Liability Of Clearing Firms: Traditional and Developing Perspectives

By: Gerald B. Kline, Esq. and Raymond L. Moss, Esq.
[Published in Practising Law Institute; Securities Arbitration Handbook (1998 ed.)]

I. Introduction

Plaintiffs, seeking to maximize their recoveries, are generally inclined to cast a liability net over as many potential wrongdoers as possible. This observation is particularly valid in securities litigation and arbitration where broker-dealers, registered representatives, supervisory personnel, issuers and other parties are routinely joined as a matter of course. In the context of financially distressed or defunct introducing brokers, the plaintiff's search for the deep pocket frequently brings it to the clearing firm's front door. But is a clearing firm an appropriate liability target? Are clearing firms responsible for the alleged wrongdoings of introducing firms and their representatives? Do some clearing firms create liability for themselves where others do not? Do arbitrators adhere to court-ordained liability standards? Will potential industry rule revisions expand or contract clearing firm liability? This article generally explores these questions and surveys the current landscape and climate.1 

II. The Role of Clearing Firms

In a typical securities clearing arrangement, an "introducing broker" formally contracts with a "clearing" or "carrying" broker to complete and settle the securities trades of the introducing broker's customers. The arrangement benefits the introducing broker, which while providing investment advice through direct contact with its investor customers, may not have the financial resources, net capital, personnel or expertise to clear its own trades. As such, the clearing broker performs numerous back room and administrative functions for the introducing broker, including: record keeping functions related to transaction clearance and settlement; mailing of customer account documentation; maintenance of margin and income transactions; and protecting customer account assets. The clearing broker typically performs these functions through a "fully disclosed agreement" in which the introducing broker's customer is disclosed to the clearing broker to enable the mailing of trade confirms and account statements. The clearing arrangement itself is well-regulated; see ยง 17, Securities Exchange Act of 1934; NYSE Rule 382; Rule 3230, NASD Conduct Rules. Clearing arrangements abound within the securities industry. Indeed, they provide a vital resource to many securities dealers who could not otherwise participate in the retail industry. Recent industry statistics reflect that approximately one hundred twenty NYSE clearing firms serve the needs of more than four thousand introducing brokers.

1    The authors' commentary and observations in this article are solely designed to promote the bar's active and ongoing analysis of this area of broker-dealer litigation. Any views expressed herein do not apply to future cases, which by necessity will turn upon their particular facts and circumstances.