“A Forum Controlled by the Securities Industry”: The History of Mandatory Arbitration in Securities Disputes

Arbitration as the Standard in Securities Cases

Defrauded investors who seek recovery for their losses have no choice but to go to arbitration, a process that by its very nature favors brokerage firms over investors. Securities disputes between investors and brokerage firms end up in arbitration before the nation’s only self-regulatory organization (SRO) for the securities industry — the Financial Industry Regulatory Authority (FINRA), formerly known as the National Association of Securities Dealers (NASD).

It wasn’t always this way, however. The history of binding arbitration in the securities industry is a story fraught with complexities, reversals, and losses. Let’s look at how arbitration came to be the preferred — and, later, only — avenue to recover funds lost through securities fraud.

Securities Arbitration Before 1987

The Federal Arbitration Act of 1925 made arbitrations “valid and enforceable.” After this, brokerage firms began including clauses in their brokerage agreements requiring investors to use arbitration if they wanted to raise a dispute with the firm. Then, in 1977, the SEC established the Securities Industry Conference on Arbitration (SICA), which developed the Uniform Code of Arbitration. The NASD (now FINRA) based its codes after the Uniform Code of Arbitration. Ten years later, however, a landmark court case would arise that would shape arbitration for years to come.

Shearson/American Express, Inc. v. McMahon (1987)

Despite the provisions of the Federal Arbitration Act, until 1987, investors could take their claims to court. Everything changed, however, with the 1987 Supreme Court case of Shearson/American Express, Inc. v. McMahon, which led to greater acceptance of arbitration as a method of dispute resolution. From then on, arbitration was used more often in securities disputes.

Eugene and Julia McMahon were persuaded to invest by a fellow parishioner at their church, who was also a broker with Shearson/American Express. The McMahons opened brokerage accounts with Shearson/American Express between 1980 and 1982. McMahons first tried to sue the firm and their broker in the United States District Court for the Southern District of New York for breach of fiduciary duty, churning, and RICO violations, . Two of the accounts contained agreements providing that conflicts would be submitted to arbitration, however. As a result, Shearson took steps to compel arbitration, and the Court agreed that they could — except on the RICO claim. The Court of Appeals for the Second Circuit disagreed, however, applying the Wilko doctrine, which arose from Wilko v. Swan (1953) and which stated that the Securities Act of 1933 should take precedence over the Federal Arbitration Act. They refused to compel arbitration, so the case went all the way to the Supreme Court.

Oral arguments were held in March 1987. The court rendered a decision in June 1987, ruling 5–4 in favor of Shearson that the RICO claims must be arbitrated. Justice Sandra Day O’Connor, in writing for the majority, stated, “Unlike the Exchange Act, there is nothing in the text of the RICO statute that even arguably evinces congressional intent to exclude civil RICO claims from the dictates of the Arbitration Act. This silence in the text is matched by silence in the statute’s legislative history.”

The long-standing result of McMahon has been that brokerage firms have made customers sign agreements waiving a trial and going straight to FINRA (formerly NASD) arbitration. These agreements are enforceable. This is problematic because, as Justice Harry Blackmun wrote in his dissent in McMahon, “there remains the danger that, at worst, compelling an investor to arbitrate securities claims puts him in a forum controlled by the securities industry.”

Rodriguez de Quijas v. Shearson/American Express Inc. (1989)

The history of arbitration does not end with McMahon, however. Two years later, with Rodriguez de Quijas v. Shearson/American Express Inc. (1989), investors would no longer be able to litigate disputes in court.

In the Indiana Law Journal article entitled “Arbitration of Securities Disputes: Rodriguez and New Arbitration Rules Leave Investors Holding a Mixed Bag,”[1] author William C. Hermann writes:

After the McMahon decision, brokerage customers with grievances continued to attempt to circumvent arbitration. Since McMahon had not explicitly overruled Wilko, investors would bring their cases in federal court under the only avenue left open to them: section 12 of the Securities Act. It was only a matter of time before the Supreme Court would move to block this path by invalidating Wilko completely. On May 15, 1989, a 5–4 majority of the Supreme Court, in Rodriguez de Quijas v. Shearson/American Express, Inc., decided that Securities Act claims were subject to arbitration in the same way as the Exchange Act claims in McMahon. This holding finally overruled Wilko. The petitioners were a group of unsophisticated investors in Brownsville, Texas, who lost over $400,000 they had invested at the local Shearson office.

These investors alleged that their brokers engaged in unauthorized trading and fraudulent trading, but ultimately had no avenue to resolve their disputes apart from forced arbitration. Why? Because Wilko was reduced to “obsolescence.” As part of its decision, the Supreme Court struck down Wilko v. Swan. Justice Anthony Kennedy wrote, “Wilko and McMahon are incompatible as a matter of securities law.” The majority of Justices repeated their previous argument that investors should trust the SEC’s oversight of arbitrations. In reality, that oversight power is limited.

Why Claimants Lose: Investors Often Fare Poorly in Arbitration

The defeat of Wilko means that investors have no choice but to arbitrate their cases before a FINRA arbitration panel (which includes arbitrators affiliated with the securities industry), as opposed to in court, before a jury of their peers. This is problematic for investors because studies show that investors tend to fare poorly in arbitrations.

In a 2007 study conducted by Edward S. O’Neal and Daniel R. Solin, the authors reference a March 17, 2005 hearing before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises in which the chief securities regulator for Massachusetts, William F. Galvin, railed against forced arbitration, stating in part:

the process is not about two evenly matched parties to a dispute seeking the middle ground … what we have in America today is an industry sponsored damage containment and control program masquerading as a juridical proceeding.

If, as Galvin asserts, the arbitration process is not a level playing field, how often do claimants win as opposed to broker-dealers? According to FINRA’s dispute resolution statistics, claimants were awarded damages in 40% of cases in 2018. In 2014, claimants were awarded damages in just 38% of cases.

O’Neal and Solin’s study goes on to report that when claimants do win, their awards tend to be lower: “The average amount an investor can expect to recover going into arbitration has declined from a high of 38% in 1998 to a low of 20% in 2004.” This drops to 12% when going up against a large brokerage firm and seeking a high amount of damages ($250,000 or more).[2]

Given this data, it is easy to see how the arbitration system favors powerful broker-dealers as opposed to everyday investors. What is being done to fix this problem?

“An Uphill Battle in the Senate”: The Future of Arbitration

What does the future hold for the status of arbitration in securities disputes between investors and broker-dealers? Although there have been some proposals for reform, as of right now everything remains status quo.

On February 28, 2019, the Arbitration Fairness for Consumers Act was introduced in the Senate Banking, Housing, and Urban Affairs committee. The bill would essentially end mandatory arbitration in securities disputes by prohibiting “a predispute arbitration agreement from being valid or enforceable if it requires arbitration of a dispute related to a customer financial product or service.” The bill never made it out of Committee. The same day, the Forced Arbitration Injustice Repeal Act (FAIR Act) was introduced in the Senate Judiciary Committee. The bill would prohibit “a predispute arbitration agreement from being valid or enforceable if it requires arbitration of an employment, consumer, antitrust, or civil rights dispute.” As with the Arbitration Fairness for Consumers Act, the bill never made it out of Committee. InvestmentNews reports that the bill passed the House 225–185. It will likely not pass the Senate, however. “It’s an uphill battle in the Senate,” George Friedman, who formerly directed FINRA’s arbitration program, told InvestmentNews. Rep. Bill Foster, a Democrat from Illinois, has drafted the Investor Choice Act, which would prohibit forced arbitration clauses in brokerage agreements. The bill has not yet been formally introduced. Unfortunately, it is extremely unlikely that any of these bills would become law, especially given their questionable constitutionality (as they deal with private contracts).

There is another way to end forced arbitration, however. Per the provisions of Dodd-Frank (the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010), the SEC can end mandatory arbitration. Yet the SEC has not taken action.

As you can see, in arbitration, the deck is stacked against wronged investors. Thus, it is crucial to have an experienced securities attorney by your side as you go through the process. Call (877) 238–4175, email info@fkesq.com, or visit www.stopbrokerfraud.com for your free consultation with the securities attorneys of Fitapelli Kurta.

[1] Hermann, William C. (1990) “Arbitration of Securities Disputes: Rodriguez and New Arbitration Rules Leave Investors Holding a Mixed Bag,” Indiana Law Journal: Vol. 65 : Iss. 3, Article 7.
Available at: https://www.repository.law.indiana.edu/ilj/vol65/iss3/7

[2] O’Neal, Edward S, and Daniel R Solin. “Mandatory Arbitration of Securities Disputes: A Statistical Analysis of How Claimants Fare.” https://www.slcg.com/pdf/workingpapers/Mandatory Arbitration Study.pdf.