WRITTEN STATEMENT OF
COMMISSIONER OF THE MINNESOTA DEPARTMENT OF COMMERCE
ON BEHALF OF THE
NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION (NASAA)
BEFORE THE SENATE JUDICIARY COMMITTEE
DECEMBER 17, 2013
Chairman Leahy, Ranking Member Grassley, Senator Franken and Members of this Committee, thank you for the opportunity to submit this statement for inclusion in the record of the hearing by the Senate Judiciary Committee on December 17, 2013 entitled “The Federal Arbitration Act and Access to Justice: Will Recent Supreme Court Decisions Undermine the Rights of Consumers, Workers, and Small Businesses?”
On behalf of the North American Securities Administrators Association, Inc. (NASAA), I appreciate the opportunity to share my views on arbitration as it impacts the public and specifically, investors. As the Commissioner of the Minnesota Department of Commerce, I am the securities regulator for the state of Minnesota and a member of NASAA. I am also a member of NASAA’s Board of Directors and serve on its Federal Legislation Committee, which is responsible for developing NASAA’s biannual Legislative Agenda and works with NASAA’s leadership to set the organization’s federal policy priorities. One of NASAA’s top legislative priorities for the 113th Congress is to promote efforts aimed at providing aggrieved investors meaningful remedies and a choice of forum in which to pursue those remedies. On June 14, 2013, I spoke to the Upper Midwest Securities Conference in Minneapolis. In my speech, I discussed the need for Congress to encourage the U.S. Securities and Exchange Commission (SEC) to use its authority granted under the Dodd-Frank Act to take action and curb the use of mandatory pre-dispute arbitration agreements.
From the outset, I want to applaud Senator Franken for introducing the Arbitration Fairness Act of 2013 (S. 878) and for recognizing the importance of including services related to securities and other investments in the definition of “consumer dispute” under the bill. Your bill will help retail investors in Minnesota, and across the country, seek effective recourse through the judicial system to resolve securities disputes. I also wish to recognize Senator Amy Klobuchar, as a member of this Committee, for her leadership and work on behalf of all Minnesotans.
NASAA was organized in 1919 and is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Canada, Mexico, Puerto Rico and the U.S. Virgin Islands. Ten securities administrators are appointed by Secretaries of State, five come under the jurisdiction of their states’ Attorneys General, some are appointed by their Governors and Cabinet officials, and others work for independent commissions or boards.
NASAA is the voice of these securities agencies that are responsible for both grass-roots investor protection and efficient capital formation. Securities regulation is a complementary regime of both state and federal laws. The securities administrators in your states are responsible for enforcing state securities laws by pursuing cases of suspected investment fraud, conducting investigations of unlawful conduct, licensing firms and investment professionals, registering certain securities offerings, examining broker-dealers and investment advisers, and providing investor education programs and materials to your constituents.
State securities regulators have protected Main Street investors for the past 100 years, longer than any other securities regulator. State securities regulators continue to focus on protecting retail investors more so than any other regulator. Our primary goal and mission is to act for the protection of these investors, especially those who lack the expertise, experience, and resources to protect their own interests. States are also the undisputed leaders in criminal prosecutions of securities violators. In 2012 alone, state securities regulators conducted nearly 6,000 investigations, leading to nearly 2,500 enforcement actions, including 339 criminal actions. Moreover, in 2012, 4,300 licenses of brokers and investment advisers were withdrawn, denied, revoked, suspended, or conditioned due to state action, up 27 percent from the previous year.
Federal Arbitration Act – Legislative History
The Federal Arbitration Act (FAA) was enacted in 1925 to honor agreements to arbitrate between mutually consenting parties. The “principal purpose” of the FAA was to “require courts to enforce privately negotiated agreements to arbitration, like other contracts, in accordance with their terms.”1 Form contracts or “contracts of adhesion,” where one party offers terms on a non-negotiated “take-it-or-leave-it” basis, are contrary to the intended purpose of the FAA. In fact, the legislative history makes clear that Congress intended the FAA to target commercial parties of generally comparable bargaining power, rather than consumers or, by extension, investors.
Legislative history reveals that Congress intended the Federal Arbitration Act to cover disputes between merchants of approximately equal strength, Arbitration of Interstate Commercial Disputes: Hearing of S. 1005 and H.R. 646 Before the J. Comm. of Subcomms. on the Judiciary, 68th Cong. 10 (1924), but not involving disputes with workers, Sales and Contracts to Sell in Interstate and Foreign Commerce, and Federal Commercial Arbitration: Hearing on S. 4213 and S. 4214 Before a Subcomm. of the S. Comm. on the Judiciary, 67th Cong. 9, 14 (1923), or disputes where the arbitration agreement could be considered an adhesion contract, Arbitration of Interstate Commercial Disputes: Hearing of S. 1005 and H.R. 646 Before the J. Comm. of Subcomms. on the Judiciary, 68th Cong. 15 (1924).” 2 As Representative Graham noted in the House floor debate in 1924, “[t]his bill simply provides for one thing, and that is to give an opportunity to enforce an agreement in commercial contracts and admiralty contracts—an agreement to arbitrate, when voluntarily placed in the document by the parties to it.” 68
Unfortunately, the reach of the FAA has been expanded by the Supreme Court over the last twenty years to apply in contracts between parties of unequal bargaining power. The House Committee on the Judiciary’s Report on Activities during the 111th Congress discussed this expansion and some of the benefits associated with traditional litigation.
Although arbitration was initially conceived as a privately- run, voluntary process for resolving disputes, mainly between businesses, written and oral testimony from Congressional hearings during the 110th Congress indicated that the use of arbitration had expanded in the last twenty years. Many businesses are now requiring arbitration of disputes in their consumer, employment, and franchise relationships. Ironically, during the passage of the Federal Arbitration Act, Congress did not intend to allow binding arbitration agreements on individuals if the contracts were between parties of unequal bargaining power. The secret nature of arbitration, the ability of the drafter to dictate the terms of the arbitration process, and the apparent loss of civil protections when compared to a court proceeding have created controversy among consumer and employee advocates and small business owners.
Because arbitration avoids the public court system in favor of a private industry of arbitration groups, individuals lose some of the benefits and rights associated with traditional litigation. These benefits and rights include lower initial financial hurdles, pretrial discovery, formal civil procedure rules, proximity to the resolution forum, access to counsel, class action options, and fairness. Arbitration clauses may even negate the protection of some federal statutes.4
State securities regulators are deeply concerned about the implications of the recent Supreme Court decisions expanding the scope of arbitration, including the Court’s recent decision in American Express Co. v. Italian Colors Rest., which held that a group of merchants were bound by individual arbitration agreements with American Express even if a class action was the only way to make their claim – alleging a violation of federal antitrust law – economically viable.5 As the scope of this hearing suggests, these decisions may further undermine the rights of consumers, workers and small businesses.
Mandatory Pre-dispute Arbitration Clauses in Investor Contracts
NASAA has had a longstanding concern about the use and proliferation of mandatory pre-dispute arbitration provisions (i.e., before a dispute or loss is known) that appear in the overwhelming majority of customer agreements used by broker-dealers. This concern has deepened in recent months, in part due to the decision, discussed further below, by one major brokerage firm to expand the scope of its arbitration clause to include a waiver of class action rights, thus further eroding investors’ rights to fair recourse.
Prior to 1987, an investor’s claim against his or her stock broker for alleged wrongdoing could generally be pursued as a lawsuit against the broker or the brokerage firm. But that year, the Supreme Court upheld the enforceability of agreements to arbitrate investors’ claims arising under the Securities Exchange Act of 1934,6 and subsequently, mandatory pre-dispute arbitration clauses have become a fixture in contracts between investors and brokerage firms. In addition to requiring arbitration, these agreements direct that such arbitration must be conducted in only one forum: the arbitration forum administered by the Financial Industry Regulatory Authority, or FINRA.7 Increasingly, investment advisers are also requiring that their clients agree to binding pre-dispute arbitration. 8 In fact, a survey conducted by the Massachusetts Securities Division of its registered investment advisers revealed that 87% of those advisers now use a standard form of investment advisory agreement, and of those almost half include a pre-dispute arbitration agreement.9
NASAA believes that investors must have a choice of forum when it comes to resolving disputes with their investment professionals. Investor confidence in fair and equitable recourse is critical to the stability of the securities markets and long-term investments by retail investors. NASAA has argued that participation by “mom and pop” investors in our capital markets, and, by extension, job growth, is directly tied to their level of trust in having a reasonable avenue to seek recovery if they are victimized by securities fraud or other unethical conduct.
Unfortunately, investor confidence in the U.S. markets remains low as reflected by a recent Bankrate survey.10
As noted above, NASAA was particularly alarmed when, in late 2011, Charles Schwab & Co. sent over 6.8 million existing account holders monthly account statements accompanied by immediately effective amendments to their account agreements. These amendments included a class action waiver (i.e., denial of the right to participate in class action litigation or on a representative basis). The waiver was also included in new account agreements. Schwab’s decision to make these changes came after the Supreme Court’s decision in AT&T Mobility v.Concepcion, holding class action waivers in consumer contracts enforceable.11 Interestingly, just a few years prior to issuing this amendment, investors that purchased one of Schwab’s mutual funds brought class actions against Schwab, including its broker-dealer affiliate, alleging violations of federal and state securities laws.12 The court approved a $235 million settlement, with an average estimated payment to individual investors of $881, which the court noted offered “substantial recoveries” that “will provide real benefits” to those investors.13 Had those investors been prohibited from participating in a class action, their potential recovery, even if greater than $881, would have been too small to warrant pursuing an individual arbitration.14
In the instance of Schwab seeking to expand its arbitration clauses to include class action waivers, FINRA instituted a disciplinary action against Schwab for the violation of its own member rules which preserve judicial class actions as an alternative to arbitration.15 However, to the detriment of investors, in February 2013 a FINRA Hearing Panel determined that those rules and, by extension, the agreement between Schwab and FINRA to abide by those rules, could not be enforced under Concepcion.16 FINRA has appealed the Hearing Panel ruling and a decision by FINRA’s National Adjudicatory Council is forthcoming. However, if Schwab is successful in the appeal,17 it is likely that every broker-dealer and investment adviser will follow suit and include class action waiver language in their customer agreements.18 Even publicly-traded companies may attempt to insulate themselves from shareholder liability by including mandatory arbitration and class action waiver language in their governing documents.19
A decision in favor of Schwab would pose an imminent threat to investors’ ability to seek redress, particularly for small dollar claims.20 In other words, the practical effect of the Hearing Panel’s decision could be the elimination of the ability of investors to bring or participate in class actions, which is the only viable means for most small investors to recoup their losses. As the Seventh Circuit Court of Appeals has correctly observed “[t]he realistic alternative to a class action is not 17 million individual suits, but zero individual suits, as only a lunatic or a fanatic sues for $30.”21 The high cost of attorneys’ fees and expenses alone makes adequate representation in a FINRA arbitration, particularly against a large and sophisticated brokerage firm, insurmountable for a single investor.
Restoring protections for Americans with limited means to invest is even more critical in light of changes enacted as part of the Jumpstart Our Business Startups Act (JOBS Act), which became law on April 5, 2012. The JOBS Act established a mechanism for small investors to engage in crowdfunding and loosened restrictions on advertising and solicitation of private securities. NASAA anticipates that these provisions of the JOBS Act will lead to an increase in very small investments. If these investors are forced to waive their right to participate in class actions, they will be left with no economically viable remedy when they are defrauded, thereby undercutting the goal of the JOBS Act to spur investment in smaller offerings.
Securities Arbitration and the Dodd-Frank Act
Congress recognized the potential harm to investors from mandatory pre-dispute arbitration clauses when it enacted, on July 21, 2010, Section 921 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). This section provided the SEC with the authority to prohibit or impose limitations on the use of mandatory pre-dispute arbitration clauses in broker-dealer and investment adviser customer contracts.
Section 921 was included in response to Congressional concern that mandatory pre-dispute arbitration agreements were unfair to investors.22 During deliberation, lawmakers observed the following with regard to mandatory pre-dispute arbitration clauses in broker-dealer contracts:
For too long, securities industry practices have deprived investors of a choice when seeking dispute settlements, too. In particular, pre-dispute mandatory arbitration clauses inserted into contracts have limited the ability of defrauded investors to seek redress. Brokerage firms contend that arbitration is fair and efficient as a dispute resolution mechanism.
Critics of mandatory arbitration clauses, however, maintain that the brokerage firms hold powerful advantages over investors. Brokerages often hide mandatory arbitration clauses in dense contract language. Moreover, arbitration settlements generally remain secret, preventing other investors from learning about the performance of a particular brokerage firm.
If arbitration truly offers investors the opportunity to efficiently and fairly settle disputes, then investors will choose that option. But investors should also have the choice to pursue remedies in court, should they view that option as superior to arbitration. For these reasons, H.R. 3817 [the precursor to Section 921] provides the SEC with the authority to limit, prohibit or place conditions on mandatory arbitration clauses in securities contracts.23
Section 921 of the Dodd-Frank Act gives the SEC explicit rulemaking authority to prohibit or limit the use of mandatory pre-dispute arbitration agreements if it finds that doing so is in the public interest and for the protection of investors. Although Congress gave the SEC an important tool to act in this area, in the three years since the Dodd-Frank Act was passed, the SEC has not exercised its authority to conduct rulemaking or even examine the impact of mandatory pre-dispute arbitration clauses on investors and the public.24 It is uncertain whether the SEC will take action in the near future under its Section 921 rulemaking authority,25 even given the exigent circumstances presented by Schwab.
NASAA has urged the SEC to take such action, and has argued that as the agency chosen by Congress to oversee FINRA arbitration, the SEC’s exercise of its specific authority under Section 921 of the Dodd-Frank Act supersedes the FAA’s general provisions.26 We are deeply thankful to Senator Franken for spearheading a letter to the SEC along with 36 other Members of Congress urging the SEC to exercise its Section 921 authority in light of the actions taken by Schwab to limit investors’ class action rights.27
The Federal Arbitration Act was never intended to enforce contracts of adhesion, where one party offers terms on a non-negotiated, take-it-or-leave-it basis. Unfortunately, these contracts of adhesion containing mandatory pre-dispute arbitration clauses in their fine print are commonplace in the brokerage and investment adviser industry. Schwab’s actions to expand these clauses and prohibit class action participation are an example of the pernicious effect of forced arbitration and brokerage “form” contracts. It is also an alarming example of the continued erosion of investor protections. Indeed, without a class action vehicle, many small dollar claims and potentially harmful activity will go undiscovered by the harmed investor, thus resulting in windfalls to violators.
The Arbitration Fairness Act of 2013 reaches beyond the securities regime and eliminates mandatory, pre-dispute arbitration clauses in a wide range of consumer contracts. It restores investors’ access to the courts, and allows them to determine, after a dispute arises, if arbitration is the appropriate and desired forum. This legislation is consistent with the intent and spirit of Section 921 of the Dodd-Frank Act, and it removes the ability of any brokerage firm to unilaterally restrict an investor’s ability to seek judicial relief. This legislation goes a long way to restore investor participation and confidence in the markets.
Thank you, Chairman Leahy, Ranking Member Grassley, Senator Franken, and Members of this Committee, for the opportunity to submit this written statement.
1 Volt Info. Scis., Inc. v. Bd. of Trs. of Leland Stanford Junior Univ. U, 489 U.S. 468, 478 (1989).
2 House Committee on the Judiciary, Report on Activities During 111th Congress, H.R. Rep. No. 111-712, at n. 128. Cong. Rec. 1931 (1924).3
3 Id. at n. 126.
4 Id. at 55-56.
5 American Express Co. v. Italian Colors Rest., Slip Op. No. 12-133 (S. Ct. June 20, 2013) (“AMEX III”).
6 Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220 (1987).
7 The Financial Industry Regulatory Authority, or FINRA, is a private non-profit self-regulatory organization for broker-dealers organized as a national securities association pursuant to Section 15A of the Securities Exchange Act. 15 U.S.C. § 78o-3.
8 In December 2012, FINRA issued “Guidance on Disputes between Investors and Investment Advisers who are not FINRA-Regulated firms.” This guidance discusses the conditions required for an investor and registered investment adviser to submit a case to the FINRA arbitration forum, which has traditionally been open only to broker dealers and their customers. This Guidance requires that both parties sign an agreement to arbitrate after their dispute arises, and then a second agreement to have FINRA arbitrators hear the dispute.
9 Massachusetts Securities Division, Report on Massachusetts Investment Advisers’ Use of Mandatory Pre-Dispute Arbitration Clauses in Investment Advisory Contracts by Massachusetts Securities Division Staff (Feb. 11, 2013), available at http://www.sec.state.ma.us/sct/sctarbitration/Report%20on%20MA%20IAs%27%20Use%20of%20MPDACs.pdf.
10 When asked to pick the best way to invest money that would not be needed for the next ten years, investors picked cash, real estate, and even precious metals over the stock market. The findings of the Bankrate survey are available at http://www.bankrate.com/finance/consumer-index/financial-security-charts-0713.aspx.
11 AT&T Mobility v. Concepcion, 131 S. Ct. 1740 (2011).
12 In re Charles Schwab Sec. Litig., No. C08-01510 WHA, 2011 WL 1481424 (N.D. Cal. Apr. 19, 2011).
14 See Black, Barbara and Gross, Jill, Investor Protection Meets the Federal Arbitration Act (Sept. 5, 2012), 1 Stan. J. Complex Litig. 1 (2012).
15 Department of Enforcement v. Charles Schwab & Co., FINRA Disciplinary Proceeding No. 2011029760201 (Feb. 1, 2012), available at http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p210893.pdf; see also Letter from Sen. Franken and 36 Members of Congress to SEC Chair Mary Jo White (Apr. 26, 2013), available at https://www.nasaa.org/wp-content/uploads/2013/08/Bicameral- Letter-to -SEC-re-Mandatory-Arbitration-April-26-2013.pdf (“While the Supreme Court in Concepcion did find that the FAA preempts state actions that would restrict the use of arbitration, the facts in the Schwab case are notably distinguishable—not least because FINRA is a membership organization seeking to enforce its own rules.”); see also infra n.19 (arguing that the Hearing Panel erred “because FINRA is statutorily required to enforce its rules and its membership agreement with Schwab” and “[t]he only agreement at issue in this enforcement action is the agreement between FINRA and Schwab and that agreement is unquestionably valid and permissible under the [FAA])”.
16 See Dept. of Enforcement v. Charles Schwab & Co., FINRA Disciplinary Proceeding No. 2011029760201 (CRD No. 5393) (Feb. 1, 2012), available at http://www.finra.org/web/groups/industry/@ip/@enf/@ad/documents/industry/p210893.pdf.
17 On May 15, 2013 Schwab released a statement on its website that it was suspending class action waivers in its account agreements. Notably, however, it qualified this measure as temporary “until the issue is resolved by the appropriate regulatory and/or court decisions.” The Schwab statement is no longer available on its website.
18 As Secretary Galvin has stated “This ruling is akin to giving every rogue broker-dealer the green light to steal from their customers in small dollars amounts.” Letter from Secretary William Francis Galvin of the Commonwealth of Massachusetts to SEC Chairman Elisse B. Walter (Feb. 26, 2013), available at http://www.sec.state.ma.us/sct/sctschwabarb/Schwab-letter.pdf.
19 See supra n. 13, at pgs. 7-9 (discussing the 2012 attempt by Carlyle Group LP to amend its initial public offering registration statement to require arbitration of investor disputes and recent attempts by shareholders to include in proxy statements of four publicly traded companies bylaw amendments that would require arbitration, and prohibition on class actions, of all shareholder claims including securities law violations); see also Letter from Sens. Al Franken, Richard Blumenthal and Robert Menendez to SEC Chair Mary Shapiro (Feb. 3, 2012) (urging the SEC to maintain its policy of opposing the inclusion of provisions requiring mandatory arbitration of shareholder disputes in the corporate documents of public companies in response to Carlyle Group, LP’s attempt to amend its registration papers to prohibit litigation and instead require individual arbitration).
20 See Amicus Curiae Brief of NASAA at 14, Dept. of Enforcement v. Charles Schwab & Co., FINRA Disciplinary Proceeding No. 2011029760201 (Feb. 1, 2012).
21 Carnegie v. Household Int’l, Inc., 376 F.3d 656, 661 (7th Cir. 2004).
22 Congress considered the following concerns about the arbitration process: “high upfront costs; limited access to documents and other key information; limited knowledge upon which to base the choice of arbitrator; the absence of a requirement that arbitrators follow the law or issue written decisions; and extremely limited grounds for appeal.” AARP letter to Senators Dodd and Shelby, November 19, 2009. See also Senate Committee on Banking, Housing, and Urban Affairs on S. 3217, S. Rep. No. 111-176, at 110.
23 House Committee on Financial Services on H.R. 3817, H.R. Rep. No. 111-687, Part 1, at 50.
24 Notably, even the SEC has previously advised brokerage firms that “form” contracts requiring mandatory pre-dispute arbitration are against public policy. “Requiring the signing of an arbitration agreement without adequate disclosure as to its meaning and effect violates standards of fair dealing with customers and constitutes conduct that is inconsistent with just and equitable principles of trade.” Notice to Broker-Dealers Concerning Clauses in Customer Agreements which Provide for Arbitration of Future Disputes,” 1979 WL 174165 (S.E.C. Release No. 34-15984), p. 4.
25 See SEC published agency rule list – Fall 2013, available at (http://www.reginfo.gov/public/do/eAgendaMain?operation=OPERATION_GET_AGENCY_RULE_LIST¤t PubId=201310&showStage=longterm&agencyCd=3235&Image58.x=11&Image58.y=9&Image58=Submit.
26 See Letter from NASAA to SEC Chair Mary Jo White (May 3, 2013), available at https://www.nasaa.org/wp-content/uploads/2011/07/NASAA-Letter-to-SEC-on-Arbitration-and-Class-Action-Waivers.pdf.
27 Letter from Sen. Franken and 36 Members of Congress to SEC Chair Mary Jo White (Apr. 26, 2013), available at https://www.nasaa.org/wp-content/uploads/2013/08/Bicameral-Letter-to-SEC-re-Mandatory-Arbitration-April-26-2013.pdf.