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By Sean Forbes
Aug. 10 — Allowing financial advisers to include mandatory arbitration clauses in agreements with their customers, as would be permitted under the proposed best-interest contract exemption to the Department of Labor's fiduciary rule proposal, would undermine the purpose of the rule, an arbitrator said during the first day of public hearings on the rule.
James D. Keeney, a retired securities attorney but active Financial Industry Regulatory Authority arbitrator, said that he “strongly supports” the DOL's proposed fiduciary rule but that it suffers from a “fundamental flaw”—it doesn't prohibit mandatory arbitration.
“The best-interest contract exemption is self-defeating because it will allow brokerage firms to continue mandating arbitration clauses in these customer agreements,” Keeney said Aug. 10 during the first day of the three-day DOL hearing. Investors would have to waive their Sixth Amendment right to a jury trial, and by doing so would waive the fiduciary protections that would be required under the DOL's proposal, he added.
The proposed fiduciary, or conflict-of-interest, rule (RIN 1210-AB32), would require investment brokers to work under a fiduciary duty, meaning they would have to act in their clients' best interest, rather than being held to the present “suitability” standard under which they can sell products that generally fit an investor's needs and risk tolerance.
Under the best-interest contract exemption (ZRIN 1210-ZA25) to the rule, also known as the BIC exemption, advisers wouldn't be able to include exculpatory provisions in contracts with clients or prohibit clients from being involved in a class action lawsuit against the advisers. However, they would be able to include mandatory arbitration provisions with respect to individual contract claims.
Keeney elaborated by saying that there are two “major problems” with mandatory arbitrations as regulated by FINRA.
First, parties to an arbitration must rely upon arbitrators, without having any assurance that the result will be based on established protections of law, he said. Under the Federal Arbitration Act, awards must be enforced by state or federal courts, and can't be overturned or modified except in very limited circumstances, he said.
Second, FINRA has limited discovery rules in arbitration cases, which means that customers would find it difficult to martial evidence to prove a case against a broker, he said.
Individual investors are also disadvantaged because arbitrations aren't required to be public, he said.
“In secret and unrecorded arbitrations, FINRA arbitrators can and probably will simply choose to ignore the new fiduciary standard,” and apply the lower suitability standard regulated by the Securities and Exchange Commission, or even use a “common sense” standard, Keeney said.
Kenneth E. Bentsen Jr., president and chief executive officer of the Securities Industry and Financial Markets Association, testified that the most common claim in FINRA arbitrations is for breach of fiduciary duty.
Joe Canary, director of the Office of Regulations and Interpretations for the DOL's Employee Benefits Security Administration, asked Keeney if either a voluntary arbitration system or mandatory nonbinding dispute resolution system would work instead of the mandatory arbitration scheme.
A voluntary system would work, Keeney said, because both parties could negotiate on who the arbitrators would be, what rules would apply and the arbitration costs. But if the arbitrations are mandatory, the industry would “dictate” the terms, and the investors would be “just stuck with it,” he said.
If a contract included a nonbinding clause, the investor could go through mediation, and then if there were a disagreement, could proceed to arbitration, and if there were still a disagreement, could then pursue the case in court, Keeney said.
Bentsen said that developing another arbitration system would create additional dispute requirements for broker-dealers, who are already subject to the FINRA requirements. The FINRA rules mandate that broker-dealers are bound to arbitration if the client requests it, so pre-dispute arbitration largely creates a “two-way street,” he said.
If the DOL develops a different mechanism, broker-dealers would still be subject to the FINRA arbitration requirements, which would raise further questions about the impact of those rules on broker-dealers “who have to live under securities laws,” he said.
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