Fifth Circuit Reverses the Vacatur of a FINRA Award Because the Award was not Procured by Fraud and the Arbitrators did not Exceed Their Powers

by Jeremy Clare

The United States Court of Appeals for the Fifth Circuit reversed the vacatur of a FINRA Award because it disagreed with the district court’s finding that the award was procured by fraud, or in the alternative, that the arbitration panel exceeded its powers.

Background

In Morgan Keegan & Company, Inc., v. Garrett, et al, No. 11-20736 (5th Cir. Oct. 23, 2012), a group of eighteen investors (“Garrett”) brought a claim of statutory and common-law fraud against Morgan Keegan & Company (“Morgan Keegan”) before an arbitration panel of the Financial Industry Regulatory Authority (“FINRA”). Garrett alleged that Morgan Keegan essentially created a Ponzi scheme by overvaluing assets held by mutual funds that Garrett invested in and used principal from the funds to pay purported dividends to maintain the illusion that the investments were sound. Garrett did not learn of the fraudulent scheme until another company conducted an audit of the funds’ assets. By that time, Garrett had lost most of their capital investments in the funds.

Morgan Keegan filed motions during the arbitration proceeding that argued that the claims were derivative claims and thus not subject to FINRA arbitration. Morgan Keegan also argued that two of the appellants, Goodwin and Harris, were not “customers” of Morgan Keegan and it had no binding agreement to arbitrate their claims. The arbitrators disagreed and rejected Morgan Keegan’s arguments.

During the arbitration, Dr. Craig McCann (“McCann”), a securities analyst, provided testimony as to how much money Garrett lost due to the fraudulent scheme. McCann later testified in a related arbitration between Morgan Keegan and other investors over the same issue. However, in the second arbitration, McCann testified to different numbers than he had in the Garrett arbitration. McCann claimed that the discrepancy was due to an error in calculations by one of his staff members. He only learned of the errors after his testimony in the Garrett arbitration. The corrected numbers were provided to Morgan Keegan two weeks before the award was issued in the Garrett arbitration. Even with the miscalculations, the arbitration panel issued an award in favor of Garrett.

Morgan Keegan filed a motion with the district court to vacate the award. The district court vacated the award after concluding that the arbitration panel exceeded its authority because (1) they heard claims from Goodwin and Harris, with whom there was no agreement to arbitrate, and (2) Garrett’s claims were derivative claims and not subject to FINRA arbitration. In the alternative, the district court concluded that the award was procured by fraud because McCann knowingly testified to incorrect numbers and the arbitration panel based its decision on those numbers. The district court also granted Morgan Keegan attorneys’ fees and expenses according to a provision contained in the client agreements.

Fifth Circuit

Under § 10 of the Federal Arbitration Act (“FAA”), a court may vacate an award for four reasons. The Fifth Circuit Court recognized that this case involved two of the four grounds: (1) the award was procured by fraud, and (2) the arbitrators exceeded their powers. The Court concluded that the district court erred in both of its findings and that no grounds for vacatur existed.

First, the Court addressed the issue of fraud. Citing previous opinions, the Court stated that under § 10(a)(1) of the FAA, a party alleging fraud must demonstrate: (1) that the fraud occurred by clear and convincing evidence; (2) that the fraud was not discoverable by due diligence before or during the arbitration hearing; and (3) the fraud materially related to an issue in the arbitration. The Court concluded that Morgan Keegan did not and could not meet the requirements of the second prong because Morgan Keegan was aware of the miscalculations before the award was written and it could have discovered the miscalculations if it performed its due diligence. Thus, the district court erred in vacating the award based on fraud grounds.

Second, the Court concluded that the arbitrators did not exceed their powers. The Court recognized that federal courts may review awards to ensure that arbitrators act within their jurisdiction. However, the Court also recognized that any doubts concerning the scope of arbitrability should be resolved in favor of arbitration. Citing the arbitration agreement between the parties, the Court concluded that the broad arbitration provision within the agreements allowed for such an arbitration. Furthermore, all parties involved agreed to the FINRA Submission Agreement before the arbitration began. By doing so, the parties agreed to arbitrate according to FINRA Rules which gave the authority to determine arbitrability to the arbitration panel. The Court concluded that the panel was within its authority to decide that the claims were not derivative claims and that Goodwin and Harris were “customers.” Thus, the district court erred in vacating the award based on the arbitrators exceeding their authority.

The Court reversed and remanded with instructions to enter judgment enforcing the award and reverse the order awarding attorneys’ fees and expenses to Morgan Keegan.