Pre-dispute arbitration clauses are a common component of retail customer agreements used by registered investment advisors. For many of these advisors, arbitration, thanks to its timeliness and lower cost relative to litigation, is an effective means of resolving customer complaints.
The same may not be true for their customers, according to investor advocates who participated in a panel discussion hosted last week by the Securities and Exchange Commission‘s Investor Advisory Committee. The investor advocates cited cost uncertainty, often inconvenient forums, and limitations as to the claims that can be asserted and damages sought as reasons why pre-dispute arbitration clauses are not in customers’ best interests and require SEC regulation.
In a review of 579 randomized retail investment advisory agreements, the SEC’s Ombuds, a unit of the Office of the Investor Advocate, found that 61% included pre-dispute arbitration clauses. The investor advocates largely acknowledged that arbitration is likely favorable to litigation for both the advisor and customer but took issue with restrictive clauses and other conditions included in many pre-dispute arbitration clauses.
Hedge clauses, for example, may limit the types of claims that may be asserted in arbitration or may specify that punitive damages or special damages are not recoverable, attorney Adam Gana, president of the Public Investors Advocate Bar Association said during last week’s discussion. Gana noted that one retail investment advisory agreement reviewed by the Ombuds specified that the investor could only recover damages stemming from willful misconduct or gross negligence, with basic negligence being off the table as a potential claim against that RIA.
“All RIAs are fiduciaries, yet they can limit the liability at the time of their contract. That is a conflict of interest,” Gana said last week. About 5% of the RIA agreements reviewed by the Ombuds included hedge clauses.
The Ombuds also noted that 18% of RIA agreements included fee-shifting provisions, essentially forcing the customer to pay the RIA’s legal fees and costs if the advisor prevailed at arbitration. Gana said that he recently advised an investor client to drop “an incredibly meritorious claim” alleging $400,000 in losses because of a fee-shifting provision and other potential costs written into the arbitration clause.
The other potential costs Gana referenced stemmed from a venue-designation provision. In many cases, RIAs use these provisions to force the client to travel great distances — and incur significant travel and lodging expenses — to have their claim heard in a venue designated by, and convenient to, the RIA. According to the Ombuds’ study, 97% of RIA agreements that include a venue-designation provision do not consider the customer’s location.
Meanwhile, forum-designation provisions specify the dispute-resolution service to be used and the rules that will govern resolution of the claim. For example, roughly 83% of all RIA agreements reviewed by the Ombuds specified that the claim would be resolved by the American Arbitration Association, and more than 80% of all RIAs opting for the AAA also selected that agency’s commercial rules, rather than its more cost-friendly consumer rules.
The AAA’s consumer rules require only a filing fee of $225 by the customer, but the commercial rules — typically used in business-to-business disputes — impose far greater costs on both sides, including a case-management fee of at least $1,400, a hearing fee of $500 and arbitrator compensation in the amount of $300 an hour, according to the AAA’s website.
Gana said that in one recent investor claim in which he was involved, AAA commercial rules resulted in each side paying $65,000 in arbitrator costs. In another case in the Jams dispute-resolution forum, an investor had to pay about $24,000 for an arbitrator’s three-page decision denying the RIA’s motion to dismiss, Gana said.
The potential costs involved in a private arbitration proceeding create “a chilling effect on smaller claims … claims under half a million dollars,” Gana said last week. He added that, in the broker-dealer space, the Financial Industry Regulatory Authority‘s arbitration system is much more affordably priced for consumers.
Investor advocates on last week’s panel also said the entire process of arbitration needs more transparency. In the broker-dealer space, arbitration proceedings are public, and a broker’s arbitration history can be researched through Finra’s public database or the BrokerCheck database. RIAs are not required to disclose their arbitration history, and the private dispute-resolution services most often used also do not publicize their proceedings, meaning that investors often have no way of differentiating between an advisor who has never been involved in an arbitration hearing and one who has been involved in many.
The panelists were split on their views of pre-dispute arbitration clauses in retail RIA agreements but all agreed that change is necessary.
Attorney Stephen Brey, co-chair of the Investment Adviser Regulatory Policy and Review Project of the North American Securities Administrators Association, said that the SEC needs to exercise its rulemaking authority regarding pre-dispute arbitration agreements under section 921 of the Dodd-Frank Act to allow investors a choice of forum.
“The IAC should recommend that the SEC utilizes section-921 authority to prohibit mandatory pre-dispute arbitration provisions in investment advisor contracts or to at least prohibit mandatory arbitration clauses that effectively deprive investors a chance to have their claims heard in a fair forum,” Brey said
Brey also recommended amendments to Form ADV to promote more detailed gathering of information related to RIAs’ use of pre-dispute arbitration clauses.
Panelist Kevin Carroll, deputy general counsel of the Securities Industry and Financial Markets Association, agreed that collecting more information would be a valuable step in better understanding the effects of pre-dispute arbitration clauses, but he said that RIAs would be devastated by a prohibition on mandatory arbitration.
“I think it would be a terrible idea to ban arbitration clauses,” Carroll said, noting that many RIAs could not bear the legal costs involved in a dispute-resolution system largely dependent on the court system.
“I think a regime in which investors have the unilateral post-dispute choice of dispute-resolution forum, whether it be court or arbitration, is completely unadministrable. Our member firms, as businesses, can’t manage their dispute-resolution costs,” Carroll said.
The Investor Advisory Committee last December issued recommendations to the SEC regarding pre-dispute arbitration clauses — including a ban on such clauses until further studies can be conducted — but the commission has not acted on those recommendations.
Stacy Puente, ombuds and assistant director of the IAC, said during the panel discussion that investors in the interim need to help themselves by discussing their customer agreements with their advisors and removing any clauses that restrict their dispute-resolution options.
She also recommended that customers research their advisors through the SEC’s Investment Advisor Public Disclosure database and ask advisors to disclose their arbitration history.