The connection between a New York investment firm and the Ponzi scheme run by one of its principals is strong enough to warrant a trial on a securities fraud claim, the U.S. Court of Appeals for the Third Circuit has ruled, reversing the trial court’s dismissal of that claim after a handful of Pennsylvania investors brought several claims against the firm and its directors.
However, the appeals court agreed with the district court’s holding that the firm’s directors couldn’t be held liable for negligent supervision.
"The question of whether a corporate director, rather than a corporation as employer, may be held liable for negligent supervision can be resolved by asking whether a director owes a duty to third parties to supervise the corporation’s culpable employee," Judge Kent Jordan wrote on behalf of a three-judge panel in Belmont v. MB Investment Partners.
"It is true that corporate directors are often said to have, as part of their fiduciary duty of loyalty, a duty to act in good faith for the benefit of the corporation," he said, citing the Delaware Supreme Court’s 2006 opinion in Stone v. Ritter. "That, in turn, has been held to incorporate a duty of oversight," he said, looking to the Delaware Court of Chancery’s 1996 opinion in In re Caremark International Derivative Litigation.
"But that has never been understood as placing on directors the responsibility for day-to-day supervision of employees," Jordan said. "On the contrary, those quotidian tasks are the work of employee-supervisors, not the board of directors."
The case stems from the Ponzi scheme that Mark Bloom ran for nearly a decade through a hedge fund he called North Hills. According to the opinion, Bloom maintained the scheme while he was an officer for MB Investment Partners, which was not officially affiliated with North Hills, but closed in 2009, soon after the collapse of North Hills.
Bloom was arrested on February 25, 2009, and pleaded guilty to all of the counts filed by information in the Southern District of New York, including the charges that he had taken $20 million from North Hills’ operating account for his own personal use, the opinion said.
Several people from Pennsylvania then filed suit in the Eastern District of Pennsylvania asserting claims under both federal and state law.
On appeal, after their claim for negligent supervision against the directors of MB had been dismissed, the investors argued that MB’s directors had supervisory responsibilities over Bloom under Pennsylvania law and that their failure to monitor Bloom’s activities when they knew that he was running North Hills as a separate venture made the fraud foreseeable, Jordan said. The court wasn’t convinced by either argument.
"Virtually all of the cases in which liability for negligent supervision has been found under Pennsylvania law concern corporations and their employees," Jordan said. "We take that clear feature to be dispositive, so that when, as in this case, ‘plaintiff alleges in the complaint that [defendant] is … not an employer … "negligent supervision" is not a viable theory of liability,’" he said, citing the Eastern District of Pennsylvania’s 2007 opinion in Quandry Solutions v. Verifone.
So, since the investors made their claim against MB’s directors instead of MB as Bloom’s employer, the claim of negligent supervision can’t stand, he said.
Beyond that, the investors failed to convince the court of the foreseeability portion of the negligent supervision claim.
The directors of MB had no reason to assume that they needed to supervise Bloom’s activity with North Hills, Jordan said.
"While some (and perhaps all) of the MB directors were aware that Bloom was running North Hills as a hedge fund outside of MB, nothing in Bloom’s conduct as an employee of MB suggested that Bloom would use North Hills to defraud investors," Jordan said. "Nor could the MB directors have learned of the fraud without considerable investigation, given Bloom’s success at concealing the Ponzi-scheme nature of North Hills for almost 10 years."
However, the appeals court agreed with the investors that Bloom’s violations of the Securities and Exchange Rule 10b-5 could be imputed to MB as his employer and it reversed the district court’s dismissal of that claim.
"Imputation may be appropriate in this case, if the investors can prove that the manner in which Bloom marketed North Hills to them while he was working for MB, and the apparent benefit to MB, made it appear that he marketed North Hills within the scope of his authority as a senior executive of MB," Jordan said.
Paul Madden, of Buchanan Ingersoll & Rooney in Philadelphia, who argued on behalf of the investors, said that the legal team was still examining the opinion.
"We were very pleased with the Third Circuit’s very thorough analysis which resulted in its upholding nearly all of Judge Schiller’s rulings in favor of the defendants," said Edward Kutchin and Kerry Northup of Berluti McLaughlin & Kutchin in Boston, who represented MB and several of the directors, in a prepared statement, referring to U.S. District Judge Berle Schiller of the Eastern District of Pennsylvania.
"The decision provided further clarity regarding secondary liability for officers and directors under both federal securities laws and Pennsylvania common law," they said. "In particular, the court confirmed that ‘control person’ liability under Section 20(a) of the Exchange Act requires actual knowledge of the underlying fraud, and that under Pennsylvania common law negligent supervision is not a valid theory of liability against a corporation’s officers and directors. While we were disappointed that two of the counts against MB were overturned, we believe that our client will be successful in defending against both of the remaining claims at trial."
(Copies of the 72-page opinion in Belmont v. MB Investment Partners, PICS No. 13-0447, are available from The Legal Intelligencer. Please call the Pennsylvania Instant Case Service at 800-276-PICS to order or for information.) •