T ruling from a federal appeals court in had acquired Hanifen, - PDF document

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 T ruling from a federal appeals court in had acquired Hanifen, Imhoff Clearing Corp.) had Oregon 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. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 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