FINRA Securities Arbitration & Investment Fraud Law

Most brokerage firms almost universally, require their customers to contractually agree to submit all disputes arising in connection with their securities account to binding securities arbitration, before a forum sponsored by a Self Regulatory Organization, such as the Financial Industry Regulatory Authority (or “FINRA”) formerly NASD Regulation, Inc., the New York Stock Exchange, or the American Stock Exchange. These Self Regulatory Organizations (“SROs”), as a condition of membership, require your stock broker and your brokerage firm to arbitrate all eligible claims involving public customers in securities arbitration.

The agreement to arbitrate is customarily found in all stock brokerage new account agreements, margin agreements, option agreements, and also appears on the back of most monthly customer account statements.

By agreeing to arbitrate all disputes between you and your stockbroker in arbitration, you are giving up your constitutional right to a trial before a jury. However, securities arbitration is, in fact, a quick or expedient, fair and cost effective method of resolving disputes.

Costly discovery and deposition practice, under most circumstances, are avoided in securities arbitration. Securities arbitration panels, for the most part, are familiar with most securities related issues, and claims against stockbroker and investment professionals for securities and investment fraud.

Following the Supreme Court’s holding in Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 226 (1987), courts will enforce agreements to arbitrate securities disputes between public customers and stockbrokers and their firms.

However, arbitration clauses deprive citizen access to the courts and thereby waive a time honored right to sue. The perceived unfairness of arbitration, and particularly, the “unwillingness” of the judiciary to earnestly examine “egregious” arbitration awards, has motivated Congress to seek to make these arbitrations “voluntary.”

All securities broker­dealers are required to be members of a self regulatory organization or SRO. Most securities broker dealers are members of the Financial Industry Regulatory Authority or “FINRA.” FINRA is a self­ regulatory organization or SRO established under Section 15A of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78o­3, and is the product of a merger of two self- regulatory organizations, the New York Stock Exchange (the “NYSE”) and the National Association of Securities Dealers, Inc. (the “NASD”), also known as NASD Regulation, Inc. SEC Release No. 34­56145 (July 26, 2007).

FINRA has the authority to exercise comprehensive oversight over “all securities firms that do business with the public” and “has the authority to, inter alia, create and enforce rules for its members in order to provide “regulatory oversight of all securities firms that do business with the public.” Securities and Exchange Commission Release No. 34­56145, 72 Fed.Reg. 42169, 42170 (Aug. 1, 2007).

Among FINRA’s stated purposes are to “encourage and promote among members observance of federal and state securities laws”; “[t]o investigate and adjust grievances between the public and members and between members”; and “[t]o adopt, administer, and enforce rules of fair practice.” Restated Certificate of Incorporation of Financial Industry Regulatory Authority, Inc. § 3 (July 2, 2010). Upon joining FINRA, a member organization agrees to comply with FINRA’s rules. See FINRA Bylaws Art. 4 § 1.

FINRA Rule 12200 provides that:

Parties must arbitrate a dispute under the Code if:

  • Arbitration under the Code is either:

(1) Required by a written agreement, or

(2) Requested by the customer; and

The dispute is between a customer and a member or associated person of a member; and the dispute arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company.

These Rules are “contractual in nature” and are binding on its members. The arbitration rules of the New York Stock Exchange are binding on NYSE members. Some courts have held that even the “existence” of a separate “written agreement to arbitrate” is not required to compel a member to arbitrate. The Code is sufficient in and of itself to compel arbitration of covered claims against one of its members or associated persons in the absence of a customer agreement with an arbitration clause. FINRA­membership constitutes an agreement to arbitrate disputes under FINRA’s rules. A customer under the exchange’s rules is entitled to invoke the arbitration provision “as an intended third­party beneficiary” in a dispute with a member. Compulsory arbitration rules constitute an agreement in writing under the Federal Arbitration Act. Even if there is no direct written agreement to arbitrate with a broker­dealer or associated person, the FINRA Code, which requires all members to arbitrate, is binding on its members.

Under the Code, at least as construed by the courts, every individual investor, corporation, partnership, trust, pension plan, institution, state, municipality, or other government, authority conducting business with a broker­dealer or its agent, is a “customer.” Even investment advisors may be public customers. The FINRA Code merely states only that “[a] customer shall not include a broker or dealer.” FINRA Rule 12100(i). FINRA’s glossary states that a “customer” is “[a] person or entity (not acting in the capacity of an associated person or member) that transacts business with any member firm and/or associated person.”

As one Court has observed, the meaning is plain. It provides that the party is a customer as long as [he, she it] is not a broker or dealer; nothing in the Code directs otherwise or requires more. Enforcing the limitation the securities firm seeks would be tantamount to reading language into the Code that is conspicuously absent. When Rule 12200 was proposed, the addition of the words “of a member”’ after the word “customer” was explicitly rejected because it would “narrow the scope of claims that are required to be arbitrated under the Customer Code.”

The Second Circuit has also suggested that the term “customer” is intentionally broad because FINRA intended to require its members to arbitrate disputes with the full array of parties as part of its “investor- protection mandate” and rejected the contention that FINRA has a narrow “investor­ protection mandate,” such that ‘customers’ should include only those receiving “investment or brokerage services.”

Indeed, many commentators suggest that the term “customer” has been construed broadly to include all members of the “investing public.” as part of FINRA and the NASD’s express purpose “[t]o investigate and adjust grievances between the public and members and between members.” Restated Certificate of Incorporation of Financial Industry Regulatory Authority, Inc. § 3 (July 2, 2010)(emphasis added); See also, David E. Robbins, Securities Arbitration Procedure Manual § 5­ 6(i) (5th ed. 2009); Norman S. Poser & James A. Fanto, Broker­Dealer Law and Regulation § 28.07(A) (4th ed. 2009).

In cases where, persons associated with the member firm, hold themselves out on their business cards, stationary, promotional materials, and their internet sites as offering securities through the member, courts will find that those persons are “customers” of the member. See, e.g. Multi-Financial Securities Corp. v. Brown, 2002 U.S. Dist. LEXIS 26527 (E.D. Pa. December 20, 2002)(“For example, the record includes a letter written by Kevin Brown to Defendant, regarding the trust account in question, written on his company’s stationary stating “Securities offered through Multi­Financial Corp. ­ Member SIPC and NASD.”

In addition, claims against a securities brokerage firm for the failure to supervise their registered representatives whom may be separately engaging in illegal or wrongful conduct is subject to arbitration. A dispute that arises from a firm’s lack of supervision over its brokers arises in connection with its business. A dispute that arises from a securities brokerage firm’s lack of supervision over its brokers arises in connection with its business.

Accordingly, all member broker dealers, and their associates or registered representatives are subject to the arbitration of customer claims.

Customers are also generally bound by arbitration. Owners or beneficiaries of non individual entity customers are generally bound by arbitration, and several courts have held that agreements to arbitration securities disputes are so universal that when questions as to whether a party actually entered into an agreement arise, a party’s agreement to arbitrate may be implied from that parties conduct. However, in arbitration, unlike in court, motions to dismiss, in advance of an evidentiary hearing are very limited. In arbitration, the parties are provided the opportunity to submit pertinent evidence in support of their claims or defenses. Courts have held that it would present issues of fundamental fairness if a final award were issued without the development of an additional record on the merits.” In fact, if an arbitrator refuses to hear material and pertinent evidence, prejudicing one of the parties, the award may be set aside. In arbitration all parties are entitled to an opportunity to be heard and must be allowed to present evidence without unreasonable restriction.

Former Rule 10305 of NASD Code of Arbitration Procedure used to provide that “[a]t any time during the course of an arbitration, the arbitrators may either upon their own initiative or at the request of a party, dismiss the proceedings.” This Rule was formally abolished in January 2009, however, some background may be instructive.

In June of 2005, the Securities Industry Association sought to amend what is now Rule 10305 to permit the dismissal of Customer Arbitrations prior to an evidentiary hearing. (SEC Release No. 34­ 51936). The proposed rule flatly failed, and was never heard from again, until September 2007. In September 2007, FINRA proposed amendments to Rule 10305 which were “designed to limit significantly the number of dispositive motions.”

In September 2008, the Securities and Exchange Commission approved FINRA’s proposed New Rule, Rule 12206 of the Code of Arbitration Procedure, which became effective January 23, 2009. Under the New Rule, pre­hearing Motions to Dismiss are limited to three circumstances on which to grant the motion: if the parties settled their dispute in writing; “factual impossibility,” meaning the party could not have been associated with the conduct at issue; or the existing 6­year time limit on the submission of arbitration claims.” However, in connection with the promulgation of the new Rule, “FINRA emphasize[d] that these exceptions do not constitute an invitation to parties to file motions to dismiss.” See, Regulatory Notice 09­07 (Jan. 23, 2009)(“SEC Approves New Motion to Dismiss Rule and Amendment to the Eligibility Rule in Arbitration”).

The Securities Arbitration Process

Securities Arbitration begins with the filing of a Statement of Claim by the Claimant, against the other party, typically their broker and/or brokerage firm, the Respondents. A Statement of Claim should set forth the factual and legal reasons as to why you belief you are entitled to relief against your stockbroker or investment professional for securities fraud or breach of fiduciary duty. Although there are no formal pleading requirements in securities arbitration, the Statement of Claim, in substantial part, is the equivalent of a Complaint that would otherwise be filed in federal district court.

The cost of filing a Statement of Claim depends on the amount of the claim. Filing fees range from $600 to $2,250, pending on the dollar amount of your claim or the amount in controversy.

FINRA or the Financial Industry Regulatory Authority offers approximately 48 hearing locations geographically disbursed throughout the United States. The location or situs of a hearing is usually based on the nearest location to the customer at the time their account was opened or where they resided at the time the transactions or the events giving rise to their claims occurred.

Service of the initial pleading or Statement of Claim is made by FINRA on its members. Under the Code of Arbitration Procedures, public customers are not required to arbitrate claims against former FINRA members who have been expelled or have had their registrations revoked.

Respondents, the offending brokerage firm and/or stockbroker, are provided with 45 days from the service of the Statement of Claim to respond. Answers or Responses typically contain Respondents’ version of the facts, and the legal reasons why the customer is not entitled to relief, or why the claim ought to be dismissed. Sometimes, Answers or Responses may contain copies of important documents, including correspondence or e-mails, demonstrating why the facts are different than as alleged in the Statement of Claim.

Thereafter, generally, in arbitrations before FINRA, after Respondents enter their appearances, the parties are provided arbitrator selection materials. Each party is provided with certain biographical information, including the educational and employment background, for each proposed arbitrator. Interests and potential conflicts are sought to be disclosed, and previous Awards decided by that arbitrator are also available for review.

From these lists and summaries, parties rank, in order of preference, prospective arbitrators. A Party may strike, without cause, those persons that they do not wish to serve on their Panel. If the Parties do not agree on proposed arbitrators, or all available arbitrators are stricken by both Parties, FINRA will assign an available arbitrator, whom can only be removed or challenged for actual cause or a conflict of interest.

Customer cases involving claims in excess of $100,000 are typically heard by a Panel of three individual arbitrators, which at the customer’s option may include an industry arbitrator. Public arbitrators are typically lawyers, retired judges, professional mediators, and other individuals. Industry arbitrators are individuals with a current or recent affiliation with the securities industry, and for the most part are registered representatives, retired registered representatives, branch managers, analysts, accountants, floor traders, or support personnel.

Once a Panel is appointed, a pre-hearing conference is held where the parties and the Panel scheduled final hearing dates, discovery deadlines, and other administrative matters.

Discovery and the means to obtain relevant evidence in arbitration is very important. In November 1999, FINRA adopted a specific Discovery Guide setting forth those documents and information that are discoverable in customer cases.

Generally, depending on the issues in any particular case, customers should preserve and be expected to produce all written communications between them and their broker, all documents relating to any other securities accounts, together with their tax returns for a period of at three years before they opened their account to the date they filed their Statement of Claim. Customers are also expected to provide detailed information relating to their business interests, education, and financial condition.

Among other things, brokerage firms are expected to produce all documents relating to their customer’s account, including new account forms, customer statements, confirmations, and communications between the customer and their stockbroker. Records of complaints or disciplinary action against your broker should also be made available together with information and documents relating to the brokerage firm’s supervision of your individual broker, the broker’s training, and the brokers basis of compensation should also be produced by the brokerage firm in most cases. In connection with the recommendation of any particular security, the broker or brokerage firm is also obligated to produce documents relating to the basis of any such recommendation, if any, along with information relating to any business relationship with the issuer.

While parties are not required to be represented by counsel, arbitration is very much a legal, courtroom-like, proceeding, where, in most cases, parties should be represented by competent counsel. All testimony is given at the time of a final hearing. Parties have the right to make opening statements and summarize what they intend to prove. Parties have the right to call witnesses, and may compel the attendance of nonparty witnesses by Subpoena, by Orders of the Panel, or with the assistance of a state or federal court. The parties and their witnesses present testimony under oath, and are subject to cross-examination. Documents are authenticated and offered into evidence. Expert witnesses may be called upon to testify and may be cross-examined. Closing arguments are made, and typically, within 30 days, the Panel renders a written Award.

Arbitration Awards are final, and will only be disturbed by a court in very limited circumstances upon the showing of fraud, corruption, or a manifest disregard for the law. Awards against brokers or brokerage firms must be paid within 30 days, or upon application, FINRA may suspend or revoke their licenses and registrations. Unpaid Awards must be docketed, typically in federal court, as a legal judgments in order to attempt to collect or satisfy any such Award.

FINRA Discovery

Discovery and the means to obtain relevant evidence in arbitration is very important. It is so important because it one of the only basis for seeking to vacate or upset an arbitration award based upon the panel’s refusal to hear pertinent evidence.

Discovery is important, however often the securities industry goes to great lengths to conceal or hide pertinent evidence.

Cases are won and lost, or more accurately settled, as a result of discovery.

Brokerage firm lawyers will generally, employ every device and ingenuity to avoid the production of highly relevant documents, hidden gems that can be found on inter-office e-mails, responses to exception reports, regulatory submissions, and sometimes documents contained in a broker’s employment files.

These lawyers also, typically, want unbridled discovery into every aspect of a claimant’s personal financial life, commonly referred to as a “financial colonoscopy,” in support the two most traditional defenses: “The You Should Have Know Better than to Trust Us” or “The You Could Afford to Lose the Money Anyway” defenses.

Documents relating to customer’s wealth which the brokerage firm seeks to obtain in support of these defenses are generally irrelevant because the broker did not have this information at the time of recommendation.

A registered representative is obligated to make his recommendation only on the basis of concrete information about the client’s financial situation and a representative must make recommendations only on the basis of the concrete information that the customer did supply and not on the basis of guesswork as to the value of other possible assets.

Moreover, subsequent changes in a customer’s financial condition are of no relevance to the suitability of a recommendation at an earlier time.

Perhaps more importantly, wealthy investors are allowed to be conservative, and in any event, particularly in defective product cases, a customer’s wealth or sophistication does not absolve the broker for failing to conduct due diligence or have conducted a product specific suitability analysis. Even the most sophisticated investor deserves proper recommendations.

The fact that a customer may be wealthy does not provide a basis for recommending risky investments. Suitability is determined by the appropriateness of the investment for the investor, not simply by whether the salesman believes that the investor can afford to lose the money.

Generally, depending on the issues in any particular case, customers are expected to produce certain documents, including all written communications between them and their broker, all documents relating to any other securities accounts, together with their tax returns for a period of at least three years before they opened their account. Customers are also expected to provide detailed information relating to their business interests, education, and financial condition.

Among other things, brokerage firms were and are expected to produce all documents relating to your account, including new account forms, customer statements, confirmations, and communications between you and your broker. Records of complaints or disciplinary action against your broker should also be made available together with information and documents relating to the brokerage firm’s supervision of your individual broker, the broker’s training, and in most cases, the brokers basis of compensation should also be produced by the brokerage firm.

In connection with the recommendation of any particular security, the broker or brokerage firm also ought to be obligated to produce documents relating to the basis of any such recommendation.

Accordingly, in November 1999, FINRA, then the NASD adopted a specific Discovery Guide setting forth those documents and information that are discoverable in customer cases.

However, within the last 10 years, the Discovery Guide, was attempted to be amended at least three times. The securities industry, understandably, has sought to limit its scope with respect to the documents that it has to produce and increase the burden on customers, requiring the production of documents relating to almost every aspect of their personal financial life.

While the Discovery Guide, which was expected to decrease the controversies surrounding discovery, is “guide,” for use in customer cases and is “not intended to remove flexibility from Arbitrators or the parties in a given case.” Executive Summary at 1, often the securities industry objects to the production of documents and information contemplated by the Guide, but then argues that the documents customers are contemplated to produce, must be produced in every case.

In May 2011, FINRA published the newest version of the Discovery Guide, and replaced the prior fourteen Lists with just two Lists of presumptively discoverable documents: one for firms/associated persons to produce and one for customers to produce.

Documents the Firm/Associated Persons Shall Produce in All Customer Cases

Item 1: Account record information for the customer parties, documents concerning the customer parties’ risk tolerance and agreements with the customer parties.

Item 2: Correspondence sent to the customer parties or received by the firm/associated persons, and advertising materials sent to customers of the firm.

Item 3: Documents evidencing any investment or trading strategies used or recommended in the customer parties’ accounts.

Item 4: For claims alleging unauthorized trading, all documents the firm/associated persons relied upon to establish that the customer parties authorized the transactions at issue, all documents relating to the customer parties’ authorization of the transactions and all order tickets for the transactions.

Item 5: Materials the firm and/or associated persons prepared or used and/or provided to the customer parties relating to the transactions or products at issue, and worksheets or notes indicating that the associated persons reviewed or read such documents.

Item 6: Notes the firm/associated persons made relating to the customer parties and/or the customer parties’ claims, accounts, transactions or products or types of products at issue.

Item 7: Notes or memoranda evidencing supervisory, compliance or managerial review of the customer parties’ accounts or transactions, or of the associated persons assigned to the customer parties’ accounts; and correspondence between the customer parties and firm/associated persons relating to the customer parties’ claims, accounts, transactions or products or types of products at issue bearing indications of managerial, compliance or supervisory review.

Item 8: Recordings, telephone logs and notes of telephone calls or conversations about the transactions at issue that occurred between the associated persons and the customer parties, and/or between the firm and the associated persons.

Item 9: Writings reflecting communications between the associated persons assigned to the customer parties’ accounts at issue and members of the firm’s compliance department relating to the securities/products at issue and/or the customer parties’ claims, accounts or transactions.

Item 10: Forms RE-3, U4 and U5 and Disclosure Reporting Pages for the associated persons assigned to the customer parties’ accounts at issue, customer complaints identified in the forms, and customer complaints filed against the associated persons.

Item 11: Sections of the firm’s manuals relating to the claims alleged, including separate or supplemental manuals governing the duties and responsibilities of the associated persons and supervisors, bulletins the firm issued and the table of contents/index to the manuals/bulletins.

Item 12: Analyses and reconciliations of the customer parties’ accounts, including those relating to reviews of the customer parties’ claims, accounts, transactions or the product or types of products at issue.

Item 13: Exception reports, supervisory activity reviews, concentration reports, active account runs and similar documents produced to review for activity in the customer parties’ accounts related to the allegations. For claims alleging failure to supervise, the firm/associated persons must produce the documents listed in this Item that were produced to review for activity in customer accounts handled by associated persons and related to the allegations.

Item 14: Portions of internal audit reports for the branch in which the customer parties maintained accounts that concern associated persons or the accounts or transactions at issue and discussed alleged improper behavior in the branch against other individuals similar to the improper conduct alleged.

Item 15: Records of disciplinary action taken against associated persons by any regulator or employer for all sales practice violations or conduct similar to the conduct alleged.

Item 16: Investigations, charges, or findings by any regulator and the firm/associated persons’ responses.

Item 17: Portions of examination reports or similar reports following an examination or inspection conducted by any regulator that focused on the associated persons or the customer parties’ claims, accounts or transactions, or the product or types of products, or that discussed alleged improper behavior in the branch against other individuals similar to the conduct alleged.

Item 18: Documents related to the case that the firm/associated persons received by subpoena or by document request directed to third parties.

Item 19: For the transactions at issue, documentation showing the compensation, gross and net, to the associated persons.

Item 20: For claims related to solicited trading activity, a record of all compensation, including, but not limited to, monthly commission runs for the associated persons.

Item 21: A record of all agreements pertaining to the relationship between the associated persons and the firm, summarizing the associated persons’ compensation arrangement or plan with the firm.

Item 22: For allegations regarding an insurance product that includes a death benefit, information concerning the customer parties’ insurance holdings and recommendations, if any, regarding insurance products.

Documents the Customer Parties Shall Produce in All Customer Cases

Item 1: Customer party federal income tax returns, limited to pages 1 and 2 of Form 1040; Schedules A, B, D and E; and the IRS worksheets related to these schedules, redacted to delete the customer parties’ Social Security numbers. Customer parties may redact information relating to medical and dental expenses and names of charities on Schedule A unless the information is related to allegations in the Statement of Claim.

Item 2: Financial statements, including statements within a loan application, or similar statements of the customer parties’ assets, liabilities and/or net worth.

Item 3: Documents the customer parties received from the firm/associated persons and from entities in which the customer parties invested through the firm/associated persons, including account opening documents and/or forms, prospectuses, research reports, annual and periodic reports, and correspondence.

Item 4: Account statements for each non-party securities firm where the customer parties maintained an account.

Item 5: Documents, including agreements and forms, relating to accounts at the firm or transactions with the firm.

Item 6: Account analyses and reconciliations prepared by or for the customer parties relating to the customer parties’ accounts at the firm or transactions with the firm.

Item 7: Notes, including entries in diaries or calendars, relating to the accounts at the firm or the transactions at issue.

Item 8: Recordings and notes or logs of telephone calls or conversations about the customer parties’ accounts or transactions at issue that occurred between the associated persons and the customer parties, and telephone records evidencing telephone contact between the customer parties and the firm/associated persons.

Item 9: Correspondence the customer parties sent or received relating to the accounts or transactions at issue.

Item 10: Previously prepared written statements by persons with knowledge of the facts and circumstances related to the accounts or transactions at issue.

Item 11: Complaints/Statements of Claim and answers filed in civil actions involving securities and securities arbitration proceedings in which the customer parties have been a party, and all final decisions or awards or non-confidential settlements entered in these matters. If a person is a party to a confidential settlement agreement that by its terms does not preclude identification of the existence of the agreement, the party shall identify the documents comprising the agreement.

Item 12: Documents showing the customer parties’ ownership in or control over any business entity. If the customer parties are trustees, documents showing the accounts over which the customer parties have trading authority.

Item 13: Documents the customer parties received, including documents found through the customer parties’ own efforts, relating to the investments at issue.

Item 14: For claims alleging unauthorized trading, documents the customer parties relied upon to show that they did not know about or consent to the transactions at issue.

Item 15: Materials the customer parties received or obtained relating to the claims, transactions or products at issue, and materials received relating to other investment opportunities.

Item 16: Customer parties’ resumes.

Item 17: Existing descriptions of the customer parties’ educational and employment background if not set forth in resumes.

Item 18: Documents related to the case that the customer parties received by subpoena or by document request directed to third parties.

Item 19: To the extent that an insurance product that provides a death benefit is included in the Statement of Claim, information received from an insurance sales agent or securities broker relating to such insurance.