Securities Industry Ass'n v. Connolly, Civ. A. No. 88-2153-WD.

• Decision Date: 19 December 1988
• Docket Number: Civ. A. No. 88-2153-WD.
• Citation: 703 F. Supp. 146
• Court: U.S. District Court — District of Massachusetts
• Parties: SECURITIES INDUSTRY ASSOCIATION, Dean Witter Reynolds, Inc., Donaldson, Lufkin & Jenrette Securities Corporation, Drexel Burnham Lambert, Incorporated, Fidelity Brokerage Services Inc., Kidder Peabody & Co., Incorporated, Merrill Lynch, Pierce, Fenner & Smith, Inc., Painewebber Incorporated, Prudential-Bache Securities Inc., Shearson Lehman Hutton Inc., and Smith Barney, Harris Upham & Co., Incorporated, Plaintiffs, v. Michael J. CONNOLLY, Secretary of State, and Barry C. Guthary, Director, Massachusetts Securities Division, Defendants.

703 F. Supp. 146

SECURITIES INDUSTRY ASSOCIATION, Dean Witter Reynolds, Inc., Donaldson, Lufkin & Jenrette Securities Corporation, Drexel Burnham Lambert, Incorporated, Fidelity Brokerage Services Inc., Kidder Peabody & Co., Incorporated, Merrill Lynch, Pierce, Fenner & Smith, Inc., Painewebber Incorporated, Prudential-Bache Securities Inc., Shearson Lehman Hutton Inc., and Smith Barney, Harris Upham & Co., Incorporated, Plaintiffs, v. Michael J. CONNOLLY, Secretary of State, and Barry C. Guthary, Director, Massachusetts Securities Division, Defendants.

Civ. A. No. 88-2153-WD.

United States District Court, D. Massachusetts.

December 19, 1988.

Gerald Rath, Steven Hansen, Bingham, Dana & Gould, Boston, Mass., for plaintiffs.

Thomas A. Barnico, Richard M. Brunell, and James Shannon, Atty. Gen., Boston, Mass., for defendants.

MEMORANDUM AND ORDER FOR JUDGMENT

WOODLOCK, District Judge.

The Commonwealth of Massachusetts, acting under its Blue Sky law authority over brokers and dealers in securities, has issued prospective regulations seeking to control the circumstances under which a broker may require a non-institutional customer located in Massachusetts to agree to arbitration of disputes between them.

The plaintiffs—the trade association for securities dealers and ten brokerage firms registered to do business as securities broker-dealers in Massachusetts—challenge these regulations on federal constitutional grounds, contending they are preempted by the Federal Arbitration Act, 9 U.S.C. § 1 et seq. The Act requires that in matters affecting the validity, revocability, and enforceability of arbitration agreements, those agreements must be treated no differently than other contracts.

Without adopting any view on the advisability of such provisions, I find that the Massachusetts Blue Sky authorities are without power to enforce them. The Massachusetts securities arbitration regulations are not merely state law supplementation concerning matters collateral to the validity and enforceability of arbitration agreements. Rather, they go to the heart of the process of forming contracts to arbitrate. In doing so, they single out arbitration agreements for more demanding standards than are imposed by the general law of contracts in Massachusetts. Consequently, I will grant the plaintiffs' motion for summary judgment and declare the Massachusetts securities arbitration regulations preempted by the Federal Arbitration Act.

I

In the wake of Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 107 S.Ct. 2332, 96 L.Ed.2d 185 (1987), in which the Supreme Court upheld the use of predispute arbitration clauses to govern resolution of controversies between brokers and their customers,¹ officials of the Commonwealth of Massachusetts moved quickly to crest the tide of proposals to control the circumstances in which such arbitration could be used. While the North American Securities Administrators Association was calling for reform,² while the United States Securities and Exchange Commission was seeking further study and encouraging rule making by the broker/dealer self-regulatory organizations,³ while the United States Congress was failing to enact proposed legislation regarding securities dispute arbitration,⁴ the defendant Secretary of State of the Commonwealth of Massachusetts, through the defendant Director of the Massachusetts Securities Division, was taking definitive action.

The defendants' action came on September 21, 1988, in the form of a singular Massachusetts regulatory definition of "dishonest or unethical practices in the securities business" by broker-dealers. See Mass.Regs.Code tit. 950, § 12.204-(a)(2)(G)1.a.-c.⁵

This regulatory definition forbids broker-dealers licensed in Massachusetts from requiring Massachusetts customers to sign a mandatory pre-dispute arbitration agreement as a non-negotiable condition to opening a brokerage account. The definition also requires broker-dealers to disclose fully the legal effects of arbitration agreements before entering into a negotiated contract with a customer. What constitutes negotiability, and what full disclosure of legal effects would consist of, are left undefined by the definition.

Under the Massachusetts securities arbitration regulations, non-negotiability of, and lack of full disclosure of legal effects regarding, arbitration agreements do not become dishonest or unethical until January 1, 1989.

Proscriptions against such "dishonest or unethical practices" by broker-dealers are enforced by the power of the defendant Secretary of State to deny, suspend, or revoke the registration of a broker or brokerage firm. Mass.Gen.L. ch. 110A, § 204. Because an unregistered broker may not transact business in Massachusetts, id. § 201, any broker who wishes to do business in Massachusetts must observe the securities arbitration contract regulations which the definition establishes.

Moreover, if a broker—or for that matter a customer—were to attempt to enforce a contract formed without compliance with the Massachusetts securities arbitration regulations, that attempt would be unavailing. Under Chapter 110A, § 410(f),

no person who has made or engaged in the performance of any contract in violation of any provision of this chapter or any rule or order hereunder, or who has acquired any purported right under any such contract with knowledge of the facts by reason of which its making or performance was in violation, may base any suit on the contract.

If implemented in January, these proscriptions will have an immediate effect on the contracts used by broker-dealers transacting business with customers located in Massachusetts. The affidavits submitted by the plaintiff brokerage firms indicate some variety in their use of arbitration agreements, but certain elements are common.⁶ Mandatory written pre-dispute arbitration agreements in some form are used by all the plaintiffs. And these pre-dispute agreements do not purport to advise customers of the "legal effects" of the arbitration clauses.

Each of the plaintiff brokerage firms uses arbitration agreements in its standard margin and option account contracts, with the exception of Shearson Lehman Hutton Inc., which has no arbitration clause in its option account contract. A bare majority of the plaintiffs, however, do not use arbitration agreements in standard cash accounts for individuals, although one member of that majority, Donaldson Lufkin & Jenrette Securities Corporation, does have an arbitration agreement for corporate customers. In addition, Smith Barney, Harris Upham & Co., which has an arbitration agreement in its standard cash account, avers that execution of that arbitration agreement is not a requirement for opening a Smith Barney cash account.⁷

The plaintiffs are unanimous in asserting a desire to require certain customers to agree to arbitrate disputes as a condition to opening an account.

The Massachusetts securities arbitration regulations would change this practice by establishing additional disclosure requirements in an as yet undefined format. The Massachusetts securities arbitration regulations would also prevent broker-dealers from implementing the apparently universal practice of requiring at least certain customers to enter into arbitration agreements for their disputes.

II

In confronting a preemption claim, the "sole task" of the court is to determine the intent of Congress. Massachusetts Medical Soc'y v. Dukakis, 815 F.2d 790, 791 (1st Cir.), cert. denied, ___ U.S. ___, 108 S.Ct. 229, 98 L.Ed.2d 188 (1987) (quoting California Fed. Sav. & Loan Ass'n v. Guerra, 479 U.S. 272, 280, 107 S.Ct. 683, 689, 93 L.Ed.2d 613 (1987)). The Federal Arbitration Act preempts the Massachusetts broker arbitration regulations "if and only if Congress intended it to do so." Id.

The question to be addressed is "whether Congress (expressly) did or (impliedly) meant to displace state law or state law concepts in enacting ... the federal scheme set up by Congress." Palmer v. Liggett Group, Inc., 825 F.2d 620, 625-26 (1st Cir. 1987). In answering that question, the principal consideration is whether state regulation creates a material disturbance in the field of federal concern. "If the state law disturbs too much the congressionally declared scheme—whether denominated as `occupying the field' or `actually conflicting with federal law'—it will be displaced through the force of preemption." Id. at 626.

The question whether the Massachusetts broker arbitration regulations at issue here materially disturb the federal arbitration scheme may be answered by reference to the history and the logic of the Arbitration Act.

-A-

At its enactment in 1925, the Act was intended to "reverse centuries of judicial hostility to arbitration agreements." Scherk v. Alberto-Culver Co., 417 U.S. 506, 510, 94 S.Ct. 2449, 2453, 41 L.Ed.2d 270 (1974).

In 1953, the courts still harbored reservations about full applicability of the Arbitration Act. The decision that year in Wilko v. Swan, see supra note 1, "reflected a general suspicion of the desirability of arbitration and the competence of arbitral tribunals." Shearson/American Express, Inc. v. McMahon, 482 U.S. 220, 107 S.Ct. 2332, 2340, 96 L.Ed.2d 185 (1987).

In the years after Wilko, however, the Supreme Court systematically rejected the reasons supporting Wilko's suspicion of the arbitration process. By 1987, the Supreme Court could observe that "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." Id., 107 S.Ct. at 2341.

Recent history has found the Supreme Court offering forceful endorsements of the arbitration process by expansive statements of the intent of Congress in passing the Federal Arbitration Act. In the last five years, the Court has variously found in the statute an embodiment of "Congress' intent to provide for the enforcement of...