Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Monday, March 18, 2013

Second Circuit: Clearing Broker Owes No Disclosure Duty to Customers of Introducing Broker

A recent Second Circuit opinion, Levitt v. J.P. Morgan Securities (No. 10-4596-cv, Mar. 15, 2013), brought back memories of a notorious broker-dealer fraud.(Download Levitt 03152013[1])  Sterling Foster & Co. was a broker-dealer that engaged in numerous market manipulation schemes.  The allegations in this class action suit involve SF's activities as an underwriter for an IPO in the mid-1990s (!), in which it entered into secret agreements with the insiders to "pump-and-dump" the stock. The plaintiffs in this class action are former SF customers who purchased the securities in the IPO.  Since SF is no longer around, they seek to hold the clearing broker, Bear Stearns, liable alleging that it participated in the fraud.  The district court granted class certification on the Rule 10b-5 claim.  While acknowleding that it is "well-established" that a clearing broker owes no duty of disclosure to the clients of the introducing broker, the district court made an exception because "a preponderance of the evidence shows that Bear Stearns participated in Sterling Foster's scheme in such a way as to trigger a duty to disclose."

On appeal, however, the Second Circuit reversed.  In reviewing the precedent, the appellate court affirmed previous rulings that where a clearing broker provided normal clearing services, it would not be liable for the introducing broker's misconduct.  It also acknowledged a limited category of cases in which district courts have permitted claims to proceed against a clearing broker, in instances where the clearing broker "assumed direct control of the introducing firm's operations and its manipulative scheme."  However, the Second Circuit found that the district court misapplied this approach: the plaintiffs allege, at most, that Bear Stearns, "knowing of the fraud, joined in, permitted and facilitated said fraud and market manipulation;"  plaintiffs do not allege that Bear instigated or directed the manipulative scheme.  The Second Circuit held that this did not allege sufficient participation to create a duty of disclosure on the part of the clearing broker -- assuming that such a duty of disclosure existed in the first place.  Because there was no duty to disclose, plaintiffs could not avail themselves of the presumption of reliance under Affiliated Ute.  Accordingly, plaintiffs could not satisfy the predominance requirement of Rule 23(b)(3).

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