SEC Approves FINRA’S Rule Change Proposal Implementing “Rigged Panels” Investigation Report Recommendations
Posted on Categories Arbitration, Arbitrators, FINRA Code of Arbitration, Rulemaking, SEC, Securities ArbitrationTags , , , ,

By George H. Friedman, SAA Publisher & Editor-in-Chief

The SEC has approved FINRA’s rule change proposal to implement recommendations resulting from the outside investigation of allegations that the arbitrator selection process was rigged.

We reported in SAA 2023-01 (Jan. 5) that, on the eve of the year-end holiday break, FINRA had filed a rule change proposal that would implement recommendations resulting from the outside investigation of allegations that the arbitrator selection process was rigged. The SEC approved the rule filing on September 7. Borrowing heavily from past coverage, we present below a concise history.

Brief History: Award Vacated by Trial Court

To review succinctly, Fulton County Superior Court Judge Belinda E. Edwards in Leggett v. Wells Fargo Clearing Services, LLC, No. 2019CV328949 (Ga. Super Jan. 25, 2022), vacated the Award that sparked the debate in what might be considered a primer on the basic Federal Arbitration Act grounds for vacating an award (i.e., fraud, arbitrator bias, arbitrator misconduct in not hearing relevant or material evidence or failing to grant a reasonable postponement request; or the panel exceeding its authority). Although the Trial Court found all of these bases for vacating the Award, Judge Edwards weighed in on interference with the Neutral List Selection System with some scathing verbiage:

The Court’s factual review of the record evidence leads to its finding that Wells Fargo and its counsel manipulated the FINRA arbitrator selection process in violation of the FINRA Code of Arbitration Procedure, denying the Investors’ their contractual right to a neutral, computer-generated list of potential arbitrators. Wells Fargo and its counsel, Terry Weiss, admit that FINRA provides any client Terry Weiss represents with a subset of arbitrators in which certain arbitrators (at least three, but perhaps more) are removed from the list Wells Fargo agreed, by contract, to provide to the Investors in the event of a dispute. Permitting one lawyer to secretly red line the neutral list makes the list anything but neutral, and calls into question the entire fairness of the arbitral forum.

Award “Unvacated”

Wells appealed, and, in a unanimous decision, the Georgia Court of Appeals reinstated the Award in Wells Fargo Clearing Services, LLC v. Leggett, No. A22A1149 (Ga. Ct. App. Aug. 2, 2022). The unanimous decision rejected all bases upon which Judge Edwards vacated the Award. As reported in SAA 2022-42 (Nov. 10), Leggett on August 22, 2022 filed a Petition for Certiorari, seeking review by the Georgia Supreme Court.

Independent Investigator’s Report

As summarized in SAA 2022-38 (Oct. 13), FINRA in June 2022 released a 37-page Report of the Independent Review of FINRA’s Dispute Resolution Services – Arbitrator Selection Process, which was announced in a corporate Press Release and a separate statement from the Audit Committee. The investigation was directed by Christopher Gerold, a partner in Lowenstein Sandler LLP’s Securities Litigation and Corporate Investigations & Integrity Practice Groups.

Recommended Changes

After discussing methodology and the operation of the Neutral List Selection System, the Report concluded that there were no irregularities, and it closed with recommendations for improvement. The core recommendations were (ed: presented verbatim from the Release):

  • Implementing ongoing, mandatory training for staff;
  • Requiring written explanations, upon a party’s request, of approval or denial of a causal challenge to the selection of an arbitrator or an arbitrator removal by the DRS Director for cause;
  • Conducting an updated external procedural review of the arbitrator selection algorithm to determine if it is still the most effective means for creating random, computer-generated arbitrator lists; and
  • Updating the DRS Manual and rules to clarify staff roles and procedures, and to ensure consistency and transparency.

FINRA’s management accepted all recommendations, and now posts on its Website a live progress report on implementation. Status Report on Lowenstein Sandler LLP Recommendations shows that most items have been implemented or were “in progress.”

Late December 2022 Rule Filing

On December 23, 2022, FINRA filed with the SEC SR-FINRA-2022-033, Proposed Rule Change to Amend the Codes of Arbitration Procedure. The filing describes it as: “a proposed rule change to amend the Code of Arbitration Procedure for Customer Disputes (‘Customer Code’) and the Code of Arbitration Procedure for Industry Disputes (‘Industry Code’) (together, ‘Codes’) to make changes to provisions relating to the arbitrator list selection process in response to recommendations in the report of independent counsel Lowenstein Sandler LLP. The proposed rule change also makes clarifying and technical changes to requirements in the Codes for holding prehearing conferences and hearing sessions, initiating and responding to claims, motion practice, claim and case dismissals, and providing a hearing record.” We referred readers to published analyses of the 96-page rule filing: Finra Proposes Tweaks to Arbitrator Selection, AdvisorHub (Jan. 3, 2023); Finra Moves to Make Arbitrator Selection Process More Transparent, Financial Advisor (Jan. 5, 2023); and Finra Floats Revamped Arbitrator-Selection Process, Financial Advisor IQ (Jan. 6, 2023).

Post-Rule Filing Activity

We present below in bullet format the several events that took place since the rule change proposal was filed last December:

  • The proposed rule was published in the Federal Register on January 12 (Vol. 88, No. 8, P. 2144), making comments due February 9.
  • We analyzed in SAA 2023-07 (Feb. 16) the handful of comments received from PIABA and three law school clinics posted on the SEC’s Website, describing them as generally supportive but recommending improvements.
  • FINRA by a February 14 letter extended to April 12 the SEC’s time to act.
  • On April 4, a unanimous Georgia Supreme Court declined to review the underlying case, stating: “Certiorari – Writ denied …. All the Justices concur, except Boggs, C. J., not participating.
  • FINRA on April 11 filed its response to comments, and Amendment No. 1 to Proposed Rule Change.
  • The SEC on April 18 published in the Federal Register (Vol. 88, No. 74, P. 23720 ) Order Instituting Proceedings To Determine Whether To Approve or Disapprove. The Order requested comments by May 9, with rebuttal comments to be submitted on or before May 23. No comments are posted on the SEC’s Website.
  • FINRA by a July 3 letter extended to September 8 the SEC’s time to act.

Rule Approved

The Commission approved the rule filing a day early on September 7¸via Release No. 34-98317. The Summary to the 57-page Approval Order reads:

“The proposed rule change, as modified by Amendment No. 1 …, would amend provisions of the Codes governing the arbitrator list selection process to: (1) exclude arbitrators from the arbitrator ranking lists based on certain conflicts of interest; (2) permit the removal of an arbitrator for cause at any point after receipt of the arbitrator ranking lists until the first hearing session begins; and (3) provide parties with a written explanation of the decision by the Director of FINRA Dispute Resolution Services … to grant or deny a request to remove an arbitrator. In addition, the proposed rule change, as modified by Amendment No. 1, would amend procedural rules in the Codes, such as those pertaining to holding prehearing conferences and hearing sessions, initiating and responding to claims, motion practice, claim and case dismissals, and providing a hearing record” (footnotes omitted)

What’s Next?

Next will be Federal Register publication of the Approval Order. Thereafter, FINRA will publish a Regulatory Notice setting the effective date(s). Along the way there will be staff and arbitrator training.

(ed: *Kudos to FINRA and the SEC. **The July 17 CPR Speaks Blog, has an excellent analysis, The SEC Is Considering FINRA's Refinement of Arbitrator Selection