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Regulation and Compliance > Federal Regulation > SEC

Use Them, but Carefully

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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

When drafting arbitration provisions to be included in advisory agreements, it is strongly recommended that the advisor qualify the arbitration requirement with language such as: “To the extent not inconsistent with applicable law, …”

By so doing, the advisor will be addressing the staff’s concern as expressed in McEldowney and will be providing the prospective client with disclosure that the arbitration requirement is qualified by applicable law that may provide to the contrary.

We continue to strongly recommend arbitration as the optimal forum to resolve client disputes, including disputes between industry professionals. It was once erroneously believed that arbitration consistently favored the investment industry, especially if the arbitration proceedings were conducted before securities industry affiliated arbitration forums such as the National Association of Securities Dealers (NASD) or the New York Stock Exchange (NYSE), which merged its regulatory arms in 2007 to form FINRA, the Financial Industry Regulatory Authority. Data over the past two decades belie such a contention. Moreover, arbitration provides a much more expedient and cost-effective dispute resolution forum. Finally, I continue to recommend the use of the American Arbitration Association (AAA) as the preferred arbitration forum for the following reasons:

Recognized Forum. The AAA is a widely recognized nationwide dispute resolution forum that is not affiliated with any regulatory body, as opposed to the arbitration forum provided by FINRA.

Claim Deterrent. An initial filing fee, based upon the dollar amount of the claim, is required to be paid in order to start an arbitration claim action against the advisor (e.g., $750 for claims up to $10,000; $950 for claims up to $75,000; $1,800 for claims up to $150,000; $2,750 for claims up to $300,000; $4,250 for claims up to $500,000; and so on), not including the case service fees and arbitrator fees, should the matter proceed to an arbitration hearing. These fees may serve as a deterrent for the filing of meritless claims.

Form ADV Disclosure. SEC registered investment advisors are not required (though state advisors are) to disclose the filing of a AAA arbitration claim, or an adverse decision by a AAA arbitration panel, on Part 1 of Form ADV. Why? Because the AAA is not a governmental or regulatory agency or a judicial forum.

Parting Thoughts

I’d be remiss if I didn’t mention a caveat when it comes to arbitration clauses. In McMahon and Rodriguez, the Court noted that arbitration would be conducted by a self-regulatory organization (SRO) subject to SEC oversight. Investment advisors (unlike broker/dealers) are not SRO members. Accordingly, arbitration may be conducted by organizations not subject to SEC oversight, such as the American Arbitration Association, the forum that we generally recommend for dispute resolution between advisors and their clients. Therefore, a challenge could be made that McMahon and Rodriguez may be distinguishable from arbitration between investment advisors and their clients. We believe that such a challenge would fail, especially if the advisor includes the qualifying language referred to above in its advisory agreements. Regardless, for the reasons discussed above, we strongly recommend that advisors include arbitration provisions in their advisory agreements.

Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies. He can be reached at [email protected].