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From Securities Regulation Daily, March 18, 2013

Clearing Broker Had No Duty to Disclose Introducing Broker's Fraud to Customers

By Rodney F. Tonkovic, J.D.

A Second Circuit panel reversed a district court order certifying a class. The panel found no duty of disclosure, and without that duty, the clearing broker could not have engaged in a material omission. Without a material omission, the plaintiffs were unable to employ a class-wide presumption of reliance and satisfy the predominance requirement, the panel stated (Levitt v. J.P. Morgan Securities, Inc., March 15, 2013, Livingston, D.).

The action was brought by former customers of a broker-dealer, Sterling Foster & Company, Inc., for which Bear Stearns, as a clearing broker, performed settlement and recordkeeping functions. The customers alleged that the broker-dealer had engaged in a market manipulation scheme and that Bear Stearns had participated in that scheme by, among other things, continuing to clear transactions for the broker despite alleged knowledge of the ongoing manipulative scheme. The district court found that the evidence showed that Bear Stearns participated in the scheme in such a way as to trigger a duty to disclose and that the customers were entitled to a presumption of reliance based on the failure to disclose. The district court accordingly concluded that the allegations satisfied Rule 23(b)(3)'s predominance requirement and certified the class.

Bear Stearns then filed an interlocutory appeal, arguing that as a clearing broker engaged in mere clearing conduct, it owed no fiduciary duty of disclosure to the broker's customers. Bear Stearns argued further that the district court erred in finding that it had participated in the alleged scheme to an extent that triggered a duty to disclose the scheme to the customers.

Liability of clearing brokers. In the Second Circuit, a clearing agent generally owes no fiduciary duty to the owners of the securities that pass through its hands. Also, if a clearing broker is providing routine clearing services, district courts in the circuit have declined to impose liability on the clearing broker for the introducing broker's violations; the courts held this even if the clearing broker allegedly knew of the introducing broker's fraud, the court noted. On the other hand, claims have been allowed to proceed in cases where the clearing broker is alleged to have gone beyond its role as clearing broker and to have taken direct control of the introducing firm's operations and its manipulative scheme.

Duty to disclose. In this case, the appellate court concluded that the customers failed to allege sufficiently direct involvement in the scheme by Bear Stearns to create a duty owed to the customers. The customers claimed that Bear Stearns "joined in, permitted and facilitated said fraud and market manipulation." But, the court, remarked, it was not asserted that Bear Stearns instigated or directed the scheme. At most, Bear Stearns approved the offering, agreed to serve as clearing broker for the offering, and may have violated certain NASD rules and Federal Reserve regulations. "We think substantially more direct participation by the clearing broker is required for a duty of disclosure to exist," the court stated.

The court found the customers' arguments that Bear Stearns' activities in connection with the offering were "irregular" to be unavailing. Bear Stearns required approval of the offering and demanded a personal guarantee and increased collateral from the broker, but the court determined that none of these requirements were atypical in the industry. Next, the customers asserted that Bear Stearns' trade confirmations contained misleading statements, but allowing the misrepresentations (which were made by the broker) to stand did not constitute an "extraordinarily high involvement" in the scheme, the court wrote. Finally, the customers argued that Bear Stearns violated Federal Reserve Board regulations by failing to cancel unpaid trades, but the court saw nothing that showed a duty to disclose, and, moreover, declined to create a private right of action under the regulation at issue.

The case is No. 10-4596-cv.

Attorneys: Leslie Trager (Leslie Trager) for Robert Levitt. Kerry Ann Dziubek (Arnold & Porter, LLP) for J.P. Morgan Securities, Inc.

Companies: J.P. Morgan Securities, Inc.

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