Cunningham v. Waters Tan & Co.

Citations: 65 F.3d 1351; 1995 U.S. App. LEXIS 25602; 1995 WL 534828Docket: Nos. 94-2019, 94-2146

Court: Court of Appeals for the Seventh Circuit; September 11, 1995; Federal Appellate Court

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Investors defrauded in a commodity pool scheme brought lawsuits against G.H. Miller Co. for recovery of their losses, resulting in two consolidated cases referred to as the “Cunningham action” and the “Stewart action.” The district court granted summary judgment in both cases. In the Stewart action, the court ruled that the investors could not recover from G.H. Miller because the representatives of the putative class did not invest during the effective period of Miller's guarantee. In the Cunningham action, the court found that the individual responsible for the fraud did not act as an agent of G.H. Miller while engaging in the illegal activities. G.H. Miller also sought Rule 11 sanctions in the Stewart action, claiming a crucial factual representation in the complaint was false, but the court denied this request without providing an explanation. The appellate court affirmed the district court's summary judgment rulings but remanded the denial of Rule 11 sanctions for further clarification.

In 1982, Dennis K. Tan and partner John Waters started an investment club that later suffered losses, which they concealed from investors through false reports. To raise more capital, they created commodity pools from November 1984 to September 1985, registered under Waters, Tan and Co. In May 1985, Tan registered as an introducing broker for G.H. Miller and entered into a guarantee agreement effective from May 18, 1985, to July 18, 1986. This agreement made Miller jointly liable for Tan's obligations regarding customer accounts initiated after the agreement's effective date. Tan, however, did not disclose the commodity pools to Miller and actively concealed their existence. During the validity of the agreement, promotional materials falsely portrayed Waters Tan as an introducing broker for Miller. Upon discovering this misrepresentation, Miller's representative instructed Tan to cease and desist and requested the destruction of misleading materials. The NFA subsequently censured Tan for these actions. In April 1986, Tan's counsel admitted the misrepresentation was a mistake and assured that it would not recur. Shortly thereafter, Tan sought to register Waters, Tan Co. as an introducing broker with Miller, which was refused, leading to the termination of the agreement. Ultimately, Waters, Tan Co. registered as an introducing broker with GNP Commodities, which has since settled the lawsuit with the plaintiffs.

In March 1988, the Commodity Futures Trading Commission (CFTC) shut down the Waters Tan commodity pools for fraud, leading to charges and expulsions against Tan and Waters by the National Futures Association (NFA). Tan later pled guilty to criminal racketeering in Arizona in 1989. Plaintiffs in the appeal made payments to Waters, Tan Co. but not to Tan personally, and no trades linked to the allegations were conducted with Miller through Waters Tan or Tan individually.

The appeal arises from two consolidated district court actions: Cunningham v. Waters, Tan Co., filed in March 1988, which did not name Miller, and Stewart v. GNP Commodities, Inc., filed in August 1989, which did include Miller as a defendant. The claim against Miller was solely for vicarious liability related to the fraudulent activities of Waters Tan, particularly concerning a guarantee agreement between Miller and Tan. The Stewart case was transferred to Illinois and consolidated with Cunningham.

In May 1992, the district court denied class certification and granted summary judgment for Miller, ruling that the plaintiffs did not invest in the illegal pools during the term of the guarantee. Miller also sought Rule 11 sanctions against the Stewart complaint for allegedly false claims regarding the plaintiffs' investments, which were denied without explanation. Following a settlement with other defendants, over one hundred class members attempted to intervene, with thirty-five plaintiffs claiming vicarious liability against Miller in 1994. The district court again granted summary judgment for Miller, stating that Miller was not liable for losses from pools it had not guaranteed.

The appellate court reviewed the summary judgment decisions under a de novo standard, affirming the judgment if no genuine issues of material fact existed. The review of Miller's cross-appeal concerning the Rule 11 sanctions was under a deferential standard, requiring a clear error or abuse of discretion to reverse. The plaintiffs argued that Miller should be vicariously liable for a fraudulent account opened in the Waters Tan pools after the guarantee agreement ended on July 18, 1986.

Plaintiffs assert that the guarantee agreement between G.H. Miller and Dennis K. Tan extends liability to Waters Tan and Dennis Tan, arguing that Miller should be vicariously liable for Waters Tan's commodity pool accounts, despite Miller's lack of awareness of their existence. The district court found that Miller had no liability to the plaintiffs and that the summary judgment was appropriate. The guarantee agreement, regulated by CFTC rules, specified that Miller would be liable for obligations incurred by Tan only for accounts opened on or after the agreement's effective date. The court determined that the guarantee was valid from February 15, 1986, to July 18, 1986, and that none of the plaintiffs' investments in fraudulent pools occurred until after this period. The court emphasized that liability could only arise from accounts opened during the agreement's effective term, citing that Mr. Kumm, solicited by Tan in early 1986, did not invest until 1987, after Miller's guarantee had ended and after Tan had transitioned to GNP Commodities, thereby precluding Miller's liability under CFTC regulations. Kumm acknowledged receiving notice of the termination of Miller's guarantee prior to his investment. Consequently, the court ruled that no material facts disputed Miller's lack of liability to the plaintiffs, granting judgment in Miller's favor.

In the Cunningham case, the plaintiffs purchased securities from Dennis Tan during the effective period of an agreement with Miller. However, the district court appropriately granted summary judgment for Miller based on several key points. First, the agreement only involved Miller and Dennis Tan; Waters Tan Co., the entity the plaintiffs engaged with, was a separate legal entity and not a signatory. Second, Dennis Tan registered as an introducing broker for Miller with a distinct National Futures Association (NFA) registration number, separate from that of Waters Tan, which was registered as a commodity pool operator. Third, CFTC regulations prohibit introducing brokers from accepting funds for commodity pools, indicating that Miller did not assume financial responsibility for Waters Tan's operations.

The district court's ruling that Miller was not vicariously liable for Waters Tan's commodity fraud is supported by relevant judicial and administrative precedents, particularly the case Taylor v. Vista Futures, Inc. In that case, the Commodity Futures Trading Commission (CFTC) determined that an associated person (AP) of an introducing broker was not acting within the scope of his AP duties when involved in the operation of a commodity pool, thus absolving the introducing broker and futures commission merchant of liability for the AP's actions. The CFTC emphasized that an introducing broker's role is to solicit orders, not funds. Similarly, Dennis Tan's access to funds resulted from his role with Waters Tan, not his relationship with Miller.

The court acknowledges the CFTC's interpretation of agency scope, noting its expertise in commodities regulation warrants deference. The plaintiffs' reliance on Rosenthal Co. v. CFTC is rejected, as the court finds significant factual differences that support its conclusion in this case.

In the case involving Rosenthal, a commodities pool operator executed trades through Rosenthal, an FCM, in exchange for a commission rebate. This commission-sharing was allowed only if the operator was registered as an "associated person" (AP) of Rosenthal and designated as a registered representative. From 1975 to 1978, the AP directed his salesmen to withhold subscription agreements containing mandatory CFTC risk warnings until after receiving investor funds, constituting commodities fraud and violating sections 4b and 4o of the Commodity Exchange Act. The Commission deemed the FCM vicariously liable for this misconduct, finding that the AP's actions were part of an agency relationship with Rosenthal, bolstered by the FCM's awareness and encouragement of the AP's pool activities.

In contrast, the relationship between Miller and Dennis Tan was primarily for order solicitation, with Miller unaware of Tan's operation of commodity pools and lacking intentions to earn commissions from them. The district court correctly differentiated this arrangement from Rosenthal. The case Cange v. Stotler Co. further supports the defendants’ position. In Cange, a plaintiff sued Stotler for losses from unauthorized trades by the broker-agent, who misled the plaintiff about the nature of the trades. The court confirmed that the agent’s statements might fall within the agency's scope, but the circumstances in the current case differ significantly. Waters Tan Co. had no authority from Miller regarding commodity pools, and Dennis Tan lacked any express, implied, or apparent authority to accept customer funds, which CFTC regulations forbade for introducing brokers.

If third parties are aware of a limit on an agent’s actual authority, then that authority is effectively nonexistent. This principle was pivotal in the CFTC case involving the Miller guarantee agreement. In Hazen v. Waters Tan Co., the administrative law judge (ALJ) required clarification on whether Waters Tan had ever served as an introducing broker for Miller and if so, whether it was guaranteed by Miller. After Miller demonstrated that Waters Tan never acted as an introducing broker, the ALJ dismissed the complaint against Miller, indicating that the sole issue for determining vicarious liability was whether Miller guaranteed the entity responsible for the commodity pool fraud. 

The guarantee agreement was made between Miller and Dennis K. Tan in his individual capacity as an introducing broker, which precluded further action against Miller. GNP Commodities' motion for dismissal was rejected, as it was determined that Waters Tan Co. was an introducing broker guaranteed by Miller. The district court found that Miller did not guarantee Tan’s operations as a commodity pool operator, of which Miller had no knowledge. The agreement did not imply such liabilities, especially since Dennis Tan, as an introducing broker, was legally barred from accepting customer funds and could not act under the Miller agreement when he did so for fraudulent pools. 

All funds from the plaintiffs were directed to Waters Tan, which held the certificates of ownership. Legal remedies do not extend to the plaintiffs against Miller, who only guaranteed Dennis Tan as an individual broker and not Waters Tan as a pool operator. The plaintiffs argued that Miller's guarantee was enforceable despite any subsequent corporate changes; however, the record showed no evidence of Dennis Tan merging or consolidating his operations with Waters Tan after the guarantee. Waters Tan existed prior to the agreement and registered with the National Futures Association beforehand. Without proper registration as Miller’s introducing broker, Waters Tan could not have acted in that capacity. Tan operated in dual roles without Miller's knowledge, and assertions of merger by a Waters Tan employee were insufficient to establish any material fact regarding a merger of operations.

Tan did not claim that his involvement in illegal pools merged with his activities as an introducing broker. Evidence from Miller and the NFA supports that no such merger occurred. In April 1986, Miller employee Aaron Itkin visited Waters Tan and instructed Dennis Tan to cease misrepresenting Waters Tan as an introducing broker for Miller and to destroy any misleading promotional materials. An NFA audit confirmed that Waters Tan had incorrectly presented itself as Miller's introducing broker, leading to a censure of Dennis Tan for violating NFA compliance rules. Tan acknowledged the misrepresentation as a "good faith mistake," arguing that his close customer relationships ensured no customer was misled. He claimed Waters Tan engaged in unrelated business activities. The facts indicate that all parties involved acted as if no merger had occurred, especially since Tan concealed illegal pools from Miller and was refused the status of introducing broker in 1986.

In a separate matter, the district court denied Miller's motion for Rule 11 sanctions in the 1992 Stewart litigation. Although the court's decisions on sanctions are reviewed deferentially, this does not prevent scrutiny to ensure judges consider their decisions carefully. The amendments to Rule 11, effective December 1, 1993, shifted sanction imposition from mandatory to discretionary. Since the relevant decisions occurred under the old Rule, applying the new version would be unjust. Miller's motion argued that none of the plaintiffs in the 1992 Stewart case had invested in Waters Tan's commodity pools during the Miller guarantee agreement. Plaintiffs contended that all named representatives, except for the Kumms, invested in the fraudulent pools after the termination of the Miller guarantee in late 1986.

Miller's request for sanctions merits serious consideration, but the absence of a reasoned statement from the district court hinders effective appellate review. While brief orders on sanctions can be acceptable, this case does not fall into that category, necessitating a remand for further consideration. The district court's summary judgment in favor of Miller is affirmed, but the denial of sanctions in the Rule 11 cross-appeal is vacated. On remand, the parties can revisit the sanctions issue, seeking a more detailed rationale from the district court. Miller is entitled to recover standard costs for the appeals.

The Commodity Futures Trading Commission (CFTC) oversees commodity markets under the Commodity Exchange Act and relevant regulations. Waters Tan is a registered commodity pool operator, while Dennis Tan serves as an introducing broker, both registered with the National Futures Association (NFA). Definitions for these roles are provided, clarifying their responsibilities in managing funds for commodity trading. G.H. Miller, as a futures commission merchant, has broader capabilities than an introducing broker, including accepting funds to secure trades. Regulatory requirements mandate that introducing brokers meet financial standards or establish guarantee agreements with their futures commission merchants. A related CFTC case (Hazen v. Waters, Tan. Co.) found that G.H. Miller's guarantee agreement did not hold Miller vicariously liable for losses in the commodity pools. Throughout the opinion, 1211 Corporation is referred to as "Miller."

Introducing brokers are mandated by the CFTC to maintain a minimum adjusted net capital of $20,000. They can count 50% of the value of guarantees or security deposits with a futures commission merchant (FCM) towards this capital requirement. The guarantee agreement ensures that the FCM (Miller) will uphold the introducing broker's obligations under relevant laws and regulations, acting as an alternative to meet the CFTC's financial responsibility standards. 

A district court incorrectly identified the effective start date of the Guarantee Agreement. Although signed on February 5, 1995, with an effective date of February 15, 1995, it did not actually take effect until May 18, 1985. This error, however, benefited the appellants by extending the period considered for fraudulent investments under the agreement by three months. 

Miller cannot be held liable for any actions occurring after the contract's termination on July 18, 1986, which was mutually agreed upon. The contract explicitly states that its termination does not affect the FCM's liability for the introducing broker's obligations incurred before that date. 

Additionally, Rule 11 requires that all pleadings, motions, and papers submitted by an attorney be signed, certifying that they are well-grounded in fact and law, and are not filed for improper purposes. Violations of this rule can result in sanctions, including the payment of reasonable expenses incurred due to the improper filing.

Amended Rule 11 outlines the responsibilities of attorneys and unrepresented parties when presenting documents to the court. By submitting any pleading, motion, or paper, the submitter certifies that, to the best of their knowledge, the submission is not intended for improper purposes, such as harassment or unnecessary delay. Additionally, the claims and defenses presented must be supported by existing law or a legitimate argument for changing the law. Factual allegations must have evidentiary support or be likely to have such support after further investigation. Denials of factual contentions must also be based on evidence or a reasonable belief of lack of information. If the court determines that these standards have been violated, it may impose sanctions on the responsible attorneys, law firms, or parties after providing notice and an opportunity to respond.