In the recent case Citigroup Global Markets Inc. v. Ghazi Abdullah Abbar, et al., 13 Civ. 2172 (2d Cir. Aug. 1, 2014), the Second Circuit held that, under FINRA rules, an investor who purchased an over-the-counter derivative from a financial institution was not a "customer" of the financial institution's affiliated broker-dealer, notwithstanding the broker-dealer's involvement in negotiating and structuring the sale, and with the continued operation of the transaction. As such, the broker-dealer could not be compelled to submit to a FINRA arbitration commenced by the investor to recover its losses.
In 2006, the claimant, Ghazi Abdullah Abbar, purchased two over-the-counter options through his family's wholly-owned investment vehicles (collectively, the "Claimants") from Citigroup Global Markets Ltd. (the "Seller"), a London-based affiliate of Citigroup Inc. The options offered the Claimants synthetic exposure to leveraged portfolios of hedge funds. The terms of the transactions were set forth in two option confirmations, each entered into by the Seller and one of the investment vehicles, respectively. The confirmations provided that the Claimants could make changes to the underlying portfolio of hedge funds over the life of the investments, subject to leverage limitations set forth in the confirmations.
A U.S. affiliate of the Seller, which was a registered broker-dealer and member of FINRA (the "U.S. Broker-Dealer"), negotiated the transactions with the Claimants and structured the options. Following the close of the transactions in May 2006, the U.S. Broker-Dealer continued to participate in daily operations of the transactions and stayed in contact with the Claimants. The U.S. Broker-Dealer performed due diligence on the hedge funds selected by the Claimants to determine the amount of leverage permitted under the options, assessed the Seller's risk exposure and reviewed the Claimants' portfolio changes for approval. The U.S. Broker-Dealer also prepared monthly transaction reports to send to the Claimants.
In late 2008, as a result of the financial crisis, the Claimants lost their entire investment. Thereafter, the Claimants filed a FINRA arbitration against the U.S. Broker-Dealer seeking to recover its losses. After two years of discovery and a trial on the issue of arbitrability, the district court ruled that the U.S. Broker-Dealer was not required to submit to arbitration because the Claimants were not the broker-dealer's "customers" under FINRA Rule 12200. The Court explained that "the planning, structuring, and other services performed by [the U.S. Broker-Dealer] in New York were ancillary and collateral to those central core transactions" entered into by the Claimants and the Seller. See Citigroup Global Markets, Inc. v. Ghazi Abdullah Abbar, et al., 943 F. Supp. 2d 404, 408 (S.D.N.Y. 2013).
The Second Circuit agreed. As a matter of first impression, the Court reviewed the scope of the term "customer" under FINRA Rule 12200 and held that a "customer" is a person or entity, other than a broker-dealer, which "either (1) purchases a good or service from a FINRA member, or (2) has an account with a FINRA member," and that the Claimants did neither of these things. Abbar, 13 Civ. 2172 at 17. Although the U.S. Broker-Dealer provided services to the Claimants, such as structuring the transactions and assisting in their operations, the Court found that these services were not "purchased" by the Claimants and were performed by the U.S. Broker-Dealer primarily to protect the Seller's "very considerable interest." Id. at 8. While the Abbar family investment vehicles were certainly customers of the Seller, as evidenced by the transaction documents, the Court determined that "the relationship does not allow [the Claimants] to compel arbitration against [the U.S. Broker-Dealer,] its corporate affiliate." Id. at 16.
The Court further explained that, in determining whether a party is a "customer" for the purposes of FINRA Rule 12200, it is not necessary to "make a detailed examination . . . of 'the substance, nature, and frequency of each interaction and task performed by the various persons . . . , their contemporaneous understandings . . . , and the extent to which the person's activities shaped or caused the transaction,'" because the only relevant determination will be whether the party opened an account with or purchased goods and services from a FINRA member. Id. at 19 (quoting Abbar, 943 F. Supp. 2d at 407). Recognizing the complexity often inherent in the global financial market, the Court reasoned as follows:
[F]inance nowadays often involves worldwide sources, networks of information, talent and technology. But multiple inputs do not necessarily create customer relationships in different places simultaneously. . . . The sprawling litigation that can (and did) result defeats the express goals of arbitration to yield economical and swift outcomes.
A simple, predictable, and suitably broad definition of "customer" is therefore necessary . . . [although] the definition closes the FINRA forum to some foreign transactions with little connection to the United States.
Abbar, 13 Civ. 2172 at 20.
While the Second Circuit's ruling addressed the issue of arbitrability, the Court's reasoning may have substantially broader impact. A broker-dealer has different obligations under the U.S. securities laws and rules to its customers than to entities with which it does not have a customer relationship. Under the Second Circuit's reasoning, a U.S. broker-dealer may not have the substantive obligations owed to customers where it negotiates and provides other services in connection with an over-the-counter option sold by its non-broker-dealer foreign affiliate.
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