South-Western College Publishing - Economics  
Who Watches the Watchers?
Topic Market Failure, Regulation and Public Choice
Subject conflicts of interest in financial services arbitration panels
Key Words arbitration, bias, conflict of interest, financial services, screening, monitoring.
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Reference ID: A147165561

News Story Rather than go through protracted and expensive court cases, The National Association of Securities Dealers (NASD) prefers to arbitrate disputes between securities dealers and their clients because arbitration is a low-cost, fast way of resolving disputes relative to taking cases to court. Under arbitration, both parties in a dispute argue their case to a three-person panel, and agree to submit to the panel's decision of the panel. The problem? Securities dealers won client-broker disputes 57% of the time in 2005, compared to only 46% of the time in 2001.

The fast arbitration system worked very well initially. Last year, for example, the resolution time for a dispute was 14 months, down from15 the year before. It is becoming increasingly costly and complex, though, to identify the problems in the system.
          Opponents of the arbitration system argue that the problem stems from a lack of any clear screening and monitoring mechanism of the individuals who make up arbitration panels. Of the three members, one can be an "industry arbitrators," drawn from those who have ties to the securities industry. The other two must be "public arbitrators," without ties to the securities industry. In the wake of recent mergers across the financial services industry, it is becoming increasingly difficult to find people who have no ties to the securities and financial services industries; that is, people without conflicts of interest.
          For example, one individual identified by the Public Investor Arbitration Bar Association was listed as a "public arbitrator" by the NASD, but had previously owned a securities firm, making him more likely to be an "industry arbitrator." Other individuals who sit on arbitration panels must have some familiarity with financial issues, so while potential conflicts may be more difficult to identify, familiarity with the issues also means sharing similar conflicts. For example, arbitration lawyers may be employed at firms that have affected securities firms (or individuals) as clients.
          The NASD Dispute Resolution, a firm created to handle arbitrations, argues that it expects arbitrators to be forthcoming about potential conflicts of interest. But no mechanism in place checks the accuracy of the arbitrators' profiles. Further, it may be difficult for potential arbitrators to identify every potential conflict, especially as the financial services industry becomes more complex. Finally, it may be in the arbitrator's best interests to try to hide potential conflicts. So how is the small investor going to get a fair shake?

Discussion Questions:
1. Why do you think that it's difficult to create an effective monitoring mechanism to identify conflicts of interest?
2. Would an effective monitoring system involve a new panel at the NASD Dispute Resolution, vetting every arbitrator profile it receives-in other words, an ethics board to watch the watchers?
3. If more effective monitoring is necessary, what would such a plan look like? Discuss this with your classmates.
Multiple Choice/True False Questions:
1. True/False. According to the article, no effective monitoring mechanism identifies conflicts of interest among potential arbitrators.

2. According to the article, what has happened as a result of the use of arbitration panels?
  1. More cases have been won by securities dealers than by investors.
  2. Fewer cases have been won by investors.
  3. Time from dispute to resolution has fallen.
  4. All of the above.
3. In industrial organization theory, monitoring mechanisms typically encourage individuals to model ideal behaviors so that those being monitored learn from the experience. How would this be reflected in a more effective arbitration monitoring program?
  1. Potential arbitrators identify all known conflicts of interest.
  2. Potential arbitrators individually recuse themselves in the presence of a conflict.
  3. Potential arbitrators act in their own best interests.
  4. A and B
Source Morgenson, Gretchen. "Is This Game Already Over?" The New York Times. June 18, 2006.
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