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How firms have the upper hand in FINRA arbitration

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Just how fair is FINRA arbitration?

It may depend on how good you are at picking arbitrators.

Firms are “able to better select arbitrators that are friendlier to them, which then biases outcomes in their favor,” three researchers said of a paper they submitted this month on FINRA arbitration to the National Bureau of Economic Research.

“Our findings suggest that limiting the respondent’s and the claimant’s inputs over the arbitrator selection process could significantly improve outcomes for consumers,” the report concludes.

In their latest paper, the researchers — who probed the extent of advisor misconduct in a widely noted 2016 report — covered nearly 9,000 client cases decided by 8,000 arbitrators over a 27-year period.

Clients received a median of 32% of their requested damages, and the cases show evidence of “persistent systematic differences” among arbitrators, according to the report’s authors, Mark Egan of Harvard University, Gregor Matvos of the University of Texas and Amit Seru of Stanford University.

Based on a formula tracking the disparity in awards handed out by arbitrators in similar cases linked by factors like their nature, complexity, the product involved or the location of the case, the researchers deemed arbitrators “industry-friendly” or “consumer-friendly.”

Industry-friendly arbitrators are 40% more likely to be selected. A 2007 change in FINRA’s selection process reduced the number of names that parties can strike from the list, though, and it dramatically cut down on the likelihood that the parties chose industry-friendly arbitrators, according to the study.

“For the same/similar case, some arbitrators tend to consistently grant higher awards (i.e. there are client-friendly arbitrators) while other arbitrators consistently grant lower awards (i.e there are industry-friendly arbitrators),” the authors, professors in business at their respective colleges, said in an email.

“Most importantly, though the selection process gives both firms and clients control,” they continued, “firms, especially experienced ones, are better at selecting industry-friendly arbitrators.”

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FINRA uses an algorithm to generate random pools of arbitrators, according to spokeswoman Michelle Ong. The parties to an arbitration then strike up to four names from each list consisting of 10 public or industry arbitrators. Subsequently, they rank their preferences out of the remaining names, reaching an agreement on which arbitrators will serve on the panel to hear their case.

The self-regulatory organization was not offered the opportunity to provide comments on the study, but FINRA continues “to welcome feedback to ensure FINRA arbitration is a fair dispute resolution system for all parties,” Ong said in an email.

“We are always eager to engage with academics to ensure they fully understand the processes we have in place to better inform their research,” Ong said. “FINRA strives to provide a fair and efficient venue to resolve securities-related disputes.”

FINRA has also started making efforts toward greater diversity among arbitrators based on gender, ethnic and socioeconomic backgrounds, notes Christine Lazaro, the president of the Public Investors Arbitration Bar Association. Lazaro favors making FINRA arbitrations more public, as well.

“Firms can take positions that they wouldn’t take in court,” she says. “The privacy and the confidentiality of the system can systematically hurt investors because the firms are able to take positions that are inconsistent with their public positions.”

However, the researchers also found that clients retaining an attorney who is a member of PIABA received awards four to five percentage points closer to the damages requested in their cases.

The difference stems from the experience of PIABA attorneys, and legal expertise clearly helps a case. Clients who represented themselves received awards that were two to three percentage points lower, relative to their requests, than clients who hired any type of attorney.

A rule change in 2011 allowing clients the option of an all-public panel, meaning arbitrators not connected to any industry firms, was a “very noticeable change,” according to Steven Caruso, chairman of FINRA’s National Arbitration and Mediation Committee.

Caruso, a longtime client lawyer and PIABA member, also leads FINRA’s 12-member arbitration advisory committee split between public and industry members. FINRA arbitration “has become a much fairer and more balanced process for all the parties than it used to be 10 or 15 years ago,” Caruso says.

FINRA gives clients “more input into the process than any other dispute resolution forum and remains the gold standard against which all other forums should be measured,” he said in a follow-up email after reviewing the study, which he called an “interesting paper” but not altering of his experiences or opinions.

The study’s other notable findings include:

  • The median damages requested was $175,000; the average was $785,000.
  • The median award was 32% of the requested damages; the average was 51%.
  • Nearly half (48%) of advisors named as respondents had past histories of misconduct, defined as regulatory or criminal offenses, customer disputes resolved in favor of the client and other types of serious disclosures
  • 40% of arbitrators were current or former advisors; 15% had records of misconduct
  • Unsuitable recommendation (51%) was the most common allegation by clients; stocks (9%) were involved in more cases than any other product.

Egan, Matvos and Seru filed the study as a “working paper,” meaning they are in the process of taking feedback and revising the paper to address comments. In addition to tracking advisor misconduct, the same authors studied the differences in punishment of male and female advisors.

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