Chapter 18

• Jurisdiction: United States

Chapter 18 Arbitration of Securities Disputes

Arbitration of securities disputes in the United States can be traced back to the birth of the country. The first bonds were issued by the federal government in 1789 to finance the government's decision to assume the debts of the colonies and the debts the Continental Congress incurred during the Revolutionary War. In 1792, a group of brokers agreed to trade only among themselves on behalf of their customers and this agreement was memorialized in what became known as the "Buttonwood Agreement."¹ In 1817, another group of brokers, including four signers of the Buttonwood Agreement, created the New York Stock and Exchange Board, known then as the "Board of Brokers." The board's rules forbade such things as fictitious trades, called "wash sales," and imposed penalties for the violation of the rules. Also among the rules in the board's constitution was a requirement that the board members arbitrate disputes before the full board and that "all questions of dispute in the purchase or sale of Stocks shall be decided by a majority of the Board."²

In time, the requirement that disputes be decided by the full board was replaced by the creation of an Arbitration Committee composed of five members and that committee began the practice of hearing disputes not only among board members but also between members and their customers.³ Some, including Professor Jill Gross, have traced the use of arbitration to resolve such disputes to the use of such a mechanism in England, where disputes among members of trade groups were resolved by arbitration as early as the fourteenth century.⁴

One of the reasons for the arbitration of securities disputes in the nineteenth century was to ensure that industry norms would be enforced, even if they were otherwise unlawful and not enforceable in court. This allowed the NYSE to protect its good name and reputation, thus perpetuating the near monopoly that the exchange enjoyed.⁵ This was important for at least two reasons. First, many of the practices of the NYSE could not be enforced in a court of law, and second, arbitration was seen as a necessary mechanism for ensuring investor protection, especially because there were no federal securities laws at the time.

Nevertheless, perhaps aided by the U.S. Supreme Court, there was a strong perception that the arbitration of securities disputes was a relatively new phenomenon. It was not. Below, we will discuss the modern history of the arbitration of securities disputes but first, we will briefly review arbitration generally.

Arbitration Generally: A Review

Arbitration is "a process by which parties consensually submit a dispute to a non-governmental decision-maker, selected by or for the parties, to render a binding decision resolving a dispute in accordance with neutral, adjudicatory procedures affording each party an opportunity to present its case."⁶ Some arbitrations are governed by institutional rules (e.g., ICC, AAA) and others are "ad hoc" in which the parties agree on the rules that should apply. There are many advantages in arbitrating disputes rather than litigating them. Often—but not always—arbitration is faster and less expensive than litigation while still providing a forum for a full and fair hearing on the merits. One other benefit is that, generally, the parties can choose their own arbitrators. Still another benefit is that the decision of the arbitrator or arbitrators is typically final and not appealable.

Arbitration is a contract-based dispute resolution mechanism. The parties to the arbitration must have contracted to adopt arbitration as their dispute resolution mechanism. The arbitration clause in a typical contract includes agreement with respect to the type of arbitration (institutional or ad hoc), the seat or situs of the arbitration (the state or country whose arbitration laws will prevail if the rules of the arbitration are insufficient; this is not necessarily the place where the arbitration will be held), and the language and the scope of the arbitration. Generally speaking, the award of the arbitrator or arbitrators is final and unappealable. A court order is necessary to enforce the award.

The Federal Arbitration Act (FAA) was passed in 1925. The FAA expresses and represents an explicit recognition of the importance, irrevocability, and enforcement of arbitral awards and lists the very few grounds on which they can be set aside. An amendment also incorporates the so-called New York Convention, a multinational treaty for the recognition and enforcement of international arbitration awards.

The key provision of the FAA was that arbitration agreements in any "maritime transaction or contract evidencing a transaction involving commerce shall be valid, irrevocable and enforceable save on such grounds as exist at law or in equity for the revocation of any contract." The Supreme Court later ruled that the FAA created "an emphatic federal policy in favor of arbitral dispute resolution."⁷ Even though it preceded the enactment of the federal securities laws and for a very long time was not used as a vehicle for resolving disputes under those securities laws, it could have been so used, since securities transactions were "transaction[s] involving commerce." If there is a valid arbitration agreement, a U.S. court has the power to stay court proceedings and compel arbitration.

For example, Moses H. Cone Memorial Hospital v. Mercury Constr., 460 U.S. 1 (1983), held, "The FAA creates a body of federal substantive law establishing and regulating the duty to arbitrate." But what about Erie Railroad Co. v. Tompkins, 304 U.S. 62 (1938) (no federal common law)? Is arbitration procedural or substantive?⁸

Does the FAA preempt state laws governing the enforceability of arbitration agreements? Section 2 of the FAA establishes a rule of federal substantive law regarding enforceability. See Robert Lawrence Co. v. Devonshire Fabrics Inc., 271 F.2d 402 (2d Cir. 1959). See also Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967) (creates the "separability" doctrine). What about the application of state procedural rules on an arbitration held under the FAA? The law is unsettled. See Volt Information Sciences v. Board of Trustees of Leland Stanford Junior University, 489 U.S. 468 (1989). The Court approved a choice of law provision that incorporated a state law that provided for a stay of arbitration if there is litigation involving a party that is not a party to the arbitration, even though the FAA did not permit such a stay. But see Mastrobouono v. Shearson Lehman Hutton, 514 U.S. 52 (1995). In that case, the contract apparently permitted punitive damages (by referring to rules that permit punitive damages) but selected New York as governing law. New York law does not permit arbitrators to award punitive damages. The Supreme Court said that the choice of law provision would not be interpreted to require the application of state law "limiting the authority of arbitrators" and that the arbitration clause covers the arbitration. So the parties' choice of New York law did not incorporate the procedural limitations in New York law on the power of arbitrators to award punitive damages. Lesson: It is better to be as specific as possible in drafting an arbitration clause.

It is widely held that the enforceability of the arbitration clause itself is separate from the enforceability of the rest of the contract (the so-called "separability doctrine"). In other words, even if the rest of the contract is invalid, the arbitration clause will be separately enforceable and the question of validity will be decided by an arbitral tribunal.

First Options v. Kaplan⁹

This is a very important case. The arbitral award was rendered against both an investment company and its owners with respect to debts owed to a securities clearing house. The owners, Mr. and Mrs. Kaplan, argued that they had never signed the arbitration agreement from which the tribunal drew its power and that they were not bound by its award. The Supreme Court held that unless the arbitration agreement explicitly provided otherwise, the scope of the arbitration agreement was a matter for the courts to decide independently (i.e., without regard to the arbitral finding on the matter). In dicta, the Court suggested that in some situations, the "arbitrability question itself" may be submitted to arbitration and that the courts must defer to arbitrators decisions on the limits of their own jurisdiction. The Supreme Court said there must be "clear unmistakable evidence" that the parties intended the arbitrators to decide the question of arbitrability. What does this mean, especially where there are standard form contracts such as those in the securities industry? Here is the troublesome language from the opinion: "If the parties agreed to submit arbitrability to arbitration, then the court's standard for reviewing the arbitrator's decision about the matter should not differ from the standard courts apply when they review any other matter that the parties have agreed to arbitrate. That is to say, the court should give considerable leeway to the arbitrator, setting aside his or her decision only in certain narrow circumstances."

Professor William "Rusty" Park from Boston University, a leading expert on international arbitration, notes that the term "arbitrability" in the dictum can cover many different matters. He thinks that the Court meant only that the scope of the arbitration clause should properly be delegated to the arbitrators in a separate agreement that is chronologically subsequent to the principal agreement. He adds that if there was a separate agreement in which the parties agreed that the arbitrators had sole competence to decide on their jurisdiction to hear the first agreement, then they could do so. But the suggestion that the arbitrators can determine their own jurisdiction with respect to the identity of the parties, some of which...