Arbitration Clauses in Investement Advisor Agreements McEldowney Still Rules

On August 21, 1986, a registered investment advisor named William James McEldowney wrote a letter to the SEC that posed the following question:

I am a Registered Investment Adviser and am intending to put into my Advisory Agreement the following arbitration clause:

Any controversy or claim arising out of or relating to this contract, or the breach thereof, shall be settled by arbitration in accordance with the Commercial Arbitration Rules of the American Arbitration Association, and judgment upon the award rendered by the arbitrator(s) may be entered in any court having jurisdiction.

I would appreciate your advising me as to whether the Commission would have any objection to our using the above clause in our Registered Investment Adviser Contract, which is signed by our clients.

Thank you for your attention to this matter.

The SEC objected to the above arbitration clause under the following rationale:

Under the Clause as presently written, prospective advisory clients may not be aware that they may have a non-waivable right of action under the Investment Advisers Act of 1940 ("Act"). Because the Clause may mislead clients to believe that they are barred from exercising their rights under the Act, the Clause, in our view, may violate the antifraud provisions in Section 206 of the Act. We believe that McEldowney Financial Services' investment advisory contract should disclose that the Clause does not constitute a waiver of any right provided by the Act, including the right to choose the forum, whether arbitration or adjudication, in which to seek resolution of disputes.

Interestingly, the SEC has not spoken on the subject of arbitration clauses in investment advisor agreements since McEldowney. And if an investment advisor were to write a letter to the SEC today making the same inquiry as McEldowney did thirteen years ago, the SEC would refer the advisor to McEldowney for the SECs current view of the situation.

Obviously, for an advisor to do what the SEC suggested and insert a sentence to the effect that the arbitration clause does not waive the clients right to choose the forum, i.e. sue in a court of law - well, that defeats the whole purpose of a binding arbitration clause. Why put the clause in at all? The required language makes the arbitration clause pointless. Parties can always agree to binding arbitration on their own initiative, regardless of whether or not there is reference to arbitration in the contract.

In addition, the SECs response implies that the Investment Advisors Act allows for clients to choose their forum, i.e. sue in a court of law. It does not. The Investment Advisors Act makes no reference to suing in court or in arbitration, although it does specifically addresses investment advisory contracts. And the closest Section 206 comes to supporting the SECs position is in its prohibition from engaging in any act, practice, or course of business which is fraudulent, deceptive, or manipulative. A rather amorphous phrase to constitute such specific authority.

Then why did and does the SEC discourage the use of arbitration clauses by investment advisors? In a footnote to the no-action letter, the SEC cites Section 215(a) of the Act, which states:

(a) Waiver of compliance as void

Any condition, stipulation, or provision binding any person to waive compliance with any provision of this subchapter or with any rule, regulation, or order thereunder shall be void.

Therein lies the rub. The SEC apparently believes that a binding arbitration provision potentially waives a clients right to have issues adjudicated arising under the Investment Advisors Act. An argument certainly can be made that McEldowneys binding arbitration clause does not limit a clients rights under the Investment Advisors Act, particularly in view of the fact that the Act is not even referenced in his clause. Further, assuming the client hires an attorney with half a wit, surely the attorney would discover Section 215(a) of the Act which preserves a clients rights under the Investment Advisors Act. But again, those rights do not include filing a claim in court.

It would seem that the SEC could have accomplished its objective of preserving clients rights under the Investment Advisors Act by simply requiring Mr. McEldowney to tack onto the end of his arbitration clause:

This binding arbitration clause in no way limits or affects the clients rights under the Investment Advisors Act.

That way, advisors clients could be compelled to go to arbitration, as opposed to court, and the SECs concerns about waiver of rights under the Investment Advisors Act would be accommodated.

A year after McEldowney, the United States Supreme Court sanctioned the use of binding arbitration clauses in brokerage firm customer agreements. And in the decade that followed, more and more industries adopted binding arbitration clauses as a way of resolving disputes. Registered Investment Advisors have been left behind. Until the SEC changes the views expressed in McEldowney, investment advisors, even state-registered only advisors, are well advised to steer clear of binding arbitration clauses, lest they subject themselves to the full panoply of enforcement powers under the Investment Advisors Act. Although most states courts judges view arbitration favorably, there is also a strong policy of deference to the SEC, and a state court judge might easily overturn a binding arbitration won by the advisor in light of the McEldowney no action letter. Though it stands on shaky ground, McEldowney still rules.





Ms. Stoneman


AUTHOR 

&

SECURITIES ARBITRATION ATTORNEY


Ms. Stoneman is located in Colorado and Texas, although she represents clients all over the country. Arbitrations are unique in that everything that happens takes place online, over the telephone or through the mail. Travel is required only if the case proceeds to arbitration, and most cases settle. So just because you live in Ponca City, OK, that doesn't mean you have to find a securities lawyer there!
Ms. Stoneman maintains a small firm because she recognizes that for many, even hiring a lawyer can be intimidating. Rather than shuffling you to a junior, less experienced attorney, as some attorneys do, Ms. Stoneman is accessible at virtually all times and will be the only person handling your case.
Ms. Stoneman began representing investors and stockbrokers with claims against their brokerage firms in 1992. Ms. Stoneman has handled some of the largest securities arbitrations against Prudential Securities, Paine Webber and Raymond James, yet she also handles significantly smaller cases. Ms. Stoneman takes cases on an hourly basis or a contingent fee basis. She will also agree to unique, hybrid fee arrangements in order to accommodate the needs of the client - the choice is yours. Ms. Stoneman also represents stockbrokers who have claims against their brokerage firms for such things as wrongful termination and defamation on the U-5 regulatory form.
 


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