Articles Posted in Securities Arbitration and Litigation

Depositphotos_1913696_xs-thumb-300x256-57397Last week, the U.S. Court of Appeals for the 4th Circuit issued a favorable ruling on the arbitrability of suits against FINRA members. Traditionally, under FINRA Rule 12200 any “customer” may request arbitration of a dispute with a FINRA member. UBS and Citi argued that Carilion was an issuer of securities, not a customer, and thus did not have the right to arbitrate their claims against the banks, both of which are FINRA members. The 4th Circuit joins the U.S. Court of Appeals for the 2nd Circuit and several district courts that have recently defined “customer” broadly in the FINRA context. The case is UBS Financial Services v. Carilion Clinic, (3:12-cv-00424-JAG).


Carilion is a non-profit hospital administration group based in West Virginia that issued $308 million of municipal bonds through UBS/Citi to finance a series of renovations and improvements. $234 million of that debt was issued in the form of auction rate securities (“ARS”).

UBS/Citi provided various services for Carilion in relation to the ARS issuances, acting as an underwriter, lead broker-dealer and seller of interest-rate swaps, as well as in an advisory capacity. Neither of the series of governing agreements between the parties contained an arbitration clause; one of the two contained a forum selection clause requiring that any related proceedings be filed in the Southern District of New York.

Legal Holdings

When a dispute arose, Carilion initiated a FINRA arbitration and UBS/Citi responded with a suit in federal court seeking to enjoin the arbitration on two grounds: (1) that Carilion was not a “customer” and therefore not eligible to bring a FINRA arbitration and (2) that the forum selection clause constituted a waiver of the right to arbitrate.

UBS/Citi argued that Carilion was, in this instance, acting as an issuer of securities, not as a customer receiving investment or brokerage services. UBS/Citi cited to a 2001 8th Circuit case holding that a party receiving banking and investment services was not a “customer” under NASD rules (note: this 2001 case involved a party receiving purely advisory services). In rejecting this argument, the court held that for purposes of FINRA, a customer is anyone “not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities” and that those activities include “investment banking and the securities business.” The opinion cites a couple of similar holdings by federal courts in New York and California, noting that no court faced with a similar situation found a customer relationship lacking.

The court further held – as a matter of pure contractual law – that the forum selection clause was too ambiguous to constitute a waiver of the right to arbitrate. The court noted that although an unambiguous waiver clause would be honored, the language at issue here (“all actions and proceedings arising out of this transaction… shall be brought” in New York federal court) left doubt as to whether it was intended to cover all disputes, or merely non-arbitrable ones.

Take Away

UBS Financial Services v. Carilion Clinic provides two valuable lessons:

(1) FINRA members and their “customers” should choose their words carefully if they wish to avoid arbitration, and (2) member parties acting as a jack-of-all-trades for their clients are unlikely to find courts receptive to arguments that the services they provided fall outside of FINRA’s jurisdiction. Conversely, FINRA member customers should feel confident in filing arbitration claims, no matter how large or complex the dispute.

Person's hand signing documentIt is commonplace in the securities industry for reps to transition from one broker-dealer to another. If the rep is a big producer, it is typical for the hiring firm to offer the rep a “forgivable loan” as an inducement to join. Depending upon the size of the producer’s book, the forgivable loan can equal 100% to 200% of the producer’s trailing 12 month’s of production, and is typically forgiven in equal increments annually over a 7 to 9 year period.

FINRA just published Regulatory Notice 13-02, seeking comments on a proposed rule to require disclosure of “conflicts of interest” relating to recruitment compensation practices. The proposed rule, called “Enhanced Compensation”, has the following components:

  • For one year following the rep’s start date, the “recruiting” broker-dealer must disclose the “details” of the enhanced compensation “at the time of first individualized contact by the recruiting member or registered person with the former customer after the registered person has terminated his or her association with the previous firm.” That should make for an interesting first conversation with the customer.
  • If the disclosure is made orally, “the recruiting member also must provide the disclosure in writing to the former customer with the account transfer approval documentation.”
  • If the customer seeks to transfer absent contact by the new firm, disclosure must still be made in writing with the ACAT paperwork.
  • The written disclosure must be “clear and prominent.” According to Regulatory Notice 13-02, disclosure “must include information with respect to the timing, amount and nature of the enhanced compensation arrangement.”
  • The proposed rule requires no disclosure to institutional accounts that meet the definition of FINRA Rule 4512(c) (unless the rep is a registered investment adviser) or for enhanced compensation less than $50,000.

The premise of the proposed rule is that a “conflict of interest” exists when a broker receives a recruitment package from a new employer. I, for one, reject that premise and FINRA should publish its studies – if such studies even exist – which support its premise. Why should a broker be required to disclose his or her total compensation to a customer? Brokers are not held to a fiduciary standard, and have no obligation under the law to disclose their compensation beyond the fees charged to any given customer.

The proposed rule is a follow-on to former SEC Chairman Mary Schapiro’s “open letter” to broker-dealers dated August 31, 2009 (
letter.pdf). In the letter, Schapiro warned broker-dealers not to incentivize churning by giving an incoming rep increased compensation for hitting a commission target.

However, what if a broker’s book is entirely fee-based, surely that would eliminate the Commission’s concern about “churning?” Nevertheless, FINRA’s proposed rule gives no carve-
out for fee-based brokers. And what if the hiring broker-dealer offers no increased commission targets in its compensation package? Nevertheless, FINRA offers no carve-out for that either.

The bottom line is that FINRA’s rule is ill-conceived and unsupported. FINRA should articulate these “conflicts” and then give carve-outs for all “conflict free” compensation packages.

tug of warTwo recent FINRA arbitration awards highlight increased focus by FINRA arbitrators concerning discovery abuses by litigants. FINRA’s rules require cooperation of the parties in discovery (Rule 12505) and specifically empower the arbitrators to issue sanctions for lack of cooperation, failing to comply with the discovery rules, or frivolously objecting to the production of documents or information (Rule 12511). Rule 12511 also permits the panel to dismiss a claim, defense or proceeding if prior warnings or sanctions have proven ineffectual.

Miriam Dean v. Wells Fargo Advisors, LLC (FINRA Arbitration No. 11-03911)

Although the power to dismiss a claim is in the rule book, until recently, you would be hard pressed to find an award which exercised that power. That changed with Miriam Dean v. Wells Fargo Advisors, LLC (FINRA Arbitration No. 11-03911), wherein the customer asserted claims in connection with an investment in a reverse convertible note. Apparently, the customer ignored the first discovery order. Somewhat miffed by the customer’s non-compliance, the arbitrator issued a second order giving the claimant the following 3 options:

  1. Proceed with the hearings on the scheduled dates of October 16-18, 2012, but pursuant to Rule 12511(a) of the Code, Claimant will be sanctioned by being precluded from presenting evidence in the pursuit of her case;
  2. Claimant may request a postponement of the hearings, so that Claimant can agree to adhere to the discovery requirements by a mutually agreeable date. All postponement fees incurred will be borne by Claimant;
  3. Claimant voluntarily requests withdrawal of claim. All forum fees will be assessed equally against Claimant and Respondent.

Apparently, the customer chose to disregard the second order as well. Oh well, said the arbitrator, who followed by issuing an award dismissing the customer’s claims with prejudice and assessing motion fees and hearing session fees against the customer. Even though the customer was pro se, the award strikes me as a reasonable outcome for a litigant who chose to ignore prior warnings from the arbitrator.

Robert E. McCarthy, et al. v. AllianceBernstein L.P., et al. (FINRA Arbitration No. 10-05687)

Here, the claimants sought damages resulting from investments in real estate investment trusts. Although the arbitrators awarded no compensatory damages to the claimants, they did assess sanctions in the amount of $30,000 against respondents for apparent discovery abuses. In fact, virtually the entire award is dedicated to describing the “unconscionable discovery practices” advanced by the respondents. Here are the highlights:

  1. Respondents responded to Claimants’ discovery requests by making “voluminous” production without identifying the requests to which the documents responded.
  2. Respondents refused to identify the categories of requests to which respondents had no responsive documents.
  3. Worst yet, one of respondents’ witnesses testified that “much of the research that was relevant to Claimants’ accounts with Respondents was not made available to them.”

Notwithstanding the fact that the respondents’ conduct during discovery “obstructed, prejudiced, and sidetracked the conscientious efforts of Claimants’ counsel to develop their case”, the arbitrators still zeroed the claimants because the “discovery efforts described herein would not have changed the outcome of the case.” This is an interesting award to read.

In Fidelity Brokerage Services LLC v. Morgan Stanley Smith Barney LLC and Brian Wilder (FINRA Arbitration No. 11-03937), a FINRA arbitration panel found against respondents and annexed a 25 page Arbitrators’ Report to the Award which excoriated respondents for misappropriation of trade secrets (Fidelity’s customer list) among other violations. The Award stands out for various reasons, including the punitive damages awarded against Morgan Stanley and the sizable attorneys’ fees awarded to Fidelity. Most interesting, however, is the Arbitrators’ Report itself, which carefully applied the facts to the law and is a must-read for any broker who may be considering jumping ship from a firm which is not a signatory to the Protocol for Broker Recruiting.

Facts of the Case

The underlying facts are straightforward. The rep had an employment agreement with Fidelity which contained non-solicitation and confidentiality clauses. The confidentiality clause stated that customer lists and contact information were deemed to be trade secrets by Fidelity. Prior to leaving Fidelity, the rep met with counsel and created a list of customer contact information purportedly in conformity with the Protocol for Broker Recruiting even though Fidelity is not a signatory to the Protocol. Upon leaving Fidelity, the rep began calling his former customers to inform them of his new employment and sent ACAT forms to a sub-set of his former customers.

Fidelity promptly ran off to court and received a Temporary Restraining Order protecting against further solicitation by the rep. Despite the fact that only 7 brokerage accounts transferred from Fidelity to Morgan Stanley, a contentious arbitration ensued which included 34 hearing sessions before the arbitration panel.

The Award is instructive because it clearly addresses (a) the legal protections which brokerage firms may waive by joining the Protocol for Broker Recruiting; (b) whether a customer list is in fact a trade secret; and (c) ways in which reps can notify their former customers of new employment without running afoul of the law.

Recap of the Protocol for Broker Recruiting

The Protocol for Broker Recruiting is an agreement among broker-dealers to refrain from enforcing non-compete agreements against brokers who move between signatory firms. The caveat, however, is that the transitioning rep must strictly follow the procedures set forth in the Protocol to enjoy its protections. The procedures are the following: (1) Prior to resigning, the rep should prepare two lists: the first containing his customers’ names, addresses, telephone numbers, email addresses and account types; the second containing all the information in the first, plus client account numbers. (2) The rep must submit a written resignation letter to someone in management. (3) Along with the resignation letter, the rep must provide the customer list containing the account numbers to someone in management. Assuming the three-steps are followed, the rep can take the list without account numbers to their new firm and use it to solicit customers to transfer their accounts.

Protections Waived by Joining the Protocol

The arbitrators noted that Fidelity’s customer list qualified as a “trade secret” under Massachusetts law. However, had Fidelity joined the Protocol it would not enjoy “trade secret” protections for its customer list because it would willingly release same to the departing rep. The arbitrators went on to explain why some firms, like Morgan Stanley, opt to join the Protocol, while other firms, like Fidelity, choose not to. Fidelity, on the hand, spends substantial sums of money on direct client acquisition through advertising and then provides its brokers with a book of business to service. Thus, the “good will” inures to the benefit of Fidelity, not the broker. By contrast, wire-houses like Morgan Stanley expect its brokers to develop a book of business on their own and sometimes at the broker’s own expense. Thus, the “good will” inures to the benefit of the broker, not the firm. The arbitrators went on to note that Massachusetts courts have long held that “goodwill” is a legitimate business interest which may be enforced by non-solicitation clauses like the one within the reps employment agreement.

Announcement vs. Solicitation

Notwithstanding the non-solicitation agreement, the arbitrators noted that some states (like Massachusetts and California) permit a departing rep to “announce” their new employment to their former customers. The arbitrators found a permissible “announcement” to be sending a written “wedding style” announcement card and nothing more. In contradistinction, the arbitrators found the reps conduct to be a “solicitation” because (a) the rep failed to “announce” in writing, instead doing so by telephone; (b) the rep made repeated telephone calls to his former customers; (c) the rep asked certain customers to hide his solicitation from Fidelity; and (d) sending ACAT forms to certain clients constituted solicitation in and of itself.

Kudos to the arbitrators for drafting such a thoughtful and well-reasoned Award.

FINRA issued its summary of disciplinary actions reported for June 2012. Certain actions are noteworthy and are indicative of regulatory trends money-and-gavel-150x150.jpgeffecting broker-dealers and registered representatives.

Herskovits PLLC comments on the following regulatory actions:

Net Cap Violations

Freedom Investors Corp. (CRD #23714, Brookfield, Wisconsin), Joel Reid Blumenschein (CRD #1372334, Registered Principal, Pewaukee, Washington) and Gary Lee Gossett (CRD #1939514, Registered Principal, Spokane, Washington) – FINRA Case # 2010025132201


Among other findings, FINRA found that the firm entered into a settlement with a customer that exceeded $15,000, and through its CCO, failed to timely disclose the receipt of the written complaint and the settlement to FINRA within 10 days. Furthermore, FINRA found that because the firm failed to accrue the liability resulting from the loss guarantee it made to the customer, its net capital was reduced. This resulted in it conducting a securities business without the required net capital for four months so that the firm’s books and records and Financial and Operational Combined Single (FOCUS) filings were inaccurate. The firm then failed to provide timely notice of its net capital deficiency to the Securities Exchange Commission (SEC) and FINRA.


Resolved by Offer of Settlement with a censure, fine and suspension for certain employees.


This matter highlights the importance of timely complaint reporting via Forms U4, U5 and in accordance with FINRA Rule 4530 (Reporting Requirements). Furthermore, this matter highlights FINRA’s ongoing effort to discipline members concerning net cap violations; here, resulting from the member’s “loss guarantee” to its customer. The “loss guarantee” arose from a peculiar circumstance in which a registered representative settled with a customer pursuant to an agreement which if, after a period of 18 months, the prior losses sustained in the account were not recovered, the firm would pay customer the difference plus 5% interest.

Anti-Money Laundering Violations

First Kentucky Securities Corporation (CRD #7524, Frankfort, Kentucky) and Frederick Jennings Kramer (CRD #2299599, Registered Principal, Owensboro, Kentucky) – FINRA Case # 2010021314101


The Member’s 2009 independent AML test was inadequate because it was limited to the review of deposit slips for one branch office, rather than sampling different transactions at all branch locations. The findings stated that the test did not include a review of the firm’s AML procedures, nor did it include a review of the overall adequacy of the firm’s AML compliance program. Moreover, the test did not include a sample of all of the firm’s business lines, review of the firm’s AML training program and its customer identification program (CIP), and whether its representatives were complying with the CIP.


Resolved by Acceptance, Waiver and Consent with a censure and fine of $15,000.


AML continues to be an area of focus for FINRA. Here, FINRA fined the firm and the FINOP for the violations referenced in the AWC. This matter highlights that FINRA will enforce its AML Compliance Program Rule (FINRA Rule 3310) even as against small broker-dealers. Therefore, small broker-dealers would be well served to ensure that a procedure exists for independent testing (e.g., testing by a professional not employed by the firm) along with the annual certification by the CEO (Rule 3130).

Please contact Robert Herskovits, Esq. with any questions. (212) 897-5410.

Regulators are examining whether Morgan Stanley, the investment bank that shepherded Facebook through its highly publicized stock offering last week, selectively informed clients of an analyst’s negative report about the company before the stock started trading.

Rick Ketchum, the head of the Financial Industry Regulatory Authority, the self-policing body for the securities industry, said Tuesday that the question is “a matter of regulatory concern” for his organization and the Securities and Exchange Commission.

The top securities regulator for Massachusetts, William Galvin, said he had subpoenaed Morgan Stanley. Galvin said his office is investigating whether Morgan Stanley divulged to only some clients that one of its analysts had cut his revenue estimates for Facebook before the stock hit the market on Friday.

The bank said late Tuesday that it “followed the same procedures for the Facebook offering that it follows for all IPOs,” referring to initial public offerings of stock. It said that its procedures complied with regulations.

The questions about the role played by Morgan Stanley, the lead underwriter for the deal, add to the confusion surrounding Facebook’s IPO. In the most hotly anticipated stock debut in years, the offering raised $16 billion for the social networking company, valuing it at $104 billion.

French investors urged New York’s top court on Wednesday to reinstate their lawsuit over losing $43 million out of $50 million they put into two structured investment vehicles.

The investors claim Barclays Bank, Standard & Poor’s and two management companies were complicit in leaving investors with plummeting securities shortly before the Wall Street collapse. Oddo Asset Management claimed collateral managers Avendis Financial Services Ltd. and Solent Capital Ltd. conspired with Barclays in early 2007 to transfer subprime mortgage-backed securities from Barclays to the two vehicles.

The investors also claimed S&P was complicit by confirming inflated note ratings for Golden Key Ltd. and Mainsail II Ltd.

A judge dismissed the suit, concluding the collateral managers had no fiduciary duty to Oddo, so Barclays and S&P could not be liable for abetting any breach.

“What Barclays knew was these assets were largely impaired,” Oddo’s attorney Geoffrey Jarvis argued. He said the bank solicited Oddo’s investment in what was then a new type of vehicle and selected everyone else involved in it.