Haynes and Boone
  January 31, 2011 - United States of America

“Control Person” Claim for Employee’s “Outside” Securities Transaction is Reinstated by Texas Appeals Court
  by Nicholas Even

Earlier this month, the Court of Appeals of Texas, Third District, Austin, reinstated a “control person” claim under the Texas Securities Act (“TSA”) against Merrill Lynch Pierce Fenner & Smith Inc. related to a former broker’s allegedly fraudulent outside sales transactions. David Fernea v. Merrill Lynch Pierce Fenner & Smith, Inc., No. 03-09-00566-CV (Tex. App. –Austin, Jan. 7, 2011).

Allegations. The suit alleges that a broker, while employed by Merrill Lynch, solicited the plaintiff to purchase interests in two direct-marketing corporations owned by the broker. The plaintiff alleges that after paying for a 50% interest in each, the broker “deliver[ed] a fake stock certificate for 1000 shares” in a “non-existent corporation with a deceptively similar name.” The plaintiff further alleges the securities were not registered with the Texas State Securities Board and that the broker secretly attempted to resell to others the same corporations.

Although not a Merrill Lynch customer, the plaintiff made five claims against the firm: (1) violations of New York Stock Exchange (“NYSE”) and National Association of Securities Dealers (“NASD”) rules; (2) negligence, for violation of internal policies concerning outside transactions by employees; (3) negligent supervision; (4) “aider and abettor” liability under the TSA, and (5) “control person” liability under the TSA. Merrill Lynch won summary judgment on each claim in the trial court.

Appellate Ruling. On appeal, the Court affirmed there is no private cause of action for violation of NYSE and NASD rules. It also held that adoption of internal policies did not constitute a “voluntary undertaking” that created a common law duty to the plaintiff, and affirmed summary judgment on the negligence claim. As for negligent supervision, the Court found that Merrill Lynch established that it never received the detailed written notice required by NASD (now FINRA) Rule 3040 that would have triggered a duty to supervise. (Rule 3040 provides that a broker may not engage in private securities transactions unless the firm grants prior approval, after receiving written notice. If approved, the firm is responsible for supervising the transaction.) As for “aiding and abetting,” the Court held that the plaintiff failed to present sufficient evidence as to the “general-awareness element” of that claim under the TSA.

The Court reinstated the “control person” claim, however. The TSA provides: “A person who directly or indirectly controls a seller . . . of a security is liable . . . jointly and severally with the seller . . . unless the controlling person sustains the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of the existence of the facts by reason of which the liability is alleged to exist.” Tex. Rev. Civ. Stat. Ann. art. 581-33F. “Control” has been interpreted to mean "the possession, direct or indirect, of the power to direct or cause the direction of the management or policies of a person, whether through the ownership of voting securities, by contract, or otherwise." Barnes v. SWS Fin. Servs. Inc., 97 S.W.3d 759, 763 (Tex. App. –Dallas 2003, no pet.). A plaintiff need not prove that the alleged control person culpably participated in the violation. Id. at 763-64.

The Court of Appeals noted that although NASD (FINRA) Rules do not require that a firm "authorize" outside business interests of brokers, Merrill Lynch internally imposes such a requirement. Further, Merrill Lynch admitted in discovery that it authorized the broker’s role as a director, officer and employee of these outside entities. In addition, the Court cited provisions of the firm’s private-client branch office policy manual with respect to outside securities transactions and to testimony by the firm’s representative that the effect of the internal policy was that, as a condition of employment, the broker was prohibited from engaging in a private securities sale unless he obtained written permission from Merrill Lynch.

Although the Court agreed that lack of written notice from the broker “means that Merrill Lynch did not have a duty imposed by the rule to approve or deny the transaction,” it held, however, that “conclusive proof of the absence of a duty to control does not constitute conclusive proof of the absence of the power to control or influence.” (emphasis added) (citing Black's Law Dictionary 580, 1288 (9th ed. 2009) (defining duty as "a legal obligation that is owed or due to another and that needs to be satisfied” and defining power as "the ability to act or not act; esp., a person's capacity for acting in such a manner as to control someone else's responses")).

The Court found that there was sufficient evidence that the internal policies “gave Merrill Lynch the power to control or influence the transaction at issue,” because (1) the policies required that the broker obtain permission to own and participate in his outside business, and (2) they prohibited the broker from engaging in any private securities transaction without full disclosure and prior written approval. The Court held that Merrill Lynch’s “power to control is not dependent on any notice, but rather arises from the employment bargain . . . . In light of this bargain, we cannot say that Merrill Lynch has conclusively proved that it did not have the power to control or influence the specific transaction at issue.”

The Court held that plaintiff did not need to prove that Merrill Lynch had notice of the transaction. “Rather, the legislature decided to place the burden on the defendant to prove ‘that he did not know, and in the exercise of reasonable care could not have known.’” The Court further held that “[a]s to that affirmative defense, we need not decide whether Merrill Lynch has conclusively proved that it lacked actual notice of the securities sale because Merrill Lynch has not attempted to prove the second element of the defense – that in the exercise of reasonable care it could not have known of the relevant facts.” “In sum, we hold that Merrill Lynch has neither conclusively negated one of the elements of the control-person test, nor conclusively established both elements of the relevant affirmative defense; thus, it has not shown itself entitled to summary judgment as to [the] control-person claim.”

Potential Impact. The 2005 ruling by the Texas Supreme Court in Sterling Trust Company v. Adderley, 168 S.W.3d 835 (Tex. 2005), cut off aiding and abetting liability under the TSA barring evidence that the defendant was acting with “general awareness” of the alleged fraudulent activity. However, the construction of “control” in Fernea – based on a “power to control or influence” inherent in the employment relationship and the mere existence of internal policies – leaves firms broadly exposed under the TSA for outside activities of their brokers, at least on a prima facie basis. The decision may be found here.

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Nicholas Even
[email protected]


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