Robert M. Deutschman v. Beneficial Corp., Finn M.W. Caspersen, Andrew C. Halvorsen. (d.c. Civil No. 86- 00595)

Citation: 841 F.2d 502Docket: 87-3570

Court: Court of Appeals for the Third Circuit; April 4, 1988; Federal Appellate Court

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Robert M. Deutschman appeals the dismissal of his amended class action complaint against Beneficial Corporation, its Chairman Finn M.W. Caspersen, and Chief Financial Officer Andrew C. Halvorsen, under Rule 12(b)(6). The complaint alleges violations of the Securities Exchange Act of 1934 (Sections 10(b) and 20(a)) and state common law of negligent misrepresentation, concerning misleading statements about Beneficial's insurance division losses, which Deutschman claims artificially inflated stock prices. The district court ruled that a purchaser of call options lacks standing to sue under the Securities Exchange Act, thus dismissing both the federal and related state claims. The appellate court, accepting the factual allegations as true, notes that the complaint describes how the defendants knowingly issued false statements regarding the insurance division's financial health to stabilize stock prices, leading to losses for option purchasers, including Deutschman. However, the complaint does not allege trading by the defendants in Beneficial stock or options during the relevant period, nor does it indicate that Deutschman purchased Beneficial stock itself. The appellate court has decided to reverse the district court’s dismissal.

The district court determined that option traders, specifically those who incurred losses due to intentional misstatements by a corporation's management, do not have standing to pursue a damages claim under section 10(b) of the 1934 Act and Rule 10b-5. The court emphasized that without allegations of the plaintiff trading the corporation's stock or the defendants engaging in option transactions, there was no obligation for the management to refrain from misleading statements affecting the stock's market price.

Put and call options have existed since 1790, allowing investors to hedge against future price movements of securities. Prior to the establishment of the Chicago Board Options Exchange in 1973, the use of such options was limited due to high transaction costs and lack of secondary markets. By 1985, several exchanges were trading options on over 400 stocks, with significant trading volumes.

An option contract allows its holder to buy (call) or sell (put) shares at a predetermined price, with value fluctuations based on market movements relative to the strike price. Option holders are vulnerable to deceptive practices, including insider trading and affirmative misrepresentation. Deutschman's claim focuses on the latter, alleging that corporate managers’ false statements artificially inflated the stock's market price and, consequently, the options' market price.

Section 10(b) bans manipulative or deceptive practices "in connection with the purchase or sale of any security," and the associated SEC rule outlines illegal actions such as employing fraud schemes, making false material statements, or engaging in deceptive business practices.

Defendants acknowledge that if Deutschman's allegations of affirmative misrepresentations are proven, they would constitute untrue statements of material fact capable of deceiving a purchaser of Beneficial stock, thereby satisfying the scienter requirement of Section 10(b) of the Securities Exchange Act. Despite not trading in Beneficial stock, defendants could still be held liable for damages under Section 10(b) as outlined in relevant case law, including Ernst v. Hochfelder and Peil v. Speiser. A purchaser can claim damages for misstatements by corporations and their officers, and a seller can recover for losses induced by misleading corporate communications. Additionally, Congress amended the Securities Exchange Act to explicitly include options as securities, affirming that any purchaser or seller can sue for manipulative practices in securities transactions, as established in Herman v. MacLean. The Supreme Court has set a standing limitation that plaintiffs must be purchasers or sellers of the security involved, but these plaintiffs do not need a direct relationship with the defendant. The intent of the 1934 Act was to protect active market participants, which aligns with the Birnbaum rule restricting plaintiffs to those who have dealt in the relevant security. Deutschman's complaint meets all necessary criteria for a Section 10(b) action regarding affirmative misrepresentations affecting security prices. However, the district court dismissed the complaint, citing Chiarella v. United States and Dirks v. SEC, interpreting these cases as restricting liability under Section 10(b) to individuals in a special relationship of trust or confidence with the plaintiff.

The district court's reliance on Chiarella and Dirks is misplaced, as these cases focused on trading based on undisclosed information rather than injuries from affirmative misrepresentations affecting market prices. The insider trading rule mandates that insiders must disclose material information before trading, a duty not applicable to non-insiders, who can assume equal access to information among market participants. Chiarella and Dirks addressed when outsiders might be classified as insiders regarding disclosure duties, and they did not extend these duties to mere tippees with undisclosed information. In the absence of a fiduciary relationship, Beneficial and its officers were not obligated to disclose information unless they traded on it. Deutschman argues that they chose to speak and thus could not lie.

The court also distinguishes Laventhall v. General Dynamics Corp., noting that no public misstatements were made in that case. The plaintiff's claim was based on insider trading due to the corporation's undisclosed change in dividend policy, which the Eighth Circuit found insufficient for liability without a transactional nexus. While Laventhall's reasoning has faced criticism, it is not relevant to the issue of affirmative misrepresentations affecting securities markets. No Supreme Court or Court of Appeals case has established a requirement for a transactional nexus in section 10(b) cases concerning affirmative misrepresentations.

Defendants argue that they should be shielded from liability to options traders due to policy concerns about unlimited liability. This argument is dismissed as unfounded, referencing the Supreme Court's decision in *Blue Chip Stamps v. Manor Drug Stores*, which limited section 10(b) liability to participants in national securities markets, a category that includes options traders. The proximate cause requirement already mitigates concerns of unlimited liability for defendants.

Defendants further contend that options traders deserve less protection under the 1934 Act because options trading resembles gambling. The court rejects this characterization, noting that the risks associated with options trading are not inherently greater than those of stock trading, and that options can provide risk-reducing hedging opportunities for stock traders.

The court also notes that it is not its role to critique the legislative policies concerning options trading and their classification as securities; that responsibility lies with Congress and regulatory agencies. 

Lastly, the argument that options traders lack protection under section 10(b) due to their perceived non-involvement in capital formation is considered inconclusive. The court finds that the options market contributes to liquidity similarly to the stock market, particularly when considering margin trading, and so does not interpret section 10(b) as excluding option contracts.

The court concludes that Deutschman has standing to seek damages under section 10(b) for alleged affirmative misrepresentations by the defendants, reversing the district court's dismissal of his claim. The dismissal of Deutschman's state law claim, which was contingent on federal jurisdiction, is also reversed.

15 U.S.C. Sec. 78c(a)(10) defines 'security' to encompass a wide range of financial instruments including notes, stocks, bonds, debentures, profit-sharing agreements, and various certificates and options related to these instruments. It specifies that 'security' also includes interests in mineral royalties, collateral-trust certificates, investment contracts, and voting-trust certificates. Additionally, it recognizes instruments related to foreign currency and any common financial instruments identified as 'securities.' However, it explicitly excludes currency and certain short-term financial instruments such as notes, drafts, and banker's acceptances with a maturity of nine months or less, including their renewals. The definition was amended by Pub. L. 97-303, which added specific language to clarify the scope of what constitutes a 'security.'