United States District Court, Southern District of New York
July 8, 1991
NATIONAL BANK OF YUGOSLAVIA, PLAINTIFF,
DREXEL BURNHAM LAMBERT, INCORPORATED, LEON D. BLACK, GARY S. DAVIS, FREDERICK H. JOSEPH, JOHN H. KISSICK, BARRY L. KLEIN, THOMAS R. MCHALE, AND RICHARD J. WRIGHT, DEFENDANTS.
The opinion of the court was delivered by: Stanton, District Judge.
OPINION AND ORDER
In a single motion, defendants Black, Davis, Joseph,
Kissick, Klein and Wright move to dismiss the claims against
them pursuant to Fed.R.Civ.P. 12(b)(1) for lack of
subject-matter jurisdiction and 12(b)(6) for failure to state
a claim upon which relief can be granted,*fn1 and defendant
McHale moves to dismiss Counts I and II of the complaint on
the same grounds. The remaining defendant, Drexel Burnham
Lambert, Inc. ("Drexel")*fn2 has filed a petition in
Plaintiff, the National Bank of Yugoslavia (the "Bank"),
brings this action against all defendants under section 10(b)
of the Securities Exchange Act of 1934 (the "1934 Act"),
15 U.S.C. § 78j(b) (1988), Rule 10b-5, 17 C.F.R. § 240.10b-5
(1990), and section 12(2) of the Securities Act of 1933 (the
"1933 Act"), 15 U.S.C. § 77l(2), as well as against Mr. McHale
and Drexel for common-law fraud and negligent
The claims arise out of a series of transactions in which
the Bank placed approximately $71 million with Drexel (for
investment, says the Bank; as short-term loans to Drexel, say
defendants) shortly before Drexel's bankruptcy. In this
motion, defendants contend that the transactions did not
involve "securities" within the meaning of the federal
securities laws, and that those claims must be dismissed. The
Bank counters that the notes it purchased from Drexel were
"securities" under the circumstances.
The complaint alleges the following:
The Bank is the central bank for the government of
Yugoslavia, and is responsible for maintaining and investing
Yugoslavia's monetary reserves and for its external liquidity.
(Complaint ¶¶ 3, 17). Yugoslavian law requires that safety be
its most important investment criterion, and accordingly "it
invests Yugoslavian reserves directly or indirectly (i) with
commercial banks ranking in the top 100 worldwide in terms of
assets, or (ii) in high quality debt securities issued or
guaranteed by governments of the most developed countries."
(Complaint ¶ 17).
In June 1989, Mr. McHale, describing himself as a Drexel
"Senior Economist," sent a telex to the Bank requesting a
meeting concerning "central bank reserve management."
(Complaint ¶¶ 20-21). The telex stated that Drexel was a
leading financial intermediary with many central banks in
various investment transactions. (Complaint ¶ 21). When Mr.
McHale and an associate met with Bank representatives later
that month, those representatives informed him of the Bank's
conservative investment policy. (See Complaint ¶¶ 22-28). In
reliance on Mr. McHale's statements that Drexel would act in
accordance with those policies, the Bank promptly entered into
a number of transactions with Drexel. (Complaint ¶¶ 26, 29-30).
On September 22, 1989, Drexel accepted 70 million deutsche
marks from the Bank, and agreed to return it, with interest,
on December 27, 1989. (Complaint ¶ 31). On September 27, 1989,
Drexel accepted an additional $40 million from the Bank, and
agreed to return that amount on December
29, 1989, with interest. (Complaint ¶ 33). The Bank believed
that Drexel would invest those sums in accordance with its
investment policy. (Complaint ¶¶ 32, 34).
Both transactions took place over the Reuters Screen System,
a computer communications network. (Complaint ¶¶ 16, 31, 33).
The parties negotiated some terms of the transactions,
including the interest rate. Drexel stated that it would
"borrow" the sums. The Bank said that it could "offer" and
"give" the funds, and that it would "place" them with Drexel.
(Affidavit of Francis Holozubiec sworn to March 11, 1991
exhibit B at 48, 53).
Later, the Bank and Drexel agreed to "roll over" the
deposits. The Bank accepted postponement of the return of its
money until February and March 1990, and the parties agreed
upon different interest rates. (Id. at 114-15, 120; Complaint
¶¶ 33-38). The complaint characterizes both the initial
transactions and the "roll overs" as "time deposits."
(Complaint ¶ 38).
Contrary to Drexel's representations and the Bank's
expectations, Drexel did not invest the funds with top banks
or in high-quality government or government-backed debt
securities. (Complaint ¶ 40). Rather, Drexel used the money for
itself, to alleviate its liquidity problems. (Complaint ¶ 40).
In February 1990 Drexel informed the Bank of Drexel's
liquidity problems and that approximately $71 million of the
funds could not be returned. (Complaint ¶¶ 48-49). This action
The Bank alleges that the individual defendants other than
Mr. McHale, who are Drexel officials, are liable as
"controlling persons" under section 20(a) of the 1934 Act,
15 U.S.C. § 78t(a), and section 15 of the 1933, 15 U.S.C. § 77o.
It asserts that Mr. McHale is liable as an aider and abettor of
Drexel's primary securities fraud. (Complaint ¶ 55).
I. The Standard for Dismissal
On a motion to dismiss for failure to state a claim, the
allegations in the complaint must be taken as true. They are
read in the light most favorable to the plaintiff. The
complaint must not be dismissed unless it appears beyond
question that plaintiff cannot prove any set of facts in
support of its claim which would entitle it to relief.
Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S.Ct. 1683, 1686, 40
L.Ed.2d 90 (1974); Conley v. Gibson, 355 U.S. 41, 45-46, 78
S.Ct. 99, 101-102, 2 L.Ed.2d 80 (1957).
The parties dispute whether their Reuters Screen System
communications may be considered in deciding this motion. The
complaint refers to the Reuters Screen System communications,
which are integral to the time deposits and the Bank's claims.
Their terms are undisputed, and the Bank has submitted them in
connection with this motion. Therefore, the communications may
be deemed incorporated by reference into the complaint, and
they will be considered here. See Feder v. Macfadden Holdings,
Inc., 698 F. Supp. 47, 50 (S.D.N.Y. 1988); see also Field v.
Trump, 850 F.2d 938, 949 (2d Cir. 1988), cert. denied,
489 U.S. 1012, 109 S.Ct. 1122, 103 L.Ed.2d 185 (1989); Furman v.
Cirrito, 828 F.2d 898, 900 (2d Cir. 1987).
However, their significance will be evaluated in light of
the Bank's allegations that they were but a part of its
overall relationship with Drexel.
II. Notes as Securities
A. The Statutes
Section 2 of the 1933 Act states: "When used in this
subchapter, unless the context otherwise requires — (1) The
term `security' means any note. . . ." 15 U.S.C. § 77b. Section
3(a)(3) excludes from the coverage of the 1933 Act
Any note, draft, bill of exchange, or banker's
acceptance which arises out of a current
transaction or the proceeds of which have been or
are to be used for current transactions, and
which has a maturity at the time of issuance of
not exceeding nine months, exclusive of days
of grace, or any renewal thereof the maturity of
which is likewise limited.
15 U.S.C. § 77c(a)(3).
However, this exemption does not apply to claims under
section 12(2) of the 1933 Act, such as those the Bank asserts
here. See 15 U.S.C. § 77l(2) (anti-fraud provision of 1933 Act
applies to any person who "offers or sells a security (whether
or not exempted by the provisions of section 77c of this title
. . .)")
Section 3(a) of the 1934 Act states:
When used in this chapter, unless the context
otherwise requires —
(10) The term "security" means any note . . . but
shall not include currency or any note, draft,
bill of exchange, or banker's acceptance which
has a maturity at the time of issuance of not
exceeding nine months, exclusive of days of
grace, or any renewal thereof the maturity of
which is likewise limited.
15 U.S.C. § 78c(a).
B. Reves v. Ernst & Young
In Reves v. Ernst & Young, 494 U.S. 56, 110 S.Ct. 945, 108
L.Ed.2d 47 (1990), the Supreme Court adopted the Second
Circuit's "family resemblance" test for determining whether a
particular note is a "security" under the federal securities
Under that test, any note with a term of more than nine
months is presumed to be a security*fn3 unless it bears a
strong family resemblance to one of a list of instruments
which, although commonly called "notes" have been determined
not to be "securities," or unless the defendant can show that
the note should be added to that list. Id. 110 S.Ct. at 950-51.
Whether the note in question bears a strong family
resemblance to the list of excluded instruments is evaluated
by examining: (1) the motivations that would prompt a
reasonable seller and buyer to enter into the transaction; (2)
the plan of distribution of the instrument; (3) the reasonable
expectations of the investing public; and (4) whether some
factor such as the existence of another regulatory scheme
significantly reduces the risk of the instrument, thereby
rendering application of the securities laws unnecessary.
Id. 110 S.Ct. at 951-52. "If an instrument is not sufficiently
similar to an item on the list, the decision whether another
category should be added is to be made by examining the same
factors." Id. 110 S.Ct. at 952.
C. Application of Reves
Defendants argue that the time deposits (1) bear a strong
family resemblance to one of the notes on the list of excluded
instruments; (2) should be added to that list under the four
Reves factors; and (3) are exempt from the securities laws
because they had maturities of less than nine months.
1. Strong Family Resemblance
Defendants argue that the time deposits are similar to
"notes evidencing loans by commercial banks for current
operations," one of the instruments on the list of notes not
covered by the federal securities laws. See id. 110 S.Ct. at
951 (citing Chemical Bank v. Arthur Andersen & Co.,
726 F.2d 930, 939 (2d Cir. 1984)).
Under the allegations in the complaint, the time deposits
bear little resemblance to such loans. The Bank is not a
commercial lending institution, but the central bank of a
sovereign state. The manner in which the transactions occurred
was unlike a commercial loan. There was no such documentation
and scrutiny of the "borrower" as customarily would accompany
a loan of this size. The Bank did not retain authority over
Drexel's finances, nor monitor its use of loan proceeds.
See Equitable Life
Assurance Soc'y v. Arthur Andersen & Co., 655 F. Supp. 1225,
1235-39 (S.D.N.Y. 1987) (note that business gave to insurance
company with extensive documentation and control over business'
operations was not "security"). Such precautions are
fundamental to a commercial bank's ability to reduce the risk
of its loans, and render the application of the securities laws
in such transactions less important. See Great Western Bank &
Trust v. Kotz, 532 F.2d 1252, 1261-62 (9th Cir. 1976) (Wright,
J., concurring); see also Equitable Life, 655 F. Supp. at
Defendants argue that the Bank was able to protect itself
like a commercial lending institution, and failed to do so.
They argue that its capacity to protect itself shows that the
time deposits bore a strong family resemblance to a commercial
bank loan for current operations.
However, nothing in the complaint or the parties'
communications shows that Drexel would have accepted such
scrutiny, or that terms of the transaction would have been the
same had it done so. Moreover, the fact that the Bank did not
seek or apply the customary safeguards attendant to commercial
loans shows that it did not contemplate, and members of the
investing public examining the transactions would not have
viewed them as, commercial loans.
2. The Reves Factors
Since the time deposits do not resemble notes that are not
"securities," the next step under Reves is to use its four
factors to determine whether the time deposits should be added
to the list. Reves, 110 S.Ct. at 952.
a. Motivations Prompting a Reasonable Seller and Buyer
to Enter into the Transaction
The Supreme Court in Reves stated with respect to this
If the seller's purpose is to raise money for the
general use of a business enterprise or to
finance substantial investments and the buyer is
interested primarily in the profit the note is
expected to generate, the instrument is likely to
be a "security." If the note is exchanged to
facilitate the purchase and sale of a minor asset
or consumer good, to correct for the seller's
cash-flow difficulties, or to advance some other
commercial or consumer purpose, on the other
hand, the note is less sensibly described as a
110 S.Ct. at 951-52.
Here, the reasonable motivations of the parties are alleged
as more akin to those of parties to a securities transaction
than to a consumer or business credit arrangement. The Bank
placed its funds with Drexel on the understanding that they
would, in turn, be placed in specific, safe investments,
rather than used for Drexel's operating expenses or purchases.
The Bank's interest lay in the profit that the note was to
generate, but also in the safe return of its principal; and if
Drexel believed that it could use the funds for its own
purposes, the Bank did not.
Defendants point out that the time deposits' interest rates
were fixed, while the rate in Reves fluctuated to stay above
those of local financial institutions. See id. 110 S.Ct. at
952-53. They argue that the fixed interest rates weigh in favor
of finding that the time deposits were not securities.
Nevertheless, a fixed interest rate is a feature of many notes
undoubtedly covered by the federal securities laws.
Drexel's use of the term "borrow" in its Reuters Screen
communications with the Bank does not change that conclusion.
The Bank itself did not use that word, and it may have been
regarded as merely a convenient shorthand expression of
Drexel's duty to return the funds on specified dates with
interest. Taking the complaint as true, the use of the word
"borrow" should not be given decisive significance.
b. The Plan of Distribution of the Instrument
Since there is no allegation that there was a secondary
market for the time deposits, the Bank does not show that
there was "`common trading for speculation or investment'" in
the notes. Id. 110 S.Ct. at 952 (quoting SEC v. C.M. Joiner
Leasing Corp., 320 U.S. 344, 353, 64 S.Ct. 120, 124, 88 L.Ed.
However, the absence of such an allegation is not fatal to
the Bank's securities laws claims. A debt instrument may be
distributed to but one investor, yet be a "security."
Tannebaum v. Clark, No. 88 C 7312 (N.D.Ill. Mar. 18, 1991)
(available on WESTLAW, 1991 WL 39671). Any other interpretation
of Reves would contradict the Supreme Court's determination
that in the federal securities laws Congress "enacted a
definition of `security' sufficiently broad to encompass
virtually any instrument that might be sold as an investment."
Reves, 110 S.Ct. at 949.
Moreover, the Bank asserts that discovery may show that
Drexel engaged in other transactions similar to these: it may
be that the time deposits were not the only ones of their
kind, and the Bank not their only purchasers.
c. The Reasonable Expectations of the Investing
Since there is no evidence the public either invested in
this manner, or knew of its existence, one is left to
speculate what the investing public would expect. It might
reasonably view the obligations as securities. The Bank placed
its funds with Drexel, at the time a major investment banking
and securities underwriting firm, in return for a fixed rate
of interest. The funds were to be invested in particular, safe
securities. Thus the transactions (if accurately described in
the complaint), were investment instruments, rather than
consumer or commercial bank loans or financing.
Defendants argue that Marine Bank v. Weaver, 455 U.S. 551,
102 S.Ct. 1220, 71 L.Ed.2d 409 (1982), which held that a
certificate of deposit with a fixed rate of interest issued by
a federally-regulated bank is not a security, supports their
position here. They contend that the Court's determination that
the "unique agreement, negotiated one-on-one by the parties, is
not a security," id. at 560, 102 S.Ct. at 1225, shows that the
investing public would not consider these deposits to be
However, the language that defendants quote from Marine Bank
is from the Court's determination that another transaction, an
agreement to pledge a certificate of deposit to guarantee a
business loan in exchange for profits from the business, rights
to veto future borrowing and rights to use a pasture and barn,
was not a security. See id. at 552-53, 559-60, 102 S.Ct. at
1221-22, 1225. The Court's determination that a
federally-regulated bank's certificate of deposit is not a
security, by contrast, turned on the highly-regulated nature of
such institutions and the fact that their deposits are insured
by the Federal Deposit Insurance Corporation, rather than any
public perception of such instruments. Id. at 557-58, 102 S.Ct.
at 1224-25. Such risk-reducing factors are absent here.
d. Whether Some Factor Such As the Existence of Another
Regulatory Scheme Significantly Reduces the Risk of the
It is undisputed that there is no regulatory scheme which so
significantly reduced the risk of the time deposits as to make
application of the federal securities laws unnecessary.
However, defendants argue that similar protection is available
from the short duration of the notes, as well as federal
bankruptcy law and state common law.
The short maturities of the time deposits do not, by
themselves, satisfy this factor, since notes of certain new or
financially unstable enterprises, though of short maturities,
may entail substantial risk. The brief duration of these
uncollateralized, unsecured instruments does not afford
protection comparable to the substantial safeguards of the
federal securities laws.
As for the federal bankruptcy and common law, such
protections are available in any transaction, including ones
that are clearly securities transactions, and they existed at
the time Congress perceived the need for the additional
protections of the 1933 and 1934 Acts. They are nothing like
the comprehensive regulatory and insurance scheme that was
found sufficient to exempt certificates of deposits in
In summary, three of the four Reves factors weigh in favor of
finding that the deposits were "securities," and the fourth
cannot sensibly take this investment transaction outside the
federal securities laws. Accordingly, under the Reves test, as
pleaded the transactions involved "securities."
3. Exemptions for Maturity Dates of Less Than Nine Months
Defendants argue that because the time deposits had
maturities of less than nine months, the 1933 and 1934 Acts
exempt them from their definitions of "security."
However, the exemption for short-term notes in the 1933 Act
does not apply to claims under section 12(2).
15 U.S.C. § 77l(2). Accordingly, the Bank's claims under that section are
unaffected by the short maturity of the notes.
Under the 1934 Act, the nine-month exemption is part of the
definition of "security" in section 3(a)(10), and thus the
terms of the statute facially exclude the time deposits from
the provisions of that act.
However, the Second Circuit, in accord with the other
circuits that have considered the issue, has held that the
nine-month exemption in section 3(a)(10) is not to be applied
literally. See Reves, 110 S.Ct. at 955-56 (Stevens, J.,
concurring). Instead, invoking section 3(a)'s prefatory
language, "unless the context otherwise requires," courts hold
that Congress intended the exemption to apply only to certain
prime-quality commercial paper. See Zeller v. Bogue Elec. Mfg.
Corp., 476 F.2d 795, 799-800 (2d Cir.) (Friendly, J.), cert.
denied, 414 U.S. 908, 94 S.Ct. 217, 38 L.Ed.2d 146 (1973); see
also Franklin Sav. Bank v. Levy, 551 F.2d 521, 527-28 (2d Cir.
1977); Singer v. Livoti, 741 F. Supp. 1040, 1047-48 (S.D.N.Y.
While the majority did not reach this issue in
Reves,*fn4 the four dissenters in that case contended that
under the plain terms of the statute, notes of a duration of
less than nine months are exempt from the 1934 Act (Reves did
not involve the 1933 Act), and that the arguments for going
beyond its terms were unconvincing. Reves, 110 S.Ct. at 958-60
(Rehnquist, C.J., dissenting).*fn5
While the view of the dissenters in Reves may ultimately
command a majority of the Supreme Court, at the present time
this court is bound by the established precedent of this
circuit. There is no ground for finding, at this point, that
the time deposits were the sort of prime-quality commercial
paper contemplated by the nine-month exemption in section
3(a)(10). Taking the complaint as true, the notes are alleged
to have been of poor quality.
Defendants' motion to dismiss is denied.