Two cases decided by the United States Supreme Court this past term warrant particular review. In one, the Court effectively explained how to eliminate punitive damages awards from private arbitration proceedings. In the other, the Court refused to hand plaintiffs' class action lawyers an economic sledgehammer.

In the first case, Mastrobuono, the Court upheld an arbitrator's award of punitive damages to customers of a securities brokerage firm (see endnote 1). At issue was a standard brokerage customer agreement containing both an arbitration clause and a choice of law provision that made New York law applicable to disputes under the agreement. Under the Garrity rule in New York, arbitrators may not award punitive damages (see endnote 2). The brokerage firm therefore argued, and the lower courts hearing the case had agreed, that the punitive damages award should be vacated.

The Supreme Court reversed, holding the choice of law provision insufficient to preclude the punitive damages award. At most, the Court said, the provision created an ambiguity in light of the arbitration clause in the agreement. That clause made applicable the rules of the National Association of Securities Dealers, which rules the Court in turn read to allow at least the possibility of punitive damages. The Court in addition found awards of punitive damages consistent with the pro-arbitration principles of the Federal Arbitration Act ("FAA"). The FAA, in the Court's view, preempts the Garrity rule in the absence of a contrary intent in the arbitration agreement and also requires that any contractual ambiguities concerning arbitrability be construed in favor of arbitration.

The Court thus left no doubt that it will continue to favor arbitration and to construe broadly the pro-arbitration provisions of the FAA. The real lesson of the case, however, is that any intended exclusion of punitive damages from arbitration proceedings must be clear on the face of the arbitration agreement itself. The Court indeed signaled that punitive damages could be excluded from arbitration agreements if the exclusion is clearly expressed.

The Court reiterated that the FAA "does not operate without regard to the wishes of the contracting parties." The Court pointed out, however, that the arbitration clause at issue had contained "no express reference to claims for punitive damages" and refused to find the choice of law provision itself to be "an unequivocal exclusion of punitive damages claims." The Court also stated it was unlikely that brokerage customers who signed the form agreement "had any idea" they were giving up an important substantive right. The opinion thereby strongly suggests that claims for punitive damages may be excluded from arbitration through a carefully drafted proscription on the powers of arbitrators. Any such language, however, should be clear, exacting in its parameters and take into account any regulatory or industry restrictions that may apply.

One matter the case did not concern or consider also deserves mention; that is the possible due process implications of punitive damages imposed through private arbitration proceedings. In the Pacific Mutual case, (see endnote 3) decided in 1991, the Supreme Court held that awards of punitive damages in civil judicial proceedings satisfy constitutional due process requirements so long as jury discretion in making the award is not unlimited and sufficient post-trial procedures as well as appellate review are available. These constraints, in the Court's words, "make[] certain that the punitive damages are reasonable in their amount and rational in light of their purpose." Conversely, absent "a sufficiently definite and meaningful constraint" on the discretion of fact finders to award punitive damages, a violation of due process could occur.

Unless by agreeing to enter into arbitration a party is deemed to have left its constitutional rights at the door, one would think that at the very least the same teaching should apply to extra-judicial proceedings. "Punitive" damages are just that, punishment, whatever the forum. Private arbitrations, however, are an expedient, designed to be free of rules and procedures that constrain judicial processes. Typically, arbitrators have unfettered discretion; they do not have to state any rationale for their awards; and their awards are all but substantively unreviewable. By its very nature, therefore, the arbitration process would seem to be the antithesis of the due process required by the Supreme Court for punitive damage awards even in a judicial context.

The Supreme Court may yet visit this issue. One caveat: defendants desiring to mount a constitutional challenge to arbitrable punitive damages should raise the issue as early as possible in the proceedings and preserve it at each succeeding stage, in order to preclude any finding of "waiver."

In the second case, Gustafson, (see endnote 4) the Court held that Section 12(2) of the Securities Act of 1933 (the "1933 Act") applies only to initial public offerings of securities and not to private sales or subsequent sales of securities in the secondary, or trading, market. The Court's opinion closely interprets a welter of technical terms and applies a series of arcane rules of statutory construction, an exercise that would delight legal theoreticians. The effect of the opinion, however, was anything but academic. Had the case come out the other way, the potential for increased damage awards or settlements in cases concerning the sale of securities was enormous.

Cases concerning securities trading have most generally been brought under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 (the "1934 Act"). Although legal exposure under Rule 10b-5 can be very substantial, the courts through decades of jurisprudence have defined and confined the limits of such claims. To succeed, a plaintiff has the burden of proving, among other things, fraud by the defendant and reliance by the plaintiff. Successful plaintiffs are limited to recovery of their "actual" damages.

By contrast, under Section 12(2) of the 1933 Act a securities purchaser can recover without proof of fraud by the seller or reliance by the buyer. It is also the seller's burden to negate negligence. And the successful buyer is entitled to rescissionary damages, which may be many times the "actual" damages available under Rule 10b-5 to the 1934 Act. Given the uncertainty and difficulty of proof and the enormity of exposure, allowing a claim under Section 12(2) for secondary market transactions would have provided an almost certain lever for extracting higher settlements for claimed misstatements or omissions, in the context of securities trades.

The Supreme Court was clearly aware of this potential. The Court said:

"It is not plausible to infer that Congress created this extensive liability for every casual communication between buyer and seller in the secondary market .... [A]ny casual communication between buyer and seller in the aftermarket could give rise to an action for rescission, with no evidence of fraud on the part of the seller or reliance on the part of the buyer. In many instances buyers in practical effect would have an option to rescind, impairing the stability of past transactions where neither fraud nor detrimental reliance on misstatements or omissions occurred."

Gustafson, 115 S. Ct. at 1071.

The Court thus reiterated its concern over judicially expanding the breadth of securities claims, a concern the Court also has voiced in previous decisions. This perhaps may provide some comfort to those for whom securities class actions are an inevitable part of business. Note, however, that Gustafson was decided by a bare 5-4 majority.

ENDNOTES

1. Mastrobuono v. Shearson Lehman Hutton, Inc., 115 S. Ct. 1212 (1995).

2. Garrity v. Lyle Stuart, Inc., 40 N.Y.2d 354 (1976).

3. Pacific Mut. Life Ins. Co. v. Haslip, 449 U.S. 1, 111 S. Ct. 1032 (1991).

4. Gustafson v. Alloyd Company, Inc., ___ U.S. ___, 115 S. Ct. 1061 (1995).

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