Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc.

• Decision Date: 03 April 1974
• Docket Number: No. 270,Docket 73-1677.,270
• Citation: 495 F.2d 228
• Parties: Maurice SHAPIRO et al., Plaintiffs-Appellees, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., et al., Defendants-Appellants.
• Court: U.S. Court of Appeals — Second Circuit

495 F.2d 228 (1974)

Maurice SHAPIRO et al., Plaintiffs-Appellees, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., et al., Defendants-Appellants.

No. 270, Docket 73-1677.

United States Court of Appeals, Second Circuit.

Argued January 7, 1974.

Decided April 3, 1974.

COPYRIGHT MATERIAL OMITTED

Donald N. Ruby, New York City (Lester L. Levy and Wolf, Popper, Ross, Wolf & Jones, New York City, on the brief), for plaintiffs-appellees Maurice Shapiro, Isadore Shapiro, William M. Naigles, Chaylie Saxe and Thomas F. Gibson, Jr.

Roger J. Hawke, New York City (Brown, Wood, Fuller, Caldwell & Ivey, New York City, on the brief), for defendants-appellants Merrill Lynch, Pierce, Fenner & Smith, Inc., Winthrop Lenz, Julius H. Sedlmayer, Gillette K. Martin, Dean S. Woodman, Edward N. McMillan, Phillip F. Bilbao, Norman H. Heindel, Jr., Lee W. Idleman, Lawrence Zicklin, James A. McCarthy, Elias A. Lazor and Chester T. Smith, Jr.

Samuel E. Gates, New York City (Debevoise, Plimpton, Lyons & Gates, New York City, on the brief), for defendants-appellants Burden Investors Services, Inc. and William A. M. Burden & Co.

Shearman & Sterling, New York City, for defendants-appellants Anchor Corp., City Associates and Fairfield Partners.

Ballard, Spahr, Andrews & Ingersoll, Philadelphia, Pa., for defendant-appellant Madison Fund, Inc.

Shereff, Friedman, Hoffman & Goodman, New York City, for defendants-appellants J. M. Hartwell & Co., J. M. Hartwell & Co., Inc., Hartwell Associates and Park Westlake Associates.

Milbank, Tweed, Hadley & McCloy, New York City, for defendant-appellant Van Strum & Towne, Inc.

Sullivan & Cromwell, New York City, for defendant-appellant Fleschner Becker Associates.

Seward & Kissel, New York City, for defendants-appellants A. W. Jones & Co. and A. W. Jones Associates.

Before DANAHER,^* LUMBARD and TIMBERS, Circuit Judges.

TIMBERS, Circuit Judge:

This appeal presents important questions, some of first impression, involving the scope of the antifraud provisions of the federal securities laws in their application to transactions on a national securities exchange when material inside information has not been disclosed.

Specifically, the questions presented are (1) whether Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 were violated by a prospective managing underwriter of a debenture issue and the underwriter's officers, directors and employees when they divulged material inside information to the underwriter's customers for the purpose of protecting the latters' investments in the stock of the issuer; (2) whether the same antifraud provisions of the securities laws were violated by the underwriter's customers when they traded in the stock of the issuer without disclosing the material inside information which had been divulged to them by the underwriter; and (3) whether those referred to above, if they did violate the antifraud provisions of the securities laws, are liable in damages to those persons who during the same period purchased stock in the same company in the open market without knowledge of the material inside information. In short, this case involves the liability of non-trading "tippers" and trading "tippees" under Section 10(b) and Rule 10b-5.

Defendants appeal, pursuant to 28 U.S.C. § 1292(b) (1970), from an order entered in the Southern District of New York, Charles H. Tenney, District Judge, 353 F.Supp. 264 (S.D.N.Y.1972), denying their motion for judgment on the pleadings on the ground that the complaint failed to state a claim upon which relief can be granted.

The action was brought to recover damages claimed to have been sustained as the result of defendants' trading or recommending trading of common stock of Douglas Aircraft Company, Inc. (Douglas) on the New York Stock Exchange (NYSE) in 1966. Such acts or transactions are alleged to have violated Sections 10(b) and 15(c)(1) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b) and 78o(c)(1) (1970); Rules 10b-5 and 15c-1 and 2, 17 C.F.R. §§ 240.106-5 and 240.156-1 and 2 (1973), promulgated by the Securities and Exchange Commission (SEC); and Section 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a) (1970).¹

Applying to the admitted facts before us what we believe to be controlling principles of law as enunciated by the Supreme Court and by our Court, we affirm.

I.

In summarizing here the facts necessary to a determination of the legal issues raised on this appeal, we must take as admitted the well-pleaded material facts alleged in the complaint, as the district court did, 353 F.Supp. at 268, since the order under review denied defendants' motion for judgment on the pleadings pursuant to Fed.R.Civ.P. 12(c).²

The course of events which culminated in the instant action occurred during the period April 1966 through July 1966. During this period, Merrill Lynch, Pierce, Fenner & Smith Inc. (Merrill Lynch) was engaged as the prospective managing underwriter of a proposed Douglas offering of $75,000,000 principal amount of a new issue of 4¾% convertible subordinated debentures. A registration statement for this offering was filed with the SEC on June 7; it became effective on July 12, with Merrill Lynch the managing underwriter. On June 7, Douglas had released an earnings statement which reported the results of operations for the first five months of its 1966 fiscal year, i. e. through April 30, 1966.³ This statement indicated that Douglas had earned 85 cents per share on its common stock during that period.

During the period June 17 through June 22, Merrill Lynch and certain of its officers, directors and employees (the individual defendants)⁴ were advised by Douglas' management of certain material adverse inside information regarding Douglas' earnings.⁵ This information was essentially that (a) Douglas would report substantially lower earnings for the entire first six months than it had reported for the first five months of its 1966 fiscal year; (b) Douglas had sharply lowered its estimate of earnings for its full 1966 fiscal year in that it now expected to have little or no profit for that year; and (c) Douglas had substantially reduced its projection of earnings for its 1967 fiscal year. This information was given to Merrill Lynch solely because of its position as the prospective underwriter for the Douglas debenture issue. The individual defendants and Merrill Lynch knew or should have known that the information had not yet been publicly announced.

During the period June 20 through June 24, Merrill Lynch and the individual defendants disclosed this confidential information to the following Merrill Lynch customers (the selling defendants), most of whom were institutional investors: Investors Management Co., Inc. (a wholly owned subsidiary of Anchor Corporation), Madison Fund, Inc., J. M. Hartwell & Co. (predecessor of J. M. Hartwell & Co., Inc.), Hartwell Associates, Park Westlake Associates, Van Strum & Towne, Inc., Fleschner Becker Associates, A. W. Jones & Co., A. W. Jones Associates, City Associates, Fairfield Partners, Burden Investors Services, Inc. and William A. M. Burden & Co. The selling defendants knew or should have known that this information had not yet been publicly announced.

During the period June 20 through June 23, the selling defendants either sold from existing positions or made short sales of more than 165,000 shares of Douglas common on the NYSE. This was approximately one-half of the total number of Douglas shares sold on the NYSE during this period. These sales were made prior to Douglas' public disclosure of the revised earnings information on June 24⁶ and without the sellers having disclosed this information to the investing public, including plaintiffs. As a result of these sales, the individual defendants and Merrill Lynch received commissions from the execution of the selling defendants' orders and also received compensation in the form of customer directed "give ups"—i. e. division of commissions earned by other brokers who executed orders for the selling defendants.

On June 23, plaintiff Gibson purchased an unspecified number of shares of Douglas common on the NYSE; his purchase was prior to the public release on June 24 of Douglas' revised earnings report. The other four plaintiffs— Maurice Shapiro, Isadore Shapiro, Naigles and Saxe—purchased an unspecified number of shares of Douglas common on the NYSE on June 24; their purchases were made without knowledge of the material adverse earnings information released by Douglas that day.⁷

Beginning about June 22 or 23, the market price of Douglas common on the NYSE took a sudden and substantial drop.⁸ This coincided with and, according to the complaint, was caused by the substantial sales by the selling defendants on the basis of material inside information, the disclosure of which after plaintiffs' purchases precipitated a further severe drop in the market price of Douglas common.

On August 21, 1970, plaintiffs commenced the instant action in the Southern District of New York. They sued on behalf of themselves and all others similarly situated who purchased Douglas common during the period June 21 through June 24, 1966. Essentially the complaint alleges that defendants were under a duty to disclose to the general investing public, including plaintiffs, the material inside information regarding Douglas' earnings; that defendants defrauded plaintiffs by not disclosing such information, in violation of the antifraud provisions of the securities laws; that plaintiffs would not have purchased Douglas stock if they had known of the information withheld by defendants; and that plaintiffs sustained substantial damages as a result of the acts of defendants. Plaintiffs do not claim to have purchased specific shares of Douglas stock sold by any of the selling defendants. The complaint demands damages sustained by plaintiffs and an accounting of profits realized by defendants.⁹

After the pleadings were closed and certain...