Levitin v. PaineWebber, Inc.

• Decision Date: 09 July 1996
• Docket Number: No. 95 Civ. 6508 (DC).,95 Civ. 6508 (DC).
• Citation: 933 F. Supp. 325
• Parties: Raizy LEVITIN, On Behalf of Herself and All Others Similarly Situated, Plaintiff, v. PAINEWEBBER, INC., Defendant.
• Court: U.S. District Court — Southern District of New York

933 F. Supp. 325

Raizy LEVITIN, On Behalf of Herself and All Others Similarly Situated, Plaintiff, v. PAINEWEBBER, INC., Defendant.

No. 95 Civ. 6508 (DC).

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

July 9, 1996.

Kaufman Malchman Kirby & Squire, LLP by Ira M. Press, Roger W. Kirby, New York City, Bernstein Liebhard & Lifshitz by Mel E. Lifshitz, New York City, for plaintiff.

Solomon, Zauderer, Ellenhorn, Frischer & Sharp by David E. Nachman, Richard T. Sharp, Emily Stern, New York City, for defendant.

OPINION

CHIN, District Judge.

Raizy Levitin ("Levitin" or "plaintiff") brings this action on behalf of herself and all other persons who have conducted short sales through PaineWebber, Inc. ("PaineWebber" or "defendant") since August 15, 1992 alleging that PaineWebber, by purportedly misappropriating funds that its customers provided as collateral, engaged in securities fraud. In addition to the federal securities fraud claims, plaintiff and the putative class assert various state law claims. Defendant moves to dismiss the complaint for failure to state a claim for securities fraud under section 10(b) of the Securities and Exchange Act of 1934 ("the 1934 Act"), 15 U.S.C. § 78j(b), and, if this claim is dismissed, to dismiss the remaining claims for lack of subject matter jurisdiction. Because the alleged fraud was not perpetrated "in connection with" the purchase or sale of securities within the meaning of the 1934 Act, PaineWebber's motion is granted.

BACKGROUND¹

In 1994, Levitin entered into a margin agreement with PaineWebber, a registered broker-dealer. Through her PaineWebber margin account, plaintiff engaged in short sales of securities. In the typical short sale, the customer sells stock that he or she does not own. The customer usually covers the sale with stock borrowed from the broker. If the customer is able to purchase the stock later at a lower price to repay the stock to the broker, the customer will earn a profit equal to the difference between the sale price and the purchase price.² To secure the loan of stock, the customer is required to provide the broker with collateral in the form of cash or securities.³ The proceeds of the short sale, which are applied toward the margin requirement, remain in the customer's account until the sale is covered.

The broker obtains the stock that it loans to the customer from its own reserves or by borrowing it from other brokers or other customers, as permitted by standard margin agreements. When the broker borrows the stock from external sources, the broker must secure the loan with collateral worth at least 100% of the market value of the securities borrowed. Regulation T, 12 C.F.R. § 220.16. The funds used to secure the loan of stock may be taken directly or indirectly from the account of the customer engaging in the short sale, and typically are generated by the short sale itself.

Where the broker has provided collateral to another broker or institution to secure the loan of securities, the borrowing broker typically receives a portion of any interest earned on the collateral, known as a "rebate." The borrowing broker does not usually pass any of the interest on to its customer, although an exception is sometimes made for large or professional customers.

In essence, the complaint alleges that PaineWebber uses its customers' assets, in the form of cash and stock collateral and proceeds of short sales, to earn interest and to obtain other financial benefits without notifying the customers of this practice or sharing the proceeds with them. Based upon these allegations, Levitin and the putative class assert claims for securities fraud, breach of fiduciary duty, breach of trust, breach of implied covenants of good faith and fair dealing, and violation of Article 9 of the Uniform Commercial Code.

DISCUSSION

A. Standard for Motion to Dismiss

In ruling upon the motion to dismiss the complaint under Rule 12(b)(6), I must view the complaint in the light most favorable to Levitin, accepting all allegations contained in the complaint as true. See Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S.Ct. 1683, 1686, 40 L.Ed.2d 90 (1974); Annis v. County of Westchester, 36 F.3d 251, 253 (2d Cir. 1994). All reasonable inferences are to be drawn in the plaintiff's favor, and the claims should not be dismissed unless it appears beyond doubt that the plaintiff can prove no set of facts in support of her claim that would entitle her to relief. See Scheuer, 416 U.S. at 236, 94 S.Ct. at 1686 (citing Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 102, 2 L.Ed.2d 80 (1957)); Christ Gatzonis Elec. Contractor, Inc. v. New York City Sch. Constr. Auth., 23 F.3d 636, 639 (2d Cir.1994).

B. Securities Fraud Claims

Levitin bases her securities fraud claims upon defendant's alleged violation of three rules promulgated under section 10(b) of the 1934 Act: Rule 10b-5, Rule 10b-10, and Rule 10b-16.

1. Rule 10b-5

To state a claim under section 10(b) and Rule 10b-5, the general securities fraud provision, a plaintiff must allege that "in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused plaintiff injury." In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 264 (2d Cir.1993) (quoting Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 61 (2d Cir. 1985)), cert. denied, ___ U.S. ___, 114 S.Ct. 1397, 128 L.Ed.2d 70 (1994) (internal quotations omitted); accord Acito v. IMCERA Group, Inc., 47 F.3d 47, 52 (2d Cir.1995); see Luce v. Edelstein, 802 F.2d 49, 55 (2d Cir. 1986) ("To state a claim under Section 10(b), a complaint must allege material misstatements or omissions indicating an intent to deceive or defraud in connection with the purchase or sale of a security.") (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976)).

The alleged misrepresentation or omission must be made "in connection with the purchase or sale" of a security. 15 U.S.C. § 78j(b); 17 C.F.R. § 240.10b-5; see Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930, 943 (2d Cir.), cert. denied, 469 U.S. 884, 105 S.Ct. 253, 83 L.Ed.2d 190 (1984). To satisfy this requirement, the misrepresentation or omission must pertain to the securities themselves; allegations of fraud merely involving securities are not sufficient. See Chemical Bank, 726 F.2d at 943. In Chemical Bank the Second Circuit described the rationale for this requirement as follows:

The purpose of § 10(b) and Rule 10b-5 is to protect persons who are deceived in securities transactions — to make sure that buyers of securities get what they think they are getting and that sellers of securities are not tricked into parting with something for a price known to the buyer to be inadequate or for a consideration known to the buyer not to be what it purports to be.

726 F.2d at 943. Many securities fraud claims have been dismissed because the alleged misrepresentation did not pertain to the securities involved in the purchase or sale. See, e.g., Abrash v. Fox, 805 F.Supp. 206, 208-09 (S.D.N.Y.1992) (holding that misrepresentations must involve nature or quality of security); Manufacturers Hanover Trust Co. v. Smith Barney, Harris Upham & Co., 770 F.Supp. 176, 181 (S.D.N.Y.1991) ("Misrepresentations or omissions involved in a securities transaction but not pertaining to the securities themselves cannot form the basis of a violation of Section 10(b) or Rule 10b-5.") (citations omitted); Vigilant Ins. Co. v. C. & F. Brokerage Servs., 751 F.Supp. 436, 438 (S.D.N.Y.1990) (to be actionable as securities fraud, "the misrepresentation must relate to the value of the security"); see also Crummere v. Smith Barney, Harris Upham & Co., 624 F.Supp. 751, 755 (S.D.N.Y.1985).

The holding in Vigilant is instructive here. Vigilant involved a NYSE specialist firm that satisfied its own delivery obligations with stock it borrowed from other brokerage houses through the assistance of the defendants, who served as middlemen or "finders." 751 F.Supp. at 437. The firm would provide cash collateral to the finders and, when the borrowed stock was returned, was supposed to receive its collateral plus an interest payment. Id. Claiming that the finders defrauded it of the interest payments, the firm sought to recover for securities fraud. Id. Although the fraud involved the borrowing of stock, Judge Duffy held that the alleged retention of plaintiff's interest was not perpetrated in connection with the purchase or sale of securities because it did not affect the investment value of the stock. Id. at 438.

In this case, Levitin does not allege that PaineWebber's short sale practices related in any way to the value of the securities sold by her or to the price that she received for selling those securities. Although the nondisclosure of the interest PaineWebber earned on its customer's funds may have affected the customer's decision to open an account with defendant, the interest is not part of the consideration received by the customer for the sale of securities. See Saxe v. E.F. Hutton & Co., 789 F.2d 105, 108 (2d Cir.1986). Nor does plaintiff allege that she relied upon PaineWebber's nondisclosure in deciding to conduct short sales of securities or in deciding what securities to sell.

The right to invest and earn interest on the collateral or proceeds of a short sale does not pertain to the securities, but is merely a term of the arrangement between the broker and its customer under which the broker conducts short sales for the customer. Cf. Bosio v. Norbay Sec., Inc., 599 F.Supp. 1563, 1566 (E.D.N.Y.1985) (broker's misrepresentation that he would distribute sale proceeds in accordance with customer's instructions did not constitute securities fraud, as it did not induce purchase or sale of securities but merely concerned mechanics of sale). As in Bosio, the alleged...