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Article published on May 10, 2006

It Pays to Fight NASD Charges: Study
By Tom Leswing

A new study has concluded that the NASD isn’t always infallible — at a time when fines imposed by the regulator have been growing.

The paper, titled “The House That Regulators Built (Revisited): An Analysis of Whether Respondents Should Litigate Against NASD,” concludes that some firms have been successful in fighting charges levied by the regulator.

In other cases, firms have had fines proposed by the regulator reduced, Therefore, firms facing charges by the NASD should rethink whether they should settle with the regulator, says Brian Rubin, a partner with Sutherland Asbifi & Brennan. He and Sutherland Asbill & Brennan associate Christopher Cannon co-wrote the paper.

“The message is that firms should evaluate if a settlement makes sense and at least in some cases, firms can be successful in contesting it [ charges],” Rubin says.

While the topic is relevant to broker-dealers, it also applies to mutual fund firms, which have affiliate broker-dealers as fund underwriters and as distribution units, he maintains. For example, American Funds distribution arm American Funds Distributors is facing charges by the NASD over directed brokerage practices. It is fighting the charges and hopes to have a ruling by the NASD by the fall.

The new report addresses a variety of topics regarding NASD actions, More specifically, it maintains that NASD fines have increased considerably over the past three or four years. The report is a revised version of a similar article published last year. It includes information from regulatory actions that occurred during 2005 as well as prior years.

The NASD last year filed 1,412 disciplinary actions resulting in $125.4 million in fines. The dollar amount is a 2 increase from 2004, when the regulator collected $103 million in penalties. That was three times the amount collected by the regulator in 2003, according to the paper.

Firms seeking to contest NASD charges start off with a hearing with the regulator’s Office of Hearing Officers, or OHO. Last year, four member firms contested a total of five NASD charges before the OHO. In at least one of those instances, a fine of $50,000 was reduced by the OHO to only $15,000, according to the paper.

The NASD, meanwhile, has seen at least three highly visible defeats when its decisions have been appealed. A D.C. circuit court, for example, upheld an SEC decision that overruled NASD disciplinary actions against Key West Securities last year. In addition, the NASD has faced setbacks in its actions against Invemed Associates and well- known Wall Street analyst Frank Quattrone.

Rubin adds that some firms that have faced NASD charges have been willing to settle because of a perceived “settlement discount,” In doing so, firms hope that their settlement amount will be less than resulting fines and penalties that may occur if they dispute NASD charges and lose in their legal wrangling.

But Rubin says that settlement discount has diminished as the NASD has been ramping up its fines. He traces the origins of higher fines to New York attorney general Eliot Spitzer’s initial clampdown on Wall Street research practices.

“Ever since the research analyst complaints came up there has been competition among regulators to get fines and issue press releases, and that has ratcheted up fines and penalties,” he says.

NASD spokesman Herb Perone says that the increased level of fines is appropriate. Over the past few years, regulators have uncovered issues over accounting practices, Wall Street research and mutual fund sales,

“The increase in fines is a direct and appropriate response to the bubble,” he says.

Howard Kramer, a partner at Schiff Liardin, agrees that the settlement discounts have narrowed over the past few years. He maintains, however, that the actual settlement amount is only one factor regarding the financial impact of NASD actions.

For example, firms that litigate NASD actions rack up legal fees when doing so. In addition, some of their employees may become involved in the legal dispute, which can reduce their productivity. Firms seeking to litigate against the NASD must also be willing to accept having their names associated with regulatory matters for a longer period of time than if they settle.

Still, that doesn’t mean that firms facing complaints by the NASD should automatically agree to settle, adds McCormick & O’Brien senior counsel Harry Delagrammatikas.

“Each case is an organism in itself,” he says. “A good litigator will weigh the issues and say, ‘What is the best approach for my client?”

He says that refraining from settling initially may help firms, That’s because the resulting discovery process conducted by the NASD and member firms may expose weaknesses in the regulator’s complaints. Armed with the knowledge of such weaknesses, member firms’ attorneys can negotiate reduced settlement amounts.

Kramer, meanwhile, says that more firms will contest NASD actions if penalties keep increasing.

“At a certain point, the ramping up of fines will be so hurtful that more firms will contest them,” adds Kramer. Firms with deep pockets will be more likely to contest NASD charges as they will have sufficient war chests to do so, he adds.