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Fraud Convictions

Last year, a Connecticut based hedge fund, Turnberry Capital Management LP, filed a FINRA arbitration securities claim against SunTrust Banks, Inc. to recover $13 million it lost in 2007 by investing in mortgage backed securities.

However, Turnberry Capital Management did not purchase the securities from SunTrust, who manufactured the defective securities, but purchased the securities from Raymond James Financial.

Turnberry Capital Management Was Not SunTrust Bank’s Customer

Accordingly, SunTrust Banks promptly moved the United States District Court for the Southern District of New York to enjoin the arbitration, and late last year, District Judge Naomi Reice Buchwald agreed with SunTrust Banks and enjoined Turnberry’s securities arbitration before the Financial Industry Regulatory Authority that Turnberry was not SunTrust Bank’s “customer.” SunTrust Banks, Inc, et al, v Turnberry Capital Management LP, et al, U.S. District Court, Southern District of New York, No. 13-879 (Feb. 2013).

Broker-Dealers are only required to arbitrate “customer” disputes before FINRA. As much as the claimants’ or plaintiffs’ securities bar likes to complain about FINRA, and the industrial, sometimes misguided, form of justice handed down by FINRA’s tainted pool of hack arbitrators, Turnberry, and of course mostly everyone else that does these cases wants to arbitrate their claims before FINRA rather than in court.

FINRA Securities Arbitrations

In FINRA securities arbitration, other than motions to dismiss for “eligibility,” (limited to claims arising within a specified period of time and which are becoming ever more fashionable), there are no Motion to Dismiss. Everyone gets their day in “court,” in arbitration before a panel of supposedly neutral hacks.

In Court

However, in Court, we have a gatekeeper, it is called the judge, who at least dispassionately dispenses the law, and has no problem dismissing even the most egregious case at the pleading stage or upon summary judgment based upon the statute of limitations, loss causation, the lack of scienter, or any other convoluted set of intellectual arguments concocted by the well paid and over educated defense bar. (You know who you are).

The Customer

Accordingly, whether or not someone is a “customer” is very important. As one Court has recently observed, “herculean efforts” by securities broker-dealers “to avoid resolution of disputes through arbitration” is not new. Smoothline Ltd. v. N. Am. Foreign Trading Corp., 249 F.3d 147,148 (2d Cir. 2001)

FINRA Rule 12200 requires all securities broker dealers to submit all disputes with “customers” arising in connection with it “business activities,” or those of its “associated persons” to arbitration before FINRA.

These Rules are “contractual in nature” and are binding on its members. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Georgiadis, 903 F.2d 109, 113 (2d Cir. 1990)(“The rules of a securities exchange are contractual in nature”); Scobee Combs Funeral Home, Inc. v. E.F. Hutton & Co., Inc., 711 F. Supp. 605, 606 (S.D. Fla. 1989); See also Paine, Webber, Jackson & Curtis, Inc. v. Chase Manhattan Bank, N.A., 728 F.2d 577, 580 (2d Cir. 1984) (the arbitration rules of the New York Stock Exchange can be binding on NYSE members); Kidder, Peabody & Co., Inc., v. Zinsmeyer Trusts Partnership, 41 F.3d 861 (2d Cir. 1994)(As a member of the NASD, Kidder is bound to adhere to the organization’s rules and regulations); Drexel Burnham Lambert, Inc. v. Pyles, 701 F. Supp. 217, 220 (N.D. Ga. 1988).

Admittedly, many Courts compelling the arbitration claims, where the broker-dealer firms have sought to avoid arbitration, have found the term “customer” to be ambiguous. John Hancock Life Ins.v.Wilson, 254 F.3d 48,58 (2d Cir. 2001).

The FINRA Definition of Customer

The FINRA Code states only that “[a] customer shall not include a broker or dealer.”; FINRA Rule 12100(i). FINRA’s glossary states that a “customer” is “[a] person or entity (not acting in the capacity of an associated person or member) that transacts business with any member firm and/or associated person” but provides little additional guidance.

Courts Definition of Customer

Under this definition, as one Court has observed, the meaning is plain. “[It] provide[s] that [the party] is a customer as long as [he, she it] is not a broker or dealer; nothing in the Code directs otherwise or requires more. Enforcing the limitation [the securities firm] seeks would be tantamount to reading language into the Code that is conspicuously absent.” Multi-Financial Securities Corp v. King, 386 F.3d 1364, 1368 (11th Cir. 2004)(“when Rule 12200 was proposed, the addition of the words “of a member” after the word “customer” w[as] explicitly rejected because it would “narrow the scope of claims that are required to be arbitrated under the Customer Code.” (quoting Waveland Capital Partners, LLC v. Tommerup, 2012 WL 70572, 6 (D.Mont., Jan.6, 2012) (citing Order Approving Proposed Rule Change to Amend NASD Arbitration Rules for Customer Disputes, 72 Fed. Reg. 4574, 4579 (2007)).

The Second Circuit suggests that the term “customer” is intentionally broad because FINRA intended to require its members to arbitrate disputes with the full array of parties as part of its “investor-protection mandate.” See UBS Fin. Servs. v. W. Va. Univ. Hosps., 660 F.3d 643, 651 (2d Cir. 2011) (“We also reject UBS’s contention that FINRA has a narrow “investor-protection mandate,” such that “customers” should include only those receiving “investment or brokerage services.”).

Noted Case

UBS Fin. Servs., Inc. v. W. Va. Univ. Hosps., 660 F.3d 643 (2d Cir. Sept. 22, 2011) is a very important case. W. Va. Univ. Hosps is an “issuer” case. West Virginia University Hospital is a not-for-profit health consortium that issued bonds, structured as Auction Rate Securities (ARS), where UBS served as both the lead underwriter and the main broker-dealer. 660 F.3d 643. In February 2008, the ARS market collapsed, and the auctions for the hospital’s bonds failed, forcing it to pay significantly higher rates on the bonds until October 2008. In February 2010, the Hospital filed an arbitration action against UBS before FINRA, and in May 2010, UBS filed an action in U.S. District Court in New York seeking to enjoin the arbitration.

The District Court denied UBS’s motion for a preliminary injunction and ordered it to submit these claim to arbitration. UBS Fin. Servs., Inc. v. W. Va. Univ. Hosps., Inc., 760 F. Supp. 2d 373 (S.D.N.Y. 2011), which was affirmed and the Second Circuit on September 22, 2011. In affirming the District Court’s decision, the Second Circuit did not narrow the scope of definition of the term “customer” under FINRA Rules to include a “person who purchases, or undertakes to purchase, a good or service from a FINRA Member” as suggested by Plaintiff. Quite to the contrary, mindful of FINRA’s broad “investor-protection mandate,” as set forth above, 660 F.3d at 651, the Second Circuit expanded the scope of the definition of “customer” to include investment banking clients or the issuers of securities, and expressly rejected, UBS’s contention, the same contention Plaintiff seeks to advance here, namely that “customers” should include only those receiving “investment or brokerage services.” 660 F.3d at 652. Mindful of the Eighth Circuit’s holding in Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770, 772 (8th Cir. 2001), “that banking advice did not give rise to a “customer” relationship within the meaning of the NASD [rules],” the Second Circuit in UBS expressly rejected it. 660 F.3d 651.

Expanding The Definition of Customer

Following this decision, other Courts, in other Circuits, have also expanded the scope of the definition of “customer” to include “investment banking” clients or issuers, e.g., UBS Financial Services Inc. v. City Of Pasadena, Civil Action No 12-05019-RGK (S.D. Cal. July 31, 2012) and UBS Financial Services Inc. v. Carilion Clinic, Case 3:12-cv-00424-JAG (E.D.Va July 30, 2012). It should also be noted that in the Third Circuit “investment banking” clients or “issuers” based upon have been included in the definition of “customers” for purposes of arbitration under FINRA/NASD Rules since 1987. Patten Securities Corp. v. Diamond Greyhound Genetics, Inc., 819 F.2d 400 (3d Cir. 1987)(Gibbons, C.J.)(“It is therefore clear that if Diamond, a proposed issuer of shares, is a public customer it can demand NASD arbitration of its disputes with Patten, and Patten is compelled by its NASD membership to submit even absent a specific contractual arbitration undertaking directly with Diamond”).

Probably relying on this same line of cases, Turnberry Capital Management has appealed District Judge Naomi Reice Buchwald’s decision to the Second Circuit Court of Appeals. However, Judge Naomi Reice Buchwald was right.

Turnberry Capital Management was not SunTrust’s “customer,” and I think there are a whole line of cases that actually require this result.

I call them “product” cases, i.e. a bonafide public customer not suing the broker-dealer where the securities were purchased, but the entity that manufactured or underwrote the securities, which just happens to be a broker-dealer.

The actual holdings in each of these cases is quite instructive.

In Herbert J. Sims & Co. v. Roven, 548 F.Supp.2d 759, 763 (N.D. Cal. 2008), a group of investors who purchased certain bonds through their independent investor advisor, Darden, sought to arbitrate their claims not against the investment advisor, nor the custodial broker-dealer (Siebert & Co.), with whom Darden, as an investment advisor was not registered or associated, but instead sought to bring these claims against a third party, Herbert J. Sims & Co., the underwriter of the bonds that Darden purchased. The Court properly enjoined the arbitration of the investors’ claims against Sims, because: the investors “did not invest directly with Sims, or with an agent or representative of [Sims],” Darden was not an employee, agent, representative or associated person of [Sims]; and because Darden purchased of the bonds Sims underwrote through Seibert, and not from Sims on behalf of the Investors. 548 F.Supp.2d 759.

Similarly, in Berthel Fisher & Co. Fin. Serv. v. Larmon, 2011 U.S. Dist. LEXIS 84627 (D. Minn. 2011), a group of investors who purchased securities from their respective broker-dealers sought to maintain arbitration claims not against their broker-dealers nor the associated persons who sold them the securities, but instead against Berthel Fisher, the underwriter of the securities, based upon the underwriter’s “failure to conduct due diligence.” Again expressly acknowledging that “a customer of a firm’s “associated person” is considered to be a customer of the firm,” the Larmon Court noted that “if investors had not dealt with someone who was not a firm’s “associated person,” the result changes,” 2011 U.S. Dist. LEXIS at *84627 (citing Sims, 548 F. Supp. 2d at 765).

In Goldman Sachs & Co. v. Becker, 2007 U.S. Dist. LEXIS 51359 (N.D. Cal July 2, 2007), the Beckers filed a pro se arbitration claim before the NASD against plaintiffs Goldman Sachs & Co., Goldman Sachs Execution and Clearing, L.P., and a variety of other entities because their Prudential brokers gave them “bad investment advice” relating to the purchase of Goldman Sachs from Prudential. By virtue of Prudential’s participation in the underwriting of Goldman Sachs, and Prudential’s ownership of Goldman Sachs stock, the Beckers argued that Goldman Sachs wasn “associated persons” of Prudential, and thus subject to arbitration as a “customer” under NASD (now FINRA) rules. Understandably, Judge Alsup of the Northern District of California, based upon evidence that “Goldman Sachs & Co., and Goldman Sachs Execution and Clearing, L.P. are not natural persons, he found that they cannot be “associated persons” under the NASD rules.

Similarly, Proshare Trust v. Schnall, 685 F.Supp.2d 76 (S.D.N.Y. 2010) is another “issuer” case that has no application to the instant matter. In Schnall, Steven and Sherry Schnall purchased shares of the ProShares UltraShort Real Estate Fund from their brokerage firm, LPL Financial Corporation. After the value of their investment declined, the Schnalls filed a FINRA Arbitration against LPL Financial, ProShares Trust and ProShare Advisors, the Fund’s investment advisor. The Schnall’s claims against LPL Financial proceeded in arbitration. However, neither ProShares Trust nor ProShare Advisors is, nor ever was, a member of FINRA. Accordingly, and again correctly, the Court found that the Schnalls were not “customers” of ProShares Trust and ProShare Advisors for purposes of FINRA Rule 12100, and thus were unable to compel arbitration.

Yet, Turnberry Capital Management has appealed District Judge Naomi Reice Buchwald’s decision to the Second Circuit Court of Appeals, and what the Second Circuit, probably will say at least to the Turnberry Capital Management is somewhat certain, however what the Second Circuit may say, in refining, distinguishing or clarifying their prior holdings, in what us lawyers call obiter dicta, is likely to be seized upon by the defense bar for years to come, and set back claimants’ rights and the right to use the FINRA forum by actual customers for years to come.

As Justice Oliver Wendell Holmes once said, “bad cases, make bad law,” or something like that. I guess we will have to wait and see.

Guiliano Law Group

If you have been the victim of securities fraud you should consult with an attorney. The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Group, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.