Third Circuit Affirms Right to FINRA Arbitration, Widens Circuit Split

The U.S. Court of Appeals for the Third Circuit recently ruled that a broker cannot avoid FINRA arbitration with a customer through contractual forum selection clause that fails to specifically mention arbitration (Reading Health v. JP Morgan, No. 16-4234 (3d Cir. Aug. 7, 2018)). The court’s opinion denying the company’s appeal widens an existing circuit split on the issue of contractual forum selection clauses superseding FINRA’s mandatory arbitration rules.

Under FINRA Rules 12200 and 13200, disputes arising between a FINRA member and its associated persons or customers must be arbitrated through the FINRA arbitration process. In the Third Circuit case, the customer had filed a statement of claim with FINRA in relation to various auction rate securities (ARS) offerings the company had underwritten. The broker refused to arbitrate, and the customer filed in the Eastern District of Pennsylvania seeking to compel arbitration.  The customer won at the district court level, and the broker appealed based on a forum selection clause in its broker-dealer agreements that stated:

The parties agree that all actions and proceedings arising out of this Broker-Dealer Agreement or any of the transactions contemplated hereby shall be brought in the United States District Court in the County of New York and that, in connection with any such action or proceeding, submit to the jurisdiction of, and venue in, such court.

This clause, the broker argued, supersedes FINRA Rule 12200. The Third Circuit disagreed, and sided with the customer. According to the decision, the forum selection clause did not implicitly waive the customer’s right to FINRA arbitration. Specifically, a customer must affirmatively know the rights it is waiving. In the present case, the court noted that the specific clause was silent on the issue of FINRA arbitration.

… any reference to arbitration is “[c]onspicuously absent from” the forum-selection clauses. Without a specific reference to arbitration, the forum selection clause requiring parties to litigate actions “arising out of” the contract and related transactions lacks the specificity required to advise [customer] that it was waiving its affirmative right to arbitrate under FINRA 12200… had [the broker] wanted [customer] to waive its right to arbitrate, it should “have made a reference to arbitration” in either the waiver provision or forum selection provisions of the broker-dealer agreements.

Additionally, the court cited a “strong federal policy… favoring arbitration” under the Federal Arbitration Act. Finally, the court noted public policy reasons for finding this clause insufficient in waiving a customer’s right to arbitration.

… we are reluctant to find an implied waiver here. [customer]’s right to arbitrate is not contractual in nature, but rather arises out of a binding, regulatory rule that has been adopted by FINRA and approved by the SEC. By condoning an implicit waiver of [customer]’s regulatory right to arbitrate, we would erode investors’ ability to use an efficient and cost effective means of resolving allegations of misconduct in the brokerage industry and thus undermine FINRA’s ability to regulate, oversee, and remedy any such misconduct.

Notably, this decision aggravates an existing circuit split on this issue (which the court summarizes in its opinion). In similar reasoning the Fourth Circuit ruled against a similar forum selection clause (UBS v. Carilion Clinic, 706 F.3d 319(2013)), while the Second (Goldman v. Golden Empire Schools Financing, 767 F.3d 210(2014)) and Ninth Circuits (Goldman v. City of Reno, 747 F.3d 733(2014)) have upheld form-selection clauses nearly identical to the one at issue in the most recent Third Circuit case.

In both the Third and Fourth Circuit cases, however, it appears that a customer may contractually waive its arbitration rights, if the waiver is explicit. The Third Circuit denied an implicit waiver of arbitration because the relevant clause was silent on arbitration, meaning a more specific clause could conceivably be upheld. The decision out of the Fourth Circuit, which the Third Circuit cited in support of its decision, specifically stated: “At the outset, we agree with [Brokers] that the obligation to arbitrate under FINRA Rule 12200 can be superseded and displaced by a more specific agreement between the parties.”

Thus, FINRA members wishing to avoid arbitration with customers or associated persons could agree to contractually waive the obligation, provided the language is drafted correctly.

FINRA members should note, that this position is directly disputed by FINRA itself. In 2016, following the decisions from the Second, Fourth, and Ninth Circuits, FINRA released a regulatory notice addressing these cases, stating:

The holdings of these courts rest on the assumption 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. This assumption is inconsistent with the fact that the Exchange Act requires most broker-dealers to be members of FINRA and that FINRA’s rules are approved by the Securities and Exchange Commission (SEC), binding on FINRA member firms and associated persons, and have the force of federal law. FINRA rules are not mere contracts that member firms and associated persons can modify. (FINRA Regulatory Notice 16-25)

FINRA’s stance here is not new. In 2012, FINRA stated that employment agreements with associated persons requiring them to waive their rights to arbitrate disputes in FINRA forums may violate Rule 13200. In fact, in an Acceptance, Waiver and Consent that year (In the Matter of Merrill Lynch, Pierce, Fenner & Smith Incorporated, Respondent (AWC 2009020188101/January 25, 2012)), FINRA fined Merrill Lynch $1 million “for failing to arbitrate disputes with employees relating to retention bonuses. Registered representatives who participated in the bonus program had to sign a promissory note that prevented them from arbitrating disagreements relating to the note, forcing the registered representatives to resolve disputes in New York state courts.” Thus, FINRA members seeking contractual arbitration waivers from either its customers or associated persons, may subject themselves to possible “disciplinary action” from FINRA.

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About the Author: Nicholas Wendland

Well versed in global regulations for both securities (equities, options and bonds) and derivatives (futures/swaps) Nicholas Wendland draws on his extensive experience at the Financial Industry Regulatory Authority (FINRA) and the New York Stock Exchange (NYSE), as well as in private practice, to distill the nuances of federal securities, futures, and commodities laws and regulations, and help financial institutions advance their business operations in a highly regulated industry.

About the Author: Sandra D. Grannum

Sandra Dawn Grannum concentrates her practice on securities, broker/dealer arbitration, litigation, mediation and regulatory defense. She is co-chair of the Commercial Litigation Team.

Sandy has tried complex multimillion-dollar arbitrations before FINRA, AAA and JAMS across the country. She has represented brokerage firms, banks, clearing firms, and associated persons in over 60 arbitrations before the NASD and FINRA which have been tried through award. In addition, she has successfully pursued cases in state and federal courts and in adversarial proceedings before bankruptcy courts.

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