Fifth Circuit Judge Patrick E. Higginbotham wrote a concurring opinion imploring the federal judiciary to stop enforcing arbitration agreements in cases permeated with fraud.
The appeal arose from the $7 billion Ponzi scheme orchestrated by R. Allen Stanford, now serving a 110-year prison sentence. The Securities and Exchange Commission initiated a receivership and tasked the receiver with bringing lawsuits to aid defrauded investors.
The receiver filed fraudulent transfer suits against several of Stanford’s higher-level employees to recover salaries, commissions and bonuses they received. The employees in turn filed motions to compel arbitration under rules promulgated by the Financial Industry Regulation Authority (FINRA) governing disputes between brokers and their employees.
The district court denied the arbitration motion, leading to the Fifth Circuit’s per curiam affirmance on Jan. 31. In addition to Judge Higginbotham, the panel included Circuit Judges Priscilla R. Owen and Jennifer Walker Elrod.
Although there was a lengthy predicate to the ruling, the per curiam opinion narrowly held that each of Stanford’s companies was a separate entity. The appeals court therefore upheld denial of the arbitration motion because the receiver could sue on behalf of a Stanford bank, which was not subject to FINRA’s rules requiring arbitration.
The holding was further narrowed when the appeals court said the Stanford entity on whose behalf the receiver sued must be in a position to assert the fraudulent transfer claim.
In his concurrence, Judge Higginbotham made a huge leap when he said that “arbitration agreements may be rejected when they are instruments of a criminal enterprise, as the arbitration agreements were.”
The per curiam opinion declined to go so far, saying, “we are wary of endorsing these broad policy arguments in the absence of specific direction from the Supreme Court.”
With regard to the high court, Judge Higginbotham said that the Supreme Court authority “does not suggest” that “arbitration should nevertheless be enforced” when “arbitration has been used as an instrument in fraud itself.”
In frauds like Stanford’s, Judge Higginbotham said, “Swindlers can use arbitration to mitigate discovery and cabin attending risk of exposing fraudulent activity.”
Because Stanford could use the arbitration agreements to help in keeping his fraud a secret, Judge Higginbotham said that arbitration was “central to Stanford’s Ponzi scheme with its inherent need for privacy” and the agreements were therefore “instruments of Stanford’s fraud.”
Before the adoption of the Federal Arbitration Act (FAA), courts were antagonistic to arbitration. Since the adoption of the FAA, the pendulum has swung in the other direction, bedeviling bankruptcy trustees when creditors or defendants file motions to compel arbitration. Courts therefore struggle to invent exceptions in bankruptcy to general rules strongly favoring arbitration.
The adoption of Judge Higginbotham’s approach would ease the burden on bankruptcy trustees when they are resisting arbitration agreements.
For example, click here to see ABI’s discussion of a decision from the Second Circuit in October 2016 holding that an arbitration clause cannot be enforced when the issue concerns the subordination of hundreds of employees’ claims. Soon, the Second Circuit will be deciding whether to enforce arbitration agreements when consumers file class actions alleging violations of discharge injunctions. District courts in New York are split on the outcome. To read the ABI discussion, click here.