SEC May Change Mandatory Arbitration Rules

President Obama signed The Financial Reform Act into law on July 21, 2010. While it was primarily designed to prevent future failures that led to the 2008 market crash, one particular provision makes broker-dealers and investment firms very nervous. Title IX of the Act gives the Securities and Exchange Commission the power to change or implement regulations directly involving consumers regarding securities arbitration.

After seeking comment for potential changes, the SEC may be able to change rules affecting point-of-sale disclosures, statements regarding fiduciary duty, and standards of care.

Observers believe that the Act ostensibly allows the SEC to remove mandatory-arbitration language from client-broker agreements.

Broker-dealers fear that this could expose them to huge litigation costs, as well as jury awards, should they be sued in court for securities fraud. Currently, most contractual agreements between clients and brokerage firms require arbitration to settle disputes, where parties air their grievances before arbitration panels established by the Financial Industry Regulatory Association (FINRA). Arbitration is often less expensive and more efficient than traditional lawsuits, but it also may result in a smaller award of damages.

The traditional battle lines are already set for this potential rule change. Investor groups and critics of the current rule believe that a change would be better for consumers because such a rule change would give them a choice between arbitration and filing a lawsuit.

Another ramification of investor choice would be that future published court decisions would give parties guidance in the form of newly developed case law to prevent or guide future disputes. Unlike in court proceedings, there is no traditional application of law and facts in arbitration because arbitration panels are not bound by decisions of prior arbitration panels.

Brokerage firms believe that the current arbitration process is fair and meets investors’ needs and that opening up lawsuits only would lead to more litigation. Lee Pickard, former director of trading and markets at the SEC, and a partner at Pickard & Djinis LLP, maintains that the arbitration process works well and has not been a disservice to investors. Of course, many lawyers who represent aggrieved investors take issue with the securities industry’s position that the current arbitration process is fair.

SEC spokesman John Heine says that the Commission is currently collecting comments on all aspects of the Act. However, no timetable has been set on deciding whether to submit the arbitration rule for comment.