[Federal Register Volume 69, Number 78 (Thursday, April 22, 2004)]
[Notices]
[Pages 21871-21873]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-9163]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-49573; File No. SR-NASD-2003-95]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Granting Approval to a Proposed Rule Change 
Relating to Arbitrator Classification and Disclosure in NASD 
Arbitrations

April 16, 2004.

I. Introduction

    On June 12, 2003, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), filed with the Securities and 
Exchange Commission (``Commission''), pursuant to section 19(b)(1) of 
the Securities Exchange Act of 1934 (``Act''),\1\ and Rule 19b-4 
thereunder,\2\ a proposed rule change to amend certain sections of the 
NASD Code of Arbitration Procedure (``Code'') relating to arbitrator 
classification and disclosure in NASD arbitrations. The proposed rule 
change was published for comment in the Federal Register on August 21, 
2003.\3\ The Commission received eight comment letters on the 
proposal.\4\ NASD submitted two letters in response to these 
comments.\5\ This order approves the proposed rule change.
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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. 48347 (August 14, 
2003), 68 FR 50563.
    \4\ See letters to Jonathan G. Katz, Secretary, Commission, from 
Joseph O'Donnell, dated July 16, 2003 (``O'Donnell Letter''); Cliff 
Palefsky, Co-Chair, ADR Committee, National Employment Lawyers 
Association (``NELA''), dated September 9, 2003 (``NELA Letter''); 
Stephen G. Sneeringer, Senior Vice President and Counsel, A.G. 
Edwards & Sons, Inc., dated September 9, 2003 (``A.G. Edwards 
Letter''); Edward Turan, Chair, Securities Industry Association 
(``SIA'') Arbitration Committee, SIA, dated September 11, 2003 
(``SIA Letter''); Charles W. Austin, Jr., Vice-President/President 
Elect, Public Investor Arbitration Bar Association (``PIABA''), 
dated September 11, 2003 (``PIABA Letter''); James Dolan, Attorney 
and Counselor, dated October 8, 2003 (``Dolan Letter''); and Richard 
P. Ryder, President, Securities Arbitration Commentator, Inc. 
(``SAC''), dated October 23, 2003 (``SAC Letter''). See also e-mail 
to [email protected] from [email protected] dated September 
23, 2003 (``Lipner Letter'').
    \5\ See letters to Florence Harmon, Senior Special Counsel, 
Division of Market Regulation (``Division''), Commission, from Laura 
Ganzler, Counsel, NASD, dated September 30, 2003 and February 2, 
2004 (``NASD's Response'').
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II. Description of the Proposed Rule Change

    Under the proposal, Rules 10308 and 10312 of the Code would be 
amended to: (1) Modify the definitions of public and non-public 
arbitrators; (2) provide specific standards for deciding challenges to 
arbitrators for cause; and (3) clarify that compliance with arbitrator 
disclosure requirements is mandatory.
    Specifically, the proposed rule change would amend the definition 
of non-public arbitrator in Rule 10308(a)(4) of the Code to: (1) 
Increase from three years to five years the period for transitioning 
from an industry to public arbitrator; and (2) 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: (1) Prohibit 
anyone who has been associated with the industry for at least 20 years 
from ever becoming a public arbitrator, regardless of how many years 
ago the association ended; (2) 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 (3) provide that investment 
advisers may not serve as public arbitrators and may only serve as non-
public arbitrators if they otherwise qualify under Rule 10308(a)(4) of 
the Code. The proposed rule change would also amend the definition of 
``immediate family member'' in Rule 10308(a)(5)(B) of the Code to add 
parents, children, stepparents, stepchildren, as well as any member of 
the arbitrator's household.
    The proposed rule change would also amend Rules 10308(d) and 
10312(d) of the Code to provide that a challenge for cause 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. In 
addition, the proposal would amend Rule 10308 of the Code to add a new 
paragraph (f) which would provide that close questions regarding 
arbitrator classification or challenges for cause brought by a public 
customer would be resolved in favor of the customer. Lastly, NASD 
proposed to amend 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.

III. Summary of Comments

    As noted above, The Commission received eight comment letters on 
the proposal.\6\ NASD submitted two letters in response to these 
comments.\7\
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    \6\ See supra note 4.
    \7\ See supra note 5.
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    PIABA supported the proposal as a ``positive and significant step 
toward the elimination of the appearance of pro-industry bias in the 
roster of those eligible to sit as `public' arbitrators in NASD 
arbitrations.\8\ PIABA, however, suggested that NASD consider further 
steps, such as eliminating all banking and insurance personnel from the 
public arbitrator pool, and categorizing all professional partners of 
all non-public arbitrators as non-public regardless of whether the 
partner's firm meets the proposed 10% threshold under Rule 
10308(a)(5)(A)(iv) of the Code.\9\
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    \8\ See PIABA Letter.
    \9\ See PIABA Letter.
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    Some commenters believed that the proposed amendments to Rule 
10308(a)(5)(A)(iv) of the Code to classify as non-public arbitrators an 
attorney, accountant or other professional whose firms derived more 
than 10 percent of its revenue from the industry in the last two years 
from securities industry clients is too lenient and should go 
farther.\10\ NELA suggested that attorneys whose firm represent 
industry members

[[Page 21872]]

should be classified as non-public arbitrators regardless of the dollar 
volume of the business because incentive to favor the industry is ``too 
obvious too ignore.''\11\
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    \10\ See NELA Letter, PIABA Letter.
    \11\ See NELA Letter.
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    A.G. Edwards, although generally supportive of the proposed rule 
change, argued that to exclude from the definition of public arbitrator 
any ``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 involved in the securities industry is too 
broad.\12\ SAC also objected to this exclusion from the definition of 
public arbitrator.\13\ They believed this provision could limit the 
depth of the NASD arbitrator pool and argue that excluding such persons 
from serving as public arbitrators is overly broad and not supported by 
clear evidence that such persons are actually biased in favor of the 
industry. A.G. Edwards suggested that the possible disclosure of 
revenue sources by potential arbitrators may also dissuade potential 
arbitrators from participating.\14\ In response, NASD stated that it 
took this concern into account and has concluded that the amendment, if 
approved, will not adversely impact its ability to panel cases. NASD 
also disagrees that the proposed provision unnecessarily excludes 
categories of persons from serving as public arbitrators. In its 
response, NASD stated that the new provision is not intended to 
eliminate only persons with actual bias, but also persons who could 
reasonably be perceived to be biased. NASD pointed to a report by 
Professor Michael Perino which noted, ``no classification rule could 
ever precisely define public and non-public arbitrators; there will 
always be classification questions at the margins about which 
reasonable people will differ.''\15\ Given the inherently imprecise 
nature of such definitions, NASD stated that to protect both the 
integrity of the NASD forum, and investors' confidence in the integrity 
of the forum, it prefers the definition of public arbitrator to be 
overly restrictive rather than overly permissive.
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    \12\ See A.G. Edwards Letter. See also SIA letter. SIA stated 
that even though it believes the 10 percent threshold to be too low, 
that such a provision deems as pro-industry any person whose firm 
meets the 10 percent threshold and that this proposal would remove 
many members of the plaintiffs' bar employed by firms who represent 
broker-dealers in employment actions against their employers.
    \13\ See SAC Letter.
    \14\ See A.G. Edwards Letter.
    \15\ See Michael A. Perino, Report to the Securities and 
Exchange Commission Regarding Arbitrator Conflict Disclosure 
Requirements in NASD and NYSE Securities Arbitrations, November 4, 
2002 (``Perino Report'').
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    SAC also questioned why the proposal to exclude from the definition 
of public arbitrator any ``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 involved in the securities 
industry differs from a similar provision adopted by the Securities 
Industry Conference on Arbitration (``SICA''), which would impose a 20% 
threshold.\16\ NASD stated that it carefully considered SICA's 
proposal. However, NASD stated that the Board of Directors of NASD 
Dispute Resolution, Inc. and its National Arbitration and Mediation 
Committee concluded that the proposed rule change would best protect 
the integrity of the NASD forum from both the reality and perception of 
impartiality.
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    \16\ See SAC Letter.
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    In addition, both SIA and A.G. Edwards specifically objected to the 
use of the terms ``professional'' and ``firm'' in proposed Rule 
10308(a)(5)(A)(iv), which they argue are overly vague and overbroad. In 
response, NASD stated that it does not believe that the term 
``professional'' or the term ``firm'' would prove to be problematic in 
practice. NASD noted that the term ``professional'' is used elsewhere 
in current Rule 10308 of the Code and has not been the source of 
confusion or controversy in the past. NASD sees no reason to believe 
that the use of the term ``professional'' or ``firm'' in the proposed 
provision will be any more problematic in practice than the use of the 
term ``professional'' or the term ``business activities'' elsewhere in 
the rule.
    Mr. Dolan and SIA also argue that the proposed amendment to Rule 
10308(a)(5)(B)(i) of the Code to include in the definition of family 
member the parent, child, stepparent, and stepchild of a person in the 
industry is too broad and would also severely reduce number of 
competent candidates eligible to serve as public arbitrators.\17\ Mr. 
O'Donnell objected to including an arbitrator's ``emancipated sons and 
daughters engaged in securities related work'' in the proposed 
definition of family member and stated that this relationship should be 
disclosed but not be grounds for disqualification from the definition 
of public arbitrator.\18\ In response, NASD stated that the proposed 
expansion of the definition of ``immediate family member'' was 
developed in light of the Perino Report, which recommended that NASD 
consider expanding 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.\19\ Although the Perino Report referred only to parents and 
children, NASD believes that the same rationale applies to stepparents 
and stepchildren and therefore proposed to include such relationships 
in the definition as well. NASD stated that it believes the expansion 
of the definition of ``immediate family member'' would enhance the 
overall fairness of NASD's arbitration forum, as well as the investing 
public's confidence in the fairness and integrity of the forum.
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    \17\ See Dolan Letter, SIA Letter.
    \18\ See O'Donnell Letter.
    \19\ See Perino Report, supra note 15. NASD clarified that when 
the ``immediate family member'' has not been associated with the 
securities industry for five years, as specified by Rule 
10308(a)(4)(A) of the Code, the ``immediate family member's'' past 
affiliation would cease to be a basis to exclude an individual from 
serving as a public arbitrator pursuant to Rule 10308(a)(5)(A)(i) of 
the Code. Telephone conversation between Florence Harmon, Senior 
Special Counsel, Division, Commission, from Laura Ganzler, Counsel, 
NASD, on March 10, 2004.
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    Mr. O'Donnell objected that the proposal excluded investment 
advisers from the definition of public arbitrators in Rule 
10308(a)(5)(iii) of the Code.\20\ Mr. O'Donnell further argued that the 
proposal failed to draw a distinction between ``commission based'' and 
``fee only'' investment advisors and between independent investment 
advisors and those affiliated with a broker-dealer.\21\ In response, 
NASD noted that the SICA adopted a similar amendment to its Uniform 
Code of Arbitration. NASD further stated that it believes the pool of 
qualified public arbitrators will remain deep and that the benefits of 
bolstering investor confidence in the integrity of the NASD arbitration 
process outweigh the loss of some individual investment advisers from 
the roster.
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    \20\ See O'Donnell Letter.
    \21\ See O'Donnell Letter.
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    Lastly, Professor Lipner suggested that NASD bar all persons with 
ties to banks or related institutions from serving as public 
arbitrators.\22\ NASD responded that it believes this suggestion is 
outside of the current proposal.
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    \22\ See Lipner Letter.
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IV. Discussion

    After careful consideration of the proposed rule change, the 
comment letters, and NASD's response, the Commission finds that the 
proposed rule change is consistent with the requirements of the Act and 
the rules and regulations thereunder applicable to a national 
securities association \23\ and,

[[Page 21873]]

in particular, the requirements of section 15A of the Act \24\ and the 
rules and regulations thereunder. Specifically, the Commission believes 
that the proposed rule change is consistent with section 15A(b)(6) of 
the Act,\25\ which, among other things, requires that NASD's rules 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.
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    \23\ In approving this proposed rule change, the Commission 
notes that it has considered its impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \24\ 15 U.S.C. 78o-3.
    \25\ 15 U.S.C. 78o-3(b)(6).
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    At the Commission's request, Professor Michael Perino issued a 
report assessing the adequacy of NASD's and New York Stock Exchange, 
Inc.'s (``NYSE'') arbitrator disclosure requirements and evaluating the 
impact of the recently adopted California Ethics Standards \26\ on the 
current conflict disclosure rules of the self-regulatory organizations 
(``SROs'').\27\ 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.'' The Commission believes 
that this proposed rule change implements 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.
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    \26\ See California Rules of Court, Division VI of the Appendix, 
entitled, ``Ethics Standards for Neutral Arbitrators in Contractual 
Arbitration.''
    \27\ See Perino Report, supra note 15.
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    Specifically, the Commission finds that NASD's proposal to amend 
the definition of non-public arbitrator in Rules 10308(a)(4) and 10308 
(5)(A) of the Code is consistent with the Act. NASD's proposal, among 
other things, to 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 as non-public is 
reasonably designed to reduce a perception of bias by NASD arbitration 
panel members. Some commenters argued that professional partners of all 
persons described in Rule 10308(a)(4)(C) of the Code be categorized as 
non-public regardless of whether the partner's firm meets the proposed 
10 percent threshold while others argued that the 10% threshold is too 
broad and will adversely impact the depth of the pool of potential 
arbitrators. NASD's proposal to expand the definition of ``immediate 
family member'' in Rule 10308(a)(5)(B) of the Code to include parents, 
stepparents, children, or stepchildren, as well as any member of the 
arbitrator's household is also consistent with the Act. Some commenters 
objected to this expansion of the definition of ``immediate family 
member'' stating that it too would reduce the number of competent 
candidates to serve as public arbitrators.
    The Commission believes that NASD proposal to exclude from the 
definition of public arbitrator attorneys, accountants, and other 
professionals whose firms 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 is reasonably 
designed to reduce a perception of bias by NASD arbitration panel 
members. In addition, the Perino Report recommended that NASD consider 
an expansion of the definition of ``immediate family member'' to 
include parents and children, even if the parent or child do not share 
the same home or receive substantial support from a non-public 
arbitrator.\28\ NASD considered the issue and determined to expand the 
term. The Commission also believes it is reasonable for NASD to further 
expand the definition of non-public arbitrator by including stepparents 
and step children as well as parents, children, and any household 
member in the definition of immediate family member. The Perino Report 
also noted that ``no classification rule could ever precisely define 
public and non-public arbitrators; there will always be classification 
questions at the margins about which reasonable people will 
differ.''\29\ Thus, the Commission believes that the amendments to the 
definition of public arbitrator, including the 10 percent threshold and 
definition of ``immediate family member'' are consistent with the Act.
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    \28\ See id.
    \29\ See id.
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V. Conclusion

    For the foregoing reasons, the Commission finds that the proposal 
is consistent with the requirements of the Act and rules and 
regulations thereunder.
    It is therefore ordered, pursuant to section 19(b)(2) of the 
Act,\30\ that the proposed rule change (File No. SR-NASD-2003-95) is 
approved.
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    \30\ 15 U.S.C. 78s(b)(2).

    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\31\
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    \31\ 17 CFR 200.30-3(a)(12).
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Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 04-9163 Filed 4-21-04; 8:45 am]
BILLING CODE 8010-01-P