OPINION OF THE COURT
ROSENN, Circuit Judge.
An incredible misuse of funds in stock market speculation
The United States Comptroller of the Currency closed ENB on August 8, 1970, after the discovery of the vast misappropriations of funds. According to appellants' complaint, Schotte devised a simplistic scheme of speculation in the securities market, hoping euphorically that the stocks purchased would rise in value prior to the time for payment. Without any authorization, he traded in the name of the bank and covered his losses with cashier's checks issued without consideration to the bank. Apparently, Schotte delayed payment for the purchased securities until the brokers pressed him, a delay often considerable because of a mixture of broker backroom office problems and their desire to retain Schotte's burgeoning business. When pressed for payment, Schotte either sold the stock if it had appreciated or issued a cashier's check signed by him as president of ENB. He allegedly concealed the scheme by making false statements to the shareholders and causing ENB to issue false financial statements. The scheme failed, leaving ENB with a devastating loss estimated at four million dollars.
The defendants in this suit are:
Schotte and the FDIC, as receiver (standing in for the defunct bank), are allegedly liable under section 10 of the Securities Exchange Act of 1934, 15 U.S.C. § 78j, and rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, as a result of the scheme and false representations.
As to the brokers and firms, the complaint avers: they are liable under rule 10b-5, and, independently liable, for violation of the New York Stock Exchange "know your customer" rule and regulations of the Board of Governors of the Federal Reserve System; they allowed Schotte to open accounts in violation of the National Banking Act; they knew that the accounts were a part of a scheme to defraud the shareholders; they knew Schotte was not acting in a fiduciary capacity as he purported; they allowed the fraud to continue in order to garner the commissions generated, ultimately aggregating three million dollars; and four individual brokers made misleading statements to the appellants.
The complaint alleges that the Elizabeth Bank was the correspondent bank for ENB and provided its computer services. When Schotte would issue the cashier's checks without depositing the necessary funds, the payee would deposit the checks in its bank and they would be cleared through the Reserve Bank. Although ENB did not have the requisite funds to cover the checks and pay the Reserve Bank, Schotte induced the Elizabeth Bank to somehow credit an ENB account with the funds necessary to pay the Reserve Bank. The complaint also alleges that: Schotte was in some manner able to return the same check as many as four or five times and have funds credited at the Elizabeth Bank; the Elizabeth Bank was negligent in handling the ENB account; the funds created by the Elizabeth Bank did not appear on the ENB books, thus allowing Schotte to misappropriate approximately four million dollars; and the returned cashier's checks were manually processed, and the daily statements of account of ENB revealed to the Elizabeth Bank the misuse of the account.
The complaint also alleges that the Reserve Bank was liable because it continued to process and reprocess the same cashier's checks, thus allowing payment for checks with the same or similar checks. The actions were allegedly negligent, violated contractual agreements with ENB, and violated the Reserve Bank's own rules and regulations.
The firm of Edward R. Burt & Co. prepared certified financials for ENB in the years 1967, 1968, 1969, and 1970. In addition, they were retained to conduct four partial examinations of ENB on a surprise basis each year. They allegedly issued an erroneous certification of the condition of the bank, which constituted a misstatement in violation of rule 10b-5, negligence under the New Jersey common law, and a breach of duty of care owed the shareholders. The certified financial statements, in reliance on which plaintiffs claimed to have purchased their shares, were also alleged to be false and misleading because they failed to state important facts.
The New York Stock Exchange is allegedly liable for willfully failing to enforce its rules pertaining to members. It allegedly allowed member firms to operate with incomplete records and lost securities. Plaintiffs say the records
Appellants sued the various defendants in a number of capacities. All defendants except the Elizabeth Bank, the Reserve Bank, and the NYSE were sued by the plaintiffs on behalf of themselves, derivatively on behalf of the bank, and on behalf of the class of all stockholders who purchased during the relevant period. The three designated defendants were sued only derivatively. In addition, the brokers' liability for violations of Federal Reserve Board regulations was asserted only derivatively.
In an opinion and order dated September 9, 1971, the district court denied the motions of the FDIC and Burt (except insofar as suit was brought against them derivatively) to dismiss the complaint, but granted similar motions by the brokers, the Elizabeth Bank, the Reserve Bank, and the NYSE. Schotte made no motion. In an opinion and order dated December 9, 1971, the district court granted Burt's motion to dismiss the class action against it, granted its motion for summary judgment against Gloria Landy, Gross, and Freehold Glass, and denied summary judgment against Eugene Landy. Plaintiffs have appealed from the aforesaid orders and judgments, except from the dismissal of the class action.
These decisions left standing only the claim of Eugene Landy against defendant Burt and the claims of the named plaintiffs as individuals and on behalf of the class against the FDIC as receiver and against Schotte. Subsequent to the district court decisions in this case, the FDIC, as receiver, initiated a suit on behalf of the bank against defendant corporate brokers, several additional brokerage firms, and accountant Burt.
We affirm the orders of the district court except that part of the order of September 9, 1971, dismissing the derivative counts against the parties not named as defendants in the suit since brought by the FDIC, as receiver.
We will consider the multiplicity of issues involved in the claims brought by the various plaintiffs in their varying capacities against the many defendants in the following order:
No separate discussion of the claims against the Elizabeth Bank, the Reserve Bank, or the New York Stock Exchange is included as those claims are all brought derivatively. There is also no separate discussion of the validity of the
I. THE DERIVATIVE CLAIMS
A threshold question in this multi-faceted suit is whether the plaintiffs can maintain a derivative action on behalf of ENB in the absence of a demand upon it to bring suit. Plaintiffs brought derivative actions against each of the brokerage firms named as defendants, the individual brokers, and all others named as defendants in the first 30 counts of their complaint. They also brought derivative actions against the accountant, the NYSE, the Elizabeth Bank, the Reserve Bank, and the FDIC, the latter as a nominal defendant in its capacity as receiver. In their original complaint, they explained their failure to request institution of this suit by the FDIC as follows:
The district court dismissed as "premature" the derivative causes of action on behalf of ENB against all defendants on the ground that plaintiffs, as shareholders of ENB, had no standing to institute suit in its behalf in the absence of a demand on and a refusal by the FDIC to bring such suit, as well as a failure to show why such demand need not have been made. It rejected plaintiffs' allegation that the FDIC's built in conflict of interest could serve as a basis for their derivative action because to do so would "severely restrict Congressional intent expressed in 12 U.S.C. § 1821(d)."
As a general principle, the responsibility for determining whether or not a corporation shall enforce in the courts a cause of action for damages is, like other business questions, ordinarily a matter of internal management left to the discretion of the directors, United Copper Co. v. Amalgamated Copper Co., 244 U.S. 261, 263-264, 37 S.Ct. 509, 61 L.Ed. 1119 (1917). Otherwise a litigious stockholder could easily intrude upon authority of those who are vested with responsibility for the operation of the corporation's business. Whether to forego an action or to bring suit for damages is a matter of business judgment. Such decision may involve not merely a consideration of legal principles but a balancing of business interests and relationships.
They argue that the conflicts of interests are:
(1) The FDIC is a subrogee of the claims of ENB's depositors as the insurer of their accounts and is, therefore, a major creditor of ENB interested in recovering only the amount necessary to pay the claims of depositors.
(2) The FDIC, as an insurer of the accounts of depositors of the Elizabeth Bank, has an interest in the solvency of that bank which may be endangered by this action. They further assert a conflict since FDIC supervises and regulates the Elizabeth Bank and might have an interest in concealing that which it failed to discover previously.
(3) Both the FDIC and the Reserve Bank are quasi-governmental agencies which, along with the Comptroller of the Currency, share the supervision of national banks. Two of the three directors of the FDIC are the Comptroller of the Currency and the Chairman of the Board of Governors of the Federal Reserve System, to which the defendant Reserve Bank belongs. Thus, it is "unrealistic to presume conclusively as did the Court below, that the FDIC would as vigorously prosecute the claim against the Reserve Bank as would the Eatontown shareholders." As evidence of a reluctance of the FDIC to prosecute the Reserve Bank, they assert that the FDIC has already paid it a claim for approximately three million dollars in overdrafts in the ENB account. They note that the Comptroller of the Currency is charged with examinations of ENB which failed to disclose the secret trading by Schotte, and that he might want to cover up that activity at this time. They aver also that in the suit finally instituted by the FDIC, as receiver, subsequent to the commencement of this action, the Elizabeth Bank and the Reserve Bank were not named as defendants.
The general rule is that a receiver may institute any suit on behalf of the corporation as the corporation itself might have commenced. W. Fletcher, Cyclopedia of the Law of Private Corporations § 7847 (1962 Revised Edition).
When a corporation is in receivership, any demand to bring suit in its behalf must be made upon the receiver rather than the directors. See, e. g., Wachsman v. Tobacco Products Corp., 129 F.2d 815, 819 (3d Cir. 1942); Long v. Stites, 88 F.2d 554 (6th Cir.), cert. denied, 301 U.S. 706, 57 S.Ct. 939, 81 L.Ed. 1360 (1937). This rule also applies to receivers of national banks. See, e. g., Lucking v. Delano, 129 F.2d 283 (6th Cir. 1942); Wales v. Jacobs, 104 F.2d 264 (6th Cir.), cert. denied, 308 U.S. 599, 60 S.Ct. 130, 84 L.Ed. 501 (1939); Davis Trust Co. v. Hardee, 66 App.D.C. 168, 85 F.2d 571 (1936). "The receiver . . . becomes to all intents and purposes the bank—at least he stands in the place of the bank; . . . the receiver, after his appointment, represents the bank, its stockholders and creditors." O'Connor v. Rhodes, 65 App.D.C. 21, 79 F.2d 146, 148 (1935). Section 1821(d)
A derivative suit by shareholders should not be precluded merely because a bank is in the receivership of the FDIC. The FDIC would remain free to exercise its control over the winding up of the bank and to institute suit itself on behalf of the corporation. Congress has given no indication that it intended to preclude derivative suits by the shareholders of a national bank in receivership. When a receiver refuses to bring suit or "where it would be a vain thing to make a demand upon [it], and it is shown there is a necessity for a suit for the protection of the interests of creditors," a stockholder is free to sue. O'Connor v. Rhodes, 65 App.D.C. 21, 79 F.2d at 149, aff'd sub nom. United States Shipping Board Merchant Fleet Corp. v. Rhodes, 297 U.S. 383, 56 S.Ct. 517, 80 L.Ed. 733 (1936). Moreover, we agree with the statement that:
Id. at 148-149. We believe this case should be treated under the same principles applied to any derivative suit.
The allegations in plaintiffs' original and amended complaint, however, are merely general. The amended complaint alleges that a demand upon the FDIC would have been futile because, as receiver, it would be unable to sue because of its "conflict of interest between various government agencies and its regulatory and insurance functions." These allegations do not supply with particularity the reasons for failing to make the demand required by Rule 23.1. Instead of being "a statement of appropriate and convincing facts" that a demand would have been futile, O'Connor v. Rhodes, 79 F.2d at 148, it is merely a vague, conclusory statement.
Even had the plaintiffs averred with sufficient particularity, as required by Rule 23.1, their reasons advanced on appeal for failing to make a demand upon the receiver, we do not believe that the district court would have erred in dismissing the derivative claims as premature. We do not believe that even the reasons asserted on this appeal as grounds for relieving the plaintiffs of making demand upon the receiver to
This principle enunciated in Ash applies with equal force to a national bank represented by a receiver mandated by congressional statute. Under the statutory schema created by Congress for our national banking system, the FDIC plays a vital role in the effective and efficient liquidation of insolvent national banks which is of far-reaching importance to the national government, the public, and the parties in interest. Reposed in it are broad powers, grave responsibilities, and delicate duties, all requiring the exercise of judgment and discretion. See Liberty National Bank v. McIntosh, 16 F.2d 906 (4th Cir. 1927). "He [the receiver] acts for the stockholders in dealing with the assets," and may even ratify a liquidating contract for the bank in place of the shareholders. Wegman v. National Bank of Commerce, 51 F.2d 288, 290 (W.D.N.Y.1931).
The first reason urged by defendants that FDIC, as a major creditor of ENB, has a conflict of interest which "could be extremely prejudicial to the interests of Eatontown's shareholders", flies in the face of Congressional directive. Congress has explicitly authorized the FDIC to act as receiver, 12 U.S.C. § 1819, and has required the Comptroller to appoint the FDIC as receiver of any insured national bank which is closed. 12 U.S.C. § 1821(c). Thus, under the federal banking laws the FDIC has the right to act for a closed (insolvent) bank and its stockholders. Moreover, in specifically providing in § 1821(d) that the FDIC as receiver should ". . . pay to itself for its own account such portions of the amounts realized from . . . [the] liquidation as it shall be entitled to receive on account of its subrogation to the claims of depositors . . .", Congress recognized that the FDIC would be functioning in the dual role of receiver and creditor. The FDIC's role as receiver had, as the district court aptly observed, "[t]he primary objective . . . to marshal funds for distribution, a goal which would include protection of shareholders." [Emphasis added.] Plaintiffs' argument that as shareholders of ENB they should not be compelled to rely upon the FDIC to prosecute their derivative claims is essentially predicated on the proposition that the FDIC is "a major creditor of Eatontown" and as such its interest in recovering against defendants will be "limited to its losses arising out of the payment of the insurance claims of Eatontown's depositors." Implicit in this argument is the assumption that the FDIC will not carry out its statutory duties as receiver, obligations which transcend the interests of both creditors and stockholders. We will not make such a presumption in the absence of factual allegations supporting it.
The second reason advanced by plaintiffs, namely that the FDIC, as an insurer of the Elizabeth Bank, has a conflicting interest in its solvency, is also without merit. Nothing in this record intimates that a recovery against the Elizabeth Bank would in any way threaten its solvency or have an adverse impact on the FDIC, or that any other obligation of the FDIC would prevent or inhibit it from properly performing its statutory obligations.
We also find insufficient the third reason urged by plaintiffs, that
Plaintiffs have attempted to substantiate their conflict of interest argument by asserting that two of the three directors of the FDIC are the Comptroller of the Currency and the Chairman of the Board of Governors of the Federal Reserve System. The Reserve Bank disputes the accuracy of the allegation that the Chairman of the Board of Governors of the Federal Reserve System is one of the three directors of the FDIC. Section 1812 of 12 U.S.C. provides that management of the FDIC "shall be vested in a Board of Directors consisting of three members, one of whom shall be the Comptroller of the Currency, and two of whom shall be citizens of the United States to be appointed by the President, by and with the advice and consent of the Senate." No designation whatsoever is made of the Chairman of the Board of Governors of the Federal Reserve System. By virtue of the foregoing statute, control of the FDIC Board of Directors could be in the two citizen members. Moreover, § 1821(d) expressly guards the FDIC as receiver of closed banks from supervision by the Comptroller of the Currency:
The mere presence under these circumstances on the Board of Directors of the FDIC of the Comptroller of the Currency does not per se constitute an inhibiting conflict of interest, especially in the absence of any specific allegation of the Comptroller's wrongful supervision of ENB which he might now desire to cover up, or of his bad faith as to any aspect of this litigation.
Developments since this case was heard by the district court suggest, however, that the question of the propriety of derivative claims against some of the defendants should be remanded for further consideration by the district court. When this matter was originally heard, "the receiver . . . stated to the court that it does in fact intend to bring suit against all parties responsible for the collapse of the bank. Until that representation is either contradicted by specific acts or inaction or until plaintiffs make a demand upon the FDIC they are without standing to pursue the matter independently." (District Court opinion of September 9, 1971). Appellants have in their brief called to our attention that the FDIC has brought suit against many of the defendants named in this action since the district court's entry of its order of dismissal, but has not named the Elizabeth Bank, the Reserve Bank, Schotte, the NYSE, and some of the brokers as parties. See note 3A supra. This statement is conceded in the joint brief of appellee brokers and the briefs of the FDIC and the Reserve Bank and is controverted by none of the appellees.
Normally, the court of appeals will consider only the record and facts considered in the district court. We specifically held in Jaconski v. Avisun Corporation, 359 F.2d 931, 936 n. 11 (3 Cir. 1966), that:
See also Dictograph Products Company v. Sonotone Corporation, 231 F.2d 867 (2d Cir. 1956), petition for certiorari dismissed by stipulation, 352 U.S. 883, 77 S.Ct. 104, 1 L.Ed.2d 82 (1956); Rule 10(a), Federal Rules of Appellate Procedure.
The normal rule is subject to the right of an appellate court in a proper case to take judicial notice of new developments not considered by the lower court. 31 C.J.S., Evidence § 13, at 842 (1964).
Judicial notice is frequently taken, of course, of developments not of record subsequent to a lower court decision in the application of the mootness doctrine by appellate courts. See, e.g., Johnson v. New York State Education Department, 409 U.S. 75, 93 S.Ct. 259, 34 L.Ed.2d 290 (1972) (matter called to court's attention in one of the parties' briefs); Bethlehem Mines Corp. v. United Mine Workers, 480 F.2d 917 (3d Cir. 1973). In the case sub judice, the justification for taking judicial notice is even greater because the subsequent developments were in the very court in which this suit was instituted, in a related matter, and merely involved notice of the filing of the new action and the parties thereto. This situation is similar to Pittsburgh Newspaper Printing Pressman's Union v. Pittsburgh Press Co., 479 F.2d 607 (3d Cir. 1973), in which we took judicial notice of subsequent arbitration and proceedings in the court of appeals. We also note that rule 201(f) of the Proposed Rules of Evidence for United States Courts and Magistrates, as explained by the Advisory Committee's Note, provides that judicial notice may be taken at any stage of the proceeding, even on appeal. 56 F.R.D. 183, 206.
We therefore take judicial notice of the complaint filed by the FDIC. Appellants suggest that we should consider on this appeal the subsequent developments in deciding the appropriateness of a derivative suit. We think it appropriate, however, to remand to the district court rather than decide this issue now. This is the course the Supreme Court adopted in Johnson v. New York State Education Department, 409 U.S. 75, 93 S.Ct. 259, 34 L.Ed.2d 290 (1972), in determining whether a controversy had become moot subsequent to the lower court's decision.
Under these circumstances and to serve judicial economy, we will remand to the district court for consideration of the derivative action as to the parties
(1) the refusal of the FDIC to sue them is justified, see, e.g., Kauffman v. Dreyfus Fund, Inc., 434 F.2d 727, 734 (3d Cir. 1970); Groel v. United Electric Co., 70 N.J.Eq. 616, 61 A. 1061 (Ch.N. J. 1905);
(2) the other requirements of Rule 23.1 are met, including the related questions as to whether plaintiff-appellant Landy has a conflict of interest as a former director, officer, and counsel for ENB and as a defendant now in another action growing out of the insolvency of ENB, see, e.g., Nolen v. Shaw-Walker Co., 449 F.2d 506 (6th Cir. 1971); Eisen v. Carlisle & Jacquelin, 391 F.2d 555 (2d Cir. 1968); Quirke v. St. Louis-San Francisco Ry. Co., 277 F.2d 705 (8th Cir. 1960);
(3) the failure of the FDIC to resist, when it allegedly had grounds to do so, a claim of the Reserve Bank for approximately three million dollars in overdrafts in the account of ENB, substantiates appellants' claim of conflict of interest.
We emphasize that in remanding this portion of the case we do not reverse the district court or find error in its determinations. The district court's decision was carefully limited to the facts as they appeared at the time of its decision.
We therefore affirm the district court's dismissal of all derivative claims except those asserted against those defendants not sued by the FDIC. We need not consider the merits, therefore, of the claims against the NYSE, the Elizabeth Bank, and the Reserve Bank, as well as the possible brokers' liability for violations of Federal Reserve regulations and the National Banking Act, as those claims are brought derivatively only.
II. INDIVIDUAL STOCKHOLDER SUITS
A. The Brokers
The district court, relying on Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956, 72 S.Ct. 1051, 96 L.Ed. 1356 (1952), reasoned that to have standing to bring a suit under rule 10b-5 a plaintiff must have been a purchaser or seller in connection with the fraudulent scheme alleged. It noted that plaintiffs alleged two fraudulent schemes: first, in connection with Schotte's purchase and sale of approximately two hundred million dollars in securities in the name of ENB, and, second, in connection with shareholder purchases of ENB shares. As to the former, the court held that plaintiffs could not sue because they were not purchasers from or sellers to the brokers. As to the second, it held that any fraudulent scheme by the brokers was not closely enough related to the actual sale of ENB shares to be a fraudulent scheme within the terms of rule 10b-5. The crucial factor, according to the district court, was that Schotte's scheme in which the brokers were implicated was not predicated on the rise or fall of ENB shares. The court concluded that the
The district court also noted that the depositions did not disclose any affirmative misrepresentations by the brokers to anyone, ENB director Landy included; they merely showed that the brokers, in talking with Landy, failed to volunteer information as to the scheme. The court rejected the argument that there was liability for aiding and abetting Schotte in his scheme. It stated that the facts alleged were insufficient to connect the brokers with the alleged fraud against the shareholders and that the fraud relating to the two hundred million dollars was fraud against the ENB, not its shareholders.
Consideration of the alleged broker liability involves the following issues:
The issues will be discussed in that order.
1. Rule 10b-5 Liability
Rule 10b-5 provides:
17 C.F.R. § 240.10b-5.
It is clear from the rule that a violation cannot occur unless the elements of subsections (a), (b), or (c) are present "in connection with the purchase or sale of any security." The district court correctly concluded that there were only two possible purchases or sales to which rule 10b-5 might arguably apply.
a. The Two Hundred Million Dollar Scheme
The complaint alleged a scheme to defraud in connection with the purchase and sale of approximately two hundred million dollars in securities. The threshold question is whether the scheme alleged is one which rule 10b-5 was designed to cover. In Birnbaum, the plaintiffs brought a derivative and shareholder class action bottomed on the same broad theory proposed in the case sub judice. The court dismissed the action on the two interrelated grounds that: (1) "[section 10(b)] was directed solely at the type of misrepresentation or fraudulent practice usually associated with the sale or purchase of securities rather than at fraudulent mismanagement of corporate affairs," and (2) "Rule X-10B-5 extended protection only to the defrauded purchaser or seller." 193 F.2d at 464.
In the case sub judice, there is some question whether the fraudulent scheme of Schotte and the brokers was the type "usually associated with the sale or purchase of securities" rather than mere fraudulent mismanagement of corporate affairs. Since Birnbaum, the scope of rule 10b-5 has been gradually and greatly expanded:
A. Bromberg, Securities Law: Fraud § 4.7(2) (1968) (footnotes omitted).
In Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 92 S.Ct. 165, 30 L.Ed.2d 128 (1971), the Supreme Court gave some indication how far rule 10b-5 extends to protect against corporate mismanagement. In Bankers Life, the Superintendent of Insurance of New York, as liquidator of Manhattan Casualty Company (Manhattan), commenced an action against ten defendants alleging fraud. One of the defendants, Bankers Life & Casualty Co., agreed to sell all of Manhattan's stock to one Begole for five million dollars. The complaint alleged that Begole conspired with one Bourne and others to pay for the stock with Manhattan's assets. They allegedly arranged, through Garvin, Bantel & Co., a note brokerage firm, to obtain a five million dollar check from Irving Trust Co., although they had no funds on deposit there at the time. On the same day they purchased all the stock of Manhattan from Bankers Life for five million dollars and installed one Sweeney as president of Manhattan. Manhattan then sold its United States Treasury bonds for $4,854,552.67.
Manhattan's Board of Directors was apparently deceived into authorizing the bond sale by a misrepresentation that the proceeds would be exchanged for a certificate of deposit of equal value. The money, however, plus enough cash to bring the total to five million dollars, was credited to an account of Manhattan at Irving Trust, and the five million dollar Irving Trust check was charged against it. Begole thus owned all of Manhattan's stock, having used Manhattan's assets to purchase it.
To complete the fraudulent scheme, Manhattan procured from Irving Trust a second five million dollar check. Sweeney, Manhattan's new president, tendered this check to Belgian-American Bank & Trust Co. which issued a five million dollar certificate of deposit in the name of Manhattan. Sweeney endorsed the certificate of deposit over to New England Note Corp., which was controlled by Bourne. Bourne then procured a five million dollar loan from Belgian-American, using the certificate as collateral and paying the proceeds to Irving Trust to cover Manhattan's five million dollar liability to them.
Manhattan's books reflected the purchase of the certificate of deposit but did not reflect its assignment to New England and its pledge to Belgian-American. The books, thus, did not show that Begole had used Manhattan's assets to purchase its stock.
The district court and the court of appeals in Bankers Life held that the plaintiff did not state a cause of action under rule 10b-5 against Bankers Life and certain other corporate defendants. The court of appeals relied on the first Birnbaum requirement. It dismissed the action because any deception that occurred did not affect the sales transaction and neither the purchaser nor the seller was defrauded as to the terms of the sale itself. "The fraud alleged in this case in no way affected either the securities market or the investing public . . . . The purity of the security transaction and the purity of the trading process were unsullied." 430 F.2d 355, 361 (2d Cir. 1970). The court stated that section 10(b) "is limited to preserving the integrity of the securities markets." Id.
The Supreme Court reversed. It held that Manhattan was a seller within the
Id. at 12, 92 S.Ct. at 169. The only limitation in the decision was the concession that Congress did not intend to regulate transactions that constitute no more than internal corporate mismanagement. The crux of the case, however, that took it out of the realm of corporate mismanagement, was that Manhattan suffered an injury "as a result of deceptive practices touching its sale of securities as an investor." Id. at 12-13, 92 S.Ct. at 169.
It appears, therefore, that the Supreme Court has severely limited the first Birnbaum requirement.
Although Bankers Life interpreted the Birnbaum requirement of a fraudulent practice in connection with purchase or sale of a security very broadly, it did not, as appellants argue, eliminate the purchaser or seller requirement. Plaintiff in Bankers Life was the Superintendent of Insurance, suing on behalf of Manhattan as its liquidator. In the alleged fraudulent scheme, it was Manhattan which sold the securities and was victimized by the fraud. There was therefore no question that Manhattan was a seller "in connection with" the sale of the securities. That, however, is not the factual situation in the present case. The four shareholder-plaintiffs were neither purchasers nor sellers of the two hundred million dollars in stock traded by Schotte through the ENB.
In Kahan v. Rosenstiel, 424 F.2d 161 (3d Cir.), cert. denied, 398 U.S. 950, 90 S.Ct. 1870, 26 L.Ed.2d 290 (1970), this court held that a private party not a purchaser or seller, seeking injunctive relief for a 10b-5 "violation" does have standing if he can establish a causal connection between the violations alleged and his injury. Id. at 173; accord, Mutual Shares Corp. v. Genesco, Inc., 384 F.2d 540 (2d Cir. 1967); Britt v. Cyril Bath Co., 417 F.2d 433, 436 (6th Cir. 1969). The rationale was premised on the policy of the Securities Exchange Act to eliminate deceptive and unfair practices in security trading and to protect the public from inaccurate, incomplete, and misleading information, and to provide the public with the opportunity to make knowing and intelligent decisions regarding the purchase or sale of securities. A suit seeking an injunction against deceptive practices in security sales would promote a free and open securities market and protect prospective purchasers and sellers. An injunction suit, as distinguished from an action for damages, will therefore, in appropriate circumstances, be permitted under the rule even though the complainant is not a purchaser or seller.
Although various courts and commentators have suggested elimination of the purchaser-seller requirement,
Numerous other cases exist in which the "purchaser-seller" language has been read flexibly. In S.E.C. v. National Securities, Inc., 393 U.S. 453, 89 S.Ct. 564, 21 L.Ed.2d 668 (1969), in its first expression involving rule 10b-5, the Supreme Court held that the action of shareholders in exchanging their shares for those of a company with which their company was merging was a "purchase" of the shares within the terms of the rule.
In Herpich v. Wallace, 430 F.2d 792, the Fifth Circuit held that a corporation had standing as a purchaser on the basis of the action of the board of directors in merely approving a merger of the corporation that would involve the purchase by the corporation of securities. It reasoned that standing to seek damages in such circumstances would further the broad antifraud purposes of section 10(b) and rule 10b-5. Id. at 809. Similarly, corporate action in liquidating its assets so that the plaintiff-shareholder was left with worthless stock has been deemed to be a "sale" for rule 10b-5 purposes. See, e. g., Dudley v. Southeastern Factor & Finance Corp., 446 F.2d 303 (5th Cir. 1971).
Plaintiffs also argue that Bankers Life and the foregoing cases expanding rule 10b-5 authorize their cause of action. We conclude, however, that permitting a cause of action to these plaintiffs would not be in keeping with the congressional purpose in enacting section 10(b); nor is it required by the interpretation in Bankers Life. When Congress enacted section 10(b), it did not contemplate the protection of every person injured by a fraudulent scheme in connection with the purchase or sale of securities. Its immediate concern was the protection of the purity of the informational system in the securities market. The broad language in Bankers Life is reconcilable with this purpose. It is not so broad, however, as to expand the class of protected persons to include these plaintiffs. Although the immediate legislative focus was to safeguard the informational atmosphere in the securities market from deceptive devices and enervating impurities, it must be acknowledged that the broader focus of the Securities Exchange Act was on protecting the investor and making the market place safe to trade. Equally disastrous to the investor would be schemes not involving misinformation but, nonetheless, directly related to the trading process, artifices leaving the investor with less than he bargained for. Thus, casting the seller who has parted with his securities but has been cheated of payment — as occurred in Bankers Life — to the vagaries of state law, the problems
Rule 10b-5's expanded zone of interests under Bankers Life would not encompass the plaintiffs' interests in this case. They did not engage in any market transactions with the defendants by which they sustained their losses. Were we to extend the provisions of section 10(b) beyond the buyer or seller relationship, we would be judicially extending the terms of the statute and creating new rights. The consequences of the view urged by plaintiffs would establish a new and amorphous body of rights and obligations heretofore unrecognized in federal jurisdiction. Buyer or seller status is indispensable in establishing liability for damages under rule 10b-5. Exceptional circumstances may arise in which a stockholder might have a cause of action due to fraud in connection with the stock he holds and has not sold; that situation is not before us.
Barring the plaintiffs from maintaining a private right of action is also consistent with the generally applicable rules of standing. Apart from Article III jurisdictional problems, the standing question involves rules developed by the judiciary in the exercise of self-restraint. Association of Data Processing Service Organizations, Inc. v. Camp, 397 U.S. 150, 154, 90 S.Ct. 827, 25 L.Ed.2d 184; Barrows v. Jackson, 346 U.S. 249, 255, 73 S.Ct. 1031, 97 L.Ed. 1586 (1953). Normally, standing is accorded only where "the interest sought to be protected or regulated by the complainant is arguably within the zone of interests to be protected or regulated by the statute or constitutional guarantee in question." 397 U.S. at 153, 90 S.Ct. at 830. Because these plaintiffs are not within that zone, they have no standing to assert violations of rule 10b-5.
This conclusion is also consistent with the well established rule that injury flowing directly to the corporation does not create a primary right of action in shareholders. See United Copper Securities Co. v. Amalgamated Copper Co., 244 U.S. 261, 263, 37 S.Ct. 509, 61 L.Ed. 119 (1917); Kauffman v. Dreyfus Fund, Inc., 434 F.2d 727, 732 (3d Cir. 1970).
Plaintiffs resourcefully advance the argument that they also have a right of action under the "forced seller" concept enunciated in Vine v. Beneficial Finance Co., 374 F.2d 627 (2d Cir.), cert. denied, 389 U.S. 970, 88 S.Ct. 463, 19 L.Ed.2d 460 (1967), and its progeny, Coffee v. Permian Corp., 434 F.2d 383 (5th Cir. 1970), and Dudley v. Southeastern Factor & Finance Corp., 446 F.2d 303 (5th Cir.), cert. denied sub nom. McDaniel v. Dudley, 404 U.S. 858, 92 S.Ct. 109, 30 L.Ed.2d 101 (1971). These cases are inapposite.
In Vine, a Class A stockholder of Crown Finance Company, Inc., sued Beneficial Finance Co., Inc. He alleged that Beneficial acted in concert with the officers and directors of Crown to defraud its Class A stockholders by appropriating for Class B stockholders $900,000 which should have gone to Class A stockholders and by merging Crown into Beneficial for $800,000 less than fair market value. Beneficial effected the merger by acquiring 95 percent of the Class A shares through a tender offer and then, pursuant to state law, forcing the remaining minority stockholders to sell their shares for cash. The district court dismissed the complaint, holding the plaintiff was not a seller under rule 10b-5. The Second Circuit reversed, notwithstanding that plaintiff had not yet tendered his shares. The court reasoned that the corporation was at that point non-existent
In Coffee, a minority shareholder claimed that his corporation had been substantially liquidated solely for the benefit of its 80 percent corporate stockholder. The district court dismissed a 10b-5 claim on the ground that plaintiff lacked standing because he was not a purchaser or seller. The Fifth Circuit, in an opinion written by visiting Judge Adams of this Circuit, reversed, holding that plaintiff's averments were sufficient to demonstrate standing as a seller, because, by virtue of the liquidation, his shares were converted into a claim for cash.
In Dudley, a shareholder in Southeastern Factor and Finance Corporation (SEFAF) sued the corporation, certain of its principals, its shareholders, and other corporations. He alleged that SEFAF's board of directors had adopted a fraudulent plan for the liquidation in which SEFAF's only substantive asset, its stock in First American Life Insurance Company, was to be traded for stock of Atlantic Services, Inc., which stock would be distributed to SEFAF's shareholders. The distribution of Atlantic stock was made but plaintiff received none of the shares. The district court dismissed the complaint on the ground that the plaintiff was not a purchaser or seller and therefore lacked standing. The Fifth Circuit, following Coffee, reversed, holding that the plaintiff-shareholder was a "forced seller" because his "investment in a going enterprise has been commuted into a right . . . to a payment of money." 446 F.2d at 308.
Each of these "forced seller" cases possesses elements not present in the case before us. In each case, the majority shareholders of a corporation or other insiders were taking advantage of its minority shareholders. In each, the fraudulent scheme was an integral part of the forced sale and the transaction attacked. In each, the fraudulent scheme was directly related to and in connection with the forced sale. On the other hand, in this case the purpose of Schotte and the brokers was not to achieve a forced sale of the bank stock. The alleged fraud of the brokers was not in connection with the putative "forced sale" in the bank liquidation. Plaintiffs do not allege a federal securities law violation in connection with the "forced sale" in the bank liquidation. Their complaint is directed to alleged fraud of the brokers against ENB before they became "forced sellers" by virtue of the liquidation. To the extent that they are or may become forced sellers, it is only because of internal corporate management or of possible 10b-5 fraud imposed upon ENB as a corporate entity. Under these circumstances, we do not believe the broad purpose of the Act would be served by extending standing to these plaintiffs. Granting standing to them might confer standing to sue as "forced sellers" upon shareholders in any corporation in bankruptcy because of an unfortunate securities transaction. No case has gone so far, and we decline to do so.
b. The Purchase of ENB Shares
The complaint also alleged a scheme to defraud in connection with the purchase by plaintiffs of ENB stock. In determining whether the district court was correct in finding insufficient the allegations connecting the brokers to the sale of ENB shares, it is necessary to examine, first, what the connection was, second, whether the brokers owed any independent duty to disclose Schotte's scheme, and finally, whether the brokers were closely enough connected to the scheme to be liable as aiders and abettors of Schotte.
The complaint alleges that the brokerage firms employed a scheme to defraud the ENB shareholders "in connection with the purchase of shares of the Eatontown National Bank by the plaintiff
The district court noted that the only revelation at depositions elaborating upon these alleged affirmative misrepresentations was by plaintiff Landy, to the effect that the named brokers never volunteered to him that they were doing with the bank. Landy never asked if they were, and the brokers never made any statements concerning the general nature of their activities.
The plaintiffs do not, on appeal, argue that in fact there was a closer connection between the sale of ENB shares and the brokers' activities. Instead, they argue that the brokers had a duty to disclose the illicit operations and that their silence was an integral part of Schotte's scheme to defraud them in the purchase of their ENB shares.
They argue that the definition in the Bankers Life case of the rule 10b-5 "in connection with" requirement mandates the conclusion that the brokers are liable to the shareholders in this case.
It is established that, in a case facing disposition on a motion to dismiss, the facts alleged in the complaint must be accepted as true. Kahan v. Rosenstiel, 424 F.2d 161, 164 (3d Cir. 1970). F.R.C.P. 12(b), however, provides that if a motion is made asking that the complaint be dismissed for failure of the pleadings to state a claim upon which relief can be granted, and matters outside the pleadings are presented to the court, the motion shall be treated as one for summary judgment under Rule 56, and parties shall be given reasonable opportunity to present all pertinent material. Under Rule 56(c) a party is entitled to summary judgment if there is no genuine issue as to any material fact and judgment is warranted as a matter of law. Rule 56(a) provides that an adverse party may not rest upon mere allegations in his pleading but must set forth specific facts. Thus, in this case, although the formal pleadings would appear to raise an issue of fact as to the brokers' connection with the sale of ENB shares, it is apparent from the depositions that no factual issue exists. Therefore, the question whether liability arises for fraud in connection with the purchase of ENB stock can be decided upon the supplemental factual pleadings. Schwartz v. Associated Musicians, Local 802, 340 F.2d 228 (2d Cir. 1964). There is no indication on appeal that plaintiffs desired to or could produce additional relevant evidence.
As we have already noted, Bankers Life expanded the coverage of rule 10b-5 over fraud "in connection with the purchase or sale of securities." It
A scheme deliberately calculated to manipulate the market value of a stock would be covered under the rule. Crane Company v. Westinghouse Air Brake Company, 419 F.2d 787 (2d Cir. 1969); SEC v. North American Research & Development Corp., 280 F.Supp. 106 (S.D.N.Y.1968). This follows easily from the language of the rule and from its purpose to protect investors. Annot., 3 ALR Fed. 819, 822. No such intent on the part of the brokers to manipulate ENB share prices, however, has been alleged in this case.
Notwithstanding the absence of such an intent, a scheme may be proscribed by rule 10b-5 if it includes misrepresentation which may reasonably be relied upon by the average investor in purchasing or selling the securities in question. Heit v. Weitzen, 402 F.2d 909, 913 (2d Cir. 1968); S.E. C. v. Texas Gulf Sulphur Co., 401 F.2d 833, 839 (2d Cir. 1968). This proposition also is not readily applicable to this case, since the allegations, at this stage, are not that the brokers did something upon which plaintiffs relied or could reasonably have relied, but, rather, that the brokers did not affirmatively inform plaintiffs that they were buying and selling securities for Schotte, which failure influenced plaintiffs' purchases and sales of ENB stock. The affirmative acts of the brokers in consummating the transaction were not committed in connection with the purchase of ENB shares. The relationship between the two is remote, and no stretch of the imagination suggests that plaintiffs relied upon these acts in their purchase of ENB shares.
Plaintiffs rely on Brennan v. Midwestern United Life Insurance Co., 417 F.2d 147 (7th Cir. 1969), for authority that 10b-5 imposes a duty to disclose information relating to deceptive practices in connection with securities purchases. Brennan, however, should be distinguished. In Brennan, Midwestern Life had failed to disclose what it knew about fraudulent trading in its stock by a broker (Dobich), even though customers of the broker had made inquiries of Midwestern regarding the very matter. Instead of disclosure, Midwestern merely referred the customers to the broker or suggested that they pursue the matter with the Indiana Securities Commission. In the case now before us there were no specific requests or inquiries by plaintiffs of the brokers relating to the trading by the ENB. It is notable that the court in Brennan relied on silence after specific inquiry plus affirmative costs:
Id. at 154. Brennan, too, was premised on a theory of aiding and abetting the primary violator of rule 10b-5. The applicability of an aiding and abetting theory to this case is discussed below.
In the absence of a special relationship between the parties, no case has come to our attention imposing liability on the basis of "mere inaction." There
In Wessel v. Buhler, 437 F.2d 279, 283 (9th Cir. 1971), the court rejected the very argument proffered here. It refused to impose liability upon accountant Jordan based upon mere inaction. Jordan had been retained by Rocky Mountain Chemical Corporation (RMC) to prepare three financial statements for specific, narrow purposes. RMC, unaided by Jordan, published a misleading prospectus which plaintiffs allegedly relied upon in purchasing RMC stock. They sought to impose liability upon Jordan for their losses on the ground that he owed a duty to prospective investors to disclose his knowledge of RMC's deficient financial records. In rejecting "this extraordinary theory," the court noted that the only mention in rule 10b-5 of liability for inaction is subsection (2) making it unlawful "to omit to state a material fact necessary in order to make the statements made . . . not misleading." [Emphasis added.] Also finding nothing in the congressional purpose underlying the Securities Exchange Act to justify imposition of liability, it concluded:
Nor has 10b-5 liability under an aiding and abetting theory been sufficiently alleged. Liability for aiding and abetting Schotte in his misstatements was not alleged in the complaint but was treated by the district court and argued on appeal. The district court treated the allegation by saying:
In analyzing this question, it is helpful to examine common law concepts of civil liability for aiding and abetting. Under subsection (b), section 876, Restatement of Torts, a person is liable for harm resulting to a third person if he:
Three elements are thus required for liability: (1) that an independent wrong exist; (2) that the aider or abettor know of that wrong's existence; and
The requirement of an independent wrong is no problem in this case, since plaintiffs have alleged a classic 10b-5 violation in their charge that Schotte caused the corporation to issue materially false statements upon which the plaintiffs relied in making their purchases.
The complaint is somewhat ambiguous on the question whether the brokers had knowledge of Schotte's scheme relating to the false financials. It does, however, allege that the brokerage firms knew from the volume of trading, the improper manner in which the account was handled, the instructions as to secrecy, and from personal and direct knowledge of the affairs of the bank, "that said accounts were part of a device and scheme to defraud the shareholders of the Eatontown National Bank." Some question exists as to whether this allegation is sufficient to fulfill the knowledge requirement,
Assuming arguendo sufficient knowledge, we do not believe there is sufficient allegation of assistance by the brokers to Schotte in his misleading the shareholders. It is helpful to begin by analyzing the extent of any assistance. The omission of the substance of the brokerage transactions made the financial statements false or misleading. The brokers' assistance consisted only of handling Schotte's stock purchases and sales. The brokers could reasonably foresee that Schotte would not reveal his misconduct in the corporation's financial statements. Plaintiffs, thus, would premise liability on these facts which would equate "substantial assistance" with a business transaction (stock purchases and sales), which foreseeably permits one of the parties to it (Schotte) to independently engage in illegal action as to other parties (plaintiffs).
The Restatement does not define with specificity the concept of "substantial assistance" but explains that
Restatement of Torts § 436. The Restatement suggests that in determining if the assistance is substantial enough to make an individual liable for the act of another, the relevant factors are: (1) the amount of assistance given by the defendant; (2) his presence or absence at the time of the tort; (3) his relation to the other person; and (4) his state of mind. In this case, it would appear that the amount of assistance given by the brokers was minor. The brokers were not present at the time of the fraud. As the district court pointed out, they were not involved in any manner with the sale of the Eatontown shares or the actual making of any misrepresentations. The "state of mind" criterion would also suggest no liability. Their assistance, although necessary for the accomplishment of Schotte's fraud, was intended to achieve another independent goal — the generation of commissions.
The concept of aiding and abetting applied in the criminal law context is also instructive. In Nye & Nissen v. United States, 336 U.S. 613, 619, 69 S.Ct. 766, 769, 93 L.Ed. 919 (1949) (quoting United States v. Peoni, 100 F.2d 401, 402 (2d Cir. 1938)), the Supreme Court stated:
This principle is well established and has been recognized in this circuit. See, e. g., United States v. Barber, 429 F.2d 1394 (3d Cir. 1970). It harmonizes
2. Rule 405 Liability
Plaintiffs also alleged broker liability for violation of New York Stock Exchange Rule 405. Rule 405 in part requires member brokers to use due diligence in learning the essential facts relative to each customer, order or account.
The district court dismissed this claim on the ground that any private cause of action which may exist under the NYSE rules extended only to actual customers of the erring broker. The court also dismissed common law allegations contained in the same count for lack of a federal claim with which pendent jurisdiction could be found.
This case appears to present the first opportunity this court has had to consider the issue of whether an implied federal cause of action exists for violation of stock exchange rules. Implication of such liability is a relatively recent and still evolving phenomenon. Private suits for damages for violations of the federal securities acts and regulations thereunder have been entertained widely since J. I. Case Co. v. Borak, 377 U.S. 426, 84 S.Ct. 1555, 12 L.Ed.2d 423 (1964), but the development of implied liability for violation of exchange rules since its genesis two years later in Judge Friendly's dicta in Colonial Realty Corporation v. Bache & Co., 358 F.2d 178 (2d Cir. 1966), has been limited.
In Colonial Realty, Judge Friendly found a logical statutory basis for implying private liability for violation of some exchange rules. He noted that implication of a private right of action not expressly afforded by the Exchange Act is predicated upon explicit statutory condemnation of certain conduct, a general grant of jurisdiction to enforce liabilities created by the statute, and a duty of the courts to effectuate the federal policies embodied in the Act. Courts, thus, normally consider
Id. at 181. Securities Exchange Act § 6(b) requires all exchanges to have rules insuring proper conduct of their members in order to be registered with the SEC. This requirement forms the basis for the self-regulatory scheme established by the securities acts for national stock exchanges. Further, under § 19, the SEC retains the authority in certain areas of regulation to request modification of exchange rules and promulgate superseding rules of its own.
358 F.2d at 182. Using this standard, Judge Friendly went on to find no implied private cause of action under the exchange rules involved in Colonial Realty.
In Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135 (7th Cir. 1969), the Seventh Circuit considered the very NYSE rule at issue in this case. Plaintiff Buttrey was the trustee in bankruptcy for Dobich Securities Corporation, organized in 1963 by Michael Dobich. In December, 1963, defendant Merrill Lynch permitted Dobich to open a cash account in Dobich Securities' name, although allegedly knowing Dobich was using fraudulently converted property of Dobich Securities' customers for security transactions.
Merrill Lynch's actions allegedly violated NYSE rule 405. On the basis of the allegations, the district court stated Merrill Lynch was charged with "an almost callous disregard of Rule 405." The Seventh Circuit further characterized the actions alleged as "tantamount to fraud." Under such circumstances, the court held, an implied federal cause of action existed. Although finding, in line with Colonial Realty, that rule 405 was an integral part of SEC regulation, the court apparently adopted a different standard for determining whether a cause of action should be implied:
410 F.2d at 142. See also subsequent Seventh Circuit opinions following the same test, Avern Trust v. Clarke, 415 F.2d 1238, 1242 (7th Cir. 1969); S.E.C.
The brokers in this case argue that this court should not imply federal liability for violations of stock exchange rules, as was held in the earlier Second Circuit case of O'Neill v. Maytag, 339 F.2d 764, 770 (2d Cir. 1964). They argue exchange rules are made "of, by and for" exchange members, rather than by a legislative body or regulatory agency balancing public interests. They further argue that any implied liability will discourage stock exchanges from vigorous self-regulation, thus damaging the legislative scheme. If we do not adopt a per se rule against implied liability, the brokers argue, nevertheless, no implied cause of action should be found under rule 405 since it is strictly a "housekeeping" regulation solely for the protection of member firms.
Given the present posture of this case, we need not and therefore do not express any view as to whether federal causes of action should be implied for violation of stock exchange rules, or, if such causes of action should be imposed in some instances, what standard should be used to determine whether the specific alleged rule violation gives rise to the cause of action.
Were we to accept, on the other hand, the Second Circuit's standard, we would have further reason to reach the same result. Plaintiffs have failed in this action to maintain the burden imposed of demonstrating rule 405's "place in the [federal] regulatory scheme." There is no indication in the record that the SEC participated in its formulation or was specially interested in its enactment. We find no indication that the SEC or the NYSE consider rule 405 part of the federal scheme to prevent fraudulent practices and protect investors. Indeed, to the contrary, what evidence we have been able to find in our own research points to an opposite conclusion. See Wolfson and Russo, The Stock Exchange Member: Liability for Violation of Stock Exchange Rules., 58 Calif.L.Rev.
B. The Accountants
The complaint also asserts liability on behalf of the plaintiff-shareholders, individually and as a class, against the accountant Burt for misstatements in ENB financial statements.
In addition to the averments in the complaint, plaintiff Landy alleged in oral argument before the district court that as a director he received special reports from Burt certifying the bank's sound financial position, one of which was received shortly before the bank closed. According to the district court, it was uncontroverted that no other plaintiff had access to financial reports prepared by Burt; but plaintiffs asserted that ENB, in issuing false and misleading statements, relied upon Burt's figures. An affidavit prepared by Leonard Skillman, a Burt partner, admits that Burt prepared financials for the bank, reporting its status as of April 30, 1968, February 25, 1969, and April 7, 1970, but says that Burt did not prepare the financial information set forth in the 1968, 1969, or 1970 annual reports.
In its opinion of September 9, 1971, relying on Fischer v. Kletz, 266 F.Supp. 180 (S.D.N.Y.1967), the district court denied Burt's motion to dismiss the claim against the accountants because the claim incorporated charges of false and misleading representations to the investing public resulting from gross negligence.
Plaintiffs argue on this appeal that it was foreseeable that Burt's reports "would be used as the basis for year-end and other periodic financial statements prepared by the management of Eatontown and distributed regularly to its shareholders." The record, however, does not establish that Burt knew or expected that its financial reports would be exhibited to purchasers or sellers of ENB stock. The initial agreement by which Burt was engaged by the bank, dated March 4, 1968, indicated that it was to perform a "directors examination."
None of the directors' reports was made in a manner reasonably calculated to influence the investing public. There is no proof that any were disseminated to the public or that any investor saw them except for Landy, a director and counsel for the bank. Burt delivered the reports to the bank directors for uses unconnected with stock issuance and there is no proof that anyone else saw them. We decline to extend rule 10b-5 to cover Burt's statements by finding them "in connection with the purchase or sale of any security."
Our conclusion is supported by Wessel v. Buhler, 437 F.2d 279 (9th Cir. 1971). In that case, the Ninth Circuit followed the test set forth in S.E.C. v. Texas Gulf Sulphur Co., 401 F.2d 833, 862 (2d Cir.
The Ninth Circuit also rejected the contention that liability attached because the accountant knew or should have known that his statements would be used by the corporation in preparing the prospectuses that the corporation published and on which plaintiffs relied. Judge Hufstedler noted that some of the figures from the accountant's financial statements appeared in the prospectus, along with other figures, but emphasized the absence of proof that the accountant had anything to do with the preparation of the prospectuses. As in Wessel, the facts in this case do not indicate that anyone other than Landy or other corporate officials saw the statements prepared by Burt and there is no evidence that Burt participated in the preparation of the published financials.
Fischer v. Kletz, 266 F.Supp. 180 (S.D.N.Y.1967), relied on by plaintiffs, although intimating that liability might attach if the accounting firm in question assists or encourages the corporation in the public use of inaccurate financials prepared by someone else, held that liability did not attach from mere knowledge that the statements issued by the corporation were inaccurate, where the accountant had not participated in any manner in preparation of the financials. Id. at 195. We do not have in the case sub judice any allegation of substantial assistance by Burt in the preparation of financials issued by Eatontown.
To the extent that the "in connection with" requirement narrows liability to less than the foreseeable class of injured persons, rule 10b-5 liability is constricted to a smaller field than common law liability. The common law extends a defendant's liability for "fraud" to all those persons whom he should reasonably have foreseen would be injured by his misrepresentation.
There is little question that reliance was an essential element of liability under common law theories of fraudulent misrepresentation. The requirement of reliance is well-established. See, e. g., W. Prosser, Law of Torts § 108 (1971). The Restatement of Torts § 531 expressly limits liability for a misrepresentation to "persons only for the pecuniary harm suffered by them by relying upon it in the transaction . . . in which the maker intended to influence their conduct." [Emphasis added.] A proposed revision of this section does not eliminate the reliance requirement. Restatement of Torts § 531 (Tent. Draft No. 10, 1964), discussed in 41 ALI Proceedings 490 (1964). See Ruder, supra note 17, at 614.
This court has indicated that reliance is necessary under rule 10b-5. See Gottlieb v. Sandia American Corp., 452 F.2d 510, 516 (3d Cir. 1971), aff'g, 304 F.Supp. 980, 992 (E.D.Pa.1969); Kohn v. American Metal Climax, Inc., 458 F.2d 255, 269 (3d Cir. 1972). As Judge Adams, dissenting in Kohn on other grounds, stated:
458 F.2d at 288. That conclusion accords with precedents established in other circuits. Chasins v. Smith, Barney & Co., 438 F.2d 1167 (2d Cir. 1970); Rogen v. Illikon Corp., 361 F.2d 260, 266-268 (1st Cir. 1966); List v. Fashion Park, Inc., 340 F.2d 457, 463 (2d Cir.), cert. denied, 382 U.S. 811, 86 S.Ct. 23, 15 L.Ed.2d 60 (1965); Kohler v. Kohler Co., 208 F.Supp. 808, 823 (E.D.Wis. 1962), aff'd, 319 F.2d 634 (7th Cir. 1963).
The depositions in this case revealed that none of the plaintiffs except for Landy ever saw any of the reports prepared by Burt. They have therefore failed to support their allegation of an essential element of their cause of action under rule 10b-5. Since Burt's reports to the directors were not prepared for or disseminated to the public or the stockholders, the presumption of reliance sometimes used in other circumstances when a statement is material is inapplicable here. See Bromberg, supra, § 8.6(2); Kohn v. American Metal Climax, Inc., 458 F.2d 255, 269 (3d Cir. 1972). Although such a presumption might apply to the annual reports issued by ENB, as already noted, Burt did not participate in their preparation.
KALODNER, Circuit Judge (concurring in part and dissenting in part):
I would affirm in all respects the dispositions of the District Court.
That being so, I agree with the result reached by the majority insofar as its affirmance aspects are concerned. I dissent, however, from the majority's disposition insofar as it provides that the "portion of the order dismissing the derivative counts against the brokers not named in the FDIC suit, the Elizabeth Bank, the Reserve Bank, the NYSE, Schotte, and the FDIC as receiver will be vacated," and "we remand those counts to the district court for further consideration."
The majority premises its stated vacation and remand on the circumstance that:
The FDIC suit, referred to by the majority, was filed February 8, 1972 — five months after entry of the September 9, 1971 Order here under review.
An appellate court's review of a challenged district court order is limited to the record as it existed when the district court entered it. To hold otherwise is to open a Pandora's Box.
As the majority has noted, we specifically held in Jaconski v. Avisun Corporation, 359 F.2d 931, 936 n.11 (3 Cir. 1966) that:
See too, Dictograph Products Company v. Sonotone Corporation, 231 F.2d 867 (2 Cir. 1956), petition for certiorari dismissed by stipulation, 352 U.S. 883, 77 S.Ct. 104, 1 L.Ed.2d 82 (1956).
Rule 10(a) "Federal Rules of Appellate Procedure," 28 U.S.C.A., provides:
The doctrine of judicial notice, at the appellate level, may permit recognition of the filing of an action subsequent to entry of a challenged district court order, but it does not operate to make such filing a critical or dispositive factor in determining whether the district court's order was in error. The authorities cited by the majority are not to the contrary.
The majority errs in its view that "[n]either Jaconski nor Dictograph Products Company, however, involved the right of an appellate court to take judicial notice of developments in the proceeding since the appeal was lodged." (emphasis supplied).
The majority's error is two-fold in nature.
Second, the majority has failed to discern that in both Jaconski and Dictograph Products Company, supra, the developments occurred after the district court's decision.
In Jaconski, supra, the district court dismissed the action for lack of jurisdictional amount on April 8, 1965. Notice of appeal was filed on May 3, 1965, and on that day plaintiff filed a deposition, taken in April 1963, which purported to establish that the plaintiff's damages were in excess of the required jurisdictional amount.
In Dictograph Products Company, supra, the district court's judgment was entered on May 23, 1955, and plaintiff filed an appeal on May 26, 1955. Thereafter, plaintiff sought to introduce "new evidence" by way of a deposition which had not been presented to the district court prior to its decision.
In refusing to consider the "new evidence" the Second Circuit said:
The majority errs in citing 31 C.J.S. Evidence § 13, at 842 (1964), in support of its holding that an appellate court may take judicial notice "of new developments not considered by the lower court." (emphasis supplied).
The cited section affords no nourishment to the majority's stated view, since it does not relate to developments occurring after the district court had rendered its decision.
The majority has failed to consider or discuss 31 C.J.S. Evidence § 50(2), at 1026-1027 (1964), which specifically states that an appellate court will not take judicial notice "of facts occurring subsequently to the judgment or order appealed from."
This, too, must be said:
There is no justification for the majority's transgression of permissible limits of judicial review in the instant case inasmuch as affirmance of the District Court's disposition would not foreclose appellants' future submission to the District Court of an appropriate application to institute derivative actions against those not named as defendants in the FDIC suit.
The district court further certified that his interlocutory orders denying dismissal of Counts 1, 2 and 34 involved controlling questions of law, pursuant to 28 U.S.C. § 1292; but the FDIC does not now appeal the denial of its motion to dismiss plaintiffs' complaint against it, and Burt does not appeal the denial of summary judgment as to Mr. Landy.
In Bankers Life, the Court reasoned that "misappropriation", as there involved, was actually the "garden type" referred to in Birnbaum as compared to the scheme in Brod. 404 U.S. at 11 n. 7, 92 S.Ct. at 168. The Court also relied upon two other cases giving rule 10b-5 a broad application. Allico National Corp. v. Amalgamated Meat Cutters & Butcher Workmen, 397 F.2d 727 (7th Cir. 1968); Cooper v. North Jersey Trust Co., 226 F.Supp. 972 (S.D.N.Y.1964). Id.
In a recent case, Bush v. Masiello, 55 F.R.D. 72 (S.D.N.Y.1972), the court held that the complaint stated a good 10b-5 cause of action with allegations that officers of a broker-dealer converted corporate funds in connection with the purchase and sale of securities.
The rationale behind Congress' establishment of this system of supervised self-regulation was a belief that the SEC would lack the resources to undertake total regulation itself. See SEC, Report of Special Study of Securities Markets, H.R.Doc.No.95, 88th Cong. 1st Sess. 501 (1963).
Nevertheless, implication of liability should be done reluctantly for the following reasons: first, accurate evaluation of the degree to which any particular rule represents SEC policy is often difficult, if not impossible, see articles cited note 22 supra; second, imposition of liability might chill the process of self-regulation by creating fear of damaging liability; and, finally as appellees argue, exchange rules are not promulgated by a government body after careful deliberation and weighing of the variegated competing public interests. We believe Congress intended to encourage self-regulation to invoke higher standards than could feasibly be implemented by Congress or the SEC, and we should tread carefully before interfering with that scheme.
Under this suggested standard, it would seem no liability should be implied in the present case. No specific SEC regulation led to the promulgation of rule 405, nor does the rule seem to fall within the enumerated categories under § 19(b), 15 U.S.C. § 78s(b).
The reports to the directors were based on surprise inspections on April 30, 1968, February 25, 1969, and April 7, 1970, unrelated in time or purpose to the annual or public reports.
We do not rely, however, on the complaint's failure to allege fraud because such an allegation was apparently made at some stage in the district court proceedings. The district court, in denying both the motion for summary judgment and the motion to dismiss the complaint against Landy, indicated it was relying on an allegation of "gross negligence." On appeal, plaintiffs allege that Burt's conduct amounted to fraud because Burt pretended knowledge of the financial condition of ENB when in fact it had made an insufficient investigation to know the condition. (Appellants' Brief at 47, 50.) As we do not affirm the grant of summary judgment for Burt on the grounds the complaint did not allege fraud, we need not determine whether the allegations actually made were sufficient because the conduct averred was "tantamount to fraud." See Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135, 143 (7th Cir. 1969); Kohn, 458 F.2d at 286.
31 C.J.S. Evidence § 50(2), at 1026-1027 (1964) (footnotes omitted) (emphasis supplied).