Punitive Damages in Arbitration

The issue of whether arbitrators should be permitted to award punitive damages in arbitration has been a hot issue in securities arbitration since the dawn of securities arbitration.

In some states most notably New York, where the vast majority of arbitrations are held — the law always prohibited punitive damages in arbitration. This had 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, was 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.

While the law in New York has never changed, the application of that law was significantly effected in the late 1990’s, by a United States Supreme Court decision, and a series of lower court decisions in New York. For those who are interested in the history of that development, my article, Punishing the Industry, details the changes and how we got to where we are today.

Today, in most cases, arbitrators have the power to award punitive damages, but the expansion of an arbitrator’s power in this area may be part of the rationale for the demise of the arbitration system as we know it.

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. For a deeper dive, read What is Securities Arbitration? and Overview of Securities Arbitration

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. While arbitrators undoubtedly act more like judges than juries, they are often subject to the same human frailties as juries, and often lack the legal training of judges. Emotions sometimes outweigh legal reasoning, and outrageous awards are sometimes the result.

The problem with punitive damages in arbitration is that the emotional aspect of the award, which results in huge punitive damages, is traditionally not reviewable by a court. However, outrageous awards are becoming more prominent in the arbitration arena, where arbitrators are awarding relatively huge sums of money, sometimes without regard to the law, or the merits of the case.

While every securities attorney can probably point to an outrageous award, two recent awards demonstrate the problem. The first involves a case where punitives were probably not justified, the second a case where such damages were probably justified, but the amount of the punitive damages was excessive. Both cases were decided in the last year and a half, and both clearly demonstrate the issues.

The first case was a typical arbitration against a brokerage firm and a broker by the estate of a deceased customer. The unusual aspect of the case was that it was a “selling away” case – the underlying investment was not made through the brokerage firm. The broker was accused by the estate of putting the customer into a series of investments in the broker’s own outside business, a startup company. Unfortunately for the broker, there was almost no documentation of the investment by the customer, and as the broker and customer began to exchange documents regarding the investments, the customer passed away. At the hearing, the estate presented evidence that the customer was losing his mental facilities at the time of the investments and claimed that he did not know what he was doing when he made the investments.

Given the fact that the customer had passed away, there were serious issues in the case regarding hearsay testimony. The customer’s relatives were permitted, over the strenuous objection of counsel for the broker and the firm, to testify not only what the deceased customer said, but what he thought. In a court proceeding, such testimony would never have been permitted, and there is a serious constitutional issue in such a case, as there is simply no way for the respondents to cross-examine these hearsay statements. At times the testimony became completely incredible and almost impossible to believe. However, the arbitrators allowed all of the hearsay, including double and triple hearsay, accepting such testimony as “He said that he did not want to invest” and “He told me that the broker said XYZ”. For the laymen reading this, that is an example of double hearsay, which is prohibited by every evidence code in the country. It is impossible to cross-examine the speaker – as he is not in court.

However, regardless of the hearsay, the case involved allegations of regulatory violations, which the broker and firm denied, and lost investments, which were admitted. The money from the customer had been used by the startup company, and the startup was now out of business. The estate’s case attempted to demonstrate that the broker had engaged in selling away, without notice to his firm as he had accepted a series of investments from the customer without informing the firm, that the monies were structured as loans to the broker rather than investments in the firm, that there was little documentation of the loans, that the startup company never made a dime in profits, that it was out of business, and that its own financial records failed to adequately disclose the customer’s investments. The broker on the other hand, completely acknowledged the loans and receipt of the funds from the investor, had plausible explanations for the lack of documentation, and presented evidence that the funds, as well as other funds, were used for legitimate business purposes by the startup company.

Regardless of which side of the case one believed, there were problems in the case, and the award came down after 4 weeks of hearings, that the broker was liable for the full amount of the investment by the customer, one million dollars. However, the award was carelessly drafted, awarding the million to all claimants (the customer’s family members had also invested with the broker) although the actual investments were less than that, and appeared to be an effort to give the customer everything his estate had asked for.

That appearance was made concrete when the arbitrators went further and awarded 2 million dollars in punitive damages.

The case clearly was not one where punitive damages were warranted, and the arbitrators, who were apparently intent on awarding as much as possible against the broker, gave the claimants everything they asked for, regardless of the law, or the facts. This was further demonstrated by the fact that the law of the state involved did not permit punitive damages! No matter, the arbitrators awarded them anyway.

Obviously, this was a devastating award for the broker, who had no ability to pay such a significant award. What made the award even more unique is that the arbitrators awarded nothing against the brokerage firm. Clearly, the award was irrational and apparently driven by a desire to punish the broker as severely as possible, regardless of the merits of the case, or the law. The broker, with no funds to appeal, filed for bankruptcy, and the estate objected to the discharge of the award.

The second award is well known. In Sawtelle vs. Waddell & Reed, Inc., an arbitration panel entered an award for nearly $28 million dollars in favor of a broker against his former firm. Not only was the size of the award unique, $25 million of the Award represented punitive damages. SECLaw.com reported on the award back in August 2001. and the case was extensively reported in the industry press. The conduct of the firm in the Sawtelle case was truly outrageous and shocking. According to press reports, the firm, and some of its principals, attempted to destroy the broker when he left the firm, and engaged in conduct that was simply outrageous and beyond all bounds of accepted behavior. On Wall Street ran an extensive article on the case, which detailed the firm’s conduct. Assuming one believes the press reports, a punitive damage award was not a surprise, and well deserved.

The problem with the award was the size of the punitive damage award. At 25 million dollars, it was more than 12 times the amount of compensatory damages, and if it did not put the brokerage firm out of business, it would have had a serious impact on the firm’s net capital, if not its ability to conduct business. Punishing the firm is one thing – putting it out of business, along with all of its employees, their families, and dependents, is quite another.

Whether the issue is punitive damages which are not warranted, or punitive damages which bear no relationship to the monetary harm, or the ability to pay, these cases demonstrate the issues in allowing arbitrators the ability to award punitive damages without any restrictions or guidelines.

The law provides that punitive damages, when permitted, may be awarded only for conduct that is outrageous, because of the defendant’s evil motive or his reckless indifference to the rights of others. Punitive damages must be based on conduct which is “‘malicious,’ ‘wanton,’ ‘reckless,’ ‘willful,’ or ‘oppressive’. ” Courts have long taken the position that the law provides for punitive damages only for exceptional misconduct which transgresses mere negligence, as when the wrongdoer has acted “maliciously, wantonly, or with a recklessness that betokens an improper motive or vindictiveness” or has engaged in “outrageous or oppressive intentional misconduct” or with “reckless or wanton disregard of safety or rights.” Courts have held that such conduct must be “close to criminality, . . . and that, like criminal conduct, it must be ‘clearly established.'”

Reading those standards carefully, one soon realizes that punitive damages must be reserved for the truly outrageous case, not for the typical case, and certainly not where there is an absence of conduct that is malicious, and vindictive, that is close to criminal and is “clearly established.”

Because punitive damage awards are punitive in nature, and do not have the constitutional safeguards that attend criminal prosecution, courts generally agree that punitive damages “are not a favorite in law and are to be allowed only with caution and within narrow limits…. The allowance of such damages inherently involves an evaluation of the nature of the conduct in question, the wisdom of some form of pecuniary punishment, and the advisability of a deterrent.”

All of these cases, and all of the above quotes, relate to a court’s ability and power to award punitive damages. The issues which arise in the punitive damage situation are only amplified when the discussion turns to the award of such damages by arbitrators, as there are less procedural and constitutional safeguards in the arbitration process than there are in the courts.

However, this situation may be changing, as courts are beginning to take a more active role in the review of arbitration decisions. It is clear that something has to change, and whether it is a restriction on the ability of arbitrators to grant punitive damages or an expansion of the court’s oversight of the arbitration process, change is in the winds.

Traditionally, overturning an arbitration award has been extremely difficult, and there are extremely limited grounds for doing so. I have addressed these issues in earlier columns. Over the last few years, perhaps in recognition of the increasing “odd” award, courts have expanded the grounds for the vacatur of an arbitration award, and the concepts of “manifest disregard of the law” and “manifest disregard of the evidence” have become accepted grounds for the appeal of arbitration awards.

The traditional rationale for the availability of punitive damages is to punish a defendant. Punitive damages are meant to punish defendants who would not be adequately punished if forced to pay compensatory damages alone. The theory is that absent such deterrents, if defendants are not forced to pay the full social cost imposed by their conduct, they will not discontinue that conduct.

That certainly sounds reasonable. A common complaint among plaintiffs and their attorneys, in securities and non-securities cases, is that forcing the defendant to simply return the money he took or to repay losses, is not enough. In theory, punitive damages are needed to prevent the conduct in the first place – forcing a wrongdoer to pay back the money he stole hardly prevents him from stealing again.

While such an argument has initial appeal, it ignores the criminal side of our legal system and the fact that nearly every case of fraud, theft, or deception is also a crime. While an analysis of human behavior is well beyond this article, and my expertise, I believe it is clear that the criminal law and its severe sanctions are the underlying deterrent that stops or helps to prevent rampant civil fraud.

In addition to criminal law, as as our legal system developed, and Congress developed new ways to control wrongful behavior, the authority of administrative civil sanctions almost always appears in regulatory statutes and in particular, in securities cases. Such sanctions, in turn, have come to be one of the main enforcement procedures of administrative agencies and serve as a deterrent, rather than punitive damages. See Kenneth Mann, Punitive Civil Sanctions: The Middleground Between Criminal and Civil Law, 101 Yale L.J. 1795, 1849 (1992).

It is beyond dispute that the retail securities industry is one of the most heavily regulated industries in existence, with multiple and overlapping regulatory bodies having the power to monitor, and punish, those whose conduct is deserving of such punishment. The regulatory structure in the securities industry, and the potential for civil, criminal, and administrative penalties for wrongful conduct against a respondent, is more than a sufficient deterrent to wrongful conduct. An award of punitive damages, in addition to the severe sanctions from the regulatory side, only serves as a windfall to the Claimants.

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.


Sallah Astarita & CoxRepresenting Advisors and Investors, Nationwide.

Mark J. Astarita is a veteran securities attorney representing investors and financial professionals nationwide in securities investigations and arbitrations. Have a question? Email him at mja@sallahlaw.com, call his office at 212-509-6544, or visit The Securities Lawyer

Securities Attorney at Sallah Astarita & Cox | 212-509-6544 | mja@sallahlaw.com | Website | + posts

Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.

He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.