The elderly client you represented in a personal injury matter walks into your office in despair. Her settlement money, the only significant asset she has, was invested in a "can't lose" portfolio of technology stocks in the late 1990s. Because she needed cash for her Medicare Gap Insurance, her stockbroker placed her on margin. When the technology bubble burst in 2000, her investments quickly sank. Your elderly client, too old and disabled to work, is now virtually penniless. You must now decide whether there is a claim against her stockbroker, and the forum for resolving a claim. Welcome to the world of securities arbitration.
THE ROLE OF NASD
Since 2000, new case filings with National Association of Securities Dealers ("NASD") Dispute Resolution, Inc. are increasing at record levels. The owner of the corporation, the NASD, is the world's leading private-sector provider of financial regulatory services. Almost every securities firm in the country is a member of this private not-for-profit organization. The NASD registers member firms, establishes rules to govern their conduct, examines them for compliance, and disciplines those that fail to comply.
NASD Dispute Resolution, Inc. provides a forum for customers to resolve complaints against member firms and their registered stockbrokers.
NASD Dispute Resolution administers the vast majority of securities arbitrations. There were 7,704 new case filings with NASD Dispute Resolution in 2002. This is a jump of 11 percent compared to the previous year and up 38 percent compared with 2000. NASD Dispute Resolution closed 5,957 cases last year, also a record number. The turnaround time from submission to decision was 13.7 months, compared with 13 months in 2001, although the time required for decisions involving a hearing decreased to 16.5 months and that for decisions without hearings was down significantly from previous years to 7.6 months.
The NASD Dispute Resolution also provides mediation of securities cases. More parties availed themselves of this opportunity in 2002 than in the previous year and the settlement rate as a result of mediation was 82 percent, up 6 percent from previous years. The turnaround time increased to 129 days although this is still much shorter than the turnaround time for matters that are decided through the arbitration process.
Just as every unfavorable verdict is not the result of attorney malpractice, not every investment loss means that a broker has committed misconduct. Many investors suffer significant losses but are not entitled to recover those losses from their stockbrokers. However, many types of conduct are prohibited and give rise to a claim. The NASD has published an outline of prohibited conduct by stockbrokers. Such conduct includes:
- Unsuitable Transactions. Brokers are prohibited from recommending to an investor the purchase or sale of a security that is unsuitable given the investor's age, financial situation, investment objective, and investment experience. An investment in a particular type of security may also be unsuitable due to the amount or frequency of the transactions. See NASD Code of Conduct Rule 2310; Minneapolis Employees Retirement Fund v. Allison-Williams Company, 519 N.W.2d 176 (Minn. 1994) (holding that unsuitability claim requires (1) that a broker recommended a security which is unsuitable in light of the investor's objectives, (2) that the broker recommended or purchased securities with an intent to defraud or with reckless disregard for the investor's interests, and (3) that the broker exercised control over the investor's account).
- Churning. Churning is excessive trading in an account for the purpose of generating excessive commissions. This is more easily shown where the client had a discretionary account and the broker had complete control over the account. To determine if churning has occurred based strictly on the numbers, the turnover ratio (total cost of purchases/average monthly investment), cost equity factor (annualized commission/average monthly equity), and the holding period of securities are considered. Another factor to be considered would include switching an investor from one mutual fund to another when there is no legitimate investment purpose for the switch. McGinn v. Merrill Lynch, 736 F.2d 1254 (8th Cir. 1984).
- Unauthorized Transactions. Purchasing or selling securities in an investor's account without first contacting the investor for specific authorization is prohibited, unless the broker has received from the investor written discretionary authority to conduct the transactions.
- Misrepresentation. Misrepresentation includes failing to disclose material facts concerning an investment. Material information that should be accurately presented to investors includes the risk of investing in a particular security; the charges or fees involved; the company financial information; and technical information such as bond ratings.
Beginning in the mid-1980s, most brokerage firms began incorporating a binding arbitration clause within their new customer agreements. As a result, almost all customer complaints are now resolved through binding arbitration. Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213 (1985); Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987) (holding that securities fraud claims are subject to binding arbitration). The starting point for any practitioner involved in NASD securities arbitration should be www.nasdr.org. This website provides the Code of Procedure, forms for initiating an arbitration, the filing fee calculator, and links to resources on substantive law.
The NASD Code of Procedure for arbitration is similar to the commercial rules for the American Arbitration Association ("AAA"). As in proceedings conducted by AAA, NASD arbitration is initiated through the filing of a Statement of Claim. A Case Information Sheet is submitted with the initial pleading setting forth the names and contact information for the respondents. NASD Dispute Resolution handles the service of the initial pleading. Respondents receive a copy of the Statement of Claim with a cover letter from NASD Dispute Resolution setting forth the deadline for filing a responsive pleading.
NASD Dispute Resolution forwards to the parties an Arbitrator Ranking Form soon after receiving a Statement of Answer from the respondents. Three arbitrators are appointed in cases involving an amount in controversy exceeding $25,000. Of the three arbitrators, one arbitrator is from the securities industry, often a broker or compliance officer. Unlike the AAA, NASD Dispute Resolution currently allows the parties to strike an unlimited number of potential arbitrators and rank in order of preference the names that remain. Practitioners should obtain copies of each arbitrator's prior awards from the NASD-DR website before ranking arbitrators. Often, either due to the number of strikes from the parties, or based upon recusal of the potential arbitrators, NASD Dispute Resolution randomly assigns arbitrators to fill the panel.
Discovery was streamlined in 2001. Depositions are rare. Document exchange follows a set of guidelines that set forth documents that are presumably relevant in these arbitrations. Again, these guidelines are available at the website. These sample document requests mandate the exchange of certain categories of documents, including the new account form, correspondence, monthly statements, and any account analysis. The parties are allowed to tailor their respective requests for information to the issues in their case.
The actual arbitration hearing is scheduled through mutual agreement between the parties and the arbitrators in a prehearing telephone conference call. A prehearing exchange of exhibits and witness lists occurs 20 days before the arbitration hearing. The preferable process is for the parties to use joint exhibit books. Expert witnesses are often used to complete an account analysis, as well as provide testimony relating to industry-specific practices. Some practitioners, recognizing that one member of the arbitration panel is from the securities industry, will avoid the costs of an expert witness on issues regarding the securities industry. Practitioners representing claimants will often use an expert witness simply to provide guidance in evaluating the case and during the discovery process.
The arbitrations are typically held in a conference room in a local hotel. After allowing for brief opening statements, the case proceeds like any arbitration. Each party is allowed direct and cross-examination of witnesses. One notable difference in NASD is that the parties are not required to disclose exhibits used for cross-examination or rebuttal, which often leads to surprises during the hearing. Another significant difference from aaa is that the claimant is allowed to present an initial closing argument, and reserve time for a rebuttal closing argument.
One of the authors of this article serves as an NASD arbitrator and offers the following suggestions to practitioners:
- Establish and articulate the game plan for the arbitration. Let arbitrators know what to expect and keep to those expectations. If the arbitration is more than one day or takes several days, recap with the panel at the end of each day where you are and what to expect the next day.
- Be prepared. NASD arbitrations can be fairly complicated affairs and the more prepared you are, the smoother the process works.
- It's not a jury trial. There's little need for theatrics.
- On the other hand, not all NASD arbitrators are lawyers. Indeed, at least one panel member is someone from the industry who is probably not a lawyer. If there is a legal point, make it as clear and plain for nonlawyers as possible.
- Be civil. Arbitrations are also fairly small affairs and even the slightest off-hand remark reverberates off the walls. Respect the panel. For example, direct objections to the chairperson.
- Control your client. This is a must. Panel members understand that clients may be frustrated but they don't want to hear or see grunts, sighs, gestures, or anything along those lines.
- Don't be offended if the panel lets you know they understand your point and asks you to move on.
In most cases, the arbitrators decide the case immediately following the closing argument during a private caucus. There is rarely enough time between closing argument and the private caucus to consider additional written materials submitted by the parties during closing argument. Written submissions and complex areas of the law accordingly must be addressed before or during the hearing. The Award Form is completed and distributed to the parties through NASD Dispute Resolution. One advantage for claimants is that awards not paid within 30 days are grounds for suspending the securities license of the respondent.
Especially in light of the continuing bear market, NASD arbitration is becoming more frequently used and can be an effective and efficient means of resolving a securities dispute between a customer and a broker-dealer. Practitioners should take advantage of the resources available through the NASD when representing clients in this forum.
*article courtesy of Donald R. McNeil, a trial lawyer with Coleman, Hull & van Vliet, pllp in Minneapolis and Frederick Ramos, an attorney in St. Paul with experience as an NASD arbitrator, civil and criminal trial lawyer, and attorney for a Minnesota corporation.