Opposition — John Nuveen & Co. v. Sanders

fem LDICHAEL KODAK, JR

Supreme Court of the United States

OCTOBER TERM, 1975.

No. 75-1065

JOHN NUVEEN & CO., INC., 4 Corporation, INVESTORS

SYNDICATE OF AMERICA, INC., a CORPORATION, AND

INVESTORS DIVERSIFIED SERVICES, INC., A

ORPORATION, -

CORPORAT! Petitioners,

VS.

HENRY T. SANDERS,

Respondent.

ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED

STATES COURT OF APPEALS FOR THE SEVENTH CIRCUIT.

BRIEF FOR RESPONDENT IN OPPOSITION.

RICHARD ORLIKOFF,

208 South LaSalle Street,

Chicago, Illinois 60604,

Attorney for Respondent.

JOsEPH O. KosTNER,

JOHN N. TIERNEY,

RoBERT J. PETERS,

SALVATORE A. BARBATANO,

ETTELSON & O’HAGAN,

Of Counsel.

Gunthorp-Warren Printing Company. Chicago e« Financial 66565

TABLE OF CONTENTS.

PAGE

IG Gio, cove ae Cer |

PGS uchau Gis eduuendudauan budbeeedarelk l

Questions Presented... 0... ccc cece cece, 2

Statutes and Rules Involved......................... 2

Statement of the Case... 0.0... ccc ene 3

Reasons for Denying the Petition.................... 5

I. It Is Settled Law That Non-Prime, Short-Term

Notes Sold to the Public for Investment Purposes

Are Securities Subject to the Federal Securities

Ml BAdehé phatudnkieedheeddcuaiked dee. 5

Il. The Decision Below Properly Holds Petitioners

Liable for Nuveen’s Failure to Make a Reason-

able Investigation of Winter & Hirsch, Inc..... 8

III. Issues of Scienter and Negligence Are Irrelevant

to the Standard of Liability Employed by the

We ET ce vaci ae uuie cu ceeduuecuncec., 13

IV. The Decision Below Does Not Enlarge the Statu-

tory Duties of an Underwriter............... 14

V. The Decision Sought to Be Reviewed May Be

Sustained on Several Grounds Not Reached by

the Court of Appeals...................... 15

A. The Lieber, Bleiweis Audit of Winter &

Hirsch, Inc. Was Uncertified, or at Best

Qualified in Such Manner That Nuveen

Could Not Reasonably Have Relied on It.. 15

B. Petitioners Are Liable to Respondent and

the Class Represented by Respondent for

Nuveen’s Failure to Comply with Rule 27

of the National Association of Securities

Nase h abu oe 8 eoeldaneblne.. 16

‘3

C. Nuveen Misrepresented WH Commercial

Paper and Omitted to State Material Facts

Necessary to Make the Statements Made Not

Misleading in Violation of Section 12(2)

of the 1933 Act, Section 10(b) of the

1934 Act, and Rule 10b-5............. 17

I 2 no an ae coe Ee ne A 18

SN oud Shc ebeee ae cadetendeéucseeckeeeees Al-A3

TABLE OF AUTHORITIES.

Cases.

Affiliated Ute Citizens v. U. S., 406 U. S. 128 (1972),

reh. denied, 407 U. S. 916, 408 U. S. 931 (1972).... 16

Anderson v. Francis I. duPont & Co., 291 F. Supp. 705

i en PL cc. beeen iaeeskeaanbadhecee s 6

Bellah v. First National Bank, 495 F. 2d 1109 (Sth Cir.

eT Te Ee ee oe ee re rr Te 7

Blue Chip Stamps v. Manor Drug Stores, 421 U. S. 723

Tt Lcclciihseaeteneeebaaks eee ew oak ae ca 10-12

C. N. S. Enterprises. Inc. v. G. & G. Enterprises, Inc., 508

F. 2d 1354 (7th Cir. 1975), cert. denied, 96 S. Ct.

I ie ie ae ale a ee 6,7

Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480

F. 2d 341 (2d Cir. 1973), cert. denied, 414 U. S. 910

er ne 12, 14

City National Bank of Fort Smith, Ark. v. Vanderboom,

290 F. Supp. 592 (W. D. Ark. 1968), aff'd, 422 F. 2d

221 (8th Cir. 1970), cert. denied, 399 U.$.905 (1970) 6

Cohen v. Franchard Corp., 478 F. 2d 115 (2d Cir. 1973),

cert. denied, 414 U. S. 857 (1973)................ 13

Ernst & Ernst v. Hochfelder, 503 F. 24 1100 (7th Cir.

1974), cert. granted, 421 U. §. 909 (1975)........ 13,14

ili

Escott v. BarChris Construction Corp., 283 F. Supp. 643

Se Wi IG ood onde ue due neeeskebaasdanae 14

Feit v. Leasco Data Processing Equipment Corp., 332

SO SD OS A) ere 14

Foremost-McKesson, Inc. v. Provident Securities Co., ....

U.S. ......, 44 U. S. L. W. 4056 (Jan. 13, 1976)..... 12

Franklin Savings Bank, The v. Levy, CCH Sec. L. Rep.

€ 95,389 (Current Binder) (S. D. N. Y. 12/29/75)... 6

Globus v. Law Research Service, Inc., 418 F. 2d 1276 (2d

Cir. 1969), cert. denied, 397 U. S. 913 (1970)..... 13

Jaffke v. Dunham, 352 U. S. 280 (1957)............ 15

Johns Hopkins University v. Hutton, 326 F. Supp. 250

(D. Md. 1971), aff'd in part, rev'd in part, 488 F. 2d

912 (4th Cir. 1973), cert. denied, 416 U.S.916 (1974) 13

Joseph v. Norman’s Health Club, 336 F. Supp. 307 (E. D.

Pr ae ee

Lino v. City Investing, 487 F. 2d 689 (3d Cir. 1973)... 7

McClure v. First National Bank, 497 F. 2d 490 (Sth Cir.

1974), cert. denied, 420 U. S. 930 (1975)......... 7

Rochez Bros, Inc. v. Rhoades, 491 F. 2d 402 (3d Cir.

WE 4600664 s cena ew eae ab eecaeencene 13

SEC v. Capital Gains Research Bureau, Inc., 375 U. S. 180

SE SatuSCWEs ses eekebbhabccoetnekasllaee, 7,9, 10

SEC v. C. M. Joiner Leasing Corp., 320 U. S. 344 (1943) 7

SEC v. Continental Commodities Corp., 497 F. 2d 516

Ss DUO hoe eeee ke ucveuusckebakesoucdwes 6

SEC v. First Securities Company of Chicago, 463 F. 2d

981 (7th Cir. 1972), cert. denied sub nom. McKy v.

Hochfelder, 409 U. S. 880 (1972)..............24, 16

SEC v. Goldman Sachs & Co., CCH Fed. Sec. L. Rep.

i earee Ge. GA OF. H. BORED. gc ccccccccccccccces 8

iv

SEC v. W. J. Howey Co. 328 U. S. 293 (1946)........ 7

Shapiro v. Merrill Lynch, 495 F. 2d 228 (2d Cir. 1974).. 13

Smith v. Manausa, 385 F. Supp. 443 (E. D. Ky. 1974)...

Tcherepnin v. Knight, 389 U. S. 332 (1967).......... 7

Tomera v. Galt, 511 F. 2d 504 (7th Cir. 1975)........ 13

United Housing Foundation, Inc. v. Forman, ...... U. S.

iwi p We We GR BUme CIRO vc cccisiccdcccccese 9

United States v. Hill, 298 F. Supp. 1221 (D. Conn. 1969)

Welch v. Goldman, Sachs & Co., 398 ©. Supp. 1393 (S. D.

Pe ee DD boa 6065 Whneebedseebbendeesncs 6

Zabriskie v. Lewis, 507 F. 2d 546 (10th Cir. 1974)..... 6

Zeller v. Bogue Electric Manufacturing Corp., 476 F. 2d

795 (2d Cir. 1973), cert. denied, 414 U. S. 908 (1973) 6

Statutes and Rules.

Securities Act of 1933

Section 11, 15 U.S.C. § 77k................... 9

Section 12(2), 15 U. S.C. § 771(2)............. 2,17

Securities Exchange Act of 1934

Section 3(a)(10), 15 U. S.C. § 78c(a)(10)...... 5

Section 10(b), 15 U. S. C. § 78j(b)...2, 5,9, 11, 12,17

Section 14, 15 U. S.C. § 78n................... 12

Section ISA, 15 U. S. C. § 780-3................ 16

Section 16(b), 15 U. $.C. 8 a 12

Title 28, United States Code \.

Se accu oie ee ee 5

General Rules and Regulations under the Securities Ex-

change Act of 1934

Rule 10b-5, 17 CFR 240.10b-5....... 2, 5, 8, 10-13, 17

National Association of Securities Dealers, Inc., Rules of

Fair Practice, Article II], Rule 27................. 2, 16

Miscellaneous.

American Automobile Insurance Brokers, Inc., Avail.

DUT ac he lueiee nn vie uheeuecesdscakesetaucs

American Automobile Insurance Brok<ys, Inc., Avail.

SPU Abb Oedeh ce eebeeunabd yoke déshaceecus

Central Service Corp., Avail. 7/16/73, 1973 CCH Sec.

er er eee

Forbes Magazine, “Heavy, Heavy... .”, 8/15/71, p. 21..

Lipton and Katz, “ ‘Notes’ Are Not Always Securities”,

30 Bus. Lawyer 763 ef seq. oS -

Neil Stephens Associates, Inc., Avail. gS

New York Times

“Bancorp on Coast Reveals Problems”, 12/31/73,

i SN Ks bene 64-54 bewedunséecuesiccan

“Financial Collapse and Human Tragedy Stalk Mill

Factors”, 4/23/69, p. 71, col. l..............

re Franklin N. Y. Corporation, 1/13/75, p. 44,

Gy HPSS ONGNNG E4066 060550006000 045 eK edae

“Pioneer Finance; ‘Tight Money’ Claims a Casualty”,

Peete ee Oh Ge Ge Be coc vecccscccsvccccces

“Report on Atlantic Acceptance Urges Sweeping Rule

Changes”, 12/12/69, p. 89, col. 5

Note, The Commercial Paper Market and the Securities

Act, 39 U. Chi. L. Rev. 362 (1972).............

P. L. I. Securities Law Institute—II, The Review of Securi-

ties Regulation 975-77 (V. 7, No. 3, Feb. 6, 1974)...

Real-Tex Enterprises, Inc., Avail. 5/15/72, 1972-73 CCH

UB. Be GOB. FPO BED. 00 ec cccccccccccccccececee.

Staff Report of the SEC to the Special Subcommittee on

Investigations, Committee on Interstate and Foreign

Commerce, The Financial Collapse of the Penn Central

Company (August, 1972)

10

11

10

11

10

10

11

14

IN THB

Supreme Court of the United States

OCTOBER TERM, 1975.

No. 75-1065.

JOHN NUVEEN & CO., INC., A Corporation, INVESTORS

SYNDICATE OF AMERICA, INC., a CorPorATION, AND

INVESTORS DIVERSIFIED SERVICES, INC. A

CORPORATION, ~

Petitioners,

vs.

HENRY T. SANDERS,

Respondent.

ON PETITION FOR A WRIT OF CERTIORARI TO THE UNITED

STATES COURT OF APPEALS FOR THE SEVENTH CIRCUIT.

BRIEF FOR RESPONDENT IN OPPOSITION.

Respondent respectfully submits that the Petition for a Writ

of Certiorari should be denied since the decision below does

not conflict with decisions of this Court, there is no conflict

of decisions among the Circuit Courts of Appeals on any issue

decided by the Court below, and the decision below is correct.

OPINIONS BELOW.

The opinions and orders below are described in the Petition,

and are reprinted in the Appendix to the Petition.

JURISDICTION.

The jurisdictional requisites are adequately set forth in the

Petition.

QUESTIONS PRESENTED.

1. Are non-prime, short-term notes sold in small denomina-

tions to the public for investment purposes subject to the pro-

visions of the Securities Exchange Act of 1934?

2. Is an underwriter and exclusive seller of non-prime, short-

term notes sold to the public in small denominations and sub-

sequently dishonored liable to purchasers to whom the under-

writer sold the notes for failure to make a reasonable investiga-

tion of the issuer?

3. May an underwriter of the sale of securities subject to

the Federal Securities Acts reasonably and properly rely upon

financial statements of the issuer made by auditors whom the

underwriter does not know, has never met, and does not meet,

and where the underwriter has not examined any corporate

records, contracts or income tax returns of the issuer?

4. May an underwriter reasonably and properly rely on

financial statements of an issuer of securities when the auditor

expressly states that its opinion is based upon comments which

show serious deficiencies in the auditor’s examination of the

issuer?

5. Is an underwriter-dealer in short-term notes liabie under

§ 12(2) of the Securities Act of 1933 and § 10(b) of the

Securities Exchange Act of 1934 and Rule 10b-5 thereunder

to its purchasers for failing to state to the purchasers that the

notes bear an inferior credit rating and for making misrepre-

sentations of material facts concerning the notes?

STATUTES AND RULES INVOLVED.

The statutes and rules involved are set forth in the Petition,

p. 3, and in the Appendix to the Petition, A. 69-77, with the

exception of Rule 27 of Article III of the Rules of Fair Practice

of the National Association of Securities Dealers, Inc.. which

is set forth in the Appendix hereto, Al.

STATEMENT OF THE CASE.

The facts in this case are set forth at length in the Findings

of Fact entered by the District Court. A. 20-40. Among the

salient facts not appearing in the Petition are the following.

Prior to acquisition of Ashwell & Company in September,

1968, John Nuveen & Co., Inc. (“Nuveen”) had never sold

short-term notes. From September 1, 1968 to February 10,

1970, Nuveen was the exclusive seller of notes issued by Winter

& Hirsch, Inc. (“WH”). From January 1, 1969 to the time

Nuveen ceased to sell WH notes it made approximately 275

sales of such securities with a face value of $9,305,500.

Nuveen made no examination or credit investigation of any

issuer prior to the time Nuveen commenced to sell the notes

of that issuer. None of the notes sold by Nuveen was rated

“Prime” by the National Credit Office (“NCO”). Nuveen had

no requirement that the financial statements of companies whose

notes it sold must be certified by a certified public accountant.

Nuveen’s personnel checked the credit of issuers of notes by

analyzing the financial statements sent to them by the issuers,

by reading NCO reports and by addressing credit inquiries to

banks. The replies from banks neither showed the financial

strength of an issuer, nor constituted a credit evaluation.

Nuveen never employed more than one credit investigator and

for various periods had no credit investigator in its commercial

paper department even though Nuveen sold notes issued by

40 to 50 different companies at any one time. At such times

the head of the commercial paper department assumed credit

checking duties. Nuveen’s last commercial paper department

head testified he was too busy to check credit.

One Nuveen credit investigator made on-site inspections of

issuers. In March, 1969 he made a one-day visit to the offices

of WH. He did not examine any internal control or accounting

records, or corporate records. He testified he “most likely did”

4

examine WH’s federal tax returns because it was his practice

to do so. The 1968 WH federal tax return showed a loss of

$955,000, while the 1968 audit report WH had sent to Nuveen

showed a profit of $499,119.09 before provisions of $244,000

for income taxes for the year. The beginning balance sheet on

the 1968 tax return did not agree with the ending balance sheet

on the 1967 return.

Nuveen had no written policies or directives with reference

to commercial paper.

In late December, 1969, the new head of Nuveen’s com-

mercial paper department had lunch with the President of WH,

noted that he looked ill, and ordered Nuveen’s credit investiga-

tor to do a credit report on WH. The investigator, who relied

solely on WH’s latest audit report, prepared a report in which

WH notes were rated “Desirable” rather than “Prime”, although

Nuveen had no system for rating commercial paper. Ten days

after that report the investigator sent credit inquiries on WH to

a dozen banks. Nearly a month after the credit report an ex-

ecutive of one of the banks telephoned the head of Nuveen’s

commercial paper department and gave him information which

led to the discovery by Nuveen that various banks had initiated

an investigation of WH in December, 1969, and that an in-

dependent audit of WH had been commenced in early January,

1970. Nuveen then suspended the sale of WH notes.

REASONS FOR DENYING THE PETITION.

I. It Is Settled Law That Non-Prime, Short-Term Notes Sold

To the Public for Investment Purposes Are Securities

Subject to the Federal Securities Acts.

Petitioners are attempting to obtain review not only of the

last decision in this case but also of an earlier decision that re-

sulted from certification of a controlling question of law by

the trial court.

In the earlier appeal it was held that the short-term notes

issued by WH and sold by Nuveen were securities subject to the

proscriptions of § 10(b) of the Securities Exchange Act of

1934, 15 U. S. C. § 78j(b), and Rule 10b-5, 17 CFR § 240.

10b-5. Sanders v. John Nuveen & Co., Inc., 463 F. 2d 1075

(7th Cir. 197°), cert. denied, 409 U. S. 1009 (1972). (Sanders

I, A. 49-62.) The question whether the notes here involved are

securities as defined in § 3(a)(10) of the Securities Exchange

Act of 1934, 15 U. S. C. § 78c(a)(10), was certified for im-

mediate appeal by the District Judge under 28 U. S. C. § 1292

(b) as “a controlling question of law” in order to “materially

advance the ultimate termination of the litigation.” A. 66. The

Court of Appeals accepted the interlocutory appeal and

answered the certified question affirmatively. This Court denied

certiorari and the case was remanded for trial. Voluminous dis-

covery was taken and after a full trial the District Court found

for respondent and the represented class. A. 20-48. On appeal

the judgment entered by the District Court was affirmed.

Sanders v. John Nuveen & Co., Inc., 524 F. 2d 1054 (7th Cir.

1975). (Sanders Il, A. 1-19.)

Although the Court of Appeals in Sanders I] refused the re-

quest of petitioners to reconsider its holding in Sanders | (A.

6, n. 8), petitioners argue here that the Court of Appeals

“reaffirmed its position after development of a complete record,”

and contend “the matter is now ripe for resolution by this Court.”

6

Petition, p. 9, f.n. Should this Court grant certiorari and reverse

Sanders I certification will have resulted in a large and wasteful

expenditure of time and energy by the judiciary and the litigants.

Sanders I was correctly decided and has been widely followed.

It is now settled law that the crucial distinction between notes

subject to the anti-fraud provisions of the securities acts and

those which are not is whether the transaction underlying the

issuance of the note has a commercial character or whether the

note was purchased for the purpose of investment. The date of

maturity of the note is not meaningful! to that distinction. While

Sanders I was not the first decision to enunciate the invest-

ment/commercial dichotomy in determining whether notes are

exempt securities," Sanders I has become the wellspring of a

fountain of decisions adopting and following that rationale.

Expressly following Sanders I are Zabriskie v. Lewis, 507 F. 2d

546 (10th Cir. 1974); SEC v. Continental Commodities Corp.

497 F. 2d 516 (Sth Cir. 1973); Zeller v. Bogue Electric Manu-

facturing Corp., 476, F. 2d 795 (2d Cir. 1973), cert. denied,

414 U. S. 908 (1973); and The Franklin Savings Bank v. Levy,

CCH Sec. L. Rep. 95,389, at p. 78,961 et seg. (Current

Binder) (S. D. N. Y. 12/29/75). See also Smith v. Manausa,

385 F. Supp. 443, 448 (E. D. Ky. 1974); and Welch v. Gold-

man, Sachs & Co., 398 F. Supp. 1393, 1396-8 (S. D. N. Y.

1974). In each of the foregoing cases the Court ruled that the

notes involved were investment securities. In numerous decisions

in which the Court ruled that notes were not investment securi-

ties and were exempt from the anti-fraud provisions of the 1934

Act, Sanders | is cited with approval, and the note involved is

analyzed in accordance with the Sanders I rationale. See C. N. S.

Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F, 2d 1354,

i. See Joseph v. Norman’s Health Club, 336 F. Supp. 307, 313

(E. D. Mo. 1971); United States v. Hill, 298 F. Supp. 1221, 1226-

1227 (D. Conn. 1969); Anderson v. Francis 1. duPont & Co., 291

F. Supp. 705, 707-709 (D. Minn. 1968); City National Bank of

Fort Smith, Ark. v. Vanderboom, 290 F. Supp. 592, 608 (W. D.

Ark. 1968), aff'd, 422 F. 2d 221 (8th Cir. 1970), cert. denied, 399

U. §. 905 (1970).

7

1356 et seq. (7th Cir. 1975), cert. denied 96 S. Ct. 38 (1975);

Bellah v. First National Bank, 495 F. 2d 1109, 1111 (Sth Cir.

1974); McClure v. First National Bank, 497 F. 2d 490, 493

(Sth Cir. 1974), cert. denied, 420 U. S. 930 (1975). See Lip-

ton and Katz, “ ‘Notes’ Are Not Always Securities,” 30 Bus.

Lawyer 763 et seq. (April, 1975), in which numerous District

Court decisions holding short-term notes to be either investment

or commercial securities are discussed. In Lino v. City Investing,

487 F. 2d 689 (3d Cir. 1973), the court analyzed notes issued

for the purpose of purchasing assets of a business as commercial

notes, rather than investment securities, and thus exempt from

the application of the federal securities acts.

The great majority of the decisions cited above, including

Sanders I, rely in great part upon the opinions of this Court

which call for a flexible and broad interpretation of the word

“security”, and emphasize that in this field form should be dis-

regarded for substance and economic reality. Tcherepnin v.

Knight, 389 U. S. 332 (1967); SEC v. Capital Gains Research

Bureau, Inc., 375 U. S. 180 (1963); SEC v. W. J. Howey Co.,

328 U. S. 293 (1946); SEC v. C. M. Joiner Leasing Corp.,

320 U. S. 344 (1943). This Court reaffirmed the principle of

liberal and sensible int pretation of the term “security” in

United Housing Foundation, Inc. v. Forman, ............ U.S. o00....,

95 S. Ct. 2051, 2058 et seg. (1975). In holding in Forman

that shares of stock in a nonprofit housing cooperative were not

“securities” within the purview of the 1933 and 1934 Acts, this

Court cited C. N. S., McClure and Lino, 95 S. Ct. at 2059, n.

13, in support of its determination that a literal approach to

the definition of “security” was improper.

The enormous amount of commercial paper outstanding re-

counted by petitioners in their ad terrorem argument, Petition,

11, points up the need for protection of the investing public in

the sale of “commercial paper”. Stocks and bonds are also sold

in great quantities. Nevertheless, both the securities industry and

the economy have prospered even though the sale of such secur-

ities has been subject to the restrictions of the federal securities

acts.

The decision petitioners here seek to review concerns only

notes issued in relatively small denominations and sold to the

public.* Presumably all such investment paper is now being

registered with the SEC before being sold to the public, and

the underwriters distributing and selling that paper are subject

to the absolute liability provisions of the 1933 Act, as well as

to the anti-fraud provisions of the 1933 and 1934 Acts.®

In the instant case it was clearly demonstrated in the record

that the notes issued by WH and sold by Nuveen were sold to

the public for investment purposes and were “securities” within

the application of Rule 10b-S.

II. The Decision Below Properly Holds Petitioners Liable

for Nuveen’s Failure to Make a Reasonable Investigation

of Winter & Hirsch, Inc.

While petitioners concede that Nuveen is an underwriter as

defined in the 1933 Act (assuming WH notes are ‘securities’ ),

they nevertheless argue that Nuveen should not be held to the

duties of an underwriter. Petition, 18, f.n. Petitioners and the

2. Thirty of the forty-three purchasers of notes dishonored by

WH and sold by Nuveen were individuals. They purchased in de-

nominations as low as $1,000.

3. The SEC has disapproved the sale of unregistered short-term

notes to the public in denominations as high as a minimum of

$10,000. Texas American Bancshares, Inc., letter available 9/3/74;

Central Service Corp., 1973 CCH Sec. L. Dec. ¢ 79,460. Sale of

short-term notes in lower minimum denominations without registra-

tion has been disapproved by the SEC. Real-Tex Enterprises, Inc.,

1972-73 CCH Sec. L. Dec. ¢ 78,813; Neil Stephens Associates,

Inc., letter available 1/9/74. Where notes in much larger denomina-

tions were advertised for sale to the public the SEC has disapproved

sale without registration. American Automobile Insurance Brokers,

Inc., letters available 7/19/74 and 6/24/74. The SEC has required

a dealer in commercial paper to determine whether the security

must be registered. SEC v. Goldman, Sachs & Co. (consent de-

cree arising out of sale of Penn Central notes), CCH Fed. Sec.

L. Rep. € 94,556 (S. D. N. Y. 1974).

9

amici curiae do not object, however, to being held to the stand-

ards of a broker-dealer.‘

Petitioners contend that because no registration statement was

filed covering the sale of the notes here at issue § 11 of the

1933 Act is inapplicable. The standard of duty of an under-

writer of securities is spelled out in § 11 of the 1933 Act, peti-

tioners’ argument continues, and therefore Nuveen cannot be

held to that standard in an action brought under § 10(b) of the

1934 Act.

The objective of judicial decision-making in the securities

field has been to effectuate the Congressional intent of protecting

the investing public. S$. E. C. v. Capital Gains Research Bureau,

Inc., 375 U. S. 180, 195 (1973). In light of that objective it

would be ironic if the underwriter could lessen his liabilities

under the securities acts by avoiding the duties imposed by

those acts. The decision of the Court below is based on testimony

that Nuveen sold short-term notes on the basis “that there

should be no question but what the paper will be paid at matur-

ity.” A. 2, 33. The sale of securities on that basis “enhanced the

importance of determining the basic integrity of the issuer’s

financial statements.” A. 9. The Court below properly imple-

mented the statutory structure of the securities acts by holding

that the distribution and sale of non-exempt securities by an

underwriter who fails to make a reasonable investigation of the

issuer is a “device, scheme or artifice to defraud,” or an “act,

practice or course of business which operates or would operate

as a fraud or deceit upon any person . . .”> Rule 10b-5.

4. The amici, apparently feeling themselves free of the positions

taken below by the parties, argue that the Court below erroneously

characterized Nuveen as an underwriter. On oral argument before

the Court of Appeals petitioners conceded that if the WH notes were

securities Nuveen was an underwriter. ~~: with the agree-

ment of petitioners, and by leave of the Court below, has caused

a portion of the oral argument below to be transcribed and trans-

mitted to this Court. The relevant colloquy is set forth in the

Appendix hereto, A2.

5. “Fraud” and “deceit” as used in § 10b and Rule 10b-5 are not

to be equated with the common-law cause of action for fraud, or

(Continued on next page)

10

The Court below looked to the entire statutory scheme and

the context of the transaction in weighing the proper application

of the 1934 Act. A. 9. In order for an underwriter to sell

notes on the basis that they will be paid when due, it must make

a reasonable investigation to determine whether the issuer's finan-

cial statements possess any integrity. The underwriter should at

least determine whether an audit in fact has been made. On

the other hand, in the context of the sale of short-term securities,

the validity of long-range projections and future business pros-

pects have little significance; the underwriter should not be

liable under Rule 10b-5 for a failure to investigate such pro-

jections and prospects.

Petitioners contend that if the burden of reasonable investiga-

tion of the issuer is placed upon underwriters of commercial

paper that financing instrument will be destroyed. Undoubtedly

many corporations, underwriters and broker-dealers flocked to

the short-term note in order to avoid the expense and burden

of registration with the SEC. And, as with other types of secur-

ities, numerous defalcations have occurred among issuers of

commercial paper.° However, the great bulk of commercial

(Continued from preceding page)

the classic tort of deceit. Blue Chip Stamps, et al. v. Manor Drug

Stores, 421 U. S. 723 (1975); SEC v. Capital Gains Research

Bureau, Inc., 375 U. S. 180, 194 (1963).

6. Among the companies that have dishonored their commercial

paper are the following. Atlantic Acceptance Corporation, Ltd.,

see “Report of Atlantic Acceptance Urges Sweeping Rule Changes”,

N. Y. Times, 12/12/69, p. 89, col. 5; Pioneer Finance Co. ($3 mil-

lion in commercial paper), see “Pioneer Finance; ‘Tight Money’

Claims A Casualty”, N. Y. Times 9/26/66, p. 63, col. 3; Mill

Factors Corporation ($6.7 millions of commercial paper) “Heavy,

Heavy . . .”, Forbes, 8/15/71”, p. 21, “Financial Collapse and Hu-

man Tragedy Stalk Mill Factors,” N. Y. Times 4/23/69, p. 71, col.

1; Penn Central Transportation Company ($85 million of commercial

paper), see Staff Report of the SEC to the Special Subcommittee

on Investigations, Committee on Interstate and Freight Commerce,

The Financial Collapse of the Penn Central Company (August,

1972); Beverly Hills Bancorporation ($13 millions of commercial

paper), see “Bancorp on Coast Reveals Problems”, N. Y. Times,

(Continued on next page)

il

paper is prime paper eligible for discount with the Federal

Reserve Bank and is exempt both from the registration and

anti-fraud provisions of the 1933 and 1934 Acts. Non-prime

commercial paper sold to the public in small denominations

through underwriters and dealers on an investment basis is not

and should not be exempt from either the registration or anti-

fraud provisions. The need of the public for protection from

fraud in the sale of such paper is not less than the need for

such protection in the sale and distribution to the public of any

other type of security. The burgeoning of the market for com-

mercial paper is not an argument for lowering the statutory

shield of protection for the investing public.

Contrary to the fears of petitioners and amici curiae, the

Court below specifically immunized underwriters from the obli-

gations of a guarantor. “Although the underwriter cannot be a

guarantor of the soundness of any issue, he may not give it his

implied stamp of approval without having a reasonable basis

for concluding that the issue is sound.” A. 9-10. If the proper

examination is made by the underwriter the dishonored notes

will not become his obligation.

Nor does the decision below contravene any ruling or expres-

sion of this Court in Blue Chip Stamps. The reading of Blue

Chip Stamps by petitioners distorts and misapplies that decision.

Blue Chip Stamps concerns standing of a plaintiff to sue under

$ 10(b) or Rule 10b-5, not standards of liability under that sec-

tion or Rule. There this Court expressly stated: “Blue Chip did

not here present the question of whether an implied action under

§ 10(b) of the 1934 Act and Rule 10b-5 will lie for actions

made a violation of the 1933 Act and the subject of express civil

remedies under the 1933 Act. We therefore have no occasion to

pass on this issue.” (citations omitted) 421 U. S. at 752, n. 15.

(Continued from preceding page)

12/31/73, p. 27, col. 7; Franklin N. Y. Corporation, see N. Y.

Times, 1/13/75, p. 44 col. 7. Many of these defalcations are dis-

cussed in Note, The Commercial Paper Market and the Securities

Act, 39 U. Chi. L. Rev. 362, at 378 (1972).

12

Foremost-McKesson, Inc. v. Provident Securities Co., 44 U. S.

L. W. 4056 (January 13, 1976), also relied on by petitioners,

deals with the question of standing to sue under § 16(b) of the

1934 Act—a section which imposes absolute liability for viola-

tion of its provisions. Determination of liability under § 10(b)

and Rule 10b-5 is not reasonably susceptible to the type of

absolute treatment applied in Foremost-McKesson. Determina-

tion of the identity of those a statute is designed to protect

involves considerations different in kind from a determination

of the conduct the statute prohibits, especially in construing

language such as “manipulative or deceptive device or con-

trivance .. .”

The cases applying § 14 of the 1934 Act, 15 U. S. C. § 78n

(proxy viclation), are more to the point in the construction of

analogous sections of the securities laws than the cases con-

struing § 16(b). In the decision below it is pointed out that in

Chris-Craft Industries, Inc. Vv. Piper Aircraft Corp., 480 F. 2d

341, 370 (2d Cir. 1973), cert. denied, 414 U. S. 910 (1973),

the standards for underwriters expressed in the 1933 Act were

used as a guide to determine the liability of an underwriter in a

case arising under § 14 of the 1934 Act. A. 8, n.

The decision below is one of reason and common sense, and

it is firmly grounded in the statutory scheme of the 1933 and

1934 Acts. Rule 10b-5 was expressly designed to cover the

scheme or device that does not fit neatly within the technical

provisions of the 1933 Act but which nevertheless operates to

deprive the investing public of its protections.

To hold an underwriter liable under Rule 10b-5 for failure

to make a reasonable investigation of the issuer is not to imply

remedies where none are expressed, but to apply recognized

standards of conduct in situations where those standards are

necessary for the protection of the investing public.

13

III. Issues of Scienter and Negligence Are Irrelevant To the

Standard of Liability Employed by the Court Below.

Petitioners argue that under Rule 10b-5 there can be no

liability without scienter, and proof of negligence is not enough.

Respondent believes the position of petitioners on the need

for proof of scienter in a Rule 10b-5 cause of action is errone-

ous, Petitioners invoke war cries that have long been stilled.’

More to the point, however, those issues simply are not relevant

to the decision below.

Petitioners presumptively anticipate the decision of this Court

in Ernst & Ernst v. Hochfelder, 503 F. 2d 1100 (7th Cir.

1974), cert. granted, 421 U. S. 909 (1975) (No. 74-1042),

and pray this Court grant the writ and reverse summarily if the

Court should require a showing of scienter in that case. That

prayer is far-fetched. First, the issue in Hochfelder is whether

Ernst & Ernst is liable as an aider and abettor of a violator of

Rule 10b-5, not whether Ernst & Ernst was a direct perpetrator

of a securities act violation in the context of particular trans-

actions. Ernst & Ernst did not sell securities to anyone. Respond-

ent and the members of the represented class purchased their

notes directly from Nuveen. In Hochfelder there is no nexus

of a transaction between Ernst & Ernst and a plaintiff; in this

case there is complete privity.

In the securities acts Congress has made the extent of liability

imposed upon a participant in a securities transaction dependent

7. Among recent cases holding that specific intent to deceive is

not necessary to establish liability under § 10(b) are Rochez Bros.,

Inc. v. Rhoades, 491 F. 2d 402, 407-8 (3d Cir. 1974); Cohen vy.

Franchard Corp., 478 F. 2d 115, 123 (2d Cir. 1973), cert. denied,

414 U. S. 857 (1973); Globus v. Law Research Service, Inc., 418

F. 2d 1276, 1291 (2d Cir. 1969), cert. denied, 397 U. S. 913

(1970); Shapiro v. Merrill Lynch, 495 F. 2d 228, 238-9 (2d Cir.

1974); Johns Hopkins University v. Hutton, 326 F. Supp. 250, 256

(D. Md. 1971), aff'd in part and rev'd in part, 488 F. 2d 912 (4th

Cir. 1973), cert. denied, 416 U. S. 916 (1974); Tomera v. Galt, 511

F. 2d 504 (7th Cir. 1975).

14

upon the culpability of the unlawful conduct and the relation-

ship between the defendant and the transaction that resulted in

the plaintiffs injury. The standards of liability range from

absolute liability to subtle gradations of negligence. The more

direct the relationship, the lesser the culpability required for

liability.

The bold assertion that if this Court rules scienter a require-

ment of proof in Hochfelder then this case should be summarily

reversed is to swing a very broad axe indeed. A ruling that an

aider and abettor must have an intent to deceive has little appli-

cability to the fact situation in this case.

IV. The Decision Below Does Not Enlarge the Statutory

Duties of an Underwriter.

Petitioners say that the decision below requires the under-

writer to verify the accuracy of the report of an expert such as

an independent public accountant. Nothing in the decision be-

low supports that assertion. Underwriters customarily do and

must have face-to-face meetings with auditors. In the situations

examined by the courts in Chris-Craft Industries, Inc. v. Piper

Aircraft Corp., 480 F. 2d 341 (2d Cir. 1973), Feit v. Leasco

Data Processing Equipment Corp., 332 F. Supp. 544 (E. D.

N. Y. 1971); and Escott v. BarChris Construction Corp., 283

F. Supp. 643 (S. D. N. Y. 1968), the underwriters involved

each had face-to-face (“due diligence”) sessions with the issuer's

accountants. Textbooks, manuals and guidelines for underwriters

routinely call for such face-to-face sessions.* The purpose of

these meetings is for the underwriters to determine that the

auditor really exists and is competent and independent, and has

done his job.

In the instant case the so-called “work papers” of Lieber,

Bleiweis were one-half inch thick. A glance at these work

papers would have made it known that no audit of WH had

8. See PLI Securities Law Institute—II, The Review of Securities

Regulation, 975-77 (V. 7, No. 3, Feb. 6, 1974).

15

been performed by Lieber, Bleiweis. That was only one of

several steps that, if taken, would have uncovered WH’s fraud,

or raised suspicions which mandated further investigation.

Respondent believes that is the correct reading of the decision

below on this point.

Nuveen “most likely” did not examine the federal tax returns

of WH, although that was Nuveen’s accepted procedure. The last

two federal tax returns filed by WH did not correspond at all to

the audited statements WH sent to Nuveen for those years.

Nuveen did not cause the corporate records or contracts of WH

to be examined. The corporate records had not been maintained

since 1966.

Certain’. on these facts the decision below cannot be read

as an expansion of the hitherto defined duties of an underwriter.

V. The Decision Sought To Be Reviewed May Be Sustained

on Several Grounds Not Reached by the Court of Appeals.

In reaching its decision the Court below assumed or accepted

several arguments and contentions advanced by petitioners. If

this case is to be reviewed respondent contends that the finding

of liability and the judgment entered below may be sustained

on grounds not relied on by the Court of Appeals, or on one

issue not resolved by the trial court. The judgment of the trial

court may be sustained on any ground that is supported in the

record. Jaffke v. Dunham, 352 U. S. 280 (1957).

A. The Lieber, Bleiweis Audit of Winter & Hirsch, Inc. Was

Uncertified, or at Best Qualified in Such Manner That Nuveen

Could Not Reasonably Have Relied on It.

In checking the creditworthiness of WH Nuveen relied pri-

marily upon annual and semi-annual audit reports which WH

sent to it. Those audit reports were completely fictitious and

bore no relationship to WH’s books and records or to WH’s

federal income tax returns.

16

The audit reports were so unusual or peculiar that Nuveen

could not reasonably and properly rely on them. Respondent

contends and the last credit investigator employed by Nuveen

testified that the Lieber, Bleiweis audit reports of WH were un-

certified. At best they were qualified audit reports.

Thus a serious question exists in this case as to whether

Nuveen met the standard of an underwriter, a broker-dealer, or

simply that of a reasonable investor is relying on the audit

reports. No one in this case has yet contended that a seller of

securities has no obligation of any kind to his buyers. The

federal securities acts substitute a policy of full disclosure to

investors for the philosophy of caveat emptor in the sale of

securities. Affiliated Ute Citizens v. U. S., 406 U. S. 128,153-4,

reh. denied, 407 U. S. 916, 408 U. S. 931 (1972).

B. Petitioners Are Liable To Respondent and the Class Repre-

sented by Respondent for Nuveen’s Failure To Comply with

Rule 27 of the National Association of Securities Dealers.

Rule 27 of the National Association of Securities Dealers

(“NASD”) requires that a securities dealer adopt and promul-

gate written procedures to be followed in selling securities, and

to properly supervise its salesmen. The rules of the NASD

were promulgated pursuant to § 15SA of the 1934 Act, 15

U. S. C. § 780-3. Violation of those rules provides a basis for

private damage actions. SEC v. First Securities Company of

Chicago, 463 F. 2d 981 (7th Cir. 1972) cert. denied sub nom.

McKy v. Hochfelder, 409 U. S. 880 (1972). Nuveen failed

to establish, maintain and enforce written procedures for the

sale of investment securities, or properly to supervise the sales-

men employed by it in the sale of the short-term notes here at

issue, and is liable for that failure.

17

C. Nuveen Misrepresented WH Commercial Paper and Omitted

To State Material Facts Necessary To Make the Statements

Made Not Misleading in Violation of Section 12(2) of the

1933 Act, Section 10(b) of the 1934 Act, and Rule 10b-5.

Respondent proved direct misrepresentations made by Nuveen

salesmen to various members of the class in connection with

the sale of WH notes to them. In addition, Nuveen did not

communicate to purchasers of WH notes the fact that those

notes were only rated “desirable” rather than “prime” and were

more speculative with greater attendant risks than prime paper.

That was an omission to state a material fact necessary to make

the statements made not misleading.

Should the writ of certiorari issue, respondent will request

this Court to sustain the judgment for respondent and the mem-

bers of the class on the ground that the misstatements of and

omissions to state material facts in connection with the sale of

WH notes to respondent and the represented class are violations

of § 12(2) of the 1933 Act as well as of § 10(b) of the 1934

Act and Rule 10b-5.

18

CONCLUSION.

Respondent prays that the Petition For A Writ Of Certiorari

be denied.

Respectfully submitted,

RICHARD ORLIKOFF,

208 South LaSalle Street,

Chicago, Illinois 60604,

Attorney for Respondent.

JosEPH O. KOSTNER,

JOHN N. TIERNEY,

ROBERT J. PETERS,

SALVATORE A. BARBATANO,

ETTELSON & O’HAGAN,

Of Counsel.

Al

APPENDIX TO BRIEF FOR RESPONDENT IN

OPPOSITION.

RULE 27 OF ARTICLE Ili OF THE RULES OF FAIR

PRACTICE OF THE NATIONAL ASSOCIATION OF

SECURITIES DEALERS, INC.

SUPERVISION.

Written procedures.

(a) Each member shall establish, maintain and enforce

written procedures which will enable it to supervise properly

the activities of each registered representative and associated

person to assure compliance with applicable securities laws,

rules, regulations and statements of policy promulgated there-

under and with the rules of this Association.

Responsibility of member.

(b) Final responsibility for proper supervision shall rest

with the member. The member shall designate a partner,

officer or manager in each office of supervisory jurisdiction,

including the main office, to carry out the written supervisory

procedures. A copy of such procedures shall be kept in each

such Office.

Written approval.

(c) Each member shall be responsible for keeping and pre-

serving appropriate records for carrying out the member's

supervisory procedures. Each member shall review and endorse

in writing, on an internal record, all transactions and all corre-

spondence of its registered representatives pertaining to the

solicitation or execution of any securities transaction.

Review of activities and annual inspection.

A2

(d) Each member shall review the activities of each office,

which shall include the periodic examination of customer ac-

counts to detect and prevent irregularities or abuses and at least

an annual inspection of each office of supervisory jurisdiction.

Qualifications investigated.

(e) Each member shall have the responsibility and duty to

ascertain by investigation the good character, business repute,

qualifications and experience of any person prior to making such

a certification in the application of such person for registration

with this Association.

Office of supervisory jurisdiction.

(f) “Office of supervisory jurisdiction” means any office

designated as directly responsible for the review of the activities

of registered representatives or associated persons in such office

and/or in other offices of the member.

EXCERPTS FROM ORAL ARGUMENT BEFORE THE

UNITED STATES COURT OF APPEALS.

Mr. Horwich (for Defendants-Appellants): “This case deals

with the question of the responsibility of a broker-dealer selling

commercial paper. It pertains to a class action brought by ap-

proximately 43 class members against the broker-dealer and

alleged controlling persons in connection with the sale of com-

mercial paper of a small consumer finance company, Winter &

Hirsch. .. .

“, . . There is a separate basic issue on each of the two ap-

peals. The basic issue on the first appeal from the basic judgment

in favor of the class against the defendants is whether a broker-

dealer selling commercial paper has a responsibility to discover

a joint fraud conducted by the issuer and the issuer’s auditor.”

The Court: “Do you dispute the fact that the broker-dealer

is an underwriter?”

A3

Mr. Horwich: “I do not. I think that under Section 2(11)

Nuveen was probably a statutory underwriter.”

The Court: “Probably, or do you agree that he was an

underwriter?”

Mr. Horwich: “I would agree.”

The Court: “You don’t challenge that conclusion of law?”

Mr. Horwich: “No, but I do not think that that affects the

standard of liability that is placed on Nuveen in this situation.”

The Court: “Is that an issue, though, whether it does? They

argue otherwise, I think, on that.”

Mr. Horwich: “Yes, they do, your Honor. But we believe

that the principal provision on which the District Court relied

—plaintiffs relied—Section 11—has no application to this case

for several primary reasons. The first one is—there is no regis-

tration statement here.”

The Court: “I understand that, but do you agree that even

if the case is simply a 10b-5 case, the standard of care for an

underwriter is the same as the standard of care for a broker-

dealer?”

Mr. Horwich: “If it’s an underwriter outside the context of

Section 11, I don’t believe that there is any difference in the

standard. I think whether or not it’s a statutory underwriter is

really immaterial in determining the standard there.”