B. Federal Securities Laws
1. Section 10(b)
of the Securities Exchange Act of 1934 and its implementing rule, 10b-5
broadly prohibit fraud in connection with the purchase and sale of securities. The fundamental purpose of the 1934 Act was "to substitute a philosophy of full disclosure for the philosophy of caveat emptor. . . ." Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 92 S. Ct. 1456, 31 L. Ed. 2d 741 (1972) (quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180, 186, 11 L. Ed. 2d 237, 84 S. Ct. 275 (1963)). The Act is to be applied "not technically and restrictively, but flexibly to effectuate its remedial purposes." Affiliated Ute, 406 U.S. at 151 (quoting SEC v. Capital Gains Research Bureau, 375 U.S. 180, 195, 11 L. Ed. 2d 237, 84 S. Ct. 275 (1963)). See also Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 12, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971). Although drafted as an SEC enforcement provision, a private right of action "has been consistently recognized for more than 35 years. The existence of this implied remedy is beyond peradventure."
Herman & Maclean v. Huddleston, 459 U.S. 375, 103 S. Ct. 683, 687, 74 L. Ed. 2d 548 (1983).
Judicial limitations which have been placed upon a section 10(b) claim also serve to define the elements of the cause of action. For example, in order to have standing to sue, a plaintiff must have either purchased or sold securities. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 749, 44 L. Ed. 2d 539, 95 S. Ct. 1917 (1975). The fraudulent conduct alleged must take the form of a misstatement, omission, manipulation or deception. The mere breach of a fiduciary duty is not actionable. See Santa Fe Ind., Inc. v. Green, 430 U.S. 462, 477, 479-80, 97 S. Ct. 1292, 51 L. Ed. 2d 480 (1977). As the statutory language indicates, the fraud must be "in connection with" the purchase or sale. In misstatement and omission cases, the controverted fact must also be "material." The definition of materiality in section 10(b) cases has been borrowed from the section 14(a) context. Quoting from TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 48 L. Ed. 2d 757, 96 S. Ct. 2126 (1976), the Third Circuit describes materiality as "a substantial likelihood that, under all circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder."
Healey v. Catalyst Recovery of Pennsylvania, Inc., 616 F.2d 641, 647 (3d Cir. 1980).
A plaintiff must also prove that the fraudulent conduct was accompanied by "scienter." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 47 L. Ed. 2d 668, 96 S. Ct. 1375 (1976). Although the Ernst court left the question open, this Circuit and others have held that reckless behavior is sufficient.
See e.g., Sirota v. Solitron Devices, Inc., 673 F.2d 566, 575 (2d Cir.), cert. denied, 459 U.S. 838, 103 S. Ct. 86, 74 L. Ed. 2d 80 (1982); McLean v. Alexander, 599 F.2d 1190, 1197-98 (3d Cir. 1979); Nelson v. Serwold, 576 F.2d 1332, 1337 (9th Cir.), cert. denied, 439 U.S. 970, 58 L. Ed. 2d 431, 99 S. Ct. 464 (1978); Rolf v. Blyth, Eastman Dillon & Co., Inc., 570 F.2d 38, 44-47 (2d Cir.), cert. denied, 439 U.S. 1039, 58 L. Ed. 2d 698, 99 S. Ct. 642 (1978); Coleco Industries, Inc. v. Berman, 567 F.2d 569, 574 (3d Cir. 1977), cert. denied, 439 U.S. 830, 58 L. Ed. 2d 124, 99 S. Ct. 106 (1978); First Virginia Bankshares v. Benson, 559 F.2d 1307, 1314 (5th Cir. 1977), cert. denied, sub nom., Heller & Co. v. First Virginia Bankshares, 435 U.S. 952, 55 L. Ed. 2d 802, 98 S. Ct. 1580 (1978); Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1044-45 (7th Cir.), cert. denied, 434 U.S. 875, 98 S. Ct. 224, 54 L. Ed. 2d 155 (1977).
The final two elements of a section 10b cause of action are reliance and causation. These related concepts have generated a good deal of uncertainty, see e.g., Sharp v. Coopers & Lybrand, 649 F.2d 175, 186-89 (3d Cir. 1981), cert. denied, 455 U.S. 938, 71 L. Ed. 2d 648, 102 S. Ct. 1427 (1982) (reliance); Huddleston v. Herman & MacLean, 640 F.2d 534, 547-50 (5th Cir. 1981), aff'd in part, rev'd in part, 459 U.S. 375, 103 S. Ct. 683, 74 L. Ed. 2d 548 (1983) (reliance and causation). In analyzing these concepts, I shall endeavor not to add to the existing confusion.
Defendants' section 10(b) arguments can be broken down into four major categories. First, defendants make a general Santa Fe v. Green argument, portraying the allegations as little more than breaches of fiduciary duties, devoid of the requisite material misstatements or omissions. The churning claims are also attacked as insufficient to state a cause of action. However, the more interesting and problematic issues presented focus upon the causation and "in connection with" elements.
(a) The Scope of Prohibited Conduct
When minority shareholders challenged the Delaware statutory short form merger as a "device, scheme, or artifice to defraud," the Supreme Court decided that it was time to put a halt to the seemingly endless expansion of the scope of section 10(b). Therefore, in Santa Fe v. Green, 430 U.S. 462, 51 L. Ed. 2d 480, 97 S. Ct. 1292 (1977), the Court held that in the absence of some form of deception, misrepresentation or non-disclosure, a breach of a fiduciary duty is not actionable under section 10(b). Santa Fe, 430 U.S. at 475-77. No longer can the catch-all anti-fraud provision be used to redress claims of corporate mismanagement. Id. at 477. Defendants endeavor to characterize the complaints as Santa Fe pleadings which allege little more than breach of a fiduciary duty or the failure to disclose such a breach.
Indeed, plaintiffs are portrayed as poor losers -- investors who are now crying over bad advice. After reviewing the complaints, I cannot agree.
Putting aside the churning allegations, I find allegations of material misrepresentations and omissions which elevate plaintiffs' complaints beyond the reach of Santa Fe. The complaints allege, explicitly or inferentially, knowledge or recklessness on the part of defendants -- thus fulfilling the scienter requirement.
See e.g., Gaugler Amended Complaint, paras. 25F, 25H, 29; Taraborelli Complaint, paras. 25, 26, 28; Shulik Complaint para. 40, 50; Singer Complaint, para. 39; Rastelli Complaint, para. 35.
The failure to disclose Catanella's role in the Brown litigation is an omission which, if material, would fall within the scope of section 10(b). In Sutton v. Shearson Hayden Stone, Inc., 490 F. Supp. 98, (S.D.N.Y. 1980), a broker's failure to disclose that he had been the subject of previous customer complaints survived a motion to dismiss. Although the court seemed concerned about proof of materiality, there was no suggestion that this was simply a breach of fiduciary duty barred by Santa Fe. Id. at 101. Shearson Hayden paid $34,500 to satisfy irate and potentially litigious customers. Sutton, in turn, signed a promissory note for that amount. In contrast, the Brown litigation resulted in an $813,000 verdict. The court in Sutton found that disclosure of the customer complaints would serve the purpose of protecting investors -- the goal of section 10(b). Id. at 101-03. I agree. Moreover, the allegations here indicate that plaintiffs were not sophisticated and relied heavily upon Catanella. Thus, his track record of self-dealing, churning and mishandling of other portfolios would be highly material.
Catanella's affirmative misrepresentation of his expertise in option trading, which induced Gaugler to purchase options, presents a similar situation. After losing all of the funds so invested, Catanella admitted that he had never before traded in options. Misrepresentation of expertise has been held actionable under section 10(b). See Marbury Management, Inc. v. Kohn, 629 F.2d 705, 707-08 (2d Cir. 1980), cert. denied, sub. nom., Wood Walker & Co. v. Marbury Management, Inc., 449 U.S. 1011, 66 L. Ed. 2d 469, 101 S. Ct. 566 (1980) (trainee represented himself as "licensed registered representative" and "portfolio management specialist").
Nor are the material omissions and misrepresentations limited to the Brown litigation. The Singer and Rastelli complaints contain detailed descriptions of all of the undisclosed risks and costs associated with margin trading. The mechanics of a margin account were not explained -- plaintiffs were not told that they were actually placing more money at risk. They were not informed about margin calls or the interest computation and were led to believe that margin trading was "prudent and cautious." Singer Complaint, para. 26; Rastelli Complaint, para. 26. The Shulik Complaint also contains averments of misrepresentations with respect to the risks of margin trading. Shulik Complaint, paras. 23, 25, 26. Misrepresentations or omissions with respect to the risks inherent in margin trading are within the scope of section 10(b). See e.g., Arrington v. Merrill Lynch, Pierce, Fenner & Smith, 651 F.2d 615, 619 (9th Cir. 1981); Yancoski v. E.F. Hutton & Co., Inc., 581 F. Supp. 88, slip op. at 7 (E.D. Pa. 1983). Catanella incorrectly advised Rastelli that the high volume of trading was appropriate, when in fact his account was being churned. This allegation also states a claim under section 10(b). Accord Yancoski, slip op. at 7. In all complaints, Catanella is accused of intentionally ignoring plaintiffs' conservative investment goals, plunging money into speculative, high risk securities. This is a material misrepresentation, rather than merely a breach of fiduciary duty. See Miley v. Oppenheimer & Co., Inc., 637 F.2d 318, 326 (5th Cir. 1981); Yancoski, slip op. at 7. See also Clark v. John Lamula Inv. Inc., 583 F.2d 594, 599-601 (2d Cir. 1978) (recommending unsuitable debentures violates section 10(b)). Finally, the complaints are replete with allegations of self-dealing and the general mishandling of plaintiffs' accounts. Defendants' goals were not to serve their customers, but rather to generate commissions and interest for themselves. Faced with a similar situation, the court in Troyer found material misrepresentations and omissions in defendant's failure to disclose his self-dealing and mishandling of plaintiffs' portfolio. 476 F. Supp. at 1146-47. I agree with the approach taken in Troyer. The various allegations, taken together, form a course of fraudulent and deceptive conduct, transcending Santa Fe v. Green and adequately stating a claim under section 10(b).
Churning is a term of art which is actually a "synonym for 'overtrading.'" Armstrong v. McAlpin, 699 F.2d 79, 90 (2d Cir. 1983) (citing Hazard & Christie, The Investment Business 68 (1964)). It occurs when a broker engages in excessive trading for the purpose of generating commissions, without regard to the customer's investment objectives. See e.g., Costello v. Oppenheimer & Co., Inc., 711 F.2d 1361, 1367 (7th Cir. 1983); Thompson v. Smith Barney, Harris Upham & Co., Inc., 709 F.2d 1413, 1416 (11th Cir. 1983); Armstrong, 699 F.2d at 90; Petrites v. J.C. Bradford, 646 F.2d 1033, 1035 (5th Cir. 1981); Miley v. Oppenheimer & Co., Inc., 637 F.2d 318, 324 (5th Cir. 1981); Mihara v. Dean Witter & Co., Inc., 619 F.2d 814, 820 (9th Cir. 1980); Williamsport Firemen Pension Boards I and II v. E.F. Hutton & Co., Inc., 567 F. Supp. 140, 144 (M.D. Pa. 1983). Invoking the talismanic Santa Fe decision, the Gaugler defendants argue that the churning claim represents simply another chapter in state fiduciary duty law. Similarly, they argue that churning itself is insufficient to state a section 10(b) claim. Rather, churning allegations must be accompanied by averments of specific misrepresentations, omissions or acts of deception. Defendants also attack all complaints for the lack of detail with respect to the allegedly improper transactions. For the most part, these arguments were raised and rejected in the section discussing specificity.
It appears undisputed that churning does state a cause of action under section 10(b). See e.g., Costello v. Oppenheimer & Co., Inc., 711 F.2d 1361, 1368 (7th Cir. 1983); Thompson v. Smith Barney, Harris Upham & Co., Inc., 709 F.2d 1413, 1416-17 (11th Cir. 1983); Follansbee v. Davis, Skaggs & Co., Inc., 681 F.2d 673, 676 (9th Cir. 1982); Miley v. Oppenheimer, 637 F.2d 318, 324 (5th Cir. 1981); Mihara v. Dean Witter & Co., Inc., 619 F.2d 814, 820 (9th Cir. 1980); Carras v. Burns, 516 F.2d 251, 258 (4th Cir. 1975); Landry v. Hemphill, Noyes & Co., 473 F.2d 365, 368 n.1 (1st Cir.), cert. denied, 414 U.S. 1002, 38 L. Ed. 2d 237, 94 S. Ct. 356 (1973); Hecht v. Harris Upham & Co., 430 F.2d 1202, 1206-1207 (9th Cir. 1970); Mauriber v. Shearson/American Express, Inc., 567 F. Supp. 1231, 1237-38 (S.D.N.Y. 1983); Kaufman v. Magid, 539 F. Supp. 1088, 1095 (D. Mass. 1982); Kaufman v. Merrill Lynch, Pierce, Fenner & Smith, 464 F. Supp. 528, 534 (D. Md. 1978); Dandorph v. Fahnestock & Co., 462 F. Supp. 961, 963 (D. Conn. 1979); Kravitz v. Pressman, Frohlich & Frost, Inc., 447 F. Supp. 203, 211 (D. Mass. 1978); Powers v. Francis I. DuPont & Co., 344 F. Supp. 429, 431-32 (E.D. Pa. 1972); Lorenz v. Watson, 258 F. Supp. 724, 730 (E.D. Pa. 1966). As the court stated in Follansbee:
It is settled that when a broker, unfaithful to the trust of his customer, churns an account in the brokers control for the purpose of enhancing the broker's commission income and in disregard of the client's interest, there is a violation of section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C.A. § 78a et seq., and Securities and Exchange Commission Rule 10b-5.
681 F.2d at 676. In order to prove a churning claim, plaintiff must show that the broker exercised control over the account and that the trading was excessive.
See e.g., Costello, 711 F.2d at 1368; Thompson, 709 F.2d at 1416-17; Miley, 637 F.2d at 324; Mihara, 619 F.2d at 821; Kaufman, 539 F. Supp. at 1095; Zaretsky v. E.F. Hutton & Co., Inc., 509 F. Supp. 68, 74 (S.D.N.Y. 1981). Although courts seem to be in agreement with respect to these two elements, some have added the requirement that the broker act "with the intent to defraud or with willful and reckless disregard for the investor's interest." Thompson, 709 F.2d at 1417; Miley, 637 F.2d at 324; Mihara, 619 F.2d at 821.
However, this prong only appears to formalize the general scienter requirement necessary for all section 10(b) actions.
Although the prohibition on churning can probably be traced to the fiduciary responsibility a broker owes to its customers, as the above cited cases demonstrate, churning does rise to the level of a section 10(b) violation. The act of churning itself is a deception. As the Costello court noted; "as a scheme, the essence of which is deception of a relying customer, churning, as a matter of law, is considered a violation of section 10(b) and Rule 10b-5." Costello, 711 F.2d at 1368 (citations omitted) (emphasis added). Similarly, the Ninth Circuit stated "the churning of a client's account is, in itself, a scheme or artifice to defraud within the meaning of Rule 10b-5." Mihara, 619 F.2d at 821. Accord Yancoski, slip op. at 5-6. In Armstrong v. McAlpin, 699 F.2d 79 (2d Cir. 1983), the district court had dismissed the churning claim for failing to allege an accompanying misrepresentation or omission. In reversing that decision, the court stated that "churning, in and of itself, may be a deceptive and manipulative device under section 10(b), the scienter required by section 10(b) being implicit in the nature of the conduct. The district court's reliance upon Santa Fe Industries v. Green, supra, 430 U.S. 462, was misplaced." Armstrong, 699 F.2d at 91 (citations omitted). I agree that the utilization of a customer's account to generate omissions, without regard to the customer's investment objectives, is "deceptive" within the meaning of section 10(b). To require a plaintiff to prove something in addition to the elements of control and excessiveness would be redundant and would contravene the overriding purpose behind the Securities and Exchange Act of 1934 -- the protection of the investing public.
Defendants' other arguments with respect to churning are made in the guise of pleading deficiencies under Rule 9(b) of the Federal Rules of Civil Procedure. I have already rejected the suggestion that a plaintiff must list all allegedly tainted transactions and calculate the turnover ratio. Although not as detailed as defendants might wish, the complaints do contain allegations of broad discretionary control and excessive trading in light of conservative investment objectives. See e.g., Shulik Complaint, paras. 19, 39, 44, 45; Singer Complaint, paras. 21, 24; Rastelli Complaint, paras. 21, 24. Moreover, paragraph 16 of the Gaugler Complaint sets forth in unassailable detail the names of the securities churned, the frequency of trading, the commissions paid and the estimated turnover ratio. Therefore, I conclude that churning claims are sufficient to survive a motion to dismiss.
(c) In Connection With
Section 10(b) and Rule 10b-5 proscribe fraud "in connection with the purchase or sale of any security." 15 U.S.C. § 78j (1976); 17 C.F.R. § 240.10b-5 (1983). Defendants contend that many of plaintiffs' allegations do not arise "in connection with" an actual purchase or sale. Although the failure to disclose Brown is the focal point of this argument, defendants cite the failure to disclose the risks of margin trading, churning, unsuitable purchases and other averments falling into the general category of mishandling plaintiffs' accounts.
Defendants reason that these allegations reflect upon the choice of, or confidence in a broker, rather than the decision to buy or sell a particular stock. According to defendants, the latter satisfies the "connection" element, while the former does not. I do not agree.
Despite voluminous caselaw in the section 10(b) area, the "in connection with" element has received little judicial attention. The concept does not lend itself to definition and its application has generated more than its share of confusion. The only Supreme Court precedent, Superintendent of Insurance of New York v. Bankers Life & Cas. Co., 404 U.S. 6, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971), provides little practical guidance. In Bankers Life, defendants essentially used the assets of a corporation, Manhattan Casualty Company, to acquire total ownership. Defendants purchased all of the stock of Manhattan using a check drawn at a financial institution. At the time the check was written, defendants had no funds on deposit there. After taking over Manhattan and installing a president, defendants induced the Board to sell some of its United States Treasury Bonds. The proceeds of the sale were used to cover the check with which the stock had been purchased. 404 U.S. at 7-8. Noting that "section 10(b) must be read flexibly, not technically and restrictively," id. at 12, the Court stated that "there was a 'sale' of a security and since fraud was used 'in connection with' it, there is a redress under § 10(b). . . ." Id. Although the Court did not explicitly define the "in connection with" element, it did explain that "Manhattan suffered an injury as a result of deceptive practices touching its sale of securities. . . ." Id. at 12-13. (emphasis added). Because of this phrase, Bankers Life is universally cited for the proposition that the connection requirement will be satisfied if the alleged fraud "touches" the purchase or sale. See e.g., Arrington v. Merrill Lynch, Pierce, Fenner & Smith, 651 F.2d 615, 619 (9th Cir. 1981); McGrath v. Zenith Radio Corp., 651 F.2d 458, 467 (7th Cir.), cert. denied, 454 U.S. 835, 70 L. Ed. 2d 114, 102 S. Ct. 136 (1981); Alley v. Miramon, 614 F.2d 1372, 1378 n.11 (5th Cir. 1980); Ketchum v. Green, 557 F.2d 1022, 1026 (3d Cir.) cert. denied, 434 U.S. 940, 54 L. Ed. 2d 300, 98 S. Ct. 431 (1977); Yancoski v. E.F. Hutton & Co., Inc., 581 F. Supp. 88, slip op. at 7 (E.D. Pa. 1983); Williamsport Firemen Pension Boards I and II v. E.F. Hutton & Co., Inc., 567 F. Supp. 140, 143 (M.D. Pa. 1983); Chemical Bank v. Arthur Andersen & Co., 552 F. Supp. 439, 451 (S.D.N.Y. 1982); Somogyi v. Butler, 518 F. Supp. 970, 985-86 (D.N.J. 1981).
Bankers Life raises the question what constitutes "touching" a securities transaction. Although many courts have taken a broad view of this element, there exists a paucity of viable standards. The Fifth Circuit has noted that "the plaintiff . . . need not establish a direct or close relationship between the fraudulent transaction and the purchase or sale. . . ." Alley v. Miramon, 614 F.2d 1372, 1378 n.11 (5th Cir. 1980). Accord Brown v. Ivie, 661 F.2d 62, 65 (5th Cir. 1981), cert. denied, 455 U.S. 990, 71 L. Ed. 2d 850, 102 S. Ct. 1614 (1982). The Alley court went on to state that the requirement is "satisfied when the proscribed conduct and the sale are part of the same fraudulent scheme." 614 F.2d at 1378 n.11. In Chemical Bank v. Arthur Anderson & Co., the court explained that Bankers Life and its progeny "require a nexus, albeit not a direct or close relationship, between the allegedly fraudulent conduct and the sale of securities." 552 F. Supp. at 451. This Circuit has "attempted to etch more finely the contours of the 'in connection with' clause," noting that other courts "almost without exception . . . have found compliance . . . even where fraudulent conduct is implicated only tangentially in a securities transaction." See Ketchum v. Green, 557 F.2d 1022, 1026-27 (3d Cir.), cert. denied, 434 U.S. 940, 54 L. Ed. 2d 300, 98 S. Ct. 431 (1977). However, rather than offering a standard, the Ketchum court observed that the ultimate determination is a factual one, best approached on a case by case basis. Id. at 1027.
Ketchum involved a corporate power struggle. The plaintiffs were the Chairman of the Board and President of Babb, Inc., holding between them approximately forty-five percent of the stock of the company. Babb was a closely held corporation and stock could only be owned by employees. Defendants, other members of the Board, induced plaintiffs to support their slate of candidates without disclosing their plan to oust plaintiffs. After the incumbent directors were unanimously re-elected, the Board jointly proposed and elected their own candidates for the positions of chairman and president, removing plaintiffs as officers. Plaintiffs' employment was then terminated and they were asked to surrender their stock pursuant to the corporation's stock retirement plan. 557 F.2d at 1023-24. The court found that the fraud was not "in connection with" the forced sale of plaintiffs' securities. Characterizing the dispute as a corporate foray, the court noted that the actual securities transaction was tangential to the relief requested. Plaintiffs apparently were more concerned with recovering their seats and invalidating the elections.
Id. at 1027. There, the court found the proximity between the fraud and the securities transaction to be more attenuated than in Bankers Life. As the court stated; "instead of being merely one step away from a securities deal, the supposed deception here is somewhat removed from the ultimate transaction. Indeed, there are a substantial number of intermediate steps between the fraud and the accomplishment of the forced sale of plaintiffs' shares. . . ." Id. at 1028.
The court also expressed concern over the potential federalization of state law under section 10(b).
Id. at 1029. There is another distinction between Ketchum and Bankers Life, which was implicit in the court's opinion. In Bankers Life, the securities transaction was an integral part of the fraudulent scheme. Yet in Ketchum, the fraud was aimed at removing plaintiffs from the corporation. The forced sale was merely an incidental result of that scheme.
One year after deciding Ketchum, this Circuit once again addressed the "in connection" issue in Cramer v. General Tele. & Electronics Corp., 582 F.2d 259 (3d Cir. 1978), cert. denied, 439 U.S. 1129, 59 L. Ed. 2d 90, 99 S. Ct. 1048 (1979). The plaintiffs challenged allegedly fraudulent commission payments made to a group of foreign investors. The arrangement arose out of GTE's sale of its controlling interest in a foreign company. The buyers did not have sufficient funds with which to purchase that interest, so GTE financed part of the price by paying the purchasers a commission on future equipment sales. Concluding that the payment of commissions was "in connection with" the sale of GTE's ownership interest, the court stated that: "GTE's promise to pay commissions on equipment sales was not a separate agreement. Rather, that promise was an essential part of GTE's original agreement to sell its interest in the foreign company." 582 F.2d at 271. Without further analysis or citation to Ketchum, the court concluded: "since the commission payments were inextricably linked to GTE's sale of its ownership interest . . ., we think the district court erred in concluding that the alleged fraud was not alleged to be in connection with the sale of a security."
Id. The fraud was not, as in the typical situation, the inducement for the securities transaction. Rather, the securities transaction was the inducement for the fraud. The financing problems surrounding the sale of ownership led GTE to arrange the allegedly fraudulent commission plan.
Analyzing the allegations in light of the scant principles articulated above, I conclude that the connection requirement has been satisfied. Defendants' failure to disclose Brown "touches" all of the allegedly fraudulent securities transactions. Plaintiffs here were all unsophisticated investors. They were introduced to Catanella through E.F. Hutton, a well-known and well respected brokerage house. They were told about his qualifications and expertise and subsequently opened accounts. They trusted Catanella and routinely followed his advice. In some cases, discretionary accounts were opened. Therefore, Catanella was in a position to choose the securities purchased and sold for plaintiffs' portfolios. He had de facto, if not formal control, over the accounts. It was this control which allowed him to defraud plaintiffs by churning, buying unsuitable securities, failing to disclose risks and the like. If the plaintiffs knew that Catanella had previously defrauded investors, and the extent of that fraud, it defies logic to conclude that he would have been granted the kind of control which allowed him to perpetrate the fraud. Plaintiffs may have chosen not to deal with Catanella at all. Therefore, I find a nexus between that initial failure to disclose Brown and all subsequent fraudulent transactions performed by Catanella.
I do not accept defendants' contention that the failure to disclose Brown is too remote from the transactions. In Bankers Life, the sale of the bonds was an integral part of a complex scheme of fraud. Here, the initial fraud in failing to disclose Brown played an integral role in an ongoing scheme of fraudulent securities transactions. As the Fifth Circuit stated, the connection element is satisfied where "the proscribed conduct and the sale are part of the same fraudulent scheme." Alley, 614 F.2d at 1378 n.11. The failure to disclose Brown was not only part of "the same fraudulent scheme," but enabled defendants to package and sell Catanella as expert and untarnished in his brokerage experience.
The failure to disclose the risks of margin trading has been deemed fraud "in connection with" the purchase and sale of securities. See Arrington v. Merrill Lynch, Pierce, Fenner & Smith, 651 F.2d 615, 619 (9th Cir. 1981); Yancoski v. E.F. Hutton & Co., Inc., 581 F. Supp. 88, slip op. at 7-8 (E.D. Pa. September 23, 1983). This omission induced plaintiffs to open margin accounts and there is a nexus between that fraud and the securities purchased on margin. Defendants were informed that plaintiffs were desirous of safe investments. Although the failure to disclose did not necessarily result in the purchase of a specific security, it did cause plaintiffs to purchase more securities than they otherwise would have. Thus, plaintiffs unwittingly exposed themselves to more potential liability because of the increased trading a margin account permits. The failure to disclose certainly "touches" the securities so purchased.
In Savino v. E.F. Hutton & Co., Inc, 507 F. Supp. 1225 (S.D.N.Y. 1981), the court faced a similar question. Defendants there allegedly misrepresented the risks of option trading. In holding the connection element satisfied, the court explained:
This alleged misrepresentation pertained directly to the underlying securities bought and sold for the Savino accounts. The Court is well aware of the recent admonition by the Court of Appeals for this Circuit that "not every 'risky' investment rises to the level of fraud because the risk is insufficiently disclosed."
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