June 27, 2000
The Honorable Arthur Levitt, Jr. Dear Chairman Levitt: We are writing with reference to the enclosed report by the U.S. General Accounting Office (GAO), Securities Arbitration: Actions Needed to Address Problem of Unpaid Awards (GAO/GGD-00-115, June 15, 2000), which was prepared at our request. The report is based on information collected from the Securities Arbitration Commentator, Inc., the Securities and Exchange Commission, NASD Regulation, Inc. and its Office of Dispute Resolution, the New York Stock Exchange, and the American Arbitration Association. This report discusses (1) whether arbitration forums have implemented recommendations made in GAO’s 1992 report, Securities Arbitration: How Investors Fare (GAO/GGD-92-74, May 11, 1992), and assessed the effectiveness of the changes; (2) how investors fared in securities arbitration award decisions; and (3) the extent to which investors were paid the amounts awarded by arbitration panels. Simply put, the GAO reports that the present arbitration system is deeply flawed, largely because of unpaid awards. A. Status of 1992 Recommendations In a 1992 report, GAO found no indication of a proindustry bias, but concluded that SRO-sponsored forums lacked internal controls to provide investors with reasonable assurance that arbitrators were independent and competent. GAO recommended that the SROs develop standards for selecting arbitrators, verify information submitted by arbitrators, and establish specific training for arbitrators. The 2000 GAO report found that NASD and NYSE have made changes to their arbitration programs that are responsive to the 1992 recommendations (Chapter 2, pp. 18-22). According to GAO, "these changes appear reasonable, and NASD and NYSE evaluations have shown that the changes have improved both the process and investors’ perceptions of its fairness" (p. 44). However, GAO notes that, according to SEC officials, "the sole purpose of the evaluations is to assess arbitrator performance" (p. 22) and, according to NASD officials, getting participants to complete the evaluation forms has been extremely difficult for the forums over the years. The January 1996 Arbitration Policy Task Force Report recommended that NASD make a greater effort to improve participants’ response rate (p. 21). We agree. For 2,037 cases closed by hearing between December 1, 1997, and April 1, 1999, the response rate varied from 10 to 20 percent. Of the parties responding, 93 percent indicated that their cases were handled fairly and without bias (p. 22, and NASD Regulation comment letter at p. 68). But without a better response rate, it is difficult to have confidence in this conclusion. B. Findings of the 2000 Report and Our Reactions The GAO report found that there has been a significant decline in the percentage of arbitration awards that favor investors (Chapter 3, pp. 23-32) and a significant increase in the number of unpaid awards (Chapter 4, pp. 33-43). GAO warns: "The securities industry, its regulators and Congress should be concerned about the extent to which arbitration awards are unpaid. Regardless of how effective and fair the arbitration decision process may be, unpaid awards could negatively affect investors’ confidence in arbitration." (p. 44) We emphatically agree. GAO’s principal findings regarding unpaid awards are: 1. On the basis of its survey of investors who received arbitration awards during 1998, GAO estimated that 49 percent of the awards were not paid, and an additional 12 percent were partially paid (p. 33). 2. An estimated 61 percent of investors who won arbitration awards in 1998 either were not paid or received only partial payment. This percentage rises to 64 percent, if only NASD cases are considered (Table 4.1 at p. 34). 3. GAO also estimates that these investors did not receive $129 million or 80 percent of the $161 million total awarded in 1998 (pp. 33, 34). The unpaid awards included an estimated $55 million of unpaid awards for punitive damages. About $13 million, or 8 percent of the unpaid awards, were still being disputed in court through such actions as a motion to vacate or modify the award (p. 5). Table 4.2 on p. 34 shows that larger awards are less likely to be paid than smaller awards. 4. Nearly all of the unpaid awards involved arbitration cases decided in NASD’s arbitration forum (p. 33). The number of completely unpaid NASD awards was estimated to be 410, representing nearly all (99.7 percent) of the 411 unpaid awards in all forums. Partially paid NASD awards numbered about 95, comprising most (94 percent) of the 101 partially paid awards for all forums. GAO estimates that 52 percent of the 786 NASD customer awards issued in 1998 were completely unpaid, 12 percent were partially paid, and 36 percent were paid in full (p. 36). 5. The most frequently mentioned reasons for nonpayment or partial payment were the broker-dealer was out of business (53 percent); the broker-dealer claimed to be financially unable to pay the award (32 percent); an individual broker (associated person) owing part or all of the award could not be located (28 percent); or the broker-dealer had filed for bankruptcy (21 percent) (p. 35). 6. GAO found that 504 NASD awards made in 1998 were either not paid or partially paid, but NASD records showed that it only received written complaints of nonpayment in 142 cases. GAO’s survey respondents said that they complained to the forum in an estimated 71 percent of the cases, or about 360 awards. This number vastly exceeds the 142 cases in which NASD records contained a complaint letter. Similarly, SEC officials told GAO that they received far fewer complaints about unpaid awards than the estimated 34 percent reported by the GAO sample respondents (p. 36). GAO concluded that the discrepancy may indicate that many unpaid investors do not complain to NASD or that NASD responds only to written formal complaints and not to telephone calls. Thus, nonpaying brokers may continue to operate with no action being taken (p. 38). We believe that this discrepancy needs to be investigated and resolved and better recordkeeping systems implemented and maintained. Procedures for filing a complaint should be clearly spelled out to investors. 7. GAO found that NASD did not routinely monitor the payment of awards to ensure that it took timely action against nonpaying broker-dealers (p. 33). After an NASD arbitration panel renders an award, NASD sends copies of the award to the claimant and the respondent, including a cover letter noting that all monetary awards are to be paid within 30 days of receipt, but then takes no further action unless investors complain (pp. 36-37). NASD officials told GAO that helping investors by attempts to enforce payment might give the appearance of favoring one side in arbitration over the other (p. 37). This is bunk. We agree with the following comments by GAO: "Although remaining neutral is important to help maintain the credibility of an SRO-sponsored forum, ensuring that investors are paid arbitration awards is an important part of maintaining their confidence in arbitration. Some pro-active actions can be taken that would not affect NASD’s position" (p. 37). 8. GAO reports that investors who complained to NASD had some success in collecting their awards when NASD initiated suspension proceedings against the nonpaying broker-dealers after receiving complaints (p. 33). NASDR writes that it acted on all 142 investor complaints about nonpayment of 1998 awards. NASDR action resulted in 40 percent of the awards being paid or otherwise settled to the investor’s satisfaction. In 12 percent of the cases, there were valid reasons for nonpayment, such as a petition to vacate the award or a bankruptcy filing by the member. In the remaining 48 percent of the cases, NASDR terminated the member for nonpayment of the award, thus protecting other investors from further risk of nonpayment of awards by these members (NASDR letter at p. 67). 9. GAO found that the primary cause of unpaid arbitration awards was broker-dealers and individual brokers who were no longer in business and had left the securities industry. NASD’s arbitration program had no procedures to help investors deal with these failed broker-dealers (p. 38). NASDR pointed out that investors did collect their awards in over 90 percent of the NASD cases involving active member firms (NASDR letter at p. 67). 10. GAO’s survey respondents identified 65 broker-dealers that had failed to pay at least one award. NASD officials reported that 13 of these broker-dealers were still active, while 52 went out of business after they had been expelled, suspended, terminated, or canceled from NASD membership or liquidated. According to NASD information, 25 of these broker-dealers were known to conduct business in microcap stocks. All 25 of these microcap broker-dealers were among the 52 identified as no longer in business. GAO’s survey also identified 15 individual brokers that respondents indicated had not paid awards. GAO did not have enough information on them to accurately identify the individuals and determine their status (p. 38). 11. GAO notes that SEC and the SROs have education programs to help investors understand the potential risks of dealing with broker-dealers that are undercapitalized, financially irresponsible, or unscrupulous, but these programs have not included data on the extent of award nonpayment. We agree with GAO that publicizing such data might better focus investor attention on the possibility of unpaid awards associated with doing business with these broker-dealers. We also agree that encouraging investors to use the Central Registration Depository to more thoroughly evaluate the background of a broker-dealer or individual broker could help investors who are considering opening brokerage accounts to avoid doing business with potentially troublesome brokers (p. 39). Every effort should be made to make this information easily accessible on the Internet. We are attaching to our letter a summary of GAO’s other findings, some of which raise additional concerns about how investors fare in arbitration. C. GAO’s Recommendations and Our Response Based on these findings, GAO recommends that SEC require NASD to adopt procedures for monitoring the payment of arbitration awards. Such procedures should include requesting the parties in an arbitration to notify NASD, by the end of the 30-day payment period, about the payment status of any monetary award, so NASD can begin timely suspension proceedings against nonpaying broker-dealers, as appropriate. GAO also recommends that SEC require NASD to develop procedures addressing the problem of unpaid awards caused by failed broker-dealers to help reduce costs and increase options for investors. GAO recommends that the SEC work with the SROs to (1) develop and publicize information to focus investor attention on the possibility of unpaid arbitration awards and (2) encourage investors to more thoroughly evaluate the backgrounds of broker-dealers and individual brokers with whom they intend to do business. Lastly, GAO recommends that SEC periodically examine the extent of nonpayment of SRO arbitration awards to determine the effectiveness of actions taken to improve the payment of awards. To the extent unpaid awards remain a problem, the SEC should establish a process to assess the feasibility of alternative approaches to addressing the problem of unpaid awards. We agree with these recommendations and urge their prompt adoption and respectfully request a progress report in six months. The SEC, NASD, and NYSE generally agreed that the GAO report revealed a potentially serious problem with the nonpayment of arbitration awards and agreed with GAO’s recommendations to address this problem (pp. 5, 9, 45-48, and Appendices IV-VI at pp. 66-77). Further, NASDR’s comment letter advises that ODR will take the following additional steps to address the issue of unpaid awards: 1. Propose to the NASD Board and the SEC a rule amendment that a firm that has been terminated, suspended, or barred from the NASD, or that is otherwise defunct, cannot enforce a pre-dispute arbitration agreement against a customer in the NASD forum. 2. Propose to the NASD Board and the SEC a rule amendment to provide streamlined default proceedings where the terminated or defunct member or associated person does not answer or appear, but the claimant affirmatively elects to pursue arbitration. 3. Advise claimants in writing of the status of a firm or associated person (e.g., terminated, out-of-business, bankrupt) so they can evaluate whether to continue with arbitration (p. 67). We agree with these undertakings and respectfully request a progress report in six months. GAO reports that some attorneys who have represented investors in securities arbitration have proposed other methods to ensure that investors are paid their arbitration awards. Their proposals include: first, providing for payment of unpaid arbitration awards from SIPC funds; second, establishing a separate SRO-sponsored fund to cover the compensatory damages part (actual investor losses) of unpaid arbitration awards; and third, increasing the funds available to brokers to pay arbitration awards by increasing net capital requirements or requiring additional bonding or insurance to cover malpractice claims. SIPC officials, SEC officials, SIA and other industry officials opposed these suggestions (pp. 40-43). GAO concluded that these alternatives "raise policy issues that warrant careful consideration and resolution before they could be effectively implemented" (p. 44). If the SEC, the SROs, and the industry are not able to address the problem of unpaid awards effectively, we may need to consider these and other proposals as necessary and appropriate for the protection of investors. The SEC Director of Market Regulation notes in your agency’s comment letter:
We commend this initiative and respectfully request to be informed of its outcome. Both the GAO report (p. 31) and recent press reports, "You asked for it. Here comes truly independent securities arbitration. Bring your wallet," Barron’s, June 5, 2000, pp. 30, 31, note that, in January 2000, the Securities Industry Conference on Arbitration (which includes representatives from both sides of the arbitration wars) started a 2-year cooperative pilot program to give brokerage customers the option to use non-SRO forums to arbitrate disputes. NASD, NYSE, other SROs and seven retail brokerages have committed to participate. The two non-SRO forums are AAA and the Judicial Arbitration and Mediation Service. Without any cases under its belt, and with concerns raised about comparative costs, the pilot program’s success will not be known for at least a couple of years. We also commend this initiative and respectfully request that the SEC and SICA monitor it and maintain data on the pilot program that can be accessed and evaluated by future Congresses. In closing, we commend the SROs for the changes that they have made to improve the efficiency and fairness of their arbitration forums. But to stop there would elevate form over substance. If the defrauded investor who has lost his life savings receives zilch of his arbitration award, it is small consolation that the process that produced this abominable result was fair and efficient. Thank you for your cooperation and attention to this important issue. We look forward to working with you to improve the current system. Sincerely, JOHN D. DINGELL EDWARD J. MARKEY Enclosures (Staff Summary, GAO Report)
STAFF SUMMARY OF OTHER GAO FINDINGS
1. The number of arbitrations in SRO-sponsored forums has averaged about 6,400 cases a year since 1992 (p. 14). 2. The NASD and NYSE arbitration forums decided most of the cases that were arbitrated during 1992 through 1998. For example, NASD’s arbitrators decided 1,428 cases, or 92 percent, of the total 1,552 customer-initiated arbitration cases in 1998. NYSE decided 90 cases, or 6 percent of these cases (p. 24). 3. In 1992, GAO reported that 59 percent of investors received favorable decisions in cases arbitrated from January 1989 through June 1990. This percentage declined to an average of about 51 percent for cases decided from 1992 through 1996 and increased to 56 percent in 1997 and 57 percent in 1998 (Figure 3.1 at p. 24). 4. In 1992, GAO reported that investors who had favorable decisions received an average of 61 percent of the dollar amount they claimed. This percentage declined to an average of about 51 percent during 1992 through 1998, ranging from a low of 46 percent in 1994 to a high of 57 percent in 1997 (Figure 3.1 at p. 24). 5. Regulatory officials attribute the decline in arbitration results favoring investors to a corresponding increase in the percentage of cases settled. In 1992, GAO reported that settlements occurred in 44 percent of SRO cases and 33 percent of AAA cases. In 2000, GAO estimates that between 1992 and 1998, the percentage of cases settled ranged from 43 percent in 1992 to 50 percent or greater for the years 1993 through 1998, reaching a high of 60 percent in 1997 (p. 24). 6. GAO found that investors were 23 percent more likely to receive a favorable decision at NASD between 1992 and 1998 than at NYSE. Investors received favorable decisions in an average of about 54 percent of the cases at NASD during this time period as compared with 45 percent at NYSE. The percentage of all cases decided in favor of investors in 1998 at NASD was 57 percent compared with 50 percent at NYSE. Of the 34 cases decided at the other forums, 15 favored investors (p. 25 and Table 3.1 at p. 26). 7. GAO reports that a number of factors affected case outcomes and the size of the award (pp. 26-28 and Appendix II pp. 52-59). GAO’s analysis indicated that investors were 27 percent more likely to receive an award if an attorney represented them. Investors filing claims that included more than compensatory damages, such as punitive damages, interest, or various fees, were more than twice as likely to receive an award. Cases that involved a higher number of hearing sessions were also more likely to be decided in favor of investors. Investors were 43 percent more likely to receive a favorable decision if the broker-dealer did not file a counterclaim. Investors’ chances of receiving a favorable decision decreased from 1992 to 1995 but have increased since 1995. In 1998, investors were 33 percent more likely to receive a favorable decision than they were in 1995. 8. GAO reports that investors who received a favorable decision at NASD were 45 percent more likely to receive an award in excess of 50 percent of their claim than investors who received favorable decisions in other forums. Investors with attorney representation in cases occurring at any forum were 30 percent more likely to receive an award greater than 50 percent of the amount claimed (p. 27). Large claims were less likely than small ones to win sizeable awards. Claims involving $10,000 to $100,000 were only roughly 60 percent as likely as smaller claims to win sizeable awards, and claims involving more than $100,000 were roughly 27 percent as likely as smaller claims to win sizable awards (p. 57). 9. Investors claimed punitive damages in about 20 percent (317 cases) of the 1,552 total cases decided in 1998. This percentage was less than the 28 percent GAO reported for cases decided by SRO forums in 1992. Arbitrators awarded punitive damages in 107 cases, or about 34 percent of the 317 decided cases in which investors requested such damages. This was a significant increase from the 12 percent GAO reported in 1998 (p. 29). 10. Investors claimed reimbursement for attorney fees in about 10 percent (148 cases) of the 1,552 total cases decided in 1998. This percentage had decreased considerably from the 30 percent GAO reported in 1992. Investors received attorney fees in 100, or 68 percent, of the 148 cases in which they claimed such fees. This percentage was considerably more than the 17 percent GAO reported in 1992. Arbitrators also awarded attorney fees in 44 cases in which investors had not requested such fees (p. 29). 11. In 1992, GAO analyzed the results of 248 AAA investor-initiated, securities-related awards from the period December 1989 through June 1990 and compared them to SRO-sponsored arbitration results, as an indication of the fairness of the arbitration process. GAO found no significant differences in case outcomes. GAO could not make the same comparison for this report because AAA’s securities caseload declined significantly and no longer provided a meaningful comparison. From 1992 through 1998, AAA averaged only about 35 such awards a year, ranging from a low of 20 awards in 1998 to a high of 49 in 1996. Investors received favorable decisions and large percentages of their claims often in the early 1990s and then both results declined through the years, until 1998 when investors received favorable decisions in 50 percent of the cases (down from 88 percent in 1992) and received 13 percent of their claims (down from 79 percent in 1992) (Table 3.5 at p. 31). 12. As in 1992, the results in arbitration and court cases are not comparable because of the inherent differences in the processes and their respective outcomes and the small number of litigated cases. Of the 121 securities-related disputes between individual investors and their broker-dealers identified by GAO at five federal district courts, 15 (12 percent) were decided in court, 11 in favor of the investor; 22 (18 percent) were settled by the parties before a court decision; and 85 (70 percent) were dismissed for various reasons. The average time to litigate the 15 cases was 930 days and the median time was 1,151 days (p. 32). GAO concluded that "the high dismissal rate of securities-related court cases may indicate that, in general, investors have not fared better in court" (p. 44).
| |
|
 |
 |
 |
 |
 |
 |
 |
 |
