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Don't Overlook Your Brokerage Firm's Clearing Firm In Seeking To Recover Your Investment Losses
cores of small brokerage firms do business with the public. Unfortunately, while many are legitimate operations, too many are "boiler rooms" - firms such as A.R. Baron and Stratton Oakmont. Until securities regulators close their doors, these firms leave a trail of defrauded investors.
Known as "introducing firms", these small brokerage firms exist only because larger, well-capitalized firms, called "clearing firms", aid and participate in their businesses. Without the backing of Bear Stearns, for example, A.R. Barron could not have operated. Clearing firms willingly assist introducing firms because the business is quite lucrative.
When investors seek to recover their investment losses from these small, introducing firms, they often are unsuccessful collecting their awards. And when investors look to the clearing firms, the clearing firms send a form letter "explaining" why there can be no liability because of the limited role that the clearing firm played. Unfortunately, too many investors do not challenge the clearing firm's position.
That may be a mistake. Let's examine the role of the clearing firm, overview the law and highlight recent securities rule changes.
The Clearing or "Carrying" Function
Generally, clearing firms, or "carrying firms", perform several critical functions. These functions include clearing trades, settling trades, cashiering, mailing confirmations and monthly statements, and maintaining books and records. In return for these essential "back-office" functions, the typical clearing firm will require its introducing firm to deposit substantial cash or marketable securities (usually cash), and to indemnify the clearing firm for all actions and inactions. Additionally, the typical clearing firm will retain the right to act, in all material respects, as the introducing firms themselves. For example, the clearing firm will retain the right to approve trades, reject trades, communicate with customers, require additional margin account deposits, inspect books and records and so forth.
Arguably, clearing firms retain these broad rights, receive substantial deposits and obtain indemnification because of concerns that they will remain liable for all of the actions of their introducing firms. After all, while NYSE Memorandum 82 - 18 announced the ability of an introducing firm to enter into a "carrying agreement" under NYSE Rule 342, it left no doubt as to continuing, universal liability:
The amendments do not, however, have the effect of relieving any member organization from complying with its overall supervisory responsibilities pursuant to Rule 342. Each organization will be accountable for the actual performance of all functions performed by the employees and others associated with the member organization as well as overall supervision of all functions and activities performed by it pursuant to the [carrying] agreement. Moreover, to the extent that a particular function is allocated to one of the parties, the other party is to supply that firm with all appropriate data in its possession pertinent to the proper performance and supervision of that function, and the agreement should acknowledge this obligation.
Moreover, when the Securities and Exchange Commission approved the NYSE rule change, the SEC reiterated the requirement that each organization would be accountable for the actual performance of all functions performed:
The Commission notes that no contractual arrangement for the allocation of functions between an introducing and carrying organization can operate to relieve either organization from their respective responsibilities under the federal securities laws and applicable SRO rules.
(Securities Exchange Act Release No. 18497, February 19, 1982).
Arbitration and Court Decisions
Although courts and arbitrators are split on whether to hold clearing firms liable, there is ample authority for doing so. Recently, an NASD arbitration panel awarded $1.3 million against clearing firm Hanifen, Imhoff Clearing Corp., nka Fiserv Correspondent Services (NASD No. 98 - 4276). Other arbitration awards also have found for investors against clearing firms. For example: against Gruntal (NASD No. 93-00903); against Bear Stearns (NASD 95-04099); against Prudential Securities (NASD 95-04922); and against J.W. Charles Clearing Corp. (NASD 94-03620).
Similarly, courts have found for investors against clearing firms. For example, Faturik v. Woodmere Securities, Inc., et al., 431 F. Supp. 894, 896 (S.D.N.Y. 1977); Cannizzaro v. Bache, Halsey Stuart Shields, Inc., 81 F.R.D. 719, 721 (S.D.N.Y. 1979); In re Atlantic Financial Management, Inc. Securities Litigation, 658 F. Supp. 380 (D. Mass. 1986); and Margaret Hall Foundation v. Atlantic Financial Management, Inc., 572 F. Supp. 1475 (D. Mass. 1983).
New Responsibilities
Last year the NYSE and NASD established new record keeping and reporting requirements for clearing firms. The new rules fall far short of imposing automatic liability upon a clearing firm for the misdeeds of its introducing firm. But they help. Perhaps the most helpful requirement is that clearing firms must furnish written customer complaints that they receive promptly not only to the introducing firm but also to the local securities regulator. This should enable regulators to more quickly identify patterns of wrongful behavior and intervene earlier.
In conclusion, investors, through competent securities counsel, should look beyond the introducing firms and consider the clearing firms in seeking to recover their investment losses.
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Sponsored by James J. Eccleston. This Web site contains material of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment adviser when building and protecting your wealth.
All content Copyright © 2010 Advocate Compliance Partners, Inc. except where noted. All rights reserved.
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