G 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.

he securities industry is bracing itself for a Thus, Fiserv Correspondent Services (which ruling from a federal appeals court in had acquired Hanifen, Imhoff Clearing Corp.) had TOregon that might conscript clearing performed clearing services for its introducing corporations into the role of quasi-regulator of broker, Duke & Company. The services consisted broker-dealer misconduct. Thus, the Ninth Circuit of ordinary “vanilla” functions such as mailing out Court of Appeals will take the national center stage account statements and trade confirmations, when it hears argument and then decides the case clearing and settling transactions and maintaining of Fiserv Correspondent Services, Inc. v. Koruga in the margin accounts. Several Duke customers had lost coming months. money on investments recommended by Duke, mostly in securities for which Duke had been a In essence, the court will consider whether to market maker. Fiserv itself did not make any of uphold an arbitration ruling imposing liability these recommendations to Duke’s customers and against a clearing firm for the fraudulent activities Fiserv did not make any market in these securities. of an introducing broker where the clearing firm When Duke ceased operations customers sought was thought to have aided -- or at least been aware to recover their losses by pursuing claims against of -- those improper practices. individual former Duke personnel as well as Duke’s clearing firm, Fiserv. The Arbitration Award Imposing Clearing Firm Liability The Duke customers brought an arbitration What is so shocking to industry observers is that with the National Association of Securities an arbitration panel found a clearing firm liable to Dealers, claiming that Fiserv violated the the introducing firm’s retail brokerage clients even Washington and California state statutes though the clearing firm did not itself perpetrate governing the sale of securities, which make a any fraudulent activities and indeed did nothing “broker-dealer” who “materially aids” in prohibited other than perform its customary, ministerial transactions just as liable to customers as the clearing services. However, the clearing firm is primary wrongdoers. The NASD arbitrators found being held accountable for aiding the fraud of its that Fiserv was indeed liable under these laws correspondent broker by knowing about it, but (along with Duke’s former CEO) and awarded the failing to take any remedial action. customers nearly $2 million in damages. This ruling was made notwithstanding the fact that

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. Roseland, New Jersey 65 Livingston Avenue Telephone 973.597.2500 www.lowenstein.com 07068-1791 L Fax 973.597.2400 G Fiserv tried to insulate itself from this very type of Significantly, the customers insisted that during the liability with the ordinary contractual protections time that Fiserv provided Duke’s clearing services, found in most correspondent agreements. These Fiserv knew that Duke’s customers were being protections included carefully worded provisions in defrauded. To support this charge, the customers the contract describing the ministerial clearing pointed to the more than 100 complaints that services that Fiserv would provide, as well as Fiserv received from its customers trading through carving out those duties that Fiserv would not Duke brokers; the widespread industry knowledge perform, such as monitoring the quality of Duke’s of micro cap fraud, particularly at Duke; and customers’ accounts and ensuring Duke’s Fiserv’s unique position to know about the nature compliance with relevant rules and regulations. In of the trades in Duke’s customer accounts given its addition, as is customary, Fiserv required Duke to access to Duke’s account statements and trading have its customers acknowledge in writing the records. general (and limited) nature of Fiserv’s services. But notwithstanding these serious allegations of Apparently, these measures were not enough to Fiserv’s awareness of Duke’s boiler room practices, protect Fiserv. And yet it could be credibly argued these charges against Fiserv could well be asserted that Fiserv did nothing out of the ordinary in against many similarly situated clearing firms, who performing its clearing functions, its only sin having often work with correspondent firms having been to deliver those services to a broker-dealer unhappy customers and dubious reputations. that was not on the level. Indeed, the customers Particularly troubling is the suggestion that mere argued, apparently to the arbitrators’ satisfaction, access to the broker-dealer’s account statements that Duke was well known in the industry as a and trading records imposes a duty on the clearing notorious boiler room operation that systematically firm to investigate those documents for fraud. It is defrauded investors, presenting all the hallmarks of no mere hyperbole to suggest that an outgrowth of micro-cap stock fraud. Duke was accused of using the arbitrators’ ruling against Fiserv would be to high-pressure sales tactics to dupe investors into extend liability to any other service provider who buying “house stocks,” in which Duke acted as provides ministerial services but could be said to underwriter and market-maker. In such classic have played some role in assisting the operations of schemes, the investors lose their shirts after they a crooked broker-dealer since they could have done are kept in the stock long enough for the broker- more to detect improper practices. The underlying dealer to manipulate the stock price and take theory of guilt by association -- or providing advantage of the artificially inflated market, and “material aid” to a wrongdoer -- creates a slippery then profit in sell-offs that cash them out at the slope indeed. expense of the investors who are left holding near- worthless securities. In fact, after the arbitration So what’s going on here? It might seem that the was filed, Duke and many of its principals and arbitration panel was effecting a measure of rough brokers were indicted for criminal racketeering justice to compensate Duke’s victims and putting activity involving theft and securities fraud. aside the law in the process. But whether or not G that is true, simply stating this possibility gets to the and a conscious, deliberate decision to ignore it. heart of the issue: if indeed what occurred behind While of course nobody can predict how the the closed doors of the arbitration tribunal’s appellate court will decide this case, the extremely deliberations was a decision to make whole the demanding standard of review may itself decide the innocent customers by reaching into the pockets of outcome before the judges ever reach the merits of an equally innocent clearing firm, even though the the case. Indeed, courts typically bend over strictures of the law may not have warranted it, the backwards to uphold arbitration awards, finding appellate court may very well uphold that decision. only in very rare circumstances that an arbitrator This is because the federal law supporting “manifestly disregarded” the law. arbitration is so strong that Congress has directed the courts to respect and affirm arbitration awards (ii) “Manifest Disregard” Of The Law even if they are outright incorrect under the law. In this case, among the several points of law And the courts have eagerly followed this directive, that Fiserv contends were manifestly disregarded by enjoying the obvious benefit of more widespread the arbitrators was a ruling by a sister court, Carlson use of arbitration: namely, reduced court v. Bears, Stearns & Company1. In order for the congestion. arbitrators to have manifestly disregarded the law they would had to have recognized the Carlson How Will The Appellate Court Rule? decision as binding on them and yet chosen not to Let’s take out our crystal ball and anticipate apply it. Such a standard is extremely difficult to what the Ninth Circuit Court of Appeals will likely overcome and is almost never met. do. The case’s procedural posture might very well decide the outcome. Indeed, one consequence of the Koruga ruling is that arbitration panels can have the final word on (i) Arbitration and the Standard of Review clearing firm liability, as courts will be even more Based on the standard arbitration clause in hesitant to upset these decisions. Such an outcome their customer agreements, investors with accounts exposes clearing firms to large liabilities if at Duke had agreed that all disputes would be arbitration panels rule in favor of customers. Also, submitted to an arbitration panel for final decision. since arbitration decisions are usually confidential, Here, the Duke customers duly adhered to that there may be no way to discern any general clause and brought their dispute to NASD principles or patterns either favorable or adverse to arbitration, which entered the award against Fiserv. clearing firms or customers.

Courts will not disturb even an incorrect How Should The Appellate Court Rule? arbitrator decision unless it shows a “manifest Now let’s put the crystal ball away and consider disregard for the law.” Manifest disregard for the what the appeals court should do under existing law entails something more than an error in the law law if it were able to move beyond the procedural or an arbitrator’s failure to apply it. There must be strictures of simply rubber stamping an arbitration a recognition by the arbitrator of the applicable law award and could instead analyze the merits of the case. G To impose liability against clearing firms for the perpetrate fraud. This is so because clearing firms fraudulent activities of their correspondent brokers, of course aid in the mechanical execution of the the Ninth Circuit would have to find two specific transactions placed by their correspondent firms, findings: first, clearing firms must be found to be but such ministerial work simply does not rise to “broker-dealers” under the California and the level of “substantial assistance” required under Washington statutes. Second, clearing firms must the law for aiding and abetting liability. Not have “materially aided” their correspondent surprisingly, various industry groups, such as the brokers in the perpetration of the fraud. In North American Securities Administrators determining these issues the court will be forced to Association and the Securities Industry address the broader issue of what duties a clearing Association have submitted briefs as “friends of the firm owes to customers who have accounts with court” urging the Ninth Circuit to relieve Fiserv correspondent brokers engaging in fraudulent and other clearing firms of any obligation to activities. investigate potential rogue correspondent firms and instead leave such oversight to the regulatory (i) Are Clearing Firms “Broker-Dealers?” authorities, such as the SEC and self-regulatory The law tends to support a ruling that Fiserv fits organizations like the NASD. within the definition of a “broker-dealer,” as set forth in the California and Washington statutes. What Should Clearing Both laws define a broker-dealer as any entity Firms Do In The Meantime? engaged in “effecting transactions in securities.” It’s not too early to prepare for a ruling adverse Clearing firms engage in ministerial services, such to the clearing industry. Here are some measures as execution of orders, clearance and settlement of clearing firms might consider to minimize exposure transactions, rehypothecation and lending of in the event that the Koruga decision is upheld. securities, maintenance of margin, payment and charging of interest, and preparation of client (i) Look For The Obvious Signs records. While these activities may be less According to the Duke customers, Fiserv’s significant in relation to the services provided by CEO and other key personnel knew that certain correspondent brokers, they are nevertheless important Duke documents were inaccurate and essential to effecting such transactions. Moreover, failed to disclose, for example, that all of Duke’s Fiserv, like other clearing firms, are registered with owners had well-known connections with the the SEC and NASD as broker-dealers. defunct Stratton Oakmont, a notorious “boiler room” firm that was thought to be the “worst of the (ii)Do Clearing Firms “Materially Aid” in The worst.” It was alleged that Fiserv was aware that Bad Acts Of Correspondent Broker-Dealers? Duke’s chairman had a criminal record and that On this issue, existing law does not tend to the Duke brokers had worked for Stratton or other support the position that clearing firms who known micro-cap fraud firms. Thus, Duke was perform their ordinary ministerial services could thought to be in effect a Stratton Oakmont spin- “materially aid” correspondent brokers who off. G Perhaps the encouraging news for industry · Exercise “reasonable care” to detect insiders is that Duke’s history was so extreme and improper practices by an introducing unique that even an affirmance by the Ninth broker. Most states have adopted uniform Circuit alone does not require all clearing firms to laws that protect clearing firms from exhaustively investigate all of its introducing liability if they did not know, and in the brokers, but only the most wayward ones. exercise of reasonable care could not have Nevertheless, if the storm warnings of fraud are as known, of the problems at the egregious as they appear to have been in Duke’s correspondent firm. Thus, clearing firms case, consider dropping the introducing firm or may not bury their heads in the sand to taking other responsive measures. avoid learning of any unpleasant facts, but should take some care to determine (ii)Consider Dropping whether a broker-dealer is committing The Standard Arbitration Clause improper practices, and it should Clearing firms should reconsider whether they document whatever steps it exercises as want to include the usual mandatory and final proof of the steps it took. arbitration provisions in their customer · Monitor customer complaints about a agreements. The benefits of arbitration are indeed correspondent broker. Fiserv has been far from clear, and decisions by courts such as that criticized for failing to heed the warning in Carlson indicate a more friendly forum to signs consisting of myriad customer clearing firms. While this by no means guarantees complaints about Duke. Look for any an end to liability, it may provide more consistency patterns of the complaints and examine and predictability for clearing firms. Whatever the Form U-4s for particular registered benefits have historically been thought to arise representatives to see if any new from submitting disputes to arbitration panels -- complaints tend to match a history for who are thought to provide speedy, inexpensive that person. and informal alternatives to traditional litigation -- those must be re-examined in the current climate. · Consider the prior affiliations of the correspondent’s employees. Fiserv was (iii) Develop A Safe Harbor Of Best Practices accused of overlooking an arguably well- Clearing firms might consider creating due known fact that Duke was in essence a diligence checklists or otherwise developing and Stratton Oakmont spinoff. While implementing a set of best practices in working clearing firms cannot be expected to with broker-dealers. While a clearly defined “safe investigate the personal backgrounds of harbor” has not yet been identified, certain all of the correspondent’s work force, they practices are at least more likely than others to should consider whether a substantial provide some modicum of support if the firm’s block of employees migrated from a now- practices come into question. A few general defunct firm and whether the prior firm suggestions follow: had a reputation for rogue practices. G Could the Ninth Circuit’s ruling mean that Ninth Circuit, and in future cases elsewhere in the clearing firms must cease doing all business with country the facts of any particular case may be so introducing brokers if they detect improper outrageous -- such as in the case of A.R. Baron -- conduct? We’ll have to see. Court rulings have as to warrant the imposition of liability and harsh already landed on both ends of the spectrum. On punitive damages against a clearing firm for the one end is the Seventh Circuit’s Carlson decision fraud of its correspondent. discussed above, refusing to impose liability. On the other hand, however, is at least one federal court in In any event, if the Ninth Circuit were to New York that recently imposed liability on the affirm the arbitration award, clearing firms will clearing firm to A.R. Baron & Co. in the well- need to be more diligent about investigating their known case of McDaniel v. Bear, Stearns and Co., Inc. correspondent brokers and implementing further There, the court upheld an arbitration panel’s ruling quality control measures such as those outlined that Bear Stearns was liable because it was aware of above. Indeed, even after Koruga is decided this and even participated in Baron’s fraudulent area of the law will continue to evolve and change, activities. Of course, that case involves an egregious requiring constant vigilance and the ongoing set of facts2, but must nevertheless be considered development of responsive measures to limit the when examining the risk of doing business with a risk of exposure. mischievous correspondent.

While these prior rulings show that some courts 1 In Carlson v. Bear, Stearns & Co., 906 have already considered the extent to which F.2d 315 (7th Cir. 1990), purchasers of clearing firms may be responsible for the sins of their securities brought an action against their introducing brokers, it is equally plain that these brokerage company, the salesperson and rulings depend to a large extent on the unique facts the clearing broker, alleging that all and circumstances presented in each case. defendants were jointly liable for failing to Furthermore, given the fact that arbitration panels register the securities as required under are not rigidly bound by the law, it is impossible to Illinois state law. The court held that the predict with scientific certainty how future rulings clearing firm was not liable under the will be decided. Clearing firms can only follow a Illinois Securities Act because it was not a course of best practices and hope for the best. “dealer” as defined by the act. It also reasoned that the clearing firm did not Keep Koruga In Perspective “participate or aid in any way” in the sale Lest the alarm sound too loudly, it is important of unregistered securities. The Seventh to keep in mind that the Ninth Circuit may well Circuit’s decision in Carlson, while throw out or modify the existing arbitration award. persuasive, is not controlling law in the That said, such a ruling would not necessarily mean Ninth Circuit, where Koruga is being complete absolution for all clearing firms across the decided. country. After all, the ruling may be limited to the G 2 Indeed, in McDaniel v. Bear Stearns & knowledge of Baron’s unlawful and Co., No. 01 Civ. 7054 (SAS), 2002 U.S. fraudulent conduct, (5) intervened on Dist. LEXIS 762, at * 34-35 (S.D.N.Y. behalf of Baron with NASD and assisted January 16, 2002), Bear Stearns was Baron in the NASD net capital acquisition implicated in the broker-dealer’s improper and approval process, (6) became actively practices because the panel found that, involved in Baron operations by placing among other things, Bear Stearns: (1) Bear employees on Baron’s premises, (7) either understood or did not report was aware of, communicated with Baron commissions and markups to customers about, and attempted to monitor customer with the result that Baron was able to complaints, and (8) collaborated closely conceal its unlawful conduct, (2) processed with Baron regarding Baron’s affairs. trades which were unpaid by customers and which Bear knew or had reason to know For more information regarding this or any other were unauthorized, (3) made loans above securities issue, please contact Steven M. Hecht, and beyond normal clearing debt to help Member of the Securities Litigation & Enforcement Baron meet net capital requirements, (4) Practice Group, at 973.597.2380 or at continued clearing, rescinded clearing [email protected], or you may also contact termination notices, and resumed clearing Michael J. Hahn, Associate of the Securities Litigation after Baron went off the box with & Enforcement Practice Group, at 973.597.2526 or at [email protected].