Nathel et al v. Siegal et al

MEMORANDUM OF LAW in Support re: 34 MOTION to Dismiss First Amended Complaint.. Document

S.D.N.Y.January 25, 2008

UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK ----------- ------------- -------- ------------------- ------------------- ¡¡ IRA NA THEL and SHELDON NA THEL, Plaintiffs, -against - 07-CIV-10956 (LBS) RICHARD SIEGAL, GEORGE COLEMAN, HARVEY JOSEPHSON, ROBERT A. TREVISANI, PAUL HOWARD, RICHARD S. GURALNICK, SCHA LEIFER GURALNICK, BISTATE OIL MAAGEMENT CORPORATION, SS&T HOLDING CO., LLC, PALACE EXPLORATION COMPANY, T AH DRILLING CO., INC., TAQ DRILLING CO., INC., OIL AND GAS TITLE HOLDING CORPORATION, JOHN DOES 1-20, JOHN DOE CORPORATIONS 1-20, JOHN DOE LLCs 1-20, and JOHN DOE LLPs 1-20 Defendants. -------- ------ ------- --- ------ ---------------------------------- ------ ¡¡ MOTION TO DISMISS THE FIRST AMENDED COMPLAINT BY RICHARD SIEGAL, PAUL HOWARD, BISTATE OIL MAAGEMENT CORPORATION, SS&T HOLDING CO., LLC, PALACE EXPLORATION COMPAN, TAH DRILLING CO., INC., TAQ DRILLING CO., INC.. OIL AND GAS TITLE HOLDING CORPORATION Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 1 of 24 TABLE OF CONTENTS PRELIMINARY STATEMENT .....................................................................................................2 FACTUAL BACKGROUND..........................................................................................................3 A. Plaintiffs' Introduction to the Investment Strctue ................................................3 B. The Investment Proposals.......................................................................................4 C. Plaintiffs' Investments.... ........................................... ......... ..................................... 5 D. Plaintiffs' Communications with the IRS..............................................................6 E. The Purorted Securities Fraud ...............................................................................7 ARGUMENT................................................................................................................................... 7 1. PLAINTIFFS' SECTION lO(B) CLAIM SHOULD BE DISMISSED. .............................8 A. Plaintiffs' Section 10(b) Claim is Bared By The Statute of Limitations. .............9 B. The Complaint Fails To Allege Misrepresentation Undertaken In Connection With A Purchase of Securities............................................................................... 1 i C. The Complaint Fails to Adequately Plead Pro¡¡imate Cause................................. 12 D. The Complaint Fails to Plead Scienter. .................................................................14 i. The Complaint Fails to Allege that Siegal or Howard Had The Opportity or the Motive to Commit Securities Fraud........................... 15 2. The Complaint Fails to Allege that Siegal or Howard Acted Recklessly. 16 II. THIS COURT SHOULD DISMISS PLAINTIFFS' REMAINING STATE LAW CLAIMS FOR LACK OF SUBJECT MATTER JURISDICTION. ................................. 18 CONCLUSION ............................................................................................................................. i 8 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 2 of 24 TABLE OF AUTHORITIES Cases Acito v. Imcera Group, Inc., 47 F.3d 47(2d Cir. 1995) ..................................................................................................... 15, 16 Arduini/Messina P'ship v. Natl Med. Fin. Servo Corp., 74 F.Supp.2d 352(S.D.N.Y. 1999) .............................................................................................7 Armstrong v. McAlpin, 699 F.2d 79 (2d Cir. 1983) ....................................................................................................... 10 Beck v. Mfrs. Hanover Trust Co., 820 F.2d 46 (2d Cir. I 987) ....................................................................................................... 16 Bell Atlantic Corp. v. Twombly, 127 S.Ct. 1 955 (2007).................................................................................................................. 7 Chil v. Gen. Elec. Co., 101 F.3d 263 (2d Cir. I 996) ..................................................................................................... 14 Credit Acceptance Corp. Sec. Litig., 50 F. Supp. 2d 662, 671 (E.D. Mich. 1999) ...............................................................................8 Dabit v. Merril Lynch, Pierce, Fenner & Smith, Inc., rev'd on other grounds, 126 S.Ct. 1503, (2006) 395 F.3d 25 (2d Cir. 2005) ................................................................................................... I 1 Decker v. Massey-Ferguson, Ltd, 681 F.2d I I 1 (2d Cir. 1982) ......................................................................................................9 Dresner v. Utilty. com, Inc., 371 F. Supp. 2d 476 (S.D.N.Y. 2005) ......................................................................................13 Emergent Capital Inv. Mgmt LLC V. Stone path Group, Inc., 343 F.3d 189 (2d Cir. 2003) .............................................................................................. 12 Ernst & Ernst v. Hochfelder, 425 U.S. 185 (I 976) .................................................................................................................... 9 Fadem v. Ford Motor Co., 352 F. Supp. 2d 501 (S.D.N.Y. 2005) ..................................................................................... 16 Feldman v. Pioneer Petroleum, Inc., 606 F. Supp. 916 (W.D. Okla. 1985)........................................................................................ 14 ii Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 3 of 24 Freschi v. Grand Coal Venture, vacated on other grounds, 478 U.S. 1015 (1986) 767 F.2d 1041 (2d Cir. 1985) ...................................................................................................13 Gamble v. City of New York, No. 2007 WL 2847221 (S.D.N.Y. Sept. 28, 2007) ..................................................................7 Gebhardt v. Allspect, Inc., 96 F. Supp. 2d 33 I (S.D.N.Y. 2000) .......................................................................................7 Giordano v. City of New York, 274 F.3d 740 (2d Cir. 2001) ...................................................................................................... 18 GSGSB, Inc., v. New York Yankees, 862 F. Supp. 1160 (S.D.N.Y. 1994) ........................................................................................17 Hernandez v. Childers, 736 F. Supp. 903 (N.D. Il 1990)........................................................................................ 10 Huddleston v. Herman & MacLean, 640 F.2d 534 (5th Cir. 1 981) ................................................................................................. 12 In re AFC Enters., Inc. Sec. Litg., 348 F. Supp. 2d 1363 (N.D. Ga. 2004)..................................................................................... 15 In re AOL Time Warner Inc. Sec. Litig., 381 F. Supp. 2d 192 (S.D.N.Y. 2004) .........................................................................................9 In re Carter-Wallace, Inc. Sec. Litig., 220 F.3d 36, 39 (2d Cir. 2000) ................................................................................................14 In re CMS Energy Sec. Litig., 403 F. Supp. 2d 625 (E.D. Mich. 2005) ................................................................................... 12 In re Compuware Sec. Litig., 386 F. Supp. 2d 913 (E.D. Mich. 2005) ...................................................................................13 In re Credit Acceptance Corp. Sec. Litig., 50 F. Supp. 2d 662 (E.D. Mich. 1999) ........................................................................................8 In re Merril Lynch & Co. Research Reports Sees. Litig., 272 F. Supp. 2d 243 (S.D.N.Y. 2003) ............................................................................... 15, 17 Kahn v. Kohlberg, Kravis, Roberts & Co., 970 F.2d 1030 (2d Cir. I 992) ...................................................................................................... 9 Kalnit v. Eichler, 264 F.3d 13 1 (2d Cir. 2001) ............................................................................................... 15, 16 II Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 4 of 24 Lentell v. Merril Lynch & Co., Inc., 396 F.3d 161 (2d Cir. 2005) ..................................................................................................8, 12 Liberty Natl Ins. Holding Co. v. Charter Co., 734 F.2d 545 (lith Cir. I 984) ............................................................................................ 12, 17. . Ling v. Deutsche Bank, AG, No. 04 Civ. 4566(HB), 2005 WL 1244689,2005 U.S. Dist. LEXIS 9998 (S.D.N.Y. May 26, 2005).......................... ................................. ................................................ .............................. i 1 Melder v. Morris, 27 F.3d 1097 (5th Cir. I 994) ..................................................................................................... 16 Montoya v. Mamma.com, Inc., 2006 WL 770573 (S.D.N.Y. 2006) .................................................................................... 14,15 Osofsky v. Zipl, 645 F.2d 107 (2d Cir. 1981) ...................................................................................................13 Pross v. Katz, 784 F.2d 455 (2d Cir. 1986) ................................................................................................... I I Rolfv. Blyth, Eastman Dilon & Co., 570 F.2d 38 (2d Cir. 1978) ..................................................................................................... 14 San Leandro Emergency Med Group Profit Sharing Plan v. Philp Morris Cos., 75 F.3d 801 (2d Cir. I 996) ..................................................................................................... 16 SEC v. Zandford, 535 U.S. 813, (2002) ............................................................................................................... I I SECv. Howey Co., 328 U.S. 293 (I 946) ....................................................................................................................9 Sharp v. Coopers & Lybrand, 649 F.2d 175 (3d Cir.1981), cert. denied, 455 U.S. 938 (1982)................................................13 Shields v. City trust Bancorp, Inc., 25 F.3d 1124 (2d Cir. 1994). ...................................................................................... 14, 15, 17 Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87 (2d Cir. 2001) ...................................................................................................7, 13 Wentzka v. Gellman, 991 F.2d 423 (7th Cir. I 993) .................................................................................................... 18 IV Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 5 of 24 Statutes U .S.C. § 78u-4(b )(1).......................... ......... .............................................. ..... ....... ...........................8 15 U.S.C. § 78bb(a) ....................................................................................................................... 13 15 U.S.C. § 78u-4(b)(1 )................................................................................................................8 15 U.S.C. § 78u-4(b )(2) ...............................................................................................................14 28 U.S .C. § 1 658(b)............................................ ...................... ............... ..... ............... ....................9 Fed. R. Civ. P. 9(b).........................................................................................................................8 v Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 6 of 24 Defendants Richard Siegal, Paul Howard, Palace E¡¡ploration Company ("Palace"), The Bistate Oil Management Corp. ("Bistate"), Oil and Gas Title Holding Corp. ("O&G"), and SS&T Holding Corporation (collectively, the "Palace Paries"), along with Defendants TAQ Driling Company and TAR Driling Company (the "Driling Entities," together with the Palace Paries the "Moving Defendants"), respectfully submit this memorandum of law in support of their Motion to Dismiss Plaintiffs' First Amended Complaint (the "Complaint") pursuant to Federal Rules of Civil Procedure 12(b)(6) and 12(b)(1). PRELIMINARY STATEMENT Plaintiffs allege they were induced to invest in a series of general parnerships structured to acquire oil and gas properties by Defendants' false promise that these would allow for significant tal deductions related to intangible drillng costs ("IDCs") associated with e¡¡ploiting those resources. Plaintiffs complain that retus they fied reflecting IDC deductions are presently being audited by the Internal Revenue Service (the "IRS"). This auditing activity, Plaintiffs' allege, reflects that Defendants' representations as to the propriety of their IDC deductions were false. Plaintiffs thus seek, by virte of their Section 1 O(b) claim, damages for the potential loss they e¡¡pect to incur in the event these IDC deductions are disallowed. The Complaint fails to state a claim under Section 1 O(b) of the Securities E¡¡change Act of i 934 (the "E¡¡change Act"): First, Plaintiffs' Section 1 O(b) claim is time-bared. Plaintiffs knew in Januar of2002 that the IDC deductions they sought could be subject to IRS scrutiny. To the e¡¡tent that the auditing activity now takng place evidences a fraudulent inducement -- which it does not -- the E¡¡change Act charges Plaintiffs with constrctive notice of such fraud as ofthat date. Plaintiffs' claim e¡¡pired two years later, in Januar 2004. Second, even assuming Plaintiffs' Section 10(b) claim is not time-bared, it is subject to dismissal because the Complaint fails to identify an actionable misstatement or omission attibutable to Howard or Siegal, the 2 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 7 of 24 only two Moving Defendants against whom it is asserted. Third, the Complaint is devoid of any causal link between the purorted fraud and a har Plaintiffs actually suffered. To the contrary, it is based only on speculation that Plaintiffs' IDC deductions may be disallowed in the future: pro¡¡imate cause canot be established in the absence of an injury. Fourth, the Complaint fails to adequately plead scienter. No motive or opportunty for fraud is ascribed to Howard or Siegal, and Plaintiffs identify no "red flags" from which the Cour could infer recklessness. In the absence of such allegations, a Section i O(b) claim does not lie. Finally, because Plaintiffs fail to plead a violation of Section 10(b), this Cour should dismiss Plaintiffs' remaining state law claims against the Moving Defendants. There e¡¡ists no basis for this Court to e¡¡ercise subject matter jurisdiction over these causes of action. FACTUAL BACKGROUND To the e¡¡tent it finds them to be well-pleaded, this Court should presume as true the following facts alleged by the Complaint: A. Plaintiffs' Introduction to the Investment Structure Plaintiffs Ira Nathel and Sheldon Nathel are the principals of Nathe i & Nathel Inc., a wholesale fruit and vegetable distributor based in New York. In 200 i, Plaintiffs retained a certified public accountant, Defendant Harey Josephson, to provide them with accounting advice. (Compl. ir 47.) A year into his employ, Josephson suggested that Plaintiffs! consider an investment parnership purportedly promoted by Defendant Richard Siegal, a lawyer and accountant who had worked in the "oil and gas e¡¡ploration and development industry" since the 1970s. (Compl. For the puroses of this motion, Defendants presume that Richard Byllott, Plaintiffs' corporate controller, (see Comp!. 11 47), is Plaintiffs' agent such that purorted communications among him and Defendants are properly attibuted to his principals. 3 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 8 of 24 ir 44.) Josephson made a series of representations regarding the rate of retu Plaintiffs could e¡¡pect as a result of investing in a so-called "Siegal Parership.,,2 He fuher indicated that Plaintiffs' paricipation in this investment parnership would result in a tal deduction equal to or in e¡¡cess of the cash they contributed. (Compl. irir 48-49.) Such tal savings, Josephson stated, are derived in par from promissory notes to support costs related to drillng oil and gas properties for which the investment parnership would be obligor. Josephson added, however, that these promissory notes would not be e¡¡ercised by the driling entity holding them, and that no parnership investor would ever see them.3 (Compl. irir 48,50.) In Januar 2002, Plaintiffs contacted Richard Siegal to "confirm Josephson's assessment of the propriety of the talC deductibilty of the proposed investment." (Compl. ir 51.) Siegal told Plaintiffs that previous investment parnerships with which he was affliated had been subject to the scrutiny of tal offcials on prior occasion, but that none "had (Jever lost an audit." (Compl. ir 51.) B. The Investment Proposals Plaintiffs state they obtained from Siegal "Investment Proposals" in connection with the investment parnerships. (Comp. ir 53) According to the Complaint, the Investment Proposals contained a number of "promises and representations of present fact," including the following: . An investment parership "wil be formed with a minimum of (number of) units for capitalization and would contract with a specific driling company to drll a minimum number of wells (J on sites purchased" from Defendant Palace. Defendant O&G, as nominee, would "hold( J all the titles to (theseJ properties and Plaintiffs utilze at various times the term "Siegal Parerships" (Comp!. 11 45), "Siegal partership" (Comp!. 1111 45, 47, 50), and the "Parterships" to describe this investment vehicle. (Comp!. 1111 45,61). Plaintiffs do not explain what they understood this comment to mean. 4 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 9 of 24 wells for the investors' benefit." (Compl. ir 53 (g), (m).) . Driling in connection with the investment parnership's oil and gas acquisitions would be undertaken pursuant to a "Turney Driling Contract,,4 with a driling entity, and paid for by cash and with a "Turey Note" issued by the investment parnership. (Compl. ir 53(j).) This Turey Note would be secured by Subscription Notes e¡¡ecuted by each general parner. (Compl. ir 53(P).) . Bistate would distribute on a quarerly basis to each general parner his or her share of the investment parership's revenues generated by oil and gas sales quarerly. (Compl. ir 53(n).) Such distributions would "be accompanied with a report of all sales of oil and gas by month and by well and a schedule of e¡¡penses paid on the owned wells and leases." (Compl. ir 53(0).) C. Plaintiffs' Investments Plaintiffs invested a cash total of$1,700,000 with eight investment partnerships over a period of four years commencing in 2001. (Compl. ir 66.) Documents received by Plaintiffs in connection with these contributions included a "Prospect Agreement," a "Turey Drillng Contract," a "Turney Note," a "Subscription Agreement," a "Subscription Note" and an "Assumption Agreement." (Compl. ir 56.) Plaintiffs complain that none of the signatues set forth by this contractual material was dated. (Compl. ir 57.) During this same time period, Plaintiffs sought tal deductions in connection with the promissory note obligations incured in connection with the investment parnerships' driling 4 A turnkey driling contract is a term of ar in the oil and gas industr. In its most simple terms, it refers to an agreement in which a driling contractor is paid a set fee to dril to an agreed depth (and sometimes to complete) the well or wells at issue. The driling contractor runs all risk of cost overrns (i.e., costs exceeding the amount it was paid), and is required to furnish any materials and labor necessar, controlling the entire drillng process independently. 5 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 10 of 24 efforts. D. Plaintiffs' Communications with the IRS In or about November 2006, Plaintiffs received a written notice from the IRS asking that they consent to an e¡¡tension of the statute ofliritation applicable to their returs, which were subject to audit. (Compl. ir 70.) Upon contacting the governent to clarify the basis for this request, Plaintiffs spoke with IRS Agent Patrick VilareaL. (Compl. ir 70.) According to the Complaint, and without having reviewed any of the promotional materials related to the investment parnerships, Agent Vilareal indicated to Plaintiffs that their "investments in the Siegal Parnerships were being audited, and that the Siegal Parnerships were aggressive tal shelters taking ilicit tal deductions and that Plaintiffs were facing trouble." (Compl. ir 70.) He further requested Plaintiffs forward to him the promotional materials received in connection with their parnership interests. (Compl. ir 71.) Plaintiffs thereafter contacted Paul Howard, controller for Bistate, to discuss the fact that the investment parnerships were under audit. Howard sought to "assure (Plaintiffs J that the audits were routine and would not lead to any problems." (Compl. ir 72.) According to the Complaint, however, when Plaintiffs told him of the IRS' request for promotional materials, his "demeanor changed." (Compl. ir 72-73.) Howard purortedly advised Plaintiffs that they should consider not complying with the IRS' request for promotional materials, but in the event that they did, the "first five pages" of the Investment Proposals should be removed because "the IRS is going to see something they (sicJ don't like." (Compl. ir 73.) Plaintiffs allege that, in March of2007, they received notices from the managing parners of their investment parnerships notifying them of auditing activity. (Compl. ir 75.) These letters also advised that the IRS had "proposed" to disallow a large percentage of IDC deductions "taken by a parner in a similar parnership structure" to that employed by Plaintiffs' investment 6 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 11 of 24 parnerships. (Compl. ir 76.) Plaintiffs assert that this state of affairs was alaring, because they appeared to be facing "significant accuracy-related penalt(ies J" in connection with their tal returs. (Compl. ir 81.) E. The Purported Securities Frauds Plaintiffs state that the governent audit related to their IDC deductions may conclude that some portion of the wells e¡¡ploited by the investment parnerships were driled prior to their investments. (Compl. irir 89-90,99-101, 107-108.) Accordingly, Plaintiffs complain that some portion of the IDC deductions they have sought may be disallowed, and as a result, they may be the victims ofafraud.6 (Compl. irir 15,17,21; see also Compl. irir 57,65,83,90,102.) ARGUMENT "When deciding a motion to dismiss under Rule 12(b)(6), (the cour) must accept as true all well-pleaded factual allegations of the complaint and draw all inferences in favor of the pleader." Gamble v. City of New York, No. 2007 WL 2847221, at *2 (S.D.N.Y. Sept. 28, 2007). In order to avoid dismissal, a plaintiff must do more than plead mere' (c )onclusory allegations or legal conclusions masquerading as factual conclusions. ,,, Id. (citing Gebhardt v. Allspect, Inc., 96 F. Supp. 2d 331, 333 (S.D.N.Y. 2000) (quoting 2 James Wm. Moore, Moore's Federal Practice ir 12.34(a) (b) (3d ed.l997)). Instead, a complaint must set forth factual allegations sufficient to identify some basis for the relief sought that rises above "the speculative leveL." Bell Atlantic Corp. v. Twombly, 127 S.c. 1955,1965 (2007). 5 The Complaint alleges other acts of purported misconduct, but these relate to Plaintiffs' state law claims as opposed to the alleged securities fraud. See, e.g., Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87,99 (2d Cir. 2001) (While "(p)ost-stock-purchase corporate mismanagement or breach of fiduciary duty may be just as reprehensible as a misleading statement regarding the value ofa security to be sold," "the former is not proscribed by § 10(b), while the latter is actionable."); Arduini/Messina P'ship v. Natl Med Fin. Servo Corp., 74 F.Supp.2d 352, 362 (S.D.N.Y. 1999) (allegations of corporate mismanagement and breach of fiduciary duties cannot provide the basis for a securities fraud claim) (collecting cases). 6 While the Complaint suggests that promises regarding the retu Plaintiffs are to receive were also false, (see, e.g., Compl. 11 2 i), nowhere does the pleading suggest the expected retus went unachieved. 7 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 12 of 24 For the reasons set forth below, Plaintiffs' Section 1O(b) claim does not satisfy this standard and should be dismissed. Plaintiffs' state law claims should likewise be dismissed pursuant to Federal Rule of Civil Procedure 12(b)(1) because, in the absence of an actionable federal securties violation, there is no basis for the Cour's e¡¡ercise of subject matter jurisdiction over those causes of action. I. PLAINTIFFS' SECTION IO(B) CLAIM SHOULD BE DISMISSED. The pleading standard set forth by the Private Securities Litigation Reform Act of 1995 (the "PSLRA") is exacting. A plaintiff seeking relief under Section 10(b) 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 paricularity all facts on which that belief is formed." 1 5 U.S.C. § 78u-4(b)(1); see also In re Credit Acceptance Corp. Sec. Litig., 50 F. Supp. 2d 662, 671 (E.D. Mich. 1999) (noting that, to properly allege fraud, a plaintiff need identify: "(1) the parties and the participants in the alleged fraud; (2) the time, place, and content of the representations; (3) each statement alleged to have been misleading; (4) the reason or reasons why the statement is misleading; (5) if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with paricularity all facts on which the belief is formed; (6) the fraudulent scheme; (7) the fraudulent intent of the defendants; (8) reliance on the fraud; and (9) the injury resulting from the fraud.") (citation and quotation marked omitted); see also Lentell v. Merril Lynch & Co., Inc., 396 F.3d 161, 172 (2d Cir. 2005). A complaint alleging securities fraud also must satisfy the heightened pleading standards of Rule 9(b) ofthe Federal Rules of Civil Procedure, which provides that the circumstances constituting fraud must be stated with paricularity. See Fed. R. Civ. P. 9(b). To satisfy Rule 8 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 13 of 24 9(b), a plaintiff must plead facts from which the Cour may reasonably infer fraud as to each defendant. See, e.g., Decker v. Massey-Ferguson, Ltd., 681 F.2d 11 1,115 (2d Cir. 1982) (citing Ernst & Ernst v. Hochfelder, 425 U.S. 185, 192 (1976). A. Plaintiffs' Section lO(b) Claim is Barred Bv The Statute of Limitations.7 The statute of limitations for a Section 1 O(b) claim e¡¡pires at the earlier of two years "after the discovery of the facts constituting the violation." 28 U.S.C. § 1658(b).8 The period commences after a plaintiff obtains: (i) actual knowledge of the facts giving rise to the action; or (ii) notice of facts, which in the e¡¡ercise of reasonable diligence, would have led to actual knowledge. In re AOL Time Warner Inc. Sec. Litig., 381 F. Supp. 2d 192,209 (S.D.N.Y. 2004) (quoting Kahn v. Kohlberg, Kravis, Roberts & Co., 970 F.2d 1030, 1042 (2d Cir.992)). The latter of these is commonly referred to as "inquiry notice." Id At its core, Plaintiffs' securities claim rests on the notion that they were induced to paricipate in the investment parerships by assurances as to the propriety of deductions arising, in par, from drillng cost obligations associated with the Turey and Subscription Notes. (See, e.g., Compl. irir 21,50-51, 53(j).) The Complaint implies that such assurances were false because certain of their IDC deductions are presently subject to IRS audits, (see Compl. ir 83), which may, in turn, result in the disallowance or all or par of such deductions. (Compl. irir 89- 90,99-101,107-108.) To the e¡¡tent the foregoing theory may be said to properly allege a fraud in the first place, Plaintiffs' Section 10(b) claim is time-bared. 7 The Moving Defendants do not concede that Plaintiffs' partership investments constitute securities. See. e.g., SEC v. Howey Co., 328 U.S. 293 (1946). Instead, they do not reach the issue because, even assuming this characterization is accurate, the Complaint fails to adequately plead a securities fraud. The Exchange Act likewise provides for a statute of repose allowing for a claim five years "after (a securities fraud) violation." 28 V.S.C. § 1658(b) 9 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 14 of 24 Assuming, solely for the puroses of ths motion, that the allegations of the Complaint are tre, Plaintiffs were on inquiry notice of the fraud now alleged over si¡¡ years ago. Plaintiffs knew that a portion of the IDC deductions at issue were to be obtained from driling cÇlsts supported by promissory notes. (See Compl. ir 53(j).) Plaintiffs' claim that, however, that they were told by Defendant Josephson that such promissory notes would never be e¡¡ercised, and that, in fact, Plaintiffs would "never see" them. (Compl. ir 62.) Furher, in Januar 2002, Plaintiffs spoke with Siegal about the "propriety" of the deductions that could be obtained by their contributions to the investment parnerships. (Compl. ir 51.) Siegal advised Plaintiffs that that similar parnership structures had, in fact, been subject to IRS scrutiny. Id. To the e¡¡tent that the Complaint set forth an actionable fraud - which it does not- Plaintiffs were aware offacts suffcient to trigger inquiry notice of the scheme alleged. See Hernandez v. Childers, 736 F. Supp. 903, 908 (N.D. Il 1990) (noting that when a plaintiff obtains notice of facts that would arouse "suspicion or curosity" a duty to investigate shall be imputed to it). Plaintiffs never investigated the basis for auditing activity directed at investment parnerships similar to those in which they paricipated. This is despite the fact that they were told that promissory notes that were to form a basis for their deduction would not be e¡¡ercised and that they may never see them. Constructive knowledge of the alleged fraud -- which is comprised only off acts which lead Plaintiffs to speculate that the governent may disallow some portion of the IDC deductions sought -- is properly attributed to Plaintiffs. Armstrong v. McAlpin, 699 F.2d 79, 88 (2d Cir. 1983) (where plaintiffs "shut( J (theirJ eyes to the facts which (should have calledJ for investigation, knowledge of (the allegedJ fraud (discovered should be J imputed to (themJ.") A two year statute oflimitation is applicable to Plaintiffs' Section 10(b) claim, see 28 U.S.C. § 1658(b), which e¡¡pired no later than January, 2004. 10 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 15 of 24 B. The Complaint Fails To Allege Misrepresentation Undertaken In Connection With A Purchase of Securities. Even if it is not time-bared, Plaintiffs' Section 1 O(b) claim fails because the Complaint does not allege fraudulent activity "in connection with" the purchase or sale of securities. SEC v. Zandford, 535 U.S. 813,822 (2002). In order to fall within the puriew of the E¡¡change Act, the fraud in question must be "integral" to the transaction at issue. Pross v. Katz, 784 F.2d 455, 459 (2d Cir. 1986), quoted in Dabit v. Merril Lynch, Pierce, Fenner & Smith, Inc., 395 F.3d 25,37 (2d Cir. 2005), rev 'd on other grounds, 126 S.Ct. 1503, (2006). Fraudulent acts that are merely incidental or tangentially related to the sale of securities does not meet Section 10(b)'s "in connection with" requirement. Ling v. Deutsche Bank, AG, No. 04 Civ. 4566(HB), 2005 WL 1244689, at *6, 2005 U.S. Dist. LEXIS 9998, at *14 (S.D.N.Y. May 26, 2005). Upon considering whether this standard is met, cours consider the temporal relationship e¡¡isting between a purported fraud and the security purchase or sale -- that is, courts evaluate whether these two "coincide." See SEC, 535 U.S. at 822. The Complaint does not identify any fraudulent act undertaken by either Siegal or Howard "in connection with" Plaintiffs' purchase of a security. To the contrar, the only representation that coincides with their contributions is Siegal's statement that the strcture of the investment parnership had been subject to scrutiny by taling authorities but that they had not lost an audit. (Compl. ir 51l The veracity of this statement, which also undermines the notion that Siegal engaged in a material omission regarding the prospect for an audit, is not challenged anywhere by the Complaint. It thus falls outside the puriew of the E¡¡change Act, and does not provide any basis for Plaintiffs' fraud claim. See Liberty Natl Ins. Holding Co. v. Charter Co., 9 The Complaint further states Seigal told Plaintiffs that the government allows for tax deductions related to lDCs because of its interests in fostering domestic oil and gas exploration. (CompL. 11 51.) It appears this alleged statement is unrelated to Plaintiffs' securities claim; in any event, it likewise is not said to be untre. 11 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 16 of 24 734 F.2d 545,555 (11th Cir. 1984) (observing that the "in connection with" element requires a linked deception and purchase or sale of a security). C. The Complaint Fails to AdeQuatelv Plead Proximate Cause. It is aliomatic that, in order to state a claim under Section 1 O(b), a plaintiff is required to allege both transaction and loss causation. See In re CMS Energy Sec. Litig., 403 F. Supp. 2d 625,628 (E.D. Mich. 2005); Lentell v. Merril Lynch & Co., Inc., 396 F.3d 161, 172 (2d Cir. 2005). Transaction causation has been likened to reliance; a plaintiff must plead that, but for the allegedly fraudulent misrepresentations and omissions, it would not have engaged in the transaction. Id.; see also Emergent Capital Inv. Mgmt LLC v. Stone path Group, Inc., 343 F.3d 189, 196-97 (2d Cir. 2003). Loss causation has been likened to pro¡¡imate cause; a plaintiff must plead that the fraudulent acts at issue are the direct cause of its har. Id. Pro¡¡imate cause is properly alleged only where a purorted misrepresentation relates to the reason or reasons for claimant's actual pecuniary loss. Huddleston v. Herman & MacLean, 640 F.2d 534, 549 (5th Cir. 1981). The Complaint assumes Plaintiffs' IDC deduction may be disallowed upon the conclusion of the current audit, and that accordingly, Plaintiffs "face substantial (potential) monetary losses due to unanticipated tal payments, interests and penalties." (Compl. ir 15.) It does not set forth, however: (i) a factual basis to confirm their presumption that these deductions wil, in fact, be refused; (ii) whether the deductions wil be disallowed in their entirety or in some portion; or even (iii) a causal connection between the anticipated potential disallowance and the fraudulent acts supposedly undertaken by Siegal or Howard. The reason for this is straightforward -- Plaintiffs have yet to suffer any har. Plaintiffs' effort at causation-by-prediction is precisely what the pleading standards set forth by the PSLRA are designed to eliminate. The is no ne¡¡us whatsoever between Plaintiffs' 12 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 17 of 24 claim offraud and an "actual loss (Plaintiffs) suffered." Suez Equity, 250 F.3d at 95; see also In re Compuware Sec. Litig., 386 F. Supp. 2d 913, 918-19 (E.D. Mich. 2005) ("(PJlaintiffs are required to plead ... that (the J misrepresentations pro¡¡imately caused its loss - not merely to state that there is pro¡¡imate causation between the two . . . . Plaintiffs are charged with pleading the connection, listing what it is. . . ."). This is fatal to Plaintiffs' Section 1O(b) claim. Id.; Dresner v. Utilty. com, Inc., 371 F. Supp. 2d 476, 501 (S.D.N.Y. 2005) (dismissing Section 10(b) claim as it pertained to a paricular financing because the pleading "contain( edJ no indication as to what loss was occasioned by" it). Notably, granting Plaintiffs leave to amend so that might tr to cure this defect at a later date wil be futile. Anticipated, or "hoped-for"-but-disal10wed tal benefits reflect a failed e¡¡pectation, not damages fallng within the puriew ofthe E¡¡change Act. See Freschi v. Grand Coal Venture, 767 F.2d 1041,1051 (2d Cir. 1985), vacated on other grounds, 478 U.S. 1015 (1986) ("compensation for hoped-for tal savings would be an impermissible award of damages" under the E¡¡change Act); Sharp v. Coopers & Lybrand, 649 F.2d 175, 190-91 (3d Cir.1981), cert. denied, 455 U.S. 938 (1982). Section 28(a) of the E¡¡change Act states, in relevant, par: no person permitted to maintain a suit for damages under the provisions of this chapter shall recover. . . a total amount in e¡¡cess of his actual damages on account of the (fraudulentJ act complained of. 15 U.S.C. § 78bb(a) (1981). This language means that only actual damages, or out-of-pocket loss, is subject to the protection afforded by Section 10(b). See Osofsky v. Zipl, 645 F.2d 107, 111-12 (2d Cir. 1981). It is only a "hoped for" talC benefit that forms the basis of Plaintiffs' Section 1O(b) claim. Thus, even if they were to e¡¡perience the har that the Complaint now only anticipates, it wil be one that cannot be redressed by the E¡¡change Act as a matter of law. See Feldman v. Pioneer 13 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 18 of 24 Petroleum, Inc., 606 F. Supp. 916, 924 (W.D. Okla. 1985) ("Plaintiffs have failed to prove they have suffered actual loss even though the tal benefits promised in the Prospectus may not materialize. ") D. The Complaint Fails to Plead Scienter. Finally, Plaintiffs' Section 1 O(b) claim must be dismissed because the Complaint fails to properly allege that either Defendant Siegal or Howard possessed the requisite scienter to commit fraud. A pleading involving the E¡¡change Act must "state with paricularity facts giving rise to a strong inference that the defendant acted with the required state of mind" to commit a securities fraud violation. 15 U.S.C. § 78u-4(b)(2); see also Shields, 25 F.3d at 1128. This scienter element to a Section 10(b) claim may be established in either of two ways: "either (a) by alleging facts to show that defendants had both motive and opportity to commit fraud, or (b) by alleging facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness." Chil v. Gen. Elec. Co., 101 F.3d 263,267 (2d Cir. 1996)(citation omitted). Motive and opportunity are established by setting forth a "concrete benefit" that defendant could have "realized by one or more of the (allegedly J false statements identified in the Complaint." Montoya v. Mamma.com, Inc., 2006 WL 770573, at *5 (S.D.N.Y. 2006) (citation omitted); see also Shields v. City trust Bancorp, Inc., 25 F.3d 1124,1130 (2d Cir. 1994) (noting that plaintiff need allege more than the fact that defendant sought to fuher his own economic interest to allege motive for fraud). Recklessness "is, at the least, conduct which is highly unreasonable and which represents an e¡¡treme depare from the standards of ordinary care to the e¡¡tent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it." In re Carter-Wallace, Inc. Sec. Litig., 220 F.3d 36,39 (2d Cir. 2000) citing Rolfv. Blyth, Eastman Dilon & Co., 570 F.2d 38, 47 (2d Cir. 1978)) (internal quotations omitted). 14 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 19 of 24 Notably, while a claimant could potentially engage in group pleading relative to the fraudulent representations forming the basis of its pleading, a strong inference of scienter must be alleged separately as to each defendant. In re Merril Lynch & Co. Research Reports Sees. Litig., 272 F. Supp. 2d 243,262 (S.D.N.Y. 2003) ("(T)o establish scienter in misrepresentation cases, facts must be alleged which paricularize how and why each defendant actually knew, or was reckless in not knowing, that the statements were false at the time made. . . .") (alteration and emphasis in original). That is, there is no such thing as a group pleading of scienter. In re AFC Enters., Inc. Sec. Litig., 348 F. Supp. 2d 1363, 1371 (N.D. Ga. 2004) ("It is important to note that the group pleading doctrine allows attribution of statements to individual defendants; it has no application to the determination of scienter as to individual defendants."). 1. The Complaint Fails to Allege that Siegal or Howard Had The Opportunity or the Motive to Commit Securities Fraud. The Complaint fails to identify a "concrete benefit" to be realized by Siegal or Howard reflecting a motive to commit fraud. Montoya, 2006 WL 770573, at *5 (citation omitted). This canot be accomplished by a generalized assertion of economic interest in those Palace Paries contracting with Plaintiffs. Id.; see also Shields, 25 F.3d at 1130 (noting that more than an allegation that defendant acted in its economic self interest is necessary to allege motive to commit securities fraud). That Howard and Siegal may be salaried by or maintain share ownership in such entities is the tye of motive that could be attibuted to nearly every e¡¡ecutive director or senior management officer the world over - and alone does not suggest motive for fraud. Id.; see also Acito v. Imcera Group, Inc., 47 F.3d 47,54 (2d Cir. 1995) (e¡¡ecutive' compensation dependent on stock value could not, standing alone, suffice to show motive to defraud the public); Kalnit v. Eichler, 264 F.3d 13 1, 139 (2d Cir. 2001) ("(m)otives that are generally possessed by most corporate directors and offcers do not suffce; instead, plaintiffs 15 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 20 of 24 must assert a concrete and personal benefit to the individual defendants resulting from the fraud"); San Leandro Emergency Med Group Profit Sharing Plan v. Philp Morris Cos., 75 F.3d 801, 814 (2d Cir. 1996) (noting that if a generalized desire to maintain a high bond or credit rating qualifies as a suffcient motive for fraud, "virtally every company in United States that e¡¡periences a downtur in stock price could be forced to defend securities fraud actions.") (internal quotations omitted); Melder v. Morris, 27 F.3d 1097, 1102 (5th Cir. 1994) (holding that allegations of desire to have successful IPO were insuffcient to establish motive). 2. The Complaint Fails to Allege that Siegal or Howard Acted Recklesslv. Because Plaintiffs fail to allege that Defendants possessed a motive to commit a fraud, the Complaint must set forth paricularized facts reflecting "strong circumstantial evidence (that any material misrepresentation or omission resulted from) conscious misbehavior or recklessness." Acito, 47 F.3d at 52 (citation omitted). When alleging conscious misbehavior or recklessness on the par of a securities defendant, "the strengt of (Plaintiffs') circumstantial allegations must be correspondingly greater" than those that would be suffcient to establish motive. Beck v. Mfrs. Hanover Trust Co., 820 F.2d 46,50 (2d Cir. 1987); Kalnit, 264 F.3d at 142 ("Where motive is not apparent, it is stil possible to plead scienter by identifying circumstances indicating conscious behavior by the defendant, though the strength of the circumstantial allegations must be correspondingly greater.") (internal quotations omitted). The Complaint must allege paricularized facts from which a strong inference can be drawn that Defendants had "a state of mind appro¡¡imating actual intent, and not merely a heightened form of negligence." Fadem v. Ford Motor Co., 352 F. Supp. 2d 501,517 (S.D.N.Y. 2005) (intemal quotation marks and citation omitted). The Complaint does not allege facts and circumstances reflecting that Howard or Siegal 16 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 21 of 24 knowingly or recklessly obscured the risks related to Plaintiffs' investments. To the contrar, Siegal specifically advised Plaintiffs that investment parership strctues similar to those in which they agreed to engage had been subject to governent scrutiny. (Compl. ir 51.) Although Siegal added that none of these parnerships had lost an audit, ths point is not alleged to be false. Id Nor do Plaintiffs allege a "red flag" suggesting that Howard or Siegal tured a blind eye to the risk of a disallowed talC deduction. All that Plaintiffs do here is employ a "pleading technique (thatJ couple ( s J a factual statement with a conclusory allegation offraudulent intent" -- which is insufficient to "support the inference that the defendants acted recklessly." Shields, 25 F.3d at 1129. Howard's alleged statement to Plaintiffs, in 2006, that the IRS would "not like" aspects of the Investment Proposals, does not change this result. (Compl. ir 73.) The PSLRA's requirements could not be clearer: Plaintiffs are required to allege facts evidencing scienter as to each defendant who purportedly undertook a false statement or a material omission at the time of the securities transaction at issue. GSGSB, Inc., v. New York Yankees, 862 F. Supp.1 160,1 177 (S.D.N. Y. 1994) (plaintiff is required to show that defendant "knew that (its J representations were false when made"); Liberty Natl Ins. Holding Co., 734 F.2d at 555 (Section 10(b) claim requires a causal relationship between the claimed deception and a subsequent purchase or sale). Howard himself is not alleged anywhere in the Complaint to have played a role in Plaintiffs' decision to acquire the securities at issue. Furher, his comment (in any event made years after Plaintiffs' investments), is not probative of the state of mind of any other Section 10(b) Defendant. In re Merril Lynch & Co. Research Reports Sees. Litg., 272 F. Supp. 2d 243, 262 (S.D.N.Y. 2003) ("(TJo establish scienter in misrepresentation cases, facts must be alleged which particularize how and why each defendant actually knew, or was reckless in not knowing, that 17 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 22 of 24 the statements were false at the time made. . . .") (alteration and emphasis in original). Plaintiffs' allegation as to Howard's statement hyperbolic and not evidence of scienter. II. THIS COURT SHOULD DISMISS PLAITIFFS' REMANING STATE LAW CLAIMS FOR LACK OF SUBJECT MATTER JURISDICTION. Because Plaintiffs' Section lO(b) must fail, the Complaint is left with only Plaintiffs' state law claims against the Moving Defendants. As the Second Circuit has instructed, these "should be dismissed so that (the appropriate J state cour(J can, if so called upon, decide for themselves whatever questions of state law this case may present." See Giordano v. City of New York, 274 F.3d 740, 754 (2d Cir. 2001); see also Wentzka v. Gellman, 991 F.2d 423, 425 (7th Cir. 1993) ("(WJhere a federal claim drops out before trial, a district cour should not retain the state claims absent e¡¡traordinary circumstances."). The Moving Defendants therefore request that these causes of action, set forth at Counts II-VI, be dismissed pursuant to Federal Rule of Civil Procedure 1 2(b)(1) for lack of subject matter jurisdiction. CONCLUSION Plaintiffs' claim is based on nothing more than a fear of potential loss related to audits that have yet to conclude. They identify no fraudulent act or any reason to infer fraudulent intent on the par of any Defendant. The Complaint falls woefully short of pleading a fraudulent scheme. For the reasons set forth above, the Moving Defendants respectfully request that the Cour dismiss the Complaint in its entirety. 18 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 23 of 24 Dated: New York, New York Januar 25, 2008 Respectfully submitted, AR KALAN RICE LLP By: Isl Stalev S. Arkin Staney S. Arki (SA 1373) Michelle A. Rice (MR 4254) Lisa C. Solbaken (LS 8910) Justin M. Sher (JS 8379) 590 Madison Ave., 35th Floor New York, New York 10022 (212) 333-0200 (phone) (212) 333-2350 (fa¡) 19 Case 1:07-cv-10956-LBS Document 35 Filed 01/25/2008 Page 24 of 24