Barron's Feature

Dueling for Dollars

If the bear returns, Wall Street's arbitration wars will escalate

By RICHARD KARP

There probably was a bittersweet tang in the humid Orlando air for a few days
last month, at least at the national convention of the Public Investors Arbitration
Bar Association, whose members specialize in securities actions against
brokerage firms. True, the summer had seen the stock market swoon, and
falling equity prices almost always lead to an eventual rise in broker-client
disputes and fat fees for the legal tribe that deals in them. But now, the market
was in the foul grip of a comeback that was pushing up the Dow again. What a
revolting development.

Since then, the market has continued a jittery recovery, but every downward
twitch must cause an upward blip in the pulse rates of the members of the
plaintiffs' bar, who after suffering through a mostly bullish 15 years must feel that
their biggest payday is coming. Sometime.

When the market slumps, as it did in August, the claimants' attorneys "have their
nose in the air, smelling blood," says Richard Ryder, publisher of the Securities
Arbitration Commentator newsletter.

Joel Leifer, a New York lawyer who represents brokerage firms, adds that,
while the overall volume of arbitration cases has remained steady during the bull
market, at about 6,000 a year, "the number of cases against big firms declined
dramatically, and the percentage of cases against the smaller brokers -- the
Stratton Oakmonts of the world -- increased," mainly because they deal in the
small-capitalization stocks that, in recent years, have been market laggards.
(Stratton Oakmont, a Long Island firm that drew much unfavorable regulatory
scrutiny, is now defunct.)

But, Leifer believes, if the Dow comes down, we may see more claims against
the big brokerage firms. Often, these claims don't show up for six or more
months after a slump has occurred. That gives securities firms some time to
react if they fear an onslaught of arbitration actions.

In fact, put on alert by the market's summer tumble, some brokerage houses
are gearing up for a potential avalanche of securities cases if the bear ever
bestrides Wall Street again. "A lot of big houses have been busy setting up
early-intervention groups to deal with claims before they go to arbitration,"
Leifer adds, without identifying any of them. "One fairly big house says its
early-intervention unit has seen a rise of 40% more complaints since August. I
would expect its experience is pretty representative of Wall Street's big firms in
general," the attorney says.

                       Another industry attorney, Boston's Gerald Rath,
                       agrees that there's a strong correlation between
                       investor losses and disputes since "claims require
                       losses, and successful claims require big losses."
                       But the correlation's exact shape "depends on
                       how the market drops: drip-by-drip or
                       cataclysmic. If you have a huge one-day crash,
                       you'll get an investor who claims, 'I said sell, not
                       buy.' If the drop is gradual, you will see
                       'suitability' claims and 'unauthorized transaction'
                       claims, in which the client gets amnesia and
forgets that he placed a buy order."

Although it is possible in some instances to take a brokerage house to court in a
securities dispute, most brokerage agreements require investors to agree to
settle disagreements through arbitration. And if history is any guide, in a
prolonged bear market, the industry could have a lot to worry about on one
score: margin accounts.

"Back in October 1987, when the market lost 25% of its equity in two days, a
lot of investors were susceptible to great risk because of the tremendous
amount of margin used to carry their portfolios," recalls Theodore Eppenstein, a
claimants' attorney based in New York. "When the market dropped 508 points
on October 19, some of these customers could not get through to their brokers
over the telephone, and a lot didn't have the cash required to meet the margin
calls. To protect themselves, the brokerage houses liquidated the positions of
these customers, and the customers consequently lost huge sums, sometimes
their life savings. Many were left with deficit balances in their accounts; they
went from millionaires to debtors overnight."

That produced a rash of actions from investors who contended that, if they
could have just reached their brokers, they could have dumped enough stock to
ward off disaster.

Two months before the October '87 crash, there was $41.6 billion of margin
outstanding, according to the New York Stock Exchange, which maintains
statistics covering about 95% of the U.S. margin universe. This past August, the
total was about 3 1/2 times as large: $147.8 billion.

Investors' attorney John Lawrence Allen, who runs a bi-coastal practice in
New York and San Diego, says that, since the bear market of last summer,
"I'm getting more calls from people who have been sold out of a margin call
without their knowing it."

Even more pervasive in a bear market, however, could be cases involving the
suitability of the investments that a client has been sold by a broker.

The crash of 1987 followed by just a couple of months the U.S. Supreme
Court's landmark McMahon decision that effectively forced almost all
investors' claims against securities firms out of the courts and mainly into
industry-dominated arbitration forums.

One unforeseen consequence of the landmark decision -- a ruling Wall Street
had ardently pressed for -- was that the legal concept of "unsuitable
investments" based on a customer's financial resources came to the fore. Prior
to McMahon, when investors' suits were heard in court, the key allegations
typically involved "churning" or "failure to timely execute" a trade.

"Unsuitability" had been difficult to argue before a judge
or jury because the plaintiff had to prove "scientia," that
is, actual knowledge of an intent to defraud. But in
arbitration, attorneys aren't bound by this rule. Thus, if
an investor were hurt by an unsuitable investment, and
the broker hadn't disclosed the risks, the broker could
still be liable, even if he hadn't set out to defraud
anyone. When investors' lawyers caught on to this,
suitability cases proliferated.

Plaintiffs' lawyer Eppenstein says he is seeing an increasing number of suitability
cases today, "especially with the small-cap stocks that have been taking hits for
a year now."

Against this background of deep market uncertainty, the war within the
arbitration wars continues. One major battle centers on rule changes advanced
by the National Association of Securities Dealers' Arbitration Policy Task
Force and submitted to the Securities and Exchange Commission for approval.
Chief among them: a bitterly controversial proposal to limit punitive-damage
awards to no more than $750,000 or twice compensatory damages, whichever
is less -- a limitation favored by the brokerage industry and opposed by the
plaintiffs' bar.

The SEC has been sitting on the proposal for more than a year, giving no
indication of what it will do. The NASD's executive vice president for dispute
resolution, Linda Fienberg, says that the self-regulating organization is standing
pat on its original cap. "We are not going to change the proposal in regard to
the size of the cap," she insists. Nevertheless, given the rancorous opposition of
public investor groups, a skeptical Congress and other factors, the proposal
could very well stay in limbo indefinitely.

On the other hand, the SEC recently approved another proposal by the
NASD, which handles about 90% of all U.S. securities arbitration disputes.
This involves the selection of the three-member panels that decide these cases.
Until recently, the NASD (or whatever self-regulating organization was in
charge of the proceedings) usually selected the panelists, one from the securities
industry and two from outside it. Both disputants had one peremptory challenge
and an unlimited number "for cause," but eventually had to settle for three
candidates submitted by the NASD, one of the industry's SROs.

The American Arbitration Association, which hears some securities cases, used
a method called "list selection." In essence, each side views a long list of names
submitted by the organization and strikes those it doesn't want until just three
are left. These become the arbitrators. This is the system approved by the SEC,
with a twist. If one or the other party can't agree on a name, an NASD
computer will spit one out, and it must be accepted.

Not surprisingly, the plaintiffs' bar hadn't wanted any of the names on the list to
come from industry members. Grouses Eppenstein: "Arbitrators who are still in
the industry know that, if they award large damages to investors, their names
will be known throughout the industry they depend on for their living. And what
if a case describes a fraudulent scheme at a particular firm, and the industry
arbitrator knows that the same scheme is going on at the arbitrator's firm?
There are too many conflicts to deal with, without any benefit to the investor."

Eppenstein contends it would be fairer to keep the industry arbitrator, but
produce not one list, but two: one of public and industry candidates and one of
members of the investor-advocate bar, like himself, in order to balance out the
industry arbitrator. In addition, he would like to see, in the case of a selection
deadlock, not just one mandatory name from the NASD's computer, but a
whole second-round list of candidates.

Securities industry attorneys dismiss such suggestions as unworkable and born
of a desire to secure an unfair advantage. Remarks the NASD's Fienberg: "If
we provided a whole second-round list of names, we'd be spending two years
picking a panel. I don't see why we should have a separate slot for 'claimants'
advocates' when the 'public' list already has many claimants' representatives" --
including Eppenstein. Anyway, Fienberg adds, industry arbitrators have a
vested interest in seeing that justice is done; they don't want bad apples spoiling
the security business's public image.

Another issue concerns public access to the NASD's Central Registration
Depository, which keeps records of, among other things, all customer
complaints against brokers and brokerage firms. The securities industry would
like all complaints that have not been pursued or adjudicated to be expunged
from the list.

If a customer doesn't pursue a complaint, for example, or if a brokerage
reaches a settlement with a client on condition that the latter drop charges
against an individual broker, the NASD wants the broker's name erased.

Opposition to this proposal comes from state securities regulators. Denise
Voigt Crawford, Texas Securities Commissioner and former president of the
North American Securities Administrators Association, has denounced the
proposal as a "unilateral attempt" to erase potentially important information. She
and others fear that deleting the material could hurt investigations of misconduct
by brokerage houses or their employees, and that it might make it more difficult
to detect patterns of misconduct.

Counters Fienberg: "A dismissal of a case against an individual broker in a
settlement is not indicative of anything as far as the regulators are concerned."
Moreover, she points out, some claims brought by investors are totally
unjustified. "If a court or arbitration panel finds a claim is frivolous and directs
the expungement of the claim, we expunge it from the CRD public disclosure
file."

Should the proposal be approved, investigators still would have some recourse,
but it would be rather tedious. The CRD filings, besides being kept in the
central registry, are also maintained by individual states as public records. Thus,
an investigator might have to go from state to state to find certain material.

Finally, on an unrelated front, the SEC, under pressure from Congress, civil
rights and feminist groups, has persuaded the NASD to allow employee
discrimination claims based on race, sex, age and the like to be pursued in court
-- notwithstanding any existing employee agreements that said such disputes
would be settled in arbitration.

Although Ted Eppenstein cynically dismisses this as a public-relations ploy
designed to "show the public some progress in reform," some others think that it
sets a precedent that the members of the claimants' bar might use in trying to
end the mandatory securities-arbitration rules they've been complaining about
for the past 11 years.