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SEC v. FEMINELLA

November 21, 1996

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, against STANLEY J. FEMINELLA and DAVID GRANSTON, Defendants.


The opinion of the court was delivered by: SCHWARTZ

OPINION and ORDER

 ALLEN G. SCHWARTZ, DISTRICT JUDGE:

 This Securities and Exchange Commission enforcement action is before the Court upon defendant Stanley J. Feminella's motion to dismiss, pursuant to Federal Rules of Civil Procedure 12(b)(6) and 9(b). Oral argument was held on this motion on September 27, 1996. For the reasons that follow, defendant's motion is denied.

 BACKGROUND

 In its Complaint, the Securities and Exchange Commission (the "SEC" or "Commission") alleges that for a period of at least five years, Feminella, a stockbroker, engaged in a corrupt scheme though which he paid kickbacks to the Chief Financial Officer of Consumers Union ("CU") on CU's purchases of securities, in return for directing CU's investment transactions to him. CU purchased two types of securities: Government National Mortgage Association mortgage-backed securities ("Ginnie Maes") and "stripped" United States Government Treasury notes and bonds ("STRIPS").

 The SEC further alleges that Feminella charged a 3% sales credit for routine and ordinary brokerage services, which, when added to the spreads charged by defendant's firm, caused CU to pay markups ranging from 3.54% to 4.73%. The SEC asserts that such markups exceed those customarily imposed by securities brokerage firms in transactions involving the same or similar securities for comparable dollar amounts. Feminella allegedly knew and did not disclose that the prices paid by CU and its pension fund on their purchases of Ginnie Maes and STRIPS bore no reasonable relationship to the prevailing market prices for those securities.

 The SEC claims that such acts violated Section 17(a) of the Securities Act of 1933 (the "Securities Act), 15 U.S.C. § 77q(a), Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, thereunder. The SEC requests that the Court permanently enjoin Feminella from violations of these antifraud provisions, order Feminella to disgorge the portion of the excessive markups he charged CU and its pension fund as well as the compensation he received as a result of the fraudulent conduct alleged, plus prejudgment interest thereon, and order that Feminella pay a civil penalty pursuant to Section 20(d) of the Securities Act and Section 12(d)(3) of the Exchange Act.

 DISCUSSION

 In ruling on a motion to dismiss pursuant to Rule 12(b)(6), "a court must construe in plaintiff's favor any well-pleaded factual allegations in the complaint. . . . Dismissal of the complaint is proper only where it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Allen v. Westpoint-Pepperell, Inc., 945 F.2d 40, 44 (2d Cir. 1991).

 Feminella moves to dismiss the Complaint on the grounds that (1) the two SEC Commissioners sitting at the time the Complaint was filed lacked authority to approve the enforcement action against Feminella because, at the time, a quorum of at least three Commissioners did not exist, (2) the Complaint fails to state a cause of action against Feminella under the antifraud provisions, and (3) the Complaint fails to allege fraud with particularity.

 Validity of the Action

 Feminella first argues that the SEC lacked authority to commence this action because a quorum of Commissioners did not exist at the time the action was authorized. Therefore, defendant submits, the Complaint is a nullity and the action should be dismissed.

 It is undisputed that at the time this action was commenced, only two SEC Commissioners were in office. Normally, the SEC is composed of five Commissioners, who are appointed by the President with the advice and consent of the Senate. No more than three Commissioners may be members of the same political party. See 15 U.S.C. § 78d.

 On March 30, 1995, the three Commissioners then sitting adopted a quorum rule, which provides in pertinent part:

 
A quorum of the Commission shall consist of three members, provided, however, that if the number of Commissioners in office is less than three, a quorum shall consist of the number in office.

 60 Fed. Reg. 17201 (1995) (codified at 17 C.F.R.200.41). This rule was adopted without notice to, or comment from, the public because the SEC considered it to be related solely to the "agency's organization, procedure or practice." Establishment of Commission Quorum Requirement, Exchange Act Release No. 35548 (March 30, 1995). From July 15, 1995 through February 13, 1996, the SEC operated with only two Commissioners, both of whom were Democrats. The Complaint in this action was filed on January 18, 1996; the two sitting Commissioners apparently voted to initiate the action in late December 1995 or early January 1996.

 Feminella argues that the SEC's new rule permitting a quorum of less than three sitting Commissioners is a nullity because the Commission does not have the authority to promulgate a rule "that abrogate[s] the common law quorum requirement, in contravention of the will of Congress." Defendant's Mem. Of L. at 13. Defendant further contends that even if the SEC had the authority to pass the rule, it is invalid because it was not promulgated in accordance with the Administrative Procedure Act ("APA").

 The Exchange Act, which created the SEC, is silent as to how many Commissioners constitute a quorum. See FTC v. Flotill Products, Inc., 389 U.S. 179, 181 n. 3, 88 S. Ct. 401, 403 n. 3, 19 L. Ed. 2d 398 (1967). Prior to promulgation of the new quorum rule, the SEC's policy had been that three Commissioners constituted a quorum for doing business. See Public Utility Holding Company Act of 1935, Release No. 850, n. 1 (October 13, 1937).

 Feminella argues that under the common law rule, as stated in FTC v. Flotill Products Inc., supra, a valid quorum for the SEC consists of three Commissioners. In Flotill, the Federal Trade Commission ("FTC"), by a vote of 2-1 of its sitting Commissioners, issued an administrative cease and desist order against the defendant. Like the SEC, the FTC is composed of five Commissioners, no more than three of whom may belong to the same political party. The Federal Trade Commission Act does not specify the number of Commissioners who constitute a quorum; however, the FTC had promulgated a rule providing that a majority of the members of the FTC, or three Commissioners, constituted a quorum. The Court of Appeals for the Ninth Circuit held that the cease and desist order was invalid, stating that "an order of the Commission must be supported by three members in order to constitute an enforceable order of the FTC. Two of five is too few." Flotill, 358 F.2d 224, 230 (9th Cir. 1966). The Court of Appeals reasoned that, absent statutory authority or instruction to the contrary, the FTC could act only on the concurrence of a majority of the full Commission. See id. at 228. The Supreme Court reversed, rejecting this rationale in favor of the "almost universally accepted common-law rule" that "in the absence of a contrary statutory provision, a majority of a quorum constituted of a simple majority of a collective body is empowered to act for the body." Flotill, 389 U.S. at 183, 88 S. Ct. at 404. Thus, "where the enabling statute is silent on the question, the body is justified in adhering to that common-law rule." Id.

 In short, the Supreme Court in Flotill held that a federal agency "is not inhibited from following the common-law rule" as a substitute for a statutory quorum provision where none exists. Id., 389 U.S. at 185, 88 S. Ct. at 405. The court did not hold, however, that the common law rule must be followed exclusively. Therefore, contrary to defendant's argument, Flotill does not mandate a quorum rule for the SEC or any other agency. Likewise, Congress' inaction following the Flotill decision does not signify an intent to hold the Commission to the common law quorum rule.

 The question in this case is whether Congress, in creating a Commission of five members and not specifying a quorum rule, would have intended that any action taken by less than some number of Commissioners be a nullity. Defendant is asking this Court to declare that the filing of the Complaint against him, and, by extension, all of the actions taken by the SEC for a period of approximately seven months, was an invalid act due to the fact that there were three vacancies on the Commission. In order to determine whether such a declaration would comport with the will of Congress, the Court must go beyond Flotill and the common law and attempt to glean Congressional intent from the statutes at issue. Cf. Assure Competitive Transp., Inc. v. United States, 629 F.2d 467, 473 (7th Cir. 1980), cert. denied, 449 U.S. 1124, 101 S. Ct. 941, 67 L. Ed. 2d 110 (1981) (vacancy provision in the Interstate Commerce Act showed "that Congress intended those Commissioners in office, however many there are, to be 'the Commission' for all purposes. 'A majority of the Commission,' the phrase used in the quorum provision, accordingly must mean a majority of those Commissioners in office").

 The SEC refers the Court to two statutory bases supporting its authority to adopt the quorum rule. First, the agency points to the general rulemaking authorization in Section 23(a)(1) of the Exchange Act, which provides that "the Commission . . . shall . . . have power to make such rules and regulations as may be necessary or appropriate to implement the provisions of this chapter for which [it] is responsible or for the execution of the functions vested in [it] by this chapter . . . ." 15 U.S.C. § 78w(a)(1). The Securities Act contains an almost identical provision, giving the Commission the authority to "make, amend, and rescind such rules and regulations as may be necessary to carry out the provisions of this subchapter . . . ." 15 U.S.C. § 77s(a). However, these provisions are generally cited as authority to make substantive rules prohibiting certain acts under the statutes, not as authority to establish the agency's own internal procedures. See, e.g., United States v. Chestman, 947 F.2d 551, 556-57 (2d Cir. 1991), cert. denied, 503 U.S. 1004, 112 S. Ct. 1759, 118 L. Ed. 2d 422 (1992).

 The second provision that the SEC points to provides a stronger basis in support of its authority to promulgate the new quorum rule. Section 4(a) of the Exchange Act grants the Commission the power to delegate, by published order or rule, "functions with respect to hearing, determining, ordering, certifying, reporting, or otherwise acting as to any work, business, or matter" to an individual Commissioner, a hearing examiner, an employee or an employee board. 15 U.S.C. § 78d-1. Only the function of rulemaking may not be delegated by the Commission. See id. Thus, the Commission is authorized under this section to delegate to ...


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