Arbitration Favors Firms Over Investors

By Jane Bryant Quinn
Sunday, August 3, 2008

Let's say you had $50,000 in auction-rate securities that your broker said were as safe as money-market funds. The market collapsed, and you sold at an 80 percent haircut. At your arbitration hearing, one of the three panel members works at a firm that also sold auction-rates deceptively. How fair will the hearing be? Will the industry let this conflict of interest stand?

The flood of auction-rate claims against brokerage firms points out, again, how badly the deck is stacked against you in securities-industry arbitration. For claims exceeding $50,000, your three-member panel of judges must include an industry representative and two "public" members who can also have industry ties.

The industry rep is there to explain the industry's point of view to the other panelists -- effectively, a Wall Street mouthpiece, sympathetic to the very products and practices you're complaining about. As an "expert," his or her opinion carries extra weight.

For years, the lawyers representing customers have pressed to get rid of this fifth columnist on arbitration panels. The industry always stonewalled.

Then, in 2007, a bill called the Arbitration Fairness Act appeared in Congress, containing a clause requiring all three panelists to be from the public. Coincidentally -- I'm sure -- the Financial Industry Regulatory Authority (FINRA), which runs securities arbitrations, decided to hedge its position.

Two weeks ago, FINRA announced a two-year pilot project, allowing as many as 420 cases to be heard by an all-public panel. Customers' lawyers welcomed the pilot, tepidly, as a baby step in the direction of fairness.

Then, fairness got the boot.

Last May, the Public Investors Arbitration Bar Association wrote to FINRA about the problem of conflicted panelists on the auction-rate cases. PIABA President Laurence Schultz, of Driggers, Schultz & Herbst in Troy, Mich., asked that potential panelists be excluded from the hearings if they worked for firms that originated or sold auction-rate securities. After private talks, PIABA expected a yes.

FINRA said no, in a letter that Linda Fienberg, president of FINRA Dispute Resolution, recently sent to Schultz. Arbitrators will simply be required to make additional disclosures if, after Jan. 1, 2005, they worked for firms that sold auction-rate securities, sold them themselves or supervised anyone who did.

It will then be up to the lawyers (or to the customers, if they're representing themselves) to decide whether to take those arbitrators as panelists. "The steam is coming out of my ears," says Philip Aidikoff of Aidikoff, Uhl & Bakhtiari in Beverly Hills, Calif.

To understand the steam -- and why FINRA is still being pressed to change its mind -- you need to know how arbitration panels are chosen. The parties to the dispute get three lists of eight names, chosen randomly by computer from the arbitrator pool. There's one list of industry panelists and two more lists for the two public members. Each side strikes as many as four names off each list, for any reason at all, then ranks the rest in order of preference. FINRA names the panel, choosing the arbitrators most acceptable to both sides.

By keeping the people involved with auction-rate securities in the panelist pool, FINRA forces customers' lawyers to use up their challenges to get rid of them. If four challenges aren't enough, they're stuck.

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