Published February 27, 2013
U.S. retail investors may be losing one of the most effective tools in their arsenal to make sure their brokerages treat them fairly: the threat of class-action lawsuits.
A securities industry panel's decision last week to rule in favor of Charles Schwab Corp and against the Financial Industry Regulatory Authority, the industry regulator, allows the brokerage to prohibit investors from using class-action lawsuits to resolve disputes.
FINRA said late on Tuesday it would appeal the decision made by the disciplinary panel that its system established. The appeal will be heard by FINRA's own appellate body, the National Adjudicatory Council.
But if it is not successful in that effort, other retail brokers, such as Wells Fargo & Co, Bank of America Corp's Merrill Lynch and TD Ameritrade, could follow in Schwab's footsteps by forcing customers to waive their right to take part in class action suits. Spokespeople for those firms and others declined to comment or did not return calls.
Industry-wide class action waivers could give rise to bad behavior by some brokerages, said Adam Zimmerman, a law professor at St. John's University in New York. "What these waivers do is weaken the incentive to comply with the law," said Zimmerman, who has studied how class actions overlap with regulation.
If the bans are introduced across the brokerage community, they would not only mean a closed door for thousands of customers to join lawsuits to recoup small losses, but it would also eliminate one way in which regulators can monitor the industry for fraud.
While in many industries, class suits come after regulators launch an investigation, in the securities industry, it's not uncommon that the class action comes first, sometimes serving as the tip-off for the regulator to move in.
A regulator's follow-up probes can then result in fines, penalties and additional financial restitution for investors, beyond whatever small amount they may get from a class action settlement.
Since 1987, customer agreements with brokerages have typically required investors to arbitrate individual cases instead of filing lawsuits in courts. But investors, according to FINRA rules, have been allowed to join class action suits.
The decision handed down by the panel could save Schwab - and other U.S. brokerages that follow their lead - hundreds of millions of dollars in potential liabilities from such suits in the future, but lawyers and investor advocates say it would also leave investors more vulnerable to fraud.
As an industry-funded regulator, FINRA's structure for filing disciplinary cases means that it can, indeed, be overruled by its own hearing panel.
The three-member panel's decision can then be appealed to the regulator's National Adjudicatory Council, a 14-person group appointed by FINRA's board. Those rulings can be further appealed to the U.S. Securities Exchange Commission.
Grouping hundreds to thousands of aggrieved investors into a single lawsuit also helps make the case economically viable, as claims can often be too small for an individual investor to justify hiring a lawyer to file an arbitration, said Steven Caruso, a New York-based securities arbitration lawyer who represents investors. Many lawyers will not even take on individual cases for investors who have lost tiny sums.
A Schwab spokesman pointed to a small claims process at FINRA's arbitration forum where investors can file cases by paying as little as $50 in fees. The brokerage, he said, is willing to reimburse those investors for the fees.
Still, those fees apply only to filing paperwork and do not cover other legal expenses, say lawyers. Many investors do not want to represent themselves, they say, and individual small claims are not as efficient as a sweeping class action.
The retail brokerage industry says arbitration is a speedy, fair, and low-cost process for investors. "The only ones hurt by this ruling are the plaintiffs' lawyers," said a spokesman for the Securities Industry and Financial Markets Association, an industry group, in a statement.
To be sure, class action cases can often be frivolous and even abusive. They can mire companies in litigation that results in a few dollars each awarded to plaintiffs, but hefty fees for lawyers.
Class-action lawsuits in the past have cost brokerages hundreds of millions of dollars.
In 2006, for example, Edward Jones agreed to pay cash or give credits totaling $127.5 million to settle allegations it did not adequately disclose details of revenue sharing arrangements and discouraged brokers from selling rival funds that could have been better suited to investors. Revenue sharing is a way for brokerages to receive fees from certain mutual fund companies in exchange for promoting their products to investors.
Schwab itself agreed to pay the SEC $119 million in penalties in 2011 for misleading marketing of its high-interest YieldPlus money-market product over a two-year period. A class action filed in 2008, before the regulatory agreement, led to settlements of $235 million.
The Schwab ruling could send more people to group arbitration. The panel in the case did say Schwab violated FINRA rules by limiting the powers of arbitrators to consolidate individual arbitration claims into groups. Still, those cases do not have the expansive reach of a class action that can redress a wrong committed against thousands of customers.
Arbitration proceedings are also private and allow brokerages to avoid the public scrutiny that often comes with a public court case that garners media attention.
Efforts to limit class actions could give rise to a new wave of problem securities being peddled on Wall Street, said Scott Smith, a brokerage industry analyst at Cerulli Associates, a Boston-based research firm. "Circling sharks from the legal industry is, to some degree, a good thing," Smith said.
(Reporting By Suzanne Barlyn; Editing by Jennifer Merritt, Paritosh Bansal, Martin Howell and Leslie Gevirtz)