Third Circuit: Securities Fraud Liability May Be Imputed To Employer Whose Employee Ran Ponzi Scheme On The Side

by Pepper Hamilton LLP
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On February 22, 2013, in the precedential opinion in Belmont v. MB Inv. Partners, Inc., a unanimous panel of the U.S. Court of Appeals for the Third Circuit (Judges Anthony J. Scirica, D. Michael Fisher and Kent A. Jordan) reversed in part a ruling of the District Court for the Eastern District of Pennsylvania (Judge Berle M. Schiller). In an opinion authored by Judge Jordan, the Third Circuit held that plaintiff investors were entitled to a trial on the question of whether an investment firm, MB Investment Partners, Inc. (MB), was liable under federal securities law and a state statute for the fraudulent statements of an employee. The employee and senior executive, Mark Bloom, had pleaded guilty to criminal charges relating to a hedge fund-cum-Ponzi scheme that he ran and plundered outside the scope of his MB employment. The plaintiffs had all invested in the hedge fund, North Hills, L.P. (North Hills), based on Bloom’s fraudulent advice. MB promoted North Hills and managed certain investments in the fund, but did not know of, participate in or profit from Bloom’s fraud. The plaintiffs suffered substantial losses and MB ceased operations after Bloom’s scheme unraveled.

The plaintiff investors brought suit in the district court against MB, certain of MB’s officers and directors, Bloom, and others, asserting claims under Section 20(a) of the Securities and Exchange Act and SEC Rule 10b-5. They also alleged state law negligent supervision and fiduciary duty claims, and claims under Pennsylvania’s Unfair Trade Practices and Consumer Protection Law (UTPCPL). The District Court dismissed or granted summary judgment on all claims as to all defendants except Bloom, concluding that the plaintiffs and the other defendants were all his victims. Bloom defaulted and was not a party to the appeal.

Under the facts as reviewed by the Third Circuit, Bloom’s fraud was undisputed. The negligent supervision claims against the MB directors failed because the directors were not Bloom’s “employers” and, though the directors were aware of Bloom’s involvement in North Hills, they did not know or have reason to know about his fraudulent acts. Similarly, the claim for control person liability under Section 20(a) of the Securities Exchange Act failed because the plaintiffs were unable to point to any evidence that the MB directors participated in the fraud or were intentionally inactive in preventing it. The fiduciary duty claims failed either because the plaintiffs did not show that fiduciary duties existed as between certain defendants and plaintiffs, or that certain defendants had conflicts of interest in recommending the North Hills investment. Furthermore, as to an individual MB executive defendant, the District Court properly rejected the Rule 10b-5 claim for lack of scienter and the UTPCPL claims for failure to show deceptive practices by the executive or reliance by the plaintiffs.

However, the Third Circuit parted ways with the District Court on the Rule 10b-5 and UTPCPL claims against MB. The question of 10b-5 liability turned on whether Bloom’s undisputed fraud could be imputed to MB as Bloom’s employer. The Third Circuit reasoned that even though 10b-5 is a federal provision, the question of imputation under the rule is decided as a matter of state law. Pennsylvania’s imputation doctrine would apply if Bloom acted with the apparent authority of MB, even if his conduct was unauthorized and for his own benefit. According to the Third Circuit, that rule of liability is grounded in public policy whereby the person who should bear the risk of an agent’s fraud is the principal that empowers the agent, rather than an innocent third party.

The Third Circuit further reasoned that the imputation question turned on whether the “adverse interest” exception to the doctrine applied. That exception relieves a principal of imputed liability if the lack of benefit to the principal is sufficient to charge the third party with notice that the agent is not acting within the principal’s authority. The District Court had concluded that Bloom was outside of MB’s authority merely because Bloom acted for his own benefit, and also concluded that Bloom’s interests were sufficiently adverse to MB because the fraud ultimately destroyed MB. But the Third Circuit stated that an agent may still act with apparent authority vis-à-vis a third party even if the agent is acting solely in his own interest, and that the ultimate destruction of MB did not occur until after the plaintiffs were induced to invest in North Hills in the course of Bloom’s fraud. Thus, there remained a triable question of fact as to whether the manner in which Bloom marketed North Hills to the plaintiffs made it appear that he did so within the scope of his employment, thereby imputing Rule 10b-5 liability to MB. A similar imputation question remained for the trier of fact with regard to the UTPCPL claim against MB.

Thus, Belmont cautions businesses, and investment firms in particular, to exercise care in empowering their employees and agents. MB had no affirmative duty to discover Bloom’s fraud, but could have averted potential liability, and possibly its demise, by conducting diligence on the products Bloom offered. Although an extreme case, the decision demonstrates that employers may not be immune from an employee’s self-interested fraud, even if the fraud is unknown to the employer and harmful to the employer and its clients alike.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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