Birotte v. Merrill Lynch, Pierce, Fenner & Smith

• Citation: 468 F. Supp. 1172
• Decision Date: 11 April 1979
• Docket Number: Civ. A. No. 78-469.
• Parties: Andre BIROTTE, Plaintiff, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Corporation authorized to do business in the State of New Jersey, and Frank J. Fierro, Defendants.
• Court: U.S. District Court — District of New Jersey

468 F. Supp. 1172

Andre BIROTTE, Plaintiff, v. MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Corporation authorized to do business in the State of New Jersey, and Frank J. Fierro, Defendants.

Civ. A. No. 78-469.

United States District Court, D. New Jersey.

April 11, 1979.

Blume & Weiseman by Clark Alpert, Newark, N. J., for plaintiff.

Moore & Howell by John L. Moore, Morristown, N. J., for defendants.

OPINION

MEANOR, District Judge.

Presently before the court are motions by the defendants for a partial summary judgment or, alternatively, to dismiss certain counts of the complaint for failure to state a claim upon which relief can be granted.

INTRODUCTION

On January 17, 1977, plaintiff filed Civil Action No. 77-105 in this court. The matter was assigned to Judge Frederick B. Lacey. After the case had been pretried before U. S. Magistrate William J. Hunt and was scheduled for trial, plaintiff moved to amend his complaint. While the original complaint basically alleged violations of certain provisions of the Securities Exchange Act of 1934 and SEC Rule 10b-5, the proposed amended complaint added claims for violations of Federal Reserve Regulation T, violations of the Rules of the New York Stock Exchange (NYSE), the Chicago Board of Options Exchange (CBOE), and violations of the New Jersey Uniform Securities Law. In connection with the motion to amend the complaint, plaintiff's attorney filed an affidavit to which was annexed, as an exhibit, the report of his expert Warren H. Bree, dated February 14, 1978. The Bree report identifies particular transactions in plaintiff's brokerage account which are alleged to be in violation of Regulation T and various rules of those exchanges. On March 9, 1978, the parties entered into a stipulation which noted the court's denial of plaintiff's motion to amend the complaint, and voluntary dismissal of Civil Action No. 77-105 without prejudice. An Order formally denying the motion to amend the complaint was filed on March 13, 1978. On March 9, 1978, the date the stipulation was entered into by the parties, plaintiff filed the complaint in this action, Civil No. 78-469. This complaint is an exact replica of the proposed amended complaint in Civil No. 77-105. The matter was assigned to Judge Lacey. By memorandum of March 21, 1978, Judge Lacey requested the Clerk of the Court to reassign the newly filed case to another judge. On March 23, 1978, then Chief Judge Whipple reassigned the matter to me.

I THE FACTS

This is an action for damages filed by Andre Birotte against Merrill Lynch, Pierce, Fenner & Smith, Inc., and its employee Frank J. Fierro. The complaint alleges the use of deceptive practices and fraudulent advice in violation of Rule 10b-5; churning; violations of the NYSE and CBOE Rules regarding suitability, margin maintenance requirements, and the registration and supervision of employees; violations of Federal Reserve Regulation T; and violations of the New Jersey Uniform Securities Law. Defendants have answered with denials of any violations or wrongdoing in connection with their handling of plaintiff's account. Additionally, defendants have asserted numerous affirmative defenses including the statute of limitations.

The stipulation entered into by the parties in the earlier case provided: "Defendants will not assert any statute of limitations defenses to the causes of action set forth in the new litigation which duplicate the causes of action alleged against defendants in this Civ. No. 77-105 litigation." See Appendix A (Stipulation). Plaintiff alleges that violations of duty by defendants constituted a course of conduct continuing at least until the end of plaintiff's account with defendants in April 1976. See Complaint, First Count at ¶ 5. Plaintiff further urges that defendants' course of conduct very likely continued until the Bree report enabled plaintiff to discern the nature of the violations alleged. Plaintiff's Brief at 1.

As a brokerage customer of defendant Merrill Lynch, plaintiff had an account in defendant's Newark, New Jersey office from October 1974 through April 1976, and an account in one of defendant's New York offices from May through December 1975. Complaint, First Count at ¶ 5. Defendant Fierro is the Registered Representative in defendant's Newark office who handled plaintiff's account there. Complaint, First Count at ¶¶ 3, 5. Defendants have moved alternatively for summary judgment or dismissal of the Second, Third, Fourth and Eighth Counts of the complaint. Each of these counts incorporates by reference the First Count which alleges the basic 10b-5 claim of deceptive practices and fraudulent advice in the management of plaintiff's account.

II THE SECOND COUNT AND NYSE RULE 405

In the Second Count of the complaint, plaintiff alleges that defendants are subject to the Rules of the New York Stock Exchange and, during the period of management of plaintiff's account, defendants violated NYSE Rule 405 in failing to properly exercise due diligence in handling the account. NYSE Rule 405 is the so-called "Know Your Customer" rule.¹ The thrust of the Rule is that brokerage firms which are members of the NYSE must use due diligence to learn the essential facts relative to every customer, every order and every account carried by the member firm; supervise each account handled by its registered representatives; and approve the opening of all new accounts. Plaintiff alleges that defendants violated this Rule and are thus liable for damages flowing from such violation. At issue is whether violation of this Rule gives plaintiff a private right of action.

There is a split among the Circuits as to whether violations of the stock exchange rules give rise to such action. The two major lines of thought arise from the Second and Seventh Circuits. The Second Circuit was the first Court of Appeals to address the issue of what particular circumstances may give rise to a federal cause of action for violation of an exchange rule. In Colonial Realty Corp. v. Bache & Co., 358 F.2d 178 (2d Cir.), cert. denied, 385 U.S. 817, 87 S.Ct. 40, 17 L.Ed.2d 56 (1966), Judge Friendly stated:

Whether the courts are to imply federal civil liability for violation of exchange or dealer association rules by a member cannot be determined on a simplistic all-or-nothing basis . . . rather, the court must look to the nature of the particular rule and its place in the regulatory scheme, with the party urging the implication of a federal liability carrying a considerably heavier burden of persuasion than when the violation is of the statute or an SEC regulation.

358 F.2d at 182. The Colonial Realty Court rejected a private implied cause of action for violation of Article III, section 1, of the Rules of Fair Practice of the National Association of Securities Dealers. Section 2 of that Article, "The Suitability Rule" is closely analogous to NYSE Rule 405.² The court recognized that the Securities Exchange Act of 1934 did not specifically authorize actions for violation of private association rules, but said that it would recognize an implied cause of action where the rule violated; first, amounted to a substitute for an SEC regulation, and second, established an explicit duty unknown to the common law. 358 F.2d at 182; see Utah State University v. Bear Stearns & Co., 549 F.2d 164, 167 (10th Cir. 1977).

The Seventh Circuit, in Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135 (7th Cir.), cert. denied, 396 U.S. 838, 90 S.Ct. 98, 24 L.Ed.2d 88 (1969), recognized an implied cause of action under NYSE Rule 405. That Court stated that a determination of whether a violation of a rule is actionable depends on whether its design is "for the direct protection of investors," and said that one of the functions of Rule 405 was the protection of the public. 410 F.2d at 142.³ The Buttrey Court failed to determine whether Rule 405 imposed a duty unknown at common law or could be viewed as a substitute for Commission regulation. Sacks v. Reynolds Securities, Inc., 193 U.S.App.D.C. 80, 88, 593 F.2d 1234, 1242 (1978). The two-prong Buttrey test asks: (1) is the rule designed for the direct protection of investors?, and if so (2) does the conduct involve more than mere errors of judgment or negligence so as to be tantamount to fraud. Buttrey, supra, 410 F.2d at 143.

The Buttrey case has been the subject of vigorous criticism by courts and commentators.⁴ These critics have pointed out that Rule 405 was not promulgated to protect customers from shady brokers but rather to protect brokers from unscrupulous customers. Utah State University, supra, 549 F.2d at 167. This criticism has its basis in SEC, Report of Special Study of Securities Markets of the Securities and Exchange Commission, H.R.Doc.No.95, 88th Cong. 1st Sess., pt. 1 at 316 (1963). Id. at 167-168.

The complaint in Buttrey alleged fraudulent conversion of securities. On those facts that Court recognized a private civil damage action. It did not say, however, that an alleged violation of Rule 405 was per se actionable. Buttrey, supra, 410 F.2d at 143. The facts alleged in this complaint in the Second Count make no specific allegations of fraudulent conversion or any fraud at all — only that defendants failed to exercise due diligence in the supervision of plaintiff's account, as required by Rule 405. The allegation can best be construed as negligence, and is certainly not tantamount to the fraud alleged in Buttrey. The fact that plaintiff has incorporated by reference in the Second Count the allegations of fraud contained in the First Count is insufficient to sustain a claim for fraud. The circumstances constituting fraud must be stated with particularity. Fed.R.Civ.P. 9(b). The Court of Appeals for the Tenth Circuit noted in holding that violations of exchange rules do not give rise to a private cause of action:

No different result is mandated by joining the rule violations with a Rule 10b-5 claim. It adds nothing

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