Pettit v. American Stock Exchange

Decision Date15 April 1963
PartiesWilliam D. PETTIT, Thomas J. Crawford and Harry Berger, as Trustees in Reorganization of the Estates of Swan-Finch Oil Corporation, Keta Gas and Oil Company and Swan-Finch Petro Chemical Corporation, Plaintiffs, v. AMERICAN STOCK EXCHANGE et al., Defendants.
CourtU.S. District Court — Southern District of New York

COPYRIGHT MATERIAL OMITTED

George C. Levin, James V. Hallisey, New York City, for trustees.

Forsythe, McGovern & Fetzer, New York City, for defendants American Stock Exchange, Joseph F. Reilly, James R. Dyer, Charles T. Bocklet and John J. Mann; Thomas A. McGovern and Burton L. Knapp, New York City, of counsel.

Milbank, Tweed, Hope & Hadley, New York City, for defendants Swiss Credit Bank, Zurich, Swiss Credit Bank, New York Agency and Swiss American Corp.; William Eldred Jackson and Rebecca M. Cutler, New York City, of counsel.

Fulton, Walter & Duncombe, New York City, for defendants Edward T. McCormick and Michael E. Mooney; Hugh Fulton, George Rowe, Jr., and Lawrence W. Schilling, New York City, of counsel.

Delson & Gordon, New York City, for defendant Ira Haupt & Co.; Norman Moloshok, New York City, of counsel.

PALMIERI, District Judge.

This is a suit by trustees appointed pursuant to Chapter X of the Bankruptcy Act1 against the American Stock Exchange (Exchange) and others for alleged complicity in larcenous acts perpetrated by Lowell Birrell with respect to the fraudulent issuance of Swan-Finch stock and its subsequent sale to the public. This suit follows a series of public revelations that were both startling in nature and widespread in effect.

In May of 1961 the Securities and Exchange Commission expelled defendants Gerard A. and Gerard F. Re from the Exchange and revoked their broker-dealer registration for violations of numerous provisions of the federal securities laws while acting as specialists for Swan-Finch and other stocks. Although the expulsion order affected only the Res, the facts submitted to the Commission indicated serious irregularities in the conduct of the other defendants as well, and soon afterward, the Commission directed its staff to investigate Exchange rules, policies, and other regulatory procedures to ascertain the adequacy of the protection they insured to the investing public. In an apparent and immediate response to the investigation, the Exchange adopted many far-reaching changes in personnel and procedure. These culminated in December of 1961 with the resignation of its President, Edward T. McCormick, and its General Counsel, Michael E. Mooney. The SEC staff investigation lasted some eight months, and its report of January, 1962, was a severe indictment of the Exchange. The report concluded:

"There can be little doubt that in the case of the American Stock Exchange the statutory scheme of self-regulation in the public interest has not worked out in the manner originally envisioned by Congress. The manifold and prolonged abuses of misconduct described in this report make it clear that the problem goes beyond isolated violations and amounts to a general deficiency of standards and a fundamental failure of controls."2

The particular facet of the massive Birrell frauds that is the subject of this action was a continuing conspiracy over a three-year period that resulted in an illegal and fraudulent distribution of 578,000 shares of Swan-Finch stock to the public.3 Many and continuous purchases and sales were involved. At Birrell's direction, Swan-Finch issued the shares in purported exchange for valuable or equivalent consideration. In fact, the consideration was neither valuable nor equivalent, nor was it ever intended that it should be received by Swan-Finch. Consistent with his frequently repeated pattern of larceny, Birrell succeeded in abstracting valuable assets, in this case valuable stock of Swan-Finch, behind the facade of a transaction having the appearance of legality, and ultimately in leaving those imposed upon with worthless paper on their hands. To effectuate his scheme, Birrell, who retained control over the shares, had them distributed to the public through the American Stock Exchange, with the proceeds of numerous sales appropriated for his own use and benefit or for that of persons privy with him. The distribution was effected without the required registration with the SEC and was facilitated by fraudulent statements by Birrell to the effect that Swan-Finch had acquired and retained assets in return for the original issue of shares. Additional fraud is claimed to have existed in the failure of Swan-Finch since 1955 to issue shareholder's reports in order to conceal the acts mentioned above.

Vital participants in the distribution were the Res, who engaged in transactions in Swan-Finch shares far beyond the limited scope of activity allowed specialists in connection with the maintenance of a fair and orderly market. They also utilized an elaborate series of dummies, and dummy accounts with the broker and bank defendants to conceal the actual source of shares being distributed, to control the flow of stock into the market, and to create the appearance of trading activity.

The complaint of the trustees alleging the above facts and the role of defendants in the transaction has now come under severe challenge from certain defendants on these motions to dismiss, raising several issues of broad import in the interpretation of the securities statutes.

I

The first count of the trustees' complaint is predicated on a violation by defendants of Section 10(b) of the Securities Exchange Act of 1934,4 and Rule 10(b) 5 of the Securities and Exchange Commission promulgated thereunder,5 which render unlawful fraudulent conduct in connection with the purchase or sale of a security. Defendants6 argue initially that the trustees have no rights under Section 10(b), and hence lack standing to pursue an action based on that statute. The general thrust of defendant's position is that the trustees are in reality seeking to recover for corporate mismanagement rather than for the fraud perpetrated on Swan-Finch investors. Section 10(b), argue defendants, can be utilized only when rights in the latter rather than the former instance are asserted, and then only by the investors that have been defrauded.

It is of course true that irrespective of the broad language of Rule 10(b) 5, the courts have been disinclined to allow "innumerable facets of internal corporate affairs" to be included within federal question jurisdiction on the basis of a purchase or sale of securities that is only incidental to a major mismanagement issue.7 On the other hand, that the fraud was perpetrated by insiders does not render Section 10(b) inapplicable, if the transaction represents an abuse of the securities trading process, and should properly be subject to SEC regulations for an adequate remedy.8

Application of these criteria to the present action leaves no doubt in the Court's mind that the complaint alleges a valid cause of action under Section 10(b). At the heart of this case are two fraudulent transactions in securities. By virtue of one, the initial issuance and distribution to Birrell, the corporation was defrauded of 578,000 shares of its stock, a substantial asset of the corporation. This facet of the scheme comes squarely within Section 10(b), as Hooper v. Mountain States Securities Corp.9 makes eminently clear, and gives rise to a corporate cause of action with respect to it.10

The second illegal distribution, however, was indispensable to the successful completion of the fraud. Through the facilities of the Exchange and complicity of the other defendants, Birrell and the Res were enabled to sell the shares to the public without registration, on a rigged market, and with both the Birrell ownership and the larcenous origin of such ownership concealed from investor knowledge. Having lent themselves to such misuse, defendants may not now claim that their conduct caused harm only to investors and not to the corporation. Moreover, both transactions being one overall scheme in which the channels of interstate commerce, the mail, and the Exchange were used for fraudulent manipulation, and in which people trading in corporate securities through the Exchange facilities were damaged, defendants' effort to characterize the trustees' claim as one of "corporate mismanagement" to which Section 10(b) would not apply is invalid and must be denied effect.

Howard v. Furst11 does not preclude this result. It is true that there is broad language in the Howard opinion to the effect that the corporation has no rights under the Act absent a special provision giving it such rights.12 The fact remains, however, that the case arose in the proxy area where very different considerations are relevant to determine whether the corporation should be given rights to enforce the SEC rules. At least one such consideration is that insurgents seeking to wage a proxy contest would no longer be protected from harassment by the incumbent organization that could bring suits on behalf of the corporation.13 Even in the particular area to which it relates, the Howard decision is not without its critics. Indeed, the Second Circuit has intimated that the decision is subject to reconsideration.14 Thus, Howard v. Furst should not be held to control where the issue does not relate to corporate control, but to whether recognition of Section 10(b) rights in a corporation defrauded of its stock is outside the scheme contemplated by Congress when it passed that section.15

Finally, although it is not essential to the decision on this contention, it should be noted that the elements of this case make it peculiarly appropriate for the recognition of federal rights of the corporation.16 Although both the SEC and the Department of Justice have acted to prevent the recurrence of the abuses that took place in connection with Swan-Finch, their actions have...

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