Summary
dismissing state law claims pursuant to SLUSA except for state claim not involving purchase or sale of covered security
Summary of this case from Gutierrez v. Deloitte Touche, L.L.P.Opinion
Case No. 3:99-0530
September 17, 1999
MEMORANDUM
This matter comes before the court on Defendants' Motion to Dismiss. (Docket No. 5) Plaintiff has filed a Response to Defendants' Motion to Dismiss. (Docket No. 12) The defendants have filed a Reply. (Docket No. 16) On September 3, 1999, the parties appeared before this court for oral argument. Upon further reflection, the court has reconsidered its original, tentative decision and, for the reasons expressed herein, modifies that ruling.
STATEMENT OF FACTS AND PROCEDURAL HISTORY
Defendant ESC Strategic Funds, Inc. ("ESC") is an open-end management registered investment company. Defendant SunTrust Equitable Securities Corporation ("Equitable Securities") served as the investment advisor for the ESC Strategic Value Fund ("Value Fund"). Plaintiff Allison Hines invested $50,000 in Class A shares of the Value Fund in September 1997.
Defendants offered shares of the Value Fund to the public by way of a prospectus filed with the Securities and Exchange Commission ("SEC") on February 18, 1997. The defendants sold two classes of shares of the Value Fund. Class A shares carried a maximum front-end sales charge of 4.50% and annual operating expenses of approximately 1.80%, and Class D shares carried a maximum front-end sales charge of 1.50% and annual operating expenses of 2.30%. The Value Fund began operating on May 7, 1997.
The defendants provided a 1997 Prospectus as an exhibit to their Motion to Dismiss. (Docket No. 6, Ex. A) Although the date of the 1997 Prospectus submitted as an exhibit (May 5, 1997) is not the same as the initial 1997 Prospectus cited in Plaintiff's First Amended Complaint (February 18, 1997), Plaintiff has not indicated that there are any substantive differences between the two prospectuses that should prevent the court from considering Defendants' Exhibit A.
On November 25, 1998, the defendants filed a Semi-Annual Report for all ESC funds, including the Value Fund, with the SEC. (Docket No. 6, Ex. B) The Semi-Annual Report provided the following information with respect to the Value Fund:
ESC Strategic Value Fund Like a Category 4 hurricane, the storm from Asia slammed into the world's financial markets — and wreaked havoc during the six months ended September 30, 1998. Damage was apparent across the spectrum and in all sectors — growth stocks, value stocks, large caps, small caps and international stocks — all suffered to some degree. . . .
Our contrarian/value investment philosophy was sorely tested over the course of the period. But, we believe the key to successful investing is having the discipline to stick to the strategy in all market environments. Historically, the markets have handsomely rewarded such investors for their pain and suffering. Nonetheless, the period was a very disappointing and frustrating one. . . .
Standing Strong In recent weeks, many of the situations that so frightened investors earlier in the year have calmed. Asia's rate of decline has slowed, or possibly even flattened out. The Russian economy, while still very shaky, is no longer in complete free-fall. And, in an effort to spark activity overseas, the U.S. Federal Reserve has cut interest rates twice. As a result, the stock market has firmed and even gained back some of the ground lost.
Given this, while we aren't completely out of the woods yet, we believe the worst may be over. But uncertainty lingers — so new highs are rather unlikely in the near-term. Long-term, however, we believe prospects remain extremely bright for the market in general, and our holdings in particular. Which is why we have no plans to change our strategy — we believe it is a proven one. And we know `you've gotta dance with who brung ya' to succeed over the long-term." (Docket No. 3, at ¶ 20; Docket No. 6, Ex. B, at 4)
On February 9, 1999, ESC sent a letter to all investors stating that, on the recommendation of Equitable Securities, the Board of Directors of ESC had decided to liquidate the assets and discontinue operation of the Value Fund effective March 26, 1999. (Docket No. 6, Ex. C) In the letter, ESC informed investors that "[d]uring the almost two years of its existence, the Value Fund has not attracted sufficient interest among prospective investors and is considered unlikely to do so in the future. Furthermore, because of the Fund's asset size, the Board of Directors is concerned that it cannot operate, on an ongoing basis, at a competitive or reasonable expense ratio." (Docket No. 6, Ex. C, at 1) In the letter, Plaintiff was also informed of her right to transfer her investment to another ESC Strategic Fund without incurring any front-end sales charge.Id.
Plaintiff did not exercise her transfer option. After the defendants liquidated the Value Fund, Plaintiff was sent a check in the amount of $35,000, the dollar value of a share in the Value Fund (at the time of liquidation) times the number of shares she owned.
On May 19, 1999, Plaintiff filed suit in the Circuit Court for Davidson County. On June 17, 1999, the defendants filed a Notice of Removal to the United States District Court for the Middle District of Tennessee. (Docket No. 1) On June 23, 1999, Plaintiff filed her First Amended Complaint. (Docket No. 3)
MOTION TO DISMISS STANDARD
On a motion to dismiss, all well-pleaded facts in the complaint are treated as true. See In re Comshare, 1999 WL 460917, at *3 (6th Cir. July 8, 1999). Dismissal of a complaint is not proper "unless it appears beyond doubt that plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46 (1957).
DISCUSSION
The defendants seek the dismissal of all claims in Hines' First Amended Complaint.
1. State Law Claims (Counts One through Four)
The defendants argue that Plaintiff's state law claims (Counts One through Four) should be dismissed because they are all preempted under the Securities Litigation Uniform Standards Act ("Uniform Standards Act"), 15 U.S.C. § 77p(b).
After Congress raised the pleading standards for federal securities fraud claims through passage of the Private Securities Litigation Reform Act ("PSLRA") in 1995, plaintiffs filed suits in state courts in an attempt to avoid these heightened standards in federal court. In 1998, Congress passed the Securities Litigation Uniform Standards Acts to preclude litigants from flooding state courts with securities fraud suits.
Pursuant to Section 16(b), 15 U.S.C. § 77p(b),
No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging —
(1) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or
(2) that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.
There are certain statutory exceptions to this preemption provision, including "a covered class action . . . that is based upon the statutory or common law of the State in which the issuer is incorporated . . . or organized . . . may be maintained in a State or Federal court by a private party." 15 U.S.C. § 77p(d)(1)(A).
For purposes of this section, a "covered class action" is an action which involves
(i) the purchase or sale of securities by the issuer or an affiliate of the issuer exclusively from or to holders of equity securities of the issuer; or
(ii) any recommendation, position, or other communication with respect to the sale of securities of the issuer that —
(I) is made by or on behalf of the issuer or an affiliate of the issuer to holders of equity securities of the issuer; and
(II) concerns decisions of those equity holders with respect to voting their securities, acting in response to a tender or exchange offer, or exercising dissenters' or appraisal rights. 15 U.S.C. § 77p(d)(1)(B).
Although Plaintiff attempts to argue that her class action falls under the exception listed in 15 U.S.C. § 77p(d)(1)(A), she fails to demonstrate that her suit is a covered class action under 15 U.S.C. § 77p(d)(1)(B). (Docket No. 12, at 17-18) Accordingly, Plaintiff's state law claims are not subject to these statutory exceptions. See Docket No. 16, Defendants' Reply at 7-8.
Plaintiff also requests that this court deny the defendants' motion to dismiss Counts One and Two of her First Amended Complaint in order to "allow plaintiff an opportunity to pursue discovery concerning the precise relationship between ESC and [Equitable Securities]. This would also give plaintiff depending upon what the discovery revealed, an opportunity to seek leave to amend to include a state securities law claim under the laws of the state of Maryland, where ESC is incorporated." (Docket No. 12, at 19) As the defendants point out, all discovery is to be stayed during the pendency of a motion to dismiss "unless the court finds upon the motion of any party that particularized discovery is necessary to preserve evidence or to prevent undue prejudice." 15 U.S.C. § 78u-4 (b)(3)(B); 15 U.S.C. § 77z-1(b)(i). This assertion does not persuade the court that discovery is needed to preserve evidence or to prevent undue prejudice.
Plaintiff's state claw claims are preempted if (1) Plaintiff's suit is a "covered class action," (2) the claims are based on Tennessee law, (3) Plaintiff's claims concern a "covered security," and (4) Plaintiff alleges untrue, manipulative, or deceptive statements or omissions in connection with the sale or purchase of the security.
First, Plaintiff's suit is a covered class action pursuant to Section 16(f)(2)(A)(i), which provides that a "covered class action" is
any single law suit in which —
(i) damages are sought on behalf of more than 50 persons or prospective class members, and questions of law or fact common to those persons or members of the prospective class, without reference to issues of individualized reliance on an alleged misstatement or omission, predominate over any questions affecting only individual persons or members; or
(ii) one or more named parties seek to recover damages on a representative basis on behalf of themselves and other unnamed parties similarly situated, and questions of law or fact common to those persons or members of the prospective class predominate over any questions affecting only individual persons or members. . . . 15 U.S.C. § 77p(f)(2)(A).
In her First Amended Complaint, Plaintiff asserts that she has brought this action "on her own behalf and as a plaintiff class action pursuant to Rule 23(b)(1), (b)(2), and (b)(3) of the Federal Rules of Civil Procedure on behalf of a plaintiff class (the `Plaintiff Class') consisting of those individuals and entities who purchased the Value Funds' shares from its commencement on May 7, 1997 until the time it was terminated in March of 1999 (the `Class Period')." (First Amended Complaint at ¶ 9). Furthermore, Plaintiff alleges that "[c]ommon questions of law and fact exist as to all members of the Plaintiff Class and predominate over any questions solely affecting individual members of the Plaintiff Class." (First Amended Complaint at ¶ 14)
Accordingly, Plaintiff's suit is a "covered class action" pursuant to 15 U.S.C. § 77p(f)(2)(A).
Second, Plaintiff's Counts One (State Securities Fraud), Two (Common Law Fraud), Three (Breach of Fiduciary Duty), and Four (Breach of Implied Contract) are all based on Tennessee law. (First Amended Complaint at ¶¶ 29-45)
Third, Plaintiff's state law claims concern a "covered security" as defined in Section 16(f)(3), 15 U.S.C. § 77p(f)(3). Section 16(f)(3) provides that a "covered security" for purposes of the Uniform Standards Act is the same as a "covered security" pursuant to Section 18(b)(1)(2) of the Securities Acts of 1933, 15 U.S.C. § 77r(b). Under Section 18(b)(2), a "covered security" includes "a security issued by an investment company that is registered, or that has filed a registration statement, under the Investment Company Act of 1940." 15 U.S.C. § 77r(2).
Here, ESC is a registered investment company (First Amended Complaint at ¶ 5) and filed a registration statement with the SEC (First Amended Complaint at ¶ 17). Accordingly, Plaintiff's suit concerns a "covered security."
The final factor to be considered is whether Plaintiff's individual state claims are based on allegations of untrue statements, omissions of material fact, or manipulative or deceptive devices in connection with the purchase or sale of a security. For this factor, each count will be examined separately.
(a) Count One: State Securities Fraud
In Count One of her First Amended Complaint, Plaintiff alleges that "[i]n connection with the offer and sale of these securities[,] defendants employed devices, schemes and artifices to defraud, made material misrepresentations and omitted to state material facts . . . necessary to make the statements not misleading, and engaged in acts and practices that operated as a fraud or deceit on plaintiff and the other members of the Plaintiff Class, all in violation of T.C.A. § 48-2-121 (a) and (b)." (First Amended Complaint at ¶ 30)
Plaintiff further alleges that "Defendants also made or caused to be made statements which at the time and in light of the circumstances under which they were made were false and misleading with respect to material facts as set forth herein, in violation of T.C.A. ¶ 48-2-121(c)." (First Amended Complaint at ¶ 31)
Clearly, this claim is preempted under the Uniform Standards Act because the claim is based on allegations of untrue statements, omissions of material facts, and manipulative or deceptive devices. This claim is dismissed with prejudice.
(b) Count Two: Common Law Fraud
In Count Two of her First Amended Complaint, Plaintiff alleges that "Defendants sold the Value Fund to investors through the use of intentional or reckless misrepresentations and omissions of material fact. . . ." (First Amended Complaint at ¶ 35)
As with Count One, this claim is preempted under the Uniform Standards Act because the claim is based on allegations of untrue statements and omissions of material fact. Thus, Plaintiff's second cause of action is dismissed with prejudice.
(c) Count Three. Breach of Fiduciary Duty
Although no fiduciary relationship is created between a broker and a client where the account is not discretionary, a fiduciary relationship is created where, as here, the account is discretionary such that the broker makes decisions as to what investments to make. See J.C. Bradford Futures, Inc. v. Dahlonega Mint, Inc., 1990 WL 95625, *5 (6th Cir. July 11, 1990) (unpublished opinion); Street v. J.C. Bradford Co., 886 F.2d 1472, 1481 (6th Cir. 1989).
In Count Three of her First Amended Complaint, Plaintiff alleges that "Defendants and their officers and directors owed . . . fiduciary duties to act with good faith and integrity, to act in conformance with the representations made to the Plaintiff Class, and to act in the best interests of the Plaintiff Class and not for their own self interest." (First Amended Complaint at ¶ 40)
Specifically, Plaintiff alleges that the defendants breached their fiduciary duties by "causing or allowing the fund to charge excessive fees in light of the short duration of the fund and the performance of the fund, by failing to operate the fund for a reasonable length of time consistent with representations to investors, and by terminating the fund for reasons related to defendants' economic self-interest rather than the best interests of investors." (First Amended Complaint at ¶ 40) Finally, Plaintiff alleges that "if it was defendants' view that the Value Fund had to attract a certain minimum amount of funds to be economically viable, then defendants should not have spent, invested, paid themselves fees from, and/or lost any investor money until that minimum had been achieved." (First Amended Complaint at ¶ 41). Thus, Plaintiff alleges that the defendants are liable for a continuing breach of their fiduciary duties.
The defendants argue that Plaintiff's allegations concerning her breach of fiduciary duty claim are nothing more than assertions that Plaintiff was misled through "(1) false representations about long-term investing in the 1997 Prospectus, (2) false assurances about long-term investing in the Semi-Annual Letter, and (3) false explanations in the February 1999 Letter that ESC was terminating the Value Fund because it could not attract investors." (Docket No. 6, at 8) The defendants contend that because these allegations merely boil down to allegations of untrue statements, omissions of material fact, and deception, they are preempted under the Uniform Standards Act. Id.
In their moving papers, the defendants fail to acknowledge that only those allegations based on untrue statements or omissions of material facts made in connection with the purchase or sale of a covered security are preempted under the Uniform Standards Act. 15 U.S.C. § 77p(b). In their Reply, the defendants limit their motion to dismiss this third cause of action, stating that Plaintiff's claim should be dismissed to the extent that her claim is based on allegations that the representations in the 1997 Prospectus were misleading. (Docket No. 16, at 9) The defendants alternatively argue that this cause of action should be dismissed even if it is ostensibly based on allegations unrelated to the sale of the Value Fund securities because Plaintiff has failed to separate her sale and post-sale allegations. (Docket No. 16, at 9)
Plaintiff argues that her breach of fiduciary duty claim concerns actions by the defendants after she purchased the securities in September 1997. (Docket No. 12, at 16) Because Plaintiff has alleged that the defendants' breach of their fiduciary duties resulted from their actions after she purchased her shares, Plaintiff's post-sale allegations are sufficient to withstand a motion to dismiss.
Accordingly, the defendants' motion to dismiss this third cause of action is denied.
(d) Count Four: Breach of Implied Contract
In Count Four, Plaintiff alleges that "[a]s a result of the representations made to the Plaintiff Class and the decision of the Plaintiff Class to entrust their funds to defendants, defendants assumed an implied contractual obligation to operate the fund and manage investor finds for a reasonable period of time consistent with stated goals and objectives and the load charged to investors, and an implied obligation not to terminate the fund for reasons of their own self-interest." (First Amended Complaint at ¶ 44)
Plaintiff alleges that the defendants breached their implied contract at the time they terminated the fund in March 1999. However, the obligations under the implied contract would have arisen at the time Plaintiff invested in the Value Fund. Thus, it appears that Plaintiff's allegations concern actions by the defendants "in connection with the purchase or sale of a covered security." 15 U.S.C. § 77p(b).
Accordingly, Count Four of Plaintiff's First Amended Complaint is preempted pursuant to the Uniform Standards Act and is dismissed with prejudice.
2. Count Five: Violation of § 12(2) of the Securities Act of 1933
In Count Five, Plaintiff alleges that "defendants intentionally and/or recklessly made oral and written communications which included material misrepresentations and omitted to state material facts necessary to make the statements made not misleading, all in violation of § 12(2) of the federal Securities Act of 1933, 15 U.S.C. § 771(a)(2)." (First Amended Complaint at ¶ 47) Plaintiff further alleges that she "invested in the Value Fund at a price that was affected by defendants' misrepresentations and material omissions." (First Amended Complaint at ¶ 48) Finally, Plaintiff alleges that Equitable Securities is liable for the violations of ESC under the Securities Act of 1933 as a "control person" under 15 U.S.C. § 78t. (First Amended Complaint at ¶ 49)
Section 77o provides that "[e]very person who, by or through stock ownership, agency, or otherwise, or who, pursuant to or in connection with an agreement or understanding with one or more other persons by or through stock ownership, agency, or otherwise, controls any person liable under sections 77k or 77l of this title, shall also be liable jointly or severally with and to the same extent as such controlled person to any person to whom such controlled person is liable. . . ." 15 U.S.C. § 77o. Under 15 U.S.C. § 78t, the liability of a "control person" for section 10(b) or Rule 10b-5 claims is the same. 15 U.S.C. § 78t.
The defendants argue that Plaintiff's claims against Equitable Securities — in both Counts Five and Six — are based only on Plaintiff's allegation that Equitable Securities is a "control person" with respect to ESC pursuant to § 77o (section 12(2) claim) and § 77t (section 10(b) claim). (Docket No. 6, at 19) The defendants contend that because Plaintiff's claims against ESC should be dismissed, Plaintiff's claims against Equitable Securities must also be dismissed because "control person" liability is derivative. Id. (citing In re Comshare, 1999 WL 460917, at * 10 n. 11 (6th Cir. July 8, 1999)).
Section 12(2) provides that any person who "offers or sells a security . . . 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" may be liable to an unknowing purchaser of the security. 15 U.S.C. § 771 (a)(2). In a Section 12(2) claim, reliance on alleged misrepresentations or omissions is not an element. See Wright v. National Warranty Co., 953 F.2d 256, 262 (6th Cir. 1992); see also Parkhurst v. North American Fin. Services, 919 F. Supp. 270, 275 (E.D. Mich. 1996). The defendants argue that the allegations in Count Five are not sufficient to support a claim under Section 12(2) of the Securities Act of 1933, 15 U.S.C. § 771(a)(2). (Docket No. 6, at 14-18)
In order to establish a section 12(2) violation, a plaintiff must show that "(1) defendants offered or sold a security[;] (2) by the use of any means of communication in interstate commerce; (3) through a prospectus or oral communication; (4) by making a false or misleading statement of a material fact or by omitting to state a material fact; (5) plaintiff did not know of the untruth or omission; and (6) defendants knew, or in the exercise of reasonable care could have known of the untruth or omission." Wright, 953 F.2d at 262 n. 3 (citing Ballay v. Legg Mason Wood Walker, Inc., 925 F.2d 682, 687-88 (3rd Cir. 1991)).
First, the defendants argue that Hines' Section 12(2) claim must be based only on representations contained in the 1997 Prospectus because a defendant is only liable for untrue statements in written or oral communications which offer securities for sale or confirm the sale of any securities. (Docket No. 6, at 14-15). In Gustafson v. Alloyd Co., 513 U.S. 561, 577-78 (1995), the Supreme Court held that Section 12(2) applies exclusively to public offerings by issuers and not to private agreements to sell securities. Thus, any alleged misrepresentations or omissions of material fact contained in the Semi-Annual Letter and the February 1999 Letter are not actionable under Section 12(2).
The defendants further argue that (1) Section 19(a) precludes liability for good faith conformity with SEC rules and regulations and (2) any representations in the 1997 Prospectus were not misleading. (Docket No. 6, at 15-18)
Plaintiff alleges that the misleading and untrue statements and omissions of material fact in the 1997 Prospectus were as follows: "[T]he ESC Strategic Value Fund is a suitable investment for investors seeking long-term capital appreciation from purchasing `value' securities. The Manager [of the Value Fund] expects the average holding period of its securities to be two to five years. The Fund is not appropriate for investors seeking to capitalize on short-term market fluctuations or for investors who would be likely to sell shares in the event of short-term declines in value." (First Amended Complaint at ¶ 18)
The plaintiff alleges that defendants failed to disclose in the 1997 Prospectus that one risk investors needed to consider was the possibility that they would "decide to sell out the fund prematurely because they do not like current market conditions or do not believe that they themselves are making enough money from the fund." (First Amended Complaint at ¶ 19) The plaintiff also alleges that the 1997 Prospectus "omitted to tell investors that defendants themselves might liquidate the fund if market conditions or the amount of fees they were earning were not to their liking." (First Amended Complaint at ¶ 25) Further, the defendants "wholly failed to inform investors that the defendants themselves (and not the investors) might determine the period of the investment by liquidating the fund after only a short time. Indeed, defendants failed to make any disclosures to potential investors regarding the circumstances under which the Value Fund might be terminated or whether investors would have any right to vote on the issue of termination." (First Amended Complaint at ¶ 26)
The defendants first argue that Section 19(a) precludes liability for good faith conformity with SEC rules and regulations. (Docket No. 6, at 15-16) They assert that the 1997 Prospectus addressed all of the matters required by SEC Form N1-A. In addition, SEC Form N1-A did not require the defendants to disclose that they might liquidate the fund. (Docket No. 6, at 16) Thus, according to the defendants, because they complied with Form N1-A, Plaintiff's Section 12(2) claim should be dismissed.
According to the defendants, Form N1-A requires disclosure in a prospectus of the principal risk factors concerning investment in a mutual fund, including both those risks peculiar to the fund and those generally applicable to funds with similar investment policies. (Docket No. 6, at 16)
Consideration of Form N1-A by the court as evidence that Plaintiff's Section 12(2) allegations are insufficient to withstand the defendants' motion to dismiss is not appropriate because this SEC form falls outside the four corners of the complaint. Although the Sixth Circuit has held that, on a motion to dismiss, courts may consider the full text of SEC filings, prospectuses, and statements integral to the complaint, even if they are not attached to the complaint, SEC Form N1-A does not fall within this scope. See In re Royal Appliances Sec. Litig., 1995 WL 490131, *2 (6th Cir. Aug. 15, 1995) (unpublished opinion) (citing I. Meyer Pincus Assoc. v. Oppenheimer Co., 936 F.2d 759, 762 (2d Cir. 1991)); see also In re Revco Sec. Litig., 1991 WL 353385, at *1 (N.D. Ohio Dec. 12, 1991).
The defendants also argue that Plaintiff's Section 12(2) claim should be dismissed because the representations in the 1997 Prospectus were not misleading. (Docket No. 6, at 16-18; Docket No. 16, at 6-7) Specifically, the defendants contend that there were ample warnings in the 1997 Prospectus such that there is "no credible argument that plaintiff was unaware of a material risk before she invested." (Docket No. 6, at 18)
In Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), the Supreme Court held that, for an omitted fact to be material in a 10(b) claim, "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the `total mix' of information made available."Basic Inc., 485 U.S. at 231-32 (citing TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)). Although Basic Inc. involved a 10(b) claim, other courts have used this same materiality standard for section 12(2) claims. See In re Craftmatic Sec. Litig., 890 F.2d 628, 640 (3rd Cir. 1990); Kademian v. Ladish Co., 792 F.2d 614, 622 (7th Cir. 1986);Cook v. Avien, Inc., 573 F.2d 685, 693 (1st Cir. 1978).
In reviewing the representations in a prospectus, the prospectus must be read as a whole. See McMahan Co. v. Wherehouse Entertainment, Inc., 900 F.2d 576, 579 (2d Cir. 1990); see also Werbowsky v. American Waste Serv., Inc., 1998 WL 939882, at *2 (6th Cir. Dec. 22, 1998) (unpublished opinion). Thus, the "central issue . . . is not whether the particular statements, taken separately, were literally true, but whether defendants' representations, taken together and in context, would have misled a reasonable investor about the nature of the [securities]."McMahan Co., 900 F.2d at 579.
In their moving papers, the defendants only address Hines' claim that the 1997 Prospectus was misleading in emphasizing that the ESC Value Fund was for long-term investment. (Docket No. 6, at 17) The defendants contend that this excerpt from the 1997 Prospectus is not misleading because immediately following the objected-to portion of the 1997 Prospectus, there is a cautionary statement that "[t]here can be no assurance that the Fund will achieve its investment objective." (Docket No. 6, Ex. A at 7)
They also point to the following cautionary statements in support of their argument that, as a whole, the 1997 Prospectus was not misleading:
(1) Although it is expected that the Fund will invest for long-term capital appreciation, the Manager [of the Value Fund] may liquidate securities without regard to how long they have been held, if such action is considered appropriate. (Docket No. 6, Ex. A at 7, emphasis in original)
(2) There can be, of course, no assurance that the fund will achieve its investment objective. Moreover, investors should be aware that the value of the fund's shares will fluctuate, which may cause a loss in the principal value of the investment. (Docket No. 6, Ex. A at 2, emphasis in original)
(3) The Manager will attempt to manage the Fund's risk, although there can be no assurance the Manager will be successful in this effort. (Docket No. 6, Ex. A at 7)
(4) There is, of course, no assurance that the Fund will achieve its investment objective or be successful in preventing or minimizing the rick of loss that is inherent in particular types of investment products. (Docket No. 6, Ex. A at 7)
In Olkey v. Hyperion 1999 Term Trust, Inc., 98 F.3d 2 (2d Cir. 1996), the Second Circuit held that the cautionary statements in the prospectus precluded the plaintiffs' claim under Section 12(2) of the Securities Act of 1933. In affirming the district court's dismissal of the suit under Fed.R.Civ.P. 12(b)(6), the Second Circuit found that, despite the plaintiffs' claims that the prospectus misrepresented both the investment strategy and the risks involved in the investment, there were sufficient cautionary statements in the prospectus such that the "prospectuses warn[ed] investors of exactly the risk the plaintiff's claim was not disclosed." Olkey, 98 F.3d at 5. While the plaintiffs sought to have all cautionary language in the prospectuses disregarded as "boilerplate," the Second Circuit found that the cautionary language was "too prominent and specific to be disregarded." Id.
Here, the defendants claim that, as in Olkey, the termination of the Value Fund "fell well within the terms of these warnings." (Docket No. 6, at 18) The defendants claim that because the warnings in the 1997 Prospectus were "conspicuous, clear, and readily understandable, there can be no credible argument that Plaintiff was unaware of a material rick before she invested." (Docket No. 6, at 18)
However, the cautionary language in the 1997 Prospectus is not, as it was in Olkey, specific to the actual risks Plaintiff alleges were material. Indeed, the cautionary language from the 1997 Prospectus cited in (1) above only indicates that the Manager of the Value Fund expected to keep certain securities for a period of two to five years but may need to liquidate certain securities — not the fund as a whole — in a shorter period of time. Even if this language were to apply to the Value Fund as a whole (and it does not), the language would not put investors on notice of when and under what circumstances the Value Fund would be terminated. As for the cautionary language cited in (2)-(4) above, these warnings are only general statements that the Value Fund may not achieve its investment objective. The warnings do not indicate that there was a risk that the defendants would close the Value Fund in the event that it did not reach some unspecified goal for the number of investors or the amount of investment in the Value Fund. (Docket No. 12, at 13)
Accordingly, the defendants' motion to dismiss Plaintiff's Section 12(2) claim is denied.
3. Count Six: Violation of § 10(b) of the Securities and Exchange Act
In Count Six of Plaintiff's First Amended Complaint, Plaintiff alleges that "[i]n connection with the offer and sale of securities, defendants intentionally and/or recklessly employed devices, schemes and artifices to defraud, made material misrepresentations and omitted to state material facts . . . necessary to make the statements not misleading, and engaged in acts and practices that operated as a fraud or deceit on plaintiff and the other members of the Plaintiff Class, all in violation of § 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j, and Rule 10(b)-5 of the SEC Regulations promulgated under that Act." (First Amended Complaint at ¶ 52)
Plaintiff also alleges in Count Six that "Plaintiff was unaware of defendants' misrepresentations and reasonably relied on defendants' misrepresentations, omissions and false and misleading statements." Plaintiff also invested in the Value Fund at a price that was affected by defendants' misrepresentations and material omissions. (First Amended Complaint at ¶ 53)
The defendants argue that Plaintiff has failed to allege scienter with particularity. (Docket No. 6, at 10-14)
The defendants also contend that Counts One through Four and Count Six should be dismissed because Plaintiff has failed to allege any misrepresentation of any material fact. (Docket No. 6, at 18; Docket No. 16, at 7) The defendants contend that all of the representations cited by Plaintiff were "qualified by the explicit warnings in the 1997 Prospectus. . . ." (Docket No. 6, at 18) However, as discussed above with respect to Plaintiff's Count Five (see pp. 16-17), ESC's liquidation of the Value Fund during a short-term decline in the market did not fall "within the terms of these warnings." (Docket No. 6, at 18) Thus, the defendants have failed to demonstrate that any of Plaintiff's claims should be dismissed because Plaintiff has failed to allege any material misrepresentations.
In order to state a claim under Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10(b)-5, a plaintiff must allege "in connection with the purchase or sale of securities, the misstatement or omission of a material fact, made with scienter, upon which the plaintiff justifiably relied and which proximately caused the plaintiff's injury."In re Comshare, 1999 WL 460917, at *4 (July 8, 1999) (citing Aschinger v. Columbus Showcase Co., 934 F.2d 1402, 1409 (6th Cir. 1991)). To establish liability under Section 10(b), a plaintiff "must, as a threshold matter, allege in his complaint that the defendant acted with sufficient scienter." Id.
Allegations of securities fraud, as with all allegations of fraud, must satisfy the requirements of Fed.R.Civ.P. 9(b). Rule 9(b) requires that when a plaintiff alleges fraud, "the circumstances constituting fraud or mistake shall be stated with particularity." FED. R. Civ. P. 9(b). Despite the heightened pleading standard in Rule 9(b), Congress passed the Private Securities Litigation Reform Act ("PSLRA") in 1995 after determining that Rule 9(b) had not stemmed the abuse of the securities laws by private litigants. H.R. Conf. Rep. No. 104-369 (1995).
Pursuant to the amendments in the PSLRA, a plaintiff alleging a misstatement or omission must specify "each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1). Furthermore, "the complaint shall, with respect to each act or omission alleged to have violated this chapter, state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2) (1998).
The Sixth Circuit recently held that a plaintiff must plead scienter in a Section 10(b) or Rule 10(b)-5 case "by alleging facts giving rise to a strong inference of recklessness, but not by alleging facts merely establishing that a defendant had the motive and opportunity to commit securities fraud." In re Comshare, 1999 WL 460917, at *5 In defining recklessness, the Sixth Circuit looked to earlier opinions, stating that "recklessness [is] highly unreasonable conduct which is an extreme departure from the standards of ordinary care. While the danger need not be known, it must at least be so obvious that any reasonable man would have known of it." Id. at *7 (citing Mansbach v. Prescott, 598 F.2d 1017, 1025 (6th Cir. 1979)). The Sixth Circuit further explained that recklessness is to be understood as a "mental state apart from negligence and akin to conscious disregard." Id. In applying this pleading standard to the facts of the case, the Sixth Circuit found that the plaintiff's allegations did not satisfy the standard because they merely alleged that the defendants had the motive and opportunity to commit securities fraud. Id. at *9.
Here, the defendants contend that Plaintiff's allegations are also insufficient under the pleading standard set forth in In re Comshare. (Docket No. 6, at 11-14)
First, the defendants contend that Plaintiff has not alleged any "reason for the Court to believe that it is `standard' in the mutual fund industry for prospectuses or other communications with shareholders to state that an investment company may liquidate a mutual fund if its fails to attract investors — or, as in this case, if it faces a precipitous decline in investors threatening the value of the remaining shareholders' assets." (Docket No. 6, at 12)
Although Plaintiff does not specifically allege that the defendants' omissions of material fact were clear departures from the standard of ordinary care in the mutual fund industry, her failure to make such an allegation is not fatal to her claim. Indeed, Plaintiff has alleged that the defendants failed to provide material information concerning the potential duration of the Value Fund and the risk of early termination, especially in light of the defendants' emphasis on the long-term nature of the investment and the high front-end sales charges. (First Amended Complaint at ¶¶ 25-28) Furthermore, there is circumstantial evidence in the February 1999 letter that the defendants were aware at the time the 1997 Prospectus was issued that there was a minimum investment amount needed to ensure the viability of the Value Fund. See Docket No. 6, Ex. C ("During the almost two years of its existence, the Value Fund has not attracted sufficient interest among prospective investors and is considered unlikely to do so in the future.")
The defendants also contend that Plaintiff has failed to allege that ESC had the required state of mind when ESC made the misleading statements or omitted to make material statements in the 1997 Prospectus. (Docket No. 6, at 13) Although the defendants point to the cautionary statements in the 1997 Prospectus as being sufficient to warn investors that they might liquidate the Value Fund if necessary, these cautionary statements do not inform Plaintiff of the risk that the Value Fund would not be able to successfully weather a short-term decline in the market if the Value Fund was unable to attract a minimum total investment.
In all, Plaintiff has alleged that the defendants failed to warn investors that they might terminate the Value Fund during a short-term decline in the market even though they repeatedly emphasized the long-term nature of the defendants' investment strategy. Plaintiff also alleges that, as a result of the misleading statements and omissions, Plaintiff invested in the Value Fund "at a price that was affected" by the misstatements and omissions because she invested in Class A shares which had a higher front-end sales charge but lower annual expenses.
Thus, in repeatedly emphasizing their long-term investment strategy, the defendants failed to warn investors of the risks that the defendants themselves would not be able to follow such a strategy in the event of a short-term decline in the market. Thus, Plaintiff has adequately alleged that the defendants acted with the requisite scienter and the allegations in her First Amended Complaint are sufficient to withstand a motion to dismiss. See Caremark, Inc. v. Coram Healthcare Corp., 113 F.3d 645, 650 n. 7 (7th Cir. 1997) (reversing district court's dismissal of complaint, finding that plaintiff had adequately alleged scienter where plaintiff had alleged that the defendant had represented that its business strategy was to focus on "core business" and to divest "non-strategic businesses" even though the defendant had been negotiating to acquire another business); see also Page v. Derrickson, 1997 WL 148558, at *4.6 (M.D. Fla. Mar. 25, 1997) (finding that plaintiffs had sufficiently alleged 10(b) claim); Carley Capital Group v. Deloitte Touche, L.L.P., 27 F. Supp.2d 1324, 1339-40 (N.D. Ga. 1998) (same).
CONCLUSION
Upon review of the First Amended Complaint and the papers filed in support of and in opposition to Defendants' Motion to Dismiss, this court hereby
(1) grants the defendants' motion to dismiss Counts One, Two, and Four with prejudice; and
"Although federal courts are inclined to grant leave to amend following a dismissal order, there are circumstances where amendment will not be allowed." Sinay v. Lamson Sessions Co., 948 F.2d 1037, 1041 (6th Cir. 1991). Because there is no indication that amendment of these claims would withstand a motion to dismiss, Plaintiff is not to be given an opportunity to replead these claims.
(2) denies the defendants' motion to dismiss Count Three, Five, and Six.
An appropriate Order will enter.
ORDER
Defendants' Motion to Dismiss Plaintiff's First Amended Complaint is GRANTED in part and DENIED in part. (Docket No. 5) Defendants' Motion to Dismiss Counts One, Two and Four is hereby GRANTED and these counts are hereby DISMISSED with prejudice. Defendants' Motion to Dismiss Counts Three, Five and Six is hereby DENIED.
It is so ORDERED.
ORDER
On August 20, 1999, the plaintiff filed a Motion to Certify Class. The court now having denied the defendants' Motion to Dismiss in part, it is hereby ORDERED that the defendants shall respond to the Motion to Certify Class by October 4, 1999.
It is further ORDERED that the Initial Case Management Conference shall be held on October 21, 1999 at 2:00 p.m. in the Chambers of Judge Trauger, 825 United States Courthouse, 801 Broadway, Nashville, Tennessee.
Enter this 17th day of September 1999.