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

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