Correspondent clearing firms, which settle trades for smaller broker dealers, are worried.
At issue is a decision in an arbitration case in Oregon filed by six investors of the failed brokerage, Duke & Company. The decision spelled trouble for clearing firms, while providing a victory for six investors of Duke, a controversial firm found guilty of securities fraud in 1999 by the Securities and Exchange Commission.
The decision, because it was made in arbitration, will not set a precedent in future cases. But it will likely act as a guideline in other arbitrations.
Broker dealers hoping to hitch their wagon to a correspondent clearing firm should be concerned that the decision could lead them to conduct overly conservative screenings of the introducing brokers, warns Michael Udoff, vice president and associate general counsel at the Securities Industry Association.
The Duke investors contend that Duke's clearing firm, Fiserv Correspondent Services of Denver, Co., materially assisted in the unlawful transactions conducted by Duke. The panel sided with the investors, awarding them $1.8 million. Duke is no longer in business so Fiserv was left to pick up to the multi-million dollar price tab.
Appeal Lodged
At press time, Fiserv had lodged an appeal with the federal district court to vacate the award. Officials of Fiserv were not available to answer questions about the case. But others in the clearing industry were uneasy about the decision. "It will certainly make clearing firms take a second look [at the introducing brokers they take in]," said Joseph Turk, vice president of sales and marketing at U.S. Clearing, a division of Fleet Securities.
The SIA, for its part, fired off a 25-page opinion, asking the district court that the award to be set aside.
The SIA argued that Fiserv acted only in an administrative capacity in clearing and processing Duke's trades, and could not be held accountable for the broker's actions.
"Duke would not have been able to effect those instructions if Fiserv had not executed trades on Duke's instructions," Udoff contended.
Udoff offered the example of a telephone scam to underline his point. A telephone company should not be held liable for fraud perpetrated on its system by an unethical customer.
For introducing brokers, such as smaller market makers who depend on larger, well-capitalized broker dealers to keep their costs down, the Oregon case is ominous.
The case, if it stands, could increase the overall costs of clearing as firms pass along expected legal costs, Udoff said. Alternatively, it could reduce the number of clearing firms available to introducing brokers.
The Fiserv case could go away. Nobody is betting on that course, however. The correspondent clearing business, like the rest of Wall Street, is populated with armies of hungry attorneys lusting for the next lucrative case.
"They use to chase ambulances. Now the attorneys are chasing broker dealers," said Patrick Ryan, president of a small market-making firm in McLean, Va., who is alarmed at the litigious nature of the industry. (Ryan's firm, Ryan, Lee & Co. clears through Fiserv, though he expressed confidence in the long-term future of his clearing partner.)
The Fiserv case could have been different if the alleged misdeeds had occurred since the adoption of clearing industry rules by the New York Stock Exchange and the National Association of Securities Dealers about two years ago. The rules require correspondent clearing firms to notify the regulators of complaints they receive from customers of the introducing brokers.
"If the rule had been in effect at the time [of the alleged Duke fraud] it would not have hurt Fiserv," Udoff said. "If anything, it would have helped Fiserv."
Ryan's firm is probably typical of many of the introducing brokers who flock to larger correspondent clearing firms for their services. Ryan is concerned about the current turn of events in the Fiserv case.
"Some bad people filter into this business and the firms that are pulling off the fraud on public customers are usually clearing through larger firms," Ryan said.
There were several high profile cases in recent years involving correspondent clearing firms and their introducing brokers. In one case, a clearing firm was put out of business by the questionable trading activities of one of its introducing firms.
In another case, the Bear Stearns Companies in August 1999 settled fraud charges with the SEC and the district attorney in Manhattan. The case involved one of Bear's introducing accounts, A.R. Baron, a New York broker that went out of business. It left $75 million in customer losses. Bear, without admitting or denying guilt, agreed to pay $42 million to customers supposedly swindled by A.R. Baron.
Some clearing firm executives are quick to distance themselves from the unwelcome black eyes suffered by competitors. Indeed, some stress how rigid and rigorous their own due diligence process is when potential customers come knocking.
Turk at U.S. Clearing said his firm is very careful about the introducing brokers it accepts.
"We have always had the highest standards and looked very carefully at the background and the kinds of business [the introducing brokers] do," he said.
The process at U.S. Clearing typically takes about two weeks to complete. "It is an intensive process," Turk said. "We've turned away more than most other firms over the years and that has kept us out of trouble. If something makes us nervous, we'd rather pass [on the introducing broker]."
Small Firms
Ryan, for one, hopes the Fiserv case does not have a chilling effect for small firms like his own. A firm like his uses a clearing firm for an array of services: financing margin accounts; sweeping money into money market funds for retail customers; executing orders in a multiple of markets it does not cover; financing overnight balances (though Ryan says he does not need overnight financing at his desk).
Ryan said his costs are rising. In the move to decimal pricing, for instance, spreads will get squeezed like a lemon, he said. He does not need to assume the costs of clearing his own trades. Smaller broker dealers benefit when their choices include a large crop of clearing firms.
"There could be as many as 12 counterparties on a single share order of say, 10,000 or 20,000 shares," Ryan said. "You need a well-capitalized firm to clear the transactions in the most cost-efficient manner."
