Decision Date31 May 1974
Docket NumberDocket 73-2294.,No. 550,550
PartiesSECURITIES AND EXCHANGE COMMISSION, Plaintiff, Securities Investor Protection Corporation, Applicant-Respondent, v. PACKER, WILBUR & CO., INC., et al., Defendants.
CourtU.S. Court of Appeals — Second Circuit


Edward J. Boyle, New York City (W. Foster Wollen, Shearman & Sterling, New York City, of counsel), for claimant-appellant Coggeshall & Hicks, Inc.

Martin R. Gold, New York City (Eric Bregman, Gold, Farrell & Marks, New York City, of counsel), for appellee, trustee for Packer, Wilbur & Co., Inc.

Michael E. Don, Washington, D. C. (Theodore H. Focht, Gen. Counsel, Wilfred R. Caron, Associate Gen. Counsel, Securities Investor Protection Corp., Washington, D. C., of counsel), for appellee Securities Investor Protection Corp.

Before MOORE, MANSFIELD and OAKES, Circuit Judges.

MANSFIELD, Circuit Judge:

The failure of a business is an unhappy event for debtor and creditor alike. When the bankrupt is one of the pillars of the financial community, a brokerage firm long identified in the popular mind with stability and redoubtable finance the failure can produce a tremor in financial circles throughout the nation. The near collapse in 1969 of Hayden Stone and the rumors of impending failures of other brokerage houses cast a pall over Wall Street that was reminiscent of its never-to-be-forgotten "Black Tuesday." The industry naturally feared that the breakdown of these houses would be attended by a general decline in public confidence in the securities market. Congress soon became concerned for the state of the market and in particular for the plight of the many small investors who fell victim to the economic demise of their brokers. The upshot was a legislative effort to reinforce the flagging confidence in the securities market by providing an extra margin of protection for the small investor. The measure adopted was the Securities Investor Protection Act of 1970 ("SIPA"), 15 U.S.C. § 78aaa et seq., which assures a minimum recovery to customers of insolvent brokerage houses from a quasi-public fund. The core provision of SIPA specifies that the Securities Investor Protection Corporation ("SIPC"), a nonprofit corporation consisting of all broker-dealers and members of national securities exchanges, shall advance to the trustee of a bankrupt house up to $50,000 for each customer claiming securities and $20,000 for each customer claiming cash from the brokerage house. 15 U.S.C. § 78fff(f) (1). The source of the SIPC fund is the general brokerage community, which pays tithes to SIPC to finance its work. 15 U.S.C. § 78ddd. Operation of this machinery is triggered by SIPC's determination that a broker is on the verge of insolvency, whereupon SIPC applies to the district court for an adjudication that the broker's customers are entitled to the protection of SIPA. The present case requires us to define some of the bounds of protection afforded by SIPA and, more particularly, to determine who its beneficiaries may be.

Packer, Wilbur & Co., Inc. ("Packer Wilbur") fell upon hard times in 1971. In June of that year a trustee was appointed to liquidate the brokerage house pursuant to the provisions of SIPA. Among those filing claims with the trustee were Effrem Arenstein, an individual investor, and Coggeshall & Hicks, Inc. ("Coggeshall"), a brokerage house that represented Arenstein in a transaction with Packer Wilbur. The particular deal was hardly the paradigm of responsible trading in the securities market. The largest share of the blame seems to rest with Arenstein. On February 3, 1971, he instructed Coggeshall to purchase 2,000 shares of Syntex common stock for his account. Arenstein did not remit payment for the securities. Nor did he have sufficient funds in his special cash account at Coggeshall to cover the purchase price of $90,933.82. Under the Federal Reserve Board's "Regulation T," 12 C.F.R. § 220.4(c), Coggeshall was permitted to execute the transaction only if it acted in reliance upon Arenstein's agreement that he would make prompt payment for the securities and that he did not contemplate selling the securities prior to making payment.1

The Set-up

Events proved that Arenstein was not as good as his word. It appears that Arenstein had from the very outset planned to sell the Syntex stock—at a profit—and use the proceeds of that sale to pay Coggeshall for the original purchase.2 It is a technique known in the trade as a "free-ride."

Shortly after Coggeshall had purchased the stock for Arenstein's account, Arenstein instructed his other broker, Packer Wilbur, to sell 2,000 shares of Syntex stock for his account with it, which Packer Wilbur did at a sale price of $94,203.10. Armed with this knowledge, Arenstein directed Coggeshall to deliver the Syntex shares which Coggeshall had purchased through it to Packer Wilbur against payment. Arenstein expected Packer Wilbur to pay Coggeshall for the shares with the proceeds of its sale of the same Syntex shares for his account with it. The net result of the transaction would be a $3,269.28 profit in Arenstein's account at Packer Wilbur, wrought without any cash investment by Arenstein.

The Sting

Arenstein's scheme failed on the verge of fulfillment. Packer Wilbur must have surmised that Arenstein was attempting a free-ride and seized the opportunity to improve its own lot. When Coggeshall delivered the Syntex stock, Packer Wilbur paid with two faulty checks. Meanwhile it hastened to complete its own sale of the stock to a third party, applying the proceeds to its own account. When Coggeshall discovered the fraud, it stood with the dishonored checks in its own hands. Meanwhile the Syntex stock had passed into the hands of a bona fide purchaser. Coggeshall sued Packer Wilbur on the dishonored checks. It preserved its options, however, by filing suit against Arenstein as well.

Shortly thereafter Packer Wilbur went under and a SIPC trustee was appointed for it. Coggeshall and Arenstein lodged separate claims in the ensuing liquidation. Coggeshall sought reimbursement from SIPC in the amount of $90,933.82 on the theory that the checks represented an open contractual commitment of Packer Wilbur that the trustee must complete under § 6(d) of the Act.3 Arenstein argued that as a customer of Packer Wilbur he was entitled to a $50,000 advance on his underlying claim against Packer Wilbur.4 The district court denied both claims. See 362 F.Supp. 510 (S.D.N.Y.1973). It ruled first that Arenstein, who had misrepresented his intention to make prompt payment, thereby violated the margin rules as well as Rule 10b-5 and should be denied the benefits of the SIPC fund, which was intended to protect innocent investors. As for Coggeshall, the court concluded that it too must be denied any relief under SIPA because its conduct had contributed to a violation of the margin rules. Arenstein has not appealed the adverse determination of his claim; Coggeshall has. Coggeshall strenuously argues its right to recover from SIPC on the ground that it did not in any of its actions violate Regulation T.


The district court rested its decision denying Coggeshall any relief under SIPA on its conclusion that Coggeshall had violated Regulation T, or had breached some duty of due care imposed by that Regulation, when it allowed Arenstein to obtain a free-ride. We disagree.

It is undisputed that Coggeshall had acted properly in effecting the purchase of Syntex stock for Arenstein's account. The fault, if any, must lie in the second part of the transaction, i.e., when Coggeshall, at the direction of its customer, delivered the stock to Packer Wilbur against payment. The district court noted that Coggeshall was thereby placed on constructive notice that Arenstein was attempting a free-ride. It implied that Coggeshall should have refused to deliver the stock unless it was assured that Arenstein already had sufficient funds in his Packer Wilbur account to cover the purchase price of the stock. We do not share this view. Section 220.4(c) (8) of Regulation T, which controls this problem for special accounts,5 does not prohibit free-riding; it simply imposes a foreclosure on other credit or delayed-payment transactions if a free-ride or other premature sale has occurred within the preceding 90 days. Once a free-ride has occurred, to allow the customer delayed payment during the ensuing 90 days, whether or not it eventuates in another free-ride, is to violate § 220.4(c) (8). To sell or deliver out unpaid-for stock at a customer's request when a freeze is not in effect, on the other hand, would not appear to violate the section.6 Since there was no freeze in effect on Arenstein's account at Coggeshall, the latter could legitimately comply with Arenstein's order.7

Nor was there a requirement that Coggeshall, before making delivery of the shares, obtain a "Letter of Free Credit" from Packer Wilbur. The practice of obtaining such a letter is an optional one. If followed, it would permit the delivering firm, Coggeshall, to continue Arenstein's account on an unrestricted basis. See Reg. T, 12 C.F.R. § 220.4(c) (8). But the only effect of failure to obtain such a letter was to bar use of the account for further free-rides during the ensuing 90-day period.

The SEC has apparently espoused this interpretation of Regulation T. In several of its opinions it has suggested that a free-ride does not in and of itself violate the Regulation, but that free-riding does violate the Regulation when it occurs during a freeze period. See, e.g., In the Matter of Coburn and Middlebrook, Inc., 37 S.E.C. 583, 585 n. 6 & 588 n. 14 (1957); In the Matter of Thomson & McKinnon, 35 S.E.C. 451, 458-59 (1953).8 See also 2 L. Loss, Securities Regulation 1253-54 (1961). Thus there is good reason to believe that Coggeshall did not violate Regulation T when it completed the isolated free-ride transaction for...

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