No Day in Court for Injured Investors

Investors who have been defrauded by their brokers often discover, too late, that they've given up their legal rights to have their claims heard in court. And now investors seeking redress for wrongdoing are facing even greater obstacles.

Rich Investors Pay Less for Financial Advice

Long used by brokerage firms, mandatory pre-dispute arbitration provisions are now popping up among investment advisers as well. And recent court decisions have given companies more leeway to limit customers' ability to pursue class-action lawsuits.

These provisions, typically buried in the lengthy customer agreements that investors sign when opening an account, dictate that any future disputes must be resolved in an arbitration forum rather than in court. In addition to blocking investors' access to courts, "the corporation gets to decide who the arbitration provider will be," says Christine Hines, consumer and civil justice counsel at Public Citizen, a consumer advocacy group. The arbitration proceedings are generally kept secret, and there's typically no ability to appeal, she says.

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Concerns are growing as courts bolster arbitration provisions. In a case involving American Express, the U.S. Supreme Court decided in June that a class-action ban could be enforced, even when a class action is the only economically feasible way for customers to bring a claim.

One major brokerage firm's attempts to expand the scope of its arbitration clause have helped fuel the debate over these provisions. In late 2011, Charles Schwab sent nearly seven million customers a revised account agreement with a new provision stating that customers waive their right to participate in class actions against the company, according to a complaint by the Financial Industry Regulatory Authority.

FINRA charged Schwab with violating FINRA rules governing conditions that can be included in customer agreements. A FINRA hearing panel ruled largely in Schwab's favor, saying that federal arbitration law trumps FINRA's rules. FINRA is appealing. Schwab said in May that it would voluntarily remove the class-action waiver "until the issue is resolved by the appropriate regulatory and/or court decisions."

For many individual investors with relatively small amounts of money at stake, a class action "presents the only reasonable avenue of recovery in cases of fraud by a broker-dealer," says Heath Abshure, Arkansas securities commissioner and president of the North American Securities Administrators Association. If Schwab prevails, he says, other brokerage firms will bar customers from pursuing class-action claims.

Best Interest for Whom?

Investment advisers' growing use of mandatory arbitration provisions also raises questions for investors. Unlike many brokers, advisers have a fiduciary duty to put clients' interests first. But forcing investors into arbitration may not be in their best interest. These requirements "could be viewed as limiting potential choices, and potentially better outcomes, for a client," says David Tittsworth, executive director of the Investment Adviser Association. Advisers should think about their fiduciary obligations before putting these clauses in their contracts, he says. Such provisions, Tittsworth says, are still relatively rare among larger advisers.

Consumer advocates and state regulators are pressing the Securities and Exchange Commission to exercise its authority, granted under the Dodd-Frank financial overhaul law, to restrict brokers' and advisers' use of mandatory pre-dispute arbitration clauses.

Investors, meanwhile, should read customer agreements carefully. If you see an arbitration requirement, you can ask to strike it out—though big brokerage firms may leave little room for negotiation. Before signing anything, check a broker's disciplinary record using FINRA's BrokerCheck tool at www.finra.org/brokercheck. Review an adviser's disciplinary history at www.adviserinfo.sec.gov.

Laise covers retirement issues ranging from income investing and pension plans to long-term care and estate planning. She joined Kiplinger in 2011 from the Wall Street Journal, where as a staff reporter she covered mutual funds, retirement plans and other personal finance topics. Laise was previously a senior writer at SmartMoney magazine. She started her journalism career at Bloomberg Personal Finance magazine and holds a BA in English from Columbia University.