In 2007, the United States Securities and Exchange Commission approved the creation of the Financial Industry Regulatory Authority (“FINRA”), and the FINRA arbitration forum officially came into being. As a result, the vast majority of disputes between investors and their financial advisors are resolved out of court in FINRA’s arbitration forum. Prior to the final hearing—the equivalent of a trial in state or federal court—the FINRA arbitration forum is decidedly pro-investor. FINRA’s procedural rules strip financial advisors of many of the protections afforded by state and federal courts. Barring exceptional circumstances, advisors cannot seek to dismiss frivolous complaints via a motion to dismiss or motion for summary judgment. FINRA rules also severely restrict advisors’ ability to obtain certain types of discovery—advisors are largely prohibited from deposing and serving interrogatories on the investor—while instituting document production requirements that impose a disproportionate burden on advisors. The following examines how financial advisors and their attorneys can most effectively defend against a FINRA arbitration action.
“Knowing Your Investor”
At times, investor complaints are unavoidable. Through no fault of the advisor, an investor complaint may arise from investment losses due to unexpected market activity or an investor’s unrealistic expectations. Regardless of the cause, by truly “knowing your investor,” financial advisors place themselves in the best possible position to defend against an investor complaint. Knowing your investor not only fosters a productive financial advisor-investor relationship, it reduces the risk of investor complaints and, in the event of a complaint, ensures that advisors are well-positioned to defend themselves.
From both a business and litigation perspective, “knowing your investor” is a financial advisor’s golden rule. Knowing your investor does not result from a short introductory meeting with an investor, or by sending an investor a new account form to complete on their own. It results from taking the time to truly understand an investor’s investment preferences including, without limitation, an investor’s investment goals, investment timeline, risk tolerance, and investment experience and sophistication.
New account and account update forms are good starting points to establish an investor’s investment preferences. The financial advisor should take the time to discuss these preferences with the investor until the advisor is satisfied that the investor can make an informed decision as to, for example, the amount of investment risk he or she is willing to take on. A financial advisor should also summarize any such discussion in follow up correspondence with the investor, and consider taking their own notes regarding each investor’s preferences for their files. Because investment preferences can change over time, financial advisors should also review these preferences with each of their investors on a routine basis and document this review in follow up correspondence with the investor. If an investor decides to invest in a high risk or non-standard investment vehicle that is appropriate in light of their investment preferences, an investment advisor who truly knows their investor will spend additional time explaining the investment’s characteristics and risks to the investor, and documenting these discussions and the investor’s subsequent decisions, for the investor and for the advisor’s files.
Knowing your investor also enables the financial advisor to spot potentially problematic investors at the outset of the relationship. Certain investors instruct, even demand, that their financial advisors place them in high risk investments, while refusing to accept the corresponding risk of loss. When this type of investor suffers an investment loss, their investment advisor oftentimes becomes the target of an investor complaint.
Responding to an Informal Investor Complaint
An informal investor complaint is often the first sign that litigation may be forthcoming. How an advisor responds to the complaint often determines whether or not they will prevail at a subsequent FINRA arbitration action. It is therefore important that an advisor refrain from responding to an investor complaint until consulting with a supervisor and attorney.
Sound as this advice may be, it is frequently disregarded by advisors eager to informally resolve an investor complaint before it comes to the attention of their employer or regulators. Oftentimes, an advisor will respond to the complaining investor in an apologetic or conciliatory tone. Although sent with the best of intentions, these types of responses are frequently cited by an investor’s attorney at a FINRA arbitration action as proof that the advisor “admitted” or “conceded” to wrongdoing. By consulting with a supervisor and attorney, an advisor can formulate an even-handed response that both acknowledges the investor’s unhappiness and, if appropriate, explain why the investment decisions at issue in the complaint were appropriate in light of the investor’s investment preferences.
Upon the receipt of an investor complaint, a financial advisor should also, oftentimes with the assistance of an attorney, implement a document hold to ensure that no relevant information or documents are destroyed. Although FINRA member firms are bound by certain document preservation requirements, the receipt of a customer complaint is cause to ensure that all documents and information specifically relevant to the complaint at issue are and will continue to be preserved. This applies to all information, even information that the advisor may view as damaging to their defense.
Selecting the Arbitration Panel
The FINRA arbitration panel is the state and federal court equivalent of a judge and jury. The arbitration panel hears and rules on all motions, settles disputes between the parties, decides what evidence will be admitted at the final hearing, and ultimately renders the final verdict. Selecting an arbitration panel which, pursuant to FINRA rules, is left to the parties, is one of the single most important steps in defending against a FINRA arbitration action. It is a step that financial advisors frequently neglect.
At the outset of every FINRA action, FINRA provides the parties with a list of candidates qualified to serve on the arbitration panel. FINRA rules allow both parties to strike a certain number of candidates and rank the remaining candidates in any order they see fit. The highest mutually ranked candidate or candidates (depending on the amount in controversy, FINRA arbitration panels are composed of either one or three arbitrators) are then invited to serve on the arbitration panel.
Unlike in most arbitration forums, FINRA provides the parties with an extensive biography on each arbitration candidate. FINRA also maintains a database, which the parties are free to access, detailing each candidate’s prior experience as a FINRA arbitrator including every FINRA arbitration over which the candidate presided as an arbitrator and the results of each such arbitration.
In defending a FINRA arbitration action, financial advisors should take full advantage of these resources in addition to conducting their own independent review of each arbitrator. These resources, particularly FINRA’s arbitration database, provide a wealth of information regarding each arbitration candidate and are an invaluable tool in determining how to rank and, equally important, strike arbitration candidates.
Framing the Case for the Arbitration Panel
Unlike with a state or federal court judge, a FINRA arbitration panel has little exposure to the parties’ and their respective claims and defenses prior to the final hearing. It is therefore essential that an advisor seize every opportunity available to frame their case for the arbitration panel in advance of the final hearing. The most effective way for an advisor to do so is via their response to the formal investor complaint filed with FINRA. Like the typical answer to a complaint in state or federal court, an advisor’s answer to an investor’s complaint should deny all inaccurate allegations set forth in the complaint and set forth any applicable affirmative defenses. In addition to responding to the investor’s allegations, an advisor’s answer should also present the advisor’s strongest factual and legal arguments, which often takes the form of a hybrid answer-brief.
At the initial scheduling conference, the financial advisor’s attorney should also request that the parties be allowed to submit prehearing briefs in advance of the final hearing in order to explain the controlling facts and law at issue in the arbitration proceeding. Unlike in state or federal court lawsuits, where the parties are able to limit the facts and legal issues presented at trial via dispositive and pre-trial motions, in a FINRA arbitration action, the arbitration panel is typically presented with a vast amount of information at the final hearing. The prehearing brief helps to distill this information and focus the arbitration panel’s attention on the key facts and legal issues going into the final hearing. It also provides an advisor with another opportunity to advocate in his or her defense.
Making the Most of Limited Discovery
Barring exceptional circumstances, depositions, interrogatories, and requests to admit are not allowed in FINRA arbitration actions. Rather, FINRA encourages the parties to obtain discoverable information through the use of document requests. To facilitate the exchange of documents, FINRA requires both parties to produce a number of categories of presumptively relevant documents at the outset of every arbitration. Although these initial document production requirements typically result in a substantial number of relevant documents being produced, an advisor is well-advised to conduct additional discovery of the complaining investor.
Although standard interrogatories are generally not allowed in FINRA arbitration actions, FINRA does allow the parties to pose requests directed towards the identification of individuals, entities, and time periods related to the dispute. Financial advisors should make use of these type of requests to identify, for example, witnesses the investor may call at the final hearing as well as all individuals with potentially responsive information. This enables the advisor to identify third parties who, in certain cases, may also have to be served with document requests via a subpoena.
Financial advisors should also serve a complaining investor with additional requests for documents. Although the quantity and type of supplemental document requests will vary from case to case, the financial advisor is typically well-advised to request account statements, new account forms, and account update forms from any other financial advisor with whom the investor worked. Oftentimes, an investor’s investment preferences and investment history with other financial advisors can serve as a basis to defend against an investor complaint. It is likewise best practice for a financial advisor to request that an investor produce complete tax returns (including all exhibits and attachments) for three years prior to the first transaction at issue in the complaint to present. Although tax returns should be produced in response to FINRA initial production document requirements, oftentimes investors fail to produce complete tax returns for the entire time period at issue. Supplemental document requests will ensure that an investor does so.
The Final Hearing
Adequately preparing for the final hearing in a FINRA arbitration action is as important as preparing for a trial. Unlike in a typical court case, there is a very slim record in a FINRA arbitration action from which to prepare for the final hearing. For example, rarely do the parties submit witness affidavits or substantive interrogatory responses from which the advisor’s attorney can formulate lines of questioning for the final hearing. The lack of depositions means that prior to the final hearing, an investor’s attorney need not “show their hand” in a deposition as to the key questions they’ll ask the advisor and the advisor’s witnesses at the final hearing. It means that the advisor’s attorney will not have a deposition transcript from which to impeach any of the investor’s potentially inaccurate testimony at the final hearing. It also means that the final hearing will likely be the first time that the advisor is questioned by the investor’s attorney, which may lead to undue anxiety. Combine this with a less formal application of the Rules of Evidence, and a final hearing requires instant judgment in responding to previously undisclosed allegations by the investor.
The key to prevailing at the final hearing is effectively preparing the financial advisor, and any witnesses who are called to testify on the advisor’s behalf. At the final hearing, cross-examination, particularly of the advisor, is as aggressive and hostile as cross-examination at a court trial. The arbitration panel likewise frequently interrupts cross-examination and questions the advisor on its own. It is therefore important that the advisor is adequately prepared, and is ready to handle hostile questioning without losing his or her cool.
The monetary and reputational damage resulting from a FINRA arbitration action can be substantial. Even if an investor’s complaint is frivolous, until a financial advisor prevails at the final hearing, the arbitration action is disclosed in regulatory filings, which can be reviewed by current and potential investors. The advisor, or his or her firm, also incur expenses in defending against the action. Employing the foregoing practices ensures that the advisor will be optimally positioned to prevail against the complaint.