The SEC Is Considering FINRA's Refinement of Arbitrator Selection
Changes to arbitrator selection procedures in the securities industry are imminent.
On April 11, 2023, the Financial Industry Regulatory Authority Inc., the government-authorized not-for-profit organization that oversees U.S. broker-dealers, responded to comment letters it received regarding its proposed amendments to the Code of Arbitration Procedure for Customer Disputes and the Code of Arbitration Procedure for Industry Disputes and filed further amendments.
A week later, the U.S. Securities and Exchange Commission published a notice offering a comment period that concluded in May—it stated that it would be accepting comments to the new amendments until May 9, with a rebuttal period that ended on May 23.
And earlier this month, FINRA extended the time for the SEC to act on its proposals until September.
But the extended comments and review process will provide new arbitration procedures for the financial services that rely on alternative dispute resolution. The proposals, detailed below, range from more consumer-friendly procedures involving assistance with filing claims and protecting confidential information, to dealing with arbitrator selection algorithms and examining conflicts.
There is a big back story. On Dec. 23, 2022, FINRA filed amendments to the Code of Arbitration Procedure for Customer Disputes and the Code of Arbitration Procedure for Industry Disputes with the SEC. The proposed amendments were published for public comment in the Federal Register on Jan. 12, and the commission solicited comments regarding the amendments.
The proposals emanated from an independent study, "Report of the Independent Review of FINRA's Dispute Resolution Services–Arbitrator Selection Process," Christopher W. Gerold (June 28, 2022) (available here). For details on a contentious case leading to the report and the code amendment proposals, see Paulina Jedrzejowski, “FINRA's Proposal to Amend its Arbitration Rules,” 41 Alternatives 63 (April 2023) (available at https://bit.ly/42EVB91).
The SEC received five comment letters, addressed in the Alternatives article (and available directly here), from Hugh Berkson, who is president of, and filed on behalf of, the Public Investors Advocate Bar Association, a Norman, Okla., international organization of attorneys who represent investors against broker-dealers; professors and students at the Cornell University Law School’s Securities Law Clinic, in Ithaca, N.Y.; the Fairbridge Investor Rights Clinic at the Elisabeth Haub School of Law at Pace University, in White Plains, N.Y., and St. John’s University School of Law Securities Arbitration Clinic in Queens, N.Y. (The comments are at bit.ly/3ZpU3im.)
The commenters “expressed general support for the Proposal,” FINRA noted in an April 11 response. That came after FINRA, on Feb. 14, consented to an extension to April 12 in which the commission must approve the proposed rule change, disapprove of the proposed rule change, or institute proceedings to determine whether to approve or disapprove the proposed rule change.
In fact, in the April 11 response to the comment letters, FINRA proposed an Amendment No. 1 with further amendments. This blog post looks at the comments and the FINRA response for which it solicited comments.
At this posting, FINRA had not yet posted a summary of the comments nor issued the final rules, which are expected this year. (More details on the FINRA/SEC proposal and review process are below.) FINRA also has not yet responded to the sole comment letter posted after its April response, which was a May 9 letter by Aleaha N. Jones, an associate in Washington, D.C.’s Pickard Djinis and Pisarri, who noted that the amendment proposals—last winter’s as well as the April FINRA update--harmed brokers seeking expungement of records post-arbitration.
“We urge FINRA to consider instead much-needed improvements to the expungement provisions of the Codes in order to genuinely effectuate the relief brokers seek through the FINRA arbitral forum and provide accurate disclosure information to the investing public,” Jones wrote.
* * *
In their comment letter last winter, Cornell Securities Law Clinic Director William A. Jacobson, and his Cornell students, supported the proposal, with the exception of the proposed rule regarding hearing records. They stated that while the rule regarding the hearing record fills in a gap in the code by specifying the parties’ obligations when ordered to provide a transcription of hearing records, it may be inappropriate to impose such obligation on the parties, especially on claimants with limited financial means, considering the high costs associated with providing hearing records.
The Cornell clinic recommended that FINRA (1) provide guidelines on the circumstances under which the panel might order hearing records from a party; (2) consider only allowing the panel to order hearing records from member firms; and (3) provide waivers or other forms of financial and legal assistance to indigent parties who cannot afford to provide the hearing records and whose case might be jeopardized as a result.
FINRA replied in April by explaining that in practice, with a digital recording the official proceedings’ record, a panel would order a transcript only upon a motion of a party. In the event of such a motion, parties would have the opportunity to object, including on financial grounds. The panel would determine which party or parties would pay the cost of the transcription. In deciding a motion, the panel has the discretion to determine that a party other than the one which ordered the transcription should pay the costs of the transcription.
FINRA stated that it believes that the panel is in the best position to determine how the costs should be allocated and, therefore, declined to introduce amendments to allow the panel to order hearing records only from member firms.
FINRA also explained that as the digital recording is the official hearing record, the director will provide copies of these recordings to any party upon request. Thus, parties will always have access to a record of a hearing, regardless of whether the hearing record is transcribed.
FINRA also declined to amend the proposal to provide for waivers or other forms of financial and legal assistance to parties who may not have the financial resources to pay for hearing records. FINRA did note that guidance on the process for ordering a transcript from a party may be helpful to parties in preparing their case. If the SEC approves the amendments, FINRA will add such guidance to its website.
The Cornell clinic also suggested that that FINRA should specify, in the Rule Proposal or in guidance to arbitrators, that the panel shall consider the parties’ access to and level of comfort with technology when deciding on motions to use alternative prehearing formats, in order to prevent imposing undue burden on claimants.
FINRA noted that during the Covid-19 pandemic, it developed policies and procedures around conducting arbitration causes using virtual hearings and created resource guides for parties and arbitrators for such hearings. “Over time,” the April 11 FINRA letter noted, “parties have become proficient with using this technology and have embraced it as an alternative to other hearing methods. The proposed amendment reflects the preference of parties to have the ability to conduct prehearings virtually.”
In addition, FINRA noted that once fully briefed, a panel will decide a motion regarding the hearing format based on all the information provided, which could include a party’s access to and comfort level with technology. FINRA did point out that if the SEC approves the amendments, it will update its resource guides, as appropriate, to help ensure that parties have the guidance they need to participate fully in virtual prehearing conferences.
The Cornell Securities Law Clinic Director and his students also supported FINRA's clarification regarding the process in which the Director is explicitly permitted to combine separate but related claims into one arbitration while the panel is not explicitly allowed to do so. Although they acknowledged the additional clarity and efficiency this amendment would provide, they suggested that it would be helpful if FINRA specified “what happens if a panel has only been appointed to cases numbered in the middle (i.e., neither the lowest nor the highest number case) if more than two combinable claims are involved.”
FINRA responded that although this scenario would be rare, under the proposed amendment, the default would be for the panel appointed to the lowest numbered case to preside over the combined case.
FINRA stated that in response to Cornell’s comment and to provide additional clarity, it determined to include new amendments which provide that if a panel has been appointed to one or more cases, the panel appointed to the lowest numbered case may: (1) combine separate but related claims into one arbitration, and (2) reconsider the director’s decision upon a party’s motion.
* * *
In their comment letters, Public Investors Advocate Bar Association’s President Hugh Berkson and St. John’s University School of Law Securities Arbitration Clinic Director Christine Lazaro and her students both submitted suggestions regarding the list selection process. Although they acknowledge that enhancing transparency in the list selection process would help individuals who are not familiar with the arbitration process, both stated that the process can be further improved.
Berkson wrote that the PIABA believes that the decisions of FINRA Dispute Resolution Service’s director regarding party-initiated challenges should be written and placed in a publicly available database, such as the one currently maintained for FINRA awards. This database would provide helpful precedents for future parties to consider in evaluating potential arbitrations, according to the PIABA comment, and give parties insight that would help them in understanding what FINRA considers to be a legitimate ground for a challenge to a potential arbitrator, as well as provide greater transparency, consistency, and fairness to the process.
FINRA acknowledged PIABA’s concern that there should be more transparency regarding the arbitrator list selection process and noted that it has created a webpage dedicated to explaining, in plain English, the process of selecting arbitrators. The webpage contains information about the arbitration selection process, the list selection algorithm random list selection process, conflicts of interest, challenges to arbitrators, and more.
Instead of creating a separate database as suggested by PIABA, which FINRA stated that it believes would have little precedential value as these decisions are based on the facts and circumstances of each case, FINRA will update the webpage with the most common reasons for granting or denying party-initiated challenges. The letter stated, “FINRA believes this approach would make the process more transparent–making the information easily accessible on the webpage would provide parties with useful information when considering potential challenges to remove an arbitrator and help ensure that parties are aware of the procedures and how they are applied.”
In their comment letter, St. John’s Prof. Lazaro and her students stated that the arbitrator list selection process might be improved by upgrading the algorithm used to screen conflicts. They stated that a more comprehensive and effective computerized process will limit the necessity for manual review, lending additional confidence to the arbitration selection process.
FINRA responded by stating that it believes that obvious conflicts of interest should be addressed before panel appointment to prevent unnecessary challenges to arbitrators and the attendant disruption to the case that would ensue. Thus, manual review will continue to be necessary.
Additionally, FINRA has begun the process to conduct an external procedural review of the list selection algorithm “to determine if FINRA’s current technology is still the most effective means in creating random, computer-generated arbitrator lists for the arbitrator participants.”
PIABA, the St. John’s clinic commentators, and the Pace University Fairbridge Investor Rights Clinic also had suggestions regarding the personal confidential information redaction process. The St. John’s commenters stated that they believe that the extension of the requirement for redaction will lead to unintended harm to some of the investors FINRA is trying to protect because many unsophisticated claimants may have serious difficulties complying with the redaction requirements.
To address this concern, supervising attorney Elissa Germaine and student interns at the Fairbridge Investor Rights Clinic at Pace’s Elisabeth Haub School of Law stated that FINRA needs to ensure guidance regarding the redaction process is simple and user-friendly. They suggested that FINRA explain the need to redact personal confidential information, the specific information that should be redacted, examples of what a properly redacted document looks like, and basic suggestions about how to make the redactions. They also recommended that this information is added to the FINRA Dispute Resolution Portal in a visible and accessible manner.
The Public Investors Advocate Bar Association and Pace proposed that the suggested guidance for protecting personal confidential information posted on FINRA’s website is likewise posted by the FINRA director on each case’s docket/portal so that claimants are aware and can take action to protect their information.
Yet, the St. John’s commenters state that even those steps may not be enough. They stated that merely providing guidance to pro se filers may create barriers for those who are not able to redact their personal confidential information because some pro se filers do not have the resources to adequately redact their personal confidential information. St. John’s Prof. Lazaro and students proposed that FINRA should permit the waiver of the personal confidential information redaction requirement for pro se filers or that DRS should undertake the redactions itself.
FINRA agreed with the commenters that its guidance on redaction procedures should provide clear, plain English instructions. If the SEC approves the proposal, FINRA will update its website to include guidance on redaction procedures and include the guidance on the Party Portal.
FINRA reiterated that the intent of the proposed amendment is to ensure that personal confidential information is removed from documents filed with FINRA, which would help safeguard investors’ information and their financial resources. FINRA said that investors face the same risk of harm from disclosure of personal confidential information whether the submitting party is pro se or represented by counsel.
Therefore, FINRA noted, allowing pro se investors to waive the redacting requirement would defeat the proposal’s purpose. Further, in response to the alternative suggestion that FINRA make the redactions, FINRA noted that its rules relating to the redaction of personal confidential information state that personal confidential information must be removed from the documents before they are filed with FINRA. This requirement also helps safeguard investors’ information and their financial resources.
The risks associated with the loss of personal confidential information, FINRA states, “will remain as long as parties continue to file documents containing personal confidential information. Thus, FINRA believes it is important that all parties, including pro se claimants, remove [personal confidential information] from their documents before filing" with FINRA.
FINRA also stated that it recognizes that pro se claimants may not have much experience with filing claims in the DRS forum. The letter stated that if the SEC approves the amendments, FINRA will update its website with guidance on redaction procedures.
Furthermore, FINRA said it will include such guidance on the “Party Portal” and will ensure that “the instructions are clear, concise and in plain English.” FINRA stated that “the benefits of safeguarding customers’ identities and sensitive information balance the concerns relating to pro se parties’ lack of experience with filing claims in the forum.”
* * *
Additionally, FINRA made a number of clarifying and substantive changes to its original proposal. FINRA added the following procedural amendments to its original amendment proposal:
- The Director will exclude arbitrators from the list based upon a review of current conflicts of interest not identified within the list selection algorithm. If an arbitrator is removed due to such conflicts, the list selection algorithm will randomly select an arbitrator to complete the list.
- The Director will exclude arbitrators from the lists based upon a review of current conflicts of interest not identified within the list selection algorithm. If an arbitrator is removed due to such conflicts, the list selection algorithm will randomly select an arbitrator to complete the list.
- The Director shall provide to the parties a written explanation of the Director’s decision to grant or deny a party’s request to remove an arbitrator.
- The Director will send all motions, responses, and replies to the panel after the last reply date has elapsed, unless otherwise directed by the panel. After the last reply date has elapsed, if the Director receives additional submissions on the motions, the Director will forward the submissions to the panel upon receipt and the panel will then determine whether to accept them.
- Motions relating to separating claims or arbitrations are decided in accordance with [FINRA Code of Arbitration for Customer Disputes] Rules 12312 or 12313.
- Motions relating to combining claims are decided in accordance with Rule 12314.
- If the panel grants a motion to dismiss all claims, the decision must contain the elements enumerated under Rule 12904(e) and must be made publicly available as an award.
- If the parties create lists of documents and other materials in their possession or control that they intend to use at the hearing and have not already been produced, the parties may serve the lists on all other parties, but shall not combine the lists with the witness lists filed with the Director pursuant to Rule 12514(b).
- The hearing will generally be held in person unless the parties agree to, or the panel grants a motion for, another type of hearing session.
- Executive sessions (i.e., discussions among arbitrators outside the presence of the parties and their representatives, witnesses, and stenographers) held by the panel will not be recorded.
- The panel may dismiss without prejudice a claim or an arbitration for lack of sufficient service upon a respondent.
- The Director will exclude arbitrators from the lists based upon a review of conflicts of interest not identified within the list selection algorithm. If an arbitrator is removed due to such conflicts, the list selection algorithm will generate a replacement arbitrator.
- The Director will exclude arbitrators from the lists based upon a review of conflicts of interest not identified within the list selection algorithm. If an arbitrator is removed due to such conflicts, the list selection algorithm will randomly select an arbitrator to complete the list.
- The Director shall provide to the parties a written explanation of the Director’s decision to grant or deny a party’s request to remove an arbitrator.
- The Director will send motions, responses, and replies to the panel after the last reply date has elapsed, unless otherwise directed by the panel. After the last reply date has elapsed, if the Director receives additional submissions on the motion, the Director will forward the submissions to the panel upon receipt and the panel will determine whether to accept them.
- Motions relating to separating claims or arbitrations are decided in accordance with [FINRA Code of Arbitration for Industry Disputes] Rules 13312 and 13313.
- Motions relating to combining claims are decided in accordance with Rule 13314.
- If the panel grants a motion to dismiss all claims, the decision must contain the elements enumerated under Rule 13904(e) and must be made publicly available as an award.
- If the parties create lists of documents and other materials in their possession or control that they intend to use at the hearing that have not already been produced, the parties may serve the lists on all other parties, but shall not combine the lists with the witness lists filed with the Director pursuant to Rule 13514(b).
- The hearing will generally be held in person unless the parties agreed to, or the panel grants a motion for, another type of hearing session.
- Executive sessions (i.e., discussions among arbitrators outside the presence of the parties, their representatives, witnesses, and stenographers) held by the panel will not be recorded.
- The panel may dismiss without prejudice a claim or arbitration for lack of sufficient service upon a respondent.
* * *
On Tuesday, April 18, 2023, the SEC published a notice pursuant to Section 19(b)(2)(B) of the Exchange Act to solicit comments on the proposed rule change and to institute proceedings to determine whether to approve or disapprove the proposed rule change, as modified by Amendment No. 1. The Commission requested that interested persons provide written submissions of their views, data, and arguments by May 9, 2023 and any person who wishes to file a rebuttal to any other person’s submission file the rebuttal by May 23, 2023.
In particular, the Commission invited opinions regarding whether the proposed rule change is consistent with the Exchange Act and the rules thereunder. The SEC’s mandate is to determine whether the proposal is consistent with the Securities Exchange Act of 1934. The Commission also stated that even though it does not appear that there are any issues relevant to approval that would be facilitated by an oral presentation of views, data, and arguments, the Commission will consider requests for an opportunity to make oral presentations.
As a result, the comments are under SEC review, awaiting its notice of the proposal in finalized form, for comment, in the Federal Register. The FINRA review process can be found here.
Two weeks ago, FINRA extended the time for SEC action a second time, with a new Sept. 8 deadline. That July 3 filing can be found here. FINRA’s list of filings for the proposed rule change is collected here.
For more analysis, see George H. Friedman, “June Marks One Year Anniversary of “Rigged Panels” Investigation Report,” Securities Arbitration Alert (June 6) (available here).
* * *
The author, who is a Brooklyn Law School student in New York, was a CPR 2023 Spring intern.