June 9, 2014
I am the immediate past FINRA Director of Arbitration, having retired in 2013. I submit this comment with respect to SR-FINRA-2014-005 (Notice of Filing of Partial Amendment No. 1 and Order Instituting Proceedings to Determine Whether to Approve or Disapprove a Proposed Rule Change, as Modified by Partial Amendment No. 1, Relating to Broadening Arbitrators' Authority to Make Referrals During an Arbitration Proceeding). I previously submitted comments on this rule. I repeat them below and also address the specific questions raised by the Commission in its May 20th notice. For the reasons articulated below I believe the proposed rule should be approved.
VIEWS WITH RESPECT TO QUESTIONS RAISED BY COMMENTERS ABOUT THE POTENTIALLY ADVERSE CONSEQUENCES OF THE PROPOSAL FOR RETAIL INVESTORS WHOSE CASES MAY BE DELAYED OR DISRUPTED BY A MID-CASE REFERRAL
First, the existing rule provides that arbitrators may make referrals only at the conclusion of an arbitration. The plain meaning of the rule is that arbitrators can make referrals only when the arbitration case is concluded -- no matter how potentially serious a problem they find. And, indeed, this is what arbitrators are trained to do. The proposed rule would strike the "only at the end of the case" limit, but only in the most serious circumstances requiring immediate attention in the interest of investor protection. Specifically, the proposed rule permits mid-case referral of a matter or conduct which the arbitrator has reason to believe poses a serious threat, whether ongoing or imminent, that is likely to harm investors unless immediate action is taken.
Some critics of the rule express concerns about how disruptive the proposed rule would be to an individual clamant in an arbitration where a mid-case referral is made by the arbitrators. These fears are misplaced. First, as I have said publicly before, this rule is intended to be used when it's "Send in the swat team - NOW" time. Second, the rule references information discovered at a hearing. FINRA routinely reviews case pleadings, and arbitrators are specifically instructed by the rule not to make referrals based solely on allegations in the statement of claim, counterclaim, cross claim, or third party claim. Third, the referring arbitrator will not automatically be removed from the case. And fourth, the proposed rule permits arbitrators to hold off on the referral if the case is almost over and investor protection wont suffer because of the delay.
WOULD THE PROPOSAL ADVERSELY AFFECT RETAIL INVESTORS? IF SO, HOW?
Naturally, the possibility exists that a pending arbitration will be impacted by a mid-case arbitrator referral. For example, a party may challenge the referring arbitrator(s). Although the rule is structured such that a challenge of this nature will likely not be successful, it takes time to process the challenge. And there is a chance the challenger might go to court to seek a stay of arbitration, although such an effort would likely fail. Or, a challenged arbitrator might decide to withdraw from the case, resulting in time spent replacing that arbitrator. It is also possible a case might be postponed due to a mid-case referral.
But as a practical matter, is the proposed rule likely to cause actual harm to investors? I think not. If in fact a major fraud is in the process of unraveling, that individual arbitration is a ticking time bomb. Sooner or later, the fraud will blow up the case - read: frozen assets - meaning it is very unlikely the case will be concluded and the investor claimant paid before the fraud is discovered on its own. But of course, with each passing day the investing public is subject to an ongoing fraud. And if by some chance the individual case results in an award that the fraudster actually pays, there's a good chance those funds would be subject to a subsequent "claw back" effort.
SHOULD FINRA PROPOSE A DIFFERENT STANDARD FOR REFERRAL? IF SO, WHAT STANDARD(S) WOULD BE APPROPRIATE?
In my opinion, with the exception of two minor changes suggested below, the proposed standards are appropriate. FINRA has made strenuous efforts to craft a rule that balances its investor protection mission with the interests of the very, very rare individual claimant whose case may be disrupted by the rule. We must understand that, although this rule would very rarely be used, it needs to be in place. Imagine if you will an arbitrator coming into credible proof of massive investor fraud - in other words, another Madoff situation. The current rule says the arbitrator cannot refer the matter until the case is over. With each passing day, the investing public is exposed to an ongoing fraud. The proposed rule addresses this problem.
I offer two minor suggested improvements that would simplify the rule. First, to address concerns about referrals being lost in the shuffle, I propose elimination of that part of the rule providing that the President of FINRA Dispute Resolution or the Director of Arbitration have sole discretion to evaluate the referral and forward it to the regulatory or enforcement arms of FINRA for further review. Referrals should not need intermediary evaluation, and one can hardly imagine senior FINRA officials not passing along a referral. Second, I propose eliminating that part of the rule that states "If a case is nearing completion, the arbitrator should wait until the case concludes to make the referral if, in the arbitrators judgment, investor protection will not be materially compromised by this delay." The term "nearing completion" is vague, and requiring the arbitrator to decide whether delay will not materially compromise investor protection in my opinion invites uncertainty and inconsistency.
DOES PARTIAL AMENDMENT NO. 1 AMELIORATE COMMENTERS CONCERNS THAT NOTIFYING PARTIES OF A MID-CASE REFERRAL COULD LEAD TO ADVERSE CONSEQUENCES TO THE CLAIMANT, INCLUDING REQUESTS FOR RECUSAL AND CHALLENGES TO AN AWARD? IF NOT, SHOULD FINRA AMEND THE PROPOSAL TO PRECLUDE THE DIRECTOR, OR ANYONE ELSE, FROM NOTIFYING THE PARTIES OF A REFERRAL?
I believe the proposed rule as amended ameliorates the commenters concerns. A party aggrieved by an arbitrators mid-case referral should be required to quickly make any challenge, or forfeit that right. I do not believe the referral should be kept from the parties. While a court challenge to a referring arbitrator based on the fact of the referral will very likely fail, a challenge based on failure to disclose invites a successful attack on the award (see, e.g., Commonwealth Coatings Corp. v. Continental Casualty Co., 393 U.S. 145, 150 (1968), where the Court held that an arbitrator "must disclose to the parties any dealings that might create an impression of possible bias").
As I said in my prior comment letter, I agree this rule will hardly if ever be used. But if it more quickly terminates just one massive investor fraud, it will be worth it. Like Homeland Security, FINRA and the SEC cannot afford to be 99% effective. The investor protection mission of both organizations demands approval of this rule.