807 F.

2d 297

Fed. Sec. L. Rep. P 93,013

Leonard BRAWER, Plaintiff-Appellant,
v.
The OPTIONS CLEARING CORPORATION and American
Stock
Exchange, Inc., Defendants- Appellees.
No. 102, Docket 86-7416.

United States Court of Appeals,

Second Circuit.
Argued Oct. 8, 1986.
Decided Dec. 11, 1986.

A. Arnold Gershon, P.C., New York City, for plaintiff-appellant.

Roger Pascal, Chicago, Ill. (Burton R. Rissman, Joseph H. Nesler, Schiff
Hardin & Waite, Chicago, Ill.; M. William Munno, Seward & Kissel, New
York City, of counsel), for defendant-appellee The Options Clearing
Corp.
Lord, Day & Lord, New York City (Eugene F. Bannigan, Gordon L.
Nash, Laurie E. Foster, Monica A. Derham, of counsel), for defendantappellee The American Stock Exchange, Inc.
Richard A. Kirby, Asst. Gen. Counsel, S.E.C., Washington, D.C. (Paul
Gonson, Solicitor, Daniel L. Goelzer, Gen. Counsel, Jacob H. Stillman,
Associate Gen. Counsel, Leslie E. Smith and Katharine Gresham,
Attorneys, S.E.C., Washington, D.C., of counsel), as amicus curiae.
Before LUMBARD, CARDAMONE, and PIERCE, Circuit Judges.
LUMBARD, Circuit Judge:

Leonard Brawer appeals from a judgment dismissing his complaint against

defendants The Options Clearing Corporation (OCC) and American Stock
Exchange, Inc. (AMEX) entered in the Southern District by Judge Louis L.

Stanton on April 29, 1986. Brawer's complaint alleges that OCC and AMEX
violated Secs. 6(b), 17A(b)(3), and 19(g)(1) of the Securities Exchange Act of
1934, as amended (the Act), 15 U.S.C. Secs. 78f(b), 78q-1(b)(3), and 78s(g)(1)
respectively,1 by failing to comply with their own rules. The district court, in an
opinion reported at 633 F.Supp. 1254 (1986), dismissed the complaint,
concluding that Brawer lacked a private right of action. OCC and AMEX, in a
joint brief, argue that the district court should be affirmed either on the ground
stated in its opinion or on the alternative ground that Brawer failed to allege
fraud or bad faith in his complaint. The Securities and Exchange Commission
(SEC) also submits an amicus brief which urges affirmance on the latter
ground. Agreeing with this position, we affirm and hold that a private cause of
action against an exchange or a clearinghouse for failure to comply with one of
its rules which requires an exercise of discretion, if one exists at all, may be
brought only if it is premised upon allegations of fraud or bad faith.2
2

Brawer alleges the following: AMEX, a national securities exchange registered

pursuant to Sec. 6 of the Act, 15 U.S.C. Sec. 78f, maintains a market for trading
in stocks, bonds and options. All options listed on AMEX are cleared through
OCC, a clearing agency registered under Sec. 17A, 15 U.S.C. Sec. 78q-1. Both
AMEX and OCC are selfregulatory organizations (SROs) as defined by Sec.
3(a)(26) of the Act, 15 U.S.C. Sec. 78c(a)(26). Phillips Petroleum Company
(Phillips), whose stock trades exclusively on the New York Stock Exchange,
lists its options on AMEX. Brawer sold--in securities parlance "wrote" or took a
"short" position in--a number of puts in Phillips stock which were outstanding
on March 1, 1985.

A "put option" obligates the seller (writer) to buy shares of the underlying
security at a stated price (exercise price), if the buyer (holder) decides to
exercise the option prior to its expiration date. Generally, one purchases a put
option as insurance. A put option establishes a floor at which the holder will
always be able to sell the underlying security; if the price drops below the
option's stated exercise price, the holder will be able to invoke the option and
sell the securities. On the other side, the option writer essentially takes on the
downside risk in exchange for the price of the option. Therefore, if the price of
the underlying security falls precipitously, as apparently happened to Phillips
stock in this case, the writer may suffer a significant loss.

In December, 1984, a Texas partnership led by T. Boone Pickens, Jr.

announced an unsolicited tender offer for Phillips stock. As a defensive tactic,
Phillips' board of directors proposed a plan which included the exchange of its
own debt securities for 38 per cent of its common stock, the sale of 32 million
newly issued shares of common stock to an employee stock ownership plan,

and the purchase of the Texas partnership's stock in Phillips at a premium. The
price of Phillips stock fell substantially upon the announcement of the plan.
The plan did not become effective, however, because it failed to receive the
requisite number of votes at a special meeting of Phillips shareholders.
5

Shortly after this plan was proposed, another hostile bidder for Phillips
emerged, led by Carl Icahn of New York. Between the close of business on
Friday, March 1, and the opening of trading on Monday, March 4, Phillips
fashioned and announced a second financing scheme. Under this second plan,
Phillips would issue a package of debt securities for half of its outstanding
common stock. In its offer to purchase, Phillips noted that the likely effect of its
offer would be to drive down the price of its common stock. The second hostile
bidder withdrew its tender offer in response to this plan.

Both AMEX and OCC have procedures for adjusting option prices in response
to changes in the market for an underlying security. AMEX rules 902 and 9033
make options being traded on AMEX subject to adjustment in accordance with
OCC rules. Article VI, Section 11(d) of OCC's Bylaws4 provides that in the
case of a "reorganization, recapitalization, reclassification or similar event"
affecting the underlying security, "the Securities Committee shall make such
adjustments in the exercise price, trading unit or number of contracts ... as that
Committee in its sole discretion determines to be fair to the holders and writers
of such option contracts."

Although OCC and AMEX had indicated that they would adjust if the first plan
became effective, they made no adjustment in response to the second plan. Nor
did they halt trading after the announcement of the second financing plan.
When trading opened on Monday, March 4, 1985, the prices of Phillips options
rose immediately and steeply as the market responded to expectations of a
decline in Phillips stock after the plan was implemented. During the following
week, OCC and AMEX received numerous telephone calls asking whether they
would adjust Phillips options prices in response to the second financing plan.
Both OCC and AMEX indicated that no adjustments were likely. The OCC
Securities Committee, consisting of two officers of AMEX and the chairman of
OCC, held a telephone meeting on Thursday, March 7, 1985, at 3:30 in the
afternoon, to discuss the question. They decided that the transaction should be
classified as an exchange offer,5 and, in accordance with longstanding policy,
decided not to adjust prices in response. This decision was announced prior to
trading on Friday, March 8. Brawer alleges that the Securities Committee took
this action because they believed that unadjusted Phillips options would be
more useful as instruments of arbitrage, thereby increasing the trading volumes
and revenues of the exchanges.

In an effort to recover his losses, Brawer commenced this action on behalf of

himself and all other writers of Phillips puts who had options outstanding on
March 1, 1985. OCC and AMEX moved to dismiss the complaint on two
grounds. First, they claimed that the Act does not create a private cause of
action for the failure of an exchange or a clearing house to comply with its own
rules. Second, they argued that, even if a cause of action existed, a claim that
OCC and AMEX failed to comply with their respective adjustment rules could
stand only if the complaint alleged bad faith or fraud. The district court granted
the motion on the first ground and dismissed the complaint, concluding that the
Supreme Court's recent reluctance to imply causes of action under federal
statutes, combined with the changes made by the 1975 Amendments to the Act,
had undermined Baird v. Franklin, 141 F.2d 238 (2d Cir.), cert. denied, 323
U.S. 737, 65 S.Ct. 38, 89 L.Ed. 591 (1944), and eliminated the private right of
action for violations of these three sections.6 Consequently, it did not consider
defendants' second argument. We affirm because Brawer failed adequately to
allege fraud or bad faith.

Brawer asks us to reaffirm the private cause of action established in Baird for
the failure of an exchange to enforce its rules as required by pre-1975
Amendments Sec. 6, and to extend it to include a cause of action for the failure
of an exchange to comply with its own rules under Secs. 6, 17A, and 19, as
amended. However, here the action involved was discretionary. Courts have
consistently held that "absent allegations of bad faith [an exchange and its
officials] may not be held for discretionary actions taken in the discharge of
their duties pursuant to the rules and regulations of the Exchange." P.J.
Taggares Co. v. New York Mercantile Exchange, 476 F.Supp. 72, 76
(S.D.N.Y.1979). We recently reaffirmed this view in Sam Wong & Son, Inc. v.
New York Mercantile Exchange, 735 F.2d 653, 670 (2d Cir.1984) ("That bad
faith is the standard of liability for suits against an exchange with respect to its
taking action authorized by applicable law has been established at least since
Daniel v. Board of Trade, 164 F.2d 815 (7 Cir.1947)...."). That these decisions
involved suits under the Commodity Exchange Act, 7 U.S.C. Sec. 1 et seq.,
makes no difference. The bad faith standard expressly established by Congress
for Commodity Exchange Act cases in a 1982 amendment, 7 U.S.C. Sec. 25(b)
(4), merely codified existing case law under that statute, 735 F.2d at 676 n. 30.7
Moreover, courts have applied the bad faith standard in suits alleging violations
of discretionary rules by the securities exchanges as well. See, e.g., Schonholtz
v. American Stock Exchange, Inc., 376 F.Supp. 1089, 1092 (S.D.N.Y.)
(dismissing complaint because allegations of exchange rule violations were not
coupled with claims of fraud), aff'd, 505 F.2d 699 (2d Cir.1974) (per curiam)
and cases cited therein. But cf. Rich v. New York Stock Exchange, 522 F.2d
153, 155 n. 4 (2d Cir.1975) (noting that the courts apply a negligence standard

to claims that an exchange failed to supervise adequately its members).

10

There are good reasons why a negligence standard has not been and should not
be applied to SRO decisionmaking.8 First, applying a negligence standard in
such cases would force a court to substitute its judgment for that of the experts
on the exchange. See Aronson v. McCormick, 13 Misc.2d 1077, 178 N.Y.S.2d
957, 959 (Sup.Ct.), aff'd mem., 6 A.D.2d 999, 177 N.Y.S.2d 1004 (1958). In
doing so, a court would be aided neither by specific statutory standards nor by
any particular financial expertise, cf. Auerbach v. Bennett, 419 N.Y.S.2d 920,
926, 47 N.Y.2d 619, 630, 393 N.E.2d 994, 1000 (1979). Moreover, after-thefact litigation would be a "most imperfect device" with which to evaluate SRO
decisions. Cf. Joy v. North, 692 F.2d 880, 886 (2d Cir.1982), cert. denied, 460
U.S. 1051, 103 S.Ct. 1498, 75 L.Ed.2d 930 (1983).

11

Second, such an intrusion would conflict with the Congressional scheme of

exchange self-regulation. As the Supreme Court recognized in Silver v. New
York Stock Exchange, 373 U.S. 341, 352, 83 S.Ct. 1246, 1254, 10 L.Ed.2d 389
(1963), quoting Justice Douglas during his tenure as Chairman of the SEC, the
intention of the Act was "one of 'letting the exchanges take the leadership with
Government playing a residual role. Government would keep the shotgun, so to
speak, behind the door, loaded, well oiled, cleaned, ready for use but with the
hope it would never have to be used.' " A negligence standard would bring the
government's "shotgun" into almost everyday use.

12

Third, this governmental intrusion, particularly if it did not employ statutory

standards of review, would only serve to increase market uncertainty. Every
decision made by a SRO would be subject to litigation and judicial review
because "any decision the Committee makes will benefit one group of option
investors at the expense of another." 633 F.Supp. at 1261-62. The resulting
uncertainty benefits no one. See, e.g., J. Pappas & E. Brigham, Managerial
Economics, 82-86 (3d ed. 1979). As the SEC pointed out in its amicus brief, "
[w]hat is essential in such a situation, for the benefit of all investors, is that the
decision be made fairly and considered final."

13

Brawer's argument that OCC's adjustment rule is not discretionary need not
detain us long. Although the rule employs the imperative "shall", it also vests
the decision as to what adjustments should be made "in the sole discretion" of
the Securities Committee. OCC and AMEX read the rule as allowing the
Securities Committee discretion whether to make any adjustments at all. We
agree. See, e.g., Fogel v. Chestnutt, 533 F.2d 731, 753 (2d Cir.1975) ("an
exchange has a substantial degree of power to interpret its own rules"), cert.
denied, 429 U.S. 824, 97 S.Ct. 77, 50 L.Ed.2d 86 (1976); Intercontinental

Industries, Inc. v. American Stock Exchange, 452 F.2d 935, 940 (5th Cir.1971)
("Since these are the rules of the Exchange, it should be allowed broad
discretion in the determination of their meaning and application."), cert. denied,
409 U.S. 842, 93 S.Ct. 41, 34 L.Ed.2d 81 (1972).
14

In his complaint, Brawer alleges that the Securities Committee decided not to
adjust because unadjusted options were more efficient as instruments of
arbitrage and therefore generate increased trading volumes and revenues. Even
if Brawer's claim is true, and OCC and AMEX disagree with the factual
premise, he has not made out a sufficient claim of bad faith. As we recently
recognized in denying a similar claim of bad faith as too remote and
speculative, "[i]f such a degree of self-interest were allowed to demonstrate bad
faith, then exchange board members ... would inevitably be subject to bad-faith
charges, and the concept of exchange self-regulation would be undermined."
Sam Wong, 735 F.2d at 672 (quoting, Jordon v. N.Y. Mercantile Exchange,
571 F.Supp. 1530, 1545 (S.D.N.Y.1983)). Nor do we give any weight to
Brawer's argument that bad faith may be found because there was no significant
distinction between the first Phillips financing scheme, which apparently would
have prompted OCC and AMEX to adjust option prices, and the second
financing scheme, which resulted in no action by OCC and AMEX. The
Securities Committee found that the two financing schemes were sufficiently
different to justify different treatment. We decline to substitute our judgment for
theirs. 9

15

More troublesome is Brawer's claim that OCC and AMEX sterilized their
discretion by waiting over three trading days before meeting to decide whether
to adjust. This delay was compounded by the allegation that OCC and AMEX
staff members had been stating as early as Monday, March 4 that no adjustment
would be made. Brawer claims that by the time the Securities Committee met,
they could make no other decision than not to adjust. However, some of that
time was apparently spent marshalling information about the second financing
scheme. Without this information the Securities Committee would have been
subject to a claim of bad faith for failing to be adequately informed.10 Thus, we
are reluctant to require such a Committee to make a "snap" decision. While the
issue is close, we think that the mere failure to hold a meeting until three days
after the announcement of the second financing scheme does not, without more,
amount to a claim of bad faith.

16

Affirmed.

Sections 6(b)(1) and (5), 15 U.S.C. Secs. 78f(b)(1) and (5), as amended, state:

Sections 6(b)(1) and (5), 15 U.S.C. Secs. 78f(b)(1) and (5), as amended, state:
(b) An exchange shall not be registered as a national securities exchange unless
the Commission determines that-(1) Such exchange is so organized and has the capacity to be able to carry out
the purposes of this chapter and to comply, and (subject to any rule or order of
the Commission pursuant to section 78q(d) or 78s(g)(2) of this title) to enforce
compliance by its members and persons associated with its members, with the
provisions of this chapter, the rules and regulations thereunder, and the rules of
the exchange.
(5) The rules of the exchange are designed to prevent fraudulent and
manipulative acts and practices, to promote just and equitable principles of
trade, to foster cooperation and coordination with persons engaged in
regulating, clearing, settling, processing information with respect to, and
facilitating transactions in securities, to remove impediments to and perfect the
mechanism of a free and open market and a national market system, and, in
general, to protect investors and the public interest; and are not designed to
permit unfair discrimination between customers, issuers, brokers, or dealers, or
to regulate by virtue of any authority conferred by this chapter matters not
related to the purposes of this chapter or the administration of the exchange.
In relevant part, Secs. 17A(b)(3)(A), (F), and (G), 15 U.S.C. Secs. 78q-1(b)(3)
(A), (F), and (G) provide:
(3) A clearing agency shall not be registered unless the Commission determines
that-(A) Such clearing agency is so organized and has the capacity to be able to
facilitate the prompt and accurate clearance and settlement of securities
transactions for which it is responsible, to safeguard securities and funds in its
custody or control or for which it is responsible, to comply with the provisions
of this chapter and the rules and regulations thereunder, to enforce (subject to
any rule or order of the Commission pursuant to section 78q(d) or 78s(g)(2) of
this title) compliance by its participants with the rules of the clearing agency,
and to carry out the purposes of this section.
(F) The rules of the clearing agency are designed to promote the prompt and
accurate clearance and settlement of securities transactions, to assure the
safeguarding of securities and funds which are in the custody or control of the
clearing agency or for which it is responsible, to foster cooperation and
coordination with persons engaged in the clearance and settlement of securities
transactions, to remove impediments to and perfect the mechanism of a national

system for the prompt and accurate clearance and settlement of securities
transactions, and, in general, to protect investors and the public interest; and are
not designed to permit unfair discrimination in the admission of participants or
among participants in the use of the clearing agency, or to regulate by virtue of
any authority conferred by this chapter matters not related to the purposes of
this section or the administration of the clearing agency.
(G) The rules of the clearing agency provide that (subject to any rule or order of
the Commission pursuant to section 78q(d) or 78s(q)(2) of this title) its
participants shall be appropriately disciplined for violation of any provision of
the rules of the clearing agency by expulsion, suspension, limitation of
activities, functions, and operations, fine, censure, or any other fitting sanction.
The introductory paragraph of Sec. 19(g)(1) of the Securities Exchange Act of
1934, 15 U.S.C. Sec. 78s(g)(1), in relevant part, provides:
Every self-regulatory organization shall comply with the provisions of this
chapter, the rules and regulations thereunder, and its own rules....
2

Accordingly, we express no opinion on two issues argued by the parties on

appeal. First, whether Baird v. Franklin, 141 F.2d 238 (2d Cir.), cert. denied,
323 U.S. 737, 65 S.Ct. 38, 89 L.Ed. 591 (1944), remains good law after the
1975 Amendments to the Act and recent Supreme Court decisions. Compare
Brawer v. Options Clearing Corp., 633 F.Supp. 1254 (S.D.N.Y.1986) (Baird no
longer remains good law), with Rich v. New York Stock Exchange, 509
F.Supp. 87 (E.D.N.Y.1981) (holding that recent Supreme Court decisions do
not eliminate the private cause of action established in Baird and arguing that
the Congressional silence regarding Baird in the 1975 Amendments indicates
approval of the then-existing private cause of action under Sec. 6). Second,
whether Baird v. Franklin may be extended after the 1975 Amendments to
support a private cause of action for an SRO's failure to comply with its own
rules. Compare Brawer, 633 F.Supp. at 1257 n. 5 (no significant distinction
between the facts of Baird and a case where an investor claims that an SRO
failed to comply with its own rules) and Bright v. Philadelphia-BaltimoreWashington Stock Exchange, 327 F. Supp. 495 (E.D.Pa.1971) (member stated
cause of action against exchange by claiming that exchange had intentionally
violated the election provisions of its constitution), with Lenowitz v.
Philadelphia Stock Exchange, Inc., 502 F.Supp. 428 (E.D.Pa.1980) (finding
Bright no longer persuasive in light of the evolution of the law since that
decision)

Amex Rules 902(a) and 903(c) and (d) provide:

Rule 902.

(a) Subject to the provisions of Rules 905, 907 and 909, the rights and
obligations of holders and writers of option contracts of any class of options
dealt in on the Exchange shall be as set forth in the rules of the Options
Clearing Corporation.
Rule 903. * * *
(c) The unit of trading and the exercise price initially established for option
contracts of a particular series are subject to adjustment in accordance with the
rules of the Options Clearing Corporation. When such adjustment or
adjustments have been determined, announcement thereof shall be made by the
Exchange and, effective as of the time specified in such announcement, the
adjusted unit of trading and the adjusted exercise price shall be applicable with
respect to all subsequent transactions in such series of options.
(d) Option contracts shall be subject to adjustments in accordance with the rules
of the Options Clearing Corporation.
4

OCC By-laws, Article VI, Sec. 11(d) states:

In the case of any reorganization, recapitalization, reclassification or similar
event with respect to shares of underlying securities for which adjustment is not
provided in any of the foregoing paragraphs of this Section 11, or in the case of
any event for which adjustment is provided in one of the foregoing paragraphs
but is not considered by the Securities Committee to be appropriate under the
circumstances, the Securities Committee shall make such adjustments in the
exercise price, trading unit or number of contracts with respect to the option
contracts affected by such event as that Committee in its sole discretion
determines to be fair to the holders and writers of such option contracts.

The parties disagree as to whether the second financing scheme should be

designated a "recapitalization" or an "exchange offer." Under the view we take,
we need not consider this disagreement

Baird held only that an investor had a cause of action against an exchange for
its failure to enforce compliance by a member with the Act or the exchange's
rules under Sec. 6, as it existed prior to the 1975 Amendments. That section
provided in relevant part:
(b) No registration shall be granted or remain in force unless the rules of the
exchange include provision for the expulsion, suspension, or disciplining of a
member for conduct or proceeding inconsistent with just and equitable
principles of trade, and declare that the willful violation of any provisions of
this title or any rule or regulation thereunder shall be considered conduct or

proceeding inconsistent with just and equitable principles of trade.

(d) If it appears to the Commission that the exchange applying for registration
is so organized as to be able to comply with the provisions of this title and the
rules and regulations thereunder and that the rules of the exchange are just and
adequate to insure fair dealing and to protect investors, the Commission shall
cause such exchange to be registered as a national securities exchange.
The district court noted that in this case no member was involved and that
Brawer had only alleged that AMEX and OCC had failed to comply with their
own rules. However, it concluded that "[t]he distinction does not appear to be
significant to the determination whether there is a private right of action under
Sec. 6 against an exchange." 633 F.Supp. at 1257 n. 5. We express no opinion
as to this conclusion. See note 2, supra.
7

Although Sam Wong was decided after Congress amended the Commodity
Exchange Act to include an express bad faith standard, the claim being
considered in Sam Wong arose before the amendment. The court used the
amendment as evidence of what Congress believed that the statute required
prior to its amendment. 735 F.2d at 676 n. 30

Here, the relevant by-laws obviously gave AMEX and OCC great discretion.
Under a different rule, a different sort of duty might obtain. See Baird, 141 F.2d
at 244

We do not mean to foreclose the possibility that disparate treatment of

essentially identical financing schemes might be so arbitrary as to constitute
constructive bad faith. However, in this case, Brawer has not alleged a
sufficient identity between the two plans to induce us to second-guess the
Securities Committee's conclusion

10

Indeed, Brawer makes just such a claim in the instant case