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News January 11, 2010 Issue

Score One For Mandatory Arbitration Clauses In Advisory Agreements

A quiet little case back in the fall may have loud repercussions for mandatory arbitration clauses in advisory agreements.

Mandatory arbitration, long the domain of broker-dealers, may become more mainstream in advisory agreements, thanks to a recent decision in the federal District Court in Minnesota (651 F.Supp.2d 997 (D. Minn. Sept. 3, 2009)). The court found that a mandatory arbitration clause in an advisory agreement was enforceable against a client and did not violate the antifraud provisions of the Advisers Act.

The status of arbitration clauses in advisory agreements has been a bit murky since 1986, when the SEC issued an interpretive letter to one William McEldowney. McEldowney was an RIA who sought confirmation from the staff that he could include a mandatory arbitration clause in his client agreements. The SEC advised McEldowney that such a clause may violate the antifraud provisions of Section 206 of the Advisers Act, unless the clause compelling arbitration also included language effectively stating "unless you don’t want to."

In the letter, the staff explained that it believed an arbitration clause alone may mislead clients who may have a non-waivable right of action under the Act. As a result, an advisory contract containing an arbitration clause "should disclose that the clause does not constitute a waiver of any right provided by the Act, including the right to choose the forum, whether arbitration or adjudication, in which to seek resolution of disputes."

And there it has been for twenty-three years.

The legal landscape has been evolving, however, as it does from time to time. The Federal Arbitration Act, in effect since 1925, was amended several times to enhance the favorability of arbitration, including in 1988 and 1990. The Supreme Court has since had several opportunities to interpret Congress’s intent and the FAA’s reach. Including overturning some prior precedent disfavoring arbitration clauses that the SEC cited in support of its position in McEldowney.

So let’s see what happened in Minnesota.

Minnesota resident Anastasia Bakas was an individual advisory client of Ameriprise Financial Services. Initially, and annually for several years thereafter, she signed an advisory services agreement that included a mandatory arbitration clause. The clause not only compelled arbitration of disputes related to the agreement, but also precluded making claims on a class basis.

The agreement also provided that Bakas would receive an initial financial plan that would be updated annually. Alleging that she paid for but never received the financial plan or any updates – and that Ameriprise never intended to provide them – Bakas sought to void the arbitration clause and bring a class action against Ameriprise for herself and all other similarly situated Ameriprise clients.

The court first addressed whether Bakas’s claim could be subjected to arbitration under the FAA. The process is a two-step inquiry, said the court. First, is there a valid arbitration agreement? And second, does the dispute fall within the scope of that agreement? The court found the answer to both questions was yes.

"However," wrote the court, "things are not that simple."

Ameriprise is dually registered as an adviser and a broker-dealer. In support of her argument that the arbitration clause was invalid, Bakas argued that FINRA broker-dealer rules preclude arbitration of claims brought on behalf of a class, and that Ameriprise, as a FINRA member, was subject to that rule. Ameriprise responded that only its brokerage activity was subject to FINRA regulation. Bakas was an advisory client, said Ameriprise, and advisory activity is governed by SEC regulation.

Bakas offered four arguments to rebut Ameriprise’s position.

Even if SEC regulation alone were to apply, Bakas argued, the SEC also bars compulsory arbitration of her claims. Bakas relied on the SEC’s 1986 McEldowney letter, which in turn relied on a 1953 Supreme Court case, Wilko v. Swan. Wilko buttressed the proposition that mandatory arbitration in a securities-related context was inappropriate, ruling in that case that the federal courts had exclusive jurisdiction over violations of the Securities Act and its anti-waiver provisions. Wilko was controlling in the Minnesota case, asserted Bakas.

The court noted one small problem with Bakas’s arguments, however. Wilko was expressly overruled in 1989 by another Supreme Court case, Rodrigues de Quijas v. Shearson/American Express. The McEldowney opinion letter did not preclude compulsory arbitration of Bakas’s claims, said the court, because it relied on law that was no longer "good."

The court also rejected Bakas’s claim that arbitration would be unable to provide her desired remedy. Citing to Gilmer v. Interstate/Johnson Lane Corp., a fourth circuit ruling later upheld by the Supreme Court, the Bakas court noted that "arbitrators enjoy broad equitable powers and that they may grant whatever remedy is necessary to right the wrongs within their jurisdiction." The Gilmer court also said that, in enacting the FAA, "Congress must have been aware of the respective spheres of judicial and arbitral authority and it expressed no intention that the latter be displaced." The Supreme Court expressly adopted that reasoning in its affirming opinion, and nothing in the Bakas case moved the Minnesota district court to take a different view.

Finally, Bakas argued that FINRA’s jurisdiction was triggered because the advisory services agreement contemplated the provision of brokerage services. In the alternative, Bakas argued that even absent reference to broker services in the agreement, Ameriprise’s status as a FINRA member subjected all of its business activities to FINRA’s rules.

The court flatly rejected both arguments. FINRA "members" are, by FINRA’s own definition, only "brokers" or "dealers." The activity Bakas complained of was clearly and exclusively of an advisory nature, said the court, and the FINRA rule "simply does not apply."

Summing up, the court said "this Court does not believe that a broker/dealer that also happens to be an investment adviser necessarily subjects itself to FINRA’s rules for all of its activities – including those undertaken in its capacity as an investment adviser – simply by joining FINRA. Such a conclusion would stretch FINRA’s power beyond its limits, as it enjoys no statutory authority over investment advisers."