Sec v. Zandford: a Stockbroker's Coincidental Encounter With the "in Connection With" Requirement of Section 10(b) - Page Scully

• Citation: Vol. 54 No. 2
• Publication year: 2003

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SEC v. Zandford: A Stockbroker's

Coincidental Encounter With the

"In Connection With" Requirementof Section 10(b)

In SEC v. Zandford,¹ the United States Supreme Court held that when a stockbroker sells his customer's stock with the intent to steal the proceeds, his breach of fiduciary duty and misappropriation of funds constitutes a fraud "in connection with" the sale of the securities in violation of section 10(b) of the Securities Exchange Act of 1934.² In so holding, the Court set forth a new test to determine whether a fraud is perpetrated "in connection with" the purchase or sale of a security: If a fraudulent scheme "coincides" with the purchase or sale of a security, such fraud is "in connection with" the purchase or sale for purposes of section 10(b) and Rule 10b-5.³

I. Factual Background

In 1987 securities broker Charles Zandford persuaded William Wood to open a joint investment account. Mr. Wood was an elderly man in poor health, and he opened the investment account for himself and his mentally retarded daughter. The stated objectives of the account were to secure the principal and to earn a modest amount of income. To this end, the Woods left the management of their account to Zandford's discretion and gave Zandford a general power of attorney to conduct securities transactions on their behalf without prior approval. The Woods entrusted Zandford with $419,255. By 1991 this money was gone.⁴

The National Association of Securities Dealers discovered that Zandford had misappropriated the Woods' money by repeatedly selling the Woods' securities and transferring the proceeds to accounts owned or controlled by himself. Zandford was indicted on thirteen counts of wire fraud in violation of 18 U.S.C. Sec. 1343 and was convicted on all thirteen counts.⁵

After Zandford's indictment, the Securities and Exchange Commission ("SEC") filed a civil complaint, alleging that Zandford violated section 10(b) of the Securities Exchange Act of 1934 and the SEC's Rule 10b-5 by engaging in a scheme to defraud the Woods by misappropriating their money for his own use. Once Zandford was convicted, the SEC filed a motion for partial summary judgment, maintaining that the conviction conclusively established facts showing a violation of section 10(b). The district court granted the SEC's motion for partial summary judgment, and Zandford appealed.⁶

The United States Court of Appeals for the Fourth Circuit reversed the district court's grant ofpartial summary judgment and remanded the case with instructions to dismiss the complaint for failing to state a claim upon which relief could be granted. Specifically, the court decided that the complaint failed to allege the necessary connection between Zandford's fraud and his sale of the Woods' securities because the misappropriation ofthe Woods' money was separate from Zandford's sale of securities.⁷

The United States Supreme Court granted certiorari to determine whether Zandford's fraudulent scheme to misappropriate the proceeds occurred "in connection with" the sale of the securities.⁸ In a unanimous decision, the Court reversed the holding of the Fourth Circuit and concluded that the factual allegations met the "in connection with" requirement of section 10(b) because the alleged fraud coincided with Zandford's sale of the Woods' securities.⁹

II. Legal History

Section 10(b) of the Securities Exchange Act of 1934 makes it unlawful for any person to "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."¹⁰ Pursuant to the rule-making authority granted by this statute, the SEC promulgated Rule 10b-5, which states:

It shall be 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,

(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.¹¹

Section 10(b) and Rule 10b-5 thus prohibit fraud that is perpetrated "in connection with" the purchase or sale of a security. The language of the statute and the rule, however, offers little guidance as to the meaning of the "in connection with" requirement. Courts have consequently found it increasingly difficult to determine when a fraud is, in fact, perpetrated "in connection with" the purchase or sale of a security.

Jurisprudence of the "in connection with" requirement began simply enough with a case asking whether plaintiffs in a Rule 10b-5 action must be actual purchasers or sellers of securities.¹² The United States Court of Appeals for the Second Circuit answered this question in the affirmative, holding that protection under Rule 10b-5 is limited to actual, as opposed to prospective, purchasers and sellers.¹³ The holding in Birnbaum v. Newport Steel Corp.¹⁴ was not surprising given that the statute and the rule speak only of actual purchases and sales; but the court went on to conclude that section 10(b) "was directed solely at that type ofmisrepresentation or fraudulent practice usually associated with the sale or purchase ofsecurities rather than at fraudulent mismanagement of corporate affairs."¹⁵ This conclusion represented the first of many attempts to delineate the scope of the "in connection with" requirement. The court determined that fraud would not be deemed "in connection with" the purchase or sale of a security if it amounted to nothing more than corporate mismanagement and that the requirement would remain unmet unless the fraud were ofa type "usually associated" with the purchase or sale of securities.¹⁶ In light of what was to come, this definition of the nexus requirement was a narrow one.

Sixteen years later, applying the "in connection with" requirement to a dissimilar set offacts, the Second Circuit appeared to read the statute more broadly.¹⁷ In SEC v. Texas Gulf Sulphur Co.,¹⁸ the court held that defendants in a Rule 10b-5 action need not have participated in the purchase or sale of a security in order to have perpetrated a fraud in connection therewith.¹⁹ Plaintiffs in Texas Gulfwere stockholders who alleged they were defrauded by company officers when the officers issued a misleading press release regarding the company's success in oil exploration activities. Defendants did not actually participate in the purchase or sale of the securities, but they did convey false information to the investing public anticipating that the public would enter into securities transactions in reliance thereon.²⁰ The court concluded that defendants' fraudulent acts were "in connection with" the purchase or sale of securities, notwithstanding their lack of participation, because defendants' false statements were made "in a manner reasonably calculated to influence the investing public."²¹ Thus, while the holding in Birnbaum narrowed the scope of Rule 10b-5 by requiring that plaintiffs be actual purchasers or sellers of securities,²² the holding in Texas Gulf expanded the scope ofthe rule by bringing within its purview defendants who were neither purchasers nor sellers of the securities relating to the fraud.²³

Three years later the United States Supreme Court addressed the "in connection with" requirement for the first time.²⁴ In Superintendent of Insurance v. Bankers Life & Casualty Co.,²⁵ Manhattan Casualty Company ("Manhattan") brought suit when the company discovered it had been defrauded by its managers. As part of an elaborate scheme, the managers of Manhattan agreed to sell all of Manhattan's stock to Begole for five million dollars. Begole, acting with co-conspirators, used U.S. treasury bonds owned by Manhattan to pay for the stock. Through a sophisticated and deceptive series of transactions, Manhattan's bonds were sold and the proceeds of the bonds were used to purchase Manhattan's stock. In this manner, defendants defrauded Manhattan by using Manhattan's assets to purchase Manhattan's stock.²⁶ The district court and the court of appeals concluded that the fraudulent scheme was not perpetrated "in connection with" the purchase or sale of any security because the securities transactions, by themselves, were lawful and defendants' misappropriation of plaintiffs' assets, though fraudulent, was separate from the sale of the securities.²⁷ The Supreme Court disagreed.²⁸

In a unanimous opinion by Justice Douglas, a former Chairman of the SEC, the Court concluded that the "in connection with" requirement was satisfied because Manhattan was "injured as an investor through a deceptive device which deprived it ofany compensation for the sale ofits valuable block of securities."²⁹ Though the Court concurred with the Birnbaum dicta by stating that fraud amounting to mere internal corporate mismanagement would not be deemed "in connection with" the purchase or sale of a security,³⁰ the Court ultimately deemed it irrelevant that the fraud was perpetrated by a corporate officer of

Manhattan because defendants' actions went beyond corporate misman-agement.³¹ Also irrelevant were the facts that (1) the securities transaction relating to the fraud was not conducted through a securities exchange or over-the-counter market,³² and (2) the victims of the fraud were corporations and ultimately creditors rather than individual investors.³³ Finally, because defendants' fraud related to the recipients of the proceeds of the sale, the Court's holding established that the "in connection with" requirement did not mandate that the deception relate to the value of...