(CITE AS: 476 F.SUPP. 1142)
Noah A. TROYER and Clara Troyer, Plaintiffs,
v.
Joseph KARCAGI, Prescott, Ball & Turen, Edward D. Jones & Co.,
and First Columbus Corporation, Defendants.
78 Civ. 1946 (RWS).
United States District Court, S. D. New York.
July 11, 1979.
JOHN C. KLOTZ, New York City, for plaintiffs.
Shea, Gould, Climenko & Casey, New York City, for defendant
Edward D. Jones & Co.
Burns, Jackson, Miller, Summit & Jacoby, New York City, for
defendants First Columbus Corporation, and Prescott, Ball &
Turben.
SWEET, District Judge.
Plaintiffs Noah and Clara Troyer ("the Troyers") seek in an
Amended Complaint to recover alleged losses resulting from their
investment in certain discretionary securities trading accounts.
The defendants are one individual, Joseph Karcagi ("Karcagi"),
and three brokerage houses, namely First Columbus Corporation
("First Columbus"), Jones & Co. ("Jones"), and Prescott, Ball &
Turban ("Prescott") (collectively the "company defendants"), with
which Karcagi was associated.
The Troyers claim that defendants have violated Section 10 of
the Securities Exchange Act of 1934, 15 U.S.C.'78j ("the 1934
Act"), and Rule 10b-5 promulgated thereunder, 17
C.F.R.'240.10b-5, and Section 12 of the Securities Act of 1933,
15 U.S.C.'77L ("the 1933 Act"). Defendants have moved, pursuant
to Rules 12(b)(6) and 9(b) of the Federal Rules of Civil
Procedure, to dismiss the Troyers' claims.[FN1] For the reasons
stated below, the motions pursuant to Rule 12(b)(6) are denied
and the motions pursuant to Rule 9(b), granted in part and denied
in part.
The Amended Complaint alleges that the Troyers were
unsophisticated in securities transactions, but had substantial
assets to invest; that in September of 1972 defendant Karcagi
induced them to open cash and margin securities trading accounts
with his employer, defendant First Columbus, and to grant Karcagi
complete discretion to manage the funds in these accounts ("the
discretionary accounts"); and that the Troyers' initial and
subsequent deposits of cash and securities into the discretionary
accounts totalled over $100,000 by the end of 1973. It is further
alleged that Karcagi represented:
(i) that he would invest these funds in the Troyers' best
interests, (ii) that the investments had been profitable and
(iii) that the portfolio was of great value; and that all of
these representations were false because Karcagi intended to
manage the discretionary accounts for his own benefit and because
the Troy ers' portfolio declined, rather than increased, in value.
It is further alleged that Karcagi failed to disclose to the
Troyers that in his management of the discretionary accounts he
engaged in self-dealing by: (i) buying "new issues" of stock for
the Troyers' accounts in transactions where his employer, First
Columbus, acted as a dealer or market-maker, (ii) using the
accounts to make a market in certain securities and (iii) selling
certain securities from the accounts when he anticipated that the
price of those securities would soon rise; and that as a result
of this alleged undisclosed self-dealing, the value of the
Troyers' accounts was substantially reduced as of the end of
1973.
It is further alleged that in December, 1973, Karcagi left
First Columbus and entered the employ of defendant Jones; that in
July of 1976 Karcagi again changed employers, this time becoming
employed by defendant Prescott; that each time Karcagi changed
jobs he induced the Troyers to close their discretionary accounts
with Karcagi's previous employer and to open discretionary
accounts with his new employer; and that Karcagi continued to
misrepresent that his management of the Troyers' accounts had
been profitable. The Amended Complaint finally alleges that in
November of 1977 the Troyers closed their accounts with Prescott,
and that by that time approximately 75% Of their total investment
had been lost.
The Amended Complaint survives defendants' motions to dismiss
pursuant to Rule 12(b)(6), Fed.R.Civ.P., because it contains
allegations of a material misrepresentation or omission by
Karcagi in connection with the purchase or sale of a security.
See Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S.Ct.
1292, 51 L.Ed.2d 480 (1977). Material misrepresentations and
omissions by Karcagi are alleged here, namely: (i) the
misrepresentation of Karcagi's intent to manage the discretionary
accounts in the Troyers' best interests; (ii) the
misrepresentation that Karca gi's management of the accounts had
been profitable; (iii) the misrepresentation that the Troyers'
portfolio was of great value; and (iv) the omissions occurring
when Karcagi failed to disclose his self-dealing.[FN2] These
misrepresentations and omissions were in connection with the
purchase or sale of a security, because the misrepresentations
and omissions allegedly induced the Troyers to invest in the
discretionary accounts, which ac counts are here determined to be
securities. [FN3]
The discretionary accounts were "investment contracts," and
therefore, "securities," [FN4] because these accounts had the
three characteristics necessary to create an investment contract
pursuant to the test announced in SEC v. W. J. Howey Co., 328
U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946). [FN5] Two of the
three prongs of the Howey test are satisfied because the Troyers
allegedly invested money and were led to expect profits solely
from the efforts of Karcagi as their investment manager. It is
less clear whether the other prong of the Howey test "common
enterprise" is adequately alleged, because it does not appear
from the Amended Complaint that any investors other than the
Troyers opened discretionary accounts under Karcagi's management.
The defendants have interpreted "common enterprise" to require
a pooling of the monies of various investors; that is, they see a
requirement of one relationship between an investor and an
investment manager, that is " vertical commonality," is
sufficient to create a common enterprise.[FN6] In this District
vertical commonality has been held sufficient to satisfy the
Howey test when the alleged investment contract is a
discretionary account for trading in commodities futures. See
Johnson v. Arthur Espey, Shearson, Hamill & Co., 341 F.Supp. 764
(S.D.N.Y.1972); Berman v. Orimex Trading, Inc., 291 F.Supp. 701
(S.D.N.Y.1968); and Maheu v. Reynolds & Co., 282 F.Supp. 423
(S.D.N.Y.1967). No compelling reason has been advanced for the
proposition that discretionary commodities accounts and
discretionary securities accounts differ with respect to the
interpretation of the Howey test, nor is a different result
required by the division of authority in other Circuits.[FN7] The
vertical commonality alleged here is there fore sufficient to
satisfy the common enterprise component of the Howey test.
The Amended Complaint also pleads facts sufficient to satisfy
the "purchaser-seller" or "in connection with" requirement of an
action under Rule 10b-5. See Blue Chip Stamps v. Manor Drug
Stores, 421 U.S. 723, 95 S.Ct. 1917, 44 L.Ed.2d 539 (1975). A
purchase can occur whenever an investor takes action that
"represent(s) a new decision by (him) to invest." Fischer v. New
York Stock Exchange, 408 F.Supp. 745, 755 (S.D.N.Y.1976)
(plaintiffs' agreement to extend loans they had previously made
held to be the purchase of an investment contract). In the case
at bar, there are various actions alleged which can be said to
represent a new decision to invest in a discretionary account,
and hence a pur chase of an investment contract, by the Troyers.
More specifical ly, as to the original discretionary accounts with
First Colum bus, the allegation of an initial deposit of funds to
open those accounts constitutes a sufficient allegation of the
purchase of an investment contract, as do each of the allegations
of subse quent deposits of new funds. In addition, the allegation
is sufficiently made that each time the Troyers opened new
discretionary accounts with a new brokerage house (i. e., after
Karcagi moved to Jones and to Prescott), this amounted to the
purchase of a new investment contract.
To satisfy the "in connection with" requirement, however, more
than a purchase is required. That is, there must be a causal
connection between a defendant's misstatements or omissions and
the plaintiff's purchase. See SEC v. Texas Gulf Sulphur Co., 401
F.2d 833, 860 (2d Cir. 1968). There can be no such causal
connection where the misstatement or omission occurred after the
purchase. See duPont v. Wyly, 61 F.R.D. 615, 625 (D.Del.1973).
Hence, where it is alleged that a misrepresentation or omission
by Karcagi induced the "mere retention" of the discretionary
accounts by the Troyers, no claim under Rule 10b-5 can be
asserted in connection with the purchase of the investment
contracts governing the funds already in these accounts. See Blue
Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S.Ct. 1917, 44
L.Ed.2d 539 (1975); Clinton Hudson & Sons v. Lehigh Valley
Cooperative Farms, Inc., 73 F.R.D. 420, 425-26 (E.D.Pa.1977),
Aff'd 586 F.2d 834 (3d Cir. 1978); Ingenito v. Bermec
Corporation, 376 F.Supp. 1154, 1174 (S.D.N.Y.1974). On the other
hand, where it is alleged that a misrepresentation or omission
occurred before one of the purchases of a discretionary account,
as defined above, and that this fraud induced the purchase, a
Rule 10b-5 claim upon which relief can be granted against
Karcagi is stated.[FN8] Defendants' motions pursuant to Rule
12(b)(6) Fed.R.Civ.P. are, therefore, denied as to the Rule 10b-5
claim against Karcagi.
As an alternative to the investment contract claim just
discussed, the Troyers assert a Rule 10b-5 cause of action
against Karcagi based upon fraud in connection with purchases or
sales of the underlying securities traded by Karcagi in the
discretionary accounts. The Rule 10b-5 claim for Karcagi's
alleged omissions relating to his self-dealing in the
transactions listed in Exhib it "B" to the Amended Complaint is
sufficiently alleged, but the allegations as to
misrepresentations and omissions relating to Karcagi's
performance or intentions as the Troyers' investment manager do
not adequately state a Rule 10b-5 claim. This distinc tion obtains
because of the nature of the "in connection with" requirement.
The alleged misrepresentations concerning Karcagi's investment
performance and his intentions affected the investors' confidence
in a person selected by them to be their fiduciary rather than
influencing their decision to purchase or sell particular
securities. The purpose of Rule 10b-5, I. e., to promote "the
maintenance of free and open securities markets nurtured in a
climate of fair dealing"is not therefore sufficiently served.
Niederhoffer, Cross & Zeckhauser, Inc. v. Telstat Systems, 436
F.Supp. 180, 184 (S.D.N.Y. 1977), Quoting Herpich v. Wallace, 430
F.2d 792, 808 (5th Cir. 1970). See Wilson v. First Houston
Investment Corp., 566 F.2d 1235 (5th Cir. 1978), holding that no
Rule 10b-5 claim exists where an investment manager represents
that he will utilize computer analysis to guide investments on
his client's behalf, but then never employs such analysis. See
also Sacks v. Reynolds Securities, Inc., 434 F.Supp. 37
(D.D.C.1977), holding that the "in connection with" requirement
was not satisfied where the defendant brokerage house delayed in
complying with instructions to transfer various accounts to
another brokerage house. See generally Santa Fe Industries, Inc.
v. Green, 430 U.S. 462, 97 S.Ct. 1292, 51 L.Ed.2d 480 (1977).
Hence, under the Troyers' alternative theory of fraud in
connection with purchases or sales of the underlying securities
traded by Karcagi in the discretionary accounts, a Rule 10b-5
cause of action is adequately alleged as to instances of the
purchase or sale of securities under circumstances where Karcagi
failed to disclose self-interest, but not as to other purchases
or sales where Karcagi induced the Troyers to grant him the
discretion to make the purchases or sales by generalized
representations.
The defendants have also moved for dismissal of the Rule 10b-5
claim under Rule 9(b) of the Federal Rules of Civil Procedure,
which requires that "the circumstances constituting fraud" must
be "stated with particularity." [FN9] This means that the Troyers
must state the time, place and content of Karcagi's alleged
misrepresentations. See 2A J. Moore, Federal Practice P 9.03 at
1927 (2d ed. 1975); Todd v. Oppenheimer & Co., 78 F.R.D. 415,
419-21 (S.D.N.Y.1978); Anspach v. Bestline Products, Inc., 382
F.Supp. 1083, 1091 (N.D.Cal.1974), Citing Walling v. Beverly
Enterprises, 476 F.2d 393, 397 (9th Cir. 1973). The nature of
Karcagi's alleged omissions must also be particularly stated.
The pleading of Karcagi's alleged failure to disclose his
self-interest in the transactions listed in Exhibit "B" to the
Amended Complaint is sufficiently particular in that the
transactions and the nature of Karcagi's self-interest in them
are identified. As to the alleged misrepresentations of the
profitability of Karca gi's management of the discretionary
accounts and his intentions to invest in the Troyers' best
interests, the misrepresentations are identified as to who made
them (i. e. Karcagi), and why they were false. However, the
Amended Complaint does not state when or where Karcagi made these
alleged misrepresentations. The failure to specify the time at
which the alleged misrepresentations were made flaws the Amended
Complaint, for two reasons. First, as set forth above,
misrepresentations occurring before a purchase or sale of
securities can be in connection with that transaction, while a
misrepresentation occurring after the transaction cannot be.
Second, as set forth below, the secondary liability of the
company defendants may depend on which one of them employed
Karcagi at the time a misrepresentation was made by him.
In sum, as a result of the lack of particularity as to time and
place, the claims based on misrepresentations, as presently
pleaded, fail to give the defendants "fair notice of what (the
Troyers') claim is and the grounds upon which it rests." Denny
v. Barber, 576 F.2d 465, 469 (2d Cir. 1978). The Rule 10b-5
claims against Karcagi which are based on misrepresentations are,
therefore, dismissed for failure to comply with Fed.R.Civ.P.
9(b). Those claims based on the failure to disclose self-dealing,
however, survive this dismissal.
The Court will entertain a motion for leave to amend as to the
time and place of the alleged misrepresentations if such motion
is made within 20 days of the date of this opinion.[FN10]
The Amended Complaint asserts Rule 10b-5 claims against the
company defendants as (1) controlling persons of Karcagi, (2)
aiders and abettors of Karcagi, or (3) primary violators of Rule
10b-5.
Pursuant to Section 20(a) of the 1934 Act, 15 U.S.C.'78t(a), a
"controlling person" is vicariously liable for violations of that
Act committed by the controlled person.[FN11] As Karcagi's
employer, each of the company defendants can be considered a
"controlling person" as to Karcagi pursuant to s 20(a). See, e.
g., SEC v. First Securities Company of Chicago, 463 F.2d 981 (7th
Cir. 1970), Cert. denied sub nom. McKy v. Hochfelder, 409 U.S.
880, 93 S.Ct. 85, 34 L.Ed.2d 134 (1972), where the court held
that: "Although the statute does not define what constitutes
'control' for the purposes of the foregoing, we have no doubt
that Nay, being the employee of First Securities as its
president, was 'controlled' by First Securities within the
intendment of section 20(a)." Id. at 987 (citation omitted).
Therefore, to the extent that claims for primary liability are
adequately pleaded against Karcagi, as already discussed, each
company defendant may be vicariously liable under Section 20(a)
for Karcagi's alleged violations which occurred at the time
Karcagi was employed by that company defendant.
Whereas vicarious liability pursuant to Section 20(a) can be
based on lack of "good faith," [FN12] aiding and abetting
liability requires scienter. Compare Rolf v. Blyth, Eastman,
Dillon & Co., Inc., 570 F.2d 38 (2d Cir. 1978) (aiding and
abetting) With SEC v. Management Dynamics, Inc., 515 F.2d 801 (2d
Cir. 1975) And SEC v. Geon Industries, Inc., 531 F.2d 39 (2d Cir.
1976) (vicari ous liability). Thus, the addition of an aiding and
abetting claim to a claim based on Section 20(a) will rarely, if
ever, benefit a plaintiff. Indeed, in Geon, supra, the Second
Circuit Court of Appeals refused to consider a claim based on
aiding and abetting raised against the employer of the alleged
primary wrongdoer. The court reasoned that "we find no need to
pass upon the validity of the SEC's theory, since in this context
we fail to see what it would add to the claimed violation of a
duty reasonably supervise (pursuant to'20(a) of the 1934 Act)."
Geon, supra at 51 n. 14. [FN13] Notwithstanding, because of the
uncertainties of the ultimate proof of Karcagi's relationship
with the company defendants, at this pretrial stage it is
appropriate to deal with the motions aimed at dismissal of the
aiding and abet ting claims.
To defeat a motion to dismiss an aiding and abetting claim it
must be alleged that: (i) an independent wrong existed; (ii) the
aider and abettor rendered substantial assistance to the primary
wrongdoer; and (iii) the aider and abettor had the requisite
scienter. See Rolf v. Blyth, Eastman, Dillon & Co., Inc., 570
F.2d 38, 47-48 (2d Cir. 1978). That Karcagi violated Rule 10b-5
the independent wrong is alleged as discussed Supra. "Substantial
assistance" is sufficiently pleaded because the company
defendants allegedly provided Karcagi with facilities to contact
the Troyers and to execute trades for their discretionary
accounts. See Rosen v. Dick, CCH Fed.Sec.L.Rep. P 94,786
(S.D.N.Y. Sept. 3, 1974); Kerbs v. Fall River Industries, Inc.,
502 F.2d 731, 739-40 (10th Cir. 1974). Cf. Buttrey v. Merrill
Lynch, Pierce, Fenner & Smith, Inc., 410 F.2d 135, 144 (7th Cir.
1969), Cert. denied, 396 U.S. 838, 90 S.Ct. 98, 24 L.Ed.2d 88
(1969).
With respect to scienter, the Amended Complaint alleges that
each of the company defendants "knew, or in the exercise of due
care . . . ought to have known of Karcagi's misconduct." In
another paragraph it is alleged, in addition, that Jones and
Prescott failed to make "a reasonable investigation into (the
Troyers') account" and that through such an investigation each of
these two company defendants would have discovered that (a) the
discretionary accounts were invested in ways unsuitable to the
Troyers and (b) that the portfolio had sustained large losses.
These discoveries allegedly would have "revealed" to Jones and
Prescott that Karcagi was engaging in fraudulent conduct.
Actual knowledge of wrongdoing, of course, would constitute
scienter. See, e. g., Gross v. Diversified Mortgage Investors,
431 F.Supp. 1080, 1088 (S.D.N.Y.1977). In addition, where a
fiduciary such as a brokerage house is sought to be held liable
as an aider and abettor, scienter has been defined by the Second
Circuit Court of Appeals to include recklessness. Rolf, supra.
See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47
L.Ed.2d 668 (1976). The issue therefore is presented as to what
constitutes recklessness in the circumstances alleged here.
In Rolf, supra, the defendant was held liable for conduct which
was "highly unreasonable" and which represented "an extreme
departure from the standards of ordinary care . . . to the extent
that the danger was either known to the defendant or so obvious
that the defendant must have been aware of it." Rolf v. Blyth,
Eastman, Dillon & Co., Inc., supra at 47, Quoting Sanders v. John
Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). In footnote 16
to its opinion, however, the Second Circuit refused to adopt the
above-quoted definition exclusively, leaving open the possibility
of a "less strict test" for recklessness. Rolf, supra, 570 F.2d
at 47 n. 16. Nonetheless, if recklessness means something more
culpable than negligence, as it must, then an allegation that a
defendant merely "ought to have known" is not sufficient to
allege recklessness. But cf. Stern v. American Bankshares Corp.,
429 F.Supp. 818 (E.D.Wis.1977) (sustaining a complaint that
alleged that the defendants "knew or should have known of the
facts and circumstances concerning the fraud"); Rolf, supra at 47
n. 16. Therefore, as to First Columbus no recklessness is
alleged.
On the other hand, due to the allegations of a failure to
investigate by Jones and Prescott, the court cannot, on the
present record, find that recklessness has been inadequately
pleaded against them. See SEC v. Spectrum, Ltd., 489 F.2d 535,
542 (2d Cir. 1973) (rejecting the argument that a requirement of
investigation would impose too great a burden on business
activities). See generally Rolf, supra. Cf. SEC v. Coven, 581
F.2d 1020, 1029 (2d Cir. 1978) (stating in dictum that a
defendant can be found liable if, after being put on notice that
a certain fact is questionable, and without having any basis for
believing the fact to be true, the defendant affirmatively
represented to plaintiffs that the fact was true.)
In sum, as to all three of the company defendants scienter is
allegedly based on actual knowledge of Karcagi's misconduct, and
as to Jones and Prescott scienter is also alleged based on
recklessness by failing reasonably to investigate the Troyers'
account. Hence, to the extent that claims for primary liability
are adequately pleaded against Karcagi, the claims against the
company defendants for aiding and abetting are sufficiently
pleaded to withstand defendants' motions under both Fed.R.Civ.P.
12(b)(6) and 9(b).
The Amended Complaint asserts that Jones and Prescott are
primarily liable under Rule 10b-5 for opening margin accounts
which were unsuitable for the Troyers and that First Columbus is
primarily liable, under Rule 10b-5, for maintaining a margin
account unsuitable for them.
The opening or maintenance of an unsuitable margin account,
without disclosure of the unsuitability to the client, renders a
brokerage house primarily liable if that brokerage house acts
with scienter and knowingly or recklessly fails to disclose that
unsuitability. See Clark v. John Lamula Investors, Inc., 583 F.2d
594 (2d Cir. 1978). See also cases cited in Parson v. Hornblower
and Weeks-Hemphill, Noyes, 447 F.Supp. 482, 494 (M.D.N.C.1977),
Aff'd. 571 F.2d 203 (5th Cir. 1978). If the Amended Complaint is
construed most favorably to the Troyers, such knowledge or
recklessness is sufficiently alleged as set forth above.
Therefore, a valid claim for primary liability under Rule 10b-5
is alleged against all three of the company defendants for
opening or maintaining unsuitable margin accounts. The Amended
Complaint may, in addition, be construed to allege a direct
failure by First Columbus and Jones, as entities, to disclose
that they acted as dealers or market-makers in certain
transactions.[FN14] This allegation states a claim upon which
relief can be granted. See, e. g., Chasins v. Smith, Barney &
Co., Inc., 438 F.2d 1167 (2d Cir. 1970). As to Prescott, however,
no self-interest as a dealer or market-maker in transactions for
the Troyers' accounts is alleged; hence, no failure to disclose
such self-interest can be construed to be alleged against
Prescott.
Lastly, the Troyers assert that Prescott is primarily liable to
them for a misrepresentation it allegedly made in the form of a
computer printout listing previous activity in the Troyers'
accounts. Primary liability is asserted because the alleged
misrepresentation, that certain trades had been profitable, was a
statement made directly by Prescott as an entity, rather than
through Karcagi. This claim is inadequate, however, for failure
to satisfy the "in connection with" requirement. Because the
alleged misrepresentation occurred after the purchase of the last
investment contract, the misrepresentation could not be in
connection with the purchases of the discretionary accounts.
Similarly, because the misrepresentation was allegedly made after
the purchases and sales listed on the computer printout, the
alleged misrepresentation could not be in connection with these
purchases and sales. Hence, no cause of action under Rule 10b-5
against Prescott arises from the alleged misrepresentations.
The claims asserted against all of the defendants for
conspiracy and concealed misconduct must be dismissed for failure
to comply with Rule 9(b) of the Federal Rules of Civil Procedure.
A claim of conspiracy to defraud must allege, Inter alia, facts
sufficient to support a finding of an agreement among those
alleged to be part of the conspiracy. Cf. Vermillion Foam
Products Co. v. General Electric Co., 386 F.Supp. 255, 258
(E.D.Mich.1974), Quoting from United States v. North Coast
Transportation Co., 7 F.R.D. 491, 493 (W.D.Wash.1947) (both cases
involving anti-trust conspiracies). See also
Ruder, "Multiple Defendants in Security Law Fraud Cases: Aiding
and Abetting, Conspiracy, In Pari Delicto, Indemnification and
Contribution," 120 U.Pa.L.Rev. 597, 630 (April 1972): "Once the
independent wrong has been established, aiding and abetting
liability will depend upon a showing that the defendant knew of
the wrong and gave assistance to the wrongdoer. Conspiracy
liability will require knowledge plus an agreement with the
wrongdoer." (emphasis added).
The Amended Complaint does not explicitly allege an "agreement"
nor can the allegations therein be construed to particularize an
agreement among the defendants or any two of them. The word
"conspiracy" is mentioned once, albeit in the section of the
Amended Complaint headed "Jurisdictional Allegations." The mere
use of that word, however, is not sufficient to satisfy Rule
9(b). "(A) bare bones statement of 'conspiracy' . . . without any
supporting facts permits dismissal." Heart Disease Research
Foundation v. General Motors Corp., 463 F.2d 98, 100 (2d Cir.
1972) (involving an allegation of a conspiracy under the
anti-trust laws). See Segal v. Gordon, 467 F.2d 602, 607-08 (2d
Cir. 1972) (quoting the above-quoted language to support the
dismissal pursuant to Fed.R.Civ.P. 9(b) of a claim of a
conspiracy to violate Rule 10b-5). [25] Paragraph 20 of the
Amended Complaint, construed most favorably to the Troyers,
alleges that each of the company defendants: (a) knew of
Karcagi's misconduct during his employment by it and by the other
brokerage houses, (b) benefitted by the misconduct, and (c)
concealed the misconduct from the Troyers. These allegations,
however, even if proven, do not explain in what manner an
agreement to defraud the Troyers existed among the defendants, or
between any two of them. The additional facts alleged in the
Amended Complaint, i. e., that the Troyers' accounts were moved
in sequence from one company defendant to another and that
Karcagi was hired sequentially by the company defendants, do not
supplement paragraph 20 of the Amended Complaint to the extent
necessary to particularly allege a conspiracy. Finally, the
addition of the allegation in the opposing papers that there were
transactions relating to the Troyers between Jones and First
Columbus and between Jones and Prescott, does not yield a
sufficiently particular description of an agreement among any of
the defendants. See Segal v. Coburn Corp. of America, (1973
Transfer Binder) CCH Fed.Sec.L.Rep. P 94,002 (E.D.N.Y. April 30,
1973) Quoted in Goldberg v. Shapiro, (1974-75 Transfer Binder)
CCH Fed.Sec.L.Rep. P 94,813 (S.D. N.Y. October 1, 1974). But cf.
Dewitt v. American Stock Transfer Co., 433 F.Supp. 994, 1003
(S.D.N.Y.1977).[FN15] The conspiracy claim is, therefore,
dismissed with prejudice.[FN16]
Paragraph 17(m) of the Amended Complaint asserts that the
defendants engaged in other acts of misconduct which due to their
secretive nature are as yet unknown to plaintiffs. This claim is
inadequate under Rule 9(b) Fed.R.Civ.P. because it relies In toto
on discovery to uncover wrongdoing by defendants. Such total
reliance is improper, even where it is alleged that the
defendants have concealed their wrongdoing. See generally Denny
v. Barber, 576 F.2d 465 (2d Cir. 1978); Goldberg v. Shapiro,
(1974-75 Transfer Binder) CCH Fed.Sec.L.Rep. P 94,813 (S.D.N.Y.
October 1, 1974). The rationale for this conclusion is that "the
intent of Rule 9(b) is to eliminate the type of fraud action in
which all the facts are learned after the complaint is filed
through discovery." Elster v. Alexander, 75 F.R.D. 458, 461
(N.D.Ga.1977). See also Salwen Paper Co., Inc. v. Merrill Lynch,
79 F.R.D. 130, 136 (S.D.N.Y.1978). Therefore, paragraph 17(m) of
the Amended Complaint is dismissed with prejudice for failure to
comply with Rule 9(b) Fed.R.Civ.P.[FN17]
Count II of the Amended Complaint [FN18] asserts a claim
against all of the defendants grounded on'12(2) of the 1933 Act,
15 U.S.C.'771.[FN19] Defendants challenge this claim on three
grounds. The first ground for defendants' motions to dismiss is
that the Section 12 claim is time barred.[FN20] Section 13 of the
1933 Act, 15 U.S.C.'77m, bars suits under Section 12 of that Act
commenced more than three years after the securities involved
were sold. The securities involved in the Troyers' Section 12
claim are the discretionary accounts which, as discussed above,
were "purchased" at various times during the period from
September 1972 to July 1976, the date when the Troyers opened
accounts with Prescott. Because the original complaint was filed
on April 28, 1978, the applicable three year statute of
limitations means that only those discretionary accounts
"purchased" (as purchase is defined above) after April 28, 1975
can be the basis of a Section 12 claim. Therefore, as to those
accounts purchased before April 28, 1975, the Section 12 claim is
dismissed.
The other two grounds for defendants' motion to dismiss the
Troyers' Section 12 claim have been dealt with above. The
discretionary accounts have been held by this court to be
securities. The defendants also contend that the pleadings do not
comply with Rule 9(b), Fed.R.Civ.P. For the reasons stated above,
the court rejects this contention, except that claims based on
misrepresentations, as indicated above, are dismissed for failure
to state the time and place at which those misrepresentations
occurred.
Discovery shall be completed 90 days after the date of this
opinion. The pre trial order and briefs shall be submitted to
this court within two weeks after the completion of discovery.
IT IS SO ORDERED.
.lm .5"
.rm 6"
FN1. Although Karcagi has not moved to dismiss the
Amended Complaint, he did, Pro se, join in motions by
the company defendants to dismiss the original
Complaint. See letter from Karcagi to the Honorable
Henry F. Werker, dated August 4, 1978. This court will,
therefore, treat the motions now before it as including
a motion to dismiss by Karcagi on the grounds asserted
by the company defendants. Further, although the
Amended Complaint is not a model of clarity, for the
purposes of the motions pursuant to Fed.R.Civ.P.
12(b)(6) it must be liberally construed and the
allegations therein must be taken as admitted. See, e.
g., Jenkins v. McKeithen, 395 U.S. 411, 421-22, 89
S.Ct. 1843, 23 L.Ed.2d 404 (1969). Moreover, the
Amended Complaint cannot be dismissed for failure to
state a claim upon which relief can be granted unless
it appears that the Troyers can "prove no set of facts
in support of (their) claim(s) which would entitle
(them) to relief." Id., quoting Conley v. Gibson, 355
U.S. 41, 45-46, 78 S.Ct. 99, 102, 2 L.Ed.2d 80 (1957).
FN2. The alleged failures to disclose include
Karcagi's alleged failure to disclose his or his
employer's role as a dealer or a market-maker. It
should be noted that such failures to disclose would
constitute a material omission. See Chasins v. Smith,
Barney & Co., Inc., 438 F.2d 1167 (2d Cir. 1970).
Moreover, even if the proof at trial shows that there
were formal disclosures to the Troyers via terms such
as "dealer" and "market-maker", a material omission
could obtain if, as is alleged, the Troyers were not
sophisticated enough to understand those terms. See
Chasins, supra; Cant v. A. G. Becker & Co., Inc., 374
F.Supp. 36 (N.D.Ill.1974). See also In re Scientific
Control Corp. Securities Litigation, 71 F.R.D. 491, 508
(S.D.N.Y.1976). It should be further noted that,
although he was their agent, Karcagi's knowledge of the
material facts is not imputed to the Troyers. This
conclusion can be based upon the reasoning in
Schoenbaum v. Firstbrook, 405 F.2d 200, 211-12 (2d Cir.
1968), cert. denied, 395 U.S. 906, 89 S.Ct. 1747, 23
L.Ed.2d 219 (1969), cited with approval in Blue Chip
Stamps v. Manor Drug Stores, 421 U.S. 723, 738, 95
S.Ct. 1917, 44 L.Ed.2d 539 (1975). Although Schoenbaum
involved breaches of duty owed by directors to their
corporation, this distinction, for the purposes of this
action, does not alter the result. Cf. Selzer v. Bank
of Bermuda, Ltd., 385 F.Supp. 415, 419 (S.D.N.Y.1974)
(standing of trust beneficiary to sue trustee under
Rule 10b-5 for misuse of trust corpus not contested by
defendant trustee). But see O'Brien v. Continental
Illinois National Bank and Trust Co., 431 F.Supp. 292
(N.D.Ill.1977), Appeal dismissed, 566 F.2d 1175 (7th
Cir. 1977); and Blackmar v. Lichtenstein, 438 F.Supp.
803 (E.D.Miss.1977), Rev'd on other grounds 578 F.2d
1273 (8th Cir. 1978). See also Sante Fe Industries,
Inc. v. Green, 430 U.S. 462, 97 S.Ct. 1292, 51 L.Ed.2d
48 (1977), which held that fiduciary misconduct is not
actionable under Rule 10b-5 if it does not involve a
misrepresentation or omission to the plaintiffs but,
nonetheless, acknowledged cases such as Schoenbaum,
supra, that held that where there is an "element of
deception as part of the fiduciary misconduct" an
action lies under Rule 10b-5. Santa Fe, supra at 475 n.
15, 97 S.Ct. 1292, 1301 n. 15.
FN3. That the discretionary accounts were investment
contracts is explicitly asserted in the Amended
Complaint. This assertion, however, appears only in
Count II of the Amended Complaint, which pleads a
violation of Section 12 of the Securities Act of 1933,
and not in Count I, which pleads the Rule 10b-5 claim.
Nonetheless, the Amended Complaint as a whole alleges
the facts necessary to support the theory that there is
a claim under Rule 10b-5 because it is here determined
that the discretionary accounts were themselves
securities.
FN4. The term security includes "any . . . investment
contract." '2(1) of the Securities Act of 1933, 15
U.S.C. '77b(1); '3(a)(10) of the Securities Exchange
Act of 1934, 15 U.S.C. '78c(a)(10).
FN5. SEC v. W. J. Howey Co., 328 U.S. 293, at 298-99
and 301, 66 S.Ct. 1100, 1104, at 90 L.Ed. 1244 (1946)
gave the traditional definition of an investment
contract as follows:
(A) contract, transaction or scheme whereby a person
invests his money in a common enterprise and is led to
expect profits solely from the efforts of the promoter
or a third party, it being immaterial whether the
shares in the enterprise are evidenced by formal
certificates or by nominal interests in the physical
assets employed in the enterprise. . . . The test is
whether the scheme involves an investment of money in a
common enterprise with profits to come solely from the
efforts of others. The Court noted, moreover, that this
definition: embodies a flexible rather than a static
principle, one that is capable of adaptation to meet
the countless and variable schemes devised by those who
seek the use of the money of others on the promise of
profits.
Id. at 299, 66 S.Ct. at 1103.
FN6. The concepts of "vertical" as opposed to
"horizontal" commonality are set forth in Securities
Investor Protection Corp. v. Associated Underwriters,
423 F.Supp. 168 (D.Utah 1975).
FN7. The Courts of Appeals of the Seventh and Third
Circuits, and District Courts in the Sixth Circuit,
have adopted the horizontal approach, interpreting
"common enterprise" to mean a relationship among
investors whose monies or investment proceeds are
pooled in the enterprise. See Hirk v. Agri-Research
Council, Inc., 561 F.2d 96 (7th Cir. 1977); Milnarik v.
M-S Commodities, Inc., 457 F.2d 274, 276 (7th Cir.),
Cert. denied, 409 U.S. 887, 93 S.Ct. 113, 34 L.Ed.2d
144 (1972); Wasnowic v. Chicago Board of Trade, 352
F.Supp. 1066, 1069 (M.D.Pa.1972), Aff'd without
opinion, 491 F.2d 752 (3rd Cir.), Cert. denied, 416
U.S. 994, 94 S.Ct. 2407, 40 L.Ed.2d 773 (1974); Berman
v. Bache, Halsey, Stuart, Shields, Inc., 467 F.Supp.
311. (Current Binder) (S.D.Ohio 1979). See also Stuckey
v. duPont Glore Forgan, Inc., 59 F.R.D. 129, 131
(N.D.Cal.1973); and Sunshine Kitchens v. Alanthus
Corp., 403 F.Supp. 719, 721-22 (S.D.Fla.1975) (contract
for the purchase and leasing of a computer held not to
be an investment contract). The horizontal approach of
the above-cited cases is to be contrasted with the
vertical commonality approach adopted by the Courts of
Appeals of the Ninth, Eighth, and Fifth Circuits, and
by District Courts in the Fourth and Tenth Circuits.
See, e. g., Hector v. Wiens, 533 F.2d 429, 433 (9th
Cir. 1976) (summary judgment denied where plaintiff
alleged that a bank and a feedlot operator had worked
together to sell him an investment contract by which he
would invest in the feedlot); SEC v. Glenn W. Turner
Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973); Los
Angeles Trust Deed & Mortgage Exchange v. SEC, 285 F.2d
162 (9th Cir. 1960); Miller v. Central Chinchilla
Group, Inc., 494 F.2d 414 (8th Cir. 1974); Moody v.
Bache & Co., 570 F.2d 523 (5th Cir. 1978); SEC v.
Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir.
1974); SEC v. Continental Commodities Corp., 497 F.2d
516 (5th Cir. 1974); Rochkind v. Reynolds Securities,
Inc., 388 F.Supp. 254 (D.Md.1975); Securities Investor
Protection Corp. v. Associated Underwriters, 423
F.Supp. 168 (D.Utah 1975). But see SEC v. Heritage
Trust Co., 402 F.Supp. 744, 749 (D.Ariz.1975). See also
Marshall v. Lamson Bros. & Co., 368 F.Supp. 486
(S.D.Iowa 1974); Mitzner v. Cardet International, Inc.,
358 F.Supp. 1262 (N.D.Ill.1973); Anderson v. Francis I.
duPont & Co., 291 F.Supp. 705 (D.Minn.1968). These
cases either state or imply that a link between any
single investor and the promoter is sufficient to
satisfy the common enterprise element of the Howey
test.
FN8. This conclusion does not mean that more
particularity is not required as to the time the
alleged misrepresentations occurred vis-a-vis the time
of the purchases. See discussion, Infra.
FN9. Rule 9(b) of the Federal Rules of Civil Procedure
requires that: "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." Rule 9(b) is applicable to
actions under Rule 10b-5. See e. g., Segal v. Gordon,
467 F.2d 602 (2d Cir. 1972); Lewis v. Varnes, 368
F.Supp. 45, 47 (S.D.N.Y.1974), Affd. 505 F.2d 785 (2d
Cir. 1974).
FN10. Leave to amend is not granted as to any aspect
of the Amended Complaint other than with respect to the
time and place of the presently-alleged
misrepresentations.
FN11. Although the Amended Complaint does not
explicitly assert a theory of vicarious liability for
the Section 10 claim, the Troyers raise this theory in
their Memorandum in Opposition. The Second Circuit has
yet to clarify whether vicarious liability for a Rule
10b-5 violation is to be based on'20(a) of the 1934 Act
(15 U.S.C.'78t(a), or on the common law doctrine of
Respondeat superior. Rolf v. Blyth, Eastman, Dillon &
Co., Inc., 570 F.2d 38, 48 (2d Cir. 1978). In large
part because plaintiffs mention'20(a), but not
Respondeat superior in their memorandum in opposition,
the court will not consider liability grounded on the
common law theory.
FN12. More precisely, pursuant to'20(a), a controlling
person has an affirmative defense if that controlling
person "acted in good faith and did not directly or
indirectly induce the act or acts constituting the
violation or cause of action." 15 U.S.C.'78t(a). Where,
as here, the alleged Rule 10b-5 violation is by a
registered representative of a brokerage house, that
brokerage house satisfies the good faith defense if it
takes "some precautionary measures" and "maintain(s)
and diligently enforce(s) a proper system of internal
supervision and control." SEC v. First Securities
Company of Chicago, 463 F.2d 981, 987 (7th Cir. 1970),
Quoting Lorenz v. Watson, 258 F.Supp. 724, 732
(E.D.Pa.1966) and Hecht v. Harris Uphan & Son, 283
F.Supp. 417, 438 (N.D.Cal.1968), Modified on other
grounds, 430 F.2d 1202 (9th Cir. 1970). That is, the
"good faith" defense is made out by a showing of
"reasonable supervision" of the employee. See SEC v.
Geon Industries, Inc., 531 F.2d 39, 50 (2d Cir.1976).
FN13. Indeed, the Troyers' aiding and abetting claim
appears even more superfluous than the one in Geon,
supra. In Geon, which involved an injunctive action
brought by the SEC, sanctions for both vicarious
liability and aiding and abetting could have been
imposed based on a negligence standard, rather than one
of scienter. See Geon, supra; SEC v. Spectrum, Ltd.,
489 F.2d 535 (2d Cir. 1973).
FN14. The Amended Complaint mistakenly alleges that
First Columbus and Jones were market-markers in Amrac
stock. Because Amrac was listed on the American Stock
Exchange, neither First Columbus nor Jones could
technically be a "market-maker" in Amrac stock. See the
definition of market-maker in SEC Rule 17a-9(1), 17
C.F.R.'240.17a-9. Nonetheless, First Columbus and Jones
could be dealers in Amrac stock.
FN15. Rule 9(b) does not work to penalize a plaintiff
merely because he was not privy to, and, therefore,
cannot plead the details of, the inner workings of a
group of defendants who allegedly acted in concert to
defraud him. See Robertson v. National Basketball
Association, 67 F.R.D. 691, 698 (S.D.N.Y.1975). On the
other hand, the allegations supporting a claim of a
conspiracy to defraud must be particular enough to give
the defendants "fair notice of what the plaintiff's
claim is and the grounds upon which it rests." Denny v.
Barber, 576 F.2d 465, 469 (2d Cir. 1978). This the
Amended Complaint fails to do. In light of this
conclusion, the court need not reach the issue of the
sufficiency of the conspiracy claim under Fed.R.Civ.P.
12(b)(6).
FN16. See note 10 Supra.
FN17. Id.
FN18. The Rule 10b-5 claims discussed in the text
preceding this footnote are contained in Count I of the
Amended Complaint.
FN19. Pursuant to'12(2), any person who offered or
sold a security to an investor can be liable to him if
that person made a material misrepresentation or
omission and cannot satisfy the reasonable care
defense. See generally Barnes v. Osofsky, 373 F.2d 269,
272 (2d Cir. 1967). Although the Amended Complaint
refers to Section 12 without identifying a subsection
thereof, the Troyers' claim is apparently asserted
under Section 12(2), rather than section 12(1), because
Section 12(1) involves only violations of Section 5 of
the Securities Act of 1933.
FN20. Jones has not raised the statute of limitations
issue in its motion to dismiss the Amended Complaint.
However, by a letter dated October 17, 1978, Jones did
add such a defense to its motion to dismiss the
original Complaint. The issue will be treated as if
Jones did raise it, so that the discussion in the text
accompanying this footnote applies to Jones as well as
to the other defendants.
E-Mail:
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