Securities Arbitration Part 1: A Primer
Since 1987, when the U.S. Supreme Court deemed it acceptable to require every customer who opens a brokerage account to sign away his or her right to a jury trial, an entire practice of law has emerged: securities arbitration. With the emergence of this new practice came an attorney organization for the practice (the Public Investors Arbitration Bar Association, or ("PIABA"), a detailed publication which assimilates and analyzes arbitration awards, (the Securities Arbitration Commentator, or "SAC"), and a plethora of non-attorney organizations promoting customer representation in arbitrations.
Types of Securities Arbitration Cases
- Securities arbitrations are either between the stockbroker and the brokerage firm or between the customer, on the other hand, and the broker and firm, on the other.
- At the most elementary level, typical complaints or concerns that may be voiced by clients or potential clients are:
- "I was sold an investment that did not work out."
- "My brokerage account keeps going down and I dont know why."
- "Someone is managing my money and I dont feel comfortable with it."
- "I am getting confirmations of trades, but my broker never calls me."
- "There seems to be an awful lot of activity in my account."
- Comments such as these may be an indication of securities fraud. Additional "red flags" include:
- Attorneys should be wary of large losses in the accounts of clients who have limited assets, who are recent widows, or who recently inherited funds. They also should be alert to a client who expresses surprise at losses because of the brokers continuing assertions that the client had been making money.
Return of Principal
- The broker may have led the client to believe that the clients principal is safe and intact when, in fact, it is being depleted through distributions that the client believes are income. The brokerage statements will not reflect this fact; only the 10Ks and annual reports of the investment will.
Large Amounts of Capital Gains
- The broker may be actively trading the account, thereby creating capital gains that are unnecessary. The client may be unaware of the tax ramifications of this practice because the taxes paid are not taken out of the brokerage account. Large amounts of capital losses can also be a red flag.
High Concentration in Certain Types of Investments/Lack of Diversification
- A large percentage of funds in any one investment or type of investment increases the risk of the portfolio. The saying, "Dont put all of your eggs in one basket" generally holds true.
Major Shift in Investments
- If the client is in municipal bonds and suddenly begins trading index options, this, too, may suggest a problem. When such a major shift occurs, there should be a corresponding change in investment objectives.
Allegations made in a securities fraud arbitration are no different than those that could be alleged if the case were in court, namely, fraud, negligence, breach of contract, breach of fiduciary duty, violations of the Colorado Consumer Protection Act, ("CCPA"), and violations of state and federal securities acts. Three of these causes of action - fraud, negligence, and breach of contract - are discussed below.
Allegations of fraud are common in securities arbitrations. Interestingly, the majority of arbitrations alleging fraud revolve around omissions by the stockbroker, as opposed to outright misrepresentations. Stockbrokers often overlook the necessity of revealing the downsides to an investment for fear that the risks will dissuade the customer from authorizing the purchase. Because stockbrokers are paid solely on commissions from buys and sells, an inherent conflict of interest exist: if the customer doesnt authorize the buy, the broker doesnt make a commission.
The anti-fraud provisions of the federal securities laws require a stockbroker to apprise a customer of the risks of an investment. The obligation is not discharged, however, merely by providing written material that discloses the risks, such as in a prospectus. The 1990s saw numerous arbitrations arising from sales of limited partnerships in the 1980s by brokers who provided prospectuses but no verbal warnings of risks. As a federal judge in New York aptly put it:
General risk disclosures in the face of specific known risks which border on certainties do not bespeak caution. The doctrine of bespeaks caution provides no protection to someone who warns his hiking companion to walk slowly because there might be a ditch ahead when he knows with near certainty that the Grand Canyon lies one foot away.
Securities arbitrations often boil down to swearing matches between the customer who claims the stockbroker said this and did not say that and the broker who says the opposite. Stockbrokers are not required to make notes regarding conversations with customers and most brokerage firms to not tape-record telephone conversations.
The securities industry is one of the most highly regulated industries in this country. Consequently, negligence is measured by a wide array of documentation. The central complaint in many securities arbitrations is that the broker committed an act which violated an exchange rule. Such acts include making unsuitable recommendations, churning an account, making unauthorized trades, or failing to supervise the account or the stockbroker with a view toward preventing the wrongdoing, all of which are discussed further below.
The National Association of Securities Dealers ("NASD") and the New York Stock Exchange ("NYSE") each has volumes of rules and regulations that apply to stockbrokers. Brokerage firms are required to have hefty compliance and supervisory manuals to implement these numerous rules. These documents set the standard for stockbroker and firm conduct in securities arbitrations.
A common allegation in a securities arbitration, and one that falls under the "negligence" cause of action, is that the broker made an unsuitable recommendation to a client. Stockbrokers are required to "know their customers" based on the customers financial objectives, financial resources and risk tolerance.
Stockbrokers must consider a host of personal information about customers before making a single investment trade for them. Such information includes the customers age, financial status, need for income, ability and willingness to take risk, investment knowledge, prior investing experience, and investment objectives (such as safety of principal, income, growth or speculation). All of this information is recorded on a new account form, designed to gauge what investments are suitable for the customer. Many brokerage firms, however, do not require that these forms be filled out by customers, reviewed by customers, or even mailed to customers.
Against this background, many securities arbitrations arise. Customers frequently say that they told the stockbroker one thing, while the stockbroker says that the customer said something else. Occasionally, the broker may defend himself or herself by holding up the New Account Form. This does not, however, always resolve the dispute.
For example, in one recent case, a New Account Form queried: "# Years in Stocks and Bonds?" The broker had put "10" in the blank. At the hearing, the brokerage firm defended the claim by pointing to the "purported" 10 year's investment experience -- in order to show that the broker had reason to believe the customer understood the risks of the market and that, therefore, the investment at issue was suitable for the customer. The customer asserted, however, that what he told the broker was that his only investment experience was 10 years earlier when he purchased $1,000 of IBM stock.
In other circumstances, the New Account form can be a smoking gun. For example, where an IRA account with "safety of principal" marked is seriously churned, causing large losses, the brokerage firm faces an extremely difficult burden at trial.
Failure to Supervise
The brokerage firms failure to supervise also falls under the umbrella of "negligence" and is often an issue in securities arbitrations, along with the primary wrongdoing of the broker. The firms duty to supervise extends not only to the customers account but also to the stockbroker.
In recent years, regulatory authorities have cracked down on brokerage firms hiring stockbrokers with extensive disciplinary histories, mandating that the brokerage firms impose a higher level of supervision over them. In a requirement unique to the securities industry, stockbrokers and firms are required to report each and every written complaint made against them, even if it is frivolous or subsequently resolved in the broker or firms favor. This report often provides critical evidence in a failure to supervise case.
A client who mentions getting confirmations of trades, but who rarely speaks to his or her broker, is a typical claimant in an unauthorized trading case. One of the most fundamental duties of stockbrokers is the duty to discuss the trade in detail with a client, before a transaction is completed. This is requires even though the customer claims to know nothing about investing and who tells the broker to make all of the decisions. Although many customers attempt to give their brokers such carte blanche to act on their behalf, the broker or the firm cannot accept this delegation of authority unless the customer first agrees in writing to a discretionary account.
Churning occurs when a broker or broker-dealer encourages and engages in transactions that are designed to generate commissions for the broker rather than to benefit the clients account. Some say that churning or excessive trading is like pornography - you know it when you see it. Churning, however, must be measured against the investment objectives of the client. An account with thirty trades in three months may reflect improper churning where the customers objective is safety of principal. The same activity, however, may be appropriate activity for a customer who wants to speculate.
A quick rule of thumb is that, if the value of the account (excluding margin debt) is being turned over or bought and sold two to three times a year, churning may be occurring. Another sign of excessive trading may be reflected in the cost/equity ratio of an account. If the account's annualized costs of doing business (that is, commissions) exceeds the amount of return on the investments, then churning may be occurring. Finally, if the Schedule D of a clients tax return, which reflects capital gains or losses, consists of more than one page, and the client has a small account or is not a confirmed speculator, this may also suggest churning.
Breach of Contract
Invariably, securities arbitrations involve the violation of at least one of the rules of either the NASD or the NYSE. These violations frequently provide the foundation for breach of contract claims. Typically, customer breach of contract claims against a broker or firm arise from one of two contracts.
The first contract is the Customer Agreement that every individual who opens a brokerage account signs. The Customer Agreement provides, in substance, that the brokerage firm and the stockbroker are contractually bound to follow the applicable rules of all exchanges of which the firm is a member and of exchanges through which trading is conducted.
The second contract is the contract between the broker or firm, on the one hand, and the exchange, on the other. In order to become a stockbroker or a brokerage firm licensed with the NASD or the NYSE, the firm and the individual must enter into a contract with the respective exchanges. This contract requires the firm and individual to abide by, comply with, and adhere to all of the rules and regulations of that exchange, including state and federal securities laws. Individuals such as wronged claimants in securities arbitrations are arguably third-party beneficiaries of these contracts, and they have brought suit on them.
Securities Arbitrations - A Unique Procedure
Securities arbitrations are unique in several respects, one of which is that a different set of rules apply. In all securities arbitrations (such as NASD, NYSE, and AMEX), the Code of Arbitration Procedure trumps the Rules of Civil Procedure and essentially abolishes the rules of civil evidence, giving arbitrators free reign to determine what is admissible. In fact, the Arbitrators Manual states at the outset, "The reason why arbitrators were appointed was that equity might prevail". Thus, many arbitrators believe that they are not required to apply the law; but rather to do what they think is right.
The governing procedural document, the Code of Arbitration Procedure, addresses such issues as filing the statement of claim; filing fees and hearing session deposits of $500 for a $10,000 - $30,000 claim, up to $1,250 for a $500,000 - $5,000,000 claim (significantly higher than court filing fees); and the appointment of and challenges to the arbitration panel. Moreover, discovery is limited. There are no depositions, no interrogatories, and no request for admissions.
The parties are, however, entitled to "document production and information exchange". At least twenty days prior to the first scheduled arbitration date, the parties are required to serve on each other all documents that they intend to present at the hearing and a list of witnesses to be called.
The uniqueness of Code of Arbitration Procedure can make even a seasoned litigation attorney feel like a fish out of water when representing the claimant in a securities arbitration. Respondents counsel, on the other hand, will frequently be well versed in the Code, and he or she likely will have participated in dozens, possibly hundreds, of securities arbitrations. This experience also gives respondents the upper hand in learning information regarding the arbitrators in a particular case.
In light of this difference in experience, it is critical that attorneys representing claimants in securities arbitrations be familiar with the Code, the applicable securities rules and regulations, and the protocol that takes place in securities arbitrations. Claimants counsel must also be prepared for surprises. Unlike a court case, where counsel will have deposed the opposition at length and, thus, will have been able to script out his or her cross examination, each witnesses testimony at the arbitration is being heard for the first time by the arbitrators and the lawyers alike. In addition, unlike a court case, in which a document that was improperly admitted may provide grounds for appeal, grounds for appeal of a securities arbitration are extremely limited.
Claimants can and do represent themselves pro se in securities arbitrations, however, their success rate is very low. Non-attorney representation has also burgeoned as an industry, providing competition for licensed members of the bar.
With arbitration being virtually the exclusive mechanism for the resolution of disputes between securities brokers and their customers, securities arbitration has largely been removed from judicial supervision, except for the confirmation of arbitration awards. Clients should know that, except in very rare circumstances, they are bound by whatever the arbitrators decide. Clients should also know that arbitrators are not required to make findings of fact or conclusions of law, nor are they required to itemize the components of any award that they render.
Arbitrators are empowered to award everything that a judge or jury could award, including actual damages, interest, attorneys fees, expert witness fees, punitive damages and an assessment of costs. Arbitration awards assess liability jointly and severally against the broker and the firm.
Arbitrators are generally appointed by the regulatory organization where the claim is filed. For cases in which the amount in dispute is less than $10,000, a single arbitrator hears and decides the case. For cases with greater than $10,000 at stake, parties have the choice of a single arbitrator or a panel of three arbitrators. In such an instance, a panel of three arbitrators is usually preferred.
Three-member panels consist of two public arbitrators and one "securities industry" arbitrator, with one of the public panelists serving as the chairperson. "Public" arbitrators are defined as those individuals who do not qualify as "securities industry" arbitrators. A "securities industry" arbitrator is an individual who is currently employed at a brokerage firm that is not the subject of the complaint or one who worked for another firm within the last three years. Retirement from a securities broker dealer also qualifies an individual as an "industry arbitrator".
The injection of a securities industry arbitrator on the panel causes some to characterize the arbitration as " a stacked deck". Although "majority rule" determines the panels decision, many believe that the industry panelists exert great influence over other panel members in determining the outcome of cases. In an egregious case, however, the industry panelist may be the Claimants biggest ally.
The parties are notified of the identity of the three arbitrators, along with their employment histories for the past 10 years, prior to the hearing. This begins the ten- business-day time clock within which a party can make peremptory challenges. Regardless of the number of claimants or respondents, each side has the ability to use its peremptory to strike any arbitrator for any reason. In addition, parties can make challenges for cause, which are unlimited. If parties exercise strikes, new arbitrators are appointed until a panel is in place.
The Role of the Expert Witness
Experts in securities arbitrations often play a much larger role in an arbitration than in a court case. They are sometimes referred to as the "gladiators of securities arbitrations". A good expert will frequently address three areas in dispute at the arbitration. First, the expert will perform an analysis of the investments at issue in order to render an opinion regarding their suitability for the claimant, as well as an opinion as to whether churning occurred. Second, the expert will review all of the documents produced in the case, as well as the facts, and testify regarding what rules and regulations in the securities industry were broken. Such testimony may include evidence of customer and practice at other brokerage firms. Finally, the expert will calculate damages and will attest to the theory supporting them.
Experts are not required to prepare reports in arbitration. As a matter of practice, however, most experts prepare some sort of written damage analysis to present the panel.
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