Rules Of Arbitration Panels A Disadvantage To Investors?

It’s become a predictable news headline: “Wall Street Firm Charged With Fraud In Auction Rate Securities Sales.” Following the collapse of the auction bond market in February, investment banks and securities firms have made a cottage industry out of reportedly deceiving investors by keeping the risk factors of auction-rate notes quiet.

Now, nearly major Wall Street player - from UBS, to Merrill Lynch, to Citigroup - is facing the wrath of state and federal securities regulators, as they answer tough questions of why they falsely promoted auction-rate notes as safe, liquid investments.

Investors are asking questions of their own - as well as taking action, with many lining up to file arbitration claims and class-action lawsuits against the Wall Street firms that they say caused them financial disaster because they were misled about the liquidity risks of the auction bonds.

For a number of these investors, the auction rate scandal ultimately will lead them to an arbitration hearing - a procedure in which two parties involved in a dispute (in this case, the investor and the broker or brokerage firm) - present various evidence to a three-member panel of “judges.”

And therein lies the problem. For claims of more than $50,000, the rules of arbitration can be an albatross for investors because the three-member panel must include an industry representative, as well as two individuals who also could have industry ties.

Columnist Jane Bryant Quinn addresses this issue in a July 30 story on Bloomberg.com, in which she writes: “The industry rep is there to explain the industry’s point of view to the other panelists - effectively, a Wall Street mouthpiece, sympathetic to the very products and practices you’re complaining about. As an “expert,” his or her opinion carries extra weight.”

In other words, investors could very well find themselves at a major disadvantage. Birds of a feather flock together. If one of the individuals on the three-member arbitration panel represents the very industry that investors contends wronged them, the likelihood they will receive a completely unbiased and fair hearing - let alone a favorable outcome - is certainly in question.

As reported in Quinn’s Bloomberg commentary, the Public Investors Arbitration Bar Association (PIABA), a national association of lawyers who represent investors in arbitrations against the brokerage industry, took up this matter with the Financial Industry Regulatory Authority (FINRA) last May when it asked for changes to be made in arbitration proceedings so as to avoid potential conflicts of interest. Specifically, PIABA wanted panelists who had worked for firms that originated or sold auction rate securities to be barred from arbitration hearings altogether.

That didn’t happen. Instead, FINRA, which runs the securities arbitration system, decided that an arbitrator would only be required to make additional disclosures if, after Jan. 1, 2005, “he or she worked for firms that sold auction rate securities, sold them themselves or supervised anyone who did.”As an added catch, FINRA also ruled that it would be the responsibility of the lawyers for the investors (or the investors themselves if they are going it alone) to decide whether to elect those arbitrators as part of the three-member panel.

And that can cause a host of problems during the actual selection process for the three individuals to comprise the arbitration panel. Each party in the arbitration dispute is given three lists of names, which have been created from an arbitrator pool and randomly selected via computer, according to Quinn’s article. One list contains names of industry panelists and two other lists have names of public members. Both sides can disallow, for any reason, up to four names on all three lists.

However, in that individuals involved with auction-rate securities could be in the panelist pool, investors’ lawyers are forced to use up their four challenges to strike them. After that, they are simply out of luck and must live with the names they get.

In December 2007, PIABA testified before Congress, asking that it abolish FINRA’s rule of requiring one of the three securities arbitrators to be associated with the securities industry. PIABA also requested that FINRA adopt new rules to ensure arbitrators on a panel have no ties or connections to brokerages or industry associations.

To no one’s surprise, FINRA - which is a private regulator for more than 5,000 U.S. brokerage firms - is against PIABA’s suggested reforms.

However, in an attempt to address criticism over the arbitration process, FINRA announced a two-year pilot program on July 24 that would give investors the option of having their cases heard solely by an all-public panel. Over the two-year period, 400 cases could be heard by panels consisting of investor peers. At the conclusion of the pilot, FINRA says it plans to conduct a study to determine the differences between all-public and nonpublic arbitrators, how cases settle in the two different forums and which option customers more readily choose.

So far, several major brokerage houses, including UBS, Merrill Lynch and Morgan Stanley, have agreed to participate in FINRA’s program. The first 40 clients of those firms who file arbitration cases after Oct. 6 will have the option of choosing either an arbitration panel of only public representatives or a panel with a member of the financial services industry.

Meanwhile, critics of mandatory industry panelists are calling the pilot program a long time in coming and finally a move in the right direction. Removing the industry representative component out of the three-member panel structure not only sheds the David-and-Goliath persona associated with arbitration proceedings involving auction rate securities but also is a critical and essential step to restoring faith in the process and allowing investors to believe that their voice may actually be heard this time around.

Our affiliation of securities lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.

This entry was posted on Monday, August 4th, 2008 at 7:51 amand is filed under Auction Rate Securities, Citigroup ASTA Fund MAT fund, Merrill Lynch, Morgan Stanley, UBS. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.