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3. Controlling Person Liability under Section 20(a).
Plaintiffs have also invoked Section 20(a), 15 U.S.C. 78t, in their attempts to lasso clearing firms. Here again, many of those claims have failed once their allegations were scrutinized in the course of Rule 12(b)(6) motions. In Damato v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 878 F. Supp. 1156 (N.D. Ill.1995), the court examined allegations that the clearing firm suffered controlling person liability by facilitating a fraudulent scheme when it knowingly accepted third party checks into a trading account. The court began its analysis by reciting the Seventh Circuit's test for Section 20(a) liability: did the alleged control person actually exercise general control over the controlled person's operations; and did the alleged control person have the power or ability to control the transaction or act giving rise to the primary violation even if the power was not exercised, Id. at 1159. Turning to the complaint, the court remarked that there was no allegation that Merrill Lynch had the power to control the trading entity's activities; rather, the plaintiffs simply pled that the clearing broker had permitted cash deposits and withdrawals to occur: "The mere fact that Merrill Lynch had the power to refuse to process Hoffberg's transactions is insufficient to establish control person liability . . . ., id., citing Carlson v. Bear Stearns & Co., 906 F.2d 315, 318 ("Under the federal securities laws, clearing agents performing operational or ministerial duties have not been considered controlling persons nor subject to liability"). The court then dismissed the Section 20(a) claim.
Blech I, supra, also alleged a Section 20(a) claim. Citing Dillon, supra, the court observed that the allegations simply reflected that Bear Stearns was performing the stereotypical functions of a clearing firm and, hence, there could be no fraud inference. Notably, the absence of any allegations that Bear Stearns had made customer account decisions coupled with no duty to disclose the introducing broker's fraud (even if known by the clearing firm) warranted dismissal, id. at 1295. Turning directly to the Section 20(a) claim, the court observed that under Second Circuit decisions, the plaintiffs were burdened with pleading facts demonstrating that the alleged controlling person was in some meaningful sense, a "culpable participant" in the primary wrongdoer's fraud, Id. at 1299. The complaint having failed to allege such facts, it was dismissed for failure to state a claim.
It is noteworthy to observe that a clearing firm's potential Section 20(a) liability can hinge on the plaintiff's choice of forum. For example, the Second Circuit relies upon the "culpable-participant" test to evaluate the conduct of those persons charged with Section 20(a) liability, Blech I, supra. Contrarily, in Harrison v. Dean Witter Reynolds, Inc., 974 F.2d 873 (7th Cir. 1992), the Seventh Circuit eschewed the culpable-participant test: "Clearly, we have never approved or used the culpable-participant test, nor have we ever used any similar test to so stingily limit the definition of control person," id. at 879. Rather, the circuit focuses upon whether (i) the alleged control person actually participated in the operations of the controlled person via exercise of control generally; and (ii) whether the alleged control person possessed the power or ability, whether or not exercised, to control the specific transaction or activity forming the primary violation, id. at 881.
Harrison relied in part upon the Carlson case, supra, an earlier Seventh Circuit decision which analyzed controlling person liability under Illinois' securities legislation. The Carlson plaintiffs contended that Bear Stearns was jointly liable for the sale of unregistered securities because its clearing disclosure letter pursuant to NYSE 382 reserved it the right to reject account securities orders. Citing the general non-liability rule, the court held that possessing the right to reject orders did not correspondingly create a duty not to accept a tainted securities transaction: "Yet, this alone will not bootstrap a clearing agent into a controlling or facilitating party any more than the actions of an attorney or an accounting firm will make those parties jointly or severally liable. The sale of securities, like any exchange of property in an advanced society, is usually a rather complex and convoluted transaction which requires the expertise and involvement of several parties to succeed," id. at 318, 319. Accord O'Keefe v. Courtney, 655 F. Supp. 16 (N.D. Ill. 1985) (plaintiff's allegation that clearing firm failed to use its influence to insure broker's disclosure about high-risk trading, insufficient to invoke Section 20(a) liability); Baum v. Phillips, Appel & Walden, Inc., 648 F. Supp. 1518 (S.D.N.Y. 1986) (summary judgment granted in clearing broker's favor on Section 20(a) and respondeat superior claims given the firm's limited role and dealings).
The difficulties of proving a Section 20(a) claim against clearing brokers was reemphasized in Blech III, supra. As noted, the court determined that the plaintiffs' realleged Section 10(b) and fraud claims would withstand dismissal. However, the newly amended Section 20(a) claim did fall prey to Bear Stearns' motion to dismiss. The claim failed to allege any facts evidencing that Bear Stearns had the power to direct or control Blech's management and activities or that it was in some meaningful sense a culpable participant in the underlying fraud transaction perpetrated by the controlled person: "Bear, Stearns did not have the power to direct or cause the direction of the management and policies . . . through the ownership of voting securities, by contract, or in any other direct way," id. at 586. The evolution of pleadings between Blech I and Blech III, then, underscores the difficult pleading burdens facing plaintiffs who wish to assert Section 20(a) claims even when coupled with viable Section 10(b) contentions.