Appeal by stockholder from an order of the Southern District of New York, Edward Weinfeld, J., setting aside an arbitration award in his favor based on a broker's cancellation of a short sale of stock as being in "manifest disregard" of the law, Wilko v. Swan, 346 U.S. 427, 436-37, 98 L. Ed. 168, 74 S. Ct. 182 (1953), because it would violate § 10(b) of the Securities Exchange Act and Rule 10b-4, 17 C.F.R. 240.10b-4, promulgated by the Securities Exchange Commission thereunder. Reversed. Judge Meskill concurs in a separate opinion.
Before: MANSFIELD, MESKILL and MINER, Circuit Judges.
MANSFIELD, Circuit Judge:
Jack Bobker ("Bobker") appeals from an order of the Southern District of New York, Edward Weinfeld, J., setting aside an arbitration award of $12,500 in his favor against Merrill Lynch Pierce Fenner & Smith, Inc. ("Merrill Lynch"). The award, based on Merrill Lynch's cancellation of a short sale of 2,000 shares of Phillips Petroleum Company ("Phillips") made on Bobker's behalf, was set aside as being in "manifest disregard of the law". See Wilko v. Swan, 346 U.S. 427, 436-37, 98 L. Ed. 168, 74 S. Ct. 182 (1953). We reverse.
The facts are undisputed. Bobker owned 4,000 shares of Phillips common stock. On March 8, 1985, Phillips made an offer to its shareholders to purchase 72,850,000 shares of its common stock on a pro rata basis, provided the stock was tendered to it on or before March 15, 1985, the proration date. Since Phillips had more than 140,000,000 common shares outstanding, it was likely that there would be an over-subscription in response to the offer, i.e., that the number tendered would exceed the 72,850,000 shares which Phillips offered to buy, in which event it would, on a pro rata basis, purchase from each tendering stockholder a proportionate percentage of his tendered shares.
On March 8, 1985, Bobker instructed his broker, Merrill Lynch, with whom he maintained an account, to tender his 4,000 shares in acceptance of Phillips' offer, which was done immediately. On March 11, 1985, Bobker instructed Merrill Lynch to sell short 2,000 shares of Phillips common stock at the then market price of $48.50 per share. A "short sale" is a sale of shares of stock not owned by the seller but borrowed by him from someone else for the purpose of effectuating the sale. Merrill Lynch on the same date executed the short-sale order and mailed a confirmation to Bobker. However, on March 13, 1985, Merrill Lynch cancelled the transaction and informed Bobker that it had done so because the sale violated the firm's policy. Bobker then unsuccessfully sought to consummate the short sale of 2,000 shares through the brokerage firm of Prudential Bache but was unsuccessful because the latter was unable to procure the 2,000 shares needed to effectuate the sale. If the short sale order had been executed by either Merrill Lynch or Prudential Bache, Bobker planned to purchase 2,000 shares in the market after the proration date.
On March 18, 1985, Phillips reported that 94% of all outstanding shares had been tendered by the proration date, March 15, and that it was accordingly purchasing 54% of the shares tendered, which would amount to 72,850,000 shares, the amount its offer had committed it to buy. The market price of Phillips common stock thereupon dropped to $36-$37 per share. On April 23, 1985, Bobker, claiming that Merrill Lynch's refusal to execute the 2,000 shares short-sale prevented him from making a profit of $23,000 (which he would have realized by selling the shares short at $48.50 per share on March 13 and buying an equal amount back on March 18 at $37 per share), submitted a Statement of Claim to the New York Stock Exchange. Merrill Lynch denied liability on the ground that it was not required to carry out the short-sale because to do so would have constituted a manipulative practice known as a "hedged tender" in violation of § 10(b) of the Securities Exchange Act ("Act") and Rule 10b-4 of the Securities Exchange Commission ("SEC") thereunder. Briefly, Rule 10b-4 requires that a shareholder have a "net long" position in a security both on the date the security is tendered and on the date the offer expires.*fn1 A "net long" position is not defined in Rule 10b-4 but, according to a 1938 SEC Release (see p. 9 infra) it is the balance of shares owned by a person after offsetting against shares owned by him any shares sold by him.
The arbitration panel, consisting of three persons appointed pursuant to the rules of the New York Stock Exchange, held two sessions, the first on October 17, 1985, and the second on November 12, 1985. At the first session they received opening statements and evidence, including the testimony of Bobker. The second hearing dealt mainly with the proper interpretation of Rule 10b-4. The parties also submitted briefs with respect to the question of whether Bobker's proposed short sale would have violated Rule 10b-4. It was Merrill Lynch's position before the arbitrators, as it is here, that the proposed short sale would have violated Rule 10b-4 because it would have had the effect of reducing Bobker's net long position to 2,000 shares when he had tendered 4,000 shares, and that the sale would therefore give him a disproportionate percentage of stock to be purchased from him by Phillips, as compared with the percentage to be purchased from other tendering stockholders. Bobker, on the other hand, argued that the 2,000-share short-sale would not have violated Rule 10b-4 because it was to be an independent transaction, financed separately by him.
During the second arbitration session, which was devoted entirely to the proper interpretation of Rule 10b-4, the arbitrators, following summations, engaged in an extended colloquy (20 pages of the record) with counsel. Repeatedly, one or more arbitrators expressed concern over the propriety of forbidding a stockholder who had tendered shares from selling other borrowed shares short in a transaction independently financed by him.*fn2 Merrill Lynch argued that since the purchaser of the 2,000 shares sold short by Bobker "could tender into the proration also" the effect would be to enlarge the proration pool and thereby diminish the tendering stockholders' portion of the pool. In her words, "[i]t is unfair to the small investor to let people tender and short at the same time, it makes the proration pool bigger, the small inventor is going to get a smaller portion of his stock accepted" while the "big investor or market professional" could take advantage of the market to make money on a short sale. Arbitrator Sullivan indicated dissatisfaction with this answer because short sales, which any person (whether or not a present owner of Phillips stock) could make, would not affect the size of the proration pool. He concluded:
"MR. SULLIVAN: Then it comes down to what you both said initially . . . that it is a matter of interpretation of the law, . . . and we now hopefully have to come up with the right answer on this law, and it is a very gray area. I think this is just going to be a deliberation we are going to have to go through."
On November 12, 1985, the arbitration panel rendered its decision, without any written opinion, in favor of Bobker, awarding him $12,500 ($11,500 for lost profits and $1,000 for return of deposit and costs).
On January 13, 1986, Merrill Lynch filed in the Southern District of New York a petition to vacate the arbitration award on the ground that it was in manifest disregard of the law. After receiving briefs from the parties and a requested brief from the SEC, Judge Weinfeld filed his decision and order vacating the award on that ground. After reviewing the history of Rule 10b-4 and its amendments, Judge Weinfeld held that the term "net long" as used in the Rule required "that the shareholder's long and short positions be netted against each other, without regard for the independence of the transactions" and that "even if Bobker covered the short sale by purchasing shares with cash after the probation date, his transaction would have resulted in the kind of disparate treatment of tendering shareholders Rule 10b-4 was intended to prevent", in which he would receive "not only the above-market tender price for the half of his shares [54%] accepted by Phillips but also the profits realized on his short sale of 2,000 shares." The court stated, "Bobker would have received a premium price for all 4,000 shares, rather than just those shares [2,179 shares out of 4,000 tendered by Bobker] accepted by Phillips." Accordingly, Judge Weinfeld held that "the short sale would have violated the Rule" since it was "nothing more than a thinly veiled attempt to cash in on a scheme designed to obtain $23,000 in profits he was not entitled to receive." He concluded that the "arbitrators were aware of the Rule and its purpose yet proceeded to ignore it, despite the fact that the illegality of the proposed transaction was pressed by Merrill Lynch" and that they therefore acted in manifest disregard of the law. This appeal followed.
"Manifest disregard of the law" by arbitrators is a judicially-created ground for vacating their arbitration award, which was introduced by the Supreme Court in Wilko v. Swan, 346 U.S. 427, 436-37, 98 L. Ed. 168, 74 S. Ct. 182 (1953). It is not to be found in the federal arbitration law. 9 U.S.C. § 10. Although the bounds of this ground have never been defined, it clearly means more than error or misunderstanding with respect to the law. Siegel v. Titan Indus. Corp., 779 F.2d 891, 892-93 (2d Cir. 1985); Drayer v. Krasner, 572 F.2d 348, 352 (2d Cir.), cert. denied, 436 U.S. 948, 56 L. Ed. 2d 791, 98 S. Ct. 2855 (1978); I/S Stavborg v. National Metal Converters, Inc., 500 F.2d 424, 432 (2d Cir. 1974). The error must have been obvious and capable of being readily and instantly perceived by the average person qualified to serve as an arbitrator. Moreover, the term "disregard" implies that the arbitrator appreciates the existence of a clearly governing legal principle but decides to ignore or pay no attention to it. Bell Aerospace Company Division of Textron, Inc. v. Local 516, 356 F. Supp. 354, 356 (W.D.N.Y. 1973), rev'd on other grounds, 500 F.2d 921 (2d Cir. 1974). To adopt a less strict standard of judicial review would be to undermine our well established deference to arbitration as a favored method of settling disputes when agreed to by the parties. United Steelworkers v. American Manufacturing Co., 363 U.S. 564, 80 S. Ct. 1343, 4 L. Ed. 2d 1403 (1960); United Steelworkers v. Warrior & Gulf Navigation Co., 363 U.S. 574, 4 L. Ed. 2d 1409, 80 S. Ct. 1347 (1960); United Steelworkers v. Enterprise Wheel & Car Corp., 363 U.S. 593, 4 L. Ed. 2d 1424, 80 S. Ct. 1358 (1960); Saxis Steamship Co. v. ...