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Awarding punitive damages in arbitration defines securities' due process downward.

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Awarding Punitive Damages in Arbitration
Defines Securities’ Due Process Downward
Modern securities law practice is, in many respects, coextensive with the practice ofsecurities industry arbitration. Brokers and dealers
in the securities industry have seized upon
arbitration’s ability to deliver less expensive,
more efficient, and authoritative
resolutions ofdisputes with customers and employees than does
the public court system.
In fact, University ofKentucky
Prof.Thomas J. Stipanowich,who
is joining Alternatives’ publisher
CPR Institute as its new president
in January, has observed that in
many circles, arbitral proceedings
are viewed as “[a]veritablesurrogate for the public
justice system.” But are they?
The increase in securities arbitration over
the past decade raises a number of questions
that remain unanswered. Foremost among
them, and central to modern securities arbitration, is whether securities arbitrators have
the power and authority to issue punitive damages, and, if so, whether such awards should
be subjected to constitutional or public policy
T h e modern debate over a securities
arbitrator’s authority to issue punitive damages begins with the New York Court of Appeals decision in Garrity v. LyleStuartInc., 353
N.E.2d 793 (N.Y. 1976). Writing that the “day
is long past since barbaric man achieved redress by private measures,” Id. at 797, the
Garrity court held that the issuance of punitive damages fell beyond the scope of an
arbitrator’s authority, even in those cases in
which the parties had entered into an arbitration agreement expressly providing for punitive damages. Id. at 794.
The decision’s ramifications soon were felt
throughout the securities industry. It was not
long before securities brokers and dealers seized
upon the Garrity rule to insulate themselves
from exposure to arbitral awards of punitive
damages by including New York choice-of-law
provisions in their customer agreements and
employment contracts. Furthermore, most securities firms placed a separate clause in their
customer agreements requiring that all contro-
versies be submitted to arbitration under the
arbitration rules of one of the self-regulatory
organizations, or SROs, such as the New York
Stock Exchange or the National Association of
Securities Dealers.
Combined, the effect of these provisions
was to require that all disputes
be resolved through arbitration,
and then to preclude arbitrators
from issuing punitive damages
against securities dealers. Thus,
customer agreements and employment contracts of this nature functioned as a means of
protecting securities brokers and
dealers from punitive damages
without ever making forthright mention of
that fact. But not every court was as willing to
enforce such clauses as securities dealers might
have hoped, and ultimately, the Garrity rule
and its incorporation into securities firms’
customer agreements created a schism in the
federal courts.
Some federal circuit courts were willing to
uphold these New York choice-of-law clauses
as a ban on arbitral awards of punitive damages, provided that the clauses in issue stood
in accordance with the parties’ intentions. The
Second U.S. Circuit Court of Appeals, for
example, cited the Federal Arbitration Act
(FAA), 9 U.S.C. $9 1-16, as support for the
proposition that arbitration agreements must
be enforced according to their terms and therefore that a New York choice-of-law clause in a
customer agreement with a securities firm precluded arbitral punitive damages awards. See
Barbier v. Shearson Lehman Hutton Inc., 948
F.2d 117, 122 (2d Cir. 1991).
O n the other hand, other federal circuit
courts construed New York choice-of-law
clauses in customer agreements as an indication of the parties’ intent that New York law
should govern the substantive standards as to
when remedies should and should not be
granted, not the question of whether a particular type of remedy was available in an arbitral forum. Courts falling into this latter
camp likewise supported their conclusions
with the FAA, holding that the federal policy
in favor of arbitration and the law give arbitrators broad discretion to fashion remedies,
including issuing punitive damages, and that
i t requires any doubts regarding the
Karl E. Neudorfer, a recent graduate of the Ohio
State University School of Law, i s an associate at
Shayne & Greenwald, i n Columbus, Ohio.
arbitrability of a claim to be resolved in favor
of arbitration. See, e.g., Bonar v. Dean Witter
Reynold Inc., 835 F.2d 1378 (1 Ith Cir. 1988).
It followed directly that securities arbitrators
enjoyed the authority to issue punitive damages in circumstances they deemed appropriate. The Supreme Court, however, had yet to
speak on the matter.
At long last, it did so in Mastrobuono v.
Shearson Lehman Hutton Inc., 514 U.S. 52
(1995). The Mastrobuono court enforced an
arbitral punitive damages award against a securities dealer despite the presence of a New York
choice-of-lawclause in the customer agreement
it had signed with the plaintiff. In doing so,
however, the Court may have created more
questions than it answered. It framed the issue
as being whether the parties’ inclusion of a New
York choice-of-law clause incorporated the
Garrity rule into their agreement.
In what seemed, at least superficially, a
strong blow to securities firms, the Court answered that question in the negative. Because
the NASD arbitration rules referenced in the
customer agreement‘s arbitration clause provided that arbitrators may award “damages and
other relief,” the Court held that they did not
require the conclusion that the provisions of
the agreement authorized punitive damages.
But, the Court reasoned, their incorporation
into the Mastrobuonos’ contract would at least
bear an interpretation maintaining that punitive awards were contemplated by the parties
at the time of contracting.
When that determination was coupled with
the New York choice-of-law provision, the
Court found the customer agreement to be, at
best, an ambiguous manifestation of the parties’ intentions regarding the arbitrators’authority to issue punitive damages. The Court then
cited the federal policy favoring arbitration as
grounds for resolving controversies over the
arbitrability of disputes in favor of arbitration
and seconded that conclusion with the hndamental contract law rule that ambiguous contracts be construed against the drafter, meaning,
of course, the defendant brokerage firm.
Then, construing Shearson Lehman
Hutton’s customer agreement against its drafter,
the Court harmonized the facially discordant
New York choice-of-law and arbitration clauses
by finding that the choice-of-law clause
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Awarding Punitive Damages Defines Due Process Downward
(continued from front page)
“encompass[ed]substantive principles that New
York courts would apply, but not to include
those special rules limiting the authority of arbitrators. Thus, the choice-of-law provision
covers the rights and duties ofthe parties, while
the arbitration clause covers arbitration; neither
sentence intrudes upon the other.” Mmtrobuono,
5 14 64.
But because passages such as this one seem
to speak only to the language used in the arbitration agreement at issue in that case, the extent to which Mustrobuonoresolved the dispute
among the federal circuits over arbitrators’
authority to issue punitive damages remains
elusive. In fact, as authors Bradford D.
Kaufman and Anne Tennant Cooney point
out, “this case came down to the mundane
chore of the Supreme Court interpreting the
terms of a single, isolated contract.”
Mastrobuono therefore left a host of questions
unanswered, and it caused new problems as
well. What the Mastrobuonocourt failed to take
into account was the fact that Shearson
Lehman Hutton, by virtue of its NASD membership, would have been forced to arbitrate
any disputes arising between itself and its customers regardless of whether it had signed a
contract mandating such a result.
Consequently, while the Mustrobuono decision expressly allows for securities dealers to
draft their customer agreements to preclude
arbitral punitive damages awards, provided
that such provisions are explicit and written
with precision, it is not clear that NASD member firms could incorporate such a clause into
their customer contracts without running afoul
of the NASD arbitration rules.
But those rules, as they were read by the
Mattrobuonocourt, prevent securities firms from
drafting contracts that preclude arbitrd punitive damages awards. The effect of such a reading is that NASD member firms are required to
subject themselves to arbitral proceedings to
resolve controversieswith customers or employees and simultaneously to allow for arbitrators
to level punitive damages against them. It should
be underscored, however, that those arbitral
proceedings are not equipped with the public
justice system’s due process machinery, despite
the fact that this machinery has been mandated
by the Supreme Court‘s punitive damages jurisprudence and is designed to prevent the possibilityofarbitrary deprivations of property that
exists whenever punitive damages are issued.
The conclusion that securities firms subject to the NASD rules cannot contract around
arbitral punitive damages awards-even in
spite of the fact that a narrow reading of the
Mustrobuono holding might otherwise allow
them to do so-is supported by the NASD’s
adoption of what have come to be known as
the Anti-Goren rules. The Anti-Goren rules
operate to prohibit securities dealers from including language in arbitration agreements that
restricts an arbitrator‘s authority to issue awards
of any sort, including, presumably, punitive
Though Martrobuono’s holding apparently
is narrow enough to allow for securities bro-
kerage firms to preclude arbitral punitive damages awards with express and clear language in
their customer agreements, doing so may expose an NASD member firm to sanctions by
that body. Thus, the state of the law at this
point seems to be that punitive damage awards
in the securities arbitration context must be
allowed, even in the face of a New York choiceof-law clause and even if all the parties to it
are New York residents.
But the real questions, the ones to which
this article must now must turn, are whether
such arbitral awards are proper or fair, and
whether they are in keeping with constitutional
due process requirements.
The question ofwhether securities arbitration
punitive damages awards face limits set forth
by the U.S. Constitution’s due process guarantees ultimately turns upon a threshold question ofwhether the award issuer is a state actor.
The Supreme Court has established a threeprong test for evaluating whether actions fall
within the rubric of “state action.” See
Edmonson u. Leesuille Concrete Co. Inc., 500
U.S. 614, 620 (1991). The first of the three
factors to be considered is the “extent to which
the actor relies on governmental assistance and
benefits. ...” The second asks whether the actor is performing a traditional government
function. .. .” And the third considers “whether
the injury caused is aggravated in a unique
way by the inciden[ce] ofgovernment authority.” Id. The issuance of punitive damages by
(continued on following page)
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securities arbitrators satisfies all three of these
First, it is the authority of federal law that
compels securities brokerage firms to submit
to punitive awards, irrespective of their fairness. In particular, the NASD is a creature of
congressional creation, and no less an authority than the U.S. Code is the fountainhead
from which power over its members springs.
Congress enacted laws that make registration
in an SRO “registered pursuant to section 7803 of [Title 15 of the U.S. Code]” a prerequisite to trading in securities. But the NASD is
the only SRO that satisfies this requirement.
Furthermore, 15 U.S.C. $ 780-3(b)(2)requires that any securities association registered
with the U.S. Securities and Exchange Commission pursuant to § 780-3, which is to say
the NASD alone, be equipped with the power
to force compliance with “the rules of the association.” One such rule, NASD Code of
Arbitration Procedure Rule 10301(a), mandates that securities disputes “shall be arbitrated
under this Code.”
Thus, it is essentially federal law that compels the arbitration of securities disputes between brokers and their customers or
employees. As Kaufman and Cooney put it,
“[tlhelogic is straightforward: ( 1 ) the [Securities] Exchange Act mandates that securities
firms be members ofthe NASD, an entity created by Congress, and (2) the [SEC], a government agency, made effective the NASD rule
ordering its member firms to arbitrate all their
disputes.” As such, securities arbitrators rely
heavily on “governmental assistance and benefits” in issuing punitive damages.
Second, the Supreme Court has held that issuing punitive damages is a “traditional government function,” observing that “[plunitive
damages have long been a part ofuaditional state
tort law.” Sihoodv. Km-McGee Cop.,464 US.
238,255 ( 1984).This passage does not unequivocally require the conclusion that punitive damages are within the exclusive purview of state
authority, but it certainly tolerates it.
Perhaps even more important is the Gavity
court‘s recognition that one of the purposes
“of the rule of law is to require that the use of
coercion be controlled by the State.” Garrity,
353 N.E.2d at 796. In support of this view, it
should be recognized that the issuance of punitive damages historically has been considered as remaining within the exclusive
authority of the state precisely because their
purpose is, as the name suggests, to punish
the defendant rather than to recompense the
plaintiff for injuries suffered.
Put differently, punishment is and should
remain a function of governmental authority.
If it is not, “vigilante justice” would become
sound public policy, or at least there would be
very little theoretical justification for limiting
it. It is for that reason that “[flor centuries the
power to punish has been a monopoly of the
State, and not that of any private individual.”
Id. at 796. Of course, punitive damages are a
form of punishment. As the Supreme Court
recognized, “a civil sanction that cannot fairly
Each year a t i t s January members’
meeting i n New York, the CPR Institute for Dispute Resolution, Alternatives‘ publisher, presents Awards for
Excellence i n Alternative Dispute
Resolution i n a variety of categories.
The accompanying article i s part of a
series of Alternatives adaptations and
updates of the publication awards.
This month’s article i s b y
former Ohio State Journal on Dispute
Resolution Executive Editor Karl E.
Neudorfer, an associate a t Shayne &
Greenwald i n Columbus, Ohio. I t i s
based on his article ”Defining Due
Process Down: Punitive Damages and
Mandatory Arbitration of Securities
Disputes,” 1 5 Ohio State J. on Disp.
Res. 207 (1999),which won a $2,000
first prize i n the Student Articles
category 17th annual awards presentation earlier this year.
CPR has presented the awards
annually since 1983. For details and
deadlines on the 2000 awards, see
the CPR News announcement on page
188 of this issue.
be said to serve a remedial purpose, but rather
can be explained only as also serving either
retributive or deterrent purposes, is punishment.” U.S. u. Halper, 490 U.S. 435, 448
( 1 989). Thus, issuing punitive damages is
rightly viewed as a “traditional government
Finally, the persons or bodies issuing punitive damages must be regarded as state actors
because the injuries that they cause are “aggravated in a unique way by the inciden[ce] of
governmental authority.” Not only are securities dealers forced into arbitral proceedings by
the NASD, and in turn the authority of federal law, but when punitive damages arbitral
awards are challenged by those against whom
they were leveled, it is the state’s authority in
the form of the public justice system that enforces them.
Likewise, judicial confirmation of arbitral
awards is provided under the FAA. This is significant because in Shelly u. Kraemer, 334 U.S.
1,20 ( 1 948), the Supreme Court‘s awareness
of an injury’s aggravation by judicial enforcement (i.e., governmental action) prompted it
to write that “[sltate action, as that phrase is
understood by the Fourteenth Amendment,
refers to exertions of state power in all its
forms.” As a result, when arbitral punitive
damages awards are issued against securities
brokers and dealers, they are “aggravated in a
unique way by the inciden[ce] ofgovernmental authority.”
Having run arbitral punitive damages
awards through the Edmonson state action calculus, it is difficult to deny that under the
Edmonson factors, securities arbitrators issuing punitive damages against one of the parties before them can be described in all fairness
as state actors. Their authority to do so derives
from federal law, the issuance of punitive damages traditionally has been a function wholly
within the state’s capacity, and the injuries they
cause-deprivations of property-are aggravated in a unique way by judicial enforcement
of the award. Each of these conclusions satisfies one of the Edmonson factors, such that in
the aggregate they form the basis for placing
punitive damages awards within the securities
context under the scope ofstate action. As state
actors, then, securities arbitrators issuing punitive damages are bound by the Constitution’s
due process guarantees.
It is due process that operates to secure the
constitutionality of punitive damage awards.
Such procedural protections ensure that persons or institutions are not deprived of their
property arbitrarily or unfairly. When punitive damages are at stake, however, the threat
of such an arbitrary deprivation is legion. As
the Supreme Court wrote, “[plunitive damages pose an acute danger of arbitrary deprivation ofproperty.” HondaMotor Co. u. Oberg,
512 U.S. 415, 432 (1994).That “acute danger” mandates that any state actor who issues
punitive damages against a private party be
bound by the Due Process Clauses ofthe U.S.
With regard to securities arbitrators issuing
exemplary awards, however, no such procedural
protections-which is to say the process that is
due-are in place. For example, in PacificMu(continued on following page)
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Due Process
(continued from previous page)
tzlal Life Insurance Co. u. Haslip, 499 U.S. 1
(1991), the Supreme Court was willing to uphold the constitutional validity of a jury’s punitive award, but only because the jury’s discretion
in making such an award was limited by an instruction requiring it to consider the twofold
purpose of punitive damages, retribution and
deterrence, and because the award then was
subjected to review at both the trial and appellate court levels.
Thus, the Court observed that multiple
layers of review, in which both trial and appellate judges are required to set forth in the record
a detailed exposition ofseveral factors contributing to the justice ofthe award, coupled with
a charge establishing guidelines for assessment
of punitive damages according to the degree
of reprehensibility of the defendant‘s conduct
and the necessity for deterrence, translate into
the fact that jury discretion was “not unlimited” and “confined to deterrence and retribution.” Id. at 19.
Absent these procedural safeguards, however, it is not clear that the Haslipcourt would
have reached the same result.
It should not be surprising, then, that when
punitive damages are awarded absent an adherence to the procedures discussed and endorsed in Haslip, the Court has indicated that
the awards fall beyond the constitutionally
permissible bounds. Thus, in Honda Motor Co.
u. Oberg, the Supreme Court held unconstitutional an amendment to the Oregon Constitution barring judicial review of the size of
punitive damage awards except in extraordinary circumstances. See Oberg, 512 U.S. at
418. In other words, the elimination ofjust a
single component of the procedural protections approved in Haslip rendered a punitive
damages award unconstitutional.
It must be counted as curious, though,
that none of these procedural safeguards are
available in the securities arbitration arena.
Therefore, it is doubtful that awards of exemplary damages by securities arbitrators
could be regarded as consistent with the Fifth
and Fourteenth Amendments’ due process
guarantees. None of the procedures set forth
in Haslip or Oberg-narrowed jury discretion, judicial review, or appellate review-is
available to the parties coming before an arbitration panel armed with the power to issue punitive damages.
Furthermore, as Judge C. Arlen Beam of
the Eighth Circuit pointed out, in arbitration
“[d]iscovery is abbreviated if available at all.
The rules of evidence are employed, if at all,
in a very relaxed manner. T h e
factfinders . .. operate with almost none of the
controls and safeguards assumed in Haslip.”
Lee u. Chica, 983 E2d 883, 889 (8th Cir.
1993)(Beam, J., concurring in part and dissenting in part).
Exacerbating the problem even further is
the fact that judicial review ofpunitive awards
under the FAA is so restricted that it has been
rendered virtually meaningless, as it permits
judges to vacate arbitral awards only in the
most egregious of circumstances.
And finally, because arbitrators rarely if ever
are required to set forth the bases for their resolution of conflicts, the possibility of error in
assessing punitive damages is not insubstantial. With the chances of error so great, and
the possibility for meaningful judicial review
so slim, these considerations would seem to
require the conclusion that punitive damages
awards by securities arbitrators are neither constitutional nor just.
This view is reinforced by the fact that arbitral punitive damages awards are an inadequate
mechanism to deter bad conduct. In order that
punitive damages operate to protect the public
by deterring others from engaging in the culpable conduct from which the exemplary damage award stems, it is necessary that the reasons
underlying the award be made public. Arbitral
awards, however, are rarely published, and when
they are, the decision often comes down in a
single sentence and is not accompanied by an
exposition of the arbitrator‘s reasons for issuing
the award or even a recital ofthe dispute’s facts.
The effect of all this is to render arbitral awards
of punitive damages an ineffective and inappropriate means of deterring securities firms’
egregious behavior.
In the final analysis, the effect of the
Mastrobuono decision remains unclear. What
is clear, however, is that securities arbitrators
should be required to adhere to the exacting
due process standards established by the Constitution and the Supreme Court. Yet unwavering conformity with due process guidelines
is inconsistent with the goals of arbitration
as well as a person’s motivation to enter the
arbitral forum. Therefore, until there exists
some mechanism for reconciling the two,
punitive damage awards should be regarded
as an unacceptable and constitutionally improper component of the securities arbitra*
tion process.
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