In re Adler, Coleman Clearing Corp.

• Citation: 218 BR 689
• Decision Date: 06 March 1998
• Docket Number: Bankruptcy No. 95-08203 (JLG),Adversary No 97/8423A.
• Parties: In re ADLER, COLEMAN CLEARING CORP., Debtor. Edwin B. MISHKIN, as SIPC Trustee for the Liquidation of the Business of Adler, Coleman Clearing Corp., Plaintiff, v. Daniel David ENSMINGER, et al., Defendants.
• Court: United States Bankruptcy Courts. Second Circuit. U.S. Bankruptcy Court — Southern District of New York

218 B.R. 689 (1998)

In re ADLER, COLEMAN CLEARING CORP., Debtor.

Edwin B. MISHKIN, as SIPC Trustee for the Liquidation of the Business of Adler, Coleman Clearing Corp., Plaintiff, v. Daniel David ENSMINGER, et al., Defendants.

Bankruptcy No. 95-08203 (JLG), Adversary No 97/8423A.

United States Bankruptcy Court, S.D. New York.

March 6, 1998.

COPYRIGHT MATERIAL OMITTED

Cleary, Gottlieb, Steen & Hamilton, New York City, for trustee.

Zeisler & Zeisler, P.C., Bridgeport, CT, for defendants.

MEMORANDUM DECISION ON MOTION TO DISMISS COMPLAINT SEEKING JUDGMENT UPHOLDING TRUSTEE'S DETERMINATIONS CONCERNING CERTAIN CUSTOMER CLAIMS

JAMES L. GARRITY, Bankruptcy Judge.

Approximately 90 former customers of Hanover Sterling & Company, Ltd. (collectively, "movants"),¹ an introducing broker whose trades were cleared by Adler, Coleman Clearing Corp. ("Adler" or "debtor") prior to the commencement of a proceeding against it under the Securities Investor Protection Act, 15 U.S.C. §§ 78aaa to 78lll ("SIPA"), move pursuant to Fed.R.Bankr.P. 7012 and Fed.R.Civ.P. 12(b)(6), for an order dismissing that certain Application Upholding the Trustee's Determination Denying Claims of Certain Customers Who Seek to Benefit from Fraudulent Transactions and Expunging Objections with Respect to those Transactions (the "Complaint")² filed by Edwin B. Mishkin, SIPC trustee for the liquidation of Adler (the "trustee"), seeking to uphold his determinations concerning their claims. The trustee and the Securities Investor Protection Corporation ("SIPC") oppose the motion. We deny it.

Facts

On February 27, 1995 (the "Filing Date"), SIPC commenced a liquidation proceeding against debtor under § 78eee(b) of SIPA in the United States District Court for the Southern District of New York. District Judge Loretta A. Preska thereafter ordered that the liquidation proceeding be removed to this court and appointed the trustee to liquidate debtor's remaining assets.

Prior to the Filing Date, Adler was a registered broker/dealer of securities and a clearing firm for 42 introducing broker/dealers.³ Debtor was also a member of the National Securities Clearing Corporation ("NSCC"), SIPC and the National Association of Securities Dealers, Inc. ("NASD"). It held approximately 66,000 active customer accounts on the Filing Date.

Hanover was one of the introducing firms that cleared trades through debtor. Hanover was a registered broker/dealer that acted as an underwriter and market maker for various securities, including, among others, All-Pro Products, Inc. units, American Toys, Inc. common stock, Envirometrics, Inc. common stock and warrants, Mister Jay Fashions Int'l, Inc. common stock and warrants, Panax Pharmaceutical Co. Ltd. units, Play Co. Toys common stock, warrants and units, Porter McLeod common stock and warrants and Eagle Vision, Inc. common stock (collectively, the "House Stocks"). Hanover was the initial underwriter for all of the House Stocks except the Eagle Vision, Inc. common stock, and all of these securities traded on the NASDAQ market, except Eagle Vision, which was listed on the "pink sheets".

As with all of its other introducing brokers, the relationship between debtor and Hanover was governed by a Fully Disclosed Clearing Agreement (the "Clearing Agreement"). As relevant here, that agreement provides that debtor, as Hanover's "agent" shall, among other things, "clear and settle, and if requested to do so, execute transactions" upon Hanover's instructions in customer accounts introduced by Hanover, prepare and mail confirmations to the introduced accounts, settle contracts and transactions in securities between (i) Hanover and other brokers and dealers, (ii) Hanover and the introduced accounts, and (iii) Hanover and third persons, and perform cashiering functions for the introduced accounts, including receiving and delivering securities purchased or sold, and receiving payments therefor. Clearing Agreement ¶ 3. Paragraph 3(b) of the Clearing Agreement provides that

Notwithstanding anything contained in Paragraph 3(a) to the contrary, Adler may, if it has reasonable grounds to believe such action is necessary to protect its interests, refuse to open an account for a specific customer; close an account already opened; refuse to confirm a transaction; cancel a confirmation of a transaction; refuse delivery or receipt of any cash, securities or other property; refuse to clear any transaction executed by Hanover; or refuse to execute any transaction for an introduced Account (notwithstanding its acceptance by the Introducing Firm pursuant to Paragraph 5(d)). Adler shall use its best efforts to notify Hanover of any such action in advance thereof if it is able to do so without jeopardizing its economic interests. . . .

Clearing Agreement ¶ 3(b) (all bracketed material in original except for names).

Paragraph 6(g) of the Clearing Agreement provides that

Should Hanover entrust the execution of an order to Adler, Adler will assume the responsibility for any failure by the contra broker to pay or deliver pursuant to the transaction and will reimburse Hanover for any loss sustained thereby. In case Hanover executes its own order or designates the contra broker, Hanover will assume the responsibility for any failure by the contra broker to pay or deliver pursuant to the transaction and will reimburse Adler for any loss sustained thereby. . . .

Clearing Agreement ¶ 6(g). Pursuant to ¶ 7(i) of the Clearing Agreement, Hanover agreed to indemnify Adler from and against all claims, liabilities and damages arising from, among other things, the failure of either Hanover or its customers to make payment when due for securities sold for Hanover's account or the accounts of its customer. Clearing Agreement ¶ 7(i). The Clearing Agreement further provides that Adler "shall have no liability to any Introduced Account for any loss suffered by them" and that Adler's "liability will be only to Hanover". Clearing Agreement ¶ 13.

Hanover was confronted with a growing crisis in early 1995. As the primary market maker and an underwriter for the original public offering of the House Stocks, it owned many of the House Stocks itself and used them to meet its capital requirements. Also, many of its customers, including movants, owned large quantities of House Stocks. See Complaint ¶ 7. According to the trustee, a group of brokerage houses and persons related to those firms engaged in illegal "short-selling" of the House Stocks beginning sometime prior to February of 1995. The trustee alleges that Hanover originally attempted to respond to this massive short-selling pressure by acceding to the short sellers' extortion demands, but that the short-selling continued despite substantial payments made to them by Hanover. Id. The concerted short-selling of the House Stocks caused downward pressure on their prices, and, according to the trustee, Hanover was aware that the selling could eventually force it into bankruptcy and result in enormous losses for its customers. In an effort to support the price of the House Stocks, Hanover escalated its efforts to sell them to its retail customers, and began to record "phony purchases" by retail customers from its proprietary trading accounts. Id. ¶ 8. While customers did not authorize these "buys", debits were created in their accounts at Hanover that could never be paid. These debits were secured only by the artificially inflated value of the House Stocks. Id.

Specifically, the trustee contends that starting on approximately Monday, February 13, 1995, two weeks before Adler closed its doors, Hanover began to dump stock in its customers' accounts without informing them. Hanover's trading desk processed "buy" tickets for the House Stocks, and Adler cleared them. The Hanover customers who "bought" the House Stocks did not have the cash in their accounts to pay for them, and Adler automatically charged those customers' accounts with debits to cover the price paid for the House Stocks. Id. ¶ 29. Adler also automatically credited Hanover's proprietary accounts with the proceeds, and Hanover was able to use that credit to "purchase" more House Stocks. Id. By means of this illusory buying and selling, Hanover was able for a short time to artificially support the market for the House Stocks, and thereby maintain its minimum net capital requirements. Id. ¶¶ 30-31.

By Friday, February 17, 1995, however, key officials at Hanover understood that their efforts to absorb the massive short selling were futile. As alleged by the trustee, realizing that its days were numbered, Hanover continued to create fake "buys" of the House Stocks to prevent immediate depletion of its capital reserves, while simultaneously "selling" the House Stock out of the accounts of certain favored customers, and utilizing the proceeds of the "sales" to "buy" well-known securities with real value, including Apple, Dell, Ford, Cisco Systems, IBM, AT & T, Birmingham Steel and Microsoft (designated by the trustee and referred to herein as "Blue Chips"). Id. ¶ 31. Inasmuch as there never was actually any cash to acquire the Blue Chips, but merely the proceeds of House Stocks whose prices were artificially and fraudulently inflated by Hanover's alleged machinations, the trustee contends that the Blue Chip "buys" that were used to benefit Hanover's favored customers were fake, and that the "sale" of the House Stocks was part of a scheme to defraud Adler and SIPC. Id. ¶ 32.

The trustee contends that in Hanover's final week of business, from February 17-24, 1995, Hanover customers were forced to "buy" without their knowledge and against their wishes at least $45.1 million of House Stocks at prevailing prices. Id. ¶¶ 33-57. For many Hanover customers, these alleged purchases were the only transactions ever recorded in their accounts. Id. ¶¶ 4-13; 26-55. The trustee alleges that more than 77% of the purported purchases were in accounts that had no trading activity, and in...