WINTER, Chief Judge.
Raizy Levitin brought this action on behalf of herself and a class of all others who engaged in short sales through accounts with PaineWebber, Inc. ("PW") after August 1992. Levitin claims that PW violated Section 10(b) of the Securities and Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78j(b), and New York law when PW realized profits from collateral securing her short sale transactions and failed to inform her of those profits or to remit them to her. Judge Chin dismissed her federal claims and declined to exercise supplemental jurisdiction over her state law claims. See Levitin v. PaineWebber, Inc., 933 F.Supp. 325 (S.D.N.Y.1996).
We hold that the failure to disclose profits on the posted collateral does not violate federal law because: (i) a reasonable investor would know that collateral securing short sale transactions could produce income; (ii) PW's failure to disclose profits from the use of such collateral did not constitute concealment of its misuse under state law of Levitin's property; and (iii) Levitin has not alleged any injury from PW's failure to disclose that it might negotiate with large investors remittance of some of the profits from their collateral. We therefore affirm the dismissal of Levitin's federal claims.
A. "Short Sales"
In 1994, Levitin signed a margin agreement and set up a trading account with PW, a registered broker-dealer. Thereafter, she engaged in a series of "short sales." "Short sale" is a term of art for well-established securities trading practices.
Short sales are extremely risky. If the price of the stock increases, the customer must cover by using funds in excess of the proceeds from the sale. Because the price of a stock may increase very substantially, the potential losses associated with uncovered short sales are also very substantial.
The amount of security required is not entirely a matter for negotiation between broker and customer. The collateral posted must satisfy federal margin requirements associated with short trades. For short sales
There is one further complication. Where the broker borrows the stock from external sources, the broker must secure the loan with collateral equal to at least 100 percent of the market value of the securities borrowed. See Reg. T, 12 C.F.R. § 220.12(c).
Again typically, a customer's account may involve a number of different kinds of investments and the posting of collateral for some or all of them. There may also be funds in a customer's account that are not posted as collateral or otherwise committed. The broker may, or may not, offer interest on such "free balances" through money market accounts. See Rule 15c3-2, 17 C.F.R. § 240.15c3-2 (addressing broker obligations with respect to customer free credit balances); Norman P. Singer, SEC No-Action Letter, 1979 WL 14184 at *1 (July 12, 1979) ("Inasmuch as no NYSE or Commission rule prohibits or explicitly mandates the payment of interest on customer credit balances and monies generated from the lending of customer securities, the payment of such interest is a matter for negotiation between the customer and the broker-dealer."). Customer accounts with brokers are generally not segregated, e.g. in trust accounts. Rather, they are part of the general cash reserves of the broker. See Rule 15c3-2 (requiring periodic statements containing notice that customer funds "are not segregated and may be used in the operation of the business"). When a customer posts collateral for the borrowing of stock in a short sale, the collateral — like the balance in the account — remains part of the broker's general cash reserves and is used by the broker in transactions that it hopes will generate profits. Brokers, therefore, typically earn a return on collateral that secures a short trade or other investment.
B. Levitin's Complaint
Paragraph 29 of Levitin's complaint sums up her allegations by stating that PW "borrows the customer's property, use (sic) it as it sees fit, benefits economically from such uses, and pays nothing for it." It further states that "[t]ypically, [PW] will not inform its customers of ... the interest or profits ... [PW earned] from using the customer's property." Finally, the complaint alleges that PW sometimes remits some of the money earned on collateral to "favored large customers" but does not disclose this fact to ordinary investors. Based on these allegations, Levitin asserts federal claims arising under Section 10(b) of the 1934 Act and state law claims of breach of trust, breach of fiduciary duty, breach of implied covenants of good faith and fair dealing, and violation of Article 9 of the Uniform Commercial Code ("UCC").
PW moved to dismiss on various grounds, including a failure to allege that the omissions were material, made knowingly, and were in connection with a purchase or sale of securities — all these matters being elements of a Section 10(b) violation. The district court granted the motion on the ground that the alleged violations were not in connection with the purchase or sale of securities. The court declined to exercise supplemental jurisdiction over the state law claims.
The legal theories underlying Levitin's federal claims are not clear on the face of the complaint. At oral argument, Levitin's federal claims became more defined and can be described as follows: (i) she was deceived in that she did not know that PW might earn monies from her short sale transactions in addition to the usual broker's commission, i.e., monies earned on the collateral she posted; (ii) she was deceived by PW's failure to disclose that it was misappropriating her state-law property rights in the collateral and in earnings on that collateral; and (iii) she
C. Deception as to PW's Earnings from Collateral
Levitin claims that PW's failure to disclose earnings on the collateral she posted violated Section 10(b). To state a valid claim under that section, "plaintiffs must allege, among other things, `material misstatements or omissions indicating an intent to deceive or defraud in connection with the purchase or sale of a security.'" I. Meyer Pincus & Assocs., P.C. v. Oppenheimer & Co., 936 F.2d 759, 761 (2d Cir.1991) (quoting McMahan & Co. v. Wherehouse Entertainment, Inc., 900 F.2d 576, 581 (2d Cir.1990)). A fact is material if there is "a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available." TSC Industries Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976).
In our view, the issue in the instant matter is not the importance of the omitted fact. Rather, it is whether a reasonable investor would be misled by PW's omission of the fact that PW earns (or may earn) money from collateral posted in short-sale transactions. The fatal flaw in this theory is derived from the principle that certain information is "so basic that any investor could be expected to know it." Zerman v. Ball, 735 F.2d 15, 21 (2d Cir.1984) (plaintiff assumed to have familiarity with nature of margin account); see also Basic Inc. v. Levinson, 485 U.S. 224, 234, 108 S.Ct. 978, 99 L.Ed.2d 194 (1988) ("The role of the materiality requirement is not to attribute to investors a child-like simplicity." (internal quotation marks omitted)); Dodds v. Cigna Securities, Inc., 12 F.3d 346, 351 (2d Cir.1993) (A "reasonable investor must be deemed to have some understanding of diversification and some independent view as to how much risk she is willing to undertake."); Newman v. L.F. Rothschild, Unterberg, Towbin, 651 F.Supp. 160, 163 (S.D.N.Y. 1986) ("[T]hat a market decline can precipitate a margin call" is a fact "so basic that any investor could be expected to know it." (internal quotation marks omitted)).
In the present case, the allegedly omitted fact is that PW may profit from use of the collateral posted by Levitin in a short sale transaction. However, that fact is no more than that money has a time value, and the reasonable investor simply must be held to know this. An investor who is ignorant of the fact that free cash or securities may be used to earn interest or other kinds of financial returns is simply not reasonable by any measure. Indeed, the decision to engage in short trading — or to buy common stock for that matter — is generally a decision to forgo safer interest-bearing opportunities in order to seek out higher returns, albeit at greater risk. The reasonable investor knows, therefore, that a brokerage can earn profits from funds posted with it as security for short sale transactions. Aware of the time value of money, the reasonable investor in Levitin's position also knows that the longer a short sale remains open, the more value the investor gives up by losing the opportunity to use the collateral in another way and the more profit PW can make by using the collateral.
Indeed, Levitin's agreement with PW stated that free credit balances in her account would automatically be invested in one or more money-market accounts bearing interest selected by her.
Nor is there anything in industry practice that might cause Levitin to expect a return of the time value of her collateral. The practice of broker-dealers commingling funds securing short sales
Indeed, the practice of a financial institution using money deposited with it to obtain earnings is neither unknown nor unexpected, much less nefarious. That is precisely how banks make money. Some bank accounts are not interest-bearing — e.g., most checking accounts — even though the balances in such accounts are used by banks to earn money. Even interest-bearing bank accounts — and money market accounts with brokers for that matter — do not return to the investor the amount earned but rather pay a contractual rate. None of these routine practices is regarded as deceptive or even unusual. Indeed, Levitin might as reasonably complain of PW's failure to disclose that the interest it pays to investors on money market accounts is less than that earned by PW on the amount in the account.
Levitin, therefore, is presumed to know that money has a time value and that PW would put to income-producing use any funds of hers that secured short sales. She was promised no profit or return on those funds except for the amount of decline in value of
D. Deception as to Misappropriation of Property
At oral argument, Levitin advanced a legal theory based on federal law that was not clearly set out in her brief. She argued that, under New York law, the customer is either the owner of any earnings generated from collateral or such collateral is held by PW as a fiduciary for the customer. In Levitin's view, if she owned the collateral posted for the short sale or it was held in trust for her, she would be legally entitled to profits earned on it under New York law. If that is the case, PW's non-disclosure of earnings from the collateral and retention of those earnings was arguably material under Section 10b in that it failed to inform Levitin of facts that would alert her to a violation of her rights under New York law. This omission would allegedly support a federal Section 10b claim under the so-called loss of state law remedies doctrine. See Goldberg v. Meridor, 567 F.2d 209, 221 (2d Cir.1977); RCM Securities Fund, Inc. v. Stanton, 928 F.2d 1318, 1327 n. 2 (2d Cir.1991); cf. Scott E. Jordan, Loss of State Claims as a Basis for Rule 10b-5 and 14A-9 Actions: The Impact of Virginia Bankshares, 49 Bus. Law. 295, 313-14(1993).
Levitin bases her state law ownership claims on Article 9 of the UCC, N.Y. [U.C.C.] Law § 9-207. Section 9-207(2)(c) of the UCC provides that absent a contrary agreement, profits realized from collateral while in the secured party's possession belong to the debtor. Levitin claims that Section 9-207 governs the collateral she deposited in her PW margin account. PW argues that the extensive federal regulation of short sales and margin preempt any such application of Section 9-207.
Article 9 of the UCC contains its own "reverse preemption" clause. The Article explicitly does not apply
N.Y. [U.C.C.] Law § 9-104(a). We have found little authority as to the import of Section 9-104(a) in the present context. The pertinent language is broad — "such [federal] statute governs the rights of parties to ... [secured] transactions" — and would appear easily to include the detailed federal regulations governing short sales and margin that are detailed below. It is clear, however, that Section 9-104(a) at a minimum precludes the applicability of Article 9 to transactions where its application would be preempted. Arguably, therefore, Section 9-104(a) calls for analysis more sweeping than traditional preemption analysis. Because Levitin's claim cannot survive traditional preemption analysis, we do not explore further the unfamiliar ground occupied by Section 9-104(a).
We first note, however, that application of preemption analysis in the present context does little harm to federalism. Quite apart from Section 9-104(a), the established practices of short sales and margin and the UCC have peacefully co-existed for years, without any perception that the UCC governed, much less outlawed, them. Levitin cites absolutely no precedent for her state-law legal challenge to industry practices regarding the posting and use of margin. The silence surrounding the relationship of the UCC to margin transactions — until this lawsuit — itself speaks volumes about the inappropriateness of applying UCC § 9-207 to those transactions.
Federal regulation of margin transactions and broker utilization of customer funds is extensive. As a general matter, Regulation T sets forth Federal Reserve Board margin requirements, see 12 C.F.R. § 220 (credit by brokers and dealers), and Rule 10b-16 requires, inter alia, the disclosure of credit terms in margin accounts, see 17 C.F.R. § 240.10b-16. More significant, however, are Rules 15c2-1 and 15c3-2, each of which expressly permits broker commingling of customer funds and securities in certain situations, see 17 C.F.R. § 240.15c2-1 (hypothecation of customers' securities permitted with consent); 17 C.F.R. § 240.15c3-2 (commingling of customers' free credit balances permitted with notice), and Rules 15c3-1 and 15c3-3, which address broker capital and reserve requirements, see 17 C.F.R. § 240.15c3-1 (net capital requirements for broker dealers); 17 C.F.R. § 240.15c3-3 (requiring special reserve accounts to be set up for customer protection). The reserve requirements set forth in Rule 15c3-3 exist precisely because, as Levitin was informed, see Note 5, supra, customer funds are not segregated, but instead are at risk from commingling and hypothecation. In addition, the formula by which brokers calculate their reserve requirement obligations expressly includes customer free credit balances and the market value of short securities. See Rule 15c3-3a, 17 C.F.R. § 240.15c3-3a.
Short sales, too, are the subject of complex and quite technical federal regulation.
Levitin's argument would, if accepted, allow states to regulate the terms on which margin may be accepted by brokers as security, not only for short sales, but for all transactions on margin. Although UCC § 9-207 allows parties to depart from its rule by contrary agreement,
First, a state law requiring customer collateral to be segregated would be in direct conflict with Rules 15c2-1 and 15c3-2, each of which permit the commingling of customer assets subject to certain consent and notice requirements, and in implicit conflict with Rule 15c3-3, which requires brokers to set up special reserve bank accounts for the exclusive benefit of customers and to maintain balances therein according to a formula, promulgated by the SEC, that specifically contemplates the commingling of customer monies and the lending of customer securities. See Rule 15c3-3a (setting forth formula).
Limiting Levitin's theory to short sale proceeds would not alter the analysis. As Levitin's complaint alleges, "[a] short sale is a margin transaction," and nothing in federal law suggests that the proceeds of a short sale are not subject to SEC rules on margin and commingling or are otherwise to be handled differently from other customer credit balances. In fact, there would be little sense in treating the collateral in an open short position as Levitin suggests because the customer's long securities may be hypothecated or commingled and the funds held as collateral for a short sale would in any event be subject to commingling when the short sale was covered. The protection for customers from excessive risk-taking by brokers is afforded not through segregation requirements, such as UCC § 9-207 contemplates, but through detailed federal regulations of the operation of such businesses.
Second, even if Levitin's interpretation of state law were not in direct conflict with federal rules, it would nevertheless impermissibly intrude on federal regulation of broker-dealers and of margin and short sales. Regulation by the states would directly affect the very value of security posted pursuant to federal margin requirements. A secured lender who may retain earnings on collateral has more valuable security than a lender who must remit to the customer interest on the collateral. If states may regulate as Levitin contends, the effect of federal margin requirements on particular brokers and customers would depend in part on vagaries of state law.
Her argument would also enable the states to transform customers with margin accounts from the status of general creditors to that of pledgors. Such a prohibition on the commingling of margin with brokers' cash reserves would have significant consequences. Segregated trust accounts for margin transactions, or similar devices, would have to be kept so that the appropriate amount of interest would be paid to each customer and so that creditors of the broker would not be able to reach the collateral. See UCC § 9-207(1). This would alter bookkeeping, the maintenance of accounts, and the methods by which brokers are compensated for transactions on margin.
Third, the industry practices challenged here have existed for at least most of this century and pre-date the federal statutes and regulations described above. The fact that Congress, the SEC, and the Federal Reserve Board have imposed such detailed regulations on short sales and on the use of margin without requiring brokers to pay interest on collateral or otherwise segregate such funds easily supports the inference that federal law is intended to permit such practices. See note 6, supra; cf. 17 C.F.R. § 1.29 (expressly permitting merchants subject to CFTC regulation to retain interest on customer funds posted as collateral).
In view of the pervasive federal regulating scheme that explicitly permits brokers to commingle customer funds and implicitly permits them to retain earnings on collateral posted for short sales, the intrusion of Levitin's claim on the methods by which short sales and other margin transactions are undertaken, and the direct bearing of that claim on the very value of margin to brokers, we find that "Congress [has] left no room for the States to supplement" federal law. Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230, 67 S.Ct. 1146, 91 L.Ed. 1447 (1947).
We need not address whether Levitin's alternative theory of ownership — that a fiduciary duty between herself and PW entitles her to the profits realized from collateral — is preempted by federal law because it finds no support in New York law. Under New York law, "[a] broker does not, in the ordinary course of business, owe a fiduciary duty to a purchaser of securities." Perl v. Smith Barney Inc., 230 A.D.2d 664, 646 N.Y.S.2d 678, 680 (1st Dep't 1996) (finding no fiduciary duty governing broker/client relationship where broker allegedly overcharged fees in connection with nondiscretionary brokerage account (internal quotation marks omitted)). A fiduciary relationship arises "when one [person] is under a duty to act for or to give advice for the benefit of another within the scope of the relation." Flickinger v. Harold C. Brown & Co., Inc., 947 F.2d 595, 599 (2d Cir.1991) (quoting Mandelblatt v. Devon Stores, Inc., 132 A.D.2d 162, 521 N.Y.S.2d 672, 676 (1987) (quoting Restatement (Second) of Torts § 874 cmt. a)); see also Richardson Greenshields Securities, Inc. v. Mui-Hin Lau, 693 F.Supp. 1445, 1456 (S.D.N.Y.1988) ("A broker who has discretionary powers over an account owes his client fiduciary duties."). Levitin has not alleged facts establishing such a fiduciary relationship and does not claim that PW's execution of short sales were discretionary acts on her behalf. Levitin's breach of fiduciary duty allegations therefore lack merit.
E. Deception Regarding PW's Willingness to Negotiate Remittance of Earnings on Collateral
Finally, we address Levitin's claims regarding the failure of PW to disclose that some large, favored customers are able to negotiate the partial remittance of earnings on collateral posted to secure short sales. There is a fatal defect in this claim, too.
Levitin's complaint does not allege — and her brief does not purport to argue — that she is a large customer who might have negotiated a remittance. Indeed, the class she seeks to represent consists of all investors
We do not address the issues that would arise if a plaintiff were to allege that she was a sufficiently large investor who, more probably than not, could have negotiated a remittance of one size or another had she known of the possibility. There is no such allegation here, and the individual issues of causation and measure of damages would make such an action an unlikely candidate for class certification.
We therefore affirm. To the extent that our holding disposes of state claims based on an alleged state-law property right in the collateral securing Levitin's short sales, they are dismissed along with her federal claims. We affirm the district court's decision not to exercise jurisdiction over any remaining state law claims.
RMA Disclosure Documents available to Levitin provide that debits and credits occurring during the course of a day are summed, and the net debit or credit balance then is summed with the previous day's ending balance to determine the new debit or credit balance for the purpose of calculating interest. See PW's Statement of Credit Practices (issued pursuant to Rule 10b-16 and included in the Disclosure Documents). However, the Statement of Credit Practices further provides that "[c]redit balances resulting from a short sale are disregarded because this credit balance is used to collateralize stock borrowed to make delivery against a short sale." This statement would seem to inform a reasonable account-holder that proceeds from short sales do not off-set liabilities to PW for the purpose of calculating interest charges. Because interest charges are paid where there is a net liability owed to PW, the effect of not reducing the liability by the amount of the short sale proceeds is that interest is not earned on such monies.