Amicus Curiae Brief — SEC v. Zandford

5 } Supreme Cour U.S,

Pi No.01-147 dobogeainn

IN THE

SUPREME COURT OF THE a STATES clerk

SECURITIES AND EXCHANGE COMMISSION,

Petitioner,

v.

CHARLES ZANDFORD,

Respondent.

On Writ of Certiorari To The United States

Court of Appeals For the Fourth Circuit

BRIEF AMICI CURIAE OF AARP, NATIONAL

ASSOCIATION OF SECURITIES AND

COMMERCIAL LAW ATTORNEYS, AND

CONSUMER FEDERATION OF AMERICA

IN SUPPORT OF PETITIONER

DEBORAH M. ZUCKERMAN*

STACY J. CANAN

AARP FOUNDATION

MICHAEL R. SCHUSTER

AARP

601 E Street, N.W.

Washington, DC 20049

(202) 434-2060

Counsel for AARP

*Counsel of Record

(Additional Counsel Listed on Inside Cover)

ZU pe

ADDITIONAL COUNSEL

Brian Murray Mary Ellen Fise

Rabin & Peckel LLP Consumer Federation

275 Madison Avenue of America

New York, N.Y.10016 1424 16” Street, N.W.

(212) 682-1818 Suite 604

Washington DC 20036

Denise Davis Schwartzman (202) 387-6121

Chimicles & Tikellis LLP

361 W. Lancaster Avenue Counsel for Consumer

Haverford, PA 19041 Federation of America

(610) 642-8500

Kevin Roddy

Hagens Berman, LLP

700 S. Flower Street

Suite 2940

Los Angeles, CA 90017

(213) 330-7150

Counsel for National

Association of Securities

and Commercial Law Attorneys

.

TABLE OF CONTENTS

Page

i ne < ccseeeeceodeseeces ili

INTEREST OF AMICI] CURIAE ..............4.. |

SUMMARY OF ARGUMENT ................ 4

a 5

es <i. lee tg eee ghee eee4 5

A. Individuals Are Investing in the Securities

Markets in Unprecedented Numbers,

Often For the First Time .............. 5

B. Individual Investors Have Extremely

Low Levels of “Financial Literacy”

Leading Them to Rely Heavily on Financial

Dt iit eee ek eebeces veces 7

Il. THE PREVALENCE OF SECURITIES

FRAUD REQUIRES THAT THE SEC &

INVESTORS HAVE A FULL RANGE OF

STRONG, FLEXIBLE ENFORCEMENT

(jen Dead een de eeseeeeceee « 10

A. Securities Fraud Continues to

DEE SG Sco decoccccecesccoes 10

B. SEC Enforcement Actions & Private

Lawsuits Are Powerful Tools Under The

Exchange Act and Should Not Be Weakened . . 13

1. Congress Gave the SEC Broad

Powers to Combat Fraud Under

the Federal Securities Laws ......... 13

2. The Fourth Circuit Erred in

Holding That Zandford's Fraud

Did Not Meet the “In Connection

With” Standard and Thus Fell

Outside the SEC's Broad Enforcement

Authority

Restrict Debanied | hare From

= Neither A State Civil Remedy Nor A

Criminal Precludes a Claim

Under the Federal pote

ii

TABLE OF AUTHORITIES

CASES

Aaron v. SEC,

446 U.S. 680 (1980) ..........cececenceeeeeereeeeeeereeeeeeees 15

Basic Inc. v. Levinson

485 U.S. 224 (1988) ........cececececceccererceeereeceees 19, 22

Bateman Eichler, Hill Richards, Inc. v. Berner,

472 U.S. 299 (1985) seeseeeeaeeessessnneenenseeneneaeneenssees 18

| s v. Manor Drug Store,

421 U.S. 723 (1975) .....ccccececccecceccerecceeeeeeeeeeeseees 19

In re Cendant Corp. as

264 F.3d 286 (3d Cir eee 13

Central Bank v. First Interstate Bank,

511 U.S. 164 (1994) .......cccccececeeceeceeeeeeeeeeeneeeeeees 19

Ernst & Ernst v. Hochfelder,

425 U.S. 185 (1976) ........ccccccecceccecceceeeeeeeeeees 14, 19

Green v Progressive Asset M, , Inc.,

2000 U.S. Dist. LEXIS crt i

(S.D.N.Y. Aug. 29, 2000) .........ceceeceeeeeereeeeeeeeneees 21

ry v. Piper Jaffray, Inc.,

148 F.3d 197 oy Ce, FIED cccccccccccccccccccscescocecceses 21

Head v. Head,

759 F.2d 1172 (4th Cir. 1985) .......--ccecceeeceeereeeerees 17

Herman & MacLean v. Huddleston,

459 U.S. 375 (1983) ........cececcceceeceeeeeeecesereneeeeees 22

J. I. Case Co. v. Borak,

377 U.S. 426 (1964) .....ccccccecececeececeeeeerereceeeeeeeees 18

Krull v. SEC,

ee ee Ee GG, ED ccecenasscsccctccenenacsoscotes 21

Lampf, Pleva, , Prupis & Petigrow v.

Gilbertson, 501 S. 350 (1991) — wdildieaaandeabamianiais 19

Miley v. r & Co.,

637 F.2d 318 Sth Cir. 1981) diientinemeniinntingtnniinia 21

Musick, Peeler & Garrett v. Employers Ins.

Wausau, 508 U.S. 286 (1993) ...........00. od Sibioiiagimpeiit 13

In re PaineWebber Lid. P' ship Litig.,

B71 PRD. 166 G.DI.Y. TSG) ...ccccccccccccccsccccsees 13

In re Prudential Sec. Inc. Lid. P'ship Litig.,

oF Re PNA eee 12

Randail v. Loftsgaarden,

PE EL NY UID dicniitintinnsichincadsicvesgnianinedaacdibdl 13

SEC v. Drexel Burnham Lambert, Inc..,

956 F. Supp. 503 (S.D.N.Y.1997) wee eeceeee. 15

SEC v. Drexel Burnham Lambert, Inc..,

Ysa DNY bee Sec. L. Rep. (CCH)

94,474 (S.D.N.Y. Jume 20, 1989)... 2 cece eee eee ees 10

SEC v. Manor Nursing Centers, Inc..,

—_ i | . .: S Tene eree 15

SEC v. Milken, [1989-1990 Transfer Binder]

Fed. Sec. L. Rep. (CCH) { 95,200

8 I Ae 11

SEC v. :

238 F.3d 559 (4th Cir. 2001), cert. 4

2001 U.S. LEXIS 10303 (Nov. 8, 2001) .......... 4, 16, 21

Vv

Shearson/American Express v. McMahon,

" LF |. eee 20

Superintendent of Ins. v. Bankers Life & Cas. Co.,

GO GB GOED ceccccesccccccccccccccccccesccccccsccccecsese 20

TSC Indus., Inc. v. Northway, Inc.,

GED UD. GIB IOI) cccocccvcccccccccccgsccscccscccsccccccecee 19

United States v. Benjamin,

328 F.2d 854 (2d Cir.), cert. denied,

a ea 13

United States v. O'Hagan,

a gl a 17, 22

United States v. Turkette,

ioe 23

STATUTES

Organized Crime Control Act of 1970,

Pub. L. No. 91-452, 84 Stat. 922 .............sceceseeeee- 22

Private Securities Litigation Reform Act of 1995,

Pub. L. No. 104-67, 109 Stat. 747

(codified as amended in scattered sections of

BS WBS. 8 FED ccocccccccccccccccccccccccccccccccccccceseccceces 20

Racketeer Influenced and Corrupt Organizations Act,

18 U.S.C. §§ 1961-1968 ............ccccececeeereceeeceeeeees 22

Securities Act of 1934,

15 U.S.C. § 78j(D) (2001) ......eceeeeeeeeeeeeeeeee enone passim

Securities Litigation Uniform Standards Act of 1998,

Pub. L. No. 105-353, 112 Stat. 3227

(codified as amended in scattered sections of

1S U.S.C. § TB) .....cccecorccrccccsccccrescccrscrscesecssoessees 20

vi

LEGISLATIVE HISTORY

Fraud In The ae Markets, Including

Penny Stock Fraud: Hearing re the Permanent

Subcomm. on Investigations Senate Comm. on

Governmental Affairs, 105th eo \ ar 12

Private Litigation Under the Federal Securities

Laws: Hearings Before the Subcomm. on Securities

of the Senate Comm. on Banking, Housing and Urban

PS ee 19

President Franklin D. Roosevelt, Regulation of

Issues, Remarks to the Senate

(Mar. , 1933), reprinted in 77 Cong.

Rec. 937 (1933) jeupienianidebiidempeleibianstiaebetveettiuceseqens 22

Securities Litigation Reform: Hearings Before

the Subcomm. on Telecomm. & Finance of the

House Comm. on Energy and Commerce,

ST PEPE ° darnnbthdeninlbinennascdberveteisoonenis 18

REGULATION ;

Rule 10b-5, 17 C.F.R. §-240.10b-5 (2001) .......... passim

MISCELLANEOUS

Bernard Black, The ee oe ae

Strong Securities Markets, 55 Bus. Law. 1

GL EEE? cunivucntnsedeccdeccnesishiudenddicorensseendquecee 10

Gee Terms, CSFB Agrees to P. or “1 Million

to Settle Twin IPO Investigations, W

3 & Ff Re ene 12

William O. Douglas & George E. Bates, The Federal

Securities Act of 1933, 43 Yale L.J. 171 (1933) .... 22, 23

vii

Maureen Dowd, Bush Savings Plan Calls for

Pay sey oe ag .Y. Times,

EN. Ui: MA NEED vebirecisdcccqnentbassdsnnescostscececuens il

ter wry oe Institute, About Mutual oe

Shareho Demographic Info y

Asked Questions About Mutual Fund Fund Shareholders

(Nov. 2001) available at http://www.ici.org/

aboutshareholders/ shareholders fags.html ............. 6, 9

Investment Company Institute, Mutual Funds

Facts & Figures, Current Statistical Releases,

Trends in Mutual Fund Investing, available at

http://www.ici.org/facts figures/trends_1001.html

Cele Gi DEED. eccdcccscnccccesescocecssossonctocsceccococscccese 6

Investor Protection Trust, National Association

of Securities Dealers, North American

Securities Administrators Association,

Press Release, Survey: Financial Illiteracy,

Bad Habits Dangerous Mix For Investors,

available at http://www.investorprotection.org/

nr] htm (May 14, 1996) ..........ccccccceceeeecereeceeeeeeeeees 9

Robert Jackson, The Struggle For Judicial

Supremacy 152 (1943) .......ccccceseceseeeeesesereeeeeeeeeees 23

Arthur aah the Promise of

Through Savings

a Sec. gow ncws/ speech peecharcive

1998/spch229.htm (Dec. 3, 1998) .........cccceeeeeeeeeeeeees 7

Arthur Levitt, Remarks to National Press Club,

Plain Talk About On-line Investing

Dae 4, BEBE) cevecvoscccvccvcccsccccccccccccccescconececees 10, 11

National Association of Securities Dealers, Inc..,

Press Release, NASD Launches Major Public

Disclosure, Investor Education Initiative

Gus GD SUPTEE . cepsclinncecedsndtiandsiaiilitenaddieecdiibeeniadensis 8

North American Securities Administrators

Association, Press Release," 10 Investment

Scams" List Released by State Securities Regulators,

available at http//www.nasaa.org/nasaa/scripts/

prel_display.asp?rcid = 156 (Apr. 23, 2001) .......... 10, 23

Office of Investor Education and Assistance, SEC,

The Facts on Saving and Investing 6 (Apr. 1999) ... 6, 7, 9

Towers Perrin, Preparing For Retirement:

A Survey of 1,000 Working Americans (Feb. 1995) ...... 8

SEC, Brief of Amicus Curiae in

Lampf, Pleva, Lipkind, Prupis & Petigrow v.

Gilbertson, 501 U.S. 350 (1991) 0.0... cece cece cecececece es 14

Securities Investor Protection Corporation &

National Association of Investors Corporation,

Press Release, Survey: More Than 4 Out of

5 U.S. Investors Fail Quiz of Basic “Survival”

Knowledge, available at http://216.181.142.217/sipe/

PRUE: Bi, SIE cccccncdesinnccntiubcnssceeecreres 8

Ruth Simon, We Put Investors to the Test -- and,

Boy, Did They Ever Flunk, Money (Mar. 1998) ............ 8

U.S. General Accounting Office, Report to

the Ranking Minority Member, Subcomm. on

Financial Institutions, Senate Comm. on Banking,

Housing, and Urban Affairs, “Securities and Exchange

Commission: Human Capital Challenges Require

Management Attention” (Sept. 2001) ...............ccc0cee 15

No. 01-147

IN THE

SUPREME COURT OF THE UNITED STATES

SECURITIES AND EXCHANGE COMMISSION,

Petitioner,

v.

CHARLES ZANDFORD,

Respondent.

On Writ of Certiorari To The

United States Court of Appeals

For the Fourth Circuit

BRIEF AMICI CURIAE OF AARP, NATIONAL

ASSOCIATION OF SECURITIES AND

COMMERCIAL LAW ATTORNEYS,

AND CONSUMER FEDERATION OF AMERICA

IN SUPPORT OF PETITIONER

INTEREST OF AMICI CURIAE”

AARP is a non-profit, non-partisan organization with

more than 35 million members, dedicated to addressing the

needs and interests of Americans aged 50 and older. As the

largest membership organization representing the interests of

older Americans, AARP is very concerned about fraudulent

Y The parties’ consents have been filed with the Clerk of the

Court. Amici curiae state that no counsel for any party authored

this brief in whole or in part and that no party other than these

amici curiae, their members or counsel made a monetary

contribution to the preparation or submission of this brief.

2

practices in the securities industry. Older people are frequent

targets of fraud because they often have significant assets and

are looking for investment opportunities that will supplement

the Social Security and pension benefits they will receive

during retirement. As a result, AARP has made the need to

combat securities fraud a high priority, with a particular focus

on stockbroker practices that are inconsistent with an

investor’s best interests. AARP has been very involved in

commenting on legislative and regulatory proposals that

address such practices, has filed amicus curiae briefs in cases

involving interpretation of the federal securities laws, e.g.,

Kauthar Sdn Bhd v. Sternberg, No. 98-799 (U.S. Supreme

Court Dec. 17, 1998) ( in —— of petition for writ of

certiorari); Newton, et al. v. Merrill, Lynch, Pierce, Fenner

& Smith, Inc., et al., No. 96-5045 (3d Cir. July 17, 1997) (in

support of petition for rehearing with suggestion for rehearing

en banc), and has opposed efforts to limit federal statutory

remedies that allow defrauded investors to obtain financial

redress. In addition, AARP has undertaken efforts to combat

investors’ low financial literacy and to educate them about

how to choose financial professionals who will act in their

best financial interest. For example, in 1998 AARP

commissioned a survey of people 50 and older to determine

investor awareness of broker compensation practices. The

survey revealed that investors do not have a basic

understanding of the conflicts of interest that may arise

because of such practices, such as sales contests and higher

commissions for the sale of proprietary products. AARP,

Investor Awareness of Broker Compensation Practices:

Findings From An AARP Survey 3-4 (Apr. 1998) (on file

with AARP); see also AARP, Investor Understanding of

Broker Account Statements: Findings From a Survey 5-6,

available at http://research.aarp.org/consume/broker.pdf

(Oct. 2000) (revealing that experienced investors with full-

service brokerage accounts do not understand much of the

information on typical account statements, including basic

terms such as “equity,” or fundamental transactions, such as

the number of shares reinvested in a particular fund).

The National Association of Securities and Commercial

Law Attorneys (“NASCAT”) is an association of law firms

3

and attorneys who litigate antitrust, commercial, consumer,

securities fraud, and shareholder derivative cases in federal

and state courts throughout the country. NASCAT and its

members are devoted to representing victims of corporate

abuse, fraudulent schemes, and so-called “white-collar”

criminal activity in cases that have the potential for advancing

the state of the law, educating the public, modifying corporate

behavior, and/or improving access to justice and

nsation for the wrongs inflicted upon victims.

NASCAT advocates principled interpretation and application

of federal and state securities laws to protect investors from

manipulative, deceptive, and fraudulent practices and to

ensure that the nation’s securities markets operate fairly and

efficiently. NASCAT’s members frequently represent victims

of securities fraud in cases brought under federal and state

securities laws and thus have an interest in the effective

private enforcement of these laws.

The Consumer Federation of America (“CFA”) is a non-

profit association organized in 1968 to advance the interests

of consumers through advocacy and education. CFA’s

membership is comprised of 285 national, state, and local

consumer groups throughout the United States which, in turn,

represent more than 50 million consumers. Recognizing the

growing participation of American consumers in our nation’s

financial markets, CFA has made protecting the interests of

individual investors a priority. The guiding principles behind

CFA’s work on these issues is that investors deserve effective

protection from fraud, fair dealing from financial

professionals, and full and timely disclosure of information

relevant to their interests. In keeping with these concerns,

CFA has supported federal and state legislative and regulatory

initiatives on a broad array of inveswor protection issues,

including financial planner regulation, penny stock fraud,

rights to redress for victims of securities fraud (both in court

and through arbitration), industry compensation practices, and

plain language disclosures.

The interest of amici in this case stems from their

positions among the leading consumer organizations in this

country involved in matters that concern protecting investors

4

from fraud and the substantial interests at stake for their

members and the consumers they serve. Amici submit this

brief to apprise the Court of the unprecedented degree to

which Americans are investing in the securities markets and

their relatively low level of understanding of how the markets

operate, and to more fully explain the effect the Fourth

Circuit’s erroneous interpretation of the “in connection with”

requirement will have in undermining securities law

enforcement and the protections currently afforded investors

and the national securities markets by the anti-fraud

provisions of § 10(b) of the Securities Exc e Act of 1934

(“the Exchange Act”), 15 U.S.C. § 78j(b) (2001), and Rule

10b-5, 17 C.F.R. § 240.10b-5 (2001), _ by the

Securities and Exchange Commission (“SEC”).

SUMMARY OF ARGUMENT

The Fourth Circuit erred in holding that “Zandford’s

fraudulent actions were not sufficiently connected with a

securities transaction” to support an SEC enforcement action

under the federal securities laws. SEC v. Zandford, 238 F.3d

559, 561 (4" Cir. 2001), cert. granted, 2001 U.S. LEXIS

10303 (Nov. 8, 2001). Not only did the lower court misread

the plain language of the Exchange Act and Rule 10b-5, it

also misapplied this Court’s precedent. The importance of the

Court correcting the Fourth Circuit’s error cannot be

overstated.

In recent years, Americans have entered our nation’s

securities markets in record numbers, many for the first time.

This is due, in large part, to the recognition that individuals

have to plan and eteg for their retirement security, with

less reliance on Social Security and traditional employer-

sponsored defined benefit pension plans. Yet, many investors

are ill-equi to navigate the complexities of the markets

and thus rely on the advice of a range of professionals,

including stockbrokers and financial planners. In placing

their trust in others they are, in many instances, unwittingly

placing their financial security in jeopardy. When the worst

happens, and their trust is abused through fraud, individual

investors need access to the full range of legal enforcement

5

mechanisms and remedies - federal and state, public and

private, civil and criminal - that Congress and state

legislatures have enacted for their protection.

Unless the Court reverses the Fourth Circuit and upholds

the standard intended by Congress and advanced by Petitioner

America’s individual investors and their financial futures will

remain at the mercy of unscrupulous practitioners. At the

same time, the SEC’s civil enforcement authority and the

ability of individual investors to seek redress will be severely

circumscribed. The result will be the severe dilution of two

powerful weapons in the full arsenal of legal protections

intended to benefit investors.

ARGUMENT

I. INTRODUCTION

A. Individuals Are Investing in the Securities

Markets in Unprecedented Numbers, Often For

the First Time

Demographic factors have led to considerable changes in

participation in this country’s securities markets. In the past,

wealthy individuals and corporations were the primary

investors in the stock market. That is no longer true, due to

the combined effect of the baby boom generation’s entry into

adulthood, changes in retirement regulations and strategies,

and a stock market that, for the most part, has been producing

incredibly high returns. The nation has entered a period in

which Social Security provides proportionately less of needed

retirement income, and traditional employer-sponsored

defined benefit pension coverage has decreased. In addition,

Americans have departed, in unprecedented numbers, from

their historic practice of placing primary reliance on federally-

insured products, such as savings accounts and certificates of

deposit, for their retirement needs.

6

A recent Investment Company Institute (ICI)? survey of

the mutual fund industry showed that the combined assets of

the nation’s mutual funds totaled $6.616 trillion in October

2001. Investment Company Institute, Mutual Funds Facts &

Figures, Current Statistical Releases, Trends in Mutual Fund

Investing, available at http://www.ici.org/facts figures/

trends 1001.html (Nov. 29, 2001). The ICI also indicates

that as of May 2001, an estimated 93 million individuals in

54.8 million American households, or 52% of all U.S.

households, owned mutual funds. Mutual fund ownership

among U.S. households increased steadily during the 1990s

and, in 2000, one out of three individuals in the country

owned mutual funds. Investment Company Institute, About

Mutual Fund Shareholders, Demographic Information,

Frequently Asked Questions About Mutual Fund Shareholders

(Nov. 2001) [hereinafter Frequently Asked Questions]

available at http://www.ici.org/aboutshareholders/

shareholders_faqs.html.

The increased number of individuals making mutual fund

purchases is due, in large part, to the significant trend toward

replacing defined benefit ion plans with defined

contribution plans. The ICI reported that 62% of fund

shareholders own funds through defined contribution

retirement plans. Jd.; see also ce of Investor Education

and Assistance, SEC, The Facts on Saving and Investing 6

(Apr. 1999) [hereinafter SEC, The Facts on Saving and

Investing]. This increased reliance on defined contribution

plans places significant responsibility on individuals to make

appropriate investment choices so they will have adequate

retirement income. When mutual fund assets typically

represent 40% of household assets, ICI, Frequently Asked

Questions, supra, investors face a heightened risk if they

incur losses due to bad advice, abusive practices, or fraud.

The potential for fraud and other abuses becomes even greater

» The Investment Company Institute is the national association

of the American investment company industry. Founded in

1940, its membership includes 8,710 mutual funds, 481 closed-

end funds, and 7 sponsors of unit investment trusts.

7

as large numbers of first-time investors enter the securities

markets and, due to their relative lack of sophistication and

high financial illiteracy, rely on a range of professionals,

including stockbrokers and financial planners, to advise them

in the purchase or sale of securities.

B. Individual Investors Have Extremely Low Levels

of “Financial ” Leading Them to Rely

Heavily on Financial Professionals

The complexity of the marketplace and the relative lack

of sophistication of a majority of individual investors combine

to hinder their ability to make wise investment decisions.

“America faces a financial literacy crisis. At a time when

more Americans than ever before are investing in our

securities markets through the purchase and sale of stocks,

bonds, and mutual funds, numerous studies show they lack the

financial basics.” SEC, The Facts on Saving and Investing,

supra, at 2.

Then-SEC Chairman Levitt stated that

[t]Jens of millions of Americans lack the basic

saving and investing information they need to

for retirement or to meet other

Smt ant. ... While 63 know

the difference between a halfback and a

=. only 12 percent know the

iti itenaeie ined ind op teed antes

fund

Arthur Levitt, E ing the Promise of Opportunity and

Security Through Savings and Investing, Remarks Before the

Consumer Federation of America, available at http://www.

ee 1998/spch229.htm (Dec.

3, 1998).

Several recent studies conducted by epee agencies,

financial services co tions, and non-profit organizations

have produced remarkable findings that bear out Chairman

Levitt’s concerns. The studies took different approaches but

reached the same conclusion: individual investors lack even

the most rudimentary knowledge needed to make informed

investment decisions. Investors do not know the basics of

how investmeats work, and they do not even know what they

are doing with their own money. For example, a May 1996

study conducted by the National Association of Securities

Dealers (NASD) found that while 78% of Americans can

name a character on a television sitcom, a mere 14% know

the difference between growth and income stocks. Press

Release, National Association of Securities Dealers, Inc..,

NASD Launches Major Public Disclosure, Investor Education

Initiative (Feb. 19, 1997) (on file with AARP); see also Ruth

Simon, We Put Investors to the Test ~ and, Boy, Did They

Ever Flunk, Money, Mar. 1998, at 37 (reporting on results of

on Working py pe gee (one-third of those

who partic in a or retirement sa

dit Gon le ao ah cabana tai ant 4% tink

Samp fs ap 2h canal aa a eae “mutual

fund” or a “balanced” fund) (reports on file with AARP).

spunea “anne pie aiauatn emaeieaeemes

investors do not know the first step to take when they suspect

they are dealing with a problem broker, and fewer than one in

five knows there is no insurance for stock market losses.

orporation

Than 4 Ourcl3 U.S. Invecmes Fell Get Bi , Survey: More

Than 4 Out of 5 U.S. Investors Fail of Basic “Survival”

Knowledge, available at http://216.181.142.217/sipce/release

0.html (Aug. 1, 2001).

9

The only cot ion to be drawn from this sampling of

is that i nen

—— Lacking this basic knowledge o securities

~~ being unaware of the fundamental

=. their own investments, individual investors rely in

large measure on third parties, such as brokers, for advice on

the purchase and sale of securities. More than 80% of new

mutual fund were made through intermediaries such

as brokers, , financial planners, insurance agents, and

employers,” and 37% of shareholders purchase funds

through 5 te tes brokers, — agents,

planners, or representatives requently

Aahed Qhostions supra. In of this, almost four-fifths

(79%) of investors feel it is di t to know how to choose

a good professional investment advisor. SEC, The Facts on

Saving and Investing, supra, at 24. And, the vast maj of

investors (88%) who have received advice from a

professional have never looked into the disci history of

their broker or financial planner. Press , Investor

Protection Trust, National Association of Securities Dealers,

North American Securities Administrators Association,

Survey: Financial Illiteracy, Bad Habits Dangerous Mix For

Investors, available at :-// www .investorprotection.org/

nrl.htm (May 14, 1996). Individual investors’ lack of

knowledge about the securities markets, their own

investments, and how to choose trustworthy financial

professionals place these investors at great risk of being

defrauded by unscrupulous practitioners.

¥Nearly half (48%) of mutual fund shareholders identified an

employer-sponsored retirement plan as their primary method for

purchasing mutual funds, and 57% bought their first fund

through these plans. ICI, Frequently Asked Questions, supra.

10

Il. THE PREVALENCE OF SECURITIES FRAUD

. Mr ee de a4. veh gee 5 HAVE

FULL RANG NG, FLEXIB

ENFORCEMENT TOOLS. ”

A. Securities Fraud Continues to Plague Investors

“We are living in a time when the stock market is more

a of the American consciousness than ever before.” SEC

available at http//www .nasaa.org/nasaa/scripts/prel di

asp?rcid = 156 (Apr. 23, 2001). The excesses of the l 4

which gave rise to spectacular failures of financial firms,”

* The stock market has been characterized by one commentator

as a kind of magic. “Investors pay enormous amounts of money

for completely intangible rights whose value depends entirely on

the quality of the information that investors receive and the

honesty of other people about whom investors know almost

nothing. This magic does not appear in unregulated markets.”

Bernard Black, The Core Institutions that Support Strong

Securities Markets, 55 Bus. Law. 1565, 1565 (Aug. 2000).

” The highest-flying investment banking firm of the 1980s,

Drexel Burnham Lambert pled guilty to federal felony securities

fraud charges and paid $650 million in fines and sanctions. SEC

v. Drexel Burnham Lambert, Inc., {1989 Transfer Binder] Fed.

Sec. L. Rep. (CCH) { 94,474 (S.D.N.Y. June 20, 1989)

(reflecting entry of consent decree).

11

junk bonds,” and the collapse of the thrift industry,”

threatened a loss of investor confidence in the financial

markets with a corresponding ive impact on the ability

of business to raise capital. ss. however,

ange pow

market that marked the turn of this century. ew and

enthusiastic investors entered the financial markets® and, as

could be expected, those so inclined found new and

enthusiastic ways to give honesty the slip and defraud

investors.

As Chairman Levitt also observed:

With this vast expansion in our markets and in

public participation in those markets, we

would expect to see am increase in the

incidence of fraud. We have particularly seen

° The most notorious “financier” of the 1980s, Michael

Milken, the “junk bond king,” was indicted on 98 counts of

RICO and criminal securities fraud, pled guilty to six counts

and was sentenced to ten years in prison. SEC v. Milken,

[1989-1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) 4

95,200 (S.D.N.Y. Apr. 24, 1990) (reflecting settlement of

civil enforcement action and guilty plea).

7 President George H. Bush told the nation that

“‘unconscionable risk-taking, fraud, and outright criminality

[were] factors’ that led to the savings and loan crisis.”

Maureen Dowd, Bush Savings Plan Calls for Sharing the

Cost Broadly, N.Y. Times, Feb. 7, 1989, at Al.

* For example, as of 1999, 25% of all individual trades

were conducted on line. In 1994 not one person traded over

in any form of investing. Arthur Levitt, Remarksto -

National Press Club, Plain Talk About On-line Investing

(May 4, 1999).

12

an increase in abuses in the market for micro

Cap securities, which . . . provides opportunity

for fraudsters to prey on innocent investors.

Fraud In The Micro-Capital Markets, Including Penny Stock

Fraud: Hearin ore the Permanent pte on

Investigations of the Senate Comm. on Governmental Affairs,

105" Cong. 114 (1997) (testimony of Arthur Levitt).

The Subcommittee Chair made a similar observation:

We conduct these hearings against the

backdrop of a booming stock market and a

new generation of unseasoned investors.

Hidden beneath the rising tide of the market,

micro-cap fraud represents a pernicious

undercurrent that

of American families. Many of these families

costs, unforeseen medical expenses, and

lengthier retirements. While we have the

safest and most successful capital markets in

the world, the irony is that public confidence

in our markets actually creates opportunities

for con artists to exploit the unwary.

Id. at 55 (opening statement of Sen. Susan M. Collins).

Fraud is by no means limited to the micro-cap iaarket,

Pay $100 Million to Settle Twin IPO Investigations

J., Dec. 11, 2001, at Al (SEC announci Credit Suisse First

Boston will pay $100 million to ssosive totaal investigation

into alleged abuses in distribution of its IPOs); see also In re

Prudential Sec. Inc. Ltd. P’ship Litig., 163 F.R.D. 200

(S.D.N.Y. 1995) (describing $110 million settlement with an

13

investor class ge out of Prudential’s fraudulent

marketing of 700 limited pee units); In re

PaineWebber Lid. P’ship Litig., 171 F.R.D. 104, 106

(S.D.N.Y. 1997) (approving $200 million settlement in action

growing out of limited partnership sales). Fraudulent

accounting ices remain a fertile source of Section 10(b)

and Rule 10b-5 violations. See In re Cendant Corp. — =

264 F.3d 286, 288 (3d Cir. 2001) (approving settlement for

investor class of $2.85 billion in cash from the corporation

and $335 million from Ernst & Young based on accounting

fraud).

All of these practices can, and often do, wipe out savings

accumulated during a person’s lifetime for use during

retirement. This underscores the i of ensuring that

investors victimized by these frauds can access the public and

—= enforcement mechanisms Congress provided for their

t.

B. SEC Enforcement Actions & Private Lawsuits Are

Powerful Tools Under The Exchange Act and

Should Not Be Weakened

1 C Gave the SEC Broad Powers to

—_ Fraud Under the Federal Securities

ws

The strength and stability of America’s securities markets

depend on investor confidence in the fairness and efficiency

of the marketplace. Critical to maintaining this confidence is

the availability of effective remedies against those who violate

federal anti-fraud provisions. Congress recognized this need

when it enacted Section 10(b) of the Exchange Act “‘to deter

fraud and manipulative practices in the securities markets, and

to ensure full disclosure of information material to investment

decisions[.]’” Musick, Peeler & Garrett v. Employers Ins. of

Wausau, 508 U.S. 286, 296 (1993) (quoting Randall v.

Loftsgaarden, 478 U.S. 647, 664 (1986)). As the Second

Circuit pointed out in United States v. jamin, 328 F.2d

854, 863 (2d Cir.), cert. denied, 377 U.S. 953 (1964),

compensating defrauded investors is another essential purpose

14

of the Exchange Act. In order to accomplish these goals

effectively, the SEC’s civil enforcement powers must remain

as broad and flexible as possible.

The extensive hearings that preceded passage of the

Exchange Act touched only briefly on Section 10, with most

of the discussion devoted to the specifically enumerated

devices the SEC would be empowered to proscribe under

Section 10(a). The most relevant exposition of | cee

that was to become Section 10(b) was provided by Thomas G.

Corcoran, a spokesman for the drafters.

“Subsection (c) [§ 9 (c) of H.R. 7852 - later

§ 10(b)] says, “Thou shalt not devise any

cunning devices’. . . . Of course

subsection (c) is a catch-all clause to prevent

manipulative devices. I do not think there is

any objection to that kind of clause. The

Commission should have the authority to deal

_ with new manipulative devices.”

Ernst & Ernst v. Hochfelder, 425 U.S. 185, 202 (1976)

(quoting Hearings on H.R. 7852 and H.R. 8720 before the

ouse Comm. on Interstate-and Foreign Commerce, 73d

Cong. 115 (1934)). Very little has changed in this regard

since 1934; the parameters of fraud differ only by the

ingenuity of the perpetrators.

Section 10(b) and Rule 10b-5 are the core federal

provisions that prohibit fraud against investors. The SEC,

which promulgated Rule 10b-5 under its authority to enforce

the federal securities laws, has stated that “Section 10(b) and

Rule 10b-5 have come to embrace a diversity of claims which

could not have been envisioned in 1934.” Brief of Amicus

Curiae SEC at 23, , Pleva, Lipkind, is & Petigrow

v. Gilbertson, 501 U.S. 350 (1991). In addition, a recent

General Accounting Office (“GAO”) report to Congress

concerning staff turnover at the SEC described the agency’s

primary mission as p ing investors and maintaining the

integrity of the securities markets and noted its responsibility

for conducting investigations of potential securities law

15

violations and overseeing self-regulatory organizations,

broker-dealers, mutual funds, investment advisors, and public

utility holding companies. The GAO report stated that the

“SEC’s mission has become increasingly important as retail

investors have become more involved in the securities markets

. . . and as the markets themselves have begun to change,

because of the increased use of alternative trading systems and

the potential privatization of securities exchanges.” U.S.

General Accounting Office, Report to the-Ranking Minority

Member, Subcomm. on Financial Institutions, Senate Comm.

on Banking, Housing, and Urban Affairs, “Securities and

Exchange Commission: Human Capital Challenges Require

Management Attention” 3-4 (Sept. 2001).

Justice Blackmun pointed out in Aaron v. SEC that

Sections 17(a) of the Securities Act of 1933 and 10(b) of the

Exchange Act are “the primary antifraud provisions of the

federal securities laws. They are the chief means through

which the Commission . . . can seek protection against

deception in the marketplace. As a result, they are key

weapons in the statutory arsenal for security market integrity

and investor confidence.” 446 U.S. 680, 704 (1980)

(Blackmun, J., dissenting) (citations omitted). For example,

the SEC’s ability to oy me a wrongdoer to disgorge its

profits stems in large part from its authority to seek equitable

relief in federal court. See SEC v. Manor Nursing ers,

Inc., 458 F.2d 1082, 1103-04 (2d Cir. 1972) (upholding

award of ancillary relief where court has authority to fashion

appropriate remedy and “effective enforcement of the federal

securities law ires that the SEC be able to make violations

unprofitable”); SEC v. Drexel Burnham Lambert, Inc. , 956 F.

Supp. 503, 507 (S.D.N.Y. 1997) (noting that restitution and

disgorgement are distinct remedies - the former seeks to make

the victim whole, the latter to deprive the wrongdoer of its ill-

gotten gains).

16

2. The Fourth Circuit Erred in Holding That

Zandford’s Fraud Did Not Meet the “In

Connection With” Standard and Thus Fell

Outside the SEC’s Broad Enforcement

Authority

Zandford’s fraud meets the “in connection with” standard

required by Section 10(b). The Fourth Circuit’s articulation

of the issue reveals the flaw in its analysis. According to the

court below, “[t]he question is not how Zandford stole the

money in the Woods’ account. Rather it is whether Zandford

engaged in ey of a particular security.” SEC v.

Zandford, 238 F.3d at 565. Under Section 10(b) of the

Exchange Act and related SEC Rule 10b-5, however, the

pertinent question is whether Zandford employed a scheme to

defraud in connection with the purchase or sale of a security.

The SEC alleged that an integral part of the scheme in which

Zandford had engaged to defraud the Woods involved the sale

of securities. That is all the federal securities laws require;

they do not require the manipulation of a particular security.

Moreover, the Fourth Circuit labored under the

misimpression that all securities fraud involves sophisticated

schemes to manipulate the market for a particular stock.

While this may occur in the majority of securities fraud cases

brought in the district courts, neither Section 10(b) of the

Exchange Act nor Rule 10b-5 contains such a requirement.

Fraud actionable under those provisions can be committed

with a bludgeon as well as a scalpel. In this case, Zandford

used a bludgeon.

The federal securities laws _— fraud in connection

with the purchase or sale of securities, and Zandford

committed fraud, in part by selling securities. An

examination of the statutory text at issue proves the point.

Section 10(b) makes it unlawful for any person “[t]o use or

employ, in connection with the purchase or sale of any

security . . . amy manipulative or deceptive device or

contrivance in contravention of such rules and regulations as

the [SEC] may prescribe ... .” 15 U.S.C. § 78j(b).

Pursuant to this statute, the SEC promulgated Rule 10b-5,

which states it shall be unlawful for any person, by use of

17

interstate commerce, mail, or the facilities of any national

securities exchange, “to employ any device, scheme, or

artifice to defraud” or “[t]o 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 purchase or

sale of any security.” 17 C.F.R. § 240.10b-5. The plain

language makes clear that neither the statute nor the rule

requires the manipulation of a particular security, only a

course of business that tes as a fraud in connection with

the sale of a security. t is exactly what Zandford did in

this case.

In finding that the “in connection with” requirement was

not met in this case, the Fourth Circuit .- _ a

lain statutory and regulatory language, but also mi i

this Sonne a inion Se United States v. O’Hagan, 521 US.

642 (1997).” In O’Hagan, the defendant had misappropriated

a valuable piece of information and then purchased securities

based on this stolen information. The theft and the purchase

formed the scheme to defraud. Similarly, in this case, an

unauthorized sale of securities was designed to generate

proceeds for Zandford to misappropriate. These integrated

acts -- the sale and the theft -- constituted the scheme to

defraud, and that is all the statute and the rule require.

2 The Fourth Circuit’s reliance on its decision in Head v. Head,

759 F.2d 1172 (4® Cir. 1985), is even more strained. In Head,

the husband in a divorce proceeding listed certain stock (held

only in his name) as an asset at book value (rather than market

value). The wife never held an interest in the stock which, at

one point, was placed in escrow to secure an obligation that the

husband paid off in cash when the obligation came due. The

wife later sued the husband for fraud in connection with the

divorce settlement when he sold his stock at a price significantly

higher than book value. The Fourth Circuit held that there never

was a purchase or sale of stock, so any alleged fraud could not

be “in connection with” the purchase or sale of a security. /d. at

1176.

18

3. The Fourth Circuit’s Error Also Will

Restrict Defrauded Investors From

Redress Under the Federal Securities Laws

The Fourth Circuit’s extremely narrow reading of the “in

connection with” language will severely limit not only the

SEC’s enforcement authority, but also the rights of individual

investors to seek redress under laws enacted for their benefit.

The Court and the SEC repeatedly have cited the availability

of private lawsuits as critical to effective enforcement of

federal securities laws, and to maintenance of investor

confidence in the integrity, fairness, and efficiency of the

securities marketplace. For example, the Court stated that

private actions provide “‘a most effective weapon in the

enforcement’ of the securities laws and are ‘a necessary

2 ome to Commission action.’” Bateman Eichler, Hill

Inc. v. Berner, 472 U.S. 299, 310 (1985) (quoting

J. I. Case Co. v. Borak, 377 U.S. 426, 432 (1964)).

The SEC has echoed this view. In testimony concerning

litigation under the federal securities laws, Chairman Levitt

Stated:

[TJhe Commission has consistently stressed the

importance of private actions under the

antifraud provisions of the federal securities

laws. In order to maintain investor confidence

in the fairness of our securities markets, we

must ensure that investors have a meaningful

right to seek recovery against those who

defraud them.

Securities Litigation Reform: Hearings Before the Subcomm.

on Telecomm. & Finance of the House Comm. on Energy and

— 103d Cong. 33 (1994) (testimony of Arthur

itt).

|

19

The Director of the SEC’s Division of Enforcement

expressed similar sentiments:

Due to the Commission’s inability to address

all violations, the implied private right of

action under Section 10(b) and Rule 10b-5

thereunder is critically important to the

effective operation of the federal securities

laws. . .. Given the continued growth in the

size and complexity of our securities markets,

and the absolute certainty that persons seeking

to perpetuate financial fraud will always be

among us, private actions will continue to be

essential to the maintenance of investor

protection.

Private Litigation Under the Federal Securities Laws:

Hearings Before the Subcomm. on Securities of the Senate

Comm. on Banking, Housing and Urban Affairs, 103d Cong.

111, 113 (1993) (testimony of William R. McLucas).©

12 While the industry often argues that Section 10(b) poses a

particular danger of vexatious litigation, the Court and Congress

already have addressed what were viewed as troubling aspects of

Section 10(b) and significantly narrowed and clarified the law’s

reach. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185,

202 (1976) (holding pleading scienter a requirement under

Section 10b); Blue Chip Stamps v. Manor Drug Store, 421 U.S.

723, 739 (1975) (permitting damages actions only by active

market participants, i.e., purchasers and sellers); Basic Inc. v.

Levinson, 485 U.S. 224, 249 (1988) (allowing a presumption of

reliance under the fraud-on the market theory); TSC Indus., Inc.

v. Northway, Inc., 426 U.S. 438, 449 (1976) (defining

materiality under an objective standard); Lampf, Pleva Lipkind,

Prupis & Petigrow v. Gilbertson, 501 U.S. 350, 361-62 (1991)

(fixing a uniform statute of limitations for Section 10(b) actions);

Central Bank v. First Interstate Bank, 511 U.S. 164, 191 (1994)

(holding private civil liability does not extend to those who aid or

20

The Fourth Circuit’s error will have widespread

consequences for individual investors, affecting private

lawsuits as well as arbitration proceedings. Since 1987, the

securities industry routinely includes pre-dispute arbitration

clauses in its customer agreements.” Thus, individual

broker-customer disputes only find their way to court in very

limited circumstances. If arbitration is to provide a workable

forum for recovery on meritorious investor claims and fulfill

the purpose of the Exchange Act, the law which the

arbitrators apply should be kept as clear as possible. While

a bright line rule may be unavailable here, the meaning of “in

connection with” that has been followed for years by the

courts and arbitrators does provide some measure of

certainty.” The lower court's articulation of the test narrows

the meaning of the language and creates ambiguity. In fact,

it is doubtful if the most common claims raised in arbitration,

abet a violation of Section 10(b)); see also Private Securities

Litigation Reform Act of 1995 (“PSLRA”), Pub. L. No. 104-67,

109 Stat. 747 (codified as amended in scattered sections of 15

U.S.C. § 78) (heightened pleading standards for private litigants

and set new standards for class actions) and Securities Litigation

Uniform Standards Act of 1998, Pub. L. No. 105-353, 112 Stat.

3227 (codified as amended in scattered sections of 15 U.S.C.

§ 78) (precludes class litigants from seeking relief in state court

to avoid heightened pleading standards of the PSLRA).

Significantly, neither law touched the fundamental statutory

scheme defining actionable conduct, including the “in connection

with” language.

'' Shearson/American Express v. McMahon, 482 U.S. 220,

238 (1987) (permitting pre-dispute broker-customer

arbitration agreements to be enforced even where claims

arise under Section 10(b)).

2 See Superintendent of Ins. v. Bankers Life & Cas. Co.,

404 U.S. 6, 11 (1971) (upholding a Section 10(b) claim

where the proceeds of a sale were misappropriated).

21

namely, churning and unauthorized trading, even would be

actionable under the Fourth Circuit’s interpretation of “in

connection with.”

Furthermore, because a district court can only vacate an

arbitration award if it finds “‘manifest disregard of the law’

or evidence,” Green v. Progressive Asset Mgmt., Inc., 2000

U.S. Dist. LEXIS 12428, at *4 (S.D.N.Y. Aug. 29, 2000)

(quoting Halligan v. Piper J. » Inc., 148 F.3d 197, 202

(2d Cir. 1998)), it is particularly important to private litigants

that the Court not insert a measure of ambiguity into years of

precedent.

C. Neither A State Civil R Nor A Criminal

a 6 Cee nder the Federal

Securities Laws

eee See See Senses ecanaene

was more akin to a state law tort of conversion than a

securities law violation. Zandford, 238 as he

comparison fails to recognize that the existence of a viable

state civil claim or a related criminal proceeding does not bar

the SEC or an individual from suing under the federal

securities laws.

It is axiomatic that the existence of a remedy in state

cou™ does not lude seeking a remedy for the same course

of conduct the federal securities laws. wy a ba

authority than William O. Douglas stated that the difficulties

eS ae a ae

passage of the Securities Act of 1933. See William O.

3 See Krull v. SEC, 248 F.3d 907, 908-909 (9" Cir. 2001)

(charging churning and unauthorized trading of front end

loaded mutual funds), and Miley v. Oppenheimer & Co.,

637 F.2d 318, 323 (5S Cir. 1981) (stating that civil suits

alleging excessive trading or “churning” in violation of

brokers’ common law fiduciary duty and the federal

securities laws have dotted the federal docket).

22

ool as Yee ge E. Bates, The Federal Securities Act of

1933, 43 Yale L.J. 171, 177 (1933) (“Satisfaction of the

common-law requirements <«f fraud raised almost

insurmountable barriers to recovery.”). Congress enacted the

federal securities laws in the 1930s because state law remedies

were deemed inadequate to investors. See President

Franklin D. Roosevelt, Regulation of Security Issues,

Remarks to the Senate (Mar 1933), et tnthdehne |

Rec. 937 (1933) en, yh a

the public in the past has sustained severe losses through

practices neither ethical nor honest on the part of many

_ :

521 U.S. at n.2; see also Basic Inc. v. Levinson, 485

U.S. 224, 245 n.22 (1988) (recognizing that actions brought

under Section 10(b) are distinct from common law deceit and

US. $75, 389 (198 Herman & MacLean v. Huddleston, 459

U.S. 375 389 (1983) (stating that actions under Section10(b)

~ i eli ishing higher standards

23

Pub. L. No. 91-452, 84 Stat. 922, 923 (statement of findings)

(stating that “organized crime continues to grow . . . because

the sanctions and remedies available to the Government are

unnecessarily limited in scope and impact”); see also United

States v. Turkette, 452 U.S. 576, 586 (1981) (providing that

enacted RICO because existing state law was

Congress

inadequate to address problem).

Nor does the availability of criminal law enforcement

lude a civil action under the federal securities laws.

Justice Robert Jackson observed that criminal law has

ST ee eee

So eee ee , only rarely.” Robert

Jackson, The Struggle For Judicial Supremacy 152 (1943).

State Securities Regulators, supra.

24

If the SEC’s enforcement authority is restricted to the

point it cannot challenge such obvious fraudulent conduct in

the sale of securities as occurred here, the investing public

will have lost an invaluable safeguard and the SEC will have

lost a critical weapon.

CONCLUSION

For all of the foregoing reasons, amici respectfully

request that the Court reverse the Fourth Circuit and retain

the federal securities laws as the powerful tools Congress

intended.

December 26, 2001 Respectfully submitted

Brian Murray Deborah M. Zuckerman*

Rabin & Peckel LLP Stacy J. Canan

275 Madison Avenue AARP Foundation

New York, N.Y.10016

(212) 682-1818 ’ Michael Schuster

AARP

Denise Davis Schwartzman

Chimicles & Tikellis LLP Counsel for AARP

361 W. Lancaster Avenue 601 E Street, N.W.

Haverford, PA 19041 Washi , D.C. 20049

(610) 642-8500 (202) 434-2060

Mary Ellen Fise

Consumer Federation

of America

1424 16" Street, N.W.

eles, CA 90017 Washi DC 20036

(213) 330-7150 (202) 387-6121

Counsel for NASCAT

Counsel for Consumer

Federation of America

*Counsel of Record