Friday, June 26, 2009

Fiduciary duty of brokers without the opportunity to arbitrate

The proposal by the US government to reform the financial system is fascinating in two small ways and in many big ways as well. The two small ways I am most interested include 1) the creation of a fiduciary duty for stock brokers and 2) lack of faith in the use of mandatory arbitration clauses in retail investor customer agreements. Both fit with the entire theme of the reform which is consumer protection. I believe both are mistaken and will result in many problems.

The essence of the Treasury’s proposal for reform (Proposal) is that consumers were let down by the occurrence of the Financial Crisis and consumers should be better protected. However, neither of these reforms, broker duty or mandatory securities arbitration, was involved in any form, in the Financial Crisis. Reforms can be broad and sweep wide in an effort to encompass many areas, in addition to the problematic ones; in a post-crisis regulatory frenzy-can you spell SOX? We may well be repeating the mistakes of the Sarbanes-Oxley legislation which was under-thought and overdone.

Broker fiduciary duty

Even though today a lot of banks own brokerage firms, stock brokers have never really been in a fiduciary relationship with their brokerage clients. Investment advisers do have a fiduciary duty. This is a heightened duty of care and loyalty that bankers and trustees have. They keep funds safe for clients and their beneficiaries. They are paid a fee for this service. Stock brokers sell securities to clients and earn a commission. Sometimes they act in the capacity of an investment adviser and in that capacity owes a greater duty of care to their clients. The client must understand in what capacity the broker is acting.

Stock brokers in the US are required to put their clients in suitable investments and not attempt to generate commissions by unnecessarily and repeatedly incurring trades. This forms the basis of most complaints against brokers-suitability and churning. The generation of commissions is what brokers do. They also recommend shares in companies that are appropriate given the client’s income level, life circumstances and stated ability to handle risk. These are the basics of the broker-client relationship. Clients want to make money in the market and hope to buy shares in companies whose value increases. This does not always happen due to circumstances beyond anyone’s control and this loss does not currently create a cause of action against the broker. When a client has an actionable complaint against a broker they are required to go to arbitration based upon the pre-dispute mandatory arbitration agreement contained in all customer brokerage contracts and we will get to that in a bit.

To raise a brokers duty of care, drastic changes will need to take place in the brokerage industry. Historically, stock brokers have sold stocks ideas in order to generate commissions. With a fiduciary duty added on, brokers will no longer be stock salespersons, they will be investment advisors. Professionals with a fiduciary duty do not sell things to their clients. With a fiduciary duty, stock brokers will now need to be trained in a completely different and much more extensive way. Brokers will need to understand the new level of responsibility that they now have when they make recommendations to clients. Clients will be required to provide more information when they open a brokerage account. The entire compensation regime for brokers will need to be changed from commission to fee based. I am not even clear what is the hoped for result form raising the duty of brokers. There is no real way to protect people from a loss of value in the market. Consumers need education not brokers. Stock brokers are simple creatures. They should be left alone to be regulated by FINRA. Educate consumers and provide free lectures for the elderly and disadvantaged individuals; set up websites that are easy to understand and are updated regularly. Start public service messages with celebrities explaining how to invest. Burdening brokers with a fiduciary duty accomplishes nothing good and a whole lotta bad. There are better alternatives that protect consumers more and in a better way.

Mandatory Securities Arbitration Clauses

In addition, under the proposal, the Securities and Exchange Commission (SEC) is encouraged by the Treasury to study the fairness of mandatory arbitration clauses. Recently, these clauses have come under scrutiny during Senate discussions concerning the Arbitration Fairness Act of 2007 (Act). The Act invalidated the use of binding, pre-dispute, arbitration clauses in various consumer contracts.

Mandatory arbitration clauses deprive consumers of a choice. They force plaintiffs in to a particular direction of dispute resolution-not litigation. In the US, they have been problematic in employment and credit card contracts. The larger more powerful employer or credit card company uses mandatory arbitration clauses in order to force the consumer in to forums that are biased in favour of the industry. Securities disputes that fall under mandatory arbitration clauses are very different for other kinds of consumer contracts. There is specialised knowledge necessary to resolve these disputes in a reasonable and fast manner. FINRA has transparency and accountability in the form of its website full of statistics and frequent rule changes. Also, there has always been federal agency oversight of the FINRA forum in the form of the SEC. FINRA securities dispute forum is not perfect. When problems arise it does try to address them and like most quasi-governmental bodies it is slow to change but it gets there.

The Financial Industry Regulatory Authority (FINRA-formerly the NASD) was designated as the forum to resolve securities disputes that come under these clauses after years of securities litigation began to clog NY courts. This move was heavily supported by the Securities Industry lobby groups. It has a code book which governs how arbitrations are to be run and all of this is overseen by the SEC. The rules are frequently updated in order to address problems as they arise (e.g. excessive, Motions practice, explained awards) The arbitrators that serve on these panels are paid an honorarium to serve which does not amount to much. The program is frequently review by Congress to determine if it continues to be fair and serve the interests of the investing public.

Always after a financial crisis, FINRA’s dispute resolution forum is inundated with investor complaints. It is no different now. Currently the case load is overwhelmed by complaints regarding Auction Rate Securities among others. There is no indication however, that the forum has somehow failed historically or now to be fair to investors. IF anything the proposal should be suggesting a study on how the dispute process can be made more robust in order to continue to allow these suits to avoid courts and be resolved in a civilised, fair and meaningful manner.

There are changes that could improve how disputes are resolved. Arbitration panels could be given more powers without increasing compensation. Arbitrators should be trained to provide well explained awards or eliminated from the roster for failure to do so. FINRA has increasingly become more automated and this should continue. And finally, parties should be encouraged to have organised direct communication with the Chairperson of the panel which would save time and expense of going through FINRA as an intermediary for discovery and other pre-hearing disputes.

I have been a FINRA arbitrator for 15 years. I lose money on every arbitration I serve on. Parties do not need to compensate me hourly for reading their voluminous Motions and Pleadings. I believe that being part of the system, even as a volunteer of sorts, contributes to making it better. The process works overtime to be fair to investors.

The proposal seems to be combining securities arbitration clauses with other kids of contracts that have been harmful for consumers. That is sloppy and dangerous.


The proposal includes various changes that are completely unnecessary. Why throw brokers and FINRA under the bus. The answer to any perceived problem in these areas is Education. If American consumers are going to invest their retirement savings in stocks, they should understand how the whole thing works and take responsibility for it. Additionally, if brokers have a higher duty of care where will all of the disputes regarding breach of that duty end up, back in the marvellous, efficient US court system? While the Obama Administration is nudging us in the right direction, perhaps they could nudge investors to be better informed particularly when, in the case of brokers and FINRA, no one has been trying to rip them off-recently.

Treasury Department’s Financial Regulatory Reform blueprint (entitled “A New Foundation: Rebuilding Financial Supervision and Regulation”)

Frankel, T, Fiduciary Law, May, 1983, 71 Ca. L. Rev. 795

Sunday, June 14, 2009


Work it harder, make it better,

Do it faster, Make us stronger

Kanye West

The Rwanda Stock Exchange (RSE) is the newest stock exchange in East Africa. The regulator and operator of the exchange is the Capital Market Advisory Council (CMAC). So far transactions on the exchange have been limited so that extensive substantive rules have been unnecessary. Officials are now looking around for rules that will help develop a robust regulatory structure. The question is what will guide this search for appropriate rules?

There is a limited universe of possible legal families to choose from. There are Common law, Romanistic, Germanic, People’s Republic of China, and the list goes on. Or things could be simplified in to Common law or Civil law families. This makes sense for East Africa due to its colonial past but it is incredibly simplistic. The Republic of Rwanda gained its independence from Belgium in 1962. Most of its laws have a tradition of civil law and customary law. However, law reform in the 1990’s created a hybrid of civil and common law. It is the fact of a legal hybrid that I find fascinating.

I see legal hybrids throughout East African financial services law. It is not just a civil-common law hybrids. There is a combination of something else that I have no better word for than African law. It is law with a different focus. Under African law, securities regulation is a continuum. Not all rules are intended to do the same things. How rules function will depend on the context in which they work. The context can be the historical development of the exchange, the economic history of the country as well as the sophistication of the public in financial matters. Certainly, all of the usual things, such as banking and legal infrastructure, play their part in the effectiveness of rules. They might even play a part in choice of rules. Ultimately, no matter what, the rules have got to be fit for purpose.

Exchanges serve various functions, as do the rules that govern them. Exchanges raise money by selling debt or equity. They can sell to the public in general or the world at large. The purpose of the rules may be to regulate the issuance of the securities and debt. Rules can help raise investor confidence in a market making it more credible. The RSE is in an excellent position to choose rules that achieve the most positive goals. It is also in a position to avoid others mistakes.

Currently, the RSE is looking at other East African exchanges for examples of rules that work. Rules from the Nairobi Stock Exchange (NSE) are under consideration. As discussed in this blog already, Muzungu on Africa 5 May 2009, Nairobi has had its share of difficulties. These problems were primarily in the area of broker regulation. This is all well-known in the region. Additionally, the director of the Rwanda CMAC is a former head of the NSE, Mr. Robert Mathu. He knows the NSE rules and how well they work. Moreover, rules are meaningless if they are not enforced. It could very well be that Nairobi has excellent rules that could serve as the standard for any exchange in the region. Without an authoritative enforcement regime these rules cannot prevent fraud on the market or malfeasance by brokers. That may point to a problematic exchange culture.* A problematic exchange culture could make rules toothless or could prevent effective rules from being adopted.

The East African Community hopes to create a regional exchange. For the most part, the NSE is the cornerstone of that collaborative effort. The NSE has the largest market capitalisation and it is electronic. It's rules may serve as the standard for the regional exchange. Before that happens some critical analysis of their effectiveness needs to occur. In the meantime, the RSE should pick and choose the rules as it likes and sees fit, for the purpose the new bourse can put them to. For certain, when it is all over there will be some new legal hybrids regulating securities in East Africa.


K. Zweigert & H. Kötz, An Introduction to Comparative Law (Clarenden, Oxford, 1998)

*I do not like using the C word. (corruption) I find it to be a lightening rod and the West gets lost in this word. Of course, it does exist and not only on the continent of Africa.

Friday, June 5, 2009

Jacaranda in Southern California

My camera is rubbish BUT I never really appreciated Jacaranda trees until I went to Harare.

Now I see them everywhere in So Cal!!

Thursday, June 4, 2009

Duty of care for Others

One thing struck me about my recent conference in Denver. At one of the panels discussing regulation and New Governance, the magic new buzz word, someone in the audience asked how this new style of regulation, which is supposedly flexible and orchestrates many parties, would affect the global south. The specific topic concerned food safety. The panelist replied that Africa was free to adopt whatever regulations it wanted, but that these regulations are so new their affect on the south was really unknown….and of no concern (not said in so many words). This got me thinking.

The response was immediate, almost without a pause, a rote response and uninformed. It was like much of this conference, not to go on, but also like much of America-even since Obama took office. The attitude is that we are all struggling and that the south has got to take responsibility. Then today I read a blog about how Multinational corporations are the new colonists of Africa. The linkage between these two is accountability, responsibility and culture.

Americans do not blame things on the government or other people-not fundamentally. They believe that individuals make decisions and are responsible for what happens to them. This is cultural. It is demonstrated in the American public’s lack of sympathy for people who borrowed too much to buy their houses. Public opinion holds that those individuals need to pay for that mistake-not the general public in the form of TARP $$. This is the cornerstone of individualism. This thinking is not universal.

Much of sub-Saharan Africa has a Marxist history and their orientation is to look for oppression from outside. There is a good deal of criticism of internal African problems, but that does not stop the blaming of the other. This is legitimate of course, but diverse from how Americans approach problems. And this distinction is not because American is wealthier. It is a cultural difference. The thinking comes from a different starting place. This leads to miscommunication and misunderstanding I think-on both sides.

To be clear, I am not disagreeing that the colonial powers had a long-term detrimental affect and that aid has not managed to help. I will even agree that aid has become an industry within itself and maybe no longer see helping as an objective, only sustaining its own existence. But what I have been thinking about is accountability and responsibility. Most Americans would say that there is a statue of limitations on what happened to you in the past-move on. This is cultural-not hard-hearted. I think I am trying to get my mind around a certain African perspective that blames the past for all ills. I think there is a disconnect here. African writers do not always mean to blame the past on its present day ills. It is a complaint of another nature.

I spent a lot of happy time with Marxists, and I still do stay in touch. They have a distinctly not-American context to all of their thinking. I think African writing is identifying something other than blame and many nations have a Marxist history and retain that thinking. They are not speaking about pinning their problems on someone else. They are identifying a power-imbalance that continues. ‘Don’t agonise-organise’-this is not talking about stopping the identification of past harms, it is talking about creating a balance to an economically superior partner/enemy/co-habitant.

I want to develop this idea a little further. I think within all of the diverse context in which this discussion goes on, there is one other thing that contributes to the conversation and that is a duty of care. Bill Gates recently said that all billionaires should give most of their money away to philanthropic causes because it feels good to do so. I could not agree more. With all of the discussion of Executive pay today, what exactly is Larry Ellison of Oracle doing with $450 billion a year. How much does his family need exactly? There IS a duty of care owed by those who make outrageous amount of money. They owe it to the universe that made them rich to help others. This should be the cost of capitalism. There is a duty for prosperous nations under the same paradigm. But it is not reparations. It is not a price for slavery or colonialism. It is something more fundamental and more enduring. The demand should not be a one time payment for harm but something more than restitution-something more basic. It is payment for good luck. It is socialist as an American would say. Your surplus should help support your neighbour.

There is a duty of care owed by those better off to reach out and help others. This may not be what drives the IMF and the World Bank and that needs to be reformed. This duty however is not limited to former colonial powers. This duty is owed by all countries that have HUMANS and business organisations or governments that are exceedingly profitable. This is what I find unhelpful by some of the focus of African criticism. The profitable countries, hence ones with economic power, may not have been a former colonial power yet there is still a duty. Yes, former colonial powers continue to owe a duty for sure. But the list is expanding

Are corporations representatives of their countries? Yes and no. Yes, corporations rape and pillage. But it is not always a national or race issue. They rape and pillage in the US and the UK just like they do in Africa. Banks and mortgage companies in the US have left people completely destitute and without recourse. This is not just because of the Global Financial Crisis (GFC). It happens all the time and we all pass legislation in the hope of stopping it. We all struggle with the nature of globalisation and powerful corporations. Some more than others.

The default position that everyone just wants to exploit Africa has somehow got to give way to a more complex understanding of how all of these entities –corporations, aid agencies, NGOs- function in the global economy. Exploitation happens everywhere all of the time. It is a power struggle between the strong and the weak and that crosses gender and racial boundaries. Pointing it out is essential. Feel the victim-ok. But after that-organise.

Monday, June 1, 2009

The Mile-High City

I just got back from the Law and Society conference in Denver. Colorado, USA. This conference is multi-disciplinary. Sociologists, anthropologists, political scientists, and lawyers discuss research interests in a socio-legal way.

The conference was excellent. I attended many interesting sessions on, for example, international law, South Africa, and the Global Financial crisis. Coffee was generously available. Also, the drinks party, Thursday night on the 38th floor of the Hyatt, had the most spectacular view of the Rockies. But is this of any interest to the international community? I don’t think so.

The LSA 2009 was very American. One new friend of mine from Canada suggested that the Europeans did not find a trip to DENVER to be attractive. Given the fact that UK television plays old US Westerns incessantly, I don’t think that was it. I think it had to do with the Global Financial Crisis or the GFC. Researchers could not find the funding, so they stayed at home.

This resulted in a distinct lack of ‘diversity’ so to speak. Numerous sessions concerned New Governance, the GFC, and how the US could better regulate their markets. There was an effort to be international but it was….feeble. There was little discussion about what was happening to securities and company law regulations elsewhere, besides the UK. I was a little disappointed.

This is only my second LSA. Last year it was held in Montreal and the discourse was lively and varied.

I presented my paper on Socially Responsible investing on Saturday. It went well and I received many constructive comments. I enjoyed Denver and the conference. The food was good as was a local amber ale called Fat Tire. I simply found the conference US-centric which managed to stifle the conversation somehow. The LSA 2010 will be held in Chicago. I may give that a miss.

Side trip-hot, dusty Tucson, Arizona

local history
local beer
local art
local flora