You’ve Been Warned: Ignoring FINRA Rules in Favor of Recent Second Circuit Precedent May Invite Disciplinary Action

August 2016Securities & Derivatives Alert

FINRA recently issued Regulatory Notice 16-25, which puts member firms on notice that any provisions added to their customer or employment agreements that require customers or registered representatives to arbitrate or litigate any dispute outside of FINRA, are in violation of FINRA rules and may serve as the basis for an action by the Department of Enforcement.

The notice to members presumably comes in response to a January 2016 decision from the United States Court of Appeals for the Second Circuit. In Credit Suisse Securities (USA) LLC v. Tracy, et. al., the court held that despite the requirement of FINRA rules to arbitrate certain disputes before FINRA, that “a pre-dispute private agreement to arbitrate before a non-FINRA arbitral forum is enforceable.” In other words, despite FINRA’s rules, parties may contract to alter their choice of forum.

In Credit Suisse, the firm entered into employment agreements with five registered representatives, which required them to submit employment-related disputes to either JAMS or the American Arbitration Association, rather than FINRA. When the brokers brought a claim before FINRA, Credit Suisse petitioned the District Court for the Southern District of New York to order the brokers to dismiss their FINRA case and proceed to arbitration with one of the agreed upon providers. The representatives appealed, arguing that the requirements of FINRA Rule 13200 are clear and applicable, and that any dispute between members must be brought before FINRA. Based on the language in the employment agreements, the Second Circuit held that FINRA’s “arbitration provisions are default rules which may be overridden by more specific contractual terms.”

In 2014, the Second Circuit similarly held that a customer and its brokerage firm could agree in a customer agreement to bypass FINRA for alternative forums. Goldman, Sachs & Co. v. Golden Empire Schools Financing Authority, 764 F.3d 210 (2d Cir. 2014). In commenting on FINRA’s rule set, the Second Circuit held that “Had FINRA wished to clearly state that Rule 13200 cannot be waived, it could have done so.” More so, it drew a distinction between an agreement that required a broker or customer to waive arbitration, which would likely not be enforceable, with a provision that expresses a preference for the forum of the arbitration, which the Court will honor.

For its part, FINRA has taken conflicting positions on these pre-dispute forum shifting agreements. As far back as 2012, FINRA recognized that “some brokerage firms are using employment agreements that require employees to waive their rights to arbitrate disputes with the firms in FINRA’s forum” and noted that such a provision “violates FINRA Rule 13200, and may also violate FINRA IM-13000.” (See April 13, 2012 letter of Mignon McLemore, Assistant Chief Counsel of FINRA Dispute Resolution, to the Securities and Exchange Commission).

However, in 2014, FINRA’s Board of Governors, in a decision based upon a firm’s requirement that customers waive their right to participate in a class action against the firm, held that in contrast to customer agreements, “there are no restrictions upon firms regarding the content of predispute arbitration agreements with employees.” In re Dep’t of Enforcement v. Charles Schwab & Co., No. 2011029760201, 2014 WL 1665738 (FINRA Bd. of Governors Apr. 24, 2014).

In the wake of the Second Circuit’s decisions, FINRA issued Notice to Members 16-25, which takes the position that notwithstanding the Second Circuit’s decisions in this area (or presumably, FINRA’s Board of Governors), that FINRA continues to take the position articulated in 2012, that any member firm which, through a written agreement with a customer or registered representative, seeks to move disputes outside of the FINRA arbitration forum is contrary to FINRA rules and such firms “may be subject to disciplinary action.”

Such an action would not be unprecedented. For example, the Board of Governors’ decision cited above arose from an enforcement action brought against Charles Schwab based on the firm’s amendment of its standard customer account agreement to include a provision requiring “customers to waive their right to bring or participate in class actions against Schwab and the authority of arbitrators to consolidate more than one party’s claims.”

Notice 16-25 makes it clear that member firms that decide to follow the Second Circuit’s logic and require cases to be brought outside of FINRA, may have to defend that decision in a FINRA disciplinary proceeding. It remains to be seen whether FINRA’s Department of Enforcement will actively pursue cases in this arena, or whether this notice is merely a scare tactic while FINRA pursues other avenues, including new rule making which makes the forum provisions in Articles 12 and 13 of the FINRA rules unwaivable.


© 2016 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.