Appeal from a judgment of the United States District Court for the Southern District of New York (the Hon. Lee P. Gagliardi, Judge ). A broker-dealer sued a clearing agent in New York, affiliated with a California bank, for aiding and abetting a violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5 by a third market broker in California which customarily disposed of excess shares in third market matching trades of listed securities through the plaintiff in a cash against delivery account. Without the knowledge of the bank or of the plaintiff, the third market broker, which was secretly selling "glamour" stocks short for its own account, induced the president of the clearing agent to put through clearances for it without disclosure to the bank, and to lend money to it interest-free without authorization from the bank or its personnel in charge of supervising the clearance corporation. Plaintiff continuously tolerated excessively late delivery of volatile stocks without buying in. After a trial to the court, the District Court held that the president of the clearing agent aided and abetted the 10b-5 violation by his assistance in financing stock borrowings and clearing unauthorized trades for the third market dealer, and that the clearing corporation was liable to plaintiff on respondeat superior, or as a "controlling person" under Section 20(a) of the Exchange Act which had failed to establish "good faith." It entered a money judgment. The Court of Appeals held that the acts of the president of the clearing agent were not sufficiently proximate to the fraud, which was not the short selling but the failure of its customer to disclose its short selling to the plaintiff. The Court further held that the plaintiff, by its failure to buy in, and its toleration of suspicious late deliveries, had violated Regulation T of the Federal Reserve Board, as a matter of law; and that the proximate cause of its loss was its own conduct.
Before Mulligan and Gurfein, Circuit Judges, and Pollack, District Judge.*fn*
Plaintiff Edwards & Hanly ("E&H") sued Wells Fargo Securities Clearance Corporation ("Clearance Corporation") for alleged violations of § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act").*fn1 The District Court for the Southern District of New York (Hon. Lee P. Gagliardi, Judge), after a non-jury trial, granted judgment for the plaintiff in the sum of $1,441,122.45, plus interest, on the ground that Clearance Corporation had aided and abetted T. P. Richardson & Co. ("Richardson"), a California broker-dealer, in committing a Section 10(b), Rule 10b-5 fraud, which caused damage to the plaintiff. Edwards & Hanly v. Wells Fargo Security Clearance Corp., 458 F. Supp. 1110 (1978). For reasons that will appear, we are constrained to reverse the judgment and to order a dismissal of the complaint.
The able District Court made detailed findings of fact and we refer for details to its comprehensive opinion.
Richardson was a registered broker-dealer, based in Los Angeles, which specialized as an institutional broker in the so-called "third market," that is, the over-the-counter market in securities which are listed on the major stock exchanges. Richardson matched buy and sell orders of large blocks of listed stocks made by large financial institutions. Richardson, in matching buy and sell orders, was a buyer or seller on its own, for it made its profit on the difference in price agreed to by the institutional buyer and seller. Although Richardson was generally able to match the buy and sell orders exactly, at times it would effect an unmatched trade in order to accommodate one of its institutional clients. In such instances, Richardson would take a position on the shares which were in excess after the matching of orders. To eliminate these excess positions, Richardson used the services of stock brokers like the plaintiff, Edwards & Hanly, who were members of the New York Stock Exchange, to liquidate such positions as it had assumed.
From February 1974 through April 15, 1975, Richardson maintained a special Cash brokerage account with E&H on a delivery versus payment, receipt versus payment basis. The account both bought and sold listed securities. The orders were regularly telephoned by Richardson's traders to Dominic Gulemi of E&H's Huntington, New York office. The Richardson account was the largest account in appellee's Huntington office, producing as much as $100,000 in commissions annually.
In 1973 Richardson had made a financing arrangement with the Wells Fargo Bank, N.A. ("the Bank") in San Francisco under which the Bank would advance the purchase price for Richardson's account to a seller of securities bought by Richardson, and the certificates sold would then be delivered to Richardson's buyer and the purchase price would be collected. In clearing these institutional third market trades for Richardson, the Bank utilized Clearance Corporation, its clearing agent in New York, the defendant-appellant herein, to handle the receipt and delivery of the cash and securities.*fn2 The Bank collected interest from Richardson from the time it advanced funds for the Richardson account until it collected the purchase price. The funds which it advanced to Richardson and to some 70 other brokers through the Clearance Corporation account in the Morgan Guaranty Bank in New York were "federal funds", Immediately available to it when deposited. Its clearing agent in New York, appellant herein, nevertheless paid sellers of securities to the broker in Regular funds, drawn on a bank on the West Coast, which did not clear for several days. This created a "float" or a continual lag which enabled appellant to invest the money in commercial paper and certificates of deposit, collecting interest on such instruments. Under the procedure that was prescribed by the Bank, Richardson would deliver confirmation slips to the Bank in Los Angeles which would then instruct Clearance Corporation in New York. When Richardson sold stock through brokers in New York it would deliver the certificates sold to Clearance Corporation and the buyer would receive the certificates upon payment. When Richardson bought stock it would instruct appellant through the Bank to pay against delivery. Clearance Corporation did not have authority to clear any trades for Richardson without first receiving instructions from the Bank. 458 F. Supp. at 1114.
Early in 1974, without the knowledge of the Bank, Richardson secretly began to deviate from its regular practice of matching buy and sell orders on institutional trades and began to speculate for its own account. Richardson embarked on a program of making massive short sales for its own account of highly volatile "glamour" stocks. By late 1974 this short-selling comprised a substantial part of Richardson's total business.
To cover its short positions Richardson began to borrow stock. The stock lenders received 100% Cash payments of the closing price of the stock on the most recent trading day. The stock loan agreements also required adjustments in the cash collateral as the stock went up or down. These adjustments were called "mark-to-the-market" payments.
In order to generate enough cash to make the "mark-to-the-market" adjustment, Richardson adopted a procedure of falsification. First it falsified its records by creating false order tickets showing that it had purchased stock on a matched order trade between institutions when, in fact, it had borrowed the stock. Richardson then attached these false orders to its instructions to the Bank and, thus, was able to obtain advances from the Bank pursuant to its credit line. By December 31, 1974 Richardson had borrowed in excess of $25 million worth of stock from fourteen different institutions. All this borrowed stock was used for delivery on short sales that had Previously been made by Richardson.
As a result of a rising market, Richardson was unable to meet the "mark-to-the-market" payments during March and April, 1975. On April 15, 1975, Richardson advised the SEC of its insolvency. By then its stock loans were undercollaterized by almost $3 million, and over $20 million worth of short sales, principally to broker-dealers like the plaintiff, were not covered by stock.
Upon notice of Richardson's insolvency, these broker-dealers were required to buy-in on the open market. The cash loss to the brokers the difference between the price at which Richardson sold the stock short and the buy-in price to the brokers was about $3.4 million. Of that total, appellee sustained a loss of about.$1.4 million.
Beginning as early as February 1975, Richardson's biggest brokers, E.F. Hutton, B.C. Christopher, and North American Equity (as well as Kaufman & Co.) informed Richardson that they were buying in their accounts with Richardson and would no longer do any business with it "because of its consistently late deliveries of stock that it had sold to them." 458 F. Supp. at 1117. Richardson thereupon decided to increase the volume of its short sales through E&H "because, by contrast, that firm had never pressed Richardson as hard to make timely delivery." Id.*fn3
From about March 3, 1975 to April 7, 1975, Richardson in its cash account with E&H sold 23,000 shares of Digital Equipment Corporation, 9,500 shares of E.I. duPont, 2,600 shares of Fairchild Camera Co., 17,500 shares of Halliburton Corp., and 16,500 shares of Texas Instruments. Virtually all of these were, in fact, short sales. Id.
Though the standard sales contract between brokers in the industry required delivery within five business days in a "delivery against payment" and "receipt against payment" account, E&H through March 1975 tolerated delays in delivery by Richardson of two to three months in some extreme cases, and delays of two or three weeks as a regular practice. No rule or practice precluded E&H from buying in an account once the due date for delivery had passed, but E&H had an obvious disincentive to buy in this particular account because it generated substantial brokerage commissions. 458 F. Supp. at 1118. When Richardson finally went under on April 15, 1975, E&H was then compelled to buy in about thirty failed trades, almost two-thirds of which were at least three weeks past due. Almost 90% Of the short sales which plaintiff had to buy in were made by Richardson in March after its other large brokers had closed their accounts with Richardson. Id.
Dominic Gulemi was the registered representative at E&H in charge of the Richardson account. He maintained a close personal relationship with many Richardson employees. In 1974, he took three trips to California, including one during which he and the Richardsons planned a joint venture the establishment of a restaurant business in Los Angeles. 458 F. Supp. at 1118 n. 3.
The course of particularly late deliveries on stocks sold to or through E&H by Richardson on the six stocks on which appellee claimed damages was as follows:
(1) Halliburton 1,000 shares due November 20, 1974 (4 months); 6,000 shares due December 17, 1974, not delivered until January 17, 1975 (4 weeks); 1,500 due March 7 delivered 500 March 17 and 1,000 March 26 (split delivery); 1,500 shares due March 19 not delivered by April 15; 1,200 shares due March 24, not delivered by April 15. At the time of the insolvency notice of April 15, Richardson had failed to deliver 17,500 shares of Halliburton.
(2) Texas Instruments None of the 18,000 shares sold was delivered, though 5,000 shares were due as early as March 10 (5 weeks); and one sale of 1,500 shares was due January 7 (3 months).
(3) Digital Equipment By April 15 delivery on 23,000 shares was late. Of that amount 7,000 shares were already four weeks late and 7,500 ...