Subject: Comment to File No. SR-NASD-99-07 Author: "DAN JAMIESON" Date: 6/1/99 1:19 PM June 1, 1999 Dan Jamieson 14341 Spa Drive Huntington Beach, CA 92647 Office of the Secretary Securities and Exchange Commission, 450 Fifth Street, N.W. Washington, D.C. 20549-0609 Comment to File No. SR-NASD-99-07, Discovery Rules. Via E-mail Dear Mr. Katz: The proposed guidelines are a helpful step in striking a reasonable balance between competing interests. The guidelines as generally proposed would be of tremendous help to arbitrators in issuing discovery orders. The clear, but flexible nature of the proposed discovery guidelines are an appropriate solution to the longstanding problems with discovery in NASD arbitration hearings. The advantage of an industry arbitration system for commercial disputes is that claims and defenses will often be similar, and the documents needed for a hearing will be similar from case to case as well. Therefore, guidelines for what should typically be produced are appropriate and consistent with the '34 Act and SRO standards of fair practice. Where the proposal can be criticized is in favoring slightly industry interests. Litigation is of keen concern to the securities industry and Wall Street has long been effective in making sure its views are heard at its own SROs, within its own justice system, and at the Commission as well. Meanwhile, the investors' plaintiffs' bar is relatively new and puny, and investor interests are completely unorganized. Therefore, the Commission must take extreme caution in making sure the disaffected are heard. To that end, this letter offers suggestions that in this commentator's opinion would better balance the proposal. Regarding List 2 Item 2 is unfair, since many if not most customers would have to create these financial statements of assets, liabilities and or net worth for possibly up to six years running. Most public customers have a hodge podge of accounts and statements--with no centralized reporting available from different custodians. Uncertain valuations on homes and other property would make production of this information difficult. Business owners are unlikely to have a current, independent valuation of their enterprise/s. Therefore, production of such information will be a large and costly burden for most customers. The net worth and other financial information about the customer that the broker and brokerage firm have on file should suffice for most cases. Of course, in certain cases, a panel could order production of such balance sheet type information from customers, and can continue to do so under the proposed guidelines. Item 10 seems quite invasive. Requiring a peek into the private communications from other professionals seems misplaced. Perhaps the industry has pushed for this item in an attempt to see if a claimant has been goaded by a competing brokerage firm or adviser. Whatever, the need for Item 10 is unclear, especially given the sensitive and possibly privileged nature of this information. If such information is relevant, either side can ask for its production, but it should not be on the list. Items 11 and 12, although helpful in rooting out bad-actor customers who have been parties in other securities-related litigation, also puts an unfair burden on customers. This type of information relating to brokers is available with a single request to the CRD system. But customers have no central source to easily access this information. While these Items might be kept on the list, their existence certainly helps kill any industry argument that the discovery demands in these proposed rules are unbalanced, or that similar information about a firm or broker should not be part of the lists due to its prejudicial nature. Regarding List 3 A new "Item 4" should be added. The NASDR has left off critical information relating to churning, namely, financial and career incentives faced by both the firm and the firm's management relating to sale of the securities at issue. Managers have far more impact on what gets sold than do lone brokers. Therefore, regarding the investments at issue, firms should also have to produce under a new Item 4: 1) a summary of all revenue earned by the firm from sales of the products, including total dealer reallowance (not just gross credited to the rep), "revenue sharing" arrangements and support payments received by the firm from the products' vendors; 2) the products' due diligence file; 3) full documentation of all incentives given to branch managers, regional managers, district managers and sales managers, including any sales quotas and a history of sales meetings regarding the product; 4) documentation of any sales contests. This is nearly identical compensation information to that required for brokers. It is both absurd and dangerous to assume that incentives start and end with the retail salesforce. Firms and management cannot be exempted from this disclosure. Regarding List 11 Regarding the best execution issue, only the production of order tickets would be of help. An additional list could be created for best execution claims. Additional documents could include the time-and-trade reports used by the firm; compensation information for the broker, trader, and trading desk management; records of conversations/communications between the broker and trader; and the firm's best-execution procedures, including financial arrangements with specialist firms. Regarding List 13 Items 1 and 2 lay all blame on the retail rep for unsuitability. Again, it is absurd and dangerous to assume that management incentives are not affecting what gets sold. In fact, for purposes of assessing damages, management's role in an unsuitability case will be key. Therefore, the same compensation information in Item 2 as is being proposed for retail reps should also be produced for all sales managers, branch mangers, regional managers and district managers. The worksheets or notes referred to in Item 1 should also apply to these managers since wronged customers have a right to know if managers who encourage reps to sell a particular security have also reviewed pertinent documents. Note on Part II, B The Commission should regard with care Part II, B, of the proposed rule, which says: " ... one of the parties may suggest a stipulation between the parties that the document(s) in question will not be disclosed or used in any manner outside of the arbitration of the particular case, or the arbitrator(s) may issue a confidentiality order." While important for arbitrators to have the confidentiality tool available, this seemingly innocent phrase could serve to further close the industry's arbitration process to public scrutiny. Unlike a court of law, NASD arbitration hearings are not now open to the public. Even if one party wants an open hearing, the sessions remain closed to sunlight. This lack of sunlight into the process erodes confidence in the system, despite the fact that the system, for the most part, works well. Yet investors can learn little of what happens in closed sessions, unlike industry participants who enjoy repeat player status and know full well how the system operates. This proposed confidentiality wording could further tempt participants into asking for gag orders and document seals. Already, the discovery process has been abused with participants demanding a vague standard of confidentiality in return for documents that should have been produced anyway. The rule should instead clarify the use of confidentiality orders. Panelists should be given direction as to the limited reasons why documents should be kept confidential, such as where material financial or trade secret information is at stake, or sensitive tax information at risk. Otherwise, panelists should be discouraged from using such orders. Comments on SEC Questions B. Customer Personal Financial Information Requiring both a balance sheet and tax return from customers is unduly burdensome. Unlike firms, customers are not in the business of keeping records. A balance sheet OR basic tax return information should suffice in most cases. Six years of such information could be far too long in many cases. A year prior to an alleged incident would seem reasonable. Production of this information should be limited to relevant claims, such as unsuitability. Requiring customers to produce this information DOES NOT balance the requirement of firms to produce customer complaints and disciplinary action from all time periods. Firms already retain customer complaints (letters and a log) as required by industry rules, and full broker disciplinary histories are available to customers via the CRD and to firms via their own terminals--hardly a burden for the industry. The Commission should avoid defining legal privileges. Arbitrators are quite capable of deciding privilege issues under well-established legal principles. D. Internal Audit Reports Regarding Item 3(a), the Commission is correct in questioning the "focused on" language in regard to the production of internal audit reports. In fact, it is critical that the Commission avoid restricting in any way what relevant audit reports are presumptively discoverable. Better language would be an audit report that "could relate to" a claim at issue. "Focused on" creates a semi-truck sized loophole for hiding a problem broker--a critical audit report could well avoid naming any one broker in particular, even though that very broker precipitated the audit. Many of these reports or audits will be general in nature but will be specific to a failure-to-supervise claim. Therefore, the broadest possible language should be used in describing what reports should be produced. Absolutely no date limitations should be placed around any audit reports. Generally, the older the audit report, the more longstanding the problem and the greater the failure to supervise liability the report could show. One could logically exempt newer reports, but not older ones. The wording of List 5, Item 3(a), will not help firms produce documents as much as it will help them bury adverse material. Expanding this language will not upset any purported balance; firms routinely generate and archive all such documents and can produce them with little trouble. That they want to bury past adverse reports is only natural, but the Commission should not go along with the idea. Also in Item 3, the description of audit reports "at the branch" is vague. Is this a report held at the branch, or done at the branch? This language should be removed. Particularly egregious behavior is often investigated by off-site personnel, and the subsequent report would likely be held off-site as well, resulting in a discovery exemption for these potentially "smoking gun" documents. Again, the Commission should close this industry-inspired loophole. Comments re Other Commentators The Securities Industry Association has questioned the wisdom of the SEC effecting this rule that institutes guidelines as part of the SICA manual. The SIA says it will not support the guidelines because they will "interfere with the discretion" of panelists. First, because the rule is a set of guidelines, not mandates, there can be no interference with arbitrators. Secondly, that the guidelines are issued as a rule is immaterial. The SEC has every right to set forth any kind of guideline or rule, with or without industry participation. The proposed discovery guidelines, formulated with a good deal of debate, and passed as a rule and added to the manual are entirely appropriate. Indeed, the SIA's position is puzzling since the guidelines are widely considered as necessary given past discovery abuses within the industry's own justice system. Further, the Commission is to be commended for allowing the public to comment on the guidelines via the formal rulemaking process; the public, which is mandated to litigate in the industry's own forums, has no organized lobbying constituency--quite unlike Wall Street. Remember, the public investor has interests different even from the plaintiffs' bar, which itself might lobby for rules that would make litigation more common and costly for investors, but more profitable for itself. The public comment process is the sole opportunity for the public customer to address this important rule proposal. The SIA's concerns about the process are misplaced. The SIA also worries about the "codifying" of an arbitrary list of items that must be produced. Again, these are guidelines. And they are needed now more than ever with implementation of the list-selection method for NASD arbitrators. This method will probably produce more diverse--but less experienced--groups of panelists who will need the guidance. The guideline's lists are far from arbitrary; they contain items that should be, and have been, routinely produced. In addition, the SIA complains of an unfair burden: "far more documents are required to be produced by firms," the SIA writes. A precise item count is not necessary to see that all of the material ordered to be produced by firms and brokers is produced and kept in the normal course of business, per industry recordkeeping requirements. Not so for customers (such as the balance sheet item). While it is true that certain cases require "liberal discovery" of customer financial information, which the industry of course wants, Wall Street really has no argument here as it already owns detailed information on customers (see footnote No. 1). Full tax returns are not needed in most cases. Where full returns are needed, the Street should trust its own process and count on arbitrators to order further discovery. The SIA comment letter discusses the need for providing past disciplinary actions of a broker, and the slight probative value to be gained from this information as well as its prejudicial nature. The points made are irrelevant, however, since the issue at hand is failure to supervise, not individual broker misconduct. Past disciplinary actions relate directly to failure to supervise. This is precisely why audit reports should not be restricted in any way. Meanwhile, the industry does not object to the equally prejudicial information on List 2, Items 11 and 12--past customer litigation and complaints. The Commission should discount the SIA's argument here. The hand-wringing over List 1, Items 8 and 12 is likely a straw man created for the Commission's own benefit, since substantial disciplinary information will remain publicly available regardless of the Commission's action on this rule. When the industry is "defeated" on this item the SIA can claim to have "given up" something in the interest of achieving balance--even though the status quo remains. The SIA is correct in warning against an "exhaustive list of potential privileges." The SEC should take heed of the SIA's suggestion that the Commission "should not tread in an area that is governed by the law of the state where the hearing occurs. ..." SIA commentators further claim that the vitality and candor of internal audit reports will be hurt by their production, and that the self-policing function will therefore be harmed. The opposite is true. Any increased exposure of internal audit reports will help ensure that the reports' recommendations are followed internally, rather than buried. Self-policing will be improved as a result. Specific questions about which reports are material to a case can be easily handled by arbitrators. Therefore, no time limits or "focused on" definitions should be suggested--the possible negative impact on investor protection would be too risky. The proposed discovery rules are, overall, well-thought out and clearly needed. There is some industry bias in the lists, but that is to be expected as a natural outcome of a process that does not directly involve investor interests, yet includes well-financed and well-connected industry interests. Despite the industry tilt, participants in the drafting process should be commended for their thorough work. Some minor rebalancing by the Commission is all that is needed to create a truly fair and workable set of guidelines. Sincerely Dan Jamieson Huntington Beach, Calif.