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LITIGATION 2009

Home Court Disadvantage

Investors have long complained that securities arbitration is biased toward brokerages. But this year arbitrators socked Credit Suisse with a $431 million award. More big cases are on the way.

The American Lawyer

By Nate Raymond

November 01, 2009

Most lawyers in Andrew Weissmann's position would not have chosen to bring a $400 million claim against Credit Suisse Securities (USA) LLC to the Financial Industry Regulatory Authority (FINRA). But Weissmann didn't have a choice. When investors get into disputes with their brokers, the fine print requires them to go before FINRA arbitrators, even if the plaintiff is one of the largest semiconductor manufacturers in the world, and the beef centers on the suddenly illiquid assets known as auction-rate securities.

Weissmann, a litigation partner at Jenner & Block, wasn't born yesterday. FINRA's reputation for siding with the securities industry was long lamented and well-known to even casual investors. But sometimes even the home court turns out to be unfriendly. In February the FINRA panel handed STMicro­electronics N.V. a $431 million award, surprising the industry and opening the way to a record number of similar complaints brought by aggrieved investors, large and larger.

Thanks to the financial crisis, FINRA has been inundated with a wave of claims against brokerages--not just over auction-rate securities, but over a wave of products once obscure but now commonly derided, from collateralized debt obligations to collateralized loan obligations, to derivatives. Many of the actions are from individual investors, but increasingly, large corporations have found themselves filing multimillion-dollar claims to recoup losses.

FINRA says new case filings were up 65 percent as of August 2009, to 4,991. Nearly 15 percent of those involve derivatives, auction-rate securities, or variable annuities. In some cases the claims are larger than usually seen at FINRA, where the numbers rarely go beyond seven figures. A few large claims by companies against their brokers have been disclosed in Securities and Exchange Commission filings. In September, Move, Inc., went to arbitration against Citigroup Global Markets Inc., over $111.8 million in frozen securities held by the apartment rental company; the result was not known at press time. Immunomedics, Inc., has filed a claim against Banc of America Securities LLC, scheduled to be heard in April 2010, seeking to rescind its purchase of what in June was $22.3 million in outstanding auction-rate securities. Northern Lights Fund Trust is seeking more than $10.75 million from Oppenheimer & Co. Inc. And orthopedic device maker BioMimetic Therapeutics, Inc., which had auction-rate securities valued at $40 million at the end of June, brought a claim in February against Deutsche Bank Securities Inc. (Deutsche Bank has denied the claims in a securities filing. The other respondents declined to comment.)

FINRA and its predecessors have long been the financial services industry's preferred venue for claims. But if the Credit Suisse case is any indication, securities firms should be on alert: Not only could they lose in a FINRA arbitration, but they could lose big. And with the number of large claims increasing, odds are growing that more multimillion-dollar awards could be in the pipeline. Perhaps arbitration isn't that favorable for securities defendants after all.

• Read all the features in the Litigation 2009 report.
  

Born out of the consolidation of the National Association of Securities Dealers and the enforcement and arbitration division of the New York Stock Exchange, FINRA is now the default venue for a variety of claims against the brokerage industry. Former employees have to go before FINRA if they think they were underpaid or wrongly fired. Firms fight each other there over talent raids. And customers who have gripes with their securities brokers must bring their cases there, too.

With each recession comes a wave of new securities arbitrations. This time, most customer claims focus on a range of exotic new financial products that financial institutions marketed as being as safe as money market accounts. Particularly common are claims involving auction-rate securities, a type of long-term debt instrument that investors could unload during weekly or monthly auctions. The market for this product partially froze in August 2007 and completely shut down by February 2008, making it impossible for investors to sell. "A lot of the claims are now by bond or bond-fund investors — people who thought they were not taking a lot of risk," says Brian Smiley, a partner at Smiley Bishop & Porter and president of the Public Investors Arbitration Bar Association.

Under FINRA rules, a three-person panel hears securities claims larger than $100,000, while smaller claims go before a single arbitrator. The arbitrators are selected from randomly generated lists supplied by FINRA: Each side crosses off the arbitrators it doesn't want, and ranks the remaining candidates in order of preference. The three-person panels feature two "public" arbitrators with no ties to the securities industry, and one arbitrator from the industry, usually current or former brokers or brokerage lawyers.

The inclusion of an industry representative has long fueled claims that the FINRA playing field is tilted toward brokerages. Attorneys for investors point out that from 2003 to 2008, customers won damages in only 27 percent of cases filed. Lawyers for securities firms contend that those statistics leave out settlements, which account for roughly half of results in recent years. Plus, they argue, there's value in having an industry representative on arbitration panels. "I think the [securities] defense bar has always thought and continues to feel [that] it's helpful to the case to have someone with industry experience," says Joel Forman, a partner at Curtis, Mallet-Prevost, Colt & Mosle.

FINRA takes the bias claims seriously and has been making efforts to address them. In June 2008 it began a two-year pilot program involving 11 securities firms that allows claimants to choose panels without an industry representative. And in March 2009 FINRA doubled the size of claims that can go before just one arbitrator from $50,000 to $100,000. Still, claimants argue that those measures aren't enough. In June the Public Investors Arbitration Bar Association asked the SEC, which must approve rule changes to FINRA's dispute resolution process, to require all-public panels for investor claims that top $100,000.

In auction-rate securities cases, some smaller investors benefit from new, more investor-friendly arbitration rules introduced through settlements negotiated by New York attorney general Andrew Cuomo and other state regulators. But ST, Move, and many other companies couldn't take advantage of the provisions in these settlements, which only covered claims of $10 million or less. Many large corporations holding auction-rate securities have eight-to-nine-figure claims.

Such large claims hold the promise of more large awards in FINRA arbitration, which more typically sees five-to-six-figure awards. Before the Credit Suisse award, only one award from a securities arbitration broke the $100 million mark, according to the Securities Arbitration Commentator, a newsletter and award research service [see chart, page 40]. (The $429.5 million judgment against former PaineWebber broker Enrique Perusquia has never been collected by the investors, represented by Houston's Thomas Ajamie of Ajamie LLP and Ralph Midkiff at Chamberlain Hrdlicka.)

But experts say that the paucity of large awards is mostly a result of the kind of claims filed in the past, which rarely involved large corporations clashing with their brokerages. "Arbitration, whether you like it or not, is geared toward any size and any complexity," says Fordham University law professor Constantine Katsoris.

Lawyers who represent investors are careful about what they say about the FINRA process, worried about angering an arbitrator before their case starts. Generally, though, they say they would prefer to be in litigation. "I would love this case before a jury," says one lawyer representing a company with more than $100 million at issue. But he says he has to wonder how FINRA's reputation for an industry bias might affect his client's chances.

FINRA arbitrations don't provide for discovery, which could also be a challenge for investors' lawyers, due to the complexity of the products at issue. "They're financial product liability cases, and you really need to look under the hood and see what did the brokerage know and when did they know it about these products," Smiley says.

And even as the economy hints at a recovery, filings continue, including more claims over auction-rate securities. "We're seeing kind of a second wave," says Charles Miller, a partner at Kas­owitz, Benson, Torres & Friedman, which represents more than a dozen companies in FINRA fights with claims ranging as high as hundreds of millions of dollars. "The things that [investors] were waiting for were either that the market would revive, that the issuers would redeem the securities, or that the brokers would provide liquidity as they said they would." In the auction-rate securities cases being filed now, that didn't happen, Miller says.

ST's case against Credit Suisse presents a rare window into what a large-scale securities arbitration with hundreds of millions of dollars at stake can look like. While its facts are admittedly unique, the case does hint at what lawyers say are common arguments by securities firms trying to escape paying up. They also show the uphill battle that investors face, thanks to hostile witnesses and restricted discovery, and how a need for creativity in finding evidence may help. And it shows the challenges of picking an arbitration panel in such a large case.

Credit Suisse was among the earliest firms to get hit with arbitration claims arising out of the financial crisis. The Geneva-based bank's problems spilled out of the conduct of two of its brokers, Julian Tzolov and Eric Butler.

According to prosecutors, Tzolov and Butler told clients in e-mails that they would invest their money in auction-rate securities backed by student loans, which were considered a safe investment since they had the backing of the federal government. But Credit Suisse's customers say that starting in August 2007, after the auction-rate market began to falter, they learned that Tzolov and Butler had invested their money in collateralized debt obligations (CDOs) that were heavy in subprime mortgages.

The two brokers were quietly pushed out by Credit Suisse in September 2007. The U.S. attorney in Brooklyn secured indictments against them in September 2008, and the SEC filed civil actions against the two. Tzolov, represented by Manhattan criminal attorney Benjamin Brafman, pleaded guilty to fraud charges this past July after two months as a fugitive. Butler, represented by Paul Weinstein at Emmet, Marvin & Martin, was found guilty on three counts of fraud on August 18. Weinstein says Butler will appeal.

Credit Suisse said it cooperated with the government, and the firm was never charged by the SEC or the U.S. Department of Justice. But Tzolov and Butler's former customers began filing arbitration claims. One of Credit Suisse's lawyers, Bingham McCutchen partner Kenneth Schacter, said in a declaration filed in the two brokers' criminal case in March that the bank has been targeted by "multiple" arbitrations, although the bank declined to say exactly how many. Along with Bingham, Credit Suisse has turned to Link­laters and Mayer Brown to fight off the customer complaints.

Jenner & Block's Weissmann came to represent at least three Credit Suisse customers, including ST. (Weissmann declined to comment for this article.) ST's case moved into FINRA arbitration. Weissmann argued that Credit Suisse had intentionally disregarded ST's instructions to invest in government-backed securities, instead plunging the company into CDOs and credit-linked notes. "In order so that ST would not discover that this is what Credit Suisse had done, it took a number of steps," Weissmann said in his opening argument, according to transcripts. "But the main one, and it is a word I tend not to use, is, they lied repeatedly to ST."

Linklaters partner R. Paul Wickes (now retired from the firm) countered that ST was not a typical customer. It was a sophisticated public company that should have known what it was buying, even if Tzolov and Butler were lying. Wickes said that ST had been given confirmations, monthly account statements, and reports that showed that it was invested in CDOs, not student loans. "[ST] is a major multinational company--sophisticated management, checks and balances," Wickes said. "All the kinds of things you expect in a big company and nobody, apparently, is opening the mail."

FINRA arbitrations do not typically allow for depositions, though a few took place in ST's case. The proceedings also lacked two of the primary witnesses, Tzolov and Butler, who invoked Fifth Amendment rights when subpoenaed. Weissmann was not helpless, though. The indictments of the two brokers shed light on some activities and documents at Credit Suisse. And a former CS employee, Melinda Peacock, testified for Weissmann on how Tzolov and Butler's operations worked.

ST also managed to secure what Jenner lawyers would later call in court papers "damning testimony" from several witnesses. Their biggest score came after a Credit Suisse private banking manager--responding to a question from an arbitrator — acknowledged that the bank bore "culpability." The arbitration panel subsequently suggested adding a claim of negligent supervision against Credit Suisse. The bank protested, arguing that it wasn't appropriate to add a new claim midtrial, but the panel approved adding the claim.

The culpability question came from John Duval, Sr., the industry representative on the arbitration panel. Credit Suisse now says that the panel's selection was flawed and should have screened out Duval based on undisclosed past claimants-side work.

In arbitration, picking the right panel is as important as making the right arguments. Decisions can hinge on the personalities overseeing a case. In the ST case the panel selection was especially important since the amount at stake was "unusually large," as Jenner & Block associate Matthew Alsdorf, representing ST, wrote in a letter to FINRA in May 2008. After reviewing FINRA's first list of possible arbitrators, Alsdorf wrote that both sides wanted to use "a list of arbitrators who have previously handled large, legally intricate disputes."

FINRA agreed, and a new set of 24 arbitrator candidates was given to ST and CS. During panel selection, Credit Suisse attorney Wickes had listed Duval as his second choice for the nonpublic arbitrator--the slot that, according to investors' lawyers, usually favors securities firms. A former branch manager at Merrill Lynch & Co., Inc., Duval said in his disclosure form that he had taken up a second career as a mediator and litigation consultant for both sides. (The two "public" arbitrators were former CIT Corporation general counsel Alvin Green, now at Seham Seham Meltz & Petersen in New York, and Charles Titterton, a former insurance group director at Standard & Poor's.)

But as the ST proceedings got under way, Wickes said at the hearing, Credit Suisse's lawyers noticed in the transcripts that Duval mentioned he'd been an expert witness in a lot of cases. After some inquiries, CS's lawyers got their hands on a nonpublic transcript from an arbitration from 2005 in which Duval said he'd been an expert witness more than 25 times, "once or twice for respondents and the balance for claimants." To Wickes's team at Linklaters, it seemed to suggest that their industry man was not so industry. To Weissmann's side at Jenner, it seemed like an argument designed to create delay, pressure Duval, and create an appeal issue. (Duval says his FINRA profile discloses that he takes cases for both sides, and adds that in his last two cases, he was hired by respondents.)

In a January hearing, Wickes moved for Duval to recuse himself, since "the case has moved in the direction which it now seems to have taken as being primarily about failure to supervise." Weissmann, ironically, found himself defending FINRA's arbitration structure. "These may be disadvantages, but one of the pluses is that you have people who bring to bear knowledge," he argued. The chair of the proceedings, Alvin Green, ruled against Credit Suisse, and Duval stayed on.

In the months since the arbitration, Credit Suisse has tried to vacate the $431 million award (which included $25 million in interest), citing Duval's alleged conflict and contending that the panel incorrectly applied the law. Credit Suisse also continues to argue that ST's reliance on Butler and Tzolov's misleading e-mails was not reasonable, since the bank provided other, accurate documents to the company.

Vacating awards is a tough business, thanks to FINRA's rules and those customer agreements. "The standard is a very high bar you have to clear, and most applications to vacate are rejected," says Quinn Emanuel Urquhart Oliver & Hedges partner David Elsberg, who currently represents hedge funds in FINRA arbitrations. Still, Credit Suisse has brought in appellate specialist Andrew Frey at Mayer Brown for the fight. At press time a decision from Manhattan federal district court judge Deborah Batts was pending. Regardless of the result, though, the award against Credit Suisse is a reminder that big pain can come from these arbitrations, despite their alleged bias. And, with billions lost, the odds are good that investors will keep trying their luck. •

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