Wednesday, October 31, 2012

Eighth Circuit Finds Investors Are Not “Customer” of Managing Broker-Dealer of Securities Offering Under FINRA Rule 12200

In Berthel Fisher & Co. Financial Services, Inc. v. Larmon, No. 11-2877, 2012 WL 4477433 (8th Cir. Oct. 1, 2012), the controversy arose out of securities issued by a group of Minnesota limited liability companies (collectively, Geneva) and purchased by defendants-appellants (the Investors) in 2007 and 2008.  Berthel Fisher & Company Financial Services., Inc., et al. (collectively, Berthel), a licensed broker-dealer and member of FINRA, served as managing broker-dealer for the offering. As managing broker-dealer, Berthel assembled a group of FINRA-registered broker-dealers-Selling Group Members, or SGMs-who in turn offered the securities to their own customers, including the Investors.

Although Geneva prepared the private placement memoranda (PPMs) to be provided to prospective purchasers of the securities, Berthel reviewed at least two of the PPMs, suggesting changes that Geneva adopted.  Per the agreement between Berthel and the SGMs, Berthel collected investor payments from the SGMs and passed those payments along to Geneva. In addition, the contract between Berthel and Geneva obligated Berthel and the SGMs to determine each investor's eligibility to participate in the offering. Because of this, Berthel maintained a file on each investor that included the investors' names, dates of birth, and contact information.

The securities did not perform as anticipated, leading the Investors to file FINRA arbitration claims against Berthel. The Investors alleged that Berthel performed insufficient due diligence on the offering, leading to critical omissions in the PPMs. Berthel filed suit in the United States District Court for the District of Minnesota, seeking a declaratory judgment that the Investors were not Berthel's "customers" under the FINRA Code and that Berthel was therefore not obligated to arbitrate with the Investors. Further, Berthel moved for a preliminary injunction enjoining the arbitrations, and the Investors cross-moved to compel arbitration.

The district court held that the Investors did not qualify as Berthel's customers under the FINRA Code and that the Investors' claims against Berthel were therefore not arbitrable before FINRA. Accordingly, the court granted Berthel's motion to enjoin the pending arbitrations and denied the Investors' cross-motion to compel arbitration.

The Court noted that "the first task of a court asked to compel arbitration of a dispute is to determine whether the parties agreed to arbitrate that dispute." Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614, 626, 105 S.Ct. 3346, 87 L.Ed.2d 444 (1985). The Investors did not allege that Berthel explicitly agreed to arbitrate; rather, they allege that they qualified as Berthel's "customers" under the FINRA Code. The Court found that the FINRA Code, which Berthel signed as a FINRA member, constituted an agreement to arbitrate disputes between Berthel and its customers.

The court noted that Rule 12200 of the FINRA Code states:

Parties must arbitrate a dispute under the Code if:

o Arbitration under the Code is either:

(1) Required by a written agreement, or

(2) Requested by the customer;

o The dispute is between a customer and a member or associated person of a member; and

o The dispute arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company.

The Court of Appeals stated that the question of arbitrability turned on whether the Investors are Berthel's customers under the FINRA Code.

The FINRA Code defines "customer" in the negative, stating only that "[a] customer shall not include a broker or dealer." FINRA Rule 12100(i). In Fleet Boston Robertson Stephens, Inc. v. Innovex, Inc., 264 F.3d 770, 772 (8th Cir.2001), the Court of Appeals construed "customer" to "refer[ ] to one involved in a business relationship with [a FINRA] member that is related directly to investment or brokerage services."

The Court noted that in the present case it was uncontested that the Investors had no contact with Berthel in the course of investing in the securities at issue.  The Investors argued, however, that they qualified as Berthel's customers under Rule 12200 because Berthel

provided "investment or brokerage services" to the investors in three ways. First, Berthel Fisher was responsible for conducting due diligence on the TIC interests. Second, Berthel Fisher was obligated to conduct a reasonable-basis suitability analysis on the TIC interests. Third, Berthel Fisher maintained customer files on the investors and was responsible for protecting the investors' privacy.

The Court determined that the provision of these services in the case before it failed to transform the Investors into Berthel's customers, because Berthel provided those services not to the Investors but instead to the SGMs and Geneva. The Court noted that if the provision of these services formed any customer relationships at all, it formed them between Berthel, Geneva, and the SGMs, not between Berthel and the Investors.

The Investors argued that Fleet Boston requires only "investment or brokerage related services." But the Court found that the provision of "investment or brokerage related services" is only half of the picture-not only must the FINRA member firm provide those services, but also must it provide those services to the customer either directly or through its associated persons. In Fleet Boston, the Court of Appeals had observed that "[a]lthough other cases interpreting the term 'customer' have in some ways taken a broad view of the term, in all of these cases there existed some brokerage or investment relationship between the parties." Id. at 772 (emphasis added). The Court concluded that, simply put, in the case before it there was no "relationship" between Berthel and the Investors as required by Fleet Boston. Because Berthel did not provide "investment or brokerage related services" to the Investors, the Investors were not Berthel's customers under FINRA Rule 12200. Accordingly, the Court affirmed the judgment of the district court.



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