Legal Definitions - Securities dispute resolution: Selecting arbitrators

In the world of investing, disputes can sometimes arise between investors and financial firms or brokers. When these disagreements can't be resolved directly, they often go through a process called arbitration, which is an alternative to going to court. Securities dispute resolution: Selecting arbitrators refers to the specific procedures and rules used to choose the neutral individuals who will hear and decide these financial disputes.

This process is primarily managed by the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization that oversees brokerage firms and exchange markets. FINRA aims to ensure that the arbitrators chosen are fair, impartial, and possess the necessary expertise to understand complex financial matters.

How Arbitrators Are Selected

• Panel Size: The number of arbitrators assigned to a case typically depends on the amount of money involved in the dispute:
  • For claims of $50,000 or less, a single arbitrator is usually appointed.
  • For claims between $50,000 and $100,000, there's usually one arbitrator, unless both parties agree in writing to have three.
  • For claims over $100,000, or those that don't involve a specific monetary amount, a panel of three arbitrators is typically used, unless both parties agree in writing to have one.
• Arbitrator Backgrounds: FINRA maintains a large pool of arbitrators, categorized as either "public" or "non-public."
  • Public Arbitrators are independent of the securities industry and do not have a significant professional affiliation with it. They come from diverse professional backgrounds.
  • Non-Public Arbitrators typically have a background in the securities industry, such as former brokers, compliance officers, or financial advisors.
  All arbitrators must meet general experience and education requirements, and they serve as independent contractors, receiving an honorarium from FINRA, not directly from the parties involved.
• The Selection Process: FINRA uses an automated system called the Neutral List Selection System (NLSS) to generate lists of potential arbitrators.
  • After a dispute is filed, FINRA sends the parties lists of potential arbitrators along with their background information.
  • Parties can then "strike" (remove) arbitrators they don't want from the list and "rank" (order by preference) the remaining ones.
  • For a single-arbitrator case, the list usually consists of public arbitrators. Each party can strike a certain number of arbitrators.
  • For a three-arbitrator case, FINRA typically provides lists of both public and non-public arbitrators. Parties have more flexibility to strike non-public arbitrators, even removing all of them if they prefer a panel of only public arbitrators.
  • FINRA then combines the parties' preferences to appoint the final arbitrators. If no arbitrators can be selected through this process, FINRA will randomly appoint a public arbitrator.
• Challenging Appointed Arbitrators: Even after arbitrators are appointed, parties can challenge their suitability. Arbitrators have an ongoing duty to disclose any circumstances that might affect their impartiality, such as:
  • A direct or indirect financial or personal interest in the outcome of the case.
  • Existing or past relationships (financial, business, family, social) with any party, their representatives, or potential witnesses that could create an appearance of bias.
  • Previous service as a mediator for any of the parties in the same case.
  If such a conflict is discovered, especially before the first hearing, the arbitrator may be removed to ensure a fair and objective decision.

Examples of Arbitrator Selection in Action

1. Small Investor Claiming Mismanagement:

   Scenario: Ms. Chen, an individual investor, files an arbitration claim against her brokerage firm for $45,000, alleging that her account was mismanaged, leading to significant losses. She seeks to recover her investment.

   How it illustrates the term: Because Ms. Chen's claim is for less than $50,000, FINRA's rules dictate that her case will be heard by a single arbitrator. FINRA will generate a list of ten potential public arbitrators (individuals not affiliated with the securities industry) for both Ms. Chen and the brokerage firm to review. Each party will have the opportunity to strike up to four arbitrators they deem unsuitable and then rank their remaining choices. FINRA will then appoint the arbitrator based on these preferences, ensuring a neutral party hears the smaller claim efficiently.

2. Large Institutional Dispute Over Complex Derivatives:

   Scenario: A pension fund files a claim for $5 million against a major investment bank, alleging that the bank misrepresented the risks associated with a complex derivatives product. The pension fund believes the bank's internal experts should have known better.

   How it illustrates the term: Given the claim amount is well over $100,000 and involves complex financial instruments, this dispute will automatically be assigned a panel of three arbitrators, unless both parties specifically agree to one. FINRA will provide lists including both public and non-public arbitrators. The pension fund, wanting specific industry expertise, might prioritize non-public arbitrators with a strong background in derivatives, while the investment bank might prefer a panel with more public arbitrators to avoid perceived industry bias. Both parties will strike and rank from these lists, and FINRA will appoint the final three, ensuring a diverse set of perspectives for this high-stakes, intricate case.

3. Challenging an Arbitrator Due to Undisclosed Relationship:

   Scenario: During the initial stages of an arbitration involving a dispute over a failed real estate investment trust (REIT), one of the appointed public arbitrators discloses a past business partnership with an expert witness listed by the claimant's legal team. This partnership ended five years ago, but the arbitrator failed to disclose it initially.

   How it illustrates the term: This situation highlights the "Challenging Appointed Arbitrators" aspect. Even though the partnership ended years ago, the respondent's legal team could argue that this past relationship, even if indirect, creates an "appearance of partiality or bias" and might affect the arbitrator's objectivity. They would formally challenge the arbitrator's appointment, citing the arbitrator's continuing duty to disclose any circumstances that might preclude an objective decision. FINRA would then review the challenge and decide whether to remove the arbitrator and appoint a replacement, upholding the integrity of the arbitration process.