Current Status of Arbitrating Investor Claims
What an arbitration claim against an investor’s financial professional will look like varies significantly depending on whether that professional is an associated person with a firm that is a member of the Financial Industry Regulatory Authority (FINRA) (i.e., a broker or financial advisor at a broker-dealer) or an SEC-registered investment advisor.
With very limited exceptions, FINRA members are required to arbitrate all customer claims when requested by the customer pursuant to FINRA Rule 12200. And the substantial majority of FINRA members require their customers to arbitrate claims against the firm via contractual provisions that have been upheld since Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987).
Arbitrations administered by FINRA Dispute Resolutions Services are conducted pursuant to the Code of Arbitration Procedure for Customer Disputes. These rules provide for a single arbitrator in cases involving claims damages of $50,000 or less (and up to $100,000 or less unless agreed otherwise by all parties), simplified procedures in matters involving $50,000 or less, and customer filing fees ranging from $50 to a maximum of $2,300 (in cases in which the damages sought exceed $5,000,000). Hearing fees also range from $50 per session up to $1,575 per session (for a three-arbitrator panel in cases in which the damages sought exceed $5,000,000). In addition, these rules contain a six-year eligibility requirement and prohibitions on the arbitration of both class action and shareholder derivative claims.
In contrast, there is no such uniform forum or rules governing investor claims against investment advisors. Indeed, perhaps the most surprising thing to come out of the report was the SEC’s claim that almost 40 percent of investment advisors do not require customers to arbitrate their claims. It is unclear whether this number is attributable to investment advisors’ studied decisions to remain in court with potentially stronger legal or procedural safeguards, oversight in the drafting of customer agreements, underreporting, or other unknowns.
Investment advisors that require arbitration use a number of dispute resolutions forums, typically the American Arbitration Association or JAMs. As a general rule, these forums are more expensive to all parties than FINRA due in large part to substantially higher arbitrator/hearing fees (with a perhaps unsurprising—as a general matter—corresponding increase in experience and sophistication of the arbitrators).
The SEC’s Report
At the outset of its report, the SEC notes that it had difficulty in determining the effects mandatory arbitration have on investors due to the “the lack of publicly available information about SEC-registered adviser arbitration[.]” Instead of relying on arbitration data, the staff interviewed “eight external stakeholder groups identified as having information relevant to the issue of mandatory arbitration, and/or as having publicly expressed opinion on the issue of mandatory arbitration.” These included investor and industry advocates, the North American Securities Administrators Association, and FINRA.
Based on these conversations, SEC staff concluded that “some” investment advisor agreements contain terms that “could” negatively affect the arbitration process. Issues noted included class action bans, terms governing the location of evidentiary hearings, and damages limitations. Also noted was the claim that “the costs associated with private arbitration with advisers are significantly higher than the costs associated with broker arbitration, and, in some instances, those costs could preclude advisory clients from bringing arbitration claims at all.” And while the potential for unpaid arbitration awards was also raised, no data were available for analysis. Finally, in discussing most of these issues, stakeholders and staff considered the differences between investment advisor arbitrations and those administered by FINRA.
Unsurprisingly, the Public Investors Advocate Bar Association (PIABA) immediately issued a press release responding to the report, in which it claims that the SEC’s “findings strongly echo the concerns PIABA members addressed in recent years.” Given the fact that the material underlying the report was taken in part from discussions with PIABA and other consumer advocates, one could conclude that these “echoes” are somewhat self-fulfilling. Regardless, PIABA remains focused on this issue, considering it one of its top priorities.
Congress or the SEC (or both) would have several options if they determined to address issues raised in the report. The possibilities would include the following:
- A complete ban: In recent years, legislators have introduced a number of acts that would prohibit binding pre-dispute arbitration agreements in consumer contracts or in connection with the provision of investment advice, or both. Alternatively, the SEC could attempt to use its rulemaking authority to achieve this outcome.
- Restrictions on terms: Either Congress or the SEC could also act to prohibit firms from using arbitration agreements that contain objectionable terms such as those cited in the report.
- Creation of an arbitral forum: Either Congress or the SEC could also create an arbitral forum to administer investment advisor arbitrations and require its use by investment advisors.
- Opening up FINRA Dispute Resolution Services: Instead of building a new forum from the ground up, investment advisors could conceivably be required, by congressional action or regulatory rulemaking, to use the FINRA forum.
- No change: If past performance is any indication of future results, it is also quite possible that significant change is not on the immediate horizon. Indeed, change seems somewhat unlikely until reliable data on these issues can be secured. A reasonable takeaway from the report is that the SEC seems likely to engage in such additional fact-finding.
This is an issue that seems unlikely to simply fade away, given the regulatory scrutiny and attention by investor advocates. Time will tell what changes are in store, but the issues at play certainly bear watching by practitioners.