What Your Financial Advisor's Mandatory Arbitration Clause Means for You

There's nothing arbitrary about mandatory arbitration clauses, but you can be purposeful in how you scrutinize them. The fine print you read before you sign can save you headaches and expenses down the road.

Such clauses are in the fine print of virtually every contract you read from securities brokers, says Howard Prossnitz, a Chicago attorney who specializes in investment disputes. They're also nonnegotiable, he adds. You might be able to change other parts of the contract, but if you try to strike out the arbitration clause to preserve your right to bring a complaint through the court system, the advisor will likely tear up the contract.

Most of these contracts also require disputes to be handled by the dispute resolution division of the Financial Industry Regulatory Authority, the independent regulator for all securities firms in the U.S. This summer, FINRA announced it is reviewing its arbitration process.

Prossnitz says the decision is in response to complaints about the qualifications of some 2,000 arbitrators. Those arbitrators are not retired financial executives, says a FINRA spokesperson, but typically former teachers, doctors and businesspeople.

Each dispute is heard by a three-person arbitration board that serves as both judge and jury. Their decisions are final, and short of fraud, there's no appeals process. That's why the qualifications of the arbitrators are so important.

[Read: A Guide to Understanding Mutual Fund Fees.]

"There's a need for careful consideration to be sure that the system is functioning as intended," says Barbara Roper, director of investor protection for the Consumer Federation of America and a member of the FINRA committee reviewing the arbitration process. "The question for me as we undertake this study is, 'Is the system fast, fair and affordable?'"

The recommendations of the FINRA committee won't be announced for a year. Meanwhile, here's what you need to know about mandatory arbitration.

Examining such clauses is like focusing on a prenuptial agreement: A splash of reality hits you the moment you are ready to choose someone you think will be a good fit. The advisor is certainly eager to consummate the deal, too, and start managing your money.

The time to avoid a dispute is before you sign the contract, Prossnitz says.

Roper points out that most of the disputes involve misunderstandings -- deliberate and not -- that stem from marketing claims made by the advisors and how those claims were interpreted by clients.

[Read: How to Decode Your Financial Advisor's Jargon.]

As of July, breach of fiduciary duty is the No. 1 complaint teeing up arbitration. Second is negligence, followed by misrepresentation and failure to supervise. So it's important to understand exactly what the advisor relationship entails and if the advisor is operating under a fiduciary role -- putting your best interest first -- or under the less stringent suitability role -- putting your money into investments that are suitable at the moment with no responsibility for looking out for your best interest ongoing.

The most important thing you can do to protect yourself is read and complete the contract yourself, Prossnitz says. Don't let the advisor fill out the form and hand it to you to sign. The contract will include important points, such as your risk tolerance, a subject that typically touches off the misunderstandings reflected in the FINRA statistics.

If you have a dispute, the broker's corporate attorney will rely first and foremost on the "opening account" documents you signed when you set up the relationship, Prossnitz says. He recently worked with an 87-year-old investor who trusted his new broker to fill out the forms correctly.

The broker indicated in the contract that the investor was willing to be put in speculative investments -- a level of risk completely inappropriate for someone his age, Prossnitz says. The client was subsequently wiped out, but his signature on the contract contradicts his complaint that he didn't want to direct his money to risky investments.

"You don't want to end up in arbitration, but if you do, you don't want the game stacked against you through the documents," Prossnitz says.

[See: 10 Risky Investments Billionaires Can't Resist.]

Make sure the contract's arbitration clause specifies the FINRA arbitration service, not another arbitration service. "Those arbitrations are more costly, and the FINRA service is set up for this," Prossnitz says. It costs about $1,400 just to file the complaint.

Also make sure the arbitration locale is convenient for you instead of specifying that it take place in the advisory's home state (which may be different from the office where your about-to-be-advisor is located).

Other points to consider:

-- Arbitration keeps you out of court, but not away from lawyers. Expect to hire a lawyer and go through a grueling, multipart exploratory process that opens your finances to the other side in great detail, Prossnitz says. It can take four sessions to arrive at a decision, according to FINRA.

-- The arbitration process is private, but the results are made public at the FINRA website. If you win an award, the amount will be publicly disclosed.

-- However, if you settle the case before it goes to arbitration, as has occurred in 52 percent of cases so far this year, both the process and the results are confidential.

-- One way to sidestep arbitration is to first pursue mediation, Prossnitz says. About 7 percent of disputes have been decided by mediation so far this year.

Arbitration is no guarantee that you'll win. Typically, half of the cases are decided for the investor and half are decided for the advisor, Prossnitz says.