Clearing firm liability cases dwindle after strong start Thursday February 15, 2001 By Lynn Cowan, Of DOW JONES NEWSWIRES WASHINGTON (Dow Jones)--When a National Association of Securities Dealers arbitration panel delivered an unusual $1.8 million award against Fiserv Inc. in 2000, the decision upended the prevailing belief that Wall Street's clearing firms aren't responsible for a brokerage firm's fraud. A year later, when an Irish couple won a $1 million punitive damages award in a similar arbitration against Bear Stearns Cos., and in 2002, when a group of Ohio homeowners won a total of $3 million against J.B. Oxford Holdings Inc., it seemed a sure bet that more decisions would go against the clearing industry. But in a sign of just how unpredictable securities arbitration can be, almost no NASD cases since those three have been decided in favor of investors. Instead, several arbitrators have flat-out rejected the argument that clearing firms owe the public a duty to avoid processing trades for brokerages that appear to be engaging in fraud. The clearing industry is a profitable but low-key segment of Wall Street, where large firms handle the administrative task of matching and settling trades after they are made. All brokerage firms, whether large or small, honest or fraudulent, need a clearing firm to process their trades. Some of the largest players in the industry, such as Bear Stearns, Fiserv, FleetBoston Financial Corp. and Bank of New York Co., are better known for their investment banking or consumer banking. Break With Tradition Traditionally, clearing firms have maintained that they are merely a back-office function that can't be held accountable for other firms' misdeeds. But that argument began to show cracks in 1999, when Bear Stearns agreed to pay $ 38.5 million to settle Securities and Exchange Commission charges that its clearing division contributed to fraud at now-defunct A.R. Baron. Then, in 2000, a Portland, Ore., attorney named Robert S. Banks Jr. argued in front of an NASD panel that the six investors he represented should be able to collect damages not only from Duke & Co., which was shut down by New York regulators amid a stock manipulation investigation, but also from Fiserv, which had acquired the clearing firm that processed Duke's trades. Banks relied on state securities laws in Oregon and California when he argued that Fiserv materially aided Duke in its fraud by continuing to process its trades even after it became clear that Duke was likely fleecing its customers. The $1.8 million he won wasn't the highest award against a firm in arbitration, and barely made a dent in Fiserv's profits, which were in the hundreds of millions of dollars at the time. But the 25-page decision that accompanied the award was highly unusual for a panel of NASD arbitrators, who normally provide no explanation for their decisions. Even more alarming for Fiserv and the rest of the clearing industry was a segment of the award that urged other arbitrators to issue more explanations for their awards so that some precedents could be set for future panels. Wall Street banded together to vigorously fight the Fiserv award, with its main trade organization, the Securities Industry Association, filing a motion with a U.S. District Court judge to at least strike the explanation from the award, if not vacate the entire thing. But both the district court and a federal appeals court kept the award intact. The Oregon panel's decision was followed in 2001 by a win in front of a Boston panel by Bernard and Maureen McDaniel of Ireland, who said they lost $800,000 after investing with the A.R. Baron brokerage firm, for which Bear Stearns cleared. A.R. Baron was shut down in 1996 by regulators who accused it of defrauding investors through stock manipulation. The panel found that Bear Stearns was "aware of Baron fraud and took numerous actions to involve itself in Baron's business and financial affairs and assist Baron, above and beyond those involved in a normal back-office clearing operation." A group of Ohio homeowners won $3 million against J.B. Oxford in a 2002 NASD arbitration after their attorney, Joseph Dehner of Frost Brown Todd in Cincinnati, argued that the firm was responsible for part of the losses due to the boiler-room operations of Monroe Parker Securities Inc. That panel didn't provide an explanation for its argument. Fewer Cases, Fewer Wins The Oregon case handled by Banks was seen as changing the course of clearing- firm liability cases, with expectations for a swing in arbitrator sentiment toward investors' claims. But after the Ohio case handled by Dehner, say attorneys, there were no more million dollar awards - in fact, very few awards at all came down in favor of investors. "I think the clearing side of the industry really came together and worked really hard with the Securities Industry Association to develop defenses in these cases," said Banks. "When they lost my case, then McDaniels soon after, they started getting concerned." Banks said he lost a similar clearing case against Bear Stearns in September, even though he felt he had even stronger evidence than the Fiserv award he won. In the Bear Stearns case, he represented 37 investors who had lost money through Sterling Foster & Co, another boiler room shut down in 1997 after an FBI raid. He said he presented 100 customer complaint letters written to Bear Stearns about Sterling's activities. Banks said he believes he lost the Bear Stearns case because the panel relied on New York common law, which makes clearing firm liability harder to prove than under the Uniform Securities Act, which was used in the Fiserv case. The different choice of law came about because the investors he represented were from so many different states, he said. "I thought we had eye-popping evidence," Banks said. "But they won the case, and the reason they won was because the law they were relying on was so favorable." Jonathan Kord Lagemann, who represented the McDaniels against Bear Stearns in Boston in 2001, said he thinks arbitration panels often err when they fail to consider past decisions in their deliberations. Most panels don't even offer explanations for their decisions, and none are required to follow precedent from previous panels. "When I got the results on McDaniel, I thought there was at least a good chance that subsequent panels would follow that panel's ruling," said Lagemann. Wall Street sees it another way. Michael Udoff, associate general counsel and secretary at the Securities Industry Association, said cases like the ones in Oregon, Boston and Ohio were notable exceptions to the traditional theory that clearing firms can't be held liable for an unrelated brokerage's fraud. "I think the decision in (Oregon) was kind of always viewed as aberrational. I think that the claimants in that case kind of hung their hat on the idea that a small number of states - namely California and Washington - has slightly different wording in their statutes on third-party liability. They had language that includes the phrase 'materially aids'" as a test for participation in fraud, Udoff said. Indeed, there haven't been that many cases brought against clearing firms in recent years - about a dozen have gone through arbitration in all - primarily because the kind of liability proven in Banks' and others' cases hinged on knowledge of outright fraud perpetrated by small brokerage firms such as Duke, A.R. Baron, Stratton Oakmont and Monroe Parker. Regulators have since succeeded in shutting down most such "boiler room" operations. Dehner, who represented the Ohio homeowners against J.B Oxford, said few instances exist where the clearing firm should have noticed obvious evidence that fraud was occurring. Most run-of-the mill arbitration cases can't make that link, he said. Udoff added that investors generally go after clearing firms only as a last- ditch attempt to recover some money after their brokerage firm goes out of business, since a defunct brokerage is less likely to pay an award than an operational clearing firm. "It's the old deep-pocket theory - I guess they'll try to shoehorn it into any theory they can. If Duke & Co. had still been around and had deep pockets, there never would have been any case against Fiserv," Udoff said. Lagemann said he doesn't believe there will be many more clearing firm liability cases in the future. "The clearing business, of which I'm a frequent critic, has actually cleaned up quite a bit," he said. "And the Stratton Oakmont model (of boiler-room stock fraud) is basically extinct - it isn't a viable business model any more. The Manhattan District Attorney will send you up the river if you operate like that."