From Ulmer’s Broker-Dealer Law Corner Blog
By Kenneth F. Berg
I am fortunate to have Ken Berg, a commodities regulatory guru, just down the hall from me, so I’ve never had to learn that stuff too well. But, here, as you will see, there can be considerable overlap between the securities and the commodities regulatory regimes. The decision that Ken writes about arose in the context of a commodities purchase, but it may have a significant impact on securities arbitrations. It makes good reading, therefore, even for BDs that don’t trade commodities. – Alan
I have previously written about issues uniquely affecting individuals who are dually registered as securities representatives (Series 7) and commodities associated persons (Series 3). In an Opinion and Order issued June 4, 2019, Judge Joan Lefkow, a federal district court judge in the Northern District of Illinois, ruled on an issue uniquely affecting firms that are dually registered as securities broker-dealers and commodities futures commission merchants. An issue that arises not infrequently is whether a customer who trades only commodities can force the clearing firm to arbitrate at FINRA instead of at the NFA. Judge Lefkow said, “no.”
The facts are typical. The firm has a “division” registered with the SEC as a broker-dealer and is a member of FINRA. The firm also has a “division” registered with the CFTC and is a member of NFA. A group of about 300 customers opened commodities accounts traded under a written power of attorney by an independent commodity trading adviser (“CTA”) who made all trading decisions. Pursuant to the customer agreement, trading was limited to commodities futures contracts and options, and the FCM’s responsibility was limited to clearing the trades on commodity exchanges. Customers signed an arbitration agreement in a form prescribed by CFTC Regulation 166.5 that requires the FCM to provide a customer with a choice of three arbitral forums. If the customer fails to select one of these forums within 45 days, the FCM can choose.
The CTA trading these accounts specialized in selling naked natural gas options. In November 2018, natural gas prices spiked about 30%, placing the customers’ accounts on margin calls. The FCM liquidated the customer accounts as required by exchange rules, resulting not only in a loss of all funds deposited by the customers but also sizeable unsecured debits.
The customers filed arbitrations at FINRA alleging the firm violated the Commodity Exchange Act. The FCM notified the customers that they could choose to arbitrate at NFA, the Chicago Mercantile Exchange, or the AAA. The customers ignored the FCM’s notice and persisted in prosecuting their FINRA arbitrations. After 45 days passed, the FCM filed debit collection arbitrations against the customers at the NFA and an action in federal court seeking (i) an injunction to halt the FINRA arbitrations; (ii) a declaration that FINRA lacked jurisdiction; and (iii) an order compelling the customers to proceed with arbitration at the NFA under § 4 of the Federal Arbitration Act.
Three rulings by the district court are significant: 1. Even absent diversity, the court held it had subject matter jurisdiction because there was a federal question. 2. Even though the firm was a “member” of FINRA, it did not agree to arbitrate these disputes at FINRA because these were not “customers” under FINRA Rule 12200. 3. Even though firms have been sanctioned for seeking anti-arbitration injunctions, the court denied the customers’ request for sanctions.
The Federal Arbitration Act does not create subject matter jurisdiction in federal court, so absent diversity or a federal question, a federal court cannot hear a dispute just because it involves arbitration of interstate transactions. For example, a motion under § 12 of the FAA to vacate a FINRA securities arbitration award or an NFA commodities arbitration award cannot be brought in federal court if the parties are not diverse. Here, however, Judge Lefkow held that if the underlying controversy could have been brought in federal court but for the arbitration agreement because the claims allege violations of the securities or commodities laws, under § 4 of the FAA a court may “look through” the arbitration agreement and find federal subject matter jurisdiction.
FINRA Rule 12200 requires a member to arbitrate disputes with its “customers” that “arise in connection with the business activities of the member ….” Even though Rule 12200 does not define “customer,” Judge Lefkow held that “customer” means a person who engaged in “FINRA-regulated activities” with the member. Here, the customer agreement permitted the purchase and sale of commodities products regulated by the CFTC only. The court concluded that the firm did not agree to arbitrate these claims at FINRA and noted that its interpretation of FINRA Rule 12200 “harmonizes” the separate regulatory schemes for commodities and securities carefully established by Congress. (Query, whether a dually registered firm with a customer who was hedging his securities portfolio with S&P futures would be able to avoid arbitration at FINRA even if the claim involved only a botched execution of a futures order?) The court’s holding has broader implications for arbitrability of disputes at FINRA in the context of “outside business activity” claims against broker-dealers and claims involving independent contractors who market both securities for the broker-dealer and fixed income insurance products that are not securities.
Finally, in the not-so-distant past it was common for a broker-dealer or FCM to charge into court to enjoin a customer-initiated arbitration that was filed beyond the statute of limitations or beyond the FINRA (6 years) and NFA (2 years) eligibility rules. Now, sanctions on firms seeking anti-arbitration injunctions have chilled such litigation, however. Courts have imposed sanctions because “it is impossible to suffer irreparable harm from arbitrating a claim.” Here, Judge Lefkow declined to impose sanctions on the FCM because “it does not seek an injunction to resist a court order or agreement to arbitrate; it seeks an injunction to effectuate one [i.e., the NFA arbitration].” She noted that injunctions enjoining arbitrations are expressly contemplated by § 16 of the FAA, so it cannot be that all suits to enjoin arbitrations are sanctionable.
In sum, Judge Lefkow found that FINRA lacked jurisdiction, compelled the customers to proceed with arbitration at the NFA, and denied the customers’ request for sanctions. On June 12, 2019, the customers filed a notice of appeal. INTL FCStone Financial, Inc. v. Jacobson, Case No. 19 C 1438, 2019 WL 2356989 (N.D. Ill. Jun. 4, 2019).
 A CTA is the commodity industry’s analogue to a registered investment adviser in the securities industry.