iIt makes sense that a brokerage firm can only be forced to arbitrate claims by its customers for investment activity occurring at that brokerage firm. Indeed, FINRA Rule 12200 obligates member firms to arbitrate disputes with “customers”; but then it falls short in its definition, which appears to include everyone other than a broker or dealer. The courts have stepped in and added considerable color to this nebulous definition, although the courts are not in complete agreement.
In Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., the Eighth Circuit determined that a business or investment relationship is required for customer status, suggesting that a broader application would be contrary to the expectations of FINRA members. 264 F.3d 770 (8th Cir. 2001). Although courts have extended the customer definition to include indirect relationships (through a firm’s associated person) as well as direct relationships with a firm, Fleet Boston’s basic approach has been widely adopted. See, e.g., Bensadoun v. Jobe-Riat, 316 F.3d 171, 177 (2d Cir. 2003) (customer refers to one “involved in a business relationship with an NASD member that is related directly to investment or brokerage services”); Berthel Fisher & Co. Financial Services, Inc. v. Craig Larmon, 2011 WL 3294682 at *5 (D. Minn. Aug. 1, 2011) (“To expand the definition of ‘customer” to include individuals with no direct business or investment relationship with a firm ... would frustrate the reasonable expectations of FINRA members.”). [1]
Most recently, the Fourth Circuit issued its opinion in Morgan Keegan & Company, Inc. v. Louise Silverman, which is in line with the Fleet Boston line of cases. In Silverman, investors had argued they were “customers” of Morgan Keegan by virtue of their purchases, through another brokerage firm, of bond funds for which Morgan Keegan performed marketing and valuation services. --- F.3d ----, 2013 WL 425556 (4th Cir. Feb. 4, 2013). The Silvermans claimed that their broker’s reliance on Morgan Keegan’s marketing materials was among the factors that should suffice for them to be customers and that they could therefore bring an arbitration against the firm. They argued that the FINRA definition required only that a customer not be a broker or dealer and have a dispute that arose out of Morgan Keegan’s business activities. The court soundly rejected this “anything goes” argument, instead referencing the common meaning of “customer” as a purchaser of goods or services. Because the Silvermans had not purchased any good or service from Morgan Keegan, they were not its customers and could not force it to arbitrate.
Just a few weeks prior to Silverman, the Fourth Circuit considered the “customer” issue, but in a different factual setting.[2] In UBS Financial Services, Inc. v. Carilion Clinic, Carilion brought a FINRA arbitration claim over the underwriting of its bonds handled by UBS and Citigroup. 2013 WL 239051 (4th Cir. Jan. 23, 2013). Carilion argued it was a customer of UBS and Citigroup because, among other things, the firms had served as underwriters, acted as its agents in dealing with rating agencies, and provided monitoring and advisory services. For these services, the firms earned an underwriter’s discount and an annual fee.
The brokerage firms urged the Fleet Boston limited definition of “customer,” which hinged on whether the brokerage firms provided investment or brokerage-related services. But the Fourth Circuit refused to interpret the term so narrowly. Noting that FINRA viewed its own mission as broader than the protection of investors and included supporting the investment banking and securities markets generally, the Fourth Circuit concluded that a customer “refers to one, not a broker or dealer, who purchases commodities or services from a FINRA member in the course of the member’s business activities insofar as those activities are regulated by FINRA—namely investment banking and securities business activities.”
This contractual relationship through which a service was purchased directly from the brokerage firm distinguished the bond issuer in Carilion from the investors in Silverman. A mere “connection” between the firm’s alleged misconduct and the Silvermans’ losses was insufficient to confer customer status. In Silverman, the common understanding of the term “customer” was not satisfied by “merely a remote association with alleged misconduct falling within the general ambit of FINRA’s regulatory interests.” In contrast to the multiple services the firms provided in Carilion, the investors in Silverman had no business or transactional relationship with the brokerage firm at all.
The Carilion decision is not without precedent, particularly from the Second Circuit. Some courts have previously concluded that an issuer is a customer of its underwriter. See, e.g., UBS Financial Services, Inc. v. West Virginia University Hospitals, Inc., 660 F.3d 643 (2d Cir. 2011). Just days ago, a Minnesota district court cited Carilion with approval in determining that auction rate securities bond issuer Allina was a customer of UBS, which earned a fee for its services including underwriting and serving as lead broker-dealer for the auctions. UBS Securities LLC v. Allina Health System, Case No. 0:12-cv-02090 (D. Minn. Feb. 11, 2013). However, the reach of the “customer” definition in this context is not unlimited. Merely providing advice, without more, may be insufficient; although where the firm is compensated for such advice, it may be considered a service. The service transaction must be meaningfully connected to the FINRA member’s securities or investment banking business activities. The relationship must also be direct: a customer of one entity cannot “leapfrog” over that entity to reach firms with which that entity, but not the customer, contracted. See, e.g., TradeRight Corp. v. Minakhi, 2007 WL 704528 (N.D. Ill. Mar. 5, 2007) (finding customer of securities firm could not obligate TradeRight to arbitrate where TradeRight merely licensed to securities firm the trading software used to commit fraud and acted only in customer service capacity).
At its core, the “customer” status issue is still whether the FINRA member had a reasonable expectation that the party with whom it is dealing in an arms-length transaction could force arbitration. In certain circumstances where the parties are of equal bargaining power, it may be possible to clarify the nature of the intended relationship as non-customer from the outset without running afoul of Rule 12200. In a decision issued the month after West Virginia University Hospitals, the Second Circuit refused to find that a hedge fund was a broker-dealer’s customer where the broker-dealer had limited involvement in negotiating the deal and was only an affiliate of the bank that the hedge fund contracted with. Wachovia Bank National Assoc. v. VCG Special Opportunities Master Fund, Ltd., 661 F.3d 164, 173 (2d Cir. 2011). In that case, it was significant that the parties to the transaction signed a non-reliance agreement encompassing affiliates, which specifically excluded any “agency, brokerage, advisory or fiduciary services....”
The Fourth Circuit in Carilion also acknowledged the possibility that parties could agree to forum selection language that would supersede the operation of FINRA’s customer rule, although it concluded that the clause before it that “all actions and proceedings” be brought in a New York district court was not explicit enough to operate as a waiver. The Carilion court noted that any such provision “must be sufficiently specific to impute to the contracting parties the reasonable expectation that they are superseding, displacing, or waiving the arbitration obligation created by FINRA Rule 12200.”
A decision just issued from the Southern District of New York distinguished Carilion in concluding that a very similar forum selection clause did trump the obligation to arbitrate in FINRA Rule 12200. Goldman, Sachs & Co. v. Golden Empire Schools Financing Authority, Case No. 1:12-cv-04558 (S.D.N.Y. Feb. 8, 2013). Golden Empire had retained Goldman Sachs as the sole underwriter and broker-dealer for its $95 million auction rate securities bond issuance. Golden Empire claimed customer status, but the court held that the clause in one of their agreements that “all actions and proceedings arising out of this Broker-Dealer Agreement or any of the transactions contemplated hereby shall be brought in the United States District Court in the County of New York…” supplanted Rule 12200. Whereas the Carilion court viewed more explicit language as necessary to establish that Rule 12200 was being waived or superseded, the Golden Empire court noted that Second Circuit decisions do not require an express waiver and granted Goldman’s motion to enjoin the arbitration.
Accordingly, firms may want to consider this issue when contracting with parties of relatively equal bargaining power for non-investment related services, in non-retail or investment banking contexts. Including specific disclaimer or forum selection language consistent with FINRA’s rules may help to clarify the nature of the parties’ relationship or the parties’ intent as to their chosen forum for dispute resolution.
[1] A few courts, including those in the Eleventh Circuit, seem to suggest that the definition is so broad that the only criterion is not being a broker or a dealer, but even these decisions actually analyze the question as though a business or transactional relationship at least with an associated person is required.
[2] The same panel of judges (Niemeyer, Keenan, and Diaz) decided both cases. The Silverman and Carilion opinions were written by Judge Keenan and Judge Niemeyer, respectively.
