Navigating FINRA’s Mandatory Arbitration Requirement – An Overview


 Raymond & Bennett attorney Joseph Blyskal contributed the following post to this Blog.

 I recently read an article indicating that arbitration was the preferred forum for member companies of the Financial Industry Regulatory Authority, but with a caveat–that the only real reason it was preferred was as damage control for the industry. With only some exceptions, the Financial Industry Regulatory Authority (FINRA) requires arbitration of industry disputes, which simply means disputes amongst or between its members and associated persons. In addition, while nonmembers can compel members to arbitrate, nonmembers of FINRA cannot be compelled to arbitrate. Regardless of whether the motive is fiscal, public relations, or other, the mandatory arbitration requirement may be hard to get around. However, the presence of a good faith claim against nonmembers can create the option to litigate an industry dispute outside of arbitration.   



FINRA members are defined as any entity: “who is registered or has applied for registration under the Rules of FINRA” or  “[a] sole proprietor, partner, officer, director, or branch manager of a member, or other natural person occupying a similar status or performing similar functions, or a natural person engaged in the investment banking or securities business who is directly or indirectly controlling or controlled by a member, whether or not any such person is registered or exempt from registration with FINRA.”FINRA Manual Rule 13100(r). Some examples include: Metlife Securities, Inc., Bernad L. Madoff (now obviously inactive), and ING Financial Markets, LLC.

There are only a few enumerated exceptions to the mandatory arbitration rule. Disputes arising out of the insurance business activities of a member that is also an insurance company, claims alleging employment discrimination in violation of a statute, class actions, shareholder derivative actions, and matters that are inappropriate for the forum in light of the “purposes of FINRA and the intent of the Code” are excluded. FINRA Manual Rule 13200-13205. Depending on the circumstances, these are easily applied.

Less easily applied are the two threshold requirements that trigger mandatory arbitration for a dispute–that the dispute arises from the (1) business activities of (2) members or associated persons.  These must be addressed before considering the application of the exceptions.

Whether a dispute arises from business activities is a factual inquiry. It is liberally construed, however. It includes claims for commissions earned, discharge from employment, and non-statutory discrimination claims. Generally, this is a threshold element.  

The more litigation-friendly element is the second—that the dispute is between members, a member and an associated persons, or associated persons. Whether an entity is a FINRA member is not usually debatable (there are formal registration requirements). However, whether an entity is an “associated person” is often subject to debate.  Courts often deny motions to compel arbitration where a factual showing is not made to support a finding of “associated person” as defined in the Code.

Cases where there are parent companies and subsidiaries involved in the dispute, or where there are employees or registered representatives as parties that are not FINRA members, or not employed by FINRA members, are breeding grounds for litigation over this second threshold provision.

Of course, in any case—whether the threshold elements are present or an exception applies—the general rule that those not party to an agreement to arbitrate cannot be compelled to do so applies to the FINRA arbitration provision. Thus, litigation is clearly a viable option where there is at least one entity involved that is not a FINRA member.

While difficult to get around the arbitration provisions of FINRA, it may be possible to do so. Litigants, both those prosecuting and defending claims, should identify and categorize all the disputants before making a determination that arbitration is indeed “mandatory”.


Understanding Risks and Avoiding Lawsuits – Negotiation of the Master Services Agreement

Recently, I received a call from an attorney trying to figure a way out of a Master Services Agreement for his client.  His client, the purchaser, was stuck owing a lot of money to a technology vendor under a Master Services Agreement that was not working for the client.  The problem – – there was no protection under the contract for the purchaser and no clear way out without owing money to the vendor. 

The problem is not unique to technology purchasers.  Bad contracts also can hurt technology providers.   Take for example a recent case involving a technology company in a lawsuit over installation of new software for a small business.  The business claimed loss of profits due to extended down time as a result of a claimed breach of warranty.  The problem for the technology vendor – –  no protection in the contract with a limitation of remedy provision or disclaimer of warranty.  This opened up a claim for consequential damages that neither party contemplated.

In these cases, whether you are the attorney for the customer or the vendor, many times you are left saying "I wish you called me when you negotiated this contract."   In most instances, when a large or significant service and technology purchase is involved, the relationship between customer and vendor is set forth in a Master Services Agreement.  Master Services Agreements are typically contracts in information technology or professional services that govern a long term vendor-client relationship.  The contract includes general provisions on price, payment terms, and project scope.  The contracts usually include a Statement of Work. The Statement of Work will define the project specifics, services, or deliverables.

While the negotiation of a Master Services Agreement can be quite complex depending on the scope of the project, there are some general terms and clauses that should be considered or included in each agreement to avoid mutual misunderstandings, bad financial decisions, and unnecessary business litigation.  This applies to both sides of the negotiation whether you represent the customer or the vendor.  

There are some standard clauses and considerations in Master Services Agreements that can help the parties reach a true meeting of the minds as to the scope, risks, and obligations. Here is a checklist of some topics and questions that should be discussed as part of the negotiation of a Master Services Agreement:

  • Price.  Very important to remember that the sticker price or price on the contract is many times not as important as the soft costs and expenses.  It benefits both sides of the deal to make sure the price and payment terms (including add on fees like renewals, maintenance and service) are clear and understood.
  • Payment.  Is the agreement going to call for payment by time and materials?  A fixed fee?  A hybrid of both?  Will the payments be tied to meeting milestones on deliverables?  Penalty or late fees? Any retained amounts until completion?  For both sides of any deal, it is better to work out the details on payment ahead of time and avoid problems before they arise.
  • Intellectual Property.  Who is going to own the intellectual property rights to the new software or work performed?  If this is not addressed in the contract, unintended results may occur where the vendor has future property rights for a project paid for by the customer. 
  • Warranty.  What is the scope of the warranty of the work? Will the warranty be limited to the vendor’s performance in a workmanlike manner or is greater warranty protection needed for a new product installation?  Does the vendor warrant the software or other products? The warranty many times provides the basis of the claim for damages against the vendor.  By limiting or expanding the warranty, the scope of liability is understood by both parties at the outset. 
  •  Statement of Work.  This is the document that will provide the specifics on the deliverables under the agreement.  Will it be a separate document?  How much detail will be included?  What assumptions are made?  How can the scope of the project increase?  What are the due dates and deadlines?  An overly broad Statement of Work can be a problem for both a vendor and customer. 
  • Confidentiality Agreement.  Typically, the parties to a Master Services Agreement will want a mutual confidentiality agreement or non-disclosure agreement to prevent disclosure of proprietary information and company trade secrets.  How will you define proprietary information and trade secrets?  How long will the agreement last?  What are the penalties for violation?
  • Indemnification.  These clauses typically shift the risk associated with a loss or a claim from one party to another.  For example, what happens if the customer gets sued for patent infringement for work product of the vendor?  Should the vendor have to defend and indemnify the customer for the lawsuit?
  • Attorneys fees and Alternative Dispute Resolution (ADR).  How will disputes under the contract be resolved?  ADR clauses in the contract can provide for the award of attorney’s fees to the prevailing party and force all disputes to be resolved in a binding arbitration as opposed to a typical lawsuit in court.   More and more, both customer and vendor are seeking to avoid costly litigation by electing for a streamlined dispute resolution process.
  • Insurance.  Does the vendor have errors and omissions insurance?  Should it be required in the contract?
  • Termination.  What terms will govern when one party is unhappy or if a party is in breach?  How do you get out of the contract?  30 days notice?  10 days notice?  Is there any payment for at will termination?  Does work stop upon notice?

These are just a few of the major considerations at play for both a purchaser and vendor under a Masters Services Agreement.  For any significant transaction,  it is advisable for a technology lawyer to negotiate the contract.  Early involvement of a technology attorney can save time and expense later and help each party understand the risks of any particular project.