Broker-dealers have been immune from class-action lawsuits as a result of the provisions of the Federal Arbitration Act (FAA) 1925 which overshadows the equally potent investor protection clauses in the Securities Exchange Act (SEA) of 1934. These two pieces of legislation have tussled in the courts for decades, and the FAA has prevailed.
The tide is changing as SEC, and the states press harder for the protection of investor interests. While arbitration is not going away, latitude for class-action puts the broker-dealer business model in jeopardy as liability costs will sky-rocket.
The courts have struck down judgments on class-action lawsuits, under state law, by invoking the preemption doctrine of the FAA. While state laws don’t question the primacy of arbitration, they make exceptions such as in the case of violation of consumer interests of a large group or when they surmise that the effect on consumers is unconscionable.
The Financial Industry Regulation Authority (FINRA), a self-regulatory organization (SRO) of broker-dealers, writes rules that require broker-dealers to be transparent with their customers about pre-dispute arbitration agreements and how they differ from a case in the courts. SEC reviews FINRA’s rules and ensures that they conform to SEA and protect investor interests. FINRA took disciplinary action against Charles Schwab and barred it from including an amendment in its customer agreement which prohibited class action.
The courts have been sympathetic in some cases to class action suits when the monetary recovery is for small amounts and affects a large group of people. In a case involving Charles Schwab’s YieldPlus Fund, a class action suit alleged that it misrepresented the risk profile and assets of the fund and improperly changed the fund’s investment policies. The court concluded that the resolution to the class action offered “substantial recoveries,” and the amount realized by an individual would not have been enough for a financially viable arbitration.
Maryland’s Financial Consumer Protection Commission proposed, in 2018, a Model Consumer and Employee Justice Enforcement Act which purports to strengthen the rights of financial consumers. Title 1 of the Model State Act allows a whistleblower to bring qui tam actions on behalf of the state, for violations of designated State consumer protection statutes, to recover civil penalties. Maryland’s Bankers Association expressed strong reservations about the proposed bill and successfully deferred its consideration until more information is available from the experience of other states.
In the event a financial consumer protection act demarcates the authority of FAA and creates room for class action lawsuits, broker-dealers will struggle to stay in business. According to a study by Morningstar, the operating margins of commission-compensated advisors will fall by a whopping 24-36%.
The writing is on the wall for broker-dealers—they become suspect with their commission-based compensation when a large number of their customers perceive that conflicts of interests have harmed them. Broker-dealers are at a fork in the road where a turn towards fixed compensation is insurance against class action lawsuits.
Hayden Royal provides services to put in place business processes that implement high standards for a fiduciary. Compliance with these standards help ensure that the defense will have enough proof in court to disprove that any conflict of interest existed. In any event, Hayden Royal incorporates best practices in its fiduciary standards that align the interests of the advisor and the customer to assist in the prevention of a conflict of interest.