FINRA Effort to Prevent Schwab From Further Hobbling the Rights of Retail Investors Is Not Enough

While we applaud the Financial Industry Regulatory Authority’s (“FINRA”) effort this week to appeal the recent arbitration decision denying FINRA’s right to prevent Schwab—and other brokerage firms—from using customer agreements to bar class action claims, we are concerned it is “too little, too late” in terms of protecting the rights of investors.

Clearly, Schwab’s efforts to limit investors’ rights—which will likely be mirrored by other brokerage firms—is contrary to the best interest of investors.  Last year, Charles Schwab Corp. introduced the highly touted change to its 8.8 million investor agreements that prohibited class action lawsuits and prevented the consolidation of arbitration cases. The change to the customer agreements was considered to be against FINRA Rules, a fact that FINRA itself re-affirmed when it brought a Claim against Schwab citing violation of its rules.  However, in a surprising twist, the violated rules themselves have now been called into question as the arbitrators concluded that FINRA Rules may be contrary to the Supreme Court’s fairly recent interpretation of the Federal Arbitration Act.  See AT&T Mobility LLC v. Concepcion 131 S.Ct. 1740 (2011).

Schwab’s motives to limit exposure to class action lawsuits and consolidated arbitration claims are highly questionable in that it further reduces investors’ options for seeking restitution.   We believe the reality is that Schwab’s investor agreement modification resulted from its YieldPlus debacle.  Specifically, in 2010, Schwab was forced to pay hundreds of millions of dollars to thousands of investors who invested in Schwab’s own Schwab’s YieldPlus Bond Fund, which suffered losses in excess of $800 million. The YieldPlus Fund was sold by Schwab as a cash alternative, but actually had heavy concentrations of risky and potentially illiquid mortgage-backed securities.

The decision by FINRA’s review board that FINRA rules regarding arbitration and class action lawsuits violate the Federal Arbitration Act has the potential to further limiting the investor’s ability to seek redress from Wall Street.  This is on the heels of ineffective regulatory implementation of many investor protection components of the Dodd-Frank Act Wall Street Reform and Consumer Protection Act, the law introduced by congress in the aftermath of the most recent financial crisis.  Specifically, this federal legislation empowered the Securities and Exchange Commission (“SEC”) and other regulators to fix some of the problems found within the FINRA arbitration system.  However, largely due to the lobbying power of Wall Street, there has been little done to correct any issues relating to the protection of retail investors.

Particularly, among the powers given to the SEC by the Dodd-Frank Act, is the power to reform or prohibit arbitration requirements.   As a result, securities regulators could simply make arbitration optional for the customer (which is how the FINRA rules are written) and prevent this gamesmanship by the brokerage firms.   This would take away the “big brother” attitude of most brokerage firms that they force arbitration for the “good” of the customer/investor (Schwab contends that the change made to the Agreement was intended to be an affirmation of its belief that arbitration is a “more effective mean of dispute resolution”).  The choice to file a Claim either in court or in arbitration would allow investors to make their own decision in regards to the forum.  As a result, we believe that over time the arbitration system would become fairer by necessity if it wanted to insure its own survival (i.e., investors would only choose arbitration if they truly felt it was a fair alternative to court that was faster and less expensive).

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