Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by National Association of Securities Dealers, Inc. Relating to Qualified Immunity in Arbitration Proceedings for Statements Made on Forms U-4 and U-5

SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-39892; File No. SR-NASD-98-18]

Self-Regulatory Organizations; Notice of Filing of Proposed Rule

Change by National Association of Securities Dealers, Inc. Relating to

Qualified Immunity in Arbitration Proceedings for Statements Made on

Forms U-4 and U-5

April 21, 1998.

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934

(``Act''),\1\ notice is hereby given that on April 21, 1998, NASD

Regulation, Inc. (``NASD Regulation'') filed with the Securities and

Exchange Commission (``SEC'' or ``Commission'') the proposed rule

change as described in Items I, II, and III below, which Items have

been prepared by NASD Regulation. The Commission is publishing this

notice to solicit comments on the proposed rule change from interested

persons.

---------------------------------------------------------------------------

\1\ 15 U.S.C. Sec. 78s(b)(1).

---------------------------------------------------------------------------

I. Self-Regulatory Organization's Statement of the Terms of

Substance of the Proposed Rule Change

NASD Regulation is proposing to add a new rule to the Rules of the

National Association of Securities Dealers, Inc. (``NASD'' or

``Association''), to provide members of the NASD with qualified

immunity in arbitration proceedings for statements made in good faith

in certain disclosures filed with the NASD on Forms U-4 and U-5, the

uniform registration and termination notices for registered persons.

Below is the text of the proposed rule change.

Proposed new language is in italics.

* * * * *

Rule 1150. Regulatory Form Disclosures

(a) Mandatory Disclosures

A member must make truthful and accurate statements on the covered

forms required under Article V, Sections 2 and 3 of the By-Laws.

(b) Qualified Immunity

(1) This paragraph shall apply to any arbitration proceeding

between a member or other party and a covered person relating to

statements made in response to an information requirement of a covered

form with respect to such covered person, to the extent that such

statements are contained in a covered form that has been or, at a

subsequent point in time, is (A) filed with a regulatory authority or

self-regulatory organization, and (B) disseminated by reason of such

filing, or otherwise disseminated orally, in writing, or through any

electronic medium to an appropriate person.

(2) A defending party shall not be liable in a proceeding to a

covered person for any defamation claim related to an alleged untrue

statement that is contained in a covered form if the statement was true

at the time that the statement was made.

(3) A defending party shall not be liable in a proceeding to a

covered person for any defamation claim related to an alleged untrue

statement that is contained in a covered form unless the covered person

shows by clear and convincing evidence that:

(A) the defending party knew at the time that the statement was

made that it was false in any material respect; or

(B) the defending party acted in reckless disregard as to the

statement's truth or falsity.

(c) Definitions

For purposes of this Rule:

(1) The term ``appropriate person'' means any federal or state

governmental or regulatory authority, and self-regulatory organization,

any employer or prospective employer of a covered person, or any person

who requests or is required to obtain information concerning the

covered person from the defending party and as to whom the defending

party has a legal obligation to provide such information.

(2) The term ``claim'' means any claim, counterclaim, third-party

claim, or cross-claim.

(3) The term ``covered form'' means any form or notice required

under

[[Page 23322]]

Article V, Sections 2 and 3 of the By-Laws, including Forms U-4 and U-

5. Disclosure Reporting Pages, and related explanatory materials.

(4) The term ``covered person'' means any present or former

registered person or other employee of a member who is a party to a

proceeding relating to a dispute within the scope of this Rule.

(5) The term ``defending party'' means any member who is a party to

a proceeding and who is adverse to a covered person who is a party, and

any associated person of such member.

(Rule 1150 is effective beginning on (Date) 1998 and ending on

(Date) 2002, and applies to claims relating to any covered forms, as

defined in Rule 1150, that are filed during that period.)

* * * * *

II. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

In its filing with Commission, NASD Regulation included statements

concerning the purpose of, and statutory basis for, the proposed rule

change and discussed any comments it received on the proposed rule

change. The text of these statements may be examined at the places

specified in Item IV below. NASD Regulation has prepared summaries, set

forth in Sections A, B, and C below, of the most significant aspects of

such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule Change

1. Purpose

Summary. The proposed rule is designed to deal with the prospect

that member firms may be reluctant to make complete disclosures on

forms required to be filed with the NASD because of the potential for

lawsuits relating to defamation claims by former or present employees.

The proposed rule would create a uniform qualified immunity standard

for statements made in good faith in certain disclosures filed with the

NASD on Forms U-4 and U-5. To overcome this qualified immunity, a

registered person would have to prove in an arbitration proceeding by

clear and convincing evidence that the member firm knew at the time the

statement was made that it was false in any material respect, or that

the member acted in reckless disregard to the statement's truth or

falsity. For purposes of NASD arbitration, the rule would supersede

state law on the same subject.

Background. This issue arises primarily in the context of filings

made on Form U-5 following termination of employment of a registered

person. The NASD By-Laws (Article V, Section 3) require that the member

give notice of the termination to the NASD within 30 days after the

termination, and that the member provide a copy simultaneously to the

registered person. The By-Laws also require that the member notify the

NASD, and send a copy to the registered person, within 30 days if the

member learns of facts or circumstances causing any information in the

prior notice to become inaccurate or incomplete.

Form U-5, which is entitled the ``Uniform Termination Notice for

Securities Industry Registration,'' is a form used throughout the

securities industry at both the federal and state level. It requires

that the member indicate the reason for the termination by checking one

of the blocks labeled Voluntary, Deceased, Permitted to Resign,

Discharged, or Other. If one of the last three blocks is checked, the

member must provide an explanation. Regardless of the block checked,

the member also must indicate whether the registered person, during the

period of his or her association with the member, was involved in

certain types of disciplinary actions, the subject of a customer

complaint, convicted of certain crimes, or under investigation or

internal review.

In recent years, registered persons have brought, primarily in

arbitration, a number of defamation \2\ claims for allegedly untrue or

misleading statements made on the Form U-5.\3\ Because of the financial

interests at issue the potential for substantial damages may exist in a

number of cases. The NASD believes that the potential for liability, or

for inconsistent standards of liability, is a significant disincentive

for firms to provide full and fair disclosure. Failure to make full

disclosure of disciplinary problems has the potential to compromise the

integrity of the Central Registration Depository, and hinders

enforcement action by the NASD and other regulators. At the same time,

the NASD believes it is important that any solution provide adequate

protection to employees from statements designed to penalize unfairly a

departing employee, or to prevent him or her from obtaining new

employment or attracting existing customers to another member firm

where the person has subsequently become employed.

---------------------------------------------------------------------------

\2\ ``Defamation'' has been defined as an ``intentional false

communication, either published or publicly spoken, that injures

another's reputation or good name.'' Black's Law Dictionary 417 (6th

ed. 1990). ``Libel'' (written defamation) and ``slander'' (spoken

defamation) are both methods of defamation. Id at 1388.

\3\ Defamation claims may also arise with respect to disclosures

on Form U-4, which is required to be filed by registered persons

upon the occurrence of certain events, but which in practice is

often drafted by the member firm with which the individual is

associated.

---------------------------------------------------------------------------

Development of the Rule Proposal. The NASD met periodically during

1997 to discuss defamation issues with representatives of member firms,

the Securities Industry Association, the New York Stock Exchange

(``NYSE''), the North American Securities Administrators Association,

and attorneys who often represent registered representatives in court

litigation and in arbitration proceedings.

Many members of the industry favored a regulatory standard

providing for absolute immunity. Most state court decisions that have

considered this issue in the Form U-5 or in similar contexts have

adopted a qualified immunity standard. However, one New York state

court decision has expressly recognized an absolute immunity standard

with respect to statements contained in the Form U-5.\4\ Those states

that, by court decision or statute, have adopted a qualified immunity

standard in the same or similar contexts, require that falsity or

recklessness be proved either by ``preponderance of the evidence'' or

by ``clear and convincing evidence,'' as discussed below.

---------------------------------------------------------------------------

\4\ Herzfeld & Stern, Inc. v. Beck, 572 N.Y.S.2d 683 (N.Y. App.

Div. 1991), appeal dismissed, 79 N.Y.2d 917 (1992). The court

reasoned that federal law had established a comprehensive system of

oversight and self-regulation by the NYSE in order to ensure

adherence by members of the industry to both the statutory mandates

and ethical standards of the profession, and concluded that the

NYSE's disciplinary function conforms to the requirements of a

quasi-judicial administrative proceeding. Therefore, statements made

on a Form U-5 and later used as the basis for an NYSE investigation

were considered ``statements uttered in the course of a judicial or

quasi-judicial proceeding [which are] absolutely privileged so long

as they are material and pertinent to the questions involved

notwithstanding the motive with which they are made.'' Id. at 683.

But see Fleet Enterprises, Inc. v. Velinsky, No. 604462/96 (N.Y.

Sup. Ct. Jan. 16. 1997), in which a lower court in New York rejected

a brokerage firm's petition, on absolute privilege grounds, to stay

the arbitration of Form U-5 defamation claims, and ordered

arbitration to proceed, applying the Federal Arbitration Act as to

the issue of arbitrability. The court stated that ``whether New York

substantive law will apply to Velinsky's claims in arbitration is

for the arbitrator to decide.'' Slip op. at 5. See also Fahnestock &

Co., Inc. v. Waltman, 935 F.2d 512 (2d Cir. 1991); Culver v. Merrill

Lynch & Co., Inc., 1995 U.S. Dist. Lexis 10017 (S.D.N.Y. 1995).

---------------------------------------------------------------------------

In order to obtain as many views as possible, the NASD published a

draft of the proposed rule change in a Notice to Members (``NTM 97-

77'') that was mailed to member firms and other subscribers, and was

also posted on the NASD Regulation Web site and sent to a group of

attorneys who represent employees, to registered representatives

[[Page 23323]]

groups, and to others. That proposal included a provision that would

require member firms to give notice of the contents of a Form U-5 (and

amendments) to the subject of the form at least ten days prior to

filing the form, and would require members to provide immediate

notification to employees of material revisions to be filed on Form U-

5. Fifty-three comments were received and considered by the NASD. The

advance notice provision was the subject of almost universal criticism,

as described below. A revised proposal was approved by the NASD

Regulation and NASD Boards in January 1998.

Details of the Proposed Rule. The proposal rule would provide that

members and associated persons will not be liable to an employee for a

claim that is related to an alleged untrue statement contained in Form

U-4 or U-5 pertaining to the employee, unless the employee can prove by

clear and convincing evidence that the defending party knew that the

statement was false in any material respect, or acted in reckless

disregard as to its truth or falsity.

As noted above, state law standards generally provide for some type

of qualified immunity for statements of the type that are required by

the covered forms, and therefore the rule may not represent a

substantial change in the standard that would apply in a given case,

but will instead provide a uniform standard to which parties and

arbitrators can look for guidance. NASD Regulation in concerned,

however, that the proposal not signal a willingness to tolerant false

or malicious statements by member firms with respect to their

employees, either through disclosures on the covered forms or through

other venues. Any such statements clearly violate the obligation of

members to provide accurate information to NASD Regulation and are

inconsistent with just and equitable principles of trade.

In particular, NASD Regulation is concerned with the potential that

disclosures contained on covered forms may be used deliberately by one

member to limit the mobility of registered persons who have determined

to find employment with another member, or to delay the effectiveness

of the transfer of employment.\5\ As noted, such conduct would be

grounds for disciplinary action, and during the rule's pilot period,

NASD Regulation intends to consider and investigate evidence of misuse

of covered forms other forms, or regulatory processes for improper

purpose. In addition, NASD Regulation will provide a mechanism through

its Internet Web Site to obtain input from employees, member firms, and

others as to the operation of the pilot program and to report potential

abuses. To the extent that NASD Regulation determines that misuse of

regulatory processes has increased during the pilot period, it may

determine to modify or terminate the rule prior to the end of that

period. Finally, NASD Regulation will provide training to arbitrators

to ensure that they are cognizant of these concerns, that they

understand the application of the rule, and that the rule is applied

only with respect to appropriate types of claims.\6\

---------------------------------------------------------------------------

\5\ NASD Rule 10335 of the Code of Arbitration Procedure

contains special provisions for injunctive relief in circumstances

where fast interim relief is necessary.

\6\ Because the rule as proposed would apply only to claims for

defamation, it would not affect other claims, e.g., tortuous

interference with contractual relations, to the extent that such

claims would constitute substantially different causes of action and

not merely recharacterization of defamation claims.

---------------------------------------------------------------------------

Paragraph (a) of the proposed rule states that members must provide

truthful and accurate statements in response to the information

requirements of the forms required under Sections 2 and 3 of Article V

of the Association's By-Laws, i.e., Forms U-4 and U-5 and attachments

to those forms. This paragraph make clear that the purpose of the

proposed rule is to further the goal of accurate disclosure, and is

intended to reaffirm the existing disclosure obligation of NASD members

as set forth in the By-Laws. The word ``complete'' was deleted from the

draft version of the proposed rule, to address the concern of some

commenters that this language could be construed as adding a new but

vague requirement of ``completeness'' and could create liability beyond

that contemplated by the By-Laws.

The proposed rule would apply to statements made on ``covered

forms.'' Covered forms are defined in paragraph (c)(3) to include forms

or notices required under Article V, Sections 2 and 3 of the By-Laws,

including Disclosure Reporting Pages and other explanatory materials

attached to the forms or notices. Although the area of greatest focus

has involved the filing of Form U-5 in connection with employee

terminations, members of the industry have indicated that required

disclosures pertaining to employees on Form U-4 provide the same

potential for liability, and NASD Regulation believes that the same

regulatory interests in complete disclosure apply to statements on that

form. The rule would apply to statements made by a member firm on a

covered form with respect to a present or former employee of the firm.

The rule would also apply to the liability of both member firms and

associated persons, and accordingly would apply to both the signatory

of the form or other persons involved in the preparation of the form as

well as the member itself.

The rule as proposed in NTM 97-77 would have required members to

provide employees with copies of proposed language on Form U-5

describing the reason for termination at least ten days before the

filing of the form or an amendment to the form. In addition, members

would have been required to provide to the employee immediate notice of

revisions to the proposed language. The purpose of these provisions was

to provide employees with an opportunity to seek amended disclosure

language when they could demonstrate obvious inaccuracies.

After further review, NASD Regulation has determined to delete

these provisions in light of the comments received. The comments of

both members and registered representatives were overwhelmingly

negative with regard to this part of the proposal. Many commenters

expressed the view that these provisions would lead to ``negotiated''

or ``watered down'' disclosure, and some suggested that it could

compromise ongoing internal investigations. Some commenters stated that

the period was too short for meaningful review of the Form U-5, while

other commenters felt that the period was too long in that it left

broker/dealers only 20 days within which to prepare the forms and mail

them to employees, since Form U-5 must be filed with the NASD within 30

days after termination. Some commenters pointed out that employees

already have an opportunity to comment on certain reportable events

through filing of an amended Form U-4.

The proposed rule would provide qualified protection to statements

only to the extent that they are contained in a covered form that has

been or, at a subsequent point in time, is filed with any federal or

state regulatory authority, or self-regulatory organization, and are

disseminated to ``appropriate persons.'' Therefore, oral statements are

covered by the qualified immunity only to the extent that they track

language that is already or later incorporated into the covered form.

In this context, paragraph (c)(1) of the proposed rule defines

``appropriate persons'' to include, in addition to regulatory

organizations, current or prospective employers and others who

affirmatively request information concerning the employee

[[Page 23324]]

and as to whom the member has an obligation to provide the information.

The latter provision is designed to ensure that the rule would apply to

requests from persons as to whom applicable legal standards require the

disclosure of the information.

Paragraph (b)(2) of the proposed rule provides that a defending

party shall not be liable for a defamation claim if the statement was

true at the time that the statement was made. As noted above, Article

V, Section 3 of the NASD By-Laws already requires that the member

notify the NASD, and send a copy to the registered person, within 30

days if the member learns of facts or circumstances causing any

information in the prior notice to become inaccurate or incomplete.

Paragraph (b)(3) of the proposed rule contains the basic legal

standard found in federal and state court decisions that recognize a

qualified immunity in various contexts. The courts do not, however,

consistently define the burden of proof that a plaintiff must meet in

order to show that a false statement was made knowingly or recklessly.

Some decisions apply the ``preponderance of the evidence'' standard

that most commonly applies to claims and defenses in civil litigation.

Others apply a stricter ``clear and convincing'' standard. In some

cases, decisions in the same jurisdiction conflict on this point. The

NASD believes that, because no one standard is dominant, the standard

applied should be the one that will reach best the goals to which the

proposed rule is addressed. The NASD has determined that the ``clear

and convincing'' standard provides a good balance, in that it provides

some protection to member firms against defamation claims for

statements they are required to provide, while still providing that

members are liable for clear cases of abusive or malicious disclosure.

NTM 97-77 asked for comment as to whether NASD Regulation should

seek to provide a mandatory pre-filing or arbitration procedure to

resolve termination disputes prior to the 30-day period following

termination in which the Form U-5 is required to be filed. Most of the

comments addressing this issue suggested that such a procedure could

not effectively resolve disputes within this time frame. NASD

Regulation has determined that a mandatory procedure would raise too

many difficult practical and timing issues to be useful, but will

endeavor to provide mediators on an expedited basis when both parties

are interested in resolving disputes at an early stage.

The proposed rule would apply for a pilot period of four years.

Prior to the end of that period, the staff will review a sample of

filings made during the period of the rule's effectiveness to attempt

to gauge the nature and quality of disclosure that has been provided,

in contract with forms filed prior to the pilot period.

2. Statutory Basis

NASD Regulation believes that the proposed rule change is

consistent with the provisions of Section 15A(b)(6) of the Act, which

requires, among other things, that the Association's rule must be

designed to prevent fraudulent and manipulative acts and practices, to

promote just and equitable principles of trade, and, in general, to

protect investors and the public interest. The NASD believes that the

proposed rule change will encourage fuller disclosure by member firms

of any regulatory problems concerning a registered representative and

thus provide more complete information to the investing public through

the Public Disclosure Program and to other broker/dealers through the

Central Registration Depository.

B. Self-Regulatory Organization's Statement on Burden on Competition

NASD Regulation does not believe that the proposed rule change will

result in any burden on competition that is not necessary or

appropriate in furtherance of the purposes of the Act, as amended.

C. Self-Regulatory Organization's Statement on Comments on the Proposed

Rule Change Received From Members, Participants, or Others

The proposed rule change was published for comment in NASD Notice

to Member 97-77 (November 1977). Fifty-three comments were received in

response to the Notice.

III. Date of Effectiveness of the Proposed Rule Change and Timing

for Commission Action

Within 35 days of the date of publication of this notice in the

Federal Register or within such longer period (i) as the Commission may

designate up to 90 days of such date if it finds such longer period to

be appropriate and publishes its reasons for so finding or (ii) as to

which the self-regulatory organization consents, the Commission will:

A. By order approve such proposed rule change, or

B. Institute proceedings to determine whether the proposed rule

change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views, and

arguments concerning for foregoing, including whether the proposed rule

change is consistent with the Act. Persons making written submissions

should file six copies thereof with the Secretary, Securities and

Exchange Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

Copies of the submission, all subsequent amendments, all written

statements with respect to the proposed rule change that are filed with

the Commission, and all written communications relating to the proposed

rule change between the Commission and any person, other than those

that may be withheld from the public in accordance with the provisions

of 5 U.S.C. 552, will be available for inspection and copying in the

Commission's Public Reference Room. Copies of such filing will also be

available for inspection and copying at the principal office of the

NASD. All submissions should refer to file number SR-NASD-98-18 and

should be submitted by May 19, 1998,

For the Commission, by the Division of Market Regulation,

pursuant to delegated authority.\7\

---------------------------------------------------------------------------

\7\ 17 CFR 200.30-3(a)(12).

---------------------------------------------------------------------------

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 98-11211 Filed 4-27-98; 8:45 am]

BILLING CODE 8010-01-M