* 2nd Circuit says investors can't sue Bear Stearns as group
* Investors said boiler room fraud kept hidden
* Investors' lawyer says decision is "sad day" for investor protection
By Jonathan Stempel
NEW YORK, March 15 (Reuters) - A U.S. federal appeals court on Friday threw out a class action lawsuit against JPMorgan Chase & Co, making it easier for companies that clear trades to avoid being accountable to investors who are defrauded by their brokerages.
The 2nd U.S. Circuit Court of Appeals in New York said clearing firms need "sufficiently direct" involvement in a brokerage's fraud, by instigating or directing it or through other "extraordinarily high involvement," to create a duty to disclose or correct the improper conduct.
Absent such a duty, brokerage customers could not sue as a group on the ground that they relied on inadequate disclosures, a three-judge appeals court panel said.
"A clearing broker's knowledge of the fraud alone is an insufficient basis on which to impose a duty of disclosure," Circuit Judge Debra Ann Livingston wrote for the panel.
Clearing firms perform such activities as delivering securities, maintaining records, safeguarding customer funds, and sending trade confirmations and monthly statements.
The case concerned activities at Sterling Foster & Co, a defunct Melville, New York-based penny stock firm that federal investigators said was a boiler room that defrauded thousands of investors out of more than $70 million in the 1990s.
Randolph Pace, who prosecutors said ran the fraud, was sentenced to 8-1/3 years in prison in 2002.
Investors had accused Bear Stearns Cos, which JPMorgan bought in 2008, of helping Sterling manipulate a Sept. 1996 initial public offering for ML Direct Inc, a marketer of products sold through infomercials and home shopping networks.
According to the investors, Sterling offered 3.9 million ML Direct shares though it had fewer than 1.1 million to sell, and covered the resulting 2.86 million share short position by purchasing shares from insiders at a big discount.
The investors said this let Sterling pocket more than $24 million, a profit exceeding 400 percent, when it sold the shares to the public at a price inflated by the artificial shortage.
According to the investors, Bear knew about the fraud through its role as a clearing broker, and furthered it by extending credit to Sterling, carrying the short position on its books, and dutifully mailing trade confirmations to them.
"SAD DAY FOR INVESTOR PROTECTION"
In July 2010, U.S. District Judge Arthur Spatt in Central Islip, New York certified a class action. He said the Sterling customers were entitled to rely on Bear to handle their trades properly, and disclose behind-the-scenes activity at Sterling.
But the 2nd Circuit said Bear's relationship with Sterling was too distant to warrant a special duty to the investors.
The investors "allege, at most, that Bear Stearns approved the ML Direct offering; that it agreed to serve as clearing broker for the offering; and that it may have violated certain NASD rules and Federal Reserve regulations," Livingston wrote. "We think substantially more direct participation by the clearing broker is required for a duty of disclosure to exist."
Leslie Trager, a lawyer for the investors, said in a phone interview he is weighing his options.
"The 2nd Circuit's ruling has for the first time held that a clearing firm has no duty to disclose that it is knowingly participating in market manipulation by its introducing broker," he said. "It is a sad day for investor protection."
JPMorgan spokesman Justin Perras had no immediate comment.
The case is Levitt et al v. JPMorgan Chase & Co, 2nd U.S. Circuit Court of Appeals, No. 10-4596.