Levitt v. Bear Stearns & Co., Inc.

Decision Date13 August 2003
Docket NumberDocket No. 02-7860.
Citation340 F.3d 94
CourtU.S. Court of Appeals — Second Circuit
PartiesRobert LEVITT, for himself and as custodian for Richard Levitt and Monica Levitt, Robert Rice, Stephen G. Siben, Stephen Strobehan, Stanley Veltkamp, Philip C. Vitanza, for himself and Elizabeth Vitanza and Luke Vitanza, John T. White, as Trustee, Guy V. Wood, as Trustee, Carl Zander, Jr., as Trustee, Ted. M. Jones, as Trustee, and Kathryn N. Jones, as Trustee, Plaintiffs-Appellants. v. BEAR STEARNS & CO., INC. and Bear Stearns Securities Corporation, Defendants-Appellees.

LESLIE TRAGER, Morley and Trager, New York, NY, for Plaintiffs-Appellants.

PETER L. ZIMROTH, Arnold & Porter, New York, NY, (Michael D. Schissel and David

A. Weintraub, Arnold & Porter, New York, NY, Stephen M. Sacks and Scott B. Schreiber, Arnold & Porter, Washington, DC, on the brief), for Defendants-Appellees.

Before: WALKER, Chief Judge, and MINER and KATZMANN,* Circuit Judges.

MINER, Circuit Judge.

This is an appeal from a final judgment entered in the United States District Court for the Eastern District of New York (Spatt, J.), dismissing for failure to state a claim the complaint in a federal securities fraud class action filed against defendant-appellee Bear Stearns Securities Corp. and its corporate parent, defendant-appellee Bear Stearns & Co., Inc. (collectively, "Bear Stearns"). See In re Sterling Foster & Co., Inc. Sec. Litig., 222 F.Supp.2d 312 (E.D.N.Y.2002) ("Levitt"). The putative plaintiff class consists of members of the public who purchased securities of ML Direct, Inc. ("ML Direct") from the Long Island brokerage firm of Sterling Foster & Co., Inc. ("Sterling Foster") during the approximately three-and-a-half months following ML Direct's initial public offering ("IPO"). Id. at 314. The gravamen of Plaintiffs' complaint is that Bear Stearns knowingly and actively participated in a stock fraud scheme perpetrated by Sterling Foster involving the ML Direct IPO.

The District Court determined that Plaintiffs' claim was time barred. Specifically, the District Court found, as a matter of law, that there were sufficient "storm warnings" that would have caused a reasonably prudent investor to discover Bear Stearns' alleged role in the Sterling Foster scheme at least one year before Plaintiffs filed their class action complaint. Id. at 318-26. For the reasons set forth below, we hold that the District Court's conclusion is not supported by the facts contained in the pleadings, when viewed in the light most favorable to Plaintiffs. Accordingly, we vacate the judgment and remand the case to the District Court for further proceedings consistent with this opinion.


The facts alleged in the class action complaint filed by Plaintiffs are based in large part on a 1998 federal indictment filed in the Southern District of New York against two officers of Sterling Foster, a 1997 civil action filed in the Southern District of New York by the Securities and Exchange Commission ("SEC") against Sterling Foster, and testimony taken during a 1997 arbitration brought against Bear Stearns before the National Association of Securities Dealers ("NASD").

I. Sterling Foster's Market Manipulation Scheme

On September 3, 1996, the registration statement for the ML Direct IPO became effective for the sale of 1.1 million shares. Id. at 314. The original issue was sold to the public at a price of $15 per unit, with each unit consisting of two shares of common stock and one warrant for the purchase of a share of common stock at a fixed price in the future, so that the price per share was slightly less than $7.50 per share. Id. The IPO was underwritten by Patterson Travis, Inc. Id.

When the registration statement became available, it disclosed the fact that a preregistered but delayed registration — known as a "shelf" registration — had been "piggy-backed" onto the IPO. This shelf registration pertained to 2.4 million additional shares of ML Direct common stock owned by certain insider selling shareholders (the "Selling Insiders"). These shares were subject to a twelve-month "lockup," i.e., they could not be sold for twelve months after the IPO, although the lockup could be waived by the underwriter, Patterson Travis. Id. In particular, the IPO registration statement and prospectus stated that Patterson Travis had "no agreements or understandings with any of the [Selling Insiders] with respect to release of the [Selling Insiders' shares] prior to the [expiration of the lockup period] and ha[d] no present intention of releasing any or all of such securities prior to [the expiration of the lockup period]." Id.

On September 4, 1996 — the first day that ML Direct stock was publicly traded — Sterling Foster bought up the majority of the ML Direct shares, driving the price to $15.25 per share at the close of trading. Id. During the first two days of trading, Sterling Foster sold over 3.375 million shares of ML Direct. Since there were only 1.1 million shares for sale in the IPO, Sterling Foster had sold approximately 2.3 million shares more than it actually owned. This situation, known in the securities industry as "taking a short position" or "selling short," posed a problem only insofar as the only other available ML Direct shares were the shares that had been registered for the Selling Insiders, which were subject to the twelve-month lockup. Id. The September 9 settlement date for the shares sold by Sterling Foster on September 4 came and went without Sterling Foster delivering to Bear Stearns the shares required to cover its short position. Id. However, Patterson Travis had agreed to waive the lockup on the Selling Insiders' shares as of September 10, so that Sterling Foster was able on September 11 and 12 to deliver to Bear Stearns shares that it had secretly purchased from certain of the Selling Insiders for $3.25 per share. Id. Thus, when it covered its short position, Sterling Foster made a profit consisting of the difference between the price at which it sold the shares to the public ($14 to $15 per share) and the price it paid to the Selling Insiders ($3.25 per share), a total of approximately $24 million. Id. at 315.

This market manipulation scheme, along with the misrepresentations in the offering documents that Patterson Travis had made no prior agreements with the Selling Insiders concerning the sale of their shares before the expiration of the lockup period, caused the investing public to believe that only 1.1 million shares of ML Direct were being offered. Id. In fact, three times that number of shares were being sold, most via short sales at inflated prices. Id. Indeed, the investing public believed that the market had set the price of $13 to $15 per share when, in fact, that price had been artificially created by Sterling Foster, which was at the same time purchasing shares from the Selling Insiders at only $3.25 per share. Id.

II. Bear Stearns' Alleged Role in Sterling Foster's Scheme

Bear Stearns acted as the "clearing agency" for Sterling Foster. "At the center of the securities industry, clearing firms provide the necessary services and capital typically needed by small brokerage houses to complete a securities transaction, most importantly, the clearing function." Daphna Abrams, Note, A Second Look at Clearing Firm Liability, 67 Brook. L.Rev. 479, 484 (2001) ("Abrams") (footnote omitted). "A clearing firm clears trades, i.e., completes transactions by delivering securities to the purchasing broker-dealer and by making money payments to the selling broker-dealer." Id. (footnote omitted). "Clearing responsibilities include: receiving or delivering funds from or to the customer; maintaining records that reflect the transaction; and safeguarding the funds in the customer's account." Id. (internal quotation marks omitted). "A clearing firm is also responsible for maintaining records of all trades made by the customer, including sending confirmations, monthly statements, and dividends to the customer/investor." Id. "Additional clearing services include the extension of credit for the purchase of securities on margin." Id. at 485. "Small brokerage firms, commonly referred to as `introducing firms,' typically lack sufficient capital, back office technology and personnel to `self clear.'" Id. at 484 (footnotes omitted). "As a result, they enter into `carrying agreements' with clearing firms to out source clearing and other services." Id. "In addition to performing clearing functions, on occasion, the clearing firm executes transactions, thereby limiting the role of the introducing broker to simply soliciting investor sales." Id. at 485. "The clearing firm also provides name recognition for the introducing firm, frequently inflating the image of a small, unknown introducing firm. The name Bear Stearns, for example, lends credibility, stability, business savvy, and expertise to unknown introducing firms." Id. Finally, "because clearing firms are relatively well capitalized, they become deep pocket litigation targets." Id. at 479 n. 2 (internal quotation marks omitted) (quoting Henry F. Minnerop, The Role and Regulation of Clearing Brokers, 48 Bus. Law 841 (1993)).

Plaintiffs alleged that Sterling Foster effectively acted as an underwriter with respect to the Selling Insiders' ML Direct Shares. Bear Stearns allegedly required that, before it would agree to clear transactions for introducing brokers (such as Sterling Foster) acting as "underwriters," the introducing brokers had to request permission from Bear Stearns. Levitt, 222 F.Supp.2d at 315. Consequently, prior to August 20, 1996, Sterling Foster purportedly requested that Bear Stearns permit Sterling Foster to "underwrite" the sale of the Selling Insiders' shares. Id. At the time of this request, officers at Bear Stearns allegedly knew that Sterling Foster intended to sell a lot of shares after the effective date of the ML Direct IPO and to...

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