CASE SUMMARY: Pershing LLC v. Kieback et al – Rare US Federal Court Ruling Assessing When Tribunal’s Rejection of Discovery Request May Constitute Improper Refusal to Hear Evidence Justifying Vacatur

Kantor Photo (8-2012)By Mark Kantor

Last week, the US District Court for the District of Louisiana issued a ruling in Pershing LLC v. Kieback et al (Judge Lance M. Africk, Civ. Act. No. 14-2549, May 22, 2017, available at https://scholar.google.com/scholar_case?case=5882751863819676163&hl=en&as_sdt=20006) confirming the arbitration award by a Financial Industry Regulatory Authority (“FINRA”) arbitration panel, notwithstanding efforts to vacate the award on grounds that the arbitral panel’s failure to require production of certain documents in discovery, or to even review those documents in camera before denying a motion to compel production, constituted “misconduct … in refusing to hear evidence pertinent and material to the controversy” under the US Federal Arbitration Act (FAA), “evident partiality” on the part of the arbitrators, and “manifest disregard of the law.”

This decision is one of the rare US Federal court rulings assessing when a tribunal’s rejection of a discovery request may constitute an improper refusal to hear evidence justifying vacatur.  As you will see, the Louisiana Federal District  Court set the standard high.

The dispute arose out of R. Allen Stanford and Stanford Financial Group’s fraudulent Ponzi scheme (https://en.wikipedia.org/wiki/Allen_Stanford) resulting in Stanford being ordered by law enforcement agencies to disgorge $6.7 billion  and pay a $5.9 billion fine.

A number of retired individuals living in Louisiana (the “Louisiana Retirees”) who had invested in Stanford certificates of deposit brought FINRA arbitrations for an aggregate of about $80 million in damages against Pershing LLC (“Pershing”), the clearing broker for the Stanford Group, alleging due diligence and non-disclosure theories on the basis of which the clearing broker might be held liable for a portion of the damages caused by the fraud (footnotes and many citations omitted from quotations).

They claim that Pershing, as Stanford Group Company’s clearing broker, failed to exercise due diligence in its business relationship with Stanford Group Company and failed to disclose adverse financial information which would have resulted in the Ponzi scheme being uncovered sooner than it was.

Pershing naturally presented defenses to those claims.

The Retirees’ claims were all consolidated into a single arbitration hearing, a process that (by the way) may be worth exploring by readers interested in the relationship between consolidation in arbitration and class arbitration.

During the arbitration, the Louisiana Retirees sought discovery, including document production.  As to certain of the documents covered by a discovery demand, Pershing asserted two privileges; the attorney-client privilege and a US financial services regulatory privilege known as the “Suspicious Activity Report (“SAR”) privilege” established by US Federal regulation to protect financial institutions who are required to report suspicious financial activities to Federal enforcement officials.  The arbitration panel upheld those assertions of privilege.

The arbitration panel held that Pershing was not required to produce to the Louisiana Retirees certain categories of documents which Pershing claimed were privileged. The documents consist inter alia of emails which Pershing claimed were protected under the attorney-client privilege and “Incident Reports” which Pershing says it uses to begin the process of internally investigating potential suspicious activity. Pershing claims the second category of documents are protected by the SAR privilege.

After extensive hearings, the arbitral panel ruled in favor of Pershing on the merits.

After a two week hearing at which the panel heard over 1,600 pages of testimony from fifteen witnesses and considered over 900 separate exhibits, the panel ruled in Pershing’s favor.

Pershing then sought confirmation of the FINRA award in the District Court.  The Louisiana Retirees sought vacatur.  The District Court was therefore faced with the need to balance two oft-argued principles in confirmation/vacatur proceedings; “an arbitration panel’s decision cannot be overturned simply because it was incorrect. …. But under the Federal Arbitration Act (FAA), an arbitration panel’s refusal to hear evidence material and pertinent to the controversy can result in vacatur of the arbitration award when the refusal deprived a party of a fundamentally fair hearing.

The Louisiana Retirees primarily argued that the arbitration was “fundamentally unfair” due to their inability to obtain and present the documents withheld by Pershing from document production.

The Louisiana Retirees first argue that the panel’s decision should be vacated pursuant to section 10(a)(3) of the FAA because the panel denied the Louisiana Retirees access to key documents, and the withholding of the documents was prejudicial to the Louisiana Retirees to the extent it rendered the arbitration proceeding fundamentally unfair. Their position is essentially that the Louisiana Retirees were unable to prove their case and were unable to refute false testimony offered by Pershing witnesses during the arbitration proceeding because they did not have certain documents which they have now had an opportunity to review.

In particular, the Retirees pointed to the decision by the arbitral panel not to review the documents in camera before upholding the privilege claims and to their substantive privilege rulings.

The prejudice claimed by the Louisiana Retirees really stems from two separate decisions of the arbitration panel: (1) the decision not to review the documents in camera before deciding whether Pershing should produce them; and (2) the decision on the merits of the claimed privileges.

In an earlier decision in the judicial confirmation/vacatur proceedings, Judge Africk of the District Court had previously allowed limited discovery by the Louisiana Retirees.  When faced with the same assertions of privilege by Pershing, the Court itself reviewed the documents in camera (unlike the arbitral panel) to determine whether they were covered by the SAR privilege under federal law.  In its consequent ruling on privilege (available at https://scholar.google.com/scholar_case?case=17082729013022954526&hl=en&as_sdt=20006), the District Court upheld most of Pershing’s privilege assertions but concluded that some of the documents (or parts thereof) were not privileged and should have been disclosed.

After closely reviewing the documents produced for in camera review by Pershing, the Court finds that the Incident Reports at Tabs 1-67 bear no arguable relationship to the claims or defenses in this case and are not discoverable for that reason. On the other hand, the Court finds that the Incident Reports at Tabs 68-74 should be produced, as they are relevant to the claims and/or defenses of the Defendants in this case and are not privileged. Additionally, the redacted version of the Summary Reports that correlate to Tabs 68-74 should be produced, as should the redacted versions of Tabs 1-14 of the Summary Reports produced in Pershing’s third production on March 14, 2017.

Judge Africk ordered those documents turned over to the Louisiana Retirees as part of the judicial vacatur proceedings.  The Retirees then relied upon the fact that the arbitral tribunal had neither reviewed those documents in camera nor required them to be produced in document production as their basis for arguing fundamental prejudice.  As the Court noted in its subsequent decision last week, “Now the question is simply whether, considering the produced documents in conjunction with the record of the arbitration proceeding, the Louisiana Retirees have satisfied one of the recognized grounds for vacating an arbitration award.”

The Louisiana Retirees assert three bases for vacatur in this lawsuit. According to their motion, they contend “(1.) that the arbitration proceeding was fundamentally unfair because severe prejudice occurred to the Louisiana Retirees when Pershing did not disclose to the Louisiana Retirees [certain documents which were not produced by Pershing until this Court ordered them produced in this lawsuit]; (2.) the obvious partiality and bias of the arbitrators because of the apparent `assumed veracity’ of Pershing when the Panel allowed Pershing to serve as the judge and jury on defining the scope of the documents withheld under attorney client privilege and the SARs/AML privilege; and (3.) that the Panel committed manifest error reviewing the evidence that was actually presented to the arbitration hearing based upon the review standard of the Second Circuit because of the application of New York Law.”

Judge Africk addressed the Retirees’ “fundamentally unfair” presentation first.  He rejected the Retirees’ arguments.  The Judge began by repeating the commonly-accepted “exceedingly narrow” standard for vacatur of an arbitration award in FAA jurisprudence.

“In light of the strong federal policy favoring arbitration, judicial review of an arbitration award is extraordinarily narrow.” …. “Under this review, an award may not be set aside for a mere mistake of fact or law.” …. “Instead, Section 10 of the FAA provides the only grounds upon which a reviewing court may vacate an arbitrative award.”

Looking at the argument that the panel’s failure to review the documents in camera before ruling on the privilege justified vacatur, the District Court ruling noted that the FINRA arbitration rules do not require in camera review.  Moreover, commented the Court, the overall discovery process was not fundamentally unfair (“A FINRA arbitration panel has great latitude to determine the procedures governing their proceedings and to restrict or control evidentiary proceedings.”).

With respect to the first decision—not to review the documents in camera—the Court observes that nothing in the FINRA arbitration rules requires in camera review prior to ruling on a discovery motion. To the extent the Louisiana Retirees claim that the manner in which the panel resolved discovery issues rendered the proceeding fundamentally unfair, the Court rejects that argument. Even if this Court would have proceeded differently, this Court cannot conclude that the entire arbitration proceeding was tainted because of it. See Bain Cotton Co. v. Chesnutt Cotton Co., 531 F. App’x 500, 501 (5th Cir. 2013) (“Regardless whether the district court or this court—or both—might disagree with the arbitrators’ handling of Bain’s discovery requests, that handling does not rise to the level required for vacating under any of the FAA’s narrow and exclusive grounds.”).

“A FINRA arbitration panel has great latitude to determine the procedures governing their proceedings and to restrict or control evidentiary proceedings.” …. Indeed, even in federal court the decision whether to conduct an in camera inspection is wholly within the discretion of the district court. …. The record reveals that discovery was extensively litigated before the panel, which decided six motions to compel, received multiple rounds of briefing from the parties, and held a telephonic hearing to address the SAR privilege and the request for an in camera review. …. Ultimately, the Louisiana Retirees received over 121,000 documents from Pershing totaling over 635,000 pages. …. The discovery process was not fundamentally unfair. See Prestige Ford v. Ford Dealer Computer Servs., Inc., 324 F.3d 391, 395 (5th Cir. 2003) (abrogated on other grounds) (“In the case at hand, hearings were held and each disputed item was given consideration by the panel; thus, more than adequate opportunity was afforded to the parties and the minimum standards of fundamental fairness were met.”).

Having disposed of the Retirees’ complaint based on the failure of the panel to review the documents in camera before ruling, the Court then turned to the second assertion of fundamental unfairness – the panel’s merits decision that the attorney-client privilege and the SAR privilege shielded all of the documents withheld by Pershing.  Here too, Judge Africk was not persuaded that the tribunal’s decision deprived the Retirees of a fair hearing. The District Court considered that the documents not disclosed during the arbitration were cumulative of documents that were produced (“The documents produced to the Louisiana Retirees in this litigation are cumulative of the documents produced to the Louisiana Retirees in the arbitration proceeding. …  There is no reasonable basis to suggest that if the new documents had been produced during the arbitration proceeding, the result would have been different.”).

With respect to the second decision complained of by the Louisiana Retirees— the panel’s decision that the attorney-client privilege and the SAR privilege shielded all of the documents withheld by Pershing—the Court also concludes that the decision did not render the arbitration proceeding fundamentally unfair. …. Even if this Court disagrees with the arbitration panel regarding the appropriate scope of those privileges, the Court does not find that the Louisiana Retirees were deprived of a fair hearing as a result of the decision.

The documents produced to the Louisiana Retirees in this litigation are cumulative of the documents produced to the Louisiana Retirees in the arbitration proceeding. A review of the record shows that Pershing produced a vast amount of material during the arbitration proceeding which evidenced that high-level Pershing employees were aware as early as 2006, to one degree or another, of potential “red flags” regarding Stanford Group Company. …. The Louisiana Retirees marshaled this evidence in support of their position that Pershing knew or should have known that there were serious questions about Stanford Group Company’s legitimacy during the period that the Ponzi scheme was in operation, and that Pershing should have done more sooner to raise the alarm regarding Stanford Group Company. The arbitration panel rejected the Louisiana Retirees’ arguments. There is no reasonable basis to suggest that if the new documents had been produced during the arbitration proceeding, the result would have been different.

Because the Louisiana Retirees were able to introduce comprehensive evidence supporting their theory of the case, the deprivation of additional arguably relevant evidence did not deprive the Louisiana Retirees of a fair hearing.

The Judge in any event also assessed whether the evidence in the withheld documents about Pershing’s knowledge regarding Stanford’s suspicious behavior was a primary focus of the arbitration.  Judge Africk ruled it was not.  Moreover, the additional evidence would not have shown a direct conflict with testimony of Pershing witnesses.

To the extent the Louisiana Retirees argue that the newly produced documents directly contradict the testimony of Pershing witnesses in the arbitration, the Court finds the Louisiana Retirees’ position to be a mischaracterization of the record. Pershing witnesses acknowledged that there were concerns raised regarding Stanford Group Company as early as 2006. The primary focus of the arbitration proceeding was not whether Pershing had notice of suspicious behavior by Stanford Group Company, but rather whether Pershing acted reasonably to address their concerns and—more importantly—even if Pershing acted unreasonably, whether Pershing violated any legal duty owed to the Louisiana Retirees. (Pershing argued during the arbitration that Pershing could have no liability for fraud committed by Stanford Group Company even if Pershing should have discovered that fraud or done more to prevent it). All of these issues were exhaustively litigated.

Importantly, the Court also pointed out that, if there were ambiguities in the record, any “doubts or uncertainties must be resolved in favor of upholding the arbitration award.”  Applying this legal standard, the Court rejected the Retirees’ vacatur argument.

The Louisiana Retirees also packaged the same underlying situation as an argument that, by not reviewing the withheld documents in camera, the arbitrators evidenced partiality on the part of the arbitrators. The Retirees’ “evident partiality” attack actually involved three separate issues; (1) the in camera issue, (2) the fact that the then-CEO of Pershing had been a member of the FINRA Board of Governors, and (3) the fact that Pershing had presented a defense in the arbitration (the so-called “FINRA defense”) that regulatory examination and enforcement failures (i.e., alleged misconduct by FINRA and the Securities Exchange Commission (SEC) in failing to promptly identify the Stanford Ponzi scheme) meant that FINRA and the SEC should be held equally responsible for the failure to discover the Ponzi scheme earlier.

The Louisiana Retirees next argue that the panel’s decision should be vacated pursuant to section 10(a)(2) of the FAA because there was evident partiality or corruption by the arbitrators. They say the bias was made evident in three ways. First, the Louisiana Retirees claim that the panel’s failure to conduct the in camera review proves the panel was biased in favor of Pershing. Second, the Louisiana Retirees argue the panel was biased because the CEO of Pershing during the relevant time period, Richard Brueckner, was a former member of the FINRA Board of Governors. Third, the Louisiana Retirees contend that the panel was inclined to rule in favor of Pershing because Pershing asserted a so-called “FINRA defense,” in which Pershing supposedly argued to the panel that regulator misconduct or negligence served as a defense to Pershing, i.e. that if Pershing was liable to the Louisiana Retirees then FINRA and the SEC must be deemed equally culpable for failing to discover the Ponzi scheme sooner.

Judge Africk did not accept any of these arguments by the Retirees.  With respect to the claim that the the arbitrators showed bias by declining in camera review, the Judge referred back to his conclusion that the tribunal’s conduct did not produce an unfair hearing.

The Court has already addressed the Louisiana Retirees’ argument that the panel should have reviewed Pershing’s documents in camera. The FINRA rules do not require such an in camera review, and placed in the context of the lengthy discovery proceedings as a whole the panel’s decision not to review the documents does not suggest bias.

The Court then disposed of the other two assertions of bias (“that they strenuously objected to Mr. Brueckner [the former Pershing CEO who had been on the FINRA Board] not testifying in person in the order desired by the Louisiana Retirees during the arbitration proceeding, and that they objected to Pershing advancing the FINRA defense”).  With respect to the issue of the former CEO not be compelled to testify, Judge Africk declined to consider that the former CEO’s position on the FINRA Board produced any partiality on the part of the arbitrators appointed by FINRA.

As for Mr. Brueckner’s relationship with FINRA, the U.S. District Court for the Southern District of New York recently rejected an identical argument by a losing party to an arbitration, and the Court finds its reasoning persuasive and applicable here. See Freedom Inv’rs Corp. v. Hadath, 2012 WL 383944, at *5 (S.D.N.Y. Feb. 7, 2012) (“Blumenschein’s service on FINRA’s Board of Governors is insufficient to meet the objective test for assessing bias. Pinter has not made any showing that an individual member of the FINRA Board of Governors, or indeed the Board of Governors as a whole, has any influence over the selection of FINRA [Dispute Resolution] arbitrators, their compensation, or their assignment to panels. At the very most, he has raised the specter of an appearance of bias, insufficient grounds for disturbing an arbitration award.”).

The last bias claim put forward by the Louisiana Retirees, based on the “FINRA defense,” fared no better (“Even if Pershing had notified the regulators of any concerns it had regarding Stanford Group Company, it would not have made a difference in terms of shutting down the Ponzi scheme because the regulators and law enforcement agencies already knew far more about Stanford Group Company than anything Pershing could have reported.”).

Finally, with respect to the alleged bias created by the FINRA defense, the Court finds the Louisiana Retirees’ characterization of the defense somewhat misleading. This defense—one of many advanced by Pershing—was essentially a causation argument: Even if Pershing had notified the regulators of any concerns it had regarding Stanford Group Company, it would not have made a difference in terms of shutting down the Ponzi scheme because the regulators and law enforcement agencies already knew far more about Stanford Group Company than anything Pershing could have reported. However the defense is characterized, the Court is not at all convinced that Pershing’s assertion of a particular legal theory demonstrates that the arbitration panel was biased.

Notably, the District Court independently ruled that these “evident partiality” arguments had been waived by the Louisiana Retirees.  Once again, a positive response by counsel to the formula question put by the arbitral panel at the end of the hearings (did they receive “a full and fair opportunity to present their case”) played an important role.

At the beginning of the arbitration hearing, counsel for the Louisiana Retirees stated that they accepted the panel. At the end of the arbitration hearing, counsel for the Louisiana Retirees agreed that they had enjoyed “a full and fair opportunity” to present their case. …. Counsel for the Louisiana Retirees even thanked the panel for its time. … (“We appreciate y’all’s efforts.”). At that point, the Louisiana Retirees already knew of all the panel’s decisions described above, yet they failed to object. It was only once the arbitration panel ruled against them that the bias argument emerged. The waiver rule is designed to prevent just such a circumstance from occurring.

The Louisiana Retirees also made a “manifest error” argument, arguing that, by operation of choice of law principles, the judge-made New York law “manifest error” ground for vacatur was applicable in the Louisiana District Court.  The District Court rejected the choice of law argument, holding instead that the position in the US Circuit Court of Appeals for the 5th Circuit against any “manifest error” vacatur ground was binding.  Moreover, in a brief footnote, Judge Africk also held that “Regardless, this Court finds no circumstances evidencing manifest disregard of the law by the arbitration panel.”

The principal import of this ruling lies in the willingness of the District Court to conclude, in the face of its own prior ruling that some of the withheld documents should have been produced, that vacatur was still not appropriate.  But, to reach that conclusion, the Court found it necessary to rely in part on its own conclusion that the information in those documents was cumulative of information already in the arbitration record so that no fundamental unfairness had occurred.  The decision therefore has something for everyone in future disputes on each side of this issue.  Of course, it is not unlikely the Louisiana Retirees will appeal Judge Africk’s decision to the for the 5th Circuit Court of Appeals.  So, there may very well be more to come later this year.

 

Mark Kantor is a CPR Distinguished Neutral. Until he retired from Milbank, Tweed, Hadley & McCloy, Mark was a partner in the Corporate and Project Finance Groups of the Firm. He currently serves as an arbitrator and mediator. He teaches as an Adjunct Professor at the Georgetown University Law Center (Recipient, Fahy Award for Outstanding Adjunct Professor). Additionally, Mr. Kantor is Editor-in-Chief of the online journal Transnational Dispute Management.

This material was first published on OGEMID, the Oil Gas Energy Mining Infrastructure and Investment Disputes discussion group sponsored by the on-line journal Transnational Dispute Management (TDM, at https://www.transnational-dispute-management.com/), and is republished with consent.

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