Following last month’s report by the SEC to the House Appropriations Committee on private arbitration (and the use of forced arbitration clauses) in the RIA industry, investor advocates vow that if the commission won’t mandate more industry transparency, they’ll push Congress to step in.
“I realize there’s all kinds of priorities with crypto and order flow, but it can’t be the rule that it costs you more than you lost,” incoming Public Investors Advocate Bar Association (PIABA) President Joe Peiffer said during an event highlighting the organization’s reaction to the SEC’s findings. “It can’t be the rule that you’re priced out of justice.”
The House Appropriations Committee commissioned the report to shed light on whether RIAs include arbitration clauses in clients’ contracts to forestall them from going to court. The SEC’s report found that around 61% of RIA firms included some kind of arbitration clause in contracts and that doing so could limit clients’ chances of getting damages when they allege wrongdoing.
PIABA President Hugh Berkson said that while the SEC report highlighted the “outer bounds” of the problem within the industry, the findings revealed how little data the commission actually has on advisors’ use of private arbitration forums (without that data, SEC staff drafting the report had to rely on interviews with several “external stakeholder groups”).
“There is no centralized reporting of claims against RIAs or the results of those claims,” Berkson said. “We would like to see the SEC mandate that RIAs under its jurisdiction provide that information.”
According to the SEC report, about 92% of RIAs with mandatory arbitration clauses mandated a certain dispute resolution forum (such as the American Arbitration Association or JAMS), while 6 in 10 mandated a certain venue/location, 6% included a class action waiver and more than one in ten included language limiting the fees that could be awarded.
Among the speakers at PIABA’s event was Marykay Dragovich, the cousin of Rita Berardelli, a registered nurse who suffered two brain aneurysms in 2016. Dragovich became Berardelli’s conservator after she moved into assisted living.
Dragovich sought out an advisor who claimed to specialize in advice for conservatorships. She granted the unnamed advisor “complete authority” to make trades on Berardelli’s behalf, but the trust was misplaced; in March 2020, the advisor suddenly moved Berardelli's funds into risky investments and let them sit (while losing money) for over a year.
After talking to attorneys, Dragovich found the advisor agreement limited arbitration claims to actual damages (forbidding higher, punitive damages), as well as including a hedge clause prohibiting claims against advisors when investment decisions were “made in good faith.”
And that's before considering the cost of the arbitration itself.
After filing an arbitration claim in JAMS in 2022, the organization tried to appoint three arbitrators for the case. Unlike FINRA brokerage arbitrators, JAMS arbitrators can set their own rates, generally ranging from $8,000-$9,000 per day (along with a 13% case management fee for JAMS).
With arbitration taking about five days, as well as pre- and post-hearing work and award-writing time, the arbitration’s full cost was estimated between $176,000 to $404,000, with Dragovich’s half required before the proceedings. Dragovich, on behalf of her cousin, would have to pay about $200,000 upfront (her cousin’s total losses amounted to $228,000).
The parties eventually negotiated down to a single arbitrator, but the arbitrator’s fee alone exceeded $30,000.
“It makes you wonder how many investors can afford to pay thousands of dollars out of pocket right after getting hit with huge, life-changing losses,” she said.
In 2009, Guam resident Michael Phillips wanted to capitalize his retirement savings so he could subsidize the budget for his former elementary school facing closure and partnered with Asia Pacific Investment Management Corp., a dual registrant.
During PIABA’s conference, he recalled that in 2009, though he entrusted the firm to act as his fiduciary, the advisors embarked on risky trading strategies outside his tolerance level. This trading was monitored and approved by Asia Pacific’s chief compliance officer for more than a decade.
Phillips alleged that, on discovering the discrepancy, firm executives changed his investment profile to make him seem more willing to take risky investment bets than he actually was. He pursued the firm through FINRA’s arbitration process, and won $4 million, but as the firm appealed the decision in Guam’s superior court, Asia Pacific filed for bankruptcy in order to “avoid paying the award,” in Phillips’ view.
Unlike RIAs, brokerage firms must designate FINRA as a forum for arbitration, with the self-regulatory organization setting arbitrators’ fees (though FINRA arbitration is not without its problems; Berkson estimated that $1 out of every $4 of broker/dealer arbitration awards goes unpaid)
Nevertheless, he hoped the SEC would require RIAs to disclose claims resolutions, akin to brokers, and that if the commission wouldn’t require advisors to use a particular forum, they would mandate that the RIA ensure the client can afford it, there are reasonable discovery procedures, hearings that take place near clients, and contracts exclude hedge clauses, punitive exemptions or class action waivers.
Berkson said that in conversations with legislators, he’d been “surprised” by the amount of interest in taking up these issues if the SEC did not act, stressing that the problem transcended partisanship.
“It doesn’t matter who you voted for; someone will still con you out of your money,” he said.
While Peiffer acknowledged the difficulties, he said PIABA was prepared to pressure Congress for a bill and was prepared for the time it might take to accomplish their goal.
“Someone told me ‘in Washington, don’t be prepared to do something unless you’re prepared to spend a decade on it,’” he said.
