An Arbitrary Process? : Most disputes between investors and brokerages go to arbitration. But skeptics see signs that the arbitrators’ links to Wall Street--not the evidence--are dictating the results.
The cases could hardly have been more similar.
Lawyer Stuart C. Goldberg filed so-called simplified arbitration cases before the Pacific Stock Exchange on behalf of 135 small investors who had lost money in the same series of Prudential Securities oil and gas limited partnerships. His office computer cranked out boilerplate pleadings, each making the same allegations, differing only slightly in detail. Each case was decided only on the documents, without a hearing.
Yet the results could hardly have been less similar.
Charlotte Stone of Sarasota, Fla., an 82-year-old widow who lives on her limited investment income, lost her case, receiving nothing. Margorie McCreight Jones, a divorced mother of four who had no investment experience and needed the money to support her children, also got nothing. In a two-sentence decision, the arbitrator in the Orange Park, Fla., woman’s case said the claims were “unproven.”
But James Stuart-Stevenson, the 30-year-old owner of a construction company in Bellingham, Wash.--and an experienced investor--fared better. The arbitrator who decided his case found Goldberg’s documents so compelling that he awarded Stuart-Stevenson not only all his out-of-pocket losses but also interest, attorney’s fees and punitive damages--a total of $31,736.
Do these wildly differing results show that when investors take brokerage firms to arbitration, the outcome can be, well, arbitrary?
The stock exchanges that supervise arbitrations contend that the system is basically fair. But Goldberg, who practices in Austin, Tex., contends that arbitration decisions may have much less to do with the principles of justice and the facts at hand than with who decides them.
In the 69 of his 135 cases that had been decided as of June 9, the investors lost 29, collecting nothing. Damages were awarded to investors in 40, but the results in those cases were not consistent. In 33 instances, arbitrators awarded interest as well as reimbursing investors for their out-of-pocket losses. In 20, they awarded attorneys’ fees. And in 15 cases, such as Stuart-Stevenson’s, they found Prudential’s conduct so egregious that they also awarded punitive damages.
The arbitrators who awarded nothing, Goldberg says, tended to be those with close ties to the securities industry--or those who were career arbitrators so dependent on their income from arbitration cases that they could not afford to alienate securities firms by ruling in favor of customers.
“The single factor that was most important in determining the results of these 69 securities arbitrations was the background of the arbitrators and not the facts of each case,” Goldberg said.
So erratic were the outcomes that, the lawyer said, he has reached a tentative agreement with Prudential to resolve the remaining cases.
“I decided to settle rather than play roulette,” Goldberg said. The terms of the accord prohibit him from disclosing what, if anything, his clients will receive, but, Goldberg said, “I’m very pleased.”
Since a landmark Supreme Court ruling in 1987, most customer disputes with brokerage firms go to arbitration instead of to court. But the arbitration system has come under increasing fire lately as being unfair, with investors’ attorneys charging that arbitration decisions often are mercurial or openly biased in favor of brokerage firms.
Last year, the National Assn. of Securities Dealers, which handles the lion’s share of brokerage-firm arbitration cases, appointed a task force headed by former Securities and Exchange Commission Chairman David S. Ruder to look into the complaints and recommend changes. Its report is expected by the end of this year.
In interviews, law professors and experts on arbitration said that in any decision-making forum--including juries in court--the human factor means different people may reach different conclusions about the same set of facts.
But courts have procedures and legal principles that at least aim at producing consistency. The experts said that if Goldberg’s conclusion is correct, the cases raise questions about fairness and the way arbitrators are selected.
“One of the most central ideas of what constitutes justice is that like cases should be treated alike,” noted John C. Coffee Jr., a Columbia University law professor and expert on securities law.
Richard Ryder, publisher of the Securities Arbitration Commentator, said Goldberg’s set of cases represents a unique test of the fairness and consistency of the arbitration system.
That’s because the claims were virtually identical and because Goldberg used the San Francisco-based Pacific Stock Exchange’s simplified arbitration procedure. The procedure can be used when an investor’s out-of-pocket losses are $10,000 or less. Cases can be decided without live testimony by witnesses; each case is ruled on by a single arbitrator instead of by the usual panel of three.
Because there were no hearings in Goldberg’s Prudential cases, there were no differences in testimony or questions about witnesses’ credibility that could have caused the outcomes of the cases to differ.
Instead, the spotlight was on the arbitrator.
“It is difficult to think of a better sample than this set of cases” for testing whether similar cases yield similar decisions, Ryder said--although he declined to draw any conclusions from the outcomes himself.
Rosemary MacGuinness, head of arbitration for the Pacific exchange, acknowledged that “a huge portion [of each claim] was identical in each case.” But she said the cases differed in “Reasonable people will differ about the same set of facts,” she said.
MacGuinness said the exchange proposed consolidating the cases into groups of the most similar claims, but both Goldberg and Prudential refused. Goldberg said he turned down the offer because consolidation might have meant hearings, requiring investors to fly to California and stay in hotels--potentially costing them more than their investment losses.
In any event, MacGuinness said, there were differences among the group of investors. Some were experienced investors, meaning that they had a greater likelihood of understanding the risk they took in buying into the partnerships. And some alleged that their brokers had made outright misrepresentations about the investments, whereas others did not.
But the exchange, she said, had not made any study of the cases to see if these factors explained the wildly different outcomes.
Goldberg did, in a report for the Public Investors Arbitration Bar Assn.
In the report, he contends that there was no rhyme or reason to the outcomes based on such factors as investor experience, alleged misrepresentations or the investors’ stated investment goals.
Investors who alleged that brokers made blatantly false claims about the partnerships--such as that they had “tremendous past results” and were certain to yield at least 12% per year--got nothing, while some who said their brokers made less exaggerated claims got their money back.
The crucial factor, Goldberg concluded, was the identity of the arbitrator.
For instance, in the case of Stone, the 82-year-old widow, the arbitrator was a former brokerage firm owner, Charles B. Shuford of Redondo Beach. Reached by telephone, Shuford declined to answer any questions, including ones about his background. He said he believes arbitrators should not discuss their cases.
Other arbitrators who awarded investors nothing included lawyers who represent brokerage firms, a professional investment manager and individuals whose spouses or domestic partners were employed by the brokerage industry.
(One who blanked an investor had no apparent ties to the industry. But on the personal background form he completed for the stock exchange, he stated that he had once pleaded no contest to a felony conspiracy charge related to his former occupation as a used-car dealer.)
Goldberg’s study found that the biggest awards to investors were made by arbitrators who had no ties to the securities industry. They included lawyers, a former California municipal court judge, college professors, several people in non-securities-related businesses and a registered nurse.
William T. White, professor emeritus of economics at the University of Nevada at Las Vegas, served as the arbitrator in the case of Frances Kippen, a lawyer who lost money after investing in Energy Income partnerships. White awarded her punitive damages and interest as well as her out-of-pocket losses.
In an interview, White said he was not disturbed that fellow arbitrators had ruled differently in virtually identical cases.
The Pacific Stock Exchange and other arbitration forums, he noted, offer few guidelines on when to award punitive damages, so the result is largely left to the personal views of each arbitrator. And, he said, differences are inevitable when people of different backgrounds consider a case.
The Pacific exchange selects an arbitrator for each case from a list of qualified individuals. Each side gets one peremptory challenge, meaning that it can bump an arbitrator without having to prove that he or she might be biased.
The system is similar for the larger forums run by the NASD and the New York Stock Exchange, which hear the great majority of investor arbitration cases. The key difference is that NASD and NYSE cases are heard by panels of three arbitrators--one who is officially a representative of the securities industry and two who are independent.
Leopold Korins, chairman and chief executive of the Pacific exchange, contends that arbitration decisions are no less variable than court decisions and argues that arbitration works well to resolve disputes speedily.
But, he said, once all of Goldberg’s cases are resolved, the exchange will probably review the outcomes to see if the system needs improvement.
Each of Goldberg’s clients had been persuaded by Prudential brokers to invest in a group of oil and gas limited partnerships known as Energy Income Funds. Prudential aggressively marketed the partnerships to retirees and other small investors, contending that they were safe investments guaranteed to produce high returns.
Instead, nearly all of them produced big losses.
The Energy Income units were among $7 billion worth of loss-generating partnerships that Prudential sold from the early 1980s through 1991, creating the biggest investment disaster in Wall Street history. Prudential settled SEC charges over the sales and admitted criminal wrongdoing in a settlement with federal prosecutors.
But the wording of that settlement allowed the firm to continue to assert in individual arbitration cases that it had done nothing wrong. In six of Goldberg’s cases that Prudential lost, the brokerage firm went to court asking that the arbitration awards be overturned.
A special procedure set up under the SEC settlement to date has paid out more than $750 million to more than 14,000 investors. Goldberg says his clients chose to pursue independent arbitration cases instead because arbitrations--unlike the SEC procedure--held out the possibility of awards for punitive damages and attorneys’ fees.
The SEC process, however, has won high marks for consistency from many investors’ attorneys.
Irving Pollock, the independent court-appointed administrator of the SEC settlement, said he has closely monitored the way claims are handled to make sure consistent standards are applied. About 4,500 claims still are pending.
“I would think that you shouldn’t have two people go into arbitration with the same facts and have different decisions,” Pollock said. “If the arbitrators are competent, you should receive the same results.”
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The Allegations
Lawyer Stuart C. Goldberg leveled the same fundamental charges about the Prudential-Bache Energy Income Limited Partnerships in 135 arbitration cases he filed for clients with the Pacific Stock Exchange:
1. Prudential engaged in a “systematic scheme” to misrepresent the risks of investing. Sales material stated that the partnership units were safe, conservative investments in “proven oil reserves,” but in fact were highly speculative.
2. Prudential sold the partnerships even when the level of risk was inconsistent with the clients’ investment objectives.
3. Prudential gave out misleading information about how earlier partnerships in the group had performed. Much of the money paid out was really investors’ own capital, not profits from oil and gas production.
4. Prudential touted the partnerships as producing “tax-free income,” but the partnerships in fact weren’t set up to shelter income from taxes.
The Results
$31,376
James Stuart-Stevenson, an experienced investor from Bellingham, Wash., recouped his $4,455 in out-of-pocket losses--plus interest, attorney’s fees and punitive damages. The arbitrator in his case was a lawyer with no known ties to the securities industry.
$0
Margorie McCreight Jones, a novice investor from Orange Park, Fla., got nothing from a full-time arbitrator who said the charges were “unproven.” Critics say arbitrators whose livelihoods depend on brokerage cases may hesitate to rule against Wall Street.
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Battling the Brokers
The legal recourse for most investors with grievances against their brokerage firms is to file for arbitration. The odds of winning are roughly 50-50, and the number of decisions has been declining as more cases are settled.
YEAR CASES DECIDED AWARDS IN % IN FAVOR OF FAVOR OF INVESTORS INVESTORS 1988 1,559 742 48% 1989 2,844 1,504 53% 1990 2,187 1,169 53% 1991 1,994 1,033 53% 1992 1,964 1,001 51% 1993 1,617 854 53% 1994 (preliminary) 1,366 642 47%
Note: Figures include investor arbitrations conducted by the National Assn. of Securities Dealers, the New York Stock Exchange, the Pacific Stock Exchange and other securities exchanges. Not included are cases decided by the American Arbitration Assn., which doesn’t disclose such data.
Source: The Securities Arbitration Commentator
