Harrison v. Dean Witter Reynolds, Incorporated

For nearly eighteen months Hudson T. Harrison, an Illinois resident, sent his and his company's money to a Dean Witter Reynolds, Inc. ("Dean Witter") account executive and vice president, John G. Kenning, in Boca Raton, Florida, for investment in low-risk municipal bonds. Both Kenning and his assistant, John M. Carpenter, offered Harrison an opportunity he could not resist: If he sent money to them personally, they would place it in Carpenter's personal, employee account at Dean Witter and then invest it in a specially available, municipal-bond fund. This misuse of the employee account would yield Harrison a significantly increased return because the bonds would be purchased at Dean Witter's cost and at the reduced commission allowed on employees' own transactions. Dean Witter's rules prohibited using employee accounts in this manner.

All told, Mr. Harrison and his company, Harrison Construction Inc. (collectively "Harrison"), the plaintiffs-appellants here, invested roughly $4 million. A few payments, or investments, were made by wire transfer to Carpenter's personal checking account, but most were made by check, mailed to Carpenter's home. In return Harrison received personal, promissory notes signed initially by Carpenter and later by both Kenning and Carpenter. These notes offered annualized interest rates of approximately 18% to 60%. Dean Witter points out, however, that Harrison received two notes for each transaction: one accurately stated his anticipated return, and the other, which he used for income-tax purposes, materially understated it.

The scheme, however, was a fraud perpetrated by Kenning and Carpenter, who invested not in municipal bonds but in much riskier put options. These investments went sour. Harrison and roughly 125 other investors lost most of their money. Kenning and Carpenter were later sentenced to eight and four years' incarceration, respectively, in a federal penitentiary for their criminal acts and ordered to pay $8 million restitution.

Harrison sued not only Kenning and Carpenter but also Dean Witter, seeking to impose both vicarious and direct liability. He raised claims under Section 10(b) of the Securities Exchange Act of 1934 (the "1934 Act"), 15 U.S.C. § 78j(b); Section 20(a) of the 1934 Act, 15 U.S.C. § 70t(a); the Racketeer Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. §§ 1961 et seq.; state common law; and one state statute. One of the RICO claims was dismissed early on. Harrison v. Dean Witter Reynolds, Inc., 695 F.Supp. 959 (N.D.Ill.1988). The other claims succumbed to Dean Witter's motion for summary judgment. Harrison v. Dean Witter Reynolds, Inc., 715 F.Supp. 1425 (N.D.Ill.1989). The case was then transferred from Judge Duff to Judge Lindberg, who imposed sanctions under Fed.R.Civ.P. 11 on Harrison's attorney, Thomas P. Ward, for raising two frivolous claims. Harrison v. Dean Witter Reynolds, Inc., 132 F.R.D. 184 (N.D.Ill.1990). These Rule 11 sanctions resulted in an award of attorney's fees in the amount of $20,860.50. Harrison v. Dean Witter Reynolds, Inc., No. 86 C 8003, Memorandum Opinion and Order, 1990 WL 165638 (N.D.Ill. Oct. 19, 1990). Kenning and Carpenter were then dismissed on Harrison's motion under Fed.R.Civ.P. 41(a), and final judgment was entered February 6, 1991. Harrison appeals the grant of summary judgment in favor of Dean Witter and the imposition of sanctions; Dean Witter appeals the partial denial of sanctions. For the reasons stated below we affirm in part and reverse in part.

Diversity jurisdiction exists over the state-law claims. Plaintiff, Hudson T. Harrison, is a citizen of Illinois. Plaintiff, Harrison Construction, Inc., is an Illinois corporation with its principal place of business in Illinois. The defendant, Dean Witter, is a Delaware corporation with its principal place of business in New York. The former defendants, Kenning and Carpenter, were citizens of Florida. The amount in controversy exceeds $50,000. 28 U.S.C. § 1332. We reserve for the moment Dean Witter's contention that we do not have jurisdiction over the appeal with respect to the Rule 11 sanctions imposed.

We review de novo a district court's decision to grant summary judgment, viewing the facts in a light most favorable to the nonmoving party. Prince v. Zazove, 959 F.2d 1395, 1398 (7th Cir.1992); Ooley v. Schwitzer Division, Household Manufacturing Inc., 961 F.2d 1293, 1297 (7th Cir.1992). "The movant has the burden of showing that there is no genuine issue of fact, but ... [under Fed.R.Civ.P. 56(e) the nonmoving party] must set forth specific facts showing that there is a genuine issue for trial." Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 256, 106 S.Ct. 2505, 2514, 91 L.Ed.2d 202 (1986). Where a party who bears the burden of proof fails to establish an essential element in its case, "there can be 'no genuine issue as to any material fact' ... [and] all other facts [become] immaterial." Celotex Corp. v. Catrett, 477 U.S. 317, 322-33, 106 S.Ct. 2548, 2552, 91 L.Ed.2d 265 (1986) (quoting Fed.R.Civ.P. 56(c)). See also Matsushita Electric Industrial Co. v. Zenith Radio Corp., 475 U.S. 574, 585-87, 106 S.Ct. 1348, 1355-56, 89 L.Ed.2d 538 (1986).

The district court based its grant of summary judgment on the proposition of law that under Section 20(a) of the 1934 Act the plaintiff must show "the defendant exercised some control over the wrongdoer with respect to the wrongful acts." Harrison v. Dean Witter Reynolds, Inc., 715 F.Supp. 1425, 1436 (N.D.Ill.1989) (citing Christoffel v. E.F. Hutton & Co., 588 F.2d 665, 668 (9th Cir.1978)). This is known as the "culpable participant" requirement or test. Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1574-75 (9th Cir.1990) (en banc), cert. denied, --- U.S. ----, 111 S.Ct. 1621, 113 L.Ed.2d 719 (1991); Schlifke v. Seafirst Corp., 866 F.2d 935, 949 (7th Cir.1989). The court then found, as a matter of law:

Dean Witter exercised no control over Kenning and Carpenter with respect to their sales of promissory notes [ (the allegedly fraudulent acts) ]. It did not know of these sales, nor could it have known of them, since Carpenter and Kenning structured their arrangement with Harrison to ensure that Harrison would not send any money to them at the office. Further, the sales were conducted in the names of Kenning and Carpenter alone; the payments on the notes were by Carpenter's personal checks; and Harrison never contacted Dean Witter to inquire about his investments.

Harrison, 715 F.Supp. at 1437.

In applying the culpable-participant test from Christoffel, the district court used a test we have never approved, a test, the rigors of which contravene our prior holdings, and a test expressly overruled, en banc, by the Court of Appeals for the Ninth Circuit in Hollinger, 914 F.2d at 1575.

In Schlifke we stated,

This circuit has not crystallized the test for determining when liability may be imposed on a "controlling person," yet in Barker we stated that "the ability to persuade and give counsel is not the same thing as 'control', which almost always means the practical ability to direct the actions of the people who issue or sell the securities."

Schlifke, 866 F.2d at 949 (citing Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 494 (7th Cir.1986); emphasis in Barker ). We then stated, "We need not decide whether to adopt this more rigorous[, 'culpable-participation'] formulation for the [defendant] Bank was not a 'controlling person' even under the less demanding Metge test." Schlifke, 866 F.2d at 949. In Metge v. Baehler, 762 F.2d 621 (8th Cir.1985), cert. denied, 474 U.S. 1057, 106 S.Ct. 798, 88 L.Ed.2d 774; 474 U.S. 1072, 106 S.Ct. 832, 88 L.Ed.2d 804 (1986), the court had held:

[P]laintiffs must establish, first, that the defendant lender actually participated in (i.e., exercised control over) the operations of the corporation in general; then he must prove that the defendant possessed the power to control the specific transaction or activity upon which the primary violation is predicated, but he need not prove that this later power was exercised. [Quotation marks and citation omitted.] We approve this test because it complies with precedents which counsel broad remedial construction of the statute and because it complies with precedents that distinguish between actual exercise of control in the violator's principal affairs and potential control over the violation.

Metge, 762 F.2d at 631 (first emphasis in original, others added).

While the Schlifke court clearly did not adopt the culpable-participation test, neither did it expressly adopt the two-pronged Metge test. The court did state, however, it agreed "fully with the district court's analysis," which utilized the Metge test. Id. at 949. Significantly, the control-person test approved in Metge was that used by the district court in Metge v. Baehler, 577 F.Supp. 810, 817-18 (S.D. Iowa 1984), which in turn applied elements stated in Stern v. American Bankshares Corp., 429 F.Supp. 818 (E.D.Wis.1977).

There is no requirement that the controlling person exercise control over the particular transaction which gives rise to the violation....

....

What the plaintiff in this action must establish is that those persons whom he contends are controlling persons have actively participated in the operations of [defendant] Bankshares and possessed actual control over the transaction in question. Once that is established the matters of knowledge and actual participation, which directly or indirectly induced the fraud, are matters for the defense.

Stern, 429 F.Supp. at 823-24 (citations omitted). Moreover, the Metge test comports with the definition of "control" promulgated by the Securities and Exchange Commission ("SEC")2 and, as we shall now see, with our prior holdings, which also counsel broad remedial construction of the statute and recognition of a practical ability to direct the actions of those involved.

In SEC v. First Securities Co. of Chicago, 463 F.2d 981 (7th Cir.), cert. denied, 409 U.S. 880, 93 S.Ct. 85, 34 L.Ed.2d 134 (1972) ("First Securities I" ), and a companion case, SEC v. First Securities Co. of Chicago, 466 F.2d 1035 (7th Cir.), cert. denied, 409 U.S. 1041, 93 S.Ct. 528, 34 L.Ed.2d 491 (1972) ("First Securities II" ), we reversed the district court, which had disallowed a number of liability claims brought under Section 20(a). Leston B. Nay, president of First Securities and owner of 92% of its stock, had defrauded at least sixteen clients by inducing them to invest in spurious, high-interest, escrow accounts that, upon his suicide, June 4, 1968, were worthless. Typically, an investor would sell already owned securities through First Security; First Security would collect a commission on the sale and forward the remainder to the investor, who then would draw a personal check payable to Nay or to a bank for his account. Nay issued receipts that took the form of a purported agreement or promissory note from him. Erratically, Nay made what appeared to be interest payments to the investors by personal check in envelopes on which First Securities' name and address appeared. In First Securities I, 463 F.2d at 985, the court observed,

Finally, it is clear that Nay had no actual authority to act for First Securities with regard to the escrow account. It is also clear that First Securities' employees (other than Nay) knew nothing of the nature of the escrow nor, except for his secretary, even of its existence. Nay had forbidden anyone other than himself to open mail addressed to him....

The court concluded that it "had no doubt Nay, being the employee of First Securities as its president, was 'controlled' by First Securities within the intendment of section 20(a)." Id. at 987 (citation omitted). Moreover,

First Securities made Nay its president, provided him with the trappings of a successful investment counsellor, held him out as providing such counsel, and then wilfully allowed Nay's enforcement of a rule regarding the opening of mail which was antithetical to the prevention of frauds of the type which occurred.

Id. at 988. After quoting this statement, the First Securities II court added, "First Securities also provided Nay with the printed letterheads, printed safekeeping receipts, rubber stamps and other supplies and accoutrements which enabled him to perpetrate and perpetuate his frauds." First Securities II, 466 F.2d at 1040.

In Sennott v. Rodman & Renshaw, 474 F.2d 32 (7th Cir.), cert. denied, 414 U.S. 926, 94 S.Ct. 224, 38 L.Ed.2d 160 (1973), we reversed a district court's finding of brokerage-house liability where no one at the brokerage itself had participated in the fraudulent acts. The actual fraud was committed by Jordan Rothbart some six years after he left the brokerage firm of Rodman & Renshaw. He became a commodities trader and member of the Chicago Board of Trade, where he met the plaintiff, Sennott, to whom he purported to sell $142,000 in stock options which, it turned out, never existed. The court found, however, that Rothbart's other transactions with Sennott, had they been fraudulent, would have imposed liability on Rodman & Renshaw under Section 20(a). As described by the court,

A typical [non-fraudulent] transaction involved Jordan [Rothbart] advising Sennott that his father[, William, a registered representative of Rodman & Renshaw,] believed a particular stock should be bought or sold, Sennott indicating a desire to purchase, and Jordan going to the Rodman phone on the Board of Trade floor and calling in the order. Shortly thereafter Sennott would receive a mailed confirmation slip from Rodman. Sennott, of course, paid brokerage fees on all of these transactions.

Sennott, 474 F.2d at 34 (footnote omitted). The court concluded that while Rodman & Renshaw could be held liable under Section 20(a) for the just-described transactions, there was

not an adequate foundation upon which to base liability where Rodman was admittedly not considered to be involved in the transaction. Rodman's duty to control its partners and agents, as well as its past employees, in situations such as this extends only to transactions with or by these parties where Rodman is itself involved.

Id. at 39-40.

In Henricksen v. Henricksen, 640 F.2d 880 (7th Cir.), cert. denied, 454 U.S. 1097, 102 S.Ct. 669, 70 L.Ed.2d 637 (1981), we reversed a district court's finding that a brokerage firm, Smith Barney, was liable under Section 20(a) for the fraudulently garnered commissions and margin expenses but not for the conversions by its salesman-agent, George Henricksen. We held Smith Barney was liable for the conversions, too.

Having entrusted her investment to Smith Barney's management through George [Henricksen], their agent, Wendee [Henricksen, George's former wife,] was entitled to rely on Smith Barney's fiduciary obligation to manage the investments in accordance with her recorded investment objectives and George's best professional judgment subject to the review and ultimate control of Smith Barney's supervisory personnel.

Henricksen, 640 F.2d at 888.

Lastly, we have affirmed a finding by the Commodity Futures Trading Commission that a commodity brokerage firm, Rosenthal & Company, was liable under Section 2(a) of the Commodity Exchange Act for the fraudulent acts of a non-employee who was, nevertheless, a manager, associate, and registered representative of the firm. 7 U.S.C. § 4; Rosenthal & Company v. Commodity Futures Trading Commission, 802 F.2d 963 (7th Cir.1986). Of particular relevance for us is the observation in Rosenthal that, although we affirmed the Commission's finding of liability, we could have, with equal justification, affirmed a finding that Rosenthal was not liable.

[W]e don't suppose that we or any other court would think the Commission had taken leave of its senses [had it accepted Rosenthal's line of argument]. But we also think the Commission was entitled, without being deemed to have acted unreasonably or without substantial evidence, to conclude that [co-defendant] Pinckney was acting within the scope of his agency [with Rosenthal].

Id. at 968. The issue was factual, and it was the fact-finder's choice to find liability or not.

Those cases in which we have found control wanting help define the boundaries of "control person." In Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490 (7th Cir.1986), we affirmed that neither the law firm which had provided legal advice nor the accounting firm which had furnished accounting services with regard to certain bonds were control persons. Neither firm had the ability to control the bond issuer; both firms had only the "ability to persuade and give counsel[, which] ... is not the same thing as 'control.' " Id. at 494. Neither firm had the authority to direct the actions of the bond issuer; additionally, neither had received the selling materials until after they were issued. Id. In Sennott there was no liability because there was no person which the brokerage firm could control; the fraud involved no member or representative of the firm. Rather, it was the non-fraudulent transactions which could have brought liability to the firm; one of its members did participate in the transactions, and the firm, inter alia, received attendant commissions.

In Schlifke, we affirmed a grant of summary judgment for the defendant, the parent corporation of a bank that had made a loan, secured by letters of credit, to an oil-and-gas limited partnership. The loan documents appeared in the prospectus. We found that the bank "had no power to control the ... sales personnel or to dictate the manner in which the allegedly fraudulent sales of securities were made; it merely prescribed requirements for the letters of credit...." Schlifke, 866 F.2d at 950. In a diversity action arising under the Illinois Securities Law of 1953, ILL.REV.STAT. ch. 121 1/2, p 137.1 et seq., we affirmed a district court's finding that the broker and its salesperson were jointly and severally liable and that the clearing agent, Bear, Stearns, was not:

[A]s the clearing agent in these transactions, Bear, Stearns did not play a central or specialized role. Instead, it performed a simple, albeit necessary, accounting function in order to process the orders. We will not impose the broad liability reserved under the Illinois Act for underwriters, dealers or salespersons for the performance of such limited, ministerial acts.

Carlson v. Bear, Stearns & Co., 906 F.2d 315, 317 (7th Cir.1990). The point is well made.

Clearly, we have never approved or used the culpable-participant test, nor have we ever used any similar test to so stingily limit the definition of control person. Moreover, the court of appeals that Judge Duff unfortunately relied upon as precedent for the culpable-participant test has, since, expressly rejected that test and has, instead, adopted a test which greatly expands Section 20(a)'s circle of liability.

The Court of Appeals for the Ninth Circuit, sitting en banc, reversed a district court's summary judgment for the defendant and held "that a broker-dealer is a controlling person under § 20(a) with respect to its registered representatives." Hollinger, 914 F.2d at 1573. In so doing, the court overruled prior decisions in Christoffel, the case relied upon by Judge Duff, and Buhler v. Audio Leasing Corp., 807 F.2d 833 (9th Cir.1987), among others. The court expressly rejected the "culpable participation" test of control (Hollinger, 914 F.2d at 1575), stating, instead, that a plaintiff "need only show that ... [the actor] was not himself a registered broker-dealer but was a representative employed by or associated with a registered broker-dealer." Id. at 1574. But as the court explained:

[W]e do not mean that a broker-dealer is vicariously liable under § 20(a) for all actions taken by its registered representatives. Nor are we making the broker-dealer the "insurer" of its representatives.... [T]he "controlling person" can avoid liability if she acted in good faith and did not directly or indirectly induce the violations.

Id. at 1575. In a footnote the court observed,

The broker dealer may also, of course, rely on a contention that the representative was acting outside the broker-dealer's statutory "control." For example ... [the plaintiff was] placing the money with ... [the actor] for purposes other than investment in markets to which [the actor] had access only by reason of his relationship with [the] broker-dealer....

Id. at 1575-76 n. 26.

We have long viewed the statute as remedial, to be construed liberally, and " 'requiring only some indirect means of discipline or influence short of actual direction to hold a "control person" liable.' " First Securities I, 463 F.2d at 987 (quoting Myzel v. Fields, 386 F.2d 718, 738 (8th Cir.1967), cert. denied, 390 U.S. 951, 88 S.Ct. 1043, 19 L.Ed.2d 1143 (1968), which was cited for the same proposition by Metge, 762 F.2d at 630). We have never construed "control" as narrowly as the district court below, nor have we construed it as broadly as the court in Hollinger. We have looked to whether the alleged control-person actually participated in, that is, exercised control over, the operations of the person in general and, then, to whether the alleged control-person possessed the power or ability to control the specific transaction or activity upon which the primary violation was predicated, whether or not that power was exercised.

Here Harrison alleged and Dean Witter has not disputed that Dean Witter is a broker-dealer and that Kenning and Carpenter were its employees--the former as a registered representative, vice president, and account executive and the latter as a registered representative and Kenning's assistant. Additionally, both had assigned office-space at the Boca Raton branch of Dean Witter, a local, office telephone number, an "800" telephone number, and "Dean Witter" business cards, among other indicia of authority. Carpenter but not Kenning, who was facing bankruptcy, maintained an employee account at Dean Witter; Kenning actually controlled it, however. Dean Witter's rules required the local branch manager to sign all order tickets for employee accounts and to monitor the accounts' activities; the rules also prohibited commingling employee and client funds as well as sharing an interest in an account with anyone other than a close relative. Nonetheless, Harrison's money, sent to Kenning and Carpenter either at home or to a personal bank account, always landed rather quickly in Carpenter's account at Dean Witter.

The alleged facts are sufficient to prevent our finding, as a matter of law, either that Dean Witter did not actually exercise control over the operations of Kenning and Carpenter in general or that Dean Witter did not possess the power or ability to control Kenning and Carpenter's transactions upon which the primary violation is predicated. Accordingly, it was error to grant Dean Witter's motion for summary judgment on the basis that Dean Witter was not a controlling person. We leave that determination to the factfinder.

But the analysis does not end here. The statute provides an affirmative defense for controlling persons, one which the defendant bears the burden of proving. Fey v. Walston & Co., 493 F.2d 1036, 1051-52 (7th Cir.1974); Hollinger, 914 F.2d at 1575 n. 25 (citing, inter alia, Fey, 493 F.2d at 1051-52). Section 20(a) of the 1934 Act provides that a controlling-person defendant is not liable if the defendant can show he or she "acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action." 15 U.S.C. § 78t. Thus, once controlling-person status is shown, "a broker-dealer would be liable for its employee's acts under Section 20(a) if it 'did not maintain a reasonably adequate system of internal supervision and control over the [registered representative] or did not enforce with any reasonable diligence such system * * *.' " Henricksen v. Henricksen, 640 F.2d 880, 884 (7th Cir.), cert. denied, 454 U.S. 1097, 102 S.Ct. 669, 70 L.Ed.2d 637 (1981) (quoting Fey, 493 F.2d at 1051; bracketed material and asterisks added by the Henricksen court). In affirming the district court's finding of liability, the Henricksen court held, inter alia,

We cannot agree, however, that Smith Barney was reasonably diligent in its supervision of the trading in ... [the plaintiff's] account, and we further conclude that this lack of reasonable diligence in combination with the generally casual supervision of ... [the defendant employee's] activities contributed not only to the trading losses and commission expenses but to the conversions as well.

Id. at 885.

The alleged facts indicate Dean Witter had rules in place to prevent various types of fraud. For example, in addition to those noted above, the rules also required that supervisors ensure an employee's investments were commensurate with his or her resources. Indeed, on more than one occasion the head of Dean Witter's compliance department asked the local branch manager to investigate the heavy volume in Carpenter's account. He did ask Carpenter and Kenning about it, but apparently accepted without further investigation Carpenter's explanation that it was his own money. Harrison, 715 F.Supp. at 1425. As it turned out, the two lost some $600,000 in roughly their first year at Dean Witter and some $2,000,000 over the ensuing two years without attracting, what they might consider, unwarranted attention. Under the alleged facts of the present case we cannot say, as a matter of law, that Dean Witter acted in good faith and neither directly nor indirectly induced the act or acts constituting the violation. This determination, too, must be left to the factfinder.

The district court applied Illinois law to all state-law claims Harrison raised. He argues this was error and that Florida law controls these claims. Dean Witter responds that Harrison failed to object to the district court's applying Illinois law and, thus, cannot raise this issue on appeal.

Under Erie and Klaxon a federal court exercising diversity jurisdiction "must look to the law of the forum in which it sits for substantive law, ... including the rules governing choice of law." International Administrators, Inc. v. Life Insurance Co. of North America, 753 F.2d 1373, 1376 n. 4 (7th Cir.1985) (citing Erie Railroad Co. v. Tompkins, 304 U.S. 64, 71-80, 58 S.Ct. 817, 818-23, 82 L.Ed. 1188 (1938), and Klaxon Co. v. Stentor Electric Manufacturing Co., Inc., 313 U.S. 487, 496,