Securities & Exchange Comm'n v. Dain Rauscher

• Decision Date: 26 June 2001
• Docket Number: PLAINTIFF-APPELLANT,DEFENDANTS-APPELLEES,No. 99-56828,99-56828
• Citation: 254 F.3d 852
• Parties: (9th Cir. 2001) SECURITIES AND EXCHANGE COMMISSION,, v. DAIN RAUSCHER, INC.; KENNETH D. OUGH; AND VIRGINIA O. HORLER,
• Court: U.S. Court of Appeals — Ninth Circuit

Page 852

254 F.3d 852 (9th Cir. 2001)

SECURITIES AND EXCHANGE COMMISSION, PLAINTIFF-APPELLANT, v. DAIN RAUSCHER, INC.; KENNETH D. OUGH; AND VIRGINIA O. HORLER, DEFENDANTS-APPELLEES.

No. 99-56828

UNITED STATES COURT OF APPEALS FOR THE NINTH CIRCUIT

Argued and Submitted February 9, 2001

Filed June 26, 2001

John W. Avery, Securities and Exchange Commission, Washington, Dc, for the plaintiff-appellant.

Charles Rice, Shartsis Friese & Ginsburg, San Francisco, California, for the defendant-appellee.

Appeal from the United States District Court for the Central District of California Gary L. Taylor, District Judge, Presiding D.C. No. CV-98-639GLT

Nicholas P. Coleman, Wilmer, Cutler & Pickering, Washington, DC, for amici in support of the defendant-appellee.

Before: Harry Pregerson, William C. Canby, Jr., and David R. Thompson, Circuit Judges.

Thompson, Circuit Judge

Pasadena, California

Opinion by Judge Thompson

OPINION

The Securities and Exchange Commission (SEC) sought a permanent injunction and civil penalties against Kenneth D. Ough for alleged violations of Section 17(a) of the Securities Act, 15 U.S.C. §§ 77q(a) (1994), amended by Pub. L. 106-554 §§ 302(b), 114 Stat. 2763, 2763A-452 (Dec. 21, 2000); Section 10(b) of the Exchange Act, 15 U.S.C. §§ 78j(b) (1994), amended by Pub. L. 106-554 §§ 303(d), 114 Stat. 2763, 2763A-454 (Dec. 21, 2000), and Rule 10b-5 thereunder, 17 C.F.R. 240.10b-5 (2000); and for violations of Section 15B(c)(1) of the Exchange Act, 15 U.S.C. §§ 78o-4(c)(1) (1994), and Municipal Securities Rulemaking Board (MSRB) Rule G 17.¹ The alleged violations stem from Ough's acts and omissions as an investment banker for an underwriter of municipal offerings in his investigation and disclosure of the risks attached to the offering of certain taxable municipal notes.

The district court entered summary judgment in favor of Ough, and the SEC appeals. The SEC contends the district court erred in looking solely to the industry standard as the governing standard of care by which to measure Ough's conduct. Further, the SEC asserts there is a genuine issue of material fact as to what the industry standard is, and as to whether Ough's conduct departed from that standard or from a standard of "reasonable prudence" which the SEC contends is the appropriate standard.

We have jurisdiction pursuant to 28 U.S.C. §§ 1291 (1994), and we reverse. We hold that the standard of care for an underwriter of municipal offerings is one of reasonable prudence, for which the industry standard is one factor to be considered, but it is not the determinative factor. We also conclude there are genuine issues of material fact as to what is the applicable industry standard, whether Ough's conduct met the controlling standard of reasonable prudence, and whether any departure from that standard was so extreme as to satisfy the element of scienter under the securities antifraud statutes and regulations.

I.

In 1993 and 1994, Dain Rauscher, a broker-dealer, was the senior underwriter for nine taxable municipal note offerings, and financial advisor for a tenth offering. Kenneth D. Ough, vice president in the public finance department of Dain Rauscher's municipal securities division, acted as lead investment banker on these undertakings. Two of the offerings were for the City of Anaheim, and eight were for various municipal school districts.

At the time the taxable municipal notes were offered, they were a new type of security. The 1993 Anaheim transaction was one of the first such offerings ever made. With this type of security, the issuers, all of whom were "municipalities," used the note proceeds for "interest arbitrage, " meaning that the proceeds were used solely for investment purposes, rather than for infrastructure improvement, debt reduction or other projects. The goal of "interest arbitrage" is to pay back invested money at a certain interest rate, but invest it at a higher rate so that the issuers make a profit equal to the spread between interest rates. In this case, all of the issuers invested the note proceeds in investment pools managed by Orange County Treasurer Robert Citron.

In underwriting the offering of the taxable municipal notes, the underwriter followed the procedure for underwriting the offering of municipal bonds. That procedure requires the underwriter to obtain and review an official statement and send it to potential bidders or purchasers. See 17 C.F.R. §§ 240.15c2-12(b) (2000). Here, as the principal investment banker for the underwriting firm, Ough helped prepare and draft the offering documents. Others were also involved in drafting those documents, including bond counsel, underwriting counsel and public officials. Ough was responsible for reviewing the final offering statements prior to issuance of the notes.

The Anaheim offering statements provided that the purpose of the issuance was to "provide moneys to meet the City's Fiscal Year . . . general fund expenditures, including current expenses, capital expenditures and the discharge of other obligations or indebtedness of the City." The school districts' offering statements were almost identical, although they included "investment and reinvestment" in the list of expenditures to be met with proceeds from issuance of the notes. All of the offering statements explained that the issuance proceeds would be invested directly or through investment agreements "to the greatest extent possible" by the city Treasurer or the school district's Treasurer-Tax Collector.

Although Ough was aware that the purpose of the issuances was interest arbitrage, none of the offering statements used that term. Ough also knew the money would be invested in the Orange County investment pools, but no offering statement disclosed that fact. Ough never discussed the pools' investment strategy with Citron, the manager of the Orange County investment pools, and he did not make inquiries about the specific portfolio of investments and securities held by the pools. Ough said that reviewing such portfolios was not his expertise.

In evaluating the risk level to investors, Ough relied on statements and presentations by the Assistant Treasurer for Orange County, the Treasurer of the City of Anaheim, analysis and ratings by Standard & Poor's and Moody's, the history of the Orange County pool investments, and Citron's investing and management record. Ough said that he believed the pools' investments were conservative and safe, and that Citron had "strong management expertise."

Citron's strategy was to invest in securities that were highly sensitive to interest rate changes. As long as interest rates declined or held steady, returns on investments in the pools were high. In 1994, however, the Federal Reserve raised rates. The rate increase caused significant losses in the value of the Orange County portfolio and ultimately led to the Orange County bankruptcy. Nonetheless, all of the notes issued in the ten offerings in which Ough was involved were repaid in full and on time. Notwithstanding that circumstance, the SEC filed the complaint in this case seeking a permanent injunction and civil penalties against Ough. In its complaint, the SEC alleged that the offering documents misrepresented and omitted material facts that Ough knew, or through reasonable investigation, should have known, including the risks of the investment strategy. According to the SEC, the fact no one lost any money was simply a fortuitous fluke.

Both sides moved for summary judgment. The district court granted Ough's motion. The district court determined as a matter of law that the applicable standard against which to measure Ough's conduct was the industry standard, and held there was no material factual dispute that Ough's actions complied with that standard. This appeal followed.

II.

We review a district court's grant of summary judgment de novo. Flick v. Liberty Mut. Fire Ins. Co., 205 F.3d 386, 390 (9th Cir. 2000). Viewing the evidence in the light most favorable to the non-moving party, we must determine whether the district court correctly applied the relevant law, and whether there is a dispute as to a genuine issue of material fact. Id.

III.

Section 17(a) of the Securities Act, and Section 10(b) of the Exchange Act and Rule 10b-5, prohibit fraudulent conduct or practices in connection with the offer or sale of securities.² These antifraud provisions forbid making a material misstatement or omission in connection with the offer or sale of a security by means of interstate commerce. See SEC v. Rana Research, Inc., 8 F.3d 1358, 1364 (9th Cir. 1993); SEC v. Rogers, 790 F.2d 1450, 1458-59 (9th Cir. 1986). MSRB Rule G-17 requires that brokers and dealers deal fairly with others and not engage in deceptive, dishonest or unfair practices.³

Violations of Section 17(a)(1), Section 10(b) and Rule 10b- 5 require scienter. See Aaron v. SEC, 446 U.S. 680, 701-02 (1980). Scienter is satisfied by recklessness. Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990) (en banc). Reckless conduct is conduct that consists of a highly unreasonable act, or omission, that is an"extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Id. at 1569 (quoting Sunstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977)).

Violations of Sections 17(a)(2) and (3) require a showing of negligence. SEC v. Hughes Capital Corp., 124 F.3d 449, 453-54 (3d Cir. 1997). The parties do not dispute that negligence is also the standard by which MSRB Rule G-17 liability is evaluated. See In the Matter of Merrill Lynch, Pierce, Fenner & Smith Inc., 67 SEC Docket 1807, 1998 WL 518489, *13 (Aug. 24, 1998) (applying same standard to alleged Rule G-17 violation as that of Section 17(a)(2) and (3)).

A. The Applicable Standard

In challenging the district...