64428 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

30 17 CFR 200.30–3(a)(12).

1The NASD filed Amendment Nos. 1 and 2 to the

proposed rule filing on October 17, 1997 and

November 14, 1997, respectively, the substance of

which is incorporated into the notice. See letters

from Joan C. Conley, Corporate Secretary, NASD

Regulation, to Katherine A. England, Assistant

Director, Market Regulation, Commission, dated

October 17, 1997 (‘‘Amendment No. 1’’) and

November 14, 1997 (‘‘Amendment No. 2’’)

respectively.

membership in an SRO or has had its

registration as a broker-dealer revoked

by the SEC. The requisite percentage

varies from 40 to 20 percent, depending

on the size of the firm.

4. As proposed, the Rule captures

registered persons who have worked at

a Disciplined Firm within the past two

years. Is the proposed time frame

appropriate?

5. Should the percentage of registered

persons counted in the calculation

exclude registered persons who have

worked at a Disciplined Firm within the

past two years, but who themselves

have no disciplinary history or customer

complaints?

6. Should the percentage of registered

persons counted in the calculation

include registered persons who may not

have worked at a Disciplined Firm, but

who have, as individuals, been barred

by the Commission from association

with any broker, dealer, investment

adviser, investment company, or

municipal securities dealer?

7. Should firms with fewer than five

registered persons be excepted from the

Rule?

8. As proposed, the Rule limits the

taping requirement to registered

representatives in conversation with

existing or potential customers. Should

the taping requirement apply to

registered principals in conversation

with existing or potential customers?

Should it apply to any other associated

person of a member firm?

9. What are the estimated costs to

comply with the Rule? Please comment

generally on the benefits and costs of

the Rule, as well as ways to reduce the

costs while preserving the benefits of

the Rule.

Persons making written submissions

should file six copies thereof with

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 File No. SR–NASD–

97–69 in the caption above and should

be submitted by December 29, 1997.

For the Commission, by the Division of the

Market Regulation, pursuant to delegated

authority.30

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–31846 Filed 12–4–97; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–39371; File No. SR–NASD–

97–47]

Self-Regulatory Organizations; Notice

of Filing of Proposed Rule Change by

the National Association of Securities

Dealers, Inc. Relating to Punitive

Damages in Arbitration

November 26, 1997.

Pursuant to Section 19(b)(1) of the

Securities Exchange Act of 1934

(‘‘Act’’), 15 U.S.C. 78s(b)(1), notice is

hereby given that on July 8, 1997,1 the

National Association of Securities

Dealers, Inc. (‘‘NASD’’ or ‘‘Association’’)

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 the selfregulatory organization. The

Commission is publishing this notice to

solicit comments on the proposed rule

change from interested persons.

I. Self-Regulatory Organization’s

Statement of the Terms of Substance of

the Proposed Rule Change

NASD Regulation is proposing to

amend the NASD’s Code of Arbitration

Procedure to add a new rule relating to

the award of punitive damages. Below is

the text of the proposed rule change.

Proposed new language is in italics;

proposed deletions are in brackets.

Rules of the Association

10000. Code of Arbitration Procedure

10300. Uniform Code of Arbitration

10336. Punitive Damages

This Rule explains when a party may

seek punitive damages, what standards

and limitations apply to the claim, and

what the arbitration award must state.

(a) The Availability of Punitive Damages

(1) This Rule applies to any claim that

must be arbitrated under Rule 10301

between a public customer and a

member, or between a public customer

and an associated person.

(2) A party may request punitive

damages if, at the time the party files a

claim, the party is a citizen of a state

that allows its courts to award punitive

damages for the same type of claim.

(3) A member or an associated person

may request punitive damages from a

public customer only if the public

customer is a citizen of a state that

allows its courts to award punitive

damages for one or more of the public

customer’s claims.

(4) A party seeking punitive damages

must state the amount in its claim.

(5) For purposes of this Rule, the term

‘‘claim’’ means any dispute or

controversy described in the Statement

of Claim (including Counterclaims,

Third-Party Claims, and Cross-Claims)

for which the claimant is seeking any

form of remedy.

(b) Arbitrators to Apply State Standard

(1) When arbitrators decide whether

to award punitive damages, they will

apply the same standard of conduct

applied by courts in the state where the

requesting party is a citizen at the time

a claim is filed.

(2) Arbitrators will apply this

standard even if the parties signed a

choice of law agreement that specifies a

different state.

(c) Limitations on the Amount and

Availability of Punitive Damages

(1) Punitive damages may be awarded

in an amount up to two times

compensatory damages or $750,000,

whichever is less.

(2) For purposes of this paragraph

only, compensatory damages do not

include attorneys’ fees, costs of

arbitration, or post-award interest.

(3) Arbitrators cannot award punitive

damages if they have already awarded

multiple damages for the same claim

under:

(A) the Racketeer Influenced and

Corrupt Organizations Act (RICO), or

(B) any other federal or state statute

that provides for multiple damages

awards.

(4) The limitations in this Rule apply

even if state laws differ.

(d) Statement in Award

If the arbitrators award compensatory

and punitive damages, they must state

separately the amount they awarded for

each.
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 64429

2The NASD formed the Arbitration Policy Task

Force in September 1994 for the purposes of

studying the securities arbitration process

administered by the NASD and of making

suggestions for reform. The Task Force, chaired by

David S. Ruder, former Chairman of the SEC,

delivered its Report to the NASD Board in January

1996.

3The proposed rule change does not apply to

industry and clearing controversies that may be

arbitrated pursuant to the Rule 10200 Series, such

as disputes between or among member firms,

associated persons, and other industry parties. The

NASD will address punitive damages for these

disputes in a separate filing.

4Black’s Law Dictionary 389 (6th ed. 1990).

5Restatement (Second) of Torts § 903 (1979). The

word ‘‘damages’’ is used in the Restatement of Torts

in the same sense in which it is used in the

Restatement of Contracts. See id. § 902 cmt. a

(1979).

6Restatement (Second) of Torts § 908 (1979). ‘‘In

assessing punitive damages, the trier of fact can

properly consider the character of the defendant’s

act, the nature and extent of the harm to the

plaintiff that the defendant caused or intended to

cause and the wealth of the defendant.’’ Id.

7See Restatement (Second) of Torts § 908 cmt. c

(1979) and cases cited therein. Some courts allow

recovery of punitive damages when only nominal

damages have been awarded. Id.

8SICA is a group composed of representatives of

the self-regulatory organizations (‘‘SROs’’) that

provide arbitration forums, public investors, and

the securities industry. Staff of the SEC attend as

non-voting invitees. Currently, there are ten SRO

representatives, three public investor

representatives, and one representative from the

securities industry.

9 In 1994, the New York Stock Exchange

(‘‘NYSE’’) held a symposium on issues significant

in securities arbitration, including punitive

damages. Symposium: New York Stock Exchange,

Inc. Symposium on Arbitration in the Securities

Industry, 63 Fordham L. Rev. 1495 (1995).

10 514 U.S. 52, 131 L. Ed. 2d 76, 115 S. Ct. 1212

(1995).

11 514 U.S. at 58–59.

12See Garrity versus Lyle Stuart, Inc., 353 N.E.2d

793 (1976). Since Mastrobuono was decided, a New

York appellate court has held that, with respect to

arbitrations governed by the Federal Arbitration

Act, which preempts the Garrity rule, the

arbitration of punitive damages claims is required

unless the parties have unequivocally agreed

otherwise. Mulder versus Donaldson, Lufkin &

Jenrette, 648 N.Y.S.2d 535 (1996).

13 514 U.S. at 60–61.

14This is currently Rule 10330(e).

15 514 U.S. at 61.

16 Id. The Arbitrator’s Manual was compiled by

members of SICA to explain the Uniform Code of

Arbitration.

II. Self-Regulatory Organization’s

Statement of the Purpose of, and

Statutory Basis for, the Proposed Rule

Change

In its filing with the Commission, the

self-regulatory organization included

statements concerning the purpose of

and 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.

The self-regulatory organization 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

In January 1996, the NASD’s

Arbitration Policy Task Force (‘‘Task

Force’’) 2 released its report on

Securities Arbitration Reform. The Task

Force Report made numerous

recommendations to improve the

arbitration process. Since the Report

was released, NASD Regulation has

been engaged in a major effort to

implement the Task Force

recommendations.

The proposed rule change relates to

the Task Force recommendations

concerning the availability of punitive

damages in securities arbitration. In

brief, the Task Force recommended that

punitive damages remain available in

NASD arbitration, subject to a cap. The

Task Force’s recommendations are

described in more detail below.

Summary of Proposed Rule Change

The proposed rule change would

apply only to arbitration disputes

between public customers and member

firms (or their associated persons).3 The

proposed rule change would allow a

customer to seek punitive damages in

arbitration if the state of which he or she

is a citizen would allow punitive

damages for the same type of claim in

court. In deciding whether an award of

punitive damages is warranted, the

arbitration panel will look to the

standard of conduct for the award of

punitive damages applied in the state of

which the party requesting punitive

damages is a citizen at the time the

claim is filed. That state’s law is to be

applied without regard to any contrary

choice-of-law provision contained in the

parties’ agreement. The proposed rule

requires a party requesting an award of

punitive damages to specify in the claim

the amount of punitive damages

requested, and provides that punitive

damages may be awarded in an amount

up to two times compensatory damages

or $750,000, whichever is less.

Background

Damages are defined as pecuniary

compensation that may be recovered by

any person who has suffered loss,

detriment, or injury to his person,

property, or rights through the unlawful

act, omission, or negligence of another.4

Damages may be compensatory or

punitive, according to whether they are

awarded (1) as compensation,

indemnity, or restitution for harm

sustained by a party (compensatory);5 or

(2) as other damages awarded against a

person to punish him for his outrageous

conduct and to deter him and others

like him from similar conduct in the

future (punitive).6 Punitive damages

usually are awarded only if

compensatory damages have been

sustained.7

For many years, courts and legal

scholars debated whether punitive

damages should be available in

arbitration proceedings. In 1992, the

Securities Industry Conference on

Arbitration (‘‘SICA’’) 8 approved an

amendment to the Uniform Code of

Arbitration which provided that

arbitrators may grant any remedy or

relief that they deem just and equitable

and that would have been available in

a court with jurisdiction over the same

dispute. This provision has not been

adopted by any SRO.9 As noted, as in

1994, the NASD formed the Task Force

to study the securities arbitration

process administered by the NASD and

to make suggestions for reform. The

NASD has followed the Task Force’s

recommendations, described below, in

developing the proposed rule.

In 1995, the Supreme Court addressed

the availability of punitive damages in

securities arbitration in a case involving

the NASD’s arbitration forum.

Mastrobuono v. Shearson Lehman

Hutton, Inc.10 The Mastrobuono case

involved a brokerage firm’s client

agreement that contained a New York

‘‘choice-of-law’’ provision and a

provision requiring any controversy

arising out of the parties’ transactions to

be arbitrated according to the rules of

the NASD or the NYSE.11 The choice-oflaw provision required that disputes be

decided according to New York law,

which allowed courts, but not

arbitrators, to award punitive

damages.12 With regard to the

arbitration provision, the Court

examined the NASD’s rules, because the

parties had elected to proceed in

arbitration at the NASD.13 The Court

cited an NASD rule providing that

arbitrators may award ‘‘damages and

other relief,’’ 14 and determined this

language to be broad enough to include

punitive damages.15 In addition, the

Court observed that the Arbitrator’s

Manual provided to NASD arbitrators

stated that ‘‘arbitrators can consider

punitive damages as a remedy.’’ 16 The

Court concluded that the choice-of-law

provision introduced an ambiguity into

an agreement that would otherwise

allow punitive damages awards. The

Court construed the ambiguity against

the brokerage firm that drafted the

agreement, thus enforcing the award of
64430 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

17 514 U.S. at 62.

18Under the NASD’s rules, however, parties are

not allowed to include in their arbitration

agreements ‘‘any condition which limits or

contradicts the rules of any self-regulatory

organization or limits the ability of a party to file

any claim in arbitration or limits the ability of the

arbitrators to make any award.’’ Rule 3110(f)(4).

This rule was not at issue in Mastrobuono because

the Mastrobuonos’ contract was executed prior to

the effective date of the rule. 514 U.S. at 61 n.6. The

NASD intends to amend Rule 3110(f) to be

consistent with the proposed rule change.

19This informal survey of claims filed in 1994,

1995, and 1996 counted the number of separate

claimants from each state; there could have been

several claimants in one case. It also considered

each claimant’s mailing address, which may or may

not have been the claimant’s domicile for legal

purposes. In about 2% of cases, only the address of

the claimant’s attorney was provided; these

addresses were omitted from the survey.

Furthermore, the survey did not differentiate

between types of claimants, so it includes member

firms and associated persons who were claimants

in industry disputes. Therefore, these figures are

only approximate.

20California, Cal. Civ. Code § 3294 (West Supp.

1996) (punitive damages are available for ‘‘breach

of an obligation not arising from contract, where it

is proven by clear and convincing evidence that the

defendant has been guilty of oppression, fraud, or

malice. * * *’’); New York, see, e.g., Kelly v. Defoe,

636 N.Y.S. 2d 123 (N.Y. App. Div. 1996) (holding

that punitive damages are available under case law

for certain tort actions, but are not generally

awarded to redress private wrongs); Florida, Fla.

Stat. Ann. § 768.73(1)(a) (1996) (punitive damages

are allowed in civil actions based on negligence,

strict liability, products liability, misconduct in

commercial transactions, professional liability, or

breach of warranty, and involving willful, wanton,

or gross misconduct); New Jersey, N.J. Stat.

§ 2A:15–5.12 (West Supp. 1996) (punitive damages

are awarded ‘‘if the plaintiff proves, by clear and

convincing evidence, that the harm suffered was

[caused] by actual malice or accompanied by

wanton and willful disregard. * * *’’); Texas, Tex.

Civ. Prac. & Rem. Code §§ 41.002, 41.003 (1997)

(punitive damages are generally allowed, unless

excluded by statute, upon a finding of fraud or

malice, and must be proven by clear and convincing

evidence); Illinois, 735 Ill. Comp. Stat. Ann. 5/2–

1115.05(b) (1997) (punitive damages are available

for certain tort actions involving injury to person or

property where it is proven ‘‘by clear and

convincing evidence that the defendant’s conduct

was with evil motive or with a reckless and

outrageous indifference to a highly unreasonable

risk of harm and with a conscious indifference to

the rights and safety of others’’), see, e.g., Siegel v.

Levy Org. Dev. Co., 607 N.E. 2d 194, 200 (Ill. 1992)

(‘‘If a plaintiff can demonstrate gross deception or

willful and wanton misconduct, the determination

as to whether plaintiff is entitled to exemplary

damages lies with the trier of fact.’’); Michigan, see,

e.g., Veselenak v. Smith, 327 N.W.2d 261 (Mich.

1982) (exemplary damages are awardable where the

defendant commits a voluntary act that inspires

feelings of humiliation, outrage, and indignity, and

where the conduct was malicious or so willful and

wanton as to demonstrate a reckless disregard of the

plaintiff’s rights); punitive damages are also

available in Michigan under specific statutes for

causes of action inapplicable in securities

arbitration. See infra note 22.

21 In Florida, punitive damages may be awarded

in an amount up to three times compensatory

damages in certain civil actions involving willful,

wanton, or gross misconduct. Fla. Stat. Ann

§ 768.73(1)(a) (1996). Florida law requires, however,

that 35% of the punitive damages award be payable

to the state or a medical trust fund. See id.

§ 768.73(2)(b). This effectively reduces the amount

payable to the winning party to less than two times

compensatory damages. In New Jersey, the cap on

punitive damages is five times the compensatory

damages or $350,000, whichever is greater. N.J. Rev.

Stat. § 2A:15–5.14(b) (1996) (certain causes of action

are exempted from the cap). In Texas, the cap on

punitive damages is the greater of two times

‘‘economic’’ damages plus one times non-economic

damages up to $750,000, or $200,000. Tex. Civ.

Prac. & Rem. Code § 41.008 (1997). For purposes of

this provision, economic damages are defined as

‘‘compensatory damages for pecuniary loss’’ and

exclude damages for ‘‘physical pain and mental

anguish, loss of consortium, disfigurement, physical

impairment, or loss of companionship and society.’’

See id. § 41.001. In Illinois, punitive damages are

available for physical injury or property damage in

an amount up to three times economic damages,

735 Ill. Comp. Stat. Ann. 5/2–1115.05(a) (1997) (as

noted below, the court may apportion this amount

among the plaintiff, the attorney, and a state

agency). In Michigan, there is a cap for flagrant or

repeated wage law violations of two times wages

and benefits due, Mich. Stat. Ann. § 17.277(18)

(Law. Co-op. 1996), and a treble damages provision

for violations of the funds transfer facilities law

resulting in injury to business or property. See id.

§ 23.1137(28).

22The two states with no specific cap on punitive

damages are California, Cal. Civ. Code § 3294 (West

Supp. 1996), and New York. In California, however,

courts requires a ‘‘reasonable relationship’’ between

actual and punitive damages. Torres v. Automobile

Club of Southern California, 15 Cal. 4th 771, 781,

937 P. 2d 290 (Ca. 1997). See infra note 38. In

addition, Michigan courts have held that the

purpose of exemplary damages is not to punish the

defendant, but to render the plaintiff whole;

therefore, when compensatory damages can make

the injured party whole, exemplary damages must

not be awarded. See, e.g., Jackson Printing Co. v.

Teresa, 425 N.W.2d 791, 794 (Mich. Ct. App. 1988)

(citations omitted).

23 In Florida, 35% of the award is payable to the

state’s General Revenue Fund. Fla. Stat Ann

§ 768.73(2)(b) (1996). In cases of injury or death,

35% is paid to a medical fund instead. In Illinois,

for cases involving physical injury, the court may

apportion the award among the plaintiff, the

plaintiff’s attorney, and the Illinois Department of

Rehabilitation Services. 735 Ill. Comp.Stat. Ann. 5/

2–1207 (1997).

24California’s Civil Code prohibits claims for

punitive damages from stating the amount sought,

Cal. Civ. Code § 3295(e) (West Supp. 1996), and

provides that a court ‘‘shall, on application of any

defendant, preclude the admission of evidence of

that defendant’s profits or financial condition until

after the trier of fact returns a verdict for plaintiff

awarding actual damages and finds that a defendant

is guilty of malice, oppression, or fraud in

accordance with Section 3294.’’ See id. § 3295(d).

These restrictions safeguard defendants by ensuring

that they are not coerced into settlements to avoid

unwarranted intrusions into their private financial

affairs, and by minimizing potential prejudice to

them in front of a jury. Torres v. Automobile Club

of Southern California, 15 Cal. 4th 771, 777, 937 P.

2d 290 (Ca. 1997). In Florida, the Supreme Court

has recently issued revised Standard Jury

Instructions—Civil Cases for use in bifurcated

proceedings in which, during the second stage of

the proceeding, evidence is presented and argued

that will allow the jury to determine the amount of

punitive damages, if any, that should be awarded.

689 So. 2d 1042; 1997 Fla. LEXIS 22 (February 13,

1997). In New Jersey, punitive damages must be

specifically ‘‘prayed for’’ in the complaint. N.J. Stat

Ann. § 2A:15–5.11 (West Supp. 1996). In cases

involving a punitive damages claim, the defendant

may seek a bifurcated trial. See id. § 2A:15–5.13(a).

A Michigan statute provides that punitive damages

may not be recovered in libel actions unless the

plaintiff has first given the defendant notice and an

opportunity to publish a retraction. Mich. Stat.

Ann. § 27A.2911(2)(b) (Law. Co-op. 1996).

25 In the Civil Rights Act Amendments of 1991

(P.L. 102–166), Congress agreed to a compromise in

which compensatory and punitive damages became

available for violations of Title VII of the Civil

Rights Act of 1964, the Americans with Disabilities

Act of 1990, and the Rehabilitation Act of 1973,

conditioned on the right to a jury trial on the

underlying claim, proof of intentional

discrimination (as opposed to disparate impact), a

finding (for the award of punitive damages) that the

employer acted with ‘‘malice or with reckless

indifference to the federally protected rights of an

aggrieved individual,’’ and a cap of $50,000 to

$300,000 for combined compensatory and punitive

punitive damages to the customers.17

The Mastrobuono decision left open the

possibility that a more clearly drafted

agreement might permit, exclude, or

limit punitive damages.18

Trends in State and Federal Law

In the past few years, the United

States Congress and several state

legislatures have acted to place limits on

the amount of punitive damages that

may be recovered in court proceedings.

Although many of these new laws relate

to causes of action that would not

normally be alleged in securities

arbitrations, such as personal injury and

product liability, the number of statutes

restricting the award of punitive

damages is an indication of growing

legislative concern. Some examples of

state and federal laws are provided

below.

A review of NASD arbitration records

indicates that about half of all claimants

in the past three years have been

residents of California, New York,

Florida, New Jersey, Texas, Illinois, or

Michigan; over 40% of all claimants

lived in the first three listed states.19

State laws are constantly evolving;

however, it appears that all seven of the

above states allow for the award of

punitive damages for some types of tort

actions;20 five states have some statutory

limitations on punitive damages;21 and

two states have no statutory limit on the

amount that may be awarded, although

case law allows the trial or appellate

courts to reduce the amount awarded by

the trier of fact.22 Two states provide for

payment of a share of the award to the

state in certain circumstances.23 In some

of the states, punitive damages requests

must be separately pleaded or tried, or

are otherwise subject to special

procedures to avoid prejudice to the

defendant.24 As noted earlier, many of

the state statutes described above relate

to claims that one would not expect to

find in securities arbitrations.

At the federal level, Congress has

acted to provide for punitive damages in

two specific areas, while at the same

time placing limits on the amounts that

may be recovered.25
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 64431

damages, depending on the number of persons

employed by the defendant. 42 U.S.C. § 1981a. In

the Futures Trading Practices Act of 1992, Congress

provided for the award of punitive damages in the

amount of two times actual damages for certain

violations of the future trading laws. Under that

Act, punitive damages are only available for certain

claimants who prove a ‘‘willful and intentional’’

violation in the execution of an order on the floor

of a contract market. 7 U.S.C. § 25(a)(3).

26See Task Force Report at 35 et seq.

27 18 U.S.C. 1961 et seq.

28See Task Report at 40–46.

29 Id. at 43.

30The Task Force’s recommendations concerning

the contents of predispute arbitration agreements

are under consideration by NASD Regulation.

31 9 U.S.C. 1 et seq. (Supp. 1997).

32See, e.g., Allied-Bruce Terminix Cos., Inc. v.

Dobson, 513 U.S. 265, 130 L. Ed. 2d 753, 115 S. Ct.

834 (1995).

33Letter from L. Jerome Stanley, 1995–96 PIABA

President, to Deborah Masucci, Vice President and

Director of Arbitration (March 15, 1996).

34Letter from SICA Public Members to Daniel P.

Tully (December 9, 1996).

35Letter from A.B. Krongard, SIA Chairman, to

Mary Alice Brophy, Chairman, NASD Regulation

(June 7, 1996).

Task Force Report

In its Report, the Task Force noted

that the subject of punitive damages has

generated widespread controversy and

polarization between the investor and

broker/dealer communities.26 The Task

Force observed that about 50% of all

new arbitration claims include a claim

for punitive damages, although punitive

damages are awarded in only about 1%

of cases. The Task Force Report

expressed the opinion that the existence

of a punitive damages claim can lead to

more adversarial litigation, as

respondents use every available tactic to

defend themselves against a potentially

enormous award. The Task Force Report

also noted the views of some claimants’

lawyers that it could be considered

malpractice for them to omit punitive

damages claims. After interviewing

many interested groups and individuals,

and after numerous discussions, the

Task Force recommended that:

• punitive damages remain available

in NASD arbitration, subject to a cap;

• the cap on punitive damages be the

lesser of two times compensatory

damages or $750,000;

• damages under the Racketeer

Influenced and Corrupt Organizations

Act (‘‘RICO’’) 27 and punitive damages

not be awarded for the same claim;

• punitive damages be available to an

investor where they would be available

in court for the same types of claims, in

the state where the investor is

domiciled;

• the standard of conduct justifying

the award of punitive damages be based

on state law where the investor is

domiciled;

• the award specify the amount given

for compensatory damages and the

amount given for punitive damages; and

• where requested by the party

against whom the award is rendered, the

award describe the conduct giving rise

to the award.28

The Task Force noted that the cap on

punitive damages finds support by

analogy to recently enacted state and

federal statutes imposing limitations on

punitive damages.29 The Task Force

recommended further that any

predispute arbitration agreement

between the parties expressly provide

for the award of punitive damages

(subject to their availability for the same

types of claims in state court), refer to

the relevant NASD Rule, and provide

that the parties’ agreement to permit

punitive damages in arbitration

preempts any state arbitration law to the

contrary.30 The Task Force’s research

indicated that this type of agreement

would comport with existing law under

the Federal Arbitration Act (‘‘FAA’’),31

which has been held to preempt

conflicting state law.32

Positions of Interested Organizations

In order to carry out the

recommendations of the Task Force,

NASD Regulation considered the views

of various organizations and reviewed

relevant federal and state law. In

particular, NASD Regulation considered

letters from and conversations with

representatives of the Public Investors

Arbitration Bar Association (‘‘PIABA’’),

SICA, and the Securities Industry

Association (‘‘SIA’’).

Attorneys and groups representing

investors argued that arbitration should

afford the same types of relief as would

be available in court, including punitive

damages. These groups contended that,

since virtually all firm agreements with

their customers contain a clause

mandating arbitration of disputes

arising under the agreement, customers

are unable to take their claims to court

but must proceed in arbitration. Such

groups generally oppose any limitation

on punitive damages, such as ceilings

on the amount that may be awarded, or

ratios of punitive damages to

compensatory damages. For example,

PIABA expressed the initial opinion

that there should be no cap on punitive

damages, as such damages provide a

‘‘significant and important curb on

customer abuse.’’ 33

Public members of SICA, i.e., those

not affiliated with the securities

industry or with the SROs, sent a letter

to the Chairman of the NASD shortly

before the NASD Board of Governors

met to consider the proposed rule

change,34 In the letter, the public

members stated their view that the

proposed punitive damages rule would

result in an arbitrary limitation of

arbitrators’ authority to award punitive

damages, and would conflict with an

NASD rule prohibiting arbitration

agreements from containing limitations

on arbitrators’ authority. The public

members also expressed the opinion

that the issue should be returned to

SICA for development of an acceptable

resolution.

Representatives of the broker-dealer

community, however, recommended

limiting or prohibiting the award of

punitive damages in arbitration. The

SIA expressed the views that: (i)

Arbitration claimants do not have an

absolute right to punitive damages;

rather, punitive damages are purely

discretionary on the part of the jury or

arbitrator in order to punish a person for

conduct that is outrageous to society as

a whole; (ii) punitive damages were

devised to serve the purposes of

punishment and deterrence, but, in the

securities industry, state and federal

regulators already have a broad arsenal

of weapons to use against wrongdoers;

(iii) arbitration does not offer the due

process safeguards that are available in

court; for example, the rules of evidence

do not apply in arbitration; there are no

set standards of proof, such as

preponderance of the evidence, clear

and convincing evidence, or reasonable

doubt; and there is no right to appeal

the award except on very narrow

grounds; (iv) arbitration cases are

difficult to settle due to the threat of

punitive damages; because claimants

hope for larger awards in arbitration

through an award of punitive damages,

they are less willing to settle cases at

what firms consider a ‘‘reasonable’’

amount; and (v) the chief advantage of

arbitration, its relatively speedy

resolution of a dispute by ordinary

individuals using notions of simple

justice, will be lost as the process

becomes more complex and more like

the court system.

The SIA stated that its Board had

recommended that the cap be reduced

to $250,000 or one times compensatory

damages, whichever is less.35 The SIA

noted that $750,000 is greater than the

total net capital of half of the member

firms of the SIA and of an additional

several thousand firms that are members

of the NASD. The SIA contended that,

since arbitration awards are very

difficult to appeal, there should be

reasonable restraints on punitive

damages to avoid endangering the

viability of the vast majority of NASD

members.
64432 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

36See supra note 24.

37See supra note 24.

38See, e.g., Brewer v. Second Baptist Church, 197

P. 2d 713 (Cal. 1948) (if a jury awards excessive

exemplary damages, there is an adequate remedy by

way of an appropriate motion before the trial court

or by appeal).

39Under the Federal Arbitration Act, for example,

arbitration awards may be vacated on the following

grounds: (1) Where the award was procured by

corruption, fraud, or undue means; (2) where there

was evident partiality or corruption in the

arbitrators, or either of them; (3) where the

arbitrators were guilty of misconduct in refusing to

postpone the hearing, upon sufficient cause shown,

or in refusing to hear evidence pertinent and

material to the controversy; or of any other

misbehavior by which the rights of any party have

been prejudiced; or (4) where the arbitrators

exceeded their powers, or so imperfectly executed

them that a mutual, final, and definite award upon

the subject matter submitted was not made. 9 U.S.C.

§ 10(a) (Supp. 1997).

40The $750,000 amount is also larger than the

annual revenue of most member firms. The Report

of the Select Committee on Structure and

Governance of the NASD Board of Governors

(‘‘Rudman Report’’) observed that, ‘‘Most NASD

member firms are relatively small. Approximately

55% report gross revenues from their securities

business below $680,000. 80% report gross

securities revenues under $4 million. Fewer than

5% report gross revenues over $80 million. The

number of NASD member firms that generate

securities revenues over $375 million is only 43, or

0.8% of the membership.’’ Rudman Report at C–11

(Sept. 15, 1995).

41NASD Regulation estimates that as many as

one-third of all claims filed involve a pro se party.

See Securities Arbitration Commentator, Vol. VIII,

No. 9 (February 1997). The number of pro se parties

is much higher for smaller claims; more than threequarters of claims involving $10,000 or less

involved pro se claimants. Id.

42See supra note 3.

43This may mean that punitive damages will

become available under the proposed rule change

when they were not previously available in

arbitration proceedings in a particular state. For

example, in Illinois, courts have held that punitive

damages may be awarded in arbitration, but only

where the parties have expressly agreed to the

arbitrators’ authority to award punitive damages.

City of Chicago v. American Federation of State,

County and Municipal Employees, 1996 WL 496825

at *3, 669 N.E. 2d 1311 (Ill. App. Ct. 1996), citing

Edward Electric Co. v. Automation, Inc., 593 N.E.

2d 833, 843 (Ill. App. Ct. 1992).

Other suggestions made by the SIA

were that the term ‘‘compensatory

damages’’ be defined as ‘‘out-of-pocket

losses,’’ based upon the difference in

price between purchases and sales of

the investment (or current value, if still

held); that the term ‘‘exemplary

damages’’ be used instead of ‘‘punitive

damages’’; that a uniform national

standard of conduct be used to

determine when punitive damages are

appropriate; that the rule specify that

exemplary damages may be awarded

‘‘up to’’ the stated cap, to clarify that the

cap is not an automatic amount; that the

applicable state law to determine

whether punitive damages are available

be that of the investor’s domicile at the

time the transaction occurred; and that

the award of punitive damages be

considered in a separate proceeding

from the rest of the case (a process often

referred to as ‘‘bifurcation’’).

Purpose of Proposed Rule Change

During the past several years,

interested parties have been unable to

reach a consensus on punitive damages,

and NASD Regulation believes that it

must take action at this time to

implement a punitive damages rule.

After reviewing the positions of various

interested groups, NASD Regulation

adopted an amendment to the code of

Arbitration Procedure that generally

follows the Task Force

recommendations, with minor changes

considered appropriate. NASD

Regulations believes that the proposed

rule change best effectuates the interests

of providing a forum to investors that

provides appropriate relief while

limiting the potential for awards that are

disproportionate based on the claims

alleged.

NASD Regulation recognizes that it is

not appropriate or feasible to eliminate

the availability of punitive damages in

arbitration so long as public customers

are required by most member firms to

sign predispute arbitration agreements.

At the same time, NASD Regulation

realizes that some of the safeguards

against excessive punitive damages

awards that may be available to

defendants in court are not available in

arbitration, such as special pleading

requirements for requests of punitive

damages,36 separate hearings for the

liability and damages phases of the

case,37 post-trial review of the award by

a judge,38 and judicial appeals on the

merits of the decision rather than on the

narrower grounds for overturning an

arbitration award.39 Therefore, NASD

Regulation believes it has balanced

these considerations fairly in endorsing

the recommendation of the Task Force

that a cap on punitive damages is

necessary and appropriate if punitive

damages are to be permitted in the

NASD Regulation forum.

The cap on punitive damages of the

lesser of two times compensatory

damages or $750,000 is believed to be

appropriate in an industry that is

already subject to extensive regulatory

oversight. As discussed above, the

$750,000 amount is larger than the net

capital requirement of many NASD

member firms.40 Therefore, a cap of

$750,000 provides a significant

deterrent to egregious behavior, since it

could threaten a firm’s continued

operations. Considering the fact that

arbitration by its nature is more

informal than a court proceeding, with

relaxed rules of evidence and

procedure, and the fact that arbitration

awards may be modified or vacated only

on very narrow grounds, NASD

Regulation believes that the limitation

on the amount of punitive damages is

reasonable.

Description of Proposed Rule Change

The proposed rule has been drafted

using the ‘‘plain English’’ principles of

written communication that the

Commission has encouraged. NASD

Regulation believes the proposed rule

will be easier for all arbitration

participants to understand, most notably

participants who represent themselves

(pro se parties). Unlike the NASD’s

Membership and Conduct Rules, which

are mainly referred to and applied by

member firms, their compliance officers,

and their attorneys, the Code of

Arbitration Procedure is often used by

pro se parties who are not attorneys and

who are usually coming into contact

with the dispute resolution process for

the first time.41 In such circumstances,

plain English rules are particularly

important. In conformity with plain

English principles, the term

‘‘arbitrators’’ has been used instead of

‘‘arbitration panel’’ in the proposed rule

change. This usage is not meant to

imply that the proposed rule change

applies only to cases heard by more

than one arbitrator; rather, it applies to

any arbitration panel, which may be

composed of one or more arbitrators.

Proposed new Rule 10336 provides in

paragraph (a)(1) that it applies only to

disputes between a public customer and

a member or between a public customer

and an associated person. Therefore, the

proposed rule will not apply to disputes

between or among members and

associated person (‘‘industry

disputes’’).42

Proposed paragraph (a)(2) states that a

party may request an award of punitive

damages if a court (not an arbitration

panel) of the state of which that party

is a citizen, at the time the claim is filed,

could award punitive damages for the

same type of claim.43 A party seeking

punitive damages may, either at the

party’s option or at the request of the

arbitrators, brief the applicable state law

in order to demonstrate to the arbitrators

that his or her state does allow the

award of punitive damages in its courts

for the same type of claim. Thus, the

party’s citizenship at the time of filing,

rather than at the time of the underlying

transaction(s), determines the applicable

state law. This facet of the proposed rule

follows the Task Force’s

recommendation rather than the SIA’s

suggestion. NASD Regulation believes

this provision will be considerably

easier to administer, especially where
Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices 64433

44NASD Regulation did not agree with the SIA’s

suggestion that RICO awards be limited to the

formula for other punitive damages, and believes

that the same RICO damages should be available in

arbitration as in court. We note, however, that

federal RICO damages for fraud in the purchase or

sale of securities are available when a criminal

conviction has been obtained for the same conduct.

18 U.S.C. § 1964 (1995).

several transactions or events take place

over a long period of time, during which

time the party seeking punitive damages

could have moved one or more times.

Proposed paragraph (a)(3) was added

to address the situation in which an

investor lives in a state that does not

allow the recovery of punitive damages

for the investor’s claims. In that

situation, the rule would prevent a

member firm (or associated person)

which is a citizen of a state that permits

punitive damages from seeking punitive

damages against the investor. If the

investor has several claims and is able

to request punitive damages for any one

of them, then the member or associated

person may also request punitive

damages as allowed under relevant state

law.

Proposed paragraph (a)(4) requires a

party requesting an award of punitive

damages to specify in its claim the

amount of punitive damages it is

requesting. Specification is required

because the amount of the claim

determines the size of the arbitration

panel appointed, the member surcharge,

the claimant’s filing fees, and the

hearing session fees.

Proposed paragraph (a)(5) defines the

term ‘‘claim’’ for purposes of the

proposed rule as including any dispute

or controversy described in a Statement

of Claim (including Counterclaims,

Third-Party Claims, and Cross-Claims)

for which the claimant is seeking any

form of remedy, in order to reduce the

verbiage needed each time the term

‘‘claim’’ is used.

Proposed paragraph (b)(1) provides

that the standard of conduct to be

applied is that of the state of which the

party requesting punitive damages is a

citizen at the time the claim is filed.

This follows the Task Force

recommendation and conforms to

paragraph (a)(2) in looking to state law

to determine what conduct justifies an

award of punitive damages.

Proposed paragraph (b)(2) specifies

that the standard of paragraph (b)(1)

applies regardless of any choice-of-law

provision in the parties’ predispute

arbitration agreement. This provision is

intended to avoid the situation in which

a member firm inserts a choice-of-law

clause in its customer agreements that

specifies use of the law of a state that

does not allow, or that strictly limits,

the award of punitive damages in

arbitration. Often that state is the one in

which the member firm is

headquartered, but it may not be the

state in which the customer lives or in

which the customer did business with

the member firm. The NASD believes it

is fairer to apply the law of the state in

which the customer is a citizen at the

time the claim is filed, rather than to

apply the law of a state specified in a

choice-of-law provision that the

customer may not have noticed or

understood when opening an account

some months or years earlier. Paragraph

(b)(2) applies only to the availability of

punitive damages, and not to the

substantive claims, which would still be

subject to applicable choice-of-law and

conflicts of law principles to the extent

not inconsistent with other NASD rules.

Proposed paragraph (c) sets out the

limitations discussed earlier, stating in

(c)(1) that punitive damages may be

awarded in an amount up to two times

compensatory damages or $750,000,

whichever is less. The use of the phrase

‘‘up to’’ makes clear that the limitation

is not a standard amount to be awarded

in every case. The amount of the cap is

the same as contained in the Task

Force’s recommendation.

The Task Force intentionally did not

define compensatory damages, leaving it

to the discretion of the arbitrators. This

choice reflected the fact that there are

different theories of loss for

compensatory damages, such as out-ofpocket loss or lost opportunity costs,

that may be appropriate in different

circumstances. The proposed rule

deviates only in a minor respect from

this recommendation. The definition of

compensatory damages set out in

proposed paragraph (c)(2) excludes

attorneys’ fees, other costs of arbitration,

and post-award interest. Such amounts

may continue to be awarded, but simply

are not considered for purposes of the

formula in paragraph (c)(1) for punitive

damages. Arbitrators, however, may

include pre-award interest in

compensatory damages for purposes of

paragraph (c)(1) if they have awarded

such interest.

Proposed paragraph (c)(3) makes clear

that punitive damages are not to be

awarded in addition to the multiple

damages allowed by RICO or other

similar statutes for the same claim.44

This recommendation is in accordance

with the Task Force’s recommendation

that arbitrators be precluded from

awarding both RICO damages and

punitive damages for the same claim.

The term ‘‘multiple’’ was used instead

of ‘‘treble’’ to be more comprehensive,

since there may be state and federal

statutes that provide for automatic

doubling, tripling, or other multiples of

compensatory damages. For purposes of

the proposed rule, a statute providing

for punitive damages in an amount

equal to (one times) compensatory

damages would not be considered to be

‘‘multiple.’’ Likewise, a statute

providing for punitive damages in an

amount ‘‘up to’’ a certain multiple of

compensatory damage would not be

considered to be ‘‘multiple’’ for

purposes of paragraph (c)(3) because the

actual amount of punitive damages is

discretionary rather than automatic. In

the latter two cases, the amount of

punitive damages would be subject to

the cap in the NASD rule.

Proposed paragraph (c)(4) states that

the limitations of paragraph (c)

supersede any applicable state law on

the size of punitive damage awards.

This may result in a higher or lower

award of punitive damages in

arbitration than would be available

under state law. As noted above, NASD

Regulation believes this result is fair, in

that it provides uniform remedies for

claimants in different states (if there

state allows punitive damages), as well

as a consistent limit of liability for

member firms with offices in several

states. In addition, the disciplinary

processes of NASD Regulation (as well

as of the SEC, the state securities

regulators, and federal and state

criminal authorities) remain available to

customers who feel they have been

wrongly treated by their broker-dealers.

Finally, proposed paragraph (d)

requires the arbitrators to set forth

separately in their award the amounts

awarded for compensatory and punitive

damages. This requirement is in

accordance with the Task Force’s

recommendation and not opposed by

the SIA and PIABA. The paragraph does

not require arbitrators to describe the

facts and conduct upon which the

award of punitive damages was based,

or to set forth their reasons for not

awarding punitive damages. The Task

Force had recommended that, where

requested by the party against whom the

award is rendered, the arbitrators

should describe the conduct giving rise

to the award. NASD Regulation believes

such explanations could slow the

completion of the arbitration. They also

would create uncertainly as to the date

of the award for appeal purposes.

However, parties will continue to be

allowed to request an opinion of the

arbitrators as described in the

Arbitration Procedures booklet

compiled by SICA and distribution to

all public customer claimants. Under

this practice, a party must make any

such request no later than the date of

the hearing, and the arbitration panel
64434 Federal Register / Vol. 62, No. 234 / Friday, December 5, 1997 / Notices

45NASD Regulation consents to an extension of

the time projects specified in Section 19(b)(2) of the

Act until the SEC is prepared to approve NASD

Regulation’s yet-to-be-filed rule filing proposing to

amend Rule 310(f) to revise the requirements for

customer predispute arbitration agreements used by

members. NASD Regulation intends to amend the

rules governing customer predispute arbitration

agreements to give effect to the punitive damages

rule proposed herein and the eligibility rule

proposed in SR–NASD–97–44. The purpose of the

extension is to permit the SEC to act simultaneously

on this rule filing, the yet-to-be-filed rule filing

proposing to amend Rule 3110(f), and the eligibility

rule proposed in SR–NASD–97–44.

46 15 U.S.C. 78o3(b)(6). 1 17 CFR 240.9b–1.

2See Securities Exchange Act Release No. 39244

(October 15, 1997) (order approving proposed rule

change by the Chicago Board Options Exchange,

Incorporated, relating to the listing and trading of

options on the Lipper Analytical/Salomon Brothers

Growth and Growth & Income Fund Indexes).

3This provision is intended to permit the

Commission either to accelerate or extend the time

period in which definitive copies of a disclosure

document may be distributed to the public.

4 17 CFR 240.9b–1.

5 17 CFR 200.30–3 (a)(39).

has the discretion to grant or deny the

request.

All newly approved NASD arbitrators

who have not presided at a hearing are

required to attend a training program,

which includes information on the

awarding of punitive damages. If the

proposed rule change is approved,

Office of Dispute Resolution staff will

make appropriate changes to the

arbitrator training and education

materials to reflect the requirements of

the new rule.

NASD Regulation is requesting that

the proposed rule change be effective

within 45 days of SEC approval.45

2. Statutory Basis

NASD Regulation believes that the

proposed rule change is consistent with

the provisions of Section 15A(b)(6) of

the Act 46 in that it will promote just

and equitable principles of trade by

providing an additional remedy for

wrongdoing by broker/dealers and their

associated persons, and it will protect

investors and the public interest by

clarifying that punitive damages are

available in the NASD Regulation

arbitration forum, where they would be

available under relevant state law for

similar court proceedings.

B. Self-Regulatory Organization’s

Statement on Burden on Competition

The NASD does not believe that the

proposed rule change will impose any

inappropriate burden on competition.

C. Self-Regulatory Organization’s

Statement on Comments on the

Proposed Rule Change Received From

Members, Participants, or Others

No written comments were either

solicited or received.

III. Date of Effectiveness of the

Proposed Rule Change and Timing for

Commission Action

Within 35 days of the 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 organizations

consents, the Commission will:

(A) by order approve the 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 the foregoing.

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 at

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 No.

SR–NASD–97–47 and should be

submitted by December 29, 1997.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–31877 Filed 12–4–97; 8:45 am]

BILLING CODE 8010–01–M

SECURITIES AND EXCHANGE

COMMISSION

[Release No. 34–39365; File No. SR–ODD–

97–2]

Self-Regulatory Organizations; The

Options Clearing Corporation; Order

Granting Accelerated Approval of

Proposed Supplement to Options

Disclosure Document Regarding

Mutual Fund Index Options

November 26, 1997.

On November 13, 1997, The Options

Clearing Corporation (‘‘OCC’’) submitted

to the Securities and Exchange

Commission (‘‘SEC’’ or ‘‘Commission’’),

pursuant to Rule 9b–1 under the

Securities Exchange Act of 1934

(‘‘Act’’),1 five definitive copies of a

Supplement to its options disclosure

document (‘‘ODD’’), which describes,

among other things, the risks and

characteristics of trading in options on

mutual fund indexes.

The Commission has approved an

options exchange proposal to list and

trade options on particular mutual fund

indexes.2 OCC now proposes this

Supplement, which is to be read in

conjunction with the more general ODD

entitled ‘‘Characteristics and Risks of

Standardized Options,’’ that provides

disclosures to specifically accommodate

the introduction of mutual fund index

options and to reflect current rules of

options markets on which mutual fund

index options are approved for trading.

Pursuant to Rule 9b–1, the Supplement

will have to be provided to investors in

mutual fund index options whose

account is approved for trading

standardized options.

The Commission has reviewed the

ODD Supplement and finds that it

complies with Rule 9b–1 under the Act.

The Supplement is intended to be read

in conjunction with the ODD, which

discusses the characteristics and risks of

options generally. The Supplement

provides additional information

regarding mutual fund index options

sufficient to further describe the special

characteristics and risks of these

products.

Rule 9b–1 provides that an options

market must file five preliminary copies

of an amended ODD with the

Commission at least 30 days prior to the

date definitive copies of the ODD are

furnished to customers, unless the

Commission determines otherwise,

having due regard to the adequacy of

information disclosed and the

protection of investors.3 The

Commission has reviewed the

Supplement, and finds that it is

consistent with the protection of

investors and in the public interest to

allow the distribution of the

Supplement as of the date of this order.

It is therefore ordered, pursuant to

Rule 9b–1 under the Act,4 that the

proposed Supplement (SR–ODD–97–2)

regarding mutual fund index options is

approved, on an accelerated basis.

For the Commission, by the Division of

Market Regulation, pursuant to delegated

authority.5