Executive Summary

The NASD is alerting its members that customer agreements used by some members contain predispute arbitration provisions that are contrary to Article III, Section 21 of the NASD Rules of Fair Practice and/or the NASD Code of Arbitration Procedure. Members are urged to take prompt steps to ensure that their customer agreements fully comply with these requirements.

Background

In 1989, the Securities and Exchange Commission (SEC) approved a number of amendments to the NASD Code of Arbitration Procedure in an effort to improve securities industry arbitration as a fair, expeditious, and economical means for the resolution of disputes. In addition, it approved an amendment to Article III, Section 21 of the NASD Rules of Fair Practice to impose important specific disclosures and other requirements for predispute arbitration clauses in customer agreements. (See Notice to Members 89-58.) Recently, it has come to the attention of the NASD and the SEC that customer agreements used by some NASD members contain provisions that are inconsistent with this NASD rule or that subvert its purposes. NASD members should take prompt steps to ensure that their customer agreements fully comply with this important rule and the NASD Code of Arbitration Procedure.

Specifically, Section 21(f)(4) of the NASD Rules of Fair Practice, as amended, prohibits the use in any customer agreement of any language that (a) limits or contradicts the rules of the NASD or any other self-regulatory organization; (b) limits the ability of a party to file a claim in arbitration; or (c) limits the ability of the arbitrators to make an award under the arbitration rules of a self-regulatory organization and applicable law. The NASD Code of Arbitration Procedure sets forth the applicable authority and procedures in these areas.

Hearing Location

Customer agreements used by some members attempt to dictate the location for the arbitration hearing. For example, some require that the hearing be held in New York or Denver regardless of where the customer resides. Any such provision is inconsistent with Section 26 of the NASD Code of Arbitration Procedure, which states that "the time and place for the initial hearing shall be determined by the Director of Arbitration and each hearing thereafter by the arbitrators." In 1989, the SEC noted that customer agreements "may not be used to restrict the situs of an arbitration hearing contrary to SRO rules." (See, Securities Exchange Act Release No. 26805.)

Arbitration Panel Composition

Compliance problems have also been raised by customer agreements which attempt to dictate the composition of an arbitration panel. Such provisions are contrary to Section 4 of the NASD Code of Arbitration Procedure, which states that the "Director of Arbitration shall compose and appoint panels of arbitrators." In addition, such provision is contrary to Section 19 of the NASD Code of Arbitration Procedure if it redefines who may serve as either a public or industry arbitrator.

Time Limitations

Section 15 of the NASD Code of Arbitration Procedure allows arbitration claims to be submitted unless six years have elapsed from the occurrence or event giving rise to the claim or controversy. However, Section 15 does not "extend applicable statutes of limitations" under state law. Consequently, customer agreements may not be used to shorten applicable statutes of limitations or to require that a time limitations question be judicially determined instead of being submitted to a panel of arbitrators pursuant to a submission under the Code of Arbitration Procedure.

Claims and Awards

Some customer agreements attempt to directly limit the ability of a customer to file a claim or to limit the authority of the arbitrators to make an award, including an award of punitive damages. Others attempt to do so indirectly by the use of a so-called "governing law clause." For example, certain customer agreements simply state that New York law will govern any dispute in arbitration, but do not disclose that New York law prohibits an award of punitive damages in arbitration. Where the governing law clause is used to limit an award, it violates Section 21(f) of the NASD Rules of Fair Practice. Indeed, in 1989 the SEC said that:

"customer agreements cannot be used to curtail any rights that a party may otherwise have had in a judicial forum. If punitive damages or attorneys fees would be available under applicable law, then the agreement cannot limit parties' rights to request them, nor arbitrators' rights to award them." (See Securities Exchange Act Release No. 26805.)

In a case recently decided by the United States Supreme Court,

Mastrobuono v. Shearson Lehman Hutton, Inc., the customer agreement in question stated that New York law governed the agreement, but it was signed by the customer before the adoption of Section 21(f) of the NASD Rules of Fair Practice. Nevertheless, the U.S. Solicitor General and the SEC asked the Court to "leave no confusion as to the operation of Rule 21(f)(4) with respect to agreements signed after the Rule's effective date." They argued to the Court that:

"NASD Rule 21(f)(4) forbids the inclusion in broker-client arbitration agreements of provisions limiting the ability of arbitrators to award relief that would be available in a judicial forum. The Rule has an effective date of September 7, 1989; with respect to agreements executed after that date, the Rule has the force of federal law and precludes the enforcement of contractual provisions that are inconsistent with its terms."¹

Other Problems

Similar compliance problems are raised by provisions that attempt to limit the courts before whom awards may be confirmed or limit the role of arbitrators. Indeed, the use of a governing law clause or other clause anywhere within a customer agreement that thwarts any NASD arbitration provision will be deemed violative.

NASD members having arbitration provisions in customer agreements that are inconsistent with NASD rules may be subject to disciplinary action. NASD staff, District Business Conduct Committee, and arbitration panels will view provisions in agreements that can be construed as limiting the ability of customers to file claims or of arbitrators to issue awards as being inconsistent with NASD rules. NASD members should promptly review their customer agreements to ensure that they fully comply with NASD rules.

Questions concerning this Notice may be directed to Deborah Masucci, Vice President and Director of Arbitration, at (212) 858-4400.

¹ In its recent decision in this case, the Supreme Court declined to address customer agreements signed after the rule's effective date. However, the court held that, despite the limiting New York law clause in the customer agreement in issue, the arbitrators may impose punitive damages.