The Only Thing They Have to Fear Is ... a Level Playing Field

Let's assume you recently bought a car and it turned out to be a lemon. The dealer won't return your calls, let alone make good on your complaints. You seek legal advice. Your lawyer tells you that the paperwork you signed when you bought the lemon required you to submit all disputes to arbitration.

"That's not so bad", you tell your lawyer. "I have heard that arbitration is quick, less expensive than litigation and just as fair."

Not so fast. Your lawyer tells you that this is a special kind of arbitration. It is administered by the car dealers association. They make up all of the rules and have vast influence over the outcome. One of their rules requires that one member of the three arbitrators is required to be a car dealer.

How do you now feel about your chances of getting a fair hearing?

Welcome to the world of mandatory arbitration of securities disputes. If you have an account with a broker who is a member of the National Association of Securities Dealers (NASD) or the New York Stock Exchange (NYSE), you agreed that any disputes between you and your broker would be resolved by mandatory arbitration.

And who runs this process? The NASD and the NYSE. It rules require that one of the three arbitrators be affiliated with the securities industry.

How fair is this process? Well, as you already know, it certainly does not have the appearance of impartiality. But what about the reality?

My colleague, Eddie O'Neal, who did this work when he was on the faculty at the Babcock Graduate School of Management, Wake Forest University, and I, spent two years looking at over 14,000 cases decided by NASD and NYSE arbitrators over a ten year period. We are releasing the results of this study today.

Our study shows that investors have a very slim chance of recovering any meaningful damages from any of the major brokerage firms. When you crunch the numbers, an investor with a $500,000 claim against a large firm could expect to wind up with a paltry $26,000 after paying legal fees and expenses.

In fact, the larger the case, the lower the amount awarded as a percentage of the claim. Indeed, across all categories and against all brokerage firms, the average amount an investor could expect to recover in these proceedings declined from a high of 38% in 1998 to a low of 22% in 2004.

This period of declining recovery rates coincided with gross misconduct by many major brokerage firms who paid hundreds of millions of dollars and consented to findings that the reports of their analysts were conflicted and misleading.

These troublesome statistics validate the concerns of Congress that there is something radically wrong with this process. Members of the Senate Judiciary Committee recently asked the Securities and Exchange Commission, which supervises this process, to make arbitration optional instead of mandatory. And Barney Frank, the Chairman of the House Subcommittee on Capital Markets, Insurance and Government Sponsored Entities has indicated an interest in holding hearings on this subject.

Of course, the securities industry is adamant in its view that there is nothing wrong with this process. They may be right. If you are a broker or a brokerage firm, it is working really well for you.

Dan Solin is both a securities arbitration attorney and a Registered Investment Advisor and Senior Vice President of Index Funds Advisors. He is the author of the best selling book,
The Smartest Investment Book You'll Ever Read (Perigee Books 2006).