From the February 2016 issue of Investment Advisor • Subscribe!

Is FINRA the Fox Guarding the Henhouse?

FINRA reviews its own mandatory arbitration

FINRA reviews its own mandatory arbitration process and finds room for improvement (Illustration: Mart Klein/Ikon Images/Corbis) FINRA reviews its own mandatory arbitration process and finds room for improvement (Illustration: Mart Klein/Ikon Images/Corbis)

As I’ve written before, I have a grudging respect for the securities industry and its self-regulatory organization, FINRA: If he were alive today, Lex Luthor couldn't do it any better.

FINRA's latest caper comes in the form of the “Final Report and Recommendations of the FINRA Dispute Resolution Task Force,” which was released Dec. 16, 2015, after 17 months of deliberation. According to the report, “The task force looked at every aspect of FINRA's dispute resolution forum as it relates to customers’ disputes and makes 51 recommendations to improve the system.”

At the risk of leading with the punch line, 12 of those 51 recommendations suggest FINRA continue doing what it is already doing (that's bureaucrat-ese for “do nothing”). Of the remaining 39 recommendations, the most concrete is to — wait for it — give the arbitrators a raise: “from $300 to $500 per session” with “biennial increases in arbitrator compensation tied to the Consumer Price Index.”

Who's Protecting Who?

To fully understand the brilliance of FINRA's play here, we need to start with the reason for the task force's report. To do that, we need to go back to 2010 and passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. In Section 921, Congress and President Barack Obama, who signed it into law, gave the SEC the “authority to prohibit or to impose conditions or limitations on the use of agreements that require customers or clients [...] to arbitrate any future dispute between them arising under the federal securities laws, the rules and regulations thereunder, or the rule of a self-regulatory organization, if it finds that such prohibition, imposition of conditions or limitations are in the public interest and for the protection of investors [emphasis added].

That, of course, was only five and a half years ago. To be fair, the SEC has been busy circumventing its Dodd-Frank Section 913 mandate to create a standard of protection for the clients of brokers that is “no less stringent” than that of RIAs under the ’40 Act. We’re all still holding our collective breath on that one.

To solve the problem of the SEC's inaction, FINRA has stepped up (a cynical mind might speculate at the urging of the SEC) to suggest how it can better conduct its own contractually required arbitration of brokerage customer complaints. The report explains it this way: “While to date the SEC has taken no action, Dodd-Frank has revived the debate over the fairness of its pre-dispute arbitration agreements or PDAAs” — at least in the minds of people who haven't completely forgotten about that small part of Dodd-Frank or died in the intervening years.

If they look hard enough, clever minds can find opportunity in any crisis, and FINRA doesn't disappoint on this occasion: “The fairness of PDAAs is not the only important issue affecting the future of securities arbitration,” states the report. It enumerates these other issues, including “questions about the qualifications, training and incentives of arbitrators”; “the need to tailor procedures for different groups of investors”; “the separate mediation code”; and “the use of technology, [which] has the potential for greater efficiencies that have not yet been fully realized.”

Less clever observers might scratch their heads while trying to figure out what relevance these issues have to the “fairness of FINRA's arbitration” or to the SEC's mandate to “prohibit or to impose conditions or limitations on the use of agreements that require customers or clients to arbitrate” should the commission find that any of these fail to “protect investors” or are against “the public interest.”

Despite the fact that FINRA acknowledges its task force was formed to fill the void of the SEC's inaction on its Section 921 mandate, the SRO isn't bashful about tweaking that mandate just a bit: “Accordingly,” the report states, “FINRA formed this task force in June 2014 to consider possible enhancements to its arbitration and mediation forum so that the forum would meet the evolving needs of its users.”

Did you catch that? According to the task force's report, the problem at hand is no longer the fairness of the arbitration system or protecting investors, as Dodd-Frank suggested; it's now that users’ needs are evolving. As I’ve said before, these guys are good. Very good.

The Recommendations

A review of the 39 recommendations (the ones that don't suggest doing nothing) reveals that 19 involve the arbitrators themselves, including the aforementioned pay raises, plus their recruiting, training and selection. The remaining 17 address nine “procedural issues,” largely about timely hearings, mandatory mediation, small claims and motions to dismiss.

In fairness (somebody's got to focus on fairness here), FINRA does include in its report three issues that address the fairness of its arbitration process:

• The “confidential nature of arbitration”

• The “paucity of explained awards, [which] result in a lack of transparency that can lead to misunderstandings about the FINRA forum”

• The requirement of mandatory arbitration itself: “Despite FINRA's adoption of rule changes designed to increase investor confidence, criticisms of mandatory arbitration persist, and the lack of investor choice continues to generate at least some distrust of the FINRA forum.”

Notice, however, that in two of the three recommendations, the Task Force appears to be at least as concerned about the brokerage industry's image and fairness to BDs as it is about investor protections. While fairness to BDs is certainly a valid consideration (particularly for a BD SRO), is that really the fairness Dodd-Frank Section 921 is talking about when it refers to “agreements that require customers or clients to arbitrate disputes”?

What's more, is the problem with a “paucity of explained awards” really that they lead to “misunderstandings” about FINRA arbitration? Or is it that failure to explain awards makes evaluating the fairness of FINRA's arbitration system by aggrieved clients, the public and the SEC (should the commission ever decide to do its job and actually oversee FINRA's self-regulation) impossible?

Finally, the task force addresses the issue of mandatory arbitration itself and does a nice job of stating the case for the opposition: “The foundational argument for investor choice is that investors who feel aggrieved by their broker-dealers’ conduct should be able to choose the forum to assert their remedies, and that this right can be meaningfully exercised only after a dispute has arisen. Accordingly, proponents of investor choice feel strongly that [mandatory arbitration is] an impermissible curtailment of investors’ rights.”

Yet in defense of mandatory arbitration, the task force cited BD rights: “The foundational argument for [mandatory arbitration] is legal parity for the broker-dealer industry. FINRA Rule 12200 imposes mandatory arbitration on broker-dealers by requiring them to arbitrate disputes at the customer's option. Firms secure the same right for themselves by including arbitration clauses in customer agreements. Proponents of the status quo feel strongly that banning [mandatory arbitration] would unfairly strip firms of the contractual freedom to name a commercially reasonable dispute resolution forum at the outset of the relationship between broker-dealer and customer.”

Did you get that? FINRA is arguing that because its own rules force its own members to submit to arbitration, it's only fair that BDs be able to require mandatory arbitration of their clients. To settle this little difference of opinion, the task force recommended that FINRA “adopt a policy of promoting, to the maximum extent possible, transparency about its dispute resolution forum.” That's it, transparency. That will make the clients feel better. You just can't make this stuff up.

Here's a suggestion right off the top of my head: Perhaps FINRA could drop its rule requiring BDs to go to arbitration against their will. Then, they could lighten up on requiring clients to go to arbitration against their will. You know, out of fairness.

While I’m at it, here's another thought: Maybe the SEC should start fulfilling its mandate to oversee how FINRA is regulating BDs. The report cited data from the FINRA website showing that “from 2010 through 2014, the percentage of [arbitration] cases where a customer was awarded damages ranged from 38% (2014) to 47% (2010). […] The numbers also do not provide any basis for assessing whether the amounts awarded to customers adequately compensated them for their losses.”

That's right: Somewhere in the ballpark of 43% of aggrieved BD clients got “some” money through arbitration. Sure, some claims are frivolous, but really? Maybe the SEC could start there, before FINRA sets up another task force to approve this task force's recommendations.

--- Read "FINRA Broker Arbitration Task Force Suggests 51 Changes" on ThinkAdvisor.

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