Virtually all brokerage firms’ customer agreements require arbitration of disputes in the Financial Industry Regulatory Authority (FINRA) forum. FINRA regulates the contents of these predispute arbitration agreements (PDAAs) and prohibits broker-dealers from requiring customers to give up the right to bring class actions in court. A FINRA hearing officer, however, recently ruled that FINRA’s prohibition on class action waivers was unenforceable because it conflicted with the Federal Arbitration Act (FAA), as interpreted by the U.S. Supreme Court in AT&T Mobility v. Concepcion. Unless reversed on appeal, this ruling is a crippling blow to FINRA’s authority to adopt arbitration rules designed to balance the benefits of arbitration with the need to promote investor confidence. We believe the hearing officer’s analysis gave short shrift to the important question involved in this case and in other recent proposals to eliminate securities class actions through mandatory arbitration: Does the FAA limit the ability of federal regulators acting pursuant to congressional authority to impose conditions and limitations on the use of arbitration provisions in order to ensure fairness? In our law review article published just before the FINRA decision, entitled Investor Protection Meets the Federal Arbitration Act, 1 Stanford J. Complex Litig. 1 (2012), we address that question. We argue that the Securities Exchange Act supplants the FAA’s general “pro-arbitration” mandate and gives FINRA the authority to regulate the securities arbitration process to make it fairer and promote investor confidence.
Since Shearson/American Express v. McMahon, Inc., which held that PDAAs were enforceable with respect to federal securities laws, FINRA, whose rules are subject to SEC review and approval, has engaged in ongoing reform of its arbitration rules and strictly regulates the content of PDAAs in order to make arbitration a fairer process for investors. FINRA has two rules specifically addressing class action claims. First, FINRA has a long-standing rule barring class arbitrations in its forum because it views courts as better equipped to handle complex procedures. Rule 12204: (1) bars the forum from accepting class action claims; (2) bans arbitration of individual claims based on the same facts and law and involving the same defendants as in a class-certified or putative class action unless the claimant established that he was not participating in the class action; and (3) precludes a broker from enforcing any arbitration agreement against a member of a certified or putative class action until a court denied class certification or the member was excluded or withdrew from the class. FINRA’s predecessor, NASD, initially proposed the rule in 1992 in response to the SEC’s concern that investors should have access to the courts in appropriate cases, including class actions, and made clear its view that investor protection policies required the preservation of investors’ opportunity to pursue class claims in court. In approving the rule, the SEC expressed its agreement with NASD’s position: “. . . The Commission believes that investor access to the courts should be preserved for class actions. . . .”
Second, FINRA Rule 2268(f) requires broker-dealers to incorporate language in their PDAAs acknowledging that they may not enforce a PDAA against a member of a putative class action so long as the class action remains viable. Accordingly, customers who have claims against a brokerage firm suitable for class treatment may institute a class action in court, and the firm cannot thwart the class action by compelling individual class members to arbitrate their claims.
Additionally, FINRA Conduct Rule 2268(d) prohibits PDAAs from including any condition that “limits or contradicts the rules of any self-regulatory organization” or “limits the ability of a party to file any claim in court.” The SEC first approved the prohibition against inconsistent conditions in 1989 because “agreements cannot be used to curtail any rights that a party may otherwise have had in a judicial forum.” When approving a strengthened version of the rule in 2004, the SEC reiterated its view that broker-dealer PDAAs could not limit investors’ rights and remedies.
As consumer advocates well know, in its 2011 opinion, AT&T Mobility LLC v. Concepcion, the U.S. Supreme Court upheld a provision in a consumer contract that disallowed class arbitration, finding the FAA preempted state precedent that refused to enforce, on unconscionability grounds, waivers of class arbitrations and class actions. According to the Court, the “overarching purpose of the FAA . . . is to ensure the enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings.”
Immediately following AT&T Mobility and in a direct challenge to FINRA’s authority, in fall 2011, Charles Schwab amended its customer agreement to require its brokerage customers to waive their rights to bring class actions in court. According to Schwab, “it acted to protect its shareholders and customers from the high costs and inefficiencies associated with customer class actions.” FINRA Enforcement promptly instituted a disciplinary action against Schwab, alleging Schwab’s amendment violates FINRA rules governing class actions.
On February 21, a FINRA hearing officer ruled against FINRA Enforcement. While the panel had no difficulty finding that Schwab’s class action waiver violated FINRA rules, based on their plain meaning, their regulatory history, and longstanding industry understanding, it also summarily concluded that the FAA conflicted with those rules and thus barred their enforcement. According to the hearing officer, Supreme Court precedent compelled the conclusion that the FAA barred enforcement of FINRA’s prohibition on class action waivers, because “[r]ules that override an agreement to arbitrate and allow a party to an arbitration agreement to avoid arbitration represent the kind of ‘hostility’ to arbitration that the Supreme Court has repeatedly found inappropriate and unenforceable under the FAA.” So FINRA, which operates the predominant securities arbitration forum in the world, has an anti-arbitration bias?
Furthermore, while recognizing congressional intent can override the FAA’s mandate, in the view of the Hearing Panel, “[o]nly Congress can make an exception,” i.e. Congress itself must pass legislation that specifically provides for “preserv[ation] of judicial class actions as an option in customer securities claims even where there is a PDAA.” For the Hearing Panel, FINRA’s promulgation of arbitration rules, subject to SEC approval and oversight, based on its concerns for fair treatment and investor confidence, is not the same as congressional intent. (The hearing officer held that Schwab violated another FINRA rule by purporting to limit arbitrators’ powers to consolidate similar claims and imposed sanctions for this violation, but this ruling is of less significance, since Schwab had previously announced it was dropping this provision.)
Unless reversed on appeal, other broker-dealers will now perceive they have a green light to insert class action waiver language in their customer agreements, and perhaps even other provisions that further curtail investors’ rights and remedies. Unfortunately, the hearing officer’s analysis does not adequately address the most important question: Does the FAA block federal regulators — acting pursuant to congressional authority – from regulating arbitration provisions to ensure fairness? Indeed, the hearing panel’s analysis on this critical issue is only slightly more than one double-spaced page.
In our law review article, we analyze that issue comprehensively. We argue that, when in direct conflict, the Securities Exchange Act’s specific and more recent regulations designed to protect investors supplant the FAA’s general (though powerful) mandate supporting the enforceability of arbitration agreements through the long-standing doctrine of implied repeal, additional well accepted canons of statutory construction, and current Exchange Act and FAA jurisprudence. In particular, Securities Exchange Act § 15A requires FINRA to adopt rules to protect investors and the public interest, subject to SEC review and approval. FINRA’s rules, including the class action provisions, are the product of active engagement by both the SEC and FINRA “for the continual improvement of securities industry arbitration as a fair, expeditious, and economical means for the resolution of disputes.” In the view of the regulators charged with the responsibility of protecting the investing public, arbitration should not restrict rights and remedies that investors would have in court. In addition, in Dodd-Frank Congress explicitly recognized that there are grounds for concern about the use of PDAAs in customer agreements and gave the SEC broad authority to limit or even ban the use of PDAAs with respect to federal securities claims. Does it make sense to refuse to enforce a FINRA rule that has been repeatedly approved by the SEC, when the same rule, if adopted by the SEC directly, would be valid? We hope that you will read the entire article where we develop these arguments more fully.
The hearing panel’s decision is only the first round in this battle. FINRA Enforcement has already announced it will appeal this decision to FINRA’s National Adjudicatory Council. Depending on subsequent outcomes, there are possibilities for appeal to the SEC and then to a federal appellate court.
Schwab, however, should be careful what it wished for. If Schwab ultimately prevails, it may well have killed the goose that laid the golden egg. Ever since McMahon, investor advocates have fought against mandatory securities arbitration. Dodd-Frank unquestionably gives the SEC the power to limit the use of PDAAs or to prohibit their use altogether. While to date the SEC has not shown much interest in re-examining the use of PDAAs, this could be the catalyst for change. Stay tuned.