Steps to Avoiding Clearing Broker Liability
What is the relationship between a clearing broker and an introducing broker?
In the securities industry, there are two types of brokerage firms that service retail clients. There are those that process their clients’ own trades (those firms that “self-clear”), and then there are smaller brokerage firms, known as “introducing brokers,” that use a “clearing broker” to execute and process their clients’ purchases and sales of securities. Clearing brokers handle the back-office administrative tasks of executing, processing, confirming and settling trades but do not have any contact with the actual customer who is directing the securities transactions. The smaller, often “mom and pop”-like introducing brokers have direct contact with their investor customers, offering advice and making recommendations regarding their customers’ investment portfolios. Typically, these smaller introducing brokers do not have resources such as the expertise, personnel, or capital to execute their own trades.
Because clearing brokers serve an important function in the securities industry – permitting smaller firms to engage in the personal service of investors – the securities laws typically limit the liability of clearing brokers when there have been allegations of wrongdoing with regard to an introduced account. However, investors who feel that they have suffered damage in their securities account often sue both their introducing broker and their clearing broker, even though they have had little to no contact with the clearing broker at all.
What are three key steps a clearing broker can take to avoid liability?
- Ensure the clearing agreement—the contract between the introducing and clearing broker—details the exact roles of each party to the agreement, including what they will and will not do. For instance, the agreement will delineate that the introducing broker is the conduit between the client and the clearing broker and that the clearing broker’s role is limited to conducting trades that the introducing broker requests. This important agreement is the clearing broker’s first line of defense, and counsel can assist in ensuring the agreement contains the correct information and segregation of rights and duties.
- Ensure all of the paperwork between the clearing broker and customer delineates the difference in roles between the introducing broker and the clearing broker. Often because introducing brokers are small businesses, they rely on the clearing broker to send account statements and trade confirmations to the customer. It is important to have counsel review these communications to ensure that these documents fully inform the customer of the division of duties between the introducing and clearing brokers, thus properly protecting the clearing broker and educating the customer. Also, when the customer opens an account with an introducing broker, he or she typically also opens an account with the clearing broker. At this time, it is important that documents outline the clearing broker’s role and clearly state in terms that the customer will understand that the clearing broker relies solely on the introducing broker for information about the trades it will process and that the customer must contact the introducing broker for questions and information. It is very important that these communications clearly set out what the customer can and cannot expect from the clearing broker and explicitly state that all communications should be funneled through the introducing broker’s staff.
- Do not step outside the roles detailed in the clearing agreement. While arbitration panels and courts have held that clearing brokers performing ministerial duties are not liable for customers’ losses suffered at the hands of introducing brokers, there are some limited situations where clearing brokers have been found liable to customers of introducing brokers where the clearing broker stepped out of its routine responsibilities. If clearing brokers step outside the role set out in the clearing agreement and in the communications to the introducing broker’s customers, they can be at risk. It is important that they fulfill only the obligations set forth in the clearing agreement in order to limit liability.
What are some examples where arbitration panels and courts have found clearing brokers to be stepping outside its routine function?
Becoming directly involved in a specific securities transaction beyond merely processing the transaction: If a clearing broker is involved with an introducing broker’s day-to-day activity or pushing specific securities, then the clearing broker can be at risk for liability. There have been limited situations when the clearing broker has become involved in a scheme perpetuated by the introducing broker. For example, in the Blech cases in the Southern District of New York, the court found that the clearing broker had directed introducing brokers to make certain fraudulent trades and was an integral part of the fraudulent scheme at issue.
Aiding and abetting of poor or bad conduct: There have been instances where courts have found that a clearing broker could potentially be liable for aiding and abetting an introducing broker’s bad conduct where an introducing broker had a history of such conduct and the clearing broker propped up the introducing broker’s business activities by giving the introducing broker loans to continue its operations.
Are clearing brokers responsible for the alleged fraudulent behavior of introducing brokers?
Courts have found that, when clearing brokers stay within their defined roles as administrators that merely perform back office functions and executing trades, they are not liable for fraudulent or unlawful acts of the introducing brokers for whom they conduct trades. In order for the system to work, clearing brokers must stay within their contractual role, and if they do so, they will remain insulated from liability as Congress and the securities regulators intended when the rules permitting the division of introducing and clearing activities were enacted.