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Hochfelder v. Midwest Stock Exchange

decided: April 10, 1974.

OLGA HOCHFELDER, ET AL., PLAINTIFFS-APPELLANTS,
v.
MIDWEST STOCK EXCHANGE, DEFENDANT-APPELLEE. LEON S. MARTIN ET AL., PLAINTIFFS-APPELLANTS, V. MIDWEST STOCK EXCHANGE, DEFENDANT-APPELLEE



Appeals from the United States District Court for the Northern District of Illinois, Eastern Division. No. 71 C 454, No. 71 C 1204 THOMAS R. MCMILLEN, Judge.

Swygert, Chief Judge, Castle, Senior Circuit Judge, and Sprecher, Circuit Judge.

Author: Swygert

SWYGERT, Chief Judge.

This is an appeal by plaintiffs from a grant of summary judgment in favor of defendant, Midwest Stock Exchange. Plaintiffs are various individuals*fn1 who were victimized by a securities fraud perpetrated by Leston B. Nay, President of First Securities Company of Chicago and owner of ninety-two percent of its stock. First Securities was registered with the Securities and Exchange Commission as a broker-dealer in securities and was a member of the Midwest Stock Exchange and the National Association of Securities Dealers, Inc. Each member organization in the Midwest Stock Exchange had a nominee or "member officer" who would represent the member organization for certain purposes, such as casting its vote in Midwest matters or trading on the Exchange floor. Nay was First Securities' member officer or nominee in the Midwest Stock Exchange, a position which he applied for and was admitted to in 1945.

The facts surrounding Nay's fraudulent scheme are set forth in detail in our opinion in Securities & Exch. Com'n v. First Securities Co. of Chicago, 463 F.2d 981 (7th Cir. 1972), and need only be briefly restated. Plaintiffs were brokerage clients of First Securities, buying and selling securities through First Securities in regular fashion. Each plaintiff received investment advice from Nay, and each knew Nay to be the president of First Securities. Nay induced the plaintiffs to place funds in an "escrow" account which Nay represented would pay interest to plaintiffs at a high rate of return (generally twelve percent per annum, but later reduced to nine percent). Nay's fraudulent scheme came to light in 1968 as a result of a suicide note left by him describing First Securities as bankrupt due to his thefts and indicating that certain "escrow" accounts created by him were "spurious." Plaintiffs were among the investors in these spurious escrow accounts.

Nay's actions were violative of the federal securities laws and First Securities was derelict in fulfilling its duties pursuant to the Securities Exchange Act of 1934, 15 U.S.C. ยง 78a, et seq. Securities & Exch. Com'n v. First Securities Co. of Chicago, 463 F.2d 981 (7th Cir. 1972). The thrust of plaintiffs' present action, asserting violations of the Securities Exchange Act of 1934, is that Midwest was negligent in scrutinizing Nay's application as a member officer and failed thereafter to adequately investigate his continued fitness as a member, and as a result of its action and inaction Midwest aided and abetted Nay's violation of the 1934 Act.

In resolving whether summary judgment was correctly granted to Midwest we must first inquire whether there was a genuine issue of material fact as to the liability of Midwest. Butterman v. Walston & Co., 387 F.2d 822 (7th Cir. 1967). The district court found there to be none and, as our opinion will demonstrate, we agree. Since no material facts are in dispute we must then make inquiry whether, on the basis of the uncontroverted facts, the district court correctly found as a matter of law that Midwest has incurred no liability under the Securities Exchange Act of 1934. The specific issues to be decided are: (1) whether Midwest fulfilled its duties as a national securities exchange under section 6 of the Securities Exchange Act of 1934; (2) whether Midwest aided and abetted by action or inaction any violation of Rule 10b-5 by Nay under the Securities Exchange Act of 1934; and (3) whether plaintiffs' claims against Midwest are barred by the statute of limitations. The district court determined these issues favorably to Midwest and granted summary judgment. We affirm.

I

It is plaintiffs' contention that Midwest inadequately scrutinized Nay's application in 1945 for the position of member officer or nominee of First Securities and as a result Nay was improperly admitted to membership in Midwest. Also, plaintiffs assert that various events and alleged violations of Midwest rules were sufficient to put Midwest on notice that Nay was no longer fit for membership and that Midwest's failure to inquire into these matters was a dereliction of duty. Plaintiffs claim that Midwest's alleged negligence in admitting Nay to membership and allowing him to continue as a member in the Exchange was a violation by Midwest of section 6(a) (1) of the Securities Exchange Act of 1934.

Midwest is a national securities exchange registered with the Securities and Exchange Commission pursuant to section 6 of the 1934 Act and accordingly must fulfill the duties imposed under that section. Section 6(a) (1) provides that an exchange shall "enforce so far as is within its powers complaince by its members, with the provisions [of the 1934 Act and the rules and regulations thereunder]." Section 6(b) obligates the exchange to promulgate rules to "include provision for the expulsion, suspension, or disciplining of a member for conduct or proceeding inconsistent with just and equitable principles of trade," the violation of any provision of or rule under the 1934 Act being deemed conduct inconsistent with such principles. It is these provisions that prescribe in rather broad language the duties of self-regulation incumbent on Midwest as a registered exchange. With respect to the section 6 duty of self-regulation there are two inquiries which generally must be made: (1) the scope of the duties owed; and (2) whether the duties owed run to the plaintiffs.

At the outset we need not reach the question of whether the duties owed run to the plaintiffs for, assuming arguendo they do, we find that the duties owed were adequately fulfilled. Although the section 6 duty of self-regulation is framed in broad language, "to enforce so far as is within its powers", it is not a mandate of strict liability rendering the exchange a guarantor of all fraudulent schemes consummated by its members whether in listed or unlisted securities. To so read section 6 would tear at the very fabric of self-regulation, a burden which indeed no self-regulatory body could bear. The scope of the duty of self-regulation is not far reaching. Rather, the scope must be delineated to include only those acts, events, schemes, or circumstances surrounding exchange members of which the exchange knows or has reasonable cause to know, or those events and circumstances which would reasonably put the exchange on notice, of a violation or suspected violation of a securities law, regulation or rule or, exchange rule.*fn2 It is only in the face of these circumstances that a failure to proceed with the requisite due care and conduct would be a dereliction of the duty of self-regulation. Measuring the duty of self-regulation to the present action, we find that Midwest, on the basis of the uncontroverted evidence in this case, did not fail to exercise the requisite care and conduct in admitting Nay to membership and allowing him to maintain his membership.

Plaintiffs assert that Midwest failed to exercise due care in reviewing Nay's application for membership in that: (1) Midwest did not discover Nay's change of his first name from Ladislas to Leston at the age of eighteen upon migration to the United States from Hungary; (2) Midwest did not investigate the circumstances surrounding the voluntary liquidation in 1942 of Webber, Darch & Company for whom Nay had been an officer and director; (3) Midwest made no inquiry of Halsey, Stuart & Company where Nay had been employed for the period 1921 through 1933; and (4) Midwest made no investigation into the circumstances surrounding Nay's prior two divorces. It is plaintiffs' contention that Midwest failed to exercise the requisite care in scrutinizing Nay's continued fitness to remain a member in view of alleged warnings of Nay's dubious integrity and desperate financial condition, namely: (1) Nay's insistence in 1949 on employing Joseph F. Hammel as a security salesman despite the fact that Midwest's investigation of Hammel produced evidence that Hammel had falsified his employment application; (2) Nay's request in 1959 of permission from Midwest to pledge his stock in First Securities for a personal loan; although Midwest denied Nay's request, it did not inquire into the reasons for Nay's request to pledge all his stock; (3) Midwest's awareness of the fact that First Securities had experienced a net capital deficiency in late 1967 in violation of Midwest's rules; (4) Nay's borrowings from First Securities beginning in 1957; although Midwest approved of each borrowing, it did not investigate Nay's financial situation; and (5) Midwest's failure to request and examine copies of Nay's federal income tax returns which it is claimed would have demonstrated Nay's position of insolvency.

With respect to plaintiffs' charge of failure to appriately screen Nay's application for membership, we find that the investigatory procedures employed by Midwest in 1944 were sufficient to satisfy the section 6 duty of self-regulation. Those procedures included among others letters of recommendation from banks and member organizations of Midwest; two sponsors of the applicant from member organizations appeared before the Admissions Committee of the Midwest Exchange to answer questions with respect to Nay's application; Nay appeared before the Admissions Committee and answered questions pertaining to his application; and a notice of Nay's proposed admission to the Exchange was sent to all members of Midwest requesting them to inform the Admissions Committee of any reason known to them which would indicate that Nay was unfit for membership in the Exchange.

We fail to find merit in plaintiffs' contention that Midwest should have investigated the circumstances surrounding Nay's change of first name and his divorces. These matters had no relevancy. Although Midwest did not inquire of Nay's one time employer, Halsey, Stuart & Company, and did not investigate further into the circumstances surrounding the voluntary liquidation of Webber, Darch & Company with whom Nay had been associated, in view of the admission procedures employed in 1945 it cannot be said that Midwest's failure to ...


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