By Wayne Grossman

On April 24th, the Financial Industry Regulatory Authority’s (FINRA) Board of Governors issued a decision that found Charles Schwab & Co. (Schwab) violated FINRA rules by sending certain amendments to its customer account agreements to 6.8 million of its customers. These amendments prohibit customers from participating in class action lawsuits against the firm, and also require customers to agree that FINRA arbitrators have no authority to consolidate claims made against the firm. This decision, in part, reversed the findings of a FINRA Hearing Panel which had held that, although the amendments did violate FINRA rules, these rules were unenforceable because they were in conflict with the Federal Arbitration Act (FAA).

When a customer opens a brokerage account at a FINRA member firm, the customer contractually agrees to resolve disputes with the firm through arbitration. Dispute resolution is then governed by the contractual terms of a pre-dispute arbitration agreement. Section 2 of the FAA provides that such agreements are “valid, irrevocable, and enforceable….” In general, member firms enjoy a significant degree of latitude in drafting pre-dispute arbitration agreements, subject to certain limitations under FINRA rules.

On February 1, 2012 FINRA filed a complaint alleging Schwab violated FINRA rules that allow customers to participate in class actions and FINRA arbitrators to consolidate similar cases. Schwab argued that it had the right to require customers waive their rights to participate in class actions. The original Hearing Panel held that Schwab did violate these rules, but that these rules were unenforceable because they were inconsistent with Section 2 of the FAA which affords primacy to the terms and conditions of an arbitration agreement over FINRA rules. Because FINRA rules explicitly allow arbitrators to consolidate claims, the Hearing Panel found against Schwab on this matter and fined the company $500,000.

Upon independent review, the FINRA’s Board of Governors (the Board) reversed the Hearing Panel’s findings. Based upon the language and intent behind the FINRA rules, the Board found that the rules were intended to “preserve investor access to the courts to bring or participate in judicial class actions…and that Schwab violated FINRA rules.” However, the Board also found that Congress validly delegated authority to the Securities and Exchange Commission to approve FINRA’s rules on arbitration agreements, and that this authority overrides Section 2 of the FAA. The Board stated that FINRA rules have the force and effect of federal law. Stated differently, the Board ruled that Schwab’s amendments to its customer agreements violate enforceable FINRA rules, and referred the case back to the Hearing Panel to determine appropriate sanctions.

This ruling suggests that although member firms of FINRA have a significant degree of discretion in designing pre-dispute arbitration agreements, investors and their advocates should be aware that there are limits under FINRA rules. Additionally, FINRA rules have the force and effect of federal law and can affect investor rights. In this case, FINRA rules have been interpreted to recognize and protect investor rights to participate in class action suits.

By Josh Brandsdorfer

Since 1987, when the Supreme Court in Shearson v. McMahon ruled that a brokerage firm could force customers to agree to arbitration, this method of dispute resolution has become the virtually mandatory in the financial regulatory industry. However, this previously preferred method of dispute resolution could be facing a new frontier if Charles Schwab has its way. In 2011, Charles Schwab added a clause to their agreements that mandated that clients could not pursue action against the corporation in class action suits. Class actions, common amongst investors who cannot afford representation or whose claims are not lucrative enough to hire a lawyer, provided a course of action for aggrieved customers.

The court in Charles Schwab v. FINRA, finding in Schwab’s favor, reinforced that there is little to protect consumers from downright predatory customer agreements, even for the nation’s top financial regulators.

In February, Charles Schwab won its initial panel hearing; and while FINRA, the brokerage industry’s self-financed policing arm, appealed this decision, it could prove disastrous for customers looking to recover against unscrupulous broker-dealers. Though some arguments arise that class action suits benefit the attorneys more than the aggrieved investor, class action suits are sometimes the only options for individuals who do not meet the high loss thresholds many law firms hold for these types of disputes. Instead, customers are forced to become part of a class; individuals similarly situated who all have claims against a common broker or product. These actions can provide powerful results to customers who otherwise could not afford representation and allows investors seek clarity in their legal issues.

The addition of non-profit clinics, such as the University of Miami’s Investor Rights Clinic, at least gives customers another avenue should the appeals court hold that Charles Schwab, and likely every other broker-dealer, can shield themselves from class action lawsuits. It is, however, unlikely that the number of non-profit clinics will be able to cover the customer cases that were once engulfed by class actions. A Charles Schwab spokesman indicated that the company will offer to pay the arbitration forum fees for claims under $25,000, but this sum usually only accounts for a few thousand dollars. While a nice gesture, it does not solve the problem. For claims this low, it is not economical for attorneys to take these cases, unless they are categorically similar, in which the attorney would previously cluster these claims together into a class action suit.

Though class actions may be very lucrative for some attorneys, the only parties who truly suffer from the unfavorable judgment in Schwab v. FINRA are the rights of investors. If the appeals panel does rule that Schwab’s action were reasonable and class action suits are in fact not required in brokerage contracts, look for more pro bono or small scale legal practices, like the Investor Rights Clinic here at Miami to become more popular. Law students can gain an insightful look into real legal practice in this pro bono environment. Perhaps more universities will embrace the idea of providing free legal services to investors whose investment claims remain too low for most private attorneys.

For more information please visit:

http://dealbook.nytimes.com/2013/09/04/schwab-case-casts-spotlight-on-securities-arbitration-and-its-flaws/?_r=0

On January 8, 2013, the United States Supreme Court heard oral arguments in the case of SEC v. Gabelli, 11-274,  related to when the clock begins to run for the Securities and Exchange Commission (SEC) to bring a fraud suit. In Gabelli, the Obama administration asserts that the time limit accrues from the time the government discovers the wrongdoing–a contrast from the traditional view that the limitations period begins at the time of a fraudulent transaction.

The SEC complaint was filed in 2008 and centered on conduct occurring between 1999 and 2002, calling into question the five-year limitations period of 28 U.S.C. § 2462. The SEC alleges that two officials of Gabelli Funds LLC secretly allowed market timing practices by a client.

Although the “discovery” rule does apply in private actions brought by investors, the Gabelli case implicates only governmental actions brought to impose fines, not to disgorge profits or impose criminal penalties.

The Court’s ruling is not expected to come until June, but the Justices’ questions seemed to indicate that many of them disagreed with the Obama administration’s stance. The Justices further hinted that their decision could have broad implications applying to time limitations imposed on actions brought by other governmental agencies like the Federal Trade Commission and Defense Department, among others.

For more information and to listen to the oral arguments before the Supreme Court click here.

A Florida couple, Robert and Michele Billings of Naples, Florida, were recently awarded $1.34 million due to Merrill Lynch’s misrepresentation about the risks associated with Fannie Mae preferred shares. The Billings were sold Fannie Mae preferred shares after being told by their broker, Miles Pure (CRD# 2475647), that Fannie Mae preferred shares were safe and backed by the U.S. government, neither of which were true at the time of the sale. Further, as the value of the shares continued to decline after the 2008 housing market collapse the broker continued to recommend holding onto the shares. The whole story can be viewed here. This is a classic case of civil fraud and negligent supervision. If you have a case similar to this, please consider contacting the clinic to see if you meet the clinic’s requirements for representation.

Broker Thomas Casper recently consented to the entry of findings and violations and the imposition of sanctions  for his misconduct relating to loans from customers. In January of 2012, FINRA launched disciplinary proceeding No. 2010025125101 against the broker. Casper had borrowed money from customers, including three elderly widows, without the approval of his firm Stifel Nicolaus, Inc. Casper’s actions demonstrate a violation of numerous FINRA and NASD rules. As a result, on August 29, 2012, FINRA barred Casper from associating with any FINRA member firm in any capacity.

For FINRA’s Order Accepting Offer of Settlement, click here.