FINRA Board of Governors Finds Charles Schwab & Co. Violated FINRA Rules by Attempting to Prevent Customers from Participating in Class Action Lawsuits

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.