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Chasins v. Smith

decided: July 7, 1970.


Smith, Kaufman and Hays, Circuit Judges. On Petition for Rehearing Lumbard, Chief Judge, and Waterman, Moore, Friendly, Smith, Kaufman, Hays, Anderson and Feinberg, Circuit Judges.

Author: Smith

J. JOSEPH SMITH, Circuit Judge:

On petition for rehearing, the opinion filed July 7, 1970 is withdrawn and the following opinion substituted therefor. The petition for rehearing is otherwise denied.

This is an appeal by Smith, Barney & Co., Inc., a stock brokerage firm [hereinafter "Smith, Barney"] from a judgment for damages on a determination by Judge Dudley B. Bonsal in the United States District Court for the Southern District of New York that Smith, Barney had violated Rules 10b-5 and 15c1-4 (17 C.F.R. §§ 240.10b-5 and 240.15c1-4),*fn1 promulgated under the Securities Exchange Act, 15 U.S.C. §§ 78j(b) and 78 o (c), in not disclosing to appellee (Chasins) that it was making a market in the securities it sold Chasins in the over-the-counter market. Chasins has cross-appealed the district court's ruling that appellant had not violated its common law fiduciary duty to Chasins by the manner it handled the transactions between the two.*fn2 We find no error and affirm the judgment.

This action brought by Chasins in the district court under the Securities Act of 1933, 15 U.S.C. § 77a et seq., and the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq., for damages resulting from Smith, Barney's alleged violations of the Acts, and pendent common law violations, in handling Chasins' securities brokerage account was tried to the court without a jury. At the time the four transactions in question in his appeal occurred,*fn3 Chasins was the musical director of radio station WQXR in New York City and was the commentator on a musical program sponsored by Smith, Barney. According to Chasins it was due to this relationship that he opened his brokerage account with Smith, Barney by orally retaining it to act as his stock broker. Smith, Barney acted in at least two capacities in these transactions, namely as Chasins' stockbroker and as principal, i. e., the owner of the security being sold to Chasins. In all four transactions Smith, Barney sold the securities to Chasins in the over-the-counter market, and although it revealed in the confirmation slips that it was acting as principal and for its own account in selling to Chasins, Smith, Barney did not reveal that it was "making a market" in the securities involved as was the fact. Nor did Smith, Barney disclose how much it had paid for the securities sold as principal to Chasins or that it had acted as an "underwriter" as defined by the Securities Act of 1933 in connection with the distribution of securities of Welch Scientific Company and Howard Johnson Company, two of the companies whose securities Smith, Barney sold to Chasins.

Preceding the four sales of July and August, 1961, Smith, Barney sent Chasins a written analysis of his then current security holdings and its recommendations in regard to his objective of aggressive growth of his holdings. The recommendations included strong purchase recommendations for securities of Welch Scientific, Tex-Star Oil and Gas Corp., and Howard Johnson Company. Chasins and Thomas N. Delaney, Jr., an authorized agent of Smith, Barney had various telephone conversations prior to the transactions in question. Delaney testified that at least at the times of the four transactions in question Smith, Barney was "making a market" in those securities, i. e., it was maintaining a position in the stocks on its own account by participating in over-the-counter trading in them; Smith, Barney's records indicated that at least from June 30, 1961, it had been trading in those stocks and had held positions in them during the times Chasins purchased the securities from it.*fn4 There was no testimony that Chasins had any knowledge or notice that Smith, Barney was "making a market" in the securities of the three companies.

The decision of the district court was based on conflicting evidence as to whether Chasins had a "discretionary account" with Smith, Barney and on the four transactions above. Although the court ruled that Smith, Barney had not violated any common law fiduciary duty to Chasins, Smith, Barney was found to have violated Rules 10b-5 and 15c1-4 (the latter in a supplemental opinion) in not disclosing its market making (or dealer) status in the securities that it recommended Chasins purchase, when Chasins followed that advice and purchased the securities and Smith, Barney was the other principal in the sales. Damages were awarded to Chasins in the amount of $18,616.64, with interest, which constituted the difference between the price at which Chasins purchased the securities from Smith, Barney and the price at which he later sold them (prior to discovering Smith, Barney's market making in the securities).



Smith, Barney's major contention in attacking the district court's finding of a violation of Rules 10b-5 and 15c1-4 is that failure to disclose its "market making" role in the securities exchanged over the counter was not failure to disclose a material fact. Appellant contends that the district court's holding went farther than any other decision in this area and that no court had ever found failure to disclose a "market making" role by a stock brokerage firm to a client-purchaser to be a violation of Rule 10b-5. Smith, Barney also asserts that all brokerage firms had followed the same practice and had never thought such disclosure was required; moreover, the SEC had never prosecuted any firm for this violation. However, even where a defendant is successful in showing that it has followed a customary course in the industry, the first litigation of such a practice is a proper occasion for its outlawry if it is in fact in violation. See Opper v. Hancock Securities Corp., 250 F. Supp. 668, 676 (S.D.N.Y.1966), aff'd 367 F.2d 157 (2d Cir. 1966). In any event, it cannot fairly be said that no one in the trade had ever considered such nondisclosure to be significant.*fn5 Appellant's own customers man (Delaney) testified that at the time (1961) he was disclosing to retail clients the firm's role as a market maker in a given security whenever he was aware of it.

Appellant also points to the fact that in over-the-counter trading, a market maker with an inventory in a stock is considered the best source of the security (the best available market); thus, the SEC has even punished a brokerage firm for not going directly to a firm with an inventory in a stock, i. e., interposing another firm between them. See e. g. In re Thomson & McKinnon, CCH Fed.Sec.L.Rep. para. 77,572, p. 83, 203 (1967-69 SEC Rulings). However, the fact that dealing with a market maker should be considered by some desirable for some purposes does not mean that the failure to disclose Smith, Barney's market-making role is not under the circumstances of this case a failure to disclose a material fact. The question here is not whether Smith, Barney sold to Chasins at a fair price but whether disclosure of Smith, Barney's being a market maker in the Welch Scientific, Tex-Star Oil and Gas and Howard Johnson securities might have influenced Chasins' decision to buy the stock. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968) (en banc), cert. denied sub nom. Coates v. SEC, 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969); List v. Fashion Park, Inc., 340 F.2d 457 (2d Cir. 1965), cert. denied, 382 U.S. 811, 86 S. Ct. 23, 15 L. Ed. 2d 60 (1965). The test of materiality "* * * is whether a reasonable man would attach importance * * * in determining his choice of action in the transaction in question. * * *" List v. Fashion Park, Inc., supra, at 340 F.2d 462; SEC v. Texas Gulf Sulphur Co., supra, at 401 F.2d 849; i. e., a material fact is one "* * * which in reasonable and objective contemplation might affect the value of the corporation's stock or securities. * * *" Kohler v. Kohler Co., 319 F.2d 634, 642 (7 Cir. 1963); List v. Fashion Park, Inc., supra, at 340 F.2d 462; SEC v. Texas Gulf Sulphur Co., supra, at 401 F.2d 849. See also Mills v. Electric Auto-Lite Co., 396 U.S. 375, 90 S. Ct. 616, 24 L. Ed. 2d 593 (1970). In applying that test in this case, the question of materiality becomes whether a reasonable man in Chasins' position might well have acted otherwise than to purchase if he had been informed of Smith, Barney's market making role in the three stocks in addition to the fact that Smith, Barney was the other principal in the transaction. The broker-dealer, Smith, Barney, had undertaken to make a written evaluation of Chasins' securities holdings and had strongly recommended sales of some of his holdings and purchases of these three stocks in which Smith, Barney was dealing as a principal.

Knowledge of the additional fact of market making by Smith, Barney in the three securities recommended could well influence the decision of a client in Chasins' position, depending on the broker-dealer's undertaking to analyze and advise, whether to follow its recommendation to buy the securities; disclosure of the fact would indicate the possibility of adverse interests which might be reflected in Smith, Barney's recommendations. Smith, Barney could well be caught in either a "short" position or a "long" position in a security, because of erroneous judgment of supply and demand at given levels. If over supplied, it may be to the interest of a market maker to attempt to unload the securities on his retail clients. Here, Smith, Barney's strong recommendations of the three securities Chasins purchased could have been motivated by its own market position rather than the intrinsic desirability of the securities for Chasins. An investor who is at least informed of the possibility of such adverse interests, due to his broker's market making in the securities recommended, can question the reasons for the recommendations. The investor, such as Chasins, must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self-interest. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 at 196, 84 S. Ct. 275, 11 L. Ed. 2d 237 (1963).

In the case at bar, the broker-dealer had undertaken at its customer's request to make a written evaluation of his securities holdings and recommendations for further purchases and sales knowing that the customer, who was, as pointed out above, musical director of a radio station and commentator on a musical program sponsored by Smith, Barney, would rely on its report to him. In this situation failure to inform the customer fully of its possible conflict of interest, in that it was a market maker in the securities which it strongly recommended for purchase by him, was an omission of material fact in violation of Rule 10b-5, 17 C.F.R. 240.10b-5.

The Securities and Exchange Commission is presently engaged in consideration of the advisability of rules on disclosure of the fact of market making, to delineate the extent and time of disclosure to be required, and whether distinction should be made as, for instance, between situations where the particular broker-dealer is the sole or dominant market maker and situations where it is one of a number of market makers and the price is competitive with quotes of other market makers. Such rules and similar rules of the self-regulatory agencies may well promote full and fair disclosure, while, in the words of the SEC "furthering customer protection." We do not attempt to address ourselves to the question of the best mechanics for disclosure. We ...

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