United States: FINRA Increases Scrutiny Of Predispute Forum Selection Provisions

On July 21, 2016, the Financial Industry Regulatory Authority ("FINRA") issued Regulatory Notice 16-25 ("RN 16-25"), broadly prohibiting member firms from using exclusive forum selection provisions in predispute agreements to deny or restrict customers or associated persons from availing themselves of FINRA arbitration.

Notwithstanding existing Federal Appellate court precedent upholding the practice, FINRA warned that it will consider any effort by member firms to enforce such non-compliant predispute agreements a violation of FINRA rules that may result in disciplinary action. According to FINRA, "FINRA rules are not mere contracts that member firms and associated persons can modify," and FINRA specifically disapproved of the line of judicial decisions holding that contractual forum selection clauses between parties superseded the obligation to arbitrate under FINRA rules.

Predispute forum selection provisions are ubiquitous in the securities industry, in agreements with both customers and associated persons. Member firms are advised to review promptly the language of the forum selection provisions in their agreements and policies pertaining to the enforcement of such provisions, in order to ensure compliance with RN 16-25 and FINRA rules, and to avoid potential disciplinary action. Going forward, any efforts by member firms to use alternative forums, such as the AAA or JAMS, in disputes with customers and associated persons, will likely come under heavy scrutiny.

Further analysis of RN 16-25 reveals several important principles related to the drafting and enforcement of forum selection provisions in customer and industry agreements.

1. Customer Disputes

The starting point for FINRA arbitration under the FINRA Code of Arbitration Procedure for Customer Disputes ("Customer Code") is Rule 12200, which provides that parties must arbitrate if: 1) arbitration is required either by written agreement, or requested by the customer; 2) the dispute is between a customer and a member or associated person of a member; and 3) the dispute arises in connection with the business activities of the member or the associated person. Accordingly, RN 16-25 emphasizes that the obligation to arbitrate does not solely stem from a written agreement, but also can arise from a customer's request made at any time. In other words, "this rule preserves a customer's ability to resolve disputes through FINRA arbitration, regardless of whether arbitration is required by a written agreement."

Predispute arbitration agreements are contained in virtually all new account opening agreements, and they must meet various requirements under FINRA rules. For instance, FINRA Rule 2268 specifies that an arbitration agreement clause be highlighted and immediately preceded by certain disclosures regarding the nature of arbitration. See, generally, FINRA Rule 2268. Importantly, FINRA Rule 2268(d) also prohibits any predispute arbitration agreement from including any condition that: 1) limits or contradicts the rules of any SRO, or 2) limits the ability of a party to file any claim in FINRA arbitration. RN 16-25 clarifies that this Rule requires arbitration agreements to "preserve the rights of the contracting parties under SRO rules and that FINRA arbitration must be a choice for the parties as a means of dispute resolution."

In RN 16-25, FINRA also expressed disapproval of several Federal Appellate court decisions which held that forum selection clauses in agreements between member firms and customers supersede the requirements of FINRA Rule 12200, and thus permitted member firms to require customers to arbitrate outside of FINRA or to litigate in state or federal court. See, e.g., Goldman, Sachs & Co. v. Golden Empire Schs. Fin. Auth., 764 F.3d 210 (2d Cir. 2014); Goldman, Sachs & Co. v. City of Reno, 747 F.3d 733 (9th Cir. 2014). According to FINRA, these decisions were based on the erroneous premise that the "duty to arbitrate under FINRA rules, or to arbitrate in FINRA's arbitral forum, is merely contractual and can be superseded or waived." As FINRA bluntly puts it in RN 16-25, "they are not default rules that may be overridden by more specific or separate contractual terms without consequences under FINRA rules."

Importantly though, FINRA recognized that member firms and customers may elect, by mutual consent, notwithstanding an arbitration agreement, to resolve their disputes outside of FINRA arbitration without running afoul of FINRA rules. However, this election is only permitted "after a dispute has arisen between the parties." Similarly, if there is no written agreement to arbitrate, and if the customer does not elect FINRA arbitration, then the parties can agree to resolve their dispute outside of FINRA.

Through RN 16-25, FINRA makes very clear that "any member firm's denial, limitation, or attempt to deny a customer's right to request FINRA arbitration, even if the customer seeks to exercise that right after having agreed to a forum selection clause specifying a venue other than a arbitration forum" is a violation of FINRA Rules 2268, 12200 and 2010 (Standards of Commercial Honor and Principles of Trade). Additionally, FINRA warns member firms that "provisions in predispute arbitration agreements or any other customer agreements that do not comply with FINRA rules may be subject to disciplinary action." Nor are member firms permitted to "use an existing non-compliant agreement as a basis to deny a customer the right to FINRA arbitration at the customer's request, without violating FINRA rules."1

2. Associated Person Disputes

RN 16-25 expresses the same principles and policy as it pertains to predispute forum selection provisions between member firms and associated persons. Under FINRA Rule 13200 of the Code of Arbitration Procedure for Industry Disputes, disputes between member firms and associated persons arising out of the business activities of a member or an associated person must be arbitrated through FINRA.

FINRA similarly rejected recent precedent holding that Rule 13200 could be waived in a predispute agreement to arbitrate in a forum other than FINRA. See Credit Suisse Sec. (USA) LLC v. Tracy, 812 F.3d 249 (2d Cir. 2016). Again, RN 16-25 reiterated that "FINRA's arbitration rules are not default rules. FINRA Rule 13200 specifically states that industry disputes must be arbitrated at FINRA[.] Thus any attempt to override this requirement of FINRA Rule 13200 in a predispute agreement by more specific contractual terms would violate FINRA rules."

As in the case of customer disputes, RN 16-25 issued a clear warning to member firms: "[m]ember firms with provisions in predispute agreements that do not comply with FINRA Rules may be subject to disciplinary action."2

The Bottom Line

RN 16-25 further solidifies FINRA arbitration as the preferred forum for resolution of disputes between member firms and its customers or associated persons. FINRA clearly instructs member firms that, notwithstanding existing Federal Appellate court precedent upholding the practice, it will consider it a violation of FINRA rules for member firms to restrict or prohibit customers or associated persons from availing themselves of FINRA arbitration through the use of exclusive predispute forum selection provisions, or to refuse to arbitrate through FINRA arbitration disputes within the scope of Rules 12200 and 12300 upon request by customer or associated persons.

Any attempts to enforce such non-compliant provisions, whether in new agreements or existing agreements, may also subject member firms to disciplinary action. Accordingly, member firms should promptly review the language of the forum selection provisions in their agreements with customers and associated persons, and their policies pertaining to the enforcement of such provisions, in order to ensure compliance with RN 16-25 and FINRA rules, and to avoid potential disciplinary action.

Footnotes

1. If a member firm is using a forum selection clause in a predispute agreement specifying a forum other than FINRA arbitration, FINRA recommends that the member firm use a non-exclusive forum selection provision, and include the following language: "This agreement does not prohibit or restrict you from requesting arbitration of a dispute in the FINRA arbitration forum as specified in FINRA rules."

2. RN 16-25 also provides, as it does with customer disputes, recommended language for member firms to use in forum selection provisions contained in agreements with associated persons in order to comply with FINRA rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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