Arbitration in the securities industry – between broker-dealers and their customers – wasn’t always mandatory.
In 1972, the predecessor to FINRA created a rule that compelled broker-dealers to arbitrate if demanded by the customer. That rule continues today as FINRA Rule 12200.
The rule is based on the belief – true then and still true over four decades later – that many customers will want to arbitrate and will benefit from arbitration.
As the U.S. Supreme Court observed in its landmark McMahon decision in 1987, and as many courts have observed since, securities arbitration overall is less expensive, more expedient, closely monitored by the SEC, and just as fair as court-based litigation.
Notably, the original rule gave the customer the ability to unilaterally dictate the forum – whether it be court or arbitration, or even both – after a dispute arose. It thus created an incentive for customers (and their lawyers) to game the system to extract their biggest payday.
A customer could, for example, bring some claims in court, and others in arbitration, or take some discovery in a court case, and then later initiate an arbitration. A customer could use the threat of both arbitration and litigation to squeeze the firm for cash, based on the potential cost of litigating the dispute rather than its merits.
The muddled regime created by the rule left firms in the untenable position of being unable to manage or control their dispute resolution costs.
Dispute resolution costs are a fundamental cost of doing business. All businesses, not just those in our industry, need to have a firm grasp on the scope of these costs. Without it, firms cannot appropriately price their products and services and ultimately, stay in business.
To address this predicament, broker-dealer firms began to include clauses in their customer contracts, providing for the mandatory resolution of disputes in arbitration. The Supreme Court upheld the enforceability of these clauses in McMahon and subsequent decisions.
Today, FINRA Rule 12200, in addition to mandating arbitration if demanded by the customer, also mandates arbitration if “required by a written agreement.” The rule thus recognizes that both firms and their customers may be obligated to arbitrate.
Arbitration Clauses
Today, nearly all broker-dealer firms include arbitration clauses in customer contracts to:
- provide clarity and certainty about where disputes will be resolved;
- secure a lower cost, more expedient, and equally fair forum; and
- help manage and control dispute resolution costs (and thereby deliver lower cost services than they otherwise could).
As a result, today, virtually all customer disputes (except for class actions) are resolved in FINRA’s arbitration forum.
Because it is virtually the sole forum for securities dispute resolution, FINRA and its many committees, task forces and study groups – assisted by state regulators, claimants’ lawyers and industry representatives – have continually evaluated and amended the rules that govern the process to make it fairer and more user-friendly for all participants, especially customers.
This commitment to self-improvement, which over the years has addressed issues like punitive damages, pre-hearing discovery, motion practice and panel composition, to name a few, has enabled securities arbitration to nimbly adapt to the ever-changing times in ways the court system has not (and generally cannot).
FINRA’s forum has evolved into the gold standard for customer protections. Read FINRA’s robust review of how the forum serves customers.
This helps explain why customers fare so well in FINRA arbitration, recovering through settlements or awards in the vast majority of cases (e.g., 77% in 2013). Just look at the statistics on FINRA’s website.
Despite this success story, the impassioned cries to ban mandatory arbitration continue. These naysayers, however, fail to appreciate how such a ban might work out. What are some possible scenarios?
The SEC has authority under Dodd-Frank Section 921 to ban arbitration clauses in customer contracts with broker-dealers.
The SEC could use its authority to strike FINRA Rule 12200 altogether, thereby prohibiting use of pre-dispute arbitration clauses. In that case, the only way parties could arbitrate would be if they mutually agreed to arbitrate after their dispute arose.
This outcome would drastically reduce or eliminate the use of securities arbitration because, after a dispute arises, tactical considerations would inevitably lead one party or the other to refuse to arbitrate. Thus, the parties would end up in court – slow, expensive, and laden with motions practice and appeals. The securities arbitration system, rather than continuing to adapt and improve, would wither and die, and customers would pay the price.
Another option would be for the SEC to heed the (ill-conceived) calls of the securities plaintiffs’ bar to selectively amend Rule 12200 to strike only one type of mandatory arbitration (contractual arbitration clauses), but preserve the other (customer-demanded arbitration).
Doing so would return us to the unlevel playing field described above – marked by gamesmanship and unmanageable business risk – that existed before firms started using arbitration clauses.
How might firms react?
Some might elect to include forum selection clauses in their customer contracts in order to supersede the FINRA mandatory arbitration rule, and require that all disputes be resolved in court.
Federal case law generally supports this approach. It would be one way that firms could try to manage and control their dispute resolution costs under this circumstance. And, if enough firms did this, it would also mark the death of securities arbitration. Again, the customer would lose.
Simply put, banning mandatory arbitration clauses in brokerage contracts would be a colossal mistake – because it would ultimately kill securities arbitration, which provides significant benefits to customers.
Firms must remain free to name a commercially reasonable dispute resolution forum at the outset of their business relationships – before a dispute arises. Customers, in turn, are entitled to a fair forum in which to adjudicate their disputes; one that provides due process and that can adapt and improve with the changing times.
Today’s securities arbitration system fairly and optimally balances the interests of both parties and thus provides each with important benefits and protections.
I say leave well enough alone.
Kevin Carroll is Managing Director and Associate General Counsel for SIFMA
