Introduction
On December 10, 2024, the Securities and Exchange Commission’s Investor Advisory Committee hosted a panel to examine the use of mandatory arbitration clauses among SEC-Registered Investment Advisers. The panel followed a 2023 report published by SEC’s Office of the Investor Advocate (OIAD) revealing that mandatory arbitration clauses negatively affect retail investors. As a result, the SEC faces increased scrutiny and calls for regulatory changes that could affect dispute resolution and disclosure requirements for nearly 16,000 RIAs. [1]
Overview of the Study on Mandatory Arbitration Clauses
On December 5, 2023, the OIAD released its Report on Activities for Fiscal Year 2023, a report submitted annually to Congress outlining the Office’s research and policy recommendations. Among OIAD’s primary research endeavors in 2023 was studying the effect of mandatory arbitration clauses in agreements between retail investors and SEC-Registered Investment Advisers (RIA).
The OIAD studied a sample of 579 investment advisory agreements. [2] From this sample, it was estimated that 61% contained a mandatory arbitration clause. Of those agreements, nine out of every ten designated private forums, which are not subject to SEC disclosure requirements. When the agreement also designated an arbitration venue, only 3% considered the retail investor’s location. The study also found that 40% limited claims, capped awards, precluded participation in class actions, or contained fee shifting provisions. Based on these results, the OIAD recommended in its report that the SEC temporarily suspend the use of mandatory arbitration clauses in advisory agreements, a power the commission is granted under Dodd-Frank. [3] However, these results were accepted with some hesitancy, and reasonably so.
The OAID observed significant gaps in its available research data. This is due to the SEC’s lack of jurisdiction over private arbitral forums that would allow the commission to obtain data through disclosure requirements. Consequently, the study primarily relied on anecdotal evidence and input from stakeholders with relevant information, such as the American Arbitration Association, FINRA Dispute Resolution Services, and Public Investors Advocate Bar Association.
A Comparison of Arbitration Requirements for Broker-Dealers and RIAs: Regulatory Differences and Fiduciary Standards.
Unlike RIAs, broker-dealers are subject to additional regulation and oversight when using mandatory arbitration clauses in investor agreements. [4] For example, brokerage firms must comply with FINRA’s Code of Arbitration Procedure for Customer Disputes. Under this Code, broker-dealers designate FINRA as the arbitration forum, [5] and must consider the investor’s location when selecting a venue. [6] FINRA also prohibits terms that limit the type of claim or cap the amount of an award. [7] Lastly, they must disclose certain arbitration-related information to FINRA, which is published online for the public to review. However, these additional requirements have been partly attributed to the fact that broker-dealers are not fiduciaries, unlike RIAs.
Because RIAs are subject to a fiduciary standard, they are afforded less government regulation due to the increased level of care they must exercise. Therefore, RIAs are not restricted to a single arbitral forum and their rules, like broker-dealers, nor are they subject to any similar disclosure requirements. Instead, RIAs must only disclose information to the extent their fiduciary duty requires, which means disclosing “all material facts relating to the advisory relationship.” [8] Whether a fact is “material” is left to the adviser’s discretion, and as evidenced by the study’s lack of reliable data, facts relating to arbitration proceedings or awards are likely deemed immaterial.
Mandatory Arbitration Clauses Moving Forward
Although the panel did not outline a definitive course of action, it offered valuable insights into regulatory measures that the SEC may take. Starting with the most extreme, an outright ban, is not likely. To this point, SEC Commissioner Hester Pierce cautioned to “not lose sight of the importance of allowing investors and their advisers to choose binding arbitration to resolve disputes,” noting that the “freedom of contract is a bedrock principle.” [9] Moreover, an outright ban was not a position particularly advanced by panelist. Instead, the majority suggested that the SEC implement regulatory safeguards consistent with those imposed on broker-dealers. This was also the position recommended by panelist Stacy Puente, who currently serves as the Ombuds of the SEC.
As Ombuds, Puente is responsible for evaluating the effects of proposed SEC and self-regulatory organization (SRO) rules on retail investors, then reporting the results to the SEC and Congress for consideration. According to Puente, mandatory arbitration clauses, particularly those that limit claims, cap awards, or waive class-action participation, are “most likely harmful” to retail investors. She also warned RIAs that they will be “hard pressed” to demonstrate to regulators that such terms are in the “best interest” of investors, the standard used to evaluate whether an RIA’s fiduciary duty was fulfilled.
The panel also discussed implementing a disclosure scheme requiring RIAs to publish information relating to any arbitration proceedings, which would enable investors to assess the risk of entering into an agreement with a particular adviser. For example, it would allow investors to see whether a certain RIA is frequently sued by clients and any subsequent arbitration awards. Another discussed benefit of required disclosures is that it would provide the SEC quantifiable data to make more informed and developed regulatory decisions regarding mandatory arbitration clauses. Indeed, advocates on both sides generally agree that the SEC’s 2023 study lacked adequate data to truly represent the effects of mandatory arbitration clauses on retail investors. However, requiring robust disclosures, though intended to promote investor interest, may do the opposite if compliance would be overly burdensome on RIAs. As noted by SEC Commissioner Hester Pierce, such a “disclosure regime can morph into a prohibitory regime.” Therefore, the SEC will be challenged with the difficult task of balancing the interest of investors with a disclosure framework manageable for RIAs.
In conclusion, it appears the issue will not disappear anytime soon, given the persistent regulatory scrutiny by investor advocates. While it remains to be seen how the SEC will respond, there are strong indications that a change is on the horizon given the commission’s increased attention. It is important for advisers and legal practitioners alike to monitor ongoing developments related to mandatory arbitration clauses as significant changes to disclosure requirements or dispute resolution processes may arise for RIAs.
[1] Letter to SEC Chair Gary Gensler, Critical Need for Rulemaking to Prohibit Forced Arbitration (Jan. 31, 2024); Registered Investment Advisers, December 2024, SEC.gov, https://www.sec.gov/data-research/investment-management-data (last visited Dec. 10, 2024).
[2] Response to Congress: Mandatory Arbitration among SEC-Registered Investment Advisers, H.R. Rept. No. 117-393 (2023).
[3] OAID, Report on Activities: Fiscal Year 2023, at *45; Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 921, 124 Stat. 1376, 1841 (2010) (codified at 15 U.S.C. § 78o).
[4] FINRA Rule 2268.
[5] FINRA Rule 12200.
[6] FINRA Rule 12213.
[7] FINRA Rule 2268.
[8] General Instruction 3 to Part 2 of Form ADV, at *1.
[9] Hester Pierce, SEC Comm’r, Arbitration, Alternative Assets, and Aging Actors: Remarks at the Meeting of the SEC Investor Advisory Committee (Dec. 10, 2024).