Issuu on Google+

INVESTOR RIGHTS FOR THE 21ST CENTURY

By Mark E. Maddox, Esq. and Andrew J. Stoltmann, Esq.

Public Investors Arbitration Bar Association 2241 W. Lindsey Street, Suite 500 Norman, Oklahoma 73069 1-888-621-7484 www.PIABA.org


Copyright © 2001 by the Public Investors Arbitration Bar Association All rights reserved

PUBLISHER’S DISCLAIMER: Every effort has been made in this publication to achieve accuracy. The law constantly changes and is subject to differing interpretations. Therefore, always consult with one’s own attorney and act only on his or her own professional legal advice. This publication is distributed with the understanding that neither the publisher nor the authors engaged in rendering any legal, investment, or other professional advice or services. The publisher and authors shall not be responsible for any damages from any inaccuracy or omission in this publication.


DEDICATION: To the millions of investors who have been defrauded by unethical stockbrokers and brokerage firms.


Introduction Investors lose billions of dollars every year due to the fraud, misconduct or simple negligence of their financial advisers. However, most investors take no action to recover these losses. Some investors are too embarrassed to tell anyone about their losses. Others don't want their spouses or family members to find out. Most investors don't know where to go to find out whether anything can be done to help them. In most instances, their tried and true tax advisers and/or general practice attorneys lack the knowledge or experience to adequately apprise them of their rights and options. In 1990, the Public Investor Arbitration Bar Association ("PIABA") was established by investor attorneys to attempt to level the playing field between lawyers for the securities industry and those representing investors. When investors are referred to members of PIABA, there is a high probability they will be adequately advised of their rights and options regarding disputes with their financial advisers. Since 1987, the vast majority of disputes between investors and their brokers are required to be resolved through securities arbitration. This publication is intended to generally inform investors and their lawyers about securities arbitration and their rights within the process. It is intended to be a basic primer for securities arbitration, not a battle plan for complicated case specific strategy. Like any dispute resolution system, securities arbitration is far from perfect. Our friend and colleague Seth Lipner best captures the essence of these imperfections when he reminds us that "arbitration" and "arbitrary" are derived from the same root. Nevertheless, it is the only game in town for aggrieved investors and should be played on a level playing field, with all sides subject to the same rules.

v


PIABA Membership Information PIABA was established in 1990 as an educational and networking organization for securities arbitration attorneys who represent the public investor in securities disputes. While PIABA’s main purpose is further educating securities arbitration attorneys, its members are involved in promoting the interests of the public investor in securities and commodities arbitration. Mission The mission of PIABA is to promote the interests of the public investor in securities and commodities arbitration by protecting public investors from abuses in the arbitration process, such as those associated with document production and discovery; making securities and commodities arbitration as just and fair as systematically possible; and creating a level playing field for the public investor in securities and commodities arbitration. Membership Qualifications An applicant: • must be an attorney-at-law duly admitted to practice before the courts; • must be currently representing or in the past have represented at least one public investor in connection with his or her dispute with a securities or commodities brokerage firm; • must not be an employee of a securities or commodities brokerage firm; and • for the last year, neither the applicant nor his partners or associates, may have devoted twenty percent (20%) or more of their securities practice to representing securities or commodities industry clients against public investors. Benefits of Membership There are many rewards of membership in PIABA. The PIABA Quarterly is edited by Board Member L. Jerome Stanley and released in March, June, September and December. The Quarterly is subscribed to by over 400 attorneys, securities experts and consultants and CPA’s. In the fall of each year, PIABA sponsors an Annual Meeting. The Annual Business Meeting and election of directors is held at this meeting. Attorneys may receive continuing education hours for their participation at this meeting. Many PIABA members find this an excellent time to network and share ideas. Approximately 175 attorneys, securities experts and consultants attend this meeting annually. Investors and members are frequently referred to the PIABA web site at www.PIABA.org for information. From the Members Only area, members may post a message for all members on the PIABA Message Board, find uploaded cases or articles or information regarding the progress of PIABA committees and research arbitrators and past awards. PIABA members continue to utilize the Internet to communicate with each other via e-mail and member Websites. The PIABA membership roster is published and sent bi-annually to PIABA members, listing the business address, telephone and fax numbers, and e-mail address thus providing rapid access to members of the organization. Currently, the Securities and Exchange Commission and several State Securities Commissions recommend to investors they contact PIABA for attorney assistance. Upon request, PIABA will

vi


provide the names of PIABA attorneys practicing in the area for referral purposes. While this is not the main purpose of PIABA, it is a service we provide to investors and our members. Although the membership roster is published to members bi-annually, it is updated daily for referral purposes.

PIABA 2241 W. Lindsey Street, Suite 500 Norman, OK 73069 Office: 1-405-360-8776 toll free: 1-888-621-7484 E-mail: piaba@piaba.org www.PIABA.org

vii


Public Investors Arbitration Bar Association (“PIABA”) Membership Application Name: Law Firm: Office Address:

_____________________________________________________________ _____________________________________________________________ _____________________________________________________________ _____________________________________________________________ Office Phone: ___________________________ FAX: ___________________________ Toll Free Number: ____________________________________________________________ E-mail: ___________________________ Website: _________________________ Bar Information States Admitted to Practice and Dates: ____________________________________________ State Bar No(s). ______________________________________________________________ Please state if your license to practice law in any jurisdiction has ever been suspended or revoked: Yes_______ No_______ Nature of Your Practice Number of Years Practicing in the Field of Securities/Commodities Arbitration: _____________ Percentage of Overall Practice that Consists of Securities/Commodities Arbitration: ________ As to the securities/commodity portion of your practice (A & B should equal 100%): A. Percentage of Practice Representing Public Investors: __________________ B. Percentage of Practice Representing Securities/Commodities Firms: _______ As to your defense practice in the securities/commodities fields, please attach a list of all such cases in the last two years. Describe the kind of case (customer or industry) and the party your represented. Securities Licenses: If you have had any NASD or CFTC licenses, please state the date each was received, and attach a list of all firms with which you were affiliated, and pertinent dates. Please attach a current copy of your U-4. Affidavit I am an attorney-at-law admitted to practice before the courts and currently employed with an established law office. I am not affiliated with an ‘arbitration service.’ I am currently representing or in the past have represented at least one public investor in connection with his or her dispute with a securities or commodities brokerage firm. I am eligible for membership in PIABA if, and only if, at least 80 percent of my work involving securities industry/customer disputes and at least 80 percent my current law firm’s work involving securities industry/customer disputes is performed on behalf of investors. “Securities industry/customer disputes” shall mean disputes between investors, on the one hand, and any one or more the following, on the other: securities and commodities industry participants (licensed or unlicensed), securities issuers, financial counselors, and persons alleged to have liability for the acts or omissions of any of the foregoing. Any uncertainty, ambiguity, or question as to whether certain representation does or does not involve securities or commodities industry participants will be presumed to be industry representation. The percentage of my work and my firm’s work in securities industry/customer disputes shall be the percentage of hours spent rather than the percentage of revenues generated or any other measure; and the relevant time period for determining that percentage shall run from January 1 of the year preceding the date on which the determination is made to the date on which the determination is made, inclusive. I have the continuing obligation to notify PIABA immediately of any changes which affect the member’s compliance with the 80-20 Rule. I affirm that the information set forth herein is true and accurate.

Signature___________________________________________________ Date__________________________

! Check Enclosed ! Visa ! MasterCard (Note: We do not accept American Express.) Name on Credit Card________________________________________________Amount Enclosed_____________ Credit Card Number___________________________________ Expiration Date_____________________________ Signature_____________________________________________________________________________________ If you have more than one member in your firm applying for membership, please fill out a separate form for each. Thank you. Please enclose membership dues of $295.00.

April 2, 2001


INVESTORS RIGHTS FOR THE 21st CENTURY Table Of Contents—By Section Securities Industry Investment Products and their Abuses Most Common Types of Arbitration Complaints Attorneys and Expenses Initiating Arbitration Pre-Hearing Discovery Pre-Hearing Depositions Compulsory Arbitration Superiority of Arbitration Hearing Process Defenses Damages Award Mediation

Q1 . . . . . . . . . . . . . . . . . . . . . . . . . 1 Q18 . . . . . . . . . . . . . . . . . . . . . . . . . 9 Q26 . . . . . . . . . . . . . . . . . . . . . . . . 18 Q72 . . . . . . . . . . . . . . . . . . . . . . . . 43 Q77 . . . . . . . . . . . . . . . . . . . . . . . . 46 Q85 . . . . . . . . . . . . . . . . . . . . . . . . 50 Q91 . . . . . . . . . . . . . . . . . . . . . . . . 56 Q93 . . . . . . . . . . . . . . . . . . . . . . . . 56 Q100 . . . . . . . . . . . . . . . . . . . . . . . 59 Q112 . . . . . . . . . . . . . . . . . . . . . . . 63 Q126 . . . . . . . . . . . . . . . . . . . . . . . 68 Q136 . . . . . . . . . . . . . . . . . . . . . . . 73 Q142 . . . . . . . . . . . . . . . . . . . . . . . 76 Q148 . . . . . . . . . . . . . . . . . . . . . . . 78

Table of Contents—By Question Likelihood of Fraud Problem Significance Underreporting of Fraud Recovering Losses Broker Background Financial Planner Background Central Registration Depository Accuracy Broker, Investment Adviser and Financial Planner Regulation of Investment Advisors Unethical Investment Professionals Reason for Investment Abuses Investor Ignorance Brokerage Firm Problems Discount Brokerage Firm Problems Online Brokerage Firm Problems Accountant Abuses Bank Abuses

xi

Q1 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Q2 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Q3 . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Q4 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Q5 . . . . . . . . . . . . . . . . . . . . . . . . . . 2 Q6 . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Q7 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Q8 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Q9 . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Q10 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Q11 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Q12 . . . . . . . . . . . . . . . . . . . . . . . . . 5 Q13 . . . . . . . . . . . . . . . . . . . . . . . . . 6 Q14 . . . . . . . . . . . . . . . . . . . . . . . . . 7 Q15 . . . . . . . . . . . . . . . . . . . . . . . . . 7 Q16 . . . . . . . . . . . . . . . . . . . . . . . . . 8 Q17 . . . . . . . . . . . . . . . . . . . . . . . . . 8


Maddox / Stoltmann

Investment Products and Abuses Stocks Bonds Mutual Funds Margin Annuities Options Fee Based Accounts Other Investment Products

Q18 . . . . . . . . . . . . . . . . . . . . . . . . . 9 Q19 . . . . . . . . . . . . . . . . . . . . . . . . 10 Q20 . . . . . . . . . . . . . . . . . . . . . . . . 11 Q21 . . . . . . . . . . . . . . . . . . . . . . . . 12 Q22 . . . . . . . . . . . . . . . . . . . . . . . . 13 Q23 . . . . . . . . . . . . . . . . . . . . . . . . 14 Q24 . . . . . . . . . . . . . . . . . . . . . . . . 14 Q25 . . . . . . . . . . . . . . . . . . . . . . . . 15

Common Types of Arbitration Complaints Securities at Issue Compensation for Claimants

Q26 . . . . . . . . . . . . . . . . . . . . . . . . 18 Q27 . . . . . . . . . . . . . . . . . . . . . . . . 18

Misrepresentations and Omissions Defined Frequency Examples

Q28 . . . . . . . . . . . . . . . . . . . . . . . . 18 Q29 . . . . . . . . . . . . . . . . . . . . . . . . 19 Q30 . . . . . . . . . . . . . . . . . . . . . . . . 19

Breach of Fiduciary Duties Defined Frequency Criteria Responsibilities

Q31 . . . . . . . . . . . . . . . . . . . . . . . . 19 Q32 . . . . . . . . . . . . . . . . . . . . . . . . 19 Q33 . . . . . . . . . . . . . . . . . . . . . . . . 20 Q34 . . . . . . . . . . . . . . . . . . . . . . . . 20

Suitability Defined Frequency Causes NASD Rule 2310 NYSE Rule 405 Difference between NASD and NYSE Rule Online Suitability Obligation Online Suitability NASD Obligation

Q35 . . . . . . . . . . . . . . . . . . . . . . . . 20 Q36 . . . . . . . . . . . . . . . . . . . . . . . . 21 Q37 . . . . . . . . . . . . . . . . . . . . . . . . 21 Q38 . . . . . . . . . . . . . . . . . . . . . . . . 22 Q39 . . . . . . . . . . . . . . . . . . . . . . . . 22 Q40 . . . . . . . . . . . . . . . . . . . . . . . . 22 Q41 . . . . . . . . . . . . . . . . . . . . . . . 23 Q42 . . . . . . . . . . . . . . . . . . . . . . . . 26

Failure to Supervise Duty to Supervise Frequency

Q43 . . . . . . . . . . . . . . . . . . . . . . . . 27 Q44 . . . . . . . . . . . . . . . . . . . . . . . . 28

xii


Investor Rights for the 21st Century

Unauthorized Trading Defined Frequency Discretionary Account

Q45 . . . . . . . . . . . . . . . . . . . . . . . . 28 Q46 . . . . . . . . . . . . . . . . . . . . . . . . 29 Q47 . . . . . . . . . . . . . . . . . . . . . . . . 29

Negligence Defined Frequency

Q48 . . . . . . . . . . . . . . . . . . . . . . . . 29 Q49 . . . . . . . . . . . . . . . . . . . . . . . . 30

Churning Defined Frequency Occurrence Motivation to Churn Churning Elements Control Types Implied Control Investor Education or Occupation Excessive Activity Turnover Rate Turnover Rate Threshold Cost Equity Ratio Cost Equity Ratio Threshold In-And-Out Trading Levels of Excessiveness Churning Intent Account Profitability Churning Versus Excessive Trading Probability of Successful Short Term Trading

Q50 . . . . . . . . . . . . . . . . . . . . . . . . 30 Q51 . . . . . . . . . . . . . . . . . . . . . . . . 30 Q52 . . . . . . . . . . . . . . . . . . . . . . . . 30 Q53 . . . . . . . . . . . . . . . . . . . . . . . . 30 Q54 . . . . . . . . . . . . . . . . . . . . . . . . 31 Q55 . . . . . . . . . . . . . . . . . . . . . . . . 31 Q56 . . . . . . . . . . . . . . . . . . . . . . . . 31 Q57 . . . . . . . . . . . . . . . . . . . . . . . . 32 Q58 . . . . . . . . . . . . . . . . . . . . . . . . 32 Q59 . . . . . . . . . . . . . . . . . . . . . . . . 33 Q60 . . . . . . . . . . . . . . . . . . . . . . . . 33 Q61 . . . . . . . . . . . . . . . . . . . . . . . . 34 Q62 . . . . . . . . . . . . . . . . . . . . . . . . 34 Q63 . . . . . . . . . . . . . . . . . . . . . . . . 35 Q64 . . . . . . . . . . . . . . . . . . . . . . . . 35 Q65 . . . . . . . . . . . . . . . . . . . . . . . . 35 Q66 . . . . . . . . . . . . . . . . . . . . . . . . 35 Q67 . . . . . . . . . . . . . . . . . . . . . . . . 36 Q68 . . . . . . . . . . . . . . . . . . . . . . . . 36

Penny Stock Fraud Prevalence of Problem Defined Solving the Problem

Q69 . . . . . . . . . . . . . . . . . . . . . . . . 41 Q70 . . . . . . . . . . . . . . . . . . . . . . . . 42 Q71 . . . . . . . . . . . . . . . . . . . . . . . . 42

Attorneys and Expenses Attorney Experience Non-Attorney Representation

Q72 . . . . . . . . . . . . . . . . . . . . . . . . 43 Q73 . . . . . . . . . . . . . . . . . . . . . . . . 43

xiii


Maddox / Stoltmann Investor Contact Attorney Compensation Arbitration Expenses

Q74 . . . . . . . . . . . . . . . . . . . . . . . . 44 Q75 . . . . . . . . . . . . . . . . . . . . . . . . 44 Q76 . . . . . . . . . . . . . . . . . . . . . . . . 45

Initiating Arbitration Beginning Arbitration Uniform Submission Agreement Statement of Claim Claims Under $25,000 Statement of Claim and USA Time to Answer Single Arbitrator Rule 10336

Q77 . . . . . . . . . . . . . . . . . . . . . . . . 46 Q78 . . . . . . . . . . . . . . . . . . . . . . . . 46 Q79 . . . . . . . . . . . . . . . . . . . . . . . . 46 Q80 . . . . . . . . . . . . . . . . . . . . . . . . 47 Q81 . . . . . . . . . . . . . . . . . . . . . . . . 47 Q82 . . . . . . . . . . . . . . . . . . . . . . . . 48 Q83 . . . . . . . . . . . . . . . . . . . . . . . . 48 Q84 . . . . . . . . . . . . . . . . . . . . . . . . 49

Pre-Hearing Discovery Pre-Hearing Discovery Changes in Pre-Hearing Discovery NASD Discovery Guide Brokerage Firm Documents NASD Discovery Guide Investor Documents Problems Pre-Hearing Exchange

Q85 . . . . . . . . . . . . . . . . . . . . . . . . 50 Q86 . . . . . . . . . . . . . . . . . . . . . . . . 50 Q87 . . . . . . . . . . . . . . . . . . . . . . . . 51 Q88 . . . . . . . . . . . . . . . . . . . . . . . . 53 Q89 . . . . . . . . . . . . . . . . . . . . . . . . 55 Q90 . . . . . . . . . . . . . . . . . . . . . . . . 55

Pre-Hearing Depositions Depositions Deposition Options

Q91 . . . . . . . . . . . . . . . . . . . . . . . . 56 Q92 . . . . . . . . . . . . . . . . . . . . . . . . 56

Compulsory Arbitration Mandatory Arbitration Arbitration Agreement Example Arbitrator Need Arbitrator Requirements Arbitrator Compensation Advantages Arbitrator Pool

Q93 . . . . . . . . . . . . . . . . . . . . . . . . 56 Q94 . . . . . . . . . . . . . . . . . . . . . . . . 57 Q95 . . . . . . . . . . . . . . . . . . . . . . . . 57 Q96 . . . . . . . . . . . . . . . . . . . . . . . . 57 Q97 . . . . . . . . . . . . . . . . . . . . . . . . 58 Q98 . . . . . . . . . . . . . . . . . . . . . . . . 58 Q99 . . . . . . . . . . . . . . . . . . . . . . . . 58

Superiority of Arbitration Fairness Imperfections Improvements Disadvantages to Court

Q100 . . . . . . . . . . . . . . . . . . . . . . . 59 Q101 . . . . . . . . . . . . . . . . . . . . . . . 60 Q102 . . . . . . . . . . . . . . . . . . . . . . . 60 Q103 . . . . . . . . . . . . . . . . . . . . . . . 60 xiv


Investor Rights for the 21st Century Arbitration Advantages Securities Member Panelist Arbitration and Litigation Motions

Q104 . . . . . . . . . . . . . . . . . . . . . . . 60 Q105 . . . . . . . . . . . . . . . . . . . . . . . 61 Q106 . . . . . . . . . . . . . . . . . . . . . . . 62 Q107 . . . . . . . . . . . . . . . . . . . . . . . 62

Arbitrator Selection Chairperson Selection Arbitrator versus Judges Arbitration Forum Selection

Q108 . . . . . . . . . . . . . . . . . . . . . . . 62 Q109 . . . . . . . . . . . . . . . . . . . . . . . 63 Q110 . . . . . . . . . . . . . . . . . . . . . . . 63 Q111 . . . . . . . . . . . . . . . . . . . . . . . 63

Hearing Process Inside an Arbitration Arbitrator Questions Subpoenas Arbitration Guiding Principal Objections Arbitration Scheduling Stipulations Evidence Affidavits Arbitration Length Expert Witnesses Expert Attendance Pro Se Investors Disciplinary Referrals

Q112 . . . . . . . . . . . . . . . . . . . . . . . 63 Q113 . . . . . . . . . . . . . . . . . . . . . . . 64 Q114 . . . . . . . . . . . . . . . . . . . . . . . 65 Q115 . . . . . . . . . . . . . . . . . . . . . . . 65 Q116 . . . . . . . . . . . . . . . . . . . . . . . 65 Q117 . . . . . . . . . . . . . . . . . . . . . . . 65 Q118 . . . . . . . . . . . . . . . . . . . . . . . 66 Q119 . . . . . . . . . . . . . . . . . . . . . . . 66 Q120 . . . . . . . . . . . . . . . . . . . . . . . 66 Q121 . . . . . . . . . . . . . . . . . . . . . . . 67 Q122 . . . . . . . . . . . . . . . . . . . . . 67 Q123 . . . . . . . . . . . . . . . . . . . . . . . 67 Q124 . . . . . . . . . . . . . . . . . . . . . . . 67 Q125 . . . . . . . . . . . . . . . . . . . . . . . 68

Defenses Investor Initiated Transactions Statute of Limitations When Applicable Eligibility Requirement Eligibility v. Statute of Limitations Statute of Limitations Abuses Estoppel, Waiver, Laches Failure to Complain “Happiness” or “Comfort” Letters New Account Application

Q126 . . . . . . . . . . . . . . . . . . . . . . . 68 Q127 . . . . . . . . . . . . . . . . . . . . . . . 69 Q128 . . . . . . . . . . . . . . . . . . . . . . . 69 Q129 . . . . . . . . . . . . . . . . . . . . . . . 69 Q130 . . . . . . . . . . . . . . . . . . . . . . . 70 Q131 . . . . . . . . . . . . . . . . . . . . . . . 70 Q132 . . . . . . . . . . . . . . . . . . . . . . . 71 Q133 . . . . . . . . . . . . . . . . . . . . . . . 71 Q134 . . . . . . . . . . . . . . . . . . . . . . . 71 Q135 . . . . . . . . . . . . . . . . . . . . . . . 72

xv


Maddox / Stoltmann

Damages Types of Damages Interest Attorney Fees “Well Managed Account� Punitive Damages Importance of Punitive Damages

Q136 . . . . . . . . . . . . . . . . . . . . . . . 73 Q137 . . . . . . . . . . . . . . . . . . . . . . . 73 Q138 . . . . . . . . . . . . . . . . . . . . . . . 74 Q139 . . . . . . . . . . . . . . . . . . . . . . . 74 Q140 . . . . . . . . . . . . . . . . . . . . . . . 74 Q141 . . . . . . . . . . . . . . . . . . . . . . . 75

Award Time to Get Award Form of Award Arbitrator Flexibility of Awards Award Constraints Appealing Awards Finality of Awards

Q142 . . . . . . . . . . . . . . . . . . . . . . . 76 Q143 . . . . . . . . . . . . . . . . . . . . . . . 76 Q144 . . . . . . . . . . . . . . . . . . . . . . . 77 Q145 . . . . . . . . . . . . . . . . . . . . . . . 77 Q146 . . . . . . . . . . . . . . . . . . . . . . . 77 Q147 . . . . . . . . . . . . . . . . . . . . . . . 78

Mediation Mediation Different than Arbitration Mediation Success Rates Mediation as an Option

Q148 . . . . . . . . . . . . . . . . . . . . . . . 78 Q149 . . . . . . . . . . . . . . . . . . . . . . . 78 Q150 . . . . . . . . . . . . . . . . . . . . . . 79 Q151 . . . . . . . . . . . . . . . . . . . . . . . 79

Appendices Appendix 1: Appendix 2: Appendix 3: Appendix 4: Appendix 5: Appendix 6: Appendix 7: Appendix 8: Appendix 9: Appendix 10: Appendix 11:

State Securities Offices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Regulatory Agencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87 How To Avoid Problems With a Broker . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Checklist Before Doing Business With a Broker . . . . . . . . . . . . . . . . . . . . . . . . . 91 Mutual Fund Investing: Look at More Than a Fund's Past Performance . . . . . . . 93 Certificates of Deposit: Tips for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Day Trading: Your Dollars at Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101 Investment Advisers: What You Need to Know Before Choosing One . . . . . . 103 Microcap Stock: A Guide for Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 NASD Code of Arbitration Procedure Arbitrator Applications

xvi


Investor Rights for the 21st Century

The Securities Industry 1) Is there one type of investment professional who is most likely to defraud the public? No. Today, it is not just stockbrokers who defraud investors. As investors’ financial assets have exploded in recent years, to $27 trillion in 1999 from approximately $15 trillion in 1990, brokerage firms have attempted to position their employees not as “stockbrokers” but rather as “financial professionals.” Usually, this is a distinction without a significant difference. Regardless of what a firm calls its sales force, investors must be careful in their dealings with anyone in the securities or insurance industry.

2) How significant of a problem is securities fraud? Unfortunately, abuses in the securities industry are widespread. In 1999, the North American Securities Administration Association (NASAA), which represents state securities regulators, reported a 30 percent increase in fraud from the previous year. The group estimates that securities fraud costs American investors $10 billion a year, or $1 million every hour. The number of arbitration cases at the NASD alone has increased from 318 in 1980 to 5,558 in 2000.

3) Are securities abuses underreported? Yes. The overwhelming majority of all investment abuses are never reported. The cases that are actually filed against brokers, insurance agents and investment advisers are the very small tip of the iceberg. Often, investors feel embarrassed by their supposed gullibility or degree of trust that they placed in their broker. Investors often assume they are simply the victim of the market and there is nothing that can be done. However, if an investor is the victim of fraud by an investment professional, then they do have legal options.

1


Maddox / Stoltmann

4)

How do investors go about recovering their investment losses?

Usually through securities arbitration. Since 1987, the U.S. Supreme Court has allowed the securities industry to force investors into arbitration instead of court litigation. In arbitration, the decision of the arbitrators is binding and final. The arbitration proceeding is similar in many respects to a trial in a court of law with some notable exceptions. In arbitration, as in a trial in court, there are opening and closing statements, the presentment of evidence and witnesses, and a decision rendered by the panel. However, unlike court litigation, the rules of evidence are more relaxed and the arbitrators many times are concerned with what is fair and equitable.

5) How can investors check the background of their broker? One of the most important steps an investor should take when choosing a financial advisor is to examine the advisor’s background. To check out a broker, acquire a copy of the broker’s disciplinary and employment history from the National Association of Securities Dealers (800-289-9999) or from the state securities division (See Appendix 1). Another option is to log onto the NASD Regulation website (www.nasdr.com) where an investor can review brokers’ employment history, find out where they are licensed, determine what products they are registered to sell and request disciplinary records. Unfortunately, the NASD’s website section has numerous problems that often makes retrieving the information nearly impossible. Typically, the best source for retrieving information about a broker is through a state securities division.

When reviewing a broker’s Central Registration Depository (CRD) report, first examine the broker’s disciplinary history. On the NASD website, this information will fall under the heading “Disclosure Events.” It includes civil or criminal actions by securities regulators, plus arbitration cases, lawsuits and settlements stemming from investor complaints. It also lists all investor complaints filed in the past 24 months.

2


Investor Rights for the 21st Century An investor, even after checking with the NASD, should also call the state securities office of the state that the investor resides in. There are times when state regulators may disclose information that the NASD will not.

6) How can investors check the background of their financial planner or money manager? The first step, once again, is to check the CRD System. Even if the financial planner or money manager is not a licensed broker, some advisors are listed in the system. However, the most important step in checking their background is to review a copy of the adviser’s standard regulatory filing, known as Form ADV, which can be acquired from either the advisor, the investor’s state securities regulator, or the Securities and Exchange Commission (www.sec.gov).

Advisers must provide investors with Part II of their ADV, which contains information about their compensation, experience and training. In Part II, examine questions 1C, 1D, 13A and Schedule F which will disclose any financial arrangements that could contaminate the adviser’s judgment and make her recommend one investment over another. For instance, check to see if the adviser receives compensation from a mutual fund company for recommending that family of funds.

Other important information can be found in the answers to Item Seven of Schedule D which deals with financial planning credentials, Question Six, which asks for the adviser’s educational and business background and Question Eight which lists any business ties to insurers, broker-dealers or other businesses.

Part I is also important to examine and will list any legal or regulatory problems. When reviewing the ADV, first examine Question 11 of Part I. A “yes” answer to any of the questions is a signal that the adviser has had regulatory or legal problems.

3


Maddox / Stoltmann

7) Does the Central Registration Depository accurately reflect all broker wrongdoings? No. The CRD is supposed to give investors an accurate look at a broker’s record and includes information such as disciplinary problems, customer complaints, bankruptcy and criminal records. Some information does not make it to the CRD because the broker or brokerage firm failed to file it or was not required to disclose it.

There are times, however, when information should go onto a broker’s permanent record and it does not. For instance, a Wisconsin arbitration panel ordered a Wisconsin brokerage firm to pay $86,500 to a Milwaukee investor who filed a complaint alleging unsuitable investments, unauthorized trading and churning. The arbitration complaint accurately identified the broker by name, yet a full two years after the order, the information did not appear on the broker’s CRD. Even though investors and arbitrators can get detailed history on a broker’s background, there is no guarantee that all complaints and awards will be recorded.

8) What is the difference between a broker, an investment adviser and a financial planner? Brokers generally collect commissions based on the transaction while advisers and planners charge a flat advising fee or take a percentage of the investors’ assets under management for their services. However, today some brokers charge a percentage of assets while other planners may charge commissions. In essence, the investment functions of each can overlap with one another thereby blurring the distinction between the three. There is a much higher degree of overlap today than there was even ten years ago. Going forward, the line should blur even further.

9) Who regulates investment advisers and financial planners? Brokers must register with the NASD and be licensed by the states in which they do business. Financial planners, money managers and other advisers must be licensed as “investment advisers” by their states, or if they have $25 million or more under

4


Investor Rights for the 21st Century management, by the SEC. Even accountants and lawyers who provide financial advice must be licensed as investment advisers by securities regulators, unless the advice is “incidental” to their main business.

10)

Are most investment professionals unethical?

No. Even though investment abuses are widespread, underreported and extremely costly to defrauded investors, many investment professionals are honest and do add a great deal in performance to their investor’s returns. Good stockbrokers, financial planners and money managers are extremely valuable. Financial planning is not like learning how to knit. It cannot be learned on the weekends. Like any profession, it is the minority of dishonest and unethical stockbrokers, insurance agents, financial planners and accountants that cause most of the problems and bad publicity.

11)

What is the major reason for investment abuses?

There are many reasons why investors get taken advantage of by their investment advisor. Probably the most common reason is greed on the part of the registered representative. Though the securities industry is attempting to move away from commission based transactions with investors, the vast majority of all securities transactions are still commission based. For instance, insurance agents and financial planners may receive commissions of up to 7 percent on annuities, which they share with their firm. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stocks or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to sell a product that might not be suitable for the investor because the one who is making the recommendation gets paid more.

12)

What is another cause for investment abuses?

Unfortunately brokers and investment advisers prey and feed off of investors’ ignorance. An uninformed investor is generally less likely to ask questions because often he is too embarrassed to admit his lack of knowledge. For example, a survey done by the AARP in 1998 showed that 64 percent of those investors surveyed were unaware that brokerage

5


Maddox / Stoltmann firms often pay higher commissions for the sale of riskier investments and 15 percent of those surveyed did not even know that they paid a commission or markup to buy or sell stocks, mutual funds or bonds. Those surveyed were investors who had used financial advisers and brokers in the past.

A study from the Columbia University Graduate School of Business found that out of 3,300 mutual fund investors surveyed, 72 percent didn’t know if they were invested in domestic or international mutual funds and 75 percent didn’t know if they were invested in equity or fixed income funds. Unethical brokers, financial planners and insurance agents thrive off of ignorance and generally prefer that their clients stay uninformed.

13)

What securities firms have had problems in the past?

The question with a much shorter answer is which securities firms have not had problems. Most well known firms budget millions of dollars annually to pay their attorneys and damaged investors through arbitration awards. In the insurance field, one well-known company defrauded tens of thousands of investors and eventually was forced to pay investors $2 billion for the firm’s fraudulent sales practices. In the brokerage industry, a regional firm paid investors over $138 million due to losses that were incurred in a short term, government bond fund that plunged in value after a surge in interest rates battered the funds massive holdings in mortgage derivatives. By definition, the fund should have been one of the safest mutual funds in existence. In 1996, one of the largest brokerage firms in the nation agreed to pay $250 million, including a total of $45 million toward a restitution fund and civil penalty, to settle an SEC civil administrative complaint and related class action claims that some of its brokers misled investors in selling hundreds of millions of dollars in limited partnerships. In 1997, another well-known brokerage firm agreed to pay approximately $70 million to settle allegations that the firm’s dealers unfairly kept prices and profits in NASDAQ stocks unduly high between 1989 and 1994. Unfortunately, the list goes on and on.

6


Investor Rights for the 21st Century

14)

Are discount brokerage firms immune from defrauding investors?

Absolutely not. In 1998, a well known “full service discount firm” was fined over $5 million by the SEC for fraudulent sales practices. The firm’s brokers were found to have been pressured by management to sell particular stocks in the firm’s inventory where the brokers would receive a markup on the stocks from six cents a share to over a dollar a share, all the time the firm was advertising “commission free” trades.

Many other discount brokerage firms now provide research reports, generate investment ideas for their clients, provide “unbiased” advice on mutual funds, provide 24 hour access to brokers over the phone, recommend certain industries to purchase stocks from and asset allocate the portfolios for the firm’s clients. One firm’s co-CEO rhetorically asked in a SmartMoney article in 1998 that if what his firm provides is not full service, then what is? These are the traditional functions that full service brokerage firms provide to their clients and therefore in many cases, the “discount” firms have the same stringent legal obligations as full service brokerage firms.

15)

Are online investment firms immune from defrauding their clients?

No. There are an increasing number of arbitration claims being filed against online brokerage firms. In 2000, 214 claims against online firms were filed, up from none in 1998. The authors’ law firm commenced an arbitration claim against one of the largest online brokerage firms alleging margin account and suitability abuses. The client, a 27 year-old graduate student with virtually no investment experience, lost more than $40,000 in savings for medical school by trading Internet stocks in his margin account. The online firm gave the investor no warning that a margin call was imminent and virtually no time to meet his margin call before they sold the investor out at a substantial loss. Fortunately, he was able to recover his losses. The market volatility in the spring of 2000 led to hundreds, if not thousands, of other unauthorized margin liquidations for clients of online firms.

7


Maddox / Stoltmann In February of 2001, one of the nation’s largest online firm’s was fined $225,000 by the New York Stock Exchange Division of Enforcement for engaging in “conduct inconsistent with just and equitable principals of trade” including a failure to maintain appropriate procedures for supervision, maintaining inadequate telephone systems, allowing multiple non-exchange registered employees to engage in activities that required registration and failing to report, as required under the Exchange rules, over 18,000 complaints. As online trading continues to grow, arbitration complaints against ebrokers will continue to increase.

16)

Are accountants immune from defrauding investors?

No. Today, accountants sell investments and manage money just like full service brokers. A survey of accountants by the American Institute of CPAs concluded that 12 percent of their 329,000 members surveyed are already receiving fees and commissions relating to financial advisory services. At least 35 states have enacted legislation permitting accountants to receive commissions, which was once completely forbidden in the accounting industry. It is much more common today for investors to complain about abuses caused by the management of their portfolio by their accountants than even five years ago.

17)

Are banks getting in on the investment business?

Yes, and unfortunately many of the same abuses caused by full service firms are now occurring at banks. For example, in 1998, a well-known national bank agreed to pay $6.75 million in fines to settle federal charges that it misled mostly elderly investors by marketing volatile securities as safe banking products. An investor must take all of the same precautions when dealing with a bank as would be taken when dealing with a full service broker.

8


Investor Rights for the 21st Century

The Investment Products and their Abuses 18)

Stocks

The most common disputes in arbitration continue to involve individual stocks. Individual stock recommendations continue to be one of the broker’s favorite vehicles for defrauding investors. At the end of 1999, American households possessed over $5.4 trillion in individual stocks, which was second behind only the $7.4 trillion in pension funds. An individual stock purchased at a full service firm costs approximately 1 percent of the purchase price. While this may not seem to be a large amount, the commissions can pile up quickly if a broker trades frequently in the investor’s account.

Investment abuses with individual stocks are well documented. However, in recent years, more complaints are surfacing dealing with initial public offerings or IPOs. It is common for brokers to make misrepresentations and false claims concerning IPOs. The temptation is great for brokers to “sell the sizzle” and make guarantees on returns and inaccurate price forecasts with IPOs because investors generally only hear about the highly successful IPOs like Microsoft and Apple and not the hundreds of poor performing IPOs. A study commissioned by the Midtown Research Group in New York showed that of 341 IPOs in 1997 that exceeded $20 million, 55 percent traded below their IPO price and 24 percent were down more than 50 percent at the time of the study.

IPOs are typically unsuitable investments for many investors. Brokers will use an IPO to convince relatively conservative investors to start purchasing individual stocks. The IPO serves as a “lure” to convince investors to take more risk than the broker knows is appropriate. IPOs are often high-risk, speculative investments. There is never a guarantee that an IPO will open above the price that the investor paid. When coupled with the compensation that brokers usually receive from IPOs, which is typically greater than a traditional stock purchase, it is no surprise that brokers find IPOs so attractive to sell. Firms that bring many companies public will often use future IPO allocations as a recruiting tool when trying to hire brokers from other firms.

9


Maddox / Stoltmann

19)

Bonds

Bonds are one of the investments that are the least understood by investors. As a result, few other investments are as wrought with as many abuses as bonds. First, brokers typically do an awful job of disclosing the risks associated with bonds. Brokers sell bonds as a conservative investment, when in fact many times they are not. Government bond funds often load up on mortgage-backed bonds such as Ginnie Maes to increase their yields. While these bonds are backed by the government, they can still be very volatile due to changing interest rates. This is typically not disclosed to investors.

Brokers also fail to tell investors that any bond, regardless of whether it is a government bond or an AAA rated bond, can lose money if it is not held to maturity. For example, a government bond purchased when interest rates are at five percent will plummet in value if interest rates subsequently rise to seven percent. If an investor sells her bond at that point, she will have a loss on the safest investment available.

Another problem is that unlike stocks and mutual funds, bond prices are not readily discernable to most investors. In the usual principal transaction, a broker buys a bond at one price and sells it to the investor at a higher price and the broker and brokerage firm pocket the difference. When a broker buys a bond from an investor, they do the opposite, charging a “markdown.” Unfortunately, bonds do not trade on an exchange, meaning investors have little way of gauging the actual market price. The NASD only requires that bond markups be “fair.”

Another problem investors need to be wary of is that brokers are often given financial incentives to push one bond over another. Brokers receiving extra compensation for selling certain products is a significant problem in the securities industry and is especially common for fixed income products. Brokers will push a bond from their firm’s inventory because they can make more in commissions. Instead of recommending a bond to a customer because it is suitable or the best fit for that investor’s portfolio, brokers are encouraged by their compensation system to recommend one bond over another because of the higher payout that the firm’s inventoried bonds provide. Unfortunately, brokers

10


Investor Rights for the 21st Century usually receive more in compensation for selling lower quality bonds, which often takes precedence over suitability considerations.

20)

Mutual Funds

One of the major problems investors face with mutual funds is the high degree of switching between different funds. Mutual funds are one of the most popular investments that stockbrokers and financial planners sell to their clients in large part because the commissions are so high. For “A” shares, still the most frequently sold share type, the brokerage firm receives approximately 4 percent up-front on the purchase price for a load mutual fund and a “trailer” commission each year based on the amount of money in the fund. The “trailer” is usually a very small percentage of the assets in the fund averaging anywhere from approximately 5 basis points (1/20 of 1 percent) to 25 basis points (1/4 of 1 percent).

Even though most mutual funds should be held for a minimum of five years, the average holding period for growth and value funds is under three years. Brokers are a big part of the problem. If a broker can convince a client to sell one mutual fund and purchase another one from a different family of funds, the broker can receive another 4 percent commission instead of the lesser yearly “trailer” commission. Brokers find it an easy sell to convince investors to liquidate a mutual fund that is not the current year’s hot fund.

The high degree of switching is caused, in part, by brokers failing to distinguish between investment returns and investor returns. What many investors fail to realize is that there is a major difference between investment returns (what the mutual fund’s total return is from January 1st, to December 31st) versus investor return (what the investor who invests in that mutual fund actually receives as a total return).

For example, from 1984 to 1995 the average stock mutual fund posted a yearly investment return of 12.3 percent. An impressive result especially when compared to the long-term returns for stocks. However, the average investor return over that same time frame was only 6.3 percent while the average investor in a bond mutual fund earned 8

11


Maddox / Stoltmann percent. In other words, the average mutual fund bond investor did better than the average mutual fund stock investor during one of the greatest eleven year time periods in the history of the market!

There are a number of reasons for this discrepancy between what the average mutual fund returns and what the average investor who invests in those mutual funds receive. One of the major causes, however, is that brokers and financial planners generally sell investors whatever the newest, hottest mutual fund that is currently being touted. Typically, by the time the investor gets into the fund, most of the gains have already been made. The broker then has an easy sell a year or two later when he touts the new, hot, popular mutual fund. The broker’s incentive is a large commission from the purchase of the new mutual fund coming on the heels of the previous load commission from a year or two back.

21)

Margin

Margin is an extremely popular tool brokers use to take advantage of investors. A margin account allows customers of the brokerage firm to buy securities with money borrowed from the firm. The customer pays an agreed upon interest rate to the brokerage firm for the right to borrow the money. The Federal Reserve requires that investors making their initial purchase of a stock must pay cash for no less than fifty percent of the price. This is known as a margin requirement. A margin call is a demand that an investor deposits enough money or securities to bring a margin account up to the minimum requirement. If the investor fails to respond, securities in the amount will usually be sold.

One reason why margin accounts are so popular with brokers is because they give the client extra buying power. This extra buying power can be used to purchase more securities and therefore generate more commissions for the broker. One of the problems with margin accounts, though, is that many brokers are using margin for investors who are inexperienced or do not understand the risks involved with these accounts. Brokers fail to inform investors that the risks with margin accounts are extremely high. Often, the first time an investor learns about the risks inherent in a margin loan is after the investor 12


Investor Rights for the 21st Century receives a margin call and extensive loses are sustained. Brokerage firms and brokers typically do not do an adequate job of disclosing the risks to investors before they take out a margin loan.

Unfortunately, margin abuses increased dramatically in 2000 and 2001. In 1997, there were only 25 margin complaints filed with the NASD compared to 284 in 2000. Through March of 2001, the number of margin complaints was 98. If the trend continues through the rest of 2001, there will have been almost 400 margin complaints filed with the NASD, almost a 16-fold increase in only four years.

22)

Annuities

One of the major problems with annuities is that brokers have an extra incentive to sell variable and fixed annuities due to the high payouts that they provide. Annuities are typically sold, not bought. Insurance agents, stockbrokers and commission-paid financial planners can receive a payout of up to 7 percent on annuities, which they share with their firm. Very few investment products pay this well. Load based mutual funds pay only, on average, 4 percent to the registered rep. Selling stock or bonds pay the representative only 1 percent. Therefore, the incentive in many instances is to force a product that might not be suitable for the investor because the one who is making the recommendation gets paid more.

A second problem with annuities from the investor’s perspective is that annuity expenses are often extremely high. Investors pay the traditional annual management fee just like they would with a traditional mutual fund. However, with annuities there is an extra layer of fees. In addition to the investment fee on the portfolio, there is a “mortality and expense risk� charge, typically 1 percent or more a year. In 1999, the expenses (the portfolio management fees plus the mortality charge) averaged a hefty 2.1 percent a year. That is double what it costs to manage the average mutual fund and ten times what it costs to manage the Vanguard Index 500 fund.

13


Maddox / Stoltmann The best evidence of how attractive annuities are to financial representatives is that in 1998, approximately $21 billion of annuities sold went into IRAs. One of the major advantages of annuities that financial planners, brokers and insurance agents push is that annuities are mutual funds that allow for tax deferred growth. That is undoubtedly true. However, putting an annuity in an IRA is virtually useless. There is no legitimate reason to put a tax-deferred investment like an annuity into a tax-deferred account like an IRA because an investor is already getting the benefit of tax deferred growth via the annuity.

23)

Options

Not a great deal needs to be said about options. Though there are some option strategies that are conservative in nature, most options are inherently speculative and should only be used with a highly sophisticated, experienced investor. Most brokerage firms have relatively strict criterion for who can buy, sell and trade options. Options are usually not a suitable investment for most individual investors.

24)

Fee Based Accounts

Many brokerage firms are moving toward fee based compensation for their brokers which claim to align the broker’s interests along with those of the investor. With a fee based account, an investor is usually charged anywhere from half a percent (50 basis points) to three percent (300 basis points) annually. The investor then receives a substantial number of stock purchases and sales a year with no commission being charged on the individual stock transactions.

Despite the grand claims made by the brokerage firms, often the fee-based account does not serve the intended purpose of what it was designed to do. Brokers infrequently place active investors (AKA profitable investors) into a wrap or fee based account. The feebased account is often used to increase income from buy-and-hold investors. While a buy and hold strategy is usually the best option for an investor, that client does not generate much, if any, revenue for the broker. The solution for the broker and brokerage

14


Investor Rights for the 21st Century firm? Put the investor into a fee-based account and charge the investor up to three percent annually.

Often, there are other problems investors face with these accounts. For example, many fee accounts base the annual management fee off of the gross assets under managementincluding assets bought on margin. Therefore, brokers have an inherent incentive to use margin to increase the total account value, thereby increasing their fee. Assuming a one percent annual fee on a $100,000 account, a broker who utilizes margin for another $100,000 in the account can double his fee, regardless of the suitability of the margin.

Equally problematic is that the management fee is not usually based on a rolling average of the assets under management but rather it is calculated based on the total assets in the account, as of a particular day at the end of the quarter. Therefore, if a broker buys stock on margin just prior to the date the fee is calculated, he gets a larger fee. Many times, there are other undisclosed commissions or markups a broker can receive for buying certain investments being recommended by the brokerage firm. The client usually has no idea of these extra fees.

25)

What other investment products or scams do investors need to be wary of?

The North American Securities Administrators Association annually releases their “Top 10 Investment Scams.” For 2001, they listed the following scams:

1. Unlicensed individuals, such as life insurance agents, selling securities. To verify that a person is licensed or registered to sell securities, call your state securities regulator. If the person is not registered, don’t invest. In Indiana, 11 of the 16 “cease and desist” orders issued by the Securities Division in the first quarter of this year have targeted insurance agents who were selling securities without the proper license. Most were independent life insurance agents.

2. Affinity group fraud. Many scammers use their victim’s religious or ethnic identity to

15


Maddox / Stoltmann gain their trust – knowing that it’s human nature to trust people who are like you – and then steal their life savings. From “gifting” programs at some churches to foreign exchange scams targeted at Asian Americans, no group seems to be without con artists who seek to exploit others for financial gain. In Texas, an Indian immigrant who taught Sunday school took fellow Indian parishioners – roughly 40 families in all – for over $1 million.

3. Payphone and ATM sales. In early March of 2001, 25 states and the District of Columbia announced actions against companies and individuals – many of them independent life insurance agents – that took roughly 4,500 people for $76 million selling coin-operated customer-owned telephones. Investors leased payphones for between $5,000 and $7,000 and were promised annual returns of up to 15 percent. Regulators say the largest of these investments appeared to be nothing but Ponzi schemes.

4. Promissory notes. Short-term debt instruments issued by little-known or sometimes non-existent companies that promise high returns – upwards of 15 percent monthly – with little or no risk. These notes are often sold to investors by independent life insurance agents. In Indiana, 18 elderly investors lost some $1.4 million in a promissory note scam. An 80-year-old woman lost her life savings of $324,000. The perpetrators – who diverted the money to offshore bank accounts, made first-class business trips to China, India and Greece and bought expensive cars – even knelt in prayer with their victims to gain their trust.

5. Internet fraud. Scammers use the wide reach and supposed anonymity of the Internet to “pump and dump” thinly traded stocks, peddle bogus offshore “prime bank” investments and publicize pyramid schemes. Roughly half the states have Internet surveillance programs that watch for fraud or investigate investor complaints.

6. Ponzi/pyramid schemes. Always in style, these swindles promise high returns to investors, but the only people who consistently make money are the promoters who set them in motion, using money from previous investors to pay new investors. Inevitably,

16


Investor Rights for the 21st Century the schemes collapse. Ponzi schemes are the legacy of Italian immigrant Charles Ponzi. In the early 1900s, he took investors for $10 million by promising 40 percent returns from arbitrage profits on International Postal Reply Coupons.

7. “Callable” CDs. These higher-yielding certificates of deposit won’t mature for 10- to 20 -years, unless the bank, not the investor, “calls,” or redeems, them. Redeeming the CD early may result in large losses – upwards of 25 percent of the original investment. In Iowa, for example, a retiree in her 70s invested over $100,000 of her 97-year-old mother’s money in three “callable” CDs with 20-year maturities. Her intention, she told her broker, was to use the money to pay her mother’s nursing home bills. Regulators say sellers of callable CDs often don’t adequately disclose the risks and restrictions.

8. Viatical settlements. Originated as a way to help the gravely ill pay their bills, these interests in the death benefits of terminally ill patients are always risky and sometimes fraudulent. The insured gets a percentage of the death benefit in cash, investors get a share of the death benefit when the insured dies. Because of uncertainties predicting when someone will die, these investments are extremely speculative. In a new twist, Pennsylvania regulators say “senior settlements” – interests in the death benefits of healthy older people – are now being offered to investors.

9. Prime bank schemes. Scammers promise investors triple-digit returns through access to the investment portfolios of the world’s elite banks. Purveyors of these schemes often target conspiracy theorists, promising access to the “secret” investments used by the Rothschilds or Saudi royalty. In North Dakota, state securities regulators are alleging a small group of salesmen, including a local pastor, used religion and family ties to bilk investors out of $2 million in a prime bank scam.

10. Investment seminars. Often the people getting rich are those running the seminar, making money from admission fees and the sale of books and audiotapes. These seminars are marketed through newspaper, radio and TV ads and “infomercials” on cable television.

17


Maddox / Stoltmann

The Most Common Types of Arbitration Complaints 26)

What securities are involved in arbitrations?

Securities arbitrations involve all different types of securities. However, certain securities appear in more arbitrations than others. In 2000, the most common security involved in arbitrations at the NASD were common stocks with 2,018 claims filed. The second most common security type in NASD arbitration in 2000 were options with 299 cases filed followed by mutual funds (261), corporate bonds (141) and limited partnerships (72).

27)

How much compensation was awarded to customer Claimants at the NASD in 2000?

In 2000, customer Claimants were awarded $76 million, which was comprised of $21 million in punitive damages and $55 million in non-punitive damages. In 1999, customer Claimants were awarded $126 million ($48 million in punitive damages and $78 million in non-punitive damages). The punitive damage number can be misleading, however, since a significant percentage of the punitive damages awarded were against defunct, bankrupt brokerage firms which makes collectibility almost impossible.

Misrepresentations and Omissions 28)

What is a misrepresentation or omission?

A broker may be liable to a customer if the broker misrepresents material facts (lies) or fails to disclose material facts (leaves out important information) to the investor in the sale or recommendation of an investment. Usually, misrepresentations or omissions disguise the risk associated with a particular investment. The broker has a duty to fairly and accurately disclose all of the risks associated with an investment and not just the bullish, optimistic sale points.

18


Investor Rights for the 21st Century

29)

How common are misrepresentations and omissions?

In 2000, there were approximately 1,321 cases filed with the NASD alleging a broker misrepresented a material fact or failed to disclose material information to an investor.

30)

What is an example of a misrepresentation or omission?

Examples of an omission might be if a broker fails to disclose to an investor that the individual company he is recommending lost money in the previous three years or the brokerage firm is charging the customer an undisclosed commission or markup. If a broker told an investor that the stock being recommended had a new drug pending before the Food and Drug Administration and that was not the case, that would at a minimum be a misrepresentation.

Breach of Fiduciary Duties 31)

Is a stockbroker a fiduciary for the customer?

In many cases, yes. In the past, some courts and arbitrators have said there is always a fiduciary relationship between the investor and broker. A broker is generally considered the agent of a customer. As a customer’s agent, the broker owes certain duties to the customer. The level of duty that is owed to the customer can only be determined by evaluating the entire relationship between the broker and the investor. In many circumstances, the duty between a broker and his customer is considered to be a fiduciary duty.

32)

How common is it for a broker to breach his or her fiduciary duties to the customer?

Unfortunately, it is very common. In 2000, a broker breaching a fiduciary duty was the most common type of abuse perpetrated against investors with 2,489 complaints filed with the NASD.

19


Maddox / Stoltmann

33)

How do arbitrators decide whether there is a fiduciary relationship or not?

To determine the duty of a broker to his customer, arbitrators may evaluate the following factors, just to name a few: a) the sophistication of the investor; b) the customer’s prior investment experience; c) the representations of the broker; d) the ability of the customer to verify the broker’s representations; and/or e) degree of faith the investor places in the broker.

34)

What is the result when a broker is classified as a fiduciary?

When a fiduciary relationship exists between a broker and his client, the broker automatically owes his client a very high standard of care and therefore must unequivocally act in the best interests of the investor. The broker owes the client the highest possible duty of care and loyalty. A deviation from these obligations would result in almost automatic liability against the broker. However, regardless of whether there is or is not a fiduciary relationship, at the very least, the broker has an obligation to act in good faith, and with honesty and integrity.

Suitability 35)

What is an unsuitable recommendation?

An unsuitable recommendation is one which, in light of the investor’s objectives and background, the broker knows or should know is inappropriate. For instance, if a broker recommends to a 65 year-old investor to short sell a technology stock when the broker knows the investor’s investment objective is current income or long-term growth, then the broker will have made an unsuitable investment recommendation.

20


Investor Rights for the 21st Century

36)

How common are suitability claims?

In 2000, there were 900 cases filed against brokers at the NASD alleging unsuitable investment recommendations. A survey done by Prophet Market Research & Consulting in 1996 helps illustrate how wide spread the problem is of brokers and financial planners making unsuitable investment recommendations. The research company surveyed the sales practices of 21 of the nation’s largest full service brokerage firms using 93 “mystery shoppers” presenting themselves as unsophisticated, first time investors. The survey found that brokers handed out specific investment advice to more than half of the mystery shoppers without asking even the most basic questions about their finances, such as their tax bracket or income level. Incredibly, almost half of the shoppers were recommended stock mutual funds and nearly a quarter were pitched individual stocks without the broker profiling the investor.

A broker cannot make a suitable recommendation without finding out detailed information such as the investor’s tax bracket, income level, investment objectives and risk tolerance level. Unfortunately, the Prophet survey confirms what occurs on a regular basis: brokers and financial planners do not adequately profile their clients and this in effect makes it nearly impossible for many brokers to make suitable investment recommendations.

37)

Why would a broker make an unsuitable recommendation?

Extra compensation is one very common reason. Brokers make varying amounts of compensation depending on the type of security sold to the investor. For example, a broker can make considerably more in commissions by selling lower priced stocks, unit investment trusts, limited partnerships, options, new issues and in house mutual funds than by purchasing conservative certificate of deposits, T-bills or money market funds. The broker therefore has a built in incentive to sell speculative investments, regardless of suitability considerations, than more conservative (and often more suitable) securities. The mentality of many stockbrokers is to try to fit a square peg in a round hole rather than making an individualized determination based off of the facts and circumstances of

21


Maddox / Stoltmann that individual investor. Often, brokers use compensation as the primary means for determining suitability.

38)

What is the NASD Suitability rule?

NASD Conduct Rule 2310 mandates that: a) “In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and his financial situation and needs.”

b) “Prior to the execution of a transaction recommended to a non-institutional customer…a member shall make reasonable efforts to obtain information concerning: (1) the customer’s financial status; (2) the customer’s tax status; (3) the customer’s investment objectives; and (4) such other information used or considered to be reasonable by such a member or registered representative in making recommendations to the customer.”

39)

What is the New York Stock Exchange “Know Your Customer” rule?

NYSE Rule 405 mandates that “Every member organization is required…to use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…”

40)

Is there a difference between the NASD’s Suitability rule and the NYSE’s “Know Your Customer” rule?

Yes. An important difference between the NASD and NYSE rules outlined above is that there is arguably a question as to whether the NASD suitability rule is only applicable

22


Investor Rights for the 21st Century when a broker recommends an investment while NYSE Rule 405 applies anytime any investor makes any type of transaction with a brokerage firm, regardless of who recommended it.

The NYSE essentially requires its members to ensure that an investment is suited to a client’s needs and circumstances before making the sale, even if the transaction was the investor’s idea. In comparison, if a customer trading through an NASD firm buys a stock that has not been recommended by the broker, the firm arguably is not under an obligation to evaluate whether the investment is appropriate (or at least it is not as clear cut).

As online trading continues to grow, this distinction becomes more important. A customer of an NASD deep discount e-broker member firm who trades his way into huge losses from an inappropriately risky investment might have a hard time recovering on suitability grounds (clouding the issue tremendously, however, is the fact that many online firms like E*Trade, Charles Schwab and Ameritrade offer research reports and other services that do make specific recommendations.)

However, a customer at a NYSE member firm will have an easier chance to recover his or her losses due to NYSE Rule 405. NYSE member firms have an obligation to, as the Rule states, “use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization…” Simply because the firm does not recommend an investment or transaction does not shield them from liability. The online firm cannot escape liability by saying “it was the customer who wanted to do the trade and therefore our hands are free.”

41)

Should the same suitability standards that apply to traditional full service brokers also apply to online brokerage firms?

Yes. Day/short-term trading at online brokerage firms threatens billions of dollars in the retirement and brokerage accounts of this nation’s small, inexperienced individual

23


Maddox / Stoltmann investors. In order to protect the least experienced investors, the NASD needs to clearly extend the suitability rules that full service brokerage firms face to the online firms.

The growth of online trading is well documented. At the end of 1999 there were approximately 7.5 million online trading accounts nationwide. By the end of 2000, that number was expected to swell to 10.5 million according to Concord, Mass.-based Gomez Advisors. By 2002, the number is expected to reach 18 million.

Online firms actively promote themselves as a substitute for full service brokerage firms. Yet they try to hide behind their standing as an online firm to claim they have no obligations for their investor’s actions. Since many online brokerage firms are positioning themselves as a type of less expensive, full service firm, they must also be forced to abide by the same suitability standards as full service firms.

Online firms offer what looks like the same detailed research that the full service firms provide to their customers. E*Trade customers have access to work from BancBoston Robertson Stephens. Investors who use Fidelity.com now can get research from Salomon Smith Barney Inc. Discover Brokerage Direct investors have access to Morgan Stanley Dean Witter & Co. stock picks. And investors who use Charles Schwab Corp.'s Schwab.com can choose research from either Credit Suisse First Boston Inc. or Hambrecht & Quist Group.

Almost all of the major online firms also provide financial planning tools on their website that permit customers to specify certain criteria and then, based on those criterion, presents customers with investment alternatives. Most online firms provide research dealing with particular companies and their securities. Many e-brokers have links from their websites to external sites that reference and address particular pre-chosen securities.

When online brokerage firms provide research reports, generate investment ideas for their clients, provide chat rooms that allow investors to discuss investment ideas and send out price and news alerts on individual companies these activities can only be viewed as an

24


Investor Rights for the 21st Century implicit sales solicitation and an encouragement to trade. The technology offered by these firms is extremely enticing to novice and inexperienced investors.

Equally important is that online firms actively promote themselves through their advertising and marketing as a substitute for full service firms while at the same time downplaying the risks of day/short-term trading. Charles Schwab’s new advertising campaign pushes the firm as a “full-service electronic investing” firm even though Schwab made its name as a discount broker. Discover Brokerage Direct runs an ad featuring a tow truck driver shocking his towing customer with claims of his online day trading profits and the purchase of his own island-in reality, the driver says, it is a country.

Online brokerage firms must be required to make a threshold determination that the investor's strategy is appropriate for that investor. Online firms must be required to first determine if a day trading strategy is suitable or too risky for particular investors. The state does not allow a person to have a driver license without a showing of competence in driving. Nor should online brokerage firms be able to look the other way when an inexperienced investor with limited investment assets is looking to commit financial suicide by engaging in a high-risk day trading strategy.

During the account opening stage, the e-brokerage firm should be required to tell the investor that his or her account will be monitored for unusual activity and to present the customer with a “pick list” of activities that will be monitored, such as: frequency of trading, efforts to liquidate more than a specified percentage of account assets and purchases and sales that exceed a certain amount of money. If the investor's trading activity runs counter to the initially stated customer investment goals and financial situation, then the online firm must be compelled to intervene.

25


Maddox / Stoltmann

42)

What is the NASD’s position on online suitability obligations for e-brokers?

In March of 2001, the NASD released Notice To Members 01-23 (NTM 01-23) which addressed, for the first time, the suitability obligations of online brokerage firms. Specifically, NASD NTM 01-23, while disclosing "whether a particular transaction is in fact recommended depends on an analysis of all the relevant facts and circumstances," reasoned that a key factor in determining when online suitability obligations are triggered is whether a "communication from a broker/dealer to a customer reasonably would be viewed as a 'call to action,' or suggestion that the customer engage in a securities transaction." NTM 01-23 concluded "[T]he more individually tailored the communication to a specific customer or a targeted group of customers about a security or group of securities, the greater the likelihood that the communication may be viewed as a 'recommendation.'"

NTM 01-23 considers the following scenarios to be recommendations, with the suitability obligations therefore attaching:

-a firm provides a portfolio tool that allows a customer to indicate an investment goal and input personalized information such as age, financial condition and risk;

-a firm sends a customer specific electronic communications i.e. an email or popup screen;

-a member sends a customer an email stating that the customer should be invested in stocks from a particular sector.

While NTM 01-23 is a good first step by the NASD, it clearly does not go far enough. Online firms should have the obligation to monitor all accounts at their firm to ensure the trading is consistent with the investment objectives listed on the new account application. For example, if a 65 year-old online investor discloses when opening an account that her objectives are conservative income and immediately engages in a high risk strategy of

26


Investor Rights for the 21st Century shorting technology stocks, online firms should have the obligation, at a minimum, to contact that investor to inquire why there is such a dramatic discrepancy between her listed investment objectives and actual investment purchases. While online firms would likely argue this is too paternalistic an obligation, when dealing with investors’ life savings and retirement funds, online firms should have the threshold responsibility to ensure the investments are suitable since the result of an unsuitable investment strategy is many times financial devastation. The obligation is even greater when it is discovered that many online firms target less experienced investors who are typically the most likely to be swayed by the frequent barrage of encouragement by online firms to actively trade.

Failure to Supervise 43)

Does a branch manager or brokerage firm have an obligation to supervise the financial professionals working for the firm?

Yes. Brokerage firms and their managers have an absolute obligation to supervise their employees and attempt to prevent securities violations. NASD Conduct Rules require brokerage firms to establish and enforce written procedures for supervising the activities of registered representatives, reviewing customer accounts and keeping records. Failure to reasonably do so will make the brokerage firm liable.

NASD Conduct Rule 3010 outlines the brokerage firm’s obligation to supervise. Specifically, 3010 requires:

(a) Supervisory System Each member shall establish and maintain a system to supervise the activities of each registered representative and associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations, and with the Rules of this Association. Final responsibility for proper supervision shall rest with the member. (b) Written Procedures Each member shall establish, maintain, and enforce written procedures to supervise the types of business in which it engages and to supervise the activities of registered

27


Maddox / Stoltmann representatives and associated persons that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with the applicable Rules of this Association. (c) Internal Inspections Each member shall conduct a review, at least annually, of the businesses in which it engages, which review shall be reasonably designed to assist in detecting and preventing violations of and achieving compliance with applicable securities laws and regulations, and with the Rules of this Association. Each member shall review the activities of each office, which shall include the periodic examination of customer accounts to detect and prevent irregularities or abuses and at least an annual inspection of each office of supervisory jurisdiction. Each branch office of the member shall be inspected according to a cycle which shall be set forth in the firm’s written supervisory and inspection procedures. In establishing such cycle, the firm shall give consideration to the nature and complexity of the securities activities for which the location is responsible, the volume of business done, and the number of associated persons assigned to the location. Each member shall retain a written record of the dates upon which each review and inspection is conducted.

44)

How common are claims for failure to supervise?

In 1998, failure to supervise claims were the fourth most common type of abuse alleged by investors with approximately 1,270 claims filed with the NASD.

Unauthorized Trading 45)

When does unauthorized trading occur?

Unauthorized trading occurs when a broker makes a trade in a client’s account without having either written or oral authority to do so. Brokers need to get their client’s explicit authorization before each and every trade unless it is a discretionary account. Failure to do so makes the broker liable for engaging in an unauthorized transaction.

28


Investor Rights for the 21st Century

46)

How common are unauthorized trading abuses?

Investors filed approximately 611 unauthorized trading claims with the NASD against financial professionals in 2000.

47)

What is a discretionary account?

A discretionary account is a type of brokerage account where the broker gets permission from the client, upfront, to place trades in the investor’s account without the client’s approval. Therefore, a broker does not need to speak with a client before placing a trade. If the broker does have written discretionary power, then the investor cannot make a successful unauthorized trading claim.

Almost all brokerage firms have very specific, detailed procedures a customer must go through to grant a broker discretionary authority over his account. In recent years, most major brokerage firms have implemented an absolute prohibition on any type of discretionary trading due to the inherent temptations a broker faces with this type of authority. It is not hard to imagine brokers abusing their authority in managing discretionary accounts.

Negligence 48)

What is negligence with respect to a broker customer relationship?

Negligence is conduct that falls below the “legal standard” established to protect others against unreasonable risk of harm. For example, a brokerage firm that sends out monthly statements with an inaccurate account balance will have engaged in negligent conduct, at a minimum.

For an act to be negligent, the broker did not need to intend the consequence of his conduct, but a “reasonable person” in his position would have anticipated those consequences and taken reasonable precautions to guard against them. The standard of

29


Maddox / Stoltmann care that a broker owes his client is at least “reasonable care.” It is left up to the arbitrators to determine what is “reasonable.” However, arbitrators many times apply a common sense evaluation to these cases.

49)

How common are negligence claims against a broker?

1,936 negligence claims were filed against brokers with the NASD in 2000, making it the second most common type of abuse.

Churning 50)

What is churning?

Churning occurs when a broker overtrades the securities in a customer’s account for the purpose of generating commissions. Churning is a synonym for over-trading where the stockbroker advances his or her interests over the interests of the client.

51)

How common is churning?

In 2000, there were approximately 473 cases filed at the NASD alleging a broker churned an investor’s account.

52)

When does churning occur?

One definition states that churning occurs when a broker, exercising control over the volume and frequency of trading, abuses his customer’s confidence for personal gain by initiating transactions that are excessive in view of the character of the account. Some of the traditional “trademarks” of churning are high turnover, frequent in and out trading, and large commissions.

53)

Why would a stockbroker churn the investor’s account?

The reason has to do with the broker being able to make more in commissions. Most stockbrokers are still paid on a commission-based system. What this means is that a

30


Investor Rights for the 21st Century broker makes a commission for each buy or sell that occurs in a client’s account. The commission percentage is usually between one and three percent of the total transaction size. Therefore, if a broker can trade a client’s account more frequently, that means the broker will make more in “gross” commissions (brokers usually keep approximately onethird to one-half of their gross commissions) and therefore make more in take home pay.

54)

What elements must be proven in an arbitration to establish churning?

Three basic elements need to be established to prove the investor’s account has been churned. First, it must be established that the broker had control over the account. Second, trading in the account must have been excessive in light of the customer’s investment objectives. Finally, the broker must have intended to defraud the customer or had willful or reckless disregard of the customer’s interests. Most courts will simply imply the third element if the other two were established.

55)

What are the different types of control a broker can have over an investor’s account.

There are two types of control that a broker can have over an account. The first type is discretionary control. Discretionary control is where the customer gives the broker discretion as to the purchase and sale of securities, including selection, timing and price to be paid or received. The second and most common type is implied control.

56)

How is implied control over an investor’s account established?

Whether or not the customer has sufficient intelligence, understanding and market experience to evaluate the broker’s recommendation are sometimes important considerations in establishing implied control. Some of the other factors arbitrators may use to evaluate implied control are: a) the identity, age, education, intelligence, and investment and business experience of the customer;

31


Maddox / Stoltmann b) the relationship between the customer and the broker, that is, whether it is an arms length one or a particularly close relationship; c) knowledge of the market and the account; d) the regularity of discussions between the account executive and the customer; e) whether the customer actually authorized each trade; f) who made the recommendations for trades; and g) investor’s reliance on other investment advisors for advice.

57)

How important is the investor’s education level or profession in churning claims?

While these can be important factors, they are by no means the most important factors arbitrators consider. There is a significant difference between success in life or success in a field like medicine, law or business and a person’s investment sophistication. Some of the most ignorant investors are those who have reached the pinnacle in their respective career. Sir Isaac Newton, widely considered to be one of the smartest individuals ever, lost his fortune in a stock market scam.

Often, people hire a stockbroker or financial planner because they lack the knowledge in investing or do not have the time to monitor their investments. That is why they are hiring someone else to manage their money. Unfortunately, often this hands off approach is too big a temptation for a broker, financial planner or insurance agent. Many times the result is a churned account.

58)

How is excessive activity determined?

One definition of excessive activity is outlined in Hecht v. Harris, Uphan & Co. where the Court defined it as “whether the volume and frequency of transactions, considered in light of the nature of the account and the situation, needs and objectives of the customer, have been so ‘excessive’ as to indicate a purpose of the broker to derive profit for himself while disregarding the interests of the customer.”

32


Investor Rights for the 21st Century The three most common real world methods for determining excessive trading are the turnover rate, the cost equity ratio and an in-and-out trading analysis.

59)

What is a turnover rate?

The turnover rate is the number of times the average net equity is used to purchase securities. The rate measures volume rather than cost. The formula for determining the turnover rate is the dollar amount of purchases divided by the average net equity divided by the amount of time. Turnover =

Purchases

Divided by

Days in Period

Average Equity

365

For example, say an investor had $100,000 of purchases in a one-year period and the average net equity is $20,000. We arrive at a turnover rate of 5 by dividing the total purchases of $100,000, by the average net equity of $20,000. We would then divide that number by the length of time that the investment was held.

60)

What turnover rate establishes churning?

Some case law sets forth the following rules of thumb:

Turnover Rate

Excessiveness

2x

An inference of excessiveness

4x

A presumption of excessiveness

6x

A conclusion of excessiveness

It seems in the last decade the collective thought has moved to the belief that an excessive turnover rate is now lower than what it was before. A well-regarded North Carolina Law Review article entitled “A Model for Determining the Excessive Trading Element in Churning Claims� by David Winslow and Seth Anderson convincingly argued that point concluding that much lower turnover ratios constitute churning than what has been accepted in the past. The article argued that using mutual funds as an appropriate proxy

33


Maddox / Stoltmann would lead to the conclusion that a turnover rate in excess of three for any account would be evidence of churning. The article explicitly stated that courts should lower their threshold levels of the optimum turnover rates in investor’s accounts.

61)

What is the cost equity ratio?

The cost equity ratio, created in 1978 by longtime PIABA member and founder Stuart Goldberg, is used to determine the percentage of return on the client’s average net equity needed in order to pay the broker’s commissions. The cost equity ratio is computed by dividing the costs of the transactions divided by the average net equity. For instance, say a customer has a $100,000 equity account and the broker’s commissions off of the account for the year were $35,000. The cost equity ratio would be 35 percent. What this means is that the customer would have to earn a rate of return of 35 percent just to meet the expenses of the account. Considering the historical rate of return of the stock market is between 10 percent to 12 percent annually (according to Ibbotson Associates), it is easy to see why this so clearly would be considered problematic for a broker who recommended such a strategy.

62)

What cost equity ratio establishes churning?

Many commentators believe the following analysis should be utilized to evaluate if churning occurred:

Cost Equity Ratio

Excessiveness

2%

An inference of excessiveness

4%

A presumption of excessiveness

6%

A conclusion of excessiveness

It is not difficult to understand why even a two percent cost equity ratio would lead to an inference of churning. If one assumes the historical rate of return for the market is between 10 percent to 12 percent annually, trading that generates commissions of two percent means between 16 percent to 20 percent of an investor’s return (assuming the

34


Investor Rights for the 21st Century historical return) is going towards paying a stockbroker’s commissions. That is simply too much.

63)

What is in-and-out trading?

In-and-out trading occurs when the stockbroker purchases a security, resells it after a relatively short duration, and then uses the proceeds from the sale to purchase another security that is of the same general type. For example, if 1,000 shares of XYZ preferred stock is bought on August 15th and sold four weeks later on September 15th, and then the broker purchases 1000 shares of ABC preferred stock, the original two transactions could be the subject of in-and-out trading within a one month period.

64)

How does an investor establish excessiveness through the three methods?

Arbitrators usually want expert testimony and statistical data to establish “excessiveness.” While expert testimony isn’t required, an investor would be well served to have an expert testify as to this element.

65)

How is the final element of churning, an intent to defraud the customer or reckless disregard of the customer’s interests, established?

Most courts simply imply the third element if the other two elements are established. Since churning involves a conflict where the broker seeks to maximize his pay in disregard of the customer’s interests, intent tends to be obvious and therefore implied.

66)

Does a profitable account preclude an investor from prevailing on a churning claim?

No. Profitability does not preclude a claim for churning. In the bull markets of 19821987 and the 1990’s, a generally rising market masked a great deal of churning. The churning that took place in the investor’s account may have had the effect of decreasing the overall profit due to the sale of the original portfolio which might at the time of the

35


Maddox / Stoltmann filing of the statement of claim have had a market value, if left undisturbed, in considerable excess of the newly acquired securities.

67)

Is there a difference between churning and excessive trading?

Yes. Arbitrators can find that an account was not churned but excessively traded. For instance, take the investor who had $75,000 worth of purchases in a one-year period and the average net equity was $50,000. We have a turnover ratio of 1.5, which is below an inference of churning. However, if the investor was 65 years old and told the broker he only wanted to buy and hold municipal bonds, then the arbitration panel could find that the broker was liable for excessive trading, but not churning, and still award the investor damages.

68)

What are the odds of a stockbroker being able to successfully trade an investor’s account over any extended period of time?

Between slim and none. The overwhelming majority of evidence leads one to conclude that an actively traded account by a stockbroker leads to substantial fees and commissions for the broker, almost certain underperformance relative to the S&P 500 Index by the investor and a dramatically increased absorption of risk for the investor in receiving these meager returns. Paul Samuelson, a highly respected U.S. economist, summarized it best when he stated: “A respect for evidence compels me to the hypothesis that most portfolio managers should go out of business.” Replace “portfolio manager” with “stockbroker” and the truth of his statement is still accurate when it comes to market timing efforts.

Successful short term trading by a stockbroker is almost impossible. Virtually every piece of credible evidence points to the principal that the more an investor’s account is traded, the more likely the investor is to under-perform the market. Brad Barber and Terrance Odean, two professors at the University of California at Berkley, commissioned the study “The Common Stock Investment Performance of Individual Investors.” The study examined 60,000 accounts at a large discount brokerage firm (believed to be

36


Investor Rights for the 21st Century Charles Schwab) between 1991 and 1996. The study concluded that the most active accounts in terms of trading also had the lowest investment returns. The correlation between trading and performance was clearly established as being positive-the more trades in an investor’s account the lower the investment returns. The authors concluded by noting “trading is hazardous to your wealth.” The virtual impossibility of a stockbroker successfully engaging in a short term trading strategy for clients relative to the performance of the S&P 500 Index is further shown in an analysis from University of Michigan Business School Finance Professor Najet Seyhun in a study entitled “Stock Market Extremes and Portfolio Performance.” This fascinating study found that the stock market does not rise or fall steadily but rather lurches dramatically over very short intervals of time. Unfortunately for stockbrokers who believe they can time the market through trading, these movements are extremely difficult to anticipate since they happen over such short periods of time. The study found that over a 30-year period (1963 to 1993), 95 percent of the stock market gains stemmed from only 1.2 percent of the trading days. Stated another way, if a stockbroker missed the best 1.2 percent of the trading days for his client, the investor missed out on 95 percent of the stock market’s return. The study also found that over a 67-year period (1926 through 1993) more than 99% of the total return of the market was "earned" during only 5.9 percent of the months. A clear example of this phenomenon occurred in April of 2001. From March of 2000 through March of 2001, the NASDAQ declined approximately 70 percent from its peak. However, in April of 2001, in only 10 trading sessions, the NASDAQ soared 33 percent. Unfortunately, many investors missed this dramatic rebound because their stockbroker had them sitting on the sidelines, out of the market, waiting for signs that the market had “bottomed out.” Unfortunately for the customer whose account is actively traded, the only way a stockbroker can successfully identify when those top 1.2 percent of the trading days will occur is through a crystal ball and the mythical 20-20 hindsight. Nobody knows when it is that the best days in the market will occur. If a broker is trading a client in and out of securities, it is highly probable that the investor will miss out

37


Maddox / Stoltmann on the top performing days and therefore miss out on most of the market returns. Unfortunately, stockbrokers will still earn their commissions, regardless of their investor’s performance. Further demonstrating the negligence involved with a stockbroker trying to engage in a successful short term trading strategy is the concept in academic finance called skewness. The concept is based off of the premise that a stock index’s return in any year is extremely narrow and concentrated in only a few stocks. In most indexes (i.e. the S&P 500, NASDAQ or Russell 2000), it is typically only a few stocks (i.e. 5-10 stocks) that will make up a majority of that index’s return. The concept of skewness is based on the simple mathematical principal that the most a stock can decrease in any year is 100 percent but the most a stock can appreciate is unlimited. Therefore, investors need to cast a wide “net” (typically through a mutual fund) through a buy and hold strategy in order to own those unpredictable, small number of stocks that are needed in order to propel an investor’s investment return. A broker’s attempt to identify those five to ten stocks in an index like the Russell 2000, for example, is extremely difficult to do. Short term trading makes it even more likely that an investor will not enjoy the full appreciation in one of the few “highflying” stocks since they will not be held long enough to enjoy the full and complete run.

Assuming, hypothetically, that a stockbroker could accurately time the market and successfully identify stocks that would appreciate in the short term, the costs to the investor in engaging in this type of strategy would serve as such a substantial drag on the investor’s return, the account would still likely under perform the market. As noted in the Wall Street Journal in 1998 by John “Launny” Steffens, Merrill Lynch’s former Vice Chairman who was responsible for managing the firm’s 14,000 stockbrokers, “[I]f people turn their account over two to three times a year, they are guaranteed not to make money.”

There are multiple costs associated with active stock trading. The first cost incurred by an actively traded account is commission charges. Commissions typically range between

38


Investor Rights for the 21st Century one percent to three percent per transaction. When an account is actively traded, these commission costs add up quickly.

The second costs investors incur are capital gain taxes. If a broker engages in short term trading (positions held less than 1 year) for a client, then short-term capital gain taxes apply and the investor is taxed at his or her ordinary income tax rate. Typically, the individual tax rate of an investor will be higher than the long-term capital gain tax rate of 20 percent for stocks held more than one year.

A third cost incurred with an actively traded account are the spreads (the difference between the bid and the ask) associated with individual stocks. On larger capitalization stocks (i.e. Microsoft or IBM), the spread is typically about 6 cents a share. Generally, lower priced stocks trade with larger spreads. Therefore, as soon as a stockbroker buys a stock for a customer, the investor is already down in that stock. Buy and hold investors only incur the spread once and have the time to make up the initial upfront loss. The spreads tend to serve as another drag on the investment returns of actively traded accounts.

Rather than focusing on trading an investor’s account, stockbrokers need to become more like financial planners and determine what asset allocation an investor should have. The single most important decision a stockbroker makes for an investor is the asset allocation for the portfolio. According to Gary Brinson, as outlined in his now famous study entitled “Determinants of Portfolio Performance” that appeared in the Financial Analyst Journal in 1986, 94 percent of an investor’s investment return is derived not from market timing or stock selection but rather from asset allocation-how much is invested in stocks versus bonds and cash and then how each one is divided up from there. University of Chicago Professor Eugene Fama concluded in his study that 97% of all investment returns are determined by asset allocation determinations. Professor Fama concluded by saying “I’d compare stock pickers to astrologers, but I don’t want to bad-mouth astrologers.” Both Brinson and Fama’s studies support the theory that markets move in a random manner making stockbroker’s efforts to time the market almost impossible.

39


Maddox / Stoltmann

It would appear safe to assume if Wall Street’s top mutual fund managers, with access to the best investment research available and an army of stock analysts at their disposal cannot beat the market over any consistent period of time, a retail stockbroker would be unable to do it as well. Larry Swedroe, in his excellent book “What Wall Street Doesn’t Want You To Know” examines in great detail how mutual fund managers are unable to beat the performance of the plain vanilla, basic S&P 500 Index. The following facts from Mr. Swedroe’s book show how difficult it is for even the brightest minds in the securities industry to be able to outperform the market and therefore further establishing how foolish it is for stockbrokers to think that through active trading they can beat the market:

-In 1998, fewer than 20 percent of all equity mutual funds outperformed the S&P 500 Index. That figure drops to 11 percent over the previous 10 years and to just 4 percent over the previous 15 years. The four percent of money managers who did beat the Index can mainly be attributed to mere random statistical variation rather than some special insight into the stock market that others lack.

-Piscataqua Research, in a study covering the time period 1987 through 1996, found that only 10 out of 145 major pension funds (7 percent) outperformed a portfolio consisting of a 60 percent-40 percent mix of the S&P 500 Index and the Lehman Bond Index. -In the March 9th, 1998 edition of Business Week, the magazine detailed a study performed by Mark Hulbert which analyzed the performance of the portfolio of 32 market timing newsletters for the 10 years ending in 1997, a period when the S&P 500 Index was up 18 percent. The study found that the market timers’ annual average returns ranged from 5.84 percent to 16.9 percent, the average return was 11.06% and not one of the market timers beat the market.

-The same article analyzed a study done by MoniResearch, which tracked 85 managers with a total of $10 billion under management. The study found the

40


Investor Rights for the 21st Century timers annual average return ranged from 4.4 percent to 16.9 percent, the average return was 11.04 percent and none of the timers beat the market. If transactions costs like taxes and commissions were taken into consideration, the performance of the timers would have been even worse.

-In 1990, the Nobel Prize in economics was awarded to Harry Markowitz, William Sharpe and Merton Miller for their contributions to the body of work known as Modern Portfolio Theory. A major conclusion of Modern Portfolio theory is that the market is efficient at pricing securities and the current prices of securities reflects the total knowledge and expectations of all investors and no investor can consistently know more than the market does collectively. This makes it very difficult, if not impossible, for active market timers to beat the market.

Sir Issac Newton, widely considered to be one of the smartest individuals in the history of the world, summed it up best when he stated in 1768, after losing his fortune in a stock market scam, “I can calculate the motions of the heavenly bodies but not the movements of the stock market.” The foolishness of a retail stockbroker trying to short term trade the market for clients in the face of overwhelming evidence of the near impossibility of that task would almost be comical if the attempts by brokers weren’t so widespread. Unfortunately, it is the investor who pays the price in the form of lower returns, an increased assumption of risk and in many cases, the decimation of the entire portfolio.

Penny Stock Fraud 69)

Is penny stock firm fraud still prevalent?

Yes. Many experts claim that penny stock fraud is at an all time record high. Senator Susan Collins (R., Maine) stated in 1997 that “[T]he subcommittee has information that penny stock fraud is roaring back.” Investors lost an estimated $6 billion in fraudulent penny stock schemes in 1998. The New York attorney general’s office estimates final figures for 1999 may be 40 percent higher. The North American Securities

41


Maddox / Stoltmann Administration Association reported a 30 percent increase in fraud complaints last year. The group estimates that securities fraud costs American investors $10 billion a year, or $1 million every hour. Penny stock crooks typically don’t disappear but rather scatter like cockroaches only to reappear at a later time, with a different firm, with the same modus operandi.

70)

What is penny stock fraud?

Penny stock firms and their employees engage in a variety of abusive and fraudulent sales practices. Some of these practices include high pressure selling tactics, misrepresenting material facts, the omission of important negative information concerning recommended NASDAQ over the counter stocks, unauthorized trading in customer accounts and simply refusing to sell house recommended stocks.

These firms employ a systematic scheme to defraud unsuspecting investors. The organizations and their brokers generally establish credibility through misrepresentations about themselves and their firm. In the initial series of calls, these brokers will make a relatively small investment recommendation in a well-known blue chip company. Shortly after this account opening initial transaction, the account opening broker will refer the client to a “senior account executive” that has the “experience and expertise” to handle the client’s accounts. In reality, the second broker is generally a seasoned, skilled, high-pressure salesman. After the initial transaction, the brokers in these organizations only recommend house stocks. Usually, once the investor sends the penny stock firm funds, it is virtually impossible to get the money back.

71)

What can be done to rectify the problem of penny stock fraud?

One very good option would be to expand SIPC coverage to include all arbitration awards that result from fraud or other violations of securities regulations, such as suitability requirements. The nation’s financial markets have changed considerably since the SIPC was established in 1970. Brokerage firms currently pay only a nominal charge of $150 a year for SIPC coverage, regardless of their size. If investors were only charged

42


Investor Rights for the 21st Century a penny a trade that would probably cover the cost of full compensation for defrauded investors. In 1998, SIPC paid only $16 million to defrauded investors when securities fraud cost investors in excess of $10 billion. Not surprisingly, the securities industry opposes expanding SIPC coverage for such illogical reasons that it would cause investors to take less responsibility for investment decisions and lessen their incentive to question brokers about proposed or executed trades.

Attorneys and Expenses 72)

What should an aggrieved investor look for when hiring an attorney for representation in a securities dispute?

Probably the single most important factor in choosing an attorney to represent an investor in arbitration against a brokerage firm is experience in the securities arbitration field. Securities arbitration is a complex, esoteric area of law that is substantially different than traditional court litigation in many ways.

When an investor is looking for legal representation, the first question that should be asked is whether the attorney has handled securities arbitration cases in the past. If the answer is no, the investor should be very reluctant to let the attorney experiment on him. Ask the attorney whether she has handled arbitration complaints similar to the investor’s case. Find out if the attorney has securities industry experience (i.e. experience working for a brokerage firm or for a regulatory organization like the NASD or SEC). Because brokerage firms have the deep pockets to hire the best defense attorneys money can buy, it is imperative that the investor finds an attorney with extensive experience in the securities field and in securities arbitration.

73)

What about non-attorney representation?

Avoid them at all costs. Only hire a licensed attorney with experience in this area. Nonattorney representatives, who are generally unregulated, often do more harm to investors than unethical stockbrokers and brokerage firms.

43


Maddox / Stoltmann

74)

Should the investor make contact with the brokerage firm’s legal department before retaining an attorney?

No. There is virtually no better way for investors to decrease their chances for recovery than dealing with the brokerage firm’s legal department on their own. A common ploy used by many brokerage firms is to have the people who first take the complaint to be very cordial and they will sound genuinely concerned. The compliance department or legal department will ask the investor to put the complaint in writing and submit it to the legal department for consideration. Unfortunately, regardless of the validity of the investor’s complaint, the overwhelming majority of the time the brokerage firm will reject the investor’s request for remuneration.

The rejection is not particularly surprising. However, now the brokerage firm has the investor locked into a story as to what happened. If the investor later decides to pursue the complaint via arbitration and the case goes to a hearing, the brokerage firm’s attorneys will hammer the investor if the story told at the arbitration deviates one iota from what was originally written in the letter to the brokerage firm. If the investor left out one fact that was not thought to be important, the firm’s defense attorney will pounce on that seemingly innocent omission. Therefore, it is in the investor’s best interest to contact an experienced securities arbitration attorney at the first hint that there might be a problem with the broker’s actions.

75)

How are securities arbitration attorneys compensated?

There are a variety of ways that a securities arbitration attorney can be compensated. Probably the most advantageous way from the perspective of the investor is through a contingency fee arrangement. Under this type of arrangement, the attorney will only earn a fee if an award is won and the money is collected. Under a contingency arrangement, the attorney and investor’s interests are aligned to the extent an attorney has as big an incentive to recover investment losses as the investor since neither one will receive any compensation if the claim is unsuccessful. A typical contingency fee is one-third to forty percent of the amount recovered.

44


Investor Rights for the 21st Century

Some law firms or attorneys do not have the financial backing or the desire to take cases on a contingency basis due to the inherent uncertainty present in the outcome of security arbitration cases. Therefore, these attorneys take cases on an hourly basis with an upfront retainer. The client will be charged based on the number of hours that the attorney works on the case with the investor usually being billed on a monthly or quarterly basis. Hourly rates for securities attorneys vary from as low as $150 an hour too as high as $300 an hour with top attorneys charging considerably more.

76)

What type of expenses can be expected in securities arbitration disputes?

There are three major expenses that can be present in a securities arbitration dispute. First, there is the nonrefundable filing fee and hearing session deposits. These fees will vary depending on the size of the matter in dispute. In 2000, a $100,000.01 claim, for example, has a claim filing fee of $225 and a hearing session deposit of $750. A $1 million claim has a claim filing fee of $500 and a hearing session deposit of $1,200. The second major expense will be the attorney fees. As discussed previously, these fees can be based on an hourly amount or can be based on a contingency fee arrangement. The third expected expense deals with the professional fee for an expert witness or witnesses. The expert’s fees can vary considerably depending on the amount of work required by the expert and his or her reputation. An experienced securities arbitration attorney will have a number of experts he has worked with in the past and will make the determination of whether an expert is needed and which expert will eventually be used. Finally, routine office expenses such as copy charges, long distance telephone fees and overnight courier services will be incurred.

45


Maddox / Stoltmann

Initiating Arbitration 77)

How is an arbitration initiated?

An arbitration is commenced by filing a Statement of Claim, a Uniform Submission Agreement and a check for the appropriate amount of money in order to cover the hearing expenses and filing fee.

78)

What is the Uniform Submission Agreement?

In order to initiate any arbitration proceeding, signed submission agreements must be provided to the sponsoring organization (i.e. the NASD). When the investor signs the submission agreement, the investor is contracting to submit the dispute to arbitration and abide by the decision of the panel. A claim will not be processed unless the Uniform Submission Agreement is properly filed out.

79)

What is a Statement of Claim?

The Statement of Claim is the investor’s version of what happened between him and the broker. The Statement of Claim does not have to be in a particular format. Many attorneys who generally practice in the court system rather than the arbitration forum use the format that a complaint in a court of law would follow, with a caption, identification of the parties, statement of facts and request for damages, in numbered paragraphs. Some arbitrators, however dislike this type of format. Another option is to use an informal, letter format that tells the arbitrators the story of what happened in narrative form.

There are no official requirements for a Statement of Claim other than disclosing, as outlined in Rule 10314 (A) of the Code, the “relevant facts and the remedies sought.� However, the five crucial elements that all Statement of Claims should have are: a) an introduction; b) identification of the parties; c) fact sequence; d) analysis; and e) demand for relief.

46


Investor Rights for the 21st Century The Statement of Claim must be clear and should be in chronological fashion to make it as easy as possible for the arbitrators to determine what offenses may have taken place. The investor should generally attach copies of documents and supporting materials as exhibits to the Statement of Claim and provide sufficient copies for each party, the arbitrators, and the NASD (usually eight copies is sufficient).

The goal of the Statement of Claim is to provide the basic information that the arbitrators will need to decide the case in favor of the investor. Most of the necessary and relevant information should be in the Statement of Claim if for no other reason than the Statement of Claim is automatically admitted into evidence at the beginning of the hearing as “Arbitrators’ Exhibit #1.”

80)

What happens if the dollar amount of the Statement of Claim is under $25,000?

If the amount of the claim is $25,000 or less, the claim may be processed under the Simplified Arbitration Procedures. In these smaller disputes, unless the investor requests a hearing, the claim will be decided solely on the basis of reading the parties’ submissions (Statement of Claim and Answer). The arbitrator, however, may request a hearing or require either party to submit additional documentation.

81)

What happens after the Statement of Claim and the Uniform Submission Agreement are filed?

After the filing of the Statement of Claim and the Uniform Submission Agreement, the NASD staff serves the documents, along with instructions for the arbitration process, on the broker and brokerage firm. Service is typically done by mail to the address of the broker or brokerage firm.

47


Maddox / Stoltmann

82)

How long does the brokerage firm or broker have to provide an answer to the Statement of Claim?

In 1998, the SEC approved an amendment to NASD Rule 10314. The amendment increased from 20 business days to 45 calendar days the time within which a brokerage firm or broker may serve and file answers to initial claims, cross claims and third-party claims. The amendment also includes a provision that disfavors staff granted extensions of time to answer. Since the broker and brokerage firm’s time to answer has been increased substantially, the staff should grant an extension only if there is an extraordinary reason. The amendment does not apply to smaller claims filed under the simplified arbitration procedure.

83)

Is an investor ever entitled to have a single arbitrator hear his case if the amount in controversy is over $50,000?

Yes, in certain circumstances. In 2000, the Securities and Exchange Commission approved Rule 10336 and added it to the NASD Code of Arbitration Procedure. The new rule, which establishes the Single Arbitrator Pilot Program, is the first opportunity investors have been granted to have a single, public arbitrator hear their dispute for claims between $50,000.01 and $200,000. The Rule will be tested through May 15, 2002, at which time the Pilot Program will be evaluated to determine if it should become a permanent program at the NASD.

Rule 10336 allows parties with pending securities arbitration claims at the NASD between the amounts of $50,000.01 to $200,000, including damages, interest, costs, and attorneys’ fees, to select a single arbitrator to decide their case, rather than the panel of three arbitrators they would otherwise select. Claims that include a request for punitive damages will not be eligible for the Pilot Program unless all of the parties agree.

After parties receive notice that a panel of three arbitrators has been selected, as provided by Rule 10308, the parties may agree to have one of the arbitrators serve as the single arbitrator who will decide their case. The parties shall have a 15-day window from the date the NASD sends notice of the names of the arbitrators to agree on a single arbitrator. 48


Investor Rights for the 21st Century This 15-day period will run concurrently with the time period to select a chairperson under Rule 10308(c)(5).

Parties may send written materials, including information requests and motions, directly to the single arbitrator, provided that copies of such materials are sent simultaneously and in the same manner to all parties and to the NASD. Parties shall send the NASD, arbitrator, and all parties proof of service of such written materials, indicating the time, date, and manner of service upon the arbitrator and all parties. Service by mail is complete upon mailing. If the arbitrator and all parties agree, written materials may be served electronically.

If the arbitrator agrees, parties may initiate conference calls with the arbitrator, provided that all parties are on the line before the arbitrator joins the call. The arbitrator may initiate conference calls with the parties, once again provided all parties are on the line before the conference call begins. Parties may not communicate orally with the arbitrator unless all parties are present.

84)

What are the advantages and disadvantages of utilizing Rule 10336?

First, the Rule has the ability to remove the industry panelist from the panel. Under the Rule, any of the three chosen arbitrators may be the single arbitrator, but both sides must agree to the selection. Second, if the Claimant’s counsel, after agreeing to the Pilot Program, learns of additional claims that would increase the damages in excess of the $200,000 limit under Rule 10336, the Claimant may request that the other two panel members originally chosen be reinstated and the action proceed without the damage limitation of Rule 10336. If the single arbitrator refuses to grant the Claimant’s counsel request to reinstate the other two arbitrators, then the attorney may move to dismiss the claim without prejudice and the claim can then be re-filed as a regular, three-person case. Unfortunately, the new, re-filed action would involve the payment of another filing fee.

49


Maddox / Stoltmann The biggest advantage for Respondent’s counsel under the Pilot Program is that arbitration claims that include a request for punitive damages are not eligible, so long as both sides do not specifically request that they be considered. At the agreement of both parties, punitive damages may be considered by the arbitrator but the $200,000 limitation will still apply.

An advantage for both parties under Rule 10336 is lower expenses. Hearing session fees are reduced in the Pilot Program to reflect lower arbitrator honoraria. For claims between $50,000.01 and $100,000, hearing session fees under the Pilot program will be $550 per session, or $1,100 for a two-day session. This represents a reduction of $200 per session for the parties when compared with normal NASD arbitration costs. For claims between $100,000.01 to $200,000, hearing session fees under the Pilot Program will be $750 per session or $1,500 for a two-session day. This is a savings of $375 per session for the parties.

Pre-Hearing Discovery 85)

What type of pre-hearing discovery exists in securities arbitration?

In court proceedings, all parties are entitled to discovery through depositions and the exchange of documents prior to the actual trial. In arbitration, however, discovery is much more limited in its scope. A problem with this limited discovery is that investors often do not have all of the necessary documents needed to prove their case. Documents like personnel files, commission runs, compliance manuals and monthly statements are crucial documents in an investor’s case. Today, if an investor has an outstanding discovery problem, a pre-hearing conference call can be requested to clear any outstanding discovery disputes.

86)

How has the discovery process changed in the last few years?

Discovery disputes have become more numerous and time consuming in recent years. The same discovery issues unfortunately repeatedly arise. Many of the discovery abuses

50


Investor Rights for the 21st Century in traditional courthouse litigation have found their way into arbitration. Some attorneys make it their common practice to object to even the most relevant discovery requests simply to slow the process down. Changes needed to be made to the discovery process.

In January of 1999, the NASD proposed the creation of a guide to streamline the discovery process that has been implemented as outlined in NASD Notice to Members 99-90. The guide contained two changes to help standardize the discovery process. One calls for the early appointment of arbitrators to conduct an initial pre-hearing conference in which all arbitrators would participate. The initial pre-hearing conference gives the arbitrators and the parties the chance to organize the management of the case, set a discovery cut-off date, schedule hearing dates and resolve any other preliminary issues.

The second change provides the parties to the arbitration with Document Production Lists at the time that the NASD serves the statement of claim in customer cases. The arbitrators and the parties are to consider the documents listed in the Document Production Lists to be “presumptively discoverable.� Presumptively discoverable documents are those that have to be turned over automatically if a request is made by the opposing side. Absent a written objection, the documents on the Document Production Lists are required to be produced no later than 30 days from the date that the answer is due or filed, whichever is earlier. If both sides comply fully with the Document Production Lists, each side should have many of the documents needed to try their case, assuming there are no unusual issues.

87)

Under the NASD discovery guide, what documents must the brokerage firm turn over to the investor (what documents are on the brokerage firm’s Document Production List)?

1) All agreements with the customer, including, but not limited to, account opening documents, cash, margin, and option agreements, trading authorizations, powers of attorney, or discretionary authorization agreements, and new account forms.

51


Maddox / Stoltmann 2) All account statements for the customer's account(s) during the time period and/or relating to the transaction(s) at issue.

3) All confirmations for the customer's transaction(s) at issue. As an alternative, the firm/Associated Person(s) should ascertain from the claimant and produce those confirmations that are at issue and are not within claimant’s possession, custody, or control.

4) All “holding (posting) pages” for the customer’s account(s) at issue or, if not available, any electronic equivalent.

5) All correspondence between the customer and the firm/Associated Person(s) relating to the transaction(s) at issue.

6) All notes by the firm/Associated Person(s) or on his/her behalf, including entries in any diary or calendar, relating to the customer's account(s) at issue.

7) All recordings and notes of telephone calls or conversations about the customer’s account(s) at issue that occurred between the Associated Person(s) and the customer (and any person purporting to act on behalf of the customer), and/or between the firm and the Associated Person(s).

8) All Forms RE-3, U-4, and U-5, including all amendments, all customer complaints identified in such forms, and all customer complaints of a similar nature against the Associated Person(s) handling the account(s) at issue.

9) All sections of the firm's Compliance Manual(s) related to the claims alleged in the statement of claim, including any separate or supplemental manuals governing the duties and responsibilities of the Associated Person(s) and supervisors, any bulletins (or similar notices) issued by the compliance department, and the entire table of contents and index to each such Manual.

52


Investor Rights for the 21st Century

10) All analyses and reconciliation’s of the customer's account(s) during the time period and/or relating to the transaction(s) at issue.

11) All records of the firm/Associated Person(s) relating to the customer's account(s) at issue, such as, but not limited to, internal reviews and exception and activity reports which reference the customer's account(s) at issue.

12) Records of disciplinary action taken against the Associated Person(s) by any regulator or employer for all sales practices or conduct similar to the conduct alleged to be at issue.

In addition, other documents will have to be turned over depending on the type of claim involved. The complete list can be found on the NASD’s website at www.nasdr.com.

88)

Under the NASD discovery guide, what documents must the investor turn over to the brokerage firm (what documents are on the investor’s Document Production List)?

1) All customer and customer-owned business (including partnership or corporate) federal income tax returns, limited to pages 1 and 2 of Form 1040, Schedules B, D, and E, or the equivalent for any other type of return, for the three years prior to the first transaction at issue in the statement of claim through the date the statement of claim was filed.

2) Financial statements or similar statements of the customer's assets, liabilities and/or net worth for the period(s) covering the three years prior to the first transaction at issue in the statement of claim through the date the statement of claim was filed.

3) Copies of all documents the customer received from the firm/Associated Person(s) and from any entities in which the customer invested through the firm/Associated

53


Maddox / Stoltmann Person(s), including monthly statements, opening account forms, confirmations, prospectuses, annual and periodic reports, and correspondence.

4) Account statements and confirmations for accounts maintained at securities firms other than the respondent firm for the three years prior to the first transaction at issue in the statement of claim through the date the statement of claim was filed.

5) All agreements, forms, information, or documents relating to the account(s) at issue signed by or provided by the customer to the firm/Associated Person(s).

6) All account analyses and reconciliation’s prepared by or for the customer relating to the account(s) at issue.

7) All notes, including entries in diaries or calendars, relating to the account(s) at issue.

8) All recordings and notes of telephone calls or conversations about the customer’s account(s) at issue that occurred between the Associated Person(s) and the customer (and any person purporting to act on behalf of the customer).

9) All correspondence between the customer (and any person acting on behalf of the customer) and the firm/Associated Person(s) relating to the account(s) at issue.

10) Previously prepared written statements by persons with knowledge of the facts and circumstances related to the account(s) at issue, including those by accountants, tax advisors, financial planners, other Associated Person(s), and any other third party.

11) All prior complaints by or on behalf of the customer involving securities matters and the firm's/Associated Person(s’) response(s).

54


Investor Rights for the 21st Century 12) Complaints/Statements of Claim and Answers filed in all civil actions involving securities matters and securities arbitration proceedings in which the customer has been a party, and all final decisions and awards entered in these matters.

13) All documents showing action taken by the customer to limit losses in the transaction(s) at issue.

In addition, other documents will have to be turned over depending on the type of claim involved.

89)

Are there problems with the current pre-hearing document discovery process?

Yes. Despite the NASD and other self-regulatory organizations best efforts, certain abuses still occur. Brokerage firms many times are reluctant to provide even the most basic and legitimate documents requested by the investor’s counsel. While most arbitrators can see through the remedial attempts by the defense bar to avoid turning over particularly damaging documents, sometimes key documents are left out of the arbitration pre-hearing discovery production because of defense attorneys delay tactics or subterfuge.

90)

What is the NASD’s pre-hearing exchange?

The NASD’s Code of Arbitration Procedure, 10321(c), mandates that at least twenty calendar days prior to the first scheduled hearing date, all the parties exchange copies of documents in their possession that they intend to present at the hearing and shall identify witnesses they intend to present at the hearing. Any documents not exchanged or witnesses not identified may be excluded by the arbitrators. The rule does not require service of copies of documents or identification of witnesses that the parties may use for cross-examination or rebuttal.

55


Maddox / Stoltmann A well chronicled abuse that some attorneys use is to “sandbag� as much information as possible by introducing documents, mainly in cross examination, and then claiming they were not required to turn the documents over because their introduction took place via cross examination. This ploy defeats the purpose of the pre-hearing exchange and arbitrators need to be made aware of its use by counsel.

Pre-hearing Depositions 91)

Are depositions used in securities arbitration?

In most securities arbitration cases, depositions are not used. This is surprising to attorneys who are used to traditional courthouse litigation. However, typically depositions are not needed in securities arbitration and when they are, appropriate measures can be taken.

92)

Can depositions be utilized in arbitration?

Yes, but only in extreme cases. If there is a witness who might be inaccessible at the hearing for a legitimate health reason, then the arbitrators may order depositions to be taken. For example, if a potential witness was diagnosed with a terminal cancer, it would be reasonable to request a deposition to ensure the testimony of the witness would be preserved. But these cases are the very rare exception rather than the rule. Certain nonessential witnesses may also testify telephonically under certain conditions.

Compulsory Arbitration 93)

Do brokerage firms have the right to compel customers to arbitration?

Yes. Brokers and their firms are contractually bound to arbitrate their disputes with customers, even in the absence of a written contract with the customer. The contractual obligations arise from membership in the NASD or in the various stock exchanges. Every stockbroker is a member of the NASD. Upon applying for membership in the NASD, the broker-dealer and the broker agree to be bound by the rules of the NASD. 56


Investor Rights for the 21st Century The NASD Code provides that members and associated persons must arbitrate their disputes with customers at the demand of the customer.

94)

What does a standard arbitration agreement look like?

While there is no one universally accepted arbitration agreement, most look something like the following:

I agree that all controversies that may arise between us concerning any order or transaction, or the continuation, performance or breach of this or any other agreement between us, shall be determined by arbitration before a panel of arbitrators selected by the National Association of Securities Dealers or the New York Stock Exchange, Inc., as I may designate, pursuant to the rules of the organization in existence at the time of the submission to arbitration. I understand that a judgment upon the arbitration award may be entered in any court of competent jurisdiction.

95)

Are more arbitrators needed?

Absolutely. The requirements to become an arbitrator are minimal. A potential arbitrator will be required to participate in a very basic arbitrator skills training program before being assigned to a case. Applicants are required to attend a four-hour training course and pass a simple, objective test that examines the knowledge of what was just taught in the training session. There is also a $100 fee that covers the cost of the training materials, the onsite instruction, and test administration.

96)

Are there any other requirements?

Yes. The NASD requires that individuals have at least five years of business, professional, investing, or other related experience. A potential arbitrator needs to fill out the NASD arbitrator application (which can be found at www.nasdadr.com) and submit

57


Maddox / Stoltmann two letters of recommendation from individuals who can attest to the character of the applicant.

97)

Do arbitrators receive compensation for their services?

Yes. While arbitrators are not employees of the NASD, they do receive an honorarium at the rate of $200 per single-session hearing; $400 per double session. A single session lasts up to four hours and a double-session hearing lasts for more than four hours. Compensation for service on cases decided without an in-person hearing is $125 per case.

98)

What other advantages are there to being an arbitrator?

Besides the financial remuneration, arbitrators provide an invaluable service to the securities industry as people from all walks of life rely on their service. Arbitrators typically serve as the last line of defense to guard the American public against dishonest and unethical stockbrokers and brokerage firms. Qualified arbitrators are desperately needed at the NASD and NYSE.

99)

What is the demographic profile of the arbitrator pool?

The arbitrator pool is mostly comprised of attorneys, accountants, businessmen and members of the securities industry. The lack of diversity in the pool is a major problem at both the NASD and the NYSE. The arbitrator pool is nowhere near being representative of society as a whole. Unfortunately, both the NASD and NYSE have done an extremely poor job of recruiting minorities and women to be arbitrators. Women and minorities make up a very small segment of the arbitration pool. While the NASD and the NYSE claim they are doing all they can to recruit diverse arbitrators, so far the effort has not yielded enough results. With millions of new investors from all walks of life investing in the market for the first time, the obligation to have a truly representative arbitrator pool is more important than ever. The NASD and NYSE need to raise their efforts dramatically in the coming years to recruit not just women and minorities but people from all walks of life to serve as arbitrators. All possible efforts need to be exhausted to get the arbitrator pool representative of society as a whole. 58


Investor Rights for the 21st Century

Superiority of Arbitration 100) Do investors get a fair “shake” in arbitration? Generally, but certainly not all the time. There are many practitioners and commentators who think that securities arbitration is tilted to favor the industry and large brokerage firms. Some people even think that the NASD is a shill for the brokerage industry and the retail investor cannot get the equivalent of his or her day in court, so to speak. However, investors generally get a fair and equitable opportunity to present their version of what happened at the arbitration hearing.

That is not to say there aren’t inherent disadvantages for investors in arbitration that certainly favor the brokerage industry. For example, at least one of the arbitrators will be from the securities industry. The purported reason for this mandatory industry representative is to ensure at least one member of the panel has the necessary expertise to be able to wade through the complexities inherent with a securities dispute and provide some guidance and insight to the other members. However, in reality, this expertise is not needed. Juries across the country decide complex medical malpractice cases without a mandated doctor or nurse sitting on the panel to provide a medical perspective to the deliberations. Many securities arbitration practitioners feel very strongly that the reason why the securities industry demanded an industry representative on the panel was to ensure that at least one panel member would guard the interests of the securities industry and hopefully convince other panel members to do the same.

As in the court system, there will usually be a “winner” and a “loser” in every arbitration hearing. Sometimes, arbitration panels will make a decision that nine out of ten other people would not make if they were the ones deciding the case. Many times, the losing party complains in much greater frequency than the winner who goes off on his way, usually without making a great deal of noise. It is important to remember that the word “arbitration” is derived from the word “arbitrary.” Sometimes the decision is not what either party expects, but the same can be seen in any courthouse in America.

59


Maddox / Stoltmann

101) Is the arbitration system perfect? Absolutely not! There are major, significant problems with the arbitration system. There is still a great deal of work that needs to be done to level the playing field to make it truly fair for investors. Until those problems are addressed, arbitration cannot be said to be as fair as a court of law.

102) What could be done to improve securities arbitration? Some arbitration practitioners believe that mandatory mediation should be required and if the dispute cannot be resolved in mediation, then the investor should have the option to bring an action in a court of law or arbitration.

103) What was the biggest disadvantage when broker-customer disputes were decided in the courts prior to McMahon? The biggest disadvantage under the old system was the time that it took for investors to have their “day in court.” Judge Irving Kaufman of the Court of Appeals for the Second Circuit noted that the “twin demons of expense and delay” plague parties in litigation in the court system. Unfortunately, under the previous system of court litigation, some investors in bigger cities like New York, Los Angeles and Chicago had to wait five years before they even had a chance to have their case heard in front of a judge or jury. At the NASD, the average turnaround time from when an arbitration claim is filed to when it is closed is approximately thirteen months.

104) What is another advantage to arbitration? Besides the time advantage described above, another claimed advantage is that arbitration is less expensive for the individual investor. A report from Deloitte, Haskins & Sells for the New York Stock Exchange ten years ago found that the average legal costs for arbitration were approximately $12,000 less than those for court litigation. A major portion of the savings comes from the elimination of pretrial discovery, the lack or severe

60


Investor Rights for the 21st Century limitation of depositions and interrogatories and the liberal rules of evidence that decrease the amount of time fighting over esoteric legal technicalities. Unfortunately, in recent years arbitration has become considerably more expensive. Filing fees alone at the NASD can run as high as $600 and hearing session deposits for three arbitrators can cost an investor $1,200. When compared to the costs of filing a lawsuit in federal court, which will typically be under $200, it becomes apparent that even arbitration can be a costly substitute.

105) Is having a securities industry panelist inherently unfair for investors? It depends. Securities arbitration has the equivalent of a qualified “jury� determining the outcome. The overwhelming majority of all arbitrators are either attorneys, accountants or CPAs, business owners or brokerage firm employees. As previously discussed, the alleged advantage for a securities arbitration attorney and his or her client is that arbitrators tend to be more sophisticated decision makers than someone off the street. An attorney has to spend less time going over the remedial basics of the broker-investor relationship because the arbitrators already have training from a seminar necessary before becoming an arbitrator and more than likely they already have had a brokerage account in the past.

Some commentators bemoan the presence of an industry panelist being on a three-person arbitration panel. However, there are times when the industry panelist is the first one to spot the fraudulent conduct on the part of the stockbroker or management and cut through to the issue at hand. The widespread fear that the industry panelist will contaminate the panel in favor of the broker is at times unfounded. However, undoubtedly there are security industry panelists who are solely looking to protect the broker and brokerage firm. It is crucially important to identify and remove these panelists from the pool of arbitrators.

61


Maddox / Stoltmann

106) Is arbitration becoming more like litigation? Unfortunately, yes. Arbitration is beginning to look more and more like traditional court litigation with motion practice, unending hearings and frivolous discovery requests. Arbitrators need to do everything in their power to see to it that arbitration remains an efficient process for investors to recover their losses. Without steps taken by arbitrators to keep the process streamlined, arbitration is bound to become as inefficient as traditional courthouse litigation. In recent years, arbitration has also become less civilized. Antics familiar in court are creeping into arbitration. For instance, the throwing of tantrums or the calling of the other side or its lawyer’s unprintable names is much more frequent today as opposed to even 5 years ago.

107) Are motions allowed in arbitration? Yes. Motion practice is becoming increasingly prevalent in arbitration. Most motions are raised shortly before the hearing. Motion practice does little more than over-legalize the arbitration practice. The goal of arbitration is to expedite the resolution of the case. Tactical motions hinder arbitrators from focusing on the facts.

108) How are arbitrators selected? Arbitrators are now selected under the List Selection Rule. The List Selection Rule was designed to give the parties a more significant role is selecting arbitrators and is now the way that the NASD chooses arbitrators. Arbitrators are placed into the NASD’s database and a list of arbitrators is chosen based off of four criterion: public or non-public classification, geographic hearing location, rotation and conflict of interest with the parties. A party can also request that the lists include some arbitrators with subject matter knowledge on the dispute in question.

The NASD staff then provides the parties with a single round of public and non-public arbitrator lists. The parties can strike any listed arbitrator and rank those remaining in order of preference. The arbitrators are then appointed based off of the rankings. If the

62


Investor Rights for the 21st Century parties do not select a full panel, then the NASD staff will appoint arbitrators, much in the same way arbitrators use to be chosen.

109) How is a chairperson selected under the List Selection Rule? Parties are supposed to agree on who from the panel should act as the chairperson. If the parties cannot agree, then the NASD staff will select one of the public arbitrators to lead the panel.

110) Are arbitrators expected to be like judges? It depends. According to the NASD, arbitrators are appointed to resolve disputes “on the equities,” that is to say, on the basis of fairness, not necessarily on the strict letter of the law. Arbitration is an alternative to court, not a substitute for it. Some believe the arbitrator’s main duty is to render a just and equitable decision regardless of legal technicalities. However, failing to follow the law also raises the possibility of an award being overturned on appeal if it rises to a manifest disregard of the law.

111) What is the “best” arbitration forum for an investor to have his or her dispute heard? Either the NASD or the NYSE. The NASD handles over 90 percent of all arbitration cases. Their pool of arbitrators have handled the most hearings and their staff attorneys are generally competent when it comes to making sure the arbitration process runs smoothly. The NYSE consistently handles most of the remaining claims. An investor or his attorney should choose either the NASD or NYSE for their claim.

Hearing Process 112) What occurs in a “typical” arbitration hearing? An arbitration hearing is considerably different than a trial in a court of law. The hearings usually take place in a conference room at a hotel or office or at the NASD regional office.

63


Maddox / Stoltmann

The arbitration starts off with the chairman of the arbitration panel reading an approved script to all of the parties. The script contains standardized information like an introduction of the arbitrators, reconfirmation of any disclosures previously made by the arbitrators, oral confirmation by both sides of the arbitration panels composition, the oath of arbitrators and other technical procedural points.

Next come the opening statements by each side. As in a court of law, opening statements serve as a brief, non-emotional road map of what the attorney intends to prove during the hearing.

It is imperative that the opening statement outlines the themes of the case that

will be developed throughout the hearing.

After the opening statement, the investor’s attorney will begin to build his case and start calling witnesses. The attorney should focus on establishing the liability of the broker. Once liability is established, then the attorney must establish the damages suffered by the investor, if any. After the investor’s attorney has presented his case, the broker or brokerage firm presents their case. In a suitability action, for example, the defense will tend to build their case based on the investor’s sophistication, including other brokerage accounts, and knowledge of investing.

Finally, each side will have an opportunity to give a closing statement. The closing statements provide an opportunity for each party to argue their case and make a final demand for damages. Since the investor has the burden of proof, he has the option, as outlined under IM-10317, to reserve his entire closing for rebuttal or to go first and then give a rebuttal after the Respondent gives his closing. There are certain strategic advantages to deferring the entire closing for the rebuttal but different practitioners have different preferences.

113) Can arbitrators ask the witnesses questions? They can and it is relativity common for them to do so. Often, the arbitrators will have questions or concerns about the testimony of a witness. The arbitrators will typically ask

64


Investor Rights for the 21st Century the witness whatever questions they need answered to help them resolve the issue or case. An attorney should pay very close attention to what an arbitrator asks and make sure that those concerns are addressed during some point in the hearing or in closing statements.

114) Are subpoenas used in arbitration? Yes. Under 10322 of the Code, arbitrators and any counsel of record to the proceeding shall have the power of the subpoena process as provided by law. In addition, arbitrators have the power, without resorting to the use of subpoena, to direct the appearance of any person employed by the securities industry.

115) What is the guiding principal of arbitration? The stated goal of arbitration by the NASD is an outcome based off of fairness and equity. In the NASD’s Arbitrator’s Manual, the following quote appears: “Equity is justice in that it goes beyond the written law. And it is equitable to prefer arbitration to the law court, for the arbitrator keeps equity in view, whereas judge looks only to the law, and the reason why arbitrators were appointed was that equity might prevail.” Domke on Aristotle.

116) Should an attorney make frequent use of objections? Generally, no. Most panelists are not fond of objections. Objections that are most likely to be sustained are the ones that address a witness that is not answering a question or when a question has been asked and answered. Of course, there are some very valid strategic reasons for objecting to a line of questions. However, the use of objections should be made selectively.

117) How difficult is it to schedule arbitration hearing dates? It is many times very challenging. Unfortunately, in recent years, some securities defense attorneys have used alleged scheduling conflicts as a common ploy in attempting to delay the start of a hearing. It is not uncommon for some defense attorneys to contact the

65


Maddox / Stoltmann chairman of the panel a week or even days before the start of a scheduled hearing with an alleged “emergency” and a request that the hearing be delayed. Because the arbitrators are essentially acting as volunteers (they do receive a small stipend from the forum but hardly enough to compensate them for their time) and it is necessary to reconcile an agreeable hearing date between three arbitrators, at least two attorneys, the investor, broker and necessary witnesses, it becomes readily apparent why arbitrators should avoid rescheduling a hearing but for an absolute, legitimate emergency.

118) Are stipulations to be encouraged in an arbitration? Yes. Stipulations entered into between parties as to factual matters not in dispute can go a long way towards moving a hearing along and can considerably shorten the presentation of evidence. Stipulations are usually actively encouraged in court litigation and it would be helpful if they were used more often in arbitration.

119) What type of evidence is admissible in an arbitration hearing? Generally, anything the arbitrators want. The rules of evidence are typically not as stringently applied in an arbitration hearing as they are in a court of law. Rule 10323 of the Code specifically states “The arbitrators…shall not be bound by rules governing the admissibility of evidence.” The rules of evidence in arbitration can be interpreted rather liberally, depending on the arbitration panel. Much information is allowed to be introduced “for what it is worth.” This is significantly different than what typically occurs in a court of law.

120) Can affidavits be admissible evidence? Yes. Affidavits are typically allowed in arbitration. Affidavits can help expedite arbitration hearings and move them along in a timely fashion. There are times when affidavits are absolutely necessary making their acceptance extremely important in some cases.

66


Investor Rights for the 21st Century

121) How long does an arbitration usually last? A small case (under $50,000) usually takes no more than two days and can often be completed in just one day. For the average sized claim ($50,000 to $500,000) the arbitration will usually take three days. Large cases (over $500,000) can expect to take at least three to five days and sometimes longer. Unfortunately, over the last ten years the length of time a typical arbitration proceeding lasts has increased. Many of the same delay tactics prevalent in a court of law have found their way into the arbitration process. Arbitrators need to do everything in their power to keep the hearings moving along and not focused on minute detail.

122) Are expert witnesses used in arbitration hearings? Yes. Many of the issues in securities arbitration can become rather complicated. It is often necessary for either the investor and/or broker or brokerage firm to hire an expert witness to help guide the arbitrators through these issues. Expert witnesses many times play a crucially important role in arbitration hearings and must be chosen carefully by Claimant’s counsel.

123) Can the expert witness attend the entire hearing? Usually, the answer is yes. However, the arbitrators have the final say. Rule 10317 of the Code states “[T]he attendance or presence of all persons at hearings including witnesses shall be determined by the arbitrators. However, all parties to the arbitration and their counsel shall be entitled to attend all hearings.� Typically, expert witnesses will be allowed to attend the hearing. Other fact witnesses usually will not be allowed in the hearing room.

124) Can investors represent themselves in an arbitration? Yes they can. However, it is generally not recommended unless the case is too small to justify hiring counsel. NASD statistics suggest investors with counsel fare better than pro se claimants. Often, the broker or brokerage firm is represented by the best defense

67


Maddox / Stoltmann attorneys money can buy. The image that comes to mind when investors attempt to represent themselves against these attorneys is a lamb in a slaughterhouse. However, arbitrators usually do attempt to bend over backwards to assist the pro se investor in allowing them to present their case.

125) Can arbitrators initiate disciplinary referrals against brokers? Yes. However, often the NASD does not follow up on the disciplinary referral. Once a referral gets to be two years old, it seems to be the NASD’s unofficial policy at some district offices to not follow up on it. Since the typical time frame from an alleged wrongdoing to conclusion of a hearing is more than two years, usually nothing happens with the action. Therefore, it is becoming more common for arbitrators to decide to punish the broker or brokerage firm in the pocket book, where they will feel the pain immediately rather than waiting for action from the NASD on the disciplinary referral that usually never comes.

Defenses 126) If the investor is the one who initiates all of the purchases, can the broker be held liable? Usually, the answer is no. However, more arbitrators are now willing to accept a “financial suicide” argument patterned after the “Dram Shop” line of reasoning that hold bartenders liable for serving a patron even after the person has had too much to drink.

Recently, brokers have been held liable for clients who trade aggressively, even if the broker never recommended the investment and marked the ticket unsolicited. For instance, in TNGS (Belken) vs. PaineWebber, an arbitration panel awarded $2 million to a customer with an MBA from Harvard, despite the arbitrator’s findings that the investments were suitable and the customer understood the risks involved. The arbitration panel concluded that the broker and the firm undertook an express duty to monitor the performance of the customer’s investment selections. While not common

68


Investor Rights for the 21st Century and difficult to win, these types of cases are coming through the arbitration “pipeline” more frequently with the proliferation of discount brokerage firms and online firms.

127) What is a statute of limitations? An investor’s ability to bring an action against a broker or brokerage firm is arguably limited by certain time restrictions. Statute of limitations serves as a means of barring any complaint that is filed after a certain period of time. For example, if the law states that a customer has three years to bring a claim and the investor waits four years before bringing the action, then the customer might be time-barred from asserting a claim against the broker. The typical reason provided as to why we have statute of limitations is because of concerns that over time documents get lost, memories fade and employees relocate. If there is to big of a delay between when the fraudulent conduct took place and when the claim is filed, there might be too great of a burden on a broker or brokerage firm.

There are a number of practitioners who believe statute of limitations are not applicable at all in securities arbitration because statute of limitations apply only to judicial proceedings and arbitration is generally considered to be an equitable, not judicial, action. Rule 10304 of the Code specifically references “applicable statutes of limitation” which begs the question when are statute of limitations “applicable.”

128) When do statute of limitations begin? Statute of limitations generally begin to run either when the customer actually knew or should have known of the facts that caused him to have a claim. Statute of limitations based on state blue-sky laws typically varies from state to state.

129) What is the eligibility requirement? Parties in arbitration have a time limit to file a securities claim with the NASD. Rule 10304 of the NASD Code states that no dispute “shall be eligible for submission to arbitration where six years have elapsed from the occurrence or event giving rise to the

69


Maddox / Stoltmann dispute. This Rule shall not extend applicable statutes of limitations, nor shall it apply to any case which is directed to arbitration by a court of competent jurisdiction.�

130) Is eligibility different than the statute of limitation requirements? Yes. Even when a claim is filed within the six-year eligibility period, federal or state law can still preclude a monetary award for the action that took place during that time frame. However, it is important to remember that actions can be taken to toll the statute of limitations. For instance, if there is fraudulent concealment, the statute of limitations can be extended. If there is a breach of contract claim, then the statute of limitations is considerably longer. It is also important to remember that arbitration is an equitable proceeding, according to the NASD, designed to get a fair resolution for the parties. Therefore, some argue, the arbitrators may decide to follow the statute of limitations less stringently than a judge, who is bound by the strict letter of the law.

131) How have some in the brokerage industry abused the statute of limitations in arbitration? Arbitrators are arguably not bound to the application of statutory limitation periods in a matter where fundamental fairness is the purpose of the proceeding. As most arbitrators are aware, arbitration was the forum of choice selected by the securities industry, and strenuously defended as the exclusive forum for the resolution of disputes between customers and members of the industry. When the securities industry decided to impose arbitration as the sole choice for investors, they did so with the knowledge that the statute of limitations might not apply to arbitration. The industry made a trade off in choosing arbitration, namely that in exchange for quicker, more cost efficient resolution of disputes, they would lose the benefit of excluding older claims.

Since the brokerage industry has required its investors to arbitrate their disputes, some argue it is unfair to allow technical legalisms that do not belong in arbitration. To allow the brokerage firm or broker to do so, in essence, allows them to have two bites at the apple: one, depriving the investor of a judicial or court forum, and the other, picking the

70


Investor Rights for the 21st Century judicial standards it wished to have applied, to the extent it benefits them and deprives the investor.

132) What are the defenses of estoppel, waiver and laches? All three defenses are equitable defenses that argue that an investor should not be allowed to delay for an extended period of time before suing the stockbroker because excessive delays cause an unfair disadvantage to the stockbroker or brokerage firm. Estoppel is a defense where the broker argues that the customer deliberately misled the broker into performing certain acts and therefore the investor should be precluded from suing on such acts. Waiver is the voluntary relinquishment of a legal right. Laches is a defense based on a fairness argument which argues that it is unfair to allow a customer to sue after a reasonable period of time expires from the discovery of the wrongful conduct.

133) Does the investor’s failure to complain hurt his or her arbitration case? Generally, no. It is not uncommon at all for an investor not to realize for weeks, months or even sometimes years that some type of fraudulent conduct has taken place in his investment account. There are many investors who never open their monthly or quarterly statements and even if they do, they do not review in great detail the activity that took place in the account. Many investors find the brokerage statement to be very confusing and poorly organized. Some investors place complete trust in their broker and do not find it necessary to check up on the broker because of the high degree of trust they place in the broker. Therefore, an investor’s failure to complain is not necessarily a significant issue in arbitration proceedings.

134) What is a “happiness” or “comfort” letter? Often, when brokerage firms detect abuses in an investor’s account the firm will send to the customer a “happiness” or “comfort” letter in an attempt to cover for the fraudulent conduct of their broker. The letter generally states something to the effect that “we are pleased to have you as a client, we value your business, if you have a problem with your

71


Maddox / Stoltmann account please contact the firm.” Sometimes, it may say “unless we hear back from you, we will assume you accept the risks associated with such aggressive trading in your account.” Typically, a failure to respond negatively by an investor is not damaging to his or her case since many times, the investor is not aware of the fraud until some considerable time after the “happiness” or “comfort” letter was issued. In addition, it is common for a broker to tell a client who received a happiness letter not to worry about it and that it is just a formality. A letter of this type is generally not given a great deal of credence in an arbitration hearing.

135) How important is the new account application form in an arbitration? It depends on the case. An account application must be filled out before a brokerage account is opened. The application contains important information about the investor that should guide a stockbroker in recommending securities. The application contains information such as the investor’s investment experience, risk tolerance level, financial goals and age. Unfortunately, it is not uncommon for information on the application to be inaccurate or forged by a broker.

Usually, the account application is filled out by the broker either in a face-to-face meeting with the client or more frequently over the telephone. In the past, investors have told their broker one thing and the broker has recorded another. For instance, an investor might tell a broker who is filing out the account application that he is a 57 year-old, conservative investor who is interested solely with income preservation. The new account application might then contain information in the broker’s handwriting that the investor is a 47 year-old, aggressive investor who is interested in speculation. One wellknown brokerage firm was fined by the SEC, in part, because of widespread doctoring of new account applications by their brokers. Arbitrators are usually aware of the problem that sometimes intentional or unintentional inaccurate information is recorded on new account applications.

72


Investor Rights for the 21st Century

Damages 136) What are the most common types of damages awarded at an arbitration hearing? The most common type of damages in securities arbitration hearings are Out-of-Pocket damages. The investor receives the difference between the price he paid for the investment and its actual value absent the broker or brokerage firm’s fraudulent conduct. Out-of-pocket damages also many times take into consideration all the interest or dividends earned in the investor’s account.

Consequential damages may be awarded in addition to out-of-pocket damages. Consequential damages can include, for example, lost profits in the form of dividends on stock sold as a result of the fraud, taxes incurred by the investor as a result of the broker’s fraud and expenses incurred by the investor while trying to mitigate losses.

Rescission damages are another type of damages often awarded in arbitration disputes. Rescission damages are based on the concept of preventing a broker or brokerage firm from unjustly retaining the benefit from the fraudulent actions. It attempts to put the investor back where he was before the fraudulent actions occurred. With rescission, the investor returns the security in exchange for return of consideration paid. If the security is no longer available, the investor can obtain recovery of the difference between the consideration paid for the security and any consideration received for it.

137) Can arbitrators award interest to the investor? Yes. Arbitrators can and do award interest to investors. Arbitrators have discretion as to the interest rate, when the interest starts accruing and who has the responsibility to pay it. Typically, however, the individual state securities act will delineate the interest rate to be applied.

73


Maddox / Stoltmann

138) Can arbitrators award attorney fees? Yes, arbitrators may award attorneys’ fees and costs. In order to put the investor back into his or her original position, it is typically necessary to award attorney fees. Sometimes, arbitrators might ask counsel for evidence of their authority to award the fees and costs under the individual state securities act or case law.

139) What is a “well managed account” measurement of damages? A “well managed account” measurement of damages focuses on what the investor would have gained by being invested in a typical portfolio or mutual fund consistent with their objectives at the time the broker was “managing” the account. For instance, say a 40 year-old investor brought a $1 million portfolio to a stockbroker. The portfolio consisted of $500,000 in blue chip stocks and stock index funds and another $500,000 in government and high-grade municipal bonds. Instead of leaving the account in its properly diversified state, the broker decides to liquidate the holdings and purchase technology and biotechnology stocks and stock options.

A “well managed account” measurement of damages would focus on the difference between what the investor’s return was under the broker’s direction and what the account would have returned if the broker had left the account alone in its already well-diversified position. In the scenario outlined above, if the broker lost 25 percent of the investor’s portfolio due to the brokers recommendation of unsuitable investments over a 12 month period and the account would have returned, but for the broker’s negligence, 10 percent a year, then the investor’s damages under a “well managed account” measurement would be $350,000 ($250,000 in out of pocket losses plus $100,000 of damages for what the account would have returned if the broker had not acted negligently).

140) Are punitive damages allowed in arbitration? Yes. In 1994 the U.S. Supreme Court ruled in Mastrobuono v. Shearson Lehman Hutton, Inc. that a choice of law provision in a pre-dispute arbitration agreement that specified

74


Investor Rights for the 21st Century New York law did not preclude an award of punitive damages, even though New York arbitration law would prohibit such an award.

The Court’s decision, however, did not directly consider the appropriateness of arbitral awards of punitive damages. Instead, the Court focused on ambiguities in the agreement because of references both to NASD documents that permitted punitive damages, and to a choice of law provision that did not. As a result, the Court applied basic contract law and construed the contract against the drafter, Shearson Lehman. Thus, Mastrobuono did not resolve the policy issue of whether punitive damages should be available in securities arbitrations. However, today, arbitrators can award punitive damages. In 2000, arbitrators awarded $21 million in punitive damages. The year before, arbitrators awarded $48 million in punitive damages.

In 1995, the NASD released several recommendations made by a “blue-ribbon task force” proposing to revamp securities arbitration. The Board of Governors of the NASD appointed an eight-member task force in 1994 to address the various problems that undermine customer confidence in the fairness of securities arbitration. The result was a 156-page report that contained 70 recommendations to the NASD Board of Governors and all other self-regulatory organizations that offer arbitration. One of the most controversial recommendations was to limit arbitrator’s ability to award punitive damages to the lesser of $750,000 or two times compensatory damages. The proposals are still in the hands of the SEC waiting for a final determination of the issue.

141) How important is it for arbitrators to retain the right to award punitive damages? Crucially important. Punitive damages often serve as the only effective police mechanism against fraudulent stock scams. Arbitrators must retain the ability to make appropriate punitive awards even if they do so infrequently and the award is more a matter of sending a message to the industry through punishment than of a windfall to investors. Contrary to what the brokerage industry would like the SEC and the NASD to

75


Maddox / Stoltmann believe, there is no runaway punitive damage problem in the securities industry. On average, only 2 percent of arbitration cases that go to hearing result in punitive awards.

In almost every case where punitive damages are awarded, they are indeed warranted. No one can realistically question the appropriateness of a $10.5 million punitive damage arbitration award against Stratton Oakmont. Stratton Oakmont repeatedly ignored regulator’s warnings to end customer churning and unauthorized trading and their brokers continued to make grossly unsuitable recommendations; all the while the firm’s president allegedly earned up to $7 million a year. Capping punitive awards takes away the arbitrator’s ability to punish the most egregious brokerage firms like Stratton Oakmont.

Award 142) How long does it usually take for the parties to receive the award from the arbitrators? The goal, as outlined in 10330 (d) is that “arbitrator(s) shall endeavor to render an award within thirty business days from the date the record is closed.” While this is the goal, it is becoming more and more infrequent. However, even in some of the slowest situations, the parties usually have the award within 60 days (although certainly not always).

143) What form does the award have to be in? The arbitration award does not have to be in any particular form although there is some information that must be present. According to 10330 (e) “the award shall contain the names of the parties, the name of counsel, if any, a summary of the issues, including the type(s) of any security or product, in controversy, the damages and other relief requested, the damages and other relief awarded, a statement of any other issues resolved, the names of the arbitrators, the dates the claim was filed and the award rendered, the number and dates of hearing sessions, the location of the hearings, and the signatures of the arbitrators concurring in the award.” Arbitrators are not required to provide a reason for their decision or even a statement as to how they arrived at a damage figure. Sometimes,

76


Investor Rights for the 21st Century arbitrators will issue a “reasoned award” which outlines their findings and is similar in form to an opinion written by a judge.

144) What type of flexibility do arbitrators have in awarding damages to an investor? Arbitrators have wide flexibility in deciding what damages to award to investors. Arbitrators have considerably broader authority than do courts in deciding what type of award an investor will receive. This is a major difference with arbitration since arbitrators can sometimes let common sense, fairness and equity guide the fashioning of a remedy.

145) Are arbitrators ever constrained in rendering an award by other factors? Yes. Some Claimant attorneys complain that some arbitrators are intimidated and unwilling to give “fair” awards to investors who have lost money at the hands of certain wirehouses or large, national brokerage firms. These arbitrators are concerned about being struck from future arbitration panels by defense attorneys who deal frequently with these larger brokerage firms. Therefore, in order to ensure future selection as an arbitrator, they are unwilling to grant larger awards to plaintiffs even in cases where they are warranted. However, with the proliferation of a group like PIABA, it could be argued that arbitrators who consistently guard the interests of the securities industry at the expense of investors run the same risk of being permanently struck in future cases by Claimant attorneys.

146) Can arbitration awards be appealed? Yes, however it is rare for an arbitration award to be successfully overturned. The grounds on which an award can be overturned are very narrow. Typically, so long as the award was not procured by fraud or there was no manifest disregard of the law, courts will allow the award to stand. Each party is given an opportunity at the end of the hearing to state affirmatively whether they feel they were given a fair chance to be heard.

77


Maddox / Stoltmann If there is a reason why a party does not feel as though they had a fair opportunity, it is important to say so at that time.

147) Are arbitration awards final? Yes. Arbitration awards are extraordinarily final. It has been said that a “lowly arbitrator” has more “final order” power than judges on circuit courts of appeals. Arbitrators are generally free to fashion the applicable rules and determine the facts of a dispute before them without their award being subject to judicial revision.

Mediation 148) What is mediation? Mediation is a method of dispute resolution in the securities industry that serves as an alternative to binding arbitration. The NASD defines mediation as “an informal, voluntary process that employs an impartial person, the mediator, to facilitate negotiations between disputing parties, in an effort to reach a mutually acceptable resolution.”

149) How is mediation different than arbitration? Mediations are really just supercharged negotiations. In mediation, either side can walk away from the proceedings at any time. If one of the parties is not happy with the end result of the mediation, there is no obligation to accept the final negotiated settlement.

An arbitration is similar in form to a court proceeding. In arbitration, the arbitrators make a final decision. Their decision is binding upon the parties. If the investor or brokerage firm is not happy with the result, short of an appeal, which is very difficult to prevail on, nothing can be done.

78


Investor Rights for the 21st Century

150) How often do securities mediations end in a settlement? It is the authors’ experience that approximately 75 percent of all mediations end in a settlement either at the session or within a few weeks of the actual mediation.

151) Is mediation a good option in lieu of arbitration? For the right cases, mediation is an extremely attractive option. In many cases, the investor in an arbitration action has lost a significant amount or all of his or her life savings. Going to arbitration and allowing three arbitrators to decide the investor’s fate is an unattractive option for some investors since the uncertainty factor in the outcome is high. An investor can have a case that 97 out of 100 arbitrators would decide in his favor on. But any case that goes to arbitration has some potential to provide the investor with nothing. Mediation affords the luxury of allowing the investor to know exactly what outcome will result since the mediation is simply a negotiation session. As a result, many investors and their attorneys find mediation to be an extremely attractive option.

79


Maddox / Stoltmann

This page intentionally left blank

80


Appendix 1 - State Securities Offices Appendix 1 State Securities Offices CONNECTICUT Department of Banking 260 Constitution Plaza Hartford, CT 06103-1800 (860) 240-8299

ALABAMA RSA Plaza Alabama Securities Commission 770 Washington Ave., Suite 570 Montgomery, AL 36130-4700 Fedex Zip: 36104 (334) 242-2984 or (800) 222-1253

DELAWARE Delaware Division of Securities Carvel State Office Building 820 North French St., 8th Floor Wilmington, DE 19801 (302) 577-8424

ALASKA Division of Banking & Securities State Office Building, 9th Floor 333 Willoughby Avenue Juneau, AK 99801 Mailing address: P.O. Box 110807 Juneau, AK 99811-0807 (907) 465-2521

DISTRICT OF COLUMBIA Dept. of Insurance & Securities Regulation Securities Bureau of the District of Columbia 810 1st Street, N.E., 6th Floor Washington, DC 20002 Mailing address: P.O. Box 37638 Washington, D.C. 20013 (202) 727-8000

ARIZONA Arizona Corporation Commission 1300 West Washington St., 3rd Floor Phoenix, AZ 85007 (602) 542-4242 ARKANSAS Arkansas Securities Department Heritage West Building 201 East Markham, 3rd Floor Little Rock, AR 72201 (501) 324-9260

FLORIDA Division of Securities 101 East Gaines Street Tallahassee, FL 32399-0350 (850) 410-9805 GEORGIA Securities and Business Regulation Division 802 West Tower, Suite 802 2 Martin Luther King Jr. Dr., SE Atlanta, GA 30334 (404) 656-3920

CALIFORNIA Department of Corporations 980 9th Street, Suite 500 Sacramento, CA 95814 (916) 445-3062 COLORADO Division of Securities 1580 Lincoln St., Suite 420 Denver, CO 80203-1506 (303) 894-2320

81


Maddox / Stoltmann KENTUCKY Kentucky Department of Financial Institutions 477 Versailles Rd. Frankfort, KY 40601 (502) 573-3390

HAWAII Hawaii Corporate & Securities Commission 1010 Richards St., 2nd Floor Honolulu, HI 96813 Mailing address: P.O. Box 40 Honolulu, HI 96810 (808) 586-2730

LOUISIANA Louisiana Securities Commission 3445 N. Causeway, Suite 509 Metairie, LA 70002 (504) 846-6970

IDAHO Idaho Securities Bureau 700 West State St., 2nd Floor Boise, ID 83720 Mailing address: P.O. Box 83720 Boise, ID 83720-0031 (208) 332-8004

MAINE Maine Securities Division 121 State House Station Augusta, ME 04333-0121 (207) 624-8551

ILLINOIS Illinois Securities Department Lincoln Tower Suite 200 520 South Second St. Springfield, IL 62701 (217) 782-2256

MARYLAND Maryland Division of Securities 200 St. Paul Place, 20th Floor Baltimore, MD 21202-2020 (410) 576-6360 MASSACHUSETTS Massachusetts Securities Division John W. McCormack Building One Ashburton Place, Room 1719 Boston, MA 02108 (617) 727-3548

INDIANA Securities Division 302 West Washington St. Room E-111 Indianapolis, IN 46204 (317) 232-6688

MICHIGAN Michigan Corporation & Securities Bureau 6546 Mercantile Way Lansing, Ml 48910 Mailing address: P.O. Box 30222 Lansing, MI 48909 (517) 334-6215

IOWA Securities Division 340 East Maple Street Des Moines, IA 50319 (515) 281-4441 KANSAS Kansas Securities Commission 618 S. Kansas Ave., 2nd Floor Topeka, KS 66603-3804 (785) 296-3307

MINNESOTA Department of Commerce 133 East Seventh St., 2nd Floor St. Paul, MN 55101 (612) 296-2283 82


Appendix 1 - State Securities Offices NEW JERSEY Bureau of Securities Gibraltar Building 153 Halsey St., 6th Floor Newark, NJ 07102 Mailing address: P.O. Box 47029 Newark, NJ 07101 (973) 504-3600

MISSISSIPPI Securities Division 202 N. Congress St. Suite 601 Jackson, MS 39205 P.O. Box 136 Jackson, MS 39205 (601) 359-6371 MISSOURI Securities Division Missouri State Information Center 600 West Main St., 2nd Floor P.O. Box 1276 Jefferson City, MO 65101 (573) 751-2061

NEW MEXICO New Mexico Securities Division 725 St. Michaels Dr. Sante Fe, NM 87505-7605 Mailing address: P.O. Box 25101 Santa Fe, NM 87501 (505) 827-7140

MONTANA Montana Securities Department 126 North Sanders St., Room 270 Helena, MT 59620 Mailing address: P. O. Box 4009 Helena, MT 59604-4009 (406) 444-2040

NEW YORK New York Bureau of Investment Protection and Securities 120 Broadway 23rd Floor New York, NY 10271 (212) 416-8222

NEBRASKA Nebraska Securities Bureau Department of Banking & Finance 1200 North St., Suite 311 Lincoln, NE 68508 Mailing address: P.O. Box 95006 Lincoln, NE 68509-5006 (402) 471-3445

NORTH CAROLINA North Carolina Securities Division 300 North Salisbury St., Room 302 Raleigh, NC 27603-5909 (919) 733-3924 NORTH DAKOTA North Dakota Securities Commissioners' Office State Capitol Building, 5th Floor 600 East Boulevard Ave. Bismarck, ND 58505-0510 (701) 328-2910

NEVADA Nevada Securities 555 E. Washington Ave., Suite 5200 Las Vegas, NV 89101 (702) 486-2440 NEW HAMPSHIRE Bureau of Securities Regulation State House, Room 204 107 North Main St. Concord, NH 03301-4989 (603) 271-1463

OHIO Ohio Division of Securities 77 South High St., 22nd Floor Columbus, OH 43215 (614) 644-7465

83


Maddox / Stoltmann SOUTH DAKOTA Division of Securities 118 W. Capitol Ave. Pierre, SD 57501-2017 (605) 773-4013

OKLAHOMA Oklahoma Department of Securities First National Center 120 North Robinson, Suite 860 Oklahoma City, OK 73102 (405) 280-7700

TENNESSEE Tennessee Securities Division Volunteer Plaza, Suite 680 500 James Robertson Parkway, Suite 680 Nashville, TN 37243-0583 (615) 741-5905

OREGON Oregon Securities Commission Department of Insurance & Finance 21 Labor & Industries Building Salem, OR 93710 (503) 378-4387

TEXAS State Securities Board 200 East 10th St., 5th Floor Austin, TX 78701 Mailing address: P.O. Box 13167 Austin, TX 78711-3167 (512) 305-8300

PENNSYLVANIA Pennsylvania Securities Commission Eastgate Office Building 1010 N. 7th St., 2nd Floor Harrisburg, PA 17102-1410 (717) 787-5675 PUERTO RICO Commissioner of Financial Institutions Centro Europa Building 1492 Ponce De Leon Ave., Suite 600 San Juan, PR 00907-4127 (787) 723-3131

UTAH Securities Division Herbert M. Wells Building 160 East 300 South, 2nd Floor Salt Lake City, UT 84111 Mailing address: P.O. Box 146760 Salt Lake City, UT 84114-6760 (801) 530-6600

RHODE ISLAND Department of Business Regulation 233 Richmond St., Suite 232 Providence, Rl 02903-4232 (401) 277-3048

VERMONT Department of Banking, Insurance, Securities & Health Care Administration Securities Division 89 Main St., Drawer 20 Montpelier, VT 05620-3101 FedEx/Courier: 89 Main Street, 2nd Floor Montpelier, VT 05620 (802) 828-3301

SOUTH CAROLINA Office of the Attorney General Securities Section Rembert C. Dennis Office Building 1000 Assembly St. Columbia, SC 29202 Mailing address: P.O Box 11549 Columbia, SC 29211-1549 (803) 734-9916

84


Appendix 1 - State Securities Offices VIRGINIA Virginia Division of Securities 1300 E. Main Street Richmond, VA 23209 Mailing Address: P.O. Box 1197 Richmond, VA 23218 (804) 371-9051 WASHINGTON Department of Financial Institutions Securities Division General Administration Building 210 11th Avenue, SW 3rd Floor West, Room 300 Olympia, WA 98504 Mailing address: P.O. Box 9033 Olympia, WA 98507-9033 (360) 902-8760 WEST VIRGINIA West Virginia Securities Division State Capitol Building 1900 Kanawha Blvd., East Room 118 West Charleston, WV 25305 (304) 558-2257/2258 WISCONSIN Division of Securities 345 W. Washington Ave. Madison, WI 53703 Mailing address: P.O. Box 1768 Madison, WI 53701-1768 (608) 266-3431 WYOMING Securities Division Secretary of State 24th Street & State Capitol Avenue Cheyenne, WY 82002-0020 (307) 777-7370

85


Maddox / Stoltmann

This page intentionally left blank.

86


Appendix 2 – Regulatory Agencies Appendix 2 Regulatory Agencies NASD 1735 K Street, NW Washington, DC 20006-1500 (202) 728-8000

Securities and Exchange Commission U.S. Securities and Exchange Commission 450 5th Street, NW Washington, DC 20549 (202) 942-8088

NASD Regulation 1735 K Street, NW Washington, DC 20006-1500 (202) 728-8000

U.S. Securities and Exchange Commission Office of Investor Education and Assistance (800) SEC-0330 (202) 942-7040 TTD (202) 942-7065

NASD Regulation 125 Broad Street, 36th Floor New York NY 10004-2193 (212)-858-3974

Commodity Futures Trading Commission Three Lafayette Center 1155 21st Street, NW Washington, DC 20581 Phone: (202) 418-5000 Fax: (202) 418-5525

NASD Regulation 525 Market St., Suite 300 San Francisco, CA 94105 (415)-882-1234

Other Regulatory Organizations NASD Regulation 300 S. Grand Avenue, Suite 1620 Los Angeles, CA 90071 (213) 613-2680

Investment Dealers Association of Canada 121 King Street West Suite 1600 Toronto, Ontario (M5H 3T9) Canada (416) 364-6133

NASD Regulation Boca Center Tower 1 5200 Town Center Circle, Suite 400 Boca Raton, FL 33486 (561)-416-0277

Municipal Securities Rulemaking Board 1150 18th Street, NW, Suite 400 Washington, DC 20036-2491 (202) 223-9347

NASD Regulation 10 S. LaSalle St., Suite 1100 Chicago, IL 60603-1002 (312)-236-9239

National Futures Association 200 West Madison, Suite 1400 Chicago, IL 60606 (800) 676-4NFA North American Securities Administrators Association, Inc. (NASAA) 10 G Street, N.E., Suite 710 Washington, D.C. 20002 (202) 737-0900

87


Maddox / Stoltmann New York Stock Exchange 11 Wall Street New York, NY 10005 (212) 656-3000

Securities and Futures Authority Individual Registration and Qualifications Department Cottons Center Cottons Lane London SE1 2QB England 171-378-9000

Pacific Exchange, Inc. 301 Pine Street San Francisco, CA 94104 (415) 393-4000

Exchanges and Markets American Stock Exchange 86 Trinity Place New York, NY 10006-1881 (212) 306-1000

Philadelphia Stock Exchange 1900 Market Street Philadelphia, PA 19103 (215) 496-5000 (800) THE-PHLX

Boston Stock Exchange One Boston Place Boston, MA 02108 (617) 723-9500 Chicago Board Options Exchange 400 South LaSalle Street Chicago, IL 60605 (312) 786-5600 Options Hotline - general information: 1-800-Options Chicago Stock Exchange 440 South LaSalle Street Chicago, IL 60605 (312) 663-2980 Cincinnati Stock Exchange 400 South LaSalle Street Chicago, IL 60605 (312) 786-8803 Fax: (312) 939-7239 The NASDAQ Stock Market National Association of Securities Dealers, Inc. 1735 K Street, NW Washington, DC 20006-1500 (301) 590-6500

88


Appendix 3 – An NASD Guide On How To Avoid Problems With A Broker Appendix 3 An NASD Guide On How To Avoid Problems With a Broker The following steps may help you avoid problems: 1) Thoroughly read and retain your monthly account statements, confirmations, and any other information you receive about your investment transactions. 2) Immediately question any transaction or entry that you do not understand or did not authorize with your broker. If you are not satisfied with your broker’s response, consult with the firm’s branch manager and compliance department. 3) To allege improper business conduct and to make monetary claims, you should complain promptly in writing, first to your broker, then to the manager or the sales office, and then directly to the firm’s compliance officer. Retain a copy of your letter and of all other related correspondence with the broker/dealer. If the problem cannot be resolved through the firm, other alternatives, such as arbitration, may be appropriate. A delay in pursuing your complaint for whatever reason may lessen its credibility. 4) Follow up if you do not receive a satisfactory response to your complaint. Continued failure to receive a satisfactory response may warrant your filing a written complaint with NASD Regulation or another self-regulatory organization. 5) Beware of sales pitches that make exaggerated claims about the expected profitability of a particular investment or make specific price predictions, such as, "your money will double in six months," especially if dealing with a broker who is new to you. If it sounds too good to be true, it usually is. 6) Beware of any broker who pressures you to invest quickly to avoid missing out on a "once in a lifetime opportunity." Investment decisions should be made only after deliberation and thought, and with the benefit of all the relevant facts – take time to learn them. Be suspicious of any broker who uses high-pressure tactics. 7) Never send money to a firm or broker that you are hearing from for the first time simply based on a telephone sales pitch. 8) When investing for income and yield, whether in stocks, bonds, mutual funds, etc., make certain that you understand fully the nature of the security in which you are investing – there normally are varying market and price risks associated with each type of security. 9) Investing in lower-priced, so-called "penny stocks" is inherently risky and should be done only after a thorough investigation is made of the company and of the market for its shares. 10) Investing your money is a major decision, similar to the purchase of a house or an automobile. Investigate thoroughly any potential investment before you make it, as well as the broker and

89


Maddox / Stoltmann securities firm who are recommending it to you. To do so, you should request a prospectus, annual report, and/or research information, and read them carefully. Discuss your investment opportunities with your broker, certified public accountant or independent advisor.

90


Appendix 4 – An NASD “Questions to Consider” Checklist Before Doing Business With A Broker, Financial Planner or Insurance Agent Appendix 4 An NASD “Questions to Consider” Checklist Before Doing Business With a Broker, Financial Planner or Insurance Agent Q. Does the paperwork reflect reality? After an account is opened with a brokerage firm, an investor should check the papers from the new account application. It is not uncommon for a financial advisor to inflate the investor’s earnings, assets, investment experience and risk tolerance level so that the investor appears suitable for riskier investments. Also, always check the trading confirmation slips to make sure they are accurate. For instance, if a trade that the broker recommended is marked “unsolicited,” complain to the branch office manager if in reality, the broker recommended the stock. Q. Does the broker ask you to send money via a messenger service or private delivery service? An investor should never send a broker a check using a messenger service or private delivery service. If a broker suggests it, he may be trying to get around wire-fraud laws. Q. Does the broker promise things that he can't control--at least not legally? If the financial advisor swears that a stock is sure to rise, or that he has inside information, or that if you lose money, he'll make you whole, immediately cease doing business with that broker. No semi-reputable adviser will ever make such outlandish claims like the ones mentioned above. Q. Will the broker tell you how much he would earn on the recommendation? Sometimes, brokers get extra pay for selling certain stocks or funds. Ask the broker what he is getting paid on the security. Ask if the broker is making you are making an agency transaction, in which the broker is matching the investor up with other buyers or sellers, or a principal transaction, in which the investor is buying from the brokerage firm itself. Usually, principal transactions are more profitable for the broker and his firm. Q. Did the broker call you out of the blue? Even at reputable firms, new brokers often call people they don't know to try to sell them investments. But in the past, cold-calling has lead to a great deal of problems for investors. A task force of regulators looking at small companies' branches found serious problems at half of the firms that permit such calls. Q. Can you visit the broker's office? An investor should attempt to meet with the financial adviser personally. While at the office, take a look around. If every broker does not have access to a computer that calls up stock quotations and other market information, you have to wonder what their real business is. Usually, rookie brokers are placed in what is called a “bullpen” at most brokerage firms which is really one giant floor of desks and telephones. More experienced brokers will usually have their own office. Length of service at a firm or a fancy office is obviously no guarantee that the adviser is legitimate but it is one more piece of the puzzle in determining if this is a person to do business with.

91


Maddox / Stoltmann Q. Does the broker have a history of customer complaints or regulatory run-ins? Both the investor’s state and the NASD can supply a copy of a broker's CRD rap sheet. A serious problem in the last two years is worth asking about and should raise some red flags. If the financial adviser has a string of problems, the investor should refuse to do business with him. Q. Where has the broker worked? If the financial adviser has moved from firm to firm in the past, a red flag should go up in the investor’s mind. The CRD will give a broker's employment history. Take note if he or she has worked at any of the well-known penny-stock operations above or he has gone from well known, larger firms to smaller operations. Q. Does the broker seem knowledgeable about the recommendations? If the financial advisor cannot tell the investor the basics of the security like the past earnings, price earnings multiple, core products and the management team, stay away from the recommendation. At a minimum, the broker should have a strong grasp of what exactly the company does and why his firm’s research department is recommending it. Q. What is the second stock the broker tries to sell you? Sometimes brokers will lull an investor into a false sense of security by initially suggesting a bluechip investment to the investor. But the second recommendation is often the most revealing. If the second or third recommendation is a house stock or a low priced stock with questionable earnings and prospects, a red flag should immediately go up in the investor’s mind. What the broker is doing is a hybrid version of the old bait and switch scam. Q. Does the broker say you have to buy? An excellent sign of potential problems with a financial adviser are high-pressure sales tactics. If the broker tells an investor he has to purchase certain stocks to get other, better opportunities, or the investor must buy now, an immediate warning sign should go up. Q. Does the broker say you cannot sell? Legitimate brokers may try to discourage an investor from dumping stocks in a panic. However, there is a huge difference between "should not" and "cannot." If a broker tries to prevent a sale, or simply fails to carry out your orders, there is a reasonable chance that the broker or his firm is trying to fraudulently and illegally manipulate the share price.

92


Appendix 5 – The SEC Statement on “Mutual Fund Investing: Look at More Than A Fund’s Past Performance Appendix 5 The SEC Statement on “Mutual Fund Investing: Look at More Than a Fund's Past Performance” You can't open a newspaper or read a magazine without seeing ads promoting the stellar performance of "hot" mutual funds. But past performance is not as important as you may think, especially the short-term performance of relatively new or small funds. As with any investment, a fund's past performance is no guarantee of its future success. Over the longterm, the success (or failure) of your investment in a fund also will depend on factors such as: • • • • •

the fund's sales charges, fees, and expenses; the taxes you may have to pay when you receive a distribution; the age and size of the fund; the fund's risks and volatility; and recent changes in the fund's operations.

So, look at more than the fund's past performance when making your investment decisions. Read the fund's prospectus and shareholder reports, and consider these tips: •

Scrutinize the fund's fees and expenses. Funds charge investors fees and expenses. A fund with high costs must perform better than a low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858 – an 18% difference. It takes only minutes to use the SEC's Mutual Fund Cost Calculator to compute how the costs of different mutual funds add up over time and eat into your returns.

Know how the fund impacts your tax bill. The law requires a fund to make a capital gains distribution to shareholders if it sells a security for a profit that can't be offset by a loss. If you receive a capital gains distribution, you will likely owe taxes on it – even if the fund has had a negative return since you invested in it. For this reason, you should call the fund to find out when it makes distributions so you won't pay more than your fair share of taxes. Some funds post that information on their websites.

Consider the age and size of the fund. Before investing in a fund, read the prospectus to find out how long the fund has been operating and the size of the fund. Newly created or small funds sometimes have excellent short-term performance records. Because these funds may invest in only a

93


Maddox / Stoltmann small number of stocks, a few successful stocks can have a large impact on their performance. But as these funds grow larger and increase the number of stocks they own, each stock has less impact on performance. This may make it more difficult to sustain initial results. You can get a better picture of a fund's performance by looking at how the fund has performed over longer periods and how it has weathered the ups and downs of the market. •

Think about the volatility of the fund. While past performance does not necessarily predict future returns, it can tell you how volatile a fund has been. Generally, the more volatile a fund, the higher the investment risk. If you'll need your money to meet a financial goal in one year, you probably can't afford the risk of investing in a fund with a volatile history because you will not have enough time to ride out any declines in the stock market. Read the fund's prospectus and annual report, and compare its year-to-year performance figures. These figures can help tell you whether the fund earned most of its returns in a few small bursts or whether its returns came in a steadier stream. For example, over ten years, two funds may have gained 12% per year on average, but they may have taken drastically different routes to get there. One might have had a few years of spectacular performance and a few years of low (or negative) returns, while the performance of the other may have been much steadier from year to year.

Factor in the risks the fund takes to achieve its returns. Read the fund's prospectus and shareholder reports to learn about its investment strategy. Funds with higher rates of return may take risks that are beyond your comfort level and are inconsistent with your financial goals. For example, a fund that invests primarily in stocks whose prices may change quickly – like initial public offerings or high-tech stocks – will usually be riskier than other types of funds. But remember that all funds carry some level of risk. Just because a fund invests in government or corporate bonds does not mean it does not have significant risk. For example, the fund's investments could be very sensitive to interest rate changes. Thinking about your long-term investment strategies and tolerance for risk can help you decide what type of fund is best suited for you.

Ask about recent changes in the fund's operations. Has the fund's investment adviser or investment strategy changed recently? Has the fund merged with another fund? Operational changes such as these can affect future fund performance. For instance, the investment adviser or portfolio manager who generated the fund's successful performance may no longer be managing the fund.

Check the types of services offered and fees charged by the fund. Read the fund's prospectus to learn what services it provides to shareholders. Some funds provide special services, such as toll-free telephone numbers, check-writing

94


Appendix 5 – The SEC Statement on “Mutual Fund Investing: Look at More Than A Fund’s Past Performance privileges, and automatic investment programs. You should find out how easily you can buy and sell shares and whether the fund charges a fee for buying and selling shares. You can expect funds that require extra work by their managers, such as international funds, to have higher costs. •

Assess how the fund will impact the diversification of your portfolio. Generally, the success of your investments over time will depend largely on how much money you have invested in each of the major asset classes – stocks, bonds, and cash – rather than on the particular securities you hold. When choosing a mutual fund, you should consider how your interest in that fund affects the overall diversification of your investment portfolio. Maintaining a diversified and balanced portfolio is key to maintaining an acceptable level of risk.

95


Maddox / Stoltmann

This page intentionally left blank.

96


Appendix 6 – The SEC Statement on “Certificates of Deposit: Tips for Investors” Appendix 6 The SEC Statement on “Certificates of Deposit: Tips for Investors” Investors searching for relatively low-risk investments that can easily be converted into cash often turn to certificates of deposit (CDs). A CD is a special type of deposit account with a bank or thrift institution that typically offers a higher rate of interest than a regular savings account. Unlike other investments, CDs feature federal deposit insurance up to $100,000. Here’s how CDs work: When you purchase a CD, you invest a fixed sum of money for fixed period of time – six months, one year, five years, or more – and, in exchange, the issuing bank pays you interest, typically at regular intervals. When you cash in or redeem your CD, you receive the money you originally invested plus any accrued interest. But if you redeem your CD before it matures, you may have to pay an "early withdrawal" penalty or forfeit a portion of the interest you earned. Although most investors have traditionally purchased CDs through local banks, many brokerage firms and independent salespeople now offer CDs. These individuals and entities – known as "deposit brokers" – can sometimes negotiate a higher rate of interest for a CD by promising to bring a certain amount of deposits to the institution. The deposit broker can then offer these "brokered CDs" to their customers. At one time, most CDs paid a fixed interest rate until they reached maturity. But, like many other products in today’s markets, CDs have become more complicated. Investors may now choose among variable rate CDs, long-term CDs, and CDs with other special features. Some long-term, high-yield CDs have "call" features, meaning that the issuing bank may choose to terminate – or call – the CD after only one year or some other fixed period of time. Only the issuing bank may call a CD, not the investor. For example, a bank might decide to call its highyield CDs if interest rates fall. But if you’ve invested in a long-term CD and interest rates subsequently rise, you’ll be locked in at the lower rate. Before you consider purchasing a CD from your bank or brokerage firm, make sure you fully understand all of its terms. Carefully read the disclosure statements, including any fine print. And don’t be dazzled by high yields. Ask questions – and demand answers – before you invest. These tips can help you assess what features make sense for you: •

Find Out When the CD Matures – As simple as this sounds, many investors fail to confirm the maturity dates for their CDs and are later shocked to learn that they’ve tied up their money for five, ten, or even twenty years. Before you purchase a CD, ask to see the maturity date in writing. Investigate Any Call Features – Callable CDs give the issuing bank the right to terminate-or "call"-the CD after a set period of time. But they do not give you that same right. If interest rates fall, the issuing bank might call the CD. In that case, you should receive the full amount of your original deposit plus any unpaid accrued interest. But you'll have to shop for a new one with a lower rate of return. Unlike the bank, you can never "call" the CD and get your principal back. So if interest rates rise, you'll be stuck in

97


Maddox / Stoltmann

a long-term CD paying below-market rates. In that case, if you want to cash out, you will lose some of your principal. That's because your broker will have to sell your CD at a discount to attract a buyer. Few buyers would be willing to pay full price for a CD with a below-market interest rate. Understand the Difference Between Call Features and Maturity – Don’t assume that a "federally insured one-year non-callable" CD matures in one year. It doesn't. These words mean the bank cannot redeem the CD during the first year, but they have nothing to do with the CD's maturity date. A "one-year non-callable" CD may still have a maturity date 15 or 20 years in the future. If you have any doubt, ask the sales representative at your bank or brokerage firm to explain the CD’s call features and to confirm when it matures. For Brokered CDs, Identify the Issuer – Because federal deposit insurance is limited to a total aggregate amount of $100,000 for each depositor in each bank or thrift institution, it is very important that you know which bank or thrift issued your CD. Your broker may plan to put your money in a bank or thrift where you already have other CDs or deposits. You risk not being fully insured if the brokered CD would push your total deposits at the institution over the $100,000 insurance limit. (If you think that might happen, contact the institution to explore potential options for remaining fully insured, or call the FDIC.) For more information about federal deposit insurance, visit the Federal Deposit Insurance Corporation’s web site and read its publication Your Insured Deposit or call the FDIC's Consumer Information Center at 1-800-934-3342. Find Out How the CD Is Held – Unlike traditional bank CDs, brokered CDs are sometimes held by a group of unrelated investors. Instead of owning the entire CD, each investor owns a piece. Confirm with your broker how your CD is held, and be sure to ask for a copy of the exact title of the CD. If several investors own the CD, the deposit broker will probably not list each person's name in the title. But you should make sure that the account records reflect that the broker is merely acting as an agent for you and the other owners (for example, "XYZ Brokerage as Custodian for Customers"). This will ensure that your portion of the CD qualifies for up to $100,000 of FDIC coverage. Research Any Penalties for Early Withdrawal – Deposit brokers often tout the fact that their CDs have no penalty for early withdrawal. While technically true, these claims can be misleading. Be sure to find out how much you'll have to pay if you cash in your CD before maturity and whether you risk losing any portion of your principal. If you are the sole owner of a brokered CD, you may be able to pay an early withdrawal penalty to the bank that issued the CD to get your money back. But if you share the CD with other customers, your broker will have to find a buyer for your portion. If interest rates have fallen since you purchased your CD and the bank hasn't called it, your broker may be able to sell your portion for a profit. But if interest rates have risen, there may be less demand for your lower-yielding CD. That means you would have to sell the CD at a discount and lose some of your original deposit –despite no "penalty" for early withdrawal. Thoroughly Check Out the Broker – Deposit brokers do not have to go through any licensing or certification procedures, and no state or federal agency licenses, examines, or approves them. Since anyone can claim to be a deposit broker, you should always check whether your broker or the company he or she works for has a history of complaints or fraud. You can do this by calling your state securities regulator or by checking with the

98


Appendix 6 – The SEC Statement on “Certificates of Deposit: Tips for Investors”

National Association of Securities Dealers' "Central Registration Depository" at 1-800289-9999. Confirm the Interest Rate You’ll Receive and How You’ll Be Paid – You should receive a disclosure document that tells you the interest rate on your CD and whether the rate is fixed or variable. Be sure to ask how often the bank pays interest – for example, monthly or semi-annually. And confirm how you’ll be paid – for example, by check or by an electronic transfer of funds. Ask Whether the Interest Rate Ever Changes – If you’re considering investing in a variable-rate CD, make sure you understand when and how the rate can change. Some variable-rate CDs feature a "multi-step" or "bonus rate" structure in which interest rates increase or decrease over time according to a pre-set schedule. Other variable-rate CDs pay interest rates that track the performance of a specified market index, such as the S&P 500 or the Dow Jones Industrial Average.

The bottom-line question you should always ask yourself is: Does this investment make sense for me? A high-yield, long-term CD with a maturity date of 15 to 20 years may make sense for many younger investors who want to diversify their financial holdings. But it might not make sense for elderly investors. Don't be embarrassed if you invested in a long-term, brokered CD in the mistaken belief that it was a shorter-term instrument-you are not alone. Instead, you should complain promptly to the broker who sold you the CD. By complaining early you may improve your chances of getting your money back. Here are the steps you should take: 1. Talk to the broker who sold you the CD, and explain the problem fully, especially if you misunderstood any of the CD's terms. Tell your broker how you want the problem resolved. 2. If your broker can't resolve your problem, then talk to his or her branch manager. 3. If that doesn't work, then write a letter to the compliance department at the firm's main office. The branch manager should be able to provide with contact information for that department. Explain your problem clearly, and tell the firm how you want it resolved. Ask the compliance office to respond to you in writing within 30 days. 4. If you're still not satisfied, then send us your complaint using our online complaint form. Be sure to attach copies of any letters you've sent already to the firm. If you don't have access to the Internet, please write to us at the address below: Office of Investor Education and Assistance U.S. Securities and Exchange Commission 450 Fifth Street, NW Washington, DC 20549-0213

You should also contact the banking regulator that oversees the bank that issued the CD: •

The Board of Governors of the Federal Reserve System oversees state-chartered banks and trust companies that belong to the Federal Reserve System.

99


Maddox / Stoltmann • • • •

The Federal Deposit Insurance Corporation regulates state-chartered banks that do not belong to the Federal Reserve System. The Office of the Controller of the Currency regulates banks that have the word "National" in or the letters "N.A." after their names. The National Credit Union Administration regulates federally charted credit unions. The Office of Thrift Supervision oversees federal savings and loans and federal savings banks.

100


Appendix 7 – The SEC Statement on “Day Trading: Your Dollars at Risk” Appendix 7 The SEC statement on “Day Trading: Your Dollars at Risk” Day traders rapidly buy and sell stocks throughout the day in the hope that their stocks will continue climbing or falling in value for the seconds to minutes they own the stock, allowing them to lock in quick profits. Day traders usually buy on borrowed money, hoping that they will reap higher profits through leverage, but running the risk of higher losses too. As former SEC Chairman Levitt recently stated in his testimony before the U.S. Senate, "[Day trading] is neither illegal nor is it unethical. But it is highly risky." Most individual investors do not have the wealth, the time, or the temperament to make money and to sustain the devastating losses that day trading can bring. Here are some of the facts that every investor should know about day trading: •

Be prepared to suffer severe financial losses Day traders typically suffer severe financial losses in their first months of trading, and many never graduate to profit-making status. Given these outcomes, it's clear: day traders should only risk money they can afford to lose. They should never use money they will need for daily living expenses, retirement, take out a second mortgage, or use their student loan money for day trading.

Day traders do not "invest" Day traders sit in front of computer screens and look for a stock that is either moving up or down in value. They want to ride the momentum of the stock and get out of the stock before it changes course. They do not know for certain how the stock will move, they are hoping that it will move in one direction, either up or down in value. True day traders do not own any stocks overnight because of the extreme risk that prices will change radically from one day to the next, leading to large losses.

Day trading is an extremely stressful and expensive full-time job Day traders must watch the market continuously during the day at their computer terminals. It's extremely difficult and demands great concentration to watch dozens of ticker quotes and price fluctuations to spot market trends. Day traders also have high expenses, paying their firms large amounts in commissions, for training, and for computers. Any day trader should know up front how much they need to make to cover expenses and break even.

Day traders depend heavily on borrowing money or buying stocks on margin Borrowing money to trade in stocks is always a risky business. Day trading strategies demand using the leverage of borrowed money to make profits. This is why many day

101


Maddox / Stoltmann traders lose all their money and may end up in debt as well. Day traders should understand how margin works, how much time they'll have to meet a margin call, and the potential for getting in over their heads. •

Don't believe claims of easy profits Don't believe advertising claims that promise quick and sure profits from day trading. Before you start trading with a firm, make sure you know how many clients have lost money and how many have made profits. If the firm does not know, or will not tell you, think twice about the risks you take in the face of ignorance.

Watch out for "hot tips" and "expert advice" from newsletters and websites catering to day traders Some websites have sought to profit from day traders by offering them hot tips and stock picks for a fee. Once again, don't believe any claims that trumpet the easy profits of day trading. Check out these sources thoroughly and ask them if they have been paid to make their recommendations.

Remember that "educational" seminars, classes, and books about day trading may not be objective Find out whether a seminar speaker, an instructor teaching a class, or an author of a publication about day trading stands to profit if you start day trading.

Check out day trading firms with your state securities regulator

Like all broker-dealers, day trading firms must register with the SEC and the states in which they do business. Confirm registration by calling your state securities regulator and at the same time ask if the firm has a record of problems with regulators or their customers. You can find the telephone number for your state securities regulator in the government section of your phone book or by calling the North American Securities Administrators Association at (202) 737-0900. NASAA also provides this information on its website at www.nasaa.org/nasaa/abtnasaa/find_regulator.html.

102


Appendix 8 – The SEC Statement on “Investment Advisers: What You Need to Know Before Choosing One” Appendix 8 The SEC Statement on “Investment Advisers: What You Need to Know Before Choosing One” The SEC receives many questions about investment advisers-what they are and how to go about choosing one. This document answers some of the typical questions we receive from investors about investment advisers. This Q&A is for the benefit of investors. You should not rely upon it to determine if you need to register as an investment adviser. Q: What is an investment adviser? A: Investment advisers are in the business of giving advice about securities to clients. For instance, individuals who receive compensation for giving advice to a specific person on investing in stocks, bonds, or mutual funds, are investment advisers. Some investment advisers manage portfolios of securities. Q: What is the difference between an investment adviser and a financial planner? A: Most financial planners are investment advisers, but not all investment advisers are financial planners. Some financial planners assess every aspect of your financial life-including saving, investments, insurance, taxes, retirement, and estate planning-and help you develop a detailed strategy or financial plan for meeting all your financial goals. Others call themselves financial planners, but they may only be able to recommend that you invest in a narrow range of products, and sometimes products that aren't securities. Before you hire any financial professional, you should know exactly what services you need, what services the professional can deliver, any limitations on what they can recommend, what services you're paying for, how much those services cost, and how the adviser or planner gets paid. Q: What questions should I ask when choosing an investment adviser or financial planner? A: Here are some of the questions you should always ask when hiring any financial professional: • • • • • • • •

What experience do you have, especially with people in my circumstances? Where did you go to school? What is your recent employment history? What licenses do you hold? Are you registered with the SEC, a state, or the NASD? What products and services do you offer? Can you only recommend a limited number of products or services to me? If so, why? How are you paid for your services? What is your usual hourly rate, flat fee, or commission? Have you ever been disciplined by any government regulator for unethical or improper conduct or been sued by a client who was not happy with the work you did? For registered investment advisers, will you send me a copy of both parts of your Form ADV?

103


Maddox / Stoltmann Be sure to meet potential advisers "face to face" to make sure you get along. And remember: there are many types of individuals who can help you develop a personal financial plan and manage your hard–earned money. The most important thing is that you know your financial goals, have a plan in place, and check out the professional you chose with your securities regulator. Q: How do investment advisers get paid? A: Before you hire any financial professional-whether it's a stockbroker, a financial planner, or an investment adviser-you should always find out and make sure you understand how that person gets paid. Investment advisers generally are paid in any of the following ways: • • • • •

A percentage of the value of the assets they manage for you; An hourly fee for the time they spend working for you; A fixed fee; A commission on the securities they sell; or Some combination of the above.

Each compensation method has potential benefits and possible drawbacks, depending on your individual needs. Ask the investment advisers you interview to explain the differences to you before you do business with them, and get several opinions before making your decision. Q: Do investment advisers have to register with the U.S. Securities and Exchange Commission? A: Depending on their size, investment advisers have to register with either the SEC or the state securities agency where they have their principal place of business. For the most part, investment advisers who manage $25 million or more in client assets must register with the SEC. If they manage less than $25 million, they must register with the state securities agency in the state where they have their principal place of business. Q: How do I find out whether an investment adviser ever had problems with a government regulator or has a disciplinary history? A: Most investment advisers must fill out a form called "Form ADV." They must file their ADVs with either the SEC or the state securities agency in the state where they have their principal place of business, depending on the amount of assets they manage. The ADV consists of two parts. Part I contains information about the adviser's education, business, and whether they've had problems with regulators or clients. Part II outlines the adviser's services, fees, and strategies. Before you hire someone to be your investment adviser, always ask for, and carefully read, both parts of the ADV. You can get copies of Form ADVs from the investment adviser, your state securities regulator, or the SEC, depending on the size of the adviser. You can find out how to get in touch with your state securities regulator through the North American Securities Administrators Association, Inc.'s Web site or by calling (202) 737-0900. Ask your state securities regulator whether they've had any complaints about the adviser, and ask them to check the CRD.

104


Appendix 8 – The SEC Statement on “Investment Advisers: What You Need to Know Before Choosing One” If the SEC registers the investment adviser, you can get the Form ADV at a cost of 24 cents per page (plus tax and postage) from the SEC at Office of Public Reference 450 5th Street, NW, Room 1300 Washington, D.C. 20549-0102 phone: (202) 942-8090 fax: (202) 628-9001 e-mail: publicinfo@sec.gov Q: What should I do if the financial professional claims that he or she is a certified financial planner™? A: If the professional you're considering claims to be a "certified financial planner™" (CFP™), you should also visit the website of the Certified Financial Planner Board of Standards to see if the professional is licensed as a CFP and whether the professional's license has been suspended or revoked by the Board. You can also call the Board at (888) 237-6275 to obtain other disciplinary information about the professional. Q: Are investment advisers required to have credentials? A: While some investment advisers and financial planners have credentials like CFP™ (certified financial planner™) or CFA (chartered financial analyst), they are not required to by federal or state laws. Unlike federally registered advisers, many states do require their advisers and representatives to pass a proficiency exam or meet other requirements. Investment advisers and financial planners may come from many different educational and professional backgrounds. Before you hire a financial professional, be sure to ask about their background. If they have a credential, ask them what it means and what they had to do to earn it. Also find out what organization issued the credential, and then contact the organization to verify whether the professional you're considering did, in fact, earn the credential and whether the professional remains in good standing with the organization. You can find out the different types of testing and other requirements on the website of the North American Securities Administrators Association.

105


Maddox / Stoltmann

This page intentionally left blank.

106


Appendix 9 – The SEC Statement on “Microcap Stock: A Guide for Investors” Appendix 9 The SEC Statement on “Microcap Stock: A Guide for Investors” Introduction Information is the investor's best tool when it comes to investing wisely. But accurate information about "microcap stocks" – low-priced stocks issued by the smallest of companies – may be difficult to find. Many microcap companies do not file financial reports with the SEC, so it's hard for investors to get the facts about the company's management, products, services, and finances. When reliable information is scarce, fraudsters can easily spread false information about microcap companies, making profits while creating losses for unsuspecting investors. In the battle against microcap fraud, the SEC has toughened its rules and taken actions against wrongdoers, but we can't stop every microcap fraud. We need your help in winning the battle. Before you consider investing in a microcap company, arm yourself first with information. This alert tells you about microcap stocks, how to find information, what "red flags" to consider, and where to turn if you run into trouble. What Is a Microcap Stock? The term "microcap stock" applies to companies with low or "micro" capitalizations, meaning the total value of the company's stock. Microcap companies typically have limited assets. For example, in recent cases where the SEC suspended trading in microcap stocks, the average company had only $6 million in net tangible assets – and nearly half had less than $1.25 million. Microcap stocks tend to be low priced and trade in low volumes. Where Do Microcap Stocks Trade? Many microcap stocks trade in the "over-the-counter" (OTC) market and are quoted on OTC systems, such as the OTC Bulletin Board (OTCBB) or the "Pink Sheets." •

OTC Bulletin Board The OTCBB is an electronic quotation system that displays realtime quotes, last-sale prices, and volume information for many OTC securities that are not listed on the Nasdaq Stock Market or a national securities exchange. Brokers who subscribe to the system can use the OTCBB to look up prices or enter quotes for OTC securities. Although the NASD oversees the OTCBB, the OTCBB is not part of the Nasdaq Stock Market. Fraudsters often claim that an OTCBB company is a Nasdaq company to mislead investors into thinking that the company is bigger than it is. The "Pink Sheets" The Pink Sheets – named for the color of paper they've historically been printed on – are a weekly publication of a company called the National Quotation Bureau. They are updated electronically on a daily basis. Brokers who subscribe to the Pink Sheets can find out the names and telephone numbers of the "market makers" in various OTC stocks – meaning the brokers who commit to buying and selling those OTC securities. Unless your broker has the Pink Sheets or you contact the market makers directly, you'll have a difficult time finding price information for most stocks that are quoted in the Pink Sheets.

107


Maddox / Stoltmann How Are Microcap Stocks Different From Other Stocks? Lack of Public Information The biggest difference between a microcap stock and other stocks is the amount of reliable, publicly available information about the company. Larger public companies file reports with the SEC that any investor can get for free from the SEC's Web site. Professional stock analysts regularly research and write about larger public companies, and it's easy to find their stock prices in the newspaper. In contrast, information about microcap companies can be extremely difficult to find, making them more vulnerable to investment fraud schemes. The SEC has proposed new rule changes that will increase the amount of information brokers must gather about microcap companies before quoting prices for their stocks in the OTC market. No Minimum Listing Standards Companies that trade their stocks on major exchanges and in the Nasdaq Stock Market must meet minimum listing standards. For example, they must have minimum amounts of net assets and minimum numbers of shareholders. In contrast, companies on the OTCBB or the Pink Sheets do not have to meet any minimum standards. Risk While all investments involve risk, microcap stocks are among the most risky. Many microcap companies tend to be new and have no proven track record. Some of these companies have no assets or operations. Others have products and services that are still in development or have yet to be tested in the market. Which Companies File Reports With the SEC? In general, the federal securities laws require all but the smallest of public companies to file reports with the SEC. A company can become "public" in one of two ways – by issuing securities in an offering or transaction that's registered with the SEC or by registering the company and its outstanding securities with the SEC. Both types of registration trigger ongoing reporting obligations, meaning the company must file periodic reports that disclose important information to investors about its business, financial condition, and management. This information is a treasure trove for investors: it tells you whether a company is making money or losing money and why. You'll find this information in the company's quarterly reports on Form 10-Q, annual reports (with audited financial statements) on Form 10-K, and periodic reports of significant events on Form 8-K. A company must file reports with the SEC if: • •

it has 500 or more investors and $10 million or more in assets; or it lists its securities on the following stock markets: o American Stock Exchange o Boston Stock Exchange o Cincinnati Stock Exchange o Chicago Stock Exchange o Nasdaq Stock Market o New York Stock Exchange o Pacific Exchange o Philadelphia Stock Exchange

108


Appendix 9 – The SEC Statement on “Microcap Stock: A Guide for Investors”

Until recently, only about half of the companies whose securities were quoted on the OTCBB filed reports with the SEC. In January 1999, the SEC approved a new NASD rule allowing the NASD to require that all OTCBB companies file updated financial reports with the SEC or with their banking or insurance regulators. The new rule applied immediately to companies that first appeared on the OTCBB after January 4, 1999. For those companies that were on the OTCBB as of January 4, 1999, the new rule was phased in over a twelve-month period beginning in July 1999. Beginning in June 2000, the new rule applied to all companies on the OTCBB. Since then, any companies who have refused to file timely reports with the SEC or their banking or insurance regulators have been removed from the OTCBB. Tip: When an OTCBB company fails to file its reports on time, the NASD will add a fifth letter "E" to its four-letter stock symbol. The company then has 30 days to file with the SEC or 60 days to file with its banking or insurance regulator. If it's still delinquent after the grace period, the company will be removed from the OTCBB. You'll find a list of securities that have been removed from the OTCBB at www.otcbb.com. With few exceptions, companies that file reports with the SEC must do so electronically using the SEC's EDGAR system. EDGAR stands for electronic data gathering and retrieval. The EDGAR database is available on the SEC's Web site at www.sec.gov. You'll find many corporate filings in the EDGAR database, including annual and quarterly reports and registration statements. Any investor can access and download this information for free from the SEC's Web site. Click here if you want to view detailed instructions on how to use EDGAR. Caution: By law, the reports that companies file with the SEC must be truthful and complete, presenting the facts investors find important in making decisions to buy, hold, or sell a security. But the SEC cannot guarantee the accuracy of the reports companies file. Some dishonest companies break the law and file false reports. Every year, the SEC brings enforcement actions against companies who've "cooked their books" or failed to provide important information to investors. Read SEC filings – and all other information – with a questioning and critical mind. Which Companies Don't Have to File Reports With the SEC? Smaller companies – those with less than $10 million in assets – generally do not have to file reports with the SEC. But some smaller companies, including microcap companies, may choose voluntarily to register their securities with the SEC. As described above, companies that register with the SEC must also file quarterly, annual, and other reports. A Word About Offering Requirements Any company that wants to offer or sell securities to the public must either register with the SEC or meet an exemption. Here are two of the most common exemptions that many microcap companies use: •

"Reg A" Offerings Companies raising less than $5 million in a 12-month period may be exempt from registering their securities under a rule known as Regulation A. Instead of filing a registration statement through EDGAR, these companies need only file a

109


Maddox / Stoltmann

printed copy of an "offering circular" with the SEC containing financial statements and other information. "Reg D" Offerings Some smaller companies offer and sell securities without registering the transaction under an exemption known as Regulation D. Reg D exempts from registration companies that seek to raise less than $1 million dollars in a twelvemonth period. It also exempts companies seeking to raise up to $5 million, as long as the companies sell only to 35 or fewer individuals or any number of "accredited investors" who must meet high net worth or income standards. In addition, Reg D exempts some larger private offerings of securities. While companies claiming an exemption under Reg D don't have to register or file reports with the SEC, they must still file what's known as a "Form D" within a few days after they first sell their securities. Form D is a brief notice that includes the names and addresses of owners and stock promoters, but little other information about the company. You may be able to find out more about Reg D companies by contacting your state securities regulator.

Unless they otherwise file reports with the SEC, companies that are exempt from registration under Reg A, Reg D, or another offering exemption do not have to file reports with the SEC. For more information about the registration requirements and offering exemptions, read Q&A: Small Business and the SEC. What's So Important About Public Information? Many of the microcap companies that don't file reports with the SEC are legitimate businesses with real products or services. But the lack of reliable, readily available information about some microcap companies can open the door to fraud. It's easier for fraudsters to manipulate a stock when there's little or no information available about the company. Microcap fraud depends on spreading false information. Here's how some fraudsters carry out their scams: •

Questionable Press Releases Fraudsters often issue press releases that contain exaggerations or lies about the microcap company's sales, acquisitions, revenue projections, or new products or services. Paid Promoters Some microcap companies pay stock promoters to recommend or "tout" the microcap stock in supposedly independent and unbiased investment newsletters, research reports, or radio and television shows. The federal securities laws require the newsletters to disclose who paid them, the amount, and the type of payment. But many fraudsters fail to do so and mislead investors into believing they are receiving independent advice. Internet Fraud Fraudsters often distribute junk e-mail or "spam" over the Internet to spread false information quickly and cheaply about a microcap company to thousands of potential investors. They also use aliases on Internet bulletin boards and chat rooms to hide their identities and post messages urging investors to buy stock in microcap companies based on supposedly "inside" information about impending developments at the companies. "Boiler Rooms" and Cold Calling Dishonest brokers set up "boiler rooms" where a small army of high-pressure salespeople use banks of telephones to make cold calls to as

110


Appendix 9 – The SEC Statement on “Microcap Stock: A Guide for Investors” many potential investors as possible. These strangers hound investors to buy "house stocks" – stocks that the firm buys or sells as a market maker or has in its inventory. To learn more about cold calling, read Cold Calling Alert. Microcap fraud schemes can take a variety of forms. Here's a description of the two most common schemes: The Classic "Pump and Dump" Scheme It's common to see messages posted on the Internet that urge readers to buy a stock quickly or to sell before the price goes down, or a telemarketer will call using the same sort of pitch. Often the promoters will claim to have "inside" information about an impending development or to use an "infallible" combination of economic and stock market data to pick stocks. In reality, they may be company insiders or paid promoters who stand to gain by selling their shares after the stock price is pumped up by the buying frenzy they create. Once these fraudsters sell their shares and stop hyping the stock, the price typically falls, and investors lose their money. The Off-Shore Scam Under a rule known as "Regulation S," companies do not have to register stock they sell outside the United States to foreign or "off-shore" investors. In the typical offshore scam, an unscrupulous microcap company sells unregistered Reg S stock at a deep discount to fraudsters posing as foreign investors. These fraudsters then sell the stock to U.S. investors at inflated prices, pocketing huge profits which they share with the microcap company insiders. The flood of unregistered stock into the U.S. eventually causes the price to plummet, leaving unsuspecting U.S. investors with enormous losses. The SEC recently strengthened Reg S to make these frauds harder to conduct. How Do I Get Information About Microcap Companies? If you're working with a broker or an investment adviser, you can ask your investment professional if the company files reports with the SEC and to get you written information about the company and its business, finances, and management. Be sure to carefully read the prospectus and the company's latest financial reports. You can also get information on your own from these sources: •

From the company Ask the company if it is registered with the SEC and files reports with us. If the company is small and unknown to most people, you should also call your state securities regulator to get information about the company, its management, and the brokers or promoters who've encouraged you to invest in the company. From the SEC A great many companies must file their reports with the SEC. Using the EDGAR database, you can find out whether a company files with us and get any reports you're interested in. For companies that do not file on EDGAR, check with the SEC's Public Reference Room to see whether the company has filed an offering circular under Reg A. From your state securities regulator We strongly urge you to contact your state securities regulator to find out whether they have information about a company and the people behind it. Look in the government section of your phone book or visit the website of the North American Securities Administrators Association to get the name and phone number. Even though the company does not have to register its securities with the SEC, it

111


Maddox / Stoltmann

•

•

•

may have to register them with your state. Your regulator will tell you whether the company has been legally cleared to sell securities in your state. Too many investors could easily have avoided heavy and painful financial losses if they only called their state securities regulator before they bought stock. From other government regulators Many companies, such as banks, do not have to file reports with the SEC. But banks must file updated financial information with their banking regulators. If you have access to the Internet and want to find this information, visit the Federal Reserve System's National Information Center of Banking Information site at www.ffiec.gov/NIC, the Office of the Comptroller of the Currency at www.occ.treas.gov, or the Federal Deposit Insurance Corporation at www.fdic.gov. From reference books and commercial databases Visit your local public library or the nearest law or business school library. You'll find many reference materials containing information about companies. You can also access commercial databases for more information about the company's history, management, products or services, revenues, and credit ratings. The SEC cannot recommend or endorse any particular research firm, its personnel, or its products. But there are a number of commercial resources you may consult, including: Bloomberg, Dun & Bradstreet, Hoover's Profiles, Lexis-Nexis, and Standard & Poor's Corporate Profiles. Ask your librarian about additional resources. The Secretary of State Where the Company Is Incorporated Contact the secretary of state where the company is incorporated to find out whether the company is a corporation in good standing. You may also be able to obtain copies of the company's incorporation papers and any annual reports it files with the state.

Caution If you've been asked to invest in a company but you can't find any record that the company has registered its securities with the SEC or your state, or that it's exempt from registration, call or write your state's securities regulator or the SEC immediately with all the details. You may have come face to face with a scam. What if I Want to Invest in Microcap Stocks? To invest wisely and avoid investment scams, research each investment opportunity thoroughly and ask questions. These simple steps can make the difference between profits and losses: 1. Find out whether the company has registered its securities with the SEC or your state's securities regulators. 2. Make sure you understand the company's business and its products or services. 3. Read carefully the most recent reports the company has filed with its regulators and pay attention to the company's financial statements, particularly if they are not audited or not certified by an accountant. If the company does not file reports with the SEC, be sure to ask your broker for what's called the "Rule 15c2-11 file" on the company. That file will contain important information about the company. 4. Check out the people running the company with your state securities regulator, and find out if they've ever made money for investors before. Also ask whether the people running the company have had run-ins with the regulators or other investors.

112


Appendix 9 – The SEC Statement on “Microcap Stock: A Guide for Investors” 5. Make sure the broker and his or her firm are registered with the SEC and licensed to do business in your state. And ask your state securities regulator whether the broker and the firm have ever been disciplined or have complaints against them. Also, watch out for these "red flags": •

SEC Trading Suspensions The SEC has the power to suspend trading in any stock for up to 10 days when it believes that information about the company is inaccurate or unreliable. Think twice before investing in a company that's been the subject of an SEC trading suspension. You'll find information about trading suspensions on the SEC's website. High Pressure Sales Tactics Beware of brokers who pressure you to buy before you have a chance to think about and investigate the "opportunity." Dishonest brokers may try to tell you about a "once-in-a-lifetime" opportunity or one that's based on "inside" or "confidential" information. Don't fall for brokers who promise spectacular profits or "guaranteed" returns. These are the hallmarks of fraud. If the deal sounds too good to be true, then it probably is. Assets Are Large But Revenues Are Small Microcap companies sometimes assign high values on their financial statements to assets that have nothing to do with their business. Find out whether there's a valid explanation for low revenues, especially when the company claims to have large assets. Odd Items in the Footnotes to the Financial Statements Many microcap fraud schemes involve unusual transactions among individuals connected to the company. These can be unusual loans or the exchange of questionable assets for company stock which may be discussed in the footnotes. Unusual Auditing Issues Be wary when a company's auditors have refused to certify the company's financial statements or if they've stated that the company may not have enough money to continue operating. Also question any change of accountants. Insiders Own Large Amounts of the Stock In many microcap fraud cases – especially "pump and dump" schemes – the company's officers and promoters own significant amounts of the stock. When one person or group controls most of the stock, they can more easily manipulate the stock's price at your expense. You can ask your broker or the company whether one person or group controls most of the company's stock, but if the company is the subject of a scam, you may not get an honest answer.

Additional Red Flags Don't deal with brokers who refuse to provide you with written information about the investments they're promoting. Never tell a cold caller your social security number or numbers for your banking and securities accounts. And be extra wary if someone you don't know and trust recommends foreign investments. What If I Run Into Trouble? Act promptly! By law, you only have a limited time to take legal action. Follow these steps to solve your problem:

113


Maddox / Stoltmann 1. Talk to your broker and explain the problem. What happened? Who said what, and when? Were communications clear? What did the broker tell you? Did you take notes about what your broker said at the time? If so, what do your notes say? Note: If you believe your broker engaged in unauthorized transactions or other serious frauds, be sure to put your complaint in writing right away and send it to the firm. Your written complaint may be the only way to prove that you complained to the firm about unauthorized transactions. For more information about unauthorized transactions, please read our "Fast Answer" on that topic. 2. If your broker can't resolve your problem, then talk to the broker's branch manager. 3. If the problem is still not resolved, put your complaint in writing and send it to the compliance department at the firm's main office. Explain your problem clearly, and tell the firm how you want it resolved. Ask the compliance office to respond to you in writing within 30 days. 4. If you're still not satisfied, then send a letter to your state securities regulator and attach copies of any letters you've sent already to the firm. Or send your complaint to the SEC using our online complaint form. If you prefer to contact us using regular mail, please send your complaint (and any attachments) to the address below: Office of Investor Education and Assistance U.S. Securities and Exchange Commission 450 Fifth Street, NW Washington, DC 20549-0213 We will forward your complaint to the firm's compliance department and ask that they look into the problem and respond to you in writing. Please note that sometimes a complaint can be successfully resolved. But in many cases, the firm denies wrongdoing, and it comes down to one person's word against another's. In that case, we cannot do anything more to help resolve the complaint. We cannot act as a judge or an arbitrator to establish wrongdoing and force the firm to satisfy your claim. And we cannot act as your lawyer.

114


Appendix 10 – NASD Code of Arbitration Procedure

Code of Arbitration Procedure The Code of Arbitration Procedure includes the NASD's Rules governing the areas of Arbitration and Mediation. 10000. CODE OF ARBITRATION PROCEDURE 10100. ADMINISTRATIVE PROVISIONS IM-10100. Failure to Act Under Provisions of Code of Arbitration Procedure 10101. Matters Eligible for Submission 10102. National Arbitration and Mediation Committee 10103. Director of Arbitration 10104. Composition and Appointment of Panels IM-10104. Arbitrators' Honorarium 10105. Non-Waiver of Association Objects and Purposes 10106. Legal Proceedings 10200. INDUSTRY AND CLEARING CONTROVERSIES 10201. Required Submission 10202. Composition of Panels 10203. Simplified Industry Arbitration 10204. Applicability of Uniform Code 10205. Schedule of Fees for Industry and Clearing Controversies 10210. Statutory Employment Discrimination Claims 10211. Special Arbitrator Qualifications for Employment Discrimination Disputes 10212. Composition of Panels 10213. Discovery 10214. Awards 10215. Attorneys' Fees 10216. Coordination of Claims Filed in Court and in Arbitration 10300. UNIFORM CODE OF ARBITRATION 10301. Required Submission 10302. Simplified Arbitration IM-10302. Related Counterclaim 10303. Hearing Requirements—Waiver of Hearing 10304. Time Limitation Upon Submission 10305. Dismissal of Proceedings 10306. Settlements 10307. Tolling of Time Limitation(s) for the Institution of Legal Proceedings and Extension of Time Limitation(s) for Submission to Arbitration 10308. Selection of Arbitrators 10309. Composition of Panels 10310. Notice of Selection of Arbitrators 10311. Peremptory Challenge 115


Maddox / Stoltmann

10312. Disclosures Required of Arbitrators and Director's Authority to Disqualify 10313. Disqualification or Other Disability of Arbitrators 10314. Initiation of Proceedings 10315. Designation of Time and Place of First Meeting 10316. Representation by Counsel 10317. Attendance at Hearings IM-10317. Closing Arguments 10318. Failure to Appear 10319. Adjournments 10320. Acknowledgement of Pleadings 10321. General Provisions Governing Pre-Hearing Proceedings 10322. Subpoenas and Power to Direct Appearances 10323. Evidence 10324. Interpretation of Provisions of Code and Enforcement of Arbitrator Rulings 10325. Determination of Arbitrators 10326. Record of Proceedings 10327. Oaths of the Arbitrators and Witnesses 10328. Amendments 10329. Reopening of Hearings 10330. Awards 10331. Incorporation by Reference 10332. Schedule of Fees for Customer Disputes 10333. Member Surcharge and Process Fees 10334. [Reserved] 10335. Injunctions 10336. Single Arbitrator Pilot Program 10400. MEDIATION RULES 10401. Scope and Authority 10402. Submission of Eligible Matters 10403. Arbitration Proceedings 10404. Mediator Selection 10405. Limitation on Liability 10406. Mediation Ground Rules 10407. Mediation Fees 0000. CODE OF ARBITRATION PROCEDURE 0100. ADMINISTRATIVE PROVISIONS IM-10100. Failure to Act Under Provisions of Code of Arbitration Procedure It may be deemed conduct inconsistent with just and equitable principles of trade and a violation of Rule 2110 for a member or a person associated with a member to:

116


Appendix 10 – NASD Code of Arbitration Procedure

(a)

fail to submit a dispute for arbitration under the NASD Code of Arbitration Procedure as required by that Code;

(b)

fail to comply with any injunctive order issued pursuant to Rule 10335;

(c)

fail to appear or to produce any document in his possession or control as directed pursuant to provisions of the NASD Code of Arbitration Procedure;

(d)

fail to honor an award, or comply with a written and executed settlement agreement, obtained in connection with an arbitration submitted for disposition pursuant to the procedures specified by the National Association of Securities Dealers, Inc., the New York, American, Boston, Cincinnati, Chicago, or Philadelphia Stock Exchanges, the Pacific Exchange, Inc., the Chicago Board Options Exchange, the Municipal Securities Rulemaking Board, or pursuant to the rules applicable to the arbitration of disputes before the American Arbitration Association or other dispute resolution forum selected by the parties where timely motion has not been made to vacate or modify such award pursuant to applicable law; or

(e)

fail to comply with a written and executed settlement agreement, obtained in connection with a mediation submitted for disposition pursuant to the procedures specified by the National Association of Securities Dealers, Inc.

All awards shall be honored by a cash payment to the prevailing party of the exact dollar amount stated in the award. Awards may not be honored by crediting the prevailing party's account with the dollar amount of the award, unless authorized by the express terms of the award or consented to in writing by the parties. Awards shall be honored upon receipt thereof, or within such other time period as may be prescribed by the award. Action by members requiring associated persons to waive the arbitration of disputes contrary to the provisions of the Code of Arbitration Procedure shall constitute conduct that is inconsistent with just and equitable principles of trade and a violation of Rule 2110. [Adopted eff. May 1, 1973; amended July 1, 1987; amended by SR-NASD-90-03 eff. June 18, 1990; amended by SR-NASD-90-62 eff. May 7, 1991; amended by SR-NASD-95-20 eff. Oct. 2, 1995; amended by SR-NASD-93-38 eff. Jan. 3, 1996; amended by SR-NASD-99-19 eff. May 17, 1999.] 10101. Matters Eligible for Submission This Code of Arbitration Procedure is prescribed and adopted pursuant to Article VII, Section 1(a)(iv) of the By-Laws of the Association for the arbitration of any dispute, claim, or 117


Maddox / Stoltmann

controversy arising out of or in connection with the business of any member of the Association, or arising out of the employment or termination of employment of associated person(s) with any member, with the exception of disputes involving the insurance business of any member which is also an insurance company: (a)

between or among members;

(b)

between or among members and associated persons;

(c)

between or among members or associated persons and public customers, or others; and

(d)

between or among members, registered clearing agencies with which the Association has entered into an agreement to utilize the Association's arbitration facilities and procedures, and participants, pledgees, or other persons using the facilities of a registered clearing agency, as these terms are defined under the rules of such a registered clearing agency.

[Amended eff. May 7, 1991; Oct. 1, 1993; amended by SR-NASD-98-86 eff. Nov.19, 1998.] 10102. National Arbitration and Mediation Committee (a)

The NASD Dispute Resolution Board of Directors, following the annual election of its members by the NASD Board of Governors, shall appoint a National Arbitration and Mediation Committee of such size and composition, including representation from the public at large, as it shall deem appropriate and in the public interest. The Chairman of the Committee shall be named by the Chairman of the NASD Dispute Resolution Board. The said Committee shall establish and maintain rosters of neutrals composed of persons from within and without the securities industry.

(b)

The Committee shall have the authority to recommend to the NASD Dispute Resolution Board appropriate Rules, regulations, and procedures to govern the conduct of all arbitration, mediation, and other dispute resolution matters before the Association. All Rules, regulations, and procedures and amendments thereto presented by the Committee must be by a majority vote of all the members of the said Committee. It also shall have such other power and authority as is necessary to effectuate the purposes of this Code.

(c)

The Committee shall meet at least once each year and at such other times as are deemed necessary by the Committee.

118


Appendix 10 – NASD Code of Arbitration Procedure

[Amended by SR-NASD-94-77 eff. Feb. 8, 1995; amended by SR-NASD-98-48 eff. Nov. 17, 1998; amended by SR-NASD-99-21 eff. July 9, 2000.] 10103. Director of Arbitration The Board of Governors of the Association shall appoint a Director of Arbitration (Director) who shall be charged with the performance of all administrative duties and functions in connection with matters submitted for arbitration pursuant to this Code. The Director shall be directly responsible to the National Arbitration and Mediation Committee and shall report to it at periodic intervals established by the Committee and at such other times as called upon by the Committee to do so. The duties and functions of the Director may be delegated by the Director, as appropriate. In the event of the incapacitation, resignation, removal, or other permanent or indefinite inability of the Director to perform the duties and responsibilities of the Director, the President or an Executive Vice President of the Association may appoint an interim Director. [Amended by SR-NASD-98-48 eff. Nov. 17, 1998.] 10104. Composition and Appointment of Panels Except as otherwise specifically provided in Rule 10308, the Director shall compose and appoint panels of arbitrators from the existing pool of arbitrators of the Association to conduct the arbitration of any matter which shall be eligible for submission under this Code. [Amended by SR-NASD-98-48 eff. Nov. 17, 1998.]

IM-10104. Arbitrators' Honorarium All persons selected to serve as arbitrators pursuant to the Association's Code of Arbitration Procedure shall be paid an honorarium for each hearing session (including a prehearing conference) in which they participate. The honorarium shall be $200 for each hearing session, $50 for travel to a canceled hearing, and $75 per day additional honorarium to the chairperson of the panel. The honorarium for a case not requiring a hearing shall be $125. [Adopted eff. June 14, 1977; amended eff. May 30, 1980; Feb. 8, 1982; Jan. 14, 1987; amended by SR-NASD-97-79 eff. March 18, 1999.]

119


Maddox / Stoltmann

10105. Non-Waiver of Association Objects and Purposes The submission of any matter to arbitration under this Code shall in no way limit or preclude any right, action or determination by the Association which it would otherwise be authorized to adopt, administer or enforce. If any matter comes to the attention of an arbitrator during and in connection with the arbitrator's participation in a proceeding, either from the record of the proceeding or from material or communications related to the proceeding, that the arbitrator has reason to believe may constitute a violation of the Association's Rules or the federal securities laws, the arbitrator may initiate a referral of the matter to the Association for disciplinary investigation; provided, however, that any such referral should only be initiated by an arbitrator after the matter before him has been settled or otherwise disposed of, or after an award finally disposing of the matter has been rendered pursuant to Rule 10330 of the Code. [Amended by SR-NASD-93-75 eff. Aug. 15, 1994.] 10106. Legal Proceedings No party shall, during the arbitration of any matter, prosecute or commence any suit, action, or proceeding against any other party touching upon any of the matters referred to arbitration pursuant to this Code.

10200. INDUSTRY AND CLEARING CONTROVERSIES 10201. Required Submission (a)

Except as provided in paragraph (b) or Rule 10216, a dispute, claim, or controversy eligible for submission under the Rule 10100 Series between or among members and/or associated persons, and/or certain others, arising in connection with the business of such member(s) or in connection with the activities of such associated person(s), or arising out of the employment or termination of employment of such associated person(s) with such member, shall be arbitrated under this Code, at the instance of: (1)

a member against another member;

(2)

a member against a person associated with a member or a person associated with a member against a member; and

(3)

a person associated with a member against a person associated with a member.

120


Appendix 10 – NASD Code of Arbitration Procedure

(b)

A claim alleging employment discrimination, including a sexual harassment claim, in violation of a statute is not required to be arbitrated. Such a claim may be arbitrated only if the parties have agreed to arbitrate it, either before or after the dispute arose.

(c)

Any dispute, claim or controversy involving an act or failure to act by a clearing member; a registered clearing agency; or participants, pledgees, or other persons using the facilities of a registered clearing agency, under the rules of any registered clearing agency with which the Association has entered into an agreement to utilize the Association's arbitration facilities and procedures shall be arbitrated in accordance with such agreement and the rules of such registered clearing agency.

[Amended eff. Oct. 1, 1993; amended by SR-NASD-97-77 eff. Jan. 1, 1999; amended by SRNASD-99-08 eff. Jan 18, 2000. Selected Notice to Members: 99-96.] 10202. Composition of Panels (a)

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, the panel of arbitrators shall be appointed as provided by paragraph (b)(1) or (2) or Rule 10203, whichever is applicable. In all other disputes arising out of the employment or termination of employment of an associated person, the panel of arbitrators shall be appointed as provided by Rule 10212, 10302 or Rule 10308, whichever is applicable. (b)

(1) Composition of Arbitration Panel (A) Claims of $50,000 or Less If the amount of a claim is $50,000 or less, the Director shall appoint an arbitration panel composed of one non-public arbitrator, unless the parties agree to the appointment of a public arbitrator. (i)

If the amount of a claim is $25,000 or less and an arbitrator appointed to the case requests that a panel of three arbitrators be appointed, the Director shall appoint an arbitration panel composed of three non-public arbitrators, unless the parties agree to a different panel composition.

121


Maddox / Stoltmann

(ii)

(B)

If the amount of a claim is greater than $25,000 and not more than $50,000 and a party in its initial filing or an arbitrator appointed to the case requests that a panel of three arbitrators be appointed, the Director shall appoint an arbitration panel composed of three non-public arbitrators, unless the parties agree to a different panel composition.

Claims of More than $50,000

If the amount of a claim is more than $50,000, the Director shall appoint an arbitration panel composed of three non-public arbitrators, unless the parties agree to a different panel composition. (2)

Except as otherwise provided in paragraph (a), in all arbitration matters between or among members and/or persons associated with members and where the amount in controversy exceeds $50,000, exclusive of attendant costs and interest, a panel shall consist of three arbitrators, all of whom shall be non-public arbitrators.

(c)

In proceedings relating to injunctions under Rule 10335, the provisions of Rule 10335 shall supersede the provisions of this Rule.

(d)

Except as otherwise provided in this Rule or Rule 10203, the provisions of Rule 10308 shall apply to intra-industry disputes.

[Amended eff. May 10, 1989; Oct. 1, 1993; amended by SR-NASD-97-22 eff. Nov. 17, 1998; amended by SR-NASD-98-64 eff. Nov. 17, 1998; amended by SR-NASD-99-08 eff. Jan 18, 2000. Selected Notice to Members: 99-96.] 10203. Simplified Industry Arbitration (a)

Any dispute, claim, or controversy arising between or among members or associated persons submitted to arbitration under this Code involving a dollar amount not exceeding $25,000, exclusive of attendant costs and interest, shall be resolved by an arbitration panel constituted pursuant to the provisions of subparagraph (1) hereof solely upon the pleadings and documentary evidence filed by the parties, unless one of the parties to the proceeding files with the Office of the Director of Arbitration within ten (10) business days following the filing of the last pleading a request for a hearing of the matter.

122


Appendix 10 – NASD Code of Arbitration Procedure

(b)

(1)

In any proceeding pursuant to this Rule, an arbitration panel shall consist of a single non-public arbitrator.

(2)

Notwithstanding the provisions of this Rule, any member of an arbitration panel constituted pursuant to this Rule shall be authorized to request the submission of further documentary evidence in a proceeding and any such panel may by majority vote call and conduct a hearing if such is deemed to be necessary.

All awards rendered in proceedings pursuant to paragraph (a) hereof shall be made within thirty (30) business days from the date the arbitrators review all of the written statements, documents and other evidentiary material filed by the parties and have declared the matter closed.

[Amended eff May 10, 1989; amended by SR-NASD-97-22 eff. Nov. 17, 1998; amended by SRNASD-98-64 eff. Nov. 17,1998.] 10204. Applicability of Uniform Code Except as otherwise provided in the Rule 10200 Series, the Rules and procedures applicable to arbitrations concerning industry and clearing controversies shall be those set forth hereinafter under the Rule 10300 Series. 10205. Schedule of Fees for Industry and Clearing Controversies (a)

At the time of filing a Claim, Counterclaim, Third-Party Claim, or Cross-Claim in an industry or clearing controversy which is required to be submitted to arbitration before the Association as set forth in Rule 10201, above, a party who is a member shall pay a non-refundable filing fee and shall remit a hearing session deposit to the Association in the amounts stated in paragraph (k) unless such fee or deposit is specifically waived by the Director of Arbitration. A party who is an associated person shall pay a non-refundable filing fee and shall pay a hearing session deposit in the amounts specified for customer claimants in Rule 10332. If the associated person is a joint claimant with a member, the member shall pay a non-refundable filing fee and shall pay a hearing session deposit in the amounts specified in paragraph (k) of this Rule. Where multiple hearing sessions are required, the arbitrator(s) may require any of the parties to make additional hearing deposits for each additional hearing session. In no event shall the amount deposited by all parties per hearing session exceed the amount of the largest initial hearing deposit made by any party under paragraph (k) below. 123


Maddox / Stoltmann

(b)

A hearing session is any meeting between the parties and the arbitrator(s), including a pre-hearing conference with an arbitrator, which lasts four (4) hours or less. The forum fee for a pre-hearing conference with an arbitrator shall be the amount set forth in paragraph (k) below as a hearing session deposit for a hearing with a single arbitrator.

(c)

The arbitrators, in their award, shall determine the amount chargeable to the parties as forum fees and shall determine who shall pay such forum fees. Forum fees chargeable to the parties shall be assessed on a per hearing session basis and the aggregate for each hearing session may equal but shall not exceed the amount of the largest initial hearing deposit deposited by any party, except in a case where claims have been joined subsequent to filing in which case hearing session fees shall be computed as provided in paragraph (d). The arbitrator(s) may determine in the award that a party shall reimburse to another party any nonrefundable filing fee it has paid. Amounts deposited by a party shall be applied against forum fees, if any. In addition to forum fees, the arbitrator(s) may determine in the award the amount of costs incurred pursuant to Rules 10319, 10321, 10322, and 10326 and, unless applicable law directs otherwise, other costs and expenses of the parties and arbitrator(s) which are within the scope of the agreement of the parties. The arbitrator(s) shall determine by whom such costs shall be borne. If the hearing session fees are not assessed against a party who had made a hearing deposit, the hearing deposit will be refunded unless the arbitrators determine otherwise.

(d)

For claims filed separately which are subsequently joined or consolidated under Rule 10314(d) of this Code, the hearing deposit and forum fees assessable per hearing session after joinder or consolidation shall be based on the cumulative amount in dispute. The arbitrator(s) shall determine by whom such fees shall be borne.

(e)

If the dispute, claim, or controversy does not involve, disclose, or specify a money claim, the non-refundable filing fee assessed on a party who is a member shall be $500. If the dispute, claim, or controversy does not involve, disclose, or specify a money claim, the hearing session deposit to be remitted by a party shall be $1000. These amounts may be adjusted by the Director of Arbitration or the panel of arbitrators may require the maximum amount specified in the schedule.

(f)

The Association shall retain the total initial amount deposited as hearing session deposits by all the parties in any matter submitted and settled or withdrawn within eight business days of the first scheduled hearing session other than a pre-hearing conference.

124


Appendix 10 – NASD Code of Arbitration Procedure

(g)

Any matter submitted and thereafter settled or withdrawn subsequent to the commencement of the first hearing session, including a pre-hearing conference with an arbitrator, shall be subject to an assessment of forum fees and costs incurred pursuant to Rules 10319, 10321, 10322, and 10326 based on hearing sessions held and scheduled within eight business days after the Association receives notice that the matter has been settled or withdrawn. The arbitrator(s) shall determine by whom such fees and costs shall be borne.

(h)

In each industry or clearing controversy which is required to be submitted to arbitration before the Association as set forth in Rule 10201, above, where interim injunctive relief is requested or where a court has issued a temporary injunction and a party requests expedited proceedings, a total non-refundable surcharge of $2,500 shall be paid by the party or parties requesting the expedited proceedings as provided in Rule 10335. For purposes of this Rule, where expedited proceedings are mandated by Rule 10335(g), the party that sought and was granted injunctive relief by a court shall be deemed a party requesting expedited proceedings. These surcharge fees shall be in addition to all other non-refundable filing fees, hearing deposits, or costs which may be required. The arbitrator may determine that a party shall reimburse another party for any non-refundable surcharge it has paid.

(i)

Reserved

(j)

Reserved

(k)

Schedule of Fees

Schedule of Fees Amount in Dispute (Exclusive of Interest and Expenses)

Claim Filing Fee

Deposit for Cases to be Decided on the Paper Record

Hearing Session Deposit 1 Arb.1 3 Arbs.2

$.01-$1,000 $1000.01-$2,500 $2,500.01-$5,000 $5,000.01-$10,000 $10,000.01-$25,000 $25,000.01-$30,000 $30,000.01-$50,000 $50,000.01-$100,000 $100,000.01-$500,000 $500,000.01-$1,000,000 $1,000,000.01-$5,000,000 $5,000,000.01-$10,000,000 Over $10,000,000

$200 $300 $400 $500 $750 $1,000 $1,000 $1,000 $1,000 $1,250 $2,000 $2,500 $5,000

$25 $50 $125 $250 $300 NA NA NA NA NA NA NA NA

$25 $50 $125 $250 $450 $450 $450 $4503 $4504 $4504 $4504 $4504 $4504

125

NA NA NA NA NA $600 $600 $750 $1,125 $1,200 $1,200 $1,200 $1,200


Maddox / Stoltmann

1

The dispute is resolved by one arbitrator per hearing session, including pre-hearing conferences.

2

The dispute is resolved by three arbitrators per hearing session.

3

Fee applies only to pre-hearing conferences with a single arbitrator and to disputes resolved by one arbitrator per hearing session under the Rule 10210 Series. 4

Fee applies only to pre-hearing conferences with a single arbitrator.

[Added eff. May 10, 1989; amended by SR-NASD-90-03 eff. June 18, 1990; amended by SRNASD-94-75 eff. Jan. 1, 1995; amended by SR-NASD-94-10 eff. May 2, 1995; amended by SRNASD-95-25 eff. Aug. 1, 1995; amended by SR-NASD-93-38 eff. Jan. 3, 1996; amended by SRNASD-97-79 eff. Mar. 18, 1999; amended by SR-NASD-00-11 eff. November 1, 2000; amended by SR-NASD-00-65 eff. Dec. 31, 2000.] 10210. Statutory Employment Discrimination Claims The Rule 10210 Series shall apply only to disputes that include a claim alleging employment discrimination, including a sexual harassment claim, in violation of a statute. The Rule 10210 Series shall supersede any inconsistent Rules contained in this Code. [Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96. 10211. Special Arbitrator Qualifications for Employment Discrimination Disputes (a)

Minimum Qualifications for All Arbitrators

Only arbitrators classified as public arbitrators as provided in Rule 10308 shall be selected to consider disputes involving a claim of employment discrimination, including a sexual harassment claim, in violation of a statute. (b)

Single Arbitrators or Chairs of Three-Person Panels (1)

Arbitrators who are selected to serve as single arbitrators or as chairs of three-person panels should have the following additional qualifications: (A)

law degree (Juris Doctor or equivalent);

(B)

membership in the Bar of any jurisdiction; 126


Appendix 10 – NASD Code of Arbitration Procedure

(2)

(c)

(C)

substantial familiarity with employment law; and

(D)

ten or more years of legal experience, of which at least five years must be in either: (i)

law practice;

(ii) (iii)

law school teaching; government enforcement of equal employment opportunity statutes;

(iv)

experience as a judge, arbitrator, or mediator; or

(v)

experience as an equal employment opportunity officer or in-house counsel of a corporation.

In addition, a chair or single arbitrator with the above experience may not have represented primarily the views of employers or of employees within the last five years. For purposes of this Rule, the term "primarily" shall be interpreted to mean 50% or more of the arbitrator's business or professional activities within the last five years.

Waiver of Special Qualifications

If all parties agree, after a dispute arises, they may waive any of the qualifications set forth in paragraph (a) or (b) above. [Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96. 10212. Composition of Panels For disputes involving a claim alleging employment discrimination, including a sexual harassment claim, in violation of a statute: (a) Each panel shall consist of either a single public arbitrator or three public arbitrators qualified under Rule 10211, unless the parties agree to a different panel composition. (b) A single arbitrator shall be appointed to hear claims for $100,000 or less.

127


Maddox / Stoltmann

(c)

A panel of three arbitrators shall be appointed to hear claims for more than $100,000, unless the parties agree to have their case determined by a single arbitrator.

[Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96. 10213. Discovery (a)

Necessary pre-hearing depositions consistent with the expedited nature of arbitration shall be available.

(b)

The provisions of Rule 10321 shall apply to proceedings under this Rule 10210 Series.

[Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96. 10214. Awards The arbitrator(s) shall be empowered to award any relief that would be available in court under the law. The arbitrator(s) shall issue an award setting forth a summary of the issues, including the type(s) of dispute(s), the damages or other relief requested and awarded, a statement of any other issues resolved, and a statement regarding the disposition of any statutory claim(s). [Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96. 10215. Attorneys' Fees The arbitrator(s) shall have the authority to provide for reasonable attorneys' fee reimbursement, in whole or in part, as part of the remedy in accordance with applicable law. [Adopted by SR-NASD-99-08 eff. Jan. 18, 2000.] Selected Notice to Members: 99-96.

10216. Coordination of Claims Filed in Court and in Arbitration (a)

Option to Combine Related Claims in Court

128


Appendix 10 – NASD Code of Arbitration Procedure

(1)

(2)

(b)

(A)

If a current or former associated person of a member files a statutory discrimination claim in court against a member or its associated persons, and asserts related claims in arbitration at the Association against some or all of the same parties, a respondent who is named in both proceedings shall have the option to move to compel the claimant to bring the related arbitration claims in the same court proceeding in which the statutory discrimination claim is pending, to the full extent to which the court will accept jurisdiction over the related claims.

(B)

The respondent shall notify the claimant in writing, before the time to answer under Rule 10314 has expired, that it is exercising this option and shall file a copy of such notification with the Director. If the respondent files an answer without having exercised this option, it shall have waived its right to move to compel the claimant to assert related claims in court, except as provided in paragraph (b).

(A)

If a member or current or former associated person of a member ("party") has a pending claim in arbitration against a current or former associated person of a member and the current or former associated person thereafter asserts a related statutory employment discrimination claim in court against the party, the party shall have the option to assert its pending arbitration claims and any counterclaims in court.

(B)

The party shall notify the current or former associated person in writing, before filing an answer to the complaint in court, that it is exercising this option and shall file a copy of such notification with the Director. If the party files an answer in court without having exercised this option, it shall have waived its right to assert the pending arbitration claim in court.

(C)

The party may not exercise this option after the first hearing has begun on the arbitration claim.

Option Extended When Claim is Amended (1)

If the claimant files an amended Statement of Claim adding new claims not asserted in the original Statement of Claim, a respondent named in the amended Statement of Claim shall have the right to move to compel the 129


Maddox / Stoltmann

claimant to assert all related claims in the same court proceeding in which the statutory discrimination claim is pending, to the full extent that the court will accept jurisdiction over the related claims, even if those related claims were asserted in the original Statement of Claim. (2)

(c)

The respondent shall notify the claimant in writing, before the time to answer the amended Statement of Claim under Rule 10314 has expired, that it is exercising this option and shall file a copy of such notification with the Director. If the respondent files an answer to the amended Statement of Claim without having exercised this option, it shall have waived its right to move to compel the claimant to assert related claims in court.

Requirement to Combine All Related Claims

If a party elects to require a current or former associated person to assert all related claims in court, the party shall assert in the same court proceeding all related claims that it has against the associated person to the full extent to which the court will accept jurisdiction over the related claims. (d)

(e)

Right of Respondent to Remain in Arbitration (1)

If there are multiple respondents and a respondent has exercised an option under paragraph (a) or (b), but another respondent wishes to have the claims against it remain in arbitration, then any remaining party may apply for a stay of the arbitration proceeding.

(2)

The arbitration shall be stayed unless the arbitration panel determines that the stay will result in substantial prejudice to one or more of the parties. If a panel has not been appointed, the Director shall appoint a single arbitrator to consider the application for a stay. Such single arbitrator shall be selected using the Neutral List Selection System (as defined in Rule 10308) and is not required to have the special employment arbitrator qualifications described in Rule 10211.

Pre-Filing Certification (1)

Prior to or concurrently with filing a Statement of Claim, a claimant may file with the Director a certification that it had communicated unsuccessfully with the respondent concerning the consolidation of all claims in court prior to filing a Statement of Claim, in an effort to save the expense of arbitration fees. A copy of such certification shall be sent to the 130


Appendix 10 – NASD Code of Arbitration Procedure

respondent at the same time and in the same manner as the filing with the Director. (2)

(f)

If, after a certification has been filed, all the respondents later exercise the option to consolidate all claims in court, the Director will return the claimant's filing fee and any hearing session deposits for hearings that have not been held, but will retain the member surcharge and any accrued member process fees. If there are any remaining respondents, the filing fee and any hearing deposits will be adjusted to correspond to the claims against the remaining respondents.

Motion to Compel Arbitration

If a member or a current or former associated person of a member files in court a claim against a member or a current or former associated person of a member that includes matters that are subject to mandatory arbitration, either by the rules of the Association or by private agreement, the defending party may move to compel arbitration of the claims that are subject to mandatory arbitration. (g)

Definitions

For purposes of this Rule: (1)

The term "related claim" shall mean any claim that arises out of the employment or termination of employment of an associated person.

(2)

The term "statutory discrimination claim" means a claim alleging employment discrimination, including a sexual harassment claim, in violation of a statute.

Š Copyright 2001, NASD Dispute Resolution, Inc.

131


Maddox / Stoltmann

This page intentionally left blank.

132


NASD Dispute Resolution Arbitrator Application Booklet November 2000

DISPUTE RESOLUTION


DISPUTE RESOLUTION

Arbitrator Application

Letter of Recommendation: This application must be accompanied by two letters of recommendation. The letters of recommendation must, at a minimum, indicate how long the writer has known the applicant and under what circumstances; include a description of the applicant’s experience that qualifies him/her to be an arbitrator; and an attestation to the applicant’s character and fitness. If the letter is from an SRO or other dispute resolution forum, it should indicate that you are an arbitrator in good standing.

RECOMMENDATION NUMBER 1 I am recommended by: an:

NASD Committee Member

Arbitrator (NASD, NYSE, AAA, or other forum)

Other (Specify)

Arbitrator (NASD, NYSE, AAA, or other forum)

Other (Specify)

❏ ❏

Yes

RECOMMENDATION NUMBER 2 I am recommended by: an:

NASD Committee Member

I have previously served as an NASD Arbitrator. I am an NASD Mediator.

1.

Yes

❏ ❏

No No (If yes, add mediator number, if known

.)

Name Of Applicant

a. Title or Form of Address (Mr., Ms., Mrs., Dr., etc.) b. First Name c. Middle Name or Initial d. Last Name e. Suffix 1 (Jr., III, etc.) f. Suffix 2 (Esq., M.A., J.D., Ph.D., etc.) g. Social Security #

For NASD Dispute Resolution Use Only Arbitrator Classification:

■ Industry

Disciplinary (See attached ) No Disciplinary History

■ Public

CRD #

Application Received

Date

Approval Date

Arbitrator #

Certificate Sent

NOTE: If any of the spaces provided is insufficient, please use the supplementary sheets attached to this application. 1

Last Update: November 2000


2.

Current Mailing Address

a. Firm Name (If applicable, otherwise leave blank.) b. Street Address c. Building/Suite/Apt. Number d. City, State or Province, Zip or Postal Code e. Country

3.

❏ USA

Other:

Phone Numbers (Please include area code.)

a. Business or Daytime Phone

(

)

-

b. Fax

(

)

-

c. Home Phone

(

)

-

d. Other (Mobile, Page, etc.)

(

)

-

ext.

e. E-mail Address 4.

Employment Information

(Please complete this section whether you work full-time, part-time, or on a consulting basis. If you are retired, indicate that here and list your last employer in Section 7.)

a. Current Position b. Employer’s Name c. Firm Name d. Street Address e. City, State or Province, Zip or Postal Code f. Country 5.

❏ USA

Other:

Honorarium Information

Important Note: Pursuant to Section IM-10104 of the Code of Arbitration Procedure, if an arbitrator serves on a case, he/she will be paid an honorarium for each hearing session (including a prehearing conference) at the rate of $200 per hearing session, with an additional $75 per day if acting as Chairperson. Arbitrators must not set their own rates. Arbitrators serving on the NASD Dispute Resolution roster must agree to NASD Dispute Resolution's honorarium rate. a. Social Security Number (Required for IRS Form 1099 purposes.) b. To whom do you wish your honorarium fees paid?

❏ yourself

c. If payee is to be someone other than yourself.

Tax I.D. #

Last Update: November 2000

2

❏ your firm/employer


6.

Business Background:

Please fully describe your business or professional background. Sample business background statements are at the end of this application. Note: This information will be made available to parties. Please type or print clearly.

3

Last Update: November 2000


7.

Employment History: In order to qualify as an NASD Dispute Resolution arbitrator, applicants must have a minimum of five (5) years business, professional, or other related experience. If you meet the above requirement please list your employment history in reverse order with your present or most recent position first. If you are retired, please list your last employer, the number of years at the firm, and your date of retirement. Proceed to list the rest of your employment history. Start Date (Required)

End Date

Last Update: November 2000

Firm Name

Description of Position and Title

4


8.

Educational History: Please list your educational background in reverse order of attendance with the most recently attended institution first. Start Date (Required)

9.

End Date or Date Degree Awarded

School Name

Degree Awarded (If applicable)

Training: Please describe in the space below any arbitrator, mediator, and related training you have received, including the sponsoring organization, location, and date(s).

Date (Required)

Location

Sponsor

Program Title/Description

Hours

10. Arbitrator Classifications: Please indicate by marking with a “✓” which categories apply, if any. (Check all that apply.) Are you now, or within the past three (3) years have you been:

a. associated with a member or other broker/dealer, municipal securities broker/dealer, or government securities broker/dealer?

❏ ❏ ❏ ❏

b. registered under the Commodity Exchange Act?

f.

g. an employee of a bank or other financial institution who effects transactions in securities, including government or municipal securities, and commodities futures or options, or supervises or monitors the compliance with the securities and commodities laws of employees who engage in such activities?

c. a member of a commodities exchange or a registered futures association? d. associated with a person or firm registered under the Commodity Exchange Act? e. retired from engaging in any of the business activities listed (in a, b, c, or d) above but continuing to receive benefits from such activities? If yes, for how many years have you been retired? an attorney, accountant, or other professional who has devoted 20 percent or more of your professional work, in the last two years, to clients who are engaged in any of the business activities listed in a, b, c, or d above?

5

Last Update: November 2000


h. the spouse or an immediate family member of a person who is engaged in the conduct or activities described in a, b, c, d, e, f, or g above or is retired and receiving benefits? (An immediate family member is a family member who shares a home with a person engaged in the conduct or activities described in a, b, c, d, e, f, or g above; or is a person who receives financial support of more than 50 percent of his or her annual income from a person engaged in the conduct or activities described in a, b, c, d, e, f, or g above; or is a person who is claimed as a dependent for federal income tax purposes by a person engaged in the conduct or activities described in a, b, c, d, e, f, or g above.) If yes, please explain using the supplement sheets at the back of the booklet.

i.

an attorney, accountant, or other professional who has devoted 50 percent or more of your professional or business activities, within the last two years, to representing or advising public customers in matters relating to disputed securities or commodities transactions or similar matters?

j.

none of the above categories apply.

11. If you are an attorney, please complete the following:

I obtained a Law Degree (Juris Doctor or equivalent) on (law school or authorizing institution).

I am a member of the Bar in

I have substantial familiarity with employment law.

I have ten or more years of legal experience, with at least five years experience in (check all that apply):

❏ ❏ ❏ ❏ ❏ ➤

(date) from (state or jurisdiction).

❏ Yes ❏ No

Law practice Law school teaching Government enforcement of Equal Employment Opportunity statutes Experience as a judge, arbitrator, or mediator Experience as an Equal Employment Opportunity Officer or in-house counsel of a corporation

, and

I have not primarily represented the views of employers or of employees within the last five years. (The term “primarily” means 50% or more of the arbitrator’s business or professional activities within the last five years.) ❏ True ❏ False

Last Update: November 2000

6


12. Legal or Regulatory Questions (Please indicate with a yes or no if any of the following categories apply.) If an arbitrator answers in the affirmative to any questions contained in this question, the arbitrator’s explanation for the affirmative answer will be closely reviewed by the Director. If the affirmative answer does not constitute a statutory disqualification, the explanation for the answer will be disclosed to the parties unless the information is non-regulatory or does not reflect negatively on the individual’s character and is not significant to an individual’s performance as a neutral. Please see the attached criteria for temporary and permanent disqualification from the roster. a.

Have you been convicted of, or pleaded guilty or nolo contendere (“no contest”) to, a felony or misdemeanor involving: (1) investments or an investment-related business, fraud, false statements or omission, wrongful taking of property or bribery, forgery, counterfeiting, or extortion?

(4) any other misdemeanor, except minor traffic violations?

❏ Yes ❏ Yes ❏ Yes ❏ Yes

Have you, or an organization over which you exercised management or policy control, ever been charged with any felony or charged with a misdemeanor specified in question 12 a(1) or (2) above?

❏ Yes ❏ No

(2) gambling? (3) any other felony?

b.

c.

Has any court ever: (1) enjoined you in connection with any investment-related activity? (2) found that you were involved in a violation of investment-related statutes or regulation?

d.

e.

❏ Yes ❏ No ❏ Yes ❏ No

Has the U.S. Securities and Exchange Commission or the Commodity Futures Trading Commission ever: (1) found you to have made a false statement or an omission?

❏ Yes ❏ No

(2) found you to have been involved in a violation of investment-related statutes or regulations?

❏ Yes ❏ No

(3) entered an order denying, suspending, or revoking your registration, or disciplined you by restricting your activities?

❏ Yes ❏ No

Has any other federal regulatory agency or any state regulatory agency ever: (1) found you to have made a false statement or an omission or been dishonest, unfair, or unethical?

❏ Yes ❏ No

(2) found you to have been involved in a violation of investment-related statutes or regulations?

❏ Yes ❏ No

(3) found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked, or restricted?

f.

❏ No ❏ No ❏ No ❏ No

(4) entered an order against you in connection with investment-related activity?

❏ Yes ❏ No ❏ Yes ❏ No

(5) denied, suspended, or revoked your registration or license or otherwise prevented you from association with an investment-related business, or disciplined you by restricting your activity?

❏ Yes ❏ No

(6) revoked or suspended your license as an attorney, accountant, or federal contractor?

❏ Yes ❏ No

Has any self-regulatory organization or commodities exchange ever:

(2) found you to have been involved in a violation of its rules?

❏ Yes ❏ No ❏ Yes ❏ No

(3) found you to have been the cause of an investment-related business having its license revoked or restricted?

❏ Yes ❏ No

(4) disciplined you by expelling or suspending you from membership, barring or suspending your association with its members, or restricting your activities?

❏ Yes ❏ No

(1) found you to have made a false statement or an omission?

7

Last Update: November 2000


g.

h.

i.

j.

k.

l.

Has any foreign government, court, regulatory agency or exchange ever entered an order against you related to investments or fraud?

❏ Yes ❏ No

Has any other professional entity or body with licensing authority denied, suspended, or revoked your registration or license (e.g., insurance, real estate, etc.)?

❏ Yes ❏ No

Have you ever been the subject of an investment-related, consumer-initiated complaint or proceeding that: (1) alleged compensatory damages of $10,000 or more, fraud, or wrongful taking of property?

❏ Yes ❏ No

(2) was settled or decided against you for $5,000 or more, or found fraud or the wrongful taking of property?

❏ Yes ❏ No

Have you ever been the subject of any complaint or proceeding that alleged sexual harassment or any form of discrimination?

❏ Yes ❏ No

Are you now the subject of any complaint, investigation, or proceeding that could result in a “yes” answer to any question in section 12, items “a” through “j”?

❏ Yes ❏ No

Has a bonding company denied, paid out on, or revoked a bond for you?

❏ Yes ❏ No

m. Do you have any unsatisfied judgements or liens against you? n.

o.

p.

❏ Yes ❏ No

Have you or a firm that you exercised management or policy control over, or owned 10 percent or more of the securities of, failed in business, made a compromise with creditors, filed a bankruptcy petition, or been declared bankrupt?

❏ Yes ❏ No

Has a broker or dealer firm that you exercised management or policy control over, or owned 10 percent or more of the securities of, been declared bankrupt, had a trustee appointed under the Securities Investor Protection Act, or had a direct payment procedure initiated?

❏ Yes ❏ No

Have you been discharged or permitted to resign because you were accused of: (1) violating investment-related statutes, regulations, rules, or industry standards of conduct? (2) fraud or the wrongful taking of property? (3) failure to supervise in connection with investment-related statutes, regulations, rules, or industry standards of conduct? (4) sexual harassment or any form of discrimination?

Last Update: November 2000

8

❏ Yes ❏ No ❏ Yes ❏ No ❏ Yes ❏ No ❏ Yes ❏ No


13. If you answered yes to any of the questions above, please explain in the following space or attach a copy of the disposition.

14. Securities Disputes Expertise/Experience: To be completed by all applicants. Check the types of securities-related disputes below in which you have expertise and/or experience. a. Account Related Breach of Contract

Collection

Dividends

Errors/Charges

Exchanges

Failure to Supervise

Margin Calls

Negligence

Transfer

Execution Price

Failure to Execute

Incorrect Quantity

Limit Versus Market Order

Other

Other b. Executions

c. Fraudulent Activity Breach of Fiduciary Duty

Churning

Manipulations

Misrepresentations/Non-Disclosures

Omission of Facts

Suitability

Unauthorized Trading

Other

d. Employment

e.

f.

Breach of Contract

Commissions

Compensation

Discrimination-Age

Discrimination-Disability

Discrimination-Gender

Discrimination-National Origin

Discrimination-Race

Discrimination-Religion

Discrimination-Sexual Preference

Partnerships

Promissory Notes

Sexual Harassment

Training Contracts

Wrongful Termination

Libel or Slander on U-5

Libel or Slander

Other

Trading Dispute Buy-In

D.K.’s

Manipulation

Markups

Sell Outs

Stock Loan

Transfers

On-Line Trading

Options Market Making

Amex Floor Trading

Amex Specializing

Other

Other Floor Trading

Other Exchange Specializing

Other Clearing Disputes

Defamation

Indemnification

Raiding Disputes

Underwriting

Other

9

Last Update: November 2000


Securities, Financial Instruments, and Investments:

Please check the types of securities, financial instruments, and investments with which you have experience and/or expertise.

Annuities

Common Stock

Commodities

Corporate Bonds

“Fannie Maes”

”Freddie Macs”

“Ginnie Maes”

Government Securities

Limited Partnerships

Mutual Funds

Municipal Bonds

Municipal Bond Funds

Options

Preferred Stock

Repurchase Agreements

Real Estate Investment Trusts

Reverse Repurchase Agreements

Stock Index Futures

Warrants/Rights

Index Shares

Other-Other Types of Securities

15. Conflicts: Please list all known conflicts and the nature of the conflict, for example, any brokerage firm where you or any member of your family has or had an account, or where any family member is or was employed.

16. Broker/Dealer Associations: Please list the brokerage firm(s) where you maintain account(s). Firm Name

Type of Account

Do you, your employer/firm, or a member of your immediate family have any business relationship with a securities firm?

❏ Yes

If so, please state the name of the firm and the type of relationship that existed during the last five years.

Last Update: November 2000

10

❏ No


17. Controversies Involving the Securities Industry Note: Arbitrators are reminded that they have a continuing obligation to disclose the names of broker/dealers and persons associated with broker/dealers against whom they have brought an action or whom they have defended as well as broker/ dealers for which they have served as an expert witness. You should disclose any new relationship that arises during the pendency of an arbitration case that you are serving on as an arbitrator. Any change in your current status that might effect your classification as an arbitrator must also be disclosed. a. b.

Have you brought or defended actions involving a broker/dealer as an individual, attorney, or agent for a person or corporation?

❏ Yes ❏ No

If yes, list all of these broker/dealers and the approximate times when you brought or defended the actions.

Time Period

Broker/Dealer

For or Against

18. Controversies Involving Investors a. b.

Have you ever been named as a party by an investor in any civil lawsuit or arbitration proceedings?

❏ Yes ❏ No

If yes, list all of these investors and the approximate times when you were named as a party.

Time Period

Investor

Indicate Arbitration or Civil Lawsuit

19. Expert Witness a.

Have you been an expert witness for a broker/dealer in any administrative or legal proceeding, or in support of a claim against a broker/dealer in any administrative or legal proceeding?

b.

If yes, please state the names of these broker/dealers and the approximate time periods when you were an expert witness. Time Period

Broker/Dealer

❏ Yes ❏ No For or Against

11

Last Update: November 2000


20. Amount of Participation

❏ Usually ❏ Occasionally ❏ No

a.

Can you serve on cases for two or more consecutive days?

b.

Describe the amount of time you are willing to devote to arbitration.

(If the space provided above is insufficient, please use the supplementary sheets attached at the end of the application.)

21. Accommodations a.

Do you have any requests or accommodations that relate to your service as an arbitrator?

b.

If yes, please explain.

❏ Yes

❏ No

(If the space provided above is insufficient, please use the supplementary sheets attached at the end of the application.)

THE APPLICANT MUST SIGN THE FOLLOWING AFFIRMATION I swear or affirm that I have read and understand the preceding questions, and that my answers are true and complete to the best of my knowledge, information, and belief. I assume the responsibility of promptly informing NASD Dispute Resolution, Inc. of any changes to the answers to the questions contained on this form, and I understand that failure to do so may result in my immediate removal from the roster of approved arbitrators. I also agree to serve as an arbitrator in accordance with established NASD procedures, the Code of Arbitration Procedure, and the provisions of the Code of Ethics for Arbitrators in Commercial Disputes. I understand that all information submitted is subject to independent verification. I understand that my submission of this information does not create any obligation on the part of NASD Dispute Resolution to appoint me to serve on any panel of arbitrators. I also understand that NASD Dispute Resolution reserves the right to reconsider the eligibility or appointment of arbitrators at any time and to remove arbitrators as it, in its sole judgement, deems appropriate. I acknowledge that the amount of honorarium due me as an arbitrator is that set forth in IM-10104 of the Code of Arbitration Procedure.

Signature:

Date:

Last Update: November 2000

12


Sample Background Information Statement The following contains three different sample background information statements. Your background information statement is part of the arbitrator disclosure report and will be provided to the parties. NASD Dispute Resolution, Inc. encourages you to provide a detailed background information statement. There are no word limitations on its length. You should use this sample only as a guide, and you should ensure your own statement is accurate, current, complete, and comprehensive. A resume may not be substituted for the background information statement. You should identify any industry members that you have represented or by whom you have been employed. If you are an attorney or an accountant, please provide details about the specific nature of your current practice. Please remember you have a continuing obligation to provide NASD Dispute Resolution with accurate, current, and complete information. Please notify your regional office if there are any changes in your status or background. Business Professional Since 1981, I have been employed as the Executive Vice President of the Capital Markets Group of XYZ, Inc. in New York City. My responsibilities include directing all aspects of equity and bond issues for XYZ’s clients. I also oversee all SEC reporting requirements. Additionally, my office generates progress reports which are used by the Chief Financial Officer in his daily financial reporting. As Executive Vice President, my special projects were aimed at developing new clients. From 1964 to 1967, I worked for ABC Brokerage as an analyst working with pharmaceutical industry stocks. At DEIF Securities from 1967 to 1970, I made buy and sell recommendations and directed the publishing of the DEIF Securities newsletter. I was promoted at DEIF to Director of Research and Information Systems in 1970. Until 1977, I personally designed and maintained all of DEIF’s quantitative computer programs used by analysts and traders. From 1977 to 1981, I was Senior Vice President at Brokerage Securities where I was the Director of the Corporate Finance Department. I was a Captain in the U.S. Army Reserves from 1962 to 1965, and I served as a Company Commander. I received an honorable discharge in 1965. I currently hold Series 7, 63, and 24 licenses. I am a member of the Clarksville Rotary Club and am active in the local PTA. I received degrees in Business Administration from the University of Arkansas in 1962. I obtained an M.B.A. in Accounting and Management Information Systems from the University of Texas in 1964. Educator I have been a Professor of Economics at Rice University since 1992. In addition to my teaching responsibilities, I conduct research in financial market fluctuations and trends. I have published five articles in the Journal of Economics concerning the volatility of the market and predicting future market performance. I was a Lecturer of Macroeconomics at California State University Fresno from 1982 to 1986 and a Teaching Assistant from 1980 to 1982 where I conducted classes ranging in sizes from four-student seminars to two hundred-student lectures. I received a research grant to study banking and finance from 1982 to 1986 during which time I compiled statistics on the financial cost of complying with the Securities Exchange Act of 1934. I served as Chief Economist at the Hastings Institute in Seattle, Washington, from 1986 to 1992 where I specialized in European Economics. I am the author of Macroeconomics Study Guide, 1983; Associate Editor of The Journal of Finance, and the Editor of Economics Monthly. In 1992 I coordinated the National Organization For Women Financial Conference. I received the Faculty Excellence Award at Rice University in 1995 and in 1996, and I was presented with the Women in Business Award from the National Organization of Women. I received a B.A. Degree in Economics from the University of Pittsburgh in 1978 and a Ph.D. in Economics from California State University Fresno in 1982. My thesis was entitled: Current Economic Policy: A Blueprint for Disaster.

13

Last Update: November 2000


Attorney/Professional Since 1997, I have worked at the Smith Bank as Vice President and General Counsel. As General Counsel, I am responsible for the Litigation Department, and all cases involving allegations of securities fraud, internal labor controversies, and allegations concerning shareholder/management disputes. My responsibilities also include supervising 44 attorneys, screening cases to determine which ones can be settled and which ones must be litigated, and delegating litigation to outside law firms. In total, I am responsible to the Board of Directors for 93% of Smith Bank’s litigation. I worked for the U.S. Securities and Exchange Commission as a Senior Staff Attorney from 1980 to 1985. I litigated insider trading cases and accounting fraud cases. In 1985, I was promoted to Assistant Director of Enforcement, and I supervised 14 attorneys and 24 examiners. From 1986 to 1987, I worked for Sherman Stein in Jersey City, New Jersey as an Associate in the Securities Department. My duties included transactional and litigation support for the equity and bond issues. My cases primarily involved representing foreign banks in administrative hearings before various U.S. banking regulatory bodies. In 1987 I was promoted to Litigation Associate. I had primary responsibility for devising takeover defenses for major investment banks and insurance companies. I remained at Sherman Stein until 1997. My professional activities include: Panelist for the New York Bar Association’s Workshop on “Mediation and Arbitration as an Alternative Forum,” April 1983; Member, American Bar Association section on Litigation, Corporation, Banking and Law; Member, the Committee on Federal Regulation of Securities; and Chairperson of the Subcommittee on Broker Dealer Misconduct. I have been a securities arbitrator for NASD Dispute Resolution since 1990 and have sat on five panels where the issues involved employment contracts, and allegations of wrongful discharge. I am a 1977 graduate of Yale University, and graduated from New York University School of Law in 1980.

Last Update: November 2000

14


Arbitrator Disqualification Criteria Criteria For Temporary Disqualification (Temporary Disqualification will result in temporary declination as to new applicants and a status of “inactive” as to already enrolled arbitrators.) Pending Actions

Arbitrator is the subject of, or is a party to, a pending investment-related civil action or arbitration claim initiated by a customer; or, civil action or administrative complaint initiated by a regulatory body; or, a civil action or regulatory complaint alleging discrimination or sexual harassment. This provision excludes cases where the arbitrator’s conduct in his or her role as an arbitrator is at issue.

Subject of Claims or Complaints

Arbitrator is the subject of, or is a party to, three (3) or more claims or complaints (reportable on Form U-4) within the last ten (10) years regardless of outcome.

Filed a statement of claim or complaint

Arbitrator is a party (excluding representatives and unnamed parties to class actions) that has filed two or more investment-related civil actions or arbitration claims within the last ten (10) years.

Final decisions, awards

Arbitrator is the subject of, or is a party to, a final, adverse investment-related court decision or arbitration award of $25,000 or more within the past seven (7) years resulting from a customerinitiated complaint or claim.

Decisions, awards, involving discrimination/ sexual harassment

Arbitrator is the subject of, or is a party to, a final, adverse court decision or arbitration award of $25,000 or more involving any discrimination claims, including sexual harassment, issued within the last seven (7) years. Arbitrator is the subject of, or is a party to, a final, adverse regulatory decision involving any discrimination claims, including sexual harassment, issued within the past seven (7) years.

Final regulatory action

Arbitrator is the subject of, or is a party to, any final adverse decision issued by any regulatory authority within the past seven (7) years, where the adverse decision does not involve a technical violation or does not give rise to a statutory disqualification.

Director of Arbitration’s judgement

The Director of Arbitration may temporarily remove an arbitrator, if, in his or her sole judgement, it is determined that the arbitrator is not otherwise properly included in the list of eligible neutrals.

Criteria For Permanent Disqualification (Permanent Disqualification means the application of any new applicant will be rejected, and enrolled neutrals will be removed from the roster without possibility of reconsideration.) Preamble

If an arbitrator answers in the affirmative to any questions contained in Question 12 of the Arbitrator Application Form, the arbitrator’s explanation for the affirmative answer will be closely reviewed by the Director. If the affirmative answer does not constitute a statutory disqualification, the explanation for the answer will be disclosed to the parties unless the information is non-regulatory or does not reflect negatively on the individual’s character and is not significant to an individual’s performance as a neutral.

Misstatement/omission

Misstatement or failure to disclose material information.

Disciplinary actions

Final, adverse disciplinary action by any domestic or foreign regulatory or governing professional body on a finding of, including but not limited to, false statement or omissions, material violation of investment-related regulation, or the violation of a non-technical rule of such organizations or statute.

Misdemeanors/felonies

Misdemeanor involving investments, investment-related activities.

Felonies

Felony conviction, or plea of guilty or nolo contendere (no contest), to a felony charge.

Fraud

Final adverse court decisions where there has been a finding of fraud.

Statutory disqualifications

Statutory disqualifications not included above.

Director of Arbitration’s judgement

The Director of Arbitration, upon the approval of the National Arbitration & Mediation Committee, may remove an arbitrator if in his or her judgement the arbitrator is not otherwise properly included in the list of eligible neutrals.

15

Last Update: November 2000


Arbitrator Application Supplemental Sheets Applicant’s Name:

Item Number to Be Supplemented:

Item Name to Be Supplemented:

Sheet

of

Sheets

Please write in any headings and columns that are present in the section you are supplementing.

(Please photocopy this sheet if you need to supplement more than one item.)

Last Update: November 2000

16


Arbitrator Application Supplemental Sheets Applicant’s Name:

Item Number to Be Supplemented:

Item Name to Be Supplemented:

Sheet

of

Sheets

Please write in any headings and columns that are present in the section you are supplementing.

(Please photocopy this sheet if you need to supplement more than one item.)

17

Last Update: November 2000


Arbitration Program Offices Northeast Region

Southeast Region

NASD Dispute Resolution

NASD Dispute Resolution

125 Broad Street, 36th Floor New York, NY 10004-2193 (212) 858-4400 Fax: (212) 858-3974

Boca Center Tower 1 5200 Town Center Circle, Suite 400 Boca Raton, FL 33486 (561) 416-0277 Fax: (561) 416-2267

NASD Dispute Resolution 1735 K Street, NW Washington, DC 20006 (202) 728-8958 Fax: (202) 728-6952

Western Region

Midwest Region NASD Dispute Resolution 10 S. LaSalle St., Suite 1110 Chicago, IL 60603-1002 (312) 899-4440 Fax: (312) 236-9239

NASD Dispute Resolution 525 Market St., Suite 300 San Francisco, CA 94105 (415) 882-1234 Fax: (415) 546-6990

NASD Dispute Resolution 300 S. Grand Avenue, Suite 1620 Los Angeles, CA 90071 (213) 613-2680 Fax: (213) 613-2677

NASD Dispute Resolution, Inc.

125 Broad Street, 36th Floor www.nasdadr.com

New York, New York 10004


NYSE Arbitrator / Mediator Profile Please review the Guidelines for Completing or Updating the Arbitrator/Mediator Profile before completing.

Name__________________________________________________________________________________________________________________ Current Position (if employed)______________________________________________________________________________________________________________ Employer’s Name_________________________________________________________________________________________________________ Employer’s Address_______________________________________________________________________________________________________ Office Telephone Number______________________________Fax Number__________________________________________________________ Home Address_______________________________________Home Telephone Number_______________________________________________ ___________________________________________________Home Fax Number____________________________________________________ e-Mail Address_______________________________________Preferred Mailing Address

❑ Office

❑ Home

e-Mail Address_______________________________________S.S. Number__________________CRD Number_____________________________

Request consideration as:

❑ Arbitrator

❑ Mediator

❑ Both

1.(a) Are you, your spouse or any other member of your household associated with a member, broker/dealer, government securities broker, government securities dealer, municipal securities dealer or registered investment advisor?

Yes ❑

No ❑

(b) Have you been associated with any of the above within the past five years?

Yes ❑

No ❑

(c) Are you retired from or have you spent a substantial part of your business career in, with or for any of the above?

Yes ❑

No ❑

(d) Are you an attorney, accountant or other professional who devoted twenty (20)percent or more of your professional work effort to securities industry clients within the past two years?

Yes ❑

No ❑

(e) Are you registered under the Commodity Exchange Act or a member of a registered futures association or any commodity exchange or are you associated with any such person(s)?

Yes ❑

No ❑

{For office use only - Classification: Public__________Industry__________} 2.(a) Starting with your current employment (or most recent employment, if retired) list your employment history. Also indicate any employment in or related to the securities indust ry at any time in your career. (Attach additional pages as necessary). Firm Name

Position/Title

Dates

_______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________


Page 2 (b) List your educational background.(Attach additional pages as necessary). School

Degree

Year Degree Awarded

_______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ (c) Fully describe your business or professional background, indicating the nature of your work, duties and responsibilities.(Attach additional pages as necessary). _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ (d) Describe relevant experience and education (including seminars, courses, continuing legal education, etc.) which qualifies you to serve as an arbitrator and/or mediator in a securities dispute. Include your experience as an arbitrator or mediator in any type of dispute, teaching experience, publications and any other relevant information.(Attach additional pages as necessary). _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ (e) Set forth, with exact dates, arbitrator or mediator training programs you have attended. _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ (f) List your memberships in any professional or business associations,including any offices held. _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ 3. (a) List all brokerage firms where you or anyone in your household maintain an a ccount (including IRA and Keogh accounts) or where you have maintained an account during the past five years. _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________


Page 3 (b) List all brokerage firms with which you, your employer/firm or immediate family have had a business relationship during the past five years, describing the nature of the relationship. ___________________________________________________________________________________________________________________ ___________________________________________________________________________________________________________________ ___________________________________________________________________________________________________________________ ___________________________________________________________________________________________________________________ 4.(a) Have you ever been convicted of or plead guilty or nolo contendere (“no contest”) in a domestic or foreign court to: (1) a felony or misdemeanor involving: investments or an investment-related business,fraud, false statements or omissions, wrongful taking of property, or bribery, forgery, counterfeiting or extortion?

Yes ❑

No ❑

Yes ❑

No ❑

Yes ❑

No ❑

(b) Have you, or an organization over which you exercised management or policy control, ever been charged with any felony or charged with a misdemeanor specified in question (a)(1) or (2) in a domestic or foreign court?

Yes ❑

No ❑

(c) Has any domestic or foreign court ever: (1) enjoined you in connection with any investment-related activity?

Yes ❑

No ❑

Yes ❑

No ❑

Yes ❑

No ❑

(2) found you to have been involved in a violation of investment-related regulations or statutes?

Yes ❑

No ❑

(3) found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked, or restricted?

Yes ❑

No ❑

(4) entered an order denying, suspending or revoking your registration or disciplined you by restricting your activities?

Yes ❑

No ❑

(5) imposed a civil money penalty on you, or ordered you to cease and desist from any activity?

Yes ❑

No ❑

Yes ❑ Yes ❑

No ❑ No ❑

(2) found you to have been involved in a violation o f investment regulations or statutes?

Yes ❑

No ❑

(3) found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked, or restricted?

Yes ❑

No ❑

(4) entered an order against you in connection with investment-related activity?

Yes ❑

No ❑

(5) denied, suspended, or revoked your registration or license or otherwise prevented you from associating with an investment-related business, or disciplined you by restricting your activities?

Yes ❑

No ❑

(6) revoked or suspended your license as an attorney, accountant or federal contractor?

Yes ❑

No ❑

Yes ❑

No ❑

(2) found you to have been involved in a violation o f its rules?

Yes ❑

No ❑

(3) found you to have been the cause of an investment-related business having its authorization to do business denied, suspended, revoked or restricted?

Yes ❑

No ❑

(2) gambling? (3) any other felony? (4) any other misdemeanor?

(2) found that you were involved in a violation o f investment-related statutes or regulations? (d) Has the U.S. Securities and Exchange Commission or the Commodity Futures Trading Commission ever (1) found you to have made a false statement or omission?

(e) Has any other Federal regulatory agency or any state regulatory agency or foreign financial regulatory authority ever: (1) found you to have made a false statement or omission or been dishonest,unfair or unethical?

(f) Has any self-regulatory organization or commodities exchange: (1) found you to have made a false statement or omission?


Page 4 (4) disciplined you by expelling or suspending you from membership, barring or suspending your association with its members, or restricting your activities? (g) Has any foreign government ever entered an order against you related to investments or fraud,other than as reported in items a, b,c or e? (h) Have you ever been the subject of an investment-related, consumer-initiated complaint or proceeding that: (1) alleged compensatory damages of $10,000 or more,fraud, or wrongful taking of property?

Yes ❑

No ❑

Yes ❑

No ❑

Yes ❑

No ❑

Yes ❑

No ❑

(i) Are you now the subject of any complaint,investigation, or proceeding that could result in a "yes" answer to parts a-h of this item?

Yes ❑

No ❑

(j) Has a bonding company denied,paid out on, or revoked a bond for you?

Yes ❑

No ❑

(k) Do you have any unsatisfied judgements or liens against you?

Yes ❑

No ❑

(I) Have you or a firm that you exercised management or policy control over, or owned 10% or more of the securities of, failed in business,made a compromise with creditors,filed a bankruptcy petition or been declared bankrupt? Yes ❑

No ❑

(m)Has a broker or dealer firm that you exercised management or policy control over, or owned 10% or more of the securities of, been declared bankrupt,had a trustee appointed under the Securities Investor Protection Act, or had a direct payment procedure initiated? Yes ❑

No ❑

(2) was settled or decided against you for $5,000 or more, or found fraud or the w rongful taking of property?

If yes to (I) and/or (m), please provide details (e.g. the date of the filing of any petition for bankruptcy, the jurisdiction and the disposition). An affirmative answer will not necessarily be a bar to your selection, but may be a factor in assessing your qualifications to serve as an arbitrator or mediator. (n) Have you been discharged or permitted to resign because you were accused of: (1) violating investment-related statutes, regulations, rules, or industry standards of conduct?

Yes ❑

No ❑

(2) fraud or the wrongful taking of property?

Yes ❑

No ❑

(3) failure to supervise in connection with investment-related statutes, regulations, rules or industry standards of conduct?

Yes ❑

No ❑

(o) Have you ever had any license, registration or any authority to practice any business or profession revoked or suspended?

Yes ❑

No ❑

(p) Have you ever been the subject of a claim alleging discrimination,sexual harassment, or abridgement of civil rights,in a federal,state or local court or in an administrative or civil proceeding or arbitration?

Yes ❑

No ❑

If you answered yes to any of the questions in number 4,please fully explain.(Attach additional pages as ne cessary). _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ _______________________________________________________________________________________________________________________ Are you willing to serve as an arbitrator and/or mediator at other Self-Regulatory Organizations?

Yes ❑

No ❑

I swear or affirm that the above information is true and complete to the best of my knowledge.I understand that I am responsible for advising the NYSE of any changes to the above information and that the information provided is subject to independent verification.I also hereby agree that if appointed, I shall serve in accordance with established NYSE procedures,NYSE Arbitration Rules and the Code of Ethics for Arbitrators in Commercial Disputes.I understand that my submission of this information does not create any obligation on the part of the NYSE to place me on the list of persons eligible to serve as arbitrators or mediators on arbitrations or mediations organized and conducted by the NYSE or to ap point me to serve as an arbitrator or mediator; l also understand that the NYSE reserves the right to reconsider the eligibility or appointment of arbitrators or mediators at any time and to remove arbitrators or mediators as it in its sole judgement deems appropriate. ______________________________________________________________________________________________ ________________________ Signature Date


Pacific Stock Exchange Arbitrator Profile Application General Information The information you provide in the "General Information" section (Pages 1 & 2) is not disclosed to the parties under any circumstances. The information you provide is for PCX use only. Name and Address: Please provide a street address for mail as most overnight delivery services cannot make delivery to Post Office Boxes. Please also provide office (if applicable) and home phone and facsimile numbers so that we can reach you whenever necessary. Honorarium Information: For IRS Form 1099 purposes, please provide your Social Security Number. if you wish to have the honorarium payment made to a separate entity, please identify that entity and provide the taxpayer identification number of that entity. Participation and Restrictions: Please note the amount of time you are available on a monthly basis to serve on arbitration panels. In addition, please note whether you have any other restrictions as to your service as an arbitrator. Other Arbitration Organizations: Please note specifically if you are an arbitrator with any other organization. Please do not limit your response to other self-regulatory organizations. Arbitrator History and Background Question #1 - Employment History: Please state your employment history, including: 1. 2. 3. 4.

The name of your current and past employers; A description of your position(s), and title(s) held; The start date, and the end date, where applicable, of such employment; Any employment in or related to the securities industry at anytime in your career

Question #2 – Educational Background: Identify all institutions attended, the year of graduation and any degrees or certificates conferred


Maddox / Stoltmann Question #3 - Business/Professional Background: This section is intended to provide the parties with a broad overview of your practical experience and background. Please complete this section by including a narrative description of your business or professional experience without necessarily referring to specific employers. This section is intended to give the parties an insight into the type of work you have actually done. PLEASE NOTE: The information you provide in this section (Business/Professional Background) be given, verbatim, to the parties. Question #4 - Prior Experience: Describe the experience, education or other background that qualifies you to serve as an arbitrator in a securities dispute. You may include information regarding your service as an arbitrator in other areas such as labor or commercial arbitration. Also, please include any teaching experience or publications you have contributed to which relate to arbitration. Question #5 - Arbitrator Training: Please indicate the dates, subject matter or course title, and sponsoring organization of all seminars or arbitrator training programs you have attended. Question #6 - Broker/Dealer Relationships a. List all brokerage firms where you presently maintain an account or previously maintained an account within the past 5 years. Please include joint accounts, beneficiary accounts, trustee accounts and IRA or Keogh accounts b. Please describe any business relationship which you, your employer or anyone in your immediate family has had with any brokerage firm during the past 5 years. Again, err on the side of disclosure. For example, "My employer is a printing manufacturer and one of its primary customers is ABC Securities for which it regularly prints prospectuses for initial public offerings." These questions are intended to solicit information to ensure that you are property classified. Industry arbitrators should be knowledgeable and experienced in the securities industry. Public arbitrators must be free, both in fact and appearance, of ties with securities industry. Question #7 - Associated Persons - Affiliation with Industry Please indicate whether you: a. Are currently affiliated with the securities industry, or, b. Are not currently affiliated with the securities industry, but you have had an affiliation with the securities industry within the past three years; or c. Your spouse or other family member has been affiliated with the securities industry


Pacific Stock Exchange Arbitrator Profile Application within the past three years Question #8 - Retirement From the Securities Industry If you are retired from the securities industry, please answer the questions in this section Question #9 - Expert Witness If you are or have been an expert witness for or against a broker/dealer in any administrative or legal proceeding, including any arbitration proceedings, you must identify all cases and time frames where you have acted as an expert witness in section (b). Question #10 - Professional Practice If you are an attorney, accountant, securities industry professional, or other professional who devotes 20% or more of your personal profession work to securities industry clients, please mark "Yes." The actual percentage breakdown is requested in Questions # 12 and # 13. Question #11 - Professional Associations Please list the professional associations of which you are a member. Questions #12 & #13 -Securities Work For all applicants, identify the percentage of work that your firm, and you as an individual, spend on securities; securities work on behalf of public customers; and, securities work on behalf of broker/dealers. This does not include work you do as an arbitrator with any of the self-regulatory organizations. Question #14 - Controversies Involving the Securities Industry Please indicate whether you, as an individual or on behalf of any other person, have brought or defended any actions involving a broker/dealer. If you answered "YES", identify (1) the name of the broker/dealer involved; (2) the party you represented; and, (3) the time period in which the case was pending. Questions #15 & #16 -Attorney Information and Specialization If you are an attorney, please identify your major areas of practice, and any other areas of law with which you are familiar. Please respond thoroughly to this question. Question #17 - Conflicts For all applicants, please note any other conflicts not identified in you responses to any other questions.


Maddox / Stoltmann Question #18 - Securities Disputes - Expertise and Experience This question is designed to give the PCX information about your prior experience and familiarity with issues that frequently arise in arbitration proceedings. Please indicate any areas with which you have expertise and/or experience. Question #19 - Securities Products - Expertise and Experience Please indicate whether you have specific knowledge or familiarity with any particular product fisted. If the product is not listed in Question 19, please write it in under "Other," Question #20 - Regulatory History Please read each question carefully before answering. A "yes" answer must be fully explained, and must include the relevant dates and circumstances. Please note that an affirmative answer will not necessarily be a bar to your selection, but may be a factor in assessing your qualifications to serve as an arbitrator. CRD History A Central Registration Depository (CRD) check will be performed on all applicant arbitrators. Any arbitrator who has a prior or current affiliation with the securities industry will be identified by the CRD system, and any prior or pending disciplinary matters that are required to be disclosed on forms U-4 and/or U-5 are also disclosed on the CRD system. Please note that failure to disclose material information in the arbitrator profile is grounds for denying an application to become an arbitrator.


Page 1

The Pacific Exchange, Inc. ARBITRATOR PROFILE Thank you for requesting an Arbitrator Profile from the Pacific Exchange. We appreciate your interest in serving as an arbitrator with our forum. In the space provided below, please note your responses to all questions. !

If the question is not applicable to you, please mark your response as “Not Applicable.” Do not leave any question blank.

!

If you have questions regarding the information requested, please refer to the attached Instructions for Completing the Arbitrator Profile.

!

DO NOT attach your resume in lieu of filling out any section of this form.

!

Incomplete forms will be returned to the applicant.

!

Sign and date the Affirmation on Page 16.

Personal Information APPLICANT’S NAME: Mr./Ms./ Dr.

First Name

Middle Initial

Last Name

Jr./II

HOME ADDRESS: street address

city

state

telephone

zip code

facsimile

Esq./J.D.


Page 2

WORK ADDRESS: Name of Employer or Business

Title

street address

city

state

zip code

telephone

facsimile

CONTACT INFORMATION: Preferred Mailing Address:

# Work

# Home

Deliver Federal Express or Express Mail packages to:

When is the best time of day to reach you?

# Morning

Can you serve on cases for two or more consecutive days? ->

# Work

# Home

# Afternoon # Yes # No # Occasionally

What is the maximum number of days you can serve on a case?

Please indicate your Social Security Number:


Page 3

Other Arbitration Organizations Please indicate where you currently serve as an arbitrator (check all that apply) National Association of Securities Dealers

American Arbitration Association

New York Stock Exchange

Chicago Board Options Exchange

American Stock Exchange

Philadelphia Stock Exchange

OTHER:

#

I am not an arbitrator for any other organization.

1.

Employment History (PLEASE LIST THE MOST RECENT POSITION FIRST - use a separate page if necessary)

PCX RULE 12.9 REQUIRES THAT YOU TO PROVIDE YOUR EMPLOYMENT HISTORY FOR AT LEAST THE LAST TEN (10) YEARS. DO NOT ATTACH YOUR RESUME IN LIEU OF COMPLETING THIS SECTION. Firm Name

Description of Position & Title

Start Date

End Date


Page 4

2.

Educational History (PLEASE LIST THE MOST RECENTLY ATTENDED INSTITUTION FIRST) School Name

3.

Degree Awarded (i.e., BA- political science; MBA; JD; none, etc.)

Start Date

End Date

Business Background

PLEASE ATTACH A TYPEWRITTEN DESCRIPTION (200 words or less) of your practical experience and background. It is extremely important that this information give an accurate picture of your past and current job responsibilities, including a description of the type of work you do now and have done previously. Upon approval to the PCX pool of arbitrators, the information you provide in this section is given directly to the parties when you are selected to serve on a case. As you fill out this section, put yourself in the shoes of the parties --- what would you want to know about an arbitrator who was selected to hear and decide your case? Your application will not be processed without this information. 4.

Experience Describe any current or prior experience which relates to your serving as an arbitrator. #

Response:

Not Applicable


Page 5

5.

Arbitrator Training List all arbitrator training seminars attended. Attach a separate page if necessary. #

I have not attended any arbitrator training seminars

Sponsoring Organization

6.

Subject Matter

Date

Broker/Dealer Relationships (a)

List all firms where you have maintained an account in the last five (5) years, or where you currently maintain an account. #

I do not maintain any brokerage accounts.

Firm Name

(b)

Type of Account (i.e., IRA, stock, bond, mutual fund, etc.)

Open Date

Have you, your employer/firm or a member of your immediate family had any business relationship with a securities firm within the last five (5) years? #

YES

#

NO

Closed Date


Page 6

If YES, please state the nature of the family relationship, the name of the firm, the type of relationship and the relevant dates. Family Relationship

7.

Name of Firm

Type of Relationship

Associated Person (a)

Are you currently a person associated with a member or other broker/dealer, municipal securities broker dealer, government securities broker/dealer? #

(b)

YES

#

NO

Have you been associated with a member firm or other broker/dealer, municipal securities broker dealer, government securities broker/dealer within the past three (3) years? #

YES

#

NO $

(c)

Please indicate your CRD number

(d)

Do you have a spouse or other member of your household who is/has been associated with a member firm or other broker/dealer, municipal securities broker dealer, government securities broker/dealer within the past three (3) years? #

YES

#

NO

If YES, please explain affiliation:

8.

Retirement from Securities Industry (a)

Are you retired from a member firm or other broker/dealer, municipal securities broker dealer, government securities broker/dealer? #

YES

#

NO

(b)

Please indicate your CRD number

$

(c)

Please indicate the date of your retirement.

$

Dates


Page 7

(d)

Do you have a spouse or other member of your household who is retired or is receiving benefits from a member firm or other broker/dealer, municipal securities broker dealer, government securities broker/dealer? #

YES

#

NO

If YES, please provide date of spouse/family member retirement and date of commencement of benefits. Retirement Date:

9.

Benefit Commencement Date:

Expert Witness (a)

Have you been an expert witness FOR a broker/dealer in any administrative or legal proceeding, including arbitration? #

(b)

YES

#

NO

Have you been an expert witness AGAINST a broker/dealer in any administrative or legal proceeding, including arbitration? #

YES

#

NO

If YES to either (a) or (b), please identify below the broker/dealers you testified for or against, and the time periods when you were an expert witness. Attach a separate sheet if necessary.

Broker/Dealer Name

FOR (%)

AGAINST (%)

Time Period


Page 8

10.

Professional Practice Are you an attorney or other professional who has devoted twenty percent (20%) or more of YOUR personal professional work effort to securities industry clients (i.e., broker/dealers, brokerage firms, associated persons, registered representatives, etc.) within the last two (2) years? #

11.

#

YES

NO

Professional or Business Affiliations Are you a member of any professional or business associations? #

#

YES

NO

If YES, please list the names of such associations, including any offices or titles held. Organization

12.

Office or Title Held

Firm’s Securities Work Does your firm allocate any percentage of its practice to securities work, work on behalf of public investors, or work on behalf of broker/dealers (securities industry clients)? #

YES

#

NO

If YES, identify the percentage of work that YOUR FIRM spends on securities work, work on behalf of public customers, and work on behalf of broker/dealers (securities industry clients). (a)

Percentage of your firm’s practice which consists of securities work. %

(b)

Percentage of your firm’s practice undertaken on behalf of public customers. %

(c)

13.

Percentage of your firm’s practice undertaken on behalf of broker/dealers or associated persons, registered representatives, etc.

% Arbitrator’s Securities Work


Page 9

Do you, in your personal practice, allocate any percentage of your practice to securities work, work on behalf of public investors, or work on behalf of broker/dealers (securities industry clients)?

NOTE: Your response to this question should not include work you do as an arbitrator with any self-regulatory organization. #

#

YES

NO

If YES, identify the percentage of work that YOU spend on securities work, work on behalf of public customers, and work on behalf of broker/dealers (securities industry clients). (a)

Percentage of your own practice which consists of securities work. %

(b)

Percentage of your own practice undertaken on behalf of public customers. %

(c)

Percentage of your own practice undertaken on behalf of broker/dealers or associated persons, registered representatives, etc. %

14.

Controversies Involving the Securities Industry Your response to this question should include any actions you have brought personally, or where you have represented a party as a non-attorney representative. (a)

Have you BROUGHT any actions against a broker/dealer? #

(b)

YES

#

NO

Have you DEFENDED any actions filed against a broker/dealer? #

YES

#

NO


Page 10

If YES to either (a) or (b) above, please list ALL of the broker/dealers involved, including the approximate time periods when you brought or defended the actions. Attach a separate sheet if necessary. Broker/Dealer Name

15.

Defended (%)

Time Period

Attorney Information (a)

Are you currently a practicing attorney?

#

YES

#

NO - I HAVE A LAW DEGREE BUT I AM NOT AN ACTIVE MEMBER OF THE BAR

#

NO - I AM NOT AN ATTORNEY

(b)

If YES, please list your major practice concentration and give the percentage of your personal practice devoted to each area. Area of Concentration

16.

Filed Against (%)

Attorney Specialization

Percentage of Practice


Page 11

If you are a practicing attorney or you have practiced law in the past, please indicate the following areas of law with which you are familiar. & Commodities & Bankruptcy & Employment & Civil Rights & Criminal Law & General Business & Securities & Banking & Discrimination & Municipal & Copyright & Sexual Harassment & Negligence & Corporate & Estates - Probate & Antitrust & Trademark & Insurance & Product Liability & Landlord/Tenant & Trusts & Taxation & Debtor-Creditor & Family Law & International & Collection & Mineral, Oil & Gas & Real Estate & Other: 17.

Conflicts - all applicants Please review your Arbitrator Profile for conflicts. Do you have any other conflicts of interest not already disclosed in QUESTIONS 1, 6, 9, or 14? #

YES

#

NO

If YES, please describe the conflict below, including the nature of the conflict (i.e., client, account, firm, personal, family, employer or former employer), a description of the conflict, and the relevant time period. Conflict

18.

Description

Time Period

Securities Disputes Expertise and Experience

Check the types of securities related disputes in which you have expertise and/or experience. #

None (no expertise or experience in any category)

Account Related & Breach of Contract & Margin Calls & Error-Charges & Other:

& Failure to Supervise & Dividends & Transfers

& Collection & Negligence & Exchanges


Page 12

Executions & Execution Price & Failure to Execute

& Limit v. Market Order & Incorrect Quantity

& Other:_________

Fraudulent Activity & & & &

Churning Unauthorized Trading Suitability Manipulation

& & & &

Omission of Facts Misrepresentation Breach of Fiduciary Duty Other: ______________

Employment & & & & &

Breach of Contract Commission(s) Training Contracts Wrongful Termination Promissory Notes

& & & & &

Sexual Harassment Compensation Discrimination Partnerships Other:

Other & Clearing Dispute & Defamation & Underwriting

& Raiding Disputes & Indemnification & Other:

Trading Disputes & Buy-In & Stock Loan & Mark-Up(s)

19.

& Sell Out(s) & Manipulation & Price Discrepancies

& D.K.'s & Transfers & Other:

Securities Product Expertise and/or Experience

Check the types of securities, financial instruments and investments with which you have expertise and/or experience. &

No expertise or experience

& Annuities & Common Stock & “Fanny Maes” & “Freddie Macs” & Municipal Bonds & Preferred Stock & Options & Warrants/Rights &Real Estate Investment Trust & Stock Index Futures Agreements & Other Types of Securities: 20. Regulatory History

& & & & &

Commodities “Ginnie Maes” Mutual Funds Repurchase Options Trading

& Corporate Bonds & Government Securities & Limited Partnerships &Equity Trading Floor Floor


Page 13

You must answer EACH question below. Failure to do so will result in the Arbitrator Profile being returned to you for completion. (a) Have you ever been convicted of or plead guilty or nolo contendere ("no contest") in a domestic or foreign court to: (1) A felony or misdemeanor involving investments or an investment-related business, fraud, false statements or omissions, wrongful taking of property, or bribery, forgery, counterfeiting or extortion?

Yes & No &

(2) Gambling?

Yes & No &

(3) Any other felony?

Yes & No &

(4) Any other misdemeanor?

Yes & No &

(b) Have you, or an organization over which you exercised management or policy control, ever been charged with any felony or charged with a misdemeanor specified in Question 20(a)(1) or (2) above?

Yes & No &

(c) Has any domestic or foreign court ever: (1) Enjoined you in connection with any investment-related activity?

Yes & No &

(2) Found that you were involved in a violation of investment related statutes or regulations?

Yes & No &

(3) Found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked, or restricted?

Yes & No &

(4) Entered an order denying, suspending or revoking your registration or disciplined you by restricting your activities?

Yes & No &

(5) Imposed a civil money penalty on you, or ordered you to cease and desist from any activity? Yes & No &

(d) Has the U.S. Securities and Exchange Commission or the Commodity Futures Trading Commission ever: (1) Found you to have made a false statement or omission?

Yes & No &

(2) Found you to have been involved in a violation of investment-related regulations or statutes?

Yes & No &

(3) Found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked or restricted?

Yes & No &

(4) Entered an order denying, suspending or revoking your registration or disciplined you by


Page 14

restricting your activities?

Yes & No &

(5) Imposed a civil money penalty on you, or ordered you to cease and desist from any activity?

Yes & No &

(e) Has any other Federal regulatory agency or any state regulatory agency or foreign financial regulatory authority ever: (1) Found you to have made a false statement or omission, or been dishonest, unfair or unethical?

Yes & No &

(2) Found you to have been involved in a violation of investment-related regulations or statutes?

Yes & No &

(3) Found you to have been a cause of an investment-related business having its authorization to do business denied, suspended, revoked or restricted?

Yes & No &

(4) Entered an order against you in connection with investment-related activity?

Yes & No &

(5) Denied, suspended or revoked your registration or license or otherwise prevented you from associating with an investment-related business, or disciplined you by restricting your activities?

Yes & No &

(6) Revoked or suspended your license as an attorney, accountant or federal contractor?

Yes & No &

(f)

Has any self-regulatory organization or commodities exchange:

(1) Found you to have made a false statement or omission?

Yes & No &

(2) Found you to have been in violation of its rules?

Yes & No &

(3) Found you to have been the cause of an investment-related business having its authorization to do business denied, suspended, revoked or restricted?

Yes & No &

(4) Disciplined you by expelling or suspending you from membership, barring or suspending your association with its members, or restricting your activities?

Yes & No &

(g) Has any foreign government, court, regulatory agency or exchange ever entered an order against you related to investments or fraud, other than as reported in Questions (a), (b), (c) or (e) above?

Yes & No &

(h)

Have you ever been the subject of an investment-related consumer-initiated


Page 15

complaint or proceeding that: (1) Alleged compensatory damages of $10,000 or more, fraud, or wrongful taking of property? Yes & No & (2) Was settled or decided against you for $5,000 or more, or found fraud or the wrongful taking of property?

Yes & No &

(i) Are you now the subject of any complaint, investigation, or proceeding that could result in a “yes” answer to Questions (a) through (h) above?

Yes & No &

(j) Has a bonding company denied, paid out on, or revoked a bond for you?

Yes & No &

(k) Do you have any unsatisfied judgments or liens against you?

Yes & No &

(l) Have you or a firm that you exercised management or policy control over, or owned 10% or more of the securities of, failed in business, made a compromise with creditors, filed a bankruptcy petition or been declared bankrupt?

Yes & No &

NOTE: If you answered “yes” to this question, please provide details (e.g., the date of the filing of any petition for bankruptcy, the jurisdiction and the disposition). An affirmative answer will not necessarily be a bar to your selection, but may be a factor in assessing your qualifications to serve as an arbitrator.

(m) Has a broker or dealer firm that you exercised management or policy control over, or owned 10% or more of the securities of, been declared bankrupt, had a trustee appointed under the Securities Investor Protection Act, or had a direct payment procedure initiated?

Yes & No &

NOTE: If you answered “yes” to this question, please provide details (e.g., the date of the filing of any petition for bankruptcy, the jurisdiction and the disposition). An affirmative answer will not necessarily be a bar to your selection, but may be a factor in assessing your qualifications to serve as an arbitrator.

(n) Have you ever been discharged or permitted to resign because you were accused of: (1) Violating investment-related statutes, regulations, rules, or industry standards of conduct?

Yes & No &

(2) Fraud or the wrongful taking of property?

Yes & No &

(3) Failure to supervise in connection with investment-related statutes, regulations, or rules of industry standards of conduct?

Yes & No &


Page 16

(o) Have you ever had any license, registration or any authority to practice any business or profession revoked or suspended?

Yes & No &

(p) Have you ever been the subject of a claim alleging discrimination, sexual harassment, or abridgement of civil rights, in a federal, state or local court, or in an administrative or civil proceeding, or in an arbitration proceeding?

Yes & No &

!

If you had any “YES� answers to Questions 20 (a) through (p), YOU MUST EXPLAIN FULLY, including dates, description and disposition. Please indicate your response(s) on a separate page and attach to this document.

!

Sign and date your response.

!

Please be advised that upon receipt of your completed Arbitrator Profile, the PCX will perform a CRD (Central Registration Depository) background check. If any incidents appear on the CRD check that are not disclosed herein, the PCX reserves the right to decline approval of the applicant to the pool of arbitrators.

***************************


Page 17

ARBITRATOR’S AFFIRMATION Please read the affirmation below and affix your signature and the date. “I swear or affirm that the information contained in the Arbitrator Profile is true and complete to the best of my knowledge. I understand that I am responsible for advising the PCX of any changes to the above information and that the information provided is subject to independent verification.” “I also hereby agree that if approved to the pool of arbitrators and appointed to any case, I shall serve in accordance with established PCX procedures, PCX Arbitration Rules and the Code of Ethics for Arbitrators in Commercial Disputes. I understand that my submission of this information does not create any obligation on the part of the PCX to place me on the list of persons eligible to serve as arbitrators on arbitrations organized and conducted by the PCX or to appoint me to serve on any panel of arbitrators.” “I also understand that the PCX reserves the right to reconsider the eligibility or appointment of arbitrators at any time, and may remove arbitrators from the eligible pool as it, in its sole judgment, deems appropriate.”

Signature:

Date:


Biographies Mark E. Maddox Mark E. Maddox, a graduate of Wabash (IN) College and Vanderbilt’s Law School, was the Indiana Securities Commissioner from 1989 to 1991. While Commissioner, Mr. Maddox also served as the Chairperson of the International Enforcement Committee of the North American Securities Administrators Association (NASAA). Mr. Maddox served two terms as the President of PIABA and has been a member of PIABA’s Board of Directors since 1994. He also served on the NASD Regulation’s National Arbitration and Mediation Committee (NAMC) as the public representative from 1996 until 1998. He is a member of the Indianapolis Bar Association, the Indiana State Bar Association where he is a past Chair of the Securities law Sub-Committee, and the American Bar Association where he has been active on the State Regulation of Securities Committee. Mr. Maddox was admitted to practice before the Supreme Court of the United States in February of 1995. He has been a speaker and lecturer for various Continuing Legal Education seminars on securities law and securities-related seminars and has been published extensively on securities related topics. For more information on Mr. Maddox and the legal association of Maddox Koeller Hargett & Caruso, please visit www.investorprotection.com.

Andrew J. Stoltmann Andrew J. Stoltmann graduated from the University of Wisconsin with a Bachelor of Business administration degree. After graduation, Mr. Stoltmann was employed as a stockbroker for Merrill Lynch. Mr. Stoltmann then decided to attend DePaul University School of Law in Chicago, Illinois. While in law school, Mr. Stoltmann clerked at the National Association of Securities Dealers (NASD) in Chicago. He now exclusively concentrates his legal practice in the Chicago office of Maddox Koeller Hargett & Caruso representing investors in arbitration who are the victims of fraud by stockbrokers, financial planners and insurance agents. Mr. Stoltmann is a member of PIABA where he currently serves on the Federal Legislation and Self Regulatory Organization subcommittees. He is a member of the Chicago Bar Association, Illinois State Bar Association, Association of Trial Lawyers of America and is admitted to the United States District Court for the Northern District of Illinois. He has written extensively and lectured on investor rights issues and securities arbitration. For more information on Mr. Stoltmann and securities arbitration, please visit www.investorprotection.com.


INVESTOR RIGHTS FOR THE 21st CENTURY