United States District Court, Southern District of New York
March 6, 1990
JOHN DILLON, INDIVIDUALLY AND ON BEHALF OF ALL OTHERS SIMILARLY SITUATED, PLAINTIFF,
VINCENT MILITANO, MILTON SONNEBERG, MOORE & SCHLEY CAMERON & CO., STANLEY CHASE AND SECURITIES SETTLEMENT CORP., DEFENDANTS.
The opinion of the court was delivered by: Milton Pollack, Senior District Judge:
Plaintiff, a putative class representative, filed suit against
the defendants alleging violations of Sections 9(a)(2), (3),
(4), 10(b) and 20 of the Securities Exchange Act of 1934,
15 U.S.C. § 78i, 78j and 78t, as amended, and Rule 10b-5,
17 C.F.R. § 240.10b-5, promulgated thereunder.*fn1
Plaintiff alleged that the defendants had engaged in a scheme
to corner the market in the common stock of Chase Medical
Group, Inc., listed and traded on the American Stock Exchange
Defendant Securities Settlement Corp. has moved under Rule
12(b)(6), Fed.R. Civ.P. to dismiss the complaint against it for
failure to state a claim upon which relief can be granted.
Securities Settlement Corp. also seeks to dismiss the complaint
pursuant to Rule 9(b), Fed.R.Civ.P.
For the reasons stated below, Securities Settlement Corp.'s
12(b)(6) motion will be granted.
Vincent Militano and Milton Sonneberg, two brokers employed by
Moore & Schley, Cameron & Co. ("Moore & Schley"), allegedly
schemed to corner the market in Chase Medical Group, Inc.,
common stock.*fn2 From August, 1988 through January, 1989,
when the AMEX suspended trading in Chase Medical stock,
Militano and Sonneberg bought up 108% of the public float of
the stock. The price of the stock rose from $4.50 per share to
a high of $13.625.
In order to make the scheme successful, Dillon and Militano
used customer accounts without authorization, purchased shares
from naked short sellers and fraudulently obtained extensions
of the time to meet margin requirements.
Securities Settlement Corp. ("SSC"), Moore & Schley's customary
clearing broker, cleared all the trades in question.
The three Counts of the complaint make undifferentiated charges
against the various defendants.*fn3
In order to state a claim against SSC, the plaintiff must show
a primary violation of one of the applicable sections of the
1934 Act or a secondary violation through "control" or by
aiding and abetting validly pleaded.
1. Section 9
The complaint explicitly removes SSC from primary liability for
§ 9 violations. "Defendants (other than . . . Securities
Settlement Corp.)" accumulated the position in Chase Medical
stock. Complaint ¶ 6.
2. Section 10(b) and Rule 10b-5
While there is no specific allegation that SSC violated § 10(b)
and Rule 10b-5, several paragraphs of the complaint and Counts
II and III allege that SSC or "all defendants" knowingly and/or
recklessly made material misrepresentations and
Clearing firms, such as SSC, relieve brokerage firms, such as
Moore & Schley, of the huge costs associated with
"back-of-fice" operations. The Securities and Exchange
Commission, and many stock exchanges, permit brokerage firms
like Moore & Schley to contract with clearing firms like SSC,
who, for a fee, will meet certain record-keeping and other
regulatory requirements for the brokerage firm. The brokerage
firm typically is known as the "introducing firm," and the
clearing firm handles the "mechanical, record-keeping functions
related to the clearance and settlement of various
transactions" in the accounts of the introducing firm's
customers. See, e.g., Lester v. Basner, 676 F. Supp. 481, 482
Although some courts have imposed primary liability against
clearing brokers, the true relationship of the clearing broker
to the introducing broker and to the latter's customer has not
been recognized. See, e.g., Cothren v. Donaldson, Lufkin &
Jenrette Securities Corp., No. TY-82-363-CA, slip op.
(E.D.Tex. 1982) (clearing broker held liable for failing to
police properly its "agent's," i.e. the introducing broker,
acts) (preliminary findings later vacated, but not replaced,
when settlement was reached); Hawkins v. Merrill Lynch,
Pierce, Fenner & Beane, 85 F. Supp. 104, 121 (W.D.Ark. 1949)
(clearing broker supplying wire to introducing broker held
liable to customer for its failure to "control" the introducing
broker and to make sure orders were legally executed).
Even if Cothren and Hawkins were correct on their narrow
facts, in this case SSC was merely performing bookkeeping
functions for Moore & Schley. In no way, shape or form does the
complaint plead that SSC was making decisions regarding the
accounts. The pleading indicates that SSC simply executed the
Chase Medical Group transactions along with the other
transactions sent to it by Moore & Schley. SSC was not in a
fiduciary relationship with Moore & Schley's customers. This
being so, no primary liability may attach to SSC. See Faturik
v. Woodmere Securities, Inc., 442 F. Supp. 943, 945 (S.D.N Y
1977) ("Certainly, one requirement for direct liability under §
10(b), namely, `control' over plaintiff's account, would be
lacking as to [the clearing broker], since the complaint does
not allege that [the clearing broker] was empowered to act on
plaintiff's behalf . . . Furthermore, if [the clearing broker
was] performing mere clerical functions on orders placed by
[the introducing broker], we would be hard pressed to find that
[the clearing broker] had the requisite `scienter,' that is,
`intent to deceive, manipulate, or defraud.'" [citations
omitted]); Livingston v. Weis, Voisin, Cannon, Inc.,
294 F. Supp. 676, 683 (D.N.J. 1968) ("It appearing that [the
clearing broker], even according to plaintiffs' Complaint, had
nothing to do with the actual purchasing and selling decisions
with respect to plaintiffs' account with [the introducing
broker], but instead served only as a bookkeeper for the
account, these counts will be dismissed as failing to state a
claim against [the clearing broker]."); see also, Congregation
of the Passion v. Kidder Peabody & Co., 800 F.2d 177, 183 (7th
Cir. 1986) ("In short, the dealers acted merely as the
instrument for executing the transactions orchestrated by Mr.
Newell. This relationship did not create a duty to disclose,
see Affiliated Ute Citizens v. United States, 406 U.S. 128,
92 S.Ct. 1456, 31 L.Ed.2d 741 . . .(1972)").
In this case, as in Faturik and in Livingston, the clearing
broker is not charged in facts well pleaded that it was going
beyond merely performing bookkeeping functions.
3. Regulation T
Although no specific Count in the complaint alleges a violation
of Regulation T, 12 C.F.R. §§ 220.1-220.18, ¶¶ 6, 14, 36 and 44
of the complaint seem to set out some elements of violations of
Regulation T applies to "creditors." SSC is covered by the
"Creditor" means any broker or dealer (as defined in sections
3(a)(4) and 3(a)(5) of the Act), any member of a national
securities exchange or any person associated with a broker or
dealer. . . .
12 C.F.R. § 220.2(b). SSC is a broker/dealer registered
pursuant to § 15(b) of the 1934 Act and is also a member of the
NYSE, AMEX, NASD and several other national securities
¶ 36 of the complaint sets out the elements of a violation of
12 C.F.R. §§ 220.4 and 220.8, i.e. the duty to make a margin
call and liquidate the holdings if the margin is not met, but
it goes on to state:
If a customer of the Moore & Schley Group failed to make a
timely payment required by Regulation T, a "Regulation T Call"
or demand for payment was sent to the customer by Moore &
Schley's clearing broker, SSC . . . the Moore & Schley Group
submitted or caused the submission of false statements to the
appropriate securities exchange in order to obtain extensions
of time for payment.
In other words, SSC did exactly what was required of them under
Regulation T. Moore & Schley violated the terms of the
¶¶ 6, 14 and 44 of the complaint set out the elements of a
violation 12 C.F.R. § 220.8. Allegations are made that SSC
cleared short sales knowing that the sellers did not have and
could not readily obtain the securities.
Even if SSC violated Regulation T, it is of no help to the
plaintiff. Regulation T was promulgated pursuant to section 7
of the 1934 Act, 15 U.S.C. § 78g.
Prior to 1985, the Second Circuit allowed private actions for
violations of § 7. Pearlstein v. Scudder & German,
429 F.2d 1136 (2d Cir. 1970) (Judge Friendly dissented from the majority
opinion), cert. denied, 401 U.S. 1013, 91 S.Ct. 1250, 28
L.Ed.2d 550 (1971) (Pearlstein I). The holding of Pearlstein
I, however, was often questioned.
[The addition of § 7f] cast[s] doubt on the continued viability
of the rationale of our prior holding.
Pearlstein v. Scudder & German, 527 F.2d 1141
, 1145 n. 3 (2d
Cir. 1975) (Pearlstein II). See also, Bassler v. Central
National Bank, 715 F.2d 308
(7th Cir. 1983) (no private right
of action under § 7); Walck v. American Stock Exchange,
687 F.2d 778
(3d Cir. 1982) (same) cert. denied, 461 U.S. 942
103 S.Ct. 2118
, 77 L.Ed.2d 1300 (1983); Gutter v. Merrill
Lynch, Pierce, Fenner & Smith, 644 F.2d 1194
(6th Cir. 1981)
(same), cert. denied, 455 U.S. 909
, 102 S.Ct. 1256
L.Ed.2d 447 (1982); Stern v. Merrill Lynch, Pierce, Fenner &
Smith, 603 F.2d 1073
(4th Cir. 1979) (same); Utah State
University v. Bear, Stearns & Co., 549 F.2d 164
(same), cert. denied, 434 U.S. 890
, 98 S.Ct. 264
, 54 L.Ed.2d
In 1985, the Second Circuit joined the 3rd, 4th, 6th, 7th and
10th circuits in holding that no private right of action under
§ 7 exists. Bennett v. United States Trust Co., 770 F.2d 308,
313 (2d Cir. 1985):
In sum, the addition of section 7(f) [15 U.S.C. § 78g(f)] and
the Supreme Court's modification of its method of analyzing
claims of implied causes of action [in Cort v. Ash,
422 U.S. 66, 95 S.Ct. 2080, 45 L.Ed.2d 26 (1975) ] require a
reexamination of our Pearlstein I holding. Upon such a
reexamination, we agree with the unanimous view of the circuit
courts that have subsequently considered the issue and hold
that there is no implied cause of action for violations of
cert. denied, 474 U.S. 1058
, 106 S.Ct. 800
, 88 L.Ed.2d 776
1. Section 20
The complaint fails specifically to allege any control by SSC
over any of the other defendants. SSC is, presumably, lumped
together with the other "defendants" in Counts II and III.
Even if the complaint could be read to allege control person
liability against SSC, no relief to the plaintiff could be
granted on such a claim.
The introducing broker is the one who hires the clearing broker
to perform certain designated functions for it. As such, it
would be incongruous to hold that the clearing broker
"controlled" the introducing broker absent some sufficient
allegations showing that the clearing broker could or did
direct the actions of the introducing broker.
The Second and Third Circuits have concluded that the term
"controlling person" requires proof . . . of a relationship
between the controlling and the controlled persons which gives
the former direct or indirect influence over the policy and
decision-making process of the latter. . . .
Chrietoffel v. E.F. Hutton & Co., 588 F.2d 665
, 668 (9th Cir.
1978). See also, Ross v. Bolton, Fed.Sec.L.Rep. (CCH) ¶
94,410, 1989 WL 80428 (1989) ("That [the clearing broker]
affected [the introducing broker's] actions, however, does
not mean, however, that it directed those actions.")
At the hearing on this motion, counsel for plaintiff argued
that because SSC had the power to stop Moore & Schley from
purchasing such large quantities of Chase Medical Group stock,
this showed that SSC was a controlling person. Putting aside
the question of whether SSC had a duty to stop Moore & Schley's
purchases,*fn6 this argument also fails.
Although the precise meaning of "control," . . . is difficult
to define, it is clear that defendant must have had the power
to do more than prevent unlawful activity.
Neiman v. Clayton Brokerage Co., 683 F. Supp. 196, 201
Under the allegations of the complaint in this case, there is
no control person liability pleaded against SSC.
2. Aiding and Abetting
Plaintiff's last stab at holding SSC liable is as an aider and
abettor of a primary violation of the securities laws.
The three requirements for aiding and abetting liability are:
1) A primary violation by someone other than the aider and
abettor; 2) knowledge of the primary violation; and 3)
substantial assistance of the violation. Armstrong v.
McAlpin, 699 F.2d 79, 91 (2d Cir. 1983); see also, IIT v.
Cornfeld, 619 F.2d 909 (2d Cir. 1980); Rolf v. Blyth,
Eastman. Dillon & Co., 570 F.2d 38 (2d Cir.), cert. denied,
439 U.S. 1039, 99 S.Ct. 642, 58 L.Ed.2d 698 (1978).
Plaintiff misses the point on the third requirement,
No facts are pleaded that indicate substantial assistance was
afforded by SSC to improprieties of the introducing broker in
respect to customers' orders and mere conclusions of the
pleader of substantial assistance do not suffice.
In his complaint and brief, citing IIT v. Cornfeld,
619 F.2d 909, 927 (2d Cir. 1980) ("inaction can create aider and abettor
liability only when there is a conscious or reckless violation
of an independent duty to act"). plaintiff alleges that SSC's
violation of its duties under the "federal securities
laws"*fn7 and the "rules of the AMEX"*fn8 is enough to
create liability as an aider or abettor.
Inaction may be found to be substantial assistance only where
the independent duty to act was a duty owed to the defrauded
investor. In IIT v. Cornfeld, supra, and Brennan v.
Midwestern United Life Ins., 417 F.2d 147 (7th Cir. 1969),
cert. denied, 397 U.S. 989, 90 S.Ct. 1122, 25 cert. denied,
397 U.S. 989, 90 S.Ct. 1122, 25 L.Ed.2d 397 (1970), the
"independent duty to act" was the duty of an accountant to
correct misstatements upon which they know the public will
rely. In addition, the Midwestern defendant also knew and
intended that its inaction would enable the fraudulent scheme
to go forward.
As the clearing broker performing bookkeeping functions, SSC
owed no duty to the investors whose contact and relationship
was solely with the introducing broker. SSC's "independent duty
to act" was a duty vis-a-vis the SEC, the AMEX or Moore &
Schley only.*fn9 Even assuming, as we must on this motion to
dismiss, that SSC violated the "federal securities laws" or the
"rules of the AMEX" by continuing to clear trades in Chase
Medical Group stock, SSC owed no compensable duty to the
investors and the inaction of a clearing broker is not enough
to constitute the "substantial assistance" that aiding and
abetting liability requires.*fn10
Plaintiff has failed to state a sufficient claim against SSC
upon which relief can be granted.
The plaintiff has supplied a letter indicating a desire to
replead his claims. It is doubtful whether a sufficient claim
exists against SSC. However, amendments are liberally allowed.
The complaint is dismissed as insufficient against SSC with
leave to plaintiff to replead within 20 days, if so advised.