SACKS v. REYNOLDS SECURITIES, INC., 593 F.2d 1234 (D.C. Cir. 1978)

PAULINE SACKS ET AL., APPELLANTS, v. REYNOLDS SECURITIES, INC., ET AL.

No. 77-1775.United States Court of Appeals, District of Columbia Circuit.Argued May 2, 1978.
Decided December 19, 1978.

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S. Churchill Elmore, Washington, D.C., for appellants.

Edward M. Statland, Washington, D.C., with whom Barry A. Zaslav and David W. Buckley, Washington, D.C., were on the brief, for appellees.

Appeal from the United States District Court for the District of Columbia (D.C.Civil 76-2191).

Before TAMM and ROBB, Circuit Judges, and RONALD N. DAVIES, Senior United States District Judge for the District of North Dakota.[*]

Opinion for the court filed by TAMM, Circuit Judge.

TAMM, Circuit Judge:

[1] Appellants, Pauline Sacks, et al.,[1] brought suit in the United States District Court for the District of Columbia to recover compensatory and punitive damages from appellees, Reynolds Securities, Inc. (RSI), et al.,[2] which allegedly resulted from delay in transferring certain of appellants’ stock accounts. The district court (Waddy, J.) dismissed the complaint pursuant to Rule 12(b)(1), Federal Rules of Civil Procedure, for lack of subject matter jurisdiction. We find that, although appellants have invoked federal jurisdiction, the factual allegations in their complaint fail to establish a federal cause of action. Accordingly, we affirm the dismissal of the district court.

I
[2] The facts of this case are, for the most part, uncontroverted. RSI is a securities broker and dealer with offices in the District of Columbia and Virginia. Pauline Sacks, a Virginia resident, is a former RSI account representative and a former customer. In November 1975, Mrs. Sacks left her position at RSI to work as an account representative at Loeb, Rhoades Co. (Loeb), another securities broker. When she resigned, Mrs. Sacks arranged to have her personal accounts and the accounts of some of the customers she serviced transferred from RSI to Loeb. RSI failed to transfer the accounts within the five-day period provided by New York Stock Exchange (NYSE) Rule 412.[3]
Appellants

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claim to have suffered various injuries and damages as a result of this delay.[4] See Sacks v. Reynolds Securities, Inc., 434 F.Supp. 37, 38-39 (D.D.C. 1977).

[3] Appellants attempted to establish federal jurisdiction on two grounds — diversity of citizenship, see 28 U.S.C. § 1332
(1976),[5] and the existence of a question arising under the Securities and Exchange Act of 1934 (Act), 15 U.S.C. §§ 78a–78kk
(1976); see 15 U.S.C. § 78aa (1976).[6] The district court found that because some plaintiffs and defendant Masci were citizens of the same state, diversity jurisdiction was not properly invoked. 434 F.Supp. at 39; see Strawbridge v. Curtiss, 7 U.S. 159, 3 Cranch 267, 2 L.Ed. 435 (1806). Appellants have not appealed that ruling.

[4] Appellants advanced two arguments in support of their contention that the factual allegations in the complaint raise a question under the federal securities laws. First, they asserted that appellees failure to promptly transfer the accounts amounted to a violation of section 10(b) of the Act, 15 U.S.C. § 78j(b) (1976),[7] and of the Securities and Exchange Commission’s (Commission) Rule 10b-5, 17 C.F.R. § 240.10b-5 (1977).[8]

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Second, they argued that a private federal right of action arose from the alleged violation of NYSE Rule 412. The district court rejected both arguments and granted appellees’ motion to dismiss for lack of subject matter jurisdiction. 434 F.Supp. at 38-39.

[5] We agree that neither argument sufficiently establishes a federal cause of action. Subject matter jurisdiction exists, however, when a complaint purports to state a claim under federal law, and the right of recovery will be sustained if the law is given one construction, but defeated if given another. See Wheeldin v. Wheeler, 373 U.S. 647, 649, 83 S.Ct. 1441, 10 L.Ed.2d 605 (1963); Bell v. Hood, 327 U.S. 678, 682-85, 66 S.Ct. 773, 90 L.Ed. 939 (1946). Under these facts, we note that the correct motion for dismissal would have been made pursuant to Rule 12(b)(6), Federal Rules of Civil Procedure, for failure to state a claim upon which relief can be granted.

[6] If material other than the pleadings is considered by the court, a Rule 12(b)(6) motion will be treated as a Rule 56 motion for summary judgment, and both parties must be afforded a reasonable opportunity to submit affidavits and extraneous proofs.[9] Fed.R.Civ.Pro. 12(b). The district court considered extra-pleadings material in this case. 434 F.Supp. at 39. Each side, however, had full and fair opportunity to offer both oral and written evidence in support of their position, and conversion of a Rule 12(b)(6) motion to one for summary judgment would be entirely proper.

[7] The district court’s action under Rule 12(b)(1) does not affect our disposition in this case. “The liberality of the Federal Rules is such that erroneous nomenclature does not prevent the court from recognizing the true nature of a motion.” Owen v. Kronheim, 113 U.S.App.D.C. 81, 83, 304 F.2d 957, 959 (1962) (per curiam). Despite the invocation of Rule 12(b)(1), the memoranda submitted by both parties adequately discuss the existence of a federal cause of action. Accordingly, we uphold the district court’s dismissal on the ground that appellants have failed to establish a federal claim upon which relief can be granted. See Dennis v. Hein, 413 F.Supp. 1137, 1139 (D.S.C. 1976); Davis v. Rio Rancho Estates, Inc., 401 F.Supp. 1045, 1047 (S.D.N.Y. 1975).

II
[8] The antifraud provisions of section 10(b) of the Act and Rule 10b-5 prohibit the use of manipulative or deceptive practices in connection with the purchase or sale of any security. By their express terms, see notes 7 8 supra, a transfer of security ownership is necessary in order for an action to lie under either the statute or the rule. The district court found, and we agree, that appellants failed to meet this requirement.[10] 434 F.Supp. at 39.

[9] In determining what may be considered a purchase or a sale, we look to the meaning of the words within the context of section 10(b). SEC v. National Securities, Inc., 393 U.S. 453, 466, 89 S.Ct. 564, 21 L.Ed.2d 668 (1969). Congress has provided statutory definitions of the terms “purchase” and “sale”: a “purchase . . . include[s] any contract to buy, purchase or otherwise acquire” securities, 15 U.S.C. § 78c(a)(13) (1976); and a “sale . . . include[s] any contract to sell or otherwise dispose of” securities, 15 U.S.C. § 78c(a)(14) (1976). Appellants attempt to show that

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the alleged wrongful conduct of appellees was in connection with the purchase or sale of any security by contending that the transfer of accounts between brokers, pursuant to a contract, comes within the meaning of the statutory phrase “otherwise dispose of,” 15 U.S.C. § 78c(a)(14). Brief for Appellants at 12. The district court correctly rejected this argument. 434 F.Supp. at 39.

[10] In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975), the Supreme Court held that only actual purchasers or sellers of securities may bring a private action for damages under Rule 10b-5. The Court emphasized that “the wording of § 10(b), making fraud in connection with the purchase or sale of a security a violation of the Act, is surely badly strained when construed to provide a cause of action, not to purchasers or sellers of securities, but to the world at large.” Id. at 733 n. 5, 95 S.Ct. at 1924 (emphasis in original).

[11] Consonant with this purpose, lower federal court interpretations of purchase and sale, although encompassing many transactions that bear little overt resemblance to conventional cash sales,[11] require some surrendering of control, change in ownership, or change in the fundamental nature of an investment before a transfer will be deemed within the ambit of Rule 10b-5.[12] None of these elements is present in this case. Appellants never parted with ownership of the securities, nor was such ownership ever vested in any other party. Moreover, appellants made no showing that their control was alienated, or that RSI appropriated their property. Appellants likewise cannot contend that the transfer changed the nature of their investments, stripped the stock of its value, or converted it into a remote right to receive money. Thus, the custodial transfer of stock from one broker to another while legal ownership remains in the same investor cannot be construed as a sale within Rule 10b-5.

[12] Nevertheless, appellants urge us to hold that the transfer comes within the statutory phrase defining sale as a transaction that “otherwise dispose[s] of” securities. See 15 U.S.C. § 78c(a)(14). The Supreme Court’s admonishment in Blue Chip Stamps, along with the plain meaning of the phrase,[13]
compels us to reject a definition of “otherwise dispose of” that disregards the traditional elements of a sale under Rule 10b-5.

[13] Appellants also attempt to bring themselves within the purchase and sale requirement of Rule 10b-5 by arguing that appellees’ failure to timely transfer their accounts “prevented [appellants] from buying or selling securities for long periods of time.” Brief for Appellants at 10. Assuming that the delayed transfer did inhibit trade as appellants contend, this action would still remain without the protective umbrella of Rule 10b-5.

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[14] In Blue Chip Stamps, the Court explained that the actual purchaser or seller requirement barred three principal classes of potential plaintiffs from maintaining an action under Rule 10b-5: first, potential purchasers of shares; second, actual shareholders who refrain from selling; and third, shareholders who claim that fraudulent activity decreased the value of their investment. 421 U.S. at 737-38, 95 S.Ct. 1917. Fear of wholly subjective proof and its capacity for distortion and abuse supports the distinction between actual and potential purchasers and sellers. If potential purchasers and sellers could sue under Rule 10b-5, a plaintiff could maintain an action on the strength of uncorroborated oral testimony about his motivation in not pursuing a profitable, but perhaps hypothetical, course of action. The jury would be forced to assess critical factors guided only by the undocumented, subjective testimony of the plaintiff. Id. at 735, 746-47, 95 S.Ct. 1917. In this context, opportunities to present misrepresentative oral testimony are particularly prevalent and the concomitant dangers particularly grave. Id. at 743, 95 S.Ct. 1917. As Mr. Justice Rehnquist explained:

While much of the development of the law of deceit has been the elimination of artificial barriers to recovery on just claims, we are not the first court to express concern that the inexorable broadening of the class of plaintiffs who may sue in this area of the law will ultimately result in more harm than good.

[15] Id. at 747-48, 95 S.Ct. at 1931.

[16] The decision in Blue Chip Stamps disposes of appellants’ argument. Testimony as to courses of action appellants would have pursued had the transfer been executed promptly is inherently subjective and defies objective corroboration. Appellants attempt, however, to avoid the effect of Blue Chip Stamps by asserting that the failure to transfer forced them to sell stock not held by RSI, and that this sale satisfies the requirements of Rule 10b-5 with regard to the stock held by RSI. See Brief for Appellants at 10. As we previously have explained, Blue Chip Stamps does not permit recovery under Rule 10b-5 when alleged fraud causes an investor to retain ownership of securities. See Halperin v. Edwards Hanly, 430 F.Supp. 121, 124-25 (E.D.N.Y. 1977). This principle, based on the need to prevent speculative recovery, cannot be evaded by the simple allegation that appellants sold something, be it security or nonsecurity, to gain capital needed during the retention period. A contrary holding would substantially diminish the vitality of Blue Chip Stamps.

[17] We conclude that appellants cannot show that they fulfill the statutory purchase and sale requirements necessary to invoke Rule 10b-5. We therefore turn to an evaluation of whether a federal claim may be premised on the violation of NYSE Rule 412.

III
[18] NYSE Rule 412, see note 3 supra, provides a mechanism for the orderly transfer of customers’ accounts between member brokers. The rule provides that, upon written request of a customer to transfer his account, the receiving broker may submit a current statement of the account to the carrying broker. Within five days of receipt of this statement, the carrying broker must verify its accuracy. The receiving broker then, at his option,
may call upon the carrying broker to complete the transfer within five days.

[19] Appellants contend that a private federal cause of action may be predicated on an exchange rule. They assert that appellees’ violation of Rule 412[14]

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therefore renders their claim cognizable in federal court. See
Brief for Appellants at 14-20. We agree that some exchange rules may provide the basis for a federal action, however, we do not believe Rule 412 is one of those rules.

[20] Two lines of lower court cases have discussed the particular circumstances that may give rise to a federal right of action for violation of an exchange rule. The Second Circuit was the first specifically to address the issue. In Colonial Realty Corp. v. Bache Co., 358 F.2d 178 (2d Cir.), cert. denied, 385 U.S. 817, 87 S.Ct. 40, 17 L.Ed.2d 56 (1966), a securities customer brought suit against a NYSE member for losses resulting from the member’s breach of an oral agreement not to require margins in excess of the NYSE member for losses resulting from the member’s breach of an oral agreement not to require margins in excess of the NYSE’s minimum requirements. The plaintiff alleged that this constituted, inter alia, a violation of a NYSE rule requiring brokers to conduct dealings with high standards of commercial honor, consistent with just and equitable principles of trade Id. at 180; see NYSE Const. art. XIV, § 6; NYSE Rule 401. Judge Friendly, writing for the court, stated:

[W]hether the courts are to imply federal civil liability for violation of exchange or dealer association rules by a member cannot be determined on [a] simplistic all-or-nothing basis . . . rather, the court must look to the nature of the particular rule and its place in the regulatory scheme, with the party urging the implication of a federal liability carrying a considerably heavier burden of persuasion than when violation is of the statute or an SEC regulation.

[21] 358 F.2d at 182. According to the Second Circuit, the case for imposition of private civil liability is the strongest when the rule is a “substitute for regulation by the SEC,” and “imposes an explicit [legal] duty unknown to the common law.” Id.

[22] The Seventh Circuit has formulated different standards. I Buttrey v. Merrill Lynch, Pierce, Fenner Smith, Inc., 410 F.2d 135 (7th Cir.), cert. denied, 396 U.S. 838, 90 S.Ct. 98, 24 L.Ed.2d 88 (1969), the trustee in bankruptcy for a securities corporation brought suit against a national brokerage firm that allowed the president of the bankrupt corporation to maintain cash and margin accounts for speculative purposes without inquiring into the source of his funds or discerning his financial responsibility. The court held that a violation of NYSE Rule 405, the “know-your-customer” rule,[15] provided the basis for a federal action. Id. at 142-43. The Buttrey court failed to determine whether Rule 405 imposed a duty unknown at common law or could be viewed as a substitute for Commission regulation. The court applied instead its own two-prong analysis. The first and “touchstone” determination, according to the Seventh Circuit, is whether the particular rule is designed ” `for the direct protection of investors.'” Id. at 142 (quoting

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Lowenfels, Implied Liabilities Based Upon Stock Exchange Rules,
66 Colum.L.Rev. 12, 29 (1966)). If so, the court then must determine whether the conduct involves more than mere errors of judgment or negligence and is “tantamount to fraud.” Id. at 143.

[23] As both appellants and appellees emphasize, see Brief for Appellants at 14-20; Brief for Appellees at 14-20, conflicting criteria emerge from the Colonial Realty and Buttrey cases Colonial Realty articulates a substitution test, which asks whether an exchange rule stands in place of a federal statute or rule. Buttrey emphasizes a public benefit standard, which focuses upon whether the exchange rule is designed for protection of the public. Appellants urge that we judge this case under th Buttrey test, see Brief for Appellants at 19; and appellees maintain that we should apply the Colonial Realty standard see Brief for Appellees at 16-17.

[24] Although we note the strong criticism levied against th Buttrey test by courts and commentators,[16] we need not adopt one test to the exclusion of the other. We are guided instead by the Supreme Court’s recent decision, Piper v. Chris-Craft Industries, Inc., 430 U.S. 1, 24-42, 97 S.Ct. 926, 51 L.Ed.2d 124 (1977),[17] which specifically discusses the implication of private rights of action under the Act. The standards applied in that case embody elements of both th Colonial Realty and Buttrey tests, and we rely on the lower court cases only to the extent that they aid our application of the Supreme Court’s analysis to this action.

[25] In Piper, the Court held that a defeated tender offeror cannot maintain a suit under section 14(e) of the Act, 15 U.S.C. § 78n(e) (1976). The Court’s refusal to imply a private action was premised upon an evaluation of the four factors set out i Cort v. Ash, 422 U.S. 66, 95 S.Ct. 2080, 45 L.Ed.2d 26 (1975):

First, is the plaintiff “one of the class for whose especial benefit the statute was enacted” . . . that is, does the statute create a federal right in favor of the plaintiff? Second, is there any indication of legislative intent, explicit or implicit, either to create such a remedy or to deny one? Third, is it consistent with the underlying purposes of the legislative scheme to imply such a remedy for the plaintiff? And finally, is the cause of action one traditionally relegated to state law . . ..

[26] Id. at 78, 95 S.Ct. at 2088 (citations omitted) (emphasis in original).

[27] These factors are not intended as inflexible hurdles to be surmounted identically in each case. Indeed, the Court never refers to the factors collectively as “tests,” nor does it mandate a wooden application of them. Rather, the factors provide general, analytical guidelines to be used in evaluating the appropriateness of implying a cause of action in a wide range of situations. Thus, although both Piper and Cort deal specifically with the implication of a private action from a federal statute, we believe the concerns of that inquiry, as reflected in the four factors, are equally pertinent here. We therefore adopt the Cort criteria, adapt them to an analysis of Rule 412, and proceed along the lines suggested by the Supreme Court.

[28] First, we look to Rule 412 and consider whether it was adopted for the especial benefit of the investor. Although the final paragraph of the rule, see note 3 supra, manifests concern for the customer, that concern appears to have been of secondary importance. Appellants’ own evidence demonstrates that promulgation of the rule was impelled primarily by a desire

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to protect the receiving broker. The NYSE, in a letter soliciting Commission comment on Rule 412 before its enactment, stated that the rule was

designed to establish a system for financial protection of both the customer and the receiving firm in the event that the transfer of a customer’s account from one firm to another is unduly delayed. At present, such delays create a situation where the receiving firm may incur a risk in executing trades for the customer whose account is being transferred because it may not be possible to establish that securities sold or funds needed for purchase are on hand with the carrying broker.
The proposed rule . . . would permit the receiving firm to make transactions for the customer with financial protection.

[29] Joint Appendix (J.A.) at 103 (emphasis added).

[30] Further, Rule 412 vests no rights in the customer. By its terms, the five-day rule is invoked completely at the option of the broker. There is no provision permitting the investor to compel implementation of the procedure, or to enforce compliance once the broker has invoked the rule. Although the NYSE intended some benefit to flow to the customer, we cannot conclude that Rule 412 exists for the primary, or especial, benefit of the investor. See Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 477-78, 97 S.Ct. 1292, 51 L.Ed.2d 480 (1977); Cort v. Ash, 422 U.S. at 80-82, 95 S.Ct. 2080.

[31] Next, we determine whether implication of a new cause of action is consistent with the structure and purposes of the Act. The Act is designed specifically for “the American people trading on . . . exchanges,” 78 Cong.Rec. 2270 (1934) (remarks of Sen. Fletcher), and protection of the investing public is of primary concern. See, e. g., S.Rep. No. 792, 73d Cong., 2d Sess. 4 (1934); 78 Cong.Rec. 7921-22 (remarks of Rep. Maples). Congress anticipated three modes of securities control to achieve this goal: statutory provisions, Commission regulations, and exchange rules. Under this scheme, exchanges are imbued with quasi-governmental power and transformed from private trade associations into organizations sharing responsibility for maintenance of an orderly and fair securities market. In establishing this tripartite system, Congress specifically contemplated active self-regulation of the industry and the aggressive promulgation of exchange rules. See Silver v. New York Stock Exchange, 373 U.S. 341, 351-52, 83 S.Ct. 1246, 10 L.Ed.2d 389 (1963); S.Rep. No. 1455, 75th Cong., 3d Sess. 3-5 (1938); H.Rep. No. 2307, 75th Cong., 3d Sess. 4-6 (1938); H.Rep. No. 1383, 73d Cong., 2d Sess. 5 (1934).

[32] Exchange rules are basically of two types. Some rules are merely “housekeeping devices,” concerned with internal exchange organization and uniformity of procedure.[18] Although these rules indirectly benefit the customer, they are concerned with matters primarily of interest to exchange members. In contrast, other rules are promulgated directly for the protection of the investing public and regulate the kind of fraudulent conduct to which the Act is specifically directed.[19] These rules insure the integrity of the securities market, not simply the efficient functioning of exchanges. They often serve as substitutes for Commission regulations and are vital to effective securities control. Implication of a cause of action from them is not only permissible, but may be necessary to the success of the tripartite system. See generally J. I. Case Co. v. Borak, 377 U.S. 426, 84 S.Ct. 1555, 12 L.Ed.2d 423 (1964).

[33] Rules intended as substitutes for Commission regulation, although not easily

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categorized, may be: (1) those whose promulgation caused termination of Commission rulemaking proceedings, see Colonial Realty Corp. v. Bache Co., 358 F.2d at 182 n. 4; (2) those that the Commission is explicitly authorized, under section 19(b) of the Act, 15 U.S.C. § 78s(b) (1976), to modify if inadequate; (3) those adopted pursuant to Commission regulation see 17 C.F.R. § 240.11a-1(7) (1977); 17 C.F.R. § 240.15c31(b)(2) (1977); or (4) those enacted at the suggestion of the Commission, see Independent Broker-Dealers’ Trade Association v. SEC, 142 U.S.App.D.C. 384, 393-394, 442 F.2d 132, 141-42, cert. denied, 404 U.S. 828, 92 S.Ct. 63, 30 L.Ed.2d 57 (1971).

[34] Appellants have failed to demonstrate that Rule 412 was intended to serve as a substitute for Commission regulation. Indeed, their evidence tends to prove the contrary. The NYSE provided initial motivation for the rule, and failed to adopt a suggested Commission modification.[20] See J.A. at 102-03. Rule 412 is more akin to a “housekeeping rule,” one that suggests a uniform procedure for the orderly transfer of accounts, but one that cannot be deemed sufficiently related to the purposes of the Act to warrant implication of a federal claim. Were we to imply federal liability for all exchange rules, even those of a housekeeping nature, we would inhibit the vigorous promulgation of rules which is crucial to the success of the self-regulatory system. Emasculation of this carefully constructed system would thwart congressional intent. We therefore find that implication of a private federal right of action for violation of Rule 412 cannot be considered consistent with the structure and purposes of the Act.

[35] Finally, we note that appellants have a sufficient remedy at common law for either breach of contract or tort, two areas “traditionally relegated to state law.” Cort v. Ash, 422 U.S. at 78, 95 S.Ct. 2080. An action brought under section 27 of the Act, 15 U.S.C. § 78aa, can be heard only in a federal court. Expansive implication of federal liability would displace adequate common law actions and undermine a state court’s power to apply traditional remedies. The advantageous arbitration procedure, currently existing between customers and brokers, also would be effectively undermined. See Starkman v. Seroussi, 377 F.Supp. 518 (S.D.N.Y. 1974). When existing remedies are sufficient, we need not reach to imply additional means of achieving congressional policy, and we decline to do so now. See Santa Fe Industries, Inc. v. Green, 430 U.S. at 477-78, 97 S.Ct. 1292; Colonial Realty Corp. v. Bache Co., 358 F.2d at 182 Baird v. Franklin, 141 F.2d 238, 244-45 (2d Cir.) (Clark, J., dissenting in part from the opinion, and from the judgment) cert. denied, 323 U.S. 737, 65 S.Ct. 38, 89 L.Ed. 591 (1944).

IV
[36] We conclude that appellants have failed to allege facts sufficient to state a federal claim. For the foregoing reasons, their complaint is not cognizable under Rule 10b-5, and NYSE Rule 412 does not provide a private federal right of action. In so ruling, however, we expressly do not preclude the possibility of state court relief, and we remind appellants of this alternative.[21]

[37] Affirmed.

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