Tuesday, April 22, 2014

FYI: 1st Cir Upholds Dismissal of RICO Claims Against Lender for Alleged Fraud in Loan to Purchase Securities

The U.S. Court of Appeals for the First Circuit recently affirmed the dismissal of a Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §§ 1961-1968 (“RICO”) claim against a bank, in which the bank was accused of engaging in a scheme to entice investors into borrowing money to buy securities in violation of federal securities regulations. 


In so ruling, the First Circuit confirmed that private plaintiffs may not bring RICO claims based on conduct that would have been actionable as fraud in the purchase or sale of securities.


A copy of the opinion is available at: http://media.ca1.uscourts.gov/pdf.opinions/12-2128P-01A.pdf


Two investors (“Borrowers”) sued their bank, several officers/employees of the bank and the bank’s parent/subsidiary/affiliated companies, and several insurance companies (collectively, “Bank”), alleging that Bank enticed them into borrowing money to buy and trade securities.  Borrowers claimed that Bank intentionally concealed the fact that the entire arrangement violated Regulation U, 12 C.F.R. Ch. II, Pt. 221, a regulation issued by the Board of Governors of the Federal Reserve Board pursuant to the Securities Exchange Act of 1934, 15 U.S.C. § 78a, et seq. (“Regulation U”).  See 12 C.F.R. § 221.1(a).


Regulation U “imposes credit restrictions upon persons other than brokers or dealers (hereinafter lenders) that extend credit for the purpose of buying or carrying margin stock if the credit is secured directly or indirectly by margin stock.”  12 C.F.R. § 211.1(b)(1).  “Margin stock” includes “[a]ny equity security registered … on a national securities exchange.”  Id. § 221.2.  In pertinent part, Regulation U prohibits banks from lending more than a certain percentage of the value of the securities used to secure the loan,  see Id. § 221.3, thereby typically ensuring that the purchaser has some of his own fund invested, and reducing the extent to which holders of securities are over-leveraged.  See Capital Mgmt. Select Fund Ltd. V. Bennett, 680 F.3d 214, 221-22 & n.9 (2d Cir. 2012).


After roughly $9 million in trades, Borrowers suffered a loss of nearly $3 million, and claimed that had the Bank not loaned them the money they would not have bought so many securities and suffered such a loss.  Borrowers advanced two arguments: (1) a private cause of action under Regulation U, and (2) treble damages and attorneys’ fees under RICO.


The district court dismissed the case, ruling that (1) there is no private right of action for a violation of Regulation U, and (2) the alleged misconduct was not actionable under RICO, which, as amended, does not encompass private claims that would have been “actionable as fraud in the purchase or sale of securities.”  Private Securities Litigation Reform Act (“PSLRA”), Pub. L. No. 104-67, § 107, 109 Stat. 737 (1995), amending 18 U.S.C. § 1964(c).  Plaintiff appealed the dismissal of their RICO claim and not the claim under Regulation U.


As you may recall, “[f]raud in the sale of securities” is listed as a RICO predicate act.  18 U.S.C. § 1961(1).  For a time, this allowed private litigants to use RICO to threaten treble damage liability in securities fraud litigation.  See Bald Eagle Area Sch. Dist. V. Keystone Fin., Inc., 189 F.3d 321, 327 (3d. Cir. 1999).  In response, Congress adopted the PSLRA, which generally bars private plaintiffs from bringing RICO claims based on “any conduct that would have been actionable as fraud in the purchase or sale of securities.”  18 U.S.C. § 1964(c); see Bald Eagle Area Sch. Dist., 189 F.3d at 327.


On appeal, the issue before the First Circuit was whether the PSLRA, which amended RICO, barred the Borrowers’ RICO claim in this case.  In other words, whether the conduct in question is “actionable as fraud in the purchase or sale of the securities.” 


To provide some background, actions for fraud in the purchase or sale of securities often arise under section 10(b) of the Securities Exchange Act of 1934 and U.S. Securities and Exchange Commission (“SEC”) Rule 10b-5.  See 15 U.S.C. § 78j; 17 C.F.R. § 240.10b-6.  Borrowers argued that this “bank fraud” was not actionable under Rule 10b-5 and not barred by the PSLRA because the fraud was not in “connection with the purchase or sale of securities.”  Borrower attempted to draw a distinction between obtaining loans and using loan funds to purchase securities, arguing that the alleged fraud arose “in connection with” the issuance of loans, not “in connection with” the purchase of securities.


The First Circuit rejected the argument because of the close nexus between the alleged fraud and the purchase of securities.  The scheme essentially alleged that the Bank loans were “extended exclusively for the purchase of securities” and the damages sought directly related to the purchase and sale of securities. 


Case law interpreting the “in connection with” requirement of Rule 10b-5 and related statues supported the First Circuit’s conclusion.  The Third Circuit found sufficient nexus between a failure to disclose the interest terms of margin trading  accounts and the subsequent purchase of securities to state a cause of action under Rule 10b-5.  See Angelastro v. Prudential-Bache Sec., Inc., 764 F.2d 939, 943-45 (3d Cir. 1985).  The Ninth Circuit has held that misleading statements about stock reports and the risks of buying on margin in a declining market using borrowed funds stated a claim under Rule 10b-5.  See Arrington v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 651 F.2d 615, 618-19 (9th Cir. 1981).


In the context of a more traditional 10b-5 case dealing with a false or misleading stock tip, the Fourth Circuit identified four (non-exhaustive) factors relevant to whether a particular case satisfies the transactional nexus:


(1) whether a securities sale was necessary to the completion of the fraudulent scheme; (2) whether the parties’ relationship was such that it would necessarily involve trading in securities; (3) whether the defendant intended to induce a securities transaction; and (4) whether material misrepresentations were disseminated to the public in a medium upon which a reasonable investor would rely. 


See SEC v. Pirate Investor LLC, 580 F.3d 233, 233 (4th Cir. 2009) (citations omitted) (quotation marks omitted).


Applying the first three pertinent factors, the First Circuit found that all these facts were satisfied because the purpose of the alleged scheme was both to make loans and sell securities; the selling of securities was a necessary component of the scheme and of the relationship between the parties; and the complaint specifically alleged that the scheme was designed to make money for Bank through interest and commissions from the trading of securities. 


In sum, the First Circuit found the alleged scheme to be directly connected to purchase or sale of securities.  This was not a case where proceeds of an independent fraud that happened to be invested in securities, or where funds obtained were later invested in securities.  Here, the Borrowers obtained loans specifically to buy and sell securities and thus, the PSLRA is a bar in this action.


Accordingly, the First Circuit affirmed the district court’s ruling dismissing the action.






Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
The Loop Center Building
105 W. Madison Street, 18th Floor
Chicago, Illinois 60602
(312) 551-9320
(312) 284-4751
(312) 493-0874


Admitted to practice law in Illinois



          McGinnis Wutscher Beiramee LLP





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