With the astronomical rise of financial fraud, especially among senior investors, many broker-dealers who provide online account access are grappling with a rise in fraud-related litigation, both in the familiar comfort of securities arbitration and, far less comfortably, in state court.
Since the dawn of mandatory securities arbitration in the late 1980’s, many broker-dealers have incorporated mandatory arbitration clauses in their customer agreements. The Financial Industry Regulatory Authority (FINRA), the self-regulatory organization that oversees the activities of broker-dealers, investment firms, and registered securities professionals in the United States, administers a comprehensive arbitration and mediation program for all its registered members.
For decades, the FINRA forum was the only stop for customer disputes, with motions to compel arbitration or state court litigation routinely granted. Now, however, with the rise in the various types of fraud endemic to a growing online world, many broker-dealers find themselves in state court and are faced with the decision to stay there and attempt to negotiate a quicker, favorable result or move to compel arbitrations, which in some instances now only complicates matters more.
It used to be that only “discount brokers” allowed their clients to manage their accounts online, including the capability to perform actions such as asset transfers and beneficiary changes. With the rise of many tech-friendly newcomers, even old-line brick and mortar stalwarts are getting in the game and offering complete online account management to stay relevant.
Keep in mind, the issue here is not information security. Post-2008, many institutions have hardened their defenses against fraud, but no system is foolproof - especially against a bad actor posing as a client.
The challenge at hand is the prevalence of fraud by known actors, who either gain passwords and usernames by deception or with the permission of the client, who can now electronically send account change instructions via electronic means, often directly via an online resource.
It may come as a surprise that a good chunk of this fraud is undertaken by known actors, often relatives of older clients who are no longer focused on their finances or simply need help paying their bills.
“Beneficiary fraud” is very much on the rise. Typical scenarios often include a new spouse or other individual who gets access to a client’s credentials and adds themselves as beneficiaries to IRA’s, TOD’s, and many other account types. In doing so, they can outright remove other pre-existing beneficiaries with no notice to the people being removed.
After the death of the account holder, prior beneficiaries who process their claim are often surprised to find out that they have been replaced. Their first instinct is often to sue not only the bad actor, but the firm that held the assets.
In the past, arbitration had been favored by financial firms because it is quicker, cheaper and far more efficient than litigating in court. In New York, the CPLR, EPTL and SCPA are voluminous, and, to be fair, complicated. In comparison, the FINRA rules of arbitration procedure are much less complex.
In arbitration, the name of the game is efficiency. There are no depositions or interrogatories and discovery is governed by specific lists of documents to be produced. The average lifespan of an arbitration from pleading to an award is between nine months to a year, with basically no right to appeal. Elderly clients can even apply for “expedited” scheduling, which is liberally granted by FINRA case administrators.
As efficient as arbitration is, it is simply not built for the immediacy required when a bad actor inserts themselves into the financial life of a senior investor. Arbitrators have injunctive relief powers, but one has to go through the process of pleadings and arbitrator appointment before that ever happens, which can take months.
Often when account changes are made, litigants need to move quickly to prevent a firm from paying assets to a disputed individual. In New York, the process is moving by Order to Show Cause (“OSC”) filed with a civil complaint against the bad actor and a firm.
While firms are required by law to respond to the OSC in court, moving to compel arbitration of the contract-related causes of action in the complaint is still an option. But, the question becomes, is it always the best option?
Plaintiffs often combine causes of action that are arbitrable along with those that are not. This creates the likelihood of fracturing the litigation between state court and arbitration.
For example, a plaintiff sues an alleged bad actor for changing the beneficiary status from other family members to herself right before the death of the account holder. The complaint focuses on the actions of the bad actor, alleging coercion or some type of fraud, but it also includes causes of action against the firm for breach of contract, breach of fiduciary duty and negligence for allowing it to happen.
The legitimacy of the charge is well within the jurisdiction of the court and may have no relation to actions taken by the firm, but the firm is along for the ride as far as discovery is concerned because it holds all if not most of the relevant documents, which often include previous beneficiary designations which may be inconsistent with the last-minute changes or other factors.
Claims against the firm which are grounded in contract rightfully belong in arbitration.
When this happens, the firm has to make a choice: it can stay and fight it out in state court, mired in an elongated and expensive discovery process, or it can move to compel arbitration of only the contract-based causes of action.
The process becomes even more complicated when there are potential third parties who may have an interest in the beneficiary change and have not brought suit with the plaintiff. Once again, the firm has a series of choices, none of them good. The firm can move ahead with the state court action or arbitration, but there is a risk of the uninvolved potential party later filing a separate action against the firm. To avoid this potential litigation risk, the firm can initiate an interpleader to bring in the other party to the state action. However, that choice potentially ties the firm to state court as it may not be able to compel remote non-signatories to arbitration.
Further, if there is a distribution to an estate which is interrupted or stopped by the firm, the firm is potentially exposed as a defendant in a turnover proceeding in Surrogates Court.
As the number of fraud cases grow, these complicated situations grow with them.
Compounding the issue is the fact that many civil practitioners are not familiar with securities arbitration or the mandatory arbitration clauses contained in client agreements, and often find themselves mired in delays while fighting a motion to compel arbitration.
In New York, motions to compel arbitration are liberally granted as the law strongly favors the contractual rights afforded to firms, even when non-signatory beneficiaries seek redress based on the contract signed by a deceased client.
The effort to litigate those case for plaintiffs is time consuming and expensive. The current growing backlog of cases in state court often results in judicial decisions taking many months before they are rendered. Courts will often stay the state court litigation (including discovery) until the disposition of the arbitration, leading to an even greater delay in potential resolution.
State court practitioners are best served when they fully consider all of their options before deciding how to commence an action.
The same is true for counsel who reflexively move to compel arbitration where the facts of the case may merit remaining in state court where a reasonable disposition may be possible, especially when actions of a potential fraudster are attenuated from anything the firm may have done.
Often, the best choice is an attempt at reaching an agreement before filing or, at a minimum, having a firm grasp of the facts of the case before undergoing motion practice. Once litigants are faced with fighting a motion to compel and maintaining a potentially stayed court action, they risk long waits and a dissipation of their potential financial recovery in time and counsel fees.
Technological development is not static and with the advent of Artificial Intelligence and more sophisticated fraudulent schemes, filings in state court will continue to grow. State court resources are already stretched very thin and unbridled advances in technology will only make that tenuous situation worse. The complexities of state law and arbitration do not mix well. The only way to meet these challenges for both sides is careful consideration of the right venue at the right time. In most cases, a little cooperation on both sides goes a long way.
Reprinted with permission from the April 18, 2025 edition of The New York Law Journal © 2025 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or reprints@alm.com.