United States: The Case For Dismissing The Case: Why Dispositive Prehearing Motions Should Remain An Integral Part Of The Arbitral Process

It has been more than twenty years since the Supreme Court decided the seminal case of Celotex Corp. v. Catrett, 417 U.S. 317 (1986), in which Justice Rehnquist, for the majority, wrote:

Summary judgment procedure is properly regarded not as a disfavored procedural shortcut, but rather as an integral part of the Federal Rules as a whole, which are designed "to secure the just, speedy and inexpensive determination of every action."¹

Celotex is recognized as changing the landscape. Prior to it, many courts were wary of summary adjudications and viewed the process as threatening fundamental rights to jury trials. Difficult standards had evolved - such as denying summary judgment if there was the "slightest doubt" about its appropriateness in a case. "The oft-recounted tale of the sign posted in a New Orleans district court, 'No Spitting, No Summary Judgments,' encapsulates the extreme version of judicial antipathy to summary judgment [prior to Celotex]."²

Yet today, the securities arbitration community still struggles with the appropriateness of dispositive motions. Despite the long and consistent line of legal precedent recognizing that NASD arbitrators have implicit authority to grant prehearing motions to dismiss or for summary judgment, the response to such motions invariably includes arguments that the arbitrators lack the authority to grant the motion and/or policy arguments that such motions are inherently pernicious or contradict the goals and spirit of arbitration. Indeed, when in 2003 the NASD proposed amending the Code of Arbitration Procedure to explicitly recognize its arbitrators' authority to grant such motions, it suggested language which was replete with cautions and genuinely hostile to such motions. Even that ignited a storm of comments and disagreement that led to the rule's withdrawal to allow the approval of the other proposed amendments to the code.³

This hostility toward dispositive motions in arbitration deserves the same fate as the Federal Courts' erstwhile disfavor for summary judgment. Properly understood and in the right circumstances, prehearing motions to dismiss further advance the goals of making arbitration as inexpensive and efficient as possible for all parties. The perceived potential for abuse of such motions can be adequately dealt with by sanctions or other means. The fear of abuse should not chill the use of such motions in the proper case.

Every court to have considered the question of whether arbitrators may grant dispositive motions without holding an evidentiary hearing has answered in the affirmative, and the list of courts to have reached that conclusion has been growing. In Sheldon v. Vermonty, 269 F.3d 1202 (10th Cir. 2001), the Tenth Circuit ruled on an appeal from the confirmation of an NASD arbitration award granting pre-hearing dismissal to the broker-dealer defendants. The Claimant, who had alleged violations of state and federal securities laws, common law fraud, negligent misrepresentation, breach of fiduciary duty and unjust enrichment in connection with the sale of shares of a phone company, argued that the panel had exceeded its authority in granting the prehearing motion to dismiss and that warranted vacateur. Id. at 1205-1206. The Tenth Circuit disagreed:

a NASD arbitration panel has full authority to grant a pre-hearing motion to dismiss with prejudice based solely on the parties' pleadings so long as the dismissal does not deny a party fundamental fairness.

Id. at 1206. In Vento v. Quick & Reilly, Inc., 128 Fed. Appx. 719 (10th Cir., April 20, 2005), the Tenth Circuit reaffirmed its holding in Sheldon, citing it in affirming confirmation of an arbitration award granting prehearing dismissal of the Claimant's claim that Quick & Reilly had violated various legal duties in complying with a facially valid writ of garnishment and order directing that it turn over the proceeds of Vento's account. Id. at 721-3.

Similarly, in Tricome v. Success Trade Securities, No. 05-4746, 2006 U.S. Dist. LEXIS 33412 (E.D.Pa May 25, 2006), the Claimant sought to vacate an NASD arbitration panel's pre-hearing dismissal of his claim that the defendant online brokerage service had engaged in securities fraud by providing flawed software for his trading. Id. at *2. According to Tricome, the software was flawed because it "allowed him to make purchases in excess of the amount of money in his account" - in other words, because it allowed him to trade on margin. Id. Unsurprisingly, the panel dismissed the claim, and the court refused to vacate the award. Id. at *9-11 ("arbitrators may grant a motion to dismiss without holding a full evidentiary hearing . . . Tricome was not denied fundamental fairness because he was given opportunities to respond to the motions to dismiss that were before the arbitration panel, both in writing and during the telephone conference").

In Warren v. Tacher, 114 F. Supp. 2d 600 (W.D. Ky. 2000), the Western District of Kentucky refused to vacate the prehearing dismissal of Claimants' claims against their clearing firm, Bear Stearns. Responding to the Claimants' complaint that the arbitrators were guilty of misconduct and exceeded their powers in dismissing their claim prior to discovery or an evidentiary hearing, the court wrote:

While the granting of such motions usually means that the arbitrator "refused to hear evidence," that, by itself, is insufficient to vacate the award. Petitioners must also show that the excluded evidence was material to the panel's determination and that the arbitrator's refusal to hear the evidence was so prejudicial that the party was denied fundamental fairness. . . . In the instant case, Petitioners fail to show how any evidence that they would have obtained in discovery would overcome the panel's decision. Petitioners are not entitled to costly full-blown discovery when it would not change the outcome and the claim could be decided on a pre-hearing motion.

Id. at 602 (emphasis added, internal citations omitted).

In Intercarbon Bermuda Ltd. v. Caltex Trading and Transport Corporation, 146 F.R.D. 64 (S.D.N.Y. 1993), the Southern District of New York explicitly linked an arbitrator's duty to hear evidence to the standard of materiality underlying summary judgment motions under the Federal Rules of Civil Procedure:

"Misconduct" within the meaning of Section 10 will not be found unless the aggrieved party was denied a "fundamentally fair hearing." . . . InterCarbon asserts that the "paper hearing" it received was not fundamentally fair. Caltraport, on the other hand, points out that the procedure followed by the arbitrator is analogous to the unquestionably fair procedure for summary judgment under Rule 56 of the Federal Rules of Civil Procedure. . . Like Rule 56, which precludes summary judgment if there is a "genuine issue as to any material fact," Section 10 requires an arbitrator to hear evidence that is "pertinent and material." . . . Although the exact standards for a Rule 56 determination do not apply here, the propriety of the arbitrator's action does depend on the same underlying concern: the extent to which issues of fact were in dispute, so that a fuller hearing -- including live testimony -- would be required to reach a just decision.

Id. at 72-73 (emphasis added, internal citations omitted) Six years later, in Max Marx Color & Chemical Co. v. Barnes, 37 F. Supp. 2d 248 (S.D.N.Y. 1999), the Southern District held that an NASD arbitration panel could decline to hear certain evidence before granting a motion to dismiss:

Petitioners, however, do not explain the materiality of such evidence to the motion to dismiss. And indeed they cannot. The motion to dismiss was brought on the issues of standing, statute of limitations and preemption; the Panel stated that its decision was predicated on those issues. Petitioners apparently fail to recognize that the Panel need not address every question presented in the controversy on a motion to dismiss, and that there is no misconduct in dismissing a claim - and not receiving evidence - on matters unnecessary to disposition of the claim. In consequence, there was nothing unfair in the Panel's decision not to hear testimony at the May 15 hearing and thus no misconduct for purposes of Section 10(a)(3).

Id. at 252 (emphasis added). The Western District of Washington and Northern District of Illinois (in a decision affirmed by the Seventh Circuit) have similarly confirmed NASD arbitration awards granting dispositive prehearing motions. See Allen v. RBC Dain Rauscher, Inc., No. C06-5163, 2006 U.S. Dist. LEXIS 27974 (W.D.Wash. May 9, 2006) (confirming NASD arbitration award granting summary dismissal of a Statement of Claim without holding an evidentiary hearing); Wise v. Wachovia Secs. LLC, No. 04-C-7438, 2005 U.S. Dist. LEXIS 13630 (N.D.Ill. May 4, 2005) (confirming NASD award granting summary judgment to Wachovia without holding an evidentiary hearing) aff'd, 450 F.3d 265 (7th Cir. 2006). Indeed, the only Federal Court to have vacated an NASD arbitration award on the grounds that an evidentiary hearing was required explicitly limited its holding to the facts of the case before it and wrote that "in the appropriate case after hearing an argument, arbitrators would undoubtedly have authority to dismiss a claim." Prudential Securities v. Dalton, 929 F. Supp. 1411, 1417 (N.D. Okla. 1996) (emphasis added).

State courts faced with the issue have reached the same conclusions. See Reinglass v. Morgan Stanley Dean Witter, Inc., 2006 Ohio 1542 (Ct. of App., Ohio, 2006) (refusing to vacate arbitration award granting prehearing dismissal for failure to plead fraud with particularity); Patton v. J.P. Morgan Chase & Co., N.Y.L.J. (Aug. 23, 2004) (Sup. Ct. N.Y. County) (affirming award granting motion to dismiss without an evidentiary hearing); Goldman, Sachs & Co. v. Patel, N.Y.L.J. p. 23, col. 6 (N.Y. Sup. Ct. Aug. 18, 1999) (award embodying pre-hearing dismissal of claims confirmed by the court, with court holding "the NASD panel has the power to decide a motion to dismiss a claim on legal grounds, without holding an evidentiary hearing"); Schlessinger v. Rosenfeld, Meyer & Sussman, 40 Cal App. 4th 1096, 47 Cal. Rptr. 2d 650 (1995) (affirming confirmation of an arbitration award made as a summary judgment holding absent specific procedural provisions for such motions: "the arbitrator had implicit authority to Rule on such motions."); Gildston v. Fidelity Investments, NASD #95 05993 (Oct. 1996), Index No. 12113/96 (Sup. Ct. N.Y. County) (wherein the court, without opinion, confirmed an NASD Arbitration Award which had dismissed a claim on a pre-hearing motion); Miller v. National Financial f/k/a Seagal v. Cortlandt, NASD #96 00706 (prehearing dismissal granted in favor of clearing firm and confirmed by Superior Court of California, San Francisco, July 29, 1999 in Order holding "The National Association of Securities Dealers, Inc. arbitration panel has the authority to grant a motion to dismiss and the arbitrators did not exceed their powers by dismissing the Statement of Claim in the underlying arbitration").

Several of these cases are very good illustrations of why arbitrators must have the power to dismiss cases, even without holding an evidentiary hearing, where no amount of evidence could make a difference to the legal outcome. For example, the Claimant in Tricome sought to hold his online broker liable because its software allowed margin trading. Had the claim not been dismissed early, his broker-dealer would have been subject to costly discovery relating to its brokerage software and margin history, to attend a hearing of unspecified duration, and to sit for testimony by the Claimant to establish a fact that could not matter to the outcome. So long as the panel was (correctly) of the opinion that functionality which allowed margin trading was not a "flaw", no amount of evidentiary proof of the 'flaw' could have resulted in an award in his favor (and no amount of discovery about it would have served any purpose).

Similarly, had the panels in Vento or Warren not granted the broker-dealer's motion to dismiss, the broker-dealer respondents could have been subject to extensive discovery and potentially costly legal fees merely to allow the Claimants present evidence before the panel that could not have been material to the outcome. As the Courts have recognized, it benefits no one to require panels to have evidentiary hearings or to conduct extensive discovery when an issue of law renders the facts discovered or shown immaterial to the outcome.

III. Proposed Rule 12504 and the Reactions To It

Given the broad agreement among the courts that NASD arbitration panels have the right to grant summary judgment and motions to dismiss even absent an explicit rule in the NASD's Code of Arbitration Procedure (the "Code"), it was not particularly surprising that as part of its retooling of the Code the NASD proposed a rule to explicitly recognize NASD arbitrators' power to grant dispositive prehearing motions and provide guidance to and encourage uniformity among panels tasked with deciding such motions. However, the proposed rule was so dressed in chilling language that to many it seemed the NASD was taking away far more that it was giving.

In its initial formulation, Proposed Rule 12504 simply read:

12504. Motions to Decide Claims Before a Hearing on the Merits

(a) Except as provided in Rule 12206, motions to decide a claim before a hearing are discouraged and may only be granted in extraordinary circumstances.

(b) Motions under this rule must be made in writing. Unless the parties agree or the panel determines otherwise, motions under this rule must be served at least 60 days before a scheduled hearing, and parties have 45 days to respond to the motion.

(c) Motions under this rule will be decided by the full panel. The panel may not grant a motion under this rule unless a prehearing conference on the motion is held, or waived by the parties. Prehearing conferences to consider motions under this rule will be tape-recorded.

(d) The panel may issue sanctions under Rule 12212 if it determines that a party filed a motion under this rule in bad faith.⁴

Comments on Proposed Rule 12504 were decidedly negative. Industry commentators were concerned that the "extraordinary circumstances" language, and particularly the lack of guidance as to what that meant, would severely discourage dispositive motions.⁵ Investor representatives were also strongly opposed to the rule. Some comments accused the NASD of "obsequious toadying to its member firms" in proposing the rule. See, e.g., Comment of Barry D. Estell on File No. SR-NASD- 2003-158 dated July 14, 2005.⁶ PIABA took a more measured tone, raising various concerns:

CR 12504 is in effect a summary judgment rule, and summary judgment and arbitration form an imperfect union. Important procedural protections underlying summary judgment motions simply are not available in arbitration. The non-moving party cannot take a deposition, and has limited powers to obtain other information more readily available in court. Under the CR as written, a respondent can submit supporting affidavits from a broker, BOM, and compliance director, and the moving party has little if any opportunity to challenge the "uncontradicted" statements before the hearing. A dispositive motion rule has to recognize the limitations that nonmoving parties face in responding to the motions, and that the only way to test a respondent's position (absent the discovery safeguards available in court litigation) is through testimony at a hearing. Even though motions to dismiss are allowed (though rarely granted) in court, there are many reasons why such motions need to be severely curtailed in arbitration. First, arbitrators are not judges, and are often not in a position to make the kind of exacting legal determinations required to decide a motion to dismiss. Second, arbitrators have more flexibility than courts in adhering to the strictest rules of law, making technical dismissals inappropriate. Third, arbitration pleadings are less formal than court pleadings, making dismissal based on pleadings subject to interpretation and guesswork. Fourth, arbitrators do not write reasons for their awards. Fifth, unlike court, there is little judicial review of arbitrator decisions. Such review (of court decisions) is important because it insures against legal mistakes. Sixth, the testimonial hearing requirement is the essence of arbitration, which is not an overly legalistic procedure for resolving disputes...

Comments of Public Investors Arbitration Bar Association (PIABA) on File No. SR-NASD-2003-158 dated July 13, 2005.⁷

The Pace Investor Rights Project ("Pace") had similar comments:

Although the Current Code (Rule 10303) provides that parties are entitled to a hearing, unless all parties waive it in writing, courts have held that arbitrators have the authority to decide pre-hearing motions to dismiss, so long as the arbitrator's refusal to hold a full evidentiary hearing is not fundamentally unfair. In our view, there are only very limited circumstances where dispositive motions may be appropriate, since generally there are disputed issues of material fact and issues of credibility that would make it fundamentally unfair to dismiss a claim without giving the claimant an opportunity to complete discovery and to present evidence, both written and oral. We note also that many motions to dismiss on eligibility rule grounds involve disputed issues of fact and are not suitable for summary disposition. We therefore support the language in paragraph (a) that dispositive motions are "discouraged" and "may be granted only in extraordinary circumstances" and recommend that the exception for motions on eligibility rule grounds be stricken.

In addition, we believe that arbitrators would benefit from more specific guidance and recommend that the proposed rule state that the panel should deny dispositive motions whenever (1) credibility is an issue; (2) there are disputed issues of material fact; or (3) the panel believes a hearing is necessary in the interests of justice. We also believe that the proposed rule should make clear that arbitrators should not apply a "failure to state a claim" standard, since claimants are not required to plead legally cognizable claims. Finally, we support giving the panel explicit authority to issue sanctions against a party that makes a dispositive motion in bad faith, because we are concerned that the use of these motions will become more prevalent with the adoption of this rule.

Comments of Pace Investor Rights Project on File No. SR-NASD-2003-158 dated July 14, 2005.⁸

Both PIABA and Pace argued that any rule allowing dispositive motions should provide that such motions should be denied if material facts were in dispute or a factual finding on the motion would turn on credibility determinations. Both also raised concerns that Claimants might be held to too high a pleading standard on a motion to dismiss for failure to state a claim. Both also asked that the rule contain a nebulous "interests of justice" exception.

In response to the comments received, the NASD amended its proposed rule filing to add the following language to the narrative section relating to Proposed Rule 12504:

For purposes of this rule, if a party demonstrates affirmatively the legal defenses of, for example, accord and satisfaction, arbitration and award, settlement and release, or the running of an applicable statute of repose, the panel may consider these defenses to be extraordinary circumstances. In such cases, the panel may dismiss the arbitration claim before a hearing on the merits if the panel finds that there are no material facts in dispute concerning the defense raised, and there are no determinations of credibility to be made concerning the evidence presented.⁹

The proposed language - which made clear that a panel must deny dispositive motions if there are material facts in dispute or issues of credibility - appeared to satisfy the major concerns of both Pace and PIABA. Indeed, while Pace continued to object to the proposed rule, it reiterated only three complaints: (1) that new explanatory section for the rule did not provide that arbitrators had discretion to deny dispositive motions "in the interests of justice"; (2) that the narrative language did not reject motions to dismiss for failure to state a claim; and (3) that the rule should not provide for prehearing dismissal based on eligibility rules, since eligibility determinations "very often involve issues of fact and credibility determinations."¹⁰ Of Pace's concerns, the first remained nebulous. The third concern seemed overstated, if only because the proposed narrative would have explicitly prohibited panels from granting motions on eligibility grounds in those cases that involved issues of fact and credibility determinations

Pace's second concern, on the other hand, stood on a different footing because of the relaxed standards of pleading in arbitration. There is a difference, however, between a failure to meet some technical pleading requirements and an inability to allege in good faith all of the elements of a legitimate cause of action - even in an amended pleading or opposition to a motion to dismiss - in which case a motion to dismiss should be granted.

In contrast to Pace, the PIABA found the language almost entirely objectionable. Focusing on the first portion of the narrative, which provided examples of legal defenses upon which a panel could grant a dispositive motion, if there was no material dispute of fact or credibility determination to be made, the PIABA argued that the rule, as stated, would "open the floodgates for motion practice."

Comments of Public Investors Arbitration Bar Association (PIABA) on File No. SR-NASD-2003-158 dated May 26, 2006.¹¹

Entirely ignoring the second half of the narrative section, PIABA focused on the potential that some cases in which the defenses enumerated in the first half of the narrative section could turn on issues of fact:

One of the examples of a motion that the NASD now believes should meet the "extraordinary circumstances" requirement is the defense of accord and satisfaction. That defense requires the proof of several elements, and those elements differ from jurisdiction to jurisdiction. One court describes them as "(1) a disputed claim, (2) the debtor's tendering of a sum less than that claimed by the creditor, and (3) the creditor's acceptance of the payment." United States v. Bloom, 112 F.3d 200, 206 (5th Cir. 1997). Another court states, "there must be a disputed claim, a substituted performance agreed upon and accomplished and valuable consideration." International Union, United Auto., etc. v. Yard-Man, Inc., 716 F.2d 1476, 1492 (6th Cir. 1983). Because it involves a fact-intensive inquiry, court motions to dismiss for accord and satisfaction are almost always raised at summary judgment after full opportunity to take discovery. . .

Another of the NASD's examples of dispositive motions, the statute of repose, also presents complex legal and factual issues. . .

Likewise, the NASD's settlement and release example is fraught with difficulties. Whether a valid settlement and release exists is a complex question of law and fact. . .

The NASD's other example of "extraordinary circumstances" is the defense of arbitration and award. That, too, is a complex legal defense.. .

And PIABA pulled its comments together with a discussion of appellate review:

In judicial proceedings, if a party's claim is dismissed on summary judgment, that party has a right of review from an appellate court that is bound to closely scrutinize the legal and factual record to ensure that the plaintiff's rights have not been abridged. In arbitration, it is completely the opposite. A panel of non-lawyers, or a majority of nonlawyers, can decide to dismiss a case with prejudice, without an evidentiary hearing, even if the case involves complex factual and legal issues. When that happens, the claimant has virtually no recourse, given the fact that even clear errors of law are not sufficient grounds to vacate an arbitration award. Indeed, even if the arbitrators clearly erred, the party moving for vacatur is subject to sanctions unless they can prove that the arbitrators understood and deliberately ignored applicable law.

Id. Throughout, and despite the narrative's clear language to the contrary, PIABA expressed concern that motions might be granted even where there were disputed issues of fact. But the proposal and narrative would only have permitted the motions to be granted where the material facts were undisputed and issues of credibility were absent. Otherwise, as Prudential and the other cases discussed above clearly hold, a failure to hold an evidentiary hearing might deny fundamental fairness and be grounds for vacateur.

PIABA's secondary concern - that non-lawyers might be asked to rule on complex legal issues in the context of dispositive motions - is also not particularly persuasive. Whenever the panel decides a particular case, it will, of necessity, be forced to rule on the legal defenses raised by the respondent. Assuming the relevant facts are truly undisputed at the time of the motion (which they would need to be in order for the panel to grant the motion) the legal issues to be decided would be no less complex after an evidentiary hearing than at the time of the motion itself.

One particular area of dispositive motions not referenced in the NASD narrative, but which deserves special attention, is clearing firm claims, which readily illustrates that dispositive motions truly fit within the arbitral process. Despite the continued frequency with which clearing firms are named in claims for failing to "supervise" or for "allowing" some misconduct by introducing firms, it is well settled that the duties of clearing firms are limited. Their duties are regulated and determined by Rule 382 of the NYSE and its parallel, Rule 3230 of the NASD, which provide that clearing agreements between brokerage firms and their clearing firms shall be submitted to and approved by the NYSE and may allocate between the firms their respective functions and responsibilities. Rule 382 and clearing agreements do not permit liability to rest upon a clearing firm for the negligent or wrongful acts of the correspondent.¹²

Unsurprisingly, given the law on clearing firm liability, claims naming clearing firm respondents are highly likely to face a motion to dismiss - particularly where (as is often the case) the statement of claim makes no separate or individual factual allegations against the clearing firm other than the simple fact that it processed trades. And, motions to dismiss in favor of clearing firms have been granted with some frequency as they should be.¹³ Where a claimant has a good-faith basis to allege that a clearing firm is liable for his losses due to acts beyond simple processing of trades or supplying a margin facility -standard ministerial functions of a clearing firm - it is one thing. But all too often, it seems, clearing firms are named as respondents in arbitration claims on the bare hope of discovering facts to support such a claim or to fill the need for a deep pocket. In such cases, there are rarely factual disputes as to what the clearing firm did or did not do and credibility is not in issue. Since the authoritative law regarding the duties of clearing firms is clear, these cases are often perfect candidates for motions to dismiss. Indeed, it is notable that nothing in either the PIABA's or Pace's objections to Proposed Rule 12504 appears to apply to such cases. Judging by the sentiments of both the NASD (as seen in the proposed rule) and representatives of the Claimant's bar (as seen in their comments), with or without approval of the rule, in whatever form, the grant of prehearing dismissal in most clearing firm cases should be far more routine than it already is.

The NASD has implemented the new Code, but withdrawn the dispositive motion rule. It is anticipated that a new proposal will be announced and that, in some form or another, it will acknowledge (as the courts have) that panels may grant such motions, while at the same time discouraging and limiting their use. But while caution might be wise, the debate thus far suggests that there may be overkill.

As cases such as Tricome, Vento and Warren demonstrate, dispositive prehearing motions can be to arbitration precisely what summary judgment is to litigation: an important means of reaching just, efficient and inexpensive resolution of claims and defenses that simply have no business going to hearing. Where there really are no material facts in dispute meritorious motions to dismiss or for summary judgment are a good thing. They should not only be authorized; they should be welcomed. Particularly given the increased expenses firms now incur under the Discovery Guide's mandatory discovery provisions, allowing meritless and even frivolous claims to proceed to hearing serves no good purpose. Investors with frivolous claims, who do not have a good faith basis for alleging the elements of a cause of action, should not be allowed to drag their broker-dealers to an expensive hearing merely so that they can feel satisfied that they "had their day in court." And, those investors can have "their day" by presenting their opposition to the motion and in that context their fundamental rights to be heard are amply protected. And, where it is the motions which are frivolous or brought in bad faith, panels already have ample tools to protect the non-movant and to send the appropriate message to any who abuse the process.

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