For more than two years, Charles Schwab & Co. has been fighting a legal battle with Finra seeking to force customers to sign away their right to bring class action lawsuits against the firm.
On Thursday, Schwab threw in the towel after the Financial Industry Regulatory Authority Inc. made it clear, in no uncertain terms, that it was prepared to fight the firm tooth and nail. As a result, Schwab blinked, agreed to settle the case and pay Finra $500,000.
It was a clear victory for Finra and a defeat for Schwab.
The case dates back to 2012, when Finra claimed Schwab had violated its rules by inserting a clause in 6.8 million mandatory arbitration agreements, which all customers must sign, that waived their right to participate in class actions against the firm. But a Finra arbitration panel ruled that the Federal Arbitration Act superseded the regulator's rules, allowing Schwab to keep the class action waivers in place.
Schwab temporarily removed the provision in May last year — pending a final decision on the matter.
Finra appealed the case to its National Adjudicatory Council, which has had it for more than a year. On Thursday, Finra's board, in a surprising move, took the case away from the council and reversed the earlier decision by the Finra arbitration panel. Schwab could have appealed Finra's decision to the Securities and Exchange Commission and further through the court system if necessary, but decided to drop the case instead.
Snatching the case back from the NAC was a rare move that hasn't happened in at least a dozen years, said Marc Menchel, who was Finra's general counsel for regulation from 2002-12.
“Schwab got the message that this is of great importance to the board,” said Mr. Menchel, owner of an eponymous consulting firm. “They took into consideration the strong feelings of the board and yielded. It speaks pretty well for both parties.”
After Finra put its foot down, the regulatory and legal path ahead for Schwab was daunting, according to Mr. Menchel.
“My guess is that the SEC is not going to be warm and fuzzy on the Schwab appeal,” Mr. Menchel said. “I think they would have upheld [Finra]. Schwab thought it's not worth going to that next stage.”
Even if Schwab had prevailed, the Dodd-Frank financial reform law gives the Securities and Exchange Commission — and by extension Finra — the authority to modify mandatory arbitration regulations.
“Finra could still put in a rule that says what its rule does now, and it would have been non-preempted, if you will,” said Richard Ryder, president of Securities Arbitration Commentator in Maplewood, N.J. “That has to be part of the equation that Schwab went through in deciding not to take this to [federal] court. Schwab might have won the battle, but it would have lost the war.”
While Schwab waged its effort to prevent class action cases, it wasn't receiving much support from the rest of the financial industry as other firms did not rush to enact their own class action waivers.
“Once the broker-dealer community saw Finra's resistance, no one was going to follow in Schwab's footsteps until the issue was resolved one way or the other,” said Robert Banks Jr., owner of Banks Law Office PC.
A member of the Public Investors Arbitration Bar Association who was a leading voice against the Schwab waiver, Mr. Banks said Schwab also lost the public relations war.
“It doesn't look very good to the investing public when Finra and a number of investor and consumer groups have criticized Schwab for its class-action provision,” Mr. Banks said.
The decision was hailed by the leadership of PIABA, which represents investors in securities arbitration and other litigation, including class actions.
“This settlement is a victory for investors,” said Jason Doss, an attorney and president of PIABA. “These class action waiver provisions are not going to impact harmed investors if they choose to file a class action.”
Greg Gable, a spokesman for Schwab, suggested the discount brokerage firm had a change of heart and agreed to remove the provision permanently as part of the settlement.
“Over the last year, we heard clearly that a number of our clients and members of the general public have strong feelings about maintaining access to class action lawsuits,” he said in a statement. “We have agreed with Finra to remove the waiver from our account agreements, rather than seeking further legal appeals on the matter.”
Schwab is required to notify customers that the stipulation has been withdrawn from its customer contracts and is no longer in effect.
Mr. Doss said that Schwab could have continued to challenge the board's ruling or fight the decision in federal court, but it would have been costly.
“Maybe they made a decision to cut their losses,” he said.
Former Finra director of arbitration George Friedman said Schwab was “misreading Supreme Court cases on the class action waiver” and making “a specious argument.” The action by the Finra board is a warning to the industry to tread carefully when modifying mandatory arbitration.
“The decision is a clarion call to brokerage firms that Finra will not tolerate attempts to make arbitration clauses unfair,” said Mr. Friedman, owner of an eponymous consulting firm.
A group representing state securities regulators said that the decision had put substantial weight behind their calls for an end to mandatory arbitration clauses.
“Schwab's decision to include class action waivers in the arbitration provisions of its customer contracts is yet another example of the harmful effects of mandatory arbitration clauses and heightens the need to pass the Investor Choice Act,” which would prohibit the use of mandatory pre-dispute agreements that force investors to arbitrate disputes. said Russ Iuculano, executive director of the North American Securities Administrators Association. “These agreements, especially when coupled with class action waivers, effectively eliminate any reasonable chance for retail investors with small-dollar claims to have their claims heard in an unbiased and fair forum.”
But S. Lawrence Polk, a partner at Sutherland Asbill & Brennan, said the Finra decision was a statement about Finra's ability to enforce its own rules and is unlikely to lead to a re-examination of mandatory arbitration, which is included in almost every brokerage customer contract.
“This ruling will not have an impact one way or the other on [attempts] to put to an end to mandatory arbitration,” Mr. Polk said.