California Court of Appeals, First District, First Division
November 13, 2014
OVERSTOCK.COM, INC. et al., Plaintiffs and Appellants,
GOLDMAN SACHS & CO. et al., Defendants and Respondents.
[As modified Nov. 25, 2014.]
[CERTIFIED FOR PARTIAL PUBLICATION[*]]
San Francisco County and City Superior Court Super. Ct. No. CGC-07-460147 The Honorable John E. Munter Judge
[Copyrighted Material Omitted]
[Copyrighted Material Omitted]
Stein & Lubin, Lubin Olson Niewiadomski, Theodore A. Griffinger, Jr., Ellen A. Cirangle, Jonathan E. Sommer and Myron Moskovitz for Plaintiffs and Appellants.
Morgan, Lewis & Bockius and Joseph Edward Floren for Defendants and Respondents Goldman Sachs & Co. and Goldman Sachs Execution & Clearing, L.P.
O'Melveny & Myers, Matthew David Powers, Andrew J. Frackman and Abby F. Rudzin for Defendants and Respondents Merrill Lynch, Pierce Fenner & Smith, Inc., and Merrill Lynch Professional Clearing Corporation.
Often, it is the federal courts, applying federal law, that wrestle with claims of cross-state securities fraud involving a nationally-listed stock. Here, plaintiffs of various states allege defendants, securities firms headquartered on the East Coast, violated California and New Jersey law through their involvement in massive naked short selling of Overstock .com, Inc. shares. The trial court sustained demurrers to plaintiffs’ New Jersey Racketeer Influenced and Corrupt Organizations Act (RICO; 18 U.S.C. § 1961 et seq.) claim without leave to amend and subsequently granted summary judgment on plaintiffs’ California market manipulation claims.
We affirm the dismissal of the belatedly raised New Jersey RICO claim. We also affirm the summary judgment as to three of the four defendants, but reverse as to Merrill Lynch Professional Clearing Corporation. The evidence, although slight, raises a triable issue this firm effected a series of transactions in California and did so for the purpose of inducing others to trade in the manipulated stock. In reaching this disposition, we conclude Corporations Code section 25400, subdivision (b), reaches not only beneficial sellers and buyers of stock, but also can reach firms that execute, clear and settle trades. However, as we further explain, such firms face liability in a private action for damages only if they engage in conduct beyond aiding and abetting securities fraud, such that they are a primary actor in the manipulative trading.
II. Factual and Procedural Background
Plaintiffs are Overstock.Com, Inc., an online retailer, and seven of its investors. In their Fourth Amended Complaint, plaintiffs alleged defendants intentionally depressed the price of Overstock stock by effecting “naked short sales”-that is, sales of shares the brokerage houses and their clients never actually owned or borrowed. This practice, and specifically perpetuating the naked short positions by means of exotic trading schemes, allegedly increased the apparent supply of the stock, lead to a “pile on” of further short sales, and thereby decreased the stock’s value-including the value of shares plaintiffs sold. Plaintiffs claimed defendants’ conduct violated Corporations Code sections 25400 and 25500,  Business and Professions Code sections 17200 and 17500,  and New Jersey’s RICO statute (N.J. Stat. 2C:41-2(c.-d.). To put plaintiffs’ allegations and the nature of the evidence proffered during the summary judgment proceedings in context, we start with an overview of how securities transactions unfold, naked short sales, and the Security and Exchange Commission’s (SEC) efforts to prohibit abusive short selling.
A. Steps in a Securities Transaction
Securities transactions involve a number of steps. These include, among others, executing a trade order, clearing a trade, and settling a trade. (See generally Minnerop, Clearing Arrangements (2003) 58 Bus. Law. 917, 919 (Minnerop); 17 C.F.R. § 240.11a2–2(T) (2014).)
Execution is the process of reaching agreement on the terms of a transaction. This includes, for a buyer, not only finding the best price, but also choosing the right seller given the size of the order, the nature of the security
being traded, and the costs and fees associated with the trade. (See Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc. (3d Cir. 1998) 135 F.3d 266, 270 & fn. 2.) Execution can be accomplished manually or automatically by computer. (See Domestic Securities, Inc. v. S.E.C. (D.C. Cir. 2003) 357 U.S. App.D.C. 118 [333 F.3d 239, 243] [in the NASDAQ marketplace, buyers and sellers can automatically execute trades against quoted prices].)
Upon execution, “the actual transaction has only begun. Thereafter, several steps must be taken to complete the course of dealing. These steps are typically the responsibility of a clearing agency” associated with a given stock exchange. (Bradford Nat. Clearing Corp. v. Securities and Exchange Commission (D.C. Cir. 1978) 191 U.S. App.D.C. 383 [590 F.2d 1085, 1091, fn. 2] (Bradford).) “The clearing agency has three functions. First, the agency ‘compares’ submissions of the seller’s broker with those of the buyer’s to make sure that there is a common understanding of the terms of the trade. Following this process, the resulting ‘compared trade’ is ‘cleared.’ Most simply, this amounts to the clearing agency advising the selling and buying brokers, respectively, of their delivery and payment obligations.” (Ibid.)
“The final, ‘settlement, ’ stage in the process involves the delivery of securities certificates to the purchasing broker and the payment of money to the selling broker. Modernization of this task has led to storage of most stock certificates in a depository affiliated with the clearing agency. Thus, ‘delivery’ amounts to a bookkeeping entry that removes the security from one account and places it in another.” (Bradford, supra, 590 F.2d at p. 1091, fn. 2; see Poser, The Stock Exchanges of the United States and Europe: Automation, Globalization, and Consolidation (2001) 22 U. Pa. J. Int’l Econ. L. 497, 514.)
Some firms, known as clearing firms, specialize in postexecution, “back office” clearing and settling of trades in conjunction with the appropriate clearing agency, in which the clearing firm is a “participant.” Such firms may provide these services to “introducing” brokerage firms on a fee-for-service basis. (Dillon v. Militano (S.D.N.Y. 1990) 731 F.Supp. 634, 636–637; Branson, Nibbling at the Edges-Regulation of Short Selling: Policing Fails to Deliver and Restoration of an Uptick Rule (2009) 65 Bus. Law. 67, 91; see 15 U.S.C. § 78c(a)(23)–(24) [defining clearing agency and participant].) Their services tend to include extending credit in margin accounts; providing written confirmation of executed orders to customers; receiving or delivering
funds or securities from or to customers; maintaining books and records that reflect transactions, including rendering monthly or periodic statements of account to customers; providing custody of funds and securities in customer accounts; clearing and settling transactions effected in customer accounts. (Minnerop, supra, 58 Bus. Law. at p. 919.)
B. The Parties
Overstock sold shares in May and December 2006 through public offerings arranged by a San Francisco firm, W.R. Hambrecht Co. The other seven plaintiffs are individuals who sold Overstock shares in 2004, 2005, and 2006.
There are four defendants, two related “Goldman” entities and two related “Merrill” entities. Their ordinary activities can be understood with reference to the stages in a securities transaction discussed above.
Goldman, Sachs & Co. (hereinafter Goldman Brokerage) executes, clears, and settles securities transactions. Its operations are centered in New Jersey and New York. In some cases, Goldman Brokerage performs execution, clearance, and settlement for a single transaction. In other cases, its clients execute elsewhere and Goldman Brokerage provides only clearance and settlement services. Goldman Brokerage also houses a securities lending department which procures and supplies stock associated with certain transactions, including, as explained below, short sales. In this case, Goldman Brokerage’s execution of certain client trades and its own purchase of certain securities in connection with its securities lending business are primarily at issue.
Goldman Sachs Execution & Clearing, L.R (hereinafter Goldman Clearing) likewise executes, clears, and settles securities transactions. It is an SEC-registered broker-dealer and a member of the National Securities Clearing Corporation. It is headquartered in New Jersey and has significant operations there, and in New York and Chicago. It offers its clearing services to other SEC-registered broker-dealers, hedge funds, and institutions. In this case, Goldman Clearing’s clearing and settlement services are primarily at issue.
Merrill Lynch, Pierce Fenner & Smith Inc. (hereinafter Merrill Brokerage), like its Goldman Brokerage counterpart, provides various investment services and runs a stock lending department that borrows and lends securities. This department conducts its borrowing, lending, and related transactional activity in New York and Illinois. As with Goldman Brokerage, it is Merrill Brokerage’s trade execution and lending operations connected to naked short sales that are primarily at issue.
Merrill Lynch Professional Clearing Corp. (hereinafter Merrill Clearing), like its Goldman Clearing counterpart, provides various investment services and is an SEC-registered broker-dealer and a member of the National Securities Clearing Corporation. Merrill Clearing is a wholly-owned subsidiary of Merrill Brokerage. It is headquartered in New York and has a substantial presence in New Jersey and Illinois. It also has a San Francisco customer service office. Merrill Clearing offers only limited execution services, and most Merrill Clearing clients execute their own trades. Merrill Clearing uses Merrill Brokerage to procure stocks needed to settle (or close out) a transaction. As with Goldman Clearing, Merrill Clearing’s clearing and settlement operations are primarily at issue here.
C. "Naked” Short Selling
In a short sale, the seller sells stock the seller does not own. It is a bet against the stock. In an ordinary short sale, the seller borrows stock from a lender (such as a brokerage firm’s lending department), sells this stock to a buyer at the going price, and then purchases replacement stockhopefully at a lower priceto return to the lender. Lenders typically charge a borrow fee for lending shares to sell short. The seller profits if the stock price falls enough to cover all costs and fees associated with the sale, including borrowing the stock. Otherwise, if the stock price rises or does not fall enough to cover the costs and fees, the short seller suffers a loss. If the short seller never delivers the stock to the buyer, a “fail to deliver” occurs. The sale nonetheless appears on the seller’s and buyer’s books, and is then termed a “naked” short sale.
Stocks that are “hard-to-borrow” (also called “negative rebate” stocks) can command high borrow fees, given their scarcity and desirability for short selling. During the 2005 and 2006 timeframe, Overstock was a particularly hard-to-borrow security, and shares of the company commanded a negative rebate of up to 35 percent of its value on an annualized basis. Thus, any trader hoping to profit from selling short would ordinarily need to recoup the borrow fees through a significant decline in the price of the security. In naked short sales, however, there is no borrowing and thus no borrow fee, and it is significantly easier to make a profit.
Short selling, itself, is lawful. (GFL Advantage Fund, Ltd. v. Colkitt (3d Cir. 2001) 272 F.3d 189, 207 (GFL). Even short sales resulting in fails to deliver are not necessarily nefarious and occasionally occur in the regular press of market activity. (Cohen v. Stevanovich (S.D.N.Y. 2010) 722 F.Supp.2d 416, 424–425 (Cohen) [“allegations of failures to deliver, without more, are insufficient to state a claim for market manipulation”].) In Cohen, the alleged naked short selling activity was untethered to any “distort[tion to] the price”
of the stock at issue and so did not constitute “ ‘willful conduct designed to deceive or defraud investors’ with regard to market activity.” (Id. at p. 425.) Similarly, in Sullivan & Long, Inc. v. Scattered Corp. (7th Cir. 1995) 47 F.3d 857, 864, the short selling of more shares than could be obtained could not be viewed as manipulative when, under the peculiar circumstances, the selling drove the stock down to the correct market price, given the terms of a restructuring agreement.
But there are situations in which intentional naked short selling can be employed to manipulate the market. (See Cohen, supra, 722 F.Supp.2d at pp. 425, 424 [“fails to deliver can occur for a variety of legitimate reasons, and flexibility is necessary in order to ensure an orderly market and to facilitate liquidity, ” but some fails may be “a potential problem” when “willfully combined with something more to create a false impression of how market participants value a security”]; Hyperdynamics Corp. v. Southridge Capital Management, LLC (2010) 305 Ga.App. 283, 287, fn. 8 [699 S.E.2d 456] [noting naked short sales could “depress the price of a target company’s shares”]; In re Adler, Coleman Clearing Corp. (S.D.N.Y. 2007) 469 F.Supp.2d 112, 126 [“The Court is persuaded that the evidence sufficiently establishes that DiPrimo’s conduct, under Gurian’s control, amounted to concerted, naked short selling whose purpose was to drive down the price of Hanover House Stocks”]; Regulation SHO Proposed Release, S.E.C. Release No. 34–48709, 68 Fed.Reg. 62972, 62975 (Nov. 6, 2003); Amendments to Regulation SHO, 71 Fed. Reg. 41710, 41712 (July 21, 2006) [“large and persistent fails to deliver... can be indicative of manipulative naked short selling, which could be used as a tool to drive down a company's stock price. The perception of such manipulative conduct also may undermine the confidence of investors.”].) Thus, in GFL, supra, 272 F.3d at page 208, the Third Circuit suggested naked short selling would be actionable if it caused an “artificial depression” in price, by, for instance, “injection of inaccurate information” or “creation of a false impression of supply and demand, ” such as by means of “ ‘matched buy and sell orders’ to ‘create a misleading appearance of active trading.’ ”
D. Regulation SHO: Regulating Abusive Short Sales
The SEC began to focus on naked short selling and its potential abuses in 2003 and 2004. (See Walker & Forbes, SEC Enforcement Actions and Issuer Litigation in the Context of a "Short Attack” (2013) 68 Bus. Law. 687, 691 [relating history of SEC regulation of short sales, particularly through Regulation SHO].) It recognized manipulative short selling could pose problems for the markets and took “steps to restrict or prohibit it in various situations. See Regulation SHO Proposed Release, SEC Rel. No. 34–48709, 68 Fed.Reg. 62972, 62975–78 (Nov. 6, 2003); Short Sales, SEC Rel. No. 34–50103, 69
Fed.Reg. 48008, 48009 (Aug. 6, 2004); Amendments to Regulation SHO, SEC Rel. No. 34–56212, 72 Fed.Reg. 45544 (Aug. 7, 2007); Emergency Order, SEC Rel. No. 34–58166 (July 15, 2008).” (Pet Quarters, Inc. v. Depository Trust and Clearing Corp. (8th Cir. 2009) 559 F.3d 772, 776, fn. 3.)
In its 2003 proposal to regulate, the SEC warned: “Naked short selling can have a number of negative effects on the market, particularly when the fails to deliver persist for an extended period of time and result in a significantly large unfulfilled delivery obligation at the clearing agency where trades are settled. At times, the amount of fails to deliver may be greater than the total public float. In effect the naked short seller unilaterally converts a securities contract (which should settle in three days after the trade date) into an undated futures-type contract, which the buyer might not have agreed to or that would have been priced differently. The seller’s failure to deliver securities may also adversely affect certain rights of the buyer, such as the right to vote. More significantly, naked short sellers enjoy greater leverage than if they were required to borrow securities and deliver within a reasonable time period, and they may use this additional leverage to engage in trading activities that deliberately depress the price of a security.” (Regulation SHO Proposed Release, S.E.C. Release No. 34–48709, 68 Fed.Reg. 62972, 62975 (Nov. 6, 2003), fn. omitted.)
The following year, in 2004, the SEC adopted Regulation SHO which imposes two requirements-“locate” and “delivery”aimed at curtailing intentional naked short sales. (Electronic Trading Group, LLC v. Banc of America Securities LLC (2d Cir. 2009) 588 F.3d 128, 135–136 (Electronic Trading), citing 17 C.F.R. § 242.203 (2014).) “The regulation first imposes “a ‘locate’ requirement.... See 17 C.F.R. § 242.203(b)(1)(i)–(iii) (‘A broker or dealer may not accept a short sale order in an equity security from another person... unless the broker or dealer has: (i) [b]orrowed the security, or entered into a bona-fide arrangement to borrow the security; or (ii) [r]easonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due....’). Regulation SHO also imposes a ‘delivery’ requirement.... See 17 C.F.R. § 242.203(b)(3) (with certain enumerated exceptions, ‘[i]f a participant of a registered clearing agency has a fail to deliver position... in a threshold security for thirteen consecutive settlement days, the participant shall immediately thereafter close out the fail to deliver position by purchasing securities of like kind and quantity’).” (Electronic Trading, supra, 588 F.3d at pp. 135–136.)
In other words, Regulation SHO requires brokers to
have a reasonable belief they can locate the shares to be sold short and
requires participantsi.e., clearing firmsto “deliver” shares on a timely basis. Bona fide
market makers’ trades, however, are exempt from the locate requirement. (17 C.F.R. § 242.203(b)(2)(iii) (2014).) Thus, market makers and their brokers, when engaged in legitimate trading, can commence a short sale without first worrying about whether they have ready access to the shares. The delivery requirement, in turn, only applies to “threshold securities, ” meaning certain listed securities already suffering numerous fails to deliver (17 C.F.R. § 242.203(c)(6) (2014)), and clearing firms can “reasonably” delegate the obligation to deliver shares to bona fide market maker clients. (17 C.F.R. 242.203(b)(3)(vi) (2014); see Short Sales, S.E.C. Release No. 34-50103, supra, 2004 WL 1697019 at pp. *1, *16, *44.) Overstock, at all relevant times, was a threshold security.
E. SEC and Exchange Actions Against Market
Maker Clients of Defendants
Following the enactment of Regulation SHO, the SEC and several exchanges brought enforcement actions against a number of market participants for violating locate and delivery requirements, including two market maker clients of defendants, Steven Hazan and Scott Arenstein. While Hazan and Arenstein purported to be bona fide market makers, in fact, they were not.
Hazan, a New York resident, was sanctioned in an August 2009, SEC order for violating both locate and delivery requirements. (In the Matter of Hazan Capital Management, LLC, S.E.C. Release No. 60441 (Aug. 5, 2009) 2009 WL 2392842.) Among numerous other findings, the Commission found Hazan was not acting as a bona fide market maker and violated Regulation SHO when executing riskless and profitable “reverse conversion” trades and related “reset” trades. (2009 WL 2392842 at pp. *l-*2.)
In the reverse conversion trades, Hazan would sell short a hard-to-borrow threshold security to a counterparty. He would also buy from that counterparty a call option in the security and sell to that counterparty a put option in the security, such that he would eliminate all market risk associated with the short sale. Because all three components of the reverse conversion were priced interdependently, Hazan was assured an “agreed-upon” profit. (In the Matter of Hazan Capital Management, supra, 2009 WL 2392842 at p. *3.) Meanwhile, the counterpartyfor instance, a brokerage firm such as Goldman Brokerage or Merrill Brokeragewas willing to pay this price to Hazan to “obtain” on its books shares of the hard-to-borrow threshold security, which it could lend for a profit until the put and call options expired. (Ibid.) "Consequently” explained the SEC, “prime brokers created the demand for the reverse conversion to create inventory for stock loans on hard to borrow securities and options market makers like [Hazan] fed this demand." (Id. at p. *1.)
Hazan employed additional nefarious trading practices to insure the short sale portions of the reverse conversions remained “naked” over time. Specifically, when alerted by clearing firms of his Regulation SHO obligation to deliver shares so settlement could occur, Hazan engaged in “sham reset transactions” that only gave the appearance of delivery, while actually perpetuating his undelivered short positions. (In the Matter of Hazan Capital Management, supra. 2009 WL 2392842 at p. *2.) Hazan would “obtain” the necessary shares for delivery by buying from another market maker who was also selling short and who similarly never intended to deliver shares to Hazan. (Id. at p. *3.) Meanwhile, Hazan would “pair” or hedge his new “purchase” with option trades, creating what the SEC called “married puts” or “buy-writes, ” sometimes using “FLEX options." (Id. at pp.
*2, *4.) Even though Hazan’s clearing firm-a firm such as Goldman Clearing or Merrill Clearingwould not receive actual delivery of the shares, it nevertheless would record the transactions as generating a “close out” and a new long position. (Id. at p. *4.) There was also an appearance of delivery of the “purchased” shares back to the other market maker (who had never delivered them in the first place). (Ibid.) In the end, Hazan would reestablish his previous short position, still naked, while succeeding in having the Regulation SHO 13-day delivery clock, in the clearing firms’ eyes, “reset” to day one. As settlement dates approached again and again, Hazan would repeat this process until the options on the original reverse conversion trade “expired or [were] assigned, thus” finally “closing out the short position and eliminating the synthetic long position that the short position had hedged." (Id. at p. *5.)
Hazan pocketed over $3 million through his trading strategy. The SEC ordered him to disgorge it, enjoined him from further violations of Regulation SHO, censured his organization and barred him from association with any
broker or dealer, with the right to reapply for association after five years. The New York Stock Exchange (NYSE) issued a similar order regarding the same conduct. (Hearing Board Decisions NYSE AMEX LLC 09-AMEX-21 and 09-AMEX-22 (Aug. 4, 2009); NYSE ARCA, Inc. 09-ARCA-5 and 09-ARCA-6 (Aug. 4, 2009).) NYSE Amex and NYSE Area imposed $500, 000 in penalties, and barred Hazan from membership and association with any member for seven years.
Arenstein was sanctioned in a June 2007 order issued by the American Stock Exchange (ASE). (In the Matter of Scott H. Arenstein (Jul. 20, 2007, AMEX case No. 07-71.) He admitted engaging in the same reverse conversions and sham reset transactions as Hazan and made at least $1.4 million from his unlawful trades. The ASE ordered disgorgement, assessed a $3.6 million fine, and barred him from membership and associating with any member for five years.
In 2011, Keystone, another purported market maker and a Goldman Clearing client, was sanctioned by the NASDAQ for engaging in the same kind of sham reset transactions. “[O]n the very same day [Keystone would be] ‘bought-in’ by Keystone’s clearing firm, ” Keystone, on over 50 occasions would “negate the clearing firm’s buy-in and contradict guidance provided by the Securities and Exchange commission requiring that [it] be a net purchaser of the open fail position in the security by selling near equivalent number of shares.” Keystone was required to disgorge $2 million in profits, pay a $500, 000 fine, and suffer a censure and “three-month suspension in a supervisory capacity.” (John C. Pickford, Enforcement Counsel, NASDAQ OMX PHLX, Notice of Disciplinary Action Against Keystone Trading Partners to Members, Member Organizations, Participants and Participant Organizations regarding FINRA Matter No. 2010022926 and Enforcement No. 2011-04, July 7, 2011.)
In short, there is no question Hazan, Arenstein and Keystone, purported market maker clients of defendants, engaged in abusive naked short selling and flagrant violations of the federal securities laws.
The SEC has continued to target abusive naked short selling, recently pursuing not only traders, but the firms that enabled their manipulative trading. The SEC pulled no punches in this regard in In the Matter of OptionsXpress, Inc., in which it ruled the brokerage firm violated Regulation SHO in connection with sham reset transactions, similar to those just discussed, designed to avoid delivery: “Because [the firm] knew... shares that were the subject of [a] buy were shares for [it’s client’s] account that were the subject of simultaneous deep-in-the-money calls, which would be exercised and assigned so that no shares were delivered to [the clearing agency],
optionsXpress engaged in a sham close-out of its fail to deliver position.... [¶]... OptionsXpress did not close out its... fail to deliver positions by executing consecutive buy-write transactions and willfully violated Rules 204 and 204T. [¶]... [¶]... Feldman [the client] did not mislead those he dealt with at various clearing brokers who knew, directly or indirectly, that he was not going to the deliver securities if his calls were exercised and assigned; however, the market as a whole did not have this knowledge. See Wharf (Holdings) Ltd. v. United Int'l Holdings, Inc., 532 U.S. 588[, 596 [149 L.Ed.2d 845. 121 S.Ct. 1776]] (2001) (‘To sell an option while secretly intending not to permit the option’s exercise is misleading, because a buyer normally presumes good faith.’); Walling v. Beverly Enter., 476 F.2d 393, 396 (9th Cir. 1973) (“Entering into a contract of sale with the secret reservation not to fully perform it is fraud cognizable under § 10(b).”); 37 Am. Jur. 2d Fraud and Deceit § 41 (2013) (‘[F]raud may consist of … the creation of a false impression by words or acts.. . .')." (In the Matter of OptionsXpress, Inc., S.E.C. Release No. 490 (June 7, 2013) 2013 WL 2471113, pp. *72, *75. italics added.)
F. The Instant Lawsuit
1. Pleadings and Demurrer to New Jersey RICO Claim
Plaintiffs filed suit against Merrill Brokerage, Merrill Clearing, Goldman Brokerage and Goldman Clearing in 2007, based largely on their suspected involvement in the Hazan and Arenstein trading schemes. Plaintiffs’ Third Amended Complaint, filed in April 2009, alleged several causes of action, including as relevant here, violations of California’s Corporate Securities Law of 1968 (§ 25000 et seq.).
In December 2010, plaintiffs filed a motion for leave to file a Fourth Amended Complaint, seeking to add a cause of action under New Jersey’s RICO statute against the Merrill and Goldman defendants. According to plaintiffs, the new RICO claim was simply a new theory based on facts unearthed late in discovery on their California securities claims.
Defendants, though wary of the new complaint, ultimately chose to acquiesce in its filing and entered into a stipulation with plaintiffs, which
became an order of the trial court in January 2011. In the stipulation, the parties recited their conflicting positions on the motion for leave to amend (defendants believed the Fourth Amended Complaint was defective and prejudicial, while plaintiffs did not) and noted the court’s “tentative inclination, ” expressed at a case management conference, “to address any issues of prejudice... by continuing the trial date.” The stipulation also expressly stated defendants were “not waiving, and expressly reserve[d], all rights to file in response to the Fourth Amended Complaint any and all pleadings, motions, and other responses on any grounds available under law or equity.” The complaint was deemed filed, and the trial date was continued for approximately three months, to December 5.
As advertised, and as pertinent here, plaintiffs’ Fourth Amended Complaint re-alleged violations of sections 25400 and 25500 and additionally alleged a violation of New Jersey’s RICO statute (N.J. Stat. 2C:41-2.c.d.).
Defendants demurred to the New Jersey RICO claim, arguing California law, not New Jersey law, should apply and, in any case, plaintiffs failed to state a claim under the New Jersey law. They did not ask the trial court to dismiss the new complaint based on prejudicial delay, but sought denial of further leave to amend on that ground. Ruling from the bench on May 10, the trial court concluded the allegations about conduct in New Jersey were vague and conclusory, did not disclose whether actionable trade or commerce occurred in that state, and thus failed to state a claim.
The trial court also found such lack of detail in the pleadings so close to trial “pernicious to defendants.” However, rather than denying leave to amend outright, it allowed plaintiffs to submit a proposed Fifth Amended Complaint, stating it would consider granting leave based on the contents of the proposed pleading. Plaintiffs promptly submitted a proposed amended complaint with over 50 pages of additional allegations in support of their New Jersey RICO claim.
After extensive briefing and a lengthy hearing, the trial court, on August 1, 2011, denied leave to file the proposed Fifth Amended Complaint. It cited two grounds: (1) granting leave to add the new RICO claim would prejudice defendants on the eve of trial; and (2) the RICO claim “would be futile because the facts as alleged... do not warrant the application of New Jersey RICO [law] to this case under California choice-of-law principles.”
2. Summary Judgment on the Corporations Code and Unfair Competition Law Claims
Two weeks later, on August 19, 2011, defendants moved for summary judgment on the remaining causes of action, including those based on California’s securities laws.
Defendants advanced several arguments as to plaintiffs’ state-law securities claims: (1) no actionable conduct occurred in California, (2) defendants did not “effect” any stock transactions, (3) defendants’ conduct was not manipulative, (4) defendants did not act for the purpose of “inducing” others to trade in a manipulated stock, (5) defendants’ conduct did not cause any decline in Overstock’s share price and thus did not result in injury to plaintiffs, and (6) federal securities laws and regulations preempted the state-law claims. We do not discuss the parties’ extensive evidentiary showing here, but do so in the next section in discussing the merits of the motions.
The trial court heard three days of argument on evidentiary objections to the documents filed in connection with the summary judgment motions and a full day of argument on the merits. In an order dated January 10, 2012, the court granted the motions. As to the state-law securities claims relevant here, the court ruled plaintiffs “failed to raise [any] triable issue of material fact supportive of finding that any act by any defendant foundational to liability, causation, or damages occurred in California.” The court declined to reach any of the other grounds for judgment defendants had urged. It issued a final, comprehensive order on April 11 and entered judgment the following day.
On appeal, plaintiffs seek reversal of the dismissal of their New Jersey RICO claim and reversal of the summary judgment on their California's Corporate Securities Law of 1968 claims.
A. New Jersey RICO Claim [*]
B. California's Corporate Securities Law Claim
1. Sections 25400 and 25500
“Corporations Code section 25400, a part of the Corporate Securities Law of 1968 (Corp. Code, § 25000 et seq.), provides that it is unlawful in
this state to make false statements or engage in specified fraudulent transactions which affect the market for a security when done [for specified purposes].” (Diamond Multimedia Systems, Inc. v. Superior Court (1999) 19 Cal.4th 1036, 1040 [80 Cal.Rptr.2d 828, 968 P.2d 539], fn. omitted (Diamond).) “In short, it prohibits market manipulation.” (Ibid.) Section 25500, in turn, “creates a civil remedy for buyers or sellers of stock the price of which has been affected by the forms of market manipulation proscribed by section 25400.” (Ibid., footnotes omitted.) Sections 25400 and 25500 “are patterned after and virtually identical to section 9... of the Securities Exchange Act of 1934 (15 U.S.C. § 78i (SEA)).” (California Amplifier, Inc. v. RLI Ins. Co. (2001) 94 Cal.App.4th 102, 114-115 [113 Cal.Rptr.2d 915] (California Amplifier).) Accordingly, California courts often look to federal law for guidance in interpreting the state statute. (Id. at p. 115; see 1 Marsh & Volk, Practice Under the Cal. Securities Law (2014) § 14.05–, pp. 14-60 to 14-61 (rel. 39-7/2011) (Marsh & Volk) [discussing relationship of federal and California laws].)
Section 25400, subdivisions (a) through (e), address different species of manipulative conduct “which were common during the so-called pool operations in the 1920’s.” (Kamen v. Lindly (2001) 94 Cal.App.4th 197, 203 [114 Cal.Rptr.2d 127] (Kamen).) "For instance, section 25400, subdivision (a) prohibits ‘wash sales, ’ i.e., the entering of purchase and sale orders of equal amounts in order to create the appearance of active trading and raise or depress the price of a security. Subdivisions (c) and (e) deal with ‘tipster sheets’ where either a broker-dealer or other person engaged in the pool operations, or a third person employed by the principals, disseminates information that the price of a security will rise or fall because of the market operations of the pool.” (Ibid.; see 1 Marsh & Volk, supra, § 14.05[c], p. 14-61 (rel. 39-7/2011).)
“[T]he more general and fundamental prohibitions” of section 25400 are set forth in subdivisions (b) and (d). (1 Marsh & Volk, supra, § 14.05[c], p. 14-61.) Subdivision (b) makes it unlawful “[t]o effect, alone or with one or more other persons, a series of transactions in any security creating actual or apparent active trading in such security or raising or depressing the price of
such security for the purpose of inducing the purchase or sale of the security by others.” (§ 25400, subd. (b).) “Subdivision (d) makes it unlawful... for sellers or buyers of stock to make false or misleading statements of material facts for the purpose of inducing a purchase or sale.” (Diamond, supra, 19 Cal.4th at p. 1048.)
In this case, we are concerned with subdivision (b), which makes it unlawful “[t]o effect... a series of transactions” that create “actual or apparent active trading” raising or depressing the price of the security, for the “purpose of inducing the purchase or sale of such security by others.” (§ 25400, subd. (b).) Since “[a]lmost any conceivable series of transactions in a particular security would necessarily create either actual or apparent trading or raise or depress the price of the security to some extent, ” the “crucial question” is “intent.” (1 Marsh & Volk, supra, § 14.05[d], p. 14-62 (rel. 39-7/201 1); see California Amplifier, supra, 94 Cal.App.4th at p. 110 [as “Marsh & Volk emphasizes, ” liability under §25400 “extends to everyone whose market trades are affected by the market manipulation”; “ ‘[i]n view of this potentially enormous and virtually unlimited liability, ’ ” intention is “ ‘a necessary qualification of the defendant’s liability’ ”].)
Before examining the evidence presented in connection with the summary judgment motions as to the two brokerage firms and two clearing firms, we discuss two legal issues that are pivotal to the significance of the evidence. The first is the meaning of the term “[t]o effect” a series of transactions in a security. (§ 25400, subd. (b), italics added.) The second is the distinction between liability as a principal, and aider and abettor liability. (See California Amplifier, supra, 94 Cal.App.4th at p. 113 [a private civil action under §§ 25400 and 25500 does not reach aiders and abettors].)
2. “Effecting” a Trade Under Section 25400 Is Not Limited to Beneficial Sellers and Buyers
Defendants contend section 25400, subdivision (b), reaches only the beneficial sellers and buyers of manipulated securities and does not reach
entities that execute, clear and settle trades for clients. Thus, according to defendant clearing firms, for example, no section 25400, subdivision (b), claim can lie against them as a matter of law. Rather, any claim under this subdivision would have to be advanced against their former trader clients, such as Hazan and Arenstein, in whose name the manipulative trades were made and who have been punished by the SEC and major exchanges.
Section 25400, subdivision (b) could have been drafted to apply only to beneficial sellers and buyers. But it was not. Rather, this subdivision applies to “any person, directly or indirectly” who “effect[s], alone or with one or more other persons, a series of transactions.” (§ 25400, subd (b), italics added.) This is in stark contrast to other provisions of section 25400 that apply to narrower classes of persons. (§ 25400, subd. (a) [subd. (a)(1) applies to those who “effect” transactions, while subd. (a)(2) and (3) apply only to those who “enter an order or orders”]; id., subds. (c), (d) [both applying only to “a broker-dealer or other person selling or offering for sale or purchasing or offering to purchase the security”].)
The verb “ ‘to effect’ means ‘to bring about; produce as a result; cause; accomplish.’ (Webster’s New World Diet. (3d college ed. 1988) p. 432.)” (People v. Brown (1991) 226 Cal.App.3d 1361, 1368 [277 Cal.Rptr. 309].) A “Broker-dealer, ” in turn, is defined under California’s securities law as “any person engaged in the business of effecting transactions in securities in this state for the account of others or for his own account.” (§ 25004, subd. (a), italics added.) Thus, the plain language of the securities laws contemplates those “effecting” a transaction can include someone other than the beneficial seller or buyer, and can include broker-dealers.
Section 9 of the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq.; SEA), on which section 25400 was based, also uses the terminology “effect... a series of transactions” (15 U.S.C. § 78i(a)(2)), and that terminology is construed broadly. (United States v. Weisscredit Banca Commerciale E D’Investimenti (S.D.N.Y. 1971) 325 F.Supp. 1384, 1393–1394.) The legislative history of the SEA shows “the term ‘effect’ as used in Section 9 of the 1934 Act (15 U.S.C. § 78i) and other sections means ‘to (participate) in a transaction whether as principal, agent, or both’. S.Rep. No. 972, 73d
Cong.2d Sess. 17 (1934).” (Ibid., italics added; see 8 Loss et al., Securities Regulation, (4th ed. 2012) p. 540; S.E.C. Release No. 605 (Apr. 7, 1936) 1936 WL 31604.)
Moreover, reading section 9 of the SEA to reach, as appropriate, agents of beneficial sellers and buyers also harmonizes the section with other provisions of the SEA and its regulations, which, like California’s definitional statute, speak of brokers “effecting” transactions by carrying out various agency and back-office functions, including clearing and settlement. (See 15 U.S.C. § 78c(a)(4) [a broker “means any person engaged in the business of effecting transactions in securities for the account of others”]; id. § 78bb(e)(3)(C) [“a person provides brokerage and research services insofar as he... effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody)”]; 17 C.F.R. § 240.11a2–2(T)(b) (2014) [“For purposes of this section, a member ‘effects’ a securities transaction when it performs any function in connection with the processing of that transaction, including, but not limited to, (1) transmission of an order for execution, (2) execution of the order, (3) clearance and settlement of the transaction, and (4) arranging for the performance of any such function.”]; see also S.E.C. v. Securities Investor Protection Corp. (D.D.C. 2012) 872 F.Supp.2d 1, 8, fn. 8 [it is the clearing broker who “ ‘actually effectuates the trade’ ”].)
We therefore conclude the word “effect” in section 25400, subdivision (b), includes more than the activity of beneficial sellers and buyers, and can include execution, clearing and settlement activities by brokerage and clearing firms.
Kamen does not hold, contrary to what defendants maintain, that “effecting” a transaction refers only to beneficial sellers and buyers. Indeed, the case does not even consider the meaning of the term “effect” in section 25400, subdivision (b). The complaint in Kamen “purport[ed] to state a cause of action under section 25400, subdivision (d).” (Kamen, supra, 94 Cal.App.4th at p. 202, italics added.) That subdivision, in contrast to subdivision (b), prohibits a “a broker-dealer or other person selling or offering for sale or purchasing or offering to purchase” a security from making any “false or misleading” statement “for the purpose of inducing the purchase or sale of
such security by others.” (§ 25400, subd. (d).) While the defendants in Kamen, a corporate officer and an accounting firm, were accused of making false statements about the company’s performance, neither sold or offered for sale any of the company’s shares. (Kamen, supra, 94 Cal.App.4th at p. 200.) Thus, neither was liable under the plain language of subdivision (d), which is strikingly different from the language of subdivision (b). (Kamen, at p. 206.)
Defendants also point out the authors of Marsh & Volk were heavily involved in the drafting of the state securities laws, and their treatise states section 25400 generally reaches only those “engaged in market activity.” (Marsh & Volk, supra, § 14.05, p. 14-66 (rel. 42-7/2014).) The treatise then continues, “[s]ubdivision (a), dealing with matched orders, and subdivision (b), dealing with liability for a series of transactions manipulating the price of a security, by their very nature require that the defendant be a purchaser or seller, since the conduct prohibited is associated with a market transaction.” (Ibid.) We have no disagreement with Marsh & Volk’s general observation, as one can “engage in market activity” by executing, clearing and settling trades. However, for all the reasons we have discussed, we conclude Marsh & Volk’s second statement is unsupported and incorrect. In fact, the treatise provides no analysis on this point, let alone any discussion of either the statutory language or the like provisions of Section 9 of the SEA on which Corporations Code section 24500 was based. (See Diamond, supra, 19 Cal.4th at p. 1055 [the Marsh & Volk treatise cannot be invoked in favor of a statutory interpretation contrary to a statute’s plain language].)
3. Primary Versus Aider and Abettor Liability
Having concluded any person who “effect[s] a series of transactions” can include not only beneficial sellers and buyers of shares, but also brokerage and clearing firms that execute, clear and settle the trades, we next consider under what circumstances brokerage and clearing firms can incur liability, given the well-established rule that a private civil action under sections 25400 and 25500 does not reach aiders and abettors. Rather, only primary actors are subject to civil liability for damages. (Kamen, supra, 94 Cal.App.4th at p. 206, citing Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A. (1994) 511 U.S. 164, 179 [128 L.Ed.2d 119, 114 S.Ct. 1439] (Central Bank) [holding no secondary liability under § 10(b) of the SEA]; California Amplifier, supra, 94 Cal.App.4th at p. 113 [“To impose liability on persons who do not directly participate in a section 25400 violation would be contrary to the legislative decision to exclude aiders and
abettors from section 25500 liability.”]; cf. §§ 25530–25536, 25403 [authorizing enforcement actions by Commissioner of Corporations and allowing aider and abettor liability in such actions]).
As did Kamen, we take guidance from Central Bank. The Supreme Court in Central Bank discussed section 10(b) of the SEA-and specifically its anti-fraud provision-and concluded: “The absence of... aiding and abetting liability does not mean that secondary actors in the securities markets are always free from liability under the securities Acts. Any person or entity, including a lawyer, accountant, or bank, who employs a manipulative device or makes a material misstatement (or omission) on which a purchaser or seller of securities relies may be liable as a primary violator..., assuming all of the requirements for primary liability... are met In any complex securities fraud... there are likely to be multiple violators....” (Central Bank, supra, 511 U.S. at p. 191, citation omitted;
see In re Enron Corp. Securities, Derivative & ERISA Litigation (S.D. Tex. 2002) 235 F.Supp.2d 549, 582.)
Thus, SEA, section 10(b) liability has been imposed on brokerage and clearing firms when they have crossed the line from aider and abettor to primary violator. (E.g., Fox Intern. Relations v. Fiserv Securities, Inc. (E.D. Pa. 2007)
490 F.Supp.2d 590, 609 [liability under § 10(b) possible when not engaging in mere ordinary clearing services]; In re Mutual Funds Inv. Litigation (D. Md. 2005) 384 F.Supp.2d 845, 857–858 [“the trader defendants are alleged to have been involved in the [section 10(b)] fraudulent scheme from the outset and to have been at least one of its architects. Moreover, unquestionably it is the trader defendants who received the profits that were siphoned off from the mutual funds as a result of late trades and market timed transactions. These are not the activities of a mere aider and abettor but those of a primary participant in the unlawful conduct”]; In re Blech Securities Litigation (S.D.N.Y. 1997) 961 F.Supp. 569, 582-583 (Blech II) [“Plaintiffs have remedied the defects of their previous complaint by adding sufficient allegations to give rise to an inference that [clearing firm] Bear Stearns had actual knowledge of Blech’s fraudulent conduct as well as a motive and opportunity for engaging in the scheme with Blech and his confederates”]; id. at p. 585 [“Bear Stearns is alleged to have conceived of and participated in the initiation and clearing of sham transactions aimed at affecting... the price of the Blech Securities”].)
In the Blech cases, Bear Stearns, a clearing firm, was accused of market manipulation under SEA section 10(b) for directing and clearing trades of an introducing firm client, Blech. On the one hand, the trades were arguably legitimate efforts to reduce Blech’s debt balance on Bear Stearns's books; on the other, they were arguably known by Bear Stearns to be propping up the price of the traded securities. (Blech II, supra, 961 F.Supp. at pp. 577–578; In re Blech Securities Litigation (S.D.N.Y., Oct. 17, 2002, No. 94 CIV.7696 RWS) 2002 WL 31356498 pp. *1, *15 (Blech III).) In Blech II, the district court denied a motion to dismiss. While allegations Bear Stearns cleared or otherwise “engaged in” manipulative trades were insufficient to state a claim, as even knowingly processing the sham trades of others does not give rise to direct liability, additional allegations Bear Stearns “directed” the sales and cleared the resulting trades to its pecuniary benefit, and did so knowing Blech’s fraudulent purpose, brought Bear Stearns into the realm of a primary violator. (Blech II, supra, 961 F.Supp. at pp. 584–585.)
In Blech III, Bear Stearns moved for summary judgment. Evidence corroborated the plaintiffs’ allegations of Bear Stearns’ orchestration of the trades and knowledge of the manipulation of the market. Not only did Bear Stearns direct trades, but it decided with Blech who should be on the
purchasing side of his sales. (Blech III, supra, 2002 WL 31356498, at p. *11.) Indeed, the plaintiffs alleged “these demands forced parking and trading between Blech Accounts.” (Id. at p. *15, italics added.) Bear Stearns contended in turn, its “actions with respect to debit demands were simply consistent with its agreement... to serve as... clearing broker, ” an agreement that, under NYSE Rule 382, allocated back-office functions to Bear Stearns and compliance with rules and regulations to Blech as an introducing broker. (Blech III, at pp. *15, *5-*6.)
The district court acknowledged “margin calls by a clearing broker or a failure to make margin calls, even with suspicion or knowledge of impropriety on the part of the initiating broker, is an appropriate and essential part of the securities business.” (Blech III, supra, 2002 WL 31356498, at p. *15.) The court concluded, however, “[a]n agreement to clear does not constitute an absolution from securities fraud” and concluded “[t]he contentions here go further.” (Ibid.) “[A] margin call made with knowledge that it will cause the initiating broker to commit a securities fraud which must be cleared by the clearing broker, constitutes direct action in connection with a contrivance to manipulate a security. Here that element of causality is at issue.” (Ibid.)
In re Mutual Funds Inv. Litigation, the district court also discussed clearing firm liability and allowed a SEA manipulation claim to proceed against two such firms when their activity extended beyond mere clearing services to providing clients with access to trading platforms that allowed for late trades and trades without time stamps. (In re Mutual Funds Investment Litigation, supra, 384 F.Supp.2d at p. 862.) “These acts are ‘manipulative or deceptive’ on their face, and by virtue of the trades they enabled, they affected the worth of mutual fund shares. Thus, they are the functional equivalent in the mutual fund industry of sham transactions that artificially affect market prices in more conventional contexts. [Citation.] Moreover, these alleged acts of deception, when considered with other allegations concerning the extent of Bank of America’s and Bear Stearns’ activities on behalf of late traders and high-volume market timers, imply that Bank of America and Bear Stearns did not merely assist in facilitating late trades and market timed transactions. Rather, it is reasonably inferable that they participated in initiating, instigating, and orchestrating the scheme. If discovery
demonstrates this to be so, Bank of America and Bear Stearns face primary liability under Central Bank.” (Ibid.)
In contrast, clearing firms were absolved of liability in Fezzani v. Bear, Stearns & Co., Inc. (S.D.N.Y. 2004) 384 F.Supp.2d 618. The plaintiffs in that case alleged, much as in Blech, that Bear Stearns engaged in market manipulation under SEA section 10(b) because it knew of a client’s, Baron’s, activities aimed at inflating stock prices and “provided financial support to Baron, and directed Baron at times to sell the manipulated securities to the public.” (384 F.Supp.2d at p. 628.) But in Fezzani, the allegations “d[id] not cross the threshold laid out in Blech III.” (Id. at p. 642.) “All the complaint alleges” is Bear Stearns “knew of Baron’s fraud and cleared the transactions that were fraudulently made”; there was no allegation Bear Stearns “contrived and agreed to fund” a manipulative scheme as in Blech. (Fezzani, at p. 642.)
Scone Investments, L.P. v. American Third Market Corp. (S.D.N.Y., Apr. 28, 1998, No. 97 Civ. 3802 (SAS)) 1998 WL 205338, pp. *1, *7–*8, also distinguished the Blech cases. In Scone, a bank was “alleged to have directed that... securities be sold, not that the sale be effectuated by way of fraudulent misrepresentation. The Bank’s liquidation demand is a far cry from the ‘intimate’ ‘hands-on involvement’ and participation in ‘key decisions’ about the details of the sale which would render it a primary violator.” (Scone, at p. *8; see Abrams,
A Second Look at Clearing Firm Liability (2001) 67 Brook. L. Rev. 479, 504.)
The Second Circuit recently addressed the “normal clearing services” standard in Levitt v. J.P. Morgan Securities, Inc. (2d Cir. 2013) 710 F.3d 454, 458–459, 466–468 (Levitt), in reversing a class certification order. The circuit court concluded Bear Stearns had no duty to disclose a known fraud to the plaintiffs, clients of an introducing firm, Sterling Foster, which had a clearing agreement with Bear Stearns making Sterling Foster responsible for monitoring its customers. The plaintiffs maintained Bear Stearns knew of Sterling Foster’s plan to manipulate the market for a soon-to-be-publicly-offered stock, ML Direct, by misusing insider shares supposedly subject to a lock-up agreement. They further alleged Bear Sterns nonetheless agreed to clear transactions in these shares, extended Sterling Foster unsecured credit, failed to cancel trades as required by an SEC regulation (Regulation T), and failed to disclose to purchasers Sterling Foster’s 400 percent profit in the underwriting. (710 F.3d at pp. 462–465.)
Levitt observed courts have grouped clearing firm activity into two categories: “First, in cases where a clearing broker was simply providing normal clearing services, district courts have declined to ‘impose... liability on the
clearing broker for the transgressions of the introducing broker.’ [Citations.] The district courts have so held even if the clearing broker was alleged to have known that the introducing broker was committing fraud, [citation]; even if the clearing broker was alleged to have been clearing sham trades for the introducing broker, In re Blech, 961 F.Supp. at 584; and even if the clearing broker was alleged to have failed to enforce margin requirements against the introducing broker-thereby allowing the introducing broker’s fraud to continue-in violation of Federal Reserve and NYSE rules, [citation].” (Levitt, supra, 710 F.3d at p. 466.)
“In the second, much more limited category of cases, district courts have found plaintiffs’ allegations to be adequate-and so have permitted claims to proceed-where a clearing broker is alleged effectively to have shed its role as clearing broker and assumed direct control of the introducing firm’s operations and its manipulative scheme Thus in Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65 (S.D.N.Y.2000), the district court granted class certification in a suit brought by investors against clearing broker Bear Stearns for its role in the introducing firm... scheme to defraud investors. The Berwecky plaintiffs alleged that Bear Stearns ‘asserted control over [the introducing firm’s] trading operations by, inter alia, placing Bear, Stearns’ employees at Baron’s offices to observe Baron’s trading activities, approving or declining to execute certain trades, imposing restrictions on Baron’s inventory, and loaning funds to Baron.’... [¶] Similarly, the district court in Blech [II], 961 F.Supp. 569, found that the ‘[c]omplaint crosse[d] the line dividing secondary liability from primary liability when it claim[ed] that Bear Stearns [the clearing broker] “directed” or “contrived” certain allegedly fraudulent trades.’ ” (Levitt, supra, 710 F.3d at pp. 466-467, citation omitted.)
Applying this dichotomy to the facts before it, Levitt concluded Bear Stearns did not have a duty to disclose Sterling Foster’s fraud because the plaintiffs “failed to allege sufficiently direct involvement.” (Levitt, supra, 710 F.3d at p. 467.) “Certainly plaintiffs here do not allege that Bear Stearns, beyond merely acquiescing in the ML Direct scheme, went so far as to control and implement that scheme in the manner alleged, for example, in Berwecky. (Id. at p. 468.) That “Bear Stearns allowed...’... putatively sham or manipulative trades” was not “comparable to directing or instigating such trades.” (Id. at p. 469.)
Thus, the threshold for primary liability on the part of clearing firms is high. They do not incur such liability when they provide “normal clearing services”-and that is so even when a firm knows the trader is committing
fraud or knows it is clearing and settling sham trades. Rather, to qualify as a primary violator a clearing firm must “shed its role as clearing broker” and engage in conduct akin to “directing” the client’s manipulative trading, or “deciding with” the client how to engage in the unlawful trading, or intentionally providing a specialized tool for the client to engage in unlawful trading, or “initiating, instigating, and orchestrating” the client’s unlawful scheme, ” or having “intimate” “hands-on involvement” and participating in “key decisions” about the “details” of the client’s unlawful trading, or assuming “direct control of” the client’s “operations and its manipulative scheme.”
4. The Summary Judgment Evidence
a. Goldman Brokerage
Goldman Brokerage was, itself, a purchaser of reversion conversions, and plaintiff’s expert, J. Marc Allaire, based on his review of Goldman documents, averred Goldman bought reverse conversions from Hazan and Arenstein. Allaire and other experts also opined, based on the pricing of these trades, Goldman Brokerage knew the short sale components of these complex trades would fail and continue to fail for the duration of the options components of the trades-in short, Goldman knew the trades were shams and created a “phony” supply of Overstock shares. Indeed, there is evidence Goldman Brokerage acted as Arenstein’s agent in executing conversion trades with itself, and acknowledged Arenstein could provide the firm a supply of shares it could not obtain “in the pits.” In an e-mail, for example, Goldman acknowledged such conversion trades “create inventory to allow customers to short.” In another e-mail, it acknowledged a general goal of its Hedging Strategies Group was “to create supply and perpetuate selling in stocks with a large amount of short interest.” In sum, there is substantial evidence Goldman Brokerage was, itself, a beneficial purchaser of one species of the exotic trades in which Hazan and Arenstein engaged to circumvent Regulation SHO.
There is no evidence, however, raising a triable issue Goldman Brokerage’s own purchases, or its execution of Hazan’s or Arenstein’s or another clients’ sham trades in Overstock, were made in California. Hazan and Arenstein operated out of New York and New Jersey. Goldman Brokerage operated
out of New York, New Jersey and Chicago. Further, plaintiffs did not rebut Goldman Brokerage’s evidence that any conversion trades were consummated on regional exchanges outside of California, such as the Chicago Board Options Exchange, Midwest Stock Exchange, or Cincinnati Stock Exchange.
Accordingly, summary judgment was properly granted as to Goldman Brokerage.
b. Merrill Brokerage
There is a similar shortcoming in the evidence as to Merrill Brokerage. To begin with, there is no evidence Merrill Brokerage, in contrast to Goldman Brokerage, was, itself, a purchaser of reverse conversions in Overstock.
There is evidence Eugene McCambridge, a Merrill broker in Chicago, executed some trades in Overstock shares for Hazan and Arenstein. However, McCambridge could not identify which exchange he used for any given trade. He testified at deposition he would ordinarily route NASDAQ trades through “Arca or P-Coast.” But he was shown and testified specifically about trade tickets showing Overstock trades on the Midwest Stock Exchange in Chicago. The “blotters” (the paperwork showing the trades) also do not identify the exchange used for the trades. Thus, whether McCambridge executed any Overstock trades on the Pacific Exchange is pure speculation, insufficient to raise a triable issue Merrill Brokerage executed trades in Overstock in California.
In addition, there is no evidence the trades McCambridge executed were of the exotic variety designed to avoid Regulation SHO’s delivery requirement. Plaintiffs’ experts purported to identify the alleged manipulative trading and they focused on Goldman Brokerage’s purchases of conversions and on the clearing firms’ activities. They made no reference to the trades McCambridge executed.
Accordingly, summary judgment was also properly granted as to Merrill Brokerage.
c. Goldman Clearing
Goldman Clearing did not have a clearing office in California, and there is no evidence this clearing firm did anything, in California or otherwise, beyond normal clearing activity. There is no evidence Goldman Clearing directed, developed, or instigated-as opposed to acquiesced in-any strategy for repeatedly failing short sales, shirking delivery obligations, or clearing sham reset transactions. (See California Amplifier, supra, 94 Cal.App.4th at p. 113 [no aiding and abetting liability]; cf. In re Mutual Funds Investment Litigation, supra, 384 F.Supp.2d at p. 862 ["reasonably inferable that they participated in initiating, instigating, and orchestrating the scheme" (italics added)].) At best, there is evidence suggesting the firm was clearing purported market makers’ sham reset transactions, was aware short interest in Overstock was high, “noticed fails going up rather dramatically... at [Goldman Clearing], ” and generally monitored client short sales in Overstock and gave clients notice of their regulatory obligations to “buy-in.” However, there is no evidence raising a triable issue the firm “shed its role as clearing broker and assumed direct control” of the scheme to evade federal securities laws. (Levitt, supra, 710 F.3d at p. 466.) Indeed, the evidence pertaining to Goldman Clearing does not come close to that pertaining to Merrill Clearing and to which we now turn.
d. Merrill Clearing
Merrill Clearing, unlike Goldman Clearing, had an office in California and from that office provided clearing services to traders in Overstock shares, including Hazan and Arenstein. By February, 2005, Alan Cooper, the head of the office, was having “frequent interactions” with Hazan-approximately five-to-six times a week by telephone and e-mail. Cooper, Hazan, and Merrill Clearing’s compliance department discussed Regulation SHO and, in general, a clearing firm’s responsibility to insure delivery and not to fail trades. At his deposition, Cooper claimed he and the compliance officer were not offering opinions on Regulation SHO, but simply explaining how Merrill Clearing would be implementing it.
In one interaction, in mid-February, Hazan was upset that Merrill Clearing was automatically borrowing shares to insure delivery, when he expected it would not. In an internal e-mail, Cooper, based on a conversation with Hazan, relayed “the trader did not know we were going to be charging [fees to borrow]
negatives” and if Merrill Clearing were to buy-in Hazan on the trade, Hazan would likely re-sell shares to “maintain his hedge.” Cooper asked if the buy-ins could be stopped.
What Hazan, and in turn, Cooper, were complaining about was what Merrill termed the “flipping” of all trades for automatic delivery and settlement. This deprived legitimate market maker clients of Regulation SHO’s exemption from the locate requirement, and deprived the clearing firm of its right under the regulation to delegate delivery obligations to bona fide market maker clients. Hazan was not the only Merrill Clearing client complaining about it. Moreover, Merrill Clearing had had a “do not flip” practice for market maker clients in place prior to the time Hazan and Arenstein became clients, and the complained-about automatic “flipping” started with Merrill’s acquisition of another firm, Sage (for whom Cooper had worked), and its computer system which was not programmed to “hold back” market maker short sales.
About a week later, Hazan sent Cooper an e-mail noting an interaction with Merrill Clearing’s compliance department concerning Regulation SHO, and then posing several questions: Did a clearing firm need to pay to borrow a stock if it is "being held for less than 10 days” as would be the case with a “flex or short term option hedge?” Could the options market maker exemption exempt trades from Regulation SHO’s close-out requirements if stock did not appear on “the Reg sho list” of threshold securities until after a short sale as a hedge? If Merrill Clearing were long in the stock, could Hazan use that position to offset short sales?
On the afternoon of February 23, Cooper told colleagues, in an e-mail, Hazan was threatening to leave Merrill Clearing for another firm if Merrill could not (without providing further specifics) “accommodate his trading style.” One colleague responded “I would say we can’t.” At his deposition, Cooper could not recall what he had meant by “trading style, ” but admittedly knew at the time it involved trading in threshold (hard-to-borrow) stocks, doing “riskless” trades, “delta-neutral” trades, conversions, and reversals. He also admitted having at least a general understanding Hazan could profit from the spread between the pricing of the options components of reverse conversions. And he admitted the reverse conversions the SEC later investigated and for which it imposed sanctions, were the sort of trade Merrill was clearing.
At around the same time-that is, February 2005-Cooper also began working with Arenstein. Cooper spoke to Arenstein about possibly opening
an account, and Merrill Clearing’s Managing Director, Curt Richmond, told Arenstein he and Cooper were “speaking to compliance about Reg-SHO.”
In a March 4, 2005 e-mail, Richmond and Merrill Clearing’s President, Thomas Tranfaglia, Jr., discussed how Arenstein wanted to talk to Tranfaglia about Regulation SHO and Merrill Clearing’s related policies. Richmond stated: “After the Hazan incident I informed [Arenstein] that we had no interest in clearing his ‘Reg-SHO fail with FLEX Options Strategy.’ ” Richmond noted Arenstein had taken “some of the other side of Hazan’s closing trades, ” but told Tranfaglia “it is your call.” Arenstein particularly wanted to know if Merrill Clearing would charge market makers lending fees on a fail to deliver if there was no violation of Regulation SHO, and whether Merrill Clearing would give its clients a chance to “get out on their own” before Regulation SHO deadlines.
At the end of the month, Cooper relayed to superiors a trading strategy suggested by Hazan-to use a “one day flex” in which Hazan would buy and sell calls in the same number of shares. Cooper asked “[c]ould we fail” on those shares “from the assignment the next day.” The admitted goal was “to reestablish a new short and not borrow it.” Cooper was asked to discuss the matter in person, and the conversation went offline. At his deposition, Cooper claimed he did not believe the goal of such a trade was to evade Regulation SHO, but to address Hazan’s desire to avoid fees related to the supposedly unnecessary, automated borrowing of shares imposed by the computer system Merrill Clearing had inherited from Sage.
The following month, in April 2005, Cooper filled in parts of a spreadsheet listing certain securities Hazan was holding (none of which were Overstock). In the far right column, Cooper marked down checks indicating Hazan “will not pay negative rebate” and had a “desire to fail.”
In mid-May, Cooper oversaw a “Reg SHO test trade” by Hazan. The trade would establish a new 350, 000 share short position in a security (one other than Overstock) for which options had been placed before implementation of Regulation SHO, and Merrill Clearing would not process the trade for delivery. At his deposition, Cooper again claimed the purpose of this exotic trade was not to evade Regulation SHO’s delivery requirement, but to move a
position from a “faulty” account that required borrowing of shares, to a different account which would allow a bona fide market maker to sell short without borrowing. In an internal e-mail that same day, Cooper said he told Hazan he would be subject to Regulation SHO’s buy in requirement, even though Hazan had earlier hoped for assurances “that the position would not be subject to Reg Sho buy-in in 13 days.”
The compliance department wanted to have further discussions to get more comfortable with the test trade, and wanted to have a procedure set up to deal with “hold[ing] these trades back”-a procedure that it would “need... to provide to the SEC.” But the trade was already in motion.
On May 25, 2005, after trade execution, a Managing Director at both Merrill entities and President and Chief Operating Officer of Merrill Clearing, Peter Melz, responded to the compliance department’s concern about the trade saying: “fuck the compliance area-procedures, scmecedures.” At her deposition, Merrill’s compliance officer stated she watched Melz draft the e-mail and it was made as part of an in-office jest.
By mid 2005, Merrill Clearing remedied the computer trading system it had acquired from Sage, and completed implementation of an automated “do not flip” process. This new process ensured trades in negative rebate securities (those, like Overstock, with high borrow fees) would not automatically “flip” to settlement when a market maker was selling short. Thus, Merrill Clearing would no longer inform Merrill Brokerage of the need to acquire shares to settle such short sales. Both firms were aware if the brokerage firm kept on its books the shares of negative rebate securities it otherwise would have provided to comply with Regulation SHO, those shares could be lent out for profit.
Merrill Clearing claims the “do not flip” process was the means by which, as allowed by Regulation SHO, it allocated responsibility for delivery to bona fide market maker clients. Yet, Merrill still had a policy of (1) giving such clients notice of impending 13-day deadlines to close out fail to deliver positions, and (2) actually “buying in” clients who did not comply-a “buy in” being a trade ostensibly conducted to close out a fail to deliver and enable delivery to a waiting buyer.
By summer 2005, discussions within Merrill turned to handling “buy ins.” In late July, Cooper noted Hazan “trades many hard to borrows and will need as much color [that is, information] on potential buy-ins as possible.” On
August 29, one of Cooper’s employees, Hugh Skinner, wrote to Cooper that Hazan wanted early notification of buy-ins because late notice “could prevent him from selling into the buy-in.” At his deposition, Cooper stated traders like Hazan wanted estimates of impending buy-ins so they could “sell into it” and, in the case of naked shorts, re-obtain the naked short position and remain risk neutral. This would, Cooper understood, effectively “reset” the Regulation SHO clock and give traders, at least from Merrill’s perspective, a new period of time to complete delivery of shares. As we have discussed, the SEC found this scheme to reset the Regulation SHO clock and avoid delivery to be an egregious violation of the regulation.
It was the San Francisco office that provided the notification function for Hazan and other clients in and around August 2005, but not necessarily for the entire period relevant here. At his deposition, Cooper denied taking an active role in Hazan’s trades or the trades of other Merrill Clearing clients, and viewed his role as largely clerical. He also denied reviewing trades to see if anyone repeatedly used reset transactions to perpetuate the naked short positions.
Despite Cooper’s assertions of passive ignorance, on August 4, 2005, a Merrill Clearing director-level employee, Bill Stein, noticed Cooper’s traders “were knowingly putting on shorts and then basically rolling them every 13 days.” At his deposition, Cooper said he did not recall exactly what this statement referred to, but conceded Stein was referring to “beating the Reg SHO obligation.” Certainly by July of 2006, Cooper understood this regulation-evasion aspect of the trading strategy Hazan and others were pursuing, noting “FLEXs were being questioned” and wrote in an e-mail "[a] few traders have figured out how to use the FLEXs to deal with Reg SHO.”
In December 2005, Merrill Clearing’s chief compliance officer sent a bulletin noting the firm had received regulatory inquiries and scrutiny over “flex trades by two... clients in OSTK.”
In an internal January 2006 telephone call, the compliance officer talked about Arenstein’s trading, how he was not acting as a bona fide market maker, and how it was “not okay” to be “recycling” his “short position.” She said: “You know, Iwe reallyI got to set up a meeting where we have to talk to the business, because these guys, they must be spoken to. Likeand not by you. You know what I’m saying? Like this is not okay. Like you cannot be recycling this short position. I mean, I don’t understand. If he’s gotIf he’s got, you know, a buy-in due today, tomorrow, and the next day, right? Then he can’t short anymore in these next few days.”
That same month, the compliance officer followed up with an e-mail to Merrill Clearing executives, telling them “as you know” Arenstein had been involved in trading activity the NASD (National Association of Securities Dealers, Inc.) was questioning as inconsistent with Regulation SHO, and informing them of the flex option recycling scheme and how Merrill’s net fails to deliver in Overstock were not diminishing. She noted if the firm were to drop Hazan and Arenstein, the database of fails “shrinks unbelievably.” There is also evidence, during this time frame, of compliance communications with Hazan and Arenstein during which they insisted they were acting as bona fide market makers, and a telephone call to Arenstein confronting him about recycling of trades and requesting him to do real buy-ins.
Nevertheless, Merrill Clearing continued to clear Hazan’s and Arenstein’s trades for another seven months and did not even begin to wind down its “clearing relationship” with them until August 2006just before the SEC and New York exchange issued stipulated sanctions orders against the two traders. Even after Hazan was told to leave Merrill Clearing, he continued to increase his short positions there for several months before he was finally terminated.
All told, Merrill cleared Hazan’s and Arenstein’s exotic trades designed to support perpetually naked short positions for more than a year, and as a result failed to deliver Overstock shares for settlement every single day between August 1, 2005 and the end of 2006. The number of failed deliveries quickly rose above a million shares, and at one point reached three million shares.
i.) Triable Issue Merrill Clearing Was a Primary Violator
As we have discussed, even if there is a triable issue Merrill Clearing knew Hazan and Arenstein’s trades were designed to evade Regulation SHO and knew it was clearing sham trades, that is not enough to raise a triable issue of primary liability under sections 25400 and 25500. Rather, the evidence must be such that Merrill Clearing’s conduct was arguably akin to “directing” Hazan’s and Arenstein’s trading schemes (Levitt, supra, 710 F.3d at pp. 466–467),
or to deciding with them how to effect a manipulative trade (see Blech III, supra, 2002 WL 31356498, at p. *11), or to providing calculated “access” to the means to engage in unlawful trading (In re Mutual Funds Investment Litigation, supra, 384 F.Supp.2d at pp. 861–862), or to “initiating, instigating, and orchestrating the scheme” (id. at p. 862), or to having “intimate, ” “hands-on involvement” and participating in “key decisions” about the “details” of the exotic trades (Scone Investments, L.P. v. American Third Market Corp., supra, 1998 WL 205338, at pp. *8–*9).
While a close question, we conclude the evidence is sufficient to raise a triable issue Merrill Clearing did more than provide normal clearing services, bearing in mind the observation of the district court in Blech III, that “[i]n this difficult distinction... between aiding and abetting and direct action, the line will be drawn with respect to summary judgment in favor of protecting the investing public rather than the clearing broker.” (Blech III, supra, 2002 WL 31356498, at p. *15.)
There is clearly a triable issue Merrill Clearing had knowledge, indeed abundant knowledge, its clients were rolling shorts and engaging in sham reset transactions to mimic the appearance of genuine trading. There is a triable issue Merrill did not believe, or, at the very least, could not have reasonably believed, Hazan and Arenstein were bona fide market makers engaging in legitimate trading. And there is a triable issue Merrill took an active, direct role in their trading schemes to cause, and to profit from, ongoing failures to deliver shares in short sales of Overstock, as well as other hard-to-borrow securities.
For example, there is a triable issue Cooper and others within Merrill Clearing purposefully developed or “contrived” procedures, at the request of Hazan and Arenstein, by which Merrill Clearing could, and repeatedly did, effect their one-day FLEX options “to reestablish a new short and not borrow it.” Arguably, Hazan effectively asked Merrill Clearing to review and approve the exotic “test trade” he concocted to flagrantly violate the securities laws. Not only did Merrill give its stamp of approval, it continued to clear Hazan’s unlawful trades even after compliance personnel made it clear this was “not ok.” Indeed, Merrill did so for another seven months and only stopped clearing those trades on the eve of the SEC sanction ruling. Such contriving behavior is akin to that found actionable in In re Mutual Funds Investment Litigation, supra, 384 F.Supp.2d at page 862, in which the clearing firm provided clients with access to trading platforms that enabled manipulative late trades, and in Blech III, in which the clearing firm and clients discussed and agreed upon a strategy that would manipulate the market.
Even if Merrill’s do-not-flip procedures were initially designed as a legitimate means to correct the Sage computer problem, they arguably became deliberately employed as tools to implement Hazan’s and Arenstein’s well-understood strategy of perpetuating naked short positions. Similarly, even if buy-in notifications are usually normal clearing activities, it is arguable Cooper went beyond giving routine notice and knowingly coached Hazan and Arenstein on handling buy-in obligations for the very purpose of selling into them and re-obtaining naked short positions. Moreover, the arguable buy-in coaching of these traders cannot be viewed in isolation from the evidence showing Merrill Clearing’s involvement with the development, for these same abusive traders, of the process to “roll shorts.”
Cooper’s techniques were, indeed, known, and ratified, within Merrill Clearing. Cooper’s clients, said one colleague, “were knowingly putting on shorts and then basically rolling them every 13 days.” In 2005, Tanfaglia was given the “call” on whether to add Arenstein as a client given his “FLEX Options Strategy” and the “Hazan incident”-and Arenstein became a client. In early 2006, a Merrill Clearing compliance officer was aware of Arenstein “recycling” his “short position” and called for action, but the abusive trading practices continued.
In sum, while close, when the evidence is viewed in the light most favorable to plaintiffs, as it must be on review from summary judgment, it suffices to raise a triable issue Merrill Clearing, through its San Francisco office, did more than provide normal clearing services, and did more than knowingly clear its clients’ manipulative trades and sham reset transactions. There is enough to commit to a jury the difficult “distinction between aiding and abetting and direct action.” (Blech III, supra, 2002 WL 31356498, at p. *15.)
The judgment is affirmed as to Goldman, Sachs & Co., Goldman Sachs Execution & Clearing, L.P., and Merrill Lynch, Pierce Fenner & Smith Inc..
As to Merrill Lynch Professional Clearing Corp., the judgment is reversed as to plaintiffs’ California securities law claim under sections 25400, subdivision (b) and 25500, and is affirmed in all other respects.
The parties are to bear their own costs on appeal.
Margulies, Acting P. J., and Dondero, J., concurred.