Respect Your Arbitrators — Or Else!

he NASD National Adjudicatory Council ("NAC") recently reminded us that one must respect arbitrators hearing customer disputes at NASD Dispute Resolution. The reminder from NAC came when it affirmed a disciplinary decision imposing sanctions against Josephthal & Co., Inc.

The case is interesting. Two customers who had filed an arbitration claim against Josephthal were in the process of presenting their claims at an arbitration hearing. Presumably based upon testimony presented, the customers requested that Josephthal be ordered to produce a report of an independent consultant relating to the firm's supervisory procedures. The arbitrators granted the request.

However, Josephthal searched and found that no such report existed. That was an accurate finding and it should have ended the matter. But it did not. For whatever reason, the firm voluntarily disclosed the existence of another document, which the customers had not even requested. In the same breadth, Josephthal asserted that this new document was protected by attorney-client privilege, because it contained legal advice regarding future compliance with the securities laws and NYSE rules. The document was a memorandum that had, in fact, been prepared by a law firm for Josephthal, and it had not been disclosed to any other person or entity except Josephthal.

So, the firm stood on fairly firm ground to assert the attorney-client privilege. But the arbitrators ordered production of the memorandum anyway. Josephthal was concerned. The firm filed a motion for reconsideration, even attaching an affidavit by the firm's general counsel attesting to why the memorandum was protected by the attorney-client privilege. The customers did not dispute the facts alleged in the affidavit.

The arbitrators were swayed - at least to some extent. As a compromise, the arbitrators offered that they would review the document privately to determine whether it was, in fact, protected by attorney-client privilege. But Josephthal rejected the offer, arguing that this kind of in camera inspection would constitute a disclosure, and that the disclosure would negate any future attorney-client privilege protection. The arbitrators were not impressed. They ordered production for in camera inspection. Josephthal refused.

The arbitrators never did see the memorandum. But they ruled in favor of claimants in the arbitration. And they made a disciplinary referral to NASD Regulation for whatever disciplinary action was deemed appropriate.

NASDR did bring a formal complaint against Josephthal. Subsequently, an NASDR hearing panel found that Josephthal had violated NASD Conduct Rule 2110, which provides that, "A member, in the conduct of his business, shall observe high standards of commercial honor and just and equitable principles of trade". The hearing panel sanctioned Josephthal with a censure and a $10,000 fine.

Rather than pay the fine, Josephthal appealed to the NAC. The NAC decision is important because it confirms that NASD arbitrators do have significant authority. First, NASD arbitrators have the power to direct arbitration parties as well as NASD members and associated persons to produce documents. Second, arbitrators have the power to interpret arbitration rules and procedures. Third, arbitrators have the power to take appropriate action to obtain compliance with any of their rulings. Fourth, these interpretations and actions of the arbitrators shall be final and binding upon the parties.

Specifically in regard to the Josephthal's appeal, the NAC cited Code of Arbitration Procedure Interpretive Material ("IM") 10100 (Failure to Act Under Provisions of Code of Arbitration Procedure). That section provides in relevant part that should an arbitration party fail to produce a document in its possession or control, it is a violation of NASD Rule 2110.

Josephthal mustered an argument that Rule 2110 applies only if a firm acts in bad faith. However, NAC rejected that argument, finding that bad faith is not required to prove a violation of Rule 2110.

NAC next addressed whether Josephthal had a legitimate argument that its disclosure of the law firm memorandum to the arbitration panel for an in camera inspection would eliminate the attorney-client privilege. NAC found that such disclosure would not have eliminated the privilege, citing court opinions as support. But NAC did find that Josephthal's concerns and arguments to the contrary were not frivolous. That finding was important because, on appeal, NASD enforcement attorneys were arguing that Josephthal should be fined $30,000, not $10,000.

In the end, NAC upheld the hearing panel's decision, thereby reminding us all to respect our arbitrators! In sum, NAC stated: "We strongly support an arbitrator's authority ... to order the production of any document in a party's control, and we disapprove of a party that participates in arbitration but seeks to reserve for itself the option to disobey rulings issued by an arbitrator". Be forewarned!