Securities Arbitration

In recent years, the use of alternative dispute resolution in the U.S. has risen dramatically. The financial services industry is no different. Many brokerage firms include an arbitration clause in the paperwork signed by a client upon opening an account. As a result, many investors may have waived the right to sue their broker without knowing.

What is Arbitration?

Arbitration is a method of resolving disputes outside of the court system. To enter into arbitration, both parties must agree in writing to waive their right to file a lawsuit. Arbitration clauses are included in an increasing number of contracts, from cell phone service agreements to broker-investor contracts.

Absent an arbitration agreement, an investor who believes his or her broker has committed malpractice, misrepresentation, or some other type of securities fraud may file a lawsuit alleging a violation of Rule 10b-5 or another applicable federal or state law. The lawsuit would proceed like any other. After a period for the discovery of evidence, legal issues are resolved and, if necessary, the case goes to trial.

However, if the parties have signed an arbitration agreement, they are barred from filing a lawsuit. If one party does file a suit, the other can have it dismissed from court immediately.

Like other forms of dispute resolution, arbitration has advantages and disadvantages. Arbitration is generally quicker and less expensive than a traditional civil court case. However, consumers may find that many arbitration agreements are written to favor large corporations, especially if the consumer chooses not to hire an attorney.

Securities Arbitration

In the early 1950s, the Supreme Court held that an arbitration agreement was not a defense for an investor’s suit for misrepresentation under the Securities Act of 1933. However, since then, the Court reversed that decision, making arbitration agreements enforceable against nearly any lawsuit brought by an investor. In recent years, courts have deferred to arbitration agreements even in situations when the dispute did not involve the sale of a security but any transaction governed by the broker-investor relationship, including procedural rules.

The Financial Industry Regulatory Authority (FINRA), which is the self-regulatory body of the financial industry, promulgates rules for its members to follow. FINRA Rule 12200 requires a dispute between a client and a broker go to arbitration if either the parties agree in writing to arbitration, or the client requests arbitration. The rule applies to any dispute that is connected to the business activities of the broker, whether or not it concerns a securities transaction. Investors have six years from the event that gave rise to the claim to file a complaint.

The FINRA rules also determine the procedure throughout the arbitration process. To select the arbitrators who will hear the case, each party is presented with a list of randomly selected arbitrators. The parties strike the unwanted arbitrators and rank the rest in order of preference. The arbitrators with the top three scores hear the case.

The arbitration process is similar to a courtroom trial but with relaxed rules of evidence. First, there is a brief discovery period. At the hearing, the parties present their opening arguments, followed by the evidence that supports their case. The parties are given an opportunity to cross-examine the opposing witnesses, and the hearing concludes after closing arguments. The arbitration panel then makes a decision, which is usually binding, final, and confidential.