Alert January 19, 2010

Federal District Court Upholds Arbitration Clause in Investment Advisory Contract

The U.S. District Court for the District of Minnesota upheld inclusion of a mandatory arbitration clause in an investment advisory contract.  An investor who had executed investment services contracts with a registered investment adviser to receive a financial plan and subsequent annual updates to the plan filed a class action suit against the adviser stating various causes of actions under state law and the Investment Advisers Act of 1940 (the “Advisers Act”) based on allegations that the investor never received a financial plan or updates.  The adviser moved to compel arbitration under the terms of the agreements executed by the investor, which generally require arbitration of any controversy or claim arising out of or relating to the investment services agreements or their breach, and specifically preclude class action claims against the adviser.

Standard of Review.  The Court noted the strong federal policy in favor of arbitration expressed in the Federal Arbitration Act, which permits a party to petition a federal district court for an order compelling arbitration of a dispute covered by an agreement to arbitrate.  The Court articulated the applicable standard of review as requiring it to determine whether there is a valid agreement to arbitrate between the parties and if so, whether the dispute falls within the scope of that agreement, with any doubts concerning the scope of arbitrable issues to be resolved in favor of arbitration and the party resisting arbitration bearing the burden of proving that the claims at issue are unsuitable for arbitration.  The Court found there to be no dispute that each investment services agreement contains an arbitration clause and that the investor’s claims fall within the scope of those arbitration clauses.  The investor, however, argued that including the arbitration clause in the investment services agreement was itself improper because (a) the adviser was also a member of the Financial Industry National Regulatory Authority (“FINRA”) whose rules prohibit arbitration of putative class actions, (b) an SEC staff position and Supreme Court precedent prohibit enforcement of the arbitration clause and (c) arbitration does not offer the equitable relief sought by the investor.

Applicability of FINRA Rules.  The Court rejected the investor’s argument that FINRA rules applied to the adviser and prohibited the arbitration clause in question.  Pointing to the fact that the adviser was also registered as a broker-dealer and interpreting the investment services agreement to contemplate that the adviser’s representatives might buy and sell securities on an investor’s behalf and receive related compensation, the investor claimed that FINRA rules applied because the adviser’s representatives’ interaction with clients included broker‑dealer activities triggering the application of FINRA rules.  The Court found that the investment services agreement created no binding purchase/sale obligation for either party that would cause the adviser to necessarily act as a broker-dealer in providing investment advice.   The Court also noted that the nature of the claims asserted by the investor related to investment advisory activities, which fall outside FINRA’s jurisdiction.

Arbitration Clauses in Investment Advisory Agreements.  The investor also argued that McEldowney Financial Services,  SEC No-Action Letter (pub. Avail. Oct. 17, 1986)( arbitration clause in advisory agreement should disclose that it does not constitute a waiver of any right provided by the Advisers Act, including the right to choose the forum, whether arbitration or adjudication, in which to seek resolution of disputes) and Wilko v. Swan, 346 U.S. 427 (claims under the Securities Act of 1933 were not arbitrable) precluded an investment advisory contract from including a mandatory arbitration clause.  Citing Rodriguez de Quijas v. Shear-son/Am. Express, Inc., 490 U.S. 477 (1989), which expressly overruled Wilko, the Court held that neither McEldowney, which cited Wilko, nor Wilko precluded compulsory arbitration of the investor’s claims.  

Equitable Relief in Arbitration.  The Court also rejected the investor’s argument that arbitration should not be compelled because an arbitrator cannot grant the equitable relief sought.  The Court noted that the rules of the American Arbitration Association permit equitable relief and that the Supreme Court had rejected similar arguments in Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (1991).

Disposition.  The court granted the adviser’s motion to compel arbitration and dismissed the investor’s complaint without prejudice.