Financial Planning (October 5, 2023) – Cartoonist Ashleigh Brilliant’s quip, “I don’t have any solution, but I certainly admire the problem,” encapsulates the Securities and Exchange Commission’s report on mandatory arbitration clauses in RIA customer contracts.

Last year, Congress tasked the SEC with investigating the frequency of arbitration claims and types of predispute arbitration provisions in customer contracts used by registered investment advisors. But the report, released in June, revealed that the regulator did not possess quantifiable data with which to analyze arbitration claims or outcomes.

Why doesn’t the regulator have the arbitration data? Simple: The SEC never mandated that such data be reported and kept. Under current SEC rules, RIAs are only required to disclose information that the advisors believe is “material” to the client relationship.

The irony is that RIAs, unlike brokers, are fiduciaries and have an obligation to act in their clients’ best interests. Yet compared to FINRA’s arbitration system, RIA arbitration is an informational black hole. Brokerage firms are obliged to publicly disclose arbitration awards under FINRA rules.

Why are RIAs treated differently? The SEC’s stated rationale prioritizes protecting advisors from potential reputational harm ahead of protecting investors. Page eight of the report reveals that the “commission previously considered whether to require advisers to disclose arbitration information in their Forms ADV, but determined not to require disclosure, as arbitration settlements or awards may not actually reflect a finding that the advisor violated the law, and disclosure might cause unwarranted reputational harm to the advisor.”

In lieu of data, in preparing the report the SEC interviewed eight “stakeholders” — including trade associations, nonprofit, regulatory and self-regulatory organizations —to serve as proxies for investor views on mandatory advisor arbitration and related issues. The regulator’s report estimated that “a majority of investment advisory agreements (61%) contain mandatory arbitration clauses, and some contain restrictive terms that could negatively affect the arbitration process or outcome for clients.”

In August, the Public Investors Advocate Bar Association, whose members represent investors in disputes with the securities industry, conducted its own analysis of 189 contracts RIAs used with their clients: 28 from larger SEC-registered investment advisors and 161 from smaller state-registered investment advisors. Of those contracts, 110 — 58% — contained forced arbitration clauses, and 75% of those mandated the use of two of the leading private arbitration providers: JAMS and American Arbitration Association. Arbitrators associated with these companies set their own hourly and/or daily rates. In one case, JAMS proposed 15 different arbitrators for a case with each arbitrator’s fees ranging from $6,000 to $19,500 per day, with the average fee being $11,460
per day.

The staggering costs associated with private arbitration mean that these arbitrators are commonly hired to decide multimillion dollar disputes involving corporate clients with deep coffers, providing a shield for RIAs and a barrier for investors seeking to pursue a complaint. Following the release of the SEC’s report, PIABA sponsored a news conference in which an investor described facing a potential bill from the arbitration provider of up to $202,000 for a hearing on a claim of principal losses of $228,000. A complete win would net her next to nothing after paying the arbitrators, and losing the case would have doubled her losses.

PIABA’s study also revealed 71% of the SEC-registered and 57% of the state-registered investment advisors used improper disclaimers of liability for potential wrongdoing. Such “hedge clauses” are written to make laypeople believe they cannot bring a claim except for outright theft and state that if they lose they will be responsible for the RIA’s attorney’s fees. PIABA’s study also found that 92% of the studied RIAs used choice-of-law clauses to pick the law most favorable to them, and 31% used hearing location selection clauses to set hearing locations far from their complaining client’s home.

The SEC report’s lackluster conclusion that “stakeholder views regarding the potentially negative impact of these terms on advisory clients might merit further exploration” understates the obvious, ongoing and harmful impact defrauded investors suffer on a daily basis due to these terms.

The SEC stopped short of offering any solutions. PIABA has three to start:

Track and disclose
The SEC must begin tracking and disclosing the frequency of customer-RIA complaints, lawsuits and arbitration claims at the same level and degree that FINRA tracks and discloses disputes between customers and brokerage firms. The SEC recommended in its report that investors check their RIA’s backgrounds before deciding to do business with them. But, absent the RIA’s complaint histories, those background checks are of no value to investors.

Mandate investor choice
The SEC must require RIAs to allow investors to choose between court and arbitration after a dispute arises. Known as “investor choice,” this principle allows a client to make an informed decision about which forum would be most appropriate to resolve their dispute. And, if arbitration is to be allowed, rules must be put in place to ensure a fair forum retail investors can afford.

Eliminate hedge clauses
The SEC should use the power Congress already granted it to expressly forbid abusive contract terms like hedge clauses, choice-of-law clauses and hearing location clauses that deceive harmed RIA customers into foregoing justice.

American investors need action. Requiring the use of expensive arbitrators to decide cases involving retail clients who have lost some or all of their life savings makes no sense other than to make arbitration prohibitively expensive. Fiduciaries that handle $114 trillion in assets for American investors must not be allowed to use such mechanisms to deprive their clients of access to justice.

Hugh Berkson
President, Public Investors Advocate Bar Association

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