New York Choice of Law Defense Effectively Terminated in Securities Arbitration

ecently, National Association of Securities Dealers Regulation (NASDR) penalized Prudential Securities, Inc. for attempting to employ the "New York Choice of Law" defense in securities arbitrations involving claims by customers to recover their investment losses. The disciplinary action effectively puts to rest what has been a long, tortuous history, but may rekindle other efforts to limit the award of punitive damages in arbitration.

The History

In brief, the genesis of the defense is innocent enough: most brokerage firms have their principal places of business in New York; hence, their customer agreements select New York law as governing. But the ramifications have been remarkable. In the past (indeed through the present) some brokerage firms have argued that New York law disallows all private rights of action, both common law claims and state and federal statutory claims, even for non-New York residents. These firms also have argued that punitive damages and attorneys' fees are unavailable for the same reason.

The authority of the arbitrators to grant relief (including punitive damages) received a great deal of attention and, unfortunately, conflicting interpretation, following the Supreme Court's 1995 decision (overturning the Seventh Circuit's decision) in Mastrobuono v. Shearson Lehman Hutton, Inc.

Concerned with continuing attempts by brokerage firms to unfairly limit the relief available to investors in arbitration, the NASD (as well as the New York Stock Exchange) responded by issuing notices to their members. Thus, the NASD notice declared it to be a violation of its Rules of Fair Practice directly or indirectly (through governing law clauses) to attempt to "limit the ability of a customer to file a claim or to limit the authority of the arbitrators to make an award, including an award of punitive damages." Likewise, the NYSE alerted its members that customer agreements (including governing law clauses) could not restrict or limit the "ability of customers to arbitrate or of arbitrators to issue awards."

Prudential's Penalty

The NASDR Enforcement Release states that Prudential Securities, Inc. submitted a Letter of Acceptance, Waiver and Consent, in which the firm was censured, fined $20,000 and required to undertake to withdraw any New York choice of law defense asserted in any arbitration proceeding. Prudential also has agreed not to assert any New York choice of law defense in any future arbitration proceeding, as well as to instruct all in-house and outside counsel representing the firm in arbitration not to assert the defense.

Without admitting or denying the allegations, Prudential Securities, Inc. consented to those sanctions and consented to the entry of findings that in arbitration proceedings filed with the NASD, the firm had argued that the New York choice of law clause precluded an award of attorneys' fees and punitive damages.

The Future

This development may rekindle interest in a 1997 NASD proposal to formally recognize the availability, but also cap the amount, of punitive damages. That proposal sought to bring some consistency to the process, and greatly was influenced by a panel of academics, counsel representing investors and counsel representing brokerage firms. However, the NASD's proposal was criticized and has not yet been adopted by the Securities and Exchange Commission.

Although one should "never say never", brokerage firms now would appear to have no real prospect of convincing arbitrators that New York choice of law provisions operate to limit claims or relief that otherwise would be available. Consequently, customers of brokerage firms can, without restriction, assert claims for punitive damages. Customers also can allege common law actions, state and federal statutory actions and claims for attorneys' fees, now that New York choice of law provisions do not stand in their way.

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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat & Filipowski and can be reached at 312-621-4400.