Securities Regulation Daily Wrap Up, ENFORCEMENT—FINRA: Hearing Panel Upholds Schwab’s Class-Action Waiver, Strikes Limits on Arbitrators’ Powers, (Feb 22, 2013)

By Anne Sherry, J.D.

A FINRA hearing panel found that FINRA could not enforce rules barring new provisions in Charles Schwab & Company, Inc.’s customer agreements waiving a customer’s ability to bring a judicial class action. The panel found, however, that FINRA’s rules regarding arbitrators’ authority to consolidate multiple parties’ claims were enforceable and ordered Schwab to remove language purporting to limit that authority and pay a $500,000 fine (Department of Enforcement v. Charles Schwab & Company, Inc., February 21, 2013, McConathy, L.).

Class-action waiver. FINRA challenged the class-action waiver, arguing that it conflicts with FINRA rules prohibiting limits on a party’s ability to file a claim in court that would otherwise be permitted and providing that an individual claim may not go forward in arbitration simultaneously with its inclusion in a judicial class action. The latter rule, FINRA asserted, permits class actions, and thus the waiver constitutes an impermissible limit on a permitted claim. In a separate count, FINRA claimed that the waiver violates FINRA rules prohibiting any condition in a predispute arbitration agreement that limits or contradicts FINRA rules. Schwab responded that a class action is a procedure, not a “claim,” and that the FINRA rule does not authorize class actions but rather provides only that if a claim is included in a class action, the claimant may not simultaneously pursue it in arbitration.

The hearing panel concluded that, while the waiver does violate FINRA rules, the Federal Arbitration Act bars enforcement of those rules to preserve judicial class actions as an option notwithstanding a customer’s predispute agreement to arbitrate, as confirmed by Supreme Court precedent. The hearing panel stated, “Rules that override an agreement to arbitrate and allow a party to an arbitration agreement to avoid arbitration represent the kind of ‘hostility’ to arbitration that the Supreme Court has repeatedly found inappropriate and unenforceable under the FAA.” Countervailing policy concerns cannot override the FAA absent a clear expression of congressional intent to carve out an exception, the hearing panel noted, and it found no such expression of intent.

Consolidation in arbitration. FINRA also challenged language in the waiver by which Schwab and its customer purported to agree that an arbitrator would have no authority to consolidate multiple parties’ arbitration claims. FINRA rules permit parties in arbitration to submit claims jointly and allow the Director of Arbitration to separate joint claims and consolidate individual claims. After a panel of arbitrators is appointed, the panel can override any consolidation decision of the Director. FINRA contended that the agreement to limit the arbitrators’ power to consolidate claims violated the arbitration rule. Schwab contended that the language does not affect the ability of customers to submit claims jointly or limit the power of the Director, but was meant to prevent arbitrators from rendering the class-action waiver ineffective by using consolidation to create class actions.

The hearing panel concluded that “[t]he language depriving arbitrators of the power to consolidate claims in arbitration conflicts with the fundamental operation of FINRA’s Rules governing its arbitration forum and with specific Rule provisions relating to consolidation.” Moreover, the hearing panel found that the FAA does not preclude enforcement of FINRA rules governing the powers of FINRA arbitrators and procedures for FINRA arbitration. The consolidation language in the waiver doesn’t deal with avoiding arbitration, but rather how FINRA’s arbitration forum will be governed and operated and the manner in which arbitration will be conducted. The hearing panel concluded that the agreement attempted to circumscribe the power of FINRA arbitrators.

Remedies. The hearing panel granted summary disposition in favor of Schwab with respect to the class-action waiver, but in favor of FINRA with respect to the anti-consolidation agreement. The panel ordered Schwab to take corrective action to remove the anti-consolidation language and notify customers of the change and imposed a $500,000 fine. A substantial sanction was appropriate, the panel found, because: (1) members had sufficient notice of FINRA’s rules; (2) Schwab overreached by trying to circumscribe arbitrators’ powers; (3) Schwab failed to recognize that nothing in the jurisprudence supports the elimination of consolidation in arbitration and, by focusing on class-action waivers outside the context of the highly regulated securities industry, disregarded its responsibility to comply with FINRA rules; and (4) the panel found it important to deter members from rewriting arbitration agreements in ways that challenge FINRA’s authority to promulgate arbitration rules.

The case is Disciplinary Proceeding No. 2011029760201.

Attorneys: Gilbert R. Serota and Deborah S. Schlosberg (Arnold & Porter, LLP) and Lowell Haky for Charles Schwab & Company, Inc. Thomas B. Lawson, Daniel L. Gardner, and David R. Sonnenberg for FINRA.

Companies: Charles Schwab & Company, Inc.; FINRA

LitigationEnforcement: Enforcement