The Uncertain Future of Mandatory Arbitration Provisions

On May 20, 2010, the U.S. Senate passed its version of the financial reform bill. The U.S. House of Representatives passed its financial reform legislation earlier this year. The two bills have varying degrees of regulation and differences on how to regulate. One such difference involves mandatory arbitration provisions included in brokerage firm and investment advisory contracts. Currently, most brokerage or investment advisory firms require customers sign a contract in order to open an account. The contract usually requires all claims arising out of or related to the contract to be submitted to arbitration. These mandatory arbitration provisions often specify the arbitral venue and the arbitration rules that will apply.

According to Senate Bill 3217, the Securities and Exchange Commission (“SEC”) would be given the authority to determine the permissibility of mandatory arbitration provisions to govern the arbitrability of securities claims. The Senate specifically gives the SEC the option to reaffirm, prohibit, or impose certain conditions on the use of mandatory arbitration provision in broker-dealer and investment advisor agreements.

On the other hand, the House legislation does not give the SEC the authority to reaffirm current practices regarding mandatory arbitration. Rather, HR 4173 only permits the SEC to restrict or prohibit the use of mandatory arbitration provisions in such contracts. Therefore, without the ability to reaffirm the status quo, it would seem that mandatory arbitration provisions included in brokerage and advisory contracts would no longer restrict a defrauded investor from choosing to seek redress in a judicial forum. Further, the House legislation requires the U.S. Government Accountability Office (“GAO”) to report to Congress on the costs to parties in an arbitration proceeding versus the costs to parties in litigation and the percentage of recovery in both forums. The inclusion of the GAO report is to address concerns that arbitration may not be less costly to the parties or more expedient than litigation and that arbitration may actually undermine investor interests.

The U.S. Department of Treasury in its report last June takes the most stringent approach to mandatory arbitration provisions in brokerage agreements. In its financial reform proposal, the Treasury recommends that legislation should be enacted to prohibit mandatory arbitration provisions in these contracts and that the SEC should be given “clear authority” to enforce arbitration provision violations. Like the House, the Treasury proposal also suggests that a study should be conducted to determine whether investor rights are undermined because of an inability to seek redress in court.

Historically, violations of federal securities laws were considered a non-arbitrable issue. In 1953, the U.S. Supreme Court articulated this view in Wilko v. Swan when it held that an agreement to arbitrate a claim under Section 12(a)(2) of the Securities Act of 1933 was unenforceable. 346 U.S. 427 (1953). Over 35 years later, the Supreme Court overruled its position in Wilko in Rodriguez v. Shearson/American Express, Inc. 490 U.S. 477 (1989). The Court in Rodriguez held that a predispute agreement to arbitrate claims under the Securities Act of 1933 is enforceable and resolution of the claims only in a judicial forum is not required because arbitration does not inherently undermine a person’s substantive rights under federal securities laws. Id. at 485-86. It is important to note that since the decision in Wilko, arbitration had become more common and the Federal Arbitration Act had been significantly amended strengthening judicial and legislative favor toward the use of arbitration to settle disputes, which further justified the Supreme Court’s overruling. Id. However, the Supreme Court has also held that a predispute arbitration agreement that effectively deprives a claimant of statutory remedies violates public policy and is unenforceable, thus limiting the scope of Rodriguez. Mitsubishi Motors Corp. v. Soler Chrysler Plymouth, Inc., 473 U.S. 614, 637, n. 19 (1985).

SENATE PASSES SWEEPING FINANCIAL REGULATORY REFORM BILL

On May 20, 2010, after much debate, the Senate passed the most sweeping financial regulatory legislation since the Great Depression. The Senate’s 59-39 vote was the last major stepping stone in making the Obama administration’s proposed financial regulatory overhaul a reality. In December 2009, the House of Representatives passed its own version of the legislation by a 223-202 vote. Now, the Senate and the House have the ever important task of reconciling their two versions of the bill, which are largely the same but have important distinctions.

The financial regulatory legislation aims to curtail a repeat of the 2008 economic crisis that nearly crippled the U.S. economy. The Senate’s version of the legislation encompasses over 1,500 pages and includes major overhauls to the current laws and regulations governing the financial industry. Some of the key measures include, but are not limited to:

• A major overhaul in the regulation of banks and financial firms which were previously deemed “too big to fail,” including creating more powers for regulators to break up financial firms that are so large that they pose a threat to the stability of the entire financial system;

• Limiting the scope of banks’ investment activities by in part banning banks from trading on their own accounts and from trading derivatives;

• Empowering the Federal Reserve to supervise large financial companies to help ensure that the government understands the risks these companies pose to the economy;

• Creating a new and independent Consumer Financial Protection Bureau within the Federal Reserve charged with adopting and enforcing new regulations targeting abusive practices in consumer loans and credit cards; and

• Giving regulators the power to oversee and regulate the derivatives market that many experts believe crippled AIG and Lehman Brothers.

Both the Senate and the House have expressed a desire to come to a final resolution of the financial regulatory overhaul legislation by the Fourth of July. The bill will then be sent to President Obama for a final review before he signs it into law.

The financial industry overhaul will have large implications for financial firms throughout the country. The attorneys of Cosgrove Law, LLC have years of experience in the financial industry and will be available to assist you or your firm in maintaining proper compliance with the new financial regulatory legislation.

Second Circuit Addresses Attribution Requirement under Rule 10b-5

On April 27, 2010, the Second Circuit Court of Appeals issued a decision in Pacific Investment Management Company LLC v. Mayer Brown LLP regarding whether a corporation’s outside counsel can be liable for false statements that attorneys allegedly create, but which are not attributed to the law firm or its attorneys at the time the statements are disseminated.

The court held that a secondary actor can be held liable in a private damages action brought pursuant to Rule 10b-5(b) only for false statements attributed to the secondary-actor defendant at the time of dissemination. Absent attribution, a plaintiff cannot show that he or she relied on the secondary actor’s own false statements, and participation in the creation of those statements amounts, at most, to aiding and abetting securities fraud.

The underlying case arose from the 2005 collapse of Refco, Inc., which was once one of the world’s largest providers of brokerage and clearing services in the international derivatives, currency, and futures markets. According to plaintiffs, Mayer Brown LLP served as Refco’s primary outside counsel from 1994 until the company’s collapse. Joseph Collins, a partner at Mayer Brown, was the firm’s primary contact with Refco and the billing partner in charge of the Refco account.

The plaintiffs alleged that Refco transferred its uncollectible debts to Refco Group Holdings, Inc. (“RGHI”)—an entity controlled by Refco’s Chief Executive Officer—in exchange for a receivable purportedly owed from RGHI to Refco. Recognizing that a large debt owed to it by a related entity would arouse suspicion with investors and regulators, Refco, allegedly with the help of outside counsel, engaged in a series of sham loan transactions at the end of each quarter and each fiscal year to pay off the RGHI receivable.

Plaintiffs alleged that Mayer Brown and Collins (collectively “Defendants”) participated in seventeen of these sham loan transactions between 2000 and 2005, representing both Refco and RGHI. Plaintiffs also alleged that Defendants were responsible for false statements appearing in three Refco documents: (1) an Offering Memorandum for an unregistered bond offering in July 2004 (“Offering Memorandum”), (2) a Registration Statement for a subsequent registered bond offering (“Registration Statement”), and (3) a Registration Statement for Refco’s initial public offering of common stock in August 2005 (“IPO Registration Statement”).

Plaintiffs alleged that each of these documents contained false or misleading statements because they failed to disclose the true nature of Refco’s financial condition, which had been concealed, in part, through the loan transactions described above. Plaintiffs alleged that Collins and other Mayer Brown attorneys reviewed and revised portions of the Offering Memorandum and attended drafting sessions. Plaintiffs alleged that Collins and another Mayer Brown attorney also personally drafted the Management Discussion & Analysis (“MD&A”) portion of the Offering Memorandum, which, according to plaintiffs, discussed Refco’s business and financial condition in a way that Defendants knew to be false. The Offering Memorandum was used as the foundation for the Registration Statement, which was substantially similar in content. According to plaintiffs, Defendants further assisted in the preparation of the Registration Statement by reviewing comment letters from the SEC and participating in drafting sessions. Finally, plaintiffs alleged that Defendants were directly involved in reviewing and drafting the IPO Registration Statement because they received, and presumably reviewed, the SEC’s comments on that filing. However, none of the documents specifically attributed any of the information contained therein to Mayer Brown or Collins.

Plaintiffs, who purchased securities from Refco during the period that Defendants were allegedly engaging in fraud, commenced the lawsuit after Refco declared bankruptcy in 2005. They asserted claims for violation of § 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, along with claims for “control person” liability under § 20(a) of the Exchange Act, 15 U.S.C. § 78t(a). The District Court dismissed plaintiffs’ claims against Mayer Brown and Collins pursuant to Fed. R. Civ. P. 12(b)(6).

On appeal, there were two primary issues regarding the scope of Rule 10b-5 liability in private actions: (1) whether defendants could be liable under Rule 10b-5(b) for false statements that they allegedly drafted, but which were not attributable to them at the time the statements were disseminated; and (2) whether the allegations in the complaint were sufficient to state a claim for “scheme liability” under Rule 10b-5(a) and (c).

Plaintiffs asserted that the district court erred in holding that attorneys who participate in the drafting of false statements could not be liable in a private damages action if the statements are not attributed to those attorneys at the time of dissemination. They (along with the SEC as amicus curiae) urged the court to adopt a “creator standard” and hold that a defendant can be liable for creating a false statement that investors rely on, regardless of whether that statement is attributed to the defendant at the time of dissemination. Defendants responded that, under Second Circuit precedents, attorneys who participate in the drafting of false statements cannot be liable absent explicit attribution at the time of dissemination.

The court of appeals noted that the Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) had acknowledged that “secondary actors” could, in some circumstances, still be liable for fraudulent conduct. Specifically, the Court explained that “[a]ny person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability under Rule 10b-5 are met. In any complex securities fraud, moreover, there are likely to be multiple violators . . . .” Id. at 191 (citation omitted).

Moreover, in Wright v. Ernst & Young LLP, 152 F.3d 169, 171 (2nd Cir. 1998), the court noted that claims were made against the accounting firm Ernst & Young for orally approving a corporation’s false and misleading financial statements, which were subsequently disseminated to the public. In that case, the Second Circuit explained that, after Central Bank, courts had generally adopted either a “bright line” test or a “substantial participation” test to distinguish between primary violations of Rule 10b-5 and aiding and abetting. Because the misrepresentations on which plaintiffs’ claims were based in Wright were not attributed to Ernst & Young, the court held that the complaint failed to state a claim under Rule 10b-5. Id. at 175.

The court acknowledged that subsequent decisions in the Second Circuit may have created uncertainty with respect to when attribution is required. Notwithstanding this uncertainty, the court noted that it had recently confirmed the importance of attribution for claims against secondary actors. In 2007, in Lattanzio v. Deloitte & Touche, 476 F.3d 147, 151-52 (2nd Cir. 2007), the court considered claims that the accounting firm Deloitte & Touche had, inter alia, reviewed and approved false or misleading quarterly statements issued by a public company. There the court held that “to state a § 10b claim against an issuer’s accountant, a plaintiff must allege a misstatement that is attributed to the accountant ‘at the time of its dissemination,’ and cannot rely on the accountant’s alleged assistance in the drafting or compilation of a filing.” Id. at 153.

The court found that, based on precedent, secondary actors can be liable in a private action under Rule 10b-5 for only those statements that are explicitly attributed to them. The mere identification of a secondary actor as being involved in a transaction, or the public’s understanding that a secondary actor “is at work behind the scenes” are alone insufficient. The court found that an attribution requirement makes clear—to secondary actors and investors alike—that those who sign or otherwise allow a statement to be attributed to them expose themselves to liability. Those who do not are beyond the reach of Rule 10b-5’s private right of action. A creator standard (urged by the plaintiffs and the SEC) establishes no clear boundary between primary violators and aiders and abettors, and it is uncertain what level of involvement might expose an individual to liability.

Applying the attribution standard to the alleged false and misleading statements in the case before it, the court concluded that the district court properly dismissed plaintiffs’ Rule 10b-5(b) claims against Mayer Brown and Collins. No statements in the Offering Memorandum, the Registration Statement, or the IPO Registration Statement were attributed to Collins, and he was not even mentioned by name in any of those documents. Accordingly, plaintiffs could not show reliance on any of Collins’ statements.

The district court also dismissed plaintiffs’ Rule 10b-5(a) and (c) claims on the ground that the Supreme Court’s decision in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148 (2008) foreclosed plaintiffs’ theory of “scheme liability.” In Stoneridge, plaintiffs sought to hold two companies liable for their participation in sham transactions that allowed an issuer of securities to overstate its revenue. 552 U.S. at 153-55. Although the defendants’ conduct was deceptive and enabled the issuer to conceal the misrepresentations in its financial statements, the Supreme Court found that the essential element of reliance was absent. Id. at 159. Mayer Brown and Collins were alleged to have facilitated sham transactions that enabled Refco to conceal the true state of its financial condition from investors. However, as in Stoneridge, the plaintiffs were not aware of those transactions and, in fact, plaintiffs explicitly disclaimed any knowledge of defendants’ involvement.

The court found that it was clear from the Supreme Court’s holding in Stoneridge that although the ultimate result of the deceptive conduct of secondary actors such as the Defendants may be misleading communication to the public through a company’s financial statements, this alone is insufficient to show reliance on the secondary actor’s own deceptive conduct. Therefore, the court agreed with the district court that plaintiffs’ Rule 10b-5(a) and (c) claims for “scheme liability” were foreclosed by the Supreme Court’s decision in Stoneridge.

A full copy of the Second Circuit Court of Appeals’ decision can be found here.

Is Your Investment Adviser's Arbitration Clause Enforceable?

Many investment advisers, such as SEC registered Investment Adviser Fisher Investments, use a boilerplate JAMS commercial arbitration clause in their Account Agreements (“LOA”) with customers that include a Delaware choice-of-law provision. Whether or not the LOA is enforceable might depend upon the way the arbitrator utilizes the choice of law provision.

For example, an arbitrator’s dismissal or preclusion of a claimant’s non-Delaware state securities law claims would leave the claimant with no recourse for the alleged violation of state model securities laws since the Delaware Securities Act provides no private cause of action relating to or arising from investment advice, including unlawful or unregistered investment advice. Indeed, the clear language of the civil liabilities section within the Delaware Securities Act, 6 Del. C. § 7323, provides a private cause of action only for wrongful conduct in offering, selling or purchasing a security:
(a) Any person who:
(1) Offers or sells a security.
(2) Offers, sells or purchases a security.
See 6 Del. C. § 7317(a). (emphasis added).

Let’s assume the claimant is from Missouri and included Missouri securities law claims in his or her Statement of Claim. Missouri has adopted the 2002 Uniform Securities Act, more specifically Section 509 pertaining to civil liabilities. According to Official Comment 6 of the Uniform Securities Act, Section 509(f) “was adopted in order ‘to establish civil liability for individuals who willfully violate [sections] dealing with fraudulent practices pertaining to advisory activities.’” This comment further states that Section 509(f) is not “intended to limit other state law claims for providing investment advice.” Therefore, Missouri includes a private cause of action for fraudulent or deceptive activities involving investment advice, analyses, and reports.

Delaware, on the other hand, has not adopted the 2002 Uniform Securities Act. Instead, Delaware has adopted a version of its predecessor, the 1956 Uniform Securities Act. Chapter 6 Section 7323 of the Delaware Annotated Code closely follows the language of Section 410 of the 1956 Uniform Securities Act for civil liabilities. However, the 1956 Act, unlike the 2002 Act, limits private causes of action to activities relating to the offer and sale of securities, not investment advisory activities. Furthermore, Delaware legislative history amending Section 7323 reveals that the legislature drafted Section 7323 after the model statute proposed by NASAA’s “3005 Working Group,” which deals exclusively with revised definitions of investment advisers, not private causes of actions. This legislative history also explicitly states that the purpose of the amendment to Section 7323 is to eliminate a private cause of action for violations of stop orders, while creating private causes of action for “violations of 7311(b) (which prohibits representations that the Commissioner has passed upon filings made with him pursuant to the Delaware Securities Act), 7312 (which requires the filing of sales and advertising literature) and 7306(d) (which requires that an issuer provide a prospectus to an offeree at or near the time of the offer).” The Delaware legislature did not intend to include a private cause of action for fraudulent or deceptive investment advisory activities. Therefore, an investor cannot seek remedy under Delaware law for fraudulent or deceptive investment advice.

As a result, using a Delaware choice-of-law provision to bar a Claimant from asserting any other state securities law claims against the investment adviser for its wrongful conduct under the Delaware choice-of-law provision within an LOA likely violates public policy.

For the purposes of our discussion here, let’s assume the customer living in Missouri entered into an LOA with an investment adviser here in Missouri. First, consider that “Missouri has a very strong policy in favor of providing a judicial forum for the claims of investors under the blue-sky laws.” State ex rel. Geil v. Corcoran, 623 S.W.2d 555, 556 (Mo. App. E.D. 1981) (subsequently cited by the 8th Circuit Court of Appeals in Electrical and Magneto Service Co. v. AMBAC International Corp., 941 F.2d 660 (8th Cir. 1991)). Moreover, with regard to a claim under the Investment Advisers Act, the Supreme Court has held that language in an arbitration agreement that effectively deprives a claimant of statutory remedies violates public policy and is unenforceable. Mitsubishi Motors Corp. v. Soler Chrysler Plymouth, Inc., 473 U.S. 614, 637, n. 19 (1985). Consistent with the Supreme Court’s approach, the Eighth Circuit has held that arbitration agreements encompassing federal statutory claims are only enforceable so long as the parties can effectively vindicate their statutory rights through arbitration. EEOC v. Woodmen of the World Life Ins. Society, 479 F.3d 561, 565 (8th Cir. 2006) (citing Green Tree Fin. Corp.-Ala. V. Randolph, 531 U.S. 79, 90 (2000)).

The significant implications of applying Delaware law is not limited to a Claimant’s securities law claims. Consider, for example, state consumer fraud or unlawful merchandising claims. The Delaware Consumer Fraud Act does not provide the substantial remedies provided by the Missouri Unlawful Merchandising Act. And both Missouri and the Eighth Circuit have recognized that "the public policy involved in Chapter 407 [MMPA] is so strong that parties will not be allowed to waive its benefits." Huch, 290 S.W.3d at 725 (emphasis added) (citing Electrical and Magneto Service Co., 941 F.2d 660, 664 (8th Cir. 1991)).

In DeOrnellas v. Aspen Square Management, Inc., 295 F. Supp. 2d 753 (E.D. Mi. 2003) the plaintiffs argued in relevant part that the choice-of-law provision within the mandatory arbitration clause at issue—which required the arbitrator to apply federal or Massachusetts law—would operate to deny them the remedies afforded under a certain Michigan statute. Id. at 760. In its opinion, the Eastern District of Michigan noted that “[i]f that were the inevitable result, the arbitration agreement likely would violate public policy and would be unenforceable.” Id. (emphasis added). The court relied upon and cited Mitsubishi Motors Corp. v. Soler Chrysler Plymouth, Inc., wherein the Supreme Court held that if a choice-of-law clause operated “as a prospective waiver of a party’s right to pursue statutory remedies…we would have little hesitation in condemning the agreement as against public policy.” Id

Federal district courts must apply the choice of law rules of the state in which they sit when jurisdiction is based on diversity of citizenship. Whirlpool Corp. v. Ritter, 929 F.2d 1318, 1320 (8th Cir.1991). Notably, Missouri has adopted Section 187 of the Restatement (Second) of Conflicts, which provides in pertinent part as follows:

[t]he law of the state chosen by the parties to govern their contractual rights and duties will be applied, unless either

(a) the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties' choice, or

(b) application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest than the chosen state in the determination of the particular issue…

With regard to subsection (b) above, Missouri clearly has a materially greater interest than Delaware in our hypothetical. Specifically, the Claimant has resided in Missouri at all times relevant and has sustained all damages in Missouri. Also, the execution of the LOA occurred in Missouri. Moreover, all of the marketing materials would have been mailed to the claimant in Missouri. Finally, the Missouri Securities Act forbids the enforcement of a choice-of-law provision within an arbitration agreement that operates to waive a cause of action under the statute. Specifically, the Missouri Securities Act contains the following provision:

A condition, stipulation, or provision binding a person purchasing or selling a security or receiving investment advice to waive compliance with this act or a rule adopted or order issued under this act is void.
See Mo. Rev. Stat. § 409.5-509(l).

Indeed, the plain language of Section 409.5-509(l) indicates that an arbitrator’s use of a Delaware choice-of-law provision to circumvent Section 409.5-509 and preclude Missouri securities claims operates to void the entire arbitration clause under Missouri law, including the choice-of law provision. Notably, Section 409.4-509(l) is not simply directed at arbitration provisions in violation of federal jurisprudence.

Moreover, as discussed above, “Missouri has a very strong policy in favor of providing a judicial forum for the claims of investors under the blue-sky laws.” State ex rel. Geil v. Corcoran, 623 S.W.2d 555, 556 (Mo. App. E.D. 1981) (subsequently cited by the 8th Circuit Court of Appeals in Electrical and Magneto Service Co. v. AMBAC International Corp., 941 F.2d 660 (8th Cir. 1991)). Importantly, in Corcoran, the parties entered into an agreement in Missouri for the purchase and sale of securities. Id. at 555. Although the agreement was executed in Missouri, it provided in relevant part that “[t]his agreement and its enforcement shall be construed and governed by the laws of the state of New York.” Id. The plaintiffs subsequently brought suit against the defendants under Missouri’s blue-sky laws and the defendants sought to apply New York law pursuant to the agreement. Id. at 555-56. On appeal, the Missouri Court of Appeals found “the application of New York law to be contrary to [Missouri’s] fundamental policy regarding statutory protection of investors in securities transactions.” Id. at 556. The court ultimately held that Missouri law applied despite the parties’ choice of law provision, and that compulsory arbitration clauses for such claims are unenforceable in Missouri. Id.

As to claims under the Missouri Merchandising Practices Act (“MMPA”), the language of the MMPA is very broad in scope, thus demonstrating “the [Missouri] legislature’s clear policy to protect consumers.” Huch v. Charter Communications, 290 S.W.3d 721, 724-25 (Mo. 2009); See also Whitney v. Alltel Communications, Inc., 173 S.W.3d 300, 314 (Mo. App. W.D. 2005) (holding that an arbitration clause was substantively unconscionable because it had the effect of stripping consumers of “the protections afforded to them under the MMPA and unfairly allow[ed] companies…to insulate themselves from the consumer protection laws of this State [Missouri]”). Both Missouri and the Eighth Circuit have recognized that "the public policy involved in Chapter 407 [MMPA] is so strong that parties will not be allowed to waive its benefits." Huch, 290 S.W.3d at 725 (emphasis added) (citing Electrical and Magneto Service Co., 941 F.2d 660, 664 (8th Cir. 1991)). In Huch, the Missouri Supreme Court clearly set forth the importance of the MMPA in protecting Missouri consumers:

....Chapter 407 is designed to regulate the marketplace to the advantage of those traditionally thought to have unequal bargaining power as well as those who may fall victim to unfair business practices. Having enacted paternalistic legislation designed to protect those that could not otherwise protect themselves, the Missouri legislature would not want the protections of Chapter 407 to be waived by those deemed in need of protection. Furthermore, the very fact that this legislation is paternalistic in nature indicates that it is fundamental policy: "a fundamental policy may be embodied in a statute which ... is designed to protect a person against the oppressive use of superior bargaining power."

* * *
The Missouri statutes in question, relating to merchandising and trade practices [MMPA], are obviously a declaration of state policy and are matters of Missouri's substantive law. To allow these laws to be ignored by waiver or by contract, adhesive or otherwise, renders the statutes useless and meaningless.

Huch, 290 S.W.3d at 725-26 (citing Electrical and Magneto Service Co., 941 F.2d at 664).

The Delaware Consumer Fraud Act lacks most of the benefits (substantial remedies) of the Missouri Unlawful Merchandising Act. As such, the dismissal of a claimant’s Missouri consumer claims would seemingly violate Huch and Electrical and Magneto Service Co.

With regard to a customer’s federal securities claim, the Investment Advisers Act contains a provision nearly identical to the anti-waiver provision within the Missouri Securities Act:

Any condition, stipulation, or provision binding any person to waive compliance with any provision of this title or with any rule, regulation, or order thereunder shall be void.
See 15 U.S.C. § 80b-15(a).

Accordingly, 15 U.S.C. § 80b-15(a) forbids the use of a choice-of-law provision to cloak a federally-registered investment advisor with immunity. The United States Supreme Court has held that 15 U.S.C. § 80b-15(b) “fairly implies a right to specific and limited relief in federal court.” Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979) (emphasis added). In addition, the plain language of Section 80b-15(a) mandates that if an arbitrator enforces the Delaware choice-of-law provision to preclude a customer’s federal securities claim under the Act—thereby waiving compliance by the adviser with the provisions of the Investment Advisers Act—the entire arbitration clause is voided under federal law, including the choice-of law provision.

Importantly, Missouri courts have acknowledged that in some instances, where an arbitration clause is so prohibitive as to effectively deprive a party of his or her statutory rights, the arbitration agreement may be invalidated. Whitney v. Alltel Communications, Inc., 173 S.W.3d 300, 311 (Mo. App. W.D. 2005). Similarly, the Supreme Court has held that language in an arbitration agreement that effectively deprives a claimant of statutory remedies violates public policy and is unenforceable. Mitsubishi Motors Corp. v. Soler Chrysler Plymouth, Inc., 473 U.S. 614, 637, n. 19 (1985). Consistent with Missouri’s and the Supreme Court’s approach, the Eighth Circuit has held that arbitration agreements encompassing federal statutory claims are only enforceable so long as the parties can effectively vindicate their statutory rights through arbitration. EEOC v. Woodmen of the World Life Ins. Society, 479 F.3d 561, 565 (8th Cir. 2006) (citing Green Tree Fin. Corp.-Ala. V. Randolph, 531 U.S. 79, 90 (2000)).

“The right to compel arbitration arises from the parties' contract and, as with other contractual rights, is subject to waiver. Such waiver may be express or implied from the parties' conduct.” Fisher Investments, Inc. v. Casper, 2009 WL 27338, at *3-4 (Cal. App. 4 Dist. Jan. 6, 2009). To establish waiver, the non-waiving party must show that the opposing party’s conduct resulted in prejudice to the non-waiving party. See Boulds v. Dick Dean Economy Cars, Inc., 300 S.W.3d 614, 620 (Mo. App. E.D. 2010); Ritzel Communications, Inc. v. Mid-American Cellular Telephone Co., 989 F.2d 966, 969 (8th Cir. 1993). Courts find prejudice “where a party's actions deprive the non-waiving party of benefits of the arbitration agreement, such as the ‘efficient and low-cost resolution of disputes.’” Boulds, 300 S.W.3d at 620. The Missouri Court of Appeals recently made clear that “a failure by a party to proceed to arbitrate in the manner…provided in the arbitration provision is a waiver of the right to insist on arbitration as a defense to an action on the contract. Id. at 619. More specifically a party’s refusal to abide by an arbitration forum’s rules or cooperate in the arbitration proceedings, thereby leaving the opposing party with no option other than to re-file in court, constitutes a waiver of that party’s right to enforce the underlying arbitration agreement. Id. at 621.

Importantly, the U.S. Supreme Court has recognized that “the existence of large arbitration costs could preclude a litigant…from effectively vindicating her federal statutory rights in the arbitral forum.” Green Tree Fin. Corp.-Ala. V. Randolph, 531 U.S. 79, 90 (2000). When evaluating arbitration costs, the Sixth Circuit Court of Appeals has held that “the court must evaluate the likely cost of arbitration not in absolute terms, but relative to the likely costs of litigation.” Cooper v. MRM Investment Co., 367 F.3d 493, 511 (6th Cir. 2003).

The U.S. Supreme Court, in Lowe v. Securities and Exchange Comm’n, made clear the duties of investment advisers—such as Defendant Fisher Investments—under the Investment Advisers Act. Specifically, in Lowe, the Supreme Court noted that “[t]he aim of the [Investment Advisers Act] is the protection of the investing public against fraud or manipulation on the part of advisers.” 472 U.S. 181, 219 (1985). The Supreme Court acknowledged that:

Clients trust in investment advisers, if not for the protection of life and liberty, at least for the safekeeping and accumulation of property. Bad investment advice may be a cover for stock-market manipulations designed to bilk the client for the benefit of the adviser; worse, it may lead to ruinous losses for the client. To protect investors, the Government insists, it may require that investment advisers, like lawyers, evince the qualities of truth-speaking, honor, discretion, and fiduciary responsibility.
Id. at 229.

Moreover the Supreme Court in Lowe opined that:
[P]etitioners’ publications do not fit within the central purpose of the [Investment Advisers Act] because they do not offer individualized advice attuned to any specific portfolio or to any client’s particular needs.
Id. at 208.

In addition to the deprivation of constitutional and statutory rights, an arbitration clause within an otherwise binding account agreement might also be considered unconscionable and therefore unenforceable. Importantly, this issue is directly within the state or federal courts’ jurisdiction and cannot be decided by the arbitrator. Indeed, it is well-established that:
....where a party specifically challenges arbitration provisions as unconscionable and hence invalid, whether the arbitration provisions are unconscionable is an issue for the court to determine, applying the relevant state contract law principles. This rule applies even where the agreement's express terms delegate that determination to the arbitrator. We hold that where, as here, an arbitration agreement delegates the question of the arbitration agreement's validity to the arbitrator, a dispute as to whether the agreement to arbitrate arbitrability is itself enforceable is nonetheless for the court to decide as a threshold matter.

Jackson v. Rent-A-Center West, Inc., 581 F.3d 912, 918-19 (9th Cir. 2009) (emphasis added); See also Estate of Burford ex rel. Bruse v. Edward D. Jones & Co., L.P., 83 S.W.3d 589, 592 (Mo. App. W.D. 2002); Monex Deposit Co. v. Gilliam, 671 F.Supp.2d 1137, 1139-40 (C.D. Cal. 2009). Whether the parties have a valid arbitration agreement at all, and whether the specific dispute falls within the scope of that agreement, are for the court, not the arbitrator, to decide. Express Scripts, Inc. v. Aegon Direct Marketing Services, Inc., 516 F.3d 695, 699-700 (8th Cir. 2007).

The Eighth Circuit is clear that an agreement or any part of an agreement will be deemed unenforceable if the court finds the agreement or portion thereof to be unconscionable. See Cicle v. Chase Bank USA, 583 F.3d 549, 554 (8th Cir. 2009). The test for unconscionability is “whether one of the parties lacked a meaningful choice about whether to accept the provision in question and the challenged provision or the contract unreasonably favors the other party to the contract.” Id. The two aspects—procedure and substance—should be considered together, “so that if there exists gross procedural unconscionability then not much be needed by way of substantive unconscionability and vice versa.” Id.

In determining whether an arbitration clause is procedurally unconscionable, courts must examine the contract formation process to determine whether the agreement constitutes a contract of adhesion. See Cicle, 583 F.3d at 554. When evaluating the contract formation process, courts take into account the following pertinent factors, among others:

a. Whether one party has a superior bargaining position;

b. Whether the party with the inferior bargaining position had an opportunity in the ordinary course for negotiation, or whether the agreement was presented on a take-it-or-leave it basis;

c. Whether the party with the superior bargaining position engaged in high-pressure sales tactics to coerce the inferior party into executing the agreement;

d. Whether the terms of the arbitration clause are in easily readable, as opposed to being in fine print; and

e. Whether the arbitration clause is set forth in a conspicuous manner, such as by being introduced with a boldfaced heading and containing all-uppercase font.
See id. at 554-55.

In determining whether an arbitration clause is substantively unconscionable, courts consider the terms of the provision itself. See Cicle 583 F.3d at 554. Courts take into account “the totality of the circumstances on an objective basis, considering the reasonable expectations of the average person entering into such an agreement.” Id. In essence, courts look to whether the arbitration clause is “inherently unfair or oppressive.” Spurlock v. Life Ins. Co. of Va., 2000 WL 1785300, at *10 (M.D. Ala. Oct. 31, 2000).

In sum, attorneys representing investment advisory customers who signed an Account Agreement that includes a Delaware choice of law provision should evaluate the enforceability of that agreement and the operation of its choice-of-law provision in order to provide effective and thorough representation.

Defending the Promissory Note Arbitration Claim

While many brokers assert equitable defenses to a promissory note action brought by his or her former broker-dealer; potential legal contract defenses should also be considered.
As a part of many recruitment and sign-on transactions, several contracts are executed contemporaneously, such as: 1) a License Agreement; 2) Promissory Note; and 3) Deferred Compensation Plan Agreement. Let’s assume that one or all of these contracts contained a Virginia choice of law provision. Under Virginia law, these documents -- taken together -- form the agreement between the parties. Indeed, “where a business transaction is based on more than one document executed by the parties, the documents will be construed together to determine with intent of the parties[.]” Parr v. Alderwoods Group, Inc., 604 S.E.2d 431, 434 (Va. 2004) (citing Countryside Orthopedics, P.C. v. Peyton, 541 S.E.2d 279, 284 (Va. 2001)). “Where two papers are executed at the same time or contemporaneously between the same parties in reference to the same subject matter, they must be regarded as parts of one transaction, and receive the same construction as if their several provisions were in one and the same instrument.” Id. At 434-35 (citing Countryside, 541 S.E.2d at 284).
When such contracts are construed as if the provisions were in a single instrument, the first party to materially breach the contract cannot enforce the provisions of the integrated contract. Id. At 435. A breach is material if it is “a failure to do something that is so fundamental to the contract that the failure to perform that obligation defeats an essential purpose of the contract.” Id. (Countryside, 541 S.E.2d at 285). As such, the broker-dealer’s initial breach of one of the non-promissory note agreements may legally excuse a subsequent breach of the repayment provision of the promissory note contract. At a minimum, the recoverable damages from the initial peremptory breach may set off or even exceed the balance of the note or notes.
Beyond a potential breach of contract counterclaim or peremptory-breach affirmative defense, the broker may possess causes of action for fraudulent or negligent representation, conversion or tortious interference “[W]hen one represents as true that which is not true, and another relies thereon to his damage, the latter may recover for the false representation whether it was knowingly or innocently made.” B.W. Acceptance Corp. v. Benjamin T. Crump Co., Inc., 99 S.E.2d 606, 608 (Va. 1957). “The intent of the party making the representation is immaterial. The point is whether the other party was misled. Whether the representation is made innocently or knowingly, if acted on, the effect is the same.” Id. “In the one case the fraud is constructive; in the other it is actual.” Id.; see also Hansen v. Stanley Martin Companies, Inc., 585 S.E.2d 567, 573 n. 4 (Va. 2003) (“Negligent misrepresentation is the essence of a claim for constructive fraud in Virginia.)” An action for conversion can be maintained by one who has a property interest in and is entitled to the immediate possession of the thing alleged to have been wrongfully converted. United Leasing Corp. v. Thrift Ins. Corp., 440 S.E.2d 902, 905 (Va. 1994). Finally, tortious interference with business relations claim requires: (1) the existence of a valid contractual relationship or business expectancy; (2) knowledge of the contract or expectancy by the alleged interferor; (3) intentional interference inducing or causing a breach of the relationship or expectancy; and (4) resultant damages. Williams v. Dominion Technology Partners, LLC, 576 S.E.2d 752, 757 (Va. 2003).
In light of the generally poor reception broker’s and representative’s promissory note defenses receive in FINRA arbitrations, it is important to explore solid legally supportable theories in lieu of more general complaints rooted in equity. Complaints about the broker-dealer’s alleged failure to live-up to its recruitment promises will likely get more traction if narrowed, specified, and planted firmly in a legally cognizable contract theory.

GAO Releases Transcript of Testimony Regarding Report on Buildup of Leverage Before Financial Crisis

On May 6, 2010, the Government Accountability Office released the testimony of Orice Williams Brown, Director Financial Markets and Community Investment, before the House of Representatives Subcommittee on Oversight and Investigations, Committee on Financial Services. In Mr. Brown’s testimony, he noted that while the causes of the recent financial crisis remain subject to debate, some researchers and regulators have suggested that the buildup of leverage before the financial crisis and subsequent disorderly deleveraging compounded the crisis.

Mr. Brown noted that many financial institutions use leverage to expand their ability to invest or trade in financial assets and to increase their return on equity. A firm can use leverage through a number of strategies, including by using debt to finance an asset or entering into derivatives. Brown stated that greater financial leverage, as measured by lower proportions of capital relative to assets, can increase the firm’s market risk, because leverage magnifies gains and losses relative to equity. Leverage also can increase a firm’s liquidity risk, because a leveraged firm may be forced to sell assets under adverse market conditions to reduce its exposure. Although commonly used as a leverage measure, Brown noted that the ratio of assets to equity captures only on-balance sheet assets and treats all assets as equally risky.

Brown pointed out that federal financial regulators impose capital and other requirements such as leverage measures on their regulated institutions to limit leverage and ensure financial stability. For example, the SEC uses its net capital rule to limit broker-dealer leverage. Other important market participants, such as hedge funds, also use leverage. Although hedge funds typically are not subject to regulatory capital requirements, market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage.

Mr. Brown found that the crisis revealed limitations in the financial regulatory capital framework’s ability to restrict leverage and to mitigate crisis. First, he noted that regulatory capital measures did not always fully capture certain risks. As a result, institutions did not hold capital commensurate with their risks and some faced capital shortfalls when the crisis began. Brown acknowledged that federal regulators have called for reforms, including international efforts to revise the Basel II capital framework (an international risk-based capital framework which sets requirements for how much capital banks need to put aside to guard against certain types of financial and operational risks). Brown noted that the planned U.S. implementation of Basel II would increase reliance on risk models for determining capital needs for certain large institutions. He stated that the crisis underscored concerns about the use of such models for determining capital adequacy, but regulators have not assessed whether proposed Basel II reforms will address these concerns. Brown noted that such an assessment is critical to help ensure that changes to the regulatory framework address the limitations revealed by the recent crisis.

Second, Brown noted that regulators face challenges in neutralizing cyclical leverage trends. For example, according to regulators, minimum regulatory capital requirements may not provide adequate incentives for banks to build loss-absorbing capital buffers in benign markets when it would be less expensive to do so. When market conditions deteriorated, minimum capital requirements became binding for many institutions that lacked adequate buffers to absorb losses and faced sudden pressures to deleverage. Brown stated that regulators are considering several options to counteract potentially harmful cyclical leverage trends, but implementation of these proposals presents a challenge by itself.

Finally, with multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effects of the buildup of systemwide leverage or the collective effects of institutions’ deleveraging activities. To ensure that there is a systemwide approach to addressing leverage-related issues across the financial system, Brown stated that the GAO has asked Congress to consider, as it moves toward the creation of a systemic risk regulator, the merits of tasking this entity with the responsibility for measuring and monitoring systemwide leverage and evaluating options to limit the positive correlation between leverage trends and the overall state of the economy. Brown also noted that the GAO recommended to the financial regulators that an assessment should be made regarding the extent to which Basel II reforms may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital purposes.

A complete copy of Mr. Brown’s testimony can be found here.

Commissioner Aguilar Advocates That All Advice-Givers be Subject to the Fiduciary Framework

On April 29, 2010, SEC Commissioner Luis A. Aguilar gave a speech at the Investment Adviser Association Annual Conference in Chicago, Illinois. Commissioner Aguilar’s remarks were directed at financial regulatory reform. In particular, Commissioner Aguilar addressed the need for all providers of investment advice to be subject to a fiduciary duty.

Aguilar looked back to a congressionally mandated report conducted by the SEC of investment companies, investment counsel, and investment advisory services after the enactment of the Investment Advisers Act of 1940. The report stressed that a significant problem in the industry was the existence, either consciously or, more likely, unconsciously, of a prejudice by advisers in favor of their own financial interests.

Aguilar then asked that his audience flash forward from the 1930s to the events of the last two years. He noted that an array of examples comes to mind demonstrating the role that advice tainted by conflicts of interest played in harming investors and harming market integrity. Tainted advice led investors to invest billions of dollars in auction rate securities because brokers told them they were safe investments. Conflicts of interest at credit rating agencies contributed to AAA ratings on products that turned out to be worthless. Clearly, Aguilar noted, the concerns giving rise to the Advisers Act are even more relevant today. In Aguilar’s words: “We need to restore the clear and strong rules that protect investors and, more than ever, we need to ensure that investment advice is disinterested.”

Aguilar noted that the extension of the fiduciary duty to broker-dealers who provide investment advice is the ultimate investor protection issue — because the harm to investors is real if broker-dealers giving advice are not held to the fiduciary standard and fail to put their client's interests before their own. Aguilar noted that if someone is giving investment advice to an investor, regardless of the title on the business card, that person should always be bound to do so in the best interests of the client. While the scope of service may vary between clients, the standards of loyalty and care in providing that service should not.

Aguilar noted that because broker-dealers are not fiduciaries, investors are not required to be informed of possible conflicts that may affect the advice they receive. For example, investors may not be told that the representative sitting across from them may receive undisclosed compensation from the investment option he or she just recommended. Aguilar stated that since many broker-dealers aggressively market themselves as "financial advisers," investors have a difficult time distinguishing them from investment advisers. As a result of this confusion, Aguilar noted that investors will fail to understand that the broker-dealer, unlike an investment adviser, is not required to place their interests first.

Aguilar stated that the danger is not simply that investors are unable to distinguish between broker-dealers and investment advisers; it is that both entities are providing investment advice to investors with dramatically different consequences. Although often marketed in the same way, Aguilar believes that the investment advice that investors receive from broker-dealers does not come with the same protections as advice received from investment advisers.

Aguilar noted that the fiduciary standard guards against the inherent bias that arises when the broker-dealer is focusing on selling a product, rather than focusing only on what is best for a client. Permitting broker-dealers to provide investment advice without requiring them to act as fiduciaries is, in Aguilar's opinion, to permit a practice that undercuts the core principles of the Advisers Acts and leaves investors vulnerable to the same abuses described in the 1930s.

In that regard, Aguilar expressed disappointment in the Senate Bill, which has abandoned its strong position on application of the fiduciary duty standard in the face of determined lobbying by the insurance and brokerage industries. The revised version has eliminated the provision applying the fiduciary standard to brokers who provide investment advice. It would, instead, require a one-year study by the SEC concerning the effectiveness of existing standards for "providing personalized investment advice and recommendations about securities to retail customers."

Aguilar set out the reasons for his disappointment. First, he sees no need to study the effectiveness of existing obligations for investment advisers. He believes the system in place already has a strong, workable standard that has been in use successfully for decades, and he would not support any attempt to weaken it. Second, as with the House Bill, Aguilar questions why the protection of the fiduciary standard should be limited to "retail" customers. He sees it as readily apparent from recent Commission enforcement cases — such as the cases involving auction rate securities — that all investors, including institutional investors, need the protection of the fiduciary standard. Third, Aguilar questions why the study, as well as the reach of the House Bill, should be limited to "personalized services." This qualification would narrow the range of clients that would be protected by the fiduciary standard, and he fears that it may become a loophole that would make it easy to avoid putting clients first.

Finally, Aguilar does not believe that there is a need for an additional study to conclude that protection of investors requires that broker-dealers providing investment advice be subject to fiduciary duties. In his mind that question has long ago been asked and answered. Aguilar believes that we need to remain vigilant to make sure that investors who receive advice do so from intermediaries held to the high standards of care and loyalty embodied in the existing fiduciary standard under the Investment Advisers Act.

A complete copy of Commissioner Aguilar’s speech can be found here.