An investor advocacy group within the SEC is warning that advisors who use contract clauses to force client disputes into arbitration could be violating their fiduciary duty to look out for their customers’ best interests.
For that reason, the agency’s Office of the Investor Advocate recommended in a report Tuesday that regulators bring a temporary halt to the use of mandatory arbitration clauses until their benefits and drawbacks can undergo further study. Advisors often include provisions in contracts signed with clients requiring any disputes that might arise over investments or other decisions be settled before specially appointed arbitration panels.
These panels are run outside regular courts by groups like the Financial Industry Regulatory Authority, the broker-dealer industry’s self-regulator. Critics often complain that arbitrators in these forums are too sympathetic to the industry and that their proceedings and decisions aren’t governed by the rules that prevail in the regular justice system.
Advisors’ arbitration contracts also sometimes contain clauses setting limits on claims and damages and prohibiting investors from taking part in class-action suits. That makes them even more onerous to clients than similar agreements presented by broker-dealers, who are barred by law from imposing the same sorts of restrictions.
The SEC has previously estimated that roughly 6 out of 10 advisors have mandatory arbitration clauses in their contracts with clients. That strikes Max Schatzow, a founder and partner of RIA Lawyers in Parsippany, New Jersey, as too low a percentage.
He said the provisions figure in virtually every contract he helps draw up on behalf of his RIA clients. Schatzow said an advisor would have to explicitly express discomfort with one of the clauses for him to remove it.
For Schatzow, the biggest benefit to arbitration is that the reasons for individual decisions often do not become part of the public record. In FINRA arbitration cases, for instance, the panels overseeing cases always release a document stating the outcome of a given case. But they rarely lay out the reasoning behind their decision.
“The biggest benefit is that certain arbitration findings just might not be reportable in certain places,” Schatzow said.
Schatzow disputed the notion that forced arbitration violates advisors’ fiduciary duty to investors. He said that duty applies mainly when RIAs and other wealth managers are dispensing advice on investments and similar matters, not when they are initially entering into a relationship with a client.
“It’s a weird argument,” Schatzow said. “I don’t think it carries any legal weight.”
For some advisors, the idea of forcing clients to take up a dispute in a certain forum is distasteful in itself. Laura Mattia, the CEO of Atlas Fiduciary Financial in Sarasota, Florida, said her firm never includes mandatory arbitration clauses in the contracts it signs with investors.
“Clients can have more confidence in their advisors when they know they have the right to seek legal remedies if necessary,” Mattia wrote in an email. “Lastly, it holds investment advisors to be more accountable for their actions. They must be aware that clients have the option to take legal action, which may encourage better adherence to their fiduciary duties.”
The SEC’s Office of the Investor Advocate acknowledges in its report that there’s no comprehensive database showing how many advisors use forced arbitration clauses. To reach its estimate, it reviewed 579 advisory agreements and consulted eight different stakeholder groups. The latter included the Public Investors Advocate Bar Association, a legal group representing advisory clients, and the North American Securities Administrators Association, made up of state and provincial regulators in the U.S., Canada and Mexico.
PIABA has previously pressed the SEC to ban the use of mandatory arbitration clauses in client contracts. At a news conference held in Washington, D.C. in July, the group argued that arbitration proceedings can cost clients tens of thousands of dollars upfront. And when investors are victorious, FINRA and other arbitration groups offer few guarantees they’ll actually receive the money they’ve been awarded.
Joe Peiffer, the president of PIABA and the founder of New Orleans-based Peiffer Wolf Carr Kane Conway & Wise, said the SEC’s Office of the Investor Advocate’s report is further evidence that mandatory arbitration clauses are highly dubious. Aside from the cost of arbitration proceedings, he said the hearings are at times held at a great distance from where the investors bringing charges live, forcing them to travel if they want to present their case in person.
Peiffer agreed with the SEC’s Office of the Investor Advocate that more study is warranted.
“That’s why they are calling for this temporary halt,” he said. “We don’t have our arms around how big and how bad this problem is, but we know it’s really big and really bad.”
The Office of the Investor Advocate’s report notes that the Investment Adviser Act of 1940 gave the SEC authority to place limits on arbitration proceedings to protect investors. Peiffer said he’s not entirely sure what additional steps the SEC would have to take to institute a temporary ban on mandatory arbitration. Attempts to reach the SEC were unsuccessful.
The Office of the Investor Advocate’s report does cite one case in which the SEC hit an investment advisor with penalties for a contract clause that could mislead clients into believing they had waived their right to bring legal complaints against the firm. In January 2022, the regulator imposed a $375,000 fine on Rockaway, New Jersey-based Comprehensive Capital Management, after finding that its agreements had contained an illegal “hedge clause” purporting to make the advisory firm not liable for actions taken on investors’ behalf.
“Such claims are non-waivable,” the SEC said in a release on the case.
When advisory firms do require mandatory arbitration, the SEC’s Office of the Investor Advocate found a strong tendency to also insist that cases be taken up in a particular forum. Of the 579 contracts regulators reviewed, 92% named a specific arbitration group for settling disputes.
The most popular was the American Arbitration Association, which was specified in 83% of the contracts requiring arbitration in a particular forum. Second was FINRA’s dispute resolution services, named in 10% of the contracts. Last was Judicial Arbitration and Mediation Services, or JAMs, which was specified in only 6% of the contracts.
Nearly 4 out of 10 of the contracts required certain arbitration rules to be in place during the proceedings. The rules most commonly insisted on were those promulgated by the American Arbitration Association.
Of the 6 out 10 agreements that specified a physical venue for mandatory arbitration proceedings, almost none took into account clients’ places of residence or business. But only 6% of the total tried to preclude investors from taking part in class-action lawsuits, and 11% sought to set a limit on damage awards.