Analysis of Arbitration Agreements in Advisory Agreements

In recent years, dozens of industries from telecommunications to insurance have included mandatory arbitration provisions in their client agreements.  The brokerage industry, under the auspices of FINRA arbitration, has long required clients to arbitrate their disputes with broker dealers and registered representatives, and courts have long enforced such agreements in the context of consumer, employment and services contracts.  Recent developments in the law have strongly favored enforcement of arbitration agreements, which has led to even more industries adopting arbitration and anti-collective action provisions in consumer and employment contracts. In our experience, however, the RIA industry has lagged behind in adopting these agreements. In part, that is a holdover from early SEC guidance that suggested that such agreements may be an unauthorized limitation on liability. It is now long settled that there is nothing improper for an RIA firm to include a pre-dispute arbitration provision in an advisory agreement. The following discussion sets out the risks and benefits of including such provisions in advisory agreements.

First, what is arbitration?  Arbitration is what is commonly referred to as method of alternative dispute resolution.  It allows parties to resolve claims outside of public court proceedings.  Disputes are resolved by the parties, not before a judge or a jury, but rather a neutral arbitrator or panel of arbitrators.  The parties select the arbitrator(s) (or the parties’ agreement provides for how arbitrators are to be selected) and the arbitration rules are determined by the forum in which the arbitration is held, or may be customized by the parties.  For example, all disputes between an investor and his or her broker-dealer and registered representative are arbitrated in FINRA, pursuant to FINRA rules and procedures.  Once the arbitration hearing is held and a decision has been rendered, that decision is generally final; and unlike court verdicts or judgments, such decisions cannot be vacated or overturned except under very limited grounds. But once again, as arbitration is the subject of contract between the parties, the parties can determine their own rules, or choose to adopt the rules of an arbitral forum, such as the American Arbitration Association or Judicial Arbitration and Mediation Services.

Why is arbitration so popular, and why do so many industries include such provisions? Quite simply, arbitration is less costly, and on average leads to quicker resolutions.  This is in large part due to the fact that in most commercial arbitration forums there is less discovery practice than similar court proceedings, and the discovery process (the process by which the parties obtain and exchange documents) is far more streamlined.  In FINRA, for example, the parties are not allowed to conduct depositions (except under very limited circumstances) and are not permitted to serve interrogatories (otherwise known as written information requests).  Typically, the most-costly part of traditional litigation comes from discovery and motion practice, and in arbitration these two processes may be far more streamlined and limited.  Studies have also shown that arbitrations are resolved far more quickly than in court. Contentious disputes governing scheduling, discovery, order of witnesses, deadlines, etc. are often resolved with direct and short communication with the arbitrator.  Additionally, arbitrators are typically intelligent, knowledgeable and experienced in the subject matter of the dispute; in contrast to members of a jury who may be more likely to be influenced by emotional aspects of the matter. Finally, arbitration is generally private and the process is largely subject to the agreement and control of the parties, which is a benefit to parties who want to maintain the confidentiality of the subject matter and the records produced.

So, what are the disadvantages?  The common criticism of arbitration is that arbitration awards are generally final.  This, of course, is only a perceived disadvantage for the losing party, but signatories to an arbitration agreement must understand that there is little recourse if they lose an arbitration.  Awards can only be overturned under very limited circumstances (e.g, outward evidence of bias on the part of the arbitrator, fraud, or corruption for example).  Additionally, arbitration panels are deemed to “sit in equity”, or do what they believe is fair to the parties, as opposed to simply following the law.  That is not to say they can simply ignore the law, but arbitration panels are not necessarily required to issue reasoned decisions (and in FINRA, for example, they rarely do).  There are decisions, as in Court, where the outcome implies that the panel ignored the law (on statutes of limitations, for example), and those types of decisions lend themselves to the perception that arbitration panels can or do ignore substantive law.  Since arbitration decisions are rarely overturned by Courts, such outlier decisions are often perceived as a real risk of agreeing to arbitrate. A final consideration would be the fees arbitrators charge and the cost of administration. Filing and arbitrator fees in one of the established arbitral forums can be very expensive, and a complex matter with a three arbitrator panel and a week-long hearing could have arbitration costs in excess of $60,000.

What is the process?There are many arbitral forums, including without limitation the American Arbitration Association, Judicial Arbitration and Mediation Services, Inc. the National Arbitration Forum, and local arbitration associations. Since arbitration is a creature of contract, RIA disputes can be conducted through any of these forums, so long as the parties agree. Interestingly, due to substantial interest and considerable overlap between brokerage and RIA business, FINRA has created a procedure by which disputes between investors and investment advisors from non-FINRA-regulated firms can be resolved through FINRA Dispute Resolution[1]. There have been recent efforts by state regulators and other interested partied in urging the SEC to prohibit the use of mandatory arbitration clauses within investment advisory agreements, but no action has been taken to do so, and if the brokerage industry is any indication, the inclusion of such agreements may actually increase.

On balance, advisory firms should give significant consideration to including arbitration provisions in their advisory agreement. Advisory firms are sued less often than brokerage firms, but in the event that they are, an RIA firm may conclude it is far better to be in arbitration than in court.  The costs are likely to be far less and the resolution may be far less costly.  The financial industry as a whole has been tainted by the adverse market conditions of 2007 to 2010, and an experienced arbitration panel of former judges or experienced attorneys may be far less hostile than a public jury, who is untrained in both the law and the industry.  We have arbitrated RIA cases before experienced retired judges sitting as arbitrators, and have found that the arbitrators quickly grasp the issues, are not swayed by pleas for sympathy, and generally apply the law correctly.  There are sure to be decisions that are anomalies, and that is true of any forum, but the benefits of arbitration generally outweigh its potential disadvantages, and RIA firms would be well served by at least considering including arbitration agreements in their advisory agreements and taking the time to customize those agreements to maximize the benefit they obtain from selecting arbitration.

Guest Contributor, Amir Tadjedin
MARKUN ZUSMAN FRENIERE & COMPTON LLP
811 SW Naito Parkway, Suite 420
Portland, OR 97204
Tel: (503)224-9294
Fax: (503)224-1123

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