Petition for Writ of Certiorari — Myzel v. Fields

ite U8 No. & 9.6 _

| mors ee

ee or eH THF.

« .

ee

Bursary (Benn) Myzzn, et a Ws Palbe *.

= woh te _ Petitioners, :

. * . * & Vv.”

ine | ‘Haney Frerps, —

SO SE verre

Baxsaury (Benn) ‘Myzmr, et. al.,

: Petitioners,

‘ o Z v. , ° :

wae nies iii H. Kime, ~*~

.@, * Respondent.

| Bengamin (Benn) Myzzt, e¢ al, |

- Petitioners, -

Z ‘Rrra: Vertenyey,. Special Administratrix, etc.,

F Bungamis (Benn) Myzen, et al., Se

pk eee Shee pee ah | Petitioners,

ehatie ‘ . oe a Ee

> ° . Gorpon M. Conen,

‘PETITION FOR A WRIT OF CERTIORARI TO THE Sone

ah UNITED STATES COURT OF APPEALS ron THE

pea ts os Tiss it Enki oe

cee Attorney for. Petitioners ee

e . : New York, N.Y. 10005

- Reaves & MoGzara BeOS oe aes

SF agen oo I emeathcte aieg cae aN me

ee we 7 Aas “i

Wain oc! LO Ia Nara 2 aS rt he

*

TABLE] OF CONTENTS

Opinions AMEN IME OR re Re ee TORE De tet

Jurisdiction .... ‘é walgielaccaien waaane Ba ae a

aE FN ion. s 005 vk se ee aeedersdie cess

Statutes Involved .......... ae aa ana Om

Reasons for Granting the Writ................... :

ES. oc cckuctawanedteuns ne ae eeecee Poe oe

Be SUI gs ccrer in cide nccXiabecediivens

B.

The Decision Below Conflicts with the Land-.

mark Decision of the Second Circuit in

Fischman v. Raytheon :Mfg. Co. in Holding.

Erroneously that Proof of ‘‘Scienter’’ is Not

Required in an Action Under Rule 10b-5 ..

The Decision Below Adopts an. TS

Standard of Federal Law with Respect to the

Measure of ‘Damages, in Conflict with Deci-

sions of Other Courts and with Section 28(a)

of i Te Be soa ano concedes Sescoces

The Decision Below Rejecting the Defense of

Laches in a Rule 10b-5 Case is in Conflict with

the Decisions of Other Courts ...... wiaeeee

The Decision Below that an Intrastate Tele-

phone Call Supports Federal Jurisdiction is in’

Conflict with the- Decisions of Other. Courts «.

The Assertion of Liability Against the Cor- ©

porate Defendant Conflicts with ae

Law tog eh Ge ROR Ree wa ae een evnenidaniéanees

11

16

19

20

ii

" PAGE

—«G. The Holding Below that a Grossly Negligent

Plaintiff Can Recover Under Rule 10b-5 Con-

flicts with the Second. Circuit Decision i in’ List ;

v. Fashion Park, WR osiiscns ivneesas re ) oe

Conclusion ee Ptvcvevesidepeveces eeasthas ka a

Avrsmex A: wey

Opinion of United States Court of Appeals... Al

- Order of United States District Court ........ A54

Opinions of the United States District Court .. A59

Arvarocx B-1—J SPs in Odes No. 18,341 ...... A80

AppPENDIx B-2—Judgment i in Case No. 18,342 vanes A81

Appgnvix B-3—Judgment in Case No. 18,343 ...... . A82

Aprenvix B-4—Judgment in Case No. 18,344 ....... A83

APPENDIX C—Statutes and Rule .....2............ A84.

i . Aurnorirms Crrep_

| i Cases ;

Bailey v. Glover, a1 Wall. 342 (1875) .............. 5. 15

‘Bredehoeft v. Cornell, 260 F. Supp. 557 (D. Ore -

OD is ihren eG ia radians. — 20-

Ellis v. Carter, 291 F. 2d 270 (9th Cir. 1961) ....... “ye

Erie R.R. v. Tompkins, 304 U.S. 64 (1938) ......... 16

‘Estate Counseling Service v. Merrill Lynch, Pierce, .

- Fenner & Smith, Inc., 303 F. 2d 527 (10th Cir.

SE disc dancvas Lehuhexneaseenin ‘Sabwkes ...16, 17, 18

Fischman v. Raytheon Mfg. Co, 188 F. 2d 783 —

OND ook eccceinnqersussreotbtonacdhass , 11, 13, 15

“Hafner v. Forest Laboratories, Inc., 345 F. 2d 167 .

See Sis. HE Seb dadplanedectvsbacusesices¥euss 22

a lt Pini HEN Sa a De A 8 OR TY Oe

-

PAGE

Janigan v. Taylor, 344 F. 2d 781 (1st Cir.), cert. ee

denied, 382 U.S. 879 IDG) 5 vcivinvedecedscesses 17.

Kardon v. National Gypsum Co., 69 F. Supp. 512

- (B.D. Pa. 1946) 0.0... 0. Fcc een cece cere eeeeee 9

Kohler v. Jacobs, 138 F. 2d 440 (5th Cir. 1943) reused 21

' Kohler’v. Kohler Co., 208 F. Supp. 808 (1962), aff'd,

319 F. 2d 634 (7th Cir. 1963) 2... sceecececcon see 17,18

Lennerth y. Mendenhall, 234 F. Supp. 59 (N. D. Ohio ~

WOE) ccccscccvevecunesvccvesessscseretescesss 20.

List v. Fashion ta Inc., 340 F. Qd 457 (2d Cir.), ©

cert. denied, 382 U.S. 811 CSOD or ccdcsuctscenes 21

List v. Lerner, 0.T. 1965, No. 66 .........+- peuaes “9

Minneapolis & St. Louis RB.R. Co. v. ‘Winters, 242 U. er

‘BRB (1917)... cee ececcceenivecccseseeeseccsees 20

*. Nemitz v. Cunny, 221 F. mie, 71 (ND. il. 1963) 19

Parker v. Baltimore Paint and Chemical Corp., 244°

‘ F. Supp. 267 (D. UD ven cescchszcconsce 11,12

Pitofsky v. Brucker, (S.D.N.Y. 1966) CCH Federal .

Securities . Law Reporter, par. 91, 715 (1964-66

Transfer Binder) ..... iecbdeeadecescex er Uaenenneee 18

Repass v. Rees, 174 F. Supp. 898 (D. Colo. 1959). 20

- Richland v. Crandall, 262. F. Supp. 538 (S.D.N. y.

DDT). casdencccccctgeansccvcanchavecenvcreqeses .12

- Rosen v. Albern Color Research, Inc. 218 F. Supp. |

473 (E.D. Penn. 1963) ..........---2ee eee icvtces WO

Royal Air Properties, Inc. v. Smith, 312 £. 2d 210

(Othe Chr. 1968) ...ccccsccscccesvescescevsecss . 18,19

Sigafus v. Porter, 179 U.S. 116 (1900) eucaws a exe

Smith v. Bolles, 132 U.S. 125 (1889) :............4. 16

Straley v. Universal Uranium & Milling Corp., 289

F: 2d 370 (9th Cir. 1961) ......... SC Cupeeeneahney 19:

Stevens v. Vowell, 343 F. 2d 374 (1965) ......... dea ae

Thiele v. Shields, 131 F. Supp. 416 (8.D.N.Y. 1955) 12

iv |

' PAGE

: Tnanee and Allied Stocks v. Peimeemechin Corp.,

| 143 F. Supp. 323 (1956), aff’d 244 F. 2d 902 (Bd ,

CE EE picocecccctdsces bteessescseeseeerets _ 18

Traer v. Clews, 115 U.S..528. (1885) ohana seco, 15.

Trussell v. United Underwriters, Ltd., 228 F. ‘Supp.

. T5T_ (D; Colo. 1964) ..icccpovecccsecscsesedvec’ 11, 12, 15

| Weber v. COMP. Corp., 242 K Sue. 321 (SD.N.Y.

+ 1965) ..... Siebeebebeeesaserssedesieeceuscsicte MERE

| Statutes :

hesiatihes Act of 1933, 15 U.S.C. 77a, et- seq. ...... 3,19

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

BOG. eee cece eves cece ee secneereesereegeemeeee dF

Securities Exchange Act of 1934, § 10(b), 1b U.S.C.

TEH(D) crvecessveccecsccvecsesecesucvecesece .3, passim

Securities Exchange Act of 1934, § 27,15 U:S.C.78aa 3

Securities Exchange Act of. 1934, aKa), 15 U.S.C.

OE vis Ses oe Co euicovade cece ae

28 U.6.C. wail vessanwes Viens peeatebesd ead eeee 2

Rule

Rule 10b-5 of ™ Securities and Exchange. Commis-

GO ck ced cecbecvccvuwseseaxeeevesessensi eee ody passim -

Hinsdianedin

Fleischer, “‘Pederal Corporation Law’’: An Assess-

ment, 78 Harvard Law Review 1146, 1178 (1965) 15

10 Fletcher, Cyclopedia Corporations §4886 p. 506. 21

3 Loss, Securities Regulation 1793 (1961) 7” tadeee ae

3. Loss, Securities Regulation 1766 (2d Kd. 1961, and

1962 Supplement) puis cea Ca eberceeneabeees 15

Note, 62 Mich. L. Rev. 1080 (1964) fateasewiee ke eee 19

" Note, 63 Michigan Law Review 1070 (1965) ........ ., 15.

Restatement of. Restitution, $142 (1937) aeees Saar 3 21.

"SEC See. Exch. Act Rel. No. 3230, May 21, 1942 13

‘IN THE

Supreme Cpurt of the Biited States

October Term, 1967 |

: ——

_ Bengamin (Benn) Myzet, e¢ al., a

; Petitioners,

v. , ;

Harry Fraps, Picheeg eh

z so

» BengaMIn (Benn) Lata et al.,

Petitioners,

Ve °

Sasivse H. Kine, So es

“Sa OF Respondent.

Bensamin (Benn) Myzet, et al.,

3 | Petitioners,

v. ce

Rrra Venraixey, oa daemas Administratrix, etc.,

Respondent.

Bengamin (Benn) Myzen, et al.,

ae . Petitioners,

ov. | te

Gorpon M. Cowen, Wee

ie Respondent.

sd.

v

_ PETITION FOR A WRIT OF CERTIORARI TO THE -

. UNITED STATES COURT OF APPEALS FOR THE |

EIGHTH CIRCUIT

‘Benjamin Myzel, Philip Myzel, Zelman Levine, Clarence

S. Levine, Orrin J. Levine, William P. Levine and Lakeside

Industries, Inc., hereby petition for a writ of certiorari to

- review the judgments of the United States Court of ‘Ap-

peals for the Eighth Circuit entered on October 12, 1967,

- which affirmed the judgments of the seein Court entered

on November 22, 196. :

2

Opinions Below

_ The opinion of the Court of Appeals (App. A, pp. Al- |

; \A53, infra) is reported at °F2d . The opinions

of. the District Court are not reported: and are included in

Appendix A at pp. A54-A79. -

Jurisdiction |

The judgments of the Court of Appeals were entered on

October 12, 1967 (App. B, pp. A80-A83, infra). Respond-

' ents’ petition for rehearing was denied by order dated

N ovember 7, 1967. The jurisdiction of this court is invoked

under 28 U. S.C. §1254(1). a

- Questions. Presented

A. Whether a plaintiff must prove scienter, i.e. knowledge’

of the falsity of the representation, as a necessary ele-

ment in a private action under Rule 10b-5: ~

- B. Whether damages recoverable in a private action under

Rule 10b-5 can exceed those determined unger the tort ..

‘‘out-of-pocket’’ measure of damages. »

-C. Whether laches is an available defense 1 in a private ac-

tion under Rule 10b-5. i

D. Whether an intrastate telephone a can supply the

basis for jurisdiction under Section 10(b) and Rule —

10b-5.

E. Whether a corporation can be liable in a private action

under Rule 10b-5 for violations of that rule committed

’ by officers and shareholders of its predecessor.

F. Whether a grossly negligent director-insider of a cor-

» poration, on notice as to all relevant facts concerning

the corporation, can recover damages in a private ac-

tion under Rule 10b-5 arising from the sale by him of

_. the corporation’ s stock. .

RR SONS PEA EE OE SE LP A eS

©

.

| Statutes Involved’ op .

The relevant’ provisigns of the Securities Exchange Act

of 1934, 48 Stat. 881, 15 U.S.C. 78a, et seq., and the Securi-

ties Act of 1933, 48 Stat. 74, 15 U.S.C. 774, et.seg., are set -

forth in Appendix C, infra, pp. A58-A59, together with

the text of Rule 10b-5 of the Securities and Exchange Com-

mission, 17 C.F.R. 240.10b-5.. ;

Statement*

These four actions*were brought and raise important

questions of Jaw: under Section 10(b) of the Securities.

. Exchange Act of 1934 and Rule 10(b) thereunder. Juris-

diction) of the district court was based upon Section 27 of

the Securities Exchange Act of 1934 (48 Stat. 902, 15 US.C. .

§78aa). Respondents are Harry Fields, Samuel H. King,

Joseph 8. Vertelney** and Gordon M. Cohen. Petitioners

are Benjamin Myzel, Philip Myzel, Zelman Levine, Clar-

ence S. Levine, Orrin J. Levine, William P. Levine and ©

” Lakeside Industries, Inc. In essence, the. actions\are based

on a claim that respondents were induced to sell shares of

stock in Lakeside Plastics and Engraving Co., a small,

closely-held local corporation, to petitioners because of mis-

representations or omissions to state material facts (R.

3-5, 18-19, 23-24, 27-29). The stock had been bought seven

* Figures in parentheses preceded by the legend “R.” refer to pages

of Volume I and Volume II of the printed Record; figures in

parentheses preceded by the legend “IIT R.” refer to the pages of

Volume III of the printed Record containing various exhibits;

the legend “P. Exh.” refers to Plaintiffs’ (Réspondents’) Ex-

hibits, the legend “D.M. Exh.” refers to Defendants (Petitioners)

Myzels’ Exhibits ; and the legend “D. ‘L. Exh.” refers 0 Defend-

- ants (Petitione:s) Levines’ Exhibits. ey

** Respondent Vertelney died before these ‘actions were tried, and

‘his widow, Rita Vertelney, was substituted in his place as special

administratrix (R.»39-40, 68-70). For convenience, reference is

made to “Respondent Vertelney” as if he were still alive.

4.

4.0

years before for $10,000, and was sold for approximately

. $6,400 (R. 79-80, 105-06, 150, 316-17, 335-38). The actions

- were brought nine years later, after a number of corporate.

changes and developments. The jury found for respon-

dents and awarded damages of $411,000 (R. 804-7 j, appar-

ently based on an evaluation of the corporation’s worth

some years after the sales which gave rise to the actions.

Lakeside Plastics and Engraving Co. (LPE) was a Min-

nesota company organized in 1946 (D.M. Exh. B., IIT R. 1).

Two of the petitioners, Clarence and Zelman Levine, were

shareholders, officers and directors of. LPE (R. 502; D.M.

Exh. A., III R. 2). Respondents were among the original ,

subscribers of common stock at a price of $50 per share

and received the following number of shares: Harry Fields .

(30 shares), Joseph-S. Vertelney (100 shares), Samuel H.

King (30 shares) and Gordon M. Cohen (40 shares) (D. M.

Exh. B., III R. 2-3).

In 1948, Lakeside Pestinn Sales Co. (““LPS’) was organ- :

ized in Illinois by two other petitioners, Orrin and William

Levine (P. Exh. B., III R. 4). LPS was the sales agency

for LPE products (R. 388- 391). LPS stock was equally

held by Orrin and William Levine (R. 380; P. Exh. 5-A,

III R. 4). They were also shareholders and at various times

directors of LPE (R. 387, 411, 475-76, 479; D.M.. Exh. A.,

IIT R. 2).

In its early years, LPE made little financial progress. At ie

the 1949 annual meeting respondent Fields proposed the

liquidation of LPE (R. 333-34). Each of the respondents

were disappointed with LPH’s lack of progress (R. 96, 173,

351-52). In 1952 LPE earned a profit 6f $7,500 on gross |

sales of $249,000, but the company still had an earned sur-

-plus deficit of approximately $43,000 (P. Exh. 3-D(4),. 6,

III R. 40-41). .

5

In March, 1953 LPE repaid all accumulated bank indebt-

edness, and the bank returned LPE stock pledged by the

stockholders (R. 175-76, 263). For the first four months of

1953, LPE showed sales of $256,000 and a net profit of

approximately $30,000 (R. 556-56; P. Exh. 3-D(5), III R.

48). By year end, however, its profit was only $20,000, and

the earned surplus deficit amounted to = 000 (P. Exh. 3-

D(6), III R. 52-53).

In late 1953 and early 1954, respondents sold their LPE

Stock to either Benjamin or Philip Myzel, the latter acting

on behalf of his brother, for approximately $6,400 (R. 79-80,

.105-06, 150, 316-17, 335-38). The Myzels paid cash (R.

660-61), the stock certificates were personally delivered

(R. 84, 318, 339, 580), and all telephone calls in connection

with the transaction were wholly to persons within the same

state (R. 79-81, 148-50, 314, 318, 335; A 2).* In 1954, Ben-

jamin Myzel sold some-of these shares to LPS for approxi- -

mately $11,000 (R. 451-57; D.M. £xh. A, ITI R. 5-6, 9).

Respondents testified that the Myzels had stated that the

company was in ‘‘bad shape’’ and on the ‘‘verge of bank- ©

ruptcy,’”’ and that Benjamin Myzel had sold or was selling

his LPE stock (R. 79, 149, 315, 337). Respondents also testi-

fied to their lack of awareness that Philip Myzel was pur-

chasing stock for, Benjamin Myzel, and claimed that both

Myzels acted for the Levines (R. 3,18, 24, 28, 587, 592, 626).

Respondents indicated they were not told of LPE’s in-

creased sales and profits in 1953 (R. 4, 18, 23, 27, 133). Re-

spondents base their claim on these and similar misrepre- .

sentations and omissions.

Petitioners’ testimony contradicted that of respondents. ~

The Myzels denied making the alleged misrepresentations _

* The figures in parenthesis preceded by the letter “A” refer to the

opinion of the Court below, attached as Appendix A hereto.

(BR. 622, 659-60). Additionally, petitioners’ evidence ques- ©

tioned the materiality of and reliance by the respondents on

_ the alleged misrepresentations and omissions. For example,

the increase in LPEH’s 1953 sales and profits is less signifi-

cant when it is noted that profits declined by more than

half in the following year, and declined again in the year

after that (P. Exh. 3-D(7), 3-D(8), 3-C(2), 25-C, 25-D,

25-E, III R. 59-63).. In fact, it was not until 1957 that LPE

showed a positive earned surplus (P. Exh. 25-F,.66-7; D.M.~

Exh. DD; IIT R. 89).. .

At the time of sale of the LPE-stock, there was no market

_ for the company’s shares. The book value of the stock was

- only $11.65 per share at year-end 1952, $29.40 in 1953, and ©

$31.56 in 1954. By year-end 1957, it had risen only to $58.47.

(D.M. Exh. DD, IIT R, 89.) This contrasts with the jury

awards to respondents i in amounts ranging from a low of -

- $1,533 per share to a high of $2,266 per share (R. 804-07),

more than forty times their original cost.

Moreover, the materiality. of. the alleged misstatements

' Or Omissions is questionable when looked at in connection _

"with respondent Vertelney’ S right to recover. Vertelney, a

business school graduate and experienced executive, was a

director of LPE in Septembér, 1953 (R. 300, 462-64, 476-

78).. He conceded that he found it utinecessary to discuss

LPP’s affairs with the Myzels since he was ‘‘staying fairly

well abreast of the company’s operation” (R. 314). Fur-

thermore, the minutes of the June, 1953 Board of Directors’

‘ meeting indicate that there was considerable discussion

about LPE’s ‘‘present and future sales.’’’ (R. 478-80).

These facts led the Eighth Circuit to comment that, ‘‘If any-

thing, Vertelney was grossly negligent’’ in relying on peti-

tioner’s statements or omissions as inducements to sell his

stock (A23). ;

‘

7

In 1957 LPE contracted with Benjamin Myzel to pay hes

$35,000 over a nine year period for consultant services (R. ie

139-41). This nine-year total of $35,000 was partially in.

- consideration for Benjamin Myzel’s transfer of 255 shares

of LPE to LPS in 1958 (R. 498, 506, 536).

From the time of sale (1953-1954) onwards eer

were aware of LPE’s continued existence (RK. 113, 187, 321,

357). Each read a 1959 newspaper article announcing the

transfer of LPE from Duluth to Minneapolis (R. 113, 123-24,

187, 321, 358). There was evidence indicating Vertelney

remained on LPE’s Blue Cross records through 1959 and

knew about LPE’s expansion (R. 519-20, 715). This pattern

of awareness led the court below to question the credibility

__ of respondents’ testimony, stating: ‘‘The time gap, 1953 to

1962, between the sale and the discovery of the fraud

seriously bothers us not only as to Vertelney, but as to -

[respondents] ”’ (A23).

By 1958 the Levines and LPS had acquired all of the out-

standing shares of LPE (R.412-13, 420-21; D.M. Exh. A & P.

Exh. 15, III R. 8-14). In 1961 Lakeside Industries, Inc.

(‘‘LII’’), the corporate petitioner herein, became the suc-

cessor corporation of a merger involving LPE, and LIL

issued 500,000 shares of its stock to the Levines in exchange

for their LPE stock (P. Exh. 4; III R. 21, 122). In 1962,

150,000 shares of LII were sold to ie public at $9.00 per

share (R. 417, 420). ee 5

Vertelney, King and Fields instituted these actions on

March 28, 1963. Cohen began his action on July 11, 1963.

In each case nine years had elapsed since the alleged mis-

representations and omissions. Trial was by jury, which.

found in favor of the respondents and awarded damages -

ori y anounced “righ Arh each eS ar ef o

ne Oe DY ee

Rint Veta tie ith Ss

>

7

e

totaling $411,000. The trial judge denied petitioners’ mo-

tion for judgment notwithstanding the verdict or a new

trial (A59-A67). The Court of Appeals* for the Hight

Circuit affirmed the judgments. |

The Court of Appeals held that an intrastate Silaiteiia

‘eall constitutes a sufficient jurisdictional basis under _See-

tion 10(b) and Rule 10b-5; that proof of ‘‘scienter,”’ 1.€.,

knowledge. of the falsity of_a statement, is not required ~

under Section 10(b); “that the doctrine of laches was not

available as a defense in the action; that the respondents

could -recover damages measured by the difference be-

tween the consideration received and the actual value of

the stock at a date substantially beyond the date of the sale;

‘and that the petitioner. corporation was liable for the indi-

vidual petitioners alleged violations of Section 10(b). Thus,

respondents, who originally invested $10,000 in 1946 and

who sold their stock in 1953-54 for $6,400, were permitted

' to recover $411,000 in actions not instituted until 1963.

Reasons for Granting the Writ

A. Introduction .

These cases arise*solely under the private right of action

which the lower courts have held is created by Section

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

10b-5 of the Rules and Regulations of the Securities and

* Exchange Commission thereunder. Rule 10b-5 was promul-

gated by the SEC in 1942, in an effort to fill in by general

rule some of the interstices in the overall scheme of Fed-

eral securities regulation. Section 10(b) makes it unlawful

for any person to employ, in connection with the purchase

or sale of any security, ‘‘any manipulative or deceptive

device or contrivance’’ in contravention of SEC rules: As

relevant here, Rule 10b-5 makes it unlawful, in connection

7

Ne SS See ene a Lee en Mn Y

ee ow

9

with such purchase or sale, for any person to make any .

untrue statements: of a material fact or omit to state a

material fact.

Beginning in 1946, the courts have- held that there is an

implied. right of civil recovery for violation of Rule 10b-5.

The first'case, Kardon v. National Gypsum Co., 69 F. Supp. _

512 (E. D. Pa. 1946), has been followed by a series of cases

applying and extending the theory. Use of the Rule has

accelerated, to the point where estimates based on reported

cases indicate that Rule 10b-5tés generating almost as much

litigation as all the other general anti-fraud provisions of

the. Federal securities laws taken. together, and several

times as much as the express liability provisions of those

laws.

Despite this extraordinary growth of a body of law that

is wholly judge-made, this Court has never considered

Rule 10b-5 or its scope, although a number of occasions

have arisen in which petitions for certiorari have been filed

in cases arising under the Rule. In List v. Lerner, O.T.

1965, No. 66, the SEC appeared as amicus curiae in the cer-

tiorari proceedings at the request of the Court. Although

the SEC in that case did not believe the writ should i issue,

as the principal question had been decided correctly and

the case involved primarily factual questions, the brief

stated (p. 5):

‘“‘The issues have many ramifications, and they

may arise in a wide variety of factual situations.

They have become more important ‘in recent years,

since Section 10(b) and Rule 10b-5 have been relied

on with increasing frequency by the Commission to

prevent deceptive activities by purchasers of securi-

ties and by private parties to secure redress for such

activities. This Court has not yet interpreted these

10

‘provisions, and a decision by it would provide help-

ful guideposts in the development of this important

‘area of the law.’’ (footnote omitted) -

The principal interpretive questions in the present case

are basic to almost every private action under Rule 10b- 5.

These are (1) whether proof is required that a misstate-

ment relied on to establish liability has been made with

knowledge that it is untrue; that is, whether an innocent

misrepresentation is actionable under the Rule; (2) what

is the correct rule of damages to apply in an action brought

‘under the Rule by a seller of securities; and (3) whether

laches is available as a defense in such an action. These

issues, and the others raised in this petition, have been

decided in varying ways by the lower courts, which have

- recognized that conflicts exist among the Cireuits. There

appears, therefore, the most compelling reason for granting -

_ this petition for certiorari—different rules of Federal law

now apply in different areas of the nation, and only this

Court can prevent the evils of forum-shopping and uneven

treatment of litigants in an important area of the law:

Moreover, the decision below has significant impact on

petitioners, who have been subjected’ to a judgment of

_ $411,000, including a judgment of $212,000 in favor of re-

spondent Vertelney, who the court found had been, if any-

thing, ‘‘grossly negligent.’? One of the petitioners held .

liable in this case is Lakeside Industries, Ine., a publicly

‘held. corporation which received no tangible benefit from

the putative violation of Rule 10b-5. Thus, the present case

not only presents issues of general importance to the ad-

ministration of the Federal securities laws, it is itself a

striking illustration of the need for this Court to formulate

proper standards in this type of litigation.

Ne

bint lt. pheptlen gaa ee its ds tat Cente tates $2 |

«

4

_B. The Decision Below. Conflicts with the Landmark

Decision of the Second Circuit in Fischman v.

Raytheon Mfg. ‘Co. in Holding Erroneously that

Proof of “Scienter” is Not Required in an Action

Under Rule 10b-5

’ The®court” below held that “Proof of ‘scienter,’ i.e.,

knowledge of the falseness of the impregsion produced by

the statements or omissions made, is not required under

Section 10(b) of the Act.’ (A19.) This holding is in di-

rect and irreconcilable conflict with the decision of the Sec-

’ ond Circuit in Fischman v. Raytheon Mfg. -Co., 188 F. 2d

783 (1951), where the court, in a carefully-reasoned opin-

'. ion of first impression, held that proof of fraud is required

in an action under Rule 10b-5. The decision. below is also

in conflict with Trussell v. United Underwriters, Ltd., 228

F.. Supp. 757 (D. Colo. 1964) and Parker v. Baltimore Paint

and Chemical Corp., 244 F. Supp. 267 (D. Colo. 1965).

The opinion in the court below obscures the.issue of

‘*scienter”’ by confusing knowledge of the falsity of a rep-

resentation With the intent with which the representation.

>is made. As the court noted, the District Court’s charge to

the jury required a finding of ‘‘misrepresentations or omis-

sions’’ made with ‘‘the intent of inducing plaintiffs to. sell

their stock.’’ (A19.) An innocent misrepresentation can

be made with such an intent, however, if the person making .

the representation has an erroneous belief in the truth of |

the statement or omission and it is made in the context of

‘inducing a securities transaction. In those circumstances,

there would be no fraud—i.e., no ‘‘scienter’’—and no cause

of action under the rule sie by the Second Circuit in

Fischman v. Raytheon Mfg. Co. The court: below, on. the

other hand, concluded that a finding of intent to induce the -

purchase of stock required ‘fin effect’? a finding that the

petitioners be’ ‘conscious wrongdoers. ”? There is no sup-.

7

12

port whatever in the charge for this conclusion. The charge

plainly permitted the jury to find liability if there was a

material misstatement or dmission, without requiring any

- finding that the defendants were aware of the falsity of the

statement or had any intent to defraud the plaintiff. (See

R. 782, 786.) -. ae : aa

In holding that ‘‘proof of scienter ... is not required un-

- der Section 10(b) of the Act,’’'the court followed Ellis v.

Carter, 291 F. 2d 270 (9th Cir. 1961), which adopted the

principle that misrepresentations, to be actionable under

Rule 10b-5, need not be knowingly made. The-rule that has

emerged in the Highth and Ninth Circuits, therefore, stands |

in opposition to that adopted in 1951 by the Second Circuit

and consisténtly followed since in that court, which as a

-“eommercial and financial center deals with a significant

~ number of all-actions brought under Rule 10b-5. Sée, ¢.9.,

Weber v. C.M.P. Corp., 242 F. Supp. 3217 (S.D.N.Y. 1965) ;

Thiele v. Shields, 131 F. Supp. 416, 419 (S.D.N.Y. 1955) ;

ef. Richland ¥. Crandall,-262 F. Supp. 538, 558 n. 12 (S.D.

N.Y. 1967). There seems yo likelihood that the conflict

among the circuits can be resolved without intervention ,

by this Court. The writ should be granted so that this

Court can settle the issue, which is of vital importance not

only in the present case, but in every case brought under

Rule 10b-5."" nee

—_———— <

-' .* The Tenth Circuit in Stevens v. Vowell, 343 F. 2d 374 (1965),

may have indicated agreement with the Ninth Circuit in not

‘srequiring proof of scienter. The -confusion in this, area and the

need for clarification by this Court, however, is illustrated by

Parker v. Baltimore Paint and Chemical Corp., 244 F. Supp.

267 (D. Colo. 1965), a later case arising in the Tenth Circuit.’

The court in Parker considered the Stevens.consideration of the

“scienter” question as dictum and reaffirmed the District Court’s

prior decision in;-Trussell v. United Underwriters, Ltd., 228

F. Supp. 757 (D. Colo. 1964), which analyzed the-issue at length

' and held that scienter is an essential element of an action under

‘ Rule 10b-5. :

?,

13

Determination of whether ‘“scienter”’ should be re-

quired under Rule 10b-5 requires an examination- of the

system of securities regulation imposed under the. several

Federal securities laws. The opinion in Fischman v. Ray-

theon Mfg. Co. was written by Circuit Judge Frank, him-

self a former Chairman of the Securities and Exchange

Commission, Judge’ Frank’s conclusion rests-on a com-

pelling analysis of the Congressional policies embodied in

the securities laws: themselves. Indeed, even the SEC re-

lease announcing the adoption of Rule 10b-5: stated that |

‘the rule prohibited ‘‘individuaJs or companies from buy-

ing securities if they engage’ ‘im fraud in their purchase. vet

- (SEC See. Exch. Act Rel. No.° 3230, May 21, 1942; em-

phasis added. ) ;

~The conflict between the jcc and Ninth Circuits has —

been recently recognized by Judge Wyatt of the United

States District Court for the Southern District of New ~

York, who found that the rule in Fischman v. Raytheon

M fg. Co. is still ‘binding in the Second Circuit, and that

Ellis v. Carter ‘‘reaches a contrary result?’ on the issue

of whether misstatements which might be innocent or neg-

ligent are actionable under Rule 10b-5. Weber v. C.M.P.

Corp., 242 ¥. Supp. 321 (S.D.N.Y. 1965). The result in

- Ellis v. Carter is, of course, exactly. the result reached by

the Eighth Circuit in the’ present case. Judge Wyatt sum:

. Inarized the issue, and the reasons for the Second Circuit

rule, this way (242 F’. Supp. at p. 325):

‘‘But were I free to do so, I would not follow Ellis

v. Carter which, with great deference, seems to me’

(on the ‘specific point under discussion) to be in

error. The 1933 and 1934 Acts are closely related,

were adopted close together in point of time, and

oe.

al

were e part of the same legislative progratn. The first

Act dealt primarily with the distribution of securi-

. ties; the second Act dealt primarily with securities

transactions after. initial distribution had been

made. To give a private remedy under Rule 10b-5

and Section 17(a) ‘is simply to duplicate (without

their restrictions) the express liabilities created by

Sections 11 and 12 of the 1933 Act unless the remedy

under Section 17(a) and Rule 10b-5 be made differ-

“ent. The Fischman decision at least recognized this

aspect and did something about it. The Fischman

decision says that if you rely solely on innocent or

negligent misstatements, your sole remedy is under ~

Sections 11 and 12 of the 1933 Act with the short

statute of limitations and other procedures laid down :

by Congress. If you wish to avoid those limiting

procedures, you must allege and prove real fraud,

that is, scienter. Such an analysis seems far more

reasonable to me than the broad generality of Ellis

v. Carter.’’

The facts in t. esent case provide an excellent op-

portunity for this Court to examine this issue of ‘‘scienter,”’

since it is of critical importance in this case in determining

liability. There was conflicting testimony with respect to.

_. substantially all the alleged misrepresentations and omis-

sions involved; it must be remembered that the statement

_of the case by the Court of Appeals in its opinion assumes

all factual issues as having been resolved against the de-

fendants. On the evidence, however, the jury might have

found that petitioners made statements about the financial -

" condition of LPE, that these ‘statements were not accurate

but that petitioners honestly believed them to be true, and

that these were the only misrepresentations or omissions’ ~

involved. Under the District Court’s charge, the jury -was

- 15

required to hase liability solely on that finding. -Under

Fischman v. Raytheon Mfg. Co. and Trussell v. United

Underwriters, Lid., supra, the finding would not estab-

lish a violation of Rule 10b-5.

Moreover, the issue of scienter should in this case deter-

mine whether the action can be maintained at all. Respond-

ents brought these actions against petitioners in +1962 and

1963, almost ten years after the acts complained of were

allegedly committed. The statute of limitations would ©

plainly have run, were it not for the rule of Bailey v.

Glover, 21 Wall. 342 (1875), which tolls the statute until

plaintiff has discovered or: should reasonably have dis-

covered the fraud. The Bailey rule applies, however, only

where there has been fraud or concealment; see Traer v.

Clews, 115 U.S. 528 (1885). Thus, the jury ‘should have

been instructed that if no scienter were found, the action is

barred by the statute of limitations.

A number of commentators have ‘nfliented that the view

of the Second Circuit, or a rule which requires some degree

of sslenter to establish liability, is the correct one. See,

é.g., Fleischer, “‘ Federal Corporation Law’’: An Assess-

ment, 78 Harvard Law Review 1146, 1178 (1965) ; 3 Loss,

Securities Recunation 1766 (2d Ed. 1961, and 1962 Sup-

plement); Note, 63 Michigan Law Review 1070 (1965).

With this support for the Second Circuit’s approach, the

‘conflict ‘among the Circuits will be perpetuated ‘indefinitely

unless this Court grants the petition for certiorari and re-

solves the i issue.

16

_C. The Decision Below Adopts an Erroneous Standard

? -of Federal Law with Respect to the Measure of

Damages, in Conflict with Decisions of Other Courts

and with Section 28(a) of the 1934 Act

‘The courts below erred in permitting reéovery by the

sellers of an amount greater than the difference between the

value of the stock at the time of the sale and the amount of

consideration received. The measure of damages allowed

by the court permitted the jury to consider later accretions

. in value, a standard which permits a plaintiff to initiate

7 suit after waiting until the moment of maximum specu- .

lative advantage occurs, This holding conflicts with Estate

Counseling Service .v. Merrill Lynch, Pierce, Fenner &

a Smith; Inc., 303 F. 2d 527 (10th Cir. 1962), which held that.

the measure of damages in an action under Rule 10b-5 is

the ‘‘out-of-pocket’’. rule.

Moa SPARS eh DRT AMA sh RENT is aE IP

q + In fashioning an implied right of action under the gen-

eral standards of Rule 10b-5, the lower courts have created,

‘and are creating, a body of Federal corporate common law, .

- much like the development of Federal law before Erie R.R.

| v. Tompkins, 304 U.S. 64 (1938). The measure of damages _

; _ historically adopted in Federal cases involving common law

.- actions for fraud and deceit has been the ‘‘out-of-pocket’’

‘Tule. Smith v. Bolles, 132 U.S. 125 (1889). As this Court

: stated iti Sigafus v. Porter, 179 U.S. 116, 123 (1900), quot-

| ing from an earlier decision of the Eighth Circuit, ‘‘The

true measure of the damages suffered by oné who is fraud-

tlently induced to make a contract of sale, purchase, or

exchange of property, is the difference between the actual

value of that which he. parts with and the actual value of

that which he receives under the contract. It is the loss

which he has sustained, and not the profits which he‘might

have made by the transaction..“It excludes all speculation,

and is limited to compensation.” | :

17

Estate Counseling Service v. Merrill Lynch, Pierce, Fenner

& Smith, Inc., supra, held that this common law rule i is still

applicable in actions under Rule 10b-5,.as did the court in

Kohler v. Kohler Co., 208 F. Supp. 808 (1962), aff’d, 319

F. 2d 634 (7th Cir. 1963). See also 3 Loss, Securrrms Reav-

LATION 1793 -(1961), which accepts the out-of-pocket rule —

as the proper measure of recovery in a Rule 10b-5 case.

‘The broader remedy permitted by the court below is de- -

rived from Janigan v. Taylor, 344 F. 2d 781 (1st Cir.),

cert. demed, 382 U.S. .879 (1965). The court in Jamigan

posed the issue as whether to grant a ‘‘necessary’’ windfall

to the ‘‘conscious wrongdoer’? or to the party defrauded.

Based on this simplistic choice between the innocent victim

_ and the knowing defrauder, the court in Janigan made the

rather obvious decision. But the Janigam rule is one which

is specifically applicable only to ‘‘conscious wrongdoers.’”

As urged in this petition, the instructions to the jury in this

case permitted the finding of a violation of Rule 10b-5 with-

out a finding of ‘‘scienter.’” See pp. 11-12, supra. The

Janigan rule is thus inapplicable to the facts and posture

of this case, and in adopting that rule the court below erred.

Moreover, the allowance -of damages in an amount

greater than that permitted under the **out-of,pocket’’

rule conflicts with Section 28(a) of the Securities Exchange

Act of 1934, 15 U.S.C. § 78 bb, which specifically establishes

the outer limits of recovery in an action under Rule 10b-5.

Section 28(a) provides that ‘‘no person permitted to main-

tain a suit for daraages under the provisions of this title

shall recover ... a total amount in excess of his actual

damages on account of the act complained of.’? The court.

below stated, ‘‘. .. we feel the only _— of this provision

is to prohibit juniliiee damages ...,’’ and permitted a re-

©

=

1 oe ee Oe

i seat he fir

18

| covery greater than that of the ‘‘out-of-pocket’”’ standard.

This decision conflicts with the Federal rule adopted by

other courts. See Estate Counseling Service v. Merrill -’

' Lynch, Pierce, Fenner & Smith, Inc., supra, 303 F.2d at .

p. 533, and Kohler v. Kohler Co., supra, 208 F. Supp. at

p. 825. These cases squarely hold that Section 28(a)’s lan-

guage of ‘‘actual damages’’ incorporates the ‘*out-of-

pocket”’ measure of recovery.

D. The Decision oe Rejecting the Defense of

Laches in a Rule 10b-5 Case is in Conflict with

the Decisions of Other Courts

The court below erred in holding that the defense of

laches was not applicable to a Rule 10b-5 cause of action ~

‘*properly tried at law to a jury.’’ (A35.) Thé ruling is in

conflict with the decisions of other courts. See Royal Air .-

Properties, Inc. v. Smith, 312 F. 2d 210, 214 (9th Cir. 1962) ;

Tobacco and ‘Allied Stocks v. Tramsamerica Corp., 143 F.

Supp. 323 (1956), aff’d 244 F. 2d 902 (3d Cir. 1957) ; Pitof-

sky v. Brucker, (S.D.N.Y. 1966) CCH Federal Securities

Law Reporter, par. 91,715 (1964-66 Transfer Binder). The

Ninth Circuit in Royal Air Properties, Inc. squarely held

that in a Rule 10b-5 action laches was‘un available defense.

The District Court in Tobacco and Allied Stocks concurred’

and additionally: decided that laches was an appropriate

defense whether the claim is characterized as one in law or

equity, such a characterization being deemed by the court

to. be’ an unnecessary throwback to common law pleading~

rules. See Tobacco and- Allied Stocks v. Transamerica

Corp., 143 F. Supp. at 327.

The court below prohibited the laches dia: on the

ground that the nature of the claims was one at law. This

characterization was made despite the fact that the plain-

19

tiffs claimed alternatively damages at law and rescission in

equity. Moreover, the equitable defense of laches. was con-

sidered inapplicable despite the fact that the ultimate relief

granted was equitable, 7.e., the Janigan.rule of permitting

the one defrauded to keep any windfall as a result of accre-

tions to the value of stock after the date of sale.

, The court below relied on Straley v. Universal Uranium —

& Milling Corp., 289 F. 2d 370 (9th Cir. 1961), an action

brought under Sections 5 and 11 of the Securities Act of -

1933, 15 U.S.C. 77a, et seq., both of which are governed by

a statutory period of limitations. Rule 10b-5, however,

contains no statutory limitations period. The Ninth Circuit.

itself in Royal Air Properties, Inc., supra, refused to follow

its earlier decision in Straley, stating, ‘‘ . . . where there is

no applicable federal statute of Nesltations, as in a Section

10(b) action, there is no evidence of a Congressional intent

to exclude the traditional doctrine of laches.’’ 312 F. 2d at |

p. 214.

° ~ 3

E. The Decision Below that an Intrastate Telephone

Call Supports Federal’ Jurisdiction is in Conflict

with the Decisions of Other Courts i

Section 10(b) and Rule 10b-5 provide that ‘‘the use of

any means or instrumentality of interstate commerce or of

the mails . . .’’ constitutes a basis for federal jurisdiction.

The court below, relying upon Nemitz v. Cunny, 221 F.

Supp. 571, 573 (N.D. Il. 1963); held that the use of a tele-

phone to call another wholly within the same state consti-

tutes sufficient jurisdiction because the telephone is an

‘instrumentality of interstate commerce.’? The decision

below and the rule of Nemitz conflict with the holding in

Rosen v. Albern Color Research, Inc. 218 F. Supp. 473 (E.D.

Penn. 1963). See also Note, 62 Mich. L. Rev. 1080 (1964).

dpa Pate

oid a aM aan RI OC AO te PR er

ee es es

Eee ras:

.

20

The Court in Rosen, citing Mr. Justice Holmes’s analysis

in Minneapolis & St. Louis R.R. Co. v. Winters, 242 U.S.

"353, 357°(1917), reasoned that whether an object is to

be considered an ‘‘instrumentality of interstate commerce’’

depends entirely upon the use to which it is put. In the con-

text of a telephone, the test therefore would be whether the

call was to another within the state or whether it was in-

deed used in interstate commerce. .

The quéstion has often arisen before the Federal courts.

See Bredehoeft v. Cornell, 260 F. Supp. 557 (D. Ore 1966) ;

_ Lennerth v. Mendenhall, 234 F. Supp. 59 (N. D. Ohio 1964) ;

Repass v. Rees, 174 F. Supp. 898 (D. Colo. 1959).

Although the court below also predicated jurisdiction on

the ‘‘delivery of checks written by the Illinois Corporation

on Chicago, Illinois banks to a Minnesota citizen,’’ the trial

court’s instructions to the jury permitted a finding that

petitioners used merely the telephone to purchase respon-

- dent’s stock (R. 785-786). Thus, jurisdiction could well be.

predicated on the use of the telephone alone. Petitioners

‘ urge this court to grant certiorari in order to settle this

conflict among the courts.

F. The Assertion of Liability Against the Corporate :

: Defendant Conflicts with Applicable Law ,

The court below held that Lakeside Industries, Inc., as

the successor to LPE, is liable for thé individual defend-

ants’ alleged violations of Rule 10b-5. LII’s liability is.

predicated on misrepresentations or omissions made by a ~-

stockholder. or director of LPE solely for his own benefit

and not for.that of the corporation. LPE had no concern

over who owned its shares at the time of the sales by

respondents. ‘Imposing liability on LII, as successor to

LPE, conflicts with the well-established rule that a corpo-

®

A Ee SE nn eae

SS eee

“21

ration is not liable for misrepresentations or omissions

made by an officer or director in connection with the selling _

or buying of stock in the corporation for the officer or

- director’s own personal account. See Kohler v. Jacobs, 138

F. 2d 440, 443 (5th Cir: 1943), 10 Fuercuer, Cyciopepra Cor-

' PORATIONS §4886 p. 506; RestaTEMENT oF ‘Resrirvtioy, $142 -

(1937).

Since 1962, 150,000 additional Pam of LII have been

issued to the public. The alleged acts of the individual peti-

tioners were the acts of former stockholders of LPE and

not those of the corporation. To penalize the corporation

and all its public stockholders for the acts of these particu-

lar stockholders is a novel and inequitable notion. |

G. The-Holding Below that a Grossly Negligent

Plaintiff Can Recover Under Rule 10b-5 Con-

flicts with the Second Circuit Decision in List

v. Fashion Park, Inc.

' Respondent Vertelney was found by the Court of ‘ini

to have been, if anything, ‘*grossly negligent.’’ (A23)

The holding below that Vertelney nevertheless could re- |

cover, eve though grossly negligent, conflicts with List v.

_ Fashion ark, Inc., 340 F. 2d 457 (2d Cir.), cert. denied,

382 U.S. 811 (1965). List held that the reliance necessary

for an action under Section 10(b) is not only that the plain-

. tiff in fact relied upon the misrepresentation, but that

‘fa reasonable man would also have acted upon the fact

misrepresented.’’ 340 F. 2d at p. 462. Since Vertelney was -

an experienced man with a degree in business administra-

tion, and a director of LPE at the time of the alleged mis-

statements and omissions, he could not in these circum- ~

stances be said to have reasonably been misled or to have

relied upon the alleged misstatements. |

22

| In addition, the District Court charged correctly that

i Vertelney, because of his position as a director, was an

" ‘insider’? as a matter of law. An insider who sells his

! stock cannot recover under Section 10(b) where his claim

is based on facts which were ‘equally available to both

buyer and seller. Qf. Hafner v. Forest Laboratories, Inc.,

* 345 F. 2d 167 (2d Cir. 1965). Furthermore, because of his

aa position as a director, and his presence at relevant\.direc-

|

:

tors’ meetings, where the, nature of the business and its

prospects were thoroughly discussed, Vertelney, as a

. matter of law, was on notice'as to any falsity in any of the

« alleged representations or omissions. It cannot be: said

that one who has notice of any such_falsity meets the

criterion of reliance upon material facts which are ‘‘mis-

leading’’ within the meaning of Rule 10b-5. Any misstate- _

ments or omissions could not reasonably have been material

_ to or relied on by a man with Vertelney’s experience and

- admitted personal knowledge of. the corporation’s affairs.

When liability is imposed under the circumstances present

in this case, Rule 10b-5 becomes a trap for the unwary. In

granting Vertelney’s claim for ace tial the court below

committed reversible error.

~

7

23

CONCLUSION

The decision below coriflicts on numerous issues with de-

cisions in other Federal courts. This Court has never con-

sidered the many questions arising under Rule 10b-5. The

increasing frequency of cases arising under the Rule, and

_ the uncertainty which now pervades this area of the law,

point to the urgent need for this Court to resolve these

issues at this time. +

s -

a

For the foregoing reasons, this petition for, a writ

of certiorari should: be granted.

Respectfully submitted,

|

Leonarp M. Lerman ma

Attorney for Petitioners

1 Chase Manhattan Plaza

« New York, N.Y. 10005

Reavis & McGrara

TENzER GREENBLATT Fatton & Kapian

Of Counsel .

January 8, 1968