Why It's Hard to Fight Brokers

In her stage act, Tissa Hami, a stand-up comic who was born in Iran, boldly skewers stereotypes about her ethnicity and her Muslim religion. (Those who disapprove will be taken hostage, she jokes.) But when it comes to her finances, Hami, 36, tends to be cautious. For years, she kept her savings in a money-market account, unwilling to accept any amount of investing risk. But frequent, unsolicited entreaties from advisers in a San Francisco branch of discount broker Charles Schwab ultimately wore down her resistance. In early 2007, she agreed to invest $50,000 in Schwab Yield Plus, a mutual fund described to her as a low-risk but high-yielding alternative to a money-market account.

It was anything but. The fund had a substantial stake in securities backed by subprime mortgages. Its share price began to plummet in March 2008, and it ended up losing 35% for the year. By the time Hami dumped her shares, she was out $13,000, a devastating loss for someone who earns only about $20,000 annually. "I feel like I was totally duped," she says.

Hami is preparing to sue Schwab to recover her losses, but her case is far from a slam-dunk. For starters, she can't go to court. Like most other investors with a brokerage account, she is required to take disputes to a private arbitration system created by the brokerage industry itself. And while the Financial Industry Regulatory Authority, the agency that runs the arbitration system, insists that the process is fair to all parties, investor advocates have long contended otherwise.

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Finra's own statistics show that before ticking up in 2008, the proportion of investors who won monetary damages had been declining for years. And even when investors do win, they may recover only a fraction of their losses, according to a recent study. (Arbitration will do little for victims of Bernard Madoff's alleged Ponzi scheme because most were not customers of Madoff's brokerage. Rather, they invested directly in Madoff's money-management unit or were clients of other money managers who invested with Madoff.)

What it takes to prevail

Even so, the volume of new arbitration cases has been rising lately, as it typically does when markets tank. But you won't get much sympathy from arbitrators if you simply complain that your broker should have recommended better-performing stocks and bonds. To win, you must show that the broker engaged in some type of misconduct. Some of the most common cases are those in which brokers mislead investors, fail to act in an investor's best interests or choose clearly unsuitable securities.

Allegedly unsuitable investments are an issue in a case involving Edward Marnell, 85, and his wife, Jean, 84, of Pleasanton, Cal. The Marnells are bringing an arbitration case against a Morgan Stanley broker for investing $100,000 from the sale of their house in three auto-industry bonds and a Sears Roebuck structured note, which is similar to a bond. Jean suffers from Alzheimer's disease, and she and her husband, who depend on Social Security and veterans' disability payments, were looking for a low-risk source of additional income. Instead, they lost $30,000.

Finra says navigating its arbitration system is easier than going through the courts because its system allows more leeway in making damage claims than the law does. It is also cheaper and quicker, says Linda Fienberg, president of Finra's dispute-resolution system, because the process places limits on certain types of motions and decisions can't be appealed, except in extraordinary circumstances. The average case takes 16 months to close; court cases can stretch on for years.

Handling small claims

But the system can be challenging for investors, such as Hami and the Marnells, who lose relatively small amounts. If you claim damages of $25,000 or less, you can pursue a do-it-yourself case. In such a case, you make your argument in writing, and a single arbitrator decides the issue. Filing fees range from $50 to $425, depending on the amount of damages sought.

But even in these small-claims cases, you will face a well-trained lawyer representing the other side. So it helps to hire your own legal counsel. Unfortunately, many lawyers find it unprofitable to handle claims of less than $100,000. A small network of legal clinics run by law schools in California, Illinois, New York and Pennsylvania will take on small-claims cases for people with incomes of up to $100,000 (depending on the clinic). But local clinics are limited in their ability to help residents of other states (see www.sec.gov/answers/arbclin.htm for more details).

The Investor Justice Clinic at the University of San Francisco agreed to take the cases of Hami and the Marnells. If you, too, go the clinic route, prepare to be patient. Law students will handle the bulk of the legal work, and that may mean long periods of inactivity during their summer break. On the plus side, clinic director Robert Talbot and his students don't charge for their services.

If your losses are big enough to interest an experienced lawyer, the Public Investors Arbitration Bar Association can hook you up with a securities-law expert. But lawyers' fees could claim as much as 40% of any settlement you win. Plus, you'll have to shell out your own money for such expenses as hiring expert witnesses. Filing fees range up to $1,800, and there are hearing fees as well. All of these costs add up to serious money.

Tilted playing field?

Investors seeking compensation of more than $50,000 face another hurdle: Their cases must be heard by a panel of three arbitrators, at least one of whom must come from within the industry. (A new rule, soon to take effect, calls for one public arbitrator to hear claims of less than $100,000 unless all parties request three arbitrators.) Finra says the industry arbitrator can ensure that the two public members of the panel understand the sometimes complex rules under which brokers operate. But investor advocates say the rule tilts the playing field toward brokers. "A lot of times, the public arbitrators look to the industry arbitrators to give them advice because of their so-called knowledge of what goes on," says Theodore Eppenstein, a New York securities lawyer.

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In response to these complaints, Finra recently launched a two-year pilot program that allows up to 550 cases to be heard by three-person panels that exclude industry-affiliated arbitrators. Six brokerages (Citigroup, Merrill Lynch, Morgan Stanley, Schwab, UBS and Wachovia) have agreed to participate. "We wanted to see what would happen if we gave investors the choice" between panels with and without industry arbitrators, says Fienberg, who isn't convinced the all-public panels will prove more popular. Nevertheless, Schwab and Citigroup have already booked the maximum number of cases allowed under the first year of the program.

Finra has made other investor-friendly moves in recent years. It introduced new rules to ensure that public arbitrators have few business ties to brokerages and to prevent brokerage lawyers from delaying proceedings by filing frivolous motions as a stalling tactic. Still, investors won monetary damages in just 42% of cases decided in 2008, down from 54% in 2001. And those figures may overstate their success. Investors in winning cases received only about half the damages they asked for, according to a study of 13,810 arbitration decisions between 1995 and 2004 by Edward O'Neal, of the Securities and Litigation Consulting Group, and Dan Solin, a lawyer and investment adviser.

Finra notes that arbitrators decide only about a fourth of the cases that are filed. Most are settled either through negotiations between the parties or with the help of a mediator. (Investors can request mediation at www.finra.org; however, both parties must agree to bring in a mediator, and costs are usually split equally.) Taking into account all types of settlements, investors either recovered money or won other relief -- such as reversal of a disputed trade -- in 74% of cases settled in 2008, Finra says.

Chilling effect

Critics say the changes cannot erase the problems inherent in a system that is ultimately controlled by the people being sued. "All the problems of having the industry as judge, jury and administrator of disputes against its members remain," says Solin.

Investors' lawyers say that because big brokerages are involved in so many arbitration cases, arbitrators may fear that they'll lose work if they're perceived as favoring investors. Fienberg counters that big law firms that file a lot of cases on behalf of investors can have the same effect. (Lawyers for both sides are allowed to strike a certain number of arbitrators from lists supplied by Finra.) Still, a survey released in 2008 of more than 3,000 investors, lawyers and others who had participated in securities arbitration revealed a strong sense of dissatisfaction among investors. Almost 63% of investors disagreed with a statement that the process was fair.

A 1987 Supreme Court case opened the way for the use of mandatory arbitration not only in cases between investors and brokerages but also for disputes between clients and credit-card issuers, wireless-phone com-panies, hospitals and others. Arbitration is also widely used to settle employment disputes. Most industries, however, use unaffiliated arbitrators. Fienberg says that by subsidizing its own system, the industry holds down costs for investors. If offered the choice of taking a case to court or to Finra's arbitration system, Fienberg says, most investors would choose arbitration.

Congress may give investors a chance to test that assertion. A bill giving consumers a choice between going to court or arbitration in a wide range of disputes will probably be introduced this year. In the meantime, Finra arbitration is the only game in town, and investors will still have to factor in the possibility of an adverse judgment to the many other risks they assume when they venture into the stock and bond markets.

Blame game

Surprisingly, relatively few cases filed against brokers in 2008 alleged unauthorized or excessive trading, which have been major problems in the past. Cases may allege more than one problem, so the numbers do not add up to the number of cases filed last year.

2,836 Violating a fiduciary, or legal, obligation to act in the best interests of the customer.

2,005 Providing information to the customer that is untrue or that could be misunderstood or misconstrued.

1,658 Violating terms of the contract between the brokerage and the customer.

1,602 Failing to take action to prevent or respond to an act of misconduct.

1,201 Failing to provide an investor with all relevant facts regarding a potential investment.

1,181 Choosing investments that are unsuitable to an investor's situation.

1,029 Failure of managers to adequately supervise brokerage employees.

Source: Finra

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