Legislation to Repeal Mandatory Securities Arbitration

April 5, 2022

Legislation to Repeal Mandatory Securities Arbitration

Introduction

Virtually all securities broker-dealers and reportedly most

investor advisors require their customers to agree that

disputes that may arise between them must be resolved

through arbitration rather than through lawsuits filed in

federal or state courts. Critics of this practice argue it

unfairly denies investors the right to seek redress through

other avenues. Proponents of the practice argue arbitration

results in fair outcomes at less cost to the parties involved.

Two companion bills—S. 1171 and H.R. 2620, which was

marked up by the House Financial Services Committee

(HFSC) on November 16, 2021—would prohibit financial

intermediaries from mandating that their customers submit

to arbitration to resolve disputes instead of litigating them

through federal or state courts. To do so, the bills would

amend the Securities Act of 1933 (P.L. 73-22) and the

Investment Advisers Act of 1940 (P.L. 76-768).

Specifically, they would prohibit broker-dealers, investment

advisers, and other intermediaries from incorporating

mandatory arbitration clauses in customer agreements.

Supporters argue that this would more fairly give investors

the benefit of seeking redress in several ways.

Also, under the bills, customer agreement prohibitions on

class action suits would be banned. If enacted, the

legislation would also void mandatory arbitration

agreements that were in effect before the bills became law.

The legislation would also amend the Securities Exchange

Act of 1934 (P.L. 73-291) to require that security exchange

rules not allow the listing of any company whose bylaws,

governing documents, or contracts provide that disputes

between shareholders and the company would be subject to

mandated arbitration.

Supporters of S. 1171 and H.R. 2620 say that the bills

would ensure that securities firm customers would no

longer have to surrender their rights to litigate disputes

when they engage with the firms. Detractors acknowledge

this outcome but argue that the reform would ultimately kill

securities arbitration, ending the benefits it provides to

investors.

Background

The role of arbitration. Clients of broker-dealers and

investment advisors, who provide them with investment

recommendations, may allege that they have engaged in

various illegal acts, such as breach of fiduciary duty (for

advisors), negligence, unsuitable investment

recommendations (historically for brokers), conflicts of

interest, misrepresentation, omissions of material facts, and

fraud. Historically, such investor disputes could be resolved

through various avenues, including litigation in court or

arbitration.

Growing prevalence of arbitration. Court cases have been

instrumental in the growing use of mandatory securities

arbitration. According to one analysis, before the late

1980s, a minority of broker-dealers had voluntary customer

arbitration agreements. Since then, two U.S. Supreme Court

rulings, Shearson/American Express v. McMahon, 482 U.S.

220 (1987) and R. de Quijas v. Shearson/Am. Express, 490

U.S. 477 (1989), are widely seen to have established that

the securities industry can compel investors to have their

disputes adjudicated through arbitration forums as indicated

in their customer arbitration clauses. Now mandatory

arbitration provisions are said to be nearly universal.

The brunt of the policy debate surrounding mandatory

arbitration clauses for securities transactions revolves

around broker-dealer arbitration hearings conducted by the

Financial Industry Regulatory Authority (FINRA)—the

self-regulatory organization that is the principal regulator of

broker-dealers and has 8,000 or so arbitrators. The

Securities and Exchange Commission (SEC) oversees

FINRA. Arbitration hearings resolve a fraction of the total

number of customer disputes filed with FINRA, the vast

majority of which are settled prior to an arbitration hearing

through direct negotiation or mediation.

For cases involving investment advisers, which group

oversees the arbitration is less clear-cut. Some are dual

registered as investor advisors and broker-dealers and may

undergo FINRA arbitration. However, for those who are

solely registered as investor advisors, arbitration is typically

conducted by one of two alternative dispute resolution

groups, the American Arbitration Association (AAA) and

an arbitration group known as JAMS (formerly known as

Judicial Arbitration and Mediation Services). On a few

occasions, FINRA, also conducts some investor advisor

arbitrations where the advisor is not dual registered.

Most of the discussions and research on mandatory

securities arbitration has focused on FINRA broker-dealer

arbitration, not arbitration involving investor advisors. This

may stem from the fact that until the past decade or so the

use of mandatory arbitration in what many argued was the

more deferential to customers fiduciary-based advisory

industry was said to be limited. It is now said to be typical.

As such, the arguments presented in the next section focus

on FINRA broker-dealer arbitrations, except where

otherwise noted.

The provisions that would ban mandatory arbitration

between shareholders and their firms. The backstory

behind the aforementioned legislative provisions that would

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Legislation to Repeal Mandatory Securities Arbitration

ban mandatory arbitration agreements between shareholders

and firms dates back several years. At that time, a then-SEC

commissioner, some academics, and a number of corporate

lawyers expressed support for the SEC’s consideration of a

policy that would allow public companies to incorporate

language into their initial public offerings requiring

mandatory arbitration to resolve shareholder disputes. Some

observers argued that it would have reversed a longstanding SEC position that such mandatory arbitration

arrangements would violate the Securities Exchange Act of

1934. The intent behind initial legislative proposals would

largely appear to be that of telling the SEC to stay with the

status quo.

Since then, the only public commentary on the subject by

SEC officials appears to have been made by SEC Chair

Gary Gensler during a May 6, 2021, hearing held by the

HFSC. He remarked that the SEC has consistently informed

companies that it would not be advisable for them to

incorporate mandatory arbitration language into their

corporate charters. He explained that the public needs to be

able to seek judicial redress.

Arguments that Lend Support to the Legislation

Support for the bills has come from various groups,

including the Americans for Financial Reform (a coalition

that supports tighter financial regulation), the North

American Securities Administrators Association (NASAA,

an association of state and provincial securities regulators),

the American Association for Justice (a trial lawyer

advocacy group), and the Public Investors Advocate Bar

Association (PIABA, a group of attorneys who represent

clients in securities cases). Some arguments that lend

support to the legislation are:

when requested by both disputants, reportedly a rare

occurrence. (Shapira, 2019)

 Parties involved in FINRA arbitrations essentially

relinquish their right to an internal appeal of a decision.

They also have more limited opportunities for discovery

relative to civil litigation. (Tadjedin, 2021)

 One critique of investment advisory arbitrations, found

in comments by PIABA officials on advisory firm

arbitrations done by AAA and JAMS, expresses concern

that the costs for investors of such dispute resolutions

can reach the tens of thousands of dollars, potentially

putting them out of reach for many investors. (PIABA)

Arguments Critical of the Legislations’ Intent

Among critics of the bills are the U.S. Chamber of

Commerce (a business advocacy group) and the Securities

Industry and Financial Markets Association (a securities

firm trade group). Various arguments or observations are

critical of the legislation. Some that lend support to the

notion of arbitration as the default form of dispute

resolution are:



Various research on FINRA arbitrations has found that

they satisfy most generally recognized standards of

fairness. (Black, 2010)



FINRA arbitration tends to be generally faster than

litigation. (FINRA)



A former president of FINRA’s dispute resolution

forum asserts that, compared to litigation, claimants

before FINRA arbitration are able to plead a much

wider range of alleged violations. (New York Times,

2014)



Under FINRA’s rules, customer arbitration agreements

cannot ban civil class actions through the courts.



Various legal experts have said that many investors

would not have an opportunity to resolve their disputes

were it not for the existence of the more “investor

friendly” FINRA arbitration. (New York Times, 2014)



According to an academic’s analysis, most securities

cases would cost investors much more if they were

litigated, which is largely due to attorney’s fees.

(Forbes, 2009)



FINRA has made significant improvements to its

arbitration protocols over the decades, including

reforming the long-standing requirement that

arbitrations include an arbitrator with securities

industry connections. Arbitration panels can now solely

consist of “public” arbitrators with no connections to

the securities industry. (PIABA)

 Section 921 of the Dodd-Frank Wall Street Reform and

Consumer Protection Act (P.L. 111-203) gave the SEC

rulemaking authority to “prohibit, condition or limit the

use of mandatory pre-dispute arbitration agreements” if

it finds that doing so protects investors and is in the

public interest.” (The SEC has not used the authority.)

 At a March 2, 2021, HFSC hearing, Gensler said:

“While arbitration has its place, it’s also important that

investors—or, in that case, customers—have an avenue

to redress their claims in the courts.”

 In 2019, a national opinion poll of investors found that

83% of respondents indicated that they wanted a choice

to pursue their disputes in civil court or in arbitration

instead of solely through arbitration. (NASAA)

 If the bills’ reforms are adopted, “healthy” competition

in the securities dispute arena could result. And courts

may not be clogged, as some assert, as smaller-sized

claims remain with FINRA. (Frenkel, 2021)

 Civil litigation may generate a positive externality with

respect to having a deterrent effect on bad corporate

behavior. (Shapira, 2019)

Gary Shorter, Specialist in Financial Economics

 FINRA does not allow class action arbitrations and

provides for explanations of the basis of an award only

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Legislation to Repeal Mandatory Securities Arbitration

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