Carr v. New York Stock Exchange, Inc.

• Decision Date: 30 April 1976
• Docket Number: No. C-73-0367-SW.,C-73-0367-SW.
• Court: U.S. District Court — Northern District of California
• Parties: Robert G. CARR et al., Plaintiffs, v. NEW YORK STOCK EXCHANGE, INC., an Unincorporated Association, and American Stock Exchange, Inc., an Unincorporated Association, Defendants.

414 F. Supp. 1292

Robert G. CARR et al., Plaintiffs, v. NEW YORK STOCK EXCHANGE, INC., an Unincorporated Association, and American Stock Exchange, Inc., an Unincorporated Association, Defendants.

No. C-73-0367-SW.

United States District Court, N. D. California.

April 30, 1976.

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Timothy N. Brown, Bruce M. Casey, Jr., Kerry C. Smith, Chickering & Gregory, San Francisco, Cal., for defendant American Stock Exchange Inc.; John J. Loflin, Lord, Day & Lord, New York City, of counsel.

John B. Bates, Donald G. McNeil, Pillsbury, Madison & Sutro, San Francisco, Cal., for defendant New York Stock Exchange, Norman R. Nelson, Edward J. Reilly, Russell E. Brooks, Milbank, Tweed, Hadley & McCloy, New York City, of counsel.

Charles M. Richardson, Jr., Corte Madera, Cal., Ronald Lovitt, J. Thomas Hannan, Lovitt, Hannan & Hennigan Inc., San Francisco, Cal., for plaintiffs.

MEMORANDUM OPINION

SPENCER WILLIAMS, District Judge.

This case is presently before the court on three motions:

(1) Plaintiffs' motion to certify the class denominated in the amended complaint, pursuant to F.R.Civ.P. 23;

(2) Plaintiffs' motion to compel answers in oral examination, pursuant to F.R. Civ.P. 30(b)(6) and 37; and

(3) Defendant's motions to dismiss and for summary judgment pursuant to F.R.Civ.P. 56.

The amended complaint in this case alleges liability on the part of the New York Stock Exchange (Exchange) for the failure and forced liquidation of the brokerage house of Blair after its merger with the brokerage house of Schwabacher in 1969, and for losses sustained by the plaintiffs, who were investors in Blair. Liability is claimed to arise under Sections 6, 10(b) and 20(a) of the Securities Exchange Act of 1934 (the Act) and the Rules of the Securities and Exchange Commission (SEC) and the Exchange promulgated thereunder.

I. DEFENDANT'S MOTION TO DISMISS

The amended complaint sets forth 12 counts of alleged violations of securities laws: Counts 1, 2, and 3 allege that the Exchange breached its contractual duties to the plaintiff investors under § 6 of the Act by permitting Blair to sell unregistered securities without a "knowledgeability letter" or full disclosure of Blair's financial condition. Counts 4, 5, and 6 allege that the Exchange violated its own Rules under § 6 of the Act by allowing Schwabacher to continue operation and to merge with Blair after serious violations of Exchange Rules on recordkeeping, commingling, capital reserve ratios and Exchange audits. Count 7 relates further § 6 violations by the Exchange's suppression of material information concerning these violations from the plaintiffs and the public. Count 8 alleges a violation of Exchange Rules under § 6 in the sale of unregistered securities in Blair. Counts 9, 10, and 11 allege that the Exchange violated § 10(b) and SEC Rule 10b-5 by fraudulently omitting disclosure of information material to the sale of securities in Blair, by aiding and abetting Blair in issuing securities without necessary disclosures, and by engaging in a conspiracy with Blair to defraud plaintiffs. Finally, in Count 12 plaintiffs allege that the Exchange is a "controlling person" within the meaning of § 20(a) of the Act and is thus jointly and severally liable for the securities violations of Schwabacher and Blair. Each of the allegations of the complaint will be considered in turn below.

The § 6 Claims

Plaintiffs' claims arise out of two pertinent subsections of § 6: § 6(a) requires the execution of a contract between the SEC and any registered national securities exchange under which the exchange is bound to enforce "so far as is within its powers" compliance by its member firms with securities laws and SEC regulations; § 6(b) states that an exchange may not be registered and may not remain registered with the SEC unless its rules "include provision for the expulsion, suspension or disciplining of a member for conduct or proceeding inconsistent with just and equitable principles of trade."¹ There are two threshold issues in the application of these sections: First, do the plaintiffs have standing to assert an implied right of action either in tort or as third-party beneficiaries of the registration agreement between the SEC and the Exchange? Second, if they have standing, are their claims barred by the applicable statute of limitations? The court holds that plaintiff investors herein have standing under § 6 to pursue this action and that they are not barred by the applicable statute of limitations.

Defendants contend that by § 6 Congress intended to protect only the public customers of the Exchange and not private investors in the brokerage houses themselves. This contention is not without merit. There were no such investors in 1934 because brokerage houses were not permitted to incorporate until 1953. In addition, in 1970 Congress specifically excluded investors in brokerage houses from the protection afforded Exchange "customers" in the Securities Investors Protection Act.² However, courts have properly held that the Congressional intent in enacting § 6 was to protect all parties likely to be harmed by a breach of an exchange's self-regulation agreement with the SEC. The leading case of Baird v. Franklin, 141 F.2d 238, 239 (2d Cir.) cert. denied 323 U.S. 737, 65 S.Ct. 38, 89 L.Ed. 591 (1944) held that the New York Stock Exchange had a duty to public investors under § 6 to investigate Exchange members and to "suspend or expel members who it had reason to believe had been guilty of conduct inconsistent with just and equitable principles of trade." The courts did not reach the question whether those protected by the SEC-Exchange agreement mandated by § 6(a)(1) had an implied private right of action as third-party beneficiaries of that agreement, but implied that they would have that right. Subsequent cases have extended the scope of the implied right of action beyond the public customers of an exchange. In Pettit v. American Stock Exchange, 217 F.Supp. 21 (S.D.N. Y.1973) the court held that a corporation sustaining losses in the value of its securities due to the exchange's failure to regulate its member firms had an implied right of action under § 6. Recent cases have held that the implied right of action is vested in partners and investors in Exchange member firms as well. New York Stock Exchange v. Sloan, 394 F.Supp. 1303 (S.D.N.Y. 1975), Weinberger v. New York Stock Exchange, 403 F.Supp. 1020, CCH Fed.Sec.L. Rep. 95, 348 (S.D.N.Y.1975). Sloan and Weinberger were cited approvingly by the Ninth Circuit in Hughes v. Dempsey-Tegeler & Co., Inc. 534 F.2d 156 (9th Cir. 1976) (at n. 4), which extended the implied right of action under § 6 to a subordinated lender to a brokerage house. Plaintiff investors in the present case are in substantially the same position as the plaintiff in Hughes and are also entitled to § 6 protections. Plaintiffs here are among those

members of the Exchange community who are intended to be benefited by such rules . . . and who stand in the kind of relationship to the firm which requires them to rely on its compliance with the rules. Sloan, supra 394 F.Supp. at 1310.

The gravamen of plaintiffs' § 6 allegations is that the Exchange has breached its contractual obligations under the written registration agreement with the SEC. Weinberger, supra. The applicable statute of limitations is therefore Cal.Code Civ.Pro. § 337(1) governing third-party suits on a written contract.³ Under California law the beneficiary's cause of action accrues when the obligation is breached, and the action is not barred until four years after that date. This action was filed on March 8, 1973. The court therefore finds that plaintiffs are not barred by the statute of limitations from asserting their § 6 claims for those breaches of the SEC-Exchange agreement occurring after March 8, 1969.

While the scope of the implied right of action under § 6 is to be interpreted broadly, the scope of the duty owed by the Exchange must be circumscribed. The Securities Exchange Act is grounded in the concept of Exchange self-regulation. The § 6 mandate "to enforce so far as is within its powers," must be evaluated reasonably. Hughes, supra. While unfettered discretion on the part of the Exchange in the enforcement of its rules cannot be permitted under the Act, § 6 necessarily invests the Exchange with a great deal of discretion in the promulgation and enforcement of rules and in the supervision of Exchange members. See, e. g., Rich v. New York Stock Exchange, 379 F.Supp. 1122 (S.D.N.Y.1974).

In enforcing its rules and in making complex decisions on the suspension or forced liquidation of members, the Exchange must consider the often conflicting interests of the member firm, its partners, and investors, and the corporations whose securities are handled by the firm, as well as the Exchange's public customers. Under these circumstances it cannot be said, as plaintiffs here seem to contend, that complete suspension should automatically follow a firm's breach of Exchange rules. Nor does § 6 render the Exchange a guarantor of all its members' mismanagement or fraudulent activities. Indeed, § 6 requires only that the Exchange rules provide for the expulsion, suspension, or disciplining of member firms that are in violation of the Exchange rules. Within this context plaintiffs have a considerable task in establishing a § 6 breach by the Exchange. In Hughes, supra, the Ninth Circuit held that:

As long as the Exchange takes prompt action to investigate alleged violations, and having ascertained that violations exist, takes action reasonably designed to restore compliance with the rules, courts should not substitute their retrospective judgment concerning the appropriate action. 534 F.2d 156, 170 (9th Cir. 1976).

Under this formulation of the duty, actual knowledge of a member firm's misconduct is not a prerequisite to the...