Newly Released Disciplinary Ruling Whittles Away Investor Protections

In October 2011, Charles Schwab & Company informed its customers that it had amended its account agreement to prohibit customers from either bringing a class action suit against Schwab or participating as a class member in such an action. The amendments also purported to force the customer to agree that arbitrators would be precluded from consolidating the claims of multiple customers in a single arbitration proceeding.

Schwab’s amendments were designed to significantly reduce its potential liability to customers for fraud and other forms of misconduct. The restrictions meant that a victimized Schwab customer would be left with a single remedy: a one-on-one FINRA arbitration between that customer and Schwab. Customers could no longer participate as class members in a class action, nor could they join with other similarly situated Schwab customers in group arbitration.

The only problem with this scheme was that it blatantly violated rules of the Financial Industry Regulatory Authority (FINRA), the brokerage industry’s self-regulatory organization. Though Charles Schwab & Company is a FINRA member, Schwab obviously decided that the risk of thumbing its corporate nose at FINRA was vastly outweighed by the rewards that would accrue to Schwab if the amendments were allowed to stand.

FINRA could not abide Schwab’s new restrictions because FINRA rules permit customers of member firms such as Schwab to participate in class actions and group arbitrations. In fact, FINRA conduct rules expressly forbid the use  of a pre-dispute arbitration agreement that “limits or contradicts the rules of any self-regulatory organization.” Consequently, FINRA brought disciplinary proceedings against Schwab. On February 21, 2013, the Hearing Panel issued a decision that has potentially far-reaching consequences for all brokerage firm customers.

The Panel concluded that that Schwab had violated FINRA rules by attempting to preclude arbitrators from consolidating claimants in group arbitrations. A $500,000 fine was assessed for this violation.

The Panel also found Schwab’s attempt to preclude customers from participating in class actions to be a violation of the same rule. But surprisingly, the Panel concluded that FINRA didn’t have the power to enforce its rule in this context because the rule conflicted with the Federal Arbitration Act. Specifically, the Panel cited Supreme Court rulings  that the Federal Arbitration Act requires a party to an arbitration agreement to go to arbitration unless Congress – and Congress alone – has created an applicable exception. Schwab’s arbitration agreement thus prevailed over the FINRA rule because only Congress could create an exception to the enforcement of that agreement.

FINRA’s enforcement division now has the option of appealing the hearing panel’s decision, or the appeals board itself can call for a review. But if the ruling stands, other brokerage firms almost certainly will put the same class action prohibition in their  account agreements. This is bad news because if investors are unable to pursue any sort of class action recovery, brokerage firms will be able to safely engage in abuses that harm multitudes of customers but cause relatively small individual damages. For instance, a brokerage firm that charged excessive commissions to all of its customers would never have to answer to most of those customers because it would be impracticable for the victims to pursue such smaller claims in individual arbitrations.  Class action relief is tailor-made for that type of situation, and a prohibition on class participation will leave many people without a remedy.

Frankly, we at Stock Market Loss don’t like class actions in securities disputes and we usually recommend that most investors steer clear of them. In the interest of full disclosure, I should note that we make our living handling FINRA arbitrations for injured investors, so class actions negatively affect our business. But the reality is that class actions usually net an investor only a few cents for every dollar of loss, whereas most investors will recover far more in individual or group arbitrations. In fact, in contrast with the 2%-3% median recoveries reported for securities class actions, our group arbitrations have all returned between 55% and 85% of losses to our clients. Moreover, even claimants with relatively small losses can afford to be part of a group case.

Despite our antipathy for class actions, we think it is bad public policy to permit broker-dealers to bar their customers from participating in them. There is a need for class actions under appropriate circumstances and we hope FINRA’s fight against the Schwab amendments ultimately is successful.