Paul F. Newton & Co. v. Texas Commerce Bank

Citation630 F.2d 1111
Decision Date21 November 1980
Docket NumberNo. 79-1379,79-1379
PartiesFed. Sec. L. Rep. P 97,702, 7 Fed. R. Evid. Serv. 1080 PAUL F. NEWTON & COMPANY and Daniel O'Connell, Receiver, Plaintiffs-Appellants, v. TEXAS COMMERCE BANK et al., Defendants, Pressman, Frohlic & Frost, Defendants-Appellees.
CourtUnited States Courts of Appeals. United States Court of Appeals (5th Circuit)

Sidney Ravkind, Terrell W. Oxford, Houston, Tex., for plaintiffs-appellants.

Butler, Binion, Rice, Cook & Knapp, Norman J. Riedmueller, Tom Alexander, Houston, Tex., for defendants-appellees.

Appeal from the United States District Court for the Southern District of Texas.

Before AINSWORTH, CHARLES CLARK and TJOFLAT, Circuit Judges.

CHARLES CLARK, Circuit Judge:

Paul F. Newton & Company (Newton) appeals from the district court's grant of a directed verdict to Pressman, Frohlich & Frost, Inc. (Pressman) in its action against Pressman predicated upon alleged violations of the Securities and Exchange Commission's Rule 10b-5, 17 C.F.R. § 240.10b-5 (1979), by one of its employees, and upon common law fraud. Following the presentation of evidence by the parties, the district court granted Pressman's motion for a directed verdict, reasoning that the only basis for imposing liability upon Pressman shown by the evidence presented was the doctrine of respondeat superior, which it concluded did not apply to actions brought under the federal securities act. We reverse and remand for a new trial.

I. Facts 1

This action arises out of an allegedly fraudulent scheme to inflate the price of the stock of the Imperial Investment Company (Imperial), which stock was traded in the over-the-counter market. Newton alleged that several individuals, after acquiring control of all the tradeable shares of Imperial stock, conspired to create an active market for the stock in which they could profit from their acquisition.

A sale of an over-the-counter stock, such as the Imperial stock, typically involves five parties: the seller, the selling broker, the market maker, the buying broker, and the buyer. The market maker acts as a middleman between the selling broker and the buying broker, who represent the seller and buyer respectively. A firm that is willing to act as a market maker for a particular over-the-counter stock indicates that willingness to buying and selling brokers by listing itself in the "pink sheets," which are daily publications that list almost every stock traded in the over-the-counter market, the names of those firms maintaining a market in a particular stock, and a stated price at which each firm is willing either to buy or sell the security.

The conspirators devised a scheme whereby they could inflate the price at which Imperial stock was traded by using their control over all of the tradeable shares of the stock. They solicited several persons employed by brokerage firms to assist the scheme by acting as either selling brokers or market makers. Several other persons joined the scheme to pose as buyers of the stock. The essence of the scheme was that by controlling both the buyer and seller in each transaction involving Imperial stock, the conspirators could control the price at which the stock was traded and artificially raise that price over a series of transactions.

The conspirators allegedly acquired the services of Stanleigh Bader, a registered representative of Pressman, to act as a market maker. In return for a promise of a guaranteed profit, he agreed to enter Pressman's name in the pink sheets as a market maker in Imperial stock. The conspirators promised Bader that if he purchased more shares of Imperial stock than he could sell, they would provide a buyer for the stock who would purchase it at a price above that at which Bader bought it. Similarly, if Bader contracted to sell more Imperial stock than he possessed, they would arrange for him to buy the stock he needed at a price below that for which he had contracted to sell the stock. In return for this guarantee of a profit on every transaction, Bader was to perform the essential service to the scheme of increasing with each transaction the price he quoted to persons seeking to trade in Imperial stock.

Buyers working for the conspirators would contact brokerage firms seeking to purchase Imperial stock. They would place purchase orders with the brokers and arrange to pay upon delivery of the stock certificates. Under this arrangement, the buying broker would purchase the shares and then transmit the stock certificates to a bank designated by the buyer together with an attached draft for the amount owed to it by the buyer. The buyer would have his bank honor the draft and take possession of the shares. The buying brokers would ascertain from the pink sheets the name of brokerage firms willing to act as market makers. When contacted by the buying brokers, the market makers would quote a price for the Imperial stock, raising the quoted price with each transaction, and would contract to sell the stock to the buying broker. Selling brokers representing the conspirators would provide the stock to the market maker to satisfy their contracts.

In December 1969, Newton, whose principal place of business is in Houston, Texas, received purchase orders for Imperial stock from several individuals in New York who it alleges were part of the conspiracy. Although Newton had previously dealt with out-of-town customers on a cash-only basis, it agreed to make these purchases on a "payment-against-delivery" basis, under which arrangement Newton would purchase the stock itself and then seek payment from the buyers. To fill these New York buyers' purchase orders Newton contracted to buy more than 49,000 shares of Imperial stock. It paid over $515,000 to various market makers before it discovered that its buyers were not going to pay for the stock, at which time it refused to pay for any more of the stock it had contracted to purchase. Newton paid almost $220,000 to Pressman for Imperial stock and refused to pay for another $170,000 of stock that it had ordered. Newton ultimately received payment from its buyers for only five hundred of the shares of Imperial stock it purchased, and when the stock's price collapsed after the discovery of the fraudulent scheme, Newton went into bankruptcy.

In 1970, Newton initiated this action against Pressman and several other brokerage firms and individuals allegedly involved in the conspiracy to inflate the price of Imperial stock, alleging violations of the Securities Act of 1933, the Securities Exchange Act of 1934, and the Texas common law of fraud. By the time the suit finally went to trial in May 1978, Pressman was the only defendant who had not defaulted, settled, or been dismissed. Newton alleged that Pressman's employee Stanleigh Bader, was involved in the conspiracy to manipulate the price of Imperial stock. It contended that the conspirators had violated § 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b); § 17 of the Securities Act, 15 U.S.C. § 77q; Rule 15c2-7 of the Securities and Exchange Commission (SEC), 17 C.F.R. § 240.15c2-7 (1979); and the Texas common law doctrine of fraud. 2 Newton sought to impose liability upon Pressman for the acts of its employee under the doctrine of respondeat superior and § 20(a) of the Securities Exchange Act, 15 U.S.C. § 78t(a).

On the sixth day of the jury trial, following the close of the presentation of evidence, the district court granted a directed verdict to Pressman, ruling that the doctrine of respondeat superior could not be used as a basis for liability for a violation of the Securities Exchange Act and that Pressman could not be held liable under § 20(a) because it had neither participated in nor had knowledge of the fraudulent acts of its employee.

On this appeal Newton contends that the district court erred in several respects. First, it argues that § 20(a) is not the exclusive means by which secondary liability may be imposed under the Securities Exchange Act and does not exclude the application of common law agency principles such as respondeat superior. Second, it asserts that it was entitled to a directed verdict holding Pressman liable under the respondeat superior doctrine. Finally, it urges that Pressman was not entitled to a directed verdict on its claim under § 20(a) since material questions of fact existed as to whether Pressman had established its entitlement to the good faith defense incorporated by Congress into § 20(a).

Pressman responds that the district court properly concluded that liability for a violation of the Securities Exchange Act could not be predicated upon respondeat superior. It contends that it was entitled to a directed verdict under § 20(a) since it established as a matter of law that it had not participated in or known of the fraudulent acts of its employee and had met its duty to supervise its employee's activities. It also urged that the directed verdict could be upheld on the ground that the evidence showed that Newton had failed to act with "due diligence." Finally, it argued that the evidence presented against it by Pressman consisted largely of inadmissible hearsay statements that the district court should have excluded.

II. The Viability of Agency Principles in Federal Securities Actions

Newton urges that the district court erroneously concluded that Pressman could not be held liable under the doctrine of respondeat superior for the alleged violations of the Securities Exchange Act of 1934 committed by its employee. Such a result, it argues, contravenes prior decisions by this court, is contrary to the view adopted by a majority of other circuits deciding the issue, and conflicts with the remedial purpose of the Act and with Congress's intent in enacting § 20(a). Pressman responds that Congress intended § 20(a) to be the exclusive means by which secondary liability could be imposed for violations of the Act, thereby supplanting common law agency principles, and that a majority of those circuit...

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