Securities Law Prof Blog

FINRA's Revised Definition of Public Arbitrator Effective July 1

FINRA announced that the SEC approved amendments to the definition of public arbitrator in the Customer and Industry Codes of Arbitration Procedure.  The amended definition excludes persons associated with a mutual fund or hedge fund from serving as public arbitrators and requires individuals to wait for two years after ending certain affiliations before FINRA may permit them to serve as public arbitrators.

The effective date of the amended rule is July 1, 2013.

Schwab Eliminate Class Action Waiver in Customers' Agreements -- At Least For Now

As regular readers of this Blog know, Charles Schwab includes in its brokerage agreements with its customer a provision that purports to prohibit customers from bringing class actions against the firm.  This class action waiver violates FINRA rules, but recently a FINRA hearing officer ruled that FINRA could not enforce its rule because of the Federal Arbitration Act, as interpreted by the Supreme Court in AT&T Mobility v. Concepcion.  That decision is currently on appeal before the FINRA appellate body.  Yesterday, Charles Schwab issued a statement that it was modifying its account agreements to eliminate the class action waiver until the issue is resolved:

Effective immediately, Schwab is modifying its account agreements to eliminate the existing class action lawsuit waiver for disputes related to events occurring on or after May 15, 2013 and for the foreseeable future.

While the company believes that dispute resolution is best handled via FINRA arbitration, we have chosen to voluntarily remove the waiver going forward until the issue is resolved by the appropriate regulatory and/or court decisions.  Given that the process will likely take considerable time to resolve, and may leave clients with a degree of uncertainty about their dispute resolution options in the meantime, we have elected to remove that uncertainty until the legal and regulatory process is completed.

To help ensure that small investors have access to pursue any claims they consider appropriate within the arbitration forum available to them, we will continue our existing policy of paying for the arbitration fees of any investor electing to pursue an arbitration claim under $25,000 against Schwab.

 

Maryland Court Upholds Arbitration Bylaw in Publicly Traded REIT

Last month Steven Davidoff (the New York Times' Deal Professor) wrote a column on the hostile takeover bid for CommonWealth REIT by two hedge funds:  What’s at Stake in the Fight Over a REIT (Apr. 18, 2013).  He highlighted the fact that CommonWealth has a bylaw provision that requires arbitration of any shareholders' disputes.   Apparently when the REIT filed its registration statement for its public offering with the SEC, the agency, consistent with its longstanding position that such arbitration provisions in public corporations violate the antiwaiver provisions in federal securities laws, required the REIT to delete the provision.  But not to be thwarted, after the offering, the CommonWealth board amended the bylaws and reinstated the arbitration clause.  As Davidoff nicely frames the issue:

"If the Maryland court upholds CommonWealth's arbitration provision, more companies like Commonwealth can simply adopt these bylaws.  They can then take aggressive positions to resist a takeover, and the results will be sent to the black hole of an arbitration conducted in secret and with no timeline for an outcome."

At least as of now, CommonWealth is victorious.  On May 8, 2013, the Circuit Court for Baltimore City held that the arbitration bylaw is enforceable.  In a case of first impression for the Maryland courts, the court emphasized that arbitration is strongly favored as a matter of public policy and applied contract law principles to determine that there was both mutual assent and consideration to make the arbitration bylaw enforceable as a contract term.  Although the court's language is broad and states that constructive knowledge is sufficient, the court also found that the plaintiffs -- who, the court noted, were "two very sophisticated parties" -- had actual knowledge of the arbitration bylaw and assented to it by their stock purchases. The court also rejected plaintiffs' arguments that defendants' unilateral power to amend the bylaws made the agreement unfairly one-sided, citing case law that courts should not look beyond the "four corners" of the arbitration agreement in determining whether it is valid and enforceable.  "Because the Trustees' power to amend or revoke the Arbitration Bylaws springs from legitimate, legal sources, outside the "four corners" of the Arbitration Agreement -- namely, the company's Declaration of Trust and Maryland REIT law -- Plaintiffs' argument must fail."

So, to quote Professor Davidoff again, we now have our first ruling on this critical issue, "with real consequences for the takeover market."  I suspect that an appeal is under serious consideration.

Corvex Management LP v. CommonWealth REIT (Baltimore City Circuit Court 5/8/13)

NASAA Files Amicus Brief in Schwab Class Action Waiver Appeal

Several amicus briefs have been filed in the appeal of FINRA's disciplinary proceeding against Charles Schwab for including in its customer agreement a class action waiver, contrary to FINRA rules.  A FINRA hearing panel ruled that the FINRA rules were unenforceable because they were preempted by the Federal Arbitration Act; the case is now on appeal before FINRA's NAC.  While the docket in the appeal is confidential, NASAA posted its amicus brief on its website.  Professor Jill Gross and I also filed an amicus brief (Download Amicus Brief Final) that is a distillation of our recent law review article, Investor Protection Meets the Federal Arbitration Act, 1 Stanford J. Complex Litigation 1 and also available at ssrn.com.

NASAA Writes SEC About Class Action Waivers

The North American Securities Administrators Association (NASAA) has addressed a letter to SEC Chair White to comment on Charles Schwab's class action waiver that it now includes in its brokerage agreements.  Although the class action waiver violates FINRA Rules, a FINRA hearing panel recently concluded that FINRA could not enforce its rules against Schwab because they were "anti-arbitration" in violation of the Federal Arbitration Act.  The Hearing Panel's decision is currently on appeal before FINRA's internal appellate body.  NASAA reiterates its long standing opposition to mandatory arbitration of customers' disputes and reminds the SEC that "Section 921 [of Dodd-Frank] provides the SEC the authority, by rule, to prohibit or impose limitations on the use of mandatory arbitration clauses in broker-dealer and investment adviser customer contracts."

NASAA concludes by "commend[ing] the SEC for taking several steps over the years to improve the arbitration forum and process, and encourage[ing] the SEC to take further action to ensure that investors who are forced into arbitration receive the fairest forum possible."

Franken Calls on SEC to Prevent Mandatory Arbitration Clauses in Brokerage Contracts

Senator Al Franken (D-Minn) and other Congressional representatives have written to SEC Chair Mary Jo White, urging the agency to use its authority under Dodd-Frank to prevent mandatory arbitration clauses in brokerage contracts.  Concerns over the use of the predispute arbitration agreements have increased in the wake of Charles Schwab's inclusion of a class action waiver (contrary to FINRA rules) in its brokerage agreement.  A FINRA hearing panel recently held that FINRA could not enforce its rules prohibiting the class action waiver against Schwab because of U.S. Supreme Court's interpretation of FAA preemption in AT&T Mobility v. Concepcion.  FINRA Enforcement has appealed the hearing panel's decision.

Here is the text of the letter:

Dear Chairman White,
 
We write to express our strong belief that the Securities and Exchange Commission (the “Commission”) should promptly exercise its authority under Section 921 of the Dodd-Frank Wall Street Reform and Consumer Protection Act to prohibit the use of mandatory arbitration provisions in customer service agreements.
 
The Dodd-Frank Act was enacted, among other reasons, to protect American consumers from abusive financial services practices.  Section 921 reflects Congress’s concern over the increasingly widespread use of mandatory arbitration agreements in customer and client contracts, and grants the Commission authority to restrict or prohibit the use of these provisions.  Ensuring a choice of forum, particularly for small investors, heightens fairness and ultimately enhances participation in our capital markets.  To our disappointment, in the almost three years since the Dodd-Frank Act’s enactment, the Commission has largely disregarded this important mandate.
 
The time is ripe for the Commission to act under Section 921 to protect the investing public and prevent further abuse of forced arbitration contracts.
 
Recently, we were alarmed to see further attempts to erode investor rights when Charles Schwab, one of the country’s largest brokers, expanded the mandatory arbitration clauses in its customer agreements to include a mandatory class action waiver clause.  In this instance, Schwab argued that, in response to the Supreme Court’s interpretation of the Federal Arbitration Act (FAA) in AT&T Mobility v. Concepcion, it could include a waiver of class action and class arbitration rights in its customer agreements.  FINRA initiated a disciplinary action against Schwab for violation of FINRA rules barring class action waivers.  In February, however, a FINRA hearing panel ruled that although Schwab’s actions did in fact violate FINRA rules, those rules could not be enforced under Concepcion.[1]
 
While the Supreme Court in Concepcion did find that the FAA preempts state actions that would restrict the use of arbitration, the facts in the Schwab case are notably distinguishable—not least because FINRA is a membership organization seeking to enforce its own rules.  However, the ambiguity created by the panel’s ruling underscores the urgency with which the Commission should adopt rules under Section 921.
 
Section 921 was included in the Dodd-Frank Act to address the threat to consumers posed by mandatory arbitration clauses in investment contracts.  During Congress’s deliberation of this section, legislators heard concerns that investors forced into arbitration must face “high upfront costs; limited access to documents and other key information; limited knowledge upon which to base the choice of arbitrator; the absence of a requirement that arbitrators follow the law or issue written decisions; and extremely limited grounds for appeal.”[2]
 
If arbitration offers investors an efficient forum to resolve disputes, as some argue, investors may choose that option—but they should be given the choice.  It is equally important that investors not be precluded from bringing class actions because of contractual fine print imposed by a mandatory waiver class action clause.
 
Although evidence suggests that the use of mandatory arbitration agreements is widespread, we are concerned about the lack of transparency and reliable data regarding the prevalence of such agreements.  We encourage the Commission to track how many brokerage firms are inserting mandatory arbitration agreements and class action waivers into consumer contracts, so that this questionable practice may be better monitored and addressed.
 
We are deeply concerned that the Commission’s failure to respond to the dangers posed by widespread forced arbitration will weaken existing investor protections.  Given the uncertainty created by the recent FINRA decision, we urge the Commission to act quickly to exercise its authority under Section 921 to prevent this practice and protect investor rights.
 
We recognize that the Commission is balancing competing demands, and that it must prioritize its recent mandates by Congress.  The exigent circumstances at hand, however, require that the Commission exercise its authority under Section 921 of the Dodd-Frank Act and prohibit the use of mandatory arbitration provisions.

[1] FINRA Department of Enforcement v. Charles Schwab & Company Inc. (CRD No. 5393) Disciplinary Proceeding No. 201102976021. February 21, 2013.
[2] Senate Committee on Banking, Housing, and Urban Affairs on S. 3217, S. Rep. No.111-176, at 110.
 

FINRA Approves Proposed Rule Changes for Submission to SEC

The FINRA Board of Governors approved several proposed rule changes that will be submitted to the SEC for review and approval.

The Board approved a proposal to publicly disseminate 144A transactions in TRACE-eligible securities for those asset types currently subject to dissemination.  FINRA is taking this step after reviewing the comments submitted in response to its September 2012 Regulatory Notice and in light of JOBS Act provisions. FINRA believes that making this information publicly available will help market participants determine the quality of their executions and help firms comply with their regulatory obligations.

FINRA also approved two proposed rule changes related to securities arbitration:

Arbitration Panel Composition
The Board authorized FINRA to file with the SEC proposed amendments to FINRA Rule 12403 to simplify the panel selection rules. Rather than requiring the customer to elect a panel selection method, parties in all customer cases with three arbitrators would have the same selection method. Under this method, all parties would see lists of 10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. The rules would permit four strikes on each of the public arbitrator lists. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the non-public list. Alternatively, if the parties leave on the non-public list one or more of the same non-public arbitrators, the parties could have a majority public panel—that is two public and one non-public arbitrator.

Discovery Guide Used in Investor Arbitration Proceedings
The Board authorized FINRA to file with the SEC proposed amendments to the Discovery Guide used in customer arbitration proceedings to provide general guidance on e-discovery issues and product cases, and to clarify existing provisions relating to affirmations. Specifically, FINRA would amend the Discovery Guide introduction to:

1.include guidelines for arbitrators to consider when deciding disputes relating to the form of e-discovery;
2.add guidance on product cases to explain, among other matters, that these cases are different from other customer cases and that the Document Production Lists may not provide all of the documents parties usually request in a product case; and
3.clarify that a party may request an affirmation when an opposing party makes a partial production.

 

FINRA Board Scheduled to Consider Changes to Customer Arbitration Rules

At its April 18 meeting the FINRA board of governors will consider a proposed rule change to the Customer Code of Arbitration, to make it easier for customers to select a panel consisting of all public arbitrators (in claims over $100,000).  Currently, the default option is a panel consisting of two public and one industry arbitrator, and a customer must make an election to select an all-public panel option.  The proposed rule change, as described on the FINRA website:

The Board will consider proposed amendments to FINRA Rule 12403 (Cases with Three Arbitrators) to simplify the arbitration panel selection rules. Rather than requiring the customer to elect a panel-selection method, parties in all customer cases with three arbitrators would get the same selection method. All parties would see lists of 10 chair-qualified public arbitrators, 10 public arbitrators and 10 non-public arbitrators. The proposed rules permit four strikes on each of the public arbitrator lists. However, any party could select an all-public arbitration panel by striking all of the arbitrators on the non-public list.

When FINRA first proposed giving customers the option of selecting an all-public panel, I applauded the concept, but worried that pro se claimants might lose the option inadvertently by failing to make the election within the prescribed time period.  I suggested that the default should be an all-public option and that customers could elect to include one industry arbitrator.  FINRA was not receptive to my suggestion.

Since adoption of the all-public option, FINRA has stated that customers are electing for an all-public panel more frequently than it had anticipated, so this proposal may be in response to that.  In any event, it is a welcome development, and I hope that the Board of Governors will view the proposal favorably.

The board of governors will also consider amendments to the Discovery Guide relating to e-discovery, described as follows:

The Board will consider proposed amendments to the Discovery Guide used in customer arbitration proceedings to provide general guidance on e-discovery issues and product cases. The guidance, which would appear in the introduction to the Discovery Guide, would emphasize flexibility in the discovery process. FINRA is not proposing to amend the Document Production Lists, which specify documents that are presumptively discoverable in customer cases. The proposed amendments would also clarify existing provisions in the introduction relating to affirmations.

 

SEC Approves FINRA's Tightening of "Public Arbitrator" Definition

The SEC approved a FINRA proposed rule change to amend the definition of "public arbitrator" in its Customer and Industry Codes of Arbitration.  Specifically, the proposed rule change would (a) exclude persons associated with a mutual fund or hedge fund from serving as public arbitrators and (b) require individuals to wait for two years after ending certain affiliations before they may be permitted to serve as public arbitrators.   This amendment is another tightening of the definition of "public arbitrator" to exclude individuals with close ties to the securities industry.  SEC, Release No. 34-69297; File No. SR-FINRA-2013-003, Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving Proposed Rule Change to Amend the Customer and Industry Codes of Arbitration Procedure to
Revise the Public Arbitrator Definition (Apr. 4, 2013)

FINRA and Charles Schwab's Class Action Waiver

Jill Gross and I critique the FINRA hearing panel's recent decision in a disciplinary proceeding against Charles Schwab, holding that FINRA's arbitration rule prohibiting class action waivers was unenforceable, at the CLS Blue Sky Blog.  Do Broker-Dealers Have a Green Light to Force Investors to Waive Class Actions in Court?

FINRA's Arbitration Records Exempt from FOIA Disclosure: D.C. District Court

The D.C. district court recently rebuffed the efforts of an association of attorneys who represent public investors in securities arbitrations to obtain records related to the SEC's oversight of the FINRA arbitration forum under the Freedom of Information Act.  Public Investors Arbitration Bar Association v. SEC (No. 11-2285(BAH), Mar. 14, 2013).  Plaintiff sought records related to the arbitrator selection process of FINRA.  The court agreed with the SEC that the records were exempt under FOIA Exemption 8, which exempts from disclosure any matters "contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions." (Download PIABA.SEC)

The dispute centered on whether the records sought by plaintiff are "related to examination, operating, or condition reports prepared by, on behalf of, or for the use of" the SEC.  The court based its decision on the "plain meaning" of the exemption, as well the legislative purpose behind the exemption, which is to safeguard the relationship between the financial institution and its supervising agency, to ensure the institution's continuing cooperation.

The court also addressed an issue that the parties did not address: the definition of "financial institution" and its application to FINRA.  The plaintiff conceded that FINRA was a "financial institution" for purposes of Exemption 8, based on a 2010 amendment to the Securities Exchange Act.  The Court first reviewed the short history of in Dodd-Frank section 9291, which provided that the SEC shall not be compelled to disclose records obtained for regulatory and oversight activities.  Only a few months after its enactment, Congress repealed section 9291 because of its concern that it allowed the SEC to keep secret virtually any information it obtained through its examination authority.  However, at the same time it repealed section 9291, Congress amended the Securities Exchange Act to clarify that "any entity the SEC regulates under the Securities Exchange Act will be considered a financial institution for the purpose of FOIA Exemption 8."  The court expressed its puzzlement: "Congress appears to have given back with the FOIA what it simultaneously intended to take away by repealing Section 9291."  The Court also expressed skepticism that a self-regulatory organization like FINRA would qualify as a "financial institution" as that term is normally understood.  Nevertheless, it concluded that plaintiff's arguments about an overly broad exemption must be made to Congress, given the broad language.

Illinois Bar Association: Non-Attorney Representatives in FINRA Arbitrations Are Practicing Law

The Illinois State Bar Association recently issued an opinion stating that a nonlawyer's representation of parties in a FINRA arbitration generally constitutes the unauthorized practice of law. (Download Ill.13-03[1])  The inquiring attorney served as the chair of an arbitration panel that was hearing a dispute between customers and a brokerage firm and became aware that the customers were represented by a nonlawyer employee of a company, not a law firm, that regularly represents customers in FINRA arbitrations. 

The opinion letter notes that FINRA Arbitration Rule 12208 provides that parties may be represented by a nonlawyer "unless state law prohibits such representation."  In a thoughtful review of the policy implications as well as Illinois law, the bar association recognized that FINRA arbitrations do not "involve the same degree of legal complexities and formality" as a court proceeding, but "we nonetheless are of the strong belief that the actions of a party representative in a typical FINRA proceeding ... involves the giving of legal advice and the rendering of services requiring the use of legal knowledge or skill as to constitute the practice of law."

The opinion letter also states that the attorney/arbitrator who becomes aware of the nonlawyer's representation of a party should inform FINRA and, if necessary, notify the agency that has jurisdiction to investigate unauthorized practice of law in Illinois.  The opinion reassures, however, that "it is not our view...that an attorney having taken such steps could be said to be assisting the unauthorized practice should he or she not withdraw as an arbitrator in the event that the steps taken do not result in the discontinuation of the nonlawyer representation."

FINRA Enforcement Will Appeal Charles Schwab Victory

As readers of this blog know, last week a FINRA hearing officer refused to enforce FINRA's rules prohibiting broker-dealers from including class action waivers in their customers' agreements, in a big win for Charles Schwab.  FINRA Enforcement announced today it will appeal the decision to FINRA's National Adjudicatory Council.

Securities Firms' Attempt to Avoid Arbitration Fails -- Again

The securities industry fought hard for the power to require brokerage customers to arbitrate all disputes with their firms.  But some firms appear to think that arbitration is only a good dispute resolution mechanism when they want it and are challenging arbitration proceedings brought by dissatisfied users of their services.  UBS Financial Services, Inc. v. Carilion Clinic (4th Cir. No. 12-2066, Jan. 23, 2013) is a recent example.(Download UBSFinancial.012313[1])

Carilion, a not-for-profit organization that operates hospitals and clinics in Virginia, decided in 2005 to issue municipal bonds and retained UBS and Citigroup Global Markets to advise it on the structure of the bond issues and to assist it in implementing the financing plan.  UBS and Citigroup recommended the issuance of auction-rate bonds and acted as underwriters and lead broker-dealers in the $234 million offering.  Unfortunately, in early 2008 the auction-rate bond market collapsed for the bonds, when UBS and Citigroup stopped submitting support bids.  Carilion was forced to refinance and lost millions of dollars.  Carilion filed an arbitration claim with FINRA, claiming that the firms misled it and asserting claims under both state and federal securities laws.  UBS and Citigroup filed a declaratory judgment action and sought a preliminary injunction against the arbitration, asserting that Carilion was not a "customer" entitled to bring an arbitration under FINRA's rules.  They further argued that Carilion had waived arbitration through the forum selection clause contained in one of the contracts among the parties.  The district court rejected both arguments, and the Fourth Circuit affirmed.

FINRA Rule 12200 requires member firms to arbitrate disputes with customers when the customer requests arbitration and the dispute "arises in connection with the business activities of the member."  UBS and Citigroup asserted that Carilion was not their "customer" because that term, as used in the FINRA rule, is limited to "investors."  Carilion, in contrast, asserted that customer means anyone "who purchases some commodity or service."  The Fourth Circuit agreed with Carilion, finding the broader interpretation is consistent with the purposes of FINRA arbitration and consistent with generally accepted meaning of customer.  Thus, it held that "when FINRA uses 'customer' in Rule 12200, it refers to one, not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member's business activities insofar as those activities are covered by FINRA's regulation, namely the activities of investment banking and the securities business."

The Fourth Circuit also rejected the firms' argument that the forum selection clause, which provides that "all actions and proceedings arising out of this Agreement ... shall be brought in the United States District Court of the County of New York."  This was "a straightforward issue of contract interpretation," said the Court.  It found that the natural reading of the clause was to require any litigation to be brought in the designated court; "it would never cross a reader's mind that the clause provides that the right to FINRA arbitration was being superseded or waived," especially since the clause did not even use the word arbitration.

The Fourth Circuit relied on a previous opinion from the Second Circuit, UBS Financial Services, Inc. v. West Virginia Hospitals, 660 F.3d 643 (2d Cir. 2011), involving substantially similar facts.  

FINRA Announces Changes to Subpoena Rules in Arbitration

FINRA announced that the SEC has approved amendments to the Arbitration Codes relating to subpoenas and orders to direct the appearance of witnesses and production of documents without subpoenas.  The Customer and Industry Codes of Arbitration Procedure (Codes) provide arbitrators with the authority to issue subpoenas for the appearance of witnesses and the production of documents. The Codes also authorize arbitrators to order FINRA member firms and their employees and associated persons to produce documents and/or to appear as witnesses without using the subpoena process. The SEC approved amendments to the Codes which direct arbitrators, in most instances, to issue orders (arbitrator orders), instead of issuing subpoenas, when industry parties seek the appearance of witnesses or the production of documents from non-party firms or their employees or associated persons.

The amendments add procedures for non-parties to object to subpoenas and for parties and non-parties to object to arbitrator orders of production. They also standardize procedures under the Codes relating to service of motions for subpoenas and arbitrator orders; service of issued subpoenas and arbitrator orders; and time frames for responding to subpoenas and arbitrator orders, making them operationally consistent.

Effective Date: February 18, 2013

 

FINRA Proposes to Tighten Definition of "Public Arbitrator"

FINRA has filed with the SEC a proposed rule change that would further tighten the definition of a "public arbitrator" to exclude persons associated with a mutual fund or hedge fund from serving as public arbitrators and to require individuals to wait for two years after ending certain affiliations before they may be permitted to serve as public arbitrators. FINRA believes that the proposed changes "would improve investors’ perception about the fairness and neutrality of FINRA’s public arbitrator roster."  FINRA has amended the definition of public arbitrator a number of times since 2004 to exclude from the definition individuals with connections to the securities industry.  In the accompanying release, FINRA states that recently investor representatives have raised concerns that they do not perceive certain arbitrators as public because of their background or experience.  This proposed rule change is in response to those concerns.  Although the public arbitrator definition does not expressly prohibit individuals associated with mutual funds and hedge funds from serving as public arbitrators, FINRA believes that, because of their association with the financial services industry, they should not serve as public arbitrators.  Its current practice is to exclude these individuals from the public roster.

FINRA also proposes to add a two-year "cooling off" period before FINRA permits certain individuals to serve as public arbitrators.  This change would affect, among others, attorneys, accountants and other professionals whose firm derived $50,000 or more in annual revenue in the past two years from professional services rendered to certain financial industry entities relating to any customer disputes concerning investments.  Under the current rule, the individual may begin serving as a public arbitrator as soon as the individual ends the affiliation that was the basis for the exclusion.  FINRA notes that in one instance an individual applied to be a public arbitrator just one month after retiring from a lengthy career at a law firm that represented securities industry clients. (Download 34-68632[1])

 

SEC Approves FINRA Rule Change on Use of Subpoenas and Orders of Appearance in Arbitration

The SEC has approved a non-controversial FINRA rule change relating to the use of subpoenas and orders of appearance in arbitration proceedings.  Specifically, the rule change amends the Customer and Industry Codes of Arbitration Procedure (1) to provide that when FINRA member firms and/or
employees or associated persons of FINRA members who are parties to an arbitration (collectively, “Member Parties”) seek the appearance of witnesses by, or the production of documents from, FINRA members (and individuals associated with the member) who are not parties to the arbitration (collectively, “Non-Party Members”), FINRA arbitrators shall (unless circumstances dictate otherwise) issue orders for the appearance of witnesses or the production of documents, instead of issuing subpoenas; (2) to add procedures for any non-party (Non-Party Member or otherwise) receiving a subpoena to object to the subpoena; (3) to provide that if an arbitrator issues a subpoena to a Non-Party Member at the request of a Member Party, the Member Party making the request is (unless the panel directs otherwise) responsible for paying the reasonable costs of the appearance of witnesses by or the production of documents from the Non-Party Member; (4) to add procedures for any party to an arbitration to file a motion requesting arbitrators issue an order for the appearance of any employee or associated person of a FINRA member (collectively, “Associated Persons”) or the production of documents from such Associated Persons or members; (5) to add procedures for any party to an arbitration receiving a motion for an order and draft order to object to the order; (6) to add procedures for how the party to the arbitration that requested the order must serve the order (if issued); (7) to add procedures for any Non-Party Member receiving an order to object to the order; and (8) to add procedures for how parties to an arbitration must share documents received in response to an order issued to a Non-Party Member. ( Download 34-68404)

FINRA Proposes to Allow Non-Party Associated Persons to Seek Expungement Relief

FINRA, at its December 2012 Board meeting, discussed several rulemaking items, including:

Expungement for Unnamed Persons in Arbitration Claims

The Board authorized FINRA to file a proposal with the SEC that establishes three different procedures that would permit registered persons who are identified for alleged sales practice violations in an arbitration claim, but are not named as parties in that claim (unnamed persons), to seek expungement relief. The unnamed person could seek relief under Rule 12805 by asking a party to the customer-initiated arbitration in writing to seek expungement on his or her behalf. Alternatively, the registered person could initiate In re proceedings under new Rule 13807 at the conclusion of the underlying customer-initiated arbitration case. Finally, the unnamed person could seek expungement relief at the conclusion of the customer’s case by asking the panel for an expungement based on the record compiled in the underlying case. The proposal incorporates many of the comments and suggestions received on Regulatory Notice 12-18, as well as feedback from several FINRA committees. FINRA believes that these proposals provide unnamed persons with a remedy to seek redress concerning allegations that could impact their livelihoods, yet maintains the protections of FINRA’s expungement rules to ensure the integrity of the CRD records.

 Conflicts of Interest Relating to Recruitment Compensation Practices

The Board authorized FINRA to seek comment in a Regulatory Notice on a proposed rule that would require a member firm that provides, or has agreed to provide, to a registered person enhanced compensation in connection with the transfer of employment (or association) of the registered person from another financial services firm (previous firm), to disclose the details of the enhanced compensation to any former customer of the registered person at the previous firm who is contacted about moving or moves their account to the new firm. The proposal would require such disclosure for one year following the date the registered person associates with the new firm. The proposed rule would not apply to enhanced compensation of less than $50,000 or to customers that meet the definition of an institutional account pursuant to FINRA Rule 4512(c), except any natural person or a natural person advised by a registered investment adviser.

Purchasers in Private Placements Are Not "Customers" of Managing Broker-Dealer:Eighth Circuit

There have been a number of recent cases addressing the issue of who is a "customer" for purposes of FINRA securities arbitration.  Typically, investors assert they are "customers" in order to pursue an arbitation against a securities firm, which the firm resists.  The applicable FINRA Rule 12200 allows a "customer" to bring arbitration proceedings against a FINRA member or an associated person if the dispute arises in connection with the business activities of the member or associated person.  A FINRA rule defines "customer" as "not includ[ing] a broker or dealer." 

In a recent case, Berthel Fisher & Co. v. Larmon (8th Cir. Oct. 1, 2012)( Download BerthelFisher.100112[1]), unhappy purchasers of securities issued in private placements sought to arbitrate claims against Berthel Fisher, which served as the managing broker-dealer for the offering.  As managing broker-dealer Berthel reviewed and suggested changes to at least two private placement memoranda.  It also was required, along with the selling brokers, to determine each investor's eligibility to participate in the offering and maintained customer files for this purpose.  The purchasers alleged that Berthel performed insufficient due diligence on the offering.  Although the investors had no contact with Berthel, they argued that they were "customers" because Berthel provided "investment or brokerage services" to them in three ways:  It was responsible for conducting due diligence on the offering, it was obligated to conduct a reasonable basis suitability analysis on the securities, and it maintained customer files on the investors.

The court, however, held that the investors were not "customers" of Berthel, because there was no "relationship" between the firm and the investors.  Assuming that the firm's services were "investment or brokerage," the  firm did not provide them to the customer either directly or through its associated persons.  Its contractual obligations were with the issuer and the selling brokers, not with the customers.

FINRA Proposes Amending Procedures for Calling Witnesses or Producing Documents from FINRA Members

The SEC posted on its website a proposed rule change filed by FINRA to amend the Customer and Industry Codes of Arbitration Procedure (collectively “Codes”), to provide that when specified industry parties seek the appearance of witnesses or the production of documents from FINRA members (and individuals associated with the members) that are not parties to the arbitration, FINRA arbitrators shall issue orders for the appearance of witnesses or the production of documents, instead of issuing subpoenas. The proposed rule change would add procedures for non-parties to object to subpoenas and arbitrator orders of production (“arbitrator orders”). It would also standardize procedures under the Codes relating to service of motions for subpoenas and arbitrator orders, service of issued subpoenas and arbitrator orders, and time frames for responding to subpoenas and arbitrator orders, making them operationally consistent.
Rel. 34-67803 (Download 34-67803[1])