Second Circuit Reverses Class Certification Order, Holding That a Clearing Broker's Alleged Knowledge of Fraud Against Shareholders, Absence Direct Involvement, Is Insufficient to Create a Duty of Disclosure
In Levitt v. J.P. Morgan Securities, Inc., No. 10-4596, 2013 WL 1007678 (2d Cir. Mar. 15, 2013), theUnited States Court of Appeals for the Second Circuit reversed a district court order certifying a class of shareholder fraud plaintiffs in a lawsuit against J.P. Morgan Securities, Inc. and J.P. Morgan Clearing Corporation (“J.P. Morgan”). The decision reaffirms that a clearing broker generally owes no fiduciary duty to the owners of securities that pass through its hands. According to the Second Circuit, absent evidence that the clearing broker instigated or directed the alleged fraud by the securities issuer through high involvement, a plaintiff cannot establish a class-wide presumption of investor reliance sufficient to satisfy the predominance requirement of Rule 23(b)(3) of the Federal Rules of Civil Procedure.
Plaintiffs in Levitt are former customers of a defunct New York broker-dealer, Sterling Foster & Company, Inc. (“Sterling Foster”), for which Bear Stearns, as a clearing broker, performed certain settlement and record-keeping functions. J.P. Morgan acquired Bear Stearns in 2008. According to the investor plaintiffs, Sterling Foster manipulated a 1996 initial public offering of ML Direct stock, causing investors to suffer loses. Plaintiffs allege that Bear Stearns violated Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), by participating in Sterling Foster’s market manipulation scheme.
The United States District Court for the Southern District of New York granted class certification, finding that if plaintiffs’ allegations were true, Bear Stearns owed a fiduciary duty to disclose the scheme to the class. According to the district court, based upon this duty to disclose, plaintiffs alleged a material omission of fact by Bear Stearns sufficient to establish a rebuttable presumption of class-wide investor reliance and satisfy the predominance requirement of Rule 23(b)(3).
On appeal, the Second Circuit explained that for an omission to be actionable under Section 10(b), the defendant must be subject to an underlying duty to disclose. Under Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1972), an omission of a material fact by a defendant with a duty to disclose establishes a rebuttable presumption of class-wide reliance upon the omission by the investors to whom the duty was owed.
The Second Circuit concluded that plaintiffs’ allegations that Bear Stearns participated in Sterling Foster’s fraudulent conduct by continuing to clear transactions despite alleged knowledge of the ongoing scheme and by failing to cancel unpaid trades failed to trigger a duty of disclosure to Sterling Foster’s clients such that the Affiliated Ute presumption of reliance applied. Specifically, the Court contrasted the difference between a primary broker-dealer, like Sterling Foster, and a clearing broker, like Bear Stearns, which is hired to perform nominal back-office services associated with securities trading. The Court recognized that a clearing broker is generally under no fiduciary duty to the clients of the primary broker.
The Second Circuit held that plaintiffs had not adduced any evidence at the class certification stage indicating that Bear Stearns directed or instigated sham or fraudulent trades, or that it otherwise departed from normal clearing functions, such to establish that Bear Stearns owed the investors a duty of disclosure. As such, plaintiffs could not employ a class-wide presumption of investor reliance and the district court erred in certifying a Rule 23(b)(3) class.
By confirming that a clearing broker generally does not owe a duty of disclosure to investors absent extraordinary circumstances (such as where the broker is directly and highly involved in the alleged fraudulent scheme), this decision reinforces the legal protections afforded clearing brokers from liability to investors. It also exemplifies the use of Rule 23 (and related interlocutory appeal procedures) to obtain a dispositive ruling on a common merits issue at the class-certification stage.