Circuit Split Widens Over Securities Broker-Dealer Attempts to Avoid FINRA Arbitration

The United States Court of Appeals for the Third Circuit has widened a circuit split regarding whether a securities brokerage may deny clients access to the Financial Industry Regulatory Authority (“FINRA”) arbitral forum using a forum-selection clause.  In Reading Health System v. Bear Stearns & Co., No. 16-4234 (3d. Cir. August 7, 2018), a Pennsylvania-based not-for-profit healthcare system, Reading, issued over $500 million in capital campaign debt using auction rate securities (“ARS”) that were distributed by Bear Stearns, a predecessor to J.P. Morgan Securities, LLC, between 2001 and 2007.  As part of issuing the ARS, Reading executed four contracts with the securities brokerage.  Two of those agreements contained a forum-selection clause that required the parties to resolve any disputes arising out of the contract via litigation in the Southern District of New York.

The ARS market subsequently collapsed and Reading filed a request for arbitration with FINRA over J.P. Morgan’s purported mishandling of Reading’s ARS offerings.  J.P. Morgan, however, claimed Reading waived its right to arbitration when the company executed the contracts that contained a forum-selection clause.  As a result, Reading filed an action in the Eastern District of Pennsylvania seeking to compel J.P. Morgan to submit to arbitral proceedings before FINRA.  J.P. Morgan responded by filing a motion to transfer the case to the Southern District of New York and a motion to enjoin FINRA arbitration.  The Pennsylvania district court denied J.P. Morgan’s request to transfer the case and ordered the parties to engage in FINRA arbitration.  After that, the securities brokerage firm filed an interlocutory appeal with the nation’s Third Circuit Court of Appeals.

On appeal, the court first stated it would not consider whether J.P. Morgan mishandled Reading’s ARS offerings.  Instead, the court said:

In this appeal, we must answer two questions: (i) whether J.P. Morgan, as a FINRA member, is obligated to resolve Reading’s substantive claims through FINRA arbitration; and (ii) which court decides that question of arbitrability. To answer those questions we must resolve the inherent tension between Reading’s right to arbitrate its claims pursuant to FINRA Rule 12200 and J.P. Morgan’s purported contractual right to litigate those same claims pursuant to the forum-selection clauses in the broker-dealer agreements. Complicating this inquiry, the parties do not agree which of these questions must be resolved first; each side argues that the District Court lacked authority to resolve one of the two disputes at issue.

According to the appellate court, the “district court properly resolved the transfer dispute before the arbitrability dispute.”  The court said:

When Reading filed its single-count, declaratory judgment action in the District Court, the only merits issue before the court was whether FINRA Rule 12200 required J.P. Morgan to submit to FINRA arbitration. However, once J.P. Morgan moved to transfer that action, the District Court was presented with a threshold issue regarding the propriety of the venue in which Reading filed its action to compel arbitration—namely, whether the declaratory judgment action should be transferred to New York in light of the forum-selection clauses. The parties spill much ink on which of these two issues should be resolved first. In J.P. Morgan’s view, the transfer dispute must be resolved first and, since the District Court was required to transfer the action, it lacked authority to resolve the arbitrability dispute. By contrast, Reading argues that the Federal Arbitration Act (FAA) required the District Court to enforce FINRA Rule 12200 by compelling arbitration and, therefore, the court was divested of its discretion to transfer. The District Court declined to transfer the case before turning to the question of arbitrability. We agree that threshold disputes over venue and jurisdiction should be resolved before merits disputes. Thus, we conclude that the District Court’s sequence of decision-making was not only permissible, but also preferable.

The Third Circuit also dismissed J.P. Morgan’s claim that the Supreme Court’s decision in Atlantic Marine required the case to be transferred.  The appellate court stated the lower court “was required to apply Atlantic Marine and transfer the action to New York only if Reading’s declaratory judgment action fell within the scope of the forum-selection clause.”  After examining the language of both relevant forum-selection clauses, the Court of Appeals determined Reading’s declaratory action did not “arise out of” the broker-dealer contracts.  Instead, the court stated the right Reading sought to enforce was provided by “FINRA Rule 12200, which gives Reading the right to demand FINRA arbitration and imposes a corresponding duty on J.P. Morgan to arbitrate.”

After that, the Third Circuit examined how other Circuit Courts resolved similar disputes.  The court stated:

Attempts to reconcile the tension between a broker-dealer’s right to litigate pursuant to a forum-selection clause and a customer’s corresponding right to arbitrate under FINRA Rule 12200 have divided our sister circuit courts. The Second and Ninth Circuit Courts of Appeals have held that a materially identical forum-selection clause requires the parties to litigate in federal court, while the Fourth Circuit Court of Appeals has held that Rule 12200 requires the parties to arbitrate, notwithstanding the presence of a forum-selection clause. We agree with the Fourth Circuit that the forum-selection clauses in the broker-dealer agreements are insufficient to waive Reading’s right to arbitrate under FINRA Rule 12200.

Because the forum-selection clause included in the parties’ contracts did not waive Reading’s rights under FINRA Rule 12200, the Court of Appeals held the lower court “properly concluded that, under FINRA Rule 12200, J.P. Morgan is required to arbitrate Reading’s claims regarding the ARS offerings.”

In the end, the United States Court of Appeals for the Third Circuit split with the Second and Ninth Circuit Courts and affirmed the district court’s order “declining to transfer Reading’s declaratory judgment action and compelling J.P. Morgan to submit to FINRA arbitration.”

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