Arbitration, the consensual submission of disputes to third persons for binding resolution, has become extremely popular; in fact, it is mandatory in most broker-customer feuds. Its procedural simplicity, finality of decision, and reduced legal expenses make it an attractive alternative to litigation in many cases. But these very factors may militate against the investor sometimes. Hence, investors who have the option to litigate ought to carefully consider their impact upon the claims at issue in order to make an informed choice.

The Background

Until the late 80s, investors could not be compelled to arbitrate federal securities claims. Correspondingly, SEC Rules prevented brokerage houses from imposing arbitration on investors through standard form contracts. Disgruntled investors simply went to federal courts without bothering about alternatives.

However, escalating litigation expenses coupled with a change in law led to a dramatic change. In two far-reaching decisions, the United States Supreme Court permitted brokerage houses to enforce arbitration of claims arising under federal securities statutes. The financial services industry went wild with glee, partially because arbitrators were usually industry insiders. Accordingly, brokerage houses lost no time in modifying their customer agreements to include mandatory arbitration clauses.

Thus, most investors today are bound by pre-dispute agreements to arbitrate claims against their brokers. In other cases -- e.g., where investors have not signed customer agreements containing arbitration clauses, or have claims against persons other than their brokers -- investors still have the option to litigate (Brokerage houses are usually obligated to submit to arbitration upon customer demand).

Some Unique Features -- And Their Drawbacks

In terms of legal expenses alone, arbitration is certainly cheaper and quicker than litigation. Discovery, the procedure through which you gather evidence, is perfunctory. Motion practice, which enables resolution of issues before trial, is non-existent. Evidentiary rules are applied flexibly. Awards are fairly quick, non-explanatory, and non-appealable. And brokerage firms usually comply with the award without the need for any enforcement.

These factors may help -- or hurt -- a given case. First, truncated discovery virtually obliterates the potential for investigation and evidence gathering. Hence, where an investor does not possess all the evidence to support his/her claim, he/she is considerably handicapped. Although arbitrators have the power to issue subpoenas, the attendant procedural and jurisdictional constraints are significant. Thus, investors whose claims require evidentiary help from uncooperative third party witnesses -- whether by way of documents or testimony -- could be disadvantaged in arbitration.

Second, the absence of motion practice prevents a party from knocking out meritless claims or defenses before the hearing. This virtually guarantees a hearing, so that parties sometimes raise frivolous issues for purposes of delay or an amputated settlement. Arbitrators have scant powers to deter such conduct through sanctions, unlike federal courts.

Besides, motion practice assists tremendously in narrowing contested issues. Absent this device, all issues are usually reserved for hearing, which lengthens the hearing. While this factor is of marginal difference in small cases, it could be telling in others.

Third, arbitration awards typically contain only the final decision, the bottom line with no explanation. Consequently, investors have no idea of the underlying logic (or lack of it). But then, this lack of explanation makes the awards immune from review or appeal. Courts rarely disturb an arbitration award except in cases of serious misconduct by the arbitrator(s). Thus, investors have to accept the award like David Koresh's edicts -- without question, without appeal, and without knowing why.

These constraints also explain brokerage houses' near-coercive attempts to seek arbitration of customer disputes. They ensure that systematic frauds are not uncovered easily, and if uncovered, do not become too expensive. Moreover, since arbitration proceedings are usually confidential, systemic failures remain hidden from public view. Thus, class actions are seldom (if ever) arbitrated.

Even so, arbitration panels today are much more objective than their industry-captive counterparts a few years ago. Responding to widespread criticism, the Stock Exchanges and the NASD have broadened the pool of potential arbitrators. Thus, many arbitration panels have a majority of persons not employed by the securities industry. And many of them have returned meaningful awards, occasionally including punitive damages, reflecting a change in the traditional "split the difference" approach.

The Hidden Problem

Perhaps the biggest problem with arbitration is latent: Its deceptive procedural simplicity emboldens investors to embrace it unhesitatingly; some even resort to self-help without any professional guidance. In doing so, they often ignore the substantive complexity of the laws involved as well as the need for careful strategy planning.

Thus, many investors proceeding without professional help simply plead the basic facts, and expect to win based on an unshakeable belief in the righteousness of their cause. Often, they give up significant rights inadvertently. Claims under the federal racketeering statute (RICO) may be a ready example. This is not just a question of multiplying claims for the same result; significant differences could exist between the claims -- for example, in burdens of proof and availability of punitive damages. These differences could convert a defeat into a victory, or a pyrrhic victory into a real one. Small wonder, in a 1992 study, the Government Accounting Office (GAO) discovered significant differences between arbitration awards won by investors representing themselves and those won by investors represented by attorneys; in fact, it found, persons represented by attorneys are most likely to be awarded 60% or more of the amount they claim.

So, if you are considering -- or in the processof -- arbitration, you need to inform yourself adequately. WHAT YOU DON'T KNOW CAN HURT YOU BADLY. Call for a free INITIAL consultation:

By Krishnan S. Chittur, LL.M. (Bom.), S.J.D. (Harvard).