I have a wealthy investment client who was familiar with my background as a securities arbitration lawyer representing investors in claims against their brokers. He had purchased a large amount of auction rate bonds. He was told by his broker (who calls himself a "financial consultant") that these bonds were "as good as cash."
You know the rest of the story. There is no market for these bonds. Some of his holdings are on the verge of default. A significant portion of his wealth is now at risk.
He asked me if he had any legal redress. My advice: Lick your wounds and do your best to cut your losses. He was appalled.
Like most investors, he did not realize that when he opened up an account with his brokerage firm, the account opening statements required him to give up his constitutional right to access to the courts and to a trial by jury. Instead, all disputes with his broker had to be submitted to "mandatory arbitration."
It gets worse. This arbitration is run by FINRA, the Financial Industry Regulatory Authority. Virtually all brokers are members of FINRA and they all require their customers to submit to mandatory arbitration.
FINRA, which is really the securities industry, promulgates and administers the rules governing the arbitration process. It picks the arbitrators who serve on the panels that hear disputes. One of its more intriguing rules is that an arbitrator affiliated with the securities industry must sit on every panel.
The fairness of these panels has been a subject of intense debate. William Galvin, the highly respected Secretary of the Commonwealth of Massachusetts, characterized the process as "...an industry-sponsored damage containment and control masquerading as a juridical proceeding," in testimony before a House sub-committee.
Some arbitrators who have participated in cases where a large award was rendered against a major brokerage firm have reported that they were removed from consideration as arbitrators on future panels.
A study I co-authored of more than 14,000 arbitration awards over a ten year period found that investors with significant claims suing major brokerage firms could expect to recover only 12% of the amount claimed.
FINRA has been stung by these accusations, but it still refuses to take the right course: Drop the pretense of administering a fair and impartial dispute resolution system and permit customers of brokerage firms to resolve their disputes either before a totally impartial tribunal, under rules administered by an unaffiliated entity (like the American Arbitration Association) or by a jury of their peers. Instead, it has announced a new pilot program, where it will permit a small number of cases to be heard by a panel that will exclude the industry arbitrator.
The North American Securities Administrators Association (NASAA), a group of state securities administrators, was not impressed. NASAA issued a statement noting that this program affected only a relatively few cases and asserted that all investors should be given that choice "immediately."
What does all this mean for investors like my client who were induced to buy auction rate bonds?
FINRA wants to make it appear like it is doing something constructive with its new pilot program. However, it has no intention of really leveling the playing field. In a stunning development, FINRA announced that panelists on these cases could include employees of brokerage firms that originated or sold auction rate securities!
That was the final straw. Investors are unlikely to get justice from a panelist whose own firm engaged in similar behavior.
All is not lost. It is possible that a Court will refuse to enforce mandatory arbitration agreements on the grounds that these agreements violate public policy. Or pending legislation in Congress may pass which would forbid the imposition of mandatory arbitration clauses in consumer disputes altogether.
Until then, let's be practical. You can avoid these problems and increase your returns by not using the services of any broker or advisor who tells you she can beat the markets (which includes most of them). However, if you ignore this advice, be aware that you will have no effective redress for their misconduct.
FINRA has every right to put lipstick on a pig. But let's not kid ourselves. It is still a pig.
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