Appeal from an order of the United States District Court for the Southern District of New York, Sweet, J., dismissing an action brought to enjoin violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Reversed and remanded.
Before: PIERCE, WINTER and DAVIS,*fn* Circuit Judges
The Securities and Exchange Commission ("SEC") appeal from an order of Judge Sweet of the United States District Court for the Southern District of New York dismissing its complaint. The complaint alleged that appellee had violated the antifraud provisions of the federal securities laws. Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (1982), and Rule 10b-5, 17 C.F.R. § 240.10b-5 (1985) and Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a) (1982). Holding that the alleged fraud was not in connection with the purchase or sale of a security or in the offer or sale of a security as required respectively by Sections 10(b) and 17(a), Judge Sweet dismissed the complaint on the authority of Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir.) cert. denied, 469 U.S. 884, 105 S. Ct. 253, 83 L. Ed. 2d 190 (1984). We reverse.
This case arises out of the collapse of Drysdale Securities Corp. ("DSC"), a broker-dealer registered with the SEC, and Drysdale Government Securities, Inc. ("DGSI"). This collapse caused losses to investors of about $300 million. The SEC brought this civil action against DSC, three officers of DSC or DGSI and Warren Essner, an audit partner at the accounting firm of Arthur Anderson & Co. responsible for the preparation of allegedly false and misleading financial statements for DGSI.*fn1 For purposes of this appeal, the allegations of the complaints are of course accepted as true.
DSC began its government securities business in or about December, 1979, trading in both the cash or outright market and the so-called "repo" market. In the cash market, DSC sold and purchased government securities from other dealers. In the repo market, which involves the transactions pertinent to the present case, DSC engaged in sale and repurchase agreements ("repos"), which were structured as sales of securities by DSC subject to an agreement by DSC to repurchase them from the other party at a fixed price at a later date. Under reverse sale and purchase agreements ("reverse repos"), DSC purchased government securities subject to an agreement to resell them to the other party at a fixed price at a later date. A repo and reverse repo are thus descriptions of the same transaction viewed from different sides.
In January, 1982, Essner was retained by DSC to assist in the spin-off of its government securities business. He prepared a plan to transfer this business to DGSI, which DSC implemented later that month. DSC sent a letter to banks and securities dealers on February 1 announcing the formation of DGSI. This letter stated that DGSI's capital was $20.8 million. It is alleged that DGSI actually had a deficit of $190 million that it inherited along with the government securities business from DSC. When the letter failed to produce the volume of business for which DGSI had hoped, Essner was asked to prepare a more formal document to give DGSI more credibility. Accordingly, Essner, on behalf of Arthur Andersen, prepared a certified statement of DGSI's subordinated debt and equity, accompanied by an unqualified audit opinion.
According to the complaint, Essner's preparation of these reports violated generally accepted auditing standards and/or internal Arthur Anderson procedures by failing to examine certain records, to investigate the "related party nature" of certain transactions, and to have a person outside his audit team check the final report against work papers. The report, issued on February 22 and dated February 1, again failed to disclose the capital deficit or that $15.8 million of DGSI's capital was loaned to it by DSC, of which $12 million was repaid shortly after DGSI opened for business on or about February 1. Essner knew that the documents he prepared would be used by DGSI to induce customers to do business with it.
The precise legal issue before us is whether the fraud alleged is either in connection with the purchase or sale of a security, as required by Section 10(b), or in the offer or sale of a security, as required by Section 17(a). This issue arises because there is no allegation that DGSI or Essner misled investors with respect to the value of the government securities traded by DGSI rather than with respect to DGSI's financial health. Judge Sweet viewed repos as indistinguishable from collateralized loans and thus held that our recent decision in Chemical Bank controlled the outcome. We disagree.
In Chemical Bank, Frigitemp, a publicly held company, entered into a secured financing agreement with various banks in 1975, including Chemical. In this transaction, the banks provided Frigitemp with an $8 million line of credit and took a security interest in Frigitemp's customer notes receivables. Within a year, it became clear that Frigitemp would need to restructure its debt. A restructuring took place in August, 1977 pursuant to which the maturity dates of certain notes issued under the secured credit agreement were extended, certain unsecured notes were replaced with other unsecured notes, and $4 million in fresh cash was advanced to Elsters, a wholly-owned Frigitemp subsidiary. In exchange for the advance to Elsters, the banks received Elsters' promissory notes, which were guaranteed by Frigitemp, and a pledge by Frigitemp of 100% of Elsters' common stock as security. Frigitemp filed a petition in bankruptcy in March, 1978. The banks, holding substantial unpaid Frigitemp loans, sued three of Frigitemp's principal officers and Arthur Andersen, Frigitemp's auditor. The banks claimed that Arthur Andersen knew that Frigitemp had submitted false and misleading financial statements in order to obtain financing, and that these misrepresentations were in connection with the pledge of the Elsters stock for purpose of the antifraud provisions.
We held that the pledge of the Elsters stock was a purchase and sale of a security for the purposes of Section 10(b) on the authority of Mallis v. Federal Deposit Insurance Corp., 568 F.2d 824 (2d Cir.), cert. granted, 431 U.S. 928, 97 S. Ct. 2630, 53 L. Ed. 2d 243 (1977), cert. dismissed as improvidently granted, 435 U.S. 381, 55 L. Ed. 2d 357, 98 S. Ct. 1117 (1978). We also held, however, that misrepresentations regarding the financial health of Frigitemp could not form the basis of a violation of Section 17(a), Section 10(b), or Rule 10b-5 despite the fact that Frigitemp had pledged securities in order to procure the advance for Elster. Judge Friendly's opinion noted:
Andersen is not alleged to have deceived the Banks with respect to the pledge of the Elsters stock; the Banks got exactly what they expected . . . The Act and Rule impose liability for a proscribed act in connection with the purchase or sale of a security; it is not sufficient to allege that a defendant has ...