353 F.Supp.2d 141 (2005) | Cited 10 times | D. Massachusetts | January 5, 2005


This civil case involves allegations by the Securities andExchange Commission ("SEC") that defendants, former stock brokersand their branch manager, violated the Securities Act of 1933("the Securities Act") and the Securities Exchange Act of 1934("the Exchange Act") in connection with market timing activities.The SEC brings this action pursuant to Section 20(b) of theSecurities Act, 15 U.S.C. § 77t(b), and Section 21(d)(1) of theExchange Act, 15 U.S.C. § 78u(d)(1).

I. Background

A. Factual Background

The following facts are set forth as alleged in the AmendedComplaint, a 67-page tome with 434 pages of exhibits. Defendants Druffner, Ficken, Ajro, Peffer and Bilotti ("thedefendant brokers") were securities brokers in a Boston office ofPrudential Securities, Inc. ("PSI"). From January, 2001, untiltheir resignations in September, 2003, they engaged in thousandsof "market timing" trades in an aggregate amount of more than OneBillion dollars and which generated more than Five Milliondollars of net commissions for the defendants. The SEC allegesthat, in the process, the defendant brokers defrauded more than50 mutual fund companies.

Druffner led a group of brokers which handled market timingtransactions for five principal clients ("the Druffner Group").Ficken and Ajro were members of the Druffner Group. Peffer led agroup of brokers which handled market timing transactions for twoprincipal clients ("the Peffer Group"). Bilotti was a member ofthe Peffer Group. Defendant Shannon joined PSI in 1996 and wasthe Manager of the Boston branch of PSI from December, 2001 untilSeptember, 2003, when he resigned.

Market timing is a form of arbitrage in which investors buy,sell and exchange mutual fund shares on a very short-term basisin order to exploit inefficiencies in mutual fund pricing.Although market timing can lead to profits for individualinvestors, such profits come at the expense of long-terminvestors in the fund. As a consequence, many mutual fundsattempt to prohibit market timing by, for example, imposing restrictions on excessive trading by individual accounts.

The SEC alleges that defendants violated the securities laws bymaking false statements and material omissions in connection withtheir market timing activities. The defendant brokers allegedlyused numerous broker identification numbers (called "FA numbers,"shorthand for "financial advisor numbers") and opened nearly 200customer accounts under fictitious names. The use of fictitiousnames concealed the brokers' identities and the identities oftheir clients, thereby making it difficult for the funds todetect and stop their market timing activities and causing thefund companies to process transactions that they otherwise wouldhave rejected.

When mutual fund companies detected defendant brokers' markettiming activities and imposed blocks on further market timing(through a so-called "block letter"), the defendant brokersallegedly would use FA numbers and customer accounts that had notyet been blocked to evade the restrictions imposed by the mutualfunds and to place more market timing transactions. The defendantbrokers allegedly continued the offending activities even afterPSI announced a policy prohibiting the use of manipulativetechniques designed to avoid detection of certain tradingactivities, such as executing transactions through alternate FAnumbers.

The SEC alleges, in the alternative, that the defendant brokers are liable for aiding and abetting their clients'uncharged violations of the securities laws.

The SEC further alleges that Shannon assisted the defendantbrokers' scheme by approving new customer accounts and FAnumbers, approving the transfer of cash between accounts andfailing to enforce PSI's policies against market timing.

The three-count, amended complaint alleges that 1) thedefendant brokers violated Section 17(a) of the Securities Act(Count I), 2) the defendant brokers violated Section 10(b) of theExchange Act and Rule 10b-5 thereunder or aided and abetted theuncharged violations of those provisions by their clients (CountII) and 3) defendant Shannon aided and abetted the brokerdefendants' violations of Section 10(b) and Rule 10b-5 byproviding knowing and substantial assistance to their markettiming activities (Count III).1 The complaint seeks 1) a permanent injunction to restrain thedefendants and their agents from violating the statutes and ruleinvolved in this case, 2) disgorgement and pre-judgment interestand 3) civil monetary penalties pursuant to Section 20(d) of theSecurities Act, 15 U.S.C. § 77t(d) and/or Section 21(d)(3) of theExchange Act, 15 U.S.C. § 78u(d)(3).

B. Procedural History

The SEC filed a complaint against defendants on November 4,2003. At a motion hearing on June 14, 2004, Judge Lindsay foundthat the SEC had failed to comply with the requirements ofFed.R.Civ.P. 9(b), which requires that fraud be pled withparticularity, and granted defendants' motions to dismiss thecomplaint with leave to the SEC to re-file within 30 days.

The case was transferred to this Session on June 24, 2004. TheSEC filed an amended complaint on July 14, 2004. Pending beforethe Court are the defendants' renewed motions to dismiss theamended complaint. II. Discussion

Defendants have filed four separate motions to dismiss in thiscase: Docket Nos. 57 (Peffer), 59 (Bilotti), 63 (Shannon) and 66(Druffner, Ajro and Ficken). Each motion is supported by aseparate memorandum. The SEC filed a single memorandum inopposition which addressed the arguments raised by alldefendants. Because defendants' motions and memoranda containsimilar arguments, the Court will address them conjointly.

Each defendant argues that the amended complaint should bedismissed because it fails to state claims with the particularityrequired by Fed.R.Civ.P. 9(b). The defendants also raise otherdefenses, including the contention that the action violates dueprocess and that the SEC has failed to allege a primary violationas required for aider and abettor liability.

A. Standard for Motions to Dismiss

A court may not dismiss a complaint for failure to state aclaim under Fed.R.Civ.P. 12(b)(6) "unless it appears, beyonddoubt, that the [p]laintiff can prove no set of facts in supportof his claim which would entitle him to relief." Judge v. Cityof Lowell, 160 F.3d 67, 72 (1st Cir. 1998) (quoting Conley v.Gibson, 355 U.S. 41, 45-46 (1957)). In considering the meritsof a motion to dismiss, the court may look only to the factsalleged in the pleadings, documents attached as exhibits orincorporated by reference in the complaint and matters of whichjudicial notice can be taken. Nollet v. Justices of the Trial Court ofMass., 83 F. Supp. 2d 204, 208 (D. Mass. 2000) aff'd,248 F.3d 1127 (1st Cir. 2000).

Furthermore, the court must accept all factual allegations inthe complaint as true and draw all reasonable inferences in theplaintiff's favor. Langadinos v. American Airlines, Inc.,199 F.3d 68, 69 (1st Cir. 2000). If the facts in the complaint aresufficient to state a cause of action, a motion to dismiss thecomplaint must be denied. See Nollett, 83 F. Supp.2d at 208.

B. Legal Analysis

1. Particularity Required by Rule 9(b)

Rule 9(b) of the Federal Rules of Civil Procedure providesthat: In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally.Because the SEC's allegations rest on fraud, the complaint mustsatisfy the requirements of Rule 9(b). The SEC does not disputethat the pleading requirements of Rule 9(b) apply to it.

Courts in the First Circuit interpret Rule 9(b) to require thatthe complaint allege the "time, place, and content of the allegedmisrepresentations with specificity." Greebel v. FTP Software,Inc., 194 F.3d 185, 193 (1st Cir. 1999). Further, the complaintmust explain why the challenged statement or omission ismisleading by "provid[ing] some factual support for the allegations of fraud." Id., quoting Romani v. ShearsonLehman Hutton, 929 F.2d 875, 878 (1st Cir. 1991). Thus, thecomplaint must specify

(1) the allegedly fraudulent statements; (2) the identity of the speaker; (3) where and when the statements were made; and (4) why the statements were fraudulent.In re Allaire Corp. Secs. Litig., 224 F.Supp.2d 319, 325 (D.Mass. 2002); see also Suna v. Bailey Corp., 107 F.3d 64, 68(1st Cir. 1997).

The amended complaint meets all of the requirements of Rule9(b). It details the allegedly fraudulent scheme, including thebroker's role in placing the trades and how the brokers usedmultiple FA numbers and customer account numbers to disguisetheir clients' purchases and sales of mutual fund shares and toplace trades even after certain clients had been blocked fromfuture trading due to their market timing activities. Itidentifies the seven principal clients for whom the brokersprocessed market timing trades, the various FA numbers each ofthe brokers used, the various customer account numbers used foreach client and the date, dollar amount, fund and identifiers foreach transaction involved in the allegedly fraudulent scheme. Theparticularity with which the amended complaint is pled meets therequirements of the Federal Rules of Civil Procedure and thecaselaw of this circuit. See, e.g., Fed.R.Civ.P. 9(b); Inre Allaire Corp. Secs. Litig., 224 F.Supp.2d at 325. The broker defendants argue that the complaint fails to allegethat they made actionable misrepresentations or omissions. Theycontend that they had no duty to disclose to the fund companiesthat they were using multiple account numbers and FA numbers. AsJudge Linsday noted in a hearing on the motion to dismiss theoriginal complaint, however, the securities laws give rise to aduty to disclose any information necessary to make anindividual's voluntary statements not misleading. See Rule10b-5(b), 17 C.F.R. § 240.10b-5(b) (providing that it is illegalto "omit to state a material fact necessary in order to make thestatements made, in light of the circumstances under which theywere made, not misleading"). The complaint sufficiently allegesthat, at the very least, defendants failed to state materialfacts necessary in order to render the statements they made notmisleading under the circumstances.

Defendants have gone to great lengths to inform this Court thatmarket timing is not illegal. The SEC does not dispute thatspecific contention but alleges that the defendants' other actsand omissions with respect to the market timing scheme amount tofraudulent misrepresentations. Specifically, the SEC alleges thatthe defendant brokers' use of multiple FA numbers and accountnumbers constitute material misrepresentations and/or omissionswhich are prohibited by the securities laws.

The defendant brokers contend that the complaint fails sufficiently to differentiate between defendants or to identifythe role each broker played in the allegedly fraudulent scheme.That argument is unavailing.

Recently, a federal district court found that [W]hen information giving rise to securities fraud is exclusively held by defendants, the particularity requirement of Rule 9(b) is relaxed. . . . [The] plaintiff is required to distinguish among defendants to the extent that they may reasonably be expected to do so, but the complaint need not attribute specific acts to specific defendants if the complaint sufficiently describes the fraudulent acts and provides the individuals with sufficient information to answer the allegations.SEC v. Santos, 292 F.Supp.2d 1046, 1051 (N.D. Ill. 2003)(citations and quotation marks omitted). The point is well taken.

The complaint alleges that Druffen, Ficken and Ajro workedtogether to effectuate their fraudulent scheme and that Pefferand Bilotti worked together to effectuate a similar fraudulentscheme. Each allegedly fraudulent transaction is identified alongwith the FA number that was used in processing it. Although someFA numbers were assigned to groups of two or three brokers, theSEC's failure to identify which broker actually processed eachtransaction does not render the amended complaint defectivebecause, to the extent it lacks details as to which defendantundertook certain acts, such information is in the exclusivecontrol of the defendants. This is not a case in which theplaintiff has made vague and undifferentiated allegations against a large group of defendants without explaining what roleeach individual played in the scheme.

Shannon contends that the complaint against him must bedismissed because it fails to allege that the defendant brokersviolated any provisions set forth in the prospectus of anyindividual fund. He offers no legal support for that assertion,however, and the securities laws do not require that a violationof Section 10(b) or Rule 10b-5 must involve a violation of theprovisions of the prospectus of a particular fund. The plainlanguage of those provisions proscribes fraudulent devices orstatements without limiting their reach to the kinds ofstatements that are prohibited in a prospectus.

Mr. Shannon also sets forth a list of details which he claimsare required with respect to each transaction. He contends thatthe SEC must specify, with respect to each prohibitedtransaction, several details including that 1) a defendant brokerreceived a block letter blocking his FA number, 2) Shannon alsoreceived the letter, 3) Shannon approved a new FA and/or clientnumber and 4) the new number was used, with Shannon's knowledge,to trade using market timing strategies. He fails to cite caselawin support of his proposition and the caselaw and statutes thatrequire fraud to be pled with particularity simply do not requirethe level of detail Shannon suggests. The amended complaintrecites sufficient information about the allegedly fraudulent acts or omissions to state a claimagainst the defendant brokers and Shannon.

2. Scienter

Proof of scienter, "a mental state embracing intent to deceive,manipulate or defraud," is required in securities fraud cases.Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976).To survive a motion to dismiss a securities fraud case in theFirst Circuit, the plaintiff must allege facts which give rise toan inference of scienter that is "both reasonable and strong."Greebel, 194 F.3d 195-96 (internal quotation marks omitted);see also Maldodano v. Dominguez, 137 F.3d 1, 9 (1st Cir.1998) ("This circuit has been clear and consistent in holdingthat, under section 10(b), plaintiffs must plead specific factsgiving rise to a `strong inference' of fraudulent intent.")(citation omitted). While some circuits look for motive andopportunity when evaluating allegations of scienter, the FirstCircuit uses a fact-specific inquiry. Greebel, 194 F.3d at 196.

Each defendant contends that the complaint fails adequately toallege scienter. To the contrary, the information set forth inthe complaint, including the long lists of multiple accountnumbers for identified clients and multiple FA numbers ande-mails set forth in Paragraph 39, offers reasonable and strongsupport for an inference that each broker intentionally misleadcertain funds with respect to the identities of the investors. Although Peffer correctly notes that none of the e-mails setforth in Paragraph 39 was sent to or from him, the complaintsufficiently alleges scienter with respect to him by listingtrades that were processed using the three different FA numbersassigned to him and stating that those trades were made infurtherance of the allegedly fraudulent scheme.

Druffner and Ajro note that the allegations in the complaint donot prove that the purpose of using multiple account numbers andFA numbers was to make the brokers' market timing activitiesdifficult to detect and that there are other plausible purposesfor such behavior. Their observation is accurate but, at thisstage, the SEC need not prove its allegations to the exclusion ofall other possibilities. It has set forth specific facts thatgive rise to a reasonable, strong inference of fraudulentbehavior and that is adequate to survive a motion to dismiss.

The complaint alleges that Shannon knew about the brokers'scheme and provided knowing and substantial assistance by, amongother things, authorizing the brokers to open more customeraccounts to obtain additional FA numbers. Those allegations aresufficient to create a reasonable and strong inference ofscienter with respect to Shannon.

3. Aiding and Abetting Liability

To establish aiding and abetting liability in a Section 10(b)action, a plaintiff must establish (1) the commission of a violation of § 10(b) or rule 10b-5 by the primary party;

(2) the defendant's general awareness that his role was part of an overall activity that is improper; and (3) knowing and substantial assistance of the primary violation by the defendant.Cleary v. Perfectune, 700 F.2d 774, 777 (1st Cir. 1983),overruled on other grounds by Cent. Bank of Denver v. FirstInterstate Bank of Denver, 511 U.S. 164 (1994); see also SECv. Peretz, 317 F.Supp.2d 58, 63 (D. Mass. 2004).

Count II alleges that the defendant brokers violated Section10(b) of the Exchange Act and Rule 10b-5 thereunder or, in thealternative, that they aided and abetted the uncharged violationsof those provisions by their clients. The defendant brokerscontend that the complaint insufficiently charges aiding andabetting because it fails to allege a primary Section 10(b) orRule 10b-5 violation underlying the aiding and abetting charges.They are correct in that the complaint does not allege that anyclients violated the securities laws.

Although the complaint contains information from which one mayinfer that the clients were aware of the use of multiple clientor FA numbers, the complaint does not allege facts that give riseto a "reasonable and strong" inference of scienter with respectto the defendants' clients. The portion of Count II that allegesthat the defendant brokers aided and abetted their clients'uncharged violations of Section 10(b) or Rule 10b-5 will, therefore, be dismissed. Because the SEC has already hadthe opportunity to re-plead its complaint, that portion of CountII will be dismissed with prejudice.

Count III alleges that Shannon aided and abetted the brokerdefendants' violations of Section 10(b) and Rule 10b-5. Shannon'scontention that the complaint fails to allege any affirmativeconduct by him that could amount to knowing and substantialassistance is self-serving and erroneous. The complaint allegesthat Shannon knew about the fraudulent scheme and furthered it by1) approving additional account numbers and FA numbers, 2)authorizing the processing of unfinished transactions at the NewYork office and 3) failing to stop the brokers' fraudulentactivity after he received numerous block letters complaining ofsuch activity when he had a duty as Branch Manager to do so. Suchallegations involve specific instances of affirmative conductthat supports the charge the Shannon aided and abetted thebrokers' securities law violations.

4. Due Process

Peffer and Bilotti contend that, because market timing is notillegal per se, it would violate due process to hold themliable in this case in that they could not have known that thealleged misconduct was wrong. "Due process requires that lawsgive the person of ordinary intelligence a reasonable opportunityto know what is prohibited." Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (quotation marks omitted).

The case on which both Peffer and Bilotti rely, Upton v.SEC, is clearly distinguishable. In Upton, the Second CircuitCourt of Appeals held that it violated due process to hold anexecutive liable for failing reasonably to supervise asubordinate with a view toward preventing the firm's violation ofRule 15c3-3(e) (relative to the requirement that broker-dealersmaintain a certain balance in a special reserve bank account forthe benefit of customers) in a case in which 1) the rule wascomplex, 2) it was undisputed that the firm complied with theliteral terms of the Rule at all times and 3) the SEC'sinterpretation of the rule represented a substantial change inSEC enforcement policy that had not reasonably been communicatedto the public. Id.

In the case at bar, by contrast, the defendants are chargedwith fraud and the violation of Rule 10b-5, no doubt the mostfrequently cited rule in securities law. The defendants wereprofessional (presumably licensed) brokers and cannot claim thatthey had no notice of the illegality of defrauding mutual fundsby making material misstatements or omissions. As the SecondCircuit Court of Appeals stated three years after Upton whenrejecting another due process claim, defendants cannot "crediblyclaim lack of fair notice of the proscription against defraudinginvestors." Valicenti Advisory Services, Inc. v. SEC, 198F.3d 62, 66 (2d Cir. 1999).

5. Statutory Sellers

Druffner, Ajro and Ficken contend Count I, which allegesviolations of Section 17(a) of the Securities Act, must bedismissed because the defendant brokers were not statutorysellers. Section 17(a) applies to "any person in the offer orsale of any securities." 15 U.S.C. § 77q. Section 2(a)(3) of theSecurities Act provides the following definitions for terms usedin that Act: The term "sale" or "sell" shall include every contract of sale or disposition of a security . . . for value. The term "offer to sell", "offer for sale", or "offer" shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.15 U.S.C. § 77b.

The SEC's response to defendants' argument is deficient. Whilethe SEC states that defendants' alleged liability as sellers isbased upon their role in their clients' exchanges (not purchases)of shares, it fails to address the argument that, as brokersmerely executing their clients' buy and sell orders, thedefendant brokers cannot be liable under Section 17(a) asstatutory sellers.

Nonetheless, it is inappropriate to dismiss the Section 17(a)claim. Defendants have cited no caselaw in the First Circuit orelsewhere to support their argument that liability cannot beimposed on brokers pursuant to Section 17(a). This Court is conscious that [t]he statutory terms [`offer' and `sale'], which Congress expressly intended to define broadly, are expansive enough to encompass the entire selling process, including the seller/agent transaction.United States v. Naftalin, 441 U.S. 768, 773 (1979). Ittherefore declines to hold that defendants are insulated fromSection 17(a) liability based upon their status as brokers.

The defendants cite cases interpreting Section 12 of theSecurities Act, 15 U.S.C. § 77l, to support the propositionthat Section 17(a) does not apply to brokers such as themselves.Section 12 applies to "any person who offers or sells asecurity." 15 U.S.C. § 77l. The applicable statutorydefinitions of "offer" and "sell" are the same as those thatapply to Section 17 which, as noted above, applies to "any personin the offer or sale of any securities." 15 U.S.C. § 77q. Even ifthe meaning of those terms in Sections 12 and 17 were identical,however, defendants' argument would fail because the casesinvolving Section 12 do not compel the conclusion that thedefendant brokers in this case cannot be found liable asstatutory sellers.2 In Pinter v. Dahl, the United States Supreme Court notedthat It long has been "quite clear," that when a broker acting as agent of one of the principals to the transaction successfully solicits a purchase, he is a person from whom the buyer purchases within the meaning of § 12 and is therefore liable as a statutory seller.486 U.S. 622, 646 (1988) (citing 3 L. Loss, Securities Regulation1016 (2d ed. 1961)). The Court cautioned that "[b]eing merely a"substantial factor" in causing the sale of unregisteredsecurities is not sufficient in itself to render a defendantliable under § 12(1)." Id. at 654. However, the Court went onto conclude that liability does extend to

the person who successfully solicits the purchase, motivated at least in part by a desire to serve his own financial interests or those of the securities owner, . . . [such as when the person] anticipates a share of the profits or receives a brokerage commission.Id. at 647, 654 (quotation marks, alterations and citationsomitted). The Court cited with approval a case in which the FirstCircuit Court of Appeals held that

Sec. 12(2) imposes a liability for misrepresentations not only upon principals, but also upon brokers when selling securities owned by other persons. This is not a strained interpretation of the statute, for a selling agent in common parlance would describe himself as a "person who sells," though title passes from his principal, not from him.Cady v. Murphy, 113 F.2d 988, 990 (1st Cir. 1940); see alsoPinter, 486 U.S. at 644-45, 646, 654. Although other circuit and district courts have held brokersnot to be liable as statutory sellers pursuant to Section 12, thecases in which courts have so held are not binding on this Courtand are distinguishable from the instant case. See Ryder Int'lCorp. v. First Am. Nat'l Bank, 943 F.2d 1521, 1522 (11th Cir.1991) (declining to impose Section 12(2) liability upon bankbased on its "mechanical act" of executing plaintiff's orders);Leonard v. Shearson Lehman/Am. Express Inc., 687 F.Supp. 177,180 (E.D. Pa. 1988) (declining to impose Section 12(2) liabilityupon defendant broker where there was no privity or specialrelationship between buyer and seller, based upon the "strictprivity requirements" of the Third Circuit).

In this case, the complaint alleges that the defendant brokersdid more than mechanically execute their clients' sell orders; italleges that they used discretion in executing the trades throughtechniques such as using multiple broker numbers and customernumbers. Such alleged actions are sufficient to bring them withinthe definition of "sellers" pursuant to Section 17. Accordingly,Count I will not be dismissed. ORDER

Based upon the foregoing, Defendants' Motions to Dismiss(Docket Nos. 57, 59, 63 and 66) are, to the extent that they seekto dismiss the portion of Count II alleging that the defendantbrokers aided and abetted uncharged violations of the securitieslaws by their clients, ALLOWED, and are, in all other respects,DENIED.

So ordered.

1. Section 17(a) of the Securities Act provides that it isunlawful for any person in the offer or sale of securities: (1) to employ any device, scheme, or artifice to defraud, or (2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.15 U.S.C. § 77q. Section 10(b) of the Exchange Act provides that it is unlawful: To use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. 15 U.S.C. § 78j. Rule 10b-5 provides that it is unlawful: (a) to employ any device, scheme, or artifice to defraud, (b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.17 C.F.R. § 240.10b-5.

2. This Court does not, by examining cases dealing withSection 12, intend to imply that the meaning of the terms "offerand "sell" as used in Section 17 is identical to those terms asthey are used in Section 12. Indeed, it is unclear that the termshave the same meaning even within the subsections of Section 12.In a case involving the meaning of those terms as used in Section12(1), the Supreme Court explicitly stated that "this case doesnot present, nor do we take a position on, the scope of astatutory seller for purposes of § 12(2). Pinter v. Dahl,486 U.S. 622, 642 n. 20 (1988).

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