decided: February 9, 1976; As Amended May 12, 1976.
Appeal by the Securities and Exchange Commission from so much of a judgment of the District Court for the Southern District of New York, Dudley B. Bonsal, Judge, 381 F. Supp. 1063 (1974), in an action for injunctions under the Securities Act of 1933 and the Securities Exchange Act of 1934, as dismissed the complaint against defendants Bloom and Edwards & Hanly, and appeals by defendants Geon Industries, Inc. and George O. Neuwirth from so much of the judgment as granted injunctions against them.
Lumbard, Friendly and Mulligan, Circuit Judges.
These appeals from a judgment in an action by the Securities and Exchange Commission (SEC) in the District Court for the Southern District of New York, 381 F. Supp. 1063 (1974), raise some novel questions about liability for "tipping" under Rule 10b-5; about the standard of frankness which a corporate executive is required to observe in answering questions from an exchange on which his company's stock is listed; and about the responsibility of a brokerage firm to police the activities of a registered representative. All these arise in a context where the sole relief sought by the SEC, against those parties who did not consent to judgment, is an injunction.
Defendant Geon Industries, Inc. (Geon or the Company), whose principal office is located in Woodbury, Long Island, is primarily engaged in the importation and distribution of repair and replacement parts for imported cars and trucks. It has outstanding approximately 2,000,000 shares of common stock which are listed on the American Stock Exchange (Amex). Defendant George O. Neuwirth was, as the company's name indicates, Geon's founder, chief executive officer, and chairman of its board of directors; he controlled, through direct ownership and a voting trust, some 28% of its stock. Defendant Frank Bloom was its Secretary-Treasurer and Financial Vice President.
In July, 1973, Geon retained Drexel-Burnham & Co. to arrange for discussions concerning a possible merger of Geon and a much larger British company, Burmah Oil Co., Ltd. (Burmah). After some preliminary discussions Burmah requested a forecast from Geon on the future of the automobile replacement parts industry, five-year pro forma income and balance sheet estimates, and an accompanying cash flow projection. Bloom was designated as the liaison officer to prepare and transmit this information. In mid-October Burmah indicated further interest in the company and a desire to pursue its investigation. Since George Neuwirth was planning a trip to England to attend the annual automobile show at Earl's Court, it was decided, in accordance with a suggestion of Bloom's, to have Bloom and George's son, Peter, join him in a visit to Burmah's headquarters. While in England, they apparently also had a preliminary discussion with another English firm interested in Geon; in any case, nothing definite was concluded in the meeting with Burmah's executives.
Before leaving for England, Neuwirth met with Roy Alpert, a friend and business associate in real estate transactions, in the bar of a country club on Long Island, in accordance with a custom whereby the Neuwirths and the Alperts would generally dine together on Wednesday nights. With some other people around, Neuwirth announced that he was going to London and, on being asked why, answered that this was for the auto show "and perhaps looking at some people in view of a merger."*fn1 Alpert, who previously had owned only 250 shares of Geon, bought 2,600 more shares shortly thereafter, and informed his two brothers of his purchase; they also bought Geon stock.*fn2
Marvin Rauch, a registered representative who had been associated with Philips, Appel & Walden, became an employee of Edwards & Hanly (E&H), at its Hewlett, Long Island, office, on August 22, 1973. Neuwirth had first met him at the Geon stockholders' meeting in 1970; Rauch indicated he was selling Geon stock to customers. After moving to E&H's Hewlett office, Rauch began to telephone Neuwirth frequently. Just before Neuwirth left for England, Rauch called him about a report on Geon of which he had heard; Neuwirth told him it was by Coenen & Co. After Neuwirth's return, Rauch resumed calling frequently and pressing Neuwirth to have lunch since Rauch's office was nearby.*fn3 The lunch was held on November 21; Rauch asked what Neuwirth termed "broker's questions" about Geon, the details of which, and of his answers, Neuwirth could not recall. After the lunch Neuwirth received two bottles of liquor from Rauch. At some time within two weeks of the luncheon, Neuwirth telephoned Rauch at his home, because Rauch's name was among those given by Neuwirth's secretary as having telephoned in his absence. Neuwirth could not recall the details of the conversation but was sure it was not about Burmah.
Between November 2 and December 3, when the first press release about the contemplated merger with Burmah was made, Rauch placed orders for 12,250 shares of Geon: 1,900 were placed in the name of his wife, 600 were placed in the name of Louis Maione but actually were bought for James McMahon, comptroller of a wholly-owned subsidiary of Geon, and 9,750 were for 17 other customers; during the same period he sold only 300 shares, none of which were from his or his wife's accounts. Rosenfeld, the partner of E&H who was manager of the Hewlett office, bought 575 shares for his wife on November 2 and 5, and Lynn, the assistant manager, between November 2 and December 3, bought 2,700 shares, 650 of which were apparently for himself.
It was not until December 3, 1973, after public rumors had begun to circulate leading to an inquiry by officials of Amex, that Geon issued a press release announcing its preliminary discussions with Burmah. On December 18, the company confirmed that negotiations were continuing, and predicted that a further announcement would shortly follow. It did; on December 20 Geon announced that the companies had reached an agreement in principle whereby Geon was to be acquired by Burmah for $36 million in cash -- about $16.80 per share.*fn4
Shortly before the second announcement, Neuwirth told Alpert, over the telephone, that he could not attend his own birthday party, planned for December 17, because business commitments would keep him in New York City. Alpert bought 1,000 shares of Geon on or about December 19, as did each of his brothers. At their weekly dinner on Wednesday, February 20, 1974, Neuwirth mentioned to Alpert that Geon's board of directors would meet the next day to "rubber stamp" the contract with Burmah; when Alpert heard nothing from Neuwirth by Friday morning, February 22, he and his brothers sold their Geon stock during the brief period when, as described below, the stock was being traded.
Under the proposed contract Burmah's obligation to purchase was conditioned on Geon's having consolidated net income before taxes, for the year ended December 31, 1973, equal to or in excess of $3,847,000, and on Geon's having a net worth, as of December 31, 1973, equal to or in excess of $14,000,000. In preparation for the board meeting on February 21, 1974, Bloom had instructed his accounting staff to prepare preliminary earnings figures for the year ended December 31, 1973. On the morning of February 21, he learned that a $313,000 intra-company profit item from a previous period had not been reversed, but rather had been improperly reflected in 1973 income -- an error which, however, would not by itself have caused Geon's earnings to fall below the stipulated figure.*fn5 Much more serious was a report to Bloom that branches were coming in with preliminary gross profits which were some $700,000 less than anticipated. These, along with a reported shortfall of $180,000 at the Aviation Export Division, indicated the possibility of a shortfall (apart from the $313,000 error) sufficient to avoid Burmah's obligation to purchase.
For various reasons detailed in the record, Bloom did not believe these preliminary figures were accurate. On arriving at the directors' meeting in New York City, he reported what he had learned during the morning. It was agreed that the meeting should be adjourned until Sunday evening, an interval which Bloom thought would be sufficient for him and his staff, along with Geon's outside accountants, to gain a firmer view of the facts. There was testimony that it was agreed to be of the utmost importance that the entire matter be kept confidential. Also, as Bloom testified, on the recommendation of John A. Friedman and perhaps also of Lewis J. Korman, both members of the law firm that was Geon's general counsel, it was agreed after the meeting "that the stock should be monitored the next day for any unusual activity, because there's always a concern with the fact that a rumor can get out and that you don't have complete confidentiality."
Bloom returned to Geon's offices and worked with James McMahon and others until after midnight. By ten o'clock they were able to confirm that an error had indeed been made in failing to eliminate $313,000 in intra-company profits. However, they were unable to make meaningful progress with respect to the shortfalls in earnings.
Seemingly McMahon was more convinced than Bloom that the preliminary information was right. After leaving the Geon office he called Rauch in the small hours of the morning and instructed Rauch to sell all of his Geon holdings as well as those in Louis Maione's account. Before trading began on February 22, Rauch advised Rosenfeld that he had 1,500 Geon shares to sell; 1,000 of these shares came from the McMahon and Maione accounts. Rauch, as he had done on other occasions, requested that Rosenfeld phone the order directly to E&H's main order room in New York. This was done.
About the same time Poster, the Amex specialist in Geon, advised Foster, a floor official, that the pre-market activity in Geon was unusual because there were outstanding sell orders for some 10,000 shares. Foster telephoned Randy B. Gromet, a senior Amex listing representative, and they decided to delay the opening of trading in Geon in order to ascertain whether there were any corporate developments that would account for the activity. Gromet immediately telephoned Bloom, whom Geon had designated to receive any such inquiries.
Before accepting Gromet's call, Bloom telephoned Friedman and informed him that Gromet was on the phone but that he did not know why. Friedman asked if Bloom knew any more facts; Bloom answered in the negative. Without knowing just what Gromet was about to ask, Friedman advised Bloom to say that Geon had no public announcement to make.*fn6
There is a minor conflict over just what then occurred, which the district court did not resolve. There is no dispute that Gromet began by stating there was an imbalance of sell orders in Geon stock. Bloom testified that Gromet also said the imbalance was not large since buyers or arbitrageurs were willing to pick up six to eight thousand of the ten thousand shares being offered for sale. Gromet denied knowing or having said anything about the buy side; however, Foster testified he had told Gromet that arbitrageurs were prepared to buy all the stock offered for sale prior to the opening. Gromet testified that he had accompanied his first remark about the imbalance of sell orders with questions whether there were any corporate developments or any change in the status of the proposed Burmah merger which would account for the sell orders and that Bloom answered both questions in the negative; that Gromet then asked why it had taken so long to reach an agreement with Burmah, to which Bloom responded that it was one thing to have informal discussions and another to iron out a definitive contract; and that Gromet asked again whether anything was pending and Bloom assured him that the company had no announcement to make. Bloom conceded that Gromet had asked him whether there was anything about the Burmah deal that would account for the imbalance of sell orders and that he had answered in the negative;*fn7 that Gromet had asked about the inordinate amount of time that had elapsed since Geon's first statement and he had explained this substantially as Gromet said; and that Gromet then asked if Geon had any announcement to make that morning, to which he answered "no, the company has no announcement to make." He added that Gromet then said "Well, I hope you are not going to tell me that you are not making an announcement this morning, but that -- and then you will make an announcement this afternoon," to which he answered "the company definitely has no announcement to make today." Following this call, Gromet telephoned Foster to say that there was no information available from Geon that would affect the price of the stock. Foster allowed trading to begin, with 14 3/8, down 1/2 from the previous close, as the opening price.
Before 11:00 a.m., it came to the attention of Mr. Connolly, another member of the firm that was Geon's counsel, that the stock had declined to 13 7/8 on heavy volume. After consulting with Friedman and Korman, Connolly called another Amex official, told him of the uncertainty that had developed at the board meeting, and requested that trading be stopped. This was done at 11:19 a.m., by which time the price had fallen to 11 7/8 on a volume of 46,000 shares.
On the evening of Sunday, February 24, the Geon board met and learned that the company's earnings would probably fall some $800,000 short of the anticipated figure, and would thus be below the sum stipulated in the Burmah contract. A press release to that effect was issued on Monday morning, February 25. When trading in Geon stock was re-opened on June 10, the price was just under $10 per share. After some discussion about concluding the deal at a lower price, Burmah terminated negotiations in July, 1974.
It remains to describe the considerable activity at the Hewlett office of E&H on the morning of February 22. Rosenfeld, who had already handled Rauch's rush order to sell 1,500 shares, learned from Rauch that Geon had not opened at the beginning of trade. Rosenfeld endeavored to ascertain the reason but could find out only that there was an imbalance of orders. When the stock opened on the downside, Rosenfeld took this to be bearish. Before trading was suspended Rosenfeld had sold 1,200 shares of Geon stock in the accounts he managed (including 550 of his own), Lynn had sold 500 shares (including 100 of his own), and Rauch had sold an additional 5,700 shares (an order for 1,200 of which was transmitted by Rosenfeld). These ...