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First American Discount Corporation v. Jacobs

August 21, 2001

FIRST AMERICAN DISCOUNT CORPORATION, PLAINTIFF-APPELLANT
v.
GEORGE JACOBS AND DEENA JACOBS, DEFENDANTS-APPELLEES



Circuit Court of Cook County. Case No. 97M1002750 The Honorable Glynn J. Elliott, Jr., Judge Presiding.

The opinion of the court was delivered by: Justice Gordon

UNPUBLISHED

The central incident in this appeal is plaintiff-appellant First American Discount Corporation's (FADC) liquidation of defendants George and Deena Jacobs' trading account, allegedly without notice, on October 27, 1997. Defendants claimed that this liquidation constituted unauthorized trading, and the Cook County Circuit Court agreed, finding that FADC carried out unauthorized trading and thereby breached its fiduciary duty to defendants. Following a bench trial, the court entered judgment in the amount of $106,511.74 (essentially the amount of defendants' equity balance plus securities on deposit prior to the liquidation) against FADC and in favor of defendants.

FADC is a registered futures commission merchant (FCM) located in Chicago, with customers whose trades are cleared at the Chicago Mercantile Exchange (CME). Among FADC's customers were defendants, whose account was introduced to FADC by Kristian Capital Management, Inc. (KCM), of Naples, Florida, a registered introducing broker (IB). Defendants, also of Naples, Florida, opened a trading account with FADC in January 1997 and executed a Customer Agreement with FADC. One of the agreement's provisions authorized FADC to liquidate the positions in defendants' accounts "without prior demand or notice."

On the morning of October 27, 1997, defendants held what are called strangle option positions in the December Standard & Poor's (S&P) 500 futures contract traded on the CME. They had sold 10 November 1025 calls and 10 November 890 puts. These options gave the purchasers the right, but not the obligation, to buy or sell the underlying S&P contract at a fixed price within a specified time. Specifically, a put option is an option sold to a buyer giving him the right to sell the contract at the fixed, strike price even if the market declines below that price, while a call option is an option sold to a buyer giving him the right to buy at the strike price even if the market rises above that level. In this case, the 10 November 1025 call options sold by defendants gave the purchasers the right to purchase the contract at the strike price of 1025, even if the price rose above that level, and the 10 November 890 put options gave the purchasers the right to sell the contract at the strike price of 890, even if the price fell below that level. Thus a "ceiling" of 1025 and a "floor" of 890 were created.

In engaging in this strategy, defendants were betting that the underlying S&P contract price would stay within the range between this ceiling and floor until the options expired, which would mean they would expire worthless. So long as the underlying contract price remained below 1025, the purchaser of the call option had no incentive to exercise it and purchase the contract at the higher strike price of 1025. Similarly, if the contract price remained above 890, the purchaser of the put option had no incentive to exercise it and sell at the lower, 890 strike price. If the options expired worthless, defendants would be able to keep the entire amount (premium) which they had collected when they sold the options. However, defendants' positions were vulnerable to unlimited risk should the underlying market move through either the ceiling or the floor.

Trading customers such as defendants are required to keep on deposit with their FCM, in this case FACD, a certain amount of what is called margin, which is a good faith deposit that generally represents from 3 to 7 percent of the underlying contract value. When this margin dwindles and the customer's account goes "under margin," the FCM generally issues a "margin call" requiring the customer to deposit additional money to bring the margin back up to the required level. According to documents introduced into evidence at trial, at the close of trading on Friday, October 24, 1997 (the last day of trading before Monday, October 27, 1997), defendants had total equity of $57,164.98 in their trading account, plus T-bills with a market value of $48,846.76, for a sum of $106,011.74. The initial margin requirement for the positions held by defendants was $94,776, which meant that they had on hand an excess margin of $11,235.74. So long as the positions in their account did not lose more than $11,235.74 in value, the account had sufficient equity to maintain the positions.

It is undisputed that the stock market fell precipitously on October 27, 1997, which the testimony disclosed was the date of the worst single-day point drop in the history of the U.S. stock market. See Great Northern Ry. Co. v. Weeks, 297 U.S. 135, 149 (1936) (taking judicial notice of the stock market collapse of 1929). As a result of this decline, defendants' account became under-margined. Plaintiff asserts, without contradiction, that at the time it liquidated defendants' positions, the account had a deficit balance of $27,631, i.e., all of the margin had been depleted, and the account balance had dropped an additional $27,631, an amount which plaintiff FACD paid to the CME at the close of business on October 27. It is also undisputed that earlier in the day, before defendants' account became under-margined, defendant George Jacobs instructed KCM, his introducing broker, to execute a series of roll-down orders which would result in a lowering of both the "ceiling" and the "floor" of his positions. According to this "roll-down" strategy, which was only partially completed prior to the liquidation, defendants would gradually buy back the 890 puts and 1025 calls, and replace them by selling the same number of 885 puts and 985 calls. Thus the "floor" would be lowered from 890 to 885, and the "ceiling" would be lowered from 1025 to 985.

In November 1997 FADC filed suit against defendants George and Deena Jacobs, seeking a judgment against them in the amount of $27,631.38. FADC alleged that under the terms of the Customer Agreement entered into between defendants and FADC, defendants agreed to pay any and all debit balances incurred in their trading account. According to the complaint, defendants' account incurred a debit balance of $27,631.38 "[a]s a result of unprofitable trades initiated by Defendants," and defendants had failed and refused to pay this amount to FADC. Thus FADC alleged that defendants breached the agreement.

Defendants counterclaimed that plaintiff's liquidation of their positions constituted unauthorized trading, and that this liquidation was a breach of plaintiff's fiduciary duty to defendants. Plaintiff moved for summary judgment, contending that it had both a legal and a contractual right to liquidate defendants' under-margined positions with or without notice. Attached to defendants' response to this motion was an affidavit of defendant George Jacobs. In this affidavit, Jacobs stated that prior to opening his account with FADC, he had spoken with Ken Kristian of KCM, the Florida broker which introduced defendants' account to FADC. According to Jacobs, Ken Kristian told him at that time that FADC would never liquidate positions in Jacobs' account unless he failed to meet a margin call.

The trial court denied plaintiff's motion for summary judgment. A bench trial began on June 4, 1999, and it was reconvened on October 14, 1999. The following relevant evidence was presented at trial.

Carl Gilmore, the director of compliance for FADC, was called by both FADC and defendants. Gilmore stated that on October 27, 1997, he noticed a dramatic downward move in the S&P 500 futures market. When the market declined to about 930, Gilmore became concerned about defendants' account, whose positions, as noted, had a "floor" of 890. Gilmore called his firm's trading desk and asked them to contact KCM and express Gilmore's concerns about defendants' positions if the market continued to decline. He told the trading desk to ask KCM what defendants' intentions were if the market continued to drop. Gilmore was told by the trading desk that defendants were unable to wire funds on that day because they were traveling. The trading desk informed Gilmore that defendants wanted to initiate a "roll-down" strategy which would lower the floor and ceiling of their positions, thereby reducing the potential margin consequences to the account. It was Gilmore's understanding that the roll-down strategy was to be initiated when the underlying futures contract price hit 910.

Gilmore further stated that he told the trading desk the roll-down strategy was acceptable for the time being, but that if the market continued to decline, the positions would have to be liquidated, since additional funds apparently were not forthcoming from defendants. Gilmore told the trading desk to inform KCM about the possible liquidation.

Gilmore testified that they began to implement the roll-down strategy but were unable to complete it. The market declined rapidly, moving through the new floor, and FADC was forced to liquidate defendants' positions in an effort to reduce the risk and protect itself. At the time of liquidation, defendants' account showed a deficit balance of $27,631, which FADC was required to pay to the CME at the close of business on October 27. According to Gilmore, this deficit amount would have been much greater had FADC not acted when it did. If FADC had simply continued the roll-down, the deficit in defendants' account would have grown by another $54,850 prior to settlement, leaving a deficit in excess of $80,000 at the end of the day. At the opening the next day, this deficit would have increased not by $55,000 but instead by $177,050. Thus the actual deficit of $27,631 would have grown to a total of some $204,000. In that event, defendants' margin call at the opening on October 28, 1997, would have exceeded $255,000.

During his testimony, Gilmore referred to an individual information form which was included in the Customer Agreement between defendants and FADC. According to this form, which as part of the agreement was admitted into evidence, George Jacobs listed his residence as Naples, Florida. The residence telephone number listed on the form had a Florida area code. On October 27, 1997, based on conversations between FADC and KCM, FADC knew that Jacobs was "on the road." Gilmore stated that since he could not have reached Jacobs at the Florida telephone number on October 27th, he did not call Jacobs at that number and give him a margin call. According to Gilmore, Jacobs never gave him a number where he could be reached on that day.

Defendant George Jacobs, who also was called by FADC and defendants, testified that on October 27, 1997, he was traveling somewhere in Maryland (apparently en route from his home in Connecticut to his home in Florida) when he heard on the car radio that the market had moved down ("toward [his] put positions from the start of the day"). He went to the nearest telephone and called KCM. Jacobs talked to Kirk Kristian (Ken Kristian's brother), a KCM broker, about the market. Kirk Kristian told Jacobs that FADC was concerned about the market, and Jacobs asked Kirk if he, Jacobs, needed to send any additional money. Kirk said he would find out. Also at this time, Jacobs instructed Kirk Kristian to begin a roll-down strategy if the market fell to 910. Jacobs testified that he did not have a cell phone, and he could not be sure that he would come to another pay telephone before 15 or 20 miles had passed. He wanted to prepare himself in case the market dropped, which is why he told Kirk to institute the roll-down strategy. According to Jacobs, there was no discussion at this time about a margin call.

Jacobs stated further that he called Kirk Kristian a short while later, and Kirk told him that FADC would not tell him (Kirk) that Jacobs "need[ed to send] any money." Jacobs called Kirk a third time and asked him if there was a problem with the margin, and Kirk told him that FADC would not tell him. When Jacobs called Kirk a fourth time, *fn1 Kirk told him that FADC had liquidated his positions.

Jacobs maintained throughout his testimony that he never received a margin call from FADC. He also insisted that he never told Kirk Kristian on October 27, 1997, that he would not meet a margin call, or that he would not wire money. Jacobs testified that he had $103,000 in his bank account which he could have wired. There were 32 branches of this bank in Maryland, and Jacobs stated that he was prepared to go to the closest one and "see what arrangements [he] could make." He never did that because, according to Jacobs, he was never asked to put up any additional money. Jacobs also stated that the market subsequently recovered and that by the end of the next day (October 28), the November 890 and 885 S&P options "were very close to the *** positions that we had [previously]."

Jacobs conceded that, since his account was liquidated at a deficit on October 27th, at some point on that day it was under-margined. He also conceded that at the point when his account became under-margined, FADC could not have reached him at his residence in Florida. Jacobs did not have a cell phone, and he did not give Kirk Kristian a number where he could be reached. He also acknowledged that he signed the Customer Agreement with FADC, and that by signing it he represented to FADC that he had read and understood its terms, and agreed to be bound by them. Jacobs said he believed that Ken Kristian of KCM had orally amended the agreement. Jacobs attempted to testify, as indicated in his earlier affidavit attached to his response to FADC's summary judgment motion, that he had been assured by Ken Kristian that he would always receive a margin call prior to any liquidation. However, the trial court sustained FADC's objection that this testimony was barred by the parol evidence rule. Jacobs conceded that no one from FADC ever told him that Ken Kristian worked for FADC or that he had the authority to amend the agreement, which was between FADC and defendants.

Kirk Kristian, a commodities broker with KCM, testified on behalf of FADC. He said Jacobs was a client of his brother, Ken Kristian, but that Ken was out of the office on October 27. Kirk Kristian stated that his first conversation with Jacobs on that day was at 1:17 p.m. eastern time. Jacobs told Kirk that he was traveling south to Naples, Florida, for the winter and that he had heard on the radio that the market was falling and he was very concerned. Kirk explained to Jacobs what FADC's concerns were. He told Jacobs that FADC wanted to know if he had money available should the market continue to move downward. Kirk and Jacobs discussed implementing a roll-down strategy if the market continued to decline, and Kirk told Jacobs that he would present that option to FADC. However, he asked Jacobs if money was available in case the roll-down strategy proved insufficient. According to Kirk ...


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