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Securities Litigation Alert

February 2002

Watch Out Clearing Firms: Courts Might Demand Increased Oversight Over Introducing Broker-Dealers

By Steven M. Hecht, Esq. and Michael J. Hahn, Esq.

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he securities industry is bracing itself for a ruling from a federal appeals court in Oregon that might conscript clearing corporations into the role of quasi-regulator of broker-dealer misconduct. Thus, the Ninth Circuit Court of Appeals will take the national center stage when it hears argument and then decides the case

• f Fiserv Correspondent Services, Inc. v. Koruga in the

coming months. In essence, the court will consider whether to uphold an arbitration ruling imposing liability against a clearing firm for the fraudulent activities

• f an introducing broker where the clearing firm

was thought to have aided -- or at least been aware

• f -- those improper practices.

The Arbitration Award Imposing Clearing Firm Liability

What is so shocking to industry observers is that an arbitration panel found a clearing firm liable to the introducing firm’s retail brokerage clients even though the clearing firm did not itself perpetrate any fraudulent activities and indeed did nothing

• ther than perform its customary, ministerial

clearing services. However, the clearing firm is being held accountable for aiding the fraud of its correspondent broker by knowing about it, but failing to take any remedial action. Thus, Fiserv Correspondent Services (which had acquired Hanifen, Imhoff Clearing Corp.) had performed clearing services for its introducing broker, Duke & Company. The services consisted

• f ordinary “vanilla” functions such as mailing out

account statements and trade confirmations, clearing and settling transactions and maintaining margin accounts. Several Duke customers had lost money on investments recommended by Duke, mostly in securities for which Duke had been a market maker. Fiserv itself did not make any of these recommendations to Duke’s customers and Fiserv did not make any market in these securities. When Duke ceased operations customers sought to recover their losses by pursuing claims against individual former Duke personnel as well as Duke’s clearing firm, Fiserv. The Duke customers brought an arbitration with the National Association of Securities Dealers, claiming that Fiserv violated the Washington and California state statutes governing the sale of securities, which make a “broker-dealer” who “materially aids” in prohibited transactions just as liable to customers as the primary wrongdoers. The NASD arbitrators found that Fiserv was indeed liable under these laws (along with Duke’s former CEO) and awarded the customers nearly $2 million in damages. This ruling was made notwithstanding the fact that

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Fiserv tried to insulate itself from this very type of liability with the ordinary contractual protections found in most correspondent agreements. These protections included carefully worded provisions in the contract describing the ministerial clearing services that Fiserv would provide, as well as carving out those duties that Fiserv would not perform, such as monitoring the quality of Duke’s customers’ accounts and ensuring Duke’s compliance with relevant rules and regulations. In addition, as is customary, Fiserv required Duke to have its customers acknowledge in writing the general (and limited) nature of Fiserv’s services. Apparently, these measures were not enough to protect Fiserv. And yet it could be credibly argued that Fiserv did nothing out of the ordinary in performing its clearing functions, its only sin having been to deliver those services to a broker-dealer that was not on the level. Indeed, the customers argued, apparently to the arbitrators’ satisfaction, that Duke was well known in the industry as a notorious boiler room operation that systematically defrauded investors, presenting all the hallmarks of micro-cap stock fraud. Duke was accused of using high-pressure sales tactics to dupe investors into buying “house stocks,” in which Duke acted as underwriter and market-maker. In such classic schemes, the investors lose their shirts after they are kept in the stock long enough for the broker- dealer to manipulate the stock price and take advantage of the artificially inflated market, and then profit in sell-offs that cash them out at the expense of the investors who are left holding near- worthless securities. In fact, after the arbitration was filed, Duke and many of its principals and brokers were indicted for criminal racketeering activity involving theft and securities fraud. Significantly, the customers insisted that during the time that Fiserv provided Duke’s clearing services, Fiserv knew that Duke’s customers were being

• defrauded. To support this charge, the customers

pointed to the more than 100 complaints that Fiserv received from its customers trading through Duke brokers; the widespread industry knowledge

• f micro cap fraud, particularly at Duke; and

Fiserv’s unique position to know about the nature

• f the trades in Duke’s customer accounts given its

access to Duke’s account statements and trading records. But notwithstanding these serious allegations of Fiserv’s awareness of Duke’s boiler room practices, these charges against Fiserv could well be asserted against many similarly situated clearing firms, who

• ften work with correspondent firms having

unhappy customers and dubious reputations. Particularly troubling is the suggestion that mere access to the broker-dealer’s account statements and trading records imposes a duty on the clearing firm to investigate those documents for fraud. It is no mere hyperbole to suggest that an outgrowth of the arbitrators’ ruling against Fiserv would be to extend liability to any other service provider who provides ministerial services but could be said to have played some role in assisting the operations of a crooked broker-dealer since they could have done more to detect improper practices. The underlying theory of guilt by association -- or providing “material aid” to a wrongdoer -- creates a slippery slope indeed. So what’s going on here? It might seem that the arbitration panel was effecting a measure of rough justice to compensate Duke’s victims and putting aside the law in the process. But whether or not

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that is true, simply stating this possibility gets to the heart of the issue: if indeed what occurred behind the closed doors of the arbitration tribunal’s deliberations was a decision to make whole the innocent customers by reaching into the pockets of an equally innocent clearing firm, even though the strictures of the law may not have warranted it, the appellate court may very well uphold that decision. This is because the federal law supporting arbitration is so strong that Congress has directed the courts to respect and affirm arbitration awards even if they are outright incorrect under the law. And the courts have eagerly followed this directive, enjoying the obvious benefit of more widespread use of arbitration: namely, reduced court congestion.

How Will The Appellate Court Rule?

Let’s take out our crystal ball and anticipate what the Ninth Circuit Court of Appeals will likely

• do. The case’s procedural posture might very well

decide the outcome. (i) Arbitration and the Standard of Review Based on the standard arbitration clause in their customer agreements, investors with accounts at Duke had agreed that all disputes would be submitted to an arbitration panel for final decision. Here, the Duke customers duly adhered to that clause and brought their dispute to NASD arbitration, which entered the award against Fiserv. Courts will not disturb even an incorrect arbitrator decision unless it shows a “manifest disregard for the law.” Manifest disregard for the law entails something more than an error in the law

• r an arbitrator’s failure to apply it. There must be

a recognition by the arbitrator of the applicable law and a conscious, deliberate decision to ignore it. While of course nobody can predict how the appellate court will decide this case, the extremely demanding standard of review may itself decide the

• utcome before the judges ever reach the merits of

the case. Indeed, courts typically bend over backwards to uphold arbitration awards, finding

• nly in very rare circumstances that an arbitrator

“manifestly disregarded” the law. (ii) “Manifest Disregard” Of The Law In this case, among the several points of law that Fiserv contends were manifestly disregarded by the arbitrators was a ruling by a sister court, Carlson

• v. Bears, Stearns & Company
• 1. In order for the

arbitrators to have manifestly disregarded the law they would had to have recognized the Carlson decision as binding on them and yet chosen not to apply it. Such a standard is extremely difficult to

• vercome and is almost never met.

Indeed, one consequence of the Koruga ruling is that arbitration panels can have the final word on clearing firm liability, as courts will be even more hesitant to upset these decisions. Such an outcome exposes clearing firms to large liabilities if arbitration panels rule in favor of customers. Also, since arbitration decisions are usually confidential, there may be no way to discern any general principles or patterns either favorable or adverse to clearing firms or customers.

How Should The Appellate Court Rule?

Now let’s put the crystal ball away and consider what the appeals court should do under existing law if it were able to move beyond the procedural strictures of simply rubber stamping an arbitration award and could instead analyze the merits of the case.

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To impose liability against clearing firms for the fraudulent activities of their correspondent brokers, the Ninth Circuit would have to find two specific findings: first, clearing firms must be found to be “broker-dealers” under the California and Washington statutes. Second, clearing firms must have “materially aided” their correspondent brokers in the perpetration of the fraud. In determining these issues the court will be forced to address the broader issue of what duties a clearing firm owes to customers who have accounts with correspondent brokers engaging in fraudulent activities. (i) Are Clearing Firms “Broker-Dealers?” The law tends to support a ruling that Fiserv fits within the definition of a “broker-dealer,” as set forth in the California and Washington statutes. Both laws define a broker-dealer as any entity engaged in “effecting transactions in securities.” Clearing firms engage in ministerial services, such as execution of orders, clearance and settlement of transactions, rehypothecation and lending of securities, maintenance of margin, payment and charging of interest, and preparation of client

• records. While these activities may be less

significant in relation to the services provided by correspondent brokers, they are nevertheless essential to effecting such transactions. Moreover, Fiserv, like other clearing firms, are registered with the SEC and NASD as broker-dealers. (ii) Do Clearing Firms “Materially Aid” in The Bad Acts Of Correspondent Broker-Dealers? On this issue, existing law does not tend to support the position that clearing firms who perform their ordinary ministerial services could “materially aid” correspondent brokers who perpetrate fraud. This is so because clearing firms

• f course aid in the mechanical execution of the

transactions placed by their correspondent firms, but such ministerial work simply does not rise to the level of “substantial assistance” required under the law for aiding and abetting liability. Not surprisingly, various industry groups, such as the North American Securities Administrators Association and the Securities Industry Association have submitted briefs as “friends of the court” urging the Ninth Circuit to relieve Fiserv and other clearing firms of any obligation to investigate potential rogue correspondent firms and instead leave such oversight to the regulatory authorities, such as the SEC and self-regulatory

• rganizations like the NASD.

What Should Clearing Firms Do In The Meantime?

It’s not too early to prepare for a ruling adverse to the clearing industry. Here are some measures clearing firms might consider to minimize exposure in the event that the Koruga decision is upheld. (i) Look For The Obvious Signs According to the Duke customers, Fiserv’s CEO and other key personnel knew that certain important Duke documents were inaccurate and failed to disclose, for example, that all of Duke’s

• wners had well-known connections with the

defunct Stratton Oakmont, a notorious “boiler room” firm that was thought to be the “worst of the worst.” It was alleged that Fiserv was aware that Duke’s chairman had a criminal record and that the Duke brokers had worked for Stratton or other known micro-cap fraud firms. Thus, Duke was thought to be in effect a Stratton Oakmont spin-

• ff.

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Perhaps the encouraging news for industry insiders is that Duke’s history was so extreme and unique that even an affirmance by the Ninth Circuit alone does not require all clearing firms to exhaustively investigate all of its introducing brokers, but only the most wayward ones. Nevertheless, if the storm warnings of fraud are as egregious as they appear to have been in Duke’s case, consider dropping the introducing firm or taking other responsive measures. (ii) Consider Dropping The Standard Arbitration Clause Clearing firms should reconsider whether they want to include the usual mandatory and final arbitration provisions in their customer

• agreements. The benefits of arbitration are indeed

far from clear, and decisions by courts such as that in Carlson indicate a more friendly forum to clearing firms. While this by no means guarantees an end to liability, it may provide more consistency and predictability for clearing firms. Whatever benefits have historically been thought to arise from submitting disputes to arbitration panels -- who are thought to provide speedy, inexpensive and informal alternatives to traditional litigation -- those must be re-examined in the current climate. (iii) Develop A Safe Harbor Of Best Practices Clearing firms might consider creating due diligence checklists or otherwise developing and implementing a set of best practices in working with broker-dealers. While a clearly defined “safe harbor” has not yet been identified, certain practices are at least more likely than others to provide some modicum of support if the firm’s practices come into question. A few general suggestions follow:

• Exercise “reasonable care” to detect

improper practices by an introducing

• broker. Most states have adopted uniform

laws that protect clearing firms from liability if they did not know, and in the exercise of reasonable care could not have known,

• f

the problems at the correspondent firm. Thus, clearing firms may not bury their heads in the sand to avoid learning of any unpleasant facts, but should take some care to determine whether a broker-dealer is committing improper practices, and it should document whatever steps it exercises as proof of the steps it took.

• Monitor customer complaints about a

correspondent broker. Fiserv has been criticized for failing to heed the warning signs consisting of myriad customer complaints about Duke. Look for any patterns of the complaints and examine the Form U-4s for particular registered representatives to see if any new complaints tend to match a history for that person.

• Consider the prior affiliations of the

correspondent’s employees. Fiserv was accused of overlooking an arguably well- known fact that Duke was in essence a Stratton Oakmont spinoff. While clearing firms cannot be expected to investigate the personal backgrounds of all of the correspondent’s work force, they should consider whether a substantial block of employees migrated from a now- defunct firm and whether the prior firm had a reputation for rogue practices.

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Could the Ninth Circuit’s ruling mean that clearing firms must cease doing all business with introducing brokers if they detect improper conduct? We’ll have to see. Court rulings have already landed on both ends of the spectrum. On

• ne end is the Seventh Circuit’s Carlson decision

discussed above, refusing to impose liability. On the

• ther hand, however, is at least one federal court in

New York that recently imposed liability on the clearing firm to A.R. Baron & Co. in the well- known case of McDaniel v. Bear, Stearns and Co., Inc. There, the court upheld an arbitration panel’s ruling that Bear Stearns was liable because it was aware of and even participated in Baron’s fraudulent

• activities. Of course, that case involves an egregious

set of facts2, but must nevertheless be considered when examining the risk of doing business with a mischievous correspondent. While these prior rulings show that some courts have already considered the extent to which clearing firms may be responsible for the sins of their introducing brokers, it is equally plain that these rulings depend to a large extent on the unique facts and circumstances presented in each case. Furthermore, given the fact that arbitration panels are not rigidly bound by the law, it is impossible to predict with scientific certainty how future rulings will be decided. Clearing firms can only follow a course of best practices and hope for the best.

Keep Koruga In Perspective

Lest the alarm sound too loudly, it is important to keep in mind that the Ninth Circuit may well throw out or modify the existing arbitration award. That said, such a ruling would not necessarily mean complete absolution for all clearing firms across the

• country. After all, the ruling may be limited to the

Ninth Circuit, and in future cases elsewhere in the country the facts of any particular case may be so

• utrageous -- such as in the case of A.R. Baron --

as to warrant the imposition of liability and harsh punitive damages against a clearing firm for the fraud of its correspondent. In any event, if the Ninth Circuit were to affirm the arbitration award, clearing firms will need to be more diligent about investigating their correspondent brokers and implementing further quality control measures such as those outlined

• above. Indeed, even after Koruga is decided this

area of the law will continue to evolve and change, requiring constant vigilance and the ongoing development of responsive measures to limit the risk of exposure. 1 In Carlson v. Bear, Stearns & Co., 906 F.2d 315 (7th Cir. 1990), purchasers of securities brought an action against their brokerage company, the salesperson and the clearing broker, alleging that all defendants were jointly liable for failing to register the securities as required under Illinois state law. The court held that the clearing firm was not liable under the Illinois Securities Act because it was not a “dealer” as defined by the act. It also reasoned that the clearing firm did not “participate or aid in any way” in the sale

• f unregistered securities. The Seventh

Circuit’s decision in Carlson, while persuasive, is not controlling law in the Ninth Circuit, where Koruga is being decided.

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2 Indeed, in McDaniel v. Bear Stearns & Co., No. 01 Civ. 7054 (SAS), 2002 U.S.

• Dist. LEXIS 762, at * 34-35 (S.D.N.Y.

January 16, 2002), Bear Stearns was implicated in the broker-dealer’s improper practices because the panel found that, among other things, Bear Stearns: (1) either understood or did not report commissions and markups to customers with the result that Baron was able to conceal its unlawful conduct, (2) processed trades which were unpaid by customers and which Bear knew or had reason to know were unauthorized, (3) made loans above and beyond normal clearing debt to help Baron meet net capital requirements, (4) continued clearing, rescinded clearing termination notices, and resumed clearing after Baron went off the box with knowledge

• f

Baron’s unlawful and fraudulent conduct, (5) intervened on behalf of Baron with NASD and assisted Baron in the NASD net capital acquisition and approval process, (6) became actively involved in Baron operations by placing Bear employees on Baron’s premises, (7) was aware of, communicated with Baron about, and attempted to monitor customer complaints, and (8) collaborated closely with Baron regarding Baron’s affairs. For more information regarding this or any other securities issue, please contact Steven M. Hecht, Member of the Securities Litigation & Enforcement Practice Group, at 973.597.2380

• r

at shecht@ lowenstein.com, or you may also contact Michael J. Hahn, Associate of the Securities Litigation & Enforcement Practice Group, at 973.597.2526 or at mhahn@ lowenstein.com.

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