Mandatory arbitration isn't just for brokers — some investment advisers rely on it

But potentially high-fees outside Finra arbitration could make the process too expensive for investors

Jan 15, 2019 @ 2:31 pm

By Mark Schoeff Jr.

Requiring clients to use arbitration to settle disputes is most often associated with brokers, who put mandatory arbitration clauses in customer contracts.

But registered investment advisers rely on similar language in their customer agreements. There's no recent data, but, anecdotally, the number seems to be rising.

"In my experience it's fairly typical," said Barry Temkin, partner at Mound Cotton Wollan & Greengrass. "I've seen it often."

Although a decision on a claim can be made more quickly through arbitration than in the court system, discovery is more limited in arbitration, which is seen as an advantage for the defendant. Discovery allows one side in a lawsuit to obtain evidence from the other before the trial through depositions and documents, for example.

"RIAs have figured out the arbitration hustle," said Andrew Stoltmann, a Chicago securities attorney. "It's far better having these cases adjudicated in the darkness of arbitration without a judge overseeing discovery."

A potential drawback for adviser clients is the cost.

Brokers use the arbitration system run by the Financial Industry Regulatory Authority Inc. Finra only hears arbitration cases against standalone RIAs if both sides agree to use the Finra forum and other stipulations.

Also, Finra can't discipline an RIA if it doesn't pay an arbitration award, because RIAs are overseen by the Securities and Exchange Commission. Customer claims against RIAs usually are heard in forums run by the American Arbitration Association or other groups.

"It's not surprising that the majority of investment adviser cases end up at AAA," said George Friedman, a former Finra arbitration director and an adjunct law professor at Fordham University.

Finra tends to be more affordable. For instance, in a case involving a claim of between $100,000 and $500,000, Finra assesses an initial filing fee of $1,425, according to the regulator's fee schedule. For a claim between $300,000 to less than $500,000, AAA charges an initial filing fee of $4,400 and a final fee of $3,850, according to its fee schedule.

Finra charges a hearing session fee for a case between $100,000 and $500,000 of $450 per session with one arbitrator and $1,125 per session for a hearing with three arbitrators.

The AAA doesn't list hearing fees. A spokesman for AAA didn't respond to a request for comment.

Mr. Temkin said parties in the AAA forum are responsible for an arbitrators' hourly fee, which can range between $400 and $500 an hour for commercial disputes in large metropolitan areas.

Whether an arbitration is defined as commercial or consumer makes a big difference in AAA.

In consumer arbitration, the initial filing fee is $200 for the consumer. There is a hearing fee of $500 and arbitrator compensation is set at $2,500 per hearing day per arbitrator.

"The fees are very low for the consumer; it's not an issue," Mr. Friedman said.

But consumer claims are often those that revolve around credit card charges and other small-dollar disputes, according to Mr. Stoltmann. When a customer files a claim against an investment adviser, it is most often defined as a commercial dispute by AAA — and some customers can't afford the forum.

"You're bolting the adjudicatory door shut on many investors," Mr. Stoltmann said.

A former president of the Public Investors Arbitration Bar Association who has often called for Finra arbitration reform, Mr. Stoltmann nonetheless said it may be the best forum for RIA disputes.

"I can't believe I'm saying this, but the SEC should consider a rule making the Finra arbitration forum mandatory for RIA customers," Mr. Stoltmann said.

RIAs who have mandatory arbitration clauses in their customer contracts may not be fulfilling their fiduciary duty with respect to disputes, according to Knut Rostad, president of the Institute for the Fiduciary Standard.

"I don't think it's in the best interests of investors because they're giving up a right that they shouldn't have to give up," Mr. Rostad said. "That's what the other guys do, not what investment advisers do."

Mr. Temkin disagrees.

"I don't think it's a violation of fiduciary duty to have a dispute arbitrated," he said. "I don't see there being a different standard in [pre-dispute arbitration agreements] for investment advisers."


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