Petition — Hughes v. Dempsey-Tegeler & Co.

Supreme Court brief1976

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Supreme Court of the United States '° ™”

ee Rune

—

October Term 1976

REUBEN P. HUGHES,

Petitioner,

VS.

DEMPSEY-TEGELER & Co., INC., a Delaware corporation,

Lewis WHITNEY and New York Stock EXCHANGE,

INc., a New York corporation,

Respondents.

Petition for a Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit.

KINDEL & ANDERSON,

By ANGELO J. PALMIERI,

1020 North Broadway,

P.O. Box 325,

Santa Ana, CA 92702,

(714) 558-7777,

Attorneys for Petitioner.

Parker & Son, Inc., Law Printers, Los Angeles. Phone 724-6622

SUBJECT INDEX

Page

RENAE SUNN a EES a en Be YE 1

REESE alae nea Seto aera ee ee ee l

A ALE EE CET BOER 2

eT ORO NR Te ee 2

I ki ahiassedath és 3

Reasons for Granting the Writ ..........................-....... 9

1. A Plaintiff's Encouragement to a Regulator

to Breach a Congressionally Imposed Duty

to Regulate Should Not Act as an Excuse for

OI oo nna ccsicencniiicsislnipehabanaponpetinn 9

2. Even the Standards Which Have Been

Adopted to Govern Anti-Fraud Actions

Would Not Permit a Defense to Bar Re-

covery for a Section 6 Breach Where the

Fault of the Plaintiff Rests Upon His Nego-

tiation for a Lifting of Regulation -............... 11

3. A Decision of the Supreme Court Would Act

as Guidance to Resolve Suits Pending in the

Be CIID eicticccccssncesacediveduad i soihiiniiiiaiie 13

4. Section 29 Renders Void Negotiated Oral

Understandings Which Amount to a Waiver

I IIE settsictsietticctaiinnccistsibencaienanes 13

I a 14

INDEX TO APPENDIX

Page

Appendix. Pertinent Provisions of the 1934 Act ......

oosthdteipasiaiatnnmaaainienniaiaiasaauadiiimtieiaiiaataictninial App. p. 1

Section 6 of the Securities Exchange Act of 1934,

ee Ns UE FI Sctecensnshsiaescienehdicealiniaiebiniaildninuapinnninee |

Section 8 of the Securities Exchange Act of 1934,

aPC Oe PD iecnieciiciescuncilentclddaaalaiidabinatan 3

Section 29 of the Securities Exchange Act of

Ae 4

Pertinent Provisions of the Constitution of the Ex-

EN ae ee Dane Pe REN RE oe RR 5

Article XIII, Exchange Constitution, Sections |

Ey OF sekalisnatigabalpmiatabieadisiinsctiaitsiniesininlibnaais 5

Pertinent Rules of the Exchange .............0000000002200.... 7

NN 7

A ee rR 8

I iliac aati telaiasieateadalene 9

RTE va ee aT a 1]

I hie ecrmethcteinnitidalinaciineraghin 12

I acsiassssthcssinscnslicidecheisennigtsltiiibdemaneni 13

ae eNO RUE 13

PUTIN sccsiciicsicsdenhsiiicsincabhabbacenigiadinhasichtsbaamenasieiiilalnn bias 93

United States Court of Appeals for the Ninth Cir-

Ce SIE cudicccensidantiieiesstteibianial aaa AD 94

Trask, Circuit Judge (Concurring and dis-

STTTEED ticcvcsitensscisiapstpebusininiensiaadiciisiaeadiatiiaaniiaaiiatadiitieies 136

ili.

TABLE OF AUTHORITIES CITED

Cases Page

Can-Am Petroleum Co. v. Beck, 331 F.2d 371

US a i 11

James v. Dubriel, 500 F.2d 155 (Sth Cir. 1974)

PD » Micinidaalaiadltbagtiipdntseentdeseininddibiansitiliitnebatiditieceen: 11

Kieter-Stewart Co. v. Seagram & Sons (1951), 340

U.S. 211, 71 S.Ct. 259, 95 L.Ed. 219 _.....00.0...... 12

Kuenhart v. Texster, 412 F.2d 700 (5th Cir. 1969)

Malamphy v. Real-Tex Enterprises, Inc., 527 F.2d

Oe I a elite 1]

Naftalin & Co., in re, 469 F.2d 1166 (8th Cir.

a a 10

Pearlstein v. Scudder & German, 429 F.2d 1136 (2d

Cir. 1970), cert. den., 401 U.S. 1613, 91 S.Ct.

1250, 29 L.Ed. 2d 550 (1971), after remand,

IY I 10

Perma Life Mufflers, Inc. v. International Parts

Corp. (1968), 392 U.S. 134, 88 S.Ct. 1981, 20

a aa 12

Rogen v. Ilikon, 361 F.2d 260, (1st Cir. 1968) .... 14

Simpson v. Union Oil Co. (1964), 377 U.S. 13, 84

ee ek’ | | eee 12

Spoon v. Walston, 478 F.2d 246 (6th Cir. 1973)

MEE ER TRE RE 8 RSA RO 10

Woolf v. S. D. Cohn & Co., 515 F.2d 591 (Sth

Cir. 1975), pet. for rehrg. den. 521 F.2d 225

LEDS SARTES EES eee 2, 11, 12

iv.

Miscellaneous Page

Senate Study of Self-Regulation in the Securities In-

dustry, 92nd Cong., 2nd Sess., pp. 241, 242 .... 13

Rules

New York Stock Exchange Rules, Rule 325 ...... 4

Statutes

New York Stock Exchange Constitution, Art. XIII,

BOB. OD cccecncssncessscsevesensenionnstuionseniiniianiiannnnnannnn 4

Securities Exchange Act of 1934, Sec. 6 (15 U.S.C.

VIED ivinesossniusnniecniiemaa 2, 3, 5, 8, 9, 10, 11, 13

Securities Exchange Act of 1934, Sec. 7 .............. 10

Securities Exchange Act of 1934, Sec. 7(f) ...... 10

Securities Exchange Act of 1934, Sec. 10b (15

CIB. BIG) niccccsncccccssscccetesnnbiannennne ~ em Be

Securities Exchange Act of 1934, Sec. 29 (15 U.S.C.

) re ne a mm & oe

United States Code, Title 15, Sec. 78aa .............. 3

United States Code, Title 15, Sec. 78h(b) .......... 3

United States Code, Title 28, Sec. 1254(1) ........ 2

IN THE

Supreme Court of the United States

October Term 1976

ES a

REUBEN P. HUGHES,

Petitioner,

vs.

DEMPSEY-TEGELER & Co., INC., a Delaware corporation,

Lewis WHITNEY and New York Stock EXCHANGE,

INc., a New York corporation,

Respondents.

Petition for a Writ of Certiorari to the United States

Court of Appeals for the Ninth Circuit.

The petitioner Reuben P. Hughes (*‘Hughes’’) prays that a

writ of certiorari issue to review the judgment and opinion of

the United States Court of Appeals for the Ninth Circuit

entered in this proceeding on March 29, 1976.

Opinions Below. q}

The opinion of the Court of Appeals is reported in 534 F.2d m

156 (9th Cir. 1976). The opinion of the District Court for the

Central District of California is reported in (1973 Transfer

Binder) CCH Fed. Sec. L. Rep., §94,133 (C.D. Cal. 1973).

Both opinions are reproduced in the Appendix.

Jurisdiction.

The judgment of the Court of Appeals was entered on

March 29, 1976. A timely petition for rehearing and rehear-

ing en banc was denied on June 4, 1976. This petition was

filed within 90 days of that date. This court’s jurisdiction is

invoked under 28 U.S.C. §1254(1).

Questions Presented.

In determining whether a common law defense should bar

recovery for a violation of the Securities Exchange Act of

1934 (°*34 Act’’):

Should there be any circumstances which would allow

a defense when a national securities exchange has know-

ingly breached its enforcement duties under 15 U.S.C. §78f

(“*Section 6°’).

Should the standards for allowing a defense be any differ-

ent under Section 6, an enforcement provision, than they are

under 15 U.S.C. §78j(b) (‘Section 10b’’), an anti-fraud

provision?

Where a plaintiff's conduct is the basis for a defense,

should the standard adopted by the fifth circuit to govern a

10b action become the standard for allowing a defense under

Section 6.'

Should 15 U.S.C. §78cc (**Section 29”’) which declares

void a waiver of compliance with any provision of the 34 Act,

be limited to written waivers?

Statutes Involved.

This case presents a question of first impression in this

court concerning whether common law defenses should be

‘The standards applied by the Fifth Circuit to a 10b claim require that

the fault of the plaintiff be equal and simultaneous with the fault of the

defendant and vital to the defendant's breach, and that the purpose of the

securities laws be furthered more by allowing the defense than by disal-

lowing it. Woolf v. S. D. Cohn & Co., 515 F.2d 591 (Sth Cir. 1975);

petition for rehearing denied 521 F.2d 225 (1975).

allowed to bar a plaintiff's recovery in an action brought

under Section 6 of the 34 Act, an enforcement provision.

Section 29 of the same Act is pertinent to the applicability of

the doctrine. Sections 6 and 29 of the 34 Act are reproduced

in the Appendix hereto. The provisions of 15 U.S.C. §78h(b)

and the New York Stock Exchange Inc. (*‘Exchange’’) Con-

stitution and Rules, all pertinent to the Section 6 duty of the

Exchange to regulate its member firm, Dempsey-Tegeler &

Co., Inc. (“‘Dempsey’’), are also reproduced in the Appen-

dix hereto.

Statement of the Case.

Hughes, a citizen of California, brought suit in the United

States District Court, Central District of California. Federal

jurisdiction over his claims against the Exchange, a New

York Corporation and Dempsey, a Delaware Corporation,

was provided under 15 U.S.C. §78aa. Trial determined that

Hughes’ loss was $1 ,614,993.18.

In the regular course of carrying out is statutory obligation

to police the operations of Dempsey, the Exchange, in Sep-

tember 1969, received Dempsey’s financial audit and ques-

tionnaire. Both the audit and the questionnaire revealed that

Dempsey was perilously close to insolvency and deteriora-

ting in every important aspect of its operational and financial

condition, a situation which evidenced a worsening of 1968

problems. Dempsey’s 1969 condition had become so grave,

and its continued operation so gross a violation of Exchange

Rules, that questions were immediately raised by staff mem-

bers of the Securities Exchange Commission (*‘SEC’’) and

by the Exchange Constitution itself concerning whether the

— i

Exchange had a mandatory duty to close Dempsey’s doors.”

The Exchange answered these questions in a contradictory

manner. To lessen the danger to Dempsey’s customers, the

Exchange restricted Dempsey’s operations. At the same

time, the Exchange encouraged Dempsey tw raise capital

through borrowings from those same customers in subordina-

tion transactions.

The District Court found that the options open to the

Exchange in regulating Dempsey had been *‘narrowed by the

burgeoning inertia of its past decisions.’’ Since 1949, the

Exchange had been compelled on several occasions to take

action against Dempsey because of its serious operations

problems. More recently, because of a grossly deficient 1968

audit, the Exchange was required to restrict Dempsey’s oper-

ations. These restrictions ended in a few months with an

Exchange prescribed placebo of subordinated capital.

Through an interpretation of its Constitution and Rules

favorable to Dempsey, the Exchange gave capital credit for

the subordination of unregistered, unmarketable Siboney

stock.*

Because of the deluding ease by which subordinated capi-

tal had glossed over Dempsey’s 1968 problems, the Ex-

“During meetings held in the fall of 1969 between staff members of the

SEC and officials of the Exchange, the staff took the position that

Dempsey’s continued operation would be a fraud upon the public and that

the proper regulatory response would be a closing of Dempsey’s doors.

As recently as December of 1968, the Exchange, in order to eliminate the

delay attending protracted hearing procedures, had amended its constitu-

tion to require the summary suspension of any member which **. . . is

insolvent, or is in such financial or operating condition that it cannot be

permitted to continue in business with safety to its creditors. .

Article XIII, Exchange Constitution, Section 1.

*The Exchange, through a relaxed interpretation of its enforcement

responsibilities, gave Dempsey more than 9 million dollars of capital

credit for unregistered common stock of Siboney Corporation, although

such stock was not entitled to any capital credit under Exchange Rule

325.

a om

change not only prescribed but personally administered

another sugar-coated pill for Dempsey’s 1969 moribund

state. Exchange officials actively sought a subordinated loan

from John King (**‘King’’) and then granted Dempsey 7

million dollars of capital credit for a subordination of unregis-

tered, and therefore unmarketable, common stock in King

Resources Company. The Exchange at that time was hoping

for a turn-around in a market which was then in the throes of

the longest sustained decline since the Depression. Concur-

rently, and reacting to the Exchange prescription, Dempsey

officials negotiated with Hughes for his subordination of high

grade, negotiable bonds and securities. The subordination

was completed on March 24, 1970. Within four months of

the Hughes’ loan, Dempsey’s liquidation began and Hughes

was completely sold out. The relation between Hughes and

his long-time friends and fiduciaries Lewis Whitney (‘*Whit-

ney’’) and James Walraven (‘*Walraven’’), the true and the

false statements made to Hughes, and the abandonment of its

regulatory duties by the Exchange, all factors in Hughes’

loss, were to plague the Section 6 and waiver issues before

the District Court and Court of Appeals.‘

Partly because of his wealth — which came from an early

‘Particularly troubling to the waiver issue was the testimony of Robert

Peck (**Peck’’) — just hired to research Dempsey’s problems — that he

gave documents to Hughes which emphasized very recent and great

Dempsey progress in overcoming operational and net capital problems.

While discussing these documents, Peck told Hughes that there was a

good chance that he could lose his money. This negative sell was quickly

followed by assurances, in Peck’s presence, from both Walraven and

Whitney that every investment was subject to risk but that the risk of loss

in a Dempsey investment ‘was nil’’ since Dempsey was a ‘sound firm

with a sound net worth.’’ The District Court found that the sum of this

information resulted in a waiver by Hughes of both a 10b and a Section 6

breach. The Ninth Circuit agreed while cautioning against too easy an

application of 10b waiver factors to a Section 6 breach. It held that a

waiver under Section 6 depended upon a knowing relinquishment by

Hughes of the Exchange’s enforcement obligations.

_—

and modest investment in a one-product company (Hawaiian

Punch), a product which caught on in phenomenal fashion —

and partly because of his close, twenty-year personal rela-

tionship with his securities broker, Walraven, Hughes was a

natural target for a subordination solicitation. Whitney, Pres-

ideat of Dempsey, joined Walraven to make the case for

subordination. Hughes had known Whitney for almost as

long as he had known Walraven, although in a less personal

vay. Robert Peck (‘*Peck’’), hired by Dempsey only a few

weeks before the subordination, and a stranger to all, ap-

peared for the closing presentation to Hughes. The District

Court found that — although false statements were made to

Hughes about Dempsey’s financial and operating condition

— because he had been given complete access to information

relating to his loan, a complete disclosure had been made to

Hughes. The total presentation consisted of separate and

seemingly corflicting lines of advice. One line warned that

Dempsey was in serious violation of Exchange net capital

requirements. The other line assured that Dempsey was a

sound firm with a substantial net worth. The seeming conflict

was smothered in complicated distinctions between net capi-

tal and net worth which the District Court found were beyond

the ability of Walraven and Whitney to grasp. Nevertheless,

they each spoke to Hughes out of an authority which office

and years of specialty gave. From that authority, the very

need for capital was made to seem a reason for sub-

ordinating.°

*The Dempsey fiduciaries represented that Exchange determinations

of net capital deficiencies were only a technical by-product of a great

volume of business; record keeping had lagged; Dempsey’s true worth,

unrecorded, could not be counted in the net capital determinations, an

unfair effect upon a sound firm. Hughes was also told, in emphasis of the

technical and vagrant nature of the Exchange rules, that Dempsey ’s

(This footnote is continued on next page)

~—

Included in the information given to Hughes were docu-

ments of Exchange origin. These documents contained no

specific representation of Dempsey’s financial soundness.

However, they did give official approval to the subordination

and of the false fact that Dempsey was in compliance with

Exchange rules. The Exchange documents, the relaxation of

its net capital requirements through rule interpretation and

the encouragement of subordination by the Exchange,

prompted the District Court to describe the Exchange as the

‘“major protagonist’ in the Hughes transaction.

One Exchange document given to Hughes reported its

release of Dempsey from regulation. Another document,

signed by Hughes, contained a stipulation that he was not

relying upon the Exchange’s surveillance of Dempsey; it also

included Hughes’ ‘‘agreement’’ that the Exchange had no

responsibility to disclose to him information concerning

Dempsey. Peck-produced documents dovetailed nicely with

the Exchange documents by falsely detailing great Dempsey

progress in overcoming problems. One of these documents

claimed that Dempsey, within only 4 months, had reduced its

net capital deficit from 19.9 million dollars to 5.8 million

dollars, a deficit which would be eliminated by the King

loan. The true fact, known only to the Exchange through

computations of its own examiners, was that at the time of the

Hughes loan Dempsey had an actual net capital deficiency of

17.9 million dollars. The Exchange also knew that at that

time Dempsey’s operating condition was still deteriorating.

Nevertheless, the Exchange decided to lift its restrictions

potential net capital deficit could be from 6 to 16 million dollars more

than a determined 5.6 million. Hughes was also falsely assured that the

King subordination, by itself, would put Dempsey in capital compliance

since the amount of the King subordination was greater than the existing

and actual deficit.

against Dempsey’s operations. The Ninth Circuit found

that the Exchange knowingly had breached its Section 6

duties by lifting its restrictions against Dempsey’s opera-

tions. However, the Court also found that Hughes had

waived that breach by encouraging the Exchange to lift those

restrictions. ®

*The Ninth Circuit determined that Hughes conditioned his subordina-

tion upon the lifting of the restrictions. However, there was neither a

District Court finding nor evidence to support the determination. Interest-

ing questions are raised by the Ninth Circuit's determination. However,

the determination itself does not prejudice the right of Hughes to recover;

for if Hughes did negotiate for a lifting of the restrictions in the transac-

tion and thereby can be said to have waived the Exchange’s violation of

Section 6, Section 29 should render his waiver void. Actually, it was

King, not Hughes, who had conditioned his subordination upon the

lifting of the restrictions. Hughes was not privy to the details of the King

subordination meetings. He had never met King and knew only whai

Walraven and Whitney told him about those meetings. They told him

that: King’s accountants and lawyers had made an extensive investigation

of Dempsey’s condition; the King subordination was enough to put

Dempsey in capital compliance; and that King was awaiting Exchange

and SEC decisions regarding the regulatory remedy for Dempsey. From

the information given him, Hughes understood that the lifting of the

restrictions made the subordination ‘‘the proper thing to do.”’

—

REASONS FOR GRANTING THE WRIT.

1. A Plaintiff's Encouragement to a Regulator to

Breach a Congressionally Imposed Duty to Regulate

Should Not Act as an Excuse for a Knowing Breach.

The Ninth Circuit decision, by permitting a common law

defense to bar recovery for a knowing breach of a Section 6

enforcement duty, raises unsettling questions about the ac-

countability of national securities exchanges in fulfilling

their statutory obligations — questions which trouble a Sys-

tem of private regulation founded upon the exchanges’ prom-

ises to be accountable. The powerful economic forces set in

motion by the securities industry, require, for beneficial,

national direction, the self-restraint of integrity, born of

accountability. The courts have spoon-fed accountability by

allowing private rights of action for a regulator’s breach. In

time, issues arose in these actions as to whether, and by what

standards, the courts should allow common law defenses to

bar recovery. The Ninth Circuit decision, by allowing a

defense to Section 6, on the basis of the plaintiff's encour-

agement of the defendant’s breach of the section, conflicts

with other circuit decisions which have refused to allow

defenses in suits brought for a knowing breach of a duty

under an enforcement provision.’

The particular emphasis and basis of the Ninth Circuit's

waiver decision® is the ‘‘loss of innocence’ of Hughes

"The question of whether to allow common law defenses to bar recov-

ery for a violation of a security law has been the subject of many district

court decisions which are here ignored because of the many decisions of

the circuit courts on the subject.

*The particular defense involved in the Ninth Circuit decision is

labelled **waiver.’’ However, the court discusses the defense in terms of

the fault existing in Hughes, an in pari delicto concept. Whatever am-

my may exist in the labelling is considered by Hughes as having no

affect upon the principles under discussion.

which, in the Section 6 claim, rests upon a finding that

Hughes encouraged the Exchange to breach its enforcement

duties. But no amount of encouragement from a plaintiff

should relieve a defendant of a congressionally imposed

enforcement duty. The Second Circuit in Pear/stein v. Scud-

der & German, 429 F.2d 1136 (2d Cir. 1970)* permitted

recovery to a less than innocent investor — even an unscrupu-

lous one who would reap a windfall by recovery — when the

one charged with the duty to enforce a statute knowingly

breached that duty. The Pearlstein court was aware of the

distastefulness of permitting an unworthy investor to re-

cover. Pearlstein was decided as it was — and has merit as a

principle — because the distastefulness of permitting a re-

covery to an unscrupulous investor is outweighed by the need

to compel those with an enforcement duty to fulfill that duty.

Hughes does not seek after the Pearlstein doctrine as does

a scoundrel who seeks sanctuary among other scoundrels.

There was nothing unscrupulous in the conduct of Hughes in

this transaction. He was found wanting out of a lack of

diligence — out of trusting too much to pursue information to

which he was given access — not out of any desire to gain

"The Second Circuit in Pearlstein v. Scudder & German, 429 F.2d

1136, 1143 (2d Cir. 1970), cert. den., 401 U.S. 1013, 91. S.Ct. 1250, 29

L.Ed. 2d 550 (1971), after remand, 527 F.2d 1141 (1975), refused to

permit a defense to bar recovery on the grounds that denying the common

law defenses in private suits act as a prod to those with enforcement

obligations to properly perform their obligations. The Sixth and Eighth

Circuits have followed Pearlstein. Naftalin & Co., in re, 469 F.2d 1166

(8th Cir. 1972); Spoon v. Walston, 478 F.2d 246 (6th Cir. 1973). After

the Pearlstein decision, Congress added 7(f) to the 34 Act which placed a

responsibility upon the investor, along with the broker, to comply with

margin requirements. Thus, the rationale of Pearlstein — as it specifi-

cally relates to Section 7 of the 34 Act — may no longer be valid.

Pearlstein v. Scudder & German, 527 F.2d 1141, note 3 (2d Cir. 1975).

Nevertheless, the principle itself remains sound.

vee eee -

advantage.'® Upholding the doctrine is not at all essential to

Hughes’ right to recover. The doctrine is only one way to

resolve the conflict between promoting the objectives of

required private regulation under the securities laws through

a disallowance of defenses and the objectives of allowing

common law defenses.

2. Even the Standards Which Have Been Adopted to

Govern Anti-Fraud Actions Would Not Permit a De-

fense to Bar Recovery for a Section 6 Breach Where

the Fault of the Plaintiff Rests Upon His Negotiation

for a Lifting of Regulation.

Defenses have been allowed to defeat a suit brought under

an anti-fraud provision — in special circumstances.'! De-

fenses have also been disallowed.'? In denying a petition for

rehearing in Woolf v. S. D. Cohn & Co., 521 F.2d 225 (Sth

Cir. 1975), the Fifth Circuit explained its reasons for disal-

lowing an in pari delicto defense. The circuit reviewed the

growth of the defense, which had emerged prior to the adop-

tion of federal regulatory schemes governing commerce and

finance, and noted that even the early allowance of the

‘Even the normal desire for an unusual profit should not be ascribed to

Hughes. He was a man who, at that time, would have paid a 70% tax on

the ordinary income which the investment was designed to yield. If

petitioner was guilty of anything, it was of friendship.

''The Fifth Circuit in James v. Dubriel, 500 F.2d 155 (Sth Cir. 1974)

and Kuenhart v. Texster, 412 F.2d 700 (Sth Cir. 1969) permitted a

common law defense to defeat recovery. In both cases the plaintiff had

conspired with the defendant to circumvent the securities laws. In both

cases, the Court declined to settle accounts between co-conspirators

where the transaction had no affect upon the investing public. The Fourth

Circuit, in Malamphy v. Real-Tex Enterprises, Inc., 527 F.2d 978 (4th

Cir. 1975), allowed an in pari delicto defense where the plaintiffs had

culpably participated with defendant in a violation of the securities laws.

'"2Woolf v. S. D. Cohn & Co., 515 F.2d 591 (Sth Cir. 1975), petition

for rehearing denied, 521 F.2d 225 (1975).

Can-Am Petroleum Co. v. Beck, 331 F.2d 371 (10th Cir. 1974).

Katz v. Amos Trust & Co., 411 F.2d 1096 (2d Cir. 1969).

eile.

defense required that the wrongdoing of a plaintiff bear an

immediate and necessary relationship to the relief sought

from the court. Then, addressing the plaintiffs’ 10b claim,

the court reaffirmed its earlier decision not to allow the

defense, even though the plaintiffs were not free from sin,

Stating:

**But the question is not the purity of the plaintiffs in

an abstract sense, but rather whether their fault was

equal, simultaneous, and vital to the effectuation of the

fraudulent scheme (as the cooperation of a co-

conspirator is vital to the accomplishment of the ends of

a conspiracy): and whether the remedial purposes of the

securities laws will be furthered more by allowing the

defense than by disaliowing it.. . . .’ Woolf, supra, p.

228.

As an aid to its decision, the Woolf court noted a similarity

between the development of the law in the anti-trust area a

good many years before regulation of the securities industry.

A conflict emerged among the circuits, with some circuits

refusing recovery to a plaintiff in pari delicto and other

circuits deciding to promote the regulatory objectives of

anti-trust legislation by refusing to allow the defense. The

Supreme Court stepped in to settle the matter.'* There is now

a need for the Supreme Court to do the same in the securities

area — to coalesce the varying opinions of the various cir-

cuits into one clarifying standard. The Fifth Circuit on page

227 of Woolf took note of this need.

“Perma Life Mufflers, Inc. v. International Parts Corp. (1968), 392

U.S. 134, 88 S.Ct. 1981, 20 L.Ed. 2d 982; Simpson vy. Union Oil Co.

(1964), 377 U.S. 13, 84S8.Ct. 1051, 12 L.Ed. 2d 98; Kieter-Stewart Co.

v. Seagram & Sons (1951), 340 U.S. 211, 71 §.Ct. 259, 95 L.Ed. 219.

-— =

3. A Decision of the Supreme Court Would Act as

Guidance to Resolve Suits Pending in the District

Courts.

A decision of the Supreme Court could not be more timely.

Of the many suits which were filed after the 1969-70 prac-

tices of exchanges were revealed,'* this is the first to be

decided by a circuit court. The district courts, now asked to

decide these often complex suits, the SEC, the securities

industry and the investing public would benefit from a clear

statement of the principles to be applied to the assertion of

common law defenses.

4. Section 29 Renders Void Negotiated Oral Under-

standings Which Amount to a Waiver of a Section 6

In its decision the Supreme Court should consider the

effect of Section 29 of the 34 Act. The Ninth Circuit noted

that any waiver contained in a letter signed by Hughes was

void under Section 29. In that letter, Hughes acknowledged

that he had been **. . . furnished with all financial informa-

tion with respect to Dempsey . . .”’ and that he was not

relying *‘upon the Exchange’s surveillance of the organiza-

tion or its capital position.’ Despite the bar of Section 29, the

'’There have been a number of official studies which were submitted to

Congress covering the attempt of the Exchange to assist its weakest

members by ignoring their rule violations in the hope that time would

dispense with the need for regulation. The Exchange practice, which led

to millions of dollars of investor damage, was reported in a Senate Study

of Self-Regulation in the Securities Industry, Ninety-Second Congress,

Second Session. During hearings held on August 8 and 9 and on October

5, 1972, the number of suits then in process was reported to be thirty (pp.

241, 242 of the Senate Study, judicially noticed by the trial court as

judicially noticed materials Exhibit B). At the present time there are at

least 12 suits against various exchanges still pending before the trial

courts. Because he does not have the means of ferreting out all of the

suits filed in the various district courts, Hughes does not know how many

other suits have been filed against exchanges involving the same issues as

his suit.

a’

Ninth Circuit found a waiver, not because of the letter, but

because Hughes knew of the restrictions and because he had

negotiated for their lifting, thereby encouraging the Ex-

change to breach its duty. Such a finding makes a distinction

between a waiver contained in a writing (invalid) and a

waiver which is brought about during oral negotiation

(valid). The First Circuit in Rogen v. Ilikon, 361 F.2d 260,

268 (Ist Cir. 1968) warned against too narrow an interpreta-

tion of the language and circumstances of waiver. Section 29

does not purport to void only written waivers, its language

embraces a plaintiff's negotiated oral condition, which con-

dition amounts to a waiver.

Conclusion.

For the above reasons, a writ of certiorari should issue to

review the judgment and opinion of the Ninth Circuit.

Respectfully submitted,

KINDEL & ANDERSON

ANGELO J. PALMIERI

Attorneys for Petitioner.

APPENDIX

APPENDIX.

PERTINENT PROVISIONS OF THE 1934 ACT.

Section 6 of the Securities Exchange Act of 1934,

15 U.S.C. § 78f.

REGISTRATION OF NATIONAL SECURITIES

EXCHANGES

Sec. 6. (a) Any exchange may be registered with the

Commission as a national securities exchange under the

terms and conditions hereinafter provided in this section, by

filing a registration statement in such form as the Commis-

sion may prescribe, containing the agreements, setting forth

the information, and accompanied by the documents, below

specified:

(1) An agreement (which shall not be construed as a

waiver of any constitutional right or any right to contest the

validity of any rule or regulation) to comply, and to enforce

so far as is within its powers compliance by its members, with

the provisions of this title, and any amendment thereto and

any rule or regulation made or to be made thereunder;

(2) Such data as to its organization, rules of procedure,

and membership, and such other information as the Commis-

sion may by rules and regulations require as being necessary

or appropriate in the public interest or for the protection of

investors;

(3) Copies of its constitution, articles of incorporation

with all amendments thereto, and of its existing bylaws or

rules or instruments corresponding thereto, whatever the

name, which are hereinafter collectively referred to as the

“‘rules of the exchange’’; and

—

(4) An agreement to furnish to the Commission copies of

any amendments to the rules of the exchange forthwith upon

their adoption.

(b) No registration shall be granted or remain in force

unless the rules of the exchange include provision for the

expulsion, suspension, or disciplining of a member for con-

duct or proceeding inconsistent with just and equitable prin-

ciples of trade, and declare that the willful violation of any

provisions of this title or any rule or regulation thereunder

shall be considered conduct or proceeding inconsistent with

just and equitable principles of trade.

exchange from adopting and enforcing any rule not inconsis-

tent with this title and the rules and regulations thereunder

and the applicable laws of the State in which it is located.

(d) If it appears to the Commission that the exchange

applying for registration is so organized as to be able to

comply with the provisions of this title and the rules and

regulations thereunder and that the rules of the exchange are

just and adequate to insure fair dealing and to protect inves-

tors, the Commission shall cause such exchange to be regis-

tered as a national securities exchange.

(e) Within thirty days after the filing of the application,

the Commission shall enter an order either granting or, after

appropriate notice and opportunity for hearing, denying reg-

istration as a national securities exchange, unless the ex-

change applying for registration shali withdraw its applica-

tion or consent to the Commission's deferring action on its

application for a stated longer period after the date of filing.

The filing with the Commission of an application for registra-

tion by an exchange shall be deemed to have taken place upon

—

the receipt thereof. Amendments to an application may be

made upon such terms as the Commission may prescribe.

(f) An exchange may, upon appropriate application in

accordance with the rules and regulations of the Commis-

sion, and upon such terms as the Commission may deem

necessary for the protection of investors, withdraw its regis-

tration.

Section 8 of the Securities Exchange Act of 1934,

15 U.S.C. § 78h.

RESTRICTION ON BORROWING BY MEMBERS,

BROKERS, AND DEALERS

Sec. 8. It shall be unlawful for any member of a national

securities exchange, or any broker or dealer who transacts a

business in securities through the medium of any such

member, directly or indirectly —

oe ss

(b) To permit in the ordinary course of business as a

broker his aggregate indebtedness to all other persons, in-

cluding customers’ credit balances (but excluding indebted-

ness secured by exempted securities), to exceed such per-

centage of the net capital (exclusive of fixed assets and value

of exchange membership) employed in the business, but not

exceeding in any case 2,000 per centum, as the Commission

may be rules and regulations prescribe as necessary or appro-

priate in the public interest or for the protection of investors.

Commission shall prescribe for the protection of investors to

hypothecate or arrange for the hypothecation of any securi-

ties carried for the account of any customer under cir-

cumstances (1) that will permit the commingling of his secu-

rities without his written consent with the securities of any

other customer, (2) that will permit such securities to be

commingled with the securities of any person other than a

bona fide customer, or (3) that will permit such securities to

be hypothecated, or subjected to any lien or claim of the

pledgee, for a sum in excess of the aggregate indebtedness of

such customers in respect of such securities.

Oe eae

Section 29 of the Securities Exchange Act of 1934,

15 U.S.C. § 78cc.

VALIDITY OF CONTRACTS

Sec. 29. (a) Any condition, stipulation, or provision bind-

ing any person to waive compliance with any provision of

this title or of any rule or regulation thereunder, or of any rule

of an exchange required thereby shall be void.

(b) Every contract made in violation of any provision of

this title or of any rule or regulation thereunder, and every

contract (including any contract for listing a security on an

exchange) heretofore or hereafter made the performance of

which involves the violation of, or the continuance of any

relationship or practice in violation of, any provision of this

title or any rule or regulation thereunder, shall be void (1) as

regards the rights of any person who, in violation of any such

provision, rule, or regulation, shall have made or engaged in

the performance of any such contract, and (2) as regards the

rights of any person who, not being a party to such contract,

shall have acquired any right thereunder with actual knowl-

edge of the facts by reason of which the making or perfor-

mance of such contract was in violation of any such provi-

sion, rule, or regulation . . .

a on

PERTINENT PROVISIONS OF THE

CONSTITUTION OF THE EXCHANGE.

Article XIII, Exchange Constitution, Sections 1 and 2.

ARTICLE XIII

INSOLVENT MEMBERS—SUSPENSION—

REINSTATEMENT

Sec. 1. A member who fails to perform his contract, or is

insolvent, shall immediately inform the Secretary of the

Exchange in writing that he is unable to meet his engage-

ments and prompt notice thereof shall be given to the Ex-

change. Such member shall thereby become suspended from

membership until he has been reinstated as provided in Sec-

tion 5 of this Article.

Suspension for insolvency on declaration

A member or allied member who is a general pariner in a

member firm or a holder of voting stock in a member corpora-

tion, which firm or corporation fails to perform its contracts,

or is insolvent, or is in such financial or operating condition

that it cannot be permitted to continue in business with safety

to its creditors or the Exchange, shall immediately inform the

Secretary of the Exchange in writing of such fact and prompt

notice thereof shall be given to the Exchange. Such member

firm or member corporation shall thereby become suspended

as a member firm or as a member corporation and every

member or allied member who is a general partner or holder

of voting stock therein shall thereby become suspended from

membership or allied membership, until reinstated as pro-

vided in Section 5 of this Article.

Notice from Exchange — Suspension

Sec. 2. Whenever it shall appear to the Chairman of the

Board that a member has failed to meet his engagements, or is

_— =

insolvent, or the Chairman of the Board has been advised by

the Board of Directors of the Exchange or by the Board of

Directors of Stock Clearing Corporation that such member is

in such financial or operating condition that he cannot be

permitted to continue in business with safety to his creditors

or the Exchange, prompt notice thereof shall be given to the

Exchange. Such member shall thereby become suspended

from membership until he has been reinstated as provided in

Section 5 of this Article.

Suspension by Exchange for insolvency

Whenever it shall appear to the Chairman of the Board that

a member firm or member corporation has failed to meet its

engagements, or is insolvent, or the Chairman of the Board

has been advised by the Board of Directors of the Exchange

or by the Board of Directors of Stock Clearing Corporation

that such member firm or member corporation is in such

financial or operating condition that it cannot be permitted to

continue in business with safety to its creditors or the Ex-

change, prompt notice thereof shall be given to the Ex-

change. Such member firm or member corporation shall

thereby become suspended as a member firm or as a member

corporation and every member or allied member who is a

general partner or holder of voting stock therein shall thereby

become suspended from membership or allied membership,

until reinstated as provided in Section 5 of this Article.

va, eR

PERTINENT RULES OF THE EXCHANGE.

Exchange Rule 325.

Operation of Member Organizations

Capital Requirements

(Rules and Policies Administered by the

Department of Member Firms. )

Capital Requirements for Member Organizations

and Individual Members

Rule 325. (a) No member or member organization doing any

business with others than members or member organizations

or doing a general business with the public, except a member

or member organization subject to supervision by State or

Federal banking authorities, shall permit, in the ordinary

course of business as a broker, his or its Aggregate Indebted-

ness to exceed 2000 per centum of his or its Net Capital,

which Net Capital shall be not less than $50,000 in the case of

a member organization carrying any accounts for customers

and shall be not less than $25,000 in the case of any other

member or member organization subject to this rule, unless a

specific temporary exception is made by the Exchange in the

case of a particular member or member organization due to

unusual circumstances.

The initial Net Capital of a member corporation shall be at

least 120% of the Net Capital required to be maintained by

this rule.

The Exchange may at any time or from time to time in the

case of a particular member or member organization pre-

scribe greater requirements than those prescribed herein.

Each member or member organization shall promptly

notify the Exchange if his or its Net Capital does not equal or

exceed the minimum required by this rule.

—

Exchange Rule 325.20.

Rule 235.20 Subordinated borrowings by member or-

ganizations.—All subordinated accounts and all sub-

ordinated borrowings by a member organization—wheth-

er of cash or securities or both—where the proceeds

are to be considered in the computation of net capital

under Rule 325 |42325| must receive prior approval

of the Exchange. Such borrowings may be arranged

with anyone acceptable to the Board of Governors and

are subject to the following provisions:

(1) Subordinated borrowings of cash

(A) The lender may be paid interest not to

exceed the rate set from time to time by the Ex-

change.

(B) If the lender is

(i) a member of the family of one of the

borrowing organization’s general partners or

holders of voting stock, or of a deceased gener-

al partner or ho!der of voting stock;

(ii) an estate of or trust established by or

for one of the borrowing organization’s general

partners or holders of voting stock;

(iii) one of the borrowing organization’s em-

ployees or the employee pension, retirement or

profit-sharing plan of the borrowing organiza-

tion; or

(iv) a limited partner or holder of non-vot-

ing stock of the borrowing organization

he may also share in organization profits to a reasonable

extent.

(2) Subordinated borrowings of securities: subordi-

nation of equities in customers’ accounts

_—

(A) If the lender is a person listed in (1)(B)

above, he may be paid interest not exceeding 8%.

He may also share in organization profits to a

reasonable extent.

(B) If the lender is anyone other than those

listed in (1)(B) above

(i) the lender’s major account shall have

been with the borrowing organization for at

least two years, unless the lender had not been

a customer of any organization for two years.

(ii) the number of such borrowings by a

member organization shall be reasonable in re-

lation to the size of the organization, and the

total dollar amount of such borrowings shall

not constitute more than 25% of the total Capi-

tal of the borrowing organization.

(iii) Compensation for the loan or subordi-

nation of the account shall not exceed 4% on

the value of the securities.

Exchange Rule 342.

Rule 342. (a) Each office, department or business

activity of a member or member organization (includ-

ing foreign incorporated branch offices) shall be under

the supervision and control of the member or member

organization establishing it and of the personnel dele-

gated such authority and responsibility.

The person in charge of a group of employees shall

reasonably discharge his duties and obligations in

connection with supervision and control of the activi-

ties of those employees related to the business of their

employer and compliance with securities laws and regu-

lations.

— =

(b) The general partners or directors of each mem-

ber organization shall provide for appropriate supervi-

sory control and shall designate a general partner or

principal executive officer to assume overall authority

and responsibility for internal supervision and control

of the organization and compliance with securities’ laws

and regulations. This person shall:

(1) delegate to qualified principals or em-

ployees responsibility and authority for supervi-

sion and control of each office, department or

business activity, and provide for appropriate pro-

cedures of supervision and control.

(2) establish a separate system of follow-up

and review to determine that the delegated author-

ity and responsibility is being properly exercised.

tained for each office established by a member or mem-

ber organization, other than a main office.

(d) Qualified persons acceptable to the Exchange

shall be in charge of:

(1) any office of a member or member organi-

zation,

(2) any regional or other group of offices,

(3) any other organizational group of regis-

tered representatives.

(e) The amounts and types of credit extended by a

member organization shall be supervised by members

or allied members qualified by experience for such con-

trol in the types of business in which the member or-

ganization extends credit.

Exchange Rule 402.

Conduct of Accounts

(Rules and Policies Administered by the

Department of Member Firms. )

Restrictions on Pledge of Customers’ Securities

Rule 402. (a) No agreement between a member or-

ganization and a customer authorizing the member

organization to pledge securities carried for the ac-

count of the customer either alone or with other securi-

ties, either for the amount due thereon or for a greater

amount, or to lend such securities, shall justify the

member organization in pledging or lending more of

such securities than is fair and reasonable in view of

the indebtedness of said customer to said member or-

ganization, except as provided in paragraph (d) of

this Rule.

Agreements for Use of Customers’ Securities

(b) No member organization shall lend. either to

itself as a broker or to others, securities held on mar-

gin for a customer and which may be pledged or

loaned under paragraph (a) hereof, unless such mem-

ber organization shall first have obtained a separate

written authorization from such customer permitting

the lending of such securities by such member organi-

zation.

Restrictions on Delivery of Customers’ Securities

ganization and a customer shall justify the member

organization in delivering securities carried for the cus-

tomer on sales made by the member organization for

any account in which such member organization or

=— =

any partner thereof or stockholder therein is directly

or indirectly interested.

Free or Excess Margin Securities

(d) No securities held by a member organization

for the account of a customer, whether free or rep-

resenting excess margin, may be loaned to itself as

broker, or to others, or delivered on sales made by

the member organization for any account in which the

organization or any partner or stockholder has a direct

or indirect interest unless a specific written agreement

designating the particular securities to be loaned is first

obtained from the customer.

Exchange Rule 417,

Financial Statements and Reports

(Rules and Policies Administered by the

Department of Member Firms. )

Audit

Rule 417. The Exchange may require any member or

member organization to cause to be made as of the

date of an answer to a financial questionnaire an audit,

by an independent public accountant, of his or its ac-

counts and assets, including securities held for safe-

keeping, in accordance with such regulations as shall be

prescribed and to file a statement to the effect that

such audit has been made and whether it is in accord

with the answer to the questionnaire. Such statement

shall, in the case of each member not a partner or a

stockholder in a member organization, be signed by

such member and, in the case of each member organi-

zation, shall be signed by cach member and _ allied

—

member thereof unless, for good cause shown, the Sig-

nature of one or more of them is waived by the Ex-

change provided, however, that the signatures of only

two members or allied members shall be required if

the answer to such financial questionnaire is made

available to all members and allied members of the

Organization. Such statement shall in all cases be at-

tested by the auditors, and the original report of the

audit signed by the auditors shall be retained as part

of the books and records of the member or organization.

Exchange Rule 440.

Books and records

Rule 440. Every individual member and every mem-

ber organization shall make and preserve for at least

three years such books and records as the Exchange

may prescribe.

Meinorandum Opinion.

United States District Court, Central District of Cali-

fornia.

Reuben P. Hughes, Plaintiff, v. Dempsey-Tegeler

& Co., Inc. a Delaware corporation, Lewis Whitney,

James Walraven, and New York Stock Exchange, Inc.

a New York corporation, Defendants. No. 71-1299-

MML.

Filed: Sept. 6, 1973.

Preliminary Statement

Plaintiff, a resident of the Central District of Cali-

fornia, filed a complaint alleging seven causes of ac-

tion based upon the Securities Act of 1933, the Se-

curities Exchange Act of 1934, and the common law.

Jurisdiction is sustained under section 22(a) of the

Securities Act, 15 U.S.C. 77v(a), section 27 of the

Securities Exchange Act, 15 U.S.C. 78aa, and the doc-

trine of pendent jurisdiction. The first cause of action

alleges a violation of section 10(b) of the Securities

Exchange Act, 15 U.S.C. 78j, of Rule 10b-5 promul-

gated thereunder, and of sections 12(2) and 17 of the

Securities Act, 15 U.S.C. 77L(2) and 77q by Demp-

sey-Tegeler (Dempsey), a Delaware corporation doing

business within this district, and by Lewis Whitney and

James Walraven, residents of this district. The second

cause of action alleges a violation of section 29(b)

of the Securities Exchange Act, 15 U.S.C. 78cc(b),

and of section 12(2) of the Securities Act by Dempsey,

{1; 1172] and seeks rescission for the violations by that

corporation alleged in the first cause of action. The third

cause of action alleges a violation of section 6 of the Se-

curities Exchange Act, 15 U.S.C. 78f, by the New York

Stock Exchange (Exchange). The fourth cause of ac-

tion alleges a violation of section 10(b) of the Securi-

ties Exchange Act, and of Rule 10b-5 by the Exchange.

The fifth cause of action alleges a violation of section

10(b), of Rule 10b-5, and of sections 12(2) and 17

of the Securities Act by the Exchange. The sixth cause

of action seeks declaratory judgment against the Ex-

change. And, the seventh cause of action alleges a viola-

tion of section 1710 of the California Civil Code, and

of section 25401 of the California Corporation Code

by Dempsey.

Defendant Lewis Whitney, a resident of this district,

was an officer of Dempsey, or a gencral partner of its

predecessor partnership, during the relevant period.

Defendant James Walraven is also a resident of this

district, and was employed as a registered repre-

sentative and Vice-President-Branch Manager of

Dempsey’s office in Fullerton, California within this

— a

district. Defendant Exchange is a New York non-

Profit corporation, registered as a national securities ex-

change with the Securities and Exchange Commission

pursuant to section 6 of the Securities Exchange Act.

Plaintiff seeks damages of not less than $1.4 million,

punitive damages of $250,000.00, interest at the rate of

7 percent, and costs against all defendants. Alternative-

ly, plaintiff seeks rescission of a subordination agree-

ment concluded with Dempsey, and the return of se-

Curities submitted pursuant to that agreement, and,

concurrently, a declaratory judgment against the Ex-

change requiring that institution to reimburse plaintiff

for his losses sustained arising out of the implementa-

tion of the subordination agreement.

General Background

Plaintiff is a college educated businessman with con-

siderable business knowledge and expericnce. Approx-

imately two decades ago, he met Walraven. At that

time, Hughes was the President, and principal stock-

holder, of Pacific Hawaiian Products Company, the

producer of [2; 1173] “Hawaiian Punch.” Walraven

solicited a securities account at Dempsey for the plain-

tiff, which advice Hughes accepted, and thereafter Wal-

raven became his “registered representative” in his

securities transactions. By the late fifties, Walraven was

not only a professional consultant, but a personal friend

of Hughes. At about the same time that Hughes met Wal-

raven, he also was introduced to Whitney, then a

general partner of Dempsey. Subsequently, Whitney be-

came a director of Pacific Hawaiian. Between 1955

and 1964 there were two public offerings of Pacific

Hawaiian stock. one a direct issue by the Company

and the other a secondary offering by Hughes and

—16—

others. Hughes realized $2,000,000.00 from the latter

transaction. Dempsey was the principal underwriter for

both offerings. Following the advice of his friend, Wal-

raven, Hughes invested $1,250,000.00 in mutual funds,

later reinvesting this sum in municipal bonds.

By the spring of 1969, Pacific Hawaiian had merged

with Reynolds Tobacco, subsequently named Reynolds

Industries. Hughes became its largest individual share-

holder, a member of the Board of Directors, and an

officer of that organization. Hughes also became a di-

rector of the El Camino Bank in Anaheim, California,

and of the Anaheim Stadium Corporation. In 1967,

Hughes received the “Business Man of the Year Award”

in Orange County. His net worth was $1 1 ,000,000.00,

and his yearly income by 1969 from investments was at

least $300,000.00. Although Hughes relied upon the

information and advice extended to him by those as-

sociated with Dempsey, particularly Walraven, he made

his own final decisions relating to the investment of

his capital. Through his acquired experience, or through

the application of investment counseling coupled with

that experience, Hughes had engineered the growth of

an interest in Pacific Hawaiian’s small predecessor, a

concern with an annual sales of only slightly over

$500,000.00, into a combined investment and manage-

rial position with Reynolds Tobacco, an enterprise with

annual sales of slightly over $25,000,000.00. Hughes

was an uncommon man, with an uncommon business

acumen. [3; 1174]

Dempsey was a member organization of the New

York Stock Exchange engaged in the general business

of a broker-dealer, whose internal accounting practices

were based upon a method of branch office reporting

=< =

to various regional accounting centers. This particular

accounting operation coupled with marked deficiencies

in managerial leadership were to make Dempsey partic-

ularly vulnerable to the dramatic vicissitudes which

were to affect adversely the securities market in the

late sixties. The implementation of internal controls

by the Exchange over member firms' during this period

was subject to criticism and to debate by both the

Executive and Congress. See discussion, infra. In

1964 and 1965, the Exchange had determined that

Dempsey was in violation of the Exchange’s capital

and record-keeping rules,” apparently, as a conse-

'The various institutions principally concerned with the control

and guidance of the securities industry, the registered national

securities exchanges, including the New York Stock Exchange,

and the National Association of Securities Dealers, engaged in a

mechanism called “cooperative regulation,” by which they were

charged to cooperate with the Securities and Exchange Commis-

sion in the overall regulation of the securities industry.

*The following discussion summarizes the Exchange’s rules and

constitutional provisions at issue. Rule 325 established net capital

requirements foe Exchange members which, at all material times

in this action, required that “no member [of the Exchange] . . .

shall permit, in the ordinary course of business as a broker, . .

its Aggregate Indebtedness to exceed 2,000 per centum of .. . its

Net Capital,” as that latter term is defined and computed under

Rule 325. Basically, net capital may be defined as the member

firm’s net worth less assets not readily convertible into cash (e.g.,

the value of seats on stock exchanges, fixed assets, etc.) The

purpose of Rule 325 thus is to prevent brokers from coniinuing

operations unless they have on hand the requisite cash or liquid

assets in the required ratio to aggregate indebtedness. Rule 325.20

(a)(B)(ii) limits the amount of subordinated borrowings of

securities allowed a member firm with “outsiders” at 25 percent

or less of its total capital. Thus, this rule protects the investments

of “outsiders” by requiring that “insiders,” presumably privy to

more intimate knowledge of the particular firm’s financial and

operating condition, carry the greater capital risk (e.g., for every

$.25 risk taken by an “outsider,” an “insider” would be risking

$.75). Rule 402(a) establishes a requirement that the member

firms segregate customers’ fully-paid-for securities from all other

securities owned or controlled by that member, and prohibits the

member firm from borrowing on such securities in an amount

quence of its decentralized accounting system. Demp-

sey was unable to comply fully with the Exchange’s

orders that it centralize operations and reorder its ac-

counting system, and finally, in June 1968, it requested,

and received, permission from the Exchange to main-

tain its accounts at two separate locations. However, as

late as December 1968, Dempsey continued to main-

tain a third accounting center in St. Louis. The St.

Louis accounts substantially contributed to overall in-

accuracies in the reporting of Dempsey’s capital Pposi-

tion, and these accounts still reflected inaccuracies after

a subsequent transfer of the records to New York.*

which would be unreasonable in light of the indebtness of the

customer. Under section 8(c)(3) of the Securities Exchange Act,

15 U.S.C. 78h(c)(3), such borrowings by any member, direct-

ly or indirectly, could not exceed a sum in excess of the aggregate

indebtedness of customers. Rule 402(a) thus protects the fully-

paid-for securities of customers, and prevents the use of such

securities for borrowing or other purposes. Rules 342 and 440

generally require the maintenance of accurate books and records

sO as to insure a source of information fairly reflecting the finan-

cial and operational status of the firm for customers, investors

and the general public. And Rule 345 provides for disciplinary

proceedings against member firms who violate the Exchange's

rules. Article XIII, Section 2 of the Exchange Constitution pro-

vides that whenever it should appear to the Exchange that a mem-

ber “has failed to meet his engagements |i.c., contractual obliga-

tions] or is insolvent, or . . . in such financial or operating condi-

tion that he cannot be permitted to continue in business with

safety to his creditors or the Exchange, . . . [s]uch member shall

thereby become suspended from membership. . . .” (emphasis

added.) Article XIV, Section 6 of the Exchange Constitution

provides that the Exchange, after determining that a member

was in violation of the Exchange Constitution or of any rule

promulgated thereunder, or that a member has engaged in con-

duct inconsistent with just and equitable principles of trade, may

suspend or expel the member. And Article XIV, Section 14 of the

Exchange Constitution provides for disciplinary proceedings

against member firms in instances of violative conduct ecept

that such proceedings are not required where a member has

entered into a consent to penalty with the Exchange.

“Statement of Facts. Charges and Consent to Penalty and Of-

fer of Setthement-——Jerome F. Tegeler.” October 22. 1969 (al

page 3 of Statement of Facts attached thereto). Exhibit No. 33.

Haskins & Sells, certified public accountants, con-

ducted several audits of Dempsey for the Exchange

prior to and during the member organization’s crisis

period. The surprise audit for 1968, received by the

Exchange on January 16, 1969, revealed serious Capi-

tal and accounting problems in violation of Exchange

rules. Dempsey’s net capital deficiency at the time of

the audit was $1,029,492.00, which was in violation of

Rule 325, the Exchange’s net capital requirement rule.

Its interoffice balances reflected a debit of $2,543.-

044.00, with securities long in the amount of $3.,-

272,784.00, and securities short in the amount of $17,-

452,478.00. Unresolved “long security count differences”

were in the amount of $18,363,753.00, and unresolved

“short security count differences” [4; 1175] were in the

amount of $2,631,817.00.* Improperly maintained, un-

Segregated customer securities amounted to $21,917,-

991.00, which amount included $3,784,374.00 erro-

neously pledged by Dempsey for its own borrowings.

These accounting errors were centered principally in

the New York office, where there was a conceded ab-

sence of competent supervision and direction.

Consequently, the Exchange invoked a measured re-

sponse against Dempsey by levying certain sanctions

against its business and management. Whether this

response was adequate under the circumstances is one

of the major issues of this case. See discussion, infra.

The Exchange placed restrictions on Dempsey prohibit-

ing it from advertising or adding registered representa-

tives, limiting the maximum number of weekly trades,

*“Long security count differences” indicate securities the own-

ers of which a particular firm is unable to identify and locate.

“Short security count differences” indicate securities the owners

of which are identifiable, and locatable, but the firm is unable to

locate the securities themselves.

= =

and requiring an immediate infusion of new capital.

Consequently, Dempsey obtained $14 million in sub-

ordinated capital from the Dempsey partnership, most

of which consisted of common stock in Siboney Corpo-

ration. This stock was unregistered, and therefore not

freely tradeable, nor was it entitled to be treated as

capital under a strict construction of Rule 325 of the

Exchange. However, the Exchange determined, in a

discretionary interpretation of Rule 325, that Demp-

sey could be given capital credit for this stock, and

that the restrictions imposed against that firm could

be lifted. The exercise of this discretion necessarily in-

volved the interpretation of the Exchange’s Constitu-

tion, which established broad powers for discontinuing

the business of a firm which became a risk either to

its creditors, or to the Exchange itself.’ See discussion,

infra.

The Exchange also moved against Dempsey’s top

levels of management, bringing an action against Demp-

sey and certain of its officers, which eventually re-

sulted in a consent to penalty and an offer of settle-

ment, including the levying of a $100,000.00 fine up-

on Dempsey, a $50,000.00 fine upon Jerry Tegeler,

President and principal director of Dempsey, and a

$5,000.00 fine upon Albert Gummersbach, a senior

Vice-President of the firm. Placed upon a restrictive

basis, Dempsey was required to resolve its accounting

and record-keeping problems by September 30, 1969

[5; 1176] under penalty of further reduction of its busi-

ness by the Exchange, or removal from Exchange mem-

bership.

Haskins & Sells commenced its 1969 audit on June

Ist, and, on September 18. 1969, it issued its status

*See note 2, supra.

report of Dempsey as of the first of June. The audit

pointedly avoided the issuance of an unqualified opin-

ion with respect to Dempsey’s financial condition. The

June Ist audit indicated that Dempsey’s net Capital

deficiency had increased to $1,127,000.00; however

this computation included credit for 70 percent of the

value that the Siboney stock would have had if it had

been registered and tradeable. If the Exchange had

not determined, through the exercising of its discre-

tion, to allow this stock to be utilized for capital com-

putation purposes, Dempsey’s net capital deficiency

would have been $9,305,000.00. Dempsey’s interoffice

debit balances had increased to $4,331,000.00, with

securities long raised to $5,321,000.00 and securities

Short raised to $4,480,000.00. Its unresolved “long

security count differences” had decreased to $10,878,-

000.00 and its unresolved “short security count dif-

ferences” had increased to $12,064,000.00. The

amount of improperly pledged customer securities had

increased to $9,034,000.00. In addition, the June 1st

audit revealed that Dempsey now had “fails to deliv-

er,”* to unidentifiable purchasing brokers, in the

amount of $11,206,433.00 (debit balance) at a mar-

ket value of $8,445,884.00 (long security valuation,

with no short valuations indicated.) Further, Haskins

& Sells was unable to confirm the existence of securities

with the approximate market value of $7 million dol-

lars, allegedly held by transfer agents, since replies

were not received to requests for confirmation. As of

June 1, 1969, Dempsey’s unresolved “short stock rec-

ord differences” (also known as “short security count

*These are securities of a particular amount, under a contract

providing for a predetermined settlement date, which for one rea-

son or another a selling broker is unable to deliver.

= =

differences,” see discussion and note 4, supra) exclu-

sive of subordinate borrowings were 213.46 percent

of its stated net worth, the worst in the industry, and

placed that firm perilously close to insolvency in the

event such differences were incapable of being re-

solved.’

In August 1969, the Exchange independently ar-

rived at the same conclusions as Haskins & Sells as a

result of an analysis of Dempsey con- [6; 1177] ducted

by its own examiners—in effect, that Dempsey’s records,

financial and operational reports, and net capital com-

putations were all inaccurate. Senior Exchange officers

and Commissioners had met with their staffs in liaison

meetings over six-week intervals during this period. Con-

gressional and Commission interest in the stability of

the brokerage industry had also been incited earlier

during the late spring and early summer of 1969. On

June 9, 1969, a bill was introduced in the Senate pro-

viding for a Federal insurance program for the protec-

tion of brokerage customers, and a similar bill was

introduced in the House of Representatives at about

the same time.” Subsequently, Congress called upon

the Commission to take a position on such a Federal

customer protection program. This question of protec-

tion became a recurrent topic of discussion in the Ex-

change-Commission liaison meetings, specifically con-

cerning the pivotal issue whether the Exchange's trust

fund would become available for customers of the mem-

“Study of Unsafe and Unsound Practices of Brokers and

Dealers, Report and Recommendations of the Securities and Ex-

change Commission,” H.R. Doc. No. 231, 92d Cong. Ist Sess.

102 (1971) (SEC “Unsafe Study”): see 15 U.S.C. 7&8kkk(h):

See also discussion, infra at 13-16.

his loan, the Exchange first would have to lift the

restrictions on Dempsey, thereby enhancing its imme-

diate potential for growth, and it subsequently would

have to certify that Dempsey would be in compliance

with its net capital requirement rule. The Vice Presi-

dent of the Exchange's Department of Member Firms,

Robert Bishop, refused to accept these conditions. Not-

withstanding these lack of assurances, King went for-

ward with his subordination, on or about March 19,

1970, on the condiiion that the Exchange, with the

acquiescence of the Commission, would then lift its re-

strictions on Dempsey’s underwriting business. King

thereupon executed demand notes for approximately

$7 million, which were secured by King Resources stock

held in escrow with a market value of approximately

$10 million. The Commission advised the Exchange

that the King stock was [9; 1180] marketable, and thus

qualified as capital of Dempsey, whereupon the Ex-

change then gave Dempsey the requisite capital credit.

The King negotiations were also closely watched

by Hughes. In December 1969, Hughes was invited

to the first of three meetings in Walraven’s office to dis-

cuss the feasibility of Hughes subordinating his securi-

ties to Dempsey. Whitney was also present at these

meetings, and, at this time, he advised Hughes not to

commit himself unless King followed through on his

subordination. Whitney outlined the mechanics of sub-

ordination for Hughes at this first meeting. Hughes’

execution of the subordination agreement would transfer

the securitics in his account to Dempsey’s capital ac-

count, but Hughes would continue to secover interest.

dividends and distributions on such se€urities, plus inter-

est payments at one-half o percent above the

prime rate of First Nati City Bank. This latter rate

of interest would realize an additional income to Hughes

from the securities in the amount of $80,000.00. At

this time, Hughes knew that the subordination would

subject his securities to creditors’ claims, and that there

were dangers involved in this venture. Hughes also was

apprised of Dempsey’s accounting problems, and of the

difficulty with the leadership in the New York office."

However, Hughes was impressed with King’s position

on Dempsey, and admitted to relying upon King’s busi-

ness judgment in considering subordination of his own

securities.

In the period between the release of the Haskins

& Sells’ audit of September 1969 and the first Hughes-

Dempsey meeting of December 1969, the Commis-

sion and the Exchange were becoming increasingly

aware that the earlier disciplinary action taken against

Dempsey (the consent to penalty and offer of a settle-

ment, see discussion, supra) were not working. At a

meeting in New York on September 25, 1969, between

agents of the Commission, officers of the Exchange, and

representatives of Dempsey, the substantial noncompli-

ance of Dempsey with past directives to centralize pro-

cedures, remedy deficiencies in accounting, and to take

“Hughes was a subscriber to the Wall Street Journal for

many years. He reads to keep abreast of financial developments,

rticularly with respect to news of his competitors. Hughes testi-

fied on cross-examination that he was not sure whether he had

noticed news items pertaining to the suspension of Mr. Tegeler

from the Dempsey management, which items indicated that such

suspension was a direct consequence of that firm’s accounting dif-

ficulties dating back to 1968. Hughes testified that he did not

recall the specific amount of fincs levied against Mr. Tegeler,

that he did not know that the firm had been censured and that

he did not know the effect of the term “censured” in this re-

spect. Hughes testified that the omission of an opinion by in-

dependent accountants about key aspects of the firm’s financial

status would not have affected his subsequent decision to sub-

ordinate his securities. See discussion, infra at 17-19.

—_——

— =

corrective action with respect to capital balances was

disclosed in a letter written by [10; 1181] Mr. Robert

Haack, the President of the Exchange. It became rather

apparent at this time that not only would Dempsey be

unable to comply with the formerly imposed September

30 deadline, but that it was quite uncertain when, if

ever, Dempsey could submit a statement that appro-

priate corrective measures were being implemented, and

were reflecting successful results. Mr. Tegeler for

Dempsey admitted that he had underestimated the

gravity of Dempsey’s difficulties. Mr. Bishop for the

Exchange demonstrated a firm attitude against a sub-

sequent extension of the September 30 deadline beyond

October 3rd, 1969. And Mr. Sporkin, Associate Direc-

tor of the Division of Trading and Markets for the

Commission, registered an increasing concern for the

failure of Dempsey to keep his office fully apprised of

that firm’s on-going efforts to define, and check, its dif-

ficulties. The Commission’s concern became amplified

in late October 1969. At a second meeting between the

Exchange and Commission representatives on October

24, 1969, strong disagreement over the handling of

the Dempsey problem emerged. Mr. Hurd Baruch, Spe-

cial Counsel for the Commission’s Division of Trading

and Markets, testified to conflict between Mr. Sporkin

and Mr. Cunningham, Executive Vice-President of the

Exchange (the officer in charge of the liaison pro-

gram with the Commission which had originated in late

spring 1969) on the questions of the propriety of in-

junctive action being taken to shut Dempsey down, of

the appointment of a receiver, and of an immediate

curtailment of the solicitation of new business.’* The

precise area of dispute concerned Dempscy’s continuing

'*Mr. Baruch demonstrated bias against the Exchange for its

unwillingness to move more decisively against Dempsey early in

(This footnote is continued on next page)

—_ 99...

violation of the Exchange’s net capital rule, the nature

of control over Dempsey which the Exchange was will-

ing to exercise, and the availability of the Exchange’s

trust fund to Dempsey customers in the event of Demp-

sey’s collapse. In the end, the Exchange prevailed;

Dempsey was not to be suspended. However, further

restrictions were to be imposed. The Chairman of the

Commission, Hamer Budge, demanded a course of ac-

tion from the Exchange, in writing as to its imme-

diate handling of the Dempsey problem, and as to

the availability of the trust fund for Dempsey customers.

It is quite evident [11; 1182] that the Commission’s in-

dependent research efforts into Dempsey’s difficulties,

as well as those of other member brokerage houses, re-

sulted in its conclusion that very serious difficulties

existed with respect to its internal management, ac-

counting, and capital requirements. However, — that

regulatory body eschewed the invocation of any

response under the statutory powers readily available

to it under these circumstances, and acquiesced in the

face of representations by the Exchange that Demp-

sey’s difficulties were neither irreparable nor unmanage-

able, and that it could meet such difficulties sufficiently

to curb the downward trend.’* Thus, a “gentlemen’s

the action long before the stopgap restrictions finally were re-

vealed as generally inadequate. This bias was taken into con-

sideration in determining the weight to be given to his testimony.

Some of Mr. Baruch’s insight can, and should be, attributed to

hindsight; however, apart from this, his observations proved to be

fairly accurate on the Dempsey question. Of course, the Ex-

change’s order of priorities differed—it was concerned with the

viability of the securities market as a whole—and not merely with

one aspect which focused concern on the management of broker-

age houses. Whether the Exchange's assignment of priorities was

defensible is one of the major issues of law in this action. See

discussion, at 21-46 passim.

'*This was an implied recognition of the Exchange's broad

discretionary powers. See discussion and note 2, supra. The

-— =

agreement” was arrived at by which the Exchange

would seek to order its organization in its own fashion,

without “official” pressure from the Commission.

Events subsequently demonstrated that both the Com-

mission and the Exchange erred in their estimations

and predictions. Upon first learning of the Dempsey

problem, the Commission was placed in a difficult

dilemma—Dempsey was not meeting the net capital

requirement of the Exchange, and the Exchange had

lowered its restrictions enabling Dempsey to maintain

a newly established minimum liquidity. The Commis-

sion became justifiably concerned whether Dempsey

could overcome the slowly emerging legacy of the ac-

counting and managerial deficiencies to survive in-

creasingly mounting pressures from owners of securities

and from general creditors. Thus, receivership became

an alternative with respect to solving, singularly, the

Dempsey problem. However, the Exchange reminded

the Commission that the imposition of a receivership

upon Dempsey could raise vast implications for the

brokerage industry as a whole in terms of public con-

fidence in the market. A general crisis was likely with

the potential revelation of similar overextensions on the

part of other houses, which could be compounded by

relatively passive posture adopted by the Commission in this in-

stance has a procedural source in the Commission’s own net

capital requiremeni rule, which sets forth minimum requirements

for brokers, but which provides an exemption for some of them

including “any member in good standing and subject to the

capital rules . . . of the New York Stock Exchange . . . whose

rules, settled practices and applicable regulatory procedures are

deemed by the Commission to impose requirements more com-

prehensive than the requirements of this rule.” SEC Rule 15(c)

(3)-1(b) (2): see 17 C.F.R. $240.15¢3-1(b)(2) (1973) (em-

phasis added). The presumption on the part of the Commission,

of course, was that given “more comprehensive” self-regulatory

tolls, the Exchange would be fully utilizing same. This presump-

tion did not bear fruit in this case.

—_

the absence of income generation in the face of an in-

evitable, public loss of confidence. And, if Dempsey

were thrown into receivership, under the management

of the Commission, the Exchange indicated it would ex-

ercise its discretion in withholding trust funds which

might have been otherwise available in an [12; 1183]

Exchange-controlled liquidation setting. Thus, the Com-

mission’s statutory options were confounded beyond

visible resolution by events intially vaguely understood,

and ultimately irrevocable in effect, and the Exchange’s

choice of alternatives was similarly narrowed by the

burgeoning inertia of its past decisions. Aside from

these broader problems of policy, the relatively narrow

question raised at this juncture is the propriety of the

Exchange's discretionary encouragement of Dempsey

to seek new, subordinated capital to meet an already

previously modified net capital requirement and to pro-

vide desperately needed operating capital for short-term

demand, in the face of the ever increasing likelihood

of an eventual total liquidation which might completely

absorb such subordinated capital.

On December 11, 1969, yet another inconclusive

meeting was held between representatives of the Com-

mission and the Exchange. Mr. Sporkin continued to

express undisguised concern over Dempsey noting that,

in the judgment of the Commission, three brokerage

houses including Dempsey, were in imminent danger of

collapse. Mr. Cunningham refuted these assessments

on behalf of the Exchange. He acknowledged some

problems, but asserted that the Exchange had them

under control, and was taking measures to improve

the difficulties. Specifically, the project to raise subor-

dinated capital for Dempsey was mentioned in the

context of the Exchange’s suggestion that the Commis-

_—,

sion refrain from taking any action lest efforts to solve

the capital deficiency problem be thwarted. The net

effect of the Exchange's interpretation of the Commis-

sion’s role vis-a-vis the Dempsey problem seemed to be

that of a regulatory body of necessity relegated to the

position of a formally and intensely interested, but es-

sentially nonfunctional bystander."

Notwithstanding this relatively ineffectual role for

the Commission, it was kept somewhat apprised of the

events between December 1969 and March 1970 which

led up to, initially, the King, and then the Hughes

subordination. On January 16, 1970, Chairman Budge

requested a “full report” from Mr. Haack as to the

“financial condition” of certain Exchange members. He

also requested that Exchange staff members confer with

| 13; 1184] Mr. Kevin Duffy, the Commission’s Region-

al Administrator in New York City, and with Mr. Spor-

kin to “fully explore” such problems. Mr. Cunningham

responded to Chairman Budge on behalf of the Ex-

change, on January 20, 1970, noting that Mr. Duffy

and Mr. Sporkin had met and conferred with Mr.

Bishop and other Exchange officials as to those firms

with significant business losses in the first half of

1969. Mr. Cunningham represented that these men

had been mecting “every second or third day during

the past several weeks” to confer on those firms with

“immediate problems.” On February 10, 1970, Mr.

Cunningham sent a written report pursuant to Chair-

man Budge’s request which, in substance. revealed that

the resolution of Dempsey’s difficulties was proceeding

siowly. with particular difficulty arising with respect to

Congress appeared to be disturbed by this apparent status of

the Commission. See note 1, supra, and note 29, infra.

— Te

the establishment of Dempsey’s true position on “fails

to deliver.” This report also noted that a final draft

of the King agreement was imminent, and that Mr.

Robert Peck, an accountant who had just reduced cer-

tain difficulties at Hayden Stone, had joined Demp-

sey (in response to Whitney’s solicitation) to assist in

accounting research and clarification as its Executive-

Vice-President-Finance. Upon his appointment, Mr.

Peck immediately embarked upon a detailed reorganiza-

tion effort which, based upon certain crucial assump-

tions, would resolve Dempsey’s profitability problems

by October 1970.

The Commission was supplied with the initial drafts

of the King loan agreement, and, on February 19,

1970 at a Commission conference, representatives of

King, the Commission, and the Exchange met to dis-

cuss the particular requirements of each of the three

participants which had to be resolved prior to enter-

ing into the subordination. These requirements includ-

ed, inter alia, a detailed analysis of Dempsey’s earnings

certified by a competent financial officer; an outline

of Dempsey’s earnings certified by a competent finan-

cial officer; an outline of Dempsey’s financial future

by a competent officer projecting income and expenses

for twelve months, and indicating the basis for the

assumption that Dempsey could break even with a new

interest factor load of $60,000.CO per month; an anal-

ysis of measures to be taken to correct bookkeeping

deficiencies with a time estimate as to compliance there-

with. and an estimate as to possible sanctions to be

[ 14; 1185] levied by the Commission; and, an estimate

of when the registration of the Siboney stock would be-

come effective, and of the percent of its market value

which the Exchange would allow as_ subordinated

capital.

uns.

Following this meeting, the Commission expedited

the registration of King’s stock with the knowledge that

it would be used for the Dempsey subordination. As of

the date of the King registration, February 27, 1970,

Dempsey’s operational problems reflected an increase

in “short securities count differences” ($28,004,331.00

over $12,064,000.00), an increase in securities pledged

in error ($12.668,066.00 over $9,034,000.00) and an

increase in “fails to deliver” in the unidentifiable

brokers’ account ($12,977,173.00 over $1 1 ,206,-

000.00)" over available, similar figures reflecting

the capital condition as of June 1, 1969. The Exchange

did not receive this report until after March 26, 1970

—after Hughes’ subordination entered into force. How-

ever, prior to March 19, 1970, the Exchange’s examin-

ers determined that Dempsey, as of February 27,

had a net capital deficiency of $17,909,857.00 based

upon a ratio of aggregate indebtedness to net capital

of 2000 percent. (Based upon the more stringent ratio

of 1750 percent, which had been previously imposed

pursuant to Rule 325 on September 24, 1969, Demp-

sey’s net capital deficiency was in the amount of $18,-

386,744.00).

King had sought language in the loan agreement

that his loan was contingent upon the Exchange’s certi-

fication that Dempsey was in capital compliance, and

upon the Exchange’s willingness to rescind most of

the restrictions. The Exchange expressly rejected this

condition precedent to the King subordination. The

position of the Exchange was that Dempsey would at-

—_———_

‘This increase in “fails to deliver” does not reflect Dempscey’s

adjustment as of April 1970 for bank overdrafts as of December

1968. See note 21, infra.

~ =

tain compliance after the infusion of the King and

Hughes capital, which would stimulate confidence, and

after the lifting of the restrictions upon Dempsey’s

capabilities to conduct its underwriting business,which

would stimulate expansion. This policy, and specula-

tion, was expressed in correspondence on March 19,

1970 between Mr. Bishop and Mr. Whitney. With this

knowledge and understanding, King went forward

with his subordination. He executed demand notes on

March 19, 1970 for approxi- [15; 1186] mately $7 mil-

lion secured by King Resources’ stock. See discussion,

supra. The Exchange lifted its restrictions on March

24, 1970. Assuming capital credit for the King securi-

ties, Dempsey’s net capital deficiency at this point in

time was $10,241,000.00. However, since the King

stock was “control” stock, technically Dempsey was

not immediately entitled to apply it for purposes of

capital credit. Because the King stock had been only

“shelf registered,” certain post-effective amendments

had to be filed with the Commission prior to any pub-

lic sale. These were never filed prior to the King sub-

ordination, therefore, technically the King securities

were not freely tradeable, and were consequently, im-

properly awarded treatment as “available” capital. Ac-

cordingly, after Hughes’ subordination on March 24,

1970 based upon King’s commitment of his stocks,

Dempsey’s actual net capital deficiency was $17,241.,-

000.00. At this point, a regression to Hughes’ negotia-

tion with the Dempsey executives, and subsequent con-

tacts with the Exchange is appropriate.

In February 1970, Hughes met with Walraven and

Whitney a second time. A subordination agreement was

proposed to Hughes, which was patterned after the

proposed King subordination agreement being dis-

= =

cussed in Washington at that time between the Com-

mission, the Exchange, and the King representatives.”*

Hughes was particularly impressed with the fact that

King was considering a substantial subordination of

securities to Dempsey. (He had realized extensive prof-

its earlier from investments in King stock.) Hughes

authorized extensive negotiations between his securities

counsel and Dempsey’s outside counsel in St. Louis

over the nature and structure of such a subordination

agreement. The agreement proposed to Hughes would

award him (and other “outsiders,” like King) priority

over the purported “insiders” (Dempsey stockholders

who had subordinated loans, including Whitney). Whit-

ney represented to Hughes that it appeared that King

would decide to subordinate if all restrictions were

lifted, and if the “Omega situation” could be resolved."

16At this meeting, Dempsey’s “operating problems” were specif-

ically raised and discussed. Hughes learned that the “biggest”

difficulty lay in Dempsey’s “record keeping,” and that the essen-

tial problem was in the requirement imposed by the Exchange

that Dempsey centralize its accounting in New York City, or in

some other acceptable location, which was very difficult to comply

with since Dempsey could not hire adequately experienced person-

nel to implement such measures. However, Hughes was told

that Dempsey was “doing a big volume of business,” that Demp-

sey was a “viable corporation,” and that Dempsey would be able

to demonstrate these facts once it could “straighten out the back-

office problem.” The restrictions imposed by the Exchange were

also specifically discussed. Hughes was told that the Exchange

required Dempsey to clese some of its offices, and to reduce part

of its staff in order to streamline operations, and that Dempsey

was in “technical violation” of the Exchange’s rules setting mini-

mum capital requirements in relation to the amount of business

being transacted. Hughes was told that Dempsey was “doing more

business than they had capital to back up,” and that that was the

reason for wanting the subordinated capital from him and King.

''Whitney indicated that he would leave soon for Washington

to discuss with the Commission the possibility of resolving, at a

private hearing, the Commission's investigation of Dempsey’s

conduct in relation to the securities of Omega Equities Corpora-

tion.

—_37—

At approximately this time, Whitney renewed his own

subordinated loan to Dempsey in the amount of rough-

ly $485,000.00 (which amount reflected nearly

[16; 1187] 90 percent of his net worth). (His sister

also subordinated capital to Dempsey in the amount of

approximately $400,000.00.) However, under the ierms

of his particular agreement and the rules of the Ex-

change, Whitney was free to withdraw his funds.

The third and final meeting between Hughes, Whit-

ney and Walraven occurred on March 23, 1970—one

day prior to the date of Hughes’ execution of his sub-

ordination agreement. Mr. Peck was present at this

meeting. (Mr. Slavek Uhlir, another accounting expert

employed by Dempsey who was assisting with its rec-

ord-keeping and operations problems, was also pres-

ent.) At this meeting, Walraven and Whitney, either

jointly or individually, represented to Hughes that sub-

ordination of his securities to Dempsey was a good

idea; that the probability of a loss was remote; and

18Whitney never exercised these options, and eventually he

sustained extended personal losses. In addition to his “insider”

subordinated loan, he lost a 5 percent interest in partnership

securities, and $200,000.00 in direct cash contributions to Demp-

sey, thus resulting in a total personal loss of about $700,000.00.

(Whitney's sister also lost her subordinated capital in the amount

of $400,000.00). Whitney emerged as Dempsey’s chief executive

officer in October, 1969. He brought Peck into Dempsey specifi-

cally to devote exclusive, initial efforts toward the resolution of

both accounting and operations problems, after which he would

devote his principal efforts to the operations area. Prior to Whit-

ney’s elevation in the firm, he was responsible for the West Coast

operations centered in Los Angeles, which branch office had a

reputation, both within Dempsey itself and within Haskins & Sells,

for minimizing the difficulties experienced in Dempsey’s other

branch offices. Thus, paradoxically, that very characteristic which

enervated Dempsey nationally in terms of public image-decen-

tralization—enabled Whitney to maintain a relatively strong re-

gional center in Los Angeles. Whitney thus inherited Dempsey’s

problems in general—he certainly did not generate them from

Los Angeles.

= =

that they, as long-standing friends and trustworthy

business advisors, would not suggest subordination to

him if they seriously believed that he would suffer

losses as a result. Neither Walraven nor Whitney were

accounting specialists, and Hughes was fully aware of

that fact. Walraven and Whitney conveyed an optimis-

tic appraisal of Dempsey’s dilemmas, emphasizing ap-

parently meaningful progress in resolving record-keep-

ing and operations problems; deemphasizing the im-

port of such record-keeping and operations problems

by suggesting that they were caused in part by the

Exchange’s imposition of restrictions, which merely cut

down Dempsey’s profitability margin in underwriting;

misconstruing Dempsey’s true capital state (by no

means a unique error in this case); and misplacing the

final effect of the expected King subordination by sug-

gesting that it alone was sufficient to cure Dempsey’s

capital plight.” It is patently obvious that neither

Walraven nor Whitney knew of the _ substantially

weak position of Dempsey, or of the full extent of the

accounting errors, which, in turn, precluded a presenta-

tion of a true picture of Dempsey’s capital structure.

However, Peck also had Hughes’ undivided attention at

times during this third meeting.

Peck presented an array of documents, which, if

closely examined and given careful thought, would

'‘*Hughes was told by these two men that Dempsey had been

able to reduce its capita! deficiency by about 15 million dollars

(reducing the deficiency from 23 million to five million dollars. )

He was told that there was a possibility that he could lose his

money, but that it was not very “probable.” He recalled Walraven

saying that he would not let Hughes “go into this thing if I

thought you were going to lose anything.” During that meeting,

and even prior to this mecting, Walraven had offered the sugges-

tion of Hughes arranging to meet with King, the latter's private

(This footnote is continued on next page)

—_— =

have at least raised serious [17; 1188] questions and

doubts far more substantial than those engendered by

Walraven and Whitney's representations.” Peck of-

fered Hughes his assessment of Dempsey’s contempo-

rary accounting and capital state, including the import

of its stock record differences, “fails to deliver,” and

intercompany accounts.’ Most critically, Peck offered

plane apparently being accessible to Hughes for this purpose.

Hughes was not told that Dempsey was insolvent, or close

insolvency.

*“*These included: (1) Dempsey’s financial statement as of

June 1, 1969; (2) Dempsey’s comparison of capital charges; (3)

Dempsey's interoffice correspondence from John Ellis to Whitney

of February 23, 1970; (4) Dempsey’s profit plan of February 20,

1970; (5) Dempsey’s “Registered Representative Status”; (6)

Dempscy’s income and expense projections; (7) Dempsey’s prog-

ress report contained in a letter from Whitney and Mr. Peck to

Mr. Sporkin on March 9, 1970; (8) Dempsey’s schedule of its

problems, and Mr. Peck’s proposed plan for resolving them (also

contained in the letter of March 9 to Mr. Sporkin); (9) Demp-

sey’s organization chart, (also featured in the March 9 letter to

Mr. Sporkin); and (10) a statement containing certain data

which was a pro forma balance sheet reflecting Dempsey’s finan-

cial position as of February 27, 1970. Hughes was also presented

with the various documents needed to consummate his subordina-

tion. See discussion, infra; see also note 21, infra.

21Peck read the March 9, 1970 letter to Mr. Sporkin, amplify-

ing upon the technical terms contained therein. Peck projected

that, in the coming eight-month period ending in October 1970,

he planned to reduce the suspense items by $!,800,000.90 per

month in short differences, and, by October 1970, have remain-

ing short differences and suspense items in the amount of $4

million. He also projected that the intercompany accounting prob-

lem could be reduced at the rate of $1,500,000.00 per month

starting in April 1970, and could be completed in October 1970.

(With respect to these projections and others, Peck subsequently

achieved the progress which he had contemplated in most of the

areas.) Peck pointed out to Hughes that 1968 had been a profit-

able , but that 1969 refiected losses—specifically, operating

Senas to Denunap 1970 or $876,000.00. He projected that losses

would continue thr to and including October 1970 so that

not until November 1970 could he project Dempsey operating at

a profit. Peck specifically discussed the capital state of Dempsey

as reflected in the pro forma financial data statement as of

February 27, 1970, noting that, even after the King and Hughes

—

Hughes his professional opinion that a doubling of the

firm’s income was required to break even on Dempsey’s

accounts, and that such a projection of breaking even

was founded upon the basic premise that Dempsey

would encounter renewed growth (e.g. expansion in

the sales force) which, in turn, was further premised

on the even more fundamental factor that general

market conditions would have to improve. Peck care-

fully pointed out that if these premises became en-

dangered, he would have to revise his projections. Peck

further advised Hughes that Bishop had refused to

extend the Exchange’s certification of Dempsey’s capi-

tal compliance prior to King’s execution of his sub-

ordination. See discussion, supra. Peck expressly

disagreed with Walraven and Uhlir’s optimistic assess-

ments of Dempsey’s operational trends, and flatly told

Hughes that there was a “good chance” that he would

lose his money if he went ahead with the subordina-

tion. In addition to these admonitions by Peck, Hughes,

prior to this third meeting, had been informed as to

several background events which, cumulatively at least,

loans, Dempsey would have a capital stock and surplus of only a

little more than $2 million. At this point, Peck physically handed

the pro forma statement to Hughes. During this discussion,

Hughes learned that Dempsey’s earlier computations revealed

a deficit of about $5 million, that Peck estimated potential addi-

tional capital charges, over and above that $5 million deficit, in

the range between $6 million and $16 million, and that Peck also

had discovered, on the eve of this meeting, an error in the recon-

ciliation of the bank statements in the amount of about $5 mil-

lion, consisting primarily of two substantial checks which had

never been recorded in the books. Therefore, Hughes was on no-

tice that as to potential additional financial charges, Dempsey

faced a potential capital deficiency of over $26 million.

“It was mentioned at this meeting that Dempsey’s usage of

the Siboney stock was limited by the Exchange—that the Ex-

change weuld not allow that stock to be used for capital compu-

tation pusposcs. Hughes had specific knowledge of the restricted

use of the Siboney stock.

— wa

Suggested that extracrdinary caution was merited.” In

closing, Peck offered to elaborate upon the data which

he had revealed to Hughes at this third, and final,

meeting. Hughes did not request further explanations.

He gave no indication that he did not understand that

which Peck had related to him, and Peck concluded

that Hughes understood everything which Peck had

communicated to him. In light of the nature of the in-

formation offered by these three sources, which Hughes

could have given equal weight, and, particularly in

light of the different roles each of these advisors played

prior to and during this meeting, it is not an unreason-

able inference to conclude that, in the final analysis,

Hughes simply followed that advice which he wanted

to hear. And, he wanted to believe that subordination

would be fruitful, and not based upon a substantial

risk. In [18; 1189] this sense, Hughes alone was to

blame for his losses, for the signals of potential disaster

were pregnant in Peck’s statements. Hughes just either

dismissed them lightly, or decided to ignore them en-

tirely.

**Those background events of which Hughes had prior knowl-

edge were that: Dempsey was generally plagued with back-office

paperwork, reflecting its subpar record-keeping of transactions

(which resulted in the Exchange’s requirement that it centralize

its accounting department in one location); Dempsey was having

difficulty hiring adequately experienced personnel to operate its

accounting department; the Exchange had directed Dempsey to

close some offices, reduce its staff, and not hire any more regis-

tered representatives, Dempsey was overextending its business

(i.e. it was doing more business than it had capital to back up);

Peck, an operations expert, had been directed in early 1970 to

take over the New York situation, and straighten matters out;

Tegeler had been ye by the Exchange for one year, and

had also been fined for mismanagement; and Hughes had been

previously informed by his contemporary securities counsel that

the effect of the subordination agreement, as contemplated and

ultimately executed, would expose his subordinated capital to the

representatives of Dempsey’s creditors in the event of a situation

calling for their financial protection.

4)...

After the meeting, Hughes took the documents home

with him. Whitney told him to confer with his securi-

ties’ lawyer, and to await Whitney’s notification that

the King loan had been consummated and that the

restrictions against Dempsey had been lifted. After

notice of these events, Hughes executed the appropriate

documents on March 24, 1970, including the subor-

dination agreement of that date;** a subordination

agreement dated January 20, 1970;” a “knowledge-

ability letter” addressed to the Exchange;** and a doc-

ument required by the Exchange for its approval of

Hughes as a subordinated lender to a member organi-

zation.*’ Hughes returned all documents to Whitney,

except the “knowledgeability letter,” which he mailed

directly to the Exchange.

Shortly after the King and Hughes subordinations

of March 1970, the entire stock market plummeted.

The New York Stock Exchange Index declined by

approximately 25 percent, the American Stock Ex-

change and over-the-counter averages declined by sub-

stantially greater amounts. The stock securing the King

loan dropped from $23 per share in March 1970 to

approximately $6 per share at the end of May 1970.

On April 30, its market value had been $5.5 million

($14 per share); by May 22, its net value had de-

24 Agreement Subordinating Individual’s Account,” between

Hughes and Whitney, dated March 24, 1970. Exhibit 15.

“Subordination Agreement,” between Hughes and various of-

ficers acting on behalf of Dempsey, dated January 20, 1970.

Exhibit 11.

*“Letter from Hughes to the Exchange’s Department of Mem-

ber Firnis-—Division of Finance, undated. Exhibit 12.

™Financial Supplement to Application of Reuben P. Hughes

|djated March 24, 1970 Concerning the Member Corporation,

Dempsey-Tegeler & Company, Inc.,” signed by Hughes and

Whitney, undated. See Exhibit J.

—

clined to $2.7 million. By July 1970, there was no

market for the King stocks, the market value had fallen

to $1.50 per share.» The precipitous decline of the

stock market in general, and the King stock in particu-

lar, was disastrous for Dempsey. It not only reduced

the value of-the securities constituting Dempsey’s capi-

tal position, but it also limited Dempsey’s ability to

obtain new financing,.and to maintain existing financ-

ing collateralized by securities. The decline in volume

of general trading in the securities industry was so

precipitous from April 1970 to June 1970 that emer-

gency relief (implemented by the Exchange, but ap-

proved by the Commission) was required in the form

of a $15 surcharge placed upon each securities trans-

action. This decline in volume adversely affected Peck’s

[19; 1190] profit projections for Dempsey, and his con-

verse proposition was borne out as Dempsey’s operating

losses continued. This precipitous failure in the securi-

ties market, particularly in the King stock, and the

recession in securities trading were not anticipated on

the date of Hughes’ subordination. Hughes acknowl-

edged the unforeseeability of these dramatic events to

be a simple truth. Another unforeseeable factor was

King’s failure to shore up his stock held in escrow to

secure his $7 million note. Under the King loan agree-

ment, he was required to add whatever additional

security was necessary in order to maintain the value of

the stock. King did not perform its obligation, and

the capital value of his loan declined as a direct con-

sequence of the decline in value of his stock.

In the first week of June 1970, the Exchange deter-

mined that Dempsey might not be able to meet its pro-

28SEC “Unsafe Study,” supra, at 72.

—44—

jections, and that its customers might require recourse

to the trust fund. On June 4, 1970, the trustees au-

thorized $5 million from the trust fund to be placed

on standby. Liquidation of Dempsey became an im-

mediate possibility. On or about July 15, 1970,

Hughes’ subordinated securities were sold as provided

for in the subordination agreement. On August 7,

1970, Dempsey’s liquidation was commenced by the

execution of a liquidation agreement by Dempsey’s vot-

ing stockholders and the Exchange, which provided for

the appointment of a liquidator. The trust fund ex-

pended $22.6 million to Dempsey’s customers. At the

time of this case’s initial submission, the liquidation

had recovered $1.7 million, with contemporary, max-

imum prospects for recovery set at $13 million above

the $1.7 million figure. Of the approximately $36

million negative net worth set for Dempsey as of the

liquidation audit on August 20, 1970, the liquidator had

recovered $15 million through accounting research,

which has been used to the benefit of Dempsey’s cred-

itors. The $15 million recovered by the liquidator plus

the $1.7 million recovered by the trustees reduced the

actual negative net worth of Dempsey upon liquida-

tion as of August 20, 1970 to $19.3 million. Contin-

ued recoveries up to the maximum amount of $13

million may eventually reduce the ultimate negative net

worth of Dempsey to $6.3 million. [20; 1191] Hughes

lost $1,271,600.00 in his subordination to Dempsey.

He maintained an account with a member firm, dealing

through Walraven as his registered representative, and

through Whitney as the supervisor of his account at

that firm, until April 1971, on the eve of this lawsuit.

—

Statement of the Issues.

The issues in this case are quite complex and do

not lend themselves to simple statement or to inde-

pendent formulation. However, five very broad ques-

tions can be phrased at this juncture, which allow

for some frame of reference for the following discus-

sion and analysis.

I. Whether the inherent nature of Hughes’ sub-

ordination entitles it to protection under the two

Federal securities statutes.

Il. Whether the Exchange was obligated toward

Hughes under Federal law, and if so, what was

the nature, extent, and consequences of nonper-

formance of that obligation.

III. Whether the Commission’s role affected the

nature, performance, and consequences of any

obligation to be performed by the Exchange for

Hughes.

IV. Whether the nature of the subordination

agreement, and of Hughes’ status and role vis-a-

vis the Exchange and Dempsey, allowed recovery

by Hughes against the Exchange, Dempsey and

Whitney.

V. Whether any basis lies for Hughes’ recovery

premised on the August 1970 liquidation agree-

ment executed between the Exchange and Demp-

sey.

These issues do not necessarily signal order of dis-

cussion, or of priority in treatment. Equally important

subissues implicitly raised by the very statement of

these five primary issues may appear to be more dis-

positive in the final analysis. There will be no at-

_ =

tempt to segregate discussion of the primary issues or

subissues, indeed, the dovetailing of the issues of law

is inevitable. [21; 1192]

Discussion of Law.

The threshold question challenges the viability of

Hughes’ statement of claims inasmuch as it pertains to

the effect of the subordination agreement under the se-

curities laws. An analysis begins with two basic prem-

ises: (1) Hughes negotiated and purchased a subordina-

tion agreement with Dempsey which would subject his

securities to the claims of actual and potential creditors

in exchange for standing interest on the securities, plus

an additional interest rate which was also provided by

the agreement; and (2) the Federal securities laws were

designed for the purpose of avoiding frauds, and to this

end they should not be construed restrictively nor tech-

nically, but flexibly to effectuate their remedial pur-

poses. S.E.C. v. Capital Gains Research Bureau, Inc.,

375 U.S. 180, 195 (1963).

The latter premise is to be applied to the very def-

inition of a “security” within the two statutes. See

section 2(1), Securities Act, 15 U.S.C. 77(b)(1),

and section 3(a)(10), Securities Exchange Act, 15

U.S.C. 78(c)(10). Particularly, these definitions should

embody flexible rather than static ideas, which are

capable of matching the various schemes devised by

those who seek the application of others’ property for

the promise of profit, S.E.C. v. W. J. Howey Co., 328

U.S. 293, 299 (1946), and should look to substance,

not form, with emphasis on the economic realities of

the transaction or device. Tcherepnin v. Knight, 389

U.S. 332, 336 (1967). The term “security” is defined

within sections 2(1) and 3(a)(10) as including “any

—_— =

. Investment contract.” An “investment contract”

within the Securities Act is “a contract, transaction or

scheme whereby a person invests his money in a com-

mon enterprise and is led to expect profits solely from

the efforts of the promoter or a third party.” S.E.C.

v. W. J. Howey Co., supra at 298-299. The facts clear-

ly indicate that Hughes contemplated acquisition of

profits from his investment of securities, pursuant to the

subordination agreement, which investment was con-

trolled solely by the efforts of those who promoted

the idea to him. Therefore, the subordination agree-

ment was an “investment contract” under the Securities

Act, and is entitled to protection as “security.” [22;

1193] Inasmuch as the subordination agreement does

not fall within the short-term commercial paper exemp-

tion provided for in section 3(a)(1), it is to be con-

sidered an “investment contract” under the Securities

Exchange Act, and is also entitled to protection as a

“security” under that statute. See Sanders v. John

Nuveen & Co., Inc., 463 F. 2d 1075, 1078-1079 (7th

Cir., 1972). Furthermore, inasmuch as the subordina-

tion agreement, on its face, establishes an obligation to

pay an amount of money earned as interest for the use

and application of securities, it is deemed to be an “evi-

dence of indebtedness” within sections 2(1) and 3(a)

(10). See United States v. Jones, 450 F. 2d 523, 525

(Sth Cir., 1971); Farrell v. United States, 321 F. 2d

409, 417 (9th Cir., 1963); cert. denied, 375 U.S. 992

(1964). Finally, inasmuch as the subordination agree-

ment created an obligation for Hughes to transfer or

otherwise dispose of certain interests in his securities

in exchange for value, it is deemed to have constituted

a “sale” of securities within section 2(3) of the Se-

—_48—

curities Act, 15 U.S.C. 77b(3) and within sections

3(a)(14) and 3(a)(10) of the Securities Exchange

Act, 15 U.S.C. 78c(14) and (10). See S.E.C. v. Na-

tional Bankers Life Insurance Co., 334 F. Supp. 444,

456 (N.D. Texas, 1971). Accordingly, the subordina-

tion agreement is entitled to protective coverage by the

two Federal statutes.

The next three broad questions cannot, as a prac-

tical matter, be compartmentalized. However, they do

suggest an approximate order of treatment. The first

question must concern the source of the Exchange’s

powers to regulate member firms, and the nature of

such powers, i.e. what is the meaning to be attributed

to the Exchange’s “discretionary powers” under the

Securities Exchange Act. Section 6 of this statute pro-

vides for the registration with the Commission of any

exchange as a “national securities exchange” “under

the terms and conditions” therein provided. See 15

US.C. 78f(a). The import of section 6 is clear on its

face. Broad powers are indeed granted to such “national

securities exchanges,” but their ultimate direction and

purpose are not subject to academic dispute—such in-

stitutions are to “enforce so far as is within [23, 1194]

{their | powers” compliance by their member firms with

the provisions of Chapter 3B—Securities Exchanges.

15 US.C. 78f(a)(1). Since Congress provided for the

delegation of such authority to the exchanges, the latter

have the clear responsibility to pursue that charge. A

section 6 registration agreement is subject to an appar-

‘ent condition subsequent that it shall not remain in

force unless the exchange’s rules provide for the “ex-

pulsion, suspension, or disciplining of a member for

conduct or proceeding inconsistent with just and equi-

—

table principles of trade,” and unless the exchange’s

rules declare that the “willful violation” of any pro-

visions of said chapter “shall” be considered conduct

inconsistent with just and equitable principles of trade.

15 U.S.C. 78f(b). Thus, the “discretionary” charge

foresees mandatory action under certain conditions.

Accordingly, it cannot be deemed that the Exchange

has been given unrestrained, discretionary authority to

regulate member firms—rather its charge was to com-

ply in all respects with the provisions of Chapter 2B

in relation to its control over member firms. This was

expressly provided for in a separate subsection where

Congress saw fit to allow exchanges to fashion and

adopt new rules implement the purposes of Chapter

2B. 15 U.S.C. 78f(c). Such “rules” as the exchanges

promulgated included. constitutional provisions within

the scheme of section 6— “whatever the name” given

to such self-regulatory guidelines. 15 U.S.C. 78f(a)(3).

Thus, the assertion that the Exchange’s regulation of

member firms is essentially a “discretionary” function is

shallow once the statutory charge is closely examined.

This is consistent with the purpose and scope of the

Securities Exchange Act. The impotency of a private-

club atmosphere, with its attendant tendencies to es-

chew self-regulation, became inapposite to the demands

and risks of a national economic and financial system.

Silver v. New York Stock Exchange, 373 U.S. 341,

351 (1963). Congress’ intent in providing the en-

forcement scheme in this statute was to supply a pro-

tective shield in place of the “ ‘enlightened self-interest

in private leadership’” which, as a result of “ ‘inertia,

pressure of vested interests, lack of organization, or

otherwise,” had [24: 1195] not been able to provide

the methods of protection to match the challenges of

_— =

rapid change and growth in business. Silver, supra (cit-

ing H.R. Rep. No. 1383, 73d Cong., 2d Sess. 15 (1934)

at 3). In support of its argument that section 6 leaves

“broad discretion” to the exchanges in interpreting and

applying their own rules, the Exchange cites /ntercon-

tinental Industries, Inc. v. American Stock Exchange,

452 F. 2d 935, 940 (Sth Cir., 1971). The Fifth Circuit

did refer to such discretion, but in the context of up-

holding the American Stock Exchange’s discretion in

the application of one of its own rules, which applica-

tion was previously approved by the Commission. /d.

Two crucial facts distinguish the instant case: (1)

Hughes is suing for the Exchange’s failure to apply its

rules: and (2) the Commission took no formal action

whatsoever, indeed there is a suggestion that the Com-

mission did not perform its duty, under section 19(b),

to order changes in exchange rules in appropriate sit-

uations. See discussion, infra. The defendant’s exposi-

tion of the Commission’s posture toward the imposi-

tion of penalties against Dempsey by the Exchange, and

its suggested conclusion that, if the Exchange had been

remiss the Commission could have taken action, begs

the question whether a private cause of action remains

notwithstanding any executive response on the part of

the Commission, or in the absence of any such response.

The cases indicate that a private right of action does

lie against the Exchange for an alleged violation of its

duties established by Congress under section 6. Baird

v. Franklin, 141 F. 2d 238, 244-245 (2nd Cir., 1944);

cert. denied, 323 U.S. 737 (dissenting opinion) (ma-

jority held damages not caused by breach of duty);

Bright v. Philadelphia Baltimore-Washington Stock Ex-

change, 227 F. Supp 495, 500-503 (E.D. Pa.. 1971)

(duty to abide by rules in insuring fairness in annual

~—

elections; Weinberger v. New York Stock Exchange,

335 F. Supp. 139, 142 (S.D.N.Y., 1971) (duty to

plaintiff on third party beneficiary theory created cause

of action not barred by statute of limitations); see also

Butterman v. Walston & Co., 387 F. 2d 822, 825

(7th Cir., 1967); rehear. denied en banc (1968);

Pettit v. Americar. Stock Exchange, 217 F. Supp 21,

29 (S.D.N.Y., 1963). [25; 1196} Accordingly, Hughes

did have a private right of action against the Exchange

for an alleged violation of iis section 6 duties toward

Deiapsey under the Securities Exchange Act. The meas-

ure of this duty as applied to the facts of this case, i.e.

whether the Exchange abused its discretion, or other-

wise violated its statutory charge, depends to a certain

extent upon Hughes’ status, and, to a greater extent,

upon the nature and amount of information to which

Hughes had access—or to which he should have had

access. These are questions which must be reserved for

a simultaneous treatment of Hughes’ relationship with

the other principal characters, and of the evolution of

the subordination agreement. See discussion, infra.

However, other preliminary questions as to the status of

the Exchange have been posed.

Hughes contends that the Exchange was a “control-

ling person” under the securities acts, and that its

relationship with him was that of a fiduciary. The

liability of a “controlling person” under these acts is

governed by section 15 of the Securities Act, 15

U.S.C. 770, and by section 20(a) of the Securities

Exchange Act, 15 U.S.C. 78t(a). In essence, these sec-

tions provide for the joint and several liability of any

person who, directly or indirectly “controls” any other

person who is subject to liability under sections 11 and

12 of the Securities Act, 15 U.S.C. 77k and 77L, and

—_

under Chapter 2B of the Securities Exchange Act, un-

less such “controlling person had no knowledge of or

reasonable ground to believe in the existence of the

facts by reason of which the liability of the controlled

person is alleged to exist,” under the Securities Act,

or unless such “controlling person acted in good faith

and did not directly or indirectly induce the act or acts

constituting the violation or cause of action” under

the Securities Exchange Act.

The reach of potential liability under sections 15

and 20(a) is very broad. (At this juncture, the dis-

tinction between the dispositive language in the two

sections pertaining to “knowledge,” “belief,” and “good

faith” is deemed to be insignificant for purposes of

determining whether the Exchange was a “controlling

person” under these sections. Liability will be raised

[26; 1197] subsequently. See discussion, infra.) Section

15 was rot intended to serve as a limitation on liability

of persons extending control over others, rather it was

intended to supplement and extend beyond the common

law principles of agency and respondeat superior. Johns

Hopkins University v. Hutton, 297 F. Supp 1165,

1211-1213 (D. Md., 1968); rev’d on other grounds,

422 F. 2d 1124 (4th Cir., 1970). Similarly, section

20(a) has been given equally broad treatment, which

is consistent with the liberal rules of construction af-

forded the Securities Exchange Act to enable that stat-

ute to achieve its remedial purpose. S.E.C. v. First Se-

curities Co. of Chicago, 463 F. 2d 981, 986-987 (7th

Cir., 1972): rehear, denied (1972); cert. denied., 93

S. Ct. 85 (1972). Section 20(a) “has been inter-

preted as requiring only some indirect means of dis-

cipline or influence short of actual direction to hold a

‘controlling person’ liable.” Myzel v. Fields, 386 F.

2d 718, 738 (8th Cir., 1967); cert. denied, 390 US.

951 (1968); Strong v. France, 474 F. 2d 747, 752

(9th Cir., 1973). Clearly, in light of the plain language

of sections 15 and 20(a) and the cases cited, the Ex-

change was a “controlling person” under these two

statutes. Indeed, to hold otherwise would be anom-

alous. One of the Exchange’s prime defenses is that it

fully and satisfactorily exercised its “discretionary” pow-

ers under section 6 with respect to the handling and

management of Dempsey during the critical period.

The Exchange directed Dempsey to make personnel

changes, close offices, reduce operations, and to cen-

tralize accounting procedures, in addition to suspend-

ing its own requirements pertaining to Dempsey’s cap-

ital position and accounting practices. See discussion,

supra and note 23. Accordingly, the Court finds the

Exchange to be a “controlling person” of Dempsey

during the relevant period within the meaning of sec-

tions 15 and 20(a). A fortiori, the Exchange must be

deemed to have been a fiduciary vis-a-vis Hughes un-

der these circumstances, and must be considered to

have been under all obligations attendant to that po-

sition. Baird, supra at 246-247. Finally, with respect

to the question whether the Exchange was an aider

and abettor of the alleged fraudulent conduct engaged

in by Dempsey, Whitney or [27; 1198] Walraven, two

general requirements must be satisfied: (1) knowledge

that there was a breach of duty; and (2) substantial

contribution or encouragement to the person commit-

ting the breach. See Brennan v. Midwestern United

Life Insurance Company, 286 F. Supp 702, 708-709

and 725 (N.D. Ind., 1968), aff'd, 417 F. 2d 147, 154-

155 (7th Cir., 1969): cert. denied, 397 US. 989

(1970); Pettit v. American Stock Exchange, supra

at 28. 217 F. Supp 21, 28 (S.D.N.Y., 1963). How-

ever, both of these requirements raise duty, breach and

causation elements which must be dealt with sub-

sequently. See discussion, infra.

Before applying the conclusions above to the facts

and remaining questions of law, a focus upon the

Commission and its role in this case is appropriate

at this time. The question might be phrased as fol-

lows: whether the Commission abstained from imple-

menting statutory sanctions against the Exchange, bas-

ing its response upon the information supplied by the

Exchange as to the condition of Dempsey, and, if

such a posture was in fact assumed by the Commis-

sion, what significance is to be attached to such reg-

ulatory abstention. This, of course, raises very crucial

questions, including: (1) whether the Commission did

abstain from moving against the Exchange; (2) whether

the Commission had full and complete information as

to the condiiion of Dempsey so as to credit an appro-

priate weight to its response; and (3) whether any ac-

tion or inacticn of the Commission, nevertheless, is

moot insofar as an injured party may be entitled to a

private right of action against the Exchange.

The facts indicate that the Commission did not take

“formal” action against the Exchange pursuant to its

statutory mandate under section 19(b), 15 U.S.C.

78s(b). See discussion, supra. Section 19(b) author-

izes the Commission to request exchanges to imple-

ment specified changes in their rules and practices,

and, if such changes are not thus implemented, it au-

thorizes the Commission to alter or supplement such

rules and practices by rules or regulations “appropriate

for the protection of investors or to insure fair deal-

ing in securities traded in upon such exchange or to

insure fair administration of such exchange.” The facts

[28; 1199] indicate that the Commission endeavored to

create an informal information-gathering relationship

with the Exchange on the state of its member firms,

particularly Dempsey, and that the Commission sought

to make its presence felt as an intensely interested of-

ficial body. However, the facis are also very clear that

the Commission’s options under the Securities Ex-

change Act were, for all intents and purposes, pre-

cluded by two paramount factors in this case: (1) the

Exchange's essentially exclusive control over, and ac-

cess to, the barometers by which the financial and ac-

counting state of the member firms could be deter-

mined, in particular, the capital and accounting rec-

ords of Dempsey; and (2) the Exchange’s singularly

dispositive, unilateral decision, entirely within its dis-

cretionary powers, to. withhold the availability of its

trust funds from creditors should the Commission im-

pose receivership upon Dempsey. The former simply

made the Commission wholly dependent upon the Ex-

change as a source of necessary information as to

Dempsey. The latter simply made relative inaction on

the part of the Commission mandatory if it sought to

maintain stability within the industry as a whole. Thus,

these two paramount factors, in effect, relegated the

Commission’s stature in this instance to that of, essen-

tially, an advisory board. Accordingly, not only did the

Commission abstain in this case, but the Court certainly

cannot conclude that it had that measure of available

information which would then render such inaction on

its part as an indication of either tacit administrative

approval, or unequivocal administrative sanctioning of

the Exchange’s efforts vis-a-vis the Dempsey question.

_ =

Both parties cite Silver, supra and Ricci v. Chicago

Mercantile Exchange, 409 U.S. 289 (1973) in support

of their respective positions. Silver recognized that the

Commission had power under the Securities Exchange

Act to request rule changes of the exchanges, and to

disapprove of any adopted rules. 373 U.S. at 357.

However, the Supreme Court noted that the Act “does

not give the Commission jurisdiction to review particu-

lar instances of enforcement of exchange rules,” and

therefore the question of administrative exhaustion be-

fore the Commission was [29; 1200| precluded. /d. The

Supreme Court limited the issue to the extent to which

the character and objectives of the duty of exchange

self-regulation contemplated by the Securities Exchange

Act are incompatible with the maintenance of an anti-

trust action.” 373 U.S. at 358. Immediately thereafter,

the Court concluded that the mere absence of Commis-

sion jurisdiction contributed to the solution of the prob-

lem—there was nothing built into the regulatory

scheme which would perform the antitrust function of

insuring noninjury to competitors by the application of

exchange rules. Jd. By way of analogy, the issue here

is only that of the extent to which the character and

objectives of the duty of exchange self-regulation con-

templated by the Act are incompatible with the main-

tenance of a securities fraud action, which action direct-

ly raises matters involving the “safeguards in respect

of the financial responsibility of members and adequate

provision against the evasion of financial responsibil-

ity.” See section 19(b), 15 U.S.C. 7s8(b). Inasmuch

a§ Silver represents a holding that the Exchange's du-

ties of self-regulation under the Act are not incompati-

ble with the insintenance of an antitrust action, it fol-

lows in analogous fashion, that-such duties of self-

=~ =

regulation as are practiced by the Exchange, and as

are subject to interpretation, alteration or revocation

by the Commission, nevertheless are not incompatible

with the maintenance of this securities fraud action.

See Ricci, supra, at 301-302. Accordingly, in response

to the third, and final, question posed, it appears that,

notwithstanding the Commission’s response in this case,

Hughes was entitled to a private right of action against

the Exchange for its application and interpretation of

its rules. This would appear to be particularly impor-

tant in an instance such as this where the Government

not only “{k]jept the shotgun, so to speak, behind the

door,” but, apparently, removed its firing pin, and

placed the weapon in a display case. See Silver, supra

at 352.

The most crucial area of inquiry is now reached.

What was the nature of Hughes’ status vis-a-vis Demp-

sey, Whitney and the Exchange as determined both by

oral representations and written communications,

[30; 1201] including the very source of the controversy

—the documents comprising the subordination agree-

ment.

A discussion of the unresolved elements of the prin-

cipal causes of action under section 12(2) of the

Securities Act and section 10(b) of the Securities Ex-

change Act would be appropriate at the outset. (The

two sections’ interstate commerce communication and

instrumentality requirements, respectively, are clearly

satisfied by the facts.) The section 12(2) elements in

controversy in this case are as follows: (1) a com-

munication of an untrue statement of a material fact,

or of a statement which omits to provide a material

fact necessary in order to make that statement, in light

of the circumstances under which it is made, not mis-

leading; (2) which arises in the course of an offer or

= =

sale of a security; (3) which was made without

Hughes’ knowledge of such untruth or omission; and

(4) which was made with the knowledge of the offeror,

or, in the exercise of reasonable care, could have

been made with his knowledge. See Johns Hopkins

University, supra, 422 F.2d at 1128. The elements at

issue for a section 10(b) recovery in this case are less

restrictive; (1) the use or employment of any manipu-

lative or deceptive device which incorporates a com-

munication of a “material misstatement of an omis-

sion of a material fact;’ and (2) which communica-

tion was made “in connection with the purchase or

sale of any security.” See Royal Air Properties, Inc. v.

Smith, 312 F. 2d 210, 212 (9th Cir., 1962); Ellis v.

Carter, 291 F. 2d 270, 274 (9th Cir., 1961): Mathe-

son v. Armbrust, 284 F. 2d 670, 673 (9th Cir., 1960).

In addition, certain other burdens and privileges ob-

tain under these sections’ causes of action. Although

the purchase language of section 12(2) would seem to

clearly embrace the concepi, privity of contract does

not seem to be required for the maintenance of a sec-

tionl0(b) cause of action, see Texas Continental Life

Insurance Company v. Dunne, 307 F.2d 242, 249

(6th Cir., 1962); rehear. denied (1962), indeed, it

may have all but disappeared as a prerequisite. See

2 Bromberg, Securities Law: Fraud §8.5 (511) and

cases cited. In order to prevail under a section 12(2)

claim, Hughes is neither required to demonstraie scien-

ter, or intent {31: 1202] to defraud, on the part of the

defendants, Phillips v. Alabama Credit Corporation,

403 F. 2d 692 (Sth Cir., 1968); Woodward v. Wright,

266 F. 2d 108, 116 (10th Cir., 1959); rehear. denied

(1959), nor is he required to prove reliance. Wood-

ward, supra; John Hopkins University, supra, 422 F.

— =

2d at 1129. Hughes does not need to prove scienter to

prevail in a section 10(b) cause of action. Hecht v.

Harris, Upham & Co. 430 F. 2d 1202, 1209 (9th Cir.,

1970); mod’f on denial of rehearing (1970). And, un-

der circumstances involving primarily a failure to dis-

close, circumstances found to exist in the instant case,

Hughes need not submit “positive proof of reliance” to

recover under section 10(b) and the Commission’s

Rule 10b-5 promulgated thereunder. Affiliated Ute

Citizens of Utah v. United States, 406 U.S. 128, 152-

153 (1972); see 2 Bromberg, supra at §8.6(2). Cau-

sation-in-fact between the subject representations and

Hughes’ loss apparently may be presumed, as a matter

of law under a section 12(2) cause of action, if the

representations conveyed which surrounded the con-

summation of the subordination agreement were, in

fact, false or misleading. Johns Hopkins University,

supra, 422 F. 2d at 1129-1130. Causation-in-fact as a

requisite element for a successful section 10(b) cause

of action similarly may be presumed to exist where

the element of materiality is present in connection with

the purchase of the subordination agreement, either as

to the communication of a statement which fails to

provide certain facts or as to the communication of a

misrepresentation. See 2 Bromberg, supra at §8.7(2).

An appropriate test for materiality under section 12

(2) is whether a fact concerns information about

which “‘an average prudent investor ought reasonably

to be informed before purchasing the security,’ ” Johns

Hopkins University, supra, 422 F. 2d at 1128, or

whether its “ ‘existence or nonexistence is a matter to

which a reasonable man would attach importance in

determining his choice of action in the transaction in

question.” ” Jd, at 1129; see 3 Loss, Securities Regula-

— ae

tion, 1431 2d ed (1961). Essentially the same test for

materiality is applied under section 10(b), for exam-

ple, whether it would have been reasonable for a per-

son to [1203j have been influenced differently if a

communicant had not misrepresented or withheld a

particular fact. See List v. Fashion Park, Inc. 340 F.

2d 457, 463 (2nd Cir., 1965).

With respect to Hughes’ personal status, any meas-

ure of his investment sophistication is deemed to be an

irrelevant criterion under a section 12(2) claim, Johns

Hopkins University, supra, 297 F. Supp. at 1217. This

Court has previously noted that Hughes was gifted

with an uncommon ability to nurture and manage busi-

ness enterprises, however, he was neither principally

an investor of stocks, nor was he a trained and ex-

perienced accountant, knowledgeable in the finer de-

tails of data interpretation. In any event, even if this

Court were to conclude otherwise, that Hughes’ status

lay beyond the definition of an “ordinary” investor,

this would seem to be an irrelevant criterion as well

for a section 10(b) claim. Some circuits have pointedly

imposed the requirements c’ « relatively stringent duty

of continuously maintained diligence upon “sophisti-

cated” investors. Heit v. Weitzen, 402 F. 2d 909, 913

(2nd Cir.. 1968); cert. denied 395 U.S. 903 (1969);

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

422 F. 2d 221, 230 (8th Cir., 1970); cert denied,

399 U.S. 905 (1970): Clement A. Evans & Co. v.

McAlpine, 434 F. 2d 100, 103 (Sth Cir., 1970); re-

hear. denied (1970). The Ninth Circuit, emphasizing

particularly demonstrated facts applied in light of

general principles, has not fashioned a set formula.

Rather it appears to emphasize that measure of knowl-

edge, however acquired through discovery (whether

by means of self-initiative, or inadvertent or intentional

enlightenment provided by others) which would satisfy

the element of “knowledge” as it may be applied, re-

spectively, within the available defenses of waiver, es-

toppel or laches, and which, if relevant and appro-

priate, would appear to afford a particular defendant

the usage and successful application of such defenses

in countering a section 10(b) cause of action. This

measure of knowledge on the part of a plaintiff ranges

from that which may be obtained through the exercise

of reasonable diligence in the discovery of one’s rights

in a given situation, which rights may be subsequently

impaired as a result of the transaction in [33; 1204]

question (generally, instances involving the defenses of

estoppel and laches) to that which can only be ob-

tained by full and complete discovery, and which can

only be demonstratively established by a showing that

the party acted with actual knowledge as to the impair-

ment of said rights (generally, an instance involving

the defense of waiver.) See Royal Air Properties, Inc.

v. Smith, 333 F. 2d 568, 572 (9th Cir., 1964); Hecht,

supra, at 1207-1208. It appears, thus, that the Ninth

Circuit places no special distinction upon a particular

person’s past status or experience, i.e. whether he

should be deemed to be a “sophisticate” or a “novice”

in securities investment, since the former label still

raises the ultimate issues of quantity, quality, and se-

quence of the information acquired. Thus, the test ap-

pears to emphasize the nature of knowledge acquired

by an individual as it may be applied in a particular

instance with respect to that same individual, against

whom such defenses may be utilized by a defending

party at a given point in time.

_- =

Having established a framework of principles, the

body of fact found in this case may now be applied to

determine the obligations of the parties. The following

is a synopsis of the more pertinent facts found pre-

viously on the instant issue. The Haskins & Sells audit

of June 1, 1969, released on September 18, 1969, re-

vealed that Dempsey was in very serious financial

trouble, and was experiencing unascertainable ac-

counting difficulties. See discussion, supra at 6, 8-9.

For example, its unresolved “short stock record dif-

ferences,” exclusive of subordinated borrowings, were -

213.46 percent of its stated net worth, the worst in the

industry. These conditions placed Dempsey perilously

close to “insolvency.” See discussion, infra. In August

1959, the Exchange independently arrived at the same

conclusions as a result of an analysis conducted by its

own examiners. These findings were available to

Hughes, and Hughes. as a matter of fact, admitted

that they signaled significant discrepancies. Although

Hughes himself probably did not fully comprehend the

meaning of this data, he had the advice of his business

lawyer at all relevant times. In addition, he had access

to subsequent, more current |34; 1205| data, and the

pointed admonitions offered by Peck on the eve of his

subordination. See discussion infra; see also discussion,

supra at 16 and note 16 supra.

Notwithstanding the knowledge that Dempsey was

in violation of its capital and record-keeping rules,

the Exchange, for reasons critiqued in depth previous-

ly, decided to try to “save” Dempsey. In the course of

this action, the Exchange made questionable assump-

tions, but such assumptions were made in what this

Court feels to be essentially characterized as a good

faith effort to do principally two things: (1) rescue

— Ss

Dempsey, and thereby protect its creditors; and (2)

prevent a general market loss of confidence, and there-

by protect other firms within its responsibility. To this

end, the King and Hughes subordinations were

solicited, encouraged and ultimately consummated.

King provided his own background investigation, and

eventually sought certifi ations from the Exchange

prior to his subordination which the latter unequivo-

cally rejected as unacceptable conditions. Nevertheless,

King went ahead with his subordination. The King

subordination was a major and constant factor influ-

encing Hughes, and was definitely neither insignificant

nor remote in causing Hughes to proceed with his

own subordination. On the general topic of “influence,”

a term of broader connotations than causation, more

should be mentioned. It appears that six general factors

“influenced” Hughes’ ultimate decision to proceed with

his own subordination, although clearly Hughes did not

assign equal weight to them in arriving at this conclu-

sion:

(1) the King subordination—which was based

upon an independent investigation, totally apart

from the Exchange’s control, the results and au-

thenticity of which Hughes did not avail himself,

although opportunities to do so timely presented

themselves;

(2) the representations of Walraven and Whit-

ney—which, because they originated from old

trusted friends, were assigned inordinate weight,

notwithstanding their emphasis on_ generalities

and patent absence of specific analysis on hard

data; [35; 1206]

(3) the representations of Peck—which, because

they originated from an unknown technician, were

—

assigned relatively lesser weight by Hughes in the

final analysis, notwithstanding this man’s creden-

tials and sobering analysis of Dempsey;

(4) the conclusions of Hughes’ own prior investi-

gation—which, generally, were necessarily limited

to current imp-essions or hard data received direct-

ly from Dempsey, and indirectly from the Ex-

change, as to the viability of the proposed sub-

ordination, but which were based also upon only

a general knowledge of King’s investigation, and,

in part, upon past audits of Dempsey;

(5) the contemporary general market conditions

—which, on the eve of subordination, certainly

did not betray harbingers of the subsequent gener-

al market deterioration which substantially con-

tributed to the overall weakening of Dempsey al-

most immediately after Hughes’ subordination;

and,

(6) the knowledge of the Commission's apparent

acquiescence in the face of the Exchange’s quasi-

arrogation of total influence over the Dempsey

matter—which, indirectly at least, lent an appear-

ance of “official” sanctioning of Dempsey’s solici-

tation of subordinated capital.

Of these six contributing factors, the King subordina-

tion and the representations of Walraven and Whitney

were given exceptional weight by Hughes in arriving

at the decision to proceed with his subordination.

Based upon the record in this case, it is not unreason-

able to conclude that Hughes assigned a greater pro-

portionate weight to these two factors than to the re-

maining four in combination with each other. The con-

clusion is also warranted by the record, although per-

_- =

haps it is less easier to infer, that Hughes assigned

the least significant weight to the representations of

Peck. Perhaps, this was so because the Peck factor

provided the most recent and complex data for Hughes,

personally, to grasp and comprehend, and [36; 1207]

because it was the one particular individual with whom

he was least familiar. This was most unfortunate, for

the Peck factor represented two dispositive facets of in-

formation: (1) the most detailed and current assess-

ment of Dempsey on the eve of Hughes’ subordination;

and (2) the (most professional conservative projection

personally offered to Hughes as to the viability of the

entire subordination scheme. Hughes lightly dismissed

Peck’s representations—in causal effect, the “influence”

of the Peck factor was relatively remote and insignifi-

cant.

At this juncture, it is appropriate to return to the

decisive question posed earlier as to the paramount

duty existing under section 6: whether the Exchange

abused its discretion in applying its “rules,” either

regulatory guidelines or constitutional provisions, or

otherwise breached its statutory duty toward Dempsey

under the Securities Exchange Act, so as to be found

liable for Hughes’ losses suffered as a result of his sub-

ordination. The one case most instructive on this cru-

cial point, Baird, supra, is distinguishable in two im-

portant particulars: (1) the Exchange’s role vis-a-vis

Richard Whitney’s defalcations and stock mismanage-

ment was apparently one of relatively total inaction

under its statutory duty, for which it was strongly

criticized, 141 F. 2d at 242-246 (dissenting opinion;

and (2) the Commission’s role vis-a-vis the misconduct

of this particular member of the Exchange was virtually

nonexistent. (Of course, the latter was primarily due

to the surreptitious nature of Whitney's activities,

but, nevertheless, the nature of the “concealment” al-

legations in this case certainly must be viewed in light

of at least an “attempt” by the Exchange to inform

the Commission as to what was happening to Dempsey,

and what the Exchange intended to do about that mem-

ber firm’s difficulties. Accordingly, these distinctions

should be emphasized for very important, even though

limited, reasons: (1) the Exchange in this case en-

gaged in a carefully measured response with respect

to the member firm, Dempsey, which did involve the

invocation of some internal disciplinary action prior

to the introduction of the claimant, Hughes, upon the

scene; and (2) the Exchange did make some attempt

to inform the Commission and all subsequently inter-

ested persons, including King and Hughes, of the past

{37; 1208] status and current condition of Dempsey

(irrespective of the attempt’s final effect.) The latter is

deemed to be very important because it is in marked

contrast to the blatant suppression of the Whitney

scandal by the Exchange until extrinsic rumors floated

the discovery of the details in January 1938: Baird,

supra, at 241. These two distinctions pertain most

directly and intimately to the question whether the Ex-

change fulfilled its section 6 duty.

Hughes seeks recovery against the Exchange under

several theories of breach of duty for basically two

broad, but separable instances of conduct: (1) the

carefully modulated imposition of restrictions against

Dempsey, and the simultaneous failure to suspend

Dempsey under Articles XIII and XIV of the Ex-

change Constitution; and (2) the encouragement and

approval of the subordination agreement between

Hughes and Dempsey. Gencrally, the five broad theo-

ries of recovery, which overlap to a great extent, are:

(1) the duty under section 6 of the Securities Exchange

Act: (2) the duty under section 10(b) of the Securi-

ties Exchange Act, which, for purposes of this case,

extends substantially beyond the fraudulent sale duty

contemplated within section 12(2) of the Securities

Act, and encompasses the related, potential liabilities

contained within section 17 of the Securities Act, 15

U.S.C. 77q: (3) the duty of a “controlling person”

under the two Federal securities laws; (4) the general

duty of a fiduciary at common law (which, Hughes

seeks to emphasize by analogizing the Exchange as

an “insider” within section 16 of the Securities Ex-

change Act, 15 U.S.C. 78p); and (5) the general

duty under tort law, the breach of which makes one

an aider and abettor to a principal tortfeasor at com-

mon law.

Because of its sweep, and the continuing nature of

its obligation, the section 6 duty is intimately linked

with the two broad instances of conduct described

above. It may be phrased more precisely now as fol-

lows: whether the Exchange satisfactorily performed

its obligation under section 6 to take disciplinary ac-

tion against Dempsey, either through imposition of in-

creased restrictions or through invocation of final sus-

pension proceedings, in light of facts and conditions it

knew, or should have known, [38; 1209] pertaining to

Dempsey’s financial and accounting condition up to

and including March 24, 1970, the date of Hughes’

entry into subordination.

The following are the dispositive conclusions of fact

and law which provide the resolution to that question

concerning the section 6 duty of the Exchange:

(1) the Exchange initially became aware of Demp-

sey’s difficulties in 1964-1965, and, during that

— =

period, it ordered compliance by Dempsey with

the Exchange’s capital and record-keeping rules;

(2) the Exchange subsequently restricted Demp-

sey’s business, including the limiting of weekly

trades, and the requiring of an infusion of new

capital, which eventually came from the Dempsey

partnership; ,

(3) the Exchange sanctioned Dempsey’s manage-

ment, which eventually resulted in the installa-

tion of new leadership under Whitney:

(4) the Exchange sought to accommodate the in-

terests and concerns of the Commission, the reg-

ulatory body ultimately responsible for the conduct

of Dempsey, and attempted to cooperate as much

as possible with that agency by keeping it apprised

of developments (however, too often this effort

was compromised and curbed by factors beyond

the control of both the Exchange and the Com-

mission, including imponderable economic forces);

(5) the Exchange solicited subordinated capital

to shore up Dempsey, but only under certain con-

ditions which were carefully and clearly communi-

cated to the two proposed subordinators, King and

Hughes, and which included a substantial un-

known factor of incalculable weight in affecting

the eventual outcome of the subordination solu-

tion;

(6) the Exchange subsequently determined that

Dempsey was facing increasingly scrious difficul-

ty. but that the planned [39; 1210] subordina-

tions still might solve Dempsey’s problems, hence

the Exchange determined not to suspend Demp-

sey, Or to so restrict its business as to amount to

—

a termination of Exchange support and backing

—such determination was highly presumptuous

yet still implemented in good faith;

(7) the Exchange viewed the proposed subordina-

tion by Hughes as a partial remedy for Dempsey,

which view was essentially in accord with that of

Peck (who had been hired by Dempsey under

the reorganization efforts instigated by the Ex-

change, and who had also communicated in rea-

sonably complete and coherent terms to Hughes at

the final conference prior to subordination, and

which was sinported by documentation available

for Hughes’ personal, professional assessment for

a sufficient period of time prior to his entry into

subordination;

(8) the Exchange concluded that the nature and

extent of the risk in the Hughes subordination

scheme was reasonably apparent to Hughes, and

assumed that he was fully aware that Dempsey’s

recovery was premised on contingent factors, other -

than the mere infusion of a stated amount of

capital, which factors were beyond the prediction

and control of the Exchange, and thus beyond

its duty to disclose;

(9) the Exchange’s conclusions and assumptions,

including its doubt about Dempsey’s recovery,

were patently described to Hughes by Peck, which

description raised not only the hard “known” data

at the time, but the presence of the “unknowns”

which had to be accounted for; and

(10) the Exchange did not foresee, could not

have foreseen, nor should it have heen required

to foresee, the subsequent surprise factor that

—70—

market conditions would undergo a dramatic, rap-

id and sharp decline almost immediately after

the Hughe’’ subordination entered into force—

these market conditions were [40; 1211] deci-

sively fatal to the reorganization plan Peck ex-

plained to Hughes on the eve of subordination.

Based upon an overall assessment of the above dis-

positive conclusions, it cannot be determined that, un-

der the specific circumstances of Hughes’ subordination

of his securities, the Exchange breached its section

6 duty toward Hughes, in light of the facts of which

it had knowledge, or reasonably could have acquired,

by the time of his subordination, and in light of the

prior and contemporaneous conduct practiced and

measures taken during the relevant period from the

time the Exchange first became aware of Dempsey’s

deficiencies to the time of Hughes’ subordination. Al-

though it was controversial, it was not unreasonable for

the Exchange to refrain from taking further, perhaps

more drastic, measures against Dempsey prior to

Hughes’ subordination (particularly in light of the two

priorities previously determined and implemented with-

in its discretionary powers vis-a-vis member firms, which

determination. incidentally, also stemmed from the sec-

tion 6 obligation, see discussion, supra at 35. And,

although it was momentous, it was not an abuse of

discretion. nor a violation of a statutory charge, for the

Exchange to affirmatively solicit a subordination with

the character, qualifications, and. understanding, of

that which was eventually consummated with Hughes.

A contrary finding under the section 6 theory of re-

covery would appear to place national securities ex-

changes in an impossible position of making an ul-

—

timate choice between two alternative courses of action

—either to submit themselves to a form of strict liabili-

ty for the potential risks inherent in the type of pro-

tective scheme devised to preserve Dempsey, or to fore-

go equally important obligations—legal and ethical—

to other members of their national organizations and

their clients. Such a choice does not seem to make

sense under the Securities Exchange Act for it would at

once remove fundamental flexibilities and discretions

necessary for the effective functioning of national se-

curities exchanges.” Accordingly, the section 6 duty

“Congress seemed to be aware of this dilemma thrust upon

the national securities exchanges, and, simultaneously, appeared

to provide a mechanism by which such future crises could be

avoided. In enacting the Securities Investor Protection Act of

1970, 15 U.S.C. 7 et seq., Congress provided a statutory

scheme by which such crises could be anticipated, dealt with,

and resolved on a fair and equitable basis. For example, section

5, 15 U.S.C. 78eee, sets up a comprehensive scheme by which

customers of member firms may invoke remedies to regulate the

firm in difficulty or otherwise gain assistance. Section 5 requires,

in mandatory language, that the Commission, or the

“self- ” body [including national security e , see

15 U.S.C. 78LLL(1)] notify immediately the Securities or

Protection Corporation of any member firm in financial diffic

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