Schwab Case Casts Spotlight on Securities Arbitration and Its Flaws

Class-action lawsuits are the bane of most financial firms, and many recoil at the prospect of paying out millions to groups of clients if investments go sour. Now, the discount brokerage firm Charles Schwab & Company finds itself at odds with regulators as it seeks to eliminate the option of such suits for its clients.

For Wall Street, the skirmish has inadvertently brought fresh and unwelcome attention to the investor arbitration process and its flaws, and could severely curtail efforts by investors hurt by widespread problems, including claims of being marketed unsuitable investments by brokers who gave a deceptive sales pitch.

Investors generally have not been able to use the public court system for their disputes with their stockbrokers since 1987, when the Supreme Court ruled in Shearson v. McMahon that a brokerage firm could force customers to agree to arbitration. Since then, virtually every firm has added a so-called mandatory arbitration agreement to its new-account documents.

One exception was for issues that were pervasive enough to warrant class-action status, that way allowing groups of investors to sue a firm or firms.

But in 2011, Schwab added a clause to its customer agreement that required clients to agree not to pursue or participate in class-action suits.

That move, however, didn’t sit well with the Financial Industry Regulatory Authority, the private corporation that is the brokerage industry’s self-financed policing arm. The enforcement division of Finra filed a disciplinary action against Schwab last year to force the firm to do away with the provision on class-action suits. (Schwab has since removed the clause until the Finra proceeding, or possible court appeals, are completed.)

Schwab challenged Finra’s decision and won at a panel hearing on Feb. 21. Finra appealed, and the case will go before the association’s adjudicatory panel next Wednesday.

After the ruling in favor of Schwab in February, state securities regulators, investor advocates and Democratic members of Congress took up the cause. The nonprofit advocacy group Public Citizen started an online petition entitled “Stand Up to Chuck: Demand That Charles Schwab Corporation Stop Denying Its Customers’ Rights,” collecting 17,000 signatures.

“The decision in favor of Schwab is backfiring on the industry,” said Jill I. Gross, director of the Investor Rights Clinic at Pace Law School.

If Schwab prevails, other Wall Street brokerage firms are likely to follow suit with similar waivers. It is the potential for such moves that worry investor advocates.

“The Schwab case is potentially an enormous sea change,” said F. Paul Bland Jr. of Public Justice, a nonprofit consumer advocacy group. “If Schwab succeeds, investor protection will be enormously damaged.”

The issue has cast a harsh spotlight on the arbitration process of the entire securities industry. Although Finra is taking the side of the small investor in the Schwab case, the organization is often depicted as soft on the industry that underwrites its operations.

The group’s critics point out that the selected arbitrators do not have to follow the law, rarely permit depositions and typically do not award punitive damages.

In the seven months through the end of July, arbitrators granted awards to only 39 percent of claimants, the lowest win rate in five and a half years, based on Finra’s statistics.

Class-action lawsuits, though not always successful, have been one recourse for groups of investors who lose money on the same investment. But given that they can often result in millions in damages, brokerage firms have been eager to avoid them.

If Schwab succeeds in its efforts, small, unsophisticated investors will have a tougher time preparing to pursue claims against brokers, said A. Heath Abshure, president of the North American Securities Administrators Association, an organization of state securities regulators.

Many claims involve losses of $10,000 or less, making it tough for investors to find legal experts who will help support arbitration claims.

Without class actions as an option, “no attorney is going to take a securities fraud case for a chance to recover 30 percent of $10,000” in arbitration, Mr. Abshure said.

The class-action cases of early 2008 against brokers who marketed auction-rate securities as an alternative to money-market funds are one example of how the legal tool benefited consumers, said Scott C. Ilgenfritz, president of the Public Investors Arbitration Bar Association, a group that represents investors in disputes against brokers. (Those cases ended up being settled by regulators.)

For Wall Street brokerage firms, however, answering to such cases costs time and money.

Greg Gable, a Schwab spokesman, said in an e-mail that class-action suits “are grindingly slow” and mainly benefited lawyers, not class members. He said that Finra ran an efficient forum in which “the majority of investors who make claims” obtained relief. Schwab offers to pay the arbitration fees for claims under $25,000, Mr. Gable said.

Industry experts also point out that the clause that Schwab has proposed would not inhibit other class-action suits, like shareholder litigation. Such lawsuits, though aimed at corporations, often pull in the brokerage firms that issue the securities or underwrite bond offerings.

The outcome of the closed-door hearing in the Schwab case next week is being closely watched by investor representatives, who fear a decision against Finra could substantially weaken investor protections.

The industry’s trade group, the Securities Industry and Financial Markets Association, has applauded the arbitration process as a low-cost system that “serves the best interests of investors.”

Over the years, Finra has changed its policies in response to criticisms. Investors today have the option of a panel with no industry representatives, for example. Previously, one person on each three-person panel had to come from the securities industry.

Yet rebukes over the organization’s arbitration process persist. Recently, the group faced a flurry of criticism over the ability of brokers to appeal to arbitrators to wipe complaint information off their records.

Finra’s system of monitoring its arbitrators came under more scrutiny after a federal judge in Pennsylvania threw out an arbitration decision on Aug. 1 that had been won by Goldman Sachs, which had been sued by a customer seeking $1.4 million in a fraud and misrepresentation case. It turned out that one of the arbitrators hearing the case had been indicted by a grand jury in Burlington County, N.J., on charges of running an unauthorized legal practice. The arbitrator had also been disciplined by Michigan for writing a bad check for $18,000.

Finra has said it will begin to conduct annual background checks on its arbitrators.

Various parties have pressed the Securities and Exchange Commission, which has authority over the industry, to intervene in the Schwab matter. The Dodd-Frank regulatory overhaul also gave the agency broad new authority to prohibit or restrict mandatory arbitration.

Stephen W. Hall, securities specialist at the investor advocacy group Better Markets, said it was conceivable that the S.E.C. could intervene on the Schwab case. “Then they’d be in a position to say, ‘Look, we did something to address some of the problem.’ ”

But Mr. Hall suggested that the agency should take on “the entire litany of problems in this mandatory arbitration system,” and not just the matter of class-action waivers.

It would be a welcome surprise to investor advocates if the S.E.C. went as far as to stop brokers from requiring arbitration, but few expect the agency will take such a bold step.

The agency has made no public move to use its authority. John Nester, an S.E.C. spokesman, said in an e-mail that Mary Jo White, the agency’s new chairwoman, was committed to discussing the issues regarding mandatory arbitration agreements with fellow commissioners and staff, but offered no timeline.