UFITEC v. CARTER (1977)

Ufitec, S. A. (Ufitec) a Swiss banking corporation appeals from a judgment in favor of William H. Carter rendered in an action on common counts in which Ufitec sought to recover from Carter some $381,979.70.

Carter is a resident of Los Angeles and during the time in which this controversy arose he was president of Kleiner Bell Realty Company, a subsidiary of Kleiner Bell Company, Inc. The latter company was a security brokerage firm which as part of its business underwrote speculative new issues.

In the Fall of 1968, in Los Angeles, Ufitec and Carter negotiated an oral contract concerning the purchase of securities including some that were underwritten by Kleiner Bell. The pertinent provisions of the contract, as found by the trial court in its written findings of fact were:

‘(a) UFITEC would advance 100% of the funds necessary for the purchase for the joint venture of securities recommended by Carter up to a projected maximum of $250,000; (b) Each of the proposed purchases by CARTER for the joint venture was subject to UFITEC's absolute right of veto; (c) A discretionary trading account would be opened in UFITEC's name at Kleiner, Bell & Co. to facilitate such purchases and sales. Carter would be granted a power of attorney to place orders with Kleiner, Bell & Co. on UFITEC's behalf; (d) All securities purchased by Carter for this joint venture were to be taken in either UFITEC's name or in street name and were to be held by or for UFITEC, UFITEC to have the absolute right at any time, at its sole and absolute discretion to cause said securities to be sold; (e) UFITEC was to open a special house account to be known as the ‘BCU Account’ (said initials standing for Bill Carter-Ufitec), in which all purchases and sales made by Carter for the joint venture would be recorded and accounted for; (f) UFITEC was to charge to this BCU Account interest at a variable rate on all moneys it advanced for the purchase of securities credited to said account, as well as its standard commissions on all securities purchased for and sold from said account; (g) The trading profits, if any, remaining in said BCU Account, after UFITEC's interest charges and commissions and other normal costs of trades had been paid, were then to be distributed 2/3 to Carter and 1/3 to UFITEC; (h) All losses to the BCU account were to be borne solely by Carter; (i) Quarterly statements on the status of the BCU account were to be rendered by UFITEC to Carter.' (Emphasis added.)

As to performance of the contract the trial court found:

‘Between October 1968 and July 1969, pursuant to said joint venture agreement, Carter recommended to UFITEC, and executed for UFITEC, a number of securities purchases and sales. The bulk of said purchases was placed with or made through the Kleiner, Bell & Co. discretionary account and involved securities underwritten by Kleiner, Bell & Co.

‘Carter purchased securities for UFITEC from approximtely October 1968 to July 1969. UFITEC paid $341,288.75 for securities recommended by Carter. The net result of the various transactions was a substantial loss. . . .

‘As of June 30, 1974 the losses suffered by UFITEC totalled $381,979.70.’

Although not mentioned in the findings, a portion of the transactions involved purchases of Canadian shares through Canadian exchanges.

From these facts the trial court concluded that Ufitec was barred from enforcing its claim for the losses by force of provisions of the Securities Exchange Act of 1934 (15 U.S.C. § 78g (hereafter the Act) and Regulation ‘T’ (12 C.F.R. § 220.1 et seq.) of the Board of Governors of the Federal Reserve System (Board) promulgated pursuant to authority granted by the Act.

Section 78cc(b) of the Act declares that any contract which violates any provisions of the Act or any rule or regulations promulgated thereunder ‘Shall be void as regards the rights of any person who in violation of such provision, rule or regulation, shall have made or engaged in the performance of any such contract. . . .’

The provisions and regulations here involved and which the trial court concluded were violated by these arrangements between Carter and Ufitec, pertain to the purchase of securities ‘on margin.’ The objectives of Congress in imposing control on ‘margin’ transactions were (1) to provide a method for reducing the amount of the nation's credit resources which could be directed into stock speculation and away from other commercial purposes, (2) to protect the unsophisticated investor against improvident speculation on credit, and (3) to prevent the use of excessive credit from causing untoward fluctuations in the market. (H.R.Rep.No.1383, 73d Cong. 2d Sess. (1934) 8; S.Rep.No.792, 73d Cong. 2d Sess. 3–4, 8 (1934); S.Rep.No.7443, 73d Cong. 2d Sess. 11 (1934); Report of Special Study of Securities Market of Securities Exchange Commission, H.R.Doc.95, 88th Cong. 1st Sess., Pt. 5, at 158 (1968).)

Relevant to these proceedings is 15 United States Code section 78g(c) which provides:

‘It shall be unlawful for any member of a national securities exchange or any broker or dealer, directly or indirectly, to extend or maintain credit or arrange for the extension or maintenance of credit to or for any customer—(1) on any security (other than an exempted security), in contravention of the rules and regulations which the [Board] shall prescribe . . ..’ (Emphasis added.)

Regulation ‘T’ is the margin requirement promulgated by the Board to regulate ‘credit by Brokers and Dealers.’ Companion Board Regulations ‘U’ (12 C.F.R., §§ 221 et seq.) and ‘G’ (12 C.F.R., §§ 207 et seq.) govern credit extension by domestic banks (‘U’) and lenders other than brokers, dealers, or domestic banks (‘G’). The specific ‘margin’ requirements of Regulation ‘T’ are not important here inasmuch as it is conceded that if that regulation applies the requirements were not met by the Carter-Ufitec arrangement.

The issues presented by Ufitec's appeal are (1) whether the arrangement constituted an extension of credit by Ufitec to ‘a customer’, (2) whether Ufitec was a ‘broker or dealer,’ (3) whether Ufitec as a foreign institution is subject to regulation, (4) whether certain transactions in Canadian stock were subject to the regulation, and finally (5) whether in any event Ufitec should be entitled to recover from Carter because of the unique status of the parties.

DID THE AGREEMENT AMOUNT TO AN EXTENSION OF CREDIT TO A CUSTOMER?

Yes! Neither the Act nor the Regulation further defines the term ‘extension of credit.’ Regulation ‘T’ does (12 C.F.R., § 220.2(c)) define a ‘customer’ to include ‘any joint venture in which a creditor participates and which would be considered a customer of the creditor if the creditor were not a participant.’

The trial court found on the basis of substantial evidence that the Carter-Ufitec arrangement was a ‘joint venture’ and the BCU account was a joint venture account. Carter in contending that the arrangement constituted an extension of credit to a ‘customer’ relies essentially on two Board rulings, one interpreting Regulation ‘G’ and one interpreting Regulation ‘T’.

One board ruling (31 F.R. 7169) dealt with a joint account created by two brokerage firms. The firms agreed to split the profits and losses. Both firms had the privilege of buying and selling securities in the account. The board ruled that the account was a ‘customer’ to which each firm was extending credit ‘since both make purchases for the account that are not settled until the month end.’ The second relevant board ruling (34 F.R. 9121) was an interpretation of Regulation ‘G’ which applies to credit extensions for security purchases by lenders other than brokers, dealers or domestic banks. The rationale, however, is applicable to those other types of lenders.

In that ruling an individual and a corporation established a joint venture to engage in the business of buying and selling securities. The individual contributed 20% of the capital and the corporation 80%. The individual, however, was to receive 80% of the profit and bear 80% of the loss and the corporation shared in 20% of the profits and bore 20% of the loss. The corporation reserved the right to liquidate the portfolio when the losses exceeded the individual's 20% investment. The board ruled that the transaction amounted to an extension of credit by the corporation collateralized by the securities and was thus subject to the regulation. The ruling emphasized the disproportionate ratio between the individual's capital investment (20%) and his share in the profits (80%) and the fact that the individual's profit or loss was dependent solely on the rise or fall of the price of the securities.

Similarly in the case at bench Carter contributed no capital but was to receive 2/3 of the profits and bear 100% ofthe loss. Thus Carter's profit or loss as reflected by the status of the BCU account was totally dependent on the rise or fall of the price of the securities in that account.

The scheme patently was one by which Ufitec advanced money to Carter to purchase securities in exchange for 1/3 of the profits plus commissions and interest on the money advanced. Ufitec held the securities as collateral and was, to the greatest extent possible, protected against loss.

We here adopt a portion of the learned trial judge's memorandum decision which is a very succinct and well-reasoned analysis of this situation.

‘UFITEC argues that this ruling is not applicable because here the account was in UFITEC's name and only UFITEC could make purchases and sales for the account. While this distinction may be superficially correct, it seems clear that the actualities of the BCU Account constituted an extension of credit by UFITEC to the BCU Account of Carter. UFITEC's position in these transactions was in essence that of a secured lender. UFITEC advanced the trading funds and was guaranteed against all loss by Carter; in addition it charged the Account (and Carter) 11% interest on all funds advanced by it. The fact that the trading account was in UFITEC's name and that all securities were purchased in its name with its funds confirms that the transactions were in essence loans, since this method of doing business enabled UFITEC to hold the securities as collateral for its advances with the right to sell them at any time. In short, as compensation for advancing the funds, UFITEC received Carter's guarantee of repayment, one-third of the profits, if any, interest on the funds advanced, and held the securities as collateral.’

WAS UFITEC A ‘BROKER’ OR ‘DEALER?’

Yes! Section 3 of the Act (15 U.S.C., § 78c) provides in part: (4) ‘The term ‘broker’ means any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank. (5) The term ‘dealer’ means any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise, but does not include a bank, or any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary capacity, but not as a part of a regular business. (6) The term ‘bank’ means (A) a banking institution organized under the laws of the United States, (B) a member bank of the Federal Reserve System, (C) any other banking institution . . . doing business under the laws of any state or of the United States a substantial portion of the business of which consists of receiving deposits or exercising fiduciary powers similar to those permitted to national banks . . ..'

The exclusion for banks does not apply to Ufitec because Ufitec as a foreign bank does not meet the statutory definition.

‘The phrase ‘engaged in the business' is common to both definitions [i. e., broker or dealer], with the adjective ‘regular’ modifying the word ‘business' in the second part of the ‘dealer’ definition. With or without the adjective, the phrase connotes a certain regularity of participation in purchasing and selling activities rather than a few isolated transactions. But there is no requirement that the purchase and sale of securities be a person's principal business or the principal source of his income.' (Loss, Securities Regulation, vol. II, p. 1295; see also footnote 26 on page 1295 citing Loomis (Director SEC Division of Trading & Exchange). The Securities Exchange Act of 1934 and the Investment Advisor's Act of 1940, 28 Geo.Wash.L.Rev. 214, 246 (1959).

Ufitec concedes that in 1968 and 1969, its United States securities trading amounted to about $2,000,000 a year ‘house trading’ and $8,000,000 a year client trading. It argues that since that amounted to only about 3 or 4% of its lending activity as an investment bank it could not be held to be ‘engaged’ in the securities business.

The determining factor of whether an individual or company is engaged in the business of dealing in securities is not simply the percentage of the person's or company's total business which is devoted to trading in securities. The critical considerations are the frequency, regularity and volume of that trading. Regular and frequent trades of securities in the amount of $10,000,000 a year is a significant and substantial amount of activity with a potentially significant impact on the American Securities Market. It clearly meets the definition of being ‘engaged in the business.’

IS UFITEC AS A FOREIGN INSTITUTION SUBJECT TO THE REGULATION?

Yes! In the case at bench Ufitec, albeit a foreign business enterprise was engaged in the business of buying and selling securities in the United States securities market. The contract between Ufitec and Carter was made in the United States. Carter is a United States citizen and Ufitec has invoked the jurisdiction of the California courts to enforce its contract with Carter.

15 United States Code section 78dd(b) provides that the provisions of the Act and resulting regulations do not apply to persons or entities engaged in a security business without the jurisdiction of the United States. (Also see Kook v. Crang, D.C., 182 F.Supp. 388; Securities and Exchange Commission v. Kasser, D.C., 391 F.Supp. 1167.)

This does not mean, however, that a person who engages in a security business both within and without the United States jurisdiction is immune from regulation as to that business conducted within jurisdiction of the United States.

Restatement 2d of the Foreign Relations Law of the United States recognizes two bases of jurisdiction, the exercise of which has extraterritorial effect. Those are (1) conduct or interest present within the territory, and (2) effect within the territory.¹

Case law dealing with extraterritorial application of the Act has developed two major themes based upon those Restatement provisions.

Leasco Data Processing Equip. v. Maxwell, 2 Cir., 468 F.2d 1326 applied certain anti-fraud provisions of the Act to a situation where officers of American publicly held corporations were induced by false representations made in the United States to purchase, in England, shares of an English corporation. This was an application of Restatement section 17 based on conduct within the United States which had an extraterritorial effect.

Schoenbaum v. Firstbrook, 2 Cir., 405 F.2d 200, involved a derivative suit by shareholders, some of which were American investors of a Canadian corporation. It was alleged that certain ‘insiders' in Canada had purchased shares in the company at an inordinately low price. Thus adversely affecting the price of the shares on the American Exchange.

The court there held at page 206 that neither ‘the usual presumption against extraterritorial application of legislation nor the specific language of Section 30(b) shows Congressional intent to preclude application of the Exchange Act to transactions regarding stocks traded in the United States which are affected outside the United States when extraterritorial application of the Act is necessary to protect American investors.’

Schoenbaum is an application of Restatement section 18 to conduct outside the United States which had domestic impact. The tests of Leasco and Schoenbaum are complementary and permit application of the Act to situations of either ‘conduct’ or ‘impact’ within the United States. (Also see Securities Exchange Commission v. United Financial Group, Inc., 9 Cir., 474 F.2d 354.)

Ufitec argues that since domestic credit resources were not involved in this venture the stated objectives of the Act are not served by applying the regulation as a bar to its claim. We disagree.

The unrestricted use of foreign credit in domestic securities speculation can only result in a significant and deleterious impact on the domestic securities market, domestic investors and in fact the national economy. The Congressional objectives are well served by applying the Act and its progeny, the regulations, to credit arrangements such as the one between Ufitec and Carter.

When a domestic investor such as Carter suffers substantial losses as a result of security speculation financed by foreign credit, the result is an outflow of United States capital in satisfaction of that credit obligation. Consideration of this potential impact on the domestic economy leads us to conclude that it is immaterial that in this case some of the transactions which generated the loss in fact involved Canadian shares traded on Canadian Security Exchanges. The impact of the loss is domestic.

ARE THE CIRCUMSTANCES SUCH AS TO PERMIT RECOVERY BY UFITEC NOTWITHSTANDING THE REGULATION?

No! The trial judge opined in his memorandum decision that both Carter and Ufitec in good faith believed their agreement to fall outside the ambit of the Act. Ufitec thus seeks to invoke section 29(c) of the Act which provides:

‘Nothing in this chapter shall be construed (1) to affect the validity of any loan or extension of credit . . . unless at the time of the making [thereof] . . ., the person making such loan or extension of credit . . . shall have actual knowledge of facts by reason of which the making of such loan or extension of credit . . . is a violation of the provisions of this chapter or any rule or regulation thereunder, . . ..’ (15 U.S.C., § 78cc(c).) (Emphasis added.)

Ufitec, however, was not lacking in any factual knowledge. There was no fraud or misrepresentation practiced on Ufitec. Its ignorance, if it could be called that, was one of law or legal interpretation, which, of course, is no basis for relief. (Civ.Code, § 1578; Larsen v. Johannes, 7 Cal.App.3d 491, 86 Cal.Rptr. 744.)

We recognize that ‘The general rule denying relief to a party to an illegal contract is subject to a wide range of exceptions. In each case, the extent of enforceability and the kind of remedy granted depend upon a variety of factors including the policy of the transgressed law, the kind of illegality, and the particular facts involved,’ (14 Cal.Jur.3d Contracts, § 142) and that under very limited circumstances, not comparable to those here, it has been held that a contract in violation of the Act is ‘voidable’ rather than ‘void.’ (Emphasis added.)

We hold no brief for Carter. He was a sophisticated and knowledgeable investor whose improvidence cannot be laid at the feet of Ufitec. Ufitec was also sophisticated and knowledgeable. Both Carter and Ufitec studiously sought to avoid the law and regulations which applied to their joint operation, but each did, as the court found and the facts show, evade and violate those laws and regulations.

The public policy embodied in the Act is a strong one and the public interest to be considered transcends the question of who on this case is to bear the loss. Giving preeminence to that public policy and interest will hopefully serve to deter foreign lending institutions in the future from attempting to circumvent Congress' intent in protecting the national economy by restricting the use of credit in speculative security purchases.

Since the evil to be prevented can only occur when the lender makes the credit available, the only effective method of deterrence is to deny to the lender the right to recover.

The judgment is affirmed.

FOOTNOTES

1.  Section 17 provides: ‘Jurisdiction to prescribe with respect to conduct, thing, status, or other interest within territory.‘A state has jurisdiction to prescribe a rule of law.(a) attaching legal consequences to conduct that occurs within its territory whether or not such consequences are determined by the affects of the conduct outside the territory, and(b) relating to a thing located, or a status or other interest localized, in its territory.'Section 18 provides: ‘Jurisdiction to prescribe with respect to effect within territory.‘A state has jurisdiction to prescribe a rule of law attaching legal consequences to conduct that occurs outside its territory and causes an effect within its territory, if either(a) the conduct and its effect are generally recognized as constituent elements of a crime or tort under the law of states that have reasonably developed legal systems, or(b) (i) the conduct and its effect are constituent elements of activity to which the rule applies;(ii) the affect within the territory is substantial(iii) it occurs as a direct and foreseeable result of the conduct outside the territory, and(iv) the rule is not inconsistent with the principles of justice generally recognized by states that have reasonably developed legal systems.'

COMPTON, Associate Justice.

ROTH, P. J., and BEACH, J., concur.