Barron's (February 6, 2024) By Kenneth Corbin
Democratic lawmakers are calling for an end to the use of mandatory arbitration proceedings to settle disputes between clients and financial advisors. It’s the latest effort to roll back the common arbitration provisions in service agreements that have long drawn criticism from investor advocates.
The Investor Choice Act, backed by Democrats in the House and Senate, would bar brokers, registered investment advisors, and other financial professionals from using arbitration forums as the default for resolving client complaints. The bill would also outlaw prohibitions against clients engaging in class-action litigation against their advisor.
“Individuals shouldn’t need to surrender their legal rights because they choose to work with a financial advisor or broker-dealer to plan for their retirement and invest their hard-earned money,” says Rep. Bill Foster (D., Ill.), the author of the House bill.
The bill is the latest effort to reform a system that critics say unfairly advantages advisors, who often seek out a favorable venue for arbitration and can determine the rules for the proceedings. Their disclosure obligations during the discovery phase are also limited. For example, brokerage industry self-regulator Finra maintains its own rules for discovery, a process that it acknowledges is more limited than discovery under the federal rules of civil procedure or state discovery rules. In practice, this means that clients will have less access to materials from a firm that they could use to build their case. This amounts to what the bill’s authors call a system that is “rigged” against consumers.
Critics of the arbitration system also note the exorbitant costs that are associated with the proceedings, suggesting that the payments arbiters receive create an incentive structure that works against fair and unbiased dispute resolution.
“Every consumer deserves a fair shot at justice when they’ve been wronged or taken advantage of,” says Jeff Merkley (D., Ore.), the bill’s lead backer in the Senate. “But when an investment advisor or broker chooses the judge, pays the judge, and promises future business to the judge, it’s clear that the system meant to deliver that justice is rigged.”
Those criticisms are voiced frequently by groups like the Consumer Federation of America and the Public Investor Advocate Bar Association, which are supporting the Investor Choice Act.
Industry groups have defended arbitration as a faster method of resolving disputes than litigation in court. In the political arena, the issue has become partisan, with Republicans tending to favor preserving the forced-arbitration provisions and resisting calls to allow class-action litigation. Measures to end forced arbitration have advanced on party lines before, but never gained enough bipartisan support to make it into law.
Congress directed the Securities and Exchange Commission in a 2022 funding bill to study the issue in the RIA space, which, unlike brokers whose disputes end up before industry self-regulator Finra, often relies on private and highly paid arbiters, usually from the American Arbitration Association.
The SEC estimates that 61% of advisors include mandatory arbitration clauses in their service agreements, and that of those, 83% use the AAA as their forum for hearing disputes.
The commission found precise data hard to come by, as there are no rules requiring advisors to disclose their use of arbitration to settle disputes, and judgments against advisors and information on whether they paid an award as directed by an arbitration panel aren’t public.
In December, the SEC’s Office of the Investor Advocate issued a report criticizing many aspects of forced-arbitration provisions and suggesting that forcing clients to bear the cost and inconvenience of those proceedings could be a violation of advisors’ fiduciary duty.
Earlier this month, some of the same groups backing the Investor Choice Act launched a new coalition advocating for the end of forced arbitration.
“These fake fiduciaries use their boilerplate agreements to stack the deck against investors,” Piaba President Joe Peiffer said at an event announcing the Investor Advocacy coalition. “It’s time that either the SEC or Congress put an end to this nonsense.”