A “Reasoned” Arbitration Decision? Be Careful What You Wish For
by Jacob H. Zamansky

After listening for years to criticism from investors and the lawyers who represent them, the National Association of Securities Dealers, the country’s main forum for securities arbitration, approved an amendment to the NASD Code of Arbitration Procedure allowing customers arbitrating disputes with brokers or brokerage firms to require a “written explanation” of the arbitration panel’s decision.¹ Registered representatives (brokers) arbitrating industry disputes also may require written explanations of the decisions. Currently, issuing an explained decision is solely within the discretion of an arbitration panel. The proposed rule is subject to approval by the Securities and Exchange Commission.

NASD Chairman and Chief Executive Officer Robert R. Glauber explained the impetus for the new rule as follows:

“We [NASD] have found that investors want to know more about how a panel reaches its decision. By giving investors the option of requiring a written explanation of an arbitration panel’s decision, we will increase investor confidence in the fairness of the NASD arbitration process.”²

While investors and their attorneys may be heartened that they can now choose to obtain a “reasoned” (written) explanation of the arbitration panel’s decision, that choice should be used sparingly, as it could be a double-edged sword. If a customer requests a written decision and then “wins” the arbitration, the customer is providing fodder for the brokerage firm to try to vacate the award if the panel’s reasoning is not sound or is subject to other legal challenges. If an investor requests a reasoned decision and “loses” the arbitration case, the decision will offer little solace and probably little opportunity to vacate an award and obtain a new arbitration hearing given the stringent legal standards governing appeals of arbitration awards.

In any event, the appeal process is time consuming and expensive and undercuts the purportedly expeditious and cost-effective nature of arbitration. For that reason, investors should rarely and prudently exercise this option to avoid giving the brokerage firms an opportunity to challenge the award.

Background of the Arbitration Process

An investor with a complaint against his brokerage firm is virtually guaranteed to end up in arbitration, as brokerage contracts generally require that investors’ disputes with the brokerage firm be heard in arbitration before the NASD or the New York Stock Exchange.

Arbitration panels are composed of three members: one “Securities Industry” arbitrator (a former or current member of a brokerage firm such as a broker or branch manager), and two “Public” arbitrators who are not affiliated with a brokerage firm. The arbitrators are selected by the parties based on a list supplied by the NASD. The “Public” arbitrators may or may not be attorneys, but panels usually have at least one attorney who often serves as chairperson, making evidentiary rulings and conducting the prehearing and hearing process.

After the pre-hearing process (including the exchange of discovery and various motions addressed to the process), the arbitration panel conducts a hearing on the record—usually with a court stenographer or a tape-recorded transcript. Arbitration is generally binding and there are very limited grounds for appeal under the Federal Arbitration Act.³ The only grounds for vacating an award on appeal from an arbitration panel’s decision are fraud, evident “bias” by the panel, or a “manifest disregard of the law.”⁴

The typical issues decided by arbitrators involve whether the investments recommended by the broker were “suitable” for the investor; whether the broker breached a fiduciary duty owing to the customer; whether the broker committed fraud against the investor (made a false statement or omitted to disclose a key fact, such as the risk of the investment); whether there was unauthorized trading, or churning, in the account; or whether the case involved allegedly misleading research by stock analysts. In addition, arbitrators often are asked to decide issues regarding damages, such as whether the investor’s recovery should be limited to “net out of pocket” damages and whether an investor had a duty to mitigate his or her damages and whether that duty was fulfilled.

Often, an arbitration panel’s decision cannot be rationalized by the parties with the facts of the case. For example, if an investor claims losses of $300,000 and the award was only $50,000, parties often are confused as to how such an award could be justified. Similarly, investors who go through the formal arbitration hearing and do not receive any award often are perplexed as to why the panel ruled against them.

Court Process

In contrast to arbitration, the court process usually involves a judge who issues evidentiary rulings and decides various motions, and a jury composed of lay people. In a typical case, the jury may be directed to answer a series of questions, such as whether the plaintiff has proven his or her case and whether damages should be awarded. The jury often sets the amount of the damage recovery. As in the arbitration process, jurors are not required to, and rarely do, give any reasons for why they reached a particular decision.

Some cases are tried solely before a judge who may issue a “reasoned” decision setting forth findings of facts and conclusions of law. That decision, as with jury verdicts, can be appealed.

There is a presumed “finality” to an arbitration panel’s decision.

Appeals courts usually defer to the trier of fact (judge or jury) and will reverse a judge or jury verdict only where there has been a significant error in the admission or exclusion of evidence or if the law clearly requires a disposition in one party’s favor.

A major advantage of arbitration over court cases is that arbitration is purportedly more cost efficient and less time consuming. There is a presumed “finality” to an arbitration panel’s decision and very limited grounds for appeal under the current system, where “reasoned” decisions are rarely granted. Thus, the entire layer of the appeals process is usually not a consideration in arbitration as it is in court cases.

The average arbitration case usually takes one to one-and-one-half years from start to finish. Court proceedings, including appeals, usually take several years.

The Proposed New Rule

Under the proposed rule, the party bringing the complaint—either an investor with a claim against a broker or brokerage firm or a registered representative with a claim against a firm—can choose to require a written explanation of the arbitration panel’s decision. Currently, issuing an explained decision is solely within the discretion of an arbitration panel.

According to the NASD, the request for a reasoned decision must be made at the initial pre-hearing conference. Thus, a claimant must decide early on whether to request the reasoned decision or will be deemed to have waived the right to do so. A claimant cannot wait until the eve of the arbitration hearing—presumably after becoming acquainted with the panel through various pre-hearing conferences—to make the decision. If a written decision is requested, the panel will explain why each claim was granted or denied after the hearings end.

The new rule will have a cost. Arbitrators will receive $200 for each requested decision, with the NASD paying half and the brokerage firm and investor sharing the rest of the cost.

Unlike in court cases, the reasoned explanation of an arbitration award would not have to cite court cases or statutes. Presumably, the explanation would be a recitation of the relevant facts (testimony or documents) that led the panel to its conclusions with regard to each claim.

Investor Choice for a Reasoned Award

The investor choice to seek a reasoned award by an arbitration panel is a double-edged sword. While a written decision will inform the investor why there was a particular result in his or her case, there are many reasons investors and their lawyers should think twice about requesting such a decision.

[T]he reasoned award process is likely to result in delays due to appeals.

First, the reasoned award process is likely to result in delays due to appeals, and will pose a threat to the award should some court decide to overturn it. One of the key principles underlying arbitration is that it is a cost efficient and expeditious way of resolving disputes; the reasoned award process will tend to escalate costs to investors and render arbitration more like court proceedings.

Second, a poorly-worded decision by an arbitration panel (particularly a panel composed of two or three non-lawyers) might provide meritorious grounds for a brokerage firm to challenge the award when no such grounds would otherwise have existed.

Third, the issuance of reasoned awards by arbitration panels could lead to the creation of securities arbitration common law. Currently, arbitration awards have no precedential value in other cases. While arbitrators are encouraged to review and follow the law, there is no strict requirement that they do. Thus, it is likely that if a customer in one case received a “zero” award and a reasoned decision, that decision could be used against investors with similar cases as grounds to deny them awards.

Fourth, where an investor receives an award of punitive damages and requests a reasoned decision, there is likely to be greater scrutiny by a reviewing court given the recent United States Supreme Court decision limiting punitive damages. ⁵ A punitive damage reasoned award also is more likely to be appealed by a brokerage firm, particularly where a decision is either poorly worded or is not in strict compliance with the Supreme Court decision.

[T]he issuance of reasoned awards by arbitration panels could lead to the creation of securities arbitration common law.

Reasoned awards could pose particular problems in disputes such as the analyst conflict or “research” cases premised upon an investor’s reliance on fraudulent or misleading stock market research. In this relatively new area of securities arbitration, reasoned awards will likely be cited as precedent in subsequent cases and could hurt investors, as many of the “research” cases are resulting in zero awards.⁶

Thus, there are several reasons why an investor should be careful, and probably reluctant, to request a reasoned award, and few reasons to request one.

The Industry’s View of the Proposed Rule

While many brokerage firms may decide as a matter of policy that they will ignore reasoned awards because they will lead to protracted litigation, other firms may decide that it is in their overall financial interest to challenge all (or at least a lot of) reasoned awards in the hope that some awards will be vacated. In any event, the firms may decide that a challenge will, at the very least, delay for perhaps several years their payment obligations. This could create another financial pressure for investors, who might be coerced into accepting smaller settlements if they cannot wait to have their awards confirmed and paid.

Brokerage firms undoubtedly will use reasoned decisions to challenge those monetary awards (or awards with factual findings such as fraud) that they believe should be challenged for financial or policy reasons. Brokerage firms are in a stronger financial position than the average investor and may decide to challenge any monetary award as a matter of course.

[I]nvestors … might be coerced into accepting smaller settlements if they cannot wait to have their awards confirmed and paid.

If the customer choice rule is approved, the likely next step would be for the securities industry to lobby for parity, so that both investors and brokerage firms can request reasoned awards. It is not unforeseeable that parity will become the rule; that would be the first step in eliminating awards without reason in favor of awards with explanations.

The Arbitrator’s Perspective

A reality of arbitration is that many (if not most) arbitrators sit on many panels. Some arbitrators have sat on 50 and even 100 cases. Some arbitrators actually consider arbitration their “job”; many arbitrators’ primary employment is as a mediator resolving disputes between investors and customers.

Repeat arbitrators may be less likely to issue a reasoned award in favor of a customer for fear that brokerage firms may not select them to sit on other cases. Reasoned awards will create a paper trail or track record upon which customers and the securities industry will judge potential panelists. Thus, transparency may chill arbitrators who might otherwise issue pro-investor reasoned awards.

Moreover, cases are decided not on legal principles but, rather, based upon the arbitrators’ belief as to whether industry standards were followed or whether the witnesses (broker or customer) are credible. An arbitrator who decides a case based on the industry standard or simply not believing a key witness’ testimony may think it necessary to provide some “scholarly” explanation of his decision. Arbitrators also may believe that their “reasons” would be subject to challenge by a reviewing court and therefore may be less candid or more cautious in what they write.

[T]ransparency may chill arbitrators who might otherwise issue pro-investor reasoned awards.

In short, it is likely that the reasoned award request will make many arbitrators feel uncomfortable now that courts might be looking over their shoulders.

Conclusion

While investors may at first glance be pleased to obtain a choice to obtain a reasoned award, the choice should be exercised in rare situations only. The main concern is that investors winning awards would now be providing fodder to brokerage firms to contest the awards—threatening to overturn the awards or at the very least delaying collection and increasing costs to investors.

The best advice to investors is, be careful what you wish for; you just might get it.

Notes

1. See “New Arbitration Rule Requires Award Explanations Upon Investor Request,” NASD Press Release (Jan. 27, 2005), available through links at <www.nasd.com>.

2. Id.

3. The Federal Arbitration Act can be found at 9 U.S.C. chapter 1 et seq.

4. See Halligan v. Piper Jaffray, 148 F.3d 197 (2d Cir. 1998).

5. See State Farm Mutual Automobile Insurance v. Campbell, 538 U.S. 408 (2003) (holding that punitive damages up to nine times compensatory damages could be reasonable and comport with due process requirements, but that larger awards likely would not).

6. See Susanne Craig, “Despite Pact Over Research, Goal is Elusive,” WALL STREET JOURNAL (Jan. 17, 2005) (reporting that investors have won only 25% of arbitrations based on allegations of misleading stock research).

About the Author

Mr. Zamansky (Jacob@zamansky.com), founding partner of Zamansky & Associates in New York, represents investors in securities litigation and arbitration matters.