Update: Permanent Rule Change Arising Out of FINRA’s Pilot Program

New Rule Helps Level Playing Field during Arbitration

On January 31, the Securities and Exchange Commission (SEC) announced that it had accepted a rule change to give investors in securities arbitration the option of selecting an all-public arbitration panel to hear their disputes. The rule was proposed by the Financial Industry Regulatory Authority (FINRA) based on the results of a pilot program it had been running over the past two years.

Previously, investors had the option of choosing public arbitrators to fill two out of the three positions on the panel that would hear and decide their cases. The third position, however, was held by an industry arbitrator, who currently or formally worked in the securities industry, often as a broker or other financial executive. Investors also had the right to strike four out of 10 possible arbitrators, but now with the rule change, investors have been given the choice to strike every single one to ensure that no industry arbitrator is on the panel.

The new rule eliminates what some believed to be an unfair advantage held by well-financed brokers over individual investors during arbitration. Critics of the old system believed that having someone from the securities industry on the panel brought a certain level of bias to the arbitration, giving investor-claimants an unequal footing in the process before it even began.

The decision by the SEC to give investors the unilateral option to change the composition of arbitration panels handling investor disputes should go a long way to altering this perception and renewing confidence in the securities arbitration process.

Majority of Investors Chose Public Arbitrators during Pilot

FINRA proposed the rule change based on the positive results of a pilot program the independent agency began in 2008. Known as the “Public Arbitrator Pilot Program”, or PAPP, the organization’s goal in running the program was to determine whether bias existed in the arbitration process and whether the bias could be eliminated by offering investors the option of choosing all public arbitrators to hear their claims.

During the pilot, investors opted for an all-public arbitrator panel in roughly 60 percent of the cases. In the other 40 percent, they accepted having one industry arbitrator sit on the panel. More importantly, investors who participated in the pilot thought the process was fairer by virtue of having the choice of an all-public panel, regardless of whether they actually chose to eliminate all of the industry arbitrators in favor of public ones.

The pilot program began in October 2008 and was set to last for two years. But after the early successes of the program, it was later extended through 2011 to better determine the impact of industry arbitrator bias in securities arbitration. The pilot stopped taking new cases on February 1, 2011, after the SEC announced it had accepted the proposed rule change.

New Rule Improves Possibility of Positive Outcomes for Wronged Investors

Hopefully the option of using all public arbitrators will heed more positive results for investors, like it did for Maimoona Mirdad, who had her case decided by a public arbitrator last fall.

Mirdad took the federal pension she had earned from her career with the US Postal Service and invested it with Wells Fargo Advisors (formally Wachovia Securities). The pension represented Mirdad’s sole income for the remainder of her retirement. Accordingly, she needed conservative investments to ensure that the funds would sustain her for the remainder of her life. The broker in charge of managing her account, however, took her funds and placed them in high-risk growth accounts, which happened not only to generate high fees for the broker, but also steep tax consequences for Mirdad.

In its defense, the brokerage firm claimed that Mirdad knew of the risks of investing and pointed to the language in the risk profile that was included in the account opening statement she had signed. The public arbitrator overseeing her case, however, quickly disregarded this defense, pointing out that these documents are blank forms when they are initially signed by new customers and that the preferences are not filled in until after they have been approved, which typically takes several days after the customer has signed them.

The public arbitrator found in favor of Mirdad and awarded her $49,000, which represented the difference between actual returns on her investment in the risky portfolio and what she would have earned had her funds been more conservatively invested. She also was compensated for the management fees and taxes she paid as a result of the high-risk, fee heavy investments.

This is a classic case of improper asset allocation, and is just one form of stock broker misconduct. Positive outcomes for investors like Mirdad are more likely with the passage of the new SEC rule.

If you have a claim against a broker or brokerage firm for mishandling your funds or breaching another fiduciary duty, contact a securities arbitration attorney for legal representation.