Although Arbitration is Favored, Courts Will Not Allow Investors to Arbitrate Claims
The United States Fourth Circuit determined that investors were not able to arbitrate claims against Raymond James Financial Services (RJFS) when they purchased fraudulent securities directly from Inofin, Inc. Raymond James Financial Services, Inc. v. Cary, 709 F.3d 382 (4th Cir. 2013). Investors were denied the right to arbitrate the claim because the investors established neither a contractual relationship that defined them as customers nor an agency relationship with RJFS. This case demonstrates that investors should have a clear understanding of the parties contractually responsible for managing their investment in order to obtain the broadest legal protections for their assets.
How the Securities Failed
Inofin, Inc. (“Inofin”) was a Massachusetts corporation that generated over $110 million from investors between 1994 and 2010. In January 2011, Inofin revealed that it was insolvent from losses that began in 2004 after the company commenced new types of lending that were not properly disclosed to investors.
Appellants in this matter were Inofin investors, who sustained losses on the unregistered promissory notes purchased between 2006 and 2008. In May 2011, Appellant/Investors filed a claim as a member of the Financial Industry Regulatory Authority (FINRA) against RJFS alleging that Kevin Keough, a registered representative of RJFS, assured them that “their investments were fully collateralized by auto loans when Inofin was actually operating a Ponzi scheme in which executives diverted the invested funds towards propping up their own businesses and covering personal expenses.” The Investors sought to arbitrate their claims pursuant to a FINRA rule, which requires FINRA members, including RJFS, to arbitrate disputes with customers.
Why The Court Did Not Allow For Arbitration
RJFS sought declaratory and injunctive relief barring arbitration of the investors’ claims because the investors were not customers of RJFS. The parties stipulated to the following facts regarding the investment:
- The investors had no personal contact with Kevin Keough, a registered representative, but David Affeldt, a tax attorney, personally met with the investors and recommended each invest in Inofin. David Affeldt never represented to the customers that he was acting for a person who claimed to be an RJFS representative or that he was affiliated with RJFS.
- The investors did not hold any accounts including trade accounts with RJFS at any time.
- The investors did not understand that they were purchasing Inofin or any other security from RJFS.
Based on these stipulated facts, the District Court agreed with RJFS that the investors were not customers and were not subject to the FINRA arbitration provisions.
On appeal, the investors requested that the Fourth Circuit read the FINRA Rule broadly based on the judiciary’s presumption in favor of arbitration. The investors’ claim to RJFS customer status hinged on their argument that Affeldt was an agent for Keough, such that when they were doing business with Affeldt, the investors were actually doing business with Keough – and by extension with RJFS.
Arbitration is a Matter of Consent
The Fourth Circuit explained arbitration is a matter of consent not coercion. The court was unwilling to require arbitration because a court cannot apply any presumption in favor of arbitration unless there already exists an enforceable arbitration agreement between parties. See UBS Fin. Svcs. V. Carilion Clinic, 706 F.3d 319, 323-325 n.2 (4th Cir. 2013).
As the District Court concluded, the Fourth Circuit affirmed that the connection between the investors and RJFS is much too attenuated. The Fourth Circuit explained that while a customer frequently relies upon the representations or reputation of the entity with which the entity deals, in this case, the investors made their decision to invest independently of any recommendation on the part of RJFS. To find a customer relationship in such a situation would impose responsibility on a company whose name was never so much as utilized to induce the investors to part with their funds. The Fourth Circuit rejected the investors’ claims that mere interaction between a member firm and third party can transform an investor who dealt only with the third party into a customer of the member firm.
The court went on to explain that the parties’ stipulations demonstrate the absence of apparent authority. Apparent authority is created by written or spoken words or any other conduct of the principal which, reasonably interpreted, causes a third person to believe that the principal consents to have the act done on his behalf by the person purporting to act for him. See Restatement (Second) of Agency §27. The investors did not have personal contact with a representative of RJFS or understand that they were purchasing Inofin or any other security from RJFS. Thus, the investors did not have the apparent authority of RJFS and are not customers.
The investors were not contractually defined customers entitled to arbitration as required by the FINRA Rules. Therefore, the investors were not able to take advantage of this procedural device to expedite the resolution of their claims. This case demonstrates an overarching importance for investors to identify the parties that owe a contractual obligation to properly manage their investment at the outset, as opposed to waiting until litigation arises.
Allen & Gooch is providing this legal update for informational purposes only. This article should not be construed as legal advice or a legal opinion as to any specific facts or circumstances. You should consult your own attorney concerning your particular situation and any specific legal questions you may have.