Opinion ID: 177377
Heading Depth: 2
Heading Rank: 2

Heading: Assertion of Violations of Regulations G and U as Affirmative Defenses

Text: The Borrowers argue that the district court erred in concluding that they had no private right of action under § 7(d) or § 29(b) of the Securities Exchange Act of 1934 and therefore lacked standing to assert the alleged violations of Regulations G and U as affirmative defenses. [6] The district court's decision followed Blair v. Bank One, N.A., 307 B.R. 906 (N.D.Ill. 2004), appeal dismissed in light of settlement, which relied on Bassler v. Cent. Nat'l Bank, 715 F.2d 308 (7th Cir.1983). The Borrowers contend that the district court's reliance on Bassler and Blair was misplaced. In Bassler, a borrower sought to void a group of loans that were obtained to finance the purchase of stock. The borrower claimed that the lender violated § 7(d) of the Securities Exchange Act of 1934 and Regulation U by failing to obtain a Regulation U statement from him. He also alleged that the lender violated § 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 by failing to disclose that the stock was worthless. Bassler held that neither § 7(d) nor § 29(b) conferred a private right of action in investment borrowers as against investment lenders. Id. at 313. We considered the Act's main purposes which were to give a Government credit agency an effective method of reducing the aggregate amount of the nation's credit resources which can be directed by speculation into the stock market and out of other more desirable uses of commerce and industry, id. (citing H.R.Rep. No. 1383, 73d Cong., 2nd Sess. 8 (1934)) and to safeguard the national economy, id. The House Report noted that the Act's main purpose was not the protection of the small speculator, though that would be achieved as well. Nothing suggested a Congressional intent to create a private right of action in borrowers as against lenders. We therefore concluded that the district court properly dismissed the plaintiff's claim that the loans were void based on violations of Regulation U. Id. Blair arose from Comdisco's bankruptcy. Bank One filed a proof of claim for the outstanding loans to SIP Participants. Comdisco objected on the grounds that the loans violated margin regulations. Several SIP Participants (including most of the Borrowers in our case) intervened. The bankruptcy court held that neither Comdisco nor the intervenor borrowers had statutory standing to challenge the legality of the loans underlying Bank One's claim. On appeal to the district court, Comdisco and the borrowers asserted that the loans violated Regulation U and that § 7(d) and § 29(b) of the Securities Exchange Act provided them a defense to Bank One's claim. Comdisco and the SIP Participants argued that Bassler was not controlling because they asserted the regulatory violation as an affirmative defense, not a separate cause of action. The district court rejected this argument as one of semantics. Blair, 307 B.R. at 909. Although the district court noted that the intervenor borrowers had moved for declaratory judgment rather than asserting a defense (whereas Comdisco filed an objection to Bank One's claim), the court held that neither § 7(d) nor § 29(b) provided Comdisco or the SIP Participants with a defense to Bank One's claim and they therefore had no standing to challenge the legality of the loans. Id. at 909-10. Thus, the Borrowers' argument that the district court misplaced its reliance on Blair because the intervenors did not raise § 29(b) defensively lacks any traction. The Blair court concluded that no matter what the label, this cause of action does not exist under § 7(d) and § 29(b)because the intervenor SIP Participants and Comdisco sought a declaration that the loans were void because of the alleged margin violations, Bassler controls. Id. at 910. The court reasoned that Congress did not intend to protect investors with § 7.... [T]he main purpose of § 7 was to control the excessive use of credit in security transactions. Id. (quotation omitted). It also concluded that Bassler 's holding was not limited to a technical violation of Regulation U but also reached direct, substantive violations, including where the bank loans financed 100% of the stock purchases. Id. Shearson Lehman Bros., Inc. v. M & L Invs., 10 F.3d 1510 (10th Cir.1993), provides additional authority for the conclusion that the Borrowers cannot assert violations of margin regulations as an affirmative defense. In Shearson, a stockbroker brought a breach of contract action and the purchasers asserted an affirmative defense for nonpayment based on the stockbroker's violation of Regulation T, a margin regulation concerning extensions of credit by brokers and dealers. The court found that the stockbroker violated the regulation, which required the holder of a cash account to promptly liquidate in the event of a purchaser's failure to make timely payment. Id. at 1514. However, the court concluded that there is no affirmative defense to a breach of contract claim for Regulation T violations. Id. at 1516. The court stated that its conclusion was most consistent with the policy behind Regulation T and other regulationsto protect the market in generalnot to benefit individual investors. Id. It also reasoned that the regulations placed the burden of compliance with margin requirements on both broker and client, so it would be inconsistent to place the burden of noncompliance on brokers in contract disputes. Id. We find the reasoning of Bassler, Blair, and Shearson persuasive. Even if Comdisco and the Bank violated Regulation G or U, the Borrowers' illegality defense based on such a violation fails. There is nothing inherently illegal in a contract to borrow money to purchase stock, and a regulatory violation does not make such a contract illegal. See ADM Investor Servs., Inc. v. Collins, 515 F.3d 753, 755-56 (7th Cir.2008). Furthermore, Regulations G and U were not designed to protect individual investors such as the Borrowers; they were designed to protect the general public. See id. (balky customers are not in the zone of interests protected by margin-posting requirements). To allow the Borrowers to assert the margin violations as an affirmative defense to the Trustee's action on the Notes would place the Borrowers in a heads I win, tails you lose position. See Bache Halsey Stuart, Inc. v. Killop, 509 F.Supp. 256, 259 (D.Mich.1980). If the value of the Comdisco stock went upas it did for a while the Borrowers gain on their investment. And if the stock goes down, the Borrowers can void the loan contract and lose nothing. See id. We have little doubt that if Comdisco had not filed bankruptcy and its stock had continually soared in value, the Borrowers would not be before us now seeking to void the Notes. The district court correctly decided that the Borrowers could not assert violations of Regulations G and U as affirmative defenses. The Borrowers try in vain to persuade us that they may assert the alleged margin violations as affirmative defenses. They first contend that no private right of action is necessary to assert a plaintiff's violation of federal law as an affirmative defense. Yet the cases upon which they rely actually support the Trustee's view that an illegality defense is available only to those whom the statute at issue was designed to protect. See Kaiser Steel Corp. v. Mullins, 455 U.S. 72, 86, 102 S.Ct. 851, 70 L.Ed.2d 833 (1982) (defense under § 8(e) of the National Labor Relations Act could be raised by a party which § 8(e) was designed to protect, and where the defense is not directed to a collateral matter but to the portion of the contract for which enforcement is sought); Transamerica Mortg. Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 17, 100 S.Ct. 242, 62 L.Ed.2d 146 (1979) (holding that the Investment Advisors Act implies a limited remedy to void an investment advisors contract while recognizing that the Act was intended to benefit the clients of investment advisers); Mills v. Elec. Auto-Lite Co., 396 U.S. 375, 381, 90 S.Ct. 616, 24 L.Ed.2d 593 (1970) (provision at issue was intended to promote the free exercise of the voting rights of stockholders (internal quotations omitted)); Rush-Presbyterian-St. Luke's Med. Ctr. v. Hellenic Republic, 980 F.2d 449, 455 (7th Cir. 1992) (noting that illegality may be a defense to contract but not allowing hospital's failure to comply with statutory certification requirement to be used as a defense to contract action for payment of hospital bills); Bankers Life Co. v. Denton, 120 Ill.App.3d 576, 76 Ill. Dec. 64, 458 N.E.2d 203, 205 (1983) (allowing mortgagees to assert noncompliance with HUD mortgage servicing requirements as an affirmative defense to a foreclosure action because it was necessary to effectively insure that the interests of the primary beneficiaries of the H.U.D. mortgage servicing requirements are being protected). Other cases they cite involved contracts the subjects of which were themselves illegal or infected by an illegal conflict of interest; as a result, the contracts were unenforceable. See United States v. Miss. Valley Generating Co., 364 U.S. 520, 566, 81 S.Ct. 294, 5 L.Ed.2d 268 (1961) (allowing nonenforcement of contract infected by an illegal conflict of interest on the part of the government official who participated in contract negotiations in violation of federal conflict-of-interest statute aimed at ensuring honesty in government's business dealings); E. Bement & Sons v. Nat'l Harrow Co., 186 U.S. 70, 88, 22 S.Ct. 747, 46 L.Ed. 1058 (1902) (assuming that only the Attorney General could bring an action to enforce the Sherman Act and allowing the defense that the contract is illegal under the antitrust laws); Kessinger v. Standard Oil Co., 245 Ill.App. 376, 1925 WL 4623, at  (1925) (holding tenant could not recover against appellant where his cause of action was founded on his own violation of the law which prohibited the tenant's action of excavating and taking sand from river). Johnston v. Bumba, 764 F.Supp. 1263, 1279 (N.D.Ill.1991), aff'd, 983 F.2d 1072 (7th Cir.1992), also cited by the Borrowers, did allow a defendant to assert as a defense to an action to recover on a promissory note that the securities were sold in violation of the securities laws. However, our affirmance in Johnston did not adopt or even address the district court's ruling that the defendants prevailed based on the securities law violations. Instead, we affirmed on the alternate ground that plaintiffs failed to prove the amount due on the note. The Borrowers then argue that they may assert the defense of illegality to an action on the Notes under Illinois law. While Illinois recognizes illegality as an affirmative defense to a breach of contract action, the defense applies where the contract itself is illegal. See, e.g., Kramer v. McDonald's Sys., Inc., 77 Ill.2d 323, 33 Ill.Dec. 115, 396 N.E.2d 504, 508-09 (1979) (holding Illinois's Uniform Limited Partnership Act prohibited a limited partner from taking collateral to secure repayment of his capital contributions and franchisor had standing to assert this as a defense to limited partner's conversion action); Cothran v. Ellis, 125 Ill. 496, 498-99, 16 N.E. 646 (1888) (assuming that a note representing debt for gambling transactions would be against public policy); Am. Buyers Club of Mt. Vernon, Ill., Inc. v. Grayling, 53 Ill.App.3d 611, 11 Ill.Dec. 449, 368 N.E.2d 1057, 1058-61 (1977) (holding that an unconscionable contract for membership in a buyer's club that violated Regulation Z and the Truth in Lending Act in failing to disclose finance charges was void and note was unenforceable). Furthermore, where, as here, the statute allegedly violated is federal, federal law determines... whether the statute was violated but also, if so, and assuming the statute itself is silent on the matter, the effect of the violation on the enforceability of the contract. N. Ind. Pub. Serv. Co. v. Carbon Cnty. Coal Co., 799 F.2d 265, 273 (7th Cir.1986) (supposing that the contract does violate section 2(c) of the Mineral Lands Leasing Act, this does not necessarily make it unenforceable); see also Kelly v. Kosuga, 358 U.S. 516, 519, 79 S.Ct. 429, 3 L.Ed.2d 475 (1959) (the effect of illegality under a federal statute is a matter of federal law); Sola Elec. Co. v. Jefferson Elec. Co., 317 U.S. 173, 176, 63 S.Ct. 172, 87 L.Ed. 165 (1942) (When a federal statute condemns an act as unlawful the extent and nature of the legal consequences of the condemnation ... are ... federal questions, the answers to which are to be derived from the statute and the federal policy which it has adopted.). Thus, the effect of an alleged violation of Regulation G or U on the enforceability of the Notes is determined by federalnot Illinois law. The Borrowers next argue that § 29(b) permits them to assert violations of Regulations G and U as affirmative defenses. The principal authority they cite is TAMA v. Lewis, which held that there is a limited private remedy under the Investment Advisers Act of 1940 to void an investment advisors contract, see 15 U.S.C. § 80b-1-15. In so holding, the Court stated that the Act was intended to benefit the clients of investment advisers. 444 U.S. at 17, 100 S.Ct. 242. The Court said: the statutory language itself fairly implies a right to specific and limited relief in a federal court. By declaring certain contracts void, § 215 by its terms necessarily contemplates that the issue of voidness under its criteria may be litigated somewhere. At the very least Congress must have assumed that § 215 could be raised defensively in private litigation to preclude the enforcement of an investment advisers contract. Id. at 18, 100 S.Ct. 242. The Court stated that this Court has previously recognized that a comparable provision, § 29(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78cc(b), confers a `right to rescind' a contract void under [that statute]. Id. at 18-19, 100 S.Ct. 242 (citing Mills, 396 U.S. at 388, 90 S.Ct. 616). In Mills, stockholders sought to set aside a corporate merger, alleging it was accomplished through a materially false and misleading proxy statement in violation of the Securities and Exchange Act's disclosure requirements. The Court observed that the provision relating to proxies was intended to promote `the free exercise of the voting rights of stockholders' by ensuring that proxies would be solicited with `explanation ... of the real nature of the questions for which authority to cast his vote is sought.' Mills, 396 U.S. at 381, 90 S.Ct. 616. The Court held that the stockholders had a cause of action; to hold otherwise would frustrate the congressional purpose. Id. at 382-83, 90 S.Ct. 616. The Court instructed lower courts that this conclusion implie[d] nothing about the form of relief to which they may be entitled, id. at 386, 90 S.Ct. 616, and in selecting a remedy, courts should exercise `the sound discretion which guides the determinations of courts of equity[.]' Id. ; see also Rondeau v. Mosinee Paper Corp., 422 U.S. 49, 64, 95 S.Ct. 2069, 45 L.Ed.2d 12 (1975) ( Mills could not be plainer in holding that the questions of liability and relief are separate in private actions under the securities laws, and that the latter is to be determined according to traditional [equitable] principles). Mills explained that § 29(b) did not require that the merger be set aside just because the merger agreement was a void contract. Id. at 386-87. 90 S.Ct. 616. Rather, it precluded the guilty party from enforcing the contract against an unwilling innocent party and rendered the contract merely voidable at the option of the innocent party. Id. at 387, 90 S.Ct. 616. Neither TAMA nor Mills involved an alleged violation of Regulation G or U. Thus, neither case recognized that investors are among those the Regulations were designed to protect. (And it was not determined that the Borrowers were unwilling innocent parties anyway.) The Borrowers also cite to Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1036-37, 1051 (7th Cir.1977), and Sundstrand Corp. v. Standard Kollsman Indus., Inc., 488 F.2d 807, 816 (7th Cir.1973), for the proposition that Section 29(b) can be asserted defensively ... to defeat the enforcement of contracts, and if successful, outright dismissal of the contract claim.... In Sun Chemical Corp., we affirmed the dismissal of a counterclaim based on a stock option transfer agreement that was made in violation of § 10(b) and Rule 10b-5. We concluded that the agreement was void under § 29(b) based on the violations. 553 F.3d at 1051. However, courts have implied from § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 a private right of action for fraud. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 731, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975). As discussed, the Borrowers have no private right of action to assert Regulation G or U violations. The Borrowers also rely on § 29(c), which they say implies a right to assert a Regulation G or U violation defensively under § 29(b). [7] Notably, no authority is offered to support this view. And nothing in the Securities Exchange Act compels the conclusion that Congress specified in § 29(c) the few circumstances under which a contract made or performed in violation of § 7(d) may escape invalidation under § 29(b). Moreover, § 29(c) preserves the validity of a loan made in violation of the margin regulations unless the person making the loan has actual knowledge that the loan violated the regulations. The record at this stage does not establish that the Bank or Comdisco had such knowledge. The district court found that Comdisco and the Bank obtained the advice of outside counsel, who obtained an opinion that the loans did not violate the regulations, before making any representations as to the SIP Plan's compliance. Such a finding seems at odds with an inference that Comdisco or the Bank had actual knowledge of the alleged violations of the regulations. We find no error in the district court's conclusion that the Borrowers lack standing to raise a violation of Regulation G or U as an affirmative defense.