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Dear Dagen: Navigating the Arbitration System

If you ask a securities attorney to list the pros and cons of the arbitration process, you’ll likely get the following response:What difference does it make? You don’t have any other option.

That’s true. In the securities industry, complaints are typically heard in arbitration (a private legal proceeding that’s legally binding on both parties), rather than in a court of law. When you open a brokerage account, you have to agree to arbitration in the event of a dispute. You can refuse, but the firm probably won’t let you open the account.

And these days a lot more people are walking through that door. There has been a big jump in the number of arbitration filings. During the first three months of the year, 1,817 new cases were filed with NASD Dispute Resolution, an arm of the National Association of Securities Dealers that runs the largest forum for securities arbitration. That’s a 17% increase from the same period a year ago and a 34% spike from the first quarter of 2000. (The New York Stock Exchange oversees the other major venue for hearing arbitrations.)

Historically, 6,000 to 7,000 cases are brought before arbitration every year, says Rick Ryder, editor of the Securities Arbitration Commentator, a newsletter based in Maplewood, N.J. “But we’re expecting 8,000 arbitrations this year.”

That jump isn’t surprising. An unprecedented number of people started investing money in the market during the ’90s. And by 2000, an unprecedented number of people started losing money in the market.

The bull market was great cover for incompetent or unethical brokers. And many investors realized they were totally inappropriate investments only after they’d lost scads of money.

Since the arbitration process is the primary way you can go after a broker or firm, here are a few tips you can use when dealing with this system.

Do You Have a Legitimate Complaint?

If you’ve watched your money evaporate as the market headed south, you have every reason to scream and complain. But you don’t necessarily have a case that’s worth taking to arbitration. “People who pursue arbitration claims on that simplistic basis will quickly find they’re wasting time and additional money,” says Ryder.

You have to prove that a broker and/or a brokerage firm acted negligently or fraudulently. One common arbitration complaint is that a broker made unsuitable investments on an investor’s behalf. A broker has to know the customer and make recommendations that fit a person’s investment profile and risk tolerance. If you’re age 75, retired and living on a fixed income, and your broker put all your money in tech stocks in 1999, you have a complaint that’s worth pursuing.

Unauthorized or excessive trading — known as churning — in your account are two other valid reasons for filing a claim against a broker. And everyone these days seems to be going after Wall Street analysts for their biased research. But it isn’t clear how successful investors will be in winning arbitration cases against these analysts and their firms. (One high-profile victory: Investor Debases Kanjilal claimed that analyst Henry Blodget’s ridiculously optimistic research coverage of InfoSpace cost him $500,000 in losses, and the analyst’s firm, Merrill Lynch, settled the arbitration claim for $400,000.)

“There has to be a connection between what an analyst did wrong and your loss,” says Ryder.

Should You Hire a Lawyer?

Frankly, the easiest way to know if you have a complaint that’s worth pursuing is to talk to a lawyer. Very often, an investor might not understand the problem from a legal standpoint. For example: Does the legal definition of churning fit what happened to you? An attorney who is experienced in handling arbitration cases will be able to steer you through this complicated process. You have to pick a forum for the arbitration (generally it’s NASD Dispute Resolution or the NYSE), decide who to name in the claim, file the complaint, select the arbitrators, handle the discovery process and attend the actual hearing. Just read through the NASD’s code of arbitration procedure on its Web site and you’ll understand how complicated it is. Reading Beowulf — in Old English — is easier.

Even if you’re well versed in securities regulations, you may still want to consult an attorney. A brokerage firm will undoubtedly be represented by a lawyer who fights arbitration claims for a living. If you decide to go it alone, you could wind up at a huge disadvantage.

Of course, money is a crucial issue in deciding if you should hire a lawyer. A lawyer might charge you $150 to $400 an hour or bill you based on a contingency fee that typically runs about one-third of any amount awarded. Or an attorney might ask that you pay a fixed amount upfront, say $5,000 to $10,000, against that contingency fee.

If your arbitration claim is $25,000 or less, you can use what’s called simplified arbitration at the NASD. A standard arbitration proceeding involves a hearing from a panel of three people — one of whom needs to be from the securities industry. With simplified arbitration, you deal with only one arbitrator and you generally don’t have a hearing.

But simplified arbitration isn’t necessarily easier. Because the case is conducted entirely through documents, you have to know what you’re doing. But if your claim is less than $25,000, it might not make economic sense to hire a lawyer. In fact, a good, busy attorney might not take a case this small.

Mediation is also an option. It’s a less formal, voluntary process in which a mediator tries to help the two parties reach a resolution. If you have a claim of more than $250,000, the NYSE actually requires mandatory mediation before a hearing.

In the past, most arbitration cases have settled before they reach the hearing stage. The settlement rate runs around 65% to 70%, says Ryder. But several attorneys say that brokerage firms are less willing to settle today and more aggressive in defending cases. “Times are tougher and firms aren’t making as much money,” says Morgan Bentley, an attorney in Newark, N.J.

The brokerage firms are willing to fight. And you should be, too, if you’ve been wronged.