As the Fourth Circuit Court of Appeals made clear a week or so ago, serving as a FINRA arbitrator seems rather apropos in a world where the score is not kept in kids’ baseball games (to avoid there being any “losers”), and where adults receive medallions celebrating the fact that they are “participants” in distance races, regardless of where they happen to finish, because merely trying is good enough.
With that in mind, pity poor Interactive Brokers: at almost the same time that it simultaneously settled three AML cases with the SEC, FINRA and the CFTC, respectively – to the collective tune of over $38 million – its successful vacatur of a $1 million arbitration award against it – an award that a Federal District Judge called “perplexing” and “baffling” – was reversed on appeal by a panel of the Fourth Circuit in a 2-1 decision, based on the application of the trying-is-good-enough standard. Not surprisingly, it wasn’t just the claimants who argued that arbitrators are free to ignore clear legal precedent, as they were joined in their appeal by several amici, consisting of the usual host of entities that complain that the entire arbitration system is somehow unfairly stacked against customers, including PIABA and the investor clinics at four law schools (some of which were funded with grants from FINRA). Troublesome law getting in the way of your recovery, like, say, a statute of limitations? Just ignore it! Focus instead on, um, fairness, yeah, that’s the ticket.
But I digress. The facts here – as taken from the Fourth Circuit opinion – were not in dispute:
- Claimants had brokerage accounts at Interactive
- The accounts were margin accounts
- The investments in those accounts were selected not by Interactive, but by a third-party money manager – who, sadly but predictably, is judgment proof – with whom claimants separately contracted
- Among other things, the third-party manager invested the claimants in an exchange-traded note, iPath S&P 500 VIX Short-Term Futures (“VXX”), which is tied to the market’s “fear index,” meaning the price fluctuates with the stability of the market
- Specifically, the third-party manager had claimants sell naked call options for VXX. If the market remained stable, the price of VXX would remain stable, the options would not be exercised, and the strategy would make money as claimants retained the premiums they received when they sold the calls. If, however, the market became volatile, the price of VXX would increase, the options would be exercised, and the strategy would lose money
- FINRA Rule 4210(g) prohibits trades of certain high-risk securities in portfolio margin accounts, including trades of VXX
- For a time, claimants made significant profit in their accounts, including from the VXX naked call sale strategy
- On August 24, 2015, however, the Dow Jones Industrial Average underwent what was then the largest one-day drop in its history, causing claimants’ accounts to drop by 80%
- Because the value of the accounts fell below requirements for the amount needed to maintain a portfolio margin account, Interactive began auto-liquidating the accounts, pursuant to its contract with claimants
- Although Interactive sold everything in the accounts it could not recoup the full loss. Ultimately, claimants owed Interactive $384,400 for the unpaid debit balance.
Claimants won the arbitration, and Interactive filed a motion to vacate the award with the Federal Court in Virginia, essentially arguing that the arbitration panel “manifestly disregarded” the law. In short, Interactive argued this (almost) syllogism:
- It is undisputed that the controlling law provides there is no private right of action for violation of FINRA rules, including Rule 4210(g)
- The basis for the panel’s decision that claimants won was that Interactive violated FINRA Rule 4210(g) by allowing claimants to trade VXX in their margin accounts
- Because the panel was legally precluded from basing its decision on a violation of a FINRA rule, and was aware of that fact, it was evident that the panel knowingly elected to disregard controlling law, a concept known as “manifest disregard,” which certain circuits, including the Fourth, recognize as a basis for vacating arbitration awards
The District Court wholeheartedly agreed with Interactive. It scrutinized the award of damages, but could find no legal basis for it. Accordingly, the Court remanded the case back to the hearing panel to explain how it conjured up the damages.
The panel then proceeded to amend the award, in an effort to address the Court’s concern.
Not surprisingly, Interactive went back to the Court, renewing its argument that the award was not permitted under controlling law. Once again, the District Court agreed with Interactive, granting its motion to vacate the award in favor of the claimants, and remanding Interactive’s counterclaim back to a new hearing panel this time. In what has become one of my favorite lines from any court, the judge who heard the case apparently said during oral argument that he was “just astounded at the jackleg operation that I see here. I don’t know why anybody would agree to have these people [the arbitrators] do anything,” based on his determination that because the panel based its finding that Interactive was liable to the claimants on FINRA Rule 4210, it constituted “a manifest disregard of the law because the law is clear that there is no private right of action to enforce FINRA rules.” From there, claimants – aided by their friends at PIABA, et al. – appealed.
As the title of this post makes clear, the Fourth Circuit – in a 2-1 split decision – saw things differently. First, it concluded that it was not necessarily true that the panel based the award solely on its conclusion that Interactive violated Rule 4210(g) (this despite the fact that the panel, in its amended award, specifically explained that it denied Interactive’s counterclaim because of a perceived Rule 4210(g) violation, noting that Interactive’s “position that the Panel should not enforce a FINRA rule amounts to saying that FINRA should provide an opportunity for investors to commit financial suicide by investing in securities that are ineligible for inclusion in a portfolio margin account. To ignore a FINRA rule by the Panel would defeat the purpose of FINRA”).
Second, after observing that the panel “simply did not state which cause of action provided the basis of its award to the” claimants, the appeals court proceeded to speculate that it was possible the award was based on a breach of contract theory. Specifically, like probably every customer agreement ever, the claimants’ agreements recited that “All transactions are subject to rules and policies of relevant markets and clearinghouses, and applicable laws and regulations.” The Court then noted that “[t]his, of course, includes the publicly available FINRA rules,” including Rule 4210(g). Thus, “the clause could well be read as incorporating the FINRA rules, making a violation of the rules a breach of the parties’ contracts.”
So…even though a claim for violation of FINRA rules cannot be brought by a customer – because there is no private right of action – the Fourth Circuit found a back door for a customer to do just that, by calling it, instead, a breach of contract.
Why did the Court go through such mental contortions to find a way not to vacate the award? No need to guess, as the Court supplied the answer at the end of its decision: “Without appropriate deference to arbitrators, the costs of vindicating rights drastically increase, threatening to foreclose yet another avenue of relief for ordinary consumers who routinely enter contracts with mandatory arbitration provisions.”
Where does this leave us? Arbitrators are happy, since they don’t have to worry so much about applying that pesky law to the facts. As the Court recognized, its job was “to determine only whether the arbitrator did his job – not whether he did it well, correctly, or reasonably, but simply whether he did it.” (Ah, here’s your “participant” award!) Claimants – their lawyers, actually – are happy, because they are newly emboldened to encourage panels to ignore clear, binding law. The only ones who are not happy are the respondents (and their counsel, of course), who are forced to reckon with the fact that arbitrations are, basically, free-for-alls, where the law plays only a minor role in the outcome.
 The court wrote that a new panel was necessary due to the original panel’s “rather flagrant disregard of settled law.”