A U.S. state regulator is taking issue with arbitration agreements many registered investment advisers require their clients to sign when they open accounts, saying they conflict with a fundamental duty to serve their clients' best interests.
A recent survey by Massachusetts' top securities regulator, William Galvin, suggests that many registered investment advisers have agreements with clients that require arbitrating future legal disputes, instead of going to court.
While a federal arbitration law allows the practice, it clashes with an adviser's obligation to act as a fiduciary, or in a client's best interest, Galvin wrote in a letter to the U.S. Securities and Exchange Commission on Tuesday.
The regulator's concerns spotlight a longstanding debate over whether retail investors and customers in other industries should have to sign mandatory arbitration agreements with service providers. Supporters say the process is faster and cheaper than court. Opponents say consumers should have a choice between court and arbitration.
For registered investment advisers, the debate takes on an added dimension: securities laws require them to act in their clients' best interests. But the potential advantages of arbitration often benefit the adviser, some lawyers for investors say. Among them: arbitration proceedings are private. Most details about the cases are typically not made public - an advantage that can protect an adviser's reputation.
Galvin's office surveyed the 710 investment advisers registered in Massachusetts. Of 370 who responded, about half use contracts that require clients to resolve future legal disputes through arbitration. Galvin asked the SEC to ban the practice, or at least study the issue.
"They're not putting that in their agreements because it's in their customers' interests," said Mark Maddox, a securities lawyer in Fishers, Indiana, and former Indiana Securities Commissioner. "Advisers are putting it in there because it's in their own interests."
ROOM TO GROW
Mandatory arbitration clauses are standard among another type of financial adviser: those who work for securities brokerages. While registered investment advisers register with states or the SEC, brokerage advisers register with the Financial Industry Regulatory Authority (FINRA), Wall Street's industry-funded watchdog.
But brokers, unlike registered investment advisers, are not required to act in clients' best interests. Instead, they simply must recommend securities and strategies to clients, based on factors such as risk tolerance and age.
Concerns among investor advocates about such brokerage industry agreements and industry-run arbitration ran so deep on the issue that the Dodd-Frank financial reform law authorized, but did not require, the SEC to restrict mandatory arbitration agreements if it found that this would protect investors.
While the debate has focused mostly on brokerage agreements, no single source keeps track of how many of the roughly 28,000 investment advisers registered with the SEC and states also require arbitration. The results of the Massachusetts sampling, however, jolted some lawyers.
Galvin's finding that 50 percent of advisers who answered his survey use mandatory arbitration agreements is probably "slightly higher" than what it would be nationally, said Maddox, who has represented investors in arbitrations involving investment advisers. But that could change. Some states, including Vermont, tried to prohibit mandatory arbitration clauses for their registered advisers, but were thwarted by a federal law allowing arbitration when parties agree.
FINRA, in fact, recently opened its arbitration forum to disputes between investment advisers and investors. Only a small number of investment advisers resolve their disputes there. Others go to court or arbitration forums like the American Arbitration Association or JAMS Inc. Those options are typically more expensive than FINRA arbitration.
It could be a long time before the SEC takes up the issue of mandatory arbitration, if it does at all. The agency, which is in the midst of a leadership change after Mary Schapiro stepped down and former federal prosecutor Mary Jo White was nominated to succeed her, is already behind on developing many rules the Dodd-Frank Act requires.
An SEC spokesman declined to comment on whether the agency will study arbitration, but said it looked forward to reviewing Galvin's letter.
In the meantime, investment advisers who use arbitration clauses do so at their own risk. "It's a gray area, somewhat," because of potentially conflicting laws and other guidance, said David Tittsworth, executive director of the Investment Adviser Association, a Washington-based trade group.
Advisers should at least consider their fiduciary duty and potential concerns related to mandatory arbitration agreements before including one in client contracts, Tittsworth said.
Even if the practice is legal, it could raise questions among potential clients about the adviser's integrity, in a relationship rooted in trust, not a contract, said Tamar Frankel, a professor at Boston University School of Law. Asking a client to sign a waiver can undermine that trust early in a relationship, Frankel said.
(Reporting by Suzanne Barlyn in New York; editing by Jennifer Merritt and Matthew Lewis)