SEC v. Zandford

Case reversed and remanded by

Supreme Court opinion filed 6/3/02

Cert granted by Supreme Court

order filed 11/08/01

PUBLISHED

UNITED STATES COURT OF APPEALS

FOR THE FOURTH CIRCUIT

SECURITIES & EXCHANGE COMMISSION,

Plaintiff-Appellee,

v. No. 99-1733

CHARLES ZANDFORD,

Defendant-Appellant.

Appeal from the United States District Court

for the District of Maryland, at Greenbelt.

Andre M. Davis, District Judge.

(CA-95-2826-AMD)

Argued: October 30, 2000

Decided: January 26, 2001

Before WILKINSON, Chief Judge, and MICHAEL and

TRAXLER, Circuit Judges.

_________________________________________________________________

Reversed and remanded by published opinion. Chief Judge Wilkinson

wrote the opinion, in which Judge Michael and Judge Traxler joined.

_________________________________________________________________

COUNSEL

ARGUED: Erin J. Roth, Student Counsel, Appellate Litigation Pro-

gram, GEORGETOWN UNIVERSITY LAW CENTER, Washington,

D.C., for Appellant. Melinda Hardy, Assistant General Counsel,

SECURITIES AND EXCHANGE COMMISSION, Washington,

D.C., for Appellee. ON BRIEF: Steven H. Goldblatt, Director, Lisa

M. Porcari, Supervising Attorney, Robert L. Jacobson, Student Coun-

sel, Appellate Litigation Program, GEORGETOWN UNIVERSITY

LAW CENTER, Washington, D.C., for Appellant. David M. Becker,

General Counsel, Meyer Eisenberg, Deputy General Counsel, Richard

M. Humes, Associate General Counsel, Philip J. Holmes, Attorney-

Fellow, SECURITIES AND EXCHANGE COMMISSION, Washing-

ton, D.C., for Appellee.

_________________________________________________________________

OPINION

WILKINSON, Chief Judge:

Defendant Charles Zandford was convicted of thirteen counts of

wire fraud for stealing from two of his investment clients. The Securi-

ties and Exchange Commission subsequently filed this civil action

against Zandford under § 17(a) of the Securities Act of 1933, § 10(b)

of the Securities Exchange Act of 1934, and the SEC's Rule 10b-5.

The district court granted the SEC's motion for summary judgment.

Zandford now appeals. We hold that the federal securities laws do not

reach every claim for the theft or conversion of a security from a bro-

kerage account. Because Zandford's fraudulent actions were not suffi-

ciently connected with a securities transaction, we reverse the

judgment of the district court and remand with directions to dismiss

the case.

I.

Between 1987 and 1991, Charles Zandford worked as a securities

broker. In 1987, Zandford persuaded William Wood to open a joint

investment account for himself and his daughter, Diane Wood Okstul-

ski. Wood was an elderly man who was in poor health. His daughter

was mentally retarded and suffered from a multiple personality disor-

der. Zandford promised to "conservatively invest" the Woods' money.

In total, the Woods entrusted Zandford with $419,255. By September

1990, all of it was lost.

In April 1995, a federal grand jury indicted Zandford on thirteen

counts of wire fraud in violation of 18 U.S.C. § 1343. The indictment

alleged that Zandford engaged in a scheme to defraud the Woods. The

2

first count maintained that Zandford sold the Woods' shares of a

mutual fund in order to use the proceeds for his own benefit. The

remaining counts related to twelve separate checks from the Woods'

account that Zandford made payable to himself. Zandford generated

money in the Woods' account by selling their securities. A jury con-

victed Zandford on all counts. Zandford was sentenced to 52 months

imprisonment and was ordered to pay $10,800 in restitution. This

court subsequently affirmed Zandford's conviction. See United States

v. Zandford, 110 F.3d 62 (4th Cir. 1997) (Table).

In September 1995, the Securities and Exchange Commission filed

this civil action against Zandford under Section 17(a) of the Securities

Act of 1933, 15 U.S.C. § 77q(a), Section 10(b) of the Securities

Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promul-

gated thereunder, 17 C.F.R. § 240.10b-5. The SEC's complaint

alleged that Zandford violated these laws by selling the securities in

the Woods' account, by misappropriating $343,000 in proceeds, and

by using the money for his own personal needs. The SEC sought to

enjoin Zandford from further violating the federal securities laws and

to recover Zandford's ill-gotten gains.

In April 1998, the SEC moved for partial summary judgment on its

misappropriation claim. Zandford subsequently moved for permission

to conduct limited discovery on the issue of whether his fraud was "in

connection with" a securities transaction. On March 2, 1999, the dis-

trict court denied Zandford's motion and granted the SEC's motion

for summary judgment. The court determined that Zandford's crimi-

nal conviction for wire fraud established all facts necessary to satisfy

the elements of the SEC's securities fraud claim. Therefore, the court

held that the doctrine of collateral estoppel prevented Zandford from

arguing that he was not civilly liable under the federal securities laws.

The court enjoined Zandford from committing future violations of the

securities laws. It also ordered Zandford to disgorge $343,000. Zand-

ford now appeals.1 1

_________________________________________________________________

1 The SEC contends that Zandford's notice of appeal was untimely.

Because the district court did not abuse its discretion when it construed

Zandford's motion for reconsideration of the summary judgment order

and subsequent letter as a motion for an extension of time, the notice of

appeal was timely filed. See Fed. R. App. P. 4(a)(5); see also Thompson

v. E.I. DuPont de Nemours & Co., Inc., 76 F.3d 530, 534 (4th Cir. 1996)

(reviewing district court's determination of the existence of excusable

neglect for abuse of discretion).

3

II.

The district court determined that Zandford's criminal conviction

for wire fraud established all facts necessary to satisfy the elements

of the SEC's securities fraud claim. That court erred in holding that

the doctrine of collateral estoppel prevented Zandford from contesting

his civil liability under the federal securities laws.

A criminal conviction can prevent a party from relitigating issues

in a subsequent civil proceeding. See Emich Motors Corp. v. General

Motors Corp., 340 U.S. 558, 568 (1951). For collateral estoppel to

apply, the SEC must establish that: (1) the issue sought to be pre-

cluded is identical to one previously litigated; (2) the issue must have

been actually determined in the prior proceeding; (3) determination of

the issue must have been a necessary part of the proceeding; (4) the

prior judgement must be final and valid; and (5) the party against

whom estoppel is asserted must have had a full and fair opportunity

to litigate the issue in the previous forum. See Sedlack v. Braswell

Servs. Group, Inc., 134 F.3d 219, 224 (4th Cir. 1998).

At the very least, the SEC's invocation of collateral estoppel fails

to satisfy the "identity of issues" requirement. To establish that Zand-

ford violated sections 17(a) and 10(b), the SEC must prove, inter alia,

that Zandford committed fraud "in the offer or sale" of securities, or

"in connection with the purchase or sale" of securities. See 15 U.S.C.

§ 77q(a); 15 U.S.C. § 78j(b); 17 C.F.R.§ 240.10b-5. By contrast,

under the wire fraud statute, the government only need prove that (1)

Zandford engaged in a scheme to defraud, and (2) that he used inter-

state wire communications in executing his scheme. See 18 U.S.C.

§ 1343; United States v. ReBrook, 58 F.3d 961, 966 (4th Cir. 1995).

Thus, to find Zandford guilty of wire fraud it was wholly unnecessary

to determine whether his fraud was sufficiently connected to a securi-

ties transaction. Since Zandford was never charged with a criminal

violation of § 10(b), he did not have the opportunity to argue at trial

or on appeal that, as a legal matter, his fraud was not sufficiently con-

nected to a securities transaction. The SEC concedes as much when

it argues both that the criminal trial established the fact that Zandford

sold securities as part of a scheme to misappropriate proceeds, and

that the district court properly made a legal conclusion in this case

4

that such a scheme satisfies the "in connection with" requirement. It

is this legal conclusion which we will now review.

III.

A.

The Securities Act of 1933 was designed "to provide full and fair

disclosure of the character of securities sold . . . and to prevent frauds

in the sale thereof, and for other purposes." Blue Chip Stamps v.

Manor Drug Stores, 421 U.S. 723, 728 (1975). Likewise, "the funda-

mental purpose of the Securities Exchange Act of 1934 [was] to

implement a `philosophy of full disclosure,' by providing participants

in stock transactions with the information they need to make their

investment decisions." Hunt v. Robinson, 852 F.2d 786, 787 (4th Cir.

1988) (quoting Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477-

78 (1977)) (citation omitted).

The federal securities laws do not cover all types of fraud. Rather,

both the Securities Act and the Exchange Act require that the defen-

dant's fraud be connected sufficiently to a securities transaction. To

state a claim under § 17(a) of the Securities Act, the SEC must show

that Zandford's fraud, misstatement, or omission occurred "in the

offer or sale of any securities." 15 U.S.C. § 77q(a).2

2 Likewise, to state

_________________________________________________________________

2 Section 17(a) of the Securities Act of 1933 provides:

It shall be unlawful for any person in the offer or sale of any

securities . . .

(1) to employ any device, scheme, or artifice to defraud, or

(2) to obtain money or property by means of any untrue state-

ment of a material fact or any omission to state a material fact

necessary in order to make the statements made, in the light of

the circumstances under which they were made, not misleading,

or

(3) to engage in any transaction, practice, or course of busi-

ness which operates or would operate as a fraud or deceit upon

the purchaser.

15 U.S.C. § 77q(a).

5

a claim under § 10(b) of the Exchange Act and Rule 10b-5, the SEC

must show, inter alia, that Zandford misrepresented or failed to state

material facts "in connection with" the purchase or sale of a security.

See 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5.3

3

The precise contours of the in connection with requirement are not

self-evident. It seems unavoidable "that the standard be fleshed out by

a cautious case-by-case approach." See Chemical Bank v. Arthur

Andersen & Co., 726 F.2d 930, 942-43 (2d Cir. 1984) (quoting Small-

wood v. Pearl Brewing Co., 489 F.2d 579, 595 (5th Cir. 1974)).

While the in connection with requirement must be flexible, it is not

so elastic as to cover incidents which bear no relationship to market

integrity or investor understanding. In particular, it is clear that ordi-

nary state law fraud or conversion claims do not invariably violate the

federal securities laws. "Congress, in enacting the securities laws, did

_________________________________________________________________

3 Section 10(b) of the Exchange Act provides, in pertinent part, that:

It shall be unlawful for any person, directly or indirectly . . . (b)

To use or employ, in connection with the purchase or sale of any

security[,] . . . any manipulative or deceptive device or contriv-

ance in contravention of such rules and regulations as the [Secur-

ities and Exchange] Commission may prescribe as necessary or

appropriate in the public interest or for the protection of inves-

tors.

15 U.S.C. § 78j(b).

Rule 10b-5, promulgated by the SEC pursuant to section 10(b), pro-

vides, in relevant part, that:

It shall be unlawful for any person, directly or indirectly, by the

use of any means or instrumentality of interstate commerce . . .

(a) [t]o employ any device, scheme, or artifice to defraud, [or]

...

(c) [t]o engage in any act, practice, or course of business

which operates or would operate as a fraud or deceit upon any

person,

in connection with the purchase or sale of any security.

17 C.F.R. § 240.10b-5. Liability under Rule 10b-5 does not extend

beyond conduct encompassed by § 10(b)'s prohibition. See United States

v. O'Hagan, 521 U.S. 642, 651 (1997).

6

not intend to provide a federal remedy for all common law fraud."

Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d

236, 241 (4th Cir. 1988) (citing Marine Bank v. Weaver, 455 U.S.

551, 556 (1982)). Indeed, the goal of § 10(b) would not be served by

expanding its scope to include "claims amounting to breach of con-

tract or common law fraud which have long been the staples of state

law." Hunt, 852 F.2d at 787-88. With these principles in mind, we

turn to the merits of Zandford's appeal.

B.

The precise issue before us is whether Zandford's alleged fraud is

sufficiently connected to a securities transaction, as required by

§ 17(a) of the Securities Act, § 10(b) of the Exchange Act, and Rule

10b-5. The SEC advocates a very broad reading of the in connection

with requirement. It alleges that Zandford defrauded the Woods by

failing to inform them that he intended to sell their securities in order

to obtain the proceeds for himself. The SEC argues that this omission

was fraudulent since Zandford, as the Woods' investment adviser,

bore a duty to disclose material information to the Woods. The SEC

contends that Zandford's omissions were in connection with Zand-

ford's sale of the securities in the Woods' account.

We do not believe that the federal securities laws extend to Zand-

ford's fraudulent activities. The SEC has alleged what amount to ordi-

nary state law fraud and conversion claims. In order to satisfy the in

connection with requirement, "the fraud must have been integral to

the plaintiff's purchase or sale of the security." Flickinger v. Harold

C. Brown & Co., Inc., 947 F.2d 595, 598 (2d Cir. 1991); see also Tay-

lor v. First Union Corp. of South Carolina, 857 F.2d 240, 245 (4th

Cir. 1988) (holding that deception that is only"tangentially and inci-

dentally" related to the sale of a security does not satisfy the in con-

nection with requirement). We have found no violation of § 10(b), for

example, where "[t]he alleged fraud lies, not in the actual sale of the

stock, but rather in defendants' refusal to tender the shares as required

by the terms of the [employment] contract." Hunt, 852 F.2d at 787.

Here, Zandford's securities sales were incidental to his scheme to

defraud. Zandford's fraud lay in absconding with the proceeds of the

sales. The record contains no suggestion that the sales themselves

7

were conducted in anything other than a routine and customary fash-

ion.

It is the SEC's burden to identify a fraudulent act and a particular

sale of securities that would satisfy the in connection with require-

ment. This it has failed to do. Neither Zandford's inducements to

open the brokerage account, nor his failure to inform the Woods that

he intended to convert their assets, are sufficiently connected to a par-

ticular securities transaction. To take the opening of the account first,

there is no allegation that Zandford's inducements influenced any

investment decision by the Woods other than to initially open their

brokerage account. It is not even alleged that Zandford misled the

Woods about the relative merits or value of particular securities. See

Bochicchio v. Smith Barney, Harris Upham & Co., Inc. , 647 F. Supp.

1426, 1430 (S.D.N.Y. 1986) (holding that where the defendant prom-

ised to safely manage plaintiffs' investment account but later made

unauthorized sales of plaintiffs' securities and converted the proceeds,

the defendant's fraudulent activity was merely a conversion of funds

that did not satisfy the in connection with requirement); Bosio v. Nor-

bay Securities, Inc., 599 F. Supp. 1563, 1566-68 (E.D.N.Y. 1985)

(holding that where defendant promised to forward proceeds to plain-

tiffs after a stock sale but then misappropriated the proceeds, plain-

tiffs had stated a conversion claim, not a § 10(b) violation). Finally,

the SEC never contended either in briefing or argument that the

Woods' brokerage account was anything other than a discretionary

one, in which Zandford could trade securities without first having to

gain the Woods' approval.

Where, as here, the inducements to open an investment account did

not involve the sale or purchase of any security, any misrepresenta-

tions resemble more an actionable state law fraud than a federal

securities violation. Zandford's statements did not make any reference

to the attributes of a specific security. As such, they are little different

from fraudulent misstatements made, for example, in the process of

securing a personal loan. The mere "intent to cause a conversion of

ownership interests at some uncertain future time and through uncer-

tain means does not bring federal law into play, even though that

intent is held at the time a purchase or sale of securities occurs."

Pross v. Katz, 784 F.2d 455, 459 (2d Cir. 1986); see also Head v.

Head, 759 F.2d 1172, 1175-76 (4th Cir. 1985) (holding that in order

8

to satisfy the in connection with requirement, the fraud must relate to

the securities alleged to satisfy the purchase and sale requirement, and

not just to the transaction in its entirety); Chemical Bank v. Arthur

Andersen & Co., 726 F.2d 930, 943 (2d Cir. 1984) (same).

The SEC next contends that the federal securities fraud laws apply

to Zandford's misappropriation of the proceeds in the Woods'

account. The SEC has advanced but one case in which a court has

held that a broker who sells securities and misappropriates the pro-

ceeds has violated the federal securities laws, and that decision pro-

vides no analysis to support its holding. See Henricksen v.

Henricksen, 486 F. Supp. 622, 629 (E.D. Wis. 1980). The SEC relies

instead on United States v. O'Hagan, 521 U.S. 642 (1997), to support

its broad interpretation of the in connection with requirement. Specifi-

cally, the SEC argues that O'Hagan held that a defendant's misrepre-

sentations do not have to induce investors to engage in a particular

securities transaction in order to violate the federal securities laws.

We do not think, however, that O'Hagan controls this case. While

O'Hagan certainly expanded the scope of the in connection with

requirement, it did so in a specific context -- namely, in those cases

where someone traded securities based upon misappropriated confi-

dential information. O'Hagan held that an attorney committed fraud

in connection with a securities transaction when he misappropriated

inside information from his client in order to engage in securities

transactions based on this inside information. O'Hagan, 521 U.S. at

659. Important to the Supreme Court's decision was the fact that the

misappropriated confidential information had independent value to

the client. Id. at 652, 656. The defendant's actions limited the client's

opportunity to profit from this information. By contrast, in this case,

the Woods did not possess any inside information which would allow

them to earn profits in the securities markets.

O'Hagan in fact took pains to limit the extent to which it expanded

the scope of the in connection with requirement. It did not graft a gen-

eralized prohibition against breaches of fiduciary duty onto the securi-

ties laws. See O'Hagan, 521 U.S. at 655. The Court also noted, with

apparent approval, the government's contention that§ 10(b) would

not apply to a case in which a person defrauded a bank into giving

him a loan or embezzled cash from another, and then used the pro-

9

ceeds of the misdeed to purchase securities. Id. at 656-57. There

would be no violation in such a case because the embezzled proceeds

"would have value to the malefactor apart from their use in a securi-

ties transaction, and the fraud would be complete as soon as the

money was obtained." Id. (internal citations omitted). The same logic

applies to Zandford's fraudulent conduct. Unlike the defendant in

O'Hagan, Zandford's goal was not to gain guaranteed profits through

the purchase or sale of securities. Rather, his scheme was simply to

steal the Woods' assets. Id. at 656. Like the money an embezzler

would use to buy securities, the money in the Woods' account had

"value to [Zandford] apart from [its] use in a securities transaction."

Id.

The question is not how Zandford stole the money in the Woods'

account. Rather it is whether Zandford engaged in manipulation of a

particular security. Zandford's wrongdoing reflects less a federal

securities violation and more a state law tort of conversion. The mis-

appropriated proceeds might as well have come from the unlawful

sale of a car which the Woods had entrusted to Zandford's care.

The other cases upon which the SEC relies serve to underscore our

point. In each of these cases, the defendants made misrepresentations

about a particular security that induced another party either to pur-

chase or sell that security. For instance, in United States v. Naftalin,

441 U.S. 768 (1979), Naftalin's securities brokers sold particular

securities based on Naftalin's false statements that he owned shares

of those securities. Likewise, in Superintendent of Insurance v. Bank-

ers Life & Cas. Co., 404 U.S. 6, 9 (1971), the defendants, in order to

induce a company's Board of Directors to sell certain bonds, falsely

told the Board that the company would receive the proceeds of the

sale. In SEC v. Jakubowski, 150 F.3d 675 (7th Cir. 1998), Jakubowski

made false statements on a stock subscription form in order to induce

an issuer of securities to accept Jakubowski's offer to buy them. Id.

at 679. Finally, in Press v. Chemical Inv. Servs. Corp., 166 F.3d 529,

533 (2d Cir. 1999), the defendants failed to disclose that the funds

from a maturing T-bill would not be available on a particular maturity

date. This omission meant that the defendants had misrepresented the

security's yield, which had affected the plaintiff's decision to pur-

chase the particular security. In contrast to each of these cases, Zand-

ford's statements or omissions were not about a particular security.

10

Nor did his omissions induce the Woods or anyone else to buy or sell

a particular stock.

We do not, of course, condone Zandford's misconduct. For his

transgressions, Zandford was criminally convicted and he doubtless

faces other forms of civil liability and professional sanctions. The fact

that Zandford's actions were reprehensible, however, does not relieve

us of the obligation to determine whether his conversion of the

Woods' assets violated the federal securities laws. We hold that Zand-

ford's alleged fraudulent activities were not sufficiently connected to

a securities transaction to merit liability under sections 17(a) and

10(b), and Rule 10b-5. Rather, the "only connection with federal

securities laws is that the funds were converted from a securities

investment account." Smith v. Chicago Corp. , 566 F. Supp. 66, 70

(N.D. Ill. 1983). The fact that Zandford's conduct as a broker may be

within the scope of the securities statutes does not mean that his activ-

ities here necessarily constituted fraud in connection with a securities

transaction. And while Zandford breached a fiduciary duty to the

Woods, the Supreme Court has emphasized that the federal securities

laws are not an open-ended breach of fiduciary duty ban. See

O'Hagan, 521 U.S. at 655 (citing Santa Fe Industries, Inc. v. Green,

430 U.S. 462 (1977)). In sum, we decline to stretch the language of

the securities fraud provisions to encompass every conversion or theft

that happens to involve securities. See Pross , 784 F.2d at 459. This

would be tantamount to endorsing an all-purpose expansion of those

statutes which would violate Congress' intent and subsume significant

areas of state law.

IV.

For the foregoing reasons, the judgment of the district court is

reversed, and the case is remanded with directions to dismiss it.

REVERSED AND REMANDED

11