Custodial Collies of Transparency-trie Competitive Advantage of Protecting Investing Lamm[bs] from Advising Wolves: Lamm v. State Street Bank & Trust

• Citation: Vol. 66 No. 4
• Publication year: 2015

Custodial Collies of Transparency-Trie Competitive Advantage of Protecting Investing Lamm[bs] from Advising Wolves: Lamm v. State Street Bank & Trust

Steven L. Jones

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Custodial Collies of Transparency—The Competitive Advantage of Protecting Investing Lamm[bs] from Advising Wolves: Lamm v. State Street Bank & Trust

I. INTRODUCTION

Unscrupulous investment advisers who defraud their unsuspecting clients are increasingly prevalent in our society.¹ Consequently, investors must be increasingly vigilant to protect themselves from such individuals.² A custodial bank is one way investors can prevent mismanagement and misuse of funds and securities they entrust to financial advisers.³ However, the United States Court of Appeals for

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the Eleventh Circuit opinion Lamm v. State Street Bank & Trust illustrates that the mere presence of a custodial bank does not adequately insulate investors from fraudulent adviser activity.⁵ Under current Securities and Exchange Commission (SEC) regulations, specifically 17 Code of Federal Regulations (C.F.R.) Section 275.206(4)-2⁶ and boilerplate custody agreements,⁷ custodial banks have no duty to verify the validity of account statement contents, which include transactions made by clients' investment advisers and adviser-provided market valuations of account assets.⁸ Therefore, there is a strong incentive for custodial banks to distinguish their commoditized accounts by giving custodial account holders the option to supplement the custodial services banks traditionally supply with account services that facilitate increased transparency.

II. FACTUAL BACKGROUND

In 2001, Douglas Lamm hired James Tagliaferri's firm, Taurus Advisory Group, LLC (Taurus), as his investment adviser. In compliance with SEC regulation 17 C.F.R. § 275.206(4)-2, which prohibits investment advisers from having direct custody of client's funds and securities, Lamm opened two custodian accounts with separate qualified custodians.⁹ The two custody agreements¹⁰ (collectively custody agreements) Lamm executed for each account were identical in all relevant parts.¹¹ In 2007, State Street Bank & Trust Company (State Street), in conjunction with its merger with Investors Bank & Trust Company, acquired and assumed the obligations of both Mr. Lamm's custody agreements.¹²

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Taurus Advisory Group, which became by merger TAG Virgin Islands

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(collectively TAG), was named as Lamm's investment adviser under the custody agreements and was authorized to furnish transaction instructions—including instruction to remit funds—to State Street on behalf of and without any further approval from Lamm. Contractually, State Street was obligated to send Lamm monthly statements of all transactions into or out of his account, with an itemization of all the funds or securities in that account and, if provided to State Street, their current market values. In the agreements, State Street disclaimed any guarantee as to the accuracy of those market valuations.¹³ The waiver provisions in the contracts stated that Lamm was deemed to have ratified an account statement and State Street would be "released, relieved and discharged," with respect to it unless Lamm objected in writing within sixty days after the statement was issued.¹⁴ Moreover, the choice-of-law provisions designated the laws of the state of New York to govern any disputes arising under the agreements.¹⁵

The opening paragraphs of the custody agreements stated that the accounts were "for the purpose of holding or disposing of any property" State Street received from, or on behalf of, Lamm.¹⁶ When acting in accordance with issued instructions, State Street was also authorized to purchase and sell funds and securities in the custodial accounts as well as to receive and deliver such assets without receipt.¹⁷ The agreements further authorized State Street to accept, rely upon and effectuate all the instructions, without any further confirmation from Lamm that it believed, in good faith, were issued by Lamm or on his behalf.¹⁸ Additionally, the custody agreements disclaimed all liability for any act or omission attributable to State Street while acting in reliance on those instructions, unless that reliance was the result of State Street's gross negligence or willful misconduct.¹⁹ However, a reservation-of-right clause gave State Street the right to refuse to deposit into the account

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any investment that it determined was not compatible, in form or condition, with the services it provided.²⁰

Tagliaferri, TAG's principal, used the investing discretion afforded to TAG under Lamm's custody agreements to effectuate fraudulent investments that resulted in Lamm losing $1,028,500.²¹ Specifically, Tagliaferri invested Lamm's assets in highly speculative stocks and purported promissory notes from micro-cap companies as well as in the form of personal loans and mortgages.²² State Street accepted these

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purported notes on Lamm's behalf and listed them on the monthly statements it issued to him even though the notes displayed facial defects.²³ In April 2011, State Street sent Lamm a letter stating that since September 2010 it had notified him on each monthly account statement that "illiquid, thinly traded and/or private placement securities" in his account had become past due or were past their specified date of maturity.²⁴ Additionally, the letter also stated that although TAG had previously provided the reported asset valuations, and despite State Street's repeated efforts to obtain updated valuations, the bank had not received valuation instructions since November 2010. As a result, State Street declared that, on future statements, it would not assign a value to those assets. Furthermore, on future statements the value of these assets would be indicated as zero only as an indication that a current valuation had not been received.²⁵ Finally, the letter reiterated that State Street did not provide independent valuations for "illiquid, thinly traded and/or private placement securities."²⁶

Consequently, Lamm filed suit against State Street in the United States District Court for the Southern District of Florida. Lamm's seven-count complaint pleaded claims for breach of (1) express contract, (2) implied contract, and (3) fiduciary duty, as well as (4) negligence, (5)

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gross negligence, and (6) aiding and abetting breach of fiduciary duty and (7) aiding and abetting fraud.²⁷ Included in each count were multiple allegations essentially claiming State Street beached its duties owed to Lamm by failing to properly monitor and verify the transactions made and valuations supplied by TAG.²⁸ State Street moved to dismiss Lamm's entire complaint, arguing that the custodial bank's role under the custody agreements was strictly ministerial, and therefore Lamm failed to state a claim upon which relief could be granted.²⁹

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The district court held that under Florida law the custody agreements' choice-of-law provisions were enforceable.³⁰ Accordingly, New York law governed Lamm's contract claims. However, the court held that the choice-of-law provisions did not embrace Lamm's tort claims.³¹ Applying Florida's "'most significant relationship' test," the court determined that Florida law should be applied to Lamm's tort claims because Florida bore a more significant relationship to those claims than New York.³²

The district court dismissed Lamm's breach of contract claim after finding that, under New York law, State Street did not breach any of the custody agreements' contractual duties.³³ The court accepted State Street's argument that none of the duties Lamm alleged State Street breached were encompassed by the bank's actual duties under the custody agreements.³⁴ The court also agreed that the bank's custodial

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role was "merely administrative," and held that State Street was only contractually obligated to perform instructions provided to it by, or on behalf of, Lamm.³⁵ Above all, nothing in the agreements obligated State Street to ensure timely delivery of assets into the account, nor did it require State Street to verify the validity of investments it received.³⁶ In fact, the only discretion State Street contractually held was the reserved right to reject investments deemed incompatible, in form or condition, with the services the bank provided under the custody agreements.³⁷ The district court emphasized that Lamm's failure to object within the waiver provisions' sixty-day window was also fatally determinative to the breach of contract claim.³⁸ State Street's disclaimer of liability for claims arising from its reliance on issued instructions further barred Lamm's claim for breach of contract. Moreover, because the agreement did not require State Street to verify provided valuations, it could calculate its fees based on the values provided. Lamm's allegation that State Street charged excessive fees based on these valuations, therefore, also failed.³⁹

Since the custody agreements imposed no contractual duty on State Street to discover fraudulent transactions, the obvious fraudulent nature of the promissory notes in Lamm's account was insufficient to support recognition of an independent duty. Accordingly, the district court held that Lamm's "tort claims for negligence, gross negligence, negligent misrepresentation, and breach of fiduciary duty" were, in the absence of an independent duty, barred by Florida's economic-loss rule.⁴⁰ State Street did not owe Lamm a fiduciary duty because, under Florida law, banks do not typically owe customers such a duty.⁴¹ Moreover, in the custody agreements, State Street disclaimed any fiduciary responsibility.⁴²

The district court also dismissed Lamm's aiding and abetting claims. Lamm's claim failed because the facts he alleged were insufficient to establish that State Street substantially assisted or encouraged the

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commission of any breach or fraud by Tagliaferri or...