FULL TEXT FINRA Decision On Charles Schwab Arbitration Agreement

February 21, 2013

Around October 1, 2011, Charles Schwab & Co. amended its Customer Account Agreement to include provisions requiring customers:

  • to waive their rights to bring or participate in class actions against the firm, and
  • to agree that arbitrators in arbitration proceedings would not have the authority to consolidate more than one party's claims.
Here is the subject provision:

Waiver of Class Action or Representative Action

Neither you nor Schwab shall be entitled to arbitrate any claims as a class action or representative action, and the arbitrator(s) shall have no authority to consolidate more than one parties' [sic] claims or to proceed on a representative or class action basis.

You and Schwab agree that any actions between us and/or Related Third Parites shall be brought solely in our individual capacities. You and Schwab hereby waive any right to bring a class action or any type of representative action against each other or any Related Third Parties in court. You and Schwab waive any right to participate as a class member, or in any other capacity, in any class action or representative action brought by any other person, entity or agency against Schwab or you.

FINRA Complaint

The FINRA Department of Enforcement filed a Complaint charging Respondent Schwab with violating FINRA rules concerning language or conditions that firms may place in customer agreements.  FINRA alleged three causes of action (the first two largely dealing with the class action language and the third with arbitrators' ability to consolidate claims): 
  • First Cause of Action: Placing Language in Predispute Arbitration Agreements That Limits the Ability of Customers To File Claims in Court (Violations of NASD Rule 3110(f)(4)(C) and FINRA Rules 2268(d)(3) and 2010; and
  • Second And Third Causes of Action: Placing Language in Predispute Arbitration Agreements That Contradicts FINRA Rules (Violations of NASD Rule 3110(f)(4)(A) and FINRA Rules 2268(d)(1) and 2010.

Initially, Enforcement sought a $10 million penalty, a Censure, and an Order directing Respondent Schwab to conform its cited language to FINRA rules -- but that seems to have been addressing sanctions for Causes One and Two, with the financial penalty sought for Cause Three reduced to $500,000.

FINRA Hearing Panel Decision

By Decision dated February 21, 2013, a FINRA hearing panel dismissed two causes of action when it found that the amended language used in Schwab's customer agreements to prohibit participation in judicial class actions does violate FINRA rules, BUT that FINRA may not enforce those rules because they are in conflict with the Federal Arbitration Act ("FAA"). 

The Panel found Schwab liable on the third cause of action when it had violated FINRA rules by attempting to limit the powers of FINRA arbitrators to consolidate individual claims in arbitration.

The Panel found that Respondent Schwab had violated the rules cited by Enforcement; however, the Panel also found that the cited rules as they related to class actions were not enforceable.  A classic Yes But.  

As to the issues involving Schwab's attempt to limit arbitrators' ability to consolidate claims, well, that was found to be a "yes" without a "but" and the Panel found Respondent Schwab of violating enforceable FINRA rules.

The Panel ordered the following:

The Hearing Panel finds that the remedial purposes of FINRA sanctions require that Schwab be ORDERED to do the following: (i) cease using the portion of the Waiver purporting to delimit the authority of the arbitrators and complete the process of removing that language from customer agreements and account applications; (ii) notify in writing all current customers and any former customers who received the Waiver (in language consistent with this decision) that the prior limitation on the powers of arbitrators is not effective; (iii) notify and reiterate to all current customers and any former customers who received the Waiver that Schwab's agreement to arbitrate includes an agreement to arbitrate subject to FINRA Arbitration Rules . . . (iv) pay a fine of $500,000; . . .

Unless the hearing panel's decision is appealed to FINRA's National Adjudicatory Council (NAC) or is called for review by the NAC, the hearing panel's decision becomes final after 45 days.

SIDE BAR: Read FULL TEXT version of FINRA Hearing Decision in FINRA Department of Enforcement, Complainant, v. Charles Schwab & Company, Inc. (Hearing Panel Decision Granting In Part And Denying In Part The Parties' Cross Motions For Summary Judgment, Office of Hearing Officers, February 21, 2013).

Bill Singer's Comment

Okay, so what's going on here?

FINRA sought up to $10 million in fines but got $500,000. FINRA sought to find Schwab liable for violations arising from improper arbitration agreement language addressing class actions and arbitrators' powers to consolidate; but the self-regulatory organization only prevailed on the latter cause of action.

Lemme try to explain some of this legal rigmarole.

Schwab's Waiver seeks to force its customers to relinquish the right to participate in class actions in court and to agree that all disputes covered under that agreement must be adjudicated in arbitration. Essentially, if you want to be a Schwab customer you may not participate in any class action against Schwab in any forum other than FINRA arbitration. The question in this disciplinary case was whether such a waiver constituted a violation of FINRA rules that purport to permit customers the option to participate in class actions in court notwithstanding an pre-dispute arbitration clause to the contrary.  

By way of spoiler alert, the class action arbitration clearly violated FINRA rules.

The next issue was whether FINRA's rules were enforceable or constituted impermissible attempts to circumvent or constrain an Act of Congress: the Federal Arbitration Act.

By way of spoiler alert, as to FINRA rules prohibiting arbitration of class actions in FINRA arbitration, the Hearing Panel found such rules contrary to the FAA. In reaching that conclusion, the Panel considered US Supreme Court decisions. As to whether Schwab had wrongly sought to constrain FINRA arbitrators from consolidating matters, the Hearing Panel found those efforts to be sustainable violations subject to the imposition of sanctions.

FINRA's Enforcement argued that Arbitration Rule 12204(d) permits the filing of class actions in court, and FINRA member firms may not limit or contradict that option by implementing waivers that cut off resort to the adjudication of class actions in court. 

FINRA Arbitration Rule 12204: Class Action Claims:

(d) A member or associated person may not enforce any arbitration agreement against a member of a certified or putative class action with respect to any claim that is the subject of the certified or putative class action until:
 The class certification is denied;
 The class is decertified;
 The member of the certified or putative class is excluded from the class by the court; or
 The member of the certified or putative class elects not to participate in the class or withdraws from the class according to conditions set by the court, if any.

This paragraph does not otherwise affect the enforceability of any rights under this Code or any other agreement.

Schwab argued that the FAA takes priority over the mere rules of a self-regulatory organization such as FINRA and, accordingly, the doctrine of preemption required that FINRA may not countermand an Act of Congress, such as the FAA - and Schwab asserted that under the FAA it had the right to seek the customer class action waiver in dispute. 

The Rule Or Law?

An interesting aspect of this case is whether the singular finding that a respondent has violated a FINRA rule is sufficient, absent more, to impose liability and sanctions.  What if the FINRA rule itself is of dubious legitimacy? As characterized in the FINRA Decision:

Enforcement argues that if Schwab's Waiver contradicts and violates FINRA's Rules then the analysis ends there - sanctions must be imposed. According to Enforcement, the FAA is irrelevant. To the contrary, Schwab argues, even if the Waiver contradicts and violates FINRA's Rules, the FAA applies and forecloses enforcement of the Rules. According to Schwab, the FAA requires that Schwab's arbitration agreement, including the new Waiver, be given effect. 

Stop In The Name Of Law (The Supremes)

In the seminal decisions in Shearson/American Express Inc. v. McMahon (482 US 220, 1987) and Rodriguez de Quijas v. Shearson/American Express, Inc. (490 US 477, 1989) the United States Supreme Court refused to carve out an exception for the arbitrability of securities law claims under the FAA and found that predispute agreement to arbitrate claims under the Securities Act of 1933 are enforceable and resolution of the claims only in a judicial forum is not required. Moreover, the Court held that the FAA establishes a federal policy favoring arbitration, requiring that the courts rigorously enforce arbitration agreements and imposed a burden on the party opposing arbitration to show that Congress intended to preclude a waiver of judicial remedies for the statutory rights at issue based upon arguments found on the statute's text, history, or purposes. In AT&T Mobility LLC v. Concepcion (US Supreme Court, 2011), the Court found no exception that would preclude enforcement of arbitration provisions involving class actions. 

Since the FINRA Hearing Panel was unable to find any Congressional intent to except arbitration from the FAA's coverage, it would not sustain FINRA's cause of action in that regard; however, as to the other issue before the panel - that of limiting arbitrators' right to consolidate or sever cases, Schwab's Waiver was found in violation for wrongly attempting to limit the power of FINRA's arbitrators.

The Big Bang

What prompted this whole mess?  What was the Big Bang that created this universe of a waiver and the ensuing regulatory action? That's a fairly simple answer. 

When AT&T Mobility LLC v. Concepcion (US Supreme Court, 2011) was issued in 2011 by the Supreme Court, the ruling overturned a 9th Circuit Court of Appeals (includes the federal district courts for California) decision that had held an arbitration agreement unconscionable and unenforceable. Notably, the 9th Circuit's decision was based upon Discover Bank v. Superior Court (30 Cal.Rptr.3d 76, 2005), a California Supreme Court decision that had held that class action waivers in consumer contracts of adhesion are unenforceable, whether the consumer is being asked to waive the right to class action litigation or the right to classwide arbitration. 

The so-called Discover Bank Doctrine effectively prompted  California courts to find consumer arbitration agreements containing class action waivers unconscionable and unenforceable -- in essence, we wound up with a pubic policy exception to the FAA. In rejecting this state court inroad in Concepcion, US Supreme Court would not permit the blanket prohibition of requiring class actions to be arbitrated. 

Given that Schwab is headquarted in California and subject to the application of the Discover Bank Doctrine, the firm quickly sought to implement the newly enunciated Concepcion holding. Accordingly, Schwab sought to amend its customer agreements to timely reflect the US Supreme Court's holding, which it viewed as supportive of the language in its Waiver.