Friday, October 26, 2018
Some business school professors recently posted new research on FINRA arbitration and came away with interesting findings. They looked at about 9,000 different arbitration cases and found significant differences between arbitrators. Some were more industry-friendly, meaning they gave lower awards to claimants. Others were more client/customer-friendly, giving more awards to customers. Unsurprisingly, industry-friendly arbitrators were 40% more likely to be selected for panels. The authors found that industry firms were, on the whole, better at picking arbitrators than customers.
The FINRA arbitration process allows parties to influence arbitrator selection. FINRA generates lists with arbitrators for the parties and then allows the parties to strike a certain number of arbitrators before ranking the remaining arbitrators. FINRA appoints the highest-ranking remaining arbitrators to decide the case.
The study provides some support for a longstanding fear about the FINRA arbitration process. Customers with cases before arbitrators are usually not repeat players in arbitration. Once burned in a stock swindle, customers tend to become more cautious about trusting brokers. Arbitrators and firms, on the other hand, are repeat players. If the arbitrator tags the industry with a large award and rules in favor of the customer, other industry members will likely strike that arbitrator from future panels. Fears of exclusion may bias arbitrators against sticking the industry with large awards. In contrast, giving industry-friendly awards significantly increases an arbitrator's odds of picking up more cases. Because arbitrators collect supplemental income from serving on cases, some may consider their personal financial incentives when deciding cases. This financial incentive could tilt the scale against customers, making it more difficult for them to recover.
There are some customer-side repeat players involved in the process as well. The Public Investors Arbitration Bar Association is a bar association for attorneys that represent claimants in FINRA arbitration. The study found that customers represented by PIABA attorneys recovered four or five percent more on average of the amount sought. Still, PIABA attorneys do not represent every customer claimant and the study provides strong evidence that arbitrators have an economic incentive to decide cases in favor of industry members. (Quick Disclosure: Although I am a member of PIABA's board, I am not writing on behalf of PIABA.)
One possible solution to the problem--and suggested by the study's authors--is to do away with the parties' ability to influence arbitrator selection. This would take away an arbitrator's incentive to please the industry. Of course, a shift away from parties selecting arbitrators from a list would put the arbitrator selection process entirely in FINRA's hands. Because FINRA isn't subject to the Freedom of Information Act, the public would have little direct ability to verify how FINRA administered that process. Of course, the SEC supervises FINRA's operations. If the process changes, the SEC should keep a close eye on how FINRA administers the selection process.