West Virginia's Supreme Court of Appeals has made business safer for derivatives dealers, in a decision whose influence could both benefit and hurt the banking industry.
In a surprisingly colorful 36-page ruling, the court placed responsibility for a securities purchase with the buyer, rather than the seller.
For banks that want to become active securities brokers, especially if Congress repeals Glass-Steagall Act restrictions, the decision is all good news. These banks have an added layer of protection from customer lawsuits.
For small banks, the news is more grim. They could be hurt because they often purchase derivatives and other securities from brokers. Under the West Virginia court's reasoning, they can't automatically sue their broker for letting them buy contracts that are too sophisticated or risky.
Rob Rowe, regulatory counsel at the Independent Bankers Association of America, called the ruling "unfortunate." But he said most small banks have awakened to the dangers that complex derivatives can pose.
These suits have struck fear in many dealers' hearts, leading Bankers Trust New York Corp. and others to settle claims by private parties who lost money on derivative trades.
Securities industry observers said the decision rightly returns responsibility for purchases to the buyer.
"This clarification ... sends a message that as long as dealers behave in a lawful and ethical manner, they will not be held liable for losses simply because they sold the security to the customer," said Paul Saltzman, general counsel for the Public Securities Association.
The case, decided June 3, dates back to 1978, when the West Virginia legislature created an investment pool for idle state money. The fund grew to $2.5 billion in assets and earned significant returns through the early 1980s. But the fund's value nose-dived in 1987, leading to charges of financial mismanagement.
The state turned its spotlight on Morgan Stanley & Co. and six other firms, whose salesmen aggressively pursued the state's business. The other firms settled for $28 million. Morgan Stanley fought, but lost most of its claims before the case went to trial.
The Supreme Court of Appeals overturned that loss, saying a jury must decide whether Morgan Stanley aided state officials who violated their fiduciary duties. The court said the investment house should be able to rely on the competence of the state's managers.
"Morgan had the right to trade with the state without undertaking the obligation to insure the state against its elected officers' lack of wisdom," the court wrote.
The judges, in support of the state's case, did say Morgan officials had to know that fund managers were speculating in violation of numerous laws.
"Yet we are still deeply troubled," the court wrote. "Much to the consternation of law students, practicing lawyers, and even new judges, law is not physics with precise rules and mathematical formulas. Law, like medicine, is an art as well as a science.
"That is why we are called 'judges' and why Microsoft, even as we write, is not attempting to supplant us with a new judicial computer program," they wrote.
The court, in ordering a new trial, said juries should have the right to nullify state securities laws if it believes Morgan Stanley acted appropriately.
