Legal costs in the United States are enormous.  As pointed out by the Commission on the Future of Worker Management Relations, one of the major causes of the extraordinary legal costs in the U.S. “is the explosion of litigation under laws that rely in whole or in part on individual lawsuits for enforcement.”[1]  The public frequently complains about the number of cases clogging the U.S. courts.[2]

It has been suggested that one way to reduce litigation would be through the implementation of alternative dispute resolution (ADR).[3]  With respect to employment, many commentators have suggested that employers insert on form of ADR into their employment contracts.  These clauses would mandate that employment-related disputes between the employer and the employee be settled by binding arbitration.  Neither party to the employment relationship would be permitted to commence a lawsuit against the other over a dispute growing out of the employment relationship; the dispute would be settled by binding arbitration.[4]  Before employers would be willing to mandate binding arbitration, however, they would need to know that costs would be reduced.   Stated differently, employers would need to know that they would benefit financially before they agreed to have employment-related disputes settled by binding arbitration or other forms of ADR.

Prior to 1991, the ability of employers to use arbitration agreements as a means of preventing  their non-union employees from suing them in court over employment disputes was not clear.  Then, in Gilmer v. Interstate/Johnson Lane Corp.,[5] the Supreme Court held that an employee was precluded from suing his employer under the Age Discrimination in Employment Act[6] because he had signed an agreement (in his registration as a securities representative) providing that all employment disputes would be submitted to binding arbitration.  In a decision that reversed the holdings of six of the seven U.S. Circuit Courts of Appeals that had addressed and resolved the issue, the Supreme Court held a nonunion employee in such a situation would be required to arbitrate his dispute and forgo his right to litigate (a unionized employee whose arbitration clause was contained collectively‑bargaining arbitration would not be barred from commencing a lawsuit under the ADEA).[7]

This decision has proven quite controversial.  Many of the earliest reactions came from employee rights organizations and those parts of the legal community that represent plaintiffs.[8] These groups point to flaws in many nonunion arbitration procedures, including the arbitration procedure used by the securities industry.  The basic claim of these commentators is that binding arbitration will be beneficial for employers and detrimental for employees.  While many employee rights advocates continue to criticize Gilmer and the mandatory arbitration of employment disputes[9] a number of scholars have responded to Gilmers’ critics and defended the use of binding arbitration in the employment context.[10]  In contrast to Gilmers’ critics, these scholars contend that binding arbitration is neither a panacea for employers nor a death knell for employees.

To this point, however, the debate between the critics and supporters of binding arbitration in employment has been solely speculative and conjectural.  The asserted benefits to employers and detriments to employees from binding arbitration are purely hypothetical.  We are unaware of any empirical assessments of the effects of binding arbitration for employers.  In fact, the American Arbitration Association recently acknowledged that there is a lack of empirical data businesses can use in deciding whether it would behoove them to institute binding arbitration systems.[11]

This research attempted to address the lack of empirical data mentioned above by estimating whether binding arbitration of employment disputes provides any empirical benefit to employers.  Specifically, we assess whether firms received any benefit from the Supreme Court’s Gilmer decision -- the decision that provided the way for employers to institute and require their employees to use binding arbitration systems. As will be discussed more fully, the methodology we use allows us to conclude that, if firms benefited from the Gilmer decision, this indicates that they benefit from binding arbitration systems as well.   We use event study methodology, a technique that examines the effect of an event on shareholder returns in a sample of firms likely to have been affected by that event.  According to the event study, if shareholder returns to firms rose in response to an event, that indicates that the event was beneficial for those firms. In this case, the "event" is the Supreme Court's decision in Gilmer.  A rise in shareholder returns in response to the Gilmer decision will denote directly that the decision benefited those firms and indirectly that binding arbitration of employment disputes benefits employers empirically.

Since Interstate/Johnson Lane Corp. was a securities firm and since the arbitration agreement in Gilmer  was a standard securities industry arbitration agreement, the first sample of firms we use is a sample of firms in the securities industry. Then, to estimate the impact of Gilmer  and binding arbitration more generally, we examine the impact of the decision on non‑securities firms in the financial services industry, an industry in which there are few collective bargaining agreements.[12]    This second set of estimates provides evidence on the opinion of investors regarding the likely ramifications of the Gilmer decision for nonunion employers outside the securities industry. 

Further, our research takes advantage of the fact that the Gilmer decision changed the law in some -- but not all -- states, because of differing decisions by various U.S. Circuit Courts of Appeal prior to the Supreme Court’s decision.  We contrast the results for the firms located in the states in which the law changed with the results for firms located in other states.  This assures us that the change in the law -- not other events in the same period -- drove changes in shareholder returns.

THE GILMER DECISION

Since the facts surrounding the Gilmer decision and the reasoning of the Supreme Court in that decision are now common knowledge to most scholars of employment law, we provide merely an overview for those wishing a brief review of the case.  Those wanting a more extensive review of the case are invited to look at any of a number of articles that have been written that discuss the case in detail.[13]

Background

The issue addressed by the Supreme Court in Gilmer was whether or not a nonunion employee would be precluded from suing his employer under the Age Discrimination in Employment Act because he had signed an agreement stating that he would arbitrate all disputes relating to the termination of his employment and waiving his right to commence a lawsuit over those disputes.  This issue was in doubt prior to Gilmer, in large part because of the Supreme Court's 1974 decision in Alexander v. Gardner‑Denver.[14] 

Alexander was a unionized employee who had been discharged.[15]  Alexander utilized a grievance‑arbitration procedure contained in a collective bargaining agreement, but his grievance was denied by an arbitrator who held that Alexander had been discharged for just cause.[16]  When Alexander sued the employer for race discrimination under Title VII of the Civil Rights Act of 1964, the company argued that the arbitrator's decision should preclude Alexander from suing the company under Title VII.  The Supreme Court disagreed with the employer's argument and allowed Alexander's lawsuit to proceed.[17]   In other words, following Alexander v. Gardner Denver, unionized employers could not use arbitration clauses in collective bargaining agreements as a way of preventing their employees from commencing lawsuits under discrimination statutes against the employer.

Between 1974 and 1991, the lower courts disagreed over the applicability of Alexander v. Gardner‑Denver to non‑union arbitration procedures.  A plurality of courts (six of the seven Federal Circuits that had addressed the issue) held that Alexander v. Gardner‑Denver also applied to non‑union situations.[18]  In those circuits, an employee could sue his/her employer in court even if the employee had agreed to submit his/her employment disputes to arbitration and waived the right to sue.[19]  Other courts disagreed and held that arbitration/waiver agreements did preclude lawsuits in the non‑union sector.  This view prevailed in the Fourth Circuit (the court that heard Gilmer before the case went to the Supreme Court).[20]  In the remaining five circuits, findings of lower courts were mixed and the Circuit court had not ruled at the time of the Supreme Court agreed to decide the Gilmer case.

The Facts of the Gilmer Case

Robert D. Gilmer was hired by Interstate/Johnson Lane in May 1981 as a manager of financial services.  As a condition of employment, Gilmer was required to register as a securities representative with the New York Stock Exchange.  The application for his securities registration contained an arbitration clause pursuant to which Gilmer agreed to arbitrate any disputes between himself and his employer arising out of his employment or the termination of his employment.  Further, Rule 347 of the New York Stock Exchange (which covered Gilmer) states:

Any controversy between a registered representative and any member or member organization arising out of the employment or termination of employment of such registered representative by and with such member or member organization shall be settled by arbitration, at the instance of any such party, in accordance with the arbitration procedure prescribed elsewhere in these rules.[21]

In other words, Rule 347 requires any dispute between a registered representative (employee) and a member organization (employer) to be settled by arbitration.

Interstate terminated Gilmer's employment in 1987, when Gilmer was 62 years old.  After first filing an age discrimination charge with the Equal Employment Opportunity Commission (EEOC), Gilmer brought suit in the United States District Court for the Western District of North Carolina.  He alleged that Interstate had discharged him because of his age, in violation of the Age Discrimination in Employment Act (ADEA).[22]  In response to Gilmer's complaint, Interstate filed a motion to compel arbitration of the ADEA claim, relying on the arbitration agreement in Gilmer's registration application, as well as on the Federal Arbitration Act.[23]  The District Court denied Interstate's motion, based on the Supreme Court's decision in Alexander v. Gardner‑Denver.[24]  On appeal, the United States Court of Appeals for the Fourth Circuit reversed, finding "nothing in the text, legislative history, or underlying purposes of the ADEA indicating a congressional intent to preclude enforcement of arbitration agreements"[25] and Gilmer filed a petition for a writ of certiorari to the Supreme Court. On October 1, 1990, the Supreme Court granted Gilmer’s petition stating: “The petition for a writ of certiorari is granted limited to Question 1 presented by the petition.”[26] Question 1 in Gilmer’s petition was: “Are claims brought pursuant to the Age Discrimination in Employment Act, 29 U. S. C. ' 621, et seq. (“ADEA”) subject to compulsory arbitration?”[27]

Following oral argument and the filing of numerous amicus curiae briefs, the Supreme Court, in a 7 to 2 opinion, agreed with Interstate/Johnson Lane and held that NYSE Rule 347 and Gilmer's own employment agreement precluded his lawsuit under the ADEA.  In reaching its decision, the Court treated a number of contentions Gilmer had made in support of his case. First, Gilmer argued that the social policies behind the ADEA were not adequately served by arbitration.  The Court disagreed, noting that arbitration of statutory claims resolves individual grievances and furthers social policies as effectively as judicial resolution.[28]  The Court also rejected Gilmer's second argument, that compulsory arbitration of ADEA claims undermines the EEOC's role in enforcing the ADEA.[29]  The Court stated that, because the EEOC has independent authority to investigate age discrimination, its role does not depend on the filing of a lawsuit in court.  Gilmer's third contention was that requiring arbitration would deprive plaintiffs of the judicial forum provided for by Congress in the ADEA.  The Court disagreed, stating that Congress never explicitly precluded arbitration or any other non‑judicial resolution of a claim as a potential remedy.[30]  The Court also rejected Gilmer's fourth argument concerning the general inadequacy of arbitration.[31]  Although Gilmer made four general complaints about the adequacy of arbitration, the Court discounted each of these complaints.  Gilmer's fifth and final claim was that unequal bargaining power between employers and employees militated against the enforcement of arbitration agreements.  The Court disagreed, stating that arbitration agreements should be treated the same as other contracts and only held void when fraud or an overwhelming imbalance of economic power is shown.[32]

Finally, the Court treated Gilmer's arguments concerning the Alexander v. Gardner‑Denver case, finding Gilmer's reliance on [Alexander v. Gardner Denver to be] misplaced."[33]  First, the Court noted that, unlike Gardner‑Denver, Gilmer involved only an individual employment contract, not a collective bargaining agreement.  The Court stated that the inherent tension between collective representation and individual statutory rights militates against waiving judicial enforcement of those rights in a collective bargaining agreement, a concern not present in Gilmer. [34]. Second, the Court noted that Gilmer relies on the FAA's policy favoring arbitration, while Gardner‑Denver does not.[35]  Third, the Court noted that Gardner‑Denver concerned whether arbitration of contract‑based claims precludes subsequent judicial review of statutory claims, while Gilmer merely involved the enforceability of an agreement to arbitrate a statutory claim.[36] Thus, because the Court did not foreclose the possibility that Gilmer could relitigate his claim in federal court after arbitration, the finality of the holding remained an open question.

After disposing of the arguments raised by Gilmer, the Supreme Court affirmed the judgment of the Fourth Circuit Court of Appeals:  Gilmer could be required to arbitrate his claim.[37] 

THE USE OF EVENT STUDIES IN ASSESSING LEGAL EVENTS

Event study methodology has been used to assess the effects of legal events on many occasions.[38] For example, a number of studies have tested the effects of legislation with event study methodology and concluded that legislation does affect the profitability of firms.[39] Although less frequently, event studies have been used to assess the impact of court decisions as well.  Specifically, Dhaliwal and Erickson (1998)[40] and McWilliams, Turk and Zardkoohi (1993)[41] both examine the effects of Supreme Court cases and find movements in stock prices in response to the Court's decisions.

The event study model rests on the efficient market hypothesis.  According to this hypothesis, the price of a firm's stock multiplied by the number of shares outstanding is an unbiased estimate of the future profitability of the firm as perceived by the market on a given day.  Therefore, any change in a firm's stock price in response to an event is evidence of a change in the firm's anticipated profitability in response to that event.  The fact that the stock market dips and soars, moving hundreds of points on some days, does not disprove the event study model because that model statistically controls for the general level of (and movements in) the market.  The estimating models used assess the value of a particular security relative to that general market level.  Under the efficient markets hypothesis, it is not necessary that every investor knows about a particular event (like the Gilmer decision); rather, it is only necessary that some investors know about the event and that this generates market activity among these investors. 

The effect of the Gilmer decision on security returns on any particular day is estimated by examining the equation:

(1) AR_id = R_id - E(R_id|No Gilmer Information)

where AR_id is the abnormal return to firm i on day d due to information about the Gilmer decision, R_id is the actual return to firm i on day d and E(R_id|no  Gilmer Information) is the expected return to firm i on day d absent any information about the Gilmer decision. R_id is readily available.[42]  E(R_id|no Gilmer Information)  must be predicted by the researcher.  That return is predicted by the market model, which posits that the return to any security on day d is a function of the market as a whole and the risk of investing in that security relative to the risk of investing in the market as a whole.  The ex ante return to security i in any time period t equals:

(2)        R_it = α_i + ß_i(R_mt) + ε_it

where R_it is the return to security i in time t, R_mt is the CRSP value-weighted index of all securities in time t and α_i and ß_i are parameters.[43]  The parameters in equation (2) were estimated for each firm using data from day -150 through day -51, treating the first event day (the day Gilmer filed his petition for certiorari) as day 0.  Data from outside the event period were used so as to minimize the possibility of the firms' parameters having been affected by the event in question. 100 day model estimation periods from day -150 through -51 are typically used in event study research[44]

According to the market model, ε_it is a fair game variable with mean = 0 and variance = σ². Therefore, equation (1) (the abnormal return to firm i on event day d due to the Gilmer decision) is tested by examining:

        In other words, the abnormal return (AR), or measure of the impact of an event, is simply the actual return given the event minus the expected return absent the event.  To determine the average effect of the event on day d for the sample of the firms, the researcher merely averages the ARs over all the firms in the sample.

                   _n     
(4)        AR_d = 1/n ΣAR_id
                               ⁱ⁼¹

            The abnormal return computed in (4) discloses only the effect of the event on all the firms on day d.  If more than one event day is used (because the researcher hypothesizes that shareholders capitalized the effects of the event being investigated on more than one day), the average abnormal returns (ARs) computed for each day are summed over all the event days to estimate the average total effect of the event under investigation.  This total effect is known as the cumulative abnormal return ("CAR"):

                                       _t
(5)        CAR =  ΣAR_d
                          ^d=1

where d=1 and d=t, respectively,  are the beginning and ending days of the event period under investigation.

Whether or not the event being investigated did affect shareholder wealth in the sample of firms is determined by testing whether the cumulative abnormal return (CAR) computed in (5) is statistically different from zero.  In order to make this determination, the cumulative abnormal return must be standardized to account for the possibility of statistical error in the determination of abnormal returns.  Peterson discusses several ways to compute (CAR) and obtain an appropriate test statistic, consisting of the ratio of CAR (the cumulative abnormal return) to σ (CAR), the standard error of the cumulative abnormal return.[45]   Such a statistic is used to determine the probability that the relationship between the event being investigated and movement of shareholder returns arose by chance alone.

Since the Gilmer decision would have affected all firms simultaneously, it is important in constructing the test statistic to control for the that fact that the cumulative abnormal returns may be due either to the event under investigation or to something else that caused the firms' actual returns to be different from those predicted by the market model on the particular event days in question.[46]   Several procedures for dealing with this problem have been employed, each of which uses the variance-covariance matrix of the residuals from the model estimation periods to correct for the “usual” correlation in the returns across firms. Any correlation in the sample estimated in the model estimation periods is clearly not due to the event in question.  In this paper, the Burgstahler and Noreen “H-statistic” is used.[47]  The "H-statistic" includes the n x n variance-covariance matrix, C_ij, of the residuals formed from the regressions in equation (2) used to estimate the parameters for each of the firms in the sample.  Each off-diagonal element of the matrix, C_ij ,  represents the covariance between the estimated residuals from the market model for each of two firms.  The diagonal elements of the matrix (where i=j) are the variances of the estimated residuals from the market model for each firm.  In the Burgstahler and Noreen procedure, the denominator of the test statistic, σ (CAR), is constructed using this variance-covariance matrix as follows: