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SHAPIRO v. MERRILL LYNCH

December 26, 1972

Maurice SHAPIRO et al., Plaintiffs,
v.
MERRILL LYNCH, PIERCE, FENNER & SMITH INCORPORATED, et al., Defendants


Tenney, District Judge.


The opinion of the court was delivered by: TENNEY

Tenney, District Judge.

This is a civil action for money damages arising out of defendants' alleged violations of §§ 10(b) and 15(c)(1) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b), 78 o (c)(1) (1970), Rules 10b-5 and 15c1-2 promulgated thereunder by the Securities and Exchange Commission, and § 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q (1970). Plaintiffs have moved this court, pursuant to Fed. R. Civ. P. 23(c), for an order declaring that this action be maintained as a class action. Defendants, in turn, have moved the court for a judgment on the pleadings on the grounds that plaintiffs have failed to state a claim upon which relief can be granted. For the reasons set out below, both plaintiffs' and defendants' motions are denied in all respects. *fn1"

 DEFENDANTS' MOTION

 Ordinarily, the defense of failure to state a claim upon which relief can be granted is asserted either in a responsive pleading or by motion prior to a responsive pleading. Fed. R. Civ. P. 12(b). When defendant fails to avail himself of either of these procedures, Rule 12(h)(2) permits the defense to be raised in a motion for judgment on the pleadings pursuant to Rule 12(c). However, even though the 12(b)(6) defense is asserted through the procedural device of a 12(c) motion, the standards employed in determining the motion will be the same as if the defense had been raised prior to the closing of the pleadings. 5 Wright and Miller, Fed. Prac. and Proc.: Civil § 1367, at 688-89 (1969). Consequently, the well-pleaded material facts as alleged in plaintiffs' complaint will be taken as admitted for the purposes of defendants' motion. 2A J. Moore, Fed. Prac. P12.08 (2d ed. 1968).

 Facts

 The allegedly fraudulent transactions upon which plaintiffs base their complaint involved trading of Douglas Aircraft Company (hereinafter "Douglas") common stock on the New York Stock Exchange (hereinafter "NYSE"). (Subsequent to the relevant time period, Douglas merged with the McDonnell Company to form the McDonnell-Douglas Corporation, which has not been named as a party to this action.)

 From about April 1966 through July 1966 defendant Merrill Lynch, Pierce, Fenner & Smith, Inc. (hereinafter "Merrill Lynch") had been engaged as the prospective managing underwriter of a proposed Douglas offering of $75,000,000 in convertible subordinated debentures. When the registration statement for the offering was approved on July 12, 1966, Merrill Lynch became the acting managing underwriter.

 On or about June 7, 1966, Douglas released an earnings report for the first five months of its 1966 fiscal year. This report indicated that Douglas had earned 85 cents per share of common stock for that period. The complaint alleges that sometime during the period of June 17 through June 22, 1966, defendant Merrill Lynch and its then employees Lenz, Sedlmayer, Martin, Shinn, Catapano, McMillen, Woodman, Heindel, Bilbao, and Idelman (hereinafter collectively referred to as the "individual defendants"), came into possession of certain nonpublic and material information that was the exclusive property of Douglas; that such information was given to Merrill Lynch solely as a result of its position as prospective underwriter for the Douglas bond issue; that both Merrill Lynch and the individual defendants knew, or should have known, that the information was confidential and the sole property of Douglas, and that it was not to be used for any purposes of their own. This confidential information consisted of the following:

 
(a) that Douglas would report sharply lower earnings for the first six months of its fiscal year 1966 than it had for the first five months of that year;
 
(b) that Douglas had sharply reduced its estimate of earnings for the 1966 fiscal year and that it now expected to have little or no profit for that year; and
 
(c) that Douglas had substantially reduced its projection of earnings for its 1967 fiscal year.

 The complaint further alleges that from about June 20 through June 24, 1966, defendant Merrill Lynch and the individual defendants divulged this information to the following parties, all of whom were customers of Merrill Lynch: Investors Management Company, Inc. (a wholly-owned subsidiary of Anchor Corporation), Madison Fund, Inc., J.M. Hartwell & Co. (whose business has been succeeded to by J.M. Hartwell & Co., Inc.), Hartwell Associates, Park Westlake Associates, Van Strum & Towne, Inc., Fleschner Becker Associates, A.W. Jones & Co., A.W. Jones Associates, City Associates, Fairfield Partners, Burden Associates, and William A. Burden & Co. (hereinafter referred to collectively as the "selling defendants"). Plaintiffs claim that all of the selling defendants knew, or should have known, that this information was confidential and the sole property of Douglas.

 During the period of June 20 through June 23, 1966, the selling defendants either sold from existing positions or effected short sales of more than 165,000 shares of Douglas common stock on the New York Stock Exchange. These sales were made prior to public disclosure of the revised earnings information by Douglas on June 24, 1966, and without disclosure of the information to plaintiffs and other purchasers of Douglas stock during that period of time. As a result of these sales, both the individual defendants and Merrill Lynch received commissions from the execution of the selling defendants' orders and also received compensation in the form of customer directed "give-ups" (i.e., division of commissions earned by other brokers executing orders for the selling defendants).

 On June 23, 1966, plaintiff Gibson purchased an unspecified number of shares of Douglas common stock on the NYSE. On June 24, 1966, Douglas issued a report containing the revised earnings information. On the same morning, plaintiffs M. Shapiro, I. Shapiro, Naigles, and Saxe purchased an unspecified number of shares of Douglas common stock on the NYSE. All of these plaintiffs claim that defendants have defrauded them by withholding material inside information; that had they known of the information which defendants possessed they would not have purchased Douglas stock; that as a result of these acts plaintiffs have sustained substantial losses. The following is a table of prices of Douglas common stock on the NYSE for all relevant dates. Date Volume High Low Closing Price June 21 66,200 90 86 86 1/4 June 22 66,500 90 1/2 87 1/2 87 1/2 June 23 261,500 88 3/4 77 5/8 78 3/4 June 24 211,100 77 74 1/2 76 June 25 SATURDAY June 26 SUNDAY June 27 121,300 74 3/8 69 69 June 28 135,300 70 66 1/4 68 1/2 June 29 102,200 69 7/8 64 1/8 64 3/8 June 30 180,900 65 1/4 61 63 1/8 July 1 100,400 64 7/8 61 61 3/4

 Since a determination of whether plaintiffs are entitled to an order declaring a valid class action will not be necessary if plaintiffs have not stated a cause of action, defendants' motion to dismiss will be considered first.

 THE 10b-5 CLAIM

 Plaintiffs' claim, in essence, is (1) that the selling defendants, by trading in Douglas common stock without disclosing the material inside information divulged to them by Merrill Lynch and the individual defendants, have violated § 10(b) and Rule 10b-5 and thus are liable in damages to plaintiffs (and to the members of their proposed class), and (2) that defendant Merrill Lynch and the individual defendants, by divulging this material inside information to the selling defendants for the purpose of protecting their investments in Douglas stock, have violated § 10(b) and Rule 10b-5 and thus are liable in damages to plaintiffs (and to the members of their proposed class).

 There is considerable disagreement among both the courts and the commentators as to what the requisite elements of a 10b-5 cause of action are. *fn2" Those elements which have most often been determined as necessary are: misrepresentation or nondisclosure, materiality, scienter, privity, reliance and causation. 2 A. Bromberg, Securities Law: Fraud, SEC Rule 10b-5 § 8.1 (1971).

 Standing to Sue

 Before proceeding, however, to examine the various elements in detail, plaintiffs must first establish their standing to sue under the "purchaser-seller" doctrine first enunciated in this Circuit in Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956, 72 S. Ct. 1051, 96 L. Ed. 1356 (1952). There, plaintiff, a minority shareholder of defendant Newport Steel Corp., claimed that he was defrauded by various misrepresentations made by defendant regarding a merger between Newport and the Wilport Company. Suit was brought under § 10(b) and Rule 10b-5 even though plaintiff had not purchased or sold any Newport stock. It was plaintiff's contention that Rule 10b-5 should be construed to include actions for breach of fiduciary duty by corporate insiders. The court disagreed, holding:

 
"[Section] [10b] was directed solely at that type of misrepresentation or fraudulent practice usually associated with the sale or purchase of securities rather than at fraudulent mismanagement of corporate affairs, and that Rule X-10B-5 extended protection only to the defrauded purchaser or seller." 193 F.2d at 464.

 Although the " Birnbaum rule" has been questioned by the commentators, *fn3" and modified by the courts, *fn4" the Second Circuit, in the recent case of Drachman v. Harvey, 453 F.2d 722 (2d Cir. 1971), rev'd and remanded en banc, 453 F.2d 736, 738 (2d Cir. 1972), has refused to repudiate the "purchaser-seller" requirement.

 It should be noted that the " Birnbaum rule" contains two proscriptions: (1) that the fraud be of the type that is usually associated with the purchase or sale of securities, and (2) that the protection of Rule 10b-5 is extended only to the defrauded purchaser or seller. The first of these proscriptions delineates the standing requirement, with which this portion of the opinion is concerned; the second is concerned with the elements of privity and causation, discussed infra.

 Defendants urge this court that five previous decisions in this district arising out of precisely the same acts alleged in plaintiffs' complaint (Shulof v. Merrill Lynch, Pierce, Fenner & Smith, Inc., CCH Fed. Sec. L. Repr. P93,147 (S.D.N.Y. June 15, 1971); Smachlo v. Merrill Lynch, Pierce, Fenner & Smith, Inc., CCH Fed. Sec. L. Repr. P93,148 (S.D.N.Y. May 18, 1971); Hirsh v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 311 F. Supp. 1283 (S.D.N.Y. 1970); Sanders v. Merrill Lynch, Pierce, Fenner & Smith, Inc., CCH Fed. Sec. L. Repr. P93,226 (S.D.N.Y. June 29, 1970); Baehr v. Merrill Lynch, Pierce, Fenner & Smith, Inc., CCH Fed. Sec. L. Repr. P93,227 (S.D.N.Y. June 29, 1970)), all of which dismissed their respective complaints on the grounds of failure to meet the "purchaser-seller" requirement, are dispositive of defendants' motion. Notwithstanding the similarity between these cases and the one at bar, the previous decisions are readily distinguishable.

 In four out of the five cases cited by defendants (Smachlo, Hirsch, Sanders, and Baehr) not one of the plaintiffs purchased or sold any shares of Douglas common stock during the period of time between the alleged trading violations and public disclosure of Douglas' revised earnings report. In each of these cases, plaintiffs became shareholders of Douglas stock prior to the allegedly violative trading and the essence of their complaints was that had the defendants disclosed the inside information, plaintiffs, too, would have sold their stock in an effort to minimize the losses which occurred following public disclosure. In the case sub judice, however, plaintiffs each allege purchases of Douglas concurrent with or subsequent to defendants' allegedly fraudulent acts and prior to public disclosure.

 The fifth case, Shulof, more closely approaches the facts before this court. Plaintiff there was both a holder of Douglas stock and a purchaser of Douglas stock within the relevant time period. The court dismissed the complaint on the grounds, inter alia, that the requisites of the " Birnbaum rule" had not been met. Defendants in the instant case have cited to a portion of that opinion as indicating that plaintiff in Shulof, as a purchaser of Douglas stock, did not meet the "purchaser-seller" requirement:

 
"[The] alleged fraud by defendant's customers involved sales by them in which plaintiff had no part, and as a result the alleged fraud is not actionable by this plaintiff." CCH Fed. Sec. L. Repr. P93,147, at 91,134.

 Defendants, however, have conveniently omitted the two previous sentences and taken the quotation out of context:

 
"While it is true that plaintiff claims to have ultimately sold his shares and may have purchased shares during the period in which there was trading on undisclosed inside information (the complaint is ambiguous on this point), the claim of fraud in connection with nondisclosure is that defendant's customers were able to sell at a higher price than plaintiff could have sold after the disclosure was made; the claim is not that plaintiff was defrauded by the nondisclosure into purchasing such shares as he may have bought before June 24. The plaintiff in short does not claim to have been injured as a purchaser by the nondisclosure; his claim is rather that he was injured as a seller who received a lower price than the defendant's favored customers. However, the alleged fraud by defendant's customers involved sales by them in which plaintiff had no part, and as a result the alleged fraud is not actionable by this plaintiff." CCH Fed. Sec. L. Repr. P93,147, at 93,134. (Emphasis added.)

 Upon a reading of the entire excerpt, it is clear that the court did not make its finding with respect to plaintiff as a purchaser, but rather as a holder of Douglas stock who had made no transactions as either a purchaser or seller of securities during the relevant time period. In fact, all of the cases cited to by defendants dismissed their respective complaints for a lack of standing under the " Birnbaum rule". Since plaintiffs in the instant case purchased stock concurrent with or subsequent to the alleged fraud and prior to public disclosure, they clearly have standing to sue. ...


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