Corporate Finance & Securities

When are FINRA Members Subject to the Arbitration Provisions of FINRA’s Customer Code?

The United States Court of Appeals for the Fourth Circuit has issued a trio of opinions in 2013 which determine the scope of FINRA’s customer code. The customer code allows customers of FINRA members to initiate arbitration proceedings against a FINRA member.

FINRA is a private self-regulatory organization that has the authority to exercise comprehensive oversight over all securities firms that do business with the public.

FINRA’s Customer Code governs arbitration between customers of FINRA members and FINRA members. (There is also an Industry Code which governs disputes between FINRA members.)

Rule 12200 provides that parties must arbitrate a dispute under the Customer Code if: (1) Arbitration under the Code is either: (a) required by a written agreement, or (b) requested by the customer; (2) the dispute is between a customer and a member or associated person of a member; and (3) the dispute arises in connection with the business activities of the member or the associated person, except disputes involving the insurance business activities of a member that is also an insurance company. (Emphasis added.)

The Trio of Fourth Circuit Cases
The Fourth Circuit has issued three opinions in 2013 which determine the scope of Rule 12200. In particular, the Court determined the definition of the word customer as used in Rule 12200. The definition is significant to FINRA members and those aggrieved by FINRA members because the Customer Code provides an appealing avenue to remedy for parties seeking compensation from FINRA members.

In all three of the cases, the Court was faced with similar facts: a party alleging to be a customer of a FINRA member had attempted to initiate an arbitration proceeding against the FINRA member pursuant to Rule 12200; the FINRA member filed suit in a federal district court seeking an injunction preventing the arbitration proceedings on the basis that the party initiating the proceeding was not a customer under Rule 12200 and thus had no basis to initiate the arbitration proceeding.

The Rule — “Customer” as Used in Rule 12200 Defined
The Fourth Circuit held that a “customer” for the purposes of Rule 12200 is someone who (1) is not a broker or dealer, (2)  purchases commodities or services, (3) from a FINRA member, (4) in the course of the member’s business activities, which are namely the activities of investment banking and the securities business.

How the Cases Applied the Rule

UBS Financial Services; Citigroup v. Carilion Clinic
UBS and Citi served as underwriters for an auction-rate bond and served as lead broker-dealers for Carilion’s auction-rate bond auctions. Carilion claimed that UBS and Citi misled it on the nature of the auction-rate bond market, failed to disclose material information, and violated fiduciary duties. Citi and UBS argued that Carilion was not a customer under Rule 12200 because Carilion did not receive investment or brokerage services. The Court disagreed and found that Carilion was a customer because Carilion contracted with UBS and Citi to provide investment and securities advice and services.

Morgan Keegan & Company v. Silverman
Morgan Keegan  had bond funds which were traded on the New York Stock Exchange. The Silvermans purchased the bond funds not from Morgan Keegan during the initial offering, but through Legg Mason, a third party, on the secondary market. The Silvermans never had a brokerage account with Morgan Keegan, but claimed a customer relationship on the basis that Morgan Keegan encouraged the Legg Mason broker to purchase the funds. The Court found this to be too tenuous of a relationship for the Silvermans to qualify as Morgan Keegan customers under FINRA’s Rule 12200.

Raymond James v. Cary; Smith; Barkin; and Spolar
The parties alleging to be Raymond James’ customers purchased securities after consulting with an individual that was not affiliated with Raymond James. The parties alleged that they were customers because the advisor who encouraged the purchase of securities split fees with another individual that was an associated person of Raymond James. The Court held that this transaction did not create a customer relationship with Raymond James because the securities purchasers did not have accounts with Raymond James, did not receive investment advice from someone claiming to be a Raymond James representative, and did not meet with a representative of Raymond James.

Key Takeaways from the Three Opinions

  1. An individual does not become a customer of a FINRA member by interacting with a third party who interacts with that FINRA member.
  2. FINRA members that directly provide any investment banking or securities services and advice to an individual are likely subject to the arbitration provisions of FINRA’s Rule 12200 with respect to that individual.


Kyle Hulten

When I'm not in the office I enjoy cooking, gardening, and watching my toddler son explore his little universe.

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