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High Court Expands Brokers' Culpability : Securities: Industry is put on notice that customers can collect punitive damages in disputes settled by arbitration.


WASHINGTON — In a victory for disgruntled investors, the Supreme Court ruled Monday that securities brokers can be forced to pay punitive damages to their customers in disputes resolved by arbitrators.

The 8-1 decision puts the securities industry on notice that it can be hit with large penalties if its brokers cheat their customers.

The ruling reinstates $400,000 in punitive damages, on top of $159,000 in actual damages, that arbitrators awarded to a Chicago couple who had accused a Shearson Lehman broker of churning their account to generate commissions.

Despite the setback in the high court, the securities industry may take a step toward recouping some of its lost protections later this week, when the Republican-led House is expected to pass sweeping reforms of the legal system. Provisions in the GOP-backed legislation would make it harder for disappointed investors to sue when a stock plunges in price and would limit punitive damage verdicts in court.

The significance of the Supreme Court ruling lies in the fact that most investor-broker disputes already have been steered away from the courts and into arbitration, where the industry says disagreements can be solved more quickly and cheaply.

The high court spurred the trend in 1987, when it ruled that securities firms could mandate arbitration as the dispute-resolution mechanism for customers who sign the standard industry brokerage contract.

More recently, the industry tried to push its advantage one step further by adding another contract clause that says disputes with brokers "shall be governed by the laws of the State of New York." New York law allows punitive damages to be awarded by courts--but not by arbitrators.

Lawyers for the securities industry have contended that the clause shielded brokerage firms from punitive damages; a federal appeals court in Chicago relied on it in throwing out the $400,000 in punitive damages awarded to Antonio Mastrobuono, a professor of medieval literature at the University of Illinois in Chicago, and his wife Diane.

But on Monday, the Supreme Court reversed the judgment in the case (Mastrobuono vs. Shearson Lehman Hutton, 94-18) and said that arbitrators may impose punitive damages.

Writing for the court, Justice John Paul Stevens noted that "nothing in the (standard) contract could possibly constitute evidence of an intent to exclude punitive damages"--except for the reference to New York law. And, wrote Stevens, the securities industry does not deserve "the benefit of doubt" just because it added an "ambiguous" clause that only insiders would understand.

Lawyers who represent investors said they were delighted with the decision.

"This is a major victory for public investors," said Stuart Goldberg, an Austin, Tex., attorney. "It strikes down the main obstacle the industry has put in the way of paying punitive damages."

Punitive damages in securities cases are rare and are likely to remain so, attorneys said. About 2% of arbitrators' awards include punitive damages, according to the Public Investors Bar Assn. in Indianapolis.

"Arbitrators are hand-picked by the industry, but there are some frauds so egregious that even an arbitrator will award punitive damages," Goldberg said. "Usually, it's not fraud itself, but covering it up and lying about it that does it." Goldberg said he has won punitive damages in four cases in the last year and has pending a $1.6-million award against PaineWebber in a Florida case.

Brokerage industry officials said the ruling was ill-considered.

"We're disappointed," said Stuart J. Kaswell, general counsel for the Securities Industry Assn., which had urged the court to maintain the bar on punitive damages in arbitration. "There are other mechanisms to punish inappropriate behavior--the Securities and Exchange Commission and state securities law."

Justice Clarence Thomas filed a lone dissent, contending that state law, not the Federal Arbitration Act, should govern such disputes.

The securities industry has been stung by the unfavorable news coverage prompted by punitive damage awards against brokers at a time when the business has been under fire by the SEC for failing to take tough action against dishonest brokers.

In 1985, the Mastrobuonos put $169,113--nearly all their savings--into a Shearson brokerage account.

Two years later, their lawyer said, the account was wiped out.

A Shearson broker allegedly churned the account by rapidly buying and selling securities to generate brokerage commissions, made trades that the Mastrobuonos had never authorized and sent false account statements to the couple, making it appear that the value of their account was rising.

Mastrobuono said Monday that he was elated by the decision and that the court had solved "a great problem of social justice" by allowing punitive damages. The effects of losing his life savings had been disastrous, he said; the couple are still struggling to pay off a second mortgage they were forced to take out when they learned their account was worthless.

David E. Shellenberger, a Boston lawyer who represents small investors, lauded the decision but predicted that the industry would move swiftly to try to circumvent it.

Shellenberger said brokerage firms may seek to change National Assn. of Securities Dealers rules to allow them to insert a clause in brokerage contracts specifically limiting or banning punitive damages.

However, such a rule change would have to be approved by the SEC.


Savage reported from Washington, Paltrow from New York.


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