THE BLOG
08/30/2016 05:08 pm ET Updated Aug 22, 2017

Morgan Stanley Leverages FINRA's Mandatory Arbitration

A recent story in The New York Times tells you all you need to know about the mandatory arbitration process imposed on investors who use brokers.

Blatant misconduct

The story reported on the erratic behavior of Steve Wyatt, a top broker employed by Morgan Stanley in Mississippi. Mr. Wyatt had exhibited signs of erratic behavior, including sleeplessness, coming into the office in the middle of the night and trading client money "erratically." During his five years of employment, his "problematic behavior and business patterns" were brought to the attention of Morgan Stanley's compliance officers and supervisors "many times."

His conduct had a devastating effect on the portfolios of his clients. They allegedly lost about half of their investments, aggregating almost $50 million. He was fired in 2012.

The Mississippi Secretary of State entered into a settlement with Morgan Stanley. It barred Mr. Wyatt and his immediate supervisor from the securities industry for life and required Morgan Stanley to establish a fund of $4.2 million to reimburse clients.

A process inherently biased

Since the settlement was a fraction of the losses, aggrieved investors commenced arbitration proceedings, as they were required to do in the account opening statements with Morgan Stanley. The arbitration process is administered by the Financial Industry Regulatory Authority (FINRA), which describes itself as " an independent, not-for-profit organization authorized by Congress to protect America's investors by making sure the securities industry operates fairly and honestly."

The Board of Governors of FINRA is populated by members of the industry it's supposed to regulate, including representatives from Merrill Lynch and Edward Jones, among others.

Think of this arbitration system this way: If you had a dispute with a funeral director, how would you feel if you were required to arbitrate it through a process administered by a funeral trade association?

Using its leverage

Given the sordid history of this matter, you would think the arbitrations would be a slam dunk for Mr. Wyatt's clients. In fact, you might wonder why Morgan Stanley would not settle these cases and avoid the uncertainty, cost and expense of an arbitration.

Your assessment would ignore the ace Morgan Stanley had up its sleeve: The FINRA arbitration process is perceived by many to be biased in favor of the securities industry. Instead of settling these cases, Morgan Stanley is fighting them -- hard. It alleges the clients were "negligent" for not monitoring their investments with Mr. Wyatt more closely and that the losses were caused by the financial crises.

One client, an 84 year old widow, placed her trust in Mr. Wyatt and in the company's ability to supervise him. Morgan Stanley defended the arbitration she commenced, alleging she willingly signed up for an "aggressive portfolio" and should bear the responsibility for her losses.

The arbitrators tossed her a bone, and awarded her $150,000, despite evidence her losses totaled $700,000.

She was fortunate to receive any award.

The case for abolishing this process

William Galvin, the highly respected Secretary of the Commonwealth of Massachusetts testified before a congressional subcommittee on March 17, 2005. He correctly characterized FINRA's arbitration process as follows:

"The term "arbitration" as it is used in these proceedings is a misnomer.
Most often, this process is not about two evenly matched parties to a dispute seeking the middle ground and a resolution to their conflict from knowledge, independence and unbiased fact finders, rather what we have in America today is an industry sponsored damage containment and control program masquerading as a juridical proceeding."

One study found that 80 percent of arbitrators in these proceedings are male with an average age of 69.

Misleading investors

Morgan Stanley has no remorse. It's spokesperson stated: "We take extremely seriously our responsibility for placing our clients' interest first."

The reality is quite different. As indicated in this study, Morgan Stanley, and other brokerage firms, profess to "put the interest of the clients first", but disavow this obligation in arbitration proceedings. In order to be legally obligated to put the interest of clients first, Morgan Stanley would have to accept what is known as a "fiduciary" standard of care. The study quoted from its position in another arbitration as follows:

"There is no fiduciary duty where, as here, the client maintains a non-discretionary brokerage account."

Lack of political will

To date, all efforts to legislate an end to mandatory arbitration have lacked the political will to get it done, despite the views of a former SEC Commissioner, the North American Securities Administrators Association and various consumer groups, including the AARP.

You can read more about the deficiencies in FINRA's arbitration system, the lack of diversity of its arbitrators, unjust results of these proceedings and the inherent conflict of interest of arbitrators who "are reluctant to make big rulings against the industry because they won't be asked back", in this compelling blog.

Protect yourself

As an investor, you should know that your broker essentially has carte blanche to engage in wrongful conduct -- with or without the knowledge of the brokerage firm -- and, regardless of the merit of your claim, you're unlikely to find justice before a FINRA panel.

There's a simple way to avoid this fate. Don't do business with any broker. Instead, invest yourself using low cost index funds available from fund families like Vanguard and Fidelity, use a robo-advisor like Betterment or Wealthfront, or use the services of a registered investment advisor (RIA). RIAs are required by law to act solely in your best interest and will confirm that obligation in writing. Most importantly, disputes with RIAs are not subject to FINRA's mandatory arbitration process.

Don't put yourself in a position where you can be victimized by your broker, and revictimized when you try to recover your losses.

Dan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone. He is not affiliated with any broker or advisory firm. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.