Opinion

Alison Frankel

Can banks force clients to litigate, not arbitrate?

By Alison Frankel
April 3, 2014

If you are a customer of a big bank — let’s say a merchant unhappy about the fees you’re being charged to process credit card transactions — good luck trying to bring claims in federal court when you’re subject to an arbitration provision. As you probably recall, in last term’s opinion in American Express v. Italian Colors, the U.S. Supreme Court continued its genuflection at the altar of the Federal Arbitration Act, holding definitively that if you’ve signed an agreement requiring you to arbitrate your claims, you’re stuck with it even if you can’t afford to vindicate your statutory rights via individual arbitration.

But what if you’re a bank customer who wants to go to arbitration — and, in a weird role-reversal, the bank is insisting that you must instead bring a federal district court suit? Will courts show the same deference to arbitration when a plaintiff, rather than a defendant, is invoking the right to arbitrate and not litigate?

On Friday, the 2nd Circuit Court of Appeals will hear a rare tandem argument in two cases that present the question of whether bank clients have the right to arbitrate their claims even though they’ve signed contracts with forum selection clauses directing disputes to federal court. Believe it or not, the 2nd Circuit will be the third federal appellate court to answer this question, which has divided its predecessors. In January 2013, the 4th Circuit ruled that a UBS client may proceed to arbitration, but on Friday, the 9th Circuit held that a Goldman Sachs customer who agreed to a nearly identical forum selection clause must sue in federal court. To add to the confusion, the 9th Circuit panel was split, which led the majority to call the case “a close question.”

All of the appellate cases date back to the days when banks were hawking auction-rate securities as convenient instruments for clients who wanted to issue debt. Interest rates on the long-range, purported liquid securities would be periodically reset through an auction process, and banks told clients that they could hedge against a rise in rates through swap agreements. What they didn’t mention — at least according to clients — is that banks were artificially propping up the ARS market with their own bids on the securities. The whole wobbly structure collapsed in February 2008, and clients were marooned with debt carrying fast-rising interest rates that their swaps couldn’t offset.

Those debt issuer clients, to be clear, were different from bank brokerage customers who bought auction-rate securities under the misimpression that they were safe and liquid investments. Regulators made sure that banks bought back ARS from most of their brokerage customers. Other customers won great results in arbitrations before Financial Industry Regulatory Authority panels. (They fared less well in federal courts, where judges mostly ruled that banks were protected by website disclaimers about the ARS market that they’d posted after an investigation by the Securities and Exchange Commission in 2006.) Debt issuers, however, had a more subtle theory than investors in auction-rate securities, developed by the New Orleans firm Fishman Haygood Phelps Walmsley Willis & Swanson: They claimed that their financial advisers were responsible for the high interest rates they had to pay on bonds structured as ARS.

Fishman Haygood wanted to arbitrate its clients’ cases before FINRA instead of suing in federal court, at least partly because the debt issuers faced time bars in court that arbitrators can choose not to enforce in FINRA proceedings. (As Sullivan & Cromwell explained in a brief in one of the Goldman Sachs ARS cases, Fishman lawyer James Swanson admitted to the 4th Circuit that his clients were pushing for arbitration because “arbitrators have the discretion to not apply a limitation period. So, obviously, being in arbitration is more favorable to our client than being in litigation.”) Fishman Haygood contended that the debt issuers were entitled to arbitrate under a FINRA rule that requires FINRA members to arbitrate with customers at the client’s request.

But the debt issuers ran into a problem: They’d signed agreements with provisions that said “all actions and proceedings” arising from the ARS deals were to be brought in federal court. Citing nearly identical forum selection agreements, UBS, Citi and Goldman sued in various courts across the country to enjoin Fishman Haygood’s clients from moving forward with FINRA arbitrations. The judges who have presided over these injunction cases have mostly agreed on the tricky issues they raise. The consensus has been that debt issuers can be considered “customers” under FINRA rules but also that, in the context of the ARS cases, forum selection clauses in broker-dealer agreements cover underwriting activities. If the forum selection provisions apply to arbitration, in other words, the debt issuers are out of luck and have to face statute of limitations defenses in federal court. If the provisions do not apply to arbitration, the banks have to go to arbitration — where those timeliness arguments aren’t as powerful.

So do the provisions cover arbitration? That is exactly where courts have divided. The 4th Circuit’s parsing of the forum selection clause in the UBS case led to a holding that the contract directed all litigation to federal court in New York, but that arbitration wasn’t covered because it’s not specified in the provision. “We believe that it would never cross a reader’s mind that the clause provides that the right to FINRA arbitration was being superseded or waived,” wrote Judge Paul Niemeyer for a panel that also included Judges Barbara Keenan and Albert Diaz. “No word even suggesting supersedence, waiver or preclusion exists in the sentence.”

In contrast, the 9th Circuit majority, Judges Jay Bybee and Mary Schroeder, said that the forum selection clauses “clearly indicate that the parties never agreed to arbitrate claims.” The majority acknowledged the default obligation FINRA rules impose on Goldman to arbitrate customer claims, but said Goldman “was free to make alternative arrangements with each individual customer when the parties formed or modified their contractual relationship.” Those individual arrangements superseded the FINRA rule, according to the majority. The 9th Circuit opinion said that the broad deference to arbitration can expand the scope of arbitration provisions but doesn’t apply when there’s an agreement not to arbitrate, as there is in the ARS cases. (In dissent, U.S. District Judge Anthony Battaglia of San Diego, sitting by designation, said the phrase “all actions and proceedings” in Goldman’s forum selection clause is not sufficiently specific to infer an expectation that it applies to arbitration.)

Both of the Manhattan federal court judges in the cases to be heard Friday at the 2nd Circuit sided with the banks and held that ARS forum selection clauses preclude arbitration of the debt issuers’ claims. U.S. District Judge Jesse Furman ruled from the bench in Citigroup v. North Carolina Eastern Municipal Power Agency, without issuing a formal opinion. U.S. District Judge Richard Sullivan, in a decision that informed the 9th Circuit majority opinion last week, found that the “actions and proceedings” language of Goldman’s ARS forum selection clause encompasses arbitrations, so the Golden Empire Schools Financing Authority must litigate its claims in federal court rather than before a FINRA panel.

I should emphasize that the 4th and 9th Circuits and Judge Sullivan all agree that banks can strike individual agreements with clients that supersede the default right to FINRA arbitration. I doubt the 2nd Circuit will depart from their precedent on that point. The split between the 4th and 9th Circuits is over whether the specific language of the ARS forum selection clauses precludes arbitration — not whether banks can use forum selection clauses to their own ends. That prerogative seems to have been firmly established in the ARS forum selection cases.

Fishman Haygood may still be able to convince the 2nd Circuit that its ARS clients didn’t sign away their arbitration rights via contractual clauses. I suspect that banks have learned enough from this litigation, however, to tighten up the language of forum selection provisions so future clients can make no such arguments.

I left messages for issuer counsel Swanson of Fishman Haygood and Citi counsel Audra Soloway of Paul, Weiss, Rifkind, Wharton & Garrison but didn’t hear back. Goldman’s lawyer, Matthew Schwartz of S&C, declined to comment.

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