The Wall Street Journal (July 6, 2009 11:01 pm) -- A spike in claims against brokerage firms is giving regulators and consumers a chance to test changes in the dispute-resolution process that are expected to make the system fairer to investors

Many investors who suffered massive losses in their portfolios are filing complaints against the brokers and brokerage firms that sold them poor-performing stocks and mutual funds. When these individuals get to their arbitration hearings, they will experience a process that should be more investor-friendly than in the past.

Investor claims against securities brokerage firms are up 110% this year through May compared with the same period in 2008, according to the Financial Industry Regulatory Authority, the nongovernmental regulator that runs the arbitration forum investors must use when they want to press claims against their brokers. Last year, complaints involving funds outnumbered complaints involving stocks for the first time, with investors arguing that “firms sold funds with more risk in them than they were told,” according to Linda Fienberg, who heads Finra’s dispute-resolution program. That trend has continued into 2009.

After years of criticism that the system favored the industry, Finra recently introduced changes that could make the process fairer to investors, including a rule and a pilot program that allow more investors to have their cases heard by arbitrators who aren’t affiliated with the securities industry.

To be sure, some investors’ attorneys say they won’t be satisfied until industry-affiliated arbitrators are completely eliminated from panels. Others say investors will never get a fair shake until they have the option to bring their complaints to court. Indeed, the Obama administration, as part of its proposal to reform financial-services regulation, called for legislation that would give the Securities and Exchange Commission authority to examine, among other issues, whether mandatory arbitration clauses in contracts between customers and brokerage firms actually harm investors.

But at least one promising sign for investors is evident so far in 2009: Through May, investors received awards in 47% of the cases that were decided by arbitration panels, up from 42% in the same period in 2008. While it is too early to say that the higher win rate is due to the recent changes, attorneys representing both investors and brokers say they are watching developments closely.

In bear markets, the number of investor complaints filed against brokerage firms typically spikes. Lawyers who represent both investors and the securities industry say they are starting to see an increase in claims comparable to what they found in the years following the collapse of technology stocks.

Industry advocates, and even some investors’ lawyers, say many allegations made in downturns lack merit.

“The market goes up, the market goes down—it doesn’t mean the broker was acting inappropriately,” says Kevin Carroll, managing director and associate general counsel with the Securities Industry and Financial Markets Association trade group. “The mistake is this thinking, ‘The market went down; my broker must have done something wrong.’ ”

Chief among investors’ concerns in the recent rash of complaints is that products investors believed to be less volatile than stocks—such as mutual funds that invest in bonds and investments that pay a fixed rate of return—plunged in value. As Finra doesn’t have jurisdiction over funds, investors have filed complaints against the brokers and the brokerage firms that sold them these products, saying they misrepresented the risks.

“The losses that people are most upset about tend to be in the fixed-income area,” says Brian Smiley, a partner at Smiley Bishop & Porter LLP in Atlanta and president of the Public Investors Arbitration Bar Association. “The risk-reward ratio wasn’t there. No one would risk losing fifty percent or more of their principal to get a few percentage points more interest than you could get from a super-safe bond.”

Too Aggressive?

Mr. Smiley says most of the arbitration cases he is working on involve high-yield bond funds sold by Morgan Keegan & Co., the securities-brokerage arm of Birmingham, Ala.-based Regions Financial Corp. Investors claim fund management failed to disclose that these funds, referred to as RMK Funds, were invested in risky asset- and mortgage-backed securities.

Kathy Ridley, a spokeswoman for Morgan Keegan, says: “The increased volume of arbitrations and legal action is a natural reaction to the loss of personal wealth that resulted from unprecedented declines across financial markets. In the case of the RMK Funds, the results of arbitrations continue to support our belief that there were no improprieties in the management of these funds and that the funds’ unanticipated decline was directly attributable to the cascade of events that has devastated the financial sector over the last two years.”

Other funds that have been the subject of arbitration claims from investors who say they were misled about risks include OppenheimerFunds Inc.’s Oppenheimer Champion Income Fund and Charles Schwab & Co.’s YieldPlus funds, securities attorneys say.

OppenheimerFunds, a subsidiary of MassMutual Financial Group, believes the claims are without legal merit and intends to defend itself, a spokeswoman says. A Schwab spokesman says the company generally doesn’t comment on ongoing litigation or arbitration matters.

Some investors, meanwhile, are claiming they were put in portfolios that were far too aggressive for their situations. Many are alleging their brokers put them disproportionately into financial stocks and didn’t encourage them to get out when values started dropping.

Salvatore Romano Jr. is one of those investors. A 78-year-old electrical engineer who hopes to retire soon, Mr. Romano inherited money from his aunt in 2005. In an arbitration claim filed in October, he alleges that his Morgan Stanley broker urged him in February 2008 to take money out of conservative certificates of deposit in order to invest in shares of Lehman Brothers Holdings Inc., which filed for bankruptcy protection in September. He says the broker encouraged him to put 30% of his portfolio in the faltering firm; as the stock fell in August 2008, he says the broker responded to his concerns by persuading him to invest more.

“The next thing you know, [Lehman] is bankrupt,” Mr. Romano says. “Being a conservative person who didn’t want to do any gambling, to find myself in that position was shocking.”

A Morgan Stanley spokeswoman, speaking on behalf of the firm and the broker involved, says Mr. Romano’s losses are “unfortunate,” but the company believes his claim is without merit.

Jury Still Out

Generally, large investor claims are heard by a three-arbitrator panel consisting of two ”public” arbitrators who have no link to the securities industry and one who is connected to the industry. On March 30, Finra increased the size of claims that can be heard by a single public arbitrator to $100,000 from $50,000. The move is expected to save time and arbitration-related costs for both investors and brokerage firms. Finra says about one-third of investor complaints are less than $100,000.

Finra also started a two-year pilot program in October 2008 that allows a total of 276 cases against 11 participating brokerage firms to be heard each year by an all-public, three-person panel. The program gives investors the option of choosing an all-public panel when they file their complaints. If an investor doesn’t request the all-public panel, Finra will notify the investor of the option. As of mid-June, 55% of eligible investors had tried the pilot program, Finra says.

The changes are a win for investors’ advocates, who have long argued that an industry arbitrator not only creates a perception of bias, but can tilt a panel against the investor. Finra has disputed that allegation, saying the fact that most arbitration decisions are unanimous indicates that industry arbitrators don’t view cases differently than public ones. The industry also says that industry arbitrators are actually tougher on questionable behavior because they find it professionally offensive.

“The industry arbitrator isn’t going to do me a favor—he just knows more,” says Matthew Farley, a New York partner at law firm Drinker Biddle & Reath LLP who represents brokerage firms in arbitration. Finra is collecting data to determine whether all-public panels are more favorable to investors.

Another change meant to benefit investors is a rule that ensures their cases will go to hearings. In recent years, there has been an increase in the use of a “motion to dismiss,” in which defense lawyers try to prevent cases from ever making it to a panel. Under a rule that took effect in February, motions to dismiss may be granted only in limited cases, such as when investors name the wrong broker in their complaints.

Some investors’ lawyers say the changes, while not a cure-all, represent progress.

“Do I think the system is perfect?” asks Steven Caruso, a New York-based partner at Maddox Hargett & Caruso PC. “The answer is clearly no, but I think it’s getting better.”