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Securities Arbitration: California's Top Court Says Federal Law Trumps State's Ethics (Web)

Securities Arbitration: California’s top court says federal law trumps state’s arbitrator ethics scheme
The California Supreme Court has ruled that the California judiciary was authorized to adopt its tough arbitration ethics standards three years ago--but the resulting rules on disclosure and disqualification conflict with the Securities Exchange Act of 1934.

The U.S. Securities and Exchange Commission told the Court in an amicus brief in Jevne v. Superior Court, Docket No. S12153 (May 23, 2005)(available at that the California Ethics Standards for Neutral Arbitrators in Contractual Arbitration (available at are preempted by federal law for arbitrations conducted by securities self regulatory organizations.

The Jevne opinion agreed, and sent the dispute to arbitration.

In Jevne, an individual investor and his company filed suit against a broker that is licensed by the NASD Inc.  The parties’ agreement contained a standard arbitration agreement.  When the defendant J.B Oxford Holdings Inc., which owns Los Angeles-based discount broker and real estate investment firm J.B. Oxford & Co., filed an arbitration demand, the plaintiff investor, in May 2001, agreed to arbitrate.

The case was still in process when California’s arbitrator ethics rules took effect in July 2002.  A three-arbitrator panel dismissed the plaintiff’s claim only nine days after the rules took effect, but an amended claim was filed, and an arbitrator disqualified himself for undisclosed reasons, according the Supreme Court opinion, in September 2002. 

When NASD Dispute Resolution arm asked the parties to sign a statement waiving application of the California ethics rules, the plaintiff refused, and returned to court.  

But the trial and appeals courts refused to re-start court proceedings.  The appeals court, in November 2003, said that the California Judicial Council, which sets policy and makes rules for the state’s court system, had acted within its authority in making the arbitration standards.  But the court found a conflict with the Securities Exchange Act, 15 U.S.C. §78a et seq. 

By the time the unanimous Supreme Court had affirmed the appellate decision on May 23, the NASD’s dispute resolution arm and the New York Stock Exchange had been added as “real parties in interest.”  Five friend-of-the-court briefs had been filed by the California Judicial Council and the state’s attorney general; the Securities Industry Association; and two consumer groups, the California Employment Lawyers Association and the Trial Lawyers for Public Justice.

First, the Court, in an opinion by Associate Justice Joyce L. Kennard, found that the Judicial Council had the authority to adopt the ethics standards under its state constitutional mandate to adopt court administration rules.  The opinion backs the appellate decision, holding that the California Legislature “intended to authorize the Judicial Council to formulate and adopt ethical standards for neutral arbitrators in private (nonjudicial) arbitration generally, including neutral arbitrators appointed by third-party dispute resolution providers” like NASD Dispute Resolution.

But rules sections 7 and 8 on disclosure, and section 10 on disqualification, clashed with the Securities Exchange Act grant to the U.S. Securities and Exchange Commission industry oversight.  The Court rejected the self regulatory organization’s contention that since their rules were germane to the act’s purposes, they had “the preemptive force of federal law.”

Instead, the opinion states, the particular rules have to be examined.  In the opinion, Justice Kennard analyzes the rules in detail, concluding that, based on the SEC’s views of California’s rules, the Securities and Exchange Act preempts the arbitrator disclosure rules.  And, she notes, the preemption case “is even more compelling” as to the disqualification rule, because the rules’ application would allow a party to disqualify any arbitrator submitted by the regulatory organizations.

In addition, the Court rejected the plaintiff investor’s argument that the sections conflicting with federal law are severable, and other nonconflicting standards could be enforced in an NASD arbitration.

A California federal court already had concluded that the Securities Exchange Act preempts the California ethics standards for self regulatory organization-administered arbitrations.  Mayo v. Dean Witter Reynolds Inc., 258 F.Supp.2d 1097 (2003).

Concludes Kennard in Jevne, “The NASD, a registered [self regulatory organization] subject to SEC supervision, has adopted comprehensive arbitration rules, the NASD Code, that include detailed arbitrator selection procedures.  The SEC has approved these procedures, and it has determined that they should preempt the California Standards.  In making this determination, the SEC has acted within its authority, and its determination is neither arbitrary nor unreasonable.”