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O'CONNOR & ASSOCS. v. DEAN WITTER REYNOLDS

December 30, 1981

O'CONNOR & ASSOCIATES, an Illinois Limited Partnership, individually and on behalf of all other similarly situated, Plaintiffs,
v.
DEAN WITTER REYNOLDS, INC., a Delaware corporation, individually, and as agent for certain of its customers and registered representatives, Dean Callander, Bruce Seligman, Fred Collins, Mike Kemp, Larry Hayden, Robert Gilbert, Ann Marie Bero, Stephen Bradley, David Kupht, John Damsen, John Hanson, individually, and as customers and registered representatives of Dean Witter Reynolds Inc.; William Miller, Glen and Pamela Jackson, Ralph Raulli, Daniel Sharp, Cynthia Smith, Nolan Brunson, Jr., Jane Dunn, Wendy Craven, Dennis Martino, Quaker Hill Development Corporation, a California corporation, and Thomas A. Reed, individually, and as customers of Dean Witter Reynolds Inc.; certain unnamed customers of Dean Witter Reynolds Inc.; A.G. Becker Incorporated, a Delaware corporation, William E. Goldberg, John Pierce, Robert Rafford, individually, and as customers and registered representatives of A. G. Becker Incorporated; Patrick N. Macintyre, individually and as a customer of A.G. Becker Incorporated; Amax Inc., a New York corporation; and Standard Oil Co. of California, a Delaware corporation, Defendants



The opinion of the court was delivered by: LASKER

On March 5, 1981, the board of directors of Amax, Inc. ("Amax") announced publicly that Standard Oil of California, Inc. ("Socal") had made a proposal, conditioned on approval of the Amax board, to acquire the equity interest in Amax not already owned by Socal at a price of approximately $ 78.50 a share, nearly double the then-current market price of $ 38.50 per share. The total value of Socal's offer was approximately four billion dollars, making it the largest takeover bid in history at the time it was announced. Simultaneous with the announcement of the proposal, the Amax board announced its decision to reject the offer. When the market opened on March 6th, after the temporary halt in trading that accompanied the announcement, the market price of Amax stock rose approximately eighteen points and the price of the most heavily traded series of Amax options rose substantially.

O'Connor and Associates ("O'Connor") trades stock and options for its own account. Between February 23, 1981, and March 6, 1981, O'Connor sold call options on Amax stock. On March 10, 1981, O'Connor commenced this action, alleging that unknown insiders at either Socal or Amax or both had "tipped" inside information concerning the Socal takeover bid to unknown customers and registered representatives of Dean Witter Reynolds, Inc. ("DWRI") and A.G. Becker, Inc. ("Becker"), and that the customers and registered representatives had purchased Amax call options prior to March 6, 1981, with knowledge of the proposed merger. In addition, O'Connor alleges that DWRI and Becker substantially assisted its customers with knowledge that or in reckless disregard of whether the customers were trading on the basis of material, nonpublic information. O'Connor claims that it is entitled to relief under sections 10(b) and 14(e) of the Securities Exchange Act, 15 U.S.C. §§ 78j(b) and 78n(e), Rules 10b-5 and 14e-3 of the Securities and Exchange Commission ("SEC"), 17 C.F.R. §§ 240.10b-5 and 204.14e-3, and under common law fraud principles. *fn1"

On March 10, 1981, O'Connor was granted a temporary restraining order preventing DWRI and Becker from distributing any profits realized from purchases of Amax call options in the two weeks immediately preceding the public announcement of Socal's takeover proposal. DWRI and Becker were also directed to furnish O'Connor with the names of all those who had made purchases of Amax call options beyond a threshold amount in the period immediately preceding the public announcement, with the understanding that the restraining order would be lifted if O'Connor was unable to demonstrate that the buyers of the Amax call options were not financially responsible or were not within the jurisdiction of the court. On March 16, 1981, after DWRI and Becker made the required disclosures, O'Connor amended its complaint and named as defendants the DWRI customers and 12 DWRI employees and a customer and three registered representatives of Becker whose names had been disclosed. In addition, O'Connor moved for an order of attachment. When O'Connor was unable to demonstrate its entitlement to an attachment, its motion was denied and the restraining order was lifted.

 DWRI, on behalf of itself and several of its employees, *fn2" Amax, Becker, on behalf of itself and two employees, *fn3" Cynthia Smith and William Goldberg now move to dismiss the complaint. For the sake of clarity, we consider motions presenting common issues together.

 I.

 William M. Goldberg, a registered representative of Becker, Cynthia Smith, a customer of DWRI, and Becker, move to dismiss the complaint pursuant to Fed.R.Civ.Pr. 12(b)(6) on the ground that the complaint fails to state a claim under either § 10(b) of the Securities Exchange Act or § 14(e) of the Williams Act because it does not allege a fiduciary relationship between themselves and O'Connor.

 The thrust of the argument is that, because O'Connor traded in options rather than the actual shares of Amax, the insiders did not stand in a fiduciary relationship with O'Connor. Relying on the Supreme Court's opinion in Chiarella v. United States, 445 U.S. 222, 230, 100 S. Ct. 1108, 1115, 63 L. Ed. 2d 348 (1980), defendants emphasize that trading on the basis of material, nonpublic information constitutes a fraudulent practice under the securities laws only if there exists a special relationship between the alleged wrongdoer and the sellers of the security that could give rise to a duty to disclose. They argue that such a duty does not arise in such impersonal market transactions as alleged here because corporate insiders owe fiduciary duties only to the shareholders of the corporation, not to options traders involved in arm's length transactions who are each betting on the future movement of the underlying stock. Accordingly, it is claimed, the only persons to whom alleged tippees of the corporate insiders owe a duty not to trade on such information are the shareholders of the corporation. Moreover, the defendants assert that there is no precedent for an options trader to maintain a suit against corporate insiders under §§ 10(b) or 14(e) of the Securities Exchange Act and that extending a corporate insiders' duties to options traders would vastly expand the potential liability under the Securities Act of the corporation, its directors, officers and employees to a broad and increasing category of investors with which the corporation has no relationship. Finally, it is argued that options trading in an inherently high-risk form of trading involving the possibility of huge gains and losses and that, since the corporation and its officers, directors and employees have no control over such trading, they should not be considered to have fiduciary duties of disclosure to option traders.

 O'Connor responds that since options are "securities" as defined by the Securities Exchange Act, 15 U.S.C. § 78c(a)(10), the prohibitions of § 10(b) against fraudulent conduct in connection with a sale or purchase of a security are properly applied to options transactions. Moreover, O'Connor contends that the increasing volume of options trading supports rather than undercuts the applicability of the investor protections contained in the 1934 Act. Although options trading is a somewhat risky market transaction, O'Connor maintains that there is no rational basis for exposing options traders to the additional risk of loss caused by fraudulent conduct on the part of others in the market.

 O'Connor emphasizes that the risk involved in options trading is a direct function of the price movements of the underlying stock and that options traders therefore stand in the same functional position vis a vis information concerning the corporation's fortunes as those who trade in corporate stock itself. O'Connor further asserts that the options writer is either a holder of the security at the time he enters into the options contract (covered options) or obligates himself to purchase the security (naked options), and therefore is owed fiduciary duties by corporate insiders to the same extent as shareholders. O'Connor argues that to exempt options trading from the coverage of § 10(b) would be to create a gaping loophole in the securities laws for unscrupulous insiders who could thereby trade in options instead of the underlying stock and thus avoid the prohibitions on insider trading.

 O'Connor contends that Chiarella did not alter the basic duty of corporate insiders and their tippees to disclose or abstain from trading when they possess material, nonpublic information. According to O'Connor, the duty to disclose which the Chiarella opinion found to be critical to a 10(b) violation based on a failure to speak is imposed on corporate insiders because of their position of trust and confidence with respect to purchasers and sellers of the securities of the corporation. Thus, O'Connor argues, the insiders of Amax or Socal and their tippees owed a duty to disclose, or to abstain from trading, not only to shareholders, but also to those who trade in other securities of the corporation, including options.

 Defendants reply that their argument is not based on the proposition that an option is not a security or that investors may not bring an action when there has been a fraudulent, deceptive or manipulative practice in connection with the sale of an option, but rather that there can only be a fraud in an omission case when a duty to disclose arises from a confidential relationship. O'Connor's position, according to defendants, would constitute a holding that the possessor of material, nonpublic information comes under a duty to disclose or obtain from the mere fact that he possesses the information, the very proposition rejected in Chiarella.

 II.

 Corporate officers and directors owe fiduciary duties to the corporation and its shareholders to administer their duties for the common good of all the shareholders. See Pepper v. Litton, 308 U.S. 295, 60 S. Ct. 238, 84 L. Ed. 281 (1939). This fiduciary duty arises from the fact that shareholders are owners of the corporation and they expect to share in its profits. When a director or officer benefits himself at the expense of the corporation, he breaches his duty to the shareholders by preventing them from realizing their expectation to share fairly in the corporate fortunes. Pepper v. Litton, supra at 306, 60 S. Ct. at 245, 84 L. Ed. 281 (1939). The special relationship between the shareholders and the officers and directors results from the fact that the shareholders have entrusted their equity to the management of corporate enterprise. They thus have a vested interest in the fortunes of the corporation and concomitant voting rights to decide how the corporation should be run. In the event the corporate insider breaches his fiduciary duty, they may bring suit in the name of the corporation itself to make the corporation, and indirectly themselves, whole.

 The relationship between corporate insiders and shareholders stands in stark contrast to the lack of relationship between the corporate insiders and options traders. While it is true that shareholders and options traders both rely on the fortunes of corporations, the dispositive distinction is that the options trader has no equity interest in the corporation by virtue of his selling or purchasing an option on the corporation's stock. He is owed no special duty by the officers and directors of the corporation because, quite simply, the corporation is not run for his benefit. He has contributed no equity to the corporation and, in the event of insider wrongdoing, he has no right to bring suit to make the corporation whole. Moreover, while the option writer may obligate himself in the future to purchase shares of the corporation (in the event a "naked option" is exercised), this purchase is solely for the purpose of turning the shares over to the other contractual party, not for the purpose of investing in the fortunes of the corporation. Whatever relationship this may create with the corporation, it cannot be said that it rises to the level of a relationship of trust and confidence between the options trader and the corporate insider. In short, as a shareholder one is entitled to the benefits of a trust relationship. As an options trader, one is not.

 Nevertheless while the defendants' position that they owed no fiduciary duties to O'Connor is correct, their argument that the securities laws are not violated by insider (and tippee) trading on the basis of material, nonpublic information unless the insider (the tippee) owes a fiduciary duty to those with whom he trades has been undercut by the Court of Appeals' recent decision in United States v. Newman, 664 F.2d 12 (2d Cir. 1981). In Newman, the indictment charged that two employees of the investment banking firm of Morgan Stanley & Co., Inc. and Kuhn Loeb & Co. misappropriated confidential information concerning proposed mergers and acquisitions which had been entrusted to their employers by their corporate clients. They allegedly passed the information along to Newman, who in turn shared the information with two others. The three then allegedly purchased stock in the companies that were merger and takeover targets of the clients of Morgan Stanley and Kuhn Loeb. In considering whether the indictment charged a violation of § 10(b), the Court of Appeals noted that Chiarella had left open the issue whether Rule 10b-5 is violated when the conduct alleged constitutes a fraud upon the clients of the trader's employer but when no duty is owed to those with whom the trader deals. In Chiarella, that proposition was not considered because the Court found that it had not been sufficiently presented to the jury and therefore could not provide the basis for criminal liability. In Newman, however, the government charged that the conduct of the tippers and tippees constituted a breach of fiduciary duties owed to the tippers' employers, their employers' clients, and their shareholders. The Court of Appeals found that the alleged conduct constituted a breach of those fiduciary duties and that, since "the appellee's sole purchase in participating in the misappropriation of confidential takeover information was to purchase shares of the target companies," Id. at 18, the fraud was "in connection with the purchase or sale of securities" under Rule 10b-5 and therefore violated the rule.

 Applying Newman to the facts of this case, we conclude that the complaint sufficiently alleges fraudulent conduct in violation of the securities laws. The insiders of Socal and Amax owed a fiduciary duty to their respective corporations not to trade on the basis of inside information or to tip that information to others. They allegedly breached those duties when the insiders or their tippees purchased call options on Amax stock. Just as the insiders owed no fiduciary duty to the persons with whom they traded in Newman, the insiders here may have owed no fiduciary duty to the writers of call options. Nevertheless, under the Newman rationale, because their trading or tipping breached fiduciary duties owed to other parties, the alleged conduct constituted a fraudulent practice within the meaning of the securities laws.

 Since the complaint alleges fraudulent practices in violation of the securities laws, the narrow issue presented by this motion and left open by the court in Newman is whether O'Connor, as a party to whom no fiduciary duty was owed, nevertheless has standing to assert a civil claim for damages allegedly resulting from defendants' breaches of fiduciary duties owed to other persons. We hold that it does.

 While O'Connor was owed no fiduciary duties by the insiders of the corporation, it is a seller of a "security" within the meaning of Rule 10b-5. Section 3(a)(13) of the Securities Exchange Act provides that "(t)he terms "buy' and "purchase' each include any contract to buy, purchase, and otherwise acquire." Section 3(a)(14) provides that "(t)he terms "sale' and "sell' include any contract to sell or otherwise dispose of." For the purposes of Rule 10b-5, "the holders of puts, calls, options, and other contractual rights or duties to purchase or sell securities have been recognized as "purchasers' and "sellers' of securities ... because the definitional provisions of the 1934 Act themselves grant them such a status." Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 751, 95 S. Ct. 1917, 1932-33, 44 L. Ed. 2d 539 (1975). Thus, the fact that O'Connor is an options trader, rather than a shareholder of a corporation, is not in itself a bar to this suit. In addition, O'Connor is within the scope of the statute's and the Rule's intended beneficiaries. Section 10(b) makes it "unlawful for any person ... to use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe ... for the protection of investors." *fn4" Rule 10b-5 is similarly framed to ban fraudulent or deceptive practices "in connection with the purchase or sale of any security." *fn5" Furthermore, O'Connor alleges direct injury as a result of the fraudulent practices and alleges that it actually sold securities in connection with the alleged fraudulent practices. O'Connor has therefore satisfied the standing requirements traditionally associated with private actions brought under § 10(b) and Rule 10b-5. See, e.g., Blue Chip Stamps v. Manor Drug Stores, supra; Wilson v. Comtech Telecommunications Corp., 648 F.2d 88 (2d Cir. 1981); Elkind v. Liggett & Myers, Inc., 635 F.2d 156, 165 (2d Cir. 1980); Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Cir. 1974).

 Defendants argue that the Chiarella Court, by requiring that the alleged wrongdoer have violated a fiduciary duty before a violation of Rule 10b-5 may be found, implicitly altered the requirements of standing. The proposition is unsound. The Chiarella Court considered a criminal conviction under Rule 10b-5, not a civil action, and thus did not purport to rule on the requirements for civil standing once a violation of the Rule is in fact alleged. Moreover, a brief perusal of the background to the application of the "disclose or abstain" duty considered in Chiarella does not support the conclusion that those investors to whom the "disclose or abstain" duty was owed do not have standing to recover for injuries resulting from violations of the Rule.

 In SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied sub nom., Kline v. SEC, 394 U.S. 976, 89 S. Ct. 1454, 22 L. Ed. 2d 756 (1969), the Court of Appeals held that a corporate insider "in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it ..., or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed." Id. at 848. In Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., supra, this "disclose or abstain" duty was held to apply in private damage actions under § 10(b) and Rule 10b-5. Chiarella, however, was neither a corporate insider nor a tippee of a corporate insider. He learned of the inside information by decoding documents which had been delivered to his printing shop. At his trial, the jury was instructed that the possession of material, nonpublic information itself triggered the "disclose or abstain" duty. The Court of Appeals affirmed the conviction "holding that "(a)nyone -corporate insider or not-who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose.' " Chiarella v. United States, supra 445 U.S. at 231, 100 S. Ct. at 1116, quoting 588 F.2d 1358, 1365 (2d Cir. 1978). In reversing the conviction, the Supreme Court held that "a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information," Chiarella v. United States, supra at 235, 100 S. Ct. at 1118, but rather depends "on a relationship of trust and confidence," id. at 230, 100 S. Ct. at 1115.

 In the present case, in contrast to Chiarella, it is alleged that corporate insiders were the source of the material, inside information. There was no question in Chiarella that "(a)pplication of a duty to disclose prior to trading guarantees that corporate insiders, who have an obligation to place the shareholder's welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information," id. at 230, 100 S. Ct. at 1115 (footnote omitted), and that " "(t)ippees' of corporate insiders ... have a duty not to profit from the use of inside information that they know or should know came from a corporate insider," id. at 230 n. 12, 100 S. Ct. at 1115, 1116 n. 12, citing Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., supra at 237-38. Consequently, by virtue of their fiduciary duty to the corporation and its shareholders, corporate insiders become subject to the separate duty to either "abstain or disclose." Unlike the fiduciary duty, which is owed only to the corporation and its shareholders, ...


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