Fed. Sec. L. Rep. P 92,710 Stanley S. Pearlstein v. Scudder & German, a Partnership

FRIENDLY, Circuit Judge

(dissenting) :

This case illustrates the need for putting some brakes on the onrush of civil obligation for violation of the securities laws if that doctrine is to be an instrument of justice rather than the opposite. With all respect, the scholarly opinion of my brother Waterman seems to me to reach a conclusion that shocks the conscience and wars with common sense. Apart from the unfairness of the result on the facts of this case, press reports of “backroom troubles” of many brokerage houses and the sharp decline in security prices could give the decision far-reaching consequences.

Although the opinion’s statement of facts is accurate as far as it goes, a somewhat fuller narrative is needed to place the matter in proper setting: Plaintiff Pearlstein was a practicing lawyer from 1936 to 1953. Since 1956, his time has been spent in investment activity and unsuccessful attempts at free-lance writing. Before opening an account with Scudder & German on February 20, 1961, he had accounts with four other brokerage firms and had engaged in extensive convertible bond transactions. He financed these by having the broker arrange bank loans for a large portion of the cost, as the law then permitted. 1 The convertible bonds were pledged as collateral, and Pearlstein paid cash for the balance.

Pearlstein’s first transactions with Scudder & German were carried out in accordance with this practice and with applicable regulations. On February 20, 1961, he purchased 20 Richfield convertible bonds and 20 Phillips Petroleum convertible bonds for $52,509, borrowed $42,000 on them as collateral, and paid the balance of $10,509 on February 27, 1961, the settlement date. On March 6, he sold the Phillips convertibles for $24,599. He used $20,000 of this to reduce the bank loan and obtain the Phillips bonds and left the balance in his account.

On the same day Pearlstein purchased $50,000 principal amount of Lionel convertible bonds for $59,625. While there is a dispute whether defendant recom *1146 mended against the purchase, Pearlstein does not maintain that the broker encouraged it in any way. A $48,000 bank loan was arranged, and plaintiff was obligated to pay the additional $7027 above the balance in his account by March 10. The next day, March 7, he informed defendant that he wanted to purchase $100,000 of American Machine & Foundry convertibles on a when-issued basis. Defendant not merely recommended against this but reinforced its advice by telling Pearlstein it was selling the bonds short. When Pearlstein insisted on going forward, he agreed that defendant would make a short sale to him at the price next recorded on the ticker, viz., 150. At his request defendant investigated bank financing and told him this could be procured to the extent of 80%. The difference would have to be paid when the bonds were issued, to wit, March 23, if Pearlstein had not sold them by that time.

On March 8, Pearlstein advised defendant that he was being hospitalized for an operation. Scudder testified that he advised Pearlstein to sell his securities, which could have been done at a profit, and avoid concern. Pearlstein declined, and entered the hospital that afternoon. Next day, from the hospital, he ordered defendant to sell 50 of the AMF bonds at 155, but that price could not be obtained. He left the hospital on March 31 but on April 9 was brought back on an emergency basis. He underwent operations on April 10, 13 and 20, and was in danger of losing his leg and, indeed, his life. He was not discharged until June 10. Meanwhile the date fixed by Regulation T for payment of the Lionel bonds occurred on March 15 and that for payment of the AMF bonds on April 4.

Defendant did what it could to obtain payment, short of closing out the transactions, which it had every reason to think the sick man did not want. On April 5 it received payment of $48,000 from a bank on account of the Lionel bonds and delivered them as collateral. Unable to communicate directly with Pearlstein, it called Earle, his customer’s man at Dean Witter & Co., where he had his chief stock account, and his mother and sister. Earle promised payment several times but this never materialized; he conveyed no suggestion that Pearlstein wished the bonds to be sold. 2 During May, Earle obtained Pearlstein’s signature in the hospital to a $110,000 note for the AMF bonds. However, as a result of Pearlstein’s failure to pay the balance of $40,083, this was not consummated. On two occasions during May defendant wrote letters demanding payment on the AMF bonds. There being no response, it placed the collection in the hands of counsel. On plaintiff’s discharge from the hospital, he obtained legal advice and consulted the SEC, the New York Stock Exchange, and the NASD. After this he voluntarily entered into the settlements outlined by my brother Waterman. At no time did he indicate any desire that defendants sell the bonds — indeed, he specifically requested additional time to pay his debts. He now asks that, because of defendant’s having indulged his desire to retain his securities, it should pay him for the depreciation of the AMF bonds until their sale in May 1962 and of the Lionel bonds until their sale in April 1963, in a total amount of $85,466, plus many years interest. 3

*1147 It is common ground that defendant violated § 7(c) and Regulation T and thereby subjected itself to the possibility of discipline and even of criminal penalties, although those in charge of such matters evidently decided against doing anything. I recognize also that violations of these provisions may give rise to civil liability in appropriate cases, under any of several theories. See 5 Loss, Securities Regulation 3299-304 (1969). But this is not an appropriate case.

Regardless of the theory under which it is sought to establish civil liability, ¡ the starting point for discussion is j whether imposition of such liability will ' further the purposes behind the statute and the regulation. It is thus desirable to begin by examining just what the purposes of § 7(c) were.

The legislative history of that section 4 affords scant evidence that protection of the investor loomed at all large in the Congressional mind. Although passages in the Senate hearings and a later Senate report indicate that an important purpose of the Senate Bill was “to protect the margin purchaser by making it impossible for him to buy securities on too thin a margin,” the upper house was considering a bill that placed the administration of the credit requirements in the same agency, then the Federal Trade Commission, that was to enforce the rest of the Securities Exchange Act. The change, initiated by the House of Representatives and concurred in by the Senate, whereby determination of allowable credit was placed in the Federal Reserve Board, has been said to demonstrate “that concern for the investor was wholly subordinated to the achievement of macro-economic objectives.” 5 In fact, the report of the House Committee, H.R.Rep.No.1383, 73d Cong., 2d Sess. 8 (1934), stated:

The main purpose of these margin provisions * * * is not to increase the safety of security loans for lenders. Banks and brokers normally require sufficient collateral to make themselves safe without the help of law. Nor is the main purpose even protection of the small speculator by making it impossible for him to spread himself too thinly — although such a result will be achieved as a byproduct of the main purpose.

The main purpose is to give a Government credit agency an effective method of reducing the aggregate amount of the nation’s credit resources which can be directed by speculation into the stock market and out of other more desirable uses of commerce and industry- — to prevent a recurrence of the pre-cash situation where funds which would otherwise have been available at normal interest rates for uses of local commerce, industry and agriculture, were drained by far higher rates into security loans and the New York call market.

While it thus may be wrong to say that concern for the investor was “wholly subordinated” to the effect of excessive credit on the economy, the history surely does not indicate a Congressional desire that the courts should engage in an all-out effort to utilize § 7(c) to protect investors against themselves, no matter how offensive the result. 6

With deference to my brother Waterman’s contrary view, I doubt whether permitting the customer to shift the risk of market decline to the broker is generally either necessary or desirable as a means of furthering the primary purpose of § 7(c). Occasional and isolated violations of Regulation T do not threaten to cause a significant alteration in the allocation of credit in the economy; *1148 only widespread or repeated violations would pose a danger. But it is in just such situations that we may confidently expect application of the administrative and criminal sanctions provided by the Act. The economic purpose behind § 7(c) thus causes the provision to differ from those portions of the securities acts more directly aimed at protection of investors. With misleading proxy statements, for instance, one violation does threaten the purpose of the Act pro tan-to, and since the SEC cannot catch all such violations before the fact, a privately imposed sanction, whether before or after, is appropriate. See J. I. Case Co. v. Borak, 377 U.S. 426, 431-435 , 84 S.Ct. 1555 , 12 L.Ed.2d 423 (1964); Mills v. Electric Auto-Lite Co., 396 U.S. 375, 381-385 , 90 S.Ct. 616 , 24 L.Ed.2d 593 (1970). So also in regard to alleged derelictions by directors of investment companies, Brown v. Bullock, 294 F.2d 415 (2 Cir. 1961), and still more obviously with respect to the anti-fraud provisions of the securities laws.

Even assuming that the purpose of § 7(c) would be served by a degree of private enforcement, I question whether the majority’s free-wheeling approach will have the desired effect. As a result of it, speculators will be in a position to place all the risk of market fluctuations on their brokers, if only the customer’s persuasion or the broker’s negligence causes the latter to fail in carrying out Regulation T to the letter. Any deterrent effect of threatened liability on the broker may well be more than offset by the inducement to violations inherent in the prospect of a free ride for the customer who, under the majority’s view, is placed in the enviable position of “heads-I-win tails-you-lose.” 7 For these reasons, and for those given in Judge Graven’s opinion in Serzysko v. Chase Manhattan Bank, 290 F.Supp. 74 (S.D. N.Y.1968), which we affirmed “in all respects,” 409 F.2d 1360 , cert. denied, 396 U.S. 904 , 90 S.Ct. 218 , 24 L.Ed.2d 180 (1969), I would not find the decision under the anti-trust laws in Perma Life Mufflers, Inc. v. International Parts Corp., 392 U.S. 134 , 88 S.Ct. 1981 , 20 L. Ed.2d 982 (1968), to be truly pertinent even if there had been more of a consensus among the Justices than there was.

The majority’s reason for imposing civil liability thus fails, and I see no other supporting rationale to sustain the result reached in this case. To be sure, it may be proper in some instances to impose civil liability in furtherance of the subsidiary purpose of § 7(c), protection of the innocent “lamb” attracted to speculation by the possibility of large profits with low capital investment. That was the situation envisioned in the dictum in Smith v. Baer, 237 F.2d 79 , 87-88 (2 Cir. 1956), see also Junger v. Hertz, Neumark & Warner, 426 F.2d 805 (2 Cir. 1970), both affirming judgments for the defendants. 8 Pearlstein, an experienced speculator, was no lamb, and the trial judge specifically found that he was not induced to enter into the transactions by any expectation that defendant would be slow in selling him out if he were to default in payment.

A view similar to that advocated in this opinion was taken in Serzysko v. Chase Manhattan Bank, 290 F.Supp. 74, 88-90 (S.D.N.Y.1968), aff’d mem., 409 F.2d 1360 (2 Cir.), cert. denied, 396 U.S. 904 , 90 S.Ct. 218 (1969), which the majority cites as somehow opposing recognition of the plaintiff’s fault as a defense in cases of this sort, and in Judge Bartels’ thoughtful opinion in Moscarelli v. Stamm, 288 F.Supp. 453, 458-460 (E.D. *1149 N.Y.1968), also cited by the majority, fn. 7. I would follow the lead of these cases and deny recovery on the theory of an implied cause of action.

Although the majority does not reach the issue, I would reach the same result if liability were here sought to be justified under § 29(b) of the Securities Exchange Act. That section provides in pertinent part that “Every contract made in violation of any provision of this title or of any rule or regulation thereunder, and every contract * * * the performance of which involves the violation of, or the continuance of any relationship in violation of, any provision of this title or any rule or regulation thereunder, shall be void * * as regards the rights of violators. Here the contract was not in violation of any provision of the statute or any rule or regulation; its performance would not have involved any violation if Pearlstein had done as he was obligated; and the court is not here asked to enforce anything that constitutes a violation. Contrast Kaiser-Frazer Corp. v. Otis & Co., 195 F.2d 838 (2 Cir.), cert. denied, 344 U.S. 856 , 73 S.Ct. 89 , 97 L.Ed. 664 (1962). Despite the Draconian language, § 29(b) does not provide a pat legislative formula for solving every case in which a contract and a violation concur. Rather it was a legislative direction to apply common-law principles of illegal bargain, enacted at a time when it seemed much more likely than it might now that courts would fail to do this without explicit legislative instruction. See D. R. Wilder Manufacturing Co. v. Corn Products Refining Co., 236 U.S. 165, 174-175 , 35 S.Ct. 398 , 59 L.Ed. 520 (1915). There has been a conspicuous lack of judicial enthusiasm for the doctrine thus incorporated when there has been performance by the violator; the reasons are clearly set forth in Bruce’s Juices, Inc. v. American Can Co., 330 U.S. 743, 752-757 , 67 S.Ct. 1015 , 91 L.Ed. 1219 (1947), and Kelly v. Kosuga, 358 U.S. 516, 519-521 , 79 S.Ct. 429 , 3 L.Ed.2d 475 (1959).

Pearlstein’s claim for restitution based on § 29(b) is, if anything, even less attractive. Courts cannot recall too often Lord Mansfield’s observation that the action for money had and received “is the most favourable way in which he [the defendant] can be sued” since he “may defend himself by every thing which shews that the plaintiff, ex aequo & bono, is not entitled to the whole of his demand, or to any part of it.” Moses v. Macferlan, 2 Burr, 1005, 1010, 97 Eng.Rep. 676, 679 (K.B. 1760). Equity and justice are qualities that Pearl-stein’s claim conspicuously lacks. He Bought the bonds against defendant’s advice, refused to sell them on its urging, remained silent when defendant was pressing for payment, and settled his liability after having had legal advice. Equity would leave the loss where it lies.

I would therefore affirm the judgment dismissing the complaint, without reaching the grounds relied on by the district court.

. The majority’s suggestion, not advanced by the plaintiff, that in 1961 a broker could not legitimately arrange a bank loan for more than 30% of the value of securities ignores the fact that a broker arranging for a bank subject to Regulation U to extend credit on registered securities is not limited by the conditions on which he himself could make the loan. 12 C.F.R. § 221.3 (t), 33 Fed.Reg. 2705 (1968). The margin requirements of Regulation U applied to loans on convertible bonds only after the conversion privilege had been exercised. See 24 Fed. Reg. 3867 -68 (1959). No doubt it was this very liberality that attracted Pearl-stein, as it did many others, to speculation in convertible bonds.

. Pearlstein admitted that on March 17 Earle informed him of defendant’s recommendation for sale. The Lionel bonds could then have been sold at a profit. The AMF bonds ranged between a high of 150 and a-low of 147%. Pearlstein could have sold the Lionel bonds at a profit until .mid-June; the AMF bonds again sold over 150 on seven trading days in April.

. Although the majority leaves open whether defendant’s liability for depreciation of the bonds may have ended at an earlier date, it suggests no principle to aid the district court in making this determination. At the very least it should be made clear that defendant has no liability for depreciation of the Lionel bonds after it had been fully paid. In saying this I do not mean to imply that an ear *1147 lier eut-off might not be appropriate even on the majority’s view.

. A helpful Note, Federal Margin Requirements as a Basis for Civil Liability, 66 Colum.L.Rev. 1462, 1467-71 (1966), gives the references for the developments cited in the following discussion.

. Id. at 1469.

. The dominating fiscal purpose of § 7(c) is further shown by a ruling of the Federal Reserve Board that the creditor may not accept payment even if this is tendered promptly after the 7-day period. 1940 Fed.Res.Bull. 773.

. See Comment, Securities Exchange Act of 1934 — Civil Remedies Based upon Illegal Extension of Credit in Violation of Regulation T, 64 Mich.L.Rev. 940, 953-55 (1963).

. As Professor Loss has observed, many of the nisi prius decisions relied on by the plaintiff and the majority have simply refused to dismiss a complaint containing adequate allegations of causation and have postponed that issue until trial. 5 Securities Regulation 3308 (1969). There have been few appellate decisions, indeed none that is in any way controlling here.