United States: Fraud and Forbearance: State Courts Divided on Whether to Recognize Claims by Securities Holders

Last Updated: June 25 2010
Article by Stanley J. Parzen, Dana S. Douglas and Brian J. Massengill

Originally published June 14, 2010

Keywords: negligent claims, fraud, securities, holder claims, misrepresentation, divergence, US States

Two recent state appellate court cases demonstrate the division in the law regarding whether holders of securities can maintain a cause of action related to alleged fraud and negligent misrepresentation.

On February 8, 2010, the Supreme Court of Georgia issued a decision1 that expands the availability of fraud and negligent misrepresentation claims in the securities context. The court held that Georgia common law recognizes fraud and negligent misrepresentation claims based on forbearance in the sale of publicly traded securities—commonly known as "holder" claims—if plaintiffs allege that the misrepresentations were directed at them to their injury and that plaintiffs specifically relied on those purported misrepresentations.

Three months later, on May 27, 2010, a New York appellate court reached a contrary conclusion,2 casting doubt on the longstanding recognition of holder suits under New York law. These decisions illustrate the current divergence between a number of US states in their approaches to these suits.

Georgia: The Holmes v. Grubman Decision

Plaintiff William K. Holmes alleged that on June 25, 1999, he verbally ordered his broker at Salomon Smith Barney & Co., Inc. (SSB) to sell his WorldCom shares. According to Holmes, SSB and its financial analyst, Jack Grubman, convinced him not to sell his 2.1 million shares in WorldCom. Instead of selling, Holmes purchased additional shares of WorldCom as the stock price declined. In October 2000, Holmes was forced to sell all of his WorldCom shares to meet margin calls, resulting in substantial losses. Holmes' complaint, which originated in a Georgia bankruptcy proceeding, was dismissed3 for failure to state a claim by the US District Court for the Southern District of New York, which is handling the WorldCom multidistrict litigation. The US Court of Appeals for the Second Circuit affirmed4 the dismissal but certified three questions to the Supreme Court of Georgia:

  • Does Georgia common law recognize fraud claims based on forbearance in the sale of publicly traded securities?
  • With respect to a tort claim based on misrepresentations or omissions concerning publicly traded securities, is proximate cause adequately pleaded under Georgia law when a plaintiff alleges that his injury was a reasonably foreseeable result of defendant's false or misleading statements but does not allege that the truth concealed by the defendant entered the market place, thereby precipitating a drop in the price of the security?
  • Under Georgia law, does a brokerage firm owe a fiduciary duty to the holder of a non-discretionary account?

The Supreme Court of Georgia answered the first question in the affirmative, stating that one of the elements for proving fraud under Georgia law is an intention to induce the plaintiff to act or refrain from acting. The Holmes court found support for its holding in both the Restatement (Second) of Torts § 525 as well as Blue Chip Stamps v. Manor Drug Stores,5 a case in which the US Supreme Court held that holder claims were not available under Rule 10(b)(5) of the Securities Exchange Act of 1934, but also noted that holder claims may be available under state law. The Holmes court then set forth two limitations on such claims: direct communication and specific reliance. The "direct communication" limitation requires that plaintiffs allege that the misrepresentations were directed to them. The "specific reliance" limitation requires that plaintiffs allege actions, rather than unspoken or unrecorded thoughts and decisions, indicating that the plaintiffs actually relied on the misrepresentations.

With respect to the second question, the Holmes court rejected the argument that plaintiffs could establish proximate causation by simply alleging that injury was a "reasonably foreseeable result" of the misrepresentation. Rather, the court concluded that, with respect to a tort claim based on misrepresentations or omissions concerning publicly traded securities, plaintiffs have the burden of proving that the truth concealed by the defendant actually entered the marketplace, thereby precipitating a drop in the price of the security. The court further held that plaintiffs must show that it was this revelation of the concealed truth that caused the loss and not merely one of several factors that affected the price.

Finally, the Holmes court held that a stockbroker has fiduciary duties towards a customer who holds a non-discretionary account. After recognizing that the broker owes a number of limited duties to the client regarding the transaction of business, the court further concluded that fiduciary duties owed by a broker to a customer with a non-discretionary account are not restricted to the actual execution of transactions. In addition, the broker has a heightened duty when recommending an investment which the holder of a non-discretionary account has previously rejected or as to which the broker has a conflict of interest.

With the Holmes decision, Georgia joins a handful of other states that have recognized holder claims either in the state courts or in federal courts interpreting states' laws, including California, Florida, Massachusetts, New Jersey, and Wisconsin.6

New York: The Starr v. AIG Decision

New York has traditionally recognized fraud claims where a defendant's misrepresentations induced investors to hold securities.7

On May 27, 2010, however, a New York appellate court held that a plaintiff's holder claim violated the "out-of-pocket" rule governing losses recoverable for fraud. Pursuant to the out-of-pocket rule, the true measure of damages for fraud is the actual pecuniary loss sustained as the direct result of the wrong. In Starr Foundation v. American International Group, Inc., Starr Foundation alleged that, but for AIG's purported misrepresentations, it would have continued to sell 15.5 million shares of AIG stock. The appellate court held that Starr Foundation's holder claim was "virtually the paradigm of the kind of claim that is barred by the out-of-pocket rule," because "a lost bargain more 'undeterminable and speculative' than this is difficult to imagine." The court determined that, in continuing to hold the AIG stock, the plaintiff did not lose or give up any value; rather, the plaintiff remained in possession of the true value of the stock, whatever that value may have been at any given time. Accordingly, Starr Foundation did not suffer any out-of-pocket loss as a result of retaining its AIG stock.

In addition to the New York appellate court, several federal courts have expressed doubt with the approach taken by Georgia and other courts, noting that claims for damages under holder claims are untenable. The District of Connecticut dismissed a holder claim on the ground that "the claims for damages based on the plaintiffs' failure to sell or hedge their stock are too speculative to be actionable."8 Federal courts applying Mississippi, Illinois, and Virginia law have relied on similar principles of loss causation to reject holder claims, reasoning that those who hold securities during the fraud are unable to plead that the misrepresentations caused their loss.9

Implications and Conclusions

Given the division in state law, it is clear that potential liability to holders of securities varies widely depending upon the jurisdiction in which claims are brought. The Supreme Court of Georgia was quick to point out that "induced forbearance can be the basis for tort liability" and is consistent with the Restatement (Second) of Torts § 525. Courts that have not yet considered the availability of fraud and negligent misrepresentation claims to holders of securities also could rely on the Restatement (Second) of Torts § 525 to permit holder claims.

The recent decision in New York, however, adds to the doubt cast upon the enforceability of holder claims. Holder plaintiffs will face difficulty pleading reliance, making holder claims susceptible to a motion to dismiss.10 If a holder claim survives a motion to dismiss, the plaintiff will have difficulty proving causation and damages. Thus, while certain states recognize holder claims, they may remain a practical impossibility due to the difficulties most plaintiffs will have proving the critical elements of misrepresentation claims.

Footnotes

1. Holmes v. Grubman, 691 S.E.2d 196 (Ga. 2010).

2. Starr Foundation v. American Intern. Group, Inc., 2010 WL 2104535 (N.Y.A.D. 1st Dept. May 27, 2010).

3. Holmes v. Grubman (In re WorldCom, Inc. Securities Litigation), 456 F. Supp. 2d 508 (S.D.N.Y. 2006).

4. Holmes v. Grubman, 568 F.3d 329 (2nd Cir. 2009).

5. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730-31, 738 (1975).

6. Small v. Fritz Companies, Inc., 65 P.3d 1255, 1259 (Cal. 2003) (collecting cases); see also Rogers v. Cisco Systems, Inc., 268 F. Supp. 2d 1305, 1314 (N.D. Fla. 2003) (applying Florida law and recognizing "holder" claims but dismissing claims because plaintiffs' allegations of reliance were too vague); see also Seideman v. Sheboygan Loan & Trust Co., et al., 223 N.W. 430, 433 (Wis. 1929).

7. Continental Ins. Co. v. Mercadante, 222 App. Div. 181 (N.Y.A.D. 1st Dept. 1927).

8. Chanoff v. United States Surgical Corp., 857 F. Supp. 1011, 1018 (D. Conn. 1994) (applying Connecticut law).

9. See In re WorldCom, Inc. Securities Litigation, 336 F. Supp. 2d 310, 320 (S.D.N.Y. 2004) (collecting cases).

10. Dloogatch v. Brincat, 396 Ill. App. 3d 842, 849-854 (1st Dist. 2009) (collecting cases and holding that plaintiffs failed to plead reliance or damages in holder claim).

Learn more about our Professional Liability practice.

Visit us at www.mayerbrown.com.

Copyright 2010. Mayer Brown LLP, Mayer Brown International LLP, Mayer Brown JSM and/or Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. All rights reserved.

Mayer Brown is a global legal services organization comprising legal practices that are separate entities (the Mayer Brown Practices). The Mayer Brown Practices are: Mayer Brown LLP, a limited liability partnership established in the United States; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales; Mayer Brown JSM, a Hong Kong partnership, and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions