S.E.C. v. Lehman Bros., Inc.

Page 2

157 F.3d 2

Fed. Sec. L. Rep. P 90,291, 36 UCC Rep.Serv.2d 852

SECURITIES AND EXCHANGE COMMISSION, Plaintiff, Appellee, v. LEHMAN BROTHERS, INC., Relief Defendant, Appellant.

No. 98-1228.

United States Court of Appeals First Circuit.

Heard July 28, 1998.

Decided Oct. 5, 1998.

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 Com'n, with whom Colleen P. Mahoney, Acting General Counsel, Jacob H. Stillman, Assoc. General Counsel, Diane V. White, Senior Counsel, and Paul Gonson, Solicitor, were on brief for appellee.

Before SELYA, BOUDIN and LIPEZ, Circuit Judges.

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 thencurrent 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. ¹ 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. ²

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. ³

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, field-occupying provisions of federal statutory law, or occasionally by federal common law. See Atherton v. FDIC, 519 U.S. 213, 117 S.Ct. 666, 136 L.Ed.2d 656 (1997); Wallis v. Pan American Petroleum Corp., 384 U.S. 63, 68, 86 S.Ct. 1301, 16 L.Ed.2d 369 (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...