# Brief for Respondent — Supt. of Insurance v. Bankers Life & Cas. Co.

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Brief for Respondent
- **Published:** January 1, 1971
- **Citation:** 404 U.S. 6

## Text

INDEX

ed

~ PAGE
Preliminary Statement “s ; :
Questions Presented . secneepedeescsl 3
- Statement of the Case .... | . . 8
ARGUMENT:
Pornt I: =

Although. the regulatory power of the Commission .
and the scope of Rule 10b-5 are to be flexibly
interpreted, the provisions of Section 10(b) of the
Securities Exchange Act must be appropriately
limited by the scope of the protection intended’ by
Congress and by the discretion of the courts-in

defining the implied liability they have created .:.... 6

"AL Summary a o6
B. The 1934 Act must be construed in light of the |

- Congressional purpose .......... ; 8

C. The Courts have implied a private remedy ”
under Section 10(b) and should limit that
remedy consistent with the Congressional —
intent ...... oo . 11

D. The court of appeals here, responsive ‘to the °
Congressional purpose and consistent with all
prior reported decisions under the 1934 Act, .
correctly refused to finda federal cause of

action ............... 13

Pornt II:

Manhattan could not challenge the securities sale,
nor can petitioner now sue on its behalf, since Man-

hattan’s ‘sole stockholder ordered the sale ...........: . 26
A Summary Teen See NET NE Ee SRS Le 26
B. Manhattan has no claim, nor does aeltioner
as its liquidator ............... eee sesemeciey Hanscom muy 27
CONCLUSION oocccccsescccsececseeeceecsssseeeee Eaececeenlestecartchennsiins Stee 29

-TaBLE oF AUTHORITIES
Cases:

A.T. Brod & Co.'v. Parla, 375 F.2d 393 (2 Cir.

BEY ct carcestisseskeeagocsncesnnpetcacsecce aetna eesaancencecesearcecannents 16, 21
Bailes v. Colonial Press, Inc., Dkt. No. 29048 (5th Cir.
MEMBG TS, TOT cette reece eee 28
Barnett v. Anaconda Company, 238 F. Supp. 766 (S.D. |

N.Y. 1965) .oeccecocccecccsocecesceecescccsescescescssesceesheseesessuneeceneeesecuees 25

Birnbaum v. Newport Steel Corporation, 193 F.2d.461
“(2d Cir. = cert. aoe, 348 U.S. 956 (1952) ..11, 12, 15,16,
VW, 25, 29

~ Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787
(2d Cir. 1969), cert. denied, 409 U.S. 822 (1970). ..16, 18, 20

Dasho v. Susquehanna Corporation, 380 F.2d 262 (7th
Cir.), cert. denied sub nom. Bard v. Dasho, 389 U. S.

TT TE Fac pecteccerectennee ces s rcenennateaenteeientetoe 16
Drachman v. Harvey, Dkt. No. 35077 (2d Cir. July 21, .
1971) Seca een snened-cnrernsienersiiciead chanstalteaten Sederaultb eran 7, 12, 26-—

et |

. . ; PAGE
Erling v. Powell, 429 F.2d 795 (8th Cir. 1970) ...........---- -—«:16

Field v. Lew, 184 F. Supp. 23 (E.D.N.Y. 1960), aff’d ~
sub nom. Field v. Bankers Trust Company, 296 F.2d
.109 (2d Cir. 1961), cert. demed, 369 U.S. 859

(1962). weveceeeDly 28
- | “Fischman v. Raytheon Mfg. Co., 188 F. od 783 (2d Cir.
1951) ee 7 ee ae _ ...9, 12, 15
Greater: Iowa Corporation v. McLendon, ki F.2d 783
(Sth Cir, 1967) nnn cae acne cee ecco 16
- Greenstein v. Paul, 400 F.2d 580 (2a Cir. 1968) ees 16

H erpich V. War 430 F.2d 792 (Sth Cir’ 1970) ....10, 16,
21, 25

Hooper v. .M ountain States Securities Corporation, 282
F.2d 195 (5th Cir. 1966), cert. denied, 365 U.S. 814
G5.) 8 Reece ene enn een ne a - 218, 22

: Iroquois Fudustries, Inc. vy. Syracuse China Corpora.

tion, 417 F.2d 963 (2d Cir. 1969), cert. denied, 399
US. 909 6.) One reseoseeeeegpeeeeeesnnseeseene 16, 18

| JL. Case Co. v: Borak, 377 US. 426 (1964) _.0. —_ 12

Joseph v. Farnsworth Radio. & Television CFP | 198
F.2d 883 -(2d Cir. 7 = jehnsientnseiignes 12

Kahan vy. Rosénstial, 424 F2d 161 (34 Cir.), cert.
denied ‘sub nom. Glen Alden Corp. v. Kahan, a
U.S. 950 (1970) 21

: Kaminsky v. Abrams, 281 F. Supp. 501 (S.D.N.Y.

DB acc _. 18, 25

“”

PAGE

* , Lester v. Preco Industries, Inc., 282 F. Supp. 459 |
(S.D.N.Y. 1965) — = . coostoceeee ...18, 25

Mader v. Armel, 402 F.2d 158 (6th Cir. 1968), cert.
denied sub nom. Y oung v. Mader, 394 U.S. 930 (1969) 16
Marino v. Coburn Corp., CCH Fed. See. L. Rep.

* (992,959) (E.D.N.Y. February 19, 1971) ns: - 21 |
_ Mutual Shares Corporation v. Genesco, Inc., 384 F.2d {
540 (2d Cir. 1967) a Bakes nrqeeeneoeen scceenioes 13; 23, 24
New ,Y ork Credit Men’s Adjustment Bureau v v. Weiss _—
305 N.Y. 1, 110°N.B.2d'397 (1958) oto. 9
. O?Neill v. Maytag, 339 F.2d 764 (2d Cir. 1964) 2. (12
Old Dominion Copper Mining & Smelting Company v.
. » Lewisohn, 210 U.S. 206 (1908) 2.2 eeeeeeeeeee |

Pettit v. American Stock Exchange, 217 F. Supp. ral
(S.D.N.Y. 1963) ene a eal, 1S

Ruckle v. Roto American Corporation, : 339 F.2d 24
(2d Cir. 1964) ... ara ceeroepeeetase aes nesrereres “19

Schoenbaum v. Firstbrook, 405 F.2d 215 (en banc),
—rev’g 405 F.2d 200 (2d Cir. 1968), cert. denied sub.
nom. Manley v. Schoenbaum, 395 U.S. 906 (1969) 20, 23, 27
Securities and Exchange Commission v. National 7
Securities, Inc., 393 U.S. 453 (1969) ........... ee .
Securities and RrWhenge Commission v. Texas Gulf
Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. de-
med sub nom. Coates v. Securities and Exchange
~ Commission, 394 U.S. 976 (1969) sesso eee 10, 12,21 —
Superintendent.of Insurance of the State of New York
v. Bankers Life and Casualty. Co., 430 F.2d 355 (2d:
Cir. 1970), aff’g 300 F. Supp. 1083 (S.D.N.Y. 1969) ..

IO NEtsa a - ; Pes pore apd gEE RCO ER ENON IRE me asieeenennenens ost ne:

Statutes and Rules: re

Securities Act of 1933,°15 US.C. §778 et seq.:
- Section 17(a), 15 U.S.C. §77q(a) .. sesseeeeely 15
Securities Exchange Act of 1934, 15 U.S.C. §78a
et seq.: ; _
Preamble, 48 Stat. 881 ..0.00--cc-ccceccccccsceeeeseeseee “1
Section 2, 15 U.S.C. §78b ...: ~ il
Section 3(a}(10), 15 U.S.C. §78e(a) (10) ........ 14.
Section 5, 15 U.S.C. §78e a ||
Section 7(c), (d), 15 U.S.C. §78g(e), (d) ww! 11
Section. 8, 15 U.S.C. §78h: _ - ii
Section 9(e), 15 U.S.C. §78i(e) encney LA
Section 10(b), 15 U.S.C. §78j}(b) -.....2......-.-- passim
Section 11(b), (d), 15 U.S.C. §78k(b), (d)...... 11
e Section 12(a), 15 U.S.C. §78l(a) 11
Section 14, 15 U.S.C. §$78n .. - il
Section 16(b), 15 U.S.C. §78p(b) - vessseessieeeee9, 11, 15
Section 18(a), 15. U.S.C. §78r(a) on 9, 11
Section 27, 15 U.S.C. §78aa ...., 3
Section 32, 15 U.S.C. 97866 ne eeeeeaeeseeeeneen 1
New York Business Corporation Law:
Section 719 ...... fe _.9
Fw (| ec 9

Rules under the Securities Exchange Act, \1T
C.F.R. 240, et seq.:

Rule 10b-5, 17 CF-R. 240.10b-5 passim

Miscellaneous:
Boone and McGowan, Standing. to Sue Under SEC

Rule 10b-5, 49 Texas L. Rev. 617 (1971) nae 6, 10
Bromberg, Securities Law: Fraud—SEC Rule
10b-5. geceeeeeee y
Loss, Securities Regulation, (1962 ed. and 1969 (
Supp.) -2..........-. Ferhat ternespewymeceepsieieinrengedasoan nee 14, 25
SEC, Brief as Anions Curiae j in Mutual Shares v. )
Genesco, 384 F.2d 540. (2d Cir. 1967) uu. 23
SEC Release No. 3230, May 21, 1942 ceo 15
S. Rep. No. 792, 73d Cong., 2d Sess.’(1934) ......... 9

_S. Rep. No. 1455, 73d Cong., 2d Sess..(1934) ............ 11

_ Ly tae
Supreme Court of the Anited States
‘Ocroser TERM, 1971
L) No. 70-60

~ -

= ; -
a oe OF INSURANCE OF THE Srate c or NEw Yorx,
AS LiQUIDATOR OF Mannarran CasuALty Company,

+ ‘Petitioner,
v. °

»

Bankers Lire anp Casuatty Company, ET AL.,

Respondents.

ON WRIT OF CERTIORARI TO.THE UNITED STATES
-COURT OF APPEALS FOR THE SECOND CIRCUIT 2

Let

’ * s . ad is - f.
- BRIEF F R RESPONDENTS BELGIAN-AMERICAN
B G CORPORATION AND BELGIAN. -
AMERICAN BANK & TRUST COMPANY
, : —?)

; . ;

Preliminary Statement

a

This case presents the traditional dianeate of\ ommon
law fraud involving the

the Securities Act of 1938, i5 C. §77q(a), and con- |
dugted almost six years ‘of ieee y in_an effort to sup-
‘port the: sufficiency of his complaint. Only after petitioner

,

had completed his discovery and indicated his prepared- 7
‘ness for trial did Belgian-American Banking Corporation

(“Belgian-Ameryican Banking”), Belgian-American Bank &
Trust Company (“Belgian-American Trust”) ard Bankers
Life and Casualty Company (“Bankers Life”) move in le
district court to dismiss the complaint for failure to state
a claim under the federal securities laws. (App. 48a)
The district court (Herlands, ‘J.), as did ‘the court of ap-
peals in affirming the district court’s judgment, e nsidered
not. only the allegations of the complaint but Also. peti-
tioner’s various unpleaded versions of the facts-and con-
cluded that the petitioner failed to state a federal claim

_ under any federal law.

The district court declared that “the complaint, taken

as a whole, alleges no more than a common law action

for misappropriatien-of corporate funds by a fiduciary,

' embezzlement or fraudulent conveyance perhaps, or th

distribution of an illegal dividend” (App. 84a), and held
there was no federal jurisdiction under either the Se-

curities Act of 1933 or the Securities Hxchange Act of
1934. - Chief. Judge Ryan, in granting idetitjcal motions
before him by ‘the other respondents’! (App. 47a, 49a),
adopted the opinion of J udge Herlands ‘and concluded that
the “fraud-alleged was not in the purchase’or sale of se-

~ curities; but-was waste of Manhattan’s assets by diversion -

_ and misajipropriatien of its seéurities”. (App. 89a) The

dismissals were without prejudice to the prosecution of
petitioner’s pending action in the New York Supreme
Court. (App. 90a) ©

The ‘court of appeals affirmed the. judgments of fhe dis-
_ trict court and noted that the alleged fraud “in no way

“ affected either the securities markets or the investing pub-

lic. No stockholders were Aefrauded, no investor injured.

» ' :

The purity of the security transaction-and the purity of the

trading process were unsullied. There was no danger that
the -securities sold would be overvalued on reac the -
polic markets.” (App. 107a) Petitioner’s moti for .

-réhearing and rehearing in banc were denied by the ceurt
. of appeals on September 30, 1970. (App. 112a, 113a)

Questions Presented _. .

i Should the scope of Section 10(b) of the ‘Securities
Exchange Act of 1934 be € extended to reach the conversion
of the proceeds from thé sale of a corporation’s portfolio

of Treasury bonds, when the converter is the corporation’ S -
; ‘sole stockholder and when the conversion has (no conceiv-

able effect 6n any investor, any security ‘or any securities

- market?

2. ‘Does a liquidator have standing to sue on a corpora-
tion’s behalf under the Securities Exchange Act of 1934,

when thé corporation itself is barred from suit by reason

of the participation and approval of its sole stockholder?

Statement of the Case

od

ve

Potions’ s statement of facts, devoid of record cita-
tions, bears little resemblance to the complaint filed-in thi
a¢tion. The issues before this, Court arise from the oe
* tions of the complaint as well as all the alleged “facts”
which petitioner advanced in the district court as part. of
a proposed amende complaint claiming relief also under

- - -Seetion 27 of. the” Securities Exchange Act of 1934, Ys

U.S.C. §77aa, for violation of Section. 10(b), 15 U.S.C.

§77j(b), and Securities and Exchange Commission Rule

10b-5, 17 C.F.R. 240.10b-5. Both district, court judges and

. 7 e . =
4 °
, .
Anite Ng MERE: w + eeepc oa YEE OC GE PI ak POR EI PORE Mia OP LD DAGL ION ATES EDNELE OL IR PET by GE IE LE TS SRS Si staal e MEE Dp veer aE si Hy

POPC M' >:

the court of appeals extended to petitigner_wide latitude
and properly construed the complaint together with Rs

proffered sa datory allegations as not” oe any ~~

federal claim for relief. |
Petitioner’s claim, iti essence, is that the individual de-
fendants purchased all of the outstanding stock of Man-

hattan Casualty Company (“Manhattan”) for $5,000,000

’ from Bankers Life, paying for the stock with the proceeds

of the sale of United States Treasury bonds which they *

took from the treasury of Manhattan immediately after
they got control. The steps taken were in brief as follows:

First, defendants Standish T. Bourne and James F.
Begole agreed to purchase from Bankers Life all of the
stock. of Manhattan and on January 19, 1962, executed a
contract with Bankers Life as seller and’ Begole as pur-
chaser, providing for the sale of all of Manhattan’s stock

" for $5,000,000- On January 24, 1962, a check of respondent .

-Irving Trust Company (“Irving”) in the amount of
$5,000,000 was advanced by Irving and given to Bankers
Life and, in exchange, all of the shares of Manhattan were
given to Begole. (App. 98a)

On the same day, after gaining control of Manhaitan,
the individuals sold Treasury bonds from Manhattan’ s port-
folio, realized $4,854,552.67 and credited this sum plus ar

additional $150,000 in the name of Manhattan: at Irving. 7
The $5,000,000 Irving check was then charged — this |

account. (App. 99a-100a)

‘In summary, Bourne and Begole then owned the stock of
Manhattan, Bankers Life had received $5,000,000 and Man-

‘hattan’s assets, having been used to purchase the Man-.

. hattan stock, had been reduced by $5,000,000. (App. 100a)

‘ - 2 . e
A . a
,
,

: -%
“i

In order to conceal the above, petitioner charges that
the individuals used the proceeds of a second Irving loan

“in the amount of $5,000,000. to purchase a certificate of

deposit from Belgian-American Trust, assigned that -cer- —

-tificate to another corporation (New England Note Cor- |

poration) controlled by them.and then used the certificate
as "security for-a loan from Belgian- -American Banking to
New England. The proceeds of this loan were then used
to repay Irving, ‘thus resulting in a complete “wash” tran-
saction. Manhattan’s books reflected only the salé of Treas-
ury bonds and the purchase of a certificate of deposit,
without reflecting that the proceeds of the sale of the
bonds were used to repay Irving and that the certificate
of deposit had heen assigned to New Exigland and then
pledged to Belgian-American Banking. (App. 10la)

The loan and certificate were renewed to January

_ 1963, when Belgian-American Banking refused to renew

“its loan, and the individuals arranged for substitute credit

with another bank. (App. ‘101a)
, In April 1963 the New York Insurance Department dis-

covered the misappropriation of Manhattan’s assets and

the New -York Supreme Court — the company in
liquidation. (App. a += . ~ 3

ARGUMENT

POINT I

Although the regulatory power of the Commission and
the scope of Rule 10b-5 are to be flexibly interpreted,
the. provisions of Section 10(b) of the Securities Ex-
change Act must be appropriately limited by the scope
of the protection intended by Congress and by the dis- _
cretion of the courts in defining the implied care!
: ‘they have created. .

A. Summary a

The purpose of the federal securities laws and regu-
lations have in no way. been impaired by -reason of the
. decision of the court of appeals in this case. Indeed, we,
are involved here with an effort to extend Section 10(b);
and Rule 10b-5 into areas never before reached by any
-reported case or contemplated by the Congress, see Boone
and McGowan, Standing to Sue, Under SEC. Rule 10b-5,
49 Texas L. Rev. 617, 622 (1971), and to bring under the
federal regulatory umbrella all cases of fraud in the in-
ternal nianagement of state corporations whenever a se- —
curities transaction was even incidentally involved. The
‘ courts, having implied civil liability for violation of Section
10(b) and Rule 10b-5, should define and limit that Habality
consistent with the Congressional purpose.

Fraud in a: securities transaction. falls unquestionably —
within the prohibitions of Section 10(b). This was what
Congress sought to outlaw by the securities legislation;
nothing the Second Circuit has done here in any way im-
pairs: the fulfillment of that purpose.

7

But. fraudulent ‘activity: in which a security transaction

is peripherally inyolved has never been viewed as a federal

securities law violation. Pettit v. American’ Stock Ex- :
change, 217 F. Supp. 21 (S.D.N.Y. 1963). Here the ap- — .
plication of Rule 10b-5 to the alleged embezzlement of - ;
Manhattan’s assets should not turn upon whether the funds ~. ;
diverted were cash deposits or the proceeds of the sale. |
of a portfolio security. The*district court properly sought ©

to interpret the broad language of Section 10(b) and Rule
10b-5 in the context of the legislative history and suc-
cinctly summarized the four principal categories of sit-

uations in which the courts ‘iave upheld such claims:
pe ee .
2. “In order to sustain a complaint alleging fraud under

“section 10(b) of the 1934 Act, it must’ appear. with .

reasonable clarity .from the face of the complaint

either (1) that a purchase‘or sale of securities is at. -

the crux of a fraudulent scheme; or (2) that inducing

a purchase: or sale of securities is the object of a.
fraudulent scheme; or (3) that fraudulent statements,

misstatements, or omissions are—made—in—a- manner
which is reasonably calculated to influence ‘the’ invest-
ing public, or are of the sort which the reasonable in-
vesting public might rely upon; or (4) that the trading
process is abused through potential market manipula-
tion or the spread of watered. stock.” (App. 82a)

Only very recently the Second Cirauit again refused to

extend Section 10(b) liability where it could not be shown
to be “in connection with” a securities transaction, as the
_ Act requires. Drachman v. Harvey, Dkt. No. 35077 (2d
Cir. July 21, 1971). The court wrote: |

“Tn short, §10(b) liability arises only when the alleged

fraud between the parties and/or alleged market ma-
-nipulation or deception is intrinsie to the securities

.

8

transaction itself. Where this_prerequisite is not met,

as here, no féderally cognizable interest exists, and ~°
the complaint must be dismissed. ” (Shp op. at 4401--
02) - .

B. The 1934 Act must be construed in bohe of
the Congressional purpose. *

Section 10(b) must be construed against the - back-

; ground of what Congress was seeking to accomplish when

the Act was enacted. This Court has itself emphasized the §
necessity of considering this section in its proper context.
Securities and Exchange Commission v. National Secur-

_ ities, Inc., 393 US. 453, 466 (1969).

The Securities Act of 1933 (15 U.S.C. § Ta, et seq.),
enacted after the revelation of numerous stock swindles,
focused primarily on disclosures required in the initial
offering of securities to the public. From that taw the
public can today rely on the required periodic and annual

reports: by public corporations, upon the process_of_reg-——-__---- -

istering securities to be offered to the public, and upon
the full disclosures required in prospectuses to be delivered

in connection with distributions of securities to the public.
The Securities Exchange Act of 1934 (15 U'S.C. § 78a, et
seq.), enacted a year later, can be said to have been aimed
primarily at the secondary markets, particularly emphasiz-
ing the necessity for full disclosure and fair dealing in the
buying and selling of securities in the market. This Act
created the Securities and Exchange Commission as re
watchdog over the securities industry and contains nu-
-merous explicit prohibitions against. market manipulation _
and deceit in purchasing and selling securities in those
markets, Those sections in which specific remedies were
given to private individuals under the Securities Exchange =~

s

Act have been similarly. directed to those two facets of
securities dealings: disclosure of material facts in the

securities transaction and prohibitions against market
manipulation. See Sections 9(e), 16(b) and 18(a) (15
U.S.C: §§.78i(e), 78p(b) and’ 78r(a)).

Both Section. 10(b) and, the Commission's Rule, ‘now

having been accepted by the lower courts as forming the
basis of civil liability, ‘see, e.g., Fischman v. Raytheon
Mfg. Co., 188 F.2d. 783 (2d Cir. 1951), must be applied
broadly and flexibly, as the Commission properly urges,
but such broad and flexible interpretation must be con-
sistent with and in furtherance of thé Congressional pur-
pose. However desirable it might have been for Congress
to outlaw all fraudulent activity in the management of
“corporations, it has not done so and Section 10(b) was

not so intended. The-state laws are fully effective i in this _
' area, N.Y. Bus. Corp. Law §§ 719, 720 (McKinney 1963),

- as-are the state courts, New York Credit Men’s Adjustment
Bureau, Inc. v. Weiss, 305 N. X., 110 N.E.2d 397 (1953).

The conclusion that some limitations on the applicability
of Rule 10b-5 exist is beyond dispute. It is fundamental,
for example, that the Rule may not be applied to transac-

tions not intended to be reached by Congress in enacting

the statute that authorizes the Commission to promulgate
the Rule. Although the legislative history of Section 10(b)

and Rule 10b-5 is sparse, see Bromberg, Securities Law: .

Fraud, SEC Rule 10b-5, Sec. 2.2, (1970), the committee
"seports that are available indicate that manipulative prac-
_ tices affecting the market price of stock were the chief
target of the legislation. See, e.g., S. Rep. No.’ 192, 73d
Cong., 2d Sess. 7-8 (1934), which states:

N

10

“Among such practices’ are fictitious or ‘mash’ sales;
‘matched’ orders, or orders for the purchase and sale
of the same security emanating from a common source

’ for the purpose of recording operations on tle tape

and ‘thereby creating a false appearance of activity ;

. and other transactions specifically designed to manipu-

late the price ofa. security. af

Congress directed this. remedial iegidlaGan. not to bring .

corporate fraud cases into,the federal court, but te protect

_ the tfading process and the securities maftket and to pro- |

tect the investing public from. frand.in-secu Curities. trading.
The Sécond Circuit wréte:

‘

-“The dominant congressional purposes underlying the. |

. Securities Exchange Act of 1934 were to promote free

» and open public securities -msrkets- ard to protect’
the’ investing public : from. suffering ‘inequities ‘in
trading ....” Securities and Exchange Coinmission v.
Texas’ Gulf ‘Sulphur Co., 401 F.2d 833,858 (2d Cir.
1968), cert. denied sub nom. Coates v. Securities and
Exchange Commission, 394 U.S. 976 en \-

. . P|

~ Furthermore, the Fifth Cireuit wrote even more recently:

“By section 10(b) Congress meant ‘to pueat manipu- |

lation and control of the prices at which securities are
botght and sold and to. enable buyers, sellers, and

. traders of securities to make a properappraisal ‘of
the value of securities.” Herpich, v. Wallace, 430 F.2d
792, 801 (5th Cir. 1970).

See Boone and McGowan, stoadety to Sue Under SEC —

Rule 10b-5, 49 Texas L. Rev. 617, 622 (1971).

The Securities Exchange Act of 1934 was, atter all, an
Act. “To provide for the regulation of securities exchanges

and: of over- -the-counter markets operating in interstate > *

oe . ?

t

_ and foreign commerce A through the mails, . to prevent. at
inequitable and unfair practices on such exchanges. and

- markets, and for other purposes”, 48 Stat. 881. 71934). See .

also S.Rep. No. 1455; 73d Cong., 2d Sess. (1934) ; $2, of +
the 1934 Act, 15 US. C. §78b.

The provisions of the 1934 Act itself’ also indicate that

there should be some restraint. In the first placé, the Act is _ 49 ee St. —

affairs. See, e.g., O'Neil v. Maytag, 339 F.24-7 764 (2d Cir.

1964), in which the court focused on whether full dis- .
closure had been accomplished with respect to. ‘the stock- .

_holdérs;. finding that such disclosure existed, the court

refused to hold that a question of corporate. mismanage-
inent was sufficient. to: bring the coyduet within the scope

of the Securities Exchange Acti ig

. Whether the policy analysis has been stated in terms of

the effect on investors or the securities markets, © as was.
done in this case and has been dohe i in other cases, see, €.g.,

' O'Neill v. . Maytag’. supra; Drachman v. Harvey, supra

Securities and, Exchange Commis Ssiom ‘v. Texas Gulf Sul-
phur Ce., supra, or has taken the form of i imposing limita-
tions’on standing, either with notions of “privity”, Joseph

v. Farnsworth Radio & Television Corp., 198. F.2d 883 -
~ (2d Cir. 1952), or with the purchaser -and seller. require-

ment, Birnbaum v. Newport Stéel Corp, supra, it’ has’.

_, been universally reeognized that Rule 10b-5 must be read

in light of the Congressional purpose sought to be achieved.

That purpose is not frustrated by the decisions below: in

. this case. - | . |

This Court’ and the courts. of appeal have been diligent

in effectuating the Congressional purpose in enacting the

Securities. Exchange Act, J: I.. Case v. Borak, 377 US.
426, 433. (1964) ; Fischman v. Raytheon Mfg. Co., supra.

However, the courts have also Tecognized that an over-
. broad interpretation of Rule 10b-5 will destroy its effective-
ness. | : é

r

e

_ “Considered alone, the sweeplng language-of Rule 10b-5 »

rae an almost’ ‘completely undefined liability .
ithout further delineation, .civil liability i is formless,

.

se .
>

> av

. : ° on; |:
_ and the area of iaceibed activity could “become: SO
Breat ‘that the beneficial aspects- of the rule would not

' ‘warrant proscription: " H i v. Wallace, mere, a
F.2d at 804.

Since the courts originated , the convept of implied cavil .

pewuy under the Exchange Act, it is for the courts to

“construct workable limits .to liability under seetion 10(b).

and’ Rule 10b-5' which will .accommodate. the interests of
investors, the business commiunity, and the public gen-
- erally. ” Herpich v. Wallace, supra, 430 F.2d at 805.

This is not. to imply that the creation by’ the lower courts .

_ of implied civil liability was incorregt. “The timd for that

argument has presumably long ‘since passed. It does clearly ~

indiéate, however, that: it is appropriate for the judiciary
to impose workabie linfitations. on the statute and its un-
pes rulé when they were clearly intended to be limited.
The « expansion of remedies under the Ach -was found neces-

sary to effectuate, the intent of Congre#ssfm enacting certain © °

‘provisions of the 1934 Act. Granted that the courts had

the duty to’ create new: remedies to effectuate the. legis-.

lative intent, the courts have the additional responsibility

‘to ensure that their creativity not be applied in situations

remote from that intent, thereby destroying Rule i as

a workable means of policing the securities market.

. D. The court of appeals here, responsive to the Congressional
purpose and consistent with all prior reported decisions

under the 1934 Act, emreets refused to find a federal

. Cause of action. : ;

Petitioner and the Commission are asking this Court to ~
extend the ‘scope of Section 10(b) into areas never before |

reached. The Commission seizes on the sale of Manhattan’ s

> -

at ¢

,°@

Qqw

6:

u

Treasury bonds'—a sale made on. the open market for a

full’ and adejiiate consideration—as support. for its con-
a tention thatthe ‘embezzlement «the proceeds is a federal
.- eause of action, although such embezzlement had no effect

on any security, the investment value of any security. or

any_ef the securities markets. Such conduct was not what
* Congress. had in mind; no other court has so extended the
_ Act; and, indeed, it is not a subject with which the Com- -

mission should even coneern itself.

The language :of Section 10(b) and the seemingly un-
limited language of Rule 10b-5 should not be read in a
vacuum. They must; be read with an understanding of the.
purpose for which they were created. All of the decisions
relied upon by the petitioner and the Commission properly
reflect, an appreciation of the basic Congressional purpose
to protect the securities markets and the investing public

_and find securities fraud only in that context. This is pre-

cisely the approaeh properly taken by the courts below. -

™No claim under Rule 10b-5 can be made with respect to the
certificate of deposit because that certificate was not a “security”

as defined in Section 3(a)(10) of the Securities-Exchange Act of

1934. Section 3(a)(10) defines “security” in general terms, but
specifically excludes “any note, draft, bill of exchange, or banker’s
acceptance which: has a maturity at the time of issuance of not
exceeding nine months * * * *” A eertificate of deposit for cash,
representing as it, does only a negotiable time note, draft, or
bill of exchange, is necessarily excluded from the definitign of
“security”. = : . :

The definition does mention -a “certificate of deposit, for a

_ security”, which is intended to refer to certificates which reflect

an interest in equity securities deposited witha bank. For example,
reorganization trustees have-on occasion deposited securities with a
bank, and issued participation certifitates ; similarly, certain. banks
have issued certificates reflecting an interest in securities held
abroad, in ‘bearer form, commonl¥ known as American De ositary
Receipts. Congress obviously intended to-include certificatesXwhich

. reflect an interest m securities within the definition of, “securities”
_ under the Securities Exchange Act. See Loss, Securities Regula-

tion, 460-65, 795-96 (2d ed. 1961 and 1969 supp.).

. +

15

- The first real attempt: at reconciling the Congressional
intent with the needs of investors, the business community,
and the public at large was the Second Circuit’s decision in
Birnbaum v. Newport Steel Corp., supra, There, the
defendant—president. of. Newport Steel Corporation sold
his, control stock at a premium to a second corporation .
interested in securing a captive supply. of steel during a
shortage. ‘The defendant had previously broken off nego-
tiations with a third corporation concerning a merger
which would have been beneficial to all the shareholders
of the: corporation. ‘Plaintiffs, suing derivatively and as

representatives of the other minority shareholders, alleged

a violation of fiduciary duty and also alleged fraud in con-
nection with certain letters sent out to the minority share-
‘holders by the corporation’s president during the merger
negotiations. The court adopted the analysis of Fischman
v. Raytheon M fg. Co., supra, and of SEC Release No. 3230,
_ dated May 21, 1942, that Rule 10b-5 was adopted solely to
close the loophole left by the absence of an equivalent of
§.17 of the Securities Act as a remedy for defrauded sellers
of securities. The Commission only intended to make the
. same prohibitions applicable to both buyers and sellers,
a purpose made clear by the similarity of the language
used. Aware of the ability of Congress when it so intends
to protect shareholders against breaches of fiduciary duty,
§ 16(b), 15- U:S.C. § 78p(b), the court reasoned: |

“The absence of a similar provision in Section 10(p)

Strengthens the conclusion that that section was di-

“rected solely. at 4hat type of misrepresentation or
fraudulent’ practice usually associated with “the sale
or purchase of securities rather than at fraudulent
mismanagement of corporate affairs, and that Rule
_X-10B-5 extended protection only to the achreuded
—_—? or seller. ” 193 F.2d at 464

ap

16

Ris purchaser-seller requirement, adopted -by every cir-
cuit whieh has considered it,’ has been liberally interpreted
by the courts to” accommodate .the novel forms of fraud
referred to,in A. 7. Brod & Co. y. Perlow, 375 F.2d 393
' (2d Cir. 1967). See also Crane Co. v. Westinghouse Air
Brake Co., 419 F.2d 787 (2d Cir. 1969), cert. denied, 400
U.S. 822 (1970). The Commission ¢ontends that this ex-
pansion has not been broad énough and that this require-
ment should now be abolished, but agrees with these
respondents that this case does not present a proper ve-
_hicle for review of that holding since Manhattan was a
seller of the Treasury bonds. (Br., at 7, n. 6)° The long

established purchaser-seller requirement. effectively carries’:

out the Congressional intent in limiting the scope of ‘the
rule to fraud in transactions affecting securities.

Th¢ Commission objects to the refusal of the courts

- below to consider the sale of securities and the fraud per-—

_* Iroquois Industries, Inc: v. Syracuse China Corp., 417 F.2d
963 (2d Cir. 1969), cert. denicd; 399 U.S. 909 (1970); Greenstein
v. Paul, 400 F.2d 580 (2d Cir. 1968); Herpich v. Wallace, 430
F.2d 792: (5th Cir. 1970); Mader v. Armel, 402 -F.2d 158 (6th
Cir. 1968), cert. denied sub nom. Young v. Mader, 394 U.S. 930
(1969) ; Dasho v. Stisqueharina Corp., 380 F.2d 262 (7th Cir.),
cert. denied sub nom. Bard v. Dasho, 389 U.S. 977 (1967); Greater
T@va Corp. v. McLendon, 378 F.2d 783 (8th Cir. 1967); and
Erling v. Powell, 429 F.2d 795 (8th Cir. 1970).

* Although the petitioner does not claim to be suing on behalf |

‘of ereditors or policy holders and does not even allege that there
are any, the Commission asserts that the petitioner here should
nevertheless be permitted to sue on behalf of “the creditors of
the company”. (Br., at 28) As pointed out im Point II below,
creditors have no standing to sue under the 1934 Act, and the
reasoning of the Second Circuit in Birnbaum v. Newport Steel
Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956° (1952),

and the other courts following it support the creditors’ lack of ©
standing. But since this is not a creditor’s case, Birnbaum is not

involved. | ;

17.

petrated as two parts of the same transaction. The lower |

courts realized that there had been a securities transaction
—the Government bonds had been sold.out. of Manhattan’s

portfolio, but at a price that was concededly fair. They |
- also realized that the assets of Manhattan had been mis-

appropriated. But the lower courts concluded correctly

tliat these were separate actions. The essence of the plan

was the misappropriation of the assets of the corporation.
The fact that the misappropriation involved the proceeds
of the sale of securities does not change the basic form
of the transaction. If the individual defendants removed
the bonds from Manhattan’s vault, sold them and absconded
with thegproceeds, there would have been no 10b-5 viola-

tion within the Congressional intent. The fact that they '

sold the securities first and. then converted the proceeds

should not change this result. “Rule 10b-5 was not intended.

to provide a remedy for schemes amounting to no more

than ‘fraudulent mismanagement .of corporate affairs’ _~

Superintendent of Insurance of the State of New Y¥ ork

v. Bankers Life and Casualty Co., (106a), quoting in part -
-Birnbaum v. Newport Steel Corp., supra at 464..—

The complaint here was not. dismissed because Man-
hattan was neither a purchaser nor a seller, nor was it

dismissed becatse Manhattan was not deceived. The: con-

clusion of the lower courts was that the deceit in no con-
ceivable way could affect the persons or the. markets or
the purposes intended to be protected or effectuated by the

Congress in passing Section 10(b) and SushOriaing Rule
10b-5.

“The trend sliesedis in n thia case in no way affected either
the securities market or the investing public. No stock-
holders were defrauded, no. investor injured. The

.. purity of the security transaction and the purity of

%

18

the trading -process were unsullied. There was no .
danger that the securities sold would be overvalued on
reaching the public markets.” (App. 107a)

If such fraud were ken to be within the scope of Rule

« 10b-5, then the Rule itself is outside the mandate of Con-

gress and is void.. “An examination of the cases since Birn-

baum reveals that the: courts fRve invoked a simple test

of whether the transaction involved comes within the scope

of Congressional intent. Crane Co. v. Westinghouse Air
Brake. Co., supra at 798.

Although actionable under state law, common law fraud
for all types of corporate mismanagement is not: proscribed
by federal securities laws, Iroquois Industries, Inc. v. Syra-
cuse China Corporation, 417 F.2d 963 (2d Cir. 1969), cert.
‘denied, 399 U.S. 909 (1970); Mutual Shares Cérporation
v. Genesco, Inc., 384 F.2d 540 (2d Cir. 1967). The question —

i presented here is to what extent the securities markets
must be involved to warrant application, of federal sane-
tions to a fraudulent practice. Actions under $10(b) and
Rule 10b-5 will not be sustained where “purchase or the
sale of securities . . . is only incidental to a major mis-
management issue,” Pettit v. American Stock Exchange,
supra. See Lester v. Preco Industries, Inc., 282 F. Supp.

459 (S,D.N.Y. 1965); Kaminsky v. Abrams, 281 F. Supp.

= 50 (S.D.N.Y. 1968). The issue in each case is whether

or not defendants’ alleged misconduct is. so closely ‘involved

with the securities. trading process that it falls within the

ambit of the 1934 Act, making federal jurisdiction appro-
upon the nature of the effect of the alleged misgonduct mpon

the securities market or inv estors.

In Hooper v. Mountain States Weenies Corporation, .
282 F.2d 195 (Sth Cir. 1960), cert. denied, 365 U.S. 814 |

tf ‘

‘ — tetera ie ase we wrebrecee:
RO EEES NEAREST LBS IEEE PY IN ER CAD ETRY Be Pax sect they Be orate

_ priate. Every decision: cited by the Commission focuses —s_

19 ; Ll >

(1961), a trustee in bankruptcy brought an.aetion under
-§10(b) and Rule 10b-5 on’ behalf of Consolidated Americas —
Industries, the bankrupt. The former secretary.and former |
general counsel of Consolidated had written fraudulent
letters to Consolidated’s transfér agent to decbive him
into believing that he could appropriately issue 700,000
shares of stock, valued on the market at about $1 per share.
In return for various rights valued at about $40,000, the
shares were issued to Mid-Atlantic Development Company,
_ a creature of the. conspirators that had already been dis--
solved. The shares wére ultimately distributed to the in-
dividual conspirators, and over 400,000 shares were sold i in
_ turn to unknowing investors on the iattot - of

. In finding a cause of action under Rule 10b-5, the court
- pointed out that the persons sought to be protected by the
Act were those engaged in buying and selling and trading .
in corporate securities. Moreover, the issuance of 400,000
and more shares of watered stock to public investors was.
precisely the kind of abuse that Congress sought to pro- .
scribe. Ruckle v. Roto, American Corporation, 339 F.2d
24, 28 (2d Cir. 1964). . .

In -A.T. Brod € Co. v. Perlow, supra at 393, plaintiff
broker recéived orders to buy certain securities from de- ;
. fendants. After observing that the securities had failed to
rise in value -by the settlement date, the defendants re-

fused to pay. The orders had been placed and the securi-
ties traded’ on, the New York Stock Exchange. In finding
a valid cause of action under the securities laws, the court

- emphasized the impact on the caine ——. noted ee

that the

“artificial demand created by purchasing. securities
which are not to pe paid =0r unless ine market value

20

~

of the stock rises, can- have an unsettling and poten-
tially manipulative effect upon the securities market
—contrary to the very purpose of the Act.” 375 F.2d
at 397. 3

In Schoenbaum’y. Firstbrook, 405 F.2d 215 (2d Cir. 1968),
cert. denied sub nom. Manley vy. Schoenbaum, 395 U.S. 906
(1969), the original three-judge panel, 405°¥.2d 260, found
that a corporation could bring a Rule 10b-5 action where
it had been deceived as to.investment* value. The entire
court, in agreament on that point, found that if the trans-
action involved eception of the minority shareholders by
diluting their shares through the. issuance of treasury stock

for less than fair value, a good cause of action had been |

stated. —

_ a

Gan Company v. Westinghouse Air Brake Company,
419 F.2d 787 (2d Cir.), cert. denied, 400 U.S. 822 (1970) .
presented a classic example of judicial willingness to apply;

Rule 10b-5 where the court found a dramatic effect on the

market. Crane sought to take over Air Brake, much to the

_ concern of Air Brake’s management and American Stand-.

_ ard, Crane’s chief competitor. Crane made a tender offer
for Air Brake’s shares, offering $50 in stock and deben-
_ tures up to a certain date. Around the same time, Standard
and Air Brake announced plans to merge, the plan being

to exchange Air Brake common stock for a new Standard ©

. preferred stock. Standard bought large quantities of Air
Brake common on the Exchange, including huge blocks
of shares on the last day of Crane’s tender offer. These
Standard purchases were made at increasingly higher

prices—up to $50 per share—during that: last day which ~

would give the impression to the average investor watching
the trading on the Exchange that the Air Brake shares

21

would be worth more than the $50 Crane was offering. “At
the same time, Standard sold large blocks of Air Brake .
stock privately off the Exchange at a substantial loss.
“Standard’s extraordinary buying here, coupled with its
large secret sales off the market, inevitably ‘distorted the
market .picture-and deceived public investors,” 419 F.2d
at 793..The Crane court found that “(T]he purpose of.--
Congress in enacting sections 9(a) (2). and_10{b) was to-.
protect the investing public\ from manipulation and de-
ception by the use of devices which defrauded or misled
‘investors im securities transactions” (emphasis added),
419 F.2d at 798,cand quoted with approval the thrust of
its earlier decision in Securities and Exchange Commission
| v2 exas Gulf Sulphur Co.; supra at 860:

“(The phrase ‘ ‘in connection with the parehese or sale
of any security’] intended only that the device em-
‘ployed ... . be of a sort that would cause reasonable:
inv eators to rely thereon, and, in connection. therewith,

so relying, cause them to purchase or sell a corpora-
tion’ S securities.”

See Kahan v. Rosenstiel, 424 F.2d 161 (3d Gir.), cert. denied
sub nom. Glen Alden Corp. v. Kahan, 398 U.S. 950 (1970) ;
Herpich v. Wallace, supra; Marino v. Coburn Corp., CCH
Fed. Sec. L. Rep. 92,959 (E.D.N.Y. February 19, 1971):
at p. 90,542.- . ,

Each of these decisions emphasizes that the evil Congress
sought to avoid was the deception of investors, typically
centering on the value of the security in question. The
Commission in its brief (at 21) criticizes the court of
appeals’ decision for finding no cause of action hecause
there was no deception as to investment value. ‘The Com-
mission points out that the opinion in A. 7. Brod & Co. v.
_Perlow, supra, decided that ‘Rule 10b-5 was not meant to

22

deal only with fraud. as to the investment value: of securi-
ties, citing Hooper v. Mountain States Securities Corpo-
ration, supra. This misses the point. In both A. T. Brod
. and II ooper, the plaintiff suffered a loss because the value
received: was les§ than the value given. In A. T. Brod, the
broker -did not receive the sales price of the securities —
ordered and he was forced’ to sell at a loss; in Hooper
stock worth $700,000 was’ exchanged for rights worth much
less. The court of appeals meant only that there was no .
claim that equal value was not received in the sale of
Manhattan’s Treasury bonds. Therefore, since there was
no harm at that point, no investor, e€. g., in Government
bonds, could have been injured. The court went on to find
that the harm occurred at a subsequent point—the misaép-
_ propriation of théproceeds. This act of mismanagement,
determined to be a separate dct with independent legal -
significance, does not give rise to a claim for securities
fraud, because it only involved a closed corporation and
had no effect, on the securities markets or investors. |

The heart of the Commission’s position seems to attack
the separation of the fraud from the securities transaction
by the courts below, yet this fraud would not come under the

federal securities laws even-if this were to be viewed aga . |

unified transaction. The only security in which there was
any public or private market—the Treasury bonds—traded
at a concededly fair price. The only possible detriment
caused by the entire transaction—ev en considered as a uni-—
“tary transaction—was an embezzlement loss suffered by.
Manhattan. Under the peculiar facts of this ease, not even
.. this loss is within the intent of Congress in passing the
“*1934 Act. There was no public market in the stock—the
shares were not traded on any regulated exchange or over-

ie

8 .. nn
, ° 2 : 7 »

.

the- eounter.. “There was not even a private. markets in the
stock—100% ownership “has always rested with a’ single
corporation. As the court of appeals put it, “the purity
of the security transaction and the purity of the. trading

process were unsullied. “ (107a) | coe Ff

Finally, the principal architect of the loss, to the corpora .

" tion was the sole owner of the corporation. Any loss real-.

ized by the dorporate shareholder was self-inflicted; the

_ only conceivable loss would be to the creditors of Man-

hattan, when it was later liquidated, but no. loss to creditors

is even alleged 1 in the complaint. and, in any event, that loss

would be peculiarly the concern of New York law, and

would be determined by New York courts.

In Schoenbaum v. Firstbrook, supra, there were minority
‘shareholders injured by such deception. But not even
Schoenbaum can be stretched to deal with the unique situa-
tion heye,. namely,.-that the sole shareholder being de-
frauded was also the alleged leader of the conspiracy.

Since the sole stockholder could not conceivably have
been deceived, the petitioner is left with the argument
that the insider who sold the bonds implied a promise not
to misappropriate them or their proceeds. An analogous
argument was presented to the Second Circuit in Mutual
Shares Corporation v. Genesco, Inc., 384 F.2d 540 (2d Cir.
1967) and rejected in part on the reasoning of the S.E. C. Ss \
amicus brief.‘ ‘

+“The contention that plaintiffs were injured by defendants’ —
failure to disclose their alleged intention, if they akould obtain
control of Kress, to misuse its assets and otherwise ‘to mismanage
' Kres8 presents a somewhat more difficult question. It seems to
us that plaintiffs’ position in this regard, insofar as Rule 10b-5
is concerned, comes down to the proposition that defendants must
be held to have impliedly represented, not only to Kress stocklield-
ers to whom their offers were addressed but to the world at large,

\ . :

; : ¢
: . ‘
. \
.
\
\ -

ND PLES MT EEE ET CII LI ETT ROE IELEORY TE SOLE DEORE AIS

. ;
,

— he 7
Finally, the Commission laine that “the failure of the
defendants to disclose, their intention to misappropriate
_ the proceeds from the ‘sale of Manhattan’s portfolio se-
curities and their misrepresentation that such Proceeds
avould be used to purchase a certificate of deposit for
+ ‘Manhattan in a like amount fer clearly material.” (Br.
at °21). But the Commission does not identify: to whom
defendants. should have disglosed “their tmtention to. mis-
- -appropriate*~ The purchasers were not interested; they
got full value for. their money. a the seller, must *
be charged with full kngwledge th

igh the participation
of the: sole ‘stockholder, ; > 3

« In any event, just as the “implied sepieseitation” theory
was properly rejected in Genesco, supra, because a con-
trary. result would ¢ mean that any instance of corporate -
mismanagement would be turned into a securities law claim,
so this analogous contention must be rejected here. The
- claim that Genesco_failed to announce that it intended to
divert the assets. of | Kress to its own pension fund is in-
distinguishable from the claim that the alleged conspira- 7
tors here failed to reveal that they would convert the
proceeds from the sale of the Treasury bonds.

. In the imstant case, there were no investors, no markets
‘and no information withheld from any shareholder of

that they would not mismanage Kress if they deatived control‘
and that plaintiffs relied upon'this implied representation when
they purchased Kress shares after defendants had obtained con-
trol, and that consequently there was fraud on plaintiffs in con-
nection with ‘plaintiffs’ purchases. We think this proposition. is .

' ‘too broad. It would:convert practically any instance of corporate
mismanagement into a Rule 10b-5 case, since any -shareholder
could contend that at the time when he purchased the shares
-he relied on an implied representation by management that they
would not mismanage.” (S.E.C. Brief, at-6)

&
-

s eo o é “ya, ?
v =. a

_ the corporation. In such circumstagees, imposing liability
under the federal securities laws would not effectuate.
Congressional intent or come within the legislative pur- _
pose. If the:alleged. conspirators had merely stolen money:
from the till of Manhattan there would be’exactly the same,
absence of effect on the non- dustries, Inc., supra; Kaminsky v. Abrams, supra; Barnett
,v. Anaconda Company, .238 F.Supp. 766,, 7 70 ( (S.D.N.Y.
1965); and Loss, Securities Regulation 3870 (1969 Supp. ye oe

_ The Fifth Circuit: recently stated:

“Tf Congressshad intended that the federal courts in-
quire into every decision affecting the management: of
corpofations and then fashion a new federal law su-
perseding state law on the fiduciary responsibilities of

’ corporate directors, officers, and controlling persons,

. presumably so revolutionary a federal intervention into
an area traditionally handled by the states wauld have
been clearly expressed.” ’ Herpich v. Wallace, supra,
430 ahaa at 809. | -

The same warning was sounded even more recently by
the Second Circuit, which ‘after all has dealt with most:.
of. the cases arising under Rulé10b-5, and which ine the -.
instant case denied rehearing ¢ mn bane:

-. “Byen giving § 10(b) and Rule 10b-5 the most liberal
construction, .

A. Suisnmsiiry™
Petitioner and the Commission have constructed their
legal theory around a claimed fraud on the Manhattan di-
rectors, ignoring the obvious fact that the directors ‘could
not possibly have any claim of their own and that any
claim of Manhattan would be barred by the actives par-
ticipation and approval of its sole stockholder.

At least the Commission ~ appreciates the predigament
faced by petitioner, and seeks to salvage the situation by
asserting that the petitioner must really be suing fer “in
jured creditors and policy-holders.” (Br., at 27) This of.
fort must also fail for two reasons: (1) Petitioner is not
even. purporting to sue for creditors (App. 4a), nor has
he alleged that there are any; and.(2) in any event,
creditors have no standing under the federal. securities
laws to sue directly for an-alleged fraudulent sale by
the corporation.

oa ; 27

B. Manhattan has no claim, nor does petitioner
as its liquidator.

The essence of fraud is, of course, misrepresentation
and deceit. Consequently Manhattan cannot be, injured by
any fraud when.its sole stockholder (Begole) was aware
of all the circumstances of the challenged sale and himself
ordered the sale. Old Dominion Copper Mining & Smelting
Company v. Lewisohn, 210 U.S. 206 (1908); Field v. Lew,
184 F. Supp. 23 (E.D.N.Y.), aff'd sub nom. Field v. Bankers
. Trust Company, 296 F.2d 109 (2d Cir. 1961), cert. denied,
369 U.S. 859 (1962). See Schoenbaum v. Firstbrook, supra,
405 F.2d at p. 220. To speak of fraud on directors in such
circumstances is unrealistic and reflects the straining by
petitioner to locate some nail, however precarious, on which

to hang his federal theory.

Petitioner, ‘as liquidator of Manhattan, stands in no
greater position. He alleges that he is “vested with title —
‘to all property, contracts and rights of action of Man-
hattan” (Complaint, par. 2; App. 4a) ; it must follow that he
is precluded from recovery by reason of the same defenses"
applicable to, an identical suit by Manhattan itself.

OA. ‘corporate officer who uses corporate fonds for
his own purposes may be liable for conversion to the
corporation. and in bankruptcy to the trustee. Since
the officer had no title to the property, transferees
of the officer ‘may be similarly liable. .However, the
general rule of liability does not apply when the of-
ficer’s acts have been ratified by all the shareholders
of the corporation. In that case, the unauthorized acts
of the individual become the authorized acts of the’
corporation, the corporation - loses its right of action
against the officer, and the corporation, having no
right, the trustee in bankruptcy also has no right. (cit-
ing authorities) Under the facts of the instant case,
the corporation would have no action in conversion

“2

28

against Lew, any of his transferees, or any one par-

ticipating in the transfer, because Lew as sole stock-.
_ holder ratified his own actions.” Field v. Lew, supra,
184 BF. Supp. at 27. .

A sole stockholder does not, of course, have unfettered ©
discretion in the management of his corporation. He may,
as the district court recognized, be held accountable in a
proper context in a state court for the “distribution of
an illegal dividend” or “fraudulent conveyanee,”~ (App.
84a) But in order to sustain a federal claim here, Man-
hattan must be shown to be a defrauded seller, which the
active participation of its owner precludes.

Petitioner, as he has done throughout the case, responds
to the above by silence. The Commission: obviously appre-
ciates the legal obstacle which makes this case atypical
and seeks to solve the problem by referring to “injured
creditors and policyholders.” (Br,, at 27) .

But who are these “injured creditors and policyhold-

-ers”? Petitioner does not purport to sue for them; he

has not even alleged that there are. any® or that Man-
hattan was even insolvent. He knows that such a claim
would expose the truly non-federal nature of his case.

Even if this were a-creditor’s. suit,-a creditor (or repre-
sentative on his behalf) properly has no standing to sue ©
under the 1934 Act. A creditor is neither a seller nor a -

5 A recent decision of the Fifth Circuit, Bailes v. Colonial Press,
Inc., Dkt. No. 29048, (Sth Cir. Jane 15, 1971), permitted. a bank-
ruptey trustee to sue on behalf of a corporation defrauded into a
stock sale by the corporation’s promoters, The court did not analyze
the standing question, legislative history or cite any authority for
the trustee’s right to sue. It ‘is, however, different from the present
case in that the corporation was banktupt and had innocent stock-

holders who had subsequently purchased the corporation’s stock.

=

29

purchaser of any security. Birnbaum v. Newport Steel
Corp., supra. He may have claims against the corporation,
its officers and directors and stockholders, but such claims

arise dut of state law (e.g., fraudulent conveyance, illegal
~ dividend, waste) and not “in connection with the purchase
or sale of any security”, 15 U.S.C. 78)(b).

The legislative history of the 1934 Act dee not even
suggest that creditors (or a representative on their be-
half ) have any standing to sue under any provision of the
Act; the Court should not now in construing Section 10(b) -
extend the implied civil liability created by the courts to.
claims of creditors. There is no need to do so; state law
is fully adequate. _

CONCLUSION

The judgment of the court of appeals should be af-
firmed. | ; |
- Respectfully submitted,

Wuium E. Wuus, .
. - Counsel for Respondents _
a Belgian-American Banking Cor-
poration and Belgian-American
Bauk & Trust Company,
. .48 Wall Street,
New York, New York 10005.

MicHaEL M. Maney,

Bruce E. Crark,

Suuiivan & CroMWELL,
Of Counsel.

August 31, 1971

_ poten

EIN THE

Pa

| Supreme Court of the Yuited Stites

October Term, 1970
_ ‘No. 1159 |

“6 .%

SUPERINTENDENT-OF INSURANCE OF THE STATE OF NEW YORK,

as mapa of PERN EATER CASUALTY COMPANY, ,
- Petitioner;
net

BANKERS LIFE AND CASUALTY COMPANY, ravine! TRUST
_COMBANY, BELGIAN AMERICAN BANKING CORPO TION,
«BELGIAN AMERICAN BANK & TRUST COMPANY, GARVIN,

BANTEL & CoMPANY, GEORGE K. GARVIN, ©

ON WRIT OF CERTIORARI TO THE UNITED STATES
COURT OF APPEALS FOR THE SECOND CIRCUIT.

La

c-

BRIEF FOR RESPONDENTS GARVIN, BANTEL & COMPANY
. ae GER GE aniN +

PRELIMINARY STATEMENT oe

’ The beclicnttaty statements set forth in the btiefs saksaicted by
respondents Belgian-American Banking Corporation and Belgian-

. American Bank and Trust Company and Irving Trust Company

are hereby adopted by respondents Garvin, Bantel & Company and
George K. Garvin.

QUESTIONS PRESENTED

The questions presented ag set forth in the briefs of Belgian-
American and Irving Trust are hereby adopted by a

Garvin, Bantel and Garvin.

©» STATEMENT OF THE ‘CASE

. For the purpose of this appeal, the statements of the Case set
forth in the briefs of Belgian-American and Irving Trust are

=

e. - Rares

a ‘ : - - ¢

acceptable to. eeipcients Garvin, Bantel - — Garvin and are
hereby adopted. | o- | |

Whether the securities in question were used by the defendants
. to repay Irving Trust for its five million dollar loan to " purchase
_ ~Manhattan Casualty, or whether the’ securities were used to create
a certificate of deposit for five million dollars, which certificate /
was then pledged for a loan of five million dollars, makes no’
difference with respect to the critical issue presented by this ws

tJ
>

Under either interpretation®, ‘Manhattan Casualty’ S assets wefe
converted and the question is whether that conversion constitutes

a fraud in ‘connection with a securities transaction. We submit -

that it # n0e « wt Pa '

Siapenieae Irving Trust suggests in its brief that the. wrongdoing might have ~

occurred one. year after the: sale of Manhattan Casualty. This interpretation does

_ ~~ got alter the main issue of this case as to whether the fraud was in. connection with
we a sequrities transaction which violated the Securities Acts.

a

"ARGUMENT ..

I.

THE: ARGUMENTS SET FORTH IN THE BRIEFS
OF RESPONDENTS BELGIAN-AMERICAN AND
IRVING TRUST ARE HEREBY ADOPTED BY
RESPONDEN GARVIN, BANTEL & GARVIN.

. . 7 II

THE CONVERSION OF ‘MANHATTAN CASUAL: \_
-TY’S ASSETS DID NOT CONSTITUTE,A FRAUD |
‘UNDER THE SECURITIES EXCHANG® ACT OF

1934.. 3

The notion Sverebeed by petitioner and the Securities and Ex-.
change Commission that tortious activity which involves securities °

_ in any way is the’ basis’ of a cognizable federal claim is simply
incorrect. The Securities Acts:were not intended as a cure-all for
every type of corporate wrongdoing; rather, their provisions relate
only to transactions which may adversely affect investors and the
integrity of the public securities ‘market. For a particular trans-
-action to be the basis.for an action under the Securities Acts, it
mfust be alleged that there was deception, that the deception re-.
sulted in a wrong to the detriment of a person protected by the

t

P ° : vr .
+ ‘ a
‘

- Securities Acts, and that there was a causal relationship between
the securities transaction and the wrong. In their attempt to. estab-
lish the necessary link between the sale of Manhattan’s bonds |
and the wrong, petitioner and the Commission rely on the
allegation that the board of directors of Manhattan was deceived
because it was not informed that the proceeds of the bonds would
_ be used to repay Irving Trust for its loan to Begele. Although -.
_ this argument may ‘have merit logically, it is not consistént with
the facts alleged by the petitioner himself. Immediately after
. Begole became the sole stockholder of Manhattan Casualty, he
alone appointed all the members of the board of directors. (App.,
p. 128a) Manhattah’s board was’ not an independent decision- :
making body as contemplated by standard corporate. law and
procedure; it was a fubber stamp for Begole and acted at his
pleasure. Therefore, ‘the deception, if any, perpetrated upon the
board of directors had no Practical effect.

It cannot be secicualy argued that if Begole and Sweeny ‘had

simply stolen the bonds from Manhattan, sold them and kept the.
proceeds for themselves, there would be a federal claim under
the Securities Acts. This in effect is what happened and: the em- —
ployment of the vote by.an impotent board‘of directors does not
change the reality. If Begole had informed the board that the
proceeds of the bonds were to. be used to purchase Manhattan
and if one or more directors had objected, Begole could have
easily and. promptly removed the dissenters and replaced them
with more agreeable persons. The board of directors of Manhattan
Casualty was acting directly for and taking orders from Begole,
who:is the only person in this case covered by the provisions of
the Securities Aéts. Since defendant Begole cannot challenge the
sale of the bonds, neither can petitioner who stands in his shoes.

The Commission attempts to overcome this deficiency i in peti-
tioner’s claim by arguing that petitioner ‘is prosecuting on behalf
of Manhattan’s creditors.and policyholders. If there are such in-—
jured persons, they have more thah adequate remedies in the
’ New York State courts. It’ is doubtful, however, that there are
such claims in existence, since it is public record that Manhattan’s
policyholders were fully reinsured shortly after it went into liqui-
dation. Furthermote, the record herein does not reveal any claims

_or lawsuits by Manhattan’s creditors. In any event, the inclusion
' of creditors and policyholders in the- category of those persons |
permitted to sue under the Securities Acts isja matter for Con-

é

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386413_0318%3A08. Public record. Not legal advice.