Corporate Governance

The Dodd-Frank Wall Street Reform Act and the SEC: Profound Bits and Pieces (The End of Mandatory Arbitration?)

By J Robert Brown Jr.

For cases brought against securities firms, customers must submit to mandatory arbitration through FINRA.  The requirement is typically in the account opening documents and investors have little choice on the matter.  See Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987)(upholding mandatory arbitration provisions).

Most matters are heard by a panel of three arbitrators, two from the category of public arbitrators and one from the industry category.  Some have contended that the system of arbitration is biased, although those complaints have been disputed.  One recent study, however, suggests that customers continue to view the system in a more negative light.  See JILL I. GROSS & Barbara Black, PERCEPTIONS OF FAIRNESS OF SECURITIES ARBITRATION: AN EMPIRICAL STUDY REPORT TO THE SECURITIES INDUSTRY CONFERENCE ON ARBITRATION, FEBRUARY 6, 2008, at 3 ("For almost every question in the survey, statistical analysis reveals that customers have a more negative perception of the process than non-customers,").

The Dodd-Frank Wall Street Reform Act addressed this issue by giving the SEC the authority to "prohibit, or impose conditions or limitations" on mandatory arbitration.  While changes will have to await Commission rulemaking, reforms in the area could result in unintended consequences. 

To the extent allowing securities firms to have some control over the selection of the forum, investors may find themselves unexpectedly in federal court, where the entire process can be far more expensive.  Brokers confronting the possibility of significant liability would in at least some cases prefer the court system where the discovery process is far more robust (it allows, for example, the routine use of depositions).  Presumably, Goldman Sachs would have preferred robust discovery in the case involving Bayou Hedge Fund where an arbitration panel ordered it to pay $20 million. 

The devil will be in the details but its not automatic that investors will be better off.  

The Dodd-Frank Wall Street Reform Act and a short Summary of the legislation are posted online.  Section 921 is reprinted below.

SEC. 921. AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.

(a) AMENDMENT TO SECURITIES EXCHANGE ACT OF 1934.-Section 15 of the Securities Exchange Act of 1934 (15 U.S.C. 780), as amended by this title, is further amended by adding at the end the following new subsection:

( 0) AUTHORITY TO RESTRICT MANDATORY PRE-DISPUTE ARBITRATION.-The Commission, by rule, may
prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.

(b) AMENDMENT TO INVESTMENT ADVISERS ACT OF 1940.-Section 205 of the Investment Advisers Act of
1940 (15 U.S.C. 80b-5) is amended by adding at the end the following new subsection:

(f) AUTHORITY TO RESTRICT MANDATORY PREDISPUTE ARBITRATION.-The Commission, by rule, may
prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any investment adviser to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.

Full post as published by The Race to the Bottom on August 06, 2010 (boomark / email).