AlternativesTO THE HIGH COST OF LITIGATION

Alternatives to the High Cost of Litigation (Print ISSN 1549-4373, Online ISSN 1549-4381) is a newsletter published 11 times a year by the International Institute forConflict Prevention & Resolution and Wiley Periodicals, Inc., a Wiley Company, at Jossey-Bass. Jossey-Bass is a registered trademark of John Wiley & Sons, Inc.

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ORGANIZED BY PROMINENT CORPORATE COUNSEL, THECPR INSTITUTE FOR DISPUTE RESOLUTION has become aleader in developing uses of private alternatives to the costlylitigation confronting major corporations and public entities.The membership of CPR, a nonprofit organization, consistsof large companies, leading U.S. law firms, academics andjudges. See “Membership” at our Web site, www.cpradr.org.

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INTERNATIONAL INSTITUTE FOR CONFLICT PREVENTION & RESOLUTION VOL. 23 NO. 7 JULY/AUGUST 2005

Alternatives

guidance appear to be at the heights of so-phisticated commercial practice; similarfairness-related issues most often arise incontracts involving individual consumers.Big auditing firms, that likely will wind upbearing the bulk of the impact of the newguidance, and their clients at financial in-stitutions, usually have teams of attorneyson staff and law firms on call to vet liabil-ity limits.

Auditors’ engagement letters, as thecouncil points out, establish an under-standing between the external auditor andthe financial institution regarding theservices to be performed in connectionwith an external audit. And ADR proce-dures—especially—appear to reflect hard-bargained, or at least informed, clientsand customers.

“When sophisticated parties agree toADR,” says Paul J. Mode, special counselto Citigroup in New York, “they are bothagreeing to things which have certain ben-efits and certain costs—and both sideshave agreed that the benefits are worth thecosts.”

But in the wake of Arthur Andersenand other corporate governance and ac-counting scandals, the federal agencies aregetting tougher. The proposed guidancebans liability limits in the letters “regardlessof the size of the financial institution,whether the financial institution is publicor not, and whether the external audit isrequired or voluntary.”

And it bars financial institutions fromsigning auditor engagement letters that in-clude predispute mandatory ADR clausesthat incorporate liability limits.

These practices, the council concludes,would raise safety and soundness issuesabout the institution’s operations.

* * *

The council is an interagency body thatdesigns uniform principles, standards, andreport forms for the Federal Reserve Sys-tem’s Board of Governors, the Federal De-posit Insurance Corporation, the NationalCredit Union Administration, the Officeof the Comptroller of the Currency, and

the Office of Thrift Supervision.The council’s materials are used for the

federal examination of financial institu-tions, and to make recommendations topromote uniformity of financial institu-tions’ supervision.

The May 10 proposal focuses princi-pally on external auditors’ engagement let-ters that limit liability for financial state-ment audits. Liability limits, the councilstates, “may weaken the external auditors’objectivity, impartiality, and performanceand thus, reduce the [federal regulators’]ability to rely on external audits.”

The guidance notes that the provisionsmay “take many forms,” but “can be gen-erally categorized as an agreement by a fi-nancial institution that is a client of an ex-ternal auditor” that indemnifies theauditor against third-party claims; exemptsor releases the auditor from liability forclaims or potential claims by client finan-cial institutions; or limits the financial in-stitution’s liability.

The provisions, the council says, “canimpair the external auditor’s independenceand may adversely affect the external audi-tor’s performance,” and, as a result affectthe safety and soundness of the institution.

“Safety and soundness” is a bankinglaw term of art usually associated with suf-ficiency of capital. But the regulatory agen-cies covered by the council have powers tolook well beyond financial institutions’ in-vestments and balance sheets to scrutinizeoperations. For example, in addition to in-ternal accounting and audit controls, theFDIC may prescribe, via regulations orguidelines, “such other operational andmanagerial standards as the agency deter-mines to be appropriate.” 12 U.S.C.1831p-1(a)(2).

The prospect of negative safety andsoundness assessments as a result of theproposed guidance—which would lead di-rectly to questions about institutions’ via-bility—will ensure future close scrutiny byfinancial institutions when reviewing ADRprovisions.

The problem, according to the pro-posed guidance, is that certain ADR provi-sions have the same effect as the liabilitylimitations, and accordingly raise the same

PROPOSED BAN ON AUDITOR LIABILITY LIMITS ALSO TARGETS ENGAGEMENT LETTER ADR

Federally chartered and regulated financialinstitutions soon may be using less alterna-tive dispute resolution. A proposed advi-sory tells banks, thrifts and other organiza-tions to avoid liability-limiting provisionsin engagement letters with their auditors—and cites ADR clauses as a source of theclauses it seeks to ban.

Bank and accounting firm executivesare concerned about the guidance. Indus-try professionals say they expect the Fed-eral Financial Institutions ExaminationCouncil, which issued the proposal onMay 10, will receive many comments.

The brief comment period expiredJune 9. As of June 7, 13 comments hadbeen filed, according to LaJuan Williams-Dickerson, the council’s program coordi-nator. Late comment filings were expectedby some in the financial services industry,whose members maintain frequent con-tacts with their regulators. As the commentperiod was closing, some companies werestill considering whether they would file,and when.

The proposed guidance doesn’t specifi-cally point to mediation, but it mentions ar-bitration and mandatory binding processes.A section of the 12-page proposal says ADRprovisions harboring liability limits must bestricken from the agreements.

The guidance is unequivocal: Institu-tions to which the guidance applies musttell their auditors to drop the liability-lim-iting provisions or risk negative agency as-sessments about the safety and soundnessof their operations. See the full text of theguidance’s ADR-related section in the boxon page 122.

The warning about ADR language alsocan be construed as providing a safe har-bor, because it calls out specific provisionsand says they are unacceptable.

But a worst-case scenario for ADRpractice is that even sophisticated draftersmay opt to drop the clauses altogetherrather than risk federal regulators’ ire.

In fact, the institutions subject to the

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the parties do not adopt a regime that oth-erwise violates federal or state laws applica-ble to arbitration. This commitment toflexibility has been universally recognizedby the courts.” [Citations omitted.]

Marrow’s letter concludes,

ADR is neither an unsafe nor anunsound practice. No court has everheld that ADR is unsafe or unsound.Indeed, all courts from the U.S.Supreme Court down recognizeADR as a useful and important toolfor the resolution of disputes. Therights of any of the members of thisCouncil can be easily and appropri-ately preserved as a part of any agree-ment providing for ADR. In additionto preserving rights such as discoveryand appeal, any agency acceptingADR will enjoy the benefits normallyassociated with non-judicial resolu-tion of a dispute such as reduced cost,a speedy determination and confi-dentiality. Any and all concerns aboutthe rules governing arbitration caneasily be resolved through a carefullydrafted ADR agreement.

In a separate telephone interview, Mar-row says he filed the eight-page commentbecause he “felt that it was important thatarbitration be understood for what it is,and [the proposed guidance] was . . . a mis-statement on what the entire alternate dis-pute process is all about.”

* * *

While the proposal’s sudden appearancetook many by surprise, it surely hasn’tpassed by quietly. “We will file” comments,says Steven G. Silber, of Pricewaterhouse-Coopers’ corporate public relations officein New York, adding, “We’re all over it.”

Silber says the accounting, auditingand consulting firm would develop “a re-sponse to the overall thrust of the piece aswell as the particular provisions that are aconcern to us.” Silber couldn’t commenton the attention his firm might devote tothe ADR-related provisions.

J. Andrew Heaton, associate generalcounsel in the Washington, D.C., office of

safety and soundness concerns. The guidance defines ADR as “manda-

tory and binding alternative dispute reso-lution, binding arbitration, or some otherbinding non-judicial dispute resolutionprocess.” It also includes in its focus jury-trial waivers in engagement letters.

The proposal praises ADR, noting thatit “may expedite case resolution and reducecosts.” But it also warns that institutions“should consider the value of the rights be-ing waived,” adding that waiving jury trials“may effectively limit the amount it mightreceive in any settlement of its case.”

“It rings a little hollow to say to finan-cial institutions that juries are the bestway to do these things,” says Citigroup’sMode. He says that the council is “focus-ing on a world where we’re almost alwaysthe plaintiffs and not defendants. But forfinancial institutions, life usually is spentas a defendant.”

The “policy premise of jury trial as agood thing,” concludes Mode, is “a hardsell for me.”

Michael T. Heyrich, a Citigroup associ-ate general counsel, says the financial serv-ices giant is examining the proposal, andclose to the deadline still was consideringfiling a comment letter.

* * *

One attorney-arbitrator filing a commentwith the council, Paul B. Marrow, ofChappaqua, N.Y., agrees that the guid-ance’s concern about losing litigation pro-tections and potential verdicts because ofADR use is misguided.

In a comment letter filed June 6 thatfocuses on ADR issues, Marrow writes,“There is nothing in the arbitration processthat prohibits parties from contracting forwhatever procedures and safe guards [sic]they deem appropriate. The rules of thefour major ADR facilitators [the AmericanArbitration Association; the CPR Institute;Jams, and the National Arbitration Forum]provide the parties to an ADR agreementwith the flexibility to modify the applica-ble rules to meet the concerns and needs ofthe parties, provided that when doing so

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Car

toon

by

John

Cha

se

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(continued on next page)

[The Banking and Financial ServicesCommittee of the CPR Institute—whichpublishes this newsletter with Jossey-Bass,a unit of John Wiley & Sons, Inc.—dis-cussed extensively the proposed guidanceat a regularly scheduled May meeting.Heaton of Ernst & Young attended theCPR meeting; Citigroup’s Mode was in-vited but says he was unable to attend.]

[As this issue went to press, CPR Presi-dent Thomas Stipanowich, who is Alterna-tives’ publisher, announced that the CPRInstitute would file a comment letter withthe council. The letter wasn’t finalized, butStipanowich describes its focus: “Wethought it was important to clarify severalthings, including the fact that ‘ADR’ in-cludes not just arbitration but a whole spec-

trum of approaches to dispute resolution.Moreover, modern commercial arbitrationis anything but a monolith. It usually in-cludes some level of discovery and featurescourt-like remedies. The key, of course, isthe mutual intent of the parties as expressedin their agreement—in the absence of sig-nificant disparities in bargaining power.”]

* * *

The regulatory agencies represented by thecouncil “recognize that ADR procedures andjury trial waivers may be efficient and cost-effective tools for resolving disputes in somecases,” according to the proposed guidance.But they would still bar external audit en-

another large national auditor, Ernst &Young LLP, says his office will be filing acomment letter, though he was unsure if itwould be filed by the June 9 deadline.

In the ADR field, the American Bar As-sociation’s Section of Dispute Resolutionwill not take an official position with com-ments, but section communications direc-tor Kyo Suh says that some members arediscussing the proposal. At press time, theNew York–based American Arbitration As-sociation was reviewing the guidance, andhad not made a decision on filing a com-ment letter, according to Kersten Norlin,corporate communications vice presidentat the nonprofit organization.

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The “Interagency Advisory on the Unsafe and Unsound Use ofLimitation of Liability Provisions and Certain Alternative Dis-pute Resolution Provisions in External Audit Engagement Let-ters” can be found on the Federal Financial Institutions Examina-tion Council’s Web site at www.ffiec.gov/press/proposedinteragencyadvisory.pdf. Information on submitting comments,which were due on June 9, is available in the proposal.

Here is the text of the proposal’s section on ADR agreementsand Jury Trial Waivers:

“The [Office of Thrift Supervision, Treasury; the Board ofGovernors of the Federal Reserve System; the Federal DepositInsurance Corporation; the National Credit Union Administra-tion; and the Office of the Comptroller of the Currency, Trea-sury, collectively referred to as the Agencies] have also observedthat some financial institutions are agreeing in their external au-dit engagement letters to submit disputes over external auditorservices to mandatory and binding alternative dispute resolu-tion, binding arbitration, or some other binding non-judicialdispute resolution process (collectively referred to as mandatoryADR) or to waive the right to a jury trial. By agreeing in advanceto submit disputes to mandatory ADR, the financial institutionis effectively agreeing to waive the right to full discovery, limitappellate review, and limit or waive other rights and protectionsavailable in ordinary litigation proceedings. While ADR mayexpedite case resolution and reduce costs, financial institutionsshould consider the value of the rights being waived. Similarly,by waiving a jury trial, the financial institution may effectivelylimit the amount it might receive in any settlement of its case.The loss of these legal protections can reduce the value of the fi-nancial institution’s claim in an audit dispute.

“The Agencies recognize that ADR procedures and jury trial

waivers may be efficient and cost-effective tools for resolving dis-putes in some cases. However, financial institutions should takecare to understand the ramifications of agreeing to submit auditdisputes to mandatory ADR or to waive a jury trial before an au-dit dispute arises. In particular, pre-dispute mandatory ADRagreements in external audit engagement letters present safetyand soundness concerns when they incorporate additional limi-tations of liability, or when mandatory ADR agreements operateunder rules of procedure that may limit auditor liability. Exam-ples of such limitations on liability include provisions:

• Capping the amount of actual damages that may be claimed;• Prohibiting claims for punitive damages or other remedies;

or• Shortening the time in which the financial institution may

file a claim.

“Thus, financial institutions should not enter into pre-dis-pute mandatory ADR arrangements that incorporate limita-tion of liability provisions, whether the limitations on liabilityform part of an audit engagement letter or are set out sepa-rately. The Agencies encourage all financial institutions to re-view each proposed external audit engagement letter presentedby an audit firm and understand the limitations on the abilityto recover effectively from an audit firm in light of any manda-tory ADR agreement or jury trial waiver. Financial institutionsshould also review the rules of procedure referenced in theADR agreement to ensure that the potential consequences ofsuch procedures are acceptable to the institution. In addition,financial institutions should recognize that ADR agreementsmay themselves contain limitation of liability provisions as de-scribed in this advisory.” �

TEXT OF AN ADR RESTRICTION

VOL. 23 NO. 7 JULY/AUGUST 2005 ALTERNATIVES 123

gagement letters with predispute, mandatoryADR “when they incorporate additionallimitations of liability, or when mandatoryADR agreements operate under rules of pro-cedure that may limit auditor liability.”

The proposal attempts to provide a safeharbor for ADR provisions. The ADR lia-bility limits the proposal cites as threats tofinancial institutions’ safety and soundnessinclude “[c]apping the amount of actualdamages that may be claimed”; “[p]rohibit-ing claims for punitive damages or otherremedies”; or “shortening the time in whichthe financial institution may file a claim.”

At least one of the regulatory authoritiesunder the council’s rubric seems to believethat the guidance provides enough ADRspecificity. The Federal Reserve System’sBoard of Governors’ staff “does not believethe guidance will result in the wholesaleelimination of ADR provisions,” writesBoard spokesman David W. Skidmore inan E-mail to Alternatives. “Staff does notbelieve ADR alone to be a problem.”

And with regard to “appropriate super-visory action” that can be taken if the disfa-vored clauses appear, Skidmore explains, “Ifthe provisions in this guidance appear inengagement letters, the Board could issue aCease & Desist Order that is based on thefact that these agreements may weaken theexternal auditor’s objectivity, impartiality,and performance, and therefore enteringinto such agreements is generally consid-ered to be an unsafe and unsound practice.”

Erin Hickman, a public affairs official atthe Office of Thrift Supervision, says thather agency might host the posting of thecomments on the agency’s site. Near theclose of the comment period, neither theOTS nor the council had posted the com-ments, which were available for inspection inperson at the council’s Arlington, Va., office.

Of the three remaining agencies thatwill employ the final guidance, Brent Kukla,an OCC accounting fellow, declined com-ment on behalf of the agency, and calls tothe FDIC and the NCUA weren’t returned.

The proposal says that the guidancewould be retroactive to already-signed en-gagement letters for fiscal 2005, and thatboards, audit committees and manage-ment should review the letters with their

attorneys, and nullify any liability limitsthat are found. �

* * *

This ADR Briefs article began as anews item on CPR’s home page atwww.cpradr.org.

SEEKING RULES: A CRITIC ASKSTHE SEC FOR ARBITRATION REFORM

A California attorney, embracing a gadfly’srole on arbitration, has asked the Securitiesand Exchange Commission to consider avariety of rules to reverse what he says isdeclining securities arbitration practice.

In a detailed—some say scattershot—24-page petition for rulemaking posted by theSEC at www.sec.gov/rules/petitions.shtml,Les Greenberg, of Culver City, Calif., hasasked the nation’s chief securities regulatoryagency to write rules that require securities ar-bitrators to follow applicable law, and to gettrained. He also wants a better arbitrator eval-uation system. See File No. 4-502, “Requestfor rulemaking under the Securities Ex-change Act of 1934 concerning arbitrationsponsored by NASD Dispute Resolution(May 13, 2005) (available directly atwww.sec.gov/rules/petitions/petn4-502.pdf).

The target of the attorney-neutral’s ireis the NASD Inc. The NASD is a self-reg-ulatory organization that can set its ownrules for the brokers under its jurisdiction,subject to the SEC’s sign-off and oversight.Greenberg, a former New York Stock Ex-change panelist, says he is semi-retired, andonly remains on the NASD panel. He saysthat he is no longer familiar with practicesat other self-regulatory organization.

But he also tells the SEC in his petitionthat his allegations of severe arbitrationproblems are backed by responses he re-ceives to E-mails he sends out to more than1,000 NASD arbitrators. He writes in hispetition that based on his surveying, arbi-trators are “impliedly” told by the NASDto “do justice,” but the NASD “does notprovide the tools to accomplish that goal.”

Within three weeks of the petition’s

SEC posting, five comment letters hadbeen posted, mostly brief, and largely sup-porting Greenberg.

Anyone can submit a petition, whichthe SEC forwards to the appropriate officefor possible action.

Nancy Condon, an NASD public rela-tions officer in Washington, D.C., saysthat the NASD wouldn’t have a commenton Greenberg’s petition.

Greenberg says that it doesn’t matter ifchanges come gradually, because eventually,the NASD addresses systemic—or evensmall—issues. As an example, he cites themost recent edition of the NASD’s newslet-ter, The Neutral Corner, which warns thatthe NASD doesn’t authorize “unsolicited”E-mails, and isn’t responsible for such mail-ings, presumably referring to Greenberg’smissives. See The Neutral Corner (April2005) (available at www.nasd.com).

The newsletter notes that the NASDdidn’t provide addresses to the E-mailer,which it doesn’t name. It says that he had-n’t been speaking on the NASD’s behalf,and had refused to tell the NASD where hegot the E-mail addresses.

Greenberg says that people have E-mailed him based on his Internet writingsurging them to do so. His site is atwww.lgesquire.com. He said he guaranteesanonymity when he uses E-mail commentsin his newsletter, the archive for which canbe found at www.lgesquire.com/LG_Links.html. Based on the April NASDitem, Greenberg has added a disclaimer tohis site and his E-mails noting that hedoesn’t speak for the company, which over-sees more than 5,100 brokerage firms.

In fact, Greenberg, a former broker as-sociate general counsel and compliance di-rector, has a history of pushing back at reg-ulators. Three years ago, a group he formedfiled another rulemaking petition thatdealt with corporate governance issues.The group, the Committee of ConcernedShareholders, organized Internet proteststhat led to proxy contests.

Greenberg says he believes that securi-ties arbitration is ready for a similar grass-roots reform push. “I feel there has been a

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the arbitrator’s eventual recusal.After cataloging his inquiries on the

subject, Greenberg writes that, the“NASD is stonewalling my efforts to learnspecifics of its unpublished policies con-cerning the use of substantive law in thearbitration process.”

* * *

He cites a report that says the NASDneeds to evaluate its arbitrators better.“The NASD is essentially flying blind asto the quality and competence of its arbi-trators,” the petition for rulemaking states,adding that panelists’ peer reviews havebeen unsuccessful.

And while the principal target is theNASD’s operations, Greenberg isn’t happywith the SEC’s oversight either. At the endof the petition, he briefly takes the agencyto task for allowing allegedly lax NASDpractices to proliferate.

“In its current form,” Greenberg con-cludes, “the NASD arbitration process andpurported SEC oversight thereof consti-tutes a sham upon the investing public.”

In an interview, he says, “I’m not pro-industry. I’m not pro-customer. I’m pro-level playing field for both and all. . . . Iwant the process to be fair, and I see itdeclining.”

* * *

Despite early support in the submittedcomments, Greenberg’s kitchen-sink ap-proach doesn’t sit well with everyone.“They’ve made too many rules already,”says longtime arbitrator ConstantineKatsoris, a professor at Fordham Univer-sity’s Law School in New York. He addsthat the requirements have forced outgood arbitrators.

Katsoris, who is a public member of Se-curities Industry Conference on Arbitra-tion, which writes uniform rules for the selfregulatory organizations, says that theGreenberg petition really targets the roles se-curities arbitrators play, particularly indus-try arbitrators, along the lines of March 17

hearings held by the House Committee onFinancial Service’s subcommittee on CapitalMarkets, Insurance and Government Spon-sored Enterprises. He suggests that, ratherthan lose more panelists from the NASD’spool of more than 7,000 arbitrators, bothsides should get peremptory challenges inthe arbitrator selection process.

Katsoris also echoes the NASDnewsletter’s guidance on using the law athearings. “If law is involved, it’s generallyup to the attorney to prove it to the arbi-trators,” he says, regardless of whether thepanelists are sophisticated in the law. “It’spart of the arbitration case,” he says, justlike it is “part of the litigation process.”

He says that the “manifest disregard ofthe law” standard for vacating decisions—a judicial supplement to the Federal Arbi-tration Act’s Section 10 (see 9 U.S.C. §10)—is enough protection for arbitrationparties. “That’s the safeguard,” he says.“Whether arbitrators want to throw insome equity from time to time, well, you’renever going to stop that.”

Despite its flaws, the long-runningsecurities arbitration system still providesmore effective resolutions for investorsthan litigation, Katsoris says, noting thatmost arbitrators aren’t qualified to writereasoned opinions, which he suggestsGreenberg’s letter seeks.

“We’re expecting more and more fromthe arbitrators,” Katsoris says, concludingthat reasoned awards, which he suggestsGreenberg’s letter seeks, “would causemuch more mischief than benefit.” �

DOI 10.1002/alt.20086

(For bulk reprints of this article, please call (201) 748-8789.)

precipitous decline in the standards overthe past 10 years,” he says.

And in his sweeping approach, he tack-les issues that are sure to resonate amongsecurities ADR practitioners, even if thechanges his petition seeks are debatable.

* * *

Greenberg first asks the NASD to requirearbitrators to make rulings based on appli-cable law. “If an arbitrator does not under-stand the applicable law, the arbitratorcannot determine which facts are relevantand which are not or their significance,”writes Greenberg in his petition, adding,“Thus, justice is not served.”

The April issue of The Neutral Cornerdiscusses the NASD view of arbitrators’ useof the law. In a question-and-answer col-umn, it emphasizes in italics that arbitra-tors “are not to engage in any outside legalresearch, nor should they ask NASD staffto conduct legal research for the arbitra-tors. The panel must rely on the parties toprovide the research in support of their re-spective positions.”

Greenberg cites reports recommendingmore arbitrator training. He states that therecommendations haven’t been imple-mented. He says that the NASD view isthat securities industry arbitrators present“helpful and necessary” information,while arbitrators presenting legal authorityare thought to be biased. He suggests thatarbitrators act in secret to pass around in-formation they think is relevant, and failto give parties a chance to rebut.

He writes that the NASD, which pro-vides extensive training opportunities (whichcan be found at the “Arbitration & Media-tion” link www.nasd.com), nevertheless ig-nores training arbitrators in applicable law.

He even charges that NASD policy isto discourage arbitrators from using theirlegal knowledge in hearing and decidingcases. The charge includes an anonymousanecdote in which an NASD regional di-rector actively discouraged an arbitrator’sapplication of the law, and later solicited

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‘Whether arbitrators

want to throw in some

equity from time to

time, well, you're never

going to stop that. ’