Margin Violation Is Not An Affirmative Defense To An Action On A Note

Posted on October 20, 2010 by Michael Rigney

On June 16, 2011, the Court granted a petition for panel rehearing and vacated this opinion and judgment.

COSTELLO v. GRUNDON (October 18, 2010)

Several senior Comdisco, Inc. employees participated in the company’s shared investment plan (SIP) program. Under the program: a) participants purchased Comdisco stock, b) the purchase was funded exclusively by personal loans, c) the participants executed promissory notes in their personal capacities, d) Comdisco guaranteed the loans, e) the lenders remitted the loan proceeds directly to Comdisco, f) Comdisco held the shares, g) there were several restrictions on the ability to sell the stock, and h) participants delivered a blank stock power to Comdisco. Within two years, the stock price had risen from $34.50 to $53.00. Many participants sold their shares and made a nice profit. Others, however, did not and were still holding the stock when Comdisco went into bankruptcy. The lenders settled with Comdisco on the guaranty obligation. As part of the settlement, the lenders assigned their rights under the notes to the Comdisco Litigation Trustee. The Trustee brought individual actions against the participants. He moved for summary judgment against two of the participants. The court granted the Trustee’s motion, holding that the Trustee made a prima facie case and rejecting several defenses: a) the alleged misrepresentations were expressions of legal opinion and could not support a fraud finding, b) defendants had not shown reliance, c) defendants could not assert a violation of Regulation U as a defense, and d) a negligent misrepresentation defense was not available against the Trustee. The Trustee subsequently moved for summary judgment against the remaining defendants on the same papers. Defendants raised new defenses. Judge Gettleman (N.D. Ill.) granted the Trustee’s motion, rejecting the additional defenses. The defendants appeal.

In their opinion, Judges Kanne, Rovner, and Tinder affirmed in part and vacated in part. The Court addressed each of the many arguments on appeal in turn. Regulations G and U Violations Defense: Although the Court discussed at length and questioned the district court’s treatment of Comdisco’s or the lenders’ violation of Regulation U or G, it ultimately concluded that it did not need to decide the issue. It concurred with the district court that, even if a violation existed, it did not provide an illegality defense. Relying on Bassler, Blair, and Shearson, the Court noted that the regulations were not meant to protect individual investors and a violation does not make the underlying contract illegal. Section 10(b) Illegality Defense: The Court did disagree with the district court’s treatment of defendants’ defense under § 10(b) of the Securities Exchange Act of 1934. Although the Trustee moved for summary judgment based only on the absence of a false statement, the district court granted it on the absence of scienter, raised only in the reply brief. The Court stated that the Trustee had the initial burden of identifying the basis of his request for relief – the defendants were not required to respond to other grounds, even if later raised in the reply. Although the defendants could have responded to the Trustee’s arguments or sought further discovery, they were not required to do so. Furthermore, the Court found that the district court’s requirement of a heightened “strong inference” of scienter was improper. Finally, the Court declined to itself affirm on the alternative grounds raised by the Trustee in its reply below. Section 17(a) Defense: The district court’s ruling with respect to defendants’ defense under § 17(a) of the Securities Act of 1933 was erroneous for the same reason as the ruling on § 10(b). The court improperly ruled that defendants failed to present evidence of scienter when they were under no obligation to do so at this stage of the proceedings. Fraud and Negligent Misrepresentation Set-Off Defenses: With respect to the fraud and negligent misrepresentation set-off defenses, the district court adopted the ruling and reasoning of it decision on the first summary judgment motion. There is nothing wrong with that, said the Court, except here the defendants presented a new legal argument on the fraud defense and additional evidence with respect on the negligent misrepresentation defense that the court did not consider. The Court concluded that summary judgment in the Trustee’s favor on both was error. Excuse of Non-Performance Defense: Lastly, the Court held that it was error to grant summary judgment on the excuse of non-performance defense. The defendants argued that the lenders’ non-compliance with § 17(a), § 10(b), and Regulation U amounted to a breach of contract and thus excused their performance. The Court concluded that the district court erred in granting summary judgment with respect to the §§ 17(a) and 10(b) claims – given that the Court had just vacated the summary judgments on the underlying defenses. With respect to Regulation U, however, the Court agreed that a violation would not excuse performance since the participants were not in the “zone of interest.” The Court remanded for further proceedings.

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CAFA Controls the Ability to Remove Class Action Under Securities Act of 1933

Posted on March 2, 2009 by Michael Rigney

KATZ v. GERARDI (January 5, 2009)

Jack Katz brought this action on behalf of a class of persons who contributed real property to a real estate investment trust (“REIT”). In exchange, they received an interest in the REIT. The REIT merged into a new entity in 2007. The interest-holders were offered either cash or an interest in the new entity. Katz took the cash but filed suit in state court, alleging that the offer violated the terms of their original agreement with the REIT. He based the action on the Securities Act of 1933 ( “’33 Act”). Defendants removed the suit to federal court under the Class Action Fairness Act of 2005 (“CAFA”). The district court concluded that removal was not allowed by the ’33 Act. The defendants petition for appeal.

In their opinion, Chief Judge Easterbrook and Judges Kanne and Sykes granted the petition and vacated and remanded the decision of the district court. The Court first addressed whether Katz’ action was even one under the ’33 Act. The ’33 Act applies only to purchasers of securities – Katz and the class members are sellers of securities. The Court was inclined to believe that Katz was styling his claim as one under the ’33 Act in order to prevent removal. The district court had acknowledged the same issue. It decided that the weakness of the pleading went to the merits, not to whether it was removable. The Court recognized the difficulty in distinguishing between a claim designed to defeat federal jurisdiction and one, though ultimately unsuccessful, is properly pleaded. Ultimately, the Court decided to accept the pleading as one under the ’33 Act and address the conflict between the laws.

The ’33 Act provides that actions brought under the statute in state court are not removable except in particular circumstances. CAFA allows for removal of class actions if certain criteria are met – which admittedly are met here. The Court noted the canons of construction that apply when statutes are in conflict – an older statute yields to a newer and a less specific yields to a more specific. But the Court concluded that it did not have to apply those canons. The statutes, in fact, are not incompatible. The very language of CAFA provides the answer. The broad removal authority granted by CAFA is modified by the almost identical lists of exceptions in §1332(d)(9) and §1453(d). The Court concluded that class actions brought under the ‘33 Act are removable unless one of the §1453(d) exceptions applies. Katz relied on one of the exceptions – claims that relate to rights and duties relating to any security. The Court noted an inconsistency between Katz’ attempts to fit his claim into the exception while still relying on the ‘33 Act. Nevertheless, the Court decided the best course was to remand to determine whether the claim fit within the exception.

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