Sterling Trust Co. v. Adderley

• Decision Date: 26 August 2005
• Docket Number: No. 03-1001.,03-1001.
• Citation: 168 S.W.3d 835
• Parties: STERLING TRUST COMPANY, Petitioner, v. Roderick ADDERLEY, et al., Respondents.
• Court: Texas Supreme Court

168 S.W.3d 835

STERLING TRUST COMPANY, Petitioner, v. Roderick ADDERLEY, et al., Respondents.

No. 03-1001.

Supreme Court of Texas.

Argued September 29, 2004.

Decided June 17, 2005.

Rehearing Denied August 26, 2005.

COPYRIGHT MATERIAL OMITTED

Donald E. Herrmann, Dee J. Kelly, Todd W. Spake, John Thomas Wilson IV, Kelly Hart & Hallman, P.C., Fort Worth, Robert B. Gilbreath, V. Elizabeth Kellow, Alan R. Bromberg, Jenkens & Gilchrist, P.C., Dallas, Sharon E. Callaway, Crofts & Callaway, P.C., San Antonio, for Petitioner.

Rickey J. Brantley, David E. Keltner, Jose Henry Brantley & Keltner, L.L.P., Thomas G. Farrier, Murphy Mahon Keffler & Farrier, L.L.P., Fort Worth, James Dan Moorhead, Law Office of James Dan Moorhead, Arlington, for Respondents.

Karen Sue Neeley, Joseph R. Knight, Baker & Botts, L.L.P., Austin, Philip John Kuhl Jr., Sanford & Kuhl, N. Scott Fletcher, Houston, Royal B. Lea III, Bingham & Lea, P.C., San Antonio, for Amici Curiae.

Justice O'NEILL delivered the opinion of the Court.

The Texas Securities Act (TSA) imposes liability on a person who sells securities "by means of an untrue statement of a material fact or an omission to state a material fact," and imposes liability on a person who "materially aids a seller, buyer, or issuer of a security" if the person acts "with intent to deceive or defraud or with reckless disregard for the truth or the law." TEX. REV. CIV. STAT. ANN. ART. 581-33F(2) (Vernon Supp.2004-2005). The trial court and court of appeals interpreted the latter provision to allow aider liability even if the aider was unaware of its role in the securities violation. We conclude, however, that the TSA's requirement of "reckless disregard for the truth or the law" means that an alleged aider is subject to liability only if it rendered assistance to the seller in the face of a perceived risk that its assistance would facilitate untruthful or illegal activity by the primary violator. This standard does not mean that the aider must know of the exact misrepresentations or omissions made by the seller, but it does mean that the aider must be subjectively aware of the primary violator's improper activity. Accordingly, we reverse the court of appeals' judgment and remand this case to the trial court for further proceedings consistent with this opinion.

I

During the early to mid-1990s, Norman Cornelius formed Avalon Custom Homes and a number of related corporate entities (collectively referred to as "Avalon") designed to develop and sell luxury homes. At that time, Cornelius worked as an investment advisor and broker for Sunpoint Securities. Cornelius operated Avalon out of his Sunpoint office and encouraged his brokerage clients to invest their money in Avalon. Cornelius also persuaded members of his church and retirees from Mrs. Baird's Bakery to invest in Avalon, offering investors promissory notes that bore as much as an eighteen percent rate of return and allowed conversion to Avalon stock.

Many of the investors chose to invest their retirement savings in Avalon. Because certain retirement accounts such as IRAs and lump-sum pension distributions must be held by a third-party trustee to maintain their preferential tax status, Avalon needed a third-party trustee in order to accept such funds. In 1994, Cornelius began recommending that Avalon investors use Sterling Trust Company, a custodian of self-directed IRA accounts, as their IRA custodian. From 1994 until 1997, Sterling served as the exclusive trustee over the retirement money that the investors self-directed to Cornelius.

In 1997, the Securities and Exchange Commission (SEC) filed suit against Cornelius, alleging that Cornelius misrepresented the risks associated with the investments, misrepresented the uses of investment funds, and misrepresented the commingling and misappropriation of funds. Avalon was forced into receivership, and the Avalon investors collectively lost millions of dollars. A number of elderly investors lost their entire retirement savings. The investors sued Cornelius, Sunpoint Securities, Van Lewis (the owner of Sunpoint), and Sterling Trust. After suit was filed, but before the case was tried, Cornelius died and Sunpoint entered receivership. The claims against Sunpoint were severed from the suit as a result of the receivership, but Sunpoint was still included in the charge as a party to which the jury could apportion responsibility.

At trial, the investors put forth several theories of liability. The jury charge asked (1) whether each of the defendants offered or sold securities "by means of an untrue statement of material fact or the omission to state a material fact necessary in order to make the statements made, if any, in light of the circumstances under which they were made not misleading"; (2) whether Sterling aided Cornelius in committing securities fraud by "directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aid[ing] a seller of a security"; (3) whether Sterling was "part of a conspiracy that damaged [the investors]"; (4) whether Sterling "fail[ed] to comply with its fiduciary duty" to its account holders; and (5) whether the defendants committed fraud against the investors.

In support of these contentions, the investors provided evidence that Cornelius told investors that investing in Avalon carried "no risk" and that any principal invested would be protected. There was also evidence that Avalon was not profitable and that early investors were paid with the proceeds of later investors, thus creating a pyramid effect that collapsed when new investments dried up.¹

The investors argued that Sterling played an essential role in allowing the investment scheme to continue as long as it did. They argued that Sterling had a duty to undertake a "suitability analysis" and that it should have informed the investors that "too much of their net worth" was held in "overly risky investments." The investors provided evidence that Sterling's failure to comply with several of its own internal procedures facilitated Cornelius's pyramid scheme and allowed Cornelius to hide the nature of his scheme from the investors. For example, the investors showed that, although Sterling's policies prohibited it from holding promissory notes that were in default, it nevertheless held such notes. The investors also provided evidence that Sterling failed to obtain many of the Avalon stock certificates and original promissory notes; ordinarily, Sterling employees could not enter transactions into Sterling's computer system without such documents. When lower-level Sterling employees alerted management to the lack of such documents, they were told that Sterling had made an agreement allowing Avalon to retain those documents. There was also evidence that Sterling failed to obtain copies of the security agreements for the promissory notes that purported to be secured by real estate, even though Sterling's internal procedures required it to keep such documents on file. In addition, the investors provided evidence that Sterling was aware that Cornelius was commingling investors' funds by having one or more of the Avalon companies make payments on notes for which another Avalon company was indebted, and that at least one of Sterling's internal memos questioned this practice. Finally, the investors demonstrated that Cornelius did not pay the principal balance on a number of notes as they became due, but instead transferred the investors' money into new investment vehicles in other Avalon entities. There was evidence that Sterling allowed Cornelius to unilaterally make such transfers despite its own policy requiring documentation of investor approval for new investments.

The jury returned a verdict against Cornelius on all counts. On the issues pertaining to Sterling, however, the verdict was mixed. Specifically, the jury found that Sterling was not a "seller" of securities, that Sterling did not conspire to damage the investors, and that Sterling did not commit fraud. However, the jury found that Sterling aided Cornelius's securities violation and that Sterling breached its fiduciary duty to its account holders. The investors elected to recover on the aiding-and-abetting finding, and the trial court rendered judgment against Sterling for $6 million in actual damages and $250,000 in exemplary damages. The court of appeals affirmed the trial court's award of actual damages, but reversed the exemplary damages award. 119 S.W.3d 312. We granted Sterling's petition for review to consider the scope of its potential liability to the investors and related issues.

II

The Texas Securities Act establishes both primary and secondary liability for securities violations. Primary liability arises when a person "offers or sells a security ... by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading." TEX. REV. CIV. STAT. ANN. art. 581-33A(2) (Vernon Supp.2004-2005). Secondary liability is derivative liability for another person's securities violation; it can attach to either a control person, defined as "[a] person who directly or indirectly controls a seller, buyer, or issuer of a security," or to an aider, defined as one "who directly or indirectly with intent to deceive or defraud or with reckless disregard for the truth or the law materially aids a seller, buyer, or issuer of a security." Id. art. 581-33F(1)-(2). Both control persons and aiders are jointly and severally liable with the primary violator "to the same extent as if [they] were" the primary violator. Id.

In this case, the jury found that Sterling was secondarily liable as an aider. Sterling argues that the trial court erred by failing to instruct the jury that an alleged aider cannot be held secondarily liable unless it had a "general awareness" of...