A new study suggests that the securities arbitration system is seriously flawed, because it's unfair to retail clients. It's an argument that has long been made by investor advocates, of course, and even some securities lawyers and state regulators. William Galvin, Secretary of the Commonwealth of Massachusetts, has said that arbitration is “an industry sponsored damage-containment and control program masquerading as juridical proceeding.”

But is it really? The NASD says the system works well and points out that most cases are settled before going to a panel. That may be true, but in January, this magazine pointed out that the arbitration system is failing to stay true to its original intent: to serve as a fast, fair, and relatively inexpensive way to adjudicate disputes before an impartial panel. In fact, the average arbitration now costs thousands of dollars and takes more than a year-and-a-half to be resolve — rather more like a real court case.

A new study published in June is adding a further complaint: that retail brokerage clients are winning fewer arbitration cases and recovering less money when they do win. In short, the report suggests that the scales are tipped heavily in favor of the industry — particularly wirehouse firms. The study, entitled “Mandatory Arbitration of Securities Disputes: A Statistical Analysis of How Claimants Fare,” is based on analysis of 13,810 NASD and New York Stock Exchange securities arbitration cases heard from January, 1995, to December, 2004.

The percentage of investors winning arbitration disputes has dropped significantly in recent years from a high of 59 percent in 1999 to 44 percent in 2004, says the study. This includes a lower win rate (39 percent) at the three largest brokerage firms as of 2002 — Merrill Lynch, Smith Barney and Morgan Stanley — with a win defined as any case where cash is awarded. The average size of an award also slumped to 22 cents per dollar claimed in 2004 from 38 cents in 1998.

“Individual investors who are compelled to rely on industry run securities arbitration to resolve their claims against stockbrokers are winning fewer cases and earning less money in the process,” says Edward O'Neal, Ph.D, principal with Securities Litigation and Consulting Group and the primary researcher in the study. “The study shows that individual investors fare particularly poorly if they have large claims or are customers of large brokerage firms.”

Claimants in arbitration against the top 20 brokerage firms faced an estimated recovery rate of 28 percent for claims under $10,000 but for claims that exceeded $250,000 the recovery rate dropped to 12 percent, according to the study.

O'Neal argues further that a “win” can be a very subjective term, in that if an investor makes a $100,000 claim and is awarded only $5,000, can that really be considered a victory? Based on that logic, he believes the win rate to be much lower than what is reported.

What does it all mean? “It's time to change the composition of the arbitrator pools,” says Jacob Zamansky, of Zamansky & Assoc. “A bunch of old white men should not be serving on virtually every arbitration panel.”

Not the Whole Picture

The study has roused plenty of critics, who believe the arbitration system is working perfectly well. Wirehouse firms and regulators say the study fails to account for the arbitration cases that are resolved through settlement. “The vast majority of arbitration cases are settled by mutual consent — indicating satisfactory resolutions for the investors involved and illustrating the effectiveness of the arbitration forum,” says NASD spokeswoman Sarah Bohn.

In 1995, 47 percent of customer cases were settled, while 53 percent went to award. Today, more than 70 percent of arbitration cases settle through mediation or through direct negotiation between the parties, with only 20 percent going to award, according to data provided by NASD.

NASD's Bohn adds that recovery statistics used in the study are artificially low, as it's not uncommon for claimants, at the hearing, to reduce the damages sought. “It is problematic to presume that all claims filed are actionable and that each claimant is entitled to 100 percent of the requested damages,” Bohn says. In other words, perhaps not all cases have merit.

Attorneys for customers aren't buying it, of course. The reason for the greater number of settled cases, Zamansky says, is that customers are too scared to go through the arbitration process. The debate will definitely continue.