Beyond the brokerage fee: the hidden cost of investment through brokerage firms - due process protection.

• Author: Covaleski, Paul

1. INTRODUCTION II. BACKGROUND A. The Development of FINRA B. FINRA's Authority C. FINRA's Arbitration Process and Judicial Involvement 1. FINRA's Arbitration Process 2. Judicial Review of FINRA Awards and Procedures D. Connecting Individual Investors to FINRA Arbitration Through Pre-Dispute Arbitration Clauses III. ANALYSIS: DUE PROCESS DEPRIVATIONS IN FACT A. Judicially Created Due Process Deprivations B. Why FINRA's Processes Fall Short 1. Lack of Transparency 2. FINRA May Not Provide a Right to a Hearing 3. FINRA Arbitrators Have Too Many Interests to Remain Completely Impartial C. Balancing Interests: Can FINRA's Current Enforcement Regime Be Justified? D. Forcing Investors Into FINRA's Arbitration Process IV. RECOMMENDATION A. Overturning McMahon B. Removing Dispute Resolution From FINRA's Authority V. CONCLUSION I. INTRODUCTION

   Millions of Americans rely on individual brokers or brokerage firms to invest their money hoping to better support their families and eventually retire. For the many Americans unfamiliar with investment strategies, a broker may be the only means of accomplishing these goals. While most investors are willing to pay a reasonable brokerage fee to increase the likelihood of a return, investors entering into brokerage contracts must also sacrifice a substantial possession beyond the fee: their basic due process rights should the deal sour.

   The reason for this, at its simplest, is that investors entering into brokerage contracts are forced to sign pre-dispute arbitration clauses. The Financial Industry Regulatory Authority (FINRA) is responsible for all dispute resolutions involving brokers, and as a private entity, FINRA is not required to abide by governmental due process guarantees. Thus, the individual investor signing a brokerage contract is simultaneously signing away his due process protections.

   This Note examines the development and effectiveness of FINRA's regulatory regime, as well as the due process rights it curtails. In doing so, it not only outlines the potential due process deprivations of FINRA's dispute resolution mechanisms, but also explores how these deprivations have already occurred in practice. After concluding that these deprivations cannot be justified for a myriad of reasons, this Note offers two recommendations to protect investors' due process rights and create a more effective broker-investor dispute resolution process.

2. BACKGROUND

   Before determining the extent to which pre-dispute arbitration clauses in brokerage contracts affect a claimant's due process rights, it is first necessary to outline the regulatory framework governing securities disputes. (1) First, this Part describes the development, (2) functional authority, (3) and arbitration processes (4) of FINRA. Then, this Part proceeds to explain the development and use of pre-dispute arbitration clauses in the brokerage industry. (5)

   1. The Development of FINRA

      Today, FINRA is the largest private securities regulator in the United States. (6) FINRA writes and enforces regulations that every brokerage firm, and every broker, must abide by--4400 securities firms and 630,000 brokers in total. (7) Although FINRA is a non-profit, self-regulatory organization (SRO), its assets total over $2.2 billion, (8) and in 2014 alone it levied $166.3 million in fines. (9) Today, then, the nation's predominant securities regulator (10) is a private SRO worth billions of dollars; (11) it took decades of legal developments, however, to arrive at this regulatory format.

      For over 200 years, securities exchanges in the United States have enjoyed self-governance over all members listing securities on their exchange. (12) While keeping the self-regulatory platform, however, the Securities Exchange Act of 1934 (the Exchange Act), required every securities exchange in the United States to register with the newly created SEC. (13) The Exchange Act gave the SEC oversight of the activities of stock exchanges, such as the National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE); (14) however, enforcement mechanisms for securities violations and violations of membership rules remained within the SRO itself. (15) In 1938, the government expanded its regulatory reach to over-the-counter securities markets, thereby giving the Securities Exchange Commission (SEC) oversight of both exchanges and non-exchanges. (16) At this time, the NASD registered with the SEC regulatory authority and retained control over its members, and eventually the National Association of Securities Dealers Automated Quotations (NASDAQ). (17) Concurrently, the NYSE continued to monitor its members internally through an enforcement division. (18) This changed in 2007 when "FINRA assumed the NASD's enforcement and regulatory functions and the NYSE and NASD dispute resolution programs were consolidated under FINRA's authority." (19) This consolidation of SROs into FINRA, itself under the supervision of the SEC as a non-exchange SRO, reflects the current securities regulatory format.

   2. FINRA's Authority

      FINRA possesses the same authority that its predecessor, NASD, did: the ability to enforce federal securities violations and membership rules, (20) as well as the ability to manage its members' trades. (21) Of equal importance is that FINRA obtained exclusive authority to regulate the actions of, and disputes involving, brokers. (22) In FINRA's words, it "write[s] and enforces rules and regulations for every single brokerage firm and broker in the United States." (23) Further, because courts have continually held SROs are entitled to absolute immunity for their quasi-governmental duties, (24) FINRA is free to exercise its regulatory duties, including arbitrating broker disputes, without fear of repercussion. (25) The Second Circuit has recently expanded SROs' absolute immunity protections by declaring that they cannot be sued for any action incidental to their quasi-public duties. (26) While the SEC continues to have oversight over FINRA's actions, (27) it has historically declined to exercise that power, especially in arbitration disputes. (28) Given the expansive reach of those subject to FINRA regulations, FINRA's freedom to govern as it sees fit, and the finality of its decisions, FINRA possesses extremely broad authority in controlling the massive securities market and its actors.

   3. FINRA's Arbitration Process and Judicial Involvement

      Although FINRA's arbitration process for investors is governed by the procedures in its Customer Code, (29) it is also considered a private organization by courts in the context of constitutional protections. (30) Thus, FINRA has a great deal of discretion to amend, disregard, or interpret its Customer Code provisions. (31) The SEC and judiciary further this discretion by applying a highly deferential review of FINRA awards. (32) With this regulatory framework as a backdrop, this section outlines the specifics of FINRA's arbitration processes (33)--both in theory and fact--and continues on to explain the exact standards courts use in reviewing FINRA awards and processes. (34)

      1. FINRA's Arbitration Process

         When a dispute arises involving a broker or brokerage firm, FINRA's arbitration process is the sole resolution mechanism. (35) FINRA governs broker-investor disputes "pursuant" (36) to its Customer Code, which contains no formal due process protocol. (37)

         These Customer Code provisions include language requirements for the content and form of brokerage firms' predispute arbitration clauses, fair notice of pleadings, an opportunity to be heard (applicable only to cases involving an amount in dispute of greater than $25,000), a right to represent oneself or be represented by an attorney or other third party, a hearing location that is convenient for the customer, and a customer's ability to prevent individuals with industry affiliations from serving on the arbitration panel. (38) Additionally, FINRA's recent enactment of Rule 12403(d) provides litigants in disputes involving over $100,000 a three-arbitrator panel. (39) Despite the Customer Code's robust regulatory framework for arbitration proceedings, several aspects of the process leave investor-litigants with substantially fewer procedural safeguards than would a judicial remedy. (40)

         The FINRA Customer Code omits three due process protections that are considered fundamental in traditional adjudication. (41) First, FINRA lacks a requirement for written opinions in arbitration proceedings. (42) Second, the Customer Code's lack of requirements assuring investor-litigants' right to be heard in cases involving less than $25,000. (43) Finally, customers are denied a neutral arbitrator because FINRA arbitrators often have potential conflicts of interest because they are members of the financial industry or SEC officials. (44)

         Unlike judicial resolutions, parties must go through several procedural requirements to obtain a written explanation of a FINRA arbitration award. (45) Both parties must request a written decision from the arbitration panel 20 days before the hearing date. (46) Additionally, FINRA charges $400 for a written decision, an expense that the panel can award to either party at its discretion. (47) While an arbitrator may issue a written opinion absent these requirements, they are unlikely to do so because, absent a joint request for a written decision, they are not compensated for issuing one. (48) Given these disincentives, arbitrators often resolve disputes without providing claimants a cornerstone of the American legal process--a written opinion.

         The second significant procedural safeguard that the FINRA arbitration process does not guarantee is the right to be heard in claims involving less than $25,000; in fact, the FINRA Customer Code expressly denies that right. (49) Further, "courts find that arbitrators have the authority to decide pre-hearing motions to dismiss." (50) This authority allows arbitrators to dismiss a...