Securities Arbitration Primer: What Investors and Attorneys Need To Know

Posted on May 2nd, 2011 at 9:20 AM

The events of the past few years, including the Great Recession of 2008, have transformed the American financial landscape from Wall Street to Main Street.  Economic turmoil has culminated in the most sweeping changes in financial regulation since the Great Depression.  Congress has passed the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 -- and has sparked a flurry of securities litigation and arbitration. 

Investors and attorneys may think that securities litigation relates to complex class action litigation, large corporate clients or highly esoteric investment vehicles.  However, the reality is that many securities disputes involve individual, retail investors (who have suffered losses arising out of an investment or strategy recommended by their financial adviser) or securities industry employment disputes involving financial advisers. 

Let’s examine FINRA arbitration and highlight what one should know about typical investor disputes as well as securities industry employment disputes.   

FINRA (the Financial Industry Regulatory Authority) is the largest independent regulator for the securities industry in the United States.  FINRA is charged with the oversight of over 4,500 brokerage firms and approximately 630,000 registered securities representatives. 

FINRA also operates the largest and most effective securities dispute resolution forum in the world, handling virtually all securities arbitration and mediation in the country.  According to FINRA, in 2010 alone 5,680 arbitrations were filed of which 22% were resolved by arbitration, 52% resolved by settlement and 10% resolved by mediation.  The overall turnaround time for these cases was 12.7 months in 2010. 

FINRA also proves to be a favorable forum for investors who are pursuing claims against their financial adviser.  In 2010, 47% of FINRA cases that were decided by an arbitration panel awarded damages to the investor.   As of February 2011, investors were been awarded damages 51% of the time.

Historically, the most common FINRA arbitration cases involve mutual funds, common stock, bonds and annuities.  However, arbitration claims involving riskier investments such as private placements and structured products are on the rise.

FINRA lists the most common customer complaints as: (1) Breach of Fiduciary Duty; (2) Negligence/Unsuitability; (3) Fraud/Misrepresentation; (4) Failure to Supervise; and (5) Breach of Contract.  While attorneys may be familiar with those claims generally, let’s analyze them in the securities arbitration context.

Breach of Fiduciary Duty – This is the most common claim that investors allege in securities arbitration.  Financial advisers generally occupy a position of trust and confidence in relation to their customers.  While the law differs from state to state, this position generally imposes a fiduciary duty on the adviser.  When the adviser fails to put the investor’s interest ahead of the adviser’s own interest when making an investment recommendation, this duty may be breached. 

Fraud – In fraud claims, the investor typically alleges that he or she detrimentally relied on an adviser that mislead the investor by either affirmative making a misleading statement or omitting a material fact that the investor would find important in making the investment decision. 

Negligence – Negligence claims typically revolve around the adviser’s failure to act as a reasonably prudent adviser would in the same circumstances.  These claims can involve a variety of issues, including the failure to conduct proper due diligence on an investment or the recommendation of an investment or strategy that is unsuitable for the investor.

Unsuitability – Advisers have a duty to recommend investments that are suitable for an investor’s investment objectives, goals, and overall investment profile.  Advisers are also responsible for making sure that a once suitable investment recommendation continues to be suitable for the investor over time.  Although those claims tend to be fact specific, failing to make a suitable investment recommendation can expose the adviser to an unsuitability claim.  The failure to properly diversify an investor’s portfolio also can give rise to an unsuitability claim.

Failure to Supervise – Financial services firms have a duty under FINRA rules to properly supervise their advisers.  The failure to do so can expose financial services firms to liability.

Beyond investor disputes between broker-dealers and their customers, it is important to note that FINRA also serves as the primary forum for disputes between financial services firms and their employees.  Those disputes involve a number of issues such as wrongful termination, employment discrimination, defamation, and breach of contract.  FINRA maintains a separate set of arbitration rules for those disputes.

One common claim on behalf of advisers is known as Form U-5 defamation.  Firms are required to conduct due diligence and report to the regulators accurate and complete reasons for the termination of employment.  When firms fall short in fulfilling that duty, advisers may have a cause of action for U-5 defamation.  Damages sometimes can be substantial, as the employment termination record may be viewed not only by state and federal securities regulators, but also by prospective employers and investors/customers.

Likewise, although advisers are typically employees-at-will, there are circumstances that may give rise to a claim for wrongful termination.  Those include situations where the firm has taken “opportunistic advantage” of a termination to gain an adviser’s book of business. 

Finally, our firm defends many financial advisers who have been sued in promissory note collection actions.  In the securities industry, advisers transitioning from one firm to another often receive monetary compensation generally considered to alleviate the financial stress associated with such employment transitions.  However, those sums effectively are loans which must be paid off through years of employment service.  Sometimes advisers leave their employment prematurely, triggering a balance due on their promissory notes.  In those circumstances, we defend against those claims, and consider bringing  counterclaims for damages suffered by the advisers.   

As one can see, FINRA arbitration is a forum where the vast majority of routine securities disputes are heard and resolved.  While investors and attorneys still are encouraged to seek the assistance of attorneys experienced in handling FINRA arbitration matters, hopefully this article provides a basic primer on FINRA arbitration and a roadmap on some of the issues that they may encounter during the process. 


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