Levitin v. PaineWebber, Inc.

Decision Date29 September 1998
Docket NumberDocket No. 96-7994
Citation159 F.3d 698
PartiesFed. Sec. L. Rep. P 90,286 Raizy LEVITIN, Plaintiff-Appellant, v. PAINEWEBBER, INC., Defendant-Appellee.
CourtU.S. Court of Appeals — Second Circuit

Roger W. Kirby, Kaufman, Malchman, Kirby & Squire, New York, NY (Mel E. Lifshitz, Bernstein Liebhard & Lifshitz, New York, NY, of counsel), for Plaintiff-Appellant.

David E. Nachman, Solomon, Zauderer, Ellenhorn, Frischer & Sharp, New York, NY (Richard T. Sharp, Colin A. Underwood, of counsel), for Defendant-Appellee.

Christopher Paik, Office of Chief Litigation Counsel, Securities & Exchange Commission Washington, DC, for Amicus Curiae Securities & Exchange Commission.

Before: WINTER, Chief Judge, FEINBERG and PARKER, Circuit Judges.

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. 1 Briefly stated, a short sale involves a customer who, like Levitin, speculates that a particular stock will go down in price and seeks to profit from that drop. The transaction begins with the customer selling stock that she does not own. The customer "borrows" the stock to be sold, typically from her broker. The broker obtains the stock that it loans to the customer either from its own reserves or by borrowing it from external sources, such as other brokers or other customers. Later--sometimes considerably later--the customer "covers" the short by buying identical stock and restoring it to the broker-lender. If the price of the stock declines, as the customer hopes, the customer can purchase the stock at a lower price than the one at which she sold the borrowed stock, profiting from the difference between the sale and purchase prices.

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. 2 Consequently, a broker who lends a customer stock for a short sale does not typically pay the proceeds of the sale to the customer to be spent when and how she wants, waiting for the customer to cover when and if it suits her. If a broker did that, the price might increase and the customer become insolvent or disappear, leaving the broker out the entire value of the stock--the price at the time of short sale plus its increase. Brokers therefore demand collateral, usually by taking an amount from the customer's account equal to the security required. The proceeds from the sale will, of course, usually be available as security, but if those proceeds and the balance in the customer's account are not sufficient to satisfy the security requirement, the customer will have to post additional collateral.

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 of nonexempted securities, Federal Reserve Board Regulation T requires that customers meet an initial margin requirement of 150 percent of the market value of the securities being sold. See 12 C.F.R. § 220.12(c)(1). The New York Stock Exchange imposes separate margin requirements for short sales. See NYSE Rule 431(c). Adjustments in the collateral posted must be made periodically as the price of the stock fluctuates. If the stock price increases, brokers may charge the customer interest until the appropriate amount of security is restored. Of course, a broker may require particular customers to post collateral in excess of that specified by Regulation T or the NYSE.

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 was deceived by PW's failure to disclose that the remittance of earnings on the posted collateral was, for large favored customers, negotiable. 3 We discuss these claims in turn.

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...

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