Corporate Law Contract Lawyers SEC Partnership Law Securities Lawyer Contract Attorney Business Law Business Lawyers Operating Agreement Private Placement Memorandum Lawyer Limited Liability Agreement

Understanding the Arbitration Process Can Alleviate Stress, Financial Devastation and Make You a Better Broker

The information contained in this article is intended for informational purposes only and should not be construed as legal advice or a substitution for obtaining legal advice from an attorney licensed in your state. Reading this article is not intended to create an attorney-client relationship. For personal legal advice, please consult an attorney of your choice. Because of the possible unanticipated changes in industry regulations and applicable state and federal laws, the authors and creators and any and all persons or entities involved in any way in the preparation of this article disclaim all responsibility for the legal effects or consequences of the interpretation of the information provided.

You’ve got the usual 100 or so things on your mind as you head to the mailbox after an exceptionally productive day at the office. The new trainee you’ve spent four months coaching is finally starting to earn his keep, a couple of positions are starting to work and the new secretary can actually do two things at once without having a nervous breakdown. Life is good.

You open the box and the interior is loaded with the usual bills, junk mail, your third Pottery Barn catalogue this week and one exceptionally large manila envelope. The return address reads “NASD” and your lunch rolls over in your stomach as you fumble to get your thumbnail beneath the tightly-sealed flap, incurring a nasty paper cut in the process.

You let the remainder of the mail tumble to the ground as you tear open the envelope in anxious anticipation and there, in plane black 12-point courier new type, is your name along with the names of your sales manager and the full name of your firm. After is written the word “Respondents.” You’ve just been named in your first formal client arbitration.

You want to believe it’s a mistake but it’s not. Then you hope it’s for a client who is seeking return of maybe $10,000 to $20,000 in commissions. But the document is about two inches thick and as you fan through pages of incomprehensible legal jargon you realize that you are being accused of breaking every conceivable regulatory and ethics standard known to man, and a few that you think have been made up just for good measure. The only things missing from the charges are double-parking a hovercraft in a school zone and impersonating a custom’s official. When you finally get to the third to the last page you see that the client’s attorney is seeking to recover damages in excess of $250,000.

You spend the next half hour breathing into a paper bag. The office is closed until the morning so you squander the entire evening dwelling on the situation and cursing the day you laughed at your father when he offered to turn the drywall business over to you upon his retirement. But after the shock comes denial, then the anger, and then ultimately, the acceptance. Acceptance, of course, that is punctuated by recurring bouts of shock, denial and anger, but acceptance nonetheless.

Moments before you are about to begin digging your trowel and drywall stilts out of the basement you have a moment of perfect clarity. You resolve yourself to the fact that this has happened to thousands of career brokers and you are no different. You are going to suck it up and take it like a man, and hopefully learn a thing or two about the legal process in the duration.

The fact of the matter is that lots of people in business get sued sometime during their careers and it doesn’t make them bad people. Doctors get sued, as do attorneys, mechanics, handgun manufacturers, wedding planners, gumball distributors and even drywall contractors like dear old Dad. They all live to tell the tale and some of them even walk away better, more confident professionals, having stared legal ridicule in the face and come away with their collective dignities and finances intact, more or less.

The more you understand the dynamics of the arbitration process the more effectively you can react. This strategy is four-fold and will hopefully manage some of the inherent stress, aggravation and expense of being named in a formal client complaint.

Begin by deciding who is going to represent your best interests in the firm’s defense. That’s right, the firm’s defense. First and foremost opposing counsel is going after your firm for damages because they have the deepest pockets and it was their responsibility to keep you operating on the straight and narrow. You however, must be named in the action in order for them to work their case through to its most lucrative outcome. If they filed against you solely their chances of actually recovering alleged damages would be slim to none. If you lost you would have thirty days to pay the judgment or lose your series 7 registration so you would simply relinquish your license, move onto another career and go through life with a massive judgment against you.

By naming the employing firm, and in many cases the clearing firm, opposing counsel understands fully that any judgment they are awarded must and indeed will be paid in the prescribed time frame or the employing firm, or the clearing firm, would have to shut it’s doors. In all probability Bear Stearns or Merrill Lynch is not going to board up their windows and hang up the “Gone Fishin’” sign over a $200,000 hit. They are going to pay in order to stay in business, as they have done many times before, and then seek to recoup financial damages from the next man down on the food chain, typically the registered rep, in accordance with their employment contract.

Obviously, best possible scenario is that you are still employed by the firm named in the complaint so that all named parties can work together as a cohesive unit.

It is the responsibility of the firm’s compliance officer to protect the firm first and you second in any client or regulatory action. Obviously, turning on you is not in their best interest because they ratified and authorized your activities on an ongoing basis and encouraged you to take certain positions in certain stocks at certain times by way of analysts recommendations. By implicating you in any wrongdoing the firm would be shooting themselves in the foot by opening themselves up to the actions of failure to supervise and breach of fiduciary responsibility.

Regardless, it is typically prudent to retain your own counsel, someone who answers to you and you only and who is working to make sure you prevail with as little damage as possible. After all, that’s what legal counsel does, damage control. Get the idea of a “magic wand” defense out of your head.

Legal counsel is best selected on a referral basis and always ask for client references. Find an attorney who specializes in securities matters and one you feel comfortable with. Relationship is everything because this is the person you are going to rely on to not only defend you against a myriad of allegations of impropriety, but also to make sure your reputation, career and earning potential are not compromised in the process.

Ideally this will be the basis for a long-term relationship and hopefully you will not have to shop for another attorney in the near future. Once you lay the groundwork with competent legal counsel you can save time and money in the future should another problem ever rear its ugly head. Have your team in place before trouble comes knocking again.

You should have kept careful notes all along, but in the event you did not, sit down and begin a chronological explanation of everything that occurred throughout the life of the account. Begin with how the client was prospected and include every conceivable detail you can remember, no matter how inconsequential it may seem. You’d be surprised what type of information can be the saving grace in a legal defense situation.

Did the client ever speak about problems with other brokers before? At any point in the relationship did the client suffer from a substantial change in their financial profile that may have created a need to liquidate sooner than initially planned? Did they contact you with trades some of the time? Did they rely solely and exclusively on your advice? Did they ever decline your recommendation to cut losses, participate in a trade or diversify more extensively?

Your goal here is to show whenever appropriate that the client directed the account. You provided advice and they provided decisions. Opposing counsel will almost always attempt to substantiate that you, the broker, were in a control position and that the client was powerless. Without a thorough defense prepared you will be unable to prove otherwise.

The good news is that there are about six common causes of action in an arbitration and you’d better be sure that opposing counsel will attempt to apply all of them. Once you know what they are, you will be in a better position to demonstrate to the panel that you obeyed all pertinent rules and regulations, acted in the client’s best interest and maintained your fiduciary responsibility at all times.

In the eyes of the law, suitability is a primary function of a broker’s duty. It is the responsibility of the broker to know the client’s level of comprehension or trading savvy. The broker should also understand the client’s threshold for absorbing trading losses if things do not go as planned.

In laymen’s terms this means that your client should not have been trading aggressive growth NASDAQ issues under $10 per share unless they had done so previously or had the financial cushion to gamble with. But opposing counsel can claim unsuitability even if your client stuck to the “Nifty Fifty” and the portfolio was padded with four or five different value funds as well. The definition of unsuitability typically varies. The concept however, is always the same; the client was unqualified to participate.

Opposing counsel will claim either that their client was too old, too poor or not experienced enough to be involved in whatever trading strategy the two of you agreed upon. They may further state that the money they invested was earmarked for other essential purposes or that they should have embarked on an income, not a growth or speculation, path.

The most effective way to defend against this particular allegation is going to be your notes or broker log. You must be able to recount to an arbitration panel the fact that several trading approaches were presented to the client and that in the end it was their sole and exclusive decision to embark on a program where they were willing to risk their investment capital in order to achieve higher than average returns.

Also, most account applications have sections where the client must document age, education, risk tolerance and trading experience in order to open and maintain an account. If the client claimed one thing when they opened the account and claimed something contradictory when they filed against you, then this discrepancy must be brought to light. After all, you were actually misled, not the client.

Client files should be updated annually to document any changes in the client’s financial condition or goals. Ultimately, your notes should demonstrate even more detail about your client’s trading qualifications and goals.

Additional Risk Disclosures can save the day as well, if you had one signed early on in the life of the account. The typical language in these disclosures requires the clients to sign off on the fact they understand there is substantial risk involved in what they are doing and that no matter how promising a trading opportunity appears they can lose all or part of what they invest.

This is probably the most vague of all causes of actions, and open to the widest variety of interpretation. How much trading is too much after all?

If a client opens a $100,000 trading account and it increases to $200,000 over the course of a year and they are charged $20,000 in commissions odds are no one is going to complain. But if the market then reverses and the account value drops to $50,000, they have still paid the $20,000 in gross commissions, creating the appearance of churning.

While opposing counsel focuses strictly on the dollar amount spent by the plaintiff on commissions, it is necessary for you and your attorney to show that the trades were executed in accordance with sound logic and with the strictest regard for the client’s well being. The way you traded the account must match with the way you and the client agreed to trade the account at its inception. Also, it is usually beneficial to be able to show the arbitration panel that the commission schedule was fully disclosed and agreed to before the first trade was executed.

If you bought and sold the same stocks in the client’s account repeatedly be sure you can document that the client fully intended to participate in an aggressive day-trading scenario. If you cannot it is all but guaranteed that this aspect of the relationship will come under scrutiny and be used against you by opposing counsel.

If indeed the account was vigorously traded for a period of a year or two, and commissions exceeded $50,000 it may be advisable to hire an expert witness to perform a forensic accounting. An expert or professional witness is an individual who is paid to evaluate all aspects of a particular broker/client relationship and give their informed opinion based on current industry standards and related business parallels. The opinion they render is typically thorough and they may cite other cases in order to substantiate their view.

The client is relying on you as a professional and you have a legal duty to live up to every aspect of that reliance. If you fail to exercise a standard of care imposed by law and owed to another (the client) then you will indeed face problems pertaining to breach of fiduciary duty.

Stockbrokers are expected to conduct due diligence, follow all industry rules and regulations pertaining to the trading of accounts and the solicitation of clients, and to know as much about their products as other stockbrokers. In addition, it is your responsibility to put the client’s interests before your own.

Did you cut losses and let profits run? Were phone calls from the client accepted or did you simply speak to them when you wanted them to trade? Did you ever discount commissions on a subsequent transaction after a losing trade? Did you receive any commission or compensation without disclosing it to the client? Did you attend due diligence meetings on new issues and partake in continuing education courses?

Think long and hard about these questions because they are the same one’s that may come up before an arbitration panel. The best answers are usually short, honest and direct.

Make sure that you can document the fact that every, I mean every, trade was authorized by the client before execution. There is simply no excuse for not doing so. Also be prepared to document conversations you had with clients after the fact and also times when you reviewed account statements and confirmations with your clients.

If you claim that you spoke to a client when indeed you did not, you run the risk of having opposing counsel subpoena phone records from your firm and the phone company. Get caught in one lie and the rest of your defense is automatically weakened. Also, lie to your legal counsel in the process and you will make an already tough job impossible.

State securities statutes demand that brokers make full and accurate representations to potential and existing clients pertaining to exactly what they are buying. Don’t tell a client they are buying an orange if they are buying a tangerine.

Never claim to have specific knowledge about a stock or its movement that is not available to the general public.

Also, if you fail to disclose a material fact that if disclosed would tend to make one or more of your statements “less true” this is fraud.

For example, you make a series of comparisons between an up-and-coming residential homebuilder, and an established homebuilder whose stock is traded on the NYSE. You inform the client that the new homebuilder possesses all the elements that the established company does and you make numerous references to the trading history of the NYSE stock. The stock of the new homebuilder’s company is trading on the NASDAQ however, and is teetering at about 2 _ per share.

You make no attempt to educate the client to the fact that NASDAQ issues are considerably riskier than NYSE issues and that if the stock falls below $2 per share for any period of time it will be moved to the small caps, further compromising the chances of success.

You must be able to demonstrate to the opposition that you gave a fair and balanced presentation before any such trades were executed. Balanced means that for every time you spoke about potential profits you spoke about potential loss.

Breach of contract is an unjustified failure to perform when performance is due. By establishing a trading relationship with a client you are entering into a contract and promising to act as their professional liaison and guide them through the inherent pitfalls of the stock market.

This is not to be misconstrued that you are going to be their guarantor or that they are not going to ever lose money during the course of normal trading activity, but more so that you are going to be there for them in a professional capacity as necessary.

Make sure you are able to illustrate that your level of service was consistent throughout your business relationship with the client.

You have to keep opposing counsel’s motivation in the forefront of your mind at all times when preparing your defense. It is not a matter of what you did or didn’t do but more so how many of their attacks can you fend off over the procedural duration of the arbitration. The more claims they bring against you the more chance they have of something sticking, regardless of what really happened.

If they claim that you overtraded the account then you and your attorney can spend the next twelve months gathering evidence and testimony probably proving that you did not. But if they unload the entire shotgun on you, both barrels probably, you are going to have to fortify your defense on a variety of levels, and your weakest area of defense is what they are going to triangulate on.

However, deprive them of the luxury of being able to take the path of least resistance and they will understand from inception that you intend to stand your ground and fight back using every legal resource available. Attorneys handle multiple cases at any given time, and depending on their professional resources and their belief in the validity of the case and the veracity of their client they may begin to focus their efforts on another case that appears to be less work and more lucrative.

Typically, attorneys that make a career out of bringing arbitrations against brokers don’t do anything else. They run what is little more than a legal “mill” and know the process so intimately that they can draft written complaints in a matter of a few hours and hand off the remainder of the discovery process to young associates or paralegals. They will however step back into the process when it is “go time” and will have their best game on when it’s time to appear before the arbitration panel to make their allegations.

In most cases the plaintiff’s attorney is compensated through a minimal hourly fee they charge to your former client (now their client) but the real payoff comes at the end when the arbitration panel makes their decision or in the event the case is settled somewhere along the way. On the average they receive anywhere from 30% to 40% of what they recover. So just like everyone else, they are dollar-motivated.

You’ve seen the advertisements on late night television, usually around 1:30 a.m. on local access cable stations. They aggressively seek out investors and some even offer to work strictly on contingency, meaning that if they do not recoup damages they do not get paid. These are typically the most aggressive variety of plaintiff attorneys but also the easiest to deal with due to the fact that their motivation is singular.

So in theory, if you can remove the potential payoff, you eliminate opposing counsel’s motivation and the chances that case will either get dropped or settle out for a low dollar figure increases substantially.

If you have left the business and no longer need your series 7 registration, your situation is substantially better than someone who is still in the business. Typically, plaintiff’s attorneys only invest time into a case they know they can collect on. No one works for free, especially attorneys. If an action is brought against a broker who is no longer in the business then opposing counsel is going to collect from the sales manager or “24”, the employing firm, and possibly the clearing firm. Simply stated, anyone still holding a license.

If the firm is out of business, which is an increasingly common scenario these days, they are left with the option of going after the “24” who may or may not still be in the business at another firm, and the clearing firm. It is not as easy for them to prove their case against the “24” since he did not directly handle the account, and the clearing firm invariably has a staff of attorneys so large that the average plaintiff’s attorney has a better chance of holding the ocean back with a broom than they do of winning their case. Also, because the clearing firm has the “big guns” there is little chance they are going to settle out for any substantial sum.

That leaves opposing counsel with the prospect of going after a broker who has left the business, and probably has little or no assets aside from the equity in their primary residence, which is protected by Homestead laws. In order for opposing counsel to recoup damages in this scenario they must win their case, and then begin legal proceedings to perfect the judgment in the state court where the broker named in the arbitration lives. The claimant must then begin the long and laborious collection process, spending more money and more time in the process. Statistically, this doesn’t happen.

If you are in this position though, be prepared for the fact that you may indeed have a judgment on your credit history for the next ten to twenty years (terms vary from state to state) if opposing counsel decides to traverse the gamut and see the arbitration process the entire way through.

On the average the broker named in the arbitration is still employed with the original firm when the process is initiated. It is essential that your attorney works in lockstep with the firm’s compliance officer and legal counsel to make sure that everyone is on the same page. Even the slightest hint of in-fighting or inconsistency recounting the facts is going to fuel the fire and exacerbate what can possibly be a simple and painless occurrence.

You should judge the dollar amount that opposing counsel is seeking to recoup and factor that in with attorneys costs and lost production. The general rule of thumb is that if any complaint can be settled out for less then $10,000, do it. Ultimately, it is up to the parties named in the arbitration to make this decision, preferably together.

Make every possible attempt to settle the case out early on before it grows to encompass more and more of your time, since time is a valuable commodity that you can never get back. The best solution is typically to face the music and get things over with. Invariably, opposing counsel and the plaintiff will accept a smaller settlement now as opposed to rolling the dice on a larger one later. A bird in the hand is worth two in the bush, so on and so forth.

Mediation can be a simple and cost effective option for settling complaints as well.

Mediation can be formal or informal. If the formal variety is selected the NASD will provide a mediator to provide potential solutions. If the informal form of mediation is selected all concerned parties and their legal counsel will meet in open forum in an attempt to talk things out and reach a settlement.

Either form is non-binding and confidential. However, to be an effective settlement tool mediation should be taken just as seriously as an arbitration and it is still essential that you plan your legal strategy with as much attention to detail as if you were going before an arbitration panel. It is also recommended that you attend with counsel present, especially if the other side intends to.

An arbitration panel in theory is supposed to be a consortium of both industry and public professionals who can make a fair and impartial decision based on the facts of the case. They have all completed certain filing requirements and passed a test as well and are paid for their participation in the proceedings.

But you will probably not find a former producing broker amongst them. They are generally attorneys, accountants and individuals from other semi-related fields who have decided to take part in the process. Regardless of whom the panel is comprised of, do not expect a sympathetic audience. You are starting from the jumping off point that the only knowledge they have of you is what they have read in the initial client complaint and the series of responses and interrogatories that have been filed by your firm and your attorney.

You are also up against the traditional negative stereotype that the entertainment media and society as a whole has created about stockbrokers.

So the ugliness has come to a close in either one of four ways: you have been released from the proceeding somewhere throughout the process; the claim has been settled out; the panel has ruled you committed no wrongdoing; or the panel has ruled that the client is entitled to reparations.

If you have been released from the proceeding somewhere along the way it means that the panel has decided that the client may have a basis for their claim but that you had nothing to with what occurred. You can get back to business with a clear head knowing that you conducted yourself properly while plying your trade and that this came through in your defense.

In the event your firm has reached a settlement with the client you two must now come to an agreement as to what portion of the settlement you are financially responsible for. Traditionally, brokers are responsible for a portion of the settlement and are permitted to make payments back to the firm over a period of time. However, conditions for handling debts owed by the broker to the employing firm are typically spelled out in the broker’s employment contract. The manner in which this money can be repaid to the firm is infinite and typically open to negotiation. Work it out with your firm but try to make sure that it is your gross commission that goes toward paying the hit, not what you net.

If the arbitration runs its course completely and the panel rules that that the client’s assertions have no merit, once again it is business as usual for you.

If the panel concludes that you are indeed guilty of one or more of the allegations they will then decide the financial reparations that must be made to the client. Once the panel sends notification of its decision to the respondents, the respondents have 30 days to make reparations unless otherwise agreed. Once again, you must work out the details of paying your firm back.

The two things that must be kept in mind is that the decision of the arbitration panel is final and can only be appealed for very limited reasons. Also, the complaint is now a permanent part of your professional record (with certain exceptions) and is reportable on your U-4 for the rest of your career.

The exceptions being if you are about to be released from the case by the panel, if you are settling out with the client or if the panel decides you committed no wrongdoing, you have a chance of having your record expunged. Simply stated, that NASD will still have records of the fact that you were named in the action but this will not be reported on your CRD if a background search is initiated at a later date.

Whatever the outcome of the arbitration, treat the occurrence as a learning experience. If any adjustments need to be made to your business, then by all means make them. If you made mistakes then face facts, accept your share of the responsibility and don’t make the same mistakes twice. Move on, be a better broker and hold yourself to the highest professional standards.

“Knowledge is Power” Sir Francis Bacon once said. Nothing, I mean nothing, is truer than in the instance of defending one’s self in a client arbitration. Don’t just react, act. Think logically and apply your mental resources in a cohesive manner.

Most importantly, remember at all times that the arbitration process is not designed to crucify brokers for doing their job. It is intended to give the broker as well as the client the opportunity to tell their side of the story.

Laura Anthony is the founding partner of Legal & Compliance, LLC, a corporate and securities law firm specializing in securities & regulatory matters, business transactions, commercial litigation and entity formation. She is also a member the NASD Dispute Resolution Board of Arbitrators and can be reached at 800-341-2684; by e-mail at LauraAnthonyPA@aol.com or contacted through the company’s web sites http://www.LegalAndCompliance.com and http://www.MyWebLawyer.com.

[back to top]

<< back to Articles

Contact Us Immediately For a Second Opinion or Free Initial Consultation

Laura Anthony, Founding Partner e-mail: lanthony@legalandcompliance.com	800-341-2684 fax: 561-514-0832
Legal & Compliance, LLC 330 Clematis Street, Ste. 217 West Palm Beach, FL 33401	Legal & Compliance, LLC 940 Lincoln Road, Ste. 319 Miami Beach, FL 33139

[back to top]