Fourth Circuit Slaps Down Bad Arguments Regarding Arbitration and Account Contracts

In Interactive Brokers, LLC v. Saroop, the United States Federal Court of Appeals for the Fourth Circuit made it clear that a broker’s contract that incorporates FINRA rules supports a breach of contract claim when the broker violates FINRA. Further, this case reinforces the public policy of using arbitration to lower costs and create an efficient resolution forum for disputes.

Interactive Brokers that Saroop and two others (collectively, the “Investors”) opened accounts with Interactive Brokers where they were required to sign the contracts that provided that all transactions were subject to “rules and policies of relevant market and clearinghouses, and applicable laws and regulations.” Interactive Brokers hired a third-party to trade the Investors’ accounts (the “Manager”). Using the Investors’ margin accounts, the Manager invested in short-term futures, with a symbol of VXX. The Manager sold naked call options for VXX, meaning that the Investors had the right to buy VVX at a set price until the option expired. This works great if the market price increases but is a serious problem if the value decreases. To make matters worse, the Manager traded using the Investors’ margin accounts. A margin account is when you borrow money to purchase stock. This means that you can lose more money than you invested.

The high risk associated with margin trading prompted FINRA to prohibit purchases of VXX using margin.

The Manager was heavily invested in VXX when the market dropped and the Investors’ accounts dropping 80%. The drop triggered a ‘margin call’ for the Investors to deposit money or marketable securities to get the margin balance back to the minimum required. Interactive brokers began auto-liquidating wiping out the Investors’ accounts. The end result was that the Investors owed hundreds of thousands of dollars to Interactive Broker in their margin accounts.

The Investors filed arbitration against Interactive Brokers to recoup their losses alleging, among other things, breach of contract. The arbitration panel found for the Investors and awarded damages based on the account values before the margin trading started.

Interactive Brokers moved to vacate the award and the court criticized the arbitrators, essentially saying that they were not fit to make the decision. This court remanded to the arbitrators to explain their award. The arbitrators explained that the liability was based on FINRA Rule 4120 and that the damages came from value of the Investors accounts before the ineligible VXX investment. Interactive Brokers again asked the court to vacate the arbitration award, and the court did.

The Investors appealed to the Fourth Circuit that held that it is not ‘manifest disregard of the law’ to premise liability on a breach of contract. ‘Manifest disregard’ is one of the ways to overturn an arbitration award. In this case, Interactive Brokers admitted that parties may incorporate FINRA rules into a contract and the arbitrators found that Interactive Brokers had not complied with FINRA rules. As such, the Fourth Circuit held that since the contracts between the parties invoked the FINRA rules, Interactive Brokers breached the contract.

The Fourth Circuit reaffirmed that contract damages are awarded to place the injured parties in the same position had there been no breach of contract. The court found that even if this is not the best reading of the law, a court cannot overturn an arbitration award because it believes the arbitrators misinterpreted the applicable law.

This case is of interest because it holds that when investors sign contracts with a brokerage firm that incorporates FINRA rules, a finding that the brokerage firm did not comply with FINRA rules is a breach of contract. Another interesting feature of this case is that the court pointed out very clearly that it supports arbitration as a valid resolution forum.