SEC gets OK to nix mandatory arbitration

Move could mean 'more litigation and more jury trials'

Oct 17, 2010 @ 12:01 am

By Jessica Toonkel

A little-known provision within the Dodd-Frank law gives the Securities and Exchange Commission the power to remove mandatory-arbitration language from client-broker agreements, which could expose broker-dealers to huge costs, according to observers.

“This would mean more litigation and more jury trials for broker-dealers,” said Lee Pickard, former director of trading and markets at the SEC, and a partner at Pickard & Djinis LLP.

Currently, the vast majority of investors with a complaint against a broker-dealer go before an arbitration panel arranged by the Financial Industry Regulatory Authority Inc. But if the SEC nixes mandatory arbitration, in which damage awards are usually smaller, investors instead could choose to hire lawyers to pursue private lawsuits.

And unlike scores of other sections in Dodd-Frank that require the SEC to study an issue before making changes, this provision states that the commission can put out a rule for comment at any time.

Such a move would catch a lot of brokers unawares, said TD Ameritrade Trust Co. president Skip Schweiss, who oversees adviser advocacy issues for the firm. In his talks with advisers, the rescinding of mandatory arbitration is the one Dodd-Frank issue that surprises brokers the most.


“I see a lot of eyes widen when I talk about this one,” Mr. Schweiss said.

At the moment, the SEC is collecting comments on all aspects of the Dodd-Frank legislation, including the arbitration provision, said SEC spokesman John Heine. The SEC doesn't have a timetable for deciding whether to submit an arbitration rule for comment.

Nancy Condon, a Finra spokeswoman, declined to comment.

Critics of the current rule said that removing mandatory arbitration would be better for investors.

They added that if the SEC does change the rule, it doesn't mean that investors will be unable to pursue arbitration. Under Finra rules, all investors have the right to seek out arbitration; a change in the rule by the SEC merely would give investors the choice between arbitration and litigation.

Some industry participants also said that a rule change would create a more transparent decision-making process for brokerage firms.

Arbitration panels don't have to disclose how they came to decisions, whereas courts do, said Pat Huddleston, a former enforcement branch chief at the SEC and chief executive of Investor's Watchdog, an SEC-trained investor protection company.

“With arbitration panels, you win or lose, and there is no application of law and facts, because every arbitration panel is different,” he said. “Opening the courthouse back to investors is the right thing to do because it would help investors in the long run and the industry by knocking down frivolous claims and giving everyone an understanding of what brokers are allowed to do through court decisions.”

But court cases cost money, and the cost of litigation may actually prevent some investors from going to court, said Elliott Curzon, a partner at Dechert LLP.


“My guess is that if this happens, it will drive bigger cases to go to court because the perception is that plaintiff's lawyers feel they have a better chance of winning bigger judgments in court,” he said.

Smaller cases probably would still be worked out through Finra arbitration panels, Mr. Curzon said.

Advocates of mandatory arbitration think that the current setup is sufficient.

“The arbitration process works fairly well, and investors haven't been at a disservice by it,” Mr. Pickard said.

Raymond James Financial Inc. executives agree that the Finra arbitration system does a good job.

“Raymond James believes the Finra arbitration process as currently structured offers a forum for customer disputes which is both efficient and equitable,” company spokeswoman Anthea Penrose wrote in an e-mail.

Arbitration is often much faster than litigation and thus more beneficial to investors and brokers, said John Cataldo, chief compliance officer and counsel at Investors Capital Corp., an independent broker-dealer.

“I have seen many securities cases that have ended up in court and languish for years,” he said. “You don't see that in arbitration court.”

By removing mandatory-arbitration clauses and exposing brokers to greater liability of litigation, the SEC could push brokers to steer away from selling certain types of specialized or complicated products, even if they are suitable for clients, Mr. Cataldo said.

Surprisingly, not all brokers are opposed to the rule change.

“It used to be that arbitration hearings were cheaper and faster than going to court, but it seems that these proceedings have gotten longer, and the costs borne by the broker-dealer community have increased,” said Neal E. Nakagiri, president and chief executive of NPB Financial Group LLC. “Today, the costs between arbitration [and] litigation are roughly equivalent.”


This isn't the first time that the issue of mandatory arbitration has come up. In 1987, the Supreme Court ruled in favor of its use.

“This is something that has been percolating for ages,” Mr. Curzon said. “So it was pretty surprising to see it in the Dodd-Frank bill.”

Finra, for its part, seems to be doing what it can to pre-empt the SEC rulemaking process.

On Sept. 28, following a two-year pilot program, the regulator announced a proposal by which investors filing claims against brokerage firms would be able to request public arbitration panels without industry representatives. Currently, arbitration panels comprise two public arbitrators and one industry representative.

Said Mr. Huddleston: “I think the timing of this proposal is too good to be coincidental.”

E-mail Jessica Toonkel at


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