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A New Class-Action Battle

Wall Street Journal

Should investors be allowed to bring class-action lawsuits against brokerages?

Discount brokerage Charles Schwab and the Financial Industry Regulatory Authority, or Finra, are in the midst of a dispute over that issue—and it could have wide implications for investors.

When investors open brokerage accounts, they’re generally required to agree not to sue the broker. Instead, they have to settle disputes through an arbitration process run by Finra, which is funded by the industry.

Finra, however, doesn’t have an arbitration process for class-action claims—in which a large number of plaintiffs with similar complaints band together—and says its rules prohibit brokerages from making customers agree to class-action waivers.

Despite this, Schwab added a class-action waiver to its customer agreements in September. It cited an April U.S. Supreme Court decision that allowed companies to limit class-action lawsuits with arbitration clauses.

Gilbert Serota, the lawyer representing Schwab in the case, says that indicates that federal law also would override Finra’s rules that Finra says forbid the waivers. A Finra spokeswoman declined to comment.

Last month, Finra began a disciplinary proceeding to penalize Schwab for violating the rules, and in response, Schwab sued Finra in an attempt to get courts to determine that its waiver couldn’t be barred by the regulator.

The two sides are next scheduled to meet in U.S. district court in April.

“If Schwab gets what it wants, it would deprive customers of the opportunity to bring any claims as a class,” says Jill Gross, director of the Investor Rights Clinic at Pace Law School in White Plains, N.Y.

Schwab officials, for their part, say class-action lawsuits benefit lawyers more than customers.

Mr. Serota, Schwab’s lawyer, says the company believes customers are better served bringing their claims individually through arbitration or through Schwab’s internal dispute process. “It’s much more efficient and cost-effective than a class action,” he says.

Schwab has been hit by class-action lawsuits before. Last month, customers filed a class-action suit against Schwab that alleges the company secretly recorded customer phone calls without their consent.

Since last peaking at 7,137 in 2009, the number of new arbitration cases filed with Finra has tapered off. Investors filed about 4,700 cases in 2011, down almost 17% from 2010. In 2011, the arbitration process awarded damages to customers in about 44% of cases, according to Finra.

Most arbitration cases brought to Finra involve damages that run into thousands of dollars, says Ryan Bakhtiari, president of the Public Investors Arbitration Bar Association. When damages are smaller, attorneys often pursue a class-action lawsuit to make it worth their time, he says.

If a broker charged customers too wide a spread on trades, for example, a single customer’s damages might be only a few dollars, but the total damages among all of its customers could run into millions of dollars, Mr. Bakhtiari says.

Without the option to bring a class-action lawsuit, customers and attorneys would be unlikely to pursue small claims. “No one is going to hire a lawyer to litigate a $12 claim,” he says.

Changes in brokerage agreements are rare, which made Schwab’s move surprising to many attorneys in the securities industry, says Ernest Badway, co-head of the securities industry group at Fox Rothschild, a Philadelphia law firm.

“It’s an agreement that’s fairly standard across brokerages and doesn’t change often,” he says.

If Schwab prevails in this case, Mr. Bakhtiari says, other brokerage firms might follow suit in introducing their own waivers, effectively making it impossible for customers to bring class-action suits against brokerages.

“Other brokers are going to be paying close attention to this case,” he says.