Petition — Blyth, Eastman Dillon & Co. v. Rolf
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OCT 2 i978 |
IN THE
Supreme Court of the Unite
October Term, 1978
No. 78% 95 (
BLYTH, EASTMAN DILLON & CO., INC.
and MICHAEL STOTT,
Petitioners,
v.
DAVID E. ROLP,
Respondent,
and
AKIYOSHI YAMADA,
Defendant.
PETITION FOR A WRIT OF CERTIORARI TO
THE UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
Breep, Assorr & MorGan
Attorneys for Petitioners
Blyth Eastman Dillon & Co.
Incorporated and Michael Stott
One Chase Manhattan Plaza
New York, New York 10005
(212) 676-0800
Of Counsel:
Tuomas W. KELLY
Rosert G. Kunpacu
TABLE OF CONTENTS
PAGE
Opinions Below UR i duck ceacestass 2
RA EE OF cs 2
Nee ec wcase quenseceonerseereevs 3
Statute and Rule Involved ......0....0.0....0...eees 4
orl cisnsceosssasrensesscscssesse: | 4
Reasons for Granting the Petition 0.0.0.0... 9
Ne alc iccesngionnssnsvecqssesees: 29
TABLE OF APPENDICES
A. Opinion of the United States Court of —
oc cevvvsssanceessasseacceseeccens Al
B. Order Amending Opinion of the United States
Court of Appeals for the Second Cireuit.........._ A39
C. Opinion and Order of the United States District
Court for the Southern District of New York ... A41
D. Order of the United States Court of Appeals for
the Second Circuit Denying Rehearing.............. A97
E. Order of the United States Court of Appeals for
the Second Circuit Denying Rehearing in Banc... A98
F. Statute and Rule Involved .........0....00.... A99
II
TABLE OF AUTHORITIES
PAGE
Cases:
Bosser v. Magazine, Fed. Sec. L. Rep. (CCH) 96,304
ers Ms SOD vi oks sik cocadescacecleae 11
Brennan v. Midwestern United Life Insurance Co., 259
F. Supp. 673 (N.D. Ind. 1966) and 286 F. Supp.
702 (N.D. Ind. 1968), ajf’d, 417 F.2d 147 (7th Cir.
1969), cert. denied, 397 U.S. 989 (1970) 10, 19
Bronner v. Goldman, 361 F.2d 759 (1st Cir. 1966),
cert. denied, 385 U.S. 933 (1966) ahaxy. 10
Buttrey v. Merrill Lynch, Pierce, Fenner and Smith,
Inc., 410 F.2d 135 (7th Cir. a denied, 396 U.S.
838 (1969) Ar Meteid co ae
Coleco Industries v. Berman, 567 F.2d 569 (3d Cir.
1977), petition for cert. filed, 46 U.S.L.W. 3766
(June 2, 1978) (No. 77-1725) 0000. 11
Crocker-Citizens National Bank v. Controls Metal
Corp., 566 F.2d 631 (9th Cir. 1977) 0.16
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) ....3, 9, 12,
19, 29
Kquity Funding Corp. of America Securities Litiga-
tion, In re, 416 F. Supp. 161 (C.D. Cal. 1976) 12
Goitreich v. San Francisco Investment Corp., 552
F.2d 866 (9th Cir. 1977) take 16
Gould v. American-Hawaiian Steamship Co. 535 F. 2d
room! As FS | A ois eee 10,11
Grimes, Hooper & Messer, Ine. vy. ay ec he 519 F.2d
1089 (9th Cir. 1975) . ES
Gross v. SEC, 418 F.2d 103 (Qa Cis. 1969). Poe Seat Sh 11
Hirsch v. duPont, 553 F.2d 750 (2d Cir, 1977) 11
Hochfelder v. Midwest Stock Exchange, 503 F.2d 364
(7th Cir.), cert. denied, 419 U.S. 785 (1974) ....10, 28
Itt
PAGE
Kerbs v. Fall River Industries, Inc., 502 F.2d 731
(10th Cir. 1974) . Fee Potted ct ro i
Landy v. Federal Deposit Insurance Corp., 486 F.2d
139 (3d Cir. 1973), cert. denied, 416 U.S. 960
(1974) PD eens 10,17
Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir. 1973) ...24, 25
Lowenschuss v. Kane, 520 F.2d 255 (2d Cir. 1975) ......11, 18
Monsen v. Consolidated Dressed Beef Company, Inc.,
et al., Fed. Sec. L. Rep. (CCH) 996,479 (3d Cir.),
petition for cert. filed, 47 U.S.L.W. 3168 (Sept. 8,
1978) (No. 78-404) ee SB:
Murphy v. McDonnell & Co., 553 F.2d 292 (2d Cir.
1977) . I : 11
Nees v. SEC, 414 F.2d 211 (9th Cir. 1969) 11
Nelson v. Serwold, Fed. See. L. Rep. (CCH) 196, 399
(9th Cir.), petition for cert. filed, 47 U.S.L.W.
3071 (July 26, 1978) (No. 78-182) 0... 11
John Nveeen & Co. v. Sanders, 425 U.S. 929 (1976) 26
Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880 (3d
Cir.), cert. denied, 425 U.S. 993 (1976) 10, 11, 17
Rolf v. Blyth, Eastman Dillon & Co., 424 F. Supp. 1021
(S.D.N.Y. 1977) | seceecereedy 4y 6, 23
Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38 (2d
Cir. 1978) es 2, 5, 6, 7, 8, 10, 12,
13, 16, 20, 22, 24
Rolf v. Blyth, Eastman Dillon & Co., Fed. See. L. Rep.
(CCH) 96,525 (2d Cir. 1978) aie: ..2, 7, 13, 21
Sanders v. John Nuveen & Co., 554 F.2d 790 (7th Cir.
ech lrecin cas ostsstbotevinauadaaiernesuan tnbeeiva ny 26, 27
Santa Fe Industries v. Green, 430 U. S. 462 (i6f7)....... B
SEC v. Coffey, 493 F.2d 1304 (6th Cir. 1974), cert.
denied, 420 U.S. 908 (1975)... teen 11, 14
IV
PAGE
SEC v. Coven, Fed. See. L. Rep. (CCH) 196,462
(2d Cir. 1978) , 11, 25, 26
SEC v. First Securities Co. of Chicago, 463 F.2d 981
(7th Cir.), cert. denied, 409 U.S. 880 (1972) ....10, 11, 28
SEC v. Management Dynamies, Inc., 515 F.2d 801
(2d Cir. 1975) Pee be pea ER. 11
Sennott v. Rodman & Renshaw, 474 F.2d 32 (7th
Cir. 1973) \<iaebe aoe 10
State Street Trust Co. v. Ernst, 278 N.Y. 104, 15.N.E.
2d 416 (1938) eee : . 22
Strong v. France, 474 F.2d 747 (9th Cir. 1973) ..... a
Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d
1033 (7th Cir.), cert. denied, 434 U.S. 875 (1977)....27, 28
Wessel v. Buhler, 437 F.2d 279 (9th Cir. 1971) 10
Woodward v. Metro Bank of Dallas, 552 F.2d 84 (5th
Cir. 1975) 11, 15, 16, 17
Wright v. Heizer Corp., 560 F.2d 236 (7th Cir. 1977),
cert. denied, 434 U.S. 1066 (1978) 0... 27
Zabriskie v. Lewis, 507 F.2d 546 (10th Cir. 1974) 10, 15
Statutes and Rules:
Securities Exchange Act of 1934:
§10(b) Meee Sm |
§15(b) (4) (BE) ae eae 9
§20 : DY ita dn, 9, 10
Rule under the Securities Exchange Act of 1934:
Rule 10b-5 ..bassosthhy Sip By AO, 26, 28.
24, 26, 27, 29
Law Review Aritcle:
Ruder, Multiple Defendants in Securities Law Fraud
Cases, 120 U. Pa. L. Rev. 597 (1972) ......10, 18, 19, 20, 21
IN THE
Supreme Court of the United States
October Term, 1978
No. 78-
———aee- ee
Buytu, Eastman Ditton & Co., Inc. and Micnagn Stort,
Petitioners,
v.
Davin E. Ro tr,
Respondent,
and
AxryosH1 YAMADA,
Defendant.
PETITION FOR A WRIT OF CERTIORARI TO
THE UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
Petitioners, Blyth Eastman Dillon & Co. Incorporated
(“*BEDCO’’) and Michael Stott (‘‘Stott’’), respectfully
pray that this Court grant a writ of certiorari to review
the opinion and judgment of the Court of Appeals for the
Second Cireuit entered on January 3, 1978, as amended by
order dated May 22, 1978. That decision affirmed the dis-
trict court’s judgment in favor of the plaintiff on the issue
2
of liability, and reversed that judgment on the question of
the appropriate damage standard to be applied.
Petitioners do not in this application seek a writ of
certiorari to review the ruling of the court below on the
issue of damage.
Petitioners seek the issuance of a writ of certiorari only
to review the ruling of the court below on defendants’
cross appeal on the issue of liability.
Opinions Below
The opinion of the Court of Appeals (Appendix, here-
inafter ‘‘ App.’’, A), is dated January 3, 1978 and reported
at 570 F.2d 38. After application was made for a rehear-
ing in bane, that opinion was amended by an order filed
May 22, 1978 (App. B); this addition to the opinion is
not contained in the published decision (570 F.2d 38).*
Rehearing in bane was denied with four dissenting votes,
on July 3, 1978. The opinion of the United States District
Court for the Southern District of New York (App. C)
is reported at 424 F. Supp. 1021.
Jurisdiction
The judgment of the Court of Appeals for the Second
Cireuit was entered on January 3, 1978 (Smith, Senior
Cireuit Judge, and Oakes, Circuit Judge, with dissent by
Mansfield, Circuit Judge). On February 13, 1978, the See-
ond Circuit filed orders granting leave for the following to
file papers amicus curiae in support of petitioners’ petition
* The amendment is reported at CCH Fed.
(2d Cir. 1978). : ed. Sec. L. Rep. 96,525
3
for rehearing: New York Stock Exchange; Securities In-
dustry Association; Merrill Lynch, Pierce, Fenner & Smith
Incorporated; and Bear, Stearns & Co., Shearson Hayden
Stone Inc., and Loeb Rhoades, Hornblower & Co. On July
3, 1978, the Second Circuit denied petitioners’ timely Peti-
tion for Rehearing or, Alternatively, Suggestion for Re-
hearing In Bane (Apps. D and E). Judges Mansfield,
Mulligan, Gurfein and VanGraafeiland dissented from the
denial of rehearing in bane.
The jurisdiction of this Court is invoked under 28
U.S.C. §1254(1).
Questions Presented
(1) Can there be any vicarious secondary liability for
damages under Section 10(b) of the Securities Exchange
Act of 1934 (15 U.S.C. §78j(b)), and Rule 10b-5 for aiding
and abetting an independent primary fraud committed in
violation of that statute and rule by a third party? This
is an issue expressly left open by this Court in Ernst &
Ernst v. Hochfelder, 425 U.S. 185, 192, note 7 (1976) (here-
inafter ‘‘Hochfelder’’) for future determination.
(2) If there is such liability what are the elements
necessary to establish such a cause of action? This is an
issue also expressly left open by this Court in Hochfelder
for future determination.
(3) In any case asserted against an aider and abettor,
such as in the circumstances present here, can liability
attach where the fault found was a failure to investigate
or make inquiry?
Statute and Rule Involved
Section 10(b) of the Securities Exchange Act of 1934
(‘£1934 Act’’), 15 U.S.C. §78j(b), and Rule 10b-5 promul-
gated thereunder, 17 C.F.R. §240.10b-5, are set forth as
Appendix F to this petition.
Statement of the Case
This case was tried by Judge Pierce, sitting without a
jury, in the United States District Court for the Southern
District of New York. The trial court entered judgment
in favor of plaintiff in the amount of $55,790. That sum
was composed solely of commission charges made by
BEDCO and interest charges on margin debt in the BEDCO
account of plaintiff. It did not include any trading losses.
The trial court allowed damage on this basis and in that
amount on the finding that:
‘*Under the circumstances of this case, all other meas-
ures of damage are rejected as wholly speculative with
respect to actual injury found by the court to have
been caused by the defendants’ actions.’’ 424 F. Supp.
at 1045; A 94,
The plaintiff appealed on the issue of damage. Defend-
ants BEDCO and Stott cross-appealed on the issue of
liability.
The Second Cireuit, by a two-to-one decision, affirmed on
the finding of liability and, on the issue of damages, re-
versed and remanded with a direction to the trial court
to compute damages in accordance with the guidelines set
forth in the decision of the court (A 20-22).
5)
The Court of Appeals heid that a securities salesman,
Stott of BEDCO, was liable* for trading losses (including
losses on transactions with which Stott had no connec-
tion**) suffered by plaintiff David Rolf, a sophisticated
and experienced customer, found by the trial court to be
a trader, not an investor, even though:
(a) the securities transactions executed in that ac-
count were made exclusively at the direction of an
independent investment advisor, and not at the direc-
tion of Stott or BEDCO;
(b) the investment advisor who directed the ac-
count was personally selected by plaintiff and, prior
to this episode, had an excellent reputation in the
industry ;
(c) plaintiff had given the advisor written and
exclusive authority to select and trade securities on
his behalf, and further instructed the advisor that he
desired to conduct a very aggressive investment pro-
gram involving substantial risks directed toward
doubling his equity;
(d) the trading losses were found to have resulted
from the fact that the plaintiff’s investment advisor
was secretly engaged in manipulative and deceptive de-
vices and contrivances directed against, and which con-
stituted a fraud upon, plaintiff; and
* The securities firm employing the salesman acknowledged below
(570 F.2d 38, 48; A 19) and does likewise here, that “for purposes of
this appeal” it is vicariously liable by reason of Section 20 of the 1934
Act (15 U.S.C. §78t) as a controlling person. By reason of this
acknowledgment, the sole issue presented here is the correctness of
the ruling of the court below as to the salesman.
** The majority said that defendants Stott and BEDCO were
liable in damages even as respect losses caused by transactions as “‘to
which Stott had no connection because he did not execute the trans-
action, recommend the security, or reassure Rolf with respect to that
security.” (570 F.2d at 49; A 22).
6
(e) the salesman did not know that the advisor was
engaged in those furtive and fraudulent practices.
Significantiy, the Court of Appeals accepted the find-
ings of the trial court that the salesman ‘‘Stott was not
aware of the manipulations in the Rolf account’’ (424 F.
Supp. at 1040; A 81) and ‘‘did not know of the direct frauds
which Yamada was perpetrating on Rolf’? (424 F. Supp. at
1043; A 89). Instead the Court of Appeals found the sales-
man liable as an aider and abettor because it concluded that
‘frecklessness satisfies the scienter requirement’’ of Sec-
tion 10(b) of the 1934 Act. In terms of the behavior found
to constitute ‘‘reckless’’ conduct, the lower court noted:
First, that the salesman ‘‘was aware that the quality
of the securities being purchased by [the advisor] was
very low’’ (570 F.2d at 47; A 17);
Second, that the salesman repeatedly assured plain-
tiff ‘‘that Yamada knew what he was doing and that
if Yamada were purchasing stocks they must be satis-
factory’’ (id.); and
Third, that the representations were ‘*conclusorily
made to Rolf without investigation”’ (id.).
Neither the court below nor the trial court meade any
finding that there was a causal connection between the
breach of the salesman’s duty to inquire and the facilita-
tion of the underlying fraud, that is, whether adequate
inquiry would have led to a discovery of the primary fraud.
The majority opinion of the Second Circuit Court of
Appeals was made in the face cf a strong dissent entered
by Judge Mansfield and was rendered with the concession
by the majority that ‘‘the evidence in this case against
7
Stott, while not overwhelming, is substantial’? (570 F.2d
at 43; A 8).
After that opinion was issued on January 3, 1978, de-
fendants promptly applied to the Second Cireuit Court of
Appeals, asking that the appeal be reheard by the Court
of Appeals in banc.
Amicus curiae briefs in support of that application were
filed by the New York Stock Exchange; the Securities In-
dustry Association; Merrill Lynch, Pierce, Fenner & Smith
Incorporated; and Bear, Stearns & Co., Shearson Hayden
Stone Ine., and Loeb Rhoades, Hornblower & Co.
Subsequent to the filing of that application, but prior
to its denial, the majority amended its opinion by the ad-
dition of Footnote 16A* (App. B). Over a month later,
on July 3, 1978, the Second Cireuit entered on Order deny-
ing a rehearing in bane (Apps. D and E; A 97-98). Four
active judges dissented from that denial, namely Judges
Mansfield, Mulligan, Gurfein and VanGraafeiland.
The Circuit Court’s factual and legal determinations
might be most effectively summarized by quoting from the
dissenting opinion of Judge Mansfieid:
‘““The majority holds a registered representative
(Stott) and his employer (BEDCO) liable under §10(b)
* In this added footnote, the majority defined the alleged wrong-
doing of Stott to be that he was “aware that the advisor was purchas-
ing junk” and despite that awareness he “actively lulled the investor
by expressing confidence in the advisor without bothering to investi-
gate whether these assurances were well-founded.” That addition to
the majority opinion stands in stark contrast to the statement in the
original opinion that the alleged wrongdoing of Stott was that he
“either recklessly failed to learn of or failed to disclose Yamada’s
web of fraud.” (570 F.2d at 48; A 18).
8
and Rule 10b-5 to their customer (Rolf) for losses suf-
fered by the customer upon purchases and sales of
securities executed at the direction of Rolf’s own inde-
pendent investment adviser (Yamada) pursuant to
written discretionary authority from Rolf instructing
Stott and BEDCO to follow Yamada’s orders. This
result is achieved on the grounds that (1) the invest-
ment advisor (Yamada) was committing various frauds
on the customer (Rolf), and (2) the broker (Stott),
although he knew nothing of the frauds, ‘aided and
abetted’ Yamada’s conversion of Rolf’s account to un-
suitable securities by ‘holding the hand’ of Rolf pur-
suant to an oral agreement to ‘look after’ Rolf’s ae-
count and by assuring him of Yamada’s competence
as an investment counsel.
‘The majority views Yamada’s investment of the
account in unsuitable securitiés as fraud in and of it-
self and Stott’s state of mind as recklessness amount-
ing to a deliberate intent to deceive. All of this is too
much for me to accept. The majority not only patches
together watered-down notions of fraud and scienter
in arriving at a result indistinguishable in any signifi-
cant respect from that reversed by the Supreme Court
in Ernst & Ernst v. Mochfelder, 425 U.S. 185, 96 S. Ct.
1375, 47 L.Ed.2d 668 (1976), but also overlooks findings
below and undisputed evidence that foreclose Rule 10b-
5D liability. we
* . .
‘The picture that emerges from these and other
statements made by Rolf is one of a sophisticated inves-
tor in securities who was well aware of the difference
between gilt-edge, relatively safe securities, on the one
hand, and speculative ‘high fliers,’ on the other, and
who had determined to get richer quick by choosing an
aggressive program involving high-risk, OTC stocks in
the hope that his adviser would succeed in picking a
few big winners, but well aware of the pitfalls that
were involved.’’ 570 F.2d at 50, 53; A 23-24, 30.
’
So)
Reasons for Granting the Petition
A
This case squarely and directly presents this Court with
the legal question of whether or not there is any vicarious
civil liability under §10(b) and Rule 10b-5 promulgated
thereunder for ‘‘aiding and abetting’’ the primary viola-
tion of those provisions by a third party, a question er-
pressly left open for future determination by this Court in
Hochfelder, at 192, note 7. This case likewise raises the
question: what are the elements necessary to establish
such a cause of action, assuming it is adjudicated that a
claim for aiding and abetting exists?
Both of these questions need resolution by this Court.
They are important issues which are currently and con-
tinuously being presented for adjudication throughout the
federal courts. (See second footnote infra, page 10.)
The 1934 Act contains no provision which states or sug-
gests that there is a civil private cause of action for aiding
and abetting.“ The only express basis for vicarious or
secondary liability for the primary wrongs of a third party
contained in the 1934 Act is the controlling persons provi-
sion of Sec. 20(a) (15 U.S.C. §78t(a)). That section pro-
vides :
‘*Every person who, directly or indirectly, controls any
person liable under any provision of this title or any
rule or regulation thereunder shall also be liable jointly
and severally with and to the same extent as such
* The statute does provide sanctions through SEC disciplinary
proceedings against registered security dealers who “willfully aided,
abetted, counseled, commanded, induced or procured” the violation
by another of the prohibitions of the federal securities laws (1934
Act §15(b) (4) (E) ; 15 U.S.C. §780(b) (4) (E)).
I EOE 8
10 \
controlled person to any person to whom such con-
trolled person is liable, unless the controlling person
acted in good faith and did not direetly or indirectly
induce the act or acts constituting the violation or cause
of action.’’*
Despite the absence of a specific statutory provision, a
very large number of cases** decided in Cireuit Courts of
* The record and reality in the instant case foreclose any con-
tention that the salesman so controlled the independest investment
advisor as to bring into play the above-cited controlling persons lia-
bility provision (§20, 1934 Act; 15 U.S.C. §78t). If, however,
such a claim could have been made, Stott would have had the defense
that he acted in “good faith” and did not “induce” the wrongful acts
of which he had no knowledge. Under existing case law, however.
the defenses available to a controlling person are apparently not avail-
able to an alleged aider and abettor, for the latter is considered an
independent and supplementary claim (SEC v. First Securities Co.
of Chicago, 403 F.2d 981, 987 (7th Cir.), cert. denied, 409 U.S. 880
(1972); Roches Brothers, Inc. v. Rhoades, 527 F.2d 880, 886, foot-
note 10 (3d Cir. ), cert. denied, 425 U.S. 993 (1976) : Ruder, Vultiple
Defendants in Securities Law Fraud Cases, 120 U. Pa. L.. Rev. 597.
638 (1972) [hereinafter cited as Ruder, Multiple Defendants}. The
majority below has apparently ruled that in this case good faith does
not constitute a defense to one charged with aiding and abetting a vio-
lation of Rule 10b-5 (570 F.2d at 46, note 15; A 15). Of course. in
some cases, the controlling evidence might be so similar as to each
claim that the same judgment would be reached on both claims.
(Gould v. American-Hawaiian Steamship Co., 535 F.2d 761, 781
(3rd Cir. 1976) ).
** Bronner v. Goldman, 361 F.2d 759 (1st Cir. 1966). cert. denicd,
385 U.S. 933 (a factor lending partnership): Buttrey v. Merrill
Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135 (7th Cir. 1969)
(a correspondent securities broker) ; Brennan v. Midwestern United
Life Insurance Co., 417 F.2d 147 (7th Cir. 1969) (corporate issuer
of manipulated stock): MWessel v. Buhler, 437 F.2d 279 (9th Cir.
1971) (accountant) ; Sennott v. Rodman & Renshaw, 474 F.2d 32
(7th Cir. 1973) (securities brokerage firm) : Strong v. France, 474
F.2d 747 (9th Cir. 1973) (potential investor): Landy v. Federal
Deposit Insurance Corp., 486 F.2d 139 (3rd Cir.), cert. denied. 416
U.S. 960 (1974) (securities brokerage firms): Kerbs v. Fall River
Industries, Inc., 502 F.2d 731 (10th Cir. 1974) (corporate issuer of
fraudulent stock certificate) ; Hochfelder v. Midwest Stock Exchanae.
503 F.2d 364 (7th Cir.), cert. denied, 419 U.S. 875 (1974) (stock
exchange) ; Zabriskie v. Lewis, 507 F.2d 546 (10th Cir. 1974)
(agents of principal wrongdoer ) ; Grimes, Hooper & Messer, Inc. v.
(footnote continued on next page)
11
Appeals have established the existence of an implied vicari-
ous and secondary liability for aiding and abetting, prem-
ised upon a showing:
(a) That a primary wrong under the federal securi-
ties laws had been committed by another;
(b) That the aider and abettor had knowledge of
that primary wrongdoing; and
(c) That the aider and abettor had provided sub-
stantial assistance in furthering the primary wrong-
doing.
Pierce, 519 F.2d 1089 (9th Cir. 1975) (bank and its manager) ;
Lowenschuss v. Kane, 520 F.2d 255 (2d Cir. 1975) (tender offer
participants) ; Woodward v. Metro Bank of Dallas, 522 F.2d 84
(Sth Cir. 1975) (bank); Gould v. American-Hawaiian Steamship
Co., 535 F.2d 761 (3rd Cir. 1976); Rochez Brothers, Inc. v.
Rhoades, 527 F.2d 880 (3rd Cir.), cert. denied, 425 U.S. 993 (1976)
(issuer in a shareholder sale among insiders) ; Murphy v. McDon-
nell & Co., 553 F.2d 292 (2d Cir. 1977) (stock exchanges) ; Hirsch
v. duPont, 553 F.2d 750 (2d Cir. 1977) (stock exchange) ; Coleco
Industries, Inc. vy. Berman, 567 F.2d 569 (3rd Cir. 1977), petition
for cert. filed, 46 U.S.L.W. 3766 (June 2, 1978) (No. 77-1725) (cor-
porate sellers in an acquisition) ; Bosser v. Magazine, Fed. Sec. L.
Rep. (CCH) 96,304 (D.C. Cir. 1977); Nelson v. Serwold, Fed.
Sec. L. Rep. (CCH) 96,399 (9th Cir.), petition for cert. filed, 47
U.S.L.W. 3071 (July 26, 1978) (No. 78-182) ; Monsen v. Consoli-
dated Dressed Beef Company, Inc., el al., Fed. Sec. L. Rep. (CCH)
$96,479 (3rd Cir.), petition for cert. filed, 47 U.S.L.W. 3168
(Sept. 8, 1978) (No. 78-404) (bank).
In addition, there are a number of cases involving Securities Ex-
change Commission injunctive or disciplinary proceedings which also
deal with the elements of aiding and abetting. Nees v. SEC, 414
F.2d 211 (9th Cir. 1969) involving aiding-abetting in a disciplinary
proceeding prior to the statutory amendment adding willful abetting
as a basis for such a proceeding (Jd. at 220, footnote 6); Gross v.
SEC, 418 F.2d 103 (2d Cir. 1969) ; SEC v. First Securities Co. of
Chicago, 463 F.2d 981 (7ts Cir.), cert. denied, 409 U.S. 880 (1972) ;
‘SEC v. Coffey, 493 F.2d 1304 (6th Cir. 1974), cert. denied, 420 U.S.
908 (1975); SEC v. Management Dynamics, Inc., 515 F.2d 801 (2d
Cir. 1975) ; SEC v. Coven, Fed. Sec. L. Rep. $96,462 (2d Cir. 1978).
Though some of these cases may be inapposite, because different
standards of fault or proof may subsist (eg., “negligence” rather
than scienter), others of them may appropriately be used in consid-
ering the significance of the issue presented and the conflict of law
that has emerged.
C0 0 VCOSESS SE
12
In none of these cases has a Cireuit Court denied the
existence of such an implied vicarious civil liability for
damage claims under the federal securities laws."
We do not find it appropriate in this petition to address
the substantive question as to what response this Court
should give to the question this Court raised in M/ochfelder,.
namely ‘‘whether civil liability for aiding and abetting is
appropriate under the section and the rule’’ (425 U.S. at
192, Note 7). Rather, our further discussion as to the ele-
ments necessary to establish such liability is made on the
assumption, arguendo, that aiding and abetting is a predi-
cate for civil liability.
The primary focus and major issue in the instant ease
rests upon the second of the three accepted elements of
aiding-abetting liability: what is the nature and extent of
knowledge that must be demonstrated to impose civil liabil-
ity for aiding and abetting?
The court below found that Stott had the requisite
‘‘knowledge’’ in the following circumstances:
“Stott was aware that the quality of the securities
being purchased by Yamada was very low. ... Stott’s
most egregious breach of his duty to Rolf was his con-
stant reassurance that Yamada knew what he was
_* However, one District Court has said: “This court is of the
opinion that where a statute specifically limits those who may be held
liable for the conduct described by statute, the courts cannot extend
liability, under a theory of aiding and abetting, to those who do not
fall within the categories of potential defendants described by the
statute. To impose such liability would circumvent the express intent
of Congress in enacting those statutes that proscribe narrowly de-
fined conduct and allow relief from precisely defined parties.” Jn re
Equity Funding Corp. of America Securities Litigation, 416 F.S ;
161, i81 (C.D. Calif. 1976). Tae, er,
13
doing and that if Yamada were purchasing stocks they
must be satisfactory. These representations were con-
clusorily made to Rolf without investigation and with
utter disregard for whether there was a basis for the
assertions.’’ 570 F.2d at 47-48; A 17.
Elsewhere the court found that Stott was ‘‘aware that
the advisor was purchasing junk’’ and despite that aware-
ness he ‘‘actively lulled the investor by expressing con-
fidence in the advisor without bothering to investigate
whether these assurances were well founded.’’ (See foot-
note added, App. B; A 40). Finally we note the comment of
the majority that Stott
‘either recklessly failed to learn of or failed to disclose
Yamada’s web of fraud.’’ 570 F.2d at 48; A 18.
Clearly the essence of the majority opinion of the lower
court was that the aiding and abetting liability of Stott
derived from an omission, namely, a failure to investigate.
Conversely, the lower court did not predicate liability upon
the basis that Stott had actual knowledge of the underlying
violation, or even that he had a knowing participation or
conscious involvement in the securities fraud of the invest-
ment advisor.*
Other Cireuit Court decisions drastically depart from
this rule of law pronounced by the lower court and require,
as a condition of holding a defendant liable as an aider and
* The Second Circuit in another case has said:
“an aider and abettor will be held liable if he assisted the prin-
cipal with knowledge of material falsity or was reckless in de-
termining the existence of material falsity... .” Lowenschuss v.
Kane, 520 F.2d 255, 268, footnote 10 (2d Cir. 1975; emphasis
added throughout unless otherwise indicated).
a
14
abettor, that he have a knowing and conscious awareness
that a federal securities law fraud is being perpetrated upon
the plaintiff by the primary wrongdoer.
The Sixth Cireuit has announced its adherence to an
actual knowledge requirement as follows:
‘‘a person may be held as an aider and abettor only
. if the aceused party had general awareness that
his role was part of an overall activity that is improper.
..’ SEC v. Coffey,o 493 F.2d 1304, 1316 (6th Cir.
1974), cert. denied, 420 U.S. 908 (1975).
The Sixth Circuit clearly concluded that unless an alleged
aider and abettor was ‘‘aware’’ or ‘‘knew’’ the primary
wrongdoers were making misleading statements to the
plaintiff, no aiding-abetting liability could attach. Jd. at
1316.**
* This court and others reaching a like definition drew upon the
Restatement of Torts 876 (1939) which would impose liability for
the tortious conduct of another person or entity only if the defendant
“knows that the other’s conduct constitutes a breach of duty and
gives substantial assistance or encouragement to the other so to con-
duct himself.”
** The court also made the following pertinent observation :
“Normally, intent to commit a securities law violation does
not require independent proof. [citations omitted]. Knowledge
that a securities law violation would be furthered by one’s silence
or inaction, however, must be proven by reliable and probative
evidence [citations omitted], though the evidence may be cir-
cumstantial as well as ‘direct.’ [citations omitted]. Were such
proof not required, a person who is not primarily liable for a
violation could yet be held personally liable for the violation,
even though he or she was unaware of the need to disclose in-
formation withheld by those primarily liable. The result would
be to impose liability for an innocent omission, for sion-culpable
inaction. This would stretch the application of Rule 10b-5 be-
yond its statutory limits, since section 10b of the 1934 Act does
not impose liability for innocent acts but only for acts of fraud
or deceit. [footnotes omitted]” Jd. at 1317.
—-s
ov
The Tenth Cireuit likewise has adopted a knowledge
standard. It has said:
‘‘When liability is to be imposed on participants, aiders
and abettors, and co-conspirators knowing participa-
tion in the fraudulent scheme must be shown.’’ Zabre-
skie v. Lewis, 507 F.2d 546, 554 (10th Cir. 1974).
The Fifth Cireuit has also adopted a knowledge stand-
ard. Woodward vy. Metro Bank of Dallas, 522 F.2d 84, 96
(5th Cir. 1975). It has stated:
‘‘[A]s Professor Bromberg pointed out, ‘the clue to
liability is some sort of knowledge.’ [citations omitted]
Knowledge may be shown by circumstantial evidence,
or by reckless conduct, but the proof must demonstrate
actual awareness of the party’s role in the fraudulent
scheme. As Professor Ruder argued, "sing an example
remarkably similar to the case at hand:
‘Tf all that is required in order to impose liability for
aiding and abetting is that illegal activity under the
securities laws exists and that a secondary defend-
ant, such as a bank, gave aid to that illegal activity,
the act of loaning funds to the market manipulator
would clearly fall within that category and would
expose the bank to liability for aiding and abetting.
Imposition of such liability upon banks would vir-
tually make them insurers regarding the conduct of
insiders to whom they loan money. If it is assumed
that an illegal scheme existed and that the bank’s
loan or other activity provided assistance to that
scheme, some remaining distinguishing factor must
be found in order to prevent such automatic liability.
The bank’s knowledge of the illegal scheme at the
time it loaned the money or agreed to loan the money
provides that additional factor. Knowledge of
wrongful purpose thus becomes a crucial element in
EE ELT ae ee
16
aiding and abetting or conspiracy cases, Ruder, su-
pra note 23, nt 630-31.’ ’’ Td. at 96.
The Fifth Cireuit concluded that
‘‘before someone can be caught within the net of
aiding and abetting liability under Rule 10b-5
the alleged aider-abettor must be generally aware
of his role in improper activity, and he must knowingly
render substantial assistance. Without these limita-
tions, the securities laws would become an amorphous
snare for guilty and innocent alike.’’ Id. at 97."
The Third Circuit has also recently stated its adherence
toa knowledge requirement. It has said:
“Knowledge of the underlying violation is a critical
element in proof of aiding-abetting liability, for with-
out this requirement financial institutions, brokerage
houses, and other such organizations would be virtual
insurers of their customers against security law viola-
tions. Culpability of some sort is necessary to justify
punishment of a secondary actor and mere unknowing
participation in another’s violation is an improper
predicate to liability.’’ Monsen v. Consolidated Dressed
Feef Company, Inc., et al., Fed. See. L. Rep. (CCH)
196,479 at 93,764 (8d Cir.), petition for cert. filed, 47
U.S.L.W. 3168 (Sept. 8, 1978) (No. 78-404).
Applying this standard, the Third Circuit in Monsen held a
bank liable as an aider and abettor, although it was eareful
* Elsewhere the Fifth Circuit has ruled that Rule 10b-5 scienter
cannot be shown by claiming that a defendant “should have known”
and the Ninth Circuit has likewise so ruled. Gottreich v. San Fran-
cisco Instrument Corp., 552 F.2d 806 (9th Cir. 1977): Crocker-
Cuitsens National Bank y. Controls Metal Corp., 566 F.2d 631 (9th
Cir. 1977). In this regard, see comment in Footnote 16 of the lower
court opinion, A 17.
17
to emphasize the distinction between its finding and that in
Woodward, supra, where a bank was found to be innocent:
‘*As is evident, in Woodward the plaintiff did not
establish the bank’s knowledge of its borrower’s fraud.
That lack of knowledge is the critical difference be-
tween that case and the instant one.’’ Jd. at 93,767,
footnote 18.
The Monsen ruling in faet comports with an earlier Third
Cireuit decision where that court said:
‘If liability is to be imposed on a secondary defendant,
the plaintiff must show a knowing participation or
conscious involvement in the fraudulent scheme.”’
Rochez Brothers, Inc. v. Rhoades, supra at 888-89.
It is meaningful that the Third Cireuit issued its recent
opinion in Monsen with a realization that its earlier decision
in Landy v. Federal Deposit Insurance Corp., 486 F.2d 139
(3rd Cir. 1973), cert. denied, 416 U.S. 960 (1974), had been
criticized by the Fifth Cireuit.
The Fifth Cireuit (Woodward v. Metro Bank of Dallas,
supra at 94-95), specifically criticized the Third Cireuit’s
definition in Landy because of its depreciation of the im-
portance of ‘‘knowledge’’ on the part of the alleged sec-
ondary wrougdoer :
‘““The elements adopted by the Nhird Cireuit in
Landy v. Federal Deposit Ins. Corp., 3 Cir. 1973, 486
F.2d 139, cert. denied, 1974, 416 U.S. 960, 94 S. Ct.
1979, 40 L. Ed. 2d 312, are similar to the Coffey test, but
Landy refers to ‘an independent wrong’ instead of a
securities law violation, and knowledge ef the wrong’s
existence instead of awareness of a role in improper
activity. Finally, Landy omits the ‘knowing’ require-
18
ment for the substantial assistance aspect. The first
two Landy elements pose a danger of over-inclusive-
ness and seem to lose sight of the necessary connection
to the securities laws. One could know of the existence
of a ‘wrong’ without being aware of his role in the
scheme, and it is the participation that is at issue. The
scienter requirement scales upward when activity is
more remote; therefore, the assistance rendered should
be both substantial and knowing. A remote party must
not only be aware of his role, but he should also know
when and to what degree he is furthering the fraud.’’
Id. at 95. (Footuote omitted.)
i, er Re . : .
This analysis of the leading Cireuit Court eases demon-
strates, we submit, a meaningful and significant conflict
on an Issue of wide and growing importance between the
Second Cireui i Si
‘ . 1 Cireuit on the one hand, and the Third, Fifth, Sixth
. isan
and Tenth Circuits on the other.
rrr Se ee, :
3 etitioner contends flat a showing of ‘‘recklessness’’,
which falls short of establishing that the defendant was
knowingly ;¢ ‘onseclowsiy involved j i
nies ngly and conscioxsiy involved in the primary fraud,
is Insufficient to make out the secondary and viearious lia-
bility of an aider and abettor, whether or not recklessness
is sufficient for scienter on the part of the principal wrong-
doer who directly participates in and by his own act com-
mits the actual violation of Rule 10b-5.*
Such a knowledge standard discourages the unwar-
ranted inclusion in a federal securities fraud ease of per
sons who are remote from the actual fraud. The ingenious
» ing
lis wi. nee Ce » . : : :
raider coy pedenng the 7 an requirement in order to impose
: ¢ ‘ or habilitv| should be distinguis j
! bility uished from the S
° " C1 ar a . . = pi
ag whether scienter is a necessary element to establish liability for
Ae primary participant.” (Ruder: Multiple Defendants, supra at 10
first footnote, at 631). Coat
19
efforts of victims of securities frauds to enlist on their
behalf vague concepts of aiding and abetting have en-
meshed such third party strangers to the real fraud as
banks, stock exchanges, correspondent securities dealers,
accountants, potential and afflucnt fellow investors, issuers
in the disputes of their controlling insiders and many
others.*
We believe that this Court has already indicated a com-
pelling need for imposing restrictions on the unbounded
extension of the federal securities laws to alleged aiders
and abettors. Santa Fe Industries v. Green, 430 U.S. 462
(1977).
In Hochfelder, this Court, in referring to the elements
necessary to establish a cause of action for aiding and abet-
ting, cited the landmark Brennan case** and characterized
it as one where the defendant ‘‘gave active and knowing
assistance to a third party engaged in violations of the
securities laws.’’ 425 U.S. at 192, footnote 7.
This Court in its ochfelder opinion also cited Profes-
sor Ruder’s learned treatises on aiding and abetting.t
That article emphasized that the ‘‘eawact identification of
the wrong is essential in order to determine which persons
should be subject to liability for giving knowing assistance
to... the primary participants in the wrongdoing.’’ (ld.
at 630).
* See cases cited second footnote, supra at 10.
** Brennan v. Midwestern United Life Insurance Co., 259 F.
Supp. 673 (N.D. Ind. 1966) and 286 F. Supp. 702 (N.D. Ind. 1968),
aff'd, 417 F.2d 147 (7th Cir.), cert. denied, 397 U.S. 989 (1970).
+ Ruder, Multiple Defendants, supra at 10, first footnote, at 620-
645.
20
‘‘Once the independent wrong has been established,
aiding and abetting liability will depend upon a show-
ing that the defendant knew of the wrong and gave
assistance to the wrongdoer.’’ Jd. at 630.
We submit that the majority below failed to satisfy these
requirements in holding Stott liable as an aider and abettor.
As Judge Mansfield properly noted:
‘*Because even the majority concedes that ‘Stott
was ignorant’ of Yamada’s ‘stock manipulations,’ it
becomes important to determine what was the fraud
‘aided and abetted’ by Stott through some ‘reckless
disregard’ on his part. The majority opinion, mak-
ing precious little mention of any frauds committed
by Yamada, fails completely to describe or analyze
the specific fraud or frauds that were furthered by
Stott other than to suggest that they were ‘Yamada’s
investment decision’ and his conversion of Dr. Rolf’s
portfolio into securities that were highly speculative
and of very low quality compared with the type of
securities that had been there when the account had
been managed directly by Mr. Stirling of BEDCO
What the district court labelled ‘tantamount to fraud?
—Yamada’s investment of Rolf’s account in unsuitable
securities, so-called ‘high fliers,’ ‘junk,’ or ‘low qual-
ity’ issues—is characterized by the majority in con-
clusory fashion as part of ‘a more exhaustive and
all-encompassing web of fraud.’ The majority’s
forbidding label cannot alter the fact that, when this
case is stripped of the brooding omnipresence of Ya-
mada’s flagrant manipulations as it must be nothing
remains but an unfocused allegation that Stott lulled
Rolf into acquiescence in Yamada’s investment of his
pen in unsuitable securities.’? 570 F.2d at 50-51 ;
21
Professor Ruder gave particular emphasis to a principle
whose existence is a major reason why this Court should
hear this case.
‘As aiding and abetting . . . liabilities in the securi-
ties field develop, careful consideration of knowledge
requirements is essential in order to achieve sound and
balanced policy.’’ Id. at 630.
One cannot escape the conclusion that the critical and
ultimate issue which predominates the instant case is the
legal issue of whether Professor Ruder was right when he
stated:
‘‘{I]mposition of a duty to investigate ... in essence
would amount to eliminating scienter as a necessary
element in imposing aiding and abetting liability and
the substitution of a negligence standard.’’ Jd. at 633.
As we have already shown, the lower court opinion did
not predicate liability upon the existence in defendant Stott
of a knowing, personally hel¢ purpose and intent to defraud
or cheat the plaintiff. Rather, the lower court expressly
found aiding and abetting liability as to defendant Stott
predicated upon his failure to investigate. The lower
court said:
‘‘In the present case, the broker-dealer, although
charged with supervisory authority over the advisor
and aware that the advisor was purchasing ‘junk,’ ac-
tively lulled the investor by expressing confidence in
the advisor without bothering to investigate whether
these assurances were well-founded.’’ Footnote 16A,
Appendix B; A 39-40.
We contend that ‘‘scienter’’, which is an essential ele-
ment in making out a Rule 10b-5 claim, cannot, either as to
= j
22
the primary wrongdoer or as to an aider and abettor, be
founded upon the showing of an uninformed misrepresenta-
tion whose falsity might only have been discoverable by the
speaker if a considerable investigation had been made by
him. The dissenting opinion of J udge Mansfield below sum-
marizes the essential failure of the majority to recognize
the law in this area as established by this Court:
‘even conceding that Stott believed some or many of
Yamada’s purchases to be ‘junk,’ it would have re-
quired a considerable investigation for him to deter-
mine whether Yamada’s widely-reecognized reputation
for brilliance was unwarranted or whether the ratio of
risk to return on Rolf’s portfolio as a whole was con-
sonant with the doctor’s investment objectives. A fail-
ure to perform such an investigation without more does
not, after Hochfelder, establish scienter.’’ 570 F.2d
at 52; A 28.
This case does not present a situation in which the
speaker (Stott) made statements which he knew to be false
or which were grounded on facts so flimsy as to lead to the
conclusion that there was no genuine belief by the speaker
in the truth of those statements. Nor does it present a
situation where the representation was made as to a mat-
ter upon which the speaker had no knowledge at all. State
Street Trust Co. v. Ernst, 278 N.Y. 104, 112, 15 N.E.2d 416,
418-419 (1938). If this case reflected or represented such
a situation as those just defined, the wrongdoing would
have been primary, not secondary,
Rather, this case presents a situation where the speaker
made statements as to the competence of the investment ad-
___.
23
visor (Yamada) which statments are substantiated by the
trial court’s findings.
‘‘Yamada, the son of a wealthy Japanese indus-
trialist, had attended Harvard Business School a
one year prior to 1965 when he joined the ees
banking firm of Kuhn Loeb & Co. (Tr. 557). Yama a
described Kuhn Loeb as a conservative and prestigious
firm which generally handled ‘triple-A’ clients (Tr.
509). At Kuhn Loeb, Yamada eventually became an
officer of the firm purportedly with expertise in
research and ‘special situations’. In 1969, at the age
of 26, Yamada left Kuhn Loeb to form an investment
partnership; during the period of the complaint he
was not associated with any research firm or brokerage
r. 558).
pie ile <a described at trial by John P. Cione,
BEDCO’s chief compliance officer, as one of a ‘new
breed’ of young money-managers who emerged as
highly successful in the stock market during 1969 ane
1970. Yamada was committed to ‘special situations
and was one of a number of young advisers who were
making mutual funds, hedge funds, and assorted spec-
ulative ventures very profitable (Tr. 1111). During
the period of the complaint Yamada was handling SIX
sizeable portfolios, three institutional and three in-
dividual, of which Dr. Rolf’s was the largest individual
account.’’? 424 F.Supp. at 1021; A 46.
Based upon the background and reputation of the advisor
and however erroneous in hindsight the assurances turned
out to be, it could not be said that the statements when made
were spoken with a knowledge of their falsity, o were
grounded on facts so flimsy as to warrant a conclusion that
there was no genuine belief in their correctness or that the
statements were given upon a matter as to which the
speaker had no knowledge at all.
24
Despite all of this, the court below adjudicated that as
a matter of law the defendant Stott was liable because the
statements were made ‘‘without investigation,’’ and were
made in the face of the fact that Stott ‘‘failed to learn of
..- Yamada’s web of fraud’’ (570 F.2d at 47-48; A 17-18).
We submit that other decisions in the Second Cireuit
itself are in conflict with the majority decision of the lower
court.
The decision below is in direct conflict with the majority
opinion en banc of the Second Cireuit in Lanza v. Dread
& Co., 479 F.2d 1277 (2d Cir. 1973). In fact, it might be fair
to say that the majority opinion below of Circuit Judges
Oakes and Smith rests upon, adopts and follows the mi-
nority opinion in Lanza, which minority opinion was in
fact supported by those same two judges.
In the Lanza case, an outside director, aware that the
officers of his company were negotiating for the disposition
of its stock in an exchange offering, failed to inquire to
determine whether those officers were making material mis-
statements and omissions. In fact the officers were engaged
in such fraudulent misconduct to the injury of the pur-
chaser who claimed against the director for aiding and
abetting those officers in their violation of Rule 10b-5. ld.
at 1289. The Second Circuit found that the director did
not participate in the negotiations and did not know that
the corporate officers were engaged in fraudulent miscon-
duct. The court also found that the direetor “knew many
disquieting facts’? about his company but could not find
20
that his ‘‘failure to inquire was in any way willful or cal-
eulated.’’ Zd. at 1304.
The Second Circuit majority (by a six-to-four vote)
ruled in Lanza that:
‘‘a plaintiff claiming a violation of Rule 10b-5 who
cannot prove that the defendant had actual knowledge
of any misrepresentations and omissions must estab-
lish, in order to succeed in his action, that the defend-
ant’s failure to discover the misrepresentations and
omissions amounted to a willful, deliberate or reckless
disregard for the truth that is the equivalent of knowl-
adge.’’ Id. at 1305.
Applying such a standard, the court exonerated the director
because it was not proven that the director ‘willfully
closed his eyes to or turned his back on the fraudulent
nature of the... negotiations’’ conducted by the corporate
officers. Jd. at 1306.
As further evidence of this problem in the Second Cir-
euit, we would point to the court’s recent decision in SEC
v. Coven, Fed. Sec. L. Rep. (CCH) 96,462 (2d Cir. 1978)
(opinion by Judge Mansfield), an SEC enforcement pro-
ceeding. There the court held that (17(a) of the 1933 Act
(unlike §10(b) of the 1934 Act) does not require a showing
of scienter so that a negligence standard would be applied.
On the facts, although the court found a violation as to a
lawyer’s failure to comply with an escrow provision of a
new securities offering, it refused to find him secondarily
liable, even for negligence, relating to the underwriter’s
fraud:
‘« Absent some concrete indication of knowledge by ap-
pellant that an underwriter was engaged in wrongful
26
trading, we do not think that as attorney for the issuer
he was under an obligation to investigate irading in the
issuer's securities to determine whether an underwriter
was so engaged.’’ 7d. at 93,681.
* * *
se Th; , M4 . M4
W hile we think that appellant showed bad judgment
in failing to make the minimal inquiries . .. we cannot
conclude that he ‘should have known’ that his inaction
would further illegal aetivity.”’ Id. at 93,682
We submit that the present Seventh Circuit formulation
is also in conflict with the lower court holding in this case
When this Court decided the Hochfelder case, it re-
manded another important and related case* to the Seventh
Cireuit ‘‘for further consideration in light of’? Hoch-
felder.°* On that remand, the Court of Appeals reversed
its prior ruling against a commercial paper underwriter for
its failure to adequately investigate and denied recovery
on an aider and abettor basis under Rule 10b-5.+
The Seventh Cireuit defined the case before them in
these terms:
‘The distriet court held (the underwriter) liable on
the theory that it breached 2 duty to make reasonable
inquiries that would have led to the discovery of is
suer’s fraud.’’ Jd. at 792. , is
, ;
Concluding that there was no ‘*showing of actual intent
to deceive, manipulate or defraud,’’ the Seventh Cireuit
* Sanders v. John Nuveen & Co., Inc., 554 F.2d 790 (7th Cir
1977).
** 425 U.S. at 929.
t Sanders, supra at 798.
i eter ce Pe the
27
declared that ‘‘reckless behavior can be sufficient to consti-
tute scienter.’’? Jd. It stated, however, that the definition
of such conduct ‘‘should not be a liberal one lest any dis-
cernible distinction between ‘scienter’ and ‘negligence’ be
obliterated.”’
‘‘We believe ‘reckless’ in these circumstances comes
closer to being a lesser form of intent than merely a
greater degree of ordinary negligence. We perceive
it to be not just a difference in degree, but also in kind.”’
Id. at 793.
The court then applied these rules to the facts in that case,
giving particular recognition to the fact that the underlying
fault was that the underwriter’s ‘‘investigation of the
issuer was deficient and that an appropriate examination
would have revealed the issuer’s fraud.’’ Jd. The court
then adjudicated that the underwriter was not in violation
of Rule 10b-5 because:
‘There was no finding that Nuveen’s acts of commis-
sion or omission were reckless, that is, that they were
so highly unreasonable and such an extreme departure
from the standards of ordinary care as to present a
danger of misleading the plaintiff to the extent that the
danger was cither known to the defendant or so obvious
that the defendant must have been aware of it.’’ Id.;
see also Wright v. Heizer Corp., 560 F.2d 236, 251-52
(7th Cir. 1977), cert. denied 434 U.S. 1066 (1978).
The Seventh Circuit in another case, Sundstrand Corp.
vy. Sun Chemical Corp., 553 F.2d 1033 (7th Cir.), cert.
denied 434 U.S. 875 (1977), also enunciated the require-
ment that recklessness must constitute an extreme depar-
ture from the standards of ordinary care. That court said
that ‘‘the danger of misleading buyers must be actually
known or so obvious that a reasonable man would be legally
28
bound as knowing.’’ Id. at 1045. It made clear that appli-
cation of this test must be made in the light of the facts
existing at the time and not ‘‘in the blazing light of hind-
sight.’’ Jd., footnote 19. The plaintiffs must show some-
thing more than ‘‘ ‘inexeusable negligence.’ ’’ Td., foot-
note 20.
It seems obvious that the standard enunciated by the
Seventh Circuit is in plain conflict with the standard enun-
ciated by the lower court.
We would add that the Seventh Circuit standard enun-
ciated in Nuveen after this Court’s remand, appears to
conflict with two earlier Seventh Circuit opinions which had
adopted a standard similar to the doctrine established by
the lower court:
‘“*[WJe would not go so far as to charge a party with
aiding and abetting who somehow unwittingly facil-
itated the wrongful acts of another. Rather, to invoke
such a rule investors must show that the party charged
with aiding and abetting had knowledge of or, but fora
breach of duty to inquiry, should have had knowledge
of the fraud ...’’ Hochfelder v. Midwest Stock Ex-
change, 503 F.2d 364, 374 (7th Cir.), cert. denied, 419
U.S. 875 (1974).
Also—
‘‘It is clear that one who aids and abets a violation of
... Rule 10b-5 may be held civilly liable to one who is
injured thereby [citing cases]. Moreover, liability
predicated on aiding and abetting may be found on less
than actual knowledge and participation in the activity
proscribed by ... Rule 10b-5.”" SEC y. First Securities
Co. of Chicago, 463 F.2d 981, 987 (7th Cir.), cert.
denied, 409 U.S. 880 (1972).
ee ee ee
Si 5
29
This change by the Seventh Circuit would seem readily 0
plicable in that these earlier cases enunciated a ene
rejected by this Court in Hochfelder. By similan —
we submit that the lower court’s opinion, ct eG sl d
stantially with these earlier Seventh Cireuit holdings, mus
also be reversed.
C
This petition has demonstrated that there isa casei
and meaningful body of law announced * the ue ee
the issue of whether civil liability for aiding and se se
is appropriate and identifying the elements necessary)
establish such a cause of action.
It is evident that the final resolution by this Court of
the still open question of whether aiding-abetting re
ean be imposed for a Rule 10b-9 violation, and the Be
enunciation by this Court of the elements constituting tha
liability is of wide and far-reaching importance to the
federal courts in their conduct of civil suits for damages
under Rule 10b-5.
We respectfully submit that the time has come for see
Court to confront and resolve these issues 80 as to one
the establishment of sound and balanced policy in the appli-
cation of the law to secondary defendants and to “age
undue extension of the law to parties remote from the
primary and principal wrongdoer.
30
Conclusion
For all the reasons set forth above, a Writ of
Certiorari should be granted to review the opinion
and judgment of the United States Court of Appeals
for the Second Circuit.
Respectfully submitted,
Breep, Assorr & MorGan
Atiorneys for Petitioners
Blyth Eastman Dillon & Co.
Incorporated and Michael Stott
One Chase Manhattan Plaza
New York, New York 10005
(212) 676-0800
Of Counsel:
Tromas W. Ketiy
Rosert G. Kunpacn
Dated: October 2, 1978
Appendices
APPENDIX A
Opinion of the United States Court of Appeals
for the Second Circuit
UNITED STATES COURT OF APPEALS
Seconp Circuir
Nos. 22 and 405, Dockets 77-7104 and 77-7124
ainchemnineniinsilaeitilltlialianinentein
Davin E. Ro tr,
Plaintiff-A ppellant-Cross- Appellee,
v.
Buiytu, Eastman Diuton & Co., Inc. and Micuaet Scort,
Defendants-A ppellees-Cross-A ppellants.
en eee
Argued Oct. 12, 1977
Decided Jan. 3, 1978
Sidney B. Silverman, Silverman & Harnes, New York City,
for plaintiff-appellant-cross-appellee.
Thomas W. Kelly, Breed, Abbott & Morgan, New York
City (Robert G. Kuhbach, Charles Siegel, New York
City, of counsel), for defendants-appellees-cross-appel-
lants.
Before SmitH, Mansrrevp and Oakes, Circuit Judges.
Oakes, Circuit Judge:
On cross appeals from a judgment of the United States
District Court for the Southern District of New York,
Lawrence W. Pierce, Judge,’ plaintiff David E. Rolf (Rolf)
1. The opinion below is reported at 424 F.Supp. 1021 (S.D.
N.Y. 1977).
A2
Appendia A
endorses the district court’s holding on questions of liabil-
ity, but challenges the district court’s measure of damages.
Defendants in turn attack the district court’s theories of
liability. In the court below, Judge Pierce imposed aiding
and abetting liability on defendant Michael Stott (Stott)
and derivative liability on his employer, Blyth, HKastman
Dillon & Co., Ine. (BEDCO), for Stott’s substantial assist-
ance to and participation in a web of securities fraud per-
petrated by defendant Akiyoshi Yamada (Yamada),’ con-
trary to §10(b) of the Securities Exchange Act of 1954
(SEA), 15 U.S.C. §78j(b) and Rule 10b-5 thereunder, 17
C.F.R. §240.10(b) 5. Judge Pierce also implied a private
cause of action under New York Stock Exchange (NYSE)
Rule 405 and under Article III, Section 2 of the constitu-
tion of the National Association of Securities Dealers
(NASD). The Judge then awarded damages and interest
totaling $55,790. We agree with Judge Pierce on the aid-
ing and abetting liability of Stott. We therefore affirm as
to him and in view of BEDCO’s acknowledgment for pur-
poses of this appeal that it is vicariously liable by reason
of Section 20 of the 1934 Act, 15 U.S.C. §78t(a), affirm also
as to it. Brief for Defendants-Anvpellees-Cross-Appellants
at 28n.* Accordingly, we do not reach the question wheth-
er there is an implied cause of action under the NYSE
rule or the NASD constitution. We disagree with Judge
Pierce on the measure of damages, however, and accord-
ingly remand for reconsideration thereof.
2. Yamada and Rolf settled their differences; Yamada is there-
fore not a party to the cross appeals,
A3
Appendix A
I
Facts
Rolf is an ophthalmologist from Shaker Heights, Ohio.
Long an investor and an aggressive trader in the stock
market, he began his association with Eastman Dillon
Union Securities & Co., BEDCO’s predecessor firm, in
1963 when he entrusted a discretionary account to 8S. Logan
Stirling, a partner of the firm. The value of Rolf’s port-
folio at that time was approximately $400,000. In March
of 1969 Stirling was forced to retire owing to ill health.
At the end of April, a BEDCO partner assigned the Rolf
account to Stott, a registered representative with the firm
for 11 years during 4 of which he was a manager of BED-
CO branch offices. Stott then telephoned Rolf and offered
his services. Rolf, however, wanted an investment advisor
to manage his account, not simply a broker. Stott, there-
fore, at Rolf’s request, supplied the names of two invest-
ment advisors. Rolf ultimately interviewed end selected
Yamada, one of the ‘‘new breed’’ of young money-man-
agers with supposed expertise in research and ‘‘special
situations. ’’
The district court found that Rolf’s investment intent
was to combine Yamada’s and Stott’s strengths into a
‘*Stirling-type’’ operation, 424 F.Supp. 1021, 1028 (1977).
By combining Yamada’s youth and zeal with Stott’s reli-
ability and supervision, Rolf hoped to realize, as he had
with Stirling’s advice, substantial capital gain in an invest-
ment program emphasizing preservation and augmentation
of capital. In furtherance of these investment objectives,
Rolf executed a broad authorization giving his investment
A4
Appendix A
advisor, Yamada, full trading discretion. Rolf left the ac-
count and its accompanying trading commissions with Stott
and BEDCO in return for Stott’s supervision of Yamada.
On May 9, 1969, the date of the trading authorization,
Rolf’s equity in his portfolio stood at $1,423,000. The
portfolio consisted of 21 good quality, listed securities and
the warrants of two companies.’ By January of 1970
Yamada had liquidated the entire portfolio, selling 14 is-
sues at a loss. The net value of Rolf’s portfolio had de-
clined to approximately $712,000 of which $338,000 was
invested in the restricted stock of Delanair, Inc.*’ During
this period of portfolio liquidation, Yamada and Stott were
in daily contact. The district court found that out of 41
issues purchased for Rolf in the complaint period Stott
‘‘either recommended or was somehow involved with the
decision to purchase’’ 12 securities, some of which were
highly speculative. Jd. at 1030.5
3. The securities included Anaconda Co., Asamera Ail Corp.,
Avnet Inc., Buttes Gas & Oil Co., CNA Financial Corp., Cities Serv-
ice Co., Ebasco Industries Inc., Glen Alden Corp., INA Corp., In-
ternational Industries Inc., General Electric Co., leesona Corp.,
Levin Townsend Computer Corp., Loew’s Theatres Inc, National
General Corp., Occidental Petroleum Corp., Penn Central Co.,
Pittson Co., Raytheon Corp., Scientific Resources Corp., Teledyne,
Inc., Loew's Theatres (warrants), and Leasco Data Processing (war-
rants).
4. At this time the portfolio consisted principally of securities sold
over the counter (OTC) and of low quality: Delanair, Inc. (re-
stricted), Food Fair Properties, Inc., Holobeam, Inc., Monarch In-
dustries, Inc., Synchronex Corp., West Coast Production Co., Ben-
quet Consolidated Corp., Equity Funding Corp., Outlet Company,
and Simplex Wire & Cable Co.
5. These included Simplex Wire & Cable Co., Teradyne, Inc.,
Standard Oil of New Jersey, Reading & Bates Offshore, Intertherm,
Inc., Food Fair Properties, International Funeral, Natomas Corp.,
Asamera Oil Corp., Carter Wallace, Inc., West Coast Production,
and Equity Funding Corp.
A5
Appendix A
With the rash of new, unfamiliar securities which found
their way into Rolf’s portfolio, Rolf beeame concerned and
sought assurances from Stott as early as July, 1969. Speci-
fically Rolf wished to ascertain that Yamada’s purchases
were consistent with the former’s investment goals and
strategy. To assuage Rolf’s fears, the district court found,
Stott undertook a hand-holding operation whereby Stott
would reassure Rolf of Yamada’s competence whenever
Rolf questioned it. /d. at 1031. For example, when in
August, 1969, Yamada decided to purchase nearly $400,000
in Delanair stock, Rolf checked with Stott who assured
the doctor that if Yamada recommended the stock, then it
was safe to proceed.
By March 29, 1970, the value of Rolf’s portfolio had
dropped to $446,000 of which nearly one-half was tied up
in Delanair. In early April, Rolf complained to Stott who
began to assume the posture that he was a mere ‘‘order
taker.’’ Rolf disagreed with this self-deseription, asking
Stott to ‘‘work closely with Aki,’’ and reminded Stott that
Stott was his ‘‘man in N.Y.’’ 7d. at 1032-33. Later, on
December 14, 1970, Rolf again asked Stott to ‘‘keep [his]
pulse on the situation.’
The district court discredited Stott’s testimony that he
was not involved in the management of Rolf’s portfolio
specifically finding that Stott was in fact so enmeshed. Td.
at 1028, 1030, 1031. Stott and Yamada were in daily con-
tact. Stott made numerous recommendations to Yamada
for Rolf accounts using BE DCO research analysis, id. at
1030, but never counseled against a Yamada purchase. Id.
at 1033. And most of the trades were executed through
Stott at BEDCO. For those stocks purchased through
A6
Appendix A
other brokerage houses, because of BEDCO internal rules,
Stott received confirmation slips. Additionally, such secu-
rities were delivered to and held by BEDCO.
The district court’s finding on the question of Stott’s
attitude toward the quality of the purchases is not al-
together clear. The lower court states on the one hand
that it gives ‘‘some weight to Yamada’s statement that
Stott referred to the stocks in the Rolf account as ‘junk,’ ”’
i.e., of very low quality. /d. at 1033 (emphasis added).
But the Judge goes on to conclude ‘‘that Stott did indeed
consider many of the securities to be ‘junk’ and that he
told this to Yamada.’’ 1d.
The district court unequivocally found, however, that
Yamada was engaged in fraudulent stock manipulations,
of which Stott was ignorant. The district court also con-
cluded unambiguously that Yamada’s overall management
of the account was fraudulent in nature, over and above
the specific manipulations of which Stott was unaware.
Id. at 1043. Stott was of course knowledgeable that many
of the securities purchased for Rolf were highly speeula-
tive, ‘‘high-fliers.’’ Jd. at 1035. Nevertheless, neither
Stott nor BEDCO ever identified any security as unsuit-
able for Rolf. Jd. at 1036. Stott’s services to Rolf con-
sisted solely of certain ‘‘buy’’ recommendations, executing
transactions and performing the accompanying paperwork.
The court concluded that
Stott’s practice of continually voicing his confidence in
Yamada and in Yamada’s investment decisions consti-
tuted a fraud upon Dr. Rolf, who sincerely believed
that Stott had some basis for his statements. The
statements of support and the assurances which were
AT
Appendia A
repeatedly made were made with willful and reckless
disregard for whether they were true or false.
Id. at 1042.
II
District Court Holding
The distriet court based liability on alternative legal
theories. The first was that Stott owed a fiduciary duty
to Rolf which he breached; that by virtue of that breach
Stott aided and abetted Yamada’s fraud and was therefore
liable under §10(b) of the SEA, 15 U.S.C. §78)(b), and
Rule 10b-5 thereunder, 17 C.F.R. §240.10(b)-5; and that
BEDCO’s liability for Stott’s participation in Yamada’s
fraud derives alternatively from the common law doctrine
of respondeat superior or the securities law doctrine of
controlling persons liability, §20(a), SEA, 15 U.S.C. §78t
(a). The district court also rested liability on an implied
private cause of action from violations of NYSE Rule 405
and the NASD constitution, Article TII, Section2.2 The
Judge then awarded damages of $55,790, on a ‘‘churning’’
6. There is no case decided by this court upholding, but there are
several cases discussing, this theory of liability. NYSE Rule 405
requires a broker to “know [his] customer.” Art. IIT §2 NASD
imposes supervision and suitability requirements on brokers. See
Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d
135, 141 (7th Cir.), cert. denied, 396 U.S. 838, 90 S.Ct. 98, 24 L.Ed.
2d 88 (1969) ; Starkman v. Seroussi, 377 F.Supp. 518 (S.D.NLY.
1974) ; cf. Colonial Realty v. Bache & Co., 358 F.2d 178 (2d Cir.)
(no liability under 1934 act for failure to employ “just and equitable”
principles of trade as required by NASD), cert. denied, 385 U.S. 817,
87 S.Ct. 40, 17 L.Ed.2d 56 (1966). See also Van Alen v. Dominick
& Dominick, Inc., 560 F.2d 547, 552 (2d Cir. 1977) ; Van Gemert v.
Boeing Co., 520 F.2d 1373, 1379-82 (2d Cir.), cert. denied, 423 U.S.
947, 96 S.Ct. 364, 46 L.Ed.2d 282 (1975).
A8
Appendia A
theory, even though he dismissed plaintiff’s churning claim,
on the ground that any other measure of damages would
be ‘‘speculative.’’ 424 F.Supp. at 1045,
Itt
Standard of Review
At the outset, we note that the evidence in this case
against Stott, while not overwhelming, is substantial. We
are bound by the district court’s findings, as we discern
them, on the basis of the clearly erroneous rule. Fed.R.
Civ.P. 52(a); see United States Steel and Carnegie Pension
Fund, Inc, v. Orenstein, 557 F.2d 348 (2d Cir. 1977) (sub
silentio). We have held on countless occasions that on
review of district court findings, ‘‘we may not substitute
our judgment on facts for that of the trial judge, who was
ina superior position to appraise the evidence, and we may
not reverse his findings unless, on the entire record, we
are *** “eft with the definite and firm conviction that a
mistake has been committed.’ ’? Zenith Radio Corp. v.
Hazeltine Research, Inc., 395 U.S. 100, 123 [89 S.Ct. 1562,
23 L.Ed.2d 129] (1969), quoting United States v. United
States Gypsum Co., 333 U.S. 364, 395 [68 S.Ct. 525, 92 L.Ed.
746] (1948).’?) Van Alen v. Dominick & Dominick, Inc., 560
F.2d 547, 550 (2d Cir. 1977). This is true beeause the trial
judge is particularly able to assess the demeanor and cred-
ibility of witnesses. Jd. at 551; see Newburger, Loeb & Co.
v. Gross, 563 F.2d 1057, at 1070 (2d Cir, 1977).
A9
Appendin A
IV
Liability
A, Stott
There is no doubt that Yamada perpetrated a gross
fraud upon Rolf in violation of §10(b) and Rule 10b-5. We
conclude that Stott, by virtue of assurances of confidence
in Yamada and in Yamada’s investment decisions and by
virtue of. his reckless disregard of whether those assur-
ances were true or false and of substantial evidence that
Yamada was improperly and fraudulently managing Rolf’s
account, participated in and lent assistance to the fraud
upon Dr. Rolf. The reasoning which ijeads us to this con-
clusion follows.
1. Reckless disregard of truth or falsity as constituting
scienter. The starting point is Ernst & Ernst v. Hoch-
felder, 425 U.S. 185, 96 S.Ct. 1875, 47 L.Ed.2d 668 (1976).
In Hochfelder, the Supreme Court explicitly failed to de-
cide whether §10(b) and Rule 10b-5 may, in appropriate
circumstances, give rise to aiding and abetting liability and,
if so, the elements of such a cause of action. Jd. at 192 n.
7, 96 S.Ct. 1875. Although the Supreme Court has, there-
fore, not passed on the issue, our court has adopted the
position that §10(b) and Rule 10b-5 do permit the imposi-
tion of aiding and abetting liability. Hirsch v. DuPont, 553
I’.2d 750, 759 (2d Cir. 1977); see Brennan v. Midwestern
United Life Insurance Co., 417 F.2d 147 (7th Cir. 1969),
cert. denied, 397 U.S. 989, 90 S.Ct. 1122, 25 L.Ed.2d 397
(1970) ; Note, Accountants’ Liabilities for False and Mis-
leading Financial Statements, 67 Colum.L.Rev. 1437, 1448
ALO
Appendia A
(1967). Of course, the basic holding of Hochfelder, that
scienter is an element of the §10(b)/Rule 10b-5 cause of
action,’ also establishes the standard for aiding and abet-
ting liability.’
The question then becomes precisely what level of sci-
enter is required in this type of 10b-5 case and whether the
district court’s findings indicate that plaintiff’s proof satis-
fies that standard. We conclude on one of the questions
left open by Hochfelder, 428 U.S. at 194, n. 12, 96 S.Ct.
1375, that at least where, as here, the alleged aider and
abettor owes a fiduciary duty to the defrauded party,°
recklessness satisfies the scienter requirement. We arrive
at this conclusion for several reasons.
First, by leaving open the possibility that recklessness
might satisfy the scienter requirement, the Supreme Court
recognized that in certain instances a recklessness standard
might be appropriate. See Sundstrand Corp. v. Sun Chem-
ical Corp., 553 F.2d 1033, 1044 (7th Cir. 1977) (‘‘no hint
in Hochfelder that the Court intended a radical departure
from’’ common law analogue of fraud which imposes li-
ability for reckless behavior), cert. denied, —— U.S. —,
98 S.Ct. 225, 54 L.Ed.2d 155 (1977). The relationship most
logically subjected to a recklessness standard, rather than
7. The requirement of scienter has been the rule in this circuit
for some time. See Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir.
1973) (en banc); Sonde & Freedman, “Seagulls on the Water—
Some Ships in a Storm’: A Comment on Lanza v. Drexel, 49
N.Y.U.L.Rev. 270 (1974). ;
8. Hochf:!der was pursued on an aiding and abetting theory.
9. We need not reach the question whether recklessness satisfies
the scienter requirement where the alleged aider and abettor owes no
duty of disclosure and of loyalty to the defrauded party. See Hirsch
v. duPont, 553 F.2d 750, 759 (2d Cir. 1977).
All
Appendix A
some stricter standard involving proof of intent to defraud,
is where the aider and abettor owes a direct fiduciary duty
to the defrauded party. See Woodward v. Metro Bank of
Dallas, 522 F.2d 84, 97 (Sth Cir. 1975). Liability premised
on the recklessness of one’s fiduciary in failing to perform
his duty to disclose is a far ery from awarding damages
for simple negligence. See Ernst & Ernst v. Hochfelder,
supra. Clearly, Stott, as Rolf’s broker, owed Rolf a fidu-
eiary duty. See Hanly v. SEC, 415 F.2d 589, 596, 597
(2d Cir. 1969)."°
Second, on a linguistic level, ‘he term scienter" is used
by the Supreme Court to mean, in the disjunctive, ‘‘know-
ing or intentional misconduct.’’ 425 U.S. at 197, 96 S.Ct.
1375." Use of the word ‘‘knowing’’ implies conduct which
10. We reject Stott’s argument that the trading authorization
given to Yamada relieves Stott of any duty te Rolf and thus of any
liability. Stott was still Rolf’s broker, though not his investment
advisor, and owed Rolf a duty of loyalty normally expected of brok-
ers. In addition, in view of the finding that Stott undertook to over-
see Yamada's actions, the question whether a trading authorization,
by itself, would serve to relieve a broker-dealer of liability is not be-
fore us.
11. Scienter is the Latin word for “knowingly.” See Herzfeld v.
Laventhol, Krekstein, Horwath & Horwath, 540 F.2d 27, 33 (2d Cir.
1976).
12. It has been suggested that other language in Hochfelder man-
dates the conclusion that recklessness will not satisfy the scienter
requirement. That language states:
Use of the word “manipulative” is especially significant. It is
and was virtually a term of art when used in connection with
securities markets. It connotes intentional or willful conduct
designed to deceive or defraud investors by controlling or artifi-
cially affecting the price of securities.
425 U.S. at 199, 96 S.Ct. at 1384 (footnote omitted). However, at
another point in the opinion, footnote 12 is appended to the language
(footnote continued on next page)
Al12
Appendia A
is somewhat less directed and focused than ‘‘intentional’’
activity which commonly is characterized by a specific men-
tal state whose animus is to bring about a particular result,
see W. Prosser, Law of Torts §107, at 700 (4th ed. 1971).
‘‘Knowing’’ is a word laden with common law connota-
tions: at common law, reckless conduct is viewed as a form
of knowing conduct. Jd. at 701. For example, the common
law requirement of scienter as an element of the tort of
deceit or misrepresentation may be proved in a number of
ways:
There is of course no difficulty in finding the required
intent to mislead where it appears that the speaker
believes his statement to be false. Likewise, there is
general agreement that it is present when the repre-
sentation is made without any belief as to its truth,
or with reckless disregard whether it be true or false.
“allegation of ‘scienter’—intent to deceive, manipulate, or defraud.”
Id. at 193, 96 S.Ct. at 1381. Footnote 12 then recognizes that “[i]n
certain areas of the law recklessness is considered to be a form of
intentional conduct for purposes of imposing liability for some act.”
Id. at 194n. 12, 96 S.Ct. at 1381.
The Hochfelder opinion also noted :
Although the extensive legislative history of the 1934 Act is
bereft of any explicit explanation of Congress’ intent, we think
the relevant portions of that history support our conclusion that
$10(b) was addressed to practices that involve some element of
scienter and cannot be read to impose liability for negligent con-
duct alone.
425 U.S. at 201, 96 S.Ct. at 1385 (emphasis added). The Court
seems to have recognized that scienter is not a rigid concept en-
compassing only the definitive intent to accomplish a specific pur-
pose. A less definitive mental state—recklessness—would seem to
suffice in certain circumstances and does not run afoul of Hochfelder’s
admonition that liability not be imposed for “negligent conduct alone.”
Id. See generally, Note, Recklessness Under Section 10(b): Weath-
ering the Hochfelder Storm, 8 Rutgers Camden L.J. 325, 342-45
(1977).
-—s
—~- ae
precept ag TOD gM ge OD he egg OA agreeing Nay gy NR OO AG OO OG AE GG AAA i i,
A13
Appendix A
Id. (footnotes omitted). It is unquestionable that the com-
mon law has served as an interpretive source of securities
law concepts. See Holdsworth v. Strong, 545 F.2d 687, 693-
94 (10th Cir. 1976), cert. denied, 480 U.S. 955, 97 S.Ct. 1600,
51 L.Ed.2d 805 (1977). The common law tort of fraud has
adopted a recklessness standard as one means of satisfy-
ing the requisite intent element of that cause of action."
Similarly, securities law cases have recognized that reck-
lessness may serve as a surrogate concept for willful fraud.
Concurring in SEC vy. Texas Gulf Sulphur Co., 401 F.2d
833, 868 (2d Cir. 1968) (en bane), cert. denied sub nom.
Coates v. SEC, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756
(1969), Judge Friendly noted the distinction between a
‘‘merely negligent misstatement’’ and ‘‘the kind of reck-
lessness that is equivalent to willful fraud.’’ See Haimoff,
Holmes Looks at Hochfelder and 10b-5, 32 Bus.Law 147,
162 (1976).
13. See, e. g., Ultramares Corp. v. Touche, 255 N.Y. 170, 190,
174 N.E. 441, 449 (1931) (“negligence or blindness, even when not
equivalent to fraud, is nonetheless evidence to sustain an inference of
fraud. At least this is so if the negligence is gross’) (emphasis
added). If Ultramarcs left open the common-law door on the reck-
lessness issue, State Street Co. v. Ernst, 278 N.Y. 104, 112, 15 N.E.2d
416, 418-19 (1938), closed it:
Accountants, however, may be liable to third parties, even where
there is lacking deliberate or active fraud. A representation cer-
tified as true to the knowledge of the accountants when knowledge
there is none, a reckless misstatement, or an opinion based on
grounds so flimsy as to lead to the conclusion that there was no
genuine belief in its truth, are all sufficient upon which to base
liability. A refusal to see the obvious, a failure to investigate the
doubtful, if sufficiently gross, may furnish evidence leading to an
inference of fraud so as to impose liability for losses suffered by
those who rely on the balance sheet. In other words, heedless-
ness and reckless disregard of consequence may take the place of
deliberate intention.
See Restatement (Second) of Torts $520(b), Comment at 60 (1965).
Ald
Appendix A
Third, it is consistent with, if not demanded by, prece-
dent in this cireuit' to hold that reckless conduct satisfies
the scienter requirement. See Lanza y. Drexel & Co., 479
F.2d 1277, 1306 (2d Cir. 1973) (en bane) ; Shemtob v. Shear-
son Hammill & Co., 448 F.2d 442, 445 (2d Cir. 1971) ; Buck-
lo, The Supreme Court Attempts to Define Scienter Under
Rule 10b-5: Ernst & Ernst v. Hochfelder, 29 Stan.L.Rev.
213, 214 (1977). Lanza vy. Drevel, supra, of course required
scienter as an element of a 10b-5 cause of action prior to
the Supreme Court’s decision in /Tochfelder. The Lanza
test was stated in terms of ‘‘willful or reckless disregard
for the truth,’’ id. at 1306 (emphasis added), thereby ree-
ognizing that either intentional or reckless behavior is the
predicate mental state for 10b-5 liability. The Mochfelder
Court noted that a number of courts of appeals ‘*have held
that some type of scienter—zi.e., intent to defraud, reckless
disregard for the truth, or knowing use of some practice
to defraud—-is necessary in such an action’’ and then cited
inter alia our decision in Lanza, 425 U.S. at 194 n. 12, 96
S.Ct. at 1881. Thus, on balance, we consider that /Hoch-
14. Other courts have held that a recklessness standard is con-
sistent with Hochfelder. Sce, ec. g., Sanders v. John Nuveen & Co.,
Inc., 554 F.2d 790, 792 (7th Cir. 1977); Sundstrand Corp. v. Sun
Chemical Corp., 553 F.2d 1033, 1040, 1043-45 (7th Cir. 1977) (reck-
less nondisclosure), cert. denied, —— U.S. ——, 98 S.Ct. 225, 54
L.Ed.2d 155 (1977); Bailey v. Meister Brau, Inc., 535 F.2d 982,
993-94 & n. 14 (7th Cir. 1976) (reckless disclosure) ; Stern v. Amer-
ican Bankshares Corp., 429 F.Supp. 818, 825 (1E.D. "Wis. 1977) ;
McLean v. Alexander, 420 F.Supp. 1057 (D.Del. 1976). But see
SEC v. American Realty Trust, 429 F. Supp. 1148, 1171 & n.8 (E.D.
Va. 1977) (recklessness does not satisfy /ochfelder).
Ald
Appendia A
felder left intact our rule that recklessness is a form of
scienter in appropriate circumstances."
A final basis for applying a recklessness standard in
certain instances rests perhaps on the practical problem of
proof in private enforcement under the securities laws.
Proof of a defendant’s knowledge or intent will often be
inferential, see Ruder, Multiple Defendants in Securities
Law Fraud Cases: Aiding and Abetting, Conspiracy in
Pari Delicto, Indemnification, and Contribution, 120 U.Pa.
L.Rev. 597, 635 (1972), and cases thus of necessity cast in
terms of recklessness. To require in all types of 10b-5
cases that a factfinder must find a specifie intent to deceive
or defraud would for all intents and purposes disembowel
the private cause of action under §10(b).
2. Other elements of aiding and abetting liability.
Given, then, that we find aider and abettor liability appro-
priate under §10(b) and given that we believe at the very
least that fiduciaries have acted with scienter when they
have been reckless, we pass to the other well-established
elements of the aiding and abetting cause of action. The
15. A major purpose of the //ochfelder decision was to foreclose
“liability for wholly faultless conduct where such conduct results in
harm to investors.” 425 U.S. at 198, 96 S.Ct. at 1383. Adoption
of a recklessness standard in this case does not result in liability for
“wholly faultless conduct” and thereby does not impede an important
policy of §10(b) and Rule 10b-15 as recognized in Hochfelder. Hoch-
felder itself found that “[t]here is no indication that Congress in-
tended anyone to be made liable for such practices unless he acted
other than in good faith. The catchall provision of $10(b) should be
interpreted no more broadly.” 425 U.S. at 206, S.Ct. at 1387
Reckless behavior hardly constitutes good faith. Since good faith
does not constitute a defense to reckless or intentional conduct, a reck-
lessness standard is fully consistent with Hochfelder on its own terms.
See McLean vy. Alexander, supra, 420 F.Supp. at 1081,
Al6
Appendia A
first element that a plaintiff must prove is that the primary
party, here Yamada, as distinguished from the secondary
aiding and abetting party, committed a securities law viola-
tion. Woodward v. Metro Bank of Dallas, supra, 522 F.2d
at 95; see SEC v. Coffey, 493 F.2d 1304, 1816 (6th Cir.
1974), cert. denied, 420 U.S. 908, 95 S.Ct. 826, 42 L.Ed.2d
837 (1975); ef. Landy v. Federal Deposit Insirance Corp.
486 F.2d 139, 162 (8d Cir. 1973) (requiring ‘‘independent
wrong’? instead of independent securities law violation),
cert. denied, 416 U.S. 960, 94 S.Ct. 1979, 40 L.Ed.2d 312
(1974). The district court found, and we see no basis for
concluding otherwise, that Yamada’s overall management
of the account in violation of his fiduciary duties owed by
reason of the investment advisory agreement was fraud-
ulent. 424 F.Supp. at 1043. Indeed the district court
ealled Yamada’s handling of the account a ‘gross fraud,.’’
Id. Moreover, Stott and BEDCO in their brief acknowl-
edge that Yamada committed securities fraud. Their very
purpose is to point the finger at Yamada in order to exon-
erate Stott. Brief for Defendants-Appellees-Cross-Appel-
lants at 28, 34, 42, 44, 47. There is therefore no reason to
analyze Rolf’s portfolio on a stock by stock basis to deter-
mine which purchases and sales constituted frauds upon
Rolf, a more specific and particularized investigation which
we might have to undertake if Yamada had merely manip-
ulated two or three stocks without engaging in a more
exhaustive and all-encompassing web of fraud.
The second requirement for establishing the aiding and
abetting violation is Stott’s knowledge of Yamada’s fraud.
We have indicated above that the scienter element may be
Al7
Appendix A
satisfied by proof of reckless conduct. While the evidence
in this case is not overwhelming, we believe it is sufficient
to sustain Judge Pierce’s findings on the basis of the clear-
ly erroneous rule,
Reckless conduct is, at the least, conduct which is ‘‘high-
ly unreasonable’’ and which represents ‘‘an extreme depar-
ture from the standards of ordinary care ... to the extent
that the danger was either known to the defendant or so
obvious that the defendant must have been aware of it.’’
Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir.
1977)."° Stott was aware that the quality of the securities
being purchased by Yamada was very low. The daily con-
tact between Stott and Yamada gave Stott ample opportu-
nity to supervise the investment advisor, an obligation
which the lower court found Rolf had sought and Stott had
undertaken to perform, Stott’s most egregious breach of
his duty to Rolf was his constant reassurance that Yamada
knew what he.was doing and that if Yamada were purchas-
ing stocks they must be satisfactory. These representa-
tions were conclusorily made to Rolf without investigation
and with utter disregard for whether there was a basis for
the assertions, ‘‘A representation certified as true...
when knowledge there is none, a reckless misstatement, or
an opinion based on grounds so flimsy as to lead to the
conclusion that there wes no genuine belief in its truth, are
all sufficient upon which to base liability.’’ State Street
16, For purposes of this decision we need not determine whether
Stott’s conduct would qualify as reckless under a less strict test as
set forth in, e.g., Stern v. American Bankshares Corp., supra, 429
F.Supp. at 827 (“plaintiff must allege . . . that the defendants knew
or should have known of the facts and circumstances concerning the
fraud”) (emphasis added).
A18
Appendix A
Co. v. Erist, 278 N.Y. 104, 112, 15 N.E.2d 416, 418-19 (1938).
Stott’s representations and opinions were given without
basis and in reckless disregard for their truth or falsity.
The third and final requirement to establish the aiding
and abetting violation is that Stott rendered substantial
assistance to Yamada in the fraudulent mismanagement of
Rolf’s portfolio. One commentator has suggested that sub-
stantial assistance might include ‘‘repeating . . . misrepre-
sentations (or aiding in their preparation), by acting as
conduits to accumulate or distribute securities, by execut-
ing transactions or investing proceeds, or perhaps by fi-
nancing transactions.’’ 2 A. Bromberg, Securities Law
§8.5 (515) (1974). In this case, Stott’s assistance was both
active and passive. He processed many of the relevant
securities orders; he reassured Rolf of Yamada’s compe-
tence; and he either recklessly failed to learn of or failed
to disclose Yamada’s web of fraud. See Woodward v.
Metro Bank of Dallas, supra, 522 F.2d at 96-97. The effect
of Stott’s ‘‘hand-holding operation’’ was to prevent Rolf
from discovering Yamada’s fraud. Stott’s acts, therefore,
were a substantial causal factor in the perpetuation of
Yamada’s fraud and in the cumulation of Rolf’s losses.
See Landy v. Federal Deposit Insurance Corp., supra, 486
F.2d at 163. We therefore affirm the trial court’s judg-
ment to the extent that it found Stott an aider and abettor
of Yamada’s fraud.'®
16A. This decision does not impose liability on a broker-dealer
who merely executes orders for “unsuitable” securities made by an
investment advisor vested with sole discretionary authority to control
the account. In the present case, the broker-dealer, although charged
with supervisory authority over the advisor and aware that the ad-
visor was purchasing “junk,” actively lulled the investor by express-
ing confidence in the advisor without bothering to investigate whether
these assurances were well-founded.
A19
Appendia A
B. BEDCO
While there is disagreement among the circuits’ and,
perhaps, even disharmony within the Second Circuit’® on
the relationship between §20(a) of the 1934 Act, 15 U.S.C.
§78t(a), and the common law doctrine of respondeat su-
perior, BEDCO has conceded ‘‘for the purposes of this
appeal’’ that if Stott is found liable it is vicariously liable
under Section 20, even though the decision below stated
that ‘‘BEDCO did not have actual notice of the fraud.’’”
17. Compare Hollaway v. Howerdd, 536 F.2d 690, 694-95 (6th
Cir. 1976) (§20(a) has not supplanted doctrine of respondeat supe-
rior) ; Fey v. Walston & Co., 493 F.2d 1036, 1051-52 (7th Cir. 1974)
(same), with Zweig v. Hearst Corp., 521 F.2d 1129, 1132-33 (9th
Cir.) (§20(a) has supplanted doctrine of respondeat superior), cert.
denied, 423 U.S. 1025, 96 S.Ct. 469, 46 L.Ed.2d 399 (1975). A
similar difference of opinion exists with respect to the analogous
“controlling persons” liability provision, $15 of the 1933 Act, 15
U.S.C. §770. Compare Johns Hopkins University v. Hutton, 422
F.2d 1124, 1130 (4th Cir. 1970) (respondeat superior not supplanted
by §15), cert. denied, 416 U.S. 916, 94 S.Ct. 1622, 40 L.Ed.2d 118
(1974) ; Armstrong, Jones & Co. v. SEC, 421 F.2d 359, 362 (6th
Cir.) (same), cert. denied, 398 U.S. 958, 90 S.Ct. 2172, 26 L.Ed.2d
543 (1970), with Kamen & Co. v. Paul H. Aschker & Co., 382 F.2d
689, 697 (9th Cir. 1967), cert. granted, 390 U.S. 942, 88 S.Ct. 1021,
19 L.Ed.2d 1129 cert. dismissed. 393 U.S. 801, 89 S.Ct. 40, 21 L.Ed.
2d 85 (1968) (discussion of derivative liability for securities viola-
tions solely by virtue of §$15 and 20(a) after conclusion of no liability
under agency principles with respect to common law counts).
18. Compare SEC v. Management Dynamics, Inc., 515 F.2d 801
(2d Cir. 1975), with SEC v. Geon Industries, Inc., 531 F.2d 39 (2d
Cir. 1976).
19. This permits us to avoid resolution of the rather thorny con-
trolling person-respondeat superior issue as well as to leave for an-
other day resolution of the even thornier issue of liability under NYSE
or NASD rules, note 6 supra,
OE SNL NE ET nT
A20
Appendix A
V
Damages
We are not capable of precisely measuring Rolf’s dam-
ages on this appeal, although we do not think that they
were so speculative as to compel resort solely to damages
as in a churning case, for commissions paid the broker
(and interest thereon). Accordingly, we remand to the
district court to determine damages in accordance with the
guidelines set forth below.
First, the district court should determine as near as
possible the time when Stott began to aid and abet Yam-
ada’s fraud®® and compute the market value of Rolf’s
portfolio on that date. Second, the district court should
subtract the value of the portfolio on the date when Stott’s
participation in and assistance to the fraudulent scheme
ceased from the value on the date when Stott became an
aider and abettor. This amount is Rolf’s gross economic
loss.2"_ See Note, Churning by Securities Dealers, 80 Harv.
20. Of course Stott’s liability is predicated on his contractual in-
volvement in the management of Rolf’s account, representing as he did
one-half of the “Stirling-type operation.” But Stott may not have
been an aider and abettor from the moment Rolf executed the trading
authorization to Yamada. That will depend on the district cc it’s
view of Stott’s conduct in light of the three-part test of aiding and
abetting liability discussed above.
21. What we have referred to as Rolf’s gross economic loss on
a portfolio-wide basis during a relevant period of time is often referred
to as a rescission measure of damages. 3 A. Bromberg, supra at 9.1;
see Chasins v. Smith, Barney & Co., 438 F.2d 1167, 1173 (2d Cir.
1970). This case is, however, somewhat different from the typical
rescission situation as in Chasins. Here Stott’s participation in Ya-
mada’s fraud infected Rolf’s portfolio during a specific period of time
to be determined on remand. In a sense the portfolio will be deemed
sold as of the last day of the aiding and abetting period in order to
determine what the resale price would have been if the portfolio had
been liquidated on that day. See generally Mulianey Theories of
Measuring Damages in Security Cases and the Effects of Damages on
Liability, 46 Fordham L.Rev. 277, 284-85 (1977).
A21
Appendia A
L.Rev. 869, 884 (1967). The district court should then
reduce Rolf’s gross economic loss by the average percent-
age decline in value of the Dow Jones Industrials, the
Standard & Poor’s Index, or any other well recognized
index of value, or combination of indices, of the national
securities markets during the period commencing with
Stott’s aiding and abetting and terminating with its cessa-
tion. Thus if during the relevant period the stock
22. Rolf’s portfolio, even if it had not been fraudulently misman-
aged, would have declined in value during the bear market of the aid-
ing and abetting period. Stott and BEDCO have no responsibility
for the genera! decline in economic conditions. The rescission theory
of damages which we essentially utilize here cannot restore a plaintiff
to a better position than he would have been in if the fraud had not
occurred, See generally Gerstle v. Gainble-Skoqmo, Inc., 478 F.2d
1281, 1304-06 (2d Cir. 1973); 3 A. Bromberg, supra at 9.1 & n.2
SEA §28(a), 15 U.S.C. §78bb(a), limits recovery to “actual dam-
ages.
Some courts, albeit in different securities law contexts, have used
technical computations to limit recoveries to actual damages. See
Mills v. Electric Auto-Lite Co., 552 F.2d 1239, 1248 (7th Cir. 1977)
(technical damages formula to measure fairness of merger), cert.
denied, U.S. . 98 S.Ct. 398, 54 L.Ed.2d 279 (1977) (No.
77-331) ; Bonime v. Doyle, 416 F.Supp. 1372, 1377, 1386 (S.D.N.Y.
1976) (factoring out of damages computation “losses attributable to
‘unique characteristics of a particular... .’"" by using two indices
composed of stocks of comparable value to the stock at issue); Feit
v. Leasco Data Processing }iquipment Corp., 332 F.Supp. 544, 586
(E.D.N.Y. 1971) (reducing trading losses by decline in the Standard
& Poor’s Daily Stock Price Index). Feit has been criticized for util-
izing a “broad-based index” without considering whether the index
as a whole was similar in nature to the security under consideration.
Reder, Measuring Buyers’ Damages in 10b-5 Cases, 31 Bus. Law.
1839, 1850 (1976). Here, of course, Rolf’s portfolio consisted of
numerous stocks. At the outset of Yamada’s stewardship, they were
of generally high quality. If the district judge should determine that,
when the aiding and abetting period began, the quality of stocks in
the portfolio was such that a broad-based index would not be repre-
sentative of those stocks, then he may select a more appropriate gauge,
perhaps a portion of an index, perhaps a composite of indices, perhaps
expert opinion. See generally, Mullaney, supra note 21, at 288-90.
A22
Appendix A
market declined in value by 25%, then Rolf’s gross eco-
nomic loss should be reduced by 25%. Because plaintiff’s
theory of liability is to the effect that Stott’s aiding and
abetting prevented Rolf’s discovery of Yamada’s fraud,
it is not fair to reduce damages any further by the amount
of loss on a diserete transaction to which Stott had no
connection because he did not execute the transaction,
recommend the security, or reassure Rolf with respect to
that security.“ However, should the loss on the Delanair
stock be determined to have oceurred during the aiding
and abetting period, Rolf’s damages must be reduced by
$175,000, the amount for which he settled his claims against
several Delanair-related defendants. We also hold that
Rolf is entitled to a return of commissions paid to Stott
and BEDCO, but only as to transactions falling within
the aiding and abetting period, with interest thereon as
determined by the district judge.
Finally, we request the district judge to reconsider
his decision on the question of prejudgment interest in
view of our obvious conclusion that Rolf was deprived of
a principal sum. See Nelson v. Hench, 428 F.Supp. 411
(D.Minn.1977). While such an award is a matter of ju-
dicial discretion, Blaw v. Lehman, 368 U.S. 403, 414, 82
S.Ct. 451, 7 L.Ed.2d 403 (1962); Norte & Co. v. Huffines,
416 F.2d 1189, 1191-92 (2d Cir. 1969), cert. denied sub nom.
Muscat vy. Norte & Co., 397 U.S. 989, 90 S.Ct. 1121, 25 L.Ed.
2d 396 (1970), it is not unreasonable to request the district
23. Rolf, for example, may not collect damages for losses in ac-
counts opened at other brokerage houses where those accounts were
managed by himself and not Yamada or without Stott’s participation
or knowledge.
A23
Appendia A
judge to set forth his reasons should he again deny pre-
‘judgment interest. See Wessel vy. Buhler, 437 F.2d 279,
284 (9th Cir. 1971).
Judgment affirmed in part and remanded.
MansrFie.p, Cireuit Judge (dissenting) :
I must respectfully dissent.
The majority holds a registered representative (Stott)
and his employer (BEDCO) liable under §10(b) and Rule
10b-5 to their customer (Rolf) for losses suffered by the
customer upon purchases and sales of securities executed
at the direction of Rolf’s own independent investment ad-
viser (Yamada) pursuant to written discretionary author-
ity from Rolf instructing Stott and BEDCO to follow Ya-
mada’s orders. This result is achieved on the grounds that
(1) the investment advisor (Yamada) was committing vari-
ous frauds on the customer (Rolf), and (2) the broker
(Stott), although he knew nothing of the frauds, ‘‘aided
and abetted’? Yamada’s conversion of Rolf’s account to
unsuitable securities by ‘‘holding the hand”’ of Rolf pursu-
ant to an oral agreement to ‘‘look after’’ Rolf’s account
and by assuring him of Yamada’s competence as an invest-
ment counsel.
The majority views Yamada’s investment of the account
in unsuitable securities as fraud in and of itself and Stott’s
state of mind as recklessness amounting to a deliberate
intent to deceive. All of this is too much for me to accept.
The majority not only patches together watered-down no-
tions of fraud and scienter in arriving at a result indis-
tinguishable in any significant respect from that reversed
A24
Appendix A
by the Supreme Court in Ernst & Ernst v. Hochfelder, 425
U.S. 185, 96 S.Ct. 1375, 47 L.Fd.2d 668 (1976), but also
overlooks findings below and undisputed evidence that fore-
close Rule 10b-5 liability.
With regard to the ‘*fraud’? by Yamada that Stott is
held to have aided and abetted, Judge Pierce found, and the
majority here seems to agree, that ‘‘Stott did not know of
the direct frauds which Yamada was perpetrating on Rolf”?
—such as the investment adviser’s manipulation of the
public market price of certain securities obtained for Rolf’s
account and the use of the purchasing power of that account
to make purchases of securities that might improve the
price for others. Nor is there any basis for a finding that
Stott shut his eyes to any such manipulation or use of
Rolf’s account to help others. Indeed, it is undisputed that
at all pertinent times Yamada’s reputation as an investment
adviser was excellent and his successful accomplishments
in the trade were well known. Even on the majority’s ‘‘aid-
ing and abetting’ theory, therefore, Stott could not be held
responsible for Yamada‘’s manipulations, since they were
not known to Stott and would not have been readily appar-
ent upon exercise of due diligence, including compliance
with New York Stock Exchange Rule 405 (‘‘know your
customer’’ rule).
Because even the majority concedes that ‘‘Stott was
ignorant’’ of Yamada’s ‘‘stock manipulations,’’ it becomes
important to determine what was the fraud ‘‘aided and
abetted’’ by Stett through some ‘‘reckless disregard’’ on
his part. The majority opinion, making precious little
mention of any frauds committed by Yamada, fails com-
pletely to describe or analyze the specific fraud or frauds
ro auteelll
Beet
A25
Appendix A
that were furthered by Stott other than to suggest that they
were ‘‘Yamada’s investment decisions’’ and his conversion
of Dr. Rolf’s portfolio into securities that were highly
speculative and of very low quality compared with the type
of securities that had been there when the account had been
managed directly by Mr. Stirling of BEDCO. What the
district court labelled ‘‘tantamount to fraud’’-—Yamada’s
investment of Rolf’s account in unsuitable securities, so-
called ‘‘high fliers,’’ ‘‘junk,’’ or ‘‘low quality’’ issues—-is
characterized by the majority in conclusory fashion as part
of ‘‘a more exhaustive and all-encompassing web of fraud.’’
The majority’s forbidding label cannot alter the fact that,
when this case is stripped of the brooding omnipresence of
Yamada’s flagrant manipulations as it must be, nothing
remains but an unfocused allegation that Stott lulled Rolf
into acquiescence in Yamada’s investment of his account in
unsuitable securities. To hold that he thereby aided and
abetted a Rule i0b-5 ‘‘fraud’’ is to confuse the common law
duties of fiduciaries or accountants, see, e. g., Ultramares
Corp. v. Touche, 255 N.Y. 170, 190, 174 N.E. 441, 449 (1931),
with the limited prohibitions of §10(b) and Rule 10b-5
against the use of any ‘‘manipulative or deceptive device or
contrivance’’ in the purchase or sale of securities.
Even assuming arguendo that the investment of a eus-
tomer’s funds in unsuitable securities could on occasion
rise to the level of Rule 10b-5 fraud, the majority errs in
concluding that Stott’s conduct, principally his assurances
regarding Yamada’s competency as investment counsel,
coupled with Stott’s personal belief that some of the in-
vestments were ‘‘junk,’’ establishes recklessness equivalent
to an intentional and deliberate participation in or aiding
A26
Appendix A
and abetting of such ‘‘fraud.’’ In my view this determina-
tion violates fundamental principles established by the
Supreme Court in Ernst & Ernst v. Hochfelder, supra,
and stems from an erroneous concept of ‘‘recklessness’’ or
‘*reckless disregard’’ of material facts.
In Hochfelder the Court reversed a decision of the
Seventh Circuit which had held ‘‘that one who breaches
a duty of inquiry and disclosure owed another is liable
in damages for aiding and abettmg a third party’s viola-
tion of Rule 10b-5 if the fraud would have been discovered
or prevented but for the breach. 503 F.2d 1100 (1974).’’
425 U.S. at 191, 96 S.Ct. at 13880 (emphasis added). The
Supreme Court held that proof of scienter, i. e., an ‘‘intent
to deceive, manipulate or defraud,’’ was essential and that
this element was not satisfied by proof of negligence or
breach of a duty to inquire. It left open the ‘‘question
whether, in some circumstances, reckless behavior’’ might
be treated as the equivalent of scienter, 425 U.S. at 194 n.
12, 96 S.Ct. at 1381.
While Hochfelder did not clarify entirely the meaning
of scienter, it did make clear that the failure of a fiduciary
or accountant to fulfill a ‘‘common-law and statutory duty
of inquiry,’’ 425 U.S. at 192, 96 S.Ct. at 1380, which would
reveal fraud on someone else’s part, is not without more
the equivalent of scienter as defined by the Court. Since
Hochfelder we have reiterated that
‘*. . . before [a party] can be held liable as an aider
and abetter, there must be a showing that [such a
party]: (a) knew of the investment adviser-client
relationship; (b) had knowledge of the fraud; and
(c) acted in concert with the investment adviser. Cf.
~
A27
Appendix A
Ernst & Ernst v. Hochfelder, 425 U.S. 185 [96 S.Ct.
1375, 47 L.Ed.2d 668] (1976).’’ Abrahamson v. Flesch-
ner, 568 F.2d 862, at 871-872 n. 16 (2d Cir. 1977).
See also Hirsch v. du Pont, 553 F.2d 750, 759 (2d Cir. 1977)
(‘‘knowing assistance of or participation in a fraudulent
scheme gives rise to liability under §10(b) as an aider
and abettor. ... knowledge of the fraud .. . is indispen-
sable’’); Kerbs v. Fall River Indus., Inc., 502 F.2d 731,
739-40 (10th Cir. 1974); SEC v. Coffey, 493 F.2d 1304,
1316 (6th Cir. 1974), cert. dented, 420 U.S. 908, 95 S.Ct.
826, 42 L.Ed.2d 837 (1975). Accordingly, in my view, be-
fore ‘‘reckless disregard’? may be equated to scienter,
there must be a showing that the party charged with vio-
lation of Rule 10b-5 deliberately shut his eyes to the ob-
vious, such as material facts that would be patent upon a
mere cursory examination or review.’ Failure to conduct
an investigation—even if required by one’s status as a
fiduciary—will not suffice.
Judged by this standard, the facts as stated by the
majority fail to support a conclusion that Stott participated
in any fraud with the scienter required by Hochfelder.
As proof that Stott ‘‘rendered substantial assistance to
Yamada in [his fraud],’’ the majority relies upon Stott’s
processing of Yamada’s securities orders given pursuant
1. The cases cited by the majority do not warrant the recognition
of any more inclusive definition of scienter. See, e.g., Lanza v. Drexel
& Co., 479 F.2d 1277, 1306 & n. 98 (2d Cir. 1973) (en banc) (judg-
ment for defendant affirmed; no showing that he “willfully closed his
eyes to or turned his back” on the fraud; material failure to disclose
must be apparent “without any extraordinary effort.”) ; Sanders v.
John Nuveen & Co., 554 F.2d 799, 793 (7th Cir. 1977) (no finding
that “danger was either known to the defendant or so obvious that
the defendant must have been aware of it”).
A28
Appendia A
to his discretionary authorization from Rolf, Stott’s rep-
resentations to Rolf to the effect that Rolf could depend
on his adviser’s judgment, and Stott’s failure to disclose
Yamada’s fraud (i. e., the purchase of low-grade securi-
ties). However, the majority is vague as to how any of
this conduct can be said to have been undertaken with the
‘*reckless disregard’’ that must be treated as the equivalent
of knowledge of Yamada’s fraud. Apparently, the theory
of the majority opinion is that Stott’s continuing expres-
sions of confidence in Yamada and his willingness to ac-
cept the adviser’s orders were reckless in view of his
‘*fawareness]| that the quality of the securities being pur-
chased by Yamada was very low.’’ The opinion describes
Stott’s reassurances regarding Rolf’s reliability as having
been made ‘‘concluserily . . . without investigation and
with utter disregard for whether there was a basis for
the assertions.’’ Likewise, it states that Stott ‘‘either
recklessly failed to learn of or failed to disclose Yamada’s
web of fraud’’—again referring only to the purchase of
unsuitable securities. However, even conceding that Stott
believed some or many of Yamada’s purchases to be
‘*junk,’’ it would have required a considerable investiga-
tion for him to determine whether Yamada’s widely-
recognized reputation for brilliance was unwarranted or
whether the ratio of risk to return on Rolf’s portfolio as
a whole was consonant with the doctor’s investment ob-
jectives. .\ failure to perform such an investigation with-
out more does not, after Hochfelder, establish scienter.
Sympathetic as I am to vigorous enforcement of the
antifraud provisions of our federal securities laws, I can-
not subscribe to a process of extrapolation, approved by
RH as
A29
Appendix A
the majority opinion, whereby Yamada’s investment of
Rolf’s account in unsuitable securities is elevated to the
level of Rule 10b-5 fraud and Stott’s personal belief that
some of the investments were ‘‘junk’’ is recognized as a
sufficient basis for concluding that he acted with scienter.
Reasoning along these lines, the majority has ended up
with a holding that is virtually indistinguishable from that
reversed in /iochfelder. A broker (Stott) is held liable
under Rule 10b-5 for negligence in failing to make an
adequate inquiry into the investments recommended by
the plaintiff’s investment adviser (Yamada), who turned
out to be dishonest even though widely acclaimed as a
competent and successful investment adviser at the time.
In short, stripped of its conclusory characterizations, the
majority opinion would barely make out a case of negli-
gence on the part of Stott, much less one of his deliberately
shutting his eyes to facts that would have revealed the
‘*fraud’’ on Yamada’s part. When additional lower court
findings and undisputed evidence, unmentioned or glossed
over by the majority, are taken into account, the failure
te make out a case of *‘fraud’’ based on unsuitable invest-
ments or aiding and abetting of that fraud by recklessness
becomes apparent. In the first place, Dr. Rolf was no
novice or ‘‘babe in the woods’’ in the investment field.
He had had 19 years of experience, including 10 years
completely on his own, during which he was his own ad-
viser and the supervisor of various trading accounts main-
tained by him with several different Cleveland brokers.
Having tasted success in the predominantly bull market
of the 1950s and 1960s, Rolf had advised Stirling of
BEDCO as early as June, 1967, that his ‘‘objective [was]
A30
Appendia A
to d uble my equity’’ and told Yamada as late as Septem-
ber 970 (after the value of his portfolio had greatly
declined, principally because of investments made by
Yamada), ‘‘As you recall, we started out with roughly
$2,000,000 of Securities which could be used for trading.
... It was my impression that we would wind up with
3.5 to 5 million in a year’s time.’’
The picture that emerges from these and other state-
ments made by Rolf is one of a sophisticated investor in
securities who was well aware of the difference between
gilt-edge, relatively safe securities, on the one hand, and
speculative ‘‘high fliers,’’ on the ot!cv, and who had de-
termined to get richer quick by choosing an aggressive
program involving high-risk, OTC stocks in the hope that
his adviser would succeed in picking a few big winners,
but well aware of the pitfalls that were involved.*
From this record it is small wonder that when intro-
duced by Stott to a couple of prospective investment ad-
visers, whom he personally interviewed, he chose 26-year
old Yamada, ‘‘one of the ‘new breed’ of young money-
managers who had emerged as highly successful in the
stock market’’ during the late 1960s by dealing in special
situations, mutual funds, new issues, hedge funds and
assorted speculative ventures.* Rolf’s correspondence
discloses that he could hardly be classified as a naive, trust-
2. Judge Pierce found Rolf to be a “sophisticated” investor, will-
ing to take “substantial risks” and “to engage in extensive trading,”
who “wanted a very aggressive investment program” and “kept care-
ful watch over his securities,” verifying current market prices fre-
quently and employing a bookkeeper to follow his investments.
3. Rolf and Yamada both testified that from the outset of their
relationship it was agreed that in an effort to obtain a greater capital
gain on Rolf’s investments than he was presently able to realize
Yamada would be making changes in Rolf’s portfolio.
A3l
Appendix A
ing person of limited intelligence looking for safe invest-
ments designed to yield substantial income and security.
Rolf testified that he ‘‘wanted somebody other than Stott’’
to handle his account. In short, he wanted to gamble on
some ‘‘high fliers’? and for this he looked to Yamada, not
Stott. Indeed, Rolf never even met Stott in person until
October, 1970, some 17 months after Rolf had selected
Yamada as his investment adviser. By that time Rolf’s
portfolio had declined in market value from $1,423,000 to
approximately $223,000.
The tenuousness of holding Stott liable as an aider and
abettor is further underscored by the anomalous nature of
his responsibilities toward Rolf, once Rolf had chosen Ya-
mada rather than BEDCO to advise him as to his invest-
ments. The oral Rolf-Stott arrangement, according to
Judge Pierce’s findings, was that while Yamada alone
would have discretionary responsibility with respect to
what was to be bought and sold for Rolf’s account, Stott
would ‘‘supervise his [ Rolf’s] account and Rolf understood
that Stott was to look after his interests.’’ In such a con-
text the role of overseer, in the absence of some fixed
written delineation of authority and responsibility, borders
on the meaningless.’ It is an elementary market facet, which
4. The weakness inherent in attempting to predicate liability on
Stott’s telephonic agreement to “look after” Rolf’s account is under-
scored by Rolf’s maintenance of accounts with at least seven broker-
age concerns other than BEDCO, through which purchases and sales
were executed, some on Yamada’s advice, at a net loss of $133,229,
without the knowledge or participation of Stott or BEDCO. The
other concerns included Lynch, Jones & Ryan; Kordich, Victor &
Neufeld ; Woodcock, Moyer, Fricke & French; Provident Securities ;
Bearwald & DeBoer; Amswiss International; and Laird Incorpo-
rated. Although it seems that Stott often received notice of trans-
actions conducted through firms other than BEDCO, he was hardly
in a position to influence specific purchases or sales,
A382
Appendix A
should be judicially noticeable, that since there are literally
thousands of business ventures traded on various exchanges
in the United States, it is impossible for any one investment
adviser or brokerage concern to follow all traded business
ventures closely or to maintain suffiicent information with
respect to each and every one to furnish an informed expert
opinion with respect to its prospects as an investment. As
a result, each investment adviser and group of security
analysts on the staff of a broker or investment banking
concern usually limits itself to in-depth study of a fraction
of the entire gamut, maintaining a detailed analysis of each
company in the selected group, based on studies of every
available bit of information about it, including visits to and
conferences with its top personnel, customers and others.
Although an adviser or brokerage house may have expertise
with respect to companies within its selected group, it
would have much less knowledge, or even none, about
hundreds of other traded companies unless it undertook a
special study.
If Rolf had looked to Stott and BEDCO for investment
counsel, as he had to Stirling, Stott would undoubtedly
have learned more about Rolf’s investment objectives and
maintained for him a portfolio of securities with which
BEDCO’s experts were intimately familiar. As it was,
Stott was justified in relying upon Yamada’s expertise with
respect to the securities recommended by him, Although
Stott may have personally thought that some of the latter
were ‘‘junk”’ or ‘‘high fliers’? it must be remembered, first,
that Yamada then enjoyed an excellent reputation as a
sueeessful adviser. Onee a student at the Harvard Busi-
A33
Appendix A
ness School, he had risen rapidly to the position of officer
in the investment banking firm of Kuhn Loeb & Co., de-
scribed by Judge Pierce ‘‘as a conservative and prestigious
firm which generally handled ‘triple-A’ clients,’’ where
Yamada developed ‘‘expertise in research and ‘special sit-
uations’.’’ Yamada had then left Kuhn Loeb to form a
partnership with others, including Keither [sic] Funston,
former President of the New York Stack Exchange, John
Burns, former President of RCA and Chairman of the
Board of Cities Service, and J. Richardson Dilworth, head
of the Rockefeller Brothers Fund. Yamada was well known
in the securities field, managed approximately $20 million
for customers and was in daily consultation with numerous
securities firms. Rolf himself, an experienced trader on his
own behalf, after personally interviewing Yamada was fa-
vorably impressed by him as ‘‘very brilliant and capable.”’
In short, although Rolf later testified, after Yamada’s
advice had proved disastrous, that he had ‘‘expected
BEDCO to look after his account,’’ (emphasis added), Rolf
never put this in writing or defined precisely what was to
be BEDCO’s area of responsibility other than to keep him
advised as to what securiues were being purchased and
sold for the account. On the contrary, by letter dated May
9, 1969, to BEDCO Rolf directed, ‘‘You will kindly follow
his [Yamada’s] instructions in every respect concerning
my account with you...as he may order and direct.’’ Rolf
had what amounted to a custody account with BEDCO.
When it came to investment decisions, although Stott
(whom Rolf had never met and hardly knew) made recom-
A34
Appendix A
mendations to Yamada, it was clear that Yamada was in
command.°
Against such a background, I fail to find any substantial
basis for holding that Stott’s assurances to Rolf, made long
prior to the time when Yamada’s fraud and manipulations
became known, regarding Yamada’s competence and Stott’s
expressions of opinion to the effect that if Yamada recom-
mended certain investments they must be all right, consti-
tuted aiding and abetting of any fraud on Yamada’s part.®
Although Stott might have personally considered some of
the investments made by Yamada to be unproved and hence
‘*junk,’’ it would have been foolhardy for him to voice such
a view to Rolf, since Yamada, who was in command and had
gained his reputation in part from his successful dealing in
special situations, might well be possessed of detailed infor-
mation not available to or obtained by BEDCO or Stott.
5. Rolf also appears to have made some investment decisions that
may not have been shared even by Yamada, much less by Stott. For
instance, in June 1969, Rolf operated a non-discretionary account with
en & Weeks-Hemphill & Noyes, through which he pur-
chased
American Scientific Corp.
Dasa Corp.
Data Network Mega Systems, Inc.
Ampex Corp.
Mohawk Data Science.
6. Moreover, the generality of Stott’s conclusory assurances—
“that Yamada knew what he was doing and that if Yamada were
purchasing stocks they must be satisfactory’—must have made it
readily apparent to Rolf from the outset that Stott was relying on
Yamada's excellent reputation rather than on an investigation into
the merits of each investment, conducted personally or through
BEDCO's staff of analysts. Otherwise, he would have reported to
Rolf on the results of his independent research. Yet Rolf never re-
quested or received any such check-up, even though he was well
aware from past experience of BEDCO’s facilities.
ee
A35
Appendix A
Absent evidence to the contrary, we cannot assume that
Stott’s views were based on independent research, as dis-
tinguished from hunch. Some of the greatest gains and
widest movements in traded securities have occurred in
OTC stocks, of which astute advisers have taken advantage
because of intensive private investigation revealing busi-
ness prospects or probable takeovers not generally known.
In this case, for instance, as Judge Pierce noted, ‘‘ Yamada
made fairly substantial profits for Polf on short-term trad-
ing in six of the seven manipulated stocks’’ which he bought
for Rolf in 1970. 424 F.Supp. at 1034.
An analysis of the securities issues purchased by Ya-
mada for Rolf reveals that many of the investments, al-
though they declined in market value when the bloom faded
on the bull market, were concededly not unsuitable, that
others were listed on major stock exchanges, and that some
‘‘ynsuitable’’ issues turned out to be profitable. Of the
40-odd security issues purchased for Rolf’s account which
form the basis of his claim, the district court found that
Stott had ‘‘either recommended or was somewhat involved
with the decision to purchase the following twelve.’**? There
7. The 12 were:
Simplex Wire & Cable Co.
Teradyne, Inc.
Standard Oil of N. J.
Reading & Bates Offshore
Intertherm, Inc.
Food Fair Properties
International Funeral
Natomas Corp.
Asamera Oil Corp.
Carter Wallace, Inc.
West Coast Production
Equity Funding Corp.
A36
Appendix A
is no evidence that any of these 12 were unsuitable for
Rolf’s account. Nor was there any testimony as to the
suitability of certain other securities bought for Rolf.’
Under these undisputed circumstances, including Ya-
mada’s investment of a substantial portion of Rolf’s ac-
count in apparently suitable securities, I cannot share the
majority’s conclusion that investment of the balance in
securities labelled unsuitable by an expert witness amounts
to fraud, much less that Stott’s conduct aided and abetted
such ‘‘fraud.’’ I favor holding a broker to his duties
under Rule 405, for violation of which remedies are pro-
vided by the New York Stock Exchange, N.Y.S.E. Constitu-
tion Art. VITI, Rules 481, ef seq. (providing for arbitration
of disputes between member firms and others) and §§6, 13
(authorizing suspension, expulsion, fines and censure), and
an investment adviser for fraud in violation of the Invest-
ment Advisors Act, see Abrahamson v. Fleschner, 568 F.2d
862 (2d Cir. 1977). But to hold that investment of a cus-
tomer’s account in unsuitable securities constitutes §10(b)
fraud and that a broker who executes orders given by an
investment adviser pursuant to his discretionary authority
may be held liable as an aider and abettor of such fraud,
places an extraordinary and unconscionable burden on both
the adviser and the broker.
8. These include:
Benquet Consolidated
City Investing
Consolidated Oil & Gas
Funeral Homes of America
Loews Theatres
Outlet Co.
Four Seasons Nursing Centers of America
U.S. Natural Resources
Milgo Electronic Corp.
Appendia A
Nor do I agree with the distriet court’s view that an
implied right of action for damages in favor of Rolf may be
based on Stott’s alleged violations of N.Y.S.E. Rule 405°
er Article III, 62, of the Rules of Fair Practice of the
National Association of Securities Dealers.’ Accepting
the premise that ‘‘the court must look to the nature of the
particular rule and its place in the regulatory scheme, with
the party urging the implication of a federal liability earry-
ing a considerably heavier burden of persuasion than when
the violation is of the statute or an SEC regulation,’’
Colonial Realty Corp. v. Bache & Co., 358 F.2d 178, 182
(2d Cir.), cert. dented. 385 U.S. 817, 87 S.Ct. 40, 17 L.Ed.2d
56 (1966), we must also follow the guidelines established
by the Supreme Court in Cort v. Ash, 422 U.S. 66, 78, 95
S.Ct. 2080, 45 L.Fid.2d 26 (1975), which require us to deter-
mine (1) whether the plaintiff is a member of the class for
whose especial benefit the law was intended; (2) whether
9. Rule 405 provides in pertinent part:
“Every member organization is required through a general part-
ner, a principal executive officer or a person or persons desig-
nated under the provisions of Rule 342(b)(1) to “(1) Use due
diligence to learn the essential facts relative to every customer,
every order, every cash or margin account accepted or carried
by such organization and every person holding power of attorney
over any account accepted or carried by such organization.
jand to]
“(2) Supervise diligently all accounts handled by registered rep-
resentatives of the organization.”
10. Article III, $2, provides:
“In recommending to a customer the purchase, sale or exchange
of any security, a member shall have reasonable grounds for
believing that the recommendation is suitable for such customer
upon the basis of the facts, if any, disclosed by such customer as
to his other security holdings and as to his financial situation
and needs.”
A388
Appendix A
Congress expressed any preference for or against a rem-
edy ; (3) whether a private action would be consistent with
the underlying purposes of the legislative scheme; and (4)
whether the cause of action is one in an area traditionally
relegated to state law.
Applying these guidelines, it is not at all clear that Rule
405 or Art. ITI, 62, were intended solely for the particular
benefit of investors. Indeed, they appear designed as much
to protect brokers from being victimized by unserupulous
customers. See Landy vy. FDIC, 486 F.2d 139, 166 (38d Cir.
1973), cert. denied, 416 U.S. 960, 94 S.Ct. 1979, 40 L.Ed.zd
312 (1974). To imply a damages remedy based on non-
feasance or gross negligence weuld, noreover, run counter
to the principles of Hochfelder and possibly inhibit the
NYSE and NASD from promulgating additional standards
for the guidance of their members. In short, NYSE and
NASD rules are not the same for the purpose of implied
remedies as SEC rules. See Jenny v. Shearson, Hammill &
Co., [1974-75 Transfer Binder] Fed.L.See.Rep. (CCH)
95,021, at 97,582 (S.D.N.Y.1975); Plunkett v. Dominick &
Dominick, 414 F.Supp. 885 (D.Conn.1976). Lastly, what-
ever obligation might be imposed by rule on a broker deal-
ing solely with his customer, the interposition of an invest-
ment adviser with the sole discretionary authority to de-
termine what investments shall be made for the customer
weighs against extending any liability of the broker that
might othe: wise be implied on the basis of a direct broker-
customer relationship.
For these reasons, I would reverse the judgment of the
district court and remand with directions to enter judgment
in favor of the defendants dismissing the action.
A39
APPENDIX B
Order Amending Opinion of the United States
Court of Appeals for the Second Circuit
UNITED STATES COURT OF APPEALS
For THE SEcoND Crrevit
Docket Nos. 77-7104, 77-7124
salen gn lintalitibitesbittanechcitims het
Davi K. Rotr,
Plaintiff-A ppellant-Cross-A ppellee,
v.
Buytu, Easrman Ditton & Co., Ixe.
and Micnagn. Srorv,
Defendants-A ppellecs-Cross-A ppellants.
aaa
The opinion in the above entitled case is hereby amended
by inserting Footnote 16A at the end of the first paragraph
on slip opinion 905, after the word ‘‘fraud,’’ said footnote
reading as follows:
16A. This decision does not impose liability on a
broker-dealer who merely executes orders for ‘‘un-
suitable’’ securities made by an investment advisor
vested with sole discretionary authority to control
the account. In the present case, the broker-dealer,
although charged with supervisory authority over the
A40
Appendia B
advisor and aware that the advisor was purchasing
‘*junk,’’ actively lulled the investor by expressing con-
fidence in the advisor without bothering to investigate
whether these assurances were well-founded.
/s/ J. Josepu Situ
/s/ James L. Oakes
U.S. Cireuit Judges
| SEAL]
United States Court of Appeals
FILED
MAY 22 1978
A. DANIEL Fusaro, Clerk
SECOND CIRCUIT
A41
APPENDIX C
Opinion and Order of the United States District
Court for the Southern District of New York
UNITED STATES DISTRICT COURT
S. D. New Yorx«
No. 73 Civ. 2967
—EEEeEw eee
Davw K. Rots,
Plaintiff,
Vv.
Buiytu Eastman Ditton & Co., Inc., et al.,
: Defendants.
or
Jan. 17, 1977
Sidney B. Silverman, Silverman & Harnes, New York
City, for Plaintiff.
Thomas W. Kelly, Richard W. Lyon, Breed, Abbott &
Morgan, New York City, for defendants Blyth
Eastman Dillon Co. and Michael Stott.
Barry A. Tessler, New York City, for defendant Aki-
yoshi Yamada.
Pierce, District Judge.
This securities action brought by plaintiff David E.
Rolf presents important questions concerning the duties
and responsibilities of a broker dealer and its registered
representative under circumstances in which their customer
is being defrauded by his investment adviser. Unlike the
si } .
A42
Appendix C
usual case brought under the federal securities laws, here
it is clear that fraud and breach of fiduciary duty are pres-
ent. The key questions in this case are whether the broker
aided or participated in the fraud, and whether the broker
and his employer took adequate steps to protect their
customer against the investment adviser who traded plain-
tiff’s account pursuant to a power of attorney.
The matter was tried before the Court without a jury
for nine days in June and July 1976. The allegations of
the complaint are as follows.
Plaintiff David Rolf’s complaint seeks to hold defend-
ants liable in damages for alleged violations of Section
10(b) of the Securities Exchange Act of 1934, and Rule
10b-5 promulgated thereunder, which prohibits securities
fraud by any person through the instrumentalities of inter-
state commerce or of any facility of any national securities
exchange. Also claimed are violations of Section 15(c) (1)
of the Exchange Act, and Rule 15cl-2, which similarly pro-
hibit securities fraud by broker dealers in the over-the-
counter markets. Plaintiff also alleges violations of Sec-
tion 15A of the Exchange Act, dealing with registration
and regulation of broker dealer associations, and of Article
III, Section 2 of the Rules of Fair Practice adopted by the
National Association of Securities Dealers, Inc. (‘‘NASD’’)
promulgated thereunder, the latter requiring suitability of
securities recommended by brokers for investors. Finally,
plaintiff asserts violations of Rule 405(1) and (2) of the
New York Stock Exchange (‘‘NYSE’’), which require due
diligence and diligent supervision in the managem>nt of
securities accounts handled by registered representatives.
A438
Appendix C
This Court has jurisdiction over this action brought
to enforce liabilities and duties created under the Exchange
Act and by the rules and regulations promulgated there-
under pursuant to 15 U.S.C. §78aa.
In brief, plaintiff claims that the defendants churned
his account, that they severely altered the nature of his
securities portfolio by placing unsuitable securities therein,
that they failed to properly supervise his account, and that
they aided and abetted each other in these alleged viola-
tions. In sum, plaintiff claims that the defendants took
an account worth $1,423,000 in May of 1969 and returned
to him in January of 1971 an account worth only $225,000
as a result of their fraud. For damages, plaintiff seeks,
inter alia, a return of commissions and interest; an award
equal to the net trading losses claimed; and, although the
complaint states no cause of action under state law, puni-
tive damages of one million dollars.
At the trial of this action, plaintiff abandoned all claims
made against his investment adviser, defendant Akiyoshi
Yamada, in exchange for Yamada’s testimony against the
remaining defendants (see PX-19). Defendants Blyth
Eastman Dillon & Co. (‘“‘BEDCO’’) and its registered
representative Michael Stott assert that they are not liable
because plaintiff has not proved his claims, because
Yamada and not the other defendants controlled plaintiff’s
‘account, and because they breached no duty owed to the
plaintiff. In their answer defendants BEDCO and Stott
assert cross-claims against Yamada for indemnity.
Having heard all the evidence and having considered
the matter, the Court dismisses plaintiff’s churning claim,
A44
Appendix C
but finds defendants BEDCO and Stott liable for violations
of the NYSE and NASD rules, which violations involved
breach of defendants’ fiduciary duties tantamount to fraud.
The Court also finds defendant Stott liable for aiding and
abetting Yamada in the fraud which the investment adviser
perpetrated upon plaintiff in violation of Rule 10b-5 and
through breach of his own fiduciary duties. The following
shall constitute the Court’s findings of fact and conclusions
of law pursuant to Rule 52(a) Fed.R.Civ.P.
The Parties
Plaintiff David E. Rolf is a physician, surgeon and
ophthalmologist, residing in Shaker Heights, Ohio. Dr.
Rolf has practiced medicine since 1936, and at the time of
trial he was sixty-eight years old. Rolf began investing
his earnings in the stock market in 1950, and by 1962 his
portfolio was worth approximately $400,000. Plaintiff tes-
tified that he works long hours at the hospital, and that he
is on twenty-four hour call. During the period 1950
through 1962, plaintiff retained several different Cleveland
brokers, switching firms often because he felt that the
brokers were not sufficiently knowledgeable and that they
did not have his interests at heart. During this period
plaintiff maintained non-discretionary accounts, making bis
own decisions with respect to transactions in securities.
Rolf was an active follower of the stock market, primarily
through the Wall Street Journal. Prior to his first contact
with BEDCO in 1963, plaintiff had maintained accounts
at Merrill Lynch, Pierce, Fenner & Smith, Inc., Paine
Webber & Co., Hartzmark & Co., Prescott & Co., Bache &
Co., and finally, at Walston & Co. where Rolf first engaged
an investment adviser with discretionary authority over
A45
Appendix C
his securities. Rolf stated that during this period his in-
vestment objective was capital growth first and security
second. Plaintiff testified that he switched to discretionary
accounts in 1962 because he was too busy with medicine
to be in constant consultation with brokers, and because
he felt his portfolio was too large for him to handle.
In 1963, plaintiff took his securities to Kastman Dillon
Union Securities & Co., and entrusted their management
to S. Logan Stirling, a partner and a prominent invest-
ment adviser associated with that firm and with defendant
BEDCO, the successor corporation to Eastman Dillon
Union Securities & Co. BEDCO was at all relevant times
a registered broker dealer and a member of the New York
Stock Exchange and the National Association of Securities
Dealers. During the relevant period, BEDCO engaged in
corporate and municipal underwritings, maintained a large
research department, and employed a substantial retail
sales force. BEDCO dealt in listed and over-the-counter
securities for individual clients and as a market-maker
(Tr. 1005).
While Dr. Rolf did not come into contact with BEDCO’s
Michael Stott until 1969, Stott had been a registe ed repre-
sentative with that firm since 1958, and in 1963 Stott was
branch manager of BEDCO’s Paterson, New Jersey, office.
Later Stott became branch manager of BEDCO’s Newark
office; at each branch office one of his primary respon-
sibilities was supervision of the registered representatives
(Tr. 757). In the fall of 1967 Stott returned to BEDCO’s
New York office as a registered representative. By 1969,
Stott was handling approximately 150 individual and in-
stitutional accounts at BEDCO, earning one-third of all
eee ae
A46
Appendix C
commissions on the securities he traded (Tr. 914-15). That
year Stott first met a young and ambitious investment
adviser Akiyoshi Yamada.
Yamada, the son of a wealthy Japanese industrialist,
had attended Harvard Business School for one year prior
to 1965 when he joined the investment banking firm of
Kuhn Loeb & Co. (Tr. 557). Yamada described Kuhn
Loeb as a conservative and prestigious firm which gen-
erally handled ‘‘triple-A’’ clients (Tr. 509). At Kuhn
Loeb, Yamada eventually became an officer of the firm
purportedly with expertise in research and ‘‘special situ-
ations’’. In 1969, at the age of 26, Yamada left Kuhn Loeb
to form an investment partnership; during the period of
the complaint he was not associated with any research
firm or brokerage house (Tr. 558).
Yamada was described at trial by John P. Cione,
BEDCO’s chief compliance officer, as one of a ‘‘new breed”’
of young money-managers who emerged as highly success-
ful in the stock market during 1969 and 1970. Yamada
was committed to ‘‘special situations’? and was one of a
number of young advisers who were making mutual funds,
hedge funds, and assorted speculative ventures very profit-
able (Tr. 1111). During the period of the complaint
Yamada was handling six sizeable portfolios, three insti-
tutional and three individual, of which Dr. Rolf’s was the
largest individual account. Yamada traded plaintiff’s
stocks on a discretionary basis from April 1969 through
January 1971 (Tr. 1041-42).
In 1972, defendant Yamada was enjoined by the Secu’ -
ties and Exchange Commission from engaging in fraudu-
lent and manipulative practices in connection with the
i
A47
Appendix C
purchase and sale of securities. On December 21, 1972, at
the age of thirty, Yamada pleaded guilty before Judge
Irving Ben Cooper of this Court to a criminal conspiracy
to violate the federal securities laws as set forth in Count
One of Indictment 72 Cr. 363, in connection with the sale
of Lady Goldie Bracelet Co. securities. On May 18, 1973,
Yamada plended guilty to two further violations of 18
U.S.C. §371 set forth in criminal informations 73 Cr. 426
and 73 Cr. 427, in connection with a securities fraud in-
volving Microthermal Applications, Inc., and a manipula-
tion of Health Evaluation Systems, Inc., the stock of the
latter being one involved in this action. On June 26, 1973,
Judge Cooper sentenced Yamada to two years in prison,
five years on probation, and fined him $30,000. Thereafter,
on April 15, 1974, Yamada pleaded guilty to submitting
false statements to Judge Cooper in support of a motion
to reduce or suspend his sentence, in violation of 18 U.S.C.
§1001. For this crime, Judge Morris Lasker of this Court
sentenced Yamada to one year, later reduced to six months,
consecutive to the previously imposed period of imprison-
ment. (See DX-VV). Yamada admitted each of these
convictions at trial, and further admitted that he had
perjured himself before the Securities and Exchange Com-
mission (Tr. 695).
The foregoing discussion raises questions regarding Ya-
mada’s credibility as a witness in this action. However,
the Court finds that on many points Yamada’s testimony is
supported by that of Rolf or by documentary evidence.
Further, the Court finds that it cannot credit the whole of
the testimony of either of the other two principal witnesses,
Dr. Rolf and Michael Stott.
A48
Appendia C
Plaintiff’s Investment Intent
Dr. Rolf’s claim that he was an unsophisticated investor
is undereut both by the events leading up to and those
during the period of the complaint. First, as noted, plain-
tiff in earlier years had engaged a series of brokerage firms
ona non-discretionary basis. Further, plaintiff makes no
complaint concerning the securities bought for his account
by S. Logan Stirling of BEDCO from 1963 through March
1969, and there is substantial evidence that certain of those
stocks were aggressive investments.
The best evidence of Rolf’s investment intent during the
Stirling period is contained in a letter from the plaintiff
to Stirling dated June 14, 1967:
‘“My objective is to double my equity. It will be inter-
esting to see how long it takes.”’ (DX-C)
Plaintiff testified that during the Stirling period, he
would have been happy with an annual growth rate of ten
percent, but that he would have been dissatisfied with any-
thing less (Tr. 315).
There is substantial evidence that Dr. Rolf kept careful
watch over his securities, During the period of the eom-
plaint, plaintiff checked the published prices of his seecu-
rities three or four times per week (DX-III). He also
employed a bookkeeper to keep track of his holdings and
their value, both during the Stirling period and during the
period of the complaint (Tr. 307: PX-24),
Further, although Rolf gave Stirling complete disere-
tionary authority over his account (DX-P), the doctor tele-
phoned Stirling’s office as many as six times per week (‘T'r,
741). Rolf testified that he was fully satisfied with Stirling’s
ee
A49
Appendix C
handling of his BEDCO account, and pleased by the fact
that the size of the portfolio more than doubled in the six
years between 1963 and 1969.
In mid-March 1969, S. Logan Stirling took ill and left
BEDCO, having suffered a brain tumor which proved
fatal. Plaintiff claims, but the evidence does not support
the conclusion, that Stirling was incapacitated as early
as late 1968. However, the Court does conclude that
from March through early May 1969, Rolf’s million-
dollar account went unattended by anyone at BEDCO.
BEDCO’s compliance officer admitted not only that the
account was ‘‘dormant’’ during the period between’ Stir-
ling’s illness and Rolf’s selection of Yamada, but further
that during April 1969 some unidentified person at BEDCO
sold one thousand shares of Talcott National Corp., pur-
chased one thousand shares of Asamera Oil Corp., and sold
one thousand shares of Occidental Petroleum Corp. (Tr.
1069-71; see DX-UU). This apparent indifference to plain-
tiff’s investment needs at BEDCO is further illustrated by
the manner in which Akiyoshi Yamada came to be selected
as Rolf’s investment adviser.
Michael Stott testified that following Stirling’s depar-
ture from BEDCO, Mr. Schlesinger, a BEDCO partner,
assigned the Rolf account to him. In late April 1969, Stott
telephoned Rolf and offered to handle his account. Rolf
stated that he wanted an investment adviser, and that Stott,
while a capable and experienced broker, was just not an
analyst with sufficient expertise to direct his investments.
However, Rolf was willing to keep the account at BEDCO,
and he asked Stott to recommend an investment adviser,
OE RT ne ee
A50
Appendix C
Stott testified flatly that he never knew what Rolf’s
investment objectives weve (Tr. 881-82), and further, that
he did not even look at the stocks in plaintiff’s portfolio
prior to their first contact (Tr. 941-48), Accordingly, the
Court concludes that Stott recommended two advisers, Aki-
yoshi Yamada and Donald Geddes, knowing nothing about
the plaintiff beyond the fact that Rolf’s account had been
handled by Mr. Stirling.
While Stott’s trial testimony on the point is somewhat
inconsistent with his deposition (see Tr. 888-89), it appears
that Stott did little more than give plaintiff two names and
two telephone numbers.
Dr. Rolf testified that Stott told him Geddes had eXx-
perience with large accounts; however, according to the
plaintiff, Yamada wa: more fully described. Stott told
Rolf that Yamada had a Harvard Business School back-
ground, that he was from an illustrious and wealthy Jap-
anese family and that he was a brilliant analyst. Rolf
travelled to New York shortly thereafter to interview the
two.
Rolf and Yamada met in a New York restaurant to dis-
cuss plaintiff’s investments. Rolf thought Yamada both
brilliant and capable, but was somewhat wary of Yamada’s
youth (Tr. 31). When Rolf spoke of an interest in pre-
serving his equity, Yamada assured him that none of his
clients had ever lost a penny (Tr. 30).
Yamada’s testimony concerning Rolf’s objectives is con-
sistent with the rest of the evidence in the case. While
Yamada stated that Rolf was unsophisticated and ** grop-
ing’’ for guidance, it was clear to Yamada that Rolf wanted
A51
Appendix C
a very aggressive investment program, and that he was
willing to engage in extensive trading in order to ‘‘double
his equity’? (Tr. 511, 514; PX-3),
Yamada’s testimony to the effect that Rolf was inter-
ested in special situations, new issues, and aggressive trad-
ing is confirmed by a letter written by Rolf to Yamada much
later. In that letter dated September 2, 1970, Rolf referred
to his original investment intent as follows:
‘*As you recall, we started out with roughly $2,000,000.
of Securities which could be used for trading. ... It
was my impression that we would wind up with 3.5 to 5
million in a years time.”? (PX-3)
In brief, Dr. Rolf decided that Yamada would be an
appropriate investment adviser, and although he also inter-
viewed Geddes, plaintiff settled on Yamada.
Rolf and Yamada agreed that Yamada would receive
compensation equal to ten percent of plaintiff’s capital
gains. Rolf requested that trading be done through BED-
CO and Stott, if at all possible. Rolf testified repeatedly,
and the Court credits the statements, that Rolf sought to
balance Yamada’s youth and zeal with BEDCO and Stott’s
reliability and supervision. Indeed, in the plaintiff’s mind,
by the combination of Stott and Yamada, he was obtaining
a “‘Stirling-type’’ operation (Tr. 35). Rolf told Stott that
he expected BEDCO to look after his account, and that he
didn’t intend to keep his commission business at BEDCO
without receiving something in return (Tr. 34). On May 9,
1969, Rolf executed a trading authorization granting to Ya-
mada full discretionary authority over his BEDCO ac-
count:
|
A52
Appendix C
‘*Messrs. Eastman Dillon,
Union Securities & Co.
‘*Gentlemen:
‘“‘T hereby authorize Axr Yamapa to buy, sell, in-
cluding short sales, and trade in, for my account and
risk and in my name, stocks, bonds and any other
securities .... You will kindly follow his instructions
in every respect concerning my account with you...
as he may order and direct. In all matters and in all
things aforementioned he is authorized to act for me
and in my behalf in the same manner and with the same
force and effect as J might or could do... .”? (DX-B)
The Stocks
It is clear from the evidence that in May 1969, Rolf
expected Yamada to take substantial risks for capital gains,
but at the same time to preserve the million dollar portfolio
which Rolf had built up over the years through his own
earnings and efforts and through the efforts of prior brok-
ers. Indeed, since Rolf had no pension or retirement plan,
his stocks represented his main security for his later years
(Tr. 19).
It is also clear that Rolf expected BEDCO to supervise
his account and Rolf understood that Stott was to look
after his interests. As Rolf testified, he made this clear
to Stott at the outset:
‘*T said, ‘Mike, I can take this account any place. I am
going to leave this account here,’ but I said, ‘Look, I
want you to watch this. After all, you are going to
be compensated for this, you are going to get all the
commission business, and when T am back in Cleveland
and busy, you keep your eye on things,’ ”’ (Tr. 34)
A53
Appendia C
Contrary to his expectations, Rolf received from Ya-
mada only the substantial risks and he received no super-
vision by BEDCO. The explanation lies in how Stott and
Yamada saw their respective roles and in the very effective
methods they used to shuffle Rolf between the two of them.
On May 9, 1969, the date when Rolf gave Yamada the
trading anthorization, Rolf’s margin account contained
twenty-three issues, all but one of which had been pur-
chased by Stirling:
Loew’s Theatres Wis.
Leasco Data Processing Wts.
Anaconda (Co.
Asamera Oil Corp.
Avnet Ine.
Buttes Gas & Oil Co.
CNA Financial Corp,
Cities Service Co.
Ebasco Industries Ine.
Glen Alden Corp.
INA Corp.
International Industries Ine.
General Electric Co.
Leesona Corp.
Levin Townsend Computer Corp.
Loew’s Theatres Inc.
National General Corp.
Occidental Petroleum Corp.
Penn Central (Co.
Pittson Co.
Raytheon Corp.
Scientific Resources Corp.
Teledyne Ine.
(DX-UU at 2)
A54
Appendia C
With the exception of the two warrants, each of the
above securities were listed on the American or the New
York Stock Exchange. Eighteen were issued by companies
that had enjoyed continuous profits for five years or longer.
Sixteen paid cash dividends. Yamada characterized six
of the issues as ‘‘blue chip’’ and plaintiff’s expert witness
made similar observations. Yamada described the war-
rants as ‘‘aggressive’’ investments and two of the stocks
as ‘‘racy’’. As of May 9, 1969, after reducing the value
of the portfolio by the debit balance, plaintiff’s margin
account was worth $1,423,000 net.
Both Yamada and Rolf testified that they agreed in
April 1969 to make certain changes in the account. Yamada
was of the opinion that many of the stoeks involved had
seen their day, and that it was time to move on to newer
and more profitable investments. However, Yamada stated
that Rolf did not agree to liquidate the account; that de-
cision was made by the adviser alone. Between May 1969
and January 1970, Yamada sold all 23 issues, 14 at a loss.
Plaintiff made no complaint.
The evidence in this case most fraught with hazards
concerning credibility is the testimony of Stott and Yamada
regarding their relations with each other. However, it
is clear that the two were in contact by telephone several
times daily." Further, Stott continually conveyed to
Yamada the recommendations of BEDCO’s research de-
partment with respect to certain issues, and many of those
stocks were subsequently purchased for Rolf’s account.
1. Stott testified in his deposition that he spoke to Yamada only
twenty or thirty times during the entire one and one-half year period.
However, at trial Stott admitted that he was in daily contact with
Yamada (Tr. 775, 817).
A55
Appendix C
While Yamada and Stott met socially only on occasion,
it is clear that their business interests were intertwined.
Yamada stated that he relied upon Stott for reeommenda-
tions with respect to oil and gas stocks; Stott’s testimony
on this point is equivocal... There is no dispute that Stott
had family connections with the management of two oil
companies whose issues were purchased for Rolf, Standard
Oil of New Jersey and West Coast Production.
Stott testified that he handled a total of six accounts
referred to him by Yamada, but he stated that these ac-
counts produced only a small proportion of his commission
income (Tr. 794-95). Of the forty-one issues purchased
for Rolf by Yamada and Stott during the complaint period,
thirty-five were at some point traded through BEDCO
(PX-24). Yamada testified that Stott recommended a
total of twelve of the issues involved (Tr. 518-530) ; Stott
admitted to recommending six of these.
With respect to the stocks which he did admit he recom-
mended to Yamada, Stott testified that he did not spe-
cifically recommend the stocks for Rolf. Rather, Stott
maintained that he simply gave Yamada the results of
BEDCO’s research, and that the recommendations were in
actuality for Yamada’s more speculative ventures, such as
Takara Partners and the hedge funds (Tr. 780-81). The
Court does not find this attempted distinction credible,
particularly in light of the fact that Stott himself continu-
ally executed purchases and sales in these very stocks for
Rolf’s account; in these circumstances, there can be little
2. When asked if oil stocks were one of his specialties, Stott
answered “not really” (Tr. 965). Stott did admit that Yamada
bought Rolf oil stocks “partially” on his advice (Tr. 965).
A56
Appendix C
doubt that Stott realized that Yamada was, at least in part,
relying on the recommendations made by Stott and by
BEDCO research in determining what to buy for the plain-
tiff; indeed, Stott admitted as much (Tr. 965).
Moreover, BEDCO’s cross-index of all securities traded
by Stott reveals that as to seven, not six, of the issues,
Stott was at the time in question recommending and buying
the stocks for his non-diseretionary accounts of other cus-
tomers (see PX-25). With regard to three more of the
stocks listed by Yamada, the cross-index shows that Stott
bought the issues for other investment advisers as well as
for Yamada. Finally, as to one issue which Yamada
claimed Stott was recommending, defendants report that
there is no record in the cross-index as to whether or not
Stott bought this issue for others (see PX-25). While
PX-25, standing alone, doe not establish that Stott ree-
ommended each of the twelve issues for Rolf, the docu-
ment does serve to credit the testimony of Yamada to the
effect that Stott was involved with the decision to purchase
the issues.* Accordingly, in light of all of the findings
hereinabove, and weighing all the evidence on the question,
including the Court’s observation of the demeanor of the
witnesses, the Court concludes that Stott either recom-
mended or was somehow involved with the decision to pur-
chase the following twelve securities for plaintiff:
Simplex Wire & Cable Co.
Teradyne, Ine.
Standard Oil, N. J.
Reading & Bates Offshore
3. The Court notes that Yamada’s testimony as to the twelve
issues allegedly recommended by Stott was given before defendants
produced the documents constituting the cross-index, PX 25.
A57
Appendix C
Intertherm, Inc.
Food Fair Properties
International Funeral
Natomas Corp.
Asamera Oil Corp.
Carter Wallace, Ine.
West Coast Production
Equity Funding Corp.
(PX-25; Tr. 518-530)
Accordingly, contrary to his testimony at trial, the
Court finds that Stott was indeed involved with the man-
agement of the Rolf account, particularly during the first
eight months of the complaint period. '
One internal regulation at BEDCO prevented the trad-
ing of certain stocks through the firm. According to
BEDCO’s compliance officer, BEDCO would not solicit
stocks which were selling at less than $5.00 per share (Tr.
978-79). For this reason, as well as for reasons of his
own, between May 1969 and March 1971, Yamada opened
no less than eight other accounts in plaintiff’s name at
eight different brokerage firms. Plaintiff stated that he
was almost completely ignorant as to why all these other
accounts were being opened. Upon inquiry, he learned
that in some cases, Yamada had opened the accounts to
give other broker associates some business; in other cases,
Yamada opened the accounts to buy stocks from the firms
that were engaged in underwriting new issues which
BEDCO would not handle.
Despite these new accounts and the purchase and sale
of stocks through those houses, Dr. Rolf was under the
impression that BEDCO was looking after his portfolio
A58
Appendix C
as a whole. Indeed, the BEDCO account was a custody
account, and in the great majority of cases where stocks
were bought elsewhere by Yamada, Stott nevertheless re-
ceived confirmation slips and the securities were delivered
into BEDCO. Even though BEDCO received no commis-
sions on these outside purchases, in a few cases the stocks
were subsequently sold through BEDCO, producing com-
missions for Stott and his employer. According to Dr.
Rolf, Stott assured him that BEDCO could still oversee
the account since the stocks were often delivered in, and
since confirmation slips were sent to Stott.
As Yamada’s liquidation program quickly resulted in
a wealth of new issues, many of which were over-the-counter
stocks, Dr. Rolf was apparently both excited by the chal-
lenge of speculation and concerned over the strange names
of the new issues. Beginning in July 1969, Rolf began
calling Stott for assurance and for information about the
new stocks. Stott testified that Rolf called him six or seven
times per month from July 1969 through May 1970. There-
after, Stott or his secretary called Rolf every day to give
him quotations on the over-the-counter prices. There is no
evidence that Rolf and Yamada were in such frequent
contact.
The testimony is consistent that Rolf called Stott to
complain about the amount of trading and the nature of
the stocks in the account. Stott stated that he simply told
Rolf to speak to Yamada. However, plaintiff’s version of
the calls, which is supported by certain documentary evi-
dence and by the testimony of Yamada, is that Stott con-
tinually assured Rolf with respect to Yamada’s competence
and ability, and that Stott repeatedly stated that if Yamada
A59
Appendix C
had decided to buy a stock, then Stott was sure that it was
okay. Yamada referred to this arrangement as a procedure
whereby if Rolf called him to complain, Yamada would call
up Stott and tell Stott to speak to Rolf and ‘‘hold his
hand.’’ (Tr. 545). The Court finds that this was exactly
what occurred.
Rolf believed that Stott was intimately involved with
the management of the account. Indeed, since Stott and
Yamada were in daily contact discussing securities which
ended up in the plaintiff’s account, Rolf’s was a reasonable
belief. It was moreover a correct belief; Stott was involved
with the management of the account.
The period between May 1969 and January 1970 was
characterized by the sale of the listed stocks and the pur-
chase of very different issues. While there was some short-
swing trading in U. S. Natural Resources between May 22
and 26, 1969 (DX-UU at 3), and while there was one short-
swing trade of International Funeral Services in December
1969 (DX-UU at 17), Yamada’s program during that period
was a gradual liquidation of the Stirling securities and the
purchase of large quantities of unlisted and even restricted
stocks. By the completion of the transformation in Janu-
ary 1970, the account stood as follows:
Delanair, Ine. (restricted)
Food Fair Properties, Ine.
Holobeam, Inc.
Monarch Industries, Inc.
Synchronex Corp.
West Coast Production Co.
Benquet Consolidated Corp.
Equity Funding Corp.
A60
Appendix C
Outlet Company
Simplex Wire & Cable Co.
(DX-UU at 20)
In eight months, the value of Rolf’s securities had
dropped by over $700,000. Further, while his net position
was approximately $712,000, $338,000 of this was invested
in Delanair, a restricted stock through which plaintiff was
clearly defrauded by Yamada.
In August of 1969, Yamada persuaded Rolf to invest
nearly $400,000 in stock, calls and warrants of Delanair,
Inc. The securities were purchased through BEDCO, but
the parties all agree that the stock was initially Yamada’s
idea and that Stott received no commissions on the pur-
chase. Rolf was concerned that the investment would tie
up too large a portion of his money, so he telephoned Stott
after he had spoken with Yamada but before the funds had
been committed. Stott stated that if Yamada had recom-
mended the transaction, then it must be okay; in effect,
Stott said to go through with it (Tr. 82). The Court does
not accept Stott
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