Securities arbitration surged after 1987 when the United States Supreme Court decided the case of Shearson v. McMahon, 482 U.S. 220 (1987) upholding a pre-dispute arbitration provision in an account agreement between customers and their brokerage firm. Most if not all broker dealers subsequently added mandatory arbitration provisions to their customer account agreements and for the last two decades, the primary method of resolving disputes between investors and their brokerage firms has been arbitration through what is now the Financial Industry Regulatory Authority ("FINRA").
The days of mandatory arbitration may be over, however, as a result of the newly signed Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010) (hereinafter "Dodd-Frank Act"). The Dodd-Frank Act gives authority to the United States Securities Commission ("SEC") to limit or prohibit arbitration provisions in agreements between customers and broker dealers, and customers and investment advisors.
Section 921 of the Dodd-Frank Act
On July 21, 2010 President Barack Obama signed into law the Dodd-Frank Act. The Dodd-Frank Act takes a dim view of pre-dispute arbitration clauses, to put it mildly. The new law flatly bans pre-dispute arbitration clauses in residential mortgages and home-equity loans (§1414) and agreements to argue whistleblower claims on securities fraud (§922) and commodities fraud (§748). See Dodd-Frank Act, §§ 748, 922 and 1414. It also requires the new Bureau of Consumer Financial Protection, created by the Dodd-Frank Act, to conduct a study of the use of pre-dispute arbitration provisions in consumer financial services, and then, if warranted by the study, gives the Bureau the authority to "prohibit or impose conditions or limitations on the use of" arbitration provisions. See Dodd-Frank Act, §1028.
Pre-dispute arbitration agreements between customers and their brokers were not spared. Section 921 of the Dodd-Frank Act amends the Securities and Exchange Act of 1934 ("Exchange Act") and the Investment Advisors Act of 1940 to provide that the United States Securities and Exchange Commission ("SEC") "may prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate..." The full text of section 921 is below:
Subtitle B—Increasing Regulatory Enforcement and Remedies
SEC. 921. AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.
(a) AMENDMENT TO SECURITIES EXCHANGE ACT OF 1934.—Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 78o), as amended by this title, is further amended by adding at the end the following new subsection:
(o) AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.— The Commission, by rule, may prohibit, or impose conditions or 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, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.
(b) AMENDMENT TO INVESTMENT ADVISERS ACT OF 1940.—Section 205 of the Investment Advisers Act of 1940 (15 U.S.C. 80b– 5) is amended by adding at the end the following new subsection:
(f) AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.— The Commission, by rule, may prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any investment adviser to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.
Dodd-Frank Act § 921.
The SEC will solicit public comments on proposed changes through the rulemaking process but until the SEC adopts a contrary rule, mandatory arbitration clauses are still valid and enforceable. In considering the future of mandatory arbitration, it is important to consider the past and in particular circumstances out of which securities arbitration developed.
Background – Shearson v. McMahon
To open an account with a broker dealer, a customer normally signs an account agreement containing a pre-dispute arbitration clause requiring disputes between the customer and the broker dealer be arbitrated before FINRA. FINRA was created in 2007 after a consolidation of the National Association of Securities Dealers ("NASD") and certain divisions of the New York Stock Exchange ("NYSE"). Account agreements prior to 2007 likely require arbitration before the NASD or NYSE.
In 1987, the U.S. Supreme Court issued its landmark decision Shearson/American Express v. McMahon, 482 U.S. 220 (1987) addressing pre-dispute arbitration clauses in customer account agreements with a broker dealer. In the case, two customers (husband and wife) challenged the pre-dispute arbitration clause in their account agreement with Shearson/American Express Inc. arguing the language of the Exchange Act provides the district courts of the United States have exclusive jurisdiction of all violations under The Exchange Act and further forbids any waiver of this language.
In enforcing the pre-dispute arbitration clause, the Supreme Court found the Federal Arbitration Act establishes a federal policy favoring arbitration and, quoting a previous decision stated, "we are well past the time when judicial suspicion of the desirability of arbitration and of the competence of arbitral tribunals should inhibit enforcement of the Act. . . ." McMahon at 226 (quoting Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc. 473 U.S. 614, at 626-627 (1985)). The Supreme Court also specifically found the SEC "has sufficient statutory authority to ensure that arbitration is adequate to vindicate Exchange Act rights. . . ." McMahon at 238.
The McMahon decision occurred the same year as Black Monday – October 19, 1987, when the Dow Jones Industrial Average dropped by 22.6% and the economy weakened, not unlike our current economic situation. Securities arbitration claims surged. In 1989, the SEC established a set of rules to administer arbitrations through its self regulatory organizations, the NASD and NYSE, which although have been revised over time are the arbitration rules still used today. The SEC requires firms to use certain language in its mandatory arbitration provisions which language is set forth in Rule 3110(f) of the NASD Manual. Arbitration cases are heard by a panel of three arbitrators, two of which are public arbitrators and one which is associated with the securities industry.
Several United States Courts of Appeal have recognized the enforceability of pre-dispute arbitration provisions in agreements between customers and their broker dealers. See, e.g., Threlkeld v. Metallgesellschaft Ltd., 923 F.2d 245 (2nd Cir. 1991) (agreements between American investor and British metal futures trader would not be stricken as contracts of adhesion, so as to release investor from obligation to arbitrate dispute.); Securities Industry Ass'n v. Connolly, 883 F.2d 1114 (1st Cir. 1989) (Federal Arbitration Act preempted Massachusetts from adopting regulations requiring arbitration clauses in pre dispute arbitration agreements between broker dealers and their customers to be conspicuous and to be subject to full written disclosure concerning their legal effect).
In the wake of McMahon and Black Monday, broker dealers embraced and relied upon mandatory pre-dispute arbitration provisions in their customer agreements to promptly and efficiently resolve disputes with their customers. Notwithstanding this, mandatory arbitration provisions in customer account agreements have been controversial. Opponents contend the FINRA arbitration process is biased in favor of the broker dealer because one member of the three member arbitration panel is involved in the securities industry and because broker dealers comprise the membership of FINRA. Supporters, on the other hand, contend the process is fair, prompt and inexpensive.
A potential outcome of the SEC's rulemaking is that we will return to the pre-McMahon era where the customer could choose whether to arbitrate his claim. Several unintended consequences could result from such a change, however. Not surprisingly, the number of arbitration cases filed with FINRA has increased dramatically over the last two years. According to FINRA's website (www.finra.org) arbitration filings increased 43% from 2008 (4,982 filings) to 2009 (7,137 filings). If this trend continues, and the SEC prohibits mandatory arbitration, many of these claims will likely be filed in court, which could considerably increase the expense to both the customer and broker dealer to resolve their disputes and potentially clog court dockets causing delay.
The bottom line is that changes are coming and it is likely that mandatory arbitration provisions as we know them today may soon be a relic of the past. The SEC official comment period has not yet opened, but the SEC has invited members of the public to post comments on this issue, and others in the Dodd-Frank Act, on their website (http://www.sec.gov/news/press/2010/2010-135.htm)
About the Author
Tamara Hoffbuhr-Seelman is a director at Fairfield and Woods P.C. She is a member of the Securities Litigation Practice Group and focuses her practices on representing broker-dealers, investment advisers, issuers, individuals and officers and directors on securities litigation, arbitration and complex commercial litigation matters. Mrs. Hoffbuhr-Seelman is also an adjunct professor at the University of Denver Sturm College of Law, Securities Law. She can be reached at firstname.lastname@example.org.