WASHINGTON - yesterday by ruling 8 to 1 that securities arbitrators can award punitive damages under contract principles established by federal law, even if a state law precludes such awards.
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The ruling in Mastrobuono v. Shearson Lehman Hutton Inc. held that if a contract is ambiguous about what arbitration standards should prevail in a dispute, courts should give greater weight to provisions of the Federal Arbitration Act, which allows arbitrators to award punitive damages, and to the party that did not draft the disputed contract, which is typically the investor.
Writing for the majority, Justice John Paul Stevens said Shearson Lehman in this case "drafted an ambiguous document, and they cannot now claim the benefit of the doubt" that the agreement did not permit punitive awards. The contract should be enforced according to its terms under the federal law allowing the award, the court said.
At issue was a 1985 standardized contract between Shearson Lehman and an Illinois couple, Antonio and Diana Mastrobuono, to open a securities trading account. The Mastrobuonos closed the account in 1987 and sued the brokerage firm and the account executive, Nick DiMinico, for fraud under federal securities law and state consumer protection laws. The investors alleged unauthorized trading, churning, and margin exposure.
The contract included a "choice of law" clause that specified that disputes would be subject to arbitration under New York State law, which allows courts, but not arbitrators, to award punitive damages.
The contract also specified that National Association of Securities Dealers rules, which allow punitive damages, could govern arbitration proceedings.
A three-member NASD panel ultimately awarded the Mastrobuonos $159,327 in compensatory damages, which Shearson did not dispute, and $400,000 in punitive damages, which Shearson fought.
The U.S. Court of Appeals for the Seventh Circuit struck down the punitive award on grounds that the contract was governed by the New York State law that precludes such awards.
Yesterday's ruling reversing the appeals court is a victory for the Public Investors Arbitration Bar Association and the Securities and Exchange Commission, which had argued that investors should be entitled to the same remedies through arbitration proceedings that are available through the court system.
The type of customer agreement at issue in the case is used throughout the securities industry, said Mark Maddox, an attorney with Coons Maddox & Koeller in Indianapolis, which represented the Public Investors Arbitration Bar Association.
The NASD, New York Stock Exchange, and other securities self-regulatory organizations have prohibited securities contracts from waiving customers' rights to arbitration since 1989, Maddox said. But securities firms tried to make an "end run" around the rules through the Mastrobuono case, which drew the participation of the Securities Industry Association and other friend-of-the-court parties, he said.
Yesterday's ruling "completely slammed the door on the end run," Maddox said. He predicted that securities firms would seek to change the stock exchanges' arbitration rules when the NASD considers expected recommendations by an arbitration policy task force it set up last September.
The nine-member commission, which is headed by former SEC chairman David Ruder, is expected to a issue a final report with recommendations by the end of this year on securities arbitration rules.
Spokesmen for NASD and Shearson had no comment on the ruling.
Stuart Kaswell, general counsel of the securities association, said in a statement only that the group is "extremely disappointed that...the Supreme Court has ruled in favor of the awarding of punitive damages in arbitration cases...Our overarching concerns are that punitive damages are often disproportionate to the conditions of the real dispute and are often awarded without any check or balance."
Too often, punitive damages are awarded "either because the defendant is thought to have 'deep pockets,' or because those making the award decide to make a statement or 'send a message' via the damage award," which is "unfair and unreasonable," Kaswell said. He added that the association is "encouraged that the court appeared to limit the ruling to the construction of this contract."
Justice Clarence Thomas in his lone dissent said the ruling affected only the contract at issue.
But Maddox said the ruling affects any agreement with the same "defect" as the Mastrobuono-Shearson contract.
The high court majority reconciled the choice-of-law and arbitration contract clauses by saying that the laws of New York State "encompass substantive principles that New York courts would apply," but not special rules that limit the authority of arbitrators.
"Thus, the choice-of-law provision covers the rights and duties of the parties, while the arbitration clause covers arbitration; neither (provision) intrudes upon the other," the court said.
In contrast, Shearson had argued that the two clauses are in conflict with each other because the choice-of-law provision foreclosed punitive damages while the arbitration clause did not. "This interpretation is untenable," the court said.
The Seventh Circuit "misinterpreted" the contract and should have enforced the arbitration award under contract interpretation law, the court said.
