CityWire (June 29, 2023) – While Finra-registered brokers are required by Finra to report any pending complaints, results of arbitration hearings and the existence of settlements, RIAs don’t have to report any arbitration-related information.

A new report to Congress from the Securities and Exchange Commission (SEC) highlights several potential shortcomings of RIAs’ use of mandatory arbitration clauses in client agreements, suggesting that regulations around arbitration mandates and disclosures benefit advisors in ways that may leave clients vulnerable to wrongdoing.

The report notes that a lack of publicly available information about RIA arbitration made it difficult for SEC staff to collect accurate and wholly representative data and to determine the effect that mandatory arbitration has on investors that have been legitimately harmed by an advisor’s conduct. This lack of information, the report said, also impacts clients who want to do due diligence on an advisor they are considering hiring.

As a proxy for the perspectives of advisory clients, the SEC interviewed stakeholder groups such as industry trade groups, nonprofits and self-regulatory organizations. These groups ‘unanimously agreed’ that mandatory arbitration clauses benefited advisors by simplifying dispute resolution, limiting discovery, maximizing privacy, and increasing predictability and efficiency by allowing for the designation of certain venues with familiar rules. While proponents of arbitration argued that clients share in these benefits, critics argued arbitration often leaves clients with high costs and enables advisors to conceal allegations of wrongdoing.

The SEC reviewed the client advisory agreements of 579 retail-focused RIAs and found that 61% included clauses mandating that any dispute be resolved through arbitration. Of those with arbitration mandates, 92% designated a specific forum in which dispute resolution would take place, with the vast majority selecting the American Arbitration Association (AAA).

One problem with private arbitration venues like AAA and JAMS, the SEC notes, is that they do not maintain jurisdiction over the involved parties after the issuance of an award. While most parties abide by the terms of an arbitration award, sometimes awards go unpaid. In such cases, parties looking to enforce an award would need to litigate a dispute through the court system, which is an expensive prospect for most clients, sometimes prohibitively so.

Arbitration in private forums can itself be an expensive process. Filing fees can range from a few hundred to a few thousand dollars, but hourly charges for filing reviews or hearings can cost $600 to $1,800 an hour per arbitrator, leading to weekly costs of $100,000 or more, according to Public Investors Advocate Bar Association (PIABA) president Hugh Berkson. PIABA has long been a staunch critic of arbitration mandates in RIA client agreements. The group’s leadership was interviewed by the SEC for the report.

The report also outlines what Berkson said is a troubling discrepancy between the arbitration-related disclosure requirements for SEC-registered advisory firms and Finra-registered brokerage representatives. Brokers, for example, are required by Finra to report any pending complaints, results of hearings and the existence – but not the specific outcomes – of settlements with claimants. This information is then publicly available to investors on their BrokerCheck profiles.

SEC-registered advisors, despite generally being held to a higher standard of client care than brokers, are not required to disclose any information about client arbitrations in their Forms ADV – a result of an SEC ruling in 2010 that determined not to require disclosure because ‘arbitration settlements or awards may not actually reflect a finding that the adviser violated the law, and disclosure might cause unwarranted reputational harm to the adviser,’ the SEC’s report said.

Additionally, while RIAs can mandate that arbitration take place in private forums, brokers must arbitrate within Finra Dispute Resolution Services, which does maintain jurisdiction over the involved parties following the issuance of an award. And unlike RIAs, Finra-registered firms are not allowed to include clauses that disallow clients from participating in class action lawsuits or claiming certain types of damages as part of their contracts.

‘When it comes to the registered investment advisors the SEC was charged with looking into, it’s remarkable that the people under SEC jurisdiction who are fiduciaries get to use arbitration to hide from investors in a way Finra will not allow its members to do,’ PIABA’s Berkson told Citywire. ‘The SEC has taken a completely hands off approach to this to American investors’ detriment.’

The report stopped short of offering up solutions to these issues, and the SEC maintained that it ‘expressed no view regarding the analysis, findings, or conclusions contained herein.’ However, the report concludes that ‘data obtained from this study support stakeholder views that: (1) certain restrictive terms limiting the claims and/or damages available to advisory clients are sometimes included in advisory agreements; (2) other terms in advisory agreements might increase arbitration expenses for advisory clients; and (3) many of these terms are impermissible in agreements between brokers and their customers, and might also be impermissible in other dispute resolution fora.’