Firms under FINRA oversight should review the predispute arbitration provisions of their customer agreements...
Because Financial Industry Regulatory Authority (FINRA) recently issued Regulatory Notice 21-16 highlighting several practices that could lead to disciplinary action, advisors and firms under FINRA oversight should review the predispute arbitration provisions of their customer agreements.
Investor Choice Act Would Ban Mandatory Arbitration
Under legislation introduced on April 15, 2021, mandatory arbitration would be banned completely in any client agreement with a broker, dealer, or investment advisor. The Investor Choice Act of 2021 (ICA) would also prohibit provisions that stipulate arbitration forums and prohibit class actions.
“Issuers, brokers, dealers, and investment advisers hold powerful advantages over investors, and mandatory arbitration clauses leverage those advantages to severely restrict the ability of defrauded investors to seek redress,” the legislation states. Investors “should be free to either choose arbitration to resolve disputes if they judge that arbitration truly offers them the best opportunity to efficiently and fairly settle disputes and pursue remedies in court should they view that option as superior to arbitration.”
The ICA would specifically amend the Securities Exchange Act of 1934, the Securities Act of 1933, and the Investment Advisors Act of 1940 to impose new requirements on certain investor agreements. Specifically, the legislation:
Prohibits issuers of securities from mandating arbitration for a dispute between the issuer and its shareholders in any governing document or contract.
Makes it unlawful for any broker, dealer, funding portal, or municipal securities dealer to enter into, modify, or extend an agreement with customers or clients that mandates arbitration, restricts the ability of a customer or client to select or designate a forum for resolution of disputes, or restricts a customer or client from bringing class-action claims.
Makes it unlawful for an investment advisor to enter into, modify, or extend an agreement with customers or clients that mandates arbitration, restricts the ability of a customer or client to select or designate a forum for resolution of disputes, or restricts a customer or client from bringing class-action claims.
Prohibits a security from being registered with the Securities and Exchange Commission (SEC) if the issuer of the security, in the bylaws of the issuer, other governing documents, or any contract with a shareholder relating to the parties as issuer and shareholder, mandates arbitration for any dispute between the issuer and the shareholders.
The bill’s provisions regarding customer agreements between investor and advisers/brokers would apply retroactively. Accordingly, provisions that mandate arbitration, include forum selection clauses, or limit class actions would be void.
Similar legislation was introduced in the past and failed to gain enough support to become law. The 2021 version has been introduced in both the House and Senate. While the Investor Choice Act has several Democratic co-sponsors, no Republicans have signed on to support the bill. The legislation, however, is endorsed by North American Securities Administrators Association (NASAA), American Association for Justice (AAJ), Public Citizen, and Public Investors Advocate Bar Association. New SEC Chair Gary Gensler has also expressed support for banning mandatory arbitration in investor agreements.
On April 15, 2021, the Public Investors Advocate Bar Association (PIABA) issued a Press Release supporting the ICA of 2021 as protecting Main Street Investors who are disadvantaged by mandatory arbitration by providing a right to choose forums[1]. The Securities Industry and Financial Markets Association (SIFMA) published a responsive Press Release to PIABA’s statement stating that “the securities arbitration system has worked effectively for decades because it is subject to public oversight…”
FINRA Regulatory Notice 21-16
FINRA Regulatory Notice 21-16 reminds member firms about their compliance obligations when using predispute arbitration agreements for customer accounts and that failing to comply may subject member firms to disciplinary action. “FINRA has become aware that customer agreements used by some member firms contain provisions that do not comply with FINRA rules,” the Notice states. “Member firms with customer agreements that include provisions that do not comply with FINRA rules should take prompt steps to ensure that their customer agreements fully comply with FINRA rules.”
As set forth in the Notice, FINRA rules establish minimum disclosure requirements when member firms use mandatory arbitration clauses. Because class action claims are not allowed in FINRA arbitration, FINRA rules also prohibit member firms from incorporating provisions that would prevent customers from bringing or participating in judicial class actions by adding waiver language into customer agreements (class action waivers) and prohibit member firms from enforcing arbitration agreements against members of a certified or putative class action.
Under FINRA Rule 2268, which became effective May 10, 1989, predispute arbitration clauses must be highlighted in the member’s customer agreement, immediately preceded by disclosures that the customer agreement contains such a clause and describe the consequences of agreeing to arbitration. In addition, FINRA Rule 2268 prohibits any predispute arbitration agreement from including any condition that: (1) limits or contradicts the rules of any self-regulatory organization (SRO); (2) limits the ability of a party to file any claim in arbitration; (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement; or (4) limits the ability of arbitrators to make any award.
The Notice provides examples of non-compliant provisions in customer agreements:
Hearing Locations: Some customer agreements attempt to dictate the location of the arbitration hearing, such as requiring it to be held in a particular state. As FINRA emphasizes, any such provision does not comply with FINRA Arbitration Rule 12213, which provides that the Director of Dispute Resolution Services determines which of FINRA’s hearing locations will be the hearing location for the arbitration.
Time Limitations: Some customer agreements attempt to shorten or extend applicable statutes of limitations. FINRA Arbitration Rule 12206 allows arbitration claims to be submitted unless six years have elapsed from the occurrence or event giving rise to the claim. The arbitrator or panel resolves any questions regarding the eligibility of a claim under this rule or under an applicable state statute of limitations. Consequently, customer agreements may not be used to shorten or extend statutes of limitations or require that a question of whether a time limitation applies be judicially determined instead of being submitted to an arbitrator or panel under the Code of Arbitration Procedure for Customer Disputes
Class Action Claims: Some customer agreements attempt to limit a customer’s right to pursue class actions in court. FINRA cites the following examples: customer agreements that state that the customer waives any right to bring a class action; customer agreements that state that any claims between the parties must be brought in an individual capacity; and customer agreements that state broadly that the agreement to arbitrate constitutes a waiver of the right to seek a judicial forum, without sufficiently indicating that class actions are excepted from this waiver. As set forth in the Notice, limiting a customer’s right to pursue class actions in court through a customer agreement, or seeking to enforce such an agreement, does not comply with FINRA rules. Specifically, FINRA Rule 12204(a) provides that class action claims may not be arbitrated under the Customer Code, and FINRA Rule 12204(d) prohibits member firms and associated persons from enforcing arbitration agreements against members of a certified or putative class action until certain events such as the denial of class certification occur.
Claims and Awards: Some customer agreements attempt to limit the ability of a customer to file a claim or to limit the authority of the arbitrators to make an award, such as using provisions that purport to limit the member firm’s liability for consequential or punitive damages, or damages that do not arise from the member firm’s gross negligence or intentional misconduct. Other customer agreements attempt to do so indirectly by incorporating a choice of law or governing law clause. As the Notice explains, including a choice of law or governing law clause in a customer agreement without an adequate nexus between the law chosen and the transaction or parties at issue, which suggests an intent to limit an award, or otherwise including provisions that attempt to limit the ability of a customer to file a claim or the authority of arbitrators to make an award, is a prohibited condition under FINRA Rule 2268(d).
Indemnity and Hold Harmless Provisions: Some customer agreements contain indemnification or hold harmless provisions, such as broad provisions that require that the customer indemnify and hold harmless the member firm from all claims and losses arising out of the agreement. As set forth in the Notice, indemnification and hold harmless provisions do not comply with FINRA Rule 2268 where the provisions, if given effect, would limit the customer from bringing a claim or receiving an award from the member firm or associated person that they would otherwise be entitled to receive.
Conclusion
Although it is premature to assess the likelihood of passage of the ICA through Congress, FINRA’s notice is a sufficient reminder for member firms to assess their current dispute resolution provisions in their customer agreements.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
[1] Also endorsing the legislation was the N.A. Securities Administrators Association (NASAA), and American Association for Justice (AJA).
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Has the Time Arrived For Advisors to Revise Their Arbitration Agreements?
Author: Scarinci Hollenbeck, LLC
Firms under FINRA oversight should review the predispute arbitration provisions of their customer agreements...
Because Financial Industry Regulatory Authority (FINRA) recently issued Regulatory Notice 21-16 highlighting several practices that could lead to disciplinary action, advisors and firms under FINRA oversight should review the predispute arbitration provisions of their customer agreements.
Investor Choice Act Would Ban Mandatory Arbitration
Under legislation introduced on April 15, 2021, mandatory arbitration would be banned completely in any client agreement with a broker, dealer, or investment advisor. The Investor Choice Act of 2021 (ICA) would also prohibit provisions that stipulate arbitration forums and prohibit class actions.
“Issuers, brokers, dealers, and investment advisers hold powerful advantages over investors, and mandatory arbitration clauses leverage those advantages to severely restrict the ability of defrauded investors to seek redress,” the legislation states. Investors “should be free to either choose arbitration to resolve disputes if they judge that arbitration truly offers them the best opportunity to efficiently and fairly settle disputes and pursue remedies in court should they view that option as superior to arbitration.”
The ICA would specifically amend the Securities Exchange Act of 1934, the Securities Act of 1933, and the Investment Advisors Act of 1940 to impose new requirements on certain investor agreements. Specifically, the legislation:
Prohibits issuers of securities from mandating arbitration for a dispute between the issuer and its shareholders in any governing document or contract.
Makes it unlawful for any broker, dealer, funding portal, or municipal securities dealer to enter into, modify, or extend an agreement with customers or clients that mandates arbitration, restricts the ability of a customer or client to select or designate a forum for resolution of disputes, or restricts a customer or client from bringing class-action claims.
Makes it unlawful for an investment advisor to enter into, modify, or extend an agreement with customers or clients that mandates arbitration, restricts the ability of a customer or client to select or designate a forum for resolution of disputes, or restricts a customer or client from bringing class-action claims.
Prohibits a security from being registered with the Securities and Exchange Commission (SEC) if the issuer of the security, in the bylaws of the issuer, other governing documents, or any contract with a shareholder relating to the parties as issuer and shareholder, mandates arbitration for any dispute between the issuer and the shareholders.
The bill’s provisions regarding customer agreements between investor and advisers/brokers would apply retroactively. Accordingly, provisions that mandate arbitration, include forum selection clauses, or limit class actions would be void.
Similar legislation was introduced in the past and failed to gain enough support to become law. The 2021 version has been introduced in both the House and Senate. While the Investor Choice Act has several Democratic co-sponsors, no Republicans have signed on to support the bill. The legislation, however, is endorsed by North American Securities Administrators Association (NASAA), American Association for Justice (AAJ), Public Citizen, and Public Investors Advocate Bar Association. New SEC Chair Gary Gensler has also expressed support for banning mandatory arbitration in investor agreements.
On April 15, 2021, the Public Investors Advocate Bar Association (PIABA) issued a Press Release supporting the ICA of 2021 as protecting Main Street Investors who are disadvantaged by mandatory arbitration by providing a right to choose forums[1]. The Securities Industry and Financial Markets Association (SIFMA) published a responsive Press Release to PIABA’s statement stating that “the securities arbitration system has worked effectively for decades because it is subject to public oversight…”
FINRA Regulatory Notice 21-16
FINRA Regulatory Notice 21-16 reminds member firms about their compliance obligations when using predispute arbitration agreements for customer accounts and that failing to comply may subject member firms to disciplinary action. “FINRA has become aware that customer agreements used by some member firms contain provisions that do not comply with FINRA rules,” the Notice states. “Member firms with customer agreements that include provisions that do not comply with FINRA rules should take prompt steps to ensure that their customer agreements fully comply with FINRA rules.”
As set forth in the Notice, FINRA rules establish minimum disclosure requirements when member firms use mandatory arbitration clauses. Because class action claims are not allowed in FINRA arbitration, FINRA rules also prohibit member firms from incorporating provisions that would prevent customers from bringing or participating in judicial class actions by adding waiver language into customer agreements (class action waivers) and prohibit member firms from enforcing arbitration agreements against members of a certified or putative class action.
Under FINRA Rule 2268, which became effective May 10, 1989, predispute arbitration clauses must be highlighted in the member’s customer agreement, immediately preceded by disclosures that the customer agreement contains such a clause and describe the consequences of agreeing to arbitration. In addition, FINRA Rule 2268 prohibits any predispute arbitration agreement from including any condition that: (1) limits or contradicts the rules of any self-regulatory organization (SRO); (2) limits the ability of a party to file any claim in arbitration; (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement; or (4) limits the ability of arbitrators to make any award.
The Notice provides examples of non-compliant provisions in customer agreements:
Hearing Locations: Some customer agreements attempt to dictate the location of the arbitration hearing, such as requiring it to be held in a particular state. As FINRA emphasizes, any such provision does not comply with FINRA Arbitration Rule 12213, which provides that the Director of Dispute Resolution Services determines which of FINRA’s hearing locations will be the hearing location for the arbitration.
Time Limitations: Some customer agreements attempt to shorten or extend applicable statutes of limitations. FINRA Arbitration Rule 12206 allows arbitration claims to be submitted unless six years have elapsed from the occurrence or event giving rise to the claim. The arbitrator or panel resolves any questions regarding the eligibility of a claim under this rule or under an applicable state statute of limitations. Consequently, customer agreements may not be used to shorten or extend statutes of limitations or require that a question of whether a time limitation applies be judicially determined instead of being submitted to an arbitrator or panel under the Code of Arbitration Procedure for Customer Disputes
Class Action Claims: Some customer agreements attempt to limit a customer’s right to pursue class actions in court. FINRA cites the following examples: customer agreements that state that the customer waives any right to bring a class action; customer agreements that state that any claims between the parties must be brought in an individual capacity; and customer agreements that state broadly that the agreement to arbitrate constitutes a waiver of the right to seek a judicial forum, without sufficiently indicating that class actions are excepted from this waiver. As set forth in the Notice, limiting a customer’s right to pursue class actions in court through a customer agreement, or seeking to enforce such an agreement, does not comply with FINRA rules. Specifically, FINRA Rule 12204(a) provides that class action claims may not be arbitrated under the Customer Code, and FINRA Rule 12204(d) prohibits member firms and associated persons from enforcing arbitration agreements against members of a certified or putative class action until certain events such as the denial of class certification occur.
Claims and Awards: Some customer agreements attempt to limit the ability of a customer to file a claim or to limit the authority of the arbitrators to make an award, such as using provisions that purport to limit the member firm’s liability for consequential or punitive damages, or damages that do not arise from the member firm’s gross negligence or intentional misconduct. Other customer agreements attempt to do so indirectly by incorporating a choice of law or governing law clause. As the Notice explains, including a choice of law or governing law clause in a customer agreement without an adequate nexus between the law chosen and the transaction or parties at issue, which suggests an intent to limit an award, or otherwise including provisions that attempt to limit the ability of a customer to file a claim or the authority of arbitrators to make an award, is a prohibited condition under FINRA Rule 2268(d).
Indemnity and Hold Harmless Provisions: Some customer agreements contain indemnification or hold harmless provisions, such as broad provisions that require that the customer indemnify and hold harmless the member firm from all claims and losses arising out of the agreement. As set forth in the Notice, indemnification and hold harmless provisions do not comply with FINRA Rule 2268 where the provisions, if given effect, would limit the customer from bringing a claim or receiving an award from the member firm or associated person that they would otherwise be entitled to receive.
Conclusion
Although it is premature to assess the likelihood of passage of the ICA through Congress, FINRA’s notice is a sufficient reminder for member firms to assess their current dispute resolution provisions in their customer agreements.
If you have questions, please contact us
If you have any questions or if you would like to discuss these issues further, please contact Paul A. Lieberman or the Scarinci Hollenbeck attorney with whom you work, at (201) 896-4100.
[1] Also endorsing the legislation was the N.A. Securities Administrators Association (NASAA), and American Association for Justice (AJA).
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