[J-TAO Report] ars of bull market bliss gave brokerage clients few reasons to open their account statements—until March.

Within one month, stocks in the United States notched their biggest one-day losses—and gains—as mounting fears about COVID-19’s economic impact and efforts to contain the fallout whipsawed indexes by 30 percent. The market swings likely prompted many brokerage customer to scrutinize their advisers’ investments, and some might not have liked what they saw.

“There's a Warren Buffett quote: ‘Only when the tide goes out do you discover who’s been swimming naked,’” says Mark L. Egan, an assistant professor of finance at Harvard Business School. When they do find out, they often want to sue, but they can’t.

Financial services companies require customers to waive their right to litigate and instead resolve their disputes through arbitration. Rather than argue before an impartial judge and jury, consumers must bring their grievances to an expert panel that’s more likely to take the brokerage’s side, reducing consumer awards by $40,000 on average, says HBS research.

“Unlike judges, arbitrators aren’t randomly assigned,” Egan says. “The ones that are getting systematically selected [by the disputing parties] tend to be more industry friendly. This also incents arbitrators to slant their decisions in favor of the industry to increase their chance of being selected in the future.”

Building on his 2018 research of 9,000 arbitration cases, Egan and fellow researchers found that 40 percent of arbitrators previously worked as advisers and they tended to favor brokers. The 8 percent of these arbitrators who were forced to pay clients restitution during their adviser careers were even more biased against consumers.

Egan—along with Northwestern University Professor Gregor Matvos and Stanford University Professor Amit Seru—detail their findings in the revised working paper Arbitration with Uninformed Customers, released in May.

Brokers’ critical advantages in arbitration

About 40 percent of American investors rely on financial advisers to manage their portfolios in mostly productive relationships. However, every year, a few thousand customers file new arbitration cases with Finra, the US brokerage industry’s regulatory organization, alleging everything from negligence to fraud.


During arbitration, claimants and brokerages rank their preferred arbitrators from a random Finra-generated list, striking ones that might side with the opposing party. Brokerages typically tap into vast troves of proprietary information about arbitrators’ past rulings, allowing them to eliminate arbitrators that might sympathize with customers.

However, many consumers “have no idea who these arbitrators are. They’re just names on a list,” Egan says. “But the firms know each one of these arbitrators very well and have worked with them in the past.” While customers can access public information about brokers through Finra, they generally lack the time, resources, and expertise to harness the data. And even though most claimants hire lawyers to represent them in arbitration, brokerages still have the upper hand.

The degree to which a panel favors the defending company accounts for 24 percent of the variation in arbitration awards to consumers. In dollar terms, choosing an arbitrator who’s even slightly sympathetic to brokers—by one standard deviation more than average—cuts $21,000 from the median award of $175,000.

“As soon as one party is substantially more informed than the other, it’s going to result in pretty unfair outcomes,” Egan says.

More incentives that give brokers an edge

Becoming an arbitrator—and earning as much as $2,900 during the average four-day case—can be an alluring way for an adviser to supplement their income. On an hourly basis, arbitrators make at least $75 an hour, almost twice as much as advisers’ $40 median hourly pay, according to Egan’s research.

The pressure to maintain a steady stream of cases further incents arbitrators to side with brokers. Arbitrators who seem lenient to advisers are 40 percent more likely to be picked. After all, ending up on a brokerage’s “strike” list can doom an arbitrator’s career.

“Our estimates suggest that, ‘If I want to make a career out of this, I will make more money if I look industry-friendly,’” Egan says.

To be sure, some arbitrators are more likely to support consumers, including the 11 percent of arbitrators who were previously fired as advisers by their firms. But these arbitrators are less likely to make the panel’s cut.

The proliferation of arbitration

Companies from internet service providers to nursing home operators use arbitration to shield themselves from expensive, protracted lawsuits. Proponents say the approach resolves disputes faster than the court system and at lower cost. Critics say the process leaves consumers too vulnerable, especially when they’ve been physically harmed by a product or service.

Many people don’t realize that they’re waiving their right to sue in a US court when they sign contracts or click “Agree” to a company’s terms of service. Arbitration becomes their only recourse to address grievances and the rulings are usually final and binding. An unhappy party can’t appeal the outcome.

In 2017, the Consumer Financial Protection Bureau tried to bar financial services companies from imposing “forced arbitration” on the roughly 20 million US households with brokerage accounts. However, Congress repealed the regulations shortly after they were introduced.

Finra has considered measures to level the playing field, including letting parties eliminate more arbitrators and boosting arbitrators’ pay. Egan’s research suggests that those approaches tip the scales further toward brokerages, but simply providing a longer list of potential arbitrators could help more consumer-leaning arbitrators serve on panels.

How consumers can protect themselves

Egan recommends two resources to consumers who find themselves in arbitration with a financial adviser:

  • Finra’s BrokerCheck. This free, public database provides brokers’ work history and past violations—valuable clues that might signal the potential for bias.
  • Arbitration experts. Attorneys and firms that specialize in brokerage arbitration are more likely to maintain their own arbitrator data.

Above all, consumers should monitor their investments and never assume that years of education will make them more aware of misdeeds. Egan started studying ethics in financial services after an adviser swindled his aunt, a high-level university administrator. Watching her seek restitution highlighted the vulnerability of all investors.

“It was very powerful to see someone who’s very sophisticated still be taken advantage of,” he says. “If you think about how many people in the US lack financial knowledge, you can only imagine what could potentially be happening to them.”

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