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Regulation and Compliance > Federal Regulation > FINRA

Beyond Mandatory Arb: 4 Options for Advisor-Client Dispute Resolution

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Mandatory pre-dispute arbitration clauses in advisory contracts are all the rage… and I mean that both literally and figuratively. It has become both a popular dispute resolution mechanism between advisors and their clients, and at the same time has enraged critics the likes of which include a cadre of House and Senate members led by Senator Stuart Smalley of Minnesota. I’m paraphrasing, but Senator Smalley thinks mandatory arbitration clauses in advisory contracts are “stinkin’ thinkin’”. 

Criticisms notwithstanding, the SEC has yet to act on its Dodd-Frank-given powers to restrict mandatory pre-dispute arbitration clauses pursuant to Section 205(f) of the Advisers Act, and it does not appear to be a current priority to do so. Thus – at least for the time being – such clauses appear here to stay. 

But it’s worth pointing out that arbitration is not the only game in town. When crafting investment advisory contracts, it’s important to carefully consider other dispute resolution mechanisms that may be a more attractive alternative for both firms and their clients. The point of this article is not to say that arbitration is good or bad, but simply to emphasize the point that other options exist. 

Option 1: Smoke the Peace Pipe

Before taking to arms and preparing for an expensive battle in a formal proceeding like arbitration, an advisory contract can either encourage or attempt to require the parties to first try to resolve the dispute among themselves. The primary goal here is for the advisor and client to settle the matter as soon as possible after a dispute arises, and for both parties to either amicably part ways or even let bygones be bygones and continue the advisory relationship. 

Avoided cost is the mutual motivator; attorneys are expensive and arbitration is far from free. Avoided cost can also be thought of in terms of the value placed on both parties’ time. Formal proceedings can be incredibly long, laborious and involved, and the longer the process the more the parties can become emotionally invested (and drained). 

Because we don’t live in Utopia and disputes don’t often end with a beer and a handshake, and because such contractual clauses are hard to define and enforce, internal resolution should only be thought of as the first step in a longer, pre-scripted dispute resolution sequence. 

Option 2: Mediate

The next potential step in a pre-scripted dispute resolution sequence (after singing Kumbaya) is mediation. There is one important thing to remember about mediation: it is not binding in and of itself. Unlike a judgment rendered in a court of law or by arbitrators, a mediator can only encourage the parties to reach a binding, mutually agreeable settlement. A mediator does not render a decision, assess damages or pick a winner and a loser. But at the same time, it can be helpful to have a third-party act as the “go between” whose only motivation is to help the parties find a solution to the dispute. 

Mediators cost money as well, but the costs should pale in comparison to a drawn-out arbitration or court proceeding. If mediation fails, however, it is a sunk cost to both parties. Like smoking the peace pipe and unlike arbitration, a mediation does not guarantee a decisive outcome (settlement only occurs if both parties agree). It can, however, be just the persuasive influence the parties need to diffuse a dispute. 

Option 3: Go Straight to Court. Do Not Pass Go. Do Not Collect $200

This alternative doesn’t need much explanation, but for the avoidance of doubt, this contractual alternative eliminates all other forms of alternative dispute resolution. No negotiation, no mediation, no arbitration. Lawyer-up and go. 

Proponents of the judicial route generally contend that arbitration is unpredictable, increasingly expensive, just as time-intensive as court and doesn’t afford enough discovery to sufficiently prove or disprove the allegations at hand. The short version is that some people believe either through first-hand experience or advice of counsel that arbitration is overrated. 

Option 4: Go to FINRA

Advisors seem to like FINRA about as much as the insurance and brokerage industry like the DOL about now, but FINRA has opened its tentacles arms for non-member investment advisors to participate in its arbitration forum. According to guidance posted to FINRA’s website, it will accept non-member investment advisory disputes into its arbitration forum on a voluntary, case-by-case basis if a laundry list of conditions are met. Importantly, “FINRA cannot enforce awards entered against non-member IAs and/or their employees (because FINRA is not a Self-Regulatory Organization for IAs).” The prevailing party will still need to go to court to enforce any award. 

The Waterfall 

As I’ve alluded to above, the alternative dispute resolution process can be thought of as a waterfall. The highest pool is intra-party negotiation. If that fails, the dispute would flow into a mediation. And if that fails, the bottom pool can either be arbitration or court. There are pros and cons to this approach, and it is important to draft the dispute resolution clause in a contract with enough clarity to avoid bickering about the alternative dispute resolution process itself (e.g., how are costs allocated?, where will mediation/arbitration be held?, what mediation/arbitration service will be utilized?, is it mandatory or at the election of the client? etc.).

Alternative dispute resolution (or “ADR”) can be flexible and adaptable, so consider all the options before assuming that mandatory pre-dispute arbitration is the only way to go. 


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