Although the 2009 Annual Meeting of the Securities Industry and Financial Markets Association (SIFMA) Compliance and Legal Division was marked by a dramatic decrease in attendance by the industry and many law firms, the sessions were very informative and, in particular, addressed the rapidly changing landscape in the areas of litigation, arbitration, regulation, examination and enforcement. Here are some of the highlights from several sessions.  

Arbitration and Litigation Highlights

Linda Fienberg, President of Financial Industry Regulatory Authority (FINRA) Dispute Resolution, was a featured participant on two panels and addressed many important developments, including changes in the Code of Arbitration Procedure and the swelling number of arbitration filings.  

Pilot Program

Last year FINRA instituted the “pilot program,” in which a growing list of firms (now 11) have volunteered to allow investors to choose all-customer panels, up to a set maximum number of cases against each firm.1 During the course of the program, investors in more than 550 arbitrations will be able to choose an all-public arbitration panel. The stated purpose of the program is (1) to allow FINRA to evaluate the number of cases where claimants will elect an all-public panel, and (2) to compare the rate of settlement and length of hearings in the cases using those panels. According to Ms. Fienberg, thus far in 38% of the cases in the program the claimants elected to allow an industry arbitrator to be on the panel. FINRA’s evaluation is ongoing, and it is likely that more member firms will be asked to voluntarily participate in the project, especially in light of congressional activity to limit or modify mandatory arbitration. The arbitrator-ranking process under the pilot program begins with the same three-list system, including a list of eight non-public arbitrators. The parties, however, are permitted to strike all eight non-public arbitrators; in such cases, the second-highest ranked public arbitrator joins the highest-ranked public arbitrator on the panel.  

Increase in Case Filings

In 2008 new customer case filings increased 94% when compared to 2007. Mutual funds are the product most often the subject of the claim, followed (in order) by common stock, annuities, bonds, options and limited partnerships. Ms. Fienberg stated that the percentage of cases where the claimants prevail rose to 42% in 2008, compared to 37% in 2007. Perhaps in response to the new expungement rules, individual brokers were named as respondents in only 37% of the 2008 filings, compared to 76% in 2001.  

There has also been a substantial uptick in the number of filings involving Auction Rate Securities, Collateralized Debt Obligations and Collateralized Mortgage Obligations. The number of cases involving subprime issues rose dramatically, with 925 new filings in 2008.

Single Arbitrator

Beginning March 30, 2009, any filing with a damage claim of less than $100,000 will be assigned a one-arbitrator panel, under SEC-approved amendments to Rule 12401 of the Code of Arbitration Procedure for Customer Disputes (Customer Code) and Rule 13401 of the Code of Arbitration Procedure for Industry Disputes (Industry Code). In contrast to prior practice, for cases with damages between $50,000 and $100,000, FINRA will allow a three-person panel only if all parties agree in writing to a larger panel. In calculating the dollar limits, FINRA will consider only the claim for actual damages; a request for an unspecified amount of punitive damages, interest or attorneys fees will not be taken into consideration. If a respondent files a counterclaim, it will trigger a three-person panel only if the relief sought in the counterclaim itself exceeds $100,000. The prayers for relief in the statement of claim and any counterclaims will not be aggregated in order to meet the $100,000 threshold.

Ms. Fienberg addressed the situation where a single arbitrator has been selected but an award is rendered in excess of $100,000. FINRA will not consider the inclusion of attorneys’ fees, interest and costs to exceed the $100,000 limit. Even if the single arbitrator renders an award with actual damages in excess of $100,000, FINRA will not override the award; it is up to the aggrieved party to file a motion to vacate. Additional information about this rule change can be found in FINRA Regulatory Notice 09-13, which is available from FINRA’s website here.

Reasoned Decisions

Effective April 13, 2009, FINRA will require the consent of all parties for the panel to issue a reasoned award. Under the current rules (Rule 12904(f) of the Customer Code and Rule 13904(f) of the Industry Code) the arbitrators are permitted to provide “a rationale underlying the award” but are not required to do so. Ms. Fienberg commented that she does not believe there will be a significant number of reasoned decisions, as most experienced counsel for claimants and respondents do not want an explained award, which can possibly invite a motion to vacate. Additional information about this rule change is contained in FINRA Regulatory Notice 09-16, which is available through FINRA’s website here.  

Motions to Dismiss

FINRA adopted new rules on motions practice (Rule 12504 for Customer Disputes and Rule 13504 for Industry Disputes), which became effective February 23, 2009. The rules essentially prohibit consideration of a motion to dismiss prior to the close of a claimant’s case, except in three limited circumstances: (1) eligibility, (2) prior settlement, and (3) factual impossibility (e.g., naming the wrong broker or supervisor). Ms. Fienberg indicated that the first ground applies only to the cases that violate the six-year eligibility rule (Code § 12206(b)(7) for Customer Disputes; Code § 13206(b)(7) for Industry Disputes). The new motion to dismiss rules do not permit respondents to file a motion to dismiss based upon a state or federal statute of limitation prior to the conclusion of the claimant’s case.

It appears that the new rules only prohibit a panel from ruling on the motion prior to the close of the claimant’s case. Thus a respondent potentially could file a motion to dismiss at the beginning of a hearing in order to educate the panel, making clear that the panel will not be asked to rule on the motion until the claimant rests. However, Rules 12504 and 13504 (among other provisions) require both (1) that the panel assess forum fees against respondents if the motions are denied, and (2) that the panel award costs and forum fees to claimants for motions the panel deems frivolous. Both rules do not apply to motions filed after the completion of the claimant’s case. Additional information about this rule change can be found in FINRA Regulatory Notice 09-07, which is available from FINRA’s website here.

Auction Rate Securities Cases

Effective December 20, 2008, FINRA implemented special expedited arbitration procedures for cases involving auction rate securities filed by customers of firms that entered into regulatory settlements with FINRA or the SEC, allowing a claimant to seek “consequential damages” before a single public arbitrator. An example of a “consequential damage” is the allegation that the claimant had to take out a loan to pay for an expense when the claimant’s auction rate holdings were frozen. It must be noted that attorneys’ fees and punitive damages are not considered an element of “consequential damages” and thus may not be sought using the expedited single-arbitrator procedure. According to Ms. Fienberg, a claimant seeking attorneys’ fees or other non-consequential damages under these circumstances must seek a “regular way” arbitration, potentially before a three-person panel (assuming the prayer for relief exceeds $100,000; see discussion of the new single-arbitrator procedures, supra). Ms. Fienberg further explained that there may be variations on these procedures in the future based upon settlements with state regulators, which could allow recovery of attorneys’ fees using the expedited single-arbitrator procedures. At the present time, FINRA anticipates that the expedited procedures will be used primarily by pro se claimants.  

Discovery Arbitrators

Since 2005, FINRA has permitted the use of a special arbitrator, who is not a member of the panel, to resolve discovery disputes. This procedure has rarely been used, primarily because the arbitrators at a hearing may not be familiar with the rulings of the discovery arbitrator, and who therefore may make evidentiary rulings during the course of the hearing that conflict with the special arbitrator’s prior rulings.  

Enforcement and Regulatory Highlights

The Top 13 Inspection Priorities

On March 24, 2009, John Walsh, Chief Counsel in the SEC’s Office of Compliance Inspections and Examinations (OCIE), discussed OCIE’s top 13 inspection priorities for 2009 (Mr. Walsh made it clear that his list of priorities should be attributed to OCIE’s Division Director, Lori Richards, who was not able to attend the conference this year). The list, in order, is as follows:  

1) Custody and Control of Customer Assets  

  • Small firms with a “dominant principal” are considered high risk  
  • SEC is looking at who the auditor is  
  • SEC at least on a sample basis will verify custody directly with customers and custodians  

2) Controls Over Valuations  

  • Is there adequate diligence on the part of the firm with respect to who is doing the valuation?  
  • Is the valuation agent independent?  
  • Is the firm following its own procedures?  

3) Retail Sales Practices  

  • What are the firm’s policies and procedures with respect to its characterization (if any) of certain investments as being “safe”?  
  • Statements that a particular product is “safe” or “liquid” must be accurate  
  • Examiners will look at unusual claims regarding the performance of a product  
  • Firms should be vigilant regarding statements made about investments in municipal securities

4) Supervision and Compliance  

  • Do you follow your own procedures?  
  • What testing have you done?  
  • Be careful not to undercut the effectiveness of your systems with cuts in compliance staff  

5) Net Capital Compliance and Financial Controls  

  • Focus on reserve formula calculations, the valuation of proprietary assets, and disclosure to customers of precarious firm situations (e.g., financial distress)  

6) Trading Issues  

  • What are you doing to prevent the spread of rumors?  
  • Compliance with the short sale rule and Regulation NMS  

7) Rating Agencies  

  • See OCIE’s June 2008 report on certain rating agencies  
  • OCIE will examine the remainder of the rating agencies this year  

8) Revenue Sharing  

  • SEC is concerned that the number of undisclosed payments for business will increase in the current economic environment  
  • Ask: “Why are we using this service provider?”  
  • Ask: “What is being paid for?”  

9) Hedge Funds  

  • SEC will look for preferential treatment of certain shareholders in a liquidation  
  • Undisclosed arrangements  
  • Insider trading  

10) Changes Brought About by a Merger, Acquisition or Similar Event  

  • What has the firm done to integrate new or merged business lines?  
  • Firms that outsource need to focus on changes in service providers  

11) Fixed Income  

  • Focus on pricing, mark-ups, suitability and execution quality, particularly for CMOs and municipal securities  

12) Safeguarding Non-Public Information  

  • Focus on firm policies and procedures to prevent insider trading  

13) Anti-Money Laundering  

  • Focus on customer identification programs and independent testing  

Variable Annuity Sales Practices

Sutherland Partner Eric Arnold participated on a panel discussion entitled “Variable Annuities Sales Practices.” The panel spent substantial time on the implications of the financial markets crisis on variable annuity distribution. In particular, the panel focused on the issues raised by insurance company financial difficulties and ratings downgrades. The process and steps taken by variable annuity distributors as described by the panel included:

  • Considering terminating new sales of products issued by troubled issuers;
  • Developing precise standards and conditions with respect to accepting replacement business where the annuity product being replaced is issued by an insurer that appears to be in financial distress;  
  • Considering potential options with respect to recommendations to existing clients holding annuity contracts from such distressed insurers;  
  • Exploring the ability to refer representatives and their clients to appropriate sources explaining the contours of state guaranty fund coverage; and  
  • Requiring special disclosures to be signed by clients where they were moving into, or out of, the annuity contract of a potentially troubled company.  

The panel also provided an update on the status of NASD Rule 2821 and explored the remaining issues in that rule focusing on:  

  • The timing of principal review (triggered off of the receipt of a complete and correct application by an OSJ of the firm); and  
  • Different issues raised by the proposed rule with respect to handling funds, including (1) the SEC’s order providing exemptive relief, under certain conditions, from the requirement to promptly transmit customer checks, and (2) the new insurance suspense account provisions under SM.03 of the proposed rule.  

The panel also provided background on FINRA’s proposed revisions to the advertising rules affecting variable annuities as proposed under Regulatory Notice 08-39. Mr. Arnold indicated that, while the comment period closed on September 30, 2008, it appears that FINRA is continuing to evaluate the comments and the proposed changes and may need some additional time to move this proposal forward.

Finally, the panel focused on proposed Rule 151A, which effectively would require equity indexed annuities to become registered securities by January 2011. In that regard, the panel focused on the work that FINRA would need to do to possibly update its rules to identify whether or not registered indexed annuities would be subject to, for example, the advertising filing, cash and non-cash compensation, and suitability rules that are applicable to variable (but not registered indexed) annuity contracts.