[Federal Register Volume 68, Number 162 (Thursday, August 21, 2003)]
[Notices]
[Pages 50563-50566]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-21402]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-48347; File No. SR-NASD-2003-95]


Self-Regulatory Organizations; Notice of Filing of Proposed Rule 
Change by the National Association of Securities Dealers, Inc. Relating 
to Arbitrator Classification and Disclosure in NASD Arbitration

August 14, 2003.
    Pursuant to section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act''),\1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on June 12, 2003, the National Association of Securities Dealers, Inc. 
(``NASD''), through its wholly owned subsidiary, NASD Dispute 
Resolution, Inc. (``NASD Dispute Resolution'') 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 the NASD. 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. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    The NASD proposes to amend Rules 10308 and 10312 of the NASD Code 
of Arbitration Procedure (``Code'') to provide additional assurance 
that individuals with significant ties to the securities industry may 
not serve as public arbitrators in NASD arbitrations. Below is the text 
of the proposed rule change. Proposed new language is in italics; 
proposed deletions are in brackets.
* * * * *

10100. Code of Arbitration Procedure

* * * * *
Rule 10308. Selection of Arbitrators
    This Rule specifies how parties may select or reject arbitrators, 
and who can be a public arbitrator.
(a) Definitions.
    (1)-(3) Unchanged.
* * * * *
    (4) ``non-public arbitrator''
    The term ``non-public arbitrator'' means a person who is otherwise 
qualified to serve as an arbitrator and:
    (A) is, or within the past 5 [three] years, was:
    (i) associated with a broker or a dealer (including a government 
securities broker or dealer or a municipal securities dealer);
    (ii) registered under the Commodity Exchange Act;
    (iii) a member of a commodities exchange or a registered futures 
association; or
    (iv) associated with a person or firm registered under the 
Commodity Exchange Act;
    (B) is retired from, or spent a substantial part of a career, 
engaging in any of the business activities listed in subparagraph 
(4)(A);
    (C) Is an attorney, accountant, or other professional who has 
devoted 20 percent or more of his or her professional work, in the last 
2 years, to clients who are engaged in any of the business activities 
listed in subparagraph (4)(A); or
    (D) Is an employee of a bank or other financial institution and 
effects transactions in securities, including government or municipal 
securities, and commodities futures or options or supervises or 
monitors the compliance with the securities and commodities laws of 
employees who engage in such activities.
    (5) ``public arbitrator''
    (A) The term ``public arbitrator'' means a person who is otherwise 
qualified to serve as an arbitrator and [is not]:
    (i) Is not engaged in the conduct or activities described in 
paragraphs (a)(4) (A) through (D); [or]
    (ii) Was not engaged in the conduct or activities described in 
paragraphs (a)(4) (A) through (D) for a total of 20 years or more;
    (iii) Is not an investment adviser;
    (iv) Is an attorney, accountant, or other professional whose firm 
derived 10 percent or more of its annual revenue in the past 2 years 
from any persons or entities listed in paragraph (a)(4)(A); and
    (v) Is not the spouse or an immediate family member of a person who 
is engaged in the conduct or activities described in paragraphs 
(a)(4)(A) through (D).
    (B) For the purpose of this Rule, the term ``immediate family 
member'' means:
    (i) The parent, stepparent, child, or stepchild, of a person 
engaged in the conduct or activities described in paragraphs (a)(4)(A) 
through (D);
    (ii) A member of the household of [family member who shares a home 
with] a person engaged in the conduct or activities described in 
paragraphs (a)(4)(A) through (D);
    (iii) A person who receives financial support of more than 50 
percent of his or her annual income from a person engaged in the 
conduct or activities described in paragraphs (a)(4)(A) through (D); or
    (iv[iii]) A person who is claimed as a dependent for federal income 
tax purposes by a person engaged in the conduct or activities described 
in paragraphs (a)(4)(A) through (D).
* * * * *
    Remainder of (a) through (c) unchanged.
* * * * *
    (d) Disqualification and Removal of Arbitrator Due to Conflict of 
Interest or Bias

[[Page 50564]]

    (1) Disqualification by Director
    After the appointment of an arbitrator and prior to the 
commencement of the earlier of (A) the first pre-hearing conference or 
(B) the first hearing, if the Director or a party objects to the 
continued service of the arbitrator, the Director shall determine if 
the arbitrator should be disqualified. If the Director sends a notice 
to the parties that the arbitrator shall be disqualified, the 
arbitrator will be disqualified unless the parties unanimously agree 
otherwise in writing and notify the Director not later than 15 days 
after the Director sent the notice.
    (2) Removal by Director
    After the commencement of the earlier of (A) the first pre-hearing 
conference or (B) the first hearing, the Director may remove an 
arbitrator based only on information that is required to be disclosed 
pursuant to Rule 10312 and that was not previously disclosed.
    (3) The Director will grant a party's request to disqualify an 
arbitrator if it is reasonable to infer, based on information known a 
the time of the request, that the arbitrator is biased, lacks 
impartiality, or has an interest in the outcome of the arbitration. The 
interest or bias must be direct, definite, and capable of reasonable 
demonstration, rather than remote or speculative.
(e) Discretionary Authority
    The Director may exercise discretionary authority and make any 
decision that is consistent with the purposes of this Rule and the Rule 
10000 Series to facilitate the appointment of arbitration panels and 
the resolution of arbitration disputes.

(f) Challenges by Customers

    In cases involving public customers, any close questions regarding 
arbitrator classification or challenges for cause brought by a customer 
will be resolved in favor of the customer.
* * * * *
Rule 10312. Disclosures Required of Arbitrators and Director's 
Authority to Disqualify
    (a) Each arbitrator shall be required to disclose to the Director 
of Arbitration any circumstances which might preclude such arbitrator 
from rendering an objective and impartial determination. Each 
arbitrator shall disclose:
    (1) Any direct or indirect financial or personal interest in the 
outcome of the arbitration;
    (2) Any existing or past financial, business, professional, family, 
social, or other relationships or circumstances that are likely to 
affect impartiality or might reasonably create an appearance of 
partiality or bias. Persons requested to serve as arbitrators must 
[should] disclose any such relationships or circumstances that they 
have with any party or its counsel, or with any individual whom they 
have been told will be a witness. They must [should] also disclose any 
such relationship or circumstances involving members of their families 
or their current employers, partners, or business associates.
    (b) Persons who are requested to accept appointment as arbitrators 
must [should] make a reasonable effort to inform themselves of any 
interests, relationships or circumstances described in paragraph (a) 
above.
    (c) The obligation to disclose interests, relationships, or 
circumstances that might preclude an arbitrator from rendering an 
objective and impartial determination described in paragraph (a) is a 
continuing duty that requires a person who accepts appointment as an 
arbitrator to disclose, at any stage of the arbitration, any such 
interests, relationships, or circumstances that arise, or are recalled 
or discovered.
(d) Removal by Director
    (1) The Director may remove an arbitrator based on information that 
is required to be disclosed pursuant to this Rule.
    (2) After the commencement of the earlier of (A) the first pre-
hearing conference or (B) the first hearing, the Director may remove an 
arbitrator based only on information not known to the parties when the 
arbitrator was selected. The Director's authority under this 
subparagraph (2) may be exercised only by the Director or the President 
of NASD Dispute Resolution.
    (3) The Director will grant a party's request to disqualify an 
arbitrator if it is reasonable to infer, based on information known at 
the time of the request, that the arbitrator is biased, lacks 
impartiality, or has an interest in the outcome of the arbitration. The 
interest or bias must be direct, definite, and capable of reasonable 
demonstration, rather than remote or speculative.
* * * * *

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

    In its filing with the Commission, the NASD included statements 
concerning the purpose of, and 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. The NASD 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
    The NASD represents that the proposed rule change would amend Rules 
10308 and 10312 of the Code to: (1) Modify the definitions of public 
and non-public arbitrators to further ensure that individuals with 
significant ties to the securities industry are not able to serve as 
public arbitrators; (2) provide specific standards for deciding 
challenges to arbitrators for cause; and (3) clarify that compliance 
with arbitrator disclosure requirements is mandatory.
Background
    In July 2002, the SEC retained Professor Michael Perino to assess 
the adequacy of NASD (and New York Stock Exchange) arbitrator 
disclosure requirements, and to evaluate the impact of the recently 
adopted California Ethics Standards \3\ on the current conflict 
disclosure rules of the self-regulatory organizations (SROs). The SEC 
released professor Perino's report, Report to the Securities and 
Exchange Commission Regarding Arbitrator Conflict Disclosure 
Requirements in NASD and NYSE Securities Arbitrations (Perino Report), 
on November 4, 2002.
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    \3\ California Rules of Court, Division VI of the Appendix, 
entitled, ``Ethics Standards for Neutral Arbitrators in Contractual 
Arbitration.''
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    The Perino Report concluded that undisclosed conflicts of interest 
were not a significant problem in SRO-sponsored arbitrations. 
Specifically, the Perino Report concluded that adoption of the 
California Ethics Standards by SROs would yield very few benefits to 
parties, but would impose significant costs and could have significant 
unintended consequencies that might reduce investors' perception of the 
fairness of SRO arbitrations. However, the Perino Report recommended 
several amendments to SRO arbitrator classification and disclosure 
rules that, according to the Perino Report, might ``provide additional 
assurance to investors that arbitrations are in fact neutral and 
fair.''

[[Page 50565]]

    This rule change would implement those recommendations, as well as 
several other related changes to the definition of public and non-
public arbitrators that are consistent with the Perino Report 
recommendations.
Definition of Public and Non-Public Arbitrators
    The Code classifies arbitrators as public or non-public (i.e., 
``industry''). When investors have a dispute with member firms or 
associated persons in NASD arbitration, they are entitled to have their 
cases heard by a panel consisting of either a single public arbitrator, 
or a majority public panel consisting of two public arbitrators and one 
non-public arbitrator, depending on the amount of the claim.
    Rule 10308(a)(5) of the Code defines ``public'' arbitrators as 
persons who are qualified to serve as arbitrators and who are not 
either personally engaged in certain activities that would make them 
non-public, or the immediate family member of a person engaged in such 
activities. Specifically, under Rule 10308(a)(4) of the Code, a person 
is currently classified as a non-public arbitrator if he or she:
    (A) Is, or within the past three years, was:
    [sbull] Associated with a broker or a dealer (including a 
government securities broker or dealer or a municipal securities 
dealer);
    [sbull] Registered under the Commodity Exchange Act;
    [sbull] A member of a commodities exchange or a registered futures 
association; or
    [sbull] Associated with a person or firm registered under the 
Commodity Exchange Act;
    (B) Is retired from engaging in any of the business activities 
listed in subparagraph (4)(A).
    (C) Is an attorney, accountant, or other professional who has 
devoted 20 percent or more of his or her professional work, in the last 
two years, to clients who are engaged in any of the business activities 
listed in subparagraph (4)(A);
    (D) Is an employee of a bank or other financial institution and 
effects transactions in securities, including government or municipal 
securities, and commodities futures or options or supervises or 
monitors the compliance with the securities and commodities laws of 
employees who engage in such activities; or
    (E) Is the immediate family member of anyone who meets the criteria 
above.
    Rule 10308(a)(5) of the Code currently defines ``immediate family 
member'' to include spouses of non-public arbitrators, as well as 
family members who share a home with, receive substantial financial 
support from, or are declared as dependents for federal income tax 
purposes by, non-public arbitrators.
    The proposed rule change would amend these definitions in several 
ways to further ensure that individuals with significant ties to the 
securities industry are not able to serve as public arbitrators. 
Specifically, the proposed rule change would amend the definition of 
non-public arbitrator in Rule 10308(a)(4) of the Code to:
    [sbull] Increase from three years to five years the period for 
transitioning from an industry to public arbitrator; and
    [sbull] Clarify that the term ``retired'' from the industry 
includes anyone who spent a substantial part of his or her career in 
the industry.
    In addition, the proposed rule change would amend the definition of 
public arbitrator in Rule 10308(a)(5)(A) of the Code to:
    [sbull] Prohibit anyone who has been associated with the industry 
for at least 20 years from ever becoming a public arbitrator, 
regardless of how may years ago the association ended;
    [sbull] Exclude from the definition of public arbitrator attorneys, 
accountants, and other professionals whose firms have derived 10 
percent or more of their annual revenue, in the last two years, from 
clients involved in the activities defined in the definition of non-
public arbitrator; and
    [sbull] Provide that investment advisers may not serve as public 
arbitrators, and many only serve as non-public arbitrators if they 
otherwise qualify unde Rule 10308(a)(4) of the Code.
    The proposed rule change would also significantly amend the 
definition of ``immediate family member'' in Rule 10308(a)(5)(B) of the 
Code to further ensure that individuals with significant, albeit 
indirect, tries to the securities industry may not serve as public 
arbitrators. The Perino Report recommended that NASD expand the 
definition of ``immediate family member'' to include parents and 
children, even if the parent or child does not share a home with or 
receive substantial support from, a non-public arbitrator. Although the 
Perino Report referred only to parents and children, NASD believes that 
the same rationale applies to stepparents and stepchildren, and 
therefore recommends including such relationships in the definition as 
well. And, although the Perino Report did not address the issue, NASD 
believes that it is consistent with the Perino Report recommendations 
to amend the definition of the term ``immediate family member'' to also 
include anyone, related or not, who is a member of the household of a 
non-public arbitrator.
Standard for Deciding Challenges for Cause
    Rules 10308(d) and 10312(d) of the Code provide that under certain 
circumstances, the Director of NASD Dispute Resolution may remove an 
arbitrator upon request of a party or under the Director's own 
initiative. Rule 10308(d)(1) of the Code provides that, before the 
first hearing session, if a party objects to the continued service of 
an arbitrator, the Director may disqualify an arbitrator if the 
Director determines that the arbitrator should be disqualified. Rule 
10312(d)(1) of the Code provides that the Director may remove an 
arbitrator from a panel based on information that must be disclosed 
pursuant to the rule. Under both rules, once the first hearing session 
has begun, the Director may only remove an arbitrator based on 
information that was required to be disclosed under Rule 10312 of the 
Code but was not previously disclosed.
    The Code does not provide a specific standard for deciding whether 
an arbitrator should be removed under these provisions. However, the 
NASD Arbitrator's Manual states that such challenges:

will be granted where it is reasonable to infer an absence of 
impartiality, the presence of bias, or the existence of some 
interest on the part of the arbitrator in the outcome of the 
arbitration as it affects one of the parties. The interest or bias 
must be direct, definite, and capable of reasonable demonstration, 
rather than remote or speculative.\4\
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    \4\ As the Perino Report noted, this is essentially the same 
standard followed by the New York Stock Exchange.

    The Perino Report noted that including this standard in the Code 
would provide greater transparency with respect to challenges for 
cause, and would enhance the parties' confidence that all challenges 
for cause will be granted or denied on the same basis. Therefore, NASD 
is amending Rule 10308(d) of the Code and Rule 10312(d) of the Code to 
provide that in deciding challenges for cause, the Director will apply 
the standard described above.
    In addition, based on the recommendation of the Perino Report, NASD 
is amending Rule 10308 of the Code to add a new paragraph (f) providing 
that, consistent with both NASD current practice and the New York Stock 
Exchange's Guidelines for Classifying Arbitrators, close questions 
regarding arbitrator classification or

[[Page 50566]]

challenges for cause brought by a public customer will be resolved in 
favor of the customer.
Arbitrator Duty To Disclose and Update Conflict Information
    Rule 10312(a) of the Code currently provides that arbitrators 
``shall be required to disclose'' any circumstances which might 
preclude an arbitrator from rendering an objective and impartial 
determination, and enumerates specific personal, and professional and 
financial information that ``should'' be disclosed under the rule. Rule 
10312(b) of the Code provides that arbitrators ``should'' make a 
reasonable effort to inform themselves of any such conflicts. Rule 
10312(c) of the Code provides that the duties imposed by paragraphs (a) 
and (b) are ongoing, and that arbitrators must disclose at any stage of 
the proceeding any such information that arises, is recalled or 
discovered.
    While NASD has always interpreted Rule 10312 of the Code to impose 
a mandatory duty on arbitrators to disclose the required information, 
and to update their disclosure, the Perino Report noted that the use of 
the term ``should'' in paragraphs (a) and (b) of the Rule may create 
the misimpression that disclosing and updating the information are 
merely recommended, but not required. Therefore, to eliminate any 
possible misunderstanding or confusion, NASD is amending Rule 10312(a) 
and (b) of the Code to clarify that arbitrators ``must'' disclose the 
required information and ``must'' make reasonable efforts to inform 
themselves of potential conflicts and update their disclosures as 
necessary.
2. Statutory Basis
    NASD believes that the proposed rule change is consistent with the 
provisions of section 15A(b)(6) of the Act\5\, which requires, among 
other things, that the Association's rules 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. NASD believes that, by providing further 
assurance to parties that individuals with significant ties to the 
securities industry are not able to serve as public arbitrators in NASD 
arbitrations, the proposed rule change will enhance investor confidence 
in the fairness and neutrality of NASD's arbitration forum.
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    \5\ 15 U.S.C. 78o-3(b)(6).
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(B) Self-Regulatory Organization's Statement on Burden on Competition

    NASD 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.

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

    Written comments were neither solicited nor received.

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 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 the 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, NW., Washington, DC 20549-0609. 
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 No. SR-NASD-2003-95 and 
should be submitted by September 11, 2003.

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\6\
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    \6\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 03-21402 Filed 8-20-03; 8:45 am]
BILLING CODE 8010-01-P