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The NASD has enacted a new rule governing the expungement of customer dispute information from the Central Registration Depository (CRD) that will raise the hurdle for securities industry members seeking to remove allegations of wrongdoing from their CRD records even after an award in their favor.

Given the current regulatory climate, it is not surprising that the new rule favors the broadest disclosure of information — even allegations determined to be unfounded — at the expense of the brokerage community’s interest in securing a fair process and protecting their members’ reputations from false accusations. How far the scales will tip against the brokerage industry largely depends on how arbitration panels and the NASD implement the new rule.

Background

The CRD system is an electronic registration and licensing system for the U.S. securities industry jointly administered by the NASD and the North American Securities Administrators Association (NASAA). Broker-dealers file their registration forms (Forms BD and BDW) and registration forms for associated persons (Forms U4 and U5) through the system. These registration forms provide comprehensive information, including reporting on criminal and regulatory investigations and infractions, and civil actions and customer complaints.

An NASD member is required to continually update the CRD information for its registered persons through the filing of an amended Form U4 in the event of a new reportable event, such as the filing of a customer complaint. 1 Much of the information contained in the CRD system is also available to the public through the NASD’s Public Disclosure Program. 2

NASD rules provide that a member may file an amended Form U4 for a registered person to update that person’s CRD records to reflect that an arbitration panel has issued an award in his favor. However, NASD rules require more to expunge any reference to that claim. The NASD’s previously existing rule governing the expungement of information from the CRD system was adopted in 1999 and is set forth in NASD Notice to Members 99-09 (NtM 99-09). While the NASD stated that arbitration panels had the authority to order expungement of information from the CRD system, NASAA disagreed. Bowing to NASAA concerns, the NASD issued NtM 99-09, announcing that the NASD would honor only court-ordered expungements, including expungement orders contained in an arbitration award later confirmed by a court.

The NASD would no longer expunge information based solely on an arbitration award, except awards rendered in disputes between firms and current or former associated persons, where the arbitrators awarded such relief based on the defamatory nature of the CRD entry.

Before the enactment of the new rule, the NASD solicited comments from the public in two separate notices to members. In each, the NASD reaffirmed its view that arbitrators’ authority to award equitable relief included the authority to expunge information from the CRD system.

In Notice to Members 99-54 (NtM 99-54), the NASD suggested that the arbitrators be permitted to expunge information based on a finding that (1) “the information on the CRD system is defamatory in nature, misleading, inaccurate, or erroneous”; or (2) a claim was “frivolous or groundless (i.e., had no basis in fact), or was brought for an improper purpose (e.g., to damage the reputation of the named person/firm).”

The NASD set out a more detailed proposal in Notice to Members 01-65 (NtM 01-65), proposing that expungement be permitted if a court or arbitrators find that the claims were (1) a “factual impossibility/’clear error’ “; (2) “without legal merit”; or (3) “defamatory in nature.” The proposal also suggested that the NASD be named a party to any action so that it would have the opportunity to oppose the request for expungement.

NASD Rule 2130

By order dated Dec. 16, 2003, the SEC approved the NASD’s adoption of NASD Rule 2130 entitled “Obtaining an Order of Expungement of Customer Dispute Information from the Central Registration Depository” (CRD System). 3 Under this rule, a registered person is still required to obtain a court order directing expungement or confirming an arbitration award containing an expungement directive. The new rule also requires that the party seeking court confirmation of a panel award containing expungement relief to name the NASD as a party to the litigation.

The rule provides that the NASD will waive the requirement that it be named a party to the court action seeking expungement if the NASD determines that the expungement relief request “is based on affirmative judicial or arbitral findings that: (A) the claim, allegation, or information is factually impossible or clearly erroneous; (B) the registered person was not involved in the alleged investment related sales practice violation, forgery, theft, misappropriation, or conversion or funds; or (C) the claim, allegation, or information is false.” 4

Rule 2130 further provides that in “extraordinary circumstances,” the NASD will waive the requirement that it be named a party if the NASD determines that: “(A) expungement relief and accompanying findings on which it is based are meritorious; and (B) the expungement would have no material adverse effect on investor protection, the integrity of the CRD system, or regulatory requirements.” 5

The NASD will also notify state regulators when a registered person seeks waiver of NASD involvement in the court confirmation process. 6

The procedural mechanism adopted does not directly impose requirements on arbitrators, i.e., it does not directly require that arbitrators make a specific finding. Instead, the rule provides that the NASD will waive the requirement that it be named a party to any court action seeking expungement if the award contains a finding satisfying the new rule.

This indirect procedural mechanism was adopted because “[i]n no other instances in the NASD’s Code of Arbitration Procedure are arbitrators bound by substantive restrictions on how they decide an arbitration case.” 7

Rule 2130 will only apply to arbitrations or litigations filed on or after April 12, 2004. “[A]ll requests to expunge customer dispute information from the CRD system arising from arbitrations or civil lawsuits filed before April 12, 2004, including any settlement arising therefrom, will continue to be subject to the terms of [NtM 99-09].” 8

Rule 2130 does not address expungement in other contexts, such as expungement of disclosures regarding the termination of a registered person’s employment, and regulatory and criminal disclosures. The existing rules regarding expungement will continue to govern in these areas. 9

Therefore, in disputes between firms and current or former associated persons, the NASD will honor an arbitrators’ expungement award if the award provides that it was based on the defamatory nature of the CRD entry. The NASD will also honor arbitration awards absent a finding that the CRD entry is defamatory, if the expungement is directed by court order, including expungement orders contained in an arbitration award confirmed by a court. The NASD will also continue to honor court ordered expungement of criminal disclosures. 10

Critics Ignored

In adopting Rule 2130, the NASD and the SEC swept aside several significant criticisms.

The Securities Industry Association criticized Rule 2130 as demonstrating a lack of respect for arbitrators and in the arbitration process, and ultimately undermining the integrity of arbitrators by limiting their decision-making ability.

The NASD’s response — that it “will rely on arbitrators’ findings and waive participation in the court confirmation process if arbitrators have appropriately awarded expungement” — ignores the fact that in no other circumstances does the NASD review arbitration awards. 11

A panel’s award of millions of dollars in damages is not subjected to review by the NASD. But if a panel believes that expungement of unfounded claims is warranted, the NASD may nevertheless intervene.

The new rule will likely deter some future settlements and generally increase the strain on NASD resources. A record number of 8,945 NASD arbitrations were filed in 2003, a 16 percent increase over 2002 and a 60 percent increase over 2000, according to NASD dispute resolution statistics. 12

Over the last three years, between 16 percent and 25 percent of cases have been decided by arbitration panels after a full hearing. Because the new rule raises the burden on registered persons seeking expungement (e.g., requiring an affirmative determination by the panel or court), there will be less incentive to settle absent at least a hearing to establish one of the grounds for expungement.

Furthermore, the NASD will be required to devote additional resources to reviewing requests for waiver from NASD participation in the court confirmation process, or, alternatively, opposing requests for expungement in the confirmation process.

Implementation

Proper implementation will insure that Rule 2130 does not lay waste to “fundamental fairness” and the brokerage community’s legitimate interest in protecting members’ reputations from being tarnished by allegations that have been found by a panel to be unfounded. The NASD has expressly recognized that “allegations of misconduct may be without merit or may falsely or mistakenly accuse association persons of engaging in misconduct. Such allegations may unfairly tarnish the reputations of those associated persons.” 13

The NASD’s implementation of Rule 2130 should reflect both the interests favoring broad disclosure and the brokerage industry’s legitimate reputational interests. For example, while Rule 2130 provides that the NASD will not waive participation in the court confirmation process absent “affirmative judicial or arbitral findings,” the NASD should not require anything more than is currently required in NASD awards. NASD awards typically recite the relief granted, and seldom a rationale for the award. 14 No additional requirement should be imposed for expungement orders. An arbitration award that provides for expungement and recites one of the grounds for such relief contained in Rule 2130 should suffice.

Similarly, there should be no reason why a consent award reciting one of the grounds for expungement that is later confirmed by a court of competent jurisdiction should not be honored by the NASD. Earlier incarnations of Rule 2130 that provided for different treatment of stipulated awards were not included in the final rule adopted by the NASD. 15 Therefore, so long as the consent award recites one of the grounds for expungement, the NASD should waive the requirement that it be named a party to the court action seeking to confirm the award. 16

The NASD’s implementation of the new rule will ultimately determine whether Rule 2130 advances or frustrates the stated goals of the CRD system — providing “accurate and complete” information and preserving “fundamental fairness.” 17

The investing public, regulators and members of the brokerage community themselves have a strong interest in disclosure of accurate information. It is difficult to see how the interests favoring disclosure are advanced through the disclosure of allegations that an arbitration panel has determined are unfounded, particularly in light of the strong countervailing interests of members of the securities industry in a fair process and protecting their reputations from false accusations.

Donald A. Corbett and Daniel J. Horwitz are partners at Carter Ledyard & Milburn. Karl Schaffer, an associate, assisted in the preparation of this article.

Endnotes

1. Form U-4 at www.nasdr.com/pdf-text/form_u4_revised.pdf.

2. NASD Rule IM-8310-2.

3. NASD Rulemaking, Exchange Act Release No. 34-48933, 68 Fed. Reg. 74667 (Dec. 16, 2003).

4. NASD Rule 2130 ; Notice to Members 04-16 (NtM 04-16).

5. NASD Rule 2130.

6. NtM 04-16.

7. Exchange Act Release No. 34-48933.

8. NtM 04-16.

9. Exchange Act Release No. 34-47435, 68 Fed. Reg. 11435 (March 4, 2003); NtM 04-16, n. 4.

10. See, NYCPL §160.50 (McKinney’s supp. 2004) (sealing and destruction of records following acquittal); In re Farkas, 783 F.Supp. 102, 103-04 (E.D.N.Y. 1992) (discussing court’s inherent power to expunge arrest records).

11. Exchange Act Release No. 34-48933.

12. NASD dispute resolution statistics are available at www.nasdadr.com/statistics.asp-#arbitration.

13. NtM 01-65; see, NtM 04-16.

14. See, NtM 01-65, n. 8; Willenijn Houdstermaatschappij, BV v. Standard Microsys. Corp., 103 F.3d 9, 12 (2d Cir. 1997) (“arbitrators are not required to provide an explanation for their decision”); see also, Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 204 (2d Cir. 1998) (discussing circumstances when absence of an explanation is relevant).

15. Exchange Act Release No. 34-47435; NtM 01-65.

16. There is no reason why the panel’s “affirmative . . . findings” could not be based on motion papers or telephonic hearing. See, Exchange Act Release No. 34-47435; NtM 04-16.

17. NtM 99-54.

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