oversight

Follow-up Report on Matters Relating to Securities Arbitration

Published by the Government Accountability Office on 2003-04-11.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

United States General Accounting Office
Washington, DC 20548



          April 11, 2003

          The Honorable John D. Dingell
          Ranking Minority Member
          Committee on Energy and Commerce
          House of Representatives

          The Honorable Edward J. Markey
          Ranking Minority Member
          Subcommittee on Telecommunications
           and the Internet
          Committee on Energy and Commerce
          House of Representatives

          Subject: Follow-up Report on Matters Relating to Securities Arbitration

          Our June 2000 report Securities Arbitration: Actions Needed to Address Problem of
          Unpaid Awards revealed that, although investors had won a majority of awards
          against brokers, a high proportion of those awards had not been paid.1 Nearly all of
          the unpaid awards involved cases decided in the National Association of Securities
          Dealer’s (NASD) arbitration program and most involved brokers that had left the
          securities industry. A year later we reported on limited data suggesting that the rate
          of unpaid awards had declined.2 However, we noted that given the short time period
          that the data covered, regulators needed to continue monitoring the payment of the
          awards to determine whether additional steps need to be taken. Arbitration attorneys
          and claimants have also expressed concern about the timeliness of NASD’s updating
          of arbitrator disclosure information, which can be used by the parties in arbitration to
          judge the competence and objectivity of arbitrators, and with NASD’s ability to
          remove arbitrators from cases if conflicts arise. In addition, arbitration attorneys also
          expressed concern about the use of motions to dismiss and motions for summary
                                                                          3
          judgment to terminate NASD-administered arbitration cases.



          1
           U. S. General Accounting Office, Securities Arbitration: Actions Needed to Address Problem of
          Unpaid Awards, GAO/GGD-00-115 (Washington, D.C.: Jun. 15, 2000).
          2
           U. S. General Accounting Office, Evaluation of Steps Taken to Address the Problem of Unpaid
          Arbitration Awards, GAO-01-654R (Washington, D.C.: Apr. 27, 2001).
          3
           There are basically two categories of motions for prehearing dismissal. Motions to dismiss are based
          exclusively on the allegations of the statement of claim. Motions for summary judgment are those that
          depend, at least in part, on some facts that go beyond those allegations.


                                 GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
This report responds to your May 2, 2001, April 15, 2002, and May 21, 2002, requests
that we review the status of issues relating to securities arbitration and award
payment. Our objectives were to (1) describe NASD’s procedures to ensure the timely
updating of disclosure information that arbitrators provide and NASD’s procedures
for removing arbitrators from cases, (2) provide information on the use of motions to
dismiss and motions for summary judgment in arbitrations, and (3) describe recent
changes in the rate of unpaid awards and the number of arbitration claims filed with
NASD.

Results in Brief

NASD has made important changes to its arbitration program procedures, specifically
in updating and entering arbitrator disclosure information and removing arbitrators
from cases. To better manage the data entry process, in 2001 NASD centralized the
arbitrator disclosure information function in its New York City offices. NASD also put
a reporting form on line allowing arbitrators to submit new background information
such as their education and training, employment, past arbitration experience,
finances, and conflicts of interest. Also, in 2004 NASD plans to start a new computer
system that would allow arbitrators to update their own records. Since November
2001, when the Securities and Exchange Commission (SEC) reported that NASD and
SEC had not received any new complaints about the currency of arbitrator disclosure
information, NASD has received one complaint. In addition, NASD has adopted a rule
change that gives its Director of Arbitration and the President, NASD Dispute
Resolution, indelegable authority to remove an arbitrator from a case after the
hearing process has begun based on information not known to the parties when the
arbitrator was selected. NASD has used this authority in nine instances since the
change became effective in March 2001.

Motions to dismiss were filed and granted in NASD-administered arbitration cases.
Although NASD does not keep track of such motions, in 2001, for example, we
determined that motions to dismiss or motions seeking summary judgment were filed
in 55, or about 8 percent, of 719 investor-initiated, NASD-administered cases in which
the investors won a monetary award.4 We identified 54 instances in which motions
                                                                       5
were denied and 28 instances in which the motions were granted. NASD rules do not
prohibit either of the parties in arbitration from filing or the arbitrators from granting
prehearing motions to dismiss. Further, the courts have consistently recognized the
authority of arbitrators in NASD cases to grant prehearing motions to dismiss.
Moreover, an NASD official told us that these motions can save time and resources by
helping to weed out certain cases that, based on the facts set out in the parties’

4
 Securities arbitration cases are categorized as broker-broker, employee-broker, and customer-broker
cases. Because the customers of brokers are generally investors, in this report we refer to the
customers as investors.
5
 The total number of motions filed exceeded the number of cases because many cases involved
multiple respondents and multiple filings of motions. In some instances in which motions to dismiss
were granted, awards were still rendered against other parties responding to the claims.



Page 2                  GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
filings, clearly would not satisfy procedural requirements for cases in the arbitration
forum. However, a member of the Securities Industry Conference on Arbitration said
that such motions ought to be discouraged because discovery and appeal rights in
arbitration are limited.

In 2001, 236 or about 33 percent of the 719 NASD-administered monetary awards on
claims filed by investors were not fully paid, down from 64 percent not fully paid in
1998, as we reported in June 2000. About 55 percent of the $100.2 million NASD
arbitrators awarded to investors in 2001 was unpaid, down from 80 percent of the
total $161 million awarded to investors in 1998.6 The majority of unpaid awards in
both 1998 and 2001 resulted from brokers leaving the securities industry. For
example, 192 of the 236 unpaid awards in 2001 involved defunct brokerage firms or
individual brokers. Since 1998, NASD has introduced award-monitoring procedures
that are designed to encourage payment. NASD also has introduced procedures for
investors to avoid the problem of unpaid awards by defunct brokers by giving
investors more options for handling claims against defunct brokers. The noted
decline in the rate of award nonpayment also might be related to a difference in
methodologies used to measure that rate. In 2000, we directly surveyed a sample of
investors to determine if awards were paid in 1998, while for this report we used
NASD data based on its monitoring of payment for the entire year 2001. The 5,974
arbitration claims that investors filed with NASD in 2002 have increased by 64
percent over the 3,637 claims filed in 2000.

We recommend that the President, NASD Dispute Resolution, make available on
NASD’s Web site current statistics showing the frequency with which arbitration
awards against defunct brokers are not fully paid.

Background

The securities industry uses arbitration to resolve disputes among industry members,
their employees, and individual investors. Arbitration, an alternative to suing in court,
uses neutral third parties to resolve differences between parties to a controversy.
Cases involving investors, other than relatively small claims, are resolved by a panel
of three arbitrators. Two are public arbitrators and one is a nonpublic arbitrator who
brings a greater degree of expertise in the workings of the industry. Arbitrators’
decisions are final and can be appealed to the courts only for narrowly-defined
reasons such as misconduct, bias, or a manifest disregard of the law on the
arbitrators’ part. Arbitration awards are to be paid within 30 days of the date of the
award, unless a party seeks a judicial review. SEC oversees the arbitration programs
administered by securities industry self-regulatory organizations (SRO) such as
NASD. NASD administers the largest SRO arbitration program, for example, its



6
 In 2001, $12 million of the unpaid awards were not due because the respondents had requested a
hearing, filed for bankruptcy, or filed a motion to vacate.




Page 3                 GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
program accounted for about 90 percent of securities arbitration cases in 2000 and
      7
2001.

Investors have a right under NASD (and other SRO) rules to require that brokers-
dealers and individual brokers arbitrate any disputes they may have. In addition,
most broker-dealers require customers, when opening an account, to sign a customer
agreement that includes a predispute arbitration clause. If a dispute subsequently
arises between the investor and the broker-dealer, the investor can file an arbitration
claim with the forum indicated in the predispute agreement and with any SRO of
which the broker-dealer is a member.

In an investor-initiated arbitration case, the investor files a statement of claim with
the designated SRO-sponsored arbitration forum. The forum’s director of arbitration
serves the statement of claim on the broker-dealer or individual broker (called
respondents) against whom the claim has been brought. The respondent has from 20
to 45 days, depending on the forum used, to answer the claim with any defenses and
related claims. After the filing process, the director of arbitration provides the parties
with a list of potential arbitrators to hear the dispute. The parties indicate their
preference and may challenge specific arbitrators on the list.

Once the panel of arbitrators has been selected, the panel conducts hearings that may
last a day or more depending on the complexity of the case. Arbitrators are to render
their decisions after the presentation of the evidence at the hearings. Arbitrators
issue a written “award” at the end of a case. The written award is not required to
include a reason or formal written opinion supporting the award. However, the award
is required to include a statement setting out certain issues, including the basic issues
raised and resolved in a case, the amount claimed and awarded, and any other, non-
monetary issues resolved.

New NASD Procedures Address Concerns
about Information on Arbitrators
and Removing Arbitrators from Cases

NASD has taken steps to improve its procedures for updating arbitrator disclosure
information and removing arbitrators from cases. The arbitrator update
improvements included centralizing the process for updating arbitrator profiles and
making an on-line reporting form available for arbitrators to submit new disclosure
information. Another change allows the President, NASD Dispute Resolution, and its
Director of Arbitration to remove an arbitrator from a case once the hearing process
has begun and new information about the arbitrator has been disclosed.




7
 NASD Dispute Resolution facilitates the resolution of monetary, business, and employment disputes
between investors, securities firms, and employees of securities firms, offering both arbitration and
mediation services.


Page 4                  GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
NASD Procedures Help Ensure That Arbitrator
Disclosure Information Is Updated Regularly

In selecting individuals to be in its pool of potential arbitrators, NASD relies on
background information that prospective arbitrators provide. This information is first
entered into the NASD arbitrator information database when arbitrators enroll in the
program and is to be updated for any new information. NASD uses the background
                                                                 8
information to classify arbitrators as “public” or “nonpublic.” The parties in a dispute
also use this information in deciding whether to accept arbitrators to be assigned to
their case. NASD arbitrator disclosure reports include information on education and
training, employment, past arbitration experience, finances, and conflicts of interest.
The reports also include a narrative section, written by the arbitrators, describing
their professional duties and responsibilities.

As we reported in November 2000, NASD has taken steps to improve its procedures
                                                            9
for updating and entering arbitrator disclosure information. We reported that the
new procedures appeared reasonable and were likely to reduce the possibility for
errors and improve the promptness of data entry. The improvements included

    •    centralizing the process for updating arbitrator profiles in the Department of
         Neutral Management in the New York City offices of NASD’s Division of
         Dispute Resolution, and

    •    using an on-line reporting form on which arbitrators submit updated
         disclosure information via a NASD dispute resolution program Web site.

NASD procedures state that all updated arbitrator records, whether received on-line
or by phone or fax, are to be reviewed by a quality control supervisor after they are
initially entered. Records of arbitrators currently serving on panels are to be updated
within 24 hours, while updates from nonserving arbitrators can be entered in 3 to 5
days. NASD staff are also to monitor and track all entries to arbitrator profiles and
prepare a biweekly report to department managers on the receipt and computer entry
of arbitrator updates. For each arbitrator submission, the biweekly reports list the
date the information was received by the Department of Neutral Management and the
date computer entry of the information was completed. The department manager is
to use the report to verify the timeliness of the process.

In November 2001, SEC reported that, after the new procedures were implemented,
neither SEC nor NASD had received any new complaints regarding the arbitrator

8
 A public arbitrator has had no recent association with the securities industry whereas a nonpublic
arbitrator has had recent or has current association with or experience in the securities industry.
Public arbitrators are used in all investors’ cases. In single arbitrator cases in which claims are $50,000
or less, the arbitrator is a public arbitrator. In cases with three arbitrators in which claims are more
than $50,000, two of the arbitrators are public arbitrators.
9
 U.S. General Accounting Office, Procedures for Updating Arbitrator Disclosure Information,
GAO-01-162R (Washington, D.C.: Nov. 9, 2000).


Page 5                   GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
disclosure records. According to NASD, from November 2001 through the end of 2002
it had logged one complaint about an arbitrator failing to update his background
information. In that case, according to NASD, a party in a dispute asked the arbitrator
for new information, and the arbitrator sent the new information to the party by fax
and to NASD by mail. As a result, the party received the information before NASD
could receive it, update its disclosure information database, and make the
information available. SEC officials said that they did not recall receiving any new
complaints and SEC has indicated that its inspection staff will continue to monitor
NASD’s process for updating arbitrator profiles. In 2004, NASD plans to use a new
computer system that would enable arbitrators to access and update their own
disclosure records on-line at a NASD Web site.

New Procedures Make Removing
Arbitrators from Cases Easier

Effective March 2001, SEC-approved amendments to NASD’s Code of Arbitration
Procedure gave the President, NASD Dispute Resolution, and its Director of
Arbitration indelegable authority to remove an arbitrator at any juncture in the
arbitration process. These amendments allow for removal of an arbitrator from a case
after a prehearing conference or a hearing has been started, based on new
information that was not known to the parties at the time of the arbitrator’s
appointment but that the arbitrator, pursuant to NASD rules, should have disclosed.

Under the old rule, the director could disqualify an arbitrator from serving on a case
when information revealed a conflict of interest or bias such as a relationship with
one of the parties. However, this authority to disqualify was limited to the time before
the start of the prehearing conference or the first hearing. After that point, the parties
would have needed to make a motion before the arbitration panel asking the
arbitrator to recuse himself or herself or seek a court action to remove an arbitrator
from a case. In approving the rule change, SEC noted that the change should result in
lower litigation expenses for the parties, because they would not have to seek judicial
intervention to remove an arbitrator. SEC also noted that the change would help
ensure greater confidence in the fairness and neutrality of the administration of
arbitration cases.

According to NASD, after the new rule became effective in March 2001 and through
the end of 2002, NASD had received 47 requests for the Director of Arbitration to
exercise the authority to remove an arbitrator. NASD reported to us that the Director
denied these requests in 38 instances and removed an arbitrator in 9 instances.

Motions to Dismiss Are Used in NASD Arbitrations

Prehearing motions to dismiss are used in NASD-administered arbitration cases.
NASD, however, does not centrally track the motions filed in its numerous cases.
Data that we assembled from 719 investor-initiated, NASD-administered monetary
arbitration awards in 2001, showed that motions to dismiss were filed in 54 cases and
a request for summary judgment in one case, or in about 8 percent of all the cases. In


Page 6               GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
the 54 cases, 124 motions were filed. We identified 42 instances in which the motions
were not decided because the claims had been dismissed for other reasons or settled
by the parties before the case was decided. We identified 54 instances in which the
motions were denied and 28 instances in which the motions were granted. The total
number of motions filed exceeded the number of cases because any one case may
involve multiple respondents and multiple filings of motions. SEC officials said that
some motions to dismiss are based on substantive arguments, while others assert
practical ones, for example, that the wrong party was named or served. The awards
did not provide enough detail about the motions for us to determine the reasons for
their being filed.

NASD arbitration rules do not specifically provide for dismissal motions or for
motions for summary judgment. However, nothing in the rules prohibits the parties
from filing motions or precludes panels from granting them. NASD rules are
consistent with the practice of disposing of claims by motion. NASD rules allow
prehearing conferences at which the presiding person can require the briefing of
contested issues and address “any other matters which will expedite the arbitration
       10
cases.”

The case law consistently has recognized the authority of arbitrators to grant
prehearing motions to dismiss. For example, in Warren v. Tacher the underlying
dispute in the arbitration proceeding involved alleged investor losses in a brokerage
account.11 The investors brought a claim for arbitration against the broker-dealer that
maintained the account and the clearing broker-dealer. The clearing broker-dealer
moved to dismiss all claims on the ground that it had no responsibility to claimants.
The claimants filed a written response to the motion and the arbitration panel held
oral argument. The arbitration panel dismissed all claims against the clearing broker-
dealer. The claimants appealed and sought to have the arbitrators’ decision vacated
on the ground that the arbitrators engaged in misconduct and exceeded their powers
by dismissing the claims against the clearing broker-dealer prior to discovery and an
evidentiary hearing. The court stated that courts have recognized the authority of
NASD arbitrators to decide prehearing dismissals for failure to state a claim under
                 12
the NASD Code. The court rejected an argument that the arbitrators displayed a
“manifest disregard for the law” by their determination to dismiss all claims against
the clearing broker-dealer.
10
  NASD Code §10321(d)(1). General Provisions Governing Pre-Hearing Proceedings, Pre-Hearing
Conference, (1) Upon the written request of a party, an arbitrator, or at the discretion of the Director
of Arbitration, a prehearing conference shall be scheduled. The presiding person shall seek to achieve
agreement among the parties on any issue that relates to the prehearing process or to the hearing,
including but not limited to stipulation of facts, identification and briefing of contested issues, and any
other matters which will expedite the arbitrations.
11
     114 F. Supp. 2d 600 (W.D. Ken. 2000).
12
  Goldman, Sachs & Co. v. Patel (N.Y.L.J. Aug. 18, 1999, p. 23, co. 6) (“Contrary to respondent’s
assertion, the NASD panel has the power to decide a motion to dismiss a claim on legal grounds
without holding an evidentiary hearing.”).




Page 7                     GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
The court in Warren v. Tacher also addressed the issue of whether the grant of a
prehearing motion to dismiss is tantamount to a refusal to hear evidence. The court
rejected this argument and explained that while the granting of a prehearing motion
to dismiss usually means that the arbitrator “refused to hear evidence,” that, by itself,
is insufficient to vacate the award. Claimants must also show that the excluded
evidence was material to the panel’s determination and that the arbitrator’s refusal to
hear the evidence was so prejudicial that the party was denied fundamental fairness.13
In addition, the court held that a hearing for purposes of NASD rules does not
necessarily mean an evidentiary hearing. The court found that the claimants did have
a “hearing.” They were given adequate opportunity to respond to the clearing agent’s
motion to dismiss and they did so.

The courts have upheld arbitrators granting of dismissal motions in other cases.
These include dismissal on the grounds of the timeliness of the claims, a respondent’s
involvement in the matter in controversy, or whether the claimant has a private right
                                                14
of action for alleged violation of an SRO rule. We have not found any cases that do
not recognize arbitrators’ authority to grant prehearing motions to dismiss. Moreover,
an NASD official told us that these motions can save time and resources by helping to
identify certain cases that would not prevail in a hearing on the merits. For example,
in some cases the parties’ pleadings may clearly show that the case, or some portion
of the case, does not fall within the NASD’s procedural rule covering filing time
limits, which would send the case instead to court. On the other hand, a member of
the Securities Industry Conference on Arbitration said that motions to dismiss and
motions of summary judgment ought to be discouraged because discovery and appeal
rights in arbitration are limited. Another arbitration official also said that parties in
arbitration deserve the right to be fully and fairly heard.

Rate of Unpaid Awards Has Decreased,
but Many Investors Are Not Paid Awards
against Defunct Brokers

Data for 2001 show that the rate of unpaid NASD-administered arbitration awards
had decreased from the levels we previously reported for 1998. NASD procedures for
monitoring awards encourage payment by still-active brokers. However, defunct
brokers continue to not pay awards. The recent rise in arbitration claims may result
in more investors not being paid their awards.




13
     9 U.S.C. § 10(c); Campbell v. Cantor Fitzgerald & Co., 21 F. Supp. 2d 341, 344 (S.D.N.Y. 1998).
14
  In Howsam v. Dean Witter, 123 S.Ct. 588 (2002), the United States Supreme Court recently held that
arbitrators can decide that a claim is ineligible for arbitration under an NASD rule that provides that
claims submitted a certain time after they arose are ineligible. The Court’s decision does not address
whether arbitrators should make such a decision in response to a motion to dismiss an arbitration
claim. Dean Witter did not file a motion to dismiss the arbitration claim. It brought an action in federal
court asking the federal court to decide that the arbitration claim was untimely.


Page 8                      GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
Payment Rates Have Improved, but
Many Awards Still Are Not Fully Paid
Although the rate of unpaid arbitration awards has fallen, many awards rendered by
NASD arbitration panels remain unpaid. In 2001 about 55 percent, or $55 million, of
the $100.2 million NASD arbitrators awarded to investors was unpaid. However,
$12 million of the unpaid awards were not required to be paid because the
respondents had requested a hearing, filed for bankruptcy, or filed a motion to
vacate. In our June 2000 report, we estimated that about 80 percent of the $161
million awarded to investors in 1998, which were primarily NASD-administered
awards, was unpaid. In that report, we estimated that 64 percent of NASD-
administered monetary arbitration awards won by investors in 1998 had not been
fully paid. Our analysis of NASD award payment data for 2001 found that 33 percent
of awards to investors were unpaid. Of the total of 719 monetary awards that
investors won in 2001, 236 awards were not fully paid. (Nothing was paid on 216
awards and 20 awards were partially paid.)

In June 2000, we reported that most of the unpaid arbitration awards in 1998 were
against broker-dealer firms and associated persons that had left the securities
industry. Awards that were not fully paid in 2001 also were against such defunct
brokers. More specifically, as shown in table 1, nonpayment of 192 awards ($41
million) in 2001, was attributed to brokers that had terminated their NASD
membership. In an additional 16 awards, NASD suspended firms or individual brokers
for failing to pay $2.1 million of awards. In 29 awards, $12 million awarded was not
paid because the respondents had requested a hearing, filed for bankruptcy, or filed a
                              15
motion to vacate the award.




15
  NASD procedures allow the respondent to request a hearing on the matter to consider whether (1)
the respondent was given notification of the award, (2) the respondent satisfied the award, and (3) a
valid reason exists for the respondent’s failure to comply with the award.


Page 9                  GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
Table 1: Number and Amount of Dollars Not Fully Paid by Broker-dealers or
Individual Brokers with NASD-administered Arbitration Awards against
Them and Award Nonpayment Status in 2001

             Terminated                                                        Filed
                  NASD                     Requested a       Filed for     motion to
             membership      Suspended         hearing     bankruptcy        vacate         Total
Number of           192             16               7               5            17         237a
awards
not fully
paid
Dollars                $41            $2              $2             $1             $9        $55
not paid
(in
millions)

Source: NASD (data); GAO (analysis).
a
  The sum of these unpaid cases exceeds the 236 unpaid awards because cases with multiple
respondents can have different outcomes.


NASD Procedures to Monitor the Payment
of Awards Are Designed to Encourage Award Payment

NASD has put procedures in place for monitoring the payment of awards that are
designed to encourage award payment. In September 2000, NASD began requiring its
member broker-dealers to certify that they had paid or otherwise complied with an
award against them or their associated persons within 30 days after the award was
served. NASD also began asking the claimants who had won awards to notify it if an
award had not been satisfied within the 30-day period. If an award is not paid, NASD
begins the process of suspending the license of the broker-dealer firm or the
individual broker responsible for payment of the award. In 2001, NASD suspended
one or more of the respondents in 12 cases for failing to pay awards. Members and
individuals who fail to pay awards cannot apply to restore their licenses until an
award against them is satisfied.

Although these procedures may have helped to reduce the rate of unpaid awards, the
previously discussed reduction in the rate of unpaid awards also might reflect
differences in the methodologies used to compile the data used to calculate the rate.
Our June 2000 report was based on data that we obtained by surveying a sample of
investors that had won arbitration awards in 1998. For this report, the rate was
calculated from data obtained from NASD based on its monitoring of award payment
for the entire year of 2001. Additionally, arbitration attorneys said that they have
begun scrutinizing cases more closely to avoid taking cases where awards might not
be paid, a factor which may also have contributed to a reduction in the rate of unpaid
awards.




Page 10                GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
NASD Has Implemented Changes to Help Address the
Problem of Unpaid Awards by Failed Broker-Dealers

NASD is helping to address the problem of unpaid awards by defunct brokers by
making it easier for investors to seek alternative means of relief or obtain a judgment
against the broker. These procedures address the problem of unpaid awards by
defunct brokers, for example, by helping shorten the time period for obtaining a court
judgment that could be used to seize remaining assets of a defunct broker. In April
2001, SEC approved amendments to NASD’s Code of Arbitration Procedure, §10301,
effective June 2001, that provided that a broker-dealer that has been terminated,
suspended, or barred from NASD, or that is otherwise defunct cannot enforce a
predispute arbitration agreement against an investor in NASD’s arbitration forum.
Also, in June 2001, NASD began to advise claimants in writing, at the time they file a
claim, of the registration status (for example, terminated, out-of-business, bankrupt)
of broker-dealers or associated persons so that the claimants can evaluate whether to
continue with the arbitration. In October 2002, a new NASD rule, which SEC
approved in July 2002, took effect. The rule provides for streamlined default
proceedings where the terminated or defunct broker-dealer or associated person
does not answer or appear, but the claimant affirmatively elects to pursue the
arbitration. Under the streamlined proceedings, an arbitrator can make a decision
based on the statement of claim and any other material submitted by the claimant. In
addition, in August 2002, the NASD Board of Directors approved a proposed
amendment, which was submitted in January 2003 to SEC for approval, that would
strengthen NASD’s authority to preclude member broker-dealers from using
structural changes, such as consolidations or other asset sales and transfers, to avoid
meeting their arbitration obligations to investors. Also, NASD officials said that
NASD’s Enforcement Division had started reviewing new arbitration claims as they
come in as part of an effort to identify potentially troublesome members.

In our June 2000 and April 2001 reports, we discussed proposals made by investors’
attorneys to address the unpaid award problem such as insurance and bonding. In the
June 2000 report we recommended that, to the extent unpaid awards remain a
problem, the SEC’s Chairman should establish a process to assess the feasibility of
alternative approaches to address the problem. In response SEC officials said that
after our report was issued SEC staff assessed other approaches addressed in the
report including insurance and bonding. According to the officials, SEC staff met with
broker-dealer representatives and insurance companies to discuss existing broker-
dealer insurance and bonding requirements. The officials said that after those
consultations, the staff concluded that expanding broker-dealer insurance and
bonding requirements would not be an appropriate means of addressing unpaid
arbitration awards. Instead, SEC staff concluded that the efforts of NASD—which
conducts most broker-dealer examinations—to institute a procedure of reviewing all
arbitration claims as they are filed to identify problem brokers early through related
examinations and as appropriate, enforcement action, would limit the harm they
cause investors. The officials said that this, as well as other initiatives NASD has
taken, which are described earlier in this report and in our June 2000 and April 2001
reports, should be given time to work. SEC’s continuation of the process we


Page 11             GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
recommended in June 2000 to assess the feasibility of alternative approaches to
address the problem of unpaid awards by defunct brokers could further reduce the
incidence of unpaid awards. This process could consider how SEC and NASD
programs for broker registration, regulation, enforcement, as well as arbitration, and
other areas as appropriate, can further reduce the incidence of unpaid awards.

In June 2000, we also recommended that the SEC Chairman work with the SROs to
develop and publicize information to focus investor attention on the possibility of
unpaid arbitration awards. In response, NASD and SEC made information available
on their Web sites to caution investors about the possibility of having an unpaid
award. That information, while helpful, does not provide any data to inform investors
of the scope of the problem or the frequency with which awards are unpaid by
defunct brokers. Increasing investors’ awareness of the scope and frequency of the
problem may better inform investors that broker-dealers that stay in business
generally pay awards and help to reduce unpaid awards by defunct brokers.

Recent Increase in Arbitration Claims Suggests
That Many Future Awards also Might Not Be Paid

Arbitration claims have increased sharply, which may mean, assuming the rate of
unpaid awards remains the same; more investors may not be paid. In 2001, 6,926
arbitration claims were filed with NASD. In 2002, the number of new cases further
increased to 7,709, or a 39 percent increase over the 5,565 total claims filed in 2000. In
most of these cases—4,849 in 2001 and 5,974 in 2002—investors filed claims against
their brokers. Through 2002, these investor-initiated cases increased by 64 percent
from the 3,637 claims filed by investors in 2000. NASD officials said that whether this
increase in claims will mean more unpaid awards depends on the types of broker-
dealers any resultant awards might be against. For example, if the increase in claims
results in more awards against large viable broker-dealers that tend to pay awards,
the number of unpaid awards could decrease.

NASD officials said that the increase in claims filed was the result of changes in the
economy. The officials said the downturn in and increased volatility of the stock
market in 2001, an influx of new inexperienced investors during the boom years of
the late 1990s, and the overall increased number of securities holders contributed to
the increase in arbitration claims filed. According to NASD, claims alleging broker
failure to supervise their sales representatives, breach of fiduciary duty,
misrepresentation, and negligence also had increased.

Conclusions

The rule and procedural changes that NASD has adopted to improve the arbitrator
information update process and its ability to remove arbitrators from cases appear
reasonable and could improve the effectiveness and efficiency of arbitration. These
changes could help NASD to keep current the information that parties in arbitration
use in selecting arbitrators and allow for faster and less costly removal of arbitrators
in cases where there has been an undisclosed conflict of interest.


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Motions to dismiss are used, but not with great frequency, in NASD arbitrations.
Arbitration law and codes do not explicitly prohibit the use of these motions.
Because appeal rights and evidentiary discovery are limited, a Securities Industry
Conference on Arbitration member said that arbitration forums should discourage
the granting of these motions. However, NASD officials have contended that use of
these motions helps to make the arbitration process more efficient.

Data show that the rate of unpaid awards has diminished since our June 2000 report.
However, continued unpaid awards, regardless of how effective and fair the
arbitration process may be, could negatively affect investors’ confidence in
arbitration and potentially the securities markets in general. Unpaid awards also may
discourage attorneys from taking investors’ cases. It is important that regulators
continue to issue a strong message to investors about being cautious in choosing
their brokers because some brokers will never pay for the damage they cause.
Moreover, given that continued unpaid awards could erode investors’ confidence in
arbitration, SEC’s Chairman should continue the process we recommended in June
2000 to assess the feasibility of alternative approaches to address the problem of
unpaid awards by defunct brokers. This process could consider how SEC and NASD
programs for broker registration, regulation, enforcement, as well as arbitration, and
other areas as appropriate, could further reduce the incidence of unpaid awards.
Further, NASD needs to be concerned about unpaid awards, which represent
inefficient use of NASD dispute resolution program resources and futile efforts by
defrauded investors seeking restitution. By making data on the frequency with which
awards are unpaid by defunct brokers publicly available, NASD could better inform
investors of the possibility of unpaid awards by defunct brokers and increase
investors’ awareness of the scope of the problem. This, in addition, could cause
investors to be more cautious in choosing their broker and also help them decide
whether to file an arbitration claim or seek alternative means of obtaining relief and
avoid unnecessary expenses.

Recommendation for Executive Action

We recommend that the President, NASD Dispute Resolution, make available on
NASD’s Web site current statistics showing the frequency with which arbitration
awards against defunct brokers are not fully paid.

Agency Comments and Our Evaluation

SEC and NASD provided written comments on a draft of this report, which are
reprinted in enclosures I and II. SEC and NASD also provided technical comments,
which were incorporated into the final report. SEC agreed with the contents of this
report and noted that our work demonstrates that NASD has developed necessary
tools to administer its growing caseload and that implementation of our June 2000
recommendations has helped achieve an appreciable reduction in the rate of unpaid
awards. SEC commented that it welcomes our recommendation that NASD make
available on its Web site current statistics showing the frequency with which
arbitration awards against defunct brokers are not fully paid. SEC said that this more


Page 13             GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
explicit data should help deliver to investors the educational message to choose
investment professionals carefully. SEC noted that SEC staff believe that more time is
needed to realize the full effects of the steps taken after our June 2000 report and that
it continues to work with NASD to better identify individuals responsible for unpaid
awards.

NASD generally agreed with the contents of this report and provided additional
information on the various steps it has taken related to its addressing the problem of
unpaid awards. NASD also noted the dramatic improvement in the rate of unpaid
awards from our June 2000 report and provided updated information on the status of
awards we found to be unpaid. NASD updated the payment status of awards that
were paid after it threatened suspension of the member or a motion to vacate was
denied or which had motions to vacate still pending, which reduced the percent of
awards unpaid from 55 percent to 53 percent. NASD stated that it would consider our
recommendation and additional ways to enhance investor education about the
problems associated with terminated members and the payment of awards. NASD
commented that it strives to strike a balance between disclosing information and not
discouraging investors from filing valid claims. NASD stated that, with that concern
in mind, it will develop an approach to enhance the data available to investors to
enable them to make more informed decisions about whether to pursue a claim.
NASD also commented that it welcomes the opportunity to participate in a feasibility
study of alternative solutions to address the problem of unpaid awards that we
recommended in June 2000.

We commend SEC and NASD for the efforts they have taken to monitor and educate
investors about unpaid awards, and provide investors viable options when faced with
the possibility of unpaid awards. However, the extent to which awards are unpaid by
defunct brokers shows that unpaid awards, even when reduced to 53 percent for
2001, as NASD adjusted it, is still a serious problem that can affect investors’
confidence in arbitration and potentially the securities markets and discourage
attorneys from taking investors’ cases. It is, therefore, important that NASD make
available to investors current statistics on the frequency with which awards are
unpaid by defunct brokers and that regulators continue to monitor unpaid awards
and consider ways of addressing the problem.

Scope and Methodology

We analyzed information on NASD procedures for updating arbitrator disclosure
information and removing arbitrators from cases based on our review of NASD’s
procedures and interviews of NASD officials. We analyzed information on the use of
motions in arbitration based on interviews of officials of NASD and the Securities
Industry Conference on Arbitration. We also reviewed arbitration rules of NASD and
other forums and federal case law regarding the uses of motions to dismiss and
motions for summary judgment in NASD cases. We then identified the extent to
which these motions were used in 2001 NASD investor-initiated cases in which
monetary award decisions were rendered in favor of investors.



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To determine changes in arbitration claims and the rate at which awards in investor-
initiated cases were paid, we analyzed NASD data. Initial testing of the NASD data on
award payment found errors that could overstate the extent to which awards were
paid that were significant enough to require further verification and correction. We
then had NASD correct any errors found and then further tested the accuracy of the
data. We reviewed a randomly-selected sample of 34 cases out of 719 monetary
awards in 2001 to verify that NASD had documentation showing that the awards were
paid. From our random sample of 34 awards 1 award was initially listed as paid, but
we discovered on further review that the award was unpaid, and the respondent had
filed for bankruptcy. Subsequently, NASD discovered an additional award that was
mistakenly classified as unpaid. The number and magnitude of these data errors are
small enough that the data are sufficiently reliable for our purposes and should not
materially affect the estimates of payment rates in this report. Nevertheless, we
apprised SEC officials of the errors. The officials said that SEC examiners would test
the accuracy of the award payment data as part of SEC’s routine inspections of
NASD's dispute resolution program. NASD officials told us that the errors resulted
from NASD not having a means of tracking the payment status of awards. Once an
award was granted, NASD gave the case a closed status and NASD staff had to
manually compile the payment data from documents in case files. The NASD officials
said that NASD has since entered new status codes in its computer system for
tracking the payment status of awards. They said that they can now track different
outcomes related to award payment such as receiving a broker’s certification that an
award was paid or that a broker had filed a motion to vacate an award in a court. The
officials said that this change should minimize the opportunity for compilation errors.

We conducted our work in Washington, D.C., and New York, N.Y., from April 2002
through March 2003, in accordance with generally accepted government audit
standards.


As agreed with your offices, unless you publicly announce the contents of this report
earlier, we plan no further distribution until 30 days from the report date. At that
time, we will provide copies of this report to the Chairman, House Committee on
Energy and Commerce; the Chairman, Subcommittee on Telecommunications and
the Internet, House Committee on Energy and Commerce; the Chairman and the
Ranking Minority Member, Senate Committee on Banking, Housing, and Urban
Affairs; and the Chairman and the Ranking Minority Member, House Committee on
Financial Services. Copies also will be provided to the Honorable William H.
Donaldson, Chairman, SEC; Mr. Robert R. Glauber, Chairman, NASD; and other
interested parties. In addition, the report will be available at no charge on the GAO
Web site at http://www.gao.gov.




Page 15             GAO-03-162R Follow-up Report on Matters Relating to Securities Arbitration
Please call me or Orice M. Williams, Assistant Director, at (202) 512-8678 if you or
your staff have any questions concerning this report. David Tarosky and Sindy Udell
also contributed to this report.




William O. Jenkins Jr.
Director, Financial Markets
 and Community Investment

Enclosures




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Enclosure I

              Comments from the Securities and Exchange Commission




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Enclosure I




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Enclosure I




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Enclosure II

                            Comments from NASD




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




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Enclosure II




(250081)




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