Employment Disputes: Recommendations to Better Ensure That Securities Arbitrators Are Qualified
Released: 2003-09-24T00:00:00

Letter

Background

The arbitration of disputes first occurred at NYSE in the late nineteenth century but eventually became the practice within the securities industry in general. Arbitration was used to settle disputes over employee contracts, and in 1991 the U.S. Supreme Court ruled that an age discrimination claim brought forth by a securities industry employee could be subject to mandatory arbitration. Subsequent court decisions permitted the use of mandatory arbitration for resolving other employment discrimination disputes, including sexual harassment.

Proponents of mandatory arbitration believe it is an efficient, cost- effective way to resolve conflicts between employers and their employees. Opponents of mandatory arbitration believe that it puts employees at a disadvantage. They argue that discovery, the process by which parties exchange documents and other information relevant to their case, is limited, hearings take place outside of public scrutiny, and arbitrators favor employers, who are more likely to be “repeat users” than employees.

SROs include NYSE that operates and regulates its market, as well as NASD, a private-sector provider of financial regulatory and dispute resolution services. Their responsibilities include overseeing the arbitration of claims brought in the securities industry by customers, firms, and employees as required by the Securities and Exchange Act of 1934 (the Exchange Act). In 2000, NASD established a separate subsidiary to administer its arbitration program. The subsidiary is headquartered in Washington, D.C., and New York City, but also maintains staff in five regional offices. NYSE administers fewer arbitration cases than NASD and its arbitration program, which is administered by its Department of Arbitration in New York, is much smaller. NASD’s subsidiary operates with a staff of about 200 while NYSE maintains a staff of approximately 18. In addition, NASD currently has approximately 7,000 arbitrators on its roster, while NYSE has 1,905.

Arbitrators play a key role in resolving disputes brought forth in the securities industry and their performance has a direct bearing on the fairness of a hearing. Like judges, they oversee the administration of proceedings, including determining the number of hearing sessions a case requires and what evidence can be admitted. Unlike judges, arbitrators are not required to base their decisions on legal precedent or to provide any reasoning for their decisions. In addition, their decisions—unlike those rendered in court—can only be appealed on limited grounds.

SEC is responsible for regulating securities market participants, including SROs such as NASD and NYSE. In addition to overseeing SROs through its inspections, SEC approves the rules they use to administer their arbitration programs to ensure they comply with the Exchange Act and other securities laws and rules. When SROs propose new rules or change existing rules, they are required to file them with SEC for approval. SEC then provides interested parties an opportunity to comment on proposed rules or rule changes. In general, SEC is to approve certain new or amended rules within 90 days after they are published or institute proceedings to determine whether they should be disapproved.

Both NASD and NYSE Have Policies and Procedures Intended to Promote Fair Arbitration for all Cases

In most employment disputes, arbitration is mandatory, although for discrimination cases NYSE rules strictly limit its use and NASD has instituted additional requirements. For both customer and employment disputes, both SROs require that all arbitrators have certain qualifications in order to be on their rosters of available arbitrators. However, neither SRO verifies the qualifications for all of the arbitrators on their rosters. Both SROs have procedures designed to ensure that the arbitrators selected to hear cases do not have conflicts and have procedures for evaluating arbitrator performance. Yet, arbitrators who hear cases at both SROs may not be receiving evaluations on a routine basis.

Most Employment Disputes, Although for Discrimination Cases NYSE Has Strictly Limited Its Use and NASD Has Instituted Additional Requirements

Prior to 1999, both NASD and NYSE rules required the mandatory arbitration of all employment-related disputes, including discrimination claims. In the 1990s, as discrimination claims filed at NASD rose, some Members of Congress challenged the use of mandatory arbitration for discrimination disputes. In 1997, the Equal Employment Opportunity Commission (EEOC), which is responsible for enforcing the nation’s employment discrimination laws, published a policy statement opposing the use of mandatory arbitration agreements for these disputes. Opposition to mandatory arbitration for these claims stemmed from concerns that arbitration eliminated the role the courts played in deterring discrimination and protecting employees. In addition, others believed that many arbitrators were unfamiliar with antidiscrimination laws and, therefore, could not provide a fair hearing on these claims.

NASD and NYSE took different approaches in changing their rules to address these concerns. NYSE followed EEOC’s recommendation and only arbitrates discrimination claims when all parties agree to arbitration after the dispute occurs. NASD, on the other hand, no longer requires that employees arbitrate employment discrimination disputes, but will arbitrate these disputes, based on agreements employees have made before or after the dispute occurs. The net result is that NASD will administer arbitration cases that include discrimination claims if the parties have entered into an agreement to do so. This includes policies employees sign as a condition of employment.

According to NASD, in conjunction with this rule change, they assembled a working group to consider recommendations contained in a document known as “A Due Process Protocol for Mediation and Arbitration of Statutory Disputes Arising out of the Employment Relationship.” This Due Process Protocol was developed in 1995 by a committee of representatives from a range of organizations, to provide arbitration procedures for statutory employment claims. Following NASD’s review of this protocol NASD introduced additional requirements for these types of claims. Changes ranged from setting qualifications for arbitrators who chair arbitrator panels to specifying how arbitrators documented their decisions.

The arbitrator chairing a discrimination case at NASD must hold a law degree, have 10 years of legal experience, have substantial familiarity with employment law, and must not have primarily represented employers or employees in the last 5 years. In addition to special chair qualifications, all the arbitrators who hear cases with discrimination claims must also be classified as “public”—that is, individuals who are not affiliated with the securities industry either professionally or through their family relationships. For employment discrimination claims of $100,000 or less, a single public arbitrator is appointed, and for claims greater than this amount a panel of three public arbitrators is selected.

In disputes subject to arbitration that arise out of the employment or termination of employment of an associated person, and that relate exclusively to disputes involving employment contracts, promissory notes or receipt of commissions, a single “nonpublic” arbitrator—that is someone who is affiliated with the securities industry—can only hear nondiscrimination claims of $50,000 or less. In similar cases with claims of $50,000 or more, a panel composed of three nonpublic arbitrators is appointed. Currently, arbitrator chairs in cases without discrimination claims need the same qualifications as any arbitrator. At NYSE, all employment disputes, at the option of the employee, are entitled to a panel of three arbitrators, and a majority of the arbitrators cannot be from the industry unless the employee requests it.

NASD rules, adopted in 2000, also made two changes to procedures concerning arbitrator decisions in cases with employment discrimination claims. First, the rules specifically state that arbitrators can award “reasonable” attorney’s fees for discrimination claims. This change also creates an incentive for attorneys to take discrimination cases because it provides greater assurance that they will be compensated for their work if they are successful. Second, NASD’s rule change requires arbitrators to document the disposition of discrimination claims, something not required for the other claims. While this rule still does not require arbitrators to explain their decisions, it requires arbitrators to specify for the parties how they ruled on any statutory discrimination claim.

Both SROs Have Similar Qualifications for Arbitrators and Neither Verify the Qualifications of All Applicants

Both SROs require that all applicants for the arbitrator roster provide information on their affiliation with the securities industry, have 5 years of work experience, supply two letters of recommendation, and complete training in basic arbitration procedures. Recommendation letters must include particular information about the person writing the letter, the prospective arbitrator, and an attestation as to the character and fitness of the nominee. NASD also requires that applicants take a multiple choice examination and receive a passing score of at least 80 percent. (See fig.1.) After receiving arbitrator applications from applicants who work or worked in the securities industry, the SROs check the Central Registration Depository (CRD), a computerized database that contains the educational, work, and disciplinary history for current and former securities registered persons. Therefore, the CRD only covers arbitrators classified as nonpublic. Currently, information from arbitrator applicants not employed in the securities industry is not checked by the SROs, but NASD is proposing a rule change that would require the verification of background information on all new arbitrators.

NASD reported that verifying the background information on all new arbitrators would enhance the reputation of its arbitration program. If SEC approves its rule change, NASD will use an independent firm to conduct the background checks and will pass the cost of this process—expected to be between $60 and $85—onto the applicant. NYSE did not report any plans to change its procedures at this time.

At NASD, once arbitrators’ applications are approved, they must take a half-day introductory training course, be evaluated by the trainer, and pass a 25-question multiple choice examination on arbitration procedures. Once they pass the examination and evaluation by the trainer, they are included on the NASD arbitrator roster. At NYSE, on the other hand, once an application is reviewed and approved by staff, the applicant is considered able to arbitrate any case once he or she participates in one training course on arbitration procedures and conduct issues.

Ongoing training at both SROs is limited. NYSE requires that arbitrators continue to attend at least one training course every 4 years. NASD does not have such a requirement but does offer chairperson training for those arbitrators wanting to chair cases. One SEC official raised concerns about mandating ongoing training for arbitrators, arguing that it may discourage the most experienced arbitrators from serving.

Both SROs Have Procedures for Selecting Arbitrators for Cases Intended to Ensure That They Are Unbiased

Both SROs, recognizing that arbitrators are one of the key factors to ensuring a fair and efficient process, have developed procedures to help ensure that the selection of arbitrators for a case is unbiased. Prior to 1998, NASD staff selected arbitrators based on the issues in the case and the expertise the arbitrators held. In 1996, a NASD task force, organized to review the securities arbitration process, reported that claimants and their representatives were concerned that staff could be biased in selecting arbitrators. To address this concern, NASD changed how arbitrators were selected. Since 1998, NASD has allowed both parties involved in a dispute to choose the arbitrators, which limited NASD staff involvement in the selection process. NASD provides parties with a computer-generated list of up to 15 arbitrators with profiles for each arbitrator. An arbitrator’s profile includes a paragraph on the arbitrator’s background, a summary of the arbitrator’s education and work history, the arbitrator’s experience, the arbitrator’s disclosure and conflict information, and a list of all the publicly available award decisions that the arbitrator has rendered. Each party may peremptorily strike any arbitrator from the list, then ranks the arbitrators who remain by order of preference. If the parties do not mutually agree on an acceptable number of arbitrators after striking and ranking, the list is extended by the computer and the parties are assigned the next available arbitrator(s) on the computerized roster. While this process reduces the potential for staff bias, some arbitrators have raised concerns that a computer-generated list may not contain arbitrators with substantial experience.

In 2000, NYSE also began giving parties three options for selecting arbitrators: (1) choosing randomly from a list drawn from all available arbitrators; (2) choosing from a list the staff compiles; or (3) having NYSE staff attorneys select, the only procedure used prior to 2000. If all parties cannot agree on one of these options, staff attorneys determine who will arbitrate. According to NYSE, staff selection has remained the most common method for selecting arbitrators, with parties using it for about 85 percent of the cases. Since this method is the default if parties cannot agree, it is not possible to determine how often this method was actually chosen by parties, or used as the default.

At both NASD and NYSE, arbitrators selected to serve on cases are asked to review the case and determine if they have any possible conflicts of interest. In addition, arbitrators must update their profile, which includes information on their employment history and affiliation with the securities industry. Both NYSE and NASD will remove arbitrators from their roster if they misstate or fail to disclose information concerning conflicts of interest.

Both SROs Have Procedures to Track Arbitrator Performance, Although Many Arbitrators May Not Be Evaluated

Each SRO has developed three types of evaluations for arbitrators: (1) party evaluations, completed by either party or their attorneys; (2) peer evaluations, completed by other arbitrators who hear the case; and (3) staff evaluations. Both SROs summarize evaluation results and input them into a centralized arbitrator database. According to NASD officials, staff are required to summarize and input only negative comments on an arbitrator, although SEC staff noted that in practice it also often sees positive comments from NASD staff recorded in the files. NYSE officials, on the other hand, reported recording a complete summary of the evaluations. NASD conducts quarterly audits in which they check to see if staff members are consistently entering information in the centralized database and documenting actions taken concerning any evaluations. In addition, the audits review how complaint letters have been recorded, reviewed, and resolved.

Both SROs reported that it has been difficult for them to get parties to return evaluations. Yet, NYSE reported that response rates have increased since it began requiring that arbitrator chairs encourage parties to complete the evaluations and reiterate that the evaluations are confidential and will not affect the case outcome. NYSE said that peers are very responsive with evaluations. NYSE said it requires that staff observe new arbitrators for their first hearing at NYSE and said it sought to evaluate all arbitrators, who serve on a case that goes to a hearing, at least once a year. Although NYSE said that it had fulfilled this requirement in 2002, NYSE could not provide data on evaluations showing that arbitrators had been observed. NASD could not report how often staff evaluate arbitrators. Officials from both SROs said that if no information is received about an arbitrator on a case, they assume the arbitrator performed adequately.

To gain a better understanding of how often arbitrators were evaluated, we reviewed the records of 124 out of the 494 arbitrators at NASD who had heard discrimination claims and/or other employment claims between January 2001 and June of 2002. On the basis of this sample, we estimate that about 45 percent of arbitrators who heard cases during this time had received some type of evaluation and of those only about 2 percent received all three types of evaluations—peer, party, and staff. (See fig. 2 for a breakdown of the types of evaluations arbitrators received.)

Although NASD supplements its evaluations by rating arbitrators on a quarterly basis, our review showed that ratings are often based on little or no information. Every quarter NASD rates those arbitrators who have been active during that time, using a 3-point scale, with 1 being the lowest and 3 being the highest. Staff bases the rating on evaluations and complaints received that quarter and any notes recorded during that time frame in the arbitrator database. In general, NASD reported that any arbitrator who did not have any evaluations during the quarter is likely to be rated adequate (“2”). We estimate that the majority of the arbitrators that were rated received an adequate rating of 2, whether or not they received any evaluations during this time, and 57 percent of arbitrators with a 2 rating had not received any evaluations during this time frame. (See fig. 3.) Some arbitrators without evaluations during this time frame were also rated excellent, which could be a result of the rating from the prior quarter.

Both NASD and NYSE have mechanisms in place to address poor performance by arbitrators. If NYSE or NASD receives either a poor arbitrator evaluation or complaints about an arbitrator on a case, staff will take steps to respond. For example, the staff member assigned to the case may be asked to corroborate the complaint or be asked to consult other arbitrators assigned to the case to see if they support the allegation. A staff member who confirms the complaint may then speak to the arbitrator and suggest how he or she could improve his or her behavior. If the complaint suggests no corrective action is possible, both SROs reported that the arbitrator would be removed from the active roster immediately. All complaints are recorded in the arbitrator database, and both SROs reported that staff input how the complaint will be resolved.

In reviewing the records of NASD arbitrators, we found that staff did not always document how they responded to poor evaluations and complaints. We estimate that 10 percent of all 494 NASD arbitrators that heard cases between January 2001 and June of 2002, received some kind of complaint, either from a staff member, a party member, or another arbitrator. In our sample, 6 of the 16 arbitrators that received negative complaints were permanently dropped from NASD’s arbitrator list and 1 was temporarily made unavailable pending further review. One arbitrator, who had been permanently dropped in 2001, appeared to have complaints going back to 1993, yet the notes showed that no changes had been made to the adequate rating of 2. For another permanently dropped arbitrator, staff noted they were concerned that no negative comments were recorded on the computer file since other staff and arbitrators had complained about this arbitrator’s conduct. Of the 9 remaining arbitrators, information provided by NASD indicated that staff had followed-up on the complaints raised for 5 arbitrators.

Over the Last 10 Years, Relatively Few Employment Disputes Involved Discrimination, and Some Variations Existed between These Cases and Other Employment Disputes

Of the 1,546 employment cases decided by arbitrators at NASD and NYSE over the last 10 years, 261 (17 percent) included at least 1 discrimination claim. Cases with discrimination claims required more hearing sessions and took longer to complete than those with no discrimination claims. At the same time, the compensatory damages claimed in all cases was generally over $100,000, with claimed amounts generally higher at NYSE than at NASD. In over half of all employment cases, employees won some level of monetary compensation, although in cases with discrimination claims employees were generally less likely to win. In most cases, when employees won they received less than half of the compensatory damages they claimed, with over 50 percent of the awards over the last 10 years being $50,000 or less. When compensatory damages were awarded in cases involving discrimination, it tended to be higher than compensatory damages awarded in other employment cases, with just over 60 percent of discrimination cases receiving more than $50,000. Appendix 1 describes the reliability and limitations of these data.

Age and Sex Discrimination Were Most Prevalent in the Relatively Few Employment Cases That Included Discrimination Claims

Employment cases arbitrated at NASD and NYSE can contain 1 or more claims, some of which might involve discrimination. Of all 1,546 employment cases heard (1,289 at NASD and 257 at NYSE) at NASD and NYSE over the last 10 years, 261 (17 percent) included at least 1 type of discrimination claim. NASD arbitrated 202 of the cases that involved discrimination allegations. NYSE arbitrated the remaining 59. Given that some cases involved more than 1 type of discrimination claim, in 261 cases a total of 324 discrimination claims were made. As shown in table 1, the majority of these 324 discrimination claims was either age (33 percent) or sex-based (32 percent).

Over the last 10 years, the number of cases with discrimination claims has generally decreased at NYSE. In more recent years, this has also occurred at NASD, although prior to 2000 the number of cases at NASD involving discrimination fluctuated. (See fig. 4.) NASD and NYSE officials reported that the rule changes in 1999, which altered if and how discrimination cases are arbitrated, might have reduced the arbitration of these types of cases.

Cases That Included Discrimination Claims Required More Hearing Sessions and Took Longer to Complete

Over the last 10 years, the median number of hearing sessions in discrimination cases ranged from 5 to 10 at NASD (see fig. 5) and from 8 to 15 at NYSE (see fig. 6). The median number of hearing sessions in cases that did not involve discrimination ranged from 4 to 5 at NASD and 5 to 11 at NYSE.

Not surprisingly, cases requiring more hearing sessions also took longer to complete. For example, cases requiring 1 to 2 hearing sessions took 438 days on average to complete, while those requiring 5 to 8 hearing sessions took 490 days on average. According to NASD, discrimination cases could require more hearing sessions and take longer to complete because they are more complex.

Amounts Claimed in the Majority of Employment Cases Were over $100,000

In most cases arbitrated at NASD and NYSE over the last 10 years, employees sought more than $100,000 in compensatory damages, whether or not the case included a discrimination claim. (See fig. 7.)

Overall, employees in NYSE cases sought higher compensatory damages than employees in NASD cases with the average compensatory damage claimed at NYSE over $2 million and the average compensatory damage claimed at NASD was under $1 million. These differences might reflect differences in the membership of the two SROs. For example, members of NYSE tend to include mostly the larger, more established broker-dealers, whose employees may seek higher compensatory damages in arbitration cases.

Cases Involving Discrimination Were Less Likely to Win Some Level of Compensatory Damages Than Cases with No Discrimination Claims

In general, in more than 50 percent of cases at NASD and NYSE, employees were awarded some level of compensatory damages. (See fig. 8.)

Employees in cases involving discrimination, however, were less likely to win some compensatory damages than employees in cases with no discrimination claims. (See fig. 9.) Forty-eight percent of all NASD and NYSE cases over the last 10 years that included a discrimination claim won some level of compensatory damages compared with 61 percent of cases with no discrimination claims.

While Most Employees Received Less Than Half of the Compensatory Damages They Claimed, Cases That Included Discrimination Claims Received Higher Awards

In cases where employees received a monetary award, over 60 percent of employees received less than half of the compensatory damages they claimed. In terms of the amount of compensatory damages awarded, awards in cases at NYSE tended to be higher. (See fig. 10.) At NASD, just over half of the cases won had awards of $50,000 or less, while at NYSE 70 percent of awards were over $50,000.

Compared with cases with no discrimination claims, employees in cases involving discrimination were more likely to receive larger awards. (See fig. 11.) Sixty-two percent of cases with discrimination claims that received monetary awards had an award amount over $50,000, compared with 48 percent of cases without discrimination claims.

In addition to receiving monetary compensation, employees sometimes seek and receive nonmonetary awards. For example, an employee may want defamatory language removed from his or her record. In the employment cases that we analyzed, approximately 13 percent of employees won some type of nonmonetary award without any monetary award.

SEC Oversight Found SROs Could Improve Procedures to Ensure Arbitrators Are Qualified and Perform Well

To assess arbitration programs at NASD and NYSE, SEC conducts periodic inspections and reviews complaint letters it receives. It has cited problems at one or both SROs in the procedures used to (1) ensure arbitrators are qualified and (2) track arbitrator performance. SEC generally reviews arbitration procedures, arbitrator profiles, disclosure reports, and closed cases and interviews staff during its inspections. Although SEC officials indicated that complaint letters could affect the focus of an inspection, we found that few of the letters SEC receives focus on employment arbitration. In its most recent inspections, in addition to problems with procedures both SROs used to ensure arbitrators are qualified, SEC found that one or both SROs did not record information on arbitrator performance in a central database or disqualify all arbitrators who were poor performers from hearing cases. Both SROs have taken some steps to address the problems.

SEC Conducts Systematic Inspections and Reviews Complaint Letters to Assess SRO-Administered Arbitration Programs

Since 1995, SEC has examined NASD’s and NYSE’s arbitration programs three times each and has routinely responded to complaint letters about the process. Most inspections have focused on either case processing or recruiting and maintaining arbitrators. In general, inspections also included reviewing problems raised in previous inspections to determine whether they had been resolved. (See fig. 12.)

In conducting inspections, SEC reviews a variety of documents, summarizes findings, develops recommendations, and provides SRO with the opportunity to comment on both its findings and recommendations. The documents SEC reviews generally include case files and arbitrator profiles and disclosure reports. Some of the case files are chosen randomly while others are selected based on risk factors that suggest problems may exist, such as the length of time it took to complete a case. In addition to reviewing documents, SEC interviews SRO staff to better understand its operations. In its 2000 inspection of NASD, SEC reviewed 110 arbitrator profiles and disclosure reports and 89 arbitration case files. In its 2001 inspection of NYSE, SEC reviewed 200 arbitrator profiles and disclosure reports and 40 customer and employment cases in addition to other documents. An SEC official noted that under the Exchange Act, SEC has a broad range of authority to address deficiencies found in an inspection. As a practical matter, SEC staff and SROs discuss deficiencies and document that necessary steps have been taken.

In addition to carrying out inspections to oversee SRO arbitration programs, SEC reviews complaint letters from individuals employed in the securities industry and other interested parties regarding SRO- administered arbitration programs. Of all the complaint letters SEC receives, however, only a small percentage raise concerns about the arbitration and an even smaller percentage deal with employment cases. According to SEC’s complaint letter log, of the over 12,000 complaint letters SEC received from January 1992 through October 2002, approximately 500 contained a specific reference to arbitration. We reviewed a random sample of 100 of the letters that referred to arbitration and found 16 that discussed the arbitration of employment clams. Of the 16, 6 raised concerns about the use of mandatory arbitration to address employment or employment discrimination claims. The other 10 letters dealt with a variety of issues, including the amount of time allocated to address a claim, the scheduling of hearings, and a proposal to limit damages that can be claimed.

An SEC official with the division that approves SRO rules said the division responds to all complaint letters it receives, which are tracked using the database letter log. The official indicated that when letters register general discontent with the arbitration process but do not contain a specific allegation, parties are provided general information about arbitration, including information on the narrow procedural mechanism for challenging awards. When letters contain specific allegations, SEC attorneys contact the SRO or use other means to investigate the allegation before providing a response. SEC attorneys may also forward a copy of the letter to the office that oversees periodic inspections, so it can assess the allegation in its inspection activities. For example, an SEC official reported that SEC had placed special emphasis in a recent inspection on reviewing updates SRO staff made to arbitrator profiles and disclosure reports in response to concerns raised in a complaint letter.

SEC Has Made a Variety of Recommendations to Improve SRO Procedures

In recent inspections, SEC staff identified a number of ways NASD and NYSE could improve their procedures for ensuring that arbitrators are qualified and for tracking arbitrator performance. For example, to ensure that arbitrators are qualified, SEC staff recommended that one or both SROs ensure that they consistently conduct CRD checks of all industry arbitrators and document those reviews in arbitrator profiles; ensure that all arbitrator profiles are complete and reflect new or updated information arbitrators submit about themselves; lengthen training courses for new arbitrators; include in arbitrator training manuals guidance on certain arbitration procedures and certain problems arbitrators are likely to encounter; and develop policy on how often arbitrators must attend ongoing training, the circumstances under which it can be waived, and documentation of reasons waivers are granted.

On the basis of our review of SRO documents containing policies and standard procedures and interviews with SRO officials, we found that each SRO had taken steps to address SEC’s recommendations. One or both SROs now require that CRD checks be recorded in arbitrator profiles; have an online reporting form arbitrators can use to submit updated information about themselves; and have a basic training course for new arbitrators, more comprehensive training manuals, and a written policy regarding ongoing arbitrator training.

In addition, in recent inspections, SEC staff found that the procedures in place to track arbitrator performance could be improved. For example, SEC staff recommended that one or both SROs ensure that all pertinent information on arbitrator performance, whether negative or positive, is recorded in a central database and do more to address complaints of poor arbitrator performance, including, if appropriate, removing arbitrators from the active pool and better documenting actions taken in response to complaints of poor performance.

SEC staff reported that it appears from recent ongoing and completed inspections that the SROs have taken steps to address these recommendations.

In general, to determine if any issues raised in past inspections remain unresolved, SEC, at the beginning of each new inspection, reviews recommendations from prior inspections. SEC is currently inspecting NASD and will report on the results, including unresolved issues, if any, within the next year. NYSE will be reexamined beginning in 2003, at which time SEC will assess what additional steps, if any, NYSE has taken to address the issues reported here.

Conclusions

SEC oversees NYSE and NASD, which regulate their member firms in the securities industry. All three are responsible for ensuring that the procedures for arbitrating discrimination and other employment disputes are fair and the requirements of the Exchange Act are met. Although SEC’s approval of rules governing arbitration programs and its periodic inspections of these programs has resulted in improvements, there are aspects of these programs that deserve closer scrutiny.

Currently, NASD and NYSE verify the qualifications for those arbitrators who have worked in the securities industry and neither SRO verifies the information provided by nonindustry arbitrators. While we did not find instances where arbitrators provided false statements of qualifications, verifying the qualifications of all arbitrator applicants is an important step in ensuring that employees and employers receive accurate information on the arbitrators they select to hear their cases. Additionally, while SEC has reviewed both SROs procedures for evaluating arbitrator performance, we found evidence that arbitrators are not evaluated on a routine basis. Although NASD has procedures for peer, party, and staff to evaluate arbitrators and identify poor performers, these evaluations are not always completed. While NYSE officials indicated that NYSE has similar procedures and reported staff generally evaluate active arbitrators at least once a year, we were unable to confirm this information. Securities industry employees must use NASD and NYSE arbitration programs to resolve most employment disputes. Therefore, more effort should be made to verify that arbitrators meet the qualifications SROs require and to encourage parties, other arbitrators, and staff to submit evaluations more regularly, so that only arbitrators who perform adequately are maintained on SRO rosters.

Recommendations

To help ensure that all NASD and NYSE arbitrators possess the qualifications required by their SRO, we recommend that the Chairman of SEC direct NASD and NYSE to verify basic background information of all new applicants for their arbitrator rosters. We also recommend that SEC continue to review the adequacy of procedures for evaluating arbitrator performance in their next inspections at NASD and NYSE.

Agency and SRO Comments

We provided a draft of this report to SEC, NASD, and NYSE for their review. A copy of their written comments is in appendixes II, III, and IV, respectively. SEC, NASD, and NYSE also provided technical comments on the draft report, which were incorporated as appropriate.

SEC agreed with the focus of our recommendation concerning the verification of background information. However, SEC believed that in the absence of any indication that the falsification of information is a problem, it might not be necessary for NYSE, as a smaller arbitration forum than NASD, to add this cost to the arbitration process. As a result, SEC indicated that it should be up to NYSE to decide whether the independent verification of basic background information of arbitrator applicants is needed. NASD noted that although it has had no evidence that arbitrators ever falsified information, it is planning to verify the background information on all new applicants to increase party confidence in the accuracy of arbitrator records. NASD reported that a one-time fee for arbitrator applicants would cover the cost of this procedure. NYSE reported that since it has found no proof of anyone providing false information, there is insufficient justification for independently verifying application information and adding costs to the process. In addition, NYSE believes that it has already taken steps to ensure that its application procedures are adequate, such as having applicants affirm that the information they provide is correct and requiring two recommendation letters. NYSE also indicated that counsel for employees can and do take further actions to review the background of arbitrators.

Despite concerns raised by SEC and NYSE, we continue to believe that verifying background information for all new arbitrators is an important part of ensuring the integrity of arbitration, a process required for most disputes. While adding costs to the process is a legitimate concern, NASD’s approach of instituting a one-time application fee of $80 would not increase the expense of arbitration for the parties involved. Additionally, the fact that lawyers representing parties are already sometimes verifying information suggests that verification is valued and further supports the need for it to be done independently and systematically for all new arbitrators. Moreover, although our report has focused on the arbitration of employment cases, a small percentage of all the cases arbitrated in the securities industry, our recommendation will benefit all parties, since NASD and NYSE arbitrators are available for both employment and customer cases.

Concerning our recommendation that SEC continue to review evaluation procedures at SROs, SEC, NASD, and NYSE, all indicated that they understand the importance of evaluating arbitrators. Specifically, SEC agreed that evaluating arbitrator performance is a fundamental element of the arbitration process and reported that it will continue to review the adequacy of procedures for evaluating arbitrator performance during its inspections of SRO arbitration programs. NASD noted that it would strive to provide better documentation of the actions it takes in response to complaints or evaluations. NYSE reported it has a new computer system that creates a centralized, easily accessible record of all feedback and comments from arbitrator evaluations, which will allow staff to have a more comprehensive view of an arbitrator’s performance.

As arranged with your offices, unless you announce its contents earlier, we plan no further distribution of this report until 30 days after the date of this report. At that time, we will provide copies of this report to the Chairman of SEC, the President of NASD, and the Director of Arbitration for NYSE, appropriate congressional committees, and other interested parties. We will also make copies available to other interested parties, upon request. This report will be available at no charge on GAO’s Web site at http://www.gao.gov.

If you have any questions about this report, please contact me on (202) 512-9889. Other contacts and staff acknowledgments are listed in appendix V.

Appendix I: Scope and Methodology

This appendix provides a detailed description of the scope and methodology we used to determine (1) the characteristics and outcomes of arbitrated employment and employment discrimination disputes in the securities industry; (2) who evaluates arbitrators and what performance ratings they receive; and (3) how the Securities and Exchange Commission (SEC) responds to complaint letters it receives concerning arbitration of employment and employment discrimination cases.

Determining the Characteristics and Outcomes of Arbitrated Employment Disputes

To determine the nature and outcomes of employment and employment discrimination disputes in the securities industry, we analyzed a database containing employment disputes in which arbitration decisions had been made by NASD or the New York Stock Exchange (NYSE) from January 1993 through June 2002. We obtained this database from Securities Arbitration Commentator, Inc. (SAC), Maplewood, New Jersey. SAC is a commercial research firm that maintains a database of information from publicly available records on decided cases from all self-regulatory organizations (SRO) arbitration forums, as well as the American Arbitration Association.

The SAC database contained information on arbitration awards that resulted from employee claims for damages against SRO member firms. By definition, this database did not include cases that were settled or withdrawn before an arbitration decision was reached. The 1,564 cases in the database included fields describing a range of variables, such as the name of the forum, the parties involved in the case, types of claims in the case, amounts of compensatory damages claimed, and amounts of compensatory damages awarded. Data on every variable we analyzed were not available for all 1,546 employment cases arbitrated at NASD and NYSE over the last 10 years. Our analyses of the median number of hearing sessions were based on 96 percent of the total 1,546 cases. The amounts claimed in discrimination and nondiscrimination cases, overall, were based on 84 percent of the 1,546 cases. All other analyses presented in this report were based on the total 1,546 employment cases arbitrated over the last 10 years, unless otherwise noted.

To assess the reliability of the data we received from SAC, we reviewed 100 randomly sampled cases in the database, 50 with discrimination claims and 50 without discrimination claims. To verify the accuracy of the information for cases in the database, we compared this information with information in copies of the original awards for the same cases as issued by the forums or as reprinted by Lexis/Nexis. For most variables, data reliability was adequate for the analysis we conducted. We did not use any variables in the SAC database with high error rates. However, we were unable to verify that the SAC database included all cases decided by NASD or NYSE from January 1993 through June 2002.

Determining Arbitrator Performance

To determine who evaluates arbitrators and what performance ratings they receive, we first generated a list from the SAC data file of all NASD arbitrators who had decided at least 1 employment case that did not include a discrimination claim. We stratified this list of 494 arbitrators into two groups—those that had also decided at least 1 case involving discrimination during this time and those that had not decided any cases involving discrimination. We selected all 60 arbitrators from the group that had heard at least 1 discrimination case and selected a random sample of 64 of those that had not heard any and obtained NASD’s files containing evaluation and rating information for each of these 124 arbitrators. From the files associated with the sampled arbitrators, we extracted data on the number of evaluations, if any, these arbitrators received from the parties and/or other arbitrators in the cases they had decided and on performance ratings these arbitrators received.

Each arbitrator in our study population of 494 had a nonzero probability of being selected for our sample. In analyzing data about the arbitrators in our sample, we weighted each sampled arbitrator to account statistically for all arbitrators in the study population, including those who were not selected.

Because we followed a probability procedure based on random selections, our sample is only one of a large number of samples that we might have drawn. Since each sample could have provided different estimates, we express our confidence in the precision of our particular sample’s results as 95 percent confidence intervals. These are intervals that would contain the actual population value for 95 percent of the samples we could have drawn. As a result, we are 95 percent confident that each of the confidence intervals in this report will include the true value in the study population. The width of a confidence interval is also referred to as the sampling error associated with the estimate. Sampling errors associated with estimates from our file review do not exceed plus or minus 15 percentage points.

Determining the Content of SEC Complaint Letters

SEC tracks complaint letters in a computerized database and has logged over 12,000 from 1992 through October 2002. To determine how SEC responds to complaint letters it receives concerning arbitration of employment and employment discrimination cases, first we asked SEC staff to search its database and identify those letters that mention arbitration. SEC found that approximately 500 of the logged letters mentioned arbitration. We reviewed the content of a random sample of 100 of these letters to determine how many dealt specifically with arbitration of employment or employment discrimination claims. Out of the 100 letters, we found 16 that dealt with the arbitration of employment or employment discrimination claims. Twenty-five of the 100 letters in our sample were missing from SEC files, and the issues raised in the remaining 59 letters were either unclear or unrelated to employment cases.

Appendix II: Comments from the Securities and Exchange Commission

Appendix III: Comments from NASD

Appendix IV: Comments from the New York Stock Exchange

Appendix V: GAO Contacts and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to those named above, Susan S. Pachikara, Joan K. Vogel, and Sidney H. Schwartz made significant contributions to this report.