[Federal Register Volume 62, Number 234 (Friday, December 5, 1997)]
[Notices]
[Pages 64428-64434]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-31877]


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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 self-
regulatory organization. The Commission is publishing this notice to 
solicit comments on the proposed rule change from interested persons.
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    \1\ The 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.
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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.

[[Page 64429]]

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.
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    \2\ The 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.
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    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.
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    \3\ The 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.
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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\
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    \4\ Black's Law Dictionary 389 (6th ed. 1990).
    \5\ Restatement (Second) of Torts Sec. 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. Sec. 902 
cmt. a (1979).
    \6\ Restatement (Second) of Torts Sec. 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.
    \7\ See Restatement (Second) of Torts Sec. 908 cmt. c (1979) and 
cases cited therein. Some courts allow recovery of punitive damages 
when only nominal damages have been awarded. Id.
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    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.
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    \8\ SICA 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).
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    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-of-law 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

[[Page 64430]]

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\
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    \10\ 514 U.S. 52, 131 L. Ed. 2d 76, 115 S. Ct. 1212 (1995).
    \11\ 514 U.S. at 58-59.
    \12\ See 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.
    \14\ This 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.
    \17\ 514 U.S. at 62.
    \18\ Under 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.
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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.
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    \19\ This 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.
    \20\ California, Cal. Civ. Code Sec. 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. Sec. 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. Sec. 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 Secs. 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 
Sec. 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. Sec. 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. Sec. 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 Sec. 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. 
Sec. 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. Sec. 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. Sec. 23.1137(28).
    \22\ The two states with no specific cap on punitive damages are 
California, Cal. Civ. Code Sec. 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 Sec. 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).
    \24\ California's Civil Code prohibits claims for punitive 
damages from stating the amount sought, Cal. Civ. Code Sec. 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. Sec. 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. Sec. 2A:15-5.11 (West Supp. 1996). In 
cases involving a punitive damages claim, the defendant may seek a 
bifurcated trial. See id. Sec. 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. 
Sec. 27A.2911(2)(b) (Law. Co-op. 1996).
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    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\
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    \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 damages, depending on the number 
of persons employed by the defendant. 42 U.S.C. Sec. 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. Sec. 25(a)(3).

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[[Page 64431]]

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:
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    \26\ See Task Force Report at 35 et seq.
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    <bullet> punitive damages remain available in NASD arbitration, 
subject to a cap;
    <bullet> the cap on punitive damages be the lesser of two times 
compensatory damages or $750,000;
    <bullet> damages under the Racketeer Influenced and Corrupt 
Organizations Act (``RICO'') \27\ and punitive damages not be awarded 
for the same claim;
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    \27\ 18 U.S.C. 1961 et seq.
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    <bullet> 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;
    <bullet> the standard of conduct justifying the award of punitive 
damages be based on state law where the investor is domiciled;
    <bullet> the award specify the amount given for compensatory 
damages and the amount given for punitive damages; and
    <bullet> where requested by the party against whom the award is 
rendered, the award describe the conduct giving rise to the award.\28\
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    \28\ See Task Report at 40-46.
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    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\
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    \29\ Id. at 43.
    \30\ The 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).
    \32\ See, e.g., Allied-Bruce Terminix Cos., Inc. v. Dobson, 513 
U.S. 265, 130 L. Ed. 2d 753, 115 S. Ct. 834 (1995).
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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\
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    \33\ Letter from L. Jerome Stanley, 1995-96 PIABA President, to 
Deborah Masucci, Vice President and Director of Arbitration (March 
15, 1996).
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    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.
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    \34\ Letter from SICA Public Members to Daniel P. Tully 
(December 9, 1996).
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    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.
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    \35\ Letter from A.B. Krongard, SIA Chairman, to Mary Alice 
Brophy, Chairman, NASD Regulation (June 7, 1996).

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[[Page 64432]]

    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.
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    \36\ See supra note 24.
    \37\ See supra note 24.
    \38\ See, 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).
    \39\ Under 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. 
Sec. 10(a) (Supp. 1997).
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    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.
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    \40\ The $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).
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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.
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    \41\ NASD 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 three-quarters 
of claims involving $10,000 or less involved pro se claimants. Id.
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    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\
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    \42\ See supra note 3.
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    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

[[Page 64433]]

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.
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    \43\ This 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).
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    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-of-pocket 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.
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    \44\ NASD 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. Sec. 1964 (1995).
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    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

[[Page 64434]]

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\
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    \45\ NASD 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.
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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.
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    \46\ 15 U.S.C. 78o3(b)(6).
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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