FINRA Hearing Panel Concluded that FINRA Arbitration Rule was Preempted by Federal Arbitration Act

FINRA Department of Enforcement recently brought an enforcement action against Charles Schwab (“Schwab”) after the firm amended its customer account agreement to include provisions that would require customers to waive their rights to bring or participate in judicial class actions against the firm. The amended agreement also required customers to agree that an arbitrator would not have authority to consolidate more than one party’s claims. 

In the first two causes of action, FINRA alleged that Schwab’s pre-dispute arbitration agreements which force customers to waive rights to participate in judicial class claims violate FINRA Rules 2268(d)(1) and (d)(3) which state, “(d) No pre-dispute arbitration agreement shall include any condition that: (1) limits or contradicts the rules of any self-regulatory organization; and (3) limits the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement.” FINRA argued that Schwab’s agreement interfered with FINRA Arbitration Rule 12204(d) which preserves a customer’s option to file claims as a part of a judicial class action. Since FINRA has separate rules that prohibit class actions in arbitrations, customers would be barred from bringing a class action against Schwab in any forum.

FINRA alleged in its third cause of action that requiring customers to agree that arbitrators lack authority to consolidate parties’ claims violates FINRA Rule 2268(d)(1). FINRA contended that such a provision limits or contradicts FINRA Arbitration Rule 12312 which covers specific circumstances in which an arbitrator may consolidate claims. 

The parties had differing opinions on how the Federal Arbitration Act (“FAA”) played a role in the matter. Enforcement argued that the FAA was irrelevant and inapplicable because the only determination that need be made when imposing sanctions is whether Schwab violated FINRA Rules. Schwab’s position was that even if the waiver violated FINRA Rules, the FAA preempts FINRA rules and bars their enforcement.

In the Hearing Panel’s order, the first two claims were dismissed. While the Panel found that Schwab’s amendments to the customer agreements did violate FINRA Rules 2268(d)(1) and (d)(3), the rules cannot be enforced in light of the FAA, as construed by the United States Supreme Court in AT&T Mobility, LLC v. Concepcion. The Panel stated that the Supreme Court disfavors rules that override agreements to arbitrate and that such hostility to arbitration is unenforceable. The Concepcion case specifically established that class actions are no exception to the general rule and that a party to an arbitration agreement cannot undermine the agreement by participating in class actions.

In regard to Enforcement’s third cause of action, the Panel found that the language which limits the         power of arbitrators to consolidates cases violates FINRA Rule 2268(d)(1) in that the agreement:

(i) “undermines the fundamental operation of rule 12312 and, in fact, the overall operation of FINRA Arbitration Rules generally, by depriving FINRA of its authority to grant and circumscribe the power of arbitrators in FINRA’s forum; and (ii) the consolidation language undermines the specific authority given to the arbitrators to join individual claims in specified circumstances.

The Panel also found that the FAA did not bar enforcement of the rules in this instance because the FAA does not govern how arbitration forums operate. 

Therefore, Schwab was ordered to take corrective action by removing the language regarding an arbitrator’s power to consolidate claims and notify customers that such language is not effective. Schwab was also ordered to pay a fine of $500,000. 

FINRA still has the option of appealing to the National Adjudicatory Council within 45 days of the hearing panel’s decision. Thus, as it stands, while pre-dispute arbitration agreements that require a customer’s waiver of class claims may be volatile of FINRA Rules, such rules cannot be enforced to allow sanctions against FINRA member firms. Essentially, firms could effectively avoid being subject to class claims in any forum. This may prompt FINRA to reevaluate class arbitration rules.