Securities Law – Punitive Damages in Arbitration

Punitive Damage Awards May Increase in Securities Arbitration

By Mark J. Astarita, Esq.


Today, arbitration is  virtually a mandatory process for every broker, firm and customer: Brokers and firms are committed to arbitration due to their National Association of Securities Dealers (NASD) membership, while customers are obliged to arbitrate because of pre-dispute agreements. Although there are a number of advantages to arbitration, brokers and brokerage firms may have lost a major advantage in October 1996, when a court decided that punitive damages could be awarded in arbitration.

In some states most notably New York, where the vast majority of arbitrations are held — the law prohibits arbitrators from awarding parties punitive damages. This has been the rule in New York since 1976, when the state’s highest court ruled that punitive damages are in the nature of penalties or sanctions, and the power to grant such damages is reserved to the state courts as a matter of public policy. That decision, known as Garrity vs. Lyle Stuart, has been New York state law for more than 20 years. New York law applied in the vast majority of arbitrations through the 1980s because the major brokerage firms and the main offices of the largest securities arbitration forums are located there. Therefore, customers suing their brokers in arbitration could not obtain punitive damages. Similarly, brokers suing their firms also could not receive punitive damages if the firm was located in New York or if the arbitration hearings were held in that state.

However, the venues for arbitrations began to vary. In customer arbitrations, the NASD began holding hearings in the city where the customer resided at the time of the dispute. Broker-firm arbitrations were held in the city where the broker worked. Since the rule regarding punitive damages is governed by state law, the NASD’s change in hearing location had the presumably unintended effect of removing some arbitrations from the Garrity rule, and there was an increase in the size of arbitration awards.

Since there is no real limitation on a punitive damage award and no meaningful way to appeal an arbitrator’s decision, the industry was concerned about the potential for enormous and unappealable arbitration awards. Therefore, brokerage firms began to include a provision in their customer and margin agreements that New York law would apply to all customer-firm disputes. Similar clauses started appearing in brokers’ employment agreements with their firms.

There is nothing inherently wrong with such a provision. These “choice of law” provisions are common in contracts that involve parties from more than one state. Since particular laws differ from state to state, the parties agree which state’s law will apply to resolve any potential dispute.

This new clause worked for a while. Then, in March 1995, the U.S. Supreme Court decided Mastrobuono vs. Shearson Lehman Hutton, Inc. In Mastrobuono, the customer agreement had a choice of law provision as discussed above, but the Supreme Court decided that the New York choice of law provision did not prevent an arbitrator from awarding punitive damages. The decision’s impact was clear — using a New York choice of law provision did not provide the comfort that the industry had hoped.

What may very well have been the final blow to Garrity’s protections came on October 8, 1996. In a New York arbitration between an employee and a brokerage firm, a New York Appellate Court held that arbitrators could award the employee punitive damages.

In Mulder vs. Donaldson, Lufkin & Jenrette, the court built on the U.S. Supreme Court’s Mastrobuono decision, stating that “the arbitration of punitive damage claims [brought under the Federal Arbitration Act] is required except where the parties have unequivocally agreed otherwise.” Since virtually all of the customer arbitrations that are brought are governed by the Federal Arbitration Act, this rule applies to most customer arbitrations.

There are a number of legal issues that the Mulder decision does not address, and the Court of Appeals of New York will ultimately decide the issue. This decision will be binding upon all state court judges in New York. In the interim, a New York trial court judge followed the Mulder decision in Merrill Lynch Pierce Fenner & Smith vs. Driessens. In that decision, the court held a customer’s claims, including his claims for punitive damages, could be arbitrated since “the parties here did not explicitly agree to exclude them from arbitration.”

This decision is of significant importance since the opinion was written by Justice Jane S. Solomon, the judge designated by the Manhattan court to hear and decide all court challenges arising from arbitration agreements between customers and brokerage firms. It is reasonable to assume that until a higher court rules otherwise, Judge Solomon will continue to order customer claims for punitive damages to arbitration.

Arbitration has proven itself time and time again to be an economical and fair method of resolving disputes. Although the entire process is becoming closer to a court proceeding,  customer disputes are still resolved  relatively quickly, economically and fairly. As a constant supporter of the arbitration process, I know that arbitrators take their jobs seriously and act in a manner consistent with fairness, reasonableness and the law. Punitive damage awards are rare in arbitration, and are perhaps deserved in some cases.

However, allowing punitive damages to be awarded by arbitrators — whose rulings aren’t subject to review by any person, agency or court — is fraught with problems. Examples of juries and judges awarding outrageous sums of money to plaintiffs for punitive damages are reported daily by the press. Fortunately, those outrageous awards are only a small number of the trials in this country and are routinely overturned by a judge or appellate court.

Still, there are no protections from an errant arbitrator. Some may argue that the prospect of an outrageous punitive damage award is so remote as to be meaningless. But it certainly will not be meaningless to the broker who is the subject of that one errant award, and who loses his license to earn a living when he cannot pay the award.

While it’s true that punitive damages have been awarded by arbitrators in other states without a significant problem arising, we can only hope that that trend continues as New York arbitrators, who hear the overwhelming majority of cases, start to award punitive damages.

In preparation for this change, customer arbitration agreements at the major brokerage firms will be modified with language added to exclude punitive damages.

For the long term, there must be a concerted effort on behalf of the brokerage industry and the arbitration forums to incorporate damages limits into arbitration rules.

If such limitations are not incorporated into the process, the costs of the arbitration process will skyrocket, innocent brokers will be financially forced to settle customer claims that do not deserve to be settled, and brokers will increasingly find themselves faced with the potential that their case will be the one oddball decision in which the arbitrators award punitive damages that are far in excess of any reasonable sum.

Is the arbitration process and the interests of the investing public being served by such a turn of events? Certainly not. Is the industry going to take some steps to protect itself against the monster that it has indirectly created? I certainly hope so.


Copyright 2010. VGIS Communications LLC. All Rights Reserved. VGIS Communications, LLC – 41 Watchung Plaza, Suite 249, Montclair, New Jersey 07042 – 973-559-5566. Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial adviser before acting upon the information contained in this article. For additional information, contact Mark J. Astarita, Esq., a partner in the law firm of Beam & Astarita, LLC, who represents clients in a wide variety of finance related matters. Mr. Astarita can be contacted by email at astarita@beamlaw.com.


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