Tuesday, June 18, 2013

U.S. Supreme Court Upholds Narrow Grounds for Vacating an Arbitration Award in Sutter v. Oxford Health Plans

In today’s world, parties are often encouraged to settle legal disputes through means of alternative dispute resolution such as arbitration.  However, in order to prevent the losing party to an arbitration dispute from essentially requesting the court to re-try the case, the Federal Arbitration Act (“FAA”) provides very narrow grounds for vacatur of an arbitration award.  Section 10 of the FAA allows an arbitration award to be vacated when the award was procured by fraud or corruption, where the arbitrator was guilty of misconduct, misbehavior or evident partiality, or where the arbitrator exceeded his authority.

In Sutter v. Oxford Health Plans, Respondent John Sutter, a pediatrician, provided medical services to the members of Oxford Health Plans' (“Oxford”) network under a fee-for-services contract that required binding arbitration of contractual disputes.  However, when a contractual dispute arose, Sutter joined a class action with other physicians, alleging that Oxford failed to make full and timely payments.  The court granted Oxford’s motion to compel arbitration and referred the claims to arbitration.  The parties agreed that the arbitrator should decide whether the contact authorized class arbitration.  The arbitrator reasoned that the parties’ agreement barred the parties from bringing any civil action in court and thus, the intent of the clause was to “vest in the arbitration process everything that is prohibited from the court process.”  The arbitrator found that class actions are clearly the type of claim that could be brought in court absent the parties’ agreement and, therefore, the arbitration clause expressed the parties’ intent to provide for class arbitration.

Oxford filed a motion to vacate the arbitrator’s decision in federal court on the grounds that the arbitrator exceeded his powers under §10(a)(4) of the FAA.  The District Court of New Jersey denied the motion and the Court of Appeals for the Third Circuit affirmed.

While the arbitration was pending, the United States Supreme Court held in Stolt-Nielsen that "a party may not be compelled under the FAA to submit to class arbitration unless there is no contractual basis for concluding that the party agreed to do so." 559 U.S. at 684. The parties in Stolt-Nielsen had stipulated that they had never reached an agreement on class arbitration.  Therefore, the arbitrator had no basis for finding that the parties’ intended for the arbitration clause to include class arbitration.  The Supreme Court vacated the arbitrator’s decision pursuant to §10(a)(4) of the FAA because the arbitrator exceeded his powers.

In light of Stolt-Nielsen, Oxford requested that the arbitrator reconsider his decision allowing class arbitration. The arbitrator issued a new opinion finding that Stolt-Nielsen had no effect on the case because unlike Stolt-Nielsen, the parties disputed the meaning of their contract and agreed that the arbitrator should interpret that meaning.

Oxford filed another motion to vacate in federal court which the District Court of New Jersey again denied and the Court of Appeals for the Third Circuit affirmed.  The Third Circuit held that if the arbitrator makes a good faith attempt to interpret an agreement, “even serious errors of law or fact will not subject his award to vacatur.” 675 F.3d at 220.

On certiorari, the Supreme Court affirmed the decision of the Third Circuit reasoning that vacatur of an arbitrator’s decision only occurs in very limited circumstances. Justice Kagan’s opinion provided that allowing parties to take full legal and evidentiary appeals would cast arbitration as a “prelude to a more cumbersome and time-consuming judicial review process."  Thus, parties requesting vacatur where the arbitrator exceeds his powers under §10(a)(4) of the FAA bear a heavy burden and must show more than serious error.  The Court found that because the parties bargained for the arbitrator’s construction of the agreement, a decision that even arguably construes or applies the contract must be upheld even if the Court disagrees with the arbitrator’s interpretation.

Oxford argued, relying solely on Stolt-Nielsen, that the high burden of §10(a)(4) is overcome when an arbitrator imposes class arbitration without a sufficient contractual basis.  However, the Court disagreed with Oxford’s interpretation of Stolt-Nielsen and noted that the arbitral decision in Stolt-Nielsen lacked any contractual basis for class-actions because the parties entered into a stipulation that they had never reached an agreement on class arbitration.  Thus, the arbitrator’s decision could not have been based on the parties’ contractual intent.

In sum, the Court stated, “convincing a court of an arbitrator's error – even his grave error – is not enough. So long as the arbitrator was ‘arguably construing’ the contract…a court may not correct his mistakes under §10(a)(4). The potential for those mistakes is the price of agreeing to arbitration. As we have held before, we hold again: ‘It is the arbitrator's construction [of the contract] which was bargained for; and so far as the arbitrator's decision concerns construction of the contract, the courts have no business overruling him because their interpretation of the contract is different from his.”

The lesson to be learned from Oxford Health Plan is if a company wants to avoid class actions/arbitrations, its agreements should include an express class action waiver because an arbitrator’s construction of that agreement is given substantial deference.

Friday, June 14, 2013

In The News: Swaps and Naked Shorts

A flurry of recent events suggest that many of the provisions of the Dodd-Frank Act are finally being implemented by rule or coming of age. The June 11, 2013 edition of the Wall Street Journal lays out some perfect examples of the regulatory ripple effect of the 2008 financial markets meltdown.

I still recall happening upon a discussion between a securities regulator from Vermont and a securities regulator from Utah during the early months of my tenure as Commissioner of Securities. The two of them were discussing “naked shorts” and I initially thought I was interrupting a private discourse. Luckily, I stayed around long enough to learn about a stock option practice—now restricted—that can be used as a legitimate equity market hedge strategy or abused as a market manipulation strategy.

The Wall Street Journal reported on page C-1 that a SEC administrative law judge had ruled against a former Maryland banker in finding him liable for “naked short selling.” As you probably know, a short sale is accomplished by selling stock you don't own by borrowing it from someone who is “long” in the stock (owns it). The goal is to buy the stock back out of the market if and when the stock’s price goes down, and return the new shares to the original owner. For example—if you sold the borrowed shares for $10 and bought the replacement shares for $5, you made a nice little profit. “Naked” short selling distorts the market price of the shares because the shares being sold were never actually borrowed. This does damage to current shareholder's because it creates a negative downward market pressure on the price of the stock at issue.

The SEC judge in the case also ordered a brokerage firm owned by Charles Schwab to disgorge $1.6 million in profits and pay a $2 million fine. The judge even went so far as to bar the firm's former CEO from the securities industry. It seems the brokerage turned a blind eye towards the banker's failure to clear his short sales.

Along the lines of new and tighter restrictions mandating timely clearance, the same edition of the Wall Street Journal has an article about the new rules that recently took effect regarding swaps. A swap is a “derivative” of an actual equity. Reporter Katy Burne Succinctly explains that:

“Derivatives allow users to protect against everything from moves in interest rates to the cost of raw materials, and swaps are more-complex derivatives that have generally been traded away from exchanges. As of Monday, more are being routed to central clearing houses, which take fees to guarantee trades in the nearly $650 trillion global swaps market. The 2010 Dodd-Frank financial-overhaul law mandated that many swaps be cleared in an effort to help prevent a financial system meltdown by forcing traders to post collateral known as margin. When Lehman Brothers Holdings, Inc. failed in 2008, just a fraction of its multitrillion-dollar swaps book was cleared. Lehman's failure sent shock waves through financial markets and accelerated a general pullback by investors from riskier investment classes.”

I can't say it any better than that.

The same edition covers the rating agencies’ new-found “lack of sway” (loss of credibility) since they fell in love with and heaped AAA ratings on mortgage-backed collateralized debt obligations that were packed with junk. Journalists Nicole Hong and Carolyn Cui, however, attribute the diminished influence to factors such as “the prominence of global economic factors driving bond prices” (as opposed to the intrinsic credit soundness of the bond issuer I suppose). Finally, the edition at issue ran a story about another child of the Dodd-Frank Act—the Bureau of Consumer Financial Protection—scrutinizing bank overdraft fee practices. And it is about time on that score.

In sum, if you missed the Wall Street Journal on June 11, 2013, you are lucky you found this blog. Food for thought.

Monday, June 10, 2013

Hey Brokers--Think Before You Sign the State Consent Order

A state regulator has threatened to bring an enforcement action against you for unsuitability relative to the sale of an annuity and barely exceeding the expected churn ratio in an elderly client's brokerage account. Your sister's younger brother is a top-notch commercial litigator with the biggest law firm in town (“Hot Shot”). He comes to your rescue and goes toe-to-toe with your state regulator. To your disbelief, all you must do to extract yourself from the ugliness is sign a Consent Order requiring you to disgorge commissions and pay a modest fine. Unbeknownst to you (and Hot Shot), you become statutorily disqualified from practicing in the industry for 10 years as the instant the Commissioner accepts and signs the Order.

The following are just a few critical excerpts from FINRA's website regarding industry disqualification and eligibility requirements and proceedings:

Eligibility Requirements - Article III, Section 3 of FINRA's By-Laws provides that no member shall be continued in membership if it becomes subject to disqualification; and that no person shall be associated with a member, continue to be associated with a member, or transfer association to another member if such person is or becomes subject to disqualification. FINRA's authority to deny the registration and/or membership of disqualified persons or members is set forth in Section 15A(g)(2) of the Securities Exchange Act of 1934. Disqualification Defined - FINRA amended its By-Laws on July 30, 2007 to incorporate the definition of "disqualification" as set forth in Section 3(a)(39) of the Exchange Act.”

Section 604 of the Sarbanes-Oxley Act expanded the definition of statutory disqualification in Section 3(a)(9) of the Securities Exchange Act of 1934 by both creating and incorporating Exchange Act Section 15(b)(4)(H) so as to include persons subject to a Final Order of a state securities commission if the Order is based upon the violation of a statute or regulation that prohibits fraudulent, manipulative, and deceptive conduct. Because the list of disqualifying events prior to this expansion fell within the ambit of the obvious—such as convictions, bars, expulsions, and revocations—many members of the industry as well as the legal community remain dangerously unaware of the implications of the final state order. So, for example, while you may have neither “denied or admitted” a state enforcement section's allegations, and unsuitability is likely more a matter of negligence than deception, the Consent Order implicitly admitting you were engaged in churning could very well qualify the Final Consent Order as one based upon deceptive conduct.

No one is going to try to revoke anything from you after the Consent Order is issued. You just automatically revoked it yourself by operation of Federal Law. Once your member firm files the appropriate U-4 disclosure regarding the Consent Order, or the state enters it in to the CRD system, FINRA RAD will fax a letter to your Chief Compliance Officer politely informing your firm that it can file an MC-400 Application or “immediately terminate its association with [you].” Your firm will then have to decide if you are worth it, and you might have to hire an attorney other than Hot Shot.

One final word of caution--and I have seen this too many times--the disqualifying Final Order provision is not limited to Orders issued by your home state or even by a state in which you are registered. So don't blow off a Show-Cause Order from Alaska just because you don't have any clients there. When you default and Alaska issues a Final Order against you for something you didn't even do—you will be in the very unsavory position of having to “unring” that bell or persuade your firm to “sponsor” you through FINRA's Membership Continuation process.

Article III, Section 3(d) of FINRA's By-Laws permits a disqualified person or member to request permission to enter or remain in the securities industry. Procedural Rules 9520-27 set forth procedures for a member to sponsor the proposed association of a person subject to disqualification or for a member to obtain approval to remain a member notwithstanding the existence of a disqualification. These actions are referred to as "Eligibility Proceedings."

Generally speaking, a person who is subject to disqualification may not associate with a FINRA member in any capacity unless and until approved in an Eligibility Proceeding. If a person is currently associated with a FINRA member at the time the disqualifying event occurs, however, the person may be permitted to continue to work in certain circumstances, provided the employer member promptly files a written application seeking permission to continue the employment in an Eligibility Proceeding. A member subject to disqualification also may be allowed to remain a member, in certain circumstances, pending the outcome of an Eligibility Proceeding, provided the member promptly files an application requesting approval of its continued membership.

Once it becomes aware of a statutory disqualifying event (related to the member or a disqualified person), the member is obligated to report the event to FINRA. In the case of a disqualified person, the Firm must either file a Form U5 if it wishes to terminate the individual's association or file a Form MC-400 application if a member wishes to sponsor the association of a disqualified person. The member should file any MC-400 application when it amends the Form U4 and it must amend the Form U4 within 10 days of learning of a statutory disqualifying event (see Art. 5, Sec. 2(c) of the FINRA By-Laws). The MC-400 application requests information about the terms and conditions of the proposed employment, with special emphasis on the proposed supervision to be accorded the disqualified person.”

FINRA SD12003 is just one of the many cautionary tales I could tell. The broker in that case purchased three (3) collateralized debt obligations his firm promoted through an auction rate securities market that his firm sponsored for a municipal client in Massachusetts in 2006. The broker entered into a Consent Order with the Massachusetts Securities Division in 2008 in which he agreed to pay a modest fine and be suspended for six (6) months. Mr. Broker returned to work with a new firm in August of 2008 after Massachusetts allowed him to re-register with the state. Everything went just swimmingly until presumably a year later, his firm received “the letter” from FINRA. According to FINRA Registration and Disclosure, Mr. Broker was out of the game when the state Consent Order was entered by the Director of the Massachusetts Securities Division.

Mr. Broker's new firm filed the MC-400 application in January of 2010. FINRA's Member Regulation staff opposed the application. A hearing was held before the National Adjudicatory Council1 18 months later, in September 2011. The National Adjudicatory Council (“NAC”) issued its opinion in favor of Mr. Broker the next year. Get the picture? So--consult with an attorney trained in state and FINRA disciplinary matters before you sign a state consent order.2 Do not rely solely upon your brother-in-law or even your firm's compliance department. Same goes for you compliance officers!

1  These are fairly uncommon and very serious. I represented an applicant in one and we prevailed.
2  David Cosgrove is the former Commissioner of Securities and has represented brokers in MC-400 proceedings since 2007. He represents brokers and broker-Dealers throughout the United States.