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North v. Smarsh, Inc.

United States District Court, District of Columbia

December 4, 2015

THADDEUS J. NORTH, et al., Plaintiffs,
SMARSH, INC., et al., Defendants.



Thaddeus J. North and Mark P. Pompeo (Plaintiffs) were securities brokers who were the subject of enforcement actions by the Financial Industry Regulatory Authority (FINRA). Pursuant to the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq. (Exchange Act), FINRA initiated disciplinary actions against Plaintiffs for alleged improprieties and noncompliance with securities laws and regulations. In pursuing these actions, FINRA asked Smarsh, Inc. -- the email vendor for Plaintiffs’ former firms -- to produce copies of internal and external electronic communications concerning Plaintiffs and other registered brokers.

In the instant case, Plaintiffs allege that the data produced by Smarsh and relied upon by FINRA was spoliated and tampered. Compl. [Dkt. 1]. They seek monetary damages for the intentional or negligent spoliation of the data. Id. at 29. Plaintiffs also seek to enjoin FINRA’s disciplinary actions, as well as to prevent the dissemination and use of such data in any future proceeding. Id. Both FINRA and Smarsh (Defendants) separately move to dismiss. Plaintiffs filed oppositions to both motions to dismiss, to which Defendants filed separate replies. The parties also filed a sur-response and sur-replies. The Court will grant Defendants’ motions to dismiss.


A. The Parties

Mr. North is a resident of Connecticut. From February 2008 to August 2011, Mr. North was the Chief Compliance Officer of Southridge Investment Group, LLC (Southridge). In 2010, FINRA began investigating Southridge because of certain improprieties concerning the owner’s management of a hedge fund and an alleged business relationship between LK, a broker registered with Southridge, and TC, a person who is a statutorily disqualified from working as a broker. As a result of the investigation, Mr. North and about half of his Southridge colleagues left that firm and became registered with Ocean Cross Capital Markets, LLC (Ocean Cross). Mr. North worked at Ocean Cross, also as Chief Compliance Officer, from August 2011 to January 2013. Mr. North is also a respondent in two FINRA Enforcement Disciplinary Proceedings: (1) Proceeding No. 2010025087302 involving Southridge (Southridge Proceeding); and (2) Proceeding No. 2012030527503 involving Ocean Cross (Ocean Cross Proceeding). In both proceedings, FINRA accused Mr. North of failing to review sufficient electronic correspondence to ensure compliance with securities laws and regulations. In the Southridge Proceeding, FINRA also accused Mr. North of failing to identify and report the business relationship between LK and TC.

Mr. Pompeo is a resident of Massachusetts. He was a registered securities broker with Southridge from January 2010 to September 2011 and with Ocean Cross from September 2011 to September 2012. On August 16, 2013, FINRA charged Mr. Pompeo with violating FINRA rules pursuant to FINRA Examination No. 20120305375.[2] Mr. Pompeo settled the case against him. As such, Mr. Pompeo is not a respondent in the underlying FINRA disciplinary proceedings.[3]

Smarsh is a New York corporation with its principal place of business and headquarters in Portland, Oregon. Page Decl. in Supp. of Smarsh’s MTD [Dkt. 9-1] (Page Decl.) ¶ 2. Smarsh also has satellite offices in Atlanta, Boston, Los Angeles, New York, and London. Id. Smarsh holds itself out to be “the leading provider of archiving & compliance solutions for companies in regulated and litigious industries.” Compl. ¶ 5. Smarsh contracted with Southridge and Ocean Cross “to preserve exact and unchangeable copies of internal and external communications for all registered representatives of the two (2) firms for compliance at all times from July 1, 2009 through July 1, 2013 (Relevant Period). . . and according to the requirements of the Exchange Act.” Id.

FINRA is a private not-for-profit Delaware corporation and a self-regulatory organization (SRO) in the securities industry. FINRA is registered with the Securities Exchange Commission (SEC) as a national securities association pursuant to the Maloney Act of 1938, 15 U.S.C. § 78o-3 et seq., and has its headquarters in Washington, D.C. FINRA serves as both a “professional association [that] promot[es] the interests of its members” and as a “quasi-governmental agency” authorized “to adjudicate actions against members who are accused of illegal securities practices and to sanction members found to have violated the Exchange Act or . . . [SEC] regulations issued pursuant thereto.” Compl. ¶ 6 (quoting Nat’l Ass’n of Sec. Dealers, Inc. v. SEC, 431 F.3d 803, 804 (D.C. Cir. 2005)).[4] FINRA’s disciplinary actions “may be adjudicated before a [FINRA] Hearing Panel” and the Panel’s “decisions may be appealed to the National Adjudicatory Council (NAC), or they may be reviewed by NAC on its own initiative.” Id. (citations omitted). NAC can affirm, reverse, or modify the Panel’s decision. Once a final disciplinary action is taken against a member, FINRA must notify the SEC of said action, which “may then act sua sponte, or pursuant to a petition from the aggrieved member, to review NAC’s decision de novo.Id. (citations omitted); see also 15 U.S.C. § 78s(d). FINRA, in its role as first-level adjudicator, cannot appeal an SEC decision that reverses a NAC decision. Id. at 805. The aggrieved member, however, may appeal an SEC decision to the relevant U.S. Court of Appeals or the U.S. Court of Appeals for the District of Columbia Circuit. See 15 U.S.C. § 78y.

B. FINRA Rules on Electronic Communications

FINRA Rule 3110(a)-(d) and SEC regulation at 17 C.F.R. § 240.17a-4(f) require securities broker-dealers to preserve all written and electronic communications. Copies of all electronic communications must be preserved “exclusively in a non-rewritable, non-erasable format.” 17 C.F.R. § 240.17a-4(f)(2)(ii)(A). Such electronically stored information (ESI) includes emails, chats, instant messages, and like communications regardless of the digital device used to send or receive them. The electronic record is the original and official federal record of these communications. See Armstrong v. Executive Office of the President, Office of Admin., 1 F.3d 1274 (D.C. Cir. 1993). As a result, SEC has warned that any ESI systems that are vulnerable to the “ability to overwrite or erase records stored on these systems” are “non-compliant with Rule 17a-4(f).” Compl. ¶ 12 (quoting Electronic Storage of Broker-Dealer Records, Exchange Act Release No. 34-47806, 68 Fed. Reg. 25281-02, 25283 (May 12, 2003)).

As alleged, Southridge and Ocean Cross contracted with Smarsh to ensure their compliance with these regulatory duties of preservation. Specifically, they hired Smarsh to:

(a) use proper care to preserve by commercially responsible methods exact, unalterable, non-rewriteable, and non-erasable copies of each firm’s registered representatives’ domain emails, Bloomberg messages and other electronic correspondence in a permanent file for the Relevant Period, (b) provide access to that database of ESI for compliance review, and (c) maintain an accurate electronic record that documents ESI compliance reviews.

Id. ¶ 14. Plaintiffs allege that they reasonably relied on Smarsh’s “knowledge, expertise and representations respecting its archival and compliance solutions” and reasonably “believe[d] that Smarsh would exercise due and proper care in preserving their own and the firms’ internal and external electronic communications in a commercially reasonable manner in an accessible and properly searchable database.” Id. ¶ 28.

C. FINRA’s Investigation and Disciplinary Proceedings

William E. Schloth, who is not a party to this suit, was the Chief Executive Officer and General Securities and Financial Operations Principal at Southridge and then Ocean Cross at all times during the Relevant Period. Mr. Schloth hired LK in July 2009 and was her direct supervisor at both Southridge and Ocean Cross. Mr. Schloth interviewed TC in June 2009, but did not hire him because of the time and expense of attempting to reverse his disqualification from the industry. Mr. Schloth informed FINRA in August 2009 about a business relationship between LK and TC. As a result, FINRA began to investigate LK for allegedly working with TC.

In the course of FINRA’s investigation, Southridge and Ocean Cross “arranged for Smarsh to deliver the firms’ electronic communications directly to FINRA . . . .” Id. ¶ 34. FINRA’s Department of Enforcement conducted on-the-record interviews of Mr. North and Mr. Schloth in April 2012 and of LK in September 2011 and August 2012. Following the delivery of Smarsh’s records to FINRA, the Southridge and Ocean Cross disciplinary proceedings were initiated against Mr. North in July and August 2013. FINRA also accused Mr. Pompeo of violating FINRA Rule 2010 and NASD Rule 2210(d) because he had allegedly sent information about investments to the public through email. As noted, Mr. Pompeo settled the allegations against him and was never a respondent in a FINRA proceeding.

In November 2013 and thereafter, FINRA delivered computer disks to Mr. North containing ESI it had received from Smarsh and on which it based its disciplinary actions against him. During the on-the-record interviews, witnesses had trouble recognizing some of the emails produced by Smarsh to FINRA. Due to alleged problems accessing the computer disks and “visible indicia of spoliation to the ESI, ” Mr. North retained a computer technician in March 2014 to analyze the ESI. Id. ¶ 40.

In April 2014, LK purchased access to her Bloomberg vault -- which provides its own email preservation service -- and discovered that it contained over 212, 000 emails and a few thousand chats of various types for the Relevant Period. These communications were in extensible markup language (XML). However, the ESI produced by Smarsh and delivered by FINRA in the Southridge Proceeding contained fewer than 60, 000 records in .pst format attributable to LK and her assistant. With respect to the Ocean Cross Proceeding, Smarsh also produced fewer emails attributable to LK than the number in her Bloomberg vault for the same time period.

According to Plaintiffs and the computer technician retained by Mr. North, the spoliation included “tens of thousands of emails with language added to sender line descriptions, the substitution or insertion of inaccurate sender and recipient names, formatting and time differences, lost and incomplete content, and multiple copies of the same communication in different formats.” Id. ¶ 44. Plaintiffs also allege that “tens of thousands of electronic communications that should have been preserved by Smarsh had been lost, destroyed, or withheld.” Id.

In February and March of 2015, Berryhill Computer Forensics, Inc. (Berryhill), retained by Mr. North, examined the ESI and concluded “that FINRA has been massively misled by Smarsh.” Id. ¶ 55. Berryhill also concluded that “the data produced by Smarsh has been altered and manipulated to the point of being nearly unrecognizable compared to the original source data.” Id. In both Proceedings, FINRA rejected Mr. North’s allegations on the basis that spoliation was irrelevant to the subject of FINRA’s enforcement actions -- namely, whether or not Mr. North conducted an appropriate review of each firms’ electronic communications. FINRA also excluded Berryhill’s expert testimony from the proceedings for lack of relevance. Pls. Opp’n to FINRA’s MTD, Ex. 3 [Dkt. 13] (FINRA’s Evidentiary Order). Neither Smarsh nor FINRA investigated Plaintiffs’ spoliation allegations. Mr. North petitioned the U.S. Court of Appeals for the District of Columbia Circuit for mandamus relief to enjoin the FINRA proceedings and prevent the use of the alleged spoliated evidence. The Court of Appeals refused to intervene and denied the petition. FINRA’s MTD, Ex. 1 (D.C. Cir. Order). FINRA still has not issued a final disciplinary action against Mr. North.

Plaintiffs complain “they were wrongfully subject to disciplinary actions based on spoliated evidence, and so each was required to report said actions on their official public record and thereby have suffered retribution. . . [and] loss of gainful employment and professional reputation.” Id. ¶ 65. They also claim they incurred legal fees in responding to FINRA’s “ill-conceived and unfounded disciplinary proceedings against each of them.” Id. ¶¶ 62, 64. On April 6, 2015, Plaintiffs filed the instant lawsuit against Smarsh and FINRA. Count I of the Complaint alleges that Smarsh intentionally spoliated the ESI; Count II accuses Smarsh of spoliation through gross negligence; Count III alleges that both Smarsh and FINRA spoliated the electronic communications through simple negligence; and Count IV seeks injunctive relief against both parties to prevent further spoliation and the use and dissemination of these spoliated records. Id. ¶¶ 68-103.

FINRA moves to dismiss the Complaint for lack of subject matter jurisdiction under Federal Rule of Civil Procedure 12(b)(1) and because it is immune from suits related to its enforcement duties under the Exchange Act. FINRA’s MTD at 9. In the alternative, FINRA contends that Plaintiffs’ Complaint should be dismissed for failure to state a claim upon which relief may be granted under Federal Rule of Civil Procedure 12(b)(6). Id. Smarsh also moves to dismiss the Complaint for lack of subject matter jurisdiction under Federal Rule of Civil Procedure 12(b)(1). Smarsh’s MTD at 1. It also moves to dismiss for lack of personal jurisdiction under Fed.R.Civ.P. 12(b)(2) and for failure to state a claim upon which relief may be granted under Fed.R.Civ.P. 12(b)(6). Id.


A. Motion to Dismiss Under ...

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