Brokerages Fight Punitive Awards : Misdeeds Have Spawned Barrage of Payouts

It is a barrage of cases like the one involving investor Dale R. Pon that have prompted the brokerage industry to fight back.

Three arbitrators in September decided that a former Shearson Lehman Bros. broker had so badly wronged customer Pon by churning his account and making unauthorized purchases of highly risky stocks that merely awarding him the money he lost wouldn’t be a strong enough rebuke.

So they not only gave Pon $1.2 million in compensatory damages, but ordered Shearson and broker Lawrence J. Green to pay $250,000 in punitive damages. The giant brokerage “deliberately fostered an environment where behavior such as that of . . . Green was not only tolerated but condoned,” the arbitrators ruled.

The securities industry fought for years to keep customers out of court by limiting disputes to arbitration. But now that arbitration cases aren’t going their way, the brokerages are fighting to restrict arbitrators’ power to punish with punitive damage awards.

Arbitrators awarded unprecedented punitive damages to brokerage customers last year--an estimated $9 million, about 70% more than the $5.3 million awarded in 1991, according to figures supplied by the Securities Arbitration Commentator, a Maplewood, N.J., publication.

The number of cases involved is not great; final figures for 1992 haven’t been tallied, but punitive damage awards are expected to be down slightly from the 44 recorded in 1991. In any event, punitive damages--meant to punish a defendant for bad conduct--are awarded in only a tiny fraction of about 1,800 customer arbitration cases decided annually.

But lawyers involved in arbitration cases say the brokerages may be reacting even more to the damaging publicity that accompanies big damage awards than to the amounts awarded.

While regulators say it is unlikely the securities industry will win an outright ban on punitive damages, Wall Street may succeed in imposing limits on the size of awards and the circumstances in which they can be granted.

Securities firms saw arbitration as a way to streamline dispute resolution, save on legal fees and wipe out the possibility of astronomical awards by jurors more sympathetic to individual investors than to big, rich brokerage firms. But with the ballooning of punitive damage awards, the arbitration system has taken a turn the industry never bargained for.

The Securities Industry Assn., the trade organization and lobbying arm of Wall Street, is spearheading the campaign to ban punitive damages. It has asked committees of the National Assn. of Securities Dealers--whose arbitration service is the industry’s biggest--to ban punitive damages.

Any rules change would have to be approved by the Securities and Exchange Commission. SEC officials have declined to comment.

The issue is important to investors. As a result of a 1987 U.S. Supreme Court decision, Shearson/American Express vs. McMahon, most brokerage customers no longer have the option of going to court. In most cases, three-member panels of arbitrators decide the outcome.

To some extent, the industry’s campaign to limit arbitration awards mirrors efforts by corporations in general to limit punitive damages. Brokerages claim that the issue is even more urgent in arbitration cases, however; judges can--and commonly do--reduce jury awards they consider excessive, but the grounds for overturning arbitration awards are extremely narrow.

In the first years after McMahon, punitive damages were almost unheard of in arbitration. Arbitrators were even doubtful that they had the authority to award them.

Now, big punitive awards seem to pop up with regularity--especially in cases where the evidence showed that the problem wasn’t just a lone rogue broker, but involved wrongdoing or negligence by supervisors and the firms themselves.

“Arbitrators are not going to give punitive damages just because a miscreant broker did something wrong,” says Stuart C. Goldberg, a Texas lawyer specializing in arbitration cases who won a large punitive damage award against PaineWebber Inc. last year. “You have to prove that wrong was done by people up the chain of command.”

Arbitration cases typically involve allegations that a broker churned an account--that is, rapidly bought and sold securities just to generate commissions--made other unauthorized trades, falsified account records or deliberately put customers into riskier securities than they wished.

In many of the cases in which punitive damages have been awarded, evidence was presented that supervisors looked the other way and failed to follow the firms’ own written procedures for detecting and stopping misdeeds.

The industry’s main argument for abolishing punitive damages is that they’re unnecessary.

Lawyers for the securities industry say there already are ample, more appropriate means to punish brokers and firms that break the rules--the enforcement divisions of the NASD, the New York Stock Exchange and the SEC.

“The arbitration system is not really there to act as a disciplinary mechanism,” contends William J. Fitzpatrick, general counsel to the Securities Industry Assn.

Big awards for a single misdeed could force a small firm out of business, officials add. “This could put a lot of people out of jobs, and could put the accounts of other customers in jeopardy,” says Robert I. Kleinberg, general counsel of Oppenheimer & Co. and president of the SIA’s compliance and legal division.

Investors’ lawyers deny that punitive damages represent a mortal threat to firms that are adequately capitalized--and certainly not to the big firms that have been hit with the largest awards.

Nor, they say, are the enforcement divisions of the NASD and NYSE doing an adequate--or timely--job of punishment. Disciplinary cases commonly take six years or more to bring, during which brokers often remain at their desks and victimize other customers. Disciplinary records also show that the regulators almost never take action against high-level supervisors at the big, established Wall Street firms.

In the case in which lawyer Goldberg won punitive damages from PaineWebber last year, broker Christopher D. Hodges had a record of at least 10 formal complaints and arbitration cases that resulted in the firm paying money back to customers. But there is no record of any formal disciplinary action or investigation of Hodges by the NASD, NYSE or SEC, not uncommon for brokers with long histories of formal customer complaints.

In many instances, the legal authority to award punitive damages is still uncertain.

A New York state court decision bans punitive awards in arbitration cases within the state. And many customer account agreements specify that New York state law applies--regardless of where the customer lives.

For the most part, however, judges across the country are letting punitive damage awards stand. And even in New York, the ban did not deter arbitrators in the Pon case from awarding punitive damages.

Arbitrator Ann J. Pinciss, a New York lawyer, says the panel deliberately disregarded the New York rule to send a message.

Pinciss says the panel believed that “the compliance operation of this particular branch was so negligent that it bordered on collusion.” She says the arbitrators believed that they had to award punitive damages to drive home the point that they wanted the NYSE to launch a disciplinary investigation of the broker and Shearson.

(Doubt about whether the award would stand under New York law apparently was one reason Pon agreed to an undisclosed Shearson settlement offer after the award was made. Shearson declined to comment on the case.)

In other recent cases, too, arbitrators awarded punitive damages after considering evidence that serious wrongdoing extended beyond individual brokers:

* Five of Hodges’ customers in Florida won $2.3 million--including more than $1.6 million in punitive damages--from an NASD arbitration panel in September. The former PaineWebber broker allegedly loaded up customer accounts with over-the-counter stock in a small company in which he personally had invested. He also allegedly used the PaineWebber office in Sarasota, Fla., to mail false account statements to customers.

Arbitrators ruled that PaineWebber was “grossly negligent in its failure to supervise Hodges.”

* In late November, NASD arbitrators panel in Chicago awarded $400,000 in punitive damages and $159,000 of actual damages to college professor Antonio Mastrobuono and his wife, Diana, finding against Shearson and a broker. The broker allegedly made unauthorized trades, churned their account, deliberately hid the fact that he was earning commissions on certain trades and sent out false account statements that made it appear that the Mastrobuonos’ account was doing well.

In fact, their $169,000 investment--nearly all of the couple’s savings--was wiped out. Shearson compliance officials allegedly failed to detect or stop the wrongdoing. (Shearson is appealing the decision in court.)

* In December, an American Arbitration Assn. panel awarded $800,000--including $300,000 in punitive damages--to a Florida man whom a Prudential-Bache (now Prudential Securities) broker persuaded to invest nearly all his net worth in highly speculative limited partnerships.

Attorney Michael A. Hanzman introduced evidence that Prudential had falsely marketed the partnerships as being a safe alternative to bank certificates of deposit. Hanzman showed that internal Prudential memos raised grave concern about the stability and risks of the partnerships and seemed to indicate that some of the partnerships were using borrowed money to inflate the payout to investors.

The firm denies wrongdoing. “We obviously disagree with and are disappointed by the ruling,” a Prudential spokesman says. But he adds that the firm does not plan an appeal.

Lawyers on both sides agree that there has been a fundamental shift in arbitrators’ willingness to make big awards.

Those who represent brokerage firms contend that arbitrators are going to great lengths now to counter the impression that the system is biased against customers. Others involved in the arbitration system offer more fundamental explanations.

Mary Calhoun, a consultant and expert witness for customers as well as brokerage firms, says she believes that arbitrators are reacting to the sharp contrast between brokerage firms’ behavior and their massive advertising campaigns.

“The message was, ‘You can trust us,’ ” Calhoun says. “Arbitration panels are recognizing this. They’re saying it’s not a caveat emptor world out there anymore. Customers may very well have a right to a higher expectation of professionalism and honesty.”

Boyd Page, an Atlanta lawyer who has won big awards in arbitration cases, also credits recent press accounts for raising arbitrators’ awareness of wrongdoing by brokerage firms, including an investigative series in The Times last July. The series reported that leading securities firms knowingly employ brokers who have long records of cheating customers, often keeping them on because they brought in big commission income for the firms.

Not surprisingly, investors’ lawyers also take credit themselves for the big awards, claiming that growing expertise in the special problems of handling arbitration cases--especially more effective ways to obtain damning evidence.

In court, lawyers had the authority of the judicial system to back their demands for records and other evidence from brokerage firms. But they quickly learned that matters weren’t so simple in arbitration. The permissible scope of discovery is narrower, and investors’ lawyers complain that arbitrators often do not strictly enforce discovery rules, leaving brokerage firms free to ignore requests for records or delay turning them over.

In response, investors’ lawyers have begun cooperating, establishing an informal network for sharing evidence obtained in a variety of cases.

Brokerage firms are fighting back. In settlements, they commonly try to get lawyers and expert witnesses to sign confidentiality agreements barring them from sharing or using in another case any of the evidence they’ve obtained.

Punishing Bad Brokers

Arbitrators are handing down more big punitive damage awards to investors who charge that their brokers abused them--particularly when there is evidence of lax supervision by brokerage firms. Chart lists the biggest known punitive damage awards in 1992.

Firm Punitive Damages Total Damages Cigna Securities $3.5 million $5.3 million PaineWebber $1.67 million $2.23 million Shearson Lehman $1.04 million $1.12 million Bear Stearns $1 million $2.59 million Prudential Securities $635,000* $1.93 million Shearson Lehman $400,000 $559,000 Prudential Securities $300,000 $784,000 Shearson Lehman $250,000 $1.4 million

* Exemplary damages, which are similar to punitive damages.

Source: Securities Arbitration Commentator, Maplewood, N.J.