Like the kid who says he gets to make the rules because he’s got the only ball, the National Association of Securities Dealers and the New York Stock Exchange have blocked new investor arbitrations in California because they don’t want to follow the state’s new conflict-of-interest disclosure rules.
The California legislature, concerned about the growing use of private justice systems imposed on consumers, passed a law last year requiring the state’s judicial council to write new ethics rules for private arbitrators. The new rules from the council took effect on July 1, and require all private arbitrators who hear consumer cases in the state to make very detailed disclosures of possible conflicts of interest.
The NASD and NYSE asked the judicial council and the state legislature for an exemption, on the grounds that they are federally recognized self-regulatory bodies and that their own rules – while less stringent – were good enough to protect investors in 48 states, so they should be good enough in California.
When California refused to grant the blanket exemption, the NASD and NYSE stopped appointing new panels in the state after July 1, and they filed suit in federal court seeking an exemption from the state rules. In other words, they took their ball and went home. And it is the only ball – since nearly every investor agreement with a securities firm requires NASD or NYSE arbitration of disputes.
Whether or not you think the new state ethics rules go too far (and they may), and whether or not you think it’s fair for investors to be forced to agree to a private justice system (which works pretty well) in order to open a brokerage account — the standoff between the state and the self-regulatory organizations is ridiculous.
“The current situation is unacceptable to everybody on every side of the issue in California,” said Joe Floren, a San Francisco attorney whose practice is primarily defending securities industry defendants.
Floren, who is on the NASD list of arbitrators but has never been appointed to a panel because his defense practice leaves him with a lot of already disclosed conflicts, says the new extensive state disclosure requirements are “fairly burdensome” and he can see the advantage of having one national requirement rather than 50 different state standards.
But he also points out that securities firms doing business in different states always have to worry about state regulations, many of them more stringent than the SEC or other federal rules. That’s how New York was able to go after Merrill Lynch for analyst conflicts, for instance, without having to wait for SEC action.
“I can see their argument,” Floren says of the NASD and NYSE. “But at the same time, how hard is it to put down the information and disclose it.”
Linda Fienberg, president of NASD Dispute Resolution, says it would be too expensive and take too much effort for the NASD and its arbitrators to list all possible conflicts, including all money paid by securities firms to the NASD and relationships an arbitrator’s extended family or current and former law partners may have with parties or lawyers in an arbitration case.
“Our arbitrators already make huge amounts of disclosure,” Fienberg says. “The kinds of disclosure that are being required by California are so onerous, particularly since our arbitrators are only paid an honoraria ($400 a day for hearings) and are not professional arbitrators, that we would lose many of the arbitrators that we have worked so hard over the last five years to recruit.”
California legislators and regulators think they have every right to set the rules protecting consumers in their state. And they know their new ethics rules are more stringent than the rules of the private arbitration groups — that was kind of the point of passing the law. (The California rules are on the Web here.)
“When a person is forced to give up his right to go to a jury on certain issues, and instead must go to a private forum, the legislature, the governor and the judicial council felt that we need to ensure that this alternative system of justice is a fair system of justice,” said Gene Wong, who is chief counsel to the state Senate Judiciary Committee and has been involved throughout the process of setting the new rules.
“It so happens that these ethics guidelines are higher than what the NYSE and NASD require of their arbitrators,” Wong said. “We’ve asked for a side-by-side comparison and they haven’t provided it, because frankly I think they would be embarrassed to list how much of a discrepancy there is between how much protection the California rules provide and how little disclosure and how little protection the New York Stock Exchange and NASD rules provide.
“I don’t think the NASD and NYSE arbitration systems come up to the standards, and that’s why they’re suing to not have the standards apply to them.”
It’s the other guy’s fault
Again like kids in a schoolyard, both sides in this dispute claim the current standoff is the others fault. Fienberg says the NASD “had no choice” but to stop appointing arbitrators and sue, because the judicial council and legislature said “there was no room” for compromise.
Wong says the state was willing to talk compromise, but “their strategy has always been, ‘give us the exemption, give us the exemption, give us the exemption.”
Philip Aidikoff, a Beverly Hills investors’ attorney and president of the Public Investors Arbitration Bar Association, says there should be room for compromise if the NASD and NYSE are willing — but in the meantime investors who are being hurt through no fault of their own.
“Nobody should be against complete disclosure, but it’s a very complex issue,” Aidikoff said. “There are some problems in the California statute, but we should be able to sit down and work them out.”
Perhaps they need a mediator to force them to talk about a standard that will give more protection to consumers, while eliminating some of the loopholes and excessive or unnecessary requirements in the new California rules.