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Media Alerts - Belmont v. MB Inv. Partners, Inc.--Third Circuit
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February 25, 2013
  Belmont v. MB Inv. Partners, Inc.--Third Circuit
Headline: Court addresses issues of extended civil liability for a Ponzi scheme under federal and state law

Area of Law: Securities and Exchange Act; SEC Rule 10b-5; PA Unfair Trade Practice and Consumer Protection Law; negligent supervision; fiduciary liability

Issue(s) Presented:
1. Is inaction that prevented the discovery of a fraud sufficient to show controlling person liability under Section 20(a) of the Securities Exchange Act?
2. Under what circumstances are directors or executives of a corporation treated as supervisors for purposes of a negligent supervision claim?
3. When can an investment company be liable for fraudulent statements made by one of its employees in connection with a separate investment entity operated by the employee?
4. Under Rule 10b-5 of the Securities and Exchange Commission, is recklessness sufficient to support a secondary, imputed, liability claim?
5. What is required to establish breach of fiduciary duty by investment advisers?

Brief Summary: A group of investors decided to invest money totaling $4.4 million with North Hills, L.P., managed solely by Mark E. Bloom. Bloom enticed investors with promises of high returns and low risk, luring victims into what turned out to be a Ponzi scheme. At the time Bloom operated North Hills, he was an executive with defendant MB Investment Partners, Inc. ("MB Investment"), and he marketed North Hills' services to several of MB Investment's clients. MB Investment was aware that Bloom was operating North Hills but was not aware that it was a fraud. When Bloom's scheme finally crumbled, investors who had lost money in his scheme sued for damages. Bloom, including his former employer, MB Investment and its various affiliates were name as defendants. The injured investors sued the defendants for (1) controlling person liability under Section 20(a) of the Securities Exchange Act (the "Exchange Act"), (2) negligent supervision, (3) violations of Securities and Exchange Commission("SEC") Rule 10b-5, (4) violations of the Pennsylvania Unfair Trade Practice and Consumer Protection Law (the "UTPCPL"), and (5) breach of fiduciary duty.

Extended Summary: Barry J. Belmont, Philadelphia Financial Services LLC,(PFS) Thomas J. Kelly, Jr. and his wife Frances R. Kelly, and Gary O. Perez (collectively, the "Investors") sued MB Investment Partners, Inc., Centre MB Holdings,(CMB) Centre Partners Management, LLC, Robert M. Machinist, Mark E. Bloom, Ronald L. Altman, Lester Pollack, William M. Tomai, Guillaume Bébéar, P. Benjamin Grosscup, Thomas N. Barr, Christine Munn, and Robert A. Bernhard to recover money lost in Bloom's Ponzi scheme.

MB investment is a registered investment advisor based in New York and doing business in Pennsylvania. Machinist and Altman (together with MB Investment, "MB Defendants") were both executives and partial owners of MB Investment while Bloom worked there. Machinist, Bloom, and the executives of Centre Partners, Lester Pollack, William M. Tomai, and Guillaume Bébéar, formed CMB. (Centre Partners, the executives, and CMB form the "Centre Defendants.") CMB then acquired a controlling interest in MB Investment. CMB also acquired control of the operations of MB Investment. After the acquisition, Bloom, Machinist, Pollack, Tomai, and Bébéar served as MB Investment's board of directors.
At the time of the Ponzi scheme, Bloom was an executive officer of MB Investment. The scheme was perpetrated by Bloom through a hedge fund called North Hills, L.P. Bloom enticed victims with promises of a return of 10% to 15% without significant risk, but in actuality he secretly siphoned millions of dollars from the fund. The Investors all had money invested in Bloom's North Hills fund, totaling $4.4 million. Some Investors were also advisory clients of MB Investment.
The Investors alleged that Bloom was able to succeed in his scheme in part because of MB Investment's failure to supervise Bloom in accordance with the Investment Advisers Act of 1940 (the "Advisers Act"). The Advisers Act required MB Investment to help identify fraud and self-dealings by its employees. The Investors alleged that even though the company was aware of Bloom's dealings with North Hills, MB Investment failed to make basic inquiries with regards to Bloom's activities as required under the Advisers Act. As a result, Bloom was able to avoid disclosure of his hidden agenda to the detriment of the Investors.

Eventually, Bloom's scheme collapsed when two large investors in North Hills decided to pull all of their funds out in response to the collapse of two other unrelated fraudulent schemes. Because Bloom had already diverted much of the money away from the fund, he could only return a portion of the funds. Bloom was later indicted in the Southern District Court of New York in 2009. He pleaded guilty to various securities crimes.
After North Hills was exposed, the Investors sued the defendants for (1) controlling person liability under Section 20(a) of the Securities Exchange Act (the "Exchange Act"), (2) negligent supervision, (3) violations of Securities and Exchange Commission("SEC") Rule 10b-5, (4) violations of the Pennsylvania Unfair Trade Practice and Consumer Protection Law (the "UTPCPL"), and (5) breach of fiduciary duty. On February 17, 2012, a default judgment awarding the Investors approximately $5.7 million was entered against Bloom. At the same time, however, the District Court also granted summary judgment and dismissed all charges against the other Defendants. The Investors promptly appealed.
The Investors argued that the MB Directors and Centre Defendants' reckless failure to monitor Bloom's activities rendered them liable for Bloom's fraud. More specifically, the Investors alleged that their inaction was deliberate and intentional to further the fraud or prevent its discovery. Section 20(a) of the Exchange Act makes every person who controls any person liable under the Exchange Act liable for the violator's action. However, the Court held that in order for the MB Directors or the Centre Defendants to violate the Exchange Act as a result of inaction, the law requires plaintiffs to prove both the intent to further the fraud and the intent to prevent its discovery. The Court concluded that a claim based on inaction fails if the controlling person did not have knowledge of the controlled person's fraudulent activity. The claim will also fail if the controlling person does not have the intent to further that same activity. Here, neither the MB Directors nor Centre Defendants had the intention to further Bloom's fraud. Therefore the Investors' claim failed.

The Investors also claimed that MB Directors were liable for Bloom's fraudulent activities because they were supervisors of Bloom. Under Pennsylvania tort law, an employer may be liable under certain circumstances for negligent supervision that enabled an employee's fraudulent actions. One requirement under this tort, however, is that the defendant must qualify as an employer. The District Court ruled that the directors and officers of MB Investment were not Bloom's employers, and the Third Circuit agreed. It held that, because corporate directors and officers did not owe a duty to third parties to supervise Bloom's activities, they could not be liable for negligent supervision. Although directors have a fiduciary duty to act in good faith for the benefit of the corporation, that duty never required the day-to-day supervision of employees.
Even if MB Directors were employers of Bloom, negligent supervision under Pennsylvania law also requires employers to know or have constructive knowledge of the necessity for exercising control of an employee. Furthermore, the harm that the improperly supervised employee caused to the third party must have been reasonably foreseeable. An employer knows, or should know, of the need to control an employee if the employer knows that the employee has dangerous propensities that might cause harm to a third party. The Third Circuit held that MB Directors did not have reason to foresee the need to control Bloom with respect to his operation of North Hills. An employer has no duty to discover the fraudulent acts of an employee outside his scope of employment. While Bloom worked for MB Investment, none of his actions suggested that he would use North Hills to defraud investors. Therefore MB Directors were not liable for negligent supervision.

The District Court ruled that Altman could not be liable under Rule 10b-5 of the Exchange Act because the complaint made no allegations that he was aware of Bloom's Ponzi scheme. Furthermore, the District Court ruled that MB Investment was also not liable under Rule 10b-5 because both Bloom's fraudulent statements and Altman's alleged fraudulent statements related solely to investments in North Hills, an entity independent from MB Investment.
The Third Circuit agreed. Rule 10b-5 makes it illegal to sale any security fraudulently. To make out a securities fraud claim under Rule 10b-5, a plaintiff must show that (1) the defendant made material misrepresentations; (2) the defendant acted with the intent to deceive; and (3) the plaintiff suffered injury as a result. However, because Altman lacked the intent to deceive when he made representation that North Hills was a fine establishment to the Investors, Altman did not violate Rule 10b-5.

At trial, the Investors failed to convince the District Court that Bloom's clear violation of Rule 10b-5 should be imputed to MB Investment. On appeal, the Third Circuit decided that the District Court erred in dismissing the Investors' claim against MB Investment under Rule 10b-5. The imputation doctrine recognizes that employers are generally responsible for the acts of employees committed within the scope of their employment. The doctrine is grounded on public policy that if a principle puts an agent in the position of trust should suffer instead of an innocent stranger. Public policy concerns also implicate the adverse interest exception to the imputation doctrine. When an agent acts in his own interest, and to the corporation's detriment, the adverse interest exception will prevent imputation. The Third Circuit ruled that the determinative factor of whether the exception will apply is whether there was a sufficient lack of benefit to the corporation that it is fair to charge the third party with notice that the agent was not acting within his authority. The Third Circuit determined that whether the Investors knew Bloom was acting outside the scope of his employment with MB Investment when the securities were exchanged was a disputed issue of material fact. Therefore the District Court's summary judgment on this issue was improper.

The District Court concluded that Altman could not be held liable under the UTPCPL because the Investors did not sufficiently allege deceptive conduct on the part of Altman. The District Court also granted summary judgment to MB Investment on the UTPCPL claim. The Court recognized that statements made by Bloom could potentially be imputed to MB Investment, but it concluded under the adverse interest exception that MB was not liable. On the Investors' appeal, they argued that the District Court improperly applied the adverse interest exception because application of that exception is not determined from the perspective of the employer, but rather on how the defrauded party perceives the speaker's authority.

Pennsylvania's UTPCPL was designed to protect the public from fraud and deceptive business practices. In 1996, an amendment expanded the UTPCPL to cover deceptive as well as fraudulent conduct. Although deceptive conduct does not require proof of the elements of common law fraud, knowledge of the falsity of one's statements or the misleading quality of one's conduct is still required. Therefore, a defendant cannot be held "derivatively liable" under the UTPCPL for the fraudulent actions of a third party when plaintiff fails to allege or present any evidence that the defendant ever knowingly engaged in misrepresentation. The Third Circuit held that the Investors failed to allege conduct on Altman's part, deceptive or otherwise, that caused them to invest in North Hills. Therefore, Altman could not be liable under the UTPCPL.

With regards to the Investors' claim against MB Investment under UTPCPL, the issue is whether Bloom's violations of the UTPCPL may be imputed against MB Investment. The question again is whether Bloom acted out of self interest. The Third Circuit determined that Bloom's actions may have benefited MB Investment in part because access to North Hills was a selling point. However, the benefit was limited to only four clients. Therefore, the Court concluded that whether Investors should have known that Bloom was acting outside of his authority under MB Investment was an issue for trial. The Third Circuit concluded that the District Court erred by granting summary judgment on this issue.
The Investors claimed that Altman breached his fiduciary duty by failing to investigate North Hills before recommending it as a suitable investment. The Investors also claimed that MB Investment breached fiduciary duty by failing to recognize Bloom's fraud. The District Court rejected those contentions. It concluded that being an investment advisor at the same location as where Bloom worked did not create a fiduciary relationship on Altman's part. The Court also granted summary judgment to MB Investment because it decided that MB Investment owed no such duty to those Investors who invested directly in North Hills.

In order to succeed on a fiduciary breach claim, plaintiffs must first demonstrate that a fiduciary or confidential relationship existed. A confidential relationship exists whenever one occupies toward another such a position of advisor or counselor as reasonably to inspire confidence that he will act in good faith for the other's interest. Recognizing that the law is unclear whether a breach of fiduciary duty claim in a securities fraud case is determined under state or federal law, the Third Circuit applied the federal fiduciary standard in the breach of fiduciary claims, which requires that an investment adviser act in the "best interest" of its advisory client.
The Investors argued that Altman had a fiduciary relationship with Belmont because Belmont was an advisory client of MB Investment, and that Altman was a fiduciary to PFS because he took on an advisory role when he met with Wallace, the sole principal of PFS, to discuss North Hills. However, the Third Circuit determined that due to the minimal contact Altman had with Wallace, an investment advisory relationship was never formed. Furthermore, even if Altman had a fiduciary duty to Belmont, there was no evidence of fraud or that Altman benefited from his representation in a way that would constitute an undisclosed conflict of interest. Making an erroneous representation does not automatically count as a violation of fiduciary duty.

Perez and PFS's claim against MB Investment for breach of fiduciary duty also failed. Because the Investors signed no advisory agreements or invested money with MB Investment, there was no fiduciary duty owed. The Third Circuit noted that the Investors knew that they were dealing with Bloom and North Hills, not MB Investment.
Belmont and the Kellys also alleged that MB Investment breached its fiduciary duty to them. Unlike the other claims, there was no dispute that MB Investment owed Belmont and the Kellys a fiduciary duty as their investment adviser. Regardless, the Third Circuit determined that there was no breach. Although MB Investment's failure to uncover the North Hills fraud may have been a factor in the losses sustained by Belmont and the Kellys, it was not sufficient to establish that MB Investment failed to act solely in their interest.

The Third Circuit affirmed to the extent that the District Court dismissed all of the Investors' claims against Altman, granted summary judgment to all of the other defendants, other than MB Investment, on all of the Investors' claims, and granted summary judgment to MB on the claim for breach of fiduciary duty. The Third Circuit vacated the grant of summary judgment to MB Investment on the claims for violations of Rule 10b-5 and the UTPCPL, and it remanded this case for a trial with respect to those claims against MB Investment.
See full opinion at

Panel: Scirica, Fisher, and Jordan, Circuit Judges

Argument Date: November 13, 2012

Argument Location:

Date of Issued Opinion: February 22, 2013

Docket Number: No. 12-1580

Decided: Affirmed in part, vacated in part, and remanded for further proceedings.

Case Alert Author: Tien Cheng

Counsel: Joseph R. Loverdi and Paul C. Madden, Buchanan Ingersoll & Rooney; Peter J. Hoffman and Jeffrey P. Lewis, Eckert, Seamans, Cherin & Mellott; Counsel for Appellants. Edward D. Kutchin and Kerry R. Northup, Berluti McLaughlin & Kutchin; Joshua S. Amsel, Weil, Gotshal & Magnes; Teresa N. Cavenagh, Duane Morris; Alan T. Gallanty, Kantor, Davidoff, Wolfe, Mandelker, Twomey & Gallanty; Joseph J. Langkamer and Samuel W. Silver, Schnader Harrison Segal & Lewis; Counsel for Appellee.

Author of Opinion: Jordan, Circuit Judge

Circuit: Third Circuit

Case Alert Circuit Supervisor: Mark Rahdert

    Posted By: Susan DeJarnatt @ 02/25/2013 12:28 PM     3rd Circuit  

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