inside information by means of the joint ventures, including the Mallory Randall and Gulton deals. Rothberg negotiated the structure of the joint ventures with the defendants. Exs. D-122 - D-126, D-128 - D-132, D-136, D-138; N.T. 3.6-10, 3.60-63.
44. Rothberg also financed the joint ventures. Without his participation the joint ventures could not have come about. Neither David nor Selzer had sufficient money of their own to invest at that time. N.T. 3.54.
45. In my bench opinion, I found that Sanford was unaware of the illegal insider trading until about the onset of the litigation. N.T. 3.125.
46. Rothberg provided the capital to finance the joint ventures. In exchange, David provided inside information and was to receive half of any earned profits. Because David knew he could not legally enter into an agreement with Rothberg to purchase the stock invested, David appointed Sanford to receive his share of any profits earned from the joint ventures. Because of his superior bargaining position, Rothberg extracted a guarantee against loss from David. On paper, the Mallory Randall and Gulton joint ventures were between Sanford and Rothberg. However, Rothberg relied on David's tips and guarantee against loss. As Rothberg testified, Sanford's guarantee against loss was virtually worthless. But as part of the scheme, to disguise the illegal insider trading, David did not initially document his oral guarantees to Rothberg against loss. Only after the value of the stocks in question had declined in value and upon Rothberg's insistence, did David provide written guarantees against loss to Rothberg. These guarantees were backdated to the dates of execution of the Mallory Randall and Gulton joint ventures.
47. By providing the financing which made the investments in question possible, Rothberg knowingly profited, and enabled others to profit, from inside information from which David and Selzer were legally prohibited from profiting. If Rothberg had not furnished such financing, the trades in question would not have occurred.
48. Rothberg bears at least substantially equal responsibility with the defendants for the illegal conduct from which the notes and guarantee in this suit derive. By pressuring David to find a way to get him more money, Rothberg caused the formation of the Mallory Randall and Gulton joint ventures. Rothberg and David were aware from the inception of the joint ventures that their conduct was illegal and took affirmative steps to conceal the illegality through the structure of the joint venture, the use of oral guarantees, the concealment of Selzer's role in the deals, and the use of Sanford as a straw for David.
49. As the instigator and the financier of the joint ventures, Rothberg's culpable conduct fairly outweighs that of David and Sanford. Rothberg aggressively supported the illegal ventures to trade on inside information, and his participation was active, willing, and complete. In effect, Rothberg and David were co-conspirators to violate the securities laws against insider trading.
50. Rothberg testified that he filed this suit more than thirteen years after the Joint Venture Agreements were executed because he hoped to benefit from the inheritance which David and Sanford received after the death of their parents. N.T. 2.37-39.
51. However, Rothberg's "forebearance" from pressing the Rosenblooms to repay their debt to him stemmed from Rothberg's concern about the possibility of prosecution brought by the Securities Exchange Commission (S.E.C.). Rothberg had been the target of an S.E.C. investigation in 1971 for his alleged receipt of and use of inside information concerning proposed mergers of an entity known as Harvey's Stores, of which David was then an executive. N.T. 1.175-83.
52. Barring Rothberg from recovery here would enhance, not interfere with, the effective enforcement of the securities laws and would more likely protect the investing public than enforcing these contracts, spawned from greed and nurtured by crooked insider dealing.
53. Permitting the parties to stand where the market has left them serves to deter others from organizing and financing ventures to trade on inside information.
54. As I noted in my Bench Opinion, Rothberg is an astute, sophisticated and intelligent businessman, careful about detail. N.T. 3.126. David, on the other hand, was a voluble, limited person, unlikely to keep business secrets and insensitive to the requirements of law regarding the fiduciary duties and legal restrictions imposed on him as a corporate insider responsible for the money of the investing public. The unfortunate combination of Rothberg's greed and independence in attending to details of his affairs and David's carelessness about his legal obligations leads me to believe that David Rosenbloom furnished plaintiff the inside tips which were the basis for the investment decisions of these joint ventures. I cannot believe that Benjamin Rothberg, as he contended, would turn over his business decisions to David Rosenbloom. N.T. 3.126-27.
The Illegality Defense
Rothberg argues that the defense of illegality is unavailable to the Rosenblooms under Pennsylvania law. Rothberg cites authority to the effect that a court will enforce a claim based on an illegal contract if the plaintiff can make out his claim without reference to the illegal underlying transaction. See e.g., O'Brien v. O'Brien Steel Construction Co., 440 Pa. 375, 380, 271 A.2d 254, 256 (1970); New York & Pennsylvania Co. v. Cunard Coal Co., 286 Pa. 72, 132 A. 828 (1926); Holt v. Green, 73 Pa. 198, 200-01 (1873); Contractor Industries v. Zerr, 241 Pa. Super. 92, 97, 359 A.2d 803, 805 (1976).
Rothberg claims that he has brought suit on facially valid negotiable instruments and that the defendants have never questioned the authenticity of the notes and guaranty.
Therefore, he claims he has made out his case as Pennsylvania law requires, without reference to the underlying illegal contract.
Rothberg, however, ignores a line of Pennsylvania authority holding that courts will look at the substance, not the mere form of the transactions. See e.g. New York & Pennsylvania Co. v. Cunard Coal Co., 286 Pa. 72, 84, 132 A. 828, 832 (1926); Kuhn v. Buhl, 251 Pa. 348, 373, 96 A. 977, 985 (1916); Irvin v. Irvin, 169 Pa. 529, 32 A. 445 (1895). Accord Tucker v. Binenstock, 310 Pa. 254, 165 A. 247 (1933). Even where a plaintiff can prove his case without reference to an underlying illegal transaction, a court will not enforce such a contract where to do so would offend public policy. The "scope of the public policy doctrine is broader and more encompassing than the concept of illegality." Shadis v. Beal, 685 F.2d 824, 833 (3d Cir. 1982), cert. denied, 459 U.S. 970, 103 S. Ct. 300, 74 L. Ed. 2d 282 (1982).
In this case, I find that the Gulton and Mallory Randall joint ventures, which sustained the losses that are the basis of the notes and guarantee in question, were part of a plan between Rothberg and David to violate federal securities laws. To enforce this agreement would violate the purpose of these laws, which is to protect the investing public. Under these circumstances, Pennsylvania law tells me to leave the parties where the market has left them:
"What results to a contract against public policy is a total and irremediable paralysis, which leaves it absolutely without any force or effect whatever, so that it cannot, under any circumstances, be made the basis of a cause of action. The law when appealed to will have nothing to do with it, but will leave the parties just in the condition in which it finds them. If they have fully executed their unlawful contract, the law will not disturb them in the possession of what each has acquired under it. If one has executed in whole or in part, the law turns a deaf ear when he pleads for its aid to compel the other to do as much . . . . If the contract is still executory, the promissor is left undisturbed in the possession of the money or other property which he agreed to pay or transfer; if the contract has been executed, the promissee is left undisturbed in the possession of the money or other property which has been paid or conveyed to him." Pittsburg v. Goshorn, 230 Pa. 212, 227, 79 A. 505, 510 (1911); Dippel v. Brunozzi, 365 Pa. 264, 267-68, 74 A.2d 112, 114 (1950).
Regarding the defense of in pari delicto under Pennsylvania law, Rothberg contends that Sanford was "neither 'in pari' nor 'delecto.'" Plaintiff's Memorandum of Law at 8. Plaintiff's argument is a play on words. As Judge Spaeth noted, the doctrine of in pari delicto is a specific and limited application of the general principle that "'no court will lend its aid to a man who grounds his action upon an immoral or illegal act.'" Feld & Sons v. Pechner, Dorfman, Wolfee, et al., 312 Pa. Super. 125, 130, 458 A.2d 545, 548 (1983), appeal dismissed, 504 Pa. 177, 470 A.2d 525 (1984) (quoting Fowler v. Scully, 72 Pa. 456, 467 (1872)). Courts refuse to enforce illegal contracts or contracts made in violation of public policy to make sure that the law does now allow a wrongdoer to recover. The defense of illegality is "allowed not for the sake of the defendant, but of the law itself." Fowler v. Scully, 72 Pa. at 466; Fitzsimons v. Eagle Brewing Co., 107 F.2d 712, 713 (3d Cir. 1939) (the court's refusal to enforce a contract in violation of public policy is not for the sake of the defendant, but to avoid aiding such a plaintiff.); F.F. Bollinger Co. v. Widmann Brewing Corp., 339 Pa. 289, 295, 14 A.2d 81, 84 (1940) (the rule preventing recovery on an illegal contract is founded on public policy, not through regard for the person who sets up such a defense.).
The "Bateman Eichler" Decision
The Third Circuit remanded this case to me to apply the in pari delicto defense that the Supreme Court formulated in Bateman Eichler, Hill Richards, Inc. v. Carl F. Berner, et al., 472 U.S. 299, 105 S. Ct. 2622, 86 L. Ed. 2d 215 (1985), issued after my Bench Opinion in this case. In Bateman Eichler, a group of investors who had sustained substantial trading losses instituted a private cause of action for fraud under Section 10(b) of the Securities Exchange Act of 1934 against a securities broker and a corporate insider. The investors claimed that the broker and corporate officer had fraudulently induced them to purchase large quantities of stock in the company of the corporate officer by divulging false information about the company. The investors admitted that their purpose in purchasing the stock was to earn secret profits on inside information. The defendants contended that the doctrine of in pari delicto barred the investors' action.
The Court rejected the arguments of the defendants, severely restricting the availability of the in pari delicto defense in private damage actions under the federal securities laws. Henceforth, the defense would be appropriate "only where (1) as a direct result of his own actions, the plaintiff bears at least substantially equal responsibility for the violations he seeks to redress, and (2) preclusion of suit would not significantly interfere with the effective enforcement of the securities laws and protection of the investing public." Bateman Eichler, 105 S. Ct. at 2629.
The first part of the test requires weighing the relative culpability of the parties. In Bateman Eichler, the Court noted that the broker and corporate officer (tipsters) had violated their fiduciary duties by disclosing inside information to the plaintiff investors (tippees). The breach of duty by the plaintiff-investors derived from the breach of their tipsters, the broker and corporate officer. The Court reasoned that in the context of insider trading, a person whose liability is solely derivative could not be as culpable as one whose breach of duty gave rise to that liability in the first place. Id. at 2630. Thus, absent other culpable acts on the part of the tippees, as a matter of law, the actions of tippees were not of substantially equal culpability as those of their tipsters. Id. at 2630-31.
The second part of the test requires that a court assess the effect of allowing the defense of in pari delicto on the enforcement of the securities laws and on protecting the investing public. In Bateman Eichler, the Court noted that allowing the defendants to raise the defense "would inexorably result in a number of alleged fraudulent practices going undetected by the authorities and unremedied." Id. at 2631. In addition, the Court reasoned that "deterrence of insider trading most frequently will be maximized by bringing enforcement pressures to bear on the sources of such information -- corporate insiders and broker-dealers." Id. at 2632. The Court, thus, viewed the insider-tipster as the source of the information and of the problem. Deterrent pressures, therefore, would be placed on the tipster by limiting application of in pari delicto.
Prior to Bateman Eichler, the Third Circuit in Tarasi v. Pittsburgh National Bank, 555 F.2d 1152 (3d Cir. 1977), cert. denied, 434 U.S. 965, 54 L. Ed. 2d 451, 98 S. Ct. 504 (1977), as well as other courts, had reasoned that without the in pari delicto defense, tippees would have an enforceable warranty to trade on inside information: If the tip were correct, the tippees would reap illicit secret profits; if the tip did not yield the expected results, the tippees could sue their tipsters to recover damages. The Bateman Eichler Court rejected the enforceable warranty theory because it "overlooks significant factors that serve to deter tippee trading irrespective of whether the in pari delicto defense is allowed." Id. at 2633. The Court noted that tippees who bring suit to cash in on their enforceable warranties expose themselves to civil and criminal penalties for their own illegal conduct. Id. In addition, actions brought under section 10(b) and Rule 10(b)-5 require plaintiffs to prove scienter on the part of their defendants. For this reason, tippee-investor plaintiffs will only be able to recover from tipster-defendants where the tipsters have deliberately defrauded their tippees. Such plaintiffs will not be able to bring suit merely if the tip fails to pan out. Id.
Although Bateman Eichler limits the application of the in pari delicto defense, it does not eliminate it totally. The Court recognized that "situations might well arise in which the relative culpabilities of the tippee and his insider source merit a different mix of deterrent incentives" from those in Bateman Eichler. 105 S. Ct. at 2632. I find that this matter contains such a mix of deterrent incentives to make application of in pari delicto appropriate.
With regard to the relative culpability of the parties, the facts of this case do not resemble those in Bateman Eichler. Here there is no corporate officer or broker inducing a passive and innocent person to invest on the basis of inside information. Rather, Rothberg's participation in the six joint ventures to trade on inside information (for which he advanced over $1,365,000) was active and aggressive; it was not after-the-fact participation in an insider's breach of duty. David's testimony reveals that it was Rothberg who pressured David to come up with a way for Rothberg to earn more money on his investments. That request led to the formation of the joint ventures to trade on inside information to earn secret profits.
With the exception of the $100 in cash that Sanford contributed to the Mallory Randall and Gulton joint ventures, it was Rothberg's loans that fueled the activities of the ventures. His money was the sine qua non of the insider trading scheme. Moreover, Rothberg's ability to extract indemnities against loss shows his superior bargaining power to David's: Sanford guaranteed Rothberg and David guaranteed Sanford's guarantee.
In short, Rothberg was the instigator and financier of the scheme to trade on insider information. Rothberg was a rich and powerful financier; David was a weak and dependent tout. Rothberg called the tune; David danced. As I noted in my bench opinion:
"Mr. Rothberg, from my observing his testimony, is an astute, sophisticated and intelligent businessman, extremely careful about detail. David Rosenbloom, from my observing his testimony, is a voluble, limited person, unlikely to keep business secrets and insensitive to the basic requirements of law regarding the fiduciary duties and legal restrictions imposed upon him as a corporate insider responsible for public investors' money. The combination of Mr. Rothberg's care and interest about the details of his affairs and Mr. Rosenbloom's carelessness about his legal obligations leads me to believe that David Rosenbloom told plaintiff the inside tips which were the basis for the investment decisions of the two joint ventures. I cannot believe that Mr. Rothberg would turn over his investment decisions to a David Rosenbloom." N.T. 3.126-27.
I find that Rothberg's culpable financing of these illegal schemes can fairly be said to outweigh David's weakness in furnishing tips. See Bateman Eichler, 105 S. Ct. at 2630-31.
I also find that precluding this claim would not significantly interfere with the effective enforcement of the securities laws and protection of the investing public. Unlike Bateman Eichler, barring this suit would not result in denying a defrauded tippee an incentive to bring a tipper's misdeeds to light. Rather, it is the defendants here raising the fraudulent practices which would otherwise go undetected and unremedied. To encourage bringing illegal insider trading to light, at least in this case, means allowing the defendants, who borrowed money to participate in illegal ventures, to blow the whistle on their lendor, who shared illegal profits in this series of ventures trading on inside information.
Moreover, deterrent pressures in this case are probably stronger on the well-advised financier than on the marginal insider risk-taker. That is, denying recovery to a sophisticated lendor like Rothberg will probably discourage insider trading by cutting off the transaction at its root, money. If Rothberg does not get his money back in this case, he and others like him will be less likely to do it again. Such additional deterrence is necessary, particularly in this case, because Rothberg waited so long to bring his action in order to avoid prosecution by the Securities and Exchange Commission. The parties here got a taste of S.E.C. enforcement efforts in the early 1970's. See, S.E.C. v. Shapiro, 349 F. Supp. 46 (S.D.N.Y. 1972), aff'd, 494 F.2d 1301 (2d Cir. 1974).
The insider touts of the world are less likely to be emboldened to sell tips if I let them off the creditor's hook than the insecure financiers of illegal ventures (demanding protection by notes against losses and guarantees of guarantees) are likely to be deterred by my denying their recovery.
One of the bases on which the Supreme Court rejected the "enforceable warranty" theory of the Third Circuit in Tarasi was because of the possibility of civil and criminal prosecution of a plaintiff who tries to enforce such a warranty under the federal securities law. Bateman Eichler, 105 Sup. Ct. at 2633. In this case, however, the statute of limitations for Rothberg's civil and criminal liability under federal securities laws has run.
With regard to the enforceable warranty theory, I doubt that the David Rosenblooms of the world would be encouraged to borrow money for insider trading if they had a "warranty" that they did not have to pay back their lendors. Such a concern goes too far, like the warranty theory rejected in Bateman Eichler. First, insiders who borrow to trade expose themselves to substantial civil and criminal liability. Second, only lendors who knowingly finance illegal ventures in which they participate, like Rothberg, would be barred from recovering. Finally, what drives insider trading is the expectation of profit, not the hope or expectation of avoiding repayment of a debt where even the factual basis for such a defense is uncertain at the time of trading. The David Rosenblooms of the world will probably make their decisions whether or not to engage in insider trading without considering their chance to escape liability for repayment of the debt that finances the trading. The future financiers -- allergic to risk -- will more likely benefit from advance advice by informed counsel of the risks of financing illegal insider trading schemes than will the future irresponsible insiders of public issuers of volatile securities, who seek to profit from their position.
The Supreme Court concluded in Bateman Eichler "that the public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders . . . to full public view for appropriate sanctions." 105 S. Ct. at 2633. My conclusion in this case is that the public interest will best be served if the little fish are permitted to defend litigation by the big fish who finance illegal joint ventures to trade on insider information. This view more likely will bring to light for appropriate sanctions the wrongdoing of financiers who profit from the weakness of others. Allowing Rothberg to recover would frustrate the purposes of the securities laws by rewarding well-structured greed. Denying Rothberg recovery effectuates the laws against insider trading by putting its financiers at risk.
AND NOW, this 14th day of February, 1986, judgment is entered in favor of defendants and against plaintiff for the reasons stated in the foregoing Memorandum.