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Luis v. RBC Capital Markets, LLC

United States District Court, D. Minnesota

July 11, 2019

Gary and Caryl Luis, Gary A. Mentz, and Michael and Merri Vitse, individually and on behalf of all others similarly situated, Plaintiffs,
RBC Capital Markets, LLC, Defendant.

          Gregg M. Fishbein and Vernon J. Vander Weide, Lockridge Grindal Nauen PLLP, Daniel E. Gustafson, Daniel C. Hedlund, David A. Goodwin, and Eric S. Taubel, Gustafson Gluek PLLC, and Scott D. Hirsch, Scarlett & Hirsch PA, for Plaintiffs.

          James K. Langdon, Kirsten E. Schubert, and Michael E. Rowe, Dorsey & Whitney LLP, for Defendant.



         This is a one-count, breach of contract dispute between a putative class of investors (“Plaintiffs”) and a financial brokerage firm, RBC Capital Markets, LLC (“RBC”), over the manner in which RBC sold Plaintiffs a complex financial product called a “reverse convertible note, ” or “RCN.” In short, Plaintiffs contend (1) that their contract with RBC required RBC to abide by certain financial industry regulations, (2) that RBC failed to abide by those regulations when it sold them RCNs, and (3) that RBC must accordingly be held liable for that breach of contract, on a class-wide basis. RBC disagrees, and argues that, because the at-issue contract did not require RBC to abide by the at-issue regulations, Plaintiffs' breach of contract claim fails as a matter of law. RBC also contends that, in any event, it did not violate any applicable regulations. Plaintiffs have now moved to certify a class of affected investors, and RBC has simultaneously moved for summary judgment.

         At the motion to dismiss stage of this case, the Court agreed with Plaintiffs, and found that their complaint stated a plausible breach of contract claim. In light of the evidence gathered during discovery, however, it is now clear that the plain language of the at-issue contract, along with the relevant case law, support RBC's view of the case. In contracting with Plaintiffs, RBC did not promise to abide by the at-issue financial industry regulations, and, consequently, Plaintiffs cannot base a breach of contract claim on RBC's failure to comply with those regulations.

         The Court accordingly grants RBC's motion for summary judgment, and denies Plaintiffs' motion for class certification as moot.

         I. BACKGROUND

         Although this case's outcome centers largely around a one-paragraph contractual provision, called the “Applicable Laws and Regulations” provision, for the sake of thoroughness, the Court will nonetheless provide a more detailed accounting of this litigation's factual and procedural background below. The Court hopes this background proves useful in explaining how, exactly, the “Applicable Laws and Regulations” provision came to play the role in this litigation that it did.

         A. Factual Background

         1. The Parties

         Michael and Merri Vitse, Susan Millering, and Lois Boelter are the named Plaintiffs in this putative class action (collectively, “Plaintiffs”).[1] Plaintiffs seek to represent a class of certain individuals who invested in “reverse convertible notes” (“RCNs”), from January 26, 2010 to the present, and who lost money as a result of that investment. (See Pl.'s Br. in Support of Class Certification [Doc. No. 72] (“Pls.' Cert. Br.”) at 4-5 (providing background on named Plaintiffs' investments and losses); Pl.'s Reply Br. in Support of Class Certification [Doc. No. 87] (“Pls.' Cert. Reply Br.”) at 18 (modifying proposed class period to commence on January 26, 2010, rather than on January 1, 2008).)

         Defendant Royal Bank of Canada Capital Markets, LLC (“RBC”) is the brokerage firm, or “broker-dealer, ” that sold (or, better put, facilitated the sale of) the RCNs at issue in this litigation. RBC is a Minnesota corporation with its principal place of business in New York City, New York. (See Am. Answer [Doc. No. 46] ¶ 10.)[2]

         2. Reversible Convertible Notes (“RCNs”), and How They Are Regulated

         RCNs are a complex “structured financial product, ” that combine the consistent interest rate payments of a bond with the inherent riskiness of a stock. (See generally McCann Ex. Rep. [Doc. No. 86-1] ¶¶ 26-42.) In a prior decision in this case, the Court summarized the product as follows:

[RCNs] are, at bottom, a form of bond, consisting of a high-yield, short-term note of the issuer that is linked to the performance of an unrelated reference asset - generally a stock or basket of stocks. RCNs thus contain two components: a [bond] paying an above-market interest rate (occasionally as high as 30%), and a [stock] derivative, in the form of a put option. [This put option] gives the issuer the right to repay principal to the investors in the form of a set amount of the underlying [stock] . . . if the price of the [stock] dips below a predetermined price (often referred to as the ‘knock-in' level). It is this underlying option that gives RCNs greater risk than a traditional bond, because, [if the price of the ‘reference asset' falls below the ‘knock-in' level], an investor may ultimately lose all of his or her principal investment, and be left with only a depreciated asset in return.
Luis v. RBC Capital Markets, No. 16-cv-175 (SRN/JSM), 2016 WL 6022909, at *1 (D. Minn. Oct. 13, 2016) (emphases added) (cleaned up) (hereinafter “Luis I”).

         In other words, when an investor buys an RCN, they are not buying a traditional bond - they are betting that a reference stock (or basket of stocks) will stay at a certain price level, and are then receiving above-market “interest rate payments” in exchange for taking one side of that bet. (The Court uses the word “bet” because, again, if the reference stock falls below the fixed price level, the investor stands to lose some, or all, of their principal investment.) Indeed, in a July 27, 2011 staff report, the SEC referred to RCNs as “perhaps the riskiest [structured financial product] available to retail investors.” (July 27, 2011 SEC Staff Report on Issues Identified in Examinations of Certain Structure Securities Products Sold to Retail Investors [Doc. No. 86-2] at 4-5.)

         When it comes to the regulation of this “risky” financial product, then, the most important cop on the beat is the financial industry's “self-regulatory organization, ” called the “Financial Industry Regulatory Authority, ” or “FINRA” for short. See generally Andrew F. Tuch, The Self-Regulation of Investment Bankers, 83 Geo. Wash.L.Rev. 101, 117-142 (2014) (providing detailed background on FINRA, and describing it as the “primary” regulator of broker-dealers like RBC). Although FINRA technically sits below the Securities & Exchange Commission (“SEC”), Congress has nonetheless invested FINRA with the authority to pass rules with the force of law, enforce those rules through both arbitration and administrative proceedings, and issue guidance about its rules, which are usually called “Notices to Members.” Id.; see also Fiero v. FINRA, 660 F.3d 569, 578-79 (2d Cir. 2011) (distinguishing between FINRA rules promulgated through notice-and-comment rulemaking, which carry the force of law, and FINRA “Notices to Members, ” which do not).[3]

         One FINRA rule, and three FINRA “Notices to Members, ” are relevant here.

         The relevant rule is FINRA Rule 2111(a), also known as the “suitability” rule. (See Rule 2111 [Doc. No. 73-1].) This rule, which has existed in one form or another for decades, [4] provides that FINRA-regulated brokers, such as RBC, “must have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through reasonable diligence of the [broker] to ascertain the customer's investment profile.” (Id. (emphases added).) The Rule then lists a non-exhaustive series of factors a broker should consider as part of its “suitability” analysis, such as “the customer's age, ” “past investment experience, ” “financial situation and needs, ” “investment objectives, ” and “risk tolerance.” (Id.) However, the Rule neither bars the sale of any particular financial product, nor calls out any particular product for special scrutiny. The Rule also does not mandate any specific documentation requirements. In effect, then, the Rule functions as a kind of broad duty of care for brokers to abide by when recommending securities (such as RCNs) to their clients. See Onnig M. Dombalagian, Investment Recommendations and the Essence of Duty, 60 Am. U. L. Rev. 1265, 1297 (2011) (describing the “FINRA suitability rule” as a “middle ground between the undue paternalism associated with fiduciary duties and the assumption of sophistication and rational decision making associated with disclosure-based approaches”).

         That said, on at least three occasions, FINRA (and its predecessor agency, NASD) have provided further guidance as to how Rule 2111 (and related FINRA rules) should apply to the sale of “structured financial products” like RCNs.

         First, and most importantly, is Notice to Members (“NTM”) 5-59, issued in September 2005. (See NTM 5-59 [Doc. No. 73-1].) This NTM “provides guidance concerning the sale of structured products, ” albeit without mentioning RCNs by name. (Id. at 1.) More specifically, the NTM discusses “suitability” in terms of both “eligibility” (also known as “per se suitability”), and “case-by-case suitability.” With respect to “eligibility, ” the NTM notes that broker-dealers “should” “consider whether purchases of some or all structured products should be limited to investors that have accounts that have been approved for options trading.” (Id. at 4.) But, the NTM continues, if a broker allows customers who have not been “approved for options trading” to purchase “structured products, ” the broker “should” “develop other comparable procedures designed to ensure that structured products are only sold to persons for whom the risk of such products is appropriate.” (Id.) The NTM does not further define “other comparable procedures.”

         The next section of NTM 5-59, titled “Suitability and Fair Dealing with Customers, ” essentially parrots Rule 2111, and asserts that, even if a client account is “eligible” to trade a particular structured product as a general matter, a broker must make a “relative suitability” determination on a “customer-specific” basis, too. (Id. at 5-6; see also id. at 6 (“Suitability must be determined on an investor-by-investor basis, with reference to specific facts and circumstances of each investor.”).) This is so because “not every structured product will be suitable for every account approved to trade structured products.” (Id. at 4.)

         NTM 5-59 concludes by noting that, to ensure compliance with “all applicable securities laws, and SEC and [FINRA] rules, ” including FINRA Rule 2111, brokerages should also create “supervisory control systems” and “training systems.” (Id. at 7.)

         The second relevant guidance document is NTM 10-09, issued in February 2010. (See NTM 10-09 [Doc. No. 73-1].) In essence, this NTM repeats NTM 5-59, except this time with particular reference to RCNs. For instance, the NTM notes, “[b]efore recommending a [RCN] to a retail customer, a registered [broker] should discuss the product with the customer to ensure that the customer makes an informed decision about whether to purchase the [RCN].” (Id. at 1.) The NTM then reiterates the “eligibility, ” “suitability, ” “supervisory control systems, ” and “training” guidance noted above, in materially identical language. (Id. at 6-8.)

         The third relevant guidance document is NTM 12-03, issued in January 2012. (See NTM 12-03 [Doc. No. 73-1].) This NTM again reiterates the key concerns from NTM 5-59 and NTM 10-03, and then states that this guidance should result in “heightened supervision of complex [financial] products” like RCNs. (Id. at 1.) To that end, the NTM announces, brokerages “should” enact “formal written procedures to ensure that their registered representatives do not recommend a complex product to a retail investor before it has been thoroughly vetted, ” and “should” “consider requiring some level of supervision by a specially qualified supervisor of these recommended transactions.” (Id. at 6, 8.)

         3. How RBC Sells RCNs To Its Clients

         RBC, like many broker-dealers, is actively engaged in the sale of RCNs. (See, e.g., McCann Rep. ¶ 43 (noting that RBC “issued over 3, 500” RCNs between January 1, 2008 and January 19, 2017).) In order to comply with the aforementioned FINRA rules and guidance, then, RBC adheres to the following three-step process.

         First, RBC enters into a contract with each individual client, called the “Client Account Agreement.” (See Housh Dep. [Doc. No. 79-2] at 28.) The only notable aspect of this contract for present purposes is the aforementioned “Applicable Laws and Regulations” paragraph. (See Client Account Agreement [Doc. No. 79-3] at 5.) The paragraph is number “16” in a list of paragraphs detailing “terms” a client must agree to “in consideration of [RBC] . . . opening an account” on their behalf. (Id. at 1.)

         Specifically, in context, the paragraph reads as follows:

In consideration of [RBC] continuing to or now and hereafter opening an account or accounts (collectively, the ‘Account') for the purchase and sale of securities and commodities for me, or in my name, I agree that all transactions with respect to any such Account shall be subject to the following terms .....
16. Applicable Laws and Regulations
All transactions in my Account shall be subject to all applicable laws and the rules and regulations of all federal, state and self-regulatory agencies, including, but not limited to, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the New York Stock Exchange, Inc., (‘NYSE'), FINRA, the Board of Governors of the Federal Reserve System, and the constitution, rules, and customs of the exchange or market (and the related clearing facility or entity) where executed, as the same may be amended or supplemented from time to time.

(Id. at 1, 5.)[5]

         Second, RBC gathers basic financial information about each client through a document called “Client Account Information.” This document asks a client to list, among other things, (a) their age, (b) their occupation, (c) their “number of years as an investor, ” (d) their “investment experience, ” (e) their number of dependents, (f) their estimated tax bracket, (g) their annual income and net worth, and (h) their “investment objective.” (See Pls.' Client Account Information Forms [Doc. No. 79-4].) A client can describe their “investment objectives” as either “preservation of principal/income, ” “balanced/conservative growth, ” “growth, ” “aggressive growth, ” or “speculation.” (Id.)[6]

         Third, with respect to the sale of RCNs, RBC requires its brokers to look through this “Client Account Information, ” in addition to other information gleaned through the broker's own investigation, and determine whether RCNs are “suitable” for a client under RBC's internal rules (which are themselves a response to the FINRA ...

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