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FINRA’s ‘Total Warfare’ Against Brokers in Arbitration

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The Financial Industry Regulatory Authority’s arbitration forum that’s meant to resolve advisor-firm disputes is a farce, a kangaroo court — an appalling, broken, despicable system that is rigged against advisors.

That’s how FINRA’s mandatory program was dismissed in a number of interviews that ThinkAdvisor conducted across the industry during the last five weeks.

As proof that the arbitrations do not afford due process, sources cite the 93% win rate for firms, resulting from FINRA’s mindset that ignores other pertinent issues but focuses narrowly on unpaid balances on signing bonuses paid as promissory note loans.

“When I go into an arbitration, I know I’m dealing with the devil, and I expect the brokerage firm to lie,” says attorney Chris Vernon of Vernon Healy, in Naples, Florida. “I build my case around assuming they’re not going to tell the truth, and I fight like a dog to get documents.”

Under FINRA’s program, all disputes must be resolved only by arbitration administered by FINRA, the industry’s self-regulatory organization run and funded mainly by Wall Street. Advisors have no option for disputes to be heard in court.

“The rules are stacked in favor of the brokerages,” says Stephen Winks, principal of PCT Research and Consulting, in Richmond, Virginia. “This is not due process required under the U.S. Constitution. The brokerages have gamed the FINRA arbitration process, and it’s a no-win for the broker.”

In recent years, wirehouses have become more aggressive in pursuing breakaway brokers in an effort to collect outstanding money due on upfront bonuses they have been paid. Some firms have even set up separate departments solely for this purpose. Further, the big brokerages have hired major law firms — some on retainer — to go after advisors who have moved to another BD or have gone independent.

FINRA arbitration is “a rigged game!” contends Dale Ledbetter, a Fort Lauderdale, Florida-based attorney who has represented numerous advisors in arbitrations. “It’s stacked against the brokers. That is true in bold letters, underlined and with exclamation points!”

FINRA has long been accused of a lack of transparency concerning its dispute-resolution program, which in 2012 generated $41.7 million of its total $878.6 million revenue, according to the organization’s most recent financial report.

FINRA Responds

FINRA staunchly defends its forum. “We have no evidence whatsoever that the hearings are rigged,” says Linda Fienberg, president of FINRA’s dispute resolution and chief hearing officer, in Washington, D.C. “I would deny that it’s a kangaroo court. We’re audited internally by the SEC from time to time and by the Government Accountability Office (GAO). Brokers would be no better off in court, perhaps worse off versus arbitration.”

But many say that FINRA arbitration is deeply flawed, even horribly broken. It just doesn’t work, they maintain; and the main source of the problem is that FINRA itself conducts the program. “Brokers’ claims are adjudicated by essentially a trade association of brokerages,” says Dan Solin, a wealth advisor with Buckingham Asset Management, director of investor advocacy for the BAM Alliance and author of bestselling books on finance. “Brokers are treated like third-class citizens. They don’t get access to the courts and a jury of their peers like everyone else.”

The organization called FINRA is the result of the 2007 merger of the National Association of Securities Dealers with the regulatory function, including the arbitration forum, of the New York Stock Exchange.

FINRA says that the number of wirehouse advisors who moved their practices following the global financial meltdown has meant more suits.

“We’ve had a large number of cases of the firms against the brokers arising out of alleged failures of the brokers to pay promissory notes when they left the firms. There has been a lot of movement within the industry of brokers [switching] from one firm to another in the last couple of years,” Fienberg says.

Erwin Shustak, securities attorneyNowadays, the arbitrations are “a very serious, nasty business. Everybody is out to win. More often than not, the financial advisor loses,” says Erwin Shustak, a securities attorney who runs his namesake firm’s litigation and arbitration department in San Diego. He has represented advisors in arbitrations and also served as an arbitrator for nearly 30 years.

“In the 1970s and early 80s,” Shustak says, “these hearings were an informal process. Now it’s full-blown total warfare.”

Who’s Watching?

The Securities and Exchange Commission is responsible for overseeing FINRA, including the arbitration program. Within the last three years, it has conducted two reviews of that process. A 2012 report by the GAO found that the Commission inspects the forum “occasionally” and that there was considerable opportunity for improvement in both its approach and frequency of inspections.

Fienberg estimates that the most recent SEC review was “within the last couple of years. It’s on a cycle. I can’t remember the last cycle,” she says.

According to Paula Jenson, the SEC’s deputy chief counsel in the Division of Trading and Markets, the Commission oversees the program in two principal ways. “One is through inspections to determine whether FINRA is complying with its own rules as well as with federal securities laws,” she says. “The other is through review and approval of its rules before they can become effective.”

The Project on Government Oversight (POGO), an independent organization in Washington, D.C., that works to uncover misconduct, “has concerns that the SEC may not be equipped to adequately oversee FINRA’s arbitration process,” says Michael Smallberg, a POGO investigator. “We think there is evidence that the setup has not served the best interest of advisors.”

The Securities Industry and Financial Markets Association (SIFMA) sanctions FINRA’s broker arbitration forum. “The term ‘self-regulatory’ no longer applies. FINRA is an independent regulatory organization,” says Kevin Carroll, SIFMA’s managing director and associate general counsel, in Washington. “Brokers get a fair shake. If, in arbitration, they get beaten up and harsh words are exchanged, that’s just that nature of dispute resolution — you’re in conflict with the other party. The gloves are off. But that doesn’t make FINRA arbitration unfair or give brokers short shrift. The hearing process is just as unbiased and independent from the parties as any jury pool. FINRA isn’t run by the industry. Morgan Stanley isn’t sitting on the hearing panel.”

‘Biased’ Panelists

Many disagree with Carroll’s overall assessment.

“There is a big institutional bias,” says Ed Gartenberg, of Gartenberg Gelfand Hayton & Selden, a securities litigation firm in Los Angeles. “The sum total is that the system greatly favors the brokerage houses. FINRA is an organization that’s run by the brokerages — therefore, the arbitration is not on a level playing field.”

Gartenberg’s partner, Shirley Hayton, tried and won a case in 2013 in which advisor John Lindsey was sued by Edward Jones for $5 million. FINRA dismissed the suit.

One of the chief gripes across the board about FINRA’s forum is the questionable quality of its arbitration panelists. Lists of arbitrators from which both parties choose are provided. The names — any of which are permitted to be stricken by either side — are “drawn randomly from a computer,” Fienberg notes.

But the arbitrators are often biased, detractors say.

“The panelists, who are notorious for never wanting to offend the broker-dealers, are almost always going to rule for them. It’s appalling,” says Ledbetter.

Shustak says the top problem indeed is “the repetitive professional arbitrators who become beholden to the big firms. For them, it’s a living. So they want to make sure their bread is buttered on the right side. They tend to favor the firms because they want to keep getting jobs. I see some names over and over again. Some people are 85 years old. I’ve been in arbitrations where panelists fall asleep after lunch. I have to drop a book on the table to wake them up. They have no idea what’s going on.”

Mostly everyone interviewed agrees that the quality of the arbitrators needs to be upgraded. FINRA’s forum uses both public and industry arbitrators.

“It’s been a constant struggle for FINRA,” says Bryan Ward, a partner of Sutherland, Asbill & Brennan, in Atlanta. In intra-industry arbitrations, Ward typically represents the brokerage firms. “It’s going to require constant vigilance. FINRA simply doesn’t pay enough to arbitrators. It’s based on volunteerism, so it can be difficult to recruit. They get a lot of retirees that want to stay active and contribute in some limited fashion — so they sign up for FINRA arbitration.” Brian Hamburger, president and CEO of MarketCounselThough the pool includes knowledgeable members of the industry and securities attorneys, many others have little understanding of the fundamentals, says Brian Hamburger, president and CEO of MarketCounsel, a compliance consulting firm, and managing partner of Hamburger Law Firm, in Englewood, New Jersey.

FINRA arbitration “is probably a kangaroo court,” Hamburger says, “because I’ve been in endless hearings where some of the basic issues discussed for the benefit of the arbitrators are a joke. This is supposed to be a specialized forum with people that really understand the issues. But what they’re getting instead are, in large part, people that have nothing better to do than participate in these hearings.”

Notes Solin,who is based in Bonita Springs, Florida: “There are arbitrators whose agenda is to continue to serve in these very cushy, prestigious roles. They know that if they issue an award against a firm, they’re not going to be sitting in the future. It’s an inherent systemic bias from having basically a trade organization administer arbitration. That’s unique to the securities industry. The system doesn’t smell right. But the firms don’t want to change it.”

FINRA, to its credit, has come up with a proposal, soon going out for comment, that would increase the $200-per-hearing session honorarium, plus $75 for panel chairpersons, that it pays. This is “to make sure we have even more really available, good arbitrators,” Fienberg says.

Another upcoming rule filing, she notes, is that “anyone that has ever worked in the industry — even 30 years ago — can never become a public arbitrator.”

Lying Recruiters, Missing Records

Much to financial advisors’ chagrin, under FINRA arbitration, fraudulent-inducement claims — based on firm recruiters’ promises to support their practices with equipment, product, dedicated support staff and the like, but then not making good on those assurances — are typically ignored.

“Recruiting branch managers lie through their teeth because they want to make their [revenue] numbers,” says Shustak.

But when advisors bring suit against a firm because they haven’t received what they were told they would and cannot conduct their business, they find that FINRA’s dispute resolution pivots strictly on the promissory-note issue.

Fienberg says the upfront payment that FAs receive to move their book is “not a bonus.” “Promissory-note cases are contractual cases. Either you’ve paid that note or you haven’t, or you’ve worked it off. They are relatively routine.”

Winks observes: “FINRA characterizes every dispute as a contract dispute if there’s an outstanding balance and ignores all false- inducement claims. That only encourages recruiters to make false representations.”

Thus, even if recruiters’ sales pitches prove to be hollow, advisors have little, if any, recourse.

“If you have a beef with your firm and go to arbitration, your chances of succeeding are about nil. On the other hand, if the firm brings suit against you, they have a 100% chance of winning,” Ledbetter says. Further, the chances of overturning an arbitration award by appealing it are “slim to none,” Gartenberg notes.

One advisor who tried to appeal is Mark Mensack, now an independent fiduciary consultant and RIA with Piedmont Investment Advisors in Lansdowne, Virginia. But he was unsuccessful in his attempt after losing an arbitration case to Morgan Stanley. It mattered not at all to FINRA that, when he obtained a copy of his recorded hearing proceedings, in preparation of the appeal, eight hours were missing in 14 different places — all material that supported his case.

Fienberg says: “On rare occasions, it has happened that an arbitrator has forgotten to turn on the recording device. But we have a built-in procedure now to almost ensure that cannot happen again.”

Who Really Owns That Promissory Note?

Another issue that outrages advisors is that when firms assign FAs’ promissory notes to a non-FINRA entity to lower their net capital requirements, the brokerages, even though they no longer own the note, file suit against the advisor to collect any balance due.

“Morgan Stanley has filed multiple claims on behalf of Morgan Stanley brokerage when in fact the notes were owned by a company called Morgan Stanley Smith Barney FA Notes Holding LLC,” contends Vernon. “FINRA, or the SEC, should be condemning that.”

Morgan Stanley declined to comment for this article.

Fienberg has this to say: “When one of the firms attempted to do [the above], thereby precluding the individual from having a day in arbitration, FINRA brought an enforcement action against the firm.”

In at least one instance, Vernon challenged the practice of brokerages assigning notes to a non-FINRA member but suing the broker for payment anyway. “We proved that the brokerage firm — which was not Morgan Stanley — had no right to sue. We had a finding with the arbitrators that the broker-dealer had no standing to pursue the claim. When they brought in the firm that was owed the money, they got half of what they asked for. If advisors [win] more cases like this and start standing up, it’s going to back down the firms to be more reasonable with them.”

Fighting Back

One way to get fair treatment for advisors when they exit large firms is by requiring every brokerage to sign the Broker Protocol, thus enabling FAs to take their clients with them without hassle.

Some firms have steadfastly refused to sign the Protocol. Edward Jones is one.

“We are very, very protective of the information that our clients share with us,” says Jim Weddle, Edward Jones managing partner and a member of FINRA’s board of governors for nearly five years. “It’s our opinion that clients have not given us permission to share their names, their addresses or anything about them with another firm. They’ve shared that information with their Edward Jones advisor, and we want to protect that.” Gartenberg believes that requiring adherence to the Protocol as an industry standard would “take care of the bullying [exiting FAs] problem. You can’t impose a kind of slavery on people and say, ‘You must always stay with our firm.’”

Since broker-firm disputes often get ugly, Shustak recommends that advisors with legitimate complaints — and a note balance — sue their firms before the firms sue them.

“It’s better to be a plaintiff than a defendant,” Shustak says. “It’s a disaster when you’re a defendant. You can’t control the case.”

Still, sometimes advisors can be their own worst enemies when it comes to arbitrations: they simply don’t show up; they haven’t hired an attorney; they’ve failed to keep good records but have sent emails to colleagues with opinions and information that could ultimately be used against them.

Further, in most cases of fraudulent inducement, advisors have secured nothing from the firm in writing stipulating its promises. They say brokerages won’t comply.

“The firm says, ‘Sure we’ll do that for you.’ The advisor says, ‘OK, I’ll trust you.’ What were they thinking?” says Shustak, who advises, as do other attorneys, to seek legal advice before signing an employment contract.

A Better Way?

Some believe that giving advisors a choice to resolve disputes in other forums in addition to FINRA’s — such as the American Arbitration Association (AAA) or JAMS — would go far to make dispute resolution fairer for advisors.

At least part of the solution might be to adjudicate disputes in a court of law. This was indeed possible until brokerages won a 1987 Supreme Court case that made arbitration mandatory, according to Shustak.

“FINRA arbitration takes a very narrow view. All they look at is the issue of the note, when actually the facts in a case are much broader. In court, there’s a very broad view of the whole case and more latitude in getting discovery” upon which advisors can build their cases. “And you can have depositions,” Gartenberg argues.

But Shustak disagrees. He says that going to court would be less helpful. “With arbitration, you’re guaranteed to tell your story. With court, even before you get to a jury, you can be sliced and diced; and your case can be thrown out on a technicality. So you’ll never have your day in court.”

One possible, though improbable, remedy is to do away with upfront bonuses.

“I’d like to see them gone,” Vernon says. “Signing bonuses make advisors a little like indentured servants of the firm. They have a hard time leaving because it’s like having your mortgage due all of a sudden on the day you leave. And it puts advisors in a position where the brokerages force them to push for production, which they might not do without that extra pressure.” Pending legislation — a bill that would make arbitration optional — could somewhat lighten FAs’ plight. But as Solin points out: “It seems unlikely to be passed. Congress is influenced by the economic contributions from the securities industry. The firms have the system wrapped up, and FINRA is the trade organization of large brokerage firms.  To some extent, the SEC is strongly influenced by the securities lobby, which is huge.

“So until legislative political will changes it,” Solin continues, “this cozy arbitration system is going to continue.”

Winks therefore suggests that advisors best protect themselves when moving firms by obtaining all verbal promises in writing before joining.

“If the firm won’t sign,” Winks says, “it should be a dealbreaker.”

But when inevitable disputes do result in arbitration, Vernon thinks that “advisors should fight to the death. They should start setting some precedent and get FINRA to back down.”

That appears easier said than done. As Gartenberg stresses: “FINRA is a watchdog run by the brokerage industry, where the industry wins 90%-plus of the cases. What is that telling you! They would be desperate not to keep it right where it is.”

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