Key Points:

  • Changes to the FINRA Discovery Guide applicable to public customer disputes will alter parties' discovery obligations in the near future.
  • The new Guide will modify the original 14 lists of presumptively discoverable items into single production lists respectively applicable to customer and firm/associated person.
  • Additional discovery responsibilities will be placed on the firm/associated person with respect to items such as customer records, compensation records and compliance literature.

Providing useful guidance as to the parameters of permissible discovery in public customer arbitrations has been an ongoing task for the Financial Industry Regulatory Authority (FINRA) for more than a decade. The scope of permissible discovery has been a topic of renewed discussion over the last few years, which has finally culminated in the approval of a revised rule change which the SEC wants FINRA to adopt on an "accelerated basis." For defending parties, the result will be more time and effort devoted to preparing cases for hearing and additional potential pitfalls at the discovery stage.

For those not intimately familiar with its functions, FINRA, among other things, sponsors an arbitration forum whereby most disputes brought by retail public customers in the securities industry are adjudicated. The FINRA arbitration system does not expressly impose upon its arbitration panels the Rules of Civil Procedure from the federal courts or the relevant state courts. Rather, the arbitrators are typically given discretion to decide discovery-related issues with limited guidance from FINRA.

As anyone who has been exposed to the FINRA arbitration process knows, the most visible exception to FINRA's laissez faire attitude towards discovery is Notice to Members 99-90 ("the Discovery Guide") which was originally issued in 1999. Prior to the issuance of the Discovery Guide, arbitrators were guided by the Arbitrator's Manual published by the Securities Industry Conference on Arbitration (SICA). However, the procedures and policies described in The Arbitrator's Manual were discretionary and subject to change by the respective arbitrators. The Discovery Guide was introduced in recognition by FINRA that "[d]iscovery disputes have become more numerous and time consuming. The same discovery issues repeatedly arise." Thus, the Discovery Guide was intended to develop standardized lists of documents considered presumptively discoverable depending on the issues of a particular arbitration; i.e., suitability, failure to supervise, churning, unauthorized trading, misrepresentations/omissions and negligence/breach of fiduciary duty. The 14 enumerated lists of the Discovery Guide were evenly split between customer required production and firm/associated person required production.

FINRA originally submitted a proposal to change the Discovery Guide in 2008. However, the proposal was quickly withdrawn after being subject to vociferous attacks by the advocates of interested parties. FINRA went back to the drawing board, and a new proposal was submitted in July 2010 for approval by the SEC. Fifty-five comment letters were submitted to the SEC on the proposed change. After receiving a response to the letters from FINRA earlier this year, the SEC finally approved the new discovery rules on April 1, 2011, by SEC Release No. 34-64166. The new rules are likely to take effect later this year.

Among the more practical changes is a complete modification of the lists of presumptively discoverable documents previously set forth in the Discovery Guide. The original 14 lists will go by the wayside in favor of two lists - one for firms/associated persons and the other for customers. Parties are, of course, still free to argue that certain listed documents should not be discoverable in a particular case and seek discovery beyond the language of the new lists. Nonetheless, the two new lists will provide the initial framework of permissible discovery in the future.

The focus of this particular examination will be the expanded discovery responsibilities placed upon the defending parties. This is of particular significance to defending parties as it has broadened the scope of items for claimants to attack as being deficient in an attempt to create the perception of a failure to supervise as an overall systemic flaw. In other words, there are more presumptively discoverable items for claimants to point to as allegedly being below industry standards and practices.

The new single list applicable to firms/associated persons now sets forth 22 separate items. Some of these items have not materially changed from the original Discovery Guide. In particular, the defending party will still be expected to produce documents such as agreements with the customer, all correspondence with claimants relating to the transactions at issue, notes related to the accounts at issue and internal audit reports at the branch in which claimants maintained their accounts that focused on the associated persons or the transactions at issue which were generated not before or after one year of the transactions at issue and discussed alleged improper behavior against other individuals similar to the conduct at issue. Some items, such as holding pages and order tickets, will no longer be presumptively discoverable.

One of the more striking alterations is FINRA's clarification of the previously ambiguous requirement to produce "all records of the firm/associated person relating to the customer's account(s) at issue..." The new rule will specify that such documents include "notes or memoranda evidencing supervisory, compliance or managerial review of Claimants' accounts or trades for the periods at issue." Moreover, it requires the production of correspondence with claimants relating to the accounts or transactions that bear indications of managerial, compliance or supervisory review of such correspondence. (Proposed List 1, Item 7.)

Another significant change pertains to the production of telephone records. Previously, the Discovery Guide only provided for the production of telephone records, including telephone logs evidencing telephone contact, in matters alleging unauthorized trading. Under the new rules, FINRA would expand the disclosure of telephone logs to all causes of action. The new rule offers the caveat that such records must relate to the accounts or transactions at issue. As noted by the SEC in approving this rule, "[p]roducing records of telephone calls is labor intensive, expensive and difficult for firms unless the Claimants are able to specify a telephone call's date and time, provide the name of a person the Claimants spoke to at the firm and/or specify the trade placed during the conversation." (Proposed List 1, Item 8.)

The production of compliance manuals will also become a more daunting task. Previously, the Discovery Guide merely noted that all sections of the firm's compliance manual related to the claims alleged, including supplemental manuals, must be produced. Practically speaking, the responding party generally met its burden by producing a copy of the table of contents and asking the claimant to identify the sections to be produced, subject to objections. Now, the reference to "compliance manuals" is amended to refer more broadly to "manuals and all updates thereto," which will also include bulletins and updates for all years in which the Statement of Claim alleges that the conduct at issue occurred. FINRA also intends to amend the item to require a list of all manuals and bulletins which may contain directives related to the conduct or product at issue so that claimants can identify any additional manual or bulletin sections which may be relevant. (Proposed List 1, Item 11.)

The production of compensation records has also been amended. In particular, the original scope of the Discovery Guide related to commission runs related to accounts at issue will be expanded to now include documents reflecting the associated persons' gross and net compensation for the transactions at issue. (Proposed List 1, Item 19.)

The foregoing is not meant to be an exhaustive list of the changes. Rather, some of the more stark alterations are highlighted merely to illustrate the changes on the horizon. It remains to be seen whether the new discovery rules become a staple of the FINRA arbitration system or simply another revision in an unending string of amendments. Regardless, the obligations imposed on defending parties are now more stringent than ever before.

Joel Wertman is an associate in the Philadelphia, Pennsylvania, office of Marshall, Dennehey, Coleman, Warner & Goggin. He can be reached at 215.575.2586 or jmwertman@mdwcg.com.

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