S.E.C. v. U.S. Environmental, Inc.

• Citation: 155 F.3d 107,1998 WL 559027
• Decision Date: 25 August 1998
• Docket Number: Docket No. 97-6195
• Parties: SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellant, v. U.S. ENVIRONMENTAL, INC.; Louis J. Sepe; Maria Sepe; Castle Securities Corp.; Michael T. Struder; Leslie S. Roth; and Dudley Mihran Freeland, Defendants, John Romano, Defendant-Appellee.
• Court: United States Courts of Appeals. United States Court of Appeals (2nd Circuit)

Page 107

155 F.3d 107

SECURITIES AND EXCHANGE COMMISSION, Plaintiff-Appellant, v. U.S. ENVIRONMENTAL, INC.; Louis J. Sepe; Maria Sepe;

Castle Securities Corp.; Michael T. Struder;

Leslie S. Roth; and Dudley Mihran

Freeland, Defendants,

John Romano, Defendant-Appellee.

Docket No. 97-6195.

United States Court of Appeals, Second Circuit.

Argued April 23, 1998.

Decided Aug. 25, 1998.

Richard H. Walker, General Counsel (Jacob H. Stillman, Associate General Counsel, Lucinda O. McConathy, Assistant General Counsel, Christopher Paik, Senior Counsel, Paul Gonson, Solicitor, Securities and Exchange Commission, Washington, DC, on the brief), for Plaintiff-Appellant.

Ronald E. DePetris, DePetris & Bachrach, New York City, for Defendant-Appellee.

Before: WALKER, CALABRESI, Circuit Judges, and RESTANI, Judge. ^*

JOHN M. WALKER, Jr., Circuit Judge:

Plaintiff-appellant Securities and Exchange Commission ("SEC") appeals from the June 18, 1996 order of the United States District Court for the Southern District of New York (Peter K. Leisure, District Judge ) dismissing, pursuant to Fed.R.Civ.P. 12(b)(6), the SEC's claim that defendant-appellee John Romano engaged in market manipulation in violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b) (" § 10(b)"), and Rule 10b-5 thereunder, 17 C.F.R. § 240.10b-5 ("Rule 10b-5").

We hold that Romano can be primarily liable under § 10(b) for following a stock promoter's directions to execute stock trades that Romano knew, or was reckless in not knowing, were manipulative, even if Romano did not share the promoter's specific overall purpose to manipulate the market for that stock. We therefore vacate the order of the district court and remand for further proceedings.

Background

The following facts are taken exclusively from the SEC's amended complaint, which on a motion to dismiss at the pleading stage must be read in the light most favorable to the SEC.

Romano was employed as a trader and registered representative of defendant Castle Securities Corporation ("Castle"), a securities broker-dealer. Castle agreed to participate in a scheme whereby it and other defendants, including Romano, would manipulate upward the price of the stock of U.S. Environmental, Inc. ("USE"). At the direction of stock promoter Mark D'Onofrio ("D'Onofrio"), certain of the defendants or their nominees traded USE shares among themselves "for the purpose of creating the appearance of an actual market for trading USE shares" and thus raising USE's stock price. The complaint alleges that

Romano knowingly or recklessly participated in and furthered a market manipulation by:

(a) effecting offers, purchases, and sales of USE securities in return for promises of risk-free profit for engaging in such trades;

(b) effecting directed and controlled trades of USE securities;

(c) effecting "wash sales" and "matched orders"; and

(d) effecting trades involving undisclosed nominees.

Wash sales are "transactions involving no change in beneficial ownership" and matched orders are "orders for the purchase [or] sale of a security that are entered with the knowledge that orders of substantially the same size, at substantially the same time and price, have been or will be entered by the same or different persons for the sale/purchase of such security." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 205 n. 25, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). The complaint states further that

Romano agreed to advise D'Onofrio continuously as Castle received buy and sell orders for USE shares during each trading day. Romano agreed to execute trades as directed by D'Onofrio, and Romano also agreed to move, or adjust, the price Castle quoted for USE shares at D'Onofrio's direction. In return, D'Onofrio assured Romano that Castle would receive a profit on the transactions D'Onofrio directed.

In a typical manipulative transaction,

(a) D'Onofrio would direct a buy order from one of the ... brokerage accounts controlled by the D'Onofrio group [consisting of stock promoters Ramon N. D'Onofrio, Richard Kirschbaum, and D'Onofrio] to a market maker other than Castle;

(b) D'Onofrio would arrange in advance that the other market maker would contact Romano at Castle to buy the same number of shares;

(c) D'Onofrio would alert Romano that the other market maker would be calling Romano for stock;

(d) D'Onofrio, specifying number of shares and price, would instruct Romano to sell shares of USE to the other market maker; and

(e) D'Onofrio would supply Castle with the specified number of shares at a discount, enabling Romano to complete the transaction at a price at which both Castle and the other market maker received a risk-free profit on the transaction, as had been prearranged with Castle ... and Romano.

Romano, Castle, and the D'Onofrio group "intentionally engaged" in such "manipulative conduct ... between September 1989 and December 1989." As a result of these manipulative trades, the price of USE stock rose from $.05 to approximately $5.00 per share in this period. In June or early July 1990, Castle sold approximately 15,000 shares of USE stock to retail customers at $6.00 per share. Between September 1989 and August 1990, Castle made a profit of approximately $175,000 as a result of its market-making activity for USE.

The SEC then commenced the instant action, alleging that defendants violated various provisions of the securities laws in connection with their manipulation of USE stock and other aspects of an illegal scheme involving USE. Romano moved, pursuant to Fed R. Civ. P. 12(b)(6), to dismiss the SEC's manipulation claim under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The district court granted the motion, see SEC v. U.S. Envtl., Inc., 929 F.Supp. 168, 171 (S.D.N.Y.1996), on the sole ground that the SEC had failed to allege that Romano was a "primary violator[ ]," as required by the Supreme Court in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191, 114 S.Ct. 1439, 128 L.Ed.2d 119 (1994). Rather, the district court held that Romano was alleged only to be an aider/abettor of securities violations, because Romano "follow[ed] directions from D'Onofrio in carrying out buy or sell orders" and "did not himself make wash sales, match orders, or use undisclosed nominees to artificially affect the price of securities." U.S. Envtl., 929 F.Supp. at 170. The district court stated that "[e]ven if Romano knew that [the buyers and sellers] were D'Onofrio and undisclosed nominees of D'Onofrio, and hence knew that D'Onofrio was manipulating USE stock, he did not himself manipulate USE stock because he did not himself have a manipulative purpose." Id. In a subsequent order certifying for interlocutory appeal "[t]he issue of what level of scienter is required before a person trading in securities can be said to manipulate the securities," the district court noted that "where ... manipulation is the basis of the claim, manipulative intent, and not mere knowledge or recklessness, is required before Rule 10b-5 is violated." SEC v. U.S. Envtl., Inc., No. 94 Civ. 6608, at 1-3 (S.D.N.Y. Aug. 6, 1996). On August 25, 1997, this court granted the SEC's motion for an interlocutory appeal pursuant to 28 U.S.C. § 1292(b).

Discussion

In reviewing the district court's dismissal of the SEC's claim pursuant to Fed.R.Civ.P. 12(b)(6), we are "required to accept the material facts alleged in the complaint as true" and will vacate the dismissal "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of [its] claim which would entitle [it] to relief." Easton v. Sundram, 947 F.2d 1011, 1014-1015 (2d Cir.1991) (quotation marks omitted). Our review is de novo. See Leeds v. Meltz, 85 F.3d 51, 53 (2d Cir.1996).

Romano's principal contention on appeal, with which the district court agreed, is that he cannot be primarily liable under § 10(b) for following a stock promoter's directions to execute trades that Romano knew, or was reckless in not knowing, were manipulative, where Romano did not share the promoter's ultimate "manipulative ... purpose" to raise the stock price. We disagree.

Under § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j,

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-

. . . . .

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe. ¹

In Central Bank, the Supreme Court held that private civil liability under § 10(b) applies only to those who "engage in the manipulative or deceptive practice," but not to those "who aid and abet the violation." 511 U.S. at 167, 114 S.Ct. 1439. The Court observed that "[a]iding and abetting is a method by which courts create secondary liability in persons other than the violator [or violators] of the statute." Id. at 184, 114 S.Ct. 1439 (quotation marks omitted) (emphasis added). We have noted further that a primary violator is one who "participated in the fraudulent scheme" or other activity proscribed by the securities laws. SEC v. First Jersey Secs., Inc., 101 F.3d 1450, 1471 (2d Cir.1996), cert. denied, --- U.S. ----, 118 S.Ct. 57, 139 L.Ed.2d 21 (1997).

Under the foregoing standards, we believe that, as alleged in the complaint, Romano falls well within the boundaries of primary liability. As an initial matter, we disagree with the district court's view that "[e]ven if Romano knew that [the buyers and sellers] were D'Onofrio and undisclosed nominees of D'Onofrio, and hence knew that D'Onofrio was manipulating USE stock, [Romano] did not himself manipulate USE stock because he did not himself...