Early last year, Charles Schwab (NYSE: SCHW) was charged by The Financial Industry Regulatory Authority (FINRA), for violating its rules when the brokerage and asset management firm asked its almost 7 million customers to waive off their rights of filing class action lawsuits against it. (See FINRA’s press release here)
More than a year later, Schwab seems to have won the first round of this long drawn battle, which could potentially change the way financial firms operate. The hearing panel set up to adjudicate these charges dismissed two of the three charges made by FINRA – essentially allowing Charles Schwab to continue requiring its customers to sign on the waiver document. The panel decided in favor of FINRA’s third charge and upheld the “powers of FINRA arbitrators to consolidate individual claims in arbitration”. (See FINRA’s press release here)
FINRA has already expressed its intent to appeal against the decision.
What Is Schwab’s Motivation?
According to the firm’s annual filings, Charles Schwab was a subject of as many as “nine class action lawsuits filed between March and May 2008, on behalf of investors in the Schwab YieldPlus Fund®, alleging violations of state law and federal securities law in connection with the fund’s investment policy, disclosures and fund marketing.” They recorded total charges of $320 million in 2010 for the settlement of these cases and were also a defendant in more class action cases that claimed Schwab Total Bond Market Fund™ violated its investment policy. 
The company maintains that end customers do not benefit from class action lawsuits because the plaintiff’s lawyers usually keep a major portion of settlements. Moreover, these cases take longer to adjudicate and are more expensive than arbitration.
Is Schwab’s Claim True?
We believe that this is somewhat true. Take for instance the class action lawsuit against Facebook, as mentioned in this recent article titled “Class Action Madness Continues”. According to Executive Director of California Citizens Against Lawsuit Abuse, Tom Scott, Facebook settled a claim regarding unfair usage of “names, profile pictures, photographs, likenesses, and identities of Facebook users” for marketing purposes for $20 million. Out of this hefty sum, the plaintiff’s lawyers are likely to take home almost $8 million in fees and other costs.
However, class action lawsuits are powerful deterrents, particularly in cases where the incentive for an individual to lodge a complaint is miniscule. They allow customers who have lost small sums of monies individually to come together as a group and fight against a corporation, making it affordable for them to hire best in class legal counsels.
What Does This Mean?
If the decision is upheld, customers must bring their grievances against Schwab to an arbitration panel individually, rather than filing class action lawsuits. FINRA arbitrators could still consolidate similar claims but that does not mean a plaintiff could represent all of Schwab’s customers.
Practically, this is a big win for the company. For a case with consolidated claims to have the same scale as a class action lawsuit, all of Schwab’s customers who were impacted would have to lodge formal complaints making it even more unlikely to occur.
In essence, this means fewer complaints against Schwab. The decision also diminishes the possibility of the involvement of a law firm in such cases by reducing the total number of claimants, and hence the total amount sought in damages. Schwab also stands to gain because corporations usually find it easier to deal with individual cases rather than negotiating with the combined might of a group of customers.
How Does It Impact Schwab’s Margins?
Expenses relating to class action litigation are usually unforeseen and one time. The company reported such expenses in 2010, and we can see a sudden drop in the firm’s EBITDA margins for that year on the slide below. Assuming no further shocks, we expect the company’s margins to remain fairly stable going forward.
What To Expect?
Schwab might use this judgment as a leverage to defend pending class action lawsuits against it. Note that the firm started asking clients to waive their rights to participate in these cases in 2011. With this decision in its favor, the firm could influence all class action lawsuits filed against it since.
However, FINRA has 45 days to appeal against the verdict and has made clear their intentions of doing so.  Others, such as the Massachusetts Secretary of the Commonwealth, William F. Galvin, has also raised concerns about the decision and more debates on the matter are possible. 
Within the brokerage and asset management industry, we expect other firms to take notice of this judgment and closely watch the action. Over the next few months we could see brokerages like E*Trade (NASDAQ:ETFC) and TD Ameritrade (NYSE:AMTD), follow Schwab and modify their customer agreements accordingly.
Another likelihood, however, is that competitors may use this judgment to portray Charles Schwab as a mighty corporation that is insensitive towards its clients and try to pluck market share away from the firm.Notes:
- Schwab’s 2010 10-K form [↩]
- FINRA to appeal ruling on Charles Schwab class action ban, Thomson Reuters, February 26, 2013 [↩]
- Galvin talks to Chuck about allowing class actions, InvestmentNews, February 26, 2013 [↩]