The desirability of punitive damages in securities arbitration: challenges facing the industry regulators in the wake of Mastrobuono.

• Author: Mundheim, Peter M.
• Position: Case Note

INTRODUCTION

In 1985, an assistant professor of Medieval Literature at the University of Illinois at Chicago, Antonio Mastrobuono, and his wife, Diana Mastrobuono, entrusted all of their savings to Nick Diminico, a vice-president and representative of Shearson Lehman Hutton, Inc. (Shearson).(1) Diminico was hired to manage their money in a brokerage account.(2) After just two years, Diminico squandered a substantial part of the Mastrobuonos' investment.(3) In 1989, the Mastrobuonos charged that Shearson and Diminico "subjected [their account] to unauthorized trading, churning,(4) and margin exposure." Pursuant to the customer agreement between

Shearson and the Mastrobuonos, an arbitration panel of the National Association of Securities Dealers (NASD) heard the complaint against Shearson and ultimately awarded the Mastrobuonos $159,327 in compensatory damages and $400,000 in punitive damages.(6)

In vacating the punitive damage award, the United States District Court for the Northern District of Illinois ruled that, according to the terms of the agreement, the arbitrators did not have the authority to award it.(7) The United States Court of Appeals for the Seventh Circuit affirmed,(8) effectively stripping the Mastrobuonos of close to seventy-five percent of their award. The Seventh Circuit reasoned that, by including a clause providing that New York law would govern the agreement, the parties manifested their intent to subject the authority of the arbitrators to any constraints placed on them by New York law(9)--and New York law, as established in Garrity v. Lyle Stuart, Inc., prohibits arbitrators from awarding punitive damages.(10)

Undoubtedly, Shearson was elated by the Seventh Circuit's ruling, as brokerage firms would like to exclude punitive damages from arbitration altogether. In holding that a New York choice-of-law clause foreclosed the arbitrators' ability to award punitive damages, the Seventh Circuit made it simple for brokerage firms to avoid the possibility of such sanctions. Even before the Seventh Circuit's decision in Mastrobuono, many firms included a New York choice-of-law clause in their pre-dispute arbitration agreements.(11) They relied on the decision in Garrity and the position of courts like the Seventh Circuit to exclude, in effect, punitive damages as a remedy.(12)

The Mastrobuonos successfully challenged this tactic, however, before the United States Supreme Court.(13) They argued, and the Court agreed, that the New York choice-of-law clause does not dictate the arbitrators' ability to award punitive damages.(14) In a narrowly tailored decision, the Court held that it was not clear from the wording of the customer agreement between the Mastrobuonos and Shearson(15) whether New York decisional law, and thus Garrity, was intended to govern the authority of the arbitrators to grant remedics.(16) The Court relied almost exclusively on the ambiguity of the actual agreement to reach its decision and did not speak to broader issues such as the potential inequity of limiting the remedies available to customers or, on the other hand, the problems with allowing arbitrators to award punitive damages.(17) As a result, the fundamental question whether arbitrators should be permitted to award punitive damages in securities cases remains open. Now the agencies that regulate the securities industry must answer this question.

The regulatory agencies, primarily the NASD and the Securities Exchange Commission (SEC) have the authority to promulgate rules governing the arbitration process, including the types of awards that can be granted.(18) These agencies will seek to compel punitive damages in arbitration only if they believe punitive damages serve an important function in the securities industry. In forming their opinion, the agencies must consider the functions punitive damages are designed to serve and whether they successfully serve those functions in securities arbitration. In addition, the constitutional requirements of due process may mean that punitive damages can only be awarded under certain circumstances.(19) If punitive damages are to become a fixture in securities arbitration, the agencies must address the due process requirements.

This Comment argues that punitive damages are a necessary component of arbitration in the securities industry, but that, given the requirements of due process, arbitrators should be constrained in their ability to make such awards. To develop this argument, the Comment is divided into four parts. Part I chronicles the evolution of arbitration in the securities industry and summarizes the legal debate that developed in the courts regarding whether to uphold or vacate punitive damage awards by arbitrators. Part II analyzes the Supreme Court's decision in Mastrobuono and concludes that the ultimate question whether punitive damage awards should be available in securities arbitration has been left to the industry regulators. Part III explores the purposes of punitive damages and argues that they are vital to the legitimacy of arbitration as the primary method of dispute resolution in broker-customer cases and that they aid in policing the conduct of brokerage firms. In addition, Part III discusses the public policy concerns and the constitutional limitations on arbitrators' authority to award punitive damages. Finally, Part IV advocates a change in the current procedure for awarding punitive damages in securities arbitration which meets the constitutional requirements of due process while enabling punitive damages to serve important functions.

1. THE EVOLUTION OF THE DISPUTE OVER THE ROLE OF PUNITIVE DAMAGES IN SECURITIES ARBITRATION

   1. The Increasing Use of Mandatory Arbitration Agreements

      Today, disputes between brokerage firms and their customers are typically resolved through arbitration. Brokerage firms have increasingly compelled their customers to sign arbitration agreements as a precondition to opening an account.(20) The move toward mandatory arbitration agreements began in 1987 on the heels of the Supreme Court's decision in Shearson/American Express, Inc. v. McMahon.(21)In McMahon, the Court declared that it is the policy of the federal courts to "rigorously enforce agreements to arbitrate.'"(22) The decision in McMahon signaled that brokerage firms could require customers to agree to settle their disputes in arbitration. This legal development led to a dramatic rise in the number of securities arbitration cases. In 1980, 830 securities arbitration cases were filed with the self-regulatory organizations (SROs),(23) and that number rose to 5300 cases in 1993.(24) The oycrwhclming number of cases are brought by investors against brokerage firms.(25)

   2. The Benefits of Arbitration in Securities Cases

      Brokerage firms and their customers benefit when certain disputes are resolved in arbitration rather than in court for several reasons.(26) First, in theory, arbitration is faster than litigation.(27) The average securities arbitration case heard in an SRO forum lasts 383 days from the time the investor's claim is filed until the arbitrators notify the parties of their decision.(28) Second, costs in arbitration are relatively low because forum filing fees are reasonable and investors are not required to be represented by counsel.(29) Third, arbitrators' rulings are rarely overturned, thus rendering the arbitrators "final" decisionmakers. While their decisions may be appealed to a trial court, they are only overturned if "the arbitrators exceeded their powers."(30) This is a difficult standard to meet because there is typically no written opinion in a securities arbitration case.(31) The narrow scope of judicial review coupled with the

      difficulty of demonstrating that an arbitrator has overstepped his bounds operate to make arbitrators' decisions final. The practical finality of arbitrators' decisions reduces the incentive of the losing party to appeal, thereby benefitting both parties by avoiding costly additional litigation. Fourth, many of the arbitrators who hear securities cases have expertise in, or at least familiarity with, the disputed issues.(32) Armed with a more complete understanding of the case, they can render a more informed judgment, which is particularly beneficial in complex cases.

      Brokerage firms gain an additional benefit from arbitration because these proceedings often receive less publicity than trials. As previously noted, no opinions are written or published, although the results of most arbitration hearings are publicly available. Minimizing publicity is particularly important for brokerage firms because they stand to lose business if their reputations are tarnished in the eyes of the public.(33)

   3. How Arbitrators' Punitive Damage Awards Become the Subject of Litigation

      Arbitration cases most often begin when an investor charges a brokerage firm with some form of misconduct. The three most frequent allegations in securities claims are misrepresentation of the

      risk of an investment by the broker, negligence in managing an investor's portfolio, and unauthorized trading in the investor's account.(34) Very often, customers will assert one of these charges against the individual broker and additionally charge the broker's firm with breach of fiduciary duty or negligence for failing to properly supervise the activities of its employees.(35) In all but approximately two percent of the cases actually arbitrated, the arbitration panel grants only compensatory damages.(36) However, in cases of particularly egregious misconduct, arbitrators also award punitive damages against the firm.(37)

      Prior to Mastrobuono, punitive damage awards often became the subject of litigation, particularly if the customer agreement specified that New York law governed. As previously noted, arbitrators cannot award punitive damages under New York law.(38) Therefore, brokerage firms resisted paying punitive damage awards imposed by arbitrators where the...