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entitled 'Follow-up Report on Matters Relating to Securities
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April 11, 2003:
The Honorable John D. Dingell:
Ranking Minority Member:
Committee on Energy and Commerce:
House of Representatives:
The Honorable Edward J. Markey:
Ranking Minority Member:
Subcommittee on Telecommunications:
and the Internet:
Committee on Energy and Commerce:
House of Representatives:
Subject: Follow-up Report on Matters Relating to Securities
Arbitration:
Our June 2000 report Securities Arbitration: Actions Needed to Address
Problem of Unpaid Awards revealed that, although investors had won a
majority of awards against brokers, a high proportion of those awards
had not been paid.[Footnote 1] Nearly all of the unpaid awards involved
cases decided in the National Association of Securities Dealer's (NASD)
arbitration program and most involved brokers that had left the
securities industry. A year later we reported on limited data
suggesting that the rate of unpaid awards had declined.[Footnote 2]
However, we noted that given the short time period that the data
covered, regulators needed to continue monitoring the payment of the
awards to determine whether additional steps need to be taken.
Arbitration attorneys and claimants have also expressed concern about
the timeliness of NASD's updating of arbitrator disclosure information,
which can be used by the parties in arbitration to judge the competence
and objectivity of arbitrators, and with NASD's ability to remove
arbitrators from cases if conflicts arise. In addition, arbitration
attorneys also expressed concern about the use of motions to dismiss
and motions for summary judgment to terminate NASD-administered
arbitration cases.[Footnote 3]
This report responds to your May 2, 2001, April 15, 2002, and May 21,
2002, requests that we review the status of issues relating to
securities arbitration and award payment. Our objectives were to (1)
describe NASD's procedures to ensure the timely updating of disclosure
information that arbitrators provide and NASD's procedures for removing
arbitrators from cases, (2) provide information on the use of motions
to dismiss and motions for summary judgment in arbitrations, and (3)
describe recent changes in the rate of unpaid awards and the number of
arbitration claims filed with NASD.
Results in Brief:
NASD has made important changes to its arbitration program procedures,
specifically in updating and entering arbitrator disclosure information
and removing arbitrators from cases. To better manage the data entry
process, in 2001 NASD centralized the arbitrator disclosure information
function in its New York City offices. NASD also put a reporting form
on line allowing arbitrators to submit new background information such
as their education and training, employment, past arbitration
experience, finances, and conflicts of interest. Also, in 2004 NASD
plans to start a new computer system that would allow arbitrators to
update their own records. Since November 2001, when the Securities and
Exchange Commission (SEC) reported that NASD and SEC had not received
any new complaints about the currency of arbitrator disclosure
information, NASD has received one complaint. In addition, NASD has
adopted a rule change that gives its Director of Arbitration and the
President, NASD Dispute Resolution, indelegable authority to remove an
arbitrator from a case after the hearing process has begun based on
information not known to the parties when the arbitrator was selected.
NASD has used this authority in nine instances since the change became
effective in March 2001.
Motions to dismiss were filed and granted in NASD-administered
arbitration cases. Although NASD does not keep track of such motions,
in 2001, for example, we determined that motions to dismiss or motions
seeking summary judgment were filed in 55, or about 8 percent, of 719
investor-initiated, NASD-administered cases in which the investors won
a monetary award.[Footnote 4] We identified 54 instances in which
motions were denied and 28 instances in which the motions were
granted.[Footnote 5] NASD rules do not prohibit either of the parties
in arbitration from filing or the arbitrators from granting prehearing
motions to dismiss. Further, the courts have consistently recognized
the authority of arbitrators in NASD cases to grant prehearing motions
to dismiss. Moreover, an NASD official told us that these motions can
save time and resources by helping to weed out certain cases that,
based on the facts set out in the parties' filings, clearly would not
satisfy procedural requirements for cases in the arbitration forum.
However, a member of the Securities Industry Conference on Arbitration
said that such motions ought to be discouraged because discovery and
appeal rights in arbitration are limited.
In 2001, 236 or about 33 percent of the 719 NASD-administered monetary
awards on claims filed by investors were not fully paid, down from 64
percent not fully paid in 1998, as we reported in June 2000. About 55
percent of the $100.2 million NASD arbitrators awarded to investors in
2001 was unpaid, down from 80 percent of the total $161 million awarded
to investors in 1998.[Footnote 6] The majority of unpaid awards in both
1998 and 2001 resulted from brokers leaving the securities industry.
For example, 192 of the 236 unpaid awards in 2001 involved defunct
brokerage firms or individual brokers. Since 1998, NASD has introduced
award-monitoring procedures that are designed to encourage payment.
NASD also has introduced procedures for investors to avoid the problem
of unpaid awards by defunct brokers by giving investors more options
for handling claims against defunct brokers. The noted decline in the
rate of award nonpayment also might be related to a difference in
methodologies used to measure that rate. In 2000, we directly surveyed
a sample of investors to determine if awards were paid in 1998, while
for this report we used NASD data based on its monitoring of payment
for the entire year 2001. The 5,974 arbitration claims that investors
filed with NASD in 2002 have increased by 64 percent over the 3,637
claims filed in 2000.
We recommend that the President, NASD Dispute Resolution, make
available on NASD's Web site current statistics showing the frequency
with which arbitration awards against defunct brokers are not fully
paid.
Background:
The securities industry uses arbitration to resolve disputes among
industry members, their employees, and individual investors.
Arbitration, an alternative to suing in court, uses neutral third
parties to resolve differences between parties to a controversy. Cases
involving investors, other than relatively small claims, are resolved
by a panel of three arbitrators. Two are public arbitrators and one is
a nonpublic arbitrator who brings a greater degree of expertise in the
workings of the industry. Arbitrators' decisions are final and can be
appealed to the courts only for narrowly-defined reasons such as
misconduct, bias, or a manifest disregard of the law on the
arbitrators' part. Arbitration awards are to be paid within 30 days of
the date of the award, unless a party seeks a judicial review. SEC
oversees the arbitration programs administered by securities industry
self-regulatory organizations (SRO) such as NASD. NASD administers the
largest SRO arbitration program, for example, its program accounted for
about 90 percent of securities arbitration cases in 2000 and
2001.[Footnote 7]
Investors have a right under NASD (and other SRO) rules to require that
brokers-dealers and individual brokers arbitrate any disputes they may
have. In addition, most broker-dealers require customers, when opening
an account, to sign a customer agreement that includes a predispute
arbitration clause. If a dispute subsequently arises between the
investor and the broker-dealer, the investor can file an arbitration
claim with the forum indicated in the predispute agreement and with any
SRO of which the broker-dealer is a member.
In an investor-initiated arbitration case, the investor files a
statement of claim with the designated SRO-sponsored arbitration forum.
The forum's director of arbitration serves the statement of claim on
the broker-dealer or individual broker (called respondents) against
whom the claim has been brought. The respondent has from 20 to 45 days,
depending on the forum used, to answer the claim with any defenses and
related claims. After the filing process, the director of arbitration
provides the parties with a list of potential arbitrators to hear the
dispute. The parties indicate their preference and may challenge
specific arbitrators on the list.
Once the panel of arbitrators has been selected, the panel conducts
hearings that may last a day or more depending on the complexity of the
case. Arbitrators are to render their decisions after the presentation
of the evidence at the hearings. Arbitrators issue a written "award" at
the end of a case. The written award is not required to include a
reason or formal written opinion supporting the award. However, the
award is required to include a statement setting out certain issues,
including the basic issues raised and resolved in a case, the amount
claimed and awarded, and any other, non-monetary issues resolved.
New NASD Procedures Address Concerns
about Information on Arbitrators and Removing Arbitrators from Cases:
NASD has taken steps to improve its procedures for updating arbitrator
disclosure information and removing arbitrators from cases. The
arbitrator update improvements included centralizing the process for
updating arbitrator profiles and making an on-line reporting form
available for arbitrators to submit new disclosure information. Another
change allows the President, NASD Dispute Resolution, and its Director
of Arbitration to remove an arbitrator from a case once the hearing
process has begun and new information about the arbitrator has been
disclosed.
NASD Procedures Help Ensure That Arbitrator
Disclosure Information Is Updated Regularly:
In selecting individuals to be in its pool of potential arbitrators,
NASD relies on background information that prospective arbitrators
provide. This information is first entered into the NASD arbitrator
information database when arbitrators enroll in the program and is to
be updated for any new information. NASD uses the background
information to classify arbitrators as "public" or
"nonpublic."[Footnote 8] The parties in a dispute also use this
information in deciding whether to accept arbitrators to be assigned to
their case. NASD arbitrator disclosure reports include information on
education and training, employment, past arbitration experience,
finances, and conflicts of interest. The reports also include a
narrative section, written by the arbitrators, describing their
professional duties and responsibilities.
As we reported in November 2000, NASD has taken steps to improve its
procedures for updating and entering arbitrator disclosure
information.[Footnote 9] We reported that the new procedures appeared
reasonable and were likely to reduce the possibility for errors and
improve the promptness of data entry. The improvements included:
* centralizing the process for updating arbitrator profiles in the
Department of Neutral Management in the New York City offices of NASD's
Division of Dispute Resolution, and:
* using an on-line reporting form on which arbitrators submit updated
disclosure information via a NASD dispute resolution program Web site.
NASD procedures state that all updated arbitrator records, whether
received on-line or by phone or fax, are to be reviewed by a quality
control supervisor after they are initially entered. Records of
arbitrators currently serving on panels are to be updated within 24
hours, while updates from nonserving arbitrators can be entered in 3 to
5 days. NASD staff are also to monitor and track all entries to
arbitrator profiles and prepare a biweekly report to department
managers on the receipt and computer entry of arbitrator updates. For
each arbitrator submission, the biweekly reports list the date the
information was received by the Department of Neutral Management and
the date computer entry of the information was completed. The
department manager is to use the report to verify the timeliness of the
process.
In November 2001, SEC reported that, after the new procedures were
implemented, neither SEC nor NASD had received any new complaints
regarding the arbitrator disclosure records. According to NASD, from
November 2001 through the end of 2002 it had logged one complaint about
an arbitrator failing to update his background information. In that
case, according to NASD, a party in a dispute asked the arbitrator for
new information, and the arbitrator sent the new information to the
party by fax and to NASD by mail. As a result, the party received the
information before NASD could receive it, update its disclosure
information database, and make the information available. SEC officials
said that they did not recall receiving any new complaints and SEC has
indicated that its inspection staff will continue to monitor NASD's
process for updating arbitrator profiles. In 2004, NASD plans to use a
new computer system that would enable arbitrators to access and update
their own disclosure records on-line at a NASD Web site.
New Procedures Make Removing Arbitrators from Cases Easier:
Effective March 2001, SEC-approved amendments to NASD's Code of
Arbitration Procedure gave the President, NASD Dispute Resolution, and
its Director of Arbitration indelegable authority to remove an
arbitrator at any juncture in the arbitration process. These amendments
allow for removal of an arbitrator from a case after a prehearing
conference or a hearing has been started, based on new information that
was not known to the parties at the time of the arbitrator's
appointment but that the arbitrator, pursuant to NASD rules, should
have disclosed.
Under the old rule, the director could disqualify an arbitrator from
serving on a case when information revealed a conflict of interest or
bias such as a relationship with one of the parties. However, this
authority to disqualify was limited to the time before the start of the
prehearing conference or the first hearing. After that point, the
parties would have needed to make a motion before the arbitration panel
asking the arbitrator to recuse himself or herself or seek a court
action to remove an arbitrator from a case. In approving the rule
change, SEC noted that the change should result in lower litigation
expenses for the parties, because they would not have to seek judicial
intervention to remove an arbitrator. SEC also noted that the change
would help ensure greater confidence in the fairness and neutrality of
the administration of arbitration cases.
According to NASD, after the new rule became effective in March 2001
and through the end of 2002, NASD had received 47 requests for the
Director of Arbitration to exercise the authority to remove an
arbitrator. NASD reported to us that the Director denied these requests
in 38 instances and removed an arbitrator in 9 instances.
Motions to Dismiss Are Used in NASD Arbitrations:
Prehearing motions to dismiss are used in NASD-administered arbitration
cases. NASD, however, does not centrally track the motions filed in its
numerous cases. Data that we assembled from 719 investor-initiated,
NASD-administered monetary arbitration awards in 2001, showed that
motions to dismiss were filed in 54 cases and a request for summary
judgment in one case, or in about 8 percent of all the cases. In the 54
cases, 124 motions were filed. We identified 42 instances in which the
motions were not decided because the claims had been dismissed for
other reasons or settled by the parties before the case was decided. We
identified 54 instances in which the motions were denied and 28
instances in which the motions were granted. The total number of
motions filed exceeded the number of cases because any one case may
involve multiple respondents and multiple filings of motions. SEC
officials said that some motions to dismiss are based on substantive
arguments, while others assert practical ones, for example, that the
wrong party was named or served. The awards did not provide enough
detail about the motions for us to determine the reasons for their
being filed.
NASD arbitration rules do not specifically provide for dismissal
motions or for motions for summary judgment. However, nothing in the
rules prohibits the parties from filing motions or precludes panels
from granting them. NASD rules are consistent with the practice of
disposing of claims by motion. NASD rules allow prehearing conferences
at which the presiding person can require the briefing of contested
issues and address "any other matters which will expedite the
arbitration cases."[Footnote 10]
The case law consistently has recognized the authority of arbitrators
to grant prehearing motions to dismiss. For example, in Warren v.
Tacher the underlying dispute in the arbitration proceeding involved
alleged investor losses in a brokerage account.[Footnote 11] The
investors brought a claim for arbitration against the broker-dealer
that maintained the account and the clearing broker-dealer. The
clearing broker-dealer moved to dismiss all claims on the ground that
it had no responsibility to claimants. The claimants filed a written
response to the motion and the arbitration panel held oral argument.
The arbitration panel dismissed all claims against the clearing broker-
dealer. The claimants appealed and sought to have the arbitrators'
decision vacated on the ground that the arbitrators engaged in
misconduct and exceeded their powers by dismissing the claims against
the clearing broker-dealer prior to discovery and an evidentiary
hearing. The court stated that courts have recognized the authority of
NASD arbitrators to decide prehearing dismissals for failure to state a
claim under the NASD Code.[Footnote 12] The court rejected an argument
that the arbitrators displayed a "manifest disregard for the law" by
their determination to dismiss all claims against the clearing broker-
dealer.
The court in Warren v. Tacher also addressed the issue of whether the
grant of a prehearing motion to dismiss is tantamount to a refusal to
hear evidence. The court rejected this argument and explained that
while the granting of a prehearing motion to dismiss usually means that
the arbitrator "refused to hear evidence," that, by itself, is
insufficient to vacate the award. Claimants must also show that the
excluded evidence was material to the panel's determination and that
the arbitrator's refusal to hear the evidence was so prejudicial that
the party was denied fundamental fairness[Footnote 13]. In addition,
the court held that a hearing for purposes of NASD rules does not
necessarily mean an evidentiary hearing. The court found that the
claimants did have a "hearing." They were given adequate opportunity to
respond to the clearing agent's motion to dismiss and they did so.
The courts have upheld arbitrators granting of dismissal motions in
other cases. These include dismissal on the grounds of the timeliness
of the claims, a respondent's involvement in the matter in controversy,
or whether the claimant has a private right of action for alleged
violation of an SRO rule.[Footnote 14] We have not found any cases that
do not recognize arbitrators' authority to grant prehearing motions to
dismiss. Moreover, an NASD official told us that these motions can save
time and resources by helping to identify certain cases that would not
prevail in a hearing on the merits. For example, in some cases the
parties' pleadings may clearly show that the case, or some portion of
the case, does not fall within the NASD's procedural rule covering
filing time limits, which would send the case instead to court. On the
other hand, a member of the Securities Industry Conference on
Arbitration said that motions to dismiss and motions of summary
judgment ought to be discouraged because discovery and appeal rights in
arbitration are limited. Another arbitration official also said that
parties in arbitration deserve the right to be fully and fairly heard.
Rate of Unpaid Awards Has Decreased, but Many Investors Are Not Paid
Awards against Defunct Brokers:
Data for 2001 show that the rate of unpaid NASD-administered
arbitration awards had decreased from the levels we previously reported
for 1998. NASD procedures for monitoring awards encourage payment by
still-active brokers. However, defunct brokers continue to not pay
awards. The recent rise in arbitration claims may result in more
investors not being paid their awards.
Payment Rates Have Improved, but Many Awards Still Are Not Fully Paid:
Although the rate of unpaid arbitration awards has fallen, many awards
rendered by NASD arbitration panels remain unpaid. In 2001 about 55
percent, or $55 million, of the $100.2 million NASD arbitrators awarded
to investors was unpaid. However,
$12 million of the unpaid awards were not required to be paid because
the respondents had requested a hearing, filed for bankruptcy, or filed
a motion to vacate. In our June 2000 report, we estimated that about 80
percent of the $161 million awarded to investors in 1998, which were
primarily NASD-administered awards, was unpaid. In that report, we
estimated that 64 percent of NASD-administered monetary arbitration
awards won by investors in 1998 had not been fully paid. Our analysis
of NASD award payment data for 2001 found that 33 percent of awards to
investors were unpaid. Of the total of 719 monetary awards that
investors won in 2001, 236 awards were not fully paid. (Nothing was
paid on 216 awards and 20 awards were partially paid.):
In June 2000, we reported that most of the unpaid arbitration awards in
1998 were against broker-dealer firms and associated persons that had
left the securities industry. Awards that were not fully paid in 2001
also were against such defunct brokers. More specifically, as shown in
table 1, nonpayment of 192 awards ($41 million) in 2001, was attributed
to brokers that had terminated their NASD membership. In an additional
16 awards, NASD suspended firms or individual brokers for failing to
pay $2.1 million of awards. In 29 awards, $12 million awarded was not
paid because the respondents had requested a hearing, filed for
bankruptcy, or filed a motion to vacate the award.[Footnote 15]
Table 1: Number and Amount of Dollars Not Fully Paid by Broker-dealers
or Individual Brokers with NASD-administered Arbitration Awards against
Them and Award Nonpayment Status in 2001:
[See PDF for image]
Source: NASD (data); GAO (analysis).
[A] The sum of these unpaid cases exceeds the 236 unpaid awards because
cases with multiple respondents can have different outcomes.
[End of table]
NASD Procedures to Monitor the Payment of Awards Are Designed to
Encourage Award Payment:
NASD has put procedures in place for monitoring the payment of awards
that are designed to encourage award payment. In September 2000, NASD
began requiring its member broker-dealers to certify that they had paid
or otherwise complied with an award against them or their associated
persons within 30 days after the award was served. NASD also began
asking the claimants who had won awards to notify it if an award had
not been satisfied within the 30-day period. If an award is not paid,
NASD begins the process of suspending the license of the broker-dealer
firm or the individual broker responsible for payment of the award. In
2001, NASD suspended one or more of the respondents in 12 cases for
failing to pay awards. Members and individuals who fail to pay awards
cannot apply to restore their licenses until an award against them is
satisfied.
Although these procedures may have helped to reduce the rate of unpaid
awards, the previously discussed reduction in the rate of unpaid awards
also might reflect differences in the methodologies used to compile the
data used to calculate the rate. Our June 2000 report was based on data
that we obtained by surveying a sample of investors that had won
arbitration awards in 1998. For this report, the rate was calculated
from data obtained from NASD based on its monitoring of award payment
for the entire year of 2001. Additionally, arbitration attorneys said
that they have begun scrutinizing cases more closely to avoid taking
cases where awards might not be paid, a factor which may also have
contributed to a reduction in the rate of unpaid awards.
NASD Has Implemented Changes to Help Address the Problem of Unpaid
Awards by Failed Broker-Dealers:
NASD is helping to address the problem of unpaid awards by defunct
brokers by making it easier for investors to seek alternative means of
relief or obtain a judgment against the broker. These procedures
address the problem of unpaid awards by defunct brokers, for example,
by helping shorten the time period for obtaining a court judgment that
could be used to seize remaining assets of a defunct broker. In April
2001, SEC approved amendments to NASD's Code of Arbitration Procedure,
§10301, effective June 2001, that provided that a broker-dealer that
has been terminated, suspended, or barred from NASD, or that is
otherwise defunct cannot enforce a predispute arbitration agreement
against an investor in NASD's arbitration forum. Also, in June 2001,
NASD began to advise claimants in writing, at the time they file a
claim, of the registration status (for example, terminated, out-of-
business, bankrupt) of broker-dealers or associated persons so that the
claimants can evaluate whether to continue with the arbitration. In
October 2002, a new NASD rule, which SEC approved in July 2002, took
effect. The rule provides for streamlined default proceedings where the
terminated or defunct broker-dealer or associated person does not
answer or appear, but the claimant affirmatively elects to pursue the
arbitration. Under the streamlined proceedings, an arbitrator can make
a decision based on the statement of claim and any other material
submitted by the claimant. In addition, in August 2002, the NASD Board
of Directors approved a proposed amendment, which was submitted in
January 2003 to SEC for approval, that would strengthen NASD's
authority to preclude member broker-dealers from using structural
changes, such as consolidations or other asset sales and transfers, to
avoid meeting their arbitration obligations to investors. Also, NASD
officials said that NASD's Enforcement Division had started reviewing
new arbitration claims as they come in as part of an effort to identify
potentially troublesome members.
In our June 2000 and April 2001 reports, we discussed proposals made by
investors' attorneys to address the unpaid award problem such as
insurance and bonding. In the June 2000 report we recommended that, to
the extent unpaid awards remain a problem, the SEC's Chairman should
establish a process to assess the feasibility of alternative approaches
to address the problem. In response SEC officials said that after our
report was issued SEC staff assessed other approaches addressed in the
report including insurance and bonding. According to the officials, SEC
staff met with broker-dealer representatives and insurance companies to
discuss existing broker-dealer insurance and bonding requirements. The
officials said that after those consultations, the staff concluded that
expanding broker-dealer insurance and bonding requirements would not be
an appropriate means of addressing unpaid arbitration awards. Instead,
SEC staff concluded that the efforts of NASD--which conducts most
broker-dealer examinations--to institute a procedure of reviewing all
arbitration claims as they are filed to identify problem brokers early
through related examinations and as appropriate, enforcement action,
would limit the harm they cause investors. The officials said that
this, as well as other initiatives NASD has taken, which are described
earlier in this report and in our June 2000 and April 2001 reports,
should be given time to work. SEC's continuation of the process we
recommended in June 2000 to assess the feasibility of alternative
approaches to address the problem of unpaid awards by defunct brokers
could further reduce the incidence of unpaid awards. This process could
consider how SEC and NASD programs for broker registration, regulation,
enforcement, as well as arbitration, and other areas as appropriate,
can further reduce the incidence of unpaid awards.
In June 2000, we also recommended that the SEC Chairman work with the
SROs to develop and publicize information to focus investor attention
on the possibility of unpaid arbitration awards. In response, NASD and
SEC made information available on their Web sites to caution investors
about the possibility of having an unpaid award. That information,
while helpful, does not provide any data to inform investors of the
scope of the problem or the frequency with which awards are unpaid by
defunct brokers. Increasing investors' awareness of the scope and
frequency of the problem may better inform investors that broker-
dealers that stay in business generally pay awards and help to reduce
unpaid awards by defunct brokers.
Recent Increase in Arbitration Claims Suggests That Many Future Awards
also Might Not Be Paid:
Arbitration claims have increased sharply, which may mean, assuming the
rate of unpaid awards remains the same; more investors may not be paid.
In 2001, 6,926 arbitration claims were filed with NASD. In 2002, the
number of new cases further increased to 7,709, or a 39 percent
increase over the 5,565 total claims filed in 2000. In most of these
cases--4,849 in 2001 and 5,974 in 2002--investors filed claims against
their brokers. Through 2002, these investor-initiated cases increased
by 64 percent from the 3,637 claims filed by investors in 2000. NASD
officials said that whether this increase in claims will mean more
unpaid awards depends on the types of broker-dealers any resultant
awards might be against. For example, if the increase in claims results
in more awards against large viable broker-dealers that tend to pay
awards, the number of unpaid awards could decrease.
NASD officials said that the increase in claims filed was the result of
changes in the economy. The officials said the downturn in and
increased volatility of the stock market in 2001, an influx of new
inexperienced investors during the boom years of the late 1990s, and
the overall increased number of securities holders contributed to the
increase in arbitration claims filed. According to NASD, claims
alleging broker failure to supervise their sales representatives,
breach of fiduciary duty, misrepresentation, and negligence also had
increased.
Conclusions:
The rule and procedural changes that NASD has adopted to improve the
arbitrator information update process and its ability to remove
arbitrators from cases appear reasonable and could improve the
effectiveness and efficiency of arbitration. These changes could help
NASD to keep current the information that parties in arbitration use in
selecting arbitrators and allow for faster and less costly removal of
arbitrators in cases where there has been an undisclosed conflict of
interest.
Motions to dismiss are used, but not with great frequency, in NASD
arbitrations. Arbitration law and codes do not explicitly prohibit the
use of these motions. Because appeal rights and evidentiary discovery
are limited, a Securities Industry Conference on Arbitration member
said that arbitration forums should discourage the granting of these
motions. However, NASD officials have contended that use of these
motions helps to make the arbitration process more efficient.
Data show that the rate of unpaid awards has diminished since our June
2000 report. However, continued unpaid awards, regardless of how
effective and fair the arbitration process may be, could negatively
affect investors' confidence in arbitration and potentially the
securities markets in general. Unpaid awards also may discourage
attorneys from taking investors' cases. It is important that regulators
continue to issue a strong message to investors about being cautious in
choosing their brokers because some brokers will never pay for the
damage they cause. Moreover, given that continued unpaid awards could
erode investors' confidence in arbitration, SEC's Chairman should
continue the process we recommended in June 2000 to assess the
feasibility of alternative approaches to address the problem of unpaid
awards by defunct brokers. This process could consider how SEC and NASD
programs for broker registration, regulation, enforcement, as well as
arbitration, and other areas as appropriate, could further reduce the
incidence of unpaid awards. Further, NASD needs to be concerned about
unpaid awards, which represent inefficient use of NASD dispute
resolution program resources and futile efforts by defrauded investors
seeking restitution. By making data on the frequency with which awards
are unpaid by defunct brokers publicly available, NASD could better
inform investors of the possibility of unpaid awards by defunct brokers
and increase investors' awareness of the scope of the problem. This, in
addition, could cause investors to be more cautious in choosing their
broker and also help them decide whether to file an arbitration claim
or seek alternative means of obtaining relief and avoid unnecessary
expenses.
Recommendation for Executive Action:
We recommend that the President, NASD Dispute Resolution, make
available on NASD's Web site current statistics showing the frequency
with which arbitration awards against defunct brokers are not fully
paid.
Agency Comments and Our Evaluation:
SEC and NASD provided written comments on a draft of this report, which
are reprinted in enclosures I and II. SEC and NASD also provided
technical comments, which were incorporated into the final report. SEC
agreed with the contents of this report and noted that our work
demonstrates that NASD has developed necessary tools to administer its
growing caseload and that implementation of our June 2000
recommendations has helped achieve an appreciable reduction in the rate
of unpaid awards. SEC commented that it welcomes our recommendation
that NASD make available on its Web site current statistics showing the
frequency with which arbitration awards against defunct brokers are not
fully paid. SEC said that this more explicit data should help deliver
to investors the educational message to choose investment professionals
carefully. SEC noted that SEC staff believe that more time is needed to
realize the full effects of the steps taken after our June 2000 report
and that it continues to work with NASD to better identify individuals
responsible for unpaid awards.
NASD generally agreed with the contents of this report and provided
additional information on the various steps it has taken related to its
addressing the problem of unpaid awards. NASD also noted the dramatic
improvement in the rate of unpaid awards from our June 2000 report and
provided updated information on the status of awards we found to be
unpaid. NASD updated the payment status of awards that were paid after
it threatened suspension of the member or a motion to vacate was denied
or which had motions to vacate still pending, which reduced the percent
of awards unpaid from 55 percent to 53 percent. NASD stated that it
would consider our recommendation and additional ways to enhance
investor education about the problems associated with terminated
members and the payment of awards. NASD commented that it strives to
strike a balance between disclosing information and not discouraging
investors from filing valid claims. NASD stated that, with that concern
in mind, it will develop an approach to enhance the data available to
investors to enable them to make more informed decisions about whether
to pursue a claim. NASD also commented that it welcomes the opportunity
to participate in a feasibility study of alternative solutions to
address the problem of unpaid awards that we recommended in June 2000.
We commend SEC and NASD for the efforts they have taken to monitor and
educate investors about unpaid awards, and provide investors viable
options when faced with the possibility of unpaid awards. However, the
extent to which awards are unpaid by defunct brokers shows that unpaid
awards, even when reduced to 53 percent for 2001, as NASD adjusted it,
is still a serious problem that can affect investors' confidence in
arbitration and potentially the securities markets and discourage
attorneys from taking investors' cases. It is, therefore, important
that NASD make available to investors current statistics on the
frequency with which awards are unpaid by defunct brokers and that
regulators continue to monitor unpaid awards and consider ways of
addressing the problem.
Scope and Methodology:
We analyzed information on NASD procedures for updating arbitrator
disclosure information and removing arbitrators from cases based on our
review of NASD's procedures and interviews of NASD officials. We
analyzed information on the use of motions in arbitration based on
interviews of officials of NASD and the Securities Industry Conference
on Arbitration. We also reviewed arbitration rules of NASD and other
forums and federal case law regarding the uses of motions to dismiss
and motions for summary judgment in NASD cases. We then identified the
extent to which these motions were used in 2001 NASD investor-initiated
cases in which monetary award decisions were rendered in favor of
investors.
To determine changes in arbitration claims and the rate at which awards
in investor-initiated cases were paid, we analyzed NASD data. Initial
testing of the NASD data on award payment found errors that could
overstate the extent to which awards were paid that were significant
enough to require further verification and correction. We then had NASD
correct any errors found and then further tested the accuracy of the
data. We reviewed a randomly-selected sample of 34 cases out of 719
monetary awards in 2001 to verify that NASD had documentation showing
that the awards were paid. From our random sample of 34 awards 1 award
was initially listed as paid, but we discovered on further review that
the award was unpaid, and the respondent had filed for bankruptcy.
Subsequently, NASD discovered an additional award that was mistakenly
classified as unpaid. The number and magnitude of these data errors are
small enough that the data are sufficiently reliable for our purposes
and should not materially affect the estimates of payment rates in this
report. Nevertheless, we apprised SEC officials of the errors. The
officials said that SEC examiners would test the accuracy of the award
payment data as part of SEC's routine inspections of NASD's dispute
resolution program. NASD officials told us that the errors resulted
from NASD not having a means of tracking the payment status of awards.
Once an award was granted, NASD gave the case a closed status and NASD
staff had to manually compile the payment data from documents in case
files. The NASD officials said that NASD has since entered new status
codes in its computer system for tracking the payment status of awards.
They said that they can now track different outcomes related to award
payment such as receiving a broker's certification that an award was
paid or that a broker had filed a motion to vacate an award in a court.
The officials said that this change should minimize the opportunity for
compilation errors.
We conducted our work in Washington, D.C., and New York, N.Y., from
April 2002 through March 2003, in accordance with generally accepted
government audit standards.
As agreed with your offices, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 30 days
from the report date. At that time, we will provide copies of this
report to the Chairman, House Committee on Energy and Commerce; the
Chairman, Subcommittee on Telecommunications and the Internet, House
Committee on Energy and Commerce; the Chairman and the Ranking Minority
Member, Senate Committee on Banking, Housing, and Urban Affairs; and
the Chairman and the Ranking Minority Member, House Committee on
Financial Services. Copies also will be provided to the Honorable
William H. Donaldson, Chairman, SEC; Mr. Robert R. Glauber, Chairman,
NASD; and other interested parties. In addition, the report will be
available at no charge on the GAO Web site at http://www.gao.gov.
Please call me or Orice M. Williams, Assistant Director, at (202) 512-
8678 if you or your staff have any questions concerning this report.
David Tarosky and Sindy Udell also contributed to this report.
William O. Jenkins Jr.
Director, Financial Markets and Community Investment:
Signed by William O. Jenkins Jr.:
Enclosures:
Comments from the Securities and Exchange Commission:
UNITED STATES:
SECURITIES AND EXCHANGE COMMISSION WASHINGTON. D.C. 20549:
DIVISION OF MARKET REGULATION:
March 28, 2003:
William O. Jenkins Jr. Director, Financial Markets and Community
Investment General Accounting Office Washington, DC 20548:
Dear Mr. Jenkins:
The Commission staff appreciates the opportunity to comment on the
General Accounting Office's draft report entitled Follow-up Report on
Matters Related to Securities Arbitration. The draft report provides a
useful snapshot of the current status of several aspects of the process
used to resolve investor and other securities disputes.
GAO's draft report confirms that NASD has implemented procedures for
updating and entering arbitrator disclosure information that parties
use when selecting arbitrators. It also describes arbitrator removal
procedures implemented under a rule that became effective in March
2001. Those procedures enable NASD to remove an arbitrator based on
information not known to the parties when the arbitrator was selected.
The draft report also discusses motion practice in NASD arbitration.
Finally, the draft report provides a helpful update regarding GAO's
findings of a decreased incidence of unpaid arbitration awards since
GAO's June 2000 report Securities Arbitration: Actions Needed to
Address Problem of Unpaid Awards.
GAO's work demonstrates that NASD, which administers about 90% of
securities arbitration cases, has developed necessary tools - for the
maintenance of its arbitrator pool and removal of arbitrators from
particular cases - to administer its growing caseload. GAO also observed
that motions to dismiss are not used with great frequency. Used
sparingly, as the draft report reflects, such motions can be used
effectively to conserve the parties' resources or direct parties to a
correct forum outside of arbitration.
Much of the draft report updates GAO's earlier work concerning the
incidence of unpaid arbitration awards. As in GAO's June 2000 report,
GAO reports here that the vast majority of broker-dealers pay
arbitration awards entered against them. Defunct firms that harm
investors before going out of business do not. Implementation of GAO's
June 2000 recommendations has helped achieve an appreciable reduction
in the rate of unpaid awards.
As GAO reports, since its June 2000 report, much has been done to
contain this problem. For example, NASD refined existing procedures in
order to be able to identify and suspend more quickly firms or
individual brokers that do not pay awards. NASD also adopted rules that
give
choices to investors on how to proceed against defunct firms -
investors now have the option of going to court against defunct firms,
or of using expedited procedures against defunct firms that do not
participate in the arbitration. Those steps were designed to help a
narrow band of investors possibly reach remaining assets of defunct
firms. In addition, SEC, NASD and New York Stock Exchange educational
materials were amended to alert investors to the risk of unpaid awards,
and to reinforce the message that investors should investigate before
they do business with a particular firm. Investors who review Central
Registration Depository (CRD) information showing the regulatory
history of broker-dealers and individual registered representatives
make more informed decisions.
The staff welcomes GAO's recommendation that NASD make available on
NASD's Web site current statistics showing the frequency with which
arbitration awards against defunct brokers are not fully paid. More
explicit data, already used by NASD and SEC regulators, should help
drive home the educational message to choose investment professionals
carefully. While GAO reports that there are fewer unpaid awards in its
more recent case review, all unpaid awards are of concern. GAO's draft
report states that its estimate of the percentage of unpaid awards to
investors reduced to about 33% for cases from 2001 from about 64% for
cases in 1998, and that its estimate of the unpaid dollar amount
awarded reduced to about 55% from 80%.':
The staff believes that more time is needed before we feel the full
effects of the steps taken after GAO's June 2000 report. Cases
concluded in 2001 are likely to have resulted from investment
relationships begun before the educational effort to publicize this
problem was launched. The cumulative effects of educational efforts may
help investors avoid problem firms. Similarly, procedures allowing
access to court against defunct firms (effective June 2001) and
providing expedited procedures for cases where defunct firms do not
answer a claim or appear in an arbitration (effective October 2002),
may reduce unpaid awards to some extent. In addition, GAO reports that
NASD's Enforcement Division is reviewing new arbitration claims at the
beginning, rather than at the end of a case in order to identify
potential problem firms more quickly, and to take action more quickly,
before more investors may be harmed. This step also may further reduce
the nonpayment of awards.
The staff agrees with GAO that we should continue to consider how SEC
and NASD programs can further reduce the incidence of unpaid awards.
The staff is working with NASD to develop better means to identify
through the registration process individuals who may have had some
responsibility for unpaid awards at firms with which they were
previously affiliated. Moreover, we will continue to explore ways to
identify problem firms before they harm investors, and to promote the
full payment of arbitration awards.
[1] The staff understands that GAO is refining its data in
conversations with NASD. GAO's data indicates that 29 awards (out of
236) representing about $12 million (out of $55 million) are in post-
arbitration proceedings. Some part of those sums is either not yet
payable, because motions to vacate have not been decided, or may never
be payable, because motions to vacate have been granted.
Thank you again for the opportunity to comment on the draft report. The
Division requests that this letter be appended to the final report
delivered to Congress.
Sincerely,
Annette L. Nazareth
Director:
Signed by Annette L. Nazareth:
[End of section]
Comments from NASD:
Linda D. Fienberg President, Dispute Resolution:
Executive Vice President and Chief Hearing Officer, Regulatory Policy
and Oversight:
March 26, 2003:
Mr. William O. Jenkins, Jr.
Director, Financial Markets and Community Investment U.S. General
Accounting Office:
441 G Street, N.W. Washington, D.C. 20548:
NASD
Re: Follow-up Report on Matters Relating to Securities Arbitration:
Dear Mr. Jenkins:
NASD appreciates the opportunity to comment on the GAO Report entitled:
Follow-up Report on Matters Relating to Securities Arbitration (GAO
Report or Report).
The GAO Report covered three areas:
1. Improvements in the rate of unpaid arbitration awards in NASD's
forum;
2. Enhancements to NASD's procedures to ensure timely updating of
arbitrator disclosure information and to remove arbitrators from cases;
and:
3. The use of dispositive motions in arbitration.
We respond below to the GAO's findings in each of the three areas and
describe numerous initiatives NASD has implemented to improve our
arbitration forum. We highlight the improvement in award payment
results since the GAO's review of 1998 cases and provide a complete
picture of the results of NASD arbitration cases involving public
investors in 2001. We also discuss our proposed actions to implement
the GAO recommendations regarding measures to address further the
problem of terminated broker-dealers failing to pay awards. In
addition, we discuss NASD initiatives to improve arbitrators'
disclosures of relationships they have with participants in the
arbitrations before them. Last, we examine NASD's approach to
dispositive motions.
Executive Summary:
GAO previously found that that a large percentage of the 1998 NASD
arbitration awards was not paid. NASD committed to Congress to
implement significant procedural changes to increase the number of paid
awards. These changes had a positive impact. As a result, both the
percentage of unpaid awards and the percentage of unpaid damages in
2001 declined significantly. As in 1998, over 80 percent of the 2001
cases in which awards were unpaid involved a terminated broker-dealer
or associated person - that is a firm or individual who is no longer in
good standing with NASD and therefore unable to sell securities to the
public.
GAO's review of arbitration awards issued in 2001 shows that the
majority of the 719 NASD arbitration awards in which arbitrators
granted relief to investors were paid in full. Specifically, awards
were fully paid in two-thirds (67 percent) of the cases. Additionally,
investors received
partial payment in three percent of the cases. This is a dramatic
improvement from the 1998 awards that the GAO studied in the 2000
Report.
GAO found that, of the cases NASD closed in 2001, only 34 percent were
resolved by arbitrator decision. Most of the remainder resulted in
settlements. Of the claims decided by arbitrators, 53 percent resulted
in an award in favor of the investor. Accordingly, the combination of
settlements and awards reflects that over 70 percent of the cases filed
in the NASD forum in 2001 resulted in a disposition favorable to the
investor. In effect, the damages awarded to investors in the 719 cases
studied by GAO represent only a fraction of the compensation granted to
investors through the NASD forum. When viewed in that context, the 224
[Note 1]
cases in which a customer award was not paid represent about six
percent of the 3,499 investor cases that NASD closed in 2001. While
NASD is concerned about even one unpaid award, the significant
improvement over the 1998 results demonstrates that the measures we
have implemented have been effective. And, since many of the cases in
which awards were issued in 2001 were filed before these new
initiatives were in place, we expect these positive effects to
continue.
Call for a Forum on Unpaid Awards:
NASD recognizes that an effective dispute resolution process is an
integral part of securities industry regulation and that new measures
to prevent unpaid awards should be part of the larger effort to restore
investor confidence. NASD concurs with GAO's recognition that the
problem of unpaid awards goes beyond the scope of NASD's authority, and
also with GAO's recommendation that a broad range of participants in
the securities arbitration field - government regulators, SROs,
investors, broker-dealers, registered representatives, and other
interested parties - convene to address important "next steps" in
solving the problem of unpaid awards.
NASD also concurs with GAO's findings that NASD is addressing
appropriately the important task of providing updated information on
arbitrator disclosures and properly managing dispositive motions.
I. Unpaid Arbitration Awards:
GAO's 2000 Report on Arbitration Award Payment:
The GAO's June 2000 Report, Securities Arbitration: Actions Needed to
Address Problem of Unpaid Awards (2000 Report), concerning payment of
1998 arbitration awards, concluded that 49 percent of those awards were
not paid at all and an additional 12 percent were only partially paid.
NASD made several significant commitments in response to the 2000
Report, all of which we have fulfilled. We provide a summary of NASD's
five initiatives as follows:
1. Require member firms and associated persons to notify NASD Dispute
Resolution when_ they have satisfied an award.
NASD Dispute Resolution issued Notice to Members 00-55, effective
September 18, 2000, which requires firms to certify that they have paid
or complied with an award against them or their associated persons
within 30 days after service of the award. Since September 2000, NASD
Dispute Resolution has been sending two new letters to the parties when
it serves awards. We send one letter to members and associated persons
against whom an award has been rendered. It requires members to inform
NASD Dispute Resolution whether they or their associated persons have
paid awards against them.[Note 2]
NASD Dispute Resolution begins the process to
suspend members or associated persons from NASD if the 30-day period
has passed and payment of the award has not been confirmed or the
respondent has not met one of the enumerated justifications for non-
payment. If suspended, the firm or individual cannot sell securities to
the public or reenter the industry until the award is satisfied.
2. Request in the award service letter that investors notify NASD
Dispute Resolution if the award has not been paid within thirty days of
service.
Notice to Members 00-55 also invites claimants to inform NASD Dispute
Resolution if the firm or associated person has not paid the award so
that NASD can begin the suspension process. The second letter, also
implemented in September 2000, is sent to all parties with service of
their award. It restates the requirement to pay awards within 30 days
of service, and requests parties who have prevailed against a member or
associated person to inform NASD Dispute Resolution if their award has
not been paid within the 30-day period.
3. Propose a rule amendment that a firm that has been terminated
suspended or barred from the NASD, or that is otherwise defunct cannot
enforce a predispute arbitration agreement against a customer in the
NASD forum.
The Boards of NASD Dispute Resolution and NASD approved this proposal
in December 2000. The SEC approved the rule change on April 6, 2001.
[Note 3]
The rule change was effective for all claims served on or after June
11, 2001, giving investors the option of taking claims to court if the
brokerage firm is no longer in business.[Note 4]
4. Advise claimants in writing at the time of claim filing of the
status of a firm or associated person (e.g., terminated out of
business or bankrupt) so they can evaluate whether to proceed with
arbitration.
We implemented this procedure in June 2001, in connection with the
previous item. Dispute Resolution sends notice letters to claimants at
the time the claim is served.
5. Propose a rule amendment to provide streamlined default proceedings
where the terminated or defunct member or associated person does not
answer or appear, but the claimant affirmatively elects to pursue
arbitration.
The Boards of NASD Dispute Resolution and NASD approved this proposal
in October 2001. The SEC issued an order approving the rule change on
July 17, 2002, for all claims filed on or after October 14, 2002. [Note
5] This
rule provides an expedited default procedure for situations in which a
suspended, terminated, or otherwise defunct member or associated person
fails to answer a claim in an arbitration proceeding, but the claimant
nevertheless elects to pursue arbitration. The procedures are designed
to make it easier for claimants to obtain an award against a defunct,
non-answering party that the investor can then seek to enforce in
court.[Note 6]
NASD also developed and publicized Web site information to focus
investor attention on the possibility of unpaid arbitration awards.
That information includes a reference to the 2000 GAO study on unpaid
awards and a link to the GAO Web site and the 2000 Report. NASD also
took action to encourage investors to investigate their broker's
background more thoroughly before investing.
GAO's Study of 2001 Award Results:
Review of the Data:
GAO's review of arbitration awards issued in 2001 shows that the
majority of the 719 NASD arbitration awards in which arbitrators
granted relief to investors were paid in full. Specifically, awards
were fully paid in two-thirds (67 percent) of the cases. Additionally,
investors received partial payment in three percent of the cases. This
is a dramatic improvement from the 1998 awards that the GAO studied in
the 2000 Report. Nevertheless, NASD recognizes that more remains to be
done.
NASD Department of Enforcement Actions Related to Arbitration Awards:
Under current procedures, if a respondent member firm or associated
person does not pay an arbitration award in a timely fashion, Dispute
Resolution begins a suspension proceeding by advising that NASD intends
to suspend the member in 15 days. NASD's Department of Enforcement is
responsible for litigating these matters and, under the NASD Code of
Procedure, an NASD professional hearing officer serves as the sole
trier of fact.
NASD's Department of Enforcement tracks its actions by calendar year
rather than on the basis of the year in which an arbitration case
closed. We are not able to match the Department of Enforcement actions
with the specific cases covered in the GAO study of arbitration awards
issued in 2001. However, the following information related to calendar
year 2002 provides an example of the scope and nature of the actions
taken to enforce arbitration awards: In 2002,
NASD sent out 248 "15-day letters" (warning of possible suspension in
15 days) for failure to comply with arbitration awards or arbitration
and mediation-related settlement agreements. The vast majority --154
individuals or firms --either settled or paid the awards in full after
receiving NASD's letter. NASD suspended another 33 individuals who
failed to request a hearing or to raise a valid defense after receiving
a "15-day letter." The remaining 48 matters culminated in hearings,
with more than one-third of those resulting in settlements or payments
of the awards in full.[Note 7]
NASD Department of Enforcement Actions Related to Arbitration Awards
Issued in 2001:
The GAO noted that in seven of the 2001 awards that were unpaid, the
individual or firm requested a hearing. NASD's Department of
Enforcement disposed of these matters,[Note 8]
and, in one case, the respondent paid the $33,000 award prior to the
disciplinary hearing.
NASD suspended all active firms or individuals who did not promptly
fulfill their obligations. The remaining awards were unpaid because of
terminated membership, bankruptcy, or court challenges to the awards.
Federal bankruptcy law provisions and NASD By-Laws prohibit
disciplinary action for non-payment in these circumstances. These
numbers demonstrate that NASD has used every available means to ensure
payment of awards and settlements, and has aggressively pursued
disciplinary action against those who nevertheless fail to pay.
Adjustments to Unpaid Award Data:
The GAO Report observes that respondents did not pay 236 of the 719
arbitration awards issued in 2001 in the customer's favor. NASD
suggests that the number of unpaid awards, and associated amounts,
should be adjusted based on updated information of the payment status
of these matters.
Two Awards Subsequently Paid:
As indicated above, in one case, an award counted as unpaid was
subsequently paid prior to the requested disciplinary hearing. In
another case, the respondent paid the award after the court denied the
motion to vacate. These cases should not be included in the number of
unpaid awards. This reduces the number of unpaid awards to 234.
Three Awards Vacated by a court:
GAO noted that motions to vacate had been filed in 17 of the cases
involving unpaid awards. In three of these cases, a court decision to
vacate the award nullified the award
and therefore the obligation to pay. Thus, these three cases should not
be included in the number of unpaid awards. This further reduces the
number of unpaid awards to 231.
Seven Motions to Vacate Still Pending:
In seven of the cases involving unpaid awards, motions to vacate the
awards are still pending in court.[NOTE 9] While it is true that, as a
technical matter, these awards are not yet paid, the firms and
individuals in these cases do not have an obligation to pay unless the
court denies the challenges to the award. Accordingly, these seven
cases should be excluded from the calculation of unpaid awards until
the courts decide the motions to vacate. Excluding these seven cases
reduces the meaningful number of unpaid awards to 224.
Adjustments to Unpaid Award Amounts:
The Report states that 55 percent (approximately $55 million) of the
$100 million awarded to customers in the 2001 awards studied was
unpaid. We suggest that the amount of total damages awarded and the
total damages unpaid also should reflect the pending motions to vacate
and those decided in favor of the respondent, and the two awards paid
after threat of suspension or denial of the motion to vacate. The
result of excluding these cases is to reduce the total damages owed by
$4.2 million. With this adjustment, the damages remaining unpaid are
approximately $50.5 million out of $96 million, or a total of 53
percent unpaid.[Note 10] Of course, this reduced figure is still
entirely too high, and is of great concern to NASD.
Unpaid Awards in Context:
As the GAO pointed out in its earlier 2000 Report, awards alone do not
tell the entire story of investor results in arbitration and, in fact,
represent only one of several ways investors can recover damages for
their losses.
In 2001, NASD processed 3,499 public customer cases. Of these, nearly
two-thirds were resolved without the need for an arbitrator to decide
the matter. In over 55 percent of the cases that NASD closed (i.e.,
1,927 cases), the parties agreed on a resolution, either through direct
negotiation, mediation, or in a stipulated award. (See Exhibit 1
attached). These cases resulted in economic recovery for the investor
claimants. Claimants withdrew another seven percent of the cases. NASD
does not require investors to specify reasons for withdrawals, but it
is likely that most of the withdrawn cases also involved settlements,
and thus resulted in recoveries for the investor claimants.
In sum, of the cases NASD closed in 2001, only 34 percent were resolved
by arbitrator decision. Of the claims decided by arbitrators, 53
percent resulted in an award in favor of the investor. Accordingly, the
combination of settlements and awards reflects that over 70 percent of
the cases filed in the NASD forum in 2001 resulted in a disposition
favorable to the investor. In effect, the damages awarded to investors
in the 719 cases studied by GAO represent only a fraction of the
compensation granted to investors through the NASD forum. When viewed
in that context, the 224 cases in which a customer award was not paid
represent about six percent of the 3,499 investor cases that NASD
closed in 2001. The significant improvement over the 1998 results
demonstrates that the measures NASD has implemented have been
effective. And, since many of the cases in which awards were issued in
2001 were filed before these new initiatives were in place, we expect
these positive effects to continue.
NASD's Regulatory Initiatives:
In addition to the efforts of Dispute Resolution to address the problem
of unpaid awards, NASD has implemented significant measures to promote
the fairness and efficacy of NASD's arbitration system. These
initiatives include restrictions on expungement of awards from the
Central Registration Depository (CRD) system, prohibitions against use
of NASD regulatory "close-out" letters in related proceedings (such as
arbitration), preventing parties who have not paid arbitration awards
from becoming members of NASD, enhanced reporting of civil and criminal
complaints and arbitration claims, and the systematic review of new
arbitration claims.
Expungement of CRD Records:
In 2002, NASD worked to preserve the integrity and accessibility of its
public records system. Specifically, in October 2002, NASD's Board of
Governors approved a rule proposal limiting the removal of customer
dispute information from the CRD.[Note 11]
The CRD system, which is operated by
NASD's Regulatory Services and Operations Division, is the registration
and licensing system for the United States securities industry and its
federal and state securities regulators and SROs. NASD and the North
American Securities Administrators Association (NASAA) jointly
administer the CRD system. The new CRD policy will be implemented after
NASD's rule proposal is reviewed and approved by the SEC.[Note 12]
It will make
permanent a moratorium imposed in early 1999, requiring that a court
must confirm any arbitration order before customer dispute information
can be removed from CRD. In addition, NASD members and associated
persons would be required to make NASD a party to a court proceeding
seeking to confirm an arbitration expungement order. NASD will oppose
attempts to confirm expungement awards unless the elimination of the
information is based on findings by the arbitrators or judge that the
subject matter of the claim or the information in the CRD system: (1)
is without factual basis (i.e., is factually impossible or unclear);
(2) fails to state a claim (i.e., fails to state a claim upon which
relief can be granted or is frivolous); or (3) is defamatory in nature.
NASD also proposes to include a process by which it will waive the
requirements to be made a party if it determines that the expungement
meets one of the above standards.
The goal of the proposed rule is to balance investor protection and the
investor's ability to make an informed decision with the legitimate
fairness issues of individuals.
Use of NASD Regulatory Policy and Oversight "Close-out Letters" in
Related Proceedings:
In 2002, NASD issued Notice To Members 02-53 indicating that it has
revised the letters NASD sends to customers and members when a
determination is made to close an investigation without disciplinary
action. The revised letters now state that a determination by NASD not
to take action against a member or a member's associated person has no
evidentiary weight in any mediation, arbitration, or judicial
proceeding. Further, the notice states that NASD considers it
inconsistent with its conduct rules Oust and equitable principles of
trade)[Note 13] for a member or a member's associated person to
attempt to introduce such a determination into evidence in any
mediation, arbitration, or judicial proceeding.
NASD's decision to close out an investigation without further action
can be the result of many factors unrelated to the merits of a
complaint, such as jurisdictional limitations, the existence of an
ongoing investigation, resource limitations, or a completed enforcement
action by another regulator. Accordingly, NASD made clear that it is
unethical and misleading to suggest to an arbitrator, mediator, or
adjudicator that NASD's decision not to pursue an investigation is
probative evidence in a dispute on a related claim.
Preventing Parties with Unpaid Awards from Becoming Members of NASD:
In January 2003, NASD proposed rule amendments that strengthen NASD's
authority to preclude firms from using structural changes to avoid
meeting their arbitration obligations to investors by enhancing the
authority to screen membership applications. NASD has filed with the
SEC a proposed rule change to amend NASD Rule 1014 to clarify the
current standards of membership admission.[Note 14]
The amendment would
specifically allow consideration of the existence of unpaid arbitration
awards or other adjudicated customer awards, as well as pending
arbitration claims, when reviewing membership applications.
Enhanced Reporting of Criminal and Civil Complaints and Arbitration
Claims:
In August 2002, NASD filed with the SEC a proposed rule change to amend
NASD Conduct Rule 3070 to broaden the reporting requirements. The SEC
approved the proposed rule change on March 3, 2003.[NOTE 15] The rule
change requires members promptly to file copies with NASD of certain
criminal and civil complaints and arbitration claims filed in other
forums against a member or a person associated with a member. The
purpose of the rule change is to improve the quality and flow of
information to NASD with respect to allegations of broker misconduct,
so that NASD can enhance investor protection efforts by promptly taking
appropriate regulatory action to address the specific alleged
misconduct and to prevent similar or related misconduct in the future.
Review of New Arbitration Claims:
In June 2002 NASD's Regulatory Policy and Oversight Division began a
review of new arbitration claims as part of its effort to spot trends
early that adversely impact investors. These measures, combined with
the continued impact of the initiatives described above, should improve
future award payment results.
GAO Recommendation Regardinq Web Site Information:
The Report recommends that NASD Dispute Resolution make available on
its Web site current statistics showing the frequency with which
arbitration awards against defunct brokers are not fully paid. The NASD
Web site currently contains information helpful to investors by
highlighting the difficulty in using NASD enforcement procedures to
force payment when a firm or broker is out of the securities business.
In addition, our Web site provides a direct link to the GAO Web site
and the information needed to obtain the 2000 Report on unpaid awards.
As GAO suggests, we will consider additional ways to enhance the
education of investors about the problems associated with terminated
members and the payment of awards. NASD strives to strike a balance of
disclosing information while not discouraging investors from filing
valid claims. With that concern in mind, we will develop an approach to
enhance the data available to investors to enable them to make more
informed decisions about whether to pursue a claim.
GAO Recommendation for a Feasibility Study:
The problem of terminated or defunct firms failing to fulfill monetary
obligations is not unique to the arbitration process. As in 1998, over
80 percent of the 2001 cases in which awards were unpaid involved a
terminated broker-dealer or associated person. Thus, the same
collection problems would exist if investors brought their complaints
in a civil court proceeding: it is very difficult to collect funds from
a defunct or bankrupt entity that has little or no assets.
Nevertheless, NASD believes that, because the securities arbitration
process is part of an overall regulatory system, it should strive to
provide mechanisms that are more effective than the civil court system
in these circumstances. The GAO proposes bringing together expertise
from many interests (such as the Securities and Exchange Commission,
self-regulatory organizations and other regulators; investors;
brokerage firms; and registered representatives) to address the
problem. NASD welcomes the opportunity to participate with the GAO,
Congress, the SEC, other SROs, and other interested parties to consider
appropriate means to address the problem of unpaid awards. Such a group
could assess the feasibility of some of the alternative approaches
noted by the GAO in the 2000 Report such as:
* A change in the net capital rule;
* Insurance or bonding requirements; or:
* Expanded SIPC coverage or a separate SIPC type of fund for unpaid
arbitration awards.
In addition, NASD believes the participants should include
consideration of changes to the Bankruptcy Code or requiring bonds at
the time claims are filed for firms with marginal net capital reserves
or with a questionable regulatory history.
NASD recognizes that any proposed solution has positive and negative
aspects and must fit within the overall regulatory scheme protecting
the investing public. Some approaches will involve legislative
solutions. Others will require regulatory changes that will invoke the
formal
rule-making apparatus of the Administrative Procedure Act. Still other
improvements will require various entities to change internal
procedures and systems. As GAO recognizes, solving the problem of
unpaid arbitration awards at this juncture goes beyond the scope of
NASD's authority, and will involve a broad coalition of participants.
II. Initiatives Related to Arbitrator Disclosure:
The new GAO Report notes NASD Dispute Resolution's improved procedures
to monitor the receipt and entry of arbitrator update information. In
recent years, NASD Dispute Resolution has instituted numerous changes
responsive to recommendations contained in prior GAO reports such as:
* Establishing formal arbitrator qualification standards;
* Creating a training requirement in 1993 and a testing requirement in
1998 for new arbitrators;[Note 16]:
* Periodically collecting questionnaires from all members of the
arbitration roster to verify:
the accuracy of their background and experience;
* Instituting the Neutral List Selection System (NLSS), in November of
1998, which gives the parties significant control in the selection of
their panel; and:
* Creating in 1999 the Director of Neutral Management position with
central responsibility for all neutral qualification and maintenance
issues.
In 1999, the NASD staff updated the records of over 6,500 arbitrators
based on the arbitrators' responses to a November 1998 questionnaire,
and eliminated from the roster arbitrators who failed to respond to the
questionnaire. Dispute Resolution senior staff members conduct regular
audits to ensure that the staff inputs in a timely manner important
updates provided by arbitrators.
NASD Dispute Resolution recognizes the importance of updating its
arbitrator records in a timely and accurate manner. We believe that
when parties consider an arbitrator for possible service, they should
have information that is up-to-date, correct, and relevant. To
strengthen our procedures in this area, Dispute Resolution took the
following actions to supplement its existing efforts:
* Centralized Roster Maintenance Function: Beginning in November 2000,
the Department of Neutral Management, located in New York City, became
solely responsible for updating and revising arbitrator records. This
centralization makes record maintenance easier to control and reduces
the possibility of errors.
* Online Update Form: Since November 15, 2000, arbitrators have been
able to update their records online via NASD Dispute Resolution's Web
site. We have
designed an easy, step-by-step form that allows arbitrators to update
their information and to submit it electronically to the Department of
Neutral Management.[Note 17]
* Exchange of Arbitrator Disclosure Reports: Since November 1, 2000,
arbitrators serving on three-person panels receive a copy of the
disclosure reports of their fellow arbitrators. This practice gives
arbitrators a better understanding of the expertise and background of
the people with whom they are serving, and encourages panel members to
consider the disclosures made by other arbitrators and to make similar
disclosures themselves.
* Redesign of the Computer System: NASD Dispute Resolution has begun an
ambitious project to redesign its legacy computer system. The new
system, (MATRICS)[Note 18] will be implemented in phases over the next
few years and will feature a web-based gateway for parties, counsel,
arbitrators, mediators, and staff. Among other things, the new system
will enable neutrals to access and update their own records on our
system.
As noted in the GAO Report, NASD in March 2001 amended the Code of
Arbitration Procedure to allow NASD to remove an arbitrator from a case
after a pre-hearing conference or a hearing has started.[NOTE 19] The
removal can only be based on new information that was not known to the
parties at the time of the arbitrator's appointment, but that the
arbitrator should have disclosed under NASD rules. The authority to
remove an arbitrator at these stages can only be exercised by the
President of Dispute Resolution or the Director of Arbitration; it
cannot be delegated.[Note 20]
This new power enhances our ability to enforce the
requirement that arbitrators make all required disclosures to parties.
III. The Use Of Motions to Dismiss and Motions for Summary Judgment in
Arbitration:
The GAO Report also reviews the use of dispositive motions, such as
motions to dismiss or for summary judgment, in arbitration. NASD's
rules do not prohibit parties from filing dispositive motions; nor do
they prohibit arbitrators from granting them. And, as GAO notes, courts
have consistently recognized NASD arbitrators' authority to rule on
dispositive motions. Nevertheless, as the GAO Report concludes,
dispositive motions are rare in NASD arbitrations.
We fully agree with the GAO Report that parties deserve the opportunity
to be fully and fairly heard. NASD attempts to provide procedural
safeguards by administratively managing this motion practice to ensure
that each side gets a fair opportunity to be heard on any matter
presented to the arbitrators. Our administrative procedures and
arbitrator training focus on providing that opportunity. While
arbitrators may address such motions prior to the beginning of a
hearing, the arbitrators always accept arguments from all sides, either
through written
submissions or oral argument, before ruling. Further, the full panel is
always involved in these decisions. We allow the parties to practice
advocacy as they choose and try to provide a fair and efficient
mechanism to assist the parties in reaching a resolution.
IV. Conclusion:
We concur with GAO's findings about the efficacy of NASD's arbitrator
disclosure process and with its findings concerning dispositive
motions. We are pleased that the many steps we have taken to improve
these processes have been effective.
The scope of the unpaid award problem has diminished significantly
since 1998. NASD Dispute Resolution's initiatives and the changes
implemented by NASD's Regulatory Policy and Oversight and Regulatory
Services and Operations Divisions should result in continuing
improvement. Nevertheless, as the GAO notes, regardless of how
effective and fair the arbitration process may be, unpaid awards can
erode investors' confidence in arbitration and in the securities
markets. Further, the vast majority of broker-dealers, which meet their
award obligations fully, are harmed by the unscrupulous practices of a
very small number of firms, which do not. When investors expend the
time, effort, and resources to pursue a claim, it is critical to the
integrity of the process that arbitrators' awards be satisfied. An
effective dispute resolution process is an integral part of an
efficient marketplace, and new measures to prevent the problem of
unpaid awards should be part of the larger effort to restore investor
confidence.
Thank you for the opportunity to respond to the GAO Report and to work
with your staff to help fashion responsive initiatives. If you have any
questions or require further information, please contact me at (202)
728-8407.
Very truly yours,
Linda D. Fienberg
President:
Signed by Linda D. Fienberg:
cc: Orice M. Williams - GAO David Tarosky - GAO Robert Love -
SEC:
NOTES:
[1] GAO reported 236 unpaid awards. As discussed in more detail below,
NASD suggests that the actual number of unpaid awards is 224.
[2] The firm or associated person also may provide a justification for
non-payment: for example, that the parties have agreed to installment
payments, that the award has been modified or vacated by a court, that
a motion to vacate or modify the award has been timely filed with a
court of competent jurisdiction and such motion has not been denied by
that court, that there is a pending bankruptcy petition, or that the
award has been discharged in bankruptcy.
[3] Exchange Act Release No. 44158 (April 6, 2001) (File No. SR-NASD-
01-08), 66 Federal Register 19267 (April 13, 2001).
[4] Through March 18, 2002, 33 out of 399 eligible customers exercised
this option.
[5] Exchange Act Release No. 46221 (July 17, 2002) (File No. SR-NASD-
2002-15), 67 Federal Register 48237 (July 23, 2002).
[6] Because the rule went into effect so recently, there are no
meaningful data on its use.
[7] Of the 48 matters that resulted in hearings, 15 individuals or
firms settled or paid the awards in full prior to a hearing. Three
matters resulted in bankruptcy filings. Seven individuals were
suspended by decision after a hearing took place. Three cases were
dismissed after a hearing took place, and the hearing officer found the
respondents had a bona fide inability to pay the award. Six matters
were dismissed because of a pending motion to vacate the arbitration
award in court. Six matters were dismissed prior to hearing by the
Department of Enforcement based on a review of financial information
and a determination of a valid inability to pay. The remaining 8
hearings were set for dates in 2003.
[8] Two matters resulted in bankruptcy filings. Two matters resulted in
suspensions. One matter resulted in a termination. One matter was
dismissed based on inability to pay. One matter was dismissed because a
motion to vacate was filed. One matter was dismissed because the award
was paid. One matter is still pending. Note: numbers do not add up to
seven because, in some cases, there were multiple dispositions (e.g.,
one party filed for bankruptcy but the case proceeded against the
remaining party).
[9] The court denied the motion to vacate in the remaining six of the
17 cases listed by GAO as being subject to a motion to vacate. In each
of these cases, NASD pursued suspension after the court denied the
motion to vacate. Each of the involved firms and individuals has been
suspended or terminated, and the underlying awards, totaling $4.4
million, have not been paid.
[10] Moreover, we note that several unpaid awards exceeded $1 million.
Specifically, the 11 largest unpaid awards, constituting less than five
percent of the unpaid awards, all exceed $1 million and comprise 42
percent of the unpaid damages total ($21.2 million). These very large
awards present a skewed picture of the results; this is demonstrated by
the additional fact that the median unpaid award amount was
approximately $70,000, and nearly 60 percent of the unpaid awards
involved less than $100,000. Excluding these 11 large cases as
statistical "outliers" further reduces the unpaid damages to 39 percent
of the total dollars awarded.
[11] NTM 01-65; NASD News Release, Oct. 1, 2002.
[12] NASD filed the proposed new rule (Rule 2130) with the SEC on
November 19, 2002 and filed an amendment to the proposed rule with the
SEC on January 28, 2003. On March 4, 2003, the SEC published notice of
the proposed new rule for comments from interested persons. Securities
Exchange Act Rel. No. 47435, 2003 SEC LEXIS 507 (Mar. 4, 2003).
[13] NASD Conduct Rule 2110.
[14] File No. SR-NASD-2003-007, filed January 16, 2003.
[15] Securities Exchange Act Rel. No. 47434 (Mar. 3, 2003).
[16] We have revised and updated the arbitrator training program and
materials several times since 1993.
[17] Arbitrators may also print the form, complete it by hand, and fax
or mail it to the Department of Neutral Management.
[18] MATRICS is an acronym for Mediation and Arbitration Tracking and
Retrieval Interactive Case System.
[19] Code of Arbitration Procedure, Rules 10308(d)(2) and 10312(d)(2).
[20] As the GAO Report notes, NASD exercised this authority nine times in
47 instances from March 2001 through the end of 2002.
Exhibit 1:
How Investor Cases Closed 2001:
[See PDF for image]
[End of figure]
[End of section]
(250081):
FOOTNOTES
[1] U. S. General Accounting Office, Securities Arbitration: Actions
Needed to Address Problem of Unpaid Awards, GAO/GGD-00-115 (Washington,
D.C.: Jun. 15, 2000).
[2] U. S. General Accounting Office, Evaluation of Steps Taken to
Address the Problem of Unpaid Arbitration Awards, GAO-01-654R
(Washington, D.C.: Apr. 27, 2001).
[3] There are basically two categories of motions for prehearing
dismissal. Motions to dismiss are based exclusively on the allegations
of the statement of claim. Motions for summary judgment are those that
depend, at least in part, on some facts that go beyond those
allegations.
[4] Securities arbitration cases are categorized as broker-broker,
employee-broker, and customer-broker cases. Because the customers of
brokers are generally investors, in this report we refer to the
customers as investors.
[5] The total number of motions filed exceeded the number of cases
because many cases involved multiple respondents and multiple filings
of motions. In some instances in which motions to dismiss were granted,
awards were still rendered against other parties responding to the
claims.
[6] In 2001, $12 million of the unpaid awards were not due because the
respondents had requested a hearing, filed for bankruptcy, or filed a
motion to vacate.
[7] NASD Dispute Resolution facilitates the resolution of monetary,
business, and employment disputes between investors, securities firms,
and employees of securities firms, offering both arbitration and
mediation services.
[8] A public arbitrator has had no recent association with the securities
industry whereas a nonpublic arbitrator has had recent or has current
association with or experience in the securities industry. Public
arbitrators are used in all investors' cases. In single arbitrator
cases in which claims are $50,000 or less, the arbitrator is a public
arbitrator. In cases with three arbitrators in which claims are more
than $50,000, two of the arbitrators are public arbitrators.
[9] U.S. General Accounting Office, Procedures for Updating Arbitrator
Disclosure Information, GAO-01-162R (Washington, D.C.: Nov. 9, 2000).
[10] NASD Code §10321(d)(1). General Provisions Governing Pre-Hearing
Proceedings, Pre-Hearing Conference, (1) Upon the written request of a
party, an arbitrator, or at the discretion of the Director of
Arbitration, a prehearing conference shall be scheduled. The presiding
person shall seek to achieve agreement among the parties on any issue
that relates to the prehearing process or to the hearing, including but
not limited to stipulation of facts, identification and briefing of
contested issues, and any other matters which will expedite the
arbitrations.
[11] 114 F. Supp. 2d 600 (W.D. Ken. 2000).
[12] Goldman, Sachs & Co. v. Patel (N.Y.L.J. Aug. 18, 1999, p. 23, co.
6) ("Contrary to respondent's assertion, the NASD panel has the power
to decide a motion to dismiss a claim on legal grounds without holding
an evidentiary hearing.").
[13] 9 U.S.C. § 10(c); Campbell v. Cantor Fitzgerald & Co., 21 F. Supp.
2d 341, 344 (S.D.N.Y. 1998).
[14] In Howsam v. Dean Witter, 123 S.Ct. 588 (2002), the United States
Supreme Court recently held that arbitrators can decide that a claim is
ineligible for arbitration under an NASD rule that provides that claims
submitted a certain time after they arose are ineligible. The Court's
decision does not address whether arbitrators should make such a
decision in response to a motion to dismiss an arbitration claim. Dean
Witter did not file a motion to dismiss the arbitration claim. It
brought an action in federal court asking the federal court to decide
that the arbitration claim was untimely.
[15] NASD procedures allow the respondent to request a hearing on the
matter to consider whether (1) the respondent was given notification of
the award, (2) the respondent satisfied the award, and (3) a valid
reason exists for the respondent's failure to comply with the award.