A Hidden Danger Few Investors Understand

Over the years, I’ve written extensively on how to invest intelligently and responsibly, based on sound, peer-reviewed evidence. Together with many others, I’ve extolled the virtues of low management fee index funds, global diversification, keeping costs and fees as low as possible and avoiding or deferring taxes. I’ve warned you about the peril of listening to anyone who claims the ability to pick outperforming stocks, or predict the direction of the market or select the next “hot” mutual fund manager.

I’ve also cautioned you about the problems of using an advisor who is not a “fiduciary”. This includes most stock brokers, who are permitted to have undisclosed conflicts of interest, which they can resolve in their economic interest (and against yours), as long as their recommendation is deemed “suitable.” In stark contrast, all registered investment advisors are fiduciaries. They must disclose all conflicts of interest and always put your interest above theirs.

There’s another issue that has the potential to destroy your retirement dreams. Few investors are aware of it until it’s too late.

The FINRA threat

If you signed an account opening statement with a broker, you have agreed to waive your right to a trial by jury in the event of a dispute with your broker. Instead, you will be required to submit your claims to mandatory arbitration, administered by the Financial Industry Regulatory Authority, known as “FINRA”.

Your broker won’t discuss the mandatory arbitration clause. It’s non-negotiable.

Many investors have found this little understood clause gives their broker carte blanche to engage in misconduct that decimates their portfolio, while depriving them of any effective redress.

The illusion of impartiality

FINRA describes itself as “a not-for-profit organization authorized by Congress to protect America’s investors by making sure the broker-dealer industry operates fairly and honestly.” It’s really an industry trade association, running a mandatory arbitration system designed to protect brokers and brokerage firms from being held accountable to their aggrieved clients.. William Galvin, the highly respected Secretary of the Commonwealth of Massachusetts (who is a genuine advocate for investors), testified before a congressional subcommittee on March 17, 2005. He correctly characterized FINRA’s arbitration process as follows:

The term “arbitration” as it is used in these proceedings is a misnomer... what we have in America today is an industry sponsored damage containment and control program masquerading as a juridical proceeding.

False claims of independence

In order to buttress its claim that it’s not a front for the securities industry, FINRA touts the fact that a number of its Board of Governors are “public governors”, who are supposedly representing the investor interests. However, according to a recently released report from the Public Investors Arbitration Bar Association, nearly half of FINRA’s so-called “public” governors have ties to the securities industry and other conflicts of interest. The report found governors designated as “public” included the co-CEO of a large hedge fund, a board member of the Blackstone Group and a former “industry” governor that FINRA conveniently relabeled as a public governor.

The PIABA report concludes:

PIABA has significant concerns about 5 of FINRA’s 13 Public Governors and one recently-departed governor, almost half of the Public Governors. PIABA is concerned that FINRA is not following its own by-laws and is not meeting its obligation to ensure adequate public representation on its Board to ensure protection of investors and the public interest.

You should have similar concerns.

Protect yourself

Don’t expect Congress to protect you by outlawing FINRA’s monopoly over disputes with your broker. The only effective course of action is not to deal with any broker or advisor who requires you to submit to arbitration administered by FINRA.

The views of the author are his alone. He is not affiliated with any broker, fund manager or advisory firm.

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