Is This Game Already Over? - part 2

The story of the losses incurred by the East Islip firefighters begins like that of so many other investors who lost money during the stock market bubble. Mr. Sirico, their broker, put the group into speculative technology stocks, made risky bets on options and used borrowed money to expand the group's portfolio. In May, Mr. Sirico was fined $10,000 and suspended from associating with any NASD firm for seven months for disclosure failures. He could not be reached for comment.

But trouble in their arbitration began last fall, when Robert W. Cockren, a lawyer at Sonnenschein Nath & Rosenthal, became chairman of their arbitration panel and was to act as a public representative.

Mr. Meissner challenged Mr. Cockren's fitness to serve on the panel because of Sonnenschein Nath's extensive relationships with brokerage houses. NASD rules state that any lawyer whose firm receives more than 10 percent of its annual revenue in the prior two years from the securities industry cannot be considered a public arbitrator. But unless law firms disclose the sources of their revenue, it is impossible to determine if such conflicts exist.

NASD denied Mr. Meissner's challenge, saying that the arbitrator had done a "conflict check" with respect to the brokerage firms that were involved in the case. But Mr. Meissner learned through an extensive search that one client of Mr. Cockren's firm was the parent company of a firm being sued in the case. He presented the evidence to NASD and, on Dec. 9, 2005, Mr. Cockren withdrew from the panel.

Mr. Cockren said: "I fully complied with the NASD rules and regulations and nothing that either I or my firm did was improper. We were substantially below the revenue threshold but it wasn't worth my time or energy to deal with the attacks going on."

Mr. Meissner also challenged four other arbitrators that the NASD proposed, saying that all of them either had conflicts or had backgrounds that made them inappropriate representatives of public investors. Three withdrew from consideration, while the fourth is chairman of the panel.

The East Islip association seeks the $614,000 it lost, as well as attorney's fees, court costs and interest. It has also asked for treble damages, amounting to about $1.8 million. Hearings on the case are scheduled for October.

Problem panelists have plagued other arbitrations. Donald L. Sturm, a wealthy Colorado businessman who sold his ownership in a company to WorldCom for stock and then lost $900 million after the telecommunications company collapsed, filed for arbitration against Citigroup in 2003. He contends that Jack B. Grubman, the banking giant's former telecommunications analyst, advised him to hold onto his WorldCom stock even as it was plummeting. Mr. Grubman was barred from the securities industry for life in late 2002.

An NASD arbitration panel ruled against Mr. Sturm in November. But Mr. Sturm's lawyers are asking a federal court to overturn the decision because David H. Drennen, an arbitrator in the matter, failed to disclose past incidents that the lawyers say should have disqualified him or that they could have used as evidence to strike him from the panel.

According to a brief filed in the case, Mr. Drennen, general counsel at Bathgate Capital Partners, an investment firm in Greenwood Village, Colo., failed to disclose an arbitration panel finding from 1996 that a previous employer, "through Drennen's conduct, committed securities fraud." The panel in the case "awarded both the full amount of compensatory damages alleged and punitive damages" according to the brief.

Mr. Drennen, a former NASD regional counsel, declined to comment. In a deposition taken last month in Mr. Sturm's case, he said he recalled the earlier arbitration but said he did not disclose it on his arbitration forms because his conduct was not an issue in the current case. He also said in the deposition that he had testified in the 1996 arbitration on behalf of his employer, attended the entire proceeding and could not identify anyone else at the firm, besides himself, whose conduct was the subject of the case.

Mr. Sturm's lawyers say Mr. Drennen's involvement in the current arbitration is problematic in two ways: first, it may make him less objective or sympathetic to an investor accusing a brokerage firm of fraud, and, equally important, his disclosure of his involvement should have disqualified him from serving on the panel handling Mr. Sturm's grievance. NASD rules state that a prospective panelist is unqualified to serve if he or she, within the past seven years, has been the subject of an adverse, investment-related arbitration award of $25,000 or more. The 1996 arbitration involving Mr. Drennen resulted in a $212,103 award and occurred five years before he applied to become an NASD arbitrator.

David E. Warden, a partner at Yetter & Warden in Houston who represented Mr. Sturm, said that a disclosure failure by any arbitrator "not only deprives the parties of their right to make an informed selection decision but also strips any semblance of integrity from the process.

"There doesn't seem to be a watchdog for any of this," he added.

Plaintiffs' lawyers also say that arbitrator biases and conflicts are harder to plumb as financial services firms grow in size and scope. Rosemary J. Shockman, a former president of the Public Investors Arbitration Bar Association, testified before Congress last year that the problem of potentially biased panelists representing the public "continues to grow as various sectors of the financial services industry continue to consolidate their operations in the admitted quest for 'capturing assets' and offering the consumer 'one-stop shopping.' "

J. Boyd Page, a lawyer at Page Perry in Atlanta, said that he has often found that arbitrators assigned to represent the public in a case have close associations with the securities industry. "I just got a proposed panel in Houston and I have 10 so-called public arbitrators that I can pick from," Mr. Page said. "Of those, six had associations with the securities industry. You really wonder about the quality of monitoring."

The potential for conflicts among arbitrators would not be such a problem, defense lawyers say, if investors had an alternative to arbitration. But they do not.

"We believe that arbitrators should be properly classified and that there should be zero conflicts, either real or apparent," Mr. Caruso said. "An arbitrator is supposed to disclose conflicts but there is no follow-through and no system of checks and balances."

Return to part 1 of the story on problems with the securities arbitration process.