State regulators question RIAs' use of mandatory arbitration

'How can that be in the best interests of the client?' one asks

Oct 7, 2013 @ 3:38 pm

By Mark Schoeff Jr.

Brokers often are criticized for demanding that the contracts they sign with customers contain mandatory arbitration clauses, but registered investment advisers increasingly are doing the same thing, even though they hold themselves out as always working in the clients' best interests.

Regulators at the North American Securities Administrators Association's annual conference in Salt Lake City said on Monday that more RIAs are inserting the clauses in customer contracts and questioned the practice, since these advisers are supposed to be acting as fiduciaries.

“How can a mandatory arbitration clause fit that definition? How can that be in the best interests of the client?” said Steven Thomas, director of Lexington Compliance, a division of RIA in a Box LLC.

“We are seeing a proliferation of these agreements,” said John Cronin, securities director for the Vermont Department of Financial Regulation.

States are in a bind when it comes to policing adviser use of mandatory arbitration, he said. Vermont used to make advisers remove such clauses from their agreements; it now permits them.

Mr. Cronin's department concluded that the state would be vulnerable to lawsuits over the issue because federal courts — especially the Supreme Court — have upheld arbitration in a number of cases in recent years.

“Based on resources, you have to pick your battles,” Mr. Cronin said.

Virginia is still fighting on the adviser arbitration front.

“We make [advisers] take it out,” said Debra Bollinger, senior counsel at the Virginia State Corporation Commission. “It's probably going to end up in a lawsuit.”

State regulators have been pushing the Securities and Exchange Commission to prohibit mandatory arbitration in brokerage and adviser customer agreements, asserting that investors deserve the right to take their claims to court. Currently, the Financial Industry Regulatory Authority Inc. conducts arbitration proceedings.

A provision of the Dodd-Frank financial reform law gives the SEC the authority to end mandatory arbitration. But the commission has not indicated whether it will propose such a rule.

“This needs a one-stop fix,” Mr. Cronin said. “The best solution is for the SEC to act on the authority given to it under Dodd-Frank.”

In Monday's panel, Ira Hammerman, senior managing director and general counsel at the Securities Industry and Financial Markets Association, argued that Finra arbitration offers investors a fast, efficient and relatively inexpensive way to pursue their claims, citing statistics showing that arbitration cases usually reach a conclusion in 14 months.

“There's no way you can do that in the federal court system, given the demand on judges,” he said. “Customers get their proverbial day in court a lot faster through arbitration.”

Those advantages would be lost if customers were allowed to opt out of arbitration, Mr. Hammerman said, because it would undermine industry support for the Finra system.

“Choice for its own sake doesn't always result in a benefit,” he said. “The whole system of arbitration will eventually break down.”

Robert Banks Jr., owner of Banks Law Office PC, said that the Finra process — in which customers obtain an award about 40% of the time — is generally fair and has been improved over the years. The latest regulatory change makes the all-public arbitration panel the default choice for hearing cases, a move that likely will reduce participation by industry representatives.

But Mr. Banks supports giving customers venue flexibility.

“I don't see this as a ground-shattering move,” he said. “We are going to have Finra arbitration no matter what. Investor choice is pretty hard to argue against.”


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