Financial Planning (January 14, 2022) - Lois is an incapacitated senior suffering from a traumatic brain injury. Her conservator, who was overseeing money reserved for her long-term care and support, opened an account with a registered investment advisor. The money would need to be managed conservatively, since it was intended to care for Lois over the remainder of her life.

Instead, the RIA pursued a high-risk strategy, losing most of the money. When the conservator sought legal advice, it became apparent that, due to a provision in the RIA’s contract, the conservator’s claim could only be adjudicated in a private dispute resolution forum. To file the case, the conservator would have to advance more than $30,000 to cover the investor’s share of the anticipated forum fees.

During the 1990s and early 2000s, when brokerage firms held an iron grip on retail investors, the securities industry forced investors into arbitration. Claims were heard at FINRA’s predecessor, the NASD, and arbitration forums run by the stock exchanges.

Today, FINRA is the only industry-run forum left. While FINRA’s forum remains far from perfect, customers who are forced to resolve disputes with their brokers benefit significantly from the fact that the industry subsidizes the bulk of FINRA forum fees by paying various industry fees and surcharges. While fees may be assessed against the investor at the end of the hearing, they can proceed with their claim by paying the filing fee which, at most, will be $2,300.

Over the past decade, assets have shifted significantly from the brokerage side of the industry to the advisory side. Following the lead of the brokerage industry, RIAs now regularly include forced arbitration clauses in their account agreements. Unlike brokerage firms, which must designate FINRA as the arbitration forum, RIAs often require clients to file arbitration claims with privately run dispute resolution forums such as the American Arbitration Association or JAMS, where arbitrators set their own fees. It is not uncommon for an arbitrator to charge $8,000 or more for a day’s work. Arbitration costs can easily exceed $64,000 for five days of hearings and three days of pre-hearing and post-hearing work. Triple that amount if there are three arbitrators hearing the dispute.

Unlike FINRA, the privately run forums require the expected fees to be deposited prior to the case proceeding. This means that an investor may have to deposit tens of thousands of dollars just to have their claim move forward. RIAs, knowing the forum fees are cost-prohibitive for most clients use these types of arbitration clauses to shield themselves from liability for their misconduct. For Lois’s case, the conservator was hesitant to proceed, knowing he would have to deposit more than $30,000. So much of Lois’s money had already been lost, he was not sure he could risk losing any more of her money on fees.

Solving this problem is not easy due to the fragmented regulatory system governing RIAs. The SEC regulates advisors with assets under management in excess of $100 million, while individual states regulate those with under $100 million. Currently, there are more than 14,000 SEC-registered advisors and more than 17,000 state-registered advisors. For any uniform solution to be implemented to solve the forced arbitration problem, the SEC and the states must act in concert.

There are three possible solutions to provide investors with a meaningful opportunity to bring claims against RIAs for misconduct. First, RIAs can be prohibited from using forced arbitration clauses in their account agreements, giving the harmed clients the opportunity to file a lawsuit in court. The state of Virginia has already done this by prohibiting the use of forced arbitration clauses by RIAs as dishonest or unethical business practices.

Second, RIAs can be required to pay all the costs of the forum they have designated in their arbitration clause, except for a nominal filing fee. This is already a common practice for arbitration forums that hear consumer and employment claims, which require firms to agree to pay the forum fees as a condition of hearing the case. This puts the cost burden on the more sophisticated party that forced arbitration, as opposed to the consumer or employee, who was forced to waive their right to pursue a claim in any other forum. FINRA also permits claims against RIAs to proceed in its forum, so long as both sides agree, and the firm agrees to bear a significant portion of the forum fees. However, few RIAs agree to proceed at FINRA.

Finally, the investor can be permitted to choose between court and arbitration after the dispute arises. This is the best solution as it allows a client to make an informed decision about what will be in their best interest. After all, unlike brokers, RIAs are fiduciaries and have an obligation to act in their clients' best interests. A bill that does just this, the Investor Choice Act, has been introduced in the U.S. House.

Now is the time for the SEC and state securities regulators to address the issue of forced arbitration. The current situation is not only unjust but untenable. Investors must be afforded the opportunity to pursue recovery of funds lost due to the misconduct of a trusted advisor in a forum that is fair and accessible. Today, for a large and rapidly growing number of retail investors, that is no longer the case.

Christine Lazaro Director, Securities Arbitration Clinic At The Law School Of St. John's University

Michael S. Edmiston Attorney, Jonathan W. Evans & Associates