A New York federal court recently ruled that an information barrier in place between the “public” and “private” sides at JPMorgan Chase Bank (“JPMC”) was adequate to prevent public trust group personnel from obtaining material non-public information from JPMC’s private investment business. As such, the court found that a claim that JPMC breached its duty of loyalty by investing its client’s assets in notes of a company to which its private side extended billions in financing lacked merit. The court found the existence of “wall straddlers” who were aware of transactions on both sides of the wall, did not change this outcome as any such information passed was not material to JPMC’s investment decisions for its clients. Board of Trustees of the AFTRA Retirement Fund v. JPM Chase Bank, N.A., 09 Civ. 686 (SAS) (S.D.N.Y. Aug. 2011).
Since the passage of the Federal Reserve Act in 1913, federal law has permitted national banks to manage and invest trust accounts while at the same time engaging in commercial lending for their own account. Thus, a bank in its trust management function can invest clients’ funds in securities of a corporation while, at the same time, the bank is a lender to that corporation — provided that an information barrier, or Chinese wall, is in place between the two functions to prevent the flow of material, nonpublic information from the commercial department to the trust department. This permissive approach carries over to a variety of federal laws and regulations. For example, the Office of the Comptroller of the Currency (“OCC”) permits the commercial arm of a national bank to make secured loans directly to a fiduciary client. 12 C.F.R. § 9.12(c). The Federal Deposit Insurance Corporation also permits the simultaneous investment of fiduciary assets and commercial bank lending with respect to the same issuer, so long as an information wall is in place. Likewise, the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. § 1851(d)(1), does not contemplate the disaggregation of banks’ fiduciary asset management and corporate finance functions.
OCC regulations require that national banks exercising fiduciary powers, for example by investing for their clients funds, adopt “[m]ethods for ensuring that fiduciary officers and employees do not use material inside information in connection with any decision or recommendation to purchase or sell any security.” The OCC thus requires that a wall be established to “prevent the passage of material inside information between a bank’s fiduciary department and its commercial department in violation of securities laws and regulations, as well as fiduciary standards.” 12 C.F.R. § 9.5(b)-(c).
JPMC’s securities lending group, part of the public side of JPMC’s business, manages the accounts of various clients, including the assets of ERISA plans. In June 2007, acting in this fiduciary capacity, JPMC allegedly purchased for certain securities lending clients, using their cash collateral, $500 million in the June 2009 Medium Term Notes (the “Notes”) of SIGMA Finance, Inc. (“SIGMA”), a structured finance vehicle. Although SIGMA secured those notes with a floating first priority lien over its assets, SIGMA was contractually entitled to grant superior interests on specific assets to other lenders — thereby making such assets potentially unavailable to support the notes.
Shortly after JPMC’s securities lending group had invested its clients’ funds in SIGMA’s notes, JPMC’s private side investment bank allegedly extended billions of dollars of repo financing to SIGMA. A repo is a form of financing structured as a sale of securities with a simultaneous agreement to repurchase those securities at a later date, thus in effect making the repo a loan in the amount of the sale proceeds collateralized by the security. Specifically, between February and August 2008, JPMC entered into four agreements extending SIGMA an aggregate of $8.4 billion in repo financing. In connection with such loans, JPMC allegedly “cherry picked” SIGMA’s assets used to secure that financing, securing the best assets in SIGMA’s portfolio as security for its financings, thereby making those assets unavailable as security for the SIGMA notes.
SIGMA collapsed in September 2008, causing considerable losses to JPMC’s clients. On September 30, 2008, JPMC issued notices of default to SIGMA under its repo agreements. A day later, SIGMA entered receivership, and the receivers later held an auction sale of all of SIGMA’s assets. While JPMC’s investment side allegedly reaped substantial profits from its SIGMA repo loans, the anticipated losses to SIGMA’s noteholders, including JPMC’s securities lending clients, were substantial with an expected recovery of only about six cents on the dollar.
Following SIGMA’s collapse, a putative class action suit was brought asserting claims on behalf of JPMC’s securities lending clients whose cash collateral JPMC had invested in the SIGMA notes. The claims included breach of fiduciary duty, breach of loyalty and mismanagement of assets. The class action members governed by ERISA (i.e., member of ERISA plans whose funds were invested in the SIGMA notes) brought these claims pursuant to ERISA, whereas class members not covered by ERISA (non-ERISA plan investors) asserted analogous claims under New York common law. Thereafter, the court certified the class.
The parties cross-moved for partial summary judgment on plaintiffs’ claim that JPMC breached its duty of loyalty by investing its fiduciary clients’ cash collateral in the SIGMA notes while, at around the same time, JPMC extended billions of dollars of repo financing to SIGMA. Plaintiffs further alleged that, as part of its duty of loyalty, JPMC had a duty to disclose to them, and failed to, its role as a repo lender to SIGMA. The plaintiffs alleged that, as repo lender, JPMC “reaped nearly $2 billion of profits for itself while leaving the class notes virtually worthless.” In response, JPMC argued, among other things, that the information barrier between its securities lending and commercial segments effectively prevented any conflict of interest. The motions did not address, and thus the court did not decide, the viability of plaintiffs’ claim that JPMC failed to prudently manage their assets.
The Court’s Analysis
The court ruled for JPMC and dismissed the breach of loyalty claim.
The court initially observed that a fiduciary, whether under ERISA or common law, is charged with a duty of loyalty pursuant to which it is obligated to give its beneficiary its undivided loyalty, free from any conflicting personal interests. As such, ERISA identifies as a prohibited transaction the fiduciary dealing with its clients’ assets in its own interest or for its own account. The court further observed that an ERISA fiduciary has an affirmative duty to inform its clients of information that the fiduciary knows might be harmful to its clients. This includes disclosing a material conflict of interest that may render suspect the advice given by the fiduciary acting in a fiduciary capacity.
The court found, however, that, in extending repo financing to SIGMA, JPMC was not acting in its fiduciary capacity and, thus, no conflict of interest existed. While JPMC acted in a fiduciary capacity when lending out plaintiffs’ securities and investing their collateral in the SIGMA notes, JPMC’s private side was not acting in that fiduciary capacity in the repo financings. The court found that two Court of Appeals decisions, Ershick v. United Mo. Bank of Kan. City, M.A., 948 F.2d 660 (10th Cir. 1991), and Friend v. Sunwise Anwa Bank of Cal., 35 F.3d 466, 469 (9th Cir. 1994), provided strong support for JPMC’s argument that it did not violate its duty of loyalty merely because it acted simultaneously as an investment manager and a secured lender. The court noted that, under this precedent, action by a bank’s commercial loan department is not taken in its fiduciary capacity as a trustee. Moreover, these courts found that even direct communications between a bank’s commercial department and its trust department about the fact that the commercial side extended secure financing and the fact that the bank served as trustee does not convert the commercial department’s actions into actions taken in a fiduciary capacity. Finding no conflict of interest, the court also found that JMPC had no duty to disclose its alleged conflicted status.
The plaintiffs submitted evidence that some information concerning SIGMA had in fact crossed the wall between the public trust group and the private investment bank group. Although JPMC’s securities lending personnel were never told by the private side of the bank that JPMC was providing repo financing to SIGMA, several heard rumors in the market place that JPMC was a SIGMA repo lender. Moreover, JPMC’s CEO Jamie Dimon and other high ranking officials of JPMC’s investment bank allegedly were aware that the securities lending held SIGMA notes for its clients. The court found this evidence unpersuasive. The court stated that a wall need not be an absolute barrier to all information, but rather is intended to prevent the bank’s use of significant non-public information in making investment decisions. JPMC’s expert testified that JPMC’s status as a repo financier of SIGMA was not material nonpublic information. The court stated:
Preventing banks from aligning their private-and public-side incentives, but then penalizing them when it turns out-or their private side discovers - that their fiduciary clients’ money is invested in the same assets in which their public side holds a priority interest, would effectively penalize them for complying with the law.
Separately, the court found a lack of causation between plaintiffs’ losses and the alleged breach of loyalty. The court observed that the “notes were not paid because the market tumbled, not because JPMC loaned over $8 billion to SIGMA at its request.” The court added that plaintiffs failed to establish that JPMC would not have extended repo financing or would have prevented SIGMA’s bankruptcy if JPMC’s security lending department had not served as plaintiffs’ fiduciary. The court further found that there was no evidence that JPMC’s involvement as a repo lender to SIGMA influenced its public side’s management of clients’ assets, or that its failure to disclose its status as a repo lender was somehow motivated by the desire to protect itself to the detriment of its fiduciary clients.
Information barriers are an important aspect of compliance in today’s financial institutions. While the existence of a wall here may not have been the dispositive factor in dismissing the breach of loyalty claim, it clearly was an important element of the court’s reasoning. This decision thus reinforces the importance of honoring information barriers imposed by public side-private side walls so as to reduce potential liability risks.