Petition — Barney v. Henricksen
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JUN 29 198!
No. ALEXANDL «
CLERK
‘ @-thvAs,
IN THE
SUPREME COURT OF THE UNITED STATES
Summer Term, 1981
SMITH BARNEY, HARRIS
UPHAM & CO., INC.,
Petitioner,
WENDEE HENRICKSEN,
Respondent.
On Writ of Certiorari
To the United States Court of Appeals
For the Seventh Circuit
PETITION FOR WRIT OF CERTIORARI
W. STUART PARSONS
GERALD G. MILLER
Quarles & Brady
780 North Water Street
Milwaukee, Wisconsin 53202
(414) 277-5000
Attorneys for Petitioner
Smith Barney, Harris
Upham & Co., Inc.
QUESTIONS PRESENTED
1. Under the Securities Exchange Act of 1934 (‘‘the
Act’’), may absolute liability be imposed on a ‘‘controlling per-
son’’ for losses resulting from violations of the Act by a con-
trolled person, abrogating the ‘‘good faith’’ defense of Section
20(a) of the Act by applying the common law doctrine of
respondeat superior?
2. Does the ‘‘scienter’’ requirement of Ernst & Ernst v.
Hochfelder permit the imposition of secondary liability on a
controliing person, under Section 20(a) of the Act, without
regard to fault?
3. Does the ‘‘scienter’’ requirement of Ernst & Ernst v.
Hochfelder permit the imposition of secondary liability on a
controlling person, under Section 20(a) of the Act, where that
person did not act recklessly or with intent to deceive, |
manipulate or defraud?
SEE Saeed iiccab Ue ech nvnsa Seve ddweseeens
BELPER EE SRD Ee Ee
Ne oe Se eae kadturdeeee és
IE ER Se eer
Reasons for Granting the Writ .............c.ceeeees
III.
Review by This Court Is Required to Resolve the
Conflict between Circuits on the Question Whether
the Common Law Doctrine of Respondeat
Superior May Impose Secondary Liability on
Broker-Dealers for Violations of the Federal
EE BENE Dac ocuctven als can ncnhenea eee
The Existence of Strict Secondary Liability,
Created and Imposed by the Court Below, Con-
flicts with the Principles of Ernst & Ernst v.
Hochfelder and Constitutes an Important Question
of Federal Law Which Should Be Addressed by
NG 54 4s Laas ObEES ss cadence ts cabeenel
Whether ‘‘Controlling Person’’ Liability May Be
Imposed under §20(a) for Failure to Maintain and
Diligently Enforce a Reasonable System of Internal
Supervision Is an Important Question of Federal
Law Which Has Not Been, But Should Be, Re-
viewed by This Court, and with Respect to Which
There Exists a Conflict of Authority between
Ct iach abu nee ee eee O4 Ok 0a ee bSeee
a ee as ct at eeesube bak et
Appendix
Decision and Order of the Court of Appeals ...
Judgment of the Court of Appeals ...........
Order Denying Petition for Rehearing ........
Decision and Order of the District Court ......
Judgment of the District Court ..............
CITATIONS
Cases
Broad v. Rockwell International Corp.,
614 F.2d 418 (Sth Cir. 1980)............-. eee,
Carpenter v. Harris, Upham & Co., Inc., 594
F.2d 388 (4th Cir.), cert. denied, 444 U.S.
BOO CNSTED neo ce eebeccasccveesnceesccseceecs
Christoffel v. E. F. Hutton & Co., Inc.,
SOS F286 GES Ct Ct. IDTE) wo icc cccccccccces
Edwards & Hanley v. Wells Fargo Securities
Clearance Corp., 602 F.2d 478 (2d Cir. 1979),
cert. denied, 444 U.S. 1045 (1980).............
Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). .
Fey v. Walston & Co., Inc., 493 F.2d 1036
A Ra eon eee eee ee
Page
coe ee
io a
i
12
9,10,16
9,10
12
passim
6,8,15,16
iii
Page
Haynes v. Anderson & Strudwick, Inc., 508
Ps BaGe GRPs Ws APOE) codec cccsveccces 9
Henricksen v. Henricksen, 640 F.2d 880, Fed.
Sec. L. Rep. (CCH) 497,859 (7th Cir. 1981) .... passim
Henricksen v. Henricksen, 486 F.Supp. 622,
Fed. Sec. L. Rep. (CCH) 497,374
SE HE G bak cpeewiacessdloeeeevane se passim
Holloway v. Howerdd, 536 F.2d 690 (6th Cir.
ROA SS Seige eee eae Pe 8
Johns Hopkins University v. Hutton, 422 F.2d
1124 (4th Cir. 1970), cert. denied, 416 U.S.
EE ba acns sou tne’ 5 nbenucnanedees 9
Marbury Management, Inc. v. Kohn, 629 F.2d 705
(2d Cir.), cert. denied, 101 S.Ct. 566,
Co Eee ee 8
Myzel v. Fields, 386 F.2d 718 (8th Cir. 1967),
cert. denied, 390 U.S. 951 (1968). ............. i)
Parsons v. Hornblower & Weeks—Hemphill,
Noyes, 447 F.Supp. 482 (M.D.N.C. 1977),
aff’d per curiam, 571 F.2d 203 (4th Cir. 1978)... 16
Paul F. Newton & Co. v. Texas Commerce Bank,
ee ee Se il BO o's vccenctccveocee 6,8
Rochez Brothers, Inc. v. Rhoades, §27 F.2d
a ona a 6 as eens hasan 9,10
Sanders v. John Nuveen & Co., Inc., 554 F.2d
790 (7th Cir. 1977), cert denied, 68 L.Ed.2d
od a re nas Bales bala ioe 6% 12
iv
S.E.C. v. Geon Industries, Inc., 531 F.2d 39
Se Gk nS nas os 0k b eae nevkce cue eee
Sharp v. Coopers & Lybrand, Fed. Sec. L. Rep.
COCR) 577s CI CR. TOGED veces caveacesas
Zweig v. Hearst Corporation, 521 F.2d 1129
(9th Cir.), cert. denied, 423 U.S. 1025 (1975) ...
Statutes .
Securities Act of 1933 (amended June 6, 1934)
Santon 15, SUB STO 65 di sncceecnuanees
Securities Exchange Act of 1934
Section 10(b), 15 U.S.C. §78j(b) ..............
Section 20(a), 15 U.S.C. §78t(a) ..............
Judicial Code
SUING. BERD 6 0 Cibo ce ccnchencaheuuoee
Miscellaneous
Rule 10b-5 under the Securities Exchange Act of 1934
SPC. Be es win ck bn oe ceesecevaeene
H.R. Rep. No. 85, 73d Cong., Ist Sess. (1933) ....
S. Rep. No. 47, 73d Cong., Ist Sess. (1933).......
H.R. Rep. No. 152, 73d Cong., Ist Sess. (1933) ...
H.R. Rep. No. 1838, 73d Cong., 2d Sess. (1934) ..
Page
3,12
10
10
10
10
No.
IN THE
SUPREME COURT OF THE UNITED STATES
Summer Term, 1981
SMITH BARNEY, HARRIS
UPHAM & CO., INC.,
Petitioner,
WENDEE HENRICKSEN,
Respondent.
On Writ of Certiorari
To the United States Court of Appeals
For the Seventh Circuit
PETITION FOR WRIT OF CERTIORARI
The petitioner, Smith Barney, Harris Upham & Co., Inc.
(‘Smith Barney’’), prays that a Writ of Certiorari issue to
review the judgment and opinion of the United States Court of
Appeals for the Seventh Circuit, entered in this action on
February 6, 1981.
OPINIONS BELOW
The decision and order of the court of appeals, dated
February 6, 1981, is reported at 640 F.2d 880, Fed. Sec. L. Rep.
(CCH) 497;859, and reproduced in the Appendix to this peti-
tion, infra, at A-1 ef seq.
ade
The decision and order of the United States District Court
for the Eastern District of Wisconsin, dated March 10, 1980, is
reported at 486 F.Supp. 622, Fed. Sec. L. Rep. (CCH) 497,374,
and reproduced in the Appendix to this petition, infra, at D-1 et
seq.
JURISDICTION
The judgment of the Court of Appeals for the Seventh Cir-
cuit was entered on February 6, 1981. A timely petition for
rehearing was denied on March 30, 1981, and this petition for
certiorari was filed within 90 days of that date. This Court’s
jurisdiction is invoked under 28 U.S.C. §1254(1).
STATUTES INVOLVED
1. Section 15 of the Securities Act of 1933, as amended,
15 U.S.C. §770, provides:
Liability of controlling persons
Every person who, by or through stock owner-
ship, agency, or otherwise, or who, pursuant to or in
connection with an agreement or understanding with
one or more other persons by or through stock owner-
ship, agency, or otherwise, controls any person liable
under sections 77k or 77/ of this title, shall also be
liable jointly and severally with and to the same extent
as such controlled person to any person to whom such
controlled person is liable, unless the controlling per-
son had no knowledge of or reasonable ground to
believe in the existence of the facts by reason of which
the liability of the controlled person is alleged to exist.
2. Section 10(b) of the Securities Exchange Act of 1934,
15 U.S.C. §78j(b), provides:
x*
Manipulative and deceptive devices
It shall be unlawful for any person, directly or in-
directly, by the use of any means or instrumentality of
interstate commerce or of the mails, or of any facility
of any national securities exchange -—
(b) To use or employ, in connection with the
purchase or sale of any security registered on a na-
tional securities exchange or any security not so
registered, any manipulative or deceptive device or
contrivance in contravention of such rules and regula-
tions as the Commission may prescribe as necessary or
appropriate in the public interest or for the protection
of investors.
3. Rule 10b-5 under the Securities Exchange Act of 1934,
17 C.F.R. §240.10b-5, provides:
Employment of manipulative and deceptive devices
It shall be unlawful for any person, directly or in-
directly, 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 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 were made, not mis-
leading, or
(c) 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 pur-
chase or sale of any security.
-4-
4. Section 20(a) of the Securities Exchange Act of 1934,
15 U.S.C. §78t(a), provides:
Liabilities of controlling persons
(a) Every person who, directly or indirectly, con-
trols any person liable under any provision of this
chapter or of any rule or regulation thereunder shall
also be liable jointly and severally with and to the sarne
extent as such controlled person to any person to
whom such controlled person is liable, unless the con-
trolling person acted in good faith and did not directly
or indirectly induce the act or acts constituting the
violation or cause of action.
STATEMENT OF THE CASE
By enacting §20(a) of the Securities Exchange Act of 1934
(the ‘*Act’’), 15 U.S.C. §78t(a), Congress expressly rejected
strict or ‘‘insurer’s’’ liability as *ne standard under which ‘‘con-
trolling persons’’ may be held secondarily liable for violative
acts and omissions of their agents. Instead, Congress chose a
‘*fiduciary’’ standard, under which a ‘‘controlling person’’
(here, Smith Barney, a broker-dealer registered under the Act)
has no liability if it ‘‘acted in good faith and did not directly or
indirectly induce the act or acts constituting the violation....’’ In
this action arising under sections 10(b) (15 U.S.C. §78j(b)) and
20(a) of the Act, the court of appeals imposed liability on Smith
Barney under a common law theory of respondeat superior,
notwithstanding the district court’s findings that Smith Barney
acted in good faith and did not directly or indirectly induce the
violation. '
The circuits are in conflict on the question whether secon-
dary liability for violations of the Act may be imposed under the
common law doctrine of respondeat superior. In those circuits
‘See note 3, infra at p. 6 and appended text.
“a
where respondeat superior liability is recognized, controlling
persons are denied the ‘‘good faith’’ defense available under
§20(a). Absent resolution of this conflict, the nation’s broker-
dealers will continue to be held accountable by different and un-
predictable standards in the respective circuits where they trans-
act business.
Moreover, the court of appeals’ imposition on Smith
Barney of derivative liability under §10(b), despite Smith
Barney’s ‘‘good faith,’’ is plainly inconsistent with this Court’s
holding in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976),
that liability under §10(b) does not arise in the absence of
**scienter,’’ defined as ‘‘a mental state embracing intent to
deceive, manipulate, or defraud.’’ /d. at 194, n. 12. This incon-
sistency, a recurring problem in the application of §20(a),
presents — starkly in this case — an important federai question
which this Court should resolve.
After a three-day bench trial the district court found that
plaintiff-respondent Wendee Henricksen’s husband, George
Henricksen, while employed by Smith Barney as a stockbroker,
(1) lost $33,564.31 of his wife’s money in unauthorized options
trading (‘‘options trading losses’’), and (2) defrauded her of
$55,356.91 more in cash, as checks drawn on Smith Barney’s ac-
count payable to Wendee were delivered to George, endorsed by
him for deposit in a joint savings account the Henricksens main-
tained at a Milwaukee bank, and subsequently withdrawn as
cash from that account (‘‘withdrawal losses’’).? The trial court
concluded that George Henricksen violated §10(b) and was
liable to Wendee for $110,675.87, an amount equal to: (1) the
withdrawal losses; (2) the options trading losses; (3) the commis-
sions on all transactions in Wendee’s account during 1976 and
1977; and (4) the interest earned during the same period on sums
Wendee borrowed from Smith Barney through her margin ac-
count.
*$43,825.57 passed through the savings account. The balance
($11,531.34) did not, and how it disappeared was not developed at trial.
-6-
The trial court concluded that Smith Barney was iiable for
the commissions and interest but had no liability for either the
$33,564.31 in options losses or the $55,356.91 in withdrawal
losses. The court found that Smith Barney was reasonably
diligent in supervising both the withdrawals from and the quali-
ty of trading in Wendee’s account, and that the withdrawal and
options trading losses were ‘‘not due to any failure on Smith
Barney’s part to enforce with reasonable diligence its internal
plan of supervision.’’ (App. at D-19). Therefore, Smith Barney
acted in ‘‘good faith,’’ did not ‘‘directly or indirectly induce the
violation,’’? and so could not be liable under §20(a) of the
Securities Exchange Act of 1934.
The trial court carefully determined whether, as a matter of
fact, strict compliance with reasonable supervisory procedures
would have prevented George from defrauding Wendee by
withdrawing funds from their joint savings account. The court
found that Wendee would not have examined Smith Barney
statements or checks even if they had been sent to her home
(App. at D-9, 19); that George had sweeping powers of attorney
which authorized him to endorse checks made payable to
Wendee (App. at D-2, 4-5, 22); that the checks were in fact
deposited in Wendee’s account, pursuant to a conservative in-
vestment plan which was ‘‘plausible’’ in view of market condi-
tions (App. at D-19, 21); that two Smith Barney managers ques-
tioned George about, and received a plausible explanation for,
his arranging to have the checks delivered to his office (App. at
D-6, 19); and that this practice, as authorized by Rule 409(b)(2)
of the New York Stock Exchange, is common and accepted
within the industry (App. at D-19).
’The courts have defined lack of **good faith’’ in the §20(a) context as
the failure to ‘‘maintain a reasonably adequate system of internal supervision
and control . . . or [to] eriforce with any reasonable diligence such system but
on the contrary indirectly induc{ing], participat{ing] in or approv(ing] and ac-
cept{ing] the benefits [of the violations alleged]....°" Fey v. Walston & Co.,
Inc., 493 F.2d 1036, 1051 (7th Cir. 1974). Accord, Paul F. Newton & Co. v.
Texas Commerce Bank, 630 F.2d 1111, 1120 (Sth Cir. 1980); S.E.C. v. Geon
Industries, Inc., $31 F.2d 39, 51-54 (2d Cir. 1976); Zweig v. Hearst Corpora-
tion, 521 F.2d 1129, 1134-35 (9th Cir.), cert. denied, 423 U.S. 1025 (1975).
efe
George was able to defraud Wendee simply because, as her
husband he was able to withdraw funds from their joint savings
account. As far as Smith Barney was concerned, their represen-
tative did precisely what he should have done with checks drawn
payable to Wendee: he deposited them in her account. What he
did after deposit was beyond Smith Barney’s capacity to super-
vise.
The court of appeals somewhat grudgingly acceded to the
trial court’s logic: ‘“‘It cannot be known with certainty that
George’s conversion of withdrawals would have been deterred
or detected and stopped by a review of Wendee’s account....”’
(emphasis added). (App. at A-13). The court of appeals never-
theless reversed the district court, holding Smith Barney liable in
damages for all of the options trading and withdrawal losses.
The court of appeals divided the withdrawal losses into two
categories. It first determined that, according to Smith Barney’s
Compliance Manual, the branch managers should have re-
viewed Wendee’s account during (but not before) November
1976. Smith Barney was held liable for the November 1976
through October 1977 withdrawal losses ($15,635.80) under
§20(a). The court thus held that a broker-dealer may ‘‘induce’’
a violation of §10(b) by simply failing to detect and prevent the
violation.
Beyond that, the court of appeals held Smith Barney liable
for the pre-November 1976 withdrawal losses ($39,721.11), even
though concededly adequate supervision would not have trig-
gered a review for their detection or prevention. The court of
appeals thus imposed secondary liability without fault. Where
mere negligence does not suffice for primary liability, and where
Congress has enacted a ‘‘good faith’’ defense to secondary
liability, Smith Barney has been held secondarily liable, without
negligence, for an injury which it could not have prevented.
-8-
REASONS FOR GRANTING THE WRIT
I. Review By This Court Is Required To Resolve The
Conflict Between Circuits On The Question Whether
The Common Law Doctrine Of Respondeat Superior
May Impose Secondary Liability On Broker-Dealers
For Violations Of The Federal Securities Laws.
The court of appeals based Smith Barney’s liability for
$39,721.11 of the withdrawal losses solely upon the common
law doctrine of respondeat superior. The court articulated this
doctrine as follows:
‘Under common law principles, a principal is liable
for the deceit of its agent committed in the very
business he was appointed to carry out.‘ This is true
even though the latter’s specific conduct was carried
on without knowledge of the principal’’ [quoting from
Fey v. Walston & Co., Inc., 493 F.2d 1036, 1051 (7th
Cir. 1974)]. (App. at A-13).
The circuits are divided on the issue whether this doctrine
may create secondary liability for violations of the federal
securities laws. The Second, Fifth, Sixth and Seventh Circuits
have held or implied that respondeat superior is available to
plaintiffs proceeding under the federal securities laws. Marbury
Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir.), cert. denied,
101 S.Ct. 566, 66 L.Ed. 2d 469 (1980); Paul F. Newton & Co. v.
Texas Commerce Bank, 630 F.2d 1111 (Sth Cir. 1980);
Holloway v. Howerdd, 536 F.2d 690 (6th Cir. 1976); Fey v.
‘The appeals court held Smith Barney liable for George's fraud without
any analysis or finding that his wrongful acts were committed in the course of
the business he was appointed to carry out for Smith Barney. The court simply
ignored the fact that George withdrew the funds as Wendee’s husband, not as
Smith Barney's representative. Absent such a finding, no liability may proper-
ly be imposed under respondeat superior. Smith Barney’s liability is indeed
strict, since it is not authorized even by the doctrine upon which the court pur-
ports to have relied.
-9.
Walston & Co., Inc., 493 F.2d 1036 (7th Cir. 1974). The Third,
Fourth, Eighth and Ninth Circuits have held or implied that the
statutory ‘‘controlling person’’ provisions are the exclusive
standard for establishing secondary liability. Rochez Brothers,
Inc. v. Rhoades, 527 F.2d 880 (3d Cir. 1975);* Carpenter v. Har-
ris, Upham & Co., Inc., 594 F.2d 388 (4th Cir.), cert. denied,
444 U.S. 868 (1979);* Myzel v. Fields, 386 F.2d 718 (8th Cir.
1967), cert. denied, 390 U.S. 951 (1968); Christoffel v.
E. F. Hutton & Co., Inc., 588 F.2d 665 (9th Cir. 1978). Only
review by this Court can resolve these flatly contradictory inter-
pretations of ithe same federal statute.
By enacting §20(a) Congress defined the conditions under
which a controlling person (here a broker-dealer) may be held
liable for damages resulting from violation of the Securities Ex-
change Act of 1934 by a controlled person (here, a registered
representative). Congress defined the conditions of secondary
liability to preclude liability where ‘‘...the controlling person
acted in good faith and did not directly or indirectly induce the
act or acts constituting the violation or cause of action.”’
‘The Third Circuit has recently recognized a limited exception to the
Rochez rule that respondeat superior is inapplicable to controlling person
liability. Sharp v. Coopers & Lybrand, Fed. Sec. L. Rep. (CCH) £97,971 (3rd
Cir. 1981), involved an accounting firm’s $10(b) liability for material misrep-
resentations contained in a tax opinion letter. The letter had been reviewed by
a partner of the firm, signed in the name of the firm and released with fuil
knowledge that it would be presented to and relied upon by potential in-
vestors. Though conceding that respondeat superior liability could be imposed
in the special circumstances of this case, the court placed primary emphasis on
the firm’s direct participation in the preparation of the letter.
*In a case decided before this Court’s ruling in Erns: & Ernst v.
Hochfelder, 425 U.S. 185 (1976), the Fourth Circuit Court of Appeals had im-
plied that respondeat superior was applicable to determine secondary liability
for violations of the federal securities laws. Johns Hopkins University v. Hut-
ton, 422 F.2d 1124 (4th Cir. 1970), cert. denied, 416 U.S. 916 (1974). In
Carpenter, however, the Fourth Circuit held that secondary liability of broker-
dealers requires a showing of scienter under §20(a). Carpenter has been inter-
preted as having overruled Johns Hopkins sub silentio. Haynes v. Anderson &
Strudwick, Inc., $08 F.Supp. 1303 (E.D. Va. 1981).
-10-
Under the Securities Act of 1933, controlling person liabili-
ty had been absolute. Without qualification, a controlling per-
son was liable for controlled persons’ violations of the 1933 Act.
15 U.S.C. §770 (1933) (amended 1934). When the 1934 Act was
enacted, however, the 1933 Act was amended (Act of June 6,
1934, c. 404, §208, 48 Stat. 908) to make it clear that mere ‘‘con-
trol’’ is not sufficient for secondary liability. H.R. Rep. No.
1838, 73d Cong., 2d Sess. 42 (1934). The legislative intent, ap-
parent from the terms of §20(a) and the 1934 amendment to
§15, limits secondary liability to situations where the controlling
person is causally and culpably responsible for the third party’s
loss. As the Third Circu‘t Court of Appeals has observed:
The legislative history of Section 20(a) illustrates that
Congress intended liability to be based on something
besides control. That something is culpable participa-
tion.
Rochez Brothers, Inc. v. Rhoades, supra, at 884-85. Accord,
Carpenter v. Harris, Upham & Co., supra. This view comports
with the iegislative history relating to the general duties of con-
trolling persons:
Legislative history reveals that the Senate and the
House had advocated different versions of the stan-
dard that should govern controlling persons. The
House proposed that the standard should be a
‘fiduciary standard,’’ which would require a duty of
due care. (H.R. Rep. No. 85, 73d Cong., Ist Sess. 5
(1933); H.R. Rep. No. 152, 73d Cong., Ist Sess. 27
(1933).) On the other hand, the Senate proposed an
‘‘insurer’s liability’? (S.Rep. No. 47, 73d Cong., Ist
Sess. 5 (1935), the Fletcher Report). Congress enacted
the House version, rejecting the insurer concept.
Christoffel v. E. F. Hutton & Co., Inc., 588 F.2d 665, 668 (9th
Cir. 1978). In this context, it is clear that Congress has expressly
rejected a standard which, like respondeat superior, would
make controlling persons strictly liable for the violations of con-
trolled persons.
The ‘‘good faith’’ defense to secondary liability, delib-
erately conferred upon controlling persons by Congress, cannot
co-exist with common law liability under respondeat superior.
Under §20(a), the controlling person has a defense to secondary
liability if it shows that it acted in good faith and did not induce
the violation. At common law, this showing is no defense to
respondeat superior liability. Permitting recovery under
respondeat superior for 1934 Act violations thus abrogates
§20(a).
Review by this Court is necessary to rectify this judicial
abrogation of statutory law and to resolve the existing conflict
between circuits on this issue.
II. The Existence Of Strict secondary Liability, Created
And Imposed By The Court Below, Conflicts With
The Principles Of Ernst & Ernst v. Hochfelder And
Constitutes An Important Question Of Federal Law
Which Should Be Addressed By This Court.
The court below held Smith Barney strictly liable for the
pre-November 1976 ($39,721.11) withdrawal losses without a
finding of negligence or causation. The court found that Smith
Barney could and should have prevented subsequent withdrawal
losses ($15,635.80) by discharging its duty of adequate super-
vision. With respect to the latter, Smith Barney was liable upon
a finding of simple negligence. Both of these results are in-
consistent with this Court’s holding in Ernst & Ernst v.
«12.
Hochfelder, supra, that §10(b) liability requires a showing of
scienter.’
The facts of this case are much like the facts in Ernst &
Ernst v. Hochfelder, supra. In that case, a stockbroker
fraudulently converted plaintiffs’ funds to his own use. Plain-
tiffs sued Ernst & Ernst under §10(b), alleging that it should
have discovered certain business practices, the discovery and
disclosure of which would have led to a complete audit and thus
to the detection and prevention of the conversions. The Seventh
Circuit Court of Appeals held that liability for the conversion
losses under §10(b) could Le imposed upon Ernst & Ernst if
negligence were shown; i.e., that Ernst & Ernst had a ‘‘duty of
inquiry’’ and that the failure to discharge this duty caused plain-
tiffs’ loss. Jd. at 191. Informed by the legislative history of
§10(b), this Court reversed, holding that §10(b) liability does
not arise in the absence of an ‘‘intent to deceive, manipulate, or
defraud.’’ Jd. at 193.
With respect to the post-November 1976 withdrawal losses,
the court of appeals has held Smith Barney liable on a finding of
"In Ernst & Ernst v. Hochfelder, supra, this Court defined scienter as
follows:
In this opinion the term ‘‘scienter’’ refers to a mental state em-
bracing intent to deceive, manipulate, or defraud. In certain areas
of the law recklessness is considered to be a form of intentional
conduct for purposes of imposing liability for some act. We need
not address here the question whether, in some circumstances,
reckless behavior is sufficient for civil liability under §10(b) and
Rule 10b-5.
Id. at 194, n.12. In subsequent cases, some courts have held that where there
exists a fiduciary relationship between the plaintiff and defendant,
recklessness may satisfy the scienter requirement. See, e.g., Edwards & Hanley
v. Wells Fargo Securities Clearance Corn , 602 F.2d 478, 484-85 (2d Cir.
1979), cert. denied, 444 U.S. 1045 (1980). Where the recklessness standard is
applied, however, more than negligence is required. See, ¢.g., Broad v.
Rockwell International Corp., 614 F.2d 418, 440 (Sth Cir. 1980); Sanders v.
John Nuveen & Co., Inc., 554 F.2d 790, 792-93 (7th Cir. 1977), cert. denied,
68 L.Ed.2d 210 (1981).
413.
simple negligence — that these losses would have been detected
or deterred if Smith Barney had satisfied its ‘‘duty of adequate
supervison’’ (App. at A-13). In spite of the plain terms of
§20(a), which the Ernst & Ernst court cited as an example of
Congress’ ability to restrict recovery with respect to specific
types of securities claims (see Jd. at 209, n. 28), and in deroga-
tion of this Court’s analysis and ruling in Ernst & Ernst, Smith
Barney has been held liable under §10(b) for omissions which
were, at worst, merely negligent.
With respect to the pre-November 1976 withdrawal losses,
the court of appeals’ disregard of Ernst & Ernst is far more
dramatic. Smith Barney was held liable for these losses without
a finding that they would have been ‘‘detected or deterred’’ if
Smith Barney had discharged its duty of adequate supervision.
In fact, since the court found that November 1976 was the time
when Smith Barney first had a duty to review Wendee’s ac-
count, Smith Barney did not breach its duty of supervision until
November 1976. In this case, the Seventh Circuit Court of Ap-
peals has thus gone far beyond what it was reversed for doing in
Ernst & Ernst: it has created strict liability under §10(b).* In
terms applicable to this case in all respects, the Ernst & Ernst
Court forcefully rejected this proposed expansion of statutory
liability:
In support of its view, the Commission cites the overall
congressional purpose in the 1933 and 1934 Acts to
protect investors against false and deceptive practices
that might injure them.... The Commission then
reasons that since the ‘‘effect’’ upon investors of given
conduct is the same regardless of whether the conduct
is negligent or intentional, Congress must have intend-
ed to bar all such practices and not just those done
knowingly or intentionally. The logic of this effect-
oriented approach would impose liability for wholly
faultless conduct where such conduct results in harm
‘See note 4, supra at p. 8.
-14-
to investors, a result the Commission would be unlike-
ly to support. But apart from where its logic might
lead, the Commission would add a gloss to the opera-
tive language of the statute quite different from its
commonly accepted meaning.... The argument simply
ignores the use of the words ‘‘manipulative,’’
**device,’’ and ‘‘contrivance’’ — terms that make un-
mistakable a congressional intent to proscribe a type
of conduct quite different from negligence. [Citations
omitted].
Id. at 198-99.
An “‘effect-oriented’’ standard of liability was applied here
despite Ernst & Ernst. The results are truly incongruous.
Although scienter is required for §10(b) liability, Smith Barney
is liable without negligence. A ‘‘controlling person’’ is not liable
unless it induces the violation, but Smith Barney is liable even
though it could not have prevented the violation.
The imposition of strict §10(b) liability upon a control per-
son is an important federal question which has not been, but
should be, directly addressed by this Court. Review by this
Court is required to vindicate the principles articulated in Ernst
& Ernst v. Hochfelder, supra, and to define the standard ap-
plicable to broker-dealer liability for the §10(b) violations of its
registered representatives.
Ill. Whether ‘‘Controlling Person’’ Liability May Be Im-
posed Under §20(a) For Failure To Maintain And
Diligently Enforce A Reasonable System Of Internal
Supervision Is An Important Question Of Federal Law
Which Has Not Been, But Should Be, Reviewed By
This Court, And With Respect To Which There Exists
A Conflict Of Authority Between Circuits.
The court below held Smith Barney liable under §20(a) for
George’s post-November 1976 withdrawal losses ($15,635.80)
-15-
and for all of the option trading losses ($33,564.31). Following
Fey v. Walston & Co., Inc., 493 F.2d 1036, 1051 (7th Cir. 1974),
the court held that secondary liability under §20(a) arises where
the control person fails to ‘‘maintain a reasonably adequate
system of internal supervision and control”’ or fails to ‘‘enforce
with any reasonable diligence such system....’’ (App. at A-8).
By its terms, §20(a) provides that a control person is nor
liable if it ‘‘act[{s} in good faith’’ and does not ‘‘directly or in-
directly induce the act or acts constituting the violation or cause
of action.’’ The terms of §20(a) thus suggest, as strongly as the
terms of §10(b), a requirement of scienter. The control person
must induce the violation; if the control person, in gocd faith,
merely fails to prevent the violation, liability would not arise
under the terms of the statute. The Fey v. Walston interpreta-
tion of §20(a), however, would impose liability for a mere
breach of the ‘‘duty to supervise’’ which that decision implied
and imposed.
The court of appeals made no attempt to define the content
of the ‘‘duty to supervise’’ which formed the basis for its im-
position of §20(a) liability. Nowhere in its opinion does the
court state what the law requires for ‘‘adequate’’ supervision.
The only standard applied to Smith Barney’s conduct was the
Smith Barney Compliance Manual (‘‘the Manual’’). The court
of appeals thus equated Smith Barney’s Manual and its legal
duty of care. By employing this standard of care, the court of
appeals held Smith Barney liable not only without scienter, but
for something less than negligence. The Manual is designed to
be more restrictive than existing legal requirements. It com-
prehensively incorporates similarly rigorous standards and pro-
cedures from outside the securities laws, including the rules of
the New York Stock Exchange and the National Association of
Securities Dealers. Because, by design, the Manual exceeds
perceived legal requirements, it should not be held up as the
-16-
minimum standard of conduct under the federal securities
laws.’
This Court should dispel the confusion which reigns in the
circuits by defining a controlling person’s duty of care under the
scienter language of §20(a). Petitioners respectfully submit that,
in view of the language which appears in both sections, §20(a)
should be interpreted subject to the principles which this Court
applied to §10(b) in Ernst & Ernst v. Hochfelder, supra. The
Fourth Circuit has adopted this approach, concluding, in con-
flict with Fey v. Walston, supra, that simple negligence does not
suffice for §20(a) liability. Carpenter v. Harris, Upham & Co.,
Inc., 594 F.2d 388 (4th Cir.), cert. denied, 444 U.S. 868 (1979).
There thus exists a split of authority between circuits as to the
standard for determining liability under §20(a).
Review by this Court is required to resolve the split of
authority on this issue, to authoritatively interpret §20(a) for the
first time, and to expressly overrule decisions, such as Fey v.
Walston, decided before, and inconsistent with, Ernst & Ernst
v. Hochfelder.
CONCLUSION
A substantial portion of the judgment against Smith
Barney was awarded even though the trial court found, and the
court of appeals conceded, that the loss awarded could not have
been prevented by Smith Barney’s employment of adequate
*Sirtce the Manual incorporates N.Y.S.E. and N.A.S.D. rules, imposing
liability under §20(a) for violation of the Manual tacitly recognizes a private
right of action for violation of those rules. For the reason just suggested, it has
been held that a broker-dealer’s violation of such rules does not in itself give
rise to a private cause of action. E.z., Parsons v. Hornblower & Weeks—
Hemphill, Noyes, 447 F.Supp. 482 (M.D.N.C. 1977), aff'd per curiam, $71
F.2d 203 (4th Cir. 1978). The court of appeals’ imposition of liability for
George’s options trading on an ‘‘unsuitability’’ theory conflicts with these
cases.
-]7-
supervisory procedures. The Seventh Circuit has thus held that,
notwithstanding the statutory good faith defense, a plaintiff can
sue under §10(b) and recover from a broker-dealer without
proving either negligence or causation. In addition to
abrogating the good faith defense of §20(a), this conflicts with
the scienter requirement of Ernst & Ernst v. Hochfelder. Also in
conflict with that decision, although less dramatically, was the
imposition of liability for omissions which were, at worst, mere-
ly negligent. Certiorari should be granted to review, and to
resolve the conflict between circuits concerning, these important
federal questions.
Respectfully submitted,
W. STUART PARSONS
GERALD G. MILLER
Quarles & Brady
780 North Water Street
Milwaukee, Wisconsin 53202
(414) 277-5000
Attorneys for Petitioner
Smith Barney, Harris
Upham & Co., Inc.
APPENDIX
A-l
In the
UNITED STATES COURT OF APPEALS
* For the Seventh Circuit
Nos. 80-1488, 80-1584
WENDEE HENRICKSEN,
Plaintiff-A ppellant,
v.
GEORGE HENRICKSEN and SMITH BARNEY, HARRIS,
UPHAM & CO., INC.,
Defendants-Appellees.
Appeal from the United States District Court
for the Eastern District of Wisconsin.
No. 78-C-208—Myron L. Gordon, Judge.
ARGUED NOVEMBER 7, 1980-DECIDED FEBRUARY 6, 1981
Before CUMMINGS and WOOD, Circuit Judges, and
CAMPBELL, Senior District Judge.*
“ CUMMINGS, Circuit Judge. Plaintiff Wendee Henricksen
(Wendee) brought this securities fraud action against her former
husband, George Henricksen (George), a registered stock-
broker, and his former employer, the investment firm of Smith
Barney, Harris, Upham & Co., Inc. (Smith Barney). After a
bench trial, the district court found George liable to Wendee in
the amount of $88,921.22 plus interest and costs for conversion
and fraudulent mismanagement of Wendee’s account at Smith
.Barney. The court further found George and Smith Barney
jointly and severally liable in the amount of $21,754.65 plus in-
terest for commissions and margin expenses generated during
*The Honorable William J. Campbell, Senior District Judge of the Northern
District of Illinois, is sitting by designation.
A-2
George’s mismanagement of the account. Wendee appeals from
that portion of the judgment denying recovery against Smith
Barney for the $88,921.22 plus interest and costs she lost
through George’s unlawful conduct. Smith Barney cross-
appeals from the $21,754.65 judgment against it. We conclude
that the district court erred in not finding Smith Barney liable
for the total damages Wendee suffered and therefore reverse in
part and affirm in part.
George and Wendee were married in August 1969. In 1970,
the couple moved to Milwaukee, Wisconsin, where George went
to work as a stockbroker at Smith Barney.' Wendee was
employed as a third grade schoolteacher, but left teaching in
1973 when the couple’s daughter was born.
At George’s request, Wendee opened three discretionary
accounts at Smith Barney—a regular account, an option ac-
count and a margin account—in June 1972, November 1975 and
January 1976 respectively. A discretionary account is one in
which the broker—in this case, the client’s husband—is given
discretion to conduct transactions without the client’s prior ap-
proval. Accordingly, Wendee executed two powers of attorney,
in June 1972 and November 1975 respectively, giving George
complete discretion over the management of her Smith Barney
accounts. According to the testimony at trial, Wendee had no
interest in the details of her financial matters, did not under-
stand the nature of option or margin trading, and never read
any of the documents George gave her to sign in connection
with the accounts.
A new account form filled out in June 1972 in accordance
with the New York Stock Exchange ‘‘Know Your Customer’”’
Rule listed Wendee’s investment objective as ‘‘long-term
' Smith Barney & Co., Inc. merged with Harris, Upham & Co. in February
1976.
A-3
growth of capital-income secondary,’’ the second most conser-
vative investment objective listed on the form.’ As required by
Smith Barney’s internal rules, an option client information
sheet and an option client approval sheet were prepared in con-
nection with the opening of Wendee’s option account. The op-
tion client information sheet, prepared and signed by George,
indicated that Wendee’s investment objective was ‘‘growth’’ as
opposed to ‘‘income’”’ or “‘speculation’’ and that the only type
of option transaction anticipated was ‘‘covered writing.’’’ The
option client approval sheet, signed by the branch manager of
Smith Barney’s Milwaukee office, a registered options prin-
cipal, and a member of Smith Barney’s New York compliance
section, stated that Wendee’s was a discretionary account and
that it was ‘‘Approved for covered writing transactions only’’
(Tr. 284). The option client information sheet prepared by
George also indicated that Wendee’s option account was a
single, not a joint, account; that the client was a 28-year-old
housewife with an annual income of $5,000 or less, a net worth
of ‘*100,000-250,000’’ and net assets of $123,000; and that her
husband’s annual income was $30,000.
The Smith Barney Compliance Manual provided that each
order in a discretionary account had to be approved by the
branch manager prior to the entry of the order, that the New
York compliance section had to make a daily and monthly
review of all discretionary account transactions, and that such
approvals and reviews were to be made in light of the client’s in-
vestment objectives. The Compliance Manual also provided
that option transactions were to be approved only for clients
having at least a $20,000 annual income and $20,000 of invest-
ment assets and then only for the categories of option trading
approved on the option client approval sheet.
? The choices on the form were: ‘‘Conservation of capital with stable in-
come,”’ ‘‘Long-term growth of capital—income secondary,’’ **Moderate
capital appreciation with reasonable income,”’ “‘Short-term trading profits,"
and ‘*Speculative capital gains’’ (Exhibit 17, Tr. 137).
’ The forms of option trading not anticipated or approved for the account
were: unsolicited transactions, purchasing calls, spreading, uncovered writing,
and discretionary transactions (Exhibit 19, Tr. 205).
A-4
With the exception of one transaction not relevant here,
Wendee’s accounts were inactive until January 1976. In that
month, Wendee received a distribution from a family trust and
deposited it in her regular account at Smith Barney. The
distribution consisted of 822 non-saleable voting certificate
shares in Badger Meter Company, ‘‘blue-chip”’ securities with a
market value of $97,814, and $8,000 in cash, which was im-
mediately used to purchase another ‘“‘blue-chip’’ stock. The
value of Wendee’s portfolio in January 1976, including some
stock already in the account and not including the Badger Meter
voting certificates, was $105,814. Wendee had an express agree-
ment with George that her capital was to be preserved and
ultimately used for the education and life needs of the couple’s
daughter.
In February 1976, George arranged to have the address on
Wendee’s accounts changed from the couple’s home to Smith
Barney. Thereafter, all monthly statements, confirmation slips
and checks issued out of the account were received by George at
his office. Smith Barney’s Compliance Manual required that a
client’s change of address should be ‘‘carefully reviewed’’ and
that a letter confirming the requested change of address should
be mailed to the client at the old address. Although Smith
Barney had no record of a written change of address request on
the account, Milwaukee Branch Manager Richard Vermillion
testified that it was his belief that George had filed such a writ-
ten change of address request. No letter confirming the re-
quested change was ever sent by Smith Barney to Wendee at her
home address.
In October 1976, George and Wendee separated because of
marital problems due apparently in part to George’s involve-
ment with a group of friends who engaged in gambling and
heavy drinking. Although the couple initially hoped to recon-
cile, Wendee filed a divorce action in the spring of 1977. They
were divorced in 1978.
Despite George’s problems and their marital difficulties,
Wendee left her investment arrangement unchanged because she
A-5
retained ‘‘100% faith’’ in George as her broker; because the ac-
count was supervised by other Smith Barney personnel, in-
cluding Branch Manager Richard Vermillion, a personal friend
of Wendee’s parents; and because she believed that having her
investments at Smith Barney was ‘‘like having money in a
bank.’’ Vermillion and his successor Leonard Walsh, testified
that they were aware of George’s marital problems and of his
gambling activities.‘ Vermillion on several occasions in 1976
spoke with George about his gambling and told him to stop it.
Vermillion also testified that he knew Wendee relied totaily on
George to manage her accounts. Both Vermillion and Walsh
knew that Wendee was not receiving any written information on
the accounts from Smith Barney after January 1976.
Starting in February 1976, after the change of address on
the account and before their separation, George began to sell
off Wendee’s ‘‘blue-chip”’ securities. Between then and October
1977, George ordered 17 Smith Barney checks totalling
$54,798.57, derived from the sales and payable to Wendee, to be
drawn on Wendee’s Smith Barney account but delivered to him.
Another Smith Barney check for $558.40 was issued on January
20, 1976, before the address on the account was changed, bring-
ing the total to $55,356.91. Wendee never knew of the sales
transactions nor saw any of the checks, although a facsimile of
her signature appeared on each of them. Checks totalling
$43,825.57 were deposited in the couple’s joint savings account
and within a few days of each deposit an amount approximately
equal to the deposit was withdrawn by George. The remaining
converted $11,531.34 did not pass through the savings account.
Wendee testified that she did not know that the joint savings ac-
count was still in existence.
Smith Barney’s internal rules prohibit any stockbroker
from receiving a check for delivery to a client unless the branch
manager approves the delivery and makes. a written record of
* Wendee argues on appeal that the district court erred in excluding from
evidence the fact that Leonard Walsh placed a bet or bets through George and
George’s bookie. In view of our disposition of the case, we find it unnecessary
to discuss this alleged error.
A-6
the circumstances requiring delivery to the stockbroker. No
such written records were produced at trial, but Vermillion and
Walsh testified that between them they had approved all 17
checks delivered to George. Vermiilion testified that George had
' told him that he was liquidating Wendee’s securities because he
did not like the market and that it was more convenient for him
to receive the checks at the office as they were to be deposited in
a bank in the same building as the Smith Barney office. Walsh
testified that he never asked, and George never told him, why
George was withdrawing the cash.
During the same period of time, George activated
Wendee’s option and margin accounts. Between July 1976 and
February 1977, the outstanding loan balance in the margin ac-
count ranged from a high of $71,180 in August of 1976 to a low
of $45,480 in October 1976, and in February 1977 stood at
$60,280. In that month, George began purchasing calls, a form
of option trading which the district court found was inconsis-
tent with the option client approval sheet on Wendee’s account
and unsuitabie in terms of Wendee’s recorded investment objec-
tives. How these transaction were approved by Smith Barney’s
branch manager and the New York compliance section will be
discussed in detail in Part II. As a result of the call purchases,
Wendee’s account lost $33,564.31. The trading activity in the
accounts also generated $21,754.65 in commissions and margin
interest. Consequently, by the end of October 1977 nothing re-
mained in Wendee’s portfolio except the 822 nonsaleable shares
of Badger Meter Company.
Throughout this time, George was furnishing Wendee with
periodic account summaries fraudulently indicating an equity
above $100,000. George also completed, in connection with the
divorce proceedings in the spring of 1977, a financial declara-
tion fraudulently stating the value of Wendee’s securities to be
$114,000. Wendee did not suspect that there might by anything
wrong with her accounts until January 1978 when she learned
that George had re-mortgaged their house. Leonard Walsh, the
branch manager who had responsibility for supervising
Wendee’s account throughout 1977, did not learn that the ac-
A-7
counts had been depleted until March 1978 when this lawsuit
was commenced.
Wendee’s complaint stated eight claims and alternative
claims based on provisions of the federal securities laws, state
common law ana the rules of the New York Stock Exchange
and the National Securities Dealers Association. At the trial
George invoked his Fifth Amendment rights and declined to
answer any questions concerning his alleged wrongdoing.
The district court found that George had unlawfully con-
verted to his personal use $55,356.91 of Wendee’s account
funds in violation of state common law, Section 10(b) of the
Securities and Exchange Act of 1934 (15 U.S.C. §78j) and the
Securities and Exchange Commission Rule 10b-5 (17 C.F.R.
§240.10b-5). He also found that George’s purchase of calls was
a part of a scheme to offset and conceal his conversion and that
taken as a whole George’s activities constituted a scheme to
defraud his client in violation of his fiduciary duty, Section
10(b) and Rule 10b-5. He therefore held George liable for the
$33,564.31 loss resulting from the call purchases, thus far total-
ling a recovery of $88,921.22 for Wendee. Finally George was
held liable for $21,754.65 for commissions and margin account
interest. Those rulings are not challenged in this appeal.
Wendee also sought damages against Smith Barney alleging
liability under the common law doctrine of respondeat supericr
and under Section 20(a) of the Securities and Exchange Act of
1934 (15 U.S.C. §78t(a)). The district court denied recovery of
the $88,921.22 trading losses and monies converted under either
theory but found Smith Barney jointly and severally liable with
George for the $21,754.65 in commissions and margin expense
(plus interest) on the reasoning that Smith Barney would be un-
justly enriched if permitted to profit from George’s misconduct.
Wendee’s appeal and Smith Barney’s cross-appeal tollowed.
A-8
Section 20(a) of the Securities and Exchange Act of 1934
provides in pertinent part:
**Every person who, directly or indirectly, con-
trols any person liable under any provision of this
chapter or of any rule or regulation thereunder shall
also be liable jointly and severally with and to the same
extent as such controlled person to any person to
whom such controlled person is liable, unless the con-
trolling person acted in good faith and did not directly
or indirectly induce the act or acts constituting the
violation or cause of action.”’
In Fey v. Walston & Co., Inc., 493 F .2d 1036, 1051 (7th
Cir. 1974), this Court held that a broker-dealer would be liable
for its employee’s acts under Section 20(a) if it ‘‘did not main-
tain a reasonably adequate system of internal supervision and
control over the [registered representative] or did not enforce
with any reasonable diligence such system***.’’ Wendee’s con-
tention is that Smith Barney failed to enforce its internal com-
pliance rules with reasonable diligence and is therefore liable
under Section 20(a) for all the damages she suffered as a result
of George’s unlawful acts.
The district court found first that George’s unlawful con-
version of $55,356.91 of Wendee’s account funds could not
have been prevented by Smith Barney’s reasonably diligent en-
forcement of its internal rules because Wendee would not have
discovered the thefts even if the address on the account had
been changed since by her own admission she did not concern
herself with correspondence from Smith Barney and since the
first converted check had in fact gone to the couple’s home. The
court also found that even if the change of address had
facilitated George’s misconduct, Smith Barney had not been
guilty of an unreasonable lack of diligence with respect to the
change of address or the approval of the cash withdrawals
delivered to George because Rule 409(b)(2) of the New York
A-9
Stock Exchange expressly permits a registered representative to
receive his wife’s checks on accounts over which he holds a
power of attorney and because Branch Managers Vermillion
and Walsh received plausible explanations for both the change
of address and the cash withdrawals. Finally, the district court
found that Smith Barney was not guilty of unreasonable
diligence in supervising the quality of trading in Wendee’s ac-
counts.
We think the record shows plainly that Smith Barney in
fact did not properly follow its own compliance rules with
respect either to the change of address request or to the checks
delivered to George, but we nevertheless agree with the district
court for the reasons it gave that the technical lack of com-
pliance in these matters standing alone would not have con-
stituted a violation of Section 20(a). We cannot agree, however,
that Smith Barney was reasonably diligent in its supervision of
the trading in Wendee’s account, and we further conclude that
this lack of reasonable diligence in combination with the
generally casual supervision of George’s activities contributed
not only to the trading losses and commission and margin ex-
penses but to the conversions as well.
As noted, each transaction in Wendee’s account should
have been approved by the Milwaukee branch manager prior to
entry and reviewed by the compliance section in New York.
However, of the 40 ticket orders produced by Smith Barney at
trial for Wendee’s accounts in 1976, four were approved by
someone other than the branch manager and 13 were not ap-
proved by anyone. Moreover, as the district court found, call
purchases were not authorized for Wendee’s account. Although
George Howard, a compliance officer in New York, testified to
the effect that the account ‘‘must have’’ been approved for call
purchases because otherwise the computer would have flagged
the orders, no written record was produced to contradict the
original option client approval sheet authorizing only covered
writings. Vermillion, Walsh and Howard each conceded that
call purchases were, as the district court found, unsuitable for
an account with stated investment objectives of ‘‘long-term
A-10
growth’’ and ‘‘growth,”’ but stated their belief that Wendee’s
recorded objectives were superseded when she executed the op-
tion and margin account agreements because a client who enters
such am agreement automatically becomes a speculator. Smith
Barney’s Compliance Manual does not so provide, however,
and Vermillion and Walsh admitted that there was no Smith
Barney policy of communicating such a consequence to clients
at the time they execute either an option or margin account
agreement.
In addition, Smith Barney’s internal rules, as noted, pro-
hibit option trading for investors having less than $20,000 in in-
vestment assets and a $20,000 annual income. Wendee, whose
annual income was less than $5,000 annually, was therefore not
a qualified options investor. Her account was nevertheless ap-
proved for option trading on the strength of George’s $30,000
annual income despite the facts that the compliance rules do not
authorize consideration of a spouse’s income on a single ac-
count, that George had his own option trading account, and
that Vermillion, Walsh and Howard thought it unnecessary to
review the activity in the two option accounts (supported by one
salary) in conjunction with one another. An expert witness
testified that a spouse’s income is irrelevant to an investor’s
suitability for option trading under the ‘*20-20’’ rule unless the
account is jointly held.
Finally, Smith Barney requires, in addition to daily and
monthly reviews for discretionary accounts, that any account
generating five or more trades in one month be reviewed for ex-
cessive activity or ‘‘churning’’ by the compliance section, the
branch manager and the broker on the account. After four
months of reported excessive activity in a 12-month period, a
comprehensive six-month review of profits, losses and commis-
sions by the branch manager is required and a direct consulta-
tion with the client recommended. Excessive activity reports
should have issued for Wendee’s account in January, February
and July 1976, but did not issue because, according to the
testimony of Compliance Officer Howard, the computer in New
York had not yet been fully programmed following Smith
A-1l
Barney’s merger with Harris, Upham & Co. in February 1976.
New York did issue excessive activity reports for October and
December 1976, but these reports were not reviewed as required
by the Milwaukee office, apparently because of some disruption
in procedure when Leonard Walsh replaced Richard Vermillion
as branch manager.
Had excessive activity reports issued in accordance with
Smith Barney procedure, a 6-month review would have been re-
quired on the account after the October 1976 report. As it turn-
ed out, it was not until the account was flagged by the computer
for excessive activity (18 trades) in January 1977 that Com-
pliance Officer Howard requested Leonard Walsh to obtain
from George a review of Wendee’s account. George did not
complete the requested review until March 8, 1977, and his
report misrepresented the equity in Wendee’s account at
$110,000. Walsh did not detect the misrepresentation because,
according to his testimony, he was interested only in the profits
and losses and not the equity figures.
When the account was flagged again in February 1977 (20
trades), Howard requested Walsh to obtain from Wendee, as
the Compliance Manual required, a letter stating that the
trading activity in her account was in accord with her investment
objectives. Waish told Howard that such a letter was un-
necessary because he had just had dinner with Wendee, and
Howard agreed to waive the need for written approval. Walsh
testified, however, that in fact the dinner had been a social visit
and that he had never discussed Wendee’s account with her on
that or any other occasion.
When the account was again flagged for excessive activity
(24 trades) in May 1977, Walsh had an office worker prepare a
six-month profit and loss analysis on the account. The resulting
report was, by Walsh’s admission, erroneously prepared and as
a consequence showed $100,000 of equity, $14,926.29 in profits
and $12,500 in commissions when it should have shown
$55,916.85 of equity and a $294.57 loss for the period before
commissions of $12,500. As a result of this sequence of omitted
A-12
‘
and erroneous reports, Leonard Walsh had no idea what had
happened to Wendee’s account until this lawsuit was com-
menced.
The foregoing summary of the record clearly establishes a
lack of reasonably diligent enforcement of internal supervisory
rules. However, the district court reached the conclusion that
Smith Barney was not liable under Section 20(a) on the ground
that Smith Barney’s supervisory personnel were entitled to rely
on George’s investment decisions because Wendee had given
him broad discretionary power over the accounts. This view is
based on a misunderstanding of the fiduciary relationship be-
tween George and Wendee. Wendee opened discretionary ac-
counts at Smith Barney giving George, as her broker and as
Smith Barney’s representative, discretionary powers over her
accounts. In short, Wendee’s agent in the management of her
accounts was Smith Barney as represented by their agent George
Henricksen. By accepting Wendee’s discretionary accounts,
Smith Barney took upon itself a far more stringent fiduciary
responsibility than it undertakes with respect to nondiscre-
tionary accounts in which the client retains control over the
management of his investments. See, e.g., Kravitz v. Pressman,
Frohlich & Frost, Inc., 447 F.Supp. 203, 213 (D. Mass. 1978).
Smith Barney recognizes this greater obligation in its com-
pliance rules by requiring supervisory approval of discretionary
transactions on a daily basis as well as monthly reviews. The
fact that Wendee and George were husband and wife did not in
any way relieve Smith Barney of its duty of supervision over
Wendee’s accounts. Indeed, if anything, it increased that duty
because, as Smith Barney’s internal rules also provide,
employee-related accounts, whether discretionary or not, are
subject to greater scrutiny than non-employee-related accounts.
Smith Barney failed to follow its own compliance rules and pro-
cedures for supervising discretionary accounts, and it cannot
now claim in defense that it relied on the discretionary judgment
of the very person it was supposed to be supervising to justify
the lack of supervision.
A-13
Had Wendee’s account been properly supervised, it would
have been subject to a full review in November 1976 following
the fourth excessive activity month in a 12-month period. The
computer programming delay and the turnover in personnel in
the Milwaukee office do not excuse the absence of required
supervision in this period. It cannot be known with certainty
that George’s conversion of withdrawals would have been de-
terred or detected and stopped by such a review. However, there
can be no doubt that Smith Barney’s failure to enforce its super-
visory procedures violated Section 20(a) and that it contributed
not only to George’s unauthorized option trading but also to the
ease with which he withdrew and converted the proceeds from
the sale of Wendee’s ‘‘blue-chip’’ stocks. Consequently, we
hold that Smith Barney is liable to Wendee under Section 20(a)
for the $33,564.31 lost through the unauthorized purchase of
calls, the $21,754.65 in commissions and margin expenses, and
the monies lost through conversion between November 1976,
when the first full review of her Smith Barney account should
have been conducted, and the end of October 1977 when that
account reached zero, plus prejudgment interest and costs.
III
Wendee also charged Smith Barney with liability for the
unlawfui acts of its agent, George, under the common law doc-
trine of respondeat superior. This claim is independent of, and
the potential liability broader than, that under Section 20(a).
See Fey v. Walston, supra, 493 F.2d at 1052-1053; see also
Marbury Management, Inc. v. Kohn, 630 F.2d 704 (2d Cir.
1980); Paul F. Newton & Co. v. Texas Commerce Bank, ...
F.2d ..., 49 LW 2392 (Sth Cir. November 21, 1980). As we
stated in Fey, supra, 493 F.2d at 1052 n. 19:
‘*(Ujnder common law principles, a principal is liable
for the deceit of its agent committed in the very
business he was appointed to carry out. This is true
even though the latter’s specific conduct was carried
on without knowledge of the principal.’’
A-14
The district court acknowledged that ‘‘normally’’ Smith
Barney would be liable for all the damages resulting from
George’s fraudulent acts, but held that Wendee’s claim was
barred here because George was acting as her agent as well as
Smith Barney’s agent and Wendee was in a better position than
Smith Barney to detect and prevent George’s fraud. The court
then went on to hold that Smith Barney was nevertheless liable
for the $21,754.65 in commissions and margin expenses
because, notwithstanding Wendee’s greater ability to prevent
the wrong, Smith Barney should not be permitted to profit as a
result of wrongs committed by its agent.
These findings also turn on the erroneous understanding
discussed above, of the fiduciary relationships among George,
Wendee and Smith Barney. Wendee’s opening of discretionary
accounts at Smith Barney did not create a classic ‘‘dual agency”’
situation. George was not acting nor was he authorized to act as
Wendee’s agent independent of his position as a stockbroker
employed by Smith Barney. As we have already stated, the
primary agency relationship created by the discretionary ac-
counts was between Wendee and Smith Barney, with George ac-
ting on Smith Barney’s behalf.
Having entrusted her investments to Smith Barney’s
management through George, their agent, Wendee was entitled
to rely on Smith Barney’s fiduciary obligation to manage the in-
vestments in accordance with her recorded investment objec-
tives and George’s best professional judgment subject to the
review and ultimate control of Smith Barney’s supervisory per-
sonnel. It is true, of course, as Smith Barney argues, that had
Wendee not authorized discretionary accounts or had she
herself supervised George’s investment decisions, she might
have discovered and prevented the fraud. But Wendee has no
obligation to supervise George. She received periodic reports
from George indicating an equity in her account of over
$100,000 and at the time of the divorce action in the spring of
1977 was provided with a financial declaration stating the equity
to be $114,000. She was entitled to rely on George’s representa-
tions of the status of her account and to assume therefrom that
Avl5
the account was being properly managed by George and Smith
Barney. Indeed, the whole point of a client’s establishing a
discretionary account is to turn over to the investment firm
management and investment responsibilities that the client
either does not want to have or feels inadequate to handle.
Broker-dealers do not have to accept discretionary ac-
counts. Harris, Upham & Co., for example, had a policy against
accepting such accounts before its merger with Smith Barney.
But having accepted Wendee’s trust and the concomitant
fiduciary burdens, Smith Barney cannot now disclaim liability
by arguing that Wendee should not have been so trusting. Ac-
cordingly, we hold that Smith Barney is liable to Wendee jointly
and severally with its agent George Henricksen under state com-
mon law not only for the damages discussed above for which
Smith Barney is independently liable under Section 20(a) but in
addition for the monies converted by George in the course of his
management of the fund prior to November 1976 and Smith
Barney’s violation of Section 20(a).
For the reasons stated, the judgment of the district court is
reversed to the extent that it denied plaintiff recovery from
Smith Barney for the sum of $88,921.22, plus prejudgment in-
terest on that sum computed at the rate of 5% per annum since
November 1, 1977, plus costs, and in all other respects is af-
firmed. Costs on appeal are taxable to Smith Barney.
A true copy:
Teste:
Clerk of the United States Court of
Appeals for the Seventh Circuit
B-1
Opinion by Judge Cummings
JUDGMENT — ORAL ARGUMENT
UNITED STATES COURT OF APPEALS
For the Seventh Circuit
Chicago, Illinois 60604
February 6, 1981
Before
Hon. WALTER J. CUMMINGS, Circuit Judge
Hon. HARLINGTON WOOD, JR., Circuit Judge
Hon. WILLIAM J. CAMPBELL, Senior District Judge*
WENDEE HENRICKSEN,
Plaintiff-Appellant,
No. 80-1488 Vs.
GEORGE HENRICKSEN, and Appeals from the United
SMITH, BARNEY, HARRIS, States District Court for
UPHAM & CO, INC., the Eastern District of
Defendants-Appellees. Wisconsin
WENDEE HENRICKSEN, No. 78-C-208
Plaintiff-Appellee, Judge Myron L. Gordon
No. 80-1584 Vs.
SMITH, BARNEY, HARRIS,
UPHAM & CO, INC.,
Defendant-Appellant.
This cause was heard on the record from the United States
District Court for the Eastern District of Wisconsin, and was
argued by counsel.
On consideration whereof, IT Is ORDERED AND AD-
JUDGED by this Court that the judgment of the said District
Court in this cause appealed from be, and the same is hereby,
REVERSED to the extent that it denied plaintiff recovery from
B-2
Smith Barney for the sum of $88,921.22, plus prejudgment in-
terest on that sum computed at the rate of 5% per annum since
November 1, 1977, plus costs, and in all other respects is
AFFIRMED. Costs on appeal are taxable to Smith Barney in
accordance with the opinion of this Court filed this date.
* The Honorable William J. Campbell, Senior District Judge of the Northern
District of Illinois, is sitting by designation.
C-1
UNITED STATES COURT OF APPEALS
For the Seventh Circuit
Chicago, Illinois 60604
A True Copy:
Teste:
March 30, 1981
Before
Hon. WALTER J. CUMMINGS, Circuit Judge
Hon. HARLINGTON WOOD, JR., Circuit Judge
Hon. WILLIAM J. CAMPBELL, Senior District Judge*
WENDEE HENRICKSEN, Appeal from the United
Plaintiff-Appellant, States District Court
Cross Appellee, for the Eastern District
Nos. 80-1488 & 80-1584 vs. of Wisconsin
GEORGE HENRICKSEN and Ne. 78-C-208
and SMITH BARNEY, Myron L. Gordon,
HARRIS UPHAM & CO., INC., Judge.
Defendants-Appellees.
Cross Appellant.
ORDER
On consideration of the petition for rehearing and sugges-
tion for rehearing en banc filed in the above-entitled cause by
defendant-appellee and cross-appellant Smith Barney, Harris
Upham & Co., Inc., no judge in active service has requested a
vote thereon, and all of the judges on the original panel have
voted to deny a rehearing. Accordingly,
IT IS ORDERED that the aforesaid petition for rehearing
be, and the same is hereby, DENIED.
* The Honorable William J. Campbell, Senior District Judge of the
Northern District of Illinois, is sitting by designation.
D-1
UNITED STATES DISTRICT COURT
EASTERN DISTRICT OF WISCONSIN
WENDEE HENRICKSEN,
Plainti-f,
v. No. 78-C-208
GEORGE HENRICKSEN and
SMITH, BARNEY, HARRIS,
UPHAM & CO., INC.,
Defendants.
DECISION and ORDER
The plaintiff Wendee Henricksen seeks to recover in this
action the approximate sum of one hundred and twenty thou-
sand dollars from her former husband, George Henricksen, and
his former employer, Smith, Barney, Harris Upham & Co., Inc.
(Smith Barney). The complaint states eight claims and alter-
native claims for relief, based on provisions of the federal
securities laws, state common law, and certain rules of the New
York Stock Exchange and the National Association of
Securities Dealers. A two day bench trial was held in early
January 1980, aud the parties have submitted post-trial briefs.
This opinion constitutes the court’s findings of fact and conclu-
sions of law pursuant to Rule 52, Federal Rules of Civil Pro-
cedure.
D-2
I. BACKGROUND
The plaintiff and George Henricksen were married in
August 1969. In January 1970, Mrs. Henricksen received a
bachelor of arts degree. The Henricksens moved to New York
where George Henricksen underwent a six month training pro-
gram with Smith Barney to become a stockbroker. The
Henricksens then moved to Milwaukee, and Mr. Henricksen
worked for Smith Barney as a registered representative from
1970 through 1977, the time period covering the events pertinent
to this case.
On June 19, 1972, the plaintiff opened a customer account
at Smith Barney. The mailing address listed on the permanent
account record was the Henricksen’s home address. At that
time, Mrs. Henricksen’s investment objectives were recorded on
Smith Barney’s new account form. This document sets forth
five possible investment objectives, ranging in five steps from
**conservation of capital with stable income,’’ the most conser-
vative investment plan, to ‘‘speculative capital gains,’’ the most
speculative investment plan. The investment objective indicated
for the plaintiff’s account was step two, “‘long-term growth of
capital - income secondary.’’ The account was opened as a
discretionary account, which meant that the plaintiff gave
George Henricksen a power of attorney over the account. This
power of attorney was formally evidenced by a written
memorandum signed by the plaintiff, dated August 23, 1972.
The first transaction occurred in the account in June 1974.
when Mrs. Henricksen deposited 17 shares of duPont stock.
These shares were sold in June 1975, and 100 shares of J. D.
Searle were purchased with the proceeds.
On July 2, 1975, Mrs. Henricksen signed a customer’s op-
tion agreement which, she testified, she did not read before
signing. The agreement states that the person signing it has
“*been furnished with the current Prospectus of The Options
Clearing Corporation,’’ and has ‘‘read it and particularly noted
those buy and sell sections pertaining to Risk Factors, Suitabili-
D-3
ty and Limitations on Position and Exercise,...’’ The plaintiff
testified that she was not furnished a copy of the prospectus
before signing the option agreement and that she would not
have understood it had it been furnished. The option agreement
further states that the plaintiff agreed:
**l. To make transactions in Options and other
securities only in such manner as is consistent with my
investment and/or trading objectives and with my
overall and then existing financial circumstances.’’
The instrument also stated:
**14. I have read and fully understand the terms
and conditions of this agreement. I believe that I am
capable of evaluating, carrying and bearing the finan-
cial risks inherent in all options trading.”’
At this time, two Smith Barney records were prepared and
maintained with regard to the plaintiff’s option account: an op-
tion client information sheet and an option client approval
sheet. The information sheet stated that the account was a
single, not a joint, account, that the plaintiff’s estimated net
worth was between $100,000 and $250,000, that her annual in-
come was $5,000 and her husband’s was $30,000, and that her
a sets totaled $123,000. Her investment objectives were stated
to be “‘growth,”’ rather than ‘‘income’”’ or ‘‘speculation.’’ The
possible types of anticipated option transactioas were listed as:
“a. Unsolicited transactions only
Purchasing Calls
Covered Writing
Spreading
Uncovered Writing
Discretionary Transactions.’’
meangs
The only type of transaction checked for the plaintiff’s option
account was ‘“‘covered writing.’’ The option client information
sheet was signed by George Henricksen.
D-4
The option client approval sheet indicated that the account
was a discretionary account and that the client’s husband held a
power of attorney over the account. This record then reflects,
opposite the same categories listed on the information sheet,
that the plaintiff’s account was ‘‘Approved for Covered Writing
Transactions Only.’’ This document was signed by the branch
manager of Smith Barney’s Milwaukee office, Smith Barney’s
registered options principal, and by a member of its compliance
review section.
Richard Vermillion, the Milwaukee branch manager from
June 1975 through October 1976, testified that copies of both of
these Smith Barney records were on file in his office, but
Leonard Walsh, Mr. Vermillion’s successor, testified that he
was unaware of the existence of these records. George Howard,
a member of Smith Barney’s compliance section, testified that a
copy of the client option approval sheet for the plaintiff’s ac-
count is still on file in his office. Mr. Howard also testified that
sometime between April and October, 1976, a ‘‘yellow card”’
was sent to every registered representative for him to designate
his option clients’ investment objectives and that the plaintiff’s
account was thereafter programmed into Smith Barney’s new
computer system as approved for call purchasing transactions.
However, Mr. Howard stated that the yellow card for the plain-
tiff’s account could not be located, and no such card was ever
produced at trial.
On November 3, 1975, Mrs. Henricksen executed another
document giving her husband a power of attorney over her ac-
count at Smith Barney. This document, which the plaintiff
testified she did not read before signing, provides:
**That I, Wendee Henricksen of 8334 North Links
Way, City of Milwaukee, State of Wisconsin, have
made, constituted and appointed, and by these pres-
ents do constitute and appoint George B. Henricksen
my true and lawful attorney for me and in my name,
place and stead, to manage, handle and direct all ac-
counts now standing in my name, or which may at any
D-5
time be opened by me or in my name, with Smith,
Barney & Co. Incorporated, to buy and sell bonds,
stocks and other securities in my name; for me in my
name to make execute and deliver assignments and
transfers of any and all stocks and bonds, and to that
end to sign my name to any and all written instruments
which may be required in connection with such
transfer or hypothecation.
**This power of attorney shall apply to and cover
all accounts which I may have with Smith, Barney &
Co. Incorporated, until written notice of revocation
hereof is given by me to said Corporation, and I
hereby ratify and confirm any and all acts which may
hereafter be done or caused to be done by virtue
hereof by my said attorney giving and granting unto
my said attorney ful! power and authority to do and
perform all and every act and thing whatsoever re-
quisite and necessary to be done in and about the
premises as fully to all intents and purposes as I might
or could do if personally present.’’
On January 20, 1976, Mrs. Henricksen signed a margin
contract with Smith Barney. This agreement provided that, in
connection with any indebtedness incurred as a result of trans-
actions jn the plaintiff’s account, Smith Barney ‘‘may charge
monthly, as interest or otherwise, such sums to compensaie
{Smith Barney] for advances made on my account as [Smith
Barney] may determine to be reasonable in view of the current
cost of money.”’ Although the plaintiff also did not read this
document before she signed it, she testified that she had Mr.
Henricksen explain it to her.
Also in January 1976, the plaintiff deposited into her Smith
Barney account six so-called ‘‘blue-chip stocks,’’ $8,000 in cash,
and 822 shares of Badger Meter stock in the form of non-
saleable voting trust certificates, all of which she had received
from a trust. As of January 26, 1976, the plaintiff's Smith
Barney account, including the 100 shares of G. D. Searle stock
D-6
and excluding the 822 shares of Badger Meter stock, had a fair
market value o1 $!95,814. After the cash was used on January
28th to purchase stock in Kennecott Copper Corporation, the
plaintiff’s account, at the end of January 1976, consisted of the
eight ‘‘blue-chip’’ stocks and the non-saleable Badger Meter
certificates. The plaintiff testified that she and her husband had
an express understanding that these stocks and the capital they
represented were to be conserved and ultimately dedicated to
the education and other needs of the couple’s daughter,
Heather.
In February 1976, George Henricksen arranged to have the
address on the plaintiff's account changed from the couple’s
home to the Smith Barney office. Henceforth, the monthly
statements, confirmation slips, and any checks issued out of the
account were received by Mr. Henricksen at his office. With
regard to changes of address, Smith Barney’s compliance
manual provides:
**Customer requests for change of address should be
carefully reviewed and a letter sent to customer’s old
address acknowledging receipt of customer’s request
to change the address to a new address.”’
Although Smith Barney was unable to produce at trial either a
written request for a change of address from the plaintiff or a
letter from Smith Barney to the plaintiff acknowledging the ad-
dress change, Richard Vermillion testified that he believed
George Henricksen had submitted a written request. He further
testified that Mr. Henricksen, either then or later, explained
that the change of address made it more convenient for him to
deposit checks issued from the plaintiff’s Smith Barney account
into the couple’s joint savings account, because the savings ac-
count was maintained with a bank that had an office in the same
building as the Smith Barney office, and that the savings ac-
count deposits were made in order to shelter a portion of his
wife’s assets during bad market conditions. Leonard Walsh
testified that George Henricksen informed him that the address
change allowed him to keep all of the records of the account at
D-7
his office, simplifying the preparation of the plaintiff’s income
tax returns.
By the end of October 1977, the only securities in the plain-
tiff’s Smith Barney account were the 822 shares of non-saleable
Badger Meter stock; between January 1976 and November
1977, not counting these 822 shares, the equity in the account
was reduced to zero. During this period, George Henricksen
caused seventeen checks totaling $54,798.51 to be drawn on the
account in the plaintiff’s name but delivered to him at his office.
Another check for $558.40 was issued on January 20, 1976,
when the address of the account was still listed as the couple’s
home address. The plaintiff did not personally endorse the
checks, but an endorsement nevertheless was placed on the
checks; drafts totaling $43,825.57 were deposited into the
couple’s joint savings account. Within days of each deposit,
however, an amount equal or approximately equal to the
amount deposited was withdrawn from the savings account.
Also during this period the account lost $33,564.31 in the pur-
chase of calls, a form of options trading. Finally, a total of
$17,872.24 was paid to Smith Barney in commissions over the
same period, as was $3,882.41 in interest charges on margin
transactions. Thus, between January 1976 and November 1977,
the account was drained of a total of $110,675.87 in cash
withdrawals, trading losses, commissions and interest.
The plaintiff presented evidence at trial showing that Smith
Barney’s local managers knew that during 1976 and 1977
George Henricksen had engaged in gambling and heavy drink-
ing. Richard Vermillion testified that he knew that Mr.
Henricksen had been to Las Vegas several times during 1976 and
had reportedly won over $10,000 on one such visit. Mr. Ver-
million further testified that he was concerned about George
Henricksen’s personal life and that he counseled Mr.
Henricksen on numerous occasions in an effort to persuade Mr.
Henricksen to stop gambling. Leonard Walsh also testified that
he was aware of George Henricksen’s gambling.
D-8
In October 1976, the plaintiff and George Henricksen
separated; Mr. Henricksen moved out of the couple’s home.
Mr. Vermillion and Mr. Walsh were aware of the separation,
but both testified that they believed a reconciliation was possi-
ble. In the spring of 1977, however, the plaintiff filed for a
divorce, which subsequently became final.
Not until January 1978 did the plaintiff discover that only
the 822 shares of Badger Meter stock remained in her Smith
Barney account. Since the change of the account’s address, the
_ plaintiff had not been receiving any statements regarding her ac-
count. Her husband periodically provided her with summaries
of her account, but these summaries showed the account as hav-
ing an equity in excess of $100,000. Similarly, in an undated
financial declaration completed in connection with the divorce
proceeding commenced in the spring of 1977, George
Henricksen listed the value of the plaintiff’s securities as
$114,000. On each of these occasions, the equity in the account
was considerably lower than the amount George Henricksen
stated.
Mrs. Henricksen testified that she knew nothing about the
cash withdrawals and never received the proceeds of the cashed
checks. Leonard Walsh had dinner with the plaintiff and
George Henricksen in February 1977, but the account was not
mentioned. What evidently caused the plaintiff to inquire about
her Smith Barney account was her discovery in January 1978
that George Henricksen had refinanced the mortgage on the
home where only the plaintiff was then living. The plaintiff
commenced this action on April 3, 1978.
II. LIABILITY OF GEORGE HENRICKSEN
For purposes of clarity, I will analyze the potential liability
of each defendant within the four categories of losses sustained
by the plaintiff: cash withdrawals, trading losses, commissions
and interest. There is substantial evidence in the record to war-
rant the inference that George Henricksen converted to his per-
D-9
sonal use the large amount of cash ($55,356.91) withdrawn from
the plaintiff’s account during the period in question. Smith
Barney’s records indicate that this amount was withdrawn from
the account during 1976 and 1977. (Exhibit 13). The plaintiff
testified that she was totally unaware that this cash had been
taken from her account. Of the eighteen checks which were
issued, the last seventeen were delivered directly to Mr.
Henricksen at his office. The first check was apparently
delivered to the couple’s home address, but the plaintiff
testified that even before the change of the account’s mailing
address, her husband handled all mail received from Smith
Barney. Although the plaintiff testified that she never saw any
of the checks, each of the seventeen checks delivered to George
Henricksen bears a likeness of her signature. Finally, Richard
Vermillion testified that Mr. Henricksen told him that the
checks were being deposited into the couple’s joint savings ac-
count; however, the records of the savings account indicate that
only $43,825.57 reached the account, leaving $11,531.34 totally
unaccounted for.
At trial, when questioned about the large cash withdrawals
and the fate of the checks, George Henricksen invoked the fifth
amendment privilege against self-incrimination; indeed, he
responded in this fashion to all questions. It is now clearly
established ‘‘that the Fifth Amendment does not forbid adverse
inferences against parties to civil actions when they refuse to
testify in response to probative evidence offered against
them....’’ Baxter v. Palmigiano, 425 U.S. 308, 318 (1976). The
Wisconsin supreme court has articulated the following reasons
for permitting the drawing of such an inference:
**This court in Grognet v. Fox Valley Trucking Service
(1969), 45 Wis.2d 235, 172 N.W.2d 812, stated it had
long been recognized in Wisconsin that a person may
invoke the fifth amendment in a civil case in order to
protect himself from the use of such evidence against
him in a subsequent criminal action; but if he did so,
an inference against his interest might be drawn. Since
the inference is irresistible and logical in such cir-
D-10
cumstances, the court may as a matter of law draw the
inference. Such an inference is based upon an implied
admission that a truthful answer would tend to prove
that the witness had committed the crimina! act or
might constitute a criminal act.... The administration
of justice and the search for truth demands that an in-
ference may be drawn that a witness’ testimony would
be unfavorable to him in a civil action in which the
privilege is invoked to protect himself from a subse-
quent criminal action.’’ Molloy v. Molloy, 46 Wis.2d
682, 687-88 (1970).
These cases are to be distingished from the line of cases in which
the United States Supreme Court disapproved of state attempts
‘*to compel testimony that had not been immunized’’ by
threatening to impose immediate sanctions upon persons refus-
ing to waive their. fifth amendment privilege. Lefkowitz v.
Turley, 414 U.S. 70, 82 (1973). See also Lefkowitz v. Cunn-
ingham, 431 U.S. 801, 808 n.5 (1977); Sanitation Men v. Sanita-
tion Comm’r, 392 U.S. 280 (1968); Gardner v. Broderick, 392
U.S. 273 (1968); Garrity v. New Jersey, 385 U.S. 493 (1967).
Of course, as I suggested during the trial, Mr. Henricksen’s
silence should be ‘‘given no more evidentiary value than [is]
warranted by the facts currounding [t]his case.’’ Baxter v.
Palmigiano, supra, 425 U.S. at 318. Even according only slight
weight to George Henricksen’s invocation of the privilege, in
light of the testimony summarized above and under ali the cir-
cumstances of this case, his silence in the face of probative
evidence admitted against him supports my conclusion that he
did in fact, for his own purposes, dispose of the cash withdrawn
from the plaintiff’s account. Since the power of attorney the
plaintiff gave George Henricksen in 1975 did not authorize the
latter ‘‘to dispose of the assets for his own purposes,’’ and
‘*{iJnasmuch as the agent herein has failed to account for his
principal’s funds, he is liable for conversion.’’ Alexopoulos v.
Dakouras, 48 Wis.2d 32, 41 (1971).
D-11
This conversion of the plaintiff’s funds, which was ac-
complished pursuant to a scheme to defraud the plaintiff ‘‘in
connection with the purchase or sale’’ of securities, also con-
stitutes a violation of § 10(b) of the Securities and Exchange Act
of 1934, 15 U.S.C. § 78j, and Securities and Exchange Commis-
sion Rule 10b-5, 17 C.F.R. § 240.10b-5. See 1 A. Bromberg,
Securities Law: Fraud § 5.4, at 99 & n.33 (citing cases). For this
illegality the defendant George Henricksen is liable to the plain-
tiff in the amount of $55,356.91. -
George Henricksen is also liable to the plaintiff for the
losses the account sustained as a result of his purchases of calls.
The evidence clearly shows that these transactions were incon-
sistent with the plaintiff’s investment objectives and that George
Henricksen knew this to be true. When the plaintiff opened her
Smith Barney account, her investment objective was listed as
**long term growth of capital - income secondary.’’ Although
the plaintiff did execute an option agreement with Smith
Barney, both the option client information sheet and the option
client approval sheet indicate that the only type of option trans-
action authorized for the plaintiff's account was ‘‘covered
writing;’’ ‘‘purchasing calls’’ was not checked on either form.
Moreover, the plaintiff testified that she and her husband
understood that the funds in her Smith Barney account were to
be conserved for the benefit of their daughter; George
Henricksen knew that this goal was seriously jeopardized by his
speculative trading in call options.
The 1975 power of attorney does not exonerate Mr. Hen-
ricksen from liability for these trading losses. Rather, by virtue
of the execution of that document, and as an incident of the
broker-customer relationship, George Henricksen owed a
fiduciary duty to the plaintiff. See Schweiger v. Loewi & Co.,
Inc., 65 Wis.2d 56, 65 (1974). As a fiduciary, Mr. Henricksen
was duty-bound to disclose all facts relevant to the terms of the
agency, which he failed to do, and to act strictly in accordance
with his principal’s wishes and interests. His purchases of calls
were adverse to the plaintiff’s clearly-expressed interests and
therefore constitute a breach of his fiduciary duty. See Bank of
D-12
California v. Hoffman, 255 Wis. 165, 171-171a (1949); Faulter-
sack v. Clintonville Sales Corp., 253 Wis. 432, 437 (1948).
I need not decide whether, assuming George Henricksen’s
investments in unsuitable securities violated Rule 405 of the
New York Stock Exchange and Article III, § 2, of the rules of
the National Association of Securities Dealers, this constitutes a
violation of the anti-fraud provisions of the federal securities
laws. I find that, independent of those rules, Mr. Henricksen’s
purchases of calls were part of a scheme to defraud the plaintiff
within the meaning of 15 U.S.C. § 78} and Rule 10b-5. George
Henricksen’s speculative trading in calls coincided with his
large, unauthorized cash withdrawals from the plaintiff’s ac-
count. I believe that these risky but potentially very profitable
transactions were undertaken in order to offset and to conceal
the sizeable cash withdrawals. Thus, Mr. Henricksen’s
fraudulent scheme to conceal his unlawful conversion of the
plaintiff’s assets embraced a series of unsuitable investments in
call options; for the losses resulting from this undisclosed,
reckless course of conduct, George Henricksen is liable to the
plaintiff in the amount of $33,564.31. See Wright v. Heizer
Corp., 560 F.2d 236, 251-52 (7th Cir. 1977).
Turning now to the commissions the plaintiff paid on tran-
sactions in her account during 1976 and 1977, I believe these
commissions were incurred as a proximate result of George
Henricksen’s fraudulent acts. In order to withdraw cash from
the plaintiff's account, Mr. Henricksen first had to seil
securities; these sales produced commissions which were
charged to the account. George Henricksen’s unsuitable in-
vestments in call options also generated a substantial volume of
commissions.
I do not think it would be useful or helpful for me to at-
tempt to apply the ‘‘churning’’ label to Mr. Henricksen’s ex-
cessive trading in calls during the latter part of 1976 and the first
half of 1977. That term is normally applied to excessive trading
undertaken by a broker for the sole improper purpose of
generating commissions, regardless of and contrary to the
D-13
customer’s interests. In such a case, the broker’s wrongful pur-
pose of lining his own pockets is the cause of his customer’s
damages. See Fey v. Walston & Co., Inc., 493 F.2d 1036, 1040
n. 1 (7th Cir. 1974); Van Alen v. Dominick & Dominick, Inc.,
441 F. Supp. 389, 400 (S.D. N.Y. 1976), aff’d, 560 F.2d 547 (2d
Cir. 1977).
In this case, however, the purpose behind George Hen-
ricksen’s excessive trading in calls was not to generate commis-
sions, as the record shows that commissions on his wife’s ac-
count represented only 7.8% of his total commissions, but
rather his purpose was to conceal his unauthorized cash
withdrawals by reaping potentially large profits on risky in-
vestments. Thus, whether the technical churning formula does
or does not fit the facts of this case, it is clear that the commis-
sions charged on George Henricksen’s purchases of calls were
proximately caused by his scheme to conceal his simultaneous
defalcations. Under both the common law of fiduciary duty and
the federal securities laws, he is liable to the plaintiff for the
commissions charged. See Fey v. Walston & Co., Inc., supra,
493 F.2d at 1054-55.
I believe the amount of commissions for which Mr. Hen-
ricksen is liable is the total sum charged during 1976 and 1977; it
is over this period that his fraudulant scheme was perpetrated.
Although some of the transactions in the plaintiff’s account
during this period arguably were not unsuitable or were other-
wise unrelated to Mr. Henricksen’s fraudulent acts,
**[i]t is now elementary that when precise damage mea-
surements are preciuded by wrongful acts, the wrong-
doer cannot insist upon exact measurements and the
precise tracing of causal lines to an impractical extent;
fair approximations are in order.’’ Fey v. Walston &
Co., Inc., supra, 493 F.2d at 1055.
In this case it would be impossible to sort the lawful from the
unlawful transactions because the classification depends upon
Mr. Henricksen’s state of mind when any particular transaction
D-14
was initiated. Therefore, I hold that George Henricksen is liable
to the plaintiff in the amount of $17,872.24, the total commis-
sions charged during 1976 and 1977.
In my opinion, these principles also apply to the interest
charged against the plaintiff's account. If George Henricksen
had not been withdrawing cash from the account, purchases on
margin would not have been necessary. While it is conceivable
that some of the loans were contemplated by the plaintiff, par-
ticularly since she did in fact sign a margin contract after her
husband explained it to her, fair approximations of damages are
again appropriate here, because the same impossible task of
classifying lawful and unlawful margin transactions would have
to be performed. Accordingly, George Henricksen is also liable
to the plaintiff for $3,882.41.
In addition to the damages the plaintiff may recover from
George Henricksen in this case, | believe the plaintiff is entitled
to recover prejudgment interest. ‘‘[T]he general rule [is that]
prejudgment interest is available as a matter of law on a claim
which is liquidable, or fixed and determinate.’’ Murray v. Foli-
day Rambler, Inc., 83 Wis.2d 406, 439 (1978). The court of ap-
peals for the seventh circuit, has held that the amount upon
which prejudgment interest is to be computed must be ascer-
tainable with reasonable certainty. Fattore Co. v. Metropolitan
Sewerage Comm'n, 505 F.2d 1, 7 (7th Cir. 1974).
The legal rate of interest in Wisconsin is five percent.
§ 138.04, Wis. Stats. The period for computing such interest
should commence on November 1, 1977. In my opinion,
recovery of this combined sum--damages plus prejudgment
interest--will fairly compensate the plaintiff for the financial
loss caused by her ex-husband. Moreover, this sum closely ap-
proximates the fair market value her account would have had at
the time of trial had it still contained the securities held in
January 1976. See Fey v. Walston & Co., Inc., supra, 493 F.2d
at 1054-55 n.26.
D-15
Ill. LIABILITY OF SMITH BARNEY
The plaintiff has advanced two theories for holding Smith
Barney liable for her entire losses in this case: (1) derivative
liability based on the common law principle of respondeat
superior; and (2) derivative liability based on section 20(a) of the
Securities and Exchange Act of 1934, 15 U.S.C. § 78t(a). In ad-
dition, the plaintiff contends that Smith Barney is liable for the
losses the account sustained as a result of George Henricksen’s
unsuitable investments in call options based on a violation of
the “‘know your customer’’ rule of the New York Stock Ex-
change and the National Association of Securities Dealers.
An investor may recover from a broker for damages caused
by the fraudulent acts of the broker’s registered representative
under the principle of respondeat superior. Fey v. Walston &
Co., Inc., supra, 493 F.2d at 1052-53. Here, George Henricksen
defrauded the plaintiff, and, normally, as George Henricksen’s
employer, Smith Barney would be liable for any damages
caused by the fraud. Jd. However, George Henricksen was not
only Smith Barney’s agent, but, by virtue of the 1972 and 1975
powers of attorney, he was also the plaintiff’s agent. This dual
agency relation complicates the outcome, for, under the follow-
ing authorities, George Henricksen’s fraud may just as easily be
imputed to the plaintiff as it may be imputed to Smith Barney.
Although Mr. Henricksen’s fraudulent acts were not within
the authority granted by the powers of attorney and were
adverse to the plaintiff’s interests, as against third parties, sec-
tion 161 of the Restatement (Second) of Agency asserts that a
principal may be liable for even the unauthorized acts of its
general agent. Moreover, it has long been the rule in Wisconsin
**that he who has, although innocently, enabled any person to
do an act which might be injurious to himself or to another in-
nocent party, shall himself suffer the injury, rather than the in-
nocent party who has placed confidence in him.’’ Kasson v.
Noltner, 43 Wis. 646, 650-51 (1878). Accord, Bronson’s Ex-
ecutor v. Chappell, 79 U.S. (12 Wall.) 681, 683 (1870); Holl-
ingsworth v. American Finance Corp., 86 Wis.2d 172, 181
D-16
(1979); Motor Castings Co. v. Milwaukee County Bank, 254
Wis. 493, 499 (1949); Voell v. Klein, 184 Wis. 620, 622 (1924).
Since an agency relation connects both the plaintiff and Smith
Barney to George Henricksen’s fraud, the general rule that a
principal is charged with his agent’s fraudulent acts operates as
a double-edged sword in this case, and the problem cannot be
resolved by simple resort to it.
In my opinion, two other venerable common law principles
furnish needed guidance for resolving the issue of Smith
Barney’s liability under the general law. The first of these is
that, as between two parties who are otherwise similarly
situated, the one who was in a better position to prevent the
wrong should suffer any resultant loss. See generally Posner, 2
J. of Legal Studies 399 (1973). The second principle is that, not-
withstanding one party’s greater relative capacity to prevent the
wrong, neither party should profit at the other’s expense as a
result of wrongs committed by a third person. Applying these
principles to the facts of this case, I hold that the common law
liability of Smith Barney extends to the commissions and in-
terest charged to the plaintiff’s account but not to the losses at-
tributable to George Henricksen’s unauthorized withdrawals
and unsuitable investments in call options.
With regard to Mr. Henricksen’s option purchases, Smith
Barney was certainly entitled to believe that the piaintiff’s hus-
band was merely translating the plaintiff’s wishes. Not only had
she executed a power of attorney granting her husband broad
discretionary authority over her account and expressly ratifying
all acts he might perform as her attorney-in-fact, but she also
had signed an option agreement which stated that she under-
stood and accepted the inherent risks attending all option trans-
actions. With regard to George Henricksen’s conversion of the
plaintiff’s assets, it appears that the first check Mr. Henricksen
converted was delivered to the couple’s home address; Smith
Barney cannot be liable for the amount of this check in any cir-
cumstances. As to the other seventeen checks, the testimony
showed that Smith Barney’s local managers questioned George
Henricksen about the reasons behind both the change of ad-
D-17
dress on the account and his cash withdrawals. However, there
is no evidence that the plaintiff ever asked her husband why,
beginning in February 1976, she was no longer receiving any
records on her account; in fact, the plaintiff testified that she
never bothered with the records Smith Barney sent her every
month before that date.
The plaintiff places great emphasis on the fact that Smith
Barney's local managers knew during 1976 and 1977 that
George Henricksen was involved in drinking and gambling and
wa3 experiencing serious marital problems. However, these
negative factors of her husband’s personal life must also have
been known to the plaintiff. Yet, even after the couple
separated in October 1976, and after the plaintiff filed for
divorce in the spring of 1977, she failed to take any steps either
to revoke the power of attorney or to have the records of her ac-
count mailed to her directly.
I am mindful that in accomplishing his fraudulent scheme
George Henricksen utilized Smith Barney’s facilities. However,
courts should allocate liability in ways which encourage persons
to be as resonsible for their own affairs as the situation permits
and requires. In the circumstances of this case, I find that the
plaintiff could easily have prevented or at least quickly detected
her husband’s fraud by taking reasonable precautionary steps
which the facts known to her required. Accordingly, I believe it
would be unfair to hold Smith Barney responsible for losses
which stemmed in part from the plaintiff’s total failure to be
concerned about her own financial affairs.
On the other hand, I believe it would be equally unfair to
permit Smith Barney to retain any benefits it received as a result
of George Henricksen’s fraudulent course of conduct. Courts
have long been alert to force principals to disgorge the fruits of
their agents’ wrongful acts. See generally Stockwell v. United
States. 80 U.S. (13 Wall.) 531, 548 (1871); Amen v. Black, 234
F.2d 12, 20-21 (10 Cir. 1956) (en banc); Estes v. Crosby, 171
Wis. 73, 79 (1920). This type of recovery ‘‘is not aimed at com-
pensating the plaintiff, but at forcing the defendant to disgorge
D-18
benefits that it would be unjust for him to keep.’’ D. Dobbs,
Remedies § 41, at 224 (1973). Though Smith Barney may protest
that it innocently acquired the benefits it received in this case
and should therefore be permitted to retain them, even apart
from the agency relationship between it and George
Henricksen, the rule is that ‘‘restitution is generally awarded
when the defendant has gained a benefit that it would be unjust
for him to keep, though he gained it honestly.’ Jd.
As I have previously discussed, the commissions and in-
terest which were charged against the plaintiff’s account must
be treated as incidents of George Henricken’s fraudulent
behavior. in perpetrating the fraud, Mr. Henricksen utilized
both his position with Smith Barney and the latter’s facilities
and instrumentalities. While the general law does not oblige
Smith Barney to compensate the plaintiff for her losses, I hold
that it does require Smith Barney to return to her the commis-
sions and interest Smith Barney received as a result of George
Henricksen’s unlawful conduct.
The plaintiff is also entitled to recover prejudgment interest
from Smith Barney, because the latter benefited from the use of
the sums it received. The defendants will be jointly and severally
liable for the sum of the commissions, interest, and prejudg-
ment interest, but, since George Henricksen acted as Smith
Barney’s agent and was the wrongdoer, Smith Barney is entitled
to indemnity from him for any amount it pays to the plaintiff.
See Culver v. Webb, 244 Wis. 478, 491 (1944). Cf. Heizer Corp.
v. Ross, 601 F.2d 330 (7th Cir. 1979) (indemnity not allowed
where all defendants are wrongdoers).
Application of these general principles does not dispose of
Smith Barney’s potential liability under the federal securities
laws. The relevant statute, 15 U.S.C. § 78t(a), provides that:
“Every person who, directly or indirectly, controls
any person liable under any provision of this title or of
any rule or regulation thereunder shall also be liable
jointly and severally with and to the same extent as
D-19
such controlled person to any, person to whom such
controlled person is liable, unless the controlling per-
son acted in good faith and did not directly or indirect-
ly induce the act or acts constituting the violation or
cause of action.”’
The court of appeals for this circuit has interpreted this provi-
sion to mean that persons in control shall be liable if they ‘‘did
not maintain a reasonably adequate system of internal supervi-
sion and control...or did not enforce with any reasonable
diligence such system....’’ Fey v. Walston & Co., Inc., supra,
493 F.2d at 1051. The question is whether Smith Barney is liable
under this statute for the plaintiff’s losses due to George
Henricksen’s unauthorized cash withdrawals and option trans-
actions.
Upon careful consideration of all the relevant facts, I am
satisfied that George Henricksen’s unlawful conversion of the
plaintiff’s funds was not due to any failure on Smith Barney’s
part to enforce with reasonable diligence its internal plan of
supervision. Though the plaintiff contends that the change of
address on the account enabled George Henricksen to convert
her assets, the record shows that the first check Mr. Henricksen
converted was delivered to the couple’s home address. In fact,
according to the plaintiff’s own testimony, she would not have
discovered the continuing thefts even if the address on the ac-
count had not been changed because she did not concern herself
with mail from Smith Barney but left such matters to her hus-
band.
Assuming the change of address did facilitate George
Henricksen’s defalcations, | believe Smith Barney was not guilty
of an unreasonable lack of diligence. Rather, both its local
managers questioned Mr. Henricksen about the change of ad-
dress and received plausible explanations as to the reasons
behind both the change of address and the cash withdrawals.
Moroever, rule 409(b)(2) of the New York Stock Exchange ex-
pressly permits a registered representative to receive his wife’s
mail over those account he holds a power of attorney. It should
D-20
be remembered that the checks themselves were made out to
Wendee Henricksen, and only by placing her endorsement onto
the checks was George Henricksen able to cash them; certainly
Smith Barney had no more control over this circumstance than
it had over the ease with which George Henricksen was able to
deposit a large portion of the checks into the couple’s joint sav-
ings account and shortly thereafter withdraw such amounts
without being discovered by the plaintiff.
With the benefit of hindsight, the plaintiff argues that
Smith Barney’s local managers should have drawn a connection
between the large, continuous cash withdrawals and George
Henricksen’s personal problems, including the couple’s separa-
tion. Awareness of these same problems did not trigger similar
concern on the plaintiff’s part which itself suggests that Smith
Barney’s supervision of Mr. Henricksen was not unreasonable
or inadequate. On the contrary, I find that Smith Barney
discharged its duty to supervise with reasonable diligence
George Henricksen’s withdrawals of cash from the plaintiff’s
account and therefore hold that Smith Barney is not jointly and
severally liable for Mr. Henricksen’s fraudulent conversion of
the plaintiff’s funds.
I also find that, considering all the circumstances, Smith
Barney was reasonably diligent in its supervision of the quality
of trading in the plaintiff’s account. The plaintiff’s investment
objectives were relatively conservative when she opened the ac-
count in 1972, and, even after she signed an option agreement in
1975, the account retained a generally conservative quality.
However, in light of the sweeping terms of the power of at-
torney the plaintiff executed in favor of George Henricksen, it is
clear to me that he was given the power to make whatever in-
vestments he deemed suitable for the plaintiff’s account. Thus,
in discharging its duty to supervise with reasonable diligence
Mr. Henricksen’s actions, Smith Barney was entitled to rely on
George Henricksen’s investment decisions just as the plaintiff
relied on her husband's expertise.
D-21
This approach finds support in Ocrant v. Dean Witter &
Company, Inc., 502 F.2d 854 (10th Cir. 1974), and Marshak v.
Blyth Eastman Dillon & Co., Inc., 413 F. Supp. 377 (N.D.
Okla. 1975). In Ocrant, the court found an apparent agency
relationship between the plaintiff wife and her husband and that
the plaintiff relied exclusively on her husband to handle her in-
vestment account. What the court said in Ocrant is germane
here:
**Throughout this action [the plaintiff] has stressed
her complete reliance on her husband’s skill and exper-
tise to excuse her own inattentiveness and inaction.
She cannot now reject that reliance for purposes of
disaffirming his activities.’’ § 2 F.2d at 858.
The Marshak court similarly held that, after relying on the man-
ner in which her husband handled her account, the plaintiff
could not disavow his control simply because problems subse-
quently arose. 413 F. Supp. at 381-83.
Of course, in this case, unlike Ocrant and Marshak, the
husband upon w'iom the plaintiff relied was employed by the
defendant broker, and the latter was duty-bound to supervise
the husband’s activities. I do not suggest that, by virtue of the
agency relation, George Henricksen’s knowledge must be im-
puted to the plaintiff, thereby estopping her from challenging
the uncontroverted option transactions. I do believe, however,
that the reasonableness of Smith Barney’s supervision of
George Henricksen must be evaluated in light of the express
agency relationship which existed between Mr. Henricksen and
the plaintiff and in light of Mr. Henricksen’s investment ex-
perience.
Smith Barney’s local managers, because they approved of
each of Mr. Henricksen’s orders, knew that the account was
trading heavily in options. However, they also believed that
George Henricksen was mitigating the impact of this trading by
sheltering large amounts of cash in a savings account. On the
one occasion when Mr. Henricksen clearly exceeded the ac-
D-22
count’s approved level of trading by making an ‘‘uncovered’’
transaction, Smith Barney’s compliance section required him to
cover the transaction.
That the plaintiff’s account incurred substantial losses as a
result of options trading does not alone make Smith Barney’s
supervision unreasonable or indicate a lack of diligence. Rather,
based on all the facts known to Smith Barney, including the
power of attorney, the option agreement, George Henricksen’s
investment experience and his reported placing of large amounts
of cash in a safe harbor, I am satisfied that the plaintiff's losses
in options trading were not due to a failure on Smith Barney's
part to supervise George Henricksen with reasonable diligence.
I also conclude that Smith Barney is not liable for the plain-
tiff’s trading losses based on an alleged violation of the New
York Stock Exchange’s ‘‘know your customer”’ rule. In Buttrey
v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135,
143 (7th Cir.), cert. denied, 396 U.S. 838 (1969), the court held
that a violation of this rule wouid constitute a violation of
federal law in certain circumstances but that ‘‘mere errors of
judgment by defendant might not support a federal cause of ac-
tion....’” In this case, Smith Barney’s customer had given her
broker-husband wide discretionary authority over her account,
expressly ratifying whatever acts he might perform. She had
also signed an option agreement and a margin contract. In these
circumstances, Smith Barney was entitled to believe that George
Henricksen was executing his wife’s wishes. While this belief
can be described as an error of judgment, in my opinion this er-
ror affords and insufficient basis upon which to base liability
against Smith Barney.
CONCLUSION
Therefore, IT IS ORDERED that the plaintiff recover
from the defendant George Henricksen the sum of $88,921.22,
plus prejudgment interest on such sum computed at the rate of
D-23
5% per annum since November 1, 1977, plus the plaintiff's costs
in this action.
IT IS ALSO ORDERED that the plaintiff recover from
both defendants jointly and severally the sum of $21,754.65,
plus prejudgment interest on such sum computed at the rate of
5% per annum since November 1, 1977.
IT IS FURTHER ORDERED that the defendant Smith,
Barney Harris Upham & Co., Inc. may recover from the defen-
dant George Henricksen any sum it pays to the plaintiff as a
result of the above order.
IT IS FURTHER ORDERED that no costs be recovered
from the defendant Smith, Barney, Harris Upham & Co., Inc.
Dated at Milwaukee, Wisconsin, this 10th day of March,
1980.
/s/ MYRON L. GORDON
U. S. District Judge
E-1
JUDGMENT ON DECISION BY THE COURT
UNITED STATES DISTRICT COURT
FOR THE
EASTERN DISTRICT OF WISCONSIN
WENDEE HENRICKSEN, CIVIL ACTION FILE NO.
78-C-208
Plaintiff,
vs. JUDGMENT
GEORGE HENRICKSEN and SMITH,
BARNEY, HARRIS, UPHAM & CO., INC.,
Defendants.
This action came on for trial before the Court, Honorable
MYRON L. GORDON, United States District Judge, presiding,
and the issues having been duly tried and a decision having been
duly rendered,
It is Ordered and Adjudged that the plaintiff recover from
the defendant George Henricksen the sum of $88,921.22, plus
prejudgment interest on such sum computed at the rate of 5%
per annum since November 1, 1977, plus the plaintiff’s costs in
this action.
IT IS ALSO ORDERED that the plaintiff recover from
both defendants jointly and severally the sum of $21,754.65,
plus prejudgment interest on such sum computed at the rate of
5% per annum since November |, 1977.
IT IS FURTHER ORDERED that the defendant Smith,
Barney, Harris Upham & Co., Inc. may recover from the defen-
dant George Henricksen any sum it pays to the plaintiff as a
result of the above order.
E-2
IT IS FURTHER ORDERED that no costs be recovered
from the defendant Smith, Barney, Harris Upham & Co., Inc.
Dated at Milwaukee, Wisconsin, this 10th day of March,
1980.
RUTH W. LA FAVE
Clerk of Court
By:
Deputy Clerk
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.