California Court of Appeals, First District, First Division
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
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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 ...