In a securities arbitration by a brokerage client, the client's former broker was not named as a party nor mentioned in the claim. Attorneys for the parties exchanged witness lists 20 days before the first hearing, as required, but the lists were not sent to the NASD arbitration staff attorney for distribution to the arbitrator (since that is not required). On the first hearing day, the broker — no longer employed by the brokerage firm — was called by the customer as her second (and adverse) witness. The broker noticed one of the three arbitrators is a very elderly member of his large church, but the arbitrator doesn't seem to recognize him. Must the broker disclose this relationship? (Note: The customer is elderly, unwell and has waited a year for the hearing.)
One of the few grounds to vacate an arbitration award is arbitrator partiality. Courts consider whether a reasonable person would conclude an arbitrator was partial to a party. Appearance of bias alone is insufficient.
All arbitrators also are required to uphold The Code of Ethics for Arbitrators in Commercial Disputes. Canon II requires arbitrators to disclose known existing or past financial, business, professional or personal relationships which might reasonably affect impartiality or lack of independence in the eyes of any parties, including relationships with “any individual whom they have been told will be a witness.”
The broker here should have asked for a break to speak with the customer's attorney and the brokerage firm's attorney outside of the hearing room and disclosed the relationship to them. Upon their return, without the broker, the attorneys should have told the arbitrators of the broker's disclosure and asked the arbitrator involved whether he felt the witness' testimony would sway him because of who the broker was, not because of what he would testify. If the arbitrator assured them he could remain neutral and both attorneys agreed, the case could go forward, provided the broker's disclosure and parties' agreement to proceed were part of the record. But if a party was uncomfortable, even with the arbitrator's assurances of impartiality, the arbitrator must be asked to withdraw.
David E. Robbins
Kaufmann Feiner Yamin Gildin and Robbins LLP
New York, N.Y.
The simple answer to your question is that the broker has no obligation to make the disclosure, though perhaps for a different reason than you may think. The broker in your question is only a witness, and not a party. Nothing in the NASD Code of Arbitration Procedure requires nonparty witnesses to make any unsolicited disclosures to the parties or the panel. A witness is only obliged to appear at the appointed time and to truthfully answer all questions he is asked.
Note that if the arbitrator knows of the facts you describe, he must disclose them. The Code (Rule 10312) requires arbitrators to disclose social and other relationships that might create even the appearance of partiality or bias. Attending the same church is certainly within the scope of the rule. The customer's age and health, and the age of the case, are completely irrelevant to the duty to disclose, though they may affect claimant's attorney's response to the disclosure.
Finally, although your question correctly assumes that the Code (Rule 10321(c)) does not require parties to provide a copy of their witness lists to the NASD before the hearing, experienced attorneys routinely provide the NASD copies of the witness and exhibit lists when they exchange them with the other parties 20 days before the hearing. The NASD encourages that practice so that potential disqualification issues can be resolved before the hearing.
Robert S. Banks, Jr.
Banks Law Office
As a manager of investments for buy-and-hold clients, I charge an annual fee on assets. I feel this aligns my interests with those of my clients and removes the temptation to recommend transactions for the sake of generating commissions. My clients get the benefit of the buy-and-hold approach, which include low or no taxes on gains, etc. I feel it is the best way to serve my clients. Though I can appreciate the counter perspective — that clients might pay less per year through commission-based arrangements — I believe in my heart that the fee-based arrangement compensates brokers most fairly for the investment advice, service and management we provide. Is there an ethical issue here?
Your feelings are part of a growing trend toward fee-based arrangements in the securities industry. It's true such arrangements remove the incentive for churning (that is, recommending gratuitous transactions in a quest for commissions). Fee-based accounts, however, are not a panacea: One size does not fit all. Certainly for a trading or moderately active account, it would be appropriate. On the other hand, if a large account remains dormant for a long period of time, it is only a matter of time before the client will question its use. Furthermore, if margin is used in connection with a fee-based account, extra care should be taken to thoroughly explain the problems and risks so as to avoid the possible future criticism that you used margin to boost the dollar value of the account under management only to increase your asset management fee.
Constantine N. Katsoris
Fordham University Law School
New York, N.Y.
Your comment raises the issue of why it is so important, in a commission-based compensation environment, to adequately regulate those commissions. Accordingly, on the broker/dealer side of the securities business, where commissions commonly serve as compensation, various regulatory techniques are used to protect investors. Limitations on excessive markups and churning, for example, come to mind.
Of course, it should not be ignored that annual fees, when permitted in the securities industry, also may raise compliance issues and concerns, such as proper disclosure of the fees. Although one can argue about whether certain forms of compensation fit more naturally with an investment advisor or broker/dealer business, it seems clear that investor protections should be tailored to whichever form of compensation ultimately is permitted and used. Moreover, securities professionals' diligence in following applicable rules is critical to giving such investor protections their fullest effect.
Kenneth M. Rosen
University of Alabama School of Law
Editor's note: The following question ran in the March issue, but one of its responses was accidentally omitted. To correct this error, we are re-running the questions and answers as they should have appeared.
I've got a $200,000 account and I am charging the client 1 percent in a wrap program. The client understands he's paying a management fee and understands what I get in the payout grid. But, clients don't understand many mutual funds pay trails via 12b-1 fees of between 25 to 100 basis points. At my firm, brokers don't get the trail; the firm keeps 100 percent of it. But retail clients pay this fee. It's a hidden, completely invisible fee despite it being in the prospectus — somewhere. In my view, customers are paying twice and don't know it. I haven't spent time talking about it with clients, but don't you think that brokerage firms and mutual funds should quit this arrangement of paying 12b-1 fees in wrap programs?
Your suspicions are correct. If you have knowledge that there is a failure to disclose fees that your client is paying, it's your responsibility to educate the client fully about all fees involved in the investments being made. It doesn't matter whether you receive a portion of the 12b-1 fees or your firm gets 100 percent of the fee.
Your belief that fees are hidden and clients don't understand or have knowledge of these fees makes it all the more imperative that you give full disclosure so clients know what they're paying. That's true whether it's a front- end or back-end fee or commission. Don't rely on a prospectus to cover your responsibilities here. The prospectus alone usually will not satisfy your disclosure duties when you are dealing with the public. This policy should certainly be reviewed by firms and the mutual funds.
Theodore G. Eppenstein
Eppenstein & Eppenstein
New York, N.Y.
Investment Company Act Rule 12b-1 permits a mutual fund to finance sales and distribution activities. While NASD rules limit the amount of 12b-1 compensation paid to brokers, the magnitude of the fees is substantial. Prospectus disclosure of 12b-1 fees generally has been considered adequate. Wrap programs have additional disclosure requirements. Recently, the SEC proposed rule amendments to enhance the information brokers provide to their customers when selling funds. These new rules would require, among other things, point-of-sale and enhanced confirmation disclosures of 12b-1 fees that customers could incur in the year following the purchase. Senators Fitzgerald (R-Ill.) and Levin (D-Mich.) would go further. They are in the process of introducing legislation that would eliminate 12b-1 fees altogether.
Steven M. Malina
Ungaretti & Harris
Ethical Rep is a monthly feature in which more than 30 prominent securities attorneys, experts and law school professors help Rep. readers deal with work-related ethical quandaries. Have you encountered a situation at work that makes you uncomfortable? Are you confused about how your responsibilities to clients might change as regulations continue to evolve? Drop a line to Rep.'s contributing editor, Ann Therese Palmer, and our group of experts will help you work through the problem.
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