August,
2001
The Supreme Court's Decision
in Wharf Holdings:
An Opportunity for Clarification Missed
In
its recent decision, Wharf (Holdings) Ltd. v. United
International Holdings, Inc., the Supreme Court missed
the opportunity to clarify how courts should draw the
line between federal securities fraud and state law
fraud.
by
Richard A. Levan
Because
Section 10(b) of the Securities and Exchange Act of
1934 (Exchange Act) requires fraud in connection with
the purchase or sale of a security, it is by its language
limiting. A person may not bring an action under Section
10(b) for fraud in connection with a security retained,
or a security never purchased, and a person cannot bring
an action under Section 10(b) for fraud that is unrelated
to the purchase or sale of a security. Although the
first limitation (that there be a purchase or sale of
a security) is subsumed within the second (that the
fraud be in connection with the purchase or sale), courts
have struggled with the precise scope of the "in connection
with" requirement. For that reason, there was general
excitement when the Supreme Court accepted certiorari
on Wharf (Holdings) Ltd. v. United International Holdings,
Inc., a case that promised to resolve some of these
issues. Unfortunately, the opinion did not fulfill expectations.
Section
lO(b) Antecedents
The
Supreme Court has not taken many 10(b) cases recently,
and most of the past Supreme Court cases involving Section
10(b) or Rule 10b-5 have been milestones in securities
fraud analysis. The Court has clarified the following
10(b) issues over the years.
Purchase
or Sale
In
Blue Chip Stamps v. Manor Drug Stores, 1
the Court stated explicitly that Rule 10b-5 would not
serve as a basis for liability where the plaintiff alleged
that he/she had refrained from entering into a securities
transaction due to a material misrepresentation. The
proof problems inherent in demonstrating that a person
did not trade based solely on a misrepresentation or
omission would make such cases unmanageable.
Scienter
The
need for scienter was established in Ernst & Ernst v.
Hochfelder 2 decided by
the Supreme Court in 1976, where the Court clarified
that a misrepresentation must be intentional in order
to be actionable.
Materiality
In
1988, in Basic Inc. v. Levinson, 3
the Court resolved a Circuit split over the standard
for assessing materiality. Particularly with regard
to merger negotiations, courts had decided differently
at what point it was incumbent on a company to disclose
those negotiations, and, conversely, when silence or
denial became a material misrepresentation. The Court
used the TSC v. Northway 4
standard (a reasonable investor would view the disclosure
as having significantly altered the total mix of information)
as its starting place. It then qualified that standard
for events that may not occur, holding that, as of any
given point in time, materiality should be determined
by weighing the likelihood that the event will occur
against the magnitude of the event compared to the company's
total activities. The Court also affirmed the use of
the "fraud on the market theory," which allows presumptive
reliance on a material misrepresentation that is publicly
disseminated rather than requiring each individual investor
to demonstrate actual reliance.
Contribution
and Secondary Liability
In
two cases decided in the early 1990s, the Court confronted
the issue of how far liability could extend from the
initial perpetrator.5 The
Court inferred from the structure of the liabilities
provisions in both Securities Acts and the express provisions
in Section 9 and Section 18 of the Exchange Act that
those charged with violating Section 10(b)have a right
to contribution against joint violators. The Court declined
to find that aider or abetter liability was likewise
implied.
Duty
to Disclose
Through
a series of decisions between 1963 and 1997, the Court
has articulated the duty to disclose material facts
and defined the bounds of that duty, 6
most recently in United States v. 0'Hagan 7
decided in 1997. There, the Court imposed Section 10(b)liability
against an attorney who had received material nonpublic
information about a company with whom his client was
negotiating. The Court ruled that the lawyer violated
Section 10(b)when he traded on that information in-breach
of a duty to his client to maintain the confidentiality
of the information entrusted to him. 0'Hagan was significant
because it was the first time the Court imposed insider
trading liability on an individual with no relationship
to the company that originated the material nonpublic
information.
Ambiguity
Remained
Even
with the rich history of Section 10b-5 cases, Circuit
splits remained prior to the grant of certiorari in
Wharf Holdings. One split arose from the question, specifically
reserved by the Court in a footnote in Ernst & Ernst
v. Hochfelder,8 as to whether
recklessness is sufficient to establish intent under
Rule lOb-5. Another involved the ability of employees
to establish Rule 10b-5 violations in connection with
their employers' issuance or vesting of employee stock
options. Still another was the extent to which Rule
IOb-5 liability could attach to an intermediary in a
securities transaction. In United States v. Naftalin,9
the Court had held that the government could bring suit
against brokers to establish Section 10(b)liability,
rationalizing that a purchase or sale included the "entire
selling process," so the injury could extend to or be
caused by an agent. Lower courts, however, have split
as to whether the rationale in Naftalin applies equally
to private plaintiffs. A related question arises when
a broker acts in unauthorized ways with respect to a
client's account. Some courts, for example, consider
churning (excessive trading to generate fees for the
broker rather than to service a client) to be a Rule
l0b-5 violation so long as the broker exercised discretion
in a customer's account and traded excessively-either
intentionally or recklessly-in light of the customer's
investment objectives.10
Likewise, courts have held that a customer who was sold
a fictitious security had a Rule l0b-5 claim against
the broker.11 In contrast,
the Fourth Circuit has held that a broker who sold his
clients ' securities without authorization and misappropriated
the proceeds could not be liable under Section 10(b).12
Because Wharf Holdings involved determining whether
a security was involved and whether there was an actual
sale, the case appeared to be fertile grounds for resolving
some of these disputes.
The
Wharf Holdings Case
Wharf
Holdings was a company seeking a Hong Kong cable franchise.
In order to secure the franchise it required technical
assistance, for which it recruited United International
Holdings, a Colorado partnership. United agreed to help
Wharf so long as it received a right to purchase a stake
in the company. Wharf agreed, and while the two companies
were negotiating a written agreement between themselves,
United provided Wharf the assistance requested. Hong
Kong awarded the franchise to Wharf and United raised
the funds that Wharf had said would be needed for the
equity stake. At that point, Wharf refused to issue
the securities to United, and United sued, alleging
that, under Section 10(b), Wharf had misled it in connection
with a purchase or sale of a security.
Wharf's
defenses were first, that United never purchased a security,
and second, that any communications about the option
were merely contract negotiations, and that the most
United could claim to have was an unenforceable oral
contract. Wharf relied heavily on Blue Chip Stamps for
its first defense, and on a series of cases for its
second defense in which courts had denied relief to
employees who had not been allowed to exercise stock
options that they had claimed were part of their employment
contracts. As Wharf noted in its brief to the Court,
the Seventh Circuit, 13
the Fourth Circuit,14 and
the Ninth Circuit 15 had
all explicitly rejected these claims, reasoning that
misrepresentations were not in connection with a purchase
or sale if they did not concern "the value of the stock
or the value of the consideration in return for it."16
Each of the courts recognized the danger in allowing
the expectation of receiving a security to be viewed
as a purchase for 10(b) liability purposes.
As
Wharf argued, an "expectation of receipt" sounds very
similar to the "intent to purchase" that the Court had
held to be insufficient to constitute a purchase in
Blue Chip Stamps. In oral argument, in fact, Justice
Breyer posited a hypothesis for United's attorney as
to whether a securities ftaud violation would occur
if a pizza delivery person represented on the phone
that he would deliver stock and pizza to the customer
but showed up at the door with the pizza alone. The
complexity of the issues presented to the Court in Wharf
Holdings, however, was not reflected in the Court's
resolution. The grant of certiorari had been on the
questions of whether the Court of Appeals erred in its
application of Section 10(b) and Rule 10b-5 to an ownership
dispute in which there was no claim of misrepresentation
or nondisclosure of financial information and to a claim
based on the nonperformance of an "alleged unenforceable
oral option."17
The Court's unanimous decision in favor of United held
simply that United had, through its performance, purchased
a security. In a brief opinion by Justice Breyer, the
Court cited only five cases, and most of those for unremarkable
propositions.18 Only Blue
Chip Stamps was mentioned more than once.19
The first page and a half of the opinion is a narrative
of salient facts. Then, when the Court concluded that
United's performance had purchased a security, all of
the remaining issues before the Court dissolved.
The
Court relied on Wharf's concession at the appellate
level that an option is a security, as well as on the
lists of potential securities in the Exchange Act and
in Blue Chip Stamps, to conclude that a purchase of
a security had in fact taken place. That finding is
not remarkable. In a different but related context,
the Court had confronted and resolved a similar question
in the same way. In Dunn v. CFTC,20
the Court was asked to determine that a foreign currency
option was not a "transaction in foreign currency,"
and that in order for a transaction to take place, the
option had to be exercised. The structure of the argument
in Dunn was very similar to Wharfs: Since United never
exercised an option to purchase Wharf's stock, there
was no purchase. In Dunn, the Court described transactions
in foreign currency as encompassing "all transactions
in which the foreign currency is the fungible good whose
fluctuating market price provides the motive for trading."
Dunn further defined an option as "a transaction in
which the buyer purchases from the seller for consideration
the right, but not the obligation, to buy or sell an
agreed amount of a commodity at a set rate at any time
prior to the option's expiration." Those definitions
would apply equally to an option to buy securities.
Because
the Court relied on Wharf's concession, however, its
guidance for lower courts as to when an option is purchased
was only indirect. In Gurwara v.Lyphomed,21
for example, one of the cases on which Wharf had relied
heavily in its briefs to the Court, an employee had
stock options as part of his employment package. He
developed a brain tumor that forced him to go on short-term
disability. His employer offered him the opportunity
to continue on short-term disability and maintain his
stock options or to change positions. He chose to retain
his stock options and continue on short-term disability.
Instead, the employer shifted him to "terminated and
permanently disabled" status and the change in status
occurred prior to his vesting period. Gurwara brought
suit for the recovery of the difference between the
option price and the stock's value. The Seventh Circuit
said that there was no securities law claim because
the only misrepresentation by the employer was as to
the intent to allow the employee "opportunity to purchase
the stock at the described price." In a footnote, the
court specifically declined to address whether Gurwara
might have been successful if he had alleged that the
misrepresentation went to the option's purchase rather
than its exercise.22
Implicit
in the distinction of whether a misrepresentation is
as to the exercise or purchase of an option is the timing
of the misrepresentation. In Tafuri v. Air Products
and Chemicals,23 for example,
the court held that employment agreements containing
stock options can constitute a sale under Rule 10b-5,
because there was more than a breach of contract; there
was also an allegation of "fraud directly relating to
the terms of the stock option plan and the defendants'
intentions to transfer stock to plaintiffs." In contrast,
where there was no fraud in the terms of the stock option
plan and the plaintiff was simply deprived of exercising
the option, he was "a deprived purchaser," not a 10(b)
claimant.24 Likewise, the
jury in Wharf Holdings had determined that Wharf had
intended not to honor the option from the time it agreed
to provide it. In the original grant of certiorari,
it appeared as though the Court would provide guidance
on how to distinguish an intent to sell securities-which
would be actionable-and an oral contract to sell-which
would not (hence Justice Breyer's question about the
offer of pizza with stock). However, once the Court
established that the security at issue was the option
to purchase the Wharf stock, there was no longer an
obstacle to United's recovery. There was no real dispute
that United had, to paraphrase Dunn, given consideration
for the right to buy Wharf's stock. The Court thus characterized
the misrepresentation about the intent to sell securities
as embedded in an actual sale and the Court held that
misrepresentation actionable under Section 10(b)and
consistent with Blue Chip Stamps.
Because
of the posture of its decision, the Court did not need
to decide whether there was an implied requirement under
Section 10(b)for the misrepresentation to relate to
the value of a security. The Court did mention the question--Dbliquely-but
in its comments the Court provides little guidance to
judges and practitioners trying to identify the essential
elements of a Section 10(b)claim. The Court said:
But
even were it the case that the Act covers only misrepresentation
likely to affect the value of securities, Wharf's secret
reservation was such a misrepresentation. . . . Since
Wharf did not intend to honor the option, the option
was unbeknownst to United, valueless.25
The
Court cites only the Restatement 2d of Torts as its
authority. The cited Restatement 2d Section (530, comment
c) states that because a promise implies intent to perform,
the withholding of that intent is fraudulent. The Court
then infers that "[f]or similar reasons" the intent
not to honor the option rendered it valueless.26
One
court has reached a similar conclusion. In Ambassador
Hotel v. Wei-Chuan Investment , 27
the Ninth Circuit held that where there were material
misrepresentations and omissions in soliciting participation
in a joint venture that later issued stock, the misrepresentations
did misstate both the value of the securities and their
risk, and that but for the misrepresentations the plaintiff
would not have invested in the stock. The language in
Gurwara appears contradictory: "[T]he promise may have
misrepresented the value of the option by suggesting
that it would continue to have value, but the company
did not misstate the value of LyphoMed's stock."28
At the end of the opinion the Seventh Circuit suggested:
"Had LyphoMed made the same promises to Gurwaraincluding
a promise to sell shares it valued at over thirty dollars
for eight dollars and change-but overstated the 'real'
value of the shares (which were actually worth only
twelve dollars), Gurwara would have just cause to believe
a misrepresentation 'in connection with' the putative
sale of securities had occurred."29
Is Gurwara distinguishable because the plaintiff's allegations
were as to the exercise of the option rather than the
issuance of it? Or is Gurwara overruled by Wharf Holdings?
The Court did not say.
The
Supreme Court's decision is logical, but because it
did not explicitly address the questions raised, it
is strangely unsatisfying. In viewing the fuzzy lines
being drawn by the lower courts, there appears to be
a compelling need for guidance as to where to draw the
line between a Rule 10b-5 fraud claim and a garden variety
fraud or conversion or breach of contract claim. The
Supreme Court warned in Virginia Bankshares v. Sandberg
30 that it was not the
role of the federal securities laws to supplant state
law claims. Wharf Holdings seemed to offer an opportunity
for clarity: How should judges decide when a misrepresentation
is a violation of the federal securities laws and when
it is only appropriate as a state law claim? When does
an oral agreement need to be enforceable under state
law in order to be within the scope of the securities
laws? The answers, however, remain murky.
The
Road after Wharf Holdings
How
should courts draw the line between federal securities
fraud and state law fraud? The key may lie in the conclusion
in Wharf Holdings that "by providing Wharf with its
services, it actually bought the option that Wharf sold."31
The Southern District of New York has stated the principle
more globally: "A misrepresentation of future intentions
can be a violation of the securities laws only if the
statement or promise constitutes part of the consideration
for the sale or purchase of securities."32
It would be consistent with Wharf Holdings to require
that a plaintiff demonstrate that a misrepresentation
occurred at the time of the purchase or sale and that
misrepresentation deprived the plaintiff of an essential
component of the security bargained for. United's bargaining
to undertake Wharf's project depended on its evaluation
of the worth of the option. By deceiving United from
the beginning, Wharf violated Section 10(b).
Ascertaining
whether a misrepresentation is as to an option or its
underlying security is complicated. The Third Circuit
recently undertook an even more attenuated analysis,
holding (in a case that the Supreme Court declined to
review) that there can be a misrepresentation about
a security that is different altogether than the security
bought or sold.
The
facts that gave rise to Semerenko v. Cendanf 33
grew out of a takeover triangle. American International
Group (AIG) had agreed to acquire all of American Bankers
Insurance Group, Inc. (ABI). Cendant made a competing
offer. At the same time Cendant filed a Schedule 14D-l
with the SEC that materially overstated its earnings.
The rival bids continued for two more months, with Cendant
emerging victorious with a cash and stock deal. Three
weeks later, Cendant announced that it had discovered
potential irregularities in its accounting and that
it would restate its annual and quarterly earnings.
In response, ABI's stock price immediately dropped by
11 percent. Three months later, Cendant made another
public statement, this time saying that its income would
need to be reduced by twice as much as it had originally
announced. A month later, Cendant announced that the
investigation was complete and reported that the cumulative
effect of the errors had been to overstate income by
$500 million. By the day after the disclosure, ABI's
stock had fallen to a level 10 percent below its level
just following the first announcement. Two months later,
Cendant terminated its offer for ABI. In response, ABI's
stock traded at just over half of what it had traded
at immediately after the merger announcement. ABI's
shareholders filed a class action against Cendant, alleging
that its material misrepresentations in connection with
Cendant's financial condition caused harm to them as
ABI shareholders. The district court had dismissed the
complaint. On appeal, the Third Circuit reversed and
remanded the case with instructions for the lower court
to assess the materiality and public dissemination of
Cendant's statements and the reasonableness of a purchaser's
or seller's reliance on those statements. The court
found no reason that a material misrepresentation as
to Cendant's condition could not be "in connection with"
a purchase or sale of ABI stock.
Conclusion
The
Supreme Court has noted that the "Federal courts have
accepted and exercised the principal responsibility
for the continuing elaboration of the scope of the IOb-5
right and the definition of the duties it imposes."34
Over the years, both practitioners and courts have greatly
benefited from the Supreme Court's guidance and clarifications
in Section 10(b)jurisprudence. Elaboration and definition
have been sorely needed on the questions Wharf Holdings
raised. Unfortunately, they still are.
NOTES:
1.
421 US. 723 (1975).
2.
425 US. 185 (1976).
3.
485 US. 224 (1988).
4.
429 US. 810 (1976).
5.
Musick, Peeler & Garrett v. Employers Insurance of Was
au, 508 u.s. 286 (1993); Central Bank of Denver v. First
Interstate Bank of Denver, 511 u.S. 164 (1994) (superseded
in part by the provisions allowing the SEC to establish
aider and abetter liability under 15 US.C. 78(t), as
noted in Trustees of Boston Univ. v. ASM Communs., Inc.,
33F. Supp. 2d 66 (D. Mass. 1998).
6.
SEC v. Capital Gains Research Bureau, Inc., 375 US.
180 (1963); Santa Fe Industries, Inc. v. Green, 430
US. 462 (1977); Chiarella v. United States, 445 US.
222 (1980); Dirks v. S.E.C., 463 US. 646 (1983).
7.
521 U S. 642 (1997).
8.
425 US. 185 (1976).
9.
441 US 768 (1979).
10.
See, e.g., Rizek v. SEC, 215 F.3d 157, 162 (1st Cir.
2000).
11.
Local 875 I.B.T. Pension Fund v. Pollack, 992 F. Supp.
545 (E.D.N.Y.).
12.
S.E.e. v. Zandford, 2001 U.S. App. LEXIS 1071 (4th Cir.
January 26, 2001).
13.
Gurwara v. LyphoMed, Inc., 937 F.2d 380 (7th Cir. 1991).
14.
Hunt v. Robinson, 852 F.2d 786 (4th Cir. 1988).
15.
Stanford v. Humphrey, 894 F.2d 410 (9th Cir. 1990) (listed
in LEXIS as an unpublished opinion; the Petitioners'
Brief cites to 1990 WL 4659 at * I).
16.
Gurwara, supra n.13.
17.
Brief for Petitioners, Filed December 21,2000.
18.
For example, the Court cited Ernst & Ernst v. Hochjelder,
425 u.S. 185 (1976) and Basic Inc. v. Levinson, 485
U.S. 224 (1988) for "other requirements not at issue
here." The other citations were to Threadgill v. Black,
730 F.2d 810, 811-812 (D.C. Cir. 1984) for the proposition
that a secret reservation not to sell when negotiating
a contract to sell securities is within Rule 10b-5.
19.
The Court noted that in Blue Chip Stamps itself the
Court had recognized that an option could be a security
and cited O'Hagan in its discussion of Blue Chip Stamps
as characterizing the Court's concern in Blue Chip Stamps
as not opening the door to the potential abuse and proof
problems attendant on allowing suits by investors who
did not buy or sell.
20.
519 U.S. 465 (1997).
21.
Gurwara, supra n.13.
22.
Id. at n.2.
23.
1997 u.S. Dist. LEXIS 16116 (E.D. Pa. 1997).
24.
Garrett v. Tseng Labs, 1998 U.S. Dist. LEXIS 19418 (E.D.
Pa.).
25.
121 s. Ct. 1776, 1782 (May 12,2001).
26.
Id.
27.
189 F.3d 1017 (1999).
28.
Gurwara, supra n.13 at 382.
29.
Id. at 383.
30.
501 u.S. 1083 (1991).
31.
Garrett, supra n.24.
32.
S.E.C. v. Norton, 1997 U.S. Dist. LEXIS 15167 (S.D.N.Y.
1997).
33.
223 F.3d 165 (3d Cir. 2000) (as amended).
34.
Musick, Peeler & Garrett, supra n.5 at 292.
Copyright
2006. Richard A. Levan. All rights reserved
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