Order Code RS22127
April 26, 2005
CRS Report for Congress
Received through the CRS Web
Securities Arbitration:
Background and Questions of Fairness
Gary Shorter
Specialist in Business and Government Relations
Government and Finance Division
Summary
When an investor has a dispute with a broker-dealer in which damages of a certain
size or more are alleged, it may be mediated by a panel of securities industry and non-
securities industry arbitrators under the auspices of the NASD. Although the process
has been criticized for having a pro-industry bias, research on the issue has not
substantiated the bias claims.
A smoothly functioning discovery process is integral to the fairness of arbitration
hearings. In recent years, in the wake of the market collapse of 2000, there has been a
surge in reported abuse of the discovery process largely concerning brokerage firms.
Incidents of abuse have attracted the attention of the NASD and others. But due to the
persistence of potentially perverse incentives, the efforts of the NASD to remedy the
problems may prove to be unsuccessful. This report provides background on the
NASD’s securities arbitration process and examines concerns over its fairness. It will
be updated as developments warrant.
Before 1987, a securities investor’s claim against his or her broker for alleged
wrongdoing would generally be pursued as a lawsuit against the broker’s brokerage firm.
But that year, in Shearson/American Express Inc. v. McMahon (482 U.S. 220), the
Supreme Court upheld the enforceability of agreements to arbitrate investors’ claims
arising under the Securities Exchange Act of 1934. Since then, arbitration clauses have
become an integral part of the contract between investors and brokerage firms. And
securities arbitration has become the standard means by which investor complaints are
mediated. The arbitration process is primarily overseen by two self regulatory
organizations (SROs), the New York Stock Exchange (NYSE) and the NASD,1 which
also regulates broker-dealers. The Securities and Exchange Commission has substantial
oversight over SROs through the Securities and Exchange Act of 1934.
While the securities arbitration process has been described as relatively fast,
efficient, flexible, and inexpensive, there are some concerns over its fairness. These
1 The NASD was formerly known as the National Association of Securities Dealers, Inc.
Congressional Research Service ˜ The Library of Congress

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concerns were aired during a hearing held by the House Financial Services Capital
Markets Subcommittee in March 2005.2
This report begins with an introductory background look at securities arbitration
overseen by the NASD, which oversaw 9,000 arbitrations in 2004, and handles about 90%
of such cases nationwide. The report concludes with an examination of criticism of its
fairness.
The Basics of the Securities Arbitration Process
Securities arbitrations can take a number of forms. These forms are dependent on
a number of factors, including the size of an investor’s claim, and whether the investor
opts for voluntary mediation over going before arbitrators. The variety of factors that
shape the process is discussed below.
In securities arbitration, investors with cases involving less than $25,000 in claims
go through “simplified” arbitration, in which an investor submits his allegations to a
single arbitrator who then makes a written decision without resort to a hearing. For
grievances of up to $50,000, a single arbitrator conducts the hearing, unless the investor
requests a three-member panel. If the claim exceeds $50,000, the case automatically goes
to a three-member panel.
Three-member panels are composed of one non-public arbitrator who is currently
employed by the securities industry, and two public arbitrators with no current affiliation
with the securities industry. Historically, the rationale for having a non-public arbitrator
was that such a person would provide valuable insight into the inner workings of
brokerage firms. The rationale for the public arbitrators was that they would inject a
greater measure of independence into the process.
Some investors who submit to securities arbitration engage an attorney who
generally operates on a contingency basis, while others opt to represent themselves. By
contrast, brokerage firms always use attorneys to defend themselves.
Investors who submit to securities arbitration can opt for voluntary mediation, an
informal non-binding process in which a mediator facilitates negotiations between
disputants. The mediation can be initiated at any stage of the arbitration process, and
according to the NASD results in settlements more than 80% of the time.
If there is no settlement, the dispute proceeds to an arbitrator deliberated process.
An investor prevails if a majority of the arbitrators on a three- member panel, or the single
2 The hearing was held at the request of Rep. Barney Frank, the ranking member of the House
Financial Services Committee, who said that the arbitration system was not in crisis but that there
were some issues worth exploring. Rep. Richard Baker, chairman of the Financial Services
Subcommittee on Capital Markets, which held the hearing, remarked that the system appeared
to be sound. House Committee on Financial Services Subcommittee on Capital Markets,
Insurance, and Government-Sponsored Enterprises Holds a Hearing on the Securities
Arbitration Process, Mar. 17, 2005.

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member of a one-member panel, decide to direct the brokerage firm to award the claimant
some or all of the claims against it. Decisions made in arbitrations are generally final.
The people who populate arbitration panels are drawn from a nationwide pool of
some 7,000 potential arbitrators. The much smaller potential pool for each three-member
panel is initially selected by the NASD’s arbitrator selection system, which provides the
two parties to a dispute with the names of 15 potential arbitrators — 10 public and five
non-public — to choose from. The two disputants can then make an unlimited number
of “peremptory challenges” to “strike” any arbitrators for any reasons. After the
peremptories, the remaining arbitrators are eligible for appointment to the panel. If more
than the necessary number of arbitrators remain on the list, the panelists are selected on
the basis of earlier rankings by the disputants. If any vacancies still remain, they are filled
by arbitrators who are selected on a rotational basis by the selection process’s computer
system.
Non-public arbitrators are currently employed by a brokerage or securities firm.
While many public arbitrators have never had any affiliation with the brokerage business,
a person can qualify as a public arbitrator if he or she has held a job in the brokerage
industry for fewer than 20 years and has been out of the business for at least five years.
The NASD also permits accountants and lawyers to be public arbitrators if they receive
less than 10% of their income from brokerage clients.
Key Criticisms
A number of observers, including William Galvin, secretary of the Commonwealth
of Massachusetts, New York State Attorney General Eliot Spitzer, and representatives
from the Public Investors Arbitration Bar Association, the trade group for lawyers who
represent investors, have criticized aspects of the arbitration process for injecting a pro-
industry bias into the hearings’ outcomes. Key criticisms include
! the presence of the mandatory non-public (industry) arbitrator, which
some say introduces a pro-industry bias into the process; and
! the existence of an overly expansive definition of who qualifies as a
“public” arbitrator. Retired individuals who formerly worked for a
brokerage firm for a number of years can serve as public arbitrators. And
in an era that has seen significant consolidation of various parts of the
financial services industry, some non-securities financial service workers
may be employed by a firm (like an insurance or banking firm) that is
under the same financial conglomerate ownership as a brokerage firm.
NASD rules allow such workers to serve as public arbitrators, which
raises some potentially credible questions over the possibility of pro-
industry bias.
Some commentary and research on evidence of a pro-brokerage industry bias in
NASD securities arbitrations are discussed below. Generally, there appears to be little
concrete evidence of a pro-industry bias. But the evidence that the arbitration process is
devoid of a pro-industry bias does not appear to be definitive.

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Arbitration panels rule a majority of the time in favor of investors. Attempting
to rebut criticism that the arbitration process has a pro-industry bias, NASD officials
observe that in 2004, the SRO’s arbitration panels ruled for investors in 55% of
arbitrations, a percentage roughly comparable to those in previous years. But the fact that
the arbitrators tend to rule somewhat more than half of the time for investors may not tell
us very much. We still don’t know whether 60% or 70% (or 40% for that matter) of the
arbitrated cases may have actually merited rulings favorable to investors. In addition,
when an investor wins a securities arbitration case, there is a monetary award that the
brokerage firm is directed to pay. According to a number of investor attorneys, there is
a de facto “common law” at the NASD that says that even in the most compelling cases,
awards generally shall not exceed half of an investor’s claim, which NASD officials
refute.3 Others, however, say that monetary awards that tend to “split the difference” are
commonplace in the world of arbitration.4 This suggests that the NASD awards are not
inconsistent with awards in the realm of arbitration but it has nothing to say about whether
there is pro-industry bias. Indeed, to the extent that the securities arbitration award
process tends to conform to such a model, one could probably find various NASD
arbitrated cases in which investors deserved more than they got, and various cases in
which investors probably got less than they actually deserved.
Public and non-public arbitrators tend to reach unanimous decisions. In another
rebuttal to the pro-industry charge, NASD officials cite the fact that 98% of NASD
securities arbitrations result in unanimous verdicts, which is said to be an indication that
public and non-public arbitrators are almost always “on the same page” in their decision
making. The statistic appears to provide at least some support for the view that the
outcomes in the arbitration process do not reflect the presence of a pro-industry bias.5
The vast majority of those involved in NASD arbitration view the process as
fair. Defenders of the arbitration process’s fairness also cite a NASD survey and a
follow-up study involving participants in 2,037 arbitration cases between December 1997
and April 1999. The participants were roughly divided between investors and their
representatives and the representatives of securities firms. After analyzing the NASD
study, the U.S. Military Academy at West Point reported that 93% of the respondents
3 Gary Weiss, “Walled Off From Justice?,” Business Week, Mar. 22, 2004, p. 90.
4 For example, see Henry Farber, “Splitting-the-Difference in Interest Arbitration,” Industrial and
Labor Relations Review, vol. 35, no. 1, 1981. Orley Ashenfelter and David E. Bloom, “Models
of Arbitrator Behavior: Theory and Evidence,” American Economic Review, Mar. 1984, pp.
111-124. The NASD does not supply data on the size of awards relative to the amounts that were
sought.
5 The observed unanimity, however, raises a few questions. For example, NASD officials
acknowledge that the mandatory training that all arbitrators are required to have focuses on
procedural, not substantive issues related to the mechanics of investor trades. In addition, some
investors’ attorneys have spoken of encountering many public arbitrators who appear to be
essentially clueless about investment basics. These kinds of observations give rise to the question
whether there is evidence of non-public (industry) arbitrators dominating the public arbitrators
— given the fact that they may often have a significant informational advantage with respect to
the basics of investing and the inner workings of brokerage firms.

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concluded that the process was fair.6 This would appear to indicate that there was a
significant amount of satisfaction with the process on the part of a large proportion of
winning and losing investors, which also provides some support for those who deny the
presence of an industry bias.
Securities arbitrations on the NASD and arbitrations outside of the securities
industry provided roughly similar outcomes. A 1992 study by the Government
Accountability Office (GAO)7 analyzed securities arbitrations between January 1989 and
June 1990. The cases were divided between those arbitrated by an SRO like the NASD
and those that were brought before the American Arbitration Association (AAA), an
independent mediating organization that has no connection with a SRO or any securities
industry group. The study found that investors prevailed in the SRO-based arbitrations
59% of the time and prevailed an almost identical 60% of the time in arbitrations before
the AAA. It also found that when investors prevailed in SRO arbitrations, they recovered
approximately 61% of their claimed damages compared to 57% in the AAA arbitrations.
These results provide some support for the absence of a pro-industry bias in the arbitration
process.

The GAO study was, however, conducted a decade and a half ago and since then,
there have been a number of changes to the arbitration process. Some of the changes have
involved reforms that have removed some potentially pro-industry facets of the arbitration
protocol. For example, since the GAO study was conducted (1) a public arbitrator must
be retired from the securities industry for at least five years compared to the earlier
requirement of at least three years; and (2) investors or their representatives were given
the opportunity to take part in the selection of the arbitrators who are to preside over their
hearing. But by various accounts, one part of the process that can have a corrosive effect
on its fairness — abuse in the discovery process — has been growing. This is discussed
below.
Abuse in the Discovery Process
The securities arbitration process is dependent on the free exchange of documents
pivotal to the case being arbitrated, a process known as discovery. In the wake of the
stock market collapse of 2000, there has been an explosion in the numbers of securities
arbitration cases (and apparently the number of frivolous cases). Accompanying this
explosion, and the doubling of the number of annual arbitrations, since the collapse, has
been a surge in the incidence of reported discovery abuse.8 The abuse often takes the
6 David Robbins, ed., Securities Arbitration 2000, Today’s Trends, Predictions for Tomorrow
(Practicing Law Institute, 2000), p. 153.
7 U.S. General Accounting Office, Securities Arbitration: How Investors Fare, GAO/GGD-92-74,
May 11, 1992, p. 6. At the time of the study, the agency was known as the General Accounting
Office.
8 For example, see William S. Shepherd, “Ending Discovery Abuse in Securities Arbitration,”
Texas Lawyer, Sept. 20, 2004, p. 27. “NASD Sparks Controversy as it Seeks to Address
Discovery Abuse During Arbitrations,” Securities Week, Nov. 17, 2003, p. 1. Emily Thornton,
(continued...)

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form of a securities firm’s lawyer prolonging the release of or withholding documents
deemed necessary for evidentiary purposes. As a result, cases can be dragged out and
complainants can be worn down. The resulting evidentiary shortfalls, which may also
have other causes, and should reduce an investor’s odd of winning.9
NASD officials acknowledge that discovery abuse is an issue at the NASD. But they
also indicate that they are getting a grip on the problem. For example, they note that in
2003, the NASD formally reminded brokerage firms of their obligation to comply with
NASD discovery rules and procedures for production of documents and materials in
arbitration claims. The reminders emphasized the NASD’s intent to monitor the firms’
ongoing compliance with the discovery rules as well as its willingness to refer perceived
cases of discovery abuses to its enforcement side for investigation. The officials also note
that in 2004, the NASD censured and fined three registered brokerage firms a total of
$750,000 for failing to comply with their discovery obligations in 20 arbitration cases
between 2002 and 2004. They also stress that the SRO is currently working on a number
of initiatives to improve the discovery process, including the creation of a voluntary pilot
program for the use of a special roster of trained discovery arbitrators who would have
responsibility for reviewing and resolving discovery problems.10
But because of the possible persistence of perverse incentives, these kinds of reform
initiatives may ultimately prove to be inadequate to address the issue. Many arbitrators
reportedly harbor fears of being removed from selection lists, or even of being blacklisted
if they confront attorneys about their improper behavior. And because the sanctions that
are only occasionally meted out for discovery abuse tend to be dwarfed by the amount of
money that securities firms have at stake in the arbitrations, the incentives for their
attorneys to fully cooperate in the discovery process may be less than robust at times.11
8 (...continued)
“The Brokers Strike Back; They’re Dragging Their Feet in Investor Cases and Suing
Ex-Customers for Damages,” Business Week, Aug. 16, 2004, p. 70. Discovery abuse from the
investor side is, however, not uncommon but most key documents tends to be held by securities
firms.
9 For example, see William S. Shepherd, “Ending Discovery Abuse in Securities Arbitration,”
Texas Lawyer, Sept. 20, 2004, p. 27. “NASD Sparks Controversy as it Seeks to Address
Discovery Abuse During Arbitrations,” Securities Week, Nov. 17, 2003, p. 1. Emily Thornton,
“The Brokers Strike Back; They’re Dragging Their Feet in Investor Cases and Suing
Ex-Customers for Damages,” Business Week, Aug. 16, 2004, p. 70. Discovery abuse from the
investor side is, however, not uncommon but most key documents tend to be held by securities
firms.
10 “Statement of Linda D. Feinberg President, NASD Dispute Resolution, Inc. Before the
Committee on House Financial Services Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises,” Mar. 17, 2005.
11 Some think that these perverse incentives are so deeply embedded that the only effective way
to counter them is through a rather draconian procedure known as a death penalty sanction. Under
this, arbitration participants who have been found to have violated the discovery process would
simply lose their cases. William S. Shepherd, “Ending Discovery Abuse in Securities
Arbitration,” p. 27.

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