A New York federal district court granted a broker’s motion to temporarily enjoin arbitration proceedings involving a credit default swap dispute, finding that the party seeking arbitration had failed to clearly show that it was a “customer” that could unilaterally seek and compel FINRA arbitration proceedings.
In Citigroup Global Markets Inc. v. VCG Special Opportunities Master Fund Ltd., No. 08-CV-5520 (BSJ), 2008 WL 4891229 (S.D.N.Y. Nov. 12, 2008), VCG and Citibank Global Markets (CGMI) entered into a prime brokerage contract (PBC) covering the “clearance and settlement of trades performed by other executing brokers” involving fixed income securities. The PBC contained a provision stating that no dispute or controversy arising out of or relating to the PBC would be subject to or settled by arbitration.
Later, VCG also entered into a contract contemplating multiple credit default swap (CDS) transactions. In one of these later CDS transactions, the “Millstone CDO,” VCG entered into an agreement with CGMI’s parent company, Citibank, in which VCG acted as the “protection seller” and was due periodic obligation payments from the “protection buyer.” Citibank acted as the protection buyer and received collateral in support of the transactions and other periodic payments.
VCG later brought suit against Citibank, alleging that Citibank had improperly requested additional collateral from VCG to secure its obligation under the Millstone CDO. The district court granted Citibank’s motion and dismissed the suit with prejudice. VCG Special Opportunities Master Fund Ltd. v. Citibank, N.A., No. 08-CV-01563 (BSJ), 2008 WL 4809078 (S.D.N.Y. Nov. 5, 2008).
Subsequently, VCG initiated arbitration proceedings against CGMI pursuant to CGMI’s membership as a broker with the Financial Industry Regulatory Authority (FINRA). VCG alleged that CGMI fraudulently induced VCG into the Millstone CDS transaction for the benefit of another client, its parent company Citibank. CGMI then moved the Court for a preliminary injunction to enjoin the FINRA arbitration proceedings, maintaining that the dispute was not arbitrable under the clear language of the PBC.
After first determining that CGMI would suffer irreparable harm should it be improperly compelled to arbitrate the dispute, the Court turned to whether CGMI agreed to arbitrate the claims brought by VCG. As a threshold matter, the Court could find no clear and unmistakable evidence that the parties agreed to submit arbitrability questions to the arbitrator, noting that the PBC, the only explicit contract between the parties, contemplated only fixed income security transactions and did not contemplate arbitration. Because the instant dispute concerned CDS transactions, and not fixed income securities, the Court found the PBC inapplicable and determined that it must decide the question of arbitrability.
The Court next turned to CGMI’s membership in FINRA, and whether this membership obligated it to arbitrate the dispute with VCG. Under the FINRA Code, members need only arbitrate a dispute if so required by a written agreement or if arbitration is requested by the customer. Here, the Court decided that no written agreement required arbitration, but observed the parties’ disagreement as to whether VCG was a “customer” that could compel arbitration with a FINRA member.
The Court noted VCG’s reliance on a third-party manager’s declaration that characterized VCG as a “customer of CGMI since 2006.” It also noted CGMI’s assertion that the CGMI employees negotiating the CDS transactions with VCG were acting on behalf of Citibank, not CGMI. Under these circumstances, the Court determined that CGMI could not make a showing of probable success that there was no relationship between CGMI and VCG, considering CGMI’s actions as an agent of Citibank.
However, the Court did decide that there were “serious questions raised” as to VCG’s customer status under the FINRA rules, because all relevant documents confirmed that the CDS transaction contracts were between VCG and Citibank, not CGMI. Under the circumstances, the Court questioned whether VCG could ever be a “customer” in this transaction if CGMI was also charged with “negotiating and settling” the transactions between Citibank and VCG as a fiduciary advisor.
In light of the close question of arbitrability and the irreparable harm to CGMI if it was improperly compelled to arbitrate the dispute, the Court granted CGMI’s motion for a temporary injunction. The Court emphasized that the harm to VCG in merely delaying arbitration if the Court ultimately found the dispute arbitrable was far less than the harm to CGMI if arbitration proceeded and the Court ultimately determined the dispute was not arbitrable.