Behind Closed Doors

Behind Closed Doors

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ecent attacks in the Wall Street Journal have put NASD arbitration under the spotlight. Certain industry pundits, and groups including the Public Investors Arbitration Bar Association (PIABA), have alleged there are serious problems with the process. These groups see the arbitrator selection process as one of the main problems that prevent investors from obtaining fair decisions.

PIABA asserts the mandatory industry arbitrator should be eliminated from the panel and three public arbitrators, who are truly public and have not ever had any ties to the industry, should hear cases. In PIABA’s opinion, the industry arbitrators are inherently biased and tend to favor industry practices and respondents over investor claimants. In addition, they claim that many public arbitrators are not truly public because they once had ties to the industry. As a result, PIABA is lobbying for the NASD to have a panel of public arbitrators only.

Attorney Jim Eccleston takes the opposite view. The industry expert is a necessary part of the process, according to Eccleston, because you need someone on the panel who understands the intricacies of the case. “One of the theories used to bolster PIABA’s argument is that most cases now have a paid expert for both claimants and respondents, therefore there is no need for an industry expert to be on the panel,” he says. Eccleston does not favor eliminating the industry member because it would require all claimants to find an expert to help them explain their case to the arbitrators. “This can be an expensive burden on investors, particularly for smaller cases,” he says. Some investors or even smaller firms may not be able to afford the services of an expert witness. This would make it more difficult for them to get a fair hearing.

Attorney Terry Lister believes many of the cases are just too complicated to be left solely in the hands of public arbitrators. Take a case involving the minutiae of certain derivatives. “Most industry arbitrators would have a difficult time sorting through the evidence without the help of an expert witness to explain the details, says Lister. “Therefore, it is likely it would be much too complex for a public arbitrator.”

Lister is comfortable with two public arbitrators so long as there is at least one industry arbitrator on the panel. The industry arbitrator can help explain the industry-specific details of the case to the other panel members.

Also the industry member can be a big help when it comes to a battle of the experts.

“It is not unusual for both sides to have paid expert witnesses. They might look at the facts and come to exactly opposite opinions depending on who paid them, the investor or the broker/dealer,” says Lister. With at least one industry member on the panel, they can sort through the expert testimony and help decipher it for the other panel members.

Dave Markun says just because they qualify as an industry arbitrator does not necessarily mean that they are “experts” or even more knowledgeable than anyone else with respect to the particular issues that arise in an arbitration. “I have had many industry arbitrators who did not know anything about suitability or options or the other issues in a case,” he says.

Arbitrator Competence and Bias

“I have seen arbitrators who were so old or tired, they nodded off during the proceedings,” says Markun. This puts the attorneys in a difficult position. If they bring it to the attention of the other arbitrators, they risk the ire of all the arbitrators and ultimately penalizing their client. “Usually I just press on and pretend they are just resting their eyes so I don’t jeopardize my case,” he says.

And, Markun says, the system has inherent biases. Take the professional arbitrator, the one who may be retired and needs to continue receiving arbitration assignments as a way to maintain income in retirement. That arbitrator is going to be very careful about awarding punitive damages, even in the most egregious situations, says Markun. The reason is the selection process. “Attorneys will be looking at previous awards,” Markun says. Any arbitrator who has ever rendered an award for punitive damages would be struck by the attorney representing the respondent,” he says. “Most respondents would blackball these arbitrators because they would not want to take a chance on their client being hit with a large punitive damage award.

Jurors, on the other hand, can just walk away when a case is through. Jurors are not worried about their future livelihood. In general, jurors try to do the right thing, because they will leave the courtroom and go back to their employment, says Markun. “Professional arbitrators may want to do the right thing,” Markun says, “but their own future financial needs may affect their judgment.”

NASD ARBITRATION 101 Arbitration is an alternative means for investors to resolve their disputes in lieu of traditional court litigation. The investor, or claimant, files a claim with the NASD, where an impartial panel of three arbitrators for larger cases, or a single person for smaller ones, studies the evidence and then makes a final and binding decision. The arbitration process is generally quicker and cheaper than pursuing the same claim in court. The decision is subject to appeal in a very limited number and only a small number of cases is reversed on appeal. Although the NASD does not require any investor to arbitrate a claim against a brokerage firm or broker, since 1987 most firms have investors sign a binding arbitration clause when they become clients of the firm. Three-person arbitration panels consist of two public arbitrators and one industry arbitrator. Arbitrators are required to disclose any conflicts of interest and extensive background information, including past awards to parties to help them select their arbitrators. Participants are asked to complete a “satisfaction survey” at the end of their case and the NASD has an extensive process for maintaining competent, unbiased arbitrators including peer review, staff observation, and party feedback.

The arbitrator’s pay of about $40 per hour is appealing to inexperienced attorneys who do not have any other work. So many of the arbitrators, attorneys, retirees and others are using this as a way of boosting their income. This means there is a good chance any panel will have one or more inexperienced or unqualified arbitrators, whether they are from the public or the industry sector. “In my mind this type of arbitrator, the ones just looking to supplement their income, are just not qualified to render a decent decision,” says Lister. “In fact, I would guess about 40 percent of all arbitrators are not qualified,” he said. Markun agrees but said it is likely that as many as 50 percent of arbitrators are either too biased, uninformed or incompetent to render a fair verdict. According to Lister, one of the major problems with both public and industry arbitrators is they have no training that assists arbitrators in understanding the business and the specific issues they will be asked to evaluate. Lister also cites a complaint common among our experts: The NASD does not pay enough to attract arbitrators who are trained in alternative dispute resolution or have any real experience with the process or the industry.

The time commitment is another problem with attracting qualified public and industry arbitrators. In years past, arbitration would take one or two days. This was a reasonable amount of time in which to expect experienced arbitrators to resolve disputes. Now cases can take months. “I heard one arbitration case involving derivatives that was so complicated, it went off and on for two years,” says Lister. This expenditure of time, which can easily go for numerous sessions over a period of months, is not attractive to experienced and qualified arbitrators, particularly at the low pay.

Each party to an arbitration receives a list of potential arbitrators from the NASD, who has trained them. There will be five industry candidates and 10 public candidates. Each side ranks their choices and sends it back to the NASD who makes the final selections. It is very important to do your due diligence on potential arbitrators, according to Eccleston. Many veteran arbitrators may not be up to speed with the newer investment techniques like asset allocation and using hedging strategies to reduce risk, he says. “We always look at the history of previous awards, the arbitrator’s age and experience,” said Eccleston. He pays particular attention to their previous experience. “If they are a commodities trader, they are probably too much of a risk taker for some of our cases.”

To combat some of these issues, the NASD has participants complete a “satisfaction survey” at the end of the process. The NASD had procedures in place that are designed to disqualify incompetent or biased arbitrators. Lister has not found these procedures helpful in the past. “It is important that we only have competent and fair arbitrators,” asserts Lister. “Because it is important that the public have confidence in the system.”

Problems with the Process

The standards for admitting and excluding evidence are far more strict in a court case than they are in arbitration. Arbitrators can admit hearsay or even out-ofdate evidence. This would not usually be allowed in a court case, except in certain limited circumstances. This can have a big impact on the outcome of the case, sometimes changing it completely.

Also, most arbitrators will admit just about any evidence “for what it is worth,” according to our experts. Parties will never know if the arbitrators gave the evidence a lot of weight, or no weight at all in deciding their case.

In a court case, a judge could make an error in admitting evidence but it would be appealable. That is not allowed in an arbitration.

In arbitration, admitting and excluding evidence should be a simple and streamlined process. However, as the arbitration practice is moving closer to typical litigation, gathering evidence has also come to look more like gathering evidence for a court case.

It is not unusual for both parties to present a lengthy list of possible documents to the other side for discovery. This can be an expensive and time-consuming process to locate and reproduce documents that are many years old and stored in offsite locations. In a court case a few years pack, the plaintiff requested emails from the defendant broker/dealer. The broker/dealer estimated it would cost about $175,000 just to retrieve the emails, an expense the broker/dealer claimed should be incurred by the plaintiff. After a lengthy court battle and appeal, the plaintiff was only ordered to pay 25 percent of the cost and the defending firm picked up the balance.

Many times this lengthy list of items is not even required for the case, but used to harass the opposing party. “Parties will make outrageous requests for documents and testimony,” explains Lister, “Then they hunker down and get nothing.” Some brokerage firms have sought to evade and avoid discovery obligations and thwart the intention of the rules. This practice of failing to deliver required documents can stymie a party’s chance of getting a fair decision.

Markun also believes the discovery process is unfair. He says there is no real accountability for a broker/dealer who withholds a document that is necessary for a claimant to present his case. To combat this problem the NASD has issued a new list of sanctions for failing to comply with legitimate evidence requests. Although there are sanctions available for willfully avoiding the rules, Markun has never seen them imposed against an offending firm. Even worse, without being able to depose the person responsible for producing the documents, many abuses undoubtedly go undiscovered, Markun says.

Another problem with discovery is inconsistent rulings. “I have seen the exact same evidence in five cases, and get five different decisions by different arbitrators,” says Markun. Eccleston also cites similar problems.

To combat this, the NASD has proposed a new type of arbitrator, an Evidence Arbitrator, who only rules on evidence. Most of the experts interviewed liked this solution and felt it would help to get more consistent evidence rulings.

Markun would amend the arbitration rules to allow for one deposition. He would depose, under oath, the person who is most knowledge about production of the needed documents. He believes using the deposition process, parties would be able to get honest testimony about evidence and it would reduce the likelihood parties would destroy or alter documents or just fail to produce them. Many attorneys favor this change because it would allow them to bring criminal actions for perjury.

The Right to Appeal

One of the trade-offs for speed and reduced cost is the ability to appeal. Most arbitration cases are not appealed for two reasons: first the grounds for appeal, under the NASD rules, are very limited, and second, most awards do not contain enough information in them on which to base an appeal. Bigelow believes this inability for an effective appeal is unfair to everyone.

Few cases are appealed. Eccleston estimated only one in 10 were appealed, and out of those maybe one in 10 was reversed on appeal. Markun, who has won many arbitration cases, says he has never seen a successful petition to set aside an award.

Getting the Right Counsel

It has become a widespread practice for the carrier to request bids from different law firms for this type of work. Most carriers will select the least expensive firm—and they may not be the most qualified.With law firms actively seeking this kind of business, usually the new and inexperienced attorney wins the bid. Rarely are the experienced attorneys willing to reduce their fees to become the winning bidder.

Under the terms of the policy, brokers or broker/dealers are not usually given the right to select their own counsel. This rarely bodes well for the party with the inexperienced counsel. “Although I have had clients who made sure my firm was listed in their policy,” says Markun. “These broker/dealers wanted to be sure they had someone representing them whom they knew and could trust.”

Insurance defense attorneys have moved into the security litigation arena in a big way and have won a lot of bids from E&O carriers. “What they don’t understand,” says Eccleston, “is this is a much different and very complicated area of law.” He tells of one longtime litigator taking on his first NASD arbitration. “During the entire proceeding he kept referring to the NASD as the NSAD!” Eccleston recounts with a smile. “I knew we would succeed,” he explains, “Because it became apparent he hadn’t even read the rules.”

When selecting your attorney, Markun recommends doing your due diligence on your potential candidates. Interview them about the number of cases they have handled and the results. Be sure to get references from other firms, too.

NASD ARBITRATION BY THE NUMBERS: $750,000 the amount of money three firms were fined for failing to comply with their discovery obligations in 20 arbitration cases 8,201 the number of arbitrations filed in 2004 6,626 the number of NASD arbitrators currently approved for taking cases $400 typical daily pay for an arbitrator 146 average number of days to turn around a case in 2004 86% the number of mediation cases settled in 2004 46% the amount of time arbitrators ruled in favor of an investor/claimant in 2004 15% the number of investor awards that went unpaid in the first half of 2004

The Problems with E&O Coverage

Bigelow explained this unfortunate situation could happen to any broker or firm whose policy says the insurer has the option to defend. In those cases, the insurer can legally decline to defend, sometimes without a good reason.

“What you want in a policy,” Bigelow advises, “is the duty to defend.” If your policy is written to include the duty to defend, then the insurer must defend you, Bigelow explains. Unfortunately, almost none of the broker/dealer policies have language that specifies the duty to defend.

Strong insurance companies with good financials and integrity will probably defend the suit. If you get an insurance firm that is in some financial trouble and they don’t have a strong sense of integrity, they may decline to cover you, Bigelow says “Regrettably” he says, “there is not much you can do about that.”

Having an insurance company decline coverage can be devastating. Most companies and brokers have no idea what their policy says, Bigelow maintains. It is a good idea to review your policy now and make sure you won’t be surprised later. “Our policies always have a duty to defend,” he explains, “And this is pretty unusual in the industry.”

Lessons Learned

Eliminate your problem brokers upfront. Markun also suggests weeding out the bad brokers. If you have reps with four or five claims, absent unusual circumstances, cut them loose. They will cause you problems in the future, he says.

A broker/dealer’s most important line of defense is the broker—choose them carefully and don’t be afraid to spend money on good reps says Markun.

Negotiate for the right to your own counsel. Do not let the insurance carrier pick your attorney. Review your insurance policy and negotiate these terms when it comes up for renewal.

Do what is in the clients’ best interest. “I tell my broker and adviser clients they should treat every customer like they are your mother,” says Eccleston.

Think before you act. “I believe brokers should do everything as if three strangers will be reviewing it down the road,” he explains. There is a good chance that one day three arbitrators will be deciding if you did things properly. If you can picture them reviewing your files, it helps you make better choices up front.

Don’t ignore angry clients. Many times angry clients can be calmed down if you handle their complaint fairly and honestly up front. Eccleston says almost every case he has defended involved someone responding callously to an unhappy investor. They frequently will blow them off with a stock letter that says something like “Too bad. We are not responsible. Everyone lost money.” Eccleston says this can be one of the worse things you can do, because it just inflames unhappy clients. You have then missed an opportunity to keep them happy and settle for a smaller amount of money. Instead, you find yourself in an expensive arbitration case where the firm will have much larger losses.

Eccleston reminds firms not to delay. The sooner you can work this out, the less chance you have of the investor hiring an attorney.

Come clean with your attorney. It is important to tell your attorney everything, good and bad, about your case. “One of the worst things that can happen to us is to discover something that hurts our case during the arbitration,” Eccleston says. “If we had known about it in advance we can usually mitigate the problem. However, when we are blind sided right in front of the arbitrators there is usually not much we can do.”

Branch office managers need to be careful when testifying. Sometimes they get involved because there is a failure to supervise claim. “One of the worst things I see is when a branch office manager testifies something along these lines: “I have known this broker for years and I trust him. I seldom inquire about what he does because he is such a wonderful person.” What they have just done is shoot themselves in the foot, Eccleston says. The branch office manager basically just confessed to failing to supervise. Eccleston’s advice: It does not matter what a great person the broker is, the branch office manager should still be doing his duty.

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We would like to thank our experts: Attorney Jim Eccleston, partner, Shaheen, Novoselsky, Staat, Filiposki & Eccleston, (JEccleston@snsf-law.com. 312-621-4400); Attorney Dave Markun, partner, Markun, Zusman Compton (dmarkun@mzclaw.com, 310-454-5900); Attorney Terry Lister, Chief Regulatory Officer, Waddell and Reed (tlister@waddell .com); Bud Bigelow, President of Cambridge Alliance (bbigelow@cambridgealliance.com. 802-864-1891).

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Katherine Vessenes, JD, CFP®, RFC, according to Bloomberg Press, is America’s best-known authority on the legal and ethical issues of financial advisors. As president of Vestment Advisors, she helps financial advisory firms of all sizes build better, more profitable businesses. She can be reached at 952-401-1045 or Katherine@vestmentadvisors.com