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When Will Self-Regulation Get It Right?

October 6th, 2008 by Madelaine Eppenstein

It began today, a day on which the Dow broke a new record for volatility: FINRA’s two-year “pilot program” permitting investors to effectively opt out of having mandatory industry arbitrators in a small proportion of cases relative to all filings.  It may be a gross understatement to say that the program is too little, too late.  FINRA has undertaken to study over a period of the next two years, more likely longer, the issue that investor advocates have complained about for decades: the fundamental unfairness of the SRO arbitration system, in which the public has been forced to adjudicate its claims, that requires an industry arbitrator on all three member panels.  The results will presumably enable FINRA to distill subjective conclusions about the “fairness” of it’s own system, possibly in time for the next presidential election four years hence.

For over twenty years, our firm has advocated improvements to the SRO arbitration system to combat this unequal playing field, including banning mandatory SRO arbitration and the mandatory industry arbitrator.  As we explained to the U.S. Supreme Court:

“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. . . . the public customer is at a disadvantage from the start.” *

*Argument of Theodore G. Eppenstein, Official Transcript, Proceedings Before the Supreme Court of the United States, Docket/Case No. 86-44, March 3, 1987 at U.S. Supreme Court in Shearson/American Express, Inc. v. McMahon, March 3, 1987.  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.

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We also raised the topic with the federal and state regulators and in the media:

“Comprehensive suggestions for SRO arbitration reform which this firm presented recently before the 70th Annual Conference of the North American Securities Administrators Association in Snowmas, Colorado on August 31 through September 3, 1987, would further ensure that the public’s right to a fairer hearing than is currently available in SRO arbitration would be available to investors. . . . Among the most urgent of our recommendations is that the panel not contain any industry representatives or individuals related to the securities industry.  This would allow the arbitration panelists who are the judges of both fact and law to more closely represent the cross-section of the lay community such as the juries we find in state and federal courts.”*

*Letter, Theodore G. Eppenstein to Richard G. Ketchum, Director, SEC Division of Market Regulation, December 23, 1987.

“But substantive improvement has been slow, and a perception remains that arbitration is a stacked deck.  Skepticism persists largely because the rules require a person affiliated with the industry to sit as an arbitrator on every three-member panel.

The industry asserts that it is better for the customer to have an individual knowledgeable about the workings of the market sitting in judgment of fraud claims. But the public suspects that an industry arbitrator will have difficulty determining impartially whether another firm engaged in fraudulent activity like unauthorized trading, unsuitable investing or churning. And will that industry arbitrator have the courage to render a multimillion-dollar award, including punitive damages, against another member of the Wall Street club? An industry arbiter who does that risks being blackballed by the industry in his career and in future cases.

But there is no need for the purported expertise of the industry “Solomon” on these panels because most disputes turn on the credibility of witnesses, not on technical trading issues. And our judicial system has generally functioned well over the centuries by leaving it up to lay jurors to understand even the most complex disputes.”*

*Theodore G. and Madelaine Eppenstein, “An Arbitration Albatross,” Originally Published as Op Ed Article in The New York Times, Money and Business Viewpoint (Sunday, June 8, 1997).

“We respectfully request that the SEC return to the public customer the ability to choose court or arbitration at the election of the customer, and that the SEC consider the abolition of the requirement that a member of the industry sit in judgment of their brethren brokers. The appearance of grave impropriety continues to pervade the arbitration process as a result of these fundamentally unfair procedures.”*

*Theodore G. and Madelaine Eppenstein, Letter to Jonathan G. Katz, Secretary, SEC, October 3, 2003.

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We have also presented to Congress the reasons supporting change in the SRO arbitration system:

“For sure, arbitration has served the securities industry well these past 20 years, where public scrutiny of all kinds of brokerage evils are hidden behind arbitration’s closed doors and the firms’ pocketbooks are sheltered from a jury’s wrath.  But the abrogation of basic fairness in favor of the “black hole” into which most investor gripes fall should be evident even to the short sighted regulators.  At the top of the list is the perception, and for many veterans of SRO arbitration the harsh reality, that there is a stacked deck against the public. That’s because investor complaints in the SRO arbitration system, which is unlike any other, are typically decided by three individuals, one of whom must be reared, and usually is embedded, in the very industry on trial.  That panelist is called a “non-public” or “securities industry arbitrator” by the forum.  Yet there is no designated “investor arbitrator” to counterbalance the industry’s representative on the panel, merely a pool of so-called “public” arbitrators who supposedly have no significant ties or sympathies with the industry.  But the customer often faces panelists who are mis-classified and connected to the industry, administratively appointed by the SROs without any peremptory challenge available to the investor, trained to look for mitigating circumstances that will spare the brokerages big hits, and often financially reliant on being selected to adjudicate future cases.  Because all arbitrators are aware that their final rulings are made public, this can cause concern even to the fairminded that issuing large awards to customers can put that arbitrator on the industry’s blacklist and on the sidelines for future assignments.”*

*Statement of Theodore G. Eppenstein in Support of Prohibiting Mandatory Arbitration  of Investor Claims in Securities Arbitration, Before the Subcommittee on Commercial and Administrative Law, U.S. House of Representatives Committee on the Judiciary, Hearing on H.R. 3010, the “Arbitration Fairness Act of 2007,” October 25, 2007.

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Surely by now it should be self-evident to the industry self-regulator that yet another “study” to placate disgruntled investors is not the answer.  Investors are in need of public only securities arbitrators at FINRA – now!

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