An Interesting Twist Where Broker-Dealer Seeks To Enjoin Customer From Arbitration In FINRA And Is Denied By The Second Circuit

An interesting case that securities arbitration attorneys should find ironic. In the case of UBS Financial Services, Inc. v. West Virginia University Hospitals, Inc., decided on September 22, 2011, the Second Circuit upheld the decision of the district court to dismiss a motion to enjoin arbitration in FINRA filed by a FINRA member, UBS, against its customer.

Although the more typical case involves a customer filing a securities fraud action in court, and having the defendant move to enforce an arbitration agreement, and remove the case to FINRA, in this recent case the tables were turned. Instead, it was the customer, West Virginia University Hospitals (WVUH) who wanted to bring an action against UBS in FINRA arbitration, and UBS fought tooth and nail to try to get it thrown out of arbitration and into court.

The case deals with auction rate securities (ARS), which UBS persuaded WVUH to use as the vehicle for a large financing project, where UBS would serve as both the underwriter and the broker-dealer in the auction services. Unknown to WVUH, UBS, as the broker-dealer, would place additional bids on all its auctions to make sure they did not fail, which concealed the true risks of liquidity of this made-up market which collapsed in February 2008 during the financial crisis. This collapse caused WVUH to have to pay much higher interests rates on the debt until it could refinance several months later.

Therefore, WVUH filed an arbitration Statement of Claim against UBS, alleging that UBS had violated the Securities Exchange Act of 1934 and the Uniform Securities Act by advising WVUH to issue ARS while withholding critical information about the ARS market and UBS’s role. Further, WVUH alleged that UBS fraudulently induced it to purchase auction services, while UBS withheld critical information about the ARS market and UBS’s role. Interestingly, in all the agreements between the parties there were no documents which contained an arbitration clause, and none referred to any provisions of the FINRA code.

UBS is a member of FINRA, and as such when it joined it agreed to comply with FINRA’s rules. One of those is Rule 12200 of the FINRA Code, which obligates UBS to arbitrate a dispute with a “customer” at the customer’s demand, if the dispute arises “in connection with” the business activities of the member. This is the rule WVUH used to initiate arbitration. UBS argued this rule did not apply because WVUH was not a “customer,” but the Second Circuit determined, as a matter of law, that WVUH was a customer of UBS when it served as a broker-dealer for the ARS auctions. The court further determined that a “customer” is a non-broker or non-dealer who purchases, or undertakes to purchase, a good or service from a FINRA member.

This case is interesting for all securities arbitration attorneys to note, because it turns the tables on the normal considerations in FINRA arbitration cases. Normally FINRA arbitration is seen as a shield for the broker-dealers, who invoke their arbitration clauses to stay away from the court. However, as this case demonstrates in certain instances customers who wish to can use this FINRA rule as a sword to compel a FINRA member into arbitration even without an arbitration agreement in place, if they so desire.

Will The Dodd-Frank Wall Street Reform Act Make FINRA Arbitration Obsolete?

The Dodd-Frank Wall Street Reform Act shows a congressional dislike for mandatory arbitration provisions, to say the least. This Act, which was signed into law on July 21, 2010, by President Barack Obama, contains many provisions which could lead, after study, to the prohibition or limitation on these boilerplate clauses in consumer contracts. This includes arbitration provisions in client agreements with broker dealers that cause many securities fraud causes of action to be arbitrated at FINRA at this time.

Widespread Prevalence of These Arbitration Clauses

Statistically, just about everyone in the United States has knowingly, or unknowingly, agreed to a boilerplate mandatory arbitration clause in the contracts or agreements we enter into day in and day out. Some of the most common are those contained in credit card agreements, for example, in which you’ve agreed to take any disputes to arbitration instead of going to court.

The Problem with Mandatory Arbitration Provisions

Arbitration is an alternative way to resolve legal disputes outside the judicial system. Using this method a neutral third party is supposed to hear both sides of the story and then make a binding decision. When arbitration was first introduced in this country it held the promise of improving the dispute process by speeding it up, making it cheaper, and keeping parties from jumping through some of the legal hoops involved in going to court. Arbitration, when conceived, however, imagined two parties of approximately equal bargaining power voluntarily choosing to use the process. That is no longer the case.

Over the years big business has begun inserting these mandatory arbitration provisions in just about every contract they can think of. They’ve done this because they’ve figured out that these arbitration provisions tend to give them the upper hand over consumers in dispute resolution. For instance, there is no jury, no public trial, little to no review by the courts, and instead of going to your local courthouse the arbitration can be located hundreds of miles away from where you live. What makes this worse is that consumers cannot negotiate these provisions, but it is take it or leave it. That assumes, of course, that we even know the fine print clause is in the document, or understand its legal implications to begin with.

Mandatory Arbitration in the Context of Securities Fraud

Arbitration provisions have also creeped into many customer account agreements between customers and their brokers, often without the customer being aware of the provisions existence, and/or unaware of its legal implications. These agreements are typically signed when a customer first begins a relationship with a broker, and agrees that any future disputes between the party, meaning things that have not even happened yet, will be subject to arbitration by the Financial Industry Regulatory Authority (“FINRA”).

The mandatory arbitration provisions in these agreements have been just as controversial as those in credit card and other consumer agreements. Some of the criticisms leveled against FINRA arbitration include that it is biased in favor of the broker dealer, because one of the three arbitrators on the panel is from the securities industry. Further, the broker dealers themselves are the people who make up the membership of FINRA, so is FINRA really going to bite the hand that feeds it? There are those, of course, from the securities industry themselves who defend the FINRA arbitration process [link to SAM article: what is FINRA arbitration?] saying it is speedy, less expensive and fair. However, as hard as many brokers and securities firms fight to enforce these arbitration provisions, and avoid court, critics may just have a point about who is most favored between the brokers and the customers.

The Dodd-Frank Act’s Potential Blow to FINRA Arbitration

It seems Congress may finally be waking up to some of these criticisms, and showing a willingness to investigate the issue further. The language related to FINRA arbitrations in the Dodd-Frank Act is found in Section 921, which confers authority on the SEC to make rules that limit or prohibit these provisions between customers and broker dealers or investment advisors.

Specifically, the section states:

The Commission, by rule, may prohibit, or impose conditions or limitations on the use of, agreements that require customers or clients of any broker, dealer, or municipal securities dealer to arbitrate any future dispute between them arising under the Federal securities laws, the rules and regulations thereunder, or the rules of a self-regulatory organization if it finds that such prohibition, imposition of conditions, or limitations are in the public interest and for the protection of investors.

Currently Arbitration Clauses Are Legal and Common In Securities Fraud Cases

Of course, the Act’s language does not currently prohibit such arbitration provisions in customer agreements, and therefore the industry still includes them as standard at this time. Unless and until the SEC creates a contrary rule these mandatory arbitration provisions continue to be valid and enforceable, as a general rule.