Lutz v. Chitwood

• Decision Date: 06 September 2005
• Docket Number: No. C-1-05-010.,C-1-05-010.
• Citation: 337 B.R. 160
• Parties: In re Douglas L. LUTZ, Trustee, Plaintiff/Appellant, v. Richard CHITWOOD, Defendant/Appellee.
• Court: U.S. District Court — Southern District of Ohio

337 B.R. 160

In re Douglas L. LUTZ, Trustee, Plaintiff/Appellant, v. Richard CHITWOOD, Defendant/Appellee.

No. C-1-05-010.

United States District Court, S.D. Ohio, Western Division.

September 6, 2005.

Appeal from the Bankruptcy Court, Jeffery P. Hopkins, J.

COPYRIGHT MATERIAL OMITTED

Frederick Jaeger McGavran, Frost & Jacobs, Cincinnati, OH, for Trustee, Plaintiff/Appellant.

Robert Bowman Craig, Taft, Stettinius & Hollister, Covington, KY, for Defendant/Appellee.

ORDER

HERMAN J. WEBER, Senior District Judge.

I. Introduction

This is an appeal from a decision issued on October 7, 2004, by the United States Bankruptcy Court for the Southern District of Ohio in a consolidated liquidation proceeding brought under the Securities Investors Protection Act (SIPA), 15 U.S.C. § 78aaa, et seq. Plaintiff/Appellant Douglas L. Lutz, Trustee, (Trustee) appeals from the Memorandum Decision Granting Defendants' Motion to Dismiss Claims for Negligence, Breach of Fiduciary Duty and Negligent Supervision asserted on behalf of the debtors' estate and the Securities Investors Protection Corp. (SIPC). See In re Donahue Securities, Inc., 318 B.R. 667 (Bkrtcy. S.D. Ohio 2004).

Plaintiff/Appellant is the Trustee of Donahue Securities, Inc. (DSI) and S.G. Donahue & Company, Inc. (SGD). In the liquidation proceeding, the Trustee brought claims for negligence and breach of fiduciary duty against defendant/appellee Richard Chitwood and co-defendants Michelle Schumacher and Sharyn Meyer. The Trustee claims that defendants failed to discover and prevent Stephen Donahue, the President and sole shareholder of DSI and SGD, from converting customer funds and engaging in other misconduct involving customers' funds and securities trading. The Bankruptcy Court held that the Trustee had failed to state a claim for relief against the defendants. The Trustee appeals the Bankruptcy Court's decision only as to defendant/appellee Chitwood.

There is no dispute that the Trustee has standing to assert claims against Chitwood; that the Trustee has paid over $ 4 million in customer claims from funds advanced by the SIPC, so that the SIPC is subrogated to those customers' claims and the Trustee has standing to assert the SIPC's subrogation claims in this adversary proceeding; and the Trustee may also assert claims against defendant in this adversary proceeding as a bailee of customer property.

II. Issues on appeal

The Trustee states the issues on which he bases this appeal as follows: (1) The Bankruptcy Court erred by making findings of fact on a Rule 12(b)(6) motion; (2) Chitwood had a duty to DSI's customers to supervise Donahue; (3) Ohio recognizes a claim for negligent supervision; (4) Chitwood's duty may be proved by securities rules and regulations; and (5) As DSI's Compliance Principal, Chitwood had a duty to supervise.

III. Request for oral argument

Defendant/appellee Chitwood requests oral argument. The Court has determined, in compliance with Bankruptcy Rule 8012-1, that the facts and legal arguments are adequately presented in the briefs and record and that oral arguments would not significantly aid the Court in deciding the matter. The Court therefore denies the request for oral argument.

IV. Factual allegations and claims

The following allegations are made in the amended complaint filed in the Bankruptcy Court on October 9, 2003: DSI is a corporation that was registered with the Securities Exchange Commission (SEC) as a broker-dealer to engage in the securities business. DSI is a member of the SIPC. SGD is an Ohio corporation that was incorporated to conduct business other than the securities business. Donahue was the President and sole shareholder of both DSI and SGD. Although SGD was not licensed as a broker-dealer, Donahue operated it in such a manner that its business and that of DSI were one and the same with common employees, common customers, and common offices.

Donahue was licensed by the National Association of Securities Dealers (NASD) as a Registered Representative.¹ He was also a Registered Principal of DSI as defined by relevant NASD regulations. Defendants Chitwood, Schumacher, and Mayer were employees of DSI. They were licensed by NASD as Registered Representatives as defined by relevant NASD regulations. Chitwood was also DSI's Registered Compliance Principal as defined by relevant NASD regulations.

DSI was a broker-dealer for the purchase, sale, and redemption of mutual funds, variable annuities, and other securities. DSI and its employees, including Donahue, Chitwood, Schumacher, and Mayer, were agents and fiduciaries for DSI's customers. As such, they stood in a special relationship with DSI's customers and owed them a duty to use reasonable care and to exercise the skills and diligence necessary to protect customers' interest. It was foreseeable that DSI would suffer loss, and that DSI's customers would suffer loss of cash and securities as well as loss of interest, appreciation, and surrender charges, if defendants breached their duties as described in the amended complaint. Chitwood, Schumacher, and Mayer are liable to the Trustee on behalf of the Estate of DSI, on behalf of the SIPC as subrogee of customers' claims it has paid, and as bailee of customer property for negligence for breach of defendants' duties.

Donahue, Chitwood, Schumacher, and Mayer were required by law to follow DSI's Compliance Manual and Written Supervisory Polices and Procedures (Compliance Manual), which stated the duties and responsibilities of its Registered Representatives and Registered Principals to DSI. These individuals were also required by law to follow all industry-wide applicable rules and regulations promulgated by the NASD, the SEC, and any other authoritative source. As DSI's Registered Compliance Principal and as Registered Representative, Chitwood had a duty to DSI and its customers to supervise DSI's Registered Representatives, including Donahue, Schumacher, and Mayer, to assure that they complied with their duties and responsibilities stated in the Compliance Manual and in applicable SEC and NASD rules and regulations. As DSI's Compliance Principal, Chitwood had a duty to DSI and to DSI's customers to monitor and review securities activities and related records of DSI; to personally review the accounts and transactions of all DSI's Registered Representatives, including the accounts and transactions of Donahue, or to delegate such duties to a properly designated supervisor; and to supervise DSI's Registered Representatives to assure that they complied with their duties and responsibilities stated in the Compliance Manual and in applicable SEC and NASD rules and regulations.

Donahue, Chitwood, Schumacher, and Mayer had a duty to DSI and to DSI's customers to know DSI's minimum stated capital requirement. They also had a duty to DSI and its customers to know the rules and regulations governing accounts known as § k(2)(i) accounts.

DSI served as a broker-dealer for non-profit corporations whose employees were participants in investment plans established pursuant to § 403(b) of the Internal Revenue Code (§ 403(b) Plans). A broker-dealer for such Plans receives aggregate contributions from non-profit corporations (§ 403(b) Funds), segregates such contributions for the accounts of individual employee participants, and must remit all such Funds to the employees' designated investments within twenty-four hours of receipt of such funds from the non-profit employer. If a broker-dealer for the § 403(b) Plans does not do so, its minimum stated capital increases to protect the employee-owners of the Funds, and such broker-dealer is required to file periodic reports documenting compliance with additional SEC requirements.

Based on these allegations, the Trustee asserts in the amended complaint that defendants were negligent in the following respects:²

(1) Defendants negligently failed to safeguard customer funds: Donahue violated § k(2)(i) of SEC Rule 15c3-3, the Compliance Manual, and proper practice by having § 403(b) Funds made payable to SGD, which was not licensed as a broker-dealer and was not otherwise authorized to receive such funds, depositing them in the "S.G. Donahue DBA Investment Custodial Account" (the "SGD Account"), failing to remit the Funds to employees' designated investments within twenty-four hours of receipt, and building up excess funds (the float), which Donahue then converted to his own use. Chitwood negligently failed to supervise Donahue, and he and Schumacher and Mayer negligently failed to discover and prevent Donahue from depositing § 403(b) Funds in the SGD Account and converting those funds to his own use.

(2) Defendants negligently failed to expose a fictitious mutual fund. Donahue represented to customers that he would invest their money in a non-existent DSI money market fund and in a bond fund, and he delivered copies of checks for the non-existent fund to Schumacher and Mayer so that they could credit the customer's account. Donahue deposited the funds instead into accounts under his control and converted the funds to his own use. Chitwood knew that Donahue was selling a non-existent security but chose to remain silent, and he negligently failed to supervise Donahue and his "off the books" accounts and to discover and prevent Donahue's wrongdoing.

(3) Defendants negligently failed to expose fictitious credits in customers' fictitious "Bond Fund" Accounts. Chitwood negligently failed to supervise the other defendants and negligently failed to discover and prevent Donahue from selling securities without a prospectus in violation of the Compliance Manual and applicable SEC and NASD rules and regulations.

(4) Defendants negligently failed to discover and prevent Donahue from depositing customers' funds in his personal account. Chitwood negligently supervised the other defendants and DSI's customer accounts, and he negligently failed to discover and prevent Donahue from selling fictitious...