United States: Arguing For Arbitration Clauses In Customer Agreements

In a landmark decision with potentially wide implications, a Financial Industry Regulatory Authority hearing panel recently ruled that Charles Schwab & Company Inc. could include a provision in its customer agreements prohibiting customers from bringing class action claims against Schwab and requiring customers to arbitrate their claims. The decision should come as welcome news to brokerage firms and likely will prompt other firms to amend their customer agreements to include similar clauses.

Background

In early October, 2011, Schwab amended its customer account agreements to include a waiver of Schwab customers' right to initiate class action proceedings against Schwab.¹ In particular, Schwab amended the section of its customer agreements titled "Waiver of Class Action or Representative Action" to provide:

Neither you nor Schwab shall be entitled to arbitrate any claims as a class action or representative action, and the arbitrator(s) shall have no authority to consolidate more than one parties' claims or to proceed on a representative or class basis.

You and Schwab agree that any actions between us and/or Related Third Parties shall be brought solely in our individual capacities. You and Schwab hereby waive any right to bring a class action, or any type of representative action against each other or any Related Third Parties in court. You and Schwab waive any right to participate as a class member, or in any other capacity, in any class action or representative action brought by any other person, entity or agency against Schwab or you.²

The practical effect of the change was to eliminate class actions and force all customer claims to go to arbitration.³

In enacting the changes, Schwab seized upon the U.S. Supreme Court's recent decision in AT&T Mobility LLP v. Concepcion as the basis for the class action waiver.⁴ In Concepcion, the Supreme Court struck down a judicially created exception in California, which excepted certain consumer disputes involving relatively small damages from the Federal Arbitration Act's requirement that agreements to arbitrate be enforced.⁵ In doing so, the Supreme Court relied in part on the "liberal federal policy favoring arbitration" and the "fundamental principal that arbitration is a matter of contract."⁶

Disciplinary Proceeding

Shortly after Schwab amended its customer agreements, FINRA's Department of Enforcement ("FINRA Enforcement") filed a complaint on Feb. 1, 2012, challenging the enforceability of the changes. FINRA Enforcement brought three causes of action arising from two components of Schwab's amended customer agreements. In its first two causes of action, FINRA Enforcement claimed that Schwab improperly violated FINRA rules preserving customers' options to join in class action litigation.⁷ In the third cause of action, FINRA Enforcement claimed that Schwab's prohibition against consolidating the claims of multiple parties in arbitration impermissibly limited the power of FINRA arbitrators in violation of FINRA rules.⁸

Class Action Prohibition

FINRA Enforcement's first two causes of action implicated two sets of FINRA rules. The first set of rules, FINRA Rules 2268(d)(1) and (d)(3), and their predecessors, NASD Rules 3110(f)(4)(A) and 4(C), which are identical to the FINRA rules, generally prevent any effort to limit or contradict FINRA rules. The rules specifically provide:

The second set of rules implicated by Schwab's class action waiver were FINRA Arbitration Rules 12204(a) & (d), which provide, respectively, that "[c]lass action claims may not be arbitrated under the Code" and that "[a] member or associated person may not enforce any arbitration agreement against a member of a certified or putative class action with respect to any claim that is the subject of the certified or putative class action" unless certain conditions are met, such as the denial of class certification.

After reviewing the arguments of FINRA Enforcement, a FINRA hearing panel initially observed that in precluding its customers from participating in class actions, Schwab's Waiver denied them a form of relief permitted under FINRA Rule 12204. As the hearing panel reasoned, FINRA Rule 12204 "is clearly premised on the availability of judicial class actions, and allows customer claims to be pursued in that manner in a judicial forum, rather than by arbitration."⁹

Because FINRA Rule 2268(d)(1) prohibits conditions that limit or contradict the Rules and FINRA Rule 2268(d)(3) "more narrowly specifies that a member firm may not limit the ability of a customer to file a claim in court that FINRA permits to be filed in court," the hearing panel concluded that "[t]hese provisions operate in conjunction with Rule 12204 to preserve the option for customer claims to be resolved in court in a class action."¹⁰ Therefore, on its face, Schwab's class action waiver violated FINRA Rules 2268(d)(1) and (d)(3).

In its defense, Schwab countered that the Federal Arbitration Act ("FAA") prohibited FINRA from enforcing rules that would allow Schwab customers to participate in class action lawsuits rather than arbitration where the customers were subject to an arbitration agreement. Section 2 of the FAA, in particular, provides that "[a] written provision in any ... contract evidencing a transaction involving commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction ... shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."¹¹

The hearing panel agreed that the FAA applied because Schwab's customer agreement was "an agreement involving transactions in commerce."¹² Schwab's customer agreements also specifically provided that the FAA governed. This language had been included for years without objection from FINRA, leading the hearing panel to further conclude that, "given FINRA's close regulation of what can and cannot be included in a member firm's customer agreements," FINRA "has understood the FAA to apply to such agreements."¹³

The hearing panel further cited precedent in which courts determined that FINRA's arbitration rules themselves were covered by the FAA.¹⁴ Because Schwab's customer agreements incorporated FINRA's arbitration rules, the hearing panel concluded that this "confirms that the FAA is applicable."¹⁵

After determining that the FAA applied, the hearing panel turned its attention to a trio of Supreme Court opinions to guide its analysis. In Shearson/American Express Inc. v. McMahon, the Supreme Court enforced an agreement to arbitrate a claim brought under section 10(b) of the Securities Exchange Act of 1934.¹⁶ Similarly, the Supreme Court in Rodriguez de Quijas v. Shearson/American Express Inc. concluded that a predispute agreement (which contained no express class action waiver) to arbitrate claims brought under the Securities Act of 1933 was enforceable.¹⁷

The hearing panel paid particularly close attention to McMahon's emphasis that the FAA "mandates enforcement of agreements to arbitrate statutory claims" unless "overridden by a contrary congressional command.¹⁸" The hearing panel further pointed to the Supreme Court's determination in Concepcion (where the agreement in question did expressly waive class procedures) that "[w]hen state law prohibits outright the arbitration of a particular type of claim, the analysis is straightforward: The conflicting rule is displaced by the FAA."¹⁹ The hearing panel interpreted Supreme Court precedent since Concepcion as instructing that "claims subject to an arbitration agreement covered by the FAA must be sent to arbitration for resolution, and that countervailing policy concerns cannot override that mandate."²⁰

Applying Supreme Court precedent to the Schwab customer agreements, the hearing panel concluded that FINRA Rules could not invalidate the Schwab arbitration agreement. The hearing panel reasoned that while FINRA's rules "have the force and effect of federal regulation and may preempt state law, FINRA's rules can only be enforced to the extent that they are not inconsistent with federal law."²¹ Because federal law includes the FAA, "FINRA's rules may not be enforced to the extent they are inconsistent with the FAA, unless Congress has created a relevant exception."²² Since enforcement of the FINRA Rules to invalidate the Schwab arbitration agreement would violate the FAA, the hearing panel concluded that the rules could not be so applied.

The hearing panel then framed the "critical issue on which this case turns" as whether "Congress has created an exception from the FAA for either FINRA's Rules or for the subject matter of those Rules — judicial class actions in securities disputes between customers and industry members."²³ The hearing panel answered that question in the negative, explaining that "FINRA's promulgation of a Rule pursuant to SEC approval and oversight that preserves judicial class actions as an option is not the same as a congressional command creating an exception to the FAA."²⁴

Absent such a congressional command, FINRA's rules could not create an exception to the FAA. Therefore, the hearing panel concluded that the FAA required the enforcement of Schwab's customer agreements to the extent they waived Schwab customers' ability to pursue class actions and required customers to arbitrate their claims instead.

Joinder and Consolidation in Arbitration

Although the hearing panel ruled that the FAA allowed Schwab to require its customers to arbitrate their claims and to prohibit class actions, the panel refused to permit Schwab to determine all aspects of how the arbitration would be conducted. In its third cause of action, FINRA Enforcement took issue with Schwab's prohibition against consolidating the claims of multiple parties in arbitration as an impermissible limitation of the power of FINRA arbitrators, violating FINRA rules. The Enforcement Department argued that Schwab's prohibition implicated FINRA's Rule 12312, which provides:

1. one or more parties may join multiple claims together in the same arbitration if the claims contain common questions of law or fact and:
   
   
   • The claims assert any right to relief jointly and severally; or
   • The claims arise out of the same transaction or occurrence, or series of transactions or occurrences.
     
     
2. After all responsive pleadings have been served, claims joined together under paragraph (a) of this rule may be separated into two or more arbitrations by the Director before a panel is appointed, or by the panel after the panel is appointed. A party whose claims were separated by the Director may make a motion to the panel in the lowest numbered case to reconsider the Director's decision.

Because Schwab prohibited consolidation in its amended customer agreements, the Enforcement Department claimed that Schwab limited or contradicted FINRA Rule 12312 in violation of FINRA Rule 2268(d)(1).²⁵

The hearing panel agreed and explained that "the FAA does not require that arbitration agreements follow any particular rules or procedures"²⁶, so FINRA could require members to allow consolidation of customer claims. In reaching its decision, the hearing panel also relied on the Supreme Court's acknowledgement in McMahon that the regulated nature of the securities industry and the U.S. Securities and Exchange Commission's oversight over the rules adopted by self-regulatory organizations helped to ensure that arbitration proceedings were adequate.²⁷ Therefore, if Schwab were permitted to re-write FINRA's procedural rules for arbitration, it would undermine the Supreme Court's reasoning "that arbitration does not deprive customers of substantive protections under the securities laws."²⁸

Potential Impact of the Decision

Brokerage firms likely will take comfort in the hearing panel's decision and likely will amend their customer agreements to include similar waivers of the ability to initiate class action lawsuits. By precluding class action litigation, the decision also serves a number of public policy objectives by avoiding many of the well-documented problems associated with class actions, such as the high costs associated with discovery, the distraction to company officials caused by prolonged litigation, and the often-large settlements extracted from plaintiffs due to the great uncertainty associated with taking a case to trial, regardless of the actual merits of a case.²⁹

Although the hearing panel ruled that Schwab could not prohibit the consolidation of claims in arbitration, it is unlikely that arbitrators, as a matter of practice or efficient administration, will use case-by-case consolidation to aggregate large numbers of claims and thereby effectively circumvent the ability of companies' to effectuate class action waivers. More helpfully, the hearing panel emphasized the fairness of arbitration in the securities industry³⁰ and desirability of arbitration procedures over class action litigation in the courts.³¹

Indeed, arbitration potentially offers both plaintiffs and defendants a number of benefits that include faster and more narrowly tailored discovery, limited motions practice, and the potential use of arbitrators with superior knowledge and skills pertaining to such disputes.³² As more brokerage firms include class action waivers such as Schwab's in their customers agreements, more parties may benefit from the potentially greater efficiencies afforded by arbitration.

Originally published in Law360, New York (March 25, 2013, 3:22 PM ET)

Footnotes

1. Dep't of Enforcement v. Charles Schwab & Co., Inc., Disciplinary Proceeding No. 2011029760201, at *19 (FINRA Feb. 21, 2013).

2. Id. at **3, 19.

3. Id. at *3.

4. Id. at *21.

5. AT&T Mobility LLP v. Concepcion , 131 S.Ct. 1740 (2011).

6. Id. at 1745 (citations omitted).

7. Schwab, at **3, 6-7.

8. Id. at *3. The Supreme Court will decide two cases in the current term addressing issues concerning class actions waivers. Depending on the outcome, these decisions may provide companies with greater clarity regarding their ability to include class action waivers in their agreements. See Sutter v. Oxford Health Plans LLC, 675 F.3d 215, 222-23 (3d Cir.), cert. granted, No. 12-135, 2012 BL 321896 (U.S. Dec. 7, 2012)); Italian Colors Restaurant v. American Express Travel Related Services Co. (In re American Express Merchants' Litigation), 667 F.3d 204, reh'g in banc denied, 681 F.3d 139 (2d Cir.), cert. granted, 133 S. Ct. 594 (2012).

9. Schwab, at *24.

10. Id. at *25.

11. 9 U.S.C. § 2.

12. Schwab, at *33.

13. Id. at *34.

14. Id.

15. Id.

16. Shearson/American Express Inc. v. McMahon, 482 U.S. 220 (1987). The customer agreement broadly stated in relevant part that "any controversy arising out of or relating to my accounts, to transactions with you for me or to this agreement or the breach thereof, shall be settled by arbitration." Id. at 223.

17. Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989).

18. Schwab, at *34 (quoting McMahon, 482 U.S. at 226).

19. Id. at **35-36 (quoting Concepcion, 131 S.Ct. at 1747).

20. Id. at **36-37. For a more detailed discussion of these opinions, see Jason M. Halper, Bradley J. Bondi & Martin Seidel, Mandatory Arbitration as Substitute for Private Securities Class Actions, N.Y.L.J., June 14, 2012 and Bradley J. Bondi, Facilitating Economic Recovery and Sustainable Growth Through Reform of the Securities Class-Action System: Exploring Arbitration as an Alternative to Litigation, 33 HARV. J.L. & PUB. POL'Y 607, 634 (Spring 2010).

21. Schwab, at *40

22. Id.

23. Id.

24. Id. at *41.

25. Schwab, at *8.

26. Id. at *42.

27. Id. at *44.

28. Id. at *45.

29. Bondi, supra note 20 at 634; see also Halper, et. al., supra note 20 (noting additional problems with securities class actions, such as their failure to deter corporate malfeasance and inadequate compensation to purportedly injured shareholders).

30. Schwab, at *44-45.

31. Id. at *41.

32. Bondi, supra note 20 at 627-29; Halper, et. al., supra note 20.

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