Palmer v. Thomson & McKinnon Auchincloss, Inc.

• Decision Date: 01 March 1977
• Docket Number: Civ. No. H-74-42.
• Citation: 427 F. Supp. 915
• Court: U.S. District Court — District of Connecticut
• Parties: Raymond L. PALMER and Cora R. Palmer v. THOMSON & McKINNON AUCHINCLOSS, INC.

427 F. Supp. 915

Raymond L. PALMER and Cora R. Palmer v. THOMSON & McKINNON AUCHINCLOSS, INC.

Civ. No. H-74-42.

United States District Court, D. Connecticut.

March 1, 1977.

COPYRIGHT MATERIAL OMITTED

W. Wilson Keithline, Alcorn, Bakewell & Smith, Hartford, Conn., for plaintiffs.

Americo R. Cinquegrana, Day, Berry & Howard, Ernest A. Inglis, Jr., Philip S. Walker, Hartford, Conn., for defendant.

RULING ON CROSS-MOTIONS FOR SUMMARY JUDGMENT

BLUMENFELD, District Judge.

In this action for recission and damages, plaintiffs charge the defendant brokerage firm with violating the federal securities laws and regulations thereto by leading the plaintiffs into sophisticated margin transactions in speculative securities, inappropriate to their financial needs and circumstances. Plaintiffs and defendant have executed a stipulation of fact and cross-moved for summary judgment as to the issue of liability on Count Three of the complaint. In that count, plaintiffs contend that defendant violated Section 7 of the Securities Exchange Act, 15 U.S.C. § 78g and Regulation T of the Federal Reserve Board, 12 C.F.R. § 220 et seq., by extending credit in excess of the initial margin requirements set by the Reserve Board. The gravamen of this allegation is that defendant made purchases for the plaintiffs' margin account which were secured by illusory credits in their Special Miscellaneous Account (SMA) rather than the deposit of cash or securities as ostensibly required by Regulation T. These credits are claimed to be illusory because they were derived from unrealized appreciations in securities which had dropped in value by the time of the purchases in question.

The parties have at the request of the court also submitted briefs on the continued viability of this cause of action in light of the passage of Section 7(f) to the Exchange Act, 15 U.S.C. § 78g(f) (1970), making it unlawful for an investor to obtain credit in excess of the margin limits.¹

Factual Background

To understand fully the issues involved in these motions, it is necessary to trace in some detail plaintiffs' transactions with defendant, especially the use of their SMA to meet the initial margin requirements of Regulation T. Plaintiffs Raymond and Cora Palmer are a retired couple in their seventies. On March 21, 1972, they transferred their margin account with Shearson Hamill & Co., Inc. to the defendant. This transfer resulted in a deposit with the defendant of 2,500 shares of Jack Eckerd Corp. (Eckerd) and an extension of credit by defendant to plaintiffs of $30,735.²

On that date, defendant credited plaintiffs' SMA in the amount of $6,390. The SMA is an account designed to preserve an accrued balance of cash or credit for margin customers. Such accounts are in general use throughout the securities industry. As described by Judge Pollack in Manevich v. duPont, 338 F.Supp. 1124, 1127 (S.D.N.Y), aff'd, 465 F.2d 1398 (2d Cir. 1972) (per curiam), credits in the SMA are derived from:

"cash deposited by the customer, dividends on securities held by the broker for the customer's account, any available portion of the sales proceeds of securities sold in the margin account by the customer and any appreciation in market value of the securities held in the account over the price at which they were purchased."

It is this fourth component which is at issue in this case. The credit of $6,390 represented the difference between the excess loan value of the securities and plaintiffs' adjusted debt balance. With a margin requirement of 55 per cent, the excess loan value of securities worth $82,500 was $37,125 (45% of $82,500).³

On March 28, 1972, the value of the Eckerd stock rose to $85,000. Forty-five per cent of the $2,500 increase was credited to the Palmers' SMA ($1,125). April 5, 1972, the shares' value rose an additional $2,500 to $87,500. Again $1,125 was added to the SMA. The next day, April 6, 1972, the value of plaintiffs' securities jumped $5,000 to $92,500. Forty-five per cent of this increase, or $2,250, was added to the SMA which now totaled $10,871.75.⁴ By April 28, 1972, the value of plaintiffs' Eckerd stock had declined $10,000 and returned to its initial worth of $82,500. No entry was made to the SMA to reflect this loss in value. In addition, a dividend of $87.41 was credited to the SMA and subtracted from the adjusted debit balance. Thus as of May 9, 1972, plaintiffs had an SMA of $10,959.26 and a debit balance of $30,839.79.

On May 9, 1972, defendant purchased 500 more shares of Eckerd stock for the plaintiffs at a cost of $16,952.75. To meet the 55 per cent margin requirement of Regulation T, defendant debited plaintiffs' SMA $9,324.01 (55% of $16,952.75). After the purchase, plaintiffs had a debit balance of $47,792.54 ($30,839.79 + $16,952.75) and an SMA of $1,635.25 ($10,959.26 - $9,324.01). It is clear that if the SMA had been adjusted to reflect the decline in value of plaintiffs' prior holdings in Eckerd, they would not have had sufficient equity in their accounts to purchase the new shares at the 55 per cent margin requirement.

Between May 9, and November 14, 1972, the only entries to plaintiffs' margin accounts consisted of interest charges of $1,782.21 and a dividend credit of $225. At plaintiffs' request, on November 15, 1972, the defendant sent plaintiffs a check for $200. This transaction was effected by reducing the SMA $200 and adding $200 to their debit balance. The defendant did not execute a Federal Reserve Form T-4 which is normally required in cases of non-securities related customer borrowings. 12 C.F.R. § 220.7.

Finally on November 28, 1972, defendant purchased 4,500 shares of Ward Cut-Rate Drug Co. (Ward) for plaintiffs margin account at a cost of $111,936.60. On the same day, defendant created a "short" account for the plaintiffs and sold the 3,000 shares of Eckerd for $113,921.65.⁵ In conformity with its interpretation of Regulation T's "same day transaction" rules, defendant did not require the deposit of any additional equity to plaintiffs' account since the shares sold had a greater market value than those purchased. As the value of their Ward shares declined, plaintiffs fell below the house maintenance margin requirements of defendant.⁶ The short account was closed out March 9, 1973; the Ward shares were sold on April 24, 1973.

Plaintiffs contend that the May 9th purchase of Eckerd stock, the November 15th "withdrawal" of $200, and the November 28th purchase of Ward securities were all violations of Regulation T for which they claim damages.

The Existence of a Private Cause of Action⁷

As a preliminary question, the court must explore whether plaintiffs can maintain a cause of action against Thomas & McKinnon Auchincloss for the alleged violations of Section 7 of the Exchange Act⁸ and Regulation T. Section 220.3(b)(1) of Regulation T provides in pertinent part:

"A creditor shall not effect for or with any customer in a general account . . any transaction which . . . creates an excess of the adjusted debit balance of such account over the maximum loan value of the securities in such account . . unless in connection therewith the creditor obtains, as promptly as possible and in any event before the expiration of 5 full business days following the date of such transaction, the deposit into such account of cash or securities in such amount that the cash deposited plus the loan value of the securities deposited equals or exceeds the excess so created . . .." (Emphasis supplied).

Plaintiffs argue that the uncorrected appreciations in the SMA were not the equivalent of cash or securities and so could not be used to satisfy the margin requirements. In Pearlstein v. Scudder & German, 429 F.2d 1136 (2d Cir. 1970), cert. denied, 401 U.S. 1013, 91 S.Ct. 1250, 28 L.Ed.2d 550 (1971), the Court of Appeals held that an investor has a federal implied right of action for violations of Regulation T. Subsequent to that decision, Congress enacted Section 7(f) of the Exchange Act which renders an investor equally responsible with his broker for observance of the margin requirements by making it unlawful for a borrower to secure credit in violation of the Reserve Board limits. 15 U.S.C. § 78g(f). The court is therefore faced with the unenviable task of determining to what extent, if any, the holding in Pearlstein has been undercut by the amendment to the Act.⁹

Section 7(f) states that:

"It shall be unlawful for any United States person . . . to obtain, receive, or enjoy the beneficial use of a loan or other extension of credit from any lender . . . for the purpose of (A) purchasing or carrying United States securities . . . if, under this section or rules and regulations prescribed thereunder, the loan or other credit transaction is prohibited."

The Act's implementation is entrusted to the Federal Reserve Board which may in its discretion exempt any class of persons from the statute's application. The Reserve Board has promulgated Regulation X to enforce the Act's prohibitions. 12 C.F.R. § 224 et seq.

First there is nothing in the legislative history to suggest that Congress intended to overrule the Pearlstein decision by amending Section 7 of the Exchange Act. Rather Congress' stated purpose was to prevent "the infusion of unregulated foreign credit into American securities markets."¹⁰ According to the House Report, investors were using secret foreign banks and credit sources to finance purchases in American securities markets. There was doubt as to whether Section 7(c) reached such foreign lenders. See Metro-Goldwyn-Mayer, Inc. v. Transamerica Corp., 303 F.Supp. 1354 (S.D. N.Y.1969). To maintain the fiscal integrity of national securities and credit markets, Congress felt it most feasible to place on the investor a duty to comply with the initial margin requirements if his sources of credit were outside the United States. The House Report notes:

"Part of the reason why Section 7 was originally enacted in its present form may

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