Congregation of the Passion, Holy Cross Province v. Kidder Peabody & Co., Inc.

• Decision Date: 04 September 1986
• Docket Number: No. 85-2427,85-2427
• Citation: 800 F.2d 177
• Parties: Fed. Sec. L. Rep. P 92,901 CONGREGATION OF THE PASSION, HOLY CROSS PROVINCE, Plaintiff-Appellant, v. KIDDER PEABODY & CO., INC., Bankers Trust Company, and Touche Ross & Co., Defendants-Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 177

800 F.2d 177

Fed. Sec. L. Rep. P 92,901

CONGREGATION OF THE PASSION, HOLY CROSS PROVINCE, Plaintiff-Appellant, v. KIDDER PEABODY & CO., INC., Bankers Trust Company, and Touche Ross & Co., Defendants-Appellees.

No. 85-2427.

United States Court of Appeals, Seventh Circuit.

Argued April 1, 1986.

Decided Sept. 4, 1986.

Thomas P. Ward, Chicago, Ill., for plaintiff-appellant.

Francis J. Higgins, Joe A. Sutherland, Gardner Carton & Douglas, Chicago, Ill., P.B. Konrad Knake, White & Case, New York City, for defendants-appellees.

Before CUMMINGS, Chief Judge, FLAUM and RIPPLE, Circuit Judges.

RIPPLE, Circuit Judge.

This appeal presents three issues. First, whether the appellees, Kidder Peabody & Co., Inc. (Kidder Peabody) and Bankers Trust Company (Bankers Trust), violated section 10(b) of the Securities Exchange Act of 1934 (SEA), 15 U.S.C. Sec. 78j(b), and Securities Exchange Commission (Commission) Rule 10b-5, 17 C.F.R. Sec. 240.10b-5. Second, whether Kidder Peabody, Bankers Trust or Touche Ross & Co. (Touche Ross) aided and abetted in any violation of the statute and the Rule. Third, whether the Congregation of the Passion, Holy Cross Province, (Congregation) is liable for the debt which remained in the accounts maintained on its behalf by Bankers Trust and Kidder Peabody. The district court granted the motions of Kidder Peabody, Bankers Trust and Touche Ross for summary judgment on the securities law violations. It further declined to exercise pendent jurisdiction over the remaining state claims against Touche Ross and dismissed those claims without prejudice. Several months later, it granted summary judgment in favor of Kidder Peabody and Bankers Trust on their counterclaims. We affirm the judgment of the district court.

I FACTS

The Congregation is a Roman Catholic religious community consisting of priests, brothers and students. To provide for the education of members of the community, the Congregation maintained a "Permanent" fund. The Congregation also established a "Retirement" fund to provide for older members of the community. In 1975, the treasurer of the Congregation, Father Parsons, decided that an investment advisor should manage these funds. While investigating candidates to fill that position, Father Parsons received several excellent letters of recommendation about Cranford Newell. Father Parsons invited Mr. Newell to make a presentation to the Congregation's Provincial Council. With the approval of the Council, on July 28, 1975, the Congregation hired Mr. Newell as the investment manager of its "Retirement" fund. The Congregation gave Mr. Newell "full discretion to develop and implement a Mr. Newell selected a course of investment which included a series of arbitrage transactions. ² In a letter addressed "To whom it may concern," Father Parsons confirmed Mr. Newell's authority "on a fully discretionary basis, to effect arbitrage transactions (involving 'long' and 'short' positions in fixed income securities) for the accounts of the CONGREGATION OF THE PASSION, HOLY CROSS PROVINCE." R. 309, Kidder Ex. 3. The letter also requested and authorized dealers to accept and execute orders placed on behalf of the Congregation by Mr. Newell. Id. Mr. Newell used this authority to make all the investment transactions with the funds entrusted to him by the Congregation. On behalf of the Congregation, Mr. Newell placed orders with over thirty dealers. He would direct the dealer to execute a purchase or sale of a security for the Congregation's account. The dealers never offered Mr. Newell or the Congregation any investment advice. The dealers executed the transactions in accordance with Mr. Newell's instructions. A confirmation slip was sent to Mr. Newell, the Congregation and the Congregation's bank, United California Bank (Bank). The confirmation slip indicated: the transaction number; a trade date; the name of the customer; a description of the security involved; a description of the transaction; the quantity of the security involved; the price; the principal; the interest; and the net amount due. When a transaction earned a profit, the dealers would wire money to the Bank and when a transaction lost money, the Bank would wire funds to the dealers. Other than the confirmation slips, the dealer had no contact with the Congregation. When Sister Flaherty, who was tracking the transactions for the Congregation, had a question, she called Mr. Newell, not the dealers.

                prudent portfolio strategy" for investment of the million dollar fund. 1   R. 309, First Boston Ex. 2.  Shortly thereafter, the Congregation also entrusted Mr. Newell with a million dollars from the "Permanent" fund
                

As early as 1976, members of the Business Advisory Board of the Holy Cross Province (Board) expressed some concern not only about the high risk involved in the arbitrage transactions but also about the pressure that the high expectations of return placed on Mr. Newell. R. 309, First Boston Exs. 20, 22, 315, 316, 318, 323. The Board solicited a study of Mr. Newell's investments. An independent firm concluded that Mr. Newell had taken substantial risks in a period of uncertainty in the bond market. R. 309, First Boston Ex. 223.

It was Touche Ross, the Congregation's accounting firm, which ultimately uncovered the extent of the risks Mr. Newell had taken. Beginning in 1973, the Congregation hired Touche Ross to prepare an annual report based on a review of unaudited financial statements. While preparing the 1976 report, Touche Ross consulted with the Congregation and decided to report the arbitrage investments on a cost basis. Each year, a footnote appeared in the report indicating that the arbitrage investments were not reported at current market value; instead, "[o]nly the required margin payments were carried as investments." This accounting method made Mr. Newell's investments appear profitable.

While preparing the 1980 report, however, Touche Ross began to question the location of the $3.6 million balance reported The Congregation filed suit against Mr. Newell, several dealers (including Kidder Peabody and Bankers Trust) and Touche Ross. The complaint alleged that Mr. Newell and the dealers had violated section 10(b) of the SEA, 15 U.S.C. Sec. 78j(b), and Rule 10b-5, 17 C.F.R. Sec. 240.10b-5. The Congregation also alleged that the dealers and Touche Ross aided and abetted in these violations. Finally, the complaint contained pendent counts alleging common law breach of fiduciary duty, conversion and breach of contract. The dealers responded with counterclaims for the unpaid deficit remaining in the Congregation's accounts.

by Mr. Newell. Further investigation revealed that the actual market value of the accounts was $2.4 million less than Mr. Newell had reported. Touche Ross disclosed this information to the Congregation in February 1981. Despite this information and the Board's concerns, the Congregation transferred, in April 1981, another $500,000 to Mr. Newell. Finally, on May 6, 1981, the Congregation revoked Mr. Newell's authority to invest its funds and instructed the dealers to close all remaining accounts. By this time, Mr. Newell's investment program had not only completely depleted the $2.5 million entrusted to him but also created large debts in the accounts maintained by the dealers.

The district court granted Bankers Trust, Kidder Peabody and Touche Ross' motions for summary judgment. R. 314. The court found that the dealers made no material misrepresentations and owed the Congregation no duty to disclose any information. The district court also found that this court's holding in O'Brien v. Continental Illinois National Bank and Trust Company, 593 F.2d 54, 60 (7th Cir.1979), precluded a finding of primary liability under the securities laws since Mr. Newell had full discretion to develop and implement the Congregation's investment policy. R. 315 at 7. Therefore, these defendants had not violated section 10(b) and Rule 10b-5. The district court also concluded that, because there was no primary violation of the statute or the Rule, these defendants could not have aided or abetted such a violation. Accordingly, the district court dismissed the securities counts against Kidder Peabody, Bankers Trust and Touche Ross and it refused to exercise pendent jurisdiction over the remaining counts. The district court also found that, because Mr. Newell had full discretion to act as the Congregation's agent in arbitrage transactions and because the plaintiff had knowledge of the types of transactions Mr. Newell entered into on its behalf, the dealers were entitled to look to the Congregation for payment of the debt remaining in the accounts. Accordingly, the district court granted the dealers' motion for summary judgment on their counterclaims. R. 347. Finding no just reason for delay, the district court entered final judgment in favor of Kidder Peabody, Bankers Trust and Touche Ross on all issues in both the complaint and the counterclaims. ³ The Congregation has appealed the district court's decisions.

II PRIMARY VIOLATION

The first issue the Congregation raises on appeal is whether Kidder Peabody or Bankers Trust violated section 10(b) of the SEA, 15 U.S.C. Sec. 78j(b), and Rule 10b-5, 17 C.F.R. Sec. 240.10b-5. Section 10(b) makes it unlawful for any person to use "any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe" in connection with the purchase or sale of any security. Pursuant to section 10(b), the Commission promulgated Rule 10b-5 which makes it unlawful:

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

under which t...