Securities Regulation Daily Wrap Up, ARBITRATION—W.D. Wash.: Court grants preliminary injunction enjoining investors from pursuing claims in FINRA arbitration, (Mar 13, 2023)

By Sara Cracau, J.D.

Investors were not “customers” within meaning of FINRA Rule 12200 and, therefore, the FINRA proceeding was not properly commenced.

A federal district court in Washington has granted the motion for a preliminary injunction of a member of the Financial Industry Regulatory Authority (FINRA) barring investors from compelling the FINRA member to arbitrate the investors' claims to recover funds they lost in a private equity fund. The court found that the investors were not “customers” within the meaning of FINRA Rule 12200 and, therefore, the FINRA proceeding was not properly commenced against the FINRA member. Furthermore, it found that the FINRA member showed a strong likelihood of success on the merits, that it faced irreparable harm without issuance of the injunction, and that both the equities and public interest favored issuance of the injunction. Therefore, the four Winter factors favored issuance of the preliminary injunction (Oppenheimer & Co. v. Mitchell, March 9, 2023, Pechman, M.).

Firm says arbitration unavailable. A company, a FINRA member, filed a declaratory judgment action seeking to enjoin four investors from compelling it to arbitrate claims to recover funds they invested and lost in a private equity fund called Horizon Private Equity III LLC (Horizon). The investors had alleged that a broker registered with the FINRA member allegedly created and operated this fund as a Ponzi scheme. The court examined the crux of the issue in this case to decide whether the investors were “customers” within the meaning of FINRA Rule 12200. The court reviewed the facts surrounding the Horizon Ponzi scheme, the investors' investments in Horizon, and the investors' relationship to the FINRA member.

The investors alleged that from 2003 to the end of 2016, a registered broker of the FINRA member, operated Horizon as a $110 million Ponzi scheme through which the investors lost several million dollars. They alleged that this registered broker used his status as a registered broker to convince the public to invest. The registered broker also owned another entity, a registered investment advisory firm that was involved in the Horizon scheme and recruited his cousin to work for the second entity as an investment adviser. His cousin testified in a prior FINRA arbitration that he was led to believe when he was hired that Horizon was a fund created under the umbrella of the FINRA member. Furthermore, he marketed Horizon to the investing public at his cousin's direction and he received sales commissions based on the proportion of investments in Horizon.

The investors alleged that the FINRA member permitted and assisted its registered broker and his representatives to sell Horizon Ponzi scheme investments to the FINRA member's customers and the investing public. They further alleged that the FINRA member's management actively assisted his fraud as he funneled investor money into the Horizon Private Equity scheme and that they failed to supervise him while he was their licensed representative.

Two investors alleged that they lost $1.6 million investment in Horizon after being assured by its registered representative and his cousin that Horizon was a “safe, low-risk investment.” Two other investors alleged that they invested $600,000 in Horizon in 2016 after being pitched by the company's registered representative and his cousin. All the investors received statements indicating that they had investments in the FINRA member. The parties agreed, however, that the investors did not have a direct relationship with the FINRA member, did not receive account statements from it, and had no written agreement with it. The FINRA member also provided evidence to show that the registered agent was not associated with or employed by it in 2016 when the investors allege that he pitched them on investing in Horizon.

Subject matter jurisdiction. The court determined that it had subject matter jurisdiction over this matter because the parties were diverse and the amount in controversy exceeded $75,000.

Likelihood of success. The court determined that it had authority to determine arbitrability. The parties agreed that FINRA Rule 12200 was the relevant agreement for the court to review and that binds parties like the FINRA member to arbitrate disputes in certain circumstances. Here, the FINRA member did not provide "clear and unmistakable" evidence to rebut the presumption that the court determines arbitrability. Because the obligation for FINRA members to arbitrate disputes arises from their business activities at the request of a “customer,” the court examined in detail whether the investors were “customers” within the meaning of the rule.

The court noted that the FINRA Rules defined “customer” only in the negative and then reviewed the various definitions articulated by various circuit courts. It concluded that an investor who purchases commodities or services from a FINRA member's associated person could also qualify as a “customer” and that this interpretation is supported by FINRA Rule 12200's plain language.

Here, however, the court found insufficient evidence that the investors purchased their shares of Horizon from an associated person or received services from him. As such, there was a strong likelihood that the FINRA member would succeed on the merits of its declaratory action. There was no evidence of a direct relationship between the FINRA member and the investors. There was also insufficient evidence to show that there was an agency relationship between two associated persons.

Irreparable harm. The court agreed with the FINRA member that it would be irreparably injured if it is forced to arbitrate when it is not required to even if the arbitration can be set aside. The court also found that the equitable considerations favored the FINRA member and noted that forcing a party to engage in arbitration when it is not required to serves no equitable purpose.

There also was no public interest in compelling the FINRA member to arbitrate if it was not required. Although FINRA rules are intended to help investors, the court noted that they should not be applied in a manner that would coerce FINRA members to arbitrate claims when they are not required.

The court, finding no realistic likelihood of harm resulting from enjoining a party's conduct, dispensed with the requirement for a bond.

The case is No. 23-cv-00067-MJP.

Attorneys: Jason D. Frank (Morgan Lewis & Bochius LLP) for Oppenheimer & Co. Inc. Craig Kuglar (Law Firm of Craig H. Kuglar LLC) for Steven Mitchell.

Companies: Oppenheimer & Co. Inc.

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