duty to learn essential facts about the customer. The broker must have a reasonable basis to believe that a recommendation or strategy is suitable for a customer in view of customer’s resources, age, tax status, financial sophistication, risk tolerance, and investment objectives. FINRA Conduct Rule 2111. Suitability is also an aspect of the fiduciary or fiduciary-like duty owed to a client. Failure to make suitable recommendations may violate state securities laws, constitute negligence, or breach the broker’s contractual obligation to follow industry rules.
2. There are two types of suitability violations:
a. Some investments that are not suitable for any client (“reasonable basis” suitability); and
b. Investments that are suitable for some investors, but not for the particular claimant (“customer specific” suitability).
3. Key suitability factors
a. Facts about the investment risk of the product or strategy (e.g., options, margin trading, illiquid securities, private placements, hedge funds, variable annuities).
b. Facts about client (e.g., a 92 year old widow with no experience in stock market versus confirmed speculator). The question is not only what risks could the client take, but what risk did he/she intend to take.
c. Evidence from firm’s due diligence files and “internal use only” sales materials provided to brokers.
d. Evidence that risks were misrepresented, whether intentionally or negligently, is not required to find a suitability violation, but often the client was actually misled. Disclosing the risks of an unsuitable recommendation (such as by giving the client a prospectus) does not “cure” the offense.
e. What do new account agreements, margin forms, investment profiles, etc. show about the client’s resources, income needs, sophistication and objectives? What were the firm’s guidelines for speculative trading? What did management know (often reflected in the firm’s due diligence files and research reports) and do?
f. As opposed to looking only at specific holdings, one can focus on the overall portfolio to establish unduly concentrated positions, and lack of diversification across asset classes, etc.
C. Churning/Excessive Commission Cases
1. Theory—broker trades a customer’s account excessively in light of client’s investment objectives in order to generate commissions. “Churning occurs when a broker exercising control over the volume and frequency of trades, abuses his customer’s confidence for personal gain by initiating transactions that are excessive in view of the character of the account and the customer’s objectives as expressed to the broker. Churning, if established by a preponderance of the evidence, is a scheme or artifice to defraud and a fraudulent and deceptive device within the meaning of Rule 10b-5.” See, Devitt & Blackmar, Federal Jury Practice and Instructions §98.13 (3rd ed. 1977).
2. Key churning factors
a. Essential facts about the client (e.g., age, sophistication, income, liquid assets, etc.); and
b. Broker control (i.e., broker given formal discretion, broker traded nondiscretionary account without consulting client, unauthorized trades, or client routinely accepted broker’s advice).
c. Objective measures of excessive trading include:
i. turnover ratio—total cost of purchases divided by average monthly equity equals turnover. Turnover divided by number of months of trading equals monthly turnover (MT). MT times 12 equals annual turnover rate;
ii. account maintenance costs;
iii. day-trading or “in and out” trading; and
iv. holding periods.
3. Note, however, that excessive commissions can be generated other ways such as by switching mutual funds with sales loads, using margin in wrap fee accounts, or selling the client certain high commission products.
4. Experts may be used to prove ratios, costs and losses.
D. Misrepresentation/Omission
1. Theory – broker may not lie to client or fail to give him all material facts to induce him or her to buy or sell a security. These claims may be brought under SEC Rule 10b-5, FINRA Conduct Rule 2020, state securities laws, or under common law or as part of other theories. The violation can be based on intentional acts, recklessness, or even negligence (under some theories of recovery).
2. Key misrepresentation factors
a. What the broker or firm represented—hyperbole, guarantees, unjustifiable predictions of stock price increases, statements that principal is protected, etc.
b. What information was available about the investment (poor earnings, history, deficits, defaults, downgrades by Moody’s, etc.), and what information was not known to the broker, but should have been considered. Look for the firm’s due diligence records, recent releases of financial and other information by or about the company, and the brokerage firm’s relationship to the issuer.
c. What other evidence showed the real risks of the product or strategy? This can include objective data concerning the volatility of the product or mathematical deconstruction to show it could not perform as represented.
E. Unauthorized trading
1. Theory – absent written discretionary power granted by the client, a broker may not trade a client’s account without the customer’s approval before the trade. FINRA Conduct Rule 2510. Unauthorized trading is a form of conversion of the client’s money.
2. Key unauthorized trading factors
a. Is there a valid, written and signed grant of discretion from the client to the broker?
b. Are trade confirmation slips properly marked to show when discretion was exercised?
c. Is management giving proper scrutiny to discretionary trades?
d. Verbal discretion is not permitted.
3. The fact that the client did not immediately object to an unauthorized trade is not a bullet-proof defense. Dishonest brokers often tell clients that it’s just a computer error. Also, the brokerage firm has an affirmative duty to explain that the client has the right to reject an unauthorized trade. Merrill Lynch v. Cheng, 901 F.2d 1124, 1129 (D.C. Cir. 1990)
F. Supervision
1. Theory – in addition to common law rules making an employer liable for the acts of its employee, and §20(a) of the Securities Exchange Act, and state securities laws, FINRA Rule 3010 requires broker-dealers to establish and maintain a system to supervise the activities of all representatives and associated persons.
2. Key supervision factors
a. Firms must have written procedures, active enforcement of rules, follow up on red flags, and review correspondence and complaints.
b. Procedures that exist on paper, but not in practice, can result in liability.
c. FINRA often specifies supervisory duties for certain situations or products. For example, there are supervisory notices from FINRA concerning products like variable annuities, bond funds and private placements. Likewise, there are particular requirements for supervising remote offices, brokers with poor compliance records, and communications by brokers.
