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Some Investors Face Flip Side of Arbitration

Los Angeles Times

The securities industry’s arbitration process has long been viewed as a small investor’s last resort to press grievances against a broker.

But some investors are discovering to their dismay that arbitration is a two-way street: Brokerage firms also can bring claims against them–often with painful financial results for investors.

This has been a particular surprise during the last two years to investors who bought stocks with loans–or “margin” credit–from their brokers, then had their accounts sold out by the firms when the market plunged.

Many people believe they were sold out unfairly. Now, they have a new problem: Brokers are dragging people into arbitration to force repayment of margin loans.

The firms have sent letters and made phone calls, hoping customers will agree to payment plans for money still owed. If they refuse, brokers sometimes turn them over to collection agencies.

If that fails, a broker can file an arbitration claim, which brings a case before a panel of securities industry experts for judgment.

“We’re seeing more cases that Wall Street is bringing against individual investors for margin deficiencies than ever before,” said Mark Maddox, an Indianapolis securities attorney. “The pure number of cases is unprecedented.”

Unlike arbitrations lodged by investors, Wall Street appears to win the vast majority of cases it brings.

An arbitration victory for a broker paves the way for the firm to secure a court judgment and place a lien on an investor’s assets.

For investors who already have suffered huge losses buying stocks on credit, forced arbitration can feel like insult added to injury. Many people already blame brokerages for their losses, saying the firms improperly sold their stocks or didn’t give them enough time to raise capital to cover loans.

The collection efforts are the final chapter in a long-running saga over margin loans.

Though buying stocks on credit is a high-risk strategy, many brokerages were happy to make margin loans to customers in the bull market’s heyday. The firms received interest income and reaped commissions off investors’ trades.

Total margin debt peaked at $278.5 billion in March 2000, up 79% in just one year. Margin lending inflated investor profits when the market was rising. But the leverage exacerbated investor losses when stocks began sinking.

As of late May, margin debt had plunged to $174.2 billion.

Often, investors paid off loans on their own to cut their losses. But brokerages also liquidated many margin accounts to limit their exposure to losses–in some cases emptying accounts and leaving investors owing money.

Though legal, the brokerage actions were highly controversial. Some customers claimed the firms caused their losses by selling stocks at a market low. Others accused the firms of not giving them time to deposit new cash.

The margin issue already has generated a torrent of arbitration cases. Margin-related cases surged to 284 last year from 39 two years earlier, according to the National Assn. of Securities Dealers. This year, 190 cases were filed through May, a pace that could mean more than 450 cases for the full year.

The NASD does not disclose whether cases were filed by brokers or customers. While investors still file the majority of claims, attorneys say broker-filed cases are rising.

What’s more, arbitration panels usually rule in favor of brokerages, often granting them all or most of the money they seek, experts say.

Last November, for example, an arbitration panel sided with discount broker E-Trade Group in a claim it brought against Wichita, Kan., investors Thomas C. Tran and Ann T. Nguyen.

The firm alleged that the couple defaulted on a margin loan involving a 1998 purchase of 7,600 shares of, a small Internet commerce firm that was later acquired by another company.

E-Trade liquidated the couple’s account, claiming in an arbitration hearing that Tran did not follow through on a promise to deposit money to cover the debt, according to the award decision.

Tran countered that the firm’s computer system mistakenly bought more stock than he wanted. But the panel ordered the couple to pay E-Trade the full $41,325 the firm sought, plus 8.75% interest.

“They’re still quite upset about” the decision, said their attorney, B. Scott Tschudy.

E-Trade declined to comment.

Most brokerages say they do everything possible to work out agreements with investors.

“Arbitration is the last resort,” said Hardy Callcott, general counsel of Charles Schwab Corp.

In part because it had implemented more stringent margin-lending standards, Schwab filed half as many arbitration cases last year as in 1999, a spokesman said.