The Ontario Court of Appeal has recognized the contractual obligation of brokerages to stop dealings with clients who could land them in regulatory hot water.

Brokerages are “gatekeepers” for the securities markets, the OCA says in its May decision of Venture Capital USA Inc. v. Yorkton Securities Inc., and they must ensure that they are facilitating trades in accordance with securities law.

“Bravo to the Court of Appeal for understanding the onerous obligations dealers and advisors face in this highly regulated industry,” says Ellen Bessner, a partner with Gowling Lafleur Henderson LLP in Toronto and a lawyer who practises in the area of broker liability.

“If they’re going to be charged with the responsibility of gatekeeping,” she says, “they can’t be exposed to damages when it comes to freezing and terminating client accounts in good faith.”

The OCA overturned an award of $500,000 plus pre-judgment interest and costs given by the trial judge as penalty for “freezing” Venture’s accounts.

The case began in late 1999, when Yorkton’s director of compliance, Patrick McNenly, became aware that Ventures was controlled by Harold Arriv, who had been convicted of extortion, “placing an explosive substance with intent,” as well as racketeering in Florida.

(The OCA notes that Yorkton, itself, was under Ontario Securities Commission scrutiny for its business conduct in the same period.)

On Jan. 11, 2000, Yorkton notified Arriv that “no further transactions” would take place on Venture’s accounts and advised him to find another broker. The accounts were transferred to another broker by Feb. 3, 2000. Then Venture sued for alleged losses resulting from the suspension of its accounts.

Yorkton testified at trial that, as Venture was trading large blocks of shares of U.S.
companies, it was concerned the trades might cross the line with the U.S. Securities and Exchange Commission. Yorkton also provided the court with evidence of a “refusal clause” in its contract with Venture, giving it “the right to refuse to accept purchase or sale instructions from the client whenever Yorkton shall deem it necessary for its protection or otherwise.”

However, the trial judge found Venture’s inability to transact business from Jan. 11 to Feb. 3 was solid ground for liability and damages. “In my view, Yorkton had a contractual duty to continue to operate accounts for the plaintiffs unless the proposed transaction was illegal or involved other significant malfeasance; otherwise, the defendant was obliged to give reasonable notice that the activities were being suspended,” the court said.

The judge also found that McNenly was motivated by “the desire to disassociate the firm from the name of Harold Arriv” because of his criminal past. The evidence showed the affected transactions were not illegal. As a result, she ruled, a “reasonable notice” period was required.

The OCA disagreed.

It notes that brokerages owe two legal duties to their clients: to follow and carry out client instructions; and to give notice when terminating the contractual relationship.
However, says the OCA, both these duties “may be modified by contract.” Therefore, it reasons, the trial judge made a mistake by imposing a contractual term of giving notice on top of Yorkton’s common law and contractual duties.

The OCA is saying Yorkton had the contractual right to terminate the account, says Ed Waitzer, chairman of national law firm Stikeman Elliott LLP in Toronto. The OCA also says the way Yorkton did it was “flawed,” Waitzer notes. “Leaving the conflicted broker to manage the transition led to less-than-clear communication with the client,” he adds.

However, notes the OCA, part of the delay involved in transferring the accounts was because Venture did not transfer them to CIBC World Markets, where it already had an account. Instead, Arriv transferred the securities and cash into an account at Thomson Kernaghan & Co. Ltd., which was initially reluctant to open an account for him.

By taking notice of failure on both sides, says Waitzer, the OCA is acknowledging the obligations are reciprocal for both parties, including the brokerage’s duty to give reasonable notice, and the client’s duty to mitigate its damages by taking reasonable steps to go elsewhere.

Although there were some missteps in the notice process, he adds, the appeal court found no damages were warranted.

“The only constraint upon Yorkton’s right to refuse instructions under the refusal clause is that it must have ‘deemed’ the refusal necessary for its protection or otherwise,” says the OCA. Deeming the refusal necessary must be “carried out in good faith,” the court adds. “The term implied by the trial judge would unduly constrain the broker’s gatekeeper function and, accordingly, it fails to accord with modern commercial reality.” .

@page_break@Bessner agrees. “Brokers have to be very, very careful about whom they take on as clients. They don’t want to be subject to expensive litigation.” IE>/b>