Has Schwab Opened Pandora’ Box for RIAs?

Schwab’s recent victory upholding its class action waiver provision in its customer contracts raises a number of potential issues for fiduciaries, especially since most B/D’s can be expected to follow suit with similar provisions if Schwab’s waiver provision withstands the anticipated appellate review.  In most cases, broker-dealers (B/D’s) are not held to a fiduciary standard, so actions that they take may not raise the same fiduciary concerns that such actions may raise for RIAs.

After the Schwab decision was announced, I had a number of clients call me and ask me what, if any, ramifications would it have on them. Many of the callers suggested that anything Schwab did should not have any ramifications on them since they could not control Schwab’s actions. While this is certainly true, it does not follow that RIAs and other fiduciaries can ignore potential implications of the class action waiver.

Fiduciary law is based primarily on trust law and agency law.  The fact that RIAs are fiduciaries is clearly established by law. As fiduciaries, RIAs owe their clients a duty of loyalty, a duty to always put the clients interests first and to disclose any actual or potential conflicts of interest.

RIAs routinely maintain relationships with B/D’s. In some cases, RIAs receive soft dollar benefits from B/D’s in exchange for the RIA’s recommending that the client open or maintain a custodial account with the B/D. These soft dollar arrangements often involve the B/D providing an RIA with research and/or money for office provisions.

The right to participate in a class action is a potentially important legal right for many investors.  Class actions have long been criticized on many fronts, including the potential to bring frivolous lawsuits and using leverage to force defendants to settle actions rather than bear the financial burden such actions often create.

As a trial attorney, I feel compelled to point out that in many cases, class actions are the only realistic opportunity that those whose rights have truly been violated have to seek redress for such wrongs.  The costs of litigation can effectively prevent some victims from pursuing claims unless they can pursue a class action.

Like it or not, the law says that there shall be a right for every wrong, whether in law or equity. As is often the case, people do not care about inequitable treatment  or unjust laws until and unless it involves them or their family. Professional prejudices aside, denying the public access to the legal system flies in the face of fundamental rights guaranteed by the Constitution.

OK, I’m off the soap box.  Back to the issue at hand, the potential implications of a class action waiver provision in B/D customer contracts.  In my opinion, an RIA that knowingly recommends that clients open or maintain an account with a B/D that requires that customers waive their legal rights, including an important legal right such as the right to participate in class actions, may very have violated their fiduciary duties. The situation should definitely concern RIAs.

I can already hear the argument that “I’m not an attorney, so I cannot give legal advice.” With all due respect, that is not the point.  Giving up a legal right is an important issue. Both federal and state RIA laws prohibit any advisory contract that requires a client to give up any legal right. RIAs can put in certain clauses that address a client’s legal rights. However, any RIA that chooses to do so must include “clear and conspicuous” language stating that such language is not meant as a waiver of a client’s legal rights.

Supporters of the waiver provision will argue that a client can simply choose not to open an account with a B/D that requires a class action waiver provision or, if their RIA only works with B/D’s that use such a provision, the client can find another RIA. Is that really what RIAs want?  RIAs work so hard to find clients and develop strong client relationships as it is.

If the Schwab provision is upheld on appeal, it is reasonable to assume that other B/D’s will adopt similar provisions in order to protect themselves.  If so, would clients really have a choice? Common sense would suggest that a few B/D’s would not follow suit for marketing purposes and to grow their own business, but due diligence review may raise other fiduciary issues for RIAs and/or clients. Would it be in an RIA’s best interests to work with more than one B/D, one of whom would be a B/D that does not require clients to waive their legal rights?

To me, the strongest case against RIAs who recommend B/D’s that adopt the class action waiver provision would be situations where the RIAs receives some sort of benefit from the B/D, such as common soft dollar benefits like research and money for office needs.  Schwab has their popular annual IMPACT conference.  an argument can be made that any RIA that recommends that their clients agree to the class action waiver and also receive any sort of discount on travel, lodging, etc. in connection with such a conference has violated their fiduciary duty to their clients, both in terms of the “exclusive interests” rule and the conflict of interests rule.

I obviously do not know how the Schwab case will be resolved.  My point is that RIAs and other fiduciaries need to monitor such cases and re-examine what, if any impact, such cases could have for them with regard to their obligations as a fiduciary.  As I always remind my clients, ignorance of the law is no excuse and, to quote my favorite fiduciary quote from the courts, “a pure heart and an empty head are no defense” to a breach of fiduciary claim.

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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2 Responses to Has Schwab Opened Pandora’ Box for RIAs?

  1. lynneacres says:


    This is a really good blog post!


  2. Interesting article. Permit me to comment on a few aspects of same.

    Most custodians that work with RIAs offer a range of services for RIAs, including access to trading platform, research, and online connections to facilitate reviewing of client account information. RIAs are seldom charged for these services. Instead, they are paid by clients, as part of the transaction fees charged for a mutual fund trade, for example. Hence, compensation flows to the RIA from the BD firm. While only part of this can be called “soft dollars” (technically), these benefits to RIAs must be disclosed on Form ADV Part 2A.

    An RIA’s choice of custodians to recommend to clients is an important decision. Best execution in stock trades is always an issue (though not as big an issue as regulators think, for most firms). The amount of transaction fees charged by mutual funds is also a factor. The quality of BD monthly statements, tax reporting, accuracy in establishing accounts, fees for wire transfer or other services, are all additional factors in the selection of the custodian. Of course, the custodian’s financial strength is a key concern, as well as the availability of private insurance in the event of BD default (the foregoing being larger issues after the Bear Stearns and Lehman Brothers collapses, and continued concerns over mark-to-market avoidance and the continued concerns over the level of capital of many investment banks/BDs).

    The author, a securities litigation attorney, opines that recommending a BD which requires a waiver of legal rights (in this case, the right to join a class action against the BD) may violate the RIA’s fiduciary duty. Does this opinion withstand scrutiny?

    Generally, under the law an RIA possesses three major fiduciary duties – that of due care, undivided loyalty, and utmost good faith. In this instance, undertaking “due diligence” on choice of custodian is an important function of the RIA, and certainly implicates fiduciary duties. But is the restriction of the legal rights of a client just one of many factors in undertaking the recommendation, or is this single aspect of the relationship so important that it involves crossing the Rubricon for an RIA, with respect to observing its (or his or her) fiduciary duty to the client.

    As noted by the author, the waiver of the right to participate in securities class actions is potentially the waiver of an important right. There have been many instances of BD practices being subjected to class action claims. And, as the author suggests, individual claimants could not likely afford to pursue an action, without joinder in such a class action. For example, the Schwab YieldPlus settlement was for $200,000,000 in total settlement funds (including payment of attorneys fees); it is doubtful that many individual investors would have pursued individual claims against Schwab, except for those with very large investments in the fund. Also, a pending class action claim, involving the alleged recordation by Schwab of client telephone calls without customer consent, may be affected by the recent decision upholding the use of the waiver of class action securities litigation provision.

    Unlike a private cause of action, which BDs may compel arbitration for as well (and nearly all so do), the denial of a class action claim participation effectively – at least for most customers of the BD, and in most instances of BD misconduct subject to class action claims – denies the customer the ability to seek redress. The costs of arbitration, relative to the damages suffered by each individual customer, simply do not merit the bringing of individual actions. This is the most troubling aspect of the waiver of the right to bring a class action right. While not a de jure denial of the right to seek redress (arbitration is still an option), for most customers of the BD the waiver operates as a de facto denial, due to economic concerns.

    In a letter to Schwab, the Commonwealth of Massachusetts’ Secretary of State opined that the recent ruling upholding Schwab’s waiver, “is akin to giving every rogue broker the green light to steal from their clients in small amounts.”

    While not directly on point, another letter from the Massachusetts Secretary of State is noteworthy. It has been recently asserted by state securities regulators, in a letter to the SEC from Secretary Galvin, that RIAs who place mandatory arbitration provisions in their own contracts may be violating their own fiduciary duties, stating: “a clause binding an investor to arbitration before the circumstances are known may not be in the client’s best interest nor consistent with the advisor’s fiduciary duty.” Many state securities regulators have long taken the stance that arbitration agreements in RIA contracts breach the fiduciary duties of the RIA.

    I would also note that Dodd-Frank provides the SEC with authority to prohibit pre-dispute arbitration clauses, if the SEC finds that it is in the public interest and for the protection of investors.

    Yet, under the Federal Arbitration Act, we have a national public policy which promotes alternative dispute resolution. Arbitration serves many purposes. Unfortunately, some of these purposes are not always good. In fact, industry-controlled arbitration, as exists with FINRA, has a history of abuses of participant rights, and may in fact be contrary to the fiduciary duties of an RIA if required by RIAs in their fee agreements. (Hence, a good reason for all RIAs to avoid submitting clients to FINRA arbitration (as opposed to the use of an independent arbitration organization), if they impose arbitration mandates at all.

    The U.S. Supreme Court recently heard arguments in a case (AmEx) that could determine the extent to which companies might rely on arbitration clauses to fend off class action lawsuits. Consumer advocates claim the clauses give unfair advantages to companies, and effectively deny consumers the right to bring claims. But in recent years, the Supreme Court has upheld the enforcement of mandatory arbitration clauses under the Federal Arbitration Act, which was intended to encourage their use. However, I would note that this case does not involve fiduciary duties.

    So, back to the question – will an RIA violate its fiduciary duty if it recommends a BD which has in its agreement a binding clause waving the right to participate in class action suits (and instead arbitrate claims individually)?

    At the minimum, I would suggest that the BD’s agreement term is a significant factor in the RIA’s recommendation of the BD. If other BDs exist which offer the same quantity and quality of services, without imposing such a restriction on the legal rights of the RIA’s client (the BD’s customer), then such an effective (de facto) denial of rights to redress may well result in the RIA’s choice to be another BD (custodian) without such a restriction.

    Under the RIA’s fiduciary duty to disclose all material facts, this also appears to be a fact that must be disclosed to the client. Especially given the fact that an inherent conflict of interest exists, because the RIA is receiving compensation (in the form of services) provided by the custodian which are paid for by client funds.

    But, the issue remains, is this such an important waiver of rights that the RIA should not recommend the BD under any circumstances? I cannot reach that conclusion. For example, what if the quality and pricing of the custodian’s services are so exceptional (and so beneficial to the client) that these benefits are perceived to outweigh the potential recovery (measured by likelihood of class action claims, and likelihood of the amount recovered) in future class action claims? There is, of course, a great deal of uncertainty in undertaking such a projection.

    What if other custodians (such as TD Ameritrade, Fidelity, etc.) follow suit and add similar clauses to their agreements? Must RIAs then choose to work only with smaller custodians, who may possess (although not necessarily the case) less quality or quantity of services for the fees paid by the client, or who may be (although not necessarily so) less financially strong?

    Hence, I reach a somewhat different conclusion than the author. I would suggest that RIAs consider, as a strong and SUBSTANTIAL factor in the selection of the custodian to recommend to the RIA’s new clients, the existence of this waiver of the right to participate in class actions, given the very real impact it may possess upon the client at some future time. Some RIAs may well conclude, especially in situations where there is a “close call” between the use of one custodian versus another, that they should go with the custodian who does not impose such a mandatory waiver of the right to participate in class actions.

    I would also suggest that all RIAs considering enhancing their disclosures in their Form ADV, Part 2A, to inform clients that such a waiver of legal rights is mandated by certain recommended custodians, and that not all custodians possess such waivers. Also that class actions against BDs for misconduct are somewhat frequent, and often result in recoveries of funds for customers (albeit in relatively small amounts, per customer, in most instances). Also that it is highly unlikely that the client would pursue the legal rights which are effectively waived, such as by bringing a private (individual) arbitration proceeding.

    What about existing clients who already have accounts at such a custodian? I would suggest a timely Form ADV Part 2A amendment, with the Statement of Material Changes sent to the client and accompanied by a letter to the client explaining the situation in more detail.

    I would also urge the discussion of this issue to continue. What historic data exists as to the amount of recovery, by individual customers of a BD, in class action settlements? If such settlement amounts are found, through research, to be quite large (on a per-customer basis), RIAs may well feel compelled to only work with custodians who do not possess waivers of class action claims – as long as such qualified custodians exist. In other words, while I conclude, for now, that the existence of such a waiver is a strong and substantial factor in the RIA’s recommendation of a custodian to a client, I can be swayed by historical data demonstrating that the waiver could substantially harm the client. Hence, I don’t necessarily disagree with the author’s conclusion. I only opine, for now, that – at a MINIMUM – the existence of such a waiver clause is a significant and substantial factor which should be considered in the RIA’s recommendation of a custodian to the client.

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