Appeal by defendant Kohn from a judgment of the United States District Court for the Southern District of New York, Lee P. Gagliardi, Judge, 470 F. Supp. 509, awarding damages under Section 10(b) of the Securities Exchange Act to purchasers of securities who relied on Kohn's alleged is statement of his status in the securities business in making purchases through him. Cross appeal by plaintiffs from the judgment dismissing the action against defendant-appellee Wood, Walker& Co., Kohn's employer. Affirmed in part and reversed and remanded in part.
Before Meskill and Kearse, Circuit Judges, and Dooling,*fn* District Judge.
Marbury Management, Inc., ("Marbury") and Harry Bader sued Alfred Kohn and Wood, Walker & Co., the brokerage house that employed Kohn, for losses incurred on securities purchased through Wood, Walker allegedly on the faith of Kohn's representations that he was a "lawfully licensed registered representative," authorized to transact buy and sell orders on behalf of Wood, Walker.*fn1 After a non-jury trial before the Honorable Lee P. Gagliardi, District Judge, the court found that Kohn was employed by Wood, Walker as a trainee and that his repeated statements that he was a stock broker and his use of a business card stating that he was a "portfolio management specialist" were undeniably false; the court found further that Kohn made the statements with intent to deceive, manipulate or defraud in making them, and that his misstatements were material. The court found that Kohn's misrepresentations about his employment status caused Marbury and Bader to purchase securities from Kohn between summer 1967 and April 1969. The district court also found that the predictive statements Kohn made about various securities were not fraudulently made, and that there was no evidence that they were made without a firm basis.
Judge Gagliardi reasoned: a trainee at a brokerage firm can accept buy or sell orders by phone only under the supervision of a broker and cannot recommend the purchase of a security outside the brokerage office; moreover, the qualifications and expertise of a security salesman are particularly significant criteria in evaluating any information as inherently speculative as future earnings predictions; and a reasonable investor would consider the total mix of information that he received significantly altered if he learned that the investment advice was being furnished to him by a trainee in the field rather than by a specialist. Judge Gagliardi concluded that the important circumstance was that the terms "broker" and "specialist" themselves connote a level of competence to the reasonable investor. Thus, he held Kohn liable to plaintiffs under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b). Inferentially Judge Gagliardi found that Kohn's misstatements of his status not only induced the purchase of the securities involved but their retention as investments as well, until it became evident that Kohn was not, as his business card asserted, a "security analyst" and "portfolio management specialist" associated with Wood, Walker, but simply a trainee. Since both plaintiffs learned the true facts about Kohn's status on about January 28, 1970, Judge Gagliardi computed the damage award to each plaintiff by taking the difference between the price each plaintiff paid for the securities and either the selling price of the securities, if sold before January 28, 1970, or the value within a reasonable time after that date, if the securities were still held on that date.
Judge Gagliardi dismissed the plaintiffs' claims against Wood, Walker on the ground of plaintiffs' failure to prove that Wood, Walker participated in the fraudulent manipulation or intended to deceive plaintiffs; treating plaintiffs as basing their claims against Wood, Walker solely on the theory that the firm aided and abetted Kohn's fraud, the court found that the evidence supported neither a finding of conscious wrongful participation by the firm nor a legally equivalent recklessness but at best a finding of negligence in supervision.
Judge Gagliardi's findings of fact are not clearly erroneous. The cross-appeals of defendant-appellant Kohn from the judgment against him and of plaintiffs-appellants from the judgment exonerating Wood, Walker from liability raise questions of law that are hardly novel but are not free from difficulty in application. It is concluded that the judgment against appellant Kohn must be affirmed and that in favor of Wood, Walker reversed.
1. The substantial question that the appeal of defendant-appellant Kohn raises is whether Kohn's misrepresentation was the legal cause of the loss for which Marbury and Bader have been allowed recovery. The securities bought did not lose value because Kohn was not a registered representative with Wood, Walker, and this case, accordingly, is not one in which a material misrepresentation of an element of value intrinsic to the worth of the security is shown to be false, and in which it is shown that disclosure of the falsity of the representation results in a collapse of the value of the security on the market. In such cases one induced to buy the security on the faith of the misrepresentation of the value element is obviously damaged, and the chain of causation is clear.
Here the claim and finding are that Kohn's statements by their nature induced both the purchase and the retention of the securities, the expertise implicit in Kohn's supposed status overcoming plaintiffs' misgivings prompted by the market behavior of the securities.*fn2 Plaintiffs' recovery of their whole loss measured by the decline in value of the securities to the date when they learned the truth certainly does not fit the familiar rubric, for example, of Section 11(e) of the Securities Act of 1933, 15 U.S.C. § 77k(e) limiting recovery on account of a false or misleading registration statement to the depreciation in value of the security resulting from the untruthfulness of the statement made about it. Cf. Restatement (Second) of Torts § 548A (Comment b, Illustration 1) (1977) (security bought on faith of untrue representation that issuer had received full consideration for it; later full consideration received by issuer, but a court invalidated the security on other grounds; buyer not allowed to recover his loss because it was not considered a proximate consequence of the untrue representation). But plaintiffs in such a case as this, whether or not their claims fall under the more familiar rubric, are, nevertheless, entitled to recover the damages that they suffered as a proximate result of the allegedly misleading statements, Globus v. Law Research Service, Inc., 418 F.2d 1276, 1291 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S. Ct. 913, 25 L. Ed. 2d 93 (1970).
As Judge Weinfeld observed in Miller v. Schweickart, 413 F. Supp. 1062, 1067 (S.D.N.Y.1970):
Proximate cause, of course, is a concept borrowed from the law of torts, and generally requires that one's wrongful conduct play a "substantial" or "essential" part in bringing about the damage sustained by another.
The generalization is that only the loss that might reasonably be expected to result from action or inaction in reliance on a fraudulent misrepresentation is legally, that is, proximately, caused by the misrepresentation. Restatement (Second) of Torts § 548A (1977). See Levine v. Seilon, 439 F.2d 328, 333-34 (2d Cir. 1971). Oleck v. Fischer, Fed.Sec.L.Rep. (CCH) P 96,898, at 95,702-03 (S.D.N.Y.1979), aff'd (2d Cir. 1980), in effect requires that the damage complained of be one of the foreseeable consequences of the misrepresentation. The case for Marbury and Bader is that, since the misrepresentation was such as to induce both their purchases and their holding of the securities, their holding and its duration determined the extent of their losses. As in Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380-81 (2d Cir. 1974), cert. denied, 421 U.S. 976, 95 S. Ct. 1976, 44 L. Ed. 2d 467 (1975), the claim is that the misrepresentation was the agency both of transaction causation and of loss causation.
Liability for representations having the effects of Kohn's representation was familiar in the law even before the Securities Act of 1933 and the Securities Exchange Act of 1934 were enacted. For example, in Rothmiller v. Stein, 143 N.Y. 581, 38 N.E. 718 (1894), the defendant officers of a small corporation told plaintiff that the company was prospering and would pay at least a 10% dividend, and they recommended that plaintiff reject an offer of $80 a share for his stock and accept an offer at $50 a share plus a deferred payment of $50 a share if there were an interim dividend of 10% on the stock. Plaintiff acted on the advice, relying on the defendants' fraudulent statements about the company's affairs. In holding defendants liable, the court said that defendants
Id. at 588, 38 N.E. at 719. So in David v. Belmont, 291 Mass. 450, 197 N.E. 83 (1935), plaintiff had retained stock of a certain company and bought additional shares of the same stock in reliance on certain representations made by defendant which were false. The court said:
Presumably (plaintiff) continued to hold the stock after the purchase in reliance on the representations. The fraud was therefore continuing in its effect until such time as the plaintiff discovered the falsity of the representations. A loss which he suffered would manifestly be the difference in the then value of the stock and the price which he paid for it.
Id. at 454, 197 N.E. at 85. Similarly in Cartwright v. Hughes, 226 Ala. 464, 147 So. 399 (1933), the plaintiff bought stock of the defendants' bank on their representation that it was "a good investment," that the bank was solvent, and that its assets were "good clean assets." The bank ceased to function and its stock became worthless. The issue in the appellate court was the appropriate measure of damages. Agreeing that the ordinary rule measures damages by the difference between value at the time of the fraud and what the value would have been had the representations been true (the so-called "warranty" measure of damages), the court said:
The question of time is not often involved, but in such a transaction as this in 4 Sutherland on Damages, § 1172, at p. 4409, it is said that "the value of the stock sold is not uniformly fixed as of the time of the sale, especially if the purchase was made as an investment. The fraud in such a case has been considered operative until the purchaser learned of it; that is regarded as the time when his cause of action arose."
Id. at 467, 147 So. at 401.
The proposition that fraudulent representations may induce the retention of securities as an investment and entail liability for the damages flowing from retention was given a more general form in Continental Insurance Co. v. Mercadante, 222 A.D. 181, 225 N.Y.S. 488 (1st Dept. 1927). The court there said:
Where the damage is caused by inducing plaintiff's inaction, it is necessarily more difficult to allege or prove causation than in those cases where active conduct is induced. Indeed, in all fraud cases, the element of proximate cause is more impalpable than in negligence cases because we are dealing with the plaintiff's state of mind. The defendants cannot, therefore, require the same exact proof of causation.
Id. at 186, 225 N.Y.S. at 494. See to the same effect Hotaling v. A.B. Leach & Co., 247 N.Y. 84, 93, 159 N.E. 870, 873 (1928) ("As long as the fraud continued to operate and to induce the continued holding of the bond, all loss flowing naturally from that fraud may be regarded as its proximate result."); Stern Bros. v. New York Edison Co., 251 A.D. 379, 381, 296 N.Y.S. 857, 859 (1st Dept. 1937) ("Fraud which induces non-action where action would otherwise have been taken is as culpable as fraud which induces action which would otherwise have been withheld."); Hadden v. Consolidated Edison Co., 45 N.Y.2d 466, 470, 410 N.Y.S.2d 274, 276, 382 N.E.2d 1136 (1978). See 1 F. Harper and F. James, The Law of Torts 600-603 (1956).
Although the theory of plaintiffs' case relates their damages to the inaction of retaining the securities on the faith of their belief in Kohn's assertion of his status, the claim is nevertheless one within Section 10(b) and Rule 10b-5 because the representation relied upon was made in connection with the purchase of securities, and both Marbury and Bader sue as purchasers of securities. Cf. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731, 755, 95 S. Ct. 1917, 1924, 1934, 44 L. Ed. 2d 539 (1975) (private damage action under Rule 10b-5 is confined to actual purchasers or sellers of securities). The case is not one in which nothing has been shown except an inducement to hold as in Parsons v. Hornblower & Weeks-Hemphill, Noyes, 447 F. Supp. 482, 487 (M.D.N.C.1977), aff'd, 571 F.2d 203 (4th Cir. 1978), if that case is a correct reading of Blue Chip. Nor is this case similar to Hayden v. Walston & Co., 528 F.2d 901 (9th Cir. 1975): there the plaintiffs had purchased securities through a salesman who was not a duly licensed registered representative, but did not show that the salesman's nondisclosure of his status rendered his other statements misleading within the meaning of Rule 10b-5, and there was, evidently, no claim or proof that he held ...