“What is the reason we have the securities industry. . . trying to get everything into arbitration? I think it is simple. The reason is, they feel they have a leg up when they go to arbitration and the reason for that mainly is because they have a member of their industry sitting on each panel.” *

Theodore G. Eppenstein, March 3, 1987 at U.S. Supreme Court in Shearson v. McMahon.

Our last post here covered our subsequent statements to Congress over the twenty years since the McMahon case in the Supreme Court, and we have noted Ted’s proposals on behalf of investors as a member of the SICA committee to eliminate the requirement of an industry arbitrator in securities arbitrations. We are not alone in this effort.

The same day as the release of SICA’s “Perceptions of Fairness of Securities Arbitration: An Empirical Study,” ** the North American Securities Administrators Association (NASAA) press release filed on February 6, 2008 wasted no time in calling up front for:

“immediate action to improve the fairness of the system of securities arbitration, beginning with the removal of the mandatory industry representative from arbitration panels used to resolve securities disputes involving customers and industry.”

The industry’s mandatory requirement that an industry representative sit as judge and jury on most customer cases in securities arbitration goes beyond the obvious problem of the appearance of bias and the fact that the industry doesn’t impose a comparable requirement of a “customer” representative to balance the equation on the three-arbitrator panels that sit on every case filing over $50,000 at FINRA. Scholarly work cited in the SICA study indicates that attorney arbitrators who represent the industry appear to have a bias in favor of the brokerage industry, which we believe may translate into lower awards for customers.

The SICA Study cited an empirical academic review of the role of attorneys as arbitrators based on a very large data set of 422 randomly selected arbitrators and their 6,724 arbitration awards from 1992 to 2006. This working paper, released by three law professors in January 2008, concluded that:

“conflicts of interest may affect arbitration awards. Arbitrators who act as attorneys for brokerage firms or brokers have an incentive to side with brokerage firms and brokers in customer arbitration proceedings. Alternatively, those relationships may cause those attorneys to have a more sympathetic view of the industry generally. Similarly, those with an industry background may also retain ties with the industry that may affect their judgment in arbitration proceedings.” ***

The SICA Study also noted academic work by Jiro E. Kondo, a Ph.D candidate at MIT Sloan
School of Management. This study looked at NASD arbitration data from January 1991 through December 2004:

“Using data on securities arbitration cases at the NASD, I focus on one of the most important stages of this enforcement process: arbitrator selection. In the first stage of the analysis, I document general patterns in arbitrator selection and provide evidence that arbitrators who are classified as pro-industry or as having more expertise are selected more often to arbitration panels (selection on bias and expertise, respectively). Furthermore, I provide evidence that arbitrator bias is allocated across cases to benefit industry by showing that selection on bias is stronger in more important cases, as proxied by a brokerage Firm’s financial and reputational stake in a case. The largest brokerage Firms also enjoy substantially more bias than other firms.” ****

The O’Neal Solin Analysis, which has been mentioned in previous posts here, asserts that
“[c]laimant [investor] win rates are lower against larger brokerage firms,” and there’s a “diminished expected recovery percentage” in these significant cases:

“Claims against top 20 brokerage firms exhibit expected recovery percentages that decline significantly as the size of the claim increases. Claimants in arbitrations against top 20 brokers face an expected recovery percentage that is approximately 28% in claims under $10,000. The expected recovery percentage plunges to approximately 12% in claims over $250,000.” *****

Based on the academic literature, the striking correlation between the increased use of
pro-industry arbitrators and the fact that customers continued their slide downward in SRO arbitration and lost everything 63% of the time in 2007 (up from 58% in 2006, according to FINRA’s own statistics) can no longer be ignored.

*Historical Note:

On March 3, 1987 before the U.S. Supreme Court in the landmark Shearson/American Express v. McMahon case, Ted Eppenstein, representing the investors, made this statement his first point on the reason the industry backs mandatory SRO arbitration.

**Barbara Black, Jill I. Gross, “Perceptions of Fairness of Securities Arbitration: An Empirical Study,” at 5 (2008), available at http://digitalcommons.pace.edu/cgi/viewcontent.cgi?article=1477&context=lawfaculty.

***Steven J. Choi, Jill E. Fisch, A.C. Pritchard, “Attorneys as Arbitrators,” at 22 (2008),
available at http://www.ssrn.com/abstract=1086372 , cited in SICA Study at 5.

****Jiro E. Kondo, “Self-Regulation and Enforcement in Financial Markets: Evidence from
Investor-Broker Disputes at the NASD” at 34 (November 2006), available at
http://web.mit.edu/jekondo/www/jobmkt_paper.pdf.

*****J. O’Neal and D. Solin, “Mandatory Arbitration of Securities Disputes, A Statistical
Analysis of How Claimant’s Fare,” at 17 (2007), available at http://www.slcg.com (Securities Litigation and Consulting Group Web site).