Capital Management Select Fund Ltd. v. Bennett , 670 F.3d 194 ( 2012 )

08-6166-cv(L)
Capital Management Select Fund Ltd., et al. v. Bennett et al.
1 UNITED STATES COURT OF APPEALS
2 FOR THE SECOND CIRCUIT
3 August Term, 2009
4
5 (Argued: October 19, 2009 Decided: January 10, 2012)
6 Docket Nos. 08-6166-cv(L) 08-6167-cv (Con) 08-6230-cv (Con)
7 - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
8 CAPITAL MANAGEMENT SELECT FUND LTD., INVESTMENT & DEVELOPMENT
9 FINANCE CORPORATION, IDC FINANCIAL S.A., GLOBAL MANAGEMENT
10 WORLDWIDE LIMITED, individually and on behalf of all others
11 similarly situated, ARBAT EQUITY ARBITRAGE FUND LIMITED,
12 RUSSIAN INVESTORS SECURITIES LIMITED, VR GLOBAL PARTNERS, L.P.,
13 PATON HOLDINGS, LTD., VR CAPITAL GROUP LTD., and VR ARGENTINA
14 RECOVERY FUND LTD.,
15
16 Plaintiffs-Appellants,
17 v.
18 PHILLIP R. BENNETT, PHILIP SILVERMAN, ROBERT C. TROSTEN,
19 RICHARD N. OUTRIDGE, SANTO C. MAGGIO, LEO R. BREITMAN, GRANT
20 THORNTON LLP, TONE N. GRANT, and REFCO GROUP HOLDINGS, INC.,
21
22 Defendants-Appellees,
23 JOSEPH J. MURPHY, RONALD O’KELLEY, NATHAN GANTCHER, DENNIS A.
24 KLEJNA, PERRY ROTKOWITZ, CREDIT SUISSE GROUP, CREDIT SUISSE
25 FIRST BOSTON, GOLDMAN SACHS GROUP, INC., GOLDMAN SACHS & CO.,
26 BANK OF AMERICA SECURITIES, LLC, BANK OF AMERICA CORP, MERRILL
27 LYNCH & CO, MERRILL LYNCH PIERCE, FENNER & SMITH INCORPORATED,
28 JP MORGAN CHASE & CO, JP MORGAN SECURITIES, INC., SANDLER
29 O’NEIL & PARTNERS, L.P., HSBC HOLDINGS, PLC, HSBC SECURITIES
30 {USA} INC., WILLIAM BLAIR & COMPANY, LLC, HARRIS NESBITT CORP.,
31 CMG INSTITUTIONAL TRADING, LLC, SAMUEL A. RAMIREZ & CO., INC.,
32 THE WILLIAMS CAPITAL GROUP, L.P., UTENDAHL CAPITAL PARTNERS,
33 L.P., REFCO SECURITIES, LLC, THL ENTITIES,
34
35 Defendants,
1
1 BANK FUR ARBEIT UND WIRTSCHAFT UND OSTERREICHISCHE POSTPARKASSE
2 AKTIENGESELLSEHAFT, GERALD M. SHERER, WILLIAM M. SEXTON, THOMAS
3 H. LEE PARTNERS, LP, THOMAS H. LEE ADVISORS, LLC, THL MANAGERS
4 V, L.L.C., THL EQUITY ADVISORS V, LLP, THOMAS H. LEE EQUITY
5 FUND V, L.P., THOMAS H. LEE PARALLEL FUND V, LP, THOMAS H. LEE
6 EQUITY (CAYMAN) FUND V, LP, THOMAS H. LEE INVESTORS LIMITED
7 PARTNERSHIP, 1997 THOMAS H. LEE NOMINEE TRUST, THOMAS H. LEE,
8 DAVID V. HARKINS, SCOTT L. JAECKEL, SCOTT A. SCHOEN,
9
10 Consolidated-Defendants.
11 - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
12 B e f o r e: WINTER and POOLER, Circuit Judges.*
13 Appeal from an order entered by the United States District
14 Court for the Southern District of New York (Gerard E. Lynch,
15 Judge), dismissing plaintiffs’ claims under Section 10(b) for
16 failure to plead deceptive conduct. We affirm.
17 SCOTT A. EDELMAN (Sander Bak &
18 Michael Shepherd, on the brief),
19 Milbank, Tweed, Hadley & McCloy
20 LLP, New York, New York, for
21 Plaintiffs-Appellants; Co-Lead
22 Counsel for Lead Plaintiffs and
23 the Putative Class.
24
25 Richard L. Stone (Mark A.
26 Strauss, on the brief), Kirby
27 McInerney & Squire LLP, New York,
28 New York, for Plaintiffs-
29 Appellants; Co-Lead Counsel for
30 Lead Plaintiffs and the Putative
31 Class.
32
33 Claire P. Gutekunst, Jessica
34 Mastrogiovanni, and Jed Friedman,
*
This panel originally included the Honorable Jed S. Rakoff,
United States District Judge for the Southern District of New
York, sitting by designation; however, Judge Rakoff has recused
himself. Therefore, this case is decided by the remaining judges
in accordance with Second Circuit Internal Operating Procedure
E(b).
2
1 Proskauer Rose, LLP, New York,
2 New York, for Defendant-Appellee
3 Richard N. Outridge.
4
5 Barbara Moses, Judith L. Mogul,
6 and Rachel Korenblat, Morvillo,
7 Abramowitz, Grand, Iason, Anello
8 & Bohrer, P.C., New York, New
9 York, for Defendant-Appellee
10 Robert C. Trosten.
11
12 Stuart I. Friedman, Ivan Kline,
13 and Jonathan Daugherty, Friedman
14 & Wittenstein P.C., New York, New
15 York, for Defendant-Appellee
16 William M. Sexton.
17
18 LINDA T. COBERLY and Bruce R.
19 Braun, Winston & Strawn LLP,
20 Chicago, Illinois, for Defendant-
21 Appellee Grant Thornton LLP.
22
23 Laura E. Neish, Zuckerman Spaeder
24 LLP, New York, New York, for
25 Defendant-Appellee Tone N. Grant.
26
27 David V. Kirby, Krantz & Berman,
28 LLP, New York, New York, for
29 Defendant-Appellee Philip
30 Silverman.
31
32 Susan S. McDonald, Jacob H.
33 Stillman, Mark D. Cahn, and David
34 M. Becker, Securities and
35 Exchange Commission, Washington,
36 D.C., for Amicus Curiae Securites
37 and Exchange Commission.
38
39 RICHARD A. ROSEN (Walter Rieman,
40 Paul, Weiss, Rifkind, Wharton &
41 Garrison LLP, New York, New York;
42 Greg A. Danilow, on the brief,
43 Weil Gotshal & Manges LLP, New
44 York, New York, Paul, Weiss,
45 Rifkind, Wharton & Garrison LLP,
46 New York, New York, for
47 Defendants THL Partners.
48
3
1 WINTER, Circuit Judge:
2 Former customers (“RCM Customers”) of Refco Capital
3 Markets, Ltd. (“RCM”), a subsidiary of the now-bankrupt Refco,
4 Inc., appeal from Judge Lynch’s dismissal of their Section
5 10(b) securities fraud claims against former corporate officers
6 of Refco and Refco’s former auditor, Grant Thornton LLP.1
7 Appellants claim that appellees breached the agreements with
8 the RCM Customers when they rehypothecated or otherwise used
9 securities and other property held in customer brokerage
10 accounts.
11 The district court dismissed the claims for lack of
12 standing and failure to allege deceptive conduct, see In re
13 Refco Capital Mkts., Ltd. Brokerage Customer Sec. Litig., No.
14 06 Civ. 643, 2007 WL 2694469 (S.D.N.Y. Sept. 13, 2007) (“RCM
15 I”); In re Refco Capital Mkts., Ltd. Brokerage Customer Sec.
16 Litig., 586 F. Supp. 2d 172 (S.D.N.Y. 2008) (“RCM II”); In re
17 Refco Capital Mkts., Ltd. Brokerage Customer Sec. Litig., Nos.
18 06 Civ. 643, 07 Civ. 8686, 07 Civ. 8688, 2008 WL 496298519 (S.D.N.Y. Nov. 20, 2008) (“RCM III”) (on a motion for
20 reconsideration).
21 We hold that appellants have no remedy under the
22 securities laws because, even assuming they have standing, they
23 fail to make sufficient allegations that their agreements with
1
A group of defendants associated with Thomas H. Lee Partners, L.P., a
private equity firm that at relevant times held a majority interest in Refco
(the “THL Defendants”) were also appellees; however, the appeal against those
parties is hereby dismissed pursuant to a joint stipulation.
4
1 RCM misled them or that RCM did not intend to comply with those
2 agreements at the time of contracting. We therefore affirm.
3 BACKGROUND
4 On an appeal from a grant of a motion to dismiss, we
5 review de novo the decision of the district court. See Staehr
6 v. Hartford Fin. Servs. Group, 547 F.3d 406, 424 (2d Cir.
7 2008). We construe the complaint liberally, accepting all
8 factual allegations in the complaint as true, and drawing all
9 reasonable inferences in the plaintiff’s favor. Chambers v.
10 Time Warner, Inc., 282 F.3d 147, 152 (2d Cir. 2002). “To
11 survive a motion to dismiss, however, a complaint must allege a
12 plausible set of facts sufficient to raise a right to relief
13 above the speculative level.” S.E.C. v. Gabelli, 653 F.3d 49,
14 57 (2d Cir. 2011).
15 a) The Parties and Their Businesses
16 Capital Management Select Fund Limited and other named
17 appellants2 are investment companies, which, along with members
2
This appeal arises from three separate actions that were consolidated
at the pretrial phase: RCM I, 2007 WL 2694469 (S.D.N.Y. Sept. 13, 2007) (the
“Class Action”); VR Global Partners, L.P. et al. v. Bennett et al., No. 07
Civ. 8686, 2007 WL 4827764 (S.D.N.Y. filed Oct. 9, 2007) (the “VR Action”; and
Capital Management Select Fund Ltd. v. Bennett, No. 07 Civ. 8688, 2007 WL
4837768 (S.D.N.Y. filed Oct. 9, 2007) (the “Capital Management Action”). Lead
plaintiffs in the original Class Action are Global Management Worldwide Ltd.,
Arbat Equity Arbitrage Fund Ltd., and Russian Investors Securities Ltd. All
three lead plaintiffs in the Class Action are commonly controlled investment
funds. Plaintiffs in the VR Action are VR Global Partners, L.P., Paton
Holdings Ltd., VR Capital Group Ltd., and VR Argentina Recovery Fund, Ltd.
(collectively “VR Plaintiffs”). In their complaint, VR Plaintiffs describe
themselves as “private investment funds,” each of which operates as either a
limited liability partnership or limited liability company registered in Grand
Cayman. Plaintiffs in the Capital Management Action are Capital Management
Select Fund Ltd., Investment & Development Finance Corporation, and IDC
Financial S.A. Capital Management is an investment company incorporated under
5
1 of the putative class, held assets in securities brokerage
2 accounts with RCM. RCM is one of three principal operating
3 subsidiaries of the now-bankrupt Refco, a publicly traded
4 holding company that, through its operating subsidiaries,
5 provided trading, prime brokerage, and other exchange services
6 to traders and investors in the fixed income and foreign
7 exchange markets. Appellees are various former officers and
8 directors of Refco and/or its affiliates (the “Refco Officer
9 Defendants”), and Refco’s former auditor, Grant Thornton, LLP.
10 RCM operated as a securities and foreign exchange broker
11 that traded in over-the-counter derivatives and other financial
12 products on behalf of its clients. Although RCM was organized
13 under the laws of Bermuda and represented itself as a Bermuda
14 corporation, it operated from New York at all relevant times.
15 These operations were under the leadership of, and through a
16 sales force of account officers and brokers employed by, its
17 affiliated corporation, Refco Securities, LLC, (“RSL”), a
18 wholly-owned subsidiary of Refco that operated as a U.S.-based
19 broker-dealer registered with the SEC.
20 b) Brokerage Account Customer Agreements
21 RCM Customers held securities and other assets in non-
22 discretionary securities brokerage accounts with RCM pursuant
the laws of the Bahamas. Investment & Development Finance is an investment
company incorporated under the laws of the British Virgin Islands. IDC
Financial is an investment company incorporated under the laws of Panama.
6
1 to a standard form “Securities Account Customer Agreement” with
2 RCM and RSL (the “Customer Agreement”). RCM Customers’
3 securities and other property deposited in their accounts were
4 not segregated but were commingled in a fungible pool. As a
5 result, no particular security or securities could be
6 identified as being held for any particular customer. Such a
7 practice is common in the brokerage industry. See Levitin v.
8 PaineWebber, Inc., 159 F.3d 698, 701 (2d Cir. 1998) (“Customer
9 accounts with brokers are generally not segregated, e.g. in
10 trust accounts. Rather, they are part of the general cash
11 reserves of the broker.”); U.C.C. § 8-503 cmt. 1 (“[S]ecurities
12 intermediaries generally do not segregate securities in such
13 fashion that one could identify particular securities as the
14 ones held for customers.”); Adoption of Rule 15c3-2 Under the
15 Securities Exchange Act of 1934, Exchange Act Release No. 34-
16 7325, 1964 WL 68010, *1 (1964) (“[W]hen [customers of broker-
17 dealers] leave free credit balances with a broker-dealer the
18 funds generally are not segregated and held for the customer,
19 but are commingled with other assets of the broker-dealer and
20 used in the operation of the business.”).
21 The Customer Agreement included a margin provision that
22 permitted RCM Customers to finance their investment
23 transactions by posting securities and other acceptable
24 property held in their accounts as collateral for margin loans
25 extended by RCM. Under the margin provision, RCM, upon
7
1 extending a margin loan to a customer, had the right to use or
2 “rehypothecate”3 the customer’s account securities and other
3 property for RCM’s own financing purposes. For example, RCM
4 might pledge customers’ securities as collateral for its own
5 bank loans or sell the securities pursuant to repurchase
6 agreements (“repos”).4 The parties dispute whether the
7 rehypothecation rights were limited to securities serving as
8 collateral or whether they also included securities that were
9 excess collateral. We discuss this dispute, infra.
10 We briefly provide a generic background. From an ex ante
11 perspective, such margin provisions provide distinct, but
12 related, economic benefits to both the brokerage and its
13 customers. For the customers, the margin provision provides
14 the ability to invest on a leveraged basis and thereby earn
15 amplified returns on their investment capital. As for the
16 brokerage, the ability to rehypothecate its customers’
17 securities presents, among other things, an additional and
18 inexpensive source of secured financing. See Michelle Price,
3
Rehypothecation technically refers to a broker’s re-pledging of
securities held in its customer’s margin account as collateral for a bank
loan. Similarly, a broker may sell the securities through a repurchase
agreement, which is functionally equivalent to a secured loan. See infra Note
4. Hereinafter we will refer to rehypothecation in the general sense -- i.e.,
a broker’s use and/or pledging of its customer’s margin account securities to
obtain financing for its own transactions.
4
A repurchase agreement is an agreement involving the simultaneous sale
and future repurchase of an asset. In a typical repurchase agreement, the
original seller buys back the asset at the same price at which he sold it,
with the original seller paying the original buyer interest on the implicit
loan created by the transaction. See In re Comark, 124 B.R. 806, 809 n.4
(Bankr. C.D. Cal. 1991).
8
1 Picking over the Lehman Carcass - Asset Recovery, Banker, Dec.
2 1, 2008, available at 2008 WLNR 24064913 (“[Without
3 rehypothecation rights] the prime broker would have to use its
4 unsecured credit facilities, the cost of which is currently in
5 the region of 225 to 300 basis points above that of secured
6 credit.”).
7 While these types of margin provisions provide economic
8 benefits to both parties, like any creditor-debtor arrangement
9 they also create counterparty risks. The brokerage bears the
10 risk that its customers default on margin loans that could
11 become under-secured due, for example, to a precipitous decline
12 in the value of the posted collateral. Likewise, of course,
13 the customers face the possibility that the brokerage, having
14 rehypothecated its customers’ securities, fails, making it
15 unable to return customer securities after those customers meet
16 their margin debt obligations.
17 Counterparty risks associated with margin financing have
18 long been recognized by industry participants and regulators
19 alike. In the United States, for example, margin financing has
9
1 been subject to federal5 and state6 regulation, and, even
2 longer still, to self-imposed limitations by brokers and self-
3 regulating organizations.7 In general, margin restrictions
4 attempt to reduce the counterparty risk associated with margin
5 financing by limiting the types of securities that can be
6 posted by an investor as collateral for a margin loan and
7 limiting the amounts that can be borrowed against that
8 collateral.8
9 Similarly, at least in the United States, brokers’
10 rehypothecation activities have long been restricted by
11 federal9 and state law,10 and by rules promulgated by the
5
Federal regulation of margin financing for securities purchases was
introduced in the 1913 Federal Reserve Act. See Board of Governors of the
Federal Reserve System, A Review and Evaluation of Federal Margin Regulations
45 (1984). After the 1929 stock market crash, Congress imposed sweeping
regulation of margin financing under the Exchange Act, 15 U.S.C. §§ 78a to
78hh-1. Statutory authority for regulating margin financing was granted under
Section 7 of the Act. See id. § 78g.
6
State regulation of margin financing generally arises under Article 8
of the Uniform Commercial Code.
7
The New York Stock Exchange (“NYSE”) first established margin
restrictions for exchange members in 1913 when it required its members to
impose margin levels that were “proper and adequate.” See Board of Governors
of the Federal Reserve System, supra, at 45. The NYSE currently restricts
customer margin levels under NYSE Rule 431 which, inter alia, limits the
amount of credit that can be used by a customer to purchase securities. See
NYSE Rule 431, available at 2003 WL 25658590.
8
See, e.g., Federal Reserve Board Regulation T, 12 C.F.R. § 200.1 et
seq. (imposing initial and maintenance margin requirements on investors
purchasing securities on margin); see also Federal Reserve Board Regulation U,
12 C.F.R. § 221.1 et seq. (similar margin restrictions applicable to banks and
other lenders); Federal Reserve Board Regulation X, 12 C.F.R. § 224.1 et seq.,
(similar margin restrictions applicable to margin loans not explicitly covered
by other regulations).
9
The SEC first restricted brokers’ rehypothecation rights with the
adoption of Rule 8c-1, 17 C.F.R. § 240.8c-1, and Rule 15c2-1, 17 C.F.R. §
240.15c2-1, in 1940. In general, these rules prohibit the following
10
1 principal stock exchanges.11 These restrictions generally
2 limit a broker’s ability to commingle its customers’ securities
3 without their consent, and limit a broker’s rehypothecation
4 rights with respect to a customer’s “excess margin securities”
5 i.e., securities not deemed collateral to secure a customer’s
6 outstanding margin debt, and “fully-paid securities, ” i.e.,
7 securities in a cash account for which full payment has been
8 made.12
9 The upshot of these restrictions is that in the United
10 States, brokers and investors alike are limited in the amount
11 of leverage that is available to amplify returns. However,
12 since the development of globalized capital and credit markets,
13 investors have sought to avoid these limitations by seeking
14 unrestricted margin financing through, among other sources,
15 unregulated offshore entities. See, e.g., Metro-Goldwyn-Mayer,
16 Inc. v. Transamerica Corp., 303 F. Supp. 1354 (S.D.N.Y. 1969)
activities without first obtaining consent from the customer: (i) commingling
of the securities of different customers as collateral for a loan; (ii)
commingling a customer’s securities with its own under the same pledge; and
(iii) pledging a customer’s securities for more than the customer owes. See
Statement of Commission Issued in Connection with the Adoption of Rules X-8C-1
and X-15-C2-1, Exchange Act Release No. 2690, 1940 WL 974 (1940).
10
See Report of Special Study of Securities Markets of the Securities
and Exchange Commission, H.R. Doc. No. 88-95, pt. 1, at 406 (1963) (listing
statutory hypothecation restrictions under the laws of Iowa, Michigan,
Nebraska, and New York).
11
Id. at 405-07 (listing rehypothecation restriction rules of the
various exchanges).
12
See, e.g., SEC Rule 15c3-3 (prohibiting a broker from rehypothecating
an amount of customer’s collateral in excess of 140 percent of the customer’s
outstanding margin debt), 17 C.F.R. § 240.15c3-3.
11
1 (leveraged buyout of Metro-Goldwyn-Mayer financed through the
2 Eurodollar market, thus avoiding U.S. margin restrictions);
3 Martin Lipton, Some Recent Innovations to Avoid the Margin
4 Regulations, 46 N.Y.U. L. Rev. 1 (1971). In recent years,
5 U.S.-based broker-dealers have satisfied investor demand for
6 unrestricted margin financing by providing financing to
7 institutional investors, -- e.g., hedge funds -- through, inter
8 alia, unregulated foreign affiliates that are not subject to
9 U.S. margin or rehypothecation restrictions. See Noah Melnick
10 et al., Prime Broker Insolvency Risk, Hedge Fund J., Nov. 2008
11 (“US prime brokers commonly rely on [foreign] unregulated
12 affiliates for margin lending or securities lending and/or to
13 act as custodians in non-US jurisdictions.”); Sherri Venokur &
14 Richard Bernstein, Protecting Collateral against Bank
15 Insolvency Risk--Part I, Sept. 8, 2008, at 1 (“U.S. registered
16 broker-dealers enter into derivatives transactions through
17 their unregulated affiliates in order to reduce capital reserve
18 requirements but also to be able to use counterparty
19 collateral.”); Roel C. Campos, SEC Comm’r, Remarks before the
20 SIA Hedge Funds & Alternative Investments Conference (June 14,
21 2006) (noting that certain hedge fund financing is generally
22 booked through foreign, unregulated affiliates).
23 In the instant case, RCM held itself out as, and the
24 record indicates that at least some of the RCM Customers
25 understood it to be, an unregulated offshore broker.
12
1 c) The Lawsuit
2 The event giving rise to this action is the collapse of
3 Refco, RCM’s now-bankrupt parent corporation. On October 20,
4 2005, a little more than two months after issuing an initial
5 public offering of its stock, Refco announced a previously
6 undisclosed $430 million uncollectible receivable and disavowed
7 its financial statements for the previous three years. The
8 uncollectible receivable stemmed, in part, from losses suffered
9 by Refco and several of its account holders during the late
10 1990s. Rather than disclose its losses to the public and its
11 investors at that time, Refco’s management devised and
12 implemented a “round robin” loan scheme to conceal the losses.
13 The first part of this scheme involved Refco transferring its
14 uncollectible receivables to the books of Refco Group Holdings,
15 Inc. (“RGHI”), an entity owned and controlled by appellee-
16 defendant Phillip R. Bennett, Refco’s then-President, CEO, and
17 Chairman. Then, in order to mask the magnitude and related-
18 party nature of the RGHI receivable, a Refco entity (alleged by
19 plaintiffs typically to be RCM) would extend loans to multiple
20 unrelated third parties that would in turn lend the funds to
21 RGHI to pay down the uncollectible receivables. In this
22 manner, Refco effectively eliminated the uncollectible related-
23 party receivable from its books just prior to each relevant
24 financial period but would unwind the loans shortly thereafter.
25 The transactions allegedly took place over the course of six
13
1 years, between 1998 and 2004, and were never disclosed in
2 Refco’s public securities filings. By 2004, the RGHI
3 receivable had grown to an amount alleged to be in excess of $1
4 billion.
5 Prior to Refco’s 2005 disclosure, beginning in late 2003,
6 THL, a private equity investment fund that focuses on the
7 acquisition of equity stakes in mid-to-large capitalization
8 companies, began exploring investment opportunities in Refco,
9 and ultimately completed a leveraged buyout in August 2004.
10 Following Refco’s disclosure of its $430 million
11 uncollectible receivable, customers holding accounts with RCM,
12 including appellants, attempted to withdraw their assets from
13 RCM. This began the proverbial “run on the bank,” and, on
14 October 13, 2005, Refco announced a unilateral 15-day
15 moratorium on all RCM trading activities. On October 17, 2005,
16 Refco, along with RCM and several other Refco affiliates, filed
17 for Chapter 11 bankruptcy protection in the Southern District
18 of New York. In a December 30, 2005 bankruptcy filing, RCM
19 disclosed that it owed its customers approximately $4.16
20 billion, while holding only $1.905 billion in assets.
21 Along with a host of other plaintiffs who brought actions
22 in the wake of Refco’s collapse,13 on January 26, 2006,
13
See Am. Fin. Int’l Group-Asia, L.L.C. v. Bennett, No. 05 Civ. 8988,
2007 WL 1732427 (S.D.N.Y. June 14, 2007); In re Refco, Inc. Sec. Litig., 503
F. Supp. 2d 611 (S.D.N.Y. 2007); Thomas H. Lee Equity Fund V, L.P. v. Bennett,
No. 05 Civ. 9608, 2007 WL 950133 (S.D.N.Y. Mar. 28, 2007); In re Refco, Inc.,
14
1 plaintiff-appellant Global Management Worldwide Limited, an
2 investment fund organized under the laws of Bermuda, filed a
3 putative class action on behalf of all brokerage customers of
4 RCM who held securities with RCM and/or RSL between October 17,
5 2000 and October 17, 2005. On September 5, 2006, Global
6 Management Worldwide filed a Consolidated Amended Class Action
7 Complaint, in which Arbat Equity Arbitrage Fund Limited and
8 Russian Investors Securities Limited, both “commonly controlled
9 investment funds,” were added as Co-Lead Plaintiffs of the
10 putative class. The amended complaint named appellees as
11 defendants. The complaint alleges that Refco’s corporate
12 officers caused RCM to improperly sell or lend securities and
13 other assets from RCM Customers’ trading accounts to various
14 Refco affiliates in order to fund Refco’s operations. The
15 complaint further alleges that this practice was approved by,
16 and well known to, all members of Refco senior management.
17 On September 13, 2007, the district court dismissed the
18 putative class action suit for plaintiffs’ failure to allege
19 deceptive conduct. However, it granted plaintiffs leave to
20 replead as to certain defendants. RCM I, 2007 WL 2694469, at
21 *12-13. On October 9, 2007, two separate groups of plaintiffs
22 -- one group associated with investment fund VR Global
23 Partners, L.P., (“VR Plaintiffs”), and a second group
No. 06 Civ. 1888, 2006 WL 1379616 (S.D.N.Y. May 16, 2006); In re SPhinX, Ltd.,
371 B.R. 10 (S.D.N.Y. 2007).
15
1 associated with investment fund Capital Management Select Fund
2 Ltd. (“CM Plaintiffs”) -– filed individual actions based on
3 allegations similar to those raised in the putative class
4 action complaint. Thereafter, on November 20, 2007, the
5 district court consolidated all three actions for pretrial
6 purposes, subsequent to which the lead plaintiffs in the
7 putative class action filed a Second Amended Complaint.
8 In the consolidated action, all plaintiffs alleged
9 violations of Sections 10(b) and 20(a) of the Exchange Act and
10 Rule 10b-5 against all Refco Officer Defendants, and violations
11 of Rule 10b-16 against all Refco Officer Defendants who,
12 together with RCM and Refco, allegedly extended margin credit
13 to RCM Customers without adequately disclosing RCM’s use of
14 Customer securities. 15 U.S.C. §§ 78j(b), 78l (Sections 10(b)
15 and 20(a) of the Exchange Act); 17 C.F.R. §§ 240.10b-5, .10b-16
16 (Rules 10b-5 and 10b-16). In addition, VR Plaintiffs alleged
17 violations of Section 10(b) and Rule 10b-5 as against Grant
18 Thornton.
19 On August 28, 2008, the district court granted motions to
20 dismiss filed by various Officer Defendants and Grant Thornton.
21 RCM II, 586 F. Supp. 2d at 174. In granting the motions to
22 dismiss, the court rejected RCM Customers’ Section 10(b) claim
23 for lack of standing under the purchaser-seller rule of Blue
24 Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). RCM II,
25 586 F. Supp. 2d at 178-81. As a separate ground for dismissal,
16
1 the court ruled that plaintiffs failed to adequately plead
2 deceptive conduct through any affirmative act or
3 misrepresentation, breach of fiduciary duty, or any other
4 manner. Id. at 181-94.
5 Finally, as to RCM Customers’ Section 20(a) claims, the
6 court concluded that because plaintiffs could not bring a claim
7 against any defendant for a primary violation of Section 10(b)
8 and Rules 10b-5 and 10b-16, plaintiffs necessarily lacked
9 standing to bring a controlling person action under Section
10 20(a). Id. at 195.
11 In considering RCM Customers’ request for leave to
12 replead, the court first noted that all plaintiffs had the
13 benefit of filing their complaints after the court’s September
14 13, 2007 Opinion and Order, which detailed the deficiencies in
15 the initial class-action pleading. Id. at 196. The court also
16 observed that VR Plaintiffs and CM Plaintiffs all had more than
17 adequate access to Refco’s internal files, including books,
18 records, and corporate minutes, as a result of their
19 participation in the Refco bankruptcy proceeding. Id. Finding
20 no indication that RCM Customers could provide additional facts
21 to cure their pleading defects, the district court denied RCM
22 Customers’ request for leave to replead. Id.
23 On September 12, 2008, plaintiffs filed a motion to
24 reconsider the district court’s denial of leave to replead. In
25 their motion, RCM Customers asserted that, given the
17
1 opportunity to replead, they would be able to establish
2 deceptive conduct by showing that RCM improperly rehypothecated
3 the Customers’ fully-paid securities. The district court
4 granted the motion for reconsideration but again denied RCM
5 Customers leave to replead. RCM III, 2008 WL 4962985. The
6 court determined that even if RCM Customers could establish
7 deceptive conduct based on RCM’s rehypothecation of fully-paid
8 securities, plaintiffs still had no standing as “actual
9 purchaser[s] or seller[s]” under Blue Chip Stamps. Id. at *3.
10 This appeal followed.
11 DISCUSSION
12 RCM Customers seek to recover under Section 10(b) of the
13 Exchange Act, 15 U.S.C. § 78j(b). RCM Customers assert that
14 they were deceived by, inter alia, the terms of the Customer
15 Agreement and RCM’s written Trade Confirmations, RCM’s written
16 account statements, and oral representations by certain
17 appellees.
18 a) Section 10(b)
19 We turn first to Section 10(b), which makes it unlawful to
20 “use or employ, in connection with the purchase or sale of any
21 security . . . any manipulative or deceptive device or
22 contrivance in contravention of such rules and regulations as
23 the Commission may prescribe.” 15 U.S.C. § 78j(b). The
24 elements of a Section 10(b) claim are familiar to all federal
25 courts. A plaintiff claiming fraud must allege scienter, “a
18
1 mental state embracing intent to deceive, manipulate, or
2 defraud,” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551
3 U.S. 308, 319 (2007) (quoting Ernst & Ernst v. Hochfelder, 425
4 U.S. 185, 193 n.12 (1976)), and must “state with particularity
5 facts giving rise to a strong inference that the defendant
6 acted with the required state of mind.” 15 U.S.C. § 78u-
7 4(b)(2). A “strong inference of scienter” is one that is “more
8 than merely ‘reasonable’ or ‘permissible’ -- it must be cogent
9 and compelling, thus strong in light of other explanations.”
10 Tellabs, 551 U.S. at 323-24. This strong inference of scienter
11 can be established by alleging either “(1) that defendants had
12 the motive and opportunity to commit fraud, or (2) strong
13 circumstantial evidence of conscious misbehavior or
14 recklessness.” ECA & Local 134 IBEW Joint Pension Trust of
15 Chi. v. JP Morgan Chase Co., 553 F.3d 187, 198 (2d Cir. 2009).
16 Although no claim for breach of contract is pursued by
17 appellants, the gravamen of their Section 10(b) claim is such a
18 breach. Breaches of contract generally fall outside the scope
19 of the securities laws. See Gurary v. Winehouse, 235 F.3d 792,
20 801 (2d Cir. 2000) (“[T]he failure to carry out a promise made
21 in connection with a securities transaction is normally a
22 breach of contract and does not justify a Rule 10b-5 action
23 . . . unless, when the promise was made, the defendant secretly
24 intended not to perform or knew that he could not perform.”
25 (citation and internal quotation marks omitted) (quoting Mills
19
1 v. Polar Molecular Corp., 12 F.3d 1170, 1176 (2d Cir. 2000)));
2 Desert Land, LLC v. Owens Fin. Grp., Inc., 154 Fed. App’x. 586,
3 587 (9th Cir. 2005) (“[T]he mere allegation that a contractual
4 breach involved a security does not confer standing to assert a
5 10b-5 action.”).
6 However, although “[c]ontractual breach, in and of itself,
7 does not bespeak fraud,” Mills, 12 F.3d at 1176, it may
8 constitute fraud where the breaching party never intended to
9 perform its material obligations under the contract. See Cohen
10 v. Koenig, 25 F.3d 1168, 1172 (2d Cir. 1994) (“The failure to
11 fulfill a promise to perform future acts is not ground for a
12 fraud action unless there existed an intent not to perform at
13 the time the promise was made.”). Private actions may succeed
14 under Section 10(b) if there are particularized allegations
15 that the contract itself was a misrepresentation, i.e., the
16 plaintiff’s loss was caused by reliance upon the defendant’s
17 specific promise to perform particular acts while never
18 intending to perform those acts. See Wharf (Holdings) Ltd. v.
19 United Int’l Holdings, Inc., 532 U.S. 588 (2001) (defendant
20 violated Section 10(b) when it sold a security while never
21 intending to honor its agreement); Ouaknine v. MacFarlane, 897
22 F.2d 75, 81 (2d Cir. 1990) (Section 10(b) plaintiff adequately
23 alleged facts to imply the defendants intended to deceive when
24 they issued an offering memorandum); Luce v. Edelstein, 802
25 F.2d 49, 55-56 (2d Cir. 1986) (allowing Section 10(b) claim
20
1 where plaintiff alleged defendant’s promises made in
2 consideration for a sale of securities were known by defendant
3 to be false); cf. Mills, 12 F.3d at 1176 (denying Section 10(b)
4 claim because plaintiff alleged no facts probative of
5 defendant’s intent at contract formation).
6 We have also held that where a breach of contract is the
7 basis for a Section 10(b) claim, the “promise . . . must
8 encompass particular actions and be more than a generalized
9 promise to act as a faithful fiduciary.” Luce, 802 F.2d 55.
10 With respect to the present action, we add that a simple
11 disagreement over the meaning of an ambiguous contract combined
12 with a conclusory allegation of intent to breach at the time of
13 execution will not do. Either the alleged breach must be of a
14 character that alone provides “strong circumstantial evidence”
15 of an intent to deceive at the time of contract formation, ECA,
16 553 F.3d at 198, or there must be allegations of particularized
17 facts supporting a “cogent and compelling” inference of that
18 intent, Tellabs, 551 U.S. at 324; Int’l Fund Mgmt. S.A. v.
19 Citigroup Inc., Nos. 09 Civ. 8755, 10 Civ. 7202, 10 Civ. 9325,
20 11 Civ. 314, 2011 WL 4529640, at *9 (S.D.N.Y. Sept. 30, 2011).
21 In the present case, there are no particularized allegations of
22 fact supporting such an inference of deceptive intent at the
23 time of execution of the Customer Agreements. Therefore, the
24 requisite intent must be inferred, if at all, from the Customer
25 Agreement itself and the nature of the alleged breach.
21
1 b) The Customer Agreement as a Misrepresentation
2
3 RCM Customers claim that they were deceived into believing
4 that their securities and other assets would be safeguarded,
5 and, in particular, that RCM would not rehypothecate excess
6 margin or fully-paid securities. They allege that, in fact,
7 RCM routinely rehypothecated all of its customers’ securities,
8 regardless of the customers’ outstanding margin debt, and did
9 so from the start of each customer’s account. The allegations
10 as to RCM’s conduct are sufficient to satisfy the element of
11 intent at the time of contract formation. The crux of the
12 issue, therefore, is whether RCM’s rehypothecation of
13 securities even when they were not deemed collateral was so
14 inconsistent with the provisions of the Customer Agreement that
15 the Agreement was itself a deception.14
16 Section B15 of the Customer Agreement establishes the
14
There is no issue regarding the financial sophistication of the RCM
Customers. They are investment funds with access to the finest advisory
resources. Indeed, all plaintiffs have alleged that, from the outset, they
knew of, and were sensitive to, the counterparty risk associated with a
broker-dealer’s rehypothecation of its customers’ securities.
15
Section A of the Customer Agreement clearly indicates that RCM
Customers’ accounts were non-discretionary. This section states, in relevant
part:
A. AUTHORIZATION
1. Authority to Act. You hereby authorize [RCM] to purchase, sell,
borrow, lend, pledge or otherwise transfer Financial Instruments
(including any interest therein) for your account in accordance with
your oral or written instructions . . . Except to the extent you have
expressly authorized someone else to buy, sell and otherwise effect
Transactions on your behalf and for your account, all Transactions
introduced to [RCM] by RSL on your behalf and entered into pursuant to
this Agreement shall be initiated orally or in writing by you.
22
1 terms by which RCM would extend margin financing to RCM
2 Customers, and provides in relevant part:
3
4 B. MARGIN
5
6 This Margin section applies in the event [RCM]
7 finances any of your Transactions from time-to-
8 time in Financial Instruments.
9
10 1. Security Interest. [RCM] reserves the right
11 to require the deposit or maintenance of
12 collateral (consisting of cash, United States
13 government obligations or such other marketable
14 securities or other property which may be
15 acceptable to [RCM]) to secure performance of
16 your obligations to [RCM]. . . . To secure your
17 obligations under Transactions entered into
18 pursuant to this Agreement, you hereby grant to
19 [RCM] and its affiliates (collectively, “Refco
20 Entities”) a first priority, perfected security
21 interest in all of your cash, securities and
22 other property (whether held individually or
23 jointly with others) and the proceeds thereof
24 from time-to-time in the possession or under the
25 control of such Refco Entities, whether or not
26 such cash, securities and other property were
27 deposited with such Refco Entities.
28
29 2. Rights and Use of Margin. [RCM] shall have
30 the right to loan, pledge, hypothecate or
31 otherwise use or dispose of such cash, securities
32 and other property free from any claim or right,
33 until settlement in full of all Transactions
34 entered into pursuant to this Agreement. [RCM’s]
35 sole obligation shall be to return to you such
36 cash, like amounts of similar cash, securities
37 and other property (or the cash value thereof in
38 the event of any liquidation of collateral) to
39 the extent they are not deemed to be collateral
App. 154.
Because RCM could not trade securities for RCM Customers’ accounts
without oral or written instructions, it is clear that RCM Customers’ accounts
were non-discretionary -- that is, RCM Customers, not RCM, had “control over
the account[s] and ha[d] full responsibility for trading decisions.” de
Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293, 1302 (2d Cir. 2002).
23
1 to secure Transactions entered into pursuant to
2 this Agreement with any Refco Entities or have
3 not been applied against obligations owing by you
4 to Refco Entities, whether as a result of the
5 liquidation of positions and any Transactions
6 entered into pursuant to this Agreement or
7 otherwise.
8
9 App. 154.
10 Section B.1 states that upon RCM’s extension of margin
11 financing to a customer -- even a dime -- RCM would obtain a
12 “first priority, perfected security interest in all of [RCM
13 Customers’] cash, securities and other property (whether held
14 individually or jointly with others) and the proceeds thereof.”
15 App. 154. Section B.1 also gave RCM the right to demand
16 additional collateral in the event that a customer’s collateral
17 became insufficient to secure the customer’s outstanding margin
18 debt -- if, for example, the value of the customer’s securities
19 collateral decreased in value such that RCM’s margin loan was
20 under-secured.
21 In addition, Section B.2 states that, if a customer’s
22 securities are no longer deemed collateral to secure the
23 customer’s outstanding margin debt, RCM was obligated to
24 “return” such securities to the customer. It is evident that
25 the promised “return” did not contemplate either securities or
26 their value being returned to the actual possession of the RCM
27 Customers. Margin accounts move up or down with both the
28 buying or selling by the customer and the price movements of
29 the collateral. The constant transfer of collateral back and
24
1 forth between accounts in RCM’s name or a customer’s name would
2 have imposed administrative costs on all parties, and no one
3 argues that such constant transfers were required by the
4 Customer Agreement. Moreover, all of the RCM Customers had to
5 have been aware that, if RCM was not asking for more
6 collateral, some of their securities were probably excess
7 collateral. However, there is no allegation or indication that
8 any RCM Customer ever noticed or complained about the lack of
9 back-and-forth transfers.
10 In context, therefore, “return” must mean that, with
11 respect to securities not deemed to be collateral, the customer
12 could demand their return from the fungible pool. Moreover, in
13 the case of a requested “return,” RCM had the option of
14 transferring physical securities or the “cash value thereof in
15 the event of any liquidation of collateral.” Thus, RCM, after
16 rehypothecating all its customers’ securities, could have
17 satisfied a demand for “return” of excess securities by paying
18 their cash value in lieu of the actual securities.
19 On review of the Customer Agreement, we conclude that it
20 unambiguously warned the RCM Customers that RCM intended to
21 exercise full rehypothecation rights as to the Customers’
22 excess margin securities.
23 Stripped of verbiage not pertinent to this dispute and
24 substituting a crude and colloquial description for the
25 specified collateral, Sections B.1 and 2 read:
25
1 B. Margin
2
3 This Margin section applies in the event
4 [RCM] finances any of your Transactions . . . in
5 [your account].
6
7 1. Security Interest. [RCM] reserves the
8 right to require . . . [appropriate stuff as]
9 collateral . . . [T]o secure performance of your
10 obligations to [RCM] . . . you hereby grant to
11 [RCM] . . . a first priority, perfected security
12 interest in all your [stuff] in the possession of
13 . . . [Refco Entities] . . . .
14
15 2. Rights and Use of Margin. [RCM] shall
16 have the right to . . . use or dispose of such
17 [stuff] free from any claim or right, until
18 settlement in full of all Transactions . . . .
19 [RCM’s] sole obligation shall be to return to you
20 such [stuff] . . . to the extent [it is] not
21 deemed to be collateral to secure Transactions
22 . . . .
23
24 App. 154.
25 Appellants’ argument that the first use of “such [stuff]”
26 in B.2 refers only to “stuff” deemed to be collateral is not
27 consistent with the language of the agreement. The only
28 referent for the first “such [stuff]” is “all your [stuff]” in
29 B.1. Moreover, the second use of “such [stuff]” in B.2 is
30 modified by “to the extent [it is] not deemed to be collateral,”
31 a most peculiar modifier if “such [stuff]” means only “stuff”
32 deemed to be collateral.
33 RCM Customers also allege that RCM rehypothecated Customer
34 assets at times that RCM Customers had no outstanding margin
35 debt in breach of the Customer Agreement. However, the Customer
36 Agreement provides only that the cash value of securities not
26
1 deemed collateral shall be “return[ed]” to the customers, i.e.,
2 recorded on RCM’s books as money payable on demand to the
3 particular customer. A perfectly plausible reading of the
4 Agreement is that, on the occasions that some customers had no
5 outstanding margin transactions, they had only a right to demand
6 payment of the value of 100 percent of the securities that had
7 been given to RCM.
8 There is, therefore, no disparity between the provisions of
9 the Customer Agreement and RCM’s conduct remotely supportive of
10 a claim that the Agreement was a misrepresentation actionable
11 under Section 10(b).
12 The Trade Confirmation also supports this conclusion.
13 Section D.2 of the Customer Agreement incorporates the terms of
14 the Trade Confirmation, which include, among other things, a
15 reiteration of RCM’s rights to “sell, pledge, hypothecate,
16 assign, invest or use, such collateral or property deposited
17 with it.” App. 712.
18 c) Consistency with Federal and State Law
19
20 RCM Customers also contend that our interpretation of
21 Section B.2 is inconsistent with federal and/or state law and
22 that ambiguities in the Customer Agreement should be construed
23 to comply with applicable legal rules.16 RCM Customers argue
16
Appellants also argue that the district court’s interpretation was
inconsistent with custom and practice, but they do not state what the customs
and practices are or how they are inconsistent with this agreement. Absent
allegations as to such customs and practices and given the clarity of the
27
1 that RCM was subject to SEC Rules 15c3-1, 17 C.F.R. § 240.15c3-
2 1, and 15c3-3, 17 C.F.R. § 240.15c3-3,17 and New York state law,
3 which would have limited RCM’s rehypothecation rights with
4 respect to excess margin securities. However, even assuming
5 arguendo the existence of ambiguities in the Customer Agreement,
6 we disagree.
7 The district court rejected these arguments regarding
8 federal law based on our decision in United States v. Finnerty,
9 533 F.3d 143 (2d Cir. 2008). RCM II, 586 F. Supp. 2d at 191-92.
10 Finnerty held that a defendant may be liable under Section
11 10(b) and Rule 10(b)(5) for violation of a NYSE rule only if the
12 defendant had made a representation regarding compliance with
13 the rule. Finnerty, 533 F.3d at 149-50. The district court
14 concluded that because plaintiffs made no allegations that “RCM
15 (or any Refco affiliate or employee) made any representation
16 that RCM was subject to, or would comply with, any such
17 regulations, much less [Rules 15c3-1 and 15c3-3],” RCM could not
Customer Agreement and Trade Confirmations, we will not discuss this claim
further.
17
SEC Rule 15c3-1, the so-called Net Capital Rule, generally requires
brokers and dealers to maintain sufficient capital to protect their customers
from the firm’s potential insolvency, see 17 C.F.R. § 240.15c3-1, and Rule
15c3-3, the so-called Customer Protection Rule, requires brokers and dealers
to obtain and maintain physical possession or control of all fully-paid and
excess margin securities in a customer’s account. See 17 C.F.R. § 240.15c3-
3(b)(1). Under Rule 15c3-3, “excess margin securities” is defined as those
securities in the customer’s account whose market value exceeds 140 percent of
the customer’s outstanding margin debt. 17 C.F.R. § 240-15c3-3(a)(5). Thus,
the Customer Protection Rule prohibits a broker from rehypothecating a
customer’s margin account securities in excess of 140 percent of the
customer’s outstanding margin debt.
28
1 be found liable under Section 10(b) and Rule 10b-5 for violating
2 Rules 15c3-1 and 15c3-3. RCM II, 586 F. Supp. 2d at 192.
3 Here, more than simply remaining silent as to whether it
4 was complying with U.S. law, RCM represented that it was not a
5 U.S.-regulated company. Although RCM did state that it was
6 subject to “all applicable laws” in the trade confirmations,
7 that simply raises the question of what laws were applicable.
8 In short, RCM’s alleged violation of federal law does not in and
9 of itself constitute deceptive conduct.
10 The Security and Exchange Commission has expressed a
11 concern, as amicus curiae, that affirming the district court in
12 this regard will viscerate the so-called “shingle theory” of
13 broker-dealer liability under Section 10(b), and will be
14 inconsistent with our recent decision in VanCook v. SEC, 653
15 F.3d 130 (2d Cir. 2011). We disagree.
16 Under the shingle theory, a broker makes certain implied
17 representations and assumes certain duties merely by “hanging
18 out its professional shingle.” Grandon v. Merrill Lynch & Co.,
19 Inc., 147 F.3d 184, 192 (2d Cir. 1998).
20 In VanCook, we held that VanCook’s late-trading practice
21 “violated [Rule 10b-5] because it constituted an implied
22 representation to mutual funds that” VanCook was complying with
23 a rule restricting late-trading. VanCook, 653 F.3d at 141. We
24 reasoned that “by submitting orders after that time for
25 execution at the current day’s [Net Asset Value], VanCook made
29
1 an implied representation that the orders had been received
2 before 4:00 p.m., because such late trading incorporates an
3 implicit misrepresentation by falsely making it appear that the
4 orders were received by the intermediary before 4:00 p.m. when
5 in fact they were received after that time.” Id. at 140-41
6 (internal quotation marks and alterations omitted). We also
7 noted that VanCook’s scheme violated his employer “mutual funds’
8 own express wish’s, as set out in their propectuses,” id. at
9 140, and involved “steps to make it appear to any outside
10 observer . . . that his customers’ . . . orders had been
11 finalized by 4:00 p.m.,” id. Based in part on the explicit and
12 implied misrepresentations, we affirmed the order of the SEC
13 that VanCook violated Rule 10b-5 and Section 10(b). Id. at 141.
14 However, the facts alleged in the instant matter do not, as
15 asserted by appellant, give rise to liability based on “conduct
16 inconsistent with an implied representation; specifically a
17 broker-dealer’s implied representation under the ‘shingle
18 theory’ that it will deal fairly with the public in accordance
19 with the standards of the profession.” Appellants’ 18(j) Letter
20 at 2. Surely, RCM’s affirmative representations that it was not
21 a U.S.-regulated company trump any implied representation under
22 the shingle theory.
23 Indeed, we have previously denied shingle theory claims
24 against a broker that made adequate explicit disclosure with
25 regard to the subject matter of the claimed implied duties. See
30
1 Starr ex rel. Estate of Sampson v. Georgeson S'holder, Inc., 412
2 F.3d 103, 111 (2d Cir. 2005) (denying plaintiffs' Rule 10b-5
3 claim under the shingle theory because defendant disclosed
4 allegedly excessive markups). In the instant case, RCM's
5 Customer Agreement and its standard form Trade Confirmation
6 expressly disclosed RCM's rehypothecation rights as well as
7 RCM's status as an offshore unregulated entity. These
8 disclosures were made in conjunction with a bargained-for
9 agreement between sophisticated counter-parties that could be
10 expected to understand the relevant benefits and risks. Thus,
11 there is no liability under the shingle theory.
12 The terms of the Customer Agreement indicated that, insofar
13 as RCM was acting as executing broker for its customers, RCM was
14 not purporting to comply with the Rules in question but was
15 relying on the safe harbor from broker registration provided
16 under SEC Rule 15a-6, 17 C.F.R. § 240.15a-6. In general, Rule
17 15a-6 exempts from the federal broker-dealer registration
18 requirements of Section 15(a) of the Exchange Act, 15 U.S.C. §
19 78o, “foreign entities engaged in certain activities involving
20 U.S. investors and securities markets.” See Registration
21 Requirements for Foreign Broker-Dealers, Exchange Act Release
22 No. 27,017, 54 Fed. Reg. 30013, 30013 (July 18, 1989). In
23 particular, Rule 15a-6(a)(3) exempts from registration foreign
31
1 brokers18 that induce or attempt to induce trades in securities
2 by “major U.S. institutional investors” and “U.S. institutional
3 investors” so long as any trades are “effected through” a U.S.-
4 registered broker-dealer and various conditions are met both by
5 the foreign broker and the registered dealer that effects the
6 trades. See 17 C.F.R. § 240.15a-6(a)(3)(i)(A).
7 Section G.1 of the Customer Agreement, entitled “Respective
8 Status of [RCM] and RSL,” provides in relevant part:
9 [RCM] and RSL are all wholly owned subsidiaries
10 of the Refco Group Ltd., LLC, a US corporation.
11 RSL is a US corporation and a broker-dealer
12 registered with the US Securities and Exchange
13 Commission. [RCM] is a Bermuda Corporation.
14
15 App. 156-57.
16 This language clearly indicates that RSL is a U.S.
17 corporation and registered with the SEC, thereby implying that
18 RSL would comply with SEC regulations. However, Section G.1
19 represents RCM only as a Bermuda Corporation and makes no
20 suggestion that RCM was registered with the SEC or would comply
21 with federal securities regulations. Furthermore, the Customer
22 Agreement’s frequent references to RSL as “introducing”
18
Under Rule 15a-6, a “foreign broker or dealer” is defined as:
[A]ny non-U.S. resident person (including any U.S. person engaged in
business as a broker or dealer entirely outside the United States,
except as otherwise permitted by this rule) that is not an office or
branch of, or a natural person associated with, a registered broker or
dealer, whose securities activities, if conducted in the United States,
would be described by the definition of “broker” or “dealer” in sections
3(a)(4) or 3(a)(5) of the Act.
17 C.F.R. § 240.15a-6(b)(3).
32
1 transactions to RCM on the customers’ behalf clearly represented
2 that trades executed at RCM for its customers would be “effected
3 through” RSL to RCM in accordance with the requirements of Rule
4 15a-6(a)(3)(i)(A).19
5 Accordingly, whether or not RCM was technically in
6 compliance with the Rule 15a-6(a)(3) safe harbor,20 the Customer
7 Agreement clearly represented that RCM undertook no obligation
8 to comply with Rules 15c3-1 and 15c3-3.
9 Similarly, to the extent that RCM was acting as its
10 customers’ prime broker, RCM undertook no apparent obligation to
11 comply with federal securities laws, including Rules 15c3-1 and
12 15c3-3. Section G.1 of the Customer Agreement establishes the
13 role and function of RCM when acting as prime broker and states:
14 Trades Executed Away From [RCM], but cleared by
15 [RCM] (Prime Brokerage) –- [RCM] acts as your
16 clearing, settlement and financing agent (your
17 prime broker) in connection with Transactions
18 executed at your Executing Broker(s). Where
19 [RCM] is acting as your prime broker, no [RCM]
20 entity is involved in executing Transactions.
21
22 App. 157.
19
Although RCM would have been exempt from registration under Rule 15a-
6, RSL, as introducing broker, would have been required to comply with Rules
15c3-1 and 15c3-3, because, pursuant to Rule 15a-6, the U.S.-registered broker
through which transactions between the U.S. customer and the foreign broker
are effected retains responsibility for, inter alia, complying with Rules
15c3-1 and 15c3-3. See 17 C.F.R. §§ 240.15a-6(3)(iii)(A)(5),(6). Thus, to
the extent that trades were executed by RCM for its customers, with RSL acting
as introducing broker, it was RSL, not RCM, that bore the responsibility of
complying with Rules 15c3-1 and 15c3-3.
20
RCM Customers cite in their complaint a draft memorandum from Refco’s
counsel, Mayer, Brown, Rowe & Maw LLP, expressing counsel’s view that RCM was
unable to rely on the exemption from U.S. registration provided by Rule 15a-6.
33
1 The SEC has defined “prime broker” as “a registered broker-
2 dealer that clears and finances the customer trades executed by
3 one or more other registered broker-dealers (‘executing broker’)
4 at the behest of the customer.” Prime Broker Comm. Request, SEC
5 No-Action Letter, 1994 WL 808441, at *1 (Jan. 25, 1994). The
6 Commission requires prime brokers to comply with certain federal
7 securities laws, including Rules 15c3-1 and 15c3-3. Id. at *11.
8 However, insofar as RCM was not a U.S.-registered broker-dealer,
9 and thus not a “prime broker” for purposes of complying with
10 U.S. federal securities laws, RCM, when acting in its role as
11 prime broker, was not representing that it would comply with
12 Rules 15c3-1 and 15c3-3.21 We therefore conclude that the
13 Customer Agreement represented that RCM intended to exercise
14 full rehypothecation rights without being subject to the Rules
15 in question.
16 RCM Customers also assert that RCM was subject to New York
17 General Business Law Section 339-e, which, in general, restricts
18 a broker’s rehypothecation rights with respect to fully-paid or
19 excess margin securities. N.Y. Gen. Bus. Law § 339-e (McKinney
20 2004). RCM Customers argue that Section 339-e applies because
21 Section H of the Customer Agreement and Paragraph 6 of the Trade
21
We cannot, from the pleadings, reach any conclusions as to whether,
at the time it rehypothecated its customers’ securities, RCM was acting as
executing broker or prime broker. Nor can we make any conclusions as to
whether RCM and/or RSL were actually in compliance with Rules 15a-6, 15c3-1 or
15c3-3. Such conclusions are not, however, pertinent to our disposition of
this matter.
34
1 Confirmation specified that the agreement would be governed by,
2 and construed in accordance with, New York law. In particular,
3 Section H of the Customer Agreement, entitled “LAW AND
4 JURISDICTION,” reads:
5 This Agreement shall be governed by and construed
6 with New York law and you agree that the courts
7 of New York, located in the Borough of Manhattan
8 (Federal or State), are to have jurisdiction to
9 settle any disputes which may arise out of or in
10 connection with this Agreement. Any suit, action
11 or proceedings arising out of or in connection
12 with this Agreement (“Proceedings”) commenced by
13 you, may only be brought in New York. [RCM] may
14 take proceedings against you in New York (Federal
15 or State) or any other court of competent
16 jurisdiction, US or otherwise. The taking of
17 Proceedings by [RCM] in one or more jurisdictions
18 does not preclude the taking of Proceedings by
19 [RCM] in any other jurisdiction, whether
20 concurrently or not. You irrevocably waive (and
21 irrevocably agree not to raise) any objection
22 which you may have now or subsequently to [RCM’s]
23 laying of the venue of any Proceedings in any
24 court and any claim that any such Proceedings
25 have been brought in an inconvenient forum.
26
27 App. 157.
28 The district court determined that Section H constituted a
29 choice of law provision that governed only the Customer
30 Agreement itself. RCM II, 586 F.Supp.2d at 192 n.27. However,
31 RCM Customers assert that Section H establishes that New York
32 law governed the overall relationship between RCM and RCM
33 Customers, including RCM’s use of RCM Customers’ collateral. We
34 agree with the district court. Section H neither created, nor
35 represented, any affirmative obligations on RCM to conform to
35
1 New York margin-lending restrictions.22 By its clear terms, the
2 provision was included only as a choice of law and venue
3 provision that would govern should any conflicts arise “out of
4 or in connection with” the Customer Agreement.
5 d) The Account Statements as a Misrepresentation
6
7 In addition to their deception-in-the-contract argument,
8 appellants also claim that the monthly account statements sent
9 by RCM were deceptive because those statements identified
10 security positions that were “In Your Account” and other
11 securities as “Open Financing Transactions,” indicating that the
12 latter were being held as collateral. They argue that these
13 statements implied that the securities held “In Your Account”
14 were not being rehypothecated but were being held on behalf of
15 the customer.
16 However, no such inference could reasonably have been drawn
17 by a signatory to the Customer Agreement, which gave RCM the
18 right to rehypothecate all securities, whether excess collateral
19 or not, as discussed supra. Based on the terms of the Customer
20 Agreement, the distinction between collateral securities and
22
The Trade Confirmation also did not create, deceptively or otherwise,
an inference that New York law would apply. Paragraph 6 of the Trade
Confirmation provides that:
All transactions between RCM and you shall be subject to all
applicable laws, rules, practices and customs and to the terms of
the applicable customer agreement and of any other written
agreement between you and RCM.
App. 712. This provision cannot be portrayed as deceptive in this matter
because neither the Trade Confirmation nor the Customer Agreement state which
bodies of laws are “applicable.”
36
1 non-collateral securities had no bearing on rehypothecation
2 rights, but rather on what securities, or the equivalent cash
3 value thereof, customers could withdraw from their account.
4 Thus, these statements do not purport to make any
5 representation, deceptive or otherwise, about what securities
6 may or may not have been rehypothecated.
7 e) Oral Statements by RCM Representatives
8
9 RCM Customers also allege that oral statements made by RCM
10 representatives were deceptive. They state that during
11 discussions about the RCM Customers’ desire for low-risk
12 investments and a safe place to hold securities, RCM
13 representatives stated that: (i) RCM did not engage in
14 proprietary trading; (ii) their business involved only
15 executing, clearing, and financing trades in exchange for
16 commissions and interest payments; and (iii) RCM’s securities
17 financing business was a matched-book, which insulated RCM from
18 direct market risk.23 Appellants argue that, in context, these
19 statements created the perception that RCM was “a dependable
20 custodian” for their securities and would not rehypothecate
21 excess margin securities.
22 However, none of these statements had any bearing on how
23 RCM intended to use excess margin securities. They state only
24 that RCM’s business was that of a broker-dealer and that it took
23
In a matched-book business, a broker accepts securities as collateral
for a loan and then uses those same collateral securities to borrow funds,
thereby offsetting its exposure to risk that the original loan will become
under-secured.
37
1 steps to limit its risk. No reasonable, much less
2 sophisticated, investor would understand these statements as an
3 affirmative representation that RCM would not rehypothecate
4 excess margin securities.
5 Moreover, any doubt was removed by the terms of the
6 Customer Agreements, which granted RCM the right to
7 rehypothecate all customer securities whenever a customer had a
8 margin balance and the right to return customer securities in
9 the form of cash. These provisions clearly represented that
10 securities might be tied up in transactions even when not deemed
11 to be collateral. Therefore, the only affirmative statements by
12 RCM concerning the rehypothecation of customer securities were
13 the terms of the Customer Agreement, which were not deceptive.24
14 CONCLUSION
15 We have also considered appellants’ remaining claims and
16 find them without merit. For the foregoing reasons, we affirm.
17
18
24
We note two additional matters. First, RCM Customers do not argue
that the alleged oral misrepresentations constitute a fraud independent of
their rehypothecation claims. Second, if the oral statements might be taken
to suggest that RCM would not rehypothecate excess margin securities, there is
caselaw holding that “the written statement controls the oral one.” Ambrosino
v. Rodman & Renshaw, Inc., 972 F.2d 776, 786 (7th Cir. 1992) (quoting
Teamsters Local 282 Pension Trust Fund v. Angelos, 762 F.2d 522, 530 (7th Cir.
1985)).
38