BofA-SEC Ruling Could Have Cascading Effect

Last week, when pressured by federal Judge Jed Rakoff to explain why neither Bank of America CEO Ken Lewis nor Merrill Lynch CEO John Thain was held accountable or even named as a defendant, an SEC lawyer responded that the two top executives “relied on the lawyers’ advice and didn’t know what was in the disclosure schedule.”

The exchange between Judge Rakoff and the SEC attorney brings to light a very important question. If we except the simple fact that Wall Street CEO’s are paid massive salaries to make tough decisions for their company, why are they allowed to skirt responsibility when those decisions are found to be wrong, or in this case potentially illegal, regardless of who advised them to make the decision? As President Truman famously said, “The buck stops here”.

As Judge Rakoff puts it, Bank of America and Merrill Lynch “effectively lied to shareholders,” yet neither the SEC or company representatives can tell us who is responsible.

“Was it some sort of ghost or a human being,” asked Judge Rakoff.

The venerable judge expects clarity on this issue and so he ordered all parties to submit an explanation, due at the end of August.

Judge Rakoff very well might have set events into motion that will significantly impact Wall Street and the SEC.  When the dust settles, it’s a real possibility that at least one Wall Street CEO will formerly admit he lied to shareholders and in doing so, reveal that the SEC’s settlement did not square with the violation. As a result, Wall Street CEO’s will be held to a higher standard and will no longer feel impenetrable behind a shield of lawyers and accountants. Secondly, the SEC’s penalties will finally become commensurate with what is alleged.

When a judge says that it’s his or her duty to ensure settlement agreements are in the public’s best interest, this is exactly what it means.

The Arbitration Fairness Act’s Unintended Consequences

This Friday the House Committee on Financial Services will host a hearing to discuss President Obama’s plan for regulatory reform.  As they debate the new rules, they would be wise to consider shelving one that’s already in the works.  I am referring to HR 1020, also known as the Arbitration Fairness Act (AFA).  In short, the AFA would put an end to what’s known as pre-dispute arbitration agreements.  While this may have looked like a good idea on paper, it actually has disastrous unintended consequences for individual investors.

Many industries include pre-dispute arbitration agreements as part of their contracts such as those for credit cards, mortgage loans, even internet domain names.  The securities industry also uses pre-dispute arbitration agreements.  Whenever an investor contracts with a broker to purchase a security, mutual fund, etc., he or she waives the right to a court hearing in favor of arbitration, a process managed by FINRA.

With very good reason, this is a controversial issue.  Many industries have used arbitration as a way to steamroll over their customers when a dispute arises.  However, when it comes to securities arbitration for investors, the system actually works relatively well. Make no mistake, FINRA’s arbitration system is not perfect and needs reform, but when compared to a court hearing investors are often better served.

Arbitration is significantly more cost effective than litigation and far more expeditious. For example, it could take up to 5-7 years to complete a court case-even for relatively small claims.  Naturally the legal fees and expenses involved in such a drawn out proceeding would be astronomical.  If the same case were heard by a three member arbitration panel, the investor would have his or her dispute resolved in one to two years with about a 40-50 percent chance of prevailing.  Though this “win” percentage is still too low and awards are nowhere near the investor’s total investment loss, it still can be much better than litigation.

FINRA is most certainly better than the National Arbitration Forum (NAF), a for-profit company based in Minneapolis, which mainly manages the claims process for millions of credit-card accounts in addition to disputes involving website domain-names, auto insurance, and other matters.  NAF was the focus of a cover story in BusinessWeek last month which investigated whether the arbitration proceedings the company handles are fair.  According to a lawsuit filed in California, the only state that makes such statistics public, creditors win 99.8% of the NAF cases.  Now, clearly something is wrong with this picture.

To its credit, FINRA is making strides to make the arbitration system more equitable. Specifically, it has made it difficult for brokerages to make motions for dismissal, and launched a pilot program to do away with the securities industry arbitrator (required on each panel), which hopefully will be implemented on a permanent basis.  If Congress adopts the Administration’s reform plan to hold brokers to a higher “fiduciary standard”, requiring them to only recommend financial products which are in the customer’s best interest, dare I say it…investors might finally be able to play on a level field.

Haphazardly eliminating all pre-dispute arbitration agreements would be heading in the wrong direction.  Securities arbitration, warts and all, is actually working and with a few more tweaks can be the investor-friendly system for which it was designed. Investors bore the brunt of the economic downturn. We can’t let them down with poorly crafted reform laws.

Universities Seek Answers After Huge Sums Vanish