Opinion ID: 333764
Heading Depth: 1
Heading Rank: 5

Heading: Bloom--Failure to Give Full and Fair Answers to Questions

Text: From a Stock Exchange 35 We have no occasion to consider what the proper result would have been if Gromet had asked only whether Geon intended to make an announcement on February 22 with respect to the Burmah deal. 11 Gromet did not let it go at that. On Bloom's own testimony Gromet had inquired whether there was anything about the Burmah deal that would account for the large number of sell orders. If Bloom's negative answer was not actually false as it seems to have been, surely it was an omission 'to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.' Rule 10b--5(2). Bloom had received information which, if verified, would imperil the Burmah deal. He knew also that there was enough concern about the possibility of improper use of this information that counsel had recommended that trading on February 22 should be monitored. Yet, when confronted with the fact that the feared breach of confidence might have transpired, 12 he withheld from the Exhange the facts it needed to make an informed decision whether to suspend trading. Bloom knew also that his answer to Gromet's inquiry about the long delay in concluding the Burmah deal was not the whole truth. If anything more was required to make him realize the need for greater frankness, it was furnished by Gromet's remark that he hoped that after Geon had said it had no announcement to make that morning, it would not make one in the afternoon. This should have led Bloom to say what he ought to have said earlier, namely, that Geon had encountered a problem; that it did not yet know what the real facts were; and that the board was to meet again on Sunday evening when more information would be available. It is no excuse that Bloom expected that any further release would be made on Monday morning rather than Friday afternoon. 36 We have no quarrel with the judge's findings, 381 F.Supp. at 1069, that 'as of the morning of February 22, Geon had only raw, unverified information, which might have been misleading had it been made public,' and that Bloom had a good faith belief that the raw information might prove to be untrue. If the issue here were whether Bloom or Geon violated Rule 10b--5 by failing to issue a public statement on February 22, we would agree they did not; there was too great a danger that such a statement would induce selling that might prove to be unwarranted. We would also decline to find a violation if, in answer to inquiries from stockholders or brokers, Geon had adopted a policy of 'no comment.' Gromet was not in the position of a stockholder or a registered representative; he was charged with the responsibility of maintaining orderly trading on the exchange on which Geon had listed its shares. Moreover, Bloom's answer to Gromet's pointed queries went considerably beyond 'no comment'--an answer that could well have led to action by the Exchange, as Bloom must have known. He denied there was anything about the Burmah deal that would account for the sell orders when he knew that there well might be. Bloom may indeed have feared that a full and fair answer would have led to suspension of trading and have thought that to be contrary to the best interests of Geon's stockholders. But that decision was confided not to him but to the American Stock Exchange, and the Exchange must be able to rely on officials of listed companies to respond fully and fairly to its inquiries. 37 We likewise see no sufficient force in the argument that Bloom relied on the advice of counsel. Apart from all else, Bloom could not reasonably have interpreted Friedman as saying that disavowal of an intention to issue a release on February 22 would inevitably be a proper answer no matter what Gromet might ask. Moreover, at the time of their telephone talk, neither Bloom nor Friedman had definite knowledge of the large number of sell orders--although prudence might have suggested to them, particularly in light of the conversation after the board meeting, that something like this had prompted Gromet's call. 38 We do not mean to minimize that Bloom was in a difficult position. But so were the officials of Texas Gulf Sulphur when confronted with what they regarded as exaggerated rumors about the importance of the drilling at Timmins. If Gromet had asked for the precise details of what had developed, Bloom would have been entitled to respond that he was not yet in a position to say. What he could not do consistently with the securities laws was to give Gromet the impression that all was serene when he knew there was a significant risk of trouble. 39 We therefore reverse the finding of no violation and remand to the district court to determine whether injunctive relief should be awarded, see SEC v. Texas Gulf Sulphur Co., 312 F.Supp. 77, 87--88 (S.D.N.Y.1970), 13 and, if so, what this should be.VI. Edwards & Hanly--Adequacy of Supervision 40 The trial court dismissed the complaint against E&H, 381 F.Supp. 1071, saying: 41 The Court finds that Edwards acted in good faith and that the evidence fails to establish that Edwards participated in or knew of Rauch's misconduct or that Edwards did not exercise reasonable supervision over Rauch. Accordingly, there is no basis for an injunction against Edwards. 42 The SEC's argument on appeal is that the evidence does show a lack of reasonable supervision, and that, even if it does not, an injunction should issue. 14 43 The SEC sets the stage for its claim by pointing to the treatment that Rauch received while at E&H and E&H's knowledge of his activity in Geon stock. As recounted by Rosenfeld, this was as follows: When Rauch came to E&H in August, 1973, Rosenfeld was aware that Rauch held a position of 25,000 to 35,000 shares in Geon for customers and himself and was very familiar with the stock. Under E&H's policies, there had to be 'research approval' before Rauch could execute further orders in Geon, since the stock was selling under $15 per share; such approval was quickly obtained. By January 1974, Rauch had become the premier producer at the Hewlett office. Rauch requested and received the privilege of calling orders directly to E&H's main wire room--a privilege accorded to four or five of the twenty registered representatives in the Hewlett office. Regarding Rauch as a comer, Rosenfeld seated him directly in front of the assistant manager, Lynn. 44 In October, 1973, Rosenfeld began to solicit his customers to purchase Geon stock. Lynn began this in November, as did other registered representatives at the Hewlett office. Allegedly Rosenfeld had no conversations with Rauch about Burmah until after the press releases. 45 In October, 1973, Rosenfeld received a call from E&H headquarters asking if he was aware of the Hewlett office's growing accumulation of stock in Geon and warning him to be careful. Stronger cautions were issued in late November when the price of the stock had fallen. The fear was of customers' inability to respond to margin calls and that Rauch might be 'using special miscellaneous buying power to purchase additional shares of Geon.' Rosenfeld told Rauch he would have to see every ticket for the purchase of Geon and recommended that Rauch lighten his position. Despite this, Rosenfeld approved purchase tickets, including purchases on margin. Rosenfeld considered the warnings to be no longer in effect after the possibility of the Burmah deal was announced and the stock had gone up. 46 The generally favorable treatment accorded to Rauch, however, had no specific causal relationship to Rauch's misconduct, 15 and we must focus more precisely on two points: Should E&H be enjoined for negligently failing to prevent Rauch's contacts with Neuwirth? Should E&H be enjoined for negligently failing to prevent Rauch from selling on inside information on the morning of February 22? 47 On the first of these questions, we do not think the evidence would sustain a holding that E&H negligently failed to see to it that Rauch knew of his legal obligations. Rauch was already an experienced broker when hired by E&H, and the SEC made no effort at trial to establish that E&H's compliance manuals, furnished to Rauch, were in any way faulty. The more serious issue is whether E&H should have gone farther and established definite procedures for preventing, or monitoring, contacts between registered representatives and high executives of companies in whose stock the representatives had substantial positions. Rosenfeld's testimony, as it relates to this point, was as follows: 48 In the fall of 1973 and early winter of 1974, E&H's compliance manual placed no restrictions on a registered representative's calling executives of companies the stocks of which were in personal or company accounts so long as he did not represent himself as Edwards & Hanly, as an investment advisor, or as an analyst, but identified himself only as an account executive. Rauch talked with Rosenfeld about Geon--'Mr. Rauch was tremendously familiar with the company . . . he had a portfolio of information put together, annual reports, any report that was ever written on Geon Industries.' Rosenfeld was aware Rauch had spoken to Neuwirth and had been at Geon's plant. All he knew of the content of Rauch's talks with Neuwirth was that on one occasion they had discussed the probable effect of the energy crisis on Geon's business and that on another Rauch had inquired whether there would be a tender offer fee on the Burmah deal after this had been announced. 49 One further point was in evidence. In March, 1974, as a result of the events that here transpired, E&H introduced a new regulation requiring a registered representative to get branch manager approval before he could contact a company whose stock he, or his customers, held. However, the subsequent taking of measures which would have made a violation less likely normally cannot be considered as proving that failure to take them earlier was negligent, see Federal Rules of Evidence 407; Smyth v. The Upjohn Co., 529 F.2d 803 (2 Cir. 1975), in part because 'the supposed inference from the act is not the plain and most probable one,' 2 Wigmore, Evidence § 283 (3d ed. 1940). 16 The trial court, of course, declined to make the desired inference. 50 We should also mention one other point. The SEC adduced no evidence, and makes no argument, that it or any stock exchange of which E&H was a member had proposed a prophylactic practice of this sort or that it was common in the industry. 17 Had such a practice existed, we would have expected the SEC to have been zealous in showing it; and, of course, the Commission had the burden of proof. Accordingly, we think that the lack of proof of any specific industry practice that E&H should have followed in order to make Rauch's contacts with Neuwirth less likely argues in its favor and is relevant to the issue of negligence. See Prosser, Torts 166--68 (1971); 2 Harper & James, Torts § 17.3 (1956). We do not mean, of course, that this absence of proof is conclusive, for 51 a whole calling may have unduly lagged in the adoption of new and available devices. It never may set its own tests, however persuasive be its usages. 52 The T. J. Hooper, 60 F.2d 737, 740 (2 Cir.) (L. Hand, J.), cert. denied sub nom., Eastern Trans. Co. v. Northern Barge Corp., 287 U.S. 662, 53 S.Ct. 220, 77 L.Ed. 571 (1932). But what this lack of proof does indicate is that the SEC must argue, in this part of the case, that the standard of supervision for the whole brokerage industry should have been upgraded, not just that E&H ought to have been more careful. 53 Turning now to the testimony as regards the events of February 22, the issue is somewhat different. On the evidence it is clear that Rosenfeld did nothing to impede Rauch's trading activities; the question is whether Rauch's order to sell 1,500 Geon shares at the opening, and his sales of an additional 5,700 shares before trading ceased, should have led Rosenfeld to make inquiry, rather than to follow Rauch's lead for himself and some of his customers and to permit Lynn to do the same. Rauch had been preponderantly a buyer of Geon stock; 18 Rosenfeld testified that he knew that Rauch had been 'exceedingly bullish' as late as February 21, and that he thought that Rauch had 60,000 to 70,000 shares of Geon in his own or his customers' accounts. Rauch's order to sell 1,500 shares from three accounts at the opening on February 22 thus could well have prompted inquiry. However, the evidence is not so overwhelming as the SEC contends. Fifteen hundred shares were only some 2 1/2% of what Rosenfeld thought Rauch's position to be, and the later sales by Rosenfeld, Lynn and Rauch were explicable on the basis of the poor market action of the stock after trading began, especially in view of the small upside 54 In favor of the SEC's position it may be said that the testimony is susceptible to the interpretation that Rosenfeld was more interested in looking after his own and his clients' interests than in preventing misconduct by his subordinate. Against this is his testimony that his selling activities were motivated solely by his dislike of the market action of the stock; that Rauch conveyed no information to him; and that, indeed, Rauch succeeded in establishing the impression that 'quite obviously he knew nothing.' 19 Evidently the trial court credited this testimony, or at least the bulk of it. 55 Failure of a firm reasonably to supervise the acts of employees is, of course, a basis for suspension or revocation of the registration of a broker or dealer under § 15(b)(5)(E) of the Securities Exchange Act, subject to the provisos there contained. We assume, although we need not decide, that in an appropriate case the SEC may obtain an injunction where the brokerage firm has breached this duty. See SEC v. Lum's, Inc., 365 F.Supp. 1046, 1064--65 (S.D.N.Y.1973). However, the trial court found no sufficient proof of negligent lack of supervision, and the rule in this circuit is that while a trial judge's finding of negligence or the lack of it is reviewable as a matter of law, 'it will ordinarily stand unless the lower court manifests an incorrect conception of the applicable law.' Cleary v. United States Lines Company, 411 F.2d 1009, 1010 (2 Cir. 1969); Whelan v. Penn Central Co., 503 F.2d 886, 892 (2 Cir. 1974). 56 We think the evidence suffices to support the trial judge's determination with respect to both branches of the SEC's attack. Concerning Rauch's contacts with Neuwirth, E&H was exercising some supervision in that it required its registered representatives to identify themselves as such. With the benefit of hindsight we can see that the later-established rule, requiring branch manager approval, is a beneficial precaution, but E&H might reasonably have thought that the measures it had required would be sufficient to alert company executives to the possible dangers, and thus to prevent their disseminating inside information. We thus sustain the holding of the trial judge that the SEC failed to make a sufficient showing that E&H was acting unreasonably, or that it should have been alerted to the need to take further steps before these events came to light. 57 Rosenfeld's failure to make inquiry on February 22 raises a much closer issue. If the question came before us on review of an order of the SEC entered pursuant to § 15(b)(5)(E) of the Securities Exchange Act or after a finding by the district court of a negligent failure to supervise, we would doubtless sustain the ruling. However there was evidence which, if believed would sustain the trial court's apparent view that Rauch was sufficiently circumspect as not to give Rosenfeld cause for alarm. These credibility determinations were for him to make, and we decline to reverse him on this record. 58 The judge's citation of SEC v. Lum's, Inc., supra, 365 F.Supp. at 1064--65, does not indicate, as the SEC argues, that he held 'an incorrect conception of the applicable law.' It is true that Lum's proceeded in part on the view that a firm in E&H's position could be liable only as a 'controlling person' under § 20(a), which rules out liability where the controlling person 'acted in good faith and did not directly or indirectly induce the act or acts constituting the violation . . .,' and we have since held this view to be erroneous, SEC v. Management Dynamics, Inc., 515 F.2d 801, 811--13 (2 Cir. 1975). However, the judge in Lum's was also of the view that lack of good faith and negligent supervision were, in this context, equivalent legal standards, and set as his test, 365 F.Supp. at 1064, that 'even in enforcement proceedings . . . there should be at least negligent conduct required before the imposition of liability.' The trial court in our case recognized that 'good faith' was not a sufficient test, as is shown by the findings below that E&H acted in good faith and also did not fail to exercise reasonable supervision. We think, therefore, that its determinations as to the adequacy of supervision should be upheld. 59 The SEC argues, however, that this is not the end of the matter, Management Dynamics, according to the Commission, points in the direction of imposing liability on E&H on the basis of the principle of respondeat superior even though E&H did not fail reasonably to supervise. That argument, however, is based on a significant extension of Management Dynamics, an extension which, at least in this context, we decline to make. 60 In Management Dynamics the brokerage employee in question was the vice president in charge of trading, and by virtue of his position was able to submit fictitious quotations in the firm's name, thereby creating a misleading appearance of activity in the stock in question. This court was careful to 'intimate no view as to other cases which may involve lesser employees,' and the opinion was at pains to say that there was no need to decide 'whether the entire corpus of agency law is to be imported into the securities acts for all purposes,' 515 F.2d at 813. To say that an injunction must issue against a brokerage firm whenever one could have been issued against a registered representative significantly overreads Management Dynamics. As the carefully qualified approach of the case makes clear, the fact that use of common law agency concepts may be appropriate in some circumstances does not mean that we should import them where this will not further the policies of the securities acts. 61 We think there are good reasons for saying that an injunction should not here issue once it has been determined that there was no violation of E&H's duty reasonably to supervise Rauch. While there are circumstances in which the showing required by the SEC to get injunctive relief is less than when other parties are requesting other types of relief, see SEC v. Texas Gulf Sulphur Co., supra, 401 F.2d at 868 (Friendly, J., concurring), we do not think that this case falls completely within that category. It is true that courts have used agency principles to impose liability for rescission or damages on brokerage firms, in suits brought by persons in privity, in circumstances similar to those here present. Lewis v. Walston & Co., 487 F.2d 617, 623--24 (5 Cir. 1973) (sale of unregistered stock, within scope of employment); Fey v. Walston & Co., 493 F.2d 1036, 1051--53 (7 Cir. 1974) (churning); see also Johns Hopkins University v. Hutton, 422 F.2d 1124, 1130 (4 Cir. 1970), cert. denied, 416 U.S. 916, 94 S.Ct. 1622, 40 L.Ed.2d 118 (1974) (fraudulent misrepresentations). Doubtless in part because of its recognition of such liability, E&H allowed all those who had purchased the shares sold out of the Hewlett office on February 22 to rescind their transactions. But an injunction, in this case, is a different matter. 62 It cannot be said that, unless an injunction issues, there will be no incentive for brokerage firms to improve their standards for supervising their salesmen; the cases just cited show exactly the opposite. Indeed, even without this judicial remedy, the SEC and the stock exchanges have administrative procedures at their disposal which can be more easily adapted to the introduction of new procedures in the industry as a whole than can injunctive relief in this single case. The need for the injunctive remedy on the facts here present is not pressing. 63 By contrast, the consequences of an injunction against a brokerage firm are potentially very great. On reasoning parallel to the SEC's contention, an injunction could appropriately be issued that would place the firm in contempt if any other registered representative repeated Rauch's performance, again regardless of the adequacy of supervision. 20 In addition, brokers and dealers face special collateral consequences: the possibility that the injunction will serve as a partial predicate for discipline or revocation under § 15(b)(5)(C) of the Securities Exchange Act; the unavailability of Regulation A, 17 C.F.R. §§ 230.251--63 in cases where the firm is an underwriter; and disqualification under § 9(a)(2) of the Investment Company Act from serving as an employee or official of a registered investment company. 21 64 In Management Dynamics, the employee held a prominent position in his firm, spoke in his firm's name, and had 'apparent authority' to do so. On those facts it was not unfair to enjoin the firm because of his acts. Here, we have only a registered representative, making no special use of his connection with his firm, and with no profit other than ordinary commissions going to it. Given the lack of balance between the need for an injunction and the hardship which it would create, we do not think that one should issue here once it has been determined that E&H exercised reasonable supervision over Rauch. However, we wish to make clear, just as did not court in Management Dynamics, that we intimate no view as to cases with different facts, and that situations which fall between that case and this one will have to await future resolution. In the end, a court of equity must act in accordance with Mr. Justice Douglas' admonition in Hecht Co. v. Bowles, 321 U.S. 321, 329--30, 64 S.Ct. 587, 592, 88 L.Ed. 754 (1944), to which we have so frequently referred: 65 The historic injunctive process was designed to deter, not to punish. The essence of equity jurisdiction has been the power of the Chancellor to do equity and to mould each decree to the necessities of the particular case. Flexibility rather than rigidity has distinguished it. The qualities of mercy and practicality have made equity the instrument for nice adjustment and reconciliation between the public interest and private needs as well as between competing private claims. 66 We therefore affirm the judgments against Neuwirth and Geon, reverse the dismissal of the complaint against Bloom and remand for consideration of the propriety and terms of an injunction, and affirm the dismissal of the complaint against E&H. In view of § 27 of the Securities Exchange Act no costs are awarded.