[Federal Register Volume 64, Number 175 (Friday, September 10, 1999)]
[Notices]
[Pages 49256-49261]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-23610]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-41833; File No. SR-NASD-99-07]


Self-Regulatory Organizations; Order Granting Approval to 
Proposed Rule Change by the National Association of Securities Dealers, 
Inc. Creating a Discovery Guide for Use in NASD Arbitrations

September 2, 1999.

I. Introduction

    On January 29, 1999, the National Association of Securities 
Dealers, Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary NASD Regulation, Inc. (``NASD Regulation''), filed with the 
Securities and Exchange Commission (``SEC'' or ``Commission'') a 
proposed rule change pursuant to Section 19(b)(1) of the Securities 
Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 thereunder.\2\ Under 
its

[[Page 49257]]

proposal, NASD Regulation seeks to create a discovery guide for use in 
NASD arbitrations. Notice of the proposal, as amended by Amendment No. 
1 and Amendment No. 2, was published in the Federal Register on April 
23, 1999 (``Notice'').\3\ The Commission received eight comment letters 
on the filing.\4\
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
    \3\ See Securities Exchange Act Release No. 41302 (April 16, 
1999), 64 FR 20036 (File No. SR-NASD-99-07).
    \4\ See letters from Cliff Palefsky, National Employment Lawyers 
Association (``NELA''), to Secretary, Commission, dated May 4, 1999 
(``NELA Letter''); Barbara Black, Professor of Law, to Secretary, 
Commission, dated May 13, 1999 (``Black Letter''); Mark E. Maddox, 
Public Investors Arbitration Bar Association (``PIABA''), to 
Jonathan G. Katz, Secretary, Commission, dated May 18, 1999 (``PIABA 
Letter''); Linda P. Drucker, Charles Schwab & Co. Inc. (``Schwab''), 
to Jonathan G. Katz, Secretary, Commission, dated May 14, 1999 
(``Schwab Letter''); Stephen G. Sneeringer, Securities Industry 
Association (``SIA''), to Jonathan G. Katz, Secretary, Commission, 
dated May 14, 1999 (``SIA Letter''); Paul L. Matecki, Raymond James 
& Associates, Inc. (``Raymond James''), to Jonathan G. Katz, 
Secretary, Commission, dated May 14, 1999 (``Raymond James 
Letter''); Norman S. Poser, Professor of Law, to Secretary, 
Commission, dated May 13, 1999 (``Poser Letter''); Dan Jamieson, to 
Jonathan G. Katz, Secretary, Commission, dated June 1, 1999 
(``Jamieson Letter'').
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II. Description of the Proposal

    NASD Regulation proposes to create a Discovery Guide to streamline 
the discovery process in NASD arbitrations involving customers. The 
Discovery Guide, which contains Document Production Lists, provides 
parties to an arbitration proceeding guidance on which documents they 
should exchange without arbitrator or NASD Regulation staff 
intervention. Further, the Discovery Guide provides arbitrators with 
guidance in determining which documents should be produced by customers 
and member firms or associated persons in customer arbitrations.
    The Discovery Guide, which includes the Document Production Lists, 
is intended to function as a guide for parties and arbitrators in the 
discovery process. It is not intended to bind arbitrators or parties in 
a particular case. Further, nothing in the Discovery Guide precludes 
parties from voluntarily agreeing to an exchange of documents in a 
manner or scope different from that set forth in the Discovery Guide or 
Document Production Lists. In addition, any party can make a motion 
objecting to the production of particular documents included on the 
applicable Document Production List(s) in any arbitration proceeding. 
Likewise, any party can request that additional documents, not included 
on any of the Document Production Lists, be produced. However, if an 
arbitrator directs compliance with the Discovery Guide in connection 
with ordering the production of documents, the order, like any other 
document production order, is binding on the parties.

Background

    The Discovery Guide is a consensus document that was developed over 
a two-year period. In January 1996, the Arbitration Policy Task Force 
(``Task Force'') chaired by former Commission Chairman David Ruder 
recommended that ``[a]utomatic production of essential documents should 
be required for all parties, and arbitrators should play a much greater 
role in directing discovery and resolving discovery disputes.'' \5\ 
Based on Task Force recommendations, the NASD's National Arbitration 
and Mediation Committee, together with advisors from various diverse 
backgrounds, helped to draft the Discovery Guide in an effort to 
implement these recommendations. Among those contributing to the 
Discovery Guide were persons who are members of the Securities 
Industries Conference on Arbitration (``SICA'') \6\, members of SIA, 
directors of PIABA, industry representatives, representatives from 
major broker-dealers, counsel for claimants, and counsel for the 
industry. The Discovery Guide reflects a compromise between the various 
interests of the drafters.
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    \5\ See Securities Arbitration Reform: Report of the Arbitration 
Policy Task Force to the Board of Governors of NASD (``Task Force 
Report'') at 2.
    \6\ SICA was formed to develop and maintain a Uniform Code of 
Arbitration and to provide a forum for the discussion of new 
developments in securities arbitration among arbitration self-
regulatory organization (``SRO'') forums and participants in those 
forums. The membership includes representatives from the SROs with 
securities arbitration forums, three or four ``public'' members, and 
a representative from the SIA.
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Discovery Guide Features

    NASD Regulation proposes that the Discovery Guide be used as a 
supplement or an addendum to the guidance regarding discovery set forth 
in The Arbitrator's Manual, published by SICA, and particularly the 
provisions in the section entitled, ``Prehearing Conference,'' at pages 
11-16. SICA members compiled The Arbitrator's Manual as a guide for 
arbitrators, and it is designed to supplement and explain the Uniform 
Code of Arbitration as developed by SICA. The procedures and policies 
set out in both The Arbitrator's Manual and the Discovery Guide are 
discretionary and may be changed by the arbitrator(s) so long as they 
are consistent with the rules of the forum. Further, nothing in the 
Discovery Guide, including the Document Production Lists, precludes the 
parties from voluntarily agreeing to an exchange of documents in a 
manner different from that set forth in the Discovery Guide.
    The Discovery Guide consists of introductory and instructional 
text, and fourteen Document Production Lists. The first two lists, one 
for firms or associated persons and one for customers, contain 
documents that are presumptively discoverable in all customer cases, 
unless the arbitrator(s), in the exercise of discretion, determines 
that some or all of the documents in the two lists should not be 
produced. The next twelve lists, which are dispute specific, contain 
additional documents that should be produced by both customers and 
firms or associated persons for respectively, claims of churning, 
failure to supervise, misrepresentation/omissions, negligence/breach of 
fiduciary duty, unauthorized trading, and unsuitability. For example, a 
party involved in a churning claim should produce documents from either 
List One or Two, which apply to all customer cases, and documents from 
List Three or Four, which apply to churning claims.
    NASD Regulation's Office of Dispute Resolution (``ODR'') will 
provide the parties with the Discovery Guide at the time ODR serves the 
statement of claim. If a particular Document Production List is 
applicable, the parties should consider those documents to be 
presumptively discoverage. Unless the party files a timely objection, 
those documents should be produced not later than 30 calendar days from 
the date the answer is due or filed, whichever is earlier. Objections 
to production of any document on a Document Production List, and any 
responses thereto, are to be considered by the arbitrator(s). The 
arbitrator(s) then determine whether the objecting party has overcome 
the presumption of discoverability based upon sufficient reason(s).
    In addition to specific document production requirements, the 
Discovery Guide provides general guidance on other issues such as 
confidential treatment of documents, additional discovery requests, 
depositions, admissibility of evidence, arbitrator participation, and 
sanctions. This guidance is discussed below.
    Confidential Treatment. The Discovery Guide provides that parties 
may stipulate to the confidential treatment of documents. 
Alternatively, the arbitrator(s) may issue confidentiality orders. 
However, the Discovery Guide further advises that arbitrator(s) should 
not issue orders or use confidentiality agreements to require parties 
to produce documents

[[Page 49258]]

otherwise protected by established privileges. As discussed more fully 
below, a party objecting to discovery on grounds of privilege has the 
burden to demonstrate that a particular document is privileged.
    Additional Discovery Requests. The Discovery Guide states that 
parties may request documents in addition to those identified in the 
Document Production Lists, and it provides guidance regarding the 
timing of such requests. Unless a longer period is allowed by the 
requesting party, requests should be satisfied or objected to within 30 
days from the date of service of the document request. Any response to 
objections to a request should be served on all parties within 10 days 
or service of the objection.
    The Discovery Guide also provides a mechanism for a party to seek 
to compel production of documents when the adverse party refuses to 
produce such documents or offers only to produce alternative documents 
that are unacceptable to the requesting party. The Discovery Guide 
instructs that the arbitrator(s) carefully consider such motions, 
regardless of whether the item requested is on any of the Document 
Production Lists.
    Depositions. The Discovery Guide discusses the arbitrator(s)' 
authority to permit depositions. It suggests depositions be limited to 
circumstances such as: (a) To preserve the testimony of ill or dying 
witnesses; (b) to accommodate essential witnesses who are unable or 
unwilling to travel long distances for a hearing and may not otherwise 
be required to participate in the hearing; (c) to expedite large or 
complex cases; and (d) to address unusual situations where the 
arbitrator(s) determines that circumstances warrant departure from the 
general guidance.
    Admissibility. Production of documents listed in the Discovery 
Guide does not create a presumption that the documents are admissible 
at the arbitration hearing. Nothing in the Discovery Guide prevents a 
party from objecting to the introduction of any document as evidence at 
the hearing to the same extent that any other objection may be raised 
in arbitration.
    Arbitrator Participation. Under the Discovery Guide, the NASD 
arbitrator(s) will participate in the initial and subsequent prehearing 
conferences to organize the management of the case, set a discovery 
cut-off date, identify dispositive or other potential motions, schedule 
hearing dates, determine whether mediation is desirable, and resolve 
any other preliminary issues. If, at the time of the initial prehearing 
conference, the exchange of properly requested discovery has not 
occurred, the Discovery Guide provides that the arbitrator(s) should 
order the production of all required documents subject to production
    Sanctions. The Discovery Guide instructs arbitration panels to 
issue sanctions if any party fails to produce documents or information 
required by a written order, unless the panel \7\ finds that there is 
``substantial justification'' for the failure to produce the documents 
or information. The Discovery Guide recognizes that panels have wide 
discretion to address non-compliance with discovery orders. For 
example, the panel may make an adverse inference against a party or 
assess adjournment fees, forum fees, costs and expenses, and/or 
attorneys' fees caused by noncompliance. In extraordinary cases, the 
Discovery Guide suggests the panel may initiate a disciplinary referral 
against a registered entity or person who is a party or witness in the 
proceeding or may, pursuant to Rule 10305(b), dismiss a claim, defense, 
or proceeding with prejudice as a sanction for intentional failure to 
comply with an order of the arbitrator(s) if lesser sanctions have 
proven ineffective.
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     \7\An arbitration panel's ruling need only be by majority vote; 
it need not be unanimous.
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III. Summary of Comments

    The Commission received eight comment letters on the proposal.\8\ 
One commenter urged the adoption of the Discovery Guide as proposed.\9\ 
Further, none of the commenters opposed the concept of creating a 
Discovery Guide for use in customer arbitration.\10\ However, most of 
the commenters had particular criticisms about certain aspects of the 
Discovery Guide. Additionally, seven of the eight commenters made 
suggestions on how to improve the Discovery Guide.\11\ With respect to 
several specific criticisms, the comments were evenly distributed on 
both sides of the issue.
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    \8\ See supra note 4.
    \9\ See PIABA Letter.
    \10\ Out of the eight commenters, seven stated that they were in 
favor of the concept of a Discovery Guide. See PIABA Letter, Black 
Letter, Schwab Letter, SIA Letter, Raymond James Letter, Poser 
Letter, and Jamieson Letter. The eighth, from NELA, stated that 
while the desire to facilitate discovery is appropriate, NELA 
believed that the proposed Discovery Guide is problematic in certain 
material aspects. See NELA Letter.
    \11\See NELA Letter, Black Letter, Schwab Letter, SIA Letter, 
Raymond James Letter, Poser Letter, and Jamieson Letter.
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Discovery Guide as a Proposed Rule Change

    Three commenters assert that the Discovery Guide should not be 
filed with the Commission as a proposed rule change.\12\ They content 
that arbitration relies on the flexibility of arbitrators, and adopting 
the Discovery Guide as a rule would limit arbitrator(s)' discretion. In 
addition, they argue that because the Discovery Guide will be part of 
The Arbitrator's Manual, which is not a rule, and will only be a 
``guide,'' it should not be submitted as a rule under the rule filing 
process. Finally, the commenters maintain that adopting the Discovery 
Guide as a rule will give it more importance than what was intended by 
its drafters. In contrast, another commenter contends that, because the 
Discovery Guide contains guidelines and not mandates, whether it is 
issued as a rule is immaterial.\13\ Further, that commenter commends 
the Commission for allowing the public to comment on the guidelines 
through the formal rulemaking process.
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    \12\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \13\See Jamieson Letter.
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Customer Personal Financial Information

    Three commenters contend that producing certain documents 
reflecting personal financial information infringes on customers' 
privacy rights.\14\ In particular, these commenters argue that the 
production of tax returns and other financial information, such as 
business ownership records, should be limited to certain types of 
claims, not be required at all, or the firm should have the burden of 
establishing the relevance of these documents in specific cases. One of 
these commenters asserts that a customer's right to privacy can only be 
waived by the customer, and not by the committees who created the 
Discovery Guide or by the securities industry as a condition of the 
industry complying with its legal obligation to provide relevant 
information in an arbitration.\15\ The commenter argues that decisions 
affecting important rights of individual customers (i.e., forced 
disclosure of personal and private information) should be made on a 
case-by-case basis, and the information should not be subject to 
routine disclosure. In addition, another commenter states that the 
production of statements concerning a customer's net worth is unfair 
because most customers would have to create these statements.\16\
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    \14\ See NELA Letter, Black Letter, and Poser Letter.
    \15\ See NELA Letter.
    \16\ See Jamieson Letter.
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    On the other hand, three industry commenters argue that customer 
tax returns and other financial information are crucial in all types of 
customer/

[[Page 49259]]

broker disputes.\17\ According to one of these commenters, tax returns 
and information about net worth are often the only pertinent 
documentation that a customer has.\18\ Further, they assert that a 
customer's entire tax return (not only the portions listed in the 
Discovery Guide) and the customer items in List 8, such as a resume, 
should be produced in every case. These commenters believe that this 
information is relevant in every dispute.
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    \17\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \18\ See Schwab Letter.
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Production Burden on Firms

    The three industry commenters argue that the use of documents 
dealing with an associated person's disciplinary history violates a 
basic premise of the Federal Rules of Evidence.\19\ They maintain that 
evidence of prior bad acts, such as records of disciplinary history or 
information reported on Forms U-4 and U-5, should not be used in 
arbitration to demonstrate an alleged bad act. In response to these 
comments, another commenter states that production of these records is 
not prejudicial since an associated person's disciplinary history is 
already publicly available through the NASD's Public Disclosure 
Program.\20\
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    \19\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \20\ See Jamieson Letter.
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    Additionally, one industry commenter argues that the production of 
disciplinary history documents would be particularly burdensome for 
discount and on-line brokers.\21\ The commenter contends that because a 
customer of a discount broker deals with many associated persons, a 
firm's production burden would be tremendous for many types of 
disputes. In response to this problem, the commenter suggests limiting 
the production of documents to those concerning an associated person 
who is regularly and permanently assigned to the account, if any. On 
the other hand, another commenter notes that the materials to be 
produced by firms under the Discovery Guide are kept in the normal 
course of a firm's business pursuant to industry recordkeeping 
requirements.\22\
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    \21\ See Schwab Letter.
    \22\ See Jamieson Letter.
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    The three industry commenters also argue that firms should not have 
to produce internal audit reports in failure to supervise claims.\23\ 
They maintain that since failure to supervise can be alleged in almost 
all claims, internal audit reports will have to be produced in every 
case. Moreover, these commenters assert that production might affect 
the vitality and candor of internal audit reports, and thus harm the 
``self-policing'' obligation of firms.\24\ Another commenter, however, 
argues that any increased exposure of internal audit reports will help 
ensure that the reports' recommendations are followed internally, and 
that self-policing will thereby by improved.\25\ Furthermore, one 
commenter agrees with the Discovery Guide that internal audit reports 
are likely to be relevant in a failure to supervise case, regardless of 
whether they focus on a particular associated person.\26\
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    \23\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \24\ Notwithstanding these comments, the Commission reminds all 
regulated entities and persons that nothing in the Discovery Guide 
or Document Production Lists changes or reduces their obligations to 
monitor compliance with the federal securities laws or rules of 
self-regulatory organizations.
    \25\ See Jamieson Letter.
    \26\ See Poser Letter.
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Miscellaneous

    Most of the commenters make suggestions on how to improve the 
Discovery Guide and, in particular, the Document Production Lists. For 
example, one commenter suggests that the first two lists, which apply 
to all customer cases, be ``pruned'' to avoid placing an unreasonable 
burden on the parties.\27\ In addition, another commenter suggests that 
confidentiality orders or stipulations be used sparingly because 
investors already have little information about the arbitration 
process.\28\ Another commenter expressed concern that the Discovery 
Guide's recognition of ``privacy'' and ``confidentiality'' as valid 
objections to document production may encourage parties to make 
objections to delay the discovery process.\29\
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    \27\ See Poser Letter.
    \28\ See Jamieson Letter.
    \29\ See Black Letter.
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    Several commenters addressed privilege issues. Four commenters 
contend that the Discovery Guide should not contain a list of 
privileges because privileges are traditionally governed by state 
law.\30\ Similarly, three of these commenters state that because most 
privileges would only be available to customers, a list of applicable 
privileges should not be included in the Discovery Guide.\31\ In 
addition, one commenter recommends that the Discovery Guide contain a 
requirement that parties produce a privilege log to identify documents 
not produced as a result of the assertion of a privilege.\32\ The 
commenter believes this will help protect parties from the improper 
assertion of a privilege.
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    \30\ See Schwab Letter, SIA Letter, Raymond James Letter, and 
Jamieson Letter.
    \31\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \32\ See NELA Letter.
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    In addition, one commenter argues that arbitrators should be given 
more power to sanction parties for non-production of documents.\33\ The 
commenter states that with the current proposal, an arbitrator first 
needs an order for production before the arbitrator can issue 
sanctions. The commenter believes that the Discovery Guide should be 
amended so that if a party fails to produce a listed document, the 
party should be sanctioned unless the party can provide a substantial 
justification for not producing the document. Similarly, another 
commenter contends that the documents on the lists should not be 
presumptively discoverable, but automatically produced.\34\ The 
commenter believes this will help streamline the arbitration process.
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    \33\ See Poser Letter.
    \34\ See Black Letter.
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IV. Discussion

    One commenter states that the Commission should give deference to 
this proposal because it was reached through compromise by 
organizations who represent opposing interests.\35\ The Discovery Guide 
reflects a compromise between the various interests of the drafters. 
The Discovery Guide was drafted over a two-year period with the input 
of organizations who represent different interests within the 
securities industry. Among those contributing to the Discovery Guide 
were persons who are members of SICA, members of SIA, directors of 
PIABA, industry representatives, representatives from major broker-
dealers, counsel for claimants, and counsel for the industry. 
Similarly, the comment letters received by the Commission reflect the 
views of a cross section of the securities industry, plaintiff 
representatives, academicians, and others involved in the arbitration 
process. The Discovery Guide, when considered as a whole, provides 
useful guidance to arbitrators, claimants, and industry participants in 
customer arbitrations and fairly balances their respective interests.
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    \35\ See PIABA Letter.
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    As noted above, several commenters assert that the Discovery Guide 
should not be filed with the Commission as a proposed rule change 
because arbitration relies on the flexibility of arbitrators, and 
adopting the Discovery Guide as a rule would limit arbitrators'

[[Page 49260]]

discretion.\36\ In addition, one commenter notes the Discovery Guide 
states that an arbitration panel should issue sanctions if a party 
fails to produce documents or information required by a written order, 
not for non-compliance with the Discovery Guide itself.\37\ That 
commenter, therefore, argues that arbitrators should be given more 
power to sanction parties for non-compliance with the Discovery Guide. 
Further, another commenter asserts that instead of being presumptively 
discoverable as they are under the Discovery Guide, the Documents on 
the document Production Lists should be automatically produced.\38\
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    \36\ See Schwab Letter, SIA Letter, and Raymond James Letter.
    \37\ See Poser Letter.
    \38\ See Black Letter.
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    By its terms, the Discovery Guide provides for arbitrator(s) to 
exercise discretion in tailoring the Discovery Guide to particular 
cases.\39\ Arbitrator(s) can change any Provision of the Discovery 
Guide. Further, nothing in the Discovery Guide shifts the burden of 
proof a party bears in arbitration, and the mere fact that a document 
is contained in a Document Production List does not make the document 
automatically admissible in any arbitration proceeding.
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    \39\ Under Rule 19b-4, a stated policy, practice, or 
interpretation of the self-regulatory organization shall be deemed 
to be a proposed rule change unless (1) it is reasonably and fairly 
implied by an existing rule of the self-regulatory organization or 
(2) it is concerned solely with the administration of the self-
regulatory organization and is not a stated policy, practice, or 
interpretation with respect to meaning, administration, or 
enforcement of an existing rule of the self-regulatory organization. 
17 CFR 240.19b-4(c). Proposed rule changes submitted under Section 
19 of the Act and Rule 19b-4 are subject to a notice and comment 
period. The Discovery Guide falls within Rule 19b-4.
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    As stated in the Discovery Guide and the Purpose section of NASD 
Regulation's filing with the Commission, the Discovery Guide (including 
the Document Production Lists) is intended to function as a guide for 
arbitrators and parties in the discovery process and is not intended to 
bind arbitrators or parties in a particular case. While parties should 
consider the documents on the lists to be presumptively discoverable, 
the Discovery Guide specifically notes that all of the documents on 
each list are not required to be produced in every case. Nothing in the 
Discovery Guide prevents parties from voluntarily agreeing to an 
exchange of documents in a manner or scope different from that set 
forth in the Discovery Guide.
    Furthermore, parties may also object to the production of any 
particular document, or seek the production of additional documents not 
on any of the Document Production Lists. The arbitrator(s) then makes a 
determination whether production is required. To the extent that an 
arbitrator uses the Discovery Guide in connection with ordering the 
production of documents, the order is binding on the parties. The 
failure to comply with the Discovery Guide itself does not 
automatically result in sanctions; rather, sanctions are imposed only 
after a party has failed to comply with an arbitrator's order. Thus, 
arbitrators retain their discretion under the Discovery Guide to manage 
arbitrations as they deem appropriate.
    Some commenters objected to the burden on customers to produce 
certain documents in all customer arbitrations. For example, three 
commenters contend that producing certain documents infringes on 
customers' privacy rights.\40\ Conversely, other commenters object to 
firms' production burdens under the Discovery Guide.\41\ The Discovery 
Guide reflects a fair compromise between the interests of the drafters 
and will benefit arbitrators in handling document production. Further, 
we note that the Document Production Lists were drafted to provide 
parties with information that is reasonably calculated to lead to the 
discovery of admissible evidence in arbitrations.\42\ Arbitrator(s) 
should use their discretion to consider whether in a particular case, 
the documents on the Document Production Lists will lead to the 
discovery of admissible evidence. Nothing in the Discovery Guide 
affects a party's ability to object to the production of any particular 
document or class of documents, or to request additional documents.
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    \40\See NELA Letter, Black Letter, and Poser Letter.
    \41\See Schwab Letter, SIA Letter, and Raymond James Letter.
    \42\See e.g., Fed. R. Civ. P. 26(b)(1).
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    Three commenters also assert that firms should not have to produce 
documents about an associated person's disciplinary history because 
production would be burdensome and the documents would be 
inadmissible.\43\ As one commenter noted, some disciplinary information 
about firms and associated persons is already available to the public 
through the NASD's Public Disclosure Program. Furthermore, as stated in 
the Discovery Guide, the production of documents in discovery under the 
Discovery Guide does not create a presumption that the documents are 
admissible in the arbitration proceeding.
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    \43\See Schwab Letter, SIA Letter, and Raymond James Letter.
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    In addition, three commenters argue that firms should not have to 
produce internal audit reports in failure to supervise claims because 
production might affect the vitality and candor of these reports. 
Another commenter, however, takes the opposite view--the commenter 
believes the production of these reports will result in better self-
policing. The Discovery Guide is narrowly focused in that it only calls 
for the production of internal audit reports, if they exist, in failure 
to supervise claims. In addition, internal audit reports may help a 
firm defend a failure to supervise claim. Nothing in the Discovery 
Guide or the Document Production Lists changes firms' obligations to 
monitor compliance with the federal securities laws or rules of self-
regulatory organizations. To the extent a firm objects to the 
production of such internal audit reports in any particular claim, 
nothing in the Discovery Guide precludes a firm from filing an 
objection with the arbitrator(s). In addition, whether such a report is 
admissible is a decision for the arbitrator(s).
    Many of the commenters made specific suggestions on how to improve 
the Discovery Guide and, in particular, the Document Production Lists. 
For example, one commenter suggests that confidentiality orders or 
stipulations be used sparingly because investors already have little 
information on the arbitration process.\44\ The Discovery Guide does 
not change current features of the arbitration process. Stipulations 
are, by definition, made by agreement of the parties and 
confidentiality orders can only be issued by arbitrator(s) after they 
fully consider the issue. While a confidentiality order may prevent the 
public dissemination of particular documents or information, it should 
not affect the arbitration process. The same commenter also asserts 
that the production of statements concerning a customer's net worth is 
unfair because most customers would have to create these statements. 
Nothing in the Discovery Guide requires customers to create documents 
that do not otherwise exist. Indeed, the Discovery Guide provides that, 
if a party has no responsive documents to any document request, the 
party should provide an affirmation to that effect.
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    \44\See Jamieson Letter.
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    In addition, many of the commenters made specific suggestions to 
modify one or more aspects of the Document Production Lists. Many of 
these suggestions may have considerable merit in particular cases. For 
example, one commenter suggests that the first

[[Page 49261]]

two Document Production Lists be ``pruned'' to avoid placing an 
unreasonable burden on the parties. In this regard, if production of a 
particular document or class of documents called for under an 
applicable Document Production List is unduly burdensome to a party, 
that party may object to production on that or any other grounds. The 
arbitrator(s) retains the ability to modify any request in order to 
protect against discovery abuses. Furthermore, there is nothing in the 
Discovery Guide that prevents a party from asking for additional 
documents such as those suggested by some commenters. We recognize the 
commenters' intentions to improve the Discovery Guide and the discovery 
process in general. However, the Discovery Guide reflects a compromise, 
which was obtained after a long period of negotiation, between various 
interests of the drafters. For each item that one commenter thought 
would be burdensome for a customer, another commenter believed a 
different item would be burdensome to a firm. As adopted, the Discovery 
Guide will benefit arbitrators and parties in handling document 
production.
    One commenter suggests that parties produce a privilege log to 
identify documents not produced as a result of the assertion of a 
privilege. NASD Rule IM-10100 states that ``[i]t may be deemed conduct 
inconsistent with just and equitable principles of trade and a 
violation of Rule 2110 for a member of a person associated with a 
member to * * * fail to appear or to produce any document in his 
possession or control as directed pursuant to provisions of the NASD 
Code of Arbitration Procedure * * *'' All parties should act in good 
faith and carefully consider the relevant case law when asserting a 
privilege, and arbitrators should consider whether a privilege log is 
necessary to help facilitate the discovery process.\45\ It is expected 
that the NASD Regulation will take appropriate action against members 
and registered persons who do not act in good faith or otherwise 
violate IM-10100.
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    \45\ The Commission agrees with several commenters that 
applicable privileges, which are usually a matter of state law, 
should not be specified in the Discovery Guide.
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    The Discovery Guide will streamline the discovery process. By 
creating lists of documents that should be produced in all customer 
arbitrations as well as particular types of cases, the Discovery Guide 
will help expedite the discovery process and reduce the number of 
discovery disputes between parties, which in turn should help lower the 
cost of the arbitration discovery process. Further, nothing in the 
Discovery Guide changes the burden of establishing or defending any 
aspect of a claim. When considered as a whole, the Discovery Guide 
provides useful guidance to parties and arbitrators in NASD-sponsored 
customer arbitrations.
    In addition, the Commission finds that the proposal is consistent 
with the requirements of Section 15A of the Act \46\ and the rules and 
regulations thereunder that govern the NASD.\47\ In particular, the 
Commission finds that the proposal is consistent with Section 15A(b)(6) 
of the Act \48\ which requires, among other things, that the rules of 
an association 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; and are not 
designed to permit unfair discrimination among customers, issuers, 
brokers, or dealers.
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    \46\ 15 U.S.C. 78o-3.
    \47\ In addition, pursuant to Section 3(f) of the Act, the 
Commission has considered the proposed rule's impact on efficiency, 
competition, and capital formation. 15 U.S.C. 78c(f).
    \48\ 15 U.S.C. 78o-3(b)(6).
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    It is therefore ordered, pursuant to Section 19(b)(2) of the 
Act,\49\ that the proposed rule change (SR-NASD-99-07), as amended, is 
hereby approved.

    \49\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\50\
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    \50\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 99-23610 Filed 9-9-99; 8:45 am]
BILLING CODE 8010-01-M