SEC v. Pinez

• Court: Court of Appeals for the First Circuit
• Decided: October 5, 1998
• Docket: 98-1228
• Status: Published

Opinion

USCA1 Opinion

                 United States Court of Appeals

                     For the First Circuit


No. 98-1228



               SECURITIES AND EXCHANGE COMMISSION,



                       Plaintiff, Appellee,



                                v.



                      LEHMAN BROTHERS, INC.,



                   Relief Defendant, Appellant.


APPEAL FROM THE UNITED STATES DISTRICT COURT



                FOR THE DISTRICT OF MASSACHUSETTS



            [Hon. Patti B. Saris, U.S. District Judge]


Before



            Selya, Boudin and Lipez, Circuit Judges.


John D. Donovan, Jr. with whom Mark P. Szpak, Crystal D.

Talley and Ropes & Gray were on brief for appellant.

     Henry F. Minnerop, Brown & Wood LLP, Stuart J. Kaswell and

Fredda L. Plesser, Office of the General Counsel, on brief for

Securities Industry Association, Inc., Amicus Curiae.

     Mark Pennington, Senior Litigation Counsel, Securities and

Exchange Commission, with whom Colleen P. Mahoney, Acting General

Counsel, Jacob H. Stillman, Associate General Counsel, Diane V.

White, Senior Counsel, and Paul Gonson, Solicitor, were on brief

for appellee.  


October 5, 1998


BOUDIN, Circuit Judge.  This difficult case concerns a

preliminary injunction obtained by the Securities and Exchange

Commission to freeze certain assets in the brokerage account of

Emanuel Pinez who (according to the SEC) secured those assets

through unlawful insider trading.  The assets were held in Pinez's

brokerage account with Lehman Brothers, Inc., which claimed an

overriding security interest in the assets.  Having failed to

persuade the district court on this point, Lehman Brothers now

appeals.

  The background facts are essentially undisputed.  Pinez,

who was chairman of Centennial Technology, Inc., opened a personal

brokerage account with Lehman Brothers in February 1996.  Frederick

E. Pierce II became Pinez's account representative at Lehman

Brothers.  In September 1996, Pinez executed a margin account

agreement with Lehman Brothers (explicitly to be governed by New

York law); the agreement permitted him to borrow from Lehman

Brothers to cover a portion of the cost of his purchases.  The

agreement also gave Lehman Brothers a security interest as

collateral for any margin debt in all assets held in the account. 

  During 1996, Centennial stock performed remarkably well,

reaching a high of $58 per share in December 1996.  According to

the SEC, the reason was fraudulent bookkeeping by Pinez, including

fictitious sales and inventory figures.  Indeed, after the events

to be recounted, the company revised its financial statements to

show a $28 million loss for the three-and-a-half years ending in

December 1996, rather than the $12 million profit originally

reported.

  Well before this public restatement, reports began to

appear in newspapers in January and February 1997, suggesting

doubts about Centennial's earnings and management.  Throughout

January 1997, the price of Centennial stock fell, reaching $23.75

on January 31, 1997.  On February 5, 1997, Centennial's board of

directors set up a special committee to investigate the company's

earnings, and the vice chairman of the board told Pinez the next

day that Pinez would likely have to leave if the company had to

restate its earnings.

  On February 7, 1997, Pinez called Pierce and directed him

to arrange a "zero-cost collar" on Centennial stock owned by Pinez;

Pinez then had almost $10 million in Centennial stock (at then-

current market prices) in his Lehman Brothers account.  Pinez's

apparent purpose was to ensure that he would have the necessary

funds to cover his $5 million margin-account debt with Lehman

Brothers even if the market price of his Centennial-stock

collateral fell sharply and led Lehman Brothers to demand immediate

payment of the debt, as it was entitled to do under the margin

account agreement.

  A zero-cost collar involves two contemporaneous

transactions: the sale (here, by Pinez) of call options, giving the

option buyers the right to purchase from the seller up to a certain

amount of the stock at a fixed price, and the purchase (again by

Pinez) of an equal number of put options, giving the buyer the

right to sell a similar amount of stock to the sellers of the puts

at some future period at a similar or closely related fixed price. 

What matters here is that the put options that Pinez acquired

became assets held in his Lehman Brothers margin account.

     When Pinez called Pierce on February 7, 1997, Pierce

asked whether Pinez was in a "quiet period," during which he would

be precluded from trading in Centennial securities; Pinez said that

he was not.  Pierce then obtained the necessary approvals from

Lehman Brothers.  Pierce filled the order the same afternoon,

selling 2700 Centennial "call" options and purchasing 2700

Centennial "put" options.  At this time, Pinez's account at Lehman

Brothers held securities (mostly Centennial stock) providing barely

adequate collateral for Pinez's total margin debt.

     Whatever Lehman Brothers should or might have suspected

on February 7, 1997, there is no claim by the SEC that Lehman

Brothers knew at that time either that Pinez had falsified

Centennial's financial statements or that this possibility was

under investigation by Centennial's board.  However, on February

11, 1997, Centennial announced publicly that it was undertaking an

inquiry into its earlier financial statements, that it had removed

Pinez from its management, and that the New York Stock Exchange had

suspended trading in Centennial stock.  Lehman Brothers issued an

immediate margin call demanding that Pinez pay it all outstanding

margin debt, then more than $6 million.  Pinez failed to do so. 

Lehman Brothers now had a contractual claim against Pinez for his

margin debt, a claim Lehman Brothers much later reduced to a state-

court judgment.

     In the meantime, one of the valuable assets in the Pinez

account was the 2700 put contracts giving Pinez as put owner the

right to make the unfortunate put sellers pay $20 per share for

Centennial stock now worth much less.  Before Lehman Brothers could

take advantage of this opportunity to dispose of its security, the

SEC on February 14, 1997, brought the present civil action in the

district court and obtained an ex parte temporary restraining order

"freezing" all assets in Pinez accounts with various financial

institutions, including Lehman Brothers.  The government also began

criminal proceedings against Pinez.

     The SEC's civil action, out of which the present appeal

grows, charged Pinez with having secured the put options through

the unlawful use of inside information--specifically, knowledge

that Centennial's financial health was much worse than publicly

known--in violation of various securities law requirements,

primarily section 10(b) of the Securities Exchange Act of 1934, 15

U.S.C.  78j(b).  Lehman Brothers was later named in an amended

complaint as a "relief defendant."  One object of the complaint was

to require "disgorgement" by Pinez of his "ill-gotten gains,"

including the put options that are the subject of this case.  By

agreement of the parties, the put options were liquidated before

they expired, so the controversy is now about the proceeds.

     Following the grant of the temporary restraining order,

the district court held a hearing on March 6, 1997, on the SEC's

request to transform the now expired TRO into a preliminary

injunction.  Despite the expiration of the TRO, Lehman Brothers, as

a courtesy to the court, agreed to maintain the proceeds derived

from the put options in an escrow account while the court

considered the SEC's motion.  Those proceeds now represent almost

$5 million, which Lehman Brothers says is barely enough to cover

the still unpaid portion of Pinez's margin-account debt.

     On December 16, 1997, the district court released a

memorandum and order granting the instant preliminary injunction

insofar as  it maintained a freeze on Pinez's assets, including the

put option proceeds held in escrow by Lehman Brothers.  SEC v.

Pinez, 989 F. Supp. 325 (D. Mass. 1997).  After detailed analysis

of federal and state law, the court concluded that at trial the SEC

was likely to establish not only that Pinez had committed fraud in

acquiring the put options, but also that "Lehman [Brothers] is not

a bona fide purchaser of those securities . . . ."  Id. at 345. 

This appeal followed.

     In this court, Lehman Brothers has assumed that but for

its asserted security interest in the margin account assets, the

SEC would have a valid claim to recoup the proceeds as the product

of an unlawful transaction by Pinez (the put options purchases). 

Conversely, the SEC has assumed that its claim to the proceeds is

subordinated if Lehman Brothers is treated as a bona fide purchaser

of the put options for value; the SEC does not dispute that Lehman

Brothers should be treated as a purchaser for value, and the

relevant law supports this concession.

     Accordingly, the dispute--as framed by the parties--is

whether Lehman Brothers is a bona fide purchaser.  We accept the

assumptions of the parties but do not independently endorse them. 

Cf. In re Newport Plaza Assoc. v. Durfee Attleboro Bank, 985 F.2d

640, 643-44 (1st Cir. 1993).  As to the law governing Lehman

Brothers' status as a bona fide purchaser, the SEC regards the

issue as governed by New York law, while Lehman Brothers invokes

federal securities law.  We address the legal issues in that order.

     New York law is a sound starting point because in this

instance, as in most commercial transactions, state law provides

the matrix of background rules and is ordinarily displaced, if at

all, only by conflicting or field-occupying provisions of federal

statutory law, or occasionally by federal common law.  See Attertonv. FDIC, 519 U.S. 213 (1997); Wallis v. Pan American Petroleum

Corp., 384 U.S. 63, 68 (1966).  Here, the margin account agreement

relied on by Lehman Brothers for its priority is expressly governed

by New York law.

     The parties agree that save as federal law may dictate

otherwise, Lehman Brothers' rights to the proceeds vis-a-vis  the

SEC are controlled by article 8 of New York's Uniform Commercial

Code, N.Y.U.C.C.  8-301 et seq. (McKinney 1987).  Article 8

governs investment securities, and section 8-302 defines a "bona

fide purchaser" as "a purchaser for value in good faith and without

notice of any adverse claim" who obtains a security (under certain

specified conditions which the SEC here assumes to have been

satisfied).  Section 8-302(3) then provides: "A bona fide purchaser

in addition to acquiring the rights of a purchaser (Section 8-301)

also acquires his interest in the security free of any adverse

claim."

     "Adverse claim" is defined in fairly general terms (in

section 8-302(2)) but we need not pursue the subject because the

SEC appears to assume that its own claim for "disgorgement" of the

put options (or their proceeds) constitutes an adverse claim that

would not prevail against a bona fide purchaser.  Instead, it says

that it is entitled to prevail over Lehman Brothers because Lehman

Brothers, even though a "purchaser for value," was not one "in good

faith and without notice of any adverse claim."  N.Y.U.C.C.  8-

302.

     The factual predicate for the SEC's position is that

Pinez was known to be an insider, he was engaging in a transaction

that made a good deal of sense if one expected a dip in the price

of his stock, and there was some public information suggesting that

the company might be in more difficulty than its past financial

reports would indicate.  These facts are undisputed and we will

assume, in unison with the SEC, that they amply amount to

suspicious circumstances that should have alerted Lehman Brothers

to the possibility of trouble.

     The key to the SEC's legal argument is that Lehman

Brothers' disregard of "suspicious circumstances" deprives it of

bona fide purchaser status (Lehman Brothers did make a brief

inquiry of Pinez as already recounted, but no more).  In the words

of the district court, which took a similar view of New York law,

"a failure to act on actual knowledge of suspicious circumstances

constitutes bad faith on the part of a lienholder" and thereby

defeats a claim of bona fide purchaser status. Pinez, 989 F. Supp.

at 344.  Lehman Brothers, by contrast, asserts in its brief that

under New York's UCC, "good faith" is "entirely 'subjective,' andthat it excludes any duty of inquiry."

     We adopt neither position outright, but think that the

law is closer to Lehman Brothers' view.  In our view, the emphasis

in the New York case law is on subjective bad faith and

dishonesty, an emphasis echoed in parallel provisions of section

3-304 which--in relation to commercial paper--describe notice of a

claim or defense as including "knowledge of such facts that his

action in taking the instrument amounts to bad faith."  N.Y.U.C.C.

 3-304(7) (McKinney 1987).  Although the case law provides the

decisive gloss, plain language confirms it: in ordinary parlance,

one can certainly be "suspicious," without being dishonest, in

deciding to proceed with a transaction where suspicions are

outweighed by competing considerations.

     New York has deliberately adopted a standard somewhat

more favorable to the recipient of the securities than have a

number of other states.  As New York's highest court has noted, New

York and Virginia are the only states to insist that notice "be

determined by a subjective test of actual knowledge."  Hartford,

542 N.E.2d at 1094; see also Chemical Bank, 411 N.E.2d at 341; cf.Lawton v. Walker, 343 S.E.2d 335, 337-38 (Va. 1986) (construing the

parallel provision of the Virginia UCC  8.3-304).  Where one draws

the line, in requiring more or less inquiry by the purchaser, is a

policy choice; the New York legislature could plausibly choose to

facilitate stock transactions by limiting the obligation to inquire

and giving bona fide purchaser status a generous reach.

     The SEC points to cases that forbid someone from

deliberately averting his eyes from evident misconduct.  We agree

that such conduct, even if literally short of actual knowledge,

could fairly be equated with dishonesty or bad faith.  But there is

nothing in the facts before us to suggest that Pinez's use of a

"collar" transaction could only be explained by the use of inside

information.  Nor has the SEC shown that Lehman Brothers

deliberately closed its eyes to some easily obtained information

that would have confirmed that Pinez was engaging in securities

fraud.  

     Indeed, we can imagine in extreme circumstances imputing

bad faith to a purchaser who had very strong suspicions of grave

misconduct, who could readily have verified or dispelled the

suspicion, and who failed to do so without any plausible excuse. 

To this limited extent, there may be a duty of inquiry where a

failure to inquire amounts to bad faith.  But here, misconduct was

merely a possibility; Lehman Brothers had been directed to execute

an immediate transaction, and the SEC does not suggest how it could

have swiftly and definitely assured itself that no insider

information had been used.

     Taking New York law to require dishonesty and not mere

suspicion, and applying that standard to the facts currently of

record, we do not think that the SEC has shown a reasonable

likelihood of prevailing against Lehman Brothers on the merits. 

This disagreement with the able district judge rests primarily on

our reading of New York law which we assess de novo.  Of course,

the present record does not reflect an evidentiary hearing, let

alone a full trial; whether eventually the SEC might adduce more

facts that would meet the dishonesty standard is another matter.

     This brings us to the question whether federal law

supersedes state law, either in favor of Lehman Brothers or in

favor of the SEC.  Lehman Brothers relies on two provisions of the

federal securities law, which it reads as saying that only "actual

knowledge" of Pinez's violation would impair its security interest. 

Conversely, the district judge, but not the SEC, thinks that a

third provision of the federal securities laws makes suspicious

circumstances enough.  We think that none of the three provisions

cited alters the result in this case.

     Lehman Brothers first relies upon section 29(b) of the

Securities Exchange Act of 1934, 15 U.S.C.  78cc(b).  In pertinent

part, section 29(b) provides as follows:

          Every contract made in violation of any

     provision of this chapter . . . shall be void

     (1) as regards to the rights of any person

     who, in violation of any such provision . . .

     shall have made or engaged in the performance

     of any such contract, and (2) as regards to

     the rights of any person who, not being a

     party to such contract, shall have acquired

     any right thereunder with actual knowledge of

     the facts by reason of which the making or

     performance of such contract was in violation

     of any such provision . . . .



Relying on subsection (2), Lehman Brothers argues that the "actual

knowledge" requirement controls, with no ifs or buts based on

suspicious circumstances.

     We will assume without deciding that Lehman Brothers is

right in its reading of the phrase "actual knowledge."  We will

also assume that Lehman Brothers is a person who, "not being a

party" to such put option contracts, acquired a right thereunder,

namely, the right as successor to Pinez to enforce the put options

contracts.  It therefore would follow from these (untested)

assumptions that Lehman Brothers could defeat any claim under

section 29(b) by the put options sellers that, because of Pinez's

violation, the contracts were "void."

     But subsections (1) and (2) are merely limitations on the

consequences that would otherwise be visited by the principal

directive of section 29(b), namely, that the options contracts

would be voidable under federal law.  No one, including the SEC,

says that Lehman Brothers cannot enforce the options contracts, as

it has already done in liquidating them.  Instead, the SEC is

challenging Lehman Brothers' security interest in the proceeds

created by the margin agreement and is arguing that that security

interest, created by New York law, is also undermined by New York

law because of Lehman Brothers' alleged bad faith.

     If there were conflict between section 29(b) and New York

law, the latter would give way under the Supremacy Clause.  There

is no such conflict.  Section 29(b) is a federal law that makes the

put option contracts unenforceable by the buyer against the seller

where acquired through the buyer's violation of "this chapter"

(presumably, Lehman Brothers was rescued by subsection (b)(2)). 

The New York UCC provision relied on by the SEC does not contradict

this outcome; it merely gives the SEC an independent ground under

New York law for saying that Lehman Brothers has no valid security

interest, a security interest that Lehman Brothers itself assumes

it needs in order to prevail over the SEC.

     Lehman Brothers' other resort is to section 29(c)(1), 15

U.S.C.  78cc(c), which in pertinent part provides as follows:

          Nothing in this chapter shall be

     construed (1) to affect the validity . . . .

     of any lien . . . unless at the time of . . .

     the creating of such lien, the person . . .

     acquiring such lien shall have actual

     knowledge of facts by reason of which . . .

     the acquisition of such lien is a violation of

     the provisions of this chapter . . . . or (2)

     to afford a defense to . . . the enforcement

     of any lien by any person who shall have

     acquired such . . . lien in good faith for

     value and without actual knowledge of the

     violation of any provision of this chapter . .

     . .



The literal language of subsection (1) is no help to Lehman

Brothers since it merely protects the lien (i.e., the security

interest) against any provision of the Securities Exchange Act that

might otherwise be taken to invalidate it.  Here, the SEC is

relying upon provisions of the New York UCC--not "this chapter"--so

the quoted language of section 29(c) does not by its terms apply.

     To be sure, in unusual circumstances a federal statute

like section 29(c)(1) might be judicially expanded to protect the

validity of the favored lien not just against the provisions of

"this chapter" but against invalidation on any basis; literal

language does not always prevail.  Cf. Church of Holy Trinity v.

United States, 143 U.S. 457 (1892).  But it would require a

remarkable showing to persuade a court to read out of the statute

the explicit limiting phrase ("in this chapter").  No such argument

has even been attempted by Lehman Brothers.

     For a similar reason, we think that the district court

read too broadly the subsection (2) of the same section 29(c),

quoted above, which says that the Securities Exchange Act shall not

be read to give a defense to enforcement of a lien where the lien

holder acquired it "in good faith for value and without actual

knowledge" of any violation of that statute.  The district court

took this provision to mean--apparently without support from the

SEC--that "federal law governs Lehman's status as a bona fide

purchaser in an action to enforce its lien."  989 F. Supp. at 343. 

Yet read literally, section 29(c)(2) is concerned only with the

possible use of the federal statute, not New York law, to

invalidate a lien.

     Further, section 29(c)(2) does not by itself purport to

invalidate any lien: it merely provides a defense to lien

invalidation under certain circumstances.  The possible reach of

the defense is beside the point unless and until someone makes out

a claim of invalidity, and the only effort to do so here--the SEC's

claim of invalidity under New York law--has thus far fallen short. 

We leave for another day the interesting question whether the

defense could ever operate where the attack on a lien was premised

primarily upon state law and where state law invalidated a lien

even of a good faith purchaser for value without actual knowledge

of the securities-law violation. 

     Ordinarily, our reasoning would lead us to vacate the

preliminary injunction at once.  However, the put options have been

reduced to a sum of money being held by Lehman Brothers in escrow,

and there is no obvious harm to Lehman Brothers in maintaining the

escrow in the short run.  Possibly (the issue has not been argued)

the SEC's ability to obtain "disgorgement" of these proceeds

depends on the separate maintenance of this concrete stake, since

there is no claim that Lehman Brothers itself violated the

securities laws.

     On remand, the district court can ascertain whether or

not the SEC desires to pursue its disgorgement claim in light of

our reading of New York law.  If so, the district court can also

decide whether the preliminary injunction is needed to avoid

mooting the case; if there is such a need, and some prospect of

success, the district court may choose to maintain the preliminary

injunction, pending a prompt trial.  See Washington Metro. Area

Transit Comm'n v. Holiday Tours, Inc., 559 F.2d 841, 844-45 (D.C.

Cir. 1977).

     Accordingly, the matter is remanded for further

proceedings consistent with this opinion.