SEC Shingle Theory: Continuing Viability; Continuing Questions
By Franklin D. Ormsten*

Here's a scenario that sometimes arises in a securities arbitration.

The Claimant alleges that he's been bilked by a super aggressive retail selling operation. Coupled with that allegation is the claim that he's been charged excessive, even exorbitant prices way above permissible markups and allowable spreads. Claimant caps those allegations with the claim of wrongful concealment not only did respondent broker-dealer overcharge, but it compounded that wrong by concealing the excess charges.

The respondent broker-dealer counters those charges by asserting that all requisite disclosure was made. Transaction confirmations that were sent to the claimant investor reflected price and markup information as required by the SEC. Claimant answers this defense with the argument that the broker-dealer's dominated and controlled market allowed it to charge prices way beyond permissible markups which charges should have been disclosed. In support of his contention claimant cites the SEC's shingle theory.

It's a theory that has an ancient lineage and, as will be shown, one that retains its viability and application to current litigation and arbitrated disputes between brokers and investors. The strengths, weaknesses, and continuing relevance of the theory are the subject of this article. The best place to start is with a definition.

The shingle theory holds that when a broker hangs out its shingle to do business it impliedly represents that it will deal fairly with its customers and in accordance with industry standards. The theory had its origins in an early SEC administrative case. In re Duker & Duker, 6 SEC 386, 388 (1939). Most often the theory is applied to the concept of fair pricing and full disclosure. An early and important case, Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), cert. denied, 321 U.S. 786, illustrates this.

In Hughes the broker-dealer's license had been revoked by the SEC and the broker-dealer petitioned to overturn the revocation in the Second Circuit Court of Appeals. In reviewing the facts of the underlying proceeding, the Court of Appeals found that some of the prices charged by the broker exceeded market price by as much as 40 percent. The court also found a failure by the respondent broker to disclose true market prices to investors. Thus, the essential finding of the Hughes case was twofold: that the broker-dealer charged excessive prices and that it failed to disclose those charges. At page 446 of the opinion the court encapsulated its holding:

"An over the counter firm which actively solicits customers and then sells them securities at prices far above the market as were those which petitioner charged here must be deemed to commit fraud."

Language in the opinion that emphasized the (1) benighted nature of the investors ("...customers were almost entirely single women or widows who knew little or nothing about securities...."); (2) the expertise ("expert knowledge and proffered advice") of the broker-dealer; and, (3) the reliance of investors ("confidence ... instill[ed] in the customers") seems to sound in a theory of fiduciary responsibility. But the essential rationale of the opinion is SEC shingle theory grounded on the professional status of the broker-dealer and attendant requirements of full disclosure.

The continuing viability of the shingle theory, particularly as applied to the practice of overcharging customers, is shown by SEC v. First Jersey Securities, Inc., 101 F.3d 1450 (2d Cir. 1996). In First Jersey the Second Circuit upheld the district court's finding of a broker-dealer's securities law violations. And, in support of its holding, the court, at p. 1469 of its opinion, cited directly to the Hughes opinion in observing that sales "of securities by broker-dealers to their customers carry with them an implied representation that the prices charged in those transactions are reasonably related to the prices charged in an open and competitive market."

In furtherance of its holding the court analyzed First Jersey's position in the market for the securities it sold to its customers (it found it dominated and controlled such market) and found, too, that the prices charged in such market were excessive. The First Jersey analysis illustrates the scenario of allegation and denial with which this article opens. The court's reasoning says, effectively, that the cure for such market domination and control and the excess pricing it allows, is fairness in pricing and/or disclosure as to the nature of the prices charged:

"In sum, we see no error in the district court's findings that First Jersey sold securities to its customers at prices that included excessive markups, that it was able to do so in part because of its nondisclosures to customers as to the nature of the market and the Firm's control of the market, and that the purpose of the nondisclosures was to facilitate the excessive markups. The district court correctly concluded that this conduct violated sections 17(a) and 10(b) and Rule 10b-5."

Recently the Second Circuit affirmed the continuing viability of the shingle theory and its concomitant requisite of full and fair disclosure in Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184 (2d Cir. 1998). Grandon has special relevance for parties in arbitration because unlike Duker & Duker, supra, an SEC administrative case, and First Jersey, supra, an SEC injunctive action, it was a dispute over pricing and disclosure by private parties. In reversing the district court, which had granted defendant Merrill Lynch's motion to dismiss, the Second Circuit held that a private action exists where excessive markups are charged, without proper disclosure, on sales of municipal bonds. Other cases, such as Hughes and First Jersey had involved equity securities.

Finding a cause of action to exist the Grandon court closely echoed the earlier language of Hughes and First Jersey that there is an implied representation that prices charged will be a reflection of those attained in an open and competitive market. And, at p. 192 of the opinion, the court referred approvingly to SEC enforcement actions based on the "shingle theory" that inferred from a broker-dealer's "hanging out its shingle" a "duty to disclose excessive markups." The court also cited Ettinger v. Merrill Lynch, Pierce, Fenner & Smith, Inc,, 835 F.2d 1031, 1033 (1987), a Third Circuit case which had similarly endorsed the shingle theory.

Indeed, Grandon quoted (at p. 192 of the opinion) language from Ettinger that gives the nub of the shingle theory:

"In recognizing a private right of action under Section 10(b) and Rule 10b-5, the Ettinger court noted 'the SEC has established through its enforcement actions the principle that charging undisclosed excessive commissions constituted fraud.' Ettinger, 835 F.2d, at 1033. This fraud is 'avoided only by charging a price which bears a reasonable relation to the prevailing price or disclosing such information as will permit the customer to make an informed judgment upon whether or not he will complete the transaction.'"

Why is the shingle theory requirement for fair pricing or, in the alternative, full disclosure concerning the material facts about prices and markets, so important? Because in the absence of any other legal requirement, the shingle theory provides a uniform, understandable, court-approved requirement for fair pricing and full disclosure. The main legal requirement that, absent the shingle theory, would require such disclosure is a fiduciary relationship between the broker and his customer. 

The fact is, however, that a fiduciary relationship is not always found as between brokers and customers. New York courts provide a case in point. They hold, generally, that "a broker does not, in the ordinary course of business, owe a fiduciary duty to a purchaser in securities." (Citations omitted). Fekety v. Gruntal & Co., Inc., 595 N.Y.S.2d 190 (App. Div. 1st Dept. 1993). Press v. Chemical Investment Services Corp., 988 F. Supp. 375 (S.D.N.Y. 1997) is decidedly to the same effect, emphasizing with numerous citations that the mere existence of a broker-customer relationship is not proof of its characte

Without the existence of a fiduciary relationship the requirement of disclosure (as to pricing and, indeed, as to many aspects of the broker-customer relationship) is, to say the least, questionable. On at least two occasions the United States Supreme Court has made that point in explicit language. Thus, in Basic Inc. v. Levinson, 485 U.S. 224. 239, n. 17 (1988), it opined that "silence is not actionable unless there is a duty to disclose." And, in the insider trading case of Chiarella v. United States, 445 U.S. 222, 228 (1980), the court explained that the duty to disclose "arises when one party has information that the other [party] is entitled to know because of a fiduciary or other similar relationship of trust and confidence between them."

Respondent attorneys in an arbitration involving issues of pricing and disclosure would be remiss if they did not cite cases like Basic and Chiarella, where liability against their clients was sought to be imposed based on unfair pricing coupled with claims of incomplete disclosure. Indeed, there is an open question as to whether the shingle theory itself (despite its recent court endorsement) can continue to hold sway as against the Supreme Court's explicit linking of disclosure to fiduciary obligation.

For now, certainly, the shingle theory should be a basic component of claims based on excessive pricing and nondisclosure. Respondents' challenge to such claims should start by emphasizing the close, possibly exclusive, link between the requirement of disclosure and fiduciary obligation. In concluding this discussion it is worth noting that the tension between shingle theory and fiduciary law has been implicit from the early days of SEC jurisprudence. This is shown by the 1949 case of Hughes v. SEC, 174 F.2d 969 (D.C. Cir. 1949) that also involved a broker named Hughes, but not the Charles Hughes featured in the earlier case.

Indeed, for those who find serendipitous coincidence beguiling, it can be noted that both Hughes cases were federal court of appeals cases; both were appeals from SEC license revocations; both involved issues of excess charges and incomplete disclosure; and, both, though actually decided by a different judge, resulted in opinions authored by a judge named Clark. The crucial similarity between the cases is that both upheld the SEC shingle theory in decrying the wrongs of an errant broker. The real, though subtle, difference between the cases was that the second, later Arleen Hughes case is much more ambivalent about the source of a broker's disclosure obligation.

The first Hughes court was clearer, more tightly focused, in seeing SEC shingle theory as the legal source of disclosure whereas the Arleen Hughes opinion's approach to broker-dealer disclosure requirements was marked by repeated references to the fiduciary status of the petitioner broker-dealer. Perhaps this was so because Arleen Hughes acted as both a broker and in the more traditional and obvious fiduciary role of investment advisor. 

The court's opinion is replete with references to Arleen Hughes' fiduciary status. Thus, it is noted at p. 971 that the SEC Order of Proceeding against Hughes had alleged that she was in a "fiduciary relationship" with her clients; and noted again at p. 971, that the examiner's report had found that Hughes had "violated her duty as a fiduciary;" noted, too, at p. 972 that the Commission had "found that Hughes was a fiduciary." The court further observed, at p. 975, that in "the vast majority of transactions between this petitioner and her clients, petitioner concededly acted as a fiduciary" and it further observed at p. 976 that petitioner was "one who had acted as an admitted fiduciary." Notwithstanding such repeated characterizations, the court was explicit in not making fiduciary status per se the basis of its decision:

"But the Commission in this case did not, and we in turn do not, base the validity of the revocation order upon common law principles of fraud or deceit. Section 17(a) of the Securities Act of 1933, Sections 10(b) and 15(c)(1) of the Securities Exchange Act of 1934 and Commission-made rules thereunder in prohibitory language, set out the statutory proscription as to the conduct of the business of a broker and dealer in securities." Id. at 975.

The court continued by pointing out in shingle theory like language that the securities business, specialized and intricate, requires "unique legal treatment." It then went on to apply the legal requirement of full and complete disclosure to brokers in holding that Hughes' failure to provide informative pricing data to clients was a violation of the "antifraud sections" of the SEC statutes. In essence this second (1949) Hughes case bore the superstructure of a shingle theory decision resting firmly on a foundation of repeatedly cited fiduciary fact. Such a holding reveals the historic tension between the expansiveness of shingle theory law and the restrictiveness that inheres in holding a genuine fiduciary relationship as the essential prerequisite for disclosure.

Claimants' counsel who bring cases on issues of pricing and disclosure should, of course, direct the arbitrators' attention to the precedential basis of shingle theory holdings; respondents' counsel will respond by pointing to the limitations of fiduciary law and the tensions between it and the shingle theory implicit now for at least the last fifty years.

Hopefully, this article has armed all positions of advocacy on this issue with a heightened awareness of potential differences of analysis and approach.

* Franklin D. Ormsten is a partner in Ormsten & Evangelist, a law firm in Jericho, Long Island, specializing in the representation of parties, both claimants and respondents, in securities arbitrations.

Reference: Securities Arbitration Commentator, Vol. X, No. 8

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