How Does a FINRA Hearing Work?

By Dennis E. Boyle[1]

[1] Dennis E. Boyle is a Financial Industry Regulatory Authority arbitrator and a member of the Public Investors Arbitration Bar Association.

We just finished a FINRA (Financial Industry Regulatory Authority) evidentiary hearing—it is the third arbitration we have successfully finished in the past year. One was a AAA (American Arbitration Association), and the other two were before FINRA. From talking to clients in these hearings, I have come to understand that most people do not understand what “arbitration” is or how it works. So, I would like to take an opportunity to explain what arbitration is, and, more importantly, how it works. I also need to stress at the beginning that most of our arbitrations involve investments, and most of our clients are individual investors.

Yes, you agreed to arbitration. When most people find that they have been a victim of securities fraud or some other form of misconduct, they usually think that there should be some governmental entity that cares about them and wants to correct the crimes that may have occurred. As a practical matter, there is not. The victim can call the police or the FBI or the SEC, but unless there is a significant loss associated with the individual or multiple individuals whose combined loss is significant, law enforcement is unlikely to be interested. Even if they are interested, they will be more inclined to seek a prison sentence for the perpetrator than they will be to recover the lost funds for the victim.

The next thought is: “I’m going to sue”. Unfortunately, however, in nearly every investment dispute, there will be an “arbitration clause”. This clause constitutes an agreement by you to give up your right to file a lawsuit in court. Now, I know you didn’t know it was there, had never seen it before and never would have signed it if you had known it was there, but you did sign the agreement and it is binding. There is a federal statute, the Federal Arbitration Act, that makes arbitration clauses completely enforceable. There is almost no way to escape an arbitration clause.

Maybe the Arbitration Clause isn’t that bad. Ok, so the victim can’t go to court, but they do have a forum available to litigate their claim, so it’s not all bad, right? Arbitration is a form of Alternative Dispute Resolution (ADR) that has been around for decades. It is quicker than a court proceeding, and, we are told, less expensive. But it is not a court. Discovery is limited. There are no depositions. In most cases, all the victims can do is request documents which the defendant may or may not produce. An arbitrator can be anyone from a trained lawyer to someone with no legal or professional experience. Furthermore, the decision of an arbitrator is final. There are no appeals, even if the arbitrator is completely wrong.

In terms of damages, although courts tend to be stingy when it comes to imposing punitive damages or awarding a recovery of attorney’s fees, arbitrators can be worse. One of the greatest flaws in the system occurs in arbitrator selection. Judges in the various states are either elected by the people or appointed by the governor. When a case is filed, it is assigned to a judge who will then preside over the case.

Arbitrators are selected by the parties (or rather, stricken by a party who does not like an arbitrator). Therefore, an arbitrator who has ruled too favorably for an investor will likely be stricken from further arbitrations. Potential arbitrators know this, and, if they want to be picked as an arbitrator in the future, will be cautious in how much they award. The result seems to be diminished recoveries, or no recovery at all.

There are other issues with arbitration. Often, it is necessary to dig into a transaction to determine whether there has been any fraud. In courts, this often involves taking depositions of witnesses, compelling the production of relevant documents belonging to the company, and sometimes going back to the court for sanctions when the firm’s attorneys are not cooperative. These avenues for obtaining evidence either do not exit or are significantly limited when it comes to arbitration. There is certainly no ability “to go on the record” as there would be with a judge, and depositions of witnesses are nearly unheard of—it is unlikely any arbitrator is going to approve or order depositions.

Arbitrations are not great, but they are the only forum available if an investment agreement has an arbitration clause.

But it was my entire life savings; I need that money to live. We often represent elderly people who have lost all or nearly all their retirement. Many times, the amount lost will be less than $100,000. Unfortunately, attorney’s fees and expert costs will take a big chunk out of any recovery, so the amount an investor can expect to recover will be far less than they lost. In fact, the firm’s lawyers will do everything in their power to see that victim recovers nothing. Often times in the law, lawyers and judges will say that the purpose of the legal system is to make innocent victims “whole”, meaning that they should be in the same position after the arbitration as they were before the loss. Unfortunately, this concept is not often going to be applied in arbitration.

This is the bad news. Investors would be better off if the FAA were repealed or limited to commercial transactions between corporations or other businesses. However, that is unlikely to happen.[2] Therefore, if an investor is going to recover the funds they lost, they will have to understand the arbitration process and learn how to use it to their advantage. Just as arbitrations are not appealable for the investor, they are likewise not appealable for the firm, regardless of whether the firm should have lost or not. Fortunately, there is a small cadre of attorneys who understand and focus on the representation of investors in these arbitrations. Most are members of the Public Investors Arbitration Bar Association (PIABA). These attorneys often achieve superior results in FINRA arbitrations.

[2] In 2022, Congress did end forced arbitration for sexual assaults and sexual harassments. Congress could certainly go further and end forced arbitration.

The first thing to understand is that FINRA is the regulatory authority for member firms. It was created in 2007 as a self-regulatory agency for member brokerage firms and exchange markets. It is the successor to the National Association of Securities Dealers, Inc., and the arbitration operations of the New York Stock Exchange. The U.S. Securities and Exchange Commission (SEC) is the ultimate regulatory authority with jurisdiction over both FINRA and member firms; however, as a practical matter, FINRA is the agency that most frequently regulates brokers.

FINRA has adopted a system of rules to govern the activities of member firms, and these rules, referred to as “FINRA Rules” often provide the basis for recovery. It is therefore important to know and understand these rules. For example, FINRA Rule 2111 establishes the principle of “suitability” and requires that member firms ascertain the investment profile of every investor and then only recommend investments that are reasonable for that particular investor. A common breach occurs when a representative recommends an investment that is extremely risky for an elderly investor or someone with a conservative risk profile. These rules apply specifically to member firms in the securities industry.

However, although FINRA Rules are important, they are not the only rules or laws that regulate broker dealers. The SEC, for example, has a series of regulations concerning “Best Interest”. 17 CFR 240 15l-1. This regulation requires member firms to use their “best interest” when advising investors on the purchase of a security.  The rule requires the firm or any associated person “… when making a recommendation of any securities transaction or investment strategy involving securities (including account recommendations) to a retail customer … [to act] … in the best interest of the retail customer at the time the recommendation is made”. This is a new and important regulation aimed at conflicts of interests within the member firms. Significantly, it is an SEC regulation, not a FINRA Rule.

It is also possible to include state statutes, like those involving elder exploitation, as well as common law causes of action like negligence or breach of contract into an arbitration claim. The important thing to understand, however, is that there is a wide body of law, regulations, and rules, that expose a member to liability, and it is important to include all possible bases for recovery in a claim. A wider Statement of Claim also provides a greater basis for uncovering relevant documents.

Once an investor’s attorney has completed an investigation, the attorney will prepare a “Statement of Claim” which sets forth the basis for recovery. The Statement of Claim is then filed with FINRA. FINRA then serves the Statement of Claim on the member firm. The firm will then file a Response, and FINRA will issue a list of potential arbitrators. Each side can then object to arbitrators, and, ultimately, FINRA will establish the arbitration panel. This panel will have one arbitrator if the claim is $100,000 or less and three arbitrators if the claim is more than $100,000. Unlike courts, motions to dismiss or for summary judgment are almost unheard of, so the formal processes of the arbitrator or arbitration panel will involve the resolution of discovery disputes and the conduct of a hearing. Once the arbitration has been initiated, the investor becomes known as the “claimant”, and the member firm and associated persons become known as “respondents”.

In most of the cases we have done recently, we find increasing conflict with respondents’ law firms over the issue of discovery. Often, respondents will fail or refuse to produce relevant documents. If these documents are required, another attempt to retrieve them should be initiated, and, if that fails, a motion to compel should be filed. We have seen member firms refuse to provide documents even after they have been ordered to do so by the arbitrator(s). There may also be requests to serve subpoenas that result in litigation. This is the only opportunity, however, to obtain the information necessary to win a case.

Many times, an expert witness will be used by the claimant, and it is important to work with an expert from the beginning. The correct expert can be the difference between winning and losing a case.

Finally, a hearing will be held, usually within a year of the claim being filed. At this hearing, the claimant’s counsel will begin by making an opening statement. Respondent’s counsel will then make an opening statement. The claimant’s counsel will then present the claimant’s case followed by the respondent’s counsel who will present the respondent’s case. There may or may not be rebuttal, depending on the decision of the arbitrator. Each counsel will then make a closing argument. The arbitrator or arbitrators will then make a decision which will be forwarded to FINRA. FINRA will then notify the parties of the decision.

Arbitrations are less formal than court hearings. Arbitrators do not wear robes, and the proceedings frequently occur in hotel conference rooms or other similar locations. Claimants frequently win, and it is definitely important to pursue these cases.