SEC report on RIA mandatory arbitration leaves many questions about potential investor harm

The report says more than half of investment advisors force their clients to go to arbitration to settle disputes, but it doesn't put a number on RIA arbitration cases or the costs for claimants.

An SEC report showing more than half of investment advisors use mandatory arbitration clauses in client agreements still leaves much unknown about potential investor harm, lawyers and an advisor said Thursday.

The study by the Securities and Exchange Commission found that about 61% of advisors registered with the agency force their clients to go to arbitration to settle disputes. The vast majority of advisors use private arbitration forums, such as the American Arbitration Association, to hear claims.

Those venues don’t track advisor cases, which meant SEC staff “could not obtain reliable data about the frequency of SEC-registered adviser arbitration,” the agency said in the report, which was delivered Wednesday to the House Committee on Appropriations.

“I’m surprised it’s only 61%,” said Michael Hansen, co-founder of Frontier Wealth Strategies.

Forcing customer claims into arbitration helps mitigate legal risk for RIAs because there’s a better chance the forums will be more favorable to them than a court jury might be, said Hansen, who has served as an expert witness in brokerage arbitration cases in the Financial Industry Regulatory Authority Inc.’s dispute resolution system.

“If I was a legal advisor to RIAs, I would definitely [encourage them] to have an arbitration clause in there,” he said. “There’s more upside to the [investment advisor] than to the investing public.”

The SEC said some provisions in arbitration clauses can work against investors, such banning class action waivers and limiting damages. The SEC also said it could not estimate how often arbitration claims are not paid by advisors.

“I’m very happy [the SEC] took the first step in studying the problem,” said Michael Edmiston, a former president of the Public Investors Advocate Bar Association. “RIAs are using arbitration clauses as a shield from viable compensable claims brought by harmed investors.”

PIABA has made illuminating RIA arbitration one of its top priorities. Current PIABA President Hugh Berkson said the report should be a starting point rather than an end.

“I’d like to see this report as a stepping stone to meaningful reform and investor protection,” said Berkson, a principal at McCarthy Lebit Crystal & Liffman. “There’s no actual policy recommendation in the report. It’s a real missed opportunity.”

But the report highlights how little is known RIA arbitration, said Edmiston, an attorney at the Law Offices of Jonathan W. Evans & Associates. For instance, questions remain about the number of RIA arbitration cases, where they’re heard, the costs for claimants and the amount of damages that are awarded and actually paid.

Regulators “don’t have the hard data they need to engage in rulemaking or work with Congress to develop laws regulating the use of arbitration,” Edmiston said.

Advisors only have to report arbitration claims if they deem them “material” to the operation of their firms. That means many don’t offer any insight on them.

“Future clients of these firms have no way of knowing if there’s any history of misconduct because the history of arbitration claims … and awards are not disclosed,” Edmiston said.

Investor claimants are rarely made whole, Hansen said. It would be good to know details about damages claimed in RIA arbitration and the amounts of awards won by investors.

“They definitely should be more transparent so people know what to expect,” he said.

Proponents argue that arbitration is more efficient and less costly than the court system. Critics say that limited discovery and other arbitration rules can truncate justice for plaintiffs.

Although Finra’s arbitration system for adjudicating customer and registered representatives’ claims against brokerages is often criticized for a lack of transparency, experts agree that it is much less costly for litigants than the private arbitration forums that advisors use.

Unlike advisors, brokers must report all customer disputes, arbitration cases and outcomes.

“Non-fiduciary brokers are held to a higher disclosure standard than advisors, who are fiduciaries, which is ironic,” Berkson said.

Amber Miller, founder of Rising Financial, said that she doesn’t put a mandatory arbitration provision in her client contracts.

“Including a forced arbitration clause in my service agreement is not in the spirit of empowering clients to make informed decisions,” Miller said. “It doesn’t give them an option, which is my job in every other financial aspect of their lives.”

Miller’s clients can take her to arbitration or to court if they have a complaint. But she’s confident clients won’t put her in either forum.

“It’s a relatively safe bet,” she said. “The risks are pretty low.”