Use Them, but Carefully

In my previous column for Investment Advisor (November 2007), we addressed some of the “Confusion and Misinformation” that exists regarding the use of hedge clauses in advisory contracts. As promised, this month I will address a topic that is the subject of even greater misinformation and confusion, the use of arbitration clauses in investment advisory contracts.

So, what is the status of arbitration clauses in advisory contracts? They are expressly prohibited, right? Wrong! In order to remove the confusion, a historical understanding is necessary.

In 1986, the SEC staff, in the McEldowney Financial Services no-action letter, took the position that a contractual provision that is likely to lead a client to believe he/she/it has waived any available right of action against the investment advisor may violate the Advisers Act’s antifraud provisions as set forth at Section 206 thereof. If prohibited by the antifraud provisions of Section 206 of the Advisers Act, the use of such a contractual provision would be rendered null and void by Section 215 of the Advisers Act. Section 215(a) declares void any contract term binding a person to waive compliance with any provision of the Advisers Act. This means that a contract provision that seeks to hold an advisor to a standard of care lower than that required by the Advisers Act is invalid. As such, the SEC staff in McEldwoney believed that a provision that requires arbitration as the only dispute resolution forum generally may not be included in an advisory contract if it could reasonably lead the client to believe that she has waived any rights which she may have under federal securities laws. Specifically, the arbitration clause at issue in McEldwoney stated:

“Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association, and judgment upon the award rendered by the arbitrator(s) may be entered into any court having jurisdiction.”

Thus, in McEldwoney the advisor sought to enforce a mandatory (“shall be settled”) arbitration provision without any qualifying language indicating that the requirement to arbitrate was qualified by applicable law that might provide to the contrary.

However, the 1986 SEC staff position as expressed in McEldwoney must be viewed in light of subsequent United States Supreme Court cases. The staff position was based on the reasoning set forth in the 1953 Supreme Court case of Wilko v. Swan. The Supreme Court subsequently overturned Wilko in two separate cases: Shearson/American Express, Inc. v. McMahon in 1987; and Rodriguez de Quijas v. Shearson/American Express, Inc. in 1989.

In these post-McEldowney cases, the Supreme Court held that: (1) a pre-dispute agreement to arbitrate claims under the Securities Act of 1933 is enforceable and a resolution of the claim in a judicial forum is not required; and (2) that pre-dispute arbitration agreements between brokerage firms and their customers to be conducted before self regulatory organizations (i.e., NASD, NYSE, etc.) are enforceable in the context of a claim under the Securities Exchange Act of 1934. Based on these subsequent Supreme Court cases, it is reasonable to conclude that an arbitration provision in the context of the Advisers Act is as enforceable as a similar clause in the context of the 1933 Act or 1934 Act.

The SEC has sometimes been uneven in its interpretation and/or enforcement of arbitration clauses. During some examinations, the Commission has pressed advisors on the use of arbitration clauses. For this reason, advisors must be knowledgeable about the above historical analysis and be prepared to defend such clauses based on the impact of the subsequent McMahon and Rodriguez Supreme Court rulings on the staff’s position in McEldwoney.

Use This Language