The Wall Street Journal-20080116-Credit Crunch- Aggrieved Investors Sue a Clearing Firm
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Credit Crunch: Aggrieved Investors Sue a Clearing Firm
Dozens of investors are suing a stock trade-processing firm over its role in their heavily margined investments in mortgage-backed securities, reawakening a debate over how much responsibility these "clearing" firms share for misdeeds committed by brokerage firms.
Lawyers say they have filed more than 40 arbitration claims against Brookstreet Securities Corp., an Irvine, Calif., brokerage that shut last summer, in which they also blame National Financial Services, a unit of Fidelity Investments, for clients' losses.
The common thread is an allegation that National Financial allowed them to go deep into margin debt even though the collateralized mortgage obligations in their accounts were illiquid, and therefore virtually worthless.
Stuart Meissner, a lawyer who in December filed two lawsuits on behalf of five Brookstreet investors, said National Financial played an active role in his clients' losses. "Without them, the damages could not have been incurred," Mr. Meissner said. "They were a necessary component to the fraud."
Fidelity spokesman Vincent Loporchio said the claims against National Financial are without merit. "The decision to take margin loans is made by clients and their brokers, not by clearing firms," he said. National Financial "used reputable third-party firms to price the securities held in brokerage accounts," he said.
Tom Fehn, the lawyer for Brookstreet and its executives, declined to comment on the cases.
In June 2007, Brookstreet Securities collapsed when a markdown in the value of its collateralized mortgage obligations, or CMOs, led National Financial to issue a margin call. Brookstreet has since been flooded with arbitration claims alleging that brokers assured investors that CMOs, some of which regulators have explicitly stated were only for sophisticated investors able to handle high risk, were safe investments that would generate consistent returns.
The claims against Brookstreet argue that the investors were heavily margined, leaving them with negative balances when the firm collapsed.
Few individual, or retail, investors appear to have been exposed directly to the high-risk mortgage-backed securities at issue. Still, the cases could have implications for other clearing firms that let customers borrow against mortgage-backed securities. Arbitration panels don't follow precedent, but the momentum from one win could push more investors burned by subprime investments to pursue similar claims against clearing firms.
Clearing firms match and settle trades after they are made. All brokerage firms need a clearing firm to process trades. Some large firms have their own clearing arms, but many rely on other firms. In the past, clearing firms have maintained that they bear little if any responsibility for the misdeeds of the brokerage firms, known as introducing firms, for which they clear trades. Because they are merely performing a back-office function, they have argued, they don't have an obligation, or even the ability, to scrutinize introducing firms' transactions.
According to Financial Industry Regulatory Authority rules, an introducing firm is generally responsible for sales practices with customers. A clearing firm is responsible for the operational aspects of transactions.
