Shearson/American Express Inc. v. McMahon, 482 U.S. 220 (1987), is a United States Supreme Court decision concerning arbitration of private securities fraud claims arising under the Securities Exchange Act of 1934. By a 5–4 margin the Court held that its holding in a 1953 case, Wilko v. Swan, that the nonwaiver provisions of the Securities Act of 1933 prevented the mandatory arbitration of such claims, did not apply to claims under the 1934 Act due to differences in the corresponding language of the two statutes, reversing a decision of the Second Circuit Court of Appeals that had affirmed what had been considered settled law, despite the lack of a precedent. It likewise held that claims under the Racketeer Influenced and Corrupt Organizations Act (RICO) were arbitrable, affirming an order from the district court that the Second Circuit had also upheld.
The question of whether claims under the 1934 Act were likewise exempt from the Federal Arbitration Act had first been raised in a 1974 case, Scherk v. Alberto-Culver Inc.. At that time Potter Stewart had found them not relevant to the case and upheld the arbitration order on the grounds that the case involved an international dispute. They had resurfaced in the previous term, in Justice Byron White's concurrence in Dean Witter Reynolds Inc. v. Byrd. Lower courts began embracing White's analysis, eventually creating a conflict in the circuits on appeal.
Justice Sandra Day O'Connor wrote the majority opinion, reiterating and deepening White's analysis. Harry Blackmun dissented for himself and justices Brennan and Marshall, who had written for a unanimous Court in Byrd. John Paul Stevens wrote a separate dissent. Both of those dissents concurred in the holding that the RICO claims were arbitrable. On remand, the case remained unresolved for another three years. The district judge fined the McMahons' counsel for filing frivolous motions, sanctions which were reversed on appeal, setting another precedent.
McMahon greatly expanded the use of arbitration in securities disputes, since many of them take place under the 1934 Act, which regulates the secondary market in which most investors trade. It also signaled a greater acceptance of arbitration as a desirable and fair method of dispute resolution. This was cited by the Court three years later in Rodriguez de Quijas v. Shearson/American Express Inc., when it overturned Wilko completely and held that claims under the 1933 Act could also be arbitrated if the parties had clearly chosen to do so. The expansion in securities arbitration as a result led to reforms during the 1990s to make the process more investor-friendly.
Underlying dispute In 1979, Eugene and Julia McMahon, who owned two funeral homes in Yonkers, New York, became friendly with Walter and Mary Ann McNulty, fellow parishioners at their church. Mrs. McNulty, a broker with what was then Shearson/American Express, persuaded Mrs. McMahon to invest not only their personal savings but also their employee's retirement and profit sharing funds with her company. Two years later, McNulty persuaded the McMahons to sign power of attorney forms allowing Shearson to make trades without their consent. Those standard form contracts contained an arbitration clause committing either party to use that method of resolving disputes.
By that time, they had invested over a half a million dollars with Shearson. The McMahons claimed that after they signed the power of attorney forms, McNulty began trading at a faster pace. The account statements they received in the mail showed at least three trades a day, sometimes as many as 50 a week. Most were in high-risk options, and the McMahons said they did not have sufficient financial sophistication to make sense of what was occurring. Eugene McMahon says his accountants could not, either.
However, they were able to see that their account was showing losses. McNulty reassured them, but their misgivings increased. When they closed the account early in 1983, it was nearly empty. Their trading losses reached $350,000 ($ in modern dollars) and commissions accounted for the rest.
Relations between the two couples collapsed. Mrs. McNulty filed a defamation lawsuit against Eugene McMahon alleging he had promised to destroy her reputation in revenge. In late 1984, the McMahons sued Shearson and McNulty in federal court for the Southern District of New York alleging the defendants had churned their account, or traded simply to generate commissions. They claimed violations of the regulations of the Securities and Exchange Commission (SEC) based on the Securities Exchange Act of 1934, often referred to as "the 1934 Act" by securities lawyers, and violations of the more recent Racketeer Influenced and Corrupt Organizations Act (RICO), along with violations of corresponding New York state laws. In addition to being reimbursed for their losses they sought $5 million in punitive damages.
Arbitration vs. litigation The McMahons' suit was one of a rising number filed against brokers by disgruntled investors during a bull market. Many brokers felt, as McNulty and Shearson did about the McMahons, that clients expected ever-increasing returns and did not understand that these were just ordinary, unavoidable market losses. "The brokerage relationship is not a guarantee relationship or an insurance relationship," said Edward O'Brien, president of the Securities Industry Association. "You're not supposed to simply turn things over to someone else." They wanted arbitration clauses to be enforced so that they would spend less time and money defending lawsuits.
Juries, the brokerages felt, could not understand the complexities of securities trading and law as well as arbitrators with experience in the industry. They saw arbitration as cheaper, faster yet still fair. "[T]he industry person is often likely to bend over backward in favor of the customer," said Edward Morris, director of arbitration for the New York Stock Exchange. More than half the time, the industry said, arbitration panels ruled in the customer's favor.
Investors and their lawyers did not agree. "The houses basically like the present system because they own the stacked deck", said Sheldon Elsen, director of the American Bar Association's securities arbitration task force. "I would rather defend a capitalist before the comrades' court than a client before an arbitration panel of the New York Stock Exchange," said a Los Angeles lawyer who had, with his client, walked out of a hearing because of the conflicts of interest they believed panelists had.
They said the investors' victory rate was misleading as a measure of arbitration's effectiveness since they often merely reimbursed investors for their losses, most of which then went to pay legal bills, and did not include punitive damages such as a court might award that could deter future misconduct. Nor did investors arbitrating claims have access to the full range of procedures they would in court. They could not force the brokerage to produce evidence, and they often charged that the brokerages falsified or improperly withheld documents. Arbitrators also did not have to provide a written explanation for their decisions.
Applicability of Wilko to 1934 Act claims In 1950, when a brokerage firm had tried to compel arbitration with an investor alleging his broker left him holding the bag in a pump and dump scheme, the case had gone all the way to the Supreme Court. In 1953 it had held in Wilko v. Swan that three provisions of the Securities Act of 1933 (or, the 1933 Act), which regulates the primary market in which securities issuers sell directly to buyers, were controlling, allowing investors to take their claims to court regardless of what contracts and the Federal Arbitration Act (FAA) said. It found that the language in the 1933 Act voiding any waiver of any provision of the statute was broad enough to cover arbitration clauses, and deduced congressional preference for the courts in language that allowed a special cause of action where the burden of proof was on the seller of the security to show that they were unaware of the dubious nature of the security sold, and allowed buyers to sue in any state or federal court of competent jurisdiction.Wilko v. Swan, .
Lower courts, when faced with similar attempts to force arbitration in claims under the 1934 Act, which regulates the secondary market where previously sold securities are resold and the vast majority of trades take place, held that Wilko applied to it as well since the language of the latter statute was similar. Several appellate circuits upheld this interpretation and it was never considered by the Supreme Court, until 1974. That year, in Scherk v. Alberto-Culver Co., a German company had sought to compel arbitration in a dispute with an Illinois company alleging it had misrepresented several trademarks prior to the sale.Scherk v. Alberto-Culver Co.,
Wilko had been part of the respondent's argument against arbitration, since the deal had also included some stock. During his majority opinion holding for the petitioner, Justice Potter Stewart noted that "a colorable argument could be made" that Wilko did not reach the 1934 Act due to differences in the corresponding sections of the statutes. The non-waiver provision was narrower, the private right of action only implied, and the 1934 Act only provided for federal jurisdiction. Stewart found those concerns irrelevant to the case, since it concerned an international transaction under which arbitration might be a better solution.Scherk at 513–14, Stewart, J.
The question had not been before the Court in Dean Witter Reynolds Inc. v. Byrd, the next time the Court had considered arbitration in a securities dispute, decided as the McMahons were filing their lawsuit. But Justice Byron White, who had joined William O. Douglas's Scherk dissent (which had not considered the "colorable argument") had devoted a short concurrence with the unanimous opinion to noting that it was still an open question.Dean Witter Reynolds Inc. v. Byrd, , 224–25, White, J., concurring. In the wake of the decision, many district court judges, and some on the appellate circuits, began following his analysis.Durrer, Michael; Enforcing Arbitration of Federal Securities Law Claims: The Effect of Dean Witter Reynolds, Inc. v. Byrd 28 Wm. & Mary L. Rev. 335, 346–48 (1987).
In lower courts Before trial began, Shearson filed for a motion to compel arbitration per the contract. District Judge Lloyd MacMahon granted it, citing the Supreme Court's recent holding in Byrd. Since it went against Second Circuit precedent, the order to arbitrate the 1934 Act claims was reversed on appeal by a panel from the circuit, while the order to arbitrate the RICO claims was affirmed.
District court To counter the defense motion to compel arbitration, the McMahons relied on Wilko. In that 1953 case, the Supreme Court had held that the provisions of the Securities Act of 1933 invalidating any contractual requirement that a securities buyer waive rights under the statute, allowing for a special right to recover for misrepresentation and granting jurisdiction to all state and federal courts created an exception to the Federal Arbitration Act (FAA), which says that an arbitration clause "shall be valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract". More specifically to the case, they argued that fraud was not arbitrable under the language of the arbitration clause, that their agreement with Shearson was an unenforceable adhesion contract and that McNulty's action in state court voided the arbitration clause.