APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. Civil. No. 75-01313)
Before Aldisert and Higginbotham, Circuit Judges, and Markey, Chief Judge.*fn*
This appeal from verdicts in favor of the three named plaintiffs in a securities fraud class action raises several important questions under the antifraud provisions of the Securities Exchange Act of 1934. Specifically, we are asked to decide whether the district judge properly instructed the jury on imputed or secondary liability, on § 20(a) of the Act, on reliance, and on the measure of damages. For the reasons below, we affirm on all issues except the measure of damages, which we reverse and remand for a new trial.
The factual setting of this case*fn1 combines Caribbean intrigue, creative accounting, and high finance against the backdrop of investors attempting to limit their tax obligations. Westland Minerals Corporation was the promoter of a venture, the "Ohio Program," in which multiple limited partnerships were formed for the purpose of drilling for oil and gas. WMC sold interests in each of these partnerships from July 22, 1971, through early July, 1972. Each limited partnership was to spend $140,000 on drilling and developing a well. Of this amount, $65,000 was to be raised from contributions by investors in the partnership, and the balance from "suitable banks or other lending institutions."
As part of its sales presentation, WMC used a tax opinion letter issued by the accounting firm of Coopers & Lybrand, the appellant. WMC requested the letter in April, 1971, in behalf of one investor, Muhammed Ali, and on July 22, 1971, an opinion letter signed by a Coopers & Lybrand partner in the firm name was sent to the president of WMC. The letter stated that "based solely on the facts contained (in the WMC Limited Partnership Agreement) and without verification by us," a limited partner who contributed $65,000 in cash could deduct approximately $128,000 on his 1971 tax return. Herman Higgins, a tax supervisor employed by Coopers & Lybrand who worked directly under the supervision of four partners, drafted the letter. In October, 1971, Higgins told David Wright, a partner at Coopers & Lybrand, that WMC was showing copies of the letter to investors as part of its sales program, and Wright decided that a more complete letter should be drafted for those purposes. On October 11, 1971, Wright sent to WMC a revised letter, which he signed in the name of Coopers & Lybrand.
Under the investment plan, investors would purchase partnership shares in WMC's Ohio Program, with the money raised to be used in oil drilling. The investors would be limited partners in the sense that their liability would be limited, but their participation in the profits would be quite extensive once the oil started to flow. The plan's main attraction was the investors' ability to deduct twice the amount invested from their federal income tax returns in the first year of investment. The reason for this double deduction was that WMC would borrow on a nonrecourse basis, secured only by the oil wells, an amount of money approximately equal to that invested. Because the outside investors received their interests as limited partners, they did not subject themselves to liability on the loans merely by being partners; because the loans were nonrecourse, they were also not subject to them by explicit agreement.
The tax benefit arose because oil drilling requires large initial noncapital expenditures before any recovery can occur. These expenditures would be incurred in 1971, the year of investment. The partnership agreement allowed the profits and losses to be passed through the partnership to the partners. Not only would they be able to claim a total loss for the money actually invested, but they would also be able to claim a loss for the money borrowed and spent on the oil wells. The result was that each investor was able to deduct twice what he actually invested as ordinary (noncapital) losses, and could recover his investment in the first year by tax savings if he was in a fifty percent or higher tax bracket.
The practical problem with this is that banks are seldom if ever willing to lend money for oil drilling when their only security is the oil well. The reason is obvious: the well may not produce, and the bank will then have no security. Obtaining large amounts of loans was crucial to the scheme. Higgins, the Coopers & Lybrand associate, proposed a solution. He suggested that WMC borrow the money from a bank, and then use the money borrowed to purchase savings certificates from the bank, which the bank would hold as collateral. The net result of this arrangement was a paper transaction, by which WMC obtained loans on paper without actually receiving the money.*fn2 WMC decided to transact these loans through a bank in the Bahamas that it acquired in September, 1971, before Coopers & Lybrand issued the second opinion letter. The scheme began to unravel when WMC was indicted for securities violations. The IRS began denying the deductions taken by the investors, the wells were frequently dry, and WMC collapsed.
Stanley Sharp filed this suit on behalf of himself and 210 other WMC investors similarly situated on May 8, 1975, alleging violations of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities Exchange Commission rule 10b-5, 17 C.F.R. § 240.10b-5.*fn3 The trial judge granted class certification, and a jury trial of the class issues was held from February 27 through March 10, 1978. By answers to special interrogatories, the jury found that the October 11, 1971, tax opinion letter contained material misrepresentations and omissions, and that Herman Higgins had acted recklessly and intentionally. Although the jury found that no partner of Coopers & Lybrand had acted with scienter in causing the omissions and misrepresentations, the district court concluded as a matter of law that the firm was liable under the common law doctrine of respondeat superior for the actions of its employee, Higgins. Sharp v. Coopers & Lybrand, 457 F. Supp. 879, 891 (E.D.Pa.1978). The court also concluded as a matter of law that Coopers & Lybrand was liable for Higgins' conduct by virtue of § 20(a) of the 1934 Act, 15 U.S.C. § 78t(a). 457 F. Supp. at 893-94.
A second jury trial on the issue of damages sustained by the three named plaintiffs was held from May 12 through May 19, 1980. This jury found, also by special interrogatories, that the three class representatives had exercised due diligence, had filed their claims within one year of the date on which the fraud reasonably could have been discovered, and would not have invested in the partnerships absent the opinion letter. The jury also found that the "actual value" of a one-eighth limited partnership share in 1971 was $1,240.00. Based on these findings, the trial judge entered judgment in favor of Stanley L. Sharp in the amount of $6,885, Sam Geftic in the amount of $3,442.50, and H. James Conaway, Jr., in the amount of $6,193. Each representative also received prejudgment interest at the rate of six percent from December 31, 1971.
In this appeal, Coopers & Lybrand advances four principal arguments.*fn4 First, it argues that the trial judge erred in concluding after the first trial that Coopers & Lybrand was secondarily liable for the acts of its employee, Herman Higgins, under the common law doctrine of respondeat superior. Second, it argues that the trial judge erred by failing to give proper jury instructions on § 20(a) of the 1934 Act. Third, it argues that the trial court erred during the second trial in creating a presumption that the class representative relied on the misrepresentations and omissions of the second opinion letter. Finally, it attacks the measure of damages used by the district court in the second trial.
Appellant's primary argument is that it may not be held liable for the actions of Higgins in light of the jury's finding, in answer to a special interrogatory, that no Coopers & Lybrand partner possessed the necessary scienter to violate rule 10b-5. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 201-11, 96 S. Ct. 1375, 1384-1389, 47 L. Ed. 2d 668 (1976). The trial court rejected this argument, holding as a matter of law that Coopers & Lybrand was liable for the securities law violations of Herman Higgins committed in the scope of his employment. The district court noted that this court has not recognized respondeat superior as a basis for establishing secondary liability under rule 10b-5, see Rochez Brothers, Inc. v. Rhoades, 527 F.2d 880, 884 (3d Cir. 1975) (Rochez II ), cert. denied, 425 U.S. 993, 96 S. Ct. 2205, 48 L. Ed. 2d 817 (1976), but reasoned that this case presents a sufficiently egregious situation to distinguish it from the prevailing case law. It relied on a "broker-dealer" exception alluded to in Rochez II, id. at 886, reasoning that an accounting firm issuing a tax opinion letter to be used in selling securities is laden with the same public trust as a broker-dealer. 457 F. Supp. at 891.
As an alternative basis for imposing liability on Coopers & Lybrand, the district court relied on § 20(a) of the 1934 Act. The district court declined appellant's invitation to instruct the jury to determine whether Coopers & Lybrand had "culpably participated" in the securities law violations. See Rochez II, 527 F.2d at 884-85. The court reasoned that an adequate instruction on culpable participation would have been difficult to construct, that the facts regarding the issue were not in dispute, and that the proper manner of resolving the issue was by the court as a matter of law. 457 F. Supp. at 893.
The starting point in this court for analysis of secondary liability under rule 10b-5 is Rochez II. In that case we held that material omissions in violation of rule 10b-5 by a purchaser serving as Chairman of the Board of Directors, Chief Executive Officer, and President of a corporation, to the seller of a substantial block of stock in the corporation, could not be attributed to the corporation involved under principles of respondeat superior. Rochez II, 527 F.2d at 885-86; see also Rochez Brothers, Inc. v. Rhoades, 491 F.2d 402, 405-06 (3d Cir. 1974) (Rochez I ). The court examined § 20(a), which imposes liability on certain controlling persons, and concluded that imposition of respondeat superior liability would circumvent the good faith defense provided in that section. 527 F.2d at 885. The court noted:
If we were to apply respondeat superior as appellant wishes, we would in essence impose a duty on a corporation to supervise and oversee the activities of its directors and employees when they are dealing with their own corporate stock as individuals, and not for the corporation or for the benefit of the corporation. To impose such a duty would make the corporation primarily liable for any security law violation by any officer or employee of the corporation. We believe that Congress did not intend to expand liability to this degree when it passed the Securities Exchange Act.
Id. Later, in Gould v. American-Hawaiian Steamship Co., 535 F.2d 761, 779 (3d Cir. 1976), the court declined to impose secondary liability on two corporations, the joint director of which had failed to disclose a conflict of interest in a proxy statement issued prior to a merger. In doing so, the court stated that "(t)he liability of Litton and Monroe for the acts of Casey cannot be upheld on the agency theory utilized by the district court." Id. at 779. This statement operates as an explicit reaffirmation of Rochez II.
Relying on Rochez II and Gould, Coopers & Lybrand argues that the district court erred by imposing secondary liability on it under a respondeat superior theory. The Securities and Exchange Commission, as amicus curiae, argues that Rochez II should be narrowly construed to allow the use of respondeat superior in private damage actions under rule 10b-5, or alternatively should be overruled.*fn5 Appellees, although suggesting that Rochez II is no longer viable, propose a less drastic course of retaining the general prohibition against the use of respondeat superior in rule 10b-5 actions while adopting an exception for accounting firms that render investment-oriented opinion letters. We conclude that the rule announced in Rochez II is and should be viable, that Rochez II envisioned exceptions to that rule, and that this record supports the district court's determination that Coopers & Lybrand is liable for the wrongful acts of Higgins under the precise exceptions set forth therein.
Our examination of the case law regarding employer liability under rule 10b-5 discloses that other courts have emphasized the special duties that certain employers assume under the federal securities laws when their conduct is likely to exert strong influence on important investment decisions. For example, the second circuit has recently relied on respondeat superior to impose liability on a brokerage house for the fraudulent conduct of a trainee in its employ. Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir.), cert. denied, 449 U.S. 1011, 101 S. Ct. 566, 66 L. Ed. 2d 469 (1980). In holding that the plaintiff could not recover from the employer, the district court found that the employer had exercised due care in its supervision of the employee. The second circuit reversed the judgment in favor of the employer and remanded for a new trial, adopting principles of respondeat superior in this limited context. Id. at 716. Prior second circuit decisions had expressly declined to apply respondeat superior in other contexts,*fn6 however, and the only distinction between those decisions and Marbury Management seems to be the court's conclusion that a brokerage firm owes a higher duty to its customers than do other employers.*fn7 The implicit reasoning in Marbury Management that brokers have a higher public duty under the securities laws than do other persons leads to imposition of a duty to exercise a high standard of supervision. This duty is enforceable through imposition of secondary liability based on respondeat superior.
Other courts of appeals that have employed respondeat superior have done so in cases in which the employee was a high level officer or director of the employer,*fn8 the employer was a brokerage firm,*fn9 or both.*fn10 In many of these decisions, the courts have emphasized the public trust of the firms involved, and the duty to supervise arising therefrom.*fn11 These decisions are consistent with our decision here. We draw support from them for our conclusion but emphasize strongly that the doctrine of respondeat superior, though applicable in this case, has not been and should not be widely expanded in the area of federal securities regulation. See Rochez II, 527 F.2d at 885.
Aaron v. SEC, 446 U.S. 680, 100 S. Ct. 1945, 64 L. Ed. 2d 611 (1980), decided soon after Marbury Management, does not compel a different result. In Aaron, the Court reversed the second circuit's decision holding that the SEC need prove only negligence to obtain an injunction for violations of rule 10b-5. Aaron, a management employee at a brokerage firm, had been informed that two employees under his supervision were making gross misrepresentations in their sales of a particular security. Aaron did nothing about the complaint other than inform one of the employees about it and direct him to contact the complainant. The fraudulent conduct continued. The district court held that Aaron had "intentionally failed to discharge his supervisory responsibility," and issued an injunction. The second circuit affirmed, holding that Aaron had acted negligently in supervising the two employees, and declining to reach the question whether the record supported a finding of scienter. The Supreme Court reversed, holding that the SEC, like private litigants, must prove scienter as an element when it sues for an injunction under § 10(b) and rule 10b-5. In Aaron, the Court dealt with a supervisory employee rather than an employer, and this distinction is important for purposes of applying respondeat superior. See SEC v. Coffey, 493 F.2d 1304, 1315 (6th Cir. 1974), cert. denied, 420 U.S. 908, 95 S. Ct. 826, 42 L. Ed. 2d 837 (1975). We conclude that Aaron does not foreclose imposition of secondary liability in the situation before us. We now address the adjudicative facts upon which the decision in this case turns.
Here, two opinion letters were issued by Coopers & Lybrand. The first went out on July 21, 1971, to WMC and was signed in the firm name by a partner. The letter was in response to a request by WMC in behalf of one of its investors. The second letter went out in October, 1971, after a partner, Wright, had learned that WMC was showing copies of the letter to investors generally as part of WMC's sales program. With full knowledge of the letter's intended use a tool to be used by a securities seller as part of a sales program the partnership, through a partner, made the calculated decision to send out a more complete letter. Moreover, it was also decided that the letter be signed, not in the name of a partner, but in the partnership name. These facts are central to the important inquiry, whether this activity propelled Coopers & Lybrand into a position in which the investing public would place their trust and confidence in it. We determine that it did ascend to that position, and the ultimate issue turns on this determination.
In Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980), the Supreme Court emphasized that the petitioner, a printer who had abused inside information obtained from financial statements delivered to him for printing, "had no prior dealings with (the investors). He was not their agent, he was not a fiduciary, he was not a person in whom the (investors) had placed their trust and confidence." Id. at 232, 100 S. Ct. at 1116. By contrast here, a realization, even an expectation, by Coopers & Lybrand that buyers of partnership interests would "place( ) their trust and confidence" in the information provided them required appellant to exercise a high degree of care in preparation of the letter, and this care included close supervision of its employee, Higgins. We recognized in Rochez II that situations can arise in which corporations owe a duty of careful supervision to the public:
We recognize that corporations do have certain duties imposed on them for protection of public interest. To exact this duty on a mere showing of a principal-agent relationship would violate the legislative purpose and effectively nullify the "controlling person" provision of the Act. See ...