On February 28, 2020, Judge M. James Lorenz of the United States District Court for the Southern District of California dismissed a putative securities class action against an investment management company ("Company") and its clearing bank ("Clearing Bank," and collectively, "Defendants") that alleged violations of Section 10(b) of the Securities and Exchange Act of 1934 ("Exchange Act") and Rule 10b-5. Jiao v. Merrill Lynch, Pierce, Fenner & Smith, 17-cv-409-L (MDD) (S.D. Cal. Feb. 28, 2020). Plaintiffs, who were customers of Defendants, brought the lawsuit after the Securities and Exchange Commission ("SEC") entered into a consent and cease-and-desist order with Defendants ("SEC Order") for violations of the Customer Protection Rule of the Exchange Act, 15 U.S.C. § 78aa; 17 C.F.R. § 240.15c3-3 ("CPR"), which required Defendants to maintain physical possession or control over customers' fully paid and excess margin securities. The Court dismissed the action with prejudice because claims under Section 10(b) require a plaintiff to plead and prove an "out-of-pocket" loss, which Plaintiffs failed to do.
Prior to the action, the SEC Order found that Defendants violated two provisions of the CPR. First, from 2009 to 2015, the Clearing Bank imposed a lien on customers' fully paid and excess margin securities in contravention of a CPR requirement to maintain physical possession or control over such securities. Second, from 2009 to 2012, Defendants were required to maintain a balance in the Customer Reserve Bank Account ("Reserve Account") that was calculated according to a particular formula but instead executed a series of Leveraged Conversion Trades ("LCTs"), which reduced the amount Defendants were required to hold in the Reserve Account by billions of dollars, and used the freed-up funds to finance securities trading for their own gain. Defendants' maintenance of the Reserve Account at levels lower than was required might have posed a risk if Defendants failed financially. The SEC found that "no customers were harmed by Defendants' wrongdoing" because Defendants did not fail. The SEC Order required (i) the disgorgement of $50 million (plus interest) from earnings on the LCTs and (ii) that the Company pay a $385 million civil monetary penalty.
Plaintiffs commenced the investor action "based on substantially the same facts as alleged in" the SEC Order. Defendants moved to dismiss, arguing that Plaintiffs failed to allege "economic loss" as required to maintain a Section 10(b) claim. Plaintiffs maintained they were entitled to one of three different recoveries, none of which was based on an "actual" or "out-of-pocket" loss: (1) Defendants' LCTs exposed them to increased risk of loss, (2) had Plaintiffs known of the increased risk of loss, they would have demanded a greater rate of return from Defendants, and/or (3) disgorgement of profits Defendants earned from the LCTs.
The Court concluded that Section 28 of the Exchange Act requires a plaintiff to allege "actual damages" and that the measure of such damages is "out-of-pocket" loss. The Court held that plaintiffs were not entitled to "lost opportunity cost or disgorgement of profits," and it distinguished a number of prior cases cited by Plaintiffs on the ground that they all involved out-of-pocket losses. After finding that Plaintiffs failed to plead such losses, the Court turned to their request for leave to amend and concluded such leave would be futile because Plaintiffs failed to specify how Plaintiffs could plead the required out-of-pocket losses.
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