By Brian N. Smiley
As the bulls run wild on Wall Street, there is increasing evidence that the nation’s securities markets have also provided a home for vipers. Names of prominent executives and major brokerage houses have appeared under headlines announcing investigations, indictments and plea bargains for insider trading, market manipulation. Conspiracy, and other conduct that they don’t teach at the Harvard Business School. Unfortunately, the problem of dishonesty can be found at all levels of the securities industry, including that at which individual investors stake their savings on the wisdom and integrity of their stockbroker. Reports in the news media indicate that complaints against brokers by customers have reached record levels. These complaints encompass many forms of misconduct. including: churning accounts (trading excessively in order to generate commissions), engaging in unsuitable or unauthorized trading, failing to follow instructions, misrepresentations, market manipulation, and charging excessive markups. When an investor’s faith and fortune have been misplaced, his lawyer must choose the forum best suited for vindication of the client’s rights.
The conventional legal wisdom has long had it that arbitration is good for the broker and bad for the investor. It is time to reexamine this dogma to assess if it is truly wise, or merely conventional. In the interest of brevity, a comparison will be made between federal litigation and arbitration under the Code of Arbitration Procedure of the National Association of Securities Dealers, Inc. (“NASD”), although the NASD’s arbitration procedures are similar to those of the American Stock Exchange (“AMEX”) and the New York Stock Exchange (“NYSE”). As will be shown, contrary to the prevailing wisdom of the plaintiffs bar, arbitration offers the injured investor a prompt, efficient, competent, inexpensive, and fair forum. Moreover, there is a good change that whatever choice the investor once had in deciding whether to litigate or arbitrate may soon be removed as the result of a case now pending in the United States Supreme Court.
The Obligation to Arbitrate
The first, but by no means obvious, reason to arbitrate is that the investor may be required to do so. When an investor opens an account with a brokerage house, he or she usually signs a customer agreement, margin agreement, or similar document which provides that disputes arising out of or related to the handling of his account shall be settled by arbitration in accordance with the rules then in effect before the NASD, NYSE, AMEX, or some other exchange or the American Arbitration Association (“AAA”). Under the United States Arbitration Act, agreements to arbitrate contained in contracts involving interstate commerce are “valid, irrevocable, and enforceable save upon such grounds as exist at law or in equity for the revocation of any contract,” and may be enforced by orders compelling arbitration issued by the United States district courts. Contracts involving the purchase and sale of stocks or commodities traded on national markets involve interstate commerce.
Notwithstanding the federal Arbitration Act, the securities industries’ standard arbitration clause received a hostile reception in the courts for many years. In Wilko v. Swan, 346 U.S. 427, (1953), the Supreme court held that Section 14 of the Securities Act of 1933 (the “1933 Act”), 15 U.S.C. §77n, rendered a brokerage house’s boilerplate arbitration clause unenforceable in a suit by a customer who claimed that the broker had defrauded him in violation of Section 12(2) of the 1933 Act, 15 U.S.C. 77e. According to the Supreme Court, the arbitration clause was void under Section 14 of the 1933 Act because it constituted a “condition, stipulation, or provision to waive compliance” with the right afforded under Section 22(a) of the 1933 Securities Act, 15 U.S.C. §77v(a), to bring suit in state or federal court. The Court recognized that absent Section 14, the arbitration agreement would have been enforceable under the federal Arbitration Act, but it concluded that the policy of allowing investors access to federal courts outweighed the Arbitration Act’s promise of “an opportunity generally to secure prompt, economical and adequate solution of controversies through arbitration if the parties are willing to accept less certainty of legally correct adjustment.”
In the years since Wilko, the federal courts generally assumed that the Supreme Court’s holding also extended to claims for violations of Section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”), 15 U.S.C. §78j(b), and Rule 10b-5, since the 1934 Act includes an anti-waiver provision 15 U.S.C. §78cc(a), similar to that under the 1933 Act. On the other hand, state law claims against brokers for fraud, negligence, breach of fiduciary duty and the like were considered arbitrable in accordance with the Arbitration Act.
After Wilko, customers who wished to litigate their claims against brokers found it expedient to sue in federal court and allege that the defendant’s conduct violated Section 10(b) of the 1934 Act and its Rule 10b-5. The l0b-5 claim provided a basis for federal jurisdiction, as well as the insurance, thanks to Wilko and its progeny, that the client would not be forced into arbitration. Typically, the plaintiff added pendent state law claims to his complaint in order to have an alternative theory of relief in store should the Rule 10b-5 claim be dismissed. The pendent state claims also provided a legal basis for the recovery of punitive damages, which are not available under the federal securities laws.
In cases such as Miley v. Oppenheimer & Co. and Belke v. Merrill Lynch, Pierce, Fenner & Smith, courts ruled that where the facts supporting the federal and state claims were intertwined, the district court should refuse to order arbitration of the state claims out of concern that the arbitrators not make factual findings on issues such as intent to defraud which might have a preclusive effect on the federal securities claim. Under this so-called intertwining doctrine, arbitration was avoided and the district court’s jurisdiction over the federal securities claims was preserved. Through application of the intertwining doctrine, claimants who wanted to litigate their suits in federal court were, in the main, able to do so.
In Dean Witter Reynolds. Inc. v. Byrd, 470 U.S. 213 (1985), the Supreme Court rejected the intertwining doctrine and held that where federal securities claims arise from the same facts as state law claims (such as for violations of state securities laws, fraud, and breach of contract and of fiduciary duty) the arbitrable state claims should be sent to arbitration, even though the result would be piecemeal resolution of issues. The Court refused to address the question of whether it would be appropriate for a federal court to compel arbitration of a 10b-5 claim, since the defendant did not raise that issue by seeking arbitration of the Rule 10b-5 claim in addition to the state claims. In his concurring opinion, however, Justice White stated that this was a “matter of substantial doubt” since “Wilko‘s reasoning cannot mechanically be transplanted to the 1934 Act.” Justice White supported this proposition by pointing out that jurisdiction under the 1934 Act was more limited than under the 1933 Act, since the 1933 Act offers concurrent state and federal jurisdiction, whereas the 1934 Act calls for exclusive federal jurisdiction. Justice White also noted that the right to sue under the 1933 Act which was protected in Wilko was created by statute, but the Rule 10b-5 civil action had been implied by the courts.
Since Byrd, the Second and Eleventh Circuits have continued to hold that claims under Section 10(b) of the 1934 Act are not subject to mandatory arbitration. With a split in the circuits, the Supreme Court granted certiorari in the Second Circuit case, Shearson/American Express, Inc. v. McMahon, which was argued before the Court on March 3, 1987. McMahon may, at last, resolve the issue of the arbitrability of 10b-5 claims.
Arbitration vs. Litigation – Procedural Advantages of Arbitration
Even if the Supreme Court holds that Wilko‘s prohibition against compelled arbitration of 1933 Act securities fraud claims extends to 10b-5 claims, the mere fact that an investor may have the right to choose litigation over arbitration does not mean that litigation is the preferable forum. The perceived tradeoffs of arbitration and litigation were noted in Wilko, wherein the Supreme court commended the economy and speed of arbitration, but tempered its praise with concern that parties to arbitration must accept “less certainty of legally correct adjustment.”
The economy and speed of arbitration are clearly superior to litigation. To commence arbitration the claimant need only file a Statement of Claim containing the relevant facts, supporting documents, and describing the remedies sought. A filing fee of up to $750 (for cases in which the amount of principal in dispute is over $100,000) is also required. The claimant also executes a submission agreement in which he agrees to submit the controversy to arbitration and to be bound by awards entered by the arbitrators. These documents are sent to the NASD, which forwards them to the respondents, who also sign the submission agreement and file their own Answer, including defenses, counterclaims and third-party claims. The Answer must specify “all available defenses and the relevant facts thereto that will be relied upon at hearing …” Motion practice is quite limited in arbitration, so the merits of controversies can be reached and decided without the delays which can sap a federal court plaintiff of economic resources.
A widely perceived disadvantage of arbitration is limited ability to conduct discovery. The NASD Code of Arbitration Procedure, Sec. 32(b), provides:
The arbitrators and any counsel of record … shall have the power of the subpoena process as provided by applicable laws. However, the parties shall produce witnesses and present proof to the fullest extent possible without resort to the issuance of the subpoena process.
Prior to the first hearing the parties shall cooperate in the voluntary exchange of documents and information as will serve to expedite the arbitration…
Although the Code grants less in the way of formal discovery than the Federal Rules of Civil Procedure, the voluntary exchange set forth in the Code is generally more than adequate to allow the parties to prepare for the arbitration hearing. While discovery needs vary with the particular type of case, documents pertaining to the handling of the customer’s account (e.g., account opening forms, monthly statements and confirmation slips, broker’s notes, and letters to the client) which are pertinent to the conflict usually can be obtained from the brokerage house on an informal and voluntary basis. Brokerage houses recognize that the NASD has the right to discipline members or employees of members who fail to cooperate in arbitration, as by refusing to produce documents in their possession or control. Customers also tend to appreciate the fact that failure to respond to requests for documents pertinent to the case will be viewed with disfavor at the arbitration hearing. Although arbitration does not, as a rule, provide for depositions and discovery from non-parties such as is readily allowed under the Federal Rules of Civil Procedure, this sacrifice helps parties avoid the expense, burden and loss of valuable time which too often characterizes federal discovery practice. Of course, where important information is in the hands of third parties, counsel can often develop it through voluntary interviews.
Arbitration hearings are considerably less formal than trials, although testimony is taken under oath. Under Sec. 34 of the Code of Arbitration Procedure, arbitrators are to determine materiality and relevance but are not otherwise bound by the rules of evidence. Testimony is often given in narrative fashion. Cross examination is allowed, and the arbitrators frequently play an active role in questioning parties and witnesses.
Arbitration awards are based upon majority vote and are frequently issued within days of the hearing. As the result of streamlined procedures, arbitrated disputes are resolved far more promptly than litigated cases. According to the Securities Industry Conference on Arbitration, most claims involving customers are concluded in less than a year. In contrast, in federal district courts, the median period of time elapsed from the filing of the Answer to the commencement of trial exceeds a year, according to the 1985 edition of Federal Court Management Statistics. And, of course, district court cases may be appealed, leading to still greater delays.
Arbitration vs. Litigation — Substantive Law
It would be difficult to argue the superiority of litigation to arbitration if the product of arbitration’s speed and economy were erroneously decided disputes. However, to arrive at a legally correct decision requires correct adjudication of factual questions. In federal courts, either party can demand that a jury decide issues of fact — issues which can be terribly technical and complex in securities cases. By way of contrast, in NASD sponsored arbitration proceedings, except in simplified arbitration for claims of $5,000 or less (in which there is only one arbitrator), there are three to five arbitrators, all of whom are familiar with the securities industry. Sec. 22 of the Code of Arbitration Procedure generally gives parties one peremptory challenge to the panel, and unlimited challenges for cause are allowed. A majority of the panel members are so-called public arbitrators, who are not employed in the industry and have not been for three years prior to appointment. The public arbitrators frequently are lawyers who are experienced in handling stockbroker/customer disputes. Often the lawyers are selected from the ranks of counsel for claimants who have appeared in other NASD arbitrations. Typically, the panel also includes at least one representative from the securities industry. Although it may surprise many claimants and a few lawyers, the industry representatives are seldom blindly partisan in favor of brokers. More often their primary concern is whether the broker behaved in a professional and ethical manner. In short, panels are frequently fully capable of grasping the facts in complex cases, and are generally quite protective of the investor who has been the victim of unprofessional and unethical conduct.
While it is fair to assume that federal judges know more about federal securities law than arbitrators, that body of law has been severely restricted by the courts since the mid-1970’s. A 10b-5 claim must be dismissed if the plaintiff fails to prove that the defendant acted with scienter, which is to say intent to defraud, Ernst & Ernst v. Hochfelder, 425 U.S.185 (1975), or at least a reckless disregard for the truth exceeding mere negligence. In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), the Court held that standing for 10b-5 action requires that the plaintiff bought or sold a security based upon the defendant’s misrepresentation or omission of material fact. Presumably, under this test a broker will not have violated Rule 10b-5 if he fails to tell an investor of facts which would lead the investor to sell securities already purchased. In short, litigation under Rule 10b-5 is difficult and fraught with technical defenses which can result in dismissal of the complaint.
NASD arbitrators are not constrained by the strictures of federal securities law adjudication. They sit to do justice and equity. NASD arbitrators can accomplish this admirable end by giving NASD and exchange rules great, and even controlling, weight. These rules are investor-oriented and set a lofty standard of conduct for the broker. Indeed, the NASD’s most basic rule requires members to “observe high standards of commercial honor and just and equitable principles of trade.” In contrast, the courts are reluctant to imply a private cause of action for violation of NASD or exchange rules. Of course, arbitrators are also free to consider other theories of recovery including under the federal securities laws and state laws.
Punitive Damages in Arbitration
One of the primary reasons customers’ lawyers have traditionally avoided arbitration in cases in which the broker engaged in fraudulent conduct has been the belief that punitive damages are unavailable in arbitration. This belief arose from a series of cases, most in the labor field, which denied the right of arbitrators to award punitive damages. However, in Willis v. Shearson/American Express, Inc., a district court rejected the view that punitive damages are not allowable in stockbroker/customer arbitration. In Willis, the customer opposed the defendant’s motion for a stay under Section 3 of the federal Arbitration Act and argued that his federal suit for fraud and breach of fiduciary duty against his stockbroker should not be subject to mandatory arbitration because arbitrators could not award the punitive damages he sought. The bad news for the plaintiff was that the court granted the motion to stay. The good news was that the court held that the broad language of the standard broken customer arbitration clause (calling for arbitration of “any controversy arising out of or relating to” the account) did not preclude the arbitrators from considering the issue of punitive damages, even though the agreement stated that it was governed by the laws of New York, under which arbitrators may not grant punitives. According to the district court, the federal Arbitration Act, not state law, governs the categories of claims which may be arbitrated:
The Court perceives no public policy persuasive enough to justify prohibiting arbitrators from resolving issues of punitive damages submitted by the parties. Concluding that arbitrators may determine such issues comports with the principle that under the federal act ‘any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration …’ Citing Moses H. Cone Memorial Hospital v. Mercury Construction Co., 460 U.S. 1, 103 S.Ct. at 941, 74 L.Ed.2d at 785.
569 F.Supp at 824.
In Willoughby Roofing & Supply Company. Inc. v. Kajima, a tightly-reasoned and scholarly opinion, the District Court for the Northern District of Alabama followed Willis, upheld a commercial arbitration panel’s award of compensatory and punitive damages, and held that under the “federal substantive law of arbitrability” only if there were a “clear and express exclusion” in the arbitration contract should arbitrators be denied the authority to award punitive damages. The court rejected the argument that as a matter of public policy, the power to award damages should be limited to courts:
Nor is there reason to believe that the purposes of punitive awards — punishment of the present wrongdoer and deterrence of others who might otherwise engage in similar conduct — will not be furthered by arbitral awards every bit as much as by formal judicial awards. Indeed, an arbitrator steeped in the practice of a given trade is often better equipped than a judge not only to decide what behavior so transgresses the limits of acceptable commercial practice in that trade as to warrant a punitive award, but also to determine the amount of punitive damages needed to (1) adequately deter others in the trade from engaging in similar misconduct, and (2) punish the particular defendant in accordance with the magnitude of the misdeed. 598 F. Supp. at 363.
In a brief but significant decision, the Eleventh Circuit affirmed the district court’s refusal to vacate the award of punitive damages, “substantially on the basis of the district court’s opinion ….”
Review of Arbitration Awards
The greatest advantage of arbitration is that awards are almost irreversible. That is perhaps its greatest peril as well. Awards entered pursuant to the Federal Arbitration Act may only be challenged by an action filed in the United States District Court in and for the district in which it was entered. An award which has a legal or factual basis which may be rationally inferred from the evidence will be upheld. Arbitration awards will not be set aside for a mistake of law unless the arbitrators have acted in “manifest disregard” of the law. Since arbitrators need not explain the reasons for their decisions, it is, however, extraordinarily difficult to prove “manifest disregard.” According to a recent Second Circuit decision, Merrill Lynch, Pierce, Fenner & Smith v. Bobker, to vacate an award for “manifest disregard”:
The error must have been obvious and capable of being readily and instantly perceived by the average person qualified to serve as an arbitrator. Moreover, the term “disregard” implies that the arbitrator appreciates the existence of a clearly governing legal principle but decides to ignore or pay no attention to it.
Otherwise awards may only be overturned upon a finding of corruption, fraud, evident partiality or misconduct, acting in excess of authority, refusal by the arbitrators to postpone a hearing for adequate cause, refusal by the arbitrators to hear material evidence, or failure to make a mutual, final, or definite award. Given this extremely limited standard of review and the presence of nonlawyers on the panel, arbitrators have a commendable tendency to reject technicalities which might be fatal to a suit filed in federal court.
In the last analysis, arbitration is not a trap for investors, neither is it a second class forum. It is an arena in which customers can obtain an expert and fundamentally fair resolution of their claims in a prompt and economical manner. The investor who has been wronged by his broker can ask for no more and should not settle for less.