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Rothberg v. Rosenbloom

argued: September 18, 1986.

BENJAMIN ROTHBERG, APPELLANT,
v.
SANFORD ROSENBLOOM AND SANFORD ROSENBLOOM AS EXECUTOR OF THE ESTATE OF DAVID B. ROSENBLOOM, DECEASED, APPELLEES



Appeal from the United District Court for the Eastern District of Pennsylvania, Civil No. 83-2387.

Author: Rosenn

Before: SEITZ, SLOVITER, and ROSENN, Circuit Judges.

JUDGMENT OF THE COURT

ROSENN, Circuit Judge.

Plaintiff Benjamin Rothberg sought payment in this diversity action on two promissory notes, each executed by one of the defendants. The defendant David Rosenbloom guaranteed the note executed by defendant Sanford Rosenbloom, and all instruments were dated February 7, 1979. In answers filed by each of the defendants, they made no challenge to the validity of the notes and the guarantee, but asserted that the notes arose out of obligations created by agreements between the parties in 1969 to engage in transactions prohibited by section 10(b) of the Securities Exchange Act of 1934 as amended and Rule 10-5 of the Securities Exchange Commission promulgated thereunder.

After a bench trial, the district court found that the promissory notes had their genesis in two of several joint ventures formed by the parties some ten years before for the purpose of trading on insider information contrary to law. It therefore denied Rothberg relief on an in pari delicto theory, relying on this court's decision in Tarasi v. Pittsburgh National Bank, 555 F.2d 1152 (3d Cir.), cert. denied, 434 U.S. 965, 98 S. Ct. 504, 54 L. Ed. 2d 451 (1977).

Rothberg appealed to this court, contending that Tarasi did not control because the suit was brought on the notes only, not for redress of a securities laws violation. Before a decision was rendered on that appeal, the Supreme Court overruled Tarasi in Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S. Ct. 2622, 86 L. Ed. 2d 215 (1985), which rejected the general availability of the in pari delicto defense to tippers of securities information sued by their tippees. This court therefore remanded Rothberg's suit for reconsideration of the in pari delicto defense in light of Bateman Eichler. Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985).

On remand, the district court, on the basis of the original record, held that although Bateman Eichler bars the in pari delicto defense in most suits by tippees against their tippers, this case fell within an exception set forth in that opinion, and that the in pari delicto defense was therefore available to the Rosenblooms. Furthermore, the court held that Pennsylvania law did not bar a separate defense of illegality, specifically disclaimed by the Rosenblooms, because enforcement of the notes would offend public policy. Accordingly, the court again entered judgment for the defendants. Rothberg appeals this judgment. We reverse.

I.

A brief description of the cast of characters in the scenario before us is helpful. Plaintiff Benjamin Rothberg is a chemist and cofounder of Montrose Chemical Company. He also served as a director of the publicly held Mallory Randall Corporation for one year.*fn1 David Rosenbloom, an officer and director of several corporations prior to his death, served as chairman of the executive committee and a director of Nytronics, Inc., a publicly held corporation, from 1967 through 1973. He also was a member of the control group, a salaried executive, and a director of Mallory Randall from 1968 through 1976. A graduate of the Wharton School of the University of Pennsylvania, David had twice attended but never completed law school. His brother, Sanford, is a practicing lawyer since 1955, specializing in real estate. Benson Selzer, not a party here, is a registered representative for a New York securities brokerage firm. A close friend and business associate of David, Selzer was part of the group (including David) which acquired control of Nytronics. He served as a vice-president and director of both Nytronics and Mallory Randall. Rothberg and David met when a corporation controlled by David, Centlivre Brewing Co., merged with Montrose Chemical. David introduced Rothberg to Selzer, who subsequently became Rothberg's stock broker.

In 1968 and 1969, Rothberg entered into six "joint ventures" with either Sanford or David. All but the first of these joint ventures were formed to trade on inside information available to David or Selzer as officers or directors. Rothberg, not an insider, advanced about $1,365,000 for these joint ventures, with the co-venturer (either David or Sanford) contributing only $100 each time. Under the agreements, the co-venturer had the power to sell the securities involved. If the investments were profitable, all profits were to be shared equally. If the investments lost money, however, Sanford was to indemnify Rothberg for any losses. David executed a separate guaranty for this indemnification agreement.

The first three ventures yielded profits, which were shared according to the agreement. The fourth resulted in a loss, for which the Rosenblooms accordingly indemnified Rothberg. The last two ventures, involving investments in Mallory Randall Corporation and Gulton industries, also resulted in losses. This time, the Rosenblooms did not reimburse Rothberg.

In 1972 Rothberg agreed to extend the joint ventures and not to sue for indemnification. In return for this forbearance, Sanford gave him a demand note, guaranteed by David. In a contemporaneous letter, prepared by David, the Rosenblooms waived any defenses, counterclaims, or set-offs to the note. In 1979, the Rosenblooms, still not having paid the note, entered into an arrangement with Rothberg to give him two new notes for a liquidated sum at a reduced rate of interest and Rothberg agreed not to sue on the earlier note. Rothberg's suit on these notes and the guarantee are the subjects of this appeal.

II.

On appeal, Rothberg argues first that the district court erred in allowing an in pari delicto defense, because that defense is unavailable to the defendants under the general rule of Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S. Ct. 2622, 86 L. Ed. 2d 215 (1985), and because the exception to that rule does not apply here. Second, he asserts that the trial court erred in holding that under Pennsylvania law the notes were unenforceable because they were related to a transaction illegal under federal law and offended public policy.*fn2

The in pari delicto defense is related to the illegality defense in its goal of deterring wrongdoing and its policy of denying judicial relief to wrongdoers. Prior to the Supreme Court's decision in Bateman Eichler, Hill Richards, Inc. v. Berner, supra, the circuits had disagreed whether the in pari delicto defense was available to tippers in securities litigation.*fn3 Some courts held that the defense's inconsistency with effective enforcement of the insider trading prohibitions of the securities acts outweighed its usefulness in tipper-tippee actions. See, e.g., Nathanson v. Weis, Voisin, Cannon, Inc., 325 F. Supp. 50, 53 (S.D.N.Y. 1971). Others, including this court, felt that "the prophylactic impact on the use of inside information that allowance of the defense will lead to" predominated over the deterrence value of nonrecognition of the defense. Tarasi v. Pittsburgh National Bank, supra, 555 F.2d at 1163. Tarasi had been the controlling authority for this circuit at the time of the original trial in the case at bar. Before this court issued its option in the first appeal, however, the Supreme Court resolved the conflict in Bateman Eichler, Hill Richards, Inc. v. Berner, U.S., 472 U.S. 299, 105 S. Ct. 2622, 86 L. Ed. 2d 215 (1985).

In Bateman Eichler, the Court noted that the in pari delicto doctrine had always required a careful consideration of public policy implications before allowing the defense. Id. at , 105 S. Ct. at 2628. "Implied private actions," continued that Court, "provide 'a most effective weapon in the enforcement' of the securities laws and are 'a necessary supplement to Commission action.'" Id. (quoting J.I. Case Co. v. Borak, 377 U.S. 426, 432, 12 L. Ed. 2d 423, 84 S. Ct. 1555 (1964)). Denial of the defense best promotes protection of the investing public because (1) allowing suits by a defrauded tippee will expose wrongdoers and facilitate civil, administrative, and criminal action; (2) placing pressure on insiders will maximize the deterrence of insider trading; (3) insiders are usually more responsive to the pressures of potential sanctions; and (4) tippees are deterred by means other than the in pari delicto defense. Id. at , 105 S. Ct. 2631-33. Furthermore, the Court observed that it had "eschewed rigid common-law barriers in construing the securities laws." Id. at , 105 S. Ct. at 2628.

The Court therefore rejected the in pari delicto defense to implied causes of action brought by a tippee against a tipper under the federal securities laws generally, stating the rule in terms of its own two-prong exception:

(A) private action for damages in these circumstances may be barred on the grounds of the plaintiff's own culpability only where (1) as a direct result of his own actions, the plaintiff bears at least substantially equal responsibility for the violations he seeks to redress, and (2) preclusion of suit would not significantly interfere with the effective enforcement of the securities laws and protection of the investing public.

Id. at , 105 S. Ct. at 2629. Rejecting the Tarasi rule, id. at , 105 S. Ct. at 2631, the Court concluded that "the public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders. . . ." Id. at , 105 S. Ct. at 2633.

Because of the possible application of the Bateman Eichler exception, a previous panel of this court remanded this case to the district court specifically for the purpose of making factual findings under the new standard announced in that case. Rothberg v. Rosenbloom, 771 F.2d 818, 824 (3d Cir. 1985).*fn4 Our primary inquiry thus becomes whether the factual findings*fn5 made by the district court support its conclusion that Rothberg bore at least substantially equal responsibility in the underlying illegal transactions. We also consider the legal question of the potential effect upon the investing public of precluding this suit.

Only one other circuit has construed Bateman Eichler. In Dahl v. Pinter, 787 F.2d 985 (5th Cir. 1986), the Fifth Circuit gave the extent to which the plaintiff's illegality must outweigh the defendant's before the threshold in the first prong of Bateman Eichler is met.*fn6 That court held that the in pari delicto defense applies "only where some unconscionable act of one coming for relief has immediate and necessary relation to the equity that he seeks in respect of the matter in litigation.'" Id. at 988 (quoting Keystone Miller Co. v. General Excavator Co., 290 U.S. 240, 245, 78 L. Ed. 293, 54 S. Ct. 146 (1933)) (emphasis added by the court). The court rejected the tipper's in pari delicto defense to the tippee's action under ยง 12(1) of the Securities Act of 1933.*fn7

The Rosenblooms assert that in order to come within the Bateman Eichler exception they need only have shown that Rothberg bears at least substantially equal responsibility for the violations of law involved. This is a gross misstatement. First, it ignores entirely the existence of the second prong of the Bateman Eichler test. Second, the first prong of the test requires substantially equal responsibility for the violations that the plaintiff seeks to redress : here, the plaintiff seeks to redress only the nonpayment of the last set of notes executed in 1979, not any of the insider transactions. See In re Olympia Brewing Co. Securities Litigation, 1986 Fed. Sec. L. Rep. (CCH) P 92,461 (N.D. Ill. 1985). The Rosenblooms' quotation of only half of the rule and their alterations of its language distort the Court's meaning almost to the point of inversion.

In support of its conclusion that the first prong of the Bateman Eichler test is met, the district court characterized Rothberg as the "instigator" of the insider trader scheme:

Although Rothberg did not come up with the specific details of the plans to trade on inside information, it was his pressure on David to come up with a means to make Rothberg more money, in short, his greed, that ...


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