By: Clare Tanner, Paul F. Donahue
The current turmoil in financial markets has led to an increase in disputes involving financial institutions. Parties may have entered into transactions in better times with little consideration given to the forum in which future disputes would play out. In today’s far more challenging circumstances, the choice of forum may be central to the satisfactory resolution of disputes.
In some areas, it is common for disputes involving financial institutions to be resolved through arbitration. The Financial Industry Regulatory Authority (FINRA) is the largest self-regulatory organization, i.e., non-governmental regulator, for all securities firms doing business in the United States. (FINRA’s rulemaking, however, is subject to approval by the Securities and Exchange Commission (SEC).) Both individual and institutional customers can require a FINRA member to arbitrate disputes. Indeed, most, if not all, securities broker/dealers will refuse to do business with customers who do not agree to arbitrate disputes. Disputes between FINRA members may also be submitted to arbitration.
The financial crisis has resulted in a dramatic increase in the number of cases referred to FINRA arbitration. In 2007, slightly more than 3,000 arbitration cases were filed. In 2008, the number was almost 5,000 and the upward trend has only increased in 2009. The number of cases filed in January 2009 was double that of a year earlier.
An award handed down by a FINRA tribunal last month, arising from transactions in auction rate securities, illustrates the enormous magnitude of disputes arising from the financial crisis and the speed with which they can be resolved through arbitration. The FINRA tribunal ordered Credit Suisse Securities USA LLC, a brokerage unit of the Swiss bank, to pay $400 million to its customer STMicroelectronics NV, a European semiconductor maker. STMicroelectronics claimed it had authorized Credit Suisse to make investments in top-rated securities backed by U.S. Government guaranteed student loans, but instead the funds were invested in collateralized debt obligations some of which were backed by sub-prime mortgages. The entire process including 28 hearing sessions over two months took just under a year. Any court proceeding would undoubtedly have taken far longer. Nonetheless, STMicroelectronics, according to the award, incurred more than $4 million in legal fees during that time.
While FINRA members can be compelled to arbitrate customer disputes and most require their customers to agree to arbitrate disputes, other financial institutions have traditionally been reluctant to commit to arbitration and have preferred to submit disputes to national courts. Some of the risks and benefits associated with arbitration as a means of resolving disputes involving financial institutions can be illustrated by reference to FINRA’s procedures.
Confidentiality
As is common with arbitration, FINRA arbitrations are confidential. The evidence submitted and procedural and substantive hearings are not open to the public. Although FINRA arbitral awards are made public, that is the exception, not the rule for most arbitrations unless the parties agree otherwise. FINRA awards are not necessarily fully reasoned and may simply amount to a requirement that one party pay as was the case in the STMicroelectronics case. Under a recent rule approved by the SEC, however, beginning next month, if both parties request it, FINRA arbitrators will have to give an “explained decision,” i.e., “a fact based award stating the general reasons for the decision” but which need not include legal authorities or damage calculations.
Confidentiality can be a significant attraction of arbitration as it avoids both financial institutions and their institutional clients airing their dirty laundry in public. In current markets, disputes may give rise to a damaging loss of confidence in the financial institution. Equally, even if sophisticated institutional customers feel they have been misled by a financial institution, they may wish to avoid public allegations that they share some responsibility or may not want detailed aspects of their financial dealings laid open to public scrutiny. In disputes between sophisticated commercial enterprises, the risk of adverse publicity is seldom limited to one party.
Arbitration will not be appropriate where a financial institution seeks to establish a legal precedent that will be publicly available. Only a court ruling can provide that and, of course, it can be a double-edged sword.
The Tribunal
FINRA’s arbitration rules for customer disputes generally provide for a three-person tribunal with one “industry member” and two independent members. Under a rule change effective at the end of this month the size of cases to be decided by a single arbitrator will increase to $100,000. Three-arbitrator panels are intended to provide both industry knowledge and experience while also protecting the customer’s interests, but some have criticised such panels as too industry friendly. Under a pilot program now underway for 400 cases, several securities firms have agreed to have panels made up of three independent arbitrators. FINRA’s approach may not be appropriate in all cases and, for example, the arbitration rules of the London-based City Disputes Panel provide that the tribunal will usually consist of a legally qualified chairman and two experienced financial services practitioners.
Given the complex and technical nature of modern financial products, there may be a significant advantage in decisions being reached by tribunals with necessary expert knowledge. Both financial institutions and their institutional customers may prefer such a tribunal to the vagaries of a jury trial in the U.S. The speed at which law and market practice change are such that, even in jurisdictions where disputes may come before an experienced judge, a tribunal made up of industry experts may still be preferable.
Procedure
Recent rule changes have sharply curtailed the ability to obtain a summary determination of a dispute in FINRA arbitrations. The loss of the opportunity of having a frivolous claim dismissed at an early stage may be unattractive for respondents and correspondingly attractive for claimants in those jurisdictions where summary determination is only available to a claimant. However, expedited procedures are available by agreement between the parties in both FINRA arbitrations and in other arbitral rules. Equally, the absence of, or restrictions on, wide-ranging discovery exercises and pre-trial depositions found in FINRA and other arbitral rules may mean that, even without a summary determination, arbitration is still more attractive than litigation through national courts.
Finality
The ability to challenge an arbitration award is usually strictly limited and FINRA arbitration is no exception. The attraction of a final award is that the cost and risk associated with any given dispute can be more easily judged. The prospect of a defaulting party endlessly prolonging the proceedings while attempting to protect assets against enforcement is greatly diminished as is the prospect of a successful party deciding to settle simply to end the bloodletting.
Enforcement
Many financial transactions will have an international element, as illustrated by the STMicroelectronics case. A party may be reluctant to commence proceedings in the home court of the other party fearing “home advantage.” Even if the parties agree to resolve disputes in the courts of a neutral state, many national courts will not permit parties to “manufacture” jurisdiction and simply will not hear such cases. Even when they do, the successful party still faces the cost and difficulty of enforcing that judgment in another country.
Arbitration awards made in a country which is a party to the 1958 New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards can be enforced in any other Convention State, by the local court giving effect to the award as if it were a court judgment. This is subject to limited, mostly due process, exceptions.
Conclusion
Arbitration is not a panacea — as with litigation through the courts, expense and delay can be features of arbitration — but there are advantages for disputes between financial institutions or between financial institutions and their institutional clients, particularly where there is an international element. Even parties who did not commit to arbitration at the outset may still agree, after a dispute has arisen, that arbitration is a more suitable dispute resolution mechanism. A failure to consider arbitration may leave parties at a disadvantage and, of course, it is always best to make the decision at the outset, before disputes arise.
