Amicus Curiae Brief — Mastrobuono v. Shearson Lehman Hutton, Inc.

Supreme Court brief1995

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In the Supreme Court of the Bnited States

OCTOBER TERM, 1994

ANTONIO C. MASTROBUONO, ET AL.,

PETITIONERS,

On Writ Of Certiorari To The United States Court

Of Appeals For The Seventh Circuit

BRIEF FOR THE

SECURITIES INDUSTRY ASSOCIATION AS

AMICUS CURIAE SUPPORTING RESPONDENTS

STUART J. KASWELL ANDREW L. FREY*

General Counsel ANDREW J. PINCUS

Securities Industry Mayer, Brown & Platt

Association 2000 Pennsylvania Ave. , N. W.

1401 Eye Street, N.W. Washington, D.C. 20006 .

Washington, D.C. 20006 (202) 778-0602 4

(202) 326-5314

EST AVAILABLE COPY Mame

QUESTION PRESENTED

Whether the contract between petitioners and respondent

Shearson Lehman Hutton precluded the arbitrators from

awarding punitive damages.

‘3

TABLE OF CONTENTS

Page

INTEREST OF THE AMICUS CURIAE.......... 1

or rere er er 2

SUMMARY OF ARGUMENT ..............-. 5

AGE nc cent eee saekowes he eee 7

PETITIONERS MAY NOT RECOVER

PUNITIVE DAMAGES IN THE

ARBITRATION PROCEEDING ............ 7

A. The Courts Below Correctly Interpreted

The Parties’ Agreement As Incorporating

yp Ff PPT ee ee 7

B. Relevant Policy Considerations Weigh

Sharply Against Construing The Contract

To Allow Awards Of Punitive Damages In

AGE oc cn actawunes ensues 12

1. Permitting Awards Of Punitive

Damages Would Substantially

Vitiate The Considerable

Practical Benefits Of Securities

yf OV TE TT eee 13

2. In View Of The Pervasive Regulatory

Oversight Of The Securities Industry,

Arbitral Punishment Is Not Necessary

To Deter Securities Violations ....... 17

3. The Contract Provision Is Not

CS. i. ca ka eee eee 21

C. NASD Rule 21(f)(4) Does Not Override

Contractual Choice-of-Law Provisions ..... 24

TABLE OF CONTENTS - Continued

1. Petitioners’ Construction Makes

No Sense And Is Inconsistent With

MEN vou ccc cc ce

2. Petitioners’ Interpretation Of

The Rule, If Adopted, Would Raise

Serious Questions About The Con-

stitutionality Of The Current

Arbitration System. ww ww ww www.

CONCLUSION

ee ee ee ee ee ee ee ee ee ee oe ae a

TABLE OF AUTHORITIES

Pages

Cases

Abood v. Detroit Board of Education,

ee ee ec eke een ea eeee vas 27

Baravati v. Josephthal, Lyon & Ross, Inc.,

y Pe pb Ty ls ee) ee 11

Barbier v. Shearson Lehman Hutton Inc. ,

948 F.2d 117 (2d Cir. 1991).......... 8, 11, 26

City of Newport v. Fact Concerts, Inc.,

Se es eT En cee cece ecco eneneen 22

Dean Witter Reynolds Inc. v. Byrd,

4 & 5 re ae a oe

Edmonson v. Leesville Concrete Co.,

De Me EE. ce cece se ceseceene 29

Electrical Workers v. Foust,

ee E- on eee bes cndtiecwenetes 22

Fahnestock Co. v. Waltman, 915 F.2d 512

(2d Cir.), cert. denied, 112 S. Ct. 389

aE ee ee ee a ee 11

Gage v. CIGNA Sec., Inc., No. 90-01371

SP PCD «ha nccteeconecvecssns 16

Garrity v. Lyle Stuart, Inc.,

353 N.E.2d 793 (N.Y. 1976) ........... passim

Georgia v. McCollum,

eS 8 5 Fae eee ee 29

Gertz v. Robert Welch, Inc.,

ee EN o's 6 io 6-6 4 4 od 8 8 8 Oe 15

Harper v. Shearson Lehman Bros., Inc..,

No. 91-00508 (NASD Mar. 26, 1992) ........ 16

etd Pu aS 9% FP St mp hm hee PVG DR

TABLE OF AUTHORITIES - Continued

Pages

Hickman v. PaineWebber, Inc. , No. 90-03354

OCT occcudcbeessesben 16

Honda Motor Co. v. Oberg,

8 ee ee 6, 15, 29

INS v. Lopez-Mendoza,

ee re... ww ee ees becuse 20

Johnson v. Zerbst,

I ww cece cunebeee 22

Keller v. State Bar of California,

ee ew bene 27

McDermott, Inc. v. AmClyde,

i wo ew tee eer ees 14

Mitsubishi Motors Corp. v.

Soler Chrysler-Plymouth, Inc..,

pe es MPD cs ccc cc etc sewses 7, 13, 21

Moose Lodge No. 107 v. Irvis,

gO 28

Moses H. Cone Memorial Hospital v.

Mercury Construction Corp..,

tc eeer 8, 9, 10

Pacific Mutual Life Insurance Co. v.

Haslip, 499 U.S. 1 (1991) ......... 6, 14-15, 29

In re Paris Air Crash, 622 F.2d 1315

(9th Cir.), cert. denied,

re ee 22

Pierson v. Dean Witter Reynolds, Inc..,

742 F.2d 334 (7th Cir. 1984) ............. 22

TABLE OF AUTHORITIES - Continued

Pages

Railway Employees’ Dept. v. Hanson,

rf fe | eT eee eee 27-28

Robertson v. Prudential Bache,

No. 33 136 00114 92 00

oS | ee ee 16

Rodriguez de Quijas v.

Shearson/American Express, Inc.,

Is ob ok oe S640 + 2 ee + ee 8 2

San Francisco Arts & Athletics v.

United States Olympic Comm. ,

ee sg ow cence pees ewes eee 29

Shearson/American Express Inc. v. McMahon,

— fe TT eee ee 2, 6, 23

Volt Information Sciences, Inc. v.

Board of Trustees, 489 U.S. 468 (1989) .. 7-8, 9, 10

Statutes, Rules and Regulations:

Federal Arbitration Act, 9 U.S.C.§4 ........... 7

Federal Arbitration Act, 9 U.S.C.§10.......... 12

ee er ere eee ae ee 3

DO 2 bs 6 6 o:0.0's oo 62.6 042 65.0 em 18

ik 6's 'a o'4-$.¢- 4-6 0 © 90's 9 8'O 4-08 20

Coos ss 5 oO see saw eee eal eee 3

a Re eee ere ee 18

iL 2. dis 5 5 os 6 ee te eee bee’ 3, 19

Se ee ED wove e ccc echecnces 4, 28

DTTC sce t ei csencancecsee teases 20

PRUE cestwecotesaaacevedeueees 20

Vii

TABLE OF AUTHORITIES - Continued

Pages

I te a a 20

A ra a en 21

Se CS a a 5 ee 4 bc Kees 20

Se Ge EE oc no i bob ee ecceceeeecs 18

54 Fed. Reg. 21144 (1989) ................. 25

ep 26

Ariz. Rev. Stat. Ann. §§ 44-1961 to 44-1962 ...... 20

Ariz. Rev. Stat. Ann. § 44-1991 .............. 20

Ariz. Rev. Stat. Ann. § 44-1995 .............. 20

Ariz. Rev. Stat. Ann. § 44-2036 to 44-2037 ....... 20

Colo. Rev. Stat. Ann. §§ 11-51-410 to 11-51-501 ... 20

Colo. Rev. Stat. Ann. § 11-51-60] to 11-51-603 .... 20

Wee Gee Se. Gs DW, GD nw ww ccc cc cc ccccee 20

We ee thee een 20

es FF % Se re 20

Miscellaneous:

General Accounting Office, Securities

Arbitration — How Investors Fare

a hg Pe es Oc wk ce be 3, 23

5 Securities Arbitration Commentator,

cs ine WWiae eye ebb db ceeceas 16

Securities Industry Conference on Arbitration

I 3

NASD By-Laws Art. IV & ScheduleC .......... 19

NASD Code of Arbitration Procedure §5 ........ 19

NASD Code of Arbitration Procedure § 12(a) ...... 11

NASD Code of Arbitration Procedure § 14-45 ...... 4

Vili

TABLE OF AUTHORITIES - Continued

Pages

NASD Code of Arbitration Procedure § 19(c) .. . . 16, 23

NASD Code of Arbitration Procedure § 23(a) ...... 23

NASD Code of Arbitration Procedure §32 ..... 13, 24

NASD Code of Arbitration Procedure §33 ....... 24

NASD Code of Arbitration Procedure § 34 ....... 13

NASD Code of Arbitration Procedure § 41 ..... 13, 24

NASD Rules of Fair Practice Art. T11,§1........ 18

NASD Rules of Fair Practice At. IV,§2........ 19

NASD Rules of Fair Practice Art. IV,§3 ........ 19

NASD Rule of Fair Practice 21(f)(1) & (2) ........ 4

NASD Rule of Fair Practice 21(f)(4) ....... 6, 24-30

NASD Rule of Fair Practice 21(f)(5) ........... 24

NASD, Disciplinary Procedures (1990) .......... 19

NASD Notice to Members 88-87 (Nov. 1988) ...... 25

NASD Notice to Members 93-32 (May 1993) ...... 19

GURL, AEE TENNIS = TI ww ccc ccc eeses 19

Uniform Code of Arbitration § 28(h) ........... 26

ot tS tea, SO

Jn the Supreme Court of the Anited States

OCTOBER TERM, 1994

No. 94-18

ANTONIO C. MASTROBUONO, ET AL.,

PETITIONERS,

Vv.

SHEARSON LEHMAN HUTTON, INC., ET AL.,

RESPONDENTS.

On Writ Of Certiorari To The United States Court

Of Appeals For The Seventh Circuit

BRIEF FOR THE

SECURITIES INDUSTRY ASSOCIATION AS

AMICUS CURIAE SUPPORTING RESPONDENTS

INTEREST OF THE AMICUS CURIAE

The Securities Industry Association (SIA) is the principal

trade association of the securities industry, with more than

750 member firms in the United States and Canada. As a

member of the Securities Industry Conference on Arbitration,

the SIA has been intimately involved in the evolution of the

arbitration process. That process began in the securities

industry as far back as 1872, when the New York Stock

Exchange began using alternate means of resolving disputes.

From the time of that rudimentary beginning to today’s

substantial arbitration system, which disposes of more than

five thousand claims annually, the securities industry has been

a pioneer in the use of arbitration to resolve disputes quickly,

fairly, efficiently, and economically.

This case brings before the Court an important question

about arbitration. The arbitration agreements between

securities firms and their customers frequently contain a

choice-of-law clause; different agreements reference the laws

of different States. The industry contends, and numerous

courts — including the courts below — have agreed, that

clauses referencing New York law incorporate into the

agreement the rule of Garrity v. Lyle Stuart, Inc., 353

N.E.2d 793 (N.Y. 1976), which held that arbitrators may not

award punitive damages. Petitioners argue that this provision

of the agreement is preempted by the Federal Arbitration Act

or unenforceable for various other reasons.

Because the SIA’s members have a significant interest in

ensuring that their arbitration contracts are enforced according

to their terms, the Association tenders this amicus brief to

assist the Court in its consideration of this case. The SIA has

participated as amicus curiae in other cases involving issues

arising in securities industry arbitrations, including Dean

Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985);

Shearson/American Express Inc. v. McMahon, 482 U.S. 220

(1987); and Rodriguez de Quijas v. Shearson/American

Express, Inc., 490 U.S. 477 (1989).

STATEMENT

The arbitration proceeding giving rise to this case was

one of literally thousands of arbitrations that take place each

year pursuant to agreements between securities firms and

their customers. In 1993, for example, 6,561 cases were

received by the organizations principally involved in connec-

tion with arbitration of securities disputes. Securities Industry

Conference on Arbitration Report #8 29 (June 1994). That

represents a nearly fourfold increase over the number of cases

received in 1983. Ibid.

A total of 5,363 cases were resolved in 1993; of those,

1,617 were decided on the merits and the remainder were

settled. Securities Industry Conference on Arbitration Report

# 8, supra, at 29. The increase in resolutions from 1983 to

1993 more than exceeded the increase in cases received,

indicating that the arbitration fora have succeeded in keeping

pace with the tremendous increase in demand for their

services.

Moreover, recent analyses of the results of these

arbitrations confirm the general fairness of the process:

outcomes are closely divided between claimants and securities

firms, with claimants winning a slightly higher percentage of

the cases. Thus, the General Accounting Office found that

investors prevail in 59% of the cases that they file. General

Accounting Office, Securities Arbitration — How Investors

Fare 35 (May 1992). The arbitration process also is compar-

atively expeditious. The GAO Study found (id. at 43) that

securities disputes were resolved, on average, in a little over

one year when arbitrated through the securities industry self-

regulatory organizations (SROs) — the national exchanges and

registered securities association endowed with statutory

authority to regulate the securities industry (see 15 U.S.C. §§

78f, 780-3 & 78s) — whereas cases litigated in the court

system took considerably longer (id. at 49).

Although the use of arbitration as an alternative to the

judicial system dates back to practices instituted by the New

York Stock Exchange in 1872, the arbitration process has

evolved considerably since that time. The SROs have

adopted rules governing arbitration. These rules establish

procedures governing, for example, filing of a claim,

selection of arbitrators, pre-hearing discovery, the hearing,

and entry of the arbitrators’ decision. See generally NASD

Code of Arbitration Procedure §§ 14-45. The SROs also

regulate the terms of the agreement between the customer and

the securities firm. See, e.g., NASD Rule of Fair Practice

21(f)(1) & (2) (requiring that predispute arbitration clauses

contained in post-September 1989 customer agreements “be

highlighted” and disclose specified information regarding the

arbitration process). Moreover, the SEC is endowed with

plenary authority over SRO rules. 15 U.S.C. § 78s(b) & (c).

Some of the contracts between securities firms and their

customers contain a clause similar to the one at issue here,

which provides in pertinent part:

This agreement * * * shall be governed by the laws

of the State of New York. * * * [A]ny controversy

arising out of or relating to [the petitioners’]

accounts * * * shall be settled by arbitration in

accordance with the rules then in effect of the

National Association of Securities Dealers, Inc. or

the Boards of Directors of the New York Stock

Exchange, Inc. and/or the American Stock Exchange

Inc. as [petitioners] may elect.

Pet. App. 44.’

The district court concluded that this provision constituted

an agreement by the parties to bar awards of punitive

damages in arbitration (at least unless and until New York

law changes). It found that “a customer of a brokerage firm

who signs an agreement expressly governed by New York

law” has agreed that punitive damages will not be available

in arbitration because — under the holding of Garrity v. Lyle

' The selection of New York law is by no means uniform across

the securities industry. Other contracts, especially those of regional

securities firms, reference the law of other States.

Stuart, Inc., 353 N.E.2d 793 (N.Y. 1976) — New York law

9g arbitrators from awarding punitive damages. Pet. App.

1, 33.

The court of appeals agreed. It stated that “the parties

agreed to arbitrate all of their controversies under New York

law. By choosing New York law without excluding its

arbitration rules, the parties adopted Garrity as a binding

tule.” Pet. App. 12. “Given our conclusion that the parties

wished to arbitrate all of their disputes subject to Garrity,

there is no need to consider whether the Garrity rule is

preempted by the [Federal Arbitration Act] or by the federal

common law ‘govern[ing] the construction of arbitration

agreements.’” Jd. at 20 (citation omitted).

SUMMARY OF ARGUMENT

The questions before the Court in this case are in the first

instance issues of state law. “The preeminent concern of

Congress in passing the [Federal Arbitration] Act was to

enforce private agreements into which parties had entered.”

Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213, 221

(1985). The courts below concluded that the arbitration

agreement's choice-of-law provision referencing New York

law incorporates the Garrity rule barring the imposition of

punishment by arbitrators. Because the parties agreed to that

provision, it is binding under the Arbitration Act.

Petitioners contend that the parties’ agreement should be

invalidated for several reasons, all of which are meritless.

They claim, for example, that availability of punitive damages

provides needed deterrence of misconduct; but that contention

is utterly unfounded, because existing SRO disciplinary

systems ensure that any wrongdoing brought to light in

arbitration will be scrutinized by expert regulators and

punished when appropriate. If anything, the injection of

uncontrolled punitive damages into the arbitration process will

distort and undermine the comprehensive SRO disciplinary

mechanisms. As for petitioners’ claim that the arbitration

agreement is unconscionable, it rests on the very contentions

rejected by this Court when it upheld the arbitrability of

federal securities claims in Shearson/American Express Inc.

v. McMahon, 482 U.S. 220, 223-224 (1987).

Subjecting a party to liability for punitive damages in

arbitration against his or her will, on the other hand, would

raise concerns of fundamental fairness and constitutional due

process. To the extent petitioners and their amici contend

that the arbitrators are entitled to administer punishment

despite the parties’ contrary agreement, whether through

preemption under the FAA or by operation of the SRO rules

that respondent must obey under compulsion of federal law,

the arbitration standards would have to satisfy due process.

This Court’s decisions in Honda Motor Co. v. Oberg,

114 S. Ct. 2331, 2340 (1994), and Pacific Mutual Life

Insurance Co. v. Haslip, 499 U.S. 1 (1991), establish that

specific procedural protections — including, most

importantly, independent review of any punitive award by a

court or, perhaps, a separate appellate tribunal within the

arbitration process — are essential prerequisites for a

constitutional punishment regime. Because the current

securities arbitration system includes no such protections, the

unconsented injection of punitive damages exposure would be

unconstitutional.

Finally, the government solicits an advisory opinion from

the Court stating that NASD Rule 21(f)(4), which it

acknowledges is inapplicable to the customer agreement here,

would, where applicable, preclude enforcement of choice-of-

law provisions that have the effect of barring arbitrators from

imposing punitive damages. The government suggests that

the meaning of the rule is so obvious that the Court should

save itself the trouble of waiting to decide the question until

some future case in which it actually is presented. In fact,

however, it is the government’s construction that is manifestly

in error. The language of the rule, informed by the relevant

et ene sr a nN eee

—s

rulemaking history, leaves no doubt that the rule was not

intended to restrict the operation of choice-of-law clauses.

ARGUMENT

PETITIONERS MAY NOT RECOVER PUNITIVE

DAMAGES IN THE ARBITRATION PROCEEDING

A. The Courts Below Correctly Interpreted The

Parties’ Agreement As Incorporating The Garrity

Rule.

Section 4 of the Federal Arbitration Act (FAA), 9 U.S.C.

§ 4, empowers the district courts to direct parties “to proceed

to arbitration in accordance with the terms of the agreement.”

Thus, “the federal policy is simply to ensure the

enforceability, according to their terms, of private agreements

to arbitrate.” Volt Information Sciences, Inc. v. Board of

Trustees, 489 U.S. 468, 476 (1989). See also Mitsubishi

Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S.

614, 625 (1985) (the policy of the FAA “is at bottom a policy

guaranteeing the enforcement of private contractual arrange-

ments”); Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213,

221 (1985) (“[t}he preeminent concern of Congress in passing

the Act was to enforce private agreements into which parties

had entered”).

The critical — and disp»sitive — question in this case

accordingly is whether the parties agreed that punitive

damages would not be available if they had a dispute that

went to arbitration. Both courts below concluded that by

expressly choosing New York law to govern the agreement,

the parties incorporated the rule of Garrity v. Lyle Stuart,

Inc. , 353 N.E.2d 793 (N.Y. 1976), which holds that arbitra-

tors may not award punitive damages.

This Court faced a virtually identical issue in Volt. The

agreement there provided that “[t]he contract would be

governed by the law of the place where the project is

located,” and the lower courts held that this choice-of-law

clause incorporated California rules of arbitration into the

parties’ agreement. 489 U.S. at 470, 472 (internal quotations

omitted). The lower courts therefore ordered the arbitration

stayed under a provision of California law authorizing a court

to stay an arbitration pending the resolution of related

litigation between a party to the arbitration agreement and

third parties not bound by the agreement. /d. at 472.

Observing that “the interpretation of private contracts is

ordinarily a question of state law, which this Court does not

sit to review,” this Court declined to revisit the lower courts’

determination that “by incorporating the California rules of

arbitration into their agreement, the parties had agreed that

arbitration would not proceed in situations which fell within

the scope of” the state law stay provision. 489 U.S. at 474,

475. That same conclusion is appropriate here.

As in Volr, the lower courts’ construction of the contract

rests on their interpretation of state contract law. Accord,

Barbier v. Shearson Lehman Hutton Inc. , 948 F.2d 117, 122

(2d Cir. 1991) (holding that the choice-of-law clause

incorporates the Garrity rule). There simply is no reason for

this Court to revisit that issue.

Moreover, again as in Volt, the principle that, in applying

State-law rules of contract interpretation, “questions of

arbitrability * * * [are to] be addressed with a healthy regard

for the federal policy favoring arbitration” (489 U.S. at 475)

affords no basis for setting aside the lower courts’

construction of the contract. To begin with, this Court has

utilized that principle only in determining whether a particular

cause of action is arbitrable. See, e.g., Moses H. Cone

Memorial Hospital v. Mercury Construction Corp. , 460 U.S.

1 (1983). The federal policy favoring arbitration is implicat-

ed in that context because of the risk that an ambiguous

contract provision could be misinterpreted and a cause of

action erroneously found nonarbitrable.

When, by contrast, the question involves not the

availability of arbitration but simply the standards governing

the arbitration proceeding — procedures, available remedies,

and the like — the Court has not invoked this federal

principle of interpretation. That is because, as the Court put

it in Volt, “[t}here is no federal policy favoring arbitration

under a certain set of procedural rules; the federal policy is

simply to ensure the enforceability, according to their terms,

of private agreements to arbitrate.” 489 U.S. at 476. In

other words, although the FAA embodies a preference for

erring on the side of overinclusiveness in determining what

causes of action are subject to arbitration, the statute simply

does not prefer one set of arbitration standards over another.

That issue is left entirely to the parties’ agreement, as

construed pursuant to governing state law principles.

The government attempts (Br. 21-23) to inject the Cone

principle into this case on two grounds, neither of which

withstands scrutiny. First, it recites the truism that by

agreeing to arbitrate a claim, a party does not forego the

substantive rights associated with that claim. Here, of

course, petitioners did more than simply agree to arbitrate:

they also agreed to the application of New York law. That

selection of a particular State’s law may, among other things,

impact upon the circumstances in which relief is available

under the agreement. Surely the FAA allows parties to an

arbitration agreement to make such a choice.

If the government means to assert that Cone’s interpre-

tative principle extends to construing any contractual

restriction on the arbitrator’s authority, it is equally mistaken.

Volt upheld a significant limitation on arbitration that, as the

dissenters observed (489 U.S. at 487), effectively vitiated the

right to arbitration. Even though the stay of arbitration

overrode the provisions of the FAA itself, the Court held the

Cone principle inapplicable and enforced the parties’ agree-

ment:

[w]}here, as here, the parties have agreed to abide by

state rules of arbitration, enforcing those rules

according to the terms of the agreement is fully con-

sistent with the goals of the FAA, even if the result

is that arbitration is stayed where the Act would

otherwise permit it to go forward.

489 U.S. at 479. To the extent the government’s Cone

derived “unambiguous intent” standard (see Br. 23) would

override the parties’ choice of state law here, it is squarely

inconsistent with Volt. The Court there limited the arbi-

trator’s authority based on the very same manifestation of the

parties’ intent relied upon by the courts below in this case —

the contract’s choice-of-law clause.

Second, the government asserts (Br. 22-23) that the

courts below were wrong to hold that the New York choice-

of-law provision incorporates Garrity because that decision

allegedly rests on “mistrust of arbitrators.” But the wisdom

of and basis for the policy underlying Garrity is irrelevant

because that rule does not apply here of its own force; it

applies because the parties chose to abide by New York law.

Moreover, as we discuss below (at 15-17), the government’s

characterization of Garrity is wrong.’

* The government states (Br. 23) that “[tJhe necessary

consequence of the Garrity rule * * * is that execution of an

arbitration agreement entails not simply consent to an alternative

forum, but a waiver of substantive rights as well.” While that

observation might have some relevance in a case in which the

arbitration agreement was silent or expressly provided for punitive

damages awards, it is wholly inapposite here, where Garrity applies

not because the parties executed an arbitration agreement, but

rather because the parties expressly chose to be bound by New York

law.

aE Pm

The Cone principle is inapplicable here for the additional

reason that the contract is not ambiguous. The lower courts’

construction of the choice-of-law clause is the same one

adopted by the lower courts in Volt: a choice-of-law clause

incorporates the state law rules governing arbitration. As the

Second Circuit put it, a contract such as the one here is

“clear” on that point. Barbier, 948 F.2d at 122.

The only possible question is whether the reference in the

contract to the arbitration rules of the NASD and other SROs

introduces any ambiguity into the equation. All of these rules

are silent with respect to the availability of punitive damages.

What they mean, we believe, is simply that the arbitrator has

such powers as may be conferred by the contract. NASD

Code of Arbitration Procedure § 12(a) (dispute “shall be

arbitrated as provided by any duly executed and enforceable

written agreement”). Accordingly, whatever the appropriate

default rule might be when the contract is silent (compare

Fahnestock Co. v. Waltman, 915 F.2d 512, 519 (2d Cir.)

(punitive damages barred), cert. denied, 112 S. Ct. 389

(1991), with Baravati v. Josephthal, Lyon & Ross, Inc., 28

F.3d 704, 710 (7th Cir. 1994) (punitive damages allowed

where there is no choice-of-law clause)), the default principle

has no application to the situation in which, as here, the

contract resolves the point.?

Petitioners argue this case (see Br. 17-58) as if the

contract stated “punitive damages may be awarded in arbitra-

* The court below observed (Pet. App. 15) that the NASD

Arbitration Manual states that the issue of punitive damages “may”

arise and arbitrators “can” consider that remedy. To begin with,

the agreement refers to the NASD “rules” — the NASD Rules of

Fair Practice and Code of Arbitration Procedure — not to the

Manual. Moreover, the Manual does not state that punitive

damages are always available. Rather, it recognizes that arbitrators

“can” consider them — which we do not dispute, if the arbitration

agreement allows that remedy.

tion” and the question before the Court was whether the FAA

preempted the application of Garrity to thwart the will of the

parties. But the contract said nothing of the sort; rather, it

explicitly selected New York law, meaning, as discussed

above, that the parties agreed to be bound by Garrity. Far

from being in a position to invoke the FAA to avoid that

agreement, petitioners are confounded by the FAA’s policy

of enforcing arbitration agreements.‘

* bead Saal -

In addition to addressing the questions presented in this

case regarding the meaning and enforceability of the choice-

of-law provision contained in the arbitration agreement, the

government raises an argument not presented in the petition,

contending (Br. 12-19) that the arbitrators’ determination that

the agreement authorized punitive damages is not subject to

de novo review under Section 10 of the Federal Arbitration

Act, 9 U.S.C. § 10. The SIA agrees with respondents that

— for the reasons stated in their brief — the de novo review

Staudard applies here.

B. Relevant Policy Considerations Weigh Sharply

Against Construing The Contract To Allow

Awards Of Punitive Damages In Arbitration.

Petitioners and their amici advance a number of policy

arguments in support of their contention that punitive

damages should be available in cases such as this one.

Although, as we have discussed, we believe that this case is

controlled by the parties’ agreement and not general policy

considerations, we cannot fail to respond to these arguments.

* The government’s musings (Br. 26-27) about how the issue

might be resolved if there were no choice-of-law provision in the

contract are entirely irrelevant: the contract before the Court does

contain such a provision, and the critical question here is the

meaning of that contract, as the government itself recognizes (id.

at 12, 20-25).

In fact, the relevant policy considerations fully support the

court of appeals’ construction of the contract.

1. Permitting Awards Of Punitive Damages

Would Substantially Vitiate The Considerable

Practical Benefits Of Securities Arbitration.

A principal attraction of the arbitration process is its

speed and procedural simplicity, and therefore lower cost, in

comparison to the civil litigation system. “[I]t is often a

judgment that streamlined proceedings and expeditious results

will best serve their needs that causes parties to agree to

arbitrate their disputes; it is typically a desire to keep the

effort and expense required to resolve a dispute within

manageable bounds that prompts them mutually to forgo

access to judicial remedies.” Mitsubishi Motors Corp. , 473

U.S. at 633.

Securities arbitrations are far from summary proceedings,

but they remain much more informal than civil litigation.

Procedural and evidentiary rules are relaxed; only focused

discovery is permitted; claimants are often able to present

their cases without having to retain legal counsel; and

arbitrators are not required to provide reasons for their

decisions. NASD Code of Arbitration Procedure §§ 32, 34,

41.

Injecting punitive damages into this system would alter it

in two significant respects. First, the stakes in each

individual arbitration would change dramatically. Unlike the

potential magnitude of compensatory damages, which usually

can be estimated with some certainty, punitive damages are

by their very nature uncertain. The increase in monetary

stakes that would result from the addition of the “wild card”

of a possible huge punitive damages award would impel

defendants and claimants to devote more resources to the

arbitration process. That would increase the parties’ costs

and prolong the process, significantly diminishing the value

of arbitration as an efficient and speedy means of settling dis-

putes. °

Second, simple fairness — and likely due process require-

ments as well (see pages 28-31, infra) — would necessitate

significant changes if punitive damages are broadly available

in arbitration. Indeed, although petitioners and their amici

attempt to paint the result in Garrity as resting on mistrust of

arbitrators, it is in fact a decision grounded in the New York

court's concern that allowing awards of punitive damages in

arbitration would violate fundamental principles of fairness.

It is by now well settled that limits on the discretion of

a decisionmaker awarding punitive damages are essential to

prevent unfair results. “One must concede that unlimited jury

discretion -- or unlimited judicial discretion for that matter —

in the fixing of punitive damages may invite extreme results

that jar one’s constitutional sensibilities.” Pacific Mutual Life

Insurance Co. v. Haslip, 499 U.S. 1, 18 (1991).° Just last

* Amicus Public Investors Arbitration Bar Association (PIABA)

Suggests (Br. 13) that the threat of punitive damages gives defen-

dants an increased incentive to enter into settlements. Unfortunate-

ly, that threat operates against innocent defendants as well as guilty

ones. Especially in view of the absence of procedural protections

in the arbitration process, innocent parties may be forced to settle

out of fear of unjustified liability. In the arbitration context, “[t}he

additional incentive to settlement provided by [the threat of punitive

damages) comes at too high a price in unfairness.” McDermott,

Inc. v. AmClyde, 114 S. Ct. 1461, 1469 (1994). Moreover, it

takes two to settle, and any intimidation effect on defendants is

bound to be effectively neutralized by the increase in the size of

settlement demands coming from plaintiffs who see the prospect of

a punitive damages bonanza.

* See also id. at 37 (Scalia, J., concurring) (“I can conceive of

no test relating to ‘fairness’ in the abstract that would approve [the

common law] procedure for awarding punitive damages”); id. at 42

(Kennedy, J., concurring) (“[w]ere we Sitting as state-court judges,

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Term, in Honda Motor Co. v. Oberg, 114 S. Ct. 2331, 2340

(1994), the Court held that due process requires judicial

review of the size of punitive damages exactions, noting that

they pose “an acute danger of arbitrary deprivation of

property.”

The Garrity court observed that “‘[w]Jhere punitive

damages have been allowed for those torts which are still

regarded somewhat as public penal wrongs as well as

actionable private wrongs, they have had rather close judicial

supervision.’” 353 N.E.2d at 796 (citation omitted). See

also id. at 797 (“[u)nder common-law principles, there is

eventual supervision of jury awards of punitive damages, in

the singularly rare cases where it is permitted, by the trial

court's power to change awards and by the Appellate

Division’s power to modify such awards”).

The court’s objection to the imposition of punitive

damages by arbitrators was that “‘[i]f the usual rules were

followed there would ve no effective judicial supervision over

punitive awards in arbitration,’” because of the very deferen-

tial judicial review of arbitrator's awards. Garrity, 353

N.E.2d at 796 (citation omitted). “It would mean that the

scope of determination by arbitrators, by the license to award

punitive damages, would be both unpredictable and uncon-

the size and recurring unpredictability of punitive damages awards

might be a convincing argument to reconsider those rules or to urge

a reexamination by the legislative authority”); ibid. (O’Connor, J.,

concurring) (“[iJmposed indiscriminately, * * * [punitive damages]

have a devastating potential for harm. Regrettably, common law

procedures for awarding punitive damages fall into [that] cate-

gory”); Gertz v. Robert Welch, Inc., 418 U.S. 323, 350 (1974)

(“In most jurisdictions jury discretion over the amounts [of punitive

damages] awarded is limited only by the gentle rule that they not

be excessive. Consequently, juries assess punitive damages in

wholly unpredictable amounts bearing no necessary relation to the

actual harm caused”).

irollable.” Jbid. That would amount to “‘an unlimited draft

upon judicial power’” because the courts would be obliged to

enforce these “penal sanctions.” Ibid. (citation omitted).

Indeed, arbitration closely resembles the jury system in

significant respects. Securities arbitrators are not required to

have a legal background and, in all cases involving disputes

with customers, the majority of an arbitration panel must be

composed of members of the general public. NASD Code of

Arbitration Procedure § 19. Like juries, moreover, arbitra-

tion panels need not explain their determinations.

And the threat of unpredictable arbitral awards of

punitive damages is not an empty one. One study found that

the average arbitral punitive award in the first six months of

1992 was more than double the average for the prior six

months. 5 Securities Arbitration Commentator, Chart D

(May 1993). Indeed, despite the ongoing dispute about the

availability of punitive damages, arbitrators are imposing

substantial penalties in a number of cases.’

A decision broadly empowering arbitrators to impose

punitive damages would therefore require, at a minimum,

creation of a separate appellate tribunal to review punitive

awards imposed by arbitration panels or, alternatively,

provision for substantive judicial review of arbitral punish-

ments. And, in order that review could be meaningful,

arbitrators would have to memorialize in writing the grounds

for their punitive damages decision. These changes by

themselves would obviously have a dramatic impact on the

efficiency — and the cost — of the arbitration process.

” See, e.g., Gage v. CIGNA Sec., Inc., No. 90-01371 (NASD

Mar. 10, 1992) ($3.5 million); Hickman v. PaineWebber, Inc. , No.

90-03354 (NASD Sept. 9, 1992) ($1.7 million); Harper v.

Shearson Lehman Bros., Inc., No. 91-00508 (NASD Mar. 26,

1992) ($1 million); Robertson v. Prudential Bache, No. 33 136

00114 92 00 (AAA July 26, 1993) ($700,000).

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Moreover, the SROs would have to give careful

consideration to incorporating other procedural protections

that courts and legislatures have found appropriate to ensure

fairness in the punishment decision. Indeed, given the

purposes of punitive damages, the stigma that may be

suffered by a defendant found to have coinmitted the kind of

Outrageous acts that warrant punitive damages, and the

importance to the industry as a whole that punishments be

rational in amount and generally consistent from one case to

another, procedural protections equivalent to those available

in the disciplinary process would be appropriate. These

additional protections — clear, detailed standards to guide

arbitration panels in the initial decision whether to award

punitive damages, a heightened burden of proof, and some

form of guidelines to be employed in setting the amount of

punishment that is appropriate in various circumstances —

would also increase the complexity and cost of the arbitration

proceeding.

Changes of this nature, however essential to a fair

punishment regime, would to a large extent vitiate the

benefits of simplicity and speed that prompted creation of the

arbitration process in the first place. Moreover, as we next

discuss, these very substantial impairments of the arbitration

process would yield no countervailing benefits, because the

purposes of punishment and deterrence are already served by

the existing disciplinary process.

2. In View Of The Pervasive Regulatory

Oversight Of The Securities Industry,

Arbitral Punishment Is Not Necessary To

Deter Securities Violations.

Amicus PIABA contends (Br. 13-22) that availability of

punitive damages is necessary to deter misconduct by

securities firms. That is entirely wrong. The existing SRO

disciplinary systems, supplemented by federal and state

governmental oversight of the securities industry, already

ensure that any wrongdoing brought to light in arbitration will

be scrutinized by expert regulators and that penalties suf-

ficient to punish and deter misconduct will be imposed when

appropriate. The injection of punitive damages into securities

arbitrations will, if anything, jeopardize the effectiveness of

these thorough and carefully calibrated disciplinary

mechanisms.

All securities firms and their employees are subject to

comprehensive regulation by a statutory self-regulatory

organization — the National Association of Securities Dealers

(“NASD”). See 15 U.S.C. § 780(b)(8) (requiring all broker-

dealers with retail customers to belong to a national securities

association registered with the SEC; the NASD is the only

such association). The federal securities laws and regula-

tions, the NASD By-Laws, and the NASD Rules of Fair

Practice establish a comprehensive code of conduct governing

every aspect of the business of member firms.’ The task of

ensuring compliance with these standards — and imposing

appropriate disciplinary sanctions for violations — is entrusted

in the first instance to the District Business Conduct Commit-

tees (DBCCs), which are located in each of the NASD’s 11

districts, and the Market Surveillance Committee (MSC), a

central committee responsible for reviewing alleged violations

of market-related rules.

There simply is no realistic danger that a claim of

wrongdoing lodged against an NASD member would escape

the attention of these disciplinary committees. There are a

variety of means by which the disciplinary process could be

triggered:

* See, e.g., 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5;

NASD Rules of Fair Practice Art. Ill, § 1 (“[a] member, in the

conduct of his business, shall observe high standards of commercial

honor and just and equitable principles of trade”); see generally id.

Art. IIL.

° “[aJny person” who feels aggrieved by an act of

a member or person associated with a member

may file a complaint with a DBCC;’

° arbitrators may refer a matter for disciplinary

investigation if they have “reason to believe

[there has been conduct that] may constitute a

violation of the [NASD] rules or the federal

securities laws” ;'°

° NASD members and associated persons must

report most allegations of misconduct to the

Central Registration Depository, and the NASD

regularly monitors these reports;"!

° evidence of misconduct may be detected in the

course of the regular examination of an NASD

member or the NASD’s ongoing market surveil-

lance program. '?

Sanctions for violations include fines, suspension, expulsion

from the securities industry, restitution, or any other appro-

priate measure. NASD Notice to Members 93-32 (May

1993). And the NASD’s decisions are reviewed by the SEC.

15 U.S.C. § 78s. The Securities and Exchange Commission

has recognized the effectiveness of the program. See, e.g.,

SEC, Annual Report - 1990 42 (the NASD “operates an

effective and thorough [disciplinary] program”).

* NASD Rules of Fair Practice Art. IV, § 2.

'' NASD By-Laws Art. IV & Schedule C.

2 NASD Rules of Fair Practice Art. IV, § 3; see also NASD,

Disciplinary Procedures 6, 12-13 (1990).

Moreover, the conduct of member firms and associated

persons is also regulated by the relevant government agencies.

The SEC has its own authority to discipline broker-dealers for

violations of federal law and regulations (15 U.S.C. § 780);

it may institute enforcement proceedings seeking civil

monetary penalties (15 U.S.C. § 78u-2); and it may refer

matters to the Department of Justice for criminal prosecution

(15 U.S.C. §§ 78u, 78u-1, 78ff). State regulators have

similar oversight authority."

The private disputes adjudicated in the SRO arbitration

system are thus fundamentally different from those in the civil

litigation system: the securities industry already has in place

mechanisms fully capable of effectuating society’s interest in

punishing and deterring wrongdoing that might be the subject

of punitive damages claims in arbitrations. And federal and

State agencies are specifically charged with ensuring that

securities firms and their employees do not violate applicable

standards of conduct. Accordingly, the purpose underlying

punitive damages does not apply here: there simply is no

need to invest individual litigants with power to act as

unsupervised “private attorneys general” when the SRO

disciplinary and enforcement process, supplemented by

government regulators, already is performing that function in

a fully satisfactory manner. The case is in this respect just

like INS v. Lopez-Mendoza, 468 U.S. 1032 (1984), which

held that application of the exclusionary rule in deportation

proceedings was not justified because of existence of a

meaningful administrative disciplinary regime.

Indeed, because the SRO disciplinary process is funded

in significant part by the fines collected in disciplinary

'* See, e.g., Ariz. Rev. Stat. Ann. §§ 44-1961 to 44-1962, 44-

1991, 44-1995, 44-2036 to 44-2037 (1994); Colo. Rev. Stat. §§ 11-

51-410 to 11-51-501, 11-51-601 to 11-51-603 (1994); Vt. Stat.

Ann. tit. 9, §§ 4221a, 4224a-4225a (1994).

proceedings, and fairness would require those fines to be

diminished or abated to reflect penalties already imposed on

defendants by arbitrators, the injection of punitive damages

into securities arbitration would actually undermine the goal

of rational, fair, and effective deterrence of wrongdoing.

3. The Contract Provision Is Not Un-

conscionable.

Petitioners (Br. 58-69) and their private amici (PLIABA

Br. 23-32; American Ass’n of Limited Partners (AALP) Br.

21-28) contend that if the contract bars the award of punitive

damages in arbitration, it is unconscionable. They advance

a bewildering array of charges in support of that proposition.

All of them are meritless.

To begin with, petitioners’ unconscionability argument

necessarily rests on state law. Their claim for punitive

damages arises solely under state law; the federal securities

laws do not provide for awards of punitive damages (see 15

U.S.C. § 78bb(a))."* The question whether public policy

invalidates an agreement barring punitive damages awards

accordingly must be answered by reference to state law.’

Insofar as petitioners’ claim is that the entire contract is

unconscionable, that issue too is one of state law. Neither

petitioners nor their amici discuss state-law unconscionability

standards or explain why this Court should address these

state-law issues. Moreover, the factors that petitioners and

the amici cite to justify their conclusion are utterly

unconvincing.

'* Thus, petitioners’ reliance (Br. 59) on the “federal goal of

investor protection” is entirely misplaced.

'* For that reason, petitioners’ citation (Br. 67-68) of this

Court’s statement in Mitsubishi Motors regarding federal statutory

claims is inapposite.

First, petitioners argue (Br. 60) that the effectiveness of

their “waiver” of punitive damages must be evaluated under

the “intentional relinquishment or abandonment of a known

right or privilege” standard established in Johnson v. Zerbst,

304 U.S. 458, 464 (1938). See also PIABA Br. 30-31;

AALP Br. 21. While that standard may govern some waivers

of constitutional rights, we know of no case invoking it to

measure the validity of a commercial contract between private

parties, and petitioners have cited none. Given the many

circumstances in which contract provisions are interpreted to

apply to unforeseen circumstances, petitioners’ approach

would effect a substantial reordering of basic principles of

contract law.'°

Petitioners’ argument also depends on the existence of a

“right” to punitive damages. But petitioners have no such

right. Punitive damages “‘are not compensation for injury.

Instead, they are private fines levied * * * to punish repre-

hensible conduct and to deter its future occurrence.’”

Electrical Workers v. Foust, 442 U.S. 42, 48 (1979) (citation

omitted). They are thus “a windfall to a fully compensated

plaintiff,” not a sum to which he or she has an entitlement by

virtue of a status as an injured party. City of Newport v. Fact

Concerts, Inc., 453 U.S. 247, 267 (1981). “So far is this

opportunity [to recover punitive damages] from being a

fundamental personal right that it is an interest not truly

personal in nature at all. It is rather a public interest * * *.”

In re Paris Air Crash, 622 F.2d 1315, 1319-1320 (9th Cir.)

(Kennedy, J.), cert. denied, 449 U.S. 976.

‘* Petitioners’ argument rings hollow in view of the fact that at

the time they entered into the agreement, industry members had

clearly staked out the position that the choice-of-New-York-law

clause barred imposition of punitive damages. See, e.g., Pierson

v. Dean Witter Reynolds, Inc., 742 F.2d 334 (7th Cir. 1984)

(holding punitive damages barred by choice-of-law clause).

Third, PIABA suggests (Br. 25-26) that the securities

arbitration system is tilted in favor of the securities industry.

This is a wholly unfounded assertion. In reality, impartial

studies show that claimants prevail more often than defendants

(see page 3, supra). Thus, the General Accounting Office’ s

“analysis of statistical results of decisions in arbitration cases

at both industry-sponsored and independent forums showed no

indication of a pro-industry bias in decisions at industry-