Contract clauses that force RIA clients into private arbitration when they have disputes with advisors are a “disaster” for regular investors, according to a leading securities lawyer.

Adam Gana, the managing partner of the New York-based firm Gana Weinstein, said Tuesday that mandatory arbitration in RIA disputes forces clients to bring claims in forums where costs are high, the results are shrouded in secrecy and the rules are often tilted against them. His remarks came during a meeting of the Securities and Exchange Commission’s investor advisory committee, which is weighing recommendations for possible restrictions on required arbitration.

Arbitration clauses are generally meant to keep disputes out of the regular court system by requiring claimants to go before private panels such as those provided by the Financial Industry Regulatory Authority, the broker-dealer industry’s self-regulator. Supporters of the system say it helps expedite resolutions.

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But critics argue there is no consistency among the rules that different arbitration forums follow, while the cost of resolving disputes before private panels is often high and offers little opportunity for appealing adverse decisions. Gana and others are now arguing for reforms meant to make pursuing complaints against RIAs easier and less expensive for everyday investors.

“The current system is a disaster for the industry at large because it is too expensive and too inconsistent,” Gana said.

Mandatory arbitration by the numbers

The investor advisory committee’s look Tuesday into mandatory arbitration came in response to an SEC staff report from June 2023 finding that the contract provisions are common in the RIA industry. The agency’s Office of the Investor Advocate reviewed 579 agreements between advisory firms and clients and interviewed eight industry organizations. It found that roughly six out of 10 of those required arbitration for the resolution of disputes.

Citing concerns that RIAs could be violating their fiduciary duty to always put their clients first, the office called in October for the SEC to bring a temporary halt to mandatory arbitration in industry disputes. That recommendation wasn’t heeded, but SEC staff continued their review.

The office’s report found that 92% of the reviewed advisor agreements named a specific provider of arbitration services — and it was seldom the least costly option for investors. Roughly 83% of the clauses reviewed required disputes to go before a panel provided by the American Arbitration Association, or AAA.

AAA charges a minimum filing fee of $4,400 for claims brought before three-member arbitration panels. FINRA, by contrast, has a maximum filing fee of $2,300. But FINRA was the specified forum in only 10% of the advisor agreements the SEC’s Office of the Investor Advocate reviewed.

Stephen Brey, the staff attorney for the state of Michigan Corporations, Securities and Commercial Licensing Bureau, said during the committee meeting that the SEC should consider giving investors the right to choose which forum they want to pursue claims against RIAs in. Brey noted that many states don’t allow clauses specifying an exclusive venue for dispute resolution.

“If arbitration truly offers investors the opportunity to more efficiently and fairly settle their disputes, they’ll certainly choose that option. But investors should have the choice to pursue disputes in court, or if that is something that they view as superior to arbitration,” said Brey, also a representative of the North American Securities Administrators Association, which represents state regulators.

The chilling effect

Gana, who is also the current president of the Public Investors Advocate Bar Association, said the high costs have cooled investors’ willingness to bring disputes against RIAs. Gana said a client of his who lost $60,000 from an advisor’s mismanagement had to pay $25,000 to bring his claims before Judicial Arbitration and Mediation Services, or JAMS, another arbitration provider.

Gana said this chilling effect is real but impossible to measure.

“This is something that no study will be able to see, which is what I think the value is of my testimony here today,” he said. “All the people who feel the need to bring a claim but then ultimately decide to do nothing — that is not quantifiable.”

RIAs’ arbitration clauses are often contrasted with FINRA’s similar requirement that any complaints against its member brokerage firms go before arbitration panels. Critics like Gana often note that registered investment advisors often impose harsher terms on investors than their broker-dealer counterparts.

RIAs’ contracts, for instance, sometimes limit the types of damages clients can win in arbitration, prevent investors from pursuing claims as class actions or require the loser in any given dispute to bear the legal costs. FINRA rules, by contrast, bar those restrictions in claims against broker-dealers.

Cases against brokerages are also usually brought before arbitration panels that are within easy geographic reach of claimants. RIAs are free to have their disputes taken up wherever they want.

FINRA rules also provide some transparency into arbitration proceedings with broker-dealers, and awards against individual firms and representatives, for instance, must be posted to the agency’s BrokerCheck database online. There is no corresponding requirement for disputes with RIAs.

Riding roughshod over the fiduciary duty?

Gana said the RIAs’ arbitration restrictions run counter to their fiduciary duty to always put their clients’ interests first. Ironically, he said, investors have a fairer shake pursuing claims against brokers, which are merely required to look out for customers’ best interests. Gana called on the SEC to limit RIAs’ ability to include provisions like damage limits and class-action bans in their arbitration clauses.

The SEC has more than 15,000 registered investment advisors within its jurisdiction. FINRA meanwhile oversees more than 3,000 member brokerage firms.

Still less expensive than court

Others on Tuesday cautioned that it would be a mistake to abandon arbitration as the primary means of dispute resolution. Although costs may vary from one forum to another, arbitration is generally still less expensive than going through the courts, SEC Commissioner Hester Peirce said.

“Today’s discussion, therefore, should not lose sight of the importance of allowing investors and their advisers to choose binding arbitration to resolve disputes,” said Peirce, a Republican appointee to the SEC, during the committee meeting. “Freedom of contract is a bedrock principle. Submitting a dispute to arbitration is, in many instances, a cheaper and less burdensome process than litigation.”

Kevin Carroll, deputy general counsel for the Securities Industry and Financial Markets Association, said pre-dispute resolution agreements like arbitration clauses also help RIAs control costs. Arbitration may be opaque because it doesn’t require written decisions and may offer only limited opportunities for appeals. But that’s partly the point, Carroll said.

“Decisions are faster and final,” he said. “Customers’ sensitive financial business is kept private. And all parties benefit from these qualities.”