Commercial Litigation and Arbitration

Securities — 10b-5 Liability for Breach of Contract — Shingle Theory of Broker-Dealer Liability

Capital Management Select Fund v. Bennett, 2012 U.S. App. LEXIS 471 (2d Cir. Jan. 10, 2012):

Former customers ("RCM Customers") of Refco Capital Markets, Ltd. ("RCM"), a subsidiary of the now-bankrupt Refco, Inc., appeal from Judge Lynch's dismissal of their Section 10(b) securities fraud claims against former corporate officers of Refco and Refco's former auditor, Grant Thornton LLP. Appellants claim that appellees breached the agreements with the RCM Customers when they rehypothecated or otherwise used securities and other property held in customer brokerage accounts.***

Although no claim for breach of contract is pursued by appellants, the gravamen of their Section 10(b) claim is such a breach. Breaches of contract generally fall outside the scope of the securities laws. See Gurary v. Winehouse, 235 F.3d 792, 801 (2d Cir. 2000) ("[T]he failure to carry out a promise made in connection with a securities transaction is normally a breach of contract and does not justify a Rule 10b-5 action . . . unless, when the promise was made, the defendant secretly intended not to perform or knew that he could not perform." (citation and internal quotation marks omitted) (quoting Mills v. Polar Molecular Corp., 12 F.3d 1170, 1176 (2d Cir. 2000))); Desert Land, LLC v. Owens Fin. Grp., Inc., 154 Fed. App'x. 586, 587 (9th Cir. 2005) ("[T]he mere allegation that a contractual breach involved a security does not confer standing to assert a 10b-5 action.").

However, although "[c]ontractual breach, in and of itself, does not bespeak fraud," Mills, 12 F.3d at 1176, it may constitute fraud where the breaching party never intended to perform its material obligations under the contract. See Cohen v. Koenig, 25 F.3d 1168, 1172 (2d Cir. 1994) ("The failure to fulfill a promise to perform future acts is not ground for a fraud action unless there existed an intent not to perform at the time the promise was made."). Private actions may succeed under Section 10(b) if there are particularized allegations that the contract itself was a misrepresentation, i.e., the plaintiff's loss was caused by reliance upon the defendant's specific promise to perform particular acts while never intending to perform those acts. See Wharf (Holdings) Ltd. v. United Int'l Holdings, Inc., 532 U.S. 588 (2001) (defendant violated Section 10(b) when it sold a security while never intending to honor its agreement); Ouaknine v. MacFarlane, 897 F.2d 75, 81 (2d Cir. 1990) (Section 10(b) plaintiff adequately alleged facts to imply the defendants intended to deceive when they issued an offering memorandum); Luce v. Edelstein, 802 F.2d 49, 55-56 (2d Cir. 1986) (allowing Section 10(b) claim where plaintiff alleged defendant's promises made in consideration for a sale of securities were known by defendant to be false); cf. Mills, 12 F.3d at 1176 (denying Section 10(b) claim because plaintiff alleged no facts probative of defendant's intent at contract formation).

We have also held that where a breach of contract is the basis for a Section 10(b) claim, the "promise . . . must encompass particular actions and be more than a generalized promise to act as a faithful fiduciary." Luce, 802 F.2d 55.

With respect to the present action, we add that a simple disagreement over the meaning of an ambiguous contract combined with a conclusory allegation of intent to breach at the time of execution will not do. Either the alleged breach must be of a character that alone provides "strong circumstantial evidence" of an intent to deceive at the time of contract formation, ECA, 553 F.3d at 198, or there must be allegations of particularized facts supporting a "cogent and compelling" inference of that intent, Tellabs, 551 U.S. at 324; Int'l Fund Mgmt. S.A. v. Citigroup Inc., Nos. 09 Civ. 8755, 10 Civ. 7202, 10 Civ. 9325, 11 Civ. 314, 2011 WL 4529640, at *9 (S.D.N.Y. Sept. 30, 2011).


The Securities and Exchange Commission has expressed a concern, as amicus curiae, that affirming the district court in this regard will viscerate the so-called "shingle theory" of broker-dealer liability under Section 10(b), and will be inconsistent with our recent decision in VanCook v. SEC, 653 F.3d 130 (2d Cir. 2011). We disagree.

Under the shingle theory, a broker makes certain implied representations and assumes certain duties merely by "hanging out its professional shingle." Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184, 192 (2d Cir. 1998).

In VanCook, we held that VanCook's late-trading practice "violated [Rule 10b-5] because it constituted an implied representation to mutual funds that" VanCook was complying with a rule restricting late-trading. VanCook, 653 F.3d at 141. We reasoned that "by submitting orders after that time for execution at the current day's [Net Asset Value], VanCook made an implied representation that the orders had been received before 4:00 p.m., because such late trading incorporates an implicit misrepresentation by falsely making it appear that the orders were received by the intermediary before 4:00 p.m. when in fact they were received after that time." Id. at 140-41 (internal quotation marks and alterations omitted). We also noted that VanCook's scheme violated his employer "mutual funds' own express wish's, as set out in their propectuses," id. at 140, and involved "steps to make it appear to any outside observer . . . that his customers' . . . orders had been finalized by 4:00 p.m.," id. Based in part on the explicit and implied misrepresentations, we affirmed the order of the SEC that VanCook violated Rule 10b-5 and Section 10(b). Id. at 141.

However, the facts alleged in the instant matter do not, as asserted by appellant, give rise to liability based on "conduct inconsistent with an implied representation; specifically a broker-dealer's implied representation under the 'shingle theory' that it will deal fairly with the public in accordance with the standards of the profession." Appellants' 18(j) Letter at 2. Surely, RCM's affirmative representations that it was not a U.S.-regulated company trump any implied representation under the shingle theory.

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