Opinion ID: 219846
Heading Depth: 1
Heading Rank: 3

Heading: Whether the Borrowers May Assert Violations of Regulations G and U as an Affirmative Defense

Text: We begin by considering whether the district court erred in concluding that the Borrowers lacked standing to assert violations of Regulations G and U as an affirmative defense. The district court's conclusion was based on Bassler v. Central National Bank, 715 F.2d 308 (7th Cir. 1983), which held that investment borrowers have no private right of action against investment lenders under Section 7(d), Section 29(b), [4] or any other provision of the Securities Exchange Act of 1934. Id. at 313. The district court also relied on Blair v. Bank One, N.A., 307 B.R. 906 (N.D.Ill.2004), appeal dismissed in light of settlement with instructions to dismiss sub nom. In re Comdisco, Inc., No. 04-2108, 2005 WL 6136323 (7th Cir. Jan. 28, 2005), and vacated by Blair v. Bank One, N.A., 1:03-cv-3095 (N.D.Ill. Mar. 31, 2008), which applied Bassler. The Borrowers contend that the district court erred in relying on Bassler and Blair. We agree. The Bassler plaintiff entered into a series of loan transactions to finance the purchase of stock and pledged the stock as security for the notes. The bank failed to obtain a Regulation U statement from him, which he claimed violated Section 7(d) of the Securities Exchange Act and Regulation U. The plaintiff sought a judgment voiding the loans. The district court dismissed the complaint, holding that no private action was available. Bassler, 715 F.2d at 308-09. The plaintiff asserted that Section 7(d) and Section 29(b) implied a private right of action for borrowing investors against lending banks. Id. at 309, 311. We affirmed the district court, holding there was no right of action in investment borrowers as against investment lenders. Id. at 313. Blair took Bassler a step further. Bank One filed a proof of claim in Comdisco's bankruptcy proceeding for the outstanding loans to SIP participants. Blair, 307 B.R. at 908. Comdisco filed an objection seeking to void Bank One's claim based on alleged margin violations. Several SIP participants (including most of the Borrowers in our case) intervened and sought a declaratory judgment that Bank One could not pursue its claims against them. The bankruptcy court held that neither Comdisco nor the intervenors had statutory standing to challenge the legality of the loans underlying Bank One's claim. On appeal to the district court, Comdisco and the intervenors asserted that the loans violated Regulation U and that Section 7(d) and Section 29(b) of the Securities Exchange Act provided them with a defense to Bank One's claim. They argued that Bassler was not controlling because they wished to assert an affirmative defense, not a separate cause of action. The district court rejected the argument as one of semantics, Blair, 307 B.R. at 909, noting that they were seeking a judgment in their favor rather than raising an affirmative defense. Id. The court concluded that Bassler was controlling because the intervenors sought a declaration that the loans were void. Id. at 909-10. The appellants argued that they could assert Regulation U violations as an affirmative defense under Section 7(d), relying primarily on Transamerica Mortgage Advisors, Inc. (TAMA) v. Lewis, 444 U.S. 11, 100 S.Ct. 242, 62 L.Ed.2d 146 (1979). TAMA held that § 215(b) of the Investment Advisers Act of 1940 created a private right of action in clients of investment advisers to void an investment contract based on violations of the Act. Id. at 18-19, 100 S.Ct. 242. The court was not persuaded. It said that Bassler had addressed TAMA, concluding that TAMA did not require an implied right of action arising from § 7(d). Blair, 307 B.R. at 910 (citing Bassler, 715 F.2d at 311-12). Thus, Blair read Bassler as precluding a party from raising margin violations defensively. However, Bassler was an action by a plaintiff investor against a lending bank to void a contract. Bassler did not hold that Section 7(d) and Section 29(b) cannot be raised defensively by a borrower against a lender in an action to enforce a contract, which is the case presented here. Thus, Blair extended Bassler beyond its reach. Neither Blair nor Bassler offers authority for the proposition that the Borrowers need a private right of action under Section 7(d) or Section 29(b) in order to assert an affirmative defense that the Notes are void and unenforceable because they violate Section 7(d) and Regulations G and U. No private right of action under a statute is necessary to assert a violation of that statute as an affirmative defense. See, e.g., Kaiser Steel Corp. v. Mullins, 455 U.S. 72, 86, 102 S.Ct. 851, 70 L.Ed.2d 833 (1982) (allowing defense under § 8(e) of the National Labor Relations Act where defendant had no private right of action to enforce the statute); United States v. Miss. Valley Generating Co., 364 U.S. 520, 566, 81 S.Ct. 294, 5 L.Ed.2d 268 (1961) (holding conflict of interest on the part of a government official who participated in contract negotiations in violation of federal law rendered contract unenforceable); 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, yet allowing the defense that the contract was illegal under the antitrust laws); 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 even though statutes that make conduct illegal ordinarily prescribe public remedies); Johnston v. Bumba, 764 F.Supp. 1263, 1279 (N.D.Ill.1991) (allowing defendant to assert as a defense to an action on a promissory note that the securities were sold in violation of securities laws), aff'd on other grounds, 983 F.2d 1072 (7th Cir. 1992). Kaiser Steel explains: Refusing to enforce a promise that is illegal under the ... laws is not providing an additional remedy contrary to the will of Congress. A defendant proffering the defense seeks only to be relieved of an illegal obligation and does not ask any affirmative remedy based on the ... laws. [A]ny one sued upon a contract may set up as a defence that it is a violation of the act of Congress, and if found to be so, that fact will constitute a good defence to the action. 455 U.S. at 81 n. 7, 102 S.Ct. 851 (quoting E. Bement & Sons, 186 U.S. at 88, 22 S.Ct. 747). Recognizing that only the National Labor Relations Board could provide affirmative remedies for unfair labor practices, id. at 86, 102 S.Ct. 851, the Court held that a court may not enforce a contract provision which violates [federal law]. Id.; see also id. at 83, 102 S.Ct. 851 ([A] federal court has a duty to determine whether a contract violates federal law before enforcing it.). By refusing to enforce a contract that violates a statute, the court serves the public interest of deterring contracts in violation of the law and promoting adherence to the law. Id. at 77, 102 S.Ct. 851; see also N. Ind. Pub. Serv. Co. (NIPSCO) v. Carbon Cty. Coal Co., 799 F.2d 265, 273 (7th Cir.1986) (refusing to enforce a contract that violates a statute deters behavior forbidden by that statute). Accordingly, the Court held that the defendant was entitled to raise and have adjudicated its defense that the agreement sued on was void and unenforceable as in violation of federal law. Kaiser Steel, 455 U.S. at 77-86, 102 S.Ct. 851. The Trustee attempts to distinguish these authorities; he stops short, however, of challenging whether they support the proposition that no private right of action is needed to assert an affirmative defense of illegality. He first argues, citing Kaiser Steel and Rush-Presbyterian, that some of the cases relied on by the Borrowers required the parties asserting the illegality defense to show that the statute at issue was designed to protect their interests. Kaiser Steel did say that a defense under § 8(e) of the National Labor Relations Act could be raised by a party which § 8(e) was designed to protect. Id. at 86, 102 S.Ct. 851. But this was in the context of addressing whether the district court had authority to adjudicate a defense based on the illegality of a promise under the antitrust and labor laws, or whether the NLRB had exclusive jurisdiction over the matter. See, e.g., id. at 83, 102 S.Ct. 851 (We also do not agree that the question of the legality of the ... [promise] under ... the NLRA was within the exclusive jurisdiction of the [NLRB]....). In that context, the Court stated a general rule with broad applicability: a court may not enforce a contract provision which violates [federal law]. Id. at 86, 102 S.Ct. 851. The Trustee also overreads Rush-Presbyterian. In that case, two Chicago hospitals sued the government of Greece and two of its agencies for payment of bills for more than $500,000 for services provided in connection with kidney transplants. The defendants argued that one of the hospitals could not collect for its services because it had not obtained a required state permit. Rush-Presbyterian, 980 F.2d at 451, 455. The illegality defense did not fail on the ground that the statute did not provide a private right of action or was not designed to protect the defendants' interests. Instead, we followed the equitable, balancing approach that applies when a contract itself is not illegal but is carried out in an illegal manner, and determined that the hospital's failure to comply with the permit requirement did not bar it from collecting payment. Id. at 455-56; see also NIPSCO, 799 F.2d at 272-74 (applying equitable, balancing approach where, assuming a violation lurking somewhere in the background, the contract itself is not illegal). Important to our decision was the fact that barring recovery would produce a sanction disproportionate to the wrong. Rush-Presbyterian, 980 F.2d at 455-56. Thus, the defendants were allowed to assert the defense of illegality; they just lost on the merits. The Trustee next argues that other cases relied on by the Borrowers such as Mississippi Valley Generating Co. and E. Bement & Sons involved challenges to contracts or conduct whose very subject matter was illegal or infected by an illegal conflict of interest. Some of the cases fall within this category; others such as Rush-Presbyterian do not. Furthermore, a court has the power to refuse to enforce a contract when enforcement would violate clearly articulated congressional goals and policies. Stuart Park Assoc. v. Ameritech Pension Trust, 51 F.3d 1319, 1326 (7th Cir.1995). The Trustee asserts that [i]t has long been held that a party is not entitled to raise a violation of a statute as an affirmative defense unless it can be shown that the party asserting the defense possesses a private right of action under that statute. Appellee Br. 14 n.2. He cites Inland Commercial Property Sales, Inc. v. Atlantic Assocs., Inc., No. 90 C 1036, 1991 WL 278311, at  & n. 3 (N.D.Ill. Dec. 18, 1991) (striking affirmative defenses based on noncompliance with statute because defendant does not have a private cause of action pursuant to the Real Estate License Act and therefore cannot raise these affirmative defenses), and Farm Credit Bank of St. Louis v. Dorr, 250 Ill.App.3d 1, 189 Ill.Dec. 581, 620 N.E.2d 549, 551-53 (1993) (concluding that a private cause of action is necessary to assert a claim based on noncompliance with a statute whether the claim is made in a complaint or as an affirmative defense). These are the only authorities cited for this proposition and they are relegated to a footnote. These decisions are not persuasive; they erred in requiring a private right of action as a prerequisite to the assertion of a statutory violation as an affirmative defense. Furthermore, Section 29(b) of the Securities Exchange Act provides the Borrowers with the right to raise violations of the Act and margin regulations defensively to preclude enforcement of a contract. As stated, TAMA held that Section 215(b) of the Investment Advisers Act created a private right of action in clients of investment advisers to void an investment advisers contract. The language of Section 215(b), 15 U.S.C. § 80b-1-15, closely parallels the language of Section 29(b). While the Court noted that the statutory sections involved were intended to benefit the clients of investment advisers, TAMA, 444 U.S. at 17, 100 S.Ct. 242, it stated that whether Congress intended additionally that these provisions would be enforced through private litigation is a different question, id. at 18, 100 S.Ct. 242. To answer that question, the Court looked to the legislative history, which was silent on the issue, and the statutory language. Id. at 15-19, 100 S.Ct. 242. The Court concluded: [T]he 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 then observed that it has 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 v. Elec. Auto-Lite Co., 396 U.S. 375, 388, 90 S.Ct. 616, 24 L.Ed.2d 593 (1970)). And in Mills, a stockholders' action to set aside a corporate merger allegedly in violation of the Securities Exchange Act, the Court stated that Section 29(b) establishes that the guilty party is precluded from enforcing the contract against an unwilling innocent party. Mills, 396 U.S. at 387-88, 90 S.Ct. 616 (approving of the interpretation of Section 29(b) as rendering a contract voidable at the option of the innocent party); Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1051 (7th Cir.1977) (affirming dismissal of counterclaim for specific performance or damages under agreement that violated the Securities Exchange Act and Rule 10b-5 as void as regards the rights of [the violator] under Section 29(b) of the Act). Accordingly, TAMA supports the conclusion that a borrower has the right under Section 29(b) to assert violations of the Securities Exchange Act and margin regulations as an affirmative defense to a breach of contract action. The Trustee asserts that TAMA, Mills, and Sundstrand are in harmony with Bassler because the statutory provisions violated in those cases were intended to benefit the parties seeking redress through Section 29(b). It is true that TAMA and Mills addressed whether the statute at issue created a cause of action, and Sundstrand similarly considered whether a party could assert a claim to enforce a contract. Nonetheless, their reasoning supports the assertion that the Borrowers may assert the alleged margin violations as affirmative defenses. And there is more authority reinforcing the Borrowers' position. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 735, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975) (dictum noting that Section 29(b) provides that a contract made in violation of any provision of the [Securities Exchange] Act is voidable at the option of the deceived party); Natkin v. Exch. Nat'l Bank of Chi., 342 F.2d 675, 676 (7th Cir.1965) ([A] violation such as here alleged [making loans in violation of Regulation U] operates to void the contract rights of the party in violation); Staff Opinion of May 5, 1982, Federal Reserve Regulatory Service 5-900.11 (Contracts made in violation of Regulation U are voidable under Section 29(b) of the [Exchange Act].). Allowing the Borrowers to assert the alleged violations of Regulations G and U as an affirmative defense is consistent with the Restatement (First) of Contracts § 598 (1932), which sets forth the general rule that a party to an illegal bargain cannot recover damages for breach of contract. It is also consistent with the Restatement (Second) of Contracts § 178 (1981), which provides: A promise or other term of an agreement is unenforceable on grounds of public policy if legislation provides that it is unenforceable.... Section 29(b) expressly provides that any contract made in violation of any provision of this chapter or of any rule or regulation thereunder ... shall be void.... 15 U.S.C. § 78cc(b). Shearson Lehman Bros., Inc. v. M & L Invs., 10 F.3d 1510 (10th Cir.1993), is cited as additional authority for the view 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 broker's violation of Regulation T, a margin regulation. The court found that the broker violated the regulation, id. at 1514, but concluded there was no affirmative defense to breach of contract for such violations. Id. at 1516. The court thought this conclusion was most consistent with the policy behind Regulation T and other regulations which protect the market in general. Id. Another consideration was that the Securities Exchange Act and Regulation X required clients to comply with margin requirements. The court reasoned that since the regulations place the burden of margin requirement compliance equally upon broker and client, it [would be] inconsistent to place the entire burden of compliance upon brokers in contract disputes. Id. In this case, though, it remains to be determined whether the Borrowers were responsible for compliance with margin requirements. Regulation X exempts from compliance [a]ny borrower who obtains purpose credit within the United States, unless the borrower willfully causes the credit to be extended in contravention of [the regulations]. 12 C.F.R. § 224.1(b)(1). Moreover, Section 29(c) of the Securities Exchange Act implies a right to assert a violation of the Act or Regulation G or U defensively under Section 29(b). Section 29(c) provides in pertinent part: Nothing in this chapter shall be construed (1) to affect the validity of any loan or extension of credit ... unless at the time of the making of such loan or extension of credit ... the person making such loan or extension of credit ... shall have actual knowledge of facts by reason of which the making of such loan or extension of credit ... is a violation of the provisions of this chapter or any rule or regulation thereunder, or (2) to afford a defense to the collection of any debt or obligation ... by any person who shall have acquired such debt [or] obligation ... in good faith for value and without actual knowledge of the violation of any provision of this chapter or any rule or regulation thereunder affecting the legality of such debt [or] obligation.... 15 U.S.C. § 78cc(c). By setting forth circumstances under which a loan or extension of credit cannot be avoided, Section 29(c) implies that a loan or extension of credit can be avoided under other circumstances. See Charles F. Rechlin, Securities Credit Regulation § 11:11 n.19 (2d ed.2007, database updated June 2010); cf. Int'l Union of Operating Eng'rs, Local 150, AFL-CIO v. Ward, 563 F.3d 276, 286-87 (7th Cir.2009) (concluding that the Labor Management Relations Act implied a right in labor organizations to sue officers for breach of fiduciary duties and stating that [b]y nullifying any exculpatory provisions, the statute removes a possible defense to liability. It follows that the union must have a statutory remedy for liability for breach against which this sort of defense might potentially be asserted.). The Trustee asserts that the illegality defense may only be asserted against contracts that are `intrinsically illegal' and not in cases where one party would have to violate a statute to perform its obligations, citing NIPSCO. But NIPSCO itself refutes this argument. NIPSCO and a coal company entered into a contract for the purchase of coal for twenty years. NIPSCO became able to buy electricity at prices below the costs of generating electricity from coal and stopped accepting coal deliveries. It then sued the coal company, seeking a declaration that it was excused from its obligations under the contract. NIPSCO argued that the contract violated the Mineral Lands Leasing Act, which prohibited railroads from holding leases or permits to mine coal except for its own use for railroad purposes, because the coal company was affiliated with a railroad. NIPSCO, 799 F.2d at 267-68. We stated: this is not a case where the contract itself is illegal. Id. at 272. Nonetheless, the analysis did not stop there. We assumed that the contract violated the Act and considered whether the contract was nonetheless enforceable. Id. at 273. We compared the pros and cons of enforcement of the contract, and concluded that the balance favored enforcement. Id. at 273-74. Similarly, in Rush-Presbyterian, we held that the illegality defense did not bar the hospital from collecting unpaid bills. We determined that the forfeiture of $200,000 in voiding the contract was an excessive punishment for an offense punishable by a fine of $10,000. We noted that the permit violation was neither a serious affront to public policy nor harmful to the public welfare as would justify nonenforcement. Rush-Presbyterian, 980 F.2d at 455-56. In effect, we weighed the pros and cons, or the equities, of enforcement. In any event, the Trustee ultimately acknowledges that the weight of authority... holds that Section 29(b) renders contracts made in violation of the regulations voidable at the option of an innocent and unwilling party. While he may dispute whether the Borrowers were innocent and unwilling parties, that determination is for the district court. Given Section 29(b)'s provision for voiding contracts made in violation of the Act or any rule or regulation thereunder, the fact that neither Regulation G nor Regulation U has a self-contained provision for doing the same thing is no bar to the affirmative defense. The Trustee asserts that when presented with the illegality defense, a court must critically examine the claimed statutory violations and determine whether it is being asked to enforce the precise conduct that is made unlawful by the statute, or if it is merely being asked to give legal effect to an agreement that was otherwise lawful. If the Borrowers are right that Comdisco and/or the Bank violated Regulation G or U, then enforcing the parties' contracts would appear to enforce the very conduct prohibited by the regulations. That would make this case unlike Kelly v. Kosuga, 358 U.S. 516, 521, 79 S.Ct. 429, 3 L.Ed.2d 475 (1959), in which an unlawful agreement to fix the price of onions was divisible from a lawful agreement to pay for purchased onions. The district court erred in concluding that a private right of action under Section 7(d) or Section 29(b) is a prerequisite to asserting margin violations as an affirmative defense. The court misread Bassler ; that case did not address whether a private right of action is necessary to raise a violation of law defensively. Similarly, the court erred in concluding that the illegality defense failed because the defendants were outside the zone of interests protected by the margin regulations. The zone of interests requirement is a limitation of prudential standing to maintain an action. Elk Grove Unified Sch. Dist. v. Newdow, 542 U.S. 1, 11-12, 124 S.Ct. 2301, 159 L.Ed.2d 98 (2004); Winkler v. Gates, 481 F.3d 977, 979-80 (7th Cir.2007). The Borrowers do not seek to maintain an action under the Securities Exchange Act or Regulations G and U, but rather, to defend against an action based on alleged violations of the statute and regulations. They therefore need not establish that they fit within the zone of interests protected by those laws to be entitled to assert their affirmative defense. Accordingly, we find that the district court erred in deciding that the Borrowers could not assert alleged violations of Regulations G and U as an affirmative defense. Therefore we must consider whether the district court also erred in granting summary judgment on the ground that Comdisco and the Bank did not violate Regulation G or U.