Dispute Resolution & Arbitration

This document discusses the case study of Shearson/American Express Inc. v. McMahon and the judgment of the Supreme Court regarding the enforceability of the arbitration clause. It provides an overview of the facts of the case, the legal issues and analysis, and the court's decision. The document also explores the implications of the decision for brokers and investors in the securities trading industry.

Running head: DISPUTE RESOLUTION & ARBITRATION
Dispute Resolution & Arbitration
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Case Study
Name of the Case:
Shearson/American Express Inc. v. McMahon1
Citation:
482 U.S. 220 (1987)
Facts of the Case
The origin of the case can be identified during the year 1979 when Eugene McMahon and
Julia McMahon has developed friendly terms with Walter McNulty and Mary Ann McNulty.
Mrs. McNulty has been a broker connected with the Shearson/American Express. She
advised Mrs. McMahon in making investments in her company and convinced her to invest
all the profit sharing funds, employee’s retirement and their personal savings. After two years
of making such an investment, McNulty successfully convinced the McMahons in signing a
power of attorney, which has the effect of allowing the company in making trade in the
absence of express consent of the McMahons. It has been effected with a standard form of
contract in which a clause of arbitration has been included as a method of dispute resolution.
During this time, more than half a million dollars has already been invested in Shearson by
the McMahons and after the signing of the power of attorney, the trading has become more
frequent. The statement of accounts has evidenced three trades in a day and fifty in a week
and majority of the trades were made with respect to high-risk investment. The McMahons
were not adequately aware of the financial complexities and their accountants were also
unable to detect the same. Consequently, the accounts started inflicting losses and in the year
1983 the account was almost empty when they closed the same. The losses connected with
trading has summed up to $350,000 excluding the commissions that has been paid. The terms
between the McMahons and the McNulty deteriorated and the a suit for defamation has been
initiated by Mrs. McNulty against Mr. Eugene. The defamation suit has followed the promise
made by Mr. McMahon to injure the reputation of Mrs. McNulty as revenge of this fraud
trading.
In the year 1984, a suit has been initiated by the McMahons against the McNulty and the
Shearson in the federal court of the New York Southern District. In this suit, McMahons has
accused the defendants to have churned the accounts belonging to the McMahons and all the
1 Shearson/American Express Inc. v. McMahon 482 U.S. 220 (1987)

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trade they made were alleged to have effected only with the motive of earning commissions
for the defendants. It has been argued by the McMahons that the acts of the defendants were
in contravention of the regulations relating to the Securities and Exchange Commission
(SEC) which has been implemented by virtue of the Securities Exchange Act of 19342. A
violation of the Racketeer Influenced and Corrupt Organizations Act (RICO)3 has also been
contended along with the contraventions of other state laws prevailing in New York. The
McMahons has claimed to be compensated for the losses that has been caused to them with
respect to the fraud trading. They also claimed for punitive damages amounting to five
million dollars from the defendants. In response to that, a motion has been filed by Shearson
in order to enforce the arbitration clause that has been incorporated in the contract initially.
Judgment
In an appeal to the Supreme Court, the certiorari was granted by the Supreme Court. The
decision of the Supreme Court with respect to this appeal has been declared in the favour of
the Shearson. The court held the circumstances of the case to be outside the purview of the
Wilko case. The Court has contended that both the claims under the Securities Exchange Act
(SEC) of 1934 and the Racketeer Influenced and Corrupt Organizations Act (RICO) can be
subjected to arbitration.
It has been contended by the court that the principles of the Wilko case is not rejected
while deciding on the case, but the two situations needs to interpreted from a different
perspective. The arbitration clause has been ignored in the Wilko case as the arbitration of the
case may have led to injustice and a demand for litigation was much needed in order to
protect the rights of the aggrieved party. Moreover, the arbitration clause was present and the
same has been included in the contract for trading that has been entered into by the parties.
The contention of the McMahons regarding the involuntary standard form of agreement
cannot be enforced was rejected by the court as the signing of the document relating to
contract has the effect of agreeing to the terms and all the negotiations regarding the terms of
the same needs to be done at that time only.
It has also been pointed out by the court that the laws with respect to the 1934 Act has
been subjected to a considerable amount of transformation within these years. Subsequent
amendments in the Act of 1934 has made an overall modification in the laws relating to the
enforceability of the arbitration clause has made the circumstances of this case different from
2 The Securities Exchange Act of 1934
3 Racketeer Influenced and Corrupt Organizations Act 1970

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that has been existing in the Wilko case. The court, in this present case, has contended that
the principles of the Wilko case cannot be enforced in a proceeding when there is a
legislation existing that can be applied to a situation. Hence, the court held that the Wilko
case cannot be applied in this case as it cannot change the existing laws that has been
prevalent in that matter.
However, the Rico claim has also been addressed by the courts in this proceeding. It has
been contended by the court that there has been no prohibition or obligation with respect to
the arbitration of the RICO Claim that has been provided by the legislation. This silence of
the legislation in this respect has been construed by the court to be agreement towards the
arbitration clause to be enforced with respect to the same. Hence, the court is of the opinion
that the RICO claim can also be addressed with the help of arbitration, as the Act does not
provide for any prohibition with respect to the same.
The contentions made by the McMahons against the enforceability of the arbitration
clause has been rejected by the Supreme Court. In this context, it has been pointed out by the
court that as the arbitration clause has been agreed upon by the parties at the time of signing
the documents, the same has become binding upon them and the parties does not have the
option of denying the same.
Legal Issue & Analysis
In this instant case, the Supreme Court has been presented with the dispute regarding the
arbitration of the fraud claims in relation to private securities that arises by virtue of the
Securities Exchange Act of 1934. The enforceability of the arbitration clause with respect to
the fraud claims in relation to private securities has been brought under question. In addition
to that, the arbitration with respect to the claims in relation to the Racketeer Influenced and
Corrupt Organizations Act (RICO) has also been brought under consideration before the
court. In this context, the exemptions with respect to the Federal Arbitration Act has also
been put into question. The principle established in the case of Wilko v. Swan, 346 U.S. 427
(1953)4 has also been argued in this case. However, the Supreme Court has declared both the
claims to be arbitrable. However, in order to analyse the decision of the Supreme Court, the
legal principles and the issues in the case relating to these legal principles needs to be
discussed.
4 Wilko v. Swan, 346 U.S. 427 (1953)

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The issue that has been raised by this case has been a concern for many other brokers and
investors. From the viewpoint of a broker, the clients are expecting an assurance to receive a
huge bulk of return from the investment that they are making and are disputing the contract of
brokerage on not being satisfied with the returns they are actually receiving. The clients has
been acting to be ignorant regarding the market risks of losses that are connected with the
investments, which are unavoidable being out of the control of the brokers. The brokerage is
to be viewed as a relationship that is not identical or similar to the insurance relationship or
the relationship of guarantee. The risk of incurrence of losses in the return accrued from the
investment is not to be attributable to the fault or incompetence of the brokers. A loss in the
return with respect to an investment can be treated as an unavoidable market risk not in the
control of the broker.
Moreover, the courts are not well acquainted with the complex structure and functioning
of the securities trading and the stock market. Any dispute redressal with respect to the
securities trading will require the an expert knowledge of the stock market and the trading of
securities. This cannot be assured in case the claims regarding the same reaching the courts.
This requires arbitrators having vast knowledge and adequate command over the same to
address the disputes in an appropriate manner. It can be contended that the arbitrators, being
appointed by the parties to the contract, has a proper understanding of the contract in question
and he is properly acquainted with the concepts of securities trading and stock exchange.
However, the principles of the Wilko case has been argued in this proceedings by the
McMahons with a view to render the arbitration clause of their contract unenforceable. In the
case of Wilko v. Swan, 346 U.S. 427 (1953)5, the Supreme Court has been made to face the
arbitration of the fraud claims with respect to the securities. This case has been initiated by an
investor against a broker, who has traded in stock without furnishing proper disclosure of the
fact that the firm and the broker were the primary seller in those transactions. The Supreme
Court, in this case, has held that the right to opt for litigation cannot be waived in case of a
person whose rights have been infringed. The provision of the Federal Arbitration Act, which
made the enforceability of the arbitration clause in a contract to be binding and waives the
right of the parties to opt for litigation, once the arbitration clause has been signed by them,
has been rejected by the Supreme Court in case a right of the parties has been infringed
owing to fraud trading of securities. It has been held in this case that even if there exists an
arbitration clause in the contract relating to the trading of securities, the right to litigation of a
5 Wilko v. Swan, 346 U.S. 427 (1953)

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person in the event of any infringement of his rights cannot be denied under any
circumstances.
In this present proceeding, the main issue that has been put under discussion is the fact that
whether the dispute between the McMahons and the broker firm can be addressed by
arbitration as the same has been provided in the contract they have operating through or they
can opt for a litigation. The fraud claims with respect to trading of securities has been argued
by the McMahons to be subjected to litigation and they have claimed the arbitration clause to
be unenforceable. On this claim, the Wilko case has been referred to be by the McMahons, in
which the court has opined for a litigation to be pursued. Moreover, the enforceability of the
arbitration clause to the RICO claim has also been put to question.
The Supreme Court has rejected the principles of the Wilko case, to be extended in the
present proceeding and stated both the claims to be subjected to arbitration as the contract has
contained a clause requiring the dispute settlement to be addressed by the process of
arbitration. The Supreme Court has ruled in the favour of the Shearson is by a margin of 5-4.
In this case the, Supreme Court has rendered both the claims under the Act of 1934 and the
RICO to be arbitrated as the contract, which has initiated the trading in securities contained
an arbitration clause. A reference to the case of Mitsubishi Motors Corp. v. Soler Chrysler-
Plymouth, Inc., 473 U.S. 614 (1985)6 has been made by the court in that context. There has
been a considerable amount of dissents that has followed this decision, but the decision of the
majority has been inflicted in the favour of the enforcement of the arbitration clause.
The main argument that has been forwarded by the McMahons is the contention of the
Wilko case that requires the right of an individual to litigate in case of a dispute. The
enforceability of the arbitration clause has been questioned by the McMahons being in
violation of the right to avail litigation as a dispute resolution. However, in this case the
Supreme Court has adopted an approach of investigating the reason to not allow the
enforceability of the arbitration clause in the situation. The right to litigation has been
available to the aggrieved in case the arbitration has the possibility of yielding injustice. But
where the arbitration can be appropriately utilised to resolve a dispute, the calling for the
right to litigation would be excessive. Moreover, where the contract has already contained an
arbitration clause, the same cannot be disputed on the grounds of the right to avail litigation
6 Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614 (1985)

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as a method of dispute resolution. The same can be illustrated with the case of Dean Witter
Reynolds Inc. v. Byrd, 470 U.S. 213 (1985)7.
The objective of the Supreme Court in this case is not to reject the principle laid down in
the Wilko case. It has a different approach to the situation. In the opinion of the Supreme
Court, the Wilko case has been decided in a different condition, as the circumstances of both
the cases are not the same. It has been contended by the court that the right to litigation can
only be obtained when the arbitration would invite a sheer injustice. When the arbitration can
be implemented as a dispute resolution method and the contract also provides for an
arbitration clause, the calling for a litigation will not be appropriate. A right to litigation can
be availed only in the cases where a substantive right of an individual is at stake and the same
cannot be resolved or redressed through arbitration. While discussing the same the court has
made references to the case of Scherk v. Alberto-Culver, Inc. 417 U.S. 506 (1974)8.
Moreover, the form of arbitration that has existed at the era of the Wilko case has changed
with time. The provisions of the 1934 Act has also underwent a considerable amount of
modification with the different amendments that the Act has been subjected to. This required
the enforceability of the arbitration clause to be considered. The decision of the Supreme
Court in this proceeding is to address the situation with an approach that is best suited in the
given situation. While contending the same, the court has made references to the case of
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1980), 2069. The objective of the court was not to
suppress the decision of the Wilko case, but to interpret the instant case to be considered in a
situation, which is different from the Wilko case. Moreover, the contention presented by the
McMahons regarding the arbitration agreement to be involuntary as the same has been signed
by them under a standard form of contract not having much power to negotiate, has been
rejected by the Court. In this context, the court is of the opinion that the contract while being
signed has all the terms disclosed, which requires the parties to dissent from the same at that
time only. Once the contract has been signed the same cannot be disputed on being
improperly negotiated.
There has been dissents to the majority decision by the court. The rejection of the
application of the Wilko case principle has been deeply criticised by the juries dissenting. It
has also been contended by the dissenting section of the court that the rejection of the
7 Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985)
8 Scherk v. Alberto-Culver, Inc. 417 U.S. 506 (1974)
9 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1980), 206

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principle laid down in the Wilko case, might lead to the abuse and exploitation of the
investors at the hands of the brokers and securities trading firms. However, it needs to be
mentioned that the services provided by the brokers and the firms are not to be confused with
guarantee relationship or assurance services. The brokers and the firms trading in securities
are mere advisors and the services they render might be followed by an unavoidable market
risks.
Moreover, arbitrators are well acquainted with the situation and are specifically trained to
address those specific areas, which is subjected to arbitration. This specialisation cannot be
ensured in case of litigation. Hence, arbitration that had existed at the time of the Wilko case
has been subjected to a considerable amount of modification and transformation over the
period of time. Hence, the decision of the court in the favour of the Shearson, enforcing the
arbitration clause can be conceived as apt.
Conclusion
This case can be regarded as a landmark in the history of arbitration. The decision of the
court, in this case, has laid the foundation of the undisputed enforceability of the arbitration
clause when it has already been provided for in the contract. The claims arising under the
Securities Exchange Act (SEC) of 1934 and the RICO has now being undoubtedly admitted
to arbitration. This has enhanced the scope of arbitration. This case has opened the gates for a
huge number of subsequent cases to be addressed by the arbitration. The case of Rodriguez
de Quijas v. Shearson/American Express Inc., 490 U.S. 477 (1989) has also been subjected to
arbitration applying the trend that has been laid down by the instant case. This case has laid
the foundation of a reform in the arbitration. The significance of the arbitration as a form of
dispute resolution has become more acceptable as well as desirable with this case. However,
a probability of abuse and exploitation of the investors in the hands of the brokers and
brokerage firms might follow, but as the technique of arbitration has transformed in a
considerable amount the same cannot be contended. Moreover, arbitration provides for a
more speedy and less expensive remedy.

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Reference
Dean Witter Reynolds Inc. v. Byrd, 470 U.S. 213 (1985)
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1980), 206
Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614 (1985)
Racketeer Influenced and Corrupt Organizations Act
Rodriguez de Quijas v. Shearson/American Express Inc., 490 U.S. 477 (1989)
Scherk v. Alberto-Culver, Inc. 417 U.S. 506 (1974)
Shearson/American Express Inc. v. McMahon 482 U.S. 220 (1987)
The Securities Exchange Act of 1934
Wilko v. Swan, 346 U.S. 427 (1953)