SEC Submits Staff Report to Congress on Investment Adviser Arbitration: Bombshells Galore

Just ahead of a late June deadline, the SEC submitted a staff report to the Congress on investment adviser arbitration. To say the report expresses concerns is an understatement.

Introduction

We reported in SAA 2023-19 (May 18) that by our reckoning the SEC might be facing a looming late June deadline to report to the House on investment adviser arbitration. Our precise reporting was: “The 180 days would appear to translate to about June 29.” We also published a May 18 SAA Blog post, SEC Seems to be Facing a Late June Deadline to Report to Congress on Investor Adviser Arbitration. We later reported in SAA 2023-25 (Jun. 29): “The Alert has it on good authority that the report’s release is imminent. But with the holiday weekend looming, we had to put this issue to bed. We will tweet and blog on any developments during our upcoming off week.” It turns out our source was spot on accurate, as the Commission on June 27 released a staff report, Response to Congress: Mandatory Arbitration Among SEC-Registered Investment Advisers (“Report”). To describe the Report as expressing concerns is putting it mildly. We analyze the 30-page Report below, after providing background borrowed from our past coverage.

Committee Report to SEC: Provide Info on RIA Use of PDAAs

The Report, which was issued when the Democrats controlled the House in the 117th Congress, reads in pertinent part (ed: bulleted format added):

Pre-Dispute Arbitration Contracts: The Committee is concerned about proliferation of mandatory pre-dispute arbitration contracts by SEC-registered investment advisers. The Committee directs the SEC as follows:

• Gather detailed information about how such contracts are used by SEC-registered investment advisers and the effect such contracts have on investors who are harmed by the conduct of advisers.
• When such contracts are used, the SEC shall gather information about whether a dispute resolution forum has been designated; whether particular forum rules are designated; whether a venue is designated; whether a class action waiver is included; whether there are limitations on claims that may be asserted or damages that may be awarded; whether the contract includes any fee shifting provision; whether any complaints have been filed against the advisor in accordance with the contract; and whether the firm has any arbitration awards or unpaid arbitration awards in the last five years.
• The SEC is directed to provide a report to the Committee and to the House Financial Services Committee within 180 days of enactment of this Act.

PIABA: What About RIA Arbitration?

The SEC in August 2022 issued a notice requesting comments on its draft Strategic Plan for Fiscal Years 2022-2026. The SEC notice included solicitation of comments from the public: “to gain the benefit of additional outside perspectives.” As reported in SAA 2022-38 (Oct. 13), among the several comments received was one dated September 29, 2022 from PIABA that focused on RIA use of mandatory predispute arbitration agreements (“PDAA”). Said the letter:

“Since the SEC is tasked with protecting the investing public and overseeing more than 14,000 SEC-registered RIAs, the Strategic Plan should call for the SEC to make efforts to control RIAs’ use of pre-dispute clauses and require, among other things, standardized pre-dispute clauses, shifting of the majority of arbitration fees to the RIAs using such clauses, increased transparency of the scope and implications of the dispute process, as well as the mandatory disclosure of information regarding an RIA’s dispute history so the SEC and investing public may be better informed.”

As reported in SAA 2022-45 (Dec. 10) the final Plan, announced in a November 23, 2022 press release, made no references to arbitration, mediation, or dispute resolution.[1]

SEC Staff Report

The SEC staff’s Report, dated June 27, was released on June 29. The core conclusions (presented verbatim; footnotes omitted):

The number of SEC-registered advisers has increased steadily over the past decade, along with the number of clients they serve, and may continue to increase. It would therefore be reasonable to expect the number of advisory agreements with mandatory arbitration clauses might increase as well. Where an estimated 61 percent of advisers with at least some retail clients already require clients to arbitrate disputes, it is important that regulators and advisory clients understand the potential harms and benefits of mandatory advisory arbitration.

Due to the absence of information pertaining to adviser arbitration, Staff was unable to quantitatively evaluate the “effects” of mandatory arbitration clauses on advisory clients. Such a quantitative evaluation would require further study. However, data obtained from this study support stakeholder views that: (1) certain restrictive terms limiting the claims and/or damages available to advisory clients are sometimes included in advisory agreements; (2) other terms in advisory agreements might increase arbitration expenses for advisory clients; and (3) many of these terms are impermissible in agreements between brokers and their customers, and might also be impermissible in other dispute resolution fora.

Various factors, including the lack of an express, uniform disclosure requirement for advisers, and the lack of arbitrators’ jurisdiction over the parties after award, prevented Staff from measuring the frequency of adviser arbitration or unpaid awards. While investment adviser representatives must disclose certain arbitration information, the opaque nature of adviser arbitration and difficulty accessing adviser arbitration information raises questions about the ability of regulators to evaluate adviser conduct in the context of client disputes. An SEC staff report previously noted that, when selecting a financial professional, investors should consider pertinent information, including a financial professional’s current and historic arbitrations and civil litigation, “to better avoid fraud and potential investment losses.” Nevertheless, investors cannot generally access SEC-registered adviser arbitration information under the current disclosure regime.

For many advisory clients, the use of mandatory arbitration clauses in advisory agreements means that arbitration is the only avenue to obtain remedy for financial harm caused by their advisers. Further evaluation may be warranted to help ensure that arbitration is an accessible and affordable means of dispute resolution for advisory clients.

Table on Mandatory Arbitration Clauses

A table appearing on page 5 reveals the following findings:

• Agreement designates a particular dispute resolution forum: 92%
• When designating a forum, advisers designated the following fora:
  • American Arbitration Association (AAA): 83%
  • FINRA Dispute Resolution Services: 10%
  • JAMS: 6%
  • Other: 1%
• Agreement designates particular forum rules: 37%
• When designating forum rules, advisers selected the following rules:
  • AAA Commercial Rules: 83%
  • JAMS Streamlined Rules and Procedures: 3%
  • JAMS Comprehensive Rules and Procedures: 2%
  • AAA Securities Arbitration Supplementary Procedures: 1%
• Agreement designates the arbitration venue: 60%
  • When designating arbitration venue, percent of agreements that did not consider client’s location or place of business: 97%
• Agreement precludes participation in class action: 6%
• Agreement limits claims the client may assert: 5%
• Agreement limits damages that may be awarded: 11%
• Agreement includes fee-shifting provision: 18%

PIABA Reacts with Concerns …

PIABA reacted immediately with a June 29 Press Release, Double Whammy For Investors: PIABA Reacts To New SEC Report Commissioned By Congress On Injustice Of RIA-Forced Arbitration:

“The much-anticipated SEC report on the forced arbitration process for registered investment advisers (RIAs) who wronged investors was released and its findings strongly echo the concerns PIABA members addressed in recent years. The nonprofit group previously has said the system harms investors and allows RIAs, who boast that they serve as their clients’ fiduciaries, to use forced arbitration provisions as a shield to avoid liability for their ‘untenable’ system for aggrieved investors who seek restitution for improper investment practices by their RIA, which can often dissuade wronged investors from seeking compensatory damages for the breach of fiduciary duty.”

… and Praise for FINRA’s Program

PIABA’s release also expressed some appreciation for the cost-effectiveness of FINRA’s ADR program:

“Unlike brokerage firms, which must designate FINRA as the arbitration forum, RIAs most commonly require clients to file arbitration claims with privately run dispute resolution forums such as the American Arbitration Association or JAMS, where arbitrators set their own fees – unlike the FINRA forum, where FINRA sets the arbitrators’ rates. According to arbitration attorneys, it is not uncommon for an AAA or JAMS arbitrator to charge $8,000 or more for a day’s work. Arbitration costs can easily exceed $64,000 for five days of hearings and three days of pre-hearing and post-hearing work. The costs can triple if there are three arbitrators hearing the dispute.”

The Report’s Appendix contains a May 22 letter from FINRA’s Rick Berry, reporting that from January 1, 2017 through March 23, 2023:

“customers filed approximately 13,000 arbitrations in FINRA’s arbitration forum. Out of those approximately 13,000 customer-initiated arbitrations there were 63 customer-initiated arbitrations in which the claims related exclusively to investment adviser activity, or all of the named respondents were investment adviser firms or investment adviser representatives.”

Speaking of FINRA

The chart above, as well as the accompanying text in the Report, reflect concerns that are not present when firms and individuals submit to arbitration governed by the FINRA dispute resolution regime:

• Unfair arbitration clauses in general: FINRA Rule 2268 governs the placement and content of arbitration clauses in customer account agreements. As described below, the Rule specifies terms that can’t or must be included. Regarding placement, Rule 2268(b)(1) provides: “In any agreement containing a predispute arbitration agreement, there shall be a highlighted statement immediately preceding any signature line or other place for indicating agreement that states that the agreement contains a predispute arbitration clause. The statement shall also indicate at what page and paragraph the arbitration clause is located.”

• Agreement designates particular forum rules: Customers have the right to require application of the FINRA Customer Code of Arbitration Procedure.[2]

• Agreement designates the arbitration venue: FINRA designates the venue: “… closest to the customer’s residence at the time of the events giving rise to the dispute, unless the hearing location closest to the customer’s residence is in a different state, in which case the customer may request a hearing location in the customer’s state of residence at the time of the events giving rise to the dispute.”[3]

• When designating arbitration venue, agreements that did not consider client’s location or place of business: Not so at FINRA.[4]

• Agreement precludes participation in class action: Not permitted at FINRA. Customers can pursue individual claims in arbitration or elect to participate in a class action.[5]

• Agreement limits claims the client may assert: Not permitted at FINRA.[6]

• Agreement limits damages that may be awarded: Not permitted at FINRA.[7]

• Agreement includes fee-shifting provision: Fees at FINRA are allocated by the arbitrators, but the industry surcharge may not be assessed against the Customer.[8]

• Unpaid Awards: FINRA will enforce Awards against industry parties. A major tool used to encourage award payment is FINRA Rule 9554, which allows the Authority to suspend industry parties unless they raise a valid defense to non-payment.

Conclusion

We imagine this Report will touch off action on several levels and in several places. Without doubt, the Report’s findings will reverberate at Congress, the SEC, PIABA, NASAA, and FINRA. One obvious solution is to require RIAs who are not dual-registered to follow the FINRA dispute resolution requirements.[9] Time will tell, but this is only the beginning.

———————

*George H. Friedman, Publisher and Editor-in-Chief of the online Securities Arbitration Alert and an ADR consultant, retired in 2013 as FINRA’s Executive Vice President and Director of Arbitration, a position he held from 1998. He also serves as non-executive Board Chair of Arbitration Resolution Services. He is an Adjunct Professor of Law at Fordham Law School. He holds a B.A. from Queens College, a J.D. from Rutgers Law School, and is a Certified Regulatory and Compliance Professional. He is admitted to practice in New Jersey and New York, several U.S. District Courts, and the United States Supreme Court.

ENDNOTES:

[1] Our editorial comment in SAA 2022-45 was: “Of course, this doesn’t mean RIA PDAA use will not be on the Commission’s agenda. Recall that Dodd-Frank section 921 gives the SEC authority to limit or bar PDAA use, or set conditions for their use, but it has not done so. This includes: “clients of any broker, dealer, or municipal securities dealer, or investment advisers.”

[2] See Customer Code Rule 12200.

[3] See Customer Code Rule 12213(a)(1).

[4] Id.

[5] See Customer Code Rule 12204.

[6] See Rule 2268(d)(2): “ No predispute arbitration agreement shall include any condition that … limits the ability of a party to file any claim in arbitration.”

[7] See Rule 2268(d)(4): “ No predispute arbitration agreement shall include any condition that … limits the ability of arbitrators to make any award.”

[8] See Customer Code Rule 12904(e)(8).

[9] As former FINRA Director of Arbitration, who consistently asserted that the forum was fair to customers, it’s gratifying to see the forum finally held in such high regard.