UUnniivveerrssiittyy ooff PPeennnnssyyllvvaanniiaa CCaarreeyy LLaaww SScchhooooll PPeennnn LLaaww:: LLeeggaall SScchhoollaarrsshhiipp RReeppoossiittoorryy Faculty Scholarship at Penn Law 2014 TThhee IInnflfluueennccee ooff AArrbbiittrraattoorr BBaacckkggrroouunndd aanndd RReepprreesseennttaattiioonn oonn AArrbbiittrraattiioonn OOuuttccoommeess Stephen Choi NYU Law School Jill E. Fisch University of Pennsylvania Carey Law School Adam C. Pritchard University of Michigan - Ann Arbor Follow this and additional works at: https://scholarship.law.upenn.edu/faculty_scholarship Part of the Dispute Resolution and Arbitration Commons, and the Law and Economics Commons RReeppoossiittoorryy CCiittaattiioonn Choi, Stephen; Fisch, Jill E.; and Pritchard, Adam C., "The Influence of Arbitrator Background and Representation on Arbitration Outcomes" (2014). Faculty Scholarship at Penn Law. 1546. https://scholarship.law.upenn.edu/faculty_scholarship/1546 This Article is brought to you for free and open access by Penn Law: Legal Scholarship Repository. It has been accepted for inclusion in Faculty Scholarship at Penn Law by an authorized administrator of Penn Law: Legal Scholarship Repository. For more information, please contact [email protected]. THE INFLUENCE OF ARBITRATOR BACKGROUND AND REPRESENTATION ON ARBITRATION OUTCOMES Stephen J. Choi, Jill E. Fisch, & A.C. Pritchard* ABSTRACT We study the role of arbitrator background in securities arbitration. We find that arbitrator background is correlated with arbitration outcomes. Specifically, industry experience, prior experience as a regulator, and status as a professional arbitrator are correlated with statistically significant differences in arbitration awards. We find that the impact of these characteristics is affected by whether the arbitrator in question serves as the panel chair and by whether the parties to the arbitration are represented by counsel. Our findings offer some preliminary insights into the debate over arbitrator bias. On the one hand, they suggest that the party selection process is relatively effective in screening for potential bias. FINRA has imposed increasingly more rigorous qualification requirements, specifically with respect to the independence of public arbitrators, but our study suggests that these requirements are unlikely to affect outcomes in most cases. On the other hand, party selection appears to be most effective when the parties are represented by counsel. Our findings highlight the importance of legal representation in the arbitration process. * STEPHEN J. CHOI is the Murray and Kathleen Bring Professor of Law, New York University, JILL E. FISCH is the Perry Golkin Professor of Law, University of Pennsylvania, and A.C. PRITCHARD is the Frances and George Skestos Professor of Law, University of Michigan. The authors thank numerous individuals who assisted us in collecting the background information on arbitrators for our analysis. EEEllleeeccctttrrrooonnniiiccc cccooopppyyy aaavvvaaaiiilllaaabbbllleee aaattt::: hhhttttttppp::://////ssssssrrrnnn...cccooommm///aaabbbssstttrrraaacccttt===222111000999777111222 1. INTRODUCTION On January 10, 2012, the Carlyle Group filed a registration statement with the SEC in connection with an initial public offering of limited partnership interests. The form S-1 disclosed that the partnership agreement would contain provisions requiring investors to resolve any disputes through individual arbitration rather than litigation. Carlyle’s filing generated a substantial and largely critical media response, with critics arguing that Carlyle’s actions were designed to strip shareholders of important rights.1 The SEC had previously refused to allow companies to issue publicly traded securities if they required arbitration to resolve shareholder disputes but, in the last two decades, courts and commentators have become more receptive to arbitration as a substitute for litigation. In addition to claiming that litigation is “spinning out of control,” defenders of arbitration argue that it is cheaper, faster, and eliminates the lawyer-driven abuses associated with the class action. Carlyle retreated from its effort to test the legality of mandatory arbitration for shareholder suits. In the context of broker-customer disputes, however, mandatory arbitration has long been the norm. In the late 1980s, the Supreme Court upheld mandatory arbitration provisions in brokerage customer agreements,2 and mandatory arbitration has been a standard term in such agreements ever since. As a result, the 1 See, e.g., Carlyle Curbing Shareholder Rights Irritates Lawmakers Who See Precedent By Miles Weiss - Jan 26, 2012 (quoting U.S. Senator Richard Blumenthal as stating that “The SEC should reject this effort to circumvent shareholder rights because it will be an extraordinary and enduring precedent”). 2 Shearson/American Express v. McMahon, 482 U.S. 220 (1987); Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477 (1989). EElleeccttrroonniicc ccooppyy aavvaaiillaabbllee aatt:: hhttttpp::////ssssrrnn..ccoomm//aabbssttrraacctt==22110099771122 overwhelming majority of broker-customer disputes, even those involving substantial sums, are resolved through arbitration.3 Brokerage customer arbitration takes place largely behind the closed doors of the Financial Industry Regulatory Association (FINRA).4 Unlike judicial proceedings, FINRA arbitrations are not open to the public. Although FINRA releases the written decisions issued after arbitration hearings, it does not disclose the details of the claims filed or background information on the arbitrators who issue these decisions. Moreover, FINRA arbitration rules require the arbitrators to announce only bare-bones information in their awards.5 Notably, an explanation of the reasons for the arbitrators’ decision is not required unless such an explanation is jointly requested by all the parties.6 The result is a process with limited transparency. The absence of detailed case-specific information creates challenges for empirical research, making evaluation of arbitration’s effectiveness in protecting investors’ rights exceedingly difficult. Nonetheless, as commentators debate the relative merits of arbitration versus litigation, the need for tools to assess the arbitration process becomes apparent. Significant issues remain, including the selection of arbitrators and structuring of arbitration panels to limit the potential for bias, and improving the reliability of arbitration awards. 3 See, e.g., STMicroelectronics, N.V. v. Credit Suisse Sec. (USA) LLC, 648 F.3d 68 (2d Cir. 2011) (upholding trial court’s confirmation of $400 million arbitration award). 4 “FINRA is a private corporation that succeeded the National Association of Securities Dealers and the enforcement divisions of the New York Stock Exchange as the self-regulatory organization for the securities industry.” Wachovia Securities LLC v. Brand, __ F.3d __ (4th Cir. 2012). FINRA handles arbitration of both broker-customer disputes and disputes between FINRA member firms and their employees. This article only analyzes arbitration that result from disputes between brokers and their customers. 5 Code of Customer Arbitration, Rule 12904 (e). Awards (designating information required in an arbitration award). 6 Rule 12904(g) Explained Decisions. 2 Electronic copy available at: http://ssrn.com/abstract=2109712 FINRA has been particularly sensitive to concerns about potential arbitrator bias. Over the past eight years, FINRA has changed the arbitrator selection process, enhanced the independence requirements for public arbitrators, and increased the opportunity for customers to bring their disputes before all-public panels. Further refinements to that process require a better understanding of the effects of arbitrator and case-specific differences on arbitration outcomes. This project examines one such difference – arbitrator background – as well as the effect that legal representation has on that difference. To explore the role of arbitrator background in securities arbitration, we analyze a dataset of randomly selected arbitration awards from 1998 to 2000. We hand collect data on particular arbitrator background characteristics – people who serve as professional arbitrators, people with prior securities experience, prior regulators and retired arbitrators. We explore whether the presence of arbitrators with these characteristics affects the size of arbitration awards and the extent to which the impact is affected by whether the arbitrator with these characteristics serves as the panel chair. We also examine the extent to which the impact is affected by legal representation of the parties. We proceed as follows. We lay out the background on the arbitrability of securities claims, FINRA arbitration procedures and survey prior literature in Part 2. Part 3 sets forth our hypotheses. Part 4 describes our sample and variables, and reports the results of our empirical tests. Part 5 concludes. 2. BACKGROUND 2.1. Legal Status of Customer Arbitration 3 At one time, the Supreme Court was suspicious of contracts that required customers to submit disputes to arbitration. In Wilko v. Swan,7 the Supreme Court held that suits under the Securities Act of 1933 were not subject to mandatory arbitration. As the Court later explained, Wilko “reflect[ed] a general suspicion of the desirability of arbitration and the competence of arbitral tribunals.”8 Many lower courts, applying similar reasoning, extended Wilko to other securities claims, including litigation pursuant to § 10(b) of the Securities Exchange Act.9 In the late 1980s, the Supreme Court reversed its position. In Shearson/American Express v. McMahon, the Court held that the Federal Arbitration Act reflected a "federal policy favoring arbitration."10 Specifically, the Court held that arbitral forums were fully capable of resolving securities fraud disputes11 and that the “the mistrust of arbitration that formed the basis for the Wilko opinion in 1953 is difficult to square with the assessment of arbitration that has prevailed since that time.”12 Two years later, in Rodrigues de Quijas v. Shearson/American Express, Inc., the Supreme Court explicitly overruled Wilko and held that pre-dispute arbitration agreement would be upheld, even with respect to claims arising under the Securities Act of 1933.13 Subsequently, the Supreme Court has emphasized its approval of arbitration as an alternative to litigation, 7 346 U.S. 427 (1953). 8 Shearson/American Express v. McMahon, 482 U.S. 220 (1987). 9 See, e.g., Allegaert v. Perot, 548 F.2d 432 (CA2), cert. denied, 432 U.S. 910 (1977). 10 Shearson/American Express v. McMahon, 482 U.S. at 226, quoting Moses H. Cone Memorial Hospital v. Mercury Construction Corp., 460 U.S. 1, 24 (1983). 11 The Court based its holding, in part, on the fact that “the Commission has broad authority to oversee and to regulate the rules adopted by the SROs relating to customer disputes, including the power to mandate the adoption of any rules it deems necessary to ensure that arbitration procedures adequately protect statutory rights.” 482 U.S. at 233-34. The extent to which the SEC has exercised that authority to oversee the fairness of customer arbitration procedures is unclear. 12 482 U.S. at 233. 13 490 U.S. 477 (1989). 4 stating that arbitration produces “lower costs, greater efficiency and speed, and the ability to choose expert adjudicators to resolve specialized disputes.”14 The Supreme Court’s expansive reading of the FAA and its approval of alternative dispute resolution have resulted in a deferential approach to judicial review of arbitration awards. Under the Court’s interpretation of the FAA, courts are not permitted to overturn arbitration awards on the basis that the arbitrators misinterpreted or applied applicable law.15 Although traditionally the courts have granted motions to vacate arbitration awards in which the arbitrators were found to have manifestly disregarded the law, the Supreme Court’s most recent decisions on the doctrine of “manifest disregard” suggest that this language is merely a “judicial gloss” on the explicit statutory grounds for vacatur set out in the FAA.16 Lower courts have read this Supreme Court precedent as holding that the statutory grounds for vacating or modifying an arbitration award are exclusive.17 These legal standards limit the extent to which courts can exercise effective oversight over the potential for bias in arbitration procedures. Under § 10(a) of the FAA, a court can vacate a decision on the basis of “evident partiality” or “other misbehavior” 14 559 U.S., at ___, 130 S. Ct. 1758, 1776). See also Hall Street Assocs. v. Mattel, Inc., 552 U.S. 576, 581 (2008) (stating that the FAA reflects a “comprehensive scheme to replace judicial hostility to arbitration with a national policy favoring it.”). The Court recently held that California’s prohibition of class action waivers was preempted by the Federal Arbitration Act. AT&T Mobility LLC v. Concepcion, 131 S. Ct. 1740 (2010). 15 See, e.g., United Paperworkers Int’l Union v. Misco, Inc., 484 U.S. 29, 38 (1987). 16 The primary such authority is contained in FAA § 10(a)(3) which allows courts to vacate arbitration awards only "where the arbitrators were guilty of misconduct in refusing to postpone the hearing, upon sufficient cause shown, or in refusing to hear evidence pertinent and material to the controversy; or of any other misbehavior by which the rights arbitral proceedings is itself desirable, reducing the cost and increasing the speed of dispute resolution." See Stolt-Nielsen at n. 3 (“We do not decide whether “‘manifest disregard’” survives our decision in Hall Street Associates, L.L.C. v. Mattel, Inc., 552 U.S. 576, 585, 128 S. Ct. 1396, 170 L. Ed. 2d 254 (2008), as an independent ground for review or as a judicial gloss on the enumerated grounds for vacatur set forth at 9 U.S.C. § 10”) 17 See, e.g., Citigroup Global Mkts., Inc. v. Bacon, 562 F.3d 349, 358 (5th Cir. 2009); Frazier v. CitiFinancial Corp., 604 F.3d 1313, 1323-24 (11th Cir. 2010) (holding that the common law standards for vacatur are, therefore, no longer valid). 5 of the arbitrators.18 Courts have interpreted evident partiality as involving a relationship with an arbitrator, a lawyer or a party19 rather than an arbitrator’s predisposition or general views about the law or the industry.20 In addition, courts have rejected the argument that an arbitrator’s position or experience within the industry is sufficient to meet the legal standard of bias,21 even if that position might present the appearance of bias.22 Moreover, to the extent that the arbitrators disclose any potential biases or conflicts, or relationships that create the potential for bias, such disclosure insulates the award from subsequent challenge in that a party can respond to the disclosure by striking the arbitrator or seeking his or her removal from the panel.23 2.2 FINRA Procedures Arbitrators in FINRA customer arbitrations are chosen through a party selection system. In 1999-2000, the time period from which our sample is chosen, customer claims for more than $50,000 were resolved by a three-arbitrator panels.24 FINRA rules specified that the panels were to consist of two “public” arbitrators and one “industry” arbitrator. FINRA does not impose limits on the background of industry arbitrators, and they generally include current and former brokers, bankers and other professionals in the 18 Cite statute and STMicroelectronics. 19 STMicroelectronics at 74. See Positive Software Solutions, Inc. v. New Century Mortg. Corp., 476 F.3d 278 (analyzing nature of relationships that might require vacatur of arbitration award for partiality). 20 See, e.g., Repub. Party of Minn. v. White, 536 U.S. 765, 777, 122 S. Ct. 2528, 153 L. Ed. 2d 694 (2002) (“A judge's lack of predisposition regarding the relevant legal issues in a case has never been thought a necessary component of equal justice ….”). 21 See also Positive Software Solutions, Inc. v. New Century Mortg. Corp., 476 F.3d 278 (noting that “the best lawyers and professionals . . . normally have the longest lists of potential connections to disclose”). 22 STMicroelectronics. See also Owen-Williams v. BB&T Inv. Servs., 717 F. Supp. 2d 1 (DDC 2010) (citations omitted) (”'It is well established that a mere appearance of bias is insufficient to demonstrate evident partiality."”). 23 See, e.g., Cortina v. Citigroup Global Mkts., Inc., 2011 U.S. Dist. LEXIS 92954, 17-18 (S.D. Cal. Aug. 19, 2011) (“Because the arbitrator disclosed prior to the hearing the facts Petitioner contends give the impression of bias, his request to vacate the award based on non-disclosure is denied.”). 24 FINRA has now raised this limit to $100,000. FINRA Regulatory Notice 09-13 (2009). 6 securities industry.25 Public arbitrators, also known as “neutrals” are supposed to lack substantial industry ties, and FINRA rules disqualify various professionals from serving as public arbitrators on the basis of ties that include current and former employment relationships, a close relative who works in the securities industry, and, for lawyers, substantial representation of industry clients. 26 Since November 1998, arbitrators for FINRA arbitrations have been chosen through a list selection system administered by the Director of Dispute Resolution, termed the Neutral List Selection System (or NLSS).27 During most of the time period involved in our study, the National Association of Securities Dealers (NASD)28 provided the parties in each case with two separate lists, one consisting of public arbitrators and the other consisting of non-public arbitrators, in a roughly two-to-one ratio.29 The lists were generated by an NASD computer program using a rotational method, although the computer eliminated arbitrators with obvious conflicts of interest. Along with the lists, the parties were also provided with background information on each arbitrator, including 25 FINRA Rule 10308. Selection of Arbitrators, (4) “non-public arbitrator” 26 FINRA Rule 10308. Selection of Arbitrators, (5) “public arbitrator.” See also SEC, Order Approving Proposed Rule Change to Amend the Definition of Public Arbitrator, Sec. Exch. Act. Rel. No. 54792 (March 19, 2008). 27 The NASD’s Neutral List Selection System (NLSS) went into effect on November 17, 1998. The NLSS was proposed by the NASD Arbitration Policy Task Force as part of its 1996 Securities Arbitration Reform Report and modeled after the list selection system used by the American Arbitration Association. The report recommended that panels for larger cases continue to be composed of one industry member and two public arbitrators. The report recommended improving the quality of arbitrators by increased arbitrator compensation, better training, expanding the arbitrator pool and requiring arbitrator evaluation of co- panelists. The report also made some highly controversial recommendations concerning the availability of punitive damages in arbitration awards. 28 The NASD was the predecessor to FINRA. Prior to the merger, approximately 90% of securities arbitrations were handled by the NASD; the remainder were arbitrated through the New York Stock Exchange arbitration program. 29 Under FINRA’s current selection procedure, FINRA provides the parties in a customer dispute with three sets of names. One set is a list of potential public arbitrators, the second is a list of industry arbitrators, and the third is a list of chair-eligible arbitrators. 7 a copy of that arbitrator’s Arbitrator Disclosure Report.30 FINRA rules then allowed parties to strike, without cause, prospective panelists until they reached agreement on a panel. The position of panel chair has received particular attention. The chair exercises greater control over the arbitration process than the other panelists, often being the one to decide motions, discovery issues, evidentiary questions, etc.31 FINRA itself has stated that “chairpersons . . . play a vital role in the administration of cases.”32 At the time of our study, arbitration chairs were merely required to qualify as public arbitrators.33 FINRA has subsequently tightened its requirements for an arbitrator to qualify to serve as a panel chair.34 An ongoing issue in FINRA arbitrations concerns the appropriate extent to which arbitrators should have securities industry background. On the one hand, more knowledgeable arbitrators are likely to produce more accurate awards. Broker-customer disputes frequently involve technical issues in which familiarity with industry practices is valuable. Securities expertise enables an arbitrator to understand the nature of the claims better.35 As some courts have noted, “[t]he most sought-after" arbitrators “are those who are prominent and experienced members of the specific business community in which the 30 See STMicroelectronics (describing selection process and disclosure Arbitrator Disclosure Reports). Parties were allowed to request additional information on the arbitrators, and the NASD director was required to forward that request to the arbitrators, although the arbitrators were not required to respond. 31 See Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment Nos. 1, 2, 3, and 4 Thereto To Amend NASD Arbitration Rules for Customer Disputes, Sec. Exch. Act Rel. No. 51856 (June 15, 2005), 70 FR 36442, 36445 (June 23, 2005). 32 Id. 33 Choi, Fisch & Pritchard, supra at _ (explaining that FINRA would designate as chair the public arbitrator that received the higher combined ranking from the parties). 34 Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Notice of Filing of Proposed Rule Change and Amendment Nos. 1, 2, 3, and 4 Thereto To Amend NASD Arbitration Rules for Customer Disputes, Sec. Exch. Act Rel. No. 51856 (June 15, 2005), 70 FR 36442, 36445 (June 23, 2005). 35 See Bondi (defending expertise of FINRA arbitrators). 8