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Merrill, not Goldman, May|See Short-Sale Comeuppance

(CN) - Goldman Sachs need not face claims over its "naked short sales," but Overstock.com may have a case against Merrill Lynch, a California appeals court ruled.

Overstock had alleged in its 2007 complaint that the financial firms "intentionally depressed the price of Overstock stock by effecting 'naked short sales' - that is, sales of shares the brokerage houses and their clients never actually owned or borrowed. This practice, and specifically perpetuating the naked short positions by means of exotic trading schemes, allegedly increased the apparent supply of the stock, lead to a 'pile on' of further short sales, and thereby decreased the stock's value - including the value of shares plaintiffs sold," the First Appellate District summarized in its Nov. 13 ruling.

The complaint stemmed largely from the involvement of two traders, Steven Hazan and Scott Arenstein, in various fraudulent conduct involving naked short sales.

Overstock later amended its complaints to allege that Goldman and Merrill violated California's Corporate Securities Law and New Jersey's anti-racketeering law by aiding and abetting Hazan and Arenstein.

The Securities and Exchange Commission had Hazan disgorge the more-than $3 million he accumulated for his naked short-sale scheme, while the American Stock Exchange had Arenstein disgorge $1.4 million, plus pay a $3.6 million fine, the California appeals court noted.

Meanwhile the San Francisco Superior Court judge hearing Overstock's claims in 2012 found no "triable issue of material fact supportive of finding that any act by any defendant foundational to liability, causation, or damages occurred in California."

In nixing Overstock's "belatedly-raised" New Jersey RICO claims, the court found that "the New Jersey RICO claim as fleshed out in the proposed amended complaint was so different from what had been previously alleged that belatedly injecting it into the litigation would be seriously prejudicial to the defendants."

In its 61-page partial reversal last week, the First Appellate District found that the trial court had "erred when dismissing claims against Merrill Lynch."

There was substantial evidence indicting Merrill employees in the wrongful short-sale trades, according to the 61-page decision.

"All told, Merrill cleared Hazan's and Arenstein's exotic trades designed to support perpetually naked short positions for more than a year, and as a result failed to deliver Overstock shares for settlement every single day between August 1, 2005 and the end of 2006," Judge Kathleen Banke wrote for a three-member panel.

Banke added that "the number of failed deliveries quickly rose above a million shares, and at one point reached three million shares."

As such, "there is clearly a triable issue Merrill Clearing had knowledge, indeed abundant knowledge, its clients were rolling shorts and engaging in sham reset transactions to mimic the appearance of genuine trading," Banke wrote. "There is a triable issue Merrill did not believe, or, at the very least, could not have reasonably believed, Hazan and Arenstein were bona fide market makers engaging in legitimate trading. And there is a triable issue Merrill took an active, direct role in their trading schemes to cause, and to profit from, ongoing failures to deliver shares in short sales of Overstock, as well as other hard-to-borrow securities."

Dismissal was appropriate for the claims against Goldman Sachs, however, because Overstock did not show that the trades or business took place in California.

In affirming dismissal of the New Jersey RICO claims, the panel agreed that "the fourth amended complaint did not assign any particular action to any particular act of alleged 'fraud in the offering, sale or purchase of securities.'"

"Nor did any portion of the complaint disclose a specific instance of allegedly fraudulent conduct," Banke wrote.

In a separate ruling that upheld the sealing of many documents in the case, the appellate panel slapped at lower court for shielding "thousands of pages of documentation plaintiffs submitted to the court, but which they never cited and which were irrelevant to the issues raised by the summary judgment motions."

Banke said she was "appalled at the burden the parties foisted on the trial court," adding that the documents in question should be made available to the public.

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