Follow-up Report on Matters Relating to Securities Arbitration
(11-APR-03, GAO-03-162R).
Our June 2000 report Securities Arbitration: Actions Needed to
Address Problem of Unpaid Awards revealed that, although
investors had won a majority of awards against brokers, a high
proportion of those awards had not been paid. Nearly all of the
unpaid awards involved cases decided in the National Association
of Securities Dealer's (NASD) arbitration program and most
involved brokers that had left the securities industry. A year
later we reported on limited data suggesting that the rate of
unpaid awards had declined. However, we noted that given the
short time period that the data covered, regulators needed to
continue monitoring the payment of the awards to determine
whether additional steps need to be taken. Arbitration attorneys
and claimants have also expressed concern about the timeliness of
NASD's updating of arbitrator disclosure information, which can
be used by the parties in arbitration to judge the competence and
objectivity of arbitrators, and with NASD's ability to remove
arbitrators from cases if conflicts arise. In addition,
arbitration attorneys also expressed concern about the use of
motions to dismiss and motions for summary judgment to terminate
NASD-administered arbitration cases. This report responds to
requests that we review the status of issues relating to
securities arbitration and award payment. Our objectives were to
(1) describe NASD's procedures to ensure the timely updating of
disclosure information that arbitrators provide and NASD's
procedures for removing arbitrators from cases, (2) provide
information on the use of motions to dismiss and motions for
summary judgment in arbitrations, and (3) describe recent changes
in the rate of unpaid awards and the number of arbitration claims
filed with NASD.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-03-162R
ACCNO: A06640
TITLE: Follow-up Report on Matters Relating to Securities
Arbitration
DATE: 04/11/2003
SUBJECT: Payments
Securities arbitration
Claims processing
Claims settlement
Information resources management
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GAO-03-162R
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration
April 11, 2003 The Honorable John D. Dingell Ranking Minority Member
Committee on Energy and Commerce House of Representatives
The Honorable Edward J. Markey Ranking Minority Member Subcommittee on
Telecommunications
and the Internet Committee on Energy and Commerce House of Representatives
Subject: Follow- up Report on Matters Relating to Securities Arbitration
Our June 2000 report Securities Arbitration: Actions Needed to Address
Problem of Unpaid Awards revealed that, although investors had won a
majority of awards against brokers, a high proportion of those awards had
not been paid. 1 Nearly all of the unpaid awards involved cases decided in
the National Association of Securities Dealer*s (NASD) arbitration program
and most involved brokers that had left the securities industry. A year
later we reported on limited data suggesting that the rate of unpaid
awards had declined. 2 However, we noted that given the short time period
that the data covered, regulators needed to continue monitoring the
payment of the awards to determine whether additional steps need to be
taken. Arbitration attorneys and claimants have also expressed concern
about the timeliness of NASD*s updating of arbitrator disclosure
information, which can be used by the parties in arbitration to judge the
competence and objectivity of arbitrators, and with NASD*s ability to
remove arbitrators from cases if conflicts arise. In addition, arbitration
attorneys also expressed concern about the use of motions to dismiss and
motions for summary judgment to terminate NASD- administered arbitration
cases. 3 1 U. S. General Accounting Office, Securities Arbitration:
Actions Needed to Address Problem of
Unpaid Awards, GAO/ GGD- 00- 115 (Washington, D. C.: Jun. 15, 2000). 2 U.
S. General Accounting Office, Evaluation of Steps Taken to Address the
Problem of Unpaid Arbitration Awards, GAO- 01- 654R (Washington, D. C.:
Apr. 27, 2001). 3 There are basically two categories of motions for
prehearing dismissal. Motions to dismiss are based exclusively on the
allegations of the statement of claim. Motions for summary judgment are
those that depend, at least in part, on some facts that go beyond those
allegations.
United States General Accounting Office Washington, DC 20548
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 2 This report responds to your May 2, 2001, April 15,
2002, and May 21, 2002, requests
that we review the status of issues relating to securities arbitration and
award payment. Our objectives were to (1) describe NASD*s procedures to
ensure the timely updating of disclosure information that arbitrators
provide and NASD*s procedures for removing arbitrators from cases, (2)
provide information on the use of motions to dismiss and motions for
summary judgment in arbitrations, and (3) describe recent changes in the
rate of unpaid awards and the number of arbitration claims filed with
NASD.
Results in Brief
NASD has made important changes to its arbitration program procedures,
specifically in updating and entering arbitrator disclosure information
and removing arbitrators from cases. To better manage the data entry
process, in 2001 NASD centralized the arbitrator disclosure information
function in its New York City offices. NASD also put a reporting form on
line allowing arbitrators to submit new background information such as
their education and training, employment, past arbitration experience,
finances, and conflicts of interest. Also, in 2004 NASD plans to start a
new computer system that would allow arbitrators to update their own
records. Since November 2001, when the Securities and Exchange Commission
(SEC) reported that NASD and SEC had not received any new complaints about
the currency of arbitrator disclosure information, NASD has received one
complaint. In addition, NASD has adopted a rule change that gives its
Director of Arbitration and the President, NASD Dispute Resolution,
indelegable authority to remove an arbitrator from a case after the
hearing process has begun based on information not known to the parties
when the arbitrator was selected. NASD has used this authority in nine
instances since the change became effective in March 2001.
Motions to dismiss were filed and granted in NASD- administered
arbitration cases. Although NASD does not keep track of such motions, in
2001, for example, we determined that motions to dismiss or motions
seeking summary judgment were filed in 55, or about 8 percent, of 719
investor- initiated, NASD- administered cases in which the investors won a
monetary award. 4 We identified 54 instances in which motions were denied
and 28 instances in which the motions were granted. 5 NASD rules do not
prohibit either of the parties in arbitration from filing or the
arbitrators from granting prehearing motions to dismiss. Further, the
courts have consistently recognized the authority of arbitrators in NASD
cases to grant prehearing motions to dismiss. Moreover, an NASD official
told us that these motions can save time and resources by helping to weed
out certain cases that, based on the facts set out in the parties*
4 Securities arbitration cases are categorized as broker- broker,
employee- broker, and customer- broker cases. Because the customers of
brokers are generally investors, in this report we refer to the customers
as investors.
5 The total number of motions filed exceeded the number of cases because
many cases involved multiple respondents and multiple filings of motions.
In some instances in which motions to dismiss were granted, awards were
still rendered against other parties responding to the claims.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 3 filings, clearly would not satisfy procedural
requirements for cases in the arbitration
forum. However, a member of the Securities Industry Conference on
Arbitration said that such motions ought to be discouraged because
discovery and appeal rights in arbitration are limited. In 2001, 236 or
about 33 percent of the 719 NASD- administered monetary awards on
claims filed by investors were not fully paid, down from 64 percent not
fully paid in 1998, as we reported in June 2000. About 55 percent of the
$100.2 million NASD arbitrators awarded to investors in 2001 was unpaid,
down from 80 percent of the total $161 million awarded to investors in
1998. 6 The majority of unpaid awards in both 1998 and 2001 resulted from
brokers leaving the securities industry. For example, 192 of the 236
unpaid awards in 2001 involved defunct brokerage firms or individual
brokers. Since 1998, NASD has introduced award- monitoring procedures that
are designed to encourage payment. NASD also has introduced procedures for
investors to avoid the problem of unpaid awards by defunct brokers by
giving investors more options for handling claims against defunct brokers.
The noted decline in the rate of award nonpayment also might be related to
a difference in methodologies used to measure that rate. In 2000, we
directly surveyed a sample of investors to determine if awards were paid
in 1998, while for this report we used NASD data based on its monitoring
of payment for the entire year 2001. The 5,974 arbitration claims that
investors filed with NASD in 2002 have increased by 64 percent over the
3,637 claims filed in 2000.
We recommend that the President, NASD Dispute Resolution, make available
on NASD*s Web site current statistics showing the frequency with which
arbitration awards against defunct brokers are not fully paid.
Background
The securities industry uses arbitration to resolve disputes among
industry members, their employees, and individual investors. Arbitration,
an alternative to suing in court, uses neutral third parties to resolve
differences between parties to a controversy. Cases involving investors,
other than relatively small claims, are resolved by a panel of three
arbitrators. Two are public arbitrators and one is a nonpublic arbitrator
who brings a greater degree of expertise in the workings of the industry.
Arbitrators* decisions are final and can be appealed to the courts only
for narrowly- defined
reasons such as misconduct, bias, or a manifest disregard of the law on
the arbitrators* part. Arbitration awards are to be paid within 30 days of
the date of the award, unless a party seeks a judicial review. SEC
oversees the arbitration programs administered by securities industry
self- regulatory organizations (SRO) such as NASD. NASD administers the
largest SRO arbitration program, for example, its
6 In 2001, $12 million of the unpaid awards were not due because the
respondents had requested a hearing, filed for bankruptcy, or filed a
motion to vacate.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 4 program accounted for about 90 percent of securities
arbitration cases in 2000 and
2001. 7 Investors have a right under NASD (and other SRO) rules to require
that brokersdealers and individual brokers arbitrate any disputes they may
have. In addition, most broker- dealers require customers, when opening an
account, to sign a customer agreement that includes a predispute
arbitration clause. If a dispute subsequently arises between the investor
and the broker- dealer, the investor can file an arbitration claim with
the forum indicated in the predispute agreement and with any SRO of which
the broker- dealer is a member.
In an investor- initiated arbitration case, the investor files a statement
of claim with the designated SRO- sponsored arbitration forum. The forum*s
director of arbitration serves the statement of claim on the broker-
dealer or individual broker (called respondents) against whom the claim
has been brought. The respondent has from 20 to 45 days, depending on the
forum used, to answer the claim with any defenses and related claims.
After the filing process, the director of arbitration provides the parties
with a list of potential arbitrators to hear the dispute. The parties
indicate their preference and may challenge specific arbitrators on the
list.
Once the panel of arbitrators has been selected, the panel conducts
hearings that may last a day or more depending on the complexity of the
case. Arbitrators are to render their decisions after the presentation of
the evidence at the hearings. Arbitrators issue a written *award* at the
end of a case. The written award is not required to include a reason or
formal written opinion supporting the award. However, the award is
required to include a statement setting out certain issues, including the
basic issues raised and resolved in a case, the amount claimed and
awarded, and any other, nonmonetary issues resolved.
New NASD Procedures Address Concerns about Information on Arbitrators and
Removing Arbitrators from Cases
NASD has taken steps to improve its procedures for updating arbitrator
disclosure information and removing arbitrators from cases. The arbitrator
update improvements included centralizing the process for updating
arbitrator profiles and making an on- line reporting form available for
arbitrators to submit new disclosure information. Another change allows
the President, NASD Dispute Resolution, and its Director of Arbitration to
remove an arbitrator from a case once the hearing process has begun and
new information about the arbitrator has been disclosed.
7 NASD Dispute Resolution facilitates the resolution of monetary,
business, and employment disputes between investors, securities firms, and
employees of securities firms, offering both arbitration and mediation
services.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 5 NASD Procedures Help Ensure That Arbitrator Disclosure
Information Is Updated Regularly In selecting individuals to be in its
pool of potential arbitrators, NASD relies on
background information that prospective arbitrators provide. This
information is first entered into the NASD arbitrator information database
when arbitrators enroll in the program and is to be updated for any new
information. NASD uses the background information to classify arbitrators
as *public* or *nonpublic.* 8 The parties in a dispute also use this
information in deciding whether to accept arbitrators to be assigned to
their case. NASD arbitrator disclosure reports include information on
education and training, employment, past arbitration experience, finances,
and conflicts of interest. The reports also include a narrative section,
written by the arbitrators, describing their professional duties and
responsibilities.
As we reported in November 2000, NASD has taken steps to improve its
procedures for updating and entering arbitrator disclosure information. 9
We reported that the new procedures appeared reasonable and were likely to
reduce the possibility for errors and improve the promptness of data
entry. The improvements included
centralizing the process for updating arbitrator profiles in the
Department of Neutral Management in the New York City offices of NASD*s
Division of Dispute Resolution, and
using an on- line reporting form on which arbitrators submit updated
disclosure information via a NASD dispute resolution program Web site.
NASD procedures state that all updated arbitrator records, whether
received on- line or by phone or fax, are to be reviewed by a quality
control supervisor after they are initially entered. Records of
arbitrators currently serving on panels are to be updated within 24 hours,
while updates from nonserving arbitrators can be entered in 3 to 5 days.
NASD staff are also to monitor and track all entries to arbitrator
profiles and prepare a biweekly report to department managers on the
receipt and computer entry of arbitrator updates. For each arbitrator
submission, the biweekly reports list the date the information was
received by the Department of Neutral Management and the date computer
entry of the information was completed. The department manager is to use
the report to verify the timeliness of the process.
In November 2001, SEC reported that, after the new procedures were
implemented, neither SEC nor NASD had received any new complaints
regarding the arbitrator
8 A public arbitrator has had no recent association with the securities
industry whereas a nonpublic arbitrator has had recent or has current
association with or experience in the securities industry. Public
arbitrators are used in all investors* cases. In single arbitrator cases
in which claims are $50,000 or less, the arbitrator is a public
arbitrator. In cases with three arbitrators in which claims are more than
$50,000, two of the arbitrators are public arbitrators . 9 U. S. General
Accounting Office, Procedures for Updating Arbitrator Disclosure
Information, GAO- 01- 162R (Washington, D. C.: Nov. 9, 2000).
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 6 disclosure records. According to NASD, from November
2001 through the end of 2002
it had logged one complaint about an arbitrator failing to update his
background information. In that case, according to NASD, a party in a
dispute asked the arbitrator for new information, and the arbitrator sent
the new information to the party by fax and to NASD by mail. As a result,
the party received the information before NASD could receive it, update
its disclosure information database, and make the information available.
SEC officials said that they did not recall receiving any new complaints
and SEC has indicated that its inspection staff will continue to monitor
NASD*s process for updating arbitrator profiles. In 2004, NASD plans to
use a new computer system that would enable arbitrators to access and
update their own disclosure records on- line at a NASD Web site.
New Procedures Make Removing Arbitrators from Cases Easier Effective March
2001, SEC- approved amendments to NASD*s Code of Arbitration Procedure
gave the President, NASD Dispute Resolution, and its Director of
Arbitration indelegable authority to remove an arbitrator at any juncture
in the arbitration process. These amendments allow for removal of an
arbitrator from a case after a prehearing conference or a hearing has been
started, based on new information that was not known to the parties at the
time of the arbitrator*s appointment but that the arbitrator, pursuant to
NASD rules, should have disclosed.
Under the old rule, the director could disqualify an arbitrator from
serving on a case when information revealed a conflict of interest or bias
such as a relationship with one of the parties. However, this authority to
disqualify was limited to the time before the start of the prehearing
conference or the first hearing. After that point, the parties would have
needed to make a motion before the arbitration panel asking the arbitrator
to recuse himself or herself or seek a court action to remove an
arbitrator from a case. In approving the rule change, SEC noted that the
change should result in lower litigation expenses for the parties, because
they would not have to seek judicial intervention to remove an arbitrator.
SEC also noted that the change would help ensure greater confidence in the
fairness and neutrality of the administration of arbitration cases.
According to NASD, after the new rule became effective in March 2001 and
through the end of 2002, NASD had received 47 requests for the Director of
Arbitration to exercise the authority to remove an arbitrator. NASD
reported to us that the Director denied these requests in 38 instances and
removed an arbitrator in 9 instances.
Motions to Dismiss Are Used in NASD Arbitrations
Prehearing motions to dismiss are used in NASD- administered arbitration
cases. NASD, however, does not centrally track the motions filed in its
numerous cases. Data that we assembled from 719 investor- initiated, NASD-
administered monetary arbitration awards in 2001, showed that motions to
dismiss were filed in 54 cases and a request for summary judgment in one
case, or in about 8 percent of all the cases. In
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 7 the 54 cases, 124 motions were filed. We identified 42
instances in which the motions
were not decided because the claims had been dismissed for other reasons
or settled by the parties before the case was decided. We identified 54
instances in which the motions were denied and 28 instances in which the
motions were granted. The total number of motions filed exceeded the
number of cases because any one case may involve multiple respondents and
multiple filings of motions. SEC officials said that some motions to
dismiss are based on substantive arguments, while others assert practical
ones, for example, that the wrong party was named or served. The awards
did not provide enough detail about the motions for us to determine the
reasons for their being filed.
NASD arbitration rules do not specifically provide for dismissal motions
or for motions for summary judgment. However, nothing in the rules
prohibits the parties from filing motions or precludes panels from
granting them. NASD rules are consistent with the practice of disposing of
claims by motion. NASD rules allow prehearing conferences at which the
presiding person can require the briefing of contested issues and address
*any other matters which will expedite the arbitration
cases.* 10 The case law consistently has recognized the authority of
arbitrators to grant prehearing motions to dismiss. For example, in Warren
v. Tacher the underlying dispute in the arbitration proceeding involved
alleged investor losses in a brokerage account. 11 The investors brought a
claim for arbitration against the broker- dealer that maintained the
account and the clearing broker- dealer. The clearing broker- dealer moved
to dismiss all claims on the ground that it had no responsibility to
claimants. The claimants filed a written response to the motion and the
arbitration panel held oral argument. The arbitration panel dismissed all
claims against the clearing brokerdealer. The claimants appealed and
sought to have the arbitrators* decision vacated on the ground that the
arbitrators engaged in misconduct and exceeded their powers by dismissing
the claims against the clearing broker- dealer prior to discovery and an
evidentiary hearing. The court stated that courts have recognized the
authority of NASD arbitrators to decide prehearing dismissals for failure
to state a claim under the NASD Code. 12 The court rejected an argument
that the arbitrators displayed a *manifest disregard for the law* by their
determination to dismiss all claims against the clearing broker- dealer.
10 NASD Code S:10321( d)( 1). General Provisions Governing Pre- Hearing
Proceedings, Pre- Hearing Conference, (1) Upon the written request of a
party, an arbitrator, or at the discretion of the Director of Arbitration,
a prehearing conference shall be scheduled. The presiding person shall
seek to achieve agreement among the parties on any issue that relates to
the prehearing process or to the hearing,
including but not limited to stipulation of facts, identification and
briefing of contested issues, and any other matters which will expedite
the arbitrations.
11 114 F. Supp. 2d 600 (W. D. Ken. 2000). 12 Goldman, Sachs & Co. v. Patel
(N. Y. L. J. Aug. 18, 1999, p. 23, co. 6) (* Contrary to respondent*s
assertion, the NASD panel has the power to decide a motion to dismiss a
claim on legal grounds without holding an evidentiary hearing.*).
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 8 The court in Warren v. Tacher also addressed the issue
of whether the grant of a
prehearing motion to dismiss is tantamount to a refusal to hear evidence.
The court rejected this argument and explained that while the granting of
a prehearing motion to dismiss usually means that the arbitrator *refused
to hear evidence,* that, by itself, is insufficient to vacate the award.
Claimants must also show that the excluded evidence was material to the
panel*s determination and that the arbitrator*s refusal to hear the
evidence was so prejudicial that the party was denied fundamental
fairness. 13 In addition, the court held that a hearing for purposes of
NASD rules does not
necessarily mean an evidentiary hearing. The court found that the
claimants did have a *hearing.* They were given adequate opportunity to
respond to the clearing agent*s motion to dismiss and they did so.
The courts have upheld arbitrators granting of dismissal motions in other
cases. These include dismissal on the grounds of the timeliness of the
claims, a respondent*s involvement in the matter in controversy, or
whether the claimant has a private right of action for alleged violation
of an SRO rule. 14 We have not found any cases that do not recognize
arbitrators* authority to grant prehearing motions to dismiss. Moreover,
an NASD official told us that these motions can save time and resources by
helping to identify certain cases that would not prevail in a hearing on
the merits. For example, in some cases the parties* pleadings may clearly
show that the case, or some portion of the case, does not fall within the
NASD*s procedural rule covering filing time limits, which would send the
case instead to court. On the other hand, a member of the Securities
Industry Conference on Arbitration said that motions to dismiss and
motions of summary judgment ought to be discouraged because discovery and
appeal rights in arbitration are limited. Another arbitration official
also said that parties in arbitration deserve the right to be fully and
fairly heard. Rate of Unpaid Awards Has Decreased,
but Many Investors Are Not Paid Awards against Defunct Brokers
Data for 2001 show that the rate of unpaid NASD- administered arbitration
awards had decreased from the levels we previously reported for 1998. NASD
procedures for monitoring awards encourage payment by still- active
brokers. However, defunct brokers continue to not pay awards. The recent
rise in arbitration claims may result in more investors not being paid
their awards.
13 9 U. S. C. S: 10( c); Campbell v. Cantor Fitzgerald & Co., 21 F. Supp.
2d 341, 344 (S. D. N. Y. 1998). 14 In Howsam v. Dean Witter, 123 S. Ct.
588 (2002), the United States Supreme Court recently held that arbitrators
can decide that a claim is ineligible for arbitration under an NASD rule
that provides that claims submitted a certain time after they arose are
ineligible. The Court*s decision does not address whether arbitrators
should make such a decision in response to a motion to dismiss an
arbitration
claim. Dean Witter did not file a motion to dismiss the arbitration claim.
It brought an action in federal court asking the federal court to decide
that the arbitration claim was untimely.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 9 Payment Rates Have Improved, but Many Awards Still Are
Not Fully Paid Although the rate of unpaid arbitration awards has fallen,
many awards rendered by
NASD arbitration panels remain unpaid. In 2001 about 55 percent, or $55
million, of the $100.2 million NASD arbitrators awarded to investors was
unpaid. However, $12 million of the unpaid awards were not required to be
paid because the respondents had requested a hearing, filed for
bankruptcy, or filed a motion to vacate. In our June 2000 report, we
estimated that about 80 percent of the $161 million awarded to investors
in 1998, which were primarily NASD- administered awards, was unpaid. In
that report, we estimated that 64 percent of NASDadministered monetary
arbitration awards won by investors in 1998 had not been fully paid. Our
analysis of NASD award payment data for 2001 found that 33 percent of
awards to investors were unpaid. Of the total of 719 monetary awards that
investors won in 2001, 236 awards were not fully paid. (Nothing was paid
on 216 awards and 20 awards were partially paid.)
In June 2000, we reported that most of the unpaid arbitration awards in
1998 were against broker- dealer firms and associated persons that had
left the securities industry. Awards that were not fully paid in 2001 also
were against such defunct brokers. More specifically, as shown in table 1,
nonpayment of 192 awards ($ 41 million) in 2001, was attributed to brokers
that had terminated their NASD membership. In an additional 16 awards,
NASD suspended firms or individual brokers for failing to pay $2.1 million
of awards. In 29 awards, $12 million awarded was not paid because the
respondents had requested a hearing, filed for bankruptcy, or filed a
motion to vacate the award. 15 15 NASD procedures allow the respondent to
request a hearing on the matter to consider whether (1) the respondent was
given notification of the award, (2) the respondent satisfied the award,
and (3) a
valid reason exists for the respondent*s failure to comply with the award.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 10
Table 1: Number and Amount of Dollars Not Fully Paid by Broker- dealers or
Individual Brokers with NASD- administered Arbitration Awards against Them
and Award Nonpayment Status in 2001
Terminated NASD membership Suspended Requested a
hearing Filed for bankruptcy
Filed motion to vacate Total Number of awards not fully paid
192 16 7 5 17 237 a
Dollars not paid (in millions)
$41 $2 $2 $1 $9 $55 Source: NASD (data); GAO (analysis). a The sum of
these unpaid cases exceeds the 236 unpaid awards because cases with
multiple respondents can have different outcomes.
NASD Procedures to Monitor the Payment of Awards Are Designed to Encourage
Award Payment NASD has put procedures in place for monitoring the payment
of awards that are designed to encourage award payment. In September 2000,
NASD began requiring its member broker- dealers to certify that they had
paid or otherwise complied with an award against them or their associated
persons within 30 days after the award was served. NASD also began asking
the claimants who had won awards to notify it if an award had not been
satisfied within the 30- day period. If an award is not paid, NASD begins
the process of suspending the license of the broker- dealer firm or the
individual broker responsible for payment of the award. In 2001, NASD
suspended one or more of the respondents in 12 cases for failing to pay
awards. Members and individuals who fail to pay awards cannot apply to
restore their licenses until an award against them is satisfied.
Although these procedures may have helped to reduce the rate of unpaid
awards, the previously discussed reduction in the rate of unpaid awards
also might reflect differences in the methodologies used to compile the
data used to calculate the rate. Our June 2000 report was based on data
that we obtained by surveying a sample of investors that had won
arbitration awards in 1998. For this report, the rate was calculated from
data obtained from NASD based on its monitoring of award payment for the
entire year of 2001. Additionally, arbitration attorneys said that they
have begun scrutinizing cases more closely to avoid taking cases where
awards might not be paid, a factor which may also have contributed to a
reduction in the rate of unpaid awards.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 11 NASD Has Implemented Changes to Help Address the
Problem of Unpaid Awards by Failed Broker- Dealers NASD is helping to
address the problem of unpaid awards by defunct brokers by
making it easier for investors to seek alternative means of relief or
obtain a judgment against the broker. These procedures address the problem
of unpaid awards by defunct brokers, for example, by helping shorten the
time period for obtaining a court judgment that could be used to seize
remaining assets of a defunct broker. In April 2001, SEC approved
amendments to NASD*s Code of Arbitration Procedure, S:10301, effective
June 2001, that provided that a broker- dealer that has been terminated,
suspended, or barred from NASD, or that is otherwise defunct cannot
enforce a predispute arbitration agreement against an investor in NASD*s
arbitration forum. Also, in June 2001, NASD began to advise claimants in
writing, at the time they file a claim, of the registration status (for
example, terminated, out- of- business, bankrupt) of broker- dealers or
associated persons so that the claimants can evaluate whether to continue
with the arbitration. In October 2002, a new NASD rule, which SEC approved
in July 2002, took effect. The rule provides for streamlined default
proceedings where the terminated or defunct broker- dealer or associated
person does not answer or appear, but the claimant affirmatively elects to
pursue the arbitration. Under the streamlined proceedings, an arbitrator
can make a decision based on the statement of claim and any other material
submitted by the claimant. In addition, in August 2002, the NASD Board of
Directors approved a proposed amendment, which was submitted in January
2003 to SEC for approval, that would strengthen NASD*s authority to
preclude member broker- dealers from using structural changes, such as
consolidations or other asset sales and transfers, to avoid meeting their
arbitration obligations to investors. Also, NASD officials said that
NASD*s Enforcement Division had started reviewing new arbitration claims
as they come in as part of an effort to identify potentially troublesome
members.
In our June 2000 and April 2001 reports, we discussed proposals made by
investors* attorneys to address the unpaid award problem such as insurance
and bonding. In the June 2000 report we recommended that, to the extent
unpaid awards remain a problem, the SEC*s Chairman should establish a
process to assess the feasibility of alternative approaches to address the
problem. In response SEC officials said that after our report was issued
SEC staff assessed other approaches addressed in the report including
insurance and bonding. According to the officials, SEC staff met with
broker- dealer representatives and insurance companies to discuss existing
brokerdealer insurance and bonding requirements. The officials said that
after those consultations, the staff concluded that expanding broker-
dealer insurance and bonding requirements would not be an appropriate
means of addressing unpaid arbitration awards. Instead, SEC staff
concluded that the efforts of NASD* which conducts most broker- dealer
examinations* to institute a procedure of reviewing all arbitration claims
as they are filed to identify problem brokers early through related
examinations and as appropriate, enforcement action, would limit the harm
they cause investors. The officials said that this, as well as other
initiatives NASD has taken, which are described earlier in this report and
in our June 2000 and April 2001 reports, should be given time to work.
SEC*s continuation of the process we
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 12 recommended in June 2000 to assess the feasibility of
alternative approaches to
address the problem of unpaid awards by defunct brokers could further
reduce the incidence of unpaid awards. This process could consider how SEC
and NASD programs for broker registration, regulation, enforcement, as
well as arbitration, and other areas as appropriate, can further reduce
the incidence of unpaid awards.
In June 2000, we also recommended that the SEC Chairman work with the SROs
to develop and publicize information to focus investor attention on the
possibility of unpaid arbitration awards. In response, NASD and SEC made
information available on their Web sites to caution investors about the
possibility of having an unpaid award. That information, while helpful,
does not provide any data to inform investors
of the scope of the problem or the frequency with which awards are unpaid
by defunct brokers. Increasing investors* awareness of the scope and
frequency of the problem may better inform investors that broker- dealers
that stay in business generally pay awards and help to reduce unpaid
awards by defunct brokers.
Recent Increase in Arbitration Claims Suggests That Many Future Awards
also Might Not Be Paid Arbitration claims have increased sharply, which
may mean, assuming the rate of unpaid awards remains the same; more
investors may not be paid. In 2001, 6,926 arbitration claims were filed
with NASD. In 2002, the number of new cases further increased to 7,709, or
a 39 percent increase over the 5,565 total claims filed in 2000. In most
of these cases* 4,849 in 2001 and 5,974 in 2002* investors filed claims
against their brokers. Through 2002, these investor- initiated cases
increased by 64 percent from the 3,637 claims filed by investors in 2000.
NASD officials said that whether this increase in claims will mean more
unpaid awards depends on the types of brokerdealers any resultant awards
might be against. For example, if the increase in claims results in more
awards against large viable broker- dealers that tend to pay awards, the
number of unpaid awards could decrease.
NASD officials said that the increase in claims filed was the result of
changes in the economy. The officials said the downturn in and increased
volatility of the stock market in 2001, an influx of new inexperienced
investors during the boom years of the late 1990s, and the overall
increased number of securities holders contributed to the increase in
arbitration claims filed. According to NASD, claims alleging broker
failure to supervise their sales representatives, breach of fiduciary
duty, misrepresentation, and negligence also had increased.
Conclusions
The rule and procedural changes that NASD has adopted to improve the
arbitrator information update process and its ability to remove
arbitrators from cases appear reasonable and could improve the
effectiveness and efficiency of arbitration. These changes could help NASD
to keep current the information that parties in arbitration use in
selecting arbitrators and allow for faster and less costly removal of
arbitrators in cases where there has been an undisclosed conflict of
interest.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 13 Motions to dismiss are used, but not with great
frequency, in NASD arbitrations.
Arbitration law and codes do not explicitly prohibit the use of these
motions. Because appeal rights and evidentiary discovery are limited, a
Securities Industry Conference on Arbitration member said that arbitration
forums should discourage the granting of these motions. However, NASD
officials have contended that use of these motions helps to make the
arbitration process more efficient. Data show that the rate of unpaid
awards has diminished since our June 2000 report.
However, continued unpaid awards, regardless of how effective and fair the
arbitration process may be, could negatively affect investors* confidence
in arbitration and potentially the securities markets in general. Unpaid
awards also may discourage attorneys from taking investors* cases. It is
important that regulators continue to issue a strong message to investors
about being cautious in choosing their brokers because some brokers will
never pay for the damage they cause. Moreover, given that continued unpaid
awards could erode investors* confidence in arbitration, SEC*s Chairman
should continue the process we recommended in June 2000 to assess the
feasibility of alternative approaches to address the problem of unpaid
awards by defunct brokers. This process could consider how SEC and NASD
programs for broker registration, regulation, enforcement, as well as
arbitration, and other areas as appropriate, could further reduce the
incidence of unpaid awards. Further, NASD needs to be concerned about
unpaid awards, which represent inefficient use of NASD dispute resolution
program resources and futile efforts by defrauded investors seeking
restitution. By making data on the frequency with which awards are unpaid
by defunct brokers publicly available, NASD could better inform investors
of the possibility of unpaid awards by defunct brokers and increase
investors* awareness of the scope of the problem. This, in addition, could
cause investors to be more cautious in choosing their broker and also help
them decide whether to file an arbitration claim or seek alternative means
of obtaining relief and avoid unnecessary expenses.
Recommendation for Executive Action
We recommend that the President, NASD Dispute Resolution, make available
on NASD*s Web site current statistics showing the frequency with which
arbitration awards against defunct brokers are not fully paid.
Agency Comments and Our Evaluation
SEC and NASD provided written comments on a draft of this report, which
are reprinted in enclosures I and II. SEC and NASD also provided technical
comments, which were incorporated into the final report. SEC agreed with
the contents of this report and noted that our work demonstrates that NASD
has developed necessary tools to administer its growing caseload and that
implementation of our June 2000 recommendations has helped achieve an
appreciable reduction in the rate of unpaid awards. SEC commented that it
welcomes our recommendation that NASD make available on its Web site
current statistics showing the frequency with which arbitration awards
against defunct brokers are not fully paid. SEC said that this more
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 14 explicit data should help deliver to investors the
educational message to choose
investment professionals carefully. SEC noted that SEC staff believe that
more time is needed to realize the full effects of the steps taken after
our June 2000 report and that it continues to work with NASD to better
identify individuals responsible for unpaid awards.
NASD generally agreed with the contents of this report and provided
additional information on the various steps it has taken related to its
addressing the problem of unpaid awards. NASD also noted the dramatic
improvement in the rate of unpaid awards from our June 2000 report and
provided updated information on the status of awards we found to be
unpaid. NASD updated the payment status of awards that were paid after it
threatened suspension of the member or a motion to vacate was denied or
which had motions to vacate still pending, which reduced the percent of
awards unpaid from 55 percent to 53 percent. NASD stated that it would
consider our recommendation and additional ways to enhance investor
education about the problems associated with terminated members and the
payment of awards. NASD commented that it strives to strike a balance
between disclosing information and not discouraging investors from filing
valid claims. NASD stated that, with that concern in mind, it will develop
an approach to enhance the data available to investors to enable them to
make more informed decisions about whether to pursue a claim. NASD also
commented that it welcomes the opportunity to participate in a feasibility
study of alternative solutions to address the problem of unpaid awards
that we recommended in June 2000.
We commend SEC and NASD for the efforts they have taken to monitor and
educate investors about unpaid awards, and provide investors viable
options when faced with the possibility of unpaid awards. However, the
extent to which awards are unpaid by defunct brokers shows that unpaid
awards, even when reduced to 53 percent for 2001, as NASD adjusted it, is
still a serious problem that can affect investors* confidence in
arbitration and potentially the securities markets and discourage
attorneys from taking investors* cases. It is, therefore, important that
NASD make available to investors current statistics on the frequency with
which awards are unpaid by defunct brokers and that regulators continue to
monitor unpaid awards and consider ways of addressing the problem.
Scope and Methodology
We analyzed information on NASD procedures for updating arbitrator
disclosure information and removing arbitrators from cases based on our
review of NASD*s procedures and interviews of NASD officials. We analyzed
information on the use of motions in arbitration based on interviews of
officials of NASD and the Securities Industry Conference on Arbitration.
We also reviewed arbitration rules of NASD and other forums and federal
case law regarding the uses of motions to dismiss and motions for summary
judgment in NASD cases. We then identified the extent to which these
motions were used in 2001 NASD investor- initiated cases in which monetary
award decisions were rendered in favor of investors.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 15 To determine changes in arbitration claims and the
rate at which awards in investorinitiated
cases were paid, we analyzed NASD data. Initial testing of the NASD data
on award payment found errors that could overstate the extent to which
awards were paid that were significant enough to require further
verification and correction. We then had NASD correct any errors found and
then further tested the accuracy of the data. We reviewed a randomly-
selected sample of 34 cases out of 719 monetary awards in 2001 to verify
that NASD had documentation showing that the awards were paid. From our
random sample of 34 awards 1 award was initially listed as paid, but we
discovered on further review that the award was unpaid, and the respondent
had filed for bankruptcy. Subsequently, NASD discovered an additional
award that was mistakenly classified as unpaid. The number and magnitude
of these data errors are small enough that the data are sufficiently
reliable for our purposes and should not materially affect the estimates
of payment rates in this report. Nevertheless, we apprised SEC officials
of the errors. The officials said that SEC examiners would test the
accuracy of the award payment data as part of SEC*s routine inspections of
NASD's dispute resolution program. NASD officials told us that the errors
resulted from NASD not having a means of tracking the payment status of
awards. Once an award was granted, NASD gave the case a closed status and
NASD staff had to manually compile the payment data from documents in case
files. The NASD officials
said that NASD has since entered new status codes in its computer system
for tracking the payment status of awards. They said that they can now
track different outcomes related to award payment such as receiving a
broker*s certification that an award was paid or that a broker had filed a
motion to vacate an award in a court. The officials said that this change
should minimize the opportunity for compilation errors.
We conducted our work in Washington, D. C., and New York, N. Y., from
April 2002 through March 2003, in accordance with generally accepted
government audit standards.
As agreed with your offices, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from
the report date. At that time, we will provide copies of this report to
the Chairman, House Committee on Energy and Commerce; the Chairman,
Subcommittee on Telecommunications and the Internet, House Committee on
Energy and Commerce; the Chairman and the Ranking Minority Member, Senate
Committee on Banking, Housing, and Urban Affairs; and the Chairman and the
Ranking Minority Member, House Committee on Financial Services. Copies
also will be provided to the Honorable William H. Donaldson, Chairman,
SEC; Mr. Robert R. Glauber, Chairman, NASD; and other interested parties.
In addition, the report will be available at no charge on the GAO Web site
at http:// www. gao. gov.
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 16 Please call me or Orice M. Williams, Assistant
Director, at (202) 512- 8678 if you or
your staff have any questions concerning this report. David Tarosky and
Sindy Udell also contributed to this report.
William O. Jenkins Jr. Director, Financial Markets and Community
Investment Enclosures
Enclosure I
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 17 Comments from the Securities and Exchange Commission
Enclosure I
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 18
Enclosure I
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 19
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 20 Comments from NASD
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 21
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 22
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 23
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 24
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 25
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 26
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 27
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 28
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 29
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 30
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 31
Enclosure II
GAO- 03- 162R Follow- up Report on Matters Relating to Securities
Arbitration Page 32 (250081)
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