This article is meant to serve as a limited introduction to the FINRA arbitration process. Keep in mind that each case has its own unique facts and circumstances, and other issues and considerations arise alongside it.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
The Financial Industry Regulatory Authority (“FINRA”) is a self-regulatory organization authorized by the Securities and Exchange Commission (“SEC”) to regulate broker-dealers and Associated Persons, commonly thought of as stockbrokers or financial advisors. A broker-dealer buys and sells securities on behalf of its customers, typically for a commission. FINRA also provides an arbitration forum for disputes between investors and broker-dealers, and most broker-dealers include arbitration provisions in their customer agreements which require customers to pursue their legal claims against the broker-dealers in arbitration before FINRA, rather than in ordinary court proceedings.
Over the past three decades, broker-dealers have routinely included arbitration agreements in new account customer agreements for persons opening investment accounts. The Supreme Court of the United States confirmed the enforceability of these arbitration agreements in 1987. See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987). These arbitration agreements limit investors’ remedies for pursuit of claims against investment professionals.
Investors also sometimes enter into arbitration agreements with other investment professionals not subject to FINRA’s authority. This may include investment advisers, mutual fund companies, or trust companies regulated by the SEC or state agencies. Although FINRA does not regulate these investment professionals, FINRA accepts jurisdiction of these cases so long as the parties agree to arbitrate before FINRA. Investors seeking to pursue arbitration through FINRA against these non-FINRA investment professionals should check their account documentation for arbitration agreements. If an agreement to arbitrate does not exist, an investor may seek a remedy through the courts. Sometimes, investors have arbitration agreements in place with investment advisers that designate the American Arbitration Association or other forums for conducting an arbitration.
At the conclusion of the arbitration proceeding, FINRA can enter a final and binding decision against all parties. FINRA has various tools to enforce its decision against broker-dealers, including suspension or termination of a securities license. However, FINRA cannot enforce a final and binding decision against investment professionals it does not regulate. Thus, decisions against investment advisers, mutual fund companies, and trust companies regulated by the SEC or state agencies, must be taken to a court of competent jurisdiction for enforcement. Courts generally confirm FINRA decisions absent some very limited types of circumstances.
I. FINRA Arbitration Process
To initiate a FINRA arbitration proceeding, a party begins by filing a written claim known as a “Statement of Claim.” This party then becomes the “claimant” in the case. The Statement of Claim must include details of the dispute, including any relevant dates, names, and the type of relief requested. The Statement of Claim can be filed online, alongside a required “Submission Agreement” and filing fees. A typical filing fee averages around $1,500-$2,000, and increases as the total claim amount increases. https://www.finra.org/rules-guidance/rulebooks/finra-rules/12900. Once the filing requirements are met, FINRA will serve the Statement of Claim on the “respondent” identified in the Statement of Claim and Submission Agreement.
After service of the papers, the respondent has 45 days to submit a written answer to the Statement of Claim. The respondent may assert counterclaims with its answer, to which the claimant must then answer after 20 days of receipt of the counterclaim.
Once all claims have been filed and answered, the parties begin the process of selecting arbitrators. For claims of up to $100,000, the case will be decided by one arbitrator. For claims over $100,000, the case will be decided by three arbitrators. FINRA arbitrators are independent third parties with diverse backgrounds that may include regulators, lawyers, bankers, investment professionals, retirees, and more. Disclosure reports (which include information such as the potential arbitrators’ resume, background, and prior award information) are provided to the parties before selection. Parties must then rank the list of potential arbitrators and may strike a certain limited number of arbitrators. FINRA will eventually combine the parties’ ranking lists to appoint the highest-ranked arbitrators to form a panel.
FINRA will then schedule an Initial Pre-Hearing Conference, wherein the parties (or their counsel) and arbitrators meet for the first time to discuss evidentiary hearing dates, discovery deadlines, and other preliminary matters. This conference will happen either telephonically or through a virtual meeting such as Zoom. During this conference, the parties with the arbitrators come to an agreement on key dates for discovery, motions, and the ultimate hearing in the case. The arbitrator or chairman of the arbitration panel then issues a written order confirming the case schedule which is sent to the parties or their counsel.
After the arbitrators’ panel establishes the arbitration schedule, parties begin to exchange information and documents in a process known as “discovery.” The FINRA Discovery Guide sets forth a list of documents that parties must produce in all customer cases. https://www.finra.org/arbitration-mediation/discovery-guide. Parties may request some additional documents from each other, but the available requests are more limited than in general court proceedings. See FINRA Arbitration Rule 12507. For example, standard interrogatories and depositions are generally not permitted in arbitration. See FINRA Arbitration Rules 12507 and 12510. Parties are required by the FINRA Code of Arbitration Procedure to cooperate to the fullest extent practicable in the exchange of documents and information to expedite the arbitration. See FINRA Arbitration Rule 12505.
After discovery, the parties begin to prepare for the hearing. Generally, FINRA will select a hearing location closest to the investor’s residence at the time of the events, unless the hearing location closest to the investors’ residence is in a different state or the parties agreed to a different location. See FINRA Arbitration Rule 12213. With the consent of all parties or permission from the arbitration panel, hearings may also be conducted virtually. At the hearing, parties can generally offer two types of proof: oral testimony by witnesses and documentary evidence. A typical arbitration hearing can take anywhere between two days to two weeks. However, most hearings conclude within three to five days.
After the hearing, the parties can generally expect a written decision and award within 30 business days. The award typically contains little detail of the factors leading to the arbitrators’ decision. Instead, it is typically a short statement of whether the arbitrators found in favor of one party or the other and describes the amount of the award rendered. This award is binding on the parties and is generally not subject to appeal. If the arbitrators panel finds for the claimant, a respondent broker-dealer generally must pay within 30 days or risk suspension of its FINRA registration. Awards against investment advisers will have to be confirmed and enforced by the courts.
Overall, the timeline of a FINRA arbitration can vary, but an award will generally be determined within 16 months. This FINRA arbitration process, while not quick, is generally sooner and less expensive than traditional court litigation.
II. Types of Claims in Securities Arbitration
At the outset of the case, an investor must decide what claims to bring and against whom. The investor must show more than simple losses in their investments because FINRA arbitrators understand that most investments involve some degree of risk of loss. Some key considerations to determine whether the investor has a viable claim include whether material facts were adequately disclosed, whether the investment was suitable based upon the investor’s stated investment objectives, or whether the investment was otherwise fraudulent (such as a Ponzi Scheme). Investor claimants will then assert claims based on several theories of liability, including unsuitability, churning, fraud, breach of fiduciary duty, statutory securities violation, negligence, and/or failure to supervise.
Unsuitability, negligence, and breach of fiduciary duties are common claims made by investors when a broker or adviser knew or should have known that the type of security conflicted with the investor-claimant’s objectives. Documentations showing an investor’s risk tolerance, time horizon, and investment objectives tend to help prove the unsuitability of certain investments. For example, high-risk alternative investments are generally not suitable for retirees who choose a conservative risk portfolio.
An investor-claimant may also bring securities fraud claims if a financial advisor’s untrue or misleading statements of material fact directly or indirectly caused the investor to buy or sell securities. Some examples of fraudulent behavior may include a financial advisor stating a particular investment was “safe” or “low-risk” when in fact the investments were high-risk. Stockbrokers may also be liable if they provided incorrect information, mislabeled a particular investment on their investment portals, or aided and abetted a Ponzi scheme. The high commissions of Ponzi Scheme investments often encourage financial advisors and stockbrokers to recommend the fraudulent products to their clients, thereby making them an actor in the fraudulent securities transaction.
Churning claims occur when brokers excessively trade in a discretionary account to earn additional commissions. Such claims are easier to prove in FINRA arbitration because the facts are more clear. Today, most major brokerage firms have implemented some sort of automated system to police against such behaviors, and thus churning claims are less frequent now than they were several decades ago.
Finally, in addition to holding a specific registered representative or investment advisor liable, claims generally include the employing investment advisor firm or brokerage firm. Broker-dealers must “establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable FINRA rules.” See FINRA Rule 3110. Thus, any defense they may have that they are not responsible for the actions of their salespersons holds little weight. Similarly, registered investment advisors have a responsibility to prevent their representatives from violating securities law and the Investment Advisors Act of 1940.
III. Considerations before Filing a Statement of Claim
To begin arbitration, an investor must file a statement of claim. When considering the type of claims to bring against a financial advisor or his/her firm, the claimant should consider the consequences of the different choices. The most tempting course of action is to simply bring all potential claims against all potentially culpable parties so that no claims are waived and to maximize the chances of a favorable decision. However, some considerations may make an alternative strategy more appealing.
For example, if a claimant includes the financial advisor as a respondent, that advisor must then report the claim on his/her Form U5. As a result, the financial advisor would be more inclined to dispute the claim to protect his/her professional reputation. The financial advisor’s legal fees may also be paid by the firm he/she works at; thus, he/she would have no reason to not fight until the end. On the other hand, if a claimant only names the brokerage firm as the respondent, the brokerage firm will likely follow a more business-oriented decision to resolve the claim. Brokerage firms are routinely named in FINRA arbitrations, so their resolve to “win” the case may be less than a financial advisor whose reputation is on the line. Brokerage firms will weigh the cost of an adverse outcome along with the cost of defending the case, as they consider how to resolve the claims. Still, if a financial advisor has a history of customer complaints, then it may make sense to name the financial advisor personally.
Second, a claimant should consider the types of claims to assert. In general, claims sounding in negligence will be covered by insurance, while intentional-conduct claims such as fraud will be excluded under standard insurance contracts. A claim covered by insurance will likely be defended differently than a claim that is not covered. The chances of recovery will also likely be greater when there is insurance coverage.
IV. How to Select Arbitrators
The process of selecting an arbitrator is governed by FINRA Code of Arbitration Procedures Rules 12400-12410. The importance of this aspect of the overall arbitration process cannot be emphasized enough. Unlike in judicial litigation where judges are assigned, parties actually have a say in who they want to decide their arbitration case. Investor claimants will want arbitrators with a history of being open-minded about legitimate claims of investors rather than arbitrators who are skeptical of all investor claims. During this process, engaging seasoned counsel with knowledge of this process and experience with the pool of FINRA arbitrators in a certain geographical area can be critically important.
Many FINRA arbitrators have served on cases previously. Some may have served in many prior cases. A seasoned securities lawyer may have personal experience to draw upon to better understand the choice of arbitrators. An experienced securities lawyer will also have peers in his community and area of practice to consult who are a source of additional information on potential arbitrators. Third-party sources of information are also available, which should be closely examined to better understand the potential arbitrators.
V. The Discovery Process
Unlike regular judicial litigation, the discovery process in FINRA arbitration is meant to be less contentious (thus less expensive). In customer disputes, parties can make discovery responses according to the items listed in the FINRA Discovery Guide and through other case-specific document requests. The FINRA Discovery Guide contains an extensive list of items that are all presumed to be discoverable. FINRA Arbitration Rule 12506. In other words, parties generally do not have any basis to refuse to produce the necessary documents, saving time and expense.
During this process of exchanging documentary evidence, formal motions to exclude evidence or preclude areas of discovery should be kept minimal. Parties should focus on the weight and context of the evidence and not its admissibility. Arbitrators may be reluctant to exclude evidence because a court may reverse the arbitrators’ decision if they exclude material evidence that should have been considered. Also, unlike with a jury, arbitrators can consider all arguments as they assign weight to particular pieces of evidence. Attorneys can argue and articulate any legal reason why a particular piece of evidence should not be considered for the final decision. Thus, rather than spending time and expense on trying to exclude evidence by motion (arbitrators will look at the evidence regardless), parties should focus on preparing for the hearing itself.
During the discovery process, parties should focus on gathering the documentary evidence and witnesses they need to present their case at the hearing.
VI. Strategies for the Hearing
FINRA arbitration hearings are conducted very similar to court trials. Typically, the parties or their counsel make opening statements explaining what they believe the evidence will be during the hearing. Then, the claimant calls their witnesses (who are also subject to cross examination). When the claimant’s witnesses are through testifying, the claimant will “rest” their case. At that point, the respondents present their witnesses (who are also subject to cross examination by the claimant). At the end of witness presentations, closing statements are given by the parties or their counsel.
To achieve maximum impact, an attorney should deliver the client’s story in a logical format that allows arbitrators to understand the case. For example, a claimant should consider the ordering of presenting witnesses. Calling a non-party financial advisor as a first witness could be useful to help a panel immediately understand the crucial aspects of the case.
A party should also consider engaging an expert witness. Expert witnesses are often former investment professionals and able to calculate claimed damages. Experts can help testify about industry standard of care and the extent of damages suffered by an investor. Expert testimony is often beneficial to proving a case, and sometimes even a necessity.
An expert who can testify about the standard of care will be able to explain the degree of prudence required of a broker or firm under a duty of care. In layman’s terms, arbitrators will have to consider what a reasonable person would have (or should have) done under the circumstances. What may be considered reasonable when applied to one set of facts may be considered unreasonable in another case. The arbitrators will ultimately decide whether the alleged misconduct fell short of the applicable standard of care, and expert testimony can help arbitrators make that determination.
An expert can also testify about and quantify claimed damages. For example, an expert may be able to compare what an investor should have earned in a well-managed portfolio compared to the actual result. Claimants are well advised to engage a damages expert at an early stage in the process so that the expert can consult with the attorney to help identify important issues related to damages. Eventually, the damages expert will be able to present the data and explain the damages claim to the arbitrators. Engaging an expert is particularly important because the investor-claimant should not be the person explaining to the arbitrators why the financial advisor should have invested differently. Otherwise, if an investor suddenly has all this knowledge about why a different investment should have been made, why would an arbitrator believe the investor relied on and was damaged by a financial advisor?
VII. Conclusion
This article is meant to serve as a limited introduction to the FINRA arbitration process. Keep in mind that each case has its own unique facts and circumstances, and other issues and considerations arise alongside it. If you have any questions regarding a potential securities investment claim, please contact attorney Robert D. Mitchell at rdm@tblaw.com or (602) 452-2730.