Second Circuit Enjoins FINRA Arbitration against Wachovia
Christina DeIasi | Bloomberg Law
The U.S. Court of Appeals for the Second Circuit reversed a district court’s order that compelled Wachovia Capital Markets, LLC (WCM) to arbitrate a dispute with VCG Special Opportunities Master Fund, Ltd. (VCG) over a credit default swap agreement. The Second Circuit held that VCG was not a customer of WCM, and thus, arbitration is not required under FINRA Rule 12200.
CDS Agreement between VCG and Wachovia Bank
In May 2007, Jonathan Wong (acting on behalf of VCG) contacted Scott Williams (a friend and WCM employee) to initiate negotiations for a credit default swap agreement (CDS Agreement) with respect to a collateralized debt obligation (CDO) issued by Forge ABS, LLC (Forge). After contacting Williams, Wong dealt primarily with two other WCM employees—Thomas Edwards and William McAndrews. Edwards and McAndrews were both directors of WCM’s CDO Trading Desk, and McAndrews also was a director of WCM and an officer of Wachovia Bank, N.A. (Wachovia Bank). Wong testified at deposition, however, that he never knew which Wachovia entity employed Williams, Edwards, and McAndrews.
The CDS Agreement ultimately was memorialized in four separate documents: (1) an International Swaps and Derivatives Association (ISDA) Master Agreement; (2) an ISDA Master Agreement Schedule; (3) a Credit Support Annex to the ISDA Master Agreement; and (4) a Trade Confirmation. Wong’s negotiations with Williams, Edwards, and McAndrews, resulted in the Trade Confirmation that confirmed the transaction’s terms. A Wachovia Bank employee executed the Trade Confirmation, which incorporated by reference the terms of the three ISDA documents. A Wachovia Bank vice president negotiated and executed those three ISDA documents.
In sum, the CDS Agreement required Wachovia Bank to pay a fixed, periodic fee to VCG over the course of the CDO. In return, VCG agreed to pay Wachovia if Forge defaulted on the CDO and deposited $750,000 with Wachovia as collateral security for its obligations. The ISDA Master Agreement Schedule included a “Disclaimer Clause” in which “each party disclaimed any reliance on the other party, or on any of the other party’s affiliates, in deciding to enter the Trade.” Each party also acknowledged that the “other party acts only at arm’s length and is not its agent, broker, advisor, or fiduciary in any respect. . . .”
VCG Was Not WCM’s Customer
A year later, VCG initiated a FINRA arbitration against WCM, alleging that WCM had (1) fraudulently induced VCG to enter the CDS Agreement, and (2) breached the FINRA Conduct Rules and its fiduciary duties. In response, WCM and Wachovia Bank sued to enjoin the arbitration. Among other things, they argued that an arbitration could not proceed because VCG was not a customer of WCM under the FINRA Code of Arbitration Procedure for Customer Disputes (FINRA Code). The FINRA Code “requires a member to arbitrate disputes in connection with the member’s business activities when requested to do so by its ‘customer.’”
On competing motions for summary judgment, the U.S. District Court for the Southern District of New York ruled that VCG was a customer of WCM. It explained that “because Edwards and Williams were employed exclusively by WCM, their role in negotiating the [CDS Agreement] was sufficient to implicate WCM in the deal in a manner that made VCG WCM’s customer.” The Southern District was not swayed by the Disclaimer Clause, noting that FINRA Rule 12100(i) defines “customer” broadly as anyone that is not a broker-dealer. It thus concluded that “‘FINRA intended to require its members to arbitrate disputes with the full array of parties with whom they have business dealings, without limiting the scope of the rule to parties who reasonably relied on the FINRA member for impartial advice.’” Accordingly, the Southern District directed the parties to proceed to arbitration.
Instead, WCM and Wachovia appealed. The Second Circuit reversed the Southern District’s decision, holding that “no reasonable factfinder could infer that VCG was a customer of WCM.” At the outset, the Second Circuit noted that “terms such as ‘customer’ should be construed in a manner consistent with the ‘reasonable expectations’ of FINRA members.” It then explained that VCG did not have a brokerage agreement with WCM. In fact, VCG conceded that neither WCM nor Wachovia Bank recommended the CDS Agreement. Moreover, unlike the district court, the Second Circuit found the Disclaimer Clause to be dispositive. That clause expressly stated that the CDS was an arm’s length transaction and disclaimed any advisory, brokerage, or other fiduciary relationship, between Wachovia Bank and VCG, and each of their respective affiliates. As such, the Second Circuit concluded, VCG was not a customer of WCM.
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