Overstock.Com, Inc. v. Goldman Sachs & Co.

Decision Date13 November 2014
Docket NumberA135682
Citation231 Cal.App.4th 513,180 Cal.Rptr.3d 269
CourtCalifornia Court of Appeals Court of Appeals
Parties OVERSTOCK.COM, INC. et al., Plaintiffs and Appellants, v. GOLDMAN SACHS & CO. et al., Defendants and Respondents.

Certified for Partial Publication.*

Theodore A. Griffinger, Jr., Ellen A. Cirangle and Jonathan E. Sommer and Lubin Olson Niewiadomski LLP and Myron Moskovitz for Plaintiffs Overstock.com, Inc. et al.

Joseph Edward Floren and Morgan, Lewis & Bockius LLP for Defendants Goldman Sachs & Co. et al.

Matthew David Powers, Andrew J. Frackman and Abby F. Rudzin and O'Melveny & Myers LLP for Defendants Merrill Lynch, Pierce Fenner & Smith, Inc. et al.

Banke, J.

I. INTRODUCTION

Often, it is the federal courts, applying federal law, that wrestle with claims of cross-state securities fraud involving a nationally listed stock. Here, plaintiffs of various states allege defendants, securities firms headquartered on the East Coast, violated California and New Jersey laws through their involvement in massive ‘‘naked short selling’’ of Overstock.com, Inc. shares. The trial court sustained demurrers to plaintiffs' New Jersey Racketeer Influenced and Corrupt Organizations Act (RICO; 18 U.S.C. § 1961 et seq. ) claim without leave to amend and subsequently granted summary judgment to defendants on plaintiffs' California market manipulation claims.

We affirm the dismissal of the belatedly raised New Jersey RICO claim. We also affirm the summary judgment as to three of the four defendants, but reverse as to Merrill Lynch Professional Clearing Corporation. The evidence, although slight, raises a triable issue this firm effected a series of transactions in California and did so for the purpose of inducing others to trade in the manipulated stock. In reaching this disposition, we conclude Corporations Code section 25400, subdivision (b), reaches not only beneficial sellers and buyers of stock, but also can reach firms that execute, clear and settle trades. However, as we further explain, such firms face liability in a private action for damages only if they engage in conduct beyond aiding and abetting securities fraud, such that they are a primary actor in the manipulative trading.

II. FACTUAL AND PROCEDURAL BACKGROUND

Plaintiffs are Overstock.c om, Inc., an online retailer, and seven of its investors. In their fourth amended complaint, plaintiffs alleged defendants intentionally depressed the price of Overstock stock by effecting "naked short sales"--that is, sales of shares the brokerage houses and their clients never actually owned or borrowed. This practice, and specifically perpetuating the naked short positions by means of exotic trading schemes, allegedly increased the apparent supply of the stock, led to a "pile on" of further short sales, and thereby decreased the stock's value--including the value of shares plaintiffs sold. Plaintiffs claimed defendants' conduct violated Corporations Code sections 25400 and 25500,1 Business and Professions Code sections 17200 and 17500,2 and New Jersey's RICO statute ( N.J.Stat.2C:41-2(c)-(d) ). To put plaintiffs' allegations and the nature of the evidence proffered during the summary judgment proceedings in context, we start with an overview of how securities transactions unfold, naked short sales, and the Security and Exchange Commission's (SEC) efforts to prohibit abusive short selling.

A. Steps in a Securities Transaction

Securities transactions involve a number of steps. These include, among others, executing a trade order, clearing a trade, and settling a trade. (See generally Minnerop, Clearing Arrangements (2003) 58 Bus. Law. 917, 919 (Minnerop ); 17 C.F.R. § 240.11a2-2(T) (2014).)

Execution is the process of reaching agreement on the terms of a transaction. This includes, for a buyer, not only finding the best price, but also choosing the right seller given the size of the order, the nature of the security being traded, and the costs and fees associated with the trade. (See Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc. (3d Cir.1998) 135 F.3d 266, 270 & fn. 2.) Execution can be accomplished manually or automatically by computer. (See Domestic Securities, Inc. v. S.E.C. (D.C.Cir.2003) 333 F.3d 239, 243 [in the NASDAQ marketplace, buyers and sellers can automatically execute trades against quoted prices].)

Upon execution, "the actual transaction has only begun. Thereafter, several steps must be taken to complete the course of dealing. These steps are typically the responsibility of a clearing agency..." associated with a given stock exchange. ( Bradford Nat. Clearing Corp. v. Securities and Exchange Commission (D.C.Cir.1978) 590 F.2d 1085, 1091, fn. 2 ( Bradford ).) "The clearing agency has three functions. First, the agency ‘compares’ submissions of the seller's broker with those of the buyer's to make sure that there is a common understanding of the terms of the trade. Following this process, the resulting ‘compared trade’ is ‘cleared.’ Most simply, this amounts to the clearing agency advising the selling and buying brokers, respectively, of their delivery and payment obligations." ( Ibid. )

"The final, ‘settlement,’ stage in the process involves the delivery of securities certificates to the purchasing broker and the payment of money to the selling broker.

Modernization of this task has led to storage of most stock certificates in a depository affiliated with the clearing agency. Thus, ‘delivery’ amounts to a bookkeeping entry that removes the security from one account and places it in another." ( Bradford, supra, 590 F.2d at p. 1091, fn. 2 ; see Poser, The Stock Exchanges of the United States and Europe: Automation, Globalization, and Consolidation (2001) 22 U. Pa. J. Int'l Econ. L. 497, 514.)

Some firms, known as clearing firms, specialize in postexecution, "back office" clearing and settling of trades in conjunction with the appropriate clearing agency, in which the clearing firm is a "participant." Such firms may provide these services to "introducing" brokerage firms on a fee-for-service basis.3 ( Dillon v. Militano (S.D.N.Y. 1990) 731 F.Supp. 634, 636-637 ; Branson, Nibbling at the Edges--Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule (2009) 65 Bus. Law. 67, 91 ; see 15 U.S.C. § 78c(a)(23)-(24) [defining clearing agency and participant].) Their services tend to include extending credit in margin accounts; providing written confirmation of executed orders to customers; receiving or delivering funds or securities from or to customers; maintaining books and records that reflect transactions, including rendering monthly or periodic statements of account to customers; providing custody of funds and securities in customer accounts; clearing and settling transactions effected in customer accounts. (Minnerop, supra, 58 Bus. Law. at p. 919.)

B. The Parties

Overstock sold shares in May and December 2006 through public offerings arranged by a San Francisco firm, W.R. Hambrecht + Co. The other seven plaintiffs are individuals who sold Overstock shares in 2004, 2005, and 2006.

There are four defendants, two related "Goldman" entities and two related "Merrill" entities. Their ordinary activities can be understood with reference to the stages in a securities transaction discussed above.

Goldman, Sachs & Co. (hereinafter Goldman Brokerage) executes, clears, and settles securities transactions. Its operations are centered in New Jersey and New York. In some cases, Goldman Brokerage performs execution, clearance, and settlement for a single transaction. In other cases, its clients execute elsewhere and Goldman Brokerage provides only clearance and settlement services. Goldman Brokerage also houses a securities lending department which procures and supplies stock associated with certain transactions, including, as explained below, short sales. In this case, Goldman Brokerage's execution of certain client trades and its own purchase of certain securities in connection with its securities lending business are primarily at issue.

Goldman Sachs Execution & Clearing, L.P. (hereinafter Goldman Clearing), likewise executes, clears, and settles securities transactions. It is an SEC-registered broker-dealer and a member of the National Securities Clearing Corporation. It is headquartered in New Jersey and has significant operations there, and in New York and Chicago. It offers its clearing services to other SEC-registered broker-dealers, hedge funds, and institutions. In this case, Goldman Clearing's clearing and settlement services are primarily at issue.

Merrill Lynch, Pierce Fenner & Smith Inc. (hereinafter Merrill Brokerage), like its Goldman Brokerage counterpart, provides various investment services and runs a stock lending department that borrows and lends securities. This department conducts its borrowing, lending, and related transactional activity in New York and Illinois. As with Goldman Brokerage, it is Merrill Brokerage's trade execution and lending operations connected to naked short sales that are primarily at issue.

Merrill Lynch Professional Clearing Corp. (hereinafter Merrill Clearing), like its Goldman Clearing counterpart, provides various investment services and is an SEC-registered broker-dealer and a member of the National Securities Clearing Corporation. Merrill Clearing is a wholly owned subsidiary of Merrill Brokerage. It is headquartered in New York and has a substantial presence in New Jersey and Illinois. It also has a San Francisco customer service office. Merrill Clearing offers only limited execution services, and most Merrill Clearing clients execute their own trades. Merrill Clearing uses Merrill Brokerage to procure stocks needed to settle (or close out) a transaction. As with Goldman Clearing, Merrill Clearing's clearing and settlement operations are primarily at issue here.

C. "Naked" Short Selling

In a short sale, the seller sells stock the seller does not own....

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