Some RIAs have less client-friendly arbitration than brokerages: SEC, By Tobias Sallinger

Financial Planning (June 29, 2023) – Brokers subject to a less stringent duty than fiduciary advisors have a more customer-friendly arbitration process than some registered investment advisory firms, according to the SEC.

An estimated 61% of RIAs serving retail clients use mandatory arbitration clauses in their advisory agreements that sometimes include restrictive terms, impose higher costs and enforce provisions that are “impermissible in agreements between brokers and their customers,” the Securities and Exchange Commission said in a June 27 report to a Congressional committee. The December 2022 government appropriations law contained language directing the regulator to study the “proliferation” of mandatory arbitration clauses among SEC-registered RIAs.

The “opaque nature” of RIA arbitration prevented the regulator’s staff from gathering very much data, but SEC officials spoke with FINRA, client attorneys and trade and advocacy groups and compiled a sampling of 579 advisory agreements. To varying degrees, each of the stakeholders agreed that RIAs “should consistently be required to disclose more complete information about customer arbitrations and unpaid awards,” according to the report. Not surprisingly, they disagreed about whether the mandatory arbitration clauses benefit clients as much as RIAs.

“For many advisory clients, the use of mandatory arbitration clauses in advisory agreements means that arbitration is the only avenue to obtain remedy for financial harm caused by their [RIAs],” the study said. “Further evaluation may be warranted to help ensure that arbitration is an accessible and affordable means of dispute resolution for advisory clients.”

The main findings

SEC staff compared the mandatory arbitration process for customers of advisors at RIAs to FINRA’s client complaint procedures for brokers and brokerages.

RIAs must uphold the fiduciary duty to clients and put the customer’s interest first. In contrast, brokers make recommendations under a lesser standard mandating them to act in a client’s best interest. The distinction represents the most important divide in the industry, but most financial advisors act in both capacities by dually registering with a brokerage and an RIA.

Much more public disclosure, lower costs and, in certain cases, less restrictive terms are causing “seasoned attorneys” to opt for FINRA arbitration over an RIA’s forum of choice when filing cases against dually registered advisors, one stakeholder told the SEC.

At least 92% of the mandatory arbitration clauses used by RIAs designate a particular forum for customer complaints. Just 10% of them face client claims in FINRA arbitration, compared to 83% that go to the American Arbitration Association, 6% that use JAMS and 1% in other forums.

A small but substantial portion of the clauses have restrictive terms that aren’t allowed by FINRA’s rules, with 11% limiting the types of damages clients may seek, 6% waiving a client’s right to class action and 5% curbing what kind of claims customers can assert against an RIA.

In addition, 60% of the required arbitration clauses forced the venue to be in a particular location, with nearly all of them, 97%, choosing a place that “disregarded” any convenience for the client. As another difference with FINRA, which makes the venue closest to a customer’s residence the default location, those provisions “might foreseeably cause clients to incur travel and lodging costs when attending a distant hearing in person,” according to the report.

The “lack of an express, uniform disclosure requirement for RIAs” also distinguishes their mandatory arbitrations from those of brokerages, SEC staff wrote in the conclusion.

“While [RIA] representatives must disclose certain arbitration information, the opaque nature of [RIA] arbitration and difficulty accessing adviser arbitration information raises questions about the ability of regulators to evaluate [RIA] conduct in the context of client disputes,” the report said. “Investors cannot generally access SEC-registered [RIA] arbitration information under the current disclosure regime.”

Questions for the future

AdvisorHub first reported the SEC study, which one of the stakeholders that spoke with the regulator about the issue, the client lawyer group called the Public Investors Advocate Bar Association (PIABA), made available to the media. The other groups were: FINRA, the North American Securities Administrators Association, the Securities Industry and Financial Markets Association, the Financial Services Institute, the Investment Adviser Association, the American Association of Individual Investors and Better Markets.

The SEC should conduct “a thorough and complete sweep of all things related to arbitration” at RIAs because the report “plainly acknowledges it does not have sufficient data to understand the scope of this investor-protection problem,” former PIABA President Michael Edmiston, of the Studio City, California-based Law Offices of Jonathan W. Evans & Associates, said in an email. The report demonstrates that RIAs need “stronger and more thorough regulation,” he said.

“No one knows how many RIAs are using arbitration clauses and the fees of private arbitration providers as shields against claims, the number of arbitration claims filed or the outcomes,” Edmiston said. “By comparison, the report acknowledged all of that information is accessible from the broker-dealer industry regulator, FINRA. The use of forced arbitration, its exorbitant costs, the improper and illegal limitations of claims and remedies and outcomes are all tactics that a fiduciary should never use.”

Other stakeholders expressed more support for the current system, even as the advocates acknowledged that greater public disclosure of the cases “would create a competitive advantage for honest [RIAs] and promote fairer markets,” the report said. One unidentified stakeholder asserted that the low number of arbitration cases disclosed by the RIAs might be “because they abide by their fiduciary duty and do not frequently engage in wrongdoing,” the study said.

“Stakeholders unanimously agreed that mandatory arbitration clauses benefited [RIAs] by, among other things, simplifying the dispute resolution process through limited discovery and no right to appeal, maximizing privacy during and after the arbitration and increasing both predictability and efficiency through the designation of a known venue with familiar rules,” according to the report. “Proponents of mandatory arbitration further asserted that clients — like advisers — experienced these same benefits.”

The SEC staff found areas of “majority” agreement, or among “most stakeholders.” They told the regulator that the option to take an RIA court “in certain circumstances” would help them and the inability to file appeals is “potentially problematic,” according to the study.

“A majority of stakeholders believed [RIAs] benefited from mandatory arbitration at the expense of their clients,” the study said. “These stakeholders frequently expressed the concern that advisers select the forums, rules, and other arbitration terms that increase client costs and favor the [RIA].”