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Judge Rejects New Disclosure Requirements: U.S. Rules Pre-empt State’s Ethics Law

Los Angeles Daily Journal

San Francisco – In a significant blow to the state’s tough new ethical standards, U.S. District Judge Jeremy Fogel of San Jose ruled Tuesday that the new disclosure requirements for arbitrators cannot be applied to securities groups because the rules are pre-empted by federal statues.

In a 28-page ruling, Fogel agreed with the claims made by securities groups that the Securities Exchange Act and the Federal Arbitration Act pre-empt the state’s new rules. Mayo v. Dean Witter Reynolds, C01-20336 (N.D. Cal. April 22, 2003).

The 15 comprehensive ethics standards adopted last April by the Judicial Council were the first such standards in the country. They require detailed disclosure of financial relationships between arbitrators and parties involved in a dispute. The standards were adopted in response to a growing chorus of complaints as mandatory arbitration has become increasingly popular among businesses for its ability to cut costs and time.

Conflict of Interests

Under the new rules, parties to arbitration are able to disqualify arbitrators if the disclosure reveals a conflict of interest; violations can result in the decision being vacated by trial judges.

In response, the New York Stock Exchange and the National Association of Securities Dealers sued the Judicial Council, claiming the rules are too burdensome and are pre-empted by federal rules. The stock exchange and the securities dealers oversee 7,000 securities arbitration cases nationwide each year.

In November, U.S. District Judge Samuel Conti of San Francisco ruled that the 11th Amendment protects the judiciary and its agencies against such suits, but he did not rule on the pre-emption issue. NASD Dispute Resolution Inc. v. Judicial Council, 232 F.Supp.2d 1055 (N.D. Cal. Nov. 12, 2002).

Account Agreement

In his ruling Tuesday, Fogel found an irreconcilable conflict between the strict state standards and the looser federal regulation of arbitrators.

The ruling requires a Los Gatos resident, Richard Mayo, to submit his dispute with Dean Witter Reynolds to arbitration instead of the courts.

Mayo’s client account agreement requires that all disputes “must be resolved through binding arbitration before the NYSE, the NASD or the Municipal Securities Rulemaking Board.”

Mayo filed suit in March 2001 against Dean Witter Reynolds, which oversees Morgan Stanley Dean Witter. He sued after several unauthorized withdrawals from his account, including thousands of dollars in point-of-sale transactions and automated-teller-machines withdrawals.

After Mayo complained about the withdrawals, Morgan Stanley reimbursed him for all the point-of-sale transactions but not $15,000 in withdrawals, which apparently occurred after his debit card was stolen in the mail.

Mayo’s Santa Clara attorney, William E. Kennedy, said he was “obviously disappointed” by the ruling.

Kennedy said it would “tie the hands of the state with respect to passing any legislation which would require a certain level of procedural fairness in these arbitrations.”

Dean Witter attorney Gilbert R. Serota of Howard, Rice, Nemerovski, Canady, Falk & Rabkin in San Francisco said his client is “very happy the arbitration agreement between Morgan Stanley and its client is going to be honored.”

While the two stock market groups challenged the new rules, they required investors to either waive the state standards or go out of state for an arbitration hearing.

He added that he thinks the case will be appealed to the 9th Circuit because it is a “very important issue.”

Amy J. Winn, who represented the state attorney general’s office, declined to comment, saying she had not read the decision completely.

Mayo’s customer agreement “clearly and unambiguously” requires him to submit to the NYSE’s arbitration rules, Fogel ruled.

He said that the agreement “leaves no room to infer that some other arbitration rules, such as the California standards, might apply.”

Fogel also rejected Mayo’s contention that he was coerced into signing the agreement as a condition of obtaining access to an arbitral forum.

The new rules conflict with federal arbitration statutes in several ways, Fogel said, including that the state’s standards “require disclosure of information by an arbitrator even when that information does not disclose actual bias or partiality.”

Most important, he found that the “comprehensive system of federal regulation of the securities industry is designed to provide uniform, national rules for participants in the securities markets.”

Allowing California or other states to adopt different requirements “would conflict with the objectives of the federally regulated scheme of securities arbitration because it would destroy the uniformity of procedural rules applicable to [securities] arbitrations,” Fogel ruled.

If securities organizations were forced to comply with state standards, they “would be subject to a patchwork of state regulation that would lead to inconsistent disclosures and disqualifications across the states,” Fogel said.

In addition, allowing states to impose a variety of rules would “override the federal regulatory scheme and result in different treatment of similarly situated investors based solely on their location,” he wrote.