Most investors do not understand the difference between two types of financial advisors who they often rely on for investment advice. These are Registered Investment Advisers (“RIAs”) and broker-dealers. A lack of understanding of the differences between the two can lead to incorrect assumptions by investors. These differences are on a fundamental level, including fee structures, fiduciary duty, services, and which arbitration forum will be used to resolve disputes. An RIA is an individual or firm registered with the Securities and Exchange Commission (“SEC”), while a broker-dealer is an individual or firm that receives a commission for buying and selling securities for investors. Broker-dealers, however, are registered with the Financial Industry Regulatory Authority (“FINRA”) whereas RIAs are not required to do so unless they provide such broker-dealer services. While there are only 3,400 brokerage firms that are members of FINRA, there are over 21,000 federal and state-registered investment advisors.[1] Over the last several years, there has been a steady decrease in the number of FINRA registered representatives. However, between 2015 and 2021, the number of RIAs has increased from 11,847 to 14,806.[2] FINRA Rules mandate that FINRA-registered firms use their Dispute Resolution forum if requested by the investor, even if other forum selection language is included in the arbitration clause in an investor account agreement. Various protections and prohibitions regarding dispute resolution provisions are set forth in FINRA’s rules. For example, per FINRA Rule 2268, member firms must highlight pre-dispute arbitration clauses in the customer agreement and disclose that the agreement contains such a clause. FINRA Rules 2268(d)(1) and d(3) prohibit the incorporation of class action waivers into customer agreements. Further, FINRA Rule 12213 prohibits the specification of a hearing location for any claims. FINRA member firms also pay various fees and surcharges, which subsidizes the bulk of FINRA arbitration forum fees. Therefore, an investor’s filing fee will not exceed $2,300.
But RIAs are not subject to these same rules and are not required to use the FINRA dispute resolution forum if requested by an investor. As a result, RIAs often include arbitration clauses requiring private run dispute resolution forums, including the American Arbitration Association (“AAA”) or Judicial Arbitration and Mediation Services, Inc. (“JAMS”).
How do private run dispute resolution forums harm investors? Arbitrators in JAMS and AAA set their own fees, so it is not uncommon for Arbitration costs to exceed over $60,000 for three days of pre-hearing and post-hearing work, along with five days of hearings. The amount doubles or even triples if there are two or three arbitrators hearing the dispute.[3] A further issue is that these privately run forums, unlike FINRA, require payment of the expected fees prior to the case proceeding. Claimants are required to pay the filing fee and half of the hourly fees that the arbitrator charges. RIAs are aware of these exorbitant upfront costs and intentionally name these forums to shield themselves from client claims as the forum fees are often cost-prohibitive for most clients. How are RIAs acting in a customer’s best interest when taking away a customer’s right both to a jury trial and a neutral and fair dispute resolution forum through exorbitant cost factors? While a true fiduciary agent would not impose forced arbitration upon its principal, a fiduciary should, at a minimum, disclose the economic consequences associated with RIAs choosing arbitration forums. These mandatory arbitration clauses do not provide transparency, do not protect investors, and nor do they make the markets more honest or hold RIAs accountable. The SEC’s Role in Restricting Mandatory Arbitration Clauses in Investment Adviser Agreements
Problems associated with mandatory arbitration clauses in investor agreements have been discussed for over a decade. In the 2009 financial reform proposal, the Treasury Department recommended that the SEC prohibit or condition mandatory arbitration clauses in broker-dealer and investment adviser agreements. Historically, the SEC has taken the position that mandatory arbitration clauses do not constitute a waiver of rights provided under the Investment Advisers Act of 1940.[4] These rights include the right to choose the forum of the dispute resolution (arbitration or adjudication). However, the federal district courts have since upheld arbitration clauses in investment advisory agreements, citing the Supreme Court decisions upholding arbitration clauses under federal securities laws.[5]
Does the SEC have the power to restrict mandatory arbitration clauses in investment agreements? It does. The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was enacted, in part, as a protection for American consumers against abusive financial services practices. Section 921 provides the SEC with the authority to “prohibit, or impose conditions or limitations on the use of, agreements that require customers” of financial advisors to “arbitrate any future dispute between them arising under the Federal securities laws…”[6] In discussing the inclusion of Section 921, legislators discussed concerns that mandatory arbitration clauses forced investors to face “high upfront costs; limited access to documents and other key information; limited knowledge upon which to base the choice of arbitrator; the absence of a requirement that arbitrators follow the law or issue written decisions; and extremely limited grounds for appeal.”[7] This Section was incorporated in Dodd-Frank to address the threat mandatory arbitration clauses pose to investors. Even though the SEC has the power to declare the end of mandatory arbitrations in investment advisory agreements, it simply has done nothing till date.
In 2021, Senator Jeff Merkley and Representative Bill Foster introduced a bill addressing whether to ban mandatory arbitration agreements between investors and advisors.[8] The Investor Choice Act of 2021 sought to amend the Securities Exchange Act of 1934 to make it unlawful for any investment advisor or broker-dealer to mandate arbitration in the event of a dispute. It also outlawed any customer agreement that “restrict[ed], limit[ed], or condition[ed] the ability of a customer or client of that entity to select or designate a forum for resolution of that dispute.” Although the bill ultimately did not pass, it signals a continued focus on banning mandatory pre-dispute arbitration clauses and push towards investor choice in forum selection.
The SEC has been asleep on the job for far too long. Congress provided the SEC with the tools to protect investors and promote efficient markets. Since mandatory arbitration clauses are still included in customer agreements, RIAs should be regulated by a self-regulatory organization, such as FINRA, or one should be created for the specific purpose of regulating RIAs. The arbitration forum for investor-RIA disputes should be the option of the investor, not the RIA. RIAs are obligated to put their clients’ interests first as they are fiduciaries, and the RIA is doing what is best for the client when consenting to the client’s dispute resolution forum choice.
[1] Leading Worker, Consumer and Investor Advocates Urge SEC to Investigate RIA Mandatory Arbitration (May 18, 2022), https://www.piaba.org/piaba-newsroom/press-release-leading-worker-consumer-and-investor-advocates-urge-sec-investigate.
[2] See Statista, Total number of investment advisors registered at the U.S. Security and Exchange Commission (SEC) from 2000 to 2021 (Jun. 2022), https://www.statista.com/statistics/1251310/total-number-of-sec-registered-investment-advisors/.
[3] Christine Lazaro & Michael S. Edmiston, OPED: Costly forced arbitration against RIAs harms investors, By Christine Lazaro and Michael S. Edmiston (Jan. 14, 2022), https://www.piaba.org/piaba-newsroom/oped-costly-forced-arbitration-against-rias-harms-investors-christine-lazaro-and.
[4] SEC, Staff Study on Investment Advisers and Broker-Dealers 44 (2011), www.sec.gov/
news/ studies/2011/913studyfinal.pdf.
[5] Ibid.
[6] Dodd–Frank Act, § 921, 124 Stat. at 1841.
[7] Senate Committee on Banking, Housing, and Urban Affairs on S. 3217, S. Rep. No.111-176, at 110.
[8] S. 1171, 117th Congress (2021).
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