Cases by Issue - Federal Regulation of Securities

Matrixx Initiatives, Inc. v. Siracusano - Oral Argument

Sat, 15 Jan 2011 01:44:52 +0000

Case:

Matrixx Initiatives, Inc. v. Siracusano

Media File:

09-1156_20110110-argument.mp3

Related Transcript:

09-1156_20110110-argument.xml

Transcript:

ORAL ARGUMENT OF JONATHAN HACKER ON BEHALF OF THE PETITIONERS

Chief Justice John G. Roberts: We will hear argument first this morning in Case 09-1156, Matrixx Initiatives v. James Siracusano.

Mr. Hacker.

Mr. Hacker: Mr. Chief Justice, and may it please the Court:

All drug companies receive on an almost daily basis anecdotal hearsay reports about alleged adverse health events following the use of their products.

Those incident reports do not themselves establish any reliable facts about the drug's performance or its safety, especially where, as here, there are only a handful of reports out of millions of products sold over a 4-year period, and--

Justice Ruth Bader Ginsburg: Mr. Hacker, do we know that from this record?

I mean, we know that the plaintiffs were able to identify -- there's some dispute whether it's 12 or 23, but do you represent that there were no other complaints made?

So that, let's say, there has been discovery; now we're just at the pleading stage.

The company would have said: That's it, we didn't have any more?

Mr. Hacker: --All I can speak for is what's alleged in the complaint, and the complaint, no matter how read, doesn't allege any more than 23 adverse event reports.

Justice Ruth Bader Ginsburg: But they might have been able through discovery to find that there were many more.

Mr. Hacker: That's true, but there's no allegation that what they -- what they know about or what they could find would have been a statistically significant difference between the rate of reported events and the background of--

Justice Ruth Bader Ginsburg: But why shouldn't that determination be deferred until there's discovery, and then we can know how many reports there really were?

Mr. Hacker: --Because it's incumbent on a plaintiff to come to court with a case, to plead the facts necessary to establish all of the elements of a claim.

And a securities fraud claim, of course, requires both materiality and scienter, and neither of those is established unless the company has knowledge of facts establishing a reliable basis for inferring that the drug itself is the cause of the reported event.

Absent information like that, there is neither materiality nor scienter under the securities laws, because neither the company nor an investor -- until there's reliable evidence of a causal link between the two products, neither a company -- excuse me, a link between the product and the event -- neither the company nor investor would have any reason to think that an adverse event report is -- actually indicates a problem with the product, as opposed to a coincidence.

Justice Samuel Alito: Can there be some situations in which statistically significant evidence would not be necessary?

For example, suppose some very distinguished physicians concluded based on clinical trials that there was a connection between a drug and a very serious side effect.

Could that establish materiality?

Mr. Hacker: I think a distinguished physician would not conclude that there's a connection unless the clinical trials reveal a statistically significant difference between what they've seen and what they would expect to see were there no association.

So there's that point, Your Honor.

But the second point I would make is, we acknowledge there are a very narrow, limited number of circumstances under which a claim can be pled absent statistically significant evidence, but that's -- that's because doctors and researchers will conclude that there may be causation under narrow circumstances.

For example, I think the most common set of criteria are the Bradford-Hill criteria.

But nothing like that is pled here, Your Honor.

Justice Antonin Scalia: Mr. Hacker, the complaint did not rely exclusively upon these adverse incidents but also referred to a study, a report by researchers at the American Rhinologic Society--

Mr. Hacker: Yes.

Justice Antonin Scalia: --which -- which asserted that there was a connection.

So the -- is the question before us simply whether in isolation the adverse incidents would be enough, or is not the question whether those adverse incidents placed next to this study would be enough?

Mr. Hacker: Well, two points, Your Honor.

First, the plaintiffs have throughout this litigation framed their case as one based on the failure to disclose adverse event reports.

It's the number of adverse event reports that they say is the problem, and they're not saying that there was a study out there and that we failed to disclose the study.

But they say it's the fact of the adverse event reports.

Justice Antonin Scalia: Why didn't they say that?

Mr. Hacker: Well, I think if you look at the -- to be clear, the study is not attached to the complaint, so there wasn't a basis in the complaint for saying the company was aware of a reliable study and here are the details of the study and they failed to disclose it.

Justice Antonin Scalia: Well, I thought the -- you're saying the complaint did not refer to the study?

Mr. Hacker: It did refer to it.

That's true.

And if you look at the study, there's really nothing there.

It's based on, primarily on a case study of one -- and again, this isn't in the complaint.

It is attached to the red brief, Your Honor.

There's one case study of one man who is 55 year old -- 55 years old, which is the population most likely to experience anosmia.

You're more likely to get it when you're -- he's suffering from signs of lupus.

Which causes anosmia, and he is taking Flonase, which also causes anosmia.

And so the idea that you can infer from that one incident out of millions over years of product sales that -- that Zicam causes anosmia under the--

Chief Justice John G. Roberts: You're talking about -- you're talking about who is right or wrong about the connection between Matrixx and anosmia.

But that's not the question.

I'm an investor in Matrixx; I worry whether my stock price is going to go down.

You can have some psychic come out and say

"Zicam is going to cause a disease. "

with no support whatsoever, but if it causes the stock to go down 20 percent, it seems to me that's material.

Mr. Hacker: --That's precisely the point, Your Honor.

If a psychic came out or a lunatic on the street corner is barking, you know, through a megaphone that there's a problem with the product, that's not the kind of information to rely -- a real investor would rely on.

Justice Sonia Sotomayor: But wait a minute.

These weren't psychics.

These were 3 clinical doctors in this area, one of them you knew poised to go to a society meeting to make this allegation.

Doesn't it make a difference who the reports are coming from and what the substance of those reports may do to your product?

Mr. Hacker: It may make a difference, Your Honor, and I didn't mean to suggest that, you know, these are psychics.

The point simply is, following up on the Chief Justice's question, that it does matter what the basis of the allegation, and is the evidence, the facts available to the company, reliable?

Does it create a reliable inference that a reasonable investor would be concerned about?

Justice Anthony Kennedy: Well, suppose you stipulate in response to the Chief Justice's question that it is irrational, that it is probably baseless, but that the market will react adversely.

Is there a duty then to address the claim?

Mr. Hacker: Under the case law, it's not clear that that's true.

In this case, looking at this case specifically, Your Honor, when the market reacted, what the market was reacting to was a Good Morning America report.

It's very important to be clear about what that report said.

On Good Morning America, a leading morning news program, the allegation was made by Dr. Jafek that Zicam causes anosmia.

That's a very different allegation that what the company was -- than what it was the company was aware of, which was simply the adverse event reports.

Justice Anthony Kennedy: But if there's a baseless report and we stipulate that, although it's baseless, it's going to affect the market, could that be the basis for an allegation, assuming the requisite scienter, that there's liability?

Mr. Hacker: Two answers I would say, Your Honor.

First of all, we have to be very careful about creating a rule through our interpretation of materiality that would require companies in advance to disclose the fact that a baseless, false allegation about the company is going to come out because it requires the company to ring the bell--

Justice Anthony Kennedy: But it's not the allegation.

It's the fact that the market may be affected.

Mr. Hacker: --Well, I understand, but the problem is it's the underlying -- what the rule would say is, because the company is aware the market may be affected, the company in advance has to say: A false report about us is about to come out.

It requires the company to first ring the bell and then un-ring it in the same statement, and that's not a good rule for companies.

Shareholders wouldn't want that rule, to require companies to denigrate their product and then do their best to explain why the allegation is untrue.

Justice Ruth Bader Ginsburg: Mr. Hacker -- Mr. Hacker, you just said, if I understood you correctly, that when the -- when the news came out on Good Morning America, accurate or not, there was an obligation to do something about it, but among the -- the charges, it's not simply that there was these reports, but it's the way the company responded to them: Two press releases that said allegations of any link of these drugs to anosmia are completely unfounded.

That statement was made even after the -- what was it, Dr. Jafek?

Mr. Hacker: Right.

Justice Ruth Bader Ginsburg: --had this presentation, and he was going to put Zicam's name on it and the company said, you don't have any permission to do that.

So the company prevented Good Morning America from happening earlier, and it made these affirmative statements that there's no linkage.

Mr. Hacker: Well, what they said was, and this was true, that it was completely unfounded and misleading.

The very scientific panel that plaintiffs themselves rely on, which convened and issued its report 2 weeks later, confirms that.

There was no -- it's absolutely unfounded at the time to--

Justice Ruth Bader Ginsburg: I thought that the scientific report that came out later said, we can't say one way or the other, as opposed to the company saying that any suggestion of linkage is completely unfounded.

Mr. Hacker: --And that's correct, there isn't.

When -- when the scientific panel said you can't make that claim, it's unfounded, there's no basis in the available science.

Justice Ruth Bader Ginsburg: They didn't say "unfounded".

They said the evidence is not -- we can't say yes and we can't say no.

That's different from completely unfounded.

Mr. Hacker: Well, I'm -- with respect, Your Honor, I'm not entirely sure it is.

When you're talking about science, you make a claim that's either supported in the science or it's without support, and the point the scientific panel was making is there was no support in the available science, and what Jafek was relying on was unreliable.

As I just described, the one--

Justice Elena Kagan: Well, Mr. Hacker, you were saying that the question of whether there is support is reducible to the question of whether there are statistically significant findings.

Now, as I understand it, the FDA takes action all the time as to drugs -- they force the withdrawal of a drug from the market, they force relabeling of a drug -- on the basis of findings that are not statistically significant.

Now, clearly in those cases the market has a right to know the very things that are going to make the FDA take action against a product and that are going to severely affect the product's value to the company.

Not statistical significance there.

Mr. Hacker: --That's true, but the problem with that sort of standard -- well, first of all, to emphasize, to look at the facts of this case, the FDA didn't take any action until 5 years later, but -- which shows--

Justice Elena Kagan: Well, it could and eventually it did.

Mr. Hacker: --But that's--

Justice Elena Kagan: And you are suggesting a test for what -- what counts as material, which is statistically significant, a test that the FDA itself doesn't use when it thinks about what it should what it should regulate.

Mr. Hacker: --The problem is ex ante.

You have to -- you can't look at this through hindsight.

You have to look at it ex ante.

When a company has a handful of reports, it's absolutely true, nobody would dispute, that some day in the future, with the accumulation of more data, the FDA may take action based on its own prophylactic public health regulatory discretion.

But at the time, ex ante, no company when it gets an adverse event report can possibly know whether that's enough information for the FDA to act.

So the prospect that the FDA may some day act on the basis of additionally accumulated information would require disclosure of all reports all the time, and that we submit cannot be the standard.

Justice Antonin Scalia: Mr. Hacker, suppose Good Morning America made the same claim, categorically saying that this drug caused this condition, but did so simply on the basis of these adverse incidents, and they didn't have Dr. Jafek's, or whatever his name is, reports, but nonetheless Good Morning America comes out on the basis of those incidents saying Zicam causes whatever the condition is.

Would that have to be reported?

And if not, why not?

Mr. Hacker: I think what you would have to be hypothesizing is evidence that the company, say a week in advance, knew that Good Morning America was going to come out and say that.

Because once Good Morning America says it, it's said it and the effect is what it is.

But even in the hypothetical, you'd have to sort of unpack what you said.

If Good Morning America came out and said just what Matrixx knew at the time, there are a handful of adverse event reports, it's over millions of product uses over a 4-year period, and no indication that that's at all in any way different from the incident rate in the general population, especially among cold users, who of course are most likely to experience anosmia, we don't know what would have happened.

But then you add the element that Good Morning America then declares that Zicam causes anosmia -- again, the hypothetical would have to be in advance Matrixx is aware that the false claim is going to be made.

Justice Antonin Scalia: Fine.

Mr. Hacker: Right, and I would say, first of all, we have to be very careful, as I said before, about a rule that requires a company to disclose false facts.

I would say, second, that a reasonable investor doesn't want false information; a reasonable investor wants accurate information.

And a reasonable investor would actually--

Justice Antonin Scalia: These are unreasonable investors who are relying on some talking head on Good Morning America who says that this is true, even though it isn't true.

Mr. Hacker: --That's the third point I would make, Your Honor, is it's a different case, a fundamentally different case, if you're talking about a media--

Justice Antonin Scalia: You've neither answered yes or no.

There's no basis for its being said on Good Morning America, but unreasonable investors by the thousands rely upon it.

Mr. Hacker: --And I think the answer is no.

I think the reason it's no, a qualified no, is because--

Justice Antonin Scalia: No--

Mr. Hacker: --the law doesn't respond to irrational, unpredictable, or unreasonable investors.

It responds to a reasonable investor who wants accurate -- a reasonable investor is going to hold the stock.

Chief Justice John G. Roberts: A reasonable investor is going to worry about the fact that thousands of unreasonable investors are going to dump their Matrixx stock.

Mr. Hacker: I absolutely understand that.

Chief Justice John G. Roberts: I mean, there's nothing unreasonable about that.

If it looks -- if you're looking at Good Morning America, you say, my gosh, everybody else is going to sell this; I'm going to sell, too.

And if it turns out you knew about it you should have told me about it before.

Mr. Hacker: The point I would make is, first of all, a company ex ante can't know when that's going to happen.

So all the hypotheticals are suggesting some way of knowing the company--

Chief Justice John G. Roberts: It may not know, but it certainly can know.

If you know this is a very false report, but we know that, I don't know, the surgeon general, somebody, is going to come out and announce it and that will cause an effect--

Mr. Hacker: --That's why it's a meaningfully different case.

If the plaintiffs had plead in their complaint that there's a memo inside the company, for example, so this false fact is going to come out, and we know it's going to cause a stock drop, that would be a case involving the materiality of a media splash, a big media event.

It can't be that there's a false claim out there somewhere and the company becomes aware of the false claim and then purely hypothetically it's possible that somebody will make the false claim.

It becomes also possible that the media will pick up and not be persuaded to ignore the false claim.

That's the kind of case we're talking about here.

Justice Elena Kagan: In most cases we don't know whether the claim is false or not.

So let me give you a hypothetical.

There's a pharmaceutical company and it comes out with its first and only product, it's 100 percent of the sales, and it's a new contact lens solution.

And it sells this product to many, many, many hundreds of thousands of people.

And most of them use this product with no adverse effect whatsoever, but there are ten cases where somebody uses this product and they go blind.

Three of those ten cases, the person had to borrow a contact lens from a friend, only used it in one eye, they go blind only in that one eye.

This is not statistically significant.

There is no way that anybody would tell that you these ten cases are statistically significant.

Would you stop using that product and would a reasonable investor want to know about those ten cases?

Mr. Hacker: I would want to know more about the number of uses and all that, but, no, there wouldn't be a basis.

A reasonable investor would want to know all the facts and details that would establish a reason to draw a--

Justice Elena Kagan: There are a lot of contact lens solutions in the world.

So if I heard that, ten people went blind, three used it in one eye, three went blind in that eye, I'd stop using the product; and if I were holding stock in that company, I would sell the stock.

Mr. Hacker: --The problem is, there has to be some reliable basis.

You may be describing facts that would satisfy the Bradford Hill criteria, for example, where you can draw a reliable inference that the product is the cause.

That's the key here.

There has to be a reliable basis for inferring causation.

Justice Stephen G. Breyer: This is the same kind of question, but suppose I don't really know how drug companies operate.

I suspect, but I don't know, that where you have a serious drug, people are hurt all the time and they blame the drug.

So probably drug companies operate in an environment where they get all kinds of complaints and some are valid, some are not; who knows?

People are frightened.

Mr. Hacker: Very much so.

Justice Stephen G. Breyer: Okay.

Now, I don't know that.

But you say at the beginning your client says: Look, we get complaints all the time; you know, just put up with it if you buy our stock.

Now, I don't know to what extent that's true.

I don't know how that fits in.

I don't know whether their complaint is unusual or not unusual or general.

Who is supposed to decide that?

The judge at the complaint stage?

Or the judge after you get some evidence on it?

Or the jury?

And the same is true of scienter, after all, because the scienter -- and you have to plead that with particularity.

Okay.

What's your answer?

What's -- I mean, Justice Kagan had an interesting view of this, and it could be that she's putting forward and others might have a different view.

Who is to decide this?

Mr. Hacker: Well, ultimately it's a question -- it would go all the way to the jury if the plaintiffs were able to plead facts in the complaint that entitled them to--

Justice Stephen G. Breyer: Well, we don't know.

You see, what they're saying is we have one respectable doctor, studier, at, you know, in Colorado.

He, by the way has an abstract, which isn't in the complaint, which says that they do allege that it's zinc that's the problem, a free zinc ion.

And they say we also have 25 people who were hurt and some burning sensations in people that didn't rise to that level.

You know, I don't know.

I don't know if that's within the range of expectation of drug companies as part of the normal course of business which investors should know about, and I suspect a district judge doesn't know, either.

So how does it work where we in fact just don't know whether this does or not arise above the background noise of a drug company?

Mr. Hacker: --We think the answer is statistical significance, just like the Second Circuit said in Carter-Wallace--

Justice Stephen G. Breyer: Oh, no, it can't be.

I'm sorry, I don't mean to take a position yet.

But, look, Albert Einstein had the theory of relativity without any empirical evidence, okay?

So we could get the greatest doctor in the world and he has dozens of theories, and the theories are very sound and all that fits in here is an allegation he now has learned that it's the free zinc ion that counts.

And that could be devastating to a drug even though there isn't one person yet who has been hurt.

So I can't see how we can say this statistical evidence always works or always doesn't work.

Mr. Hacker: --But, Your Honor, out of millions of uses, if there was that problem, it wouldn't be hard to plead a case that says there is a significant problem--

Justice Stephen G. Breyer: They did.

They said -- they said the free zinc ion was -- that word on this was told to your client by a person who knows a lot about it, is apparently reputable, and was told to a person who also knows a lot about it.

I think they're saying you ought to have been very nervous at that point.

That isn't just the usual background noise, okay?

So I'm back to my question, which is -- you can answer the other one too if you like.

But my question is: Who is supposed to decide, how?

Mr. Hacker: --Well, I think a plaintiff -- I mean, I may just be repeating myself, but a plaintiff has to plead the facts that would entitle them to relief at the end of the day.

So, I'm not saying a judge--

Justice Stephen G. Breyer: I know, and we are back to my question--

Mr. Hacker: --And--

Justice Stephen G. Breyer: --The question is, the facts that are pleaded is -- I think it's assumed that this is above the normal background noise; they certainly argue that at length -- that there was this free zinc ion conversation, that there are 25 people who were hurt, and there is a lot of burning sensation going on, even though it doesn't rise to the level of people being hurt, and that's supported by some of the zinc sulfate studies in the fish--

Mr. Hacker: --I think you need to--

Justice Stephen G. Breyer: --okay?

Now, they're saying that's above the background noise and you say, no, it isn't.

Now, who decides and how do we decide?

Don't we have to go to a trial?

Mr. Hacker: --The answer is no, Your Honor, because there is no basis on those pleaded facts for inferring that there's actually a problem with the zinc ion--

Justice Stephen G. Breyer: I know.

I know, but over--

Mr. Hacker: --but look at the allegations--

Justice Stephen G. Breyer: --We're not saying -- you're saying if you are a scientist -- now we're back to Justice Scalia's questions and the--

Mr. Hacker: --But it matters what a scientist would think because it's only then that anybody ex ante, again, remember--

Justice Stephen G. Breyer: --Well, then what--

Mr. Hacker: --has a basis for inferring that there is a causal link which would be the problem, and the zinc -- to be very clear, to be very clear about the zinc studies, the claim made on the telephone wasn't even a claim of causation.

It said, are you aware of the zinc sulfate studies, which of course is a fundamentally different compound than--

Justice Stephen G. Breyer: --No, because the sulfate -- you see in the abstract, which they didn't put in the complaint, that the problem that they saw arising out of the zinc sulfate studies was the free zinc ion.

Mr. Hacker: --No, the zinc sulfate studies were -- totally irrelevant.

What they cited for the free zinc ions were studies of catfish and turtles.

And nobody thinks, nobody thinks, that you can infer anything from a study of catfish and turtles about their smell sensation and human beings.

Justice Stephen G. Breyer: The trouble is, you know, the truth is I don't know, and so I'm back to my question.

Mr. Hacker: Well, in terms of scienter, under the securities law there has to be a plausible basis--

Justice Sonia Sotomayor: Counsel, you got cert granted on a limited question, and the limited question was whether in a complaint that alleges only adverse reports can you prove materiality and scienter without proving statistical importance.

That's the question presented.

Justice Kagan started with the point that the FDA doesn't require that.

It requires just reasonable evidence of a connection, not statistical.

Many of the amici here have done a wonderful job of explaining why statistical importance can't be a measure because it depends on the nature of the study at issue.

So given all of that -- and even in your brief, in a footnote, you answered the question by saying, no, we can't establish that rule as an absolute, because there are additional factors that could prove materiality and scienter.

So you've already answered the question presented.

Are we down to what Justice Scalia asked you, which is: We got a no to the question: Are the facts in this case enough?

I don't know why we would have granted cert on that, but you presented a different question presented.

Given the question presented, is the answer no?

And if not, why not?

Mr. Hacker: --Let me -- let me start with the premise of the question presented.

It's presented on the facts as the case has been litigated today, trying to rely on adverse event reports, which is understandable.

The plaintiffs don't want to have to prove all of the other -- you wouldn't think they would want to prove all the other facts.

Justice Sonia Sotomayor: Can I just interrupt a second?

Mr. Hacker: Sure.

Justice Sonia Sotomayor: This wasn't an FDA-approved drug.

Mr. Hacker: Right.

Justice Sonia Sotomayor: So there weren't any adverse reports in the legal sense of that word.

Mr. Hacker: In the FDA sense, that's true.

Justice Sonia Sotomayor: In the FDA sense.

So we're using a misnomer here to start with.

Mr. Hacker: Well--

Justice Sonia Sotomayor: Continue.

Mr. Hacker: --I would just say that adverse event reports are not limited to what qualifies for the FDA, certainly not by the way the case is--

Justice Antonin Scalia: --Of course, if I may interject--

Mr. Hacker: --litigated.

Justice Antonin Scalia: --the FDA acts in the public interest, doesn't it?

Mr. Hacker: Yes.

Justice Antonin Scalia: And it doesn't make money by withdrawing a drug from the market?

Mr. Hacker: Yes.

Justice Antonin Scalia: As opposed to somebody who sues, who makes money on the lawsuit?

Mr. Hacker: That's true.

But there's a broader point about the FDA, which I think is underlying your question and Justice Kagan's question, which is I don't even think it's true that the FDA really requires reasonable evidence.

They have broad discretion and should have broad discretion.

Nobody is contesting that.

But the question is, again ex ante, before you know what the FDA might do, before there's sufficient evidence to justify the FDA to act.

Remember, the FDA didn't act for 5 years.

The FDA didn't act on the basis of what Matrixx was aware of at the time, and so, that can't be the standard, the idea that the FDA may some day act.

Statistical significance -- the question of statistical significance is presented in this case to the extent the courts below were arguing about and the plaintiffs were arguing about whether or not the small number of raw adverse event reports tell you anything meaningful.

The real standard -- the -- the case got developed in the briefing here when the plaintiffs came back and said, well, there's more to it and there can be more to it, and that, of course, is true, but the standard has to be reliability.

Justice Ruth Bader Ginsburg: You have said raw adverse event reports.

Am I not right that all of these reports came from medical doctors, and in response to the very first one, the company representative said, yeah, we've been getting reports since 1999?

Mr. Hacker: Well, there's a reference -- I mean, there's a -- 1999 was the first call from Dr. Hirsch, who reported one patient.

There is a discussion with Dr. Linschoten about one other patient.

And there were some reports -- nobody is disputing that there were some reports out there.

Justice Ruth Bader Ginsburg: My question is, does it make a difference if these reports come from medical experts in this particular field?

Mr. Hacker: No, because a doctor doesn't have unique expertise in diagnosing causation.

A doctor -- if you have a sore knee, a doctor is qualified to tell you -- to diagnose the fact that your sore knee is the product of bone cancer.

A doctor is not qualified to tell you why you got bone cancer, and that's the problem that we have here.

I would like to reserve the balance of my time.

Chief Justice John G. Roberts: --Thank you, Mr. Hacker.

Mr. Frederick.

ORAL ARGUMENT OF DAVID C. FREDERICK ON BEHALF OF THE RESPONDENTS

Mr. Frederick: Thank you, Mr. Chief Justice, and may it please the Court:

In TSC and Basic, this Court reaffirmed the longstanding rule that materiality is judged based on the total mix of information available to investors.

Matrixx initially sought a major change to this Court's contextual approach to materiality by offering a bright line standard of statistical significance.

In its reply brief, Matrixx offer -- offers a rule that would apply only in the hypothetical scenario where investors rely solely on numbers of adverse event reports in pleading securities fraud.

This Court should reject both arguments in this case.

The broad theory has numerous legal and policy flaws.

First, the longstanding totality of the circumstances test best comports with the varied reasons why investors make investment decisions.

Justice Samuel Alito: Suppose the allegations of materiality are based solely on adverse event reports?

Suppose that it's alleged that ten million people during -- during -- during 1 year have taken a particular drug and five people shortly after taking the drug have developed certain -- have had an adverse -- have had -- experienced an adverse event.

Is that sufficient to go to a jury?

Mr. Frederick: Well, probably not sufficient to go a jury absent a drop in the stock price, absent evidence that there was a scientifically plausible link, absent evidence that the product was highly important to the company's long-term financial prospects.

All of these things go into the contextual mix that investors would regard as important in making an investment decision, and they all happen to be present here.

We--

Justice Antonin Scalia: If it was the only product, they sold that might be enough, five adverse reports out of ten million?

If -- if that's the only product they make, you say, totality of the circumstances, that may be enough?

Mr. Frederick: --Under the Basic test, Your Honor, that very well might if the probability and the magnitude of the harm -- if those five incidents were deaths from a product that was easily substitutable, that might be a relevant decision and information that investors might want to take into account.

Chief Justice John G. Roberts: In response to Justice Alito, I heard you say something about a scientifically plausible link?

Mr. Frederick: Correct.

Chief Justice John G. Roberts: That seems to me to be a rather significant concession.

In other words, you're saying it's not simply the fact that some psychic would say something, that that is not sufficient, even if that has an impact on the market price, that there has to be some scientifically plausible link to the report?

Mr. Frederick: I think this goes back to Justice Kennedy's question as well, Mr. Chief Justice, because there could very well be materiality.

The information might be important for investors, but it could very well be that the people making the disclosures don't have the requisite scienter because there is an absence of any plausible relationship.

The stock price might drop on news that would not be regarded as news that the most highly scientifically rational people would take into account.

Justice Anthony Kennedy: Well, I thought this might come up.

At some point do we look at scienter and then go back from that to whether or not it's material, i.e., the argument would be the company knew that this would affect the price, and that's why they didn't disclose it and therefore that shows it's material?

Or do we do this with two isolated boxes: one, materiality, two, scienter, and we don't mix the analyses.

Mr. Frederick: They're both analytically distinct and related, Justice Kennedy, and I don't have a simple answer for you because many of the recorded cases raise issues of both materiality and scienter.

What the Court has said in Basic is that the test is the total mix of information and whether that -- under that total mix the investor would find that information important.

In Tellabs the Court said that whether or not the inferences of scienter could be deemed as plausible as other inferences based on the mental state of the people making the information.

So the Court has announced separate tests.

In a case like this there is a natural overlap, and in fact the other side has litigated this case on the basis that no one would have thought within the company, based on the adverse event reports, that there was a basis for thinking there was information.

We plead the other way by saying that when you have three medical specialists in three distinct periods where the last wants to bring findings to the leading ear, nose and throat medical society suggesting that, based on studies that go back as far back as the 1930s, there is a scientifically plausible link based on the zinc ions, that's something that the company should have taken seriously and disclosed to investors.

Justice Elena Kagan: But Mr. Frederick, suppose you are the CEO of a pharmaceutical company with a new drug, you've just put it back on the market, and you get a report back, this drug has caused a death, right?

This is your first adverse effect report.

Do you have to disclose it?

Mr. Frederick: Well, I guess the first thing I would say is if the drug has not been FDA approved, that would be material information that investors might want to know.

If the drug had been FDA approved and that report was then submitted to the FDA, I think that there's a closer call depending on the, you know, effect of the report that might be on the stock price, because that's the only company product and the other factors that we've mentioned in our brief.

I think the question of one event is obviously much more difficult than where there are multiple events submitted by doctors with a scientifically plausible basis on a product that's 70 percent of the company's revenues.

Justice Samuel Alito: Now we're told that there are hundreds of thousands of these; for a -- for a typical drug there may be thousands of these adverse event reports in -- in a year, and you're -- basically you're saying all of those have to be disclosed?

Mr. Frederick: Justice Alito, they already are all disclosed.

Justice Samuel Alito: Well they -- already.

So then why does the company have to make additional disclosure?

Mr. Frederick: The--

Justice Samuel Alito: Analysts who follow the stock price can easily look at the FDA web site and see the adverse event reports that have been reported--

Mr. Frederick: --Right.

Justice Samuel Alito: --and draw whatever conclusions seem to be warranted based on that.

Mr. Frederick: That's why I think this presents the issue in a rather artificial way, because the reports here were not the classic FDA-regulated adverse event reports.

This was a homeopathic drug that was put on the market without FDA approval, and there were no requirements of reports until 2006 which was after the -- at issue here.

Justice Stephen G. Breyer: How would you write -- look, I'm asking how do you write this, because what -- where I think where the other side has a point, is if -- with these -- this is a big class of these kinds of things, you know, vitamins, all kinds of things like that -- and if we say that they have to disclose too much, what will happen is people won't pay attention to it, you know.

And if -- if you have, you know, 4,000 pages of small print saying everything that was ever reported, what really happens in -- in such instances is the public pays no attention, and they think -- and it will hide things that are actually important.

So how would you write some words -- assuming that you're right, that their test is wrong -- but how would you write some words that will put a disclosure obligation such that it's not going to be overkill and it is going to get incidents that rise above the background noise, and those are the incidents that are -- that would be significant for a reasonable investor?

Mr. Frederick: I would start with the language in Basic which says the total mix of information is what has long standing been the test for materiality under this Court's cases.

I would say that where there is credible medical professionals describing the harms based on credible scientific theories to back up the link, a very serious health effect risk for products with many substitutes, and the effect is on a predominant product line, then the company ought to disclose that information.

I will not--

Justice Stephen G. Breyer: Okay, I'll go back and read what you've just said, and -- I will, because it will be in the transcript, and -- and the -- I -- this case, you are very good, your clients, and the lawyers at writing complaints.

Mr. Frederick: --Right.

Justice Stephen G. Breyer: All right?

So they've alleged in this complaint everything they can show, and I -- I suspect -- and during the class period.

And what it doesn't say is that very helpful chart that you put in the brief, in the pocket.

It doesn't say they ever showed that to the company.

All it says is there was a phone call and this individual from -- from Colorado said something, which it doesn't specify, about zinc and the -- and the number of deaths.

Mr. Frederick: Well, in 1999, though, Justice Breyer, Dr. Hirsch, and this is outlined at paragraph 25 of the complaint, also said that intranasal application of zinc could be problematic, and he specifically asked about how much zinc is put in Zicam precisely because of his awareness of prior studies going all the way back to the polio period in which zinc had created a problem of persistent anosmia.

But our submission here is that--

Justice Sonia Sotomayor: How was your -- that long litany of factors you mentioned a few moments ago about how a company will go about determining whether an adverse event report is material or not or should be disclosed or not, are you saying that companies don't have to respond to irrational securities holders?

Are you accepting your adversary's proposition that on some level -- you said credible evidence -- that they don't have to respond to things they judge are not credible?

Mr. Frederick: --It really depends, Justice Sotomayor, and I don't mean to be evasive, but if there is a product, say, that has some link to satanic influences, and there is some reason to think that a large body of followers in an irrational way might regard there to be satanic influences on the basis of a particular product, a cautious, reasonably prudent investor might want to know that on the basis of that information that most of us would regard as irrational, might affect the stock price.

Chief Justice John G. Roberts: So what protection is there at the summary judgment stage in response to allegations?

Because it doesn't have to be scientifically valid; it can be completely irrational.

All you have to do is allege that, you know, if you had told this the price would have gone down.

If you had disclosed this the price would have gone down, and the response from the company is, well, but this is just ridiculous.

This is some guy in his garage who writes this out on -- on a -- you know, a piece of paper in -- in handwriting; and the response is going to be, well let's let the jury sort it out.

Mr. Frederick: There are two answers, Mr. Chief Justice.

One is in Basic itself, the Court talked about the actions of a reasonable investor, and this Court and many courts have always looked at a reasonable person's standard in making all sorts of these fine judgments about the importance of particular information.

But the second answer is--

Chief Justice John G. Roberts: Well, you just told me that it would be enough if somebody says that there's a satanic, you know, impact on this, because a reasonable investor would say there are enough crazy people out there that this is going to affect the price.

Mr. Frederick: --What I said was if the product was one that might be, you know, attractive in some way to people who had that particular following.

I think you have to link up the product with the nature of the complaint and the effect of the importance of the information--

Chief Justice John G. Roberts: So it matters whether -- I don't know what kind of product has particular satanic susceptibility--

[Laughter]

--but I mean, are you saying it matters if it's something that -- that Satan's not going to be interested in?

I don't understand.

[Laughter]

Mr. Frederick: --You're--

Chief Justice John G. Roberts: I don't mean to be facetious, but your way of distinguishing the satanic product is that it depends on whether people who follow satanic cults are going to be interested or not.

I mean--

Mr. Frederick: --Well, Your Honor, there are people who follow those things, and they spend money and they buy stocks, but my second point is that scienter -- scienter is the other way around this problem.

Because even though information--

Justice Antonin Scalia: I don't know if scienter is -- it seems to me ridiculous to -- to hold companies to -- to irrational standards; and we did -- and we did say in -- in Basic that it's viewed -- whether it would be viewed by the reasonable investor.

And -- and you are saying well, the reasonable investor takes account of the irrationality.

I don't think that's what we meant in -- in Basic.

Mr. Frederick: --Well, Justice Scalia, you can certainly write as a prophylactic here that that isn't part of -- the test.

We certainly have here all of the indicia of credible medical professionals on a credible scientific theory on a product that was important to the company's finances, and a very serious side effect for a drug that had ready--

Chief Justice John G. Roberts: --So that -- I'm just trying to get your response to that.

You just talked again about credible scientists and all that, and you're putting those other things to one side.

So even if you have your satanic problem, that is not enough.

And you can sit there and allege it would cause a drop of 30 percent in the stock price, and you should have let this know.

Your answer is no, they don't have to let -- they don't have to disclose this because there is no scientific credible basis for the link that's alleged?

Mr. Frederick: --Now, I'm saying two things.

One is that there is a difference between scienter and materiality.

There is importance of information and an intent to deceive, and the questions are analytically distinct.

In your hypothetical, Mr. Chief Justice, I think you merged them, and I would like to keep them separate because as we -- as this case comes to the Court, the issue is what is the standard for materiality and whether or not statistical significance is the only way to--

Justice Samuel Alito: Can I give you -- because I'm having a little difficulty understanding the boundaries of the argument you're making.

Let me give 2 hypotheticals, and they both involve companies that have one product, and this is their one product.

The first one was what I mentioned before, and I wasn't -- I wasn't clear about your answer.

All that's alleged is that a very large number of people took the drug and that three people, after taking the drug, within a week developed a certain syndrome.

That's the first one.

Is that enough for materiality?

The second one is that a company receives a telephone call: Hello, I'm a general practitioner from wherever, and I treated a patient and the patient took your medication and shortly after that developed this syndrome, and I think there might be a connection.

Is that enough for materiality?

Mr. Frederick: --On the second one, I would say probably not.

And I would say on the first one, there's not enough information about the side effect and what the drug is intended to solve.

I mean, the probability magnitude test as articulated by this Court goes to the probability of the effect versus the magnitude that would be perceived by investors, and those are important factors they go into.

So your hypothetical is very difficult to answer as you have framed it.

Justice Samuel Alito: All right.

This drug, let's say it's a drug to relieve the common cold and the effect is loss of the sense of smell.

Five million people take it.

Three people, after taking it, lose their sense of smell.

Is that enough for materiality by itself?

Mr. Frederick: It -- by itself, that could be enough, and the reason we know that could be enough, Justice Alito, is that when, you know, some score additional were released and this information was disclosed, the stock price went down by 23.8 percent.

Justice Ruth Bader Ginsburg: Mr. Frederick your time is running out, and there is one thing you emphasize in your brief, and I haven't heard you say one word about it here.

And that is: You're saying this is not a case of a company that remains silent.

The company, in response to this, issued press releases in which it said any suggestion of a linkage is completely unfounded.

Now, that's something different from, there are X number of reports.

To what extent are you relying on the affirmative statements that the company made?

Mr. Frederick: We're relying on those to establish scienter, both at the beginning of the class period when they forced Dr. Jafek, through their legal threats, to take Zicam off his poster presentation, and then later when they said that the reports of anosmia were completely unfounded.

And "misleading" was the word that they used.

"And misleading".

And they repeated that after the Good Morning America program came on, only to say three weeks later, after empaneling a scientific expert panel, that the information was insufficient to make that determination.

Our submission is that that is enough.

Justice Antonin Scalia: Mr. Frederick, I'm -- I'm not clear on why you can draw a distinction between materiality and scienter for purposes of the issue before us here.

If, indeed, satanic effect is enough for materiality, you say, well, it may not be enough for scienter.

Why?

I mean, if the company knows that satanic effect is material, then the company has -- knowingly withholds it because it thinks satanic effect is irrational, why doesn't that company have scienter, if it's material?

The scienter is withholding something that is material that is known to be material, and once you say that -- you know, that Satan is material, if the company thinks Satan is involved here, it has to put it in its report, no?

Mr. Frederick: And it would depend on what kind of stock effect occurred.

Justice Antonin Scalia: So there's no difference between the materiality issue and the scienter issue.

Mr. Frederick: Well--

Justice Antonin Scalia: You can't push this problem off onto the scienter side of the equation.

Mr. Frederick: --It depends -- it depends on this Court's application of its known precedent, which my colleague here has not even referenced in his opening argument, Basic, which says you look at the total mix of the information.

And all of these things go into play.

Justice Stephen G. Breyer: Okay.

I get that.

Can I just ask you one question in response to -- just picking up on the last, what about the need for a, quote, "strong inference of scienter", end quote, and does this complaint show more than a borderline situation where it doesn't strongly infer that the person intended to mislead the defendant?

What about that argument?

Mr. Frederick: Well, we believe, and they haven't argued that this complaint is not sufficient under the PSLRA, which set the heightened pleading standard for scienter that this Court articulated and construed in the Tellabs decision, so we believe that scienter is adequately pleaded here based on--

Justice Stephen G. Breyer: Well, page 49 of their brief -- they have two pages on it -- it does not give rise to a strong inference of scienter.

Mr. Frederick: --What I'm saying is that there is already a heightened pleading standard, Justice Breyer.

I was not -- I misunderstood your question to say, is there some other heightened pleading standard other than the one--

Justice Stephen G. Breyer: No, no, I mean -- I just want to know why, if their inference on materiality is enough to survive the background noise reply, is it enough to show a strong inference that they did do this intending to mislead, a strong inference of scienter?

Mr. Frederick: --The key aspects here are their treatment of Jafek when Jafek was going to go public with his scientifically linked claim of anosmia from the Zicam, and then subsequently when they issued press releases saying it would be completely unfounded and misleading to assert any causal link.

That is sufficient to establish a strong inference of scienter.

Chief Justice John G. Roberts: Thank you, Mr. Frederick.

Mr. Shah.

ORAL ARGUMENT OF PRATIK A. SHAH ON BEHALF OF THE UNITED STATES, AS AMICUS CURIAE, SUPPORTING THE RESPONDENTS

Mr. Shah: Mr. Chief Justice, and may it please the Court:

For 35 years, this Court's precedents have instructed that information is material for securities fraud purposes if a reasonable investor would have viewed it as having meaningfully altered the total mix of information.

Under the terms of their question presented, petitioners propose to depart from that contextual inquiry in favor of a categorical rule that deems information about an adverse drug effect immaterial absent statistical significance.

Justice Antonin Scalia: Mr. Shah, what do you think about Satan?

Mr. Shah: Let me try to unpack the satanic connection hypotheticals a little bit.

Now, to be sure, if someone just called a company and said, hey, I think you guys are affiliated with satanic practices, surely a company would not have to go and disclose that to all the investors.

But this is going to depend on what the actual reality is and what the company's statements have been.

Now, if the company has made a statement that, look, consumer confidence in our products is at an all-time high and we expect sales to double in the next quarter, and yet they are aware that there -- a consumer boycott is being planned by, let's say, 10 percent of their consumer base premised on the irrational notion that their company is tied to Satan, then certainly to correct their affirmative representation that consumer confidence is at an all-time high and that they expect their sales to double, a reasonable investor would want to know--

Justice Antonin Scalia: They haven't said that.

They haven't said that our sales are going to double.

They're just walking along at normal sales.

Mr. Shah: --Right.

Justice Antonin Scalia: And they find out that 10 percent of nutty-nuttys out there are not going to buy their stuff because of Satan.

What about that?

Mr. Shah: Your Honor, in that hypothetical, it depends on what affirmative statements the companies have made.

Under the securities law -- and this is an important point that I don't think has come through yet.

Under the securities laws, there is no baseline duty to disclose for a manufacturer or a company.

A company creates a duty to disclose once they have spoken.

So it's going to depend on what the company has said.

Now, in your scenario, if a company has made statements projecting their company's success into the next quarter, for example, and they have a concrete basis to know that, as your hypothetical submits, 10 percent of their computer -- consumer base is going to leave the company's products, that is almost certainly going to be material to an investor, and so yes, they would have to disclose that we have reason to believe, however ridiculous it is and untrue it is, that 10 percent of our consumer base has decided to boycott our products.

That's certainly reasonable.

Chief Justice John G. Roberts: You would have -- you just said they would have a duty to disclose?

Mr. Shah: Yes, your honor.

Chief Justice John G. Roberts: I thought you earlier just said there's no affirmative duty to disclose; it only is based on what they say?

Mr. Shah: It's based on what they said.

So, for example, if the company had simply remained silent and not said anything about its future sales, its prospects, then under the securities laws there is no duty to disclose.

Basic and other cases have long made clear that there has to be something to trigger a duty to disclose.

That is, under Rule 10b-5 it's only statements that are rendered misleading by the omission of a material fact that can trigger liability.

If there is no projection about the company's future success, then it wouldn't have to disclose in that situation.

Justice Samuel Alito: What if the company makes the kind of relatively common statements that were made here, poised for growth in the upcoming season, very strong momentum going into the season, extremely well positioned for successful season?

Mr. Shah: Sure, Your Honor--

Justice Samuel Alito: That -- that triggers the duty to disclose the satanic rumors?

Mr. Shah: --In certain cases where there are very generalized statements, for example, we think our product will do well, that may close -- come close to the line of puffery that is a nonactionable statement that no reasonable investor would rely on.

Petitioners have never pressed that argument before this Court.

There is no dispute about whether the statements that Matrixx made in this case are actionable, even though I agree with you that some of them probably come close to that puffery line.

Here, though, we don't just have those statements about the company being well positioned for future growth.

There are additional statements, and these were made to stock analysts that they expected a 50 percent increase in annual revenues, and, of course, there are the much more affirmative statements that the drug's safety had been well-established and that the reports of anosmia were completely unfounded and misleading.

Those statements certainly crossed the line.

And as I said before, there hasn't been an argument in this case as to whether those less specific and arguably puffery type statements--

Justice Antonin Scalia: So the government's position is that reports of adverse effects that have no scientific basis, so long as they would affect irrationally consumers, have to be disclosed, assuming the company has said we're doing well, right?

Mr. Shah: --Well, Your Honor, yes, I think it would depend, again, on the statements the company makes.

If -- if--

Justice Antonin Scalia: Well, I mean, if Satan comes in, surely lousy science comes in as well, no?

Mr. Shah: --Okay.

So -- so, for example, if -- if a company had been faced with potential adverse effect and it had assembled its blue ribbon panel of scientists, conclusively determined that there is no causal connection between this purported adverse effect and their drug, the question is, would they have to disclose in that circumstance?

I think if the company had simply made statements relating to the drug safety, we think our drug is safe, there is no reason to believe that it causes any adverse effects, then the answer is no, because the reported adverse effect would not call into question the accuracy of the company's statements relating to the safety of the drug.

If, however, the company had made specific statements relating to consumer demand for its products and it knew, notwithstanding the fact that there was no causal connection, it knew or had good reason to believe that a significant portion of its consumer base would avoid the product, then, yes, a reasonable investor would want to know that information, and under Basic the company would have a duty to disclose that, even though unfounded, these reports may lead a significant percentage of our consumer base to leave the product.

I think that falls squarely within the definition of materiality, which is would a reasonable investor want to have known that information?

Justice Elena Kagan: Mr. Shah, what deference do you think that the SEC's understanding of materiality it's entitled to and why?

Mr. Shah: Well, Your Honor, this Court in both TSC and Basic accorded what it called due deference to the SEC's views on the application of the materiality standard.

I think it's certainly true -- and -- and those, by the way, were both -- the -- the Court was deferring to the views of the SEC as expressed in amicus briefs to the Court just like in this case.

I think the SEC is due a significant deference based on, one, its long-standing historical practice in applying the materiality standard, which is part of its own rule, Rule 10b-5, and its special expertise in knowing what a reasonable investor would want to know based upon its experience in this area.

So, I do think that to the extent there is any ambiguity remaining in this case, the Court should defer to the SEC's views.

And back to Justice Breyer's questions about what should the Court write simply beyond reiterating the Basic standard, I think what the Court did in Basic was it not only articulated the general standard, but it laid out some factors.

And in laying out those factors, that's where the Court deferred to the SEC's brief.

And it laid out factors that a reasonable investor might find relevant in that case it was the merger context.

In here on page 28 of our brief, we lay out several factors that we think bear on the materiality question in this particular context; that is, involving adverse drug information.

Chief Justice John G. Roberts: Is there any way that consideration of those factors would support a -- a summary judgment in favor of the pharmaceutical manufacturer, other than the fact of having an extremely poor lawyer drafting a complaint?

Anytime you have a variety of factors like that--

Mr. Shah: Sure.

Chief Justice John G. Roberts: --I think it's very difficult for the judge to say anything other than that's for the jury.

Mr. Shah: If you mean at the motion to dismiss phase, Chief Justice?

Chief Justice John G. Roberts: Yeah.

Mr. Shah: I think there would be some cases.

And in fact, we know there are dozens of 12(b)(6) motions granted in securities fraud cases, and let me lay out a few scenarios for you.

One would be in the -- in the -- in the scenario where the company has not made any actionable statements.

It has either -- statements predicated to duty to disclose.

It either has been made--

Chief Justice John G. Roberts: No, no, I'm talking about the -- I'm talking about materiality.

In other words, based solely on -- in other words, you're saying if they say anything related, it's going to be enough--

Mr. Shah: --Sure.

Chief Justice John G. Roberts: --whether it's a scientific basis or not.

Mr. Shah: Sure.

Two responses to that.

One, the PSLRA does have a safe harbor for companies once they make forward-looking statements, that if they add in meaningful cautionary language -- and this is in the PSLRA itself, section 5(c)(1)(A), that if they add in meaningful cautionary statements, then they cannot be subject to liability.

And I think there are a couple other scenarios that would -- would trigger, for example, if the product at issue is such a small percentage of the company's income or expected growth that no reasonable investor would care if it tanked, then that might be a circumstance where a motion to dismiss would be appropriate.

Thank you, Your Honor.

Chief Justice John G. Roberts: Thank you, counsel.

Mr. Hacker, you have three minutes remaining.

REBUTTAL ARGUMENT BY JONATHAN HACKER ON BEHALF OF THE PETITIONERS

Mr. Hacker: Thank you, Mr. Chief Justice.

I would like to return to Justice Kennedy's question about the role of scienter here, which I think absolutely is critical as this Court emphasized recently in the Merck v. Reynolds case.

Mr. Frederick correctly, I think, conceded that there has to be a scientifically plausible basis.

And what you're talking about here is the company's knowledge of a scientifically plausible basis.

And he has to make that concession in this case because of what is alleged to be the material omission.

The material omission is not knowledge of dubious scientific -- medical claims, it's not that we get one phone call from a doctor.

The real material omission is that the adverse event reports told Matrixx that Zicam causes anosmia.

That's ultimately the fact that -- that Matrixx supposedly did not disclose.

So there has to be a basis for believing that -- there has to be allegation in the complaint that sufficient to establish Matrixx actually knew that Zicam causes anosmia and yet willfully refused to tell investors that fact, and there's nothing in the complaint like that.

There's not -- you're not talking about a case where there was a failure to disclose the doctor's completely dubious untested claim.

It's not a case -- it's not the Satan case where you're talking about a media splash, a known fact that there is going to be a major media splash and the company knows for a fact that that splash is going to have the adverse effect on the stock.

There is not even a claim here--

Justice Sonia Sotomayor: Has that -- the solicitor general's argument.

He wasn't actually even talking about causation.

He was talking about a statement you made about the company poised to double its growth.

And I think he was saying that on the basis of what you had heard up until that time, you had to have known that that statement was misleading, as was the statement that this drug, that there was absolutely no proof or connection of causation, which was your scientific panel said you couldn't make that extreme statement.

Mr. Hacker: --Well, two points, Your Honor.

First, if the claim was about, you know, the consumer sales, you would need an allegation in the case that consumer product sales were actually affected.

There's no allegation like that, and the truth is they weren't.

And so you're not talking about falsifying any prior claim.

There's not even an allegation that that happened, Your Honor.

Second, with respect to the -- the statement, as I was discussing with Justice Ginsburg in the beginning part of the argument, the statement was what the scientific panel was addressing primarily was Jafek's claim that Zicam causes anosmia, and the company said accurately that that is completely unfounded and misleading because there is no scientific support for it.

You can't go out and claim that Zicam causes anosmia unless you have a scientific basis for that and the scientific panel was saying that isn't true.

So the question is whether you can draw an inference of scienter from the fact that -- from what's alleged here, and there is simply no basis for an allegation, supportable allegation that the company knew it causes anosmia and nevertheless refused to tell investors that.

Thank you.

Chief Justice John G. Roberts: Thank you, counsel.

The case is submitted.

At this moment, the court will observe a moment of silence in honor of the victims of the shooting in Tucson and join the rest of the nation in doing so and I invite the members of the bar and the spectators to join, thank you very much.

Featured:

Dura Pharmaceuticals, Inc. v. Broudo - Oral Argument

Fri, 09 Jan 2009 14:49:02 +0000

Case:

Dura Pharmaceuticals, Inc. v. Broudo

Media File:

03-932_20050112-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of William F. Sullivan

Justice Stevens: The Court will now hear argument in Dura Pharmaceuticals against Broudo.

We finally get to the arguments.

[Laughter]

Mr. Sullivan: Justice Stevens, and may it please the Court:

This case presents two disparate views of what kind of loss is necessary to sustain a claim for securities fraud under the Reform Act's loss causation requirement.

The minority view of artificial inflation articulated by the Ninth Circuit is illogical and equates loss with purchase, regardless of whether the investor has suffered any economic harm.

An investor does not suffer any harm until some form of corrective disclosure occurs and the artificial inflation is removed from the stock.

The two events must be related.

There is no causal connection between the harm and the misrepresentation otherwise.

The majority rule correctly requires a causal connection between the misrepresentation and a decline in value.

The... and the statute itself is expressed in terms of causation that a plaintiff prove that the act of the defendant caused the loss.

When we look at the statute of the Reform Act and other provisions, we see supporting language.

In section 21D of the Reform Act, we see under the provision that has been known as the look-back provision that the Congress discussed the loss in terms of trading price after a corrective disclosure.

Similarly in section 105 of the Reform Act, although dealing with section 12 of the Securities Act, the Reform Act, in its one place where it actually spoke of loss causation and its definition, defined it in terms of depreciation in value.

And the... the depreciation in value of the security would be attributable to the fraud.

Justice Kennedy: Can... can you tell me if... if we had not granted certiorari in the case and the Ninth Circuit's opinion became final, what would have happened on remand?

What would have happened in the trial court?

Mr. Sullivan: At the trial court, the--

Justice Kennedy: And... and wouldn't there have been a... a motion to make the pleadings more specific and they would have then come up with a measure of damages, or am I wrong about that?

Mr. Sullivan: --Well, the Ninth Circuit remanded for specific reasons on repleading, which Your Honor has articulated, and those would have occurred.

The other issues relating to loss raise questions concerning whether some of the... the claims might be time barred and whether or not those claims could be stated.

So that would have raised a different issue.

In addition, throughout the pleadings of this case... we're now on the third complaint... the... the plaintiffs have not raised that issue and have not sought to plead causation consistent with the... our view of the world.

Justice Kennedy: Well, I mean, I... I assume you say that the trial judge and... and defense counsel and... and the trial court would have had real problems with this opinion.

What... what were those problems--

Mr. Sullivan: Well--

Justice Kennedy: --insofar as the measure of loss is concerned?

Mr. Sullivan: --Well, the... the real problems that the trial court had and what we would continue to espouse with this opinion is that it doesn't link the loss with the misrepresentation.

And in this case, the misrepresentation offered occurred 9 months after the price drop that is being sought.

I think when you... when you carve it all back and you look at what the real issue is, at the end of the day, it's... it becomes an issue of what... what damages does the plaintiffs' class seek.

Justice Kennedy: Under this opinion, how would... under the Ninth Circuit's opinion, how would the jury have been instructed to come... to calculate the loss?

I assume you have a problem with that and I want to know what it is.

Mr. Sullivan: The... the problem is we wouldn't have been able to... to frame a clear jury instruction that would have indicated whether or not the loss that the jury should look at would be related to the disclosure about Albuterol Spiros, which would have occurred in the November time frame, or whether we would have had to step back to the February time frame and... and the loss that was incurred then.

And the issue would have not only related to the... the damages instructions but would have related to the misrepresentation instruction.

And the... the problem that... that we continue to have with the... the case after the Ninth Circuit's opinion is where do you look for the misrepresentation and where do you look for the damage and how do you know that there is a loss under the statute.

You're looking at a... at a--

Justice O'Connor: What would have happened if the disclosure about Albuterol was made before the company announced revenue shortfalls?

Mr. Sullivan: --Well, I think that would have been different.

That would have been a disclosure prior to the... to the drop, and there... I would expect under pleading that the plaintiffs could have done, they could have tied the two of them together and argued that the cause of the loss was the combination of the two events in the marketplace.

Justice Breyer: Why is it difficult to figure out what the Ninth Circuit was thinking?

I... I found it... am I right?

I thought they said the... the seller says we found gold.

The stock sells for $60.

They have loads of experts who say in the absence of that statement, which was a lie, we found gold, it would have sold for $10.

The loss is $50.

I mean, I take it that's their theory.

Mr. Sullivan: That... that would be the theory under the Ninth Circuit.

Justice Breyer: All right.

Now, what's wrong with that theory?

Mr. Sullivan: Well, the--

Justice Breyer: It's clear.

I mean, it's certainly clear.

Mr. Sullivan: --The problem with... with that theory is that Congress has told us that the misrepresentation has to have caused the loss and--

Justice Breyer: Yes.

They say it caused the loss, $50.

Mr. Sullivan: --And... and what we would be looking for is evidence that... that such a actual loss occurred in response to a corrective disclosure in the marketplace.

Justice Scalia: Well, it doesn't depend on... on what you... what you consider to be the value of the stock.

Until the disclosure of the fact that they didn't find gold is made, the stock is still worth $60, isn't it?

Mr. Sullivan: Yes, it is.

Justice Scalia: Because everybody else thinks they found gold too.

So you're still holding stock worth $60, if worth means its market value.

Right?

Mr. Sullivan: That is correct.

Justice Scalia: And we're dealing with a special rule that looks to market value.

Right?

You don't have to have the... the representation made explicitly to the plaintiff.

It's a representation that was made to the market at large which caused the market value of the stock.

Right?

Mr. Sullivan: That is correct.

Justice Scalia: So he paid $60, he got $60.

There's no loss.

Mr. Sullivan: And would have the ability to continue to sell that stock for $60 in the marketplace until such time as there was a corrective disclosure.

Justice Breyer: Is there any other problem?

I'm trying to get a list of what the problems are with the simple theory.

Now, I've heard one that you've ratified.

[Laughter]

And... and is there any other?

Mr. Sullivan: Thank you.

The... the other is... is I think an issue of certainty as to the marketplace.

Remember, we are operating on a fraud-on-the-market theory context here in this kind of action, and in that... in that context, when there is a disclosure in the marketplace, you have certainty as to what the market actually valued the decline to be as opposed to speculation that there was in fact inflation at the... at the time of purchase.

The Ninth Circuit's purchase time rule in the... in the fraud-on-the-market context doesn't necessarily identify the decline in the value of the stock which you can get from the marketplace, and that I think is just better... a better indicator.

Justice Breyer: Now, can we... can they prove this?

$60.

$50 is wrong, is inflated because of the gold.

It turns out that gold never existed and they knew it.

The stock is not selling for $60 anymore.

It's selling for $200.

They found platinum.

No one expected it.

All right.

They want to prove maybe it is selling for $200, but if we had found gold as well, it would have sold for $250.

Can they do it?

Mr. Sullivan: The Congress has told us that we should look for loss, and that--

Justice Breyer: It's a loss.

$250 versus $200.

Mr. Sullivan: --and that leads us to the... the point that... that whether the increase can actually be pled.

But if there is a disclosure that indicates that the gold component was not part of the... of the... the discoveries, and the plaintiffs can indicate that there was an upward tick because of the platinum and a downward movement in the stock because of the disclosure about gold, then I think those two can be separated and pled accordingly.

Justice Ginsburg: And both would be all right because what's the difference between not getting as much appreciation as you would have gotten if the correct information had been out there and getting less than you would have gotten.

I mean, in both cases the shareholder is affected the same way.

It didn't get as much in one case.

So you're not distinguishing between those.

I think you're agreeing that in both cases the... the discovery of platinum is the shares go up, but they would have gone up much higher if there had been gold as well.

That shareholder has a claim under your theory, doesn't she?

Mr. Sullivan: Well, that shareholder... it would depend on what has happened in the marketplace.

If there has not been a disclosure about the absence of gold, that stock would still reflect the... the value of the expectation of gold.

Justice Ginsburg: Yes, but I'm assuming that... that there is, and so the stock goes up but not as much as it would have.

But on the point of disclosure, there is a difference between your position and the Government's, and I really would like you to tell me if that's genuine or it's my misperception.

Your view is there's the disclosure of the bad news, the lie, and the price drops.

In the Government's presentation... and I'm reading from page 19... the fraud can be revealed by means other than a corrective disclosure and a drop in the stock price may not be a necessary condition for establishing loss causation in every fraud on the marketplace.

Mr. Sullivan: Our position is we believe that a drop in the price is necessary to demonstrate the loss.

Justice O'Connor: But the Government--

Mr. Sullivan: They do.

Justice Scalia: It doesn't matter in this case, does it?

Is... is that issue before us?

Mr. Sullivan: In this case--

Justice Scalia: Do we have to decide that issue here?

Mr. Sullivan: --We don't have to decide that issue for this case.

Justice Scalia: And is it... is it easy to prove that... that the price of this now valuable stock because they found platinum would have been $40 higher had they found gold?

I mean, the burden would be on the plaintiff to prove that... would... I mean, if we adopted that theory.

Mr. Sullivan: The plaintiff has that burden--

Justice Scalia: It would be very hard to prove, it seems to me.

Mr. Sullivan: --And... and at the pleading stage, I believe that they could be segregated and... and an upward movement in the stock could be distinguished from a downward movement in the stock.

But the downward movement in stock would be the focus from our standpoint.

Justice Kennedy: In... in your view, is the plaintiff entitled to an expectancy measure of damage, or is it more the traditional tort measure which is out-of-pocket losses?

Mr. Sullivan: We don't believe that they are entitled to any expectation damages.

It would be an out-of-pocket loss calculation.

Justice Kennedy: Is the... is the respondents' position properly characterized as asking for expectancy damages or is that too simplistic a view?

Mr. Sullivan: I... I think that it is perhaps inclusive of expectancy.

It really depends on how you view their price inflation theory.

Justice Scalia: I think they'd be called reliance damages.

You know, I used to teach contract law.

We would call it reliance damages.

Mr. Sullivan: And it gets back in our view to the transaction causation distinction in the securities cases that talk about the reliance transaction, price inflation that occurs at the front end.

Justice Breyer: If that's so then... then on the platinum/gold theory, you can't really recover what would have happened if there had been gold because it might be that the stock would have been worth $400 if there had been gold even though 15 years earlier when he only paid $50 for it, he's only out of pocket, at most, $50.

But if there had been gold, because of the gold market in the world, it would have been a lot more valuable.

And you're saying he can't do that?

I don't know.

Maybe that question isn't in the case, but that strikes me as a difficult question.

Mr. Sullivan: Following your... your suggestion about the price of gold, it would depend on where that... that disclosure occurred in connection with the price of... the price of gold, if that disclosure occurred, and if there was an economic loss that could be... could be tied to it.

The passage of time here is important only insofar as it allows for the corrective disclosure and a chance for the market to reflect an economic loss.

Justice Stevens: But, Mr. Sullivan, you refer to the disclosure as being the key point and when you measure the... the loss and so forth.

What if the information leaks out and there's no specific one disclosure that does it all and the stock gradually declines over a period of 6 months?

Mr. Sullivan: I think--

Justice Stevens: How would you handle that case?

Mr. Sullivan: --I think that a plaintiff would be able to handle that in... in a pleading and they would have to identify the leaks and if there are several, identify each of them and identify them as--

Justice Stevens: Well, maybe they don't know the leaks.

The only thing they can prove is that there was a gross false statement at the time they bought the stock and they don't know what happened to the decline.

Later on they find out that it gradually leaked out.

Do they have to prove exactly how the information became public?

Mr. Sullivan: --The key is that they have to prove that the loss was connected to the misrepresentation and that the drop in--

Justice Scalia: Well, they... they wouldn't have to prove how it came out.

They would just have to prove that the market knew the truth, no matter how the market learned the truth.

I mean, if it was published in a... in a column by some market reporter who doesn't disclose how he found out.

So long as the market knows the truth, isn't that all they need?

Mr. Sullivan: --So I was distinguishing... yes is the answer to your question.

I was distinguishing a situation where the price just trickled down and no one knew until later.

And the... the question that Justice Scalia poses about the... the leak coming out over time but it is the... the fact that the market becomes aware of the reason for the misrepresentation, it is in fact appropriate.

The... the other point that I would like to make, in addition to the statutory scheme, is... is this Court's decision in Basic v. Levinson creates a tension here, and I... and I think a conflict that is very important to... to discern.

The... Basic v. Levinson presents the fraud-on-the-market theory, and from that fraud-on-the-market theory we have a rebuttable presumption of reliance for transaction causation.

The Ninth Circuit's view collapses the... the Ninth... the Ninth Circuit's view of transaction causation with loss causation and presents a conflict as it relates to that presumption.

The presumption, which is based on a well-developed, efficient capital market that gets the information out quickly and is easily digestible... that... that presumption is at odds with the Reform Act's requirement that there be a burden of proof.

If you collapse the transaction causation and the loss causation, you've got a head-on collision between the rebuttable presumption of reliance and the Congress' codification of the loss causation act and the Reform Act.

And we think, at the end of the day, the Ninth Circuit's decision really renders that conflict apparent and makes the act of Congress in the Reform Act one that was meaningless.

The... I think the legislative history is also supportive of our position so far as particularly the Senate report is very important in the... in the phrase where it talks about the obligation of the plaintiff to prove that the loss in the value of the stock was caused by the section 10(b) violation and not by other factors.

That is a critical component here of the analysis and I think very helpful from the standpoint of the legislative history in identifying what we have.

Finally, I... the last point I'd like to make is that the Reform Act from Congress was designed to and sought to establish uniform and fairly stringent pleading guidelines, and this was to address congressional concerns over frivolous suits.

And Congress, in enacting the Reform Act, was not signaling any intention to relax the requirements of section 10(b), was... rather, was enacting a very specific loss causation requirement.

And historically there was a very clear and distinct body of law at the time, the Huddleston case, the Bastian case, and that was codified.

And there was a very clear perception that Congress was acting and not collapsing the loss causation transaction rule into the loss... the transaction causation into the loss causation, which I think creates this conflict.

If there are no further questions, Justice Stevens, I'd like to reserve the balance of my time for rebuttal.

Justice Stevens: You certainly may.

Mr. Sullivan: Thank you.

Justice Stevens: Mr. Hungar.

Argument of Thomas G. Hungar

Mr. Hungar: Thank you, Justice Stevens, and may it please the Court:

In a fraud-on-the-market case, a plaintiff who buys a security at an inflated price suffers no loss at the time of purchase because the market continues to value the security at the inflated price, and that's--

Justice O'Connor: Would you tell us how you differ with petitioner on what ought to happen here and why?

Mr. Hungar: --Well, our view... well, what ought to happen in this case is that the judgment of the court of appeals should be reversed because the court failed to require loss causation.

In effect, what the court said is that transaction causation is sufficient.

But what--

Justice O'Connor: You agree with the bottom line.

Mr. Hungar: --Yes.

Justice O'Connor: Now, where do you disagree?

Mr. Hungar: Well, I'm not sure that I can accurately tell you petitioners' position, but I can tell you our position, which is that in a fraud-on-the-market case the plaintiff cannot... has failed to plead loss causation unless the plaintiff pleads that the... the inflation attributable to the misrepresentation or omission has been removed or reduced from the price of the stock through dissemination of corrective information of some sort to the market.

That does not mean that the company must make an announcement or that there must be an admission of fraud or that there must be really any information, any... any sort of formal disclosure.

But if the information is disseminated to the market such that the market, in whole or in part, becomes aware of the truth and adjusts the price accordingly, that price adjustment is loss and the plaintiff has alleged loss causation in an amount to be proven at trial.

Justice O'Connor: Well, doesn't the general rule 8 governing complaints... isn't that adequate?

You have to plead under that every element of an affirmative case.

Mr. Hungar: That's right.

Exactly right, Your Honor.

Justice O'Connor: Why is the Government proposing that you have to follow rule 9 not 8 or some other requirement?

Mr. Hungar: Well, the... I don't think the question... we cited rule 9(b) in our brief because fraud must be pled with particularity and... and that... and that rule applies to all the, quote, circumstances constituting a fraud.

But the Court doesn't need to address the question because even under rule 8, the plaintiff must allege all the elements of the cause of action.

Justice O'Connor: We don't have to get into that.

Mr. Hungar: That's correct.

That's absolutely right.

Justice Ginsburg: But, Mr. Hungar, if you look at the forms of what's proper pleading under the Federal rules on causation, the sample pleadings say, for example, for money lent, the defendant owes the plaintiff for money lent.

Period.

Or for goods sold and delivered.

Nothing more.

Just alleged causation.

Defendant... plaintiff alleges I lost X amount and it was caused by defendant.

I thought you pointed to the 9(b) rule because fraud must be pleaded with particularity, but causation does not, not under the rules and not under the statute.

Mr. Hungar: Well, as we said in our brief, we think 9(b) applies here.

Obviously, this is a fraud case.

Justice Ginsburg: But that... that's to the... to the allegation of fraud, but not causation.

Mr. Hungar: Well, Congress has made very clear that loss causation is an element of the cause of action.

The elements must be pled.

In a fraud case, they must be pled with particularity, but even... even in a... in a common law--

Justice Ginsburg: It says... no.

It said fraud must be pleaded with particularity, not all the elements of a fraud claim.

Mr. Hungar: --Well, with respect, Your Honor, we think circumstances... it does not constitute fraud if there is no loss causation.

At least it certainly doesn't constitute securities fraud under this statute, and if the complaint does not plead loss causation, it hasn't pled fraud.

So we submit that--

Justice Stevens: Well, that's not correct I don't think.

I think there could be a completely fraudulent statement but no... no damages as a result of it.

There would still be fraud.

Mr. Hungar: --Yes, but in a... in a private action for securities fraud, loss causation is an element of the cause of action.

It's not an element in every fraud case.

Justice Stevens: It's not an element of the fraud.

It's an element of the cause... cause of action.

Mr. Hungar: Well, it may be a semantic question.

That's--

Justice Stevens: Well, that's what Justice Ginsburg's point--

Mr. Hungar: --But there... I mean, there are cases in the... in the courts of appeals saying that... that rule 9(b) applies to all the elements, and we're not aware of cases... the... the... one of the amicus briefs cites cases which focus on the nature of the representation, and that's certainly where 9(b) issues are generally fought out because in a... in a typical securities case, loss causation is not a difficult issue because the... the bad news is... is announced, the stock drops, and the plaintiff pleads loss causation as a matter of course.

It... it's... it's not a difficult burden to satisfy in your run-of-the-mill securities case.

Justice Souter: Well--

Justice Scalia: In any event, the difference between getting the... the complaint dismissed on the pleadings or having to wait for a... a 12(b)(6) motion because as soon as you, you know, ask for the... the proof of the elements of the cause of action, you're entitled to have, if... if your analysis of the case is correct, you're entitled to have the drop in... in the value of the stock shown.

Mr. Hungar: Well, as a... as a practical matter, Your Honor, there's a huge difference in how these cases are litigated because it's the difference between spending millions of dollars on discovery, literally millions of dollars on discovery, or not.

If... if the plaintiff has failed to allege loss causation and for some reason feels unable to allege it, the... the case is going to be dismissed.

If the court doesn't require loss causation, as the Ninth Circuit did... did here, that means the case is going to go to discovery and the defendant is going to have to either spend millions of dollars on their own lawyers or spend millions of dollars to settle even in a case that... where the plaintiff might be unable to establish loss causation.

That's why--

Justice Souter: --Is... is the--

Mr. Hungar: --Congress did what it did in 1995.

Justice Souter: --Is the reason... is there a further reason that they've got to... to plead loss causation?

And that is, by reading (e)(2), in effect, as... as making... as... as saying that if you were going to recover on a fraud-on-the-market theory, you in effect have... have got to prove your loss in a certain way.

And you're saying if you're going to... if you're going to sue on a fraud-on-the-market theory, you've got to allege all the elements of fraud on the market.

And if you allege all the elements of fraud on the market, you're going to allege exactly what you've just been saying is required.

So it's not so the... I... I guess what I'm... I'm getting at is maybe what... maybe the nub of the answer is not necessarily that there's... that there's fraud involved, but there is a fraud-on-the-market theory as the basis for the cause of action, and if that is the basis, it's got to be disclosed in the pleadings as an element.

Mr. Hungar: I think that's... that's a helpful way to look at it, Justice Souter, because it's... in... in a fraud-on-the-market case, by definition the plaintiff is alleging that there was an efficient national market and that is what makes the difference.

If this were the... you... you buy a gold mine, like the... the old common law cases that respondents cite, there's no efficient national market on which the... the plaintiff can turn around and sell it at the same price until the information has been disclosed.

But when it is an... a national, active stock market, the market continues to reflect the inflation, and so... so the plaintiff has not been injured, and the allegation that it was an efficient market and I bought it at an inflated price does not support an inference of... of injury.

And the... and so because it is a fraud-on-the-market case, that's exactly right.

The additional information must be pled in the complaint or else no injury has been... been pled and the complaint must be dismissed.

Justice Souter: Do you... do you take the position that the phrase in (e)(2), if the plaintiff... I'm sorry.

Let me find it.

Mr. Hungar: You're referring to section 12(b) or?

Justice Souter: No.

I'm trying to find a phrase in (e)(2).

If the plaintiff seeks to establish damages by reference to the market price of a security, do you take that phrase as... as referring to a fraud-on-the-market theory or as being broader than a fraud-on-the... on-the-market theory.

Mr. Hungar: Well, I suppose a plaintiff in--

Justice Souter: It certainly includes it.

There's no question about that.

Does--

Mr. Hungar: --I think what that encompasses is a... is a case in which the plaintiff purchased the stock on the market... on... on a open market, which will typically be in practice a fraud-on-the-market case.

I suppose a plaintiff, in an unusual case, might not allege... might not choose to plead it as fraud-on-the-market case if they have some specific evidence or reliance that they view is stronger, but--

Justice Souter: --If... if it's not confined to fraud-on-the-market, then there's the argument on the other side that all... all (2) is really doing is saying that if you are going to establish your damages by reference to market price, this is the way you've got to do it.

You've got to go through this mean price analysis and so on.

But they are saying we are not simply trying to establish our damages by reference to the market, and therefore we're not bound by... and therefore, (e)(2), in effect, is... is irrelevant.

What... what is your answer--

Mr. Hungar: --Well, I think they... they unquestionably are trying to establish their damages.

The Ninth Circuit's damage theory or... or injury theory establishes damages by reference to the market price.

Justice Souter: --To the... to the purchase price.

Mr. Hungar: The plaintiffs alleged they purchased at the market price in this fraud-on-the-market case, and... and the damages are the difference between what they paid at that market price and what it should have been.

That is in our view an attempt to establish damages by reference.

Justice Scalia: But they paid... they paid whether it was a market price or not.

I mean--

Mr. Hungar: Well, they... they alleged they purchased on the market.

If... if they weren't purchasing on the market--

Justice Scalia: --Well, what they paid happens to be the market price, but... but you can't really say that the Ninth Circuit was referring to the market price as part of its... its damages.

Its damages are what they paid.

Whether that... if they paid above market, it would be the same.

Mr. Hungar: --Well, in any event, we interpret it to refer to... I mean, by definition they are, in a fraud-on-the-market case, alleging that they have purchased at the market price, and that's exactly what this statute would be encompassing.

But beyond that, as... as Mr. Sullivan identified, Congress' explanation of how it understood loss causation, when it... when it enacted section 12(b) as part of the Reform Act, is entirely consistent with our position, and the common law is entirely consistent with our position.

Thank you.

Justice Stevens: --Thank you, Mr. Hungar.

Mr. Coughlin.

Argument of Patrick J. Coughlin

Mr. Coughlin: Justice Stevens, may it please the Court:

In answer to your question, Justice Kennedy, yes, that's what... exactly what we would do.

We would go back and replead, if we were required to do that, with more specificity.

We don't think that (9)(b) applies in this situation because both the Eleventh and the Third Circuits have held that (9)(b) only applies to the circumstances constituting fraud.

It has never been applied to materiality, loss causation, or damages.

Justice Breyer: But surely they wanted to have a person be able to read a complaint and just understand what it's about in a securities fraud case.

And I don't see how you could understand it unless you have in the complaint what your theory is.

That's all.

Nobody is asking for some facts.

Is your theory that the loss took place at the time the person bought the stock because he overpaid $30?

Is your theory that the stock went down and, because of that, he lost the money?

Is your theory that the stock didn't go down but it would have gone up more?

All they're asking is not for evidence, but a simple, clear explanation of the theory, and plead in the alternative if you want.

But I mean, what's the problem?

Why is that so hard to do?

Mr. Coughlin: I don't think that's so hard to do.

And you're right.

We have to plead the theory, and... and the theory is--

Justice Breyer: And this case doesn't seem to do it.

I looked through the entire complaint.

I found exactly two paragraphs.

I didn't.

My law clerk did, frankly.

[Laughter]

But I told him to underline it.

In paragraph 179, he found the word, and it caused damage.

Okay?

And in paragraph 177, it says the same.

That's all he could find.

And they were harmed.

That's what it says.

Mr. Coughlin: --And... and you're right, Your Honor.

There's not much in here.

We plead the rises.

There are approximately seven rises.

We plead the purchases.

We plead the big drop.

Do we plead with specificity?

The... the losses as to AlSpiros?

No.

We could have done a better job.

Under the Ninth Circuit, though, the law, as we pled it at the time, was that we have to plead an inflation and identify the causes.

And that's what we did under Ninth Circuit law.

If this Court were to decide that we had to do more, could we?

Certainly.

I mean, we have some of the information in there.

We... we tie AlSpiros to the sales force, which is an announcement on 2/24.

You know, there's a lack of integrity in management.

Justice Ginsburg: But there's a... but there... there is a basic difference between, as was pointed out in the colloquy with Mr. Hungar... one thing is the particularity of pleadings.

Yes, you have to tell the details of the fraud.

No, you don't have to tell the details of the loss.

But you do have to have a theory on which you can recover, and if your theory is simply I bought at an inflated price and the law doesn't give you a claim for relief on that theory, then you're out the window.

There's no discovery.

There's nothing.

You have to have, as Justice Souter pointed out, a viable theory of relief, and that's the difference between... you say it's enough that the stock was selling for much more than it should have, and the other side said, no, that's not enough.

You have to show that when the misrepresentation was corrected, the price dropped.

Mr. Coughlin: Your Honor, I don't think it's enough to prove that we just paid an overinflated price.

You cannot recover under Ninth Circuit law unless you not only prove that you paid an inflated price, but also that you prove that inflation came out.

I think where we differ from the Government and petitioners is that it... conceptually, at least with the Government, the right framework is to analyze did the inflation come out of the stock.

And our quarrel here is how can the inflation come out of the stock?

Does there have to be a corrective disclosure?

And we say no.

Time itself can take inflation out of the stock.

Company-specific information is our biggest concern.

If somebody walks a stock down, so to speak, they give out information lowering expectations because stock prices are based on cash flow.

If they walk it down and say, hey, our... we're going to have a revenue miss, but they don't announce their problems with AlSpiros at the time, or we're closing some factories, or we're taking a significant write-off, that stock drops.

We believe that lowers inflation.

I think a good case to take a look at to illustrate this is the Wool v. Tandem case out of the Ninth Circuit.

In that case, Tandem was shipping to its own warehouses for 2 years, lying about its revenues.

Wool went out and bought the stock.

The stock was inflated.

The Wall Street Journal, subsequent to that, reported we don't see how Tandem can continue to book these revenues, and then the company itself lowered expectations in one of their SEC filings saying, hey, lower than expected revenues coming up.

The stock has dropped and now Wool sells.

And now then after that, it's admitted that there was a fraud.

Does... and the stock barely drops hardly at all because the expectations in that stock have already been taken out.

Justice Scalia: Why?

I don't understand.

I mean, there would be even more expectation taken out after the fraud is announced.

I mean, it's just like saying, you know, besides... besides fact that our CEO just died, there's no gold there.

Don't you think it would go down still further?

Mr. Coughlin: Maybe and maybe not much.

It depends on what's your cash in the bank.

In this case, they had gone to the market and gotten $400 million of cash in the bank.

So as the expectations were lowered with the Ceclor CD sales here not once but twice and the sales force inadequacy, before it was ever announced, they knew when the FDA was coming out.

This is not the perfect situation.

You're right.

We could have just taken this out and--

Justice Breyer: But it sounds to me as if the things you're saying now are matters for proof, and I... I think the wiggle room in the Government's position was it said it has to be disclosed to the market in some form or other.

Well, if you're prepared to be broad and turn those over to the experts for the proof, you end up with your theory.

The... the inflation comes out and it comes out because they didn't get the earnings that they would have had or there may be many reasons.

Mr. Coughlin: --There's no doubt, Your Honor.

And if we have to do it at the pleading stage, it would be impossible.

Justice Breyer: Well, you just have to say at the pleading stage what your theory is.

Mr. Coughlin: And... and I think we did that.

We said the stock was inflated and there was damage, and we could have done a better job.

Absolutely--

Justice Ginsburg: I thought your theory was, at least as I read your brief, that your loss occurs at the moment of purchase, not at some later time, that when you bought the stock, the price was inflated and that's when you suffered your loss, on the day of the purchase, not at a later time.

Mr. Coughlin: --That's absolutely correct.

We believe that you suffer your loss and damages on the date you make the purchase.

On the day--

Justice Scalia: How can you reconcile that with your concession that if the person who... who buys it at an inflated price turns around 2 days later and sells it at that same inflated price, he cannot bring suit?

You would not allow recovery in that situation.

Mr. Coughlin: --Would not allow recovery in that--

Justice Scalia: How... how can you reconcile that--

Mr. Coughlin: --Because those--

Justice Scalia: --with the notion that the loss occurred at the time your purchased?

Mr. Coughlin: --Justice Scalia, because those are... what we're talking about are recoverable damages, and then there's a limitation from section 28.

In other words, all the cause of action was satisfied on the date you overpay.

The day you pay $100 for a stock that's worth $50, you're out the $50, the economy is out the $50 because it's not working market.

But you cannot recover, we would agree, until later.

And the problem with analyzing that at the pleading stage is that is the... that is expert analysis and discovery to connect up how... how the losses came out and what you can recover.

So I agree with you that you cannot recover that.

Justice Scalia: They're saying there's no losses.

I mean, that's... it's inconsistent how the losses come out.

You just told us the loss occurs, bang, when you buy it.

You've gotten stock that really isn't worth what you paid for it, the notion of... of worth as some... you know, some objective thing rather than what... what people are willing to pay.

Mr. Coughlin: Well, that's--

Justice Scalia: But that's your theory and it seems to me you're stuck with it.

And if that theory is true, then it shouldn't matter that you later sell it to some other poor, unsuspecting individual for the same amount you bought it for.

Mr. Coughlin: --It doesn't matter for that plaintiff if they sell it to a poor... somebody unexpected.

For example, Fannie Mae just publicly, a couple of weeks ago, found out they bought $300 million worth of bonds, and they... they found out about a fraud.

They sold it and got fined by the Government because they heard about the fraud and sold it back into the market to recoup their losses or back through their broker.

That's... that's not okay.

That's just one outrageous example.

But somebody ends up with that stock that's inflated.

Okay?

And when you make the purchase.

We agree we have to show the inflation come out before recovery, and... and 90 percent of the time--

Justice Scalia: You have to show what before recovery?

You have to show?

Mr. Coughlin: --The inflation came out of the stock.

In other words, if you pay $100 for a stock that's worth $50, it's inflated by $50.

You don't recover that $50 until you show that $50 inflation came out of the stock.

It can come out a number of ways.

Let's say, for example, that somebody announced a competitive product.

Well, that would take some of the inflation.

That would be a market factor that would take some of the inflation out of your false statement that you had a product, the AlSpiros product.

There are different ways inflation can come out besides a corrective disclosure.

Justice Souter: Yes, but if you've got to show the inflation, then you don't have a complete cause of action the day after you buy the stock if there's no loss.

I mean, if you've got to show the... the drop following the inflation, you don't have the complete cause of action if there's no drop the day after you buy the stock.

Justice Scalia: That's what they're saying.

Mr. Coughlin: You can only recover--

Justice Scalia: To me your... your--

Mr. Coughlin: --You can only recover if that inflation is taken out of the stock.

Those are recoverable damages under Ninth Circuit law.

Justice Souter: No, but I... I thought you were conceding that you... you, in fact, do not have a... a loss... forget what you can recover... that you don't have a loss until the inflation is followed by a drop.

And if there's no drop at the... at time of purchase plus 1 minute, then I don't see how there is even the element of a cause of action.

Mr. Coughlin: I... I believe that the day you overpay something, just like in the Sigafus, just in the... in the Bolles case, both of them had to do with gold mines--

Justice Souter: Then you're talking about a cause of action without damages.

Mr. Coughlin: --You may not have recoverable damages.

That is true.

Justice Souter: If you have no damages, you have no cause... I mean, on normal tort theory, you have no cause of action.

Mr. Coughlin: I understand, and I think you have $50 worth of damages right there.

And our concern is what you have to prove--

Justice O'Connor: Well, that's exactly what we're debating, I suppose, that very point.

And... and it's hard to justify, under this statute, finding a cause of action before there's any damage or if there isn't any.

That's... that's just very hard to understand.

Mr. Coughlin: --In the most complex frauds, a... a company is reporting revenue and earnings and their stock is, let's say, trading at $60 a share.

Perhaps, because of fraud, it's overstated by $30.

There are people in the market buying that stock at $60.

That company starts to lower those expectations.

This happens to be a real world example, Worldcom.

They say we're going to miss revenues by $172 million.

The stock starts dropping down.

The inflation that was in that stock because of what they lied about starts coming out.

Nobody knows there's fraud.

Nobody understands that.

In fact, it's not until that stock goes down at 80 cents that there was an admission of fraud.

Justice Breyer: All right.

But then you're not saying what I think Justice Scalia and I actually thought you were going to say which is that the minute he pays $60 for a stock that should be worth $30 but is $60 because of the lie, at that instant he suffered a loss.

After listening to you, I now think you're saying... but I'm not sure because I've heard you say things that are... both... I now think you're saying, no, he has not suffered a loss until later on when that $30 comes out of the price of the stock.

Justice Scalia: --And that's worrying me too.

Justice Breyer: It might come out in many different ways.

It could come out because he announces I'm a liar.

Justice Scalia: Right.

Justice Breyer: It could come out because he doesn't say anything but it sort of oozes out as earning reports come in, but it has to come out.

Now, if you're saying that, then I find what you're saying consistent what I think Judge Posner said.

And that's really what I'm interested in because I read what he said.

It seemed to me right.

Now--

Mr. Coughlin: I certainly don't want to be disagreeing with Judge Posner.

So I--

[Laughter]

The other--

Justice Scalia: I think... I think you're... I think you're agreeing with the petitioners.

I think this... this whole thing is a great misunderstanding.

You... you didn't--

[Laughter]

Mr. Coughlin: --I would agree with that, Your Honor.

That's just... we come to the same conclusion.

There is no doubt about that.

We come to the same conclusion.

We have to prove that that inflation was in there when we prove it.

And what we're talking about is what the burden is going to be on us at the pleading, and that's what we're concerned about.

Justice Breyer: --When we have this happy agreement and if you'll agree, you at least have to prove what you... you have to plead what you intend to do, that is, you have to plead and there was a loss and this is my theory.

I would like to know... maybe we won't get beyond this, but in looking at this, I wondered now suppose that the stock goes up in value because of extraneous things.

Can you recover because it would have been still higher?

Mr. Coughlin: Justice Breyer, I think the Government says that we can recover.

We believe that we could recover.

In other words, it didn't go up as high.

I think it is... as Justice Ginsburg said, it's the same difference.

You lost $50 whether you lost it--

Justice Breyer: What happens with the transaction causation?

Because I think you'd probably say with your transaction causation in the... in the case that the... that the lie wasn't there, we wouldn't have bought the stock.

Mr. Coughlin: --Right.

Justice Breyer: All right.

If you say that, they come along and say, okay, you wouldn't have bought the stock.

I'll tell you, here's one bad thing happened.

You lost your $30.

But there were six good things that happened that you never thought of, and so the stocks were four times what it would have been and you'd never have those gains, just as you'd never have the losses.

How does that factor?

Mr. Coughlin: Well, I dream to have those clients that gain four times, but since we don't usually have those and it is the drops that we're really talking about.

The but-for transaction, when they say, hey, and... and you buy it, and then it goes up, and then you learn about the fraud... and I'm assuming that there's no drop but you can prove that the inflation was there and never came out, and can you prove that it should have gone to $250?

You know?

I'd have to prove that it went to $250.

I agree with you.

You know, I would agree with you that, you know, that I'd get an expert.

Mr. Fischel would come in and testify that it should have been worth $250.

And that's what, you know, would happen.

Justice Ginsburg: But there's a problem.

Take the concrete facts of this case.

The bad news about... what is it?

Albuterol?

Mr. Coughlin: AlSpiros.

Justice Ginsburg: Yes.

That bad news didn't come out until 9 months after the end of the period that you identify for your class.

You say the class is April 15th, '97 until February 24th, '98 purchases.

The bad news doesn't come out until November of '98.

So how could you possibly hook up your loss to the news that comes out later?

Mr. Coughlin: If... if we move to the proof stage, the people that purchased in the class period and sold before that announcement will not be able to recover that 20 cent drop at the end.

People who purchased during the class period and held until all of the inflation was taken out by either final announcement from the FDA or when they announced they were abandoning the product would be able to recover from that inflation because all of the inflation was taken out as to AlSpiros.

Justice Ginsburg: I... I thought that you were trying to pick up on the drop that seemed to be attributable to the other--

Mr. Coughlin: Product, Ceclor?

Justice Ginsburg: --Yes, and that's what... well, there... there are two frauds going on.

The first one is discovered and the price drops substantially.

And I thought you were trying to attribute that drop to the other product.

Mr. Coughlin: There... there are some things in that drop attributable to the other product.

The sales force insufficiency, as well as management integrity, and there are some other things that weren't pleaded well.

First of all, we were being conservative when we pled this and we pled the rises.

We pled the insider sales.

We pled the stock offerings.

And all the statements were in that earlier period.

They make the announcement.

The stock starts down, 50 percent drop.

It's walked down another 40 percent after that.

Finally, you get the FDA announcement.

And we certainly could have, and... and maybe should have, taken that period out right then.

The district court ended up having problems with it.

The Ninth Circuit, in their questionings... Judge Reinhardt had problems with the... with that.

And they gave us leave to replead, and we told them at that time if that's what we need to do, is tie that in also, if that's a loss that we intend to recover for or seek recovery for, then we'll do that and we'll go back to replead.

If there are statute of limitations, that's a different issue, but we can plead that and could have.

Justice Ginsburg: Well, one of the problems for me is the Ninth Circuit seems to think that it has a theory... and it is the theory of your complaint... that's different from, say, the Third Circuit.

The Ninth Circuit says we recognize that the loss is you bought it at an inflated price, and the Ninth Circuit thinks that's different from a circuit that says you don't have any loss until somehow the bad news comes out and there's a drop in price as a result.

Mr. Coughlin: I wish that the circuit said if the bad news came out, but the Koger case and... and emergent out of the Second Circuit seem a little stronger and talk about almost the only way it can happen is with a corrective disclosure.

And that's... and that's a concern of ours.

The Ninth Circuit law is pretty clear, is very clear actually, with the three cases, Blackie, Green, Judge Sneed in the Green v. Occidental case, and the Wool case, saying that the loss occurs at the time of purchase and overpayment, but recoverable damages--

Justice O'Connor: Well, that may be clear but it may be clearly wrong.

[Laughter]

Mr. Coughlin: --That... it... it... I understand that, Your Honor.

I'm hoping that it's not clearly wrong.

It's been on the books for 30 years.

It was the law.

It was the law on the books at the time that this was codified.

There was no real or perceived conflict in the circuits at the time this was codified.

Justice Kennedy: Well, I... I thought that Judge Sneed recognized that if the stock was sold before any loss was incurred, even if there's been a misrepresentation, recovery should be denied.

Mr. Coughlin: That's correct.

Justice Kennedy: All right.

Mr. Coughlin: That's absolutely correct.

Justice Kennedy: That's not what the Ninth Circuit said in this case.

Mr. Coughlin: The Ninth Circuit didn't... it cited... it cited the Green v. Occidental opinion and the Blackie I believe.

Justice Kennedy: But I'm submitting it cited it for the wrong conclusion.

Mr. Coughlin: I... I think it... I think it--

Justice Scalia: It cited... I thought cited Knapp and... which, in turn, cited Gray or... or--

Mr. Coughlin: --There are all the appendants.

There's... there's the three that started off.

Knapp is the ATV case that we tried, and that was Judge Wallace and he relied on Gray.

All of them are the same in that you have to... to get by the pleading stage, that you have to plead the inflation and identify the causes for it.

It's for proof and expert testimony and discovery to see if you have recoverable damages.

If this Court were to say, no, we want identifiable drops, then we could do that.

You know, if this Court were to say, listen, you've got to identify the drops, whether they... whether you can connect them up to the fraud at this time, we want a full theory in the complaint... and we can do that.

If that's what the... if that's what this Court directs us to do, then we'll do that and we'll put in all the losses, as well as the rises, as well as identifying the causes.

You know, we'll do that in... in the complaints.

Sometimes what... what we're saying and where we differ a little bit from the Government is it's hard to necessarily tie one of those innocuous disclosures that may be taking the inflation out back to the misrepresentation, and yet the stock is dropping and inflation is coming out.

And that's what we're worried about.

And there are other market forces that may take it out.

So at the pleading stage, we're worried about the burden that almost puts us in... in the position of having an expert come in, and we think that's for a later time for summary judgment or trial.

Justice Scalia: --I mean, if you're worried about it, why aren't you worried about it later, as well as earlier?

I mean, if that's going to be a problem, we should know it sooner rather than later, rather than... you know.

If you say that's terribly difficult to prove, we can hardly ever prove it, well, good.

Then let's get rid of this... rid of the case earlier.

Mr. Coughlin: I don't think I said--

Justice Scalia: I don't... I don't know why... why it's desirable not to include that at the pleading stage.

Mr. Coughlin: --I don't think I said that that was difficult or hard to prove.

I said it was difficult or hard to plead.

It is difficult and hard to plead, and... and to tie that... those inflationary things back up because you only get to recover... you only get to recover for things that took the inflation out.

I mean, if the stock drops... let's say... let's say the stock drops $60 or $50, and where he paid $60, it drops down to $10.

But half of that... half of that drop is unrelated to the fraud absolutely.

Well, under a 10(b) cause of action, you don't get to recover for that market loss.

We have to tie... that's why Judge Sneed in Occidental... in Green v. Occidental tied it right to the overpayment because Judge Sneed was worried about... about the issuers being insurers for the market.

In other words, if the stock... if... if a down market takes the stock way past what you paid over inflation, defendants should not be liable for the whole market loss as they might in a section 33 case.

And that's really what the... what the point is, to fix the loss.

That's why Judge Sneed fixed the loss at the date of overpayment because Judge Sneed didn't want somebody coming in and saying, hey, you paid $60 for a stock that was really worth $30.

When you brought suit, the stock was down at $10.

Do you get to pay... do you get $50?

And Judge Sneed said no.

You only get the overpayment on the date.

Admittedly in up or down markets, what petitioners and the Government would suggest might move the damages up or down.

In an up market... you know, we're talking about something that was going down here.

In an up market, you might get a bigger drop.

Justice Breyer: But that's a--

Justice O'Connor: That's why the term loss causation is used because under the statute it's... it's a loss experienced by the plaintiff caused by the misrepresentation.

Mr. Coughlin: Justice O'Connor, I... I couldn't agree more, and that's why it goes to proof.

It says this is a proof statute--

Justice O'Connor: Well--

Justice Souter: No.

Mr. Coughlin: --I agree.

It has to be alleged.

Justice O'Connor: --The Government said you don't want unnecessary discovery.

You have to put out pleadings that make clear what your theory is--

Mr. Coughlin: There's no doubt.

Justice O'Connor: --which yours don't do.

Mr. Coughlin: They don't do well enough in this case.

Justice Souter: No, but what... it seems to me that what Judge Sneed's theory boils down to is this.

You cannot recover any loss except the loss that was caused by the fraud in question.

In theory, that limit is established by the inflation at the time you purchase.

So that is the limit of your recovery, but it does not follow from that that you have anything to recover for until you have your actual loss if you're pleading a... a fraud-on-the-market theory.

Isn't that fair to say?

Mr. Coughlin: That's fair to say.

Justice Souter: Okay.

Mr. Coughlin: I agree with that, Your Honor.

That is... that's exactly what... that's exactly what Judge Sneed did.

And when we were talking about this statute here, it talks about us proving those... that loss causation and tying it to the actual omissions.

And it follows two sections that deal with pleading, material... deal with particularized pleading as to falsity and as to scienter.

And this statute says that if you don't plead one or two with the particularity required, then the complaint shall be dismissed.

This section here--

Justice Scalia: So... so... I'm not sure I understand what... I'm... I'm really coming to believe that this is a misunderstanding.

It seems to me you're now saying that the loss does not occur when you make the purchase.

It is just that that is the limit on your loss, the difference between what the stock would have cost you had the... the absence of gold been known and what you actually paid.

Mr. Coughlin: --It's the limit on your loss.

Justice Scalia: But that is not your loss.

You're saying now the loss has to occur later when the price goes down and you're thereby harmed.

Is that it?

Mr. Coughlin: No.

I apologize if I haven't been clear.

The loss occurs at the time you purchase, but you cannot recover any portion of the loss until the inflation is taken out.

Justice Souter: But the... let's approach it a different way.

On a fraud-on-the-market theory, there are two facts I think that can be assumed.

Number one, there was no misrepresentation that was made peculiarly to you.

The misrepresentation was to the broad market and was reflected in the broad market price.

Mr. Coughlin: Correct.

Justice Souter: Number two, you as a purchaser do not know about the fraud until the market finds out about the fraud.

Mr. Coughlin: Correct.

Justice Souter: If that is the case, then I don't see that it makes any sense at all to talk about your having a cause of action the day after you purchase before the market has found out and before the fraud is known.

I mean, this... this strikes me as an exercise in... in an inconsistent theory.

Mr. Coughlin: And here's why it matters, if I might, is that what petitioners and perhaps the Government would say is that you're right.

You don't find out about the fraud until the whole market finds out.

But before you find out about the fraud, there can be terrific drops in the stock, which we think we could prove are related to the fraud.

Okay?

Because we've had certainly a market loss to what we paid.

The stock has dropped down.

We don't know about fraud yet.

All of a sudden, there's a disclosure of fraud, and we all learn about it.

Justice Scalia: You don't know about it, but the market knows about it.

That's... that's why the stock has gone down.

Mr. Coughlin: Not necessarily, Your Honor.

In other words, you can lower expectations by lower revenue numbers.

Other market forces like a competitor coming out with a product.

There are other things that can lower that.

I'm sorry.

And when it gets down there, the rule that we fear is being urged is that you only get the drop from either the admission of the fraud or the full disclosure of the fraud, and in the complex cases, the Enrons, the Worldcoms, the Healthsouths of the world, that didn't happen even until long after they were in bankruptcy.

And if we only get the drop, the $3 drop at the end, or the 80 cents to 50 cents that the Government just returned $750 million to in the Worldcom, with every large institution in the country already out of that stock, well, then those that were sought to be protected by the Reform Act aren't.

We have to be able to plead certainly... and... and we can... the... the market moving down.

And then that's at the pleading stage, a plain 8(a) statement.

And then we have to prove and tie that back up to get damages.

Justice Ginsburg: I thought that that's what the Government was getting at in the passage I read earlier where they don't make it... there must be a statement by the issuer of the correction.

They have more leeway.

But you... the Ninth Circuit... the litany that it's using, the... the set of cases... for example, plaintiffs were harmed when they paid more for the stock than it was worth.

The... the notion that's repeated, that your loss is established on the day you purchase the price, that's just wrong, and I think we would have to at a minimum say that.

Mr. Coughlin: I... I don't agree with that, Your Honor.

I agree with the Ninth Circuit that you suffer the loss of overpayment.

You have something in your hand that's worth half as much as its true value.

Justice Ginsburg: You... you seem--

Mr. Coughlin: Can you recover?

Is it like the UCC where you've got to mitigate your damages?

You cannot recover those damages even though you've suffered them.

You have a stock certificate that's worth half of what it's worth even in an efficient market.

And when the truth comes out, that's true, you'll be damaged, and if you sell it before then, you get no recovery.

Justice Souter: But aren't... aren't you... aren't you, in... in effect, equating two different things: one, a loss that you suffer which you say occurs immediately upon purchase of the inflated stock; and on the other hand, a limit on the loss that is attributable to the fraud?

Those are two different things.

I understand the limit on the loss.

I don't understand the... the suffering of the loss in fact.

Mr. Coughlin: Well, Your Honor, I think that that's an interesting statement because if the limit is... let's say for a $100 stock that's worth $50 and you overpay by $50, let's say that's the limit of our loss, even if the stock--

Justice Stevens: Mr.... Mr. Coughlin, I'm afraid you've had a full opportunity to explain this very difficult case.

You'll have to... your time is up.

Mr. Coughlin: --Thank you, Justice Stevens.

Justice Stevens: Mr. Sullivan, you have 2 minutes.

Rebuttal of William F. Sullivan

Mr. Sullivan: Justice Stevens, and may it please the Court:

One point I think I want to focus upon for the... for the Court is... is the comment in the Senate report which said that the damages had to be a result of the cause... the... the misrepresentation, not other factors.

I think what we've just heard about, in terms of the decline in the market value, is... is a look at a number of the other factors.

And there are disclosures that are related to fraud and there are disclosures that are not related to fraud.

And if there was a misrepresentation in the marketplace, that... that is one thing.

If a new competitor comes out with a new product, that's not--

Justice Breyer: What's the problem here?

He... I mean, well, you heard what he said.

And it sounded to me that he agrees with you he has to prove that in fact the fraud not only led to the overpayment, but that also later on the client who bought the stock lost money because the market went down, and that default, which cost him the money, is caused by the fraud.

Mr. Sullivan: --And... and--

Justice Breyer: When it comes out, it just comes out in subtle ways as well as direct ways.

Now, do you agree with that?

If they... if you do, it seems to me there's no case here.

Mr. Sullivan: --I would... I would agree with you and... and I would just--

Justice Breyer: Where do you disagree?

Mr. Sullivan: --I would just add... I don't disagree.

I would add that the cause is not by other factors because I think when we heard the discussion about the... the reduction of inflation, we were hearing about factors other than that.

I just want to close by saying the loss causation codification in the Reform Act was meaningful and was part of the Reform Act.

And that really indicates that this is a pleading standard that we... we... we're dealing with, that the cause of action for a securities fraud has to be stated at the time.

And that's consistent with what the Reform Act was trying to achieve which is to give the defendants a chance to respond and actually have the motion to dismiss serve as a meaningful screen in dealing with those cases.

Thank you.

Justice Stevens: Thank you, Mr. Sullivan.

The case is submitted.

Attribution:

The Oyez Project

Featured:

SEC v. Edwards - Oral Argument

Fri, 09 Jan 2009 14:49:07 +0000

Case:

SEC v. Edwards

Media File:

02-1196_20031104-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Gen Theodore B. Olson

Chief Justice Rehnquist: We'll hear argument next in No. 02-1196, the Securities and Exchange Commission v. Charles E. Edwards.

General Olson.

Mr. Olson: Thank you, Mr. Chief Justice, and may it please the Court:

Over 10,000 persons in 38 States invested $300 million in respondent's payphone business on the expectation that their investments would yield a 14 percent return due to respondent's experience, efficiency, and management expertise.

The decision below that these transactions were not investment contracts merely because they specified a fixed return to the investor, rather than an unspecified portion of the enterprise's profits, can not be squared with the language, history, and purpose of the Securities Acts, 70 years of consistent SEC interpretation and enforcement, and this Court's jurisprudence.

The congressional definition of security, as this Court has repeatedly said, is broad and flexible, and intended to be all-inclusive to cover the countless and variable schemes devised by those who would seek money from others on the promise of a return.

Congress intended, in the words of this Court, to encompass virtually any instrument that might be sold as an investment, and the term investment contract, this Court has held, was intended to be a broad catch-all.

Therefore, substance, not form or title, governs.

These terms, investment contract, are to be construed broadly to embrace... again, in the words of this Court... all forms of investment schemes that bear a resemblance to what is commonly understood to be a security.

And this Court has said, because promoters are so creative, these terms must be flexible and inclusive.

A catch-all must catch all.

It is irrational to conclude that Congress would have defined security...

Justice Stevens: Mr. Solicitor General, may I jump ahead for a second?

Is the... is your adversary correct in saying that as far as decided cases are concerned, not the position of the SEC, but there is no judicial decision holding that a... an instrument that provides a fixed return is an investment contract?

Mr. Olson: Well, Justice Stevens, I can answer this by saying that the seminal case, Howey, referred to and cited Blue Sky cases and Federal court of appeals decisions, which did contain those type of instruments, fixed return instruments.

This specific question has not previously been decided by this Court, but the Court has never decided, and the cases that the Court referred to in Howey did not ever say that... that the fixed return instrument was excluded from the term investment contract.

Chief Justice Rehnquist: How about the United Housing case?

Mr. Olson: Well, again, with respect to that case, the... I... the Court has decided consistently that what is critical is the... that the investor expects a return.

The Court has never said...

Chief Justice Rehnquist: But the United Housing case did refer... suggest that the requirement that the income come from profits, did it not?

Mr. Olson: Well, the... the references to the... to the... this... from this... our perspective, Mr. Chief Justice, is that the return must be examined from the standpoint of the investor, the invest... and the Court... I don't think the Court intended to restrict in that case, and the language is not reasonably susceptible in my judgement to the... to the understanding that that was intended to exclude investments or instruments that provided a fixed return.

What the Court has repeatedly referred to is the... from the standpoint of the investor, what the investor is expecting to do is to put his or her money to work for him or her, that is to say, put that money into an enterprise of some sort so the investor can sit back and watch the returns come in.

The investor doesn't care whether that's a fixed return or a speculative return.

In fact, the definition in both the 33 and the 34 Act includes types of investments, such as common stock, that have speculative returns built into their definition, so to speak, fixed returns instruments, such as bonds, preferred stock, indentures, and that sort of thing.

Then the term, as this Court has repeatedly said, those terms are relatively fixed and understood.

But because Congress wanted to embrace, because this is a remedial statute intended to protect the investing public and the integrity of the marketplace so that people will feel secure in investing their resources in other instruments that promoters are offering...

Justice Ginsburg: General Olson, you... you put the stress on investment and that seems right with the statute refers to investment contracts, but there are surely debt instruments that would not be investment contracts.

So what is the dividing line between something that constitutes a plain old debt that is not an investment contract and not a security, and one that is?

I mean, how do we identify something as an investment contract rather... rather than an ordinary debt?

Mr. Olson: Well, I think the answer, Justice Ginsburg, is that many of those instruments that are ordinary debt instruments may be investment contracts as well.

This Court has repeatedly said is that these terms are overlapping...

Justice Ginsburg: And what makes it... what makes something an investment contract?

Mr. Olson: Well, what this Court has said is that when a person puts their money into a common enterprise with the expectation... expectation of a return, that is... through the... as a result of the efforts of others, that is an investment contract.

Now, many notes, or many types of offerings, might be based upon a fixed return and might appear in the... to look like notes or fixed return types of investments and still be investment contracts.

Justice Kennedy: But the... depending on the investment skills of others, that's... is very unhelpful to me.

I... I would think most creditors who extend credit rely on the investment skill or the financial responsibility of... of the lender.

That's how they're going to get their money back.

So, I... I find that test hard to work with as a limitation.

I know it comes from Howey.

Mr. Olson: It does... it does come from Howey, and I think that the best way to look at that, Justice Kennedy, is to look at that the investor, as opposed to using his own resources, his own efforts, his own energy, his own creativity, is counting on other people to make the... the instrument...

Justice Kennedy: Well, but my point is all creditors do that just on straight loans...

Mr. Olson: Well... well...

Justice Kennedy: so that doesn't advance us very far.

Mr. Olson: Well, that's right.

That's correct.

And there are some overlap, but this Court has said, and it repeated it and analyzed it from that context in the Reves case, that there are some commercial contexts and some consumer contexts in which the Securities Acts were never intended to cover.

Justice Kennedy: Well, the Reves case had language that doesn't help you because it seems to exclude a fixed return, but...

Mr. Olson: Well...

Justice Kennedy: so I... I don't...

Mr. Olson: We...

Justice Kennedy: know how great the Reves case is for you.

Mr. Olson: What the Reves case says, and I think Your Honor is referring to footnote 4 in the case, in which the Court, in construing what was meant by the... the term note, looked at the definition of... in... in the Forman case, which included the earlier Howey case, as to define an investment contract.

But in that footnote, the Court very carefully went on to say the definition that we're examining here with respect to investment contract is irrelevant with respect to notes.

That is dicta piled upon dicta in a sense, because the Court... we... I... we respectfully submit... mischaracterized Forman, the case that the... where the Court was concentrating on the difference between someone investing their resources to get something to use, in that case...

Chief Justice Rehnquist: Well, if... if you... if you don't like dicta that's against you, a lot of the things you've been quoting are dicta that weren't really necessary to deciding the case.

Mr. Olson: Well, what we... Mr. Chief Justice, I don't think that what we're quoting with respect to what we're relying on is dicta.

What the... the Court is... has defined the term investment contract, first of all, in the Joiner case, and then in the Howey case in very broad terms.

Chief Justice Rehnquist: Supposing I... I loaned someone $10,000, they've just hung out their shingle to practice law, and I'm... I want obviously the money back, but whether I get the money back or not is very much going to depend on his skill.

Is that an investment contract?

Mr. Olson: That's... that is... that is probably not an investment contract because it is a personal transaction between individuals.

What this... could the factors that this Court used in the Reves...

Chief Justice Rehnquist: Well, but all these are transactions between individuals.

That doesn't distinguish anything.

Mr. Olson: Well, what the... one of the... one of the things that the Court said in Reves is that, to the extent that there are any ambiguities at the edge and those particular factors were considered in Reves, it... the... the scheme of distribution, the nature of the relationships between the individuals, is this... the... is someone seeking to acquire money to use as capital in the... in the operation of an enterprise...

Chief Justice Rehnquist: Well, is... are you saying then that a one-on-one transaction can never be an investment contract?

Mr. Olson: No, we're not saying that.

In fact, the Court held to the contrary in the Wharf Holdings case that there may be... and in another case in this Court's jurisprudence... that simply because there are one individual or one entity dealing with another entity doesn't exclude the... the operation of the term investment contract.

Justice Kennedy: But the problem is, as... as you well know, Justice Ginsburg begins it, and the Chief Justice is asking the same question, if we're going to write this opinion, it seems to me we have to have some limiting principles, some limiting language.

Now, we could just talk about these facts and it'd be a case good for this ride only, but we're... we're wondering about whether or not these facts yield certain insights as to what might be definitional principles for an investment contract.

Mr. Olson: Well, with respect to the cases at the margin, the Court articulated the same kind of analysis that the Securities and Exchange Commission does.

Where there are cases at the margin, the Court will consider the motivation of the person raising the money, the person investing in the... in the operation, the nature and type of promotion that's taking place, and... and the motivations of the seller and things of that nature.

What... what the question presented here is considerably more narrow, the question presented here is it... is... is it disqualified as an investment contract simply because the return is fixed or specified?

Now, if the Court were to adopt that definition, imagine the size of the super highway loophole that would be created in the Securities Act.

Instead of promising the sky or... or a speculative return, the investors that develop these types of schemes will simply say 50 percent or 25 percent...

Justice Kennedy: Yes, but... but... but you don't... well, maybe you do... we just say an investment contract can include a fixed return and then remand it to the Eleventh Circuit for it to figure out the puzzle?

Mr. Olson: Well, it's not... the... the only reason that the Eleventh Circuit decided that this case couldn't go forward... they couched it in terms of jurisdiction, but it's really failure to state a claim... was that this instrument had a fixed 14 percent return and said investment contracts can't not include that...

Justice O'Connor: So your point is that's all we have to decide, whether the fact that it's a fixed return excludes it from the definition of a security?

Mr. Olson: Precisely.

Justice O'Connor: But it would be desirable to have some clearer understanding of what's covered, and if you had to take your best shot at constructing a definition, what would it be?

Mr. Olson: Well, I would adopt, and the Government would propose, that the Court do no more than rearticulate what the Court has repeatedly stated... and it's stated it as well in Howey as it could possibly state it... a transaction in which a person invests money in an enterprise with the expectation of a return, gain, profit.

Now, in the Forman case that we submit was not characterized correctly in the Reves footnote, the Court used all of those terms, the expectation of a profit, the expectation of a return.

In Howey itself the Court...

Justice Scalia: We... we've gone... gone around that.

I mean, the problem is the ordinary loan, the ordinary loan from one individual to another.

I loan you $10,000 and you will pay it back over so many years and give me so much interest a year, meets that qualification, meets that description, and you acknowledge that that is not an investment contract.

Mr. Olson: The... what the Court has said is that in... in those kind of cases, where it does not look as typical as the typical investment scheme...

Justice Scalia: What makes it look like a typical investment... I mean, that's what we're trying to get...

Mr. Olson: What makes it look like a...

Justice Scalia: What makes it look like the typical investment...

Mr. Olson: Well, the characteristics are...

Justice Scalia: You say it is not the mere fact that it's not a fixed return.

That isn't it.

What is it then?

Mr. Olson: Well, the things that make it look like an investment contract in this context is that the individual is putting himself, his money, into an enterprise that is being, in this case, widely promoted... as I said, 10... over 10,000 investors put their money into this enterprise hoping to get some return as a result of the... the efficiency or effectiveness...

Justice O'Connor: So at least where it's marketed to the public you would say it's covered, at least that, even though you don't know backing up where to cut it off?

Mr. Olson: Well, the... the precise lines here, Justice O'Connor, may be difficult in a particular one-on-one investment case.

The Court acknowledged that in the Reves case, said that there... there are... there are situations that look more like consumer transactions or they may look... more look like...

Justice Stevens: So isn't the question about the individual transaction really related to the conflict on this horizontal and vertical distinction that Judge Lay relied on in his concurring opinion?

And as I understand it, that's not before us as to the validity of his vote in the case.

Mr. Olson: That's... that's correct, Justice...

Justice Stevens: Because I don't understand either party to have addressed the... this alleged conflict over horizontal or vertical.

Mr. Olson: That was not what... yes, that's correct.

Judge Lay discussed that in his concurring opinion, but the court did not rely upon that, the parties have not briefed that, and that question is not before this Court.

Justice Stevens: So it's entirely possible that you could win here and the case would be remanded for the court of appeals to decide whether or not Judge Lay was right?

Mr. Olson: I guess that's... I guess that's... that's possible.

I...

Justice Kennedy: Your... your opening argument says there are agreements for investment contracts...

Mr. Olson: Yes, we did.

Justice Kennedy: that's what you asked us...

Mr. Olson: Yes, we do.

And... and... I think that there is... this is not a difficult case from that standpoint, because all of the indicia that the SEC has been using for years, and what the SEC has articulated this standard in formal adjudications, to which this Court defers under Chevron, it did 2 years ago in the Zandford case, with respect to the SEC, there is here in this case 70 years of consistent enforcement of this principle by the Securities and Exchange Commission...

Justice Breyer: So to be clear about your... what you're saying is, there are a lot of criteria that rule out loans, ordinary loans, because after all, they would otherwise come in the words evidence of indebtedness.

There are a lot of words in this contract that could pick up ordinary loans, but then there are a lot of criteria that rule them out, of all those words, not just investment contract.

And this case is about one word.

What you would like is a decision that says, the word profit in Howey meant profit in the sense of ordinary return, return being broad enough to encompass fixed or variable returns of various kinds, period, end of the matter, reversed or remanded.

That's... that's your... that's your point, not get into these other criteria for other things.

Mr. Olson: Precisely, and the Court has not done that in the past, does not need to do so here.

There are situations like the Reves case where the Court said, well, some notes are securities, some notes are not securities, and then goes through... what the Court in that case was looking at, a Second Circuit decision that said, well, some notes are not securities, some are securities, and then laid out a methodology, which, by the way, is the same methodology that the SEC understand... well... widely understood to employ with respect to those cases at the margin.

But, Justice Breyer, I agree completely.

This is a paradigmatic investment contract.

It's like the cases involving chinchillas or rabbits, one of these cases involving rabbits, it... there's two of the... two of the...

Chief Justice Rehnquist: Except it's different in that here there's a fixed return.

In those, there was not.

Mr. Olson: That's not correct, respectfully, Mr. Chief Justice.

Two of the... two of the cases cited in Howey, People v. White and Stevens v. Liberty Packing, were...

Chief Justice Rehnquist: Well, I thought you meant cases in this Court.

Mr. Olson: No.

I'm talking about cases that this Court accepted when it decided the Howey case, but this Court has never...

Justice Scalia: Well, that's a pretty, you know, that's a pretty tentative attribution to... to this Court, that... that it was paying that close attention that it understood in all of those cases whether it was a fixed return or not.

Mr. Olson: Well, it certainly wasn't ruling it out, Justice Scalia.

What this Court... what the... this Court specifically said in Howey, because it had nothing to go on.

Congress, first of all, decided to make the definition as wide as possible to use again this Court's language to cover everything that might commonly be understood to be a security, and because promoters are so ingenious, to cover all types of investments that might carry some of those characteristics.

So the Court said, we're going to look at the cases that involve the Blue Sky statutes that... that had been in existence and had been interpreted prior to the adoption of the 33 Act.

There's not one of those statutes that limited investment contract to a variable return and excluded fixed return, was not one of those cases under the Blue Sky statutes that excluded fixed return investment contracts from the definition of investment contract.

Chief Justice Rehnquist: Well, were... were they all fixed return cases then?

You say there was not one of them that excluded fixed returns.

Mr. Olson: They were not... they were not... some of them were variable returns, Mr. Chief Justice, but some of them were fixed return.

The two cases I cited, the one was People v. White, where, if the Court looks at that case, the Court will find that the... the... the language of it is... the party of the first part will pay $5,000 and the party of the second part after 5 years will pay $7,500 back.

That was a fixed return investment.

But not only did the Court in Howey cite those two Blue Sky cases that involved fixed returns, but the Court cited then four... and we mention these, I'll not go through the names again here, we mention them in our briefs... four court of appeals decisions that had involved no pooling of interest and there... there have been two SEC formal adjudications, which again, as I said, this Court gives deference to.

And the first time the SEC sought to enforce an investment contract in this kind of context is SEC v. Universal Services, which goes back to 1936.

Very seldom does this Court have that kind of 70-year history of consistent enforcement by the agency vested with responsibility, and again, these have matured themselves into not only court decisions but, in addition, formal adjudications.

The securities laws have prophylactic purposes.

They are designed to protect people that put their money in the hands of other people who are running business... businesses... and from whom they expect to make a return.

I invite the Court's attention to exhibit 17 and particularly pages 116 through 119 of the joint appendix, and this is the type of note that the... the respondent will say, well, this was not our document, this was one of our distributor's documents, but it's alleged in the... in the complaint and there is evidence to support that this is... this was out there available for investors to see.

There are millions to be made from pay... owning payphones, watch the profits add up.

And then on page 119, this document goes on to say, for the payphone owner, the need to do individual things to make money is taken care of through these management contracts, because the payphone owner can benefit from the experience, operating efficiencies, and management expertise provided by ETS Payphones.

Chief Justice Rehnquist: What sort of management expertise is required to manage payphones?

Mr. Olson: Well, there's... there are many of things, at least, A, there was a promise that it was done, and secondly, Mr. Chief Justice, where that payphone is put, how it is managed, the appearance of the payphone, is it... is it mechanically functioning properly.

This was the promise that was held out... give your money to us, we have thousands and thousands of these payphones...

Chief Justice Rehnquist: This isn't exactly Warren Buffett, though, running around replacing payphones.

Mr. Olson: Well, that's correct, Mr. Chief Justice, and maybe that's the point, that... that the thousands of investors who invested in this type of scheme are the same type of thousands of investors that invest in other types of schemes.

What the Securities Exchange Acts require is that for people who are marketing opportunities to invest widely to the public... and I use the word widely carefully because it doesn't have to be that widely, but it was here... to expect people to provide their money and then to provide a return to put their money to work, that's what the securities laws are all about, to provide that remedial prophylactic purpose of requiring registration so honest transactions will take place in the marketplace.

If the investor could do to... to... to comply with the Eleventh Circuit and say, well, I'm not going to say 14 percent anymore, I'm going to say you're going to double your money every 5 years, or it's going to be a good return, it's going to... it's going to be pie in the sky, you're going to go home and retire, that would all of a sudden make it not an investment contract.

And the very people...

Justice Scalia: But you're... you're saying that it... it somehow remains... does it remain or not remain an investment contract is... if all that you alter is that it was not offered to the public, it's one individual who loans money to this company and the business of this company is with... with payphones, okay, and the deal with him is you will get 14 percent a year back on your...

Mr. Olson: If it's... if...

Justice Ginsburg: on your loan.

Mr. Olson: Mr.... Justice Scalia, if it's the same kind of transaction where I... I'm going to buy this payphone, lease it back to me, I'm going to have a management contract, and you're going to make a lot of money, the fact that it's one person, this Court's jurisprudence says does not make it not that... does not make it not an investment contract.

Justice Scalia: What... what makes it different just from a straight loan?

What makes it different?

The buying...

Mr. Olson: Because it is a... it is...

Justice Scalia: the buying of the phone first or what?

Mr. Olson: It is a... it is a package in which it... in the... in the first place is, I think, Justice Breyer's question suggests it might... that might be a note and that might be a security under certain circumstances.

But is it a... it is the type of scheme transaction in which people invest their money on... for those types of purposes, and... and in... where... where there are difficulties at the margin, this Court and the SEC have provided a formula by which these various different factors can be examined as in the Reves case.

What I was about to say is that to the extent that you change the requirement and allow it to be speculative, the more speculative you can be, the less likely you're required to comply with the securities laws.

That seems like tilting the securities laws completely on their head.

The people that are the least... that are the most risk-averse are looking for guarantees of returns and fixed returns.

The people that depend... that aren't the Warren Buffetts, that depend upon the integrity of the system, are the ones that are going to be most vulnerable if the Eleventh Circuit decision is upheld.

Mr. Chief Justice, I'd like to reserve the balance of my time.

Argument of Michael K. Wolensky

Chief Justice Rehnquist: Very well, General Olson.

Mr. Wolensky, we'll hear from you.

Mr. Wolensky: Mr. Chief Justice, and may it please the Court:

We start with the language of the statute, and that tells us two things.

First of all, commercial leases is not a term included in the statute, and second of all, the term investment contract is undefined.

But over a course of 10 decisions during the past 60 years, this Court has identified the essential attributes of investment contracts.

It has identified those, defined those, and explained those.

One of the essential attributes of investment contracts is a return of profits.

The Court's restrictive definition of profits in the... in the Forman case and then reiterated in the Reves case, captures very effectively the investment risk and investment reward characteristics...

Justice Stevens: Is it your position that no debt security could ever be an investment contract?

Mr. Wolensky: As long as it was a fixed return, that is correct.

Justice Stevens: Well, why it distinguished between a fixed return and an other kind of debt security?

Mr. Wolensky: Well, under the SEC's explanation in its briefs, it refers to a lot of things as fixed returns, which are really just sham, boastful promises by promoters, and I believe that's what takes this situation completely out of what the SEC is proposing.

Both parties here agree that the correct test the Court should apply is the Howey test.

There... we don't disagree on that.

Justice Stevens: And you contend that test would never cover a debt security?

That's my question.

Mr. Wolensky: That is correct.

That test would never cover a debt securities because this Court has defined profits for Howey test purposes to mean an expectation of profits from earning...

Justice Stevens: What would be the underlying reason for excluding debt securities and limiting the coverage of the Act to equity securities?

Mr. Wolensky: Investment risk, Your Honor.

That is the key.

Justice Stevens: Well, there was an investment risk here.

Mr. Wolensky: Well, there really wasn't, because what you have is a commercial lease arrangement, a telephone acts as the collateral, so to speak, to use this Court's words from the Reves case, but you have a commercial lease arrangement like commercial lease arrangements done throughout the country...

Justice Stevens: Well, but this is a leasing arrangement that's really a financing arrangement.

The use of leasing for financing purposes really developed after the Act was passed...

Mr. Wolensky: It did...

Justice Stevens: and this is really a financing transaction.

Mr. Wolensky: It can be characterized that way, Your Honor.

That's correct.

Justice Stevens: Well, certainly the person's return, it didn't depend on what happened in his own phone booth, the one he happened to own.

His... his risk was what the overall enterprise would produce, as I understand it.

Mr. Wolensky: That's absolutely correct, Your Honor, and that is a credit risk, not an investment risk.

Justice Breyer: What's preferred stock?

Mr. Wolensky: Preferred stock is an... has both investment risk, because it can have fluctuating values, some do.

Justice Breyer: So can debt.

Mr. Wolensky: Debt can if there's a market for the debt.

That's correct.

Justice Kennedy: There is.

Mr. Wolensky: But the investor... that's correct... but the characterization of the return to the investor in debt is generally viewed as... as a return, the interest rate, and as far as the market... market...

Justice Breyer: That is preferred stock.

Mr. Wolensky: Preferred stock, but it's a capital appreciation issue and that's not an issue here.

Justice Breyer: So can debt appreciate.

Mr. Wolensky: Well, that's right, but that's capital appreciation and we don't have capital appreciation in this case.

Justice Scalia: What about bonds?

The definition also includes bonds.

The term security means any note, stock, bond.

Mr. Wolensky: That's correct, and a bond is a fixed return instrument.

Justice Souter: It is indeed.

Mr. Wolensky: It's a specifically designated type of security by Congress.

It is not... it does not fall under the investment contract rubric.

It may vary in its value and have capital appreciation...

Justice Scalia: Yes, but... but when some of the things that are specifically listed are fixed return items, it seems hard to credit your contention that somehow the reason investment contracts cannot cover this particular arrangement is because this arrangement has a fixed return.

But... but Congress intended the term security to cover some things that have fixed return.

Why not investment contracts?

Mr. Wolensky: Without question, it did, but Congress and... and this Court has stated very clearly, certainly in the Reves case...

Justice Souter: Yeah, but the Reves case was dictum, and the question here is, are we going to turn that dictum into a holding?

And before we get to a holding I think you've got to answer Justice Scalia's question.

When we have specific examples of... of... of fixed returns, why should the general proposition investment contract somehow be held not to include as a generality a fixed return contract?

Mr. Wolensky: Our position is that investment contract is an equity-type security, and we think that is founded on all of the history and when Congress used the term investment contract...

Justice Souter: Let... let me... I... I don't want to be... be short with you, but I don't think you're getting at what he and I want.

We... we have examples in which the fixed returns securities are specifically listed.

Why... let's be specific... why would Congress have wanted to exclude this kind of a scheme?

Mr. Wolensky: Because...

Justice Souter: It's being marketed as a classic investment scheme.

Why would it have wanted to exclude this one?

Mr. Wolensky: Because this is a... this is a commercial lease.

Justice Souter: Well, it's not a... a normal commercial lease.

It's a... it's a commercial lease of an essentially trivial piece of property, which is replicated thousands and thousands and thousands and thousands of times.

It is marketed on... on the theory that you're going to get an extraordinarily generous rate of interest.

These are... these are not classic sale and lease-back contracts.

Mr. Wolensky: Well, I... I disagree with Your Honor.

I believe it is a legitimate lease.

There's never been a question that it's not an enforceable lease.

There's never been a question that the telephone didn't have the value ascribed to it.

It was fairly valued.

Justice Souter: But it's being marketed not to people who want to go into the lease business, but people who want to invest their money and sit back at home and get at return.

Mr. Wolensky: That may be true, but it cannot be denied that in fact there was a lease agreement.

Every witness who testified or provided a declaration in connection with the case acknowledged that it was a lease.

Justice Souter: Let's assume it is not denied.

Why would Congress have wanted to exclude this kind of fixed return transaction when it is classically being marketed as an investment?

Mr. Wolensky: There were leases that were being used for commercial purposes in 1933.

Lease financing was being used on very significant items then in the railroad area and other areas, but leases are not new, novel, or unusual.

Investment contract was designed, as this Court has said...

Justice O'Connor: No, but as a public policy issue, I have the same question Justice Souter has.

From a standpoint of public policy, why in the world would Congress want to exclude a broadly marketed scheme like this from the definition of investment contract?

Why would it?

It's marketed like other schemes that might have a variable return.

They put all these little phone booths together and it required the management of others to know how to place them and service them and make it work.

It's not something that the... a person acquiring the lease is going to do individually.

I mean, why isn't... why would Congress have wanted to exclude this?

Mr. Wolensky: Justice O'Connor, the... the only answer I can give is because it does not have investment risk.

It's... it is excluded from the term investment contract because it doesn't have investment risk.

All of the pre-33 Act cases...

Justice O'Connor: Well, I suppose it does from the standpoint of the management required to make this scheme work.

Mr. Wolensky: Well, that's a credit risk...

Justice Scalia: Anybody who was investing in... in payphones in the era of the... the satellite was taking an investment risk, I would think.

Mr. Wolensky: Well, when the...

Justice Scalia: Like the buggy went just before the horse... just before the automobile.

Mr. Wolensky: Justice Scalia...

Justice Breyer: Must mean something special by investment risk.

You must not mean what we ordinarily mean because I think your investors don't feel that way.

So what do you mean by it?

When you say no investment risk, you know, we're all reacting this way because it seems so obvious to us, anybody who invested money in this has now lost all his money, so it must have been pretty risky.

So... so I... you must mean something special by it.

If you do, I want you to explain it.

Mr. Wolensky: Well, the... the money that was lost was lost as a result of a bankruptcy and what occurred in the bankruptcy, but when the bankruptcy was filed, these phone owners still owned their telephones and they were still entitled to their lease payments.

That was dealt with in the bankruptcy and the details of that are not involved in the record here but in... there's a... a significant difference between investment risk, which this Court characterized in Forman and recognized from the VALIC case, is a matter of fluctuating value generally.

When you look at credit risk you're...

Justice Stevens: I'm sure you don't think a person who buys a bond doesn't take an investment risk.

Mr. Wolensky: A person who buys a bond takes a credit risk, not an investment risk.

There is a difference, and I believe...

Justice Breyer: There's a significant...

Justice Stevens: You think buying a... a whole portfolio of bonds is not an investment?

Mr. Wolensky: Well, it... it is an investment, but it... it is not the type of investment risk that you see in fluctuating values securities or equity securities.

Justice Souter: Have you ever held a bond when interest rates were going up?

Mr. Wolensky: I... I agree...

Justice Souter: You would have learned what an investment risk was.

Mr. Wolensky: Justice Souter, I agree that bonds can fluctuate in value and that deals with a capital appreciation...

Justice Souter: Which means that it is more than a mere credit risk.

Mr. Wolensky: To the extent you were looking to the bond to return a value and... and hold it for purposes of changing value, it theoretically could.

Justice Souter: And anyone who buys a bond with the possible expectation of selling before maturity assumes exactly that.

Mr. Wolensky: They are going to face that risk and that... that is, in fact, an investment risk.

But the key here, it seems to me, is the fact that you do have a lease agreement, that is what it is involved here.

It is a legitimate lease agreement.

It is like any other equipment lease agreement and it is going to be dealt with under State law.

There is also a significant issue here with respect to the coverage of other regulatory agencies.

We have in fact Federal Trade Commission coverage here.

There's no question about that.

It is involved...

Justice Ginsburg: Mr. Wolensky, you don't challenge, do you, that under State Blue Sky Laws, this distinction between variable and fixed return is not made, that State Blue Sky Laws treat as investment contracts... do not draw the line between fixed and variable returns?

Mr. Wolensky: The... the challenge I make is that before 1933 the State Blue Sky Laws that were... cases that were incorporated and mentioned in Joiner and in Howey were variable return cases.

I disagree with the SEC on the two cases.

Justice Ginsburg: Do you agree that there are a body of cases under State Blue Sky Laws that involve... maybe some of them even involve these payphone schemes... but that have fixed and not variable returns?

Mr. Wolensky: As of today, that is correct.

That is what I see in the amici brief and I have no reason to question that.

The way the law has developed under State law, it would include fixed returns, that's correct.

Justice Ginsburg: So why, if this notion of an investment contracts comes out of State Blue Sky laws and we are told that the one thing in this area, because schemes are invented every day, is that... that the interpretation should be flexible, not static, to meet the countless and variable schemes devised by those who seek the use of money of others?

Mr. Wolensky: Justice Ginsburg, this Court has... has repeated that over and over.

I will agree with that, but the Court has talked about new, novel, and unusual schemes.

There is nothing new, novel, or unusual about lease agreements and commercial leases, and what you have to focus on here is what the Court has said.

It has given guidance.

It has said that unanimously... it may have a been a footnote in Reves, but certainly...

Justice Ginsburg: But when the issue isn't in the case, what a court says in a casual footnote, when the case had nothing to do with fixed versus variable returns.

I mean, yes, the Court made it used in cautious languages, but we... but in none of the cases that came here was the question, do you draw the line between fixed and variable returns?

In the case that... that you featured... you call it Forman or United Housing... there it was a question of investment versus consumption.

Did you buy this thing to sit back and get money from it or did you buy it so you could live in the house?

That was the distinction that was before the Court in this case.

I don't know any of our cases that... that drew the line between... that where the issue was before the Court.

Mr. Wolensky: Justice Ginsburg, in Forman, the Court had to address the issue of whether there was an investment contract involved, and it stated what I would call the Forman formulation of profits in connection with doing that analysis on the three types of profits that allegedly... or that had been found and allegedly were present in the Second Circuit decision, and it applied that formulation to each one of those.

So it was...

Justice Ginsburg: But it did... but the case was not about equity versus debt classification.

It was about whether you were attracted... whether you were attracted to purchasing the shares by a desire to get a financial return or were you attracted because you wanted a place to live.

That's what... that's the two questions... that was the dividing line that the Court was dealing with there.

It wasn't dealing with equity versus debt.

Mr. Wolensky: That is correct, Justice Ginsburg.

And then in Reves, it was dealing with the distinction between equity and debt.

Justice Kennedy: Well, but in... in Forman there was no distinction between fixed and variable income.

Mr. Wolensky: It was not, but when you read the... Justice Kennedy, when you read what the Court said in Forman, it's talking about an expectation of profits or capital appreciation, and those are two variable forms.

They're not... they're not fixed.

They necessarily vary with the marketplace.

If I can finish answering your question, Justice Ginsburg, with respect to Reves, there was a distinction, a very specific distinction there, between fixed and... and variable.

That's what that case was about, investment contract versus note.

And the Eighth Circuit had decided that the investment contract case of... that the investment contract test of Howey would apply to notes.

There were a series of tests and this Court used the Reves opinion to... to go through those and decide, and it came up with a family resemblance test that had been used by the Second Circuit.

In the footnote in Reves, it is very clear that what the Court is doing is distinguishing and explaining why Howey does not apply to notes, which are fixed instruments.

I think it is not just a passing reference and it... it was unanimously stated that...

Justice Ginsburg: But I thought that... I thought that the meaning of investment contract was not at issue in Reves.

Mr. Wolensky: The meaning of investment contract was not at issue, but distinguishing investment contract was at issue in Reves, and explaining why it was not applicable in that case.

The parties briefed the issue, the SEC briefed the issue as amicus took the same position it... it has taken here, and the Court in Reves said that is not the position we accept.

Justice Scalia: And it's... it's taken that position for a long time, Mr. Wolensky.

It's not just the case law that you have to contend with, it's also... this is after all an administrative law case.

The meaning of investment contract, you must admit, is at least ambiguous, and the SEC has taken the position it's taken here for a very long time.

Mr. Wolensky: Well, if I can address...

Justice Scalia: Why shouldn't we defer to the F... SEC's judgement about the matter?

Mr. Wolensky: If I can address that for just a moment, Justice Scalia...

Justice Scalia: That's why I asked the question.

Justice Breyer: I hoped you would.

Mr. Wolensky: [Laughter]

Mr. Wolensky: Thank you, sir.

With respect to the very long time, if you go back to the case the SEC has pointed to a number of times, the Universal Service case from 1939 in the Seventh Circuit, when you... and the SEC talks about its position in that case... its position in that case was stated in its brief in that case, and when you look at its brief in that case, it recognizes that it is not dealing with a fixed return as we would talk about it.

In fact, in the brief, the SEC says the amount ultimately credited to the contributor's account, the amount itself being dependent upon the degree of success attending the venture... and I'm reading from pages 39 and 40 and footnote 10... with respect to the Abbett, Sommer case, which is a 19... I believe 62 decision... by the SEC, the SEC admitted in Abbett, Sommer that it wasn't looking at traditional profits analysis.

That was a mortgage loan servicing case and they said that what was being offered there was not just the repayment on the notes but also the services, and they found that the reduction of risk in that case was the... basically the profit.

So they departed from what is a normal profit analysis and that's freely admitted.

In the interpretative release they've issued, the multi-level release under the 33 Act, number 5211, in there the SEC admits that Howey is an equity-type test.

They specifically say that.

So I think that when you look at the history of what this Court has done and what the SEC has done, when you get to... when you get to Reves and when you get to Forman, it is... there's no ambiguity left as to what is meant by profits at that point.

So I think a position...

Justice Ginsburg: I think there is.

I think that in United Housing itself they spoke about profit may be derived from income yielded by an investment, income yielded by investment.

That doesn't say income from earnings.

Mr. Wolensky: That is correct, but in the very same area of the opinion is where the Court says by profits in the Howey analysis, we have meant a participation in earnings or capital appreciation, citing the earlier cases.

Justice Ginsburg: They said that in one place.

They said financial returns in another place.

They said income in another place.

Maybe they were so incautious about the precise use of those terms because they were focusing on an investment purpose versus a... a utilitarian purpose.

Mr. Wolensky: I would agree with that, but the fact that Reves concluded what it did about Forman's requirements would tend to show that that's really what Forman required.

The... the court of appeals, of course, was not free to disregard what was a unanimous statement by this Court.

This Court obviously can change its opinion or change its view, but there is no compelling reason to depart from what has been accepted for 25 years.

Other courts of appeals...

Justice Ginsburg: Well, why isn't there, when the SEC... let's assume that you're right about that the SEC was never crystal clear about its position.

But now it says, we've looked at these schemes, payphones is a good one, a lot of elderly people are investing in these schemes because they promise a fixed return and that sounds secure to them, better than variable out of earnings and profits, so this is exactly what we should be protecting the public against.

If the SEC takes that position clearly now and you're dealing with a statutory term that's in a line, some of the things are equity, some are debt, and in the middle is this term investment contract.

Why should we tie it to variable versus fixed?

Mr. Wolensky: Justice Ginsburg, because this Court has said more than once, every fraud is not a securities fraud.

There are other avenues of protection.

There are several risk-reducing factors involved in these leases.

The leases themselves are covered by State law in the Uniform Commercial Code.

There's other regulatory coverage, other agencies.

In fact, some of the State agencies that filed amici briefs here have indicated that they believe they have coverage of those.

So the fact that the Federal securities laws might not cover this doesn't mean that there's not going to be protection of the public.

The consequence, and I think it's an important consequence that the Court has to be aware of here if it agrees with the SEC's position, is that every equipment lease can be brought under the rubric of Howey if...

Chief Justice Rehnquist: Why, why, why?

Justice Breyer: That's not...

I mean, there are all kinds of other criteria, you know.

I mean, you have to be putting up money, it has to be... if it is a big market... scheme marketed to the... to the public like this, yes.

But if it isn't, if GM happens to buy some... a railroad car from one of its suppliers, I would think the answer's no.

But there are a lot of other criteria, so why everyone?

Mr. Wolensky: Well, the... it is not in the record but it is public knowledge and information that is available that some $200 billion of equipment leasing occurs every year, and it... equipment leasing involves everything from telephone systems to computers, office equipment.

It is a very, very large industry.

If that applies to this large industry...

Justice Breyer: You'd have to be passive, you'd have to... you'd have to treat it as an investment.

I doubt that most of that leasing is really that, but I mean, my point is, aren't there dozens of other criteria that you have to satisfy, not just this fixed variable one?

And that's a serious question.

I'm interested.

Mr. Wolensky: Well, on... Justice Breyer, there are... there essentially are four criteria that the... that the SEC would say you have to apply: an investment of money... and this Court said in Daniel that investment of money doesn't just mean money, it can mean services, it can mean assets

That's why we say in analyzing this it doesn't matter whether you bring your phone to the agreement or money to the agreement, but if you put equipment into a lease arrangement, you have an investment...

Justice Breyer: Invest money may itself refer to the thousands of public people who simply want to give money to an enterprise in contrast to General Motors that rents a railroad car as part of its business.

Mr. Wolensky: I can contrast that and agree with you that in General Motors, renting a railroad car is part of its business.

It is not going to be probably found to run afoul of the securities laws.

Justice Breyer: So what is the example of the bad thing that happens when we agree with the SG?

Mr. Wolensky: General, broad, small item equipment leases will be covered by the Howey test.

Justice Breyer: The people who are not themselves in business, by people who are not themselves in business or by people who are themselves in business?

Mr. Wolensky: Well, whether they're in business or not in business the securities laws would still cover them and I don't believe there's an exemption that would be available for the ordinary business.

Justice Souter: Why... why isn't your argument equally applicable to notes?

We've been through that in Reves.

I mean, you could have argued in Reves, my God, are you going to cover every note.

You're making the same argument here with investment... investment contract, aren't you?

Mr. Wolensky: Well, not necessarily.

I think the Court did set forth some very specific criteria in Reves.

The family resemblance test exempts out commercial notes that have credit risk and not investment risk.

Justice Souter: Justice Breyer has just been applying a family resemblance test to exclude General Motors' boxcar.

Why isn't that sort of thing just as feasible under investment contract as it is under note?

Mr. Wolensky: It is, and if you... if you look at the criteria the Court looked to, I think you will see that several of the criteria that this Court has talked about indicate that this would not be covered.

I believe it is... it's not specifically related, but the Court noted four criteria, and if you apply those criteria, I think you find that they in fact...

Justice Breyer: You've come to this quite late, but I mean, it seems to me that there are other words besides working with the nature of the fixed or variable return that will draw the kind of line that you think... and I guess I would think... you should draw between an ordinary business, sale and lease-back so they can carry on their business, and some kind of general marketing to the public.

And I'm actually quite interested in that.

You've written about it, though, and I'll get it out of the briefs.

Mr. Wolensky: We have and... and I was... have been trying to address the question that was presented although we felt a different question was involved.

This Court for 60 years has set a jurisprudential standard for investment contracts and while the courts work on the habits of people, people work on the habits of courts.

There are lines that have...

Justice Stevens: In those 60 years we've never said that a fixed return can never be an investment contract.

Mr. Wolensky: That is correct.

You've never explicitly said that, but by never explicitly saying that, that doesn't mean that it necessarily is covered.

The decision of the court of appeals followed this Court's precedents.

It was correct and it should be affirmed.

Rebuttal of Gen Theodore B. Olson

Chief Justice Rehnquist: Thank you, Mr. Wolensky.

General Olson, you have 4 minutes remaining.

Mr. Olson: Thank you, Mr. Chief Justice.

I will try to make just three points.

One, this is about securities.

The statute, which is extraordinarily broad, says note, stock, treasury stock, fractional undivided interest in oil, gas, mineral rights, straddle, option.

It's... there... it would be difficult to draft the statute that was intended to be more all-inclusive than the words used in these two provisions of the 33 and 34 Act.

It is manifestly clear that Congress wanted to cover the waterfront, as this Court has said, everything that looks like a security, and wanted to cover the whole range from pure equity, if there is such a thing, to pure debt, if there is such a thing.

It would be... and then they put catch-all provisions.

If the... if the words didn't cover it, there were catch-all provisions, investment contract is one.

It would be irrational for Congress to say, well, we've got a catch-all for those... from A to Z... that go from A to H that look more... look like equities, but not S to Z that look more like debt, and then we're don't... not sure about the ones in the middle.

The purpose for the catch-all provision is to catch all.

That is what this investment contract was.

Secondly, just two of the cases that were attempted to be distinguished by my colleague, People v. White, he said that did not involve a fixed return.

Well, the language of the case... this is in 12 P. 2d at 1081... the individual promised to spay... pay... a specified sum on a specified date as principal and earnings for the stated period of time upon the investment.

That's pretty much identical to what we have involved in this case.

And in the Securities and Exchange Commission v. Universal Services, another one that my colleague referred to, page 234 of 106 F. 2d, at the end of 5 years there would be returned to each member an amount equal to total contributions plus 30 percent per annum.

Now, this case is 14 percent.

The argument's that being made by the respondent here is an argument that the Blue Sky... a distinction that the Blue Sky Laws don't make.

Congress did not make this distinction.

The Court has never made this distinction.

It conflicts with 70 years of consistent SEC enforcement.

It is squarely inconsistent with the notion of a broad, flexible, remedial purpose of the securities statutes.

It would make no sense, would create a gigantic loophole where individuals, by changing the terms of... from pie in the sky to 14 percent, and they would do that immediately, and Congress would have to deal with it in a way the Congress has already dealt with, and there is no reason to change what they... what the law has been, and the Eleventh Circuit decision should be reversed.

Chief Justice Rehnquist: Thank you, General Olson.

The case is submitted.

Justice O'Connor: The honorable court is now adjourned until tomorrow at 10 o'clock.

Attribution:

The Oyez Project

Featured:

SEC v. Zandford - Oral Argument

Fri, 09 Jan 2009 14:50:22 +0000

Case:

SEC v. Zandford

Media File:

01-147_20020318-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Matthew D. Roberts

Chief Justice Rehnquist: Mr. Roberts.

Mr. Roberts: Mr. Chief Justice, and may it please the Court. Stockbrokers like the respondent are the critical link between the National Securities Markets and individual investors who trust brokers to buy and sell securities for their benefit.

Respondent betrayed that trust by selling his customers' securities not for their benefit, but for a secret purpose of misappropriating the proceeds and by embezzling the proceeds as he had planned.

In so doing, Respondent violated Section 10(b) of the Securities Exchange Act and Rule 10b-5.

Those provisions prohibit the use of fraud in connection with the purchase or sale of any security.

Respondent--

Justice Scalia: Mr. Roberts, could you clarify for me what the government's position is in this case?

Suppose... suppose that the broker had not, when he sold the stock, intended to embezzle but then he made the sale and the sale enabled his embezzling.

After selling it, he conceived the scheme to embezzle.

Is it the government's position that in that situation a 10(b) would still cover it?

Mr. Roberts: --That embezzlement would not be in connection with the prior sale under the theory that we are asking the Court to adopt here.

But the SEC believes that it would be a violation of 10(b) under a different theory which isn't a necessary consequence of the one--

Justice Scalia: We don't have to agree with that to rule for you--

Mr. Roberts: --You don't have to agree with that to find a violation here.

Justice Scalia: --Now, the SEC adjudications that you rely upon, what kind of a situation do they involve?

Do they all involve--

Mr. Roberts: They involve both situations, Your Honor.

Justice Scalia: --Both situations.

Mr. Roberts: Both situations.

Justice Kennedy: Does the SEC routinely audit brokers' accounts or do spot audits to ensure compliance with the theory you are suggesting here or are they just reactive when they find out about a firm?

Mr. Roberts: I am not aware that they routinely audit the brokers.

The NASD does do that and then refers matters to the SEC and consults with the SEC.

The SEC also would respond to complaints that they got or take investigations if they had reason to believe it was called to their attention.

Justice Kennedy: And I take it that if the NASD tells the SEC of the existence of a fraud, the SEC can then request the United States Government to prosecute if there is a wire fraud or--

Mr. Roberts: They could request a prosecution, Your Honor, but it's important that the SEC is the federal agency that's charged with maintaining the integrity of the markets and investor confidence in the markets, have direct authority to prevent and to pursue the kind of fraud that's involved here which is very... potentially very unsettling to the markets.

Because since most transactions are made through brokers, if customers and investors can't trust their brokers to be executing their transactions for the customer's benefit rather than for the broker's benefits, the markets can't function effectively.

Chief Justice Rehnquist: --Well, do you say then that any fraud by a broker in connection with a customer is actionable by the SEC.

Mr. Roberts: That goes back to the question that Justice Scalia asked me, Your Honor.

And under the theory that we are advocating here, and for the Court to rule for us here, you don't need to conclude that.

The SEC does take that position.

Chief Justice Rehnquist: Does take what position?

Mr. Roberts: That any fraudulent conversion by a broker from a brokerage account is a violation of 10(b) because it's fraud and it's in connection with the purchase or sale of securities; because the very purpose of the brokerage account is to buy and sell securities.

And the broker has access to the customer's assets--

Chief Justice Rehnquist: That's quite a leap--

Mr. Roberts: --for the purpose of--

Chief Justice Rehnquist: --That's a leap from any case we've ever decided.

Mr. Roberts: --That is beyond any case that I'm aware that you have decided.

But here the broker actually converted the securities by means of fraudulent sales.

And his deception not only caused the sales, it was material to the sales.

And the sales themselves, because they were fraudulent, coincided with and completed the fraud.

And that's very much in tune... that's really controlled by past cases of the Court.

For instance in the Bankers Life case, the Court held that corporate fiduciaries violated Section 10(b) when they deceived the corporation into believing that it would receive the proceeds of the securities that the corporation sold.

Chief Justice Rehnquist: But there were misrepresentations about a particular security.

That didn't happen here.

Mr. Roberts: There wasn't a misrepresentation in Bankers Life about a particular security, there was a misrepresentation that the corporation would receive the proceeds.

And there was that same misrepresentation here, Your Honor, only it was by way of an omission or a course of conduct rather than an affirmative statement.

Because the customers had entrusted Respondent with the authority to trade on their behalf, with the understanding and the implicit representation that he would trade on their behalf and that they would receive the proceeds of the sales, that they would be used for their benefit in other trades when--

Justice Souter: So in this case the fraud could have been avoided under your theory if the broker had gotten in touch with the clients and said I'm going to sell this but I'm going to use the money for myself.

That would have turned it from fraud under 10(b) into theft.

Mr. Roberts: --That would have turned it from fraud into theft.

It would have also been a breach of his fiduciary duty if he went ahead and they didn't authorize him.

But just like in O'Hagan--

Justice Souter: But it wouldn't have been fraud.

Mr. Roberts: --It wouldn't have been fraud if there was no deception.

It's critical to a 10(b)e violation that there be deception of some kind.

Justice Ginsburg: Mr. Roberts, there's one point in your reply brief that I didn't quite grasp.

This action is brought by the SEC.

Mr. Roberts: Yes.

Justice Ginsburg: And it hinges on the wrong that was done to the customer.

Could the customer bring this very lawsuit, could the customer have sued the broker for a 10(b) violation?

Mr. Roberts: In this circumstance, yes, the customer could have brought a private action against the broker, Your Honor.

That wouldn't be true in every circumstance because the customer, a private plaintiff seeking damages has to prove elements of a violation in addition to what the SEC must prove.

A customer has to show causation of the transaction and loss or damages to the customer.

The customer also has to be an actual purchaser seller.

In the situation where there's a sale by the broker of the customer's securities, the purchaser-seller requirement will be met.

But there might not be the damages that are necessary unless the broker follows through with his scheme to misappropriate the proceeds of the sale.

Justice Ginsburg: But this time he did.

Mr. Roberts: But he did.

Justice Ginsburg: There's another curiosity in this case.

There was a prosecution for wire fraud, the restitution sought was $10,800.

And now the SEC is going after the broker for a much larger sum.

Why wasn't a greater sum asked in the wire fraud case?

Mr. Roberts: I don't know, Your Honor, why the restitution award in the criminal action was limited to $10,000.

But it's clear that Respondent, it's clear from the allegations in the complaint and also from the criminal trial that Respondent did embezzle far more than that amount of the Woods' assets.

And that's one of the reasons that it's important for the SEC to be able to pursue this action.

Because if it had to rely on the criminal action, then there wouldn't be a full disgorgement of the improper gains by the broker.

And there would be far less deterrent to this kind of activity.

Of course a criminal prosecution is significant deterrent, but--

Justice Scalia: Mr. Roberts, did the allegations of your complaint in this case accord with the narrower theory that you now say is enough to decide this case?

That is to say, as I read your description of the complaint, it did not say that the sales of the security were made with the intention at the time the sales were made of absconding with the proceeds.

All it said is that he sold the securities and stole the funds.

Mr. Roberts: --It does... it does comport with our theory, Your Honor.

It doesn't in so many words allege the intent at the time.

But the factual allegations in the complaint necessarily give rise to that inference.

Because, first, one of the allegations is that Respondent issued checks to himself on the mutual fund account and that the cashing of those checks caused the sales.

And so when he took the money, he necessarily by writing the checks to himself, he necessarily had the intent at the time.

And then there are additional allegations--

Justice Scalia: Wait.

Excuse me.

He wrote the checks before the sales were made?

Mr. Roberts: --In the... in the mutual fund checks, if you look at Page 28A, of the petition, in paragraph 16 of the complaint, it describes the beginning of the fraudulent scheme in May of 1988, shortly after Mr. Wood was hospitalized as a result of his stroke, and notes that between May and June 1988, Zandford, without the prior knowledge or consent of Wood and Okstulski, issued three checks to himself totaling $41,000.

The checks were drawn on a joint mutual fund account held by Wood and Okstulski outside of their Dominick account, and the funds represented therein were obtained through the sale of mutual fund shares--

Justice Scalia: It doesn't say they were later obtained.

It just says they were obtained.

I don't see that that says that the funds weren't there until the... until the checks were written.

Mr. Roberts: --I think the way that that kind of account works is that it's like a checking account with your mutual funds.

You write the check, you write the checks on the account and the redeeming of the check causes the sales of the mutual funds.

But regardless of whether it precisely states that, that's certainly a reasonable inference or facts that can be proved based on these allegations which is all that's necessary to get past the dismissal of the complaint, Your Honor.

And in addition on the other allegations on the next page and the paragraphs on the next page, there are description of repeated sales and repeated conversions over a long period of time.

And, you know, one time maybe he formed the intent after the sales, although that's unlikely given that this happened after the allegations in the previous paragraph.

But 13 more times, Your Honor, I think that it's hard to believe.

Justice Ginsburg: Who gets the recovery, Mr. Roberts?

Mr. Roberts: The recovery goes to the... to the government, but the SEC has a policy of if there are identifiable victims to endeavor to give the victims those... those funds and to make them whole if they are available.

So here where there are identifiable victims, they would do that.

Chief Justice Rehnquist: Well, isn't it a little odd, you have two different branches of the government, perhaps not branches, but two different proceedings, one a criminal proceeding which authorizes restitution.

And in that proceeding the decision was made that $10,000 would be allowed, awarded in restitution.

Then the SEC comes along and says, no, that wasn't enough.

We want to get, you know, several hundred thousand more.

Mr. Roberts: Well, the restitution, first of all, the purposes of restitution and disgorgement are different in that one is aimed on the... is focused on the making whole the loss to the... to the people that are injured, whereas the other is aimed at requiring the wrongdoer to disgorge any benefit that he got from the scheme.

But in addition, Your Honor, the statute provides for a civil action and gives the SEC the power to do that in order to further its role in ensuring the integrity of the markets and ensuring investor confidence in the markets.

And it empowers the SEC rather than the individual U.S. attorneys to determine when it's necessary to ask for that kind of a remedy in order to further those purposes.

And the SEC properly made that determination, made that determination here.

Justice Kennedy: Well, just to explore the point, is there anything in the record to show that these victims lost only $10,000 and that the broker just made all the rest by churning--

Mr. Roberts: No.

Their record I think establishes that they lost everything that they had entrusted to him which was 420 roughly, thousands of dollars' worth.

Justice O'Connor: --Mr. Roberts, isn't it the case sometimes in criminal proceedings where restitution is ordered that full restitution is not ordered for a variety of reasons, the victim's family... the defendant's family may have certain needs and the Court may decide, well, I'm just going to order a limited amount of restitution.

Does that happen sometimes?

Mr. Roberts: Yes, that certainly happens, Your Honor.

Thank you.

Chief Justice Rehnquist: And if the family has needs, the SEC doesn't have to worry about it, I take it?

Mr. Roberts: Well, the SEC does its own balancing of what's appropriate to further the interests and it asks for a disgorgement which is an equitable remedy.

And the Court takes into account those concerns in deciding whether to award it.

And here the District Court did determine that it was appropriate to award disgorgement in the amount of $343,000.

Justice Ginsburg: It is odd that there was no kind of, apparently no cooperation here, that the criminal case goes on for that limited amount and then the SEC comes in after.

Don't the relevant prosecutors talk to each other in advance about a case like this?

Mr. Roberts: Yes, they do talk to each other.

But the decision, Your Honor, whether to bring the prosecution and what to charge and what to ask for is the decision of the prosecutors, whereas the decision of what is appropriate to pursue as a civil action in order to further the purposes of the securities laws is the responsibility of the SEC.

And if the two arms don't necessarily agree that that can all be done in a criminal proceeding, then sometimes a civil proceeding is necessary to accomplish the goals and--

Justice Scalia: The SEC is an independent regulatory agency, isn't it?

Mr. Roberts: --Yes, it is.

Justice Scalia: So it's not within the control of the President?

Mr. Roberts: Um--

Justice Scalia: So if the Justice Department disagrees with the SEC, the SEC can still go off on its own.

Is that the way the scheme works in theory?

Mr. Roberts: --Well, in theory, Your Honor, yes.

Although here in the Supreme Court the Solicitor General represents the SEC.

And in order for the SEC to come here, the Solicitor General has to authorize the action.

Justice Ginsburg: Is there any limit, if we have a broker, a licensed broker, is there any limit at all or just any fraud by a licensed broker falls within 10(b)?

Mr. Roberts: Well, again, I'd like to reiterate that to decide this case and under the theory that we are advancing here, you don't need to reach that.

But even under the other theory that I alluded to, there are limits to what would be covered.

For instance a broker could defraud customers by convincing them to pursue an investment advisory relationship.

And that would not be... that would not necessarily be covered.

In addition, the broker might defraud the customers of assets that are outside of the brokerage account and that aren't securities because the broker has developed a relationship of trust with the customer.

That wouldn't be covered under the other theory.

In addition, the broker, I guess it's a similar thing, the broker could defraud the customer into making some other kind of investments, real estate investments, because of the relationship of trust that had developed.

But the SEC has consistently taken the position that with regard to brokerage accounts and the brokerage relationship that involves the purchase or sale of securities and that exists for the purpose of the purchase or sale of securities, that it is a violation when the broker defrauds its customer.

Justice Ginsburg: Suppose the... suppose Zandford were not a licensed broker, he just was pretending to be a broker but he wasn't at all.

He went to these people and said, I'm a broker, give me your money; and the same thing happened?

Mr. Roberts: That would still be... and then he... they gave him the money and he purchased securities and then sold the securities?

Justice Ginsburg: Yes, but he's not licensed to sell any.

Mr. Roberts: That would still be a violation, Your Honor, because he would have the same fiduciary relationship with them by virtue of them making him their agent for securities transactions and entrusting their assets to him to engage in securities transactions.

And when he sold for the secret purpose of misappropriating the proceeds rather than for their benefit, and he did not disclose that he was doing that, he would be deceiving them in connection with the sale of securities, just as Mr. Zandford did here.

And that would be a violation under these circumstances.

If there are no further questions, I would like to reserve the remainder of my time for rebuttal.

Argument of Steven H. Goldblatt

Chief Justice Rehnquist: Very well, Mr. Roberts.

Mr. Goldblatt, we'll hear from you.

Mr. Goldblatt: Mr. Chief Justice, and may it please the Court: We do not dispute, I don't think it can be disputed, that this conduct obviously is covered by any number of laws, civil, criminal, state, federal, the rules of this self-regulatory organization, and the Court below recognized that as well.

But it treated the question of whether or not Mr. Zandford was also liable under Section 10(b) as a different question requiring a specific proof.

And it is that proof that the Court found wanting.

In that regard, I think it's also important that one of the pivotal factors in our theory of the case was that this was a discretionary account.

And the SEC was relying on the bare facts alleged in the wire fraud indictment to prove its case.

And under those circumstances, there was no investment decision being made by the victims in this case.

And we argued to the Court below and we submit to this Court that that's a pivotal distinction in 10(b) context.

Because 10(b) deals with investment decisions.

And if no one is being defrauded in the decision they are making as to the purchase or sale, all that leaves the SEC with in this case is the conversion of the proceeds.

Chief Justice Rehnquist: Well, the District Court granted summary judgment in favor of the SEC as I understand it.

Mr. Goldblatt: That's correct.

Chief Justice Rehnquist: And the Court of Appeals reversed and in effect granted summary judgment for Mr. Zandford.

Mr. Goldblatt: That's also correct.

Chief Justice Rehnquist: So you have to take the allegations in the complaint as true at that point I think, don't you?

Mr. Goldblatt: Mr. Chief Justice, we don't think so, because those allegations were not being considered by the Court of Appeals.

I think the SEC at various points has indicated in its pleadings that the facts alleged in the indictment were the same as the complaint, and that may have caused part of the problem.

But the only facts alluded to by the Court of Appeals as you indicated is in effect granting summary judgment to the non-moving party.

In that regard, there's no reference at all in the opinion of the Court of Appeals referring to any of the facts in the complaint.

They refer to the indictment.

Chief Justice Rehnquist: Well, should there have been some reference to the facts in the complaints since they were about to render summary judgment against the SEC?

Mr. Goldblatt: That may well be the case.

The problem we have with that is the question of issue preservation.

When the SEC petitioned for rehearing, ordinarily... in the ordinary case, if you reverse an order granting summary judgment, you obviously don't grant summary judgment to the non-moving party; you remand for further proceedings.

But when the SEC moved for rehearing and rehearing en banc, it did not raise the issue with the Court as to why it had remanded with instructions to dismiss.

So on this record you really don't know what the reasoning of the Court of Appeals was.

Justice Ginsburg: But wouldn't they have to, Mr. Goldblatt?

This... a complaint to be thrown out when there's been nothing beyond the complaint doesn't... mustn't you listen to the facts as pled in the complaint?

Mr. Goldblatt: Justice Ginsburg, my point is, is that the question that I think that is presented in this case is whether the SEC by its own actions limited itself to the facts asserted for purposes of summary judgment which were the facts in the indictment.

Now, if the Court of Appeals is operating under the assumption that that was their case, it could, if that was their case and it was clear that was what it had to consider, if it concluded those facts were insufficient as a matter of law, that would be the only rationale in light of its opinion which only considered the facts in the indictment.

Chief Justice Rehnquist: But the government's petition here sets forth some facts.

The stockbroker sells his customers for his own benefit.

And so it... and in your brief in opposition you didn't challenge that question, did you?

Mr. Goldblatt: Yes, I did.

Chief Justice Rehnquist: You did?

What did you say?

Mr. Goldblatt: I challenged the... in our brief in opposition, we challenged any consideration of any facts beyond the indictment, that any issue with regard to facts in the complaint were not before the Court of Appeals and were not relied on by the SEC.

Chief Justice Rehnquist: But that just seems weird in a way.

I mean, this is a civil action.

And to insist that it be tried on the facts and an indictment in the criminal case as opposed to as alleged in a complaint in this very case seems odd.

Mr. Goldblatt: I absolutely agree.

But the question is not so much whether that was of the making of the Court of Appeals or whether that was of the making of the SEC.

And I think it was the Court's understanding that that was the SEC's position, that they were narrowing themselves to the indictment, and that's what the Court considered.

But regardless, even with the facts, I mean, if I'm wrong on that, regardless of the facts even with the facts that the SEC relies on from the complaint, you essentially have the same problem.

And again, it's not a question of whether this conduct is covered.

It's covered under the broker rules.

But for purposes of 10(b) as the SEC now concedes, this would also affect private actions.

And in that regard, these facts simply do not meet the paradigm for a 10(b) violation which is either that somebody is duped into buying or selling a security, a particular security, because that's the paradigm for the statute, or in limited circumstances such as a case like O'Hagan, where it affects market integrity, the Court has also found liability.

But that's in a situation--

Justice Kennedy: Suppose that the customer comes to the broker and says, here's 100 shares of the ABC Company, sell these shares for me and put the money in your broker account.

And the broker, before he sells, has the intent to take the money for the broker's own account.

Is there a fraud under your theory?

Mr. Goldblatt: --Under that theory, I would submit there is a fraud.

That is unauthorized to take the money in that situation and he's duped into turning over the securities to the broker, and there is an investment decision being made.

But you have a particular--

Justice Kennedy: No.

No.

He's made the investment decision in my hypothetical.

He said, I don't want your advice about selling.

You sell these things.

I'm directing you to do that.

Mr. Goldblatt: --In that circumstance, if he then sells the security and places it in the account, then he has completed the instructions.

But if he sells the security and converts it to his own use, then I believe you don't have in that situation, in other words, if those are the instructions from the client to the broker... I correct myself.

That would not be a 10(b)e violation.

It will be a violation of the broker rules.

It will be a conversion.

It will be a criminal act.

But there will be no fraud.

He will have carried out the instructions to sell the stock.

There's no inducement there to sell--

Justice Kennedy: Well, only in really a Pickwickian sense of the term.

He carried out the instructions to sell the stock but he keeps the money.

Nobody would construe the instructions that way.

Mr. Goldblatt: --Understood.

But nor were... the instructions were to sell the stock.

He is not being duped into selling the stock.

That is exactly what he wanted done.

What he's being duped into is the proceeds are being converted.

But the difference with Bankers Life is that the 10(b) violator in that case actually goes to the person and says we should sell this, with the intent of diverting the proceeds.

That person is duped into believing by the actor that they are making the sale with the understanding that they will get the proceeds.

Again it... for purposes of--

Justice Breyer: How does that differ from here?

I thought here that what our facts that we are assuming are that the stockbroker says to the client, I have control of your account and I'll sell for your benefit.

That's the implicit instruction.

The client says sell for my benefit.

And here the stockbroker sells for his own benefit.

What's the difference between that case which is this one, and the one Justice Kennedy is putting?

Mr. Goldblatt: --I think the difference is for purposes of the 10(b) paradigm it requires that the sale be induced by the broker for fraudulent reasons.

If all he's doing is converting the proceeds--

Justice Breyer: But here we also have, as they have emphasized about 50 times, not simply stealing.

What we have is a sale of stock where the stockbroker has the intent when he sells the stock to keep the money, contrary to what the implicit assumption is about what the client wants.

Now, that seems to be a little extra thing here so we don't have to reach all these broad issues.

Now, what do we... that's what I find indistinguishable.

Mr. Goldblatt: --Justice Breyer, here is the distinction that I would draw.

In the Bankers Life situation where you have the sale induced, the 10(b) violation is complete when the sale is made.

In the situation you describe, until and unless the broker, having followed the instructions and sold the stock, until and unless he actually converts the proceeds to his own use, you don't have a 10(b) violation.

Justice Breyer: Why don't you?

I mean, if we could ever prove it?

Suppose in fact the broker, because we had a mind-reading machine, sold the stock in order to convert the proceeds, puts the money in the account and then dies.

I mean, you know, it's a little weird, but nonetheless if we could ever prove such a thing, why wouldn't that be a violation of 10b-5?

Mr. Goldblatt: Because until and unless he actually converts the proceeds, he hasn't violated 10(b).

He has not done anything against his client's instructions.

Justice Breyer: He hasn't?

He has converted... he has sold the shares, contrary to the instruction, sell them for my benefit, for his own benefit.

Mr. Goldblatt: My point is that until he actually converts, while that money is still in the acccount, while the stock has been sold consistent with the directions, until and unless he actually converts the proceeds to his own use, he has not violated 10(b).

Justice Scalia: But what about, never mind the taking of the proceeds.

Suppose you have a broker who for some reason because he has an interest in a company or something else sells stock in a customer's account where it didn't really make sense to sell it.

The only benefit from selling it is a benefit for the broker himself.

His brother-in-law is with a company that would profit from this sale of the stock.

Would that be covered by 10(b)?

Mr. Goldblatt: I think that would be covered by 10(b).

Justice Scalia: Well, why isn't that the same situation here?

Because this sale was not a sale... never mind the later theft... the sale was not a sale for the benefit of the customer which is what he's promised to do.

He's promised, I'll manage these stocks for your benefit.

And here he sells them when the customer's interest did not call for a sale.

The only reason the sale happened is that the broker had his own interest in mind.

Mr. Goldblatt: Justice Scalia, the reason why that doesn't work here is because as the Court of Appeals found, there's no evidence in this record to establish that the sales themselves were inconsistent with the client's interests.

Regardless of what Zandford may have been thinking, the evidence simply showed that they were sold.

He has discretionary power to do it--

Justice Scalia: Well, does it have to be inconsistent?

Do you have to prove that they were inconsistent with the interest or is it enough to prove that the broker did not act in the customer's interest?

Isn't that enough for the breach of the fiduciary duty?

Even if it turns out that, what do you know, it was a good idea to sell, the market crashes, nonetheless he was guilty of a fiduciary breach if he didn't sell it because he thought it would help the customer but he thought it would help him.

Wouldn't that be a breach right then and there?

Mr. Goldblatt: --It might be a breach of fiduciary duty in the trust sense.

It does not affect the sale unless you can establish that the sale is unauthorized, it is inconsistent with the client's interest.

Justice Scalia: It is unauthorized.

I didn't authorize him to sell stock for his benefit.

The whole idea was he was supposed to sell it for mine.

Mr. Goldblatt: But the sale itself was authorized.

The only point I'm bringing out is in a situation like Bankers Life where the broker induces the sale with fraudulent intent, you have a complete violation when the stock is sold.

It makes no difference after that whether the broker is successful or unsuccessful in diverting the proceeds.

You have established a fraudulent sale in which an investor's decision has been induced by fraudulent intent.

In the situation where the sale is authorized, either because the client calls the broker and says I want you to sell XYZ Corporation today, and the broker does that--

Justice Scalia: That one I agree with.

Mr. Goldblatt: --In that situation, regardless of what the broker is thinking, he may be thinking I'm going to take the money and run.

Justice Scalia: But that isn't what happened here.

The customer didn't call up and say sell.

Mr. Goldblatt: No, but--

Justice Scalia: The broker has authority to sell but he has authority to sell in the interest of the client.

And no interest of the client called for the sale of these securities.

The only thing that called for the sale of the securities was without selling them, I can't get the money to steal.

Mr. Goldblatt: --Justice Scalia, in that regard we point to two decisions from the 7th Circuit in O'Brien and Congregation that deal with discretionary accounts.

And when a client turns money over to an investment counselor or broker and says, you make the decisions, I'm giving you blanket authority, and that's what we have in this record; in that situation, that takes you out of the 10(b) paradigm.

Chief Justice Rehnquist: Well, it's true in effect that not every breach of fiduciary duty is a fraud.

Mr. Goldblatt: That's correct.

Not every breach of fiduciary duty is a fraud, and not every breach of fiduciary duty will violate 10(b).

Justice Souter: But in your paradigm, you are saying the authorization is induced by fraud and that's crucial.

But in... why don't you have the equivalent of it here?

Because what you have here is a continuing authorization.

There is an authorization generally given at the beginning and the theory is that that authorization continues so that at every moment subsequent to that the client is saying yes, you may sell these things or buy as you see fit for my benefit, so that at any moment at which the client remains silent and allows that authorization to continue, if at that moment the broker has formed the intent, which you would take to be sufficient, why doesn't that function in the same way as the authorization specifically induced?

The client is being quiet and he's continuing the authorization because the broker is implicitly lying.

Mr. Goldblatt: Justice Souter, my answer to that is this: If it is shown, in other words, assuming you have a discretionary account to invest conservatively, if a broker then goes and buys a penny stock, that is outside the scope of the discretionary authorization and it would be a violation of 10(b).

What the--

Justice Souter: Well, it's outside of the authorization at the beginning because the authorization under no circumstances covered that kind of a sale.

Mr. Goldblatt: --Yes, it was outside the scope of the authority.

Justice Souter: But the term of the authorization that I'm saying is crucial, and what I thought you were saying is crucial in the case that you succeed is the term of the authorization that in effect says, you may sell this stock for my benefit.

And you are saying if a specific decision to that effect is induced by fraud, that's enough.

It gets you within the rule.

And I'm saying if a continuing decision, a decision evidenced by the client's silence is induced, that should be sufficient too.

Mr. Goldblatt: And one of the things that the Court of Appeals found here was that that was not established.

With regard to the various sales, when these checks were written, the Court concluded there was nothing in the record to conclude that those sales--

Justice Souter: Okay.

Then maybe this case should come out your way.

But as a matter of theory, isn't it the same case whether it's a continuing authorization or an authorization which is specifically induced?

Mr. Goldblatt: --In either situation if you can show that the sale itself is a violation of that authorization or a breach of it, yes.

But in this case the Court was very careful on that in saying not only that this was a discretionary account, but in light of the allegations in the indictment there was just no proof in the record that any of these sales were in violation--

Justice Stevens: Yes, but you are going back to the indictment and ignoring the complaint.

Mr. Goldblatt: --Even with the complaint there's really nothing in the complaint that they are relying on other than the mutual fund account, and again--

Justice Stevens: Well, the course of conduct, one transaction after another is relevant; isn't it?

Mr. Goldblatt: --Not given the time factor.

And we are not talking... the time factor is actually from March of '88 to September of '90.

And in that regard there's just nothing in the record... we don't even know what the securities were that were bought or sold.

And that's the problem with their theory of this case.

It's overarching in where it goes.

There's no proof that any of these sales were not consistent with the authorization, were not in the client's interests.

And they didn't attempt to prove it.

Justice Ginsburg: In the case of churning would you--

Justice Stevens: --Well, is there any proof that any of the proceeds were ever given to the owner of the principal?

Mr. Goldblatt: The proof is that the proceeds go to three contracts that were determined by the jury in the wire fraud case to be fraudulent that are agreements that were between Zandford and the clients.

One was a personal loan, one was an investment that the Court determined to be fraudulent.

That's where the fraud takes place.

That's where the conversion takes place, not sooner, under our theory and under what the Court found.

Justice Scalia: You say that there's no evidence that the sale was made for the fraud.

But if as the government says, some of these sales were made to cover a check written on the account, the sale would not have occurred had the check not been written.

And that check he wrote to himself or to one of these contract accounts.

Doesn't that make it automatic that the sale occurred in order get the money to pay him?

Mr. Goldblatt: I don't believe so, Justice Scalia.

And I don't believe that was their theory in the indictment.

The checks were written on the account but he had authority to do that.

There's no--

Justice Scalia: Fine.

Mr. Goldblatt: --indication that was wrong--

Justice Scalia: And is the writing of the check what caused the sale?

Mr. Goldblatt: --Positions were liquidated in order to pay the checks.

Justice Scalia: Right.

Mr. Goldblatt: But there's no indication that those sales were not a deliberate decision to sell those securities at that point to take the money and put it into something else.

There's nothing to indicate that that was unauthorized to do that.

Because we don't know what the thoughts were.

Justice Scalia: It was authorized?

Justice Souter: I'm missing something.

Why do you write the check first if all you intend to do is to take the proceeds and buy another stock for the client's benefit?

It's the sequence of the check, I think, that's bothering me.

Mr. Goldblatt: Well, the sequence of the check is to take the money out of the account and invest it otherwise, which is why you would do it that way or could do it that way.

But we know very little about it.

But there's nothing--

Justice Souter: Doesn't it matter who the check is written to?

I mean, I presume these checks that the government was referring to were not checks sort of payable to the mutual fund to buy more stock or payable for the purchase of other stock.

It was simply payable to the broker; wasn't it?

Mr. Goldblatt: --Well, it was payable to the broker or accounts controlled by the broker.

But as the evidence establishes in the record on affirming the appeal on the sufficiency of the evidence claim, the money went into other investments.

And that's what Zandford's defense was.

These were other legitimate investments and that's what I was doing with the money, and they knew about it and that's what that was.

Justice Souter: So they can't... you are saying they can't trace any proceeds necessarily from the checks drawn into Zandford's personal accounts or--

Mr. Goldblatt: Well, they... the way they describe it, it goes to accounts controlled by Zandford.

So they do indicate that the conversion of the proceeds into other investments was fraudulent.

Justice Kennedy: --Well, let me just see what your theory is here.

Suppose the way it works is that there's a mutual fund account and the broker decides, I want to take this money for my own purposes to spend on a pleasure cruise.

I write the check that causes the sale of the security.

Under your theory, is there a 10b-5 violation?

Mr. Goldblatt: If the writing of the check is unauthorized, it's going to be a 10b-5 violation.

Justice Kennedy: Everybody knows he didn't... the client didn't authorize the broker to take a pleasure cruise.

That's my hypothetical.

Mr. Goldblatt: Then it would be a 10b-5e violation.

What the Court found lacking here was any evidence that the sale itself of the securities by the writing of the check established a 10b-5--

Justice Breyer: But it's alleged properly.

I mean, I read on Page 29A, in July... there's a misprint in the paragraph, but in July 1998 Zandford without the prior knowledge or consent of... must be of Wood... sold three securities in the Wood account for a total of $145,000.

What their claim is, is that without the client's consent, the broker sold the securities and then after that he used the proceeds for himself.

All right.

Now, on your theory, that alleges a violation of the securities law.

Is that right?

Mr. Goldblatt: --Under my theory, that would allege it.

Justice Breyer: All right.

Mr. Goldblatt: But the Court of Appeals found--

Justice Breyer: Fine.

Then the correct thing of disposition in your view of this case, since the allegation is there, and since the Court of Appeals said that the criminal case didn't investigate this matter about whether it was or without the client's consent, your view is we should have a remand so that they can have a trial on the question of whether Mr. Wood did consent to the sale.

Is that right?

Mr. Goldblatt: --No, Justice Breyer, that's not right.

Justice Breyer: Because?

Mr. Goldblatt: Because two things.

One, the Court of Appeals found that there was no evidence because it was a discretionary account, that there was anything unauthorized about it.

There wasn't any consent needed.

Justice Breyer: Of course there was no evidence.

That's because the government relied upon the criminal case.

So the Court of Appeals says they are wrong to rely on that.

Then as you pointed out at the beginning, the correct result is to send it back so now the government has a chance to put in other evidence, if you are right about what the evidence shows.

Mr. Goldblatt: In the ordinary course I would agree with that.

All other things being equal, that would be the result.

But if in fact the SEC by its litigation posture chose to rest exclusively on the criminal indictment, this other case--

Justice Breyer: You mean there is something in this record where the SEC says, by the way, if this criminal case does not provide sufficient evidence, we do not intend to put in any other evidence.

Where does it say that?

Mr. Goldblatt: --It doesn't say that.

There are representations that the criminal case is the same as the civil case.

At the time of our argument in this case, we argued to the Court that if this is all they have, if the criminal indictment is... yes, in the Court of Appeals.

If this is all they have, then there's nothing to send it back for.

Because this evidence in the criminal case--

Justice Breyer: You mean it's going to be agreed that there is no doubt that this retarded individual of a very advanced age agreed that his securities would be sold for the purpose of the broker running off with the money?

Mr. Goldblatt: --Justice Breyer, I think that--

Justice Breyer: I say that with some sarcasm in my voice, because it sounds to me incredible.

Mr. Goldblatt: --Obviously these are very hard facts to argue.

But my point is, he went to jail for almost five years.

It violates all sorts of rules, provisions, statutes, there's no question about this.

This conduct is controlled.

The Court of Appeals had no doubt about that.

But a 10(b) violation is different.

And also the SEC's litigation posture is different.

If they are going to give up the facts in the complaint and argue the case on the indictment, in a strategical attempt to get the Court to rule the way they want, which is the broadest possible 10(b), then they have got to live with it.

And when the fact--

Justice Stevens: That's for purposes of their affirmative motion for summary judgment.

They could then say these facts are established.

That's not a sufficient reason for granting summary judgment the other way around.

Mr. Goldblatt: --I absolutely agree, Justice Stevens, and our only point there is--

Justice Stevens: Therefore, we should not ignore the allegations of the complaint that go beyond the indictment.

Mr. Goldblatt: --The only objection I have to that is the fact that they sought rehearing and they sought rehearing and bond, and not one word was mentioned about a remand for dismissal.

They were still arguing collateral estoppel and on the facts of the indictment we win outright.

They did not even bring it to the attention of the Court.

Justice Stevens: That's because they were trying to win outright.

Mr. Goldblatt: That's right.

Justice Stevens: But that doesn't justify your winning outright.

Mr. Goldblatt: When they file... of course.

There's no question that both sides agree that Bankers Life and O'Hagan control and we say it's clear we win.

That's the normal case.

But when they don't seek rehearing on that basis so this Court doesn't even know why the Court of Appeals did what it did, and when they file for certiori and don't raise that as a claim for reversing or--

Chief Justice Rehnquist: Well, when you say we don't know the reason why the Court of Appeals did what it did, I mean, it wrote an opinion, which usually gives the reason why the Court of Appeals did what it did.

Are you complaining that they didn't say anything on rehearing?

Mr. Goldblatt: --What I'm saying is when this comes up for the first time in the opinion of the Court of Appeals and they file for rehearing, and they don't even bring it to the attention of the Court so that the Court can determine whether there is something to be corrected or whether this is the Court's understanding from oral argument that is what their case is.

Chief Justice Rehnquist: You are saying that the government didn't raise this issue in their petition for rehearing to the Court of Appeals.

Mr. Goldblatt: They did not even mention it.

Chief Justice Rehnquist: Well, but I don't know that they have to.

I mean, so long as they properly petition here, I don't know that you need have a petition for rehearing in the Court of Appeals.

Mr. Goldblatt: Ordinarily I would absolutely agree, Mr. Chief Justice.

But I think when it's something that comes up in the opinion from the Court of Appeals that on its face doesn't have any explanation that basically says instead of going back so you can prove your case, we're throwing it out completely, and they don't say a word to the Court of Appeals, that's the wrong remedy.

I mean, that's the first thing--

Justice Ginsburg: But Mr. Goldblatt, the Court of Appeals decision didn't turn on issue preclusion, it turned on a notion that in order to have a violation of 10(b) you had to have some kind of misleading about the merits of a certain security, something tied to the security, and not that they regarded this as a common law crime as theft.

Mr. Goldblatt: --The Court concluded--

Justice Ginsburg: I mean, the point they made was it's the same as if what was entrusted to the broker were a car and he sold the car for himself instead of the customer.

Mr. Goldblatt: --The point was that the securities were incidental to this fraud.

They were not an integral part of it, and--

Justice Stevens: May I just interrupt with one.

The question presented is whether when the stockbroker sells his customer's certain securities for his own benefit.

Now, do we have to assume he sold them for his own benefit at the time the sale was made or are you saying in fact he sold them for his principal's benefit and later decided to appropriate the proceeds?

Mr. Goldblatt: --Justice Stevens, what I am saying is there is no proof in this record that at the time of the sales--

Justice Stevens: Well, maybe there's no proof but the question we are asked to decide is when he does it for his own benefit is it a violation of 10(b)4?

That's what the question is.

Mr. Goldblatt: --I understand that, Justice Stevens, and--

Justice Stevens: And what's your answer to the question?

Your answer to the question is he didn't do it.

Mr. Goldblatt: --My answer to the question is it is authorized sale, either on the instructions of the--

Justice Stevens: Well, if it's a sale for his own benefit.

Mr. Goldblatt: --And at the same time it is also consistent with the client's instructions, until he converts, he has not violated 10(b).

Justice Stevens: Even though the sale was for his own benefit at the time he made the sale.

Mr. Goldblatt: Even though he... if it is for his own benefit... in other words, it could be both at the same time.

At the time of the sale, if the client calls you and says sell my XYZ stock, I want it sold today, and you sell it with the intent to convert the proceeds, that sale is not simply for the broker's benefit.

It is consistent with the instructions.

It is an authorized sale.

Until and unless he actually converts the proceeds, he has violated nothing.

Justice Souter: But when you say it is consistent with the instruction, you are assuming the instruction simply means you can buy or you cancel, whereas the argument is that the instruction is you can buy for my benefit or you cancel for my benefit.

And if we accept the latter characterization as true, then even under your own theory, he was not making a sale that he was authorized to make.

Mr. Goldblatt: I would disagree, Justice Souter.

On this record it may well be that it was for his benefit, but I don't think you can conclude it was not for his client's benefit as well.

Justice Scalia: Mr. Goldblatt, before you sit down, would you say something about the fact that you have adjudications by the SEC that adopt the theory that they are arguing before us, why shouldn't we defer if the question is a close one?

Mr. Goldblatt: As I understand it--

Justice Scalia: These are formal adjudications under the Administrative Procedures Act and they have ruled in accordance with the theory that the government is now arguing.

Why isn't that entitled to deference?

Mr. Goldblatt: --Justice Scalia, assuming... and because my time has run out... assuming that Congress in fact delegated the discretion to the Agency, I don't think you can find in any of the various things that they rely on, any rule dealing with 10(b) or Section 10b-5 that speaks to the precise issues that are raised in this case or even close to them.

What they do is they have rules that in 16 or so cases, or whatever the number, they have prosecuted for 10(b) violations brokers who convert.

But they are not necessarily, as a matter of fact I don't recall any of them being discretionary accounts or presenting the type of 10(b) analysis, fraud in connection with a purchase or sale of securities.

Justice Souter: So you are saying we can defer it, but there's nothing to defer it to.

Mr. Goldblatt: That is correct.

Assuming there is deference, there's nothing to defer it to, and if there was, it would be a rule that they are ultimately asking for that a broker any time they convert from the account violates 10(b) and that would be arbitrary.

That is not the way this rule is applied.

It is applied on a careful case-by-case basis.

So whichever way you go on that, I don't think it gets them the deference they seek.

I would add, however, with the little time that I have left, that I do not believe they would get that deference.

On churning, Justice Ginsburg, just to get to that point, in a churning case, I think that is more the O'Hagan paradigm.

You consummate the fraud through the sale itself.

It is the sale that completes the violation.

It is the sale that consummates the violation of fiduciary duty.

That's the difference between here and a churning case.

Until and unless Zandford converts those proceeds, which is done through agreements that are outside the scope of the securities laws, he has not violated 10(b).

In a churning case, the sale itself consummates it and it meets the other conditions that are required in O'Hagan.

That is a different situation and it is also established, of course, in that situation through the pattern of sales you have the proof that you don't have here, which is that those sales were not in the client's interests.

If you cannot establish that they--

Chief Justice Rehnquist: Thank you, Mr. Goldblatt.

Mr. Goldblatt: --Thank you.

Rebuttal of Matthew D. Roberts

Chief Justice Rehnquist: Mr. Roberts.

Mr. Roberts, the government wants the Court of Appeals reversed here, I'm sure.

But does it want the summary judgment granted by the District Court for the SEC affirmed?

Mr. Roberts: No, Your Honor, we didn't seek review of the reversal of the summary judgment.

We sought review of a different part of the Court of Appeals opinion.

After it reversed the summary judgment, it explained why it didn't think summary judgment could be granted, it went on to say that the allegations in the complaint didn't state a claim under 10(b).

And that's what we want reversed.

And the Court of Appeals relied on the facts in Page 8A of the petition.

The Court of Appeals states in the part of the opinion that's relevant here that the SEC, I'm in the middle paragraph of that page under the B, and I think it's the third sentence, says it, meaning the SEC, alleges that Zandford defrauded the Woods by failing to inform them that he intended to sell their securities in order to obtain the proceeds for himself.

So the facts that the Court of Appeals were considering are precisely the same facts that we are relying on here, Your Honor.

And the--

Justice Scalia: Go ahead.

I have a different subject.

Finish this one.

Mr. Roberts: --Okay.

I was just going say that the indictment is no different in any event, and on Page 41A in paragraph 5 of the indictment it alleged that Charles Zandford caused checks to be issued against the security positions of William R. Wood and Diane Okstulski and made payable to Charles Zandford, thereby causing their securities to be liquidated.

Justice Breyer: But it doesn't say it was without their consent.

Nowhere in the--

Mr. Roberts: It says it was part of a scheme and artifice to defraud.

Justice Breyer: --That's true.

That's true.

Mr. Roberts: So I think that pretty well encompasses that.

Justice Scalia: Mr. Roberts, we have apparently some, I would call it a factual disagreement, as to whether any adjudications by the SEC adopt the theory that you are arguing before us today.

What are your best cases?

Mr. Roberts: Okay.

I would point to, on page 36 of our brief we discuss the Southeastern Securities Corporation adjudication, Your Honor, from 1949, seven years after the SEC promulgated Rule 10(b).

In that case the facts were that the president and director of the brokerage firm sold the customer's securities without her knowledge or consent and converted the proceeds of the sale to his own use.

And after explaining that there was a relationship of trust and confidence and that he had a fiduciary duty, the SEC addressed the argument that this conduct was authorized because he had discretion over the customer's affairs by virtue of a general power of attorney, and rejected that argument, noting that even assuming the power of attorney's validity, it didn't authorize this conduct absent a showing of full and specific disclosure to and understanding consent by the customer.

And then the Commission concluded that the stockbroker's taking and sale of the customer's securities and his use of the proceeds constituted a willful abuse of his trust and a violation of--

Justice Scalia: When do you say Rule... or Section 10(b) is violated?

Let's assume that this scheme is discovered before he actually runs off with the money.

He sold the stocks in order to run off with the proceeds, but you get him before he runs off with the proceeds.

Has there been a violation--

Mr. Roberts: --Yes.

Justice Scalia: --at the time of the sale?

Mr. Roberts: Yes.

There's a violation at the time of the sale.

Justice Scalia: Okay.

Mr. Roberts: The discretionary authority doesn't make the sale authorized because he's authorized only to sell for the benefit of the customers.

Justice Scalia: Well, I mean, it seems to me that's logical and that sort of makes me worry about... about the great scope of litigation that we are inviting if you say civil actions not by the Commission but by individuals are also available under this theory.

Whenever a broker sells stock, he's always open to the charge that he wasn't doing it in my interest, he was doing it in his own, and you have a lawsuit.

Mr. Roberts: Two... two points to address that concern, Your Honor.

First of all, as I was discussing with Justice Ginsburg earlier, when there is... a private action requires proof of damages.

And if the broker doesn't follow through with his plan to convert the proceeds, there will be... it will be frequently the case that the customer can't show damages and needs to be able to allege those as a required part of the action, couldn't bring it at all, end of case.

Justice Scalia: Well, the stock's gone up.

I mean, the stock that has been sold has gone up enormously.

Mr. Roberts: Right.

Justice Scalia: And all the plaintiff has to allege is you really didn't sell it in my interest, you sold it because you were going to run off with the proceeds, and look what happened, the stock went way up.

Mr. Roberts: No, Your Honor.

Under the Private Securities Litigation Reform Act, the plaintiff has to state with particularity facts giving rise to a strong inference that the defendant acted with the requisite fraudulent state of mind.

Chief Justice Rehnquist: Well, are you saying that every breach of fiduciary duty is a fraud under 10(b)?

Mr. Roberts: No, Your Honor.

Only secret or deceptive breaches of fiduciary duty are frauds.

Justice Kennedy: What about a standard churning case?

Chief Justice Rehnquist: Aren't most breaches of fiduciary duty secret?

I mean, you don't announce that you are breaching a fiduciary duty.

Mr. Roberts: Many of them, particularly breaches of the duty of loyalty will be secret, Your Honor.

But not every breach of fiduciary duty is going to be... is going to be secret or knowing.

A breach of the duty of care wouldn't even be knowing necessarily.

A breach of the duty of fairness as in the Santa Fe case where all the factors disclosed would not be deceptive, there would be no violation.

But in O'Hagan, the Court explained that when the... when a fiduciary pretends loyalty to the principal and instead embezzles the principal's property, that's a fraud.

And that's a fraud--

Justice Kennedy: What happens with standard churning cases?

Mr. Roberts: --This is... this is just like a standard churning case, Your Honor.

A churning case is one--

Justice Kennedy: Well, is there authority that this is a 10b-5 violation--

Mr. Roberts: --Yes.

Justice Kennedy: --and it's a given or are we holding that in this case.

Mr. Roberts: Well, you are not addressing churning because obviously that's not here.

But I think that the courts of appeal have unanimously concluded that churning is a violation.

And that's because the broker who has control over the account and who's been entrusted with trading authority by the customer is making the trades, not in furtherance of the customer's investment objectives but in furtherance of the broker's aim of gaining commission.

Justice Kennedy: So if you prevail in this case, this case will be authority which validates all of the circuit opinions holding that churning is a violation.

Mr. Roberts: Well, again, Your Honor, churning is... it's a different... it's a different factual scenario because there are repeated sales and because the proceeds aren't taken.

And I suppose that a distinction could be drawn between when the proceeds are taken and if the proceeds... if it isn't a question of taking the proceeds but just making a commission, which the customer knows that the broker is doing.

But I do think this would be strong precedent in support of those cases.

Justice Scalia: Would you want to argue that distinction, Mr. Roberts?

Mr. Roberts: Not particularly.

I was acknowledging that I think this would be strong precedent.

But I... Respondent concedes that churning is covered, the courts of appeals unanimously have held that churning is covered.

I have no doubt that churning is covered.

The SEC has no doubt that churning is covered.

So you wouldn't be breaking... wouldn't be breaking new ground in holding that.

I mean, it would be in the sense that it would be your decision, but you can make the distinctions in future cases that you feel are appropriate and necessary, Your Honor.

[Laughter]

Justice Scalia: Too true.

Too true.

[Laughter]

Mr. Roberts: If there are no further questions, the Government would ask that the decision of the Court of Appeals be reversed.

Chief Justice Rehnquist: Thank you, Mr. Roberts.

The case is submitted.

Attribution:

The OYEZ Project

Featured:

Wharf Holdings Ltd. v. United International Holdings - Oral Argument

Fri, 09 Jan 2009 14:50:32 +0000

Case:

Wharf Holdings Ltd. v. United International Holdings

Media File:

00-347_20010321-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Paul M. Dodyk

Chief Justice Rehnquist: We'll hear argument on Number 00-347, The Wharf Limited, et al., v. United International Holdings.

Mr. Dodyk.

Mr. Dodyk: Mr. Chief Justice, and may it please the Court--

Let me start by suggesting that whether my client Wharf Holdings misrepresented its intention to sell stock of Wharf Cable to UIH is a matter of no concern under the '34 Act.

The paradigm Section 10(b) plaintiff is an investor who has purchased a security which has been inflated by deception, the price of which was been inflated by deception or manipulation.

I submit the central purpose of the '34 Act is to protect such investors from financial loss.

The '34 Act, I submit, was not passed to provide a Federal remedy to plaintiffs who complained of their inability to purchase stock.

The '34 Act was not passed for the purpose of Federalizing the adjudication of disputes over the ownership of securities.

Justice Scalia: It depends on what you consider the security to be in this case.

Mr. Dodyk: In part that is true, Your Honor, but I think not solely.

Not solely.

I think there are also issues going to the nature of the misrepresentation involved, and the first--

Justice Scalia: But first about what the security is.

Mr. Dodyk: --Yes, Your Honor.

Justice Scalia: And what the Respondents say, and what the court below believed is that the security here was an option.

And the definition of security in the Act includes an option to purchase securities.

Mr. Dodyk: That is correct.

That is correct, Your Honor.

But what I am suggesting to Your Honor is that the oral expression which passes or is asserted to be a security in this case should not be accepted as such, that in this case that what you're basically dealing with is a conversation which gave rise to an asserted right to purchase common stock in a subsidiary.

The answer to why, as I understand the law, Your Honor, is rooted in the Blue Chip Stamps case.

And as I interpret that case, Your Honor, I believe it to reflect a reluctance on the part of the Court to accept oral assertions as satisfying the predicate to establish standing to sue as a purchaser of securities.

Justice Ginsburg: Mr. Dodyk, how far do you take that?

Are you saying that no oral representations count under the Exchange Act?

Are you saying that that goes for the SEC as well as what we have here, private suitor?

Mr. Dodyk: Well, certainly Your Honor, I'm not saying then oral statement cannot constitute a misrepresentation.

Far be it from me to suggest that.

Going to the second part of your question, Your Honor, I certainly think that distinctions can be made between the breadth of section 10(b) in the hands of the SEC and the breadth of the judicially implied private right of action under Section 10(b).

And as Your Honor is aware, there are distinctions.

In an SEC action, it is of no concern whether anyone relied on misrepresentation.

In fact, there is no purchaser requirement constraining the SEC's enforcement bar.

So I think the contours of the private right of action which is implied under Section 10(b) are quite different from the contours within which the SEC might bring an enforcement action.

Justice Ginsburg: Are you saying, Mr. Dodyk, that there can't be any oral options as a matter of Federal securities law?

Mr. Dodyk: Your Honor, I think as a matter of Federal securities law, as I read the Blue Chips Stamps case, that a conversation which a person asserts via an oral option should not, under the doctrine of that case, be accepted as a security.

Chief Justice Rehnquist: Well, that would certainly take it beyond the holding of the case.

Mr. Dodyk: There is no question about that.

The holding of the case itself was limited to a situation in which the offerees in that situation did not purchase the stock.

But what I say to Your Honor is I don't think given what I understand to be... and of course Your Honor would know better than I... the thrust of that opinion.

The reluctance of the Court to accept wholly oral testimony not for the purpose of saying whether or not there has been a misrepresentation, but for the purpose of satisfying the threshold predicate requirement of whether or not the plaintiff has purchased securities.

The Court, time and again in the course of that opinion, said that the principal advantage of that doctrine was to place as a requirement for standing in a 10(b) case a transaction which could be proven by document.

Justice Scalia: But that isn't the issue here... whether the plaintiff purchased or not.

The issue here is whether the security existed.

Whether there was, indeed, an option, or there wasn't an option.

If there was an option, there's no doubt that this plaintiff purchased it.

It isn't a question of whether the plaintiff, you know, agreed to accept the option or not.

That's, as I understand it, not an issue.

The question is was there an option.

Mr. Dodyk: Well, I'm not sure that Your Honor is correct in saying that there's no question as to whether or not there was a purchase of an option here in a contractually binding sense, because as Your Honor is aware, it certainly is our position that the court, the district court, failed to properly instruct the jury with respect to the statute of fraud.

Justice Scalia: It's quite a different question in Blue Chip.

The question in Blue Chip is whether the plaintiff would have bought the stock or not.

You have no idea whether the plaintiff would have bought this stock.

Plaintiff said I would have but for this misrepresentation, or I would have sold it but for the misrepresentation.

It's totally up in the air.

The question here is much simpler, much more focused.

Was there a promise by the alleged seller of the option to deliver the stock or not?

Mr. Dodyk: I don't think it's simpler, Your Honor, in the sense in which Blue Chip Stamps saw a difficulty, if I could explain.

Justice Scalia: Okay.

Mr. Dodyk: It's not simpler for the following reasons, What was the core, as I understand it, of Blue Chips Stamps' concern was that you'll get someone who attempts to establish standing to bring a Section 10(b) action based on an oral assertion of what it is they would have done.

Now I submit to Your Honor, that this case is no different in that respect.

The oral option... the purchase of the oral option... all of that is a lawyer's description of what happened in a conversation.

And just as in--

Justice Scalia: It's not a description of would have, could have, should have.

I mean, and that's what was at issue in Blue Chip.

Oh, had I known this, I would have.

Had I not known it, I would not have.

And it's all speculation about the future.

There's no speculation about the future here.

It is a simple past fact.

Was there this promise to deliver the stock in exchange for certain actions by the other side, or was there not?

That's not at all as hard to prove as the would have, could have, should have stuff is.

Mr. Dodyk: --I think it is, if I may.

I think this is a would have, could have, should have case.

No question about it.

Don't forget that in the Blue Chips Stamps case, you weren't talking about a drive by offeree in the market place.

What you were talking about in Blue Chip Stamps were a group of retailers who as a result of a plan of reorganization that was entered after a consent decree had the right to purchase a determinate number of shares which was defined in the consent decree.

Therefore, their right to make the purchase was clearly documented.

In addition, in terms of the damage claim in that action, in terms of the injury, they were pointing to the difference between what the price the stock was trading at currently and the price which it was offered at in the prospectus.

And they said that is the measure of my damages.

Here, you're dealing with I think very much a weaker case in the sense that the alleged act of purchase, the existence of the option, was throughout a lawyer's description of an oral event.

And the would have, could have, should have goes like this, I would have exercised my option; I would over a period of years have invested fifty million dollars in this business; the business would have succeeded, and the stock market would have valued my stock interest at X million dollars.

Justice Souter: Well, you've raised... it seems to me in your last point you've raised two points.

One is a valuation point, which I don't think is directly what Justice Scalia is concerned with.

The other, the would have, should have point is I would have exercised my option.

But as I understand it, it's not open to us to assume that that is the case.

As I understand it, the finding was that they did exercise the option.

That they exercised the option by going ahead in effect and paying part of the consideration for that... for getting the option which was the help that they gave to your client in getting the license.

So that as I understand it, we have a finding that this is not a hypothetical should have or would have case, but a case in which we did.

We went ahead, and when we performed... when we did the part performance, at least... that sealed the deal for the option.

We had the option, and there is no question as I understand it that they sought to exercise the option at a later time.

So I don't see where the subjunctive gets into this.

Mr. Dodyk: Well, I think where the subjunctive gets in... and perhaps it's not a subjunctive as such... what I'm saying to you is that the nature of the jury's conclusion in this particular case, I think, should not be relevant to the determination which the Court is making, if my construction of the Blue Chip Stamps case is accurate.

Justice Souter: Well, your construction... I thought your construction is that yes, Blue Chip Stamps, as Justice Scalia put it, is a would have, should have case, and this is a would have, should have case.

And I don't think this is.

Mr. Dodyk: No it's not... I'm not saying... I think it's a would have, should have case in many regards, Your Honor, in many regards.

But what I'm saying with respect to the reason why Blue Chip Stamps should be applied to the facts of this case is that I don't see any difference in the quality of the oral evidence, or the oral event which gave rise to the finding, and the quality of the oral evidence which drove the Court in Blue Chip Stamps to say no, I'm not going to extend the doctrine to that situation.

Justice Souter: Then I think you in essence are saying that they cannot be the oral creation of the security within the meaning of the Act.

Mr. Dodyk: That's what I am saying.

Justice Souter: Yeah.

Mr. Dodyk: That's right.

I'm not saying that oral representation cannot be fraudulent.

What I am saying is where a plaintiff cannot satisfy the threshold requirement of purchase of a security except by a purely oral event, then I would--

Justice Ginsburg: There's a statute that lists a whole bunch of things that constitute a security; one of them is an option.

It doesn't say anything about in writing in the text of the statute.

Mr. Dodyk: --Well, Your Honor, as to that I would suggest that if you look at Section 3810 that all of the elements of a security there as defined are elements which are ordinarily written instruments... common stock, bonds, notes.

There is nothing I think, Your Honor, in 3810... no one of the individual elements... which is not a written document and therefore--

Justice Scalia: Do you think that Blue Chip would have come out differently if there were a writing from the president of the purchaser to his mother saying we intend to purchase this stock of this corporation next week.

Do you really think that the only problem in Blue Chip was the lack of a writing, or was it the inherent difficulty of showing what somebody would have done when it has not, in fact, been done.

Whereas the claim here is that something has been done; not that it would have been done, but that it has been.

Mr. Dodyk: --I'm not saying that that... I can't tell you what element alone would have sufficed for the conclusion.

Justice Scalia: You think a letter might have done the job, if--

Mr. Dodyk: No, I don't.

I don't think it would have.

No, I don't.

Justice Scalia: --I don't think it would have, either.

Chief Justice Rehnquist: I think it has very little to do with the writing and much more to do with the inherent ineffability of future intentions.

Mr. Dodyk: Well, that is certainly true.

Justice Souter: If that is true, then you have to admit that Blue Chip doesn't stand for the proposition that you can't have an orally created security, and that we are, as Justice Scalia started out by saying, going to have to go beyond Blue Chip to hold your way here.

Mr. Dodyk: Well, I'm not suggesting that the Blue Chip Stamps opinion governs the facts of this case, but I would point out to Your Honor is that two circuit courts have interpreted Blue Chip Stamps to bar standing to a plaintiff who sought to assert... satisfied the purchase requirement and sought to assert standing on the basis of an oral agreement to purchase securities.

Justice Souter: Why--

Mr. Dodyk: In the Kagen case... the Kagen case--

Justice Souter: --Yes?

Mr. Dodyk: --in the Seventh Circuit, and the Pelletier case in the Eleventh Circuit both held that, and those are, to my understanding, the only reasoned interpretations of Blue Chip Stamps since that case was decided with respect to this particular issue.

Justice Souter: Let me ask you this question.

You're in effect saying that the '34 Act should be construed as, in effect, incorporating the statute of frauds for purposes of determining how a security, or what can qualify as a security within the meaning of the Act.

My question is, why should we interpret it when the statute of frauds has traditionally had an independent life of its own, and of course incidentally in this case, the statute of frauds has either been satisfied by part performance, or has been satisfied by part performance as I understand it in the findings of the jury.

Mr. Dodyk: Well, Your Honor, I would say a couple of things about that.

First of all, certainly the courts of appeal have construed Blue Chip Stamps to hold that if you had a purely oral event to satisfy the purchase requirement which is unenforceable under the statute of frauds, that under Blue Chips Stamps that didn't suffice, number one.

Number two, the argument I was making about Blue Chip Stamps and the significance of oral evidence is not limited to the statute of frauds.

After all, you're talking about the meaning of the Federal statute, and my interpretation of Justice Rehnquist's opinion in Blue Chip Stamps... excuse me, the Court's opinion in Blue Chip Stamps as underlying the Kagen and Pelletier decisions is that where the quality of the satisfaction of the purchase is oral, the quality of the evidence is purely oral, that the claim is too dubious in its nature to satisfy that threshold requirement--

Justice Souter: So you're saying there could be an oral contract, and there could be the oral creation of a security, but that the act of exercise cannot be oral.

Mr. Dodyk: --No, I'm not saying that.

Justice Souter: I thought that's what you just said.

Mr. Dodyk: No, no, no.

Justice Souter: I'm sorry.

Mr. Dodyk: No, what I was saying was that where for purposes of construing the Federal statute, irrespective of the statute of fraud, that the rule is a Federal rule, and the rule should be that where the event which is said to satisfy the purchase of a security requirement is wholly oral, that that should be insufficient for very much the same reasons as the underlay of the Blue Chip Stamps requirement.

Now, with respect to--

Justice Ginsburg: Mr. Dodyk, may I ask?

There is an aspect of this case that is very disturbing to me, and I want you to get to it before your time runs out.

Mr. Dodyk: --Yes, Your Honor.

Justice Ginsburg: This is a case with one Federal claim.

I think there were ten or eleven State claims.

It was thoroughly tried.

There were determinations of those State claims.

The damages, as I understand them, would have been the same if you never had 10(b) in the picture.

And at this stage, at least going in, I mean, you're urging that the Court hold something today that it has never held before.

There is an arguable question of the interpretation of Federal law.

The State claims were pended to that and thoroughly tried.

This is not a case that was dismissed at the threshold.

Why are we... it seems to me that we're talking about something that is academic in this case if a judgment is going to stand based on the adjudication of the State claims.

Mr. Dodyk: Well, let me speak to that if I may, and also it comes back to the second part of Justice Souter's question.

And this has to do with the significance of the statute of frauds in this case.

And the proposition which I'm going to advance, Justice Ginsburg, is that the errors committed by the district court and by the Eleventh Circuit with respect to the statute of frauds are clear and undeniable and are fatal to every cause of action which was asserted in this case, State or Federal.

Now, grant me the indulgence of assuming, although I've had little indication of this, that the Kagen and Pelletier approach would prevail, and that the Court was at least open to the argument that, well, Blue Chip Stamps means that if you have an oral event upon which you are basing your purchase argument, and you don't have an enforceable contract under the statute of frauds, you don't have a purchase.

Now, I think... and I don't mean to be rude or over reaching... but I think it's clear that both the district court and the Eleventh Circuit committed undeniable errors in the way they treated the statute of frauds question.

In the court of appeals they said that the statute of frauds did not apply to this case because the oral option, although a security for Securities Act purposes was not a security for the purpose of the statute of frauds.

Now, bear in mind that what we're talking about here is an oral agreement contract option for the sale of securities.

And I submit that there can't be any question that the proper analysis on these facts is that the oral option was the contract for the sale of securities which the statute of frauds rendered unenforceable.

Justice Ginsburg: Then one might say, if we accepted everything you said, that the Federal claim would fail on a 12(b)(6).

But there was Federal question jurisdiction by virtue of a claim... of an arguable claim.

And there was indeed a trial.

And I just don't understand why, even if I accepted what you just said, that touches the fact that there was Federal question jurisdiction, that everything that you're talking about would go to, has there been a claim for relief stated?

Mr. Dodyk: Well, Your Honor, if I understand where we're at at this point, and that is, what is the... what should be the consequence of a decision in this case?

That there was no Section 10(b) violation because of the existence of the State claim.

If I can address that question briefly.

My position on that question is that if you take a look at the decided case authorities since Santa Fe and Blue Chip Stamps, there are two lines of authority which unanimously would have resulted in the dismissal of these claims.

Now, we've been talking about one of those lines, and that is to say whether or not you can create a purchase out of an oral event.

There is another line of cases which doesn't deal with the purchase question.

Another line of cases which says that where you have a misrepresentation of a party's intention to sell securities, as distinguished in the language of the courts, from a misrepresentation going to the value of the securities, you don't have a Section 10(b) violation.

There are four circuit courts that have come to that conclusion; there are two district court cases within the last three years that have followed those cases.

Just this year--

Chief Justice Rehnquist: What's the reasoning, Mr. Dodyk?

You know, there's some English chancellor hundreds of years ago said that the state of a man's mind is as much a question of fact as the state of his digestion.

Unknown Speaker: [Laughter]

Mr. Dodyk: --Yes, indeed, and that made it all the way into the restatement, did it not?

Did it not?

But what I say to you is this, and it's not a simple thought to get across, but to the extent we're talking about whether or not that type of statement which has been made in this case is actionable, that we've gone a long way beyond the state of the digestion, and where we have gotten to in the United States, generally speaking, is to the economic loss doctrine, which is squarely applicable to the facts of this case.

And I think it's also, Your Honor, a doctrine which this Court should take into account in deciding what types of misrepresentation are actionable under Section 10(b).

The proposition is--

Justice Scalia: Even giving you the point that the only kind of misrepresentation that counts under 10(b) is a misrepresentation of value, do you really think that an option to purchase from someone who, when he gives you the option, has no intention of ever selling you what he has promised to sell you?

Is it worth as much as an option from someone who when he gives you the option intends to go through with the delivery of stock if you exercise it?

Mr. Dodyk: --Your Honor--

Justice Scalia: Doesn't that... I can't imagine what would more go to the value of the option than the intent of the optionor to follow through on the contract or not.

Mr. Dodyk: --Your Honor, I think whether or not you recognize the distinction here depends on how you characterize the purpose of the Securities Act... if we're talking about a 10(b)(5) case, which is what we're talking about.

And what I mean to say by that is there are lots of actions which can undermine the value of a security or an option to purchase a security.

But I submit that there is a very clear distinction between a misrepresentation about the financial condition of a company and the refusal to accede to an asserted contractual obligation to delivery securities, and I suggest to Your Honors that given the way in which this Court has articulated the purpose of the '34 Act that a line should be drawn between those representations which in the garden variety Section 10(b)(5) case speak to the value of a security in a situation such as this in which a person says he should have sold me the stock and he didn't, and he lied about it in the first place.

Justice Ginsburg: Mr. Dodyk, you still haven't gotten to why, even if we accept what you said, there should be any redoing of this case when the State claims were tried, and the same damages would apply to those.

Mr. Dodyk: I keep trying to get there, but I get diverted.

And the reason is this, and this is the reason that I was speaking to the other reason why you shouldn't find a Section 10(b) violation here, which is in terms of the character of the representation which has been made here, and the limited purpose of the '34 Act.

And I was about to get to that point when I said there are four circuit courts who have decided uniformly, consistently, that the '34 Act does not apply to an alleged misrepresentation of a party's intention to sell securities.

Justice Breyer: But the question--

Mr. Dodyk: I'm about there... I'm about there.

[Laughter]

And the answer is... the answer is that is the kind of decision which can be made in a Rule 12 case.

Now I understand Your Honor's formulation of well, if they've got jurisdiction and there is a decision, what is all this about?

What I'm saying to you is this.

There is a great deal of difficulty with a standard which says whether or not the court should proceed to adjudicate the State law claims depends on the degree of frivolity of the Federal action.

I say to you that those courts... those circuit courts... which have decided that if you have a case which is dismissable under Rule 12, then you shouldn't go forward and adjudicate the State claims is squarely applicable here.

Justice Ginsburg: --The question is, we're not in the posture of should you go forward?

They have gone forward, and what you're saying is that we should upset this entire adjudication.

If we were back in the beginning and the question was should the Federal court go forward on the State claims once the Federal claim is out of the picture, one gets one answer.

But we're at the end of the line, and these cases have, in fact, been tried.

Mr. Dodyk: Well, I say that that factor is not worth consideration which Your Honor is according to it for the following reason.

Number one, there is a value in having important, unsettled questions of State law decided by State courts, and that is why the courts have been restricted from asserting jurisdiction over the State claim when they have dismissed the Federal claim prior to the trial.

Now, I say that if you accept my construction of Section 10(b), if you accept my construction of Blue Chip Stamps as six circuit courts have done, the answer is when that case came up on a Rule 12 motion, Judge King should have thrown it out.

Now, he should not have gone forward at that point to have adjudicated the State cause of actions, and I say to you--

Justice Ginsburg: And that is a matter of lack of jurisdiction, but abuse of discretion.

Mr. Dodyk: --That's correct.

Abuse of discretion, because had he made the right decision assuming, granting me the assumption, that there is no 10(b)(5) action here, he should have thrown the case out at that point.

Now you have to ask yourself, well, does it make a difference that we have had some investment of time as a result of a judicial mistake?

And, again, a couple of circuits have said no, it doesn't make any difference because there are values in restraining the Federal judiciary from deciding State court issues in those circumstances which are not excused by the fact that someone made a mistake at the district court level and we should therefore vacate that decision.

That's what happened in Tully v. Mott Supermarkets, for example.

Now, I say to you also--

Justice Ginsburg: We would not reach that judgment if we thought that the case for the Federal claim was a lot more solid than you suggest, even if you would ultimately win on it, that this was not frivolous by any means.

Mr. Dodyk: --That is true but for one other consideration, Your Honor, and that's this.

I say to you that the Tenth Circuit and the district court were unquestionably wrong in the way they decided the statute of frauds question, and in the way they decided the economic loss doctrine question.

A proper decision on either one of those theories would have thrown out every cause of action in this case, and I suggest to you that where you're in a situation where there is in fact at the end of the day no Federal question, and you present it with a--

Justice Scalia: Thank you, Mr. Dodyk.

Mr. Cohen, we'll hear from you.

Argument of Louis R. Cohen

Mr. Cohen: Thank you, Mr. Chief Justice, and may it please the Court--

UIH pleaded and the jury found that UIH purchased a security, an option, and paid for that separate security with services that Wharf requested and crucially needed.

Justice Kennedy: I have one question.

Justice Souter asked counsel for Petitioner whether or not the option was not exercised when these additional services were performed, I take it after October 8, 1992.

I thought--

Mr. Cohen: Thank you.

Justice Kennedy: --And I thought there was some agreement from Petitioner's counsel that that was in fact the theory of the case.

Of course, he says there's no option at all.

When was this option exercised?

Mr. Cohen: It was both a purchase and a separate attempt to exercise.

Justice Kennedy: When was it exercised in here?

Mr. Cohen: In the spring of 1993, after Wharf got the cable franchise from the broadcast authorities.

Justice Kennedy: Okay, so the option was--

Mr. Cohen: Wharf had conducted a public offering, raised the money, called Mr. Ing and sought to exercise the option.

Justice Kennedy: --So the option was not exercised in your view immediately after October 8 when the additional services were performed.

Mr. Cohen: It could not be.

Its terms were that UIH would have the option, and had bought the option.

In return for these massive services, it would have the option to invest ten percent of the capital required by this newly formed company and get ten percent of the stock.

That option would be exercisable... this is all in our complaint... would be exercisable for six months after the award of the franchise to Wharf Cable by the broadcast authority, because without that award there would be nothing.

Justice Scalia: Mr. Cohen, I must say I just marvel at the bon homme or the old fashioned nature of your client to gamble all of this money on an oral handshake deal.

Do people still do that out there?

Mr. Cohen: They do.

[Laughter]

Justice Scalia: I mean, how much money was involved in this deal?

Mr. Cohen: Well, the cost of providing the services with which we purchased the option was about a million dollars out of pocket, but it was the time of people who were investors in these businesses.

Justice Scalia: You know, I wouldn't even buy an automobile without a written contract.

Mr. Cohen: Well, there was a good deal of testimony at trial--

Justice Scalia: I'm not sure that we ought to protect this kind of recklessness.

If you want to rely on a handshake deal, then you better be sure you're shaking the hand of somebody who can be trusted.

Mr. Cohen: --It was a handshake deal that had been preceded by a written reference to an option in the bid that Wharf submitted to the broadcast authority, that language was pulled at the last minute.

It's an option that is referenced in later internal Wharf documents.

Justice Scalia: We have over a million lawyers in this country, and one of the main things they do is to make sure that people make things easy by putting it in writing.

Mr. Cohen: And UIH would have been well advised to come out of that meeting, call its lawyer and say how do we document this?

But the agreement at that meeting was that documentation would be prepared.

The agreement at that meeting also was that Wharf needed--

Justice Scalia: You went ahead before the documentation was prepared.

Mr. Cohen: --Yes, because Wharf--

Justice Scalia: And I'm making a serious point here, I'm just not saying your client was foolish.

I'm questioning whether we ought to protect foolish people like that... whether we ought to enable strike suits, enable people to be accused of having sold an option in order to protect somebody who's foolish enough to invest a million dollars on the basis of a handshake.

Mr. Cohen: --The kind of person you're talking about is a person who is a victim of an unscrupulous securities salesman who calls up and says I've got an oil company here, and I've got some shares to sell you, and fails to say there isn't any oil and says give me your credit card number, or send me a check and I'll send you a certificate.

Justice Breyer: Unlike those typical securities situations, what worries me about this case is the pizza man says, Smith, my customer told me over the phone that if I got the pizza there on time he'd give me fifty shares of his stock.

Do we have a securities fraud?

Mr. Cohen: You have a fraud if there--

Justice Breyer: No, in my example.

Mr. Cohen: --If--

Justice Breyer: In my example.

In my example the pizza man calls up... pizza man, I called him yesterday, and he said if I got the pizza there in fifteen minutes he would sell me fifty shares of his stock for forty dollars.

Is that a securities fraud?

Mr. Cohen: --I think yes.

Justice Breyer: Yes?

Mr. Cohen: Yes, because I think--

Justice Breyer: I thought you'd say no to that one.

I was about to tell you--

Mr. Cohen: --No, because I think there is a contract.

I don't think I need that one.

I think my case is much easier.

Justice Breyer: --You're saying then that any kind... any time a person claims that somebody sold them a share of stock, or promised to sell them a share of stock orally, that becomes a Federal securities case.

I didn't think you were going to say that, but if you are, I'm quite interested.

Mr. Cohen: Any time someone has a provable, enforceable contract to buy a share of stock--

Justice Breyer: We're saying the same thing, and I guess the argument against that would be that the securities statute doesn't intend to have every oral contract for selling some stock to become a securities fraud case.

There was no intention to have that done, there is no reason to have it done.

It's perhaps a contract action.

Most States wouldn't permit it because it would be oral, but--

Mr. Cohen: --Justice Breyer, what we have here is not merely an executory contract to purchase some stock.

We have a completed, consummated contract to sell and purchase an option which is a separate security as defined--

Justice Breyer: --I know, but I'm trying to get at the policy that would underlie my concession exactly right.

The pizza man says I have a completed executory contract to sell me an option in return for my getting the pizza there on time.

Mr. Cohen: --He hasn't--

Justice Breyer: He has promised to sell me fifty shares of stock.

Now, that's an option.

Mr. Cohen: --He hasn't been defrauded out of anything except perhaps driving fast to deliver the pizza.

We have been defrauded out of services... the valuable services... that we undertook to deliver only because Wharf agreed to grant and granted us an option.

That option is a separate security which we were then--

Justice Breyer: You're missing my question, and I won't pursue it except to add what I thought you'd answer.

I thought you'd answer my question no, because there's no fraud there.

And then I was about to say, but all you have to do is add the allegation.

And at the time he intended not to carry it out.

And that allegation always can be added, for after all he is defending the case, isn't he?

And if he's defending the case, that's pretty good evidence that he intended not to carry it out, and therefore you've made all, or almost all, oral promises into securities cases, contrary to the intent of the statute.

Now, I was trying to get you to address the policies that might refute my hypothetical, but maybe it's too complex, and maybe you can't do that easily.

Mr. Cohen: --Well, let me say this about the policy.

First, there is the difference between a mere breach of contract and an intent at the time that a contract is entered into not to perform, and several courts of appeals have spoken to that.

Second, we are talking here about the defendants' intention quite different from the problem in Blue Chip of the plaintiff proving the plaintiff's own intention by his own affidavit, an inherently untestable thing that gets into the jury to get past the defendant's intention, a statement that he intended to fulfill the contract, the plaintiff is going to have to come up with some concrete evidence.

We had that evidence here... written evidence from Wharf's files that Wharf did not intend at the time that it entered into the contract to fulfill it.

And furthermore, Congress has taken much of this burden off the Court's shoulders, if you'll excuse me for just a second, by adding the requirement in the Private Securities Litigation Reform Act of 1995 in which it recognized a 10(b)(5) claim and cited how to cabin it, and it requires a specific pleading of facts sufficient to create a quote strong inference of intent to defraud, and if you can't do that, your claim is dismissed under that statute.

Justice Scalia: Okay.

Mr. Cohen: So that policy has been addressed.

Justice Scalia: Somewhere in that long sentence you made the point that in Blue Chip there was no solid written evidence as you say there was in your case.

Do you think Blue Chip would have come out differently if there was solid written evidence to demonstrate that the alleged purchaser would have purchased?

Mr. Cohen: No.

Blue Chip was interpreting the statute.

Justice Scalia: Right.

So what difference--

Mr. Cohen: The statute requires a purchaser--

Justice Scalia: --Okay, what difference does it make if you have written evidence?

And Blue Chip didn't.

Mr. Cohen: --I don't--

Justice Scalia: If Blue Chip wouldn't come out any differently, written evidence or not, what difference does it make?

Mr. Cohen: --The difference is that we have a completed purchase.

We have a completed purchase that is sustained by testimony--

Justice Scalia: Well, that's fine, but the evidence makes up... the evidence, or the existence of written evidence or not makes no difference.

Mr. Cohen: --Let me say one other thing about Blue Chip--

Justice Scalia: Yes or no?

The existence of written evidence or not in this case makes no difference.

Mr. Cohen: --I think it makes no difference to the outcome.

Chief Justice Rehnquist: Mr. Cohen, I think... what if this contract were found to be void because it didn't comply with the Colorado statute of fraud?

Could it nonetheless be acted upon?

In other words, would that be a final death knell for your suit, or can you say that under Federal securities law that isn't conclusive?

Mr. Cohen: Well, first, of course, it was valid under the Colorado securities--

Chief Justice Rehnquist: Could you get to the answer?

Mr. Cohen: --No, I don't think you would be--

Chief Justice Rehnquist: You can't get to the answer?

Mr. Cohen: --I don't think it would be a death knell.

I'm trying to answer the question.

Chief Justice Rehnquist: Then even though we're invalid under Colorado statute of frauds, it could proceed under the Federal Securities Act?

Mr. Cohen: I think the sale of a security that is an invalid security that is represented to be a security is sufficient under Blue Chip to support a 10(b)(5) claim, whether the security is enforceable or not, and I think the majority of the courts of appeals have agreed with that.

Justice Breyer: If you win... this is just what's worrying me.

Imagine every State says sales of goods or services over ten million dollars has to be in writing.

All right?

Now, to a person who's... that would make no difference.

That statement I just made would be, as a practical matter, irrelevant because anybody in the stock area, because anybody who wanted to allege an oral contract to sell ten million dollars' worth of stock would run right into Federal court and say it's a securities claim.

Mr. Cohen: Well, it has to have a security--

Justice Breyer: No, what he says is he promised to sell me some stock.

The promise is an option on your view, and therefore it is a security.

Mr. Cohen: --The promise... that promise is not an option on my view.

An option is a security that you pay separate consideration for that gives you the right but not the obligation to purchase another security.

Justice Breyer: A promise.

I'm sorry.

Mr. Cohen: That's what we have here.

Justice Breyer: I'm sorry.

In return for my services, he promised that he would sell me some stock.

Mr. Cohen: Yes.

Justice Breyer: All right.

All those cases which would be outlawed by the State statute of frauds, I've imagined, would suddenly come into Federal court as securities claims.

It's the same problem I have.

What's bothering me is the sweep of a decision in your favor, and that's what I want you to--

Mr. Cohen: What I've tried to say is that you can decide this case in my favor without reaching that by determining... agreeing with the court of appeals that what you had here was a completed actual paid for sale of a different security, an option which the parties intended to document but didn't end up documenting, because that was part of the fraud, and then there was a--

Justice Scalia: --Why wasn't that sale worth a million dollars, or whatever the statute of frauds limit is?

Mr. Cohen: --The statute of frauds--

Justice Scalia: I mean, surely that contract is worth something, and what was the value of that?

Mr. Cohen: --It was, and we paid for it in services that had a cost to us of about a million dollars, and--

Justice Scalia: And is that below the State's statute of frauds amount?

That million dollars?

Mr. Cohen: --Justice Scalia, first of all, the present statute in Colorado and every other State says sales of securities are enforceable without a writing.

There is no statute of frauds applicable to securities.

Justice Scalia: That's the answer, then.

Mr. Cohen: And at the time there was a statute of frauds which was determined not to apply because of the... because of Wharf's... because of UIH's completed performance of its obligations.

Justice Souter: Mr. Cohen, I just want to go back to Justice Breyer's question--

Mr. Cohen: Performance took this out of the statute of frauds.

Excuse me.

Justice Souter: --Tell me if I'm wrong here.

I think we've got to say something definite about what the statute of fraud rule is that will underlie our case, even if you are right on part performance, and I will assume you are, because we could construe the statute either to say there is no requirement of writing in the statute.

In other words, it has no built in statute of frauds.

Or we could say there is some kind of a built in statute of frauds, but it is satisfied by part performance.

Or we could say possibly... I don't know whether we should... but we could say the Federal statute in effect simply leaves the problem of writing to State law.

If State law would in fact recognize the contract under its statute of frauds, then that contract is sufficient to create a security, or whatnot, for the purposes of the Securities Act.

I think we've got to say one of those three things.

Which should we say?

Mr. Cohen: I think you should say that the question whether there has been a sale of securities is a question of State law, as it has been.

Justice Souter: And then the question of whether there is a creation of the security in the case of the creation of the option... that too... I mean, that's essentially a contractual act, and that too is a question to be governed by the State statute of frauds.

Mr. Cohen: Yes, I think whether the resulting contract fits the definition of a security is, of course, a question of Federal law.

Justice Scalia: Mr. Cohen, though, the Federal court determined what the State statute of frauds was in this case, and the Federal court determined that performance took this out of the statute?

Mr. Cohen: Yes, as a matter of--

Justice Scalia: What if I disagree with that?

Mr. Cohen: --matter of State law.

Justice Scalia: I mean, it seems to me performance takes a contract out of the statute where you have a bilateral contract.

I promise to do one thing, you promise to do another.

One of us performs.

The contract is then out of the statute of frauds.

But when you have something that is called a unilateral contract, if you do something... you don't have to... but if you do something, then I am obligated to do something else.

And that's what you have here.

Mr. Cohen: No.

Justice Scalia: If you did these things, you will have... I will give you an option.

Mr. Cohen: No.

Justice Scalia: You did the things, you got the option.

That is what concluded the contract, and I would not hold it, if I were the State supreme court judge, that that statute was out of the State statute of frauds.

Mr. Cohen: What we had was not a unilateral contract.

It was a bilateral contract as the jury found.

Wharf sold us an option on April 8... on October 8, 1992.

Justice Scalia: Were you obliged... were you obliged to go out and do those acts which created the option for you?

Mr. Cohen: Yes, we were.

Justice Scalia: Did you promise to do those acts?

Mr. Cohen: Yes, we did.

Yes, we did.

But we also... but we promised to do--

Justice Scalia: That contract was within the statute of frauds then, because there certainly wasn't any performance of that.

Mr. Cohen: --Yes, there was.

There was a performance of our contract to acquire an option by providing services that Wharf requested which included dispatching named people immediately to Hong Kong at our expense to serve as officers of Wharf Cable--

Justice Kennedy: And you could have been sued if you didn't do that?

Mr. Cohen: --We could have been sued if we hadn't done that.

Justice Scalia: That is not an option.

That promise is not a security.

If you promise to do some act, and I, in exchange, promise that if you do the act I will give you an option... that contract is not an option and is not therefore a security.

Mr. Cohen: It wasn't an if.

They granted... they entered into a contract... this is a jury finding on a stipulated verdict forum... they entered into a contract granting UIH an option.

In that contract, granting us an option, we promised, and immediately did, pay for that option by providing required services.

There was a completed actual sale here.

That's what this trial was about for eleven weeks.

Unknown Speaker: But it still turns on characterizing what was done here as going in never intending to perform, and the concern that Justice Breyer expresses is that you could make that up.

Justice Ginsburg: How do you extinguish between a garden variety breach of contract where somebody doesn't perform and one where from day one there was no intent to perform?

Mr. Cohen: You need to prove that at day one there was no intent to perform.

You need to get past some... motion to dismiss, to have concrete evidence of that, and there needs to be a completed contract... completed sale... in connection with it, which that misrepresentation is made.

Argument of Matthew D. Roberts

Chief Justice Rehnquist: Thank you, Mr. Cohen.

Mr. Roberts, we'll hear from you.

Mr. Roberts: Mr. Chief Justice, and may it please the Court--

When the seller of a stock option misrepresents its intention to permit the buyer to exercise the option, the seller violates Section 10(b).

The text of Section 10(b) prohibits the use of any manipulative or deceptive device in connection with--

Justice O'Connor: The seller of an option?

Mr. Roberts: --The seller of the option.

Justice O'Connor: Would you rephrase that?

Mr. Roberts: Which here is Wharf Cable... sold the stock option which was the right to purchase... excuse me.

Justice O'Connor: It was not an agreement to be performed?

Do you think the sale took place?

Mr. Roberts: A sale took place.

At the meeting, there was a contract, as was explained, the contract was an exchange of a promise to provide services for the sale of the option.

The promise was performed--

Justice O'Connor: You say what happened was that Wharf said I give you an option today, and in return you must, in the future, perform certain services.

Was that the agreement?

Mr. Roberts: --I sell you an option in exchange for your promise to perform services, and that there was performance, which would take that contract out of the statute of frauds.

Justice Scalia: And you think that the Respondent here could have been sued for breach of contract if the Respondent did not perform those services?

I didn't read the transaction as really envisioning that.

Mr. Roberts: Under the understanding that there was a sale for a promise, yes.

You know, under the understanding there was a sale for services.

Justice Scalia: Yes, that would follow, but you think that that was the reality?

That the Respondent could have been sued if it didn't send those people over to do the work that was... you see, I viewed it as much more of a unilateral contract.

If you send the people over, you'll have an option.

Mr. Roberts: I don't think it makes any difference, Your Honor.

Justice Scalia: I think it does for the statute of fraud purpose.

Mr. Roberts: Well, there was performance of the promise which would take it out of the statute of frauds.

Even if it is was a contract that was unilateral, the performance of the services would take it out of the statute of frauds as well, and once the option was purchased, the option was a security, and the misrepresentation of the intention to permit the exercise of the option was a misrepresentation.

Justice Kennedy: Well, I think it is important, and you agree with the counsel for the Respondent that this was a bilateral contract in which they could have been sued if they did not provide the necessary services, and those services were sufficiently specific to have a contract that was not illusory in the trial courts, and the jury so found?

Mr. Roberts: What the jury found was that they entered into a contract selling them an option for... to purchase ten percent of the stock.

I don't recall right at the moment... I don't have it in front of me... that finding.

I'm not sure whether it said in exchange for the promise or not in the specific language of that finding, but the finding was on page E21.

Justice O'Connor: I think the concern, Mr. Roberts, is that we not sweep in under the Securities Act a lot of breach of contract suits.

Mr. Roberts: Yes, Your Honor, and you don't do that, because in order for there to be a 10(b)(5) violation, there must be a misrepresentation.

There has to be a fraud, not just a breach of contract.

Justice Breyer: That was exactly why I asked.

Justice O'Connor: Yes, it's easily--

Justice Breyer: --That's why I asked... it seems like the simplest thing in the world, look, this will come up in families.

No brokers, no securities, Uncle Joe promised to lend me... to give me securities if I would take care of him for a year or two, which I did.

Okay, we've got your option.

And you say, oh, well, but what about the misrepresentation?

Well, if Uncle Joe is alive.

Look... he's defending the case, isn't he?

And therefore if you believe that he made the oral statement, why didn't he carry it out?

So he's here defending it, so he must have intended not to carry it out.

Now, maybe that isn't totally sufficient, but you'd be well along the way.

Mr. Roberts: It's not sufficient, Your Honor.

Just as it's easy to allege, it's very hard to prove.

In order to avoid dismissal under the Private Litigation Securities Reform Act, the plaintiff has to allege with particularity facts that give rise to a belief that there was misrepresentation--

Justice Breyer: He is here... he is here defending the case which proves he never intended from day one to follow his oral thing and, besides, I remember his saying that once.

Mr. Roberts: --That would be insufficient to meet that burden, Your Honor.

The fact that he's defending a suit, obviously, would be insufficient.

And the plaintiff's own testimony about what he thought the defendant's intention was does not prove the state of the defendant's mind, nor does the fact that the defendant failed to perform prove anything more than a breach of contract.

The restatement makes that clear... that same principle would apply.

Failure to perform alone is not sufficient.

There has to be additional evidence, and there was additional evidence in this case... both testimonial and documentary evidence... that there was no intention to perform at the time.

In addition, it's important to understand that... it's important to cover oral contracts such as these because many contracts for the purchase of securities are oral, such as when customers contract with their brokers over the telephone to buy stock.

And oral contracts for the sale of securities are generally enforceable under the law of all fifty States.

In addition to that, the Act does not require that there be a writing to make someone a purchaser or a seller of a security.

The Act provides that the options are securities, and the Act also provides that a purchase includes any contract purchase.

Justice Souter: Do you agree that the statute, in effect, looks to State law on the question of statute of frauds issues?

Mr. Roberts: No, I don't, Your Honor.

I think the statute of frauds is irrelevant to a violation of Section 10(b).

The statute of frauds is a--

Justice Souter: So there is either a standard implied in the statute itself, or there is no... a requirement implied in the statute itself, or there is no requirement, period.

Mr. Roberts: --There is no requirement.

Even under common law, the traditional rule is that fraud in inducing a contract is actionable, even if the contract is unenforceable under the statute of frauds.

The same principle applies to Section 10(b), as well, and--

Chief Justice Rehnquist: Whether or not something is a contract... does that depend on State law?

Mr. Roberts: --Whether something... no, a contract is a Federal term in the statute; it is a Federal question, I think whether it's a contract--

Chief Justice Rehnquist: Is there a court authority for that?

Mr. Roberts: --There's court authority for the fact that purchasers... parties to an oral contract to purchase are purchasers of securities.

Chief Justice Rehnquist: They say notwithstanding State law?

Mr. Roberts: Notwithstanding State law?

Chief Justice Rehnquist: State contract law, not statute of frauds.

Mr. Roberts: No, they don't specifically address notwithstanding State law, but in the court of appeals case that comes to mind, the Threadgill case from the D.C. Circuit, the district court had said that there was no purchase or sale because the contract had not been performed, fully performed, and the court of appeals reversed and said that the Act defines contract to include... the Act defines purchase, excuse me, to include any contract to purchase.

Justice Souter: Yes, but that leaves open the question of what a contract is.

And don't we look to State law to determine what that contract is?

Mr. Roberts: I don't think so, Your Honor.

It wouldn't serve the purposes of the Securities Act for--

Justice Souter: Well, it would open the doors of the Securities Act, presumably, to claims that State law would not recognize and that in itself might be a good reason, if we knew nothing else, to say that the question of contractual formation is a State law question.

Mr. Roberts: --First, you don't have to address that issue here because there is a--

Justice Souter: Well, but we may... we may get very close to it if we have to address what the source of any writing requirement or the dispensation of any writing requirement is.

And if we look to State law on that, presumably it would be odd if we didn't look to State law as well for what a contract is.

Mr. Roberts: --I don't think that you should look to State law for any of these questions, Your Honor.

It's a question of--

Justice Scalia: How old do you have to be to buy a security?

You mean we can adopt a Federal rule that sixteen year olds can buy securities?

Mr. Roberts: --If there's fraud--

Justice Scalia: Surely that's a question of State law, isn't it?

Mr. Roberts: --Whether it's a sale under State law is a question of State law, whether it's a sale for purposes of the Securities Act is a question of Federal law.

And it wouldn't serve the purposes of Section 10(b) to hold that because there isn't a sale that's enforceable under State law--

Chief Justice Rehnquist: But to say it wouldn't serve the purposes of Section 10(b) isn't the final answer on a case like this.

Congress legislates with a background of what has been decided under State law, and what is a matter of Federal law.

Mr. Roberts: --Yes, Your Honor, Congress does.

But Congress simply used the term contract in the definition of purchase to include any contract, and used the term contract, and that was commonly understood at that time, if I may issue that answer.

Chief Justice Rehnquist: No, you may not.

Thank you, Mr. Roberts.

Unknown Speaker: [Laughter]

Mr. Roberts: Sorry.

Thank you.

Chief Justice Rehnquist: The case is submitted.

Attribution:

The Oyez Project

Featured:

United States v. O'hagan - Oral Argument

Fri, 09 Jan 2009 14:50:07 +0000

Case:

United States v. O'hagan

Media File:

96-842_19970416-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Michael R. Dreeben

Chief Justice Rehnquist: We'll hear argument now in Number 96-842, United States v. James Herman O'Hagan.

Mr. Dreeben.

Mr. Dreeben: Mr. Chief Justice, and may it please the Court:

Information is the lifeblood of the securities markets.

Markets thrive on legitimate efforts to acquire, analyze, and use information, but the deceptive acquisition and use of information in securities trading serves no legitimate purpose.

Respondent's securities trading involved just such deception.

Respondent is a lawyer whose firm was entrusted with the confidential plans of a client that had planned to make a tender offer for the Pillsbury company.

While posing as a loyal partner in his law firm, respondent misappropriated that information in breach of his fiduciary duties to the firm and his client and reaped personal profits in virtually risk-free trading in Pillsbury stock and options.

By engaging in that form of deception in connection with his trading, respondent violated three prohibitions of Federal law: section 10(b) of the Securities Exchange Act, section 14(e) of the Exchange Act, and the mail fraud statute.

Now, the misappropriation theory under section 10(b) of the Securities Exchange Act posits that a fiduciary or other person with a similar relationship of trust and confidence commits deception on the legitimate owner of information if that fiduciary or other agent misappropriates the information by using it in securities trading, contrary to the view of the United States Court of Appeals for the Eighth Circuit.

Unknown Speaker: Mr. Dreeben, just by misappropriating?

I mean, suppose the defendant here had instead come clean, and he told his superiors in the law firm that he was going to use this information.

Then he would not be posing as a loyal employee any more, and it would have been okay.

Mr. Dreeben: He would not have deceived his employer.

He still would have breached independent fiduciary duties that he owed to that employer.

Unknown Speaker: And you say he would still have breached the securities laws.

Mr. Dreeben: No, I do not think he would have breached the securities laws.

Unknown Speaker: So that's the line.

He didn't tell them that he was going to go out and use it.

Mr. Dreeben: That's absolutely correct, and the reason why that is significant is that section 10(b) prohibits deceptive devices and contrivances.

It requires deception.

The misappropriation theory does involve a breach of fiduciary duty, but the distinctive factor about that breach is that it is a deceptive breach.

It involves, just as the facts did in Carpenter v. United States, an agent entrusted with information by a principal under the understanding between the parties that the agent would not use that information for any personal gain without obtaining the principal's agreement.

Unknown Speaker: Well, Mr. Dreeben, then if someone stole the lawyer's briefcase and discovered the information and traded on it, no violation?

Mr. Dreeben: That's correct, Justice O'Connor.

Unknown Speaker: And if a partner perhaps in the law firm, the lawyer let his daughter know about the planned merger inadvertently and the daughter relied on the information and bought stock options, violation?

The daughter has no obligation to disclose.

Mr. Dreeben: Correct, Justice O'Connor, and the answer to that is probably not, although there has been litigation about whether in particular circumstances a family relationship is sufficiently imbued with a business context that there is a duty that runs to it, but I accept the general thrust of your hypotheticals.

There are forms of improper conduct that section 10(b) does not reach, and the reason why section 10(b) does not reach them is it is a statute that is framed to reach fraudulent deceptive activity in connection with securities trading.

That is--

Unknown Speaker: Well, Mr. Dreeben, where is... the thing that bothers me about the case here is, where is the connection between the deceptive device and the purchase or sale of a security?

Mr. Dreeben: --The connection, Chief Justice Rehnquist, lies in the fact that the misappropriation does not occur until the lawyer uses the information as the basis for his trades.

It is that very information which drives his participation in the market and allows the profits to be reached... reaped by him.

Unknown Speaker: But he didn't deceive anyone who sold him securities.

Mr. Dreeben: That is true.

The misappropriation theory doesn't rely on the notion that he owed a duty of disclosure to the shareholders on the other side of the transaction, but it does satisfy the requisite connection between the fraud and the securities trading, because it is only in the trading that the fraud is consummated.

There could be no closer--

Unknown Speaker: But you think of fraud being practiced on a person who is damaged by it.

Mr. Dreeben: --I think that under the common law view of fraud, Chief Justice Rehnquist, that is an accurate statement, but the securities laws are not framed to pick up only those violations that are covered by common law fraud.

Congress did not pass a statute that says, it is unlawful to commit fraud on the purchaser or seller of securities.

Congress did not pass a law even that said it is unlawful to commit fraud in a securities transaction.

It passed a law with a broader phrase, in connection with a securities transaction, because the very aim of this section was to pick up unforeseen, cunning, deceptive devices that people might cleverly use in the securities markets--

Unknown Speaker: That's rather unusual, for a criminal statute to be that open-ended, isn't it?

Mr. Dreeben: --I don't think that it's unusual to give the text of this statute its natural reading.

What it requires is proof of fraud, and then it requires proof that there's a connection between the fraud and the trading.

In this case, as I've said, there could be no closer connection.

It is only by the trading itself that the fraud is consummated, and that is exactly a connection that is picked up by the language of the statute.

Unknown Speaker: What if Grand Met had its own strategy to purchase shares for some reason to make the price go up temporarily?

I don't know quite how the hypothetical would play out, but suppose this was in Grand Met's interest, and yet all the facts were the same.

The lawyer... it didn't know the lawyer was doing it.

It was doing it on it's own, but what the lawyer did was also helping its grand scheme.

Mr. Dreeben: That--

Unknown Speaker: Would there be a misappropriation there?

Mr. Dreeben: --Yes, there would.

First of all that wouldn't have any effect on the violation that respondent committed on his law firm.

He owed his law firm a duty of trust and confidence in addition to the duty he owed to the client, but more importantly than that, in this case there was no evidence that Grand Met knew about--

Unknown Speaker: But in the hypothetical you and I are discussing, if he came clean with the law firm and the whole law firm was doing it, then no violation?

Mr. Dreeben: --If he didn't deceive anyone by doing this, he would not--

Unknown Speaker: What if he didn't tell the client.

Mr. Dreeben: --Well, then the client would be deceived.

Whoever does not know about this and has not authorized it is a victim of the fraud, just as in the Carpenter case, if Weinans had gone to the Wall Street Journal and said, look, you know, you're not paying me very much.

I'd like to make a little bit more money by buying stock, the stocks that are going to appear in my Heard on the Street column, and the Wall Street Journal said, that's fine, there would have been no deception of the Wall Street Journal.

The statute does require deception, but there can be no doubt in a case like this that there is deception.

This is the identical kind of fraudulent conduct that the Court had before it in the Carpenter case.

Unknown Speaker: Well, I'm not so sure I agree with you on that point, at least as to the... the Wall Street Journal in Carpenter was said to have a property interest in the confidentiality, or in the use of the notes for the column.

Here, there doesn't seem to be any property interest involved.

Mr. Dreeben: Well, the property interest here is exactly the same as it was in Carpenter.

It's the information itself, which Grand Met has a right to determine how it would be used.

It has a right to maintain its exclusive right to use the information and not to have the agents, upon whom it must rely if it's going to engage in any kind of business activity, misappropriate that information for personal gain, and I think it's a very well-settled concept of the common law and of the law of fraud that information is a species of property, so that--

Unknown Speaker: Mr.... I'm sorry.

I didn't mean to interrupt.

Mr. Dreeben: --So the deceptive conduct here is, in essence, indistinguishable from the deceptive conduct that the Court found in the Carpenter case.

Unknown Speaker: Do you take the position that every relationship of trust also implies the duty to disclose if the trust is to be breached?

Mr. Dreeben: I don't, Justice Souter.

I think that--

Unknown Speaker: How do we know this is such a case and the others are not, then?

Mr. Dreeben: --Well, this is such a case because it involves a relationship right at the core of what has been defined as the principal agent-fiduciary trustee relationship.

Unknown Speaker: Well, but so does a... I suppose a lawyer in a trust relationship with his client in the handling of funds, and yet if a lawyer... I presume that if a lawyer disclosed to his client that he was going to commingle, or he was going to borrow, as it were, the client's funds for personal reasons, that that would not be a defense either to a professional or a statutory charge against him.

Perhaps I'm wrong there, but I assumed it would not, so I'm not sure why, then, number 1 there is a disclosure obligation here, whereas a disclosure obligation there would be of no point--

Mr. Dreeben: The--

Unknown Speaker: --and the one would be a defense and the other wouldn't.

Mr. Dreeben: --Justice Souter, the reason why it makes a difference is that the disclosure obligation is a prerequisite to obtaining the consent of the principal or the owner of the trust.

Unknown Speaker: But I thought... maybe I misunderstood your answer earlier.

I thought that if there were a disclosure but no consent that would in effect preclude liability.

You're saying there must be a disclosure and consent.

Mr. Dreeben: To satisfy the common law rule that a trustee may not use the property that's been entrusted with him, there would have to be consent.

To satisfy the requirement of the Securities Act that there be no deception, there would only have to be disclosure.

Unknown Speaker: I thought that was what you answered Justice Scalia when he asked the question.

Yes, that's what I thought, too.

Mr. Dreeben: That's correct.

Unknown Speaker: And... but there would be in that case other sanctions immediately.

Mr. Dreeben: That's correct.

Unknown Speaker: If you told the law firm, look, I'm going to do this, the law firm isn't going to consent but it's not likely he'll retain his job, and there might be other sanctions.

Mr. Dreeben: That's correct.

It would still be--

Unknown Speaker: In that case it's not 10(b)5.

Mr. Dreeben: --It's not 10(b)5.

It would still be a breach of fiduciary duty, but that makes the point that I'm trying to make here.

Not every breach of fiduciary duty involves deception, but a breach of fiduciary duty when that breach involves the obligation to make disclosure does involve deception.

That, in fact, is the foundation of this Court's rulings in Chiarella and Dirks that an insider in a corporation has a duty to his shareholders to make disclosure before trading with them.

Unknown Speaker: There's one thing that I'm still not clear on, and that is, what is it that is peculiar about some breaches of trust, or some obligations of trust, that raise the disclosure obligation whereas others do not have a disclosure obligation that would at all be relevant?

Mr. Dreeben: The answer, Justice Souter, is that there are some things that a trustee cannot do even if he does disclose them.

They will still be breaches of fiduciary duty, but there are some breaches of fiduciary duty that inherently require a breach of the duty to make disclosure.

Unknown Speaker: You rely on disclosure as just a reverse mechanism for defining deception.

Mr. Dreeben: Correct.

I think that it's clear under this Court's decisions in Chiarella and Dirks that generally silence is not fraudulent in conducting a transaction, but it becomes fraudulent if there is a duty to make disclosure, and the Court in the Chiarella and Dirks cases looked to well-settled understandings which it then believed were incorporated into 10(b) about when disclosure is required.

Unknown Speaker: If you read a horn-book on tort law does it say that the essence of deception is nondisclosure?

That's what you're asking us to write, I suppose.

Mr. Dreeben: I'm not asking the Court to do anything more than to reaffirm the basic principle that it adopted in Carpenter v. United States that an agent who misappropriates his principal's property by posing as a loyal employee when in fact he's reaping personal gain with that property has committed a form of deception, indeed, a form of fraud, and that fraud satisfies both the mail fraud statute and it satisfies section 10(b).

Unknown Speaker: May I ask you one question, Mr. Dreeben?

I'm a little puzzled by your statement that... if I understood you correctly, that if the defendant here had disclosed to his partners, that would have avoided liability, and you're suggesting there was therefore no duty to disclose to the client.

Mr. Dreeben: No, I think there is a duty to disclose to the client as well.

I think that there are two victims, direct victims of the deception.

Unknown Speaker: But supposing in this case he had disclosed to his partner, and his partner had just kept the information to himself, and then he had gone... the defendant had gone ahead with his trading.

Would there be a violation?

Mr. Dreeben: Yes, there would, but we would not have been able to charge it the same way as we charged this case.

Unknown Speaker: I see.

You then would have said there was a breach of the firm's duty to the client.

Mr. Dreeben: That's correct.

In this case, the jury was instructed that it could rely on a finding of a breach of duty either to the law firm or to the client or to both, and it had to be unanimous about which one it found, but it had to find one or the other, or it could find both, and if there was disclosure, the party that received the disclosure would not be a victim of the fraud on our theory.

Unknown Speaker: Mr. Dreeben--

--Now, Mr. Dreeben, we... this Court has always required either a misrepresentation or an omission to find 10(b) liability, I think, and you say there was an omission here by the failure to disclose.

Mr. Dreeben: Yes, and I say that there is an omission by the failure to disclose in exactly the same way as there was in Carpenter.

I also believe that the Court has never ruled out what seems commonsensical under 10(b), the idea that the conduct itself, even without a statement or an omission, can be deceptive.

I mean, here you have a lawyer who worked in his firm, came to work every day posing as a loyal partner, engaging his partners in discussions about firm business, under the understanding that he was doing this in the interests of the firm, when in fact, as the jury concluded, he used the information that he acquired to finance... to enable his own securities purchases and to profit--

Unknown Speaker: Well, any, any fraud is deception, then.

I assume that, you know, if a lawyer takes the client's money that's supposed to be in a trust account and just removes it posing as an honest lawyer, I mean, you know, everybody who commits any fraud is guilty of deception.

Isn't that right?

Mr. Dreeben: --And the Court... yes, Justice Scalia, and the Court said--

Unknown Speaker: What if I appropriate some of my client's money in order to buy stock?

Mr. Dreeben: --The fact--

Unknown Speaker: Have I violated the securities laws?

Mr. Dreeben: --I do not think that you have.

Unknown Speaker: Why not?

Isn't that in connection with the purchase of security just as much as this one is?

Mr. Dreeben: It's not just as much as this one is, because in this case it is the use of the information that enables the profits, pure and simple.

There would be no opportunity to engage in profit--

Unknown Speaker: Same here.

I didn't have the money.

The only way I could buy this stock was to get the money.

Mr. Dreeben: --The difference--

Unknown Speaker: And I got the money posing as an honest lawyer.

Mr. Dreeben: --The difference, Justice Scalia, is that once you have the money you can do anything you want with it.

In a sense, the fraud is complete at that point, and then you go on and you can use the money to finance any number of other activities, but the connection is far less close than in this case, where the only value of this information for persona profit for respondent was to take it and profit in the securities markets by trading on it.

Unknown Speaker: Why isn't the client entrusted just as totally when he entrusts money as when he entrusts information?

I don't under... I guess my problem is--

Mr. Dreeben: He does, Justice Souter.

Unknown Speaker: --the same as Justice Scalia's.

I don't... if we're starting with a breach of trust, I don't see why a breach of trust with respect to a fact which is communicated gives rise to a disclosure obligation when a breach of trust with respect to some other thing of value, e.g., the contents of the trust account, does not.

Mr. Dreeben: I perhaps was not clear in answering Justice Scalia, Justice Souter.

It is just as much of a breach, and it is just as much fraudulent and deceptive, and that, in fact, is what the Court said in Carpenter.

Embezzlement is a form of fraud.

The question is whether that fraud is in connection with the purchase or sale of the security, and the question is whether that form of fraud which I submit is complete at the time the money is obtained is in connection with the purchase or sale versus this one.

Unknown Speaker: So that every breach does give rise to a duty to disclose.

Mr. Dreeben: Every breach that involves the misuse of information entrusted to a person or the misuse of property entrusted to a person--

Unknown Speaker: Yes.

Mr. Dreeben: --for personal gain, yes.

Unknown Speaker: Okay.

Mr. Dreeben: That's hornbook law, and I don't think that there's any dispute about that at all.

Unknown Speaker: So what you're saying is, is in this case the misappropriation can only be of relevance, or is of substantial relevance, is with reference to the purchase of securities.

Mr. Dreeben: Exactly.

Unknown Speaker: When you take the money out of the accounts you can go to the racetrack, or whatever--

Mr. Dreeben: That's exactly right, and because of that difference, three can be no doubt that this kind of misappropriation of property is in connection with the purchase or sale of securities.

Other kinds of misappropriation of property may or may not, but this is a unique form of fraud, unique to the securities markets, in fact, because the only way in which respondent could have profited through this information is by either trading on it or by tipping somebody else to enable their trades.

Unknown Speaker: --With respect to the tip, I wasn't quite sure of your answer to Justice O'Connor when she brought up the child.

Were you responding to her word inadvertent, because if this parent tipped off the child and told the child to purchase the security, surely there would be--

Mr. Dreeben: Yes.

Unknown Speaker: --responsibility.

Mr. Dreeben: Yes, there would.

In a case like that, Justice Ginsburg, a fiduciary cannot do indirectly what he's prohibited from doing directly, and so using the child as the medium for conducting the transaction would be equally forbidden.

I think Justice O'Connor's question was getting at the point about whether the child would be committing fraud on the parent if the child engaged in this trading after having learned inadvertently--

Unknown Speaker: Right.

Now--

Mr. Dreeben: --of the information, and I--

Unknown Speaker: --Let me ask you whether you think section 14(e) provides you with an easier argument for liability than 10(b).

Mr. Dreeben: --Well, I certainly think that 14(e) provides us with a perfectly valid argument for liability.

The theory under section 14 is that Congress specifically gave the Commission regulatory authority in the area of tender offers because it recognized that tender offers pose a very significant threat to investors in the target company having the ability to make decisions about whether to buy, sell, or hold when a tender offer is on the horizon.

Congress also knew that there is a great opportunity for insider profiting because the information about a tender offer is necessarily circulated to many professionals in advance of the tender offer who then have the opportunity to go out and trade on it, and as a result of its recognition about the dangers of fraudulent and deceptive practices and tender offers, Congress was not content to rely simply on section 10(b) but drafted a new and different antifraud provision which is backed up by regulatory authority that gives the SEC the power to define and prescribe means reasonably designed to prevent fraudulent, deceptive, manipulative conduct.

Unknown Speaker: You omitted one little part there from that sentence, Mr. Dreeben... designed to prevent such acts and practices as are fraudulent, deceptive, or manipulative.

Mr. Dreeben: That's correct, Justice--

Unknown Speaker: And it seems to me one could read that as saying that that does not give the SEC authority to define what is fraudulent, what is deceptive or manipulative, but simply to define practices which are in fact fraudulent, and you can't expand on the definition of fraudulent or deceptive.

Mr. Dreeben: --There are several reasons, Chief Justice Rehnquist, why I think that you're correct that I omitted the words, acts or practices as are fraudulent, but I think that the statute is accurately paraphrased the way that I read it.

First, the regulatory authority that is found in section 14(e) was modeled on a different section of the securities laws, not section 10(b), but section 15(c), which dealt with regulating broker-dealers, and in that context Congress had specifically given the SEC the authority to define fraudulent practices because it wanted to establish a higher standard of obligations and duties than would otherwise be imposed by the common law.

It adopted that language in section 14(e) after the SEC had previously exercised its power to create new obligations that weren't found in the common law, unless it's reasonable to infer that Congress expected that authority to be exercised in that fashion.

Unknown Speaker: Well, except, now, the Schreiber case indicated that the SEC can't define offensive conduct more broadly than the statute provides.

Mr. Dreeben: Actually the Schreiber case, Justice O'Connor, didn't involve any SEC regulation at all.

It involved simply the question about whether a fully disclosed act would be deemed manipulative under the first sentence of section 14(e).

There were no regulations at issue in the case whatsoever.

Unknown Speaker: But there certainly is language in that opinion.

I think footnote 11 indicates that SEC can't go more broadly than the terms of the statute.

Mr. Dreeben: I think the footnote, read in context, says that the mere promulgation of the regulatory authority for the SEC, the addition of the sentence that gave the SEC regulatory authority, didn't change the meanings of the words in the first sentence, but the Court expressly recognized that Congress had authority... that Congress had given authority to the SEC not only to define acts or practices as are fraudulent but to prescribe means reasonably designed to prevent them, and the Court explicitly said there that the SEC could prohibit nondeceptive conduct as a means reasonably designed to prevent fraud.

So the Court in Schreiber I think did acknowledge that the SEC has very vast regulatory power in order to protect against the abuses that Congress had identified in the tender offer context.

Rule 14(e) 3 does that by establishing a flat ban on trading by persons who come into possession of information about an upcoming tender offer when they know that it was received from the bidder or somebody acting on its behalf, and that flat ban serves two valuable purposes.

The first is that it protects shareholders who are going to be facing a tender offer, or who actually are facing a tender offer, from not having adequate time and adequate information to make a decision whether to buy, sell, or hold.

It also prevents collusion between the bidder and other parties operating in the marketplace that has not disclosed to the marketplace, as the Williams Act requires, from buying up stock from unsuspecting shareholders in the target company.

A second purpose that is served by 14(e)3 is the prevention of fraudulent activity that involves, as this case did, the deceptive acquisition of information from the bidder or law firm's accountants, investment bankers that represent it, and it thereby serves to prevent that kind of fraud from occurring, which is a very great danger, and which involves a very great danger of not being detected, because this is in essence a crime that involves surreptitious activity that is not often easy to bring to light.

So 14(e)3 carves out in the tender offer context very special heightened rules.

It carves out and creates in the tender offer context a disclose or abstain from trading obligation, but it does not apply, as section 10(b) does, to the rest of the universe of securities transactions in which the misuse of information can pose very serious threats.

Unknown Speaker: Well, 10(e) perhaps does not require a breach of fiduciary duty, or does it?

Mr. Dreeben: I'm sorry, which section?

Unknown Speaker: 10(e), liability under... excuse me,--

--14.

14(e).

Does that require a breach of fiduciary duty?

Mr. Dreeben: As the SEC has defined the acts that are prohibited in 14(e)3, it does not.

Unknown Speaker: Right.

Mr. Dreeben: And I think that that is justified, Justice O'Connor, on two bases.

First, Rule 14(e)3 in essence creates the duty to make disclosure, drawing on Congress' recognition that tender offers pose particular shareholder harms, and they pose particular dangers that the shareholders will not be able to make an important decision.

The SEC drew on the regulatory authority it was given to impose a duty to make disclosure, and second, the SEC's rule prevents violations that are akin to the misappropriation violation that occurs under section 10(b) by ensuring that when someone has material information of this character, they simply may not trade, even when there is no proof of a breach of fiduciary duty and deception in that.

Unknown Speaker: So that would extend liability to the thief?

Mr. Dreeben: It would extend liability to the thief so long as the thief acquired the information from the bidder or somebody acting on its behalf and knew that.

Now, what is important about section 10(b)'s application to fraudulent conduct of this kind is that investors in the securities markets rely on the fact that the markets are essentially honest.

No investor expects that he may have the skill, expertise, or analytical ability of everybody else in the market, and everyone who enters the market knows that they may be trading with somebody who's smarter than you are or better informed, and you're going to lose.

But investors do assume that they are not trading with someone who acquired the informational advantage simply by fraud, simply by stealing information in breach of a fiduciary duty and using it for trading.

That--

Unknown Speaker: Mr. Dreeben, may I... you've come back to 10(b), and I had a question that I wanted to ask you and then I got distracted, and I'd like to pose it now.

You made it clear, I think, that if the defendant in this case had simply disclosed his intention to use the information but did not receive authority, that there still would be a violation.

Mr. Dreeben: --No, I think that my position on that is that if there is disclosure to the client there would be no deception of the client.

If there's disclosure to the firm, there would be no deception of the firm.

There might be--

Unknown Speaker: Okay.

That's the point at which I guess I got mixed up.

You've clarified it now.

Mr. Dreeben: --Okay.

Thank you.

I would like to reserve the remainder of my time for rebuttal.

Unknown Speaker: Very well, Mr. Dreeben.

Mr. French, we'll hear from you.

Argument of John D. French

Mr. French: Mr. Chief Justice, and may it please the Court:

The respondent in this case was a regular substantial investor in the stock market.

He was convicted of 57 counts arising out of an alleged securities fraud and sentenced to 41 months in prison.

The basis of that conviction was a set of legal theories that are not incorporated into the text of any statute, that have sown confusion among the courts, and that provide no guidance to participants in the stock market.

I ask the Court to consider briefly the application of the Government's theories to what are, for purposes of this appeal, the undisputed facts in this case.

I am not now contesting facts.

I am asking the Court to think about the way the Government's theories apply to these facts.

On August 12, 1988, the Wall Street Journal reported that a British firm called Grand Metropolitan had put its hotel subsidiary, Intercontinental, up for auction to raise money for an acquisition.

On August 18, just 6 days later, a financial columnist named Dan Dorfman, announced on the Cable News Network that people close to Grand Metropolitan... and that is a common synonym in the trade for people inside Grand Metropolitan... are telling people in the street that Grand Metropolitan is interested in acquiring Pillsbury.

Also on August 18, a broker called respondent to advise that he'd received a $9 million order to buy 250,000 shares of Pillsbury stock for a customer in London.

Unknown Speaker: Mr. French, I gather you're trying to convince us that the doctrine would apply even if all the relevant information were in the public domain, and I'm assuming that we have a case that the jury found the relevant information was not in the public domain.

Mr. French: What I'm suggesting is that if a theory can be applied to result in a conviction of Mr. O'Hagan on the basis of facts which very clearly in the record indicated that he placed all of his orders for Pillsbury options before August 26, and the Government only indicts him, as the prosecutor says, for trades made from August 26 on, then the theory is grotesque.

You cannot, with--

Unknown Speaker: The reason it's grotesque, as I understand your presentation, is because the relevant information was in the public domain at the time he made his purchases.

Mr. French: --The relevant information was in the public domain and, as Your Honor knows, you may only be convicted, even under the Government's theory, if you trade on the basis of.

Unknown Speaker: Right, but I would like to try and address the question of what we do with a case in which the facts are the way the Government presents them and the way presumably the jury thought they were, namely that your client acted entirely on the basis of inside information that was not in the public domain.

Mr. French: That's--

Unknown Speaker: And in that connection I'd be curious to know your view on whether, if it was... instead of your client, if it had been the partner who was in charge of the matter within the firm who had done this, would you say he would also be... would he be covered or not, in your view?

Mr. French: --In my view, we are dealing here with a statute that involves, as Mr. Dreeben said, disclosure.

If Mr. O'Hagan had made... had had this private, nonpublic information that you're hypothesizing and disclosed to the Dorsey firm that he was going to trade on it, according to the Government's theory he couldn't have been prosecuted.

To me, that seems to be preposterous.

What's wrong with the Government's theory is, it doesn't have anything to do with unfair advantage being taken of a participant in the marketplace.

Unknown Speaker: Well, I'm... my question is, what if he had been the partner in charge of the matter within the firm, and had acted entirely on the basis of nonpublic information.

Could the statute apply in that situation, in your view?

Mr. French: In my view, according to the Government's theory, the statute would apply.

No.

In my view, the statute cannot apply.

There has been no--

Unknown Speaker: Even if this man were the only lawyer working on the matter in the firm for the client.

Mr. French: --That's correct.

Unknown Speaker: And had a clear duty to his client not to disclose.

Mr. French: That's correct, Justice Stevens.

In my view, it could not apply because--

Unknown Speaker: But Mr. French, you would give a different answer, would you not, if the lawyer were in the firm that was assisting Pillsbury in this matter?

Mr. French: --I certainly would, Your Honor.

Unknown Speaker: You have two lawyers, both with the same information, but one is working for the target company and the other is working for the potential takeover company, and you would distinguish those two cases.

So everything that you said in the beginning, if we just made one change, made O'Hagan with the firm that's representing Pillsbury, there would be liability and you wouldn't contest that.

Mr. French: I wouldn't be here today, Your Honor.

The--

Unknown Speaker: Is--

Mr. French: --The statute encompasses deception, and in the context of a nondisclosure, deception occurs in the presence of a fiduciary duty.

The lawyer inside Pillsbury has a fiduciary duty to the Pillsbury shareholders.

The lawyer outside Pillsbury does not have a fiduciary duty to the Pillsbury shareholders.

Unknown Speaker: --Well, are you basing your--

--Deceive the sellers not just deceive somebody who's working for the... for... right?

Mr. French: That's correct.

He has to have deceived the sellers in order--

Unknown Speaker: That's the basis for the distinction.

Mr. French: --A deception in connection with the purchase or sale of a security is the basis of--

Unknown Speaker: But what you're focusing on is not the definition of fraud, not the definition of deception, but in connection with securities.

Mr. French: --I'm focusing on two things, Your Honor.

First of all, I believe that what the Congress tried to adopt here was something to prevent securities fraud.

I don't believe the Congress is attempting to regulate the relationships between lawyers and their firms, which are regulated by codes of professional responsibility, or husbands and wives, or fathers and sons, which is the context in which these misappropriation cases come up.

Unknown Speaker: Well, is it wrong for me to proceed through the statute and the relevant... and 10(b) 5 by asking first, is there fraud?

Second, is it in connection with the sale of securities?

And it seems to me that in the case that Justice Stevens put to you, where the principal partner working for Grand Met starts trading on the inside information, that there is fraud in the sense of deception.

Mr. French: It is possible--

Unknown Speaker: Now... now, maybe that's right, maybe that's wrong under your view, and I'd like to hear why.

Now, I could understand if you went further and said there's not in connection with the sale of securities, but that's quite a different point.

Mr. French: --There is not even deception there.

There is theft, and contrary to Mr. Dreeben's position, theft of a piece of information is no different from theft of money.

It's not fraud.

You can be prosecuted for the theft vis-a-vis yourself and the person from whom you stole, or the person from whom you stole may proceed against you to recover the money, but it's not deception.

Otherwise, every single theft would result in a prosecution for fraud, and that never happens.

Unknown Speaker: What about the Carpenter case, Mr. French?

What about the Carpenter case?

I mean, doesn't that suggest that theft can be brought within the securities statute?

Mr. French: It suggests that theft can be brought within the mail fraud statute, Your Honor.

As to the securities fraud statute, the Court was equally divided, and therefore I don't know what the Court thinks with respect to that issue.

The Government cannot rely on Carpenter with respect to the mail fraud claim.

Unknown Speaker: Is it possible that some of these difficult cases... you know, what you call the preposterous cases, the mothers, whatever it is... would be fairly dealt with through a requirement that a criminal conviction must be willful?

I notice that word was in the criminal section, and does wilful mean that in this area, if you don't know the law, that's an excuse, so therefore in any of these borderline cases a defendant who didn't realize that what he was doing was against the securities law would be home free, and this would be reserved for the instances where people know that what they're doing is wrong as a matter of securities law.

I'd like your reaction to that.

I'm not certain whether that's correct or not.

Mr. French: Yes, Justice Breyer.

I have several problems with it.

One is that under the misappropriation theory no one will ever really know, because the misappropriation theory, even in the courts that have adopted it and follow it, is so confusing that the courts themselves... the court in Chestman, for example, says when you get outside the relationship with the shareholder, the... knowing whether or not the relationship applies is unclear.

Unknown Speaker: But you see, that's the basis of my question.

The defendant would be entitled to an instruction that if he didn't know that what he was doing was unlawful, he hasn't done it willfully.

I'm thinking of Ratzlaf.

I'm thinking of the cases that interpret willfully, and I wonder if that saves for the Government... saves them from your argument, because you're arguing this is all very unclear, and that's what I'd like a response to.

Mr. French: Well, it would be very helpful if that turned out to be, as the Government prosecutes these cases, the instruction.

There are several instructions in this case, as the record shows, against Mr. O'Hagan, that tell the jury that he doesn't have to know elements of the offense, for instance that he didn't have to know substantial steps were taken.

But to me, it doesn't answer the question.

I believe, as Judge Luttig said in the Bryan case, this mode of analysis pulls apart a unitary concept.

The unitary concept is deception or manipulation in connection with the purchase or sale of a security.

To me, that means the buyer or seller of the security deceives the person on the other side of the transaction.

It's not as if you deceive someone over here and then later on you benefit from it by dealing with somebody else.

Mr. Dreeben's remark, it seems to me, fits with my theory of this case.

He says, there... it has to be in connection with the purchase or sale of a security because the only way Mr. O'Hagan could profit was in the purchase or sale of a security.

Not so.

That assumes Mr. O'Hagan has no imagination.

Mr. O'Hagan could have said, I now have a useful piece of information.

I have misappropriated it.

I'm going to profit on it by selling it to the trade press.

I can get a good fee for this information.

So the misappropriation would have occurred, but it had been disconnected from the purchase or sale of the security.

Unknown Speaker: It's not entirely disconnected.

The trade press would only be interested in it because the people who read the trade press would be able to buy securities on the basis of this confidential information.

I doubt if they would have--

--They would have just pushed it one step further back, but it still necessarily--

--They wouldn't have paid this kind of price for it, either.

Mr. French: All right.

I'll give you another hypothetical, Your Honor, because I'm firmly convinced that the statute doesn't read the way Mr. Dreeben says it does.

You cannot disconnect the misappropriation from the purchase and sale of securities and say it's satisfied.

Mr. O'Hagan's office in Minneapolis is across the street from the Pillsbury Company.

He could have said to himself, I have always wanted the business of the Pillsbury Company.

I will walk across the street, misappropriating this information of my law firm and its client, deliver it to the Pillsbury Company, and suggest to the Pillsbury Company that in the future they might find it very desirable to use me for legal work.

That wouldn't have had anything to do with the purchase and sale of the security, and yet it would have profited Mr. O'Hagan if it had worked.

Unknown Speaker: Yes, but all you're saying is, he could have done a lot of things that were not in connection with the sale of the security, but what he did it seems to me was in connection with the sale of the security.

Mr. French: The cases of this Court have confined the statute to relationships between market participants.

I admit not merely buyers and sellers.

They've included brokers.

They've included other investors.

But at the time of the alleged fraud, neither Dorsey & Whitney nor Grand Met was a market participant.

Grand Met had a desire for a takeover.

It had no money for the takeover.

The transactions presumably ended by August 26.

Grand Met's own chief financial officer said that by September 18th they still didn't have the money.

They wanted to make a takeover.

They couldn't make a takeover.

It wasn't until October 4th that the takeover was proposed, was announced, so we have, I think for the very first time, a proposal by the Government that a fraud on a nonmarket participant be deemed to be in connection with the purchase and sale of securities.

Unknown Speaker: Well, the rule is written that way.

The rule... I know you're going to bring me back to the statute, but just so far as the rule is concerned, the rule says it's unlawful to have a deceit or a fraud upon any person--

Mr. French: Right.

Unknown Speaker: --in connection with the purchase or sale of securities.

It doesn't say upon a purchaser or seller of securities.

That's what it would say if your theory were to be adopted.

Mr. French: I agree it says any person, but it seems to me that rules are not allowed to stray outside the scope of their statute.

Unknown Speaker: Then we have to assume that Congress wouldn't intend... on your theory we could take the insiders, the most complete insiders of a corporation, say Grand Met if it were American, and they could go out and buy all the shares they wanted, knowing that those companies are about to be taken over.

They can buy the shares of the companies that are about to be taken over, and that would be lawful under the securities law, in your view.

Mr. French: It would up until a point but there's a whole panoply of regulation relating to tender offers.

Once you've embarked on a tender offer you have to announce it, and there's restraints on how you can conduct it, and you cannot make misrepresentations in connection with it.

I do not think this particular reading of this statute is necessary to keep tender offers clean.

Unknown Speaker: Mr. French, would you tell me, if your position is the one we adopt, what becomes of the 1988 legislation that provides... provided for a private right of action?

It appeared that Congress was operating on the basis of certain understandings about what 10(b) and 14(e) meant.

Mr. French: Well, Justice Ginsburg, two things about the 1988 legislation.

First, it was adopted... whatever they mean, it was adopted after my client's acts, and therefore it seems to me he can't have anticipated--

Unknown Speaker: Oh, I don't mean with respect to your case, but you're asking us to make a ruling that will govern not simply this day and case--

Mr. French: --Yes.

Unknown Speaker: --but that will interpret 10(b) and 14(e), and so I would like to know what becomes of that later legislation.

Is it in shambles?

Mr. French: I think what I'd like the Court to do is think about all of the legislation and attempted legislation throughout the 1980's in thinking about that issue.

In 1984, the SEC went to the Congress and proposed legislation that would have covered this subject matter, would have covered the misappropriation area, and then when Congress got ready to enact it said no, we would prefer vagueness and ambiguity.

Please don't enact it.

Then in 1987, when the SEC went to the Congress with a proposal to enact the misappropriation theory, the Congress rejected it.

Then in '88 it enacted something having to do with participants in the market that once again did not amend the language of 10(b)5, so it seems to me there is no basis for saying, as some of the amici have said, that the Congress has codified these theories into law.

It has not enacted any of this into law.

So my answer is the 1984 legislation and the 1988 legislation have to be left to apply to 10b-5 as interpreted ultimately by this Court, and the Congress, if it wants to get the misappropriation theory into law, has to write it into law.

Unknown Speaker: So you disagree with what one of the amici briefs said, that... I think it was the one from the NASAA... stated that you virtually conceded that O'Hagan's conduct would have violated the 1988 act if it had post-dated that legislation.

Mr. French: I disagree, Your Honor.

The amici briefs... one of the amicus briefs says the Congress codified the misappropriation theory.

The Government says the Congress has validated the misappropriation theory.

A third amicus brief says the Congress has not codified the misappropriation theory, but ratified it.

I don't know what ratified or validated means in these circumstances.

I know what enact means.

Congress has not enacted it.

So yes, I disagree.

Unknown Speaker: Why hasn't Congress... what I'm actually thinking, Congress has... think of the case of the insider for the company itself, the company that's going to take over another company.

Everybody knows that those insiders shouldn't go out and buy up stock in the takeover target secretly, and it deceives everybody in the company for which he works.

So the SEC, the expert organization, decides that that's so.

It fits within the language of the statute.

And then of course you would be worried about criminal liability for vague theories, but that's where I came back to the word willfully.

So I'm really asking this to see if there's anything more you want to say in that area.

Mr. French: I'd be happy--

Unknown Speaker: Should I see it as a delegation problem, an expert agency, literal language complied with, and criminal liability taken... unfair criminal liability taken care of by willfully?

I'm sketching that out for you so that I can get it--

Mr. French: --Yes, Justice Breyer.

What we have is a... and I am not in a position to ask this Court to reverse several decades' worth of law, but what we have is a situation that's slipped its moorings.

Insider trading was supposed to be governed by section 16(b).

Katie Roberts worked very hard to get insider trading under 10(b) more than 30 years after the statute was passed by saying it depends upon nondisclosure as between participants to a transaction.

This Court went along with that in Chiarella, but not further.

What the Congress needs, if it wants to get passed... and I can even conceptually do that.

I can... in my mind I can say, misrepresentation... deception can encompass nondisclosure when there is a duty to speak.

I can't get beyond that.

So if the Congress wants within the framework of 60 years of law to get beyond misrepresentation or nondisclosure constituting deception when there's a duty to speak, it should pass a statute about it, which it has not.

Perhaps I should move to 14(e).

It seems to me that there are two serious problems with 14(e) which I think the Government cannot deal with.

One is the agency has not promulgated rules designed to help prevent frauds from arising.

It simply redefined the word fraud.

The statute prohibits fraudulent, deceptive, or manipulative acts.

The SEC announces that something is a fraudulent, deceptive, or manipulative act which doesn't have any element of fraud in it.

It just says you can't trade if you have the information.

Again, if you look at one of the courts that's gone along with the rule, SEC v. Maio in the Seventh Circuit, says the rule requires a duty to disclose regardless of whether such information was obtained through a breach of fiduciary duty, so it seems to me that the rule has just outstripped the statute it's supposed to be implementing, and that's impermissible.

The second thing wrong with the rule is, the rule says you mustn't trade in connection with a tender offer.

The SEC has said you may not trade if substantial steps have been taken toward a tender offer.

That's not in the law.

That is an accretion to the law that's not there.

It--

Unknown Speaker: --But their rulemaking authority under the law allows them to go beyond the law.

It allows them to make rules that will prevent a violation of the law.

You concede that that allows them to make unlawful by rule some things that are not made unlawful by the statute, don't you?

Or don't you?

Mr. French: --I do, but I don't concede that it authorizes them to change the criminal application of this statute.

If the Court when it has an--

Unknown Speaker: I don't really understand your response.

If it authorizes them to go beyond the law... you mean only for civil purposes?

Is that what you're saying?

Mr. French: --I'm... I'll say two things.

First, it plainly can't do it in the criminal context because it can't transform fraud into nonfraud and say, this is criminal, but beyond that, what I think it can do--

Unknown Speaker: Before you go beyond that, it's not transforming fraud into nonfraud.

It's saying, this is nonfraud.

It's not covered by the statute, but we're prohibiting it nonetheless because the statute allows us to do it.

It allows us to prohibit things in order to prevent fraud, not just to prohibit fraud but to prohibit other things in order to prevent fraud.

That's how the statute reads.

Mr. French: --No, Your Honor.

This redefines the word, fraud.

It says, it shall be, it shall constitute fraudulent activity if you purchase after substantial steps have been taken.

Unknown Speaker: That's a different point you're making.

You are making the point that this rule might have been okay if it had read differently, if it had read, thou shalt not do this.

Instead, however, it reads doing this constitutes fraud under the... under 14(e), and that's simply false, so the rule is false.

It's not that it--

Mr. French: The rule is false.

The rule is--

Unknown Speaker: --It's not that it does something that the Commission couldn't.

It does it in the wrong way.

Mr. French: --The rule is false.

Moreover--

Unknown Speaker: But could it have done it another way?

Mr. French: --I don't think it could do... let me try to do this in conjunction.

I don't think it could do this in another way because there's no definition of substantial steps, and it is not possible for most participants in securities transactions to know that substantial steps have been taken.

Unknown Speaker: Well, but that's essentially a vagueness argument.

Mr. French: It certainly is a vague--

Unknown Speaker: I suppose rather than a breach of delegated... or an excess of delegated authority.

Mr. French: --That's correct.

May I take an example in an area in which I practice heavily.

The Federal Trade Commission Act prohibits deceptive acts, unfair or deceptive acts or practices.

In the context of that statute the agency, in prosecuting for deception, just takes straightforward misrepresentations, lots of different kinds but straightforward misrepresentations.

In the concept of unfairness, it treads very carefully, conducts investigations, promulgates trade regulation rules, and then says we have identified a practice here that we deem to be unfair.

We haven't amended the law to allow us to prohibit things that are fair.

We've identified this act as unfair.

And then it goes forward on a very careful basis with prosecutions that only lead to injunctive results.

Unknown Speaker: But that basically is then kind of an administrative process argument, and once again it seems to me you're not saying when you make that argument that they have exceeded their... that the essential problem is that they have exceeded their delegated authority, but the contrast that you are drawing is that they were more careful about predicating their exercise of delegated authority.

Mr. French: And they certainly have been more careful.

Unknown Speaker: But if that's the nub of what you're arguing, it's not that they've exceeded the authority in our case, if that's the point of your argument, but that they just didn't go about it the right way.

Their process was defective.

Mr. French: No, I really am going beyond that.

I am--

Unknown Speaker: Okay, then I don't--

Mr. French: --I am saying... I am saying that when the statute says you must not commit fraud in connection with a tender offer, the agency cannot say, you are also subject to prosecution when... even when you don't commit fraud, and even when no tender offer has been launched, but because substantial steps have been taken.

That rewrites the law.

That is not a rule that implements the law.

It rewrites the law, and that's the distinction I'm drawing.

Unknown Speaker: --Mr. French, does the Federal Trade Commission Act say that the Federal Trade Commission shall, by rules and regulations, define and prescribe means reasonably designed to prevent unfair or deceptive trade practices.

Mr. French: I don't recall the language producing the implementation.

Unknown Speaker: I don't think it does.

That's the crucial sentence here which allows this agency, as I think the Federal Trade Commission Act does not allow the Federal Trade Commission to go beyond what the statute says and to define other things as unlawful in order to prevent the things that the statute prohibits.

I think that's the fair meaning of that sentence, now.

Maybe you say that's an unconstitutional delegation or something, but it seems to me you have to grapple with the reality that Congress has told this agency, you can make unlawful things that the statute does not make unlawful.

Mr. French: You can put into a class of prohibited conduct in some way or another things that you define as reasonably designed to prevent fraudulent acts.

Unknown Speaker: And suppose you go on and say, and we will treat these as if they were fraudulent acts?

Mr. French: I do not believe you can go on and say, you may treat... we will treat these as fraudulent acts.

There has to be for people to be not at risk all the times--

Unknown Speaker: Well but the sanction is the same.

It just says that the sanction mechanisms of the statute are employed.

Mr. French: --You may not, Your Honor, I think, put people at risk of prosecution for fraudulent acts committed in connection with a tender offer by announcing that nonfraudulent acts are fraudulent acts and can be prosecuted when there isn't any--

Unknown Speaker: Well, there has to be the premise that they're necessary to avoid other fraudulent acts.

Of course, the text says fraudulent, deceptive, or manipulative.

It's kind of a broad term.

Mr. French: --It certainly is, but I believe the Court in Schreiber has equated deceptive and manipulative under this statute with deceptive and manipulative under 10(b), so it has some content that narrows somewhat the breadth of it.

I don't know if the Court wishes me to speak on the subject of mail fraud.

Mr. Dreeben did not, and I'm willing to leave it to the briefs.

I would say with respect to that that all that happened here is that in the Eighth Circuit, the Eighth Circuit--

Unknown Speaker: Mr. French, your time has expired.

Mr. French: --Thank you, Mr. Chief Justice.

Unknown Speaker: Mr. Dreeben, you have a little over a minute left.

Rebuttal of Michael R. Dreeben

Mr. Dreeben: Thank you, Mr. Chief Justice.

In order to convict respondent on the section 10(b) count, the jury had to find that he acted with the intent to deceive, manipulate, or deprive... these are in the jury instructions at page 199 of the joint appendix... and the statutory requirement for the imposition of imprisonment requires that he be shown to have knowledge of the regulation or rule that he violated.

He cannot show that... if he shows that he did not have knowledge of it, he cannot be imprisoned, but the statute does require proof of wilfulness in order to sustain any criminal conviction.

Unknown Speaker: Mr. Dreeben, I hate to use up any of your short time, but there's a new point which came out in oral argument here which I don't recall in the briefs, and I want to know what your response to it is, and that is, assuming that 14(e), as I think is true, does allow this agency to make unlawful things that the statute itself does not, has it purported to do that in its regulation?

Mr. Dreeben: Justice Scalia--

Unknown Speaker: And if it has not purported to do that, has not purported by that regulation to prescribe means reasonably designed, but rather in its regulation simply redefines what constitutes fraud or deception, then is that an exercise of the power that's given by that second sentence of 14(e)?

Mr. Dreeben: --I think that it is, Justice Scalia.

The ultimate... may I answer?

Unknown Speaker: Yes.

Mr. Dreeben: The ultimate question is whether the SEC's prohibition on trading, which is clearly described in the rule, is within its statutory authority which is a question for the court, and the court may determine that the SEC's prohibition does satisfy the statute based on either the defining prong or the means reasonably designed to prevent, and it's analysis of the reasons that are given.

We address this question in our brief in opposition in the Chestman case.

Chief Justice Rehnquist: Thank you, Mr. Dreeben.

I think you've answered the question.

The case is submitted.

Attribution:

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Featured:

Dunn v. Commodity Futures Trading Commission - Oral Argument

Fri, 09 Jan 2009 14:50:08 +0000

Case:

Dunn v. Commodity Futures Trading Commission

Media File:

95-1181_19961113-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Gary D. Stumpp

Chief Justice Rehnquist: We'll hear argument now in No. 95-1181, William C. Dunn and Delta Consultants, Inc. v. Commodity Futures Trading Commission.

Mr. Stumpp.

Mr. Stumpp: Mr. Chief Justice, and may it please the Court:

The Treasury Amendment to the Commodity Exchange Act, which is quoted in full on page 1 of our brief, provides in pertinent part, nothing in this chapter shall be deemed to govern or in any way be applicable to transactions in foreign currency unless such transactions involve the sale thereof for future delivery conducted on a board of trade.

The question presented in this case is whether the Treasury Amendment excludes off-exchange foreign currency options from CEA regulation, thus whether off-exchange foreign currency options are transactions in the foreign currency within the Treasury Amendment--

Unknown Speaker: Now, if it were a... an off-exchange futures deal--

Mr. Stumpp: --I'm sorry?

Unknown Speaker: --If it were an off-exchange futures--

Mr. Stumpp: Yes, Your Honor.

Unknown Speaker: --agreement that we were dealing with, I guess the Commodity Futures Trading Commission... both parties agree, it wouldn't have jurisdiction?

Mr. Stumpp: I believe... yes, both parties would agree, Your Honor.

The only dispute is because it's an off-exchange foreign currency option transaction rather than an off-exchange--

Unknown Speaker: Why shouldn't futures and options be treated the same?

Mr. Stumpp: --I believe they should be, Your Honor, and I believe both of them are exempt by the Treasury Amendment, as long as they're off-exchange transactions in foreign currency, whether in futures or in options.

Unknown Speaker: Although the Treasury Amendment didn't really speak of the options.

Mr. Stumpp: No.

The Treasury Amendment spoke broadly, Your Honor, of transactions in foreign currency.

It did not limit it to foreign currency futures.

It spoke broadly of transactions in foreign currency.

And accordingly, the ordinary meaning of the phrase would indicate that any transaction in which foreign currency is the subject matter would be excluded by the Treasury Amendment... off-exchange.

Unknown Speaker: But there are some holdings that distinguish transactions in from a future or an option agreement.

Mr. Stumpp: I would think the holdings Your Honor is referring to are certain holdings that have distinguished off-exchange futures from off-exchange options, along the lines that an option until exercised does not become a transaction in the foreign currency itself.

And if those are the decisions to which Your Honor is referring, I think they were... first, I think both courts that decided that way were dicta because you were dealing with exchange traded futures, although that was not the ground on which the courts went, and therefore it would be subject... it would not be subject to the act.

Unknown Speaker: Exchange traded futures or exchange traded options?

Mr. Stumpp: In the two cases I believe Justice O'Connor is referring to... is the Chicago Board of Trade and the American Board of Trade case... they both dealt with off-exchange options on foreign currencies, and--

Unknown Speaker: She said futures I think.

Mr. Stumpp: --Thank you.

Your Honor.

Unknown Speaker: But you... would you run by me what you said about dictum because the Second Circuit said we might have gone on another ground but we didn't.

The ground that we went on was the first one.

So--

Mr. Stumpp: As I said, Your Honor, I believe that the holding in the American Board of Trade case on which the court below relied in this case was dicta because it was on-exchange trading.

However--

Unknown Speaker: --But in that earlier case, the court didn't decide it on the basis that it was on-exchange trading.

It decided it on the basis that it was an option.

Right?

Mr. Stumpp: --No.

I agree, Your Honor.

I'm not questioning the way the court got there.

I'm saying they could have gotten there another way, but obviously the way the court did decide, they did not go on an on-exchange/off-exchange--

Unknown Speaker: Is their holding.

Is their holding.

Mr. Stumpp: --The holding in American Board of Trade was options do not become transactions in foreign currency--

Unknown Speaker: Right.

Mr. Stumpp: --until they're exercised.

Unknown Speaker: Right.

Mr. Stumpp: The court below recognized that they could have gone on a different basis--

Unknown Speaker: But didn't.

Mr. Stumpp: --but did not, and accordingly could not overrule the decision of the prior panel and noted the conflict with the Fourth Circuit and indicated that that... such a conflict was for this Court to resolve.

Unknown Speaker: Yes.

Well, I just wanted to be clear that you recognized it was a holding.

Mr. Stumpp: Oh, I... my only point, Your Honor, was I said I thought it could have been dicta, but clearly that is not the way the court, the Second Circuit, went.

Unknown Speaker: Right.

Mr. Stumpp: The question, thus, is whether the off-exchange foreign currency options are transactions in foreign currency within the Treasury Amendment and thus exempt from regulation under the Commodity Exchange Act.

We submit that that question should be answered in the affirmative for two reasons.

The ordinary meaning of the phrase transactions in foreign currency means any commercial dealings involving foreign currency or any dealings where foreign currency is the subject matter of the transaction.

Here off-exchange foreign currency options that were traded are dealings and they are... and they do have foreign currency as the subject matter.

Accordingly, under the ordinary meaning of the Treasury Amendment, they are exempt from Commodity Exchange Act regulation by the Treasury Amendment.

The second reason really confirms the first.

The congressional purpose in enacting the Treasury Amendment was to exclude off-exchange foreign currency transactions of whatever type from the Commodity Exchange Act.

Unknown Speaker: Well, you say whatever type.

Now, this type was not known at the time of the amendment.

Right?

Mr. Stumpp: That's true, Your Honor.

There was not the established market there is for off-exchange foreign currency markets in 1974.

Unknown Speaker: Tell me who were the traders that the Treasury had in mind when it proposed this amendment.

I take it it's the large banks I assume.

Mr. Stumpp: The majority... the off-exchange interbank market is primarily composed of the major banks.

Unknown Speaker: All right.

Mr. Stumpp: And in fact the trading in this case was done in such banks.

Unknown Speaker: Now, are the major... that's in part an answer to my next question.

Are the same major banks for whom the Treasury had concern at the time the amendment was proposed engaging in the kind of option trading which is the subject of this case?

Mr. Stumpp: I'm only unclear, Your Honor, if you're asking back in 1974 or--

Unknown Speaker: No.

I know in '74 they couldn't have, but today.

They're trading options the same way they used to be trading futures.

Mr. Stumpp: --They're trading--

Unknown Speaker: As they're now--

Mr. Stumpp: --They are trading foreign currency options now, Your Honor.

In fact, I believe from the amici briefs that were submitted by the banks and the industry associations, it indicates the hundreds of billions of dollars that are trade in that market on a--

Unknown Speaker: --So that if the concern at the time the amendment was originally proposed was to keep this business within the United States, or keeps the... keep the American banks competitive, that concern of policy I presume then would be just as applicable to options trading today as it was for future tradings then.

Mr. Stumpp: --I think that's precisely correct, Your Honor.

I would also note that although the primary perhaps concern with the Treasury Amendment related to the large banks, that was not the only concern.

The Treasury Department noted that it was also to affect the traders and investors that were dealing in this off-exchange market.

So, I will not deny that the majority of the traders were the major banks, but they are not the only traders who are dealing in this market either then or now.

Unknown Speaker: If... as I understood your answer to Justice Souter, there were very few traders other than the large banks in options in foreign currency.

How about options in Government securities?

Mr. Stumpp: Again, Your Honor, are we speaking then or now?

Unknown Speaker: Then.

Mr. Stumpp: I don't know what traders existed back in '74 in the Government securities market.

I would certainly assume that the major banks were trading there.

The Treasury Department in its letter spoke generally of this off-exchange market referring to banks, referring to investors.

The CFTC itself has indicated there are other participants, abritrageurs, import-export companies, et cetera, dealing in the general foreign currency market.

I have not individually focused underneath that in terms of--

Unknown Speaker: One of the concerns that I have is that whatever we say here with reference to foreign securities... options in foreign currencies is going to apply also to options in Government securities.

And there's a suggestion in some of the briefs that accepting your position would lead to a substantial regulatory gap.

So, just during the course of your remarks, I hope you could address that.

Mr. Stumpp: --All right, Your Honor.

The second meaning that I... or the second reason I was suggesting the question should be answer in the affirmative was the congressional purpose in enacting this to exclude the entire off-exchange market from regulation under the Commodity Exchange Act.

And as has been suggested by the... some of the questions today, that unless that decision is reversed and foreign currency options are held to be excluded by the Treasury Amendment, the congressional purpose in enacting it would be defeated and the vast majority of foreign currency options may move to banks and institutions without the United States.

Now, to provide just a brief description of petitioners' activities in this case, petitioner Dunn was the President of petitioner Delta Consultants which served as an advisor concerning foreign currency transactions to various investment companies.

However, the foreign currency options that were transacted were not traded with investors and they were not traded on a board of trade.

Instead, the transactions were entered into in the international off-exchange interbank market with major banks, primarily Credit Lyonnais, Bank Julius Baer, Societe Generale, and Chase, and are different from the foreign currency futures contracts that are traded on exchanges and which the CFTC does regulate.

The district court rejected the argument that the Treasury Amendment provided an exclusion for these off-exchange foreign currency options and therefore there was no subject matter jurisdiction.

The Second Circuit affirmed but did not independently analyze the Treasury Amendment exclusion.

We submit the decision should be reversed.

Petitioners here engaged in transactions in foreign currency.

Those transactions were not conducted on a board of trade, and thus the Treasury Amendment excludes CEA regulation of petitioners off-exchange foreign currency trading.

As this Court has held, where the terms of a statute are not defined in the statute or have no common law... established common law meaning, they must be given their ordinary meaning.

And here the ordinary meaning of transactions in foreign currency are any dealings where foreign currency is the subject matter.

Really then we're dealing with the meaning of four words in the Treasury Amendment, transactions in foreign currency.

The CFTC concedes these are transactions.

There is no issue that foreign currency is involved.

So, the dispute comes down to the meaning of the word in as used in the four-word phrase transactions in foreign currency.

Unknown Speaker: Why couldn't in have a narrower meaning given that the statute also uses the word involving?

We think of transactions in interstate commerce as different from transactions affecting interstate commerce.

We have that kind of difference in the law.

Why shouldn't it apply here?

Mr. Stumpp: Because there is no indication of any congressional purpose to indicate such a distinction.

I think that the argument being made by respondents is that Congress selected the word in to draw a rather critical regulatory distinction, and I don't think there's any indication that that was the intent of Congress to do so.

There would be no reason why if that in fact were the intent, the Treasury Amendment would not simply have been drafted as transactions in foreign currency futures as opposed to leaving the broad description of transactions in foreign currency.

Unknown Speaker: Is there some reason in policy why you would want to distinguish between the two?

Mr. Stumpp: There is no reason why I would wish to distinguish between the two.

Unknown Speaker: Why one would wish to distinguish between the two then.

Mr. Stumpp: I don't think that there would be a reason in light of the legislative intent indicated in enacting the statute.

The Treasury Department letter which was submitted as the Commodity Exchange Act... the amendments were being proposed and the definition of commodity was being substantially expanded beyond the traditional agricultural commodities, the Treasury Department was concerned that that language might include foreign currency transactions and communicated that concern to Congress.

Most of the specific discussion contained in the Treasury Department's letter referred to foreign currency futures.

However, the specific language which the Treasury Department proposed and which Congress enacted as the Treasury Amendment does not speak of foreign currency futures.

It speaks more generally and more broadly of transactions in foreign currency.

So, there would be no reason to take that approach unless the intent were to exclude the entire field of off-exchange foreign currency futures.

Indeed, the respondents point out that, as has already been commented on, in 1974 there was not an established market for off-exchange foreign currency options.

Thus, it really doesn't make sense to suggest that without such a market Congress intentionally chose the word in to distinguish futures from an options market which did not yet exist to any real extent.

So, accordingly, I think the ordinary meaning and the most logical meaning, which is confirmed by the congressional purpose, is that transactions in foreign currency was a broad exclusion to this new expansion of the definition of commodity under the CEA and accordingly should be given that effect by this Court, namely, to exclude the entire field of off-exchange foreign currency transactions, whether those transactions happen to be in the nature of futures, options, or any other type of transaction that there may be.

Unknown Speaker: Because we're going to have to draw the distinction with respect to the sort of recapture proviso at the end, aren't we, because that refers to sales for future delivery?

So, that's going to draw back the futures contracts, but it's not going to draw back the options contracts.

Mr. Stumpp: I do not agree, Your Honor, that the savings clause only relates to futures.

I think the savings clause exempts from... the Treasury Amendment excludes all off-exchange transactions in foreign currency, and the savings clause brings back those in the language of the statute which involve the sale thereof for future delivery conducted on a board of trade.

Unknown Speaker: But sale for future delivery is a fairly straightforward description, isn't it, of the future versus the options contract?

Mr. Stumpp: I would say, Your Honor, that the description of sale for future delivery would include both futures and options.

I think the act in different places uses phrases such as a contract of sale for future delivery.

Here it's a broader phrased sale thereof for future delivery.

So--

Unknown Speaker: If you were describing an option alone, would you use the word delivery?

You don't deliver under one of these kinds of options.

You don't deliver anything, do you?

Mr. Stumpp: --Well, I think you deliver under an option as much as you deliver under a future because--

Unknown Speaker: But you don't deliver until you... until somebody exercises the option; whereas, under the futures contract, if the contract is not canceled, you do have to deliver.

Isn't that right?

Mr. Stumpp: --Oh, that's true, but my point is first that most futures contracts are offset rather than actual delivery being made under them, and the nature of the transaction is both futures and options are derivative transactions.

They are not transactions actually involving the underlying commodity, whatever that commodity might be.

It's not--

Unknown Speaker: Well, whether actually delivered or not, whether they're offset instead of executed, doesn't alter whether they are a sale for future delivery.

When the sale occurs, it is a sale for future delivery.

Mr. Stumpp: --And I believe that is true for both options and futures.

Unknown Speaker: An option is not a sale at all.

It's an option to make a purchase and a commitment to make a future sale if the option to make a purchase is exercised.

Mr. Stumpp: From the writer's standpoint, Your Honor, there's an obligation.

Perhaps from the buyer's standpoint, he might have the decision to make as to whether to exercise the option, but from the standpoint of the writer of the option, he's obligated to make whatever, depending on whether it's a put or call option... to make delivery or to get out of the contract, offset the contract in the same way you would do with a futures contract.

Unknown Speaker: Mr. Stumpp, I thought section... 7 U.S. Code, section 6(c) had some specific bearing on this case, and it's entitled Regulated Option Trading and says that no person shall offer to enter into or enter the execution of any transaction involving any commodity regulated under this chapter which is of the character of or is commonly known to the trade as an option contrary to any rule, regulation, or order of the Commission.

And then subsection (f) of the same section says that nothing in this chapter is deemed to govern or be applicable to any transaction in an option on foreign currency traded on a national security exchange.

Apparently the purpose there is to preserve SEC jurisdiction.

Mr. Stumpp: On 6c(f), that's exactly the purpose, Your Honor.

Unknown Speaker: Yes, but on the first... on subparagraph (b) it seems to give to the Commodity Futures Trading Commission the power to regulate or prohibit some transaction in the character of an option.

Mr. Stumpp: That's true.

I don't think there's a dispute that the CFTC has general jurisdiction over options.

However, when specifically dealing with foreign currency... or transactions in foreign currency, whether those transactions are options, futures, or any other type of transaction in foreign currency, those, provided they occur off exchange are exempt from the Commodity Exchange Act pursuant to the Treasury Amendment.

There are other provisions.

Section 2(i) of the Commodity Exchange Act also gives regulation authority to the CFTC over options.

But again, those are options... regulation generally resides in the CFTC which is not disputed.

However, if the option is in foreign currency, if it is a transaction in foreign currency, the Treasury Amendment pulls it out, exempts it from the Commodity Exchange Act, whether it be under section 6c(b), section 2(i), or any other section.

The Treasury Amendment would exclude them from regulation under the act.

The ordinary meaning, as I've stated, of transactions in foreign currency basically is any transaction where the subject matter involved is foreign currency.

The CFTC--

Unknown Speaker: But to reach your conclusion, you have to say, as you do apparently, that an option with respect to foreign currency is a transaction in foreign currency.

That's necessary for your result.

Mr. Stumpp: --An option is as much a transaction in foreign currency as a future is, Your Honor.

Unknown Speaker: Would you look at, let's see, section 6(c).

Where is it?

It's on page 6a of the Government's--

Mr. Stumpp: Brief on the merits, Your Honor.

Unknown Speaker: --Brief on the merits, and it's item 2 on page 6a which is section 6c(d)(2).

The Commission shall issue regulations that permit grantors and futures commission merchants to offer to enter into... enter into... or confirm the execution of, any commodity option transaction on a physical commodity subject to the provisions of.

Elsewhere the act speaks of an option transaction on a commodity, and you're saying that the earlier expression, transaction in, includes options.

Doesn't this later language suggest that transaction in does not refer to options?

Options are on the commodity, not in the commodity.

Mr. Stumpp: Well, first, Your Honor, I don't agree with that kind of a conclusion.

The CFTC or the respondents have spent a great deal of time arguing that transactions in are different from transactions involving.

Your Honor is now suggesting transactions on.

The meaning, particularly in light of the way the Treasury Amendment came up, was clearly to exempt the field.

The Treasury Department proposed the specific language and Congress adopted the language.

I think it is clear that again if the intent were only to exclude futures, it would have been easy to say transactions in foreign currency futures.

The language selected by Congress as proposed by the Treasury Department which wished to exclude CFTC regulation in the entire off-exchange foreign currency market was simply transactions in foreign currency.

The fact that the act in different places may provide regulations for options generally does not detract from the exclusion that the Treasury Amendment provided for those transactions in foreign currency whether they happen to be options or any other type of transaction in that foreign currency.

I would also note that, and getting back to one of the prior points in terms of delivery as a future compared to an option, is that the CFTC respondents argue that options only create a right rather than an obligation to purchase or sell the commodity.

That type of distinction is really inaccurate because it doesn't properly describe a future itself.

Under the act there have been determinations that futures... instruments can be futures without that type of purchase and sale obligation.

The CFTC... if purchase and sale of the underlying commodity were an actual requirement of being a futures contract, then the CFTC would not have been able to approve a number of exchanged-traded, cash-settled futures.

Where there are no... where they can be no delivery, there is no obligation to purchase or sell the underlying commodity, and in fact some of these, such as Eurodollars... the underlying commodity doesn't really exist.

You couldn't deliver.

You have to cash settle.

So, the delivery aspect in an attempt to differentiate futures and options simply does not work because that is not an accurate description of commodity futures contracts themselves.

Unknown Speaker: Why couldn't you deliver Eurodollars, Mr. Stumpp?

Mr. Stumpp: They don't exist as such.

Unknown Speaker: That's a good reason.

[Laughter]

May I ask--

--In answer to the gap problem that has been raised, one of your friends said that what Dunn/Delta are doing... that doesn't fall between the regulators because clearly what Dunn is doing falls within the SEC bailiwick because you are... what you're doing is having contracts with your investors and those would count as securities.

Do you agree that that would be so, that you might escape the CFTC, but you're with the SEC?

Mr. Stumpp: Speaking here, Your Honor, I don't think there is any regulatory gap because even the CFTC's complaint describes the investments that were entered into here as investment strategies, and I think that would fall within the definition of investment contracts for SEC jurisdictional purposes.

So, I don't think there is any regulatory gap.

I think there is no jurisdiction of the CFTC over these transactions, but it is not to suggest that there is not jurisdiction of other agencies, most appropriately the SEC, to regulate those type of transactions.

As I said, the transactions were not made between petitioners and the individual investors.

The transactions were made between... with the major banks.

The investors were not counter-parties to any of the off-exchange foreign currency options that were transacted here.

Unknown Speaker: If we think that the language is open to either interpretation, and at the time they enacted it, nobody really thought about the options market developing, and if there's a good practical way to get your... the industry's concerns dealt with through negotiations between Treasury and CFTC dividing responsibility, why wouldn't we then, other things being equal, say, all right, the people who administer this, apparently the Treasury and the CFTC, think it's better to read the language as inclusive and then get the exclusion through negotiation with the industry between the agencies?

It introduces more flexibility, deal more subtly with congressional and Treasury purposes, et cetera.

Why not go in that direction?

I'm not saying I would.

I'm just trying to get your response to it.

Mr. Stumpp: First, Your Honor, I'd note that it might not have been intended that way, but I think your question has a hypothetical element to it simply because the CFTC and the Treasury Department most certainly do not agree over the way this provision is read.

I think perhaps the--

Unknown Speaker: But I was thinking they could work out... they don't agree.

Mr. Stumpp: --They don't agree.

They have filed amicus briefs in the Fourth Circuit in Salomon Forex.

They filed amicus briefs on opposite sides of the issue, and that was 4 years ago.

In fact, in the opposition to the petition for certiorari in this case, which was jointly submitted by the CFTC and the Treasury Department, one of the reasons that were offered why this Court should not grant cert was that there might be a chance the agencies would work it out between themselves.

Unknown Speaker: Right.

Mr. Stumpp: Obviously--

Unknown Speaker: I noted that that brief was filed for the Commodity Futures Trading Commission and for the United States as amicus curiae, whereas the opposition on the merits is just for the CFTC.

Mr. Stumpp: --That's right.

The Treasury Department, I think it's fair to say, does not share the view of the CFTC.

Unknown Speaker: And this thing was called the Treasury Amendment, wasn't it?

Mr. Stumpp: Yes, it was, Your Honor.

Unknown Speaker: Because it was introduced by the Treasury Department.

Mr. Stumpp: Specifically by... or specifically enacted as they proposed it.

Unknown Speaker: But if I may just vary Justice Breyer's question, yes, these agencies right now do not seem to be in agreement, but if this Court made a decision that would say what the law is, then does it follow that there are going to be this tight regulation then that would drive everyone to the London or other markets instead of reasonable exemptions being made?

Mr. Stumpp: I think that that's... obviously, it's a hypothetical because it hasn't happened, Your Honor.

I think that in the number of years the dispute has existed, if it were possible to reach some kind of agreement without a direction from this Court, I think it would have happened by this time.

Unknown Speaker: Well, isn't your answer that if Treasury were that confident, they would never have introduced the Treasury Amendment?

If they were content to rely upon the good offices of the communities... Commodity Futures Trading Commission, they wouldn't have introduced the amendment at all.

They would have just said we'll cut our deal with the Commission.

We know they're reasonable people.

Mr. Stumpp: I will agree with that observation.

[Laughter]

If I may, Your Honor, if there's no further questions, Mr. Chief Justice, at this time I'd like to reserve whatever remains for rebuttal.

Unknown Speaker: Very well, Mr. Stumpp.

Mr. Minear, we'll hear from you.

Argument of Jeffrey P. Minear

Mr. Minear: Thank you, Mr. Chief Justice, and may it please the Court:

We submit that foreign currency futures are transactions in foreign currency, but foreign currency options are not.

We think that is the most accurate and sensible interpretation of the Treasury Amendment's text.

Unknown Speaker: Well, so you both agree that it's a... an option is a transaction in.

Mr. Minear: No.

I... we disagree that--

Unknown Speaker: Then I misunderstood you.

Mr. Minear: --Yes.

A... we say that a futures contract is properly described as a transaction in a commodity because it is an actual sale of the commodity although at a... for settlement and delivery at a later date.

An options contract by contrast is a sale of a future right to buy or sell the commodity.

It involves the commodity, but it is not a transaction in the commodity itself.

Unknown Speaker: Is it a transaction involving a commodity?

Mr. Minear: It would be fair to characterize it as a transaction involving a commodity.

And in fact, that is how the CEA actually characterizes it, and it's one of the reasons why we have concerns with treating a transaction in foreign currency as a transaction in foreign currency options.

Petitioners argue--

Unknown Speaker: May I clarify one thing at the outset, Mr. Minear?

Justice Kennedy pointed out that the statute also applies to Federal Government securities.

Mr. Minear: --That's correct.

Unknown Speaker: And the Chicago Board of Trade has filed a brief in which they express concern about the status of off-exchange transactions in Federal securities.

And as I understand your position, they would... the options and the futures transactions would be treated differently in that security as well as foreign exchange.

Mr. Minear: To a large extent, that is true, Your Honor.

Let me first say that Government securities are traded on the exchanges, on the Chicago Board of Trade.

Unknown Speaker: Correct, but they're concerned about the off-exchange transactions.

Mr. Minear: Yes.

There the Chicago Board of Trade is concerned that that type of trading introduces the possibility of fraud, just as the CFTC is concerned as well.

Unknown Speaker: And your position is that the trading in options will... would be regulated, but trading in futures would not.

Mr. Minear: That is true.

Unknown Speaker: Yes.

Mr. Minear: I think it's also important to point out, however, that it's not clear if there is actually a market off... over the counter in Government security options.

There certainly is a market in Government security futures and there is a market on options on Government security futures, but we do not have anything in the record--

Unknown Speaker: But the irony then is you would retain the power to regulate the less... I mean, the market that may not exist, namely, the options, and you would have no power to regulate the market we know exists in futures.

Mr. Minear: --Well, that simply reflects what happened in 1974.

When Congress enacted the CEA in 1974, it was sweeping in a large number of new commodities that were subject to regulation.

At that time all options had been prohibited.

There was no allowable option trading on the regulated commodities.

The Treasury Department noted that could raise problems with regard to certain futures trading in foreign currency, as well as trading in certain types of other financial instruments, and it responded to that market condition that existed at that time.

I think it's important to understand also that Congress also provided that the CFTC can exempt transactions if in fact it determines that it is appropriate not to regulate them.

So, Congress actually did provide for these types of problems, these new markets that would emerge.

Unknown Speaker: Well, it could exempt... but it could not regulate the futures, the off-exchange trading in futures.

Mr. Minear: It could not.

Unknown Speaker: Yes.

Mr. Minear: That is correct.

Unknown Speaker: Now, what regulations has the CFTC imposed on the market in foreign currency options?

Mr. Minear: Generally foreign currency options would be subject to the usual requirements of a contract market and the usual requirements that govern options trading.

For the most part, options trading off of exchanges is not allowed.

There are certain exemptions that do apply, however.

Unknown Speaker: They just prohibit it.

Mr. Minear: They have largely prohibited it with certain very important exceptions, however.

There is a dealer exception which covers people who are dealing in the retail trade of a particular commodity at issue.

There's a trade option exemption also that deals with people who are engaging in a transaction for a commercial purpose.

And then there's also what is known as the swap exemption which covers certain types of transactions which may or may not be futures or options but, the CFTC has determined, can safely be subject to... can be engaged in without substantial problems of fraud.

Unknown Speaker: Could it be said that the trade here was under one of the exceptions?

Commercial?

Mr. Minear: No, I do not believe that they would qualify for any of the exceptions here.

And in fact, the trading that was involved here is exactly the problem that Congress was concerned about in 1974, the so-called Ponzi scheme of trading in naked options and then not being able to cover--

Unknown Speaker: I think Congress was also concerned that the Treasury Department ought to have control over matters that involve trading in foreign currency which probably affect our own currency as well.

The CFTC is an independent regulatory agency, isn't it?

Mr. Minear: --That is correct.

Unknown Speaker: It can do what it wants and the President cannot alter its decision.

Mr. Minear: That is largely true.

Unknown Speaker: I think Congress was concerned that these decisions should lie with the President of the United States through the Treasury Department, and I don't see, as far as the impact of that upon our national life is concerned, how options are any different from futures.

You're talking about fiddling around with foreign currency, and given the international market that now exists, you're talking about fiddling around with our currency.

Mr. Minear: Well, it's not clear, Your Honor, first of all, in the record what effects this will have on the foreign currency markets.

But I think more specifically to your point, I think we have to look to what Congress really intended, and what it said in the statute.

That is what we have used as the guide here.

Unknown Speaker: Well, I certainly don't think that just the use of the word in... it bears the meaning you want to give it, but if that same terminology had been used in some legislation, I can just envision the Government coming up here and saying... let's say, an SEC authorization says that it can regulate transactions in something, and you would say, well, it's ridiculous to think that you can avoid all of this by simply dealing in options.

Of course, options are transactions in that kind of thing.

I don't think Congress had that distinction in its mind when it drew this thing.

So, we're really--

Mr. Minear: We think what... we think... Congress had in its mind was the problem of futures trading and not options trading, and we think the language it used actually indicates that.

And it's a good deal more than simply the word in.

We also ask you to look at two other provisions of the CEA, section 2(i) which describes the CFTC's exclusive jurisdiction, and section 6(c) which grants the CFTC authority to regulate options.

In both of those cases--

Unknown Speaker: --Where are those in your brief?

Mr. Minear: --Yes, those are in our brief.

The section 2(i) appears at page 1a of the appendix, and the relevant provision of section 6(c) which is subsection (b) appears at page 4.

What you note with regard to both of--

Unknown Speaker: There's no sound coming out of your speaker.

Are you not speaking into it or is there a problem?

Mr. Minear: --I'm not sure if there is a problem.

Unknown Speaker: It's not connected.

Mr. Minear: I will try and speak more loudly if that would be of assistance.

Unknown Speaker: I think you'll have to because it isn't working.

That might be a good idea.

That or don't say anything important.

[Laughter]

Mr. Minear: I would much prefer to speak to the important matters here.

And in that regard, I think the provisions... these two provisions that I've cited are important and very significant because they both mention... they discuss options and they both describe them as transactions involving the commodity, and they both use very specific language to talk about options.

I think what's clear throughout the CEA is that when Congress meant to deal with options, it dealt with them quite specifically.

It either mentioned them by name or it used the transactions involving terminology.

That same language is found also in section 2(a) of the CEA.

And we think that that is very significant in determining what Congress meant when it used the more restrictive phrase transactions in foreign currency.

Unknown Speaker: To go back to Justice Scalia's question for a minute--

Mr. Minear: Yes.

Unknown Speaker: --I'm... it may well be that the language determines this in your favor, but if it does not and if it really is open and if Congress did in fact regulate... exempt the foreign transactions for the reasons set out in the Treasury letter, then is there any reason why, in a world where options transactions now serve the same purposes and are used to the same extent as futures transactions, the result should differ?

Mr. Minear: Yes.

Unknown Speaker: I mean if the language is open and the world is such that the purpose is the same and the Treasury Department apparently thinks that's what it meant.

Mr. Minear: Yes, we think there is a very good reason--

Unknown Speaker: What is that?

Mr. Minear: --that they shculd be treated differently, and that is Congress' historic concern that options posed a more serious risk of fraud than futures.

Unknown Speaker: If that isn't so, that is to say, if in today's world it's just as easy to be fraudulent or not fraudulent in respect to a futures transaction when engaged in by thousands of people as a options transaction, then what do we do?

Mr. Minear: Well, I think--

Unknown Speaker: I mean, is it like the Commerce Clause not foreseeing the automobile?

Mr. Minear: --I think it's a matter of the Court looking to the expertise of two bodies: first, Congress which has continued to regulate options more strictly and has vested authority for exceptions with the CFTC; and then the CFTC itself and its assessment of whether these markets do pose a serious risk or not.

The CFTC carefully examined the options market in the newly regulated commodities in 1976.

It initially decided to deregulate that market and it found that there were numerous problems with fraud in the marketplace.

In 1978 it reimposed those limitations.

Unknown Speaker: But if they trusted the FTC to make these determinations, they wouldn't have needed the Treasury Amendment.

They would have said that the CFTC has exemption authority.

We will rely upon their good offices, unreversible by the President of the United States, to exempt those things that need exempting.

They were not willing to do that.

Mr. Minear: I think what Congress was doing in 1974, it was looking at the markets that existed at that time, and it was saying, yes, we feel we can safely exempt the foreign currency futures market, the only market that existed and the only market that was described in the Treasury Amendment's... the Treasury Department's correspondence respecting the Treasury Amendment.

As to future markets that might develop, CFTC would be given the authority to make those judgments based on its ability to gather the facts and make--

Unknown Speaker: Well, no, but the legislative findings deal with... in section 5 deal with both futures and options.

Mr. Minear: --Yes, that is true, and again I think section 5 is probably most notable for the fact that it distinguishes between transactions in commodities and options.

Unknown Speaker: I thought you were saying that Congress really wasn't thinking about options at all when it passed this bill.

Mr. Minear: It was not to a large extent, and with regard to section 5--

Unknown Speaker: Well, then why did it include options in the legislative findings?

Mr. Minear: --The legislative findings... you're talking about the last two sentences of that section which appear on page 3a.

Unknown Speaker: Well, I presume those are as good as any other findings.

Mr. Minear: But those findings were added in 1983, some time after 1974.

Many of these markets have grown dramatically.

I think that's the most remarkable effect about the commodities market, is they have been subject to dramatic expansion since 1974.

And the CFTC is exercising judgment in terms of where there are serious problems of fraud.

They believe there are serious problems of fraud in the foreign currency market as indicated by this very case, and in fact--

Unknown Speaker: With respect to this very case, Mr. Minear, the point that was made I think in the Chase Manhattan brief about the SEC has ample jurisdiction to take care of this kind of operation.

Mr. Minear: --That is not necessarily true, Your Honor.

That... I think that that brief suggested that some of these transactions would be... would fall within the description of an investment contract, and therefore would be a security for purposes of the Securities and Exchange Act.

The problem with that is that you can avoid the investment contract terminology... or the requirement... the satisfy... you can avoid a... creating a transaction that is an investment contract by simply how you structure it.

So, fraudulent bucket shops can in fact avoid that problem by simply avoiding a... structuring their dealings in a way that does not create an investment contract.

So, there's still a residual need for CFTC oversight in some of these areas unless--

Unknown Speaker: Isn't it true also, or is it... it's something I picked up from one of the briefs... that as the traders become more and more sophisticated, it's harder to tell a difference in a futures and an option, and you can even have an option on a future, et cetera, et cetera?

Isn't it very difficult sometimes to tell which of the two it is?

Mr. Minear: --It could be.

It depends.

I think that the swap exemption is an example of that.

It discusses the fact that there are very sophisticated transactions that are being engaged in that may have the aspects of a future but are not actually a future.

And in those situations, the CFTC has carefully looked at the transactions, has indicated which ones they think are permissible and which ones are not.

And that is in fact a very reasonable way to go forward with respect to these--

Unknown Speaker: But if they are so close that you can't tell them apart, what sense would it make to say that the futures are out but the options are in?

Mr. Minear: --Well, we think that what Congress did in 1974 is it looked at the futures market as it existed then and said those... that area is exempt.

There are no... there will not be CFTC regulation in that area.

But as to these new instruments that come in, we'll make a case-by-case determination.

We'll vest that authority with the CFTC which has the authority and the time and the expertise to evaluate these transactions and determine whether or not they're serving a useful market purpose and whether or not they pose an unacceptable risk of fraud in the marketplace.

Unknown Speaker: Mr. Minear, don't futures and options involve the same market participants?

I'm not sure the sense of regulating one and not the other.

And if you regulate the options market, it seems to me, particularly if they're the same participants and it's the same general market, that you're affecting futures anyway.

Mr. Minear: Well, I think all of these can raise very complex economic questions in terms of the relationship between the options market and the futures market.

But I think we can say this, that with regard to commercial expectations, the futures market is secure.

With regard to the newly created options market, those questions ought to be evaluated by someone.

We shouldn't simply provide an open-ended exception that says... simply says that anything that involves a foreign currency is going to be exempt from regulation.

Unknown Speaker: Well, then maybe you need to adopt the Board of Trade's position that they're both subject to the act.

Mr. Minear: No.

We think the problem with that position is it runs into the difficulty with the board of trade proviso that was discussed earlier.

It's clear that Congress did want futures transactions to be... that were conducted on a board of trade to be subject to CFTC regulation.

So, we think that that's a textual problem of taking that approach.

Unknown Speaker: Could you refer me to something just in respect to your answer to Justice Kennedy?

I had assumed throughout this we weren't discussing no regulation of fraud.

I thought the issue was who would regulate: CFTC on the one hand or SEC and Treasury on the other.

Now you're saying that if we hold that the CFTC does not have the authority, no one has the authority in respect to a significant number of off-exchange option currency transactions.

Now, is that so?

Is that what you're saying, and if it is, where would I find out the scope of that problem?

Mr. Minear: Yes, we are saying that there would be... if you hold that options are excluded, there will be a significant portion of the market that will not be subject to regulation by anyone.

The Treasury Department does not directly regulate these markets for fraud.

It does regulate banks for safety and soundness, and as long as these transactions take place in the interbank market, that provides some substantial protection.

But any other protection would have to come from another agency.

Those agencies would be the CFTC or the SEC.

The problem with SEC regulation here is unless the transaction involved qualifies as an investment contract under this Court's decision in Howey, there would not be--

Unknown Speaker: Who monitors futures contracts for fraud?

Mr. Minear: --No one is monitoring the futures contracts for fraud, and in part that was because--

Unknown Speaker: So, it works there.

Why can't it work here?

Mr. Minear: --The... and again, we're talking--

Unknown Speaker: Is there some rule that everybody has to be regulated or--

Mr. Minear: --Let me clarify this again that with regard to the over-the-counter market, there is no CFTC direct regulation of futures, but that was based on the Congress... congressional determination that that was not necessary.

Congress has never made an--

Unknown Speaker: --That's begging the question.

I mean, you're just begging the very question.

Did they make that determination just for futures or for all transactions involving foreign currency?

You point out that they do use the term involving to refer to options.

Mr. Minear: --That's correct.

Unknown Speaker: But they also use the term on to refer to options.

So, they're obviously not using any consistent language.

Mr. Minear: I think the context--

Unknown Speaker: They use in, they use on, they use involving.

Mr. Minear: --I think you will find that they refer to transactions in options in only one case and that's in section 6c(f) where they say, transactions... where they actually refer to that the CFTC would have no jurisdiction over transactions in options on foreign currency traded on a national securities exchange.

Now, it's clear when Congress uses the term transactions in, I think they're talking about a very specific type of transaction.

It is accurate to describe an option as a transaction in an option, a foreign currency option.

I do not think it's accurate to describe as a transaction involving... or an options transaction as a transaction in the foreign currency, the underlying commodity itself.

Unknown Speaker: But the problem with that argument is the unless such transactions involve at the end of the subsection.

That is obviously a subcategory of those which are in.

Mr. Minear: That's right.

And so that... and that supports our view I believe.

Unknown Speaker: Not if involve is the broader term.

Mr. Minear: Our view is this, that the transactions in foreign currency would include spot transactions, would include cash forward transactions, and would include futures transactions.

All three of those transactions involve situations where you're actually purchasing the underlying commodity.

If you enter into one of those transactions and do nothing else, you will receive the commodity that's involved.

We think that options are different because they do not have that distinction.

All you're buying in that case is a right.

You're not buying the underlying commodity.

Unknown Speaker: But, Mr. Minear, now do you agree that if the petitioners had engaged in exactly the same scheme, including misrepresentations and all, with their customers in trading in off-exchange foreign currency futures, the CFTC would have no jurisdiction over it?

Mr. Minear: We think that would--

Unknown Speaker: Same conduct exactly--

Mr. Minear: --There would be one--

Unknown Speaker: --but in connection with futures.

Mr. Minear: --Excuse me, Your Honor.

There would be one question that we'd ask, whether this is conducted on a board of trade or not.

But let's assume it's not on a--

Unknown Speaker: No.

Let's say it's an off-exchange.

Mr. Minear: --Well, board of trade is not necessarily--

Unknown Speaker: They're off, not a board of trade.

Mr. Minear: --with your hypothetical assuming it's not on a board of trade.

Unknown Speaker: Yes.

Mr. Minear: In that situation it's true that the CFTC would not be able to bring an enforcement action, but it might be far more difficult to bring that type of fraudulent scheme and let me explain why.

I think this is important.

That options are peculiarly subject to fraud because they're very easy to market to an unsuspecting public.

They can be sold very much like a lottery ticket.

The way--

Unknown Speaker: An option can?

Mr. Minear: --An option can because what you're telling the person is, here, you pay this premium, a small premium, and you... and the sky is the limit on what you might get in the form of your investment return.

A futures contract... to explain a futures contract to an investor would be no simple matter to begin with.

But beyond that, it also... they have to explain to the person that you're making an investment in a future purchase and you might be obligated to buy that future commodity.

Much of this has really to do with the market mentality.

Unknown Speaker: Wouldn't there be even less reason to find an exception for an option where the buyer doesn't have to go ahead with it?

He can not exercise the option.

Mr. Minear: The difficulty here--

Unknown Speaker: I mean, it's just a strange argument it seems to me.

Mr. Minear: --Well, I think that this... the answer here is largely a part of history and largely a part of market psychology.

But it has always been easier to market options than... fraudulently than futures.

Unknown Speaker: Well, how do you know that?

Mr. Minear: I think Congress made that determination in terms of how it decided in 1922, since 1922, that there would be no options.

Options would not be sold on agricultural commodities because they posed such a danger of fraud, but futures would be allowed.

And that was the law from 1922 until 1974.

Unknown Speaker: And so all that proves is what you're saying was true in 1922.

It doesn't prove it's true now.

Mr. Minear: And what it proves is that in 1974, the relevant time for determining the Treasury Amendment, Congress continued to hold that view.

Unknown Speaker: Well, if we adopt your view of the Treasury Amendment, not if we adopt the petitioners'.

Mr. Minear: Well, even apart from the Treasury Amendment, Congress continued to impose a ban on options in 1974 even though it was allowing trading in the futures market.

It simply--

Unknown Speaker: Mr. Minear, has anybody... who's representing the President's position in this case?

I assume that's Treasury's position since he controls Treasury.

Mr. Minear: --Yes, that's right.

Let me tell you candidly what occurred in this case.

The Solicitor General was called upon to make a determination between the Treasury Department and the CFTC in terms of what is the appropriate position to take on this case.

He looked at the statutory language here and made the determination that the CFTC's view was more in accord with the statutory language, and that's why we're taking that position in this case.

So, this does represent the view of the Solicitor General in determining what is the best reading of this statute.

Unknown Speaker: Thank you.

Mr. Minear: Now I'd like to point to some other textual indicia because I think we haven't really spent much time talking about those.

One of the things that I think is significant about the Treasury Amendment is it actually does include certain types of options within its reach.

It makes specific reference to security warrants and also repurchase options.

So, Congress was aware that certain options would be included in the exclusion here.

Yet, it nevertheless decided against including foreign currency options.

One would think that if Congress had intended to include foreign currency options within the exclusion, it would have said so expressly like it did with regard to the other options that were involved here.

We think that they also... that this... we also find textual support from the board of trade proviso.

This has been discussed by the--

Unknown Speaker: Does the word transactions in modify just foreign currency?

Mr. Minear: --No.

It modifies all six of the items that are described there.

Unknown Speaker: So, then you do have transactions in an option.

Mr. Minear: Yes, in repurchase options which in that case were specialized... is a specialized type of option.

But I think what it indicates here is that Congress--

Unknown Speaker: That means you can have a transaction in an option.

Mr. Minear: --You can have a transaction in an option, and we... our view would be different if Congress had said transactions in foreign currency options, but it simply said transactions in foreign currency.

That's what lies at the heart of our view here on the statutory text.

In the Treasury Amendment, Congress said... exempted transactions in certain items.

It did not include foreign currency options among those, even though it included foreign currency--

Unknown Speaker: I guess there's no such thing--

Mr. Minear: --even though it included other kinds of options.

Unknown Speaker: --There's no such thing as a repurchase future I suppose.

Mr. Minear: I think not, and in fact I think that is true.

Unknown Speaker: Would you help me out with the term repurchase options?

What is the universe that that encompasses?

Mr. Minear: This is actually an area where there's some uncertainty, but let me explain.

We do know what repurchase agreements are, that the repurchase--

Unknown Speaker: But we don't know what repurchase options are.

Mr. Minear: --We think options are options on repurchase agreements, and we think that Congress might have been looking forward to the possibility of options on repurchase agreements.

Now, I don't know if that market exists or not.

Unknown Speaker: And the universe that repurchase agreements covers, is that all agricultural commodities?

Mr. Minear: No.

It's primarily Government securities.

In fact, I think it's... that term is used almost exclusively.

If you look to a financial dictionary, you'd find that when we talk about repurchase agreements, we're largely talking about parking Government securities with one holder for a temporary period and then selling them back.

So, what we really have here with repurchase options... and I think this Congress was envisioning the possibility that repurchase agreements might be included.

Repurchase--

Unknown Speaker: Help me again.

A repurchase agreement is a commitment by the Government to rebuy a previously issued security.

Is that what it is?

Mr. Minear: --Yes, although this more often takes place between banks.

They can take place between the Federal Reserve Board and a bank or between the banks.

Unknown Speaker: I see.

Mr. Minear: But these are all Government securities, so they fall within the Government security exemption anyway.

Unknown Speaker: Mr. Minear, if we should disagree with you and hold that options are included within the exemption, do you think the language at the end of that Treasury Amendment, unless such transactions involve the sale thereof for future delivery conducted on a board of trade... do you think that that is... can be applied to options?

Mr. Minear: We think it cannot be applied to options.

There's a possible argument--

Unknown Speaker: You're going to be in big trouble if we disagree with you then.

Mr. Minear: --Yes, I think that's right.

I think that might well be the case.

But again, we have to look at what the words of the statute say, and that is what we've used as our guide here.

The term, unless such transactions involve the sale thereof for future delivery... and I'm reading on page 2a of our appendix.

We think that's a term of art that really refers specifically to futures, and I think you can see that if you look directly below at section 5 which says transactions... this is the legislative finding section.

Transactions in commodities involving the sale thereof for future delivery is commonly conducted on boards of trade and known as futures.

So, that proviso--

Unknown Speaker: Mr. Minear, you said some part of that legislative finding was added in 1983?

Mr. Minear: --Yes.

Unknown Speaker: What was added and what was put in in 1974?

Mr. Minear: The 1974 language actually I think can be traced back to 1922.

I believe--

Unknown Speaker: But what was added in 1983 that wasn't there... but was there in 1974?

Mr. Minear: --The language respecting options which appears on page 3a of our appendix, and it begins at about halfway below the page.

Unknown Speaker: Furthermore?

Mr. Minear: Furthermore, transactions which are of the character of and are commonly known to the trade as options.

Again, here's Congress using the term, very specific term, options when it means to deal with options.

Unknown Speaker: And that was added in 1983.

Mr. Minear: That was added in 1983.

Now, I would like to reemphasize a point here that I think is very important to bear in mind, and that is the Treasury Amendment is an exemption from a general regulatory program, and if there are doubts about its reach, we think the more narrow interpretation is the preferred one here.

That rule has particular force where Congress has appointed an expert agency, namely, the CFTC to... and given it authority to provide further exemptions from the regulatory program.

It's the CFTC that has the expertise in this area and can make those determinations of whether or not the transactions at issue pose the threat of fraud that was the underlying concern of the securities... the Commodity Exchange Act when it was enacted in 1936 and when it was expanded in 1974.

We think that petitioners' non-textual argument really is ultimately unpersuasive.

Their notion is simply that it would be illogical for Congress to exempt both foreign currency futures and foreign currency options because they serve similar marketing and hedging functions.

But ultimately Congress has always recognized the difference between futures and options.

It has done so in the agricultural commodities, and we believe it has done so in these other commodities as well.

We think Congress has drawn a line here, and it has drawn a line between foreign currency futures and options.

It had a reasonable and sound basis for drawing that line, namely, the fact that options pose more serious risks of fraud.

Finally, the last point I would like to make is although we believe that the statutory language here is clear, if you disagree with us on that, then it's appropriate to give deference to the CFTC's view as the administrative agency that is administering the statute.

Unknown Speaker: But that would be a matter of the agency's jurisdiction, wouldn't it?

We don't ordinarily give deference on the jurisdictional point.

Mr. Minear: I think that you do in fact.

In fact, in CFTC v. Schor, this Court made that point.

It was a question whether CFTC had jurisdiction over reparation proceedings, but you did recognize that we do... it's almost inevitable... inevitably necessary to give deference to an agency's determination.

Unknown Speaker: Yes, but that isn't a rule in thin air.

That's the rule of what Congress would have liked the courts to do.

Mr. Minear: Yes.

Unknown Speaker: And if anything here where it's the Treasury Amendment, why wouldn't you think Congress would like the courts to pay particular attention to the Treasury, if anyone?

Mr. Minear: Well, we think that the Court's explanation of deference in Smiley is that Congress has delegated this authority to the agency that's charged with administration of the statute.

Unknown Speaker: But on this point, hasn't the Government taken different positions at times and said that both futures and options in foreign currency were excluded from CFTC jurisdiction?

Isn't that the position the Government has taken at times in the past.

Mr. Minear: The United States filed a brief in the Fourth Circuit--

Unknown Speaker: Exactly.

Mr. Minear: --taking that position.

Unknown Speaker: And so why is any deference owed here?

Isn't it a litigation position and not anything entitled to deference?

Mr. Minear: Well, the CFTC's position is not a litigation position.

The Commission voted on whether or not to bring this suit, and so it is conducted with sufficient authoritativeness and deliberateness to be entitled to deference.

I see my time has expired.

Unknown Speaker: Thank you, Mr. Minear.

Mr. Stumpp, you have 1 minute remaining.

To just briefly touch on a few points raised, the exemptions, the dealer trade option and swap exemption, I think are adequately covered in the amici briefs.

They're limited exemptions.

They're certainly well subject to CFTC interpretation, modification, or withdrawal.

The point that continues to be made concerning that options have been dealt with differently by the CFTC.

As I said it is not relevant once you... once the CFTC acknowledges, as they have, that the foreign currency options market didn't exist at that time and the agricultural options regulation, whatever purpose may have been served specifically dealing with agricultural options, would not be relevant to the expansion of the definition of commodity in the '74 amendments beyond the traditional agricultural commodities.

Chief Justice Rehnquist: Thank you, Mr. Stumpp.

The case is submitted.

Attribution:

The OYEZ Project

Featured:

Gustafson v. Alloyd Co., Inc., Fka Alloyd Holdings, Inc. - Oral Argument

Fri, 09 Jan 2009 14:49:58 +0000

Case:

Gustafson v. Alloyd Co., Inc., Fka Alloyd Holdings, Inc.

Media File:

93-404_19941102-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Donald W. Jenkins

Chief Justice Rehnquist: We'll hear argument now in Number 93-404, Arthur L.... do you know how your client's full name... is it Gustafson, or Gustafson?

Mr. Jenkins: Gustafson.

Chief Justice Rehnquist: Arthur L. Gustafson v. Alloyd Company, Incorporated.

Mr. Jenkins.

Mr. Jenkins: Mr. Chief Justice and may it please the Court--

As the briefs indicate, this case turns in large part on whether or not the phrase, by means of a prospectus or oral communication, as used in section 12(2) of the Securities Act of 1933, is a phrase of limitation.

The case also turns on whether, by section 12(2), the act covers negotiated private transactions even though the act does not otherwise intrude into such business arrangements.

The House report answers both these questions, stating the bill affects only new offerings of securities.

It does not affect ordinary redistribution of securities.

As to liability provisions, the report states the bill's civil liabilities attach only when there's been an untrue statement of material fact in the registration statement or the prospectus, the basic information on which the public is solicited.

This case involves no new offering of securities, and presents the paradigm example of a private transaction the act plainly left free from regulation other than by its section 17.

Art Gustafson, Dan McLean, and Francis Butler sold their company to a sophisticated investor which conducted its own due diligence and negotiated the deal it wanted.

The buyers had full access to information about Alloyd.

Indeed, Mr. McLean and Mr. Butler were officers and shareholders of the buyer.

The stock purchase agreement contained numerous riskallocating provisions.

In particular, the parties knew that Alloyd's interim earnings were estimated, so, as is common, they closed with an estimated purchase price subject to a later dollar for dollar adjustment after an audit determined actual earnings.

They plainly could have, but did not, agree that some multiple of the variance should apply to the transaction.

After the audit, the parties agreed that the estimated price had been 815,000 dollars too high, and sellers paid that amount to buyers as the agreement required.

Buyers, who knew Alloyd's interim earnings were estimated, now claim that sellers warranted a certain level of such earnings in the agreement.

They claim a breach of that warranty, which is a contract law matter, and also claim a violation of section 2 of the... 12(2) of the Securities Act.

They have made no claim of fraud.

As to the section 12(2) claim they assert, it is that the purchase agreement itself, the negotiated purchase agreement, was a prospectus, and they claim they are entitled to rely on oral communications during due diligence about Alloyd's inventory, even though the agreement specifically provided such oral statements were superseded by the terms of the agreement.

Buyers seek rescission of the transaction or rescissionary damages, even though by the agreement they agreed that they would not seek rescission.

The act, and section 12(2) in particular, makes a seller, we submit, a fiduciary only when there is an initial public offering of securities.

It does not do so in the context of ordinary secondary transactions such as privately negotiated resales of stock that have never been publicly distributed.

A stock purchase agreement memorializing the terms of a negotiated deal is not a prospectus, nor are discussions in the course of due diligence regarding the reliability of inventory estimates.

Unknown Speaker: If it had been an offering circular... not just a purchase agreement, but would an offering circular fit within the definition of section 2(10)?

Mr. Jenkins: An offering circular would certainly be a circular, I think, within the meaning of section 2(10).

It specifically uses that phrase.

But the preceding words in 2(10) is, the very first definition of prospectus is prospectus itself, which as commonly defined then had a public solicitation connotation.

We believe the correct interpretation, as demonstrated by numerous portions of the House report and other commentary by draftsman, is, an offering circular is a prospectus when it's used to solicit the public to purchase securities.

Unknown Speaker: But if it's in connection with a private offering, it would not... is that what you're saying would not?

Mr. Jenkins: We don't believe that would be the proper definition under 2(10), or, particularly, under section 2(12), given the context of 2(12) as a liability provision in the act.

Unknown Speaker: But 2(10) just says, offers any security for sale.

It doesn't... it's not... the words of the statute aren't limited to a public offering.

Mr. Jenkins: The very first word that section 2(10) uses is prospectus.

In defining what a prospectus is, prospectus, as commonly used then, connoted, or was defined as, a document prepared by a company describing its stock or prospects and inviting the public to subscribe to an issuer.

Inviting the public.

That's the first word used in the definition of prospectus.

We believe the following words have similar import.

Unknown Speaker: Where is that limitation used?

I mean, suppose you had what might be called an offering circular in connection with this private offering, but it was labeled, prospectus.

Would it then fit within the definition?

Mr. Jenkins: We don't believe so, not for section 2(10) purposes, and certainly not for section 12(2) purposes, because of their use of the word prospectus, used as a selling document.

Unknown Speaker: And you're... when you say similar import, you mean public offering import?

Mr. Jenkins: Public offering, yes, Your Honor.

Unknown Speaker: So if this deal has... no, it would still be... well, if this deal had been done with the company, the control company issuing new shares, and then Gustafson redeeming the shares that they had originally, then that... otherwise everything is the same.

That would be covered, right?

Mr. Jenkins: If Alloyd had issued new shares to--

Unknown Speaker: To the--

Mr. Jenkins: --The buyers?

Unknown Speaker: --Yes.

The buyers got new shares, and then the sellers redeemed their old shares.

I don't think--

Mr. Jenkins: As to the first portion of the transaction, the issuance by Alloyd of new shares to the buyers, the exemption of section, I think it's 4(2) of the act, would exempt that transaction.

As to the second portion, a redemption, then, of the seller's shares by the company, I believe that would also be a 4(2)-exempted transaction, but I'm not certain.

But in either event, because there is no public selling, no public offer involved in the transaction, no--

Unknown Speaker: --But then you would have to make your distinction turn on the actions of a public offering, not on the sale versus resale.

In other words--

Mr. Jenkins: --There--

Unknown Speaker: --I gave you a situation where you end up with the same result, but in one case it's done in the form of a sale of new shares, redemption of old shares, in the other it's done in the form of just a direct sale of the--

Mr. Jenkins: --There is some authority, particularly in the comments of legislators, and I think these are cited in the SIA's brief in particular, for the proposition that the act just does not apply to transactions in old stock, period.

Some of the commentary in the House report is inconsistent with that sort of declaration, because the commentary in the House report indicates that if there's a redistribution of old stock either by a company or a control person, that transaction is subject to regulation by the act.

To the extent one prefers to rely on the House report, declared rationale, or the Congressmen's statements of intent that the act doesn't apply to resales of old stock at all, I think either way you reach the same result as to the application of section--

Unknown Speaker: --Yes, but I'm giving you two ways of doing essentially the same deal.

One, it would involve a resale, and the other would be a first sale, and wholly apart from the private versus public sale, I think you said resales are never included.

Mr. Jenkins: --Some Congressmen so stated when they were debating the act.

Unknown Speaker: But that's not your position?

Mr. Jenkins: That is part of our position.

One view that could be taken of the act based on those statements is the act just doesn't apply to resales of old stock, period.

Unknown Speaker: Yes, but you--

--That's all it needs, just a couple of Congressmen to say... it's not even in the committee report, just a couple of Congressmen say it--

Mr. Jenkins: I--

Unknown Speaker: --and that is enough to interrupt the act that way?

Mr. Jenkins: --No, Your Honor.

I think the preferred view is the view that is articulated in our briefs, that the House report carefully lays out how the bill... the bill... regulates such transactions.

If a redistribution of old stock looks like a public offering, becomes a public offering, then the act applies.

I think that is the better--

Unknown Speaker: As I understand it, you don't rely at all on the distinction between a sale and a resale, do you?

You rely on the distinction between public offerings or nonpublic offerings.

Mr. Jenkins: --That is the primary position we take.

There is a--

Unknown Speaker: But you wouldn't--

Mr. Jenkins: --a different position... I'm sorry.

Unknown Speaker: --You wouldn't contend that a secondary offering... say I'm a major shareholder of General Motors.

I have a public offering of my stock.

You'd admit that's covered, wouldn't you?

Mr. Jenkins: I would admit that is... I personally believe that is covered by section 12(2).

Unknown Speaker: Sure.

Mr. Jenkins: I personally also believe that that is a transaction that the act requires to register.

Unknown Speaker: Of course.

I'm just saying that there are some secondary offerings that must be registered, so there is no basis in the statute for drawing a distinction simply about whether it's a primary offering or secondary offering.

Mr. Jenkins: I think the only basis is the statements over and over in the House report and by legislators--

Unknown Speaker: There's nothing--

Mr. Jenkins: --it applies to new stock, and looking at just the entire structure of the act, it just does not appear to be designed to apply to secondary transactions, period.

Unknown Speaker: --Unless they're public offerings.

Mr. Jenkins: That's my view as to the proper position to come down on.

Buyers and the SEC argue that section 12(2) extends far beyond the otherwise limited coverage of the act, and applies to all communications in all contexts involving sales of securities.

Their argument in both their briefs is based in part on the 1948 decision of Moore v. Gorman and its progeny.

They reason, as that court did, that section 12(2) covers secondary transactions and including private resales, because section 4 exempts such transactions from section 5, but does not exempt such transactions from section 12.

Seller's position, of course, is that this begs the initial question, what did section 12(2) intend to regulate in the first instance?

Plainly, Congress would not have seen any need to exempt a transaction from section 12(2) if it didn't perceive the transaction as covered by section 12(2) in the first place.

Unknown Speaker: Well, Mr. Jenkins, I guess the problem is that the language of the section 12(2) does say that any person who offers or sells a security by means of a prospectus or oral communication which includes an untrue statement is liable, so the language itself, of course, is broad, as you have to concede.

Mr. Jenkins: I respectfully do not so concede.

The language itself is limiting language.

If Congress had meant to say it broadly, it would have said, any communication, or it would have said nothing, as it did in section 17 of the act.

Section 17 says, you shall not acquire money by means of any untrue statement.

That is a broad statement.

When they put the phrase, by means of a prospectus or oral communication in section 12(2), they had to be connoting some limitation.

We believe the limitation is the limitation that flows from the natural lay understanding of the term prospectus, which is a document soliciting the public to subscribe to an issue of stock.

We don't think section 2(1) requires that you go any differently and, indeed, if it does, as the buyers are attempting to read section 2(10), why did Congress not simply use the word, any written communication or broadcast in section 2(10)?

It used many more words than that.

We think that the usage of all of the words have to be read together in light of the initial word, prospectus, as further communications which are used to solicit the public to purchase securities.

Unknown Speaker: And then, having defined prospectus in a way that's contrary to the definition in the statute, you define oral communication the same way, by sort of guilt by association, right?

It does say, prospectus or oral communication.

How do you get oral communication to mean something less than an oral communication?

Mr. Jenkins: Certainly by guilt by association, or noscitur a sociis, or whichever term you want to put on it, and by the reverse reasoning that also applies to section 2(10).

If they meant any communication, why didn't they just simply say so?

They knew how to write that way.

That's the way they wrote section 17.

When they used more words than just, any communication, they were connoting limitation.

We have articulated in our briefs where we believe the limitation leads.

The SEC and the buyers are in the position of necessarily being all or nothing.

If it's totally unlimited, their view is the phrase does require application to every communication in every context involving securities.

As just mentioned, the list of items that 12... 2(10) uses in defining prospectus is limited to selling statements.

The words used when the act was passed were, first, any prospectus, notice, circular, advertisement, letter... which could be broad... or communication, written or by radio, which offers any security for sale.

That is treating and describing a specific type of communication, not a negotiated stock purchase agreement and not comments made during the course of due diligence, which the parties agreed were superseded by the stock purchase agreement.

Unknown Speaker: One of the briefs in support of respondents said... discussed section 410(a)(2) of the Uniform Securities Act, said it was similar to 12(2), and said that the consensus among the States is contrary to your position.

The consensus is that both private sales and secondary market transactions are covered.

Mr. Jenkins: Well, 4... the section of the Uniform Securities Act that they're referring to does not, specifically does not include the phrase, by means of a prospectus or oral communication.

Those words are left out of that act.

Certainly, with those words left out, I think they're correct the Uniform Securities Act does apply to such transactions, but it's an awfully big distinction.

I mean, they're saying the things mean the same even though the '33 act has words of limitation in them that the uniform act does not have.

Unknown Speaker: I thought perhaps the reason for the use of the word prospectus is it's a term of art, which is as broad as you say but also encompasses (a) and (b), which are exceptions, in 2(10).

You know, it defines prospectus as any prospectus, notice, circular, advertisement, letter, or communication, but then it specifically says, by the way, two things are not prospectuses, and that's if you comply with certain SEC rules and so forth, so the reason that they wouldn't say, any written communication, is they wanted to tie it directly to that definition.

Mr. Jenkins: Except that that would have been so much easier to do.

Just say, any defin... any written communication or broadcast except--

Unknown Speaker: But then it wouldn't have had the two exceptions, (a) and (b).

If they said, any written communication, it wouldn't pick up the two exceptions, which are not relevant here, because... I might be not right about that, but that's--

Mr. Jenkins: --Are you referring to the... I think it's called the freewriting--

Unknown Speaker: --2(10) defines prospect, and then says... very broadly, and then says, except that... except that a communication sent or given, and so forth, then it says, and a notice, circular, shall not be deemed a prospectus if, you know, that stuff.

Mr. Jenkins: --Right.

Those are referring to two categories of stuff--

Unknown Speaker: Nothing to do with--

Mr. Jenkins: --Well, in some sense they are related, that the (a) part of that exception is reference to socalled freewriting, which is specifically permitted.

The whole intent of carving that out is to specifically permit freewriting--

Unknown Speaker: --Yes.

Mr. Jenkins: --during the period after a statutory prospectus--

Unknown Speaker: Right, but you see, my question is, you're argument depends on well, if they meant any written communication, why didn't they just say it, and one possible reason they didn't just say it is because they wanted to use the word prospectus, which would then have the technical exceptions written into it.

That was my question.

Mr. Jenkins: --But I... unless I'm missing it, I nonetheless still believe the same result would be reached if they'd written, any communication, prospectus means, any communication, they would have still needed to carve out those two types of communications from the definition, unless I'm missing something.

Unknown Speaker: Yes... all right.

Mr. Jenkins: Okay.

Unknown Speaker: I want to talk about what would have been an easier way to say it.

I mean, you've made allusions to that several times.

I find it very odd that the limitation that you're seeking to import into the statute would be imported by the word prospectus, rather than by the word sale.

I mean, that limitation, it would have been way up at the top of section 12, any person who publicly offers or sells a security, or offers or sells to the public a security.

Why would you seek to import that limitation, it has to be a public offering or sale, much later in the provision?

Why all the way down, by saying, who offers or sells by means of a prospectus, aha, prospectus must mean a public offering.

It's a very strange way to do it.

Mr. Jenkins: I think the reason--

Unknown Speaker: You can simply say, public offering or sale.

Mr. Jenkins: --I think the reason that Congress didn't put, public offering or sale, is by that point in the statute, if you look at how the statute is drafted it's clear that the whole statute only applies to public offerings or sale, and the words would have just been superfluous.

Unknown Speaker: Well, you just said section 17--

Mr. Jenkins: 17 is a unique distinction.

12(2)--

Unknown Speaker: --So if 17 is not so limiting, well then, 12(2) could be not so limiting.

Mr. Jenkins: --Two answers.

One, the language of 17 is, in comparison to section 12, significantly different and significantly broader, as this Court observed in United States v. Naftalin.

Second, there is specific commentary in the Senate report that this Court felt clearly showed an intent that section 17 extend beyond the rest of the provisions of the act and extend beyond them in the sense that it was applicable to secondary transactions.

The court felt that both of those points warranted a treatment of section 17 as departing from the other scope of the act.

Unknown Speaker: Following up on Justice Scalia's question, am I correct in understanding that the term, public offering, is not defined in the statute?

Mr. Jenkins: I believe that's correct.

Unknown Speaker: Rather, what they do, they talk... use the broad term, sale, and then list a series of exemptions from the registration requirement, and anything--

Mr. Jenkins: That's correct.

Unknown Speaker: --that's nonexempt therefore becomes public in the way we use the term.

Mr. Jenkins: I believe that's correct also.

Unknown Speaker: Section 4 exempts certain transactions from section 5, but not from section 12.

Mr. Jenkins: That's--

Unknown Speaker: Does that silence suggest that section 12 applies to transactions that do not have to be registered?

Mr. Jenkins: --We believe not.

We know that section 12 applies to transactions in exempt securities that do not have to be registered.

That is pretty clear from the language that got added to section 12(2).

Unknown Speaker: The point is that the style of the act does use exemptions in section 4, exempting one section from another.

Mr. Jenkins: That's correct in terms of exempting transactions, if you will, and securities, from section 5 which is the heart of the act, and the section from which violation flows.

The fact... excuse me.

I apologize.

I think I've lost the thrust of the question.

Oh, the exemption--

Unknown Speaker: You were saying, the heart of the act--

Mr. Jenkins: --from section 12(2) is just only necessary if 12(2) was intended to cover.

We believe it wasn't, as the House report makes clear at various points.

Unknown Speaker: --Is it your position that the word prospectus includes only transactions required to be registered--

Mr. Jenkins: No.

Unknown Speaker: --under section 5?

Mr. Jenkins: No.

Prospectus can clearly be a term that applies in the context of a public distribution of an exempt security.

The act, for whatever reasons, chose to exempt the security, but if there's a public distribution of that exempt security, plainly section 12(2) intends to bring the communications, selling communications oriented toward the public, within its definition in that context.

The act treats Government securities in a fairly unique way, which we believe supports our interpretation of section 12(2).

Government securities are specifically carved out with section 12.

They bring in resales, they bring in public sales of all other securities but exclude public sales of Government securities, obvious reasons of comity and that sort of thing, or perhaps even constitutional considerations.

If, as the buyers claim, section 12(2) was some broad remedy, though, that applies to all aftermarket trading and so on, why would the Congress have felt any need to, in that aftermarket context, still exempt resellers who might make misleading statements about Government securities from the coverage of the provision?

We believe that that special provision of the Government in section 12(2), or any governmental entity, further reflects the fact that section 12(2) was perceived as applying solely in a public offering context.

That's when they intended to protect the Government even if the Government made an untrue statement, not in later contexts.

I will reserve the remaining time, if I may.

Unknown Speaker: --Mr. Jenkins--

--If I could ask you one question... excuse me, Chief Justice.

The brief of the amicus for the Securities Industry Association says that research reports would be covered if we were to rule against you in favor of the respondent, and tells us the adverse consequences of that.

Do you agree with their theory in that?

Mr. Jenkins: I think there's a possibility of research reports being included.

There is also the potentiality, which I believe also applies to a stock purchase agreement, to conclude that those are not the kind of selling documents that even 2(10) intended to include, even if you apply it as including all written communications.

Unknown Speaker: The question is, what is a selling document?

Mr. Jenkins: Yes, and I think that point is even touched upon in the buyer's briefs, that maybe they're not a selling document and therefore not a prospectus.

I think the same argument can be made as to a prospectus itself.

I do think in the context of research reports, though, there's a severe danger that the issuer of the report could be deemed a seller, having used a prospectus, and the liability imposed by section 12(2) in that context on one who just receives a commission for selling stock is drastic.

Unknown Speaker: Very well, Mr. Jenkins.

Mr. Kopecky, we'll hear from you.

Argument of Robert J. Kopecky

Mr. Kopecky: Mr. Chief Justice, and may it please the Court--

We begin with the presumption that the plain language of the statute reflects Congress' intent.

Here, neither the text of section 12(2) nor the structure of the act as a whole supports imposing upon section 12(2) the limitations that petitioners ask this Court to read into that express civil remedy.

Unknown Speaker: Mr. Kopecky, in 2(10), after it says, the term prospectus means any prospectus, et cetera, et cetera, which offers any security for sale, now, would you say that an, simply an agreement of sale signed by both parties is always something which offers a security for sale?

Mr. Kopecky: I'm not sure an agreement, per se, would always offer a security for sale.

I think in this case the agreement clearly did.

Unknown Speaker: Why is that?

Mr. Kopecky: Well, the agreement here was the culmination of a long process.

The agreement included specifically representations by the sellers that were made as an inducement, and that's in the language of the agreement itself, as an inducement to the buyers to buy the stock, so the agreement itself was part of the selling process.

Unknown Speaker: So if there had been no representations in the agreement, then perhaps it would not be a prospectus?

Mr. Kopecky: I think perhaps it would not be.

Section 12(2) reaches those communications that convey information to the buyer about some security.

If there's no representation being made, then I'm not sure how you would ever have a cause of action under section 12(2).

Unknown Speaker: But take a very simple agreement in which the seller represents that he or she is the owner of the stock.

The only representation says, I, as the owner, hereby offer the following stock, you describe it, you send it in the mail, it said if you want to buy it, sign here.

That would be a prospectus, wouldn't it?

Mr. Kopecky: In my view, it would, because in that case there would be a representation being made about the security.

Unknown Speaker: So you could, have very simple transactions would be covered by this.

Mr. Kopecky: It is conceivable that--

Unknown Speaker: And it could be true, just five shares of stock.

Mr. Kopecky: --Of course, you would have to prove that the person who made that statement was negligent.

Unknown Speaker: Sure.

It has to be something--

Mr. Kopecky: Right.

Unknown Speaker: --that, he in fact didn't own three of the shares or something like that.

Mr. Kopecky: Correct.

That's correct.

Unknown Speaker: But that would be Federal jurisdiction, to resolve that.

Mr. Kopecky: If you use the jurisdictional means--

Unknown Speaker: Right.

I--

Mr. Kopecky: --I would agree--

Unknown Speaker: --Excuse me.

I thought negligence was not required under section 12.

Mr. Kopecky: --It is, Your Honor.

It is.

It's an affirmative defense.

The seller is required to prove that he was not negligent, but if he can prove that he was not negligent, there is no liability under the statute.

Unknown Speaker: So it's affirmative.

Mr. Kopecky: But it is commonly referred to as a negligencebased liability.

Unknown Speaker: Mr. Kopecky, if your interpretation of the statute prevails, wouldn't it virtually swallow up any 10(b)-5 causes of action?

Mr. Kopecky: Not at all, Your Honor.

The scope of transactions covered by section 12(2) is a very small subset of those now covered by 10(b)-5, in this respect, 10(b)-5 covers any statement or omission in connection with the sale of the securities.

It doesn't require that there be a buyerseller relationship between the parties.

Most 10(b)-5 actions, and most class actions under 10(b)-5, are brought in the context of statements by issuers that then get relied upon by the market or by some buyer who bought his stock from somebody else, not from the issuer.

That is the vast majority of 10(b)-5 cases.

Those would be unaffected by this case, because section 12(2) simply doesn't reach them.

Section 12(2) requires privity between a buyer and a seller.

Unknown Speaker: But where a 10(b)-5 action would also lie, or a plaintiff such as you represent, your preferred route would be section 12(2) I assume because of its attorneys' fees and lesser requirements for proof.

Mr. Kopecky: The attorneys' fees would be hard for the plaintiff to get in this case, so I don't think that's a motivating factor.

The negligence standard is obviously a benefit, so it is true that in those categories of cases where there's an overlap between section 12(2) and 10(b)-5, a plaintiff would prefer to sue under 12(2), just as in the context of a registered public offering of securities, if there's a misstatement in the registration statement, the plaintiff in that case would much prefer to sue under section 11 of the '33 act, which has no scienter requirement whatsoever, than under 10(b)-5, where he would have to prove fraud.

Unknown Speaker: I was going to say, what is your answer to the question why the drafters didn't simply use the word, statement, in place of prospectus, or oral communication?

Mr. Kopecky: The answer to that question is not clear from the legislative history, so I can only speculate, but let me offer a couple of explanations.

One, this statute was basically walking into new territory.

There had not been significant regulation of the securities industry.

I think it is reasonable for Congress to have started with some terms that were known and commonly used, prospectus, circular, notice, and then worked from that in increasing breadth, ending with the term, written communication.

Could they have simply said any communication, or any written communication?

They certainly could have.

I think a second explanation is that, as pointed out in the Solicitor General's brief, we know that the draftsmen started with the British Companies Act as a model, and the British Companies Act has a definition of prospectus that starts out similarly to the definition of this case.

However, in this case the drafters diverted significantly, because the British Companies Act referred to public offerings of securities.

That was eliminated from the definition of prospectus by the Congress that enacted the '33 act.

Unknown Speaker: Under the British Companies Act, would there be a remedy such as this, for this transaction?

Mr. Kopecky: Under the British Companies Act... well, certainly if we were relying on a prospectus I think we'd have a hard time, because the British Companies Act defines prospectus to include a public offering, so I think we would have a harder case.

I do not have clearly in mind what the British Companies Act says about oral representations, which is a key part of our case here, so I don't know if we could win under that statute.

Unknown Speaker: Has this issue been litigated over in--

Mr. Kopecky: Your Honor, I confess I have not studied that.

Unknown Speaker: --Well, you brought up the British Companies Act.

Mr. Kopecky: A fair--

Unknown Speaker: All right.

How would you answer Justice Kennedy's question that was brought up in the SIA brief, the question of the research reports done by a brokerage firm?

Mr. Kopecky: --I think it is far from clear that brokerage research reports would be subject to liability under section 12(2) for a couple of reasons.

First, in order to have liability under section 12(2), you must be a seller.

You must be a statutory seller.

It's unclear, far from clear, I think, that someone who issues a research report is a seller.

In Pinter v. Dahl, this Court explained what it means to be a statutory seller under section 12(1).

Assume for a minute that definition extends to 12(2).

You must either be the person who passes title to the security, or one who solicits the sale for your own financial benefit, so someone who issues an analyst's report is not necessarily soliciting anybody to buy stock.

Second, the analyst's report itself would have to be a prospectus, and prospectus is defined as a document that offers or confirms the sale of the security.

Now, an analyst's report does not offer a security for sale, nor does it confirm the sale of the security, so I think the concerns about openended liability for analysts is significantly overblown.

Unknown Speaker: Why do you say that prospectus is defined as a document that offers or confirms the sale of a security?

Where do you... I thought it means... I thought part of your case was precisely that it means any notice circular, not just, it means any prospectus, notice, circular, advertisement, letter or communication written--

Mr. Kopecky: That offers... any of those that offers--

Unknown Speaker: --I see.

Mr. Kopecky: --any security for sale--

Unknown Speaker: I see, which offers--

Mr. Kopecky: --Right.

Unknown Speaker: --Which offers any security for sale.

Mr. Kopecky: Right.

Right, exactly.

That's the end of the definition.

All of those things, any of them have to offer the security for sale, or they're not covered.

Unknown Speaker: That's... although my thought favored you, I hope you'll disabuse me of it if it's not correct, as I'll just get mixed up if it is, but I thought the reason they used the word prospectus instead of any written communication is because they wanted to pick up that particular definition with its limitations, and the limitations are two you just mentioned, plus the fact that a written prospectus, a written communication is not a prospectus if a registration statement has been filed previously and certain things have been done.

Mr. Kopecky: That's correct, Your Honor.

Unknown Speaker: And they wanted to build that all in--

Mr. Kopecky: I--

Unknown Speaker: --which the word written communication couldn't have done.

Am I on a correct track?

Mr. Kopecky: --I agree with that, Your Honor.

Unknown Speaker: Fine.

Then why didn't they use the word oral communication next, because oral communication doesn't have those limitations?

Mr. Kopecky: Again, the legislative history doesn't enlighten us much on why they used oral communication.

I believe what Congress was getting at in enacting the statute was the process by which owners of securities solicit people to buy those shares from them, and there are two ways you can do that.

You can do it in writing, or you can do it orally.

If the question is, why didn't they subject oral communications to the freewriting exception, I don't know the answer to that.

Unknown Speaker: That cuts off my thought, because I can't get it to work with oral communication.

Mr. Kopecky: I understand, and I'm not sure the logic of all that hangs together, and there's been a lot of question raised about exactly what the freewriting exemption is meant to accomplish and why it was there, so I can't answer how the oral communication precisely fits into that exception from the definition of prospectus.

Unknown Speaker: A prospectus has to be related to the registration statement, doesn't it?

Mr. Kopecky: No.

Unknown Speaker: I thought section 10 required that.

Mr. Kopecky: Section 10 requires what has to be in a prospectus that is issued in conjunction with a registered offering of securities.

If you have a registered offering, the act requires you to provide certain information to the SEC in your registration statement.

It also requires you to provide certain information to investors in the prospectus that's issued with that registration statement, but those requirements, the strict, detailed requirements of section 10, apply only to prospectuses issued in connection with registered offerings of securities.

Unknown Speaker: But section 10 doesn't say, some prospectuses, it says all, so I had thought, unless--

Mr. Kopecky: I think where that--

Unknown Speaker: --qualifications.

Mr. Kopecky: --I think that comes out of section 5, Your Honor.

Section 5 makes it unlawful to sell any securities that have been registered unless you comply with the provisions of section 10, so section 10 only--

Unknown Speaker: So then you can limit the term, prospectus, in section 10 at least by reference to other provisions of the act.

Mr. Kopecky: --I believe... I believe that's correct, Your Honor.

The meaning of section... of prospectus in section 10 is defined by its context, which is in reference back to registered offering under section 5.

Unknown Speaker: Are punitive damages available in this sort of a cause of action?

Mr. Kopecky: I don't believe so, Your Honor.

Unknown Speaker: Why not?

Mr. Kopecky: I'm not aware of any case that has upheld punitive damages.

Unknown Speaker: Are punitive damages available under a 10(b)-5 action?

Mr. Kopecky: I'm not sure, Your Honor.

Let me return, if I could, to what I think are the key points in our argument today.

One is that the language of section 12(2) simply does not expressly impose the limitation that petitioners are asking for.

Second, the other provisions of the act demonstrate that when Congress meant to exempt either a particular type of transaction or particular type of security from some portion of the act it did so explicitly, and we've talked about, during Mr. Jenkins' argument, sections 4(2), 4(1), which create express exemptions from the registration requirement.

There's no comparable exemption from section 12(2) and, further, again as Mr. Jenkins pointed out, when Congress meant to exempt a particular type of security from section 12(2), it did that explicitly as well.

So when Congress meant there to be exemptions, it enacted them.

Unknown Speaker: Does... Justice Breyer asked you whether one aspect of the definition of prospectus is carried over into the phrase, oral communication.

What about the aspect that requires a prospectus to be in connection with the offer to sell, in connection with the offer or confirmation of sale?

Is oral statement in section 12 limited to that as well?

Mr. Kopecky: I believe it is, Your Honor, by the bymeansof language in section 12(2).

I think to say that a particular security is sold by means of either a written or oral communication means that that statement is made in connection with the solicitation of the sale.

I think the whole purpose of section 12(2) was to focus in on that process by which sellers solicit buyers, and the focus of the bymeansof clause I believe is to hone it right in on just that, those statements, whether oral or written, that are used to solicit sales of securities.

I want to return to just one other point in the text of section 12(2) itself, if I may, and that's the term, oral communication.

This Court has said repeatedly, and most recently in FDIC v. Meyer, that undefined statutory terms are to be given their ordinary, or natural meaning.

Now, petitioners cannot dispute that giving the words of the statute their ordinary meaning, section 12(2) on its face unambiguously applies to any security sold by means of a false or misleading oral communication.

There simply is no connotation you can give to oral communication that limits it to a public offering or an initial offering of securities.

To the contrary, an oral communication is going to occur most often in the context of a private transaction, a negotiated transaction where people are talking to each other, so oral communication, it seems, if you read it just in its natural sense, clearly applies to all transactions.

Now, they say you can't do that.

You have to look to prospectus as a term of limitation on oral communication.

It seems to me that what they're asking you to do is take a term that we think is unambiguously defined... that is, prospectus... find some ambiguity in that, construe it narrowly, and then use that to narrow a clearly broad term.

Unknown Speaker: Are you suggesting that one of the major purposes Congress had in mind was to eliminate the statute of frauds from these transactions?

Mr. Kopecky: I don't think that was a major purpose, Your Honor.

Unknown Speaker: I don't, either.

Mr. Kopecky: I think the major purpose Congress had in mind was--

Unknown Speaker: It surely wasn't primarily concerned with oral communications.

Mr. Kopecky: --I don't disagree with that, Your Honor.

I don't disagree with that.

I would note that in the conference report on the bill, in discussing section 12 in particular, and this is one of the few places we have any reference to section 12 in the legislative history, in paraphrasing section 12, the conference committee said that this bill reaches the sales of securities by means of representations which are untrue or misleading.

That's a very broad term, representations which are untrue or misleading.

Unknown Speaker: Is it fair to say, though, that the 1933 Securities Act was really an act that concerned initial public offerings, and that the '34 act generally addressed private and secondary trading?

Mr. Kopecky: I think as a--

Unknown Speaker: I mean, isn't that the general thrust?

Mr. Kopecky: --As a generality, I think that's correct, Your Honor, but I'd like to respond to that in a couple of ways.

Unknown Speaker: And so this interpretation of 12(2) doesn't fit exactly with that general thrust.

Mr. Kopecky: If you're going to limit the statute by the primary purpose I think one could make that argument.

It is interesting that in the '34 act there was no express right of action created that would cover the transaction in our case, so I think that suggests just the contrary, that Congress thought they had taken care of that in 1933.

Unknown Speaker: Could you have brought a 10(b)-5 action?

Mr. Kopecky: In theory, we could.

Unknown Speaker: Yes.

Mr. Kopecky: The reason we didn't allege it is because we felt we didn't have a Rule 11 basis for asserting fraud, scienter, and so we brought the cause of action we felt the facts supported.

Let me return to the question about primary purpose.

I think the situation here is analogous to RICO, a statute this Court has construed repeatedly in the last few years.

You can look at the legislative history of RICO, and it is absolutely clear that what motivated RICO, the primary purpose, was to seek the eradication of organized crime in the United States, and yet Congress wrote the statute to pick up persons other than mobsters or organized criminals.

Unknown Speaker: A good example.

Mr. Kopecky: And this Court has said, we're going to construe RICO not in light of what was the primary motivation, but the way Congress wrote the statute, and I suggest that's what the Court should do here with section 12(2), is construe the statute the way Congress wrote it.

Unknown Speaker: And put us in the same boat we are with all those unpleasant RICO cases.

Mr. Kopecky: Your Honor--

[Laughter]

Your Honor, that's a good point, but I think I have a response to it.

It has been the law in the circuits for 50 years that section 12(2) reaches privately negotiated sales of securities.

Even today, no appellate court has ever reached a contrary conclusion.

That tell us something about 1) how the statute should be read, 2) this Court has said on a number of occasions that it is inappropriate to set aside longstanding interpretations of express statutory remedies that parties have come to rely on, but third, in response to your question, Justice O'Connor, there simply hasn't been a flood of section 12(2) suits.

This cause of action has been around for 50 years.

Unknown Speaker: Maybe that's because of our more recent holding here as to the scienter requirement under 10(b)-5.

Mr. Kopecky: Perhaps.

I think the explanation is that section 12(2), even if you read the term prospectus as we think it should be read, still applies to a fairly narrow universe of transactions.

You have to be able to prove that you bought from the seller.

You have to prove that he sold to you by means of some misleading statement.

It really focuses in on those transactions that are a small subset of what is driving the explosion of securities litigation in the country today.

I don't think a ruling construing the statute our way is going to add to the burden of the Federal courts or cause an explosion of litigation.

It hasn't happened to date.

If there are no further questions, I thank the Court.

Unknown Speaker: Thank you, Mr. Kopecky.

Mr. Dreeben.

Argument of Michael R. Dreeben

Mr. Dreeben: Mr. Chief Justice, and may it please the Court--

In our view, the cause of action provided in section 12(2) of the Securities Act of 1933 does extend to all sales of securities made by means of a prospectus or oral communication that contains a misleading statement, and there is no limitation to initial offerings, initial public offerings, or an exclusion of private transactions or secondary transactions.

The key in construing section 12(2) is the phrase, prospectus or oral communication, which is a defined term in the act, and when one looks at the definition in section 2(10) of the prospectus, it's fairly clear that Congress used words that cover a very, very broad range of kinds of communications that offer a security for sale or confirm the sale of a security.

And as my cocounsel alluded to, the origins of the statutory definition of prospectus are very revealing, because they show that the first four terms in that definition are the same that appear in the British Companies Act, and there is evidence from the people who wrote this act that they used the British Companies Act as a model.

Unknown Speaker: Mr. Dreeben, how do you answer Justice Kennedy's question about section 10, which uses the word, a prospectus, but that is definitely the kind of prospectus that would be part of a registration statement?

There, the word prospectus does have a circumscribed meaning.

Mr. Dreeben: Well, for most of section 10, that is true.

Section 10 is by and large concerned with the kind of formal prospectus that's included with a registration statement.

There is also authority for the Commission later in section 10 to classify various prospectuses according to type, and that is not a limitation that would necessarily apply to prospectuses filed in a registration statement.

But I think the most important point here is that the structure of the acts, the securities laws as a whole, reflects that Congress understood the difference between the broad definition in section 2(10) and the narrower association of prospectus used in a registration statement.

In the Investment Companies Act of 1940, Congress included a definition of prospectus that says, prospectus for certain sections of the act means the prospectus that is described in section 10 of the Securities Act of 1933.

Elsewhere, it has the definition that is contained in section 2(10) of the Securities Act of 1933.

So Congress itself was fully capable of drawing that distinction, and the act itself invites courts to draw appropriate distinctions in--

Unknown Speaker: Well, Mr. Dreeben, speaking of distinctions, what would you do about research reports that brokers commonly use in the sale of securities?

Mr. Dreeben: --There is no one, unqualified answer to that, Justice O'Connor.

The question would be, is the research report being used as a selling tool by the broker?

If the broker is using this--

Unknown Speaker: Broadly speaking how could it not be?

I mean, the broker says, well, here's a stock to consider and here's our research report.

Mr. Dreeben: --Well, I think in that context, Justice O'Connor, a research report would be the kind of document that's picked up by the language, and the application of section 2, 12(2) would be justified in light of the cause of action.

Unknown Speaker: So all research reports sent out by brokers are prospecti?

Mr. Dreeben: To the extent that they are used in a situation that one can conclude, Justice Kennedy, that they are offering a security for sale.

Unknown Speaker: Does that mean they have the same high standard of full disclosure that the prospectus that accompanies the normal public offering has?

Mr. Dreeben: No, Justice Stevens, they don't, because the requirement that would attach under 12(2) is not a requirement of affirmative disclosure.

The only requirement that's imposed by virtue of 12(2) is that the research report not contain false or misleading statements, and misleading statements in this context means an omission which makes the statements that are made misleading.

Unknown Speaker: Well, that's the same standard under the prospectus.

Mr. Dreeben: Well, but the question that I thought you were asking, Justice Stevens, is whether there was a laundry list of things that had to be included in a research report analogous to the kinds of things that are required to be included in a registered public offering.

Unknown Speaker: Not by... itemized, but it has the same standard, same high standard of care.

Mr. Dreeben: Well, it would have a... it would have the same standard of care under section 12(2).

Of course, under section 11 of the Securities Act, a registered offering would subject the issuer to strict liability for--

Unknown Speaker: Right.

Mr. Dreeben: --misstatements, and the persons who signed the registration statement would also have a very high duty of care.

Unknown Speaker: May I ask, since I interrupted you, do you know the answer to my question about the British Companies Act?

How did the English treat this?

Mr. Dreeben: The British Companies Act only applies to initial public offerings.

It doesn't regulate any secondary transactions, and it doesn't regulate private transactions.

And the point that I was trying to make about the comparison between the language is that the British Companies Act quite deliberately included the word, prospective circular, et cetera, and then said, in offering of securities to the public, and the Securities Act drafters dropped that language and substituted in the words, which offers any security for sale, which really expresses a quite different and deliberately broader connotation.

And when picked up in 12(2), I think as Justice Ginsburg indicated, you can have offering circulars that are used in private placements, private transactions.

The plain language of the statute quite clearly applies to seller misstatements in the context of those transactions.

Unknown Speaker: Mr. Dreeben, do we owe any deference to the SEC interpretation of these sections?

Mr. Dreeben: Not in the sense of Chevron, Justice O'Connor.

We're not asking for deference in that sense, but we do think that it is extraordinarily revealing and very important to the construction of 12(2) that at the time that this statute was passed, the administrators who were responsible for its implementation, which was the Federal Trade Commission, issued releases that quite clearly said that the act in the main applies to new public offerings, but note, industry, that section 17 and section 12(2) apply also to old securities which exist in the marketplace already.

Section 17, of course, is the remedy that the Government has available against fraud.

Unknown Speaker: Well, that would just affect the distinction between initial and secondary, not necessarily between public and private.

Mr. Dreeben: That is true, but the... in addition to the interpretations by the Federal Trade Commission there were also a raft of articles that were written at the time, or around the time, by such people as William O. Douglas and Felix Frankfurter... Felix Frankfurter was at the time very heavily involved in the drafting process... and those articles asserted without qualification that section 12(2) applied to any sale of securities and wanted to educate the investment community that was concerned with this that that was true.

This understanding continued not only immediately after the '33 act was passed but for decades, until the late 1980's.

There was very significant work trying to revise the act in 1940, in which the industry and the Commission together met, and everybody understood and expressed in written documents that section 12(2) applies to a really broad range of transactions, it doesn't distinguish among the various types, it doesn't distinguish broker transactions from initial public offerings, and it should, and recommendations were made to Congress to amend it, and then World War II came along and those amendments were not acted upon.

But the revealing thing here is that these very knowledgeable practitioners, who had every reason to understand--

Unknown Speaker: The one question that prompts us, how do you account for the fact there have been so very few cases like this?

Mr. Dreeben: --Well, I... the... probably the principal explanation in years up until the late 1980's was the existence of Rule 10(b)-5 and causes of action under it, which had really swamped the area, and so litigation under 12(2) certainly did increase as the statute of limitations for Rule 10(b)-5 was held to be shorter and scienter requirements were imposed, but it is a very significant point, Justice Stevens, that Rule 10(b)-5 did not exist when the '34 acts were enacted.

Unknown Speaker: Can I ask you a quick question about the research reports?

Mr. Dreeben: Sure.

Unknown Speaker: A research report is this, would perhaps be, you offer something for sale, you include a research report, it would be picked up.

Mr. Dreeben: Yes.

Unknown Speaker: But I take it you could get out of that if in fact you had enclosed as well a prospectus that had met the SEC's registration requirement because of the exception in (a).

Is that right, or not?

Mr. Dreeben: That question has not been definitively decided in the courts.

The weight of the view of commentators is that the exceptions that are contained in section 2(1) do not apply to the remedy that's provided in section 12(2).

There are several reasons for that, and there is a statutory argument that supports it.

The first reason is that there is an unequivocal statement in the House report that assumed that freewriting, oral communications made in the sale of securities are absolutely covered by section 12(2) whether or not a prospectus has been delivered.

There was no sort of free zone for fraud in that area.

And the statute allows you to reach that result because it introduces all of its definitions--

Unknown Speaker: Because it's oral, freewriting oral.

Oral isn't picked up with the definition of prospectus.

Prospectus picks up the written part.

Mr. Dreeben: --That is true.

The legislative history doesn't--

Unknown Speaker: Is there any reason (a) and (b) don't apply?

Mr. Dreeben: --The reason is--

Unknown Speaker: To a written... to a written.

Mr. Dreeben: --The reason is that the result would be that you would have a free zone for fraud or misstatements so long as you provided a copy of the written prospectus, and commentators have viewed that as an implausible result and one that is contrary to the direct evidence of legislative intent.

Unknown Speaker: Thank you, Mr. Dreeben.

Mr. Dreeben: Thank you.

Unknown Speaker: Mr. Jenkins, you have 3 minutes remaining.

Rebuttal of Donald W. Jenkins

Mr. Jenkins: The fundamental issue here is whether, when everybody says the '33 act was following the British act, which only applied to public offerings, did Congress somehow in the process, by section 12(2), totally convert the '33 act to apply to all private communications in all privately negotiated contexts?

The references by the draftsmen, by the House report, and others that were involved in the process, not later commentary in magazines, demonstrate irrefutably that the overall scope of the act, and its civil liability provisions in particular, didn't expand so drastically from the British Companies Act.

They said it was the same act.

Unknown Speaker: What do you say about commentators named Frankfurter and Douglas?

Mr. Jenkins: Mr. Frankfurter was involved in the drafting of the act but not as heavily as Mr. Landis, I think, if you believe what Mr. Landis wrote, which may be a stretch, I don't know, but it appears accurate that Mr. Frankfurter was overseeing it but was not as heavily drafted.

In fact, I think Mr. Landis in his article referred to Mr. Frankfurter seeing the draft of the act for the first time before a meeting, or something along those lines.

He was not as heavily involved as Mr. Landis, who said public offerings not private offerings defines the exact scope of the act.

The act was not intended to regulate sales to institutional--

Unknown Speaker: --the British act which did include an express limitation to public offerings?

Mr. Jenkins: --I think the simple answer is, they felt it wasn't necessary.

The whole design of the first ten sections of the act, and in particular section 5, the heart of the act, is directed solely at one context, public offerings.

Everything else is exempt.

Unknown Speaker: You rely on using the same litany of prospectus, notice, circular, et cetera, but then say, well, it's all right for them to have skipped out the other part, that they didn't copy the British wording to that extent.

Mr. Jenkins: That's correct, they did not follow the phrase, include the phrase, to the public, which is in the British Companies Act, but Congress repeatedly said, the draftsmen said, this act is the British securities act.

How could those statements be correctly made if one applies only to public distributions and the other is much, much broader, applying to every private transaction that ever involves the sale of a security and an interstate communication?

The lack of any explanation, specific discussion or anything, anywhere in the legislative history or the House report of any notation that the act extended so much more broadly is to our mind very, very strong proof that Congress, none of the Congressmen, none of the drafters intended such a broad departure from the public offering context.

They just simply couldn't have said the things they said in the reports about the act or in Mr. Landis' article about the act if that were the case, if the act intended to go into such a wide range of private, negotiated transactions.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Jenkins.

The case is submitted.

Unknown Speaker: The honorable court is now adjourned until Monday next at 10 o 'clock.

Attribution:

The OYEZ Project

Featured:

Central Bank Of Denver, N. A. v. First Interstate Bank Of Denver, N. A. - Oral Argument

Fri, 09 Jan 2009 14:49:54 +0000

Case:

Central Bank Of Denver, N. A. v. First Interstate Bank Of Denver, N. A.

Media File:

92-854_19931130-argument.mp3

Related Transcript:

1993_92_854_argument.xml

Transcript:

Argument of Tucker Karl Trautman

Chief Justice Rehnquist: We'll hear argument first this morning in Number 92-854, the Central Bank of Denver v. the First Interstate Bank of Denver.

Mr. Trautman.

Mr. Trautman: Thank you, Mr. Chief Justice, and may it please the Court:

The two central issues that you are faced with today are whether Congress intended to create a private cause of action for aiding and abetting under 10(b), and secondly, if you so conclude, whether or not recklessness can provide a sufficient level of scienter, even though there is no duty breached either to disclose, or a duty of action.

Resolutions of these issues is shaped by the unique features of this case.

Specifically, Central Bank was not sued as a primary violator who allegedly engaged in deceptive or manipulative practices.

Instead, Central Bank was accused of substantially assisting the primary violation of others by agreeing to delay a new appraisal until after bonds were issued, thereby allowing the fraud to occur.

Central Bank was not involved in selling the bonds or marketing the bonds, but instead acted as indenture trustee, who had specific duties under a contractual document known as an indenture setting out the duties and setting out the bounds of its discretion.

This case was decided originally by the district court on a motion for summary judgment after full discovery, and at that time it was undisputed that the alleged substantial assistance by Central Bank involved no misrepresentation, involved no violation of duty of action or duty to disclose under the indenture, and in fact was a discretionary act under the indenture.

Resolution of the first issue--

Unknown Speaker: What was that act?

Mr. Trautman: --The act that they claim Central Bank engaged in, Your Honor, was to delay, if you will, an appraisal until after the bonds were issued.

The resolution of the first issue on private right of action in our view turns on the very nature of what aiding and abetting is.

Unknown Speaker: May I just ask one other question--

Mr. Trautman: Sure.

Unknown Speaker: --the delay.

It was discretionary.

Did they have the authority under their agreement, under the indenture, to insist that the appraisal not be delayed?

Mr. Trautman: Yes.

Yes.

It was a discretionary act.

They could either require a new appraisal, not require a new appraisal, and they could determine the timing of that appraisal.

Unknown Speaker: And whether they did it or not was entirely discretionary, no standards about whether they had any duty to--

Mr. Trautman: That's correct, Your Honor.

Unknown Speaker: --Why, under the agreement, did they have anything to say about the appraisal?

Mr. Trautman: Well, an indenture trustee essentially has ministerial acts, carries out ministerial acts.

Some courts have characterized this kind of trustee as a stakeholder, essentially owing duties both to the issuer of the bonds and the bondholder, and in this particular case, the indenture set forth what the duties were and what the bounds of discretion were.

Unknown Speaker: But would the decision of whether to delay or not delay the appraisal be a ministerial act, in your view?

Mr. Trautman: It would be... I don't know what label you would put on it, but it would be an act that the trustee could decide in its sound discretion, and the whole purpose of doing that--

Unknown Speaker: It seems to me there's some tension between the notion that it's a discretionary matter and it's a ministerial matter.

It seems to me one of those would be correct, but it's hard for me to see how both could be correct.

Mr. Trautman: --Well, Your Honor, I think it would be a discretionary matter.

Unknown Speaker: So the duties of the indenture trustee are not entirely ministerial.

Mr. Trautman: That's correct.

That's correct.

Now, let me focus for a moment on what aiding and abetting is, because I think that is the crux of the problem with the private right of action.

Aiding and abetting, in all circuits but the Seventh Circuit, does not require a plaintiff to show a manipulative or deceptive practice.

What it requires the plaintiff to show is a violation, a primary violation by somebody else, and substantial assistance of that violation by some act or inaction, and finally, a level of scienter.

Unknown Speaker: Is there a requirement that it be done in concert with the principal actor?

Mr. Trautman: The courts don't seem to be saying that, Your Honor.

What they--

Unknown Speaker: I mean--

Mr. Trautman: --What they--

Unknown Speaker: --could the substantial assistance required by the other circuits be rendered unconscious of the fact that it is substantial assistance?

Mr. Trautman: --It appears that that is the case, and I think that's exactly what has happened in this particular case, is that you have a situation where a professional, a bank in this particular case, was acting pursuant to its duties, and pursuant to its discretion, and is accused here in taking an act which essentially allowed a fraud to occur.

Now, if I may--

Unknown Speaker: Mr. Trautman, it seems to me that it really is a quite separate offense from the fraud itself, however.

Is it not the case that you can be convicted of aiding and abetting an offense even though the person who has been accused of committing the offense itself is acquitted?

Mr. Trautman: --That appears to be the case, Your--

Unknown Speaker: Whereas with contribution, of course, you can't be compelled to contribute unless the principal has been held liable.

Mr. Trautman: --That's correct.

Unknown Speaker: Well, it seems to me to separate it from the... you know, the kind of inevitable accompaniments of private rights of action that we've found in the past in Musick, for example.

Mr. Trautman: We agree, Your Honor, because the aiding and abetting act, if you will, is not necessarily deceptive or manipulative.

Unknown Speaker: Although as I understand it you didn't question that in the district court, and the district court ruled simply on the state of mind question, is that not so?

Mr. Trautman: We did not raise the issue of whether there was a private right of action because it would have been fruitless, Your Honor.

Unknown Speaker: It would have been fruitless because the law was so solidly against you in the lower courts, is that--

Mr. Trautman: The Tenth Circuit had found in 1974, without any analysis whatsoever... they had assumed that there was a private right of action, and we think that those cases, Your Honor, essentially are premised upon a methodology that this Court has now abandoned.

That is, the methodology from Borak, the methodology that would allow courts to essentially import tort principles into the... into the act without an analysis as to whether Congress really intended for that to happen.

Unknown Speaker: --But you're arguing here that there shouldn't be any aiding and abetting liability, period.

You're not arguing that there shouldn't be any aiding and abetting only in the case of the innocent aider and abettor.

Mr. Trautman: That's correct.

Unknown Speaker: Okay.

And your argument would cover the SEC as well, as it's not limited to... you're talking about a private right of action here, but if there is no aiding and abetting liability, then the SEC could not go after it either, is that correct?

Mr. Trautman: That is not correct, Your Honor.

This Court could decide the issue on a broad basis, which would be to say that the words of 10(b) do not reach aiding and abetting, and that would have the effect of covering both private actions and SEC actions.

On the other hand, the Court could find, using its approach announced in Musick, which essentially followed the approach that had been followed for years, could say that either it was a separate cause of action, and we all know that Congress did not intend to create a cause of action for 10(b) and therefore they did not intend to create a cause of action for aiding and abetting, or even if you don't find it's a separate cause of action and you adopt the Government's view that this is merely rounding out of an existing cause of action, you look to, under the Musick case, section 9 and section 18, those sections which were intended to be a measure, if you will, of how Congress would have dealt with the issue, and you find that they are silent as to aiding and abetting, and we think that that is significant in this case because of the fact that prior to 1934, as early as--

Unknown Speaker: Silent as to the Commission as well as the individual.

I'm... what I'm trying to understand is if you are acknowledging, or you're saying I don't have to answer that question, that the SEC could similarly... if you're correct, it's not aiding and abetting.

Mr. Trautman: --No.

What I'm saying, Your Honor, is that there are two roads that the Court could take, both of which would result in my client winning the case, and so from that point of view I don't particularly mind which course you take.

If you take the broad course, I think that that would have the effect, and that broad course would say that the 10(b) was just never intended to cover any aiding and abetting.

You could also take the narrow course, which would be to merely say that this is a separate cause of action, private cause of action, and therefore Congress did not intend to create that private cause of action and not get to the question of the language of 10(b), so I think that there is a way for you to avoid the damage.

I might also--

Unknown Speaker: That is to say, it is not the private cause of action that we have heretofore recognized.

Mr. Trautman: --That's correct.

Unknown Speaker: And we're not going to recognize any other private causes of action under 10(b).

Mr. Trautman: That is correct.

That is correct.

Unknown Speaker: Under the allegations of the complaint taken in the light most favorably to the plaintiff, could there have been a cause of action or an allegation for liability as co... of the bank as coconspirator?

Mr. Trautman: Well, I suppose there could have been any allegation at the onset.

What they chose to do here, Your Honor, was to not sue us as a primary violator, but instead to sue us as an aider and abettor.

Unknown Speaker: Well, suppose they alleged that there was an agreement to hold up the appraisal, and then alleged that this was a conspiracy, would that be a separate cause of action?

Mr. Trautman: In our view, a conspiracy would also be a separate cause of action.

Unknown Speaker: Has it been treated as such in the writings, in the general law of torts?

Mr. Trautman: In the general law of torts, conspiracy has been considered as part of the underlying tort, but here, and the problem we have with aiding and abetting, I think it's the same problem you have with conspiracy, is what the courts have tended to do is just to assume that these peripheral rights are there without any analysis as to whether Congress really intended them to be there, and if, in fact, the key is--

Unknown Speaker: We all agreed that Congress didn't provide any indicia of intent.

You can't blame them for doing what we all concede wouldn't work.

Mr. Trautman: --That's correct.

Unknown Speaker: The question, as Justice Scalia raised, is whether it really falls within sort of the rounding-out jurisprudence, and I mean, Justice Kennedy's point is that they could have been pursued on a conspiracy theory, and at least on traditional tort principles that would not have been regarded as a departure, and if that's so, why should this be regarded as a departure?

Mr. Trautman: Well, I think the difference... there is a difference between aiding and abetting and conspiracy, and let me just focus on that for a moment.

As you know, conspiracy is based upon an agreement, essentially that there has been a relationship set up based on an agreement.

What aiding and abetting is really premised on is additional conduct, additional conduct that the courts have struggled to define and have used words of substantial assistance and put all sorts of factors in front of that, such as, was the defendant benefited, and that sort of thing, and it has become a morass, as you look at the cases, as to what substantial assistance means, but that is separate conduct.

It is not a relationship, such as a conspiracy.

It is not, as this Court said in Musick, an allegation of existing 10(b) liability, because it is additional conduct beyond manipulation or deception.

If the fact--

Unknown Speaker: Well, in a sense... in a sense, conspiracy requires an element that aiding and abetting doesn't, namely, an agreement, so in a sense, an aider and abettor is acting closer to the principal actor than is a conspirator.

Mr. Trautman: --That's correct, but there is a difference in terms of the actual... you see, my problem with what the lower courts have done is that they have focused on this substantial assistance issue, and they've lost their eye on the ball, and the ball really here is, did my client engage in deceptive or manipulative conduct, and if they did, they could be sued as a primary violator.

It so happens that the facts of this case, I think it's clear or undisputed, that we did not do anything that this Court has defined previously as being deceptive or manipulative, and so what you have out there essentially that's been applied... implied by the courts is a cause of action which allows a plaintiff to come in and sue a defendant because the defendant was around the transaction, was there, has deep pockets, and essentially to make allegations that they have benefited from the transaction, that they caused... they helped cause the transaction, if they had just acted differently, this fraud wouldn't have occurred, but they did not engage in any deceptive or manipulative conduct.

Unknown Speaker: But do you--

--But why is that so clear?

Why couldn't one say that deliberately delaying the time that this property would be reappraised was a manipulative practice?

Mr. Trautman: Well, the reason why you can't say that, Your Honor, is because manipulative practice has really focused on two concepts.

One is misrepresentation, and second is either a failure to act or failure to disclose in a context where you have a duty to do so.

Neither of those two things are presented by this case.

Unknown Speaker: Do you acknowledge that this horrible thing which you just described could happen if your client was sued for conspiracy to violate 10(b)?

Mr. Trautman: Well--

Unknown Speaker: What about a cause of action for conspiracy to violate 10(b)?

Would that exist?

Mr. Trautman: --Your Honor, obviously that is not presented here.

We think that a conspiracy is different than aiding and abetting.

It does have the same dangers--

Unknown Speaker: I know it's different, but will you first answer my question?

Do you acknowledge that there is a private cause of action for conspiracy to violate 10(b)?

Mr. Trautman: --I don't believe that there... I don't think this Court has ruled as such.

Unknown Speaker: Do you think that there should be?

Mr. Trautman: No, I don't.

Unknown Speaker: For the same reason that--

Mr. Trautman: Exactly.

Unknown Speaker: --you have for your--

Mr. Trautman: And my point is, though, that you don't need to reach that, and in trying to respond to Justice Kennedy, I do think that there is a distinction.

In the Curran case this Court, in a very... a very quick passage, without, it appeared, much discussion, said that... I think it was under the Commodities Act, that there could be... conspirators could be held liable, but if you look at that case, that those so-called "coconspirators" were really primarily liable in our view, under the facts of the Commodities case.

Unknown Speaker: --Mr. Trautman, in your response to me, were you suggesting that there must be a duty to disclose, otherwise you can't have liability as a principle, and if so, what case held that?

Mr. Trautman: No, I'm not saying that there has to be just a duty to disclose.

I'm saying there either has to be misrepresentation or a duty to disclose, neither of which were present here, and with respect to the duty to disclosure, I think this Court's cases in Chiarella and Dirks essentially stand for that proposition, among others.

If I could focus for a moment on the... what I think is the unavoidable legislative determination here is that prior to 1934 in the context of the criminal law, the Court essentially knew how to create criminal aiding and abetting liability.

They used very specific language.

After 1934, in a whole series of amendments, in 1964, '75, '86, and 1990, they also knew how to create liability for SEC disciplinary action.

Unknown Speaker: Who is the Mr. Trautman?

Mr. Trautman: This is the Congress.

Unknown Speaker: The Congress.

Mr. Trautman: I apologize.

There are a lot of them.

The... and by contrast here, in 1934, in the act itself, in section 10(b) there is no mention of aiding and abetting, and we believe that that is very strong evidence that both before and after 1934, they used very specific language when they wished to create such a right, that in the act in 1934 it is silent, and also, if you use the measure, if you will, of--

Unknown Speaker: You are now making the broader argument in... under Justice Ginsburg's question, so if we agree with you on this argument, even the SEC could not enforce aiding and abetting liability.

Mr. Trautman: --Well, Your Honor, I think there maybe three levels to go with this.

I said there were two.

The first level is to find that there is a separate cause of action, and at that point in time, you can then very quickly conclude that Congress intended no such cause of action.

The second level is to say that it is rounding out, but the first thing we're going to do is to look at whether there is a private cause of action, using section 9 and 18 as models, and if you do that, you can come to the conclusion that there's no private right of action.

You don't have to get into the broader issue even in that second realm of looking at whether or not it exceeds, if you will... whether the conduct exceeds what is permitted by section 10(b).

The third is the broader one, and that would be to say that we look at the language, we knew what we said in Ernst and Ernst, and that is manipulation and deception means manipulation and deception, it doesn't mean something else such as substantial assistance of manipulation and deception.

That is the broader ruling, Your Honor, and I think that one would take care of the SEC.

However, let me just mention, there is some implication here that the SEC is going to be left powerless if in fact you take that broad ruling, and I think that that is incorrect.

Yes, Congress after all has given the SEC aiding and abetting authority in section 15 with regard to these disciplinary proceedings.

And also in 1990, in a recent amendment, they... they held that the SEC... this is the Congress again, Mr. Chief Justice... held that the SEC had cease and desist authority against any person who is violating, has violated, or is about to violate any provision of the statute, or any other person that is, was, or would be a cause of the violation due to an act or omission such other person knew or should have known would contribute to such violation.

The point being, it seems to me, that the SEC still does have enforcement authority both in section 15 as well as this section, which is 21(c), added in 1990.

The second point that I think that this brings out is that Congress knew again how to create liability beyond just the direct liability that is set forth in the statute.

They used aiding and abetting language in the SEC disciplinary proceedings, and they used contribution language in this particular case.

Let me just spend a moment, if I may, on the second issue which hopefully you will not have to reach, and that is the issue of what is the proper scienter standard if, in fact, there is such an aiding and abetting right.

Unknown Speaker: May I ask you, counsel, if you would concede that recklessness is a sufficient mens rea to satisfy any scienter requirement for primary liability?

Mr. Trautman: Well, Your Honor, we think that that question obviously is not raised here, does not have to be decided, but if in fact--

Unknown Speaker: No, but would you answer the question?

Mr. Trautman: --If in fact... if in fact that question were presented, we think that the proper approach would be to look at the words of 10(b) and to say that you cannot have a reckless manipulation, you cannot have a reckless device, so I don't think it should.

However, there may be cases that come before this Court where the Court would--

Unknown Speaker: Have most of the courts of appeals held that recklessness is sufficient--

Mr. Trautman: --Yes.

Unknown Speaker: --in the primary liability--

Mr. Trautman: Yes, they have.

Unknown Speaker: --the same?

Mr. Trautman: They have.

Unknown Speaker: I think all of them have, haven't they?

Mr. Trautman: Yes.

Unknown Speaker: Yes.

Mr. Trautman: They all have, Your Honor.

I think the point being that if you decide, however, that recklessness were sufficient for aiding and abetting, I think almost by necessity everybody will assume that it's good enough for a primary violation even though you may try to reserve the question.

By contrast, there is a principal basis--

Unknown Speaker: We might approach it just the other way and say clearly its enough under primary--

Mr. Trautman: --Exactly.

Unknown Speaker: --liability and why shouldn't it be enough if there's aiding and abetting?

Mr. Trautman: Okay, and the reason why there shouldn't be enough if it's aiding and abetting would be to recognize that... if you find that there is a separate cause of action for aiding and abetting, or that there is an additional cause of action implied by Congress for aiding and abetting, the principal difference being that that is one step removed from a primary violation and yet carries with it joint and several liability, and so there is a logical basis for saying that in that circumstance we're going to require a higher degree of knowledge or scienter than we are in the primary violation.

Also, the other basis would be to recognize, ask as this Court did in the criminal law context in Nye and Nissen that aiding and abetting, as Justice Learned... Judge Learned Hand at that point in time said,

"in some sort you must associate yourself with a venture that he participated as is something he wishes to bring about, that he seek by his action to make it succeed, and it would be true and consistent with what I think the origins of aiding and abetting really were, that there has to be purposeful, conscious conduct to further what was going on. "

The most difficult problem that you have with recklessness, in my view, I think is pointed out by the SEC's brief, where in the same breath they say that the standard is both a flexible and predictable standard, and I think we would agree with the first part that it is flexible.

It is so flexible, however, that the only prediction that we can give our clients is that every case will be decided on its facts.

Unknown Speaker: It's predictably flexible.

Mr. Trautman: Exactly.

[Laughter]

The difficulty created for professionals in complex litigation such as this one, complex securities transactions where you have underwriters, appraisers, accountants, bond and disclosure counsel and trustee, all of whom have specific duties and expertise, and to a large extent all of whom rely on the others to carry out their particular roles, those differences, however, are overridden by a common trait in these transactions.

They all assist.

By definition, they all assist, and therefore they are potential targets for aiding and abetting if their actions or inactions allowed the fraud to occur, and as this... I think it's the Tenth Circuit opinion indicates, oftentimes the difference between action and inaction is found in the eye of the beholder.

Did Central Bank take affirmative action by delaying the appraisal until after the bonds were issued, or by contrast, did Central Bank fail to have a new appraisal done before the bonds were issued, and we think that a determination of liability on such characterizations would not be appropriate.

Recklessness is too much--

Unknown Speaker: In this case you've got one other ingredient.

They took another $2 million in collateral in order to be quiet, didn't they?

Mr. Trautman: --I'm sorry?

Unknown Speaker: In this case you've got another factual ingredient, because the bank took another $2 million of collateral in order to be quiet about it until after the '88 issue.

Mr. Trautman: No, the $2 million of collateral, Your Honor, related to an earlier bond issue.

Unknown Speaker: No, I realize it did, but they accepted the collateral for that earlier bond issue as part of their... or as the consideration for their agreement to insist on no immediate reappraisal.

Mr. Trautman: Inevitably in these transactions problems are going to come up and problems have to be resolved, and I think Your Honor's point is well taken, is that there is certainly give-and-take with respect to these.

It's not as if Central Bank was essentially lining its pockets.

It was looking for... looking out for the interest of the '86 bondholders.

Let me just focus my last comments before sitting down on what I think the fundamental problem with recklessness is, and that is, it is too much like negligence, which this Court has already found in Ernst & Ernst is not a sufficient level of scienter for 10(b).

Both negligence and recklessness involve a deviation from a standard of care.

To that extent, they're identical.

The only difference between the two, however, is that recklessness requires an extreme departure from that standard of care, and in our view that's a very slippery standard which will prevent summary judgment from being granted for wrongfully accused defendants, and it will allow liability based upon a jury's view of the extremity of the defendant's conduct.

It will also allow judges and juries to, in essence, create a Federal standard of conduct after the fact which, as this Court... as this case demonstrates can be contrary to the State law duties of the particular defendant.

Unknown Speaker: How did the Tenth Circuit define recklessness?

They didn't say, extreme lack of care, or they--

Mr. Trautman: It defined it... it essentially used the Sundstrand approach, which was that it had to be an extreme departure from a standard of care.

That was the definition that they used, Your Honor.

And so what we're left with is scienter being the only reliable screen that this Court has to sort out conduct that is truly the use of a manipulative or deceptive device or contrivance from other conduct believed by plaintiffs to be unfair, and as we indicate, we believe that in the case of aiding and abetting, because it is one step removed from primary liability, that the better approach is to use conscious intent.

If there are no further questions, I'll save the balance of my time.

Unknown Speaker: --Very well, Mr. Trautman.

Mr. Gersh, we'll hear from you.

Argument of Miles M. Gersh

Mr. Gersh: Mr. Chief Justice and may it please the Court:

Our position is that the aiding and abetting remedy which has been developed over 30 years by the lower Federal courts in hundreds of cases and which has been approved and applied by every one of the Federal appellate courts is a fully actionable part of the 10b-5 cause.

This Court said 6 months ago in Musick, Peeler that we must confront the law in its current form, and the current form of the law is that there is a section 10(b) private action, that it reaches primary violators, and after Musick, Peeler it reaches at least one form of joint tortfeasors... that is, contributors... and this case raises the question or the issue about a different form of joint tortfeasor, that is, aiders and abettors.

Unknown Speaker: There is this--

--Musick is arguably quite different from your case here, in that given the primary liability, it could be easily argued that the right of contribution flowed as a result of that.

I don't think the same is true of aider and abettor liability.

It seems to me that's a separate inquiry.

Mr. Gersh: Contribution, Justice Rehnquist, it's correct... Chief Justice... is a different form, in other words, of secondary liability from aiding and abetting.

Unknown Speaker: Well, I'm not sure that it's secondary liability.

I agree with the Chief Justice.

In Musick we did not expand the universe of persons who had a duty to the purchaser of the securities.

Here, we would be doing that.

Mr. Gersh: It... in other words, it's not allocation among primarily liable parties.

Unknown Speaker: In Musick, yes.

Mr. Gersh: --that's correct.

Unknown Speaker: In Musick, the premise was that there was a duty under the Securities Act.

Mr. Gersh: That is a difference, Justice Kennedy.

I... in the Musick, Peeler case, though, the Court was answering or asking and answering the basic question about whether this... this remedy, this cause, this right contribution was a part of the 10b-5 action or separate, how it should be treated.

Justice Kennedy, you asked about conspiracy, whether that... in the sense of this Court's jurisprudence that is relevant here today, whether that's a separate cause of action, and really the relevant case there is this Court's decision in Curran, where there was an implied action under the Commodity Futures Act.

And the Court said, in the course of considering whether there should be a conspiracy, an action... a right against conspirators, that because there was an implied action that the Court had recognized, that it necessarily followed that there should be a right against conspirators, and in a similar context in the case cited by the SEC in their brief, American Society of Mechanical Engineers v. Hydrolevel, there you had an express private action under the Sherman Act, and the question there was whether there should be a right against an employer on an agency theory, and similarly there, the courts said, looking at the common law and saying that the agency theory was well-established in the common law, that to be faithful to the purpose of the Congress in the express private action, that the case should reach beyond primary violators to an agency theory.

All of these, we would say, these cases that I've just been discussing... Musick, Peeler in respect to contribution, ASME in respect to employer liability, the Curran case in respect to conspiracy, and here in this case, aiding and abetting... what they do, although these are different forms of joint tortfeasor liability, they are all questions which arise in different contexts under existing private actions, and this is a question of aiding and abetting liability, another form... different, but another form of joint tortfeasor liability under an existing cause of action, the section 10(b) action.

The Court has said another way to look at it--

Unknown Speaker: Well, certainly, but it's not really joint tortfeasor liability because you can find one guilty and the other not guilty.

Mr. Gersh: --I think the Court--

Unknown Speaker: That's wherein this differs a whole lot from contribution.

You can find someone guilty of aiding and abetting an offense even though the alleged primary offender is acquitted.

Mr. Gersh: --In the aiding and abetting cause, Your Honor, the first element, Justice Scalia, would be that there was a primary violation, so--

Unknown Speaker: You have to get the jury who's trying the aider and abettor to find that there was a primary violation, but another jury could have found that the primary violator in fact didn't do it, and it would not eliminate the aiding and abetting liability, whereas with contribution, if the primary offender is not found liable, there's no question that there can't be any contribution.

Mr. Gersh: --The link... at least with aiding and abetting, justice Scalia, there is a direct link to the primary violation in the first element of the aiding and abetting cause.

That is, the existence of a primary violation.

We do have to show that.

We had to show that in this case.

We had to show that there was a fraud by the developer, and we did do that, and had we not done that, we couldn't... we wouldn't have gotten past summary judgment on that issue.

Unknown Speaker: Mr. Gersh, would liability as an aider and abettor be available as a theory for your client against the lawyer that advised the bank, and perhaps the accountant--

Mr. Gersh: If they had--

Unknown Speaker: --as well as the bank?

The lawyer was aware of what the bank was doing in connection with this transaction.

Now, under your theory of aiding and abetting, the lawyer perhaps could have been made liable as well.

Mr. Gersh: --Knowledge, participation... knowledge and substantial assistance in a primary violation would all have to be proved with respect to that lawyer.

It wouldn't be enough just--

Unknown Speaker: Well, assistance to the bank to do whatever the bank was doing.

Mr. Gersh: --It would have to be, Justice O'Connor, not just assistance to the bank, but substantial assistance in the fraud.

In her words, Mr. Trautman has suggested that the court were... here's a cause or a remedy which can gather up all kinds of professionals who participate in these kinds of transactions, and they're all going to be doing something, but what they aren't all going to be doing, and that's the purpose and the direct object of the aiding and abetting remedy, is they're not all going to be substantially assisting a fraud.

We didn't charge Central Bank... we didn't draw our complaint in this case just because they were helping in a bond deal.

We drew it because they were substantially, actively assisting a fraud, and that would have to be the proof with respect to that lawyer or these other professionals.

In the... in the--

Unknown Speaker: Mr. Gersh, do you concede that you could not have charged Central Bank as a primary violator so that you were forced into the aiding and abetting mode?

Mr. Gersh: --Yes.

Unknown Speaker: You concede that.

Mr. Gersh: Yes, I would concede that.

Central Bank here did not... the primary violation here was a fraudulent bond deal that was portrayed in an official statement that misrepresented the crucial aspect of this transaction, which was that it was supposed to be backed by property that was worth 160 percent of the principal amount of the bonds, and that's the primary wrongdoing, that fraudulent official statement.

Central Bank's role, and the only way that we could reach them under the securities laws... and it was a critical role, but was one of assisting, actively, substantially aiding and abetting that fraud by a series of acts, not just one.

Not just delaying the appraisal, but a series of acts over a period of 2 or 3 months that had the effect of making certain that the defects of that appraisal would never be known until it was much too late... 6 months after the bond deal went into effect.

The... another way to put this issue, besides as a pleading matter, whether it's separate or not separate... and we can talk about that in various ways.

In some respects it is separate from the core, from primary liability, in some ways it's not, but the most relevant aspect of separateness is whether the remedy or the issue that arises would have been included by the Congress or thought to be within the scope of the 10b-5 action had that action been provided for expressly.

That's the... we would suggest the most relevant sense of separate or not, and in that most relevant sense, the indicia that this Court has used to determine the intent and purpose and scope of 10b-5 and issues that arise under it, this is not a separate cause.

Unknown Speaker: Mr. Gersh--

Mr. Gersh: This is one of those items that will round out an existing cause of action.

Unknown Speaker: --Well, that's a different question.

I mean, rounding out is quite different from asking yourself, would the Congress that created a private right of action under 10(b) of the sort we've already recognized also create a private cause of action for this?

The answer to the latter question is, God, a Congress that would do it for that would do it for all sorts of violations of the Security Act, and that's quite different from rounding out.

Rounding out is to say, we've already held that Congress has created this, but whether they really did or not doesn't matter.

We've held that.

This is such an inherent part of that that we can't possibly withhold acknowledgement of that as well.

You're inviting us to adopt a quite different test, to say, would the Congress that created the private right of action we've already acknowledged create another private right of action?

Well... well, I think they'd create right of actions all over the place if they accepted the one we've already found.

Mr. Gersh: Justice Scalia, I would say that the rounding out test is related in this sense, that there is no rounding out doctrine in any of the Court rounding out cases... Lampf, Musick, Peeler... that is separate from the question of how Congress would have originally designed the cause of action.

The courts, even where there was an express cause of action... actually, the Curran case is another good example of this... are not at large simply to round out a cause, or that cause of action when another issue comes to them.

They have to do it in a way that is faithful to the scope of the express cause of action, and in that sense the question, the rounding out question, is the same one.

In other words, is the section 10(b) action as designed by the Congress one within which the aiding and abetting remedy would have a part, and we say--

Unknown Speaker: Well, they overlap.

They're not identical.

I mean, it's fair to say that we wouldn't find it appropriate to round out unless Congress would have created the liability on the premise of what we've done so far, but it doesn't follow that everything that Congress would have done would amount to rounding out for existing kinds of action, isn't that true?

Mr. Gersh: --No, I think that that's... I think that that's true.

We would say that in... that the answer to the question whether aiding and abetting would be within the purpose, within the intent, or scope, or contour of the 10b-5 private action, is answerable by looking at the same sources of intent, congressional purpose, that the Court has looked at in other cases in its 10(b) jurisprudence.

First, at the background of... the common law background of the section 10(b) action, and there, with respect to aiding and abetting, the answer we would submit is a clear one, that aiding and abetting had a place in the common law when the 1934 Congress came to its job in enacting 10(b), but it went back--

Unknown Speaker: As a matter of fact, in the law of torts generally, I can't off-hand... maybe you can help me... think of an example where an aider and abettor is not liable for the commission of a tort.

Mr. Gersh: --Your Honor... Justice Kennedy, I would agree.

We have cited cases going back to the 1800's, and I don't think that Central Bank in any of its briefs has cited anything to the contrary in... in... and therefore, the point of that is simply that, as this Court has said, it was one of the undoubted purposes of Congress, when it came to its task in 1934, to correct perceived deficiencies of the common law.

And therefore had this... had the Congress considered aiding and abetting in 1934, it would not have left it out of a private action had it... if it had done that, it would have taken a step backward in the opposite direction from bolstering the protections for investors, and so the common law is a powerful demonstration that aiding and abetting belongs within the scope and the purpose of the 10b-5 remedy that the Congress enacted.

I would like to address briefly the recklessness point, very briefly, in the time that I have remaining.

The recklessness issue has to be analyzed, first of all, in the same way, in a way that is faithful to the purpose of Congress in the 10b-5 action itself, and if you start with the common law, recklessness also, as a matter of satisfying the scienter or the culpable state of mind requirement, has a history that goes back really into the 19th Century in the common law of deceit that the Congress was looking at when they developed the 10b-5 action, and to this--

Unknown Speaker: It may well for the principal offense, but does it for the allied offense of aiding and abetting?

Does it for conspiracy, for example?

Can you become a coconspirator by being reckless?

Mr. Gersh: --I'm not certain about conspiracy, but as to aiding--

Unknown Speaker: I am.

I'm certain you cannot become a coconspirator by being very reckless.

You have to have an agreement, the intent to make alliance with the other person, and isn't it the same for aiding and abetting?

You need the intent to aid and abet.

Mr. Gersh: --As for aiding and abetting, the cases of aiding and abetting common law deceit, the ones that we located, do say that... include recklessness, or reach recklessness, Your Honor, so as to the aiding and abetting, the history of aiding and abetting, recklessness was the standard there as well.

Unknown Speaker: Where are those cases in your brief?

Do you recall?

Mr. Gersh: I think we cite these cases--

Unknown Speaker: Well, go on.

I don't want to make you waste your time.

You have little left.

I'll find them.

Mr. Gersh: --In the footnote, which is on page 34 of our brief, footnote number 27, we cite a number of these cases, and then I think we also in the text cite... we do cite in the text several aiding and abetting cases as well.

Unknown Speaker: But... yes, but most of those cases... as far as the text shows, all of those cases involve the tort of deceit, includes reckless behavior.

I have no doubt that it does, but does aiding and abetting deceit include just being reckless?

It seems to me you have to want to aid and abet.

You have to want to assist.

I don't see how you can do that recklessly, any more than you can conspire recklessly.

Mr. Gersh: Actually, Justice Scalia, if you look at the... if you look at the criminal law, which if anything should have a more stringent form of intent, the criminal law uses recklessness, or defines the intent necessary for aiding and abetting as reckless, at least in some of the cases, and it's... the level of intent required for aiding and abetting has been considered to be a general intent, closer to general intent and not specific intent.

There's--

Unknown Speaker: Well, when you're talking about aiding and abetting someone else who might deceive or manipulate, I take it that it would be a requirement that the aider and abettor at least appreciate that there may be someone in a position to manipulate or to deceive who would be helped by the aider and abettor's conduct.

The aider and abettor may not have to make an agreement with this primary defendant, and perhaps the aider and abettor wouldn't have to know that this primary defendant was about to manipulate or deceive, but the aider and abettor would have to know that someone was in a position to do that.

And isn't that perhaps the answer to the problem that we've got, that it's perfectly true, you do have to have some kind of knowledge in order to put yourself into the category of aiding and abetting, but that knowledge is sufficient if you know that someone... not necessarily the primary defendant that we later identify, but someone is in a position to deceive and manipulate, and your gross deviation would aid or abet that enterprise?

Isn't that the knowledge that is required that is sort of peculiar to recklessness in a context like this?

Mr. Gersh: --I would agree, Justice Souter, and I would also add to that that the recklessness standard is a stringent one.

As presented by Central Bank it would seem not to be, but it requires... to complete that, it requires that the risk of the harm be so obvious that it must have been known to the defendant, and in that sense it's tantamount to actual knowledge.

I thank the Court.

Unknown Speaker: Thank you, Mr. Gersh.

Mr. Kneedler, we'll hear from you.

Argument of Edwin S. Kneedler

Mr. Kneedler: Thank you, Mr. Chief Justice, and may it please the Court:

This Court recently reaffirmed in Musick, Peeler that it's the responsibility of the Federal courts to give content to and round out the private right of action that has been recognized under section 10(b) of the '34 act and the Commission's implementing rule, 10b-5.

For the past 30 years, the lower Federal courts have uniformly held that aiders and abettors are properly named as defendants in suits under 10(b) and 10b-5.

There are hundreds of such reported decisions in the lower courts.

In our view, a practice that is so embedded in the enforcement of the Federal securities laws should not lightly be overturned.

In our view there... not only are there no compelling reasons for doing so, but the relevant indicia that this Court has looked to in giving content to the 10b-5 cause of action all strongly reinforce the existence of aider and abettor liability.

First of all is the very practice that has gone on for 30 years, a point the Court noted in Musick, Peeler, that the experience of the lower Federal courts is itself a factor to be taken into account, but turning to the text of the securities laws themselves, section 10(b), in statutory terms, is written very expansively, referring to any person who directly or indirectly engages in the conduct to which the section speaks, language that is broad enough in itself to include aiders and abettors, especially given the common law background, and we cite a case of this Court going back to 1869 holding aiders and abettors liable in common law fraud.

Read against that background, and the background of protecting investors, the language of section 10(b) itself is a basis for finding aider and abettor liability.

Unknown Speaker: Did that case speak about the necessary intent for the aider and abettor of agreement--

Mr. Kneedler: No, this is just the existence of aider and abettor liability on that case, Your Honor.

But beyond that, there are a number of other important indicia in the securities laws themselves.

For example... well, not in the securities laws.

I think I would start with 18 U.S. C section 2, which is significant here.

It provides that an aider and abettor is liable as a principal, and we think that is significant, that in terms of giving content to the private right of action under section 10(b), it is important to look to the persons whom Congress has deemed to be responsible when a violation of 10(b) occurs and section 2 of title 18 makes absolutely clear that Congress deemed a person who aids and abets a violation of section 10(b) to be responsible.

Unknown Speaker: --You think Congress when it enacted section 2 of title 18, which applies to the whole criminal code, really had this narrow problem in mind here?

Mr. Kneedler: No, my point is that as applied to section 10(b), Congress has deemed and in fact held criminally responsible persons who substantially participate in a violation of section 10(b).

In other words, in terms of rounding out the cause of action, it's not necessary to find that Congress had a specific intent under... in enacting title 18 with respect to section 10(b).

My point is simply that Congress has deemed that a person who aids and assists any violation of a law to be liable, and not only liable, liable as a principal, who has substantially participated and therefore is equally culpable.

Unknown Speaker: One can make the opposite argument from Article 2, and that is that if it was a rounding out matter, you wouldn't even have to have section 2, that it would automatically go along.

Mr. Kneedler: Well, no--

Unknown Speaker: Congress felt the need to say, by the way, aiders and abettors will be held the same as principals.

Mr. Kneedler: --Well, in the criminal law context, you would of course need a statute to say who is responsible, and the reason the Congress had adopted... enacted section 2, as this Court said in Standefer, was to, for example, overcome the common law rule that if the principal is acquitted the aider and abettor could not be found liable, and Congress wanted to eliminate that artificial distinction.

After all, someone who substantially participates in a violation of the law is quite culpable in bringing about the injury in this case to the plaintiff, so we think that section 2 is very important, because it not only identifies whom Congress thought was responsible, but also puts the person on notice that his substantial participation in the fraud will give rise to liability.

Unknown Speaker: Is it the position of the SEC that there was sufficient evidence here to support a finding that the petitioner substantially participated in the circumstances of delaying the appraisal?

Mr. Kneedler: Yeah, we think there's... yes.

We think there's sufficient evidence to avoid summary judgment, that the case has been sent back to the district court because of the agreement to postpone the appraisal.

Unknown Speaker: Well, the agree... I wasn't aware there was an agreement.

I thought this was something that the petitioner did on its own.

Mr. Kneedler: No, there was a letter agreement... a letter from the authority and developer endorsed by Central Bank to put off the appraisal until December of the issuing year, so it was... it was more than just--

Unknown Speaker: You say there was an agree--

Mr. Kneedler: --Right, there was a letter dated May 13th, I think, of 1988.

The other... the other places in the act where Congress has identified that aiders and abettors should be responsible and the Commission's longstanding ability to get injunctions against aiders and abettors under section 21 also reinforce the idea that aiders and abettors are responsible and therefore set the... an appropriate parameter for the private right of action.

Also, the statutory analogues that this Court has looked to, particularly sections 9 and section 18 of the act, far from supporting petitioner's position support respondent's position in this case.

Section 9 imposes liability on anyone who wilfully participates, and participates is an expansive term, in fact the term that respondent elsewhere identifies with aiding and abetting based on this Court's decision in Nye and Nissen, someone who participates in the transaction, so section 9 we think is clearly broad enough to include aiding and abetting liability, and the same with section 18, which refers to any person who makes or causes to be made any misleading statement in a registration statement.

And finally, the private right of action for aiding and abetting is a very important supplement to the SEC's own enforcement authority.

The SEC can go after aiders and abettors just as it can go after primary violators, but just as in the case of primary violators, the SEC is not in a position to uncover every bit of wrongdoing and also is not in a position to compensate victims.

Its role is the different one of deterring violations by disgorging profits or enjoining future violations.

That's why, just as in the case of primary violators, the private right of action is important in the case of aiders and abettors.

If I could move on to the recklessness standard, in terms of primary... primary violators, it's settled in all the courts that recklessness is an adequate showing in order to establish liability.

That was also true at common law fraud, against which section 10(b) should be read.

Indeed, in this Court's decision in Cooper v. Schlesinger, the Court said a statement recklessly made without knowledge of its truth is a false statement knowingly made, and when an aider and abettor substantially participates in the making of a false statement, then we believe that the same standard of recklessness that applies to the primary violator should apply to the aider and abettor, because after all, again, the aider and abettor is liable in the criminal law as a principal.

Unknown Speaker: --Does the aider and abettor at least have to know that the primary participant has a duty under the securities laws?

Mr. Kneedler: I don't think knowledge of the law is important.

I think knowledge of the nature of the transaction that the primary violator is engaged in is important, but that is... that is obviously true here.

The recklessness in this case comes up with respect to recklessness of... with respect to whether the information was true or false, and it... I--

Unknown Speaker: Anyone who recklessly creates the conditions that enables someone else to perpetrate a fraud becomes an aider and abettor of the fraud?

Mr. Kneedler: --Yes, because he's participating in the perpetration of the fraud, and again, for example--

Unknown Speaker: No, but you're saying... I think Justice Scalia and I both understood you to mean that the aider and abettor's act, as it were, can come first, before he knows of anyone in particular, or anyone in general that is likely--

Mr. Kneedler: --Yes, and in theory he may not know who will be the ultimate principal.

That's true.

My only point is that the aider and abettor has to have a connection, has to lend substantial assistance to a primary--

Unknown Speaker: --But he has to know... you're saying that he has to know that someone may be in a position to take advantage of what he's doing.

Mr. Kneedler: --Yes, right.

Unknown Speaker: Okay.

Mr. Kneedler: And again, a reference to section 9 of the act is useful.

It refers to someone who wilfully participates, and as this case held last term in Hazen Paper, wilfully--

Unknown Speaker: Thank you, Mr. Kneedler.

Your time has expired.

Mr. Trautman, you have 3 minutes remaining.

Rebuttal of Tucker Karl Trautman

Mr. Trautman: Thank you, Mr. Chief Justice.

Mr. Gersh's concession that he could not have brought an action against my client for a primary violation speaks volumes as to whether or not my client engaged in manipulative or deceptive conduct which is the keystone of section 10(b).

However, I don't want the Court to get the impression that professionals could never be sued under a primary violation.

I think clearly they could, but they would have to essentially have participated in and engaged in deceptive conduct, something that did not happen here.

I think as Justice Scalia indicated, the allegation against our client is not that we participated in a misrepresentation, because we didn't.

We had nothing to do with the selling process.

What we are accused of doing is essentially by our conduct allowing the fraud to occur.

The Government argues that the common law was so well-established at the time the Congress passed 10(b) that it must have presumed to have incorporated it, and we think that this Court's decisions in Blue Chip, Ernst & Ernst, and Santa Fe Minerals, essentially made clear that there is not an automatic implementation of those principles into the law, but instead, that there has to be some demonstrated showing that Congress intended to do so.

The common law... or, strike that.

The Securities Act was not intended to be a panacea for all evils under the securities laws, and I think those decisions indicate it.

Finally, let me just comment that, interestingly enough, the very source of the recklessness standard... that is, section 876 of the Restatement of Torts, which talks about substantially assisting, in that standard, recklessness is not enough.

You have to have knowledge, under the tort law, for substantial assistance, whereas here, what our opponents are asking you to do is to graft on a principle in the deceit context onto substantial assistance, which even the tort law doesn't do.

Thank you very much.

Chief Justice Rehnquist: Thank you, Mr. Trautman.

The case is submitted.

Attribution:

The OYEZ Project

Featured:

Musick, Peeler & Garrett v. Employers Insurance Of Wausau - Oral Argument

Fri, 09 Jan 2009 14:49:29 +0000

Case:

Musick, Peeler & Garrett v. Employers Insurance Of Wausau

Media File:

92-34_19930301-argument.mp3

Related Transcript:

1992_92_34_argument.xml

Transcript:

Argument of Charles A. Bird

Chief Justice Rehnquist: We'll hear argument next in Number 92-34, Musick, Peeler & Garrett, et al. v. Employers Insurance of Wausau.

Mr. Bird, you may proceed.

Mr. Bird: Mr. Chief Justice, and may it please the Court:

This case concerns the implication of a cause of action for contribution in a Federal statute.

The statute in question is section 10(b) of the 1934 Securities Exchange Act.

It is a statute in which courts have previously implied a cause of action for people who suffer losses as a result of purchases or sales of securities where the... as a result of damage... or, pardon me, as a result of violations of section 10(b).

My theme today is simple.

The Court should apply its intent-based jurisprudence of implied rights, a standard which respondents concede they cannot meet when asked to apply a cause of action for a contribution in a statute in which a victim's civil claim has previously been implied.

Respondents and their amici assert that the Court should apply a different line of cases.

That is, a line of cases involving fleshing out the victim's remedy itself.

My burden today is to show that a contribution claim is a separate claim, and it should be treated as any other potential implied right of action in this Court's jurisprudence.

Implied contribution is to be treated like any other request for an implied action, first, because this Court has said so.

In the Northwest Airlines and Texas Industries cases, the unsuccessful petitioners made arguments which are indistinguishable from the arguments made by the respondents in this case.

The Court treated contribution there as an implied claim over those arguments.

In Texas Industries, the petitioner asserted that contribution was not at all a new cause of action, but only a supplement to the victim's express remedy in that statute for damages under section 4 of the Clayton Act.

The respondent... petitioner in that case also argued that contribution was a necessary corollary to judicial creation under the antitrust laws of joint and several liability among violators of that law, and amici in that case actually argued that contribution was somehow within the penumbra of the statute itself.

The court in that case said that in almost any statutory scheme, courts may have to interpret ambiguous or incomplete provisions, but the authority to construe a statute differs fundamentally from the authority to fashion new remedies.

The court also said that the judicial determination that defendants shall be jointly and severally liable does not suggest that courts have the power to order contribution among the defendants, for joint and several liability only assures that the victims whom Congress intended to protect shall have full recovery from some, if not all, of the perpetrators.

Were there any lingering doubt that somehow Texas Industries and Northwest Airlines differed from this Court's general jurisprudence of implied rights of action, I would suggest that was put to rest last year in footnote 6 of Franklin v. Gwinnett County Public Schools, where the Court cited all of those cases as a single line and said that it's intent-based jurisprudence shall apply to all such cases.

Implied contribution is to be treated like any other request for an implied claim, second, because contribution is a distinct action and--

Unknown Speaker: I suppose that footnote sort of grandfathered the implied cause of action under 10(b).

Mr. Bird: --That footnote did not discuss the implied contribution under section 10(b).

Unknown Speaker: No, not contribution, just cause of action.

Mr. Bird: The implied cause of action under 10(b) itself was grandfathered as far back as Bankers Life.

I think the Court has accepted the fact that lower courts have adopted that implied cause of action for victims and repeatedly in a number of cases the Court is fleshed out that cause of remedy, but as... the Court is never addressed the issue whether there shall be implies contribution.

Contribution is a separate action because it always involves a different plaintiff, and that different plaintiff is someone whose claim has not been recognized that different plaintiff is someone who is always a perpetrator of a violation of the statute, always a member of the class that Congress intended to regulate, never a member of the class that Congress intended to protect.

Second, contribution very often involves a different defendant.

Even if contribution is sought in the same action where the victims seek their compensation third party practice permits other parties, other defendants to be brought in by contribution actions, and often, as is the case here, contribution brings to Federal court a new suit.

Implying contribution truly extends Federal jurisprudence to embrace a dispute which Congress has not assigned the Federal courts to resolve, and that is a dispute for adjustment of damages among defendants as opposed to a suit for compensation by a victim.

Unless Congress tells the Federal courts that it wants them to embrace that dispute, to reach out--

Unknown Speaker: Did we ever pretend when we created the 10(b) cause of action that Congress intended that cause of action to exist?

Mr. Bird: --No, Justice Scalia, you acquiesced in the lower court's 10b-5 cause of action under standards which differ profoundly from the standards that this Court now uses to determine whether there shall be implied rights of--

Unknown Speaker: So under a Lampf kind of analysis, having created 10b-5 actions, which you might say without any express indication of congressional intent, why shouldn't we continue to round out the scheme without any indication of congressional intent?

Mr. Bird: --Contribution is not rounding out.

There is... the rounding-out cases, of which Lampf is one, start from the... start with the assumption that the court must reach an answer.

To illustrate with an example even simpler than Lampf, the court cannot walk away from the question whether the standard for liability under section 10(b) shall be negligence, shall be scienter.

The court cannot say, well, Congress didn't instruct us on this so we simply won't answer the question.

There is absolutely no need, in rounding out the victim's cause of action, to develop an entirely new jurisprudence of what should be the rights of perpetrators.

Unknown Speaker: You think we're just... we think we'd just be off-base if we tried to devine what Congress' intention might be if it thought about it.

Mr. Bird: I do, Your Honor, very much so.

I believe the kind of analysis which exists in the respondent's brief in this case is a kind of analysis in which this Court should never indulge in the process of deciding whether to create a cause of action.

The question is an attempt... Your Honor put it very succinctly.

What would Congress have done if it had known?

That is not an effort to determine legislative intent, it is an effort to impute intent to a mind which had none whatsoever.

Unknown Speaker: Congress... don't you think Congress has embraced the notion of a cause of action under 10(b)?

Mr. Bird: I believe Congress has... beyond any question, has embraced the notion that victims of violations of section 10(b)--

Unknown Speaker: So your answer's yes.

Mr. Bird: --Yes.

Unknown Speaker: It's just plain yes.

Mr. Bird: Yes.

Congress has said that victims shall have a cause of action against perpetrators it has seen and approved of this Court's jurisprudence.

It has not said in any way whatsoever that perpetrators shall have remedies against each other to adjust what they--

Unknown Speaker: But it has said in comparable sections... maybe you don't think they're comparable... that there should be contribution.

Mr. Bird: --I do not believe they are comparable, though I would--

Unknown Speaker: What if they were?

What if 9 and 18 you could say are sort of fellow travelers with 10(b) and Congress has expressly provided for contribution?

Mr. Bird: --I would still argue that the Court should not engage in that kind of reasoning by analogy that says well, Congress did it here, and Congress did it there, so Congress would have done it if it had only known.

Unknown Speaker: Well, we did it for the statute of limitations.

Mr. Bird: But that was an entirely different situation, Your Honor where you were--

Unknown Speaker: Well, it always is.

[Laughter]

No, but why?

You said that we had no choice, that we had to come up with some... we didn't have to pick a statute of limitations.

We could have said, there is no statute of limitations.

There are such things.

Just the law of laches governs, and nothing else.

Why couldn't we have said that?

Mr. Bird: --The analysis in... you could have, but you did not.

Unknown Speaker: Right.

Mr. Bird: The Court did not do that, Your Honor.

The analysis in Lampf commences with a phrase which says,

"excepting that some limitation must apply. "

and by saying that this Court squarely placed the analysis of Lampf within the same line of cases that says, we will determine what is the standard of liability, that says, we will determine whether purchasers or sellers or perhaps someone else shall have a cause of action.

That was not the creation of the cause of action.

It is not a form of reasoning which should be applied in a case like this.

Unknown Speaker: Well, why doesn't... I'm sorry.

Go ahead, please.

No, go ahead.

Why doesn't this form of reasoning apply?

One of our sort of rounding-out theories is that if there is in fact a class of plaintiffs who are given an implied cause of action, and there are other potential plaintiffs who are in essentially the same equitable kind of position that we ought to round out and extend to that second group of plaintiffs, why don't we have sort of the converse situation here... that if in fact there is a group of defendants who are in some comparable position and have a right of contribution, then we ought to round out our cause of action to do the same thing for defendants under 10(b)?

As Justice White referred a moment ago to the section... what is it, the section 9 and section 18 causes of action, there is contribution.

Why isn't the same equitable argument for the sake of defendants an appropriate argument to make here as the equitable argument in the case of plaintiffs that we recognized in Virginia Bankshares?

Mr. Bird: Because initially, Your Honor, you do not approach these people as defendants.

You approach these people as plaintiffs.

They have brought to court... and this case is a classic illustration.

They have brought to court a lawsuit separate from the victim's lawsuit, in which they assert an entirely new cause of action against new defendants.

That is an extension of Federal--

Unknown Speaker: Well, if... may I just interrupt you and ask this: if we get over the question of whether to call them plaintiffs or whether to call them defendants, do they not have essentially the same equitable argument to make:

We are in a worse position than those who have been subjected to express causes of action where express rights of contribution apply, and therefore we ought, as a matter of equity, be accorded the same right, whether you call us a plaintiff or whether you call us a defendant?

Mr. Bird: --Justice Souter, that is an issue of pure policy.

They can make that argument.

The fundamental question is whether the Federal courts should entertain an argument of pure policy when what is before them is the question whether Congress authorized a... the courts to create a cause of action.

Unknown Speaker: May I... first of all, you don't really draw a distinction between whether the contribution claim is asserted after a judgment or after settlement or before, do you?

Mr. Bird: I do not, Justice Stevens.

Unknown Speaker: I just wanted to be sure, because then it wouldn't matter whether you call them plaintiff or defendant in that context.

But what about the reasoning in the Blue Chip case, where you talked about the acorn growing into a judicial oak, and that therefore it's too late to chop the oak down, in effect.

Don't we in a... to a certain extent have a judicial oak here, in that courts of appeals have rather consistently found a right of contribution over the years, and that's sort of what the law, with one exception, is today?

Mr. Bird: Your Honor, you do not.

Contribution in Federal security... in 10b-5 cases at this point is not a judicial oak.

What the Court is being asked to do here is to plant--

Unknown Speaker: It's certainly more than an acorn, and there are a lot of cases out there and there have been for a good many years.

And it's a hard nut to crack, too.

[Laughter]

Mr. Bird: --Well, perhaps it's a little sapling, but it certainly does not have the dignity that the 10b-5 cause of action had when it reached this Court in Bankers Life, nor does it have even the theoretical underpinnings of that.

When this Court first met the implied cause of action under section 10(b), it had been recognized by far more courts, including the courts of appeal, and it also had an underpinning that that cause of action was implied, under whatever theory of jurisdiction, for the very people investors, who were the people to be protected when Congress enacted section 10(b).

This is not a class of people who were to be protected when Congress enacted section 10(b).

Congress enacted section 10(b) as an extremely broad regulatory statute, not simply the disclosure statute which the Court sees most often.

There is no reason to suggest that in attempting to regulate disclosures markets and anything else the Securities and Exchange Commission thought was necessary to protect the public and investors Congress intended to do anything to adjust the rights and liabilities of perpetrators of violations of the section.

Implied contribution also is to be treated like any other implied action, because abandoning the intent-based jurisprudence in this case is bad judicial policy.

The real... if the real intent-based standard is abandoned, Federal courts will face countless arguments like the colloquy we have just had here suggesting that through some reasoning by analogy, or some principle of equity, some party is entitled to assert a cause of action because some other party is entitled to do so.

This reasoning by analogy is like looking at legislative history through dark glasses.

Two things are true of it--

Unknown Speaker: Or at all.

Mr. Bird: --Or at all, but in this case certainly, first it's obscure, and second, what one sees depends on the color of the glasses, because whenever the Court begins trying to create causes of action by analogy, the question is, what analogy is valid?

The validity of an analogy depends on adopting the same premises that Congress adopted when it enacted the statute, and the sort of reasoning which is being urged on this Court today is a kind of reasoning which attempts to create intent in congressional minds which was not there.

Unknown Speaker: Were there pendant State law claims in this case?

Mr. Bird: Justice Kennedy, there were.

Unknown Speaker: Does State law allow a contribution?

Mr. Bird: State law would allow contribution for certain purposes.

In California, it's called comparative equitable indemnification.

The claims alleged in State law in this case were dismissed by the district court at the same time that all other claims were dismissed and there would remain an issue in the district court, upon dismissal of the 10b-5 or 10(b) attempted contribution claim, whether any of the State law claims would be valid.

The State law claims obviously are not here before this Court.

A second critical issue of judicial policy in applying the intent-based standard is that any time the Court departs from it, especially with respect to a right of contribution, that--

Unknown Speaker: Mr. Bird, what point in time do you think Congress' intent is relevant when you're talking about intent-based standards, back in '34, or more recently?

Because all the way back to '34, the general rule was if they passed the statute, why, they expected the judges to figure out the appropriate remedy, so I'm wondering whether you're talking about intent in '34, or intent since we changed the law a few years ago.

Mr. Bird: --Well, the Court has uniformly applied its intent-based jurisprudence looking at the intent when the statute was created.

Unknown Speaker: So we're looking at '34.

Mr. Bird: You would be looking at '34, Your Honor, although that's one of the very issues that comes up once one starts to reason by analogy, and that is, what Congress does one look at?

The secondary jurisprudence in this case already includes what's the effect of partial settlement without guidance of Congress, whether contribution, if allowed, would be pro rata or by relative fault, some guidance by Congress in section 11 of the 1933 act, none any place else.

In this very case, if one were to look to sections 9 and 18 and say well, Congress might have done the same thing, in any case where there is both a section 10 claim and a 1933 section 11 claim, it's possible for the section 10 contribution analysis utterly to overwhelm the plain language of section 11, which says that those who were intentional wrongdoers shall not have contribution against those whose violation was recklessness or of some lesser character.

And I think, Justice Stevens, although in general one would look at 1934, it is certainly valid in this case to say, once one gets into the analysis of contribution, should we look at section 20A and see if in section 20A, which Congress passed in 1988.

it had learned something about whether contribution was efficacious or not, and explicitly declined to adopt it as part of the Insider Trading Act.

I think that secondary jurisprudence is one which cautions this Court not to attempt to create causes of action for contribution where they did not exist before.

The Court should set a clear and simple principle to apply to requests for implied contribution wherever the Court has previously accepted an implied victim's cause of action.

This is not the only case in which a request for implied contribution could come to the Court.

It could arrive in the Commodity Exchange Act, it could arise under title IX, it could arise under the Rehabilitation Act... perhaps most importantly, in terms of volume impact on the Federal court, it could arise, it has arisen, it has created a conflict in the circuits under the Civil Rights Act, and I would urge the Court to take the opportunity in this case to write clear, simple, principled, intent-based jurisprudence which will guide the lower Federal courts in all of those cases and prevent the necessity for resolving them on a case-by-case basis using the kind of analysis that comes out of hypotheticals.

The Court has never fleshed out one implied right with another.

This is not the first time to do it.

I would urge that the Court in this case ask itself the question, in writing a decision in this case, is this the end, or is it a beginning?

The entire fleshing out line of cases defines, it often limits, a section 10(b) cause of action.

Or is this a beginning?

Is it the planting of an oak, or perhaps the cultivation of what's now only a sapling, does this case shape an old claim, or does it create a new claim?

Emphatically, this case creates a new claim which this Court should not recognize.

If there are no further questions, Mr. Chief Justice, I would reserve the remainder of my--

Unknown Speaker: Could I ask you if, in developing intent-based jurisprudence, would you say that... just have a real simple rule, Congress either provides a cause of action, or you just never imply one?

I suppose that would be your choice.

You either imply... Congress either expressly creates it, or courts don't imply it, period.

Mr. Bird: --That goes beyond the Court's current rule, and I would not urge that the Court has to adopt a position that is that strict.

Unknown Speaker: So we're going to be constantly, as we have been for years, trying to divine congressional intent from almost any source.

Mr. Bird: What I've urged, Justice White, is that the Court's jurisprudence under the Touche Ross and Transamerica line of cases is a currently successful analysis which provides adequate guidance.

If the Court were to choose to say, if it's not in the statute it's not there, that's certainly a sustainable basis to decide this case.

It's not a necessary basis.

Unknown Speaker: Very well, Mr. Bird.

Mr. Olson, we'll hear from you.

Argument of Theodore B. Olson

Mr. Olson: Mr. Chief Justice, and may it please the Court:

With the Court's permission, I would like first to place the question presented in this case in its proper context and then emphasize four points concerning its resolution.

The context is that for 22 years, and over the course of 10 decisions, this Court has been engaged in a continuous process of defining the configurations and contours of the 10(b) implied remedy to make it consistent with the regulatory scheme from which it is derived.

This case is simply part of that continuum.

The Court must decide how 10(b) defendants will allocate among themselves the damages for which 10(b) makes each of them liable.

The only question is how that issue will be decided: in favor or against contribution among 10(b) defendants.

Unknown Speaker: Well, is this contribution between defendants, or contribution from nonparty defendants?

Mr. Olson: It's contribution among the persons who would be liable to the plaintiff under section--

Unknown Speaker: So they are people who weren't parties.

Mr. Olson: --They are people who may not necessarily have been parties, but people whose liability was established by the conduct that gave rise to the 10(b) action or in the comparable Securities Act express remedies, the violation of section 9, section 18, and section 11.

There are four reasons, we submit--

Unknown Speaker: That's point to be tried, though, isn't it, or not... whether, indeed, their conduct made them liable for this damage?

Mr. Olson: --Yes, it would be, but their liability would be established by the conduct that occurred at the time of the violation of section 10(b).

We submit that there are four reasons why this Court's jurisprudence and the choice Congress has already made require a decision in favor of contribution over no contribution.

The first relates to the means by which the decision should be made, the second is the outcome that that method ordains, the third responds to petitioner's central argument, and the fourth concerns the consequences of a decision against contribution.

First, the methodology.

Petitioner suggests that there's some sort of dichotomy between divining the intent of Congress and filling out the contours of the section 10(b) remedy.

We submit that the Court has applied a consistent, fundamental, jurisprudential principal in defining the 10(b) remedy.

The Court looks to the 73rd Congress, the interrelated '33 act and '34 act, to the express statutory remedies that are the analogues of section 10(b), and then decides what Congress would have intended had it considered the issue, and what result would conform the 10(b) implied remedy most faithfully to the statutory regime.

This approach, we submit, has three very strong and powerful virtues.

It respects the separation of powers, leaving the policymaking decision to the policymaking branch.

It yields consistent results by consulting with the same oracle on each occasion a 10b-5 issue or a 10(b) issue is presented, and it provides a clear and predictable path for lower courts deciding future 10(b) cases as well as guidance for those who must litigate past inventions.

Unknown Speaker: If it's such a terrific approach, why have we abandoned it--

Mr. Olson: You have not abandoned--

Unknown Speaker: --For everything except 10(b)?

Mr. Olson: --We submit that the Court has considered 10(b) cases... 10 10(b) cases over the last 22 years, and for all intents and purposes that precise methodology, visited most recently 2 years ago in Lampf, involved that same process, consulting the statutory framework from which 10(b) arose, the analogue... most comparable provisions of the section comparable to section 10(b) section... in that case section 11, section... and particularly section 9 and 18 of the 1934 act, and that is the methodology that the Court applied.

The Court applied a similar and virtually identical methodology to the other 10(b) cases, so far from abandoning any approach that the Court has applied in 10(b) cases, we're asking the Court consistently to do what it has done over and over again and what it did most recently in Lampf.

Unknown Speaker: Well, Mr. Olson, though, don't Texas Industries and Northwest Airlines indicates that a contribution action is separate?

It's separate from the underlying cause of action--

Mr. Olson: Well, we have--

Unknown Speaker: --Which might move it beyond Lampf.

Mr. Olson: --I've several responses to that.

That is the central and exclusive core to the petitioner's argument in this case.

In the first place, the reference in those two cases to the phrase, cause of action, was not necessary to the decisions in either of those two cases.

What the Court was doing in those two cases, we respectfully submit, and the Court did unanimously, was look to the intention of Congress.

In each of those cases, Congress had created an explicit statutory remedy, and in each of those cases Congress had not included a cause of action or a claim or a remedy for contribution as a part of the explicit cause of action.

As a result, the Court determined Congress created this cause of action explicitly, did not want contribution as a part of it, and we will adhere to the judgment of Congress.

The phrase, cause of action, really had very little to do with it.

What we submit is what is happening in the Securities Act... and by the way, in the Northwest Airlines case the court said specifically when... in a footnote, the Court specifically said, when Congress did want to create a cause of action or a remedy or a right for contribution, it did so, and the Court in that footnote pointed explicitly to the securities laws, the '33 and '34 acts.

Those... the rule of contribution explicitly provided in the Securities Acts is very unusual in Federal law.

There are very few explicit rights to contribution.

Thus, Congress knew what it was doing when it included a rights... rights to contribution in the Securities Acts.

In fact, in section 11 and in section 9 and in section 18, the reference to contribution is included in the definition of the right or the remedy itself, thus suggesting that Congress felt that contribution was a part of the cause of action or a part of the remedy, and suggesting that Congress felt that that contribution right was an important essential feature of the remedy itself.

Thus, we don't believe that contribution is a separate cause of action, but even if it were a separate cause of action, the very same methodology would apply.

The Court would try to determine whether implying the cause of action, if that's what's going to be done, would be most consistent with the statutory framework.

We submit that, again, it would be most consistent with the statutory framework, because every time the... when Congress did create a mechanism for securities fraud in 1933 and 1934, it repeatedly put contribution as a part of those rights.

This Court has determined over and over again that the provisions to which I've referred are most like section 10(b).

Section 10(b) is a part of them, it's a judicial overlay to section 10(b).

In the same rules Congress would have wanted to include a right of contribution in a 10(b) remedy just as it did... it wanted to include a right of contribution with respect to the sections 11, 9, and 18 remedy.

Probably most telling is the consequences of what might occur if the Court were to hold a noncontribution right in this case.

Because section 10(b) is an overlay to these explicit Securities Act provisions, the parade of horribles that the plaintiffs refer to about... that result allegedly from contribution are going to exist anyway.

Petitioner's concern about the complexity in settlements and so forth we submit is going to occur anyway because contribution does exist, it will exist, and it will continue to exist in section 10b-5 cases because sections 9, 11, and 18 are also going to be involved in those cases.

In fact, what would happen if this Court adopted a no-contribution rule in section 10(b) cases, it would give the plaintiffs a choice to write out of existence the contribution rights that Congress so explicitly intended.

In 10(b) cases or in securities fraud cases, you'd have a choice of the plaintiff to select contribution or no contribution.

Because section 10(b) overrides everything else, if the plaintiffs chose to select 10(b), it could write out the provisions of contribution that exist in sections 9, 11, and 18.

Thus, you would involve... as a result of the judicial creation of section 10(b), involve yourself in a judicial implied repeal of the contribution rights that Congress so explicitly intended.

Unknown Speaker: Well, maybe--

--Are those acts... excuse me.

Go ahead. Are those actions exclusive?

Do you have to elect between--

Mr. Olson: You don't have to elect, but--

Unknown Speaker: --Why can't you just plead them all and ask for contribution as to the former but not as to 10(b)?

Mr. Olson: --You could do that.

Plaintiff could do that, and then you would have what the... the concern that the plaintiff is worried about, that you would have complexity involved in contribution.

You're going to have a further complexity of the court having to resolve contribution and noncontribution in the same case and try to assign the amount of liability that was a result--

Unknown Speaker: Well, that may be true.

My only point was that's not necessarily a repealer of the contribution, as you indicated.

Mr. Olson: --Well, but it could be used by a plaintiff as a repealer to avoid--

Unknown Speaker: Only if he elects.

Mr. Olson: --If he elects, but Congress, when it established a mechanism for enforcement through private remedies of securities fraud clearly wanted contribution to be a part.

Contribution ensures that the wrongdoers cannot completely escape.

Even if the plaintiffs don't select out the wrongdoers, the defendants may select out the wrongdoers.

In addition to that, as this Court indicated in Bateman Eichler, there's affirmative value in the enforcement process to allow the wrongdoers to sue one another.

It allows them, the defendants, to bring cases against other potential defendants to bring to the attention of the law enforcement authorities possible violations of the securities laws.

That's why the Securities & Exchange Commission has filed a brief and is here today supporting the inclusion of contribution, because contribution is such a necessary... as perceived by Congress, inclusion in the Securities Act.

If you give plaintiffs an opportunity to repeal contribution, and plaintiffs may well choose to decide not to plead violations of the statute that do involve contribution because they may decide that may give them some leverage against some of the defendants, or they may decide to dismiss some of the cases if they can make a deal with some of the defendants because of joint and several liability.

That would allow section 10(b), the nocontribution rule of section 10(b) to be used as a judicial implied repeal of the contribution rights in the other sections.

Furthermore, a decision against contribution would, as Justice Stevens suggested in his questions a moment ago, overturn 25 years of consistent lower court case law.

Until a few months ago, when the Eighth Circuit decided the Chutich case, there was 25 years of consistent law.

Now, earlier, we... there was some debate by Mr. Bird as to the size of the judicial oak.

It's interesting, and I think quite compelling, that when section 10(b) got to this Court for the first time in 1971, it was 25 years old.

It had first been recognized 25 years before in the Kardon case.

In the Blue Chip case, when this case first reached the Birnbaum rule, that rule, which came from the Second Circuit, was 22 years old, and the Blue Chip case, in the words of the Chief Justice speaking... Justice... then Justice Rehnquist, speaking for the Court, was that the 25 years of consistent judicial interpretation should not... was significantly persuasive in and of itself.

Today, we are facing the decision with respect to contribution or no contribution.

Contribution has been around in the Federal courts in the securities fraud area for 25 years, the same length of time, and with about the same judicial pedigree... Mr. Bird said contribution hadn't been approved by as many courts as section 10(b) at the time section 10(b) got here, but there are seven... five or six circuits that have approved contribution, and I suspect the weight of judicial authority is about the same.

The same is true of the Birnbaum rule.

So the contribution rule comes to this Court with the same weight of judicial authority behind it from the lower courts as did the 10(b) rule itself and the purchaser-seller rule found by the Court to continue to be appropriate in the Blue Chip case.

In summary, the choice is an outcome consistent with congressional intent as expressed in section 10(b)'s closest analogues, with 25 years of judicial interpretation, the SEC's view of the enforcement scheme and how it can best be administered, and the framer's decision as to where policy decisions should be made.

The alternative cannot possibly be said to be consistent with congressional intent.

In fact, it would repeal congressional decisions, and it would fail to fulfill this Court's duty to complete the task it undertook beginning in 1971 to make the section 10(b) remedy as close as possible to the instrument Congress would have created and as compatible as possible with the regulatory and enforcement regime Congress did create.

To summarize, we are only asking this Court to do what the Court has consistently done with section 10(b).

Having created the judicial remedy, what are its configurations and contours going to be, and how can we best make it more closely approximate what Congress would have intended and how may we make it the closest possible approximation to what will not interfere with the enforcement provisions of the remaining provisions of the Securities Act and how best to fulfill the purposes of those acts?

Thank you.

Unknown Speaker: Thank you, Mr. Olson.

Mr. Long, we'll hear from you.

Argument of Robert A. Long, Jr.

Mr. Long: Thank you, Mr. Chief Justice, and may it please the Court:

The Securities and Exchange Commission has concluded that the Court should recognize a right of contribution under section 10(b) and rule 10b-5.

The Commission has made that conclusion for essentially two reasons.

First, Congress provided for contribution in provisions of the 1934 act that create express private rights of action for securities fraud, that is, sections 9 and 18.

Because section 10(b) is part of a family of rights that should be construed as a coherent whole, Congress' decision to recognize a right to contribution in the comparable express causes of action should govern in actions under section 10(b).

Second, the Court has the power to recognize a right of contribution.

The section 10(b) right of action is an implied right.

Defendants are liable under section 10(b) only because courts have said so.

In prior cases, this Court has defined the contours of the section 10(b) right of action to maintain evenhanded administration of the securities laws.

The Court can and should exercise that power in this case to recognize a right to contribution.

Now, let me address the second point, the power point, first.

Unknown Speaker: Mr. Long, do you think in recent cases we've said that the courts have the power to create causes of action?

Mr. Long: Well, I think what we have here is, we would agree this is a cause of action, but it's not an independent cause of action.

Contribution is entirely derivative of the underlying section 10(b) cause of action.

The parties are all parties who either were present in the original action or they could have been present if the plaintiff had named them, and the liability is the liability that's established in the original action.

So we do not view this as a case in which it's appropriate to apply the Texas Industries or Northwest Airlines type of analysis.

That analysis is appropriate where Congress has expressly created a cause of action but has omitted a right of contribution.

Unknown Speaker: Well, you might think that if Congress has expressly created the cause of action and we lack the power to create a right of contribution that a fortiori there wouldn't be such a right if it's only an implied cause of action in the first place.

Mr. Long: Well, again, the approach the Court has followed is when it has implied the cause of action it has undertaken the necessary process of defining the contours of that action of rounding it out, and where the question is whether there should be a right of contribution, we see no essential difference between answering that question and answering the kinds of questions that this Court has answered in many prior cases under section 10(b), whether to recognize a defense, the measure of damages... this is really, we think, just another question in that line.

Unknown Speaker: Well, to the extent that it is a new cause of action, it seems to me it's a step beyond questions about whether there should be a statute of limitations or a defense.

Mr. Long: I would agree with you that it's a step beyond in that sense, but again, I would emphasize this is quite different from implying a freestanding cause of action.

And in the situation the Court is presented with here, when section 10(b) really sits among some express causes of action that Congress created, where Congress expressly recognized rights of contribution and section 10(b) not only sits in the middle of those but in fact is a kind of catch-all that overlaps to a great degree, for the Court to not imply, or not recognize a right of contribution we think would in fact be less respectful to the intent of Congress than to apply the same policy choice, the same weighing of policy considerations that Congress made in 1934.

Unknown Speaker: I wonder what underlies that policy choice in these other sections, or under 10b-5.

Why is the Commission so intent on furnishing retribution in 10(b) cases... or, retribution?

Contribution.

[Laughter]

Mr. Long: The Commission reached this conclusion because it decided as a matter of fairness and as a matter of evenhanded administration of the securities laws that a contribution right ought to be recognized under section 10(b).

Unknown Speaker: Well, how does that work out?

You mean these people who are jointly and severally liable, if somebody gets stuck for the whole bill it's fairer to dig out the other fellows who should share the liability, is that it?

Mr. Long: That's part of it.

It is... under section 10(b), a very wide variety of defendants may be sued, and there may be quite a range of responsibility, and it is possible for a defendant with a deep pocket but with rather less serious culpability to be stuck, as you say, for the entire liability.

That's part of the fairness argument.

As I say, the other part is a desire to harmonize the securities laws and give these defendants the right to contribution that Congress gave them in the comparable express causes of action.

Unknown Speaker: In our--

--I suppose you could always be fair by just limiting recoveries to the named defendants' fair share.

Mr. Long: To the... well, of course, that would... it's possible for the plaintiff, the victim, not to name all the possible defendants.

That's why contribution may be a cause of action.

It can result in some cases in an additional action.

Unknown Speaker: But that would be within the plaintiff's own power?

Mr. Long: Yes.

The plaintiff would have the power to--

Unknown Speaker: So I mean, if the plaintiff suffers, it's the plaintiff's own fault--

Mr. Long: --Oh--

Unknown Speaker: --On Justice White's hypothesis.

Mr. Long: --Well, the plaintiff may be quite confident, or reasonably confident on getting a full recovery, because it is joint and several liability, and if the plaintiff knows it's got a deep pocket--

Unknown Speaker: Well, wouldn't you... would you guess that most plaintiffs would be in favor of the Commission's suggested policy... contribution?

Would they rather have contribution or not?

Mr. Long: --I think most plaintiffs would not want to have contribution.

Unknown Speaker: Because--

Mr. Long: The absence of contribution I think gives plaintiffs additional control over the lawsuit, I think is the short answer to that.

Let me say, then, just a word about the second point I have, why the Commission believes that the comparable provisions in the securities laws evince a congressional intent to allow contribution in private actions for damages for securities fraud.

In Lampf, the Court identified the express rights of action that are most analogous to the implied right of action under section 10(b).

They are found in sections 9 and 18 of the 1934 act.

Sections 9 and 18 target the precise dangers that are the focus of section 10(b), and they provide remedies for investors injured by manipulative practices or false or misleading statements, and of course both sections 9 and 18 expressly provide for contributions... contribution rights.

Section 10(b) is the catch-all provision.

It overlaps both sections 9 and 18.

It provides a general remedy for manipulative or deceptive practices.

Because sections 9, 10(b), and 18 are integral elements of a complex web of regulations, as the Court said in Lampf, they should be construed to form a coherent whole.

Consequently, Congress' express determination to allow contribution under sections 9 and 18 should also govern under section 10(b).

Unless there are further questions, I thank the Court.

Unknown Speaker: --Thank you, Mr. Long.

Mr. Bird, you have 5 minutes remaining.

Rebuttal of Charles A. Bird

Mr. Bird: Thank you, Mr. Chief Justice.

Contribution is a new cause of action whether the underlying victim's claim is expressed in a statute, implied in a statute, or arising from the common law.

That is a simple error I believe I heard one of the respondents make.

Respondents referred to footnote 11 in the Texas Industries case.

In footnote 11, the Court wrote,

"We intimate no view as to the correctness of. "

and followed with citation to the three cases which then said there would be contribution in 10b-5 actions.

If contribution in 10b-5 actions is a sapling, it was never cultivated by this Court.

Complexity of contribution is an issue of policy.

Fleshing out a new cause of action for contribution is an Article 1, Article 3 problem.

That is our point.

Finally, this case is at the intersection of two lines of authority.

One line of authority says that as to all causes of action there shall be implication if, in a Federal statute, if, and only if, Congress clearly and affirmatively intended that that be so.

Another line of cases says, we have this 10b-5 victim's cause of action.

We must flesh it out, and because we have no other signpost, we must look to what Congress would have done if Congress had realized there was going to be this cause of action.

The question is which of those lines of authority shall govern the cause of action, if any, for contribution under section 10b-5.

The would-have-done analysis is exactly what got this Court to the Borak cause of action, and it is exactly what this Court rejected in Touche Ross, in Transamerica Mortgage Advisers, in Texas Industries, and in Northwest Airlines, and it is exactly what this Court should reject here.

From this intersection, the Court should say the intent-based jurisprudence implies... applies to all implied causes of action, whether for contribution or for anything else.

Thank you.

Chief Justice Rehnquist: Thank you, Mr. Bird.

the case is submitted.

Unknown Speaker: The honorable court is now adjourned until tomorrow at ten o'clock.

Attribution:

The OYEZ Project

Featured:

Kamen v. Kemper Financial Services, Inc. - Oral Argument

Fri, 09 Jan 2009 14:49:41 +0000

Case:

Kamen v. Kemper Financial Services, Inc.

Media File:

90-516_19910327-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Richard M. Meyer

Chief Justice Rehnquist: We'll hear argument next in No. 90-516, Jill S. Kamen v. Kemper Financial Services.

Spectators are admonished the Court remains in session.

There is to be no talking in the courtroom until you get out beyond the walls here.

Mr. Meyer, you may proceed whenever you are ready.

Mr. Meyer: Mr. Chief Justice, and may it please the Court:

This action was brought by a shareholder of Cash Equivalent Fund to recover damages for two wrongs.

The one at issue before the Court today is a proxy violation, the deception of the fund shareholders by a proxy statement which induced them to approve a management agreement with the investment advisor, which I will refer to as KFS, by misrepresenting comparative fees paid to KFS by other mutual funds managed by KFS.

That misrepresentation was in violation of rules of the Securities and Exchange Commission.

The--

Unknown Speaker: Mr. Meyer, can I just ask one question?

What remedy do you seek for that violation?

Mr. Meyer: --We are seeking damages, and--

Unknown Speaker: And who is the we?

To whom would the damages be paid?

Mr. Meyer: --We ask that the damages be paid to the fund.

Unknown Speaker: To--

Mr. Meyer: To Cash Equivalent Fund, which is the mutual fund involved.

Unknown Speaker: --I see.

So it's in the nature of a derivative action, then?

Mr. Meyer: This is a matter which the Solicitor General takes--

Unknown Speaker: Right.

Mr. Meyer: --a somewhat different view of.

We have always taken the view that it is in the nature of a derivative action, yes.

This... the matter now before the Court requires the review of an unprecedented holding by the court of appeals for the Second Circuit that the claim must be dismissed--

Unknown Speaker: The Seventh Circuit.

Mr. Meyer: --Seventh Circuit.

I beg your pardon.

That the claim must be dismissed because a plaintiff must, prior to bringing the action, in all cases, make a precomplaint demand upon the board of directors to bring the action, even if such a demand would be futile.

I propose to discuss this morning three questions.

First, whether a demand must be made even though futile.

Second, the practical consequences of requiring a precomplaint demand.

And finally, the question of what law applies.

On the first question, whether a demand must be made even if futile--

Unknown Speaker: Can you answer that question without explaining first what law applies?

Mr. Meyer: --I agree--

Unknown Speaker: Or are you going to say it doesn't make any difference?

Mr. Meyer: --I am going to say that it doesn't make any difference.

That's correct.

And the order, I agree, Justice White, does suggest that it is presented in inverse order, but I believe that you will see, as the argument unfolds, the conclusions become compelling.

At least I hope they will become compelling.

Beginning with the question of making a demand when it is futile, it's an ancient precept of the common law that the law does not require a futile act.

And that precept has been applied to demand on directors by this Court in cases going back well over 100 years.

The decision by the court of appeals for the Seventh Circuit is the only judicial decision that I have been able to find or that has been cited by any party suggesting that even though the demand is futile it must nevertheless be made.

These futility--

Unknown Speaker: Excuse me there.

It has been proposed by several respected organizations, such as the American Bar Association, I gather, and the American Law Institute.

Mr. Meyer: --The American Law Institute and the American Bar Association have adopted... taking the American Law Institute, which has been a little more active in the area, a... what they call a tentative draft, which is, I think they are now up to tentative draft number 10, which suggests what is called the universal demand requirement.

That is, demand may be made in every case, and that this will obviate the difficulty of determining whether or not the demand is in fact futile.

It will compel a demand.

And indeed this is somewhat in line with the reasoning of the Seventh Circuit which cites at some length the tentative draft of the American Law Institute.

The basic... excuse me.

Unknown Speaker: It goes along with this.

Does the American Law Institute, like the Seventh Circuit opinion here, also say that the business judgment rule would not be applied to the determination of the directors?

Mr. Meyer: The... no, I don't believe they say that.

On the contrary, the basic rationale followed by the court of appeals in this case is that the introduction of a universal demand requirement is suggested by the recent developments in the growth of special litigation committees.

Even where, as in the present case, the board of directors is directly implicated in the wrong, the court below says the board can create a special litigation committee by... perhaps by expanding its number, bringing in people who were not involved in the wrongdoing.

These committees supposedly will dispassionately review the facts of the matter, make a recommendation to the board of directors, and the board will act accordingly.

Unknown Speaker: Well, Mr. Meyer, under the Seventh Circuit's view, if a demand is made and refused, what's the legal effect of that on the suit?

Can it go forward?

Mr. Meyer: That is a question--

Unknown Speaker: Under the Seventh Circuit's holding?

Mr. Meyer: --That is a question that has not been answered.

And the Seventh Circuit--

Unknown Speaker: And how do you understand its holding in that regard?

What would be the effect?

Mr. Meyer: --I understand it in the following way, that assuming that a special litigation committee is formed and makes a recommendation, which invariably is a recommendation that the litigation not go forward, that's invariably the case--

Unknown Speaker: Well, it may or may not be.

Let's assume it is a recommendation not to go forward.

Mr. Meyer: --All right.

The question then becomes one of reviewing the determination of the special litigation committee, and the focus of the litigation has now changed.

We are now looking to see not whether the original complained of conduct was inappropriate.

We're not looking to see whether a fiduciary accused of self-dealing has satisfied the fiduciary's normal burden of justifying the intrinsic fairness of his dealings with his corporation.

We are looking instead to see whether an independent committee (a) had some kind of bias or conflict of interest, and (b) whether it exercised a judgment that was so egregious that no reasonable businessman could be said to have come to a similar judgment.

This is such an enormous burden to place upon a shareholder who is, in this particular case and in many of these cases, attempting to enforce the public policies, important public policies--

Unknown Speaker: Well, then the legal issue changes, as I understand you, Mr. Meyer?

The plaintiff has a harder row to hoe if a demand is made and turned down than if the plaintiff can simply show that a demand would be futile?

Mr. Meyer: --Mr. Chief Justice, I submit that the plaintiff has an impossible row to hoe.

Unknown Speaker: Well, could you answer my question?

I asked you to compare two burdens.

Mr. Meyer: Yes.

The burden of reviewing... the burden that the plaintiff has where a demand is made and turned down is virtually insuperable.

Unknown Speaker: So the futility exception really gives the plaintiff a leg up, then.

It allows it to litigate under different standards than if its demand is turned down?

Mr. Meyer: That's correct.

That's correct, and the futility exception is the one that has been recognized by this Court for well over 100 years and by every court that has ever passed upon the question.

The--

Unknown Speaker: But Mr. Meyer, excuse me.

I thought the Seventh Circuit had explicitly repudiated imposing upon the disappointed would-be plaintiff that kind of a burden.

I thought what the Seventh Circuit is saying is in exchange for always requiring a request to be made we will not impose the normal business judgment rule.

Mr. Meyer: --At one point in its opinion the Seventh Circuit does suggest that.

At other points in its opinion it suggests quite the contrary.

But I submit to you that the first suggestion made by the Seventh Circuit, I don't know if it comes in that order, but in our discourse it's the first suggestion, is an illogical suggestion to follow.

After all, why go to the trouble of forming a special litigation committee, having it go through an extensive investigation, hiring counsel, making a report, and then coming back to court and the court saying we're going to totally ignore it.

We'll pretend it hasn't occurred, and we will review the bringing of the litigation as though it didn't exist.

Manifestly it must have some purpose, and manifestly if these special litigation committees are to exist, which ineluctably follows from the imposition of a universal demand requirement, then the courts must give some deference to the recommendations of special litigation.

Unknown Speaker: I thought the Seventh Circuit went through... I don't know where it is in the opinion.

Oh, yes, on 13A of the petition for cert. We seem to be dealing with 13A and 14A today.

The opinion gives four reasons why demand may be inappropriate, and it went through the bases, possible bases for requiring demand, and only one of which is what you have just addressed.

Another purpose of it is to let the corporation take over the suit if it wishes.

Now, that purpose would be fully served whether or not you apply the business judgment rule.

Mr. Meyer: There are a number of reasons why demand may not be futile.

In this case, clearly demand was futile.

And I would submit that the arguments that even where it is futile some good may nevertheless come out of making a demand is not really an appropriate consideration for courts to consider.

For example, in the Fox case which is oft cited in the briefs, the Court came to the conclusion that demand would be futile because under the statute the corporation was disabled from bringing the claim.

And that's a little bit different from what we have here.

But in that case the petitioner argued that even though the corporation could not bring the claim... it also involved a mutual fund... demand would serve many useful intra-corporate purposes.

It would cause the directors to focus on the contract with the investment advisor.

They might revise the contract.

They might even fire the investment advisor.

All other intra-corporate rearrangements could be made.

That's always true, but I submit that the purpose of the Federal Rules of Civil Procedure are, while undoubtedly having some effect on corporate governments, are really directed toward corporate litigation and not with the operation of corporate law internally.

And therefore I don't subscribe, obviously, to the Seventh Circuit's views on this matter.

The third point that I want to talk to, and I would like to address this as briefly as possible because I do want to reserve, if permitted, some time for rebuttal.

The third point I want to address is what law applies to the case.

Our view is that State law should apply to the case, in this case Maryland law, unless that State law is so inconsistent with the enforcement of the important Federal public policies underlying the proxy rules, in this case section 20 of the Investment Company Act, that to insist upon the enforcement of the rule and impose burdens upon plaintiffs seeking to enforce that public policy would thwart the public policy.

This may sound like a heads, I win, tails, you lose proposition, but it's... there is support for it in the cases.

Galef v. Alexander, which is cited in our brief, is on point.

We also mention Levitt v. Johnson.

And there is a--

Unknown Speaker: Where... what courts decided these cases?

Mr. Meyer: --These are appellate courts, circuit courts.

Unknown Speaker: Federal courts of appeals?

Mr. Meyer: Federal courts of appeal.

There is a decision by this Court in Boil v. United Technologies which did indicate that Federal common law would prevail where State tort law would threaten a result that was contrary to what was involved in that case, the Government defense contractor defense.

Unless there are further questions I would like to reserve the remaining time for rebuttal.

Unknown Speaker: Very well, Mr. Meyer.

Mr. Dreeben, we'll hear from you.

Argument of Michael R. Dreeben

Mr. Dreeben: Thank you, Mr. Chief Justice, and may it please the Court:

Prior to the decision below it was the law in virtually all jurisdictions that shareholders need not make demand before commencing a derivative action where that demand would be futile.

In this case the court of appeals abolished the traditional futility exception and replaced it with a rule that requires universal demand in every case.

In our view, the court of appeals erred in addressing this question as one of Federal common law for the courts of appeals to decide as they perceive the policy balances to require.

Rather, State law should govern this area of core governance of corporations' internal affairs, absent a conflict with Federal policy.

Unknown Speaker: Mr. Dreeben, that's a little odd, isn't it, because this is an action brought under a Federal statute?

Mr. Dreeben: That's correct, Justice O'Connor.

Unknown Speaker: A Federal cause of action.

And the cases saying that you nevertheless look to State law are a little unusual, it seems to me.

Mr. Dreeben: Well, I think the case that's closest related to the particular problem here today is Burks v. Lasker.

Unknown Speaker: Yes.

Mr. Dreeben: It's quite similar, really.

Unknown Speaker: Yes.

Mr. Dreeben: It was another derivative action under the Investment Company Act.

Unknown Speaker: Yes.

I guess I just don't understand that case, and why, when you have a cause of action based on violation of a Federal law you would have to look to State law for one of these initial sort of procedural requirements.

Mr. Dreeben: Well, there are two responses I'd like to give to that.

First of all, the question of whether demand is required or not is a Federal question because the cause of action arises under a Federal statute.

There is no doubt about that.

The next issue is from what source does Federal law derive the rule of decision.

This Court has in many contexts held that even when a question is governed by Federal law, Federal law may turn to State law rather than fashioning an entire body of law on its own.

I think the Kimbell Foods case is the outstanding example of this, and the Court applied a very similar principle in Burks v. Lasker when it comes to the law of corporations.

Corporations, after all, are created under State law.

When Congress regulated in the Investment Company Act, as it did in the other securities acts to regulate corporate activities, it did not provide for Federal chartering of corporations.

It relied on States to charter corporations and to basically regulate the activities of corporations subject only to the predominant Federal policy.

So Federal law displaces State law to the extent it is necessary to achieve Federal goals.

Otherwise State law governs.

Unknown Speaker: What if the State law says that there will be a demand made in every case?

Mr. Dreeben: That... in our view the initial step for a court to follow is to adopt that rule, and then to consider whether it infringes any Federal policy to follow it.

That question, of course, isn't here today, since we don't have a State that provided for universal demand, although there are several.

I think that the real way to answer whether it conforms to Federal policy is to look at what happens after demand is made.

Does that... does the making of demand in a particular State give the corporation a leg-up in dismissing the derivative action?

If it does and the corporation is invested with too much power to cut off a Federal claim, there may very well be a conflict with Federal policy.

But it probably will not flow from the demand requirement itself.

It more likely will flow from what happens after demand is made and refused.

Unknown Speaker: And how do you read the Seventh Circuit's holding about... insofar as that is concerned?

Mr. Dreeben: Well, the Seventh Circuit thought it could achieve a nice distinction, a very logical, tidy distinction between a Federal rule of universal demand and State law governing what happens after demand is made.

The problem with that approach is, although it sounds nice in theory, in fact it doesn't work.

The reason it doesn't work is because many States place an integral connection between whether a shareholder has to make demand and what standard of review is subsequently applied to the board of directors' decision.

So Delaware, for example, which is a leading State in corporate law, says that if a demand is required of the shareholder and not excused, then the directors' subsequent decision not to sue is judged very deferentially under the business judgment rule.

On the other hand, if demand is futile because the board is either biased or too implicated in the transaction to act on it, then a much higher standard of review applies when the corporation attempts to terminate the suit.

Unknown Speaker: Mr. Dreeben, I understood the Seventh Circuit to avoid that problem by federalizing the latter question as well, that is by saying how much deference you give to the board decision is also a Federal question, and we will not adopt as a matter of Federal law the business judgment rule.

Mr. Dreeben: Well, I am not sure that the court said exactly either of those things.

If it said... if it thought it was saying that it's a Federal question what standard of review applies to the board of directors' decision, then in effect it overruled Burks v. Lasker, because Burks v. Lasker held that the power of corporate directors to terminate a derivative action, even based on a Federal statute, derives in the first instance from State law unless it conflicts with Federal policy.

So there's a two-pronged inquiry.

I don't think that the court of appeals actually intended that.

I think what the court of appeals thought is that we can have a Federal rule, which it thought was procedural, of universal demand followed by the application of State law as it's found.

But the real difficulty with that proposition, I think, is that State law simply does not draw the distinction between demand and the standard of review in every instance.

In some cases, in many, it ties them together.

And once a shareholder makes a demand under Delaware law, the business judgment rule applies in every single case.

So under the Seventh Circuit's Federal universal demand rule you have two options.

One option would be to say since the shareholder made a demand we now apply the Delaware standard of review.

It's the business judgment rule, in every single case, even though Delaware might have applied a different standard because demand was actually futile.

The other alternative... that alternative I think is not only conceptually incorrect, it overrides State policy needlessly.

The other alternative would be for the court to engage in a hypothetical inquiry.

Would Delaware have excused demand in this case?

If we answer that question we'll then know what standard of review Delaware wanted to apply.

But if you engage in that inquiry you're right back where you started.

You're litigating demand futility, and the court of appeals rule serves no purpose.

The basic reason why the court of appeals got off on the wrong foot, I think, is it evaluated the demand question as one of Federal procedure.

It's really not.

It's really a rule that governs substantive law of corporate internal affairs.

A corporation may have a claim that can be asserted in court, but it is an artificial entity, and the question in a derivative action is who has the right to speak for a corporation.

Normally it's the board of directors under State law, but State law almost universally recognizes an exception for derivative actions where the directors have wrongfully refused to protect corporate claims.

In that instance shareholders may step in and speak for the corporation.

The demand rule stands as a threshold requirement that helps to regulate when shareholders can do that.

The demand rule says that before shareholders may take the extraordinary step of usurping the board of directors' prerogatives, they have to make a demand on the directors to see whether the directors want to take over the suit or how they will react to it, to give them a chance to make a corporate judgment.

State law, however, recognizes that in some instances it would only obstruct the protection of shareholder rights, who are, after all, the owners of the corporation, to have to go to the very board of directors that may be implicated in the transaction--

Unknown Speaker: Well, how would it obstruct them if you can do pretty much what you want in the way of prosecuting your suit after a demand is turned down?

Wouldn't it simplify things?

Mr. Dreeben: --It would simplify things if there were a coherent way of applying it, and the way of applying it were consistent with Federal law.

But the way that many States regulate derivative actions is that if demand is excused the courts take a more active role in regulating the directors' efforts to cut it off.

If demand is required, then the directors have a greater power.

They can rely on their business judgment and say this derivative action should be terminated.

Unknown Speaker: Well, might not the States change some of their laws if... in that regard, if a demand under this statute were treated as a matter of Federal law, and you say you require it in every case?

Mr. Dreeben: Well, it's certainly possible the States might be forced to change their internal law of corporations if Federal law reached out and grabbed a portion of it.

But there is no authorization--

Unknown Speaker: This whole statute is a Federal statute.

I mean, it specifies for what the basis of suit is.

It's not as if you're suing under a State cause of action.

Mr. Dreeben: --That's true, Chief Justice Rehnquist, and if the Court in Burks v. Lasker had ruled that it is always a Federal question when directors can terminate a derivative action under a Federal statute, then we would not be here today arguing that State law is the primary source.

But once Burks v. Lasker and its principles are established there is really no alternative but to borrow the coherent set of State law rather than simply taking one piece of it here and another piece of it from Federal law.

Thank you.

Unknown Speaker: Thank you, Mr. Dreeben.

Mrs. Hall, we'll hear from you.

Argument of Joan M. Hall

Mr. Hall: Mr. Chief Justice, and may it please the Court:

The district court correctly dismissed the proxy claim in this case, and the court of appeals correctly affirmed that dismissal.

We respectfully submit that regardless of whether this Court chooses to apply Federal law or State law, and regardless of whether the futility exception is applied or the futility exception is abolished, this Court should affirm the dismissal of the proxy claim in this case.

I would like to make three points.

First, both courts below correctly concluded that the allegations of futility in the complaint in this case were totally inadequate to excuse the making of a demand upon the directors.

Second, both courts below correctly concluded that Federal law should apply in dealing with the demand issue on this Federal cause of action.

And third, the court of appeals correctly held that under Federal law the futility exception to the demand requirement should be eliminated in order to promote important policies underlying the demand requirement, including judicial economy.

Turning first to the insufficiency of the allegations, the district court found that if you disregard the conclusory allegations in petitioner's complaint only two factual allegations of futility remain, that the directors receive fees for serving as directors, and the directors voted to send out the challenged proxy material.

Petitioner cites no case, State or Federal, in which boilerplate allegations of futility such as these have been held to excuse demand.

The Federal law as to facts which would be sufficient to excuse the making of a demand is well stated in the Kauffman case.

In Kauffman the First Circuit said that demand could be excused only upon a particularized showing that the directors are so antagonistic to the interests of the corporation that they could not discharge their duties.

In our case the directors are not named as defendants, nor are they alleged to have engaged in any wrongdoing whatsoever.

This is particularly significant because full discovery on the merits was available to petitioner in this case.

Unknown Speaker: Ms. Hall, you may be dead right that the allegations are insufficient, but neither the court of appeals... the court of appeals didn't rely on that ground, did it?

Mr. Hall: They did, Your Honor.

They did, Your Honor.

Unknown Speaker: But the questions presented by the cert. petition don't raise that.

I thought we took a case assuming that there were sufficient allegations.

You may be right, but I'm just saying I'm not sure that's one of the issues we're addressing under the cert. petition.

Mr. Hall: I think that issue is properly before the Court and that it provides an independent ground for affirming the judgment of dismissal, Your Honor.

Unknown Speaker: I see.

Mr. Hall: And it also is one part of the holding of the court of appeals.

The Seventh Circuit has alternative holdings.

They specifically find that the allegations are insufficient, and then they go forward with this alternative holding abolishing the futility exception.

Unknown Speaker: Can we say that's all... well, that's an alternative holding rather than dicta, then?

Mr. Hall: It is an alternative holding, we believe.

The Seventh Circuit expressly states that the district court found the allegations of futility insufficient, as do we.

Unknown Speaker: Well... gee, I... see, I didn't understand.

Mr. Hall: At both A16 and A17 of the Seventh Circuit opinion, the Seventh Circuit finds the allegations of futility to be--

Unknown Speaker: 16 and 17?

Mr. Hall: --insufficient.

Unknown Speaker: What page was that on?

Mr. Hall: At A16, Your Honor.

The court of appeals states the district court thought these allegations insufficient to excuse a demand under rule 23.1, as do we.

That's at the conclusion of the first paragraph under Roman numeral I.

And at A17... no, I've got the wrong page number there.

Well, there's another place in the opinion where the district court... the court of appeals refers to the able opinion of the court of appeals finding that these allegations of futility are insufficient, and then states we are in accord.

Unknown Speaker: Mrs. Hall, I'm having trouble finding what you're... even A16.

I have a--

--I think if you say 6A, Ms. Hall, you'll get to the--

Mr. Hall: I'm sorry.

6A.

Unknown Speaker: --portion of the appendix where the "as do we" language is found.

Mr. Hall: 6A, Your Honor.

Roman numeral I, the first paragraph, the last sentence in the paragraph.

"Judge Nordberg thought these allegations insufficient to excuse a demand under rule 23.1, as do we. "

Unknown Speaker: Well, but they do.

But for quite separate reason that you always have to make a demand.

That's how I interpreted that.

Mr. Hall: I think it's an alternative holding, Your Honor, and provides an alternative ground for affirmance of the dismissal in this case.

Unknown Speaker: I don't see... it isn't necessarily alternative.

Then they go, he goes on to explain why we do, and the reason we do is that you always have to make a demand, and therefore these allegations are not sufficient to excuse a demand.

Isn't that the--

Mr. Hall: I think he... I think he also reviews these particular allegations and finds them insufficient, and goes on to say in addition that he is abolishing futility as an exception to the demand requirement.

Your Honors, even after substantial discovery in this case petitioner did not make any charges of wrongdoing against these directors, and we think that the allegations of futility in this case were completely inadequate, whether the Court chooses to apply Federal law or State law.

We think that both courts below properly chose to apply Federal law to the demand issue in this Federal cause of action for two reasons.

The first reason is that petitioner induced both courts below to apply Federal law, and waived any argument that State law applies.

petitioner cited only Federal law to the district court.

petitioner did not mention State law until her reply brief in the court of appeals, and even then she argued only that if the court did not apply Federal law, then State law should be applied.

The district... the court of appeals found that the State law argument had been waived, relying upon a rule of that court, a rather unremarkable rule which holds that reply briefs are to be limited to matters in reply.

The court of appeals has consistently applied that rule in both civil and criminal cases.

Petitioner here failed to comply with that rule, and the court of appeals properly concluded that the State law argument had been waived.

Unknown Speaker: --Well, what should apply in another suit where the State law argument is not waived?

Mr. Hall: In that instance, Justice O'Connor, we submit that Federal law would apply, and that's the second reason why we think Federal law properly applies in this case.

In Burks this Court stated that legal rules that govern legal... Federal causes of action are to be treated as raising Federal questions.

And since Federal law applies to this Federal cause of action, the question then becomes what is the source of this Federal law?

Is the Federal court going to look to Federal common law or to State law?

In Burks this Court looked to State law to supply the Federal rule of decision on the question regarding directors' power to terminate shareholders' derivative litigation.

The Court found that applying State law to the corporate law issue in that case would relieve the Federal court of the burden of fashioning out of whole cloth an entire body of Federal corporate law.

We submit that this case is much different than Burks.

This case also involves a Federal cause of action, so Federal law applies.

But at the next step, which is selecting the source of the Federal law, we submit that there is no need here to look to State law.

Here the Federal court has a fully developed body of Federal common law of demand which stems from this Court's decision in Hawes in 1882 which created a demand requirement.

Here the Court does not need to fashion entirely out of whole cloth a law of, Federal common law of demand.

That law already exists.

Unknown Speaker: Well, how about the question of the effect of the demand requirement?

What happens if the demand is rejected?

Now what law do we look to?

Mr. Hall: Your Honor, the question of standard of review is not before the Court in this case, and the commission is in agreement with us on that point, that this Court should not reach that issue in this case.

The court of appeals--

Unknown Speaker: Well, we certainly have to be concerned with it, because it seems to me the questions are very much interrelated ultimately.

Mr. Hall: --We think, Your Honor, that under Burks the question of standard of review would be governed by State law, and in fact that statement appears in the opinion of the court of appeals.

Unknown Speaker: But I take it the Solicitor General's point is that that just brings us around to where we began, because Delaware's law is predicated on the assumption that there are two types of situations, one where there is demand and one where there is demand excused.

And the reason that Delaware can afford to be very... to give great deference to its directors in the demand required case is because there are whole other class of cases where demand is excused and the suits can then go forward without that deference.

So you're really asking us to apply a State law which has not at all been developed for the contingency of demand being required in every case.

That is the Solicitor General's argument, is it not?

Mr. Hall: I believe it is, Your Honor.

I can't speak for the Solicitor General.

Let me say again that the standard of review is not presented in this case, and there are no questions of Delaware law presented in this case.

If State law applies it's only a Maryland law.

Unknown Speaker: Well, I am suggesting, as Justice O'Connor suggested, I believe, that it's necessarily involved because you're asking us to adopt a standard that might be completely unworkable.

Mr. Hall: I think the standard is not unworkable, Your Honor.

What the court of appeals did was to adopt a very straightforward rule that in every derivative case the shareholder must make a demand before proceeding to the Federal court.

The court of appeals said nothing about what the standard of review should be.

Therefore what the court of appeals has done applies only to steps that the shareholder must take before the shareholder is permitted to go to court.

After the shareholder goes to court the very same State law which now exists can be applied, only at that time--

Unknown Speaker: But that law provides either no answer or an answer that is quite incorrect because it is premised on a false assumption.

Mr. Hall: --No.

At that point, for example in a case which Delaware characterizes now as demand excused, the shareholder plaintiff would still be required under the court of appeals' opinion to make a demand.

However, the shareholder could then file suit if the demand was refused and contend that this is a case in which demand should have been excused.

The Federal court could then rule upon that with the benefit of actual experience rather than having to deal with hypothetical facts about what the board would have done had it been presented with a demand.

Your Honors--

Unknown Speaker: It may well be that even though you do come full circle, I suppose, and have to confront the same State law issues, you may not have to do it in as many cases.

Mr. Hall: --That's correct, Your Honor.

Unknown Speaker: In some of the cases, presumably, the corporation will decide to take up the cudgels on behalf of the shareholder.

Mr. Hall: Either the corporation will decide to take up the cudgels on behalf of the shareholders, or in fact the board of directors of a corporation when they are presented with demand have a whole range of intra-corporate dispute resolution mechanisms available to them.

For example, the shareholder may be acting on mistaken information.

The corporation may be able to furnish correct information and settle the dispute that way.

There's a whole range of options that the board of directors can exercise when presented with a demand which may totally obviate the suit so that it never, never appears in the Federal courts.

Unknown Speaker: But where those options do fail, you really don't have any answer to the SG's argument that you may have to get into the same kind of inquiry that we have up to now been conducting or the courts have been conducting under the futility rubric.

Mr. Hall: I have two answers.

One is the answer we have already discussed, which is that some of those cases may never end up in court.

The second answer is, if they do end up in court, the court can then conduct its analysis on the basis of actual facts rather than hypotheticals, which is how litigation normally is conducted.

This case differs from Burks for another reason, which is that the court in Burks in dealing with the question of when directors may properly terminate shareholders' litigation was concerned with an issue of the directors' powers, which this Court found to be a core issue of corporate law--

Unknown Speaker: Mrs. Hall, more precisely, what exactly was the question decided in Burks what... as to what the directors could do?

Was it whether they should, would prosecute litigation or whether they would terminate a shareholder's prosecution?

Mr. Hall: --It... I believe the precise question, Your Honor, was whether they had the power to terminate, whether a special litigation committee appointed by the board of directors had the power to terminate a suit brought under the 1940 act.

Unknown Speaker: Brought by whom?

Mr. Hall: A shareholder.

Unknown Speaker: By the shareholder.

Mr. Hall: A derivative suit.

Unknown Speaker: Thank you.

Mr. Hall: In this case we're not... we are confronted with an issue involving the futility exception to the demand requirement which is not a core issue of corporate law.

This question deals with the relationship between the shareholder and the Federal court, and what the shareholder has to do before he is permitted to file suit in the Federal court.

It is not an issue of corporate law.

It is an issue relating to demand, and as I mentioned, we have a fully developed body of Federal common law of demand stemming from this Court's decision in Hawes.

There is an additional reason for applying a Federal common law of demand, and that is the need for uniform... uniformity in the rules governing access to the Federal courts.

Legal proceedings in the Federal courts should be administered under uniform, predictable rules.

Unknown Speaker: May I interrupt here because I want to be sure I understand.

Mr. Hall: Yes, Your Honor.

Unknown Speaker: On the review... I know you say it's not before us now--

Mr. Hall: Yes.

Unknown Speaker: --But do you have the position there that that is a matter of State law?

Mr. Hall: Yes.

I believe under Burks.

Unknown Speaker: But then why doesn't your, why wasn't your uniformity argument apply equally to that?

Mr. Hall: Well, I think--

Unknown Speaker: Because that, in last analysis that's a question of access to the courts.

Mr. Hall: --I think that that argument is foreclosed by Burks, and we're not urging the overruling of Burks.

And also I think that that issue more directly implicates the power of directors, which is a core issue of corporate law.

Unknown Speaker: Thank you.

Mr. Hall: Whereas our issue deals with the right of shareholders to come to the Federal court.

We think that applying the laws of the 50 States to, with regard to the futility exception to the demand requirement will result in unnecessary litigation over what should be a straightforward matter.

The virtue of a uniform Federal law of demand is particularly evident under the Federal policy that is reflected in the independent director provisions of the Investment Company Act of 1940.

And in the Burks decision this Court considered those independent director provisions and noted that those directors are to serve as watch dogs for the interests of all of the shareholders of the mutual funds.

Applying a uniform Federal law of demand will help ensure that the demand rules do not evolve in such a way as to usurp the watch dog role of the independent directors under the Investment Company Act of 1940.

As my third argument, Your Honors, I submit that this judgment can be approved on the separate ground that the court of appeals correctly held that the futility exception to the demand requirement should be abolished.

This was a very straightforward rule and would require demand in all cases.

We believe that abolishing the futility exception will benefit the Federal judicial system without unduly burdening shareholder laintiffs, and that abolishing the futility exception is a natural evolution of the common law which will help sustain the vitality of the demand requirement.

Looking first at judicial economy, when Hawes was decided the Federal courts were in need of protection from the collusive manufacture of diversity jurisdiction.

And today the Federal courts are confronted with cases where the futility exception is routinely used in order to avoid intra-corporate means of resolving disputes.

In each case involving the futility exception the district court must confront as a threshold issue the hypothetical fact-specific question as to whether demand would have been futile because the board is alleged to be biased or to have engaged in some improper conduct.

We submit that requiring demand in all cases is preferable to expending time, money, and scarce judicial resources on this hypothetical inquiry as to whether demand would have been futile.

Unknown Speaker: Mrs. Hall--

Mr. Hall: Yes, Your Honor.

Unknown Speaker: --Your opposing counsel says that the demand requirement is not just kind of a mechanical thing where you can abolish it and then everything will come out all right... come out the same way, and then... but the substantive standard of review of the shareholders' claim is much different under the law of most States where demand has been made and refused than it is where it is shown to be futile.

Do you agree with that statement?

Mr. Hall: I do not, Your Honor.

As we have been discussing, I think there is no logical or practical reason that you cannot separate the making of a demand from the standard of review, and the court of appeals said several times in their opinion that they were not making any link between the making of a demand and the standard of review to be applied to the board's decision in dealing with the demand.

I think that requiring a demand will not place any undue burden on shareholders.

All they have to do is write a letter to the board of directors of the corporation, and that in turn allows the board of directors of the corporation to have the option of trying to take some kind of action which will obviate the lawsuit.

That does not place any burden on the shareholder plaintiff other than mailing the letter.

It's only at this second stage, which is not before the Court today, the stage of standard of review of the board's action, of that, in connection with that--

Unknown Speaker: May I ask this, Mrs. Hall?

Mr. Hall: --Yes, Your Honor.

Unknown Speaker: You're saying... one of your arguments is you'll save a lot of skirmish... time skirmishing about futility if you have an automatic demand rule.

But basically the... when you allege futility you're alleging that the decision makers are biased for one reason or another, they're beholden or they've got a financial interest.

Is it not true that if you call for a demand in every case the plaintiff will still make the same charges?

Won't he say you can't rely on this decision not to litigate because the decision makers are biased?

So don't you get back to the same issue that you, as when you have a futility requirement?

Mr. Hall: Not necessarily, Your Honor, because there will be a certain number of cases in which the board will be able to take action which will obviate the need for a lawsuit.

Unknown Speaker: But even... that's not impossible after a complaint is filed either.

Mr. Hall: It's not impossible, but it becomes very unlikely, and the case law is very clear that demand futility is to be determined as of the time suit is commenced.

The courts have recognized that as soon as a lawsuit is filed, positions become hardened, people become adversaries--

Unknown Speaker: Maybe we need more reasonable lawyers on both sides is what we need.

There's no reason why that has to be true.

Mr. Hall: --It just happens to be true.

Unknown Speaker: Yeah, okay.

Mr. Hall: Your Honor, I think that this case is a classic example of a situation where a demand should have been made.

If the fund directors in this case had been presented with a demand instead of a complaint, they might very well have chosen to distribute a revised proxy material even if they didn't think that anything was wrong with the original proxy material, just in order to avoid the delay and expense of this litigation.

Unknown Speaker: Yeah, but that wouldn't have done any good because they have already hired the investment advisor.

It's already been approved.

Sending out a subsequent proxy statement wouldn't cure, assuming the original hiring was incorrect.

Mr. Hall: Well, the mutual fund must seek approval of its fees.

Unknown Speaker: Right.

And the hypothesis we have here is that they used an incomplete proxy statement to get approval of an improper investment contract.

Mr. Hall: That's correct.

What I said is--

Unknown Speaker: And if later on you send out a corrected proxy statement, what good does that do?

Mr. Hall: --Well, if, it gives the shareholders the opportunity to vote with that additional information, which petitioner claims they needed to have.

Unknown Speaker: It gives them an opportunity for a petition for rehearing in effect?

Mr. Hall: Right.

Unknown Speaker: Yeah.

Mr. Hall: And it obviates the need for a lawsuit on a proxy claim.

Now in this case petitioner did not sue until 6 months after the shareholders' meeting, but even at that time the board of directors, if they had been presented with a demand instead of a complaint, could have called a special shareholders' meeting and sent out revised proxy material and saved themselves the expense and honor of appearing before the Supreme Court on this issue 7 years after the shareholders' meeting.

Unknown Speaker: Or they might have appointed an impartial committee to resolve the question, as some corporations do, I suppose--

Mr. Hall: That's correct, Your Honor.

Unknown Speaker: --which would also avoid ever having to confront the futility question.

Mr. Hall: That's correct.

Your Honor, petitioner claims that the decision of the court of appeals was a revolutionary decision.

We think that it was more evolutionary and in the tradition of the common law, and that the decision of the court of appeals abolishing the futility exception will help to preserve the viability of the demand requirement.

Petitioner basically is taking the view that no corporate director ever can be trusted to act fairly and properly in considering a demand requirement, and it is this view that probably explains why the futility exception is eroding the demand requirement.

If shareholder plaintiffs invariably consider corporate directors to be untrustworthy, then they will invariably decide that a demand would be futile and they will always rush to the Federal courthouse to file suit without making a demand.

The inevitable result is that the demand requirement is eroded, and the rule adopted by the court of appeals which eliminates supposed futility as a reason for not making a demand will preserve the viability of the demand requirement and, we suggest, should be adopted by this Court.

The allegations of futility in this case, Your Honors, were totally inadequate.

I suggest that my client should no longer be required to defend against this proxy claim where the allegations of futility are so insufficient.

These boilerplate allegations that the directors received fees for their services and that they voted to send out the challenged proxy material would not constitute futility under any applicable law.

And this proxy claim should be dismissed, Your Honors, whether this Court chooses to apply Federal law or State law, whether you choose to apply the futility exception or abolish the futility exception.

Your Honor, we respectfully request that the dismissal of the proxy claim in this case be affirmed.

Unknown Speaker: Thank you, Mrs. Hall.

Mr. Meyer, do you have rebuttal?

You have 3 minutes remaining.

Rebuttal of Richard M. Meyer

Mr. Meyer: Thank you, Mr. Chief Justice.

I will be very brief.

Hopefully I won't need to use the 3 minutes.

At the risk of helping my opponent, I believe Ms. Hall intended to have reference to page 17A of the appendix with respect to the discussion of futility, the last paragraph on that page.

I won't take time to read it, but I think if Your Honors read it you will see that the court below says both things.

And it's pretty clear that it can't make up its mind whether the allegations are sufficient to establish futility or not, and therefore adopts a rule saying whether or not futile we must insist on demand in all cases.

I should have referred before to the Borak case as a case which insists on applying the Federal standards no matter... to proxy fraud case no matter what State law would apply, and I submit that on that reasoning, which was adopted in Galef subsequent to the Burks decision, Burks is clearly distinguishable.

Burks was that unusual type of derivative action that really was a business judgment case.

There was no self-dealing involved in Burks at all.

That was a question of whether management made a business judgment mistake in purchasing Penn Central Commercial Paper from Goldman Sachs.

And in fact prior to the decision, I think, management had instituted an action against Goldman Sachs and effected a recovery.

The only other point I might make is that on this question of waiver of State law, the State law question was never really waived.

It was never really raised by either party.

We said in our initial complaint, we hadn't really made any demand allegations except with respect to 36B.

On the motion to dismiss, we amended the complaint, added the demand allegations, and addressed the argument of the defendants by saying we now have allegations in the complaint that excuse demand, that it's not merely a question, as you know from having read the papers, of the fact that they got paid for being directors.

That would be simplistic.

Basically those are the points that I wanted to raise on rebuttal, and unless the Court has questions I thank you very much.

Chief Justice Rehnquist: Thank you, Mr. Meyer.

The case is submitted.

Unknown Speaker: The honorable court is now adjourned until Monday next at ten o'clock.

Attribution:

The OYEZ Project

Featured:

Lampf v. Gilbertson - Oral Argument

Fri, 09 Jan 2009 14:49:43 +0000

Case:

Lampf v. Gilbertson

Media File:

90-333_19910219-argument.mp3

Related Transcript:

transcript.xml

Transcript:

Argument of Theodore B. Olson

Chief Justice Rehnquist: We'll hear argument next in No. 90-333, Lampf Pleva, et al. v. Gilbertson.

Spectators are reminded the Court remains in session.

There's to be no talking.

Mr. Olson, you may proceed whenever you are ready.

Mr. Olson: Thank you, Mr. Chief Justice, and may it please the Court:

This case presents two closely related questions.

First, should Federal securities fraud claims under Section 10(b) of the Securities Exchange Act of 1934 be governed by a single Federal statute of limitations or by the law of the forum State on a case-by-case basis.

Second, should the Federal rule be the 1-year/3-year standard established by Congress for the comparable Federal securities fraud remedies at the same time that it created Section 10(b), or by a limitations period enacted... extracted from some other Federal law passed decades later.

The respondents are Oregon residents who brought actions under Section 10(b) and Rule 10b-5 to recover the losses they had sustained on limited partnership tax shelter investments.

Petitioner is a New Jersey law firm that was involved in preparing some of the offering materials.

Oregon's 2-year fraud statute of limitations was applied by both courts below in adjudicating petitioner's summary judgment motion.

The district court granted the motion.

The Ninth Circuit reversed, holding that issues of fact remained as to when the alleged fraud was discovered.

There is no dispute, however, that if the Section 10(b) claims against petitioner... that the 10(b) claims against petitioner would have to be dismissed if the 1-year/3-year limitations period were to be applied.

I will focus today on three principal contentions.

First, the wasteful and debilitating consequences of borrowing State limitations periods on Federal policies, the Federal civil justice system, and Federal litigants make it essential that a uniform Federal standard be adopted.

Second, the 1-year/3-year limitation period, repeatedly adopted by Congress when it enacted the 1933 and the 1934 securities acts, including Section 10(b), is the only choice for Section 10(b) that is compelled both as a matter of legislative intent and as the standard most compatible with the Federal remedy and the Federal policies underlying that remedy.

This solution has been endorsed with near unanimity by the courts, commentators, and the Bar.

Third, neither the 5-year limitations period adopted by Congress in 1988 for insider trading, nor the 4-year limitations period adopted in 1979 for land sales are rational, workable, or jurisprudentially acceptable alternatives.

Turning first to the operation and effect of the system that prevails in many of the circuits today, that system, with the exception of the three circuits, the Second, Seventh, and Third Circuit, is to apply the law of the forum State.

The district court applies the fraud statute of limitations, the Blue Sky statute of limitations, the contract statute of limitations, the personal injury statute of limitations, or some catch-all statute of limitations, depending upon the particular facts of the particular case and the particular forum in which the case is brought.

Thus there are 50, 100, 150, and more potential statutes of limitations to apply at the outset in a 10b-5 case.

State statutes of limitations for fraud or Blue Sky may vary from as short as 1 to as many as 10 years, and these complications are exacerbated because then the district courts apply different and numerous rules of tolling with respect to when the statute of limitations has begun to run.

Furthermore, as respondents point out and concede in their brief, State statutes of limitations with respect to fraud or Blue Sky are constantly changing.

This complicates the district court jobs further.

Unknown Speaker: Mr. Olson, these are problems that always exist whenever you borrow State statutes of limitations, but we've been doing it for a couple of hundred years.

I think what you're saying is that it's always better to make up or pick a Federal statute of limitations.

Is that always true?

Mr. Olson: Well, it may... it may be from that standpoint generally preferable to pick a Federal uniform statute of limitations for a federally created right.

But this, the securities laws under Section 10(b), are at the far end of the spectrum, because there must be an interstate nexus to begin with.

That was not the, that's not the case in many of the statute of limitations this Court has adjudicated in the last few years.

There must be an interstate nexus.

There are frequently many plaintiffs and many defendants from many different States.

There is a Federal source to turn to in this case.

Unknown Speaker: Have you read the law of conflict of laws recently?

I mean, from the standpoint of a lawyer figuring out what substantive law is going to govern his case, I don't know that securities law is any more difficult than any other field for determining what substantive law the particular court is going to apply.

Mr. Olson: Well, the commentators in the courts that have struggled with this, one judge from the Seventh Circuit said this is as enervating as it can possibly be in the Federal securities field.

The ABA special committee on Federal securities law studied this and said that this is a disaster, there is chaos, there is forum shopping, there is litigation, year after year of litigation after litigation.

Those same choice of law rules that the Court just... that you just referred to, Justice Scalia, exacerbated even further--

In New York, for example, the district court in New York will either apply the rule of New York if it's a New York resident bringing the action, or the law of New Jersey if it's a New Jersey resident bringing the action.

The Second Circuit in the Ceres Partners case described one Federal securities case in which 26 different statute of limitations were applied, and another case in which 34 different statute of limitations were applied.

Even the plaintiffs concede that there is forum shopping in this area.

The plaintiffs indicated, for example, there undoubtedly is forum shopping, and they simply said that there is no imposition on the Federal court system.

Well, this Court has said that it is an imposition on the Federal court system to be... for there to be forum shopping.

There is inconsistency, injustice, unfairness.

There are different results for different litigants similarly situated.

There is uncertainly in the marketplace for the marketing of Federal securities... this is an important segment of our national and international economy... and it undermines Federal policies, the very Federal policies that were at work in 1933 and 1934 when Congress enacted the '33 and '34 act, the importance of establishing uniform enforcement in Federal securities laws.

As this Court specifically has held in the Wilson case, few areas of the law stand in greater need of firmly defined, easily applied rules than does the subject of statutes of limitations.

Unknown Speaker: Mr. Olson, do any of the States in causes of action like this apply a doctrine of latches?

Mr. Olson: They do not apply the doctrine of latches--

Unknown Speaker: In lieu of a statute of limitations.

Sometimes latches is applied along with it, but I mean in lieu of statute of limitations.

Mr. Olson: --They do not... the doctrine of latches generally would be applied in cases involving equity rather than cases for the vindication of private rights of action for damages in the 10(b) context.

Doctrines sounding like latches are applied in that the district courts and the States sometimes apply equitable tolling doctrines, which amount to the same things, to justify whether or not a statute of limitations would apply in a given case or not.

In fact, it's true that in this case everyone, everyone... the SEC, the petitioner, the respondents... agree that the present system is unacceptable and should be changed.

The respondents offer a modification of the present system, but even they agree that the present system should be... changed.

Unknown Speaker: Has anyone sought to get legislation from Congress?

Congress does have the power to pass statutes of limitation.

Why didn't that occur to anybody?

I mean, if there is as much upset about it, if everybody is in agreement as you say, it ought to be a simple thing to get a statute.

Mr. Olson: Well, it's... as you know, Justice Scalia, it's not that simple necessarily to get a statute.

Unknown Speaker: Well, maybe there isn't that much agreement.

Mr. Olson: Many of the commentators have agreed that congressional legislation in this area would be beneficial.

The ABA study, a special study that I referred to, specifically suggested congressional legislation.

There has not yet--

Unknown Speaker: Well, Mr. Olson, in the Judicial Improvements Act passed a year ago, Congress did adopt a general 4-year statute of limitation, but apparently limited it to acts enacted after the enactment of the 4-year statute of limitations provision.

Mr. Olson: --Yes.

Unknown Speaker: In other words, they didn't seek to apply it--

Mr. Olson: Yes, that's correct, Justice--

Unknown Speaker: --to previous enactments or causes of actions.

Now, why was that?

I mean, why, why so limit it?

Mr. Olson: --I think that the Congress bit off in the judicial, or Justice Improvement Act, which was passed in 1990, about as much as it felt that it could chew at that particular point.

It decided that a 4-year statute of limitations would apply in specific--

Unknown Speaker: For all future acts of Congress, unless they provide otherwise expressly.

Mr. Olson: --For all private remedies created by future acts of Congress, that's correct.

Unknown Speaker: Well, maybe that should be a guidepost in this case.

Mr. Olson: Well, the answer to that, I think, Justice O'Connor, is found in this Court's repeated statement, and most recently, or perhaps not most recently, but recently in footnote 1 in the Patterson v. McLean case.

Congress makes law by affirmative actions of both Houses of Congress, signed by the President, not by inaction.

Every time, every time the Congress... let me resort, return to the 1 and 3-year statute of limitations, because Congress did consider the subject of statutes of limitations for private remedies under the securities acts of 1933 and 1934.

The 73d Congress spent a great deal of time considering, as this Court has indicated, we must resort--

Unknown Speaker: Well, it considered some... a limitation period for those causes of action that Congress expressly created.

I don't think you can say it considered what the cause... statute of limitations should be for a cause of action implied by the courts.

Mr. Olson: --The court... the Congress at that time... that is correct, Justice O'Connor, because the cause of private right of action under Section 10(b) is implied from Section 10(b).

Section 10(b) did not explicitly create an express cause of action or a statute of limitations.

Therefore Congress did not expressly focus it... on it and enact a statute of limitations.

But I submit that Congress focuses... focused on the subject about as closely and as carefully as Congress could under the circumstances.

The Congress in 1933 and 1934... and there were two acts... focused expressly on a uniform national legislation, a regimen, regime of governing securities transactions in the United States.

Ultimately, this Court has said, the test is what Congress, what balance would Congress have preferred.

That's the standard articulated in the Wilson case and repeated in the DelCostello case and in the Agency Holding case.

What standard would Congress have preferred.

What happened in 1933 and 1934 when the 1933 and 1934 securities acts were created, is that Congress expressly created five or six separate, specific private rights of action.

And the one thing that Congress focused on in conjunction with each of those causes of action, and the desire by Congress that Federal securities law be treated uniformly in the courts of the Nation, is that every express cause of action created by Congress in 1933 and 1934 was given an express statute of limitation.

Secondly, every express statute of limitations created by Congress in 1933 and 1934 was a nontollable outside limit, 1-year/3-year statute of limitations, a maximum outside limitation of 3 years for the vindication of the right.

Unknown Speaker: But are all those statutes identical with one another?

Mr. Olson: No, they're not, Justice Stevens.

Each of the statutes created in Section... in the securities act of '33 and '34 is somewhat different.

One of them deals with misrepresentations in registration statements.

One of them deals with misrepresentations in prospectuses.

One of them deals with stock listed on an exchange.

But the panoply of those statutes taken together, some of which have slightly different standards, they are all... they all have two or three things in common.

They are all Federal securities regulations that create private rights of actions.

They all have an express statute of limitations, and a nontollable 3-year maximum statute of limitations.

And generically, Congress decided, however much each of the specific limitations period would be different from one another, each of them would be subject to the same 1-year/3-year statute of limitations period.

So although there are differences in the remedies, there is no difference in the limitations period that Congress intended to apply.

And each time this Court has considered what should... in the first place I should step away for a moment and say this Court has repeatedly said that whether the right... whether an implied right of action should exist under a Federal statute is ultimately a matter of legislative intent.

And this Court has determined, each time it has examined the contours of an implied right of action, has looked to the Congress that created the remedy from which the courts discern a right of action.

And each time this Court has considered Section 10(b), Section 17 of the '33 act, Section 14 of the '34 act, or other aspects of Federal securities regulations, the Court has uniformly turned to the 73d Congress to determine not only whether such a right exists, but whether... what the scope and limitations and contours of that right would be.

The Court did it in the Blue Chip case, the Court did it in Ernst & Ernst... in the Ernst & Ernst case, Piper v. Chris-Craft, and on and on.

The Court has repeatedly looked to that one source of information as to what Congress might have preferred.

And in this case what Congress--

Unknown Speaker: We weren't moved, evidently, by the fact that whenever Congress wanted a cause of action it adopted a statute of limitations for it.

That didn't seem to influence us.

Mr. Olson: --It... this--

Unknown Speaker: I mean, you say every other, every instance in that statute where Congress created a private right of action, it enacted a statute of limitations for that cause of action, right?

Mr. Olson: --That's correct.

Unknown Speaker: But we found that Congress really had in mind another cause of action without a statute of limitations.

Mr. Olson: You... this Court--

Unknown Speaker: I mean, you can say we looked to it, but have we really used it?

Has that been our guiding, our guiding star, what the 73d Congress wanted?

Mr. Olson: --This... invariably when the Court has construed the scope and contours, whether sienter is required under Section 10(b), whether preponderance of the evidence or a clear and convincing standard, whether Section 10(b) is limited to purchasers and sellers, the Court has invariably turned to what Congress did in 1933 and 1934, the 73d Congress.

And this Court has not considered the statute of limitations before.

This is the first time that that has directly come before this Court and has been directly presented.

But we submit that the only source to discern, the only reliable source to discern what would Congress has intended, is that very same source.

It is also true that if the Court adopts a separate or a distinct methodology, which I think, and I respectfully submit, is really the same as looking at legislative intent anyway, but if the Court looks at it differently and applies the analogy standard that is articulated in the Agency Holding v. Malley-Duff case, one draws... comes to the same conclusion.

In Blue Chip this Court examined, in order to determine the scope and contours of Section 10(b) with respect to the purchaser and seller requirement, it... this Court looked to the express causes of action in the '33 and '34 act, called them comparable causes of action, said that they were the appropriate vehicle and analogy to compare them with.

This Court has repeatedly said that standards of fraud under the common law are light years away from the right created under Section 10(b), and that those comparable causes of action do provide an appropriate analogy because they are Federal, they are intended to be uniform, they are intended to provide private redress for securities fraud, they all arise at the same time.

And the other aspect of this from the standpoint of the analogy standard is that if this Court were to adopt a longer period of limitations for Section 10(b), 5 years, for example, as the Commission suggests, that would tend to write out, nullify, or repeal the legislation that the 30... the 73d Congress specifically focussed on and enacted with respect to these other statutes, because, as this Court has noted, the actions under Section 9 of '34 act, Sections 11 and 12 of the '33 act, and so forth, can be brought under Section 10(b).

So an artful pleader, if given a choice between a 5-year statute of limitations as the Commission urges, and the 1 and 3-year statute of limitations that Congress expressly adopted, would naturally plead it under Section 10(b) to take advantage of the 5-year statute of limitations, thus resulting in a judicial nullification of the express intent of Congress.

Now I can't emphasize enough--

Unknown Speaker: xxx true that the... is it the Insider Trading Act of '88 that the Commission relies on?

Mr. Olson: --Yes, Justice White.

Unknown Speaker: Well, isn't it true that that... that's the only time that there, that Congress has provided a statute of limitations with respect to a cause of action that can be... involve 10(b)?

Mr. Olson: It... in this sense only--

Unknown Speaker: Isn't that right?

Mr. Olson: --Only in a very limited sense, Justice White.

Unknown Speaker: Well, that... well, anyway, it's right.

Mr. Olson: It's right only in a very limited sense, in the sense that a--

Unknown Speaker: Well, tell me when it isn't right.

[Laughter]

Mr. Olson: --I will.

Most of the causes of action that might be brought under 10(b) cannot be pleaded under the... we'll call it the Insider--

Unknown Speaker: Well, that's true, that's true.

But I still ask... you can bring a cause of action under that '88 act that involves a violation of 10(b).

Mr. Olson: --That's correct.

Unknown Speaker: And there is then an express statute of limitations for it.

Mr. Olson: Congress expressly decided... you're correct in stating that Congress expressly decided for a narrow band, a very peculiar type of Section 10(b) violations.

And it's not just 10(b).

That 1988 statute--

Unknown Speaker: I agree with that.

I agree with that, but it does involve 10(b).

Mr. Olson: --It does involve 10(b).

It involves--

Unknown Speaker: Why shouldn't... why isn't that the closest statute that we should look to?

Mr. Olson: --Well, there are several reasons why that is not the closest.

In the first place, if the ultimate test is legislative intent, the appropriate place to look first of all is to the language of that specific 1988 statute.

What Congress said in that 1988 statute, and respondents concede on page 42 of their brief that Congress could not have been clearer with respect to this, it did not intend that 1988 statute to apply otherwise to Section 10(b) or any other of the securities--

Unknown Speaker: So... so you suggest we have... there are two... you suggest two statutes of limitations that would be... that would apply this... different 10(b) actions?

One that involves the '88 act, and for all others there would be this other statute of limitations?

Mr. Olson: --There is already the one--

Unknown Speaker: Is that right?

Mr. Olson: --Not... no, Justice White, because there are already the 1 and 3-year statute of limitations that apply to many of the facts that might be pleaded under Section 10(b).

Unknown Speaker: Right.

Mr. Olson: The 1988 statute carved out a very narrow niche of people trading on inside information who may sue contemporaneous traders for a very limited remedy, that is, they may only recover the profit of the contemporaneous trader in the same type of securities.

But Congress specifically said nothing in this section shall be construed to limit or condition a right of any person to enforce a requirement of this title or the availability of any cause of action implied from a provision of this title.

Thus Congress could not have been clearer that it did not intend the 1988 legislation to apply to Section 10(b) actions beyond this... the narrow hybrid remedy that was created to solve a specific problem created by... what the Congress perceived was created was a judicial decision.

Unknown Speaker: Mr. Olson, were... are there any other overlaps in the 1988 statute?

Does that limitation period cover any other actions that are governed by another Federal statute of limitations?

Mr. Olson: That limitations period covers any... let me put it this way, Justice Scalia, that that statute creates a right, a remedy for a violation of either Section 10(b) or other... violation of other provisions of the '34 act.

Unknown Speaker: Which already have their own statute of limitations?

Mr. Olson: Which already have their own statute of limitations.

Unknown Speaker: So it wouldn't be at all unusual for that 1988 statute to duplicate the 1 and 3-year statute that you're arguing for, it already duplicates other ones?

Mr. Olson: That's exact... that's precisely correct.

And what Congress was saying... the history of the 1988 statute is that Congress did not really focus on the statute of limitations at all.

There is very little legislative history.

The statute was originally, in the 1988 legislation, was taken from the Insider Trader Sanctions Act of 1984, which had a 5-year limitation period which restricted the right of the SEC to seek certain civil penalties.

That in turn was taken from the 5-year Federal criminal statute of limitations.

What Congress did in each of these events was repeat that 5-year statute of limitation.

It didn't focus on the balancing process, which is what Congress clearly did, and I probably should return to this point.

The one thing that Congress did in 1933 and 1934 is to conduct the kind of balancing that this Court says is necessary to evaluate when and what are the limitations of an appropriate statute of limitations period.

Several members of the Congress indicated that they had not in their lifetime been exposed to more debate, public commentary, public controversy, with respect to what the statute of limitations would be.

When the 1933 act was passed and express remedies were created, the Congress enacted a 2-year/10-year statute of limitations.

There was, there was a great amount of public outcry and lobbying, both from the business community and people on the other side of the issue.

Congress then had considerable hearings and debates, and specifically conducted that balancing.

They understood that they might be cutting off the rights of some plaintiffs when they enacted a statute of limitations that was the length that they enacted in 1934.

But they did so quite intentionally and they considered the impact of the potential, which is described well by this Court in Chief Justice Rehnquist's opinion for the Court in the Blue Chip case, the effect of Section 10b-5 actions might have on officers, directors, accountants, underwriters, issuers, and so forth, and the international marketplace.

The Court conducted that balancing process and decided that that 3-year statute of limitations was the right solution for securities act limitations.

The one thing that I would like to mention before I reserve the balance of my time for rebuttal is that the respondents have urged that the international... the Interstate Land Sales Act, which was amended in 1979 to have a 4-year statute of limitations, ought to be the guide.

I would simply like to reiterate what we have said in our brief, that the Interstate Land transactions act, Congress was not balancing the importance of secondary markets and the effect upon the economy of litigation with respect to securities.

This is a statute which Congress enacted without consideration of what the appropriate statute of limitations ought to be in securities cases, and it is a nontollable... it is a tollable, arguably, statute of limitations.

The respondents favor that statute of limitations because they contend that there should be a tollable statute of limitations.

I say that that is the strongest evidence that it's not the right statute of limitations, because the one thing about which there was virtually, if any... there was no dissent in 1934, none in the Senate anyway, that the absolute 3-year statute should be a bar and that there should not be in this field a tollable statute of limitations.

With the Court's permission, I'd like to reserve the remainder of my time for rebuttal.

Unknown Speaker: Very well, Mr. Olson.

Mr. Allen, we'll hear now from you.

Argument of F. Gordon Allen, III

Mr. Allen: Mr. Chief Justice, and may it please the Court:

The issue in this case is whether Section 10(b) and Rule 10b-5, private rights of action, will continue to have proper fraud statutes of limitations, statutes of limitations which are discovery based, or whether this Court will impose upon this antifraud remedy a 3-year statute of repose.

And that is what we're talking about here, a 3-year statute of repose which will, in the words of this Court in Bailey v. Glover in 1875, cited frequently since then, which statute of repose will, in the words of this Court, become the means by which fraud can be successfully accomplished.

The--

Unknown Speaker: As it is where it's used elsewhere in the Federal securities acts.

Mr. Allen: --The other Federal securities acts are not antifraud remedies.

At the time the 73d Congress enacted the 3-year statute of repose for those other sections, the little legislative history that we have on the subject tells us that a political tradeoff was made whereby a short statute of repose was put on the acts, but the proponents of that short statute of repose argued that the burden of proof on the plaintiffs would be so low they are basically strict liability causes of action with the defense of good faith available, that the burden on the plaintiffs would be so low that a short statute of limitations was justified.

Unknown Speaker: Even if you showed fraud it would do you no good.

You'd still be subject to the 3 years, wouldn't you?

Mr. Allen: Under the express remedies?

Unknown Speaker: Yes.

Mr. Allen: Yes.

But those are different remedies.

It's sort of like... those are remedies, they are strict liability remedies.

The fact that someone who is liable under those remedies may also have committed fraud, in... in many cases may be a coincidence, but fraud is not a necessary element of the burden of proof.

Unknown Speaker: Is there always intentional fraud in a 10b-5 violation?

Mr. Allen: No, Your Honor, most courts hold that recklessness is also sufficient, but they do not hold that negligence is sufficient or that there are strict liability causes of action.

And the instruction which is given for recklessness, as I can testify as plaintiff's lawyer, is exceedingly onerous.

It comes so close to fraud that it is all but fraud.

Furthermore, we should not be looking at the intent of the 73d Congress in any specific way.

This Court has held on many occasions, Bankers Life, Blue Chip Stamps, Herman & MacLean, Basic Inc., Aaron v. SEC, this Court has always looked at Section 10(b) as a catch-all antifraud remedy, Congress' invitation to the SEC and maybe the courts in the future to fashion flexible antifraud remedies that would match the evolution of securities fraud.

Those antifraud remedies have been developed in the sixties and the seventies and the eighties, in this Court in the seventies and the eighties.

They are broad remedies, and to now shoehorn them back into the intent of Congress with the result of imposing a statute of repose, a 3-year statute of repose, would be a mistake.

It is too easy for promoters to figure out how to conceal their frauds for 3 years.

This Court has, is certainly aware of Ponzi schemes whereby promoters are able to feed back proceeds from later investors to earlier investors.

There are all kinds of accounting schemes whereby corporate executives and accountants can monkey with the books and go under... undiscovered for years.

The bond investors who have filed an amicus brief here present a particularly compelling situation.

They tell us that securities fraud... they tell us that the average municipal bond which is unregistered and has no remedy except 10b-5, the average municipal bond will not default for 4 and a half years, then investors will have no idea that they have been defrauded until there has been a default.

And the result of a 3-year statute of repose is going to mean that the only Federal, the only Federal remedy for securities fraud available to bondholders will not apply in more than half of the cases where there is fraud.

Now, the respondents would like to make three points.

First, under your tests in DelCostello and Malley-Duff, it is still the norm, it is still the rule for this Court to borrow State statutes of limitations, and there is nothing about the borrowing of State statutes of limitations which has frustrated or interfered with Federal policy, and State... and the State statutes from which these statutes of limitations are taken, common law fraud and Blue Sky statutes of... Blue Sky statutes, are at least as analogous to 10(b) and Section 10b-5 as are the Federal alternatives that are being proposed.

No interference, just as analogous.

The second point we are... we want to make is that this Court should reaffirm its holdings in Bailey v. Glover and Holmberg v. Armbrecht that a statute of limitations for fraud is... it is particularly important that a statute of limitations for fraud be discovery based, that it be tollable, that is that it not start to run until the plaintiff either discovers or should have discovered that he or she has a cause of action.

Unknown Speaker: Should have discovered in the exercise of reasonable care?

Mr. Allen: Yes, Your Honor.

The third point we want to make is that recent congressional action and inaction in the face of the evolution of Section 10(b) and Rule 10b-5, particularly where Congress has turned its attention to the securities laws on a number of occasions to examine them for problems, that recent inaction and ratification by Congress is of much more significance than the intent of the 73d Congress, an intent which this Court has repeatedly said is only of the most general nature, and an intent which invited the future to fashion remedies that would deal with the evolving nature of securities fraud.

That is what you've said.

Now the respondents make a big point of the lack of uniformity.

This lack of uniformity as a problem has been only recently perceived by three circuit courts.

Prior to that, it is hard to find examples of problems arising because of the use of statutes... borrowed State statutes, and there is a reason for that.

The reason is because the Federal courts have imposed the rule of Holmberg v. Armbrecht whenever they have borrowed State statutes of limitations.

That is they have borrowed the duration from State law, but they have insisted that whatever that duration they borrowed was, that it not start until discovery.

So the result is that whatever the duration has been, it has been of minor significance because plaintiffs have been allowed... because it has not start to run until plaintiffs discover their cause of action.

So the result has been that plaintiffs bring their causes of action very quickly--

Unknown Speaker: Well then one... another result is that the statute of limitations which you say is actually applied has really no connection with any other statute of limitations at all, if it doesn't even represent the State statute.

Mr. Allen: --I'm not following you.

Unknown Speaker: It's... well, from what you say, the duration is taken from the State, but the Federal courts are insisting that it be discovery based.

Then that really severs the connection with State statute, so that the Federal courts are really just making it up.

Is that right?

Mr. Allen: No, I don't think it's right.

I think they are borrowing the State statute--

Unknown Speaker: But only part of it, you say.

Mr. Allen: --They are... well, they have never acknowledged that they were borrowing part of it.

They have borrowed the State statute of limitations subject to the Federal doctrine from this Court that it not start until the plaintiff discovered the cause of action.

Unknown Speaker: Well, but Holmbrecht against Arm... what's the name of the respondent?

Holm--

Mr. Allen: Holmberg v. Armbrecht.

Unknown Speaker: --Holmberg against Armbrecht was never laid down as a formula to apply to all statutes of limitations, was it, by this Court?

Mr. Allen: I think it was, yes.

I think that Justice Frankfurter made a fairly complete and... rule without exception that this Court in borrowing State statutes of limitations would do the same thing that it also does when acting upon Federal statutes of limitations, most Federal statutes of limitations, and that is that they not start to run until the plaintiff discovers the cause of action.

Unknown Speaker: Are you going to... suppose we disagree with you on whether the State law should apply.

What's your argument with respect to what the statute of limitations should be in that event?

Mr. Allen: All right.

First of all, it should not be a 3-year statute of repose.

I think you have heard me say that.

Second of all, we believe that the situation presented by the relationship, by the... between the Interstate Land Sales Act and the securities acts is very similar to the situation that you encountered in the Malley-Duff case in examining the relationship between the Clayton Act and Rico.

What you had in the relationship between the Clayton Act and Rico was that you had a subsequent statute, Rico, which you found had been very much patterned after the language and the concept of the Clayton Act.

And so you said that this is the best indication of what Federal policy should be in a statute of limitations for Rico.

Now look at the Interstate Land Sales Act.

In the late sixties, in 1968 or '69, Congress passed a remedy for people who are cheated by the sales through the mails and over the telephone of land in sunny climates and the like, investment properties.

And what Congress did was to enact a remedy which sort of sat between a 12-2 remedy in the securities laws and a 10b-5 remedy in the securities law, but Congress did say that it was intending to pattern this after the securities laws.

What it did 10 years later, though, is what is compelling about this analogy, because 10 years later it decided to make the Interstate Land Sales Act more like the securities act.

It decided to divide out a 12-2 remedy, a strict liability-type remedy... 12-2 of the 1933 act is what I am referring to.

They decided to divide out a 12-2 remedy, and they decided to divide out a 10b-5 remedy.

And they made that 10b-5 remedy identical, or practically identical, to Rule 10b-5 in the securities acts, and once again they said our intention here is to pattern this after the securities acts.

Then what did they do with respect to the statute of limitations?

They took a 3-year statute of repose and put it on the 12-2 remedy, the 73d Congress, and then they took a 3-year from discovery, a discovery-based statute of limitations, and put it on the 10b-5 remedy for 10b-5.

Look at what else Congress has done.

Congress, when they enacted the residual statute of limitations in the Judicial Reform Act, Section 313, enacted a 4-year statute of limitations based upon accrual.

Under the holdings of the Federal courts that notion of accrual will probably also turn out to be discovery based.

So Congress has, in the Interstate Land Sales Act, which, we would submit to you, is recent.

It's 1979.

It sits right in the middle of this Court's most important holdings in the securities area, it represents Congress' intent on what it should do in a fraud case.

And in the residual Judicial Reform Act, enacted last year, this Court has... the Congress enacted a statute of limitations which is discovery based.

Unknown Speaker: Mr. Allen--

--Mr. Allen... I'm sorry.

Mr. Allen, do you... do you take the position that if we were to apply a Federal statute of limitations and were to apply the 1-year/3-year statute of limitations, that there could never be any equitable tolling of that 3-year period?

Is that the position you want to take here?

Mr. Allen: I think you... that that is the position that this Court better figure on, because that statute has been interpreted numerous times... not numerous times, but a number of times, as it applies to the express remedies, and the courts always hold that it is a statute of repose.

And petitioner--

Unknown Speaker: Have we held that?

Mr. Allen: --No, you haven't.

Unknown Speaker: Not yet.

Mr. Allen, how does this work, I mean, when we pick a Federal statute?

You have described one that you say well, it's pretty close to 10b-5.

Suppose--

Mr. Allen: Very close.

Unknown Speaker: --Suppose 2 years from now Congress passes yet another statute that is even closer?

I suppose we jump over to that one then, right?

I mean, this is an ongoing looking, scanning the United States Code for the closest friend, right?

Mr. Allen: I read your dissent in Malley-Duff.

I agree with you.

I don't know how you would get to borrowing State statutes of limitations in this case in the first place, for the reasons that you stated, and also for the reasons stated in the test.

There's... this borrowing of State statutes has worked for 40 years.

It doesn't interfere with State policies.

It appeals to certain people who think uniformity is very important, but uniformity at what price?

And the price of this uniformity is going to be this 3-year statute of repose, which is going to oust the Federal courts of... jurisdiction over interstate securities fraud when claims are brought by the most innocent and the most deserving of this Federal... of the Federal courts' attention.

Unknown Speaker: Of course that problem of jumping from statute to statute is, I suppose, an argument for Mr. Olson's position of sticking with the limitations from the statute that this cause of action is derived from.

I mean, there is never going to be another 73d Congress.

Mr. Allen: I agree with that.

But I don't--

[Laughter]

I don't agree with Mr. Olson's position.

It would be a reversal of this Court's... this Court has always said that the legitimacy of Section 10(b) and Rule 10b-5 rests more on congressional ratification than original congressional intent.

That has been the position of this Court, the best statement of which is found in the Blue Chip Stamp case.

Unknown Speaker: Well, really what Blue Chip said was the oak had grown so big it was too late to saw it down.

That's basically what I... the way I read it.

Mr. Allen: Exactly.

And you would be sawing it down.

To put a 3-year statute of repose on this action is to saw it down.

Tolling in a... tolling in a fraud case is not only the policy of this Court which you have held on a number of occasions, it is also the policy of Congress.

In 1934 Congress was not dealing with fraud statutes of limitations.

Congress, when dealing with fraud statutes of limitations, has imposed tolling.

You... I think I have nothing else to say.

I'm going to yield back my time.

Thank you very much.

Unknown Speaker: Very well, Mr. Allen.

Mr. Olson, do you have rebuttal?

You have 3 minutes.

Rebuttal of Theodore B. Olson

Mr. Olson: I'll be very brief.

Unknown Speaker: You'll have to be.

[Laughter]

Mr. Olson: One of the points that respondents make is that there must be a discovery-based statute of limitations in the securities fraud area.

That is a concept which Congress debated and rejected.

The debate was extensive and Congress rejected it.

Congress knew that it was cutting off rights, and it intended to cut off rights, because it balanced the enforcement objectives and the remedial objectives of the '33 and '34 act with the effect of those remedies on the marketplace, and it cut off those rights and it intended it not to be a discovery based limitation.

Unknown Speaker: But your opponent says that those were not fraud actions.

Mr. Olson: Well, the problem with what my opponent says with respect to those are not being fraud actions, is that Congress repeatedly characterized those actions as fraud actions.

The legislative history of the 1933 and '34 act contain the word "fraud" literally thousands of times in reference to the express remedies created by those statutes.

They are... some of them have less of a standard of proof for the plaintiff, some of them have a greater standard of proof.

Section 9 of the '34 act does require sienter.

The one thing in common with respect to the statutes that Congress created, the remedies that Congress created that the Congress called fraud statutes... some of which had sienter, some of which did not... is that they all had an express statute of limitations, they all had the same statute of limitations, and it cut off the rights at 3 years.

The Holmberg case v. Armbrecht dicta is just that.

It's dicta by Justice Frankfurter in an equity case.

As this Court said in American Pipe and Construction v. Utah in 1974, the concept of Federal tolling must be construed to be consistent and consonant with the legislative scheme and the legislative purpose.

In this case the legislative scheme and the legislative purpose are clear.

If there is, as this Court said in Touche Ross v. Redington, if there is any injustice as a result of someone's right being cut off, that... if this result, as the Court said, then sanctions injustice, that argument, when made here, is made in the wrong forum.

This Court is not at liberty to legislate.

The 73d Congress conducted the legislative activities necessary to apply a statute of limitations to the '33 and '34 acts and the Section 10(b) remedy.

As this Court said in DelCostello, the family resemblance between Section 10(b) and the other '33 and '34 act express remedies is undeniable.

There's an, a substantial overlap of remedies and the balancing of interests is the same.

Congress has conducted that balance of interest, of remedies, and selected a 3-year statute of limitations.

Chief Justice Rehnquist: Thank you, Mr. Olson.

The case is submitted.

Attribution:

The OYEZ Project

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