By Alex Stone
Mandatory pre-dispute arbitration has been a cornerstone of the securities industry for almost three decades, but its continued existence may be in jeopardy. While many commentators and industry professionals agree that arbitration is a cost effective and efficient way to resolve disputes, there has been a wave of rhetoric demanding mandatory arbitration be prohibited altogether.
The legality of mandatory pre-dispute arbitration agreements ("PDAAs") was not always an accepted fact. In Wilko v. Swan, 346 U.S. 427 (1953), the Supreme Court held that PDAAs violated the anti-waiver provisions of the Securities Act of 1933 and were thus unenforceable. The issue was again brought in front of the Court 35 years later in Shearson/American Express v. McMahon, 482 U.S. 220 (1987). In a contentious 5-4 decision, the Court held that the anti-waiver provisions of the '33 and '34 Acts only prohibited waiver of the Act's substantive provisions, and therefore did not prohibit PDAAs, which were essentially procedural in nature. In McMahon, the SEC submitted an amicus brief in support of the industry's position that PDAAs should be enforceable.
Mandatory FINRA-administered arbitration has thus been the status quo since McMahon, but this paradigm shift did not occur without controversy. Proponents and detractors are largely divided depending on what side of the industry they represent. Investor advocates favor a ban on mandatory arbitration, while brokerage firms oppose such a ban.
Section 921 of the Dodd Frank Wall Street Reform and Consumer Protection Act ("Dodd Frank") amends Section 15 of the Securities Exchange Act of 1934, 15 U.S.C. 78o (2006) as well as Section 205 of the Investment Advisors Act of 1940, 15 U.S.C. 80b-5 (2006) by adding a new subsection to each. The amendment grants the SEC the authority to restrict mandatory pre-dispute arbitration. It states, in relevant part, "The Commission, by rule, may prohibit, or impose limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws..."
Advocates of mandatory arbitration argue that current law protects against unconscionable arbitration agreements and that arbitration benefits the customer (and the public) through lower costs and efficient dispute resolution. Proponents of the status quo also point to the "all-public" arbitration panel option, which was put in place in early 2011, although this option is only available for customers with claims over $100,000.
Critics of PDAAs claim that FINRA-administered arbitration is categorically unfair to customers. FINRA, the securities industry's self-regulatory organization, is comprised of securities dealers and brokers, and critics argue that allowing them to oversee the arbitration process is akin to letting the fox guard the henhouse. The critics also point to a low customer win rate and the potential for bias amongst the FINRA arbitrator pool.
The SEC has taken no action since soliciting comments on the costs and benefits of arbitration in March 2013 and does not seem eager to make changes to forced arbitration. However, Rep. Keith Ellison, D. Minn, introduced the Investor Choice Act of 2013 H.R. 2998 (2013) in the House of Representatives, and it was assigned to the House Financial Services Committee in August of 2013. If enacted, the bill would prohibit stockbroker and investment advisory firms from using mandatory PDAAs. Similar bills have been unsuccessfully introduced in the Senate over the years, but that was prior to the enactment of Dodd Frank Section 921. If nothing else, Rep. Ellison's bill is indicative of increasing frustration with mandatory PDAAs amongst government representatives and industry professionals. Whether the SEC promulgates rules under Section 921, or its enactment was merely symbolic, remains to be seen.
Although mandatory arbitration is cost effective and efficient, its restrictive nature and potential for bias cannot be ignored. Contracts between customers and securities brokers are not entered into at arms-length, because the relationship between broker and customer is fiduciary in nature. Customers should, at the very least, have the option to forgo arbitration in favor of traditional litigation procedure. Court litigation offers greater procedural safeguards, appellate review, and greater legal expertise. As securities claims become increasingly rife with legal morass, it may be wise to leave these complex disputes in hands of experienced judges who have the resources of the judiciary at their disposal. Ultimately, investors and their lawyers should be able to choose the best forum for dispute resolution.
Alex D. Stone is a third year student at Fordham University School of Law who has focused his studies on corporate and securities law. He worked as a legal summer intern at FINRA - Market Regulation. Alex can be reached by email here.