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Securities and Exchange Commission, Plaintiff-appellee, v. First Jersey Securities, Inc. and Robert E. Brennan,defendants-appellants, 101 F.3d 1450 (2d Cir. 1996) :: Justia
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Securities and Exchange Commission, Plaintiff-appellee, v. First Jersey Securities, Inc. and Robert E. Brennan,defendants-appellants, 101 F.3d 1450 (2d Cir. 1996)
U.S. Court of Appeals for the Second Circuit - 101 F.3d 1450 (2d Cir. 1996) Argued April 10, 1996. Decided Dec. 10, 1996
Before: LUMBARD and KEARSE, Circuit Judges, and MORAN, District Judge* .
A 41-day bench trial was held in 1994, at which the court received voluminous documents and extensive testimony, including live, videotaped, or transcribed deposition testimony of 12 former First Jersey salespersons called by the SEC, 22 former First Jersey branch managers and salespersons called by defendants, and several First Jersey officers, including Brennan. In a written opinion dated June 19, 1995, reported at 890 F. Supp. 1185, the court concluded that the SEC had
890 F. Supp. at 1209. The court found that in selling and repurchasing the unit securities, and reselling the components, First Jersey violated those provisions in two ways, to wit, by withholding material information from customers and by making excessive markups in the prices of the unbundled securities.
[d]efendants First Jersey's and Brennan's conduct [ ] was entirely purposeful. It was planned this way. This is clear not only from the patterned and repeated format of the trading, but also from the simple programmed structure of First Jersey's marketing system. Defendants orchestrated every facet of First Jersey's branch office network to ensure that the firm's underwritings and other low-priced stock recommendations were sold when they wanted--where they wanted--at prices determined not by market forces but by First Jersey itself. Its salesmen themselves, with minimal information and the incentive of earning as much as ten percent (plus a five percent managers' override) on a customer's investment dollar, were accordingly able to sell to the firm's customers securities at illegal mark-ups up to as much as 150 percent.
Id. Concluding that First Jersey was not a "market maker" in any of the securities because it did not "hold [ ] itself out to the broker-dealer community as standing ready to purchase and sell that security at particular quoted bid and asked prices," id., the court quoted the applicable SEC guidelines for determining prevailing market price as follows:
Id. at 1197-98 (footnote omitted) (quoting Zero-Coupon Securities Release No. 34-24368, 38 S.E.C. Docket 158, 1987 WL 112328 (Apr. 21, 1987)). The court found that First Jersey dominated and controlled the markets for the six securities at issue because the vast majority of the transactions in those securities were conducted by First Jersey. The court further noted that although the Firm made some purchases in the interdealer market, those trades were insignificant because their volume was tiny in comparison to the Firm's "massive retail trading" in those securities with its own customers. 890 F. Supp. at 1200. Having determined that First Jersey was not a market maker in any of those securities, the court concluded that, under the SEC guidelines, the best measure of the securities' prevailing market price was the Firm's cost of acquiring the units from its customers.
890 F. Supp. at 1200 n. 23. Whether the focus be on a single share of the common stock (essentially purchased for $.375 and resold for $.75) or on all of the elements comprised by the unit (purchased for $1 and resold for a total of $2), First Jersey's markup would have been 100%. In the securities at issue here, the court concluded that First Jersey enjoyed markups of up to 150%.
The court also concluded that the evidence of First Jersey's violations and Brennan's position and conduct established Brennan's joint and several liability for the violations as a "controlling person" of the Firm under § 20(a) of the 1934 Act, 15 U.S.C. § 78t(a) (1994). It noted that "as president, chief executive officer, and sole shareholder of First Jersey, Brennan possessed control over every aspect of First Jersey's operations," 890 F. Supp. at 1202. Applying the burden-shifting scheme articulated by this Court in Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir.), cert. denied, 449 U.S. 1011, 101 S. Ct. 566, 66 L. Ed. 2d 469 (1980), the court held that the burden had shifted to Brennan to show that he had in good faith "maintained and enforced a reasonable and proper system of supervision and internal control over sales personnel," 890 F. Supp. at 1202 (internal quotation marks omitted), and hence should not be held liable for violations by the Firm. The court found that Brennan had not met that burden. Reviewing the evidence as to the compliance procedures adopted by First Jersey, described in greater detail in Part III.C.2. below, the court found that those procedures were more cosmetic than real, and that they "were never intended for more than appearances should an occasion such as this arise." Id. at 1203.
First Jersey's Issuer Profit QT & T $ 581,659 Quasar 6,302,659 Rampart 2,110,617 Sequential 12,111,384 Sovereign 5,172,292 Trans Net 1,009,488 Total $27,288,099
In addition, the district court permanently enjoined defendants from further violations of the securities laws, finding that it was "highly likely" that such future violations would occur. 890 F. Supp. at 1210. This finding was based in part on defendants' history of " [b]rushes" with regulatory agencies in the securities industry, see Part IV.C. below, which had already resulted in censures, fines, and suspensions, and injunctions. The court observed that, while First Jersey had sold most of its retail branches in 1987, the Firm continued to operate on a day-to-day basis and that at the time of trial Brennan was still the 100% owner of First Jersey's stock, as well as the sole or majority shareholder of a number of other corporations "through which he has the power to and does continue his activities in the securities field." 890 F. Supp. at 1208.
Under the law, " [o]nce the equity jurisdiction of the district court has been properly invoked by a showing of a securities law violation, the court possesses the necessary power to fashion an appropriate remedy." SEC v. Manor Nursing Centers, Inc., 458 F.2d [1082, 1103 (2d Cir. 1972) ]; see also SEC v. Posner, 16 F.3d 520, 521 (2d Cir. 1994). Accordingly, I conclude that under the Court's general equitable powers, a special agent should be appointed to examine the records of defendant First Jersey Securities for the period from November 1, 1982 through January 31, 1987, for the purpose of determining whether there exists [sic ] excessive markups and/or markdowns charged to [Firm] customers, beyond those proved at trial. Should any such excessive markups or markdowns be determined, the special agent shall recommend to the Court that defendants disgorge and pay over, as the Court may direct, all illegally-obtained profits.
890 F. Supp. at 1212-13.
that the Commission ha [d] represented to First Jersey that upon the entry of this Permanent Injunction by Consent the Commission will forthwith enter an Order, in the form agreed to by the parties, dismissing, with prejudice, the Order for Public Proceedings issued by the Commission on May 17, 1979, ... and that the Commission will not institute an administrative proceeding against First Jersey or Robert E. Brennan on the basis of the annexed Permanent Injunction by Consent, or the Permanent Injunction by Consent of Robert E. Brennan filed concurrently herewith,
The present action was commenced by the SEC in October 1985, alleging frauds by First Jersey and Brennan beginning in November 1982 and continuing into 1985. Defendants sought summary dismissal on the basis that the SEC was aware of at least some of the transactions at issue here prior to settling the 1979 Proceeding and that these claims could have been litigated during the 1979 Proceeding. They argued that "the stock manipulation scheme alleged in the current SEC Complaint is the same as the scheme alleged in both the 1979 Notice and during the 1979-80 hearings"; that the "material issues raised in the SEC's current Complaint are in many respects identical to the issues raised by the SEC in the 1979 Order and the 1979-80 hearings"; and that " [t]he only difference ... between the issues raised by the prior 1979 Order and the issues raised by the current SEC Complaint is that the stock transactions in the current SEC Complaint cover a later time period." (Affidavit of Franklin D. Ormsten dated November 26, 1985, p 5.) Defendants pursue their res judicata defense on appeal. We conclude that the district court properly rejected it.
Under the claim preclusion branch of res judicata, " [a] final judgment on the merits of an action precludes the parties or their privies from relitigating issues that were or could have been raised in that action." Federated Department Stores, Inc. v. Moitie, 452 U.S. 394, 398, 101 S. Ct. 2424, 2428, 69 L. Ed. 2d 103 (1981).
Nevada v. United States, 463 U.S. 110, 129-30, 103 S. Ct. 2906, 2918, 77 L. Ed. 2d 509 (1983) (internal quotation marks omitted). The doctrine may be applied to judgments of administrative agencies acting in an adjudicative capacity. See, e.g., Astoria Federal Savings & Loan Association v. Solimino, 501 U.S. 104, 107-08, 111 S. Ct. 2166, 2169, 115 L. Ed. 2d 96 (1991); United States v. Utah Construction & Mining Co., 384 U.S. 394, 421-22, 86 S. Ct. 1545, 1559-60, 16 L. Ed. 2d 642 (1966); Greenberg v. Board of Governors of the Federal Reserve System, 968 F.2d 164, 168 (2d Cir. 1992).
With respect to the determination of whether a second suit is barred by res judicata, the fact that both suits involved essentially the same course of wrongful conduct is not decisive, see, e.g., Prime Management Co. v. Steinegger, 904 F.2d 811, 815 (2d Cir. 1990); nor is it dispositive that the two proceedings involved the same parties, similar or overlapping facts, and similar legal issues, see, e.g., NLRB v. United Technologies Corp., 706 F.2d 1254, 1259-60 (2d Cir. 1983). A first judgment will generally have preclusive effect only where the transaction or connected series of transactions at issue in both suits is the same, that is "whe [re] the same evidence is needed to support both claims, and whe [re] the facts essential to the second were present in the first." NLRB v. United Technologies Corp., 706 F.2d at 1260; see also Nevada v. United States, 463 U.S. at 128-30, 103 S. Ct. at 2917-19 (court must determine whether same "cause of action" is sued on); Lawlor v. National Screen Service Corp., 349 U.S. 322, 329, 75 S. Ct. 865, 869, 99 L. Ed. 1122 (1955) ("a prior judgment is res judicata only as to suits involving the same cause of action"); Woods v. Dunlop Tire Corp., 972 F.2d 36, 38 (2d Cir. 1992), cert. denied, 506 U.S. 1053, 113 S. Ct. 977, 122 L. Ed. 2d 131 (1993); Saud v. Bank of New York, 929 F.2d 916, 919 (2d Cir. 1991).
If the second litigation involved different transactions, and especially subsequent transactions, there generally is no claim preclusion. See, e.g., Lawlor v. National Screen Service Corp., 349 U.S. at 328, 75 S. Ct. at 868-69 (no res judicata bar to claim for anticompetitive conduct occurring subsequent to first suit); Greenberg v. Board of Governors of the Federal Reserve System, 968 F.2d at 168-70 (same re different financial transactions); Prime Management Co. v. Steinegger, 904 F.2d at 816 (same re subsequent breaches of contract); NLRB v. United Technologies Corp., 706 F.2d at 1260 (same re subsequent labor conflicts over same type of employee activity at different times and places, involving different employees). For example, when a contract was to be performed over a period of time and one party has sued for a breach but has not repudiated the contract, res judicata will preclude the party's subsequent suit for any claim of breach that had occurred prior to the first breach-of-contract suit, but will not preclude a subsequent suit for a breach that had not occurred when the first suit was brought. See id.; Restatement (Second) of Judgments § 24 comment d.
If a defendant engages in actionable conduct after a lawsuit is commenced, the plaintiff may seek leave to file a supplemental pleading to assert a claim based on the subsequent conduct. See Fed. R. Civ. P. 15(c). But he is not required to do so, and his election not to do so is not penalized by application of res judicata to bar a later suit on that subsequent conduct:
Los Angeles Branch NAACP v. Los Angeles Unified School District, 750 F.2d 731, 739 (9th Cir. 1984) (internal quotation marks omitted) (emphasis added), cert. denied, 474 U.S. 919, 106 S. Ct. 247, 88 L. Ed. 2d 256 (1985); see also Manning v. City of Auburn, 953 F.2d 1355, 1360 (11th Cir. 1992) (decision whether or not to attempt to assert claims that arose subsequent to the filing of the action "is optional for the plaintiff; the existence of the doctrine of res judicata does not make the filing of supplements mandatory").
Defendants assert that the SEC's present claims "could have been alleged" or "might have been raised" in the 1979 Proceeding (First Jersey brief on appeal at 14, 24), but they cite no authority holding that a claim that arose after a suit was commenced but prior to judgment is barred by res judicata if not pursued through a supplemental pleading. Their reliance on a statement in Hawkins v. Risley that " [t]he date of judgment, not the date of filing, controls the application of res judicata principles," 984 F.2d 321, 324 (9th Cir. 1993) (internal quotation marks omitted), is misplaced. The Hawkins court was not concerned with the question of claims that arose during the pendency of a lawsuit; the quoted statement was made in response to the plaintiff's argument that res judicata did not apply because the judgment to be given preclusive effect concluded an action that had been commenced later than the still-pending action in which it was to be given that effect. The holdings in Lawlor v. National Screen Service Corp. and Teltronics Services, Inc. v. L M Ericsson Telecommunications, Inc., 642 F.2d 31, 35 (2d Cir.) ("Teltronics "), cert. denied, 450 U.S. 978, 101 S. Ct. 1511, 67 L. Ed. 2d 813 (1981), likewise provide no support for defendants' position. Though the opinion in Lawlor included the statement that "judgment precludes recovery on claims arising prior to its entry," 349 U.S. at 328, 75 S. Ct. at 868, that statement was dictum insofar as it might be applied to claims that arose after a complaint was filed, for in Lawlor, all of the claims raised in the second action were based on acts that occurred either prior to the commencement of the first action or subsequent to the entry of judgment in that action. And the reference in Teltronics to the Lawlor language, see 642 F.2d at 36, was likewise dictum, since Teltronics involved a second suit that, though more detailed, asserted precisely the same claims as the first, see id. at 35 ("In this case the same parties, the same cause of action and the same facts form the basis of the second complaint.").
Affiliated Ute Citizens v. United States, 406 U.S. 128, 151, 92 S. Ct. 1456, 1471, 31 L. Ed. 2d 741 (1972) (footnote omitted). The basic aim of the antifraud provisions is to "prevent rigging of the market and to permit operation of the natural law of supply and demand." United States v. Stein, 456 F.2d 844, 850 (2d Cir.), cert. denied, 408 U.S. 922, 92 S. Ct. 2489, 33 L. Ed. 2d 333 (1972). The theory of a natural, unrigged market is that the "competing judgments of buyers and sellers as to the fair price of the security brings about a situation where the market price reflects as nearly as possible a just price." H.R.Rep. No. 1383, 73rd Cong., 2d Sess., at 11 (1934).
To this end, § 17(a) and Rule 10b-5 expressly prohibit misstatements and omissions as to facts that are material. A fact will be considered material within the meaning of these provisions "if there is 'a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total" mix of information available.' " In re Time Warner Inc. Securities Litigation, 9 F.3d 259, 267-68 (2d Cir. 1993) (quoting TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449, 96 S. Ct. 2126, 2132, 48 L. Ed. 2d 757 (1976)) (interpreting § 10(b)), cert. denied, 511 U.S. 1017, 114 S. Ct. 1397, 128 L. Ed. 2d 70 (1994); see SEC v. Rogers, 790 F.2d 1450, 1458 (9th Cir. 1986) (interpreting § 17(a)). The materiality of an item of information is a mixed question of law and fact. See, e.g., TSC Industries, Inc. v. Northway, Inc., 426 U.S. at 450, 96 S. Ct. at 2132-33. The legal component depends on whether the information is relevant to a given question in light of the controlling substantive law. See, e.g., Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S. Ct. 2505, 2510, 91 L. Ed. 2d 202 (1986). The factual component requires an inference as to whether the information would likely be given weight by a person considering that question. See, e.g., TSC Industries, Inc. v. Northway, Inc., 426 U.S. at 450, 96 S. Ct. at 2132-33.
In order to establish primary liability under § 10(b) and Rule 10b-5, a plaintiff is required to prove that in connection with the purchase or sale of a security the defendant, acting with scienter, made a material misrepresentation (or a material omission if the defendant had a duty to speak) or used a fraudulent device. See, e.g., Brown v. E.F. Hutton Group, Inc., 991 F.2d 1020, 1031 (2d Cir. 1993); McMahan & Co. v. Wherehouse Entertainment, Inc., 900 F.2d 576, 581 (2d Cir. 1990), cert. denied, 501 U.S. 1249, 111 S. Ct. 2887, 115 L. Ed. 2d 1052 (1991). Scienter, as used in connection with the securities fraud statutes, means intent to deceive, manipulate, or defraud, see, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12, 96 S. Ct. 1375, 1381 n. 12, 47 L. Ed. 2d 668 (1976); or at least knowing misconduct, see, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 382-83, 103 S. Ct. 683, 687-88, 74 L. Ed. 2d 548 (1983) (mere negligence not sufficient); Wechsler v. Steinberg, 733 F.2d 1054, 1058 (2d Cir. 1984). Whether or not a given intent existed, is, of course, a question of fact. See, e.g., id. at 1059.
With respect to § 17(a) (1), essentially the same elements must be established in connection with the offer or sale of a security. See generally Zerman v. Ball, 735 F.2d 15, 23 (2d Cir. 1984) (" [G]iven the similarity of the text of § 17(a) of the 1933 Act to that of Rule 10b-5, we conclude that if a private right of action exists under § 17(a), [plaintiff] has stated a claim upon which relief may be granted against [defendant] under that section as well."); Savino v. E.F. Hutton & Co., 507 F. Supp. 1225, 1231 (S.D.N.Y. 1981) ("Since Section 17(a), like Section 10(b), sounds in fraud, similar allegations are required to state a claim under that section."). Scienter, however, need not be established for the SEC to obtain an injunction under of §§ 17(a) (2) or (3). See Aaron v. SEC, 446 U.S. 680, 701-02, 100 S. Ct. 1945, 1958-59, 64 L. Ed. 2d 611 (1980).
The district court ruled, first, that First Jersey violated § 17(a) (1), § 10(b), and Rule 10b-5 by failing to disclose material facts to its customers with respect to, inter alia, the companies whose securities it was trading with them, the nature of the market for those securities, the Firm's control over that market, and the Firm's plans for immediate unbundling and resale of the repurchased securities at a far higher price than what it would pay to repurchase them. The court found that, by these nondisclosures, defendants succeeded in perpetrating massive and pervasive frauds on First Jersey's hundreds of thousands of customers, and that defendants had acted with scienter in that they intentionally used fraudulent devices for the purpose of enabling First Jersey to charge excessive markups, knowing they were violating the law. Defendants do not challenge the court's findings of fact. (First Jersey brief on appeal at 5 ("We ... will assume that those factual findings were not clearly erroneous....").) Hence, for purposes of this appeal, defendants have conceded that they failed to make disclosures of facts that would have been important to their customers; that their nondisclosures were intended to, and did, defraud their customers; and that these intentional frauds were designed to facilitate the markups that they charged.
It has long been recognized that the character of the market for a given security is relevant in determining the application of §§ 17(a) and 10(b), and that a broker-dealer who creates a market in securities and sells the securities to its customers without disclosing the nature of that market violates those provisions. "It is of utmost materiality to a buyer ... to know that he may not assume that the prices he pays were reached in a free market; and the manipulator cannot make sales not accompanied by disclosures of his activities without committing fraud." Halsey, Stuart & Co., 30 S.E.C. 106, 112 (1949). In Norris & Hirshberg, Inc. v. SEC, 177 F.2d 228, 232-33 (D.C. Cir. 1949), for example, the court found substantial evidence to support the SEC's finding that a broker-dealer violated §§ 17(a) and 10(b) when it failed to disclose to customers its general practice of acquiring large portions of the available issues of unlisted securities, selling them to its customers, buying them back, and then reselling them to the same and other customers. The SEC had concluded that the firm's manner of trading allowed it to fix the prices of the securities in a market largely unaffected by competition and that the noncompetitive nature of the market in which the securities were traded was a material fact that the firm had an obligation to reveal to its clients:
Norris & Hirshberg, Inc., 21 S.E.C. 865, 882 (1946), aff'd, 177 F.2d 228 (D.C. Cir. 1949); see also Richard J. Puccio, 59 S.E.C. Docket 1985, 1995 WL 419347, at * 3 (July 10, 1995) (holding that broker violated the antifraud provisions by, inter alia, "crossing" customer orders or inducing one set of customers to purchase stocks sold by another set of customers without informing the first set of customers that he recommended the securities simply to find a buyer for the selling customers' securities); S.T. Jackson & Co., 36 S.E.C. 631, 656 (1950) (finding that broker-dealers committed securities fraud by, inter alia, failing to advise clients that market for stock was "artificial, having been created and controlled by [the broker-dealers] for the purpose of profitably disposing of stock which they held or were to acquire").
Sales of securities by broker-dealers to their customers carry with them an implied representation that the prices charged in those transactions are reasonably related to the prices charged in an open and competitive market. See, e.g., Charles Hughes & Co. v. SEC, 139 F.2d 434, 437 (2d Cir. 1943), cert. denied, 321 U.S. 786, 64 S. Ct. 781, 88 L. Ed. 1077 (1944); SEC v. Resch-Cassin & Co., 362 F. Supp. 964, 978 (S.D.N.Y. 1973). Hence, a broker-dealer who charges customers retail prices that include an undisclosed, excessive markup violates § 17(a) and § 10(b) of the securities laws. See Alstead, Dempsey & Co., 47 S.E.C. 1034, 1035 (1984); see generally Norris & Hirshberg, Inc. v. SEC, 177 F.2d at 232-33.
A markup is the difference between the retail price and the "prevailing market price" of the security. A securities firm that acts as a dealer is entitled to charge a reasonable markup on the wholesale price it pays for the security; under NASD rules, a reasonable markup is generally not more than 5% over the prevailing market price. See First Independence Group, Inc. v. SEC, 37 F.3d 30, 32 (2d Cir. 1994) (citing NASD Rules, Section 4, Interpretation of the Board of Governors-NASD Markup Policy). An undisclosed markup of more than 10% above the prevailing market price has been held to constitute fraud per se. See, e.g., Powell & Associates, 47 S.E.C. 746, 748 (1982). In defining the prevailing market price of a security for purposes of calculating a dealer's markup, the SEC distinguishes between dealers who are market makers and those who are not, between markets that are competitive and those that are not, and between controlling dealers that make significant purchases in the interdealer market and those that do not.
A market maker in a security is defined in the 1934 Act as a broker-dealer that holds itself out in the interdealer market as being ready to purchase and sell that security for its own account on a regular and continuous basis. See 15 U.S.C. § 78c(a) (38) (1994). For market makers, markups in the security "may be computed on the basis of the contemporaneous prices charged by the firm or other market makers in actual sales to other dealers or, if no such prices are available, on the basis of representative asked quotations." Alstead, Dempsey & Co., 47 S.E.C. at 1036 (emphases added).
If a broker-dealer is not a market maker, the best evidence of a security's prevailing market price is generally the price at which dealers in a security trade with one another, i.e., the "wholesale" price. See generally Orkin v. SEC, 31 F.3d 1056, 1063-64 (11th Cir. 1994); F.B. Horner & Associates v. SEC, 994 F.2d 61, 63 (2d Cir. 1993) (per curiam); Barnett v. United States, 319 F.2d 340, 344 (8th Cir. 1963). If the market for the security is competitive, the markup may be determined on the basis of the prices that other broker-dealers quote; where, however, a dealer controls or dominates the market, the best evidence of the security's prevailing market price is the price the controlling or dominating dealer actually paid. See Robert B. Orkin, 51 S.E.C. 336, 340 (1993) (where market is dominated and controlled by dealer, prices paid by others are not best measure of prevailing market value), aff'd, 31 F.3d 1056 (11th Cir. 1994).
To determine whether a firm dominated the market for a particular security, the Commission considers a number of factors, including (1) whether the firm was an underwriter of the initial public offering of the security and sold a substantial percentage of the offering to its own customers; (2) whether the firm was a market maker in the secondary market for the stock and traded a significant amount of the volume in the secondary market; and (3) the number of other market makers in the stock and their percent of total trading volume as compared to the trading volume of the firm in question. See Meyer Blinder, 50 S.E.C. 1215, 1218 n. 14 (1992). "Where a firm sells all but a small portion of an initial public offering to its own retail clients, and the remainder is fragmented among several other dealers," the underwriter normally "control [s] wholesale pricing to such an extent as to preclude an independent market from arising .... [and is] empowered to set prices arbitrarily." George Salloum, 59 S.E.C. Docket 39, 1995 WL 215268, at * 2 (Apr. 5, 1995) (internal quotation marks omitted); see also Robert B. Orkin, 51 S.E.C. at 337 (where broker-dealer "effected the vast majority of the retail trades and executed most of the few wholesale trades that occurred," the broker-dealer dominated market for security).
If a controlling dealer makes few or no purchases in the interdealer market, or if the volume of trading among dealers is insignificant in comparison to the controlling dealer's retail trades, the best evidence of that security's prevailing market price is generally the retail market price that the dealer paid. See Meyer Blinder, 50 S.E.C. at 1224 n. 38; see George Salloum, 59 S.E.C. Docket 39, 1995 WL 215268, at * 3. In George Salloum, for example, the SEC found insignificant a dealer's purchases on the wholesale market in determining prevailing market price where the dealer acquired, as to one security, 546,900 shares of stock from its customers for resale and only 18,100 shares wholesale from other dealers, and, as to a second security, 250,000 shares of stock from its customers and only 13,600 shares from dealers. The Commission found that, because the dealer had "manipulat [ed] ... the markets for these securities and ... the volume of the shares acquired [from its retail customers] was so significant" that the best evidence of the prevailing market price for the securities was the price that the dealer paid to its customers, adjusted by an imputed markdown of 10%. Id. at * 3-4; cf. Meyer Blinder, 50 S.E.C. at 1224 n. 38 ("We believe that actual purchases from retail customers, adjusted for the markdowns charged, are far more probative evidence of the prevailing market price for an integrated dealer that dominates and controls the market for a security because they indicate the price the market maker is willing to pay for the security."); W.T. Anderson Co., 39 S.E.C. 630, 636-37 (1960) (using retail purchases to establish prevailing market price where dealer's sale and repurchase from customers "creat [ed] whatever market existed in the [ ] stocks except for a few transactions by other brokers in [one disputed] stock").
"Any person or entity ... 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 under [federal securities law], assuming all of the requirements for primary liability ... are met." Central Bank v. First Interstate Bank, 511 U.S. 164, 191, 114 S. Ct. 1439, 1455, 128 L. Ed. 2d 119 (1994) (emphasis omitted). Primary liability may be imposed "not only on persons who made fraudulent misrepresentations but also on those who had knowledge of the fraud and assisted in its perpetration." Azrielli v. Cohen Law Offices, 21 F.3d 512, 517 (2d Cir. 1994).
The evidence presented at trial sufficed to establish that Brennan had knowledge of First Jersey's frauds and participated in the fraudulent scheme. The district court found that "the whole point of the scheme" undertaken here, 890 F. Supp. at 1195, which required some branches to purchase and others to resell, and forbade each group to talk to the other, was to keep customers in the dark, and was coordinated from First Jersey headquarters. The magnitude of First Jersey's scheme and the degree of oversight needed to coordinate the activities carried out by dozens of branch offices throughout the United States, and hundreds, if not thousands, of sales representatives, supports the district court's determination that the illegal activity could only have occurred at the direction of First Jersey's upper-level management. The court found that Brennan was engaged in the purposeful planning of the pattern and repeated format of trading in which the respective branch offices engaged and that he "orchestrated every facet of First Jersey's branch office network." 890 F. Supp. at 1195.
Brennan's reliance on Universal Heritage Investments Corp., 47 S.E.C. 839 (1982), for the proposition that only supervisory, and not primary, liability, should have been imposed on him is misplaced. Universal Heritage involved a finding that one branch of a brokerage firm had engaged in unlawful activity, and the SEC ruled that the firm's executive vice president was not primarily liable because, though he was responsible for the daily operation of the firm, there was insufficient evidence that he was actually aware of the misconduct of the branch office in question, and hence there was an insufficient basis for a finding that he had "intentional [ly] and knowing [ly] acquiesce [d]" in the illegal activity. Id. at 844. The findings in the present case that Brennan was aware of and "was intimately involved in" the decisions as to unit-splitting and pricing, 890 F. Supp. at 1201, and that he orchestrated First Jersey's balkanization of its branches in order to keep customers in the dark, are supported by the record and distinguish this case from Universal Heritage and other cases in which an individual escaped primary liability.
15 U.S.C. § 78t. Since § 20(a) is available as an enforcement mechanism to "any person to whom such controlled person is liable," and the 1934 Act includes government agencies in the definition of "person," see 15 U.S.C. § 78c(a) (9), we have upheld the SEC's authority to pursue an enforcement action under § 20(a). See SEC v. Management Dynamics, Inc., 515 F.2d 801, 812 (2d Cir. 1975). Contra SEC v. Coffey, 493 F.2d 1304, 1318 (6th Cir. 1974), cert. denied, 420 U.S. 908, 95 S. Ct. 826, 42 L. Ed. 2d 837 (1975).
In order to establish a prima facie case of controlling-person liability, a plaintiff must show a primary violation by the controlled person and control of the primary violator by the targeted defendant, see Marbury Management, Inc. v. Kohn, 629 F.2d at 715-16, and show that the controlling person was " 'in some meaningful sense [a] culpable participant [ ] in the fraud perpetrated by [the] controlled person [ ],' " Gordon v. Burr, 506 F.2d 1080, 1085 (2d Cir. 1974) (quoting Lanza v. Drexel & Co., 479 F.2d 1277, 1299 (2d Cir. 1973) (en banc)). Control over a primary violator may be established by showing that the defendant possessed "the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise." 17 C.F.R. § 240.12b-2.
Once the plaintiff makes out a prima facie case of § 20(a) liability, the burden shifts to the defendant to show that he acted in good faith, see Marbury Management, Inc. v. Kohn, 629 F.2d at 716; Gordon v. Burr, 506 F.2d at 1086, and that he "did not directly or indirectly induce the act or acts constituting the violation," 15 U.S.C. § 78t. To meet the burden of establishing good faith, the controlling person must prove that he exercised due care in his supervision of the violator's activities in that he "maintained and enforced a reasonable and proper system of supervision and internal control [s]." Marbury Management, Inc. v. Kohn, 629 F.2d at 716.
Further, with respect to First Jersey's dealings with its customers, the record showed that the Firm gave its sales representatives little information about proper procedures or about the securities they were hawking. Former First Jersey salespersons testified, for example, that training manuals typically did not contain information about the risks inherent in the type of securities sold by First Jersey and, in any event, the manuals were not distributed to all sales personnel. The registered representatives were not permitted to do research on their own; there was no published information on the securities in question. Nor were they allowed, without permission from the branch manager, to contact the Firm's research department for information. Rather, they were scripted on what to say. The court found that " [v]irtually all of the twelve former First Jersey salesm [e]n who testified for the SEC described the 'script'." 890 F. Supp. at 1189. The branch manager would come out of his office and tell the sales representatives to clear their telephones so that they could hear and write down the script verbatim. The message "was repeated several times until we had it correct in our notes." Id. at 1190 (quoting a former First Jersey salesman). The information, taking up 1-1 1/2 pages on a legal pad, was basically the same for every stock. " ' [T]hey all started the same way. I mean, he gave us, you know, spectacular turnaround situation, was a line that was almost in every presentation.' " Id. at 1189 (quoting a former First Jersey salesman).
The district court's findings that First Jersey's training and compliance methods were not bona fide attempts to comply with the securities laws were a permissible view of the evidence, and hence are not clearly erroneous, see Anderson v. Bessemer City, 470 U.S. 564, 574, 105 S. Ct. 1504, 1511, 84 L. Ed. 2d 518 (1985) ("Where there are two permissible views of the evidence, the factfinder's choice between them cannot be clearly erroneous."). Given these findings, together with the findings as to Brennan's hands-on management and his role in orchestrating the Firm's unlawful acts, the court properly concluded that Brennan failed to carry his burden of showing a good faith effort to discharge his responsibilities.
Once the district court has found federal securities law violations, it has broad equitable power to fashion appropriate remedies, including ordering that culpable defendants disgorge their profits. See, e.g., SEC v. Lorin, 76 F.3d 458, 461-62 (2d Cir. 1996) (per curiam); SEC v. Patel, 61 F.3d 137, 139 (2d Cir. 1995); SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1104 (2d Cir. 1972). The primary purpose of disgorgement as a remedy for violation of the securities laws is to deprive violators of their ill-gotten gains, thereby effectuating the deterrence objectives of those laws. See, e.g., SEC v. Wang, 944 F.2d 80, 85 (2d Cir. 1991); SEC v. Commonwealth Chemical Securities, Inc., 574 F.2d 90, 102 (2d Cir. 1978). "The effective enforcement of the federal securities laws requires that the SEC be able to make violations unprofitable. The deterrent effect of an SEC enforcement action would be greatly undermined if securities law violators were not required to disgorge illicit profits." SEC v. Manor Nursing Centers, Inc., 458 F.2d at 1104; see SEC v. Texas Gulf Sulphur Co., 446 F.2d 1301, 1308 (2d Cir. 1971) ("It would severely defeat the purposes of the Act if a violator of Rule 10b-5 were allowed to retain the profits from his violation.").
The district court has broad discretion not only in determining whether or not to order disgorgement but also in calculating the amount to be disgorged. See, e.g., SEC v. Lorin, 76 F.3d at 462. The amount of disgorgement ordered "need only be a reasonable approximation of profits causally connected to the violation," SEC v. Patel, 61 F.3d at 139 (internal quotation marks omitted); "any risk of uncertainty [in calculating disgorgement] should fall on the wrongdoer whose illegal conduct created that uncertainty," id. at 140 (internal quotation marks omitted). We review the district court's order of disgorgement for abuse of discretion. See, e.g., SEC v. Posner, 16 F.3d 520, 522 (2d Cir. 1994), cert. denied, 513 U.S. 1077, 115 S. Ct. 724, 130 L. Ed. 2d 629 (1995).
Defendants, relying on United States v. Carson, 52 F.3d 1173 (2d Cir. 1995), cert. denied, --- U.S. ----, 116 S. Ct. 934, 133 L. Ed. 2d 861 (1996), argue that disgorgement was not proper here because the SEC did not show that that relief was necessary to prevent future violations. Even assuming the validity of defendants' premise, their reliance on Carson is misplaced. Carson was a case brought under the Racketeer Influenced and Corrupt Organizations Statute ("RICO"), 18 U.S.C. § 1961 et seq. (1994), which states that " [t]he district courts ... shall have jurisdiction" to impose civil penalties such as divestiture in order "to prevent and restrain violations of [RICO]," id. § 1964(a). In light of that language and the "forward looking" examples given in that jurisdictional section, we held that a divestiture order under RICO must be designed to prevent future conduct rather than to remedy past wrongdoing. See 52 F.3d at 1181-82. The analysis in Carson is inapposite here, since the primary purpose of disgorgement as a remedy for federal securities laws violation is deterrence, through prevention of unjust enrichment on the part of the violator.
Brennan contends that the district court erred in making him jointly and severally liable for disgorgement of the total amount of First Jersey's profits and should not have ordered him to disgorge more than the profits he personally received from the transactions in question. We conclude that that order too was within the court's discretion. As discussed in the previous sections, Brennan is primarily liable for the frauds at issue here, having been "intimately involved" in their perpetration, and is also liable as a controlling person of First Jersey. Under the express terms of § 20(a), a controlling person who has failed to establish his good-faith defense is to be held "liable jointly and severally with and to the same extent as" the controlled person. 15 U.S.C. § 78t. Accordingly, where a firm has received gains through its unlawful conduct, where its owner and chief executive officer has collaborated in that conduct and has profited from the violations, and where the trial court has, within the proper bounds of discretion, determined that an order of disgorgement of those gains is appropriate, it is within the discretion of the court to determine that the owner-officer too should be subject, on a joint and several basis, to the disgorgement order. See, e.g., Hateley v. SEC, 8 F.3d 653, 656 (9th Cir. 1993) (affirming disgorgement order imposed jointly and severally against broker-dealer securities firm, its president, and its executive vice-president for violations of NASD rules where defendants "acted collectively in violating the association's rules and because of the close relationship among the three of them"); see also SEC v. Hughes Capital Corp., 917 F. Supp. 1080, 1088 (D.N.J. 1996) (finding joint and several liability of corporation and individual defendants because all were "knowing participants who acted closely and collectively").
"The decision whether to grant prejudgment interest and the rate used if such interest is granted are matters confided to the district court's broad discretion, and will not be overturned on appeal absent an abuse of that discretion." Endico Potatoes, Inc. v. CIT Group/Factoring, Inc., 67 F.3d 1063, 1071-72 (2d Cir. 1995) (internal quotation marks omitted). In deciding whether an award of prejudgment interest is warranted, a court should consider "(i) the need to fully compensate the wronged party for actual damages suffered, (ii) considerations of fairness and the relative equities of the award, (iii) the remedial purpose of the statute involved, and/or (iv) such other general principles as are deemed relevant by the court." Wickham Contracting Co. v. Local Union No. 3, 955 F.2d 831, 833-34 (2d Cir.), cert. denied, 506 U.S. 946, 113 S. Ct. 394, 121 L. Ed. 2d 302 (1992); see also Commercial Union Assurance Co. v. Milken, 17 F.3d 608, 613 (2d Cir.), cert. denied, 513 U.S. 873, 115 S. Ct. 198, 130 L. Ed. 2d 130 (1994). In an enforcement action brought by a regulatory agency, the remedial purpose of the statute takes on special importance.
When the SEC itself orders disgorgement, see 15 U.S.C. § 78u-2(e) (1994), which as discussed above is designed to strip a wrongdoer of its unlawful gains, the interest rate it imposes is generally the IRS underpayment rate, see, e.g., SEC Rules & Regulations, 60 Fed.Reg. 32738, 32788 (June 23, 1995). That rate reflects what it would have cost to borrow the money from the government and therefore reasonably approximates one of the benefits the defendant derived from its fraud. Accordingly, courts have approved the use of the IRS underpayment rate in connection with disgorgement. See SEC v. Drexel Burnham Lambert, Inc., 837 F. Supp. 587, 612 n. 8 (S.D.N.Y. 1993) (citing cases), aff'd, 16 F.3d 520 (2d Cir. 1994), cert. denied, 513 U.S. 1077, 115 S. Ct. 724, 130 L. Ed. 2d 629 (1995).
We also reject as meritless defendants' contention that the district court erred in permanently enjoining them from future violations of § 17(a), § 10(b), and Rule 10b-5. An injunction prohibiting a party from violating statutory provisions is appropriate where "there is a likelihood that, unless enjoined, the violations will continue." Commodity Futures Trading Commission v. American Board of Trade, Inc., 803 F.2d 1242, 1250-51 (2d Cir. 1986); see also SEC v. Posner, 16 F.3d at 521-22. Such an injunction is particularly within the court's discretion where a violation was "founded on systematic wrongdoing, rather than an isolated occurrence," United States v. Carson, 52 F.3d at 1184 (internal quotation marks omitted), and where the court views the defendant's degree of culpability and continued protestations of innocence as indications that injunctive relief is warranted, since "persistent refusals to admit any wrongdoing ma [k]e it rather dubious that [the offenders] are likely to avoid such violations of the securities laws in the future in the absence of an injunction." SEC v. Lorin, 76 F.3d at 461 (internal quotation marks omitted); see also SEC v. Posner, 16 F.3d at 521 (where defendants violated securities laws with "high degree of scienter" and failed to assure court that future violations were not likely to recur, injunction was warranted).
In determining that a permanent injunction was warranted in the present case, the district court noted that First Jersey continued to be a broker-dealer owned by Brennan and that it employed a number of key personnel who worked at First Jersey between 1982 and 1985. Brennan himself has remained an active participant in the securities markets. See, e.g., Hibbard, Brown & Co., 58 S.E.C. Docket 2561, 1995 WL 116488, at * 1 (Mar. 13, 1995) (describing Brennan's purchase in 1991 of 1,450,000 units of securities). The district court also noted that First Jersey and Brennan had a history of engaging in activities that led to misconduct charges, followed by sanctions imposed by various regulatory agencies or courts, followed by new misconduct charges. Thus, the record showed, inter alia, that for a month in 1973, Brennan was suspended from the sale of mutual funds by the New Jersey Bureau of Securities. In 1974, Anthony Nadino, Brennan's brother-in-law and First Jersey's head trader at all times relevant to this case, was federally enjoined from further violations of the antifraud provisions of the securities laws based on his promulgation of false and misleading quotations and manipulation of the market while employed at another broker-dealer prior to coming to First Jersey. See SEC v. Management Dynamics, Inc., 515 F.2d 801, 810-11, 814 (2d Cir. 1975). In 1984, in settlement of the SEC's 1979 Proceeding and its Geosearch action, defendants were enjoined against engaging in certain transactions with regard to securities underwritten by First Jersey and a special consultant was appointed to monitor the Firm's practices. In 1986, NASD commenced and settled a proceeding entitled Market Surveillance Committee v. First Jersey Securities, Inc., Robert E. Brennan, and Anthony Nadino, Complaint No. MS-261 (Feb. 7. 1986), concerning markups in Trans Net warrants; First Jersey, Nadino, and Brennan were censured, First Jersey was fined $300,000, and Nadino and Brennan were fined $25,000 each and suspended for 10 days from association with any NASD member. In 1990, NASD commenced and settled a proceeding entitled District Business Conduct Committee v. First Jersey Securities, Inc., Robert E. Brennan, John E. Dell, Frederick A. Eyerman, et al., Complaint No. NEW-619 (Sept. 24, 1990), concerning violations of the NASD's Rules of Fair Practice, in which First Jersey was fined $50,000 and Brennan et al. were censured.
The district court also observed that Brennan, whose trial testimony the court characterized as "belligerent [ly] evasive [ ]," 890 F. Supp. at 1207, took the position in the present case that defendants had done nothing wrong and that if there had been any violations they were merely accidental. In light of defendants' disciplinary record, their deliberate and systematic frauds in the present case, and their continued protestations of innocence, it was well within the discretion of the district court to conclude that permanent injunctive relief is warranted.
Finally, defendants challenge that part of the judgment which provided for the appointment of a Special Agent to determine whether, during the period between 1982 and 1987, First Jersey engaged in fraudulent activity beyond that proved at trial. The district court, in its opinion, stated that it was convinced that the violations pleaded and proven with respect to the six securities at issue in the present litigation were but "the tip of the iceberg." 890 F. Supp. at 1212. Citing its general equity powers, the court stated that a Special Agent would therefore be appointed to investigate the possibility that, in 1982-1987, First Jersey had committed additional violations of the securities laws that the SEC had not pleaded or proven. The Special Agent would be directed, in the event that he found excessive markups or markdowns, to "recommend to the Court that defendants disgorge and pay over, as the Court may direct, all illegally-obtained profits." 890 F. Supp. at 1213. The final judgment stated that the Special Agent would be appointed thereafter, with his powers and duties delineated in a subsequent order. We find merit in defendants' challenge to this part of the judgment.
15 U.S.C. § 78u(a) (1). The Commission is given limited authority to delegate these investigatory powers; § 4(b) allows it to "appoint ... such officers, attorneys, examiners, and other experts as may be necessary for carrying out its functions under [the securities laws]." Id. § 78d(b) (1). This authority, which needed no court order for its exercise, provides no basis for the appointment of the Special Agent envisioned by the judgment in this case, for the agent was not to be one appointed by the SEC, but one appointed by the court.
The court itself, of course, has authority to make appointments of special personnel to assist in the court's judicial functions, such as special masters to assist in the adjudication of complicated factual issues, see Fed. R. Civ. P. 53, or trustees to oversee compliance with the court's final judgment, see, e.g., SEC v. S & P National Corp., 360 F.2d 741, 750 (2d Cir. 1966). The appointment of a Special Agent in this case, however, is not for the purpose of assisting in adjudication of a case before the court. Though the SEC argues that appointment of the Special Agent is appropriate because his appointment "is merely a mechanism to assist the court in ascertaining the appropriate amount of disgorgement" (SEC brief on appeal at 49), this argument disregards the fact that the claims brought by the SEC in this case have now been adjudicated, and the appropriate amount of disgorgement to deprive defendants of the unlawful gains from the transactions pleaded and proven in this litigation has been determined. Disgorgement is permissible relief for a valid claim of violation of the securities laws; but disgorgement is not a claim in itself. See generally Franklin v. Gwinnett County Public Schools, 503 U.S. 60, 69, 112 S. Ct. 1028, 1034, 117 L. Ed. 2d 208 (1992) (The " 'question whether a litigant has a "cause of action" is analytically distinct [from] and prior to the question of what relief, if any, a litigant may be entitled to receive.' ") (quoting Davis v. Passman, 442 U.S. 228, 239, 99 S. Ct. 2264, 2274, 60 L. Ed. 2d 846 (1979)). We do not regard the appointment of an investigator, whose instructions are to unearth claims not previously pursued by the SEC, as ancillary to the adjudication that has been completed.
The parties to an action may themselves agree, of course, subject to court approval, that a special officer is to be appointed to make such investigations. See, e.g., Handler v. SEC, 610 F.2d 656, 659-60 (9th Cir. 1979). But we are not aware of any case, other than one in which a judgment has been entered on consent, in which an investigative agent has been appointed by the court for the purpose of unearthing past wrongs in addition to those encompassed by the pleadings and proven at trial and recommending new charges to the court. See id. at 659 (emphasizing that "the district court did not impose special counsel upon" the corporation).
In sum, though "if a right of action exists to enforce a federal right and Congress is silent on the question of remedies, a federal court may order any appropriate relief," Franklin v. Gwinnett County Public Schools, 503 U.S. at 69, 112 S. Ct. at 1034, we do not regard the appointment of an investigator to determine whether or not the plaintiff had an additional right of action as either appropriate relief for the rights asserted or a proper exercise of the judicial function. Accordingly, we reverse so much of the court's judgment as appointed the Special Agent.