The stupidity of free-market chic ... in the stock market.

The Stupidity of Free-Market Chic . . . . . . in the Stock Market

Julia and Eugene McMahon never saw it coming. They were in a dark restaurant one evening with their "financial adviser" from Shearson/American Express, when she handed them a piece of paper to sign. "It's just red tape to open a brokerage account," the adviser told them. Even in the light of day, the McMahons wouldn't have read through the tiny print and understood the clause that was to win them a place in judicial history. They didn't know a lot of things that day. They didn't even guess that this nice woman who had befriended them in church would betray their trust and invest their retirement savings in dicey options trading, or that she would reap $200,000 in commissions as they lost $500,000.

Nor did they know that the document they signed that day in New York robbed them of the right to take their adviser to court. The sneaky little phrase, "the parties are waiving their right to seek remedies in court, including the right to a jury trial," is buried in a finely printed litany of boiler-plate lingo. As the McMahon's lawyer, Theodore Eppenstein, noted dryly in a congressional hearing, when five congressmen could not find the clause in his clients' agreement, "I'll give you a hint. It's not on the first page."

Brokers prefer to gloss over the issue of disputes and forced arbitration when clients are preparing to trust them with their money. "We are told by investors that time and time again brokers advise them that the agreement does not have to be gone over with a fine-tooth comb, that it is just like opening a bank account," says Eppenstein. How many customers would balk if they fully understood when they signed such agreements that their only recourse to any broker shenanigans--including fraud--is an arbitration panel run by the broker's peers?

Of course, when there are disputes, arbitration can be a worthy alternative to a long, drawn-out court trial, but not the way it is currently practiced in the brokerage business. Moreover, the Supreme Court, hoping to unclog the courts, has barred investors from seeking justice there. Although the Securities and Exchange Commission (SEC), which oversees brokerage firms, has recently proposed a number of reforms for securities arbitrations, these reforms do not go far enough. The deck is still stacked. Arbitration decisions are still mysterious and final. And for all its bravado, the SEC does not have the power to ensure that arbitrators are even following the law, and if they aren't, to undo their decisions. So much for investor protection.

Unfortunately, fraud is not a rarity in securities cases. All too often, the files of customers wiped out through options trading or margin accounts contain falsified documents. Forged signatures on margin agreements and wildly inflated net worth and income figures let brokers "churn and burn" in investments that are crazy for widows, orphans, and many other small investors. Take the case of a young widow from rural Tennessee. She was 41 with a 14-year-old daughter when her husband died. His life insurance policy paid $50,000. She turned over that money and the $10,000 equity in her house to Chris Hodges, a young Paine Webber broker in Tampa, Florida. The widow, a secretary, was impressed with Hodges's M.B.A. and certified financial planner title. Besides, her sister knew him.

At first Hodges played it safe, investing her money in municipal bonds. Then he switched her account into over-the-counter stocks and finally to one stock, Syntech. His next move was to margin her investment to the hilt by borrowing against the stock she held to buy more. It doesn't take a rocket scientist to figure out that no one of her modest means and in her precarious circumstances should invest in only one stock and never, ever, with borrowed money.

When the October 1987 crash came, the inevitable happened: the widow from Tennessee was wiped out, her life savings and her daughter's college education both gone. According to Stuart Goldberg, a Danbury, Connecticut lawyer who argued her case before an arbitration panel last July, the signature on the margin account was forged and the customer profile "X'd" out. The broker, says Goldberg, had originally bought the stock for his own account, and when it started dropping in price dumped it into his clients' accounts rather than take the hit himself. To dispose of it all, he had to margin the accounts. His supervisors at Paine Webber never said a word. "They were too busy playing with their seeing-eye dogs," says Goldberg, a former assistant U.S. attorney, SEC enforcement attorney, and New York Stock Exchange (NYSE) assistant director, who has won two other cases against Paine Webber for Hodges's misdeeds. "But the real fraud is that Paine Webber made her go through two years of arbitration after admitting they owed her the money."

As things stand, arbitration is an investor's only avenue for redress. The U.S. Supreme Court has ruled that, whether or not customers read or understand what they sign when opening a brokerage account, it is a binding contract. Furthermore, the customer agreements stipulate that any disputes will be resolved by arbitrators who are members of the securities industry and chosen by the stock exchanges. Talk about getting snookered!

Anyone not willing to play by those rules gets shut out of the market. "You cannot open an account without agreeing to arbitrate," said David Robbins, an attorney, arbitrator, and former New York special deputy attorney general. Rep. Edward J. Markey likens it to the following car transaction: "Imagine buying a car, having engine trouble, and then reading in your sales contract that you are forced to go to the Car Dealers Association of America to resolve your grievances. Imagine further your outrage when you discover you can't even own the car unless you agree to arbitrate your claim with the car dealers. . . . I know of no equivalent procedure where the forum itself is a self-regulatory organization of which one party of the dispute is a member."

That's the sorry plight of thousands of brokerage house victims since June 1987, when the Supreme Court voted 5-4 to deprive investors of the chance to air their charges publicly in a courtroom before a jury. Behind the closed doors of arbitration hearings, as the customer agreements explicitly state, "the arbitrators' award is generally more limited than and different from court proceedings."

As it turns out, the chance of recovering even some of the loss is less than one in four. In NYSE arbitrations, customers win 50 percent of the time, but only half of those who win recover even some of their money. And forget punitive damages and legal fees. Arbitrators' awards are all but impossible to appeal. The prospects for overturning an unfavorable award are equivalent to a "snowball's chance in hell," says Robbins.

The Supremes' bad record

When handing down the decision that locked brokerage clients out of the courts, Justice Sandra Day O'Connor, the author of the majority opinion, tried to reassure investors that they would get a fair shake in arbitration. Justice O'Connor acknowledged that mistrust of the arbitration process had underlined the law since the 1958 Wilko v. Swan decision, which held that an agreement to arbitrate a Securities Act claim could not be enforced. But that "is difficult to square with the assessment of arbitration that has prevailed since that time," she wrote in the landmark McMahon v. Shearson decision, which overturned the Wilko case. It appears that the Court's primary motivation for the decision was to reduce the caseload burdening the federal courts. Yet, in 1986--the last measurable year that investors had access to the courts--fewer than 2 percent of the approximately 250,000 civil cases filed in federal courts were securities-related.

Not everyone on the High Court felt so sanguine about abandoning the commitment "to protect investors from predatory behavior of securities industry personnel," as Justice Harry A. Blackmun wrote in his dissenting opinion. Concern for investor protection had been the cornerstone of the securities laws so carefully crafted in the early 1930s to restore confidence in the stock market. Four of the nine justices worried that even the perception of a rigged grievance process violated the goals of those laws. While there have been improvements in the arbitration system, Justice Blackmun wrote, "The uniform opposition of investors to compelled arbitration and the overwhelming support of the securities industry for the process suggest that there must be some truth to the investors' belief that the securities industry has an advantage in a forum under its own contorl."

How, then, did the Court justify its dramatic about-face in McMahon? It appears that the majority justices were swayed by a "friend of the court" brief filed by the Reagan-appointed SEC. That agency had done its own flip. Only four years earlier, the SEC had instituted rules requiring brokerage firms to clearly disclose to their customers that, despite any predispute arbitration language in their agreements, investors had the right to take their brokers to court for any violations of the federal securities laws, such as fraud. But in 1987, over strenuous staff objections, the SEC suddenly reneged on its duty to see that investors are protected. Instead, the commission sided with the brokerage industry, arguing that arbitration was the best means for settling differences. It also assured the Court that it was fully in charge of overseeing the exchanges and could "insure" the fairness of industry-subsidized arbitrations.

Fairness is certainly not what M. K. "Pete" Peterson is finding in his ongoing two-year arbitration hearing. "I don't think my panel could fairly arbitrate a game of checkers," says Pterson. Peterson claims his broker at Rauscher Pierce Refsnes, Inc. in Dallas ignored an explicit order from him three days in a row in September 1987 to cover certain puts (options to sell stock at a fixed price within a specified time) on his Sun Co. stock. When Peterson checked back several weeks later and discovered his order had not been carried out, he complained to the branch manager. He was still holding the options when the market crashed, causing him to lose $800,000.

But his treatment by Rauscher Pierce pales in comparison to his treatment in his subsequent New York Stock Exchange arbitration. "It's like a rape case. The rape victim is on trial and the rapist goes free," says Peterson.

On the first day, four of the five arbitrators, before even hearing the facts of the case, called peterson a "speculator." The chairman told Peterson, "I don't like your personality. But I'm not going to use that to judge you." He interrupted Peterson's expert witness, saying, "I don't think we want to learn law. I am an engineer. I want to stay an engineer." Reviewing the testimony of Peterson's hearing, Robbins, a great advocate of arbitration, stated that such belligerence is out of line. He also said that the majority of the arbitrators had acted contrary to the code of the Arbitrator's Manual. "What troubles me most about your arbitration," wrote Robbins, "is the arbitrators' apparent prejudgment of an important issue (and voicing that prejudgment on the record) and the manner in which the Chair is conducting the proceeding."

Despite such clear evidence of bias, the NYSE has adopted a laissez-faire stance in the Peterson case that is symptomatic of all that's wrong with securities arbitration. When two of the arbitrators voluntarily dropped out, the NYSE offered replacements. One, Peterson rejected outright. But the day of his next scheduled hearing, there was only a four-member panel and Peterson refused to continue. The NYSE said it would find a new arbitrator for the next day.

When Peterson arrived at his hearing, he found the same arbitrator he had just rejected. "Obviously, they are trying to wear me out. They're hopping I'll die or go crazy," says the 71-year-old Peterson. But he vows, "I'm going to fight this travesty to the bitter end if it kills me. Not just for myself but for all those poor retired people who have no one to speak for them."

Home court advantage

Since McMahon, investor rights advocates have focused on challenging the way investors are coerced into arbitration agreements and on attempting to knock out the bias inherent in the industry-subsidized system. "Arbitration as a concept is phenomental. But the way it is being administered now certainly has the earmarkings that it is biased," says Harvey Bell, an arbitrator and former Arkansas state securities commissioner. Attorneys Robbins and Goldberg maintain that the pool of arbitrators used by the NYSE is in large part to blame for the pro-industry slant. "They can play with the best rules in the world, but if the umpires are crooked, it doesn't matter," says Goldberg.

Lawyers for brokerage houses say that industry representatives who understand the products and practices of Wall Street are essential to the arbitration process. But that is only half the story. There are plenty of educated people outside the brokerage industry who understand puts and calls. What the NYSE really is doing is slipping industry arbitrators into the mix as "public" representatives. Panels are composed of three or five arbitrators, with one or two members of the industry, respectively. But real life is different. Eppenstein recently filed a case before the NYSE and all three arbitrators were pro-industry, although two were designated "public" arbitrators. Familiar with the NYSE's arbitration practices, Eppenstein discovered that two had sat on nine arbitration panels in the past year and each had ruled in favor of the investor only once. The third, who was in the nonindustry category, was called a "financial consultant" and revealed that he had a relationship with Philadelphia Capital Advisors. The NYSE maintains that since the third arbitrator derived less than 20 percent of his income from his consulting activities, he does not qualify as an industry representative.

Picking the right arbitrators is crucial to the outcome of the case. Brokers know this well. They have been keeping their own tallies of how arbitrators vote for years. But because decisions weren't released by the exchanges until last year, it was extremely difficult for plaintiffs' attorneys to obtain the same information. Many not experienced with arbitration still don't know the ropes.

Renard Chrobak, a disabled worker from Arkansas, found himself in front of blatantly biased arbitrators in his hearing against a broker from Edward D. Jones & Co. Chrobak's broker had rolled the dice and lost his $35,000 workman's compensation from a factory accident that rendered him unemployable. In typical fashion, the three-member panel was composed of one industry representative and two public arbitrators.

One of the "public" arbitrators was Harvey Bell, the former Arkansas state securities commissioner, who believes he was put on the list of arbitrators in the mistaken belief that he was a former broker since he had once taken the broker-dealer exam. The other was the chairman of the panel, an attorney, who failed to disclose that 90 percent of his income, according to Bell, came from work he performed for brokerages. In discussions with Bell, the chairman "acknowledged that Mr. Chrobak would probably recover in a jury trial, but he was going to vote no award." Bell was so shocked by the overt prejudice that he filed a rare, and controversial, dissenting opinion. Chrobak, he concluded, did not receive a fair and impartial hearing.

Fixing the brokers

A number of relatively easy changes could render arbitration a more level playing field. Including on each panel a former judge or an attorney knowledgeable about the rules of evidence would ensure orderly proceedings. Also needed are procedures for making brokers deliver all relevant documents in their files under pain of forfeiting the judgment. But the brokerage community resists change. After all, there's a lot at stake. That's why the industry continues to pour out the bucks to finance a protective lobbying on-slaught.

Critical for the brokerage business are the bottom-line costs--legal, PR, and of course, financial--of highly public court battles. The simpler arbitration process keeps litigation costs at a fraction of what it would take to fight a lawsuit. And in a forum they control, brokers expect to fare better than they would at the hands of a jury or an independent forum such as the American Arbitration Association (AAA). The brokerage industry is fighting the inclusion of the AAA as a possible arbitration choice for investors. "It isn't arbitration they want. It's pro-[brokerage] industry decisions," says Goldberg.

The lobby appears stronger then ever. For instance, last year the Massachusetts government wrote rules forbidding brokers from refusing to do business with clients who would not agree to arbitrate. Sixteen other states were ready to follow that lead. The Securities Industry Association argued successfully that Massachusetts's regulations conflicted with McMahon. And once again, the Supreme Court flashed its pro-arbitration bias, refusing to rule on the case and effectively freezing the states' securities commissioners out of an important role in consumer protection. Stunned by the court's anti-investor attitude, Barry Guthary, Massachusetts's state securities chief, says, "The tenacity of the industry in this issue is overwhelming."

Reps. Markey, John Dingell, and Rick Boucher attempted to rectify this situation with a bill in the last Congress but were forestalled by then-SEC chairman David Ruder, who called for a study of the issue due the day after Congress adjourned. The lawmakers say they intend to reintroduce the issue. Meanwhile, Dingell, chairman of the powerful Telecommunications and Finance Committee, which oversees the SEC, has asked the General Accounting Office to prepare a report on how arbitration is conducted.

Perhaps most suspect is the SEC. In 1985, the SEC declared a hands-off policy on arbitration. In response to a query by Dingell to look into a bizarre arbitration ruling, the SEC wrote: "The Commission has no authority to review a specific arbitration to assure either compliance with the procedural or accurate interpretations of underlying federal securities law or other claims by the arbitrators." In 1987 the SEC assured the Supreme Court in the McMahon case that the arbitration process was "fair." Six months after that, the SEC announced a flurry of detailed recommendations to improve the arbitration process. Only some of these were adopted, others were watered down, and none have any teeth. The entire exercise is a testament to the kind of window-dressing reforms that characterized Reagan's Washington. They fell short of helping the little investor, other than making him feel he would be better off. But they succeeded in what was perhaps the true intent: protecting Wall Street's wealth.

A key area targeted by the SEC was the arbitrator. "The absence of clear guidelines for qualifying public arbitrators . . . and the inclusion in the pool of public arbitrators of persons with clear affiliations with the securities industry is a source of great concern," said Richard Ketchum, the SEC's Director of Market Regulation.

In the changes finally adopted a year ago by the National Association of Securities Dealers, the New York, American, and other stock exchanges, the pool of public arbitrators was purged of any member, spouse, lawyer, or accountant who worked on Wall Street. However, a former broker need have quit the business only three years earlier (five at the NYSE) in order to qualify as a public arbitrator. Thus, an inexperienced investor could easily end up with a panel consisting of one arbitrator who is currently working in the securities business and two others who retired from it in 1987.

Despite the new screening and the availability of slightly more detailed biographies of arbitrators, the investor is still at a disadvantage. The NYSE permits an investor to arbitrarily reject only one of the judges assigned to any panel. Any other challenges must be made on the grounds of conflict of interest, and even then the NYSE has been known to refuse to grant them.

A more subtle problem, say attorneys, is the growing cadre of professional arbitrators. Some arbitrators in the pool essentially make their living off the $250 per day arbitration fee. "If you're an arbitrator and you do it for a living, who do you want to get a reputation for supporting? The little guy who'll come before you once in your lifetime or Shearson?" asks Neal Brown, a Boston attorney. "The plaintiff is going to get a list of arbitrators and he doesn't know them from Adam. You can bet your life that Shearson and the others know every person on that list." According to Robbins, to get that same information, a plaintiff's attorney preparing for an NYSE arbitration would waste dozens of billable hours sifting through every decision made by every arbitrator, kept, unindexed, only at the exchange.

Many of the exchanges' lists of arbitrators are in dire need of an infusion of new blood. An energetic recruitment campaign with thorough training for all prospective arbitrators would substantially broaden the pool and produce arbitrators as informed as industry representatives but free of their allegiances. It is painfully obvious from Peterson's case that the NYSE does not have a big enough pool of untainted arbitrators.

Much of the bad reputation of securities arbitration could be repaired by simply allowing all investors the option to go to the independent AAA--a proposal actually made by the SEC last spring but still not enacted. Biographies and backgrounds are more carefully screened by the AAA, say lawyers. More important, challenges to the slate of arbitrators designated for any case at the AAA are unlimited. In a recent arbitration case, for example, Theodore Eppenstein found only two arbitrators from a list of 30 that he considered acceptable. It took five months, but as Eppenstein says, "The ability to select a panel of arbitrators that you're happy with is well worth the wait."

At present, though, not everyone with a problem can take it before the AAA. Only customers whose agreements specifically include the AAA are guaranteed entry. Although Eppenstein pioneered a loop-hole in the contracts of customers at American Stock Exchange brokerages that permits them to go before the AAA's arbitration panels, it is being challenged in several courts.

Not surprisingly, the brokerage industry opposes the AAA as a choice for its customers. Investors seem to fare better at the AAA, winning about 60 percent of the time. Dean Witter spokesman Jim Flynn says, "We don't find that it's administered well." But then, Dean Witter recently lost an embarrassing case before the AAA in Florida.

The Securities Industry Association (SIA) pays lip service to the notion of including the AAA in customer agreements. Says William Fitzpatrick, general counsel of the SIA, "It's a question of perception. We get hammered by the press and people in government that we're not affording a choice." Yet the SIA's true attitude is probably more accurately revealed in a letter to the SEC last June, in which it argued against offering the AAA option to its customers. "The industry wants to be able to have better control of the outcome of arbitration. It's as simple as that," said Robert Dyer, an attorney in Florida. In a rare defeat for the brokerage industry, the Trial Lawyers Association in Florida pushed through a new law effective in October making it mandatory for brokerage houses in that state to offer customers the option of an independent arbitration.

Writing wrongs

A key reform on which the SEC just plain buckled was the issue of providing wronged investors with the kind of written opinion they could expect from a court of law. Not even the AAA issues written opinions. "I think the fundamental problem [with arbitration] in terms of perception is that people don't know the basis for the decision," says Guthary, the Massachusetts state securities chief. In lieu of written opinions the SEC suggested that arbitration boards make available a summary of the legal issues, the outcome, and the amount of any awards. Still unanswered is how the arbitrators reach their decisions.

Such explanations seem fundamental in a system that allows virtually no grounds for appeal and in which an NYSE arbitrator's training in the law consists of an evening seminar and a 44-page manual. "Arbitrators can make mistakes on the law. Even if they're using the wrong law, it can't be appealed," says Brown. Investors at the NYSE can obtain an opinion, if they request it in advance--another example of rigging the system in favor of the industry: "People usually don't request an opinion until after the case," says Edward W. Morris Jr., NYSE arbitration director. A request at that stage is easily turned down. Of course, a better solution would be to expand the right to appeal.

A quick look at the statistics shows the SEC's improvements haven't had much of an impact. According to Richard Ryder, publisher of the Securities Arbitration Commentator newsletter, arbitrations award investors about 15 percent of the total claims, just as before the new rules. "They don't seem to have shifted the scale at all, which may tell us the decision process hasn't changed in the least," says Ryder. One hopeful sign is that arbitrators are beginning to award punitive damages in the most egregious cases. Ryder says there were 11 such awards in the first three months of 1990, compared to 10 for all of last year.

Still, it is doubtful that the flaws in securities arbitration will be eliminated as long as the brokers are in charge. If the American Stock Exchange and the NYSE were fired from the arbitration business and independent organizations such as the AAA put exclusively in charge, arbitration could become what the securities industry advertises: fair, speedy, and far less costly than court trials. Investors would gladly opt for it in all but the largest cases. But given the octopus grip the securities industry has on its regulatory bodies, only Congress can make it happen. Congress must sum up the courage to restore the investor's bill of rights--to allow him to sue in court or select an arbitration forum of his choice and to have a means of appeal. Only then will small investors return confidently to the capital markets.

Carolyn Friday is a correspondent in Newsweek's Boston bureau.