Merrill Lynch, Pierce, Fenner & Smith, Inc. v. National Ass'n of Securities Dealers, Inc.

• Decision Date: 16 May 1980
• Docket Number: No. 77-3450,77-3450
• Citation: 616 F.2d 1363
• Parties: Fed. Sec. L. Rep. P 97,500 MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., William J. LaFleur, E. Richard Lewis, Plaintiffs-Appellees, Bill Wise and James Flaggert, Plaintiffs-Intervenors-Appellees, v. NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC., et al., Defendants- Appellants.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1363

616 F.2d 1363

Fed. Sec. L. Rep. P 97,500

MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., William J.

LaFleur, E. Richard Lewis, Plaintiffs-Appellees, Bill Wise and James Flaggert, Plaintiffs-Intervenors-Appellees, v. NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC., et al.,

Defendants- Appellants.

No. 77-3450.

United States Court of Appeals, Fifth Circuit.

May 16, 1980.

Peter J. Chepucavage, Nat. Ass'n of Sec. Inc., Frank J. Wilson, Andrew McR. Barnes, Washington, D. C., for Nat. Ass'n of Sec. Dealers, Inc.

Harvey L. Pitt, S.E.C., Washington, D. C., Robert C. Pozen, Associate Gen. Counsel, Katherine Malfa, Washington, D. C., for amicus curiae.

Thompson, Knight, Simmons & Bullion, Dallas, Tex., for all plaintiffs- appellees.

Brown, Wood, Ivey, Mitchell & Petty, E. Michael Bradley, Richard Conway Casey, Gerald J. McGovern, New York City, Joel H. Pullen, San Antonio, Tex., for plaintiff-intervenor-appellee Flaggert.

David R. McAtee, Dallas, Tex., for plaintiff-intervenor-appellee Wise.

Appeal from the United States District Court for the Northern District of Texas.

Before TUTTLE, AINSWORTH and SAM D. JOHNSON, Circuit Judges.

AINSWORTH, Circuit Judge:

In this novel and important securities regulatory matter, the National Association of Securities Dealers, Inc. (NASD) appeals from the district court's preliminary injunction barring it from proceeding with a disciplinary hearing against its member, Merrill Lynch, Pierce, Fenner & Smith, Inc. (Merrill Lynch), and certain named employees of Merrill Lynch. ¹ The NASD contends the district court erred in interfering with its disciplinary hearing as the NASD's decision not to sequester a complaining witness at the hearing, which prompted Merrill Lynch to seek injunctive relief, is a non-reviewable, non-final procedural ruling within the discretion of the NASD. The NASD further contends that the court erred in granting relief prior to exhaustion of administrative remedies. We agree and reverse the district court.

I.

The facts leading up to this dispute are not complex. The NASD is a registered national securities association with congressionally delegated self-regulatory authority. As such, it is mandated to secure compliance by its members with the federal security laws as well as its own regulations, which are designed to promote ethical business behavior. 15 U.S.C. § 78o -3(b)(7).

In 1975, Mrs. Grace Heusinger, a 72-year-old widow, wrote the NASD complaining that her account with Merrill Lynch's San Antonio, Texas office had been "churned" i. e., the account had been subjected to transactions which were "excessive in size or frequency in view of the financial resources and character of such account." 17 C.F.R. § 240.151c1-7(a); 15 U.S.C. § 78o (c) (1). Mrs. Heusinger inherited stock worth $240,000 upon the death of her husband, and having no prior investment experience, relied upon the expertise of Merrill Lynch in handling her account. James Flaggert, one of the individual appellees in this case, allegedly churned the account between January 1, 1970 and April 12, 1975, by recommending excessive transactions in low-priced speculative stocks that resulted in substantial losses in the value of the stock portfolio in addition to charges of $89,000 in commissions and markups.

After investigating Mrs. Heusinger's allegations, the NASD determined that it would bring a disciplinary action against Merrill Lynch and its employees responsible for the handling of Mrs. Heusinger's account. On October 21, 1976, the NASD issued a two-pronged complaint against Merrill Lynch charging that Flaggert had improperly handled Mrs. Heusinger's securities account, and that the other individually named appellees had failed to supervise properly Flaggert's handling of the account. The NASD was the named complainant.

Prior to the disciplinary hearing, attorneys for Merrill Lynch learned that Mrs. Heusinger intended to file a civil suit for damages against Merrill Lynch based on churning allegations, and would be present during the disciplinary hearing as a complaining witness for the NASD. When the hearing convened before the local District Business Conduct Committee of the NASD at Dallas, Texas, counsel for Merrill Lynch moved that Mrs. Heusinger be excluded from the hearing at any time when she was not testifying, and that her attorney be excluded throughout the entire proceeding. Counsel for Merrill Lynch argued that the hearing provided Mrs. Heusinger with a "dress rehearsal" for her civil suit, and breached the "confidential" nature of NASD disciplinary hearings contrary to NASD rules and regulations. The chairman of the District Business Conduct Committee granted the request in part, concluding that Mrs. Heusinger could be present during the first phase of the hearing, during which the handling of her account would be discussed, but not during the second phase of the hearing concerning the adequacy of Merrill Lynch's supervision of Flaggert. Dissatisfied with this ruling, attorneys for Merrill Lynch sought and obtained a temporary restraining order from the federal district court below halting the hearing in its second hour.

Following issuance of the temporary restraining order, the district court held a hearing on Merrill Lynch's application for a preliminary injunction. In that proceeding Merrill Lynch asserted that the NASD was breaking its own rules in allowing Mrs. Heusinger to be present at the hearing, as NASD hearing procedures mandate "confidentiality." ² It further claimed it should not be required to exhaust administrative remedies for to do so would subject it to "irreparable injury" in that Mrs. Heusinger would be afforded a so-called "dress rehearsal" of her civil suit, and Merrill Lynch would be forced to either not defend to preserve its right to "confidentiality," or defend at a nonconfidential hearing.

The district court agreed with Merrill Lynch's contentions and granted a preliminary injunction barring the NASD "from proceeding with a non-confidential hearing in this matter except that Ms. Heusinger may be accompanied by counsel during such time as she is actually testifying." The court held there existed a substantial likelihood that plaintiffs would prove at trial that the NASD is "endeavoring to deprive Merrill Lynch of the confidentiality to which it is entitled under established NASD policy." The court concluded that Merrill Lynch should not be required to exhaust administrative remedies, agreeing with Merrill Lynch's "irreparable injury" argument.

On this appeal the NASD contends that the district court's grant of a preliminary injunction constitutes an unwarranted intrusion upon a complex, congressionally mandated scheme of self-regulation. We agree.

II.

The concept of self-regulation, which pervades the provisions of the Securities Exchange Act of 1934 and its subsequent amendments, is crucial to the resolution of this appeal. By the Act Congress granted cooperative organizations of investment bankers, dealers and brokers self-regulatory authority over their own members in order to attain and preserve the highest standards of legal and ethical behavior in the nation's securities markets. 15 U.S.C. § 78o -3; S.Rep. No. 1455, 75th Cong., 3d Sess. 4 (1938). Self-regulation was believed to have many significant benefits, including "the expertise and intimate familiarity with complex securities operations which members of the industry can bring to bear on regulatory problems, and the informality and flexibility of self-regulatory procedures." Report of the Subcommittee on Securities of the Senate Committee on Banking, Housing and Urban Affairs, Securities Industry Study, S.Doc. No. 93-13, 93d Cong., 1st Sess. 149 (1973). Congress recently reaffirmed its commitment to self-regulation in its 1975 amendments to the Exchange Act. The Senate report on those amendments states:

The self-regulatory roles of the exchanges and the NASD have been major elements of the regulatory scheme of the Exchange Act since 1934 and 1938, respectively. Although self-regulation has not always performed up to expectations, on the whole it has worked well, and the Committee believes it should be preserved and strengthened.

S.Rep. No. 94-75, 94th Cong., 1st Sess. 23 (1975), U.S.Code Cong. & Admin.News, pp. 179, 201.

The NASD is registered with the Securities and Exchange Commission (SEC) as a national securities association, pursuant to statutory authorization. 15 U.S.C. § 78o -3. It is the only registered securities association under the Exchange Act, and has approximately 2,625 broker/dealer members. As a registered securities association, it has been "delegated governmental power in order to enforce, at (its) own initiative, compliance by members of the industry with both the legal requirements laid down in the Exchange Act and ethical standards going beyond those requirements." S.Rep. No. 94-75, 94th Cong., 1st Sess. 23 (1975), U.S.Code Cong. & Admin.News 1975, pp. 179, 201. This self-regulatory power of the NASD is subject to substantial oversight by the SEC. In particular, the SEC is authorized to suspend or revoke the registration of any national securities association that fails to enforce compliance with the Exchange Act, SEC regulations, or the rules of the self-regulatory organization. 15 U.S.C. § 78s(h)(1).

Congress has specified certain procedural safeguards for NASD disciplinary hearings. The association is required to "bring specific charges, notify such member or person of, and give him an opportunity to defend against, such charges, and keep a record." 15 U.S.C. § 78o -3(h)(1). Any disciplinary sanction must be supported by a statement setting forth the act or practice which constituted the violation, the specific provision violated, the sanction imposed, and the reasons supporting its imposition. Id. In addition, the procedure of NASD disciplinary hearings is subject to close scrutiny by the SEC. The SEC must be satisfied that NASD rules...