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SEC Under Fire for Failing to Curb Mandatory Arbitration Clauses

Joe Mont | May 7, 2013

Critics of the mandatory arbitration demands broker-dealers and investment advisers often require of their customers have stepped up their fight to get the Securities and Exchange Commission to either limit or end the practice.

In a letter to SEC Chairman Mary Jo White, the North American Securities Administrators Association, a coalition of state securities regulators, wrote that the “take it or leave it” approach of mandatory pre-dispute arbitration clauses is harmful to investors. She was reminded that the Dodd-Frank Act provides the Commission with authority to limit or prohibit these clauses, a power it has yet to exercise.

Criticism of the controversial clauses has intensified since February, when a Financial Industry Regulatory Authority panel ruled that Charles Schwab Corp. had the right to bar customers from engaging in class action lawsuits against it. In September 2011, the firm amended its customer account agreement to include a class-action waiver provision, requiring that all disputes be arbitrated. FINRA's Enforcement Department challenged the move because its rules prohibit the use of such waivers by brokerage and investment banking firms. The FINRA disciplinary panel, however, ultimately upheld Schwab's right to do so.

Schwab had argued that legal precedent established by the Supreme Court in AT&T Mobility LLC v. Concepcion and Compucredit Corp. v. Greenwood held that that federal regulations must also comply with the Federal Arbitration Act, which requires that parties agreeing to arbitration must do so instead of going to court. It also precludes state and federal courts from invalidating arbitration clauses. FINRA had countered that its rules are not governed by the FAA, but the disciplinary panel determined otherwise, on the rationale that because its rules are subject to approval by the SEC it must comply with federal statutes, including the FAA.  

The SEC has since come under fire for its failure to step in.

“Regardless of the erroneous decision by the FINRA Hearing Panel, Congress has expressed its clear intent that the SEC is empowered to take action with respect to mandatory pre-dispute arbitration clauses in broker-dealer and investment adviser customer contracts, and the SEC should not permit Charles Schwab to subvert the clear intent of Congress,” wrote A. Heath Abshure, Arkansas Securities Commissioner and NASAA president.

Speaking on behalf of his organization, Abshure wrote that by banning class action suits, firms will insulate themselves from "having to pay damages to investors who have small claims and cannot afford to file" and "thousands of investors who will never even know they have a cause of action."

“Arbitration cases are basically secret proceedings, not open to the public, and rarely publicized," he added. "The only way many investors learn that they have been defrauded is via a class action notice.”

Also voicing concern to White last week was Sen. Al Franken (D-Minn.), in a letter also signed by signed by 15 senators and 22 House members, all of them Democrats.

“In the almost three years since the Dodd-Frank Act's enactment, the Commission has largely disregarded this important mandate,” they wrote, invoking the legislation's call for it to oversee the practice. “The time is ripe for the Commission to act to protect the investing public and prevent further abuse of forced arbitration contracts.”

Although anecdotal evidence suggests the use of mandatory arbitration agreements is widespread, the legislators expressed concern about the lack of “reliable data” regarding the practice. It urged the Commission to track how many brokerage firms are inserting mandatory arbitration agreements and class action waivers into consumer contracts, “so that this questionable practice may be better monitored and addressed.”

SEC Commissioner Luis Aguilar has expressed solidarity with mandatory arbitration critics.

“Investors should have the unencumbered right to seek redress in all available forums,” he said during a speech last month at an NASAA conference in Washington D.C.  Providing investors with the ability to choose their forum for legal claims would “enhance investor protection and add more teeth to our federal securities laws,” he said.

On a related matter, Aguilar noted that nearly three years after the passage of the Dodd-Frank Act the SEC has also failed to make good on a mandate to establish an Office of the Investor Advocate.