Forbes (August 24, 2009 1:00 pm) -- This is an ongoing series by securities attorney Seth E. Lipner about arbitration. For earlier installments please read:

1. Is Arbitration Really Cheaper?

2. Suitability Claims

3. An Arbitration, Start To Finish

Arbitrators are very powerful people. The arbitrators who decide a case act as both judge and jury. Their decision, called an award, will usually contain neither reasons nor explanations. The decision of the arbitrators is final. There is no appeal.

Who are these people called “arbitrators”? How do we know they are fair?

I can’t answer these questions with any certainty. No one outside the Financial Industry Regulatory Authority can, in part because FINRA does not make its roster of arbitrators and their backgrounds public (except for the ones proposed in any particular case). That secrecy, in turn, prevents anyone outside FINRA from performing studies to give us a picture of who these arbitrators are. That bothers me.

FINRA’s nationwide roster of arbitrators is large (about 6,100). There is no age limit. Many of the arbitrators on the roster are lawyers, but many are not. FINRA doesn’t keep track of what percentage of its arbitrators are lawyers. That’s OK by me; I have nothing against lawyers being involved in legal proceedings.

To become a FINRA arbitrator, a person needs to have 10 years of employment experience (only five for lawyers, though). To get on FINRA’s roster, one first submits an application and references. FINRA then conducts a rudimentary investigation–for instance, to make sure attorneys weren’t disbarred. I don’t think they check the references.

The application is then reviewed by a committee created by FINRA. Attorneys from both sides serve on it. The committee’s deliberations are not public. This committee doesn’t get to interview the candidate; they just review the applications. Neither the public nor any bar association is notified that an individual has applied to become a FINRA arbitrator. The public gets no opportunity to know of or comment on these applications.

After an application is approved, a prospective arbitrator must take the FINRA training course, and then pass a test. It’s not a hard test.

Once placed on the arbitrator roster, removal, other than for death, is rare. Some cynics don’t even think death is a disqualification; my own experience is mixed.

Once an individual is approved by FINRA to serve as an arbitrator, that person’s name goes into the “pool.” When a case is ready for arbitrator selection, FINRA’s computer looks in the pool and randomly creates a list from which the parties will choose the panel.

FINRA provides the parties with a resume and brief biography for each potential arbitrator. In addition, the parties can look on FINRA’s Web site and read all the awards rendered by these potential arbitrators. But arbitration awards don’t say much, and the selection process (called “strike and rank”) is a lot like reading tea leaves. It is nothing like jury selection.

This “blind” auction concerns me, because there is no real opportunity to find out much more about the proposed arbitrator’s orientation and objectivity. I am also concerned that FINRA itself does not do enough to make sure that its arbitrators are objective and unbiased. How do we, or they, know that the arbitrators will decide cases on the evidence presented at the hearings, and not based on pre-conceived beliefs?

But an even bigger concern is that in every case involving $100,000 or more, one of the three arbitrators will be affiliated with the securities industry. (Cases under $100,000 are decided by a single, non-affiliated arbitrator.) FINRA calls these affiliated arbitrators “non-public arbitrators.”

“Non-public” arbitrators? What’s that?

The term “non-public arbitrators” was coined by FINRA. It’s a euphemism. The term used by everyone else is “industry arbitrator.” That term is far more descriptive. An industry arbitrator is someone who is affiliated with a financial services company. There is one industry arbitrator on every three-person FINRA panel.

Yup, you’ve got that right. There is an industry person on every panel. Some of these industry arbitrators are brokerage firm lawyers; some are or were brokers, branch managers or other employees of brokerage firms. Many work for firms whose sales practices and investment products are the same as those being challenged in the arbitration. Every one of them has, at some point in their careers, earned their livelihood working in or for the securities industry. Visions of foxes and hen houses dance in my head.

I’m sure many of these industry arbitrators are neutral, fair-minded folk who have no bias in favor of the industry that employed them. Some may even be tough on their compatriots. But others are biased, sometimes consciously, sometimes subconsciously, against investors who are complaining about brokers, brokerage firms or investments.

When I do arbitrator selection in cases, looking only at a bland resume and maybe a few arbitration awards, I can’t tell the tough industry arbitrators from ones who may be biased in favor of brokers and brokerage firms. They all work (or worked) for the industry.

Even when an industry arbitrator is truly neutral, the perception of unfairness hurts the process. Too often, an investor who lost in arbitration will believe that the panel must have been biased; the presence of an industry arbitrator on every panel adds fuel to that belief.

But the problem goes deeper. The idea of Wall-Street-judging-Wall-Street really bothers me, and it ought to bother you. That concern is especially acute at this moment, because Wall Street’s recklessness and greed were directly responsible for destroying the economy. It just seems wrong to have managers from, for example, Citi judging whether UBS screwed up. They all screwed up! How do we know they won’t just give each other a pass?

Last year, FINRA finally conceded that–are you ready for this–the industry arbitrator might be a problem. So they created a “pilot program” to study the subject. Some cases will go before three-person arbitration panels that are all “public.” Then, three years from now, when those cases are over, FINRA will study the results.

I can’t wait to read the report. Worse yet, investors now in arbitration literally can’t wait. Their cases are coming up now. And they are stuck with an industry arbitrator on their panel. If they lose their arbitration (and some will lose), will it be because of arbitrator bias?

Investor advocates have long-complained about FINRA’s mandatory industry arbitrator, and they are trying to do something about it. The Public Investors Arbitration Bar Association (I was a founder of the organization in 1990) has filed a petition with the SEC to require FINRA to make the industry arbitrator voluntary instead of mandatory. You can read the petition and submit a comment to the SEC here.

It will be interesting to see what the SEC and FINRA do with this petition. Will they support an investor’s right to an arbitration panel with no industry arbitrator? The SEC’s mission is to protect the investing public. FINRA says its does the same thing. Will the SEC and FINRA continue to allow Wall Street to judge Wall Street? I sure hope not.