The Liability of Clearing Brokers to Public Investors

By | October 20, 2020

This blog post is offered, in part, as a primer for members of the judiciary, arbitration panels, and the bar who may be faced, perhaps for the first time, with a claim against a “clearing broker.” Understandingly, the role that clearing brokers play in the securities markets is not well understood by the general public, as clearing brokers operate under the radar of Wall Street and rarely make news.

Relationship among clearing broker, introducing broker, and introduced customers

In a nutshell, a clearing broker is a Securities and Exchange Commission (SEC) registered broker-dealer that executes, clears, and settles securities transactions on behalf of other broker-dealers and their customers. The broker-dealer for whom the clearing broker performs these services is called an “introducing broker” or “introducing firm” because it “introduces” the accounts of its own customers to its clearing broker to execute, clear, settle, and otherwise process their trades. The customers, in turn, are called “introduced customers.”

The clearing relationship between the introducing broker and its clearing broker is typically memorialized in a so-called “fully disclosed clearing agreement.” This agreement allocates the respective functions and responsibilities of the clearing and introducing broker in relation to introduced customers and their accounts. Introduced customers are required to be informed of the clearing agreement and the allocation of functions and responsibilities between the clearing and introducing broker under the agreement. The form of agreement is required to be reviewed and approved by the Financial Industry Regulatory Authority, an industry self-regulatory organization, whose rules are subject to SEC approval.

After signing the clearing agreement, the introducing broker transmits the names, addresses, and social security or tax identification numbers of its customers to the clearing broker.  The clearing broker then records introduced customers’ accounts on its books and records and provides custody of their cash and securities in their accounts. The clearing broker executes orders for the purchase and sale of securities in introduced accounts, as such orders are transmitted to it by the introducing broker. Upon execution of an order, the clearing broker issues a trade confirmation to the customer and clears and settles the executed trade with its counterparty on the exchange and with the introduced customer. The clearing broker may provide margin loans to introduced customers, upon their request, using the cash and securities in their introduced account as collateral of their margin loans.

Clearing brokers typically have no personal relationship with their introduced customers. Thus, they have no “know-your-customer” obligation vis-a-vis them and play no role in assessing their investment profiles or making investment recommendation to them. All these functions are entirely the responsibility of the introducing firm.

Two theories supporting liability of a clearing broker to introduced customers

My recent paper focuses, among other things, on the liability of a clearing broker to introduced customers for the misconduct of its introducing firms under two conflicting theories of liability, one, under federal securities law and common law, and, two, under the blue sky laws.

1. Theory under federal securities law and common law

Claims under federal and common law typically allege that the clearing broker knew or should have known of the misconduct of the introducing firm and substantially participated or materially assisted in the misconduct. Such claims are usually difficult to prove as courts have held that a clearing broker, performing only routine “back-office” functions, does not substantially participate or materially aid in the misconduct of its introducing firm. These courts have also held that a clearing broker generally owes no fiduciary duty to an introduced customer and, accordingly, is not required to monitor the conduct of the introducing firm for the customer’s benefit. Not surprisingly, claims against clearing brokers under federal law and common law theories of liability are typically asserted only when the introducing firm has become insolvent, leaving the usually well capitalized clearing broker standing as the remaining deep pocket of last resort. The Second Circuit’s opinion in Levitt v. J.P. Morgan, 710 F. 3d 454 (2d Cir. 2013), is a leading decision that articulates the liability of clearing brokers under the federal and common law.

2. Theory under blue sky laws

Claims against clearing brokers under the blue sky laws have faced fewer and lower hurdles, at least in some cases. While most federal and state courts have defined the liability of clearing brokers under the blue sky laws similarly to that found under federal and common law, the Supreme Court of Kansas did not do so. In its decision in Klein v. Oppenheimer & Co., 130 P. 3d 569 (Kan. 2006), the court applied the “material aid” provisions of the Kansas blue sky laws to the conduct of a clearing broker who did no more than routinely process the sale of securities by one of its introducing firms to the latter’s own customers. To escape liability, the clearing broker was required to show that it “did not know, and in the exercise of reasonable care could not have known, of the existence of the facts” constituting the misconduct of the introducing firm. While the holding in Klein has only been followed by one federal district court in pretrial rulings in a major litigation against a clearing firm under Texas blue sky law, it has seemingly impacted a number of arbitration claims against clearing brokers.

The standard of clearing broker liability under the blue sky law, as interpreted by the Kansas Supreme Court in Klein, is in direct conflict with the standard articulated under federal and common law in Levitt and numerous other cases. Klein would impose a new business model on clearing brokers, a model that would require clearing brokers to monitor the conduct of their introducing firms to avoid liability for their misconduct. Such a model would, not only be in conflict with the federal regulatory framework and caselaw, but would substantially increase the cost of clearing services for thousands of introducing firms and their customers for the benefit of only a small number of introduced customers whose introducing firms may have become insolvent after committing the misconduct and thus may have become incapable of responding in damages. My paper addresses the history and development of the federal regulatory framework and the policy reasons that motivated the SEC to facilitate the establishment of such a framework in terms of the uniform regulation of clearing brokers nation-wide for the benefit of public investors.

Henry F. Minnerop is a retired partner of Sidley Austin LLP in New York City. Mr. Minnerop was an ex officio member of the Clearing Firms Committee of the Securities Industry Association and its successor, the Securities Industry and Futures Market Association, for over thirty years. 

This post is adapted from his paper “The Role and Regulation of Clearing Brokers-Revisited,” available on SSRN.

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