Securities Brokerage Firm Owes No Duty to Non-Customers in Ponzi Scheme Case, Says New Jersey Appeals Court

In a case of first impression, the New Jersey Appellate Division affirmed the dismissal of negligence claims brought against securities brokerage firm Merrill Lynch, finding that Merrill Lynch owed no duty of care to third parties who claimed the company should have policed its customer's account for fraud.  Frederick vs. Smith, et als., Superior Court of New Jersey, Appellate Division, Docket A-1620-09T2 (November 9, 2010).

In this case the plaintiffs alleged that defendant Maxwell Baldwin Smith (Smith) convinced them to invest in Healthcare Financial Partnership (HFP), a fictitious entity.  As part of the fraud, Smith instructed plaintiffs to convey the invested funds to an account that he maintained with Merrill Lynch.  Plaintiffs were not Merrill Lynch clients, yet Merrill Lynch accepted payment directly from the plaintiffs and the funds were deposited into Smith's account.  In support of their negligence claims, plaintiffs alleged that Smith convinced them to invest in HFP, which he claimed was "a secure tax-free investment which paid a high level of interest through investment in a diversified portfolio of high yielding income projects."  According to their Complaints, plaintiffs collectively invested approximately $10 million in HCP over a number of years.  Smith instructed plaintiffs to make their checks payable to "Merrill Lynch A/C #36641" or "directly to Merrill Lynch," in the process misrepresenting to them that Merrill Lynch was the security's underwriter.

According to plaintiffs, Smith opened up this personal account at Merrill Lynch "for the sole purpose of furthering the Ponzi scheme."  Once plaintiffs' checks were deposited in Smith's personal Merrill Lynch account, Smith remitted to plaintiffs phony correspondence memorializing the deposit and then used the funds for his own benefit.  By the time plaintiffs discovered what was happening, they lost their entire investment.

Even though Smith was not employed by Merrill Lynch, and plaintiffs maintained no legal relationship with Merrill Lynch, plaintiffs alleged Merrill Lynch was negligent for failing to discover Smith's use of his MerrillLynch account to perpetrate a fraud.   At the trial lever, plaintiffs conceded that ordinarily a bank only owes duties to its customers, but claimed that a fiduciary relationship was established in this case because they wrote checks directly to Merrill Lynch when investing in HCP.

The trial court dismissed the negligence claims against Merrill Lynch, finding that under applicable Merrill Lynch only owes a duty to its customers.   In affirming the trial court's dismissal, the NJ appellate court explained: 

Although our courts have not previously considered whether a brokerage firm owes a duty towards non-customers in this context, our Supreme Court has expressed a "reluctance to impose a duty of care on banks in respect of a total stranger."  Brunson v. Affinity Fed. Credit Union, 199 N.J. 381, 403 (2009); see also City Check Cashing v. Mfrs. Hanover Trust Co., 166 N.J. 49, 60 (2001).

The appeals court concluded that the absence of any relationship between plaintiffs and Merrill Lynch precludes the imposition of a duty on Merrill Lynch to periodically or regularly police the personal account maintained by Smith for indicia of fraud. 

"The fact that plaintiffs may have at times submitted checks directly to Merrill Lynch, as instructed by Smith, did not create a relationship where none previously existed," the Court remarked.  

Merrill Lynch deposited the checks in Smith's account as directed; it issued no statements to plaintiffs and derived no financial benefit from the fact that checks may have been written directly to Merrill Lynch instead of Smith. In the absence of no greater nexus between plaintiffs and Merrill Lynch, or between Smith and Merrill Lynch, plaintiffs possessed no viable negligence claim against Merrill Lynch.

Accordingly, the appeals court affirmed the dismissal of the negligence claims against Merrill Lynch.