Is This Game Already Over?
By GRETCHEN MORGENSON
Published: June 18, 2006 Sunday New York Times
AFTER a Long Island charity that provides financial support for 190 current or former firefighters lost $614,036 in the stock market during the Internet bubble several years ago, it eventually did what many aggrieved investors do: it filed an arbitration case against its former broker, Andrew Sirico, contending that he had churned its account to rack up trading fees and had improperly invested its funds in speculative securities.
As is also routine in the brokerage business, a panel of three arbitrators — one representing the securities industry and two designated as public investor representatives — convened to hear the case of the charity, the East Islip Volunteer Firemen’s Benevolent Association. But if the association’s members hoped to get a speedy hearing, they were disappointed. Nearly 15 months have passed since the association filed its case, and the most basic facts in the dispute have yet to be argued.
Most of the delay is attributable to the time that Stuart D. Meissner , the association’s lawyer in New York, has spent arguing that arbitrators assigned to the case were either biased or improperly classified as investor representatives when, instead, they were closely associated with the brokerage industry. Mr. Meissner said in an interview that he had found what he considered to be conflicts of interest with all five panelists assigned by FINRA to the case.
Four of five candidates nominated to serve on the panel withdrew after Mr. Meissner’s challenges. FINRA Dispute Resolution, which is one of the securities industry’s two main self-regulatory bodies, rejected his challenge on the fifth panelist. That arbitrator is now the panel’s chairman.
Panelists who decide private arbitration cases are supposed to be completely neutral, like jurors hearing public court cases. But lawyers say that arbitrators with undisclosed ties to Wall Street or other potential conflicts that might disqualify them are common, as the East Islip firefighters’ case, and others, demonstrate. Lawyers representing investors uncovered the possible conflicts in those cases, not FINRA or the Big Board, also indicating that self-regulators have holes in their screening processes.
“In every instance we uncovered,” Mr. Meissner said of his case, “it is clear the screening process is not being enforced and there is very little being done about checking on conflicts.”
FINRA says it does not discuss individual cases, but that its extensive screening process and the disclosure demands required of arbitrators keep its system fair and reliable. The New York Stock Exchange, which handles far fewer arbitration hearings than FINRA, said the same about its resolution procedures.
In theory, private arbitration panels are supposed to offer a fast and fair system in which customers can resolve complaints with their brokers. Last year, according to FINRA, the average turnaround time for a case was 14.3 months, down from 15.4 months in 2004. In 1995, the average was 10.5 months.
But from start to finish, the securities industry itself oversees the arbitration process. Brokerage firms require clients to file grievances with private arbitrators, not in state or federal court. Arbitration is the only forum that investors can use to resolve disputes — opening the door to the possibility of lax enforcement or, at worst, outright compromises of the system.
BOB SILHAN is secretary of the East Islip association, and its members include retired, indigent and disabled firefighters. “The biggest impact this has had is on our members’ families,” he said, adding that the association can give its families only about $3,500 in annual death benefits. “We were on the threshold of trying to increase that when all this happened.”
Securities arbitration has become a thriving business. Last year, 6,074 cases were filed with FINRA Dispute Resolution, which oversees more than 90 percent of investor complaints. The peak year for FINRA cases was 2003, when 8,945 were filed — most of which, lawyers say, were related to the stock market fall that began in 2000. The number of cases filed this year is down 13 percent from 2005, FINRA said.
According to FINRA, the percentage of cases in which the plaintiff won an award has declined steadily since 2001. Then, 54 percent of cases were won by plaintiffs. By last year, that figure had fallen to 43 percent.
Arbitration as a way to resolve investor disputes really took off in 1987, after the Supreme Court ruled in a case known as Shearson/American Express v. McMahon that account forms signed by customers requiring that disputes be resolved in arbitration were enforceable contracts. Brokerage firms soon required all customers to sign such documents.
Securities lawyers who have conducted arbitrations for many years say that during the 1990’s, arbitration seemed to work well — that it was an efficient, low-cost process that bypassed the increasingly clogged court system. No longer.
“Securities arbitration has become much more like formal court litigation in terms of the parties’ investment of time and money,” said Lewis D. Lowenfels, an expert in securities law at Tolins & Lowenfels in New York. “What started as a relatively swift and economical process for a public customer claimant to seek justice has evolved into a costly extended adversarial proceeding dominated by trial lawyers and the usual litigation tactics.”
At the same time that brokerage firms defending themselves in arbitration are resorting to drawn-out litigation maneuvers, some lawyers say panelists are unwilling to push the defendants to produce documents they must maintain.
“There are brokerage firms and lawyers who in the face of rules requiring them to make documents available to the claimants do not do so,” said John W. Moscow, a former prosecutor who is a lawyer at Rosner Moscow & Napierala in New York. “The unwillingness of arbitration panels to compel the firms to produce the records they are required to keep puts the less sophisticated and less well-funded claimants at a disadvantage. When a case gets heard only on evidence that one chooses to produce, that is not what the rules envisioned when the S.E.C. approved them.”
Three-member panels oversee securities arbitrations. One member represents the financial industry and has expertise in the field; the other two act as public investors’ representatives and can come from any arena.
Public panelists cannot have extensive associations with the financial services industry or any other relationship that could compromise their neutrality. Lawyers for both sides choose arbitrators from lists provided by FINRA or the New York Stock Exchange. At FINRA, for example, there is a pool of 6,340 arbitrators; 3,692 represent the public and the rest are industry panelists. In every case, lawyers for each side can strike arbitrators from the list of candidates during the initial selection process. If all are struck, the lawyers must accept FINRA’s choices for the panel. At that point, lawyers for both sides can challenge a panelist only for biases, misclassification, conflicts or undisclosed material information.
All arbitrators sign applications disclosing their professional histories and any other information — such as lawsuits filed against them — so that lawyers for both plaintiff and defendant can assess their fitness for a case. But arbitrators are expected to disclose any conflicts that may arise even after a case has begun. Under FINRA rules, an arbitrator can be removed for biases or conflicts in the middle of hearing a case; the New York Stock Exchange does not yet allow for such a removal.
THE FINRA arbitration manual states that arbitrators must disclose any direct or indirect financial or personal interest in the outcome of an arbitration, and “any existing or past financial, business, professional, family or social relationships that are likely to affect impartiality or might create an appearance of partiality or bias.” They must sign oaths stating that they have no personal interest in the case before they agree to hear it. Potential arbitrators must also disclose whether an investor has sued them or whether they have been subjected to regulatory inquiry. But according to lawyers who have uncovered evidence of bias in arbitrators, FINRA does not seem to police the disclosures for omissions, disqualifications or conflicts. Steven B. Caruso, a lawyer at Maddox, Hargett & Caruso in New York and president-elect of the Public Investors Arbitration Bar Association, a nonprofit group of 800 lawyers representing individual investors, recalled a recent case he had in Florida.
“The FINRA sent me an arbitrator’s profile of a guy who was a public arbitrator and he had previously run a securities firm,” Mr. Caruso said. “So I challenged it to the FINRA; they went to the arbitrator and came back to me and said, ‘Well, he thinks he’s properly assigned.’ “After three or four exchanges they finally took him off my panel and reclassified him as an industry arbitrator. If you didn’t have the tenacity or knowledge of the system, or if you were a pro se investor, you would have been taken advantage of.”
In fact, FINRA relies heavily on arbitrators themselves to make proper disclosures. Last month, Rina Spiewak, a staff attorney in FINRA Dispute Resolution’s West regional office, wrote an article published on the association’s Web site entitled “When in Doubt, Disclose.” In it, she wrote that arbitrators “have an affirmative duty to become aware of relationships that should be disclosed” and that the appearance of bias can be as harmful as an actual conflict.
LINDA FIENBERG, president of FINRA Dispute Resolution, said her organization’s screening and arbitrator training system is elaborate and laborious enough that some applicants drop out of the process. “We believe that our rules are adhered to,” she said. “As soon as something comes to our attention that suggests there has been a mistake we obviously look into it and take appropriate steps. We have not had very many instances where that has come to my attention and I monitor these very carefully. If it came to our attention that an arbitrator had intentionally made a material misrepresentation we would remove that arbitrator from our roster.”Karen Kupersmith, director of arbitration at NYSE Regulation, a not-for-profit subsidiary that oversees activities of the Big Board’s member firms, said the exchange relies on arbitrators to be candid about their potential conflicts. But as financial services firms have grown more complex, the exchange has narrowed the considerations for public arbitrators to exclude anyone who works for a company that may conduct securities transactions or that controls, either directly or indirectly, a brokerage firm, she said.
Previous rules have stated that the spouse of a public arbitrator cannot be engaged in the trading of securities, but under a new rule awaiting Securities and Exchange Commission approval, the list of family members that can disqualify a public arbitrator would also include in-laws, children and parents.
“We are trying to broaden the net and raise awareness,” Ms. Kupersmith said. “We also do an ongoing review of arbitrators and classifications through a number of checks and balances which is computer-oriented and picks up things.”
The story of the losses incurred by the East Islip firefighters begins like that of so many other investors who lost money during the stock market bubble. Mr. Sirico, their broker, put the group into speculative technology stocks, made risky bets on options and used borrowed money to expand the group’s portfolio. In May, Mr. Sirico was fined $10,000 and suspended from associating with any FINRA firm for seven months for disclosure failures. He could not be reached for comment.
But trouble in their arbitration began last fall, when Robert W. Cockren, a lawyer at Sonnenschein Nath & Rosenthal, became chairman of their arbitration panel and was to act as a public representative.
Mr. Meissner challenged Mr. Cockren’s fitness to serve on the panel because of Sonnenschein Nath’s extensive relationships with brokerage houses. FINRA rules state that any lawyer whose firm receives more than 10 percent of its annual revenue in the prior two years from the securities industry cannot be considered a public arbitrator. But unless law firms disclose the sources of their revenue, it is impossible to determine if such conflicts exist.
FINRA denied Mr. Meissner’s challenge, saying that the arbitrator had done a “conflict check” with respect to the brokerage firms that were involved in the case. But Mr. Meissner learned through an extensive search that one client of Mr. Cockren’s firm was the parent company of a firm being sued in the case. He presented the evidence to FINRA and, on Dec. 9, 2005, Mr. Cockren withdrew from the panel.
Mr. Cockren said: “I fully complied with the FINRA rules and regulations and nothing that either I or my firm did was improper. We were substantially below the revenue threshold but it wasn’t worth my time or energy to deal with the attacks going on.”
Mr. Meissner also challenged four other arbitrators that the FINRA proposed, saying that all of them either had conflicts or had backgrounds that made them inappropriate representatives of public investors. Three withdrew from consideration, while the fourth is chairman of the panel.
The East Islip association seeks the $614,000 it lost, as well as attorney’s fees, court costs and interest. It has also asked for treble damages, amounting to about $1.8 million. Hearings on the case are scheduled for October.
Problem panelists have plagued other arbitrations. Donald L. Sturm, a wealthy Colorado businessman who sold his ownership in a company to WorldCom for stock and then lost $900 million after the telecommunications company collapsed, filed for arbitration against Citigroup in 2003. He contends that Jack B. Grubman, the banking giant’s former telecommunications analyst, advised him to hold onto his WorldCom stock even as it was plummeting. Mr. Grubman was barred from the securities industry for life in late 2002.
An FINRA arbitration panel ruled against Mr. Sturm in November. But Mr. Sturm’s lawyers are asking a federal court to overturn the decision because David H. Drennen, an arbitrator in the matter, failed to disclose past incidents that the lawyers say should have disqualified him or that they could have used as evidence to strike him from the panel.
According to a brief filed in the case, Mr. Drennen, general counsel at Bathgate Capital Partners, an investment firm in Greenwood Village, Colo., failed to disclose an arbitration panel finding from 1996 that a previous employer, “through Drennen’s conduct, committed securities fraud.” The panel in the case “awarded both the full amount of compensatory damages alleged and punitive damages” according to the brief.
Mr. Drennen, a former FINRA regional counsel, declined to comment. In a deposition taken last month in Mr. Sturm’s case, he said he recalled the earlier arbitration but said he did not disclose it on his arbitration forms because his conduct was not an issue in the current case. He also said in the deposition that he had testified in the 1996 arbitration on behalf of his employer, attended the entire proceeding and could not identify anyone else at the firm, besides himself, whose conduct was the subject of the case.
MR. STURM’S lawyers say Mr. Drennen’s involvement in the current arbitration is problematic in two ways: first, it may make him less objective or sympathetic to an investor accusing a brokerage firm of fraud, and, equally important, his disclosure of his involvement should have disqualified him from serving on the panel handling Mr. Sturm’s grievance. FINRA rules state that a prospective panelist is unqualified to serve if he or she, within the past seven years, has been the subject of an adverse, investment-related arbitration award of $25,000 or more. The 1996 arbitration involving Mr. Drennen resulted in a $212,103 award and occurred five years before he applied to become an FINRA arbitrator.
David E. Warden, a partner at Yetter & Warden in Houston who represented Mr. Sturm, said that a disclosure failure by any arbitrator “not only deprives the parties of their right to make an informed selection decision but also strips any semblance of integrity from the process.
“There doesn’t seem to be a watchdog for any of this,” he added.
Plaintiffs’ lawyers also say that arbitrator biases and conflicts are harder to plumb as financial services firms grow in size and scope. Rosemary J. Shockman, a former president of the Public Investors Arbitration Bar Association, testified before Congress last year that the problem of potentially biased panelists representing the public “continues to grow as various sectors of the financial services industry continue to consolidate their operations in the admitted quest for ‘capturing assets’ and offering the consumer ‘one-stop shopping.’ “
J. Boyd Page, a lawyer at Page Perry in Atlanta, said that he has often found that arbitrators assigned to represent the public in a case have close associations with the securities industry. “I just got a proposed panel in Houston and I have 10 so-called public arbitrators that I can pick from,” Mr. Page said. “Of those, six had associations with the securities industry. You really wonder about the quality of monitoring.”
The potential for conflicts among arbitrators would not be such a problem, defense lawyers say, if investors had an alternative to arbitration. But they do not.
“We believe that arbitrators should be properly classified and that there should be zero conflicts, either real or apparent,” Mr. Caruso said. “An arbitrator is supposed to disclose conflicts but there is no follow-through and no system of checks and balances.”