Chris Lazarini Reviews Whether a Rule Violation Supports a Breach of Contract Claim

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Bass, Berry & Sims attorney Chris Lazarini reviewed a putative class case filed against a brokerage firm alleging that the firm breached its client agreement by purchasing risky reverse convertible notes (RCNs) for clients who did not list their investment objectives as “aggressive” or “speculative.” The firm moved for summary judgment arguing the plaintiffs could not convert an alleged statutory or regulatory violation into a breach of contract claim. The court finds both state and federal law hold that, just because a contract states that it is “subject to” or “governed by” certain rules or regulations, does not mean that violating the rules and regulations breaches the contract.

Chris provided the analysis for Securities Online Litigation Alert (SOLA). The full text of the analysis is below and used with permission from the publication. If you would like to receive additional content from the SOLA, please visit the SOLA website to sign up for the newsletter.

Luis vs. RBC Capital Markets, LLC, No. 16-cv-3873 (D. Minn., 7/11/19)

A contract that states it is “subject to” or “governed by” certain rules and regulations does not mean that violating those rules and regulations breaches the contract.

Plaintiffs are a putative class of RBC customers who lost money after purchasing reverse convertible notes (“RCNs”). RCNs are a complex structured product, which the SEC has called “perhaps the riskiest [structured financial product] available to retail investors.” An RCN is a high-yield short-term note (some pay as much as 30%) linked to a put option (usually in a stock) allowing the issuer to repay the principal in stock if the price of the stock falls below a predetermined price. An investor may lose all of his principal investment if the stock depreciates below the knock-in price. The Court summarizes FINRA’s suitability rule and three FINRA Notices to Members providing guidance on the sale of structured products, two of which specifically reference RCNs. RBC’s internal policies for the sale of RCNs were shaped by the suitability rule and NTMs.

Plaintiffs’ original complaint sounded in fraud and the Court granted RBC’s motion to dismiss, finding the claims precluded by the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”). Plaintiffs regrouped and filed a one-count breach of contract claim alleging their Client Agreements barred RBC from trading uncovered or naked put options in a client’s account, unless the client signed an options agreement with the firm. Plaintiffs survived another SLUSA-based motion to dismiss. In discovery, Plaintiffs learned that RBC did not have an internal policy requiring a client to have an options agreement to purchase RCNs, so Plaintiffs shifted their focus to the “applicable laws and regulations” provision of the Client Agreement. That provision said that all transactions in the client’s account were “subject to all applicable laws and the rules and regulations of all federal, state, and self-regulatory agencies . . ..”

Plaintiffs’ theory was that RBC breached its contract because FINRA’s suitability rule and the NTMs providing guidance on sales of RCNs and other structured products prohibited RBC from selling RCNs to clients who did not list their investment objectives as “aggressive” or “speculative.” RBC moved for summary judgment arguing Plaintiffs could not convert an alleged statutory or regulatory violation into a breach of contract claim, RBC violated no relevant FINRA rules and, even if the NTMs were treated as binding law (which RBC argued against), RBC did not violate the NTMs.

The Court grants RBC’s motion focusing only on its first argument. The Court finds both state and federal law hold that, just because a contract states that it is “subject to” or “governed by” certain rules or regulations, does not mean that violating the rules and regulations breaches the contract. The Court sides with RBC’s interpretation of the contract and finds no laws or regulations were incorporated into the agreements with “promissory” language creating a duty of compliance. Rather, the Court states, the “applicable laws and regulations” provision can only be read as an acknowledgement by the client that his transactions will be “subject to” the regulatory framework. The Court notes this conclusion makes particular sense where, as here, no private right of action exists for violating the underlying rules and regulations and courts have historically shown deference to the government in enforcing comprehensive regulatory schemes. In closing, the Court denies Plaintiffs’ motion for class certification and reminds Plaintiffs of their right to pursue their claims individually in arbitration.

The case was filed after a FINRA investigation into RBC’s supervision over RCN sales led to entry of a Consent Decree, a $1 million fine, and an order to pay $434,000 in restitution to harmed customers. RBC neither admitted nor denied FINRA’s allegations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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