Petition — Carothers v. Rice

Supreme Court brief1981

Ask Donna

What actually matters in this document.

Text

80°123 | FILED

No. JAN 21 198]

ave ¥ LL. STEVAS,

CLeRiK

SUPREME COURT OF THE UNITED STATES

October Term, 1980

JOSEPH A CAROTHERS, PAUL L. SCHMETZER,

JOSEPH A. MUNGOVAN, DAVID E. FLANIGAN,

Individually and as Representatives of a Olass of

Certain Shareholders and Stock Option Holders of

CYBEENETICS & en iat A Delaware

Corporation, - - - : - Petitioners,

W. THOMAS RICE,

PRIME F. OSBORN,

CYBERNETICS & SYSTEMS, INC.,

L & N INVESTMENT CORPORATION,

LOUISVILLE AND NASHVILLE RAILROAD

COMPANY,

SEABOARD COAST LINE RAILROAD COMPANY,

SEABOARD COAST LINE INDUSTRIES, INC. - Respondents.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF

APPEALS FOR THE SIXTH CIRCUIT

JOHN L. CARROLL

JOHNSON, CARROLL & GRIFFITH

2230 West Franklin Street

Evansville, Indiana 47712

(812) 425-4466

LAWRENCE L. PEDLEY

ROBERT P. ROSS

PEDLEY, ROSS & ZIELKE

2100 First National Tower

Louisville, Kentucky 40202

(502) 589-4600

40 Attorneys of Record for Petitioners

January , 1981

WESTERFIELD-BONTE CO., 619 W. KENTUCKY-?.0. BOX 3251, LOUISVILLE, KY.

eee

QUESTIONS PRESENTED FOR REVIEW

The questions presented for review are whether the

United States Court of Appeals for the Sixth Circuit erred

in reversing the judgment of the United Staies District

Court for the Western District of Kentucky, Gordon J.,

holding that the five year period of limitations applicable to

state common law fraud action, rather than the three year

period of limitations applicable to Kentucky Securities Act

actions, should be “borrowed” and applied to the Federal

claim based upon the facts in dispute where:

(a) This Court held, Ernest & Ernst v. Hochfelder,

425 U. S. 185 (1976) that an action under Section 10(b)

of the Securities Exchange Act of 1934 (the “1934 Act’)

requires proof of an intent to defraud (“scienter’”) ;

(b) An action under the Kentucky Securities Act, un-

like those under Section 10(b) of the 1934 Act, or the

Kentucky common law of fraud, does not require proof of

an intent to defraud;

a private remedy to individuals in the alleged position of

the Petitioners, that is, to defrauded sellers of securities;

and

(d) The Sixth Circuit Court of Appeals in Nickels v.

Koehler Management Corp., 541 F. 2d 611 (6th Cir., 1976)

cert. denied 429 U. S. 1074 (1976) established the rule in

the Sixth Circuit of applying longer, not shorter, periods

of limitations,

’%

TABLE OF CONTENTS

PAGE

Questions Presented for Review ................... i

IN oc aaah Uae p46 cas ones ch og Ctdiows ne 2

Pa) hd bp dle abn Chap aeaos onbwatinay o B:6 2

Constitutional Provisions, Treaties, Statutes, Ordi-

- mances and Regulations Involved ............... 3

Statement of the Case .................... eee eees 3- 9

Reasons for Granting the Writ .................... 9-16

I. Review Is Necessary to Resolve a Conflict Be-

tween Federal Circuits on an Important Issue

of Federal Securities Law Requiring a Uni-

form Judicial Standard ...............eeee. 9-13

II. The Decision Below Is Erroneous in View of

the Effect of the Hochfelder Decision by This

CE kv then ce Veale on Sha Dembacks cueebies 13-14

Ill. The Decision Below Is Erroneous in Determin-

ing That a Defrauded Seller Has a Course of

Action Available Under Kentucky Securities

BE sss eect R Cate iso 6 HERE Ah ae cls awe SF aed 15-16

ESN ys 6 ON caisson abe LPO bu eee Rweb ose 17

bk es ile 6 hd bu bameke eae wekeaus 19-72

Memorandum Opinion and Order—Filed November

CoE CU bth ba esewe nhl arco b aad boas epee 19-41

Memorandum Opinion and Order—Filed March 3,

Rab aea si vaas Coeaes CAn sweep ce ees OER 42-45

SN Fe a's edia' sb Vid 45S 40 Vbbd b> Ewen leeeaN 46-68

Securities Exchange Act of 1934, §10, 15 U.S.C.

RB APRS, | RENO PAR ES CRE Re 78 35K CPC ER» iaay ST 68-69

Securities Exchange Commission Rule 10b-5, 17

ree SEMIN 55 bande BS ikke cienis «Veena dbaiw> 69

The Securities Act of Kentucky, Kentucky Revised

Statute Chapter 292, Subsection 320(1) ........ 70

The Securities Act of Kentucky, Kentucky Revised

Statute Chapter 292, Section 480 .............. 70-72

Kentucky Revised Statutes, Chapter 413 ......... 72

TABLE OF CITATIONS

PAGE

Cases:

Campito v. McManus, Longe, Brockwehl, Inc., 470

B Bae 066: (N.D. NX, 2OFS) cick so Vike o v'tee 13

Cooke v. Avien, Inc., 573 F’. 2d 685 (1st Cir. 1978).. 10

Ernst & Ernst v. Hockfelder, 425 U. S. 185 (1976) .7, 9, 12,

13, 14

First Federal Savings. and Loam Association of

Miami v. Mortgage Corporation of the South,

467 F’. Supp. 943 (N.D. Ala. 1979) ............. 13

Forrestal Village, Inc. v. Graham, 551 F. 2d 411

EP RUNES REN ge oe ech KU‘ Mave Re ie ae ee's « 11, 13

Holmberg v. Armbrecht, 327 U.S. 392 (1946) ..... 7

Hudak v. Economic Research Analysts, Inc., 499 F.

Be WE SOE CE AOE co ce cob eeu dbedae Gasdene 12

I.D.S. Progressive Fund, Inc. v. First of Michigan

Corp., 533 F. 2d 340 (6th Cir. 1976) ........... 9,10

In re: Alodex Corporation Securities Litigation,

633 PF. 3d S72 (Sth Cir., 1976) 22... 06. c cece 12

Keck v. Wackers, 413 F. Supp. 1377 (E.D. Ky.

PR LAP Ce ike Ws ReaD Co bK ep aki che Nees bbe 14

Kramer v. Loewi & Co., Inc., 357 F. Supp. 83 (E.D.

ORE Ho cvs lah od wile aad wawaws Xo op d ot 12

McNeal v. Paine, Webber, Jackson & Curtis, Inc.,

508 F’. 2d 888 (Sth Cir. 1979) ...... cece c eens 13

Mitchell v. Texas Gulf Sulphur Company, 446 F. 2d

90 (10th Cir. 1971), cert. denied 404 U.S. 1004

EMRE Use i adau Las eceauderabedekaleas 10

Mooney v. Tallent, 397 F. Supp. 680 (N.D. Ga.

iA a cme Mah oul oe he obs bod oak doe 12

Morris v. Stifel, Nicholaus & Co., Inc.,600 F.2d 139

RR EMTOE can babs ndae Cueawebes bebe cab aes 13

Nichels v. Koehler Management Corp., 541 F. 2d

611 (6th Cir. 1976), cert. denied 429 U.S. 1074

PENPEE o c¥i ode uhavyn eke go uw bale dae banee een 10

O’Hara v. Kovens, 625 F. 2d 15 (4th Cir, 1980) ...11, 13

PAGE

Osterneck v. E. T. Barwick Industries Inc., 79

| FF ats ed CEs CO BED sobs oa oe hes poms vnies 13

Parrent v. Midwest Rug Mills, Inc., 455 F. 24 123

CPUUe CI SOP di disk Wield dee ORAS RRS bes ok 11

Roberts v. Magnetic Metals Company, 611 F.. 2d 450

PE EG BOUND ods wh sais aoe bn,e Codes ad'< 0 hb o's 10, 11

Sanford Construction Co. v. S & H Contractors,

Ine., Ky., 443 S. W. 2d 227 (1969) ............. 14

Schaefer v. First National Bank of Lincolnwood,

509 F.. 2d 1287 (7th Cir. 1975), cert. denied 425

os Oh RTE aa 6 oh a apdind Ua et v0.0 ce Urban ue 12

Stull v. Bayard, 561 F. 2d 429 (2nd Cir. 1977) cert.

denied 434 U.S. 1035 (1977) .............000. 10

Superintendent of Insurance v. Bankers Life and

Casualty Co., 404 U.S. 6 (1971) .............. 9

UAW v. Hoosier Cardinal Corp., 383 U.S. 969

CREE? So UR Gin GP UNUE ARG Rs Oe tne bas euecuahotes 9, 10

United California Bank v. Salik, 481 F. 2d 1012 (9th

SN MED SLi sch vbans opSiud diese BV ska Neare ewes 10

Vanderboom v. Sexton, 422 F. 2d 1233 (8th Cir.

ETO eel aay See's pada) v.80ab ope 11, 12

Statutes and Regulations:

Be Be SUA a ewe kei b spade ned eceunccee 2

Securities Exchange Act of 1934, 15 U.S.C. §78a... 6

Kentucky Revised Statutes:

EA chin $4 wadkcbuk ce en's behave eras hes 7, 16

MED Sie hile direc BR aderes REAR KOs W bee Oe 7, 10, 16

Kentucky Revised Statutes:

EE Crs ee ke rede caere vn od ed eeheumhe 8, 15, 16

a is GN anion « SW Habaio eam ¢ Chad oe dace 7

SEED Sicha cn ChGOA Wass eater Eee cee ouane 8

SO UD: sib OU habe acd.) dc be kkdnee wht 7, 10, 15, 16

Securities and Exchange Commission Rule 10b-5;

17 C.F .R. §240.10b-5 ....... 3, 7, 9, 11, 12, 13, 14, 15, 16

ni |

’ |

SUPREME COURT OF THE UNITED STATES

October Term, 1980

JOSEPH A. CAROTHERS, PAuL L. SCHMETZER,

JosePH A. MunGovAN, Davip E. FLANIGAN

Individually and as Representatives of a

Class of Certain Shareholders and Stock

Option Holders of CYBERNETICS & SYSTEMS,

Inc., A Delaware Corporation - - Petitioners,

Vv.

W. TxHomas RICcE,

PRIME F.. OsBorn,

CYBERNETICS & Systems, INc.,

L & N INVESTMENT CORPORATION,

LOUISVILLE AND NASHVILLE RAILROAD Com-

PANY,

Seapoarp Coast LINE RAILROAD COMPANY,

SEABOARD Coast LINE INpustRiEs, INc. - Respondents.

PETITION FOR A WRIT OF CERTIORARI

TO THE UNITED STATES COURT OF

APPEALS FOR THE SIXTH CIRCUIT

Joseph A. Carothers, Paul L. Schmetzer, Joseph A.

Mungovan and David E. Flanigan, individually, and

as representatives of a class of certain shareholders and

stock option holders of Cybernetics & Systems, Inc., a

Delaware Corporation, pray that a writ of certiorari

issue to review the judgment of the United States

Court of Appeals for the Sixth Circuit entered in this

case on September 15, 1980, petition for review and

rehearing en bane denied on October 23, 1980.

OPINIONS BELOW

The memorandum opinion and order of the district

court issued March 3, 1978 is unreported and a copy is

attached hereto in the Appendix at pp. 42-45.

The opinion of the Unites States Court of Appeals

for the Sixth Circuit is reported at 663 F. 2d 7 (6th

Cir., 1980) and a copy of the opinion is attached hereto

in the Appendix at pp. 46-68.

JURISDICTION

An opinion and order overruling Respondents’ mo-

tion to dismiss the allegations of Petitioners’ complaint

directed to Federal Securities law violations for lack

of jurisdiction for failure to assert the Federal claim

within the period of limitations provided by the Ken-

tucky Revised Statutes was entered by the United

States District Court for the Western District of Ken-

tucky (James Gordon, Jr.), on March 3, 1978.

On September 15, 1980, the United States Court of

Appeals for the Sixth Circuit reversed to judgment

below. Motion for rehearing en bane was requested

by Petitioner and was denied on October 23, 1980. No

extension of time within whick to petition for certio-

rari was sought.

The jurisdiction of this Court is invoked under

28 U.S.C. §1254(1).

7’.

CONSTITUTIONAL PROVISIONS, TREATIES, STAT-

UTES, ORDINANCES, AND REGULATIONS INVOLVED

This case involves the Securities Exchange Act of

1934; 15 U.S.C. §78a et seq.; Securities and Exchange

Commission Rule 10b-5, 17 C.F.R. 240.10b-5; Ken-

tucky Revised Statutes Chapter 292 ; Kentucky Revised

Statutes Section 413.120.

Pertinent portions of the above-referenced statutes

and rules are reproduced in ‘the Appendix hereto.

STATEMENT OF THE CASE

Joseph A. Carothers, Paul L. Schmetzer, Joseph A.

Mungovan and David E. Flanigan, individually and as

representatives of a class of shareholders and stock-

option holders of Cybernetics and Systems, Inc., a

Delaware Corporation, filed the Complaint in this ac-

tion, in the United States District Court for the West-

ern District of Kentucky, on February 11, 1977. The

Petitioners sought compensatory damages, or in the

alternative, rescissionary relief, and punitive damages

against Cybernetics and Systems, Inc (‘‘Cybernetics’’),

certain corporations that control Cybernetics (Louis-

ville and Nashville Investment Corporation; Louisville

& Nashville Railroad Company; Seaboard Coast Line

Railroad Company and Seaboard Coast Line Indus-

tries, Inc.) and certain controlling persons and Di-

rectors of those Corporations (W. Thomas Rice and

Prime F. Osborn) arising out of Cybernetics’ 1973 ten-

der offer for, and its purchases of, its stock and stock

options from the Petitioners and from the class which

they represent. The Complaint contains three Counts,

the First Count grounded upon violations of the Fed-

eral Securities Laws, the Second Count grounded upon

violations of the Kentucky common law of fraud and

the Third Count grounded upon violations of state

fiduciary common law.

The individual Petitioners are among a group of

persons alleged by the Complaint to have been de-

frauded by improper acts and omissions of the Respond-

ents occurring when the Respondents purchased, and co-

erced Petitioners into selling back to Cybernetics, the

Cybernetics stock and stock options owned by them.

The details of Respondents’ fraudulent plan and ac-

tions are as follows:

In 1968, the Louisville and Nashville Railroad

Company (‘‘L & N’’) recognized the need for a com-

puterized ability to account for and direct its equip-

ment and offices throughout the United States. Also,

L & N desired to offer computer services to the general

public to generate additional revenues for L & N. As

a result, in 1969, L & N caused Cybernetics to be in-

corporated to perform these functions and thereafter

offered the Petitioners employment and stock options

to participate in organizing, directing and operating

Cybernetics. Louisville and Nashville Investment Cor-

poration (‘‘L & N Investment’’), a subsidiary of L & N,

originally capitalized Cybernetics and always owned at

least 85% of its outstanding stock. The Respondents

represented to prospective employees and stock-option

holders (Petitioners) that it was Respondents’ inten-

tion that at some time in the future, internal and public

operations having achieved a sufficient level, Cyber-

neties would effect a public distribution of its securities

to the public and that Petitioners could then re-sell

their shares to the public at a profit. In order to con-

tinue to attract and retain competent, experienced per-

sonnel, Respondents continuously caused Cybernetics

to offer stock options to its employees and prospective

employees. :

At the time of Cybernetics’ formation, Respondent

Rice expressed strong opposition to the sale of its se-

curities to employees. At that time, Rice was President

of Seaboard Coast Lines Railroad Company (‘‘Sea-

board’’) which owned at least 35% of the outstanding

stock of L & N, and he also served as an L & N Director.

In 1971, Seaboard acquired 100% of the outstand-

ing stock of L & N, thereby acquiring control of Cyber-

netics, which was 80% owned by L & N Investment and

had approximately forty employees who were option

and security holders.

In 1973, Rice directed that the Respondent Corpora-

tions consolidate 100% of the stock ownership of

Cybernetics into L & N Investment. As a result, at

the direction and control of the Respondents, Cyber-

netics was caused to effect a tender offer for its own

shares from its shareholders and stock-option holders at

the grossly inadequate price of Twenty ($.20) Cents per

outstanding share and Fifteen ($.15) Cents per out-

standing stock option. The core of Petitioners’ Com-

plaint is that the means and manner by which this

tender offer was effected violated the Federal Securi-

ties Laws, state laws of common law fraud and state

fiduciary law. The Respondents first restricted the

business operations of Cybernetics, and improperly and

misleadingly manipulated its financial affairs, all to

make it appear that Cybernetics was financially un-

stable and unproductive. Thereafter, the Respondents

fraudulently coerced Cybernetics’ shareholders and op-

tion holders into tendering and selling their shares

back to the Corporation at a price which the Respond-

ents knew to be below the fair market value of such

securities. The Respondents effected the tender offer

by means of documents and information which they

knew did not adequately present a historical or current

picture of Cybernetics’ financial status or prospects.

The tender offer began in February, 1973, and was com-

pleted on May 18, 1973.

Many of the employees, stockholders and option

holders of Cybernetics resigned their employment in

the period following the expiration of the tender offer

in May, 1973. However, as a result of continuing com-

munication among the named Petitioners, the Com-

plaint in this action was filed on February 11, 1977,

demanding compensatory and punitive damages for

the wrongs done to the Petitioners and the class which

they represent.

Federal jurisdiction over the Petitioners’ Federal

Securities Law claim is based upon Section 27 of the Se-

curities Exchange Act of 1934 (15 U.S.C., §78aa).

Federal jurisdiction over the Petitioners’ state com-

mon law fraud and fiduciary duty claims, is based upon

the doctrine of pendent jurisdiction.

The various motions filed against the Complaint

assert, in essence, that the Federal Securities Law

Count is barred by limitations. Since the 1934 Act

provides no limitations period for the implied right of

action under Section 10(b), a Federal Court sitting in

such an action will apply the most analogous state

statute of limitations. Holmberg v. Armbrecht, 327

U. 8. 392 (1946), Ernst & Ernst v. Hochfelder, 425

U. S. 185 (1976). In this litigation, the choice is be-

tween the three year period of limitations established

under the Kentucky Securities Act (Kentucky Revised

Statutes, Section 292.480(3)) and the five year period

of limitations applicable to actions for common law

fraud and to statutory actions where no other time is

fixed by the statute creating the liability (Kentucky

Revised Statutes, Section 413.120(12) and (2) respec-

tively).

The District Court held that an action for breach of

the Kentucky common law of fraud, rather than an

action under the Kentucky Securities Law, was more

analogous to the Federal Securities action implied un-

der Section 10(b) of the 1934 Act. The District Court

considered it significant that the Civil Remedies Sec-

tion of the Kentucky Securities Law (KRS 292.480),

by its express terms, provides no remedy to a defrauded

seller of securities, and that the consistent position of

the United States Court of Appeals for the Sixth

Circuit is thatyis more appropriate to apply the states’

longer limitations periods,

Following Respondents’ Motion for Reconsidera-

tion to the District Court, that Court reaffirmed its

8 A

position but, under 28 U.S.C. §1292(b), certified the

question of its choice of the five year period of limi-

tations to the Court of Appeals for the Sixth Cireuit.

The Court of Appeals permitted interlocutory appeal

of the question, briefs were filed by the parties and

oral arguments were heard upon the matter. On Sep-

tember 15, 1980, the Court of Appeals panel reversed

the decision of the District Court, with a dissent to that

reversal being filed by one of the Judges on the panel.

The Court of Appeals ruled that a civil remedy for

a seller of securities would be implied +o exist under

KRS 292.320(1), even though (1) the Kentucky Courts

have not addressed this issue; (2) a specifie Civil

Remedies Section is provided in the Kentucky Seeu-

rities Act for securities fraud actions and it is expressly

limited to defrauded securities purchasers; and (3)

implication is not appropriate because defrauded

sellers already have a remedy available to them under

‘he Kentucky common law of fraud. The Court of

Appeals went one step further and ruled that an im-

plied remedy being thus available, the short limitations

period of KRS 292.480(1) would be applicable to that

state-implied action. This was without direct dicussion

of the extremely pivotal issue of the concomitant ap-

plicability of the KRS 292.480(1) decreased eviden-

tiary burdens (expressly limited to a defrauded pur-

chaser) to the seller’s implied right of action under

KRS 292.320(1).

The Court of Appeals also ruled that the Federal

action more closely resembles the implied state action

under KRS 292.320(1), even though previous deeci-

sions of that Court had ruled that the broad remedial

policies of the Federal Securities Laws are better

served by a longer, not a shorter, limitations period.

I.D.S. Progressive Fund, Inc. v. First of Michigan

Corp., 533 F.. 2d 340 (6th Cir. 1976). The longer period

would be available in Kentucky to a defrauded securi-

ties seller suing under the Kentucky Common law

of fraud.

On October 23, 1980, the Court of Appeals denied

Peiiiioner’s Motion for a Rehearing en banc on their

decision of September 15, 1980.

REASONS FOR GRANTING THE WRIT

I. Review is Necessary to Resolve a Conflict Between

Federal Circuits on an Important Issue of Federal

Securities Law Requiring a Uniform Judicial Standard.

The subject action is grounded upon allegations of

breaches of Federal Securities Laws and of state com-

mon law. Petitioners assert violations of Section

10(b) of the Securities Exchange Act of 1934 and Rule

10b-5 promulgated thereunder, basing their Federal

claim upon the now well-established implied right of

action under those provisions. Ernst & Ernst v.

Hochfelder, 425 U.S. 185 (1976); Superintendent of

Insurance v. Bankers Life and Casualty Co., 404 U.S.

6 (1971).

It is equally well settled that, there being no express

Federal statute of limitations to be applied to actions

under these provisions, the Federal Courts are to

utilize the limitations period of the forum state which

is applicable to the state action which most resembles

the federal action asserted. UAW v. Hoosier Cardinal

Corp., 383 U. S. 969 (1966).

’*%

’%

In similar actions, the various District and Circuit

Courts have taken opposite views with respect to

whether to apply the state limitations period applicable

to common law fraud or to state securities actions. In

Kentucky, the limitations period for common law fraud

is five (5) years (Kentucky Revised Statutes Section

413.120(12)) and the period for Kentucky securities

law fraud is three (3) years (Kentucky Revised Stat-

ute Section 292.480(3)).

As stated in UAW v. Hoosier Cardinal Corporation,

id., the Federal Court, in choosing the applicable state

limitations period, should look (1) to the period which

is substantially closest to the federal statute, and (2) to

the period which best effectuates the policies behind

the federal statute. In applying these standards to

previous actions arising out of other states within the

Sixth Circuit, that Court of Appeals has applied the

limitations period applicable to common law fraud

actions of the particular state. Nickels v. Koehler

Management Corp., 541 F. 2d 611 (6th Cir., 1976), cert.

denied 429 U. S. 1074 (1976) ; IDS Progressive Fund,

Inc. v. First of Michigan Corp., 533 F. 2d 340 (6th Cir.

1976). This conforms to the position taken by certain

other Circuits, including the First, Second, Third,

Ninth and Tenth.’ Other Circuits, using the same

standards, have applied the period of limitations ap-

1Cooke v. Avien, Inc., 573 F. 2d 685 (1st Cir. 1978) ; Stull v.

Bayard, 561 F. 2d 429 (2nd Cir. 1977), cert. denied 434 U. S. 1035

(1977) ; Roberts v. Magnetic Metals Company, 611 F. 2d 450 (5th

Cir. 1979) ; United California Bank v. Salik, 481 F. 2d 1012 (9th

Cir. 1973) ; Mitchell v. Texas Gulf Sulphur Company, 446 F. 2d 90

(10th Cir. 1971), cert. denied 404 U. S. 1004 (1971).

plicable to state blue sky law actions, including the

Fourth, Seventh, Eighth and the District of Columbia

Circuit.? It is unclear what particular period of limi-

tations is to be applied in the Fifth Circuit.*

It is asserted that th.s difference of positions be-

” tween the Circuits as to the appropriate limitations

period arises from a difference in the Circuits’ interpre-

tations of the test to be applied, rather than from differ-

ences among the various state laws setting forth the

components of the state actions. And this conflict gives

rise to the application by the different Circuits of un-

equal burdens and standards in actions asserting vio-

lations of Section 10(b). :

In arriving at their conflicting positions, the Cir-

cuits generally assume two approaches: (1) to con-

sider the various factors, or elements, of each state

cause of action with a view to determining which state

claim would best effectuate and most ‘‘resemble’’ the

elements of the Federal claim; or, (2) to broadly con-

sider the commonality of purposes of the state and fed-

eral causes of action, rather than dissecting the factors

and elements of each, with a view to determining the

‘‘similarity’’ of actions.

Those Circuits considering the purpose of the state

statutes have generally concluded that because the

Federal and state securities laws are for the com-

20’Hara v. Kovens, 625 F. 2d 15 (4th Cir. 1980) ; Parrent v.

Midwest Rug Mills, Inc., 455 F. 2d 123 (7th Cir. 1972) ; Vander-

boom v. Sexton, 422 F. 2d 1233 (8th Cir. 1970) ; Forrestal Village,

Inc. v. Graham, 551 F. 2d 411 (D.C. Cir. 1977).

8Roberts v. Magnetic Metals Company, 611 F, 2d 450 (5th Cir,

1979).

mon purposes of regulating securities matters and

actions, the state securities law cause of action most

‘¢resembles’’ the Federal claim. But a significant num-

ber of the Circuits considering the different detailed

elements of the state and Federal actions have con-

cluded that, in terms of actual proof burdens and al-

lowable recovery limitations, the state common law

fraud actions most ‘‘resemble’’ the Federal claim.*

In the pre-Hochfelder decisions, the Courts analyz-

ing the actions’ elements generally considered it im-

portant that an action under state securities laws and

under Section 10(b) of the 1934 Act did not require

proof of ‘‘scienter’’, while an action under state com-

mon law fraud did.**® But since the Hochfelder de-

cision, the Circuits are also split upon the ultimate

effect of this change in this important proof element

of a 10b-5 action. Some Federal Courts hold that,

though a state securities law action does not require

proof of ‘‘scienter’’, while an action under Section

10b-5 and common law fraud would, this is not sufficient

to tip the scale of resemblance factors to the fraud

4In re: Alodex Corporation Securities Litigation, 533 F. 2d

372 (8th Cir. 1976) ; Schaefer v. First National Bank of Lincoln-

wood, 509 F. 2d 1287 (7th Cir. 1975), cert. denied, 425 U. S. 943

(1976) ; Hudak v. Economic Research Analysts, Inc., 499 F. 2d 996

(Sth Cir., 1974), cert. denied, 419 U. S. 1122 (1975); Mooney v.

Tallent, 397 F. Supp. 680 (N.D. Ga. 1975).

5Vanderboom v. Sexton, 422 F. 2d 1233 (8th Cir., 1970) ; In re:

Alodex Corporation Securities Litigation, 533 F. 2d 372 (8th Cir.

1976) ; Kramer v. Loewi & Co., Inc., 357 F. Supp. 83 (E.D. Wise.

1973).

®The term ‘‘scienter’’ refers to a mental state embracing intent

to deceive, manipulate or defraud. Hochfelder, supra.

action.’ Other Federal Courts have determined just

the opposite, giving significant weight to this change.*®

This then is the two-pronged conflict in the positions

of the Circuits. That is, the Circuits differ as to what

tests or analytical factors are to be considered and

utilized in determining the particular state limitations

period to be applied to the Federal action and the Cir-

cuits also differ in their positions as to the weight

and effect of the Hochfelder determination that

‘*scienter’’ must now be proven by Plaintiffs in Section

10(b) actions.

And since it is necessary that a limitations period

be ‘‘borrowed’’, it is imperative that this Court resolve

the conflicts between the Circuits to provide consistency

and direction to the Circuits in their application of the

‘‘resemblance’’ test.

II. The Decision Below is Erroneous in View of the Effect

of the Hochfelder Decision by This Court.

This Court in Hochfelder, supra, effectively con-

verted Section 10(b) of the Securities Exchange Act of

1934 from a negligence-and-fraud statute to a fraud-

only statute. In those cases where a Federal Court is

Forrestal Village, Inc. v. Graham, 551 F. 2d 411 (D.C. Cir.

1977) ; O’Hara v. Kovens, 625 F. 2d 15 (4th Cir. 1980) ; Morris

v. Stifel, Nicolaus & Co., Inc., 600 F. 2d 139 (8th Cir. 1979) ; Oster-

neck v. E. T. Barwick Industries Inc.,79 F.R.D. 47 (N.D. Ga. 1978).

8McNeal v. Paine, Weber, Jackson & Curtis, Inc., 598 F. 2d

888 (5th Cir. 1979) ; Campito v. McManus, Longe, Brockwehl, Inc.,

470 F. Supp. 986 (N.D. N.Y. 1979); First Federal Savings and

Loan Association of Miami v. Mortgage Corporation of the South,

467 F. Supp. 943 (N.D, Ala., 1979),

considering both a state. securities statute patterned

after the Uniform Securities Act and a general com-

mon law fraud statute, Petitioners assert that the

Hochfelder decision is dispositive of the issue of re-

semblance. That is, in those instances where the forum

state bases state securities law actions on negligence,

and where common law fraud actions are based upon

proof of ‘‘scienter’’, the Federal Section 10(b) action

is an analogue to the state common law fraud action.

Therefore the state limitations period applicable to

common law fraud should be ‘‘borrowed’’ flor the

Federal action.

If the reduced procedural restrictions applicable to

Kentucky Securities Law actions were comparable to

those applied in Section 10(b) actions, then it might

be appropriate to apply the shorter Kentucky securities

limitations period. But they are not. And as this

Court has impliedly indicated, since the procedural

restrictions do not exist for a Section 10(b) action,

the reason for the shorter limitations periods like those

of the Federal Securities Acts is obviated. Hochfelder,

supra at page 209. And since a Section 10(b) action

almost exactly parallels a Kentucky common law fraud

action (i.e., without lessened procedural restrictions but

still requires proof of ‘‘scienter’’),® the common law

fraud limitations period should be ‘‘borrowed”’ and

held applicable in the case at bar.

®Keck v. Wackers, 413 F. Supp. 1377 (E.D. Ky. 1976); San-

ford Construction Co. v. S & H Contractors, Inc., Ky., 443 S. W.

2d 227 (1969).

III. The Decision Below is Erroneous in Determining That

a Defrauded Seller has a Cause of Action Available

Under Kentucky Securities Law.

In the decision from the Court of Appeals below, it

is necessary that a cause of action be found to exist for

a defrauded seller under the Kentucky Securities Law

before that cause of action can be compared to the

asserted Federal claim for purposes of applying the

‘‘resemblance’’ test. And though the Kentucky Courts

have never addressed the question, and though a Ken-

tucky security-holder would have other remedy avail-

able to him under the Kentucky common law of fraud,

the Court of Appeals still implied a defrauded seller’s

remedy under the Kentucky analogue to Rule 10b-5

(KRS 292.320(1)). This disregards the Civil Rem-

edies Section of Kentucky Blue Sky Laws, which is

expressly limited to defrauded buyers of securities,

rather than sellers.

Even more, having determined that a remedy is to

be so implied, the Court of Appeals applied the shorter

limitations period of the Civil Remedies Section of the

Kentucky Securities Law. Assuming arguendo that a

defrauded securities seller has available an implied

civil remedy under KRS 292.320(1), Petitioners assert

that the period of limitations applicable to that im-

plied remedy would not be that period set forth in

KRS 292.480(3), because that limitations period with

its lessened procedural restrictions is expressly limited

to defrauded sellers. Petitioners assert that the de-

frauded seller’s action instead would be similar to an

> >

action under Kentucky common law fraud with the

traditional burdens of proof. Therefore, the limita-

tions period which would be applicable to the implied

seller’s remedy is the five-year period set forth in KRS

413.120(2) or (12).”°

Since it is the Respondents themselves that are as-

serting the resemblance between the implied seller’s

remedy under KRS 292.320(1) in an action under

Section 10(b), then Petitioners strongly assert that

the state five-year limitations period of KRS 413.120

would be applicable to KRS 292.320(1) and would also

be applicable to the Section 10(b) action.

10KRS 413.120. The following actions shall be commenced

within five (5) years after the cause of action accrued:

|) Beenie

(2) An action upon a liability created by Statute, when no

~ other time is fixed by the statute creating the liability; . . .

(12) An action for relief or damages on the ground of fraud

or mistake.

CONCLUSION

As long as state statutes of limitations must be bor-

rowed for certain Federal securities actions, there can

be no national uniformity as to the time period of

limitations. However, there can and should be uni-

formity as to the test, and means of applying the test,

in determining which state limitations period is to be

borrowed. Only this Court can establish the standard

which will bring about the desired consistency of re-

sults. Almost all Federal Circuits have now addressed

the problem and the results are irreconcilable. The

issue is ripe for resolution by this Court.

For these reasons, Petitioners respectfully request

that their Petition for Writ of Certiorari be granted.

JOHN L. CARROLL

JOHNSON, CARROLL & GRIFFITH

2230 West Franklin Street

Evansville, Indiana 47712

(812) 425-4466

LAWRENCE L. PEDLEY

Rosert P. Ross

PEDLEY, Ross & ZIELKE

2100 First National Tower

Louisville, Kentucky 40202

(502) 589-4600

Attorneys of Record for

Petitioners

January 19, 1981

poke thoes chs ie ee PRPSEAS

Sereda = ars ot Seed Sto eal

UNITED STATES DISTRICT COURT

FOR THE WESTERN DISTRICT OF KENTUCKY

Civil No. 77-0066-L(G)

JosePpH A. CarotHers, Er Au.

W. Txomas Rice, Er Au.

MEMORANDUM OPINION AND ORDER—Filed

* November 7, 1977

John L. Carroll, Esquire, Evansville, Indiana, Law-

rence L. Pedley, Esquire, Louisville, Kentucky, William T.

Warner, Esquire, Louisville, Kentucky, and Robert P. Ross,

Esquire, Louisville, Kentucky, Counsel for the Plaintiffs.

Joseph E. Stopher, Esquire, Louisville, Kentucky, Ed-

ward H. Stopher, Esquire, Louisville, Kentucky, Robert C.

Moore, Esquire, Louisville, Kentucky, Oscar N. Persons,

Esquire, Atlanta, Georgia, F. Dean Copeland, Esquire, At-

lanta, Georgia, Franklin R. Nix, Esquire, Atlanta, Georgia,

and Jeffery P. Adams, Atlanta, Georgia, Counsel for De-

fendants.

Gordon, Senior United States District Judge.

This action was brought by Joseph A. Carothers, et al.,

individually and as representatives of a class of certain

minority stockholders and stock option holders of Cyber-

netics & Systems, Inc., [hereinafter, “Cybernetics”] against

certain “control persons” of Cybernetics for damages

and/or equitable relief arising out of violations of the Secu-

rities Exchange Act of 1934, as amended, 15 U.S.C.A. §78a

et seq., [hereinafter the “Exchange Act”]; the laws of the

States of Delaware, Virginia, and Kentucky; and those

state laws regarding the fiduciary responsibility of control

persons and/or majority stockholders and corporate officers

toward shareholders.

As for the federal claims, the plaintiffs allege violations

of Section 10(b), 14(e) and 20 of the Exchange Act, 15

U.S.C.A. §$§78j(b), 78n and 78t, and Rule 10b-5 of the Secu-

rities and Exchange Commission, 17 C.F.R. §240.10b-5.

This Court has jurisdiction of the federal claims pur-

suant to 15 U.S.C.A. §78aa and has pendent jurisdiction of

the claims arising under the laws of the States of Delaware,

Virginia and Kentucky.

These claims are before the Court on defendants’ mo-

tions for dismissal pursuant to Rule 12(b)(6) of the Fed-

eral Rules of Civil Procedure. First, defendants argue

that the plaintiffs’ claims arising under the federal and

state securities laws fail to state a claim upon which relief

may be granted because they are barred by the applicable

state statutes of limitation. Second, defendants argue that

paragraphs 40(b), 41 and 42 of the original complaint of

paragraphs 39(b), 40, and 41(a) of the amended complaint

in essence represent a shareholder’s derivation action and

fail to state a claim upon which relief may be granted be-

cause, inter alia, they do not meet the technical require-

ments of Rule 23.1 of the Federal Rules of Civil Procedure.

Third, defendants argue that the Court could not have sub-

ject matter jurisdiction over the pendent state claims in

the event the federal claims are dismissed, therefore, they

also should be dismissed.

Since matters outside the pleadings have been presented

and are not excluded by the Court, the Motion shall be

treated as one for summary judgment and disposed of as

provided by Rule 56 of the Federal Rules of Civil Pro-

cedure. Fed. R. Civ. P. 12(c). Having carefully reviewed

the voluminous memoranda of law submitted by the parties,

the Court concludes that all parties have been given rea-

sonable opportunity to present all material made pertinent

to such a summary judgment motion. The Court also finds

that the pleadings and affidavits show that there is no gen-

uine issue as to any material fact surrounding the legal

issues here decided.

Statute of Limitations Question

According to the affidavit of Robert C. Moore, General

Attorney for the Louisville and Nashville Railroad, the de-

fendants’ tender offer expired on March 16, 1973 and all of

the plaintiffs’ stock and stock options were acquired by

defendants not later than May 18, 1973. None of the plain-

tiffs held any shares or options of Cybernetics after May 18,

1973. No counter-affidavits were tendered by plaintiffs.

Furthermore, plaintiffs have neither plead nor argued the

federal doctrine of “tolling” with respect to the commence-

ment of the period of limitation. Therefore, the Court

finds that the statute of limitations commenced running no

later than May 18, 1973. This suit was filed on February 11,

1977, more than three years after the claims arose.

There is no general federal statute of limitations and

no provision in either Sections 10(b), 14(e), or 20 of the

Exchange Act as well as SEC Rule 10b-5, although other

sections of the Act have stated limitations. See e.g.

15 U.S.C.A. §§78i(e), 78p(b), 78r(c) and 78cec(b). Both

parties agree that it is well settled that when Congress has

created a federal right but has not prescribed a limitation

period, federal courts will borrow the limitation period pro-

scribed by the forum state. International Union, U.A.W.

v. Hooser Cordial Corp., 383 U. S. 696 (1966) ; Holmberg v.

Armbrecht, 327 U. 8. 392 (1946). This rule was recently

reaffirmed in Ernst ¢ Ernst v. Hochfelder, 425 U. 8. 185,

210, n.29 (1976).

The problem arises, however, when the forum state law

contains two or more different but relevant limitation

periods. This is not a matter of first impression for courts

in the Sixth Circuit. Recently, the Sixth Cirenit Court of

Appeals determined this same question with respect to

Ohio state law in Nichels v. Koehler Management Corp.,

541 F. 2d 611 (6th Cir. 1976). It held“. . . the Federal

Courts must choose among the several state statutes of

limitations and apply that one which best effectuates the

federal policy at issue.” 541 F. 2d at 613, citing I.DS.

Progressive Fund, Inc. v. First of Michigan Corp., 533 F.

2d 340, 342 (6th Cir. 1976), which quoted, Charney v.

Thomas, 372 F. 2d 97, 100 (6th Cir. 1967). The issue here

is which state statute of limitations better implements the

federal policies under Sections 10(b), 14(e), 20 and SEC

Rule 10b-5.

The defendants argue that Kentucky Revised Statute

§292.480(3) (Supp. 1976) [hereinafter “KRS”], the three-

year statute of limitations for the Kentucky Blue Sky Law,

is applicable and thus the plaintiffs’ claims are barred.

The plaintiffs, on the other hand, submit that KRS

413.120(12) (1964), the five-year statute of limitations for

general fund is applicable; therefore, their claims are not

barred.

As was noted earlier, the Sxith Circuit Court of Appeals

has considered this issue on at least three previous occa-

sions: Nichels (considering Ohio law), IDS Progressive

Fund, and Charney (both considering Michigan law). In

all three cases the Court found that the longer general stat-

ute of limitations for fraud applied rather than the statute

of limitations applicable to the states’ blue sky or seen-

rities law.

It would be an easy matter for this Court to hold that

the Kentucky genera! fraud statute of limitations applies

to the present action under the theory of stare decisis;

however, because of two factors, a closer analysis is war-

ranted. First, the Sixth Circuit’s opinions seems to repre-

sent the minority view among the several circuits that have

considered the issue. Second, this Court does not have the

benefit of a higher court’s determination of the appropriate

Kentucky statute of limitations.

The Court agrees with defendants in that the majority

of circuits have chosen to apply the applicable state blue

sky statutory period of limitatiun. See e.g., Berry Petro-

leum Co. v. Adams & Peck, 518 F. 2d 402 (2d Cir. 1975);

Newman v. Prior, 518 F. 2d 97 (4th Cir. 1975); Hudak v.

Economic Research Analysts, Inc., 499 F. 2d 996 (5th Cir.

1974) ; cert. denied, 419 U. S. 1122 (1975) ; LaRosa Building

Corp. v. Equitable Life Assurance Society, 542 F. 2d 990

(7th Cir. 1976) ; Vanderboom v. Sexton, 422 F. 2d 1233 (8th

Cir. 1970); and Forrestal Village, Inc. v. Graham, 551 F.

2d 411 (D.C. Cir. 1977).

The minority view is followed by three circuits. Nickels

v. Koehler Management Corporation, supra (6th Cir.);

United California Bank v. Salik, 481 F. 2d 1012 (9th Cir.

1973), cert. denied, 414 U. S. 1004 (1973); and Clegg v.

Conk, 507 F. 2d 1351 (10th Cir. 1974), cert. denied, 422

U. 8. 1007 (1975). The two contrasting views seem to fol-

low either Charney, supra, in the Sixth Circuit or Vander-

boom, supra, in the Eighth Circuit.

In Charney, the purchasers of common stock of the

Clinton Engines Corporation brought suit against the op-

erating officers and controlling stockholders of Clinton be-

cause of a fraudulent misrepresentation of the inventory

at the time of the sale. The District Court of the Eastern

District of Michigan granted defendants’ motion to dismiss

because the Michigan “Blue Sky Law,” MSA $19.756, Comp.

Laws 1948, §451.116, granted the sole remedy for fraud in

the sale of securities in that state and therefore the suit

was barred by the two-year statute of limitations which

applied to any claim under Section 10 of the Exchange

Act. The Sixth Cireuit Court of Appeals reversed and

held that the applicable statute of limitations for a claim

under Section 10 of the Exchange Act was the six-year

general fraud statute of limitations. The Court found that

the case of Detwiler v. Olavin, 138 N. W. 2d 336 (1965) had

been decided by the Michigan Supreme Court subsequent

to the dismissal by the district court. In Detwiler it was

held that a defrauded purchaser had his choice of remedies

under the common law or under the securities law; the

common law action for fraud had not been abrogated by

the statute.

“Thus, the legislature may have meant to provide a

potential plaintiff with a choice between the statutory

action with its short limitation period and the more

difficult to prove common law action with its longer

limitation period as a compensation.” 372 F. 2d at 99.

Beyond this, the reasoning of the Court is not as compre-

hensive as later cases; however, it is apparent that the

Court reasoned that the plaintiff should have at least as

much time to bring his suit under the federal claim as they

would under the comparable state claim.

The Ninth Circuit Court of Appeals reached the same

result in United California Bank v. Salik, supra. The

Court held that the applicable state statute of limitations

for Section 10(b) of the Exchange Act was California’s

three-year limitations period for fraud cases rather than

the special limitations statute permitting suit for security

fraud. The Court had found the fraud limitation appli-

cable in several earlier cases. The Court stated:

We do not believe federal policy iz advanced by chang-

ing the law governing the timeliness of federal claims

to correspond with each change in the substantive ele-

ments of a claim under the local securities law. Ag-

grieved persons have come to rely upon our prior hold-

ings. Reasonable stability in laws pertaining to volun-

tary relationships betwen parties, and the right of

access to the courts to question those relationships, is

a worthwhile objective as well.

481 F. 2d at 1015, quoting, Douglas v. Glen E. Hinton In-

vestments, Inc., 440 F'. 2d 912, 916 (9th Cir. 1971).

The second reason for its holding was that“. . . the

broad remedial policies of the federal securities laws are

best served by a longer, not a shorter, statute of limita-

tion.” 481 F. 2d at 1015.

The same issue was again before the Sixth Circuit and

decided twice in 1976. The first case was IDS Progressive

Fund, Inc. v. First of Michigan Corp., supra. The Circuit

Court upheld the District Court for the Eastern District of

Michigan in its holding that the six-year common law fraud

statute of limitations applied to Section 10(b) of the Ex-

change Act and SEC Rule 10b-5. The plaintiffs alleged

that they were induced to purchase the common stock of

Great Markwestern Packing Co. by a false and misleading

prospectus prepared by defendant First of Michigan.

The State of Michigan had adopted the Uniform Secu-

rities Act subsequent to the Charney case. Furthermore,

the Fifth, Seventh and Eighth Circuits had since dealt with

the issue and had found that the statute of limitations in

the state Blue Sky Laws to be the limitation periods which

best effectuates federal policy.

Although the defendant emphasized the virtual identity

of Section 101 of the Uniform Act and Rule 10b-5, the

’*

-'?

Court found Section 101 to be an exclusively criminal pro-

vision which did not give rise to civil liability. 533 F. 2d

at 343. The Court determined that Section 410 of the Uni-

form Act gave rise to civil liability and that the “but”

clause in Section 410(h) was designed to assure that no im-

plied civil cause of action would be found in Section 101 as

had developed in Rule 10b-5 actions. 533 F. 2d at 343, n.1.

After a cursory and somewhat inaccurate comparison of

Section 410 and Rule 10b-5 (since we now have the benefit

of Ernst & Ernst v. Hochfelder, supra) the Court gave

two reasons for its holding. First, the Court was unwill-

ing, absent good cause, to change their prior holdings, cit-

ing the Douglas case, supra. Second, agreeing with the

Ninth Circuit in United California Bank, the Court stated

“ ,. . the broad remedial policies of the federal securities

laws are best served by a longer, not a shorter statute of

limitations.” 533 F. 2d at 344.

Probably the most complete and best reasoned analysis

of this issue occurred in the Sixth Circuit Court of Appeals’

opinion later in 1976 in Nickels v. Koehler Management

Corp., supra. The plaintiffs in the two consolidated cases

were stockholders or former stockholders in corporations

which were acquired or merged. The plaintiffs were some-

what analogous to the present plaintiffs in that they gave

up their shares much the-same as would a seller. In

Nickels it was held that the four-year general fraud stat-

ute of limitations of Ohio, rather than the two-year limita-

tion of the Ohio Blue Sky Law, was the more appropriate

limitation period to apply to federal securities fraud claims.

The defendants urged the Court to adopt the majority

view under Vanderboom v. Sexton, supra, and hold that the

Blue Sky Laws “bears the closest resemblance to the fed-

eral statute involved.” 541 F. 2d at 615. They first con-

tended that the two-year limitation of the Ohio Blue Sky

law governed both statutory and common law claims for

securities fraud. The Court rejected this argument. The

defendants’ second argument was that the Rule 10b-5 cause

of action more closely resembled the blue sky cause of

action than the common law cause of action; therefore,

the two-year limitation period applied. The following

analysis was most revealing but not especially determina-

tive on the basis of defendants’ arguments.

The Court compared the Ohio Blue Sky Law, the com-

mon law action for fraud and the Rule 10b-5 cause of action

in regard to: (1) to whom the remedy was available;

(2) whether reliance was required; (3) whether scienter

was a necessary element; and (4) the scope of the recovery.

They found that both the Ohio common law of fraud and

blue sky statute bear a marked resemblance to the Rule

10b-5 cause of action although neither was identical with it.

Of importance is this statement:

We conclude that the common law of fraud is suffi-

ciently similar [emphasis added] to the case law de-

veloping under §10(b) and Rule 10b-5 that federal

policy will be best served by the continued application

of the four-year limitation period that we approved in

Connelly v. Balkwill, supra.

541 F. 2d at 618. The Court also relied upon IDS Pro-

gresswe Fund, Inc., supra, and further stated:

. we should not change the limitation period ap-

plicable to 10b-5 actions without “good cause” because

to do otherwise adds “unnecessary uncertainty to the

prosecution of federal claims under Section 10b-5.”

Moreover, we observe that the broad remedial pur-

poses of the federal securities acts are “best served by

a longer, not a shorter statute of limitations.” Apply-

ing these two principles to the case before us we hold

’%

that the four year fraud statute of limitations, upon

- which the parties may have relied, is applicable.

[citations omitted] 541 F. 2d at 618.

Therefore, the precedent set by the Sixth Circuit Court

of Appeals is not exact similarity with the state statute but

rather sufficient similarity for the continued application of

the common law fraud statute of limitations.

The Vanderboom line of cases, which defendants claim

to be the better reasoned as well as the majority view, could

be persuasive authority for this Court to consider. Con-

sequently, these cases deserve close analysis.

The Highth Circuit Court of Appeals decided Vander-

boom in 1970. It involved a suit based on Arkansas com-

mon law fraud as well as federal securities violations re-

lating to untrue statements or misleading omissions con-

nected with the purchase of securities. Arkansas had

adopted Section 410(e) of the Uniform Securities Act

which contained a two-year limitation period from the rele-

vant contract of sale. The Court of Appeals agreed with

the District Court in that the two-year limitation was

proper because it dealt “expressly with the sale of secu-

rities.’ 422 F. 2d at 1237. But their analysis went further

and they looked at each of the local statutes to determine

which bears the closest resemblance to the federal statute

involved, specifically Rule 10b-5.

They found that although Section 101 of the Uniform

Act as adopted by the State of Arkansas was a codification

of Rule 10b-5, it was not appropriate since it created no

private remedy. They found that Arkansas’ equivalent to

Section 410 of the Uniform Act which was modeled after

and parallels Section 12(2) of the Securities Act of 1933,

15 U.S.C.A. §77e(2), provided a civil remedy and was ap-

propriate for comparison with Rule 10b-5. They found that

’F

Rule 10b-5 and Section 410 were not identical; however,

neither required scienter which made them more analogous

than the common-law fraud cause of action. Of extreme

importance to the outcome of the case is the following

quotation:

In the case of Trussell v. United Underwriters Ltd.,

228 F. Supp. 757 (D. Col. 1964) the Court, following a

controlling 10th Circuit opinion, Rice v. United States,

149 F. 2d 601 (10th Cir. 1945), construed Rule 10b-5 to

require scienter and to be basically analogous to com-

mon law fraud. Under such a construction it was

perhaps correct to use the local statute of limitations

which specifically applied to common law fraud, rather

than the statute of limitations pertaining to the local

blue-sky law in which the private remedy was com-

parable to §12(2) of the Securities Act of 1933 which

provides recovery for negligent as well as knowing and

intentional misrepresentations. Similarly, in Charney

v. Thomas, supra, the Court held that the local blue-sky

private remedy (also taken from $410 of the Uniform

Securities Act and based upon §12(2) of the Securities

Act of 1933) was comparable to $12(2) and not to Rule

10b-5 and thus applied the state statute of limitations

applicable to fraud. However, the present rule im the

8th Circuit is that Rule 10b-5 applies to negligent as

well as intentional misrepresentations. [citations

omitted, emphasis added].

422 F. 2d at 1238.

With the enlightenment of Ernst ¢ Ernst v. Hochfelder,

supra, which held that Rule 10b-5 actions required scienter,

it is apparent that the Eighth Circuit Court of Appeals

would have found differently,

This reasoning is also quite pronounced in the Fifth

Circuit case of Hudak v. Economic Research Analyst, Inc.,

supra:

We concur in the reasoned judgments of the Seventh

and Highth Circuits which, when faced with the present

choice between a forum state’s fraud and blue sky

limitations periods for use in federal securities litiga-

tion, found the similarity between the blue sky and

10b-5 scienter requirements crucial to their determina-

tion. Parrent v. Midwest Rug Mills, Inc., 7 Cir. 1972,

455 F. 2d 123; Vanderboom v. Sexton, 8 Cir. 1970, 422

F. 2d 1233. Given the similarity of §517.301(1) and

Rule 10b-5, in both language and interpretation, and

the congruence between the specific remedy sought

here—return of the purchase money—and the remedy

of recission for which Florida securities law provides

a two-year statute, we hold that the district court erred

in applying the three-year fraud period. [emphasis

added].

499 F’. 2d at 1000.

Plaintiff urges the Court that cases subsequent to

Ernst & Ernst v. Hochfelder, supra, have adopted the ma-

jority view notwithstanding the incorrect interpretation of

the scienter requirement of Vanderboom. For this proposi-

tion, defendant relies upon Forrestal Village, Inc. v. Gra-

ham, 551 F. 2d 411 (D.C. Vir. 1977); McNeal v. Payne,

Webber, Jackson & Curtis, Inc., 429 F. Supp. 359 (N.D. Ga.

1977) ; and Bailey v. Piper, Jaffray € Hopwood, Inc., 414 F.

Supp. 475 (D. Minn. 1976).

In Forrestal Village, supra, the District of Columbia

Circuit Court of Appeals recognized that “some element of

scienter” is required under Section 10(b) of the Exchange

Act whereas the D.C. Act requires no more than negligence

but concluded;

Yet this possible difference between the federal statute

and the local statute is easily outweighed by their

similarities in both purpose and substance.

551 F. 2d at 414. The main similarity found between Sec-

tion 10(b) and the D.C. Act was that they both “deal ex-

pressly with the sale of securities.” Id.

The District Court for the Northern District of Georgia

considered the plaintiffs’ argument about the scienter re-

quirement in McNeal v. Paine, Webber, Jackson and Curtis,

Inc., supra, to be unpersuasive because the Georgia statute

still bears the closest resemblance to Rule 10b-5 and shares

a commonality of purpose with that rule. Without further

analysis the Court stated: “These factors clearly outweigh

any possible difference in the scienter requirements of the

two provisions.” 429 F. Supp. at 363.

In Bailey v. Piper, Jaffray € Hopwood, Inc. the District

Court of Minnesota entered into an extensive discussion

of the Hochfelder impact on the holdings of. Vanderboom

and the cases following it and concluded:

“The basic standard of Vanderboom for choosing

the appropriate limiiations provision—that which best

“ ‘effectuates the federal policy at issue’ ”—still stands

after Hochfelder. Also remaining is the exhortation

of Vanderboom to “. . . look to the local statute

which bears the closest resemblance to the federal stat-

ute involved.” (Citation omitted).

414 F. Supp. at 479. The Court further reasoned that:

Although the Minnesota Blue Sky Law did not have

any precise counterpart to Rule 10b-5 it is the statu-

tory scheme which bears the closest resemblance to the

federal securities law. The evidenced intent of the

legislature to prevent fraud in dealings of securities

°y

through a statutory scheme specifically concerned with

securities is sufficient to accord it a “commonality of

purpose” with the federal securities laws.

Id. at 482.

This Court agrees that this may well represent the trend

after Hochfelder; however, whether it is determinative in

the present action may be a different matter. The reason-

ing certainly does not coincide with the Sixth Circuit’s

view in Charney that the longer limitation of the more

difficult to prove common law cause of action is compatible

with the easier to prove statutory cause of action with the

shorter period of limitation. 372 F. 2d at 99.

Turning now to Kentucky law, the Court must analyze

each statutory and common law remedy to determine which

one “best effectuates the federal policy at issue” and apply

the appropriate limitation period to the federal claims here

present. There are two Kentucky statutory and one com-

mon law causes of action to compare.

KRS §292.320 (Supp. 1976) in pertinent part reads:

292.320. Fraudulent and other prohibited practices

(1) It is unlawful for any person, in connection with

the offer, sale or purchase of any security, directly or

indirectly :

(a) To employ any device, scheme, or artifice to

defraud;

(b) To make any untrue statement of a material

fact or to omit to state a material fact necessary in

order to make the statements made, in the light of the

circumstances under which they are made, not mis-

leading; or

business which operates or would operate as a fraud

or deceit upon any person.

’

KRS §292.480(1) (Supp. 1976) in pertinent part reads:

292.480 Civil liabilities

(1) Any person, who offers or sells a security in

violation of this chapter or of any rules and regula-

tions promulgated hereunder or offers or sells a secu-

rity by means of any untrue statement of a material

fact or any omission to state a material fact necessary

in order to make the statements made in the light of

the circumstances under which they are made not mis-

leading (the buyer not knowing of the untruth or omis-

sion) and who does not sustain the burden of proof

that he did not know and in the exercise of reasonable

care could not have known of the untruth or omission

is liable to the person buying the security from him,

who may sue either at law or in equity to recover the

consideration paid for the security, together with in-

terest at six percent per annum from the date of pay-

ment costs and reasonable attorneys’ fees, less the

amount of any income received on the security, upon

the tender of the security, or for damages if he no

longer owns the security. Damages are the amount

that would be recoverable upon a tender less (a) the

value of the security when the buyer is disposed of it

and (b) interest at six percent per annum from the

date of disposition.

The common law cause of action is illustrated by the

elements pointed out in Keck v. Wackers, 413 F. Supp. 1377,

1383 (E.D. Ky. 1976) :

The standard for actionable fraud is that the “mis-

representation must be made with knowledge of its

falsity or under circumstances that do not justify a

belief in its truth.” Walser v. Glenn, 400 S. W. 2d 223,

’%

224 (Ky. 1966). Similarly, it has been held that the

essential elements of actionable fraud are:

(1) that [the seller] made a material representation ;

(2) that it was false;

(3) that when he made it he knew it was false, or

made it recklessly, without any knowledge of its

truth and as a positive assertion;

(4) that he made it with intention of inducing [the

buyer] to act, or that it should be acted upon by

{the buyer];

(5) that [the buyer] acted in reliance upon it, and

(6) that [the buyer] thereby suffered injury.

Sanford Construction Co. v. S & H Contractors, Inc.,

supra, 443 S. W. 2d at 231, citing Crescent Grocery Co.

v. Vick, 194 Ky. 727, 240 S. W. 388 (1922).

The applicable limitations period for the two statutory

causes of action is three years, KRS §292.480(3), while the

applicable limitation period for the common law cause of

action is five years, KRS §413.120(12) (1964).

Following the cases cited above, the first area of com-

parison is concerned with the availability of remedies to

certain parties. It is apparent from its face that KRS

§292.480(1) provides a remedy only to a defrauded pur-

chaser while Section 10(b) and 14(e) of the Exchange Act

and Kentucky common law afford a remedy to the de-

frauded seller as well as the purchaser. The plaintiffs in

the instant case are defrauded sellers and KRS $292.480(1)

does not provide them with a civil remedy.

Defendants have argued that KRS §292.320(1) is the

appropriate statute since it would provide relief to a de-

frauded seller. On its face, KRS $292.320(1) only applies

to criminal sanction and does not expressly grant a civil

» tne ee

remedy ; however, it is defendants’ position that there is an

implied civil remedy much like what has developed under

Rule 10b-5. The defendants cite as authority for this im-

plied civil cause of action, Shermer v. Baker, 472 P. 2d 589

(1970) where the Washington State Court of Appeals held

such an implied cause of action could be maintained under

a statute much like KRS §292.320(1) patterned after Sec-

tion 101 of the Uniform Act.

Defendants further maintain that the Kentucky Court

of Appeals (now Supreme Court of Kentucky) in City of

Owensboro v. First U. S. Corporation, 534 S. W. 2d 789

(Ky. 1975) implied a civil cause of action under KRS

§$292.320(1) by citing it while applying the resemblance test

to Section 17(a) of the Exchange Act rather than making

the comparison between Section 17(a) and KRS §292.480(1).

Defendants further contend that the Kentucky legislature’s

election not to adopt Section 410(h) of the Uniform Act in

KRS §292.480 represents a clear indication that“. . . it

must have at least intended that KRS §292.320(1) (the

comparable provision to Section 101 of the Uniform Act)

could be the basis for an implied cause of action.” This

position apparently stems from the IDS Progressive Fund,

Inc. opinion where the Sixth Circuit Court of Appeals con-

sidered the official comments to Section 410(h) and deter-

mined that that Section expressly precluded such an im-

plied cause of action in Section 101. Section 410(h) pro-

vides for the preservation of rights and remedies existing

at law or equity in addition to any created by the civil

liability section of the law.

Unlike the Sixth Circuit Court of Appeals in Charney,

supra at 98, which relied upon the Supreme Court of Mich-

igan decision of Detwiler v. Glavin, supra, which expressly

held that the defrauded purchaser had his choice of rem-

edies, the Kentucky Court of Appeals in City of Owens-

boro, supra, has declared that KRS §292.320(1) represents

the exclusive remedy for a defrauded seller of securities.

The Court said:

The lot of the seller is made more onerous by the Blue

Sky Statute in misrepresentation cases when it allows

recovery where the seller “does not sustain the burden

of proof that he did not know and in the exercise of

reasonable care could not have known of the untruth

or omission, . . .” KRS 292.480(1) (emphasis sup-

plied). Some of the inhibiting strictures of the law of

misrepresentations are relaxed and the price exacted is

the shortened limitations period. It seems to us that

this is a matter of legislative policy. If the legislature

would choose to make the blue sky remedy for sale by

misrepresentation cumulative, it is free to do so, but

in our view it has not done so yet.

534 8. W. 2d at 791.

Recently, the United States District Court for the West-

ern District of Kentucky at Louisville in Payne v. Fidelity

Homes of America, Inc., No. C 74-345-L(B) (W.D. Ky.

Sept. 22, 1977) held that the three-year statute of limita-

tions in KRS §292.320 time-barred a defrauded purchaser

of securities. The Court principally relied upon the hold-

ing of City of Owensboro, supra, to distinguish its Ken-

tucky-forum case with Charney, supra, which arose in the

forum of Michigan.

We cannot disagree with the wisdom of that decision;

however, a distinction can and should be made between de-

frauded buyers and sellers. The instant case involves a

defrauded seller whereas all authority available considers

a defrauded buyer. A reading of the Draftsmen’s Com-

mentary to Section 101 of the Uniform Act (which is simi-

lar to KRS §292.320) makes this distinction apparent :

“At the same time, there is no clear need to create any

civil liability against buyers as distinct from sellers.

Although the lower federal courts have uniformly im-

plied a civil cause of action against fraudulent buyers

under the SEC rule, the federal courts when apply-

ing federal law do not have at their disposal all of

the common-law and equitable remedies of deceit and

rescission which are available to the state courts with-

out benefit of statute. In the area of civil liability,

moreover, it seems not only unnecessary but unwise to

disturb the general jurisprudence which has been de-

veloping with reference, for example, to the obligation

of corporate insiders to make affirmative disclosure

when purchasing from existing stockholder. On the

other hand, the general law is not adequate to deal with

flagrant cases of fraud by buyers on a criminal level.

and there can, of course, be no public action for an

injunction against such practices without specific statu-

tory authority.” [Emphasis added].

Therefore, notwithstanding the omission of Section

410(h) in the adoption of the Kentucky Blue Sky Laws

KRS $292.310 et seq., we find that the implied remedy, if

such exists, only applies to defrauded purchasers and not

to defrauded sellers.

The second phase of our analysis concerns the standard

of proof with respect to the wrongdoer’s knowledge of the

claimed untruth or omission (scienter). Because of the

Hochfelder decision, it is now clear and standard among

the circuits that something more than mere negligence is

necessary to maintain an action under Rule 10b-5 and by

analogy this would apply with equal force to Sections 14(e)

and 20 of the Exchange Act. In short, the federal claims

require “scienter.” KRS §292.480, in comparison, only ap-

plies the standard of negligence. It provides that one

“ . . who does not sustain the burden of proof that he

did not know and in the exercise of reasonable care could

not have known of the untruth or omission is liable to the

person buying the security from him. . . .” The common

law fraud action, in contrast, requires a specific showing

of knowing intent or scienter on the part of the defrauding

party. See Keck v. Wackers, supra.

The third factor to consider in our comparison is the

element of reliance on the part of the defrauded party.

A plaintiff need not allege or prove reliance when pursuing

his claim under KRS 4$292.480(1). On the other hand,

where an actual misrepresentation is involved, reliance

must be alleged and proved under a Rule 10b-5 cause of

action, Marx v. Computer Science Corp., 507 F. 2d 485, 491

(9th Cir. 1974) even though the requirement is relaxed in

the case of an omission to state a material fact. Affiliated

Ute Citizens v. United States, 406 U. S. 128, 154 (1972).

The common law cause of action requires that the de-

frauded person act in reliance of the material representa-

tion or omission. Keck v. Wackers, supra.

The final comparison to be made is concerned with the

relief available. Under Section 10(b), a defrauded party

may get rescission of the transaction or damages resulting

from the fraud. Affiliated Ute Citizens v. United States,

supra, at 155; Janigan v. Taylor, 344 F. 2d 781 (1st Cir.

1965), cert. denied, 382 U. S. 879 (1965); Myzel v. Fields,

386 F. 2d 718, 748 (8th Cir. 1967), cert. denied, 390 U. S.

951 (1968). The common law entitled the defrauded party

to compensation for every wrong which was the result of

the fraud. Joe-Lee, Inc. v. Francke, 531 8S. W. 2d 711

(Ky. 1976). Conversely, the remedy available under KRS

§292.480(1) simply is not appropriate since it affords a

remedy only to a purchaser and not a seller of securities.

One who retains possession of the securities may only re-

cover the consideration paid for the securities in addition

to court costs and reasonable attorneys’ fees.

In summary, we find that the Kentucky common law

cause of action is sufficiently similar to the federal claims

so as to make KRS $413.120(12), the five-year statute of

limitations for common law fraud actions, the most appro-

priate and the one which best effectuates the federal policy

at issue.

Shareholders’ Derivative Action Question

Paragraphs 39(b), 40 and 41(a) of plaintiffs’ amended

complaint request in the alternative to damages, that the

Cybernetics stock and options be restored to the plaintiffs

and that the defendants account for and restore to Cyber-

netics all sums wrongfully diverted or withheld from Cy-

bernetics. Just as the remedy of damage would restore to

the plaintiffs the reasonable value of the stock they were

fraudulently induced to sell, if the alternative remedy of

rescission is allowed, an accounting and restitution would

be appropriate to restore them to the prior value of their

holdings.

Defendants urge the Court that plaintiffs are not pres-

ently stockholders and cannot seek this relief. Although

Rule 23.1 of the Federal Rules of Civil Procedure only re-

quires that the plaintiffs be shareholders at the time of the

transaction of which they complain, defendants cite numer-

ous authorities that imply a condition of present stock-

holder status and thus relief should not be granted. The

Court does not find these authorities controlling because the

plaintiffs will in fact be present stockholders if the sale is

rescinded.

Without deciding whether damages or rescission is the

most appropriate remedy and without deciding the exact

measure of damages, we find that judicial economy would

not be furthered by deciding rescission of the sale in one

suit and then requiring the then plaintiff/stockholders to

bring an additional suit for an accounting and restitution.

The Court finds that the plaintiffs are not barred from

this relief simply because they are not presently stock-

holders of Cybernetics; nevertheless, just because the relief

is sought in the alternative in the procedural sense of Rule

8(a) of the Federal Rules of Civil Procedure does not im-

munize the plaintiffs from compliance with the technical

requirements of Rule 23.1. Therefore, paragraphs 39(b),

40 and 41(a) of the amended complaint and paragraphs

40(b), 41 and 42(a) of the original complaint shall be dis-

missed without prejudice. The Court, however, sua sponte,

grants the plaintiffs leave to amend their complaint so as

to conform to the technical requirements of Rule 23.1.

Pendent State Claims Question

Because the Court has not dismissed the federal claims

upon which subject matter jurisdiction has been conferred,

the question of dismissal of the state pendent claims is

moot.

Conclusion

For the above-stated reasons the Court Heresy Orpers

that the defendants’ motion for summary judgment insofar

as it relates to the issue of the applicable statute of limi-

tation be and is hereby OvERRULED.

Ir Is FurtHer Orperep that paragraphs 39(b), 40 and

41(a) of plaintiffs’ amended complaint and paragraphs

40(b), 41 and 42(a) of plaintiffs’ original complaint be

DisMissED without prejudice; however, plaintiffs shall have

leave of Court to amend their complaint so as to conform

to the technical requirements of Rule 23.1 of the Federal

Rules of Civil Procedure.

Ir Is FurtHer Orperep that defendants’ motion for

summary judgment relating to the pendent state claims be

OVERRULED.

James F’. Gordon

Date 11-1-77 Senior U. S. District Judge

’*%

IN THE

UNITED STATES DISTRICT COURT

FOR THE WESTERN DISTRICT OF KENTUCKY

Civil No. 77-0066-L(G)

JosepH A. CarorHers, Er At.

W. Tuomas Rice, Er At.

MEMORANDUM OPINION AND ORDER—Filed

March 3, 1978

John L, Carroll, Esquire, Evansville, Indiana, Law-

rence L. Pedley, Esquire, Louisville, Kentucky, William T.

Warner, Esquire, Louisville, Kentucky, and Robert P. Ross,

Esquire, Louisville, Kentucky, Counsel for the Plaintiffs.

Joseph E. Stopher, Esquire, Louisville, Kentucky, Ed-

ward H. Stopher, Esquire, Louisville, Kentucky, Robert C.

Moore, Esquire, Louisville, Kentucky, Oscar N. Persons,

Esquire, Atlanta, Georgia, F. Dean Copeland, Esquire, At-

lanta, Georgia, Franklin R. Nix, Esquire, Atlanta, Georgia,

and Jeffery P. Adams, Atlanta, Georgia, Counsel for De-

fendants.

Gordon, Senior United States District Judge.

This action is before the Court on defendants’ motion

to reconsider this Court’s order of November 7, 1977,

wherein it denied defendants’ motion to dismiss. Oral

arguments were heard January 9, 1978, in Louisville,

Kentucky.

The central issue of the original motion and the motion

for reconsideration concerns the statute of limitations to

be applied to plaintiffs’ claims under Sections 10(b), 14(e)

and 20 of the Securities Exchange Act of 1934, as amended,

15 U.S.C.A. §78a, et seq., and Ruie 10b-5 of the Securities

and Exchange Commission, 17 C.F.R. §240.10b-5. It is

settled that these sections have no explicit federal statute

of limitations, and federal courts should borrow the limi-

tation period proscribed by the forum state law which best

effectuates the federal policy at issue. Here is where the

problem arises. Defendants argue that the claims are

barred by the three-year statute of limitations applicable

to Kentucky’s blue sky laws, because they most closely re-

semble the federal claims. The plaintiffs, on the other

hand, argue their claims are still timely under the five-year

statute of limitations for common-law fraud in Kentucky.

In the Court’s November order, the defendants’ motion

to dismiss (treated as motion for summary judgment) was

overruled because the longer statute of limitation for com-

mon-law fraud was considered to be more reflective of the

federal policy underlying the present federal claims. Little

was added during the oral hearing on reconsideration of

that order to influence a change in this Court’s position;

nevertheless, the Court realizes that its position represents

a very “close call,” and there is substantial ground for

difference of opinion. This is especially so in light of the

decision of my colleague Judge Allen in Payne v. Fidelity

Homes of America, Inc., No. C-74-345-L(B) (W.D. Ky.

September 22, 1977), where he held that the blue sky, three-

year statute of limitations barred a defrauded purchaser

of securities. This case was distinguished by us because

the present plaintiffs are defrauded sellers of securities.

The Kentucky Court of Appeals (now Supreme Court) also

held in City of Owensboro v. First U. S. Corp., 534 S. W. 2d

789 (Ky. 1975) that the blue sky statute of limitations

would apply to the federal claim of a defrauded purchaser.

ied

Therefore, this Court’s decision, even though considered

well reasoned and the better approach, flies in the face of

two other Kentucky decisions. The majority of Circuit

Courts in other Circuits have also taken the contrary view.

The Sixth Circuit Court of Appeals’ prior treatment of

this question in Nichols v. Koehler Management Corp., 541

F. 2d 611, (6th Cir. 1976), I.D.S. Progressive Fumd, Inc. v.

First of Michigan Corp. 533 F. 2d 340 (6th Cir. 1976), and

Charney v. Thomas, 372 F. 2d 340 (6th Cir. 1967), because

of the differences in state law, has been of little benefit to

this Court in deciding the issue relative to Kentucky law.

The second matter taken under reconsideration involved

paragraph 39 (a) of the plaintiffs’ amended complaint.

Through an oversight, he Court did not mention this

paragraph in its November order. The Court agrees with

defendants in that this paragraph is derivative in nature

and should be presented in accordance with Rule 23.1 of the

Federal Rules of Civil Procedure. Therefore, just as para-

graphs 39(b), 40 and 41(a) of the amended complaint,

paragraph 39(a) should be dismissed without prejudice

until such time as the plaintiffs amend their complaint so as

to conform to the technical requirements of Rule 23.1.

Therefore,

It Is OrnprErEpD that defendants’ motion for reconsidera-

tion of this Court’s November order be, and is hereby,

OVERRULED.

However, pursuant to 28 U.S.C. §1292(b), this Judge

is of the opinion that this order involves a controlling

question of law as to which there is substantial ground for

difference of opinion and that an immediate appeal from

the order may materially advance the ultimate termina-

tion of the litigation and prays that the Court of Appeals

will accept said interlocutory appeal on our “close call” so

that defendants not improperly be subjected to extensive

preparation for the defense hereof and the large attorney

fees involved in such in the event we should be held in error.

Ir Is FurrHer Orperep that paragraph 39(a) of the

amended complaint and its corresponding paragraph in the

original complaint be Dismissep without prejudice.

(s) James F. Gordon

' Senior U. S. District Judge

Date March 1, 1978

UNITED STATES COURT OF APPEALS

FOR THE SIXTH CIRCUIT

No. 78-3366

JosepH A. CarotHers, Paut L. ScHMETzER,

JosePpH A. Muncovan and Davin E. Fuanican,

Individually and as Representative of a Class

of Certain Shareholders and Stock Option

Holders of Cysernetics & Systems, Ino.,

a Delaware Corporation, - - Plawntiffs-Appellees;

Vv.

W. Tuomas Rice,

Prime F’, Ossorn,

Cysernetics & Systems, Inc. ;

L & N Investment Corporation;

LovIsvVILLE AND NASHVILLE RatLroap CoMPANY;

Seasoarp Coast Linge Rartroap Company; and

Seaspoarp Coast Line InpustrRikEs, Ino.

Defendants-A ppellants.

Appeal from the United States District Court

for the Western District of Kentucky

at Louisville

Argued March 31, 1980 Decided September 15, 1980

OPINION

Before Brown, Kennepy and Jonzgs, Circuit Judges.

Franklin R. Nix, Uscar N. Persons, Alston, Miller &

Gaines, F. Dean Copeland, Jeffrey P. Adams, Altanta, Ga.,

Joseph E. Stopher and Edward H. Stopher, Boehl, Stopher,

Graves & Deindoerfer, Louisville, Ky., for defendants-

appellants.

John L. Carroll, Johnson, Carroll & Griffith, Professional

Corp., Evansville, Ind., Lawrence L. Pedley, William T.

Warner, Robert P. Ross, Wood, Goldberg, Pedley & Stans-

bury, Louisville, Ky., for plaintiffs-appellees.

Before: Brown, Kennepy and Jonss, Circuit Judges.

Cornetia G. Kennepy, Circuit Judge: We permitted

an interlocutory appeal in this case to decide what statute

of limitations should be applied to a claim under $10(b) of

the Securities and Exchange Act of 1934 (1934 Act) (15

U.S.C. §78j(b)) and rule 10b-5 of the Securities and Ex-

change Commission filed in Kentucky. Appellees filed their

complaint in the United States District Court for the West-

ern District of Kentucky alleging that they were fraudu-

lently induced to sell their stock in Cybernetics Systems,

Ine. by appellants’ misrepresentations and omissions in a

tender offer in violation of §10(b) and rule 10b-5 and the

laws of Kentucky, Delaware, and Virginia. They prayed

for damages or, alternatively, rescission. Appellants moved

to dismiss on the ground that the action was time-barred by

the three year statute of limitations in Kentucky’s Blue Sky

Law, Ky. Rev. Stat. Ann. §292.480(3). The District Court

denied the motion, holding that the action was timely under

Kentucky’s five year statute of limitations for claims based

on fraud, Ky. Rev. Stat. Ann. §413.120(12). He certified

the choice of the five year statute under 28 U.S.C. §1292(b)

as a controlling question of law as to which there is sub-

stantial ground for difference of opinion.

There is no federal statute of limitations for §10(b) and

rule 10b-5 actions. The private cause of action against one

who violates their terms was not expressly granted. Rather,

after numerous district courts and court of appeals found

an implied private cause of action, the United States Su-

preme Court confirmed that such a cause of action did exist.

In the absence of a federal statute of limitations, this Court

Ss;

°°

must look to the statutes of the forum state, Kentucky, and

apply that which best effectuates the purposes of the federal

securities laws. See Ernst & Ernest v. Hochfelder, 425

U. S. 185, 210 n.29 (1976) ; Gaudin v. KDI Corp., 576 F. 2d

708, 711 (6th Cir. 1978) ; Charney v. Thomas, 372 F. 3d 97,

100 (6th Cir. 1967).

Appellants argue the blue sky law should apply as de-

frauded sellers have an implied remedy therein; the crim-

inal liability section, Ky. Rev. Stat. Ann. §292.320(1), is

virtually identical with rule 10b-5; the blue sky law has the

same purpose as the federal securities laws; Kentucky has

held that its blue sky law contains the sole appropriate

limitation period for a federal claim by a purchaser of se-

curities, induced by a misrepresentation, against the seller;

and shorter, not longer, statutes of limitations better effec-

tuate the purpose behind the federal securities laws. Ap-

pellees argue that the common law fraud action is closed

to a 10b-5 claim than a claim under Kentucky’s Blue Sky

Law as defrauded sellers do not have a remedy under the

blue sky law; both 10b-5 and fraud actions require scienter

while the blue sky law claim does not; both 10b-5 and fraud

actions require the plaintiff to have relied upon the mis-

representation while the blue sky law does not; both 10b-5

and fraud actions allow rescission or damages but the blue

sky law only allows damages if the plaintiff no longer

possesses the securities; and longer, not shorter, statutes

of limitations better effectuate the purposes behind the

federal securities laws.

Section 413.120(12) provides that an “action for relief

or damages on the ground of fraud or mistake” shall be

commenced within five years after the cause of action

accrued.

Section 292.320(1) provides:

(1) It is unlawful for any person, in connection

with the offer, sale or purchase of any security, directly

or indirectly:

(a) to Employ any device, scheme, or artifice to

defraud;

(b) To make any untrue statement of fact or to

omit to state a material fact necessary in order to

make the statements made, in the light of the circum-

stances under which they are made, not misleading; or

business which operates or would operate as a fraud or

deceit upon any person.

An express civil remedy is provided in §292.480(1) :

(1) Any person, who offers or sells a security in

violation of this chapter or of any rules and regulations

promulgated hereunder or offers or sells a security by

means of any untrue statement of a material fact or

any omission to state a material fact necessary in order

to make the statements made in the light of the cir-

cumstances under which they are made not misleading

(the buyer not knowing of the untruth or omission)

and who does not sustain the burden of proof that he

did not know and in the exercise of reasonable care

could not have known of the untruth or omission is

liable to the person buying the security from him, who

may sue either at law or in equity to recover the con-

sideration paid for the security, together with interest

at six percent per annum from the date of payment

costs and reasonable attorneys’ fees, less the amount

of any income received on the security, upon the ten-

der of the security, or for damages if he no longer

owns the security. Damages are the amount that would

’%

be recoverable upon a tender less (a) the value of the

security when the buyer is disposed of it and (b) in-

terest at six percent per annum from the date of

disposition.

This remedy is limited by a three year statute of limi-

tations provided in §292.480(3).

Kentucky’s Blue Sky Law only expressly provides a

civil remedy for defrauded purchasers; it provides a civil

remedy for defrauded sellers like the appellees only if such

a remedy can be implied. If no remedy can be implied, it

would be improper to apply the statute of limitations from

the blue sky law.

Since the standard for determining the applicable

‘statute of limitations is to select the statute that best

effectuates the federal polcy involved, it is appropriate

to look to the local statute which bears the closest re-

semblance to the federal statute involved.

Vanderboom v. Sexton, 422 F. 2d 1233, 1237-38 (Sth

Cir.), cert. denied, 400 U. S. 852 (1970). If a plaintiff

could bring his federal securities claim under state com-

mon law, but could not bring any such claim under state

blue sky law, the state blue sky law could hardly be said

to bear tl} closest resemblance to the federal statute.

Kentucky’s Blue Sky Law is largely drawn from the

Uniform Securities Act (U.S.A.).. Appellants argue a

cause of action for defrauded sellers can be implied both

from the language and from the language not adopted from

that Act.

Section 292.320(1) is almost an exact copy of U.S.A.

§101, which provides:

It is unlawful for any person, in connection with the

offer, sale, or purchase of any security, directly or

indirectly

(1) to employ any device, scheme, or artifice to

defraud,

(2) to make any untrue statement of a material fact

or to omit to state a material fact necessary in order

to make the statements made, in the light of the cir-

cumstances under which they are made, not misleading,

(3) to engage in any act, practice, or course of

business which operates or would operate as a fraud

or deceit upon any person. :

The comments to $101 explain that §101 is taken sub-

stantially from rule 10b-5, which was modeled after §17(a)

of the Securities Act of 1933 (1933 Act).1 Implied remedies

under rule 10b-5 have been extended only to defrauded

purchasers and defrauded sellers. See Blue Chip Stamps v. —

Manor Drug Stores, 421 U. S. 723 (1975); Gaudin v. KDI

Corp. supra, 576 F. 2d at 711.

U.S.A. provides expressly for civil liability for de-

frauded purchasers in $410, which is similar to §292.480(1)

except that the Kentucky legislature did not adopt §410(h)

of U.S.A.. It is section 410(h) which provides that the

1Rule 10b-5 (17 C.F.R. §240.10b-5) read as folows:

§240.10b-5 Employment of manipulative and deceptive devices.

It shall be unlawful for any person directly or indirectly, by the

use of any means or instrumentality of interstate commerce, or of

the mails or of any facility of any national securities exchange.

(a) To employ any device, scheme, or artifive to defraud,

(b) To make any untrue statement of a material fact or to

omit to state a material fact necessary in order to make the

statements made, in light of the circumstances under which

they were made, not misleading, or

(ec) To engage in any act, practice, or course of business

which operates or would operate as a fraud or deceit upon any

person, in connection with the purchaser or sale of any security.

statutory remedies shall be in addition io the remedies

provided at common law and that no remedies shall be

implied under the statute except as are expressly provided

for in §410.2, The comments to $410 clearly proscribe any

implication of a remedy for defrauded sellers even though

private causes of action have been implied under rule 10b-5

for defrauded sellers as well as for defrauded purchasers.

U.S.A., in §§414(a) and 414(b), applies §410 to any per-

son who sells or offers to sell, but does not apply $410 to

any person who buys or offers to buy.

The Kentucky legislature did not enact §410(h) of

U.S.A., nor did it enact §§414(a) and 414(b). The failure

to enact these section indicates that the Kentucky legisla-

ture, unlike the drafters of U.S.A., did not intend to pre-

clude implied remedies under the Kentucky Blue Sky Law

similar to implied remedies under rule 10b-5. Compare

LaRosa Building Corp. v. Equitable Life Assurance Society

of United States, 542 F. 2d 990, 993 (7th Cir. 1976) (court

concluded defrauded sellers had a remedy under Illinois

Blue Sky Law as legislature originally had enacted sub-

section (h) precluding implied remedies but then repealed

it).

Further, Kentucky intended its blue sky law to be co-

ordinated with federal securities acts. Section 292.530

provides that the blue sky law “shall be so construed as to

effectuate its general purpose to make uniform the law of

those states which enact it and to coordinate the interpre-

tation and administration of this chapter with the related

federal regulation.” By itself this section would not neces-

*Section 410(h) provides:

(h) the rights and remedies provided by this act are in

addition to any other rights or remedies that may exist at law

or in equity, but this act does not create any cause of action

not specified in this section. . . .

sarily imply a remedy for defrauded sellers merely because

federal law implies one as U.S.A. also contains such lan-

guage and U.S.A. expressly prohibits the implication of an

implied remedy for defrauded sellers. However, combined

with the failure to enact §410(h) of U.S.A., this section is

persuasive evidence that the Kentucky legislature intended

to allow implied remedies under its blue sky law to match

those under rule 10b-5.

Kentucky case law, while not specifically addressing

this point, is not adverse to implied remedies. Before Ken-

tucky passed its present blue sky law based upon U.S.A.,

two cases came bofer Kentucky’s highest court in which

plaintiffs had argued the blue sky law then existing applied

only where the seller of a security had failed to comply

with the requirements of the Act and did not apply to com-

plaints in which plaintiffs alleged they were induced to

purchase securities by fraud and misrepresentation. Those

plaintiffs argued that the statute of limitations provided in

the blue sky law did not apply to pre-existing common law

remedies for claims based on fraud but only applied to

the new remedies created in the Act. The Kentucky court

disagreed. It held that since the blue sky law also gave a

remedy to defrauded purchasers, the statute of limitations in

the blue sky law barred plaintiffs’ claims. See First State

Bank of Pineville v. Slusher, 267 Ky. 190, 101 S. W. 2d 661

(1937) ; Thomas v. Fidelity € Casualty Co. of N.Y., 258 Ky.

360, 80 S. W. 2d 8 (1935). In Slusher, the Kentucky court

also rejected the argument that the blue sky statute of

limitations for damages did not apply to a suit for rescis-

sion in equity.

The Kentucky Supreme Court considered its current blue

sky law in City of Owensboro v. First U. S. Corp., 534

®The fact that the drafters of the U.S.A. felt it necessary to

expressly prohibit an implied cause of action is a recognition of

the broad acceptance of the implied cause of action.

S. W. 2d 789 (Ky. 1975). A defrauded purchaser’s claim

under Kentucky law was dismissed as, time-barred under

§292.480(3). The court said that the Kentucky Blue Sky

Law had been judicially construed to afford a remedy to a

purchaser induced by misrepresentation to buy securities

and that the proper statute of limitations was the one in

the blue sky law. The revisions in 1960 and 1972 were not

intended to change the result in Slusher. Indeed, the new

law now expressly gave a civil remedy to a defrauded pur-

chaser in §292.480(1). The court held that the blue sky

law was meant to be the exclusive remedy; some of the

inhibiting strictures of the law of misrepresentation were

relaxed and the price enacted was the shortened limitations

period. 5348. W. 2d at 791.

Appellees seek to distinguish defrauded sellers from

defrauded buyers. True, the language of §292.480(1) only

expressly applied to defrauded purchasers. The drafters

of U.S.A. explicitly recognized and warned against the

likelihood of implied remedies similar to those implied

under rule 10b-5 unless §410(h) was enacted to prevent im-

plied remedies. The Kentucky legislature could easily have

enacted §410(h) of U.S.A. to avoid implied remedies, but it

did not do so. Appellees argue that defrauded sellers would

have less opportunity to discover the fraud after the sale

than defrauded purchasers as the sellers would no longer

be connected with the corporation and would not receive

any information from the corporation. This argument

assumes that the owner of the shares would be likely to

receive information from the corporation that would indi-

cate fraud or misrepresentations, which is doubtful. As-

suming that the share owner would be likely to receive

helpful information, the defrauded seller would have been

receiving information before he sold and would probably

be in as good a position to detect fraud at the time of sale

as the buyer would be after the sale. To the extent the

’%

. ie

misrepresentations becomes evident through independent

sources of information, neither buyer nor seller is in a

better position to detect fraud. The purpose of the blue

sky law “is to protect the public from fraud, deceit, and im-

position in the sale of securities”. Thomas, supra, 258 Ky.

at 364. A person does not by merely buying a share of stock

become more sophisticated, informed, less in need of pro-

tection, or more likely to discover fraud when he turns

around to sell that share of stock. We hold that Kentucky

would imply a remedy for defrauded sellers under

§292.320(1) which prohibits any misrepresentation or omis-

sion of a material fact in connection witn the sale or

purchase of securities.*

4Our colleague in dissent does not agree that Kentucky would

imply a remedy for defrauded sellers under §292.320(1), relying

in part upon Cort v. Ash, 422 U. S. 66 (1975), and progeny. How-

ever, we feel that reliance is misplaced. Cort and progeny dealt

with an issue not present in the present case—that is, whether or

not a federal cause of action may be implied from a federal statute.

As the federal government is theoretically one of limited powers

rather than one with general police powers, a court implying a

federal right must be certain that a federal remedy was intended

by the legislature rather than leaving the plaintiff to his common

law and statutory remedies available in the state courts. Here,

this Court need not decide whether or not a federal remedy should

be implied—the Supreme Court has already recognized that there

is an implied remedy for defrauded sellers under §10(b) of the

1934 Act. See Ernst & Ernst v. Hochfelder, 425 U. S. 185, 196

(1976) ; Blue Chip Stamps v. Manor Drug Stores, 421 U. 8S. 723

(1975). Rather, the issue before this Court is whether or not

Kentucky would imply a state cause of action under its state

statute which is similar to the federal cause of action. The first

and fourth factor to which Cort points—whether or not the statute

creates a federal right in favor of the plaintiff and whether or not

the cause of action is one traditionally relegated to state law (see

note 1 of Judge Jones’ dissent )—clearly are not applicable. The

(Footnote continued on next page)

7 eS

Appellees argue that even if a remedy for defrauded

sellers may be implied under §292.320(1), the three year

statute of limitations in §292.480(3) would not apply as

§292.480(3) applies only to civil remedies created by “this

section”, that is, §292.480. They argue an implied remedy

under §$292.320(1) is not a remedy created by §292.480.

However, Kentucky does not limit the appiication of the

statute of limitations in §292.480(3) to civil actions created

by §292.480(1). In Owensboro, supra, the Kentucky Su-

preme Court applied §292.480(3) to a federal securities

claim under §17(a) of the 1933 Act which it held to be simi-

lar to §292.320. It found that the blue sky limitation was

“the most appropriate state statute applicable” to the claim.

It would be anomalous to have one statute of limitations

for sellers and another for purchasers. Thus, we conclude

that the defrauded sellers’ implied remedy under Ken-

tucky’s Blue Sky Law is limited by the three year statute of

limitations in §292.480(3).

II.

We now must consider which statute of limitations

should apply to a federal securities claim under §10(b) and

rule 10b-5 by determining whether the implied remedy un-

der Kentucky’s Blue Sky Law or the common law fraud

cause of action more nearly resembles the federal cause

of action. This Court has previously chosen the statute of

limitations applied to common law fraud actions when con-

(Footnote continued from preceding page)

second and third factors—what was the legislative intent and

what is legislative purpose—are logical questions to ask whether

the court is implying a state cause of action or implying a federal

cause of action. To that extent, Kentucky would probably follow

Cort in determining whether or not a private action existed under

§292.320(1) as, indeed, we have.

, ee 4

sidering Michigan and Ohio statutes. In each instance it

made a careful examination of the state’s law. Because

the law of Kentucky differs from that of Michigan and Ohio,

' those cases are distinguishable.

In Charney, supra, this Court used the limitations period

for common law fraud even though a fraud action was not

identical to a rule 10b-5 action because Michigan had no

provision similar to §10(b). After that case was decided,

Michigan repealed its blue sky law and adopted the U.S.A.

This Court again considered the limitations question in

IDS Progressive Fund, Inc. v. First of Michigan Corp., 533

F. 2d 340 (6th Cir. 1976). The Court continued to apply

the common law fraud limitations period. It held Michigan

still had no provision similar to §10(b), as §101 of U.S.A.

enacted by Michigan was exclusively a criminal statute.

Significantly, Michigan had also enacted §410(h) of U.S.A.

precluding any implied remedies other than those in §410.

The Court did not feel it had a sufficiently compelling rea-

son to change the period applicable to federal securities

claims in Michigan.

The Court used the same rationale in Nickels v. Koehler

Management Corp., 541 F. 2d 611 (6th Cir. 1976), cert.

denied, 429 U. S. 1074 (1977), followed in Gaudin, supra.

An earlier case. Connelly v. Balkwill, 279 F. 2d 685 (6th

Cir. 1960), had applied without discussion Ohio’s four year

statute of limitations for fraud actions to a federal se-

curities claim rather than the general six year statute of

limitations. The limitations period of the blue sky statute

was not raised in Connelly. Ohio also had a section similar

to §410(h) of U.S.A. The Court in Nickels concluded both

common law fraud and blue sky remedies were similar to a

rule 10b-5 claim and held that common law fraud was suf-

ficiently similar to rule 10b-5 claims to continue using the

common law fraud limitations period. To change the stat-

ute of limitations for federal 10b-5 claims, would increase

° >

uncertainty. In addition, see United California Bank v.

Salik, 481 F. 2d 1012, 1015 (9th Cir.), cert. dented, 414 U.S.

1004 (1973); but see Fox v. Kane-Miller Corp., 542 F. 2d

915 (4th Cir. 1976).

The present case does not involve a state blue sky law

which precludes implied remedies similar to those implied

under rule 10b-5. Rather, as we have held, it would permit

such a remedy. Nor has this Court previously ruled on the

appropriate statute of limitations to be applied in Ken-

tucky. Thus, we are not limited in our choice by a desire

to avoid increasing uncertainty.

Other circuits have chosen common law fraud limitations

periods over blue sky limitations periods. See McNeal v.

Paine, Webber, Jackson & Curtis, Inc., 598 F. 2d 888 (5th

Cir. 1979) ; Clegg v. Conk, 507 F’. 2d 1351 (10th Cir. 1974),

cert, denied, 422 U.S. 1007 (1975) ; Salik, supra. However,

Salk applied the common law fraud limitations period

because that period had been applied before California

enacted its blue sky law and the Court did not want to

change the federal statute of limitations every time the

state changed its law. McNeal used the common law fraud

limitations period because Georgia’s Blue Sky Law was

limited to an action for rescission and did not allow re-

covery for damages.

The majority of circuits have applied blue sky law limi-

tation periods rather than limitation periods for fraud

actions to rule 10b-5 claims. See Morris v. Stifel, Nicholaus

& Co., Inc., 600 F. 2d 139 (8th Cir. 1979) ; Forrestal Village,

Inc. v. Graham, 551 F. 2d 411. 179 U. S. App. D.C. 225

(D.C. Cir. 1977); LaRosa Building Corp., supra; Berry

Petroleum Co. v. Adams & Peck, 518 F. 2d 402 (2d Cir.

1975); Hudak v. Economic Research Analysts, Inc., 499

F. 2d 966 (5th Cir. 1974), cert. denied, 419 U.S. 1122 (1975) ;

Parrent v. Midwest Rug Mills, Inc., 455 F. 2d 123 (7th Cir.

1972); Vanderboom, supra. One court has applied the

state blue sky law statute of limitations to a federal se-

curities claim arising under §17(a) of the 1933 Act. See

Newman v. Prior, 518 F. 2d 97 (4th Cir. 1975). Most of

these cases involved defrauded purchasers, but Fox in-

volved a defrauded seller. These courts relied upon the

state blue sky law because those laws had a common pur-

pose with the federal securities laws, similar defenses, or

similar remedies.

The purpose of the federal securities laws is to substi-

tute the philosophy of full disclosure for that of caveat

emptor and thus to achieve a high standard of business

ethics in the securities industry. See Affiliated Uts Citizens

of Utah v. United States, 406 U. S. 128, 151 (1972). Both

rule .10b-5 and the Kentucky Blue Sky Law deal with

fraud in the sale of securities, whether perpetrated by seller

or buyer.

Actions based on securities fraud are distinguishable

from general actions for fraud. Some of the inhibiting

strictures of the law of misrepresentation are relaxed under

the blue sky law. See Hutto v. Bockweg, 579 S. W. 2d 382

(Ky. App. 1979). To sue for misrepresentation, the plain-

tiff must prove that the misrepresentation was made with

knowledge of its falsity or under circumstances that do not

justify a belief in its truth and that the plaintiff relied

upon the misrepresentation to his detriment. See Keck v.

Wacker, 413 F. Supp. 1377, 1383 (E.D. Ky. 1976) ; Jo’Lee,

Inc. v. Francke, 531 8. W. 2d 711 (Ky. 1976) ; Sanford Con-

struction Co. v. S & H Contractors, Inc., 443 8S. W. 2d 277,

231 (Ky. 1969). The blue sky act does not require the

plaintiff to prove scienter—rather the defendant must prove

he did not know or could not have reasonably known of the

untruth or omission, see Owensboro, supra, 534 8. W. 24 at

791, nor does it require proof of reliance upon the misrepre-

sentation. Ky. Rev. Stat. Ann. §292.480(1). One may sue

for rescission under the common law of fraud, see Keck,

supra, or for actual damages sustained, see Jo’Lee, supra;

Sanford, supra, 443 8S. W. 2d at 236-37, 239. Under the

blue sky law, a buyer may sue for the consideration paid

upon tender of the securities. The buyer may only sue for

damages if he no longer owns the security, to be measured

by the amount that would have been available upon tender

less the value of the security when the buyer disposed of

them. Ky. Rev. Stat. Ann. §292.480(1).

A plaintiff bringing a suit under $10(b) and rule 10b-5

does not have to prove he relied upon omissions of material

fact. See Affiliated Ute Citizens, supra, 406 U. S. at 152-54.

However, he does have to prove scienter—mere negligence

is not enough. See Ernst & Ernst v. Hocl.felder, 425 U. S.

185 (1976). The Supreme Court left open the question

whether proving recklessness would satisfy the scienter

requirement. See 425 U.S. at 194 n.12. Damages for the

defrauded sellers are determined by the difference from the

fair value of what was received and what would have been

received had there been no fraud. See Affliated Ute Citi-

zens, supra, 406 U.S. at 155.

Neither the Kentucky common law of fraud nor the blue

sky law is exactly like the rule 10b-5 action. The blue sky

law has the same language and the same specific purpose;

the common law of fraud has a similar defense of lack of

scienter. Other courts have held that the commonality of

purpose of the blue sky law weighed more than the com-

mon defense of lack of scienter of the common law action.

See Morris, supra; Forrestal Village, Inc., supra; Berry

Petroleum Co., supra.

This Court has previously said that the broad remedial

purposes of the federal securities laws are best served by

longer, not shorter, statute of limitations, See Nickels,

supra, 541 F. 2d at 618; IDS Progressive Fund, supra, 533

F’. 2d at 344. In addition, see Berry Petroleum Co., supra,

518 F. 2d at 409; Salik, supra, 381 F. 2d at 1015. But the

reason for using the longer statute of limitations for a

federal securities claim is tu give the person with a federal

claim at least as long an opportunity to sue as a person

with a state claim. See Berry Petroleum Co., supra, 518

F. 2d at 409. The Kentucky Supreme Court has held that

its blue sky law is the exclusive remedy for fraud in the

sale of securities. See Owensboro, supra, 534 F. 2d at 791.

The strict requirements of misrepresentation have been

relaxed and the price exacted is a shortened statute of limi-

tations, Jd. A plaintiff is also relieved from proving all

the elements of misrepresentation with his rule 10b-5 ac-

tion; thus, it is reasonable to apply the shortened statute

of limitations. Given that the language of §$292.320 is

nearly identical with rule 10b-5, that both statutes have the

same purpose, and that neither requires the plaintiff to

prove all that is required under common law of misrepresen-

tation, we hold that the proper statute of limitations is the

three year statute of limitations in Kentucky’s Blue Sky

Law, §292.480(3), and appellees’ claims under §10(b) of

the 1934 Act and rule 10b-5 are therefore time-barred. The

decision of the District Court is reversed and the cause

remanded for proceedings consistent with this opinion.

[DISSENTING OPINION]

Jones, Circuit Judge, dissenting: Because I believe the

language of Kentucky’s “Blue Sky” Statute envinces an un-

ambiguous legislative intent to deny a_private cause of

action to defraud sellers of securities and because prece-

dent in this Circuit establishes our policy in favor of longer,

not shorter, statute of limitations in securities fraud cases,

I respectfully dissent.

Plaintiffs allege fraud in the sale of their securities in

violation of §§10(b) and 14(c) of the Securities Exchange

Act of 1934, 15 U.S.C. $78 et seq. The applicable statute

of limitations period for plaintiffs’ claims of fraud is the

Kentucky statute of limitations for the state action which

most closely resembles the federal claims and which best

effectuate federal policy. Nickels v. Kochler Management

Corp., 541 F. 2d 611, 612, 615 (6th Cir. 1976).

Kentucky’s “Blue Sky” Statute, Ky. Rev. Stat. Ann.

§292.310 et seq., applies a three-year limitations period to

state law claims of securities frauds, however the statute

does not provide a cause of action to defrauded sellers of

securities. Clearly, as the majority asserts, a state statute

that denies to these plaintiffs a claim for relief cannot be

characterized as closely resembling their federal claims or

as effectuating federal policy. Alternatively, plaintiffs

have a claim for relief in common law fraud. The appli-

cable statute of limitations is five years. Rather than apply

this five-year statute of limitations to plaintiffs’ federal

securities law claim, the majority puts on its legislative

robes, and, in violation of the most basic principles of statu-

tory construction and established precedent in this Circuit,

creates an implied cause of action for defrauded sellers of

securities under Kentucky’s “Blue Sky” statute.

II.

The threshold question in this case is whether to imply

a cause of action for defrauded sellers of securities under

the anti-fraud section of Kentucky’s “Blue Sky” statute,

§229.320(1), so that it may be construed to closely resemble

federal claims and effectuate federal policy. Kentucky

jurisprudence has not specifically addressed the question

of implied causes of action in statutes. However, implying

a cause of action in a statute is a task of statutory construc-

tion. To decide the question presented, Kentucky courts

would apply basic principles of statutory construction and

would reason from the criteria federal courts follow to

imply causes of action in federal statutes.’

1See Touche Ross & Co. v. Reddington, 99 S.Ct. 2479 (1979) ;

United States v. Naftalin, 99 S.Ct. 2077 (1979) ; Cannon v. Uni-

versity of Chicago, 99 St.Ct. 1946 (1979) ; Cort v. Ash, 422 U. S.

66 (1975); and National Railroad Passenger Corp. v. National

Association of Railroad Passengers, 414 U.S. 453 (1974). The ma-

jority opinion dot not acknowledge or discuss these recent decisions.

In Cort, the Supreme Court established the following oft-cited

four-prong inquiry to guide judicial decisions to imply private

causes of action in federal statutes:

In determining whether a private remedy is implicit in a

statute not expressly providing one, several factors are rele-

vant. First, is the plaintiff ‘‘one of the class for whose especial

benefit the statute was enacted,’’ Texas & Pacific R. Co. v.

Rigsby, 241 U. S. 33, 39 (1916) (emphasis supplied )—that is,

does the statute create a federal right in favor of the plaintiff?

Second, is there any indication of legislative intent, explicit or

implicit, either to create such a remedy or to deny one? See

e.g., National Railroad Passenger Corp. v, National Assn. of

Railroad Passengers, 414 U. 8. 453, 458, 460 (1974) (Amtrak).

Third, is it consistent with the underlying purposes of the

legislative scheme to imply such a remedy for the plaintiff?

See, ¢.g., Amtrak, supra; Securities Investor Protection Corp.

v. Barbour, 421 U. 8. 412, 423 (1975) ; Calhoon v. Harvey, 379

U. S. 184 (1964). And finally, is the cause of action one tra-

ditionally relegated to state law, in.an area basically the concern

of the States, so that it would be inappropriate to infer a cause

of action based solely on federal law? See Wheeldin v. Wheeler,

373 U. 8. 647, 652 (1963) ; ef. J. I. Case Co. v. Borak, 377 U. S.

426, 434 (1964); Bivens v. Sic Unknown Federal Narcotics

Agents, 403 U. 8. 388, 394-385 (1971) ; id.; at 400 (Harlan J.

concurring in judgment).

422 U.S. at 78.

For an excellent analysis of precedent in this area, see Stein-

burg. Implied Private Rights of Action Under Federal Law, 55

The Notre Dame Lawyer 33 (1979).

The majority’s holding is premised upon the Kentucky

legislature’s: (1) failure to enact a clause proseribing the

implication of a private cause of action for defrauded

sellers; and (2) enactment of a guide to courts to interpret

the “Blue Sky” statute consistent with the federal securities

acts and decisions of other state courts.

The majority’s reliance on the Kentucky’s legislature’s

failure to enact language prohibiting judicial creation of a

private cause of action is misplaced. First, the primary

principle of statutory construction is that legislative intent

is ascertained from the words of the statute, rather than

judicial surmising of what may have been intended but nat

expressed. Although §292.320 of Kentucky’s “Blue Sky”

statute prohibits fraud in the purchase or sale of securities,

section 292.480 of the statute sets forth an express private

cause of action to enforce the anti-fraud provisions which

is explicitly limited to defrauded purchasers. As articu-

lated in the seminal decision of Cort v. Ash, 422 U. S. 66

(1975) :

In situations in which it is clear that federal law

has granted a class of persons certain rights, it is

not necessary to show an intention to create a private

cause of action, although an explicit purpose to deny

such a cause of action would be controlling.

Id. at 82 (emphasis in original). In Cort the Supreme

Court reaffirmed its earlier holding in National Railroad

Passenger Corp. v. National Association of Railroad Pas-

sengers, 414 U. S. 453, 456 (1974); (“Amtrak”), that the

enactment of an express private cause of action explicitly

limited in scope is evidence of a purpose to deny any other

cause of action.? This frequently stated principle, derived

from the ancient maxim—expressio unius exclusio alterius,

is not alien to Kentucky law. See Wade v. Commissioner,

303 S. W. 905, (1957).

The application of this well settled principle to this

case militates against judicial creation of a cause of action

for defrauded sellers under the general anti-fraud clause

of Kentucky’s “Blue Sky” Statute. The language of the

statute is clear and unambiguous. Where the express civil

eaure of action is, by its terms, limited to defrauded pur-

chasers, I am extremely reluctant to imply a cause of action

significantly broader than the remedy chosen by the legis-

lature. Indeed, as stated by the Kentucky Supreme Court

in Thomas v. Fidelity & Casualty Co. of New York, 258

Ky. 360, 80 S. W. 2d 8 (1935) :

The legislature has ample power, if it sees fit, to

promulgate additional [causes of action] under its

“Biue Sky” Statute. It is the sole judge in such mat-

ters, and where, as in the instant case, it has spoken

in plain and unmista ble language, the courts are

*Unfortunately, the majority’s footnote four mischaracterizes

my use of Cort and its progeny. I do not hold that those decisions

are precedent governing the issue of whether to imply a cause of

action for defrauded sellers pursuant to Kentucky’s Blue Sky

Statute. Rather, in the absence of a Kentucky jurisprudenre spe-

cifically addressed to the question of judicially implied causes of

action, I conclude that Kentucky would find guidance in the

“‘eriteria federal courts follow to imply causes of action in federal

statutes.’’

Aceording to the majority, my ‘‘reliance’’ on Cort is misplaced

because the State legislature possesses general police powers and

the state courts make available common law and statutory remedies.

It is ironie that the common law remedies of recission, restitution

and fraud are the very reasons cited by the drafters of the Uniform

Securities Act to purposefully deny to defrauded sellers a state

statutory remedy.

without authority to engraft an exception upon the

statute.

Id. at 10 (emphasis added).

Second, the legislative history cited by the majority is

not-elearly contrary to my textual analysis of the statute.*

A preliminary draft of the statute contained a clause pro-

hibiting judicial creation of private causes of action. The

majority relies heavily upon the Kentucky legislature’s fail-

ure to enact this provision. The “legislative history” cited

by the majority is not a recitation of the Kentucky legisla-

ture’s deliberations concerning enactment of its “Blue Sky”

Statute. Rather, the legislative history is the draftsman’s

commentary to a proposed Uniform Securities Act drafted

under the auspices of the National Commission of State

Commissioners on Uniform State Laws. Whether the

clause in question was a part of the legislation submitted

to the legislature and subsequently deleted by passage of

an amendment is uncertain. However, at least as important

to an understanding of legislative intent as the possible

amending of proposed legislation is the draftsman’s com-

mentary explaining the reason for not providing a civil

cause of action to defrauded sellers:

Although the lower federal courts have uniformly

implied a civil cause of action against fraudulent

buyers under the SEC rule, the federal courts when

applying federal law do not have at their disposal all

of the common-law and equitable remedies of deceit

and recission which are available to the state courts

without benefit of statute ...

8As stated in Amtrak, ‘‘even the most basic general principles

of statutory construction must yield to clear contrary evidence of

legislative intent.’’ 414 U.S. at 458.

Loss, Commentary on the Uniform Securities Act at 8

(1976). See also Id. at §410(a), p. 147. Before implying

a cause of action for defrauded sellers, there ought to be an

articulation of the inadequacies of the intended remedies

available to defrauded sellers.

I conclude from my examination of the statute and its

legislative history that there is a legislative intent to deny

a cause of action to defrauded sellers of securities.*

The majority also relies upon a policy statement in Ken-

tucky’s “Blue Sky” Statute that courts ought to interpret

the statute consistent with the federal securities statutes

and state court decisions construing sister states’ “Blue

Sky” statutes, Ky. Rev. Stat. Ann. §292.530. Causes of

action have been judicially implied pursuant to the general

anti-fraud provision of the federal securities act. How-

ever, the federal judiciary’s role in creating causes of action

under federal securities statutes is distinguishable. The

above-cited commentary to the Uniform Securities Code

explains that federal courts are without the traditional

arsenal of state law causes of action and remedies to pre-

vent fraud in securities transactions. In addition, the anti-

fraud provision of the federal securities act did not provide

an explicit cause of action limited to particular parties.®

‘This case, therefore, is clearly distinguishable from Cannon,

wherein Justice Stevens, writing for the majority, stated:

[Legislative history of a statute that does not expressly

create or deny a private remedy will typically be silent or

ambiguous on the question . . . But this is not the typical case.

Far from evidencing any purpose to deny a private cause of

action, the history of Title IX [20 U.S.C. §1681] plainly indi-

cates tht Congress intended to create such a remedy.

99 S. Ct. at 1956 (emphasis in original).

58ee J. I. Case v. Borak, 377 U. S. 426 (1964).

IIT.

Assuming arguendo that neither the language enacted

nor the legislative history offer definitive guidance, it is

proper to consider what may be described as policy con-

siderations. Blue Chip Stamps v. Manor Drug Stores, 421

U. S. 723, 737 (1975).

Three cases in this Court have considered the choice of

one of several state statutes of limitations to federal se-

curities claims. Nickels v. Koehler Management Corp., 541

F. 2d 611 (6th Cir. 1976) (construing Ohio law), J.D.S.

Progresswe Fund, Inc. v. Frost of Michigan Corp., 533

F. 2d 340 (6th Cir. 1976), (construing Michigan law), and

Charney v. Thomas, 372 F. 2d 97 (6th Cir. 1967), (con-

struing Michigan law). The language of /.D.S. Progres-

sive Fund, Inc. articulates the favored policy in this Circuit :

“the broad remedial purposes of the federal securities law

are best served by a longer not shorter statute of limita-

tions.” 533 F. 2d at 344. The majority’s opinion over-

rules the well establisued policy of our Circuit without any

explanation of the inappropriateness of applying longer

statutes of limitation to remedial statutes.

Accordingly, I would affirm the judgment of the district

court and remand the case for proceedings consistent with

my opinion.

SECURITIES EXCHANGE ACT OF 1934, § 10

15 U.S.C. §78

Manipulative and deceptive devices

It shall be unlawful for any person, directly or indi-

rectly, by the use of any means or instrumentality of inter-

state commerce or of the mails, or of any facility of any

national securities exchange—

(a) To effect a short sale, or to use or employ any

stop-loss order in connection with the purchase or sale, of

any security registered on a national securities exchange,

in contravention of such rules and regulations as the Com-

mission may prescribe as necessary or appropriate in the

public interest or for the protection of investors.

(b) To use or employ, in connection with the purchase

or sale of any security registered on a national securities

exchange or any security not so registered, any manipula-

tive or deceptive device or contrivance in contravention of

such rules and regulations as the Commission may prescribe

as necessary or appropriate in the public interest or for

the protection of investors.

SECURITIES EXCHANGE COMMISSION RULE 10b-5

17 O.F.R. §240.10b-5

Employment of manipulative and deceptive devices

It shall be unlawful for any person directly or indi-

rectly, by the use of any means or instrumentality of inter-

state commerce, or of the mails or of any facility of any

national securities exchange,

(a) To employ any device, scheme, or artifice to de-

fraud,

(b) To make any untrue statement of a material fact

or to omit to state a material fact necessary in order to make

the statements made, in the light of the cireumstances under

which they were made, not misleading, or

which operates or would operate as a fraud or deceit upon

any person, in connection with the purchase or sale of any

security.

i |

70 .

THE SECURITIES ACT OF KENTUCKY

Kentucky Revised Statute Chapter 292, Subsection 320(1)

(as enacted Kentucky Acts 1960, ch. 110, $18;

1972, ch. 265, §14)

Fraudulent and other prohibited practices—(1) It is

unlawful for any person, in connection with the offer, sale

or purchase of any security, directly or indirectly:

(a) To employ any device, scheme, or artifice to de-

fraud;

(b) To make any untrue statement of a material fact

or to omit to state a material fact necessary in order to

make the statements made, in the light of the cireumstances

under which they are made, not misleading; or

which operates or would operate as a fraud or deceit upon

any person.

THE SECURITIES ACT OF KENTUCKY

Kentucky Revised Statute Chapter 292, Section 480

(as enacted Kentucky Acts 1960, ch. 110, $18;

1972, ch. 265, §14.)

Civil liabilities—(1) Any person, who offers or sells a

security in violation of this chapter or of any rules and regu-

lations promulgated hereunder or offers or sells a security

by means of any untrue statement of a material fact or any

omission to state a material fact necessary in order to make

the statements made in the light of the circumstances under

which they are made not misleading (the buyer not know-

ing of the untruth or omission) and who does not sustain —

the burden of proof that he did not know and in the exer-

cise of reasonable care could not have known of the untruth

or omission is liable to the person buying the security from

Ret

him, who may sue either at law or in equity to recover the

consideration paid for the security, together with interest

at six per cent (6%) per annum from the date of payment

costs and reasonable attorneys’ fees, less the amount of

any income received on the security, upon the tender of the

security, or for damages if he no longer owns the security.

Damages are the amount that would be recoverable upon

a tender less (a) the value of the security when the buyer

is disposed of it and (b) interest at six per cent (6%) per

annum from the date of disposition.

(2) Every person who directly or indirectly controls a

seller liable under subsection (1), every partner, officer or

director (or person occupying a similar status or perform-

ing similar functions) or employe of such a seller who ma-

terially aids in the sale, and every broker-dealer or agent

who materially aids in the sale is also liable jointly and

severally with and to the same extent as the seller, unless

the nonseller who is so liable sustains the burden of proof

that he did not know, and in the exercise of reasonable care

could not have known, of the existence of the facts by reason

of which the liability is alleged to exist. There is contri-

bution as in cases of contract among the several persons so

liable.

(3) Any tender specified in this section may be made

at any time before entry of judgment. Every cause of ac-

tion under this statute survives the death of any person who

might have been a plaintiff or defendant. No person may

sue under this section more than three (3) years after the

contract of sale. No person may sue under this section

(a) if the buyer received a written offer, before suit and

at a time when he owned the security, to refund the con-

sideration paid together with interest at six per cent (6%)

per annum from the date of payment, less the amount of

any income received on the security, and he failed to ac-

cept the offer within thirty (30) days of its receipt, or (b)

if the buyer received such an offer before suit and at a time

when he did not own the security, unless he rejected the

offer in writing within thirty (30) days of its receipt.

(4) No person who has made or engaged in the per-

formance of any contract in violation of any provision of

this chapter or any rule or order hereunder, or who has

acquired any purported right under any such contract with

knowledge of the facts by reason of which its making or

performance was in violation, may base any suit on the

contract. Any condition, stipulation or provision binding

any person acquiring any security to waive compliance

with any provision of this chapter or any rule or order

hereunder is void.

KENTUCKY REVISED STATUTES

CHAPTER 413

Limitation of Actions, Subsection .120(2) and (12)

Actions to be bro ght within five years.—The following

actions shall be commenced within five (5) years after the

cause of action accrued:

(2) An action upon a liability created by statute, when

no other time is fixed by the statute creating the liability.

(12) An action for relief or damages on the ground of

fraud or mistake.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.