[Federal Register Volume 63, Number 81 (Tuesday, April 28, 1998)]
[Notices]
[Pages 23321-23324]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-11211]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39892; File No. SR-NASD-98-18]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by National Association of Securities Dealers, Inc. Relating to 
Qualified Immunity in Arbitration Proceedings for Statements Made on 
Forms U-4 and U-5

April 21, 1998.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ notice is hereby given that on April 21, 1998, NASD 
Regulation, Inc. (``NASD Regulation'') filed with the Securities and 
Exchange Commission (``SEC'' or ``Commission'') the proposed rule 
change as described in Items I, II, and III below, which Items have 
been prepared by NASD Regulation. The Commission is publishing this 
notice to solicit comments on the proposed rule change from interested 
persons.
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    \1\ 15 U.S.C. Sec. 78s(b)(1).
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I. Self-Regulatory Organization's Statement of the Terms of 
Substance of the Proposed Rule Change

    NASD Regulation is proposing to add a new rule to the Rules of the 
National Association of Securities Dealers, Inc. (``NASD'' or 
``Association''), to provide members of the NASD with qualified 
immunity in arbitration proceedings for statements made in good faith 
in certain disclosures filed with the NASD on Forms U-4 and U-5, the 
uniform registration and termination notices for registered persons. 
Below is the text of the proposed rule change.
    Proposed new language is in italics.
* * * * *

Rule 1150. Regulatory Form Disclosures

(a) Mandatory Disclosures

    A member must make truthful and accurate statements on the covered 
forms required under Article V, Sections 2 and 3 of the By-Laws.

(b) Qualified Immunity

    (1) This paragraph shall apply to any arbitration proceeding 
between a member or other party and a covered person relating to 
statements made in response to an information requirement of a covered 
form with respect to such covered person, to the extent that such 
statements are contained in a covered form that has been or, at a 
subsequent point in time, is (A) filed with a regulatory authority or 
self-regulatory organization, and (B) disseminated by reason of such 
filing, or otherwise disseminated orally, in writing, or through any 
electronic medium to an appropriate person.
    (2) A defending party shall not be liable in a proceeding to a 
covered person for any defamation claim related to an alleged untrue 
statement that is contained in a covered form if the statement was true 
at the time that the statement was made.
    (3) A defending party shall not be liable in a proceeding to a 
covered person for any defamation claim related to an alleged untrue 
statement that is contained in a covered form unless the covered person 
shows by clear and convincing evidence that:
    (A) the defending party knew at the time that the statement was 
made that it was false in any material respect; or
    (B) the defending party acted in reckless disregard as to the 
statement's truth or falsity.

(c) Definitions

    For purposes of this Rule:
    (1) The term ``appropriate person'' means any federal or state 
governmental or regulatory authority, and self-regulatory organization, 
any employer or prospective employer of a covered person, or any person 
who requests or is required to obtain information concerning the 
covered person from the defending party and as to whom the defending 
party has a legal obligation to provide such information.
    (2) The term ``claim'' means any claim, counterclaim, third-party 
claim, or cross-claim.
    (3) The term ``covered form'' means any form or notice required 
under

[[Page 23322]]

Article V, Sections 2 and 3 of the By-Laws, including Forms U-4 and U-
5. Disclosure Reporting Pages, and related explanatory materials.
    (4) The term ``covered person'' means any present or former 
registered person or other employee of a member who is a party to a 
proceeding relating to a dispute within the scope of this Rule.
    (5) The term ``defending party'' means any member who is a party to 
a proceeding and who is adverse to a covered person who is a party, and 
any associated person of such member.
    (Rule 1150 is effective beginning on (Date) 1998 and ending on 
(Date) 2002, and applies to claims relating to any covered forms, as 
defined in Rule 1150, that are filed during that period.)
* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with Commission, NASD Regulation included statements 
concerning the purpose of, and statutory basis for, the proposed rule 
change and discussed any comments it received on the proposed rule 
change. The text of these statements may be examined at the places 
specified in Item IV below. NASD Regulation has prepared summaries, set 
forth in Sections A, B, and C below, of the most significant aspects of 
such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    Summary. The proposed rule is designed to deal with the prospect 
that member firms may be reluctant to make complete disclosures on 
forms required to be filed with the NASD because of the potential for 
lawsuits relating to defamation claims by former or present employees. 
The proposed rule would create a uniform qualified immunity standard 
for statements made in good faith in certain disclosures filed with the 
NASD on Forms U-4 and U-5. To overcome this qualified immunity, a 
registered person would have to prove in an arbitration proceeding by 
clear and convincing evidence that the member firm knew at the time the 
statement was made that it was false in any material respect, or that 
the member acted in reckless disregard to the statement's truth or 
falsity. For purposes of NASD arbitration, the rule would supersede 
state law on the same subject.
    Background. This issue arises primarily in the context of filings 
made on Form U-5 following termination of employment of a registered 
person. The NASD By-Laws (Article V, Section 3) require that the member 
give notice of the termination to the NASD within 30 days after the 
termination, and that the member provide a copy simultaneously to the 
registered person. The By-Laws also require that the member notify the 
NASD, and send a copy to the registered person, within 30 days if the 
member learns of facts or circumstances causing any information in the 
prior notice to become inaccurate or incomplete.
    Form U-5, which is entitled the ``Uniform Termination Notice for 
Securities Industry Registration,'' is a form used throughout the 
securities industry at both the federal and state level. It requires 
that the member indicate the reason for the termination by checking one 
of the blocks labeled Voluntary, Deceased, Permitted to Resign, 
Discharged, or Other. If one of the last three blocks is checked, the 
member must provide an explanation. Regardless of the block checked, 
the member also must indicate whether the registered person, during the 
period of his or her association with the member, was involved in 
certain types of disciplinary actions, the subject of a customer 
complaint, convicted of certain crimes, or under investigation or 
internal review.
    In recent years, registered persons have brought, primarily in 
arbitration, a number of defamation \2\ claims for allegedly untrue or 
misleading statements made on the Form U-5.\3\ Because of the financial 
interests at issue the potential for substantial damages may exist in a 
number of cases. The NASD believes that the potential for liability, or 
for inconsistent standards of liability, is a significant disincentive 
for firms to provide full and fair disclosure. Failure to make full 
disclosure of disciplinary problems has the potential to compromise the 
integrity of the Central Registration Depository, and hinders 
enforcement action by the NASD and other regulators. At the same time, 
the NASD believes it is important that any solution provide adequate 
protection to employees from statements designed to penalize unfairly a 
departing employee, or to prevent him or her from obtaining new 
employment or attracting existing customers to another member firm 
where the person has subsequently become employed.
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    \2\ ``Defamation'' has been defined as an ``intentional false 
communication, either published or publicly spoken, that injures 
another's reputation or good name.'' Black's Law Dictionary 417 (6th 
ed. 1990). ``Libel'' (written defamation) and ``slander'' (spoken 
defamation) are both methods of defamation. Id at 1388.
    \3\ Defamation claims may also arise with respect to disclosures 
on Form U-4, which is required to be filed by registered persons 
upon the occurrence of certain events, but which in practice is 
often drafted by the member firm with which the individual is 
associated.
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    Development of the Rule Proposal. The NASD met periodically during 
1997 to discuss defamation issues with representatives of member firms, 
the Securities Industry Association, the New York Stock Exchange 
(``NYSE''), the North American Securities Administrators Association, 
and attorneys who often represent registered representatives in court 
litigation and in arbitration proceedings.
    Many members of the industry favored a regulatory standard 
providing for absolute immunity. Most state court decisions that have 
considered this issue in the Form U-5 or in similar contexts have 
adopted a qualified immunity standard. However, one New York state 
court decision has expressly recognized an absolute immunity standard 
with respect to statements contained in the Form U-5.\4\ Those states 
that, by court decision or statute, have adopted a qualified immunity 
standard in the same or similar contexts, require that falsity or 
recklessness be proved either by ``preponderance of the evidence'' or 
by ``clear and convincing evidence,'' as discussed below.
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    \4\ Herzfeld & Stern, Inc. v. Beck, 572 N.Y.S.2d 683 (N.Y. App. 
Div. 1991), appeal dismissed, 79 N.Y.2d 917 (1992). The court 
reasoned that federal law had established a comprehensive system of 
oversight and self-regulation by the NYSE in order to ensure 
adherence by members of the industry to both the statutory mandates 
and ethical standards of the profession, and concluded that the 
NYSE's disciplinary function conforms to the requirements of a 
quasi-judicial administrative proceeding. Therefore, statements made 
on a Form U-5 and later used as the basis for an NYSE investigation 
were considered ``statements uttered in the course of a judicial or 
quasi-judicial proceeding [which are] absolutely privileged so long 
as they are material and pertinent to the questions involved 
notwithstanding the motive with which they are made.'' Id. at 683. 
But see Fleet Enterprises, Inc. v. Velinsky, No. 604462/96 (N.Y. 
Sup. Ct. Jan. 16. 1997), in which a lower court in New York rejected 
a brokerage firm's petition, on absolute privilege grounds, to stay 
the arbitration of Form U-5 defamation claims, and ordered 
arbitration to proceed, applying the Federal Arbitration Act as to 
the issue of arbitrability. The court stated that ``whether New York 
substantive law will apply to Velinsky's claims in arbitration is 
for the arbitrator to decide.'' Slip op. at 5. See also Fahnestock & 
Co., Inc. v. Waltman, 935 F.2d 512 (2d Cir. 1991); Culver v. Merrill 
Lynch & Co., Inc., 1995 U.S. Dist. Lexis 10017 (S.D.N.Y. 1995).
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    In order to obtain as many views as possible, the NASD published a 
draft of the proposed rule change in a Notice to Members (``NTM 97-
77'') that was mailed to member firms and other subscribers, and was 
also posted on the NASD Regulation Web site and sent to a group of 
attorneys who represent employees, to registered representatives

[[Page 23323]]

groups, and to others. That proposal included a provision that would 
require member firms to give notice of the contents of a Form U-5 (and 
amendments) to the subject of the form at least ten days prior to 
filing the form, and would require members to provide immediate 
notification to employees of material revisions to be filed on Form U-
5. Fifty-three comments were received and considered by the NASD. The 
advance notice provision was the subject of almost universal criticism, 
as described below. A revised proposal was approved by the NASD 
Regulation and NASD Boards in January 1998.
    Details of the Proposed Rule. The proposal rule would provide that 
members and associated persons will not be liable to an employee for a 
claim that is related to an alleged untrue statement contained in Form 
U-4 or U-5 pertaining to the employee, unless the employee can prove by 
clear and convincing evidence that the defending party knew that the 
statement was false in any material respect, or acted in reckless 
disregard as to its truth or falsity.
    As noted above, state law standards generally provide for some type 
of qualified immunity for statements of the type that are required by 
the covered forms, and therefore the rule may not represent a 
substantial change in the standard that would apply in a given case, 
but will instead provide a uniform standard to which parties and 
arbitrators can look for guidance. NASD Regulation in concerned, 
however, that the proposal not signal a willingness to tolerant false 
or malicious statements by member firms with respect to their 
employees, either through disclosures on the covered forms or through 
other venues. Any such statements clearly violate the obligation of 
members to provide accurate information to NASD Regulation and are 
inconsistent with just and equitable principles of trade.
    In particular, NASD Regulation is concerned with the potential that 
disclosures contained on covered forms may be used deliberately by one 
member to limit the mobility of registered persons who have determined 
to find employment with another member, or to delay the effectiveness 
of the transfer of employment.\5\ As noted, such conduct would be 
grounds for disciplinary action, and during the rule's pilot period, 
NASD Regulation intends to consider and investigate evidence of misuse 
of covered forms other forms, or regulatory processes for improper 
purpose. In addition, NASD Regulation will provide a mechanism through 
its Internet Web Site to obtain input from employees, member firms, and 
others as to the operation of the pilot program and to report potential 
abuses. To the extent that NASD Regulation determines that misuse of 
regulatory processes has increased during the pilot period, it may 
determine to modify or terminate the rule prior to the end of that 
period. Finally, NASD Regulation will provide training to arbitrators 
to ensure that they are cognizant of these concerns, that they 
understand the application of the rule, and that the rule is applied 
only with respect to appropriate types of claims.\6\
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    \5\ NASD Rule 10335 of the Code of Arbitration Procedure 
contains special provisions for injunctive relief in circumstances 
where fast interim relief is necessary.
    \6\ Because the rule as proposed would apply only to claims for 
defamation, it would not affect other claims, e.g., tortuous 
interference with contractual relations, to the extent that such 
claims would constitute substantially different causes of action and 
not merely recharacterization of defamation claims.
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    Paragraph (a) of the proposed rule states that members must provide 
truthful and accurate statements in response to the information 
requirements of the forms required under Sections 2 and 3 of Article V 
of the Association's By-Laws, i.e., Forms U-4 and U-5 and attachments 
to those forms. This paragraph make clear that the purpose of the 
proposed rule is to further the goal of accurate disclosure, and is 
intended to reaffirm the existing disclosure obligation of NASD members 
as set forth in the By-Laws. The word ``complete'' was deleted from the 
draft version of the proposed rule, to address the concern of some 
commenters that this language could be construed as adding a new but 
vague requirement of ``completeness'' and could create liability beyond 
that contemplated by the By-Laws.
    The proposed rule would apply to statements made on ``covered 
forms.'' Covered forms are defined in paragraph (c)(3) to include forms 
or notices required under Article V, Sections 2 and 3 of the By-Laws, 
including Disclosure Reporting Pages and other explanatory materials 
attached to the forms or notices. Although the area of greatest focus 
has involved the filing of Form U-5 in connection with employee 
terminations, members of the industry have indicated that required 
disclosures pertaining to employees on Form U-4 provide the same 
potential for liability, and NASD Regulation believes that the same 
regulatory interests in complete disclosure apply to statements on that 
form. The rule would apply to statements made by a member firm on a 
covered form with respect to a present or former employee of the firm. 
The rule would also apply to the liability of both member firms and 
associated persons, and accordingly would apply to both the signatory 
of the form or other persons involved in the preparation of the form as 
well as the member itself.
    The rule as proposed in NTM 97-77 would have required members to 
provide employees with copies of proposed language on Form U-5 
describing the reason for termination at least ten days before the 
filing of the form or an amendment to the form. In addition, members 
would have been required to provide to the employee immediate notice of 
revisions to the proposed language. The purpose of these provisions was 
to provide employees with an opportunity to seek amended disclosure 
language when they could demonstrate obvious inaccuracies.
    After further review, NASD Regulation has determined to delete 
these provisions in light of the comments received. The comments of 
both members and registered representatives were overwhelmingly 
negative with regard to this part of the proposal. Many commenters 
expressed the view that these provisions would lead to ``negotiated'' 
or ``watered down'' disclosure, and some suggested that it could 
compromise ongoing internal investigations. Some commenters stated that 
the period was too short for meaningful review of the Form U-5, while 
other commenters felt that the period was too long in that it left 
broker/dealers only 20 days within which to prepare the forms and mail 
them to employees, since Form U-5 must be filed with the NASD within 30 
days after termination. Some commenters pointed out that employees 
already have an opportunity to comment on certain reportable events 
through filing of an amended Form U-4.
    The proposed rule would provide qualified protection to statements 
only to the extent that they are contained in a covered form that has 
been or, at a subsequent point in time, is filed with any federal or 
state regulatory authority, or self-regulatory organization, and are 
disseminated to ``appropriate persons.'' Therefore, oral statements are 
covered by the qualified immunity only to the extent that they track 
language that is already or later incorporated into the covered form. 
In this context, paragraph (c)(1) of the proposed rule defines 
``appropriate persons'' to include, in addition to regulatory 
organizations, current or prospective employers and others who 
affirmatively request information concerning the employee

[[Page 23324]]

and as to whom the member has an obligation to provide the information. 
The latter provision is designed to ensure that the rule would apply to 
requests from persons as to whom applicable legal standards require the 
disclosure of the information.
    Paragraph (b)(2) of the proposed rule provides that a defending 
party shall not be liable for a defamation claim if the statement was 
true at the time that the statement was made. As noted above, Article 
V, Section 3 of the NASD By-Laws already requires that the member 
notify the NASD, and send a copy to the registered person, within 30 
days if the member learns of facts or circumstances causing any 
information in the prior notice to become inaccurate or incomplete.
    Paragraph (b)(3) of the proposed rule contains the basic legal 
standard found in federal and state court decisions that recognize a 
qualified immunity in various contexts. The courts do not, however, 
consistently define the burden of proof that a plaintiff must meet in 
order to show that a false statement was made knowingly or recklessly. 
Some decisions apply the ``preponderance of the evidence'' standard 
that most commonly applies to claims and defenses in civil litigation. 
Others apply a stricter ``clear and convincing'' standard. In some 
cases, decisions in the same jurisdiction conflict on this point. The 
NASD believes that, because no one standard is dominant, the standard 
applied should be the one that will reach best the goals to which the 
proposed rule is addressed. The NASD has determined that the ``clear 
and convincing'' standard provides a good balance, in that it provides 
some protection to member firms against defamation claims for 
statements they are required to provide, while still providing that 
members are liable for clear cases of abusive or malicious disclosure.
    NTM 97-77 asked for comment as to whether NASD Regulation should 
seek to provide a mandatory pre-filing or arbitration procedure to 
resolve termination disputes prior to the 30-day period following 
termination in which the Form U-5 is required to be filed. Most of the 
comments addressing this issue suggested that such a procedure could 
not effectively resolve disputes within this time frame. NASD 
Regulation has determined that a mandatory procedure would raise too 
many difficult practical and timing issues to be useful, but will 
endeavor to provide mediators on an expedited basis when both parties 
are interested in resolving disputes at an early stage.
    The proposed rule would apply for a pilot period of four years. 
Prior to the end of that period, the staff will review a sample of 
filings made during the period of the rule's effectiveness to attempt 
to gauge the nature and quality of disclosure that has been provided, 
in contract with forms filed prior to the pilot period.
2. Statutory Basis
    NASD Regulation believes that the proposed rule change is 
consistent with the provisions of Section 15A(b)(6) of the Act, which 
requires, among other things, that the Association's rule must be 
designed to prevent fraudulent and manipulative acts and practices, to 
promote just and equitable principles of trade, and, in general, to 
protect investors and the public interest. The NASD believes that the 
proposed rule change will encourage fuller disclosure by member firms 
of any regulatory problems concerning a registered representative and 
thus provide more complete information to the investing public through 
the Public Disclosure Program and to other broker/dealers through the 
Central Registration Depository.

B. Self-Regulatory Organization's Statement on Burden on Competition

    NASD Regulation does not believe that the proposed rule change will 
result in any burden on competition that is not necessary or 
appropriate in furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in NASD Notice 
to Member 97-77 (November 1977). Fifty-three comments were received in 
response to the Notice.

III. Date of Effectiveness of the Proposed Rule Change and Timing 
for Commission Action

    Within 35 days of the date of publication of this notice in the 
Federal Register or within such longer period (i) as the Commission may 
designate up to 90 days of such date if it finds such longer period to 
be appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve such proposed rule change, or
    B. Institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning for foregoing, including whether the proposed rule 
change is consistent with the Act. Persons making written submissions 
should file six copies thereof with the Secretary, Securities and 
Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549. 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refer to file number SR-NASD-98-18 and 
should be submitted by May 19, 1998,

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\7\
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    \7\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 98-11211 Filed 4-27-98; 8:45 am]
BILLING CODE 8010-01-M