February 20, 2013

Mass. Securities Regulator Urges SEC to Ban Investment Advisers from Imposing Mandatory Arbitration

By Jill Gross

The 2010 Dodd-Frank Act empowered the SEC to study the use of mandatory arbitration in the securities industry and consider whether to ban regulated firms from imposing mandatory arbitration on customers.  To date, the SEC has not launched any such study, presumably because Dodd-Frank was loaded with so many regulatory mandates to the SEC that the agency has not had time or the resources to pursue non-mandatory rule-making.

Both broker-dealers (B-Ds) and investment advisers (IAs) – financial services entities that are regulated differently (the SEC and FINRA regulate B-Ds; the SEC and state securities commissioners regulate IAs) — are known to include pre-dispute arbitration clauses in their customer agreements.  In fact, it is widely known that virtually all B-Ds include mandatory arbitration clauses in their customer agreements, a fact that has led many to argue that this is unfair to investors, in light of the lack of choice.  A study conducted recently by the Massachusetts Securities Division found that about half of the IAs in the state included such a PDAA.

As a result of that study, Secretary of the Massachusetts Commonwealth William Galvin, the state’s highest securities regulator, wrote a letter to the SEC imploring the agency to ban registered investment advisers from including pre-dispute arbitration clauses in their customer agreements.  He argued that there is a stronger regulatory need to regulate arbitration clauses in IA customer agreements, because IAs have a fiduciary duty to their customers that is imposed by the Investment Advisers Act.  In contrast, B-Ds have more limited statutory duties to their customers, which do not rise to the level of a fiduciary duty in many circumstances (e.g., if there is no discretionary trading authority or special relationship).  Secretary Galvin contended in that letter that, “[w]hile arbitration may be appropriate in some case, a clause binding an investor to arbitration before the circumstances are known may not be in the client’s best interest nor consistent with an investment adviser’s fiduciary duty.”

Secretary Galvin raises an interesting point.  Is imposing mandatory arbitration on investors a breach of fiduciary duty by IAs?  If only half of the IAs in the state include such a provision, investors still have a choice to use an IA that does not include such a mandate.  Does the existence of that choice eviscerate the claim that imposing mandatory arbitration by any one IA is a breach of its duty?  Or is it irrelevant?  I have argued in the past that I do not believe the SEC should ban PDAAs in B-D customer agreements, because I believe that securities arbitration is fair to investors and preferable to court.  Secretary Galvin certainly gives me reason to consider whether my views are different in the context of IAs, precisely because of that fiduciary duty.

Of course, if FINRA re-wrote its rules of conduct and imposed a heightened duty on B-Ds, as it has been considering doing recently, then the elimination of mandatory arbitration throughout the entire industry might very well be a collateral consequence welcomed by many.

Last 5 posts by Jill Gross

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