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BIROTTE v. MERRILL LYNCH

April 11, 1979

Andre BIROTTE, Plaintiff,
v.
MERRILL LYNCH, PIERCE, FENNER & SMITH, INC., a Corporation authorized to do business in the State of New Jersey, and Frank J. Fierro, Defendants



The opinion of the court was delivered by: MEANOR

Presently before the court are motions by the defendants for a partial summary judgment or, alternatively, to dismiss certain counts of the complaint for failure to state a claim upon which relief can be granted.

INTRODUCTION

 On January 17, 1977, plaintiff filed Civil Action No. 77-105 in this court. The matter was assigned to Judge Frederick B. Lacey. After the case had been pretried before U. S. Magistrate William J. Hunt and was scheduled for trial, plaintiff moved to amend his complaint. While the original complaint basically alleged violations of certain provisions of the Securities Exchange Act of 1934 and SEC Rule 10b-5, the proposed amended complaint added claims for violations of Federal Reserve Regulation T, violations of the Rules of the New York Stock Exchange (NYSE), the Chicago Board of Options Exchange (CBOE), and violations of the New Jersey Uniform Securities Law. In connection with the motion to amend the complaint, plaintiff's attorney filed an affidavit to which was annexed, as an exhibit, the report of his expert Warren H. Bree, dated February 14, 1978. The Bree report identifies particular transactions in plaintiff's brokerage account which are alleged to be in violation of Regulation T and various rules of those exchanges. On March 9, 1978, the parties entered into a stipulation which noted the court's denial of plaintiff's motion to amend the complaint, and voluntary dismissal of Civil Action No. 77-105 without prejudice. An Order formally denying the motion to amend the complaint was filed on March 13, 1978. On March 9, 1978, the date the stipulation was entered into by the parties, plaintiff filed the complaint in this action, Civil No. 78-469. This complaint is an exact replica of the proposed amended complaint in Civil No. 77-105. The matter was assigned to Judge Lacey. By memorandum of March 21, 1978, Judge Lacey requested the Clerk of the Court to reassign the newly filed case to another judge. On March 23, 1978, then Chief Judge Whipple reassigned the matter to me.

 I

 THE FACTS

 The stipulation entered into by the parties in the earlier case provided: "Defendants will not assert any statute of limitations defenses to the causes of action set forth in the new litigation which duplicate the causes of action alleged against defendants in this (Civ. No. 77-105) litigation." See Appendix A (Stipulation). Plaintiff alleges that violations of duty by defendants constituted a course of conduct continuing at least until the end of plaintiff's account with defendants in April 1976. See Complaint, First Count at P 5. Plaintiff further urges that defendants' course of conduct very likely continued until the Bree report enabled plaintiff to discern the nature of the violations alleged. Plaintiff's Brief at 1.

 As a brokerage customer of defendant Merrill Lynch, plaintiff had an account in defendant's Newark, New Jersey office from October 1974 through April 1976, and an account in one of defendant's New York offices from May through December 1975. Complaint, First Count at P 5. Defendant Fierro is the Registered Representative in defendant's Newark office who handled plaintiff's account there. Complaint, First Count at PP 3, 5. Defendants have moved alternatively for summary judgment or dismissal of the Second, Third, Fourth and Eighth Counts of the complaint. Each of these counts incorporates by reference the First Count which alleges the basic 10b-5 claim of deceptive practices and fraudulent advice in the management of plaintiff's account.

 II

 THE SECOND COUNT AND NYSE RULE 405

 In the Second Count of the complaint, plaintiff alleges that defendants are subject to the Rules of the New York Stock Exchange and, during the period of management of plaintiff's account, defendants violated NYSE Rule 405 in failing to properly exercise due diligence in handling the account. NYSE Rule 405 is the so-called "Know Your Customer" rule. *fn1" The thrust of the Rule is that brokerage firms which are members of the NYSE must use due diligence to learn the essential facts relative to every customer, every order and every account carried by the member firm; supervise each account handled by its registered representatives; and approve the opening of all new accounts. Plaintiff alleges that defendants violated this Rule and are thus liable for damages flowing from such violation. At issue is whether violation of this Rule gives plaintiff a private right of action.

 There is a split among the Circuits as to whether violations of the stock exchange rules give rise to such action. The two major lines of thought arise from the Second and Seventh Circuits. The Second Circuit was the first Court of Appeals to address the issue of what particular circumstances may give rise to a federal cause of action for violation of an exchange rule. In Colonial Realty Corp. v. Bache & Co., 358 F.2d 178 (2d Cir.), Cert. denied, 385 U.S. 817, 87 S. Ct. 40, 17 L. Ed. 2d 56 (1966), Judge Friendly stated:

 
(W)hether the courts are to imply federal civil liability for violation of exchange or dealer association rules by a member cannot be determined on (a) simplistic all-or-nothing basis . . . rather, the court must look to the nature of the particular rule and its place in the regulatory scheme, with the party urging the implication of a federal liability carrying a considerably heavier burden of persuasion than when the violation is of the statute or an SEC regulation.

 358 F.2d at 182. The Colonial Realty Court rejected a private implied cause of action for violation of Article III, section 1, of the Rules of Fair Practice of the National Association of Securities Dealers. Section 2 of that Article, "The Suitability Rule" is closely analogous to NYSE Rule 405. *fn2" The court recognized that the Securities Exchange Act of 1934 did not specifically authorize actions for violation of private association rules, but said that it would recognize an implied cause of action where the rule violated; first, amounted to a substitute for an SEC regulation, and second, established an explicit duty unknown to the common law. 358 F.2d at 182; See Utah State University v. Bear Stearns & Co., 549 F.2d 164, 167 (10th Cir. 1977).

 The Seventh Circuit, in Buttrey v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135 (7th Cir.), Cert. denied, 396 U.S. 838, 90 S. Ct. 98, 24 L. Ed. 2d 88 (1969), recognized an implied cause of action under NYSE Rule 405. That Court stated that a determination of whether a violation of a rule is actionable depends on whether its design is "for the direct protection of investors," and said that one of the functions of Rule 405 was the protection of the public. 410 F.2d at 142. *fn3" The Buttrey Court failed to determine whether Rule 405 imposed a duty unknown at common law or could be viewed as a substitute for Commission regulation. Sacks v. Reynolds Securities, Inc., 193 U.S.App.D.C. 80, 88, 593 F.2d 1234, 1242 (1978). The two-prong Buttrey test asks: (1) is the rule designed for the direct protection of investors?, and if so (2) does the conduct involve more than mere errors of judgment or negligence so as to be tantamount to fraud. Buttrey, supra, 410 F.2d at 143.

 The Buttrey case has been the subject of vigorous criticism by courts and commentators. *fn4" These critics have pointed out that Rule 405 was not promulgated to protect customers from shady brokers but rather to protect brokers from unscrupulous customers. Utah State University, supra, 549 F.2d at 167. This criticism has its basis in SEC, Report of Special Study of Securities Markets of the Securities and Exchange Commission, H.R.Doc.No.95, 88th Cong. 1st Sess., pt. 1 at 316 (1963). Id. at 167-168.

 The complaint in Buttrey alleged fraudulent conversion of securities. On those facts that Court recognized a private civil damage action. It did not say, however, that an alleged violation of Rule 405 was Per se actionable. Buttrey, supra, 410 F.2d at 143. The facts alleged in this complaint in the Second Count make no specific allegations of fraudulent conversion or any fraud at all only that defendants failed to exercise due diligence in the supervision of plaintiff's account, as required by Rule 405. The allegation can best be construed as negligence, and is certainly not tantamount to the fraud alleged in Buttrey. The fact that plaintiff has incorporated by reference in the Second Count the allegations of fraud contained in the First Count is insufficient to sustain a claim for fraud. The circumstances constituting fraud must be stated with particularity. Fed.R.Civ.P. 9(b). The Court of Appeals for the Tenth Circuit noted in holding that violations of exchange rules do not give rise to a private cause of action:

 
No different result is mandated by joining the rule violations with a Rule 10b-5 claim. It adds nothing to combine the allegations. The conclusory statement in this complaint that the violations of the exchange and association rules "operated as a fraud and deceit upon the plaintiffs" is insufficient to sustain a claim of fraud or deceit.

 Utah State University, supra, 549 F.2d at 171.

 In Landy v. Federal Deposit Insurance Corp., 486 F.2d 139 (3d Cir. 1973), Cert. denied, 416 U.S. 960, 94 S. Ct. 1979, 40 L. Ed. 2d 312 (1974), the Court of Appeals for the Third Circuit found it unnecessary to decide whether a private right of action should be implied under Rule 405, although it stated in a footnote that

 
implication of liability should be done reluctantly (with respect to stock exchange rules) for the following reasons: first, accurate evaluation of the degree to which any particular rule represents SEC policy is often difficult, if not impossible; . . . second, imposition of liability might chill the process of self-regulation by creating fear of damaging liability; and, finally as appellees argue, exchange rules are not promulgated by a government body after careful deliberation and weighing of the variegated competing public interests.

 486 F.2d at 166 n. 23. In Van Alen v. Dominick & Dominick, Inc., 560 F.2d 547, 552-53 (2d Cir. 1977), the Second Circuit, while not reaching the issue whether Rule 405 gives rise to a private action against an exchange member, noted that it remains an open question in that Circuit.

 In Utah State University, supra, the Tenth Circuit found that no provision of the Securities Exchange Act creates an express civil remedy for violation of an exchange or association rule. 549 F.2d at 168. The Court of Appeals for the District of Columbia Circuit in Sacks, supra, noted "that Some Exchange rules may provide the basis for a federal action." Sacks v. Reynolds Securities, Inc., supra, 193 U.S.App.D.C. at 88, 593 F.2d at 1242 (emphasis in original). After analyzing the standards and tests of Colonial Realty and Buttrey, the Sacks Court turned for guidance to the Supreme Court's decision in Piper v. Chris-Craft Industries, Inc., 430 U.S. 1, 97 S. Ct. 926, 51 L. Ed. 2d 124 (1977), which specifically discusses the implication of private rights of action under the Securities Exchange Act, and Cort v. Ash, 422 U.S. 66, 95 S. Ct. 2080, 45 L. Ed. 2d 26 (1975), which set out the test for determining whether a private remedy is implicit in a statute not expressly providing for one. *fn5"

 The Cort test sets out four factors:

 422 U.S. at 78, 95 S. Ct. at 2088 (citations omitted) (emphasis in original).

 The District of Columbia Circuit noted that these factors are not intended as inflexible hurdles to be surmounted identically in each case but, rather, they are general analytical guidelines to be used in evaluating the appropriateness of implying a cause of action in a wide range of situations. Sacks, supra, 193 U.S.App.D.C. at 89, 593 F.2d at 1243. (The Sacks Court specifically found no private federal right of action for violation of NYSE Rule 412.)

 Applying the Cort factors to the case at bar requires that this court first look to Rule 405 and consider whether it was adopted for the Especial benefit of the investor. The Buttrey case has so held in dicta, and the great criticism of Buttrey has been on this issue. See, e.g., Utah State University, supra; Sacks, supra and cases and commentaries cited therein. In both Aetna Casualty & Surety Co. v. Paine, Webber, Jackson & Curtis, (1970) Fed.Sec.L.Rep. (CCH) P 92,748 (N.D.Ill.1970), and McMaster Hutchinson & Co. v. Rothchild & Co., (1972) Fed.Sec.L.Rep. (CCH) P 93,541 (N.D.Ill.1972), the courts distinguished their own Circuit's decision in Buttrey and held that Rule 405 violations would not constitute a federal cause of action under the Securities Exchange Act of 1934. The facts in Buttrey are inapposite to the case at bar. In Buttrey, the Court pointed specifically to the charge that the defendant broker knew a fraud was being committed, and aided and abetted the fraud. See Aetna Casualty, supra. Here, the allegations of the Second Count charge defendants with failure to exercise the duty required under Rule 405. This failure, if proven, clearly is not tantamount to the fraud alleged in Buttrey which was the basis for the creation of a private right of action in that case.

 Next to be determined is whether the implication of a new cause of action under Rule 405 is consistent with the structure and purpose of the Securities Exchange Act, and whether the Congress either expressly or implicitly intended to create or deny such a cause of action. The Court of Appeals for the District of Columbia Circuit in Sacks, supra, noted that the Act is designed specifically for "the American people trading on . . . exchanges," 78 Cong. Rec. 2270 (1934) (remarks of Senator Fletcher), and that the protection of the investing public is of primary concern. Sacks, supra, 193 U.S.App.D.C. at 90, 593 F.2d at 1244; See, e.g., S.Rep.No.792, 73d Cong., 2d Sess. 4 (1934); 78 Cong. Rec. 7921-22 (remarks of Representative Maples). The Sacks Court continues:

 
Congress anticipated three modes of securities control to achieve this goal: statutory provisions, Commission regulations, and exchange rules. Under this scheme, exchanges are imbued with quasi-governmental power and transformed from private trade associations into organizations sharing responsibility for maintenance of an orderly and fair securities market. In establishing this tripartite system, Congress specifically contemplated active self-regulation of the industry and the aggressive promulgation of exchange rules. See Silver v. New York Stock Exchange, 373 U.S. 341, 351-52, 83 S. Ct. 1246, 10 L. Ed. ...

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