An anticipated SEC report on the inclusion of mandated arbitration clauses in contracts for clients of registered investment advisors—released this week by the U.S. House Committee on Appropriations—found the practice has the potential to materially limit the ability of clients to pursue legal remedies in the case of dispute. However, insufficient disclosure requirements appear to have hindered the federal agency's ability to parse the extent to which this is occurring.
Due to the nature of existing disclosure requirements, SEC staff was unable to review a comprehensive data set or sample of clients involved in such proceedings. Instead, eight external stakeholder groups “identified as having information relevant to the issue of mandatory arbitration, and/or as having publicly expressed opinion on the issue of mandatory arbitration,” were interviewed to learn how arbitration clauses are impacting end consumers.
SEC staff also attempted to find out how unpaid arbitration awards are being settled and came up against a dearth of information.
“Private dispute resolution fora do not track information about unpaid awards, and private arbitrators do not have authority over the parties after they issue an award,” SEC noted in the report. “Parties must litigate disputes over unpaid awards in the court system. Staff’s search of state and federal court decisions within the past five years involving unpaid adviser arbitration awards yielded few relevant results. Moreover, this number would only represent situations where a client sued an adviser in court about an unpaid award, and the court issued an opinion about the case.”
“While we appreciate the SEC’s attempt to address the problem of investment advisors failing to pay investors after losing their money, we find it frustrating that the SEC ran into the same problem we did: there is no source of hard data on the subject,” President of Public Investors Advocate Bar Association Hugh Berkson said in a released statement.
In 2021, Berkson published a report alleging that 30% of arbitration awards go unpaid and, along with PIABA, has been a proponent of SEC intervention.
The SEC found approximately six in 10 RIAs are including arbitration mandates in client agreement contracts and concluded the nature and limitations imposed by many of them can disadvantage or discourage clients who might be seeking restitution. In some cases, the requirement was incorporated into another contractual provision and the language was often obscure. A handful that included “opt-out” provisions or contained other ambiguities were excluded from the results.
Designation of the arbitration forum and/or location of proceedings—estimated to be included in 92% and 60% of arbitration agreements, respectively—can result in cost-prohibitive fees and travel expenses for clients and dissuade them from pursuing legal remedy, the study concluded.
SEC staff also found that nearly a fifth of firm contracts including mandated arbitration contain fee-shifting provisions requiring the losing party to pay all legal fees, while others invoke hedge clauses that can limit advisor liability and prohibitions on disclosure of settlements.
Much of the language included in these agreements can wrongly lead clients to believe they’re restricted from pursuing other legal remedies, the study found.
“This report highlights a double whammy for American investors,” said PIABA’s incoming President Joseph Peiffer. “After losing their hard-earned money, advisors often slip fine print into contracts that prevent investors from seeking justice. The SEC must act to put an end to this.”
Ultimately, the SEC said it agrees with stakeholder findings that RIAs are including these restrictions in advisory agreements, that such terms can increase arbitration expenses for clients, and that many are not permitted to brokers or allowed in other dispute resolution forums.
The report noted the number of SEC-registered advisors has risen by 44% over the last decade, serving 64.7 million clients.
“With the population of advisers and clients on the rise, we might expect an accompanying increase in the number of adviser arbitrations,” wrote the report’s authors.
“For many advisory clients, the use of mandatory arbitration clauses in advisory agreements means that arbitration is the only avenue to obtain remedy for financial harm caused by their advisers,” they concluded. “Further evaluation may be warranted to help ensure that arbitration is an accessible and affordable means of dispute resolution for advisory clients.”