Virginia Bans Mandatory Arbitration Clauses in Investment Adviser Client Agreements

11.05.2019

The Virginia State Corporation Commission (SCC) adopted a new administrative rule[1] prohibiting investment advisers from including provisions in their advisory contracts requiring clients to submit all disputes to mandatory arbitration.[2] The new rule affects investment advisers who are registered with, and regulated by, the Commonwealth of Virginia, but not investment advisers registered with the U.S. Securities and Exchange Commission who make only notice filings to the SCC.[3]

In its proposal, the SCC noted that almost all broker-dealer financial service contracts include such mandatory arbitration provisions, and that state-covered investment advisers now include such boilerplate provisions in their client contracts. However, the SCC believes that such “take-it-or-leave-it” clauses are inherently unfair to clients. Since investment advisers are fiduciaries and must act in the best interest of their clients, they should not be allowed to deny clients the right to bring the dispute in the forum of their choice. The SCC has clarified that a client and its investment adviser may still agree to resolve a dispute through arbitration after negotiating on their own.

Although Virginia is the first state to adopt such a rule, other states will likely follow. There is some question as to whether the adoption of such a rule by a state agency such as the SCC violates the Federal Arbitration Act. However, whether the rule is enforceable ultimately will be determined upon challenge in federal court.

In the meantime, Virginia-registered investment advisers should review their investment advisory agreements to determine whether they contain mandatory arbitration clauses or provisions. Any such mandatory arbitration clauses should be removed and the newly revised investment advisory agreements should be used for any new client relationships established after the effective date of the new rule. Additionally, although not required under the Virginia Administrative Code, we recommend that the adviser send a copy of the revised investment advisory agreement to the SCC to replace the original agreement the agency may have on record for the adviser.

Finally, with respect to any existing clients who have investment advisory agreements that include a mandatory arbitration clause, the investment adviser will need to either (a) have each such client sign a revised agreement excluding the mandatory arbitration clause (which may prove burdensome), or (b) send a letter to each client informing them about the new rule and permanently waiving the mandatory arbitration clause, making such clause null, void and unenforceable. If the investment adviser chooses to send a letter, a copy should be kept on file for each client to produce during routine SCC exams. Whatever action you choose to take, client contracts containing mandatory arbitration clauses should be replaced or the clauses waived and voided as soon as reasonably possible in order to be in compliance with the new rule.

We strongly suggest that any Virginia-registered investment advisers speak with their regulatory compliance consultant and attorney about the application of the new rule and the best course of action to take with respect to their investment management contracts. The lawyers in the Investment Management Group at Hirschler will be more than happy to assist you and adopt the best solution for your compliance with the new rule.

[1] See SCC June 27, 2019 Order to Take Notice, Case No. SEC-2019-00024, available at http://www.scc.virginia.gov/srf/s190024.pdf

[2] The new rule has been added as new subsection “F” to the Dishonest or Unethical Practices section of the chapter of the Virginia Administrative Code regulating investment advisers (21 Va. Admin. Code § 5-80-200) https://law.lis.virginia.gov/admincode/title21/agency5/chapter80/section200/

[3] It is not clear whether this rule applies to investment advisers registered primarily in a state other than Virginia but registered to do advisory business in Virginia.