BACK-OFFICE RISK ON FRONT BURNER: LIABILITY OF CLEARING FIRMS AT ISSUE IN WAKE OF BEAR STEARNS CASE

Sep 7, 1998 @ 12:01 am

By Howard Kapiloff

The high-profile lawsuit against Bear Stearns & Co. over its clearing work for a now-defunct rogue brokerage has been dismissed, but that doesn't mean the debate over the liability of the trade processors is over.

The Securities and Exchange Commission is reviewing proposals by self-regulatory groups to force clearinghouses at least to provide better records of the brokerages for which they provide back-office services. The intent of the proposed changes is not to make clearing firms more liable but to get them to put additional pressure on brokerages -- commonly referred to as introducing brokers -- to keep clean, says John Ramsey, deputy general counsel at the National Association of Securities Dealers Regulation.

"You wouldn't want to charge them with strict liability (so) the real issue for us is: How do you compel the introducing firms to do what they're supposed to do?"

A clearing firm's responsibility when an investor is rooked by a broker has become a hot-button issue thanks to the Bear Stearns case, and will likely get hotter if the stock market continues to tumble. In many of these cases, the perpetrators are penny stock or bucket shop brokers. Courts have held that clearinghouses have no fiduciary obligation, but the publicity surrounding the Bear Stearns case has pressured the regulatory agencies to act. Bear Stearns is the country's biggest clearing firm with 2,000 brokerage clients.

The changes, which involve what is known as SEC Rule 382, were proposed by the National Association of Securities Dealers in conjunction with the New York Stock Exchange a year ago, spurred on by Arthur Levitt Jr., the SEC chairman. An SEC spokesman said he did not know if the agency would adopt the changes, although Mr. Ramsey believes it is likely since he worked with the agency in writing them.

The proposed changes include compelling clearing firms to inform client brokerages what kind of compliance monitoring they do. For instance, a clearinghouse monitoring mutual fund trading that red-flags questionable trading activities would be required to report those activities to the introducing broker and to regulators.

"It's easy for the clearing firm to say they never asked for it, and the introducing firm to say well, they never said they offer it," says Mr. Ramsey.

Clearinghouses would also be required to report complaints about the brokerage to regulators.

Some investor advocates say clearing firms ought to bear some responsibility, because they do research on their clients before signing contracts with them. And as processor of trades, the clearinghouses have the first peek at possible trends in a broker's investment methods.

But how much due diligence and oversight ought a clearing firm be required to do when it takes on a brokerage? Bear Stearns cleared for two years for A.R. Baron & Co., also in New York, which opened its doors in 1992 and collapsed in July 1997 after executives were convicted of stock manipulation. It took on Baron only three days after the broker had settled an NASD stock manipulation suit for $1.5 million, neither admitting nor denying wrongdoing. Baron had also switched clearing firms twice before soliciting Bear Stearns.

Investors who sued maintain that Bear Stearns extended credit and services to keep Baron going. Bear Stearns denied the charges and 10 days ago, a New York Supreme Court judge ruled that Bear Stearns performed only back-office functions and had no fiduciary responsibility because it did not have contact with clients.

Needless to say, clearing firms are worried. "There's no question Rule 382 is under attack," grouses William Behrens, chief executive of Ernst & Co., a brokerage and clearing operation in New York.

Just paper pushers

He complains that lawyers would go after the clearinghouses, because the bucket shops are often too small to collect from and the clearinghouses often have deep pockets. Small clearing firms would probably be forced out of the business, he says. "All we do is the paperwork.

We don't tell them (brokers and investors) what securities to buy and sell."

His colleague, William Spane, president of BHC Securities Inc., which clears trades for bank brokerages, agrees. "We're a processing company, and we position ourselves as that," he says. "I'd say we'd have to be on the side of Bear Stearns."

Backers of increased regulation acknowledge that clearing firms ought not to be forced to become pseudo-insurance companies, paying for the damages wrought by their clients, or the industry's policemen, monitoring every trade.

But in the case of Bear Stearns, some investors complained in published reports, the clearing firm knew that Baron was hemorrhaging capital and in a desperate situation.

"When they know an introducing firm is doing something wrong, they shouldn't place the order," says Michael Don, president of the Securities Investor Protection Corp. of Washington, an industry group that insures brokerage client accounts against insolvency.

At least one securities lawyer, Alan Markizon, who practices in Coeur d'Alene, Idaho, has written the New York Stock Exchange demanding that clearing firms be held more liable and thus less likely to work with questionable firms."The real shame of this business is that its smart business people and their self-regulators have not figured out how to stop bucket shops," he says.

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