Lessons From "Arbitration Nation:" an Empirical Study of 40,000+ Consumer Arbitrations

A recent study identifies a problem -- "we know little about what actually happens in" arbitration -- and offers a solution: find out what happened in more than 40,000 consumer arbitrations administered by four major arbitration forums over the course of six years.

In the study, "Arbitration Nation: Data from Four Providers," Professors Andra Cann Chandrasekher and David Horton analyzed "40,775 consumer, employment, and medical malpractice arbitrations filed between 2010 and 2016 in four major arbitration administrators: the AAA, Judicial Arbitration and Mediation Services (JAMS), ADR Services, Inc., and the Kaiser Health Care Office of Independent Administration (Kaiser)."

Important conclusions:

• consumer arbitration is relatively fast and affordable, with corporate defendants paying the lion's share of the costs;
• although the U.S. Supreme Court has repeatedly and emphatically enforced mandatory arbitration clauses in recent years, the uptick in the volume of arbitration "has been modest;"
• plaintiffs who represent themselves in arbitration rarely win (they only prevail in 10% of employment cases)--"pro se plaintiffs struggle mightily" (but do they fare any better in court?  -- the authors don't comment) and
• arbitration favors repeat players (what I'll call frequent flyers) on both sides--arbitration favors frequent flyer corporate defendants but also frequent flyer plaintiffs' law firms.

To encourage more lawyers to take relatively small value cases to arbitration and thus (presumably) weed out cases without merit and improve outcomes for plaintiffs who have cases with merit, the authors propose "that state lawmakers create rewards for plaintiffs’ lawyers to arbitrate. Specifically, jurisdictions should create a statutory 'arbitration multiplier': an extra bounty for winning a case in arbitration." Intriguing.  And, not likely to be preempted.

What about securities arbitration?  Alas, the authors' study did not include data on FINRA arbitrations.  That is in part because the study relied on data on consumer arbitrations made public as required by Section 1281.96 of the California Code of Civil Procedure--a law that does not cover FINRA.  

New Maine Restrictions on Non-Compete Agreements; Bans Restrictive Employment Agreements

A new Maine law will make it more difficult for Maine employers to enforce non-compete agreements, an issue of particular interest in the securities industry where non-competition agreements often have been used to deter brokers from changing jobs. In enacting the new legislation, Maine joins other New England states, including Rhode Island, Massachusetts, and New Hampshire, which also have new laws on the books limiting the enforceability of non-compete agreements.

On June 28, 2019, Governor Mills signed LD 733 (“An Act to Promote Keeping Workers in Maine”) into law. Under the new law, a noncompete agreement is defined as a contract or contract provision that prohibits an employee or prospective employee from working in the same or a similar profession or in a specified geographic area for a certain period of time following termination of employment.

The new law applies to noncompete agreements entered into or renewed after September 18, 2019.

The new law makes clear that noncompete agreements are “contrary to public policy” and enforceable only to the extent that they are reasonable and are no broader than necessary to protect one or more of the following legitimate business interests of the employer: the employer’s trade secrets, the employer’s confidential information that does not qualify as a trade secret, or the employer’s goodwill. A noncompete agreement may be presumed necessary if the legitimate business interest cannot be adequately protected through an alternative restrictive covenant, including but not limited to a nonsolicitation agreement or a nondisclosure or confidentiality agreement. 

Further, the new law prohibits an employer from requiring or entering into a noncompete agreement with an employee earning wages at or below 400% of the federal poverty level. 

If an employer requires a noncompete agreement for a position of employment, the employer must disclose that requirement in any advertisement for that position, and an employer must provide an employee or prospective employee with a copy of a noncompete agreement at least three business days before requiring that employee or prospective employee to sign the agreement. 

The terms of a noncompete agreement (except for a noncompete agreement with a physician) are not in effect until after an employee has been employed with the employer for at least one year or a period of six months from the date the agreement was signed, whichever is later. 

The law is enforceable as civil violation subject to a fine of $5,000 or more. The Department of Labor is responsible for enforcement of the law. 

LD 733 also addresses “Restrictive employment agreements,” defined as an agreement: (a) between two or more employers, including through a franchise agreement or a contractor and subcontractor agreement; and (b) prohibits or restricts one employer from soliciting or hiring another employer's employees or former employees. With respect to such agreements, an employer may not enter into a restrictive employment agreement or enforce or threaten to enforce a restrictive employment agreement. An employer that does so commits a civil violation subject to a fine of $5,000 or more. The Department of Labor is also responsible for enforcement of this section.

Investing in Private Companies: Opportunities Abound, But So Do Risks

More retail investors than ever are investing in private companies, but doing so can be "high-risk" and "more opaque" and private companies tend to be a magnet for fraud, according to the Wall Street Journal.  "More opaque" means "more secretive"--subject to lesser regulatory oversight and fewer obligations to disclose to the public how their business is performing.  Also problematic is that it can be hard to sell investments in private companies, which means that buying private companies can "tie up your money for a long time."  Sometimes, selling an investment in a private company can be subject to penalties or fees, which may not have been disclosed or understood when the investment was first made.  Investments in private companies are sometimes referred to as "private placements" and include stock and limited partnerships.

Also of concern is that tens of billions of dollars a year in securities in private companies are being sold by securities firms with a checkered past, including investor complaints and other red flags suggesting potential misconduct, according to the Journal.  Investments in private companies also tend to pay higher commissions, creating an incentive for securities professionals to overlook or justify risk in return for a larger commission.  The result is that investors facing the special risks associated with private securities are too often receiving recommendations from registered representatives at securities firms less prepared (or willing) to provide suitable recommendations and to aggressively supervise securities professionals making recommendations to buy private securities. 

Private placement memoranda and sales materials given to investors sometimes contain inaccurate statements. In addition, some materials omit information necessary to make informed investment decisions, and some firms fail to conduct an adequate investigation of the issuer to determine if the private placements were suitable for their customers, according to the Financial Industry Regulatory Authority. 

The Journal also reports that the Securities and Exchange Commission is planning to increase the number of people allowed to buy private companies, even though that population has "already grown 10-fold since the 1980s."   An investor typically must be "accredited" to buy stock in private companies, which requires an annual income of more than $200,000 ($300,000 with a spouse) or a net worth of more than $1 million (excluding the investor's primary residence).  But those thresholds were set more than 30 years ago in 1982.  "If the limits had been adjusted to keep pace with inflation, an accredited investor would now need an annual income of about $515,000--more than double the actual $200,000 limit--and a net worth of more than $2.5 million," according to the Journal.

To put it bluntly, $200,000 isn't the same income it used to be.  Nor does a net worth of $1 million automatically put someone in a position to make speculative investments.  A few years ago the Commission provided these examples of people who would generally be considered "accredited" investors:

• A single working parent of three children with an annual salary of $205,000, and likely with a home mortgage to pay;
• A recent widow who inherited $1 million, but is not earning a separate income; and
• A senior retiree who has accumulated over $1 million in his or her retirement account and needs that money for the retirement years.

Other "accredited" investors include people who have suffered catastrophic injuries and received payments as a result of personal injury claims.  But, such persons should not be assumed to have the "financial sophistication and/or investment experience to be able to assess whether any particular investment is appropriate for them," according to the Commission. 

Of course, "each year, companies raise billions of dollars selling securities in non-public offerings that are exempt from registration under the federal securities laws. These offerings . . . can be a key source of capital for American businesses, especially small or start-up companies."  But for retail investors who receive recommendations to invest in private companies, consult the Financial Industry Regulatory Authority's list of tips and cautions before buying--the gist of which is look very, very carefully before leaping.

Public Investors Bar Association Report: Draft Reforms to FINRA Supervision Rules Leave Investors Vulnerable

In a report titled, FINRA’s Attempt to Gut Investor Protections: Proposed Reforms to FINRA Supervision Rules, Public Investors Arbitration Bar Association (PIABA) argues, “FINRA is currently contemplating the evisceration of crucial protections that have been in place for decades to safeguard investors against investment schemes by brokerage firms’ registered representatives, including ‘selling away’ schemes. If FINRA’s proposed changes are approved, there will likely be more investment scams perpetrated by registered representatives. If these proposals are adopted, brokerage firms will no longer be held primarily responsible for identifying and stopping rogue brokers.” 

FINRA is currently contemplating changes to FINRA Rules 3270 and 3280 as outlined in FINRA Regulatory Notice 18-08. Both rules impose broad supervisory responsibilities and obligations for registered representatives and member firms with respect to outside business activities and private securities transactions. FINRA Regulatory Notice 18-08 proposes to exempt member firms from supervising:

• Investment-related activities at third‐party investment advisor firms;
• Investment-related activities at member affiliates, including IAs, banks, and insurance companies;
• Non‐investment–related work and outside business activities; and
• Personal investments

According to PIABA, outside business activities manifest themselves in a variety of schemes and fraudulent activity every year, including but not limited to, fraudulent private placements, Ponzi schemes, and investment frauds perpetrated through third-party IAs established by the registered representative. According to PIABA, “A common modus operandi in these schemes is for a registered representative to establish a solo or small IA firm and perpetrate the fraud through outside business activities in an effort to avoid member supervision.” 

FINRA proposed Rule 3290 narrows and reduces member firms’ supervisory obligations and, according to PIABA, results in unacceptable adverse consequences, including:

• Dramatically weakening long-standing supervisory obligations;
• Creating glaring supervisory deficiencies;
• Encouraging de facto violations of federal securities laws;
• Generating inconsistencies with other FINRA rules and regulatory guidance;
• Producing perverse incentives for registered representatives and members; and
• Leaving investors with inadequate protection

According to Financial Advisor Magazine, the comment period for the FINRA proposal is closed. “Now all eyes are on FINRA to see what they’ll do and if they’ll put investor protection interests first and let this horrific rule die,” says Andrew Stoltman, current President and member of the Board of Directors for PIABA.

FINRA Arbitration Requirements Take Priority over Forum Selection Clause

The Third Circuit Court of Appeals recently ruled that Bear Stearns must comply with the Financial Industry Regulatory Authority (FINRA) rules that require arbitration of a customer’s claims despite the existence of a forum selection clause. That ruling, in Reading Health System v. Bear Stearns & Co., n/k/a J.P. Morgan Securities, LLC, involved a broker-dealer agreement between Bear Stearns (now J.P. Morgan Securities) and Reading Health System regarding offerings of certain securities by Reading Health through which J.P. Morgan Securities served as broker-dealer and underwriter. The agreement provided that any actions and proceedings arising out of the agreement or the underlying transactions had to be filed in the U.S. District Court for the Southern District of New York. However, FINRA Rule 12200 generally requires FINRA members to arbitrate disputes with customers at the customers’ request if arbitration is required by written agreement or requested by a customer.

Reading Health filed a Statement of Claim with FINRA, alleging that J.P. Morgan Securities engaged in improper conduct in conjunction with the offerings. J.P. Morgan Securities refused to participate in FINRA arbitration. It cited the forum selection clause in its agreement with Reading Health. In response, Reading Health filed a declaratory judgment action to address the arbitration issue. 

The U.S. District Court ordered J.P. Morgan Securities to arbitrate. On appeal, the Third Circuit affirmed. The court found J.P. Morgan Securities’ argument unpersuasive that, in agreeing to the forum selection clauses included in the broker-dealer agreements, Reading Health waived the right to FINRA arbitration under Rule 12200. The Third Circuit found that the forum selection clause, which did not refer to arbitration, lacked the specificity to support a finding of waiver. Although waiver of FINRA Rule 12200 might be found under different facts, the assertion of waiver would need to be supported by explicit language waiving the specific right to FINRA arbitration. 

The court found that Reading Health System had not waived its right to compel Bear Stearns to arbitrate under FINRA’s rules. 

The deadline to file a writ of certiorari to the U.S. Supreme Court in this case is 90 days from the entry of judgment on August 7, 2018. This ruling widens a circuit split. The Second and Ninth Circuits have enforced forum selection clauses, while the Fourth Circuit has held that the FINRA Rule requires arbitration even in the face of a forum selection clause.

FINRA Issues Guidance on Heightened Supervision for Persons with a History of Past Misconduct

To reiterate the supervisory obligations of FINRA member firms regarding associated persons with a history of past misconduct that may pose a risk to investors, FINRA recently published Regulatory Notice 18-15.

FINRA Rule 3110 (Supervision) requires member firms to establish and maintain systems to supervise activities of associated persons to comply with applicable securities laws and FINRA rules. Member firms have a fundamental obligation to implement a supervisory system that is tailored to the member firm’s business and addresses the activities of all its associated persons.

Notice 18-15 highlights particular instances where heightened supervision of an associated person may be appropriate. Firms are encouraged to adopt the practices that are outlined in Notice 18-15 to strengthen their supervisory procedures. Notice 18-15 is one of several FINRA initiatives focused on associated persons with a history of past misconduct that pose a risk to investors and the firms that employ them. These initiatives are designed to strengthen oversight through guidance, rule changes, and surveillance programs.

In Notice 18-15, FINRA instructs that a firm should routinely evaluate its supervisory procedures to ensure they are appropriately tailored for each associated person and consider, among other things, the person’s activities and history of industry and regulatory-related incidents. When an associated person of the firm has a history of industry or regulatory-related incidents, the firm must determine whether its standard supervisory and educational programs are adequate to address the issues such person’s history raises or whether the firm should develop tailored heightened supervisory procedures to address such issues. The failure to assess the adequacy of its supervisory procedures in light of an associated person’s history of industry or regulatory-related incidents will be closely evaluated in determining whether the firm itself should be subject to disciplinary action for a failure to supervise should that person be the subject of a future industry or regulatory related incident.

In short, firms can’t rely on ordinary garden variety supervisory processes and procedures when a broker has a pattern of misconduct. 

Blockchain, Digital Currencies, and Securities Regulation

As with any new investment product or asset class, cryptocurrencies and related blockchain technology have been the subject of a great deal of investor interest and regulatory activity, particularly as bad actors have exploited public interest to peddle unsuitable investments or--even worse--perpetrate frauds.

A blockchain is a public, distributed ledger that is replicated and hosted on numerous computers, creating thousands of identical digital copies that give the system credibility and oversight needed to create a secure public list of an asset.  That list can describe things such as identification, contracts, or cryptocurrencies--scarce, virtual assets represented on a blockchain.  The most well-known cryptocurrency is Bitcoin.  Other popular cryptocurrencies include Dash, Monero, Litecoin, Ethereum, and Ripple.  Blockchain technology is also sometimes referred to as distributed ledger technology (DLT) or distributed database technology. 

For regulatory purposes, federal agencies categorize cryptocurrency in different ways.  To the Internal Revenue Services it is property.  To the Commodity Futures Trading Commission it is a commodity.  The Securities and Exchange Commission says that cryptocurrency tokens can be a security. 

Many securities rules administered by the SEC and the Financial Industry Regulatory Authority (FINRA) are implicated by crytocurrency, as FINRA made clear in its report, "Distributed Ledger Technology: Implications of Blockchain for the Securities Industry" (March 2018)  For example,

• a DLT application that seeks to alter clearing arrangements or serve as a source of recordkeeping by broker-dealers may implicate FINRA’s rules related to carrying agreements and books and records requirements;
• DLT may have implications for trade and order reporting requirements to the extent it seeks to alter the equity or debt trading process; and
• FINRA rules such as those related to financial condition, verification of assets, anti-money laundering, know-your-customer (suitability), supervision and surveillance, fees and commissions, payment to unregistered persons, customer confirmations, materiality impact on business operations, and business continuity plans also may to be impacted depending on the nature of the DLT application.

DLT applications are being used or tested within the equity, debt and derivative markets.

Unsurprisingly, investors have been attracted to blockchain related investments.  A new fundraising vehicle, the initial coin offering (ICO)--also called a "token generation event" or "initial token offering"--allows accredited investors (those with a net worth of more than $1 million) to bankroll the creation of a blockchain in exchange for payment cryptocurrency "coins" or tokens."  In 2017, more than 200 ICOs raised more than $4 billion.  The size and nature of ICOs vary greatly.

The SEC issued an Investor Alert: Public Companies Making ICO-Related Claims (August 2017) warning "about potential scams involving stock of companies claiming to be related to, or asserting they are engaging in [ICOs]"  According to the SEC, "Fraudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams.  These frauds include 'pump-and-dump' and market manipulation schemes involving publicly traded companies that claim to provide exposure to these new technologies." 

The North American Securities Administrators Association advises investors considering putting money into an ICO to exercise "extreme caution" in its "Informed Investor Advisory: Initial Coin Offerings" (April 2018) as follows:

• ICOs are very risky and are not suitable for many investors;
• Use extreme caution when dealing with promoters who claim their ICO offering is exempt from securities registration yet do not ask about your income, net worth or level of investing sophistication; and
• ask whether the “coins” or “tokens” are considered securities and whether the offering itself has been registered with appropriate securities regulators. 

State regulators, like the SEC, have engaged in active ongoing enforcement activity, including regulators in Texas, North Carolina, New Jersey, and Massachusetts.  Hey, let's be careful out there.