The Dodd-Frank Act Has Expanded SEC Enforcement Powers

The Dodd-Frank Wall Street Reform and Consumer Protection Act has significantly expanded SEC enforcement powers. All of the expanded powers are designed to give new protections to investors.

Previously, the SEC had the power to order a respondent to cease and desist certain activity. 1933 Act Section 8A. The SEC also had the power to file lawsuits seeking injunctive and other relief against market participants. 1933 Act Section 22. The Dodd-Frank Act has significantly expanded the SEC’s enforcement powers in several ways.

1. The Dodd-Frank Act amends Section 22(c) of the 1933 Act and Section 27(b) of the 1934 Act to allow the SEC and the United States to bring civil and criminal law enforcement proceedings involving transnational securities frauds. See Section 929Y of the Dodd-Frank Act. Thus, the holding of Morrison v. National Australia Bank, Ltd., 130 S.Ct. 2869 (2010) (holding that the securities law do not have extraterritorial application) applies only to lawsuits brought by private plaintiffs. 1933 Act Section 22(c).

2. Nationwide Service of Process in SEC Enforcement Actions.

The SEC now has the power to serve subpoenas nationwide in SEC enforcement actions. Previously, the SEC was limited to the subpoena power of the federal district court, which extends 100 miles. See 1933 Act Section 22(a); 1934 Act Section 27; Investment Company Act Section 44; Investment Advisers Act Section 214. For the SEC this is very important as it will allow the SEC to require a person who lives in California to appear at a trial in Illinois.

3. Aiding and Abetting Violations.

The Dodd-Frank Act authorized the SEC to bring claims and seek statutory penalties against persons who “knowingly” or “recklessly” aid and abet violations of the securities laws. See 1933 Act Section 15(b); Investment Company Act Section 48(b) and Investment Advisers Act Section 209(f). The Supreme Court has held that private plaintiffs may not bring aiding and abetting claims against lawyers and accountants (and others) who aid and abet a violation of the securities laws. The Dodd-Frank Act now allows the SEC to pursue such violations.

4. Cease And Desist Authority Expanded.

Under Section 8A of the 1933 Act, the Commission has broad powers to obtain a cease and desist order against anyone who has or may intend to violate the Securities Laws. The Dodd-Frank Act amended Section 8A to expand the Commission’s powers to seek and obtain cease and desist orders. Under the amended Section 8A(c)(1) the Commission has the power to issue a temporary cease and desist order when the Commission finds that “the alleged violation or threatened violation specified in the notice instituting proceedings pursuant to subsection (a), or the continuation thereof, is likely to result in significant dissipation or conversion of assets, significant harm to investors, or substantial harm to the public interest, including, but not limited to, losses to the Securities Investor Protection Corporation, prior to the completion of the proceedings.”

The respondent has an opportunity to seek judicial review of the temporary cease and desist order in the federal courts. See Section 9(a) of the Securities Act of 1933 as amended.

Subsection (g) now allows the SEC to assess civil penalties against market participants in connection with a cease and desist order. The SEC must find that the respondent (i) is violating or has violated any provision of thistitle, or any rule or regulation issued under this title; or (ii) is or was a cause of the violation of any provi­ sion of this title, or any rule or regulation thereunder; and (B) such penalty is in the public interest." The penalties increase with successive violations. Section 8A(g).

Under Section 15(b, “any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this Act, or of any rule or regulation issued under this Act, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.”

Edward X. Clinton, Jr.

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Civil Procedure - Requests To Admit - Illinois Supreme Court Rule 219(b)

A recent decision by the Illinois Appellate Court for the Second District, in the case captioned McGrath v. Botsford, 2-09-0235, will prove useful in commercial cases.

Illinois Supreme Court Rule 216 allows one party to serve requests to admit on the other party. If the requests are not admitted or denied in 28 days, they are deemed admitted. "The purpose of a request to admit pursuant to Supreme Court Rule 216 is to enable the parties and the court to limit the issues and to reduce unnecessary production of proof at trial." The answering party has a "good-faith obligation to make a reasonable effort to secure answers to a request to admit, not only from the facts within its own knowledge but also from persons and documents within its reasonable control."

Under Rule 219(b), the court may award reasonable expenses including attorney's fees for the wrongful denial of requests to admit.

In this case, McGrath denied all of the requests to admit, but later lost at trial. Moreover, McGrath contradicted his denials in deposition testimony.

After the trial, Botsford moved, pursuant to Rule 219(b) for an award of reasonable attorney fees. The trial court denied the award.

The Appellate Court reversed. The Appellate Court found that the denials were unjustified and that the trial court had abused its discretion in denying fees.

To prevail on a Rule 219(b) motion, the moving party must show: "(1) proof of the truth of the matters asserted that were denied by the nonmovant; (2) that the nonmovant lacked good reason to deny the facts asserted; and (3) the materiality to the litigation of the facts as to which admissions were sought." Citing, Exchange National Bank of Chicago v. DeGraff, 110 Ill. App. 3d 145, 160 (1982).

This is an excellent cases for commercial litigators as it allows the recovery of attorney fees for the wrongful denial of requests to admit.

Edward X. Clinton, Jr.

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Securities Law - Does Rule 10(b)(5) Have An Extraterritorial Effect?

Respondent, National Australia Bank Ltd. (“National”), the largest bank in Australia, has its shares traded on the Australian Stock Exchange and on other foreign securities exchanges but not on any exchange in the United States. National bought the stock of HomeSide and operated it as a subsidiary. HomeSide’s business was to receipt fees for servicing mortgages. These services are a valuable asset and the more valuable it is, is a function of period in which the fees will be paid. HomeSide calculates the present value of the mortgage servicing rights by using a valuation model designed to take the likelihood of prepayment into account. In other words, if mortgages are prepaid, the service fees stop to the extent of such repayment.

From the allegations in the Complaint, it is alleged that National’s Managing Director and Chief Directing Officer plotted the benefits of National but it also alleged that they did not take into account the write-downs necessary because of prepayments.

In July 2001, National wrote down HomeSide’s assets by $450,000 million and then again on September 3, 2001 by another $1.75 billion. The shares dropped in value. These plaintiffs alleged that the executives manipulated HomeSide’s financial models to make the rates of early repayment unrealistically low in order to cause the mortgaging servicing rights to appear more valuable than they actually were. Two Australians purchased ordinary shares in 2000 and 2001 before the write-downs. They sued National and HomeSide in the United States District Court for the Southern District of New York for violations of §10(b) and §20(a) of the Securities Exchange Act of 1934, and Rule 10(b)(5). They sought to represent a class of foreign purchasers of National’s ordinary shares up to the September write-downs.
Plaintiffs, the Australians, according to the Complaint, invested based on false information. The Second Circuit held that the specific language of §30(b) does not show Congressional intent to preclude application of the Exchange Act to transactions regarding stock traded in the United States which are affected outside the United States.

The Supreme Court in an opinion by Justice Scalia stated that there is no affirmative indication in the Exchange Act that §10(b) applies extra-territorially and that “we, therefore, conclude that it does not.”

The Court further stated that it is our view that only transactions of securities listed under domestic exchanges and domestic transactions and other securities to which §10(b) applies. Thus, §10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed an American stock exchange and the purchase or sale of any such security in the United States.

Justice Stevens, with whom Justice Ginsberg joined, concurred in the judgment.

Justice Stevens stated that he took exception to the statements in the majority opinion that the decision rested on the construction of the statutory text. “I happen to agree with the result the court reaches in this case. But, ‘I respectfully dissent,’ once again from the Court’s continuing campaign to render the private cause of action under Section 10(b) toothless.

Edward X. Clinton, Sr.

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Securities Law - Use of Insider Information

The SEC on October 30, 2010 filed a complaint against Dr. Yves M. Benhamou in the U.S. District Court for the Southern District of New York (10-CV-8266 (DAB)) alleging that Dr. Benhamou engaged in insider trading by providing confidential non-public information to several hedge funds.

According to the Complaint, six healthcare related hedge funds sold about 6,000,000 shares of Human Genome Sciences, Inc. (“HGSI”) and at the time the portfolio manager of the hedge funds possessed material negative non-public information concerning a clinical trial of the drug Albumin Interferon Alfa 2-a (“Albuferon”, a drug to treat ashtma). Benhamou was an advisor to the portfolio manager of the hedge funds. Benhamou, a citizen and resident of France, was one of five members of the Steering Committee overseeing the Albuferon clinical trial.

According to the Complaint, in January 2008, HGSI announced that all patients who had been administered a higher dosage level of Albuferon in its clinical trial would be moved to the lower dosage level because of safety issues with the most recent clinical trial. The Complaint alleges that Benhamou learned this negative material non-public information about the drug as a member of the Clinical Steering committee which had negative implications for commercial potential and that Benhamou passed the negative information to the portfolio manager of the hedge funds before the announcement was made public. When the information became public, the market price of HGSI’s common stock fell about 44%.

The hedge funds sold about 6,000,000 shares of HGSI representing all of its holdings before the announcement and avoided a $30 million loss. The market price of the drug went down 44% after the announcement.

It is alleged that Benhamou communicated this negative information in violation of his duty as a member of the Steering Committee and that the portfolio manager of the hedge funds knew or should have known that Benhamou served on the Drugs Trial’s Steering Committee and owed a duty of confidentiality.

The SEC charged that Benhamou violated § 17(a) of the Securities Act of 1933 by (a) employing a device scheme or artifice due to fraud; (b) obtaining money or property by means of untrue statements of a material fact or omitting a material fact in order to make the statements made in the light of the circumstances under which they were made not misleading, or (c) engaging in a practice or course of business that operated or would operate as a fraud or deceit.

The SEC seeks a permanent injunction enjoining the Defendant from violating (a) § 20(e) and (b) § 21(d)(1) of the Exchange Act and (b) from violating § 17(a) of the Securities Act, and (c) § 10(b)(5) of the Exchange Act. The SEC seeks to have (a) Benhamou disgorge with prejudgment interest all illicit trading profits or losses avoided as a result of the conduct alleged in the Complaint, and (b) ordering the Defendant to pay civil penalties pursuant to Securities Act and the Exchange Act.
According to the Wall Street Journal, the Defendant was also charged criminally and was arrested in New York

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Evidence - The Admissibility of Hearsay Statements By A Party Opponent

HEARSAY: STATEMENTS BY THE AGENT OF A PARTY-OPPONENT

By
Edward X. Clinton, Jr.
The Law Offices of Edward X. Clinton, P.C.
30 North LaSalle Street, Suite 3400
Chicago, IL 60602

Statements by an agent of a party-opponent are under certain circumstances hearsay admissions of the party-opponent.

This article will describe how to introduce or resist the introduction of statements by a party's agent under Rule 801(d)(2)(D) of the Federal Rules of Evidence and will discuss the debate concerning whether the declarant must have knowledge concerning the underlying facts and the exception for statements by government agents. These issues often arise in personal injury and employment litigation.

Some recent cases suggest that it is becoming more difficult to obtain admission of a statement by a party opponent.

To review: Hearsay is an out-of-court statement by the declarant admitted for the truth of the matter asserted. Rule 801(c). Under Rule 801, admissions of a party-opponent are not hearsay. One type of admission by a party opponent is a statement by an agent of the party-opponent. According to Rule 801(d)(2)(D), a statement is not hearsay if it is offered against a party and was made by "the party's agent or servant concerning a matter within the scope of the agency or employment, made during the existence of the relationship." The rationale is that "an agent or servant who speaks on any matter within the scope of his agency or employment during the existence of that relationship, is unlikely to make statements damaging to his principal or employer unless those statements are true." Nekolny v. Painter, 653 F.2d 1164, 1172 (7th Cir. 1981), cert. denied, 455 U.S. 1021 (1982).

I. A Three Part Showing Is Required

To prove that a statement is admissible a party must make a three-part showing. The offering party must demonstrate (1) the existence of an employment or agency relationship "independent of the declarant's statement offered as evidence;" (2) that the statement was "made during the existence of the declarant's `agency or employment" and (3) that the statement concerns a matter within the scope of declarant's employment or agency relationship. Boren v. Sable, 887 F.2d 1032, 1038 (10th Cir. 1989). I will now discuss each requirement in detail.

II. Is The Declarant The Agent or Servant of the Party Opponent?

Under the Rule the proponent must first establish that the declarant is the agent of the party opponent. Whether Rule 801(d)(2)(D) applies depends on the relationship between the declarant and the defendant. Zaken v. Boerer, 964 F.2d 1319 (2d Cir. 1992), cert. denied, 113 S.Ct. 467 (1992). In employment litigation one employee may sue a colleague and attempt to introduce a hearsay declaration by another employee. It is not dispositive that both the declarant and the defendant work for the same employer. Id. at 1323. In Zaken, plaintiff alleged that she was fired by the defendant, the president of a corporation, on the basis of her pregnancy. She sought to introduce the hearsay statement of a company vice president that another employee was fired because she was pregnant. The declaration was admissible because the vice president was directly responsible to the defendant and was therefore the defendant's agent. Id. See also Boren v. Sable, 887 F.2d 1032, 1039 (10th Cir. 1989) (in a personal injury action against a co-employee the court excluded a statement by the shop foreman because he was not the agent of the co-employee). If the foundational requirements are met, it may not even be necessary to identify the declarant. Pappas v. Middle Earth Condominium Ass'n., 963 F.2d 534, 537-38 (2d Cir. 1992) (in slip and fall case the statement by an unidentified employee was admissible to show that the defendant was aware of an icy patch on a walkway).

It is possible for an attorney to be the agent of a party. See United States v. Harris, 914 F.2d 927, 931 (7th Cir. 1990) (defendant's former attorney's statements were admissible but the court noted that "the unique nature of the attorney-client relationship, however, demands that a trial court exercise caution in admitting statements that are the product of this relationship."); United States v. Brandon, 50 F.3d 464, 468 (7th Cir. 1995) (important policies "concerning the effective assistance of the counsel of one's choosing" must also be preserved). In Harris, the court found that the conflict between the attorney-client relationship and the rule was not serious because the former attorney did not represent the defendant at trial.

III. Was the Statement Made During the Existence of The Agency?

Next, the proponent must demonstrate that the statement was made during the existence of the agency or employment relationship. This requirement is straightforward and prevents the admission of statements made after the agency relationship terminated. See Blanchard v. Peoples Bank, 844 F.2d 264, 267 n.7 (5th Cir. 1988) (statement by former employee inadmissible because the employee was not employed by defendant when the statement was made); Corley v. Burger King Corp., 56 F.3d 709, 709 (5th Cir. 1995) (statement by manager of Burger King admissible to show he was acting within scope of employment when he was driving a car involved in an auto accident).

IV. Does The Statement Concern A Matter Within The Scope of The Agency?

The proponent must also demonstrate that the statement concerns a matter within the scope of the agency or employment relationship. The Rule does not require that the declarant "have authority to bind its employer," because few employers will authorize employees to make binding admissions in litigation. Big Apple BMW Inc. v. BMW of North America, Inc., 974 F.2d 1358, 1372 (3d Cir. 1992), cert. denied, 113 S.Ct. 1262 (1993); see also Advisory Committee Note to Rule 801(d)(2)(D); Woodman v. Haemonetics Corp., 51 F.3d 1087, 1094 (1st Cir. 1995) (same).

Courts analyzing this requirement apply a common sense approach to the scope of employment. In Nesbit v. Pepsico, Inc., 994 F.2d 703 (9th Cir. 1993), plaintiffs alleged that they had been terminated because of their age. At trial, plaintiffs introduced a statement by the defendant's senior vice president of personnel that: "We don't want unpromotable fifty-year olds around." Id. at 705. The district court held the statement inadmissible because plaintiffs failed to show that the vice president was acting within the scope of his employment. The Ninth Circuit conceded that the ruling was error, but found the error harmless because "the statement was very general and did not relate in any way, directly or indirectly, to the terminations of Nesbit or Selby." Id. It is readily apparent that a personnel manager's duties include hiring and firing. Thus, the manager's comments were within the scope of employment. See also Woodman v. Haemonetics Corp., 51 F.3d 1087 (1st Cir. 1995) (in ADEA claim, statements by a supervisor that new management wanted to bring in younger employees were admissible because the statements concerned matters within the scope of the supervisor's employment); EEOC v. Watergate At Landmark Condominium, 24 F.3d 635, 640 (4th Cir. 1994) (comments of members of condominium committees concerning age of employee were admissible in ADEA action because the members had input in the decisional process).

Where the declarant has nothing to do with employment decisions, the court will exclude the hearsay statement. In Staheli v. University of Mississippi, 854 F.2d 121 (5th Cir. 1988), the court excluded statements by a colleague of a professor who was denied tenure because the colleague was not involved in the tenure decision. At trial, the plaintiff sought to testify that an accounting professor told him that the university's chancellor was unhappy about an incident involving laboratory animals. The accounting professor's statements were excluded because he had nothing to do with the denial of tenure. The statement had no relationship to the scope of his duties for the school. Id. at 127.

What about the comments of an agent of a subsidiary? Can those statements be held to be admissions of the parent corporation? In Big Apple BMW, the court found that statements by an employee of BMW credit and leasing could be attributed to the parent corporation because the parent dominated the activities of the subsidiary. 974 F.2d at 1373.

V. Exception For Statements By Agents of the Government

The rule does not apply to government employees. United States v. Prevatte, 16 F.3d 767, 778 (7th Cir. 1994). According to the Seventh Circuit, the rationale for this exception is that "no individual can bind the sovereign." Id. at 779. In United States v. Kampiles, 609 F.2d 1233, 1246 (7th Cir. 1979), cert. denied, 446 U.S. 954 (1980), the court explained that "because the agents of the Government are supposedly disinterested in the outcome of a trial and are traditionally unable to bind the sovereign, their statements seem less the product of the adversary process and hence less appropriately described as admissions of a party." In criminal cases, introducing statements of other Government agents (say FBI agents) could prejudice the Government and require the Government to call additional witnesses to rebut the alleged statement.

One commentator has criticized this exception. See Edward J. Imwinkelreid, "Of Evidence and Equal Protection: The Unconstitutionality of Excluding Government Agents' Statements Offered as Vicarious Admissions Against the Prosecution," 71 Minn. L. Rev. 269 (1986). However, there appears to be no effort in the courts or in Congress to abolish the exception.

VI. Recent Caselaw – Statements Are Often Excluded Based on Other Evidentiary Rules.

In Keri v. Board of Trustees of Purdue University, 458 F.3d 620 (7th Cir. 2006), the Seventh Circuit affirmed a grant of summary judgment to Purdue University on Plaintiff’s racial discrimination claims. Plaintiff sought to admit the statements of two professors who had previously complained that “most students were not taught by black faculty.” Neither witness provided testimony on why plaintiff was not retained by the employer. The witnesses simply gave their opinions concerning the racial climate on campus.

The District Court excluded the statements on the ground that neither professor had any decision-making authority in the employment area and that the statements were not within the scope of their agency. Moreover, the statements were improper under Rule 701 which bars a witness from expressing an opinion unless the opinion is based on first-hand knowledge.

Similarly, in Williams v. Pharmacia, 137 F.3d 944 (7th Cir. 1998), the Seventh Circuit held that it was error (in a sex discrimination case) to admit statements of other employees who were also allegedly subjected to discrimination by a particular supervisor. As the court noted, the complaints made by the women did not fall within the scope of their employment. As the Court noted, “they were the subjects of the decisions; they did not make them.” There was no evidence that the declarants had any involvement in the decision to terminate the Plaintiff. See also Hill v. Spiegel, 708 F.2d 233, 237 (6th Cir. 1983).

In Mister v. Northeast Illinois Commuter Rail Road, 571 F.3d 696 (7th Cir. 2009), the Seventh Circuit affirmed a decision excluding statements of a party opponent on Rule 403 grounds, even though it disagreed with the District Court’s analysis.
Mister was a railroad employee who was injured when he slipped and fell. The Defendant’s inspector prepared a report which included a statement that another employee had falled the previous week at the same spot. The District Court excluded the statement because the investigator had no personal knowledge of the events described.

The Seventh Circuit held that there was no requirement that the declarant (the author of the report) have personal knowledge of the events. As the Court noted, the Rule “’simply requires that the statement be made by an individual who is an agent, that the statement be made during the period of the agency, and that the matter be within the subject matter of the agency.’” quoting Young v. James Green Mgmt., Inc., 327 F.3d 616, 621 (7th Cir. 2003). However, the Seventh Circuit held that it “was not improper” to exclude the report because the report appeared to be unreliable and it lacked precise factual statements.

Statements may also be excluded when they would act as improper expert testimony. In Aliotta v. National Railroad Passenger Corp., 315 F.3d 756 (7th Cir. 2003), the plaintiff was killed by a train. The District Court excluded the statements of a risk manager of the defendant, who stated that fast trains can cause vacuums that suck nearby people underneath their wheels. The testimony was excluded on the ground that it was scientific testimony that was unreliable under Daubert and Rule 702, which require the judge to determine if scientific testimony is relevant and reliable.

On appeal the Seventh Circuit agreed that the statements of the risk manager were classic statements by a party opponent within the scope of the agency. The Seventh Circuit held that the statements were properly excluded because they were improper expert or opinion testimony that was not based on the scientific method. As the court concluded, “we see no good reason why unqualified and unreliable scientific knowledge should be exempted from the expert evidence rules simply because the speaker is an employee of a party-opponent.” The holding of Aliotto that a statement that is an admission of a party opponent is not admissible because it is unfounded and unqualified expert testimony is highly significant. In my experience, lay witnesses often attempt to offer opinions that they are not qualified to offer.

VIII. Conclusion

In sum, Rule 801(d)(2)(d) is relatively straightforward and easy to apply to most factual situations. However, a party hoping to introduce a hearsay admission by an agent of a party-opponent should make sure that it can satisfy all three foundational requirements. As I have noted, Rule 801(d)(2)(D) can be of great significance in employment litigation, where employees may comment on a termination, and in personal injury suits arising out of injuries on the jobsite, where employees may witness the accident or corrective measures. Obviously, an employer desiring to protect itself from litigation should caution employees to refrain from commenting on terminations or other adverse employment actions.

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Contract Law - An Oral Buy Sell Agreement Is Upheld

The case captioned, Prignano v. Prignano, 2-09-0439, (Illinois Appellate Court, Second District) is significant in that it recognizes a vague oral buy-sell agreement between two brothers, one of whom had passed away.

George and Louis Prignano owned several businesses together. At some point they appear to have agreed the upon the death of either of them, the survivor would buy out the other's share of the business from his heirs, using the proceeds from three life insurance policies purchased for that purpose.

The brothers discussed the arrangement, purchased the insurance, but never formalized it with a written contract signed by both of them. The case is significant because George's widow, Nancy Prignano, met the burden of proving the existence of the agreement with testimony of third parties, the insurance policies and the draft buy-sell agreement. The Appellate Court affirmed a verdict in Ms. Prignano's favor, which essentially enforced the oral agreement. Louis obtained the entire business and George's widow, Nancy, obtained the insurance proceeds.

Comment: this case again shows the importance of documenting business relationships. All too often the undersigned learns of an "agreement" between two partners that was never documented. The agreement is often very difficult to prove up at a later date. Usually unsigned documents are not worth the paper they were printed on. The buy-sell area of the law is one in which timely legal advice is invaluable. Those who try to do it themselves inevitably suffer.

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Securities Law - Recent Developments Concerning SEC v. Howey, 328 U.S. 293 (1946)

SEC v. Howey, 328 U.S. 293 (1946) is one of the most important cases interpreting the securities laws.

The Defendants offered "units of a citrus grove development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor."

The SEC sued and alleged that the Defendants had failed to register the unit offering. The Defendants responded that they were not offering securities - rather they were offering the right to engage in citrus farming.

The Supreme Court held that the units were "investment contracts" under the Securities Law. 15 U.S.C. Section 77b(a)(1). The Court defined the investment contract as "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise." Id at 299.

The Supreme Court held that the interests in the citrus farm were investment contracts because the contracts were "an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents." Moreover, the purchasers were not seeking to own land. They hoped to obtain a return on their investment. As the Court noted, "all the elements of a profit-seeking business venture are present here. The investors provide capital and share in the earnings and profits; the promoters manager, control and operate the enterprise."

The holding of Howey is crucial to the operation of the Securities Laws. Without this holding, promoters could design investment contracts that would be exempted from regulation under the Act.

Recent Developments:

Two recent decisions have reaffirmed the long-standing principles set forth in Howey.

In Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009), the Ninth Circuit held that certain charitable gift annuities were investment contracts under the federal securities laws.

The promoter, Robert Dillie, sold charitable annuities that promised an investment return to investors during their lifetimes and gifts to charities when the passed away. The Foundation raised $55 million from investors. Unfortunately it was a Ponzi scheme and had no investments. Ultimately, the Foundation collapsed. A receiver was appointed to recover assets for the victims. The receiver filed a lawsuit seeking the return of commissions paid to agents who sold the charitable annuities. After a trial the District Court entered judgment in favor of the receiver and against the agents.

The agents appealed on the ground that the charitable annuities were not investment contract and, thus, not securities.

The Ninth Circuit rejected their arguments and affirmed the judgment. The Court held that the annuities were investment contracts because there was "(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others."

The annuities were investments because the promoter promised a substantial return on the investment to the participants.

The second decision we will review is Liberty Property Trust v. Republic Properties Corporation, 577 F.3d 335 (D.C. Cir. 2009).

The Plaintiffs brought claims under the securities laws against the Defendant Republic that marketed certain limited partnership units.

The two main defendants controlled the defendant and, in exchange for limited partnership units, transferred a valuable contract to the limited partnership. Later, as a result of a scandal, that contract was terminated by city of West Palm beach. The limited partnership interests became worthless.

The Defendants argued that the limited partnership interests were not investment contracts because they were on both sides of the transaction (they owned the Defendant and some of the limited partnership interests.) The court held that the limited partnership interests were securities because two of the defendants "expected to profit from the efforts of [others]." The two defendants lacked sufficient control over the limited partnership, so they were clearly trying to profit from the work of other people.

In sum, the Howey decision remains good law and is as relevant today as it was in 1946.

Edward X. Clinton, Jr.

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Does Illinois Permit Lawsuits By Those Who Merely "Hold" Securities?

The United States Supreme Court in Blue Chip Stamps v. Manor Drugstores, 421 U.S. 723 (1975) held that investors injured by fraud may recover under the Federal Securities Law only if the deceit caused them to purchase or sell securities. In the Blue Chips case, the Supreme Court stated that states may supply the remedy when Federal Law does not. California has done so. It authorizes “holder actions” which are suits by investors who contend that the fraud caused them to hold their shares when they would have sold them had they known the truth. See, Small v. Fritz Companies, Inc., 30 Cal. 4th 167 (2003).

Plaintiff, Anderson, the holder of about 95,000 shares of Aon Corporation claimed in a U.S. District Court case that he would have sold his stock in Aon if he known earlier of fraud by the Company. When the financial information was discovered the stock dropped from about $69.00 a share to about $14 a share. Anderson’s claim was under the Illinois Securities Law and the District Judge held that the Illinois law supplies the rule of decision. Securities law in Illinois tracks federal law when the statutes use the same language, see Tirapelli v. Advanced Equities, Inc., 351 Ill.App. 3d 450, 455, 813 N.E. 2d 1138, 1142 (2004), which means that Illinois may follow the purchaser-seller rule of Blue Chip Stamps. The District Court concluded that the Plaintiff does not have a claim under Illinois law.

The Seventh Circuit in Anderson v. Aon Corporation, No. 09-1144 decided July 26, 2010, after sorting out various procedural maneuvers by plaintiff, in effect held that it was not clear if Illinois will permit holder actions, but it reversed the District Court that had dismissed Plaintiff’s complaint and remanded so that Plaintiff could pursue his claim.

Does Plaintiff have a holder claim under Illinois law? The final determination of this issue will await a trial.

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Contract Law - Illinois Court Rejects Impossibility of Performance Defense

The case captioned, YPI 180 N. LaSalle Owner, LLC, v. 180 N. LaSalle II, LLC, 1-09-1797, provides an interesting discussion of the impossibility of performance doctrine.

The Plaintiff was an assignee of a contract to purchase real estate. It argued that the 2008 financial crisis following the failure of Lehman Brothers made it impossible to obtain financing and therefore it was excused from performance.

The Court, like the trial court, rejected the rescission claim. The court noted that "Rescission is an equitable remedy that seeks to restore the contracting parties to their precontract positions." Opinion at 5.

The Court noted that "impossibility of performance as a ground for rescission of a contract refers to those factual situations where the purposes for which the contract was made have, on the one side, become impossible to perform." See 30 R. Lord, Williston on Contracts, Section 77:95 (2004). The court noted that the impossibility defense is limited "to the destruction of the means of performance by an Act of God, vis major, or by law" and that performance should only be excused in extreme circumstances. Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1294 (Fed. Cir. 2002); Kel Kim Corp. v. Central Markets, Inc., 70 N.Y.2d 900, 902, 519 N.E. 2d 295, 296 (1987). More importantly, "where a contingency that causes the impossibility might have been anticipated or guarded against in the contract, it must be provided for by the terms of the contract or else impossibility does not excuse performance.

Here, Plaintiff's claim was rejected because it was foreseeable that a commercial lender might not provide the required financing to complete the real estate purchase.

Comment: this is a novel and creative attempt by the plaintiff's lawyer to rescind a real estate contract, but it did not convince the trial court or the Illinois Appellate Court. As the court noted, if the inability to obtain commercial financing, standing alone, were sufficient to excuse performance...., then the law binding contractual parties to their agreements would be of no consequence." The Court is correct, the Plaintiff could have negotiated for a financing contingency in the contract, but apparently failed to do so. Opinion at 10.

Edward X. Clinton, Jr.

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Contract Law - Seventh Circuit Blocks An Attempt to Hold Shareholders Liable For Corporate Debts

On August 2, 2010, the Seventh Circuit issued an opinion (written by Judge Easterbrook) in the case captioned Fusion Capital Fund II, LLC v. Richard Ham and Carla Aufdenamp, 09-3723, reversing a decision by Judge Shadur, holding that corporate shareholders could be liable for the corporation's debts.

The Plaintiff sought to collect a debt incurred by a corporation directly from the corporation's shareholders. The debt arose as a result of an ill-fated merger transaction.

Millenium Holding corporation was insolvent. However, it had previously gone public and its stock was tradeable. Another company, Sutura, Inc., sought to go public by merging into Millenium. As the Court noted, "Sutura wanted to go public without all the fuss and bother (and expense) of a registration statement and the release of audited financials." As a part of the merger agreement, Millenium agreed to raise $15 million in new capital. Later, Plaintiff Fusion and Millenium signed a contract and agreed to provide the $15 million.

When the merger with Sutura failed to close, Fusion "wrote to Millenium that the money would not be forthcoming." Sutura then terminated the merger agreement.
Fusion prevailed in contract litigation and later sued in the Northern District of Illinois to collect its legal fees incurred.

Fusion brought its claim against Ham and Aufdenkamp, Millenium's controlling shareholders. The District Court held that the Ham and Aufdenkamp were personally liable for the debt under Nevada law. The District Court ruled that Ham and Aufdenkamp became the "alter ego" of the corporation because (a) they influenced and governed it; (b) there was a "unity of interest" between the shareholders and the corporation; and (c) "adherence to the corporate fiction of a separate entity would sanction fraud or promote manifest injustice." Opinion at 4.

The Seventh Circuit agreed with the analysis with respect to the first two elements of the alter ego test. However, there was no fraud because Fusion was well aware - when it entered into the contract - that Millenium had no assets and was insolvent.

The Court reasoned that Fusion should have been aware that it could never enforce its contract (for the payment of legal fees) because Millenium was broke.

"When Millenium signed a contract promising to reimburse Fusion's legal expenses if litigation ensued, Fusion knew beyond a doubt that Millenium would be unable to keep that promise - unless the merger closed. Someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the investors for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion did not get a guaranty but also did not even ask for one....A business such as Fusion that neglects to arrange for payment if the worst comes to pass is not well positioned to seek judicial aid....Fusion wants to be protected from this asymemetry [the risk that Millenium would not be able to pay], but to get this protection Fusion should have negotiated for a guaranty and refused to deal if the Hams would not give one."

The Court distinguished the situation where the debtor is solvent when the contract is signed, but later siphons off its assets to avoid payment.

Comment: This is a thoughtful opinion that takes the polar opposite view of the District Court. It is a reminder to lawyers that anything can happen on appeal and that the underlying economics of a transaction are often far more persuasive than case citations and three-factor tests.

Edward X. Clinton, Jr.

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Securities Law - A Rare Loss For the SEC

A District Court case (Southern District Of New York) involves allegations of insider trading in violation of Section of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-(5). The case is captioned SEC v. Nelson J. Obus, et. al., 06 Civ 3150, United States District Court for the Southern District of New York. The opinion was written by George B. Daniels, District Judge. The opinion can be found in the Pacer Systems. It is Document 77 and is dated September 20, 2010.

Following a SEC investigation, the SEC filed a Complaint alleging insider trading in violation of Section 10(b) and Rule 10(b)-5 against Tom Strickland, an employee of GE Capital Corp. The SEC alleged that Strickland tipped a friend, Peter Black, an analyst at Wynnefield Capital, about the potential acquisition of SunSource by a financial buyer. Black then, according to the SEC Complaint, passed the information to his superior, Opus, who purchased the stock of SunSource. The Court referred to the “Classical” and “Misappropriation” theories of insider trading.

Under each theory the SEC must prove five elements: (1) the tipper possessed material non-public information concerning a publicly traded company; (2) the tipper disclosed this information to the tippee; (3) the tippee traded in the company’s securities while in possession of the insider information; (4) the tippee knew or should have known that he tipper had violated a relationship of trust by providing the non-public material information and (5) the tippee benefited from the disclosure of the information. S.E.C. v. Warde, 151 F.3s 42, 47 (2d Cir. 1998). All of the Defendants filed a motion to dismiss the Complaint for failure to state a cause of action.

GE Capital sought to do business with SunSource. GE submitted a best effort proposal to provide 95 million dollars of financing in support of a potential buyer’s buyout of SunSource. Strickland was the front person for the GE underwriting team. Strickland learned that Wynnefield was an owner of SunSource stock and that his college classmate, Black, worked at Wynnefield. Following Strickland’s call to Black, Wynnefield purchased a block of SunSource Stock.

GE was subpoenaed by the SEC to testify pursuant to Federal Rule Of Civil Procedure 30(b)(6) about Strickland’s employment history. The GE employee testified that Strickland was trying to do some underwriting when he talked to his friend, Black.
The SEC based its insider trading allegations on the premise that by tipping Black about the impending SunSource merger, Strickland breached the fiduciary duty he owed to SunSource as a “temporary insider.” The District Court noted that neither Strickland nor his employer GE was a corporate insider of SunSource and that accordingly the classical theory of insider trading was not violated.

The Court said that the SEC cannot prove that GE or Strickland owed a duty of confidentiality to SunSource on the date of Strickland’s call to his friend Black and that summary judgment was rendered in favor or the Defendants in regard to the “classical” theory of insider trading.

The Court then considered whether the misappropriation theory applies when a person commits fraud in connection with the securities transaction. The Court concluded that Strickland engaged in no active deception. Such being the case the misappropriation theory did not apply.

Accordingly, the Court dismissed the SEC Complaint against all Defendants.

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Securities Law - Verdict Upheld by Seventh Circuit

RK Company sued Jackie R. See for violations of the Federal and State Securities Laws. The case is entitled RK Company v. Jackie R. See, No. 07-3984 decided September 22, 2010 by the Court Of Appeals for the Seventh Circuit.

The Seventh Circuit summarized the basis for the case as follows:

"Harvard Scientific Corporation and its founder Jackie R. See claimed to be developing a new product to treat male and female sexual dysfunction. Dr. See touted HSC's soon-to-be success in creating this product in a series of press releases and securities filings. This attracted an investment by RK Company..."

Plaintiffs invested $500,00 in Defendant’s LLC.

"Unfortunately, HSC's claims of success were not true, and following a bench trial, the court found Dr. See violated federal and state securities laws, state deceptive practices law, and committed common law fraud." The Seventh Circuit noted that the evidence showed that HSC's press releases included false statements and material omissions, "such as HSC's claims that the FDA had authorized clinical studies when it had actually suspended them..."

At trial, Plaintiffs sought damages equal to its investment of $500,000, prejudgment interest and attorneys’ fees. At trial, the plaintiff RK Company was successful. The opinion makes virtually no direct mention of the Securities Laws but rather discusses and rejects various claims of error by
Magistrate Judge Keys who presided.

Jackie See claimed to have a new product to treat sexual dysfunction of men and women. However, his company never received Federal Drug Administration approval and eventually went bankrupt. Defendant’s claim of FDA approval was false. The $500,000 investment by plaintiff was lost.

Following a bench trial, judgment was entered for plaintiff for the amount of the investment, prejudgment interest and attorneys’ fees.

The Seventh Circuit in an opinion by Judge Williams affirmed the ruling of the District Court. The Defendant claimed that the attorneys’ fees were excessive and that it had insufficient time to review the invoices. The invoices of the plaintiff’s attorney had been paid by his client which according to the Seventh Circuit was evidence of reasonableness. The Seventh Circuit noted that the Defendant received copies of plaintiff’s paid invoices on April 9, 2007 and had until August 2, 2010 to review and object to the invoices. The period of review was far in excess of the 15 days provided by the Local Rule.

A full victory for the Plaintiff.

Edward X. Clinton, Sr.

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Securities Law - Mark Cuban Fouls Out!

The SEC sued Mark Cuban, owner of the Dallas Mavericks and other businesses claiming that he wrongfully traded insider information in violation of § 17(a) of the Securities Act of 1933 and § 10 of the Securities Exchange Act by trading in the stock of Mamma.com in breach of his duty to the CEO of Mamma.com and Mamma.com amounting to insider trading under the misappropriation theory of liability. Cuban was a large minority stockholder of Mamma.com. In a telephone call from the CEO of Mamma.com, Cuban learned that Mamma.com was going to trade a public equity offering (PIPE). Cuban agreed in that call to keep the information confidential. Cuban then sold his stake in the Mamma.com to avoid losses from the inevitable fall in share price when the offering was announced. Cuban moved to dismiss.

The District Court found that the SEC Complaint alleged an agreement to keep information confidential, but did not include an agreement not to trade. The SEC appealed arguing that a confidential agreement creates a duty to disclose or abstain and that regardless the confidentiality agreement alleged in the Complaint contained an agreement not to trade on the information. (If interested, see our prior posts on this topic below).

The SEC alleges that Cuban’s trading constituted insider trading and violated Section 10(b) of the Securities Exchange Act. Section 10(b) makes it
unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Pursuant to this section, the SEC promulgated Rule 10b-5, which makes it unlawful to
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The Supreme Court has interpreted Section 10(b) to prohibit insider trading under two complementary theories, the “classical theory” and the “misappropriation theory.” The Cuban case involved the misappropriation theory.

The misappropriation theory rests on the principle that if a person violates Section 10(b) when he misappropriates confidential information for securities trading purposes, in a breach of a duty owed to the source of information. This theory was adopted by the United States Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997). In O’Hagan, the Supreme Court held that a lawyer who traded on confidential information misappropriated that information breaching a duty of trust and confidence he owed to his law firm and the law firm’s client.

The CEO of the Mamma.com was instructed to contact Cuban and to preface the conversation by informing Cuban that he had confidential information to convey to him in order to make sure that Cuban understood before the information was conveyed that he would have to keep the information confidential. Cuban agreed to keep the information concerning the PIPE offering confidential. At the end of the call, after learning about the offer, Cuban said “Well, now I’m screwed. I can’t sell.” Cuban then had a call with a sales representative of the proposed offering to get details of the offering. Following that call he immediately sold his entire stake in the company consisting of over six percent (6%).

The District Court found that the Complaint asserted no facts that reasonably suggest that the CEO intended to obtain from Cuban an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential.

The Fifth Circuit held that it was entirely plausible that the CEO understood that in addition to keeping the information confidential, Cuban would not sell. Accordingly, the Fifth Circuit without taking a stand on whether the disclosure by the CEO was intended to restrict Cuban from trading would only be determined following further proceedings in the District Court. Accordingly, the motion dismissing the case was vacated and the parties can proceed with discovery, a summary judgment motion and a trial, if necessary.

Edward X. Clinton, Sr.
Copyright 2010

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Seventh Circuit Approves Securities Class Certification in Conseco Case

The United States District Court for the Seventh District of Indiana approved class certification for a class of Conseco Investors. (Later Conseco changed its name to CND Financial Group.) Defendant challenged the granting of class certification to the investor class and appealed to the Seventh Circuit in the case of Schleicher v. Wendt, et al., No. 09-2154 (decided August 20, 2010). The Seventh Circuit affirmed the decision to certify a class.

The Court states that class treatment is appropriate when issues common to class members dominate over those that affect them individually. Fed.R.Civ.P. 23(b)(3). The necessary elements under Rule 23(b)3 are: (1) whether the statements were false; (2) whether the false statements are intentional; (3) whether the stock’s price was affected, and (4) whether the magnitude of such effect shows that the false information was material.

The elements of a claim under §10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule 10b-5 are falsehood in connection with the purchase or sale of securities, scienter, materiality, reliance, causation, and loss. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). Reliance usually shows how the false statements caused the loss. Until Basic Inc. v. Levinson, 485 U.S. 224 (1988), defendants tried to resist class certification by contending that each investor was bound to have received different information about the company, and that many investors would not have read the supposedly false statements at all. Thus it was argued that each investor’s fund of information differed from every other investor’s. But Basic concluded that the price of a well-followed and frequently traded stock reflects the public information available about a company.

The opinion discusses the fraud-on-the-market doctrine and states that when a statement that adds to the supply of available information that news passes on to each investor through the price of the stock. As stated, the price transmits the information and causes the change in the stock’s price. The approach supplants “reliance” as an independent element by establishing a more direct method of causation. When a stock trades in an efficient market, the contestable elements of Rule 10(b)(5) reduce to falsehood, scienter, materiality, and loss. Therefore, each investor’s loss can be established mechanically – common questions predominate and class certification is routine.

The Defendants mounted an aggressive and comprehensive defense. For example, the Defendants contend that before certifying a class, the District Court must determine that the contested statements actually caused material changes in stock prices.
Defendants also contended that even if the evidence shows scienter, materiality, causation, and loss, individual damages questions still predominate and prevent class certification.

Judge Easterbrook who wrote the opinion for the Seventh Circuit acknowledged the aggressive efforts of the defendants by stating “a more thoroughgoing challenge to class treatment of securities litigation is hard to imagine.”

In other words, the merits of the case must be proven to obtain class certification. As the Court stated, if the Defendants’ arguments were accepted, it would end the use of class actions in securities cases.

Defendants in effect contended that before certifying a class the district judge must first determine that the contested statements actually caused material changes in
stock prices.

The opinion points out that the fact that the Conseco stock was falling during the class period is irrelevant; fraud could have affected the speed of the fall. That is to say if a firm says it lose one hundred million when it actually lost two hundred million, then the announcement of the two hundred million will cause the price to continue to fall.

The Defendant’s contention that before certifying a class, a court must determine whether false statements materially affected the price, but whether the statements were false or whether the effects were large enough to be called material are questions on the merits. The Court expressly stated that the contention of Defendants that class certification is proper only when the class is sure to prevail on the merits, the opinion concluded that the chances, even the certainty that a class will lose on the merits does not prevent certification of the class.

In the writer’s opinion this case will be followed closely because there is a comprehensive review of the elements necessary for class certification and a rejection of various defensive arguments.

The lawyers for the plaintiffs were The Wagner Firm and the Law Offices of Brian Barry, Glancy Binkow & Goldberg LLP, among others and the lawyers for the defendants were Kirkland & Ellis, LLP, Baker & McKenzie, LLP and Barnes & Thornburg LLP, among others.

Edward X. Clinton, Sr.

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Evidence - Admissibility of Business Records

Obtaining the admission of business records is a often a critical component of any trial. It is a must in any business litigation and can cause problems if it is not carefully considered. Obviously, if you cannot obtain the admission in evidence of business records, such as invoices, you can't win even the most simple collection lawsuit.

Under Rule 803(6) if a document qualifies as a business record, it is not hearsay. The rule applies whether or not the declarant is available as a witness. The Rule presupposes that a business will have strong incentives to keep accurate records. Timberlake Construction Co. v. U.S. Fidelity and Guaranty Co., 71 F.3d 335 (10th Cir. 1995). I will discuss several recent decisions discussing the admission of business records.

I. The Rule

The Rule defines a business record as "a memorandum, report, record, or data compilations, in any form, of acts, events, conditions, opinions, or diagnoses, made at or near the time by, or from information transmitted by, a person with knowledge." Rule 803(6) is not limited to businesses. The Rule specifies that "the term 'business' as used in this paragraph includes business, institution, association, profession, occupation, and calling of every kind, whether or not conducted for profit." Rule 803(6).

A business record is admissible if it is "kept in the course of a regularly conducted business activity, and if it was the regular practice of that business activity to make the [record]." Id. A business record is not admissible where "the source of information or the method of circumstances of preparation indicate lack of trustworthiness." Rule 803(6).

The Ninth Circuit summarizes the Rule's requirements as follows: "a business record is admissible when (1) it is made or based on information transmitted by a person with knowledge at or near the time of the transaction; (2) in the ordinary course of business; and (3) is trustworthy, with neither the source of information nor method or circumstances of preparation indicating a lack of trustworthiness." The Monotype Corporation PLC v. Int'l Typeface Corp., 43 F.3d 443, 449 n.6 (9th Cir. 1994).

II. Regularly Conducted Business Activity

The key foundational inquiry is whether the document was prepared in the course of "a regularly conducted business activity." The document must concern business activity. In Hargett v. National Westminster Bank, 78 F.3d 836 (2d Cir. 1996), plaintiff, an african-american, was terminated from his position as an executive of the defendant bank after he allegedly retained a stripper to perform at an office meeting. Plaintiff alleged that he was terminated by reason of his race. At trial, he sought to introduce a handwritten note allegedly prepared by a co-employee of the defendant bank in which the co-employee admitted that he had procured the services of the stripper. The note was unsigned. The district court denied plaintiff's offer of admission because plaintiff could not establish a foundation for its admissibility as a business record. Indeed, it is hard to imagine that the letter was "a record of regularly conducted activity." Moreover, plaintiff could not offer testimony concerning when and where the handwritten letter was prepared.

The business activity must also be regular. In The Monotype Corporation, the defendant and plaintiff entered into a licensing agreement to allow plaintiff to distribute several of defendant's typefaces. Plaintiff developed several typefaces independently and began selling them to purchasers. Defendant claimed that plaintiff's typefaces were copies of its typefaces. Plaintiff sued to bar defendant from making such claims to plaintiff's customers, including Microsoft. At trial, defendant sought to admit a report prepared by an employee of plaintiff's customer Microsoft concerning the similarities in several typefaces sold by plaintiff and defendant. The report was not a business record because it was not Microsoft's regular practice to prepare such reports. Id. at 449-50 (also excluding an electronic mail message which was a one-time event).

III. The Chain Of Knowledge

The proponent must establish a chain of knowledge. According to Weinstein's Evidence, "Each participant in the chain producing the record -- from the initial observer-reporter to the final entrant -- must be acting in the course of the regularly conducted business." 4 Jack B Weinstein & Margaret A. Berger, Weinstein's Evidence P803(6) [04] (1994). In United States v. Warren, 42 F.3d 647 (D.C. Cir. 1994), the defendant was found in a room containing drugs and a handgun. The defendant sought to introduce a statement from a police report that two other occupants of the apartment were dealing drugs and carried handguns. The police report did not qualify as a business record because the defendant could not show that the report's author had personal knowledge concerning the activity of the other occupants of the apartment or had based the statement on information provided to him by a person with personal knowledge acting in the regular course of business. Id. at 656.

IV. The Custodian's Knowledge

The custodian of business records need not have detailed knowledge concerning who prepared a particular business record. The custodian need only show that he is "sufficiently familiar with the business practice" of the business and show that the record was made pursuant to that practice. Phoenix Associates III v. Stone, 60 F.3d 95 (2d Cir. 1995). In Phoenix Associates, the plaintiffs claimed that they had an oral contract with defendant. At trial, plaintiffs sought to introduce a record of a wire transfer to substantiate the claimed oral contract. Plaintiff's witness, its records custodian, testified that plaintiff's accounting department regularly compiled records of every wire transfer it received or issued. The district court denied plaintiff's offer of the exhibit on the ground that the records custodian worked for both the plaintiff and another company which made the wire transfer. The Court of appeals reversed. The custodian's source of employment was irrelevant "as long as his testimony can supply a sufficient foundation." Id. at 101. Moreover, the custodian was not required to demonstrate personal knowledge of the actual creation of the document. Nor was he required to identify the specific employee who prepared the document. The Rule required only that the proponent prove that the business entity's regular practice was to obtain the information from the person who created the document. Id.

V. Is The Document Trustworthy?

The Rule requires the court to determine whether the source of the information or the method or circumstances of the preparation of a document cast doubt on its trustworthiness. In Hoselton v. Metz Banking Co., 48 F.3d 1056 (8th Cir. 1995), plaintiffs, minority shareholders in defendant's business, claimed that defendants breached their fiduciary duties when they were excluded from a sale of the business to a third party. Notes taken by plaintiffs' accountant were properly admissible because they were prepared in the regular course of the accountant's activity. The notes appeared to be trustworthy because the accountant had professional duties to his clients which would give him strong motivation to make accurate notes. Id. at 1061.
Information provided by the customers of a business can create problems under the Rule because many businesses do not verify information received from customers. Such information may be admissible under Rule 803(6) if the proponent can show that "the business entity has adequate verification or other assurance of accuracy of the information provided by the outside person." United States v. McIntyre, 997 F.2d 687 (10th Cir. 1993), cert. denied, 114 S.Ct. 736 (1994). In McIntyre, the court listed two ways to demonstrate reliability: (1) proof that the business has a policy of verifying patrons' identities by examining their credit cards and other forms of identification; or (2) "proof that the business possesses 'sufficient self-interest in the accuracy of the [record]' to justify an inference of trustworthiness." United States v. Cestnik, 36 F.3d 904, 908 (10th Cir. 1994) (quoting McIntyre, 997 F.2d 687, 700 (10th Cir. 1993). In McIntyre, the court held it was improper to admit a hotel's guest registration cards because it was unclear whether the hotel had procedures to verify the accuracy of the cards. 997 F.2d at 701.

VI. Documents Prepared In Anticipation of Litigation

Documents prepared in anticipation of litigation are usually not admissible because they were not prepared in the regular course of business. Timberlake Construction Co., 71 F.3d 335; Fed. R. Evid. 803(6) Advisory Committee Note. In Timberlake Construction, the plaintiff claimed that the defendant insurer wrongfully denied insurance coverage. At trial, plaintiff introduced several letters written by plaintiff's president and by plaintiff's attorney containing legal conclusions claiming the existence of insurance coverage. The court of appeals reversed on the ground that the letters were written in anticipation of litigation and therefore did not fall within Rule 803(6).

However, an auditor's report prepared in anticipation of litigation may also qualify as a business record. In United States v. Frazier, 53 F.3d 1105 (10th Cir. 1995), the defendant was convicted of falsely describing his use of government funds on official forms. At trial, the Government admitted the report of a government auditor as a business record. The defendant objected that the report was prepared in anticipation of litigation. The court found that the report was trustworthy because the auditor prepared it pursuant to a contract with the government, the auditor had ten years experience in preparing that type of audit report and the auditor was a "neutral party" who had "nothing to gain" from litigation against the defendant. Id. at 1110.

VII. Laying A Foundation

The lawyer seeking to admit the business record must, however, lay a foundation that the record was, in fact a business record. A recent Seventh Circuit case discusses the requirement that a foundation be laid. In United States v. Adrianoros, 578 F.3d 703 (7th Cir. 2009), the Government obtained the admission of a summary of telephone and bank records of the illegal activity. The Government called a policeman to testify that he obtained records by serving a subpoena. The Government sought to admit the records under FRE 1006, which allows a party to present, and enter into evidence, a summary of voluminous writings, recordings or photographs. However, the Seventh Circuit held that the records were improperly admitted because there was no testimony to establish that the records were kept in the course of regularly conducted business activity and there was no certification by the custodian of the records. Thus, no foundation was laid and it was error for the district judge to admit the document in evidence.

A foundation must even be laid in the summary judgment context. The party seeking admission of the business record need not have secured the deposition testimony of the records custodian. The proponent of the document must establish sufficient indicia of reliability. Thanongsinh v. Board of Education, 462 F.3d 762 (7th Cir. 2006).

VIII. Specific Types of Documents

1. Laboratory Reports

It is well established that a laboratory report identifying a substance as a narcotic is admissible as a business record because such reports are routinely prepared by government lab technicians. United States v. Roulette, 75 F.3d 418 (8th Cir. 1996). Additionally, in Roulette, the defendant argued that under the Confrontation Clause, the government should be required to provide proof of the unavailability of the lab technician when admitting the report. The court disagreed reasoning that the exception to the hearsay rule was "firmly rooted." Id. See also Sherman v. Scott, 62 F.3d 136, 140-41 (5th Cir. 1995).

2. Computer Records

Computer business records are admissible if (1) they are kept pursuant to a routine procedure designed to assure their accuracy, (2) they are created for motives that tend to assure accuracy (e.g., not including those prepared for litigation), and (3) they are not themselves mere accumulations of hearsay." United States v. Hernandez, 913 F.2d 1506, 1512 (10th Cir. 1990), cert. denied, 499 U.S. 908 (1991). Computer records are thus treated no differently than other business records.

VIII. Conclusion

The business records exception is commonly used to admit documents which contain hearsay declarations. The rule presupposes that a business has strong incentives to keep accurate records. Thus, it is difficult to resist the admission of a business record, unless the record was prepared in anticipation of litigation or its trustworthiness can be legitimately questioned.

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Securities Law - The Dodd-Frank Wall Street Reform and Consumer Protection Act

The Dodd-Frank Wall Street Reform And Consumer Protection Act (the “Act”) is a massive revision of the way in which financial services are furnished. The Act was signed by President Obama on July 23, 2010.Many of the changes become law on the effective date. However, the Act promulgates various studies which could lead to other changes. Some changes may not go into effect but will become bogged down in contentious disputes. If control of Congress should change in November, some changes may never go into effect. The Act will cause a disruption in the way various issues are perceived.

Mayer Brown has published a complete summary of the Act. It was a massive undertaking. At least eight Mayer Brown lawyers worked on the summary.

The securities section of the Act sets forth a significant number of investor protection measures. Those sections of the Act dealing with Securities Law changes will be referred to as the “Amendments.” The Amendments require the SEC to conduct a six-month study of the need to impose a fiduciary duty on brokers providing personalized investment advice to retail customers. Various factors must be taken into account in determining the effectiveness of existing standards of care.

The Amendments establish within the SEC an Investment Advisory Committee composed of (1) an investor advocate who reports directly to the Chairman of the SEC, (2) a representative of State Securities Commissionaires, (3) a representative of the interest of senior citizens and (4) between ten and twenty additional members appointed by the SEC. The Committee has a responsibility of consulting with the SEC on regulatory priorities, the substance of proposed regulations and initiatives by the SEC to protect investors and promote investor confidence in the market.
The Chairman of the SEC will appoint an Investor Advocate to lead a new office within the SEC. An ombudsman will act as liaison between retail investors and the SEC in resolving issues with the SEC and/or the securities Self-Regulatory Organizations (“SRO”). The Chairman of the SEC is responsible to take action to address deficiencies identified by a report of investigation by the SEC.
The stock exchanges must, as directed by the SEC, enforce requirements in the Amendments for clawing back incentive compensation paid to executives mistakenly paid based on erroneous results later corrected and restated within three years of such payment.

The SEC must hire a consultant to study its operations and the possible need for reform of the agencies and furnish within 150 days a report to the SEC and Congress making legislative regulatory and administrative recommendations for improvement in the SEC.

The Controller General of the United States is to issue rules surrounding employees who leave the SEC for employment with regulated firms in the securities industry and report to the SEC and the House Financial Services Committee (“HFSC”) within one year of enactment of the Act.

The SEC must establish an Investor Protection Fund from revenues from certain sanctions. The Fund to be used among other things to pay whistle-blowers who provide original information in a SEC action.

The SEC will be authorized to make nationwide service of subpoenas of civil actions filed in federal court.

The Amendments change who qualifies as an “accredited investor”. These investors must now have $1 million excluding the value of their primary residence, whereas the old standard was simply a $1 million net worth.

The Amendments also authorize the SEC to limit or prohibit the mandatory predispute arbitration clauses that apply to most brokerage accounts. Such clauses force brokerage customers to take any disputes that may arise with their broker before arbitration panels, which critics claim often favor the brokerage industry, rather than taking their claims to court.

The Anti-Fraud provisions of the Federal Securities Laws were extended to apply to “conduct within the United States that constitute significant steps in the furtherance of a violation even if the securities transactions occur outside of the United States and involve only foreign investors.”

The Government Accountability Office (“GAO”) must report to Congress within one year regarding the potential consequences of authorizing a prior right of action against any person who aids or abets another person in violation of the Federal Securities laws. In other words, the new statute reverses the Stoneridge ruling. Stoneridge Investment Partners, LLC v. Scientific Atlantic, Inc., 522 U.S. 148 (2008). In Stoneridge, the U.S. Supreme Court held that those who aid or abet securities fraud are not liable.

Various changes regarding the regulation of credit rating agencies are prescribed. For example, the SEC must establish an office of credit ratings designed to administer the SEC rules applicable to Nationally Recognized Statistical Rating Organizations (“NRSRO). It can make exceptions for smaller NRSRO’s as it considers appropriate. At least two persons on the Board of Directors of NRSRO’s must be independent directors.
Not later than 270 days after the enactment of the Amendments, the SEC, Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”) and (Office of the Comptroller of the Currency (“OCC”) must issue rules requiring a securitizer of an asset backed security (other than a residential mortgage-backed security) to retain at least 5% of the credit risk in any asset that the securitizer transfers or sells to a third party. The rules become effective two years after the final version is published in the Federal Register.

Executive compensation is to be revised as follows:

Effective six months after enactment of the Amendments, publicly traded companies must hold a non-binding vote to approve the compensation of executives who are among those disclosed in public filings pursuant to SEC rules (i.e., say-on-pay votes) at least once every three years, and a separate resolution must be offered at least once every six years for a vote to determine whether say-on-pay votes should occur every one, two or three years. Although a “no vote” is not binding, it would likely cause the Board of Directors to take some action to adjust compensation standards.

The Conference Committee also agreed to require these companies to provide a non-binding vote to approve golden parachutes (effective six months after enactment). Institutional investment managers subject to Section 13(f) of the Exchange Act must annually disclose how they vote on say-on-pay and golden parachute matters unless their votes are otherwise publicly reported under SEC rules. The Amendments place ultimate responsibility for compensation decisions for executives with the respective Compensation Committees, which must be comprised of independent directors and advised by compensation consultants, legal counsel, and other advisers who are independent as well.

The SEC is required to amend item 402 of Regulation S-K under the Securities Act to require companies to disclose the relationship between executive compensation and financial performance and the ratio between the CEO’s compensation and the median compensation of all other employees.

The SEC must issue a rule requiring publicly traded companies to disclose whether executives are permitted to hedge the value of any equity securities granted to such executives as compensation.

The SEC must conduct a study, and report to Congress within two years of enactment, regarding the use by publicly traded companies of compensation consultants.

The FRB, in consultation with the OCC and FDIC, has the responsibility of establishing standards making it an unsafe and unsound practice for the holding companies of depository institutions to pay compensation that is excessive or could lead to material financial loss to the holding companies.

There will be many 3 – 2 notes by the SEC with the Commissioners nominated by the democrats winning the contentious issues but only after delays and many dissents.

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Securities Law - State Jurisdiction Issue

STATE SECURITIES LAW - JURISDICTION

Bulldog Investors and its principal, operating a group of hedge funds, by offering an unregistered security through Bulldog’s website and an email to a Massachusetts resident violated the Massachusetts Uniform Securities Act. Bulldog and its principal officer Goldstein denied violating the Act and asserted that its actions were protected under the First Amendment and that personal jurisdiction was lacking. The Administrative Hearing Officer stated that he lacked authority to consider the constitutional question. Bulldog then proceeded to court to enjoin the Secretary of State’s enforcement action. In the meantime, the Hearing Officer continued the administrative proceeding and found that Bulldog and Goldstein made an offer of an unregistered security that was not exempt. The hearing officer’s finding consisted of a cease and desist order and a $25,000 fine.

Plaintiffs’ in the Superior Court, Bulldog Investors General Partnership, et al v. Secretary of the Commonwealth Of Massachusetts, SJC 10589 (07/02/2010) asserted that the Secretary of State lacked personal jurisdiction and filed a motion for judgment on the pleading. The Court concluded that personal jurisdiction was appropriate and denied Plaintiffs’ motion.

The Bulldog Firm appealed and contended that the maintenance of a website and the sending of this email to a Massachusetts resident was not sufficient contact with the Commonwealth to create personal jurisdiction. The Court agreed with the Secretary Of State that the Massachusetts Uniform Securities Act authorized the Secretary Of State to exercise personal jurisdiction over non-residents in an administrative proceeding. According to the Court, the purpose of the Act, was to protect Massachusetts residents from offers of unregistered securities directed at them from other jurisdictions, and that the Secretary Of State’s authority to conduct investigations outside the Commonwealth would be meaningless if it did not have the authorization to subject non-residents to enforcement proceedings. Plaintiffs’ rights to due process were not violated according to the Court because Plaintiffs availed themselves of the privilege of conducting business activities in Massachusetts and came within the reach of its laws.

The Appellate Court declined to consider the First Amendment argument because the issue had not been raised on appeal. The Court reaffirmed that Plaintiffs’ email message to a Massachusetts resident offering a non-exempt unregistered security was a violation of the Massachusetts Uniform Securities Act.

Bulldog, by sending one email, voluntarily subjected itself to the Massachusetts Uniform Securities Act.

This case is significant because it illustrates how a company can become subject to a state securities law.

Look for an appeal by Bulldog to the United States Supreme Court. Bulldog would argue that there were insufficient contacts to allow Massachusetts to assert jurisdiction over it.

Edward X. Clinton, Sr.

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Securities Law - Noncompetitive Trading

NON-COMPETITIVE TRADING

The United States District Court for the Northern District of Illinois froze the assets on records of a man who claims to be a Russia national after the Commodity Futures Trading Corporation (“CFTC”) charged him with trades on the Chicago Mercantile Exchange (“Exchange”) which were not competitive (CFTC v. Yunuso, N.D. Ill., 10-3619, Judge Bucklo). According to the CFTC, Yunuso controlled two firms: Open E Cry, LLC and Velocity Futures, LLC to enter a buy or sell contract for one of his accounts and then within seconds enter an opposite or equal quantity buy or sell contract for the other account. Because the commodities were thinly traded his orders were marketed against each other. Then Yunuso would enter orders to offset the initial position and complete an equal but opposite round turn trade for each account. His trading according to the Exchange resulted in more than $7.8 million in lawsuits and an approximate $7.2 million profit in the Velocity Futures, LLC account. At the end of the trading session, Yunuso had a debit balance of about $8,000 with Open E Cry, LLC and thus no money to cover the losses.

According to CFTC, Yunuso by consistently executing trades between the Open E Cry account and the Velocity account during periods of low volume, Yunuso in effect entered into transactions without intent to take a genuine bona fide position in the market.

The CFTC is seeking restitution, fines, a trading registration ban and a permanent injunction against Yunuso and his entities.

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Securities Law - Illinois Securities Law Statute of Limitations

This case is interesting because the plaintiffs abandoned claims under the Illinois Securities Law - to avoid a dismissal on the ground that the action was time-barred.

Plaintiffs in the case captioned Carpenter, et al. v. Exelon Enterprises Company, LLC, and Exelon Corporation, Appeal No. 1-09-1222 (4th Circuit), sued Exelon claiming that Exelon abused its position as majority shareholder of InfraSource in such a way that the rights of the minority shareholders were violated and not represented fairly in a merger and sale transactions.

Exelon filed a motion to dismiss on the grounds that it was barred by the three-year Illinois Statute Of Limitations. The trial court denied Exelon’s motion to dismiss determining that the Illinois Securities Law limitation period was inapplicable and plaintiffs’ suit was therefore timely filed within the residual five-year limitation period found in § 13-205 of the Code Of Civil Procedure. However, the trial court stayed the proceedings and certified the issue of the appropriate statute of limitations for an interlocutory appeal.

Exelon filed a motion to dismiss on the grounds that the Statute Of Limitations under the Illinois Securities Law of three years was applicable and the case should be dismissed. The Plaintiffs did not respond to the motion choosing to voluntarily dismiss their initial complaint and they refiled an amended complaint. In the amended complaint, the plaintiffs abandoned their Illinois Securities Law claims and proceeded under Delaware law instead.

The amended complaint contained additional allegations of the conduct of Exelon and contained an explicit statement that it purported to be brought under Delaware law and did not allege that defendants’ conduct constituted a violation of the Illinois Securities Law. Plaintiffs sought damages in excess of $11,000,000. Exelon again filed a motion to dismiss complaining, notwithstanding the changes in the amended complaint, that the manner for which relief was sought was still provided under the Illinois Securities Law and it was therefore barred by the three-year statute of limitations. The trial court disagreed and found that the suit was properly filed within the five-year limitation of § 13-305 of the Code. The trial court entered an order denying Exelon’s Motion To Dismiss but stayed further proceedings and certified the following question for interlocutory appeal, as the trial court found this issue involving the question of law upon which substantial ground for difference of opinion existed:
“Whether plaintiffs’ claim that Exelon Enterprises Company, LLC, as majority shareholder of InfraSource, Inc., breached its fiduciary duties in connection with InfraSource, Inc.’s 2003 merger transaction is governed by the three year statute of limitations contained in the Illinois Securities Law of 1953, 815 ILCS 5/13(d).”

The trial court granted Exelon’s petition for leave to appeal the interlocutory order of the trial court denying the motion to dismiss.

The trial court made reference to of § 13 of the Illinois Securities Law which delineates the private and other civil remedies available for violations of the Law. It pointed out that of § 13(A) provides that every sale in violation of the provisions of the Act is voidable at the election of the purchaser and that § 13(B) and § 13(C) outline various notice and mitigation requirements that a purchaser must fulfill before electing the option of rescission. Subsection 13(D) provides a three-year statute of limitation.

Exelon cited various federal cases which held that the Illinois three-year statute of limitation provided a bar to certain claims for relief. On the other hand, Plaintiff states that the claim is one of minority shareholder oppression and not covered by the Illinois Securities Law or the statute of limitations.

The Defendant, Exelon, argued that of § 13(F) and of § 13(G) provides injunctive relief as well as a right of rescission to “any party in interest”. The Court while acknowledging a contrary holding by a federal court in Klein v. George G. Kerasotes Corp., 500 F.3d 669 (7th Cir. 2007) held that plaintiffs were not barred by the three-year statute of limitations.

The Appellate Court held that the three-year limitation contained in of § 13 applies to relief under § 13 for which relief is granted by § 13. Section 13 provides only for (1) a retroactive right of rescission to purchase under subsection 13(A) and (2) a prospective remedy to the Illinois Secretary Of State and “any party in interest” under of § 13(F) and of § 13(G). Section 13 does not concern retroactive common law damage claims for breach of fiduciary duty both by sellers of securities in general or minority shareholders in particular. For the three year limitation contained in § 13(D) does not apply does not apply to claims of the plaintiffs against Exelon. Therefore the certified question is answered in the negative. Such being the case, the five-year of limitations applies and the case is timely.

Abandoning a claim for relief under the Illinois Securities Law was successful.

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Securities Law - Statute of Limitations Merck v. Reynolds

On April 27, 2010, the United States Supreme Court issued its decision in Merck & Co v Reynolds, 08-905. The issue was whether the plaintiff's claim was barred under the applicable statute of limitation. The Statute of Limitations for securities claims alleging fraud, deceit or contrivance is that the claim must be filed not later than 2 years after disclosure of facts constituting the violation or 5 years after the violation. 28 U.S.C. Section 1658(b).

There have been division in the circuits on when a claim accures and whether a plaintiff had to have notice of scienter. Scienter has been defined as a mental state embracing intent to deceive, manipulate, or defraud. Ernest & Ernest, .v Hochfelder, 425 U. S, 185. In a 10b-5 case the plaintiff must prove that a defendant made a material misstatement with intent to deceive, not merely innocently or negligently.

The case arose out of the controversy involving the drug Vioxx. The District Court held that the state of Limitations barred the claim because investors were placed on inquiry notice of the claim more than 2 years before they filed suit. Inquiry notice exists when the victim is aware of facts that would lead a reasonable person to investigate and consequently acquire knowledge of the defendants misrepresentations, Great Rivers Cooperative v Farmland Industries, Inc. 120 Fed. 3rd 893

In September 2001 the FDA released a letter that stated that Merck had misstated the safety of the drug. The District Court referred to various press articles to support that proposition because of the widespread adverse publicity the investors were on notice more that 2 years before the lawsuit was filed The Third Circuit reversed and said that was not sufficient t to establish inquiry notice. The Court also stated that Merck at about the same time issued notices describing the drugs safety.

The Supreme Court granted certiorari and said that a plaintiff was required to discover facts of scienter. It started with the statutory language that the limitations period begins to run once there has been discovery of facts constituting the violation and noted that scienter was both a fact and an element of a Sec.10 (b) 5 violation. The Court concluded that facts of scienter can be distinct from establishing that there has been a material misrepresentation because an incorrect prediction does not show whether the speaker deliberately lied or just made an in an innocent error. The Court held that the statute of limitations does not begin to run until the plaintiff discovers or a reasonably diligent plaintiff would have discovered facts constituting the violation. Thus, the plaintiff's claims were not barred by the statute of limitations.

The Supreme Court affirmed the decision of the Third Circuit to the effect that Plaintiff’s claim was not barred by the statute of Limitations.

The case is also interesting because the decision of the Supreme Court was unanimous.

Edward X. Clinton, Sr.
www.clintonlaw.net

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Corporate Law - Agent Lacks Authority to Bind Company

CORPORATE LAW - COURT HOLDS THAT PURPORTED AGENT LACKED AUTHORITY TO BIND CORPORATION TO SUSPICIOUS TRANSACTIONS WHICH WERE HARMFUL TO THE CORPORATION.


Herbert W. Fritzsche, et al. v. Gregory LaPlante and M. Christine Rock, 2-09-0329, Illinois Appellate Court Second District.

This issue raised in this case is whether or not a corporate officer had the authority to bind the corporation to some highly unusual transactions. The backstory is that the corporate officer was the daughter of the founder and President of the company and that she was apparently involved a feud with her siblings.

M. Christine Rock, acting as secretary/treasurer of a family corporation, Fritzsche Industrial Park (FIP) and as holder of a power of attorney for her father, Herbert W. Fritzsche, signed a lease agreement with her live-in boy friend, Gregory LaPlante. The lease named the Industrial Park as lessor and Gregory as lessee. The premises included 16 properties within the Industrial Park. Christine Rock owned 60 shares of a total of 1,000 shares that were issued and outstanding. Her father owned the majority of 685 shares. Christine Rock, at about the same time, also signed a promissory note in favor of Gerald Shaver in the principle amount of $450,000. The maker of the note was listed as Fritzsche Industrial Park and Park National Bank as Trustee under a Land Trust.

Plaintiffs, the corporation and other family members, filed this lawsuit alleging that Christine acted without Corporate authority and entered into the lease and note and without any authority as her father’s power of attorney in entering into the Lease Agreement. Because Christine refused to furnish records of rents and expenses, the shareholders informed her that she would be removed as Secretary/Treasurer. The suspect transactions were entered into after Christine learned that she would soon be removed as Secretary/Treasurer.

Plaintiffs filed a motion for summary judgment alleging that even if Christine had been the true Secretary/Treasurer of FIP and Herbert’s power of attorney, she still would not have had the authority to enter into the lease or the note. Plaintiffs allege that Christine did not have the authority to enter into the lease under either the common law or a statute. An affidavit was attached to the Plaintiff’s Motion For Summary Judgment which stated that at no time did the shareholders of FIP or the Board meet to vote on the lease or the note and that the Board never authorized Christine to act on behalf of FIP with regard to the lease or the note. Because there was no approval by the Board of Directors Ms. Rock lacked authority to cause the corporation enter into the lease or the note.

Ms. Rock and her boyfriend argued that Board approval and other corporate formalities were not required in order to allow Christine to execute the lease. Defendants stated that some of the properties included in the lease were not owned by Fritzsche but were owned by Herbert or some other member of the Fritzsche family and, therefore, corporate formalities were not necessary.

The trial court granted summary judgment for the plaintiffs - the corporation and Herbert W. Fritzsche.

Defendants appealed the grant of summary judgment. The Appellate Court affirmed the grant of summary judgment in all respects. The Appellate Court held that the Trial Court was correct in ruling that Christine did not have authority to enter into the lease or the note.

Under common law, the mere fact that a corporation has the power to make a certain type of contract does not, of itself, clothe even the highest officer of the corporation with the apparent authority to bind the corporation to such a contract. Corn Belt Bank v. Lincoln Savings & Loan Ass’n, 19 Ill.App. 3d 238, 245 (1983). Further, officers have no apparent authority to make unusual or extraordinary contracts on behalf of a corporation. Corn Belt Bank, 119. Ill.App. 3d at 245. “’If the president of a corporation were authorized to make contracts of this character without action of the directors and without notice to or knowledge of anyone, the directors would not at any time know whether it was headed for bankruptcy.’” Sacks v. Helene Curtis Industries, Inc., 340 Ill. App. 76, 91 (1950), quoting Warszawa v. White Eagle Brewing Co., 299 Ill. App, 509. Plaintiffs further argued that the Lease of the entire industrial park was an extraordinary transaction and that Illinois common law and its statutes prohibit an officer from entering into extraordinary and unusual contracts and/or contracts involving substantially all of the corporations assets, outside the ordinary course of business, without the board's consideration and approval.

The Court concluded that the Lease was an extraordinary transaction and, it implied, one that no rational corporation would approve. "Here, FIP/Christine transferred numerous properties contained int he Fritzsche Industrial Park to Gregory, a nonfamily member and a nonofficer/nonshareholder. The Lease does not specify Gregory's obligations to FIP's existing tenants. Although the Lease includes properties under trust, no trustees ever signed the Lease. Although the Lease involved 26 different properties (PINs), it seems no professionals, such as attorneys or realtors, were involved in drafting the Lease; defendants are the only signatories and/or witnesses to the Lease. Perhaps most strangely, the Lease seems to provide Gregory profit with little to no risk or investment. If he generates income, he pays a relatively small percentage of that income to the corporation; if he generates no income, he pays the corporation only taxes due to the government. As such, under common law, the Lease is the sort of transaction that would require authorization by the Board."

The Court also made specific reference to the Illinois Compiled Statutes, § 805 ILCS 5/11.55 which provides that where a sale, lease or exchange of assets involves, 'all, or substantially all, the property and assets ...of a corporation,' the board of directors must adopt a resolution recommending the transaction, whereupon said resolution shall be submitted to a vote by the shareholders at a meeting. § 805 ILCS 5/11.60(1).

The court held that the Lease essentially put the corporation out of business and, thus, was an extraordinary transaction.

In regard to the note that was executed, the Court made specific reference to Fritzsche’s by-laws entitled “Contracts, Loans, Checks and Deposits” which states “No loan shall be conducted on behalf of the Corporation and no evidence of indebtedness shall be issued in its name unless authorized by a resolution of the Board of Directors." Of course, the promissory note was never submitted to the Board for its consideration. The Court held that Christine was not permitted to bind the corporation by executing the note and that the note was void and unenforceable.

Thus, the Appellate Court found that Christine was not authorized to enter into the lease or make the note and, accordingly, affirmed the Trial Court’s grant of summary judgment to plaintiffs. The opinion contains a through discussion of corporate formalities and the need to comply.

Edward X. Clinton, Sr.

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