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When Running to the Courthouse, Schwab Failed to Exhaust Remedies in SRO class action waiver conflict

By Edward Pekarek, Esq. and Kristen Mogavero


One of the nation's largest retail securities brokerages, Charles Schwab & Co., quietly amended its customer agreements in September 2011, just months after the U.S. Supreme Court determined in AT&T Mobility v. Concepcion that a California state law banning "unconscionable" class action waivers was pre-empted by the Federal Arbitration Act.

The firm famous for the slogan, "Ask Chuck," began to distribute the contract in October 2011, with a provision requiring its customers to waive the right to participate in class actions against the San Francisco-based broker-dealer. Schwab initially distributed the amended agreement to approximately seven million customers. Since then, Schwab has required at least an additional fifty thousand new account holders to agree to the contentious contract clause and allegedly continues to use the amended agreement containing the waiver, according to a February 1, 2012 disciplinary proceeding initiated by the Financial Industry Regulatory Authority (FINRA).

A FINRA member since 1970, Schwab has some 340 offices in the U.S., staffed by over 7,000 FINRA-registered employees. Notably, in its SRO membership application, Schwab agreed to abide by and adhere to FINRA (then NASD) rules. On February 1, 2012, FINRA announced it had initiated disciplinary proceedings against Schwab, charging the brokerage firm with violations of FINRA rules by including the provision in its customer agreements. In its disciplinary pleading, FINRA seeks to estop Schwab from including or enforcing the challenged provisions in its customer agreements and also seeks sanctions, including monetary sanctions, pursuant to FINRA Rule 8310(a). Schwab responded with a rush to the San Francisco federal courthouse by its lawyers from the firm Arnold & Porter, LLP, seeking preliminary injunctive relief from the SRO action. Schwab maintained in a press statement that it "believes a federal court is in the best position to properly and efficiently resolve this novel dispute, and intends to defend against any disciplinary action brought by FINRA." In response, FINRA sought an expedited hearing as a result of Schwab's continued use of the agreement.

USMJ LaPorte tells Chuck its complaint is dismissed

Schwab's injunctive relief application was referred to a United States Magistrate Judge, the Honorable Elizabeth LaPorte, of the U.S. District Court for the Northern District of California. Judge Laporte opined on Friday, in a 21-page opinion granting FINRA's motion to dismiss, that Schwab failed to show it had exhausted its administrative remedies, the disciplinary options of the FINRA disciplinary proceedings, before initiating litigation in federal court. Parties must first see the dispute to its conclusion in the administrative forum before seeking relief from a district court, according to the court's order. Judge Laporte agreed with FINRA that Schwab must follow SRO procedures for disciplinary cases before seeking judicial intervention. That process ultimately includes federal court review, but contrary to Schwab's tactic, it does not begin at its endpoint, which Judge LaPorte deemed sufficient to dismiss the complaint.

Schwab maintained it would be "irreparably harmed" by having to endure up to four or more years as the FINRA disciplinary process unfolded. Nonetheless, delay is an insufficient basis to avoid the SRO disciplinary process, according to Judge Laporte. The federal judicial officer opined that Schwab failed to demonstrate it was "entitled to an exception" from FINRA process. President of the Norman, Oklahoma-based group of securities arbitration lawyers the Public Investors Arbitration Bar Association (PIABA), Ryan K. Bakhtiari, told Reuters, "The rules are clear and unequivocal that Schwab did not have the right to prohibit class actions." Despite Friday's dismissal, unresolved questions remain as FINRA continues the disciplinary proceedings against Schwab, William Jacobson, a Cornell Law School professor and director of its Securities Law Clinic in Ithaca, New York, told Reuters.

FINRA alleges class action waivers violate SRO rules

FINRA alleges the class action waiver constitutes a violation of FINRA Rule 2268(d)(1) (formerly NASD Rule 3110(f)(4)(A)), which prohibits members from imposing "any condition" in a pre-dispute arbitration agreement that "limits or contradicts the rules of any self-regulatory organization." FINRA alleges Schwab's waiver is improper as it contradicts Rule 11204(d) of the FINRA Code of Arbitration Procedure for Customer Disputes, which provides that a member firm may not enforce an arbitration agreement against a member of a putative class action unless: 1) class certification is denied by a court, 2) the class is decertified for some reason, 3) the member of the putative or certified class action is excluded, or 4) the member withdraws or chooses not to participate in the class.

Schwab, for its part, contends the waiver provision is entirely valid and consistent with the rule of AT&T Mobility, decided on April 27, 2011, in which the U.S. Supreme Court held that California state contract law, which deems class action waivers in arbitration agreements to be unconscionable, and therefore unenforceable, when certain criteria are met, are preempted by the Federal Arbitration Act (FAA). The Court found California's law created an impermissible obstacle to the accomplishment and execution of the full proposes and objectives of Congress and was therefore preempted.

Does AT&T Mobility even apply?

At first glance, it may seem that the Supreme Court's AT&T Mobility decision specifically invites provisions such as the class action wavier included in Schwab's customer agreements. However, there is an important distinction to be made between the customer agreement in AT&T Mobility and the Schwab customer agreement. The disputed provision at issue in AT&T Mobility was part of a cellular telephone contract between a customer and a wireless service provider. In contrast, Schwab customer contract clause is part of a brokerage firm's customer agreement, and the particular brokerage firm, Schwab, is a registered FINRA member.

Schwab is bound by the rules and regulations of FINRA, an SRO overseen by the SEC. Moreover, the FINRA Rules, by which Schwab promised to abide, are approved by the SEC, pursuant to the Securities Exchange act of 1934. As such, FINRA's rules are federal law equivalents and therefore federal preemption, which carried the day in AT&T Mobility, is not a valid argument for Schwab in this dispute, according to Pace Investor Rights Clinic Director, Jill I. Gross, among the first academics to address the Schwab matter in her February 1, 2012 blog post, the same date the FINRA disciplinary proceeding was initiated and when Schwab rushed to the federal courthouse to seek the judicial intervention Judge LaPorte denied.

Considering the quasi-federal nature of the FINRA Rules, we suspect FINRA will ultimately prevail on this issue. However, AT&T Mobility and the Schwab class action waiver raise serious concerns about the future of class actions. Many, if not the majority, of consumer transactions in the U.S. are accompanied by a customer agreement which includes some type of dispute resolution clause. If these clauses are amended to include class action waivers, it will eventually pose significant barriers to justice for those customers. In many cases, customer claims are of low dollar value, individually, to warrant litigation or arbitration, and the only way for those customers to have their day in court is through consolidated or class actions. Without these options, customers will be denied the judicial or dispute resolution process, rights we believe are a universal entitlement for U.S. citizens. Moreover, such obstacles will inevitably encourage corporations to commit "small frauds" and other wrongs that in the aggregate may amount to substantial harms to society.

Therefore, the issue here is bigger than the parties' right to contract and federal preemption─-there remains the fundamental question of whether the judicial system will allow U.S. citizens to be deprived of court access through the use of adhesive consumer contracts. We hope judicial officers will recognize the potentially disastrous impact of these draconian waiver provisions and determine them to be unenforceable, particularly in the securities context.


Mr. Pekarek is a Visiting Professor of Law and Supervising Attorney at Pace Law School, who also serves as Assistant Director for the non-profit Pace Investor Rights Clinic of John Jay Legal Services, Inc.

Ms. Mogavero is a third-year law student at Pace Law School and student-intern for the non-profit Pace Investor Rights Clinic, as well as a member of the Pace Law Review and the national championship team of the 2011 FINRA/St. John's Securities Dispute Resolution Triathlon, and winner of the 2012 Justice Sondra Miller Scholarship, awarded by the Westchester County Women's Bar Association.

Comments (1)

May 17, 2012 -- "Schwab to hold off enforcing class action waivers," Thomson Reuters News & Insight. http://newsandinsight.thomsonreuters.com/Legal/News/2012/05_-_May/Schwab_to_hold_off_enforcing_class_action_waivers/

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