A New Arbitration Option for Investors

The Securities and Exchange Commission approved a Financial Industry Regulatory Authority, Inc. proposal giving investors the option to have an all-public arbitration panel. Traditionally, FINRA arbitration panels contain three arbitrators: two public arbitrators and one industry arbitrator—with a “nexus to the securities industry.” The public arbitrators are those who do not have any recent ties to the securities industry.

Over the last 27 months FINRA has been testing a voluntary pilot program that presented investors with the option to eliminate the industry arbitrator and replace that arbitrator with a public panelist. Results from the FINRA pilot program showed that the all-public option was chosen about 60 percent of the time. Further, the findings revealed that having the ability to choose the type of arbitration panel improved investor-claimant’s perception of the process.

The SEC cites in its approval that this new all-public option “will enhance the public’s perception that the FINRA securities arbitration process and rules are fair.” Some State regulators and other investor and consumer groups have long-advocated for all-public arbitration panels. The president of the North American Securities Administration Association, David Massey, further supports this move, but suggests that it should go one step further and allow investors to choose between arbitration and litigation.

Although there has been a big push for all-public arbitration panels, the shift has been controversial for some in the industry. Some industry arbitrators argue that because they know how things are supposed to run in the industry, they are in a unique position to be tougher on bad actors, and that they enhance the ability of the panel to reach the correct conclusion.

The option for an all-public arbitration panel is only applicable to future arbitrations and those currently pending before FINRA where the investor has not yet received a list of potential arbitrators. It is important to note that this change does not apply to investor arbitration proceedings in other arbitration forums, such as JAMS or the AAA. The rule change also does not affect disputes between brokerage firms or brokers.

Additional information about the new arbitration rules is available here.

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).

Are You Doing Something That Requires Registration?

Not everyone involved in an investment transaction is an agent requiring registration. The activities requiring registration as an agent or broker is found in statute, common law and regulatory opinions. Although no single factor has been identified by these authorities to determine whether someone engaged in a financial transaction requires registration, factors given weight have been; whether the individual was involved in negotiations, solicited the investors, discussed the details of the investment, and if the person received compensation on a transaction-related basis.

Although Missouri has not statutorily or through administrative rulemaking defined those activities, there is guidance at the federal level from SEC No Action Letters and common law. In SEC v. U.S. Pension Trust Corp., No. 07-22570-CIV, 2009 WL 2365702 (S.D. Fla. July 30, 2009), the district court looked at several factors to determine whether a person’s activities were outside of the activities requiring registration as a broker. These factors include whether the person: (1) actively solicited investors; (2) advised investors as to the merits of an investment; (3) acted with “certain regularity of participation in securities transactions; and (4) received commissions or transaction based remuneration. U.S. Pension Trust, 2009 WL 2365702 at *9.

Two states provide a registration process for persons who participate in the offer or sale of securities who are not agents or brokers, Texas and Michigan. In Michigan these persons are “finders” and are defined as a person who, for consideration, participates in the offer to sell, sale, or purchase of securities or commodities by locating, introducing, or referring potential purchasers or sellers. Section 451.801, RSMi (Cum. Supp. 2008). Finders are included in the definition of investment adviser in the Michigan Securities Act and must register as such. In Texas, finders are defined as “An individual who receives compensation for introducing an accredited investor to an issuer or an issuer to an accredited investor solely for the purpose of a potential investment in the securities of the issuer, but does not participate in negotiating any of the terms of an investment and does not give advice to any such parties regarding the advantages or disadvantages of entering into an investment, and conducts this activity in accordance with §115.11 of this title (relating to Activities of a Finder). Note that an individual registered as a finder is not permitted to register in any other capacity; however, a registered general dealer is allowed to engage in finder activity without separate registration as a finder.” TX 7 CSR 7-115.1. Texas provides a registration process for finders.

The Missouri Securities Act contains exemptions for agent registration. The Act defines an agent in Section 409.1-102(1), RSMo, (Cum. Supp. 2008), as “an individual other than a broker-dealer, who represents a broker-dealer in effecting or attempting to effect purchases or sales of securities or represents an issuer in effecting or attempting to effect purchases or sales of the issuer’s securities.” Section 409.4-402. (a), RSMo (Cum. Supp. 2008), the registration provision for agents of broker-dealers in the Missouri Securities Act reads: “It is unlawful for an individual to transact business in this state as an agent unless the individual is registered under this act as an agent or is exempt from registration as an agent under subsection (b).”

The Missouri Securities Act’s exemption provision for agent registration found in Section 409.4-402(b) RSMo. (Cum. Supp. 2008), specifically provides in subdivision Section 409.4-402(b)(3), “an individual who represents an issuer with respect to an offer or sale of the issuer's own securities or those of the issuer’s parent or any of the issuer's subsidiaries, and who is not compensated in connection with the individual’s participation by the payment of commissions or other remuneration based, directly or indirectly, on transactions in those securities.” Moreover, subdivision (8) provides: “an individual who represents an issuer and who restricts participation to performing clerical or ministerial acts is exempt from registration.”

The prudent course of action is to evaluate your status and conduct and consult with counsel or your state regulator before you engage in any securities transaction as an unregistered person.