An SEC committee is recommending that the regulator “harmonize” its rules regarding mandatory arbitration clauses between investment advisors and broker/dealers.
In a draft of recommendations filed last month (but released before an Investor Advisory Committee meeting Thursday), the committee suggested several reforms for mandatory arbitration clauses in RIA contracts and opted to approve them at the end of the meeting.
Among the recommended changes are not allowing advisors to include clauses limiting or contracting “the rules of any self-regulatory organization,” limiting parties to file any claim in arbitration or file claims in court permitted under the rules of the forum where the arbitration is taking place or limiting the award arbitrators can mandate.
“Further, investment advisors should be required to agree to a venue closest to the investor’s residence at the time of the events giving rise to the dispute,” the draft read. “Additionally, the investment advisor should be required to agree to streamlined, simplified process for smaller claims.”
The rules bring guidance over RIA arbitration agreements more closely aligned to those of broker/dealers, which FINRA regulates. They fall short of banning them outright, something investor advocates had called for.
In 2010, Congress passed the Dodd-Frank Act in response to the 2008 Financial Crisis and Great Recession; among many other changes, the bill gave the SEC authority to prohibit or limit the use of mandatory arbitration clauses on advisors and broker/dealers.
In 2022, Congress again probed the issue, asking the commission to report on how RIAs use the contracts. The House Appropriations Committee released the SEC report in 2023, leading to a panel discussion before the Investor Advisory Committee last December.
The 2023 SEC report to Congress found that such clauses often disadvantage investors and that about six out of 10 SEC-registered advisors working with retail clients included such clauses in advisory agreements. Of the 60% of mandatory clauses designating a venue for the hearing, 97% didn’t consider the client’s location.
Unlike broker/dealers, who must designate FINRA as their arbitration forum, RIAs can require clients to file claims in private dispute resolution venues, including the American Arbitration Association or JAMS, with arbitrators’ fees often running up to thousands of dollars in daily costs. Those costs could triple with multiple arbitrators hearing a case.
According to Christine Lazaro, a committee member and professor of clinical legal education at St. John’s University, the committee’s recommended changes “would help ensure investors working with an SEC-registered investment advisor receive the same types of protections with respect to dispute resolution as investors who are working with a FINRA-registered brokerage firm.”
Though the committee approved the recommendations, Jennifer Schulp, director of financial regulation studies at the Cato Institute’s Center for Monetary and Financial Alternatives, said while she was “sympathetic” to customers’ desires for greater transparency, she opposed the recommendations mandating changes to advisory agreements. To Schulp, the rules infringed on advisors’ freedom to reach terms with clients that “meet their own needs.”
“While FINRA rules govern arbitration between broker/dealers and their customers, those have grown from the industry’s agreement to bind its own contractual choices through its own self-regulatory organization,” she said.
However, Paul Roye, a committee vice chair and former senior vice president with Fund Business Management Group, said the FINRA processes “work very well,” and questioned whether freedom of contract existed for investment advisors’ clients. The rules may be in fine print and inscrutable for clients, and they lack “leverage” to oppose arbitration standards.
“In most cases, these are going to be standardized provisions that the legal department and the firms have signed off on and approved, and there’s no negotiation,” he said. “And so I see this as a package of recommendations that impose essentially fairness provisions in these agreements.”