Alert: FINRA Enforcement Appeals Hearing Panel Decision Regarding Class-Action Waiver Provisions

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March 6, 2013

The Financial Industry Regulatory Authority (FINRA) Office of Hearing Officers recently held that new class-action waiver provisions in Charles Schwab & Company, Inc.’s (Schwab) customer agreements are valid and enforceable. Although the Hearing Panel agreed with FINRA’s Department of Enforcement that the provisions violated FINRA and NASD rules, the Hearing Panel ultimately concluded that enforcement of such rules was precluded by the Federal Arbitration Act (FAA) as construed by the Supreme Court in AT&T Mobility LLC v. Concepcion and subsequent decisions. However, the Hearing Panel also concluded that provisions requiring customers to agree that arbitrators do not have power to consolidate more than one party’s claims in arbitrations are unenforceable.

The Department of Enforcement has appealed to its appellate body, the National Adjudicatory Council (NAC), with respect to the decision regarding class-action waiver provisions. FINRA’s Board of Governors may review the NAC’s decision; a firm or individual may then appeal FINRA’s action to the SEC and then to federal court. In the meantime, other broker-dealers and independent contractors are expected to add similar class-action waiver provisions to their customer agreements.

The new provisions in Schwab’s customer agreements were added after the Supreme Court’s decision in AT&T Mobility LLC v. Concepcion, in which the court held that arbitration agreements must be enforced according to their terms, even if enforcement made class-action procedures unavailable. Specifically, Concepcion rejected the Discover Bank doctrine, which taught that class actions were required to be available for cases in which an individual claim created too little incentive for an individual claimant to assert his or her rights in court. In effect, the Discover Bank doctrine, based on a 2005 California Supreme Court decision, acted as a public policy exception to Section 2 of the FAA, which provides that a dispute covered by an agreement to arbitrate must be resolved by arbitration in accord with the agreement. The Concepcion decision therefore eliminated the judicially-created loophole to the FAA’s mandate to enforce arbitration agreements.

Shortly after Concepcion was decided in April 2011, Schwab, whose headquarters are in California, amended its customer agreements to include provisions requiring customers to agree that arbitrators would have no authority to consolidate more than one party’s claims, and waiving a customer’s right to class action procedures. On February 1, 2012, the Department of Enforcement filed a complaint against Schwab on the basis that the new provisions violated FINRA and NASD rules.

The Hearing Panel concluded that the class-action waiver provision was enforceable, but that the consolidation provision was not. The Hearing Panel agreed with the Department of Enforcement that the class-action waiver provision violated FINRA Rules 2268(d)(1) and (d)(3) and NASD Rules 3110(f)(4)(A) and (4)(C) because the provision prevented customers the ability to exercise class-action procedures as permitted by FINRA Arbitration Rule 12204. But, relying on Concepcion and subsequent cases, the Hearing Panel concluded that the FAA requires that arbitration agreements be enforced unless a statutory exception applied. Determining that no such exception applied to the FINRA rules, the Hearing Panel held that the class-action waiver provision was enforceable.

The Hearing Panel came to the opposite conclusion with respect to the consolidation provision. The Hearing Panel determined that the waiver of the right to consolidate claims violated FINRA Rule 2268(d)(1) and NASD Rule 3110(f)(4)(A) because the provision undermines the fundamental operation of FINRA Rule 12312 by depriving FINRA of its authority to grant and circumscribe the powers of arbitrators in FINRA’s forum, and contravenes the specific authority given to arbitrators to join individual claims in specified circumstances. In contrast to the class-action waiver provision, the Hearing Panel concluded that the FAA did not supersede these FINRA rules because the FAA does not dictate how an arbitration forum should be governed and operated nor does it prohibit the consolidation of individual claims. Based on the violation in Schwab’s consolidation provision, the Hearing Panel ordered Schwab to take corrective action and to pay a fine of $500,000.

For more information, please contact your Briggs and Morgan attorney or a member of our Financial Markets practice group.