RIABiz.com (December 6, 2012) -- Brooke’s Note: For us laymen, the whole FINRA-as-SRO issue is confoundingly confusing at times and certainly requires more space on the old mental hard drive than we’d prefer to allocate. It is with this thought in mind that I pay great thanks to Pat Burns for bringing his lawyerly lobes — and intellectual courage — to bear on the latest FINRA move. He follows able legal brain trusts like Ron Rhoades and Brian Hamburger who have done some of this heavy lifting in the past on related issues for RIABiz.

Linda Fienberg, president of FINRA Dispute Resolution, and chief hearing officer, has stated that FINRA is opening its arbitration system to RIAs and mentioned that there are already three cases involving RIAs in FINRA’s system. This marks a major step in FINRA’s attempt to regulate RIAs, and should be watched carefully by advisors who fear falling under FINRA’s jurisdiction.

The policy change was disclosed on Oct. 18 at the Public Investors Arbitration Bar Association meeting in Austin, Texas, and though Fienberg attributes the policy to “a lot of requests from attorneys” for investors and RIAs alike, FINRA, a self-regulatory organization for member brokerage firms and exchange markets, has been campaigning vigorously to assume that role for RIAs. Fienberg has said the arbitration move was unrelated to that effort. See: Brian Hamburger hammers the FINRA SRO proposal in a letter.

Even though FINRA acknowledges on its website that it can’t enforce awards against non-members and/or their employees, Fienberg’s announcement raises numerous questions about whether FINRA has the authority to handle such arbitrations, considering FINRA’s own guidelines.

The guidelines divide FINRA cases between two codes: a customer code, which “governs arbitrations between investors and brokers and/or brokerage firms” and an industry code, which “governs arbitrations between or among industry parties only.” There has been no update to either code to include RIAs. Nor has there been an announcement of any regulatory notice to include such an amendment, or any pilot program whereby FINRA can test out RIA arbitration.

Based on the current limitations of FINRA’s arbitration process for RIAs, it is hard to comprehend why any plaintiff’s attorney would suggest that clients submit to such an ambiguous process. See: “Why Bachus’ SRO-that-must-not-be-named would prove a tyrant to RIAs.”
An unfair process?
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By opening the door for RIAs to have their arbitration cases held before a FINRA arbitration panel, it seems that FINRA has taken another step in its quest to become the SRO for RIAs. FINRA presently administers the Investment Adviser Registration Depository for RIA filings. The added capacity to hear arbitration cases helps build momentum to argue that if an SRO does regulate RIAs, FINRA would be naturally suited for the role. See: An in-depth analysis of FINRA’s attempted takeover of RIAs and why the group should be disbanded, Part 2.

The FINRA arbitration process has been widely criticized for years as being unfair to brokerage firms’ clients. A study by Edward S. O’Neal, Ph.D. and Daniel R. Solin of more than 14,000 cases over the course of a decade found that FINRA awarded investors, on average, only 12% of their claims when bringing major brokerage firms to arbitration. And it is not unreasonable to think the same could eventually be true for advisory clients. It is interesting to note that currently, there have not been any RIAs lobbying for FINRA to open its arbitration process to them and/or their advisory clients.

Solin, an attorney representing investors against broker misconduct, testified before Congress on his findings, warning about the dangers of industry-administered arbitration by SROs, calling it “a system that takes away two fundamental rights of American citizens: access to the courtroom and trial by a jury of their peers. This is a system that has neither the appearance nor the reality of impartiality, since it requires that a victim of misconduct must submit his or her claim to a tribunal administered by the very industry that he or she is suing.”
Inherent conflict
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The qualifications of FINRA arbitrators and their selection processes have been called into question numerous times. David P. Meyer, an investment fraud attorney, reported in August that, up until last year, “investors involved in a dispute of more than $100,000 were required to have at least one industry-affiliated arbitrator on their three-person panel. This requirement was often — rightly — perceived as having the potential to introduce a significant conflict of interest into the process.”

Meyer goes on to say that “when FINRA introduced a pilot program in 2010 that allowed investors to choose all-public arbitration panels instead … investors were awarded damages in a higher percentage of cases than any other year over the past six years … The number of multimillion-dollar awards also increased that year.” If these numbers are correct, then FINRA’s reliance on industry arbitrators for the majority of its history may have cost investors countless awards in damages.

And that’s just the inherent conflict of interest by profession. There are also numerous cases of conflicts of interest and successful disqualification challenges to arbitrators serving on FINRA arbitration panels that have taken place over the years. FINRA has not always been successful in policing the system and cleaning up these problems.