Shad v. Dean Witter Reynolds, Inc.

Decision Date09 September 1986
Docket NumberNo. 85-5652,85-5652
Parties, Fed. Sec. L. Rep. P 92,908, 21 Fed. R. Evid. Serv. 857 Robert SHAD, Molly Shad, and Samantha Shad, Plaintiffs/Appellants, v. DEAN WITTER REYNOLDS, INC., a corporation; Milton Ponitz and Lee McMahon, Defendants/Appellees.
CourtU.S. Court of Appeals — Ninth Circuit

Allen L. Neelley, Judith K. Otamura-Kester, Hahn, Cazier & Smaltz, Los Angeles, Cal., for plaintiffs/appellants.

Eugene W. Bell, Kevin K. Fitzgerald, Jones, Bell, Simpson & Abbott, Los Angeles, Cal., for defendants/appellees.

On Appeal From the United States District Court for the Central District of California.

Before BROWNING, Chief Judge, and KENNEDY and BEEZER, Circuit Judges.

BEEZER, Circuit Judge:

Plaintiffs Robert, Molly, and Samantha Shad appeal from a jury verdict in favor of Dean Witter Reynolds, Inc. ("DWR") and two of its account executives. The Shads alleged that DWR account executives churned four Shad accounts between August 1978 and July 1982 in violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. Sec. 78j(b). The assignments of error require us to review discovery procedures, the exclusion of expert testimony, the denial of a motion for mistrial, and the rejection of proffered instructions. We remand for a new trial on account of the exclusion of expert testimony. We otherwise affirm the district court.

In December 1977, Robert and Molly Shad, husband and wife, opened a brokerage account at DWR with a transfer of securities and the deposit of funds. The Shads told the account executive, Douglas McCombs, that Robert Shad was retired and it was necessary to pay family living expenses from dividend income. When Samantha Shad's account was opened, McCombs was told that she was not then gainfully employed and that her income consisted primarily of spousal and child support. Consequently, McCombs managed the Shads' accounts in a conservative manner, investing primarily in utilities and executing few margin transactions.

When McCombs left the Encino office in July 1978, management of the Shads' accounts was transferred to Milton Ponitz. Ponitz recommended that the Shads follow the DWR "covered writing option program," (CWOP) which involved the purchase of stock and simultaneous sale of options based on that stock. The Shads were told this conservative investment would produce more income. The Shads agreed, and their portfolio was managed accordingly. Transactions in the CWOP were based upon a computer list, ("shopping list"), generated daily by DWR. The shopping list identified the "best" stocks in ten categories based upon calculation of various measures of volatility, delta and beta, and the rate of return if the option was exercised or expired. During the four years Ponitz managed the Shad accounts, he executed 1787 transactions, totalling $13,000,000. DWR earned approximately $696,000 in interest and commissions.

The Shads allege that their accounts were churned. They allege that Ponitz controlled the account because they were "without knowledge, experience or sophistication in the area of securities, options, or securities accounts" and they had placed "their entire discretion and the control for selection, execution, purchases and sales of options and securities" in their accounts

with Ponitz. Furthermore, they allege that the trading in their accounts was excessive in light of their investment objectives, which Ponitz identified as preservation of capital, safety of principal, and generation of income to maintain their living standards. They claim damages including $700,000 in lost equity and $696,000 in commissions and interest

After the action was commenced DWR refused to produce account executive Ponitz's daily records of conversations with the Shads, claiming those conversations were interwoven with notes about other customers. The Shads then moved to compel production of documents. The court failed to rule on the motion either when it was originally noted for hearing or during the first pretrial conference. The Shads signed the second pretrial order which stated that discovery was complete and failed to raise their motion again until January 16, 1985, the fifth day of the trial.

A district court order relating to discovery is reviewed for an abuse of discretion. In the Matter of Bishop, Baldwin, Rewald, Dillingham & Wong, Inc., 779 F.2d 471, 475 (9th Cir.1986); Hatch v. Reliance Insurance Co., 758 F.2d 409, 416 (9th Cir.), cert. denied, --- U.S. ----, 106 S.Ct. 571, 88 L.Ed.2d 555 (1985).

Having waited thirteen months to remind the court of their motion, plaintiffs cannot now complain of the court's failure to rule.

A. Evidence Excluded at Trial

On January 8, 1985, the first day of trial, the Shads argued that expert testimony on churning was essential. They believed the court intended to allow that testimony because of the court's prior order and because their expert witnesses were listed in the pretrial order. The court stated that it was inclined to exclude such expert testimony as unnecessary and time consuming.

The Shads stated they wanted their experts to testify, not to the definition of churning, but rather to the significance of various types of transactions, whether they were appropriate to the Shads' circumstances and objectives, and whether the making of those transactions evidenced reckless disregard of the Shads' interests.

On January 9, the court ruled that the Shads could introduce evidence of New York Stock Exchange Rule 405, NASD Rules, Art. III, Sec. 2, and certain internal rules of DWR, to provide a standard against which the jury could judge the adequacy of defendants' knowledge of the Shads' investment objectives and circumstances. At the close of trial on January 9, the court admonished the Shads' counsel, Neelley, for his "very protracted and prolix examination of a witness." The court stated it would continue to question witnesses and admonish counsel in order to expedite the trial. At that time, Neelley stated

I had a pretrial order which had been twice amended, in open court, and signed by your honor, which said that this case would be an 11-day jury case, and I confess to this court that I was absolutely shocked and surprised when your honor said that we're going--first of all we're going to re-pretry it and then we're going to try it in four days and in that context told me that I would not be allowed to put on evidence of objective criteria of churning by experts.

The court responded that it would allow objective expert testimony but would not allow opinions on whether the accounts were churned.

At the close of court on January 14, the court indicated it was inclined to exclude the Shads' expert's testimony on Fed.R.Evid. 403 grounds.

The rule is very clear to that effect, but the rule indicates that it is where the lay person will find expert opinion helpful in the sense that without such expert opinion it would be unable to understand ...

for a ... so-called expert, to say ... this does constitute churning ... is of doubtful admissibility as the court weighs under 403 the probative value ... the prejudice ... and the need for such testimony in the sense of it being necessarily of help to triers of fact who could not understand without it

On January 17, the Shads called expert Edward Horwitz, a securities and commodities broker, who had analyzed transactions in the subject accounts against criteria for transactions in the CWOP. Horwitz testified to the mechanics of buying an option, the difference between covered and naked options, and other terms. He explained the various indices by which certain options were judged acceptable under the CWOP, including delta and beta, measures of volatility, and how the program enhanced investor's income. He explained that the CWOP contemplates that the investor will increase his income by adding the premium he earns from sale of the option to the dividend he receives as owner of the underlying security and that he will allow the option to expire unless it is exercised.

Horwitz identified four patterns of trading in the Shad accounts that deviated from the CWOP: walking up transactions, in and out trading, naked option positions, and premature liquidation. Horwitz was not allowed to testify regarding DWR's education of its account executives on churning. He then testified that those nonconforming transactions were of no economic benefit to the Shads, but he was not allowed to testify that they were excessive in view of the Shads' objectives. After the court sustained six objections to such questions, the jury was excused, and Neelley admonished.

The court made it very clear ... that it would not permit expert testimony [on whether churning took place] ... and there was a persistence of inquiry as to the opinion of this witness as to whether there was churning, and by which is meant excessive trading, and before you got to that the court said there will be no more of it. The court doesn't tolerate violations of its directions or indeed its orders.... You will not only desist from it from this point forward, you will be in contempt if you do not desist.

Neelley made an offer of proof that Horwitz would testify that the nonconforming transactions were excessive in light of the Shads' investment objectives, that their only purpose was to earn commissions for the defendants, that DWR's definition of churning was an acceptable definition in the securities industry, and that because of the complexity of the CWOP, a person of average experience and intelligence would be unable to make independent investment decisions.

On January 22, the Shads' expert Anthony Englese, a lawyer who was previously general counsel and director of compliance for DWR, testified to his analysis of the difference in management of the Shads' investments under Ponitz, under their previous account...

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