“The courts of this country should not be the places where resolution of disputes begins. They should be the places where the disputes end after alternative methods of resolving disputes have been considered and tried.” — U.S. Supreme Court Justice Sandra Day O’Connor
Alternative Dispute Resolution (ADR) refers to a variety of processes and techniques designed to help disagreeing parties come to an agreement short of litigation. In the United States, ADR emerged out of the legal reform and civil rights movements in the late 1960s. Rising legal costs and excessive delays in the litigation process made ADR a popular option to resolve conflicts. Globally, ADR is the preferred choice of dispute resolution in many ethnic, cultural, and religious communities. The importance of ADR globally is evidenced through legislation on a state and multistate level, through institutional organizations, and through various chambers of commerce.
Some of the most common types of ADR techniques include negotiation, mediation, and arbitration. ADRs are used to resolve disputes in a multitude of areas including family law, commercial law, intellectual property law, and securities law.
Introduction to FINRA Dispute Resolution
In the United States, securities disputes can be brought before ADR fora like the American Arbitration Association (AAA) or JAMS, however the Financial Industry Regulatory Authority (FINRA) [formerly the National Association of Securities Dealers (NASD)] operates the largest securities dispute resolution forum in the country for disputes between a customer and a FINRA registered entity or disputes between FINRA registered entities. FINRA has 69 hearing venues, including at least one on each state and one in Puerto Rico. One of FINRA’s most prominent dispute resolution mechanisms is arbitration. Arbitration is formal alternative to litigation in which two or more parties select a neutral third party, called an arbitrator, to resolve a dispute. Oftentimes there are three arbitrators who adjudicate a FINRA dispute. Arbitration through FINRA is generally faster, cheaper, and less complex than litigation in an American court. FINRA maintains a roster of over 7,900 arbitrators.
Arbitration panels are composed of one or three arbitrators who are selected by the parties. They read the pleadings filed by the parties, listen to the arguments, study the documentary and/or testimonial evidence, and render a decision. The panel’s decision is called an “award”. Unlike court opinions, arbitrators are not required to write opinions or provide explanations or reasons for their decision. A decision is only required to be explained if the parties jointly request one. For the year 2021, the total amount awarded to customers involved in a securities arbitration was $75 million.
Appealability of FINRA Arbitration Awards
Under FINRA rules, arbitration awards are considered final and not subject to review or appeal through FINRA. However, parties have the right under federal and state law to challenge the award by filing a motion to vacate the arbitration award in a court of competent jurisdiction. If a motion to vacate is successful, the underlying decision is invalidated and there is no payment obligation and a new arbitration proceeding may have to be initiated. If a motion to vacate is denied, the award stands, and the payment obligation is revived.
The grounds for vacating an arbitration award are extremely limited, and motions to vacate are rarely successful. A court’s ability to review an arbitration award has been described as “among the narrowest known to the law”. The review of arbitration awards is “‘highly deferential’ to the arbitrators, and relief on such a claim is therefore ‘rare.”’ According to William H. Null and Noah Rubins, such a preference for “finality” of arbitration awards has been seen as an advantage in private dispute resolution.
Standard of Review for Motions to Vacate Arbitration Awards
Section 10 of the Federal Arbitration Act specifies grounds on which a court may vacate an arbitration award. These limited grounds include corruption, partiality, misconduct, and misbehavior on the part of arbitrators. In such cases, plaintiffs have an extremely high burden of proof such that even where an arbitrator fails to abide by arbitral or ethical rules concerning disclosure of possible conflicts, such failure does not, in itself, entitle the losing party to vacatur of the arbitration award. Courts have turned a blind eye towards arbitrator behavior such as making decisions without procuring all the evidence as well as making decisions by divining what documents would show without actually reviewing the documents.
Barring such misconduct or corruption on the part of arbitrators, awards can also be vacated “where the arbitrators exceeded their powers, or so imperfectly executed them that a mutual, final, and definite award upon the subject matter submitted was not made.” The burden on the plaintiff in this case is also high and the aggrieved party must show that the arbitrator’s decision was “completely irrational”, where the arbitrator’s decision “‘escape[s] the bounds of rationality”’ and is entirely unsupported by the record.
Multiple circuits have also found two additional grounds upon which an award may be vacated: namely, where the arbitrator’s award is in “manifest disregard” of the law and where the terms of the relevant agreement between the parties are outside the reasonable expectations of the weaker party.
The most common approach to decide if an award is in “manifest disregard” came from the Second Circuit in in Merrill Lynch, Pierce, Fenner & Smith v. Bobker.92 This approach essentially entails three parts: (1) the clear existence of a governing law, (2) where the arbitrator knew of the controlling law, and (3) yet the arbitrator “consciously disregarded or ignored the applicable law.” Despite the guideline provided by this approach, circuit courts have not uniformly applied the “manifest disregard” standard.
This is evidence that the court’s review of an arbitration award is to “determine only whether the arbitrator did his job—not whether he did it well, correctly, or reasonably, but simply whether he did it.”
Disadvantages of the FINRA Arbitration Process for Retail Investors
The narrow standard of review combined with the fact that FINRA arbitrators don’t have to provide written opinions or explain their decisions unless the parties jointly request one makes it nearly impossible for a party to show “manifest disregard” or any other type of irrationality to successfully appeal FINRA awards. Such high bars set forth by courts signify the judiciary’s nod to keeping the ‘finality’ standard intact at the cost of fairness.
Null and Rubins state that finality in arbitrations can be a positive quality only if at least one of two basic assumptions is true. First, finality would always be an asset if arbitrators, unlike judges, never made mistakes. However, even the most avid proponent of arbitration is unlikely to make such a claim. Moreover, complex disputes increase the probability of an erroneous result. A more likely assumption is that the stakes in arbitration are small enough that errors are tolerable, and the risk of error is outweighed by the desire for speed and finality. While this second hypothesis may apply in many situations, there are some cases involving large losses where an erroneous result would be problematic, even if the likelihood of such a result seems, ex ante, to be low.
While an investor could litigate securities claims against broker-dealers or their representatives in court rather than in an ADR forum like FINRA, they usually have no real alternative for opting out of arbitration. In the landmark 1980s cases Shearson/American Express, Inc. v. McMahon and Rodriguez de Quijas v. Shearson/American Express, the SCOTUS compelled enforcement of arbitration clauses in broker-customer agreements, effectively closing the courthouse door to aggrieved parties and consigning the resolution of these disputes to ADR fora such as FINRA. Even though the “right to sue in court” was essential to the protection of investors under securities laws in the United States, the McMahon Court found arbitration an “adequate” means of enforcing the provisions of these laws.
Given the Supreme Court’s preference for arbitration, an overwhelming majority of retail brokerage and investment advisory agreements include language requiring all disputes between the customer and broker-dealer/investment adviser be resolved through arbitration, and almost always with FINRA.
William Alan Nelson suggested that these “take it or leave it” clauses are procedurally unconscionable because an investor is required to relinquish their constitutional right to access courts due to unequal bargaining power while signing a contract to open accounts at these firms. Indeed, they may not even have realized that they have relinquished their rights until a dispute arises many years from the time of opening an account and find these clauses buried inside disclosure documents.
These clauses may also be substantively unconscionable due to their predisposition towards mandatory arbitration and FINRA as an ADR forum. As explained above, FINRA has no appellate avenues and judicial review is very limited. This type of legal regime almost always does not give investors an option to pick a forum of their choice.
FINRA Still Has Some Advantages for Retail Investors
Notwithstanding the disadvantages of the FINRA dispute resolution mechanism, FINRA is still a force for good. The FINRA rules specifically contemplate and seek to protect investors from the disparity in the balance of power and financial resources between large brokerage firms and individual investors. Among the benefits for individuals are different rules for different-size claims, limits on dispositive motions, access to much information when indicating arbitrator preferences, and restrictions on discovery and appeals.
Despite the costs involved in arbitrating a dispute through FINRA, which start at a filing fee of $50 for claims up to $1000 and go up to tens of thousands of dollars as the arbitration progresses, the FINRA dispute resolution process is still almost always economical in terms of time and money when compared to court litigation in the United States.
According to Seth Lipner, filing fees in court and payment to licensed court reporters may be economical for a retail client at the initial stages, however, the discovery stage can get very expensive. After few days of depositions, the out-of-pocket expenses of litigation will quickly match or exceed those arbitration hearing session fees. Hiring outside attorneys on a per hour basis is also expensive, and litigation involves much more lawyer work than arbitration does.
In a nutshell, the advantages of resolving disputes through FINRA mechanisms neutralize some of the disadvantages for retail investors. However, mandatory arbitration and the preference for finality in arbitration decisions still severely hamper the continued development and vitality of securities laws from a broad market perspective.
International Arbitration Law as a Model for FINRA Dispute Resolution
“So that, however it may be mistaken, the end of law is not to abolish or restrain, but to preserve and enlarge freedom.”
Either mandatory arbitration or the preference for finality should be challenged and restricted in order to address these broad market concerns. Several scholars have presented solutions such as ending mandatory arbitration altogether, allowing “opt-out” provisions in mandatory arbitration clauses, petitioning courts to modify awards if they are unfair, incorporating judicial reviews in tailored contracts between parties, and incorporating judicial review as a statutory requirement. However, ending mandatory arbitration and looking to courts to solve customer disputes may deprive investors of the advantages of FINRA arbitrations while also congesting court dockets. Instead, FINRA can develop and expand its own internal mechanisms and address any gaps in investor protection. To do this, FINRA could examine sophisticated models of international arbitration law that have several tiers of pre and post-arbitration steps.
Multi-Tier Dispute Resolution vs. Two-Tier Arbitration
Multi-tier dispute resolution (MTDR) clauses state that when a dispute arises, parties must undertake certain steps prior to commencing arbitration, in an attempt to amicably settle the dispute. Such clauses are also called “escalation clauses” and they seek to establish arbitration as the ultimate level that should only be reached when all other pre-arbitration steps including negotiation and mediation fail. MTDR has become commonplace, particularly in complex construction contracts, joint venture agreements and other contracts where long-term relationships are created and continuous cooperation is contemplated.
While there are a number of benefits to such clauses, there are also drawbacks. Since they are mostly found in tailored commercial contracts and not as part of statues or common law, some uncertainty exists as to whether such clauses are binding, whether they constitute jurisdictional conditions precedent to the commencement of arbitrations, and what the consequences of a party’s failure to comply are.
In 2018, the Queen Mary University of London and White & Case LLP 2018 International Arbitration Survey found that nearly half the participants preferred MTDR. MTDR clauses have been part of contracts in major countries including England and Wales, the United States, Switzerland, Singapore, Hong Kong, and Australia. They have also appeared in arbitral tribunals, bilateral treaties, and cases before the International Chamber of Commerce (ICC).
On the other hand, two-tier arbitration or appellate arbitration is a system in which parties to the arbitration agreement retain the option to appeal against the original arbitral award. An appellate arbitral panel usually reviews the first arbitration decision. Two-tier arbitration is prominently found in international commercial arbitration either in an institutional set-up or in ad hoc form.
This appellate mechanism is validated by different jurisdictions across the globe including Japan, Italy, the Netherlands, Austria, and South Africa. Even in the United States, arbitral institutes including the AAA and JAMS provide for optional two-tier arbitration mechanisms if they contracted for by parties ex ante. The European Court of Arbitration also provides for two-tiered arbitration.
In summary, MTDR is a pre-arbitral step and two-tiered arbitration is an appellate review of arbitration decisions. While these mechanisms are mostly used and enforced in commercial law, India could provide a model for both these systems in securities law.
India’s Multi-Dispute Resolution System and Two-Tiered Arbitration Model
The Securities and Exchange Board of India (SEBI), a statutory body appointed by an Act of Parliament (SEBI Act, 1992), is the chief regulator of securities markets in India. SEBI functions under the Ministry of Finance and performs the triple functions as a quasi-legislative, quasi-judicial and quasi-executive body. The main objective of SEBI, as stated in its preamble, is “to protect the interests of investors in securities and to promote the development of, and to regulate the securities market . . . .”
In June 2011, SEBI set up the SEBI Complaints Redress System (SCORES)—a web-based centralized system to capture investor complaints against listed companies and registered intermediaries. In order to resolve a dispute with an entity, an investor has to first file a complaint with the concerned entity directly, and if the investor fails to do that as an initial step, the SCORES platform will reroute them to the entity. The entity is then required to respond to the investor within 30 days, and if the entity fails to do that, the complaint will be routed to SEBI through SCORES. When the complaint comes to SEBI, the complaint is examined, and SEBI decides whether the subject matter falls under its purview and whether it needs to be sent back to the concerned entity. After this initial examination, if jurisdiction is proper, SEBI forwards the complaint to the concerned entity with advice to send a written reply to the investor and file an “action taken report” on SCORES.
If the investor is still unsatisfied after the written reply offered by the entity, the complaint is further escalated to a Supervising Officer at SEBI for further investigation. By requiring the investor and the concerned entity to resolve disputes by themselves, SEBI has created a de facto MTDR system before resorting to arbitration.
The majority of complaints filed on SCORES are against stockbrokers. For most of 2022, SEBI received an average of 3,011 complaints every month. The number of days it takes to resolve a single complaint was twenty-nine days as of September 2022.
If a customer is still unsatisfied with the resolution by SEBI, arbitration is the next step in dispute resolution. SEBI states that if there is any dispute between a client and a member of Stock Exchange that has not been resolved to their satisfaction, then either party can opt for arbitration.
Arbitration is a quasi-judicial process for settlement of disputes. In India, stock exchanges provide an arbitration mechanism for settlement of disputes between a client and a member/depositories participant through arbitration proceedings in accordance with the SEBI’s provisions and Section 2(4) of the Arbitration and Conciliation, Act, 1996.
In August 2010, SEBI streamlined the stock exchange arbitration mechanism. SEBI required stock exchanges to implement new features to improve the arbitration process. Many of these new features are similar to FINRA arbitration mandates including provision of continuing education to arbitrators, and arbitrator panel limits based on size of the claim. However, unlike FINRA, SEBI also requires that stock exchanges “provide an appellate mechanism within the exchanges to avoid the need for resorting to lengthy court process.” Stock exchanges in India now have provisions in place for an appellate panel of arbitrators to review arbitration decisions. The stock exchanges have no standard of review for appeals and only require that the party filing the appeal be “aggrieved” by the decision and file within one month from the date of receipt of the arbitration award. With these 2010 mandates, SEBI established a two-tiered arbitration model for securities disputes in India. Investors can still appeal to a “court of competent jurisdiction” under certain grounds if they are unsatisfied with the decisions of the appellate arbitration panel.
The front-loaded SCORES portal to address investor grievances right after they occur and the back-loaded appellate arbitration system to appeal unsatisfactory arbitration awards provide a buffer against the pitfalls of mandatory arbitration and the stringent finality of arbitration decisions. These mechanisms are especially effective in reducing the burden on courts—India has more than 40 million cases pending in its court system.
Benefits of Mandating Tiered Dispute Resolution Mechanisms At FINRA
Currently FINRA has an Investor Complaints Center which functions like SCORES. It strongly recommends that the investor file a complaint with the broker before filing a complaint with FINRA. However, it is not mandatory to file an investor complaint before resorting to arbitration. Unlike SCORES, a FINRA complaint is primarily regulatory in nature. It exists to protect the interests of all investors. The result of FINRA’s investigation may lead to disciplinary action or sanctions against the broker or adviser involved but it does not lead to damages or other recourses for the affected investors in most cases..
FINRA may also have limited interest in ordering violators to compensate individual investors as it is a self-regulatory organization (SRO). SROs are privately funded entities that carry out quasi-governmental activities to regulate the securities markets. “Quasi-governmental” bodies are not required to offer the same type of constitutional protections that are typical of government agencies. Bejamin Edwards states that, “FINRA’s structure poses a continual risk that industry members will subvert its processes to act like a cartel, promoting industry interests at the expense of the public . . . .” FINRA status as an SRO has been critiqued even by infamous financial fraudsters like Jordan Belfort:
“Just why the [National Association of Securities Dealers (NASD)] had created a playing field that so clearly fucked over the customer was something I’d thought about often, and I’d come to the conclusion that it was because the NASD was a self-regulatory agency, “owned” by the very brokerage firms themselves.”
Moreover, in India, SCORES complaints are handled by SEBI directly, and not through an intermediary like FINRA. The equivalent of this in the United States would be the Securities and Exchange Commission (SEC), a government agency entrusted with promoting fairness in the markets, investigating investor complaints received on FINRA’s Investor Complaints Center.
Despite these limits due to its status as an SRO, FINRA still has other pre-arbitral mechanisms in its arsenal.
First, FINRA could mandate that customers participate in a settlement conference after submitting an arbitration claim. This would be similar to the judicial settlement conferences before a court hearing.
Second, FINRA could mandate that customers go through mediation before resorting to arbitration. At the end of 2022, 82% of arbitration cases were resolved by means other than arbitration including direct settlement by parties and mediation. These numbers have stayed fairly consistent over four years. FINRA also states that its mediation program is faster and less expensive than arbitration and that the success rate for mediation is 80%. The cases that settled when the parties opted for mediation was 92% as of 2022. With a turnaround time of 127 days, compared to 18.1 months for arbitration, mediation appears to be beneficial to a retail investor.
These statistics make FINRA mediation seem more desirable than arbitration. However, there are dangers that belie mandating an informal mechanism like mediation. Indeed, “mandatory mediation” may be an oxymoron. Dorcas Quek suggests that mandatory mediations could work as a temporary expedient with the aim of increasing the awareness of the benefits of mediation. FINRA mandatory mediation could be complemented by investor education and other steps to increase the general awareness of mediation and its overall benefits among retail investors. Moreover, the non-binding nature of mediation keeps the doors for arbitration open if investors are still not satisfied with the result.
FNRA could also implement a post-arbitral mechanism. Like the Indian system, FINRA could provide for optional appellate arbitration panels. Such a concept is not new in the United States—JAMS and the AAA already have provisions in place for such appeals. Like JAMS, FINRA could have suggested contract language for the appeal, which includes the option for parties to use an appellate arbitration procedure. Further, allowing arbitral appeals may outweigh any possible drawbacks. Unlike the Indian system, FINRA can delineate standards of review that are similar to or are an amalgamation of existing standards of review used in courts. The goal of the standard of review should be to limit frivolous appeals. Axay Satagopan suggests that “[a standard of review] must be sufficiently minimal in order not to abrogate the entailment of arbitral finality, but on the other hand, not so deferential, as to defeat the very purpose of introducing such review.” Other measures like selection of appellate arbitrator panels, time limits, cost limits, and security requirements could also be implemented.
While appellate arbitration may push the arbitration mechanism closer to litigation in terms of time and cost, appellate review still has significant advantages over litigation. Some of these include reducing logjams in court dockets, protecting the privacy and confidentiality of the parties, and reducing the burden on taxpayers by internalizing costs within the parties. If the parties are still not satisfied after the appellate decision, they can still resort to vacating them in court under the current standards of review provided by the FAA and common law. If anything, a two-tiered system may actually bolster the finality of the award by bestowing it with further legitimacy. Judges will be even less inclined to strike it down if it goes to court for a motion to vacate after the appeals stage.
FINRA arbitration is one of the most prominent ADR techniques to resolve securities disputes in the United States. While arbitration is advantageous to retail investors, FINRA’s current system cuts against conscionability and fairness as courts in the United States have shown a preference for mandatory arbitration and for finality of awards.
FINRA could counter these concerns by importing international arbitration techniques like the Indian tiered securities arbitration mechanism. India’s front-loaded SCORES investor complaint portal functions like an MDTR clause and requires pre-arbitral steps to be taken by an investor before resorting to arbitration. Although FINRA has an Investor Complaints Center similar to SCORES, it is unlikely to compensate investors through complaints received through the Center. Therefore, FINRA could mandate settlement conferences or mediations as a pre-arbitral step.
India also has a two-tiered arbitration mechanism which functions as a back-loaded check against unfairness of arbitration awards. Such an appellate mechanism, if established by FINRA, could curb the unfairness of incorrect and virtually unreviewable arbitration decisions especially in light of the complex cases in securities arbitration today.
Finally, pre-arbitration MTDR clauses and two-tiered arbitrations relieve the burden on court dockets, give control back to the parties to resolve disputes in a timely and cost-effective manner, and may also result in fairer awards for retail investors.