SEC Investor Advocate Recommends Halt on RIA Arbitration Clause Use

The SEC Office of the Investor Advocate has issued a report recommending that predispute arbitration agreement (“PDAA”) use by investment advisers be studied and that in the meantime PDAA use be suspended. The report also raises serious concerns about PDAAs calling for administration by private ADR providers.

The report was announced in a December 5 press release, SEC Office of the Investor Advocate Publishes Its Policy Recommendations on Mandatory Arbitration and Registered Index-Linked Annuities Research. Leads the release:

“The Office of the Investor Advocate of the Securities and Exchange Commission today published its Report on Activities for the Fiscal Year 2023 to Congress. The report highlights the work of the Office during the fiscal year.[] Notable highlights from the report include … Research findings about investment advisory agreements use of mandatory arbitration clauses including suggested approaches on combating abusive use of those clauses ….”

Concerns About PDAA Use

The report empresses serious concerns about PDAA use in advisory agreements:

“With regard to mandatory arbitration clauses, we are concerned that a number of characteristics of these clauses in advisory agreements are not in the best interest of retail investors. We make a number of recommendations to help promote a fairer, more balanced framework for arbitrations between advisers and their retail clients. In light of our concerns, we also strongly encourage investors to learn about the differences between arbitration and litigation, and to ask appropriate questions of their advisers where mandatory arbitration clauses are included in advisory agreements.”

Recommendations

The report contains several recommendations that we repeat verbatim below:

• We believe precluding advisers from using restrictive terms in mandatory arbitration clauses that negatively affect investors would help create a fairer, more balanced framework for arbitrations between advisers and their retail clients.
• We further believe that establishing arbitration-related disclosure requirements for SEC-registered advisers would better enable investors and regulators to evaluate advisers’ prior conduct, and to prevent recidivist adviser misconduct. However, we do not believe the implementation of these recommendations will resolve broader fairness concerns associated with adviser arbitration.
• Where advisory clients are compelled to arbitrate disputes in a private dispute resolution forum, where the SEC cannot help to ensure that appropriate procedural protections for investors exist in that forum, and where the SEC cannot easily obtain information about underlying arbitrations in that forum, it is our view that retail investors might face procedural disadvantages that negatively impact arbitral outcomes. Moreover, any such disadvantages or negative outcomes would not be measurable or observable, given the opaque nature of privatized arbitration and lack of information exchange between the SEC and private dispute resolution fora.

Concerns About Private ADR

The report is extremely critical of RIA arbitration at privately run arbitration venues:

“We further note, however, that the privatized nature of adviser arbitration poses a significant obstacle in any attempt to assess the truth or falsity of advisers’ arbitration-related disclosures. As illustrated in Table 3, advisers often choose to arbitrate with clients in private dispute resolution fora such as AAA and JAMS. The SEC lacks jurisdiction over these private fora, and therefore cannot easily obtain information with which to confirm the existence or outcome of an adviser’s arbitration. These fora also do not aggregate or otherwise make publicly available information about adviser arbitration. In the absence of this information, regulators would ostensibly need to rely on the integrity of an adviser’s arbitration related self-disclosures to determine whether the adviser satisfied its disclosure obligations. Conclusions We believe precluding advisers from using restrictive terms in mandatory arbitration clauses that negatively affect investors would help create a fairer, more balanced framework for arbitrations between advisers and their retail clients. We further believe that establishing arbitration-related disclosure requirements for SEC-registered advisers would better enable investors and regulators to evaluate advisers’ prior conduct, and to prevent recidivist adviser misconduct.

“However, we do not believe the implementation of these recommendations will resolve broader fairness concerns associated with adviser arbitration. Where advisory clients are compelled to arbitrate disputes in a private dispute resolution forum, where the SEC cannot help to ensure that appropriate procedural protections for investors exist in that forum, and where the SEC cannot easily obtain information about underlying arbitrations in that forum, it is our view that retail investors might face procedural disadvantages that negatively impact arbitral outcomes. Moreover, any such disadvantages or negative outcomes would not be measurable or observable, given the opaque nature of privatized arbitration and lack of information exchange between the SEC and private dispute resolution fora.”

Comparison to Broker Arbitration at FINRA’s Forum

The report compares private RIA arbitration with the FINRA dispute resolution for brokerage disputes. We’ve reformatted the findings as bullets; footnotes are omitted:

• While the FINRA Code applies uniformly to disputes between customers and their brokers and governs contractual provisions relating to mandatory arbitration, advisers may choose the terms of their respective mandatory arbitration clauses.
• As noted above, six percent of SEC-registered advisory agreements with mandatory arbitration clauses included class action waivers, five percent of agreements limited the types of claims that could be asserted, and 11 percent limited the types of damages that a client may seek in the arbitration. In contrast, the FINRA Code prohibits usage of class action waivers, prohibits language that limits a party’s ability to file “any claim” in arbitration, and prohibits language that limits the ability of arbitrators to make “any award.”
• Of the 60 percent of mandatory arbitration clauses that designated a venue for the arbitration hearing, 97 percent designated a location that disregarded the client’s location. In practice, clients could be required to participate in an arbitration far from their place of residence, incurring travel and lodging expenses to attend in-person hearings. Under the FINRA Code, the default location for the arbitration venue is generally the hearing location nearest the customer’s residence at the time of the events leading to the dispute.
• A notable percentage of advisory agreements with mandatory arbitration clauses also imposed requirements on the type and/or number of arbitrators—e.g., requiring a panel of three arbitrators, or requiring arbitrators to be affiliated with the securities industry. Because each arbitrator is compensated separately, a panel of three arbitrators would predictably increase the cost associated with the arbitration. Several stakeholders also suggested that arbitrators with securities industry ties might be biased in favor of advisers. By comparison, the FINRA rules require panels to consist of a single arbitrator, unless the claim amount exceeds $100,000, or the parties jointly agree to a three-arbitrator panel.
• In cases with one arbitrator, the FINRA Code requires the selection of a public arbitrator, unaffiliated with the securities industry, to preside over the dispute. In cases with three arbitrators, the FINRA Code guarantees parties the ability to select a panel of all public arbitrators.
• Although arbitrators in FINRA DRS are not required to write opinions or provide explanations for an award, arbitrator awards must be in writing. In contrast, many advisory agreements included provisions that prohibited arbitrators from providing written awards.
• Staff’s review also supported the notion that costs of adviser arbitration generally exceed those of broker arbitration. For instance, the frequent designation of commercial, or business-to-business, arbitration rules result in higher initial filing fees and other expenses for clients, potentially making the filing of a claim cost-prohibitive. Conversely, as noted above, the FINRA Code of Arbitration Procedure for Customer Disputes governs all disputes between brokers and their customers. In FINRA DRS, initial filings fees range from $50 (for matters valued up to $1,000) to a maximum of $2,300 (for matters valued over $5,000,000). By comparison, under the AAA Commercial Arbitration Rules, clients bringing a matter valued at $75,000 or less must pay an initial filing fee of $925 if the panel consists of one arbitrator. AAA commercial arbitrations with three or more arbitrators are subject to a minimum initial filing fee of $4,400. In many instances, this filing fee alone might prevent clients from bringing claims against their advisers.

Potential Fiduciary Problems

The report expresses concerns about potential fiduciary/best interest problems:

• If an adviser includes language in an advisory agreement preemptively limiting the damages available to clients in arbitration, or limiting the types of claims that clients may assert against the adviser in an arbitration, such limiting language might mislead retail clients into not exercising their legal rights and would constitute a breach of the adviser’s fiduciary duty in violation of the antifraud provisions of the Advisers Act.”
• We further believe that contractual provisions precluding clients from participating in class action lawsuits, designating an arbitration venue without regard to a client’s physical location, invoking commercial arbitration rules intended for business-to-business disputes, and/or imposing fee shifting provisions that unilaterally impose the costs and fees of an arbitration on the client have the obvious and likely intended effect of increasing the cost and inconvenience of arbitration for advisory clients.
• It is therefore also our view that, where such provisions are included in an advisory agreement, absent evidence the adviser has made effort to gauge whether the client understands these provisions and the client has provided informed consent, the adviser is placing its interests ahead of the client’s interests in violation of the fiduciary duty. The report .
• In similar manner, it is the view of the Office of the Investor Advocate that if an adviser includes language in an advisory agreement preemptively limiting the damages available to clients in arbitration, or limiting the types of claims that clients may assert against the adviser in an arbitration, such limiting language might mislead retail clients into not exercising their legal rights and would constitute a breach of the adviser’s fiduciary duty in violation of the antifraud provisions of the Advisers Act.
• We further believe that contractual provisions precluding clients from participating in class action lawsuits, designating an arbitration venue without regard to a client’s physical location, invoking commercial arbitration rules intended for business-to-business disputes, and/or imposing fee shifting provisions that unilaterally impose the costs and fees of an arbitration on the client have the obvious and likely intended effect of increasing the cost and inconvenience of arbitration for advisory clients.
• It is therefore also our view that, where such provisions are included in an advisory agreement, absent evidence the adviser has made effort to gauge whether the client understands these provisions and the client has provided informed consent, the adviser is placing its interests ahead of the client’s interests in violation of the fiduciary duty.

Showstopper: Temporarily Bar PDAA Use

The report concludes by recommending a temporary halt to investment advisory agreement PDAA use, until the issue can be studied:

“We note that Congress granted the SEC the authority to ‘prohibit, or impose conditions or limitations on the use of agreements that require customers or clients of any investment adviser to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.’ In light of this explicit authority, we recommend that the Commission consider temporarily suspending the use of mandatory arbitration clauses in advisory agreements until further exploration of the associated costs and benefits to advisory clients is undertaken” (footnote omitted; emphasis added).

Discovery in the FINRA DR Forum to be Studied

The report contains this note: “Discovery in FINRA Arbitration In Fiscal Year 2024: Ombuds staff intends to complete and report the findings of its study of the incidence and potential effects of abusive discovery practices in the FINRA Dispute Resolution forum.”

(ed: *Wow! **Seems to us that the temporary halt recommendation covers all PDAA use, not just agreements calling for private ADR fora. ***Wonder what this might portend for brokerage agreements? ****We will certainly track this one!)