Will New FINRA Rule Increase Transparency in the Arbitrator Selection ?

The proposed rule follows a highly publicized arbitrator selection controversy.

FINRA proposed new rules to increase transparency in the arbitrator selection process. Arbitrators decide the outcomes in many investment disputes, and investors who want to recover money following stock broker fraud or misconduct often have no choice but to go through FINRA arbitration. FINRA provides a panel of arbitrators who are supposed to be neutral parties. Their neutrality has been challenged on several occasions, raising questions about the fairness of the arbitration process.

FINRA’s new rule proposal follows a controversial decision by a Georgia court that reversed a decision to vacate an award following allegations that Wells Fargo had compromised the fairness of the arbitrator selection process. Because arbitration rulings are final and binding, it is essential that arbitrators are truly neutral. There is some evidence that FINRA arbitrators skew in favor of brokerage firms, especially when the investor does not have extensive experience in the securities industry.

Who Are FINRA Arbitrators?

FINRA arbitrators can be anyone with two years of college credits and five years of professional experience. Prior to an arbitration hearing, an algorithm randomly generates a list of potential arbitrators. Depending on the amount of money at issue, the parties will select either a single arbitrator or a panel of three arbitrators. Both parties rank the arbitrators according to preference. The highest-ranked arbitrator(s) will decide the outcome of the arbitration hearing.

What Does the New Rule Entail?

The rule change proposes that FINRA Dispute Resolution Services (DRS) should manually review arbitrator lists to identify conflicts of interest, which the computer algorithm is not sophisticated enough to detect on its own. The new rules would require a written explanation when an arbitrator is removed from the list. Today, an arbitrator can disappear from a potential pool of arbitrators with no explanation.

What is a Conflict of Interest?

Conflicts of interest could be any aspects of the arbitrator’s personal or professional life that could bias an arbitrator’s decision. FINRA states, “When making disclosures, arbitrators should consider all aspects of their professional and personal lives and disclose all ties between the arbitrator, the parties, and the matter in dispute, no matter how remote they may seem.” Family ties, personal friendships, and working relationships are all potential conflicts of interest.

An arbitrator may also be automatically disqualified if they are the subject of a FINRA arbitration award or a pending investment-related civil action.

Arbitrators must also disclose:

· Business and personal relationships,

· Any type of lawsuit,

· Any publications — online or in print,

· Professional memberships, and

· Service on boards of directors.

Challenges to the Neutrality of FINRA Arbitrators

Losing parties–both brokerage firms and investors–commonly attempt to vacate FINRA awards by citing arbitrator conflicts of interest. It is highly unlikely that these tactics will pay off. There is an exceptionally high burden of proof to have an arbitration award vacated and these motions are normally unsuccessful. Only approximately 2% to 5% of motions to vacate an award are granted.

The following are two examples of cases that challenged arbitrator neutrality but ultimatelyfailed to have an arbitration award vacated.

1. Wells Fargo’s Alleged “Secret Agreement”

An August 2019 FINRA award ordered a Wells Fargo investor to pay $83,600 to the brokerage firm after he lost his arbitration dispute. The dispute claimed that two Wells Fargo brokers had misled the investor and violated securities laws, resulting in losses of over $1 million. The investor fought the award and moved to vacate in a Georgia court, with granted the motion to vacate after the judge determined that Wells Fargo manipulated the arbitrator selection process.

One of the Wells Fargo attorneys allegedly had an agreement with FINRA that he would not have to work with a particular arbitrator. Based on previous cases, the Wells Fargo attorney believed the arbitrator had “hostile feelings” toward him. According to the lawsuit, this agreement went against the protocol for arbitrator selection, which is supposed to guarantee investors a right to a computer-generated list of neutral arbitrators.

Upon vacating the FINRA award, Judge Belinda Edwards stated, “Permitting one lawyer to secretly red line the neutral list makes the list anything but neutral, and calls into question the entire fairness of the arbitral forum.” Wells Fargo, the judge asserted, should not have been able to make a “secret agreement” with FINRA regarding arbitrator selection. Following the vacated award, the Public Investors Advocate Bar Association (PIABA) called for an SEC investigation into FINRA’s operation of its arbitration forum.

In yet another twist, another court overturned the vacated award. An outside law firm reviewed the allegations and found no evidence of a secret agreement but produced a report recommending that FINRA improve its transparency surrounding the arbitrator selection process. This report seems to have prompted FINRA’s new rule proposal.

2. Charles Schwab and IB

Wells Fargo is not the only brokerage firm to use the supposed bias of an arbitrator to their advantage. Charles Schwab and IB recently attempted to have a $4.6 million arbitration award thrown out, arguing that an arbitrator did not qualify as sufficiently neutral since she failed to disclose “her involvement in a factually similar securities-related dispute was fatal to her ability to serve as a neutral decision-maker.” The brokerage firm requested the arbitrator’s removal, which was granted. The arbitration panel then issued an award in favor of the investor. Based on the supposed bias of the previous arbitrator, representatives of the brokerage firm persuaded a court to vacate the award. And just like the Wells Fargo case, another court overturned that decision.

More Challenges to FINRA Arbitration Fairness

Firms enjoy several benefits in the FINRA arbitration process, which may explain why they require investors to use arbitration rather than civil suits.

· FINRA arbitration is confidential. Final awards are public, but they do not include every detail of the proceedings. This benefits brokerage firms that have engaged in misconduct by lessening the publicity surrounding the investor allegations.

· Both investors and brokerage firms have access to information that informs their selection. Arbitrators are either public or nonpublic. Public arbitrators have no connection to the securities industry. Non-public arbitrators have worked within the financial industry or have provided professional services to one of the parties involved in the dispute. Firms are more likely to select arbitrators who they believe are friendly to brokerage firms, perhaps based on their professional ties.

· Arbitrators have a financial incentive to skew in favor of brokerage firms, according to an article in Stanford Business. Because arbitrators will only be picked if they are attractive to brokerage firms, they may be more likely to offer awards to brokerage firms in an effort to boost their reputation.

How Can Investors Ensure Fairness in the Arbitration Process?

Hiring a securities attorney is a reliable way to level the playing field. One study from the Virginia Law and Business Review states that arbitrator selection is the “most effective when the parties are represented by counsel. Our findings highlight the importance of legal representation in the arbitration process.” Securities attorneys are familiar with brokerage firm tactics and have specialized insights into arbitrators’ backgrounds. Brokerage firms are going to shop around for sympathetic arbitrators, and investors should do the same.