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Univ. of Toledo College of Law

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Monday, August 23, 2010

Eighth Circuit Holds that Brokerage Firm can be Liable for RR's Ponzi Scheme

The Eighth Circuit recently held, in Lustgraf v. Behrens (Aug. 20, 2010)(Download LustgrafvBehrens), that investors stated controlling person claims under federal and state securities laws against a broker-dealer firm whose registered representative allegedly perpetrated a Ponzi scheme and misappropriated their investments.  The court, however, found that the investors did not state controlling person claims against the insurance company that was the parent corporation of the brokerage firm. 

In reversing the district court's dismissal of investors' controlling person claims against the brokerage firm, the court first discussed controlling person liability under Securities Exchange Act section 20(a) and reaffirmed its three-part test from previous caselaw.  To hold a controlling person liable, plaintiff must prove that (1) a primary violator violated the federal securities laws, (2) the alleged controlling person actually exercised control over the general operations of the primary violator, and (3) the alleged control person possessed -- but did not necessarily exercise -- the power to determine the specific acts upon which the underlying violation was predicated.  The court rejected the brokerage firm's argument that it could not be liable because the fraudulent transactions took place through another unaffilated firm and followed its precedent that "the involvement of a separate brokerage firm does not render inadequate an otherwise properly pleaded prima facie case for federal control person liability."  Although the RR's fraud did not take place through defendant brokerage firm, it was the firm that effectively provided the RR access to the market and that had the duty to monitor the RR's activities.  Questions of good faith and lack of knowledge, while potentially viable arguments at the summary judgment stage, are not relevant at the MTD stage.  Finally, the Eighth Circuit rejected the argument that culpable participation by a defendant is required to establish control person liability.

In contrast, the Eighth Circuit held that investors did not state control person claims against the insurance company parent of the brokerage firm because they failed to allege that the company actually exercised control over the RR's general operations.  The court stated that although it engaged in certain presumptions with respect to broker-dealers, it generally requires that a plaintiff allege facts demonstrating that the alleged control person "actually exercised" control over the primary violator's general operations.  Allegations that (1) the brokerage firm and the insurance company operated from the same location, (2) many of the brokerage firm's RRs were also agents of the insurance company, and (3) the two companies shared directors and employees were insufficient to show actual control.

The Eighth Circuit also held that investors stated control person claims against the brokerage firm under Nebraska, Iowa, and Arizona securities laws, holding that the statutes did not require a plaintiff to allege material aid in order to state a control person claim against a broker-dealer.  Rather, proof of direct or indirect control of the primary violator was sufficient.  It also held that investors stated a claim against the broker-dealer firm (but not the insurance company) based on respondeat superior, but failed to state a claim based on apparent authority.

 

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