The opinion of the court was delivered by: Robert Sweet, Senior District Judge [ Page 2]
Carl H. Loewenson Jr. Esq., as Court-appointed Receiver (the "Receiver") for Credit Bancorp, Ltd. and affiliated entities (individually and collectively, "CBL") has moved for an order (1) directing Deutsche Bank Securities, Inc. ("DBSI") and DB Alex Brown LLC ("DBAB") (collectively, "Deutsche Bank") to transfer the custody of the Receiver all assets transferred after August 11, 1999 into accounts maintained at Deutsche Bank in the name of CBL, (2) declaring unsecured all margin loans extended by Deutsche Bank after August 1999, in such accounts, as well as all interest that has accrued on such loans, and (3) directing Deutsche Bank to credit to an account designated by the Receiver certain proceeds realized from the tender of shares of Praegitzer Industries, Inc. ("Praegitzer").
Intervenor Deutsche Bank*fn1 moves simultaneously for (1) a declaration of the validity of its security interest in the 2,400,000 shares of Vintage Petroleum, Inc. ("Vintage") stock in the accounts of CBL at Deutsche Bank; and (2) authorization to sell the Vintage shares to satisfy the approximately $17.4 million in CBL's outstanding margin loans and interest, plus [ Page 3]
Intervenor Stephenson Equity Company ("SECO")*fn2 moves simultaneously with the Receiver and with Deutsche Bank for an order (1) directing Deutsche Bank to transfer to the custody of the Receiver all assets transferred into the CBL accounts after December 1, 1998, (2) declaring unsecured all margin loans extended by Deutsche Bank in the CBL accounts after December 1, 1998, as well as all interest that has accrued on such loans, and (3) directing Deutsche Bank to credit to the CBL accounts the proceeds previously received in connection with the tender offer of the Praegitzer shares.
For the following reasons, the motion of the Receiver is granted in part, the motion of Deutsche Bank is denied, and the motion of SECO is granted in part and denied in part.
This action was initiated on November 17, 1999 by the plaintiff, the Securities and Exchange Commission (the "SEC"), to freeze the assets of CBL upon the allegations that Richard [ Page 4]
Jonathan Blech ("Blech") and others had engaged in a complicated securities fraud. The fraud, which was in effect a Ponzi scheme, affected over 200 customers with interests exceeding $200 million. An equity receivership was established on January 21, 2000.
Certain of the prior proceedings are described in previous opinions of this Court, familiarity with which is presumed. The following is a partial list of opinions of relevance to the present motion: SEC v. Credit Bancorp, Ltd., 2002 WL 1792053, (S.D.N.Y. Aug. 2, 2002) ("Credit Bancorp V"); SEC v. Credit Bancorp, Ltd., 2001 WL 1658200, (S.D.N.Y. Dec. 27, 2001) ("Credit Bancorp IV"); SEC v. Credit Bancorp, Ltd., 2000 WL 1752979 (S.D.N.Y. Nov. 29, 2000) ("Credit Bancorp III"); SEC v. Credit Bancorp, Ltd., 124 F. Supp.2d 824 (S.D.N.Y. 2000) ("Credit Bancorp II"); SEC v. Credit Bancorp. Ltd., 194 F.R.D. 457 (S.D.N.Y. 2000) ("Credit Bancorp I"). In addition, the Second Circuit has issued two opinions in the case: SEC v. Credit Bancorp. Ltd., 297 F.3d 127 (2d Cir. 2002) ("CBL II") and SEC v. Credit Bancorp. Ltd., 290 F.3d 80 (2d Cir. 2002) ("CBL I").
Deutsche Bank moved on April 11, 2003 for an order declaring the validity of its security interest and for leave to sell its Vintage shares. The Receiver moved on April 14, 2003 for an [ Page 5]
order transferring certain securities to the Receiver, declaring certain of Deutsche Bank's margin loans unsecured, and directing Deutsche Bank to credit certain proceeds to an account designated by the Receiver. On May 2, 2003, SECO cross-moved for an order invalidating Deutsche Bank's asserted lien on assets held in CBL accounts and responding to the motions by Deutsche Bank and the Receiver. The Receiver submitted a brief in opposition to Deutsche Bank's motion and in further support of the Receiver's motion. Deutsche Bank submitted a brief on May 16, 2003 in opposition to the motions of the Receiver and SECO with respect to Deutsche Bank's liens. On June 20, 2003 the Court heard the testimony of Reindert Houben ("Houben"), who was an employee of Deutsche Bank at all times relevant to this motion. The Court heard the testimony of Blech on June 23, 2003, followed by oral argument on the motion. At that time the motion was deemed fully submitted.
As part of its illegal activities, CBL wrongfully deposited customer-owned securities in its own name held by a variety of securities broker/dealers, including Deutsche Bank. The broker/dealers, including Deutsche Bank, then made margin loans to CBL, using as collateral the securities deposited in the [ Page 6]
accounts of the broker/dealers.
CBL's Margin Account at Deutsche Bank
In the summer of 1998, CBL approached Deutsche Bank and opened several accounts in which it deposited and traded securities. These accounts originated in the Geneva, Switzerland office of BT Alex. Brown ("BTAB"), Deutsche Bank's predecessor, through a BTAB broker named Reindert Houben. Houben had been contacted by a CBL trader named Basil Shoukry, whom Houben had met previously when Shoukry had applied for a position in the Geneva office of BTAB. One of the accounts opened by CBL at Deutsche Bank was a margin account in which CBL purchased securities using margin loans provided by Deutsche Bank (the "CBL Account.")
On September 15, 1998, Blech, on behalf of CBL, signed a margin agreement with Deutsche Bank which granted Deutsche Bank a security interest in all of the securities held in the CBL Account. The margin agreement granted Deutsche Bank discretion to sell "any or all" of the securities in the account, as selected by Deutsche Bank in its discretion, in order to satisfy CBL's margin debts. Windels Declaration Exhibit 2, ¶ 10. CBL further agreed "to pay the reasonable costs and expenses of [ Page 7]
collection" of its indebtedness "including any reasonable attorney's fees and costs." Id., ¶ 9.
After Deutsche Bank AG acquired Bankers Trust and its affiliates in June 1999, Deutsche Bank requested that customers of BTAB authorize the transfer of their accounts to Deutsche Bank Securities, Inc. CBL authorized the transfer of the CBL Account in a form executed on June 15, 1999, and signed a new customer agreement, governed by New York law.
The agreement granted Deutsche Bank a lien on all assets in CBL's accounts at Deutsche Bank and the discretion to select securities to be liquidated to enforce the security interest. See Windels Decl. Exh. 4 ¶ 3. CBL again agreed to reimburse Deutsche Bank for the "reasonable costs or expenses of collection of any debit balance and any unpaid deficiency in any of [its] accounts, including but not limited to attorneys' fees incurred and payable or paid by [Deutsche Bank]." Id., ¶ 6.
The account documents completed by Houben with respect to the CBL Account state that the CBL Account did not contain the assets of a third party. Houben testified that he took steps to assure himself the that the assets being traded by CBL belonged to CBL and not to third parties. Eiseman Decl. Exh. 50 at 140-41. [ Page 8]
Houben also visited CBL's offices in Geneva, where he met with Blech. Houben testified that his observations of CBL's offices and his discussions with Blech were entirely consistent with his understanding that CBL was an investment vehicle exclusively for Blech's family. On a note which Houben alleges he wrote around the time he was first introduced to CBL, Houben notes that Blech "manages his own father's money" and "not money on behalf of clients." Eiseman Decl. Exh. 4 (emphasis in original); Exh. 50 at 296-97. Blech, however, testified that he never told Houben that any of CBL's assets came from his father's wealth. (6/23/03 Tr. at 129-130).
On October 7, 1998, CBL transferred five DCH Technology ("DCH") share certificates into its account at CBL, representing 450,000 shares. See Windels Supp. Decl. Exh. 1. The share certificates stated that CBL was the "record holder" of the shares and were marked "Restricted," presumably under Rule 144.*fn3 [ Page 9]
Id. Because the shares were marked restricted, Deutsche Bank classified them in CBL's account as Type 1, i.e., Deutsche Bank would not view the shares as reliable collateral for margin loans to CBL because there was a risk that they could not be sold easily. See Windels Supp. Decl. Exh. 2; Hoddinott Dep. at 64-65.
On November 16, 1998, CBL faxed a letter to Houben and Keith Cummins, one of Houben's sales assistants, requesting them to deliver from the CBL Account the "five restricted DCH Technology certificates to the transfer agent with the instruction that they are to be re-registered in the name of Oxford International" and, following re-registration, returned to CBL at its offices in Toms River, New Jersey. Eiseman Decl. Exh. 19, at DB 1843. No evidence has been presented as to what Oxford is, or identifying Oxford's relationship, if any, to DCH, CBL, or the Blech family. The letter was provided to Gail Rosen, another of Houben's sales assistants, to process. Id. at DB 1843-444; Exh. 50 at 231, 243.
Rosen conveyed Blech's request to BTAB's Restricted Securities Transfer Department, which undertook, as an initial matter, to assure itself that the re-registration requested by Blech was not inconsistent with the shares' restrictions. See [ Page 10]
Eiseman Decl. Exh. 20, at DB 2968-73. Accordingly, on December 9, 1998, a BTAB employee faxed a letter to DCH's transfer agent, Holladay Stock Transfer ("Holladay"), enclosing Blech's November 16 letter and requesting authorization for "the transfer of 450,000 shares as requested by our customer." Eiseman Decl. Exh. 21; Eiseman Decl. Exh. 20, at DB 2965.
After receiving BTAB's December 9 fax requesting authorization to re-register the shares, DCH's transfer agent, Holladay, telephoned BTAB and notified the firm that there was an obstacle to re-registering the shares. The Holladay representative explained to BTAB that on November 10 and 11, 1998, prior to Blech's letter requesting re-registration, DCH's president, William Firestone, had written to Holladay to request that Holladay cancel the certificates that CBL wished to re-register. See Eiseman Decl. Exh. 21. According to Firestone, the shares had been issued to Oxford in or around August 1998, but Oxford had still not paid for them. Id.
Handwritten notes from an unknown author produced by Deutsche Bank reflect that conversation: "Tom at Holiday [sic] Stock . . . Adverse Claim Against Customer B/C Shares were not fully pd. for . . . Company will not give clearance." Eiseman Decl. Exh. 20 at DB 2961-62. The information was then conveyed [ Page 11]
to other BTAB personnel, who noted: "Adverse claim against customer . . . shares not fully paid for co. (DCH) will not render any opinion or give any clearance for transfer . . . reject back to from the agent . . . Oxford not pd. . . . tr. in dispute." Eiseman Decl. Exh. 19, at DB 1842.
No direct evidence has been provided that indicates whether or when anyone from BTAB notified CBL of the cancellation order issued by DCH. Houben testified that he has no recollection of the matter. See Eiseman Decl. Exh. 50 at 241-50; 528-35. However, on December 15, 1998, CBL sent another letter indicating that Oxford had "failed to meet its payment obligations" for the shares and that they should be returned to the transfer agent and reissued in DCH's name. See Eiseman Decl. Exh. 19 at DB 1841 (letter from Richard J. Blech to Reindert Houben and Keith Cummins, dated Dec. 15, 1998). BTAB passed CBL's changed instruction on to the transfer agent, and the transfer agent confirmed that "[a]s per DCH company instructions, on December 18, 1998, Holladay Stock Transfer has cancelled [the] 450,000 shares." Eiseman Decl. Exh. 20, at DB 2960.
In response to these instructions from CBL and the transfer agent, Deutsche Bank's back office in Baltimore returned the shares to the transfer agent. Accordingly, the next account [ Page 12]
statement marked the shares as "confiscated" by the transfer agent. Eiseman Decl. Exh. 10. The designation of "confiscated" allowed Deutsche Bank to remove the shares from its books and close out the transaction. The designation indicated that the shares had been sent to the transfer agent and would not be returned to Deutsche Bank.
On November 30, 1998, approximately two months after the opening of the CBL Account, Blech faxed a one-page letter to BTAB's Becky Epperly. At the time, Epperly was an intermediate clerk in BTAB's Settlement Services Department, located in Timonium, Maryland. Epperly Dep. at 6-7. Epperly processed all "free deliveries" of securities, i.e., transfers of securities between a BTAB account and an account at another brokerage firm, and all "DWAC" transfers, i.e., transfers of securities from an issuer's transfer agent into a BTAB account or vice versa. Eiseman Decl. Exh. 55 at 26, 28-30. Epperly was the person at BTAB who directly handled such transactions.
Blech's letter (the "Blech Letter"), written on CBL letterhead, notified Epperly that "we have been advised by Chase Mellon that 200,000 shares of Praegitzer Industries (PGTZ) CUSIP [ Page 13]
739422103 are ready for delivery into our above referenced account via DWAC." The letter went on to request that Epperly "arrange to accept delivery on [CBL's] behalf." Eiseman Decl. Exh. 16. Blech copied Houben on the letter, and Houben testified that he received it and forward it to his assistant. Houben Dep. at 399; Eiseman Decl. Exh. 16.
On December 1, 1998, the next day, Praegitzer Industries ("Praegitzer") faxed to Epperly another letter regarding the DWAC transfer from Chase Mellon of 200,000 shares of Praegitzer Industries stock. Eiseman Decl. Exh. 17 & 18. The letter (the "Praegitzer Letter"), signed on behalf of Praegitzer by Scott Gilbert, Vice President of Finance and Treasurer, stated in reference to the share transfer:
Because the shares are held by Mr. Praegitzer, who
is the Chief Executive Officer, Chairman of the
Board, and principal shareholder of Praegitzer
Industries, Inc., the Shares, represented by stock
certificate without legend, can generally only be
sold pursuant to the provisions of Rule 144 under
the Securities Act of 1933 and your records should
Id. Deutsche Bank did not produce a copy of the Praegitzer Letter to the Receiver and has asserted that it was not in Deutsche Bank's files.
Epperly did not recall receiving or reviewing either the Blech or the Praegitzer Letters. See Eiseman Decl. Exh. 47 at [ Page 14]
22-23, 31. She testified that she received, on average, approximately 500 requests per day to process free delivery and DWAC transfers and does not recall the specific transactions she processed. Id. at 11-12, 22-23, 31. Epperly's supervisor, Deborah Rowe, does not recall either letter. See Eiseman Decl. Exh. 54 at 16. Nor, in turn, does Rowe's supervisor, James Sheaf. See Eiseman Decl. Exh. 55 at 71, 78-79.
Houben testified that he did not recall the specific circumstances surrounding receipt of the Blech Letter and that, in any case, during his involvement with CBL, no information was brought to his attention that would have caused him to be concerned that securities belonging to someone other than CBL were being transferred into the CBL Account. See Eiseman Decl. Exh. 50 at 398-99, 527. Houben was not asked about the Praegitzer Letter.
BTAB accepted delivery of the 200,000 shares of Praegitzer stock into the CBL Account, but the shares appear to have gone into a sub-account other than the designated one. The Blech Letter states that the shares are "ready for delivery into our [CBL's] above referenced account," which is "601 25666-1 5." Eiseman Decl. Exh. 16. Sheaf testified that "the second 1 . . . represents a cash account" and thus the Blech Letter indicates [ Page 15]
that the Praegitzer shares were to be transferred into a Type 1, or cash account. Despite the terms of the Blech Letter, the Praegitzer shares were placed into CBL's Type 2, or margin account. See Eiseman Decl. Exh. 9; Exh. 49 at 68. No evidence has been presented as to who at Deutsche Bank was responsible for moving the Praegitzer shares from the cash account to the margin account. Doing so, however, increased the collateral on which Deutsche Bank was willing to extend margin loans to CBL.
Transfer of Vintage Shares into CBL Account
On June 21, 1999, SECO instructed its broker, Merrill Lynch, to transfer two million shares of Vintage stock into the CBL Account as a "free delivery" through the DTC electronic book-entry system. See Windels Decl. Exh. 7; Credit Bancorp III, 2000 WL 1752979, at *6. At the same time, CBL instructed Deutsche Bank to accept the Vintage shares from Merrill Lynch. See Windels Decl. Exh. 8. The Second Circuit held that through "the documents executed by SECO to transfer its Vintage shares in fact and in law accomplished an outright transfer of share ownership from SECO to CBL." CBL I, 290 F.3d at 87.
The Vintage shares that SECO transferred to CBL were restricted pursuant to Rule 144. Nonetheless, SECO failed to [ Page 16]
provide any notice of restrictions on ownership or transfer of the Vintage shares when instructing Merrill Lynch to transfer the shares to CBL via the DTC. See Windels Decl. Exh. 7.
The electronic transfer of the Vintage shares through the DTC could not have occurred if DTC had notice of the restrictions. Restricted shares — other than certain securities eligible for transfer pursuant to SEC Rule 144A — were not eligible for electronic transfer in the summer of 1999. Shares transferred via the DTC electronic system were presumed to be non-restricted.
Shares in the custody of the DTC, and thus eligible for electronic transfer among the financial institutions that are DTC participants, had to be free of adverse claims. See DTC Services Guide § B000 ("By depositing a certificate at DTC, Participants warrant and represent to DTC that . . . the certificates are in good deliverable form . . .").
CBL also opened an account with Tasin & Co. (the "Tasin Account.") for which Deutsche Bank provided settlement services. Tasin, with which CBL had opened a brokerage account in or about [ Page 17]
June 1998, has previously used Oppenheimer & Co. ("Oppenheimer") as its clearing firm. See Eiseman Decl. Exh. 56 at 17-19. In September 1999, each Tasin customer account, and the assets credited and margin balance debited to each such account, were transferred from Oppenheimer to Deutsche Bank. See Eiseman Decl. Exh. 49 at 140. This included the Tasin Account.
On September 24, 1999, CBL and Deutsche Bank entered into a correspondent customer margin agreement related to the Tasin Account, which permitted CBL to borrow on margin in the account. See Windels Decl. Exh. 15. The terms of the Tasin margin agreement were similar in all material respects to the terms of the margin agreement for the CBL Account and granted Deutsche Bank a security interest in all of the securities held in the Tasin Account. The Tasin margin agreement is governed by Maryland Law. Id., ¶ 17.
At the time the agreement was signed, CBL's account at Tasin already held 400,000 shares of Vintage stock, as well as the securities of various other issuers. See Windels Decl. Exh. 16. These shares were apparently owned by CBL. [ Page 18]
Under Deutsche Bank's procedures in effect at the time, initial responsibility for margin lending lay with the broker assigned to the account — in this case, Houben for the CBL Account and Tasin & Co. for the Tasin Account. Once a customer's loan balance exceeded $500,000, the customer was required to apply for a credit line beyond this amount from Deutsche Bank's credit department. The credit department reviewed a credit line request form filled out by the broker and determined, by assessing a number of factors, whether to grant the request.
In making its decision, the credit department focused on the quality, diversification, liquidity and price volatility of the securities serving as collateral. All securities deposited in a Type 2 account were considered as collateral, no matter when they were deposited. The credit department sought to ensure that Deutsche Bank could sell sufficient securities in order to repay the margin loans. Deutsche Bank maintains that it extended loans only to the extent that they were secured by collateral.
As CBL increased its borrowing from Deutsche Bank, it periodically requested and received credit line extensions. On October 27, 1998, Deutsche Bank's credit department approved a [ Page 19]
$1.4 million credit line for CBL in the CBL Account. See Windels Decl. Exh. 18. Thereafter, CBL requested a number of increases in its credit line, which Deutsche Bank granted after internal review. See Windels Decl. Exh. 18. Deutsche Bank similarly approved increases in the credit line of the Tasin Account on two occasions — in October 1999 and November 1999. See Windels Decl. Exh. 21.
On several occasions, Deutsche Bank did not increase the credit line to the full extent requested by CBL. See Windels Decl. Exh. 19-20.
Deutsche Bank maintains that in approving credit line increases for both the CBL Account and the Tasin Account, it followed its customary credit department procedures. Most of the credit line increases were handled by Thomas Hoddinott, the Vice President of Credit for DBAB. Hoddinott has testified that his approvals were based on the fact that the CBL Account and the Tasin Account were "not very highly leveraged to the value of the overall collateral, and there were many securities in that collateral." Hoddinott Deposition at 62. Deutsche Bank's credit department also conducted Dun & Bradstreet and Lexis-Nexis searches into CBL's credit history, in particular looking for "negative" credit information such as bankruptcies or tax liens. [ Page 20]
Id. at 98, 169-70, 176-77, 210-11. Deutsche Bank maintains that no such negative information about CBL was uncovered. Hoddinott also testified that "none of the securities in the account that we were looking at to determine a loan had any kind of restriction according to . . . the listing of the securities in the account." Id. at 247-48. Hoddinott contends that he was not aware of any restricted securities held as collateral in the margin accounts. Id. at 257.
In the two accounts together, CBL borrowed on margin over $21 million. As of March 31, 2003, CBL's margin debt, with interest included, was approximately $17.4 million. See Windels Decl. Exh. 30. The reduction in the margin debt is primarily attributable to the tendering by Deutsche Bank of shares of Praegitzer stock from both the CBL and Tasin accounts, as described below.
World Wide Wireless Communications
According to CBL account records, 2,650,000 World Wide Wireless Communications ("WWW") shares were physically transferred to Deutsche Bank and credited to the CBL cash account on July 29, 1999. See Eiseman Decl. Exh. 26, at DB 512 and Exh. 35. CBL began selling shares WWW in three transactions in early [ Page 21]
August: 100,000 on August 5, 1999, another 100,000 on August 6, 75,000 on August 9, and 8,000 on August 12. See ...