Petition for Writ of Certiorari — Bogue Electric Manufacturing Corp. v. Zeller

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Micerel RODS, J8..CUR

IN THE L

Supreme Court of the United States

OcroBer TreRM, 1972

No. wo 1 6 r

BocvE Evectrric Manvuracrurinc Corprorarion, Epwarp P.

ScHINMAN, Ropertr S. Herwic, WiLLiAM S. GuTTENBERG

and Murray ReEirrin,

Petitioners,

—V.—

Herman L. ZELLER, IRWIN SMALL Company, a Partnership,

and Betco PoLtLturion Conrro. Corroration,

Respondents.

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Rosert L. Kiem

Counsel for Petitioners

Office and P.O. Address

41 East 42nd Street

New York, New York 10017

(212) OX 7-2310

Of Counsel:

Becker, Ross & Stone by

ALEXANDER STONE

JaMEs J. Ross

Wiuiam C. Kratenstein

SE ES SE TE SE ES

INDEX

Citations te Opinions Below .........................................

Io ciral eiknnsdsopmpearaisinlenl

INN UN 6 och lhc oencisnonecgiciccicaraecneins

Statutes and Federal Rules imvolved ..0 0000...

Te

Gr TEES See IIPS OES cer cee ee

Bespous von Gaaxtixec tHe Wri ....................................

Point I:

Certiorar: shouid be granted in view of the clear

conflict between the Second and Tenth Cireuits

as to the proper measure of a defrauded buyer's

recoverable damages under the federal securities

EERE at AE Ne ON A nO Se OR

Pot IT:

Certiorari should be granted as there is no logical

basis upon which an expanded measure of damages

ean be sustained; any such expansion would be

contrary to the prior holdings of this Court .........

Point ITT:

Certiorari should be granted because the decision

of the Court of Appeals will result in the federal

courts being deluged by state law claims -...............

1

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aT TOTES RATES

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ne ee el

APPENDICES:

AprenDix A—Opinion of the Court of Appeals dated

Mareh 22, 1973, —— F.2d — ... la

Appendix B—Opinion of the United States District

Court dated August 7, L972, 346 F. Supp.

RE aura cs rdcsenaceiseh enka sacedientconeasunescaasalaeuiatodaaaties l7a

Aprenpix C—Text of Statutes and Federal Rule In-

WRN in sccataniananennestuhcasicesasaenanacees 23a

AvTuHoritigs CITED

Cases:

Affiliated Ute Citizens v. United States, 406 U.S. 128

POOL iar pisaiadeean sncecsaieheaceaaedadbcnagnmusigtgceabacinimaces 7,12

Esplin vy. Hirschi, 402 F.2d 94 (10th Cir. 1968) cert. den.

Oe rs PI CED coctcrretecessiccoinnceersecentionocareness unineme 6

Estate Counselling Service, Inc. vy. Merrill, Lynch,

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

MID © consncsccatnishalcktauiaccoioiadoesnanomesrastastaciabadaksmantesiaeuiees 3,6

Janigan v, Taylor, 344 F.2d 781 (ist Cir. 1965) cert.

CU Te Se CE seats eens 6,7,8

Kohler v. Kohler, 208 F. Supp. 80S (.D. Wise. 1962)

aff'd 319 F.2d 634 (7th Cir. 1963) 2. eee 6

Levine vy. Seilon, 439 F.2d 328 (2d Cir. 1971)... 6

lil

PAGE

Myzel v. Fields, 386 F.2d 718 (Sth Cir, 1967) cert. den.

Be Tie, TE SD serie tesceriesnencnteinitn einstein 6

Richardson v. MacArthur, 451 F.2d 35 (10th Cir. 1971) 6

Sackett v. Beaman, 399 F.2d ss4 (8th Cir. 1968)... 6

S.E.C. vy. Manor Nursing Centers, Inc. 458 F.2d 1082 :

CNP SR crn epi cecceiareoenenciaican -- 8 4

Sigafus v. Porter, 179 U.S, 116 (1900) oe ecto 9,10

Sauith x. Bolies, 132 UB. 125 (1888) «ences ess 9, 10

Superintendent of dusurance Vv. Bankers Life & Casu-

ee we a Oe 1

Statutes:

Securities Exchange Act of 1934:

Oe ER es SED ascents 2

§27 Dey Ec. ID Soni tetencc oestrone anacrcancane 3

§28(a) (15 U.S.C. §78bb(a)) -....... ~ oe

Securities Act of 1933:

BU ea CE PR. STEED ssicleccecsesicctersinr renee 3

§22 CO ee OE aise teres casinos 3

Rules:

SEC Rule 10b-5 (17 CLF.R. §240.10b-5) 00......2, 3, 10, 11, 12

Other Authorities:

Restatement of Torts 2d, Tent. Draft #11, $549

UT es ha nce ee ec eal eo 9

2 Bromberg, Securities Law, Fraud, SEC Rule 10b-5,

§9.1 a

IN THE

Supreme Court of the United States

OcrosBeR TerM, 1972

Bocve Execrric MaNuracrurinGc Corporation, Epwarp P.

ScHINMAN, Ropert S. Herwic, WiLLiAM 8S. GurrENBERG

and Murray Reirrin,

Petitioners,

— |

Herman L. Zevier, IRwin SMALL Company, a Partnership,

and Bretco PoLLuTion ConTROL CorPorRATION,

Respondents.

—_—<@

PETITION FOR A WRIT OF CERTIORARI TO THE

UNITED STATES COURT OF APPEALS

FOR THE SECOND CIRCUIT

Petitioners pray that a writ of certiorari issue to review

the judgment of the United States Court of Appeals for

the Second Cireuit which reversed the District Court’s

order and judgment granting summary judgment in favor

of petitioners dismissing the complaint.

Citations to Opinions Below

The opinion of the District Court (Appendix B) is re-

ported at 346 F. Supp. 651. The opinion of the Court

of Appeals (Appendix A) has not yet been officially re-

ported but has been reported at 793, 903 CCH Fed. See.

L. Rep. [Current Binder].

IR Sea = ae eee ee

sa ~y

Jurisdiction

The judgment of the Court of Appeals was entered on

March 22, 1973. Petitioners’ application for rehearing and

application for rehearing in bane was denied by two orders

dated April 24, 1973. The Court of Appeals stayed its

mandate for 30 days by order dated May 8, 1973. The time

for filing this petition expires on June 20, 1973.

The jurisdiction of this Court is invoked under 28 U.S.C.

Section 1254(1).

Questions Presented for Review

1. Whether under §28(a) of the Securities Exchange Act

which limits recovery to “actual damages,” an allegedly

defrauded buyer, whose out of pocket loss has been fully

recompensed may also recover such non-out of pocket items

as lost profits, gains prevented and consequential damages.

2. Whether a measure of damages appropriate to state

law claims of corporate mismanagement should be incorpo-

rated into the anti-fraud provisions of the federal se-

curities laws.

Statutes and Federal Rules Involved

1. The Securities Exchange Act of 1934, $10b (15 U.S.C.

§78j(b)) and Rule 10b-5 thereunder (17 C.F.R.

§$240.10b-5.

The Securities Exchange Act of 1934, §28(a) (15

U.S.C. §78bb(a)).

te

:

sie PNAS ha ROCRUA Par COR I AE ORIN 5 ed DENA a enn

ores ‘ Boe . ~

all .

3

3. The Securities Act of 1983, §17(a) (15 U.S.C.

Si7q(a)).

The text of the foregoing provisions is set forth in

Appendix C,

Statement of the Case

Detailed facts are set forth in the opinions of the courts

below (Appendices A and B). Respondent Zeller, basing

jurisdiction in the first instance on Section 27 of the Se-

eurities Exchange Act of 1934 (15 U.S.C. §78aa) and See-

tion 22 of the Securities Act of 1933 (15 U.S.C. S77v),

conmnenced this shareholder's derivative action on behalf

of Belco Pollution Control Corp. (“Beleo”).

Named as defendants were Belco’s parent corporation,

petitioner Bogue Electrie Manufacturing Corp. (hereafter

“Bogue”); the members of the interlocking boards of di-

rectors of Belco and Bogue and their attorney ; and Bogue's

accountant, the respondent Irwin Small Company.

The complaint alleged violations of the anti-fraud pro-

visions of the federal securities laws, to wit. $10b of the

193-4 Act, Rule 10b-5 thereunder and §$17(a) of the 1933 Act

(the full text of those provisions is set forth in Appen-

dix C).

The heart of Zeller’s claim is corporate mismanagement

and breach of directors’ and majority shareholders’ fi-

duciary duty. This non-federal claim is couched in terms

of a security fraud. Beleo is alleged to have been the de-

frauded buyer in a security transaction when in J uly 1971

an open account indebtedness of some $300,000 resulting

from loans by Beleo to Bogue was formalized by Bogue’s

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issuance of a collateralized demand promissory note pay-

able to Belco.

In May, 1972, the loans were fully repaid together with

accrued interest at the rate of 8%. Zeller, claiming the

loans were not made for any proper business purpose of

Beleo thereupon moved for summary judgment on the

issue of liability. Petitioners cross-moved for summary

judgment dismissing the complaint on the ground that with

repayment of the loans Beleo was recompensed for all

recoverable out of pocket loss thereby mooting any federal

securities laws claim. The District Court (per Gurfein, J.,

Appendix B) dismissed the complaint, holding that under

§28(a) of the 1934 Act the pre-Erie federal rule of fraud

damages was applicable to the federal securities laws; and

as Beleo had been compensated for all out of pocket loss,

it no longer had any claim under those laws. The Court

of Appeals reversed and held (Appendix A) that a de-

frauded buyer may recover such non-out of pocket items

of alleged damage as the following:

(a) gains prevented, including (1) any greater interest

rate which Belco could have obtained by lending

the money to others, (2) higher earnings which

Beleo might have made by investing the money

in its own business and (3) proceeds of an alleg-

edly lost underwriting which might have supplied

Beleo with additional capital funds.

(b) “disgorgement” of “profits” made by the alleged

defrauder including (1) any increased interest

which Bogue would have had to pay on a loan

above the 8% actually paid to Beleo, and (2) the

alleged profit made by Bogue on the sale of the

stock which collateralized the promissory note.

REASONS FOR GRANTING THE WRIT

POINT I

Certiorari should be granted in view of the clear con-

flict between the Second and Tenth Circuits as to the

proper measure of a defrauded buyer’s recoverable dam-

ages under the Federal Securities Laws.

Prior to the Court of Appeals’ decision in this case,

damages recoverable by an allegedly defrauded buyer un-

der the anti-fraud provisions of the federal securities laws

were consistently held to be measured by the out of pocket

rule of fraud damages. The Tenth Cireuit in Estate Coun-

selling Service, Inc. v. Merrill, Lynch, Pierce, Fenner &

Smith, 303 F.2d 527, 533 (1962) summarized the law as

follows:

“The failure to show actual damages is also a fatal

defect in the cause of action based on the Securities

Exchange Act of 1934, 15 U.S.C.A. §78a et seq. That

Act permits recovery of ‘his actual damages on ac-

count of the act complained of.’ ‘Actual damages,’ un-

der the Federal rule of damages for fraud is the ‘out

of pocket rule.’ In the Federal courts the measure

of damages recoverable by one who through fraud or

misrepresentation has been induced to purchase bonds

or corporate stock, is the difference between the con-

tract price, or the price paid, and the real or actual

value at the date of the sale, together with such out-

lays as are attributable to the defendant's conduct.

Or in other words, the difference between the amount

parted with and the value of the thing received. [citing

cases }.”

rae rests ek ee RT 8

6

Following the Estate Counselling rule that a defrauded

buyer-plaintiff is entitled to recover only “such moneys

as plaintiff has paid out, with interest, and any other

outlay legitimately attributable to defendant's fraudulent

conduct * * *” (Ibid., emphasis added) are other Tenth

Cireuit decisions (see, Esplin v. Hirschi, 402 F.2d 94, 104

(1968) cert. den. 394 U.S. 928 (1969); Richardson y.

MacArthur, 451 F.2d 35, 43 (1971), and the Ninth Cireuit

in Sackett v. Beaman, 399 F.2d 884, 891 (1968). The out

of pocket rule for buyers has also been approved in dicta

in other cireuits (see, Janigan vy. Taylor, 344 F.2d 781,

786 (1st Cir. 1965), cert. den, 382 US. 879 (1965) ; MWycel

y. Fields, 386 F.2d 718, 745 (Sth Cir. 1967), cert. den. 390

U.S. 951 (1968) ; Kohler vy. Kohler, 208 F. Supp. 808 (E.D.

Wise. 1962), aff'd 319 F.2d 634 (7th Cir. 1963) and has

even been specifically approved by the Second Circuit in

its prior decisions (see, S.L.C. v. Manor Nursing Centers,

Inc., 458 F.2d 1082, 1104 (1972); Levine v. Seilon, 439 F.2d

328, 334 (1971)).

By allowing an allegedly defrauded buyer to reeover

such non-out of pocket elements of purported damages as

those listed above, the Court of Appeals has made a clear

break from the foregoing authorities and has established

a rule of law totally inconsistent with the Tenth Cireuit’s

holdings.

POINT II

Certiorari should be granted as there is no logical basis

upon which an expanded measure of damages can be

sustained; any such expansion would be contrary to the

prior holdings of this Court.

To justify its departure from the settled law the Court

of Appeals referred to this Court’s decision in Affiliated

Ute Citizens vy. United States, 406 U.S. 128 (1972) which

approved the First Circuit’s holding in Janigan v. Taylor,

supra, that defrauded sellers are entitled not only to their

out of pocket loss (i.e., the difference between the value

of what they sold and what they got) but also any addi-

tional profits realized by the defrauding buyer (Appendix

A, p. lla). We respectfully submit that the Court of

Appeals erred in not recognizing the essential difference

between buyers and sellers, which difference of necessity

precludes application of thgseller’s rule to buyers. That

essential difference is the nature of the property parted

with—the buyer parting with money while the seller parts

with a property or commodity other than money.

In Janigan, supra, 344 F.2d at 786, where the seller's

disgorgement rule was first established, Judge Aldrich was

careful to draw a distinction between buyers’ and sellers’

remedies, holding with respect to defrauded sellers that:

“future accretions not foreseeable at the time of the

transfer even on the true facts, and hence speculative

are subject to another factor, viz., that they accrued

to the fraudulent party.”

SE rcrtireswe siete. Gr es

sa Sides

8

The seller’s disgorgement theory thus is built upon two

bases: (1) there are aceretions to the property trans.

ferred; (2) restitutional principles of unjust enrichment.

If applied to buyers it is readily apparent that one of these

bases is absent and with that the disgorgement rule fails

to apply. The buyer parts with money. There are no

“accretions” to the money. Any profits accruing to the

defrauder result from the use to which the fraudulently

obtained money is put.* The seller, however, parts with

property other than money, typically shares of stock or

other security. As these properties generally have a flue.

tuating value, any “accretions” necessarily involve the

increased value of the property itself; logically such profit

should be disgorged as the defrauded seller would have

had the benefit of those accretions but for the fraud. In

Janigan, for example, the seller parted with shares of

stock which increased in value after the fraudulent sale.

It was this profit which but for the fraud would have

accrued to the plaintiff who would still have had the

security in his pocket when the increased value became

available. In our case, as in any typical buyer’s ease, the

alleged profits which plaintiff seeks to compel be “dis-

gorged” have nothing whatsoever to do with the property

(i.e., the money) parted with, and there is no way in which

Beleo would have had the benefit of those “profits” but

for the fraud. The disgorgement theory, therefore, is not

applicable and makes no sense when applied to a buyer,

and the Court of Appeals erred in applying it.

*In S.E.C. v. Manor Nursing Centers, Inc., supra, 458 F.2d at

1104 the Second Circuit recognizing the distinction between buyers

and sellers specifically held that any profits or income resulting from

a seller's use of money fraudulently obtained from a buyer could

not be recovered under the disgorgement rationale.

ne nenmeanemtes PAO pe Gest

9

Moreover, the disgorgement rule as applied to buyers

runs afoul of this Court's holdings in the touchstone se-

curities fraud cases of Smith v. Bolles, 182 U.S. 125 (1889),

and Sigafus v. Porter, 179 U.S. 116 (1900). These cases

established the pre-Lric federal rule of fraud damages

for a buyer of securities. That rule, commonly referred

to as the out of pocket rule, is summarized by this Court’s

words in Bolles where it held at 132 U.S. 129, “[wJhat

plaintiff might have gained is not the question, but what

he had lost by being deceived into the purchase,” and in

Sigafus where it held at 179 U.S. 123 that “the true

measure of damages suffered” for fraud “is the diiference

between the actual value of that which he parts with and

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

which he sustained and not the profits which he might have

made by the transaction.”* The out of pocket rule for

fraud damages enunciated in these cases (with the dis-

gorgement rule engrafted for sellers) has universally been

held to be the applicable rule for damages under the anti-

fraud provisions of the federal securities laws (see au-

thorities cited in Point I, supra; 2 Bromberg, Securities

Law, Fraud, S.E.C. Rule 1ob-5, $9.1). Each and every

item of damage which plaintiff seeks to recover represents

a non-out of pocket item and, hence, is not within the

scope of recoverable fraud damages. Judge Friendly at-

tempts to avoid this conclusion by classifying two items

*The rationale of this Court's opinion in Bolles and Sigafus is

approved by the Restaters, who have noted that:

“Logically the out-of-pocket rule appears beyond argument to

be the proper rule for a tort action, since the purpose of such

action is to compensate for loss sustained, and restore the

plaintiff to his former position, and not give him the benefit of

any contract he may have made.” Restatement of Torts 2d,

Tent. Draft #11, §549 Note 4.

ee

10

of alleged damage (the 40% return on eapital which Beleo

supposedly could have made by investing the loaned funds

in its own business, and the $800,000 lost benefit of a pro-

posed underwriting) as “consequential” damages which

admittedly “are in addition to or in lieu of what ordi-

narily constitute a fair recovery” (Appendix A, p. 14a).

Of course, these supposedly consequential damages are

not out of pocket items but represent gains which Beleo

allegedly was prevented from making. By allowing re.

covery of such gains prevented the Court of Appeals has,

in effeet, returned to the concededly rejected “benetit of

the bargain” rule of fraud damages in that an allegedly

defrauded buyer is not compensated merely for losses

sustained but is given the benefits which would have ae.

crued had there been no fraud.* The refusal of the Court

of Appeals to follow the buyer's rule of damages set forth

in Bolles and Sigafus should be corrected by this Court or

this case will stand as an aberration in the well settled

federal securities law.

POINT Ill

Certiorari should be granted because the decision of

the Court of Appeals will result in the federal courts

being deluged by state law claims.

In expanding the scope of recoverable damages for vio-

lation of Rule 10b-5, the decision of the Court of Appeals

has changed that rule from an anti-fraud regulation toa

substitute vehicle for what are properly state court cases

*None of the textwriters or authorities cited by the Court of

Appeals (see Appendix A, p. 14a) in any way hint that in a busi-

ness transaction lost profits are a proper element of consequential

damages.

Ei BNW re AO NO A EA

11

of corporate mismanagement and violation of fiduciary

duty. The effect will be to open the doors of the federal

courts, With nationwide jurisdiction, to any claim of corpo-

rate mismanagement touching upon the purchase or sale of

a security.

State law bonding requirements will no longer serve as

a deterrent to ill-founded claims of corporate mismanage-

ment.

This very lawsuit is a prime example. The reality of the

complaint is a charge of corporate mismanagement—inter-

locking directors improperly causing a subsidiary to make

illegal loans to its parent corporation. The damages

claimed are those which plaintiff would have claimed in

a stockholder’s derivative action in the courts of New

Jersey, New York or Delaware. <All of those states have

stringent bond requirements. Yet. by attaching those claims

toa claim of 10b-5 violation, plaintiff, a citizen and resident

of Pennsylvania, has been able to sue in the Southern Dis-

trict of New York, a New Jersey corporation, a Delaware

corporation and four citizens of New Jersey, none of which

corporations or individuals are in New York, and the Court

of Appeals has held that the damages which might be

recovered in the courts of New Jersey, New York or Dela-

ware for corporate mismanagement may be recovered in the

federal court as damages for a 10b-5 violation and not

merely under pendent jurisdiction of state court claims.

Neither the Congress, in enacting the securities laws,

nor the Securities Exchange Commission in formulating

Rule 10b-5 could have intended such a strange result.

Under the decision by the Court of Appeals, $10(b) and

Rule 10b-5 will cease to be anti-fraud securities regulations.

12

They will become corporation regulatory rules, under which

the federal courts will be ealled upon to develop their own

substantive federal corporation laws. This Court in Super.

intendent of Insurance v. Bankers Life & Casualty, 404

U.S. 6 (1971) did approve a limited application of 10b5

to cases of corporate mismanagement, and in the Ute case,

Supra, it approved the disgorgement rule as applied to

defrauded sellers. Whether to now stretch those two cases

and say that the disgorgement rule should be applied to

buyers together with the other rules of state law damages

concerning corporate mismanagement and breach of fiduci-

ary duty is a question of such great importance that it

should be passed upon by this Court.

CONCLUSION

For the reasons given, petitioners pray that the writ

be granted.

Respectfully submitted,

Rosert L. Kirin

Attorney for Petitioners

Becker, Ross & Stone

Of Counsel