Arbitration clauses in contracts between broker-dealers and investors have been the norm for more than 20 years. In 1987, a split and divided decision by the United States Supreme Court in Shearson/American Express v. McMahon determined that mandatory arbitration agreements between investors and financial institutions are enforceable. Since then, passionate debates have developed over the fairness of the arbitration process. But new legislation gives the SEC the opportunity to dramatically limit the use of mandatory pre-dispute arbitration clauses in customer agreements. A decision from the SEC is expected soon.
An action to ban or limit mandatory arbitration agreements could be one of the most important investor protection actions since the enactment of the Securities and Exchange Act in 1934. Banning or limiting mandatory arbitration agreements would finally level the playing field on behalf of investors who have been forced to pursue their claims in arbitration as opposed to an open court of law.
Financial institutions across the country are required to be members of the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization. FINRA has jurisdiction and authority to supervise and discipline firms that violate its SEC approved rules. However, unlike the SEC, FINRA is a private company. FINRA’s board of governors is comprised largely of members of the securities industry, and their annual meetings are closed to the public. Equally troubling is the fact that FINRA, the organization in charge of overseeing arbitration disputes between securities firms and investors, is financed by the securities industry.
In 2008, FINRA collected more than $610 million in broker-dealer member fees alone. For 2009, its unaudited revenue rose to more than $755 million. This relationship between FINRA and broker-dealers creates an enormous conflict of interest because securities broker-dealers impose mandatory FINRA arbitration agreements on their customers. When customers file a claim, the broker-dealers — who directly finance FINRA — force the dispute into a FINRA operated arbitration rather than court. Supreme Court Justice Blackmun warned of this conflict of interest in his dissent for the McMahon case more than twenty years ago with the following comment: “Compelling an investor to arbitrate securities claims puts him in a forum controlled by the securities industry.”
Until now, courts have regarded pre-dispute mandatory arbitration agreements as binding contracts over which the SEC has no authority. However that changed on July 21, 2010 when President Barack Obama signed into law the Dodd–Frank Wall Street Reform and Consumer Protection Act. This comprehensive legislation overhauls many regulations in the financial sector and empowers the SEC to impose significant restrictions on mandatory arbitration agreements. The Act deals with mandatory arbitration provisions in two ways.
First, this Act successfully amends Section 15 of the Securities Exchange Act of 1934, giving the SEC the power to restrict or prohibit mandatory arbitration agreements. The SEC has yet to write a new rule, however, it is safe to say that the SEC will affect substantial change unless it buckles to Wall Street pressure as it has in the recent past.
Second, the Act mandates the creation of the Consumer Financial Protection Bureau (CFPB).The Bureau will enforce consumer protection laws and stay current on emerging trends of abuse across the financial sector. Among other things, the Bureau is required to conduct a study on the use of mandatory arbitration agreements and report to Congress. The Act gives the Bureau authority to impose limitations on arbitration agreements based on its findings. This means that if the SEC does not have the will to change the rule on mandatory arbitration agreements, the CFPB will have the power to do so.
In anticipation of the likely SEC rule changes, certain financial institutions are starting to show some flexibility regarding investor agreements. For example, a spokesman for Wells Fargo Advisors told the San Francisco Chronicle that “if the client, during the account-opening process, indicates they will prefer to have that [arbitration] clause excluded, we will exclude it if they ask.” However, neither FINRA nor the brokerage firms inform investors that few financial institutions give this option. Investors should be made aware of this, and they should exercise the option to remove arbitration provisions from the contract.
Removal of the arbitration clause does not limit the customer’s choice of forum. FINRA Rule 12200 states that brokerage firms must arbitrate a dispute if the customer requests it. This means that investors would have the right to choose between arbitration and court litigation; a choice that needs to be placed back in the hands of investors, not broker-dealers.
Christopher Vernon is a Naples-based attorney with the law firm Vernon Healy. He advocates for the rights of investors throughout the United States and abroad—both in and out of the courtroom and arbitration hearing room. Vernon Healy represents investors in all manner of securities fraud including fraud and brokerage misconduct related to principal protected notes, structured products, Lehman notes, reverse convertibles, REITs, non-traded REITs, hedge funds, bonds, fixed-income products and others.
This article was co-written by Victor Bayata, also with Vernon Healy.
