Securities Regulation Daily Wrap Up, DODD-FRANK ACT—Sen. Franken Urges SEC to Use Dodd-Frank Powers to Prohibit Mandatory Arbitration Clauses, (May 1, 2013)

By Jim Hamilton, J.D., LL.M.

In a letter to SEC Chairman Mary Jo White, Senator Al Franken (D-Minn) urged the Commission to promptly exercise its authority under Section 921 of the Dodd-Frank Act to prohibit the use of mandatory arbitration provisions in customer service agreements. The time is ripe, he said, for the SEC to act under Section 921 to protect the investing public and prevent further abuse of forced arbitration contracts. The letter was also signed by Sens. Patrick Leahy (D-Vt), Tom Harkin (D-Iowa), Bernie Sanders (I-Vt), Richard Blumenthal (D-Conn), Dick Durbin (D-Ill), Sheldon Whitehouse (D-RI), Jeff Merkley (D-Ore), Mazie Hirono (D-Haw), Sherrod Brown (D-Ohio), Martin Heinrich (D-NM), Frank Lautenberg (D-NJ), Robert Menendez (D-NJ), Ron Wyden (D-Ore), and Elizabeth Warren (D-Mass). The letter was also signed by 22 House Members.

Arbitration. Broker-dealers generally require their customers to contract at account opening to arbitrate all disputes. Although arbitration may be a reasonable option for many consumers to accept after a dispute arises, mandating a particular venue and upfront method of adjudicating disputes and thereby eliminating access to courts may unjustifiably undermine investor interests. Thus, the Obama Administration recommended legislation that would give the SEC clear authority to prohibit mandatory arbitration clauses in broker-dealer and investment advisory agreements with retail customers.

Dodd-Frank Act. In their letter to the SEC, the senators noted that the Dodd-Frank Act was enacted, among other reasons, to protect American consumers from abusive financial services practices. Section 921 reflects congressional concern over the increasingly widespread use of mandatory arbitration agreements in customer and client contracts and grants the Commission authority to restrict or prohibit the use of these provisions. Ensuring a choice of forum, particularly for small investors, heightens fairness and ultimately enhances participation in the capital markets. The legislators expressed their disappointment over the fact that, in the almost three years since Dodd-Frank Act’s enactment, the Commission has largely disregarded this important mandate.

Recently, the senators were alarmed to see further attempts to erode investor rights when Charles Schwab, one of the country’s largest brokers, expanded the mandatory arbitration clauses in its customer agreements to include a mandatory class action waiver clause. In this instance, Schwab argued that, in response to the Supreme Court’s interpretation of the Federal Arbitration Act (FAA) in AT&T Mobility v. Concepcion, it could include a waiver of class-action and class-arbitration rights in its customer agreements. FINRA initiated a disciplinary action against Schwab for violation of FINRA rules barring class action waivers. In February, however, a FINRA hearing panel ruled that, although Schwab’s actions did in fact violate FINRA rules, those rules could not be enforced under Concepcion.

While the Supreme Court in Concepcion did find that the FAA preempts state actions that would restrict the use of arbitration, the facts in the Schwab case are notably distinguishable, reasoned the senators, not least because FINRA is a membership organization seeking to enforce its own rules. However, the ambiguity created by the panel’s ruling underscores the urgency with which the Commission should adopt rules under Section 921.

Section 921 was included in the Dodd-Frank Act to address the threat to consumers posed by mandatory arbitration clauses in investment contracts. During Congress’ deliberation of this section, legislators heard concerns that investors forced into arbitration face high upfront costs, limited access to documents and other key information, limited knowledge upon which to base the choice of arbitrator, the absence of a requirement that arbitrators follow the law or issue written decisions, and extremely limited grounds for appeal.

If arbitration offers investors an efficient forum to resolve disputes, as some argue, investors may choose that option, but they should be given the choice. It is equally important that investors not be precluded from bringing class actions because of contractual fine print imposed by a mandatory-waiver clause.

SEC action. Although evidence suggests that the use of mandatory arbitration agreements is widespread, there is also concern about the lack of transparency and reliable data regarding the prevalence of such agreements. The senators encourage the Commission to track how many brokerage firms are inserting mandatory-arbitration agreements and class-action waivers into consumer contracts so that this questionable practice may be better monitored and addressed.

They are deeply concerned that the Commission’s failure to respond to the dangers posed by widespread forced arbitration will weaken existing investor protections. Given the uncertainty created by the recent FINRA decision, they urge the Commission to act quickly to exercise its authority under Section 921 to prevent this practice and protect investor rights.

The senators recognize that the Commission is balancing competing demands and that it must prioritize its recent mandates by Congress. The exigent circumstances at hand, however, require that the Commission exercise its authority under Section 921 of the Dodd-Frank Act and prohibit the use of mandatory-arbitration provisions.

Supreme Court decisions. Historically, claims for violations of the federal securities laws were considered to be non-arbitrable based on the doctrine enunciated by the U.S. Supreme Court in Wilko v. Swan. In Wilko, the Court held that an agreement to arbitrate claims under Section 12(a)(2) of the Securities Act was not enforceable. However, as arbitration gained increasing judicial favor, the Court began to chip away at the Wilko doctrine and, in 1989, expressly overruled it. In Rodriguez v. Shearson/American Express, Inc., the Court ruled that a pre-dispute agreement to arbitrate an investor’s securities claims against a brokerage firm was enforceable in view of the strong federal policy favoring arbitration.

LegislativeActivity: Arbitration DoddFrankAct