Chapter 6

JurisdictionUnited States

Chapter 6

ADR in the Securities Industry

§ 6.01 Background of ADR in the Securities Industry

What makes alternate dispute resolution in the securities industry particularly important? As will be demonstrated in this chapter, the securities industry was an early adopter of the use of arbitration in employment related disputes, adopted arbitration on an industry-wide basis, and enforced it for employment related disputes on all of its employees who were required to register as agents who dealt in securities. Why did this industry embrace arbitration? As one commentator has noted, “the securities industry pursues uniform arbitration to lower the disputing costs associated with litigation and gain the benefit of expert decision making. But, the industry also seeks through arbitration to prevent full public viewing of some practices or episodes, to eliminate juries, to lower the possibility of punitive damage awards, and to prevent the establishment and publication of adverse precedent.”1

Compulsory arbitration of statutory and other employment related disputes may have reached its high water mark in the securities industry, before beginning to recede. In no other industry has arbitration been so universal or inescapable for large groups of employees who are not represented by collective bargaining agents. No other industry has been as zealous about establishing and amending arbitration plans to stay in tune with court decisions.

Yet, beginning in 1998, the securities industry has largely abandoned required coverage of statutory employment related disputes by pre-dispute arbitration agreements contained in U-4 Forms and one exchange, the Pacific, has abandoned coverage for all employment related disputes.2 While individual securities firms might still enter their own arbitration agreements with employees to cover these subjects, the author has seen no evidence of any widespread effort to do so. The industry regulates itself through self-regulatory organizations (SROs) such as the Financial Industry Regulatory Authority (FINRA). FINRA is the largest independent regulator for all securities firms doing business in the United States, overseeing nearly 4,570 brokerage firms, 163,325 branch offices and 630,850 registered securities representatives in 2011.3 Since the SROs are heavily influenced by member firms, it is unlikely they would have moved to voluntary post-dispute arbitration without the general approval of these firms. Ironically, at a time when many employers outside the securities industry are adopting compulsory arbitration over statutory employment matters and even pressing unions to compel their members to arbitrate such claims, the securities industry, which began the explosion in arbitration of statutory employment rights, is now moving clearly away from that position.

Because the securities industry has used arbitration for so long and so intensively, many of the key court decisions impacting employees outside the securities industry as well as within it, arose out of securities industry disputes. For this reason, counsel and human resources managers outside the securities industry should not dismiss developments within that industry as unimportant to their clients or organizations. Accordingly, this chapter has been set aside to examine the legal history, status, and current developments surrounding alternate dispute resolution in this industry.

[1]—Early History of Arbitration in the Securities Industry

There is nothing new about arbitration at securities institutions such as the New York Stock Exchange, which has used arbitration to resolve disputes between its members since as early as 1817.4 In 1872, the Exchange opened arbitration to outsiders including the industry’s own employees.5 However, it should be kept in mind that the stock market of the nineteenth and early twentieth centuries was a place frequented by bankers, business people, and others who were financially sophisticated and who, in common with merchants, could be expected to be at home with resolving disputes within their club by arbitration. This was also a period of considerable judicial hostility toward arbitration.6

[2]—Self-Regulatory Organizations

Before examining the law regarding alternate dispute resolution in the securities industry, it is essential to understand how the industry is regulated and organized. The securities industry is heavily regulated. Pursuant to federal statute, national securities exchanges, security associations, and clearing agencies are required to register with the Securities Exchange Commission (SEC). These registered organizations are self-regulatory organizations, frequently referred to as SROs. These exchanges, associations, and agencies are subject to the SEC, which has oversight responsibility. The Commission has delegated the responsibility for the design of model arbitration systems to the SROs.

Although SROs by definition regulate themselves, their rules are subject to Commission review, approval, or rejection.7 The Commission must approve proposed rule changes if it finds them to be consistent with the requirements of the Act and the rules and regulations.8 The Commission also has power, by rule, to abrogate, add to, and delete from, the rules of an SRO to the extent it deems necessary and appropriate to ensure the fair administration of the organization.9

The term “self-regulatory organization” is defined by statute as “any national securities exchange, registered securities association, or registered clearing agency.”10 Self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) set rules for their members, including those employees who are engaged in the sale or trading of securities.11 The term “member” as related to any national security exchange is broadly defined and includes any person required to comply with the rules of the exchange.12

[3]—The Securities Industry Arbitration Scheme

The securities industry arbitration scheme is made up of three basic components: the rules of the self-regulatory organization; the Form U-4 and the Code of Arbitration Procedure. Taken collectively, until 1998, the scheme required all employees of the securities industry who must register under federal law to execute pre-arbitration agreements to accept arbitration as a means of resolving employment related disputes with their employers.

The first prong of this comprehensive scheme arises because pursuant to statute every employer dealing in securities requires any person associated with the member to register with an SRO and to be bound by its rules.13 This is because no registered broker or dealer may affect any transaction in, or induce the purchase or sale of, any security unless that person is registered or approved in accordance with standards of training, experience, competence, and other qualification standards established under the rules of a national securities exchange or securities association of which that broker is a dealer or member.14 The rules of the exchange or association that constitutes an SRO will spell out the scope of matters to be arbitrated.

The second prong is the requirement that employees who must register sign a form known as a U-4. An employee’s personal agreement to arbitrate is not found within the four walls of an SRO’s rules, but rather, in this separate U-4 form, executed between the individual and the SRO and not between the employee and the employer. The U-4 is a document that asks extensive background questions and is used in the employment process.15

The critical provision of the U-4, for purposes of this discussion, is the clause that requires an applicant who wishes to work in the securities industry, as a condition of employment, to agree to arbitrate any dispute or controversy (including, until 1998, statutory discrimination claims) between the individual and the firm that may be required to go to arbitration under the SRO’s rules, thus incorporating the SRO’s rules by reference. In 2010, the Supreme Court in Rent-A-Center, West v. Jackson16 further clarified the gateway questions of: 1) whether or not there is an extant, consensual and binding agreement to arbitrate the dispute and 2) who determines whether a binding agreement to arbitrate actually exists, the arbitrator asserted to have jurisdiction or a court? Rent-A-Center was a 5-4 decision, with a vigorous dissent. There is no reason to assume the decision would not be applied in the securities industry.

The Court first reaffirmed that the Federal Arbitration Act reflects the fundamental principle that arbitration is a matter of contract.17 It then observed that the delegation to the arbitrator provision in the case before the Court constituted an agreement to arbitrate threshold issues concerning the arbitration agreement and that the parties have the right to agree to arbitrate gateway arbitrability questions.18 The requirement that an agreement to arbitrate arbitrability must be “clear and unmistakable” pertains to the party’s “manifestation of intent,”—not to the agreement’s validity.19 The Court’s Prima Paint20 line of cases holds that only a challenge to the validity of the agreement to arbitrate, and not a challenge to the agreement as a whole, is for a court to determine. This is because the arbitration provision is severable from the rest of the contract.21

What the Rent-A-Center Court did was to establish that the basis of the challenge to the arbitrator determining arbitrability must be directed specifically to the agreement to arbitrate before a court may intervene.22 In the securities industry, the agreement to arbitrate would be contained in the U-4 Agreement. Challenges to the U-4’s arbitration provisions are unlikely to be successful.

The U-4 has been approved by the SEC23 and was adopted effective October 1, 1975.24 In 1993, the Commission recognized that claims based on allegations of age, sex, or race discrimination, or relating to sexual harassment...

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