Feeling Ripped Off? Don't Rely on the Street's Arbitrators

Wall Street's self-policing body has decided to make its mandatory-arbitration system a little less rigged.

Here's some good news for anyone who ever gets ripped off by a securities broker. Wall Street's self-policing body has decided to make its mandatory-arbitration system a little less rigged. The bad news? It still will be plenty rigged.

So-called public arbitration panels no longer could include people who used to work for brokerage firms, under a new proposal by the Financial Industry Regulatory Authority. Finra's rules now say former stockbrokers, securities lawyers and others can serve on such panels after they have been out of the industry for five years. The rule change will go to the Securities and Exchange Commission for approval.

Finra has two classifications of arbitrators: non-public and public. Non-public arbitrators have experience in the securities industry. Public arbitrators aren't required to have any industry knowledge. Investors get a choice of having claims heard by one kind or the other. They choose all-public panels in most cases, although that's a misnomer because the hearings in this shadow-court system are conducted in private.

The tweak would be an improvement -- who could be against having neutral arbitrators? -- but only at the margins. The fundamental problem is that industry-sponsored arbitration is a racket. Customers have no choice but to sign away their right to sue in court if they want to open a brokerage account. (Lots of other industries get away with this too, from mobile-phone service providers to credit-card companies.)

The arbitrators are picked from a list compiled by Finra, which is financed by and functions as an arm of the securities industry. Arbitrators are independent contractors who serve at Finra's discretion. Payments to claimants are notoriously low. Arbitrators' rulings often include no explanation of why they decided the way they did.

If the arbitration system had been designed by fleeced investors and their attorneys, it probably would be biased against the securities industry. Not surprisingly, Finra's system is designed to favor the industry it represents.

Back in 2005, Massachusetts Secretary of the Commonwealth William Galvin explained how things work while testifying before Congress about the securities arbitration process, back when Finra was known as the National Association of Securities Dealers. One example he offered was of a man he knew named John J. Mark.

"Mark was an arbitrator with the Commonwealth of Massachusetts for many years, and an adjunct professor at Harvard and Boston University," Galvin said in his written remarks. "As far as I know he's a man of impeccable credentials. And yet he was dropped from the NASD's pool of arbitrators. Why? As he told a meeting of state securities regulators last summer, (and I quote): `The word on the street is if you rule against the (brokerage) houses, you will be removed from the list.'"

That perception has stuck through the years. Bloomberg View columnist William Cohan wrote an article in 2012 describing how Finra "seemingly out of nowhere fired three arbitrators in the months after a May 2011 case in which they awarded $520,000 to the estate" of a deceased Merrill Lynch customer. One after another, the arbitrators received "black spot" letters from Finra, removing them from its roster. Finra said at the time that the removals weren't related to complaints by Merrill. As Cohan wrote, Finra's explanations rang hollow. Two weeks after his column ran the three arbitrators were reinstated. (Sometimes shaming works.)

This is the reputation that Finra has created for itself, notwithstanding its claims that its arbitrators are neutral, qualified, fair and impartial. Here's how the securities industry could help fix that: Stop requiring its customers to give up their right to a day in court as a condition of doing business.

(Jonathan Weil is a Bloomberg View columnist. Follow him on Twitter.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.