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holding a question of fact existed as to Bear Stearns' intent in purportedly withholding stock from short sellers and delaying sell-outs under Reg T, even if such actions were "not a security violation in and of [themselves]"
Summary of this case from In re Blech Securities LitigationOpinion
94 Civ. 7696 (RWS)
October 17, 2002
KAPLAN, KILSHEIMER FOX, By RICHARD KILSHEIMER, ESQ., ROBERT N. KAPLAN, ESQ., of Counsel, New York, NY, MILBERG WEISS BERSHAD HYNES LERACH, By DAVID J. BERSHAD, ESQ., RICHARD H. WEISS, ESQ., BRIAN C. KERR, ESQ., of Counsel, New York, N.Y. and GILMAN AND PASTOR, By DAVID PASTOR, ESQ., PATER A. LAGORIO, ESQ., of Counsel, Saugus, MA., Attorneys for Plaintiff.
CADWALADER, WICKSERSHAM TAFT, By DENNIS J. BLOCK, ESQ., MICHAEL G. DOLAN, ESQ., SUZANNE J. ROMAJAS, ESQ., Of Counsel, New York, NY, Attorneys for Defendant Bear, Stearns Co., Inc.
WEXLER BURKHART, By: STEPHEN B. WEXLER, ESQ., Of Counsel Mitchel Field, NY, Attorneys for Defendant Baird Patrick Co., Inc.
OPINION
Defendants Bear, Stearns Co. Inc. ("Bear Stearns") and Baird Patrick Co., Inc. ("Baird Patrick") have moved under Rule 56, Fed.R.Civ.P. for summary judgment dismissing the second amended consolidated class action complaint (the "Complaint") brought by plaintiffs who purchased securities alleged to have been subject to market manipulation by David Blech ("Blech") and D. Blech Co. ("DBCO") (the "Plaintiffs"). For the reasons set forth below, the motions are denied.
Prior Proceedings
The issues in this securities fraud action have been thoroughly litigated since the initiation of these actions in 1994 and familiarity with the prior opinions with respect to pleading requirements, In re: Blech Sec. Litig., 928 F. Supp. 1279 (S.D.N.Y. 1996 ("Blech I "); In re: Blech Sec. Litig., 961 F. Supp. 569 (S.D.N.Y. 1997) ("Blech III"), is assumed.
Discovery, including expert discovery, has been completed, and the fruits of this labor have been presented in careful detail by skilled counsel for the parties. The motions were heard and marked fully submitted on May 8, 2002.
The Standard for Summary Judgment
The principles with respect to the disposition of motions for summary judgment are well recognized and not disputed.
Summary judgment is granted only if there are no genuine issues of material fact, and the moving party is entitled to judgment as a matter of law. Fed.R.Civ.P. 56(c); see generally 6 James Wm. Moore, et al., Moore's Federal Practice ¶ 56.15 (2d ed. 1983). The court will not try issues of fact on a motion for summary judgment, but, rather, will determine "whether the evidence presents a sufficient disagreement to require submission to a jury or whether it is so one-sided that one party must prevail as a matter of law." Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 251-52 (1986)
The moving party has the burden of showing that there are no material facts in dispute, and the court must resolve all ambiguities and draw all reasonable inferences in favor of the party opposing the motion, in this instance, of course, the Plaintiffs. Index Fund, Inc. v. Hagopian, 609 F. Supp. 499, 504 (S.D.N.Y. 1985) (citing Heyman v. Commerce and Indus. Ins. Co., 524 F.2d 1317, 1319-20 (2d Cir. 1975))
A material fact is one that would "affect the outcome of the suit under the governing law," and a dispute about a genuine issue of material fact occurs if the evidence is such that "a reasonable jury could return a verdict for the nonmoving party." Anderson, 477 U.S. at 248; R.B. Ventures, Ltd. v. Shane, 112 F.3d 54, 57 (2d Cir. 1997)
A motion for summary judgment should not be granted where the parties have produced competing expert testimony. See Victory v. Hewlett-Packard Co., 34 F. Supp.2d 809, 824 (E.D.N.Y. 1999) ("Resolution of the battle of experts is a matter best suited for trier of fact"); Wechsler v. Steinberg, 1976 WL 763, Fed. Sec. L. Rep. P 95,449 (E.D.N.Y. 1976) (denying defendants' cross-claim for summary judgment dismissing among others, a claim for violation of Section 10(b) (citing Judge v. City of Buffalo, 524 F.2d 1321 (2d Cir. 1975)
The Securities At Issue
As has been established by the Local Rule 56.1 Statements and the supporting papers, in the early 90's Blech and DBCO were principally engaged in private placements and investments in small and mid cap companies, primarily in the biotechnology field. In May 1993, DBCO became a full service broker-dealer, engaging in retail brokerage and making markets in public securities with its principal office in New York and branches in Boston, Atlanta and Boca Raton.
The Plaintiffs and other class members bought securities in a market manipulated by the securities fraud alleged here. By the order of May 12, 1999, three subclasses of plaintiffs were certified "involving (1) the securities in the primary market, (2) those in the secondary market which in turn should have a subclass covering the period from September 27, 1993 (the date when Bear Stearns became a market-maker of Blech Securities)." In re Blech Sec. Litig., 187 F.R.D. 97, 105 (S.D.N.Y. 1999), with a class period defined as the period between October 21, 1991 and September 21, 1994 (id. at 100), with a subclass period from September 27, 1993 to September 21, 1994 (id. at 105)
The securities at issue (the "Blech Securities") initially included the securities of twenty-two biotechnology companies. In connection with the instant motions, the Plaintiffs have determined that no damages were suffered in connection with the securities of seven of the twenty-two companies, leaving the securities of the following companies to constitute the Blech Securities:
Advanced Surgical, Inc.
Ariad Pharmaceuticals Corp.
BioSepra, Inc.
Ecogen, Inc.
Genemedicine, Inc.
Guilford Pharmaceuticals Inc.
HemaSure, Inc.
Intelligent Surgical Lasers, Inc.
LaJolla Pharmaceutical Co.
LXR Biotechnology Inc.
Microprobe Corp.
Neoprobe Corp.
Pharmos Corp.
Procept Inc.
Texas Biotechnology Corp.
A number of the practices described below affected not only the Blech Securities but other securities handled by Blech and DBCO. The Blech Securities, however, are limited to those of the companies listed above.
The Plaintiffs must establish that Bear Stearns and Baird Patrick participated in a securities fraud, as defined below, involving any of those Blech Securities with respect to which they seek to establish liability and recover damages. For summary judgment purposes there is evidence that each of the Blech Securities has been involved in one or more of the alleged unlawful activities described below.
The Liability Standard To Which The Facts Must Be Applied
Section 10(b) of the 1934 Act makes unlawful the use or employment of "any manipulative or deceptive device or contrivance" in contravention of the rules of the Securities and Exchange Commission. 15 U.S.C. § 78j (b). As the Court of Appeals for the Second Circuit has recently reiterated:
The proscriptions of § 10(b) and Rule 10b-5 were meant to be broad and, by repeated use of the word "any," are obviously meant to be inclusive. The [Supreme] Court has said that the 1934 Act and its companion legislative enactments [including the 1933 Act] embrace a "fundamental purpose . . . to substitute a philosophy of full disclosure for the philosophy of caveat emptor and thus to achieve a high standard of business ethics in the securities industry. . . . Congress intended securities legislation enacted for the purpose of avoiding frauds to be construed "not technically and restrictively, but flexibly to effectuate its remedial purpose."SEC v. First Jersey Sec., 101 F.3d 1450, 1466 (2d Cir. 1996) (citing Affiliated Ute Citizens v. United States, 406 U.S. 128, 152 (1972)
Market manipulation comprises a class of conduct prohibited by Section 10(b), which typically involves "practices, such as wash sales, matched orders, or rigged prices, that are intended to mislead investors by artificially affecting the market activity." Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977); see also Ernst Ernst v. Hochfelder, 425 U.S. 185, 197-98 (1976). As many courts have recognized:
[s]uch schemes strike at an essential purpose of the federal securities laws — "the assurance of free and open securities markets in which prices are fixed by the interaction of supply and demand, uninfluenced by manipulative activities that would cause prices to be inflated or depressed artificially."Scone Invs. L.P. v. Am. Third Mkt Corp., 97 Civ. 3802, 1998 U.S. Dist. LEXIS 5903, at 14, Fed. Sec. L. Rep. (CCH) P90, 207 (S.D.N.Y. Apr. 27, 1998) (guoting SEC v. Kimmes, 799 F. Supp. 852, 858-59 (N.D. Ill. 1992)). "[T]he basic aim of the antifraud provisions is to "prevent rigging of the market and to permit operation of the natural law of supply and demand.'" SEC v. First Jersey, Inc., 101 F.3d at 1466 (citing United States v. Stein, 456 F.2d 844, 850 (2d Cir.) cert. denied, 408 U.S. 922 (1972)).
In connection with the disposition of the earlier Rule 12(b)6 motions, the standard for liability in this action was set forth,
This Court also held that in order to state a claim against Bear Stearns, Plaintiffs must allege "that Bear Stearns caused or directed trading by Blech Co. "s customers or solicited or induced them to buy Blech Securities at inflated prices." Blech I, 928 F. Supp. at 1295 (emphasis added). In other words, in addition to alleging scienter of the Blech scheme, Plaintiffs must also allege that Bear Stearns itself engaged in the kind of manipulative conduct that Section 10(b) prohibits in this context.
* * *
Bear Stearns contends that the conduct alleged by Plaintiffs amounts to no more than aiding and abetting the scheme of Blech and his confederates. In Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 114 S.Ct. 1439 (1994), the Supreme Court held that, in a private action, secondary actors cannot be held liable for aiding and abetting a securities fraud under Section 10(b). However, the Court in Central Bank stated:
The absence of § 10(b) aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the securities Acts. Any person or entity . . . who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator under 10b-5, assuming all of the requirements for primary liability are met.Id. at 190 (emphasis added)
The question here is whether the conduct alleged against Bear Stearns constitutes the employment of a manipulative device under Section 10(b) and 10b-5. In other words, is Bear Stearns alleged conduct no more than aiding and abetting, or has it crossed the line into primary liability?
The Court of Appeals has provided some guidance on the fate of claims against "secondary" actors under Section 10(b) after Central Bank. In In re Ivan Boesky Sec. Litig., 36 F.3d 255 (2d Cir. 1995), the Second Circuit, citing Central Bank, declined to convert an aiding and abetting claim into a claim of primary liability in an insider-trading case alleging material omissions. Id. at 264. On the other hand, inS.E.C. v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996), the Court of Appeals stated that primary liability "may be imposed "not only on persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration.'" Id. at 1471, quoting Azrielli v. Cohen Law Offices, 21 F.3d 512, 517 (2d Cir. 1994)
* * *
When Plaintiffs allege mere clearing conduct against Bear Stearns, such allegations amount to no more than a non-existent claim of aiding and abetting because, at most, they allege only that Bear Stearns knowingly and substantially assisted Blech by clearing the fraudulent trades. See Azrielli v. Cohen Law Offices, 21 F.3d 512, 517 (2d Cir. 1994) (holding, in a case arising prior to Central Bank, that the elements of an action for aiding and abetting are (1) knowledge of the wrong; and (2) substantial assistance in the perpetration of the wrong)
However, the Complaint crosses the line dividing secondary liability from primary liability when it claims that Bear Stearns "directed" or "contrived" certain allegedly fraudulent trades. Under these circumstances, the Complaint adequately alleges that Bear Stearns engaged in conduct, with scienter, in an attempt to affect the price of the Blech securities. Blech I, 928 F. Supp. at 1295.
Plaintiffs allege that Bear Stearns "directed" Blech Co. to sell Blech Securities by demanding that Blech reduce its debit balance with knowledge of Blech's history of sham trading, and that Blech, in response to Bear Stearns' pressure, engaged in manipulative parking transactions, which Bear Stearns cleared. This course of conduct by Bear Stearns — the instigation of trading that Bear Stearns knew or should have known would result in fraudulent trades that would artificially inflate the price of the Blech Securities, and the subsequent clearing of the resultant fraudulent trades for its own pecuniary benefit — constitutes an attempt to affect the price of the Blech Securities. As a result, by participating at both the initiation and clearing stages of the allegedly fraudulent transactions, Bear Stearns knowingly engaged in a manipulative scheme to defraud under Section 10(b), which affected the market upon which Plaintiffs relied in purchasing the Blech Securities. The pressure exerted by Bear Stearns on Blech to reduce his debit balance, when combined with Bear Stearns' knowledge of Blech's sham trading and its clearing of such trades, does not "reflect . . . the standard practice of [a] clearing broker." Id.; compare Dillon, 731 F. Supp. at 636 (dismissing claims against a clearing broker that was merely performing back office functions")
Plaintiffs further properly allege manipulative conduct against Bear Stearns when they claim that on July 5, 1994, Bear Stearns, in an effort to sell and transfer certain Blech Securities, "contrived and agreed to fund" the pre-planned fraudulent sale of Blech Securities. Compl. ¶ 85. This allegation satisfies the conduct element of a Section 10(b) claim because Bear Stearns is alleged to have conceived of and participated in the initiation and clearing of sham transactions aimed at affecting the price of the Blech Securities.
These allegations stand on grounds different from those presented in Ross v. Bolton, 904 F.2d at 821. There, the plaintiffs were only alleging the conduct of a normal clearing broker that extends loans on margin to its clients. Here, however, it is alleged that Bear Stearns knowingly contrived and funded sham transactions. This allegation, assumed for purposes of this motion to be true, states a claim that Bear Stearns employed a manipulative device that suffices for the imposition of primary liability under Central Bank.Blech III, 961 F. Supp. at 583-85.
Scone Investments, L.P., No. 97 Civ. 3802 (SAS), 1998 U.S. Dist. LEXIS 5903 *8 (Apr. 28, 1998 S.D.N.Y.), summarized the Blech II holding, stating:
an investment bank that both (1) directs that securities be sold and (2) participates in the sale of the securities (even in its traditional market role as a clearing agent), may be primarily liable under a market manipulation theory where the sales were "sham" transactions aimed at inflating or maintaining the artificially high price of the securities sold.
There is no issue on this motion as to the manipulation of the market in Blech and DBCO resulting from trades with controlled entities, fictitious trades, wash sales, prearranged matched trades, and "painting the tape," together lending money or securities or borrowing money or securities from a customer, guaranteeing any account against loss, entering purchase or sale orders designed to raise or lower the price of a security or to give the appearance of trading for purposes of inducing others to trade (i.e., "marking the close" or "prearranged trading"), and making arrangements to "park" any security away from the true owner. Blech plead guilty to certain of these practices in USA v. Blech, 97 Cr. 403. The issue presented on these motions is the existence of evidence sufficient to create an issue of material fact as to the actions of Bear Stearns and Baird Patrick under the standards set forth above.
Bear Stearns has urged that its actions were authorized and appropriate under its clearing agreement with DBCO and comport with the requirements of the SEC and the New York and American Stock Exchanges and the NASD which have adopted rules that govern the relationship between clearing brokers and introducing brokers and their customers. NYSE Rule 382, as amended, permits clearing brokers to contractually allocate all supervisory and other responsibilities vis-a-vis the customer solely to the introducing broker. NYSE Rule 382, 2 NYSE Guide (CCH) ¶ 2382.
DBCO was allocated full responsibility for monitoring its customers' accounts and ensuring that its trading complied with applicable rules and regulations for responding to customer inquiries and complaints, for complying with the net capital rules and reporting requirements, and for reporting to Bear Stearns with respect to all reports filed with the NASD, the SEC or any SRO, including monthly and quarterly financial and operational combined uniform single reports ("FOCUS" reports), simultaneously with the filing.
Bear Stearns was allocated responsibility for issuing confirmations, monthly account statements and notices directly to DBCO's customers and for supplying DBCO with daily reports, including customer confirmations, margin status reports, money line reports and daily commission detail reports. Bear Stearns also was responsible for the following back office record-keeping and accounting tasks: (a) ensuring prompt payment for securities purchased and prompt delivery of securities sold; (b) advising DBCO of the necessity for buying in or selling out positions in accounts that have failed to comply with payment or delivery requirements; (c) arranging the extension of margin credit in accordance with applicable rules; (d) maintaining books and records, and more.
The Bear Stearns Clearance Agreement gave Bear Stearns in its capacity as creditor the right to restrict trading in DBCO's proprietary and customer accounts "to liquidating orders only or cash transactions only, or to prohibit certain trading strategies or trading of certain types of securities" and a security interest in all property (i.e., cash and stocks) contained in DBCO proprietary accounts as security for repayment of DBCO's obligations to Bear Stearns.
The issue is therefore presented as to adequacy of the evidence to raise an issue of material fact, or an inference, derived from a fact, as to whether these functions were performed knowingly in such a manner as to enhance the Blech market manipulation scheme. State Teachers v. Fluor, 654 F.2d 843 (2d Cir. 1981) See Gerald B. Kline Raymond L. Moss, "Liability of Clearing Firms: Traditional and Developing Perspectives," 1062 PLI Corp. 139 at 144 (July-Aug. 1998) ("[A] clearing broker may suffer liability exposure when it moves beyond performing its routine clearing functions or pressures the introducing broker to act wrongfully.")
The Knowledge of Bear Stearns
Blech at the time he began doing business with Bear Stearns was the sole shareholder of DBCO and had a net worth of approximately $230 million, including securities valued at over $100 million, and had been included on the Forbes list of the 400 richest Americans in 1992. DBCO's activity prior to May 1993 was limited exclusively to private financings and private placements. On May 3, 1993, DBCO entered into a clearing agreement with Gruntal Co. ("Gruntal"), pursuant to which Gruntal became the exclusive clearing broker for DBCO.
Commencing in September 1993, Bear Stearns acted as a non-exclusive clearing broker for DBCO, sharing clearing duties with Gruntal. Bear Stearns cleared all of the trades for DBCO's first three underwritten public securities offerings: Intelligent Surgical Lasers, Inc. on November 17, 1993, Texas Biotechnology Corp. on December 16, 1993, and Procept, Inc. on February 10, 1994.
During the fall of 1993, Bear Stearns and Blech discussed the possibility of Bear Stearns becoming the exclusive clearing broker for DBCO and extending credit to DBCO and Blech against their combined securities inventory. In connection with those discussions, Bear Stearns conducted a due diligence investigation from September 1993 through January 1994, during which it learned that Gruntal sought to terminate its relationship with Blech and DBCO.
It also learned that Blech's personal securities holdings were highly concentrated in thinly traded securities in small to mid-cap companies in the biotechnology field, including securities that were restricted against public sale under Rule 144 of the Securities Act of 1933 and that Blech possessed and directed accounts for various so-called "controlled trusts" (the "Blech Trusts"). It received and reviewed documents setting forth the trusts' substantial holdings of Blech Securities, which were included on Blech's personal financial statements (the "Blech Trusts"). The Blech Trusts included the Beacon Trust, Bennington Trust, Celestial Trust, Century Trust, Freedom Trust, Frontier Charitable Remainder Trust, Island Charitable Remainder Trust, Lake Charitable Remainder Trust, Oak Charitable Remainder Trust, Ocean Charitable Remainder Trust, and Sentinel Trust. Bear Stearns also gained access to detailed reports concerning DBCO's customers accounts (the "Blech Accounts") which were reviewed by Bear Stearns' retail margin department.
Bear Stearns' special credit services unit was involved in the due diligence effort because of the nature of the collateral that was going to be security for the credit facility. Bear Stearns was concerned about the concentration and low volume of Blech Securities, and initially decided not to take the Blech/DBCO proprietary trading accounts from Gruntal.
However, on March 14, 1994, Bear Stearns became the exclusive clearing broker for DBCO, including its proprietary trading accounts and customer accounts, and granted a line of credit to the firm, having a margin credit limit of $20 million on the combined accounts of DBCO and Blech. The collateral for the margin loan was the Blech Accounts' inventory of Blech Securities. DBCO and Blech were subject to an initial margin requirement of 50% and a maintenance margin requirements of 40% in their combined accounts.
At the time that Bear Stearns became the exclusive clearing broker for DBCO, the DBCO/Blech combined debit balance was already over $23.3 million (versus the $20 million loan cap), the combined equity was only 29.3% (versus the 50% initial and 40% maintenance requirement), and certain securities already exceeded the 20% limit for over-concentration. This situation drew the attention of Bear Stearns senior management, including Richard Harriton ("Harriton"), president of Bear Stearns' clearing subsidiary; Michael Zackman ("Zackman"), senior managing director, correspondent clearing; Peter Murphy ("Murphy"), senior managing director, correspondent clearing; Martin Shulman ("Shulman"), head of special credit services; Robert Steinberg ("Steinberg"), senior managing director, credit; Joseph Gottlieb ("Gottlieb"), senior managing director, credit; and Wally Dye ("Dye"), head of the retail margin department.
On March 23, 1994, DBCO underwrote the initial public offerings of 3,063,180 shares of BioSepra, Inc. ("BioSepra") common stock at $7 per share and on April 7, 1994, 2,532,370 shares of HemaSure, Inc. ("HemaSure") common stock at $7 per share. By April 11, 1994, the Blech/DBCO debit balance was over $23.7 million, while the corresponding combined equity had dropped to 10.38%. By April 18, 1994, $5.4 million remained unpaid for from the HemaSure IPO (with HemaSure's stock price then down to $5.75 per share), and $2.4 million remained unpaid for from BioSepra's IPO (with BIOSepra's stock price then down to $5.38 per share). By April 21, 1994, $9.6 million remained unpaid in DBCO cash accounts, $4.7 million of which was attributable to the Blech Trusts. In an April 19, 1994 meeting of the Bear Stearns operations committee, DBCO was identified as the only correspondent clearing firm posing material margin calls or exposure to Bear Stearns.
During April 1994, DBCO was granted 753 extensions of time for its customers to pay for their purchases. Bear Stearns sought additional guarantors from others for the obligations of Blech and DBCO. Also, during April 1994, Murphy was asked by Harriton to prepare a "Special Account Analysis," which was intended to serve as a snapshot" of the "credit risk" for Bears Stearns "as a result of being the clearing agent for D.Blech Co." Murphy prepared such documents on April 19, April 20, and April 22, 1994. The April 20, 1994 special account analysis reported that the $16.7 million total of cash account debits for unpaid trades would be reduced to $12.2 million after Blech "move[d] trades to trust accounts with money," that the Blech/DBCO combined equity was still only 37%, and that 131 DBCO accounts had house calls for deficient equity in their accounts.
John Benesch ("Benesch") was DBCO's compliance director, and his duties included monitoring trading by the firm and its brokers to assure compliance with securities law and reviewing the computerized trading runs prepared by Bear Stearns.
On April 19, 1994, Benesch wrote a memo to Blech and Steve Ross ("Ross"), the president of DBCO, concerning DBCO's trading practices, pointing out that compliance concerns had been discussed over several months, but they had not been responded to, and that as a result of the decline of the biotech market, concerns existed regarding margin calls and net capital issues. Benesch stated that if the compliance concerns were not immediately addressed, "the firm will not pass its next regulatory audit without certain restrictions or sanctions being placed on our business by the NASD."
Attached to this April 19, 1994 memo was a schedule of concerns of the compliance department relating to trading activities at DBCO, including,
• unauthorized trading;
• sell orders not being accepted or discouraged;
• sell orders not being promptly executed;
• large block transactions were executed without account numbers;
• large block transactions were executed within the last half hour of trading and involved crosses with specific market makers;
• customer tickets were stamped after the close of trading;
• wash sales occurred between D.Blech Co.'s market making account and employee or David Blech family-related accounts;
• there were numerous sellouts, reneges, and cancellations, indicating possible unauthorized trading;
• the firm paid inflated commissions on the buy side of trades and smaller commissions on the sell side (thus discouraging brokers from taking sell orders);
• positions were held in the firm's error account for several days.
In an earlier draft of the April 19, 1994 memo, Benesch noted that there were many crosses in-house, nothing hits the street." He also noted that Richard Silverman ("Silverman"), head trader of DBCO, had talked to Blech about Baird Patrick and "reductions have been made."
Michelle Kristel ("Kristel") was employed by DBCO in the compliance department from January 1994 to September 1994 and worked as a liaison to the trading department. Kristel provided a memo to Benesch, which Benesch used in preparing his April 19, 1994 memo. The Kristel memo stated, among other things, that there were a large number of cancellations per day, large blocks of stock were traded in the last half hour before the close, customer tickets were stamped after the close, there were inflated commissions on buys, and zero commissions on sales, and sell orders were not accepted or discouraged with respect to certain DBCO issues.
On a copy of the memo from Kristel, Benesch wrote the following:
Bear Stearns is controlling certain aspects of our operations and trading. They have conducted conference calls instructing informing us of the excessive violations that we are above all clearance firms when it comes to these problems their auditors will pick up these excessive practices.
In the days following April 19, 1994, Kristel noted numerous instances in which Blech engaged in large block trades at the end of the trading day, and executed transactions with no account numbers and later provided account numbers of the trusts that he controlled. During this period there were a number of sellouts because accounts did not pay for their purchases.
Under SEC rules in effect at the time, transactions in cash accounts had to be paid for on the settlement date, which was seven days after the trade date. If the account failed to pay for the purchase, the broker was to "sellout" the position. A practice at DBCO was to "cancel" the unpaid for trade and "re-bill" it to an account controlled by Blech. According to Plaintiffs' expert, an excessive number of sellouts and/or cancellations and re-bills both are indications of parking and unauthorized trades.
Kristel in a memo of May 16, noted a conversation with Silverman on May 12, 1994, who stated that the activity in these accounts was "illegal," and that, "It stinks what goes on in these accounts. That's why I get the tickets signed because it stinks and I want to get out of the loop . . . . This other stuff stinks like parking or something.
Bear Stearns' senior management regularly reviewed and discussed the margin debt levels of Blech, DBCO and DBCO's customer accounts, the problem of Regulation T and margin calls, the over-concentration of Bear Stearns' collateral for its combined loan to Blech and DBCO in Blech Securities, the lack of demand in the open market for Blech Securities, and the reports included Bear Stearns' house call reports, Type 9 trades with no names and address on file, trading support systems, management position analysis reports, unpaid purchase reports, listings of daily trades exceeding specific parameters, also referred to as the "Large Trade Report," daily activity reports, and the daily "610 Reports" (which provided a 5 day rolling history of open customer cash debits). It is the position of the Plaintiffs that this data established certain of the manipulative practices such as parking Blech Securities in order to prevent Blech Securities from otherwise being sold out of Blech Accounts in liquidations due to their failure to meet Reg T and margin calls, and preventing Blech Securities from otherwise trading publicly in genuine market transactions that would have driven down the value of Bear Stearns' collateral, and that Bear Stearns knew of these practices.
Bear Stearns also generated by hand a series of specially-created reports to scrutinize DBCO further, Blech, the Blech Securities, and the Blech Accounts, including inventory concentration reports, unpaid for trade reports, combined debit balance summaries, and logs of past due open items due for sellouts. The clearing, margin, and special credit services units of Bear Stearns all regularly communicated directly with Blech and with each other concerning these issues. Bear Stearns was aware that Blech had an unusually large volume of unpaid for trades on an ongoing basis and that the securities inventories of Blech and DBCO were overly concentrated in thinly traded Blech Securities that lacked genuine market demand, i.e., outside of Blech and his affiliated controlled accounts. In this regard, shortly after becoming the clearing broker, Bear Stearns was internally classifying a substantial portion of the Blech/DBCO combined inventory as comprising "unacceptable securities," meaning securities that Bear Stearns "potentially could not freely sell into the marketplace."
The Blech Accounts were often referred to by Bear Stearns as "house call accounts," which were monitored closely by Bear Stearns on a daily basis with respect to margin requirements.
The Bear Stearns trading database identified and detailed the transactions in Blech Securities made by the Blech Accounts and Blech proprietary accounts at Bear Stearns, which account for over 131 million shares (or over 70%) of their total reported market trading volume during the Class Period.
In connection with the BioSepra public offering in March 1994, sales in that offering to Blech Accounts were not paid for and were due for extensions. In a series of telephone conversations between Blech and Murphy, Zackman, Gottlieb and Dye of Bear Stearns, Blech revealed that he would buy out the unpaid positions into his various trust accounts. After hanging up with Blech, Zackman exclaimed, "Who's going to pay for all that sh_t?" Dye stated: "He can't put it out to the street. I would suspect the same's going to hold true on [HemaSure] next week." Similarly, Dye also added: "next week we're going to be having the same type of discussion about HemaSure" and that "it's going to be [Blech] buying the stock," but that "you know, sooner or later he's going to run out of money."
During this discussion, Gottlieb asked Zackman, Murphy and Dye whether they had any compliance concerns about Blech "taking out these customers into his trust accounts," i.e., systematically re-billing unpaid for trades to Blech proprietary and controlled accounts, and about whether Blech's offering was a "bona fide public distribution of the shares" of BioSepra in March 1994. Dye stated: "I don't have any concerns as long as we get paid," and "But we, you know, as long as the money keeps coming in, everything is fine . . . as long as the money keeps coming in, everything is beautiful."
Pursuant to Rule 10b-6 promulgated under Section 10(b) of the Securities Exchange Act of 1934, a dealer who is participating in a distribution may not bid for or purchase the stock being distributed until after he has completed his part in the distribution. 17 C.F.R. § 240.10b-6; S.E.C. v. Resch-Cassin Co., Inc., 362 F. Supp. 964, 980 (S.D.N.Y. 1973)
It is the Plaintiffs' contention that Bear Stearns knew that unpaid for trades were being continuously and systematically parked by Blech rather than sold out in genuine market transactions at prevailing market prices, pointing to statements of Murphy that: "he's got these trust accounts that are buying the sh_t out of this — when a customer doesn't pay . . ." and "we're building a house of cards between these trust accounts and everything he's doing and nothing is breaking yet," and "you can't just go to the market and sell this stuff."
Bear Stearns supplied Blech with lists of accounts having unpaid trades so that Blech would know which accounts needed to sell to the Trusts and other controlled accounts, and Bear Stearns and Blech directly discussed rebooking trades and switching trades around so that the Blech Trusts ended up buying stock from some accounts in which there were debits for unpaid trades. Shulman stated: "If we handle the liquidations and we don't sell to him but we sell to the rest of the street, we have a concern that the outside world may perceive that his world is falling apart and the other market makers may pull their bids or significantly lower their bids."
According to the Plaintiffs, Bear Stearns knew that it needed to allow an extended period of time for Blech and his controlled accounts to sell Blech Securities gradually to the public at artificially inflated prices in order to reduce the debit balance on the Blech/DBCO combined loan, while being careful not to alert regulators or other market participants to the scheme. Harriton stated that he wanted "to give [Blech] more time" rather than require sellouts due to failures to pay for trades pursuant to Reg T "because once you start liquidating, you're gonna knock his stocks down." Zackman and Dye discussed requesting extensions. Dye stated that he cannot "say there's a check in the mail when from day one, you know, he's the broker, he controls the trust. I think we'd be criticized." Zackman responded: "Dick [Harriton] spoke to him earlier . . . if we could accommodate him, I want to do that. If [Blech] tells us, there's a check in the mail, well, you know, I know you're quiet on the other end." "So, if he tells us there is a check coming in, then we could get him an extension." Dye stated: "You know, [if] he were to sit down with a regulator, in retrospect, don't you think you'd be criticized?" In an April 19, 1994 conversation concerning whether there will be sellouts due to Blech's customers failing to pay for purchases, Murphy said to Dye, "He [Blech] doesn't want them [the stock exchange] looking at him anymore than we want to have people looking at us." On May 4, 1994, Benesch of DBCO spoke with Brian Lafaman ("Lafaman") of Bear Stearns concerning requests for extensions. Lafaman stated that the reasons given for extensions were "becoming no more than lies."
On another occasion, Dye stated to Zackman during a conversation about obtaining extensions for Blech-controlled accounts: "there's no money going to come in between now and then, pal, believe me." Dye later explained: "I believe what I'm trying to communicate to Mike Zackman is that if we make the assumption that David Blech controls the Trust accounts in his capacity as a principal of the introducing firm, it is pretty unbelievable that he would pass along a request for an extension to the stock exchange using the reason "contacting the customer' or "check in the mail.'"
In a discussion among Dye, Murphy, Zackman, Gottlieb and others about requesting extensions when Blech was facing approximately 200 account sellouts in one day, Dye stated that, "it's gonna look awful funny coming in with 200 extensions. All check in the mail. You're gonna get a phone call from the exchange. it's going to set off a whole bunch of bells and whistles over there." Dye later stated to Blech that requesting 200 extensions "would raise all kinds of flags."
During August 1994, Lafaman of Bear Stearns' retail margin department received an anonymous phone call from a former Blech employee who told Lafaman that Blech was engaging in securities fraud by parking and moving stocks among controlled accounts. The caller stated that "there are a number of illegal transactions that take place on a daily basis there," and posed the questions: "I don't know if you are watching any of that or you seen any of it, or you wondered why there are hundreds of thousands of shares of buying stocks that have no street interest." Lafaman conceded: "Well we pretty much monitor the trading that goes on in the accounts."
Lafaman was further told, "You realize that you know the stocks are — are only bid up by [Blech]. And he's the only bid out there for them . . . every time you see a hundred thousand share block go by with a thirty-second or a sixty-fourth above the bid, he's trading with himself at a — with a warehouse across the street." Lafaman responded, "Really? I'll take — I'll have to keep a closer eye on the trading activity."
Lafaman played and gave the audio tape of that call to his manager, Dye, who played it for Gottlieb and Murphy. Dye instructed Lafaman that if the caller telephoned again, he should be switched over to Dye's line. When the person later called again, to repeat that Blech was involved in a stock manipulation scheme, Dye responded by asking, "Why are you making a phone call?," and advised him that "the margin department is in the business of enforcing regulations to the New York Stock Exchange Rules." Dye suggested that the caller contact Bear Stearns' clearance department.
This knowledge and activity raise material factual issues as to whether Bear Stearns knew of the market manipulation and directly participated as maintained by the Plaintiffs or merely aided and abetted the scheme with knowledge of its existence as maintained by Bear Stearns. A more detailed discussion of this fundamental issue follows.
Participation of Baird Patrick
Throughout the Class Period, Baird Patrick was a market maker for most of the Blech Securities at issue, and engaged in extensive trading of the Blech Securities with DBCO.
The Plaintiffs have adduced evidence that whenever Blech needed to move some stock, Baird Patrick would buy it, hold the stock briefly, and when Blech found a customer account into which he could place the securities, Baird Patrick would sell the stock back to Blech. Ali Prodani ("Prodani") was a registered representative and equities trader at Baird Patrick who made a market in various Blech Securities. His customer accounts included Blech and a number of the Blech Accounts as well as Berk.
The Plaintiffs have noted a discussion between Benesch and Blech on March 25, 1994, concerning late tickets, the number of cancellations, and the amount of trading with Baird Patrick as problematic. Benesch reported, "David replied that he was no longer using Baird Patrick (thereby confirming my concerns)."
The Kristel's back-up memo to Benesch already referred to noted in connection with the relationship between Blech and Prodani of Baird Patrick:
DB [Blech] initiates trade with Ali Prodani that RS [Rick Silverman] is unaware — RS feels that his relationship with other traders is jeopardized as well as his trading strategy, b/c Ali runs ahead of Rick — often Ali will call RS and tell RS what the trade is — i.e., Ali to Rick "you're selling me . . .
The Plaintiffs rely on Kristel's note of May 16, 1994, with respect to Silverman's concern referred to above, which stated:
RS: All DB's accounts should be shipped out. It stinks what goes on in these accounts. That's why I get the tickets signed because it stinks and I want to get out of the loop. Same reason why I stay away from BPAT [Baird Patrick]
MK: But other people are still doing bus [mess] with Ali [Prodani]
RS: Pat's a big boy. He's been around long enough . . . We'll get a slap on the wrist for the time stamps. You live with that but this other stuff stinks like parking or something . . .
In July 1994, DBCO was underwriting an initial public offering for Genemedicine. Stanley Berk ("Berk") managed certain funds that had opened accounts at DBCO and called Blech and requested an allocation of Genemedicine stock. Blech stated that he would give Berk a larger allocation if Berk would also agree to accept purchases of Ecogen and HemaSure into his accounts. Berk agreed. The following day, Berk checked his computer run indicating his trades and noted that the number of shares of Ecogen and HemaSure that he had bought were several times greater than the number agreed upon. He complained to Blech who offered to provide Berk with additional shares of Genemedicine at the offering price, which was already trading at a higher level. Berk agreed.
Berk then found that additional shares began to appear in his accounts. He complained to Blech, stating that he [Berk] would d.k. ("don't know") the trades and refuse to pay for them. Blech again offered to provide additional Genemedicine shares to offset any losses. Shortly thereafter, purchases of additional, larger amounts of un-ordered securities appeared in Berk's accounts. Berk explained to Blech that he was becoming overextended since he leveraged all of his purchases. Blech offered to forward the funds necessary to settle the purchases to Berk before the settlement date.
Blech then proposed that Berk would purchase shares on a normal five-day settlement and on the day before the settlement date, Berk would sell those shares either to DBCO's trading account or to other Blech-controlled accounts on a one-day settlement basis, thus removing the particular shares from DBCO's inventory for a period of at least six days without any money having to change hands. This pattern was repeated numerous times during the ensuing weeks. At one point, Berk had over $20 million of unpaid transactions outstanding, including shares of LaJolla Pharmaceutical, Guilford, Texas Biotech, Genemedicine, Intelligent Surgical Lasers, Biogen, Ariad, Microprobe, HemaSure, Procept and Biosepra. His fictitious sham trades during July and August 1994 involved hundreds of transactions with millions of shares traded.
According to Berk, on July 22, 1994, the Berk accounts at Baird Patrick bought 50,000 shares of Microprobe, 25,000 shares of HemaSure, and 93,000 shares of Envirogen for more than $650,000. On July 25, 1994, Berk's accounts at Baird Patrick bought 35,000 shares of Ariad, 125,000 warrants of Intelligent Surgical Lasers, 20,000 shares of Microprobe, and 120,000 Microprobe warrants for more than $680,000. On August 1, 1994, Berk's accounts at Baird Patrick purchased 120,000 shares of Advanced Surgical, 130,000 shares of Biosepra, 55,000 shares of Ecogen, 30,000 shares of Envirogen, 50,000 shares of Intelligent Surgical Lasers, 80,000 shares of Microprobe, 15,000 shares of Neoprobe, and 100,000 Neoprobe warrants for more than $2.1 million.
In a phone conversation between Harold Hirsch ("Hirsch") in the Bear Stearns retail margin department and John Tidona ("Tidona") in the cashier's department concerning Berk, Hirsch stated that he had a "whole bunch of boys here," and that they "watch Blech very carefully." Tidona responded: "so do we." Hirsch then commented about a $15 million open trade in a Berk account, to which Tidona replied: "yeah, we know all about that."
On August 19, 1994, there was a meeting at DBCO with Blech, Al Guido ("Guido"), the operations manager of DBCO, and Harriton and Zackman from Bear Stearns. During that meeting, Harriton stated that there could be no more purchases in Berk's accounts. Notwithstanding, Berk thereafter made substantial purchases of Blech Securities at DBCO totaling hundreds of thousands of shares involving several million dollars.
According to Berk's deposition, his accounts at Baird Patrick were used to park securities, and Prodani would call Berk and tell Berk what stocks Berk was going to purchase or sell at the direction of Blech.
The Bear Stearns Debit Reduction Demands Raise An Issue of Material Fact
From the outset of its relationship with Blech and DBCO, Bear Stearns sought to get Blech to reduce his debit balances and to stay within the initial limitations set by Bear Stearns. Bear Stearns made requests to Blech and DBCO to reduce debits on the following dates during 1994: April 29 ($15 million by Monday); May 9 ($10 million within 30 days); May 23 ($13 million by June 9, $10 million by June 30); June 2 ($15 million); June 3 ($15 million); June 8 ($15 million today, $13 million shortly thereafter); June 13 ($14 million); June 20 ($14 million); June 29 ($14 million); June 30 ("move" $4 million to customers, debit to $10 million); July 5 ($10 million); July 13 ($10.5 million); July 18 ($12 million, next week $10 million); August 10 ($16 million); August 29 and September 8 ($15 million)
In April 1994, Shulman and Murphy told Blech that debits in his personal and the firm's trading account were "going in the wrong direction" and that Blech needed to make $5 million in sales to achieve compliance with the levels previously agreed to. Shulman threatened: "If you're not taking care of it, then we will take care of it for you."
Gottlieb, in discussing unpaid for trades in BioSepra, HemaSure and "other sh_tty" Blech Securities, reminded Murphy that Bear Stearns is "not questioning what [Blech] does with the stock." Similarly, Zackman asked: "You know, he's selling out at the market and crossing it into other accounts . . . do you see any problem with that?" Gottlieb admitted: "I don't want to . . . be a Monday morning quarterback on what he does compliance-wise. We just want to settle the debits." In a conversation on April 22, 1994, Murphy told Blech that Blech must reduce debits in his trading account. When Blech indicated that he would sell some non-Blech securities, Shulman complained, "you're still focusing on the stocks we found acceptable." In June 1994, Harriton instructed Murphy to tell Blech that his debits could not exceed $14 million if he wanted to complete an underwriting, and if Blech later violated that limit, and "doesn't keep his word we're never gonna let him do another syndicate again." In another conversation in June/July 1994, Harriton stated that, "after this [syndication] deal his debit can't be more than 12.5 million."
The Plaintiffs have alleged that these demands forced parking and trading between Blech Accounts, and thereby constituted an affirmative act of manipulation. Bear Stearns has contended that its actions with respect to debit demands were simply consistent with its agreement with DBCO to serve as its clearing broker and has relied upon Cromer Finance Ltd. v. Berger, 137 F. Supp.2d 452, 471 (S.D.N.Y. 2001), a careful and thoughtful opinion of the Honorable Denise L. Cote, which stated:
A failure to enforce margin requirements, or continuing to execute trades despite margin violations, however, does not constitute substantial assistance. Dillon v. Militano, 731 F. Supp. 634, 637, 639 (S.D.N.Y. 1990); Stander v. Fin. Clearing Serv. Corp., 730 F. Supp. 1282, 1287 (S.D.N.Y. 1990). Similarly, executing trades in order to reduce "a loan of money under margin" is insufficient to create liability. Ross v. Bolton, 639 F. Supp. 323, 327 (S.D.N.Y. 1986)
The contentions here go further.
The authorities are established that when a clearing broker aids and abets a securities fraud even with knowledge by performing routine clearing functions, there is no liability. Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). Here it has been held that when a clearing broker directs or contrives a securities fraud, there can be liability. This motion poses a factual question as to which of these two categories are applicable to Bear Stearns' conduct here. An agreement to clear does not constitute an absolution from securities fraud liability.
The characterization of Bear Stearns' conduct with respect to its margin call presents this issue most sharply. As Bear Stearns has demonstrated, margin calls by a clearing broker or a failure to make margin calls, even with suspicion or knowledge of impropriety on the part of the initiating broker, is an appropriate and essential part of the securities business. However, a margin call made with knowledge that it will cause the initiating broker to commit a securities fraud which must be cleared by the clearing broker, constitutes direct action in connection with a contrivance to manipulate a security. Here that element of causality is at issue. In this difficult assessment of liability stemming from the distinction between aiding and abetting and direct action, the line will be drawn with respect to summary judgment in favor of protecting the investing public rather than the clearing broker.
The Withholding of Blech Securities Creates A Material Factual Issue
It is the Plaintiffs' position that Blech's actions artificially withheld from the market substantial quantities of Blech Securities that were moved between the Blech's proprietary trading accounts, the Blech Trusts, and other Blech-controlled accounts, and that these practices kept up the prices of the Blech Securities and further that Bear Stearns affirmatively acted to assist in this withholding.
According to the Plaintiffs, Bear Stearns withheld supply of Blech Securities from the market by instructing Blech to evade Reg T payment requirements for unpaid trades in customer accounts by placing the unpaid for shares in Blech's own trading account on an as of" basis. Zackman suggested, "Maybe — Peter [Murphy], maybe you and Wally can just speak to David [Blech] on how to do that."
The Plaintiffs' Response to the Local Rule 56.1 Statement of Defendant Bear Stearns Co. Inc. states at paragraph 68, that in April 1994, as a sell-off in biotechnology stocks and short-selling were putting pressure on Blech Securities, Bear Stearns further withheld stock from the market by "locking up" over $12 million in Blech Securities in the DBCO/Blech inventory of April 18, 1994, in two segregated accounts (102-02388 and 102-02390) where they were prohibited from being loaned out to the market. In this regard, Murphy is said to have stated to Pat Cestaro ("Cestaro") of Bear Stearns during a phone conversation that he, "will call Marty Shulman and . . . tell him we want all those accounts locked up." Cestaro inquired of Murphy, "You know and then — I mean — we're doing this because we're afraid of — we're trying to protect our interests as well?" To which Murphy confirmed, "Yeah, absolutely," and "there's no question that we're looking for ourselves at this time." The conversations of Murphy and Cestaro may indicate as alleged by the Plaintiffs that the purpose of the "lock up" was to withhold stock from short sellers in the market in order to support the value of Bear Stearns' collateral at a higher level than it would have fallen to absent the limiting of supply.
According to Bear Stearns, it is optional for a clearing broker to make securities available for lending to short sellers (12 C.F.R. § 220.10a; 12 C.F.R. § 220.1 (b)(2), which while true does not determine whether or not the withholding had the intent and effect of supporting a known artificial market.
Bear Stearns also urges that the Plaintiffs have failed to establish that the particular securities which were subject to the withholding were Blech Securities. However, this factual assertion appears in the Plaintiffs' Response to the Local Rule 56.1 Statement of defendant Bear Stearns Co. Inc. ("Plaintiffs' Response") at p. 55 ("Bear Stearns further withheld stock from the market by "locking up' over $12 million in Blech Securities in the D. Blech Co./Blech inventory on April 18, 1994 in two segregated accounts (102-02388 and 102-02390)."). Therefore, despite the Bear Stearns challenge in its Reply Local Rule 56.1 Statement ("Reply Statement") at page 77, a factual issue is presented as to whether the withheld stock included the Blech Securities.
Although the Bear Stearns's withholding is not a security violation in and of itself, an otherwise innocent act if undertaken with an intent to manipulate the market, can become a contrivance to accomplish a security fraud. An issue of material fact has been created.
Bear Stearns has also urged with respect to the delayed sellout that Reg. T was not violated on the grounds that a one-day delay does not violate the provision that the sellout must be done "promptly." 12 C.F.R. § 220.8 (b)4, and that the 300,000 shares of BioSepra, involved in April 1994, would not constitute a significant reduction in the floating supply such as to affect the market, and that only the LXR shares involved in the June 1994 delayed sellout are Blech Securities. Nonetheless, a factual issue has been created as to whether the delay in the sell out was intended to support an artificial price created by Blech.
An Issue of Fact Is Presented As To Trades To Improve The Blech Capitalization
According to the Plaintiffs, the Bear Stearns' transcripts and notes of its daily discussions with Blech indicate that Bear Stearns sought to remove sizable quantities of particularly illiquid Blech Securities from the proprietary accounts of DBCO and Blech by placing Blech Securities in the Blech Trusts, the "housecall accounts" and other friendly, controlled accounts, in order to attract a replacement broker, to prevent DBCO from being shut down for net capital violations. The notes reflect substantial trades of BioSepra, Procept and DNA Plant Technology. There is evidence that Bear Stearns sought out opportunities to sell particular securities deemed not acceptable by Bear Stearns out of DBCO and into the Blech Trusts and other customer accounts. Murphy's April 29, 1994 note stated: "To buy from the Trusts Stocks that we like and sell them Stocks that we do not like."
The Plaintiffs have submitted evidence that Bear Stearns on July 1, 1994 agreed to fund the transfer of an aggregate of $3.2 million in certain Blech Securities including those that had been deemed "unacceptable" to Bear Stearns from DBCO's firm account to Blech-controlled accounts. Shulman's July 1 contemporaneous notes of a discussion with Blech and Gottlieb include the following: "Easier for him to move if he is deleveraged"; "sell to custs."; "claims Dick [Harriton] said if BD/DB [broker-dealer/David Blech] deleverages will allow cust. debits"; "will sell `unaccept.' secs." The transactions took place on or about July 5, 1994 and were explained by Dye as follows: "Here's the deal, he's supposed to lower the debit in his trading account by $3.2 million those buyers — the other side of his trading account sales or buys in customer margin accounts." Dye added: "and the idea was to make it more attractive to another firm.
Bear Stearns has noted that these transactions are not identified as involving Blech Securities, that it is customary to lend margin credit, that the transactions did not affect the public market. The factual issue raised by the Plaintiffs is whether or not these acts were part of a clearing broker's routine activity or were performed to keep DBCO in business and to avoid capital violations with knowledge of the continuing securities fraud. Zackman told Blech that Bear Stearns was not "comfortable" with the business [Blech] was doing with [Bear Stearns]" and Bear Stearns "wanted him to find a new home."
This effort to create a circumstance where Blech could find a replacement clearing broker may create an inference that Bear Stearns recognized and acted to continue the elements of a securities fraud, or alternatively simply a desire to eliminate a continuing capitalization problem. In any event, a material factual issue is created.
An Issue of Fact Is Presented With Respect To Loss Causation
The parties are in agreement that, under the federal securities laws, causation is a two-pronged analysis: a plaintiff must allege both "transaction causation" (i.e., that but-for the fraudulent activity, the plaintiff would not have made his purchase or sale) and "loss causation" (i.e., that the defendant's actions caused the harm actually suffered). Bear Stearns Memorandum at 34-35 (citing Suez Eguity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 96 (2d Cir. 2001); Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1992); Bennett v. United States Trust Co. of N.Y., 770 F.2d 308, 314 (2d Cir. 1985), cert. denied, 474 U.S. 1058 (1986). Plaintiffs' Memorandum (citing Castellano v. Young Rubicam, Inc., 257 F.3d 171, 186 (2d Cir. 2001) (citing Suez Eguity, 250 F.3d at 96 (other citations omitted); First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769-70 (2d Cir. 1994), cert. denied, 513 U.S. 1079 (1995)
"The loss causation inquiry typically examines how directly the subject of the [activity] caused the loss, and whether the resulting loss was a foreseeable outcome of the [activity]," while also taking into account issues such as the presence of intervening causes and the lapse of time between the behavior complained of and the loss. . . . This determination may often rest in part on legal policy considerations. . . . The loss causation requirement is intended to "fix a legal limit on a person's responsibility, even for wrongful acts."Castellano, 257 F.2d at 186 (citations omitted)
As set forth in Plaintiffs' memorandum, the loss causation assessment may often rest in part on legal policy considerations. First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994) (the proximate cause determination "is not free from normative legal policy considerations," and indeed involves a judgment based upon "some social idea of justice or policy") (citing Hecht v. Commerce Clearing House, Inc., 897 F.2d 21, 23 (2d Cir. 1990); Sperber v. Boesky, 849 F.2d 60, 63 (2d Cir. 1988) (guoting W.P. Keeton, D. Dobbs, R. Keeton, D. Owen, Prosser and Keeton on the Law of Torts, 264 (5th ed. 1984))
Plaintiffs' damages expert concluded that the monetary damages suffered by the Class is approximately $77 million, noting that seven of the twenty-two Blech Securities exhibited no significant price drop when DBCO ceased operations on September 22, 1994. He stated:
The fact that there was no significant price drop at the end of the Damages Period and no or very little trading through the Bear Stearns Blech Accounts is persuasive evidence that the stock prices of the Blech Securities that did show significant price declines when the closure of D.Blech Co. is announced on September 22, 1994 were inflated because of defendant's market manipulation.
Nonetheless, Bear Stearns contends that summary judgment is appropriate dismissing the complaint because the Plaintiffs cannot demonstrate that any specific act by Bear Stearns caused Plaintiffs' losses. Bear Sterns Memorandum at 35-38. However, the Blech III decision stated:
With respect to loss causation, the Principal question is whether the loss is a reasonable foreseeable consequence of the fraudulent actions. Thornock v. Kinderhill Corp., 712 F. Supp. 1123, 1127 (S.D.N.Y. 1989). Here, the economic harm to the Plaintiffs from the ultimate collapse of the price of the Blech securities that were inflated by the actions of Bear Stearns (and Blech and his confederates) was a foreseeable consequence of Bear Stearns' alleged conduct. Accordingly, loss causation is also adequately pleaded.Blech III, 961 F. Supp. at 586 (emphasis added)
Accordingly, the Plaintiffs' expert has presented sufficient evidence of loss causation to raise questions of fact which can only be determined by a jury.
As in Dietrich v. Bauer, 76 F. Supp.2d 312 (S.D.N.Y. 1999) cited by Bear Stearns, in a fraud on the market case the issue is the causation between the alleged fraud and the consequences suffered by the Plaintiffs. The Plaintiffs' expert here has raised an issue of fact as to that causality. Facts have been presented that establish that each of the Blech Securities have been the subject of transfers between Blech Accounts, parking with Berk, and delayed sellouts, all acts, which the Plaintiffs have alleged, Bear Stearns participated directly with knowledge that their acts were essential to the Blech securities fraud. Whether or not the participation was the result of an intent to accomplish fraudulent contrivance or the ministerial act of a clearing broker remains a material factual issue as set forth above.
Baird Patrick contends that the Plaintiffs must present evidence of the damages resulting from its specific acts to establish loss causation. However, as set forth above in response to Bear Stearns's similar argument, this is not the standard that governs loss causation in this case. As just set forth, "the principal question is whether the loss is a reasonably foreseeable consequence of the fraudulent actions." Blech III, 961 F. Supp. at 586.
Baird Patrick has noted that Plaintiffs' damages expert eliminated from his calculations the trades in accounts at Baird Patrick for which Prodani was the registered representative, because of an inability to determine the participation of members of the class.
However, Plaintiffs' expert, Howard Berg, has stated:
The actions of Baird Patrick, its principals and employees were manipulative in that they engaged in sham transactions and parking trades that purposely caused the market prices for the Blech Securities to trade and be supported at artificially high prices.
Prodani accepted and executed orders from David Blech for accounts in which he knew that Blech had no authority allowing him to transaction securities business. Prodani knew that Blech's transactions were for the purpose of manipulating the price of Blech Securities, and were part of a scheme to park Blech Securities for the purpose of avoiding payment of these Securities.
Prodani executed arranged trades that he knew were intended to park Blech Securities for the purpose of artificially inflating and/or supporting the market prices of Blech Securities, that he knew were for the purpose of withholding supply from the market thereby artificially supporting the prices of Blech Securities, and that he knew were done for next day settlement in order to meet Blech's requirement to pay for trades on settlement date.
If the Plaintiffs can show that Baird Patrick actively participated in the scheme to manipulate the price of Blech Securities, and that the scheme ultimately resulted in damages to Class members, loss causation is satisfied. See Blech II, 961 F. Supp. at 586.
An Issue of Fact Is Presented As To The Control Liability of Baird Patrick
Baird Patrick has not challenged the Plaintiffs' version of Prodani' s activities but has contended that it is not a "control person" under Section 20(a) of the 1934 Act which imposes joint and several liability on any person who "directly or indirectly, controls any person liable under any provision of this title or of any rule or regulation thereunder," unless the controlling person "acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action." 15 U.S.C. § 78t(a).
Prodani has testified that he acted as a registered representative and equities trader employed by Baird Patrick during the relevant period, that he performed the functions of those positions; he was the registered representative for 20 to 30 customers, including six to eight trust accounts set up by Blech and various individuals referred by Blech, including Esther Blech [Blech's mother], Meyer Blech [Blech's father], Louis Zauderer, Adina Cohen, Jean Jofen, Aaron Eiger [Blech's uncle], Hyman Aviv, Joseph Weiss [Blech's cousin] and Berk. From time to time, he discussed trading activity in those accounts with management of Baird Patrick.
Prodani also testified that he maintained a trading account for Baird Patrick and that he made markets in various Blech Securities. Through Prodani's efforts, and with the approval of management, Baird Patrick participated in at least five underwritings with DBCO in certain Blech Securities. His compensation was based upon commissions and bonuses.
According to Baird Patrick's own liability expert, Vincent Buchanan:
The trading desk at Baird Patrick is presently situated in the same manner as it was during the relevant time period. Mr. Prodani sat immediately to the right of the Trading Department Manager on the stem of a "T," with the Manager occupying the top of the "T." In this position, Prodani's telephone conversations, ticket preparation, general recordkeeping and office demeanor were all under close observation and supervision at all times during the trading day.
* * *
In addition, as a registered representative, Prodani was subject to the same supervisory procedures as every other registered employee of Baird Patrick. Accordingly, it was necessary for him to obtain approval for every customer account that he opened before any trading could be commenced therein.
* * *
With respect to Baird Patrick's market making activities, Prodani was required to obtain approval from Baird Patrick's management prior to registering as a market maker in any security, and the firm had established procedures for maintaining due diligence files for each security in which it made a market in accordance with requirements.
Buchanan Report at 10-11.
According to Plaintiffs' expert, Howard G. Berg:
All of Prodani's action were subject to supervision and oversight by approved Baird Patrick supervisory persons. Except for some limited references to concerns about concentration based on credit considerations, I saw no evidence of any such supervisory review of Prodani's sales and manipulative trading by Baird Patrick.
Berg Report at 6.
These facts are more than sufficient to raise an issue of control of Prodani.
In Marbury Mgmt., Inc. v. Kohn, 629 F.2d 705, 716 (2d Cir. 1980),cert. denied, 449 U.S. 1011 (1980), the Second Circuit held that once a defendant's control person status is established, "the burden of proving good faith is shifted to the [defendant]." Id. at 716 (citing Stern v. American Bankshares Corp., 429 F. Supp. 818, 823 (E.D.Wis. 1977)); see also Borden, Inc. v. Spoor Behrins Campbell Young, 735 F. Supp. 587 (S.D.N.Y. 1990); In re Citisource, Inc. Sec. Litig., 694 F. Supp. 1069, 1076 (S.D.N.Y. 1988); Terra Res. I v. Burgin, 664 F. Supp. 82 (S.D.N.Y. 1987); Savino v. E.F. Hutton Co., 507 F. Supp. 1225, 1243 (S.D.N.Y. 1981)
Baird Patrick contends, in effect, that the Second Circuit has sub silentio overruled Marbury in SEC v. First Jersey Sec., Inc., 101 F.3d 1450 (2d Cir. 1996). However, several courts have since held that "culpable participation" may be shown where the controlling person "knew or should have known" that the controlled person "was engaging in fraudulent conduct." Gabriel Capital, L.P. v. NatWest Fin., Inc., 122 F. Supp.2d 407, 429 (S.D.N.Y. 2000); In re Indep. Energy Holdings PLC Sec. Litig., 154 F. Supp.2d 741, 771 (S.D.N.Y. 2001) (citing Gabriel); Ruskin v. TIG Holdings, Inc., 2000 U.S.Dist. LEXIS 11517, at *21-22 (S.D.N.Y. Aug. 14, 2000). Moreover, a controlling person's receipt of financial benefits can demonstrate culpable participation. See Gabriel Capital, 122 F. Supp.2d at 428; In re Oxford Health Plans, Inc., 187 F.R.D. 133, 143 (S.D.N.Y. 1999) (sustaining § 20(a) allegations where plaintiffs alleged that defendants "participated in the fraud at least by reaping benefits of insider trading")
Gabriel, supra ("a controlling person does not have to be a § 10(b) actor in order to culpably participate in the primary violation. Rather, a controlling person is liable under § 20(a) if that person: (a) knew or should have known that the primary violator, over whom the person had control, was engaged in fraudulent conduct but (b) took no steps to prevent the primary violation.")
See also Gordon v. Burr, 506 F.2d 1080, 1086 (2d Cir. 1974) (reversing finding of control person liability because "we fail to find in the record support for a finding that P.A.W. had knowledge of the fraudulent representations or in any meaningful sense culpably participated in them."); Chill v. Gen. Elec. Co., 101 F.3d 263, 269 (2d Cir. 1996) ("An egregious refusal to see the obvious, or to investigate the doubtful, may in some cases give rise to an inference of . . . recklessness.") (quotation marks and citation omitted)
Baird Patrick has stated that it "received substantial income therefrom in the form of commissions, mark-ups and margin interest." Baird Patrick Memo, p. 6. Although it maintained these facts are meaningless, to the extent that Baird Patrick's position is that it has shown that it acted in "good faith," that argument raises numerous questions of fact in view of Prodani's acts, precluding the granting of summary judgment.
Baird Patrick asserts that the testimony of Berk, "while perhaps acknowledging his own culpable participation in Blech's scheme is ambiguous at best as to Prodani," and notes the existence of disputes between Plaintiffs' industry expert, Howard Berg, and Baird Patrick's expert, Vincent Buchanan. However, as set forth above, the existence of a so-called "battle of the experts" can raise issues of material fact for jury resolution.
In addition, Baird Patrick's conduct also gives rise to an issue of fact concerning liability under the doctrine of respondeat superior. As set forth by the Second Circuit in Marbury, "the concern [ofrespondeat superior] is simply with scope or course of employment and whether the acts of the employee. can fairly be considered to be within the scope of his employment." Marbury, 629 F.2d at 716 (citing Restatement (Second) of Agency §§ 228, 229, 257, 258, 261, 262, 265)). As in Marbury, the evidence in this case "contains no indication that [Prodani] profited by any of the transactions other than by reason of his compensation from [Baird Patrick] as one of its employees." Id. Moreover, in Marbury, as in this case, the trader's "deviant conduct, while it may have induced the purchase of securities that would not otherwise have been purchased, did not appear, on the record made, at the trial, to make any deviation from [the trader's] services to his employer." Id. Therefore, as in Marbury, a factual issue concerning Baird Patrick's liability under the doctrine of respondeat superior has been presented.
"[T]here is no warrant for believing that Section 20(a) was intended to narrow the remedies of the customers of brokerage houses or to create a novel defense in cases otherwise governed by traditional agency principles." Id. Moreover, "where respondeat superior principles are applied, the special good faith defense afforded by the last clause of Section 20(a) is unavailable." Id.
Conclusion
Because issues of material fact exist concerning the knowledge and purpose of the acts of Bear Stearns, the effect of the securities fraud, loss causation and the control of Prodani by Baird Patrick, as set forth above, the motions are denied.
It is so ordered.