New York Becomes Unfriendly To Financial Advisers Seeking Damages Caused By Defamation On Their Employment Records

James J. Eccleston, esq.

n eagerly awaited decision from New York's highest court was issued recently and it does not bode well for New York financial advisers. Rosenberg v. Metlife, Inc. ruled that financial services firms have an absolute privilege in defamation lawsuits for statements they place on an employee's Form U-5 employment termination notice. This decision conflicts with the law in other states, including Illinois. Let's examine several questions relating to the decision and its impact.

First, what is the Form U-5? The National Association of Securities Dealers (NASD) is a self-regulatory organization that requires financial services firms (known as "member firms") to notify it within 30 days of terminating the employment of a financial adviser (known as a "registered representative"). Form U-5 requires an explanation of why the firm terminated the employment and contains several questions as to whether the financial adviser had been the subject of criminal charges, customer complaints or internal review for violations of investment-related rules. The NASD stores U-5s on its Central Registration Depository (CRD), an online registration and licensing database. The Rosenberg court finds and considers important the fact that filing the U-5 is a "preliminary step" in alerting regulators such as the NASD to possible misdeeds by financial advisers and one that "plays a significant role in the NASD's self-regulatory process."

Second, who can view the contents of the Form U-5? In addition to securities regulators, potential employers in the securities industry not only are able but also are required to review Form U-5 during the hiring process. In addition, the public may access employment and complaint information through the NASD's "Broker Check" program. Upon specific request, the NASD will release to the public additional "disclosure information", which relates to criminal actions, civil actions, customer complaints and securities-related terminations for cause.

Third, what is the possible harm to financial advisers from Forms U-5? As the dissenting opinion in Rosenberg points out, "defamatory Form U-5 reporting can unfairly penalize a departing employee and prevent that employee from obtaining new employment or retaining existing customers." Indeed, the dissenting opinion quotes from a law review article asserting that it is "widely acknowledged that false Form U-5 reporting has sometimes been used to retaliate against departing employees or threatened to gain concessions from such employees." The 7th Circuit recognized this potential harm in Baravati v. Josephthal when it wrote, "To insulate the [NASD] members from liability for the contents of their U-5s would be tantamount to allowing a member of the NASD to blackball a former employee from employment throughout the large sector of the industry that the membership of the association constitutes."

Indeed, the 7th Circuit (applying Illinois law), the 6th Circuit (applying Tennessee law) and a Florida state court all have ruled that statements made on the Form U-5 are subject to a "qualified privilege" instead of an absolute privilege. Under the qualified privilege standard, the financial adviser has the burden of showing that the U-5 statement was motivated by malice. Malice has been interpreted to mean spite or a knowing or reckless disregard of a statement's falsity. Additionally, truth always is a complete defense to a defamation claim. The Rosenberg dissent opines that the qualified immunity standard strikes a fair balance between the regulatory objective and the rights of the financial adviser.

Fourth, what are the consequences of the Rosenberg decision? As the Rosenberg dissent observes, New York financial advisers now have lesser protections from U-5 defamation than financial advisers in other states. Second, there is no "uniform standard" to be applied nationally in U-5 defamation actions. Unfortunately, that can mean that the same financial services firm has a different level of culpability depending upon where its financial adviser resides.

On the other hand, the Rosenberg decision appears to preserve the ability of the financial adviser to seek expungement of defamatory language on the Form U-5. The majority writes, "We further note that registered employees who are maliciously defamed on a Form U-5 are not wholly without remedy as they may commence an arbitration proceeding or court action to expunge any alleged defamatory language." This comment seems to suggest that the absolute privilege standard will not prevent a finding of defamation and an awarding of equitable (but not monetary) relief. Additionally, the absolute privilege standard may not protect financial services firms, or their employees, from orally defaming (that is, slandering) financial advisers outside of the narrow context of (written) Form U-5 reporting.

It remains to be seen how other states will react to the Rosenberg decision. The employment rights of financial advisers indeed hang in the balance.

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James J. Eccleston is a securities attorney, representing customers as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He maintains an informative website at www.FinancialCounsel.com. He is an equity partner with Shaheen, Novoselsky, Staat, Filipowski & Eccleston, and can be reached at 312-621-4400.