What happens when clients believe they have been harmed by their broker or advisor? It’s a tricky topic in the investment business because different advisors’ standards mean they are responsible for different actions under the law, and that can mean different resolutions in client disputes.

For more than two decades, the advisory and brokerage industries have been evolving along two parallel tracks, with advisors governed by a fiduciary standard and brokers subject to suitability rules. The question of how a fiduciary role should be expanded to cover all advisors and brokers, as mandated under the Dodd-Frank Act, is experiencing serious implementation problems in Washington, D.C.

Experts agree that a fiduciary standard, of which suitability rules are a subset, is a higher standard, since it demands that advisors act in the clients’ best interest. Suitability, on the other hand, requires only that an investment is appropriate given the investor’s age, risk tolerance, experience and other investments.

Most investors are clueless about the distinctions between the legal definitions. But when they think they’ve been harmed or when their investments tank, they may blame their advisor, rightly or wrongly. Those that do have a couple of avenues they can take. In some cases, they can go to the courts for redress.
Or they can go to an arbitration panel that resolves the matter for them. Frequently, they’ve been forced into the latter by the contract with a firm—when the arbitration becomes mandatory.

Arbitration isn’t new, and it’s not bound to the world of securities law. Even mandatory arbitration, first legalized by the 1925 Federal Arbitration Act, is common in consumer contracts for credit cards, cell phones, car rentals and checking accounts.

Since 1987, brokerages have been allowed to make arbitration mandatory for the resolution of consumer and employee disputes. In 2012, Finra opened up its arbitration process to RIAs—meaning RIAs can ask clients to use Finra’s process in its contracts with clients. Currently, RIAs can choose whether disputes should be argued before Finra’s panels, in other arbitration forums or in state or federal courts. Depending on which states they do business in, RIAs may or may not be able to include mandatory arbitration clauses in their customer contracts.

It’s not surprising that the rules don’t satisfy everybody.

Brokers complain that Finra’s arbitration process allows too many frivolous cases to be brought to a hearing. Often, brokerages give up and settle claims simply to save themselves the headache and legal fees, which can blow back on the individual brokers.

When RIAs go to Finra arbitrators, the judgments are not binding. Since most RIAs are not Finra members, the organization has no power to enforce arbitrators’ rulings against them.

Investor advocates, meanwhile, argue that clauses in brokerage contracts force claims to Finra arbitration, denying investors their right to stand in state and federal court. The arbitrator panels can’t help but favor brokerages, they argue, because brokerages fund Finra.
So what’s fair and what isn’t?

For at least 15 years, Harold Evensky of Evensky & Katz in Coral Gables, Fla., has served as a part-time expert witness in Finra arbitration cases. He thinks the system has imperfections, but that the outcomes are reasonable for the most part.

“My general experience is [that] it’s very fair, at least as fair as humanly possible,” he says. “But to the extent that it errs on one side or the other, my experience has been that it errs on the side of the plaintiff, not the brokers.”

Most of the cases Evensky has testified in concern the suitability standard of the brokerage business rather than the fiduciary standard, and the outcomes could have been different if a strict fiduciary standard, which he supports, were used.

And the gap between these two standards can be dramatic. He recalls a claimant who lost a case more than a decade ago. The man had put $250,000 into four separate accounts with a brokerage because his wealthy friend had succeeded with the same stock pickers. When the tech bubble burst, the plaintiff lost more than 50% of his investment.

“The problem was his friend was very wealthy and could afford to lose 50% of a million. For him, it was pretty much all of his money,” Evensky recalls. “But the position of the [brokerage was that] all the managers were good and honest. That’s just what happened—and he picked them. When there’s suitability, that’s not an unreasonable conclusion.”

Had the plaintiff gone to a fiduciary advisor, however, the case could well have gone the other way. From a fiduciary’s viewpoint, the brokerage obviously failed to diversify the client’s portfolio.

Evensky says it’s often that clients expect high performance and the investments fail to deliver. In one case in federal court, he testified on behalf of Northern Trust when the big trust company was sued by a group of physicians.

“The complaint was [that] they failed to take any steps to limit or offset the decline in the value of the plaintiffs’ portfolio,” Evensky says. But when one examined the investment policy that the physicians and their trustees developed with Northern Trust, all the parties agreed to a very heavy equity allocation. “The losses were very consistent with what the market was.”

The SEC is currently reviewing whether mandatory arbitration is appropriate for both RIAs and brokerages under the Dodd-Frank Act. Finra is scrutinizing the arbitration process as well. Rick Berry, a Finra executive vice president who oversees the agency’s securities arbitration, organized the Dispute Resolution Task Force in 2014 to review the process and recommend reforms. The task force consists of 13 members representing industry firms, investors, attorneys and arbitrators. Much of its work reviews the most common complaints from brokerages and consumers.

One of the topics the group addresses is the fitness of contractual clauses that prevent clients from suing their brokers. In the mandatory arbitration clauses, investors and employees waive their Sixth Amendment right to a jury trial. In 2014, 3,822 arbitration cases were filed with Finra by consumers. The vast majority alleged negligence, breach of contract, misrepresentation or unsuitability and breach of fiduciary duty.

Finra believes whether these clauses should be mandatory is an issue for elected officials and political appointees. “Finra doesn’t require anybody to arbitrate. That’s a matter of contract between firms and investors,” Berry says. “It has always been our position that the issue of mandatory arbitration is something better left to Congress and/or the SEC.”

Finra rules already mandate that brokerages be bound to arbitration if the client requests it, so a mandatory arbitration clause turns that requirement into a two-way street. (RIAs are not forced into arbitration in customer disputes unless they have dual registration with the SEC and Finra.)

By mandating arbitration, brokerages are ironically allowing investors to bring cases that would not otherwise be heard. In a sense, brokerages are supporting and mandating a process that ensures they are held accountable for the professional standards they have created for themselves, says Jeremy Hyndman, principal at Los Angeles-based Investor Defense Law.

“As much as brokerages complain about the process, they still like mandatory arbitration clauses,” Hyndman says. “It’s disingenuous for them to complain since they are the ones requiring us to be there. It ends up saving them money, too.”

There can be advantages for consumers who go to court instead. Frequently, a jury’s decision produces a binary, winner-take-all outcome, while arbitrators are prone to “split the baby,” in legal parlance. Also, juries can be swayed by factors that arbitrators would dismiss. For instance, a jury might be more likely to find for a local plaintiff against a big money center bank.

Evensky testified on behalf of an out-of-town bank that was being sued by a senior executive of a public company who failed to diversify out of his company stock. “They told him he had significant unsystematic risk, and he should liquidate,” Evensky recalls. “He kept saying no, I’m going to wait until [the stock] gets back to a certain price. It wasn’t a poor, little, naïve guy.”

Yet in the end, the plaintiff prevailed. “I don’t know how they came up with their decision,” Evensky says. “All I could conclude was that it was someone local versus a big out-of-town bank. It made no sense to me whatsoever.”

Whether the case is heard in court or in arbitration, personality counts. “Likability is an important factor on both sides,” says David Robbins, a principal at Kaufmann Gildin & Robbins, a New York securities law firm.

That can also put large brokerages at a disadvantage when seated across from small, individual clients. “Brokerage firms have problems with hubris,” Robbins says. “They have issues with being overbearing, trying to litigate cases that should be arbitrated. I don’t know why civility is so hard for people; it’s not a weakness.”

Robbins does believe, however, that Finra arbitration permits too many frivolous claims.

“When, a number of years ago, Finra greatly restricted the grounds for a motion to dismiss, it ended up letting in every kind of case,” he says. “When I say frivolous, I mean that the customer’s loss was not related to any conduct of the broker or the firm.”

But Linda Riefberg, a commercial litigator at New York-based Cozen O’Connor and former chief counsel for Finra’s Department of Enforcement, says the roster of cases look weaker because stronger cases are usually already settled by the brokerages before they even get to arbitration.

“If you look at cases that settle,” Berry says, “you’ll see that almost 81% of all cases close through some way other than award, like settlements. If you add those numbers up, around 75% of all cases brought by investors end up in some kind of monetary recovery for investors.”

But when a company settles, even a frivolous case, it can create extra problems for individual reps, who might be at a disadvantage depending on their arrangements with the settling brokerage firm. “I had a client whose firm preferred to settle a case because the plaintiff was an elderly widow,” says Riefberg, who now primarily represents defendants in Finra disputes. “My client has to pay a big portion of that settlement because that was his arrangement with the firm. I think the case is very defensible, however, and now I have to defend this guy with a settled case.”

Backlog
Finra handles 99% of securities arbitrations. “Finra is significantly faster [than going to court], even though the turnaround time for resolution keeps getting pushed back,” Hyndman says. “It also depends on the state. California courts are really clogged. If I have an option to get out of California state court for arbitration, it’s pretty appealing.”

But the streamlined process purportedly offered by Finra’s arbitration is still frustratingly slow, especially in larger cases. “As cases get bigger, arbitration begins to look a lot like the litigation process,” says Christine Lazaro, director of the Securities Arbitration Clinic at St. John’s University’s School of Law. “There aren’t as many of the traditional benefits that arbitration generally offers in terms of reduced costs and timeliness. Cases are taking a fairly long time, and they’re going to be expensive.”

In 2004, Finra’s predecessor, the National Association of Securities Dealers (the NASD), had 8,201 case filings. In 2014, there were 3,822 new case filings, but the amount of time it took arbitrators to resolve a case came in at 14.2 months. In the absence of the simplified arbitration procedures used for smaller claims, that average balloons to 18.5 months. This year, however, through July, turnaround times have dropped to 14.4 months, with larger decisions taking an average of 17.3 months.

“In 2015, our turnaround times have been dropping, and we’re still faster and less expensive than going to court,” Berry says. “I don’t think there’s a court that can get cases done in that amount of time, and at the end of court cases you have endless appeals that draw out cases as well.”

Arbitrators, sometimes criticized for being unreliable and biased, are divided into two categories: non-public arbitrators, who have served in the financial industry in some capacity, and public arbitrators who have no links to the financial industry. Under current rules, claimants can choose to strike non-public arbitrators from their pool of potential panelists.

“I think there’s a misconception that a panelist with industry experience may be unfair from the plaintiff’s perspective,” Riefberg says. “Many times, the people with industry experience end up being more harsh on people who do things improperly. People in the financial industry don’t like to see other industry people step out of line, and they really want to penalize them for it.”

At it stands today, almost 85% of arbitrations are heard before panels of all-public arbitrators. While that seems like a win for investors, it has had some unintended consequences. Without a knowledgeable industry representative on a panel, both claimants and respondents spend more to retain expert witnesses.

“I like having the option,” Hyndman says. “When I’m dealing with a client on the smaller side of the industry or a claim where I’m dealing with conduct which anyone knows shouldn’t fly, having someone from the industry on my arbitration panel can be nice.”

Finra has around 6,400 arbitrators in its pool. That might not be enough, Robbins says. “Some arbitrators sit on so many cases, when you get the list of potential arbitrators and you see their pending cases you have to wonder if you’re going to get the right damages or decisions in the case,” Robbins says.

Berry says Finra wants to add another 650 to the roster this year, in part to combat the perceived lack of diversity in the pool. According to the Public Investors Arbitration Bar Association, Finra’s arbitrators are overwhelmingly white, male and elderly.

“This is a huge priority for us,” Berry says. “We’ve increased the staffing dedicated to recruitment and have more than 100 organizations focusing on diversity that we are targeting for our recruitment.”

Typically, defense lawyers in a court would file motions to dismiss cases before they are even heard (a way to avoid expensive discovery for a frivolous lawsuit). But dismissals in arbitration are nearly unheard of: One Finra critic has likened arbitration to a “roach motel”—once a brokerage enters arbitration, it can be difficult to get out. Companies can even be sanctioned for these motions if arbitrators believe they are filed in bad faith.

“Frivolous claims are still dismissed,” Robbins says. “It happens all the time. But now they have to wait until the claimant has put on their case.”

As a result, regardless of the legitimacy of the case in front of them, the brokerages must incur the legal fees and retainers for the discovery period and evidentiary hearings. In the independent advisor world, they can end up paying the legal costs.

“I don’t think advisors have any idea of how expensive it can be if you get sued and go to court or to arbitration,” Evensky says. “If you have a big case, just getting prepared and defending it can be an order of magnitude of $100,000 to $200,000.”

Some attorneys believe that gives claimants an advantage to coerce a settlement. “It makes it too costly to fight it,” Robbins says. “There are surcharges, legal fees. It’s not really the specter of losing the case. This is a business decision. Since you have to wait until the accuser has put on the case, frequently the claimant calls the broker as a witness, so you have to prepare the broker.”

Still, a brokerage with deep pockets can always deploy its resources to fight a case for almost an eternity. Evensky served as an expert witness on behalf of Joseph Rothman, a wealthy retired real estate developer, and his wife, who claimed Merrill Lynch took advantage of them by making a $32 million investment in variable annuities on which Merrill and its broker earned about $2.5 million in commissions. A similar $32 million investment in a group of 10 load funds would have generated commissions of only about $300,000.

The couple’s lawyer alleged the Rothmans, who were declared incompetent in 1999, were told in three separate letters that the investment carried no fees or commissions. Evensky was amazed Merrill didn’t settle the case. Joseph Rothman died in 2004. In 2007, a jury awarded the Rothmans’ estate $6 million despite Merrill’s claim that the accounts within the annuity appreciated by more than $10 million. Merrill declined to respond to repeated phone calls.

Finra has no in-house appeals process in place. Parties unhappy with arbitrators’ decision have to take their cases to court, where judges rarely overturn awards handed down in binding arbitration.

“In arbitration, the process is final, the decision is made there,” says Kevin Carroll, managing director and associate general counsel at the Securities Industry and Financial Markets Association (SIFMA). “It’s one of the key factors that makes arbitration less expensive than court-based litigation.”

While punitive damages are unusual in arbitration, claimants and investors should be able to recoup their losses, lawyers say. But awards are often a fraction of the loss. Furthermore, defendants are sometimes out of business by the time an arbitration proceeding is concluded, making the recovery of awards difficult if not impossible.

This year, 11%, a total of $51 million, of arbitration awards granted in 2011 remained unpaid. Many of the outstanding awards involve defunct small brokerages and advisors. Currently, if a firm or an advisor fails to pay an award, Finra can respond by revoking his or her securities license.

Because the arbitration is funded by the very industry it is tasked with regulating, Finra is an easy target for charges of corruption and bias. But that doesn’t mean the arbitration is unfair.

“I think that’s an overly simplistic argument,” Hyndman says. “I think Finra arbitrators are paid by the parties in the case, so they are paid in part by the investors. Finra has a strong interest in making the process at least look fair, because Congress can swoop in at any time and pass laws that make mandatory arbitration clauses no longer enforceable.”

Carroll, another defense attorney, says Finra’s structure prevents direct bias in arbitration decisions. “Finra is an independent regulator. Its governance is majority non-industry, so the argument that it is somehow biased for brokerages fails there,” Carroll says. “Everything that Finra does—all of their rules, activities and their arbitration—all of it is overseen and approved by the SEC. That hardly paints the picture of an entity that is captive to the industry. In fact, it’s the opposite: Finra serves investors. That’s their mission, that’s what they do, and there are controls in place to see that is how it functions.”

Hyndman adds: “One of the things that lawyers tell each other when we’ve reached a settlement is that if nobody’s happy, it’s probably a good compromise, and that’s my view on Finra arbitration.”

“It’s proven to be faster and less expensive than court-based litigation, and the case outcomes are fair,” Carroll says. “We see a well-functioning system and we don’t want to see that system upset without good cause.”

Learning From The Inside Out
   Testifying as an expert witness for more than 15 years has taught Harold Evensky some interesting lessons. It’s more than a chance to gain business intelligence on how the rest of the industry operates and how people get into trouble.
   “It’s a great way to learn from the inside out,” he says. “The downside is you’ve got some really smart people [usually lawyers] trying to make you look like an idiot.”
   As an expert witness, Evensky is not technically representing one side but instead simply providing an expert’s opinion. If he believes his opinion will hurt the case of the side that has approached him, he makes it clear. And if the attorneys are trying to control costs and limit the material they provide to him, he indicates he needs to see everything.
   What are some of the major lessons Evensky has learned from the process? Compliance experts often tell advisors to avoid excessive documentation, but Evensky disagrees. He cites a recent case where an advisor had no investment policy statement for his client. But he did have extensive notes saying all the client really wanted was real estate investments, about which the client claimed to be very knowledgeable. When the arbitration hearing occurred, the client claimed he never said any such thing and just wanted very conservative investments.
   “As an expert, I put a lot more weight on contemporaneous notes than I do on what someone remembers three years after
the fact.”
   In his 30-plus-year career, Evensky has witnessed two severe bear markets—the tech wreck and the Great Recession. Both produced millions of angry clients. But he views these events very differently.
   The conventional wisdom that many people saw the tech bubble coming, something Evensky hears all the time, doesn’t cut the mustard. If that were true, “it wouldn’t have happened,” he says. But what ultimately occurred between 2000 and 2002 was foreseeable, given the volatility in the tech sector.
   Very few folks saw the financial crisis coming, however, and even fewer estimated its magnitude. The Great Recession was a “four-standard-deviation event. Correlations went to ‘1’ across the board. The only saving grace was fixed income.”
   Looking at future liabilities facing advisors and their clients, longevity is a risk that frequently surfaces. If many clients unexpectedly become centenarians and run out of money, would advisors who only planned for life expectancies of 95 face lawsuits?
   “I don’t think anyone could credibly argue that good planning would say plan to [live to] 120,” he says. There’s nothing in today’s mortality tables to support it.
   Besides, if clients run out of money, they can’t afford lawyers.