More On Legal & Compliancefrom The Advisor's Professional Library
- Anti-Fraud Provisions of the Investment Advisers Act RIAs and IARs should view themselves as fiduciaries at all times, whether they meet the legal definition or not. Deviating from the fiduciary standard of full disclosure while courting clients may cause the advisor significant problems.
- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
In connection with the recent economic and market meltdown, we have seen a significant increase in arbitration claims filed against fee-based investment advisors. So, what is securities arbitration, and how does it work? To assist me with the answers to these issues, I have called upon the expertise of my partner, Brian A. Carlis, who, as the chair of our Securities Arbitration Group, has successfully defended registered investment advisers in securities arbitration matters for many years.
An alternative to litigating in a court of law, arbitration has been around for more than 200 years but it has only been in the past 20 that it has become the primary method to resolve securities industry disputes. Arbitrators are neutral parties, who are typically knowledgeable in securities and investment related matters.
Arbitration as a means for resolving securities industry disputes gained popularity, in large part, because it is less expensive and less time-consuming than a traditional lawsuit. In many court systems throughout the United States, it can take two, or four, or even more years to get to trial from the time of filing a complaint. Most arbitration claims get to hearing within 16 months and many get to hearing much sooner. Arbitration awards are final and binding and subject to appeal (which would be filed in a court of law) on an extremely limited basis.
Registered representatives and their broker/dealer firms are required to arbitrate customer claims, by virtue of their membership in the Financial Industry Regulatory Authority (FINRA). Parties can be required to arbitrate by virtue of the existence of a pre-dispute arbitration clause in a contractual agreement. Many registered investment advisors have arbitration clauses written into their client investment advisory agreements and we strongly recommend including such provisions.
Because most arbitration involves registered representatives and B/Ds, FINRA is the most popular securities arbitration forum. The American Arbitration Association ("AAA") is another. Investment advisors who do not maintain FINRA registration typically may not avail themselves of the FINRA arbitration process. For this reason, we often recommend that our investment advisor clients utilize AAA pre-dispute arbitration clauses in their investment advisory agreements. Because arbitration is a creature of contract, there are additional provisions/safeguards that can be written into the arbitration clause. One such provision is that the roster of arbitrators provided by the AAA only include arbitrators on the FINRA roster of arbitrators as well. Advisors who maintain FINRA registration may want to include language that the FINRA forum be utilized if commission-based business was conducted with the client.
AAA vs. FINRA
There are several differences between AAA and FINRA arbitration. More often than not, an AAA arbitration will get to hearing faster than a FINRA arbitration. AAA fees are usually higher than FINRA fees. AAA fees do not cover the cost of hearing rooms, which are available on a rental basis. FINRA provides arbitration hearing rooms at no additional charge. AAA arbitrators dictate how they will be compensated. Most charge on an hourly or per diem basis for their service. FINRA rules mandate what their arbitrators are paid. FINRA arbitrators receive a relatively modest stipend per hearing session. Hearing sessions can last a matter of minutes up to four (4) hours. Depending upon the amount of compensation paid to AAA arbitrators and the number of pre-hearing conferences and/or days of arbitration hearing, arbitration at the AAA can potentially cost thousands of dollars more than FINRA arbitration. The magnitude of the potential fees at the AAA can act as a deterrent to a client filing a claim and/or as a potential catalyst to settlement subsequent to the initiation of the proceeding.
Securities arbitrations are commenced by the complainant (known as the "Claimant") filing a document similar to a complaint in a court of law. In AAA arbitration, a complaint is referred to as a "Demand," while at FINRA the initial filing is referred to as the "Statement of Claim." The Statement of Claim/Demand is required to set forth, at a minimum, the nature of the dispute and the remedy or remedies sought. At the AAA, no answer to the Demand is required. A Demand must be filed, however, at the insistence of the Claimant. At FINRA, a Statement of Answer is required and must be filed in order to avoid a potential default. Like a Statement of Claim, a Statement of Answer need not be in any particular form. Many answers are submitted in a narrative format. It is important that an answer specify all defenses the party intends to rely upon, as well as the factual background for those defenses.
The discovery process in arbitration is far more streamlined than in a court of law. In FINRA arbitration, for example, there are prescribed categories of documents that are considered presumptively discoverable in all cases and additional categories of documents considered presumptively discoverable where certain specified allegations are made (e.g. "unauthorized trading"). Depositions are strongly discouraged at FINRA and may only be taken under extreme circumstances and with arbitrator approval.
There is far more latitude with respect to discovery at the AAA. To the extent the parties agree on a method of discovery, that method will typically be approved by the arbitrators. Discovery at the AAA includes requests for production of documents and information and even the propounding of interrogatories. Depositions may also be taken in AAA arbitration.
A preliminary, or pre-hearing, conference is typically held among the arbitrators and counsel to the respective parties. The purpose is to schedule the arbitration hearing itself as well as establish interim dates and deadlines for discovery, the filing of motions, and anything else requested by counsel or the arbitration panel.
The Appearance of a Trial
Securities arbitrations look a lot like a trial in a court of law. Each party will make an opening statement and then the Claimant begins introducing evidence. The evidence is introduced via witness testimony and documents. Opposing counsel has the opportunity to cross-examine all witnesses. Following the Claimant's introduction of evidence is the presentation of Respondent's case. Respondents likewise present evidence through documents and live witnesses. Each party is also entitled to make a closing argument.
Strict rules of evidence do not apply in arbitration, although many arbitrators do try to follow evidentiary rules. The scope of witness direct examinations and cross-examinations is usually rather lenient. This is particularly true with respect to cross-examination. In court, a cross examination is limited to the subject matter the witnesses testified to on direct examination. In arbitration, cross-examination will usually be permitted to "go beyond the scope of direct" so long as the cross-examination relates to the issues in the case. Leniency on cross-examination makes a great deal of sense, as it would be inefficient and far more time consuming to require Respondent's counsel to recall one or more of Claimant's witnesses during Respondent's case in chief, because counsel was prohibited or restricted from examining the witness on matters not specifically testified to on direct examination.
Arbitrators are permitted to ask questions of the witnesses and often do so. Sometimes arbitrators interrupt a witness' testimony to ask one or more questions. Sometimes arbitrators wait until the witness has testified on direct and cross-examination before posing questions of their own. The extent of the questioning by one or more of the arbitrators varies greatly. Some arbitrators ask a lot of questions and others ask none.
Currently, the typical securities arbitration lasts three or four days. Most cases seem to get off to a bit of a slow start, and then pick up speed as the days progress. While "fireworks" and "Perry Mason moments" are very rare in arbitration, they do occasionally occur. In one such instance, my partner, Brian Carlis, was able to get a Claimant's expert witness to agree with the statement that his expert report was "completely and totally worthless," resulting in Brian physically tearing the report in half after the expert witness provided the confirming answer.
After the evidence is submitted and closing arguments made, the arbitration panel will deliberate. In my experience as a securities arbitrator, many arbitration decisions are arrived at within one or two hours of deliberation. Most arbitration awards are unanimous, although only a majority vote is required to render an award. Most awards are processed and delivered to counsel within 30 days of the hearing. Arbitration awards are not required to be in any particular form. Arbitrators are not required to explain their decision, which can be a source of frustration to one or both of the parties.
There is legislation currently pending that would do away with pre-dispute arbitration clauses in investment advisory agreements and brokerage account agreements. If the legislation passes, securities industry investors would have the option of filing their claims in court. There is no doubt that passage of the legislation would increase costs to investors as well as expense to the securities industry. That's Washington, never providing what is reasoned and reasonable, generally opting for what is politically expedient rather than what is most effective.
Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies, and a regular contributor to Investment Advisor. He can be reached at firstname.lastname@example.org.