Levitt v. J.P. Morgan Sec., Inc.

• Decision Date: 15 March 2013
• Docket Number: No. 10–4596–cv.,10–4596–cv.
• Citation: 710 F.3d 454
• Parties: Robert LEVITT, for himself and as custodian for Richard Levitt and Monica Levitt, Stephen G. Siben, Philip C. Vitanza, for himself, Elizabeth Vitanza, and Luke Vitanza, John T. White, as Trustee, Guy V. Wood, as Trustee, Ted M. Jones, as Trustee, Kathryn N. Jones, as Trustee, Plaintiffs–Appellees, Robert Rice, Stephen Strobehn, Stanley Veltkamp, Carl Zander, Jr., Plaintiffs, v. J.P. MORGAN SECURITIES, INC., J.P. Morgan Clearing Corp., Defendants–Third–Party–Plaintiffs–Cross–Defendants–Appellants.
• Court: U.S. Court of Appeals — Second Circuit

710 F.3d 454

Robert LEVITT, for himself and as custodian for Richard Levitt and Monica Levitt, Stephen G. Siben, Philip C. Vitanza, for himself, Elizabeth Vitanza, and Luke Vitanza, John T. White, as Trustee, Guy V. Wood, as Trustee, Ted M. Jones, as Trustee, Kathryn N. Jones, as Trustee, Plaintiffs–Appellees,Robert Rice, Stephen Strobehn, Stanley Veltkamp, Carl Zander, Jr., Plaintiffs,

v.J.P. MORGAN SECURITIES, INC., J.P. Morgan Clearing Corp., Defendants–Third–Party–Plaintiffs–Cross–Defendants–Appellants.

No. 10–4596–cv.

United States Court of Appeals, Second Circuit.

Argued: Dec. 12, 2011.

Decided: March 15, 2013.

Kerry A. Dziubek (Michael D. Schissel and Mark A. Kleyna, on the brief), Arnold & Porter LLP, New York, NY, for Defendants–Third–Party–Plaintiffs–Cross–Defendants–Appellants.

Leslie Trager, New York, NY, for Plaintiffs–Appellees.

Before: POOLER, LIVINGSTON, and CARNEY, Circuit Judges.

LIVINGSTON, Circuit Judge:

Defendants–Third–Party–Plaintiffs–Cross–Defendants–Appellants J.P. Morgan Securities, Inc. and J.P. Morgan Clearing Corporation (referred to herein collectively as “Bear Stearns” ¹), pursue this interlocutory appeal from a June 24, 2010, decision and order of the United States District Court for the Eastern District of New York (Spatt, J.), granting in part and denying in part Plaintiffs–Appellees' motion for certification of a class pursuant to Fed.R.Civ.P. 23(b)(3). The Plaintiffs–Appellees (the “Levitt Plaintiffs” or “Plaintiffs”) are former customers of the New York broker-dealer Sterling Foster & Company, Inc. (“Sterling Foster”), for which Bear Stearns, as a clearing broker, performed certain settlement and record-keeping functions. The Levitt Plaintiffs allege that Bear Stearns violated § 10(b) of the Securities Exchange Act of 1934 by participating in Sterling Foster's market manipulation scheme. The district court concluded that the Plaintiffs' allegations satisfied Rule 23(b)(3)'s predominance requirement and granted class certification for violations of § 10(b).

On appeal, Bear Stearns argues principally that, as a clearing broker engaged in mere clearing conduct, it owed no fiduciary duty of disclosure to the Levitt Plaintiffs, who were customers of Sterling Foster, and that the district court erred in finding that Bear Stearns participated in Sterling Foster's market manipulation scheme to such an extent as to trigger a duty of disclosure to the Levitt Plaintiffs. Accordingly, Bear Stearns contends, the district court erred in finding that the Levitt Plaintiffs could rely upon a class-wide presumption of reliance pursuant to Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 92 S.Ct. 1456, 31 L.Ed.2d 741 (1972), and in therefore holding that the putative class could satisfy the predominance requirement of Rule 23(b)(3).

For the reasons stated below, we conclude that the Levitt Plaintiffs' allegations—principally that Bear Stearns participated in Sterling Foster's fraudulent conduct by, among other things, continuing to clear transactions for Sterling Foster despite alleged knowledge of the ongoing manipulative scheme and by failing to cancel unpaid trades in violation of Federal Reserve Board Regulation T—fail to trigger a duty of disclosure to Sterling Foster's clients such that the Affiliated Ute presumption of reliance applies. The Levitt Plaintiffs therefore fail to satisfy Rule 23(b)(3)'s predominance requirement. Accordingly, we reverse the decision of the district court certifying a class.²

Background

I. Factual Background

1. The Role of Clearing Brokers

Approximately ninety percent of the broker-dealers registered with the Securities and Exchange Commission (“SEC”) hire a clearing broker to perform the back-office services associated with securities trading. See Henry F. Minnerop, Clearing Arrangements, 58 Bus. Law. 917, 917 (2003) (“ Clearing Arrangements ”). “Major clearing firms ... handle millions of trades daily on behalf of customers of hundreds of [broker-dealers].” J.A. 973 (Expert Affidavit of Henry F. Minnerop). A clearing broker's involvement in any given transaction typically begins after the execution of a trade, when “the clearing firm processes, settles, and clears the transaction and prepares an appropriate trade confirmation” to send to the customer. Clearing Arrangements at 923–24. “The clearing firm ... maintains custody of the customer's securities and funds upon receipt, and may provide margin financing if the introduced customer has signed a margin agreement with the clearing firm.” Id. at 924. The broker-dealer typically retains all customer-contact functions, including soliciting customers, recommending the purchase or sale of securities to customers, and monitoring customers' transactions. Under the most common form of agreement between clearing brokers and introducing firms, known as a “fully disclosed” agreement, “the introducing firm discloses the identity of each of its customers to its clearing firm. The clearing firm then establishes on its books and records an account in the name of each introduced customer and ‘carries' that account with its own net capital.” Id. at 920. “Under these circumstances, the clearing firm's primary (and frequently only) source of information about the customer is the introducing firm.” In re Bear, Stearns Secs. Corp., Exchange Act Release No. 7718, 1999 WL 569554, at *5 (Aug. 5, 1999).

Broker-dealers employing the services of a clearing broker are known as “introducing firms,” to distinguish them from “self-clearing” broker-dealers, which perform all of the functions of a clearing broker internally. Contracting out for clearance and settlement services relieves introducing firms of the “huge costs associated with [these] ‘back-office’ operations.” Dillon v. Militano, 731 F.Supp. 634, 636 (S.D.N.Y.1990).

At all times relevant to the parties here, New York Stock Exchange (“NYSE”) Rule 382 permitted clearing brokers contractually to allocate all “know your customer” responsibilities—including “opening, approving and monitoring of accounts [and] safeguarding of funds and securities”—to the introducing firm. ³ J.A. 968–69 (Minnerop Aff.). Rule 382, as amended, thus “relieved clearing firms from their prior regulatory duty under NYSE Rule 405 to supervise introducing firms, including their sales activities.” Clearing Arrangements at 935; see also Fezzani v. Bear, Stearns & Co., 592 F.Supp.2d 410, 425 (S.D.N.Y.2008) (“Pursuant to the rules of the [SEC], the clearing broker does not supervise—and is not responsible for—the sales practices of the introducing broker. The introducing broker is responsible for its own sales practices, and responsibility cannot be transferred to or imposed upon the clearing broker.”). Rule 382 thereby “encourag[ed] minimally-capitalized brokerage firms to place investor assets into the custody of well-capitalized clearing firms that possess[ ] the operational capacity to process and clear transactions promptly and accurately and maintain timely and accurate brokerage records.” Clearing Arrangements at 936.

2. Sterling Foster and the ML Direct IPO

Sterling Foster was established as a broker-dealer in 1994; it retained Bear Stearns to serve as its clearing broker pursuant to an agreement dated April 14, 1994 (the “Agreement”). The Agreement provided that Sterling Foster would be

solely responsible for the conduct of the [customer accounts, or “Accounts”], and ensuring that the transactions conducted therein are in compliance with the Applicable Rules. Such responsibility includes, but is not limited to: (i) using due diligence to learn and on a continuingbasis to know the essential facts of each Customer ...; (ii) selecting, investigating, training, and supervising all personnel who open, approve or authorize transactions in the Accounts; (iii) establishing written procedures for the conduct of the Accounts and ongoing review of all transactions in Accounts, and maintaining compliance and supervisory personnel adequate to implement such procedures; (iv) determining the suitability of all transactions, including option transactions; (v) ensuring that there is a reasonable basis for all recommendations made to Customers; (vi) determining the appropriateness of the frequency of trading in Accounts; (vii) determining the authorization and legality of each transaction in the Account; and (viii) obtaining and maintaining all documents necessary for the performance of [Sterling Foster's] responsibilities under this Agreement and retaining such documents in accordance with all the Applicable Rules.

Bear Stearns issued a so-called “Rule 382 Notice” to Sterling Foster's customers; such notices “inform[ed] ... customers that their brokerage firm had entered into a clearing agreement with a specified clearing firm [here Bear Stearns],” J.A. 959 n. 13 (Minnerop Aff.), and “provide[d] a summary of the allocation of functions and responsibilities between the introducing and clearing firm as set forth in their clearing agreement,” id.⁴ Here, the Rule 382 Notice advised Sterling Foster's customers that “your brokerage firm [Sterling Foster] shall at all times be exclusively responsible for.... [t]he conduct of your account and ensuring that transactions effected therein are in compliance with all applicable law and rules.” The Rule 382 Notice further provided that Bear Stearns would “be responsible for ... [a]ny extensions of credit to [the customer], which includes complying with Regulation T of the Federal Reserve Board determining maintenance margin, paying and charging interest and rehypothecation or loan of any of your margin securities.”

In the two years following Sterling Foster's establishment in 1994, the firm underwrote five initial public offerings (“IPOs”) for which Bear Stearns served as clearing broker. In each of these offerings, Sterling Foster engaged in stock-manipulation maneuvers whereby it entered into secret agreements with inside shareholders which...