# Petition — Hughes v. Dempsey-Tegeler & Co.

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385004_0477%3A1

## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition
- **Published:** January 1, 1976
- **Citation:** 429 U.S. 896

## Text

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).

a

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.

ae

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.”’

ee

—
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.

(c) Nothing in this title shall be construed to prevent any
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.

(c) In contravention of such rules and regulations as the
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

a

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.

(c) The prior consent of the Exchange shall be ob-
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

(c) No general agreement between a member or-
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

a

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.

a

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.

“See for example, §. 2348. June 9, 1969, “A Bill to establish
a Federal Broker-Dealer Insurance Corporation” (introduced by
Senator Muskie ).

= =

ber firms under examination in the event of a final
crisis, and whether bankruptcy and receivership of
such firms would affect subsequent access to the fund.

These facts merely serve as a prelude to the prin-
cipal events leading up to the execution of the Hughes
subordination agreement; to the constant posturing be-
tween the Commission and the Exchange subsequent
to the summer of 1969; and to the deceptive revitaliza-
tion of Dempsey through the influx of subordinated
capital, which only forestalled its eventual demise and
liquidation in August 1970. A more detailed discus-
sion of these events follows.

The August 1969—August 1970 Period.

The crucial events in this period involve three broad
topics, separable primarily for purposes of discussion,
but intimately related in terms of mutual impact: (1)
the negotiations between Hughes and the Dempsey
executives, principally Walraven and Whitney, but sub-
sequently including another important figure; (2) the
communications between the Exchange and the Com-
mission on the general subject of member firm controls,
in particular Dempsey; and (3) the capital accounting
state of [7; 1178] Dempsey, of which a true picture
never emerged during the critical period, notwithstand-
ing the efforts to all concerned parties.

Early in 1969, Walraven approached Hughes and
suggested that he subordinate a substantial portion of
his securities to Dempsey, which securities were com-
prised mainly of municipal! bonds, in order that the
firm could utilize them as additional capital in meeting
the Exchange’s net capital requirements. This was posed
as a highly profitable venture for Hughes since he
would be paid a base interest for the loaned securities,

=

while simultaneously retaining the dividends and inter-
est payable on the face of those securities. Hughes con-
tinued meeting with both Walraven and Whitney into
the fall of 1969. In response to such suggestions from
these two trusted friends and business associates,
Hughes initiated an independent inquiry into the neces-
sary mechanics of subordinating his securities to Demp-
sey. To this end, he directed his personal lawyer to
research the details of the proposed subordination
agreement, and the capital structured of Dempsey before
and after the proposed addition of his securities.°
Hughes was advised to await the return of the Haskins
& Sells audit of June 1969, and it was agreed between
Hughes and Dempsey to stay further discussion until
the fall of 1969.

Haskins & Sells released its June Ist audit on Sep-
tember 18, 1969. Hughes received this audit at about
the time of the release, and had it in his possession at
all subsequent, relevant times. Hughes conceded that
the “fails to deliver” to unidentifiable brokers in the
amount of $11,206,433.00 was a “very significant and
substantial sum for Dempsey-Tegeler.” Hughes also
admitted that the discrepancy of about $1,200,000.00
between the value of securities on hand for which
there was no record accountability, and the value of
recorded securities which could not be accounted for
was also a significant sum. And yet, Hughes repre-
sented that he was not apprised of the significance of
these figures, or of the implication underlying Haskins
& Sells’ withholding of an opinion as to certain specific
matters (including receivables from brokers and dealers

*His securitics counsel at that time had represented Hughes
in two prior Pacific Hawaiian cfferings, and had been his per-
sonal attorney on all matters for the past twenty years.

=

on “fails to deliver;” reserves for possible specified
losses; and capital |8; 1179] stock and surplus) be-
cause whenever he referred to that audit he failed to
carefully examine the details of the statement. Hughes’
explanation for this omission was that he was not suf-
ficiently motivated to put on his reading glasses. This
offered explanation for failure to discover such crucial
information at this point in time is suspect in light of
two key inferences: (1) Hughes’ reputation as a man
of good judgment, and his experience as a successful
businessman; and (2) the substantial commitment of
Hughes’ reliable municipal bonds to a subordination
scheme which, at the very least, demanded an attention
to detail commensurate with its potential for risk. In
rebuttal to these assumptions, Hughes contended that
he relied substantially upon the oral representations
made to him by Walraven and Whitney at various
times up to, and including, the date of the final subor-
dination agreement. See discussion, infra.

Late in 1969, Dempsey began negotiations with John
King, chief executive and primary stockholder in King
Resources Corporation, a holding corporation with
substantial assets. King initiated an in-depth investiga-
tion of Dempsey by a team of accountants and attor-
neys toward the view of making a subordinated loan
to Dempsey in the amount of $7 million to be secured
by King Resources’ stock. King’s investigations and
negotiations were closely watched by the Commis-
sion."” King initially insisted that, as a condition of

“The Commission was supplied with the initial drafts of the
proposed King loan documents in a letter dated January 27,
1970 from Paul Chenet of the Exchange to Charles Hartman.
Exhibit AN. Also, Mr. Cunningham, in a letter dated February
10, 1970, reported further progress with respect to the King ioan.
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 i

[Text truncated at 120,000 characters. The full text is on the page linked above.]

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385004_0477%3A1. Public record. Not legal advice.