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The arbitration agreements that bind investors and securities brokerage firms cover just about everything. These contracts usually use words like "all disputes" or "any controversy" to define the controversies that must be resolved in arbitration. But what kinds of claims are most common?
"Unsuitability" is No. 1. Unsuitability claims are usually based on Financial Industry Regulatory Authority (FINRA) Rule 2130(a), that says: When recommending to a customer the purchase [or] sale of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.
The Suitability Rule applies when there is a "recommendation" by the broker. Mere order takers have no suitability obligations. The key to the recommendation requirement is whether the broker expressed a belief that the transaction was something the customer should make. A confirmation slip marked "solicited" is usually good evidence of a recommended transaction.
The Suitability Rule says that it applies to any broker who recommends either a "purchase [or] sale." A recommendation to "hold" (i.e., advice not to sell) is thus technically not covered by the Rule, but most arbitrators would probably not excuse an unsuitable recommendation to "hold" if the evidence showed that such a recommendation was made. Arbitrators tend not to read the Rules quite so technically.
The Rule requires that brokers make inquiry into the essential facts about the investor, including financial status and investment objectives. When an investment account is first opened, brokers complete a "New Account Form," and the form must be kept up-to-date. The New Account Form, when accurate, provides a basic guide to the type of investments that are "suitable" for that particular customer. Even though most brokerage business is done on the phone, documents like New Account Forms are important.
FINRA is currently considering some changes to the suitability rule, but it should also make some other (more meaningful) pro-investor improvements. For example, in addition to amending the Rule expressly to cover recommendations to hold, the Rule should be amended to require that a broker making a recommendation have a basis for believing that the investor possesses sufficient knowledge and experience in financial matters to be capable of evaluating the investment's risks. But even without such improvements, the Suitability Rule is an important protection for investors, especially in states whose laws do not impose a fiduciary duty on brokers.
The second most common type of claim is "misrepresentation," or its malicious cousin, fraud. Misrepresentation cases involve false statements, or omissions, of material fact. Misrepresentation is actionable under federal securities statutes, state common law, and, in most states, under state securities statutes. The state securities statutes are important because they impose a high duty of honesty and do not proof of fraudulent intent. In addition, they provide that investors who win their cases can recover their attorneys' fees, a key protection that is too-often ignored by arbitrators.
Misrepresentation cases tend to raise certain unique issues. For example, there is the so-called "Prospectus Defense." In initial offerings of securities, delivery of a Prospectus is usually required. Prospectus delivery often creates questions about whether the Prospectus was sufficient to undo an alleged (previous) oral misrepresentation. The Prospectus Defense, which can be difficult to defeat in court proceedings, is applied with less rigor by many arbitrators.
In an arbitration, the viability of the Prospectus Defense may well depend on whether the arbitrators themselves carefully read prospectuses before they make their own investments. A recent study done for the Securities and Exchange Commission found what we all already knew--that most investors don't read these lengthy documents. The study, however, said nothing about the reading habits of arbitrators.
In both suitability and misrepresentation cases, "sophisticated investors" often have tougher cases than folks with less investment experience, although I'm not sure why. Experienced investors and intelligent people often rely on investment professionals, the same way they rely on doctors, accountants and lawyers. Such investors are just as entitled to the truth as are unsophisticated investors.
But defense lawyers nonetheless gleefully proclaim--in every arbitration--that the claimant is a "sophisticated investor." A few might even qualify, but I still say "so what?" If the investor was lied to, he has a claim for misrepresentation. There is no "you should not have believed us" defense.
"Theft" is the next category of common case. A broker, or, more often, a third party (usually a fiduciary), stole money or securities out of an account. Third-party theft cases require proof that the brokerage firm, in its capacity as custodian, either affirmatively assisted or turned a blind eye to thefts that should have been prevented. It's rare, but it happens, and it's usually ugly.
Cases involving commission-motivated excessive trading (called "churning"), and cases of "unauthorized trading," which once were common, seem less so these days. But they still pop up, usually in arbitrations involving fringe firms. Churning cases require proof that the broker "controlled" the account, and over-traded it to generate commissions.
Unauthorized trading requires proof that the investor did not approve a transaction in advance. Unauthorized trading claims are subject to the defense of ratification--the argument that the investor thereafter learned of the trade, but did not make a timely demand that it be reversed. But delays in starting any case can be damaging, so it is always best to act promptly after one discovers a grievance.
An investor should consult a lawyer whenever an investment's performance is inconsistent with that investor's goals and perception of risk. Not every investment loss or disappointment creates a valid claim, but performance that diverges from expectations ought to set off a signal that something might be wrong.
No matter what kind of claim is brought, arbitration cases are, at bottom, mostly credibility contests. Unlike court, in arbitration "law" usually takes a back seat to the believability of the parties and the witnesses, and what is contained in documents like New Account Forms. Arbitration, especially securities arbitration, is all about the testimony, the documents and the facts.
Seth E. Lipner is Professor of Law at the Zicklin School of Business, Baruch College, CUNY. He is also a member of Deutsch & Lipner, a law firm in Garden City, N.Y. that represents investors in arbitration. Professor Lipner is a member of the Forbes.com Investor Team.
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