Arbitrating the Brokerage Case: The Basics
by Richard Elliott
Claims against brokers and brokerage firms for investment losses are handled through arbitration with the Financial Industry Regulatory Authority (FINRA). In 2007, the SEC approved the consolidation of the enforcement functions of the NASD and the New York Stock Exchange in FINRA. FINRA conducts regulatory oversight of more than 4,500 brokerage firms and 635,000 registered securities representatives. It is responsible for all arbitration and mediation functions in disputes between member firms and their customers. FINRA is now the only forum for securities arbitration.
Claims against brokers and dealers are generally not eligible for litigation in state or federal court because the customer’s brokerage account provides by contract that any dispute between the customer and the broker must be submitted to binding arbitration. The rules of procedure and discovery are governed by the Code of Arbitration Procedure and FINRA’s rules, and not by rules governing trials of cases in court.
Types of Claims and Defenses
There are a number of claims that may be asserted arising out of losses sustained in a brokerage or retirement account. The following are the most common: (1) suitability; (2) failure to supervise; (3) fraud; (4) negligence; (5) breach of contract; (6) breach of fiduciary duty; (7) unauthorized transactions; (8) over-concentration; (9) churning; (10) statutory violations, such as the Texas Securities Act or Blue Sky Law; and (11) licensing violations. There are other, more mundane, claims such as selling away, improper execution of trades and margin account trading.
The most common claim made is that the investment was unsuitable. Pursuant to NASD Rule 2310, the Suitability rule, brokers owe customers a duty to make suitable investment recommendations. An unsuitable recommendation which causes loss may lead to an award of damages to the investor. Over-concentration of an investors’ holdings in one or a few securities or in one industry, can lead to claims for failure to diversify.
Since the collapse of the financial market in 2007-2008, another claim frequently made is that the product sold was so toxic that it would not be suitable for any investor, regardless of the customer’s level of sophistication or wealth.
There are numerous defenses available to the brokerage firms and securities representatives, depending on the facts of the case and history of the account. One of the most often used defenses is the sophisticated investor defense. Others include that the investments were suitable, ratification, the prospectus defense, failure to mitigate and contributory negligence. Statutes of limitations are generally not available as a defense in securities arbitration as FINRA Rule 12206 provides that for a claim to be eligible for arbitration, it must be brought within six years from the occurrence or event giving rise to the claim. It often becomes a fact question as to when the cause of action accrued.
The Arbitration Process
The pleadings consist of a Statement of Claim and an Answer. No particular form of pleading is required. The parties select the panel from a list of public and industry arbitrators provided by FINRA. At the Pre-hearing Conference, the panel will set discovery deadlines, briefing deadlines and dates for the final hearing. Discovery is limited to document production and requests for information. Normally, there are no depositions taken in FINRA arbitration. Jury trials are not allowed. Expert witnesses are typically used by both parties regarding both liability and damages.
Damages may include actual market losses, benefit of the bargain losses or the difference between the actual value of the account and what it would have been, had it been well-managed. Rescission is also an available remedy. If the transactions are rescinded, the damages include a return of the original investment, less any dividends or earnings, plus pre-judgment interest and attorney’s fees.
The panel may award attorney’s fees in addition to actual damages in making an award to a successful claimant. Attorney’s fees are recoverable under the Texas Securities Act, as well as under common law and FINRA’s rules. Arbitrators have authority to award attorney’s fees and costs even in the absence of an explicit statute. Punitive or exemplary damages are also recoverable by a claimant in appropriate cases. Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 107 S. Ct. 2332 (1987).
Generally there is no appeal from an arbitration award. If the award is not paid within thirty days, a successful claimant may file a suit to confirm the award. Also, either party may file suit to vacate the award. However, vacatur is rarely granted, usually only where the arbitrator failed to disclose a material conflict.
Each case is different and must be evaluated according to its own unique set of facts. Some investment advice is clearly unsuitable, such as a broker placing an elderly widow’s entire life savings into speculative stocks or a high-cost variable annuity with a long surrender period. But how do you explain to an investor the details of a credit default swap on a double-A tranche of subprime mortgage-backed collateralized debt obligations? The answer is you cannot, because hardly anyone, including the hedge fund managers on Wall Street, could understand what exactly is inside such a product.
Richard Elliott is a solo practitioner with offices in Dallas and Fredericksburg. He practices in the areas of securities litigation and personal injury. He can be reached at firstname.lastname@example.org.