Naftalin & Co. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 71-1634

• Decision Date: 29 November 1972
• Docket Number: No. 71-1634,71-1672.,71-1634
• Citation: 469 F.2d 1166
• Parties: In the Matter of NAFTALIN & CO., INC., a Minnesota Corporation, Alleged Bankrupt, Appellee-Cross Appellant, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Delaware Corporation, et al., Petitioners-Appellants-Cross Appellees.
• Court: U.S. Court of Appeals — Eighth Circuit

469 F.2d 1166 (1972)

In the Matter of NAFTALIN & CO., INC., a Minnesota Corporation, Alleged Bankrupt, Appellee-Cross Appellant, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Delaware Corporation, et al., Petitioners-Appellants-Cross Appellees.

Nos. 71-1634, 71-1672.

United States Court of Appeals, Eighth Circuit.

Submitted June 14, 1972.

Decided November 29, 1972.

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Burton R. Rissman, Chicago, Ill., for Kipnis, Donaldson and DuPont.

L. H. May, Jr., Minneapolis, Minn., for Merrill Lynch.

Joe A. Walters, Minneapolis, Minn., for Naftalin.

Before VAN OOSTERHOUT and MURRAH,^* Senior Circuit Judges, and HEANEY, Circuit Judge.

MURRAH, Senior Circuit Judge.

The primary controversy in this bankruptcy proceeding involves the proper interpretation and application of various sections of the Securities Exchange Act of 1934, 15 U.S.C. § 78a et seq., and its implementing regulations. The appellants, six firms engaged in business as securities brokers and dealers, filed involuntary bankruptcy petitions against Naftalin & Company, Inc., also a registered securities broker and dealer, alleging claims totaling more than $650,000 which Naftalin is financially unable to satisfy. The alleged claims are based on Naftalin's asserted breach of certain stock sales contracts which it had entered into with the petitioning creditors. Naftalin's defense is that the contracts are void and unenforceable because entered into in violation of section 7 of the Securities Exchange Act and Regulation T, thereunder; or, in the alternative, that even if initially valid they became unenforceable for failure of the creditors to timely liquidate the contracts as required by the Act and regulations; and, in any event, that the damages claimed should be limited to what they would have amounted to had such liquidation been properly carried out. Section 7, 15 U.S.C. § 78g,¹ prohibits securities brokers and dealers from extending credit to any customer in contravention of rules and regulations prescribed by the Board of Governors of the Federal Reserve System. Regulation T, promulgated by the Board of Governors pursuant to section 7, provides in presently material part:

"(c) Special Cash Account.

"(1) In a special cash account, a creditor may effect for or with any customer bona fide cash transactions in securities in which the creditor may:

"(i) Purchase any security for, or sell any security to, any customer, provided funds sufficient for the purpose are already held in the account or the purchase or sale is in reliance upon an agreement accepted by the creditor in good faith that the customer will promptly make full cash payment for the security and that the customer does not contemplate selling the security prior to making such payment.

"(ii) Sell any security for, or purchase any security from, any customer, provided the security is held in the account or the creditor is informed that the customer or his principal owns the security and the purchase or sale is in reliance upon an agreement accepted by the creditor in good faith that the security is to be promptly deposited in the account." 12 C.F.R. § 220.4. (Emphasis supplied.)

The District Court referred the proceedings to the Referee in Bankruptcy. 315 F.Supp. 463. After consolidating the proceedings and conducting lengthy hearings, the Referee determined that the petitioning creditors had not violated any provisions of the Act or Regulation T, that their contracts with Naftalin were legal, enforceable, and constituted valid claims, and adjudged Naftalin bankrupt. On review the District Court held that the petitioning creditors had violated Regulation T and re-referred the case to the Referee for a determination of what the creditors' claims would amount to if the contracts with Naftalin had been liquidated in compliance with the court's construction of the Regulation. 333 F.Supp. 136. The appealability of the District Court's order is uncontested. Although we are in essential agreement with the District Court's decision, we think it must be modified in some respects, and we remand the case for that purpose.

The Operative Facts

Naftalin & Co., Inc., was incorporated in 1960 by Neil T. Naftalin, its president and 80% stockholder, and two of his associates. It registered as a securities dealer under applicable federal and Minnesota securities laws, and also became a member of the National Association of Securities Dealers (NASD).² From 1960 through 1962 Naftalin conducted a general retail securities business with the public. Beginning in 1963, however, it restricted its business primarily to the purchase and sale of securities for its own account and the personal accounts of Neil Naftalin and a few of his close friends and associates. Since the time it ceased doing business with the public, Naftalin & Co. has operated as a one-man business with Neil Naftalin conducting all of its affairs.

In 1966, Naftalin began a series of "short-selling cycles" — colloquially known as "free-riding." Relying on his astuteness and sophistication in market analysis, Neil Naftalin would watch selected stocks until, in his judgment, they had peaked. He would then place orders with several securities dealers in Minneapolis and other areas of the country to sell large amounts of these stocks for the account of Naftalin & Co., although Naftalin did not own any of the stock. He specifically placed the sell orders in "cash accounts," knowing that such accounts could properly be utilized only when the seller owned the securities it was selling. Naftalin would then watch for the anticipated decline in the market for the securities sold. When he concluded that it had reached its low point, or that he had misjudged the market, he would make offsetting purchases of the securities through different brokers, obtain delivery from them, and then redeliver the securities to the broker through whom they had previously been sold. Receiving payment against delivery, Naftalin would, of course, realize a profit or loss on the difference between sale and purchase prices. This scheme was generally successful and Naftalin gradually increased the scope of its activity. In various cycles Naftalin realized profits and losses in excess of $800,000. Naftalin was at pains to conceal the fact that he was selling short, and when occasionally pressed as to why delivery of securities was slow he would mislead the questioning broker/dealers with prevarications and evasions.

In August, 1969, Naftalin embarked upon its most extensive short-selling venture — the one that resulted in this litigation. During that month Naftalin placed sell orders in excess of $10,000,000 with 27 separate securities dealers, six of whom are the petitioning creditors. As in earlier cycles, Naftalin made certain that each sale was placed in a special cash account and concealed the fact that the transactions were actually short sales. Most of these sales were brokerage or agency transactions in which the broker/dealer charged a commission for acting as Naftalin's agent in the sale of the stock to a third party. Appellant Kipnis & Company emphasizes the fact that, in addition to acting as agent on some sales, it purchased stock from Naftalin as principal for its own account in third market transactions. When Naftalin did not deliver the securities sold by settlement date the broker/dealers usually made delivery to purchasing brokers from stock in their own inventory or borrowed by them.

During this cycle the market prices of the securities which Naftalin had sold began to rise almost immediately after the sales and continued to climb for several weeks, making it financially impossible for Naftalin to effectuate offsetting purchases as he had planned. After several weeks, some of the broker/dealers began to inquire of Naftalin as to when they could expect delivery. Naftalin met these inquires with typically evasive and misleading replies.³ Kipnis, along with some of the non-petitioning broker/dealers, demanded and received mark-to-the-market payments⁴ from Naftalin. After finally concluding that his predicament was financilly hopeless, Naftalin called a meeting of the 22 broker/dealers affected by the still outstanding short sales. At this meeting the broker/dealers were informed for the first time that Naftalin did not own the securities it had sold and could not meet its delivery obligations. The broker/dealers then bought-in the undelivered stocks for Naftalin's account at an aggregate loss of more than $1,285,000.

Shortly thereafter, in response to proceedings initiated by the Securities and Exchange Commission (SEC), the District Court (Larson, J.) appointed a receiver for Naftalin. The appellants then filed two involuntary bankruptcy petitions under section 59(b) of the Bankruptcy Act, 11 U.S.C. § 95(b), alleging that Naftalin had committed the "fifth act of bankruptcy," 11 U.S.C. § 21(a) (5), by permitting a receiver to be appointed at a time when it was insolvent and unable to pay its debts as they matured. The petitioning creditors' aggregate asserted claims of $653,734.54 are based primarily on the differences between the buy-in price and the original sales price of the undelivered stock.

The Issues

Despite its obvious and calculated wrongdoing, Naftalin contends that it was the petitioning creditors' failure to comply with section 7 of the Securities Exchange Act and its implementing regulations which made the short-selling scheme possible, and, therefore, that as a matter of sound public policy the petitioning creditors should not be permitted to enforce their contracts. Naftalin's contention is that the petitioning creditors violated section 7 of the Act and section 4(c) (1) (ii) of Regulation T, supra, by accepting Naftalin's sell orders for its special cash account when the securities sold were not then held in the account and, that in light of Naftalin's past performances, the dealers...