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Brokers Beware - U5 Changes Are Here!
rokers who are contemplating leaving their current firm need to acclimate themselves with a new rule that could make departure far more painful. In the past, some brokerage firms and their managers have used negative U-5s to blackball former employees who want to take their lucrative client books with them to a new job. Soon, firms may be able to do so with greater impunity.
In January, the NASD approved a four year pilot program designed to increase the shield that brokerage firms now have from employee defamation claims. Under the proposal, firms that include negative information on a broker's U-5, generally would be protected from a defamation claim if the firm acted in good faith. In order for a broker to make a successful defamation claim, the broker would have to prove by clear and convincing evidence "that the firm knew that the statement was false or acted in reckless disregard of the truth when making the statement..." The new burden of proof is much more stringent than the recently repealed standard, which was proof by a preponderance of the evidence.
Defamation is considered to be an attack on the reputation of another through the unprivileged utterance or publication of false statements that result in injury to that person. If the defamatory words impact a person in his occupation, he or she is entitled to recover damages. The recovery in defamation actions usually is limited to actual or compensatory damages, although punitive damages can be awarded if the statements were made with "actual malice."
The NASD justifies the new proposal by claiming that partial immunity ensures that regulators and investors receive candid information concerning why a broker left his old firm. The disclosures are viewed by the NASD as a critical tool for regulators to be able to tell whether there is a problem with the broker or whether he or she can be classified as a "rogue broker. " For many years, brokerage firms were criticized not for overly harsh U-5s, but for allowing "rogue brokers" to roam freely from firm to firm by permitting them to resign without noting any problems on the termination notice.
Unfortunately, the advancement of this legitimate goal comes at the direct expense of the broker. Brokers have known how firms can smear U-5s with half truths, innuendoes or flat out fabrications for the main purpose of attempting to slow down or prevent a broker from taking the all important book of clients. The results for former employees can be disastrous because securities firms often and increasingly shy away from hiring brokers with purportedly bad records.
However, there is a silver lining. The good news is that, even under the NASD proposal, firms still face liability. First, the proposal does not affect other causes of action, such as tortious interference with a new job contract.
Moreover, the proposal does not eliminate U-5 defamation liability, it simply raises the bar to bringing a successful claim by requiring a higher evidence standard. Remember that brokerage firms paid a total of $12.1 million in damages in defamation cases for the year ended May 31 1997, up 47% from a year earlier, according to a study done by the newsletter Securities Arbitration Commentator.
In addition to arbitration to enforce a broker's rights, there are steps that a broker should take to guard against a U-5 abuse. First, ask the firm for a chance to respond to the allegations before they are placed on the U-5. Not only can this shed new light on the subject but also it may cause the brokerage firm to question the reliability of its sources. Typically, the firm will grant this request because it will show to a potential arbitration panel that the firm performed its due diligence in verifying the accuracy of the allegations. More importantly, from the broker's perspective, the best defense against a U-5 defamation is prevention. Brokers should attempt to convince the firm to keep the allegations off the U-5 by casting as much doubt as possible on the reliability of the allegation. This always is the best solution.
Second, ask other brokers at the firm whether the firm has communicated the allegations to them. This is important because arbitration panels have rendered awards against firms when they made statements arising out of the U-5 process and not necessarily because of statements made on the U-5. Once the firm departs from its function of completing and filing the U-5, moving into the area of making incorrect statements to others besides the aggrieved broker and the regulators, firms risk liability.
Finally, if the termination goes forward and the allegations are placed on the U-5, check the U-5 to see whether it contains concrete facts (i.e. the client sent a letter to the office alleging unauthorized trading) rather than accusatory inferences (i.e. the broker has shown a pattern of placing unauthorized trades.) The latter more easily can create liability. In fact, firms are advised to track the language of customer complaints, without announcing their findings and judgment as to their truth or falsity, in order to minimize liability.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
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