Liability of Clearing Broker-Dealer

Comment on the Uniform Securities Act

Changing the Liability of Clearing Broker-Dealer


Letter from Bob Banks

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
Executive Director
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 Cir. 1990).

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 stated:

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 omitted).

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. at 61.

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 judgment motion.

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

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