Levitt ex rel. Levitt v. J.P. Morgan Securities Inc.

Citations: 9 F. Supp. 3d 259; 2014 U.S. Dist. LEXIS 38564; 2014 WL 1223016Docket: No. 99-CV-2789 (ADS)(AKT)

Court: District Court, E.D. New York; March 24, 2014; Federal District Court

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Plaintiffs, including Robert Levitt and others, are pursuing a civil securities fraud case against Defendants J.P. Morgan Securities Inc. and J.P. Morgan Clearing Corp., previously known as Bear Stearns & Co. Inc. and Bear Stearns Securities Corp. The claims stem from a fraudulent scheme by Sterling Foster & Co. aimed at manipulating the market for ML Direct Inc. securities during and after its 1996 IPO. The Plaintiffs assert four claims against the Defendants: (1) participation in the fraudulent scheme in violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5; (2) knowingly false statements in violation of the same provisions; (3) liability as a control person under Section 20(a) of the Securities Exchange Act; and (4) aiding and abetting Sterling Foster’s fraud under New York State common law. The Court is currently considering the Defendants' motion for summary judgment and the Plaintiffs' cross-motion for summary judgment. The Court grants the Defendants' motion and denies the Plaintiffs' motion. Additionally, the background includes an April 1994 agreement where Sterling Foster, an introducing broker, engaged Bear Stearns as its clearing broker, highlighting the distinct roles of introducing and clearing brokers in the securities industry, including trade processing and customer account management.

Additional clearing services encompass extending credit for margin purchases of securities. Smaller brokerage firms, known as “introducing firms,” often lack the necessary capital and resources to clear transactions independently, prompting them to form ‘carrying agreements’ with clearing firms. These agreements allow clearing firms to handle not only clearing functions but also to execute transactions, which limits the introducing broker’s role primarily to soliciting investors. The clearing firm enhances the introducing firm's reputation, as in the case of Bear Stearns, which provided credibility and stability to lesser-known firms like Sterling Foster, its clearing broker until March 27, 1997.

During its relationship with Bear Stearns, Sterling Foster engaged in several market manipulation schemes, particularly related to the ML Direct IPO that launched in September 1996. The IPO's Prospectus indicated the issuance of 480,000 units at $15 each and disclosed that certain insiders held 2.4 million shares, subject to a lock-up agreement prohibiting early sales. On September 4, 1996, the day trading commenced, Sterling Foster purchased nearly 1.1 million shares of ML Direct, driving the stock price up to $15.25. Concurrently, it sold approximately 3.9 million shares to customers at prices between $13.50 and $14.50, effectively selling 2.86 million shares more than it owned. This created a short position that Sterling Foster would need to cover, but the only shares available were those held by Selling Securityholders under the lock-up, complicating their ability to fulfill their sales without incurring substantial losses.

Prior to the IPO effective date of September 3, 1996, Sterling Foster and Patterson Travis entered into a confidential agreement allowing Sterling Foster to buy shares from Selling Securityholders at a below-market price of $3.25 per share to cover a short position. This arrangement was not disclosed in the Prospectus, which suggested a twelve-month lock-up for those shares. Sterling Foster was supposed to deliver the shares sold on September 4, 1996, to Bear Stearns by September 9, 1996, but failed to do so. On September 10, 1996, Patterson Travis released the Selling Securityholders from their lock-up, and Sterling Foster subsequently purchased their shares at the agreed price, enabling it to cover its short position. The president of Sterling Foster, Adam Lieberman, directed the delivery of these shares to Bear Stearns, facilitating a payment of $7.8 million to the Selling Securityholders. Sterling Foster profited significantly by selling the shares to the public at $13.50 to $14.50, while paying only $3.25 per share, leading to a 400% underwriting profit. The offering documents misled investors into believing that only 1.1 million shares were being offered and that the market had set the price, which was manipulated by Sterling Foster through its undisclosed purchases. Subsequently, several individuals associated with Sterling Foster pled guilty to criminal fraud related to this and other securities. 

Bear Stearns, which required introducing brokers to seek permission to underwrite prior to the IPO, was informed by Lieberman of Sterling Foster's intention to take a substantial short position covered by shares from Selling Securityholders. However, there is a dispute about whether Bear Stearns was fully informed of the pre-existing arrangement due to the restrictions in the Prospectus. Brigley from Bear Stearns received the IPO Prospectus, which included the lock-up agreement, and communicated this to other officers, but there is uncertainty over whether he read the agreement or understood its implications regarding the disclosed information. Plaintiffs allege Bear Stearns was aware of the misleading representations, while Defendants argue that Brigley did not recall the details of the lock-up agreement.

Bear Stearns allegedly misled customers of Sterling Foster by not disclosing that Sterling Foster was profiting 400% on ML Direct stock transactions, with Bear Stearns earning $12 to $25 per trade it cleared. In 1997, shareholders of ML Direct initiated five lawsuits against Sterling Foster and other defendants, which were consolidated into a single action, Rogers v. Sterling Foster & Co. Inc., in the Eastern District of New York. Bear Stearns was added as a defendant in February 1999. The Levitt action, concerning securities fraud linked to ML Direct’s IPO, was transferred to the consolidated pretrial proceedings. On October 31, 2006, the court approved a settlement in the Rogers action, despite objections from the Levitt Plaintiffs, who subsequently appealed. On December 18, 2007, the Second Circuit vacated the settlement approval, citing that the Levitt Plaintiffs had the largest financial interest, should have been appointed as lead plaintiffs, and that further discovery was required to assess the fairness of the settlement. On June 24, 2010, the court partially granted the Plaintiffs' motion for class certification under Rule 23, certifying the class for Section 10(b) claims but denying it for Section 20(a) claims. The Defendants' request for an interlocutory appeal was granted, and on March 15, 2013, the Second Circuit reversed the class certification decision and remanded for further proceedings.

The Second Circuit determined that the Levitt Plaintiffs failed to provide evidence at the class certification stage showing that Bear Stearns engaged in fraudulent activity or owed a duty of disclosure to Sterling Foster’s customers, which precluded claims of material omission. Consequently, the plaintiffs could not rely on a class-wide presumption of reliance under Affiliated Ute, nor meet the predominance requirement of Rule 23(b)(3). Following the Second Circuit's decision on March 15, 2013, a status conference was held on June 5, 2013, resulting in a briefing schedule for the Defendants’ summary judgment motion and the Plaintiffs’ cross-motion. No further discovery was conducted, and the summary judgment record mirrored that used for class certification. The Defendants sought summary judgment on four claims: (1) market manipulation under Section 10(b) of the Securities Exchange Act; (2) misrepresentation or omission under Section 10(b); (3) control person liability under Section 20(a); and (4) New York State common law fraud. The Plaintiffs conceded that only two claims remained post-Second Circuit ruling: aiding and abetting Sterling Foster’s fraud under New York law, and false representations on confirmations under Section 10(b). The Plaintiffs did not address the Defendants' arguments regarding the abandoned claims of market manipulation and control person liability, leading the Court to dismiss these claims as abandoned. Federal courts may deem claims abandoned if not addressed in opposition to a summary judgment motion. Therefore, the remaining claims for consideration are the 10(b) misrepresentation or omission claim and the New York State common law aiding and abetting fraud claim.

Summary judgment under Federal Rule of Civil Procedure 56 is granted only when the moving party demonstrates no genuine dispute exists regarding any material fact, and they are entitled to judgment as a matter of law. A "material" fact affects the outcome of the case under governing law, while a "genuine" issue arises when evidence could lead a reasonable jury to rule for the nonmoving party. The court must view evidence in the light most favorable to the nonmoving party and determine if the nonmoving party has provided specific facts showing a genuine issue for trial. Mere speculation or "metaphysical doubt" is insufficient to oppose summary judgment; rather, the moving party can prevail if there is little or no evidence supporting the nonmoving party’s claims. The trial court's role at this stage is to identify genuine issues of material fact, not to resolve them.

Regarding the Plaintiffs' claim under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, these provisions prohibit fraudulent actions in securities transactions. To prove a violation, Plaintiffs must establish: (i) a material misrepresentation or omission; (ii) scienter; (iii) a connection with the purchase or sale of a security; (iv) reliance on the misrepresentation or omission; (v) economic loss; and (vi) loss causation. Each element must be demonstrated for a successful claim, as outlined in relevant case law.

For an omission to be actionable under Section 10(b), the defendant must have a duty to disclose. The Plaintiffs argue that Bear Stearns' confirmations contained material misrepresentations by not disclosing that Sterling Foster made a 400 percent profit on the ML Direct stock sale. However, the court views the confirmations as containing omissions rather than misrepresentations. The confirmations accurately show that the price difference between the Plaintiffs' purchase and the market price was $0.00, which does not constitute a misrepresentation, even if the market price was inflated by Sterling Foster's purchases. Additionally, the confirmations do not disclose Sterling Foster's purchase price or profit, rendering the lack of disclosure regarding the profit an omission rather than a misrepresentation.

The court emphasizes that the Plaintiffs’ claims involve omissions, aligning with the Second Circuit's ruling in Levitt III, which established that a clearing agent generally does not owe a fiduciary duty to security owners. Consequently, liability for the actions of the introducing broker is not imposed on the clearing broker when it provides normal services. The court found that the Levitt Plaintiffs failed to demonstrate Bear Stearns' sufficient involvement in Sterling Foster's manipulative scheme to establish a duty to disclose, and without such a duty, there can be no material omission under Section 10(b). The Second Circuit had previously rejected claims that Bear Stearns' activities were irregular, reinforcing that the lack of a duty to disclose precludes liability.

The Second Circuit found the Plaintiffs' claims regarding misleading statements on trade confirmations issued by Bear Stearns to be unsubstantiated. The confirmations included standard language indicating that Sterling Foster was making a market in ML Direct shares but were automatically populated by Bear Stearns based on data provided by Sterling Foster, which the Plaintiffs did not contest. The Plaintiffs argued Bear Stearns had a duty to correct any misrepresentation by Sterling Foster; however, the court determined that Bear Stearns' role as a clearing broker did not impose such a duty, thus they could not be held liable under Section 10(b) of the Securities Exchange Act of 1934.

Additionally, even if Bear Stearns had a duty to disclose, the Plaintiffs' claim would still fail due to a lack of evidence showing reliance on the confirmations. Reliance is critical in securities fraud claims as it establishes a causal link between a defendant's misrepresentation and a plaintiff's injury. The Plaintiffs admitted in depositions that their purchasing decisions were based solely on Sterling Foster's statements, and the confirmations were issued post-trade, meaning they could not have influenced the Plaintiffs' decisions. Consequently, the court ruled that without establishing reliance, the connection between the misleading confirmations and the Plaintiffs' injuries was absent. As a result, the court granted summary judgment in favor of the Defendants regarding the Plaintiffs' misrepresentation claim under Section 10(b).

The Plaintiffs assert a claim against Bear Stearns for aiding and abetting fraud related to Sterling Foster's actions under New York State common law. To establish this claim, three elements must be satisfied: (1) the existence of an underlying fraud; (2) the aider and abettor's knowledge of this fraud; and (3) substantial assistance provided by the aider and abettor in furthering the fraud. The first element is agreed upon, as Sterling Foster's fraud is established. The parties dispute Bear Stearns' knowledge of this fraud, with Plaintiffs alleging that Bear Stearns was aware due to Sterling Foster’s past misconduct and the Prospectus received. However, the Court finds that the Plaintiffs fail to meet the third element, leading to dismissal of the claim. The Second Circuit has clarified that merely providing routine clearing services does not constitute aiding and abetting. Bear Stearns, acting solely as a clearing broker, could not be liable based on standard operations. The Plaintiffs attempt to demonstrate irregularities in Bear Stearns’ actions, including its approval of the ML Direct underwriting and failure to provide the Prospectus, but the Second Circuit previously rejected similar arguments, stating that the activities cited do not indicate substantial assistance or a duty to disclose Sterling Foster’s fraud.

Bear Stearns' expert testified that increased collateral requirements and large IPO approvals are standard practices among clearing brokers aimed at risk mitigation. The Levitt Plaintiffs claim these demands were “irregular” due to Bear Stearns' awareness of Sterling Foster's potential market manipulation of ML Direct shares. However, merely knowing about fraud does not impose a duty of disclosure on a clearing broker, and normal practices do not become irregular based on this knowledge. The Second Circuit determined that misleading confirmations by Bear Stearns do not constitute sufficient involvement in a fraudulent scheme to necessitate a disclosure duty. Without a fiduciary duty, inaction by Bear Stearns does not support a claim of aiding and abetting fraud. Additionally, violations of Regulation T do not establish a duty to disclose a broker-dealer's misconduct to its clients. The Levitt Plaintiffs alleged Bear Stearns violated Regulation T by not canceling unpaid trades in Sterling Foster accounts during the ML Direct IPO, but the court found no private right of action for such violations. Claims that Bear Stearns’ Regulation T violations allowed market manipulation do not suffice to create a disclosure duty under Section 10(b) of the Securities Exchange Act. The reasoning applied to Section 10(b) also extends to aiding and abetting fraud claims under New York common law.

Permitting the Plaintiffs to base their aiding and abetting fraud claim on Regulation T would create a new right of action for its violation under New York State common law, contradicting the Second Circuit's ruling in Levitt III. The Second Circuit rejected Plaintiffs' claims against Bear Stearns, stating that merely allowing potentially manipulative trades does not equate to directing them. Additionally, the Plaintiffs’ arguments regarding Bear Stearns' failure to deliver the Prospectus within the required period and its clearing of unregistered shares were not addressed by the Second Circuit in Levitt III. However, the court found that Bear Stearns had no obligation to deliver the Prospectus as it was not a dealer or underwriter but a clearing broker, following the precedent set in Greenberg. The arrangement between Sterling Foster and Bear Stearns indicated that the responsibility for delivering the Prospectus rested with Sterling Foster, not Bear Stearns. Consequently, imposing liability on Bear Stearns for not complying with the prospectus delivery requirement would be inappropriate. The Plaintiffs also alleged Bear Stearns cleared unregistered shares, which remains unaddressed in this context.

Plaintiffs argue that after Sterling Foster acquired ML Direct shares from selling security holders, the registration for those shares terminated, and Sterling Foster could not sell the shares without a new registration statement. They reference the Second Circuit's ruling in SEC v. Cavanagh, which clarifies that a registration statement allows only for the offers and sales it describes, and subsequent sales must either fall under a new registration or an exemption. However, the Plaintiffs face a significant hurdle as there is no private right of action under Section 5 of the Securities Act of 1933. Private civil liability under Section 5 only arises if Section 12's conditions are met, which holds any person liable who offers or sells a security in violation of Section 5. The Supreme Court in Pinter v. Dahl determined that liability under Section 12 is limited to those who pass title or solicit offers, indicating that Congress did not intend to impose liability on those merely participating in unlawful sales. A plaintiff may only bring a Section 12 claim against a "statutory seller," defined as someone who transferred title to the security or solicited its purchase for personal gain. The record does not show that Bear Stearns solicited the Plaintiffs for purchasing ML Direct shares or had direct contact with them, which undermines the Plaintiffs' standing in this claim.

Sterling Foster solicited sales, while Bear Stearns performed only routine clearing activities, which included the ministerial task of mailing a private placement memorandum. This limited role does not meet the solicitation requirements under Pinter, indicating that Bear Stearns is not liable under Sections 5 and 12 of the Securities Act of 1933. Consequently, imposing liability for a New York State common law claim for aiding and abetting fraud would create an inappropriate private right of action against collateral participants, conflicting with the Supreme Court's decision in Pinter. The Court also rejected the Plaintiffs’ aiding and abetting fraud claim based on Regulation T for similar reasons. As the evidence does not support the “substantial assistance” necessary for such a claim, the Court grants summary judgment in favor of the Defendants, denies the Plaintiffs’ cross-motion for summary judgment, and dismisses all of the Plaintiffs’ claims. Defendants are instructed to serve a copy of the Order on all pro se parties, and the Clerk of the Court is directed to close the case.