UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW JERSEY
May 11, 1989
ELYSIAN FEDERAL SAVINGS BANK, Plaintiff
FIRST INTERREGIONAL EQUITY CORPORATION, FIRST INTERREGIONAL GVM'T SECURITIES, INC. and CHARLES BELINA, Defendants
The opinion of the court was delivered by: LECHNER, JR.
OPINION and ORDER
ALFRED J. LECHNER, JR., UNITED STATES DISTRICT JUDGE:
Succinctly stated, in this action plaintiff has alleged the defendants committed fraud by charging plaintiff excessive mark-ups in the sale of two types of securities: collateralized mortgage obligations ("CMOs") and principal only trust certificates ("PO Trusts"). Plaintiff claims the aggregate amount of the excessive mark-ups exceeds $ 5 million. In addition, it is charged defendants have attempted to conceal the excessive mark-ups. While a significant number of the legal issues presented in this matter can be adequately addressed against the backdrop of this terse summary of plaintiff's first amended complaint (the "Current Complaint"), certain of the legal claims involve consideration of additional facts. These additional facts, although not voluminous or complicated, are set forth together with a discussion of the individual legal theories which make them relevant.
Defendants filed a motion to dismiss, on various grounds, several counts contained in the Current Complaint. Simultaneously, plaintiff has made a motion to file a second amended complaint (the "Amended Complaint") which (1) drops certain of the claims defendants seek to have dismissed in their motion, (2) seeks to include claims for relief based on additional legal theories, and (3) seeks to add certain detail, the absence of which defendants claim justifies dismissal of various counts in the Current Complaint.
As to the counts in the Current Complaint which have not been voluntarily dismissed, plaintiff has strongly opposed defendants' motion to dismiss. As to plaintiff's motion to further amend the Current Complaint, defendants have strenuously argued, among other things, the new counts sought to be included fail to state a claim as a matter of law. While there are a variety of issues raised by the present motions, each of which will be addressed below, this opinion primarily addresses the viability of various legal theories for recovery on the relatively straightforward facts of this case.
More specifically, (and setting aside for the moment the assertions sought to be added in the Amended Complaint, because of defendants' motion to dismiss
and further review by plaintiff
of the issues involved) plaintiff's remaining claims which with the exception of one transaction continue to be the subject of defendants' motion to dismiss can be listed as follows:
(1) claims based on Section 10(b) of the Exchange Act and Rule 10(b)-5 for all CMO and PO Trust transactions;
(2) claims based on Section 12(2) of the Securities Act for CMO transactions only;
(3) control person liability claims pursuant to Section 15 of the Securities Act, 15 U.S.C. § 77 o for claims based on the CMO transactions only; and
(4) control person liability claims pursuant to Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a) for all CMO and PO Trust transactions.
As discussed below, defendants' opposition to plaintiff's motion to amend will, in large part, be treated as a motion to dismiss the new claims sought to be asserted which include claims under RICO, the New Jersey counterpart and of aiding and abetting. For the reasons that follow, defendants' motion to dismiss is denied in all respects; plaintiff's motion to file the Amended Complaint is granted.
I. Dismissal Standard
Virtually all aspects of this matter will be treated under the standards applicable to Rule 12(b)(6) motions. In that connection, the Supreme Court stated in Conley v. Gibson, 355 U.S. 41, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957):
In appraising the sufficiency of the complaint we follow, of course, the accepted rule that a complaint should not be dismissed for failure to state a claim unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.
Id. at 45-46. Accord, Cruz v. Beto, 405 U.S. 319, 321, 31 L. Ed. 2d 263, 92 S. Ct. 1079 (1972); Angelastro v. Prudential-Bache Securities, 764 F.2d 939 (3d Cir. 1985), cert. denied, 474 U.S. 935, 106 S. Ct. 267, 88 L. Ed. 2d 274 (1986). Indeed, the Supreme Court has stated that a Rule 12 motion should not succeed unless the complaint is found to be "wholly frivolous." Radovich v. National Football League, 352 U.S. 445, 453, 1 L. Ed. 2d 456, 77 S. Ct. 390 (1957). As articulated in this Circuit, the standard to be applied in a motion under Fed. R. Civ. P. 12(b)(6) is whether, after construing the pleading in the light most favorable to the plaintiff and resolving every doubt in favor of the plaintiff, the pleading states any valid claim for relief. Mortensen v. First Federal Savings and Loan Ass'n, 549 F.2d 884, 891 (3rd Cir. First Federal 1977).
With respect to at least two aspects of this matter -- the allegations concerning plaintiff's knowledge of the excessive markups and the related issue of statute of limitations accrual -- submissions in addition to the pleadings have been presented. To this limited extent defendants' Rule 12(b)(6) motion will be treated as a motion for summary judgment under Rule 56.
To prevail on a motion for summary judgment, the moving party must establish "there is no genuine issue as to any material fact and that [it] is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c). The district court's task is to determine whether disputed issues of fact exist, but the court cannot resolve factual disputes in a motion for summary judgment. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249-50, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986). All evidence submitted must be viewed in a light most favorable to the party opposing the motion. See Matsushita Elec. Industrial Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 587, 89 L. Ed. 2d 538, 106 S. Ct. 1348 (1986).
Although the summary judgment hurdle is a difficult one to overcome, it is by no means insurmountable. As the Supreme Court has stated, once the party seeking summary judgment has pointed out to the court the absence of a fact issue,
its opponent must do more than simply show that there is some metaphysical doubt as to the material facts. . . . In the language of the Rule, the non-moving party must come forward with 'specific facts showing that there is a genuine issue for trial.' . . . Where the record taken as a whole could not lead a rational trier of fact to find for the non-moving party, there is no 'genuine issue for trial.'
Matsushita, 475 U.S. at 586-87 (emphasis in original, citations and footnotes omitted).
The Court elaborated on the standard in Anderson v. Liberty Lobby, Inc., 477 U.S. at 249-50 (citations omitted): "If the evidence [submitted by a party opposing summary judgment] is merely colorable . . . or is not significantly probative . . . summary judgment may be granted." The Supreme Court went on to note in Celotex Corp. v. Catrett, 477 U.S. 317, 323-24, 91 L. Ed. 2d 265, 106 S. Ct. 2548 (1986) (footnote omitted): "One of the principal purposes of the summary judgment rule is to isolate and dispose of factually unsupported claims or defenses, and we think it should be interpreted in a way that allows it to accomplish this purpose." Thus, once a case has been made in support of summary judgment, the party opposing the motion has the affirmative burden of coming forward with specific facts evidencing a need for trial. See Fed. R. Civ. P. 56(e).
II. Statute of Limitations under Section 10(b) of the Exchange Act and Rule 10(b)-5 thereunder
Plaintiff purchased PO Trusts from defendants in May, June and August, 1987, and purchased the CMOs from defendants in a number of transactions during 1986. See footnote 8, infra. Plaintiff argues that, because the excessive mark-ups were not disclosed by defendants, it did not know it was being charged excessive mark-ups at the time of the transactions. In September, 1987, plaintiff, with the intervention of the Federal Home Loan Bank Board ("FHLBB"), retained Rochester Consulting Associates ("Rochester Consulting") in order to assist in the operations and management of the business. According to the deposition testimony of Peter Gensicke ("Gensicke"), former Chief Financial Officer of plaintiff, William Vail ("Vail") of Rochester Consulting asked Gensicke to prepare computer printouts of certain PO Trust and CMO transactions so that Vail could "check out" the prices for those securities.
Less than one year later, in August, 1988, Elysian filed its suit asserting claims under, among other things, Section 10(b) of the Exchange Act. Section 10 provides that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange -
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
15 U.S.C. § 78j. Subsequent to passage of the Exchange Act, the SEC promulgated Rule 10b-5, providing that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) to employ any device, scheme, or artifice to defraud,
(b) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made in the light of the circumstances under which they were made, not misleading, or
(c) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
17 C.F.R. § 240.10b-5. To prevail in an action brought under Rule 10b-5, a plaintiff must establish six elements: (1) a false representation of (2) a material (3) fact; (4) defendant's knowledge of its falsity and his intention that plaintiff rely on it; (5) the plaintiff's reasonable reliance thereon; and (6) his resultant loss. See Peil v. Speiser, 806 F.2d 1154, 1160 (3d Cir. 1986); 3 Loss, Securities Regulation 1431 (1961). Defendants have not attacked the viability of the Rule 10b-5 claims on the basis that any of the foregoing requirements were not met. Instead, defendants claim the Rule 10b-5 claims have been asserted too late.
Statute of Limitations Period
The Third Circuit recently held in In re Data Access Systems Securities Litigation, 843 F.2d 1537 (3d Cir. 1988) (en banc), cert. denied sub nom., Vitiello v. I. Kahlowsky & Co., 488 U.S. 849, 102 L. Ed. 2d 103, 109 S. Ct. 131 (1988), that the applicable statute of limitations for Section 10(b) and Rule 10b-5 claims is one year after discovery of the violation and in no event more than three years after the violation. Defendants argue that all but one of plaintiff's claims are time-barred because plaintiff has failed to bring suit within one year after the violation and plaintiff has failed to plead any facts showing when it discovered the violation.
Before addressing whether the Rule 10b-5 claims were timely under the holding of Data Access because the original complaint was filed within one year of plaintiff's discovery of the excessive mark-ups (and also within three years of the date of the transactions), it is interesting to consider a novel argument advanced by plaintiff in this case. According to plaintiff, the statute of limitations rule recently articulated in Data Access (within one year of discovery, but in no event more than three years after an alleged violation) should be deemed to be modified as a result of the enactment of the Insider Trading and Securities Fraud Enforcement Act of 1988 ("Insider Trading Act"), P.L. 100-704, 102 Stat. 4677 (1988).
Congress has basically amended the Exchange Act to expressly provide a private right of action for contemporaneous buyers and sellers asserting claims of fraud committed through insider trading. Because Congress selected a five-year statute of limitations period for insider trading cases and because insider trading is a specific type of activity prohibited under Section 10(b) and Rule 10b-5, plaintiff argues that, under the court's reasoning in Data Access, the five-year period should govern all claims under Section 10(b).
In Data Access the court was attempting to establish a single statute of limitations period for all claims under Section 10(b) and Rule 10b-5.
Plaintiff notes that at the time of the decision in Data Access, Congress had not established a limitations period for Section 10(b) claims and the court had to decide which was the " one most appropriate" statute of limitations. It is now argued that "since the decision in Data Access, Congress has now spoken and selected a five-year statute of limitations to govern at least one type of claim brought under § 10(b)." Plaintiff's Brief, p. 7.
While it is not necessary to rule on this novel argument made by plaintiff (because it appears able to survive defendants' motion to dismiss under the shorter statute of limitations previously articulated in Data Access), certain observations are made. First, although it appears the argument has never been squarely presented, it is noted the statute of limitations rule enunciated in Data Access, even after the Insider Trading Act was enacted, has not been modified. Bloch v. Prudential-Bache Securities, 707 F. Supp. 189 (W.D. Pa. 1989); Ferreri v. Mainardi, (E.D. Pa. Feb. 1989); T.R. Whitelyn Holstein Breeder Associates v. Whitelyn Farms, Inc., (E.D. Pa. Dec. 16, 1988).
Second, and more importantly, it appears plaintiff seeks a ruling on this issue which would be one based upon form rather than substance. It is arguable the Third Circuit's central goal in Data Access was to establish a uniform statute of limitations to govern all claims under Section 10(b). It does not necessarily follow, however, that it is appropriate to articulate a uniform statute of limitations period based merely upon Congress' enactment of a statute of limitations period for a particular violation of the securities laws which happens to be a species of a Section 10(b) claim.
Although uniformity may have been an objective generally, a primary analytical goal in Data Access was to determine whether, under Section 10(b) and Rule 10(b)-5, there was a federal statute of limitations more closely analogous than the state statutes courts previously "borrowed". In connection with this exercise, the Third Circuit was comfortable turning to those sections of federal securities law that are "companion provisions" to Section 10(b). In comparing these sections, the court stated:
Both section 10(b) and its companion provisions -- § 9(e) (manipulation of security prices); § 16(b) (profits from purchase and sale of securities within six months); § 18(c) (liability for misleading statements in any application, report, or filed document); and § 29(b) (validity of contract provisions in violation of Act or regulations thereunder) -- are aimed at the same objectives. All of these companion provisions, except section 16(b), have a uniform federal limitations period. All reflect, in common with section 10(b), the purpose of the original Securities Act of 1933:
to "provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes."
Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 728, 95 S. Ct. 1917, 1921, 44 L. Ed. 2d 539 (1975) (quoting 1933 Act); see Basic Inc. v. Levinson,  U.S. , 108 S. Ct. 978, 99 L. Ed. 2d 194 (1988). All aim to compensate the same type of injury. All are designed to fill a void in the common law and to create remedies that would be uniform throughout our nation's commercial universe, instead of being subjected to the vagaries of independent and diverse state statutory regulations.
Data Access, 843 F.2d at 1548.
It appears from the foregoing the Third Circuit was most interested in considering the precise nature of the claim asserted under section 10(b). It is doubtful the Circuit would have automatically endorsed, without a reasoned analysis, a five year statute of limitations period for all claims arising under section 10(b)
merely because Congress established such a limitations period for a specific type of conduct proscribed by Section 10(b).
Turning to the nature of the Section 10(b) claims asserted in this case, it appears they are more similar to claims under the "companion provisions" referred to above than to a claim under the Insider Trading Act. This case involves the alleged failure by the defendants "to provide full and fair disclosure," Data Access, 843 F.2d at 1548, concerning the amount of the markups for the PO Trust and CMO transactions.
The objectives of the Insider Trading Act are well summarized in defendants' brief. A primary purpose of the legislation was to restore public confidence in the fairness and integrity of the securities markets. House Report No. 100-910, 100th Cong., 2d Sess at 7 ("House Report"). Although an express private cause of action for contemporaneous traders was created, the thrust of the legislation was to protect the public at large, and not just individual investors. Id. Professor James Cox of Duke University School of Law testified at the House Hearings on July 11, 1988 and explained insider trading violations are different in nature from other "typical securities law violation[s]."
Insider Trading Invites Novel Detection Techniques :
The proposal in section 21A(e) introduces a very novel device into the enforcement of the insider trading. The appropriateness of this provision is best understood by considering the important difference between the standard securities law violation and insider trading. To be sure, the public would be well served by devices that would encourage earlier revelations of all securities law violations such as "cooked books" or market manipulations. However, in each of those cases the violation causes a very distinct, observable, and tangible harm. This feature of the typical securities law violation not only facilitates detection of a violation (the person so harmed complains), but this feature also stimulates in most instances the private party to sue even before a government prosecution, if any, is commenced.
In contrast with the standard misrepresentation or manipulation cases, the victim of insider trading or tipping is frequently problematic. And except in the rare cases . . . the private party (i.e., contemporaneous traders in most cases), rarely initiates suit until the government prosecution has attracted the private litigant's attention. See Dooley, Enforcement of Insider Trading Restrictions, 66 Va. L. Rev. 1 (1980). Enforcement of illegal inside trading and tipping therefore is primarily by the government and for the purpose of the public, rather than private, injury. The lower likelihood of a victim tangibly harmed reduces the likelihood as well of public complaints that will lead to government enforcement actions.
July 11, 1988 Testimony before the Subcommittee on Telecommunications and Finance of the U.S. House of Representatives Committee on Energy and Finance, p. 7.
The House Report explained the unique need for a five year statute of limitations for insider trading claims.
It also came to the attention of the Committee that part of the problem in deterring and punishing insider trading violations is the difficulty of effectively prosecuting these cases. The biggest obstacle is making the vital connection between an investor and the possession of insider information (i.e., what he knew, when he knew it and how he found it out). Unless there is an obvious connection, which is rare, the success of the case usually depends on getting someone who knows about the insider trading to talk. According to the testimony of U.S. Attorney Giuliani, there are generally two people who can provide direct evidence that insider trading has occurred -- the source of the information and the trader. It is very rare for one of these two persons to admit that they have engaged in insider trading. Most cases are based largely on circumstantial evidence. Because insider trading is so sophisticated and secretive, technical computer surveillance can only go so far in investigating crimes. In order to develop these cases effectively, information provided by other individuals who have relevant knowledge of the circumstances may prove essential.
House Report at p. 15.
The particular difficulty of discovering the fraud involved in insider trading cases does not exist in other types of securities fraud cases where the injury is more direct. Where an injury is more able to be determined (because there exists a party who has been directly injured), Data Access has made it clear there is a policy in favor of limiting the length of time for bringing a securities fraud lawsuit. The Data Access court cited a Seventh Circuit opinion where it was stated:
The legislative history in 1934 makes it pellucid that Congress included statutes of repose because of fear that lingering liabilities would disrupt normal business and facilitate false claims. It was understood that the three-year rule was to be absolute.
843 F.2d at 1546 (citing Norris v. Wirtz, 818 F.2d 1329, 1332 (7th Cir.), cert. denied, 484 U.S. 943, 98 L. Ed. 2d 356, 108 S. Ct. 329 (1987)).
While plaintiff's argument that the Third Circuit's decision in Data Access should be disregarded in this case is less than compelling, it is not necessary, as indicated, to rule on this argument. It appears more traditional grounds exist to deny defendants' motion to dismiss based upon the applicable statute of limitations, as established in Data Access.
Within One Year of Discovery
Under Data Access, plaintiff is required to bring suit within one year of discovering the undisclosed, excessive markups, but in no event more than three years after the transactions. As to the latter aspect of the rule, the original complaint was filed within three years of the various transactions.
On the issue of whether plaintiff satisfied the aspect of the rule which requires claims to be asserted within one year of discovery, defendants argue the statute of limitations begins to run not when plaintiff had actual knowledge of the violation, but rather when plaintiff should have known of the violation after exercising reasonable diligence. Bradford-White Corp. v. Ernst & Whinney, 699 F. Supp. 1085, 1091 (E.D. Pa. 1988). It is further argued the first step in determining whether a plaintiff should have known of possible wrongdoing is whether there were any "storm warnings." Gruber v. Price Waterhouse, 697 F. Supp. 859, 863-864 (E.D. Pa. 1988) ("Once on inquiry notice, plaintiffs have a duty to exercise reasonable diligence to uncover the basis for their claims and are held to have constructive notice of all facts that could have been learned through diligent investigation during the limitations period.") According to defendants, "the plaintiff cannot ignore storm warnings and await the leisurely discovery of [their] claims." Bradford-White Corp., 699 F. Supp. at 1091.
It has been held that in determining whether a plaintiff exercised due diligence in investigating fraud, factors to be considered include "the existence of a fiduciary relationship, concealment of the fraud, opportunity to detect it, position in the industry, sophistication and expertise in the financial community, and knowledge of related proceedings." Cotton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 699 F. Supp. 251, Fed. Sec. L. Rep. (CCH) para. 93,985 at 90,588 (N.D. Okla. 1988).
It might be fair to say that plaintiff, a savings institution employing investment professionals, had a "position in industry" permitting it to detect the fraud. It is noted, however, one of plaintiff's primary allegations is that defendants sought to conceal the fact excessive markups were being charged. On the issue of "knowledge of related proceedings" it appears plaintiff has become aware of other instances of excessive markups being charged by defendants. Indeed, in a prior motion brought by defendants, a request to strike references in the Current Complaint to unrelated SEC and NASD investigations of defendants was denied. See Order, dated December 29, 1988. It remains unclear exactly when plaintiff learned of defendants potentially disreputable business practices and to what extent they constituted "storm warnings" in this case.
While cases have construed the one year from discovery rule as requiring some form of due diligence once "storm warnings" exist, defendants perhaps overstate plaintiff's obligations in this case when they assert "plaintiff must include specific factual allegations of the reasons why discovery was not made sooner and what steps plaintiff took to discovery the alleged fraud." Defendants' Reply Brief, p. 13. The gravaman of the Amended Complaint is that defendants fraudulently charged undisclosed, excessive mark-ups on the PO Trust and CMO securities. Paragraph 35 of the Amended Complaint alleges:
35. Elysian did not discovery defendants' fraudulent conduct until after August of 1987 when, with the guidance of the Federal Home Loan Bank Board, the management of Elysian was changed and Rochester Consulting Associates ("RCA") was retained to assist Elysian in its operations. At that time, Elysian's portfolio of securities was reviewed. In December of 1987 or January of 1988, representatives of RCA asked Gensicke to determine whether Elysian had been charged excessive mark-ups by defendants in connection with the purchase of the POs and CMOs. Following this investigation, Elysian concluded that defendants had charged it excessive mark-ups.
Id. Defendants argue this allegation (which, under the Rule 12(b)(6) standard, is to be resolved generously in favor of plaintiff) is not sufficient because it fails to explain why plaintiff did not discover the excessive markups earlier. However, Paragraph 35, read liberally, contains an allegation to the effect there were no "storm warnings" until late 1987, after Rochester Consulting arrived on the scene. In addition, it is more than implicit from the above allegation that plaintiff was previously suffering operating difficulties. It was in need of FHLBB assistance to successfully manage the bank's affairs. Defendants' suggestion that this might be an invalid reason for not discovering fraud earlier implies a notion that perpetrators of fraud have expanded rights to take advantage of mismanaged entities.
Quite apart from the illogical nature of defendants' argument they should somehow be rewarded for successfully concealing their allegedly fraudulent conduct, at this time there is no evidence in this case that plaintiff had the benefit of "storm warnings" and simply ignored them. At oral argument, defendants' counsel was unable to point to any specific event which would have provided cause to believe overcharges had occurred in this case.
Gensicke unequivocally testified that the first person to suspect the defendants had charged excessive mark-ups to plaintiff was Vail, who was hired by plaintiff at the suggestion of Rochester Consulting, the consulting group which took over management of plaintiff after August, 1987.
Thus, it appears the "storm warnings" came in December, 1987;
plaintiff commenced this action less than one year later.
Defendants make reference to a memo by Vail, which states:
Called Mark Chaplin and indicated this error in our CMO work. Both agreed that it is immaterial and the redoing of the CMO calculation would be unnecessary at this time. Also discussed with Mark Lynelle's comment that the Travelers Series C CMO had never traded above 107. Elysian had been charged approximately 114 by InterRegional. There appears to be more and more evidence or prive gouging by the broker of First InterRegional. Currently is a backburner item but someone will eventually need to pursue this problem.
Memorandum from Vail concerning "Summary of Activities of October 14, 1987," dated October 25, 1987. It may be true this is the type of specific "storm warning" which should have triggered an investigation by plaintiff and in fact it appears an investigation did take place. As indicated, Vail was hired by plaintiff at the suggestion of Rochester Consulting (which took over the management of Elysian after August, 1987). It was in December, 1987 that Vail requested a computer printout of certain PO Trust and CMO transactions. No compelling evidence, other than general suggestions that perhaps defendants should be treated with caution, has been submitted to demonstrate plaintiff had knowledge of possible overcharging more than one year before this action was filed.
Plaintiff has alleged in the Amended Complaint that it first discovered improprieties in December, 1987. It has also submitted sworn testimony to that effect. To the extent this aspect of the defendants' motion is to be treated as a summary judgment motion, at a minimum there appears to exist a genuine issue of material fact to be resolved at trial. While defendants will be free to prove at trial that plaintiff had sufficient notice of the excess charges early in 1987, and delayed unreasonably in pursuing possible claims, defendants' current motion for summary disposition of this issue must be denied.
III. Applicability of Section 12(2) of the Securities Act
As previously indicated, plaintiff has asserted a claim under Section 12(2) of the Securities Act.
That provisions states:
Any person who -
* * * *
(2) offers or sells a security (whether or not exempted by the provisions of section 77c of this title, other than paragraph (2) of subsection (a) of said section), by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,
shall be liable to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security. (emphasis added)
15 U.S.C. § 77l.
The CMOs which are the subject of this dispute were not purchased by plaintiff in an initial offering, i.e., just after broker-dealers packaged underlying securities and issued the CMOs for the first time. Instead, the CMOs in question were purchased in the secondary market where they had been trading for a period of time. This is the only relevant fact to defendants' motion to dismiss the Section 12(2) claims. Once again, a purely legal question without controlling Third Circuit or Supreme Court precedent has arisen.
It is defendants' position that section 12(2) applies only to an initial distribution of securities and not to subsequent trading. (Citing Ralph v. Prudential-Bache Securities, 692 F. Supp. 1322 (S.D. Fla. 1988); SSH Co., Ltd. v. Shearson Lehman Bros., Inc., 678 F. Supp. 1055, 1059 (S.D.N.Y. 1987); Leonard v. Shearson Lehman/American Express Inc., 687 F. Supp. 177, 179 (E.D. Pa. 1988) ("[Section 12(2)] is intended to redress prospectus or registration statement fraud in a buyer/seller relationship in an initial transaction")).
Section 12(2) imposes liability on a "person who . . . offers or sells a security . . . by means of a prospectus or oral communication." According to defendants' interpretation, "prospectus or oral communication" refers to a prospectus, registration statement, or other communication related to a batch offering of securities, not to subsequent trading. Defendants' Brief, pp. 13-14.
Beyond asserting the meaning of the words in the statute -- which are less than explicit and the subject of somewhat inconsistent judicial interpretation -- defendants advance only one conceptual argument to support their position. Defendants argue generically that the Securities Act was intended to regulate the initial distribution of securities and that the Exchange Act was intended to regulate post-distribution trading. Defendants' Brief, p. 14, (citing Ralph, supra, 692 F. Supp. at 1323).
Although, as a practical matter, there is some validity to defendants' broad distinction between the two primary securities statutes, the conceptual overlap and interrelationships are less clearcut. For one, the Exchange Act was divided into two titles. Title I was denominated "Regulation of Securities Exchanges," and Title II was denominated "Amendments to Securities Act of 1933." On this basis alone, it does not appear accurate to flatly state the Securities Act has nothing to do with issues addressed by the Exchange Act. The comparative purposes of the Securities Act and the Exchange Act were recently described by the Third Circuit in Data Access :
The relevant law stems from two landmark statutes: the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act was described as an Act to "provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes." The Securities Exchange Act of 1934, 48 Stat. 881, as amended, 15 U.S.C. § 78a et seq., was described as an Act to provide for the regulation of securities exchanges and of over-the-counter markets operating in interstate and foreign commerce and through the mails, to prevent inequitable and unfair practices on such exchanges and markets, and for other purposes."
843 F.2d at 1547-48 (emphasis added). This recent Third Circuit articulation of the relative purposes of the Securities Act and the Exchange Act does not completely support the hard and fast distinction argued by defendants in this case. To be sure, the Securities Act contains all of the operative provisions governing new securities offerings. The above language, however, suggests that the Securities Act may have a broader concern, i.e., to ensure full and fair disclosure concerning securities sold across state lines.
There is no suggestion that the concern about full and fair disclosure is restricted to new offerings of securities across state lines. Instead, the broad language is read to apply to both new offerings and subsequent trades.
This issue of whether Section 12(2) of the Securities Act can be applied to fraud occurring in the secondary markets arose recently in another court in this Circuit. In Ballay v. Legg Mason Wood Walker, Inc., 1990 U.S. Dist. Lexis 4412, No. 88-6867 (E.D. Pa. Dec. 21, 1988), the issue was resolved as follows:
Legg Mason also argues that Section 12(2) is only designed to prohibit misrepresentations and omissions which accompany an initial offering of stock. This argument is based on the premise that the Securities Act of 1933 is a narrow statute chiefly concerned with disclosure and fraud in connection with initial public offerings of securities and that Congress waited until the Securities Exchange Act of 1934 to regulate abuses in the trading of securities in the "aftermarket." . . . Again, we do not agree. In the first instance, we note that there is no language in Section 12(2) itself which would limit its application to fraud in connection with initial distribution of securities. Moreover, although the Supreme Court has specifically stated that the "1933 Act was primarily concerned with the regulation of new offerings," United States v. Naftalin, 441 U.S. 768, 777-778 [60 L. Ed. 2d 624, 99 S. Ct. 2077] (1979), the Naftalin Court also found that the "antifraud prohibition of Section 17(a) [of the 1933 Act] was meant as a major departure from that limitation. Unlike much of the rest of the Act, it was intended to cover any fraudulent scheme in an offer or sale of securities, whether in the court (sic) of an initial distribution or in the course of ordinary market trading." Id. Although the Naftalin Court's finding was limited to the antifraud prohibition of Section 17(a) of the 1933 Act, Section 12(2) comprises the other antifraud provision of the 1933 Act. Wilko v. Swan, 127 F. Supp. 55, 58 (S.D.N.Y. 1955). Certainly, the Supreme Court's finding that the antifraud prohibition of Section 17(a) "was intended to cover any fraudulent scheme in an offer or sale of securities, whether in the course of an initial distribution or in the court (sic) of ordinary market trading" should apply to the other antifraud provision of the 1933 Act as well. After all, it has been noted that Sections 17 and 12(2) serve the dual purpose of "render[ing] unlawful and authoriz[ing] civil recovery for fraud and misrepresentation in the sale of securities . . . ." Wilko v. Swan, supra. (emphasis added).
It has not been compellingly demonstrated why the reasoning in Ballay should be ignored. The key words at issue in Section 12(2) -- "person who offers or sells a security . . . by means of a prospectus or oral communication" -- are plainly capable of being read to allow application in the secondary market context.
When defendants sold CMOs and PO Trust securities to plaintiff, they can be characterized as "person[s] who [sold] a security . . . by means of an . . . oral communication."
It is basically inclusion of the word "prospectus" in Section 12(2) (which is not included in Section 17(a), the Securities Act provision held applicable in the secondary market context) which defendants argue supplies the basis for reading the statute narrowly. Apart from the fact that the Third Circuit in Data Access emphasized the broad remedial purposes of the Securities Act (to "provide full and fair disclosure" in connection with interstate securities sales), defendants' precise and well-refined analysis of certain words in the statute (or the absence of them), although thought provoking, does not compel the conclusion Section 12(2) was meant to apply only in connection with new securities offerings.
If, on the other hand, Section 12(2) referred to a person who "offers a security by means of a prospectus or related oral communication," it would be more clear the statute was not intended to apply to after-market transactions. Instead, Section 12(2) refers to the act of a person who "offers or sells"
a security by means of a "prospectus or oral communication."
Addressing the same issue but focusing on a different word in the statute, the court in Wilko v. Swan, 127 F. Supp. 55 (S.D.N.Y. 1955), rejected a construction of Section 12(2) which would limit the scope of the statute by the status of the "seller":
Under the defendants' proffered construction of Sec. 12(2), whether a "sale" is involved would turn upon the posture of the seller, i.e., as an insurer, underwriter, dealer, or trader employing the facilities of a national securities exchange.
Such a construction would frustrate the remedial purposes of the statute and lead to absurd and wholly incongruous results. The rights of a purchaser of securities publicly offered for sale would depend not upon whether fraud in fact was practiced but upon the status of the vendor. Fraudulent seller would be placed in two categories: one encompassing those engaged in the distribution of securities; the other, those engaged in trading transactions. Purchasers from sellers of the first category would have the protection and the benefits of the Act while purchasers from sellers of the latter category would not. Nothing in the Act reflects a more tender regard for the dishonest trader, nor a purpose to protect only purchasers defrauded by sellers other than traders.
127 F. Supp. at 59. See also Scotch v. Moseley, 709 F. Supp. 95 (M.D. Pa. 1988) (citing extensive authority for proposition Section 12(2) of Securities Act is not limited to initial distributions); Steinberg, Section 17(a) of the Securities Act of 1933 After Naftalin and Redington, 68 Geo. L.J. 163, 180 (1979) ("Nothing in [section 12(2)] specifically limits the prohibition of such 'oral communications' to those occurring only during the initial distribution"). In light of the Third Circuits' broad interpretation of the purposes of Securities Act (articulated in Data Access) and the wording of the section, Defendants' motion to dismiss the Section 12(2) claims is denied.
IV. Plaintiff's Motion to File the Amended Complaint
Leave to file amendments of the pleadings under Rule 15(a) is in the discretion of the court and should be granted freely. Zenith Radio Corp. v. Hazeltine Research, Inc., 401 U.S. 321, 28 L. Ed. 2d 77, 91 S. Ct. 795, reh'g denied, 401 U.S. 1015, 28 L. Ed. 2d 552, 91 S. Ct. 1247 (1971). The most important factor in deciding whether to grant leave to amend is whether the non-moving party will suffer prejudice as a result of the amendment. Cornell & Co. v. Occupational Safety and Health Review Commission, 573 F.2d 820 (3d Cir. 1978). "The non-moving party must do more than simply claim prejudice; it must show that it will be unfairly disadvantaged or deprived of the opportunity to present facts or evidence. . . ." Hill v. Equitable Bank, N.A., 109 F.R.D. 109 (D. Del. 1985).
Plaintiff has moved to file the Amended Complaint which (1) drops certain of the claims defendants seek to have dismissed in their motion, (2) seeks to include claims for relief based on additional legal theories, and (3) seeks to add certain detail, the absence of which defendants claim justifies dismissal of various counts in the Current Complaint.
Plaintiff stresses the defendants will not suffer prejudice by the proposed amendments because none of the amendments changes the nature of the litigation. As indicated in the introduction to this opinion, plaintiff primarily seeks to include in the Amended Complaint claims under RICO (and the New Jersey counterpart). In addition, in what it refers to as a "housekeeping amendment," plaintiff also seeks to add "aiding and abetting" liability under the federal securities laws in Count I (noting that aiding and abetting liability has already been alleged under the common law fraud count, Count VIII).
According to plaintiff, as far as the racketeering claims are concerned, it is not alleging any factual issues which were not already present in the case. It is merely proposing a different theory of recovery based upon the same fraudulent conduct of the defendants. See Hill v. Equitable Bank, N.A., 109 F.R.D. 109 (D.Del. 1985) (granting leave to amend securities fraud complaint to add a RICO claim because defendant would not suffer prejudice; it had notice of the facts previously alleged and the factual posture of the case would not be substantively changed).
As to the addition of a claim for aiding and abetting liability under federal law, plaintiff again argues the amendment does not change this case either legally or factually. It argues such liability is already asserted along with the claim of common law fraud. This amendment, it is argued, simply makes the two main fraud counts identical with respect to secondary liability. Defendants were thus on notice they were charged with secondary liability for the unlawful conduct. See Index Fund, Inc. v. Hagopian, 609 F. Supp. 499 (D.C.N.Y. 1985) (granting leave to amend to add aiding and abetting liability because claims are based on the same set of facts and circumstances as previously outlined under other theories of secondary liability).
Defendants have made several arguments why leave should not be granted to add racketeering and aiding and abetting claims. First, and most importantly, defendants argue amendment would be futile under Foman v. Davis, 371 U.S. 178, 9 L. Ed. 2d 222, 83 S. Ct. 227 (1962) because, on the alleged facts of this case, plaintiff does not state a viable claim for relief under RICO, or for aiding and abetting federal securities fraud.
The prima facie validity of the new claims sought to be included in the Amended Complaint is addressed below. Because plaintiff can withstand a Rule 12(b)(6) motion to dismiss the new claims, defendants' primary argument against the filing of the Amended Complaint is rejected.
Second, defendants argue the motion to amend should be denied because it has been brought "only months from the date of trial," and the plaintiff "was aware of the all the facts" upon which the RICO claims are based at the inception of this case in August, 1988. Defendants cite Johnson v. Rogers, 551 F. Supp. 281 (C.D. Cal. 1982) where, after considering a motion to amend a securities fraud complaint eight months after filing an initial complaint to include RICO charges, the court concluded that
"Based on the severity of the remedies available under RICO, the eight month delay [in asserting the RICO claims] and the absence of any justifiable excuse for the delay, the Court exercises its discretion under Rule 15(a) of the Federal Rules of Civil Procedure and denies plaintiffs' motions to add the RICO claims."
Id. at 284.
Despite the defendants' characterization of it as an "eleventh-hour attempt at amendment," plaintiff has been responsible in this matter. Several observations are made in this regard. Unlike in Johnson (where the plaintiff delayed eight months for no apparent reason), the plaintiff here promptly attempted to proceed with discovery upon the filing of the original complaint on August 16, 1988. Defendants, however, were apparently less than cooperative when it came to plaintiff's discovery requests, a problem noted in the letter-opinion issued in this matter on December 29, 1988.
On the specific issue of plaintiff's delay before bringing its RICO claims, it is noted that plaintiff gave notice of its intent to add the RICO counts in its Memorandum of Law, served upon defendants on February 9, 1989. Plaintiff's motion to amend was actually served on defendants' counsel on February 17, 1989. During the five months between the original filing in August, 1988 and the providing of notice of intention to amend, plaintiff attempted, with little apparent cooperation, to gain access to the underlying documents in this case. While plaintiff's counsel in this matter was surely aware of the RICO statute, counsel appears to have refrained from filing a standard form complaint asserting blanket RICO claims without the benefit of more complete knowledge of the facts. It further appears plaintiff was investigating whether a "pattern of racketeering activity" existed.
It appears plaintiff did not irresponsibly or inexcusably delay in seeking to bring a RICO cause of action.
Finally, defendants argue they will suffer unfair prejudice if plaintiff is allowed to add a RICO claim -- which carries with it the possibility of treble damages -- at this time. Defendants argue they have already completed their discovery, suggesting that this case is on the eve of trial. The trial is currently scheduled to begin in this matter on September 5, 1989. The facts in this case -- which appear to be primarily in the hands of the defendants -- should be quite straightforward. Having been aware of possible RICO claims since the beginning of February, 1989, defendants will have had up to seven months (and four months from this date) to review the facts. Should this be insufficient to prepare for trial, consideration of an adjournment may be warranted. Plaintiff's motion to file the Amended Complaint is granted.
V. Addition of RICO Claims
The court's responsibility at this stage is to examine plaintiffs' purported RICO cause of action and determine whether, assuming the allegations to be true, the underlying wrongs alleged state a claim under RICO.
As the Supreme Court has indicated, RICO is to be read broadly "to effectuate its remedial purposes." Sedima, S.P.R.L. v. Imrex Co., 473 U.S. 479, 497-98, 87 L. Ed. 2d 346, 105 S. Ct. 3275 (1985) (quoting Pub.L. 91-452, section 904(a), 84 Stat. 947). Complaints alleging RICO violations are held to a liberal pleading standard. Rose, slip op. at 57.
As has been recognized by numerous district courts, the RICO statute is not one which is easily applied. For a substantive violation of RICO, a plaintiff must allege "(1) the conducting of, (2) an enterprise, (3) through a pattern, (4) of racketeering activity." Marshall-Silver Constr. Co. v. Mendel, 835 F.2d 63, 65 (3d Cir. 1987) (citing Sedima, 473 U.S. at 496). Each of these elements must be alleged to state a claim under RICO. Sedima, 473 U.S. at 495-96. Although the required elements of enterprise, pattern and racketeering activity have undergone repeated interpretation and refinement since the Supreme Court set the definitional groundwork for the RICO statute in Sedima, a coherent methodology for evaluating RICO claims remains elusive. In this case, defendants first argue plaintiff has failed to allege facts in the Amended Complaint which amount to a "pattern" of racketeering activity.
The task of clarifying the criteria necessary to establish a pattern of racketeering has proven cumbersome. The RICO statute offers little guidance. "Racketeering activity" includes state law crimes, such as murder, bribery and extortion, and a specified list of federal crimes which includes securities fraud, mail fraud and wire fraud. 18 U.S.C. § 1961(1). A "pattern of racketeering activity" requires at least two acts of racketeering activity within a ten year period. 18 U.S.C. § 1961(5) (1982). In Sedima, while the Court did not articulate a brightline test for determining whether a pattern exists, it did provide some guidance in a footnote which reads:
As many commentators have pointed out, the definition of a "pattern of racketeering activity" differs from the other provisions in § 1961 in that it states that a pattern " requires at least two acts of racketeering activity." § 1961(5) (emphasis added), not that it "means" two such acts. The implication is that while two acts are necessary, they may not be sufficient. Indeed, in common parlance two of anything do not generally form a "pattern." The legislative history supports the view that two isolated acts of racketeering activity do not constitute a pattern. As the Senate Report explained: "The target of [RICO] is thus not sporadic activity. The infiltration of legitimate business normally requires more than one 'racketeering activity' and the threat of continuing activity to be effective. It is this factor of continuity plus relationship which combines to produce a pattern." S. Rep. No. 91-617, p. 158 (1969) (emphasis added).
473 U.S. at 496 n. 14.
The circuit courts have not reached a consensus as to how the pattern requirement, and in particular the "continuity" aspect of it, is to be applied. Morgan v. Bank of Waukegan, 804 F.2d 970, 974 (7th Cir. 1986) (noting different analysis conducted by the Fifth, Eighth and Eleventh Circuits). Despite the implications of the Sedima footnote -- that at least two acts of racketeering must be alleged to constitute a RICO violation -- the Third Circuit has unequivocally rejected a two act requirement. Barticheck v. Fidelity Union Bank First Nat. State, 832 F.2d 36, 38 (3d Cir. 1987). Similarly, although Sedima emphasized the concepts of "continuity" and "relationship" in its discussion of the RICO pattern, the Third Circuit has declared that these concepts are not determinative. Id. at 39.
While clearly articulating what a pattern does not have to be, the Third Circuit declined to set forth what qualities a RICO pattern must possess. Instead the court seemed to suggest that the concept of "racketeering pattern" defies conclusive definition. Id. at 39. Accordingly, the Barticheck court chose to adopt a case-by-case analysis of the pattern requirement:
The existence of a RICO pattern does not turn on the abstract characterization of racketeering acts as 'continuous' and 'related' but rather on a combination of specific factors such as the number of unlawful acts, the length of the time over which the acts were committed, the similarity of the acts, the number of the victims, the number of the perpetrators, and the character of the unlawful activity.
Id. 832 F.2d at 38-39. The Seventh Circuit has also adopted a factually based approach to assessing the existence of a pattern. Morgan, 804 F.2d at 976 ("The requirement of pattern of racketeering is a standard, not a rule, and as such its determination depends on the facts and circumstances of the particular case, with no one factor being necessarily determinative.")
Because the case law in this area offers only abstract suggestions of what a pattern need not constitute, it is helpful to examine cases where a pattern of racketeering activity has been found to exist. Barticheck involved a claim by twenty-three investors in a failed limited partnership. Plaintiffs alleged defendants promoted the limited partnership as a venture involved in oil and gas drilling. It was alleged defendants fraudulently induced plaintiffs to purchase interests in the venture by making several material misrepresentations regarding the financing, price and potential profitability of the scheme. Finding that plaintiffs alleged sufficient facts to constitute a pattern, the court held: "Although the complaint states only that defendants committed 'two or more' acts of mail fraud in furtherance of their alleged scheme, it may fairly be inferred from the nature of the scheme that defendants engaged in considerably more than two such acts." 832 F.2d at 39. Looking beyond the specific allegations set forth in the complaint, the court inferred that the complexity of the alleged scheme in and of itself suggested a continuous -- in the sense of extensive -- pattern. Id. at 40.
Further developing this "flexible interpretation" of the RICO pattern requirement, the Third Circuit in Environmental Tectonics v. W.S. Kirkpatrick, Inc., 847 F.2d 1052 (3d Cir. 1988), pet. for cert. filed, June 17, 1988, held that even a single episode can constitute a pattern. In that case, a competitor of a company which obtained a military procurement contract from Nigeria brought a RICO action alleging a scheme to influence the award of defense contracts through the bribery of Nigerian officials. The predicate acts alleged in the complaint -- mail and wire fraud, bribery and violations of the Foreign Corrupt Practices Act -- were all committed in connection with the underlying scheme. Focusing on the complexity of the scheme, the court held that if the appellants' allegations proved to be true, the wire and mail fraud communications used to implement the scheme account for numerous violations of federal law and accordingly adequately allege a RICO violation. Id. at 1063-64; but see Superior Oil Co. v. Fulmer, 785 F.2d 252, 257 (8th Cir. 1986) (where predicate acts are all in furtherance of a single scheme, there is insufficient continuity among the predicate acts and pattern requirement is not met).
It is also instructive to note when the Third Circuit has concluded a RICO pattern was not alleged. In Marshall-Silver, a general contractor brought suit under RICO and various state laws for defendant's misconduct in allegedly filing a fraudulent involuntary bankruptcy petition. Examining the facts alleged, the court found "a single victim, a single injury, and a single short-lived scheme with only two active perpetrators." 835 F.2d at 67. Affirming the district court's dismissal of plaintiff's claims, the court concluded: "This is not criminal activity with the kind of continuity of which we spoke in Barticheck." Id.
The Second Circuit recently had occasion to examine this issue in Beauford v. Helmsley, 865 F.2d 1386 (2d Cir. 1989), pet. for cert. filed, March 7, 1989. Plaintiffs brought a class action against developers for the fraudulent promotion of a condominium conversion plan. The complaint alleged the fraudulent condominium conversion scheme was commenced in 1984 by means of an offering plan mailed to 8,286 tenants as well as other potential buyers. The offering plan was alleged to have contained a number of material misrepresentations. It was also alleged that there had been several amendments to the offering plan since 1984 which perpetuated the original misrepresentations. The court found:
There can be no question that the thousands of alleged mail frauds here had the necessary interrelationship to be considered a pattern. All of the mailings were made to groups of persons related by either their tenancy in Parkchester apartments or their potential interest in purchasing such apartments. All of the frauds allegedly had the same goal, i.e., inflating the profits to be made by the defendants in the sale of the Parkchester apartments.
Id. at 1392. Refining its analysis of RICO's pattern element, the Second Circuit concluded that a RICO pattern may be established "without proof of multiple schemes, multiple episodes, or multiple transactions; and that acts which are not widely separated in time or space may nonetheless properly be viewed as separate acts of racketeering activity for purposes of establishing a RICO pattern." Id. at 1391.
Based upon the foregoing, there appears to exist sufficient allegations of a RICO "pattern" in the Amended Complaint. Defendants essentially argue the Amended Complaint alleges a single fraudulent scheme with a single victim. Even if plaintiff is considered a single victim of the excessive markups at issue in this litigation,
it has been noted both in this opinion and in the Letter-Opinion and Order, dated December 29, 1988, that defendants are the subject (or have been) of other investigations concerning a similar practice of charging excessive markups to other investors. As indicated previously, there has not been a ruling on the relevance, for whatever purpose, of past improprieties or the historic relationship between the defendants and the two regulatory bodies which govern them (the SEC and the NASD). It is merely noted that, in connection with defendants' current effort to summarily dismiss the Amended Complaint, the past difficulties of the defendants cannot be ignored.
As to the facts asserted in this specific case, however, defendants' argument that no RICO pattern exists because plaintiff has merely alleged a single fraudulent scheme must be rejected. The essence of what has been alleged is a pattern of fraudulent overcharges, which have occurred repeatedly over the course of two years. The scope of the alleged "pattern" of fraud in this case is best revealed by referring to the data in footnote 8, which demonstrate this case involves "continuity," not "sporadic activity." Sedima, 473 U.S. at 496 n. 14. Under Barticheck's flexible approach to evaluating facts relevant to the existence of a pattern, the multiple instances of fraudulent overcharging, over this period of time, constitute a pattern in this case. See also United States v. Grayson, 795 F.2d 278, 290 (3d Cir. 1986) (six predicate acts over one and one-half years sufficient for "pattern" under RICO); Bank of America v. Touche Ross & Co., 782 F.2d 966, 971 (11th Cir. 1986) (nine separate acts of mail and wire fraud over three years sufficient for a pattern under RICO).
A claim under RICO alleging mail, wire or other fraud, must be pleaded with particularity pursuant to Fed. R. Civ. P. 9(b). Saporito v. Combustion Engineering, Inc., 843 F.2d 666, 673 (3d Cir. 1988). Rule 9(b) states:
Fraud, Mistake, Condition of the Mind. In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally.
The requirements of Rule 9(b) for a RICO claim are construed liberally in the Third Circuit. Keystone at 1128; Christidis v. First Pennsylvania Mortgage Trust, 717 F.2d 96, 100 (3d Cir. 1983). Rule 9(b) must be harmonized with the flexibility permitted under Rule 8 of the Federal Rules of Civil Procedure. Seville Indus. Machinery v. Southmost Machinery, 742 F.2d 786, 792 (3d Cir. 1984), cert. denied, 469 U.S. 1211, 84 L. Ed. 2d 327, 105 S. Ct. 1179 (1985). That Rule requires a "short and plain statement" with each pleading being "simple, concise and direct." See Simcox v. San Juan Shipyard, Inc., 754 F.2d 430, 440 (1st Cir. 1985) ("Rule 9 must be read in conjunction with Rule 8 which provides that a complaint should not be struck for the failure to follow a form if the nature of the claim is apparent.")
A complaint need not read like a laundry list of dates, times and persons involved in the underlying transaction. As the Third Circuit explained in Seville :
Rule 9(b) requires plaintiffs to plead with particularity the "circumstances" of the alleged fraud in order to place the defendants on notice of the precise misconduct with which they are charged, and to safeguard defendants against spurious charges of immoral and fraudulent behavior. It is certainly true that allegations of "date, place or time" fulfill these functions, but nothing in the rule requires them. Plaintiffs are free to use alternative means of injecting precision and some measure of substantiation into their allegations of fraud.
742 F.2d at 791. As long as the complaint sets forth enough information to provide factual support for plaintiff's allegations, it meets the standard set forth in Seville. However, although the requirements of Rule 9(b) are interpreted liberally, each element of a RICO claim must be presented with detail sufficient to put the defendant on notice of the claims against him. This requirement of particularity also serves "to demonstrate plaintiffs have investigated the alleged fraud and reasonably believe a wrong has occurred." Kronfeld v. First Jersey Nat. Bank, 638 F. Supp. 1454, 1465 (D.N.J. 1986); see also Fed. R. Civ. P. 11.
The Amended Complaint provides adequate specificity as to the allegations of fraud in this case. The allegations are quite straightforward: without disclosing it to plaintiff, the defendants charged excessive markups on a number of CMO and PO Trust security transactions. While the above cases might not have required it, plaintiff, after obtaining further discovery, is able to allege in the Amended Complaint exact details as to the dates of individual transactions and the amount of the excess overcharges. Under the liberal requirements of notice pleading, such an outline is sufficient. "It is the function of discovery to fill in the details and of trial to establish fully each element of the cause of action." Seville, 742 F.2d at 790.
" Person" and "Enterprise" Requirement
An "enterprise" is defined to include "any individual, partnership, corporation, association, or other legal entity, and any union or group of individuals associated in fact though not a legal entity." 18 U.S.C. § 1961(4) (1982). An enterprise must exist separate and apart from the RICO defendant. See Rose, slip op. at 60; Town of Kearny v. Hudson Meadows Urban Renewal Corp., 829 F.2d 1263, 1266 (3d Cir. 1987); Bennett v. United States Trust Co. v. New York, 770 F.2d 308, 315 (2d Cir. 1985), cert. denied, 474 U.S. 1058, 88 L. Ed. 2d 776, 106 S. Ct. .. 800 (1986); United States v. Computer Sciences Corp., 689 F.2d 1181, 1190 (4th Cir. 1982), cert. denied, 459 U.S. 1105, 74 L. Ed. 2d 953, 103 S. Ct. 729 (1983). This distinction between the enterprise and the person conducting the affairs of the enterprise focuses the court's attention on the culpable party and "recognizes that the enterprise itself is often a passive instrument or victim of the racketeering activity." Bennett, 770 F.2d at 315. Although the Third Circuit has not set forth any uniform interpretation of the statutory definition of enterprise, it has considered various qualities which an enterprise may possess. In Town of Kearny, defendants' association was deemed an enterprise in view of its structure for decisionmaking, its role in overseeing and coordinating the commission of several predicate offenses and other activities carried out on an ongoing basis. 829 F.2d at 1266.
As explained by defendants, a defendant in a civil RICO claim must be a "person" as that term is defined in § 1961(3): "Person includes any individual or entity capable of holding a legal or beneficial interest in property . . ." Pursuant to § 1962(c), such "person" must be "employed by or associated with" an enterprise, which is defined as
"Any individual, partnership, corporation, association or other legal entity, and any union or group of individuals associated in fact although not a legal entity." 18 U.S.C. § 1961(4).
Under the language of Section 1962(c), the "person" subject to liability must be a separate and distinct entity from the "enterprise." B.F. Hirsch v. Enright Refining Co., Inc., 751 F.2d 628, 633 (3d Cir. 1984).
One of the defendants in this case, First Interregional Equity Corporation ("FIEC"), wholly owns another of the defendants, First Interregional Government Securities, Inc. ("FIGS"). Defendants argue in this case that defendant FIEC cannot be deemed to be "associated with" FIGS because FIGS is FIEC's "wholly-owned" subsidiary. Defendants also contend: "For purposes of Section 1962(c), [FIEC] is 'the same entity' as FIGS, and not 'employed by' or 'associated with' FIGS. Plaintiff's motion to amend to include its racketeering claim against [FIEC] must thus be denied for failure to allege a RICO 'enterprise' separate and distinct from the RICO 'persons.'" Defendants' Brief in Opposition to Plaintiff's Motion to Amend, p. 19.
Once again, a purely legal question has arisen where there is a split of authority in the circuits, and an absence of Third Circuit and Supreme Court precedent directly on point. On this issue of whether a parent corporation and its wholly-owned subsidary can be "associated" with each other for RICO purposes, defendants have cited cases involving both "subsidiaries" and "operating divisions." See NCNB National Bank of North Carolina v. Tiller, 814 F.2d 931, 936 (4th Cir. 1987) ("As appellants concede, this court has previously held that a 'person' is not distinct from an 'enterprise' when a corporation and its wholly owned subsidiary are involved"); United States v. Computer Sciences Corp., 689 F.2d 1181, 1190 (4th Cir. 1982) (A corporation, in common parlance, is not regarded as distinct from its unincorporated divisions); Satellite Financial Planning v. First Nat. Bank, 633 F. Supp. 386, 405 n. 23 (D.Del. 1986) ("The complaint alleges a RICO 'enterprise' consisting entirely of wholly-owned or nearly-wholly-owned subsidiaries. Such related entities can conspire in violation of RICO no more than they could for antitrust purposes under Copperweld ").
For the reasons that follow, however, it is concluded that a parent corporation can be a "person" separate and distinct from its wholly-owned subsidiary, the "enterprise." First, as indicated above, a "person" is defined under RICO as "any individual or entity capable of holding a legal or beneficial interest in property." § 1961(3). A separately incorporated entity is clearly capable of holding a legal or beneficial interest in property.
Under the plain terms of the statute, it would appear FIEC is a person, and is thus capable of associating with FIGS.
Second, the cases which have indicated parent companies and their wholly-owned subsidiaries lack the necessary separateness for RICO purposes have apparently relied upon the Supreme Court decision in Copperweld Corp. v. Independence Tube Corp., 467 U.S. 752, 81 L. Ed. 2d 628, 104 S. Ct. 2731 (1984). Copperweld held that a parent corporation and its wholly-owned subsidiary are not capable of conspiring with one another for purposes of section one of the Sherman Act, because that Act is premised on the "basic distinction between concerted and independent action."
Corporations and their individual operating divisions were historically deemed one entity for purposes of evaluating the possible existence of an antitrust conspiracy between two persons. Intending to eliminate antitrust motivations to organize business units as divisions rather than subsidiaries, the court in Copperweld rejected the long standing notion of the "bathtub conspiracy" whereby a parent corporation and its wholly-owned subsidiary were considered two separate parties capable of conspiring. As pointed out in the cases which discuss the applicability of Copperweld in the RICO context, the more reasoned conclusion is that parents can be considered "persons" capable of associating with their subsidiaries under RICO.
In Haroco v. American National Bank & Trust Co. of Chicago, 747 F.2d 384 (7th Cir. 1984), aff'd on other grounds, 473 U.S. 606, 87 L. Ed. 2d 437, 105 S. Ct. 3291 (1985), the Seventh Circuit held "the subsection [1962(c)] requires only some separate and distinct existence for the person and the enterprise, and a subsidiary corporation is certainly a legal entity distinct from its parent." 747 F.2d at 402. Haroco distinguished RICO from the Sherman Act on the grounds that RICO is not premised on the distinction between concerted and independent action. 747 F.2d at 403 n. 22. Corporate affiliates can be said to be "associated" despite the fact that, for Sherman Act purposes, they are not held liable for conspiring.
In Philadelphia TMC, Inc. v. AT&T Information Systems, 651 F. Supp. 169 (E.D. Pa. 1986), the court stated that:
. . . the separation required by Section 1962(c) does not require that the two separate entities be fully independent in the same sense that Section 1 of the Sherman Act does. The RICO 'enterprise' could well be a passive instrumentality through which the RICO 'person' engages in a pattern of racketeering activity. The fact that a wholly owned subsidiary is compliant to the will of its parent corporation in no way precludes the parent from associating with the subsidiary, or from conducting the subsidiary's affairs through a pattern of racketeering activity.
Id. at 173.
The resolution of this issue -- which involves fairly technical reasoning and which has been approached differently by various courts to date -- turns on whether the rationale in Copperweld is automatically applied. While some courts have automatically applied Copperweld without discussion in this RICO context because, nominally, the issue involves the separateness between parent companies and their subsidiaries (which has some superficial appeal), other courts have more carefully considered the words in the RICO statute and the relative policies underlying the Sherman Act and RICO. Although it has been held parent companies and wholly-owned subsidiaries will not be held liable for conspiring to violate the antitrust laws, the words of the RICO statute appear to be aimed at restricting certain activities of such entities. Defendants' argument that the RICO claim fails as a matter of law because the "person" and the "enterprise" are affiliated corporations is rejected.
Defendants argue that in order to adequately plead "racketeering activity" for a RICO claim, a plaintiff must not only allege that the defendants committed the predicate offenses set forth in § 1961(1), but, for those predicate acts alleging fraud, such offenses must be pleaded with particularity under Fed. R. Civ. P. 9(b). Saporito v. Combustion Engineering Inc., 843 F.2d 666, 673 (3d Cir. 1988).
They go on to argue at length that plaintiff has failed to allege, with adequate particularity, predicate acts of mail fraud and wire fraud. This argument turns out to be a red herring because the existence of wire fraud and mail fraud is not necessary in this case. The primary claims contained in the Current Complaint involve claims for securities fraud. The adequacy of the pleadings, as far as particularity are concerned, was previously discussed. Securities fraud is specifically listed as a predicate act of racketeering activity under § 1962.
It appears the defendants have ambitiously attacked the adequacy of the mail fraud and wire fraud allegations because they sought to have the securities fraud claims dismissed. It has been concluded, however, that plaintiff's securities fraud claims survive defendants' motion to dismiss. At the hearing on defendants' motion, moreover, defense counsel conceded that the existence of securities fraud suffices as a predicate act under RICO.
If the securities fraud claims could not have been prosecuted because they were time-barred, it would have been necessary to address the issue of whether the alleged wrongful acts, although no longer giving rise to an actionable securities fraud claim, would be eligible to constitute "predicate acts" under RICO, with its own statute of limitations period. Because the securities fraud claims (particularly the allegations of the underlying activities) remain in the Amended Complaint, however, it is not necessary to engage in a detailed evaluation of the mail fraud and wire fraud claims at this time.
VI. Aiding and Abetting
Finally, defendants have attacked the viability of the federal aiding and abetting claims. In this Circuit, a party may be held liable as an aider and abettor to a fraud where: (1) there has been a commission of a wrongful act - an underlying securities violation; (2) the alleged aider and abettor had knowledge of the act; and (3) the aider and abettor knowingly and substantially participated in the wrongdoing. Monsen v. Consol. Dressed Beef Co., Inc., 579 F.2d 793, 799 (3d Cir.), cert. denied, 439 U.S. 930, 58 L. Ed. 2d 323, 99 S. Ct. 318 (1978).
"The 'substantial assistance' element of aider and abettor liability may be satisfied by 'inaction . . . where the plaintiff demonstrates that the aider-abettor consciously intended to assist in the perpetration of a wrongful act,'" Kronfeld, supra, 638 F. Supp. at 1470. To the extent this is a case involving inaction, the question presented is whether plaintiff has asserted facts in the Amended Complaint from which a reasonable inference could be drawn that the individual defendants had "thrown in" with each other to assist in the commission of securities fraud. See Barker v. Henderson, Franklin, Starnes & Holt, 797 F.2d 490, 497 (7th Cir. 1986); Segal v. Coburn Corp. of America, CCH Fed. Sec. L. Rep. 94,002 at p. 94,021 (E.D.N.Y. 1973).
Paragraph 36 of the Amended Complaint alleges, in relevant part,
. . . and the defendants also aided and abetted such violations by knowingly rendering substantial assistance to each other as set forth above.
While defendants attack the allegation as lacking any specificity as to how the substantial assistance requirement is met, the allegation is quite plain and, under Rule 12(b)(6), to be construed liberally.
For the reasons set forth above, defendants' motion is denied in all respects and plaintiff's motion to file the Amended Complaint is granted.
SO ORDERED, this 11th day of May, 1989.