Comment on the USA - Changing the Liability of Clearing Broker-Dealer
December 2, 2002
Richard B. Smith
Chair, Drafting Committee To Revise Uniform Securities Act
450 Lexington Avenue
New York, New York 10017
Professor Joel Seligman
Official Reporter, Committee to Revise Uniform Securities Act
Washington University School of Law
Campus Box 1120
One Brookings Drive
St. Louis, Missouri 63130
Professor William Henning
National Conference of Commissioners of Uniform State Laws
University of Missouri, Columbia
School of Law
313 Hulston Hall
Columbia, Missouri 65211
W. Reece Bader
ABA Section Advisor
1020 Marsh Road
Menlo Park, California 94025
Re: Official Comment 11 To Section 509(g)(4) of the
Uniform Securities Act of 2002
On October 15, 2002, the National Conference of Commissioners on Uniform State
Laws published the final version the 2002 Uniform Securities Act ("USA"). In so
doing, it adopted an Official Comment at the request of the Securities Industry
Association that is extremely misleading and has no place in the USA.
Regrettably, I only learned of the Official Comment recently, and was not able
to comment while you were considering its inclusion in the USA. However, I do
want to bring it to your attention because I strongly believe that, had you
understood the background and the law, you would not have included it. Because I
feel strongly that the Official Comment should not be in the USA, I do intend to
do what I can to ensure that the states considering adoption of the USA
specifically exclude the Official Comment at issue.
Official Comment 11 to Section 509(g)(4)
I refer specifically to Official Comment 11 to Section 509(g)(4). Section
509(g)(4) of the Act provides for liability to certain persons who materially
aid an unlawful securities sale.
That section was not intended to change former USA § 410. However, Official
Comment 11 to the section would, if adopted, materially change the current state
of the law. It states:
Under 509(g)(4), the performance by a clearing broker of the clearing broker’s
contractual functions–even though necessary to the processing of a
transaction–without more would not constitute material aid or result in
liability under this subsection. See, e.g., Ross v. Bolton, 904 F.2d 819 (2d
The Official Comment, which was offered by the Securities Industry Association
("SIA"), represents the SIA’s latest efforts to insulate clearing firms from
liability and reverse the decisions in Koruga v. Fiserv Correspondent Services,
Inc.,183 F.Supp.2d 1245 (D. Or. 2001), aff’d 40 Fed. App. 364; 2002 U.S. App.
LEXIS 6439 (9th Cir. 2002.). The SIA freely boasts to its members that it
believes it has reversed those decisions through the furtive insertion of
Official Comment 11 It states, in a Legal Alert that it submitted to its members
on September 12, 2002, "The Official Comment is a direct, albeit implicit [sic],
rejection of the arbitrators’ award in Koruga." A copy of the SIA Legal Alert is
attached as Exhibit A.
Official Comment 11 represents special interest lobbying at its worst. It treats
clearing broker-dealers differently than any other person or entity subject to
liability under Section 509(g)(4). Under the statutory scheme envisioned by the
2002 USA and earlier versions, broker-dealers and others are liable when they
"materially aid" an unlawful transaction. If they are able to demonstrate that
they did not know of the fraud, and could not reasonably have discovered it,
however, they avoid liability. The Official Comment changes that scheme for
clearing broker-dealers. So long as the clearing broker is performing a function
that is within its contractual obligations with its introducing firm, it does
not "materially aid" an unlawful sale. Clearing broker-dealers draft their
contracts with introducing firms. By expanding their contractual duties, they
can limit the scope of what constitutes "materially aiding" under Section
504(g)(4), since by definition anything within the contract is not materially
aiding. That is not what the law is or should become, but that is what the SIA
seeks to accomplish with Official Comment 11.
In addition, Official Comment 11 would support an argument that clearing
broker-dealers are exempt from liability even when (for a fee) they knowingly
assist criminal introducing firms that defraud customers. There have been many
introducing brokerages that were actually organized criminal operations existing
solely to defraud customers. Such operations are usually short lived and are
often ultimately shut down by regulators, but not before they defraud customers
out of millions of dollars. If Official Comment 11 is adopted, a clearing
broker-dealer could, without incurring any liability whatsoever, transfer
customer assets to such operations, knowing full well that the introducing firm
was selling worthless securities and would never return the customers’ money.
Again, that is not the law, but that is precisely what Official Comment 11 is
designed to accomplish.
Official Comment 11 is contrary to the only court decisions that have
interpreted the "material aid" provision of the USA as it applies to clearing
firms. It is contrary to the views expressed by at least one state securities
division. It is contrary to the understanding of the North American Association
of Securities Administrators ("NAASA"). And, it is contrary to the law as set
forth in a number of court cases.
Koruga v. Fiserv Correspondent Services, Inc.
The SIA offered Official Comment 11 with the unabashed intent of overruling the
case of Koruga v. Fiserv Correspondent Services, Inc. In the Koruga case, an
NASD arbitration panel held that a clearing broker-dealer is liable under the
"materially aids" provisions of the USA (formerly § 410) if it repeatedly
ignores customer requests for the return of funds being held by the clearing
firm, and continues knowingly to participate in a fraudulent scheme. In that
case, the NASD Panel unanimously found not only that the clearing firm, Fiserv
Correspondent Services, Inc., absolutely knew throughout the clearing
relationship that a fraud was being committed on its customers, but continued
for two years to transfer customer funds to the criminal brokerage operation.
The panel found that under the Washington and California equivalents of the USA
section, codified as §509(g)(4) in the 2002 USA, Fiserv was liable as a
broker-dealer that materially aided the fraudulent scheme. See: Koruga, et al.
v. Wang, et al,
NASD No. 98-04276.
The Koruga NASD award was confirmed by the United States District Court for the
District of Oregon, which denied Fiserv’s motion to vacate the award. The court
Because I find that the panel's application of the California and Washington
Securities Acts [reproduced at footnotes 3 and 4, supra] was in accordance with
the plain language of the statutes, and not contrary to any other applicable
law, I find no manifest disregard for the law."
Koruga v. Fiserv Correspondent Services, Inc.,183 F.Supp.2d 1245 (D. Or. 2001).
The Ninth Circuit agreed, and denied the clearing firm’s appeal seeking vacatur
of the award. Koruga, 2002 U.S. App. LEXIS 6439 (9th Cir. 2002.).
The decision in the Koruga case was supported by many observers. In fact, the
Washington Securities Division wrote amicus briefs at the district court and
Ninth Circuit levels in Koruga, advising the courts that the panel of
arbitrators and district court correctly interpreted Washington’s RCW
21.20.430(3). The North American Securities Administrators’ Association (NASAA)
agreed, and also submitted amicus briefs urging the courts to reject Fiserv’s
argument that clearing brokers should enjoy immunity from liability under state
"materially aids" statutes. The case was also hailed in the press as a victory
for investors against clearing broker-dealers that knowingly assisted boiler
room type brokerage firms. See, e.g., "Striking A Blow For The Little Guy",
Sunday New York Times Business Section, page 1, February 11, 2001.
In the face of the broad public and regulatory support for the Koruga decision,
the SIA opposed the decisions throughout. In both the district court and in the
Ninth Circuit, the SIA filed extensive amicus briefs. The arguments that it
asserted in those briefs were soundly rejected by both federal courts that
decided Koruga. Now, the SIA wants to overrule the Koruga decisions, which are
the only reported decisions in the nation that specifically address, post-trial
or arbitration, the liability of clearing broker-dealers under the USA
"materially aids" section. The SIA seeks to have the USA revised to adopt a
position that has never been adopted by any court interpreting a USA based
statute. As I understand it, the uniform laws are revised to codify changes in
the law, not to overrule decisions that a particular faction opposes.
Other Cases Specifically Reject The "Rule" of Official Comment 11
There are no reported USA cases which support the position, advanced in Official
Comment 11, that clearing firms are immune from liability so long as they are
performing functions that they place within the scope of their clearing
contracts. However, there are decisions denying summary judgment motions of
clearing broker-dealers under USA based "materially aids" statutes. And, there
are cases addressing clearing broker liability under the more stringent
standards of federal rule 10b-5, which has no "material aid" provision. Among
the cases are the following:
McDaniel v. Bear Stearns Co., Inc., 1967 F. Supp.2d 343 (SDNY 2002). Affirming
arbitration award against clearing broker under New York common law for aiding
and abetting fraud, and noting that "where a clearing firm moves beyond
performing mere ministerial or routine clearing functions and becomes actively
and directly involved in the introductory broker's actions, it may expose itself
to liability with respect to the introductory broker's misdeeds."
Hirata v. J.B. Oxford & Co. 193 F.R.D. 589 (S.D. Ind. 2000)(denying motion to
dismiss of a clearing firm on a claim that the clearing firm was liable under
the "material aid" provisions of the USA, as enacted by the Indiana Securities
Act, §§ 23-2-1-19(d)).
Faturik v. Woodmere Securities, Inc., et al., 431 F. Supp. 894, 896 (S.D.N.Y.
1977). Federal securities law claims against clearing broker, Bear Stearns &
Co., arising out of his relationship with his introducing broker, Woodmere
Securities. Plaintiff alleged that defendants churned his account and executed
unauthorized trades. Bear Stearns asserted that it, as clearing broker,
performed "mere clerical functions" and therefore could not be liable to the
plaintiffs under any theory. In rejecting the clearing firm’s arguments, the
court held that the clearing firm could be liable as an aider and abettor under
§10 (b)[before Central Bank’s elimination of aiding and abetting liability]. In
so doing, the court stated that "Bear Stearns’ knowledge of vigorous trading
activity in plaintiff’s account (by virtue of its record-keeping function) put
Bear Stearns on notice of possible churning." Id. Moreover, the court found that
Bear Stearns, as clearing broker-dealer, was a fiduciary to the customer and, as
such, bore "fiduciary responsibility to plaintiff requir[ing] it to inquire
further into the circumstances surrounding the trades." Id.. The court said
"that clearing brokers are [not] per se insulated from liability simply because
they execute and/or clear trades from another broker and not from the customer
himself. Suffice it to say that, in appropriate cases, subject to proof of
knowledge and assistance sufficient to establish aider or abettor liability
under § 10 (b), or proof of an actionable violation of Rule 405 [Know Your
Customer Rule], clearing brokers may be liable for the manipulative or deceptive
schemes of trading brokers." Id.
Cannizzaro v. Bache, Halsey Stuart Shields, Inc., 81 F.R.D. 719, 721 (S.D.N.Y.
1979). Federal securities claims against introducing broker and clearing
broker-dealer for churning and unsuitable transactions in plaintiffs’ account.
Clearing firm unsuccessfully asserted that it could not be liable for the wrongs
alleged because no direct relationship, contractual or otherwise, ever existed
between it and the customer and because it was merely performing mechanical
functions for the introducing firm. Id. The New York District Court, following
the Faturik decision, supra, held that where, as here, the clearing firm knew of
the wrongdoing and assisted in it by clearing the orders put to it by the
introducing broker, it could be liable under federal securities laws for aiding
and abetting. Id.
In re Atlantic Financial Management, Inc. Securities Litigation, 658 F. Supp.
380 (D. Mass. 1986). Plaintiffs in a multi-district litigation case brought
federal securities law claims against their investment advisor and clearing
broker. Plaintiff’s claims arose out of a failed fraudulent investment in a
stock whose price was intentionally manipulated by defendants. Id. at 381.
Plaintiffs alleged that the clearing broker, Paine Webber, knew of the
investment advisor defendants’ underlying wrongdoing, that as a result, the
clearing broker-dealer had a duty to inform the plaintiffs, and that its failure
to do so resulted in aider and abettor liability under § 10 (b). Id. In its
holding, the court recognized that even in the absence of a duty of disclosure
running from the clearing firm to the investor, liability will attach where the
"plaintiff proves that the defendant had actual knowledge of the improper
activity of the primary violator and of his role in that activity." (citations
Margaret Hall Foundation v. Atlantic Financial Management, Inc., 572 F. Supp.
1475 (D. Mass. 1983). Court refused to dismiss federal securities law claims
against the clearing firm, A.G. Becker, Inc. in a case involving allegations of
stock fraud by the introducing broker. As in the case at bar, the clearing firm
unsuccessfully asserted the primary argument that it was "no more than a
clearing broker," that it simply took and handled orders from [the introducing
firm]," and that it was "not required to do anything more (or less) than
faithfully carry out these orders." Id. at 1480. In refusing to dismiss the
claims against the clearing firm, the court held that evidence of a "close
relationship" between the introducing and clearing firm, evidence that the
clearing firm allowed the introducing firm to use its name to "lend credibility"
to its enterprise, and evidence that the clearing firm was the customer’s broker
because it sent confirmation slips on transactions directly to the customer, all
supported claims against the clearing firm for aiding and abetting violations of
the federal securities laws and fraud. Id. at 1480-81.
Weisman v. Oliver Rose Securities, Inc., 1987 U.S. Dist. LEXIS 16788 (D. Conn.
1987). Plaintiffs alleged that clearing broker-dealer knew that broker was
engaged in improper trading practices by churning the accounts and making
speculative and unsuitable investments but continued to clear trades. Court
denied motions to dismiss claims made under Section 10(b) of the 1934 Securities
Act and the aiding and abetting statute of the Connecticut Securities Act. Id.
The Ross Case Cited In Official Comment 11 Is Inapposite and Outdated
The case cited in the Official Comment for the support of its proposition is
Ross v. Bolton, 904 F.2d 819 (2d Cir. 1990). While there have been many clearing
broker decisions over the last decade, it is curious that the SIA and the
Commissioners chose a decision that is more than 12 years old to support the
Official Comment. The Ross case is inapposite. The case did not involve the "
material aid" language of the Uniform Securities Act. In fact, the Ross case did
not include any Uniform Act provision. It was concerned with participant
liability under Section 10b of the 1934 Securities Exchange Act, and such
liability has not existed under the federal statute since Central Bank of Denver
v. First Interstate Bank of Denver, 511 U.S. 164 (1994).
Moreover, Ross is premised upon a federal securities law concept that has no
place in the "materially aid" jurisprudence of the USA. The Ross court noted
that, under Section 10b, "if there is no fiduciary duty . . . the scienter
requirement increases, so that appellants need to show that Bear Stearns acted
with actual intent." That statement cannot be reconciled with the burden
shifting provisions in the USA "materially aid" section
Ross has been distinguished by the courts. In In re Blech Securities
Litigation., 961 F. Supp. 569, 585 (SDNY 1997), the court found Ross not to
apply to a case in which plaintiffs had alleged that Bear Stearns had knowledge
of a fraudulent scheme. And, in a later Blech decision, 2002 U.S. Dist. LEXIS
19835 (S.D.N.Y. Oct. 17, 2002), the court denied the clearing broker’s summary
Clearly, the Ross decision has nothing whatsoever to do with and does not
represent the law of broker-dealer liability under § 509(g)(4) of the USA.
In closing, I would like to say that I support your hard work in revising the
Uniform Securities Act. In light of the foregoing, however, I can only assume
that the Commissioner were unaware of the background, law and potential
consequences surrounding the inclusion of Official Comment 11 to Section
509(g)(4). If it is not too late, I would urge the Commissioners to remove the
Official Comment from the 2002 Uniform Securities Act. Alternatively, I would
ask that this letter be considered when the USA is next amended.
Thank you for your consideration.
Very truly yours,
Robert S. Banks, Jr.
cc: North American Securities Administrators Association