SEC Approves Amendment To Code Of Arbitration Procedure Permitting Arbitrator Disciplinary Referrals

Executive Summary

On July 11, 1994, the Securities and Exchange Commission (SEC) approved an amendment to Section 5 of the Code of Arbitration Procedure (Code) to specify that arbitrators, at the conclusion of a proceeding, may refer matters arising or discovered during the course of a proceeding for disciplinary investigation. The text of the amendment, which takes effect on August 15, 1994, follows the discussion below.

Background

On July 11, 1994, the SEC approved an amendment to Section 5 of the Code to specify that arbitrators, at the conclusion of a proceeding, may refer for disciplinary investigation matters that come to their attention during the course of an arbitration proceeding.

The amendment was adopted because the NASD believes that potential violations uncovered during arbitration hearings should be investigated by the NASD as part of its comprehensive regulatory program. The NASD is aware that while customers who suffer a financial loss as a result of misconduct by their registered representative may bring arbitration actions, they often do not pursue formal complaints with a self-regulatory organization (SRO) necessary to trigger an investigation of the potential violation. Further, while the filing of an arbitration complaint will alert an SRO to the existence of a potential violation,¹ because customer complaints in arbitration often do not allege or disclose sufficient information to indicate obvious misconduct on the part of a respondent, they may not trigger a disciplinary investigation. Indeed, in such cases, violations of the securities laws or the NASD's rules are not apparent until an arbitration hearing occurs and the parties testify and introduce evidence about the relevant events. Thus, in some cases, the NASD is never made aware of securities law violations or violations of the NASD's rules, notwithstanding the fact that the financial injury to the customer resulting from the violation is the subject of an arbitration proceeding.

The NASD has also observed that arbitrators seldom refer matters that come to their attention during the course of an arbitration proceeding for disciplinary investigation. Because the NASD believes that arbitration matters, and the evidentiary material related to or produced in such matters, constitutes a valuable source of information concerning potential violations of the NASD's rules and the federal securities laws, bringing such information to the attention of the NASD's regulatory staff should improve the efficacy of the NASD's regulatory function. Accordingly, the NASD believes that this amendment provides a mechanism in the Code for arbitrators to bring such information to the attention of the NASD's regulatory staff for investigation that will serve the public interest by ensuring that potential violations of the NASD's rules and the federal securities laws are not overlooked.

In addition, the NASD believes that it is important for arbitrators to understand that the arbitration process is for the resolution of civil disputes between the securities industry and others, and that the securities industry maintains a regulatory apparatus separate from the arbitration process that is designed to address misconduct that affects the public interest and the integrity of the financial markets. Thus, to the extent arbitrators are aware that they may refer matters rather than engage in ad hoc disciplinary sanctions as part of awards, the fairness of the arbitration process will be enhanced and challenges to arbitration awards may be reduced, an occurrence that would redound to the benefit of successful claimants.

The amendment to Section 5 specifies that if any matter comes to the attention of an arbitrator during the course of a proceeding, the arbitrator may initiate a referral of the matter to the NASD for disciplinary investigation. The amendment also specifies, however, that any such referral should only be initiated by an arbitrator after final disposition of the matter through settlement or award. Although the NASD is not setting forth a specific procedure for such referrals, the NASD contemplates that arbitrators will direct referrals to the Association through the Arbitration Department staff and the Director of Arbitration.

Questions regarding this Notice may be directed to the NASD Arbitration Department at (212) 858-4400.

¹ The filing of a customer-initiated arbitration complaint against an associated person alleging damages of $10,000 or more triggers a requirement of the member or associated person to amend the associated person's Form U-4 or U-5, as appropriate. Information supplied pursuant to such an amendment will be entered into the Central Registration Depository and will also be forwarded to the appropriate NASD District Office for preliminary investigation.

Text Of Amendment To Section 5 Of The Code Of Arbitration Procedure

(Note: New text is underlined.)

Code of Arbitration Procedure

Non-Waiver of Association Objects and Purposes

Sec. 5. The submission of any matter to arbitration under this Code shall in no way limit or preclude any right, action or determination by the Association which it would otherwise be authorized to adopt, administer or enforce. If any matter comes to the attention of an arbitrator during and in connection with the arbitrator's participation in a proceeding, either from the record of the proceeding or from material or communications related to the proceeding, that the arbitrator has reason to believe may constitute a violation of the Association's rules or the federal securities laws, the arbitrator may initiate a referral of the matter to the Association for disciplinary investigation: provided, however, that any such referral should only be initiated by an arbitrator after the matter before him has been settled or otherwise disposed of. or after an award finally disposing of the matter has been rendered pursuant to Section 41 of the Code.