==========================================START OF PAGE 1====== Remarks Of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. What Level of Protection is Appropriate for Brokerage Firms in Preparing Form U-5s -- Qualified or Absolute Immunity? New York Stock Exchange Legal Advisory Committee New York Stock Exchange New York, New York May 31, 1996 ______________ *The views expressed herein are those of Commissioner Hunt and do not necessarily represent those of the Commission, other Commissioners or the staff. U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Good afternoon. I appreciate this opportunity to speak to you today. As some of you may know, before joining the Commission, I was the dean of two law schools where I taught, among other things, a course on securities law. It is not surprising therefore that the topic I will address before this group of lawyers -- the level of immunity that brokerage firms should receive for statements they make on their Form U-5 filings -- raises legal as well as policy issues. In fact, the issues cut across several areas of interest to me: securities regulation, employment law principles and state common law. The Form U-5 is a very topical subject. As many of you may know, a New York State court just this week issued a TRO preventing a firm from filing a Form U-5 that the terminated associated person alleged was defamatory. That case presents slightly different issues from the ones I intend to discuss today. The Commission is reviewing the court's order and understandably I am reluctant to comment on the matter at this time. As you all know, SRO rules require a broker-dealer to file a Form U-5 -- the Uniform Termination Notice for Securities Industry Registration -- whenever one of its associated persons leaves the firm, and to disclose the reasons why the associated person left. The broker-dealer also must update the Form if it later learns of any additional information that should have been included. Before hiring any employee, the prospective firm must obtain and review the Form U-5 relating to the employee. [[1]] In recent years, a number of arbitration claims have been brought against firms and supervisors based on allegedly defamatory statements contained in sales representatives' Form U- 5s. In a few isolated cases, substantial punitive damages have been awarded against the firm where the arbitration panel concluded that the firm either intentionally or recklessly made misstatements regarding the registered representative on the Form U-5. Courts of appeals have sustained these awards in two cases: Glennon and Baravati, which I will discuss later. Understandably, firms are concerned by these defamation actions and contend that the ability of sales representatives to sue their firms over the content of the Form U-5 makes firms less candid in their reports. It is not difficult to see the looming policy issue: even though firms have a clear duty under SRO rules to file complete and candid responses on Form U-5, the manner in which they discharge that duty may be affected as concerns over litigation risk overshadow the Form's informational purposes. In theory, of course, a broker-dealer's duty to prepare an accurate Form U-5 does not expose the firm to liability since there can be no liability for telling the truth. In practice, however, the more unfavorable the statements on Form U-5, the more likely the broker-dealer is to be sued for defamation. Given this reality, absent some form of protection from civil liability, firms have ==========================================START OF PAGE 2====== an incentive to be less than frank on Form U-5 in making unfavorable reports about a problem sales representative. There is a fair degree of consensus among regulators, broker-dealers, and even courts and arbitrators that broker- dealers should be afforded some form of protection or immunity for statements made on Form U-5. But the consensus ends there. The more difficult question is how much protection should broker- dealers be given. Two approaches have been discussed: (1) absolute immunity that entails full and complete immunity for statements without consideration of motive or bad faith; and (2) qualified immunity, defined as immunity for statements made in good faith. While broker-dealers clearly favor absolute immunity, the courts are divided on the issue. About two years ago, the Commission staff released the "The Large Firm Project" report, [[2]] which discussed the immunity issue and recommended that the Commission consider finding ways to implement a uniform policy of qualified immunity for broker-dealers. [[3]] The Commission endorsed that position in subsequent congressional hearings on broker-dealer sales practice abuses. [[4]] In another report recently issued by the Commission staff in conjunction with the NASD, NYSE, and NASAA, the staff reaffirmed its view that qualified immunity is the preferable approach. [[5]] Although I remain open to other possibilities, I currently favor a qualified immunity approach. In the remainder of my remarks, I would like to discuss the prospects for a uniform immunity standard for broker-dealers for statements made on Form U-5. THE PURPOSE OF FORM U-5 The beginning point for any examination of the immunity issue must lie in the purposes of Form U-5 itself. The importance of broker-dealer candor on these termination forms cannot be understated. The Form U-5 serves not only a vital enforcement purpose but also a critical warning mechanism, alerting other broker-dealers to problem sales representatives. [[6]] The ultimate beneficiaries, of course, are the prey of the problem sales representatives -- unsuspecting investors. Broker-dealers should recognize that access to candid Form U-5 information is also very much in their own self-interest. Accurate reports assist in ridding the industry of problem sales representatives, or at least ensuring that firms have adequate notice of the potential risks and accompanying supervisory responsibilities if they hire employees with a history of sales practice problems. ==========================================START OF PAGE 3====== Three difficulties diminish the value of reports made on Form U-5. First, in some cases, broker-dealers do not attach adequate significance to the reports' vital enforcement purpose. As a result, reports may be prepared perfunctorily and may not provide the essential information sought. Second, broker-dealers may not always be fully candid, because of fears of potential lawsuits by terminated employees. In fact, a widely-held belief is that some firms supply "clean" Forms U-5 to avoid possible defamation exposure. [[7]] Finally -- and this is a problem of a different sort -- there have been recurrent charges that Form U-5 is misused by some broker-dealers to punish sales representatives with whom the broker-dealer has an unrelated employment dispute. A false report on Form U-5 to punish a sales representative is potentially as serious an abuse as withholding information about a problem sales representative. All of these problems compromise the usefulness of the reports on Form U-5. EMERGING LAW AS TO BROKER-DEALER IMMUNITY As to the litigation concern, the number of defamation claims based on allegedly false Form U-5s is relatively small, although this does not account for threatened actions that result in firms' revising their reports without litigation. Since most claims are arbitrated, the number of judicial decisions is extremely small. Publicly available files reveal approximately 55 arbitrated cases involving claims of Form U-5 defamation since 1989. [[8]] In a little more than half, plaintiffs obtained either an award or successfully compelled amendments to the Form. In a very few cases, punitive damages have been awarded. As I noted, there are only a few judicial decisions that have discussed the scope of a broker-dealer's immunity as to defamatory statements made on Form U-5. I am aware of five. It should be noted, as a preliminary matter, all courts that have addressed the issue of immunity have found that broker-dealers enjoy at least some form of immunity. The courts have disagreed, however, on whether the immunity should be absolute or qualified. The underlying legal principles governing liability in this area are relatively straightforward. Defamation is a state law tort, and defenses to that tort, alternately referred to as privileges or immunities, exist under state law. [[9]] Three privileges are potentially relevant in evaluating the potential liability of broker-dealers in completing Form U-5. One is that statements made by parties in judicial or quasi- judicial proceedings are typically absolutely immune. [[10]] Some courts have focused on this privilege as a basis for concluding that broker-dealers are entitled to absolute immunity. Another privilege is the one which extends to a former employer who gives a prospective employer information about a former employee. This privilege, however, affords the speaker only qualified immunity in most states and thus is lost if the ==========================================START OF PAGE 4====== employer deliberately lies or recklessly disregards the truth. [[11]] A final privilege which should be considered is the one for communications made pursuant to a legal requirement or other reports made to public officials. Courts have not addressed whether this privilege is applicable to broker-dealers, or whether absolute or qualified immunity would be appropriate if it is. [[12]] In three decisions, federal courts of appeal sustained arbitral awards against broker-dealers. In each case, the award had been based on a finding of bad faith on the part of the firm, and the courts concluded that the broker-dealer was entitled only to qualified immunity. The Seventh Circuit's decision in Baravati v. Josephthal, Lyon & Ross, [[13]] which was authored by Chief Judge Posner, is likely to be regarded as especially influential. In that case, a sales representative reported certain fraudulent practices to his firm regarding the underwriting of a public stock offering and also reported the conduct to the SEC. The firm terminated him and on his Form U-5 stated Baravati was under investigation by the firm for the fraudulent and wrongful taking of money owed to the firm. Baravati claimed in his arbitration action that the defamatory statements were made in retaliation for his reporting the fraud to the SEC. The arbitration panel agreed and held for Baravati, awarding him compensatory as well and punitive damages for "unconscionable language in the U-5 form." [[14]] Judge Posner, writing for the panel, rejected the firm's contention that it was entitled to absolute immunity, holding instead that, under Illinois law, only qualified immunity applied. The panel expressed the view that the statements in question were not judicial or quasi-judicial communications and noted misgivings that a policy of absolute immunity "would be tantamount to allowing a member of the NASD to blackball a former employee from employment throughout" the industry. [[15]] Just last month, the Sixth Circuit, in Glennon v. Dean Witter Reynolds, reached a similar conclusion, applying Tennessee law. [[16]] Meanwhile two courts have concluded that statements made on Form U-5 are entitled to absolute immunity. In Herzfeld & Stern v. Beck, [[17]] an intermediate New York state appellate court concluded that statements required by Form U-5 are made in connection with a quasi-judicial proceeding and, therefore, are absolutely privileged. As I have already noted, the courts in both Glennon and Baravati specifically rejected this characterization of the Form U-5 reports. In Culver v. Merrill Lynch, [[18]] the plaintiff, a sales agent, alleged that he had reported to "appropriate authorities" that the firm had "cheated" one of its trading clients on a loan. He further alleged that he was fired in retaliation for his "whistleblowing" ==========================================START OF PAGE 5====== and falsely blamed for the improper conduct. The federal district court dismissed the plaintiff's defamation action as a matter of law without reaching the merits, based entirely on Herzfeld (which the district court viewed as the most authoritative indication of New York state law). SOME OBSERVATIONS ON THE DEBATE I have three basic observations on the qualified-or- absolute-immunity debate. First, as I noted earlier, I believe the Commission should continue to favor a policy of qualified immunity with respect to statements made on Form U-5. Courts that have endorsed a policy of absolute immunity have, in my opinion, gone too far. Herzfeld ultimately rests on the view that Form U-5 is quasi-judicial in nature. The vast majority of Form U-5 filings, however, do not result in investigations or disciplinary proceedings. Moreover, the Form serves purposes for potential employers and regulatory authorities independent of its role in triggering investigations. Even if courts were to regard Form U-5 as a required governmental filing, I believe there is sufficiently compelling precedent to find that any resulting immunity is qualified rather than absolute. [[19]] Instead I find myself swayed by Judge Posner's observation that, absent safeguards, such as civil liability, the risks of broker-dealer abuse are too great and the consequences for associated persons too onerous to provide absolute immunity for Form U-5s. Regulators should proceed cautiously before establishing a system that would insulate intentional retaliatory conduct from review. In addition, toleration of such conduct ultimately could frustrate other legitimate law enforcement objectives. Indeed, in Baravati, at least according to the facts as found by the arbitrators, the associated person claimed that the defamatory statements made on Form U-5 were in retaliation for reporting improper conduct at the firm. Cases like Baravati where punitive damages have been awarded underscore, from my perspective, why it would be unwise to move to a regime of absolute immunity. Second, I have some concerns about the potential lack of uniformity on the immunity issue across state jurisdictions. Currently, courts are treating the issue of broker-dealer immunity as a state law question. This raises the possibility of different immunity standards in the various state jurisdictions. Indeed, such a situation has already begun to emerge, although the New York Court of Appeals has yet to provide definitive guidance on the correct standard under New York law. While the debate among state courts is useful in developing a legal consensus on the immunity question, my preference, which I hope the securities industry would share, is for a uniform standard. ==========================================START OF PAGE 6====== If one does not take shape at the state level, it would eventually become necessary to consider whether federal legislative or regulatory action is necessary to bring about a uniform standard. Third, in discussing the immunity issue we must not lose sight of the ultimate regulatory objective: firms are required to provide candid and timely disclosure on Form U-5s. Regardless of how the immunity debate plays out, firms have a strict responsibility to provide candid statements of the reasons for terminating an employee. Firms have been held civilly liable for subsequent acts committed by a problem sales representative at another firm when they conceal the sales representative's history from the latter firm. [[20]] In addition, a knowing failure to identify problem sales representatives may also lead to disciplinary action. I for one would hope to see strong disciplinary action by an SRO against any firm that is deficient in discharging its Form U-5 reporting obligations where the deficiencies enable a registered representative to defraud customers at another firm. WHAT'S NEXT? What, if anything, needs to be done to bring the qualified- or-absolute-immunity debate to a fruitful conclusion? For the time being, regulators and brokerage firms appear to be waiting for courts to resolve the debate. I confess a degree of academic interest in whether the Herzfeld principle will be sustained if the New York Court of Appeals ultimately considers the issue. The Commission, at least so far, has not sought to appear as amicus curiae in any case on this issue, although of course that is always a possibility. If the pendulum begins to swing in favor of absolute immunity, the Commission may need to consider whether to act. The Commission has indicated previously its willingness to work with the brokerage community on regulatory or legislative initiatives that would codify a uniform standard of qualified immunity. Such an approach might be accomplished in several ways: ù The Commission could encourage SROs to require that associated persons, as a condition of association with a broker-dealer, waive future defamation claims against broker-dealers for statements made in good faith on Form U-5. This would involve extending the current waiver contained in Form U-4 to cover prospective defamation claims. [[21]] ==========================================START OF PAGE 7====== ù The Commission could adopt a rule specifically requiring the filing, with SROs, of reports comparable to the current Form U-5. In connection with the promulgation of such a rule, the Commission could expressly state that federal policy immunizes statements made in good faith on such reports from liability under state law. ù Finally, we at the Commission could seek legislation that would statutorily codify a qualified immunity standard. The Fair Credit Reporting Act provides an example of such a statutory provision. Another proposal worthy of consideration was submitted to the Commission recently by Stephen Hammerman, Vice Chairman at Merrill Lynch. [[22]] As an alternative to affording broker-dealers with absolute immunity, he suggests a procedure in which disputes involving the termination language on Form U-5 be resolved by an arbitrator prior to the Form's dissemination. The arbitrator could affirm or modify the U-5 language, and the decision would preclude seeking other redress based upon the original or modified language. The proposal has some advantages and drawbacks. It would resolve disputes over Form U-5 language quickly, which would facilitate the ability of associated persons to move to another firm in the event of a dispute. In addition, by eliminating the threat of continued liability, broker-dealers might be encouraged to provide more candid reports. Still, the proposal could compromise the purpose of the Form U-5 by shifting the responsibility for accuracy of the Form U-5 from broker-dealers to arbitrators. Another concern is that the proposal would severely limit the ability of associated persons to seek remedies relative to the status quo: associated persons would in effect be subject to a truncated statute of limitations (essentially five days in which to seek review). Nevertheless, the proposal represents an interesting approach that potentially could be modified to eliminate some of the weaknesses. * * * In conclusion, I would like to thank you for inviting me to share my views in this area; I am sure in the coming year the Commission will have an opportunity to explore these issues further with the securities industry and the securities bar. I look forward to working with this group and receiving your input on this and other issues during my tenure at the Commission. ==========================================START OF PAGE 8====== ENDNOTES [[1]] See, e.g., NASD By Laws, Art. IV, Section 3; NYSE Rule 345. [[2]] See Divisions of Market Regulation and Enforcement, U.S. Securities and Exchange Commission, The Large Firm Project: A Review of Hiring, Retention and Supervisory Practices (May 1994) [hereinafter cited as the "Report"]. [[3]] See Report at 10. [[4]] Hearings on Rogue Brokers Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, 103d Cong., 2d Sess. 6, 18-19 (Sept. 14, 1994) (statement of Arthur Levitt, Jr., Chairman, U.S. Securities and Exchange Commission). [[5]] National Association of Securities Dealers, Inc., New York Stock Exchange, Inc., North American Securities Administrators Association, Inc., Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, The Joint Regulatory Sales Practice Sweep: A Review of the Sales Practice Activities of Selected Registered Representatives and the Hiring, Retention, and Supervisory Practices of the Brokerage Firms Employing Them at A-5 (Mar. 1996). [[6]] See Anne H. Wright, Form U-5 Defamation, 52 Wash. & Lee L. Rev. 1299, 1300 (1995) [hereinafter cited as Form U- 5 Defamation] ("for over a decade [the Form U-5] has existed * * * to offer regulators and potential employers a means of identifying problem representatives"). See also Hearings on Rogue Brokers Before the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and Commerce, 103d Cong., 2d Sess. 63-87 (Sept. 14, 1994) (statement of Edward A. Kwalwasser, Executive Vice President, Regulation, New York Stock Exchange) (filings on Form U-5 and similar Exchange Form RE-3 are the primary sources of notice to the Exchange of sales practice abuses). [[7]] See Form U-5 Defamation at 1301. [[8]] See Form U-5 Defamation at 1309. ==========================================START OF PAGE 9====== [[9]] See generally Restatement (Second) of Torts  558 (1977). [[10]] See generally Restatement (Second) of Torts  558-612; S. Speiser, C. Krause & A. Gans, The American Law of Torts  29:87, at 595;  29:88, at 602. See, e.g., Swanson v. Bixler, 750 F.2d 810, 814 (10th Cir. 1984) (applying Colorado law, statements made when seeking a temporary restraining order and conservatorship in a court proceeding). Cf. Imbler v. Pachtman, 424 U.S. 409, 431 (1976) (state prosecutor absolutely immune from liability under 42 U.S.C.  1983 in initiating and prosecuting the state's case). [[11]] E.g., Mittelman v. Witous, 552 N.E.2d 973, 981 (Ill. 1989) (former law firm associate sufficiently alleged actual malice in defamation action against law firm partner by averring, among other things, that partner knew it was false to blame associate for lost cases in order to protect partner's own reputation). See generally Restatement (Second) of Torts  600 (employers that act with an improper purpose, such as retaliation or the desire to avoid personal embarrassment, lose the privilege). [[12]] See Restatement (Second) of Torts  592A ("[o]ne who is required by law to publish defamatory matter is absolutely privileged to publish it"). See, e.g., Weber v. Cueto 568 N.E.2d 513 (Ill. App. Ct.), appeal denied, 575 N.E.2d 925 (Ill. 1991) (absolute immunity for attorney who alleged that another attorney had improperly used funds in a letter to state authorities required under state's disciplinary rules); Circus Circus Hotels, Inc. v. Witherspoon, 657 P.2d 101 (Nev. 1983) (Nevada statute conferred absolute immunity on communications from an employer to the Employment Security Department, an administrative body). But see Slaughter v. Friedman, 649 P.2d 886 (Cal. 1982) (absolute immunity applies only to statement made by government official discharging an official duty; qualified immunity applies to statement required by law from private person; expressly rejecting Section 592A of the Restatement (Second) of Torts); Moore & Assoc's. v. Metropolitan Life Ins. Co., 604 S.W.2d 487 (Tex. Ct. App. 1980) (same). A related provision of the Restatement provides only qualified immunity for statements made to public officials. See Restatement (Second) of Torts  598 comment e; Hutchinson v. New England Tel. & Tel. Co., 214 N.E.2d 57 (Mass. 1966) (communications to police in the course of investigation are entitled to qualified immunity). ==========================================START OF PAGE 10====== [[13]] 28 F.3d 704 (7th Cir. 1994), aff'g, 834 F. Supp. 1023 (N.D. Ill. 1993). [[14]] Baravati, 834 F. Supp. at 1029. [[15]] Baravati, 28 F.3d at 708. [[16]] No. 95-5257, 1996 WL 224000 (6th Cir. 1996), aff'g, No. 3-93-0847, 1994 WL 757709 (M.D. Tenn. Dec. 15, 1994). In addition to Baravati and Glennon, the Second Circuit, in Fahnestock & Co. v. Waltman, 935 F.2d 512, 516 (2d Cir.), cert. denied, 502 U.S. 942 (1991), assumed that qualified immunity was the correct standard under New York law. Accordingly, the court declined to extend the doctrine of absolute immunity to statements on Form U-5 and found that the arbitrators appeared to have "sufficient grounds to find that no qualified privilege attached" to the filing of the Form U-5 in view of evidence that the statements therein reflected "flagrantly spiteful conduct." Because the decision involved an extremely deferential standard of review for questions of law and fact underlying arbitral awards, the decision does not actually resolve whether absolute immunity might apply in such situations. [[17]] 572 N.Y.S.2d 683, 685 (N.Y. App. Div. 1991), lv. dismissed, 79 N.Y.2d 914 (N.Y. 1992). [[18]] [1995 Transfer Binder] Fed. Sec. L. Rep. (CCH) 98,811 (S.D.N.Y. July 17, 1995). [[19]] See n.12. [[20]] See, e.g., Twiss v. Kury, 25 F.3d 1551 (11th Cir. 1994); Palmer v. Shearson Lehman Hutton, Inc., 622 So. 2d 1085 (Fla. Ct. App. 1993). [[21]] Form U-4 contains a provision in which the associated person releases any employer or former employer from liability for furnishing information to a prospective employer regarding the reasons for the employee's termination. See Form U-4 Item 8. The language appears to limit liability to reasons for termination by former or current employers rather than liability for statements in the future by the prospective employer. [[22]] See Letter from Stephen L. Hammerman, Vice Chairman, Merrill Lynch & Co., Inc., to Arthur Levitt, Jr., Chairman, U.S. Securities and Exchange Commission 7-8 (Oct. 2, 1995).