The opinion of the court was delivered by: SCHWARTZ
ALLEN G. SCHWARTZ, DISTRICT JUDGE:
This matter is before the Court upon the motion of defendants Merrill Lynch & Co., Inc. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (collectively, "MLPF&S") to dismiss all claims alleged in the Second Amended Class Action Complaint (the "Complaint") under Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure, and the motion of plaintiff Louis G. Bissell, Jr. ("Bissell" or "plaintiff") for class certification. For the reasons set forth below, MLPF&S's motion is granted, and Bissell's motion is denied as moot.
In this putative class action brought under the federal securities laws and New York statutory and common law, plaintiff seeks damages relating to short sales in his stock brokerage account with defendant MLPF&S. Plaintiff does not allege that MLPF&S deprived him of any investment gains, nor does he seek to hold MLPF&S responsible for any investment losses. Rather, plaintiff asserts that he and the putative class are entitled to all of the "interest, other profits or economic benefits earned [by MLPF&S] on . . . [customers'] property pledged as collateral in connection with such short sales . . . ." Complaint P 5.
Plaintiff asserts his claims not under any provisions of federal law specifically regulating short sales and the use of customer collateral
, but under (1) general principles of section 10(b) of the Securities Exchange Act of 1934 (the "1934 Act"), 15 U.S.C. § 78a et seq., and Securities and Exchange Commission ("SEC") Rules 10b-5 and 10b-16, 17 C.F.R. §§ 240.10b-5 and 240.10b-16, (2) the common law of the State of New York, and (3) provisions of the Uniform Commercial Code.
Some background on the mechanics and regulation of short sales is necessary to put plaintiff's claims in perspective. In a short sale transaction the customer borrows stock to sell, is credited with the proceeds, and then restores the borrowed stock by purchase, hopefully at a lower price. Thus, a short sale is the sale of a security that the seller does not own, or, if he or she owns it, does not deliver to the buyer. Where the seller owns the security but does not deliver it to the buyer, the transaction is referred to as a "short sale against the box."
The monthly statements in Bissell's account reflect that all of Bissell's short sales were short sales against the box.
To secure the loan of stock, a short-selling customer is required to provide his or her broker with collateral in the form of cash or securities. In a "regular" short sale (as opposed to a short sale against the box), the collateral for the security loan usually takes the form of the cash proceeds received from the short sale, but securities may be substituted as collateral.
Whether in the form of cash or securities, however, SEC rules permit the broker-dealer to use the collateral to finance margin loans or security loans for the same or other margin customers. See, e.g., 17 C.F.R. § 240.15c3-3.
In short sales against the box, the seller's collateral for the security loan always takes the form of securities, namely, the seller's own long security position "in the box." The cash proceeds from the short sale do not serve as collateral for the security loan in a short sale against the box.
To protect the integrity of the short sale against the box (i.e., to assure that the long position is not delivered to the buyer), the broker-dealer segregates the seller's long position, thereby removing it from the pool of margin securities otherwise available to it for lending, pledging, hypothecation or any other purpose.
The broker obtains the stock that it loans to the customer from its own reserves or by borrowing it from other brokers or other customers, as permitted by standard margin agreements and applicable regulations. See 15 U.S.C. § 78h(c); 17 C.F.R. § 240.15c3-3(a)(3) and (4). When the broker borrows the stock from external sources, the broker must secure the loan with collateral worth at least 100 percent of the market value of the securities borrowed. Regulation T, 12 C.F.R. § 220.16. The funds used to secure the loan of stock may be taken directly or indirectly from the account of the customer engaging in the short sale, and typically are generated by the short sale itself.
Where the broker has provided collateral to another broker or institution to secure the loan of securities, the borrowing broker typically receives a portion of any interest earned on the collateral. The borrowing broker does not usually pass any of the interest on to its customer, although an exception is sometimes made for large or professional customers. Here, the Complaint and monthly account statements make clear that MLPF&S did, in fact, pass on some of this interest to Bissell. In September 1985, MLPF&S agreed to credit Bissell's account with 50 percent of Broker Call Rate ("BCR") interest on the entire short market value ("SMV") of his open short positions. This arrangement is reflected in Bissell's monthly statement for September 1985 and each month thereafter, and was made retroactive to January 1, 1985. In 1989, for example, Bissell's account was credited with $ 44,255.58 in interest, in effect reducing his 1989 margin interest charges from $ 94,429.97 to $ 50,174.39. See Complaint P 32.
In essence, the Complaint in this action alleges that MLPF&S uses its customers' assets, in the form of cash and stock collateral and proceeds of short sales, to earn interest and to obtain other financial benefits without notifying the customer of this practice or sharing the proceeds with them. Based upon these allegations, Bissell and the putative class assert claims for securities fraud, breach of fiduciary duty, violation of the "shingle theory" and principles of trust and agency, breach of implied covenants of good faith and fair dealing, and violation of Article 9 of the Uniform Commercial Code.
Although captioned "Second Amended Class Action Complaint," the pending Complaint is actually plaintiff's fourth complaint in this action. It was preceded by a "Substituted Amended Class Action Complaint," an "Amended Class Action Complaint," and an original "Class Action Complaint." Plaintiff has agreed and this Court has "so ordered" that the pending Complaint is "the final complaint in this action and said complaint may not be amended hereafter for any reason." See Stipulation and Order dated October 11, 1994.
A. Standard for Motion to Dismiss
In ruling upon MLPF&S's motion to dismiss the Complaint under Rule 12(b)(6), the Court must view the Complaint in the light most favorable to Bissell, accepting all allegations contained in the Complaint as true. See Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S. Ct. 1683, 1686, 40 L. Ed. 2d 90 (1974). All reasonable inferences are to be drawn in the plaintiff's favor, and the claims should not be dismissed unless "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim[s] which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46, 78 S. Ct. 99, 101-102, 2 L. Ed. 2d 80 (1957).
B. Securities Fraud Claims
Bissell bases his securities fraud claims upon MLPF&S's alleged violation of two SEC rules promulgated under section 10(b) of the 1934 Act: Rule 10b-5 and Rule 10b-16.
To state a claim under section 10(b) and Rule 10b-5, a plaintiff must allege that "in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused [plaintiff] injury." In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 264 (2d Cir. 1993) (quoting Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 61 (2d Cir. 1985)), cert. denied, U.S. , 114 S. Ct. 1397 (1994) (internal quotations omitted). The Supreme Court recently stated that Rule 10b-5 should be interpreted strictly to bar "10b-5 challenges to conduct not prohibited by the text of the statute." Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114 S. Ct. 1439, 1446, 128 L. Ed. 2d 119 (1994). The Court emphasized that "'not every instance of financial unfairness constitutes fraudulent activity under § 10(b).'" Id. (citation omitted).
Here, plaintiff's claim under Rule 10b-5 must be dismissed because it fails to satisfy the requirement that the alleged fraud was "in connection with the purchase or sale of any security." 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5. To satisfy this requirement, the misrepresentation or omission must pertain to the securities themselves; allegations of fraud merely involving securities are not sufficient. See Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir.), cert. denied, 469 U.S. 884, 105 S. Ct. 253, 83 L. Ed. 2d 190 (1984). Judge Chin of this Court recently dismissed a securities fraud complaint similar to Bissell's, holding that the broker-dealer's alleged "failure to disclose that it earned interest on its customers' collateral and the proceeds of their short sales was not 'in connection with' the purchase or sale of securities." Levitin v. PaineWebber, Inc., 933 F. Supp. 325, 1996 U.S. Dist. LEXIS 9560, 1996 WL 384912, at *4 (S.D.N.Y. 1996). I concur with Judge Chin's thorough analysis of the "in connection with" requirement in Levitin and reach the same conclusion here.
The law of this Circuit is clear that unless the alleged fraud concerns the value of the securities bought or sold, or the consideration received in return, such fraud is not "in connection with" the purchase or sale of a security within the meaning of Rule 10b-5. See Chemical Bank, 726 F.2d at 943 (claim against accountants for losses related to loans secured by notes of company audited by the accountants held not to be "in connection with" the purchase or sale of a security); Saxe v. E.F. Hutton & Co., Inc., 789 F.2d 105, 108 (2d Cir. 1986) (claim that investor was fraudulently induced to liquidate securities portfolio to invest proceeds with commodities trader held not to be "in connection with" the sale of a security").
In Chemical Bank, a leading decision on the "in connection with" requirement of Rule 10b-5 liability, Judge Friendly described the ...