Legislation to Repeal Mandatory Securities Arbitration
April 5, 2022
Legislation to Repeal Mandatory Securities Arbitration
Introduction
through various avenues, including litigation in court or
Virtually all securities broker-dealers and reportedly most
arbitration.
investor advisors require their customers to agree that
disputes that may arise between them must be resolved
Growing prevalence of arbitration. Court cases have been
through arbitration rather than through lawsuits filed in
instrumental in the growing use of mandatory securities
federal or state courts. Critics of this practice argue it
arbitration. According to one analysis, before the late
unfairly denies investors the right to seek redress through
1980s, a minority of broker-dealers had voluntary customer
other avenues. Proponents of the practice argue arbitration
arbitration agreements. Since then, two U.S. Supreme Court
results in fair outcomes at less cost to the parties involved.
rulings, Shearson/American Express v. McMahon, 482 U.S.
220 (1987) and R. de Quijas v. Shearson/Am. Express, 490
Two companion bills—S. 1171 and H.R. 2620, which was
U.S. 477 (1989), are widely seen to have established that
marked up by the House Financial Services Committee
the securities industry can compel investors to have their
(HFSC) on November 16, 2021—would prohibit financial
disputes adjudicated through arbitration forums as indicated
intermediaries from mandating that their customers submit
in their customer arbitration clauses. Now mandatory
to arbitration to resolve disputes instead of litigating them
arbitration provisions are said to be nearly universal.
through federal or state courts. To do so, the bills would
amend the Securities Act of 1933 (P.L. 73-22) and the
The brunt of the policy debate surrounding mandatory
Investment Advisers Act of 1940 (P.L. 76-768).
arbitration clauses for securities transactions revolves
Specifically, they would prohibit broker-dealers, investment
around broker-dealer arbitration hearings conducted by the
advisers, and other intermediaries from incorporating
Financial Industry Regulatory Authority (FINRA)—the
mandatory arbitration clauses in customer agreements.
self-regulatory organization that is the principal regulator of
Supporters argue that this would more fairly give investors
broker-dealers and has 8,000 or so arbitrators. The
the benefit of seeking redress in several ways.
Securities and Exchange Commission (SEC) oversees
FINRA. Arbitration hearings resolve a fraction of the total
Also, under the bills, customer agreement prohibitions on
number of customer disputes filed with FINRA, the vast
class action suits would be banned. If enacted, the
majority of which are settled prior to an arbitration hearing
legislation would also void mandatory arbitration
through direct negotiation or mediation.
agreements that were in effect before the bills became law.
For cases involving investment advisers, which group
The legislation would also amend the Securities Exchange
oversees the arbitration is less clear-cut. Some are dual
Act of 1934 (P.L. 73-291) to require that security exchange
registered as investor advisors and broker-dealers and may
rules not allow the listing of any company whose bylaws,
undergo FINRA arbitration. However, for those who are
governing documents, or contracts provide that disputes
solely registered as investor advisors, arbitration is typically
between shareholders and the company would be subject to
conducted by one of two alternative dispute resolution
mandated arbitration.
groups, the American Arbitration Association (AAA) and
an arbitration group known as JAMS (formerly known as
Supporters of S. 1171 and H.R. 2620 say that the bills
Judicial Arbitration and Mediation Services). On a few
would ensure that securities firm customers would no
occasions, FINRA, also conducts some investor advisor
longer have to surrender their rights to litigate disputes
arbitrations where the advisor is not dual registered.
when they engage with the firms. Detractors acknowledge
this outcome but argue that the reform would ultimately kill
Most of the discussions and research on mandatory
securities arbitration, ending the benefits it provides to
securities arbitration has focused on FINRA broker-dealer
investors.
arbitration, not arbitration involving investor advisors. This
may stem from the fact that until the past decade or so the
Background
use of mandatory arbitration in what many argued was the
The role of arbitration. Clients of broker-dealers and
more deferential to customers fiduciary-based advisory
investment advisors, who provide them with investment
industry was said to be limited. It is now said to be typical.
recommendations, may allege that they have engaged in
As such, the arguments presented in the next section focus
various illegal acts, such as breach of fiduciary duty (for
on FINRA broker-dealer arbitrations, except where
advisors), negligence, unsuitable investment
otherwise noted.
recommendations (historically for brokers), conflicts of
interest, misrepresentation, omissions of material facts, and
The provisions that would ban mandatory arbitration
fraud. Historically, such investor disputes could be resolved
between shareholders and their firms. The backstory
behind the aforementioned legislative provisions that would
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Legislation to Repeal Mandatory Securities Arbitration
ban mandatory arbitration agreements between shareholders
when requested by both disputants, reportedly a rare
and firms dates back several years. At that time, a then-SEC
occurrence. (Shapira, 2019)
commissioner, some academics, and a number of corporate
lawyers expressed support for the SEC’s consideration of a
Parties involved in FINRA arbitrations essentially
policy that would allow public companies to incorporate
relinquish their right to an internal appeal of a decision.
language into their initial public offerings requiring
They also have more limited opportunities for discovery
mandatory arbitration to resolve shareholder disputes. Some
relative to civil litigation. (Tadjedin, 2021)
observers argued that it would have reversed a long-
standing SEC position that such mandatory arbitration
One critique of investment advisory arbitrations, found
arrangements would violate the Securities Exchange Act of
in comments by PIABA officials on advisory firm
1934. The intent behind initial legislative proposals would
arbitrations done by AAA and JAMS, expresses concern
largely appear to be that of telling the SEC to stay with the
that the costs for investors of such dispute resolutions
status quo.
can reach the tens of thousands of dollars, potentially
putting them out of reach for many investors. (PIABA)
Since then, the only public commentary on the subject by
SEC officials appears to have been made by SEC Chair
Arguments Critical of the Legislations’ Intent
Gary Gensler during a May 6, 2021, hearing held by the
Among critics of the bills are the U.S. Chamber of
HFSC. He remarked that the SEC has consistently informed
Commerce (a business advocacy group) and the Securities
companies that it would not be advisable for them to
Industry and Financial Markets Association (a securities
incorporate mandatory arbitration language into their
firm trade group). Various arguments or observations are
corporate charters. He explained that the public needs to be
critical of the legislation. Some that lend support to the
able to seek judicial redress.
notion of arbitration as the default form of dispute
resolution are:
Arguments that Lend Support to the Legislation
Support for the bills has come from various groups,
Various research on FINRA arbitrations has found that
including the Americans for Financial Reform (a coalition
they satisfy most generally recognized standards of
that supports tighter financial regulation), the North
fairness. (Black, 2010)
American Securities Administrators Association (NASAA,
an association of state and provincial securities regulators),
FINRA arbitration tends to be generally faster than
the American Association for Justice (a trial lawyer
litigation. (FINRA)
advocacy group), and the Public Investors Advocate Bar
Association (PIABA, a group of attorneys who represent
A former president of FINRA’s dispute resolution
clients in securities cases). Some arguments that lend
forum asserts that, compared to litigation, claimants
support to the legislation are:
before FINRA arbitration are able to plead a much
wider range of alleged violations. (New York Times,
Section 921 of the Dodd-Frank Wall Street Reform and
2014)
Consumer Protection Act (P.L. 111-203) gave the SEC
rulemaking authority to “prohibit, condition or limit the
Under FINRA’s rules, customer arbitration agreements
use of mandatory pre-dispute arbitration agreements” if
cannot ban civil class actions through the courts.
it finds that doing so protects investors and is in the
public interest.” (The SEC has not used the authority.)
Various legal experts have said that many investors
would not have an opportunity to resolve their disputes
At a March 2, 2021, HFSC hearing, Gensler said:
were it not for the existence of the more “investor
“While arbitration has its place, it’s also important that
friendly” FINRA arbitration. (New York Times, 2014)
investors—or, in that case, customers—have an avenue
to redress their claims in the courts.”
According to an academic’s analysis, most securities
cases would cost investors much more if they were
In 2019, a national opinion poll of investors found that
litigated, which is largely due to attorney’s fees.
83% of respondents indicated that they wanted a choice
(Forbes, 2009)
to pursue their disputes in civil court or in arbitration
instead of solely through arbitration. (NASAA)
FINRA has made significant improvements to its
arbitration protocols over the decades, including
If the bills’ reforms are adopted, “healthy” competition
reforming the long-standing requirement that
in the securities dispute arena could result. And courts
arbitrations include an arbitrator with securities
may not be clogged, as some assert, as smaller-sized
industry connections. Arbitration panels can now solely
claims remain with FINRA. (Frenkel, 2021)
consist of “public” arbitrators with no connections to
the securities industry. (PIABA)
Civil litigation may generate a positive externality with
respect to having a deterrent effect on bad corporate
Gary Shorter, Specialist in Financial Economics
behavior. (Shapira, 2019)
IF12076
FINRA does not allow class action arbitrations and
provides for explanations of the basis of an award only
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Legislation to Repeal Mandatory Securities Arbitration
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