Why It's Hard to Fight Brokers

Mad as hell over losses? You can go to arbitration, but the deck will be stacked against you.

By David Landis, Contributing Editor

From Kiplinger's Personal Finance magazine, April 2009

In her stage act, Tissa Hami, a stand-up comic who was born in Iran, boldly skewers stereotypes about her ethnicity and her Muslim religion. (Those who disapprove will be taken hostage, she jokes.) But when it comes to her finances, Hami, 36, tends to be cautious. For years, she kept her savings in a money-market account, unwilling to accept any amount of investing risk. But frequent, unsolicited entreaties from advisers in a San Francisco branch of discount broker Charles Schwab ultimately wore down her resistance. In early 2007, she agreed to invest $50,000 in Schwab Yield Plus, a mutual fund described to her as a low-risk but high-yielding alternative to a money-market account.

It was anything but. The fund had a substantial stake in securities backed by subprime mortgages. Its share price began to plummet in March 2008, and it ended up losing 35% for the year. By the time Hami dumped her shares, she was out $13,000, a devastating loss for someone who earns only about $20,000 annually. "I feel like I was totally duped," she says.

Hami is preparing to sue Schwab to recover her losses, but her case is far from a slam-dunk. For starters, she can't go to court. Like most other investors with a brokerage account, she is required to take disputes to a private arbitration system created by the brokerage industry itself. And while the Financial Industry Regulatory Authority, the agency that runs the arbitration system, insists that the process is fair to all parties, investor advocates have long contended otherwise.

Finra's own statistics show that before ticking up in 2008, the proportion of investors who won monetary damages had been declining for years. And even when investors do win, they may recover only a fraction of their losses, according to a recent study. (Arbitration will do little for victims of Bernard Madoff's alleged Ponzi scheme because most were not customers of Madoff's brokerage. Rather, they invested directly in Madoff's money-management unit or were clients of other money managers who invested with Madoff.)

What it takes to prevail

Even so, the volume of new arbitration cases has been rising lately, as it typically does when markets tank. But you won't get much sympathy from arbitrators if you simply complain that your broker should have recommended better-performing stocks and bonds. To win, you must show that the broker engaged in some type of misconduct. Some of the most common cases are those in which brokers mislead investors, fail to act in an investor's best interests or choose clearly unsuitable securities (see the diagram on page 42 for the most common allegations).

Allegedly unsuitable investments are an issue in a case involving Edward Marnell, 85, and his wife, Jean, 84, of Pleasanton, Cal. The Marnells are bringing an arbitration case against a Morgan Stanley broker for investing $100,000 from the sale of their house in three auto-industry bonds and a Sears Roebuck structured note, which is similar to a bond. Jean suffers from Alzheimer's disease, and she and her husband, who depend on Social Security and veterans' disability payments, were looking for a low-risk source of additional income. Instead, they lost $30,000.

Finra says navigating its arbitration system is easier than going through the courts because its system allows more leeway in making damage claims than the law does. It is also cheaper and quicker, says Linda Fienberg, president of Finra's dispute-resolution system, because the process places limits on certain types of motions and decisions can't be appealed, except in extraordinary circumstances. The average case takes 16 months to close; court cases can stretch on for years.

Handling small claims

But the system can be challenging for investors, such as Hami and the Marnells, who lose relatively small amounts. If you claim damages of $25,000 or less, you can pursue a do-it-yourself case. In such a case, you make your argument in writing, and a single arbitrator decides the issue. Filing fees range from $50 to $425, depending on the amount of damages sought.

But even in these small-claims cases, you will face a well-trained lawyer representing the other side. So it helps to hire your own legal counsel. Unfortunately, many lawyers find it unprofitable to handle claims of less than $100,000. A small network of legal clinics run by law schools in California, Illinois, New York and Pennsylvania will take on small-claims cases for people with incomes of up to $100,000 (depending on the clinic). But local clinics are limited in their ability to help residents of other states (see www.sec.gov/answers/arbclin.htm for more details).

The Investor Justice Clinic at the University of San Francisco agreed to take the cases of Hami and the Marnells. If you, too, go the clinic route, prepare to be patient. Law students will handle the bulk of the legal work, and that may mean long periods of inactivity during their summer break. On the plus side, clinic director Robert Talbot and his students don't charge for their services.

If your losses are big enough to interest an experienced lawyer, the Public Investors Arbitration Bar Association can hook you up with a securities-law expert. But lawyers' fees could claim as much as 40% of any settlement you win. Plus, you'll have to shell out your own money for such expenses as hiring expert witnesses. Filing fees range up to $1,800, and there are hearing fees as well. All of these costs add up to serious money.

Tilted playing field?

Investors seeking compensation of more than $50,000 face another hurdle: Their cases must be heard by a panel of three arbitrators, at least one of whom must come from within the industry. (A new rule, soon to take effect, calls for one public arbitrator to hear claims of less than $100,000 unless all parties request three arbitrators.) Finra says the industry arbitrator can ensure that the two public members of the panel understand the sometimes complex rules under which brokers operate. But investor advocates say the rule tilts the playing field toward brokers. "A lot of times, the public arbitrators look to the industry arbitrators to give them advice because of their so-called knowledge of what goes on," says Theodore Eppenstein, a New York securities lawyer.

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