Key Takeaways From the SEC’s Report to Congress on Mandatory Arbitration Among SEC-Registered investment Advisers
In the Spring of 2022, during Chair Genlser’s annual appearance before the House Appropriations Committee, Democrats on the Financial Services and General Government (“FSGG”) Appropriations Subcommittee questioned him about the proliferation of mandatory arbitration clauses in SEC registered investment adviser (“RIA”) contracts. On the basis of this discussion, as well as concerns expressed by many major consumer and investor advocacy organizations, the House voted to include a provision in the House Report accompanying the FY 2023 Financial Services and General Government Appropriations Act directing the Securities and Exchange Commission (SEC) to take 6-months to study the impact of these clauses on investors and report to Congress. That bill became law on December 29, 2023.
The study was to be first-of-its-kind, with a clear congressional directive to fully explore the issues and concerns raised with the use of mandatory arbitration clauses in RIA contracts, about which federal regulators knew surprisingly little.
On June 28, as required, the SEC sent the Congressional banking and appropriations committees its 31-page response: a Staff Study (“Staff Study” or “SEC report”), along with brief appendixes from NASAA and FINRA. Arguably, the most profound revelation of the study was the appalling lack of data to which the SEC has access regarding arbitration by SEC-registered RIAs. Nevertheless, the Staff Study produced some notable findings, and hinted at others.
This analysis looks at the key takeaways from the SEC Report and examines their potential policy implications.
1. A significant majority of SEC-registered RIA contracts contain mandatory arbitration clauses and other restrictive terms forced on investors.
Using statistical inferences, the Staff Study found that “approximately 61% of SEC-registered advisers that serve retail investors incorporated mandatory arbitration clauses into their investment advisory agreements.” While not a complete surprise, this finding should shock the conscience of regulators, policymakers, and above all consumers – many of whom have tended to assume that the fiduciary nature of their relationship with an RIA would prohibit the use of self-dealing and self-serving practices, such as those documented by the Staff Study.
The SEC itself describes the fiduciary obligations that RIAs owe to their clients in strident terms, while industry organizations that function as the voice of the RIA industry and its business model often portray the fiduciary obligations applicable to RIAs as a sort of gold standard – “a robust investor-protective standard,” “overarching” and applicable “to all aspects of the advisory relationship,” and evidence of “essential differences between brokerage and advisory activities.”
Historically, the SEC has recognized that an advisory client’s right to choose a forum, whether arbitration or adjudication, was an indispensable investor right under the Investment Advisers Act of 1940 (“Advisers Act”). The SEC also previously expressed concerns that mandatory pre-dispute arbitration clauses in investment advisory contracts might mislead clients to believe that they have waived rights available under the Advisers Act that, by law, are not waivable. The SEC expressed the view that a mandatory pre-dispute arbitration clause in an investment advisory contract “may mislead clients to believe that they are barred from exercising their rights under the [Advisers Act], the Clause, in our view, may violate the antifraud provisions in Section 206 of the [Advisers Act].” (Notably, the SEC’s position predated the Supreme Court’s decisions upholding pre-dispute arbitration clauses under the federal securities laws, and a subsequent federal district court opinion citing those decisions upheld the validity of a pre-dispute arbitration clause in an advisory client agreement.)
Organizations like NASAA and PIABA go even further, arguing, respectively, that “forced arbitration at the demand of [RIAs] is inimical to the basic fiduciary nature of an investment advisory relationship,” and that “a true fiduciary would not impose any forced arbitration obligation and would instead let its customer make their own choice of forum, whether court or arbitration” – and many states take a similar view.
Finally, regardless of the one’s view on RIA obligations under the Advisers Act, 61% is a remarkably high number.
To the extent that the RIA industry appears to be following the broker-dealer industry in moving en mass to a place where forced arbitration is the norm rather than the exception, it logically it follows that policymakers and advocates have an obligation to insist on additional protections and guardrails around RIA arbitration, particularly with respect to RIA relationships involving retail clients.
2. RIAs that use forced arbitration contracts overwhelmingly do not consider the interests of the client when structuring forced arbitration contracts.
Another interesting finding in the Staff Study was that almost all mandatory arbitration clauses used by RIAs designated a particular forum for the dispute. Incredibly, according to the Staff Study, when designating such a forum, “97 percent designated a location that does not consider the client’s location or place of business. To the contrary, many of these agreements designed venue locations ‘of the adviser’s choosing’ or ‘wherever the adviser is located.’”[i]
Further, some RIA contracts designated not only the arbitration provider, but required specific rules. For example, the SEC report found that RIAs who designated American Arbitration Association (AAA) as their forum invoked the AAA Commercial Arbitration Rules 78 percent of the time[ii]—which is important because commercial arbitration has significantly higher fees than consumer arbitration. The SEC report concludes that, “to the extent a mandatory arbitration clause invokes AAA Commercial Arbitration Rules and requires a three-arbitrator panel, the requisite filing fees alone might deter a client from taking action against their adviser.”[iii]
Notably, the SEC Study did not delve into the fees charged by individual arbitrators. This was a missed opportunity. The fees of arbitration forums designated by RIA contracts – half of which consumers are generally forced to shoulder – are often an order of magnitude larger than the FINRA forum’s filing fees. Information about such fees would be an important data point in measuring the overall severity of the problem.
3. Mandatory arbitration clauses are inherently detrimental to RIA clients.
The overwhelming lack of transparency inherent in the arbitration process harms investors. Arbitrators may not be required to write down any of their decisions, which creates no written record from which an investor can determine how an arbitrator arrived at their decisions.[xiii] The negative impact is twofold, first it narrows the already limited ability an investor would have to challenge the award as it will be difficult to prove the arbitrator “displayed a manifest disregard of the law” and second because there is “no body of precedent to consult, arbitration awards may suffer from unpredictability and lack of uniformity.”[xiv]
Additionally, the process of selecting arbitration providers and individual arbitrators themselves is rife with problems. First, there is an inherent “repeat player” bias favoring the entity that drafted and is forcing the arbitration, as the RIA is likely to go to several arbitrations while the individual investors will only be in arbitration once.[xv] Second, with no written record of past decisions or disclosures about the arbitrator’s award history, there is little for an investor to use to determine which arbitrator to select.
Finally, many mandatory arbitration clauses in RIA contracts limit investors’ ability to proceed as a class. As mentioned above, FINRA rules prohibit brokers from employing such waivers, but because neither Congress nor the SEC have taken similar action, they are permissible in RIA contracts. Class waivers have the negative impact of suppressing investor claims for small losses, because investors are not permitted to band together and share the costs of holding the RIA accountable. This is a major disadvantage for individuals who invest with RIAs.
4. In some cases, RIAs add insult to injury by going beyond mere mandating of arbitration and attempting to strip away rights from clients while preserving and even enhancing them for the RIA.
The Staff Study observes that “Several agreements required clients to arbitrate all disputes, but permitted the RIA to pursue all other legal remedies: Notwithstanding this mandatory arbitration provision, Adviser reserves the right to pursue all legal and equitable remedies that may be available to it.”[iv] In other words, none of the terms included in the contract benefited the client or protected the client over the adviser.
The Staff Study also documented RIA client agreements including provision that purport to limit claims that could be brought, or damages that could be awarded, as well as the use of contracts with mandatory fee shifting provisions if the client fails to pay the advisor fees: “If the Client does not pay any portion of Adviser’s fee pursuant to this Agreement, Adviser shall be entitled to reimbursement of reasonable attorneys’ fees and other costs of collection.”[v]
The SEC report details RIAs troubling abuse of “hedge clauses.” These nakedly self-serving and anti-investor provisions, which are frowned upon by regulators which can enable an RIA to limit or entirely avoid their civil liability for various types of conduct or omissions arising from the advisory relationship. Today, the SEC holds “advisory agreements may not misrepresent or contain misleading statements regarding the scope of an advisor’s unwaviable fiduciary duty and lead a client to believe incorrectly that the client has waived a non-waivable cause of action against the advisor under state or federal law.” However, for a roughly twelve year period, from 2007-2019, SEC “no action” relief held that hedge clauses did not per se violate Section 206(1) and 206(2) of the Advisers Act. While the no-action letter has been withdrawn. And today, the practice apparently remains somewhat commonplace among some RIAs.
All of this is difficult to square with the fiduciary duties RIAs owe their clients.
Remember, the “fiduciary duty” standard applicable to RIAs is intended to set them apart from their broker-dealer counterparts, allowing RIAs less regulation because of the higher standard of care required. It is impossible to imagine how clauses intended to benefit the RIA, in terms of convenience and expense, would meet any reasonable standard for fulfilling a duty of care or loyalty, to account for the lack of regulatory oversight and transparency.
This is thus an area that seems ripe for reform.
5. Among investment and financial services professionals, SEC Registered RIAs are an outlier in that there is virtually no transparency into their use of forced arbitration.
The SEC study found that mandatory arbitration provisions in RIA contracts lack the transparency that accompanies state and federal court actions, and even FINRA arbitrations. “SEC-registered advisers are not generally required to disclose information about client arbitrations in their disclosure documents. By contrast, brokers must disclose arbitration-related information.”[vi] While FINRA makes such information public on its website, RIAs are directly regulated by the SEC, and thus not subject to FINRA’s disclosure and conduct rules. The SEC does not require these disclosures in RIA’s Form ADV’s.
Some RIA arbitration clauses go even further in limiting the availability of information. According to the SEC, “A number of advisory agreements imposed confidentiality provisions onto the parties and the arbitrators, generally preventing them from disclosing information about the arbitration even after it had ended.”[vii] Even worse, “some advisers prohibited arbitrators from issuing a written award, or making any findings of fact or of law.”[viii] These clauses clearly limit information available to investors, or regulators, and prevent any accountability under these forums.
The SEC report is straightforward in discussing how this framework contrasts with the framework applicable to broker-dealers, which requires brokers obtain membership with “FINRA, a self-regulatory organization (SRO) overseen by the SEC, that, in turn, oversees the activity of brokers and their associated persons doing business in the United States.”[ix] FINRA rules impose arbitration-related requirements and restrictions on its members that affect the broker arbitration process. “The FINRA Code of Arbitration for Customer Disputes governs all disputes involving customers and their brokers and requires or prohibits the usage of certain terms in brokerage agreements.”[x] RIA arbitration clauses on the other hand do not have any oversight by a SRO like FINRA, have no consistent set of rules governing the process or seeking to insure some degree of fairness and accessibility for the client.
6. State-registered RIAs may have different and more stringent disclosure and regulatory requirements than SEC-registered RIAs.
Generally, while large RIAs and firms with a national presence are required to register with the SEC, small and mid-sized RIAs (i.e. – those with under $100 million AUM) are required to register with and be regulated exclusively by state securities authorities. In many instances, state registered RIAs are subject to significantly more rigorous disclosure and conduct requirement. For example, as discussed in the Staff Report, “State-registered advisers are required to disclose arbitration claims arising from any investment or investment-related activity with alleged damages exceeding $2,500. They must also disclose certain civil proceedings to which they are currently subject or have been found liable for specific types of claims.”[xi] In addition, at least one state, Virginia, has flat out prohibited the use of mandatory arbitration clauses in investment advisor contracts.[xii]
7. The SEC report is a test for the RIA industry and its regulatory model.
The regulatory schemes for RIAs and broker-dealers are designed to protect investors through different approaches. The federal securities laws and rules and SRO rules address broker-dealer conflicts in one of three ways: express prohibition; mitigation; or disclosure. RIAs, by contrast, are fiduciaries to their clients, and accordingly the manner in which they are regulated by the SEC under the Advisers Act generally is principles-based.
In 2011, in testimony before the House Financial Services Committee, the then-President of the Investment Advisers Association (IAA) described the fiduciary duty applicable to RIAs as “the highest standard of care recognized under the law and serves as a bedrock principle of investor protection,” whereas “FINRA rules are essentially standards of fair treatment reflecting a commercial relationship rather than a relationship of trust and confidence.”
One practical consequence of these two differing approaches – with RIAs being regulated as providers of professional services and broker dealers regulated as providers of commercial services – is that the compliance costs of RIAs are much lower than those of broker-dealers.
The fact that the SEC report documented multiple instances where the SRO model appears to have succeeded in better protecting consumers and the RIA model has failed is a problem.
The fact that RIAs appear not to be meeting the high bar articulated by the IAA and others is a problem.
So what does this mean for policy?
8. The SEC report pointedly does not offer solutions to the many problems it identified.
This SEC’s Staff Study sheds much-needed light on a number of deeply problematic practices employed by RIAs that would appear obviously inconsistent with the fiduciary nature of the advisory relationship. The SEC says it plans to continue working on the issues surrounding RIA mandatory arbitration, using study as an important first step,[xvi]
Yet, as much as the study acknowledges serious problems with the oversight regime for SEC-registered RIAs, and although it draws unfavorable contrasts with the regulatory frameworks in place for broker-dealers, and even state-registered RIAs, it makes no recommendations to address this information void. Moreover, although the report does unfavorably compare the SEC’s principles-based regulation of RIAs to FINRA’s rules-based oversight of brokers, it wisely avoids even alluding to the establishment of an SRO for SEC Registered RIAs.
The SEC report’s silence raises questions and opportunities.
9. The RIA industry is capable of acting in its enlightened self-interest. If the SEC report is taken seriously by Congress and advocates, and pressure is applied, the RIA industry will have an incentive to work with the SEC and curtail many of practices documented therein, and/or, conceivably negotiate and support legislative or regulatory protections.
There is little question that the SEC has the statutory authority it needs to impose the type of reforms that would curtail and eliminate the abuses documented in the report.
In 2010, Section 921 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was included in response to congressional concern that mandatory pre-dispute arbitration agreements were unfair to investors. The Dodd-Frank Act added Section 205(f) of the Advisers Act, which authorizes the SEC to ban, or curb, “take it or leave it” pre-dispute arbitration provisions in advisory client agreements.
(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.
This being said, it has been 12 years since the Commission gained this authority, and it has never been exercised. Moreover, there are serious questions about whether such undertakings by the SEC would survive legal challenge.
Nevertheless, we are optimistic that the release of the report will in-and-of-itself have a real impact.
For one thing, all parties have an incentive to work to curtail the most problematic practices in the report.
Roughly 15,100 SEC registered RIAs spread across the country have a mutual, quantifiable, and obvious interest in discouraging any policy changes that might subject them to the much more costly SRO model of oversight – as Congress at one point seriously contemplated.
In addition to cost and compliance considerations, on the individual level, many RIAs pride themselves on being fiduciaries. It sets them apart, and in some ways, above, broker-dealer competitors, not to mention insurance agents, mortgage brokers, and most other regulated financial services providers. To the extent that the fiduciary duty is ineffective at protecting investors from the conflicts like those documented by the SEC report, it stands to be tarnished and devalued.
Finally, these 15,100 SEC registered RIAs also have an astute trade association and a top tier lobbying firm.
Therefore, at least in the near term, the most likely steps to addressing the problem seem likely to come about as a result of reforms adopted by the RIA industry under the threat of SEC and Congressional action. As the SEC continues its regulatory scrutiny, we would not be surprised to see the RIA industry try to get ahead of the problem by adopting “best practices” for the use of various contractual provisions.
10. Conclusion
The SEC study pinpoints the critical regulatory problem: little-to-no information is available to the SEC, which is of course the sole governmental entity tasked with overseeing federally-registered RIAs. If the SEC had a hard time finding information on RIA contracts, imagine the obstacles that everyday investors face. It is abundantly clear that the framework of forced arbitration in the RIA space creates an informational void that severely limits transparency of the arbitration process. The use of private dispute resolution providers and their unfair contractual provisions deny most investors the ability to hold RIAs accountable, much less publicly accountable for misconduct.
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[i]Securities and Exchange Commission Report, Response to Congress: MANDATORY ARBITRATION AMONG SEC-REGISTERED INVESTMENT ADVISERS, AS DIRECTED BY THE HOUSE COMMITTEE ON APPROPRIATIONS H.R. REPT. NO. 117-393, (June 27, 2023).
[ii] Id.
[iii] Id at page 16.
[iv] Id.
[v] Id. at page 19.
[vi] Id.
[vii] Id at page 20.
[viii] Id.
[ix] Id.
[x] Id.
[xi] See Uniform Application for Investment Adviser Registration, Part 1B (“Form ADV Part 1B), Item 2E, https://www.nasaa.org/wp-content/uploads/2011/08/Form-ADV-Part-1B.pdf.
[xii] 21 Va. Admin. Code § 5-80-200(F).
[xiii] Barr, Michael S. “Mandatory Arbitration in Consumer Finance and Investor Contracts.” In Enforcement of Corporate and Securities Law: China and the World, edited by Robin Hui Huang and Nicholas Calcina Howson, 66-85. Cambridge: Cambridge University Press, 2017. (Originally published under the same title in N.Y.U. J. L. & Bus. 11 no. 4 (2015): 793-817.)
[xiv] Id.
[xv] See Cole v. Burns Int’l Sec. Services, 105 F.3d 1465, 1476 D.C. Cir. 1997); Mercuro v. Super. Ct., 116 Cal. Rptr. 2d 671 (Cal. Ct. App. 2002); David Horton & Andrea Cann Chandrasekher, After the Revolution: An Empirical Study of Consumer Arbitration, 104 Geo. L.J. 57 (2015), available at http://papers.ssrn.com; Joshua M. Frank, Ctr. for Responsible Lending, Stacked Deck: A Statistical Analysis of Forced Arbitration (2009), available at www.responsiblelending.org (companies with more cases before arbitrators get “consistently better results from those same arbitrators” and “[i]ndividual arbitrators who favor firms over consumers receive more cases in the future”). See also Lisa B. Bingham, Employment Arbitration: The Repeat Player Effect, 1 Emp. Rts. & Emp. Pol’y J. 189 (1997) (study finding that employees recover a lower percentage of their claims in repeat player cases than in non-repeat player cases); Paul D. Carrington & Paul Y. Castle, The Revocability of Contract Provisions Controlling Resolution of Future Disputes Between the Parties, 67 Law & Contemp. Probs. 207, 218 (2004); Amy J. Schmitz, Dangers of Deference to Form Arbitration Provisions, 8 Nev. L.J. 37, 40–43 (2007) (also noting that unregulated arbitration fora have incentives to “skew their rules and decisions to favor companies they hope to attract as well-paying repeat clients”);
[xvi] Office of the Investor Advocate, Report on Objectives FY 2024, Securities and Exchange Commission, (June 2023).
