Will New FINRA Guidance Allow for Broker-Dealers To Litigate Selling Away Claims in Court?

By Denis C. Dice, Esq.*

Key Points:

• FINRA defines customers as those who have an account or purchase securities through the broker-dealer.
• New guidance may allow broker-dealers to litigate certain selling away claims in court.

In the first years of the twenty-first century, a number of broker-dealers attempted to obtain court orders under which they would be permitted to litigate selling away claims brought by non-customers in court versus arbitration. These non-customers/claimants would typically file their claims in arbitration, where they would argue that they were, in fact, customers of the broker-dealer under the applicable NASD rules, even though they had neither opened an account at the broker-dealer nor purchased anything through the broker-dealer for which it had received a commission. The broker-dealers took exception to these non-customers' claims and filed actions in court in an effort to have the arbitrations stricken.

However, a number of courts ruled against the broker-dealers in this regard. Initially, the courts would point to NASD Code of Arbitration Rule 10301(a) (now FINRA Code of Arbitration Rule 12200), which provides that a member firm must submit to arbitration "[a]ny dispute, claim, or controversy…between a customer and a member and/or associated person arising in connection with the business of such member or in connection with the activities of such associated person." In other words, there were two conditions that must be satisfied in order to trigger the NASD arbitration requirement. First, the claim must involve a dispute between either a NASD-member and a customer or an associated person and a customer. Second, the dispute must arise in connection with the activities of the member or in connection with the business activities of the associated person. Even where the claimant had no contact with the broker-dealer, the courts typically found that the claimant was a "customer" of the associated person where the claimant had purchased some type of investment recommended by the associated person, even if it had not been approved by or offered through the broker-dealer.

The courts concluded that the term "customer" plainly refers to either the member's or the associated person's customer. John Hancock Life Insurance Co. v. Wilson, 254 F.3d 48 (2d Cir. 2001). See also, Vestax Securities Corporation v. Skillman, 117 F.Supp. 2d 654, 657 (N.D. Ohio 2000). The courts also determined that the claims arose in connection with the activity of the NASD member or in connection with the business of the associated person under Rule 10301. The relevant activities of the NASD member would encompass the duty to properly supervise the activities of its registered representatives. The court determined that since both prongs of the rule had been satisfied, such claims must be arbitrated.

However, FINRA recently issued Regulatory Notice 12-55, dated December 2012, providing guidance on its new Suitability Rule 2111. In fact, the guidance found in the answer to Question 6 specifically addresses the definition of a customer for the purposes of the Suitability Rule. The guidance provides as follows:

Q6(a). What constitutes a "customer" for purposes of the Suitability Rule?

A6(a). …In general, for purposes of the Suitability Rule, the term customer includes a person who is not a broker or dealer who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer receives or will receive, directly or indirectly, compensation even though the security is held at an issuer, the issuer's affiliate or a custodial agent (e.g., "Direct Application" business, "investment program" securities, or private placements) or using similar arrangements.

Therefore, FINRA has specifically stated that a customer is a person who opens a brokerage account at a broker-dealer or purchases a security for which the broker-dealer received or will receive compensation directly or indirectly.

This guidance may have direct applicability to whether or not a certain selling away case may be litigated in court. For example, in certain selling away cases, a broker-dealer registered representative may recommend an investment to an individual who would not meet the above-referenced definition of a customer to the extent that they do not have an account at the broker-dealer and the security recommended was not offered or approved by the firm. In this situation, the firm is unaware of the unapproved recommendation and sale, and it would not receive any compensation upon the individual's purchase of the particular investment.

According to the above-referenced guidance, it could be argued that such an individual would not be a "customer" of the registered representative. If a broker-dealer were to be faced with a selling away claim by a non-customer and raised this particular issue with the court, a court could well find that, under the above-referenced guidance, such individuals are not customers of the registered representative and, therefore, the firm would not be obligated to arbitrate these claims, but could litigate them in court. There is a significant potential advantage to litigating this matter in court were there to be a preliminary finding that the claimant was not a "customer" of the broker-dealer. A court applying the law might actually rule that a firm has no duty to non-customers.

Defense Digest, Vol. 19, No. 1, March 2013