Customer Accounts Clearly Permitted Broker to Use Customer Assets to Finance Proprietary Transactions, Even Shady Ones
Susan M. Greenwood | Bloomberg Law
Resolving another piece of the fallout from the collapse of Refco, Inc., the U.S. Court of Appeals for the Second Circuit held that customer agreements (Agreements) between investors and Refco subsidiary Refco Capital Markets, Ltd. (RCM) did not contain actionable misstatements under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder.
Shady Accounting Affects Customer Accounts
Refco, the Second Circuit explained, was a holding company with three principle operating subsidiaries that “provided trading, prime brokerage, and other exchange services to traders and investors in the fixed income and foreign exchange market.” RCM served as a “securities and foreign exchange broker that traded in over-the-counter derivatives and other financial products on behalf of its clients.” RCM customers had non-discretionary brokerage accounts governed by the Agreement. In particular, the Agreement contained a provision allowing customers to finance transactions with margin loans from RCM. In exchange, the customers posted securities or other acceptable property as collateral. Once RCM extended a margin loan, it obtained the right to “rehypothecate” or repledge the securities and property in the customer’s account to finance its own transactions.
The rehypothecate provision figured prominently in plaintiffs’ fraud theory. Plaintiffs alleged that Refco suffered significant losses in the late 1990s due to uncollectible receivables. Rather than disclose these losses, however, Refco allegedly chose to hide them through a “round robin” loan scheme. First, Refco transferred the uncollectible receivables to Refco Group Holdings, Inc. (RGHI), a related entity owned by Refco’s then-CEO. Next, RCM extended loans to unrelated third parties that, in turn, lent the money to RGHI which then used it to pay down the uncollectible receivables. As a result, Refco could remove the uncollectible receivables from its books at the end of a reporting period and unwind the loans later. According to plaintiffs, RCM funded the third-party loans by using the rehypothecate provision to sell or lend customer assets. Refco undertook this alleged deception for six years. When the scheme finally came to light, Refco disclosed a $430 million uncollectible receivable and soon thereafter, filed for bankruptcy.
Refco’s downfall caused a “run” on RCM as customers attempted to claim their assets, but discovered that RCM lacked sufficient funds to cover the withdrawals. Indeed, RCM joined Refco in its bankruptcy filing and disclosed that it had only $1.905 billion in assets even though it owed its customers $4.16 billion.
Agreements Are Not Deceptive
Plaintiffs premised their Exchange Act claims on the allegedly deceptive nature of the Agreements, as well as their monthly account statements, and certain oral representations. Specifically, RCM allegedly extended margin credit to plaintiffs without adequately disclosing how the company used customer assets for its own devices. Plaintiffs’ claims, the Second Ciruit explained, essentially allege breach of the Agreement. While “[b]reaches of contract generally fall outside the scope of the securities laws,” the Second Circuit noted that such a breach “may constitute fraud where the breaching party never intended to perform its material obligations under the contract,” such that the “contract itself was a misrepresentation.” Particularized allegations, it continued, remain necessary as “a simple disagreement over the meaning of an ambiguous contract combined with a conclusory allegation of intent to breach at the time of execution will not do.”
According to plaintiffs, they believed that RCM would rehypothecate only securities and other assets that customers offered as collateral for margin loans. In reality, plaintiffs contend, “RCM routinely rehypothecated all of its customers’ securities regardless of the customers’ outstanding debt margin, and did so from the start of each customer’s account.” The issue then, the Second Circuit determined, “is whether RCM’s rehypothecation of securities even when they were not deemed collateral was so inconsistent with the provisions of the Customer Agreement that the Agreement was itself a deception.” Reviewing the plain language of the Agreement, the Second Circuit held that it was not deceptive.
As the Second Circuit explained, the Agreement “unambiguously warned the RCM Customers that RCM intended to exercise full rehypothecation rights as to the Customers’ excess margin securities.” Accordingly, RCM’s conduct did not support a misrepresentation claim under Exchange Act Section 10(b).
No Regulatory Protection
The Second Circuit, providing a background of margin trading, explained that such trading bears considerable risks and, consequently, U.S. federal and state regulations, as well as rules by exchanges and self-regulating organizations, promote restrictions on margin trading and rehypothecation. RCM, however, was organized under the laws of Bermuda. Although it operated from New York, it still held itself out as a Bermuda corporation. Indeed, the Second Circuit noted that “at least some of the RCM Customers understood it to be, an unregulated offshore broker.” Nevertheless, plaintiffs alleged that RCM was subject to multiple Securities and Exchange Commission rules and New York state law. The Second Circuit disagreed, citing precedent that a defendant cannot be held liable under the Exchange Act for violating a New York Stock Exchange rule unless the defendant represented that it complied with the rule. RCM did not represent that it complied with U.S. Federal law. Instead, it expressly noted that it was not a “U.S.-regulated company.” Similarly, RCM could not be held accountable under New York law simply because the Agreement contained a choice of law provision providing that New York law would govern conflicts arising from the Agreement.
No Additional Misrepresentations
Finally, the Second Circuit rejected plaintiffs’ allegations that their monthly account statements and certain oral statements by RCM representatives were false and misleading. Plaintiffs alleged that the identification on account statements of securities “In Your Account” falsely represented that those assets were not subject to rehypothecation. The Second Circuit, however, concluded that “no such inference could reasonably have been drawn by a signatory to the Customer Agreement” based on its plain language regarding RCM’s hypothecation rights. As for oral statements by RCM representatives, the Second Circuit explained that they “had no bearing on how RCM intended to use excess margin securities” and, therefore, did not support an action for securities fraud.
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