chevron-down Created with Sketch Beta.
March 11, 2013 Articles

Litigating Customer Claims Outside the Firm-Client Relationship

Courts analyze FINRA rules in arbitration between firms and clients

By Sandra D. Grannum and Joshua D. Jones

Arbitration is a creature of contract. However, by virtue of being a member of the Self-Regulatory Authority now known as the Financial Industry Regulatory Authority (FINRA), broker-dealers, upon the request of a customer, are required to arbitrate complaints from their customers whether or not there is a written arbitration agreement. This mandate is contained in both the FINRA By-Laws Article IV and in the Code of Arbitration Procedure for Customer Disputes, Rule 12200. The typical customer dispute in a FINRA arbitration involves a client of a brokerage firm alleging wrongdoing by the firm and/or a broker of a member firm relating to their securities account with the firm. On occasion, however, individuals who are not clients of a particular firm or broker may assert claims against the firm or broker based on purported wrongdoing that falls outside of the traditional firm-client relationship.

When faced with such claims, brokerage firms often take the position that they are not required to arbitrate these investor claims because the investors are not their client. These issues are most often brought to the attention of the courts when firms move to enjoin an arbitration from moving forward. In considering the issue, a court must start its analysis with the FINRA rules and whether they require a firm to arbitrate a particular claim.

FINRA Framework and Differing Approaches

FINRA Rule 12200 requires broker-dealers to submit to the jurisdiction of FINRA in all matters between a “customer” and a member where “the dispute arises in connection with the business activities of the member. . . .” As to the definition of a customer under FINRA rules, Rule 12100(l) is a study in definition by exception: A customer shall not include a broker or dealer.


For some courts, the inquiry as to whether a particular individual is a “customer” of a brokerage firm and thus in a position to force the firm to arbitrate his or her claim should generally be a simple, straightforward inquiry. Is the individual a broker or a dealer? If not, that individual is a customer under Rule 12100(l). In other words, a brokerage firm is required to arbitrate with any person or entity whatsoever as long as that person or entity is not a broker or a dealer. See, e.g., O.N. Equity Sales Co. v. Emmertz, 526 F. Supp. 2d 523, 530 (E.D. Pa. 2007) (analyzing pre-FINRA National Association of Securities Dealers [NASD] rules and holding that a plaintiff was a customer of a firm “because he was not a broker or dealer”); First Montauk Secs. Corp. v. Four Mile Ranch Dev. Co., 65 F. Supp. 2d 1371, 1381 (S.D. Fla. 1999) (stating that “[the Customer Code] contain[s] no limitations other than exclusion of brokers and dealers from invoking rules relating to customers”).


In contrast, at least one court has reached the same result, but only before stating that the FINRA definition of “customer” was “ambiguous[.]” See Bank of the Commonwealth v. Hudspeth, 282 Va. 216, 226 (Va. 2011). In doing so, the Supreme Court of Virginia found that FINRA Code of Arbitration Procedure “certainly supports the conclusion that ‘one who receives investment and brokerage services’ is properly considered a ‘customer[,]’” but was “also susceptible to an interpretation under which [the plaintiff] may be considered a ‘customer’ merely because it is not ‘a broker or dealer[.]’” Id. In deciding between what it viewed as two logically acceptable alternatives, the court took the more expansive approach based upon United States Supreme Court precedent providing that “the Federal Arbitration Act ‘establishes that, as a matter of federal law, any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration, whether the problem at hand is the construction of the contract language itself or an allegation of waiver, delay, or a like defense to arbitrability.’” Id. (citing Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24–25, 103 S. Ct. 927, 74 L. Ed. 2d 765 (1983)).


An additional factor that on occasion comes into play is the execution by the firm of a FINRA Uniform Submission Agreement (USA). The USA currently in effect provides that the signing parties “hereby submit the present matter in controversy . . . to arbitration in accordance with the FINRA By-Laws, Rules, and Code of Arbitration Procedure.” Execution of the USA has been viewed as evidencing an agreement to arbitrate. See, e.g., Morgan Keegan & Co. v. Garrett, 2012 U.S. App. LEXIS 22057 (5th Cir. Tex. Oct. 23, 2012). In addition, execution of a USA could be sufficient to submit the arbitrability issue to the arbitration panel, rather than a court, pursuant to FINRA Rule 12409, which provides that “[t]he panel has the authority to interpret and determine the applicability of all provisions under the Code. Such interpretations are final and binding upon the parties.” Id.


Other courts have moved past the definition offered in the FINRA Rules to consider other factors in determining whether a particular individual is a customer. For instance, the Eighth Circuit Court of Appeals has noted that the NASD (now FINRA) rules, manual, and notice to members “support a general definition of ‘customer’ as one who receives investment and brokerage services or otherwise deals more directly with securities than what occurred here.” Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770, 772 (8th Cir. 2001). A similar inquiry used by courts is whether or not there exists a “business relationship” between the firm and the investor. Id. In fact, many cases involving selling away—alleging wrongdoing by a broker in the sale of investments not offered by the broker’s employing firm—result in a finding that the investor is a customer of the firm because the investor has received investment advice from, or otherwise had a business relationship with, a broker associated with the firm. See, e.g., Wash. Square Sec., Inc. v. Aune, 385 F.3d 432, 436-37 (4th Cir. 2004); WMA Secs., Inc. v. Wynn, 32 Fed. Appx. 726, 728-29 (6th Cir. 2002); John Hancock Life Ins. Co. v. Wilson, 254 F.3d 48, 58–59 (2d Cir. 2001); Miller v. Flume, 139 F.3d 1130, 1135–37 (7th Cir. 1998); Oppenheimer & Co. v. Neidhardt, 56 F.3d 352, 358 (2d Cir. 1995).


Another somewhat related consideration is whether or not arbitrating the claims at issue would be consistent with the firm’s “reasonable expectations.” For instance, in Wheat, First Sec., Inc. v. Green, 993 F.2d 814, 820 (11th Cir. 1993), the court stated that a ruling that a NASD member could be forced to arbitrate “claims which arose while a claimant was a customer of another member merely because the claimant subsequently became its customer” would “do significant injustice to the reasonable expectations of NASD members.” Similarly, the District Court for Minnesota recently cited Wheat, First Sec. and Fleet Boston for the proposition that “[t]o 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.” Berthel Fisher & Co. Financial Services, Inc. v. Craig Larman, No. 11-889, 2011 U.S. Dist. LEXIS 84627 at *17 (D.C. Minn. Aug. 1, 2011). A court can justify looking to the parties’ expectations if it determines that there is ambiguity in the FINRA rules requiring arbitration with customers. In looking to the firm’s reasonable expectations, considerations regarding the firm’s business relationship, or lack thereof, with the investor and whether the firm or its associated persons provided the investor with investment advice would certainly be of relevance.

Recent Product and Underwriting Cases

Brokerage firms do much more than service investors’ accounts. For instance, numerous firms engage in investment banking activity that can lead to allegations of wrongdoing by investors. In UBS Securities v. Voegeli, 684 F. Supp. 2d 351 (S.D.N.Y. 2010), the Second Circuit considered whether a firm’s role as an underwriter of a security was sufficient to allow investors who suffered a loss on their investments in the security underwritten by UBS to bring an arbitration claim against the firm. It was undisputed that the investors did not have accounts with UBS, did not purchase the securities at issue from UBS, and were not direct customers of UBS. UBS sought to enjoin the FINRA arbitration on the basis that the investors were not its customers. In response, the plaintiff investors argued, among other things, “that because they are not ‘brokers’ or ‘dealers,’ they are customers of UBS Securities according to the definition of ‘customer’ in FINRA Rule 12100.” Id. at 355. The Voegeli court squarely rejected this argument, holding that


Defendants’ second theory for why they qualify as customers of UBS Securities is based on an untenable interpretation of the definition of “customer” in the FINRA rules. Defendants argue that because FINRA Rule 12100 defines “customer” to exclude only “brokers” and “dealers,” and since they are neither brokers nor dealers, they must therefore be customers of UBS Securities. Defendants’ interpretation of the definition of “customer” would imply that a party seeking to compel arbitration pursuant to the FINRA rules need not have an actual customer relationship with any FINRA member; rather, the party need only not be a broker or dealer. Such an interpretation of FINRA Rule 12100 would be absurd.


Goldman Sachs faced a similar claim before the Northern District of California in Goldman Sachs & Co. v. Becker, 2007 U.S. Dist. LEXIS 51359, at *16 (N.D. Cal. July 2, 2007). In Becker, defendants argued that they were customers of Goldman Sachs by virtue of Goldman Sachs having been an underwriter for Prudential Securities’ initial public offering, but the court held that “[j]ust as these arguments do not support a contractual relationship with plaintiffs, they do not support a customer relationship either.” Id. at *16–17.


One of the most recent cases to address the customer issue involves allegations by Carilion Corporation against UBS and Citi regarding Carilion’s issuance of auction-rate bonds and its purchase of interest rate swaps to hedge against interest rate fluctuations on those bonds. See UBS Fin. Servs. v. Carilion Clinic, 2013 U.S. App. LEXIS 1884 (4th Cir. Jan. 23, 2013). Carilion alleged that it followed UBS and Citi’s advice in the issuance of roughly $300 million in auction-rate bonds. Carilion alleged that UBS and Citi provided it with advice on the structure of the bonds, underwrote the bonds, served as lead broker-dealers for the bond auctions, sold Carilion interest rate swaps that they had recommended, dealt with the rating agencies and bond insurers on behalf of Carilion, and provided monitoring and advisory services to Carilion regarding the bonds and the swaps. Id. at *4. In determining whether Carilion was a “customer” of the firms for purposes of arbitration, the Fourth Circuit moved past the definition set forth in Rule 12100(l) and the Fleet Boston “general definition of ‘customer’ as one who receives investment and brokerage services or otherwise deals more directly with securities than what occurred here.” Id. at *12-18. Instead, the court began its analysis with FINRA Rule 12100, Rule 12200, and FINRA’s Restated Certificate of Incorporation (which identified FINRA’s mission, in part, as promoting “self-discipline among members, and to investigate and adjust grievances between the public and members and between members.”). Id. at *12-15. It coupled this analysis with customer’s “generally accepted meaning—‘one that purchases a commodity or service’ Merriam-Webster’s Collegiate Dictionary 308 (11th ed. 2007)” to conclude that “when FINRA uses ‘customer’ in Rule 12200, it 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 covered by FINRA’s regulation, namely the activities of investment banking and the securities business.” Id. By so defining the term “customer,” the court had “little difficulty concluding that Carilion is such a ‘customer.’” Id. at *21.

Cases Involving Directly Aggrieved Nonclient Investors

Another line of alleged “customer” cases involved allegations of wrongdoing by a broker-dealer with no direct relationship with the investor, but whose actions are alleged to have caused the investor direct harm. For instance, in an action initially commenced by investors in the New Jersey Superior Court, plaintiffs alleged their former broker, Smith, engaged in a fraud scheme, and for over 17 years, swindled them out of approximately $10,000,000, purporting to sell them a security—Healthcare Financial Partnership—that was, in fact, nonexistent. Frederick v. Smith, 416 N.J. Super. 594, 597, 7 A.3d 780, 782 (App. Div. 2010); see also Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Cantone Research, Inc., 427 N.J. Super. 45, 47 A.3d 1 (App. Div. 2012). The thefts were allegedly consummated when the plaintiffs sent checks payable to the broker’s personal Merrill account to Smith at a phony address for Healthcare Financial, and Smith subsequently deposited these checks into his personal account at Merrill and thereafter used the assets in the account for his own purposes. Smith never worked at Merrill. The plaintiff named all the broker-dealers at which Smith worked during the period of the alleged fraud and also named Merrill. The employing brokers-dealers did hold accounts for the plaintiffs, but those accounts never purported to contain the fictitious securities. One of the broker-dealers moved to compel arbitration, and all but Merrill agreed. Merrill, which remained a party to the New Jersey Superior Court Action, moved to dismiss all claims against it, and the plaintiffs cross-moved to compel arbitration. Frederick, 416 N.J. Super. at 597; Merrill Lynch, 427 N.J. Super. at 50.


The Superior Court of New Jersey, Law Division, denied the plaintiffs’ motion to compel arbitration and granted Merrill’s motion to dismiss the claims against it with prejudice. The court held that plaintiffs were not customers of Merrill and, therefore, Merrill had no duties to the plaintiffs and the plaintiffs did not have a written arbitration agreement with Merrill to arbitrate their claims. Frederick, 416 N.J. Super. at 600-01; (N.J. Sup. Ct. Dec. 20, 2010) at 11; Merrill Lynch, 427 N.J. Super. at 52. The plaintiffs appealed the lower court decision to the Superior Court of New Jersey, Appellate Division, which upheld the lower court’s holdings. Frederick, 416 N.J. Super. at 602; Merrill Lynch, 427 N.J. Super. at 63. In so doing, the court dismissed the plaintiffs’ argument as “without sufficient merit to warrant discussion in a written opinion” and noted that they had “no viable cause of action to be arbitrated [because] Merrill Lynch never entered into an agreement to arbitrate any disputes that might later arise between them.” Id. at 603.

Conclusion The case law in this area varies significantly by jurisdiction. If representing an investor seeking to compel arbitration, counsel should focus on the FINRA “customer” definition as is and, in the alternative, any fact that would put the firm on notice that it could be compelled to arbitrate with an individual in the client’s position. Other factors to consider include the federal policy strongly favoring arbitration, circumstances regarding execution of the USA, and whether there is a business relationship with a broker or other employee of the firm. In representing the firm, counsel would be better served to detail the lack of contractual agreement, business relationship, and investment advice, or any other evidence that could appeal to a court’s sense of fair play.

Copyright © 2013, American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. The views expressed in this article are those of the author(s) and do not necessarily reflect the positions or policies of the American Bar Association, the Section of Litigation, this committee, or the employer(s) of the author(s).