By George H. Friedman*

[The author thanks the Securities Arbitration Commentator for letting him borrow liberally from its Securities Arbitration Alert]

Much has been written in recent years about the likely demise of mandatory predispute arbitration agreements (“PDAAs”) in the consumer financial context. I should know, I’m one of the authors. But recent events have caused me to think of Mark Twain’s quote paraphrased in this blog post’s title. Or, as they say in the NFL, upon further review, FINRA had it right all along: mandatory PDAAs are OK, class action waivers are not, and the arbitration process needs to be fair.

Big news from the Department of Labor

On April 6th, word came that the Department of Labor (“DOL”) had finalized its long-awaited rule creating a uniform “best interest of investors” standard for individuals providing retirement account investment. To my surprise, DOL not only permits mandatory predispute arbitration agreements, but in fact views PDAAs as good things.

The proposed rule was published by the DOL in the Federal Register a year ago (80 Fed. Reg. 21928 et seq.). It expanded the definition of “fiduciary,” as that statutory term is used in the Employee Retirement Income Security Act of 1974 (ERISA), and would have investors and those managing their retirement accounts enter into a best interest contract (“BIC”) establishing and defining the fiduciary relationship. The proposed BIC rule referenced arbitration just once, but it was an important reference: “Adopting the approach taken by FINRA, the contract could require the parties to arbitrate individual claims, but it could not limit the rights of the plan, participant, beneficiary, or IRA owner to bring or participate in a class action against the adviser or financial institution.”

The DOL held hearings on the fiduciary standard in August, and posted on its Website transcripts of the four-day hearing. Almost immediately on the first day of four days of hearings last August, mandatory PDAAs came under attack from the usual anti-arbitration suspects. And there followed comment letters to the same effect. However, to my utter shock, the final BIC Exemption rule (29 CFR Part 2550) announced April 6th bans class action waivers but otherwise permits and even praises arbitration. Early on, the rule states: “The contract may, however, provide for binding arbitration of individual claims…” But wait, there’s more.

Surprise! FINRA’s approach to mandatory arbitration is the model

The final BIC rule cites the FINRA arbitration model as the way to go. “The Department’s approach in this respect is consistent with FINRA’s rules permitting mandatory pre-dispute arbitration for individual claims, but not for class action claims. Section 12000 of the FINRA manual establishes a Code of Arbitration Procedure for Customer Disputes which sets forth rules on, inter alia, filing claims, amending pleadings, prehearing conferences, discovery, and sanctions for improper behavior.”

The final BIC rule in footnote 72 explains the Agency’s thinking: “FINRA Rule 12204(a) provides that class actions may not be arbitrated under the FINRA Code of Arbitration Procedures. FINRA Rule 2268(d)(3) provides that no predispute arbitration agreement may limit the ability of a party to file any claim in court permitted to be filed in court under the rules of the forums in which a claim may be filed under the agreement. The FINRA Board of Governors has ruled that a broker’s predispute arbitration agreement with a customer may not include a waiver of the right to file or participate in a class action in court. Dept. of Enforcement v. Charles Schwab & Co., Complaint No. 2011029760201 (Apr. 24, 2014).” But wait, there’s more.

DOL to FINRA arbitration critics: “Sorry, but we’re not convinced”

The DOL acknowledged the many negative comments on FINRA arbitration and mandatory PDAAs, and rejected them as unpersuasive. “After consideration of the comments on this subject, the Department has decided to adopt the general approach taken in the proposal. Accordingly, contracts with Retirement Investors may require pre-dispute binding arbitration of individual disputes with the Adviser or Financial Institution. The contract, however, must preserve the Retirement Investor’s right to bring or participate in a class action or other representative action in court in such a dispute in order for the exemption to apply.”

In discussing commenters’ concerns about excessive litigation, the rule touts the benefits of arbitration as a form of risk mitigation: “The Department recognizes that for many claims, arbitration can be more cost-effective than litigation in court. Moreover, the exemption’s requirement that Financial Institutions acknowledge their own and their Advisers’ fiduciary status should eliminate an issue that frequently arises in disputes over investment advice. In addition, permitting individual matters to be resolved through arbitration tempers the litigation risk and expense for Financial Institutions, without sacrificing Retirement Investors’ ability to secure judicial relief for systemic violations that affect numerous investors through class actions.” Wow.

A clear path for the SEC

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) contains language governing the use of predispute arbitration agreements in consumer financial and investor contracts. The SEC, which has supervised securities arbitration for decades, has since 2010 had authority under Dodd-Frank section 921 to ban PDAAs, or limit or impose conditions for their use. But it has no mandate under Dodd-Frank to do anything, and after more than half a decade, there has been very little activity other than accepting comments on mandatory arbitration. Recent events, however, in my view give the Commission a clear path for what to do:

  • No ban on PDAAs: As I’ve said many times before, I don’t see the SEC issuing regs banning PDAAs. Why not? The SEC would have to find that doing so is “in the public interest and for the protection of investors.” Essentially, the SEC would be saying: “Yes, we’ve been supervising customer-broker arbitration for decades. But, you know, we just realized it’s a terribly unfair system.” That’s just not going to happen. Moreover, now that the DOL has gone on record as having evaluated and rejected criticism of arbitration, at least the FINRA brand, this prospect becomes highly unlikely.
  • Maintain the ban on class action waivers: Of course, this has been FINRA’s approach all along.
  • Study, tweak, and reaffirm: As I’ve said before, I think it’s politically untenable for the SEC to do absolutely nothing about PDAAs, especially in light of the pressure that’s been brought to bear on this issue by some in Congress, NASAA, PIABA, and others (for example the AFL-CIO), and especially in light of the Consumer Financial Protection Bureau’s (“CFPB”) robust activities in the arbitration area (more on the CFPB below).

My oft-expressed view is that, at a minimum, the SEC will study the subject and eventually require some changes (impose limits or conditions). How might that transpire? As I predicted previously, now that FINRA Dispute Resolution Task Force has finished its work, SEC will do a study of securities arbitration building on the Task Force’s recommendations. The significant recommendations in the Final Task Force Report, coupled with DOL’s warm embrace of arbitration, form a nice framework for the Commission to fulfill this part of my prediction from last year: “We’ve studied customer-broker arbitration and, like the Department of Labor, we’ve concluded that it’s a fair process. But, you know, these few changes will make it even better.”

Et tu, CFPB?

Dodd-Frank also created the CFPB and charged the new federal agency with studying the use of PDAAs in contracts for consumer financial products and services and addressing PDAAs “if the Bureau finds that such a prohibition or imposition of conditions or limitations is in the public interest and for the protection of consumers…” For example, the CFPB can promulgate a rule that permits PDAA use, but bans class action waivers in arbitration agreements.[1] Securities arbitration was left to the SEC.

In March 2015, the CFPB issued its Final Report to Congress, finding that mandatory PDAAs are widely used in contracts for financial goods and services, and that they can be harmful to consumers. At an October 2015 “field hearing” on arbitration in Denver, the CFPB announced that it intended to propose rulemaking that would: 1) ban class action waivers in arbitration clauses; and 2) require regulated financial institutions to file customer claims and Awards with the CFPB, which it may choose to publish. Banning PDAAs was not proposed.

As I’ve said previously, I’m certain that the Bureau will certainly follow through on its announced intention to ban class action waivers. However, the Agency’s director thus far has given no indication that the Bureau will attempt to ban PDAAs. Speaking February 18 at the American Constitution Society, Director Richard Cordray devoted the majority of his address to arbitration. In his prepared remarks Director Cordray acknowledged that the agency pondered an outright ban on PDAAs, but rejected the concept in favor of data collection. “One approach we might have taken would have been a complete ban on all arbitration agreements for consumer financial products and services. The proposals we are considering do not do that. Companies could still have an arbitration clause, but they would have to say explicitly that it does not apply to cases brought on behalf of a class unless and until the class certification is denied by the court or the class claims are dismissed in court.”

In my view, the DOL’s acceptance and endorsement of arbitration makes the prospect of a CFPB ban on PDAAs even more remote. Think of this possible quote from CFPB: “We know the SEC and DOL – other federal agencies that have been around for years – have studied arbitration and think it’s fair, but we disagree.” Not going to happen.

Conclusion

In my view, here’s where we are in terms of mandatory PDAAs in consumer financial contracts: mandatory PDAAs are OK, class action waivers are not, and the process needs to be fair.

During my 14 years as FINRA’s Director of Arbitration, I frequently chafed at what I perceived to be unfair, inaccurate, and unwarranted attacks on the Authority’s arbitration program. I related to Don Quixote, tilting at windmills in defending a program that to me was without doubt the fairest existing consumer arbitration program. But it seems FINRA had it right all along. Sweet, sweet vindication. Thank you, Department of Labor!

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*George H. Friedman, an ADR consultant and Chairman of the Board of Directors of Arbitration Resolution Services, Inc., retired in 2013 as FINRA’s Executive Vice President and Director of Arbitration, a position he held from 1998. In his extensive career, he previously held a variety of positions of responsibility at the American Arbitration Association, most recently as Senior Vice President from 1994 to 1998. He is an Adjunct Professor of Law at Fordham Law School. Mr. Friedman serves on the Board of Editors of the Securities Arbitration Commentator. He is also a member of the AAA’s national roster of arbitrators. He holds a B.A. from Queens College, a J.D. from Rutgers Law School, and is a Certified Regulatory and Compliance Professional.

[1] For an in-depth analysis on what CFPB can and should do, see Friedman, George, What’s a Regulator to do? Mandatory Consumer Arbitration, Dodd-Frank, and the Consumer Financial Protection Bureau, 20:4 ABA Dispute Resolution Magazine 4 (Summer 2014), available at http://www.americanbar.org/publications/dispute_resolution_magazine/2014/summer/what-s-a-regulator-to-do–mandatory-consumer-arbitration–dodd-f.html.