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News November 5, 2012 Issue

FINRA Offers Its Arbitration Forum to Advisers

FINRA hasn’t been getting its way with Congress, so now it is taking matters into its own hands. Unable so far to persuade legislators to impose a self-regulatory organization (SRO) – and specifically, FINRA as an SRO – on advisers, FINRA has determined to offer certain of its regulatory services to advisers instead.

Late last week FINRA posted guidance in its Special Procedures section inviting SEC-registered investment advisers and their clients to avail themselves of FINRA’s arbitration and mediation process. Adviser-employee disputes may also be submitted to the FINRA forum.

In its "Guidance on Disputes between Investors and Investment Advisers who are not FINRA-regulated firms," FINRA said it is offering its services to advisers in response to inquiries from lawyers representing both advisers and investors.

FINRA’s guidance states that it will accept disputes for arbitration on a voluntary, case-by-case basis provided the parties meet all of the following conditions:

  • The adviser and the investor submit a post-dispute agreement to arbitrate;
  • The adviser or other part(ies) agree to pay all arbitration surcharge fees; and
  • The investor files a special written "submission" agreement to submit the dispute to FINRA. The agreement must be signed by all parties to the dispute after the dispute occurred.

The submission agreement, which is available on FINRA’s web site as a model document, must acknowledge that FINRA cannot enforce awards against non-member parties or their employees, and that awards are enforceable in court only to the extent permitted by applicable state or federal law. The agreement also acknowledges that the parties have read and agree to be bound by FINRA’s arbitration procedures and rules.

FINRA may bar an adviser from future participation in the forum if the adviser fails to pay an award or settlement, or any FINRA fees.

FINRA’s latest move should give advisers some pause.

FINRA not only lacks expertise in the advisory business, but also specifically in the operation of fiduciary duty. FINRA has indicated publicly that it will rely on its current group of about 6,400 arbitrators nationwide to handle any dispute resolution involving advisers, and will not recruit arbitrators with advisory expertise to hear those cases.

FINRA also has publicly denied that opening its arbitration forum has anything to do with its efforts to become an SRO for advisers. In fact, FINRA said it waited its announcement until the close of the most recent Congressional session to avoid any appearance of trying to better its position.

Still, it is easy to imagine the argument in the next Congressional session when FINRA resumes its lobbying efforts, that not only is FINRA already regulating advisers in part through extension of the arbitration service, but also that investors are disserved by FINRA’s inability to enforce these arbitration decisions. The logical next step, goes the argument, would be for Congress to extend that ability by establishing FINRA as an SRO over advisers.

This "voluntary" program could very likely be used against advisers as FINRA seeks to expand its franchise.

"Before going the FINRA route, an adviser should comparison shop other dispute resolution forums and carefully consider possible unintended consequences," said Pickard & Djinis partner Mari-Anne Pisarri.

Arbitration, at least mandatory arbitration, for advisory clients has historically been disfavored by the SEC.

Section 215(a) of the Advisers Act voids contract clauses that would waive compliance with any provision of the Advisers Act. In a 1986 no-action letter, McEldowney Financial Services, the SEC took the position that mandatory pre-dispute arbitration clauses would fall under these void clauses. The SEC said that mandatory pre-dispute arbitration clauses in advisory contracts might mislead clients to believe they have waived rights that, by law, are not waivable.

The SEC noted at the time that an advisory contract containing any arbitration clause "should disclose that the clause does not constitute a waiver of any right provided in the Advisers Act, including the right to choose the forum, whether arbitration or adjudication, in which to seek resolution of disputes."

Liability disclaimers and certain hedge clauses are similarly void under the Advisers Act in the SEC’s eyes.

In the 2007 Heitman Capital Management no-action letter, the staff said that whether a hedge clause violates Section 215(a) depends on the clause’s accuracy, communications between the adviser and client, and the "particular circumstances" of the client.

In 2009 however, the Minnesota federal district court upheld an advisory pre-dispute arbitration clause by relying on prior Supreme Court decisions upholding pre-dispute arbitration clauses generally under the federal securities laws.

In the wake of that legal uncertainty, drafters of the Dodd-Frank Act added Section 205(f) to the Advisers Act, which authorizes the SEC to prohibit or restrict mandatory pre-dispute arbitration clauses in advisory client agreements. However, the SEC has not proposed or adopted any measures yet.

Investment Adviser Association executive director David Tittsworth said that it is his understanding that advisers generally do not include arbitration clauses in their client agreements.

"At a minimum, I would caution an advisory firm to at least be mindful of the SEC’s historic posture discouraging the use of mandatory arbitration clauses in advisory contracts," he said.

So where does all this leave advisers?

In offering its arbitration forum and in an apparent nod to the Advisers Act, FINRA specifically limits non-member adviser and such advisory client or employee parties to agreed post-dispute submission of matters for arbitration.

Dually registered advisers are already obligated to arbitrate any dispute that arises in connection with the adviser’s business activities as a FINRA member or associated person (see FINRA Rules 12200 and 13200). This requirement is noted in the FINRA guidance.

Seeking to avoid costly court cases.

FINRA’s arbitration forum streamlines certain procedures, such as prohibiting witness questioning in advance (i.e. no depositions), that helps in keeping dispute resolution costs down. Arbitration in general has long been viewed as a less costly alternative than court proceedings.

FINRA, as the largest SRO for broker-dealers and because it requires all member firms use its arbitration forum, is the largest dispute resolution forum in the securities industry. National exchanges offer arbitration, as well as the American Arbitration Association (AAA).

Fees vary among forums, and in arbitration they are comprehensive. It is pay-as-you-go, and by rule, FINRA assesses fees for items such as filing a dispute, filing a cross-claim, or filing an injunctive claim. Fees are assessed for expedited processing, adjournment, and "last minute" adjournment.

FINRA also assesses fees for deciding a motion without a hearing, for explaining a decision in writing, and for accommodating special services requests, among other events.

FINRA’s hearing arbitrator rates depend on the amount of the claim and the number of arbitrators (up to three) hearing a claim. A hearing session is four hours long, and two hearings a day on a matter can be held. FINRA arbitrators can earn as much as $400 per arbitrator for a four-hour hearing with three arbitrators on a claim in excess of $500,000.

Advisers choosing the FINRA dispute resolution forum should be aware that any final award is made publicly available on FINRA’s web site. An acknowledgement to this effect is included in the submission agreement.

One senior industry lawyer noted that an adviser would have to be "suicidal" to volunteer for public disclosure of its dispute resolution.

Mediation is also available through FINRA, and does not prevent the parties from later entering into arbitration in any forum.