Marc J. Goldstein Arbitrator & Mediator NYC
September 28, 2011

Second Circuit Tackles “Nexus” Issue Under FINRA’s Arbitrability Rule

The arbitration rules of America’s Financial Institutions Regulatory Authority (FINRA) present a special, and sui generis, but economically significant, species of arbitrability controversies. FINRA, as successor to the National Association of Securities Dealers (NASD) is the self-regulatory organization of the securities industry. Established pursuant to the federal securities laws, FINRA rules provide that member firms agree to resolve certain disputes by arbitration under FINRA’s arbitration rules.

Last week the US Second Circuit Court of Appeals ruled against the US arm of the Swiss investment banking giant UBS on a FINRA arbitrability issue, made complicated by the fact that the claims related to UBS’s role as a market maker in the market for Auction Rate Securities (ARS). (UBS Financial Servs. v. West Virginia University Hospitals, Inc., 2011 WL  4389991  (2d  Cir. Sept. 22, 2011)). The ARS market largely collapsed in 2008, forcing issuers of ARS debt obligations to pay penalty interest rates and to incur other unepxected costs. In this case, UBS had acted as underwriter in the initial placement of municipal bond issues structured as ARS for a West Virginia state university hospital, and, after the initial issuance, conducted the “Dutch auctions” in which the ARS were traded and their interest rates were reset according to market conditions.

FINRA’s arbitration rules provide that they may be invoked either where there is an agreement to arbitrate under those rules, or where the claimant is a customer of a FINRA Member Firm and the claim concerns business transactions of the Member Firm. Here UBS argued, inter alia, that even if Claimant was a “customer” for UBS’s  services as manager of the Dutch auctions (which itself was not conceded), the claims did not relate to the auctions but to the alleged nondisclosure of UBS’s role in the actions to induce the customer to issue ARS and engage UBS as underwriter for the initial issuance.

This argument, that FINRA arbitrability depends on a nexus between the Member-customer relationship and the transactions giving rise to the claim, found favor with the dissenting judge on the panel, who considered that such a nexus requirement is implicit in the FINRA scope of arbitration rule, and that the nexus was missing here because the fraud allegations related to the original issuance and underwriting as to which there was no customer relationship (UBS having purchased the ARS outright as part of the underwriting).

The majority, however, while equivocal as to whether the text of the rule compelled the conclusion that such a nexus must exist, concluded that the initial underwriting and the subsequent auctions were so closely related that any nexus requirement that might exist was fully satisfied.

One notable aspect of the case is simply the fact that UBS as a Member Firm of FINRA concluded as a business matter that it preferred litigation to arbitration before a panel, selected by the industry self-regulatory authority, that would normally include one or more members with considerable securities industry experience at a Member Firm. This may well be a function of recent large FINRA arbitration awards against Member Firms,  most notably the $400+ million award to ST Microelectronics against Credit Suisse.

Also notable is that the Second Circuit analyzed the arbitrability issue without reference to the pro-arbitration bias of federal arbitration jurisprudence. The reasons for this are understandable and sound. The Member Firm of FINRA, like a Member State of ICSID, makes a conditional offer to arbitrate, which may be accepted if the putative claimant meets certain conditions. In the FINRA Rule, those conditions are, at least, “customer” status of the claimant, and that the claim relates to business transactions of the Member Firm. Those two criteria must be satisfied before the Court may find that any agreement to arbitrate exists. In this context, arbitrability is simply a matter of contract law without an overlay of federal pro-arbitration presumptions.




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