United States: Clearing Firm Liability Update 2006 - 2007

Since our 2000 PLI Securities Arbitration course book chapter "Clearing Firm Liability - Has the Dam Really Cracked?" we have regularly reported on clearing firm developments. We previously devoted considerable attention to the August 1999 settlement of the SEC's charges against Bear Stearns arising out of its clearing relationship with A.R. Baron and the 1999 amendments to NYSE Rule 382. We opined that enhancing the information and tools clearing firms provided to introducing brokers and to regulators was the appropriate means by which to better monitor the activities of the introducing brokerage firms. Rather than disturb the historic allocation of responsibilities and relationships and spawn new legal duties, we saw that the approach was to improve the abilities and capabilities of the introducing firms so that they could better supervise themselves and to provide greater information to their designated examining authorities so that they could better police them. We also looked closely at two notable panel awards against clearing firms - Koruga (Koruga v. Wang, NASD 98-04276 (Oct. 2000)) and McDaniel (McDaniel v. Davis, NASD 97-00497 (July 2001)) and in our ensuing articles examined a number of subsequent court decisions, arbitration awards and statutory proposals which we concluded largely signaled consistency and stability in the area of clearing firm liability. As we noted in 2003's article, "the courts continue to hold that where the clearing firm was performing its properly allocated and ministerial responsibilities, the clearing firm should not be subjected to liability premised on the wrongdoing of the introducing firm … [However] clearing firms could be held accountable to the customers of their introducing firms for wrongful conduct which they themselves may instigate or control or for conduct which transcended their ministerial functions as a clearing firm."

The cases and decisions which have come down since 2004's article have, for the most part, continued to recognize the basic legal principles articulated in the earlier cases: clearing firms should not be held liable for the wrongful acts of an introducing broker merely by virtue of performing the clearing firm's routine and ministerial clearing function. Some recent decisions, however, bespeak a willingness to apply an expansive view of what conduct might come within the exceptions to that rule. We now report on a few recent cases, including a bankruptcy court case which, although actually in the Prime Brokerage arena, has raised some alarms in both the clearing and Prime Broker communities.

The Court Opinions - Rozsa, Lesavoy, Klein, Pension Commission, Fox International Relations, Kostoff and Manhattan Investment Fund

a) Rozsa - January 24, 2006
In Rozsa v. SG Cowen Securities Corp., 165 Fed. Appx. 892 (2d Cir. 2006) the Second Circuit affirmed the district court decision in Rozsa v. May Davis Group we discussed in 2002's article. The plaintiff in Rozsa had been defrauded by a scam artist named Thomas Baribeau. Baribeau, who had founded a Nevada corporation referred to as the "Foundation", convinced Rozsa to deposit $5,000,000 into a sub account within the Foundation's account with the May Davis Group, an introducing broker that cleared through SG Cowen, on the understanding that Rozsa would be the sole signatory on the account and the funds would be invested in money market funds until Rozsa provided other directions. Rozsa filled out account opening forms for the opening of the sub account, and May Davis submitted them to Cowen. Cowen, however, refused to open a sub account, and required that the funds be deposited into the Foundation's main account with a notation that the funds were for Rozsa's benefit.

May Davis passed Cowen's instructions to Rozsa, who then wired $5,000,000 into a Cowen account at the Bank of New York "Ref: May Davis Group, for further credit to: Aid for Humanity and Benevolence Foundation, a/c HM 10585711 FOR THE BENEFIT OF: Mr. Theodore Rozsa." Baribeau then submitted forms to Cowen on behalf of the Foundation naming himself a signatory on the account, and within a month had wired Rozsa's money out. Rozsa sued, alleging RICO violations, breach of contract, breach of fiduciary duty and conversion, and the district court granted Cowen's motion to dismiss for failure to state a claim.

On appeal, the Second Circuit affirmed. Calling the district court opinion "thoughtful and comprehensive", the Second Circuit again ruled that "in performing its ordinary clearing broker function, SGC would have had no duty to the customer of an introducing broker … let alone to a third-party who deposited funds into the account of a customer of the introducing broker."

b) Lesavoy - March 2, 2006
In our 2004 article, we also discussed the Southern District of New York's January 2004 decision in Lesavoy v. Lane, 320 F. Supp. 2d 504 (S.D.N.Y. 2004), in which Judge Sweet dismissed a claim against a clearing firm for failure to state a claim. In Lesavoy, the clearing firm ("SSB") was accused of aiding managers of a trust in breaching their fiduciary duties to the trust causing it to dissipate more than $22 million in assets. In March 2006, the Second Circuit reversed the dismissal of one of the aiding and abetting counts while affirming the dismissal of the remaining claims.

In partially reversing the dismissal¹, the Second Circuit distinguished among the breaches of fiduciary duty the clearing firm had allegedly aided and abetted. The Second Circuit affirmed the dismissal of the claims that alleged that the clearing firm had aided and abetted a breach of fiduciary duty in that trades were executed were without required consents; that funds were improperly transferred between various trusts; and that the trades made involved an unsuitable level of risk, finding, among other things, that "as a matter of law, [the clearing firm] was not responsible for the riskiness of the trustee's trades because it did not have authority to place trades without authorization from the trustee. See De Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293, 1308-09 (2d Cir. 2002)."

However, the Court reinstated the plaintiff's claim that the clearing firm had aided and abetted the trustee's breach of fiduciary duty in unnecessarily interposing an introducing broker. Finding that Lesavoy had adequately plead that the clearing firm knew that the use of the introducing broker would impose additional costs and confer no benefits on the trusts, the Second Circuit, while expressing no opinion on the outcome of the case beyond the pleadings stage, held that Lesavoy had adequately plead the elements of aiding and abetting under New York law.

c) Klein - March 24, 2006
Also in March 2006, in an opinion that echoes Koruga, the Supreme Court of Kansas issued its second decision in Klein v. Oppenheimer & Co., 281 Kan. 330 (2006).² Oppenheimer was sued as the clearing broker for L.T. Lawrence, under a fully disclosed 1993 clearing agreement.

In the complaint, Klein alleged that he bought roughly 250,000 shares of various unregistered securities through Lawrence and Oppenheimer, only 20,000 of which the trial court found were required to be registered under Kansas law. The case was tried on stipulated facts, and all parties agreed that Oppenheimer had no knowledge or information that the securities were unregistered, and the Court accepted as a fact that Oppenheimer had no duty under the clearing agreement, NYSE and NASD rules and applicable law to determine whether the securities were registered. Nevertheless, Klein contended that Oppenheimer was liable both as an aider and abettor of Lawrence's sale of unregistered securities and for materially aiding the sale of unregistered securities under Kansas' version of the Uniform Securities Act, which provided for liability for nonsellers who materially aided a violative transaction and who could not affirmatively prove that it "did not know, and in the exercise of reasonable care could not have known" of the underlying facts of the violation.

At trial, the district court found for Oppenheimer on both theories. As to aiding and abetting, the court found that aiding and abetting liability could not be applied to persons falling under Kansas' material aid statute, and in any event could not be found liable on the stipulated facts. As to material aid, the trial court, relying on the Seventh Circuit's decision in Carlson v. Bear Stearns³, found that while Oppenheimer was a broker-dealer subject to the statute, it had not provided material aid because it did not "solicit or advise Klein and … performed no more than ministerial, bookkeeping functions." Thus, the trial court ruled for Oppenheimer on all counts.

On appeal, the Kansas Supreme Court affirmed the trial court's holding with respect to aiding and abetting, but reversed on material aid. The court began by distinguishing Carlson, opining that the Carlson court ruled on the basis that as a clearing broker Bear Stearns did not qualify as an " underwriter[], dealer[] or salesperson" under the relevant Illinois statute because the ministerial nature of its activity, and thus did not have cause to consider whether it "aided in any way" the sale of the securities as required for liability under the Illinois law at issue in Carlson.

The Kansas Court then pointed out that Carlson had only been cited in one state court case, Mars v. Wedbush.⁴ Although the Court correctly noted that Mars had cited Carlson in characterizing the clearing broker's duties as ministerial, the Court inexplicably found that "the basis for [the Mars court's] affirming the trial court's ruling was Mars' failing to present evidence that would create a genuine issue of fact", and on this basis apparently dismissed Mars as a useful precedent. But this appears to be a significant misreading of Mars because the failure to present evidence discussed by the Mars court was twofold. First, the Mars court found that the bulk of the allegations of negligence "[spoke] to the actions of First United and Kantor [the introducing brokers], not respondent. As enumerated in footnote 3, supra, pursuant to the clearing agreement, respondent's duties with respect to appellant's account consisted of actions which were operational or ministerial in nature." Only after rejecting the argument that the clearing broker could be liable for the negligent act of the introducing broker given the clearing broker's ministerial function did the court rule that there was a failure of evidence as to the materiality of the sole negligent act alleged against the clearing broker itself.

The Court then cited Hirata Corp. v. J.B. Oxford & Co.⁵, and apparently found in it support for the proposition that a clearing broker could be held liable for "material aid" even if the broker's services were merely "ministerial." But the Hirata court quite clearly did not rule on that basis. First, as we discussed in our 2001 article, the Hirata court was constrained in its analysis by the fact that, under Seventh Circuit rules, it could not consider the contents of the Clearing Agreement or Rule 382 notice that had been submitted in support of the motion but was limited to the pleadings alone. Moreover, the Hirata court based its ruling, in part, on the fact that Hirata's allegation "could be predicated on acts encompassed by the contractual relationship between Stratton and J.B. Oxford or it might refer to actions or omissions that extended beyond the contractual relationship implying that J.B. Oxford played a more significant role than the Clearing Agreement delineates." In Klein, by contrast, the case was tried on stipulated facts and there was no doubt that the allegation was that Oppenheimer had provided material aid precisely by engaging in "acts encompassed by the clearing agreement."

Moving on from Hirata, the Kansas Court next cited two state court cases under similar laws in Oregon and Alabama. In the Alabama case Foster v. Jesup and Lamont Securities Co., 482 So.2d 1201 (Ala. 1986), the Supreme Court of Alabama found that liability for materially aiding the sale of unregistered securities attached to a firm that allowed its name to be used in connection with the offering document and informed purchaser's accountant that it was involved in the sale, where the purchaser relied on the firm's involvement. The Oregon case, Prince v. Brydon, 306 Ore. 146 (1988) which involved the unregistered sale of interests in a limited partnership, imposed liability for materially aiding the sale of the securities on a lawyer who drafted the partnership agreement and portions of the offering circular, gave an opinion on the tax status of the partnership to be provided to potential investors and who knew that one of the partners intended to sell interests in Oregon. Oddly, the Oregon court found that the key to imposing liability on the lawyer was the attorney's "knowledge, judgment and assertions reflected in the contents of the documents", yet the Kansas Court found support in this for imposition of liability on Oppenheimer for clearing transactions.

The Court's final case citation was to the district court opinion confirming the arbitration award in Koruga. After reviewing the facts as described in the opinion, the Kansas Court proceeded to "scrutin[ize]" the descriptions of the clearing firms' services in Carlson and Koruga. Latching on to the fact that the Koruga court included margin lending in its description of clearing services provided by the clearing firm while the Carlson decision did not, the Klein court concluded that margin lending was a relevant difference between the two: "In the present case, in addition to the Bear, Stearns-type services identified in Carlson, Oppenheimer extended and maintained margin credit to L.T. Lawrence customers."

From that point, the Court took an extraordinary and unwarranted step and ignored the numerous cases that have held that clearing firms perform only ministerial acts when they engage in their routine clearing functions, rejecting it in favor of a contrary view in a law student article:

The author of the Comment takes issue with that characterization: "However, the processing involved is quite complex, and the execution of transactions and the transfer of title to securities are not simply clerical activities. They require expertise and systems not available to other firms.

In addition, firms engage in a number of activities that go well beyond simply making transactions occur … assessments regarding whether to accept an order for processing and when to extend credit involve knowledge and judgment …Decisions regarding whether to execute a transaction in the account after a customer has requested that the clearing firm not execute transactions involve judgment. Clearing firms identify an introducing firm's compliance with net capital requirements… ."

The Court then gave lip service to the language of the statute and unabashedly adopted a deep pocket analysis for the imposition of liability on clearing brokers:

The Comment Clearer Skies for Investors advocates holding clearing brokers liable for clearing trades for introducing brokers engaged in unlawful activities for four reasons. First, from a clearing broker's position, signs of securities fraud by an introducing broker are apparent… . Second, defrauded investors seldom have other recourse, because introducing brokerage firms declare bankruptcy, go out of business or change into some other entity … Third, clearing brokers "are in an ideal position to spread the costs of due diligence to their customers - which may be preferable to imposing the cost of noncompliance on the individual victims of securities fraud." … And fourth, "clearing firms benefit financially from the fraud by continuing to process trades from broker-dealers engaged in fraudulent activity. Clearing is an extremely profitable business for large broker-dealers. Clearing firms that continue to extend credit, or fail to report introducing firms after becoming aware that they are not satisfying their net capital requirements legitimately, help those firms stay in business in violation of securities laws. The introducing firms are then able to perpetrate more violations. By keeping the introducing firm in business, the clearing firm is attempting to salvage its own financial position relative to the introducing firms at the expense of the broker's customers"

The court next proceeded to attempt to tie that fourth rationale into the facts of the case before it:

In addition to not satisfying net capital requirements legitimately, introducing firms also jeopardize customers' financial interests by other unlawful activities, such as the unregistered sales at issue in the present case.

The Court determined that the trial court had inappropriately interpreted the Kansas statute in a way that would make "imposition of liability on a clearing broker most unlikely by adding an element that is outside the scope of a clearing broker's typical activities." The court rejected the trial court's understanding that material aid required that the broker have "participated in persuading the investor to purchase unregistered stock" and have "exercised some degree of control" and found that "[e]xamination of the clearing broker's services in the present case shows that they included activities that required the exercise of professional expertise and judgment and, thus, cannot accurately be called merely clerical or ministerial."

Importantly, the Court reached its decision despite the Stipulated Facts, which included:

At the time of the transactions, Oppenheimer had a reasonable belief that L.T. Lawrence, its agents or employees were maintaining compliance and/or supervisory procedures which were adequate to assure compliance by L.T. Lawrence and its registered representatives and employees with all federal and state securities laws, particularly given L.T. Lawrence's legal and contractual obligation to do so under the clearing agreement between Oppenheimer and L.T. Lawrence, the NASD rules, and applicable law.

Oppenheimer had no duty or obligation under the clearing agreement, the NYSE and NASD rules and applicable law to determine whether these specific securities were registered with the State of Kansas and, therefore, took no actions to do so.

While the clearing agreement did not require Oppenheimer to review the registration status of securities sold by L.T. Lawrence to its customers, pursuant to paragraph 1C Oppenheimer reserved the right to refuse to execute any transactions entered for a customer account.

Also, while the trial court looked to the Official Comments to the Uniform Securities Act of 2002, § 509(g)(4), which state that "the performance by a clearing broker of the clearing broker's contractual functions - even though necessary to the processing of a transaction - without more would not constitute material aid or result in liability under this subsection," the Supreme Court was critical of them and stated that the commentary's cited authority did not support the Comment.

At the end, the Court reversed the judgment in favor of Oppenheimer and remanded for consideration of the affirmative defense that Oppenheimer could not have known of the underlying facts constituting the violation.

d) Pension Commission III and IV - July 20, 2006 and February 20, 2007
In the Pension Commission decisions, the Southern District of New York twice dismissed claims raised against Banc of America Securities (BAS) by investors seeking to recover losses sustained in connection with the liquidation of two British Virgin Islands hedge funds managed by Michael Lauer. The investors alleged that Banc of America Securities was liable for aiding and abetting and materially aiding Lauer's fraud by "providing Lauer with dial-in access to its computer network and allowing him to generate false position statements ("BAS Position Reports") of the Funds' holdings. BAS employees created BAS Position Reports using valuation information sent to them by Lauer, usually by email, without verifying the accuracy of Lauer's information." The BAS Position Reports, which were provided to third parties, had Banc of America's name at the top of each page and, when downloaded and printed, "contained 'no disclaimer or other marking to suggest they were anything other than official documents prepared by, posted on the BofA Website by, and bearing the imprimatur of, BofA.'"

In its July 2006 decision in Pension Commission III⁶, the Court dismissed the claims against Banc of America for failure to state a claim. The court found that the complaint did not sufficiently plead aiding and abetting because it did not allege that Banc of America was aware that the NAV values provided by Lauer were false, and that the plaintiffs had not alleged actual knowledge and could not proceed on a constructive notice theory because Banc of America owed them no duty to monitor, verify or investigate Lauer's information.

When a defendant is under no such duty, even alleged ignorance of obvious warning signs of fraud does not suffice to adequately allege the actual knowledge necessary to sustain an aiding and abetting claim.

The Court also rejected the substantial assistance argument because the complaint alleged no facts to suggest that Banc of America had done anything other than perform its routine functions as a prime broker or had some other "extraordinary motive" to aid the fraud. Again, the court was quite firm in rejecting the argument:

And defendants are quite correct that "[p]laintiffs make no effort to specify how BAS's failure, as prime broker, to uncover Lauer's scheme amounts to an extreme departure from the standards of ordinary care … [and] [t]heir Complaint is utterly silent as to what the supposed standard of care is for prime broker or how BAS might have departed from it." … while plaintiffs correctly note that some cases impose aiding and abetting liability on clearing brokers when their activities go beyond such routine functions, they fail to explain how the services provided by BAS were out of the ordinary in any way, or how BAS had the sort of "extraordinary motive to aid in the fraud" that might alternatively suffice to extend liability to a clearing broker. As defendants note, "there is nothing special about allowing a customer to prepare a document," nor is there anything special about allowing Lauer to access the internet using BAS resources.

The Court dismissed the complaint against BAS and reluctantly gave leave to replead.

In Pension Commission IV⁷, the Court dismissed the amended complaint as against BAS and denied further leave to replead ruling that under the facts alleged in the amended complaint, the plaintiffs could not prove that anything Banc of America did proximately caused their injuries given that the amended complaint placed responsibility for preparing and verifying the funds' NAV on parties other than BAS. The allegation that the fraudulent scheme "may only have been possible because of [BAS's] actions or inaction" was not sufficient to allege proximate cause.

e) Fox International Relations - March 20, 2007
In Fox International Relations v. Fiserv Securities⁸, the Eastern District of Pennsylvania refused to dismiss a number of claims alleged against Fiserv as the clearing broker for Penn Financial Group. The allegations arose out of a fraud committed by Michael Kogan, a broker who, while his license was suspended by the NASD for improperly transferring a customer's account and forging a customer's signature, signed on as a broker at Penn.

The complaint alleged that the plaintiffs had invested with Penn by writing checks directly to Fiserv. Kogan then transferred the plaintiffs' money to various accounts he or his wife owned or controlled. To avoid alerting the plaintiffs, Kogan altered the customer addresses so that Fiserv's statements were mailed to unknown addresses, and in their place created and submitted false monthly account statements. Kogan's scam was apparently very detail oriented; one of the allegations raised against Penn (but not Fiserv) involved their knowledge of the fact that Kogan "received large deliveries of blank paper, similar to paper used by Fiserv." The correct account statements were "frequently returned to Fiserv as undelivered."

As against Fiserv, the complaint alleged that it was "fully aware" that Kogan was unlicensed, and that Fiserv, contrary to its ordinary policy, allowed Kogan "to make trades and changes in plaintiffs' accounts without power of attorney or letter of authorization." Fiserv also allegedly shut down trading accounts operated by Kogan, but allowed him to open new accounts shortly thereafter. Finally, the complaint alleged that Fiserv "had the power to influence and control and did influence and control, directly or indirectly, the decision making of [Penn], including the content and dissemination or omission of statements which Plaintiffs content [sic] were false and misleading." The complaint alleged the following causes of action against Fiserv: (1) 10(b) and 10b-5 violations; (2) violations of the Exchange Act; (3) violations of state securities laws; (4) negligent supervision; and (5) breach of fiduciary duty.

Significantly, as in Hirata, the Fox International Relations court refused to consider the clearing agreement between Fiserv and Penn, which Fiserv had submitted as an exhibit to its motion to dismiss, in determining whether the plaintiffs' allegations stated a claim. Thus constrained, the court denied Fiserv's motion to dismiss all but the negligent supervision claims. The court articulated its primary rationale in the section of its opinion directed to the plaintiffs 10b-5 claims:

Viewing these allegations [that Fiserv was aware that Kogan was unlicensed, that Fiserv shut down accounts operated by Kogan and then permitted him to open new accounts and permitted Kogan to make trades and changes without the necessary documentation] in the light most favorable to plaintiffs, the Court concludes that plaintiffs allege behavior by Fiserv that goes "beyond merely performing bookkeeping functions." Indeed, plaintiffs allege that defendant Fiserv supervised trading accounts operated by Kogan … Combined with Fiserv's alleged knowledge that Kogan was not a licensed broker, these allegations do not "reflect … the standard practice of a clearing broker."

The court also found that the plaintiffs had sufficiently alleged control person liability against Fiserv by the allegation that it had the power to and did influence and control Penn. Finally, while acknowledging that "a clearing broker, 'in performing its ordinary clearing broker function' has no fiduciary duties to customers of an introducing broker", the court reiterated its earlier finding that the allegations of the complaint sufficiently alleged that Fiserv had engaged in acts beyond its standard clearing function, and therefore stated a claim. Perhaps in recognition of the impact of the clearing agreement it could not consider in ruling on the motion to dismiss, the court concluded by stating that it would "revisit this issue at the summary judgment stage."

f) Kostoff - April 5, 2007
On April 5, 2007, the Middle District of Florida confirmed the arbitration award issued against a clearing firm in Michael Kostoff v. Vincent Cervone, Yankee Financial, Inc. and Fleet Securities, Inc., NASD-DR Case No. 04-04259.⁹ The facts were as follows:

In March of 2000, Kostoff opened a brokerage account with Glen Michael Financial ("GMF"), a firm that cleared through Fleet Securities, pursuant to a clearing agreement that obligated Fleet to perform what the court described as "ministerial and back office clearing services" and allocated to GMF all compliance, supervisory and audit functions. Kostoff "was made aware of Fleet's responsibilities" by a standard Rule 382 notice.

In January 2001, GMF informed Fleet that its retail business was being shut down. Fleet Vice President and Director Charles LaBella then referred GMF to Yankee Financial, another introducing broker for which Fleet cleared, and essentially brokered a deal by which GMF would live on as a part of Yankee: Yankee agreed to accept not only GMF's retail business, but to hire its registered employees. In awarding Kostoff compensatory and punitive damages, the panel found that:

[Kostoff] became a third party beneficiary [of the clearing agreement] and [Fleet] had a duty to monitor the originating brokerage. Under Florida "Blue Sky" statutes, the rules and regulations of the Securities and Exchange Act, the clearing contract, and notice to [Kostoff] to act as the "Back Office" administrator for the former Co-Respondents, [Kostoff] had a right to rely on Fleet for fair dealing. By this, [Fleet] had a duty to be aware of [Kostoff's] opening documents and the obvious totally incompatible objectives filed with [Fleet] on a [Fleet] provided form.

[Fleet] equally had the duty to be aware of the malfunctioning of the Broker-Dealer Glen Michael Financial/Yankee Financial … and in matter of fact was so aware at all times during the duration of [Kostoff's] Account. The enabling of this combination to continue as Yankee Financial was shown to fall squarely on [Fleet]. It was a Fleet agent who, aware of the impending closing for cause of the Glen Michael office, not wishing to lose the business of this brokerage office, knowingly, willfully and wantonly conspired to bring together a successor Broker-Dealer so as to enable the offending Glen Michael Financial to change its name to Yankee Financial to continue to defraud [Kostoff]. Throughout the association … Fleet was aware, and under the circumstances had a duty to be aware of the constant churning of [Kostoff's] account in unsuitable and unauthorized investments …

On their motion to vacate the award, Fleet argued that the panel's award was arbitrary and capricious and in manifest disregard of the law of clearing firm liability.

The court rejected both arguments. In doing so, however, the court refused to adopt or address the arbitration panel's reasoning with respect to Fleet's alleged duty to Kostoff as a customer of the introducing broker in finding that the panel's ruling was not arbitrary and capricious. Rather, the court found that, based on the finding that LaBella had brought together GMF and Yankee Financial in full knowledge of GMF's "malfunctioning" and in order to retain the broker's business for Fleet, the panel had sufficient ground to find that "Fleet stepped outside the ministerial duties outlined in its Clearing Agreements and participated in the alleged wrongdoing, thereby stripping itself of the protections normally afforded clearing firms." As to Fleet's manifest disregard of the law argument, the court noted that Kostoff's attorney had "recognized that the law regarding clearing firm liability tends to protect clearing firms, but correctly pointed out that when a clearing firm participates in the misconduct, courts have imposed liability." Based on that, the court ruled that Fleet could not establish that the panel "was apprised of a clear and binding legal standard and consciously chose to ignore it."

g) In re Manhattan Investment Fund - January 9, 2007
In January 2007, in a case with significant implications for clearing firms, the Bankruptcy Court for the Southern District of New York granted summary judgment to the Trustee of a defunct investment fund (the "Fund") allowing it to avoid $141,100,000 in margin payments transferred to Bear Stearns in the year before the Fund filed for bankruptcy. The Fund had been used by Michael Berger, "a convicted felon and fugitive" to perpetrate a "massive Ponzi scheme." Prior to the summary judgment motion decided in the 2007 decision¹⁰, Bear Stearns had succeeded in dismissing two other counts seeking close to two billion dollars in short sale proceeds and securities delivered to Bear Stearns to cover stock loans to the Fund, but had been denied dismissal of the claim for avoidance of the margin transfers.

The court's rulings on two issues may have a significant and specific impact for clearing brokers. First, the court decided a question of first impression in ruling that prime brokers who use transferred funds to cover margin debt are not "mere conduits" but "initial transferees" under the bankruptcy code, from which transfers could be avoided under the bankruptcy laws. The court found that, because Bear Stearns both received commissions on the transfers and used the transfers to cover margin shortfalls and open positions for which Bear Stearns would have been liable if the transfers had not been made, it therefore had (and used) a right to exercise "dominion and control" over the transferred funds to "protect its own economic well being", with or without the Fund's consent, and thus could not be considered a "mere conduit."

Second, the court ruled that, as a matter of law, Bear Stearns could not avail itself of the affirmative defense that it accepted the transfers in "good faith" because it had constructive notice of the scheme. In determining whether a transferee was acting in good faith, courts look to what the transferee knew or should have known, as determined by what "diligent inquiry would have discovered". 359 B.R. at 523-4 (emphasis in original). The court found that, based on undisputed facts, Bear Stearns was on "inquiry notice" when, in December 1998, a Senior Managing Director and salesperson for Bear Stearns named Frederick Schilling had a conversation about the Fund at a party. In the conversation, Schilling, who based on risk-related conference calls understood that the Fund was losing money, was told by an investor that the Fund was reporting a 20% profit for the year. Schilling passed the information up the chain, and Bear Stearns eventually held a conference call with Berger to ask about the discrepancy. Berger explained the discrepancy by claiming that the Fund had 8 or 9 prime brokers, of which Bear Stearns was only one. Though Bear Stearns continued to demonstrate concern about the Fund - including asking Deloitte and Touche, the Fund's auditors, to be "keen and careful" - they did not attempt to verify Berger's claim until December 1999, when Schilling learned that Berger had breached his contract with a third party marketer and became concerned that Berger might be "immoral." After signing a confidentiality agreement to obtain the Fund's financials from Berger, a "ten-minute review of the financial statements" revealed that there was a problem. Based on this record, the court ruled that, as a matter of law, Bear Stearns had not exercised the requisite diligence and could not avail itself of the good faith defense:

It is clear from the record that Bear Stearns was on inquiry notice of Berger's fraud from December 1998 and throughout the following year. Based upon the information it had, Bear Stearns was required to do more than simply ask the wrongdoer if he was doing wrong. Diligence requires consulting easily obtainable sources of information that would bear on the truth of any explanation received from the potential wrongdoer.

The majority of the cases to have come down over the past few years have adhered to the principles of law articulated by the prior decisions in this area: that a clearing broker, engaged in its routine clearing functions, is performing merely ministerial tasks and may not be found liable for the wrongdoing of an introducing broker. In Rozsa, the Second Circuit again affirmed that the law respects the allocation of duties provided for in the clearing agreement, and lack of duty was the basis for the Southern District's decision in Pension Commission III as well.

Even the cases finding clearing brokers liable or allowing claims to proceed against them reaffirmed those principles. While the Second Circuit did reverse the dismissal of all claims against the clearing broker in Lesavoy, it affirmed the dismissal of those causes of action clearly predicated on the introducing broker's or trustee's wrongful acts, and reversed only with regard to the cause of action alleging that the clearing broker itself engaged in wrongful activity which went beyond the routine functions of clearing. In Fox International Relations, as in Hirata, the court's decision was primarily driven by its inability to consider the clearing agreement in ruling on the motion to dismiss.

Thus, while the court reiterated that in order for the clearing broker to be liable the plaintiffs were required to allege facts supporting a claim that Fiserv had stepped beyond its traditional role as clearing broker, the court was compelled to accept as true the allegation that Fiserv "had the power to influence and control and did influence and control" the introducing broker, an allegation which likely could not have survived consideration of the clearing agreement.

While the Fleet court confirmed an award against a clearing broker, its opinion is a strong reaffirmation of the basic principles of clearing firm liability. The court made clear its opinion that the arbitration panel had misapplied the law in finding that the clearing firm owed Kostoff a duty to monitor the introducing brokers, and instead confirmed the award on the alternative ground that - as Richard Harrington of Bear Stearns had in the A.R. Baron cases - Fleet's employee LaBella had sufficiently involved himself in the activities of the introducing broker to sustain a claim that Fleet had stepped beyond the mere ministerial duties of a clearing firm and thus opened itself to liability.

Klein, on the other hand, is a deeply flawed opinion. First, the court significantly misread the caselaw it cited in purported support of its opinion or in an attempt to distinguish contrary holdings. Second, the court assumed that the clearing agreement at issue in Carlson did not provide for margin lending, and on that basis attempted to harmonize Carlson and Koruga by deducing (erroneously) that margin lending is beyond a clearing firm's routine, ministerial function. Third, the court abandoned any serious case for statutory construction with its drawn out discussion of the Comment Clearer Skies for Investors and adopted an explicit deep pocket policy to its reasoning. Fourth, the court weaved whole cloth for new definitions of "ministerial" and "material" because the tasks entailed the "exercise of professional experience and judgment" even though the claims in Klein involved the sale of unregistered securities, and it appears clear from the discussion that Oppenheimer did no more than process the transactions as directed. Having concluded by its "scrutiny" of Carlson and Koruga that engaging in activities such as margin lending was not ministerial action and noting that Oppenheimer engaged in margin lending, the Klein court appears to have determined that Oppenheimer's relationship with Lawrence could not have been merely ministerial.

Finally, the Southern District's ruling in Manhattan Investment Fund is troubling on several fronts. First, the Court determined that the prime broker's use of funds to pay down the account's margin debt was a "transfer" and then the Court determined - in a summary judgment context - that Bear Stearns had failed to exercise sufficient diligence when, based upon suspicions that the account activity was improper, the firm made some inquiries but did not thoroughly investigate. Nonetheless, while Manhattan Investment is unsettling given the risks and duties it places on the shoulders of prime brokers and their monitoring of hedge funds, there is real doubt that the Court's imposition of a higher diligence standard will spill over into the clearing firm - introducing firm area where Rule 382 should remain as the line in the somewhat shifting sands.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.