Virginia's State Corporation Commission (SCC) has issued a new regulation, 21-VAC5-80-200(F) (the "SCC Anti-Arbitration Regulation"), that prohibits investment advisers operating in Virginia from including "any mandatory arbitration provision in an advisory contract."1 This new rule, which became effective on September 16, 2019, is apparently the result of investment adviser exams conducted by the SCC, which showed a growing trend of advisers including mandatory arbitration provisions in their client agreements. According to an interview with a representative of the SCC's Division of Securities and Retail Franchising, mandatory arbitration agreements are "contrary to the fiduciary duty" that investment advisers owe to their clients. Virginia appears to be the first state to prohibit mandatory arbitration provisions in investment adviser agreements.

Virginia's new rule is almost certainly preempted by federal law and therefore unenforceable. Specifically, the SCC Anti-Arbitration Regulation runs afoul of the Federal Arbitration Act, 9 U.S.C. §§ 1 et seq. (FAA), and clear United States Supreme Court precedent interpreting the FAA. To the extent investment advisers operating in Virginia seek to challenge the SCC Anti-Arbitration Regulation in court, it appears likely they would prevail.

Federal Arbitration Act

As the U.S. Supreme Court has repeatedly held, the FAA reflects a "liberal federal policy favoring arbitration."2 Section 2 of the FAA provides that "[a] written provision in . . . a contract evidencing a transaction involving [interstate] commerce to settle by arbitration a controversy thereafter arising out of such contract or transaction . . . shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract."3 The FAA thus requires the enforcement of agreements to arbitrate in transactions involving interstate commerce, which encompasses the investment advisor contracts that fall within the purported ambit of the SCC Anti-Arbitration Regulation.

The FAA Preempts the SCC Anti-Arbitration Regulation

Time and again, the Supreme Court has been very clear that the FAA preempts state laws that disfavor arbitration or have the effect of precluding parties from entering into arbitration agreements. The circumstances confronted by the Court in Perry v. Thomas, 482 U.S. 483 (1987), are directly on point with the SCC's efforts to preclude mandatory arbitration in investment adviser agreements. In Perry, the Court addressed a California Labor Code provision that purported to require that "litigants be provided a judicial forum for resolving wage disputes" and precluded arbitration.4 The Court, after first recognizing that the effect of the FAA was to "create a body of federal substantive law of arbitrability,"5 held that this "clear federal policy" of "enforcement of arbitration agreements within the full reach of the Commerce Clause" was in "unmistakable conflict" with California's requirement of a judicial forum. The Court concluded that in the face of this conflict, "under the Supremacy Clause, the state statute must give way" and therefore held "that §2 of the Federal Arbitration Act preempts § 229 of the California Labor Code."6

Recently, the Court has also reaffirmed that state laws, like the SCC Anti-Arbitration Regulation, that would purport to prevent parties from entering into arbitration agreements (as opposed to precluding the enforcement of already existing arbitration agreements) are contrary to and therefore preempted by the FAA. In Kindred Nursing Centers v. Clark, the Court explained:

By its terms [the FAA] cares not only about the enforcement of arbitration agreements, but also about their initial validity—that is, about what it takes to enter into them. Or said otherwise: A rule selectively finding arbitration contracts invalid because improperly formed fares no better under the [FAA] than a rule selectively refusing to enforce those agreements once properly made.7

In light of decades of Supreme Court precedent, there should truly be no dispute that the FAA preempts and invalidates state laws that would single out arbitration provisions for disfavored treatment and purport to preclude their enforceability. With regard to the Virginia SCC's new anti-arbitration rule, the agency's stated rationale for the rule is that mandatory arbitration provisions in investment advisors' clients' contracts are "inherently unfair."8 But that kind of reasoning reflects the very "hostility to arbitration agreements" that was the basis for Congress's enactment of the FAA in the first place. As a result, it should not be surprising that the Supreme Court has repeatedly rejected this type of hostility to arbitration in holding that state laws prohibiting arbitration agreements are preempted by the FAA.9

Mandatory arbitration agreements in investment adviser agreements are a growing trend in the industry—a fact that the SCC's own examination activity revealed. Indeed, experience shows that there are numerous ways in which an agreement to arbitrate as the means to resolve disputes can benefit both advisers and their clients. To the extent investment advisers registered in Virginia determine that a mandatory arbitration provision in client agreements is desirable, the SCC's Anti-Arbitration Regulation appears to be plainly preempted by the FAA, and the regulation would likely be deemed invalid if challenged in court on this basis.