December 10, 2019

December 09, 2019

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Second Circuit Defines “Customer” Under FINRA

In a recent case, the Second Circuit Court of Appeals defined a “customer” under the Financial Industry Regulatory Authority (FINRA). The Court held that under FINRA Rule 12200, a “customer” is defined as one who is not a broker or dealer who either, (1) purchases a good or service from a FINRA member or (2) has an account with a FINRA member.

This case arose after a foreign investor (the Investor) who managed his family trusts purchased complex investment options in London from a U.K.-based global brokerage (UK Brokerage). The UK Brokerage set up two reference funds to hold the investment assets. The Investor contributed $198 million to the funds and the UK Brokerage agreed to contribute between $300 and $900 million in leverage funds. The Investor would have to bear the first $198 million in losses, in exchange for getting to keep 100 percent of any upside. The UK Brokerage held ownership of all the assets in the reference funds, and in exchange for the Investor’s initial contribution and fees, the UK Brokerage issued options to the Investor which entitled them to the value of the assets, less the leverage funds contributed by the UK Brokerage.

The reference funds were managed by the Investor, who was advised and given oversight in New York by the New York affiliate of the brokerage (the New York Affiliate). The Investor selected the funds’ investments, and these decisions had to be reviewed and approved by the New York Affiliate. The New York Affiliate held the voting rights in the reference funds. The New York Affiliate performed the majority of the work to structure and negotiate the options. The New York Affiliate also monitored the risk to the UK Brokerage, prepared monthly reports regarding the status of the funds, performed due diligence on assets to assess the UK Brokerage’s leverage and exposure and had final say over investment decisions as the holder of the funds’ voting rights. The terms of the options were set forth in confirmations between the UK Brokerage and the Investor, and the transactions were recorded on the UK Brokerage’s account books.

The reference funds did not include a forum selection clause or a choice of law clause. However, the UK Brokerage and the Investor entered into structuring services agreements that contained the Investor’s agreement to pay the UK Brokerage to set up the reference fund investments. This agreement was contained in two letters, and these letters included forum selection and choice of law clauses which held that any disputes arising in connection with that agreement would be settled in English courts under English law.

The reference funds came under stress, and the New York Affiliate removed the Investor as Investment Advisor. The New York Affiliate attempted to have workout efforts, but to no avail, and the funds failed, with the Investor losing his entire investment. The investor filed a claim with FINRA, requesting arbitration against the New York Affiliate. The New York Affiliate brought an action in the Southern District of New York to enjoin the FINRA arbitration, claiming that since the New York Affiliate had no written arbitration agreement with the Investor, the FINRA rules required arbitration only if the Investor was a “customer” of the New York Affiliate. The New York Affiliate claimed that the Investor was a customer of the UK Brokerage, but not the New York Affiliate. 

The FINRA Code requires that members submit to FINRA arbitration of a dispute if (1) arbitration is required by a written agreement or was requested by a customer; (2) the dispute is between a customer and a member or associated person of a member; and (3) the dispute arises in connection with the business activities of the member or the associated person.

After two years of lengthy motions and hearings, the district court found that the Investor was not a customer of the New York Affiliate, and thus FINRA did not compel arbitration. The court examined each and every transaction and interaction between the Investor and the persons the Investor interacted with to determine whether a customer relationship was created. The district court determined that the executed transactions were with the UK Brokerage and the planning, structuring and other services provided by the New York Affiliate were ancillary and supportive of the central agreement that the Investor entered into with the UK Brokerage. Further the district court held that an investor (generally) was a customer of the party with which he had the account and consummates the transaction. The entity from whom an investor (generally) purchased the desired product defines the legal and business locus of his status as a customer, and is the core of the relationship as a customer.

On appeal, the Second Circuit determined that the core issue it needed to decide was whether the Investor was a customer of the New York Affiliate, since the New York Affiliate was a member of FINRA and the dispute arose out of the business activities of the New York Affiliate. Since FINRA does not define “customer” except to say that it does not include a broker or dealer, the Second Circuit determined that the word “customer” must be construed in a manner consistent with the reasonable expectations of FINRA members.

The Second Circuit found that the Investor did not purchase services from the New York Affiliate. All of the Investor’s agreements were with the UK Brokerage, and the fees for services rendered were also paid to the UK Brokerage. The Second Circuit agreed with the district court’s findings that the New York Affiliate provided management services to the Investor acting for the UK Brokerage in connection with the UK Brokerage’s agreement to provide services to the Investor. Although the Investor was a customer of the UK Brokerage, that relationship did not allow the Investor to compel the corporate affiliate of the UK Brokerage, the New York Affiliate, to arbitration.

For the first time, the Second Circuit defined what constitutes a “customer” under FINRA Rule 12200. A “customer” is one who, while not a broker or dealer, either (1) purchases a good or service from a FINRA member or (2) has an account with a FINRA member. The Second Circuit explained that this definition would allow FINRA members to be on notice as to who could compel the FINRA member to arbitrate their disputes. By accepting a fee for services or selling securities, the FINRA member now knows that it may be compelled to arbitrate if a dispute arises with that entity. As well, since an account holder has a reasonable expectation to be treated like a customer, the FINRA member should now anticipate that an account holder may also compel the FINRA member to arbitration if a dispute arises from their transactions.

The Second Circuit used these new guidelines to determine that because the Investor neither purchased a good from the New York Affiliate, not held an account with the New York Affiliate, the Invest was not a “customer” of the New York Affiliate and could not compel arbitration under FINRA. The New York Affiliate’s work was merely carried out in support of the agreement that the Investor entered into with the UK Brokerage. This simple, predictable and broad definition of a “customer” will make the lengthy, and costly, examination of each transaction, as occurred in the district court, unnecessary to determine whether a customer relationship has been created. 



About this Author

Alexander Barnstead Litigation Attorney

J. Alexander Barnstead is an associate in the Indianapolis office of Barnes & Thornburg and a member of the firm's Litigation Department and the Compliance, Antitrust and Competition Law, and Commercial Litigation Practice Groups.

Alexander represents individual and corporate clients in complex civil and white collar criminal litigation and focuses his practice on criminal and civil antitrust matters, internal and government investigations; he also assists corporate clients with establishing effective compliance programs and in a wide range of commercial litigation matters. He...