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Kook v. Scheinman

decided: July 11, 1969.


Waterman, Friendly and Kaufman, Circuit Judges.

Author: Kaufman

IRVING R. KAUFMAN, Circuit Judge:

In this day when the operations of the securities market and decisions concerning those operations have created an ever-widening circle of collateral problems, we are asked to determine what effect is to be given options to buy or sell a particular stock when, after the option has been written, but before it is exercised, the Securities and Exchange Commission suspends trading in the security. Plaintiffs H. Kook & Co. (Kook) and Andrew L. Wormser (Wormser) appeal from Judge McLean's order granting summary judgment in favor of defendant Scheinman, Hochstin & Trotta, Inc. (Scheinman) and dismissing the complaint. Appellants sought to recover $24,004.82 and $6,070.03, respectively, the amount their broker Scheinman debited to their accounts in order to honor the options, over appellants' protests.

The essential facts are undisputed. Kook and Wormser are wise in the ways of the securities market; Kook being a broker dealer and Wormser an officer of another broker dealer. In the transactions before us, however, they apparently were acting on their own accounts as principals. In that capacity, Kook wrote and sold four "straddles"*fn1 through Scheinman, its broker, on August 8 and 9, 1966, for which it received $3,325 in premiums. Wormser wrote one straddle, also through Scheinman, on August 9, for which he received a premium of $1,000. All of these straddles were in the common stock of Westec Corporation (Westec).

In accordance with the practice of the New York Stock Exchange which requires that each option sold be endorsed by a member broker who thereby guarantees that the purchaser will be able to exercise the option according to its terms, Scheinman made the necessary endorsements. With this act it became more than merely a broker or an agent of appellants.

On August 29, 1966, shortly after these straddles were written, the Securities and Exchange Commission suspended trading in Westec, pursuant to its powers under §§ 15(c) (5) and 19(a) (4) of the Securities Exchange Act of 1934, 15 U.S.C. § 78o(c) (5), 78s(a) (4).*fn2 This suspension was renewed every 10 days until May 5, 1969, at which time trading in the stock was permitted to resume. The suspension was ordered after an SEC investigation disclosed that Westec's liabilities far exceeded its assets, its principals had unlawfully manipulated its stock, its financial reports were misleading, and its properties had been sold to corporate insiders at inflated prices.

Upon announcement of the suspension, Kook and Wormser instructed Scheinman not to honor any attempt by option holders to exercise a straddle (i.e., to demand that appellants purchase their Westec stock at the agreed price), during the trading suspension. They also directed Scheinman to return to any optionee the consideration paid for the option and offered to indemnify Scheinman against any loss or expense that it might incur as a result of complying with these instructions.

Scheinman, nevertheless, proceeded to accept delivery of the Westec shares offered pursuant to the straddles. To pay for the shares tendered, the appellee charged $24,004.82 against Kook's account and $6,070.03 against Wormser's account. In refusing to follow appellants' instructions, Scheinman relied upon an "interpretive release," Release No. 34-7920, issued by the SEC which Scheinman insists mitigated the suspension order's broad prohibition to the extent of permitting put and call options on Westec stock to be exercised if purchased prior to the ban.*fn3 To support this claim, Scheinman also relies upon a letter dated July 21, 1966, from the Chief Counsel of the Division of Trading & Markets of the SEC to the President of the Put and Call Brokers and Dealers Association, Inc. In this communication the Chief Counsel referred to Release No. 34-7920 and went on to declare that if certain conditions indicating good faith on the broker's part were met, "no objection will be raised" because the broker or dealer "completes his contractual obligations in the particular transaction while the suspension is still in effect."*fn4 Scheinman argues that he went to considerable lengths to comply with the provisions of the release and the Chief Counsel's letter by requiring all those exercising the option to sign affidavits that they were not connected with Westec or its principals, and that the straddle was indeed owned by the optionee prior to the suspension order. It is not contested that the conditions of the release and the Chief Counsel's letter were met by Scheinman. Moreover, there is nothing to indicate that any of the Westec stock tendered to Scheinman was acquired after the suspension order became effective.

Kook and Wormser urge most strenuously that Judge McLean erred in declaring that Release No. 34-7920 modified the sweeping language of the suspension order so as to permit the completion of Scheinman's transactions. The Securities Exchange Act, they contend, contemplated that a suspension order would be absolute; that Congress intended that no trading in any form, including the exercising of prior given options, should be permitted. The argument rests primarily on § 15(c) (5) of the 1934 Act, which reads, in part: "No broker or dealer shall make use of the mails or of any means or instrumentality of interstate commerce to effect any transaction in or to induce the purchase or sale of any security in which trading is so suspended."

But we are not persuaded that there is any such inconsistency between §§ 15(c) (5) and 19(a) (4) on the one hand, and the SEC's interpretive release on the other. While the legislative history is not as informative as we would like it to be, it appears that the reason for enactment of § 19(a) (4), and its corollary for non-exchange transactions 15(c) (5) (added in 1964), was, at least in part, to preserve the status quo via the issuance of a suspension order in cases where sudden developments made informed and rational trading in a particular security difficult. See Hearings on S. 1178-82 before the Subcommittee of Senate Committee on Banking and Currency, 86th Cong., 1st Sess. at 351 (1959); 2 Loss, Securities Regulation 851-55 (1961). Thus the logic of the provision does not apply to a case such as this in which the parties had already committed themselves to a position in Westec stock before the emergency arose.

Manifestly, if the facts concerning Westec had become public causing the price of the stock to fall sharply and the SEC had failed to suspend Westec trading, Kook and Wormser clearly would have been obligated to honor the straddles. Thus, while appellants were binding themselves, by choosing to trade in straddles, to go through with a bad bargain they now assert, in substance, that because the performance of the company whose security was being traded was so wicked that the SEC was compelled to suspend trading, they have been relieved of their bad bargain. We do not agree.

Moreover, we are well aware that the laws governing the securities market become more intricate and finely spun daily. Some engaged in the business of securities trading believe themselves to be characters from Victorian novels wandering aimlessly on treacherous moors. There is much appeal in the contention that brokers and dealers should be able to rely on the few signposts that appear in this confused terrain. Release No. 34-7920 was a policy statement carefully prepared by the SEC's Division of Trading and Markets and authorized for release by the Commission itself after due consideration. The Chief Counsel's letter to the President of the Put and Call Brokers Association was also drafted in the knowledge that the industry would place heavy reliance on it.*fn5

Appellants' other objections may be dealt with briefly. They contend that, regardless of the effect of the release on the suspension order, they were excused from the obligations of the contracts because both parties were suffering from a basic misconception as to facts concerning the subject matter of the contract -- the quality of the Westec stock. Before the SEC investigation, they claim, everyone believed Westec to be a financially solid corporation and it was on this assumption that the straddles were written. The argument rests in part on an ancient case revered by teachers of contract law, Sherwood v. Walker, 66 Mich. 568, 33 N.W. 919 (1887) (Rose II of Abalone).

While the mention of the case and the doctrine it espoused brings a flood of nostalgia, it does not furnish a flood of light on this case. Scheinman argues that appellants acted as insurers and, for a premium, undertook to bear the risk of a decline in the price of Westec so that the purchasers of the straddles would be safe from loss. Kook and Wormser respond, however, that straddles are merely inexpensive ways to speculate in volatile stocks. In either event, it seems clear that Kook and Wormser were well aware that the price of Westec might decline suddenly and sharply for any of a variety of reasons and they accepted a substantial payment for assuming that risk. That they guessed wrong as to ...

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