SEC Adopts Rule 15c2-2 Governing Binding Arbitration Clauses in Customer Agreements

I M P O R T A N T

Officers * Partners * Proprietors

TO: All NASD Members

BACKGROUND

On November 18, 1983, the Securities and Exchange Commission issued Release No. 34-20397 announcing the adoption of Rule 15c2-2 (the "Rule") under the Securities Exchange Act of 1934 (the "Act") (17 CFR Part 240). Rule 15c2-2 prohibits broker-dealers from using mandatory arbitration clauses in customer agreements that purport to bind public customers to the arbitration of claims arising under the federal securities laws. Those clauses, in the view of the Commission, are inconsistent with the deceptive practice prohibitions of Section 10(b) and Section 15(c) of the Act.

In adopting the Rule, the Commission reaffirmed its support for the use of arbitration as an important and effective means for resolving certain broker-customer disputes and as an economical alternative to litigation. The Commission explained, however, that public customers were intended by Congress to have the "special protection" of the federal courts for securities acts claims and that this protection may not be waived in advance by agreement of the parties. According to the SEC, the purpose of this Rule is to ensure that public customers are not misled concerning their right to such recourse. The Rule also requires broker-dealers to disclose to existing public customers that they are not precluded by such clauses from judicial recourse with respect to those claims. The Rule requires members to undertake certain compliance measures within the timeframes specified in the Rule. These measures are described in detail below.

COMPLIANCE WITH RULE 15c2-2

All agreements entered into by a broker-dealer and a public customer after the effective date of the Rule, December 28, 1983, are prohibited from containing clauses that purport to bind public customers to the arbitration of future disputes arising under federal securities laws. However, broker-dealers may use existing supplies of preprinted forms which may contain the prohibited language for new accounts provided that a separate written disclosure is provided to these customers using the language described in paragraph (b) of the Rule.

This separate written disclosure may be utilized until December 31, 1984, and must read as follows:

Although you have signed a customer agreement form with (FIRM NAME) that states that you are required to arbitrate any future dispute or controversy that may arise between us, you are not required to arbitrate any dispute or controversy that arises under the federal securities laws but instead can resolve any such dispute or controversy through litigation in the courts.

The Commission also believes that it is important for existing customers to be made aware that they are not required by prior agreement to resolve federal securities law disputes by arbitration. Therefore, paragraph (c) of the rule requires that existing customers be so notified. The separate written disclosure noted above must also be used in providing the notification to existing public customers.

All outstanding agreements need not be amended immediately. Those customers for whom a broker-dealer, after July 1, 1983, has carried a free credit balance, or held securities in safekeeping or as collateral, or has effected a securities transaction must be sent the required disclosure prior to January 1, 1985. Any other customers would have to be provided with the required notification only upon completion of their next transaction.

By January 1, 1985, all broker-dealer customer agreement forms must be revised and may not contain the mandatory arbitration clause.

On January 1, 1985, and thereafter, it shall be considered a fraudulent, manipulative or deceptive act or practice for a broker or dealer to enter into an agreement with any public customer which purports to bind the customer to the arbitration of future disputes between them arising under the federal securities laws, or to have in effect such an agreement, pursuant to which it effects transactions with or for a customer.

Please refer to the attached chart for Rule 15c2-2 compliance action and deadlines. The text of the rule follows.

Please direct any questions concerning SEC Rule 15c2-2 to Jean McNeill, at (202) 728-8286.

Sincerely

Frank J Wilson
Executive Vice President and General Counsel

Attachments

SEC RULE 15c2-2

NOTE: Active existing customers are defined as those for whom: a free credit balance was carried, securities were held as collateral or in safekeeping, or a securities transaction was effected after July 1, 1983.

federal register

SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-20397; File No. S7-976]

Recourse to the Courts Notwithstanding Arbitration Clauses In Broker-Dealer Customer Agreements

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

SUMMARY: The Commission is adopting a rule that prohibits broker-dealers from using predispute arbitration clauses in customer agreements that purport to bind public customers to the arbitration of claims arising under the federal securities laws. The rule also requires broker-dealers to disclose to existing public customers that they are not precluded by such clauses from judicial recourse with respect to those claims. The purpose of this rule is to ensure that public customers are not misled concerning such recourse.

EFFECTIVE DATE: December 28, 1983.

FOR FURTHER INFORMATION CONTACT: Robert A. Love, Esq., Division of Market Regulation (202-272-2792).

SUPPLEMENTARY INFORMATION: The Commission today announced the adoption of a rule that prohibits the use in broker-dealer customer agreements of provisions purporting to bind public customers to the arbitration of future disputes arising under the federal securities laws. The Commission's rule codifies its longstanding view that such clauses are inconsistent with the deceptive practice prohibitions of section.l0(b) [15 U.S.C. 78j(b)] and section I5(c) [15 U.S.C. 78o(c)] of the Securities Exchange Act of 1934 ("Act") [15 U.S.C. 78a et seq.]

Discussion

The Commission proposed rule 15c2-2 for comment in Securities Exchange Act of 1934 Release No. 19813 (May 23, 1983) 48 FR 24728 (June 2, 1983). The Commission reaffirmed in that release its support for the use of arbitration as an important means for the resolution of certain disputes between broker-dealers and their customers. For example, the Commission recognizes that the Uniform Code of Arbitration (the "Code"), drafted by the Securities Industry Conference on Arbitration (SICA) and adopted by the securities industry's self-regulatory organizations ("SROs"), provides an efficient procedure for the resolution of disputes and is often an economical alternative to litigation.¹

The federal securities laws, however, provide that broker-dealer agreements purporting to bind public customers to the arbitration of disputes arising in the future are void and unenforceable as applied to claims arising under those laws.²Wilko v. Swan, 346 U.S. 427 (1953), and subsequent cases have held that Congress had determined that public customers should have available the special protection of the federal courts for the resolution of disputes arising under the federal securities laws, and that under the anti-waiver provisions of those laws, that protection may not be waived in advance by contract of the parties. For example, in First Heritage Corp. v. Prescott, Ball & Turben, ³ the court noted that "[c]ourts have consistently held that Wilko's holding and rationale [under the Securities Act of 1933] are equally applicable to cases arising under the 1934 Act."⁴

In First Heritage Corp. the litigants were broker-dealers and members of the National Association of Securities Dealers, Inc. ("NASD"), which has rules providing for the arbitration of disputes between NASD members firms.⁵The court held, however, that section 29(a), the Act's anti-waiver provision, precluded enforcement of the predispute arbitration provision because the plaintiff broker-dealer also represented numerous public customers.

The Commission has received seventeen letters of comment regarding proposed rule 15c2-2. Those comments, which can be reviewed in file no. S7-976 in the Commission's Public Reference Room, and amendments to the proposed rule are address below.

Virtually all of the commentors on the proposed rule agreed that the statutory and case law clearly render unenforceable agreements to arbitrate future disputes between broker-dealers and their public customers arising under the federal securities laws. ⁶ Nethertheless as we have stated in earlier releases, many broker-dealer continue to include in standard customer agreements language substantially as follows:

Any controversy between us arising out of or relating to this agreement or the breach thereof, shall be settled by arbitration, in accordance with the rules, then obtaining, of either * * *.

In light of the clearly contrary law in this area, such language is a misleading statement of customers' rights under the federal securities laws. Because years of informal discussions have failed to correct this practice, the Commission has decided that it is appropriate to adopt this rule.

Paragraph (a) of the rule embodies the general prohibition that broker-dealers' customer agreements may not contain clauses that purport to bind public customers to the arbitration of future disputes arising under the federal securities laws. A violation of the rule requires both the existence of a deficient clause and a purchase or sale of securities. In response to those comments noting that courts often enforce predispute arbitration clauses for disputes under the federal securities laws involving such nonpublic customers as parties to international commercial disputes and members of the securities industry's SROs, the word "public" has been added to the paragraph before "customer" to clarify the intended scope of this rule. The term "public customer" has long been used in the Code and SRO arbitration pamphlets.

Paragraph (b) of rule 15c2-2 as proposed required that predispute arbitration clauses that do purport to bind public customers to the arbitration of future federal securities law disputes include the disclosure "Arbitration cannot be compelled with respect to disputes arising under the federal securities laws." The disclosure was designed to ensure the public customers are not misled by predispute arbitration clauses.

Proposed paragraph (b) has been deleted from the rule. Beginning January 1, 1985, it will no longer be sufficient for arbitration clauses, such as the one described above, to be supplemented with disclosure language. All new customer agreement forms must reflect as of that date the prohibition expressed by the rule and this release. The use of alternate disclosure language prescribed in new paragraph (b), however, is permitted in order to amend the agreements of existing customers and to allow broker-dealers to use existing supplies of preprinted forms that otherwise violate paragraph (a). In those instances the rule requires the following disclosure:

Although you have signed a customer agreement form with FIRM NAME that states that you are required to arbitrate any future dispute or controversy that may arise between us, you are not required to arbitrate any dispute or controversy that arises under the federal securities laws but instead can resolve any such dispute or controversy through litigation in the courts.

With respect to the disclosure language contained in proposed paragraph (b), various commentators have pointed out that for certain unrelated situations, the disclosure was too broad. A discussion of those comments will be helpful in understanding the amended rule. For example, although the proposing release noted that the rule is not intended to affect existing law with respect to contractual agreements for the resolution by arbitration of international commercial disputes, the proposed disclosure in paragraph (b) did not specifically make that distinction.⁷ Also, commentators noted that certain other agreements to arbitrate federal securities laws claims have in some instances been enforced by the courts. The validity of any such agreements, between members of the securities industry's SROs or between a broker-dealer and its public customers, agreed to after a dispute has arisen,⁸ is outside the scope of rule 15c2-2. The arbitration agreements that are the subject of this rule are those entered into by a public customer with his broker-dealer prior to the existence of any dispute and before an investor normally would be concerned with the matter of choosing a forum for dispute resolution. Since the rule applies only to those standard agreements between broker-dealers and their public customers that purport to govern the parties' alternatives in future disputes under the federal securities laws, these other categories of disputes are unaffected by the rule.

Several commentators expressed the view that the Commission should not require specific disclosure language for the arbitration clauses in customer agreements.⁹ On a related point, another commentator, Wall Street Clearing Co., while "agreeing] completely with this concept [of disclosure] and find[ing] it a proper position for the Commission to take in furthering the protection of customers," commented that it believes the Commission has "sufficient authority to ensure compliance with the principles of Release No. 15984 without recourse to formal rulemaking."¹⁰

The Commission is sensitive to each of these concerns. In adopting the rule the Commission has determined that prescribing specific language for the disclosure to existing public customers would simplify broker-dealer compliance in this area. The language is intended to remove any remaining uncertainty by broker-dealers as to what language is adequate to counter language currently employed in certain of their agreements.

The use of the prescribed disclosure, however, is available only for the notification of existing public customers and the amendment of existing supplies of customer agreements. Subsequent to the transition period provided for in the rule, broker-dealers' customer agreements may not contain the representation that all future disputes between a broker-dealer and its public customers are required to be settled by arbitration.

The Commission agrees with those commentators that stated that it should not prescribe specific language for such agreements and that the broker-dealer community and the SROs are capable of drafting agreements that will be in compliance with this rule. However, as stated in the proposing release, the Commission believes that language currently appearing in some broker-dealers' customer agreement forms, such as "unless unenforceable due to state or federal law," or "to the extent consistent with state or federal law" or which is otherwise ambiguous concerning the investors' rights is inadequate with respect to the concerns addressed by the Commission in this rule.

Although the Commission agrees with the comment that it has authority under the general anti-fraud provisions to enforce compliance by broker-dealers with the principles in the 1979 release without recourse to rulemaking, we have determined to adopt this rule in order to provide guidance to the industry and promote compliance with the federal securities laws.

One commentator offered its support for an alternative "proposal which codified [attempts to compel arbitration of federal securities law disputes] as a violation of the Act, with appropriate sanctions." ¹¹Although such an approach might address "the aggressive conduct of certain broker-dealers", ¹² it would miss certain of the intended beneficiaries of this rule. For example, some public customers may decide not to pursue their claims in any forum rather than submit a claim to an industry-administered arbitration forum as dictated in their customer agreement. Whether a given public customer's reservations or suspicion of arbitration have merit, the fact remains that the federal securities laws provide him with the right to seek the resolution of his disputes under those laws in forums other than arbitration. Therefore, those cases where public customers abandon a federal securities law claim based upon the dictates of an arbitration-clause would most likely not be flagged for enforcement action.¹³

Another commentator expressed the view that no cause of action exists under the federal securities laws unless properly pleaded under the federal rules of civil procedures and that, consequently, it is appropriate for it to pursue arbitration pursuant to predispute arbitration clauses, subject to challenge by customers. ¹⁴ The comment, however, does not focus on the narrow issue addressed by the rule. The determination of claims "under the federal securities laws" is a separate question.

Other commentators stated that the approach of employing predispute arbitration clauses as a basis for submitting all claims to arbitration has resulted in wasteful and costly litigation. Egon Guttman, Professor of Law at the American University commented that:

This * * * has led to the numerous cases following Wilko v. Swan in which the broker-dealers have attempted to enforce arbitration clauses in customer contracts even though the attorneys representing the broker-dealers must have been aware that securities laws violations were in issue [citations omitted].¹⁵ The effect of such attitude is to violate the primary duty of a broker-dealer as a fiduciary to his customer as was stated by Mr. Chief Justice Cardozo in Meinhard v. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928).

* * * * *

Insistence on arbitration would thus be a clear overreaching and * * * a misrepresentation of legal rights of the customer. To deliberately obfuscate the existence of a right which has been repeatedly recognized by the courts and which would be material in determining the overall decision whether to deal through a particular broker [citations omitted] in connection with the purchase and sale of securities would lead to the conclusion that such obfuscation could amount to a violation of Securities Exchange Act 10(b) and Commission Rule 10b—5 promulgated thereunder, [citations omitted]

One commentator ¹⁶ suggested that the proposal be adopted as a rule of the National Association of Securities Dealers, Inc. ("NASD"), presumably to promote just and equitable principles of trade, rather than as a Commission rule under the anti-fraud provisions.¹⁷ Inasmuch as the Commission has determined that the clauses discussed in this release are misleading statements when employed in connection with the purchase or sale of securities,¹⁸ adoption of this rule under the deceptive practice prohibitions of sections 10(b) and 15(c) of the Act is appropriate in the public interest.

The commentator also suggested that the rule apply prospectively and not require notification of existing clients. The Commission believes, however, that it is important for existing customers to be made aware that they are not required by agreements they have signed in order to open an account with a broker-dealer to resolve federal securities law disputes by arbitration. The notification of existing customers anticipated by paragraph (c) of the rule is designed to correspond as closely as possible to the periodic mailings of broker-dealers and consequently should entail only minimal expense. Paragraph (c) provides that broker-dealers may amend outstanding customer agreements which do not comply with paragraph (a). Not all outstanding agreements must be amended. Those customers for whom a broker-dealer, after July 1, 1983, has carried a free credit balance, or held securities in safekeeping or as collateral, or has effected a securities transaction must be sent the required disclosure prior to January 1, 1985. These persons have had sufficiently recent dealings with their broker-dealers for it to be appropriate to ensure that they are supplied with the required disclosure. Furthermore, these persons should be readily identifiable by broker-dealers for inclusion into the mailing list for their next regularly scheduled mailing.

Any other customer agreements would have to be amended only upon the completion of the next transaction pursuant to that agreement. Thus, a customer who has not had any activity in his account since July 1, 1983 would not have to be sent the disclosure unless and until he again does business with the firm under the agreement.

Paragraph (b) permits broker-dealers to enter into new agreements with customers using existing supplies of preprinted forms that otherwise would violate paragraph (a) of the rule, until December 31, 1984, provided that adequate written disclosure accompany such agreements.¹⁹

Another point mentioned by a number of the commentators concerns disclosure of the Wilko doctrine contained in the arbitration pamphlets of the SROs that administer arbitrations under the Code.²⁰ These commentators believed that since all investors who are likely to submit a claim to arbitration receive the pamphlet, there is no need for additional disclosure or other changes to current customer agreement forms. The Commission does not agree with this view. First, as noted above, some investors may never receive the pamphlet because of their reluctance to submit a dispute to arbitration. Second, the disclosure in that pamphlet does not appear to have discouraged a number of broker-dealers from attempting to compel the arbitration of federal securities law claims.²¹

Two of the commentators suggested that legislation be recommended that would permit the use of binding predispute arbitration clauses for future federal securities law disputes.²² Such a change in the law would require additional study and is beyond the scope of this rulemaking proceeding.²³ Today's action should not be interpreted as inconsistent with the Commission's traditional strong support for the use of arbitration for the resolution of disputes that may arise between broker-dealers and their customers.

Regulatory Flexibility Act Certification

Pursuant to 5 U.S.C. 605(b), the Chairman certified at the time this rule was proposed that it would not, if promulgated, have a significant economic impact on a substantial number of small entities. The Commission has received one comment on the certification.²⁴

List of Subjects in 17 CFR Part 240

Reporting and recordkeeping requirements, Securities.

Text of Rule

In accordance with the foregoing. Chapter II of Title 17 of the Code of Federal Regulations is amended by adding § 240.15c2-2 to read as follows:

PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934

§ 240.15c2-2 Disclosure regarding recourse to the courts notwithstanding arbitration clauses in broker-dealer customer agreements.

Statutory Authority and Competitive Considerations

The Securities and Exchange Commission, acting pursuant to the Act, and particularly sections 2, 10, 15, 23 and 29 thereof (15 U.S.C. 78b, 78j, 73o, 78w and 78cc), hereby adopts the amendment to § 240.15c2-2. The Commission finds that there will be no burden upon competition imposed by the amendments. This action becomes effective thirty days after publication in the Federal Register.

By the Commission.

Dated: November 18, 1983.

Shirley E. Hollis,
Assistant Secretary.

[FR Doc:. 83-31895 Filed 11-25-83; 8:45 am]

BILLING CODE 8010-01-M

¹ The Commission notes that SICA has recently reconvened in an effort to improve the Code with the benefit of the industry's first few years of experience with it. The Commission notes further that its approval of the adoption of the Code by the SROs specifically took into account that with respect to claims arising under the federal securities laws, arbitations conducted under the Code were to be an alternative to litigation, which could be agreed to by public customers only after a dispute had arisen. See, e.g., Securities Exchange Act Release No. 16390 (November 30, 1979).

² The basis for this view was discussed at length by the Commission in Securities Exchange Act Release No. 15984 (July 2, 1979).

³ Fed. Sec. L. Rep. (CCH) 99,404 (6th Cir. 1983).

⁴Id. at pp. 96,328 and 96,329 (citation omitted).

⁵ Courts have recognized an exception to the Wilko doctrine for suites between members of the securities industry's self-regulatory organizations. The Commission need to consider those decisions here as they are outside the scope of rule 15c2-2.

⁶ One commentator, the Securities Industry Association ("SIA"), maintained, without citing a specific basis, that the case law "rests on questionable legal ground." Several commentators noted that to date predispute arbitration clauses have been held unenforceable only with respect to causes of action arising under the Securities Act of 1933 and the Securities Exchange Act of 1934. American Bar Association ("ABA"): Shearson/ American Express. Inc. ("Shearson"): Goldman Sachs & Co. ("Goldman"); American Stock Exchange, Inc. ("ASE"). These commentators have cited no basis upon which the Commission can determine that the Wilko analysis does not hold equally true for other federal securities acts, which contain substantially identical anti-waiver provisions.

⁷ See comments of Thurston R. Moore, Esq.; ABA: American Arbitration Association ("AAA"); Shearson: Smith Barney, Harris Upham & Co. ("Smith Barney").

⁸See comments of Thurston R. Moore. Esq.; Professor Egon Cuttman; SIA; Smith Barney.

⁹ Wall Street Clearing Co., Seligman Securities Inc.; SIA; ASE.

¹⁰ Hanifen, Imhoff Inc. commented that use of arbitration clauses that "state the customer has no other remedy for violations of the federal securities taws" is deceptive, but believed that such "deceptive practices ... can be dealt with on a case-by-case basis."

¹¹ Tucker, Anthony & R.L. Day, Inc.

¹²Id.

¹³ The same commentator also suggested the Commission might "require any firm which proposes arbitration to a customer as a forum for resolving a dispute be required to make the disclosure." The Commission believes that compliance with any such rule would be very difficult to monitor and thus less effective than this rule.

¹⁴ Shearson.

¹⁵ Similarly, Richard F. Hill, Esq. commented that "[i]n each case [in which he has represented public customers in disputes with broker-dealers], counsel to the broker-dealer has demanded that the entire action, including the securities claims, be submitted to arbitration [based upon arbitration clauses described by this release]. Consequently, [his] clients have had to incur legal fees to oppose Motions to Compel Arbitration."

¹⁶ Bear, Stearns & Co.

¹⁷ The NASD has not indicated an intention to propose such a rule during discussions on this subject over the past several years.

¹⁸ Several other commentators also questioned the connection between an agreement for the purchase or sale of securities and a purchase or sale of securities. ABA; SIA; Smith Barney: Shearson.

¹⁹ Thurston R. Moore, Esq. suggested that an interlineation on existing supplies of customer agreements would be as effective as a separate paper containing the written disclosure. Such a practice would be consistent with paragraph (b).

²⁰ Bear Steurns, ASE; SIA. Smith Barnny: ABA.

²¹See comment letter of Professor Guttman for a partial list of cases litigated on this question.

²² Goldman; SIA.

²³ For a concise statement of views in this regard see Poser, Norman "Litigate? or Arbitrate? A proposed SEC rule ensuring investors know they can sue in disputes with brokers raises a minor storm of protest" Investment Dealers Digest (September 13, 1983).

²⁴ Smith Barney commented that compliance with the rule would be "an unreasonable financial burden in light of the proposed rule's questionable benefit." The comment does not offer support that there would be any significant impact on a substantial number of small entities, the inquiry anticipated by the Regulatory Flexibility Act. The Commission finds that there would be no such impact.