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accepting plaintiff's explicit allegations concerning insolvency even though "allegations which would support the argument that [the defendant] was insolvent at the time . . . are implicit at best" because the court must "take the allegations in the light most favorable to the plaintiff"
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99 Civ. 3005 (DLC); 99 Civ. 3015 (DLC).
May 17, 2000.
Hillary Richard, Susan E. Brune, and Laurie Edelstein; BRUNE RICHARD Counsel for Plaintiffs, Thomson Kernaghan Co., Sovereign Partners Co., and Atlantic-Capital Fund, Ltd.
Eric Rieder, Daniel P. Waxman; ROBINSON SILVERMAN PEARCE ARONSOHN BERMAN, Counsel for Plaintiff, JNC Opportunity Fund Ltd.
George A. Zimmerman, Sharon Garb, and Jerome J. Lawton SKADDEN ARPS SLATE MEAGHER FLOM; Counsel for Defendant N. Norman Muller.
Andrew J. Goodman, BRESLER GOODMAN UNTERMAN, Counsel for Defendants David A. Mortman and Johan de Muinck Keizer.
OPINION AND ORDER
These related actions, initially filed on April 26, 1999, seek damages for investments made in defendant Global Intellicom, Inc. ("Global"). On June 10, 1999, plaintiff JNC Opportunity Fund, Ltd. ("JNC") filed an Amended Complaint in 99 Civ. 3015 (the "JNC action") alleging nine causes of action including securities and common law fraud, breach of contract, breach of fiduciary duty, and negligent misrepresentation. On October 6, 1999, plaintiffs Thomsom Kernaghan Co., Ltd. ("Kernaghan"), Sovereign Partners Limited Partnership ("Sovereign"), Atlantis Capital Fund, Ltd. ("Atlantis"), Dominion Capital Fund, Ltd.
These actions are related to an earlier action filed by Global Intellicom, Inc. ("Global") on January 18, 1999. Global asserted essentially that the parties who are the plaintiffs in these two actions had engaged in a market manipulation scheme by shorting Global's stock in an effort to increase their rights to Global's common stock under the conversion agreements which Global had signed when it took money from these plaintiffs to finance Global's business. See Global Intellicom. Inc. v. Thomson Kernaghan Co., 99 Civ. 342, 1999 WL 544708, at *1 (S.D.N.Y. July 27, 1999).
("Dominion"), and Canadian Advantage Limited Partnership ("CALP") filed an Amended Complaint in 99 Civ. 3005 (the "Kernaghan action"), alleging six causes of action, including claims for breach of contract, federal securities and common law fraud, and fraudulent conveyance.
Defendants David A. Mortman ("Mortman"), the former Chief Operating Officer of Global, and Johan de Muinck Keizer ("Keizer"), the former General Counsel of Global, have moved to dismiss the claims against them in the Kernaghan action, and Mortman has filed a motion to dismiss one of the claims against him in the JNC action. Defendant N. Norman Muller ("Muller"), the former Chief Executive Officer of Global, has filed a motion to stay the JNC and Kernaghan actions in light of Global's recent bankruptcy filing, or alternatively to dismiss many of the claims against him in these actions. For the reasons stated, Muller's motion for a stay is denied. The motions to dismiss are denied with the exception that the sixth claim in the Kernaghan action is dismissed against Muller as moot.
BACKGROUND
Kernaghan Allegations
The Amended Complaint in the Kernaghan action alleges the following facts. Plaintiff Kernaghan is a Canadian corporation and a registered broker/dealer whose clients include plaintiffs Dominion, a Bahamas corporation, and CALP, a Canadian limited partnership. Defendant Global is a Nevada corporation with its principal place of business in New York. Muller was, at all times relevant to the transactions at issue in these actions, the Chief Executive Officer of Global as well as Chairman of the Board of Directors of Global. Mortman was the President, Chief Operating Officer, and a Director of Global. Keizer was the Vice President, Secretary, and General Counsel of Global.
To simplify the factual presentation, the Court has only included factual allegations with respect to the defendants involved in the current motions, except where otherwise necessary.
December 1997 Financing: Series 6 Agreement
In December 1997, Global, through officers including Mortman and Keizer, solicited the participation of Kernaghan in obtaining capital financing. Kernaghan, acting on behalf of Dominion and CALP, purchased one million dollars of Global Series 6 Preferred Stock which was held in Kernaghan's name for the benefit of Dominion and CALP. The subscription agreement (the "Series 6 Agreement") was signed by Muller as Chief Executive Officer of Global, and incorporated by reference a Certificate of Designation (the "Series 6 Certificate of Designation") which, among other things, specified the rights and obligations of the parties regarding conversion of the Series 6 Preferred Stock into common stock of Global. Specifically, the Series 6 Certificate of Designation provided that the Series 6 Preferred Stock would become convertible as of the sixtieth day after the closing date of the Series 6 transaction, and set out the formula by which the rate for such conversion would be determined.
July 1998: Lock-Up Agreement Series 11 Subscription Agreement
In July 1998, Global sought to obtain additional financing from Kernaghan as well as to defer the conversion rights pertaining to the Series 6 Preferred Stock. Muller repeatedly represented that despite Global's recent financial difficulties, additional financing by plaintiffs combined with an agreement to lock-up their conversion rights until November 1998 would assure Global's financial stability. Muller also represented that providing new financing would assure that Global would be able to meet its contractual and financial obligations and would be able to honor all conversion notices when the debenture holders tendered their shares. In numerous conversations and negotiations with attorneys for the plaintiffs, Keizer and Muller essentially reiterated the assurances made by Muller as to Global's financial security and ability to comply with its conversion obligations if plaintiffs provided new financing and locked up their Series 6 conversion rights until November 1998.
Relying on these representations, Kernaghan, on behalf of Dominion and CALP, agreed to an amendment to the Series 6 Agreement. This amendment (the "Lock-Up Agreement"), which was signed by Muller as Chief Executive Officer of Global and was to take effect on August 5, 1998, provided, inter alia, that while Kernaghan could convert 11.25% of its shares to common stock at any time, it would defer its conversion rights as to the remaining 88.75% of its Series 6 shares until November is, 1998. In the event the closing price of Global common stock was $3 per share or greater, then an alternative conversion schedule would apply. Under the Lock-Up Agreement, Kernaghan was also entitled to subscribe for and purchase 300 shares of Series 11 Preferred Stock at a price of $1 per share in accordance with the terms and conditions of a Series 11 Subscription Agreement ("Series 11 Subscription Agreement").
On August 7, 1998, Kernaghan, on behalf of Dominion and CALP, paid Global $300 for the purchase of 300 shares of Series 11 Preferred Stock. The Series 11 Subscription Agreement, signed by Muller, defined the parties' rights and obligations and incorporated by reference a Certificate of Designation, signed by Mortman and Keizer, which specified the terms governing the conversion of the Series 11 Preferred Stock into Global common stock.
August 1998: Series 10 Agreement
Similarly, in August 1998, plaintiffs Sovereign and Atlantis agreed to provide Global with financing, and each paid $500,000 to purchase 500 shares of Series 10 Preferred Stock. The subscription agreement (the "Series 10 Agreement") was signed by Muller; the Certificate of Designation defining the terms of conversion, among other of the parties' rights and obligations, was signed by Mortman and Keizer.
In addition to the oral representations made to plaintiffs in July 1998, the Series 10 and Series 11 Agreements also each included written representations as to outstanding financial obligations and claims against the company. Specifically, Global represented in both the Series 10 and 11 Agreements that it had made all required SEC filings in compliance with the Securities Exchange Act of 1934 and that there were "no material claims . . . threatened or contemplated against the Company"; that Global was "not in violation or default . . . of any contract to which it is a party or by which it is bound"; and that "there are no actions, investigations . . . or other proceedings of any nature in effect or pending or to the Company's knowledge threatened . . . ." Nevertheless, despite these oral and written representations, Global and its subsidiaries were then in default on numerous contractual and other financial obligations which were never disclosed, and at least one party had threatened to initiate suit against Global based on such a default. An August 19, 1998 filing with the SEC, — a date two weeks after Global had secured additional financing from plaintiffs — was Global's first disclosure of the fact that it was in default of its contractual obligations and had been in default since at least mid-1997. These defaults had not been reported in any of the SEC filings — referred to as the "Disclosure Documents" and incorporated by reference into the subscription agreements — which were signed, where required, by Muller and Mortman. Plaintiffs allege that Muller, Mortman, and Keizer had actual knowledge of the misrepresentations and omissions of material facts regarding Global's financial situation, or acted with reckless disregard of the truth in failing to ascertain and disclose such information.
August 1998: Conversion Efforts
Beginning on August 25, 1998, various plaintiffs attempted repeatedly to convert portions of their Series 6, 10, and 11 Preferred Stock according to the terms of the relevant Agreements; in each instance of such attempted conversion, Global failed and refused to honor the tendered conversion. Plaintiffs allege that the defendants, including Muller, Mortman, and Keizer never intended for Global to honor its conversion notices with plaintiffs pursuant to the Subscription Agreements. In particular, plaintiffs marshal Global's refusal to honor plaintiffs' conversion notices so soon after the parties' execution of the Lock-Up Agreement as evidence that defendants never intended for Global to honor the Subscription Agreements.
JNC Allegations
The Amended Complaint in the JNC action alleges the following facts. Plaintiff JNC is a corporation organized under the laws of Nevada with its principal place of business in New York, New York. In April 1998, Global sought to raise capital through the sale of convertible debentures, and, on April 30, 1998, Global and JNC entered into an agreement ("Convertible Debenture Agreement") pursuant to which JNC purchased $2 million of Global's 6% Convertible Debentures. Under the Convertible Debenture Agreement, JNC was entitled to convert these securities into Global common stock, under a conversion formula set forth in the debentures themselves within three days of submitting a conversion notice to Global.
JNC alleges that in September and October 1998, in a series of telephone conversations between Muller and representatives of JNC, Muller made misrepresentations to JNC in an attempt to prevent JNC from exercising its existing conversion rights. Muller represented to JNC that Global would be delisted from NASDAQ for failure to meet NASDAQ's net tangible asset requirements if the convertible preferred debt purchased by Global was not exchanged for equity. Muller therefore requested that JNC exchange the debentures currently in its possession for a newly created Series 12 Convertible Preferred Stock, and, based on Muller's representations, on October 19, 1998, JNC and Global entered into an agreement (the "Series 12 Agreement") whereby JNC exchanged the debentures for 2,706 shares of the Series 12 Convertible Preferred Stock. The Series 12 Agreement required,inter alia, that Global make certain filings with the SEC including registering common stock that would be issuable to JNC upon conversion of its Series 12 shares. Global failed to comply with these requirements despite the fact that JNC notified Global of its failure to comply with its obligations under the Series 12 Agreement and JNC's demands for compliance.
JNC alleges that at the time it agreed to refrain from converting its debentures and instead entered into the Series 12 Agreement, Muller had no intention of honoring any exchange agreement with JNC, despite his explicit representation that such an agreement would be honored. JNC further alleges that Muller knew that once JNC's debentures were exchanged for shares of preferred stock, Muller would be able to prevent conversion of that preferred stock by failing to register common stock that would enable the conversion. "This scheme would effectively allow [Global] to reap the benefit of the $2 million paid by JNC without giving up anything of value in return."
DISCUSSION
A court may dismiss an action pursuant to Rule 12(b)(6), Fed.R.Civ.P., only if "`it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which will entitle him to relief.'" Cohen v. Koenig, 25 F.3d 1168, 1172 (2d Cir. 1994) (quoting Conley v. Koenig, 355 U.S. 41, 45-46 (1957)). In considering the motion, the court must take "as true the facts alleged in the complaint and draw all reasonable inferences in the plaintiff's favor." Jackson Nat'l Life Ins. v. Merrill Lynch Co. 32 F.3d 697, 699-700 (2d Cir. 1994). The court can dismiss the claim only if, assuming all facts alleged to be true, plaintiff still fails to plead the basic elements of a cause of action.
A. Dismissal of Mortman and Keizer from the Kernaghan Action
Mortman and Keizer contend that the Amended Complaint in the Kernighan action should be dismissed as against them for failure to state a claim on which relief can be granted. Mortman and Keizer are named only in the second, third, and fourth of the Amended Complaint's six claims.
1. Primary Violations of Section 10(b)
The second claim alleges primary violations of Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder. Mortman and Keizer assert that this claim is defective because plaintiffs failed to charge these particular defendants with any actionable misrepresentations, and failed to plead scienter with sufficient particularity.
Section 10(b) of the Exchange Act provides that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange — (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.15 U.S.C. § 78j(b). Rule 10b-5 "more specifically delineates what constitutes a manipulative or deceptive device or contrivance." Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 534 (2d Cir. 1999). Rule 10b-5 is interpreted to require the following for a plaintiff to maintain a misrepresentation claim:
"in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's action caused [plaintiff] injury."Id. (quoting In re Time Warner Secs. Litig., 9 F.3d 259, 264 (2d Cir. 1993)) (brackets in original).
While it is clear from the Supreme Court's decision inCentral Bank of Denver, N.A. v. First Interstate Bank of Denver. N.A., 511 U.S. 164, 167 (1994), that private civil liability under Section 10(b) applies only to those who "engage in the manipulative or deceptive practice," and not to those "who aid and abet the violation," it is significantly less clear how this distinction should be drawn. In the context of an alleged misstatement the Second Circuit has stated that a Section 10(b) claim
must allege a defendant has made a material misstatement or omission indicating an intent to deceive or defraud in connection with the purchase or sale of a security.Shapiro v. Cantor, 123 F.3d 717. 721 (2d Cir. 1997). Thus the Second Circuit requires that the misrepresentation "be attributed to that specific actor . . . in advance of the investment decision" in order for primary liability to attach. Wright v. Ernst Young LLP, 152 F.3d 169, 175 (2d Cir. 1998). In the context of an alleged manipulative practice in connection with a security, however, a primary violator is defined as one who "`participated in the fraudulent scheme' or other activity proscribed by the securities laws." S.E.C. v. U.S. Environmental. Inc., 155 F.3d 107, 111 (2d Cir. 1998) (quotingS.E.C. v. First Jersey Secs., Inc., 101 F.3d 1450, 1471 (2d Cir. 1996)).
Plaintiffs draw on U.S. Environmental, Inc., 155 F.3d at 111, and First Jersey Secs., Inc., 101 F.3d at 1471, to argue that Mortman and Keiser need not have made any fraudulent misrepresentations themselves, but need only have had knowledge of the fraud and assisted in its perpetration. Because the plaintiffs have sufficiently alleged misrepresentations by both defendants, the Court does not reach this alternate theory of primary liability.
The Amended Complaint alleges misrepresentations by Mortman and Keizer sufficient to withstand the motion to dismiss. As to Mortman, the plaintiffs allege that multiple SEC filings each signed by Mortman and filed between March and June 1998 — referred to as the "Disclosure Documents" in the Subscription Agreements — failed to disclose Global's significant defaults. Defendants' argument that the SEC documents cannot constitute misrepresentations because they were "filed months before the transactions at issue" is unavailing. The Second Circuit has clearly stated that
[s]o long as the fraudulent device employed is of the type that would cause reasonable investors to rely thereon and, so relying, cause them to purchase or sell the corporation's securities, a Rule 10b-5 action may lie. SEC filings generally are the type of "devices" that a reasonable investor would rely on in purchasing securities of the filing corporation.Itoba Ltd. v. Lep, Group PLC, 54 F.3d 118, 123 (2d Cir. 1995).
Thus, Mortman's filing of allegedly false and misleading documents with the SEC which misrepresented Global's financial condition cannot be dismissed as "merely preparatory to the fraud," id., but rather represent misrepresentations upon which plaintiffs' securities fraud claim may be premised.
As to Keizer, plaintiffs allege that on or before July 1998, two of plaintiffs' attorneys had numerous conversations with Keizer and Muller during which both of these defendants assured [the] attorneys that [Global] would be
financially secure and comply with its conversion obligations if plaintiffs provided new financing and locked up their conversion rights under the Series 6 Agreement until November 1998.
Defendants, relying on Shields v. Citytrust Bancorp. Inc., 25 F.3d 1124 (2d Cir. 1994), contend that "misguided optimism is not a cause of action, and does not support an inference of fraud." Id. at 1129. The failure to carry out a promise in connection with a securities transaction, however, may constitute fraud if "when the promise was made, the defendant secretly intended not to perform, or knew tha[t] he could not perform." Gurary v. Winehouse, 190 F.3d 37, 44 (2d Cir. 1999) (internal citation omitted). Consequently,
[s]tatements that are opinions or predictions are not per se inactionable . . . . Statements regarding projections of future performance may be actionable if they are worded as guarantees or are supported by specific statements of fact, or if the speaker does not genuinely or reasonably believe them.In re IBM Corp. Securities Litigation, 163 F.3d 102, 107 (2d Cir. 1998) (internal citations omitted). Here, plaintiffs allege that Keizer represented that Global would comply with its obligations under the Subscription Agreements despite his knowledge that Global did not intend to honor such obligations.
Mortman and Keizer argue, however, that the second claim also fails given the threshold requirement under Section 10(b) and Rule 10b-5 that a plaintiff allege that the defendant acted with sufficient scienter. As the Second Circuit has explained,
[t]he element of scienter . . . requires a plaintiff to show that the defendant acted with intent to deceive, manipulate or defraud, or at least knowing misconduct.Grandon v. Merrill Lynch Co., Inc., 147 F.3d 184, 194 (2d Cir. 1998) (internal citations omitted). Therefore,
[a]s a pleading requirement, a plaintiff must either (a) allege facts to show that defendants had both motive and opportunity to commit fraud or (b) allege facts that constitute strong circumstantial evidence of conscious misbehavior or recklessness.Press, 166 F.3d at 538 (internal quotations omitted). See also Stevelman v. Alias Research. Inc., 174 F.3d 79, 84 (2d Cir. 1999).
Defendants Mortman and Keizer contend that the allegations concerning their scienter are deficient since the plaintiffs have failed to allege that either of them knew that the agreements signed by Muller warranted the absence of undisclosed material contractual breaches. This omission is not fatal, however, since plaintiffs have described (1) statements by both Mortman and Keizer in which knowledge of Global's true financial condition should have been more fully disclosed and (2) strong circumstantial evidence that Keizer knowingly made false statements with the intent to deceive plaintiffs as to Global's true financial condition. Similarly, Mortman is alleged to have been involved in negotiating the August financing and lock-up agreements with plaintiffs without revealing significant defaults by Global which would impede the company's ability to fulfill its contractual obligations to plaintiffs.
2. Control Person Liability
The third claim in the Kernaghan action alleges that Mortman and Keizer are liable as control persons of Global under Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a). Mortman and Keizer contend that this claim against them should be dismissed because plaintiffs have failed to allege more than their status within Global as a basis for such liability.
In order to establish a prima facie case of liability under Section 20(a), a plaintiff must show:
(1) a primary violation by a controlled person; (2) control of the primary violator by the defendant; and (3) "that the controlling person was in some meaningful sense a culpable participant" in the primary violation.Boguslavsky v. Kaplan, 159 F.3d 715, 720 (2d Cir. 1998) (quotingSEC v. First Jersey Securities. Inc., 101 F.3d 1450, 1472 (2d Cir. 1996)). Control over a primary violator may be established by showing that "the defendant possessed `the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise.'" First Jersey, 101 F.3d at 1473 (quoting 17 C.F.R. § 240.12b-2). Actual control over the wrongdoer and the transactions in question is necessary for control person liability. See In re Blech Securities Litigation, 961 F. Supp. 569, 586-87 (S.D.N.Y. 1997). Thus, officer or director status alone does not constitute control. In re Livent Inc. Securities Litigation, 78 F. Supp.2d 194, 221 (S.D.N.Y. 1999) (collecting cases).
The plaintiffs argue that Mortman and Keizer controlled Global, and that Global, the controlled person, committed the primary violations. Mortman and Keizer do not dispute that the Amended Complaint alleges an underlying primary violation of the securities laws by Global. Further, as discussed above in connection with the scienter necessary to allege a primary violation, the plaintiffs have sufficiently pleaded Mortman and Keizer's culpable participation in Global's misrepresentations to plaintiffs. The central issue is therefore whether plaintiffs have sufficiently alleged Mortman and Keizer's control over Global.
The allegations regarding Mortman are sufficient to establish his control over Global for purposes of a motion to dismiss. As discussed above, Mortman signed multiple false SEC reports, documents which were incorporated by reference into the Subscription Agreements. Further, in each of these filings Mortman was given full power of attorney to amend the filings and to act on behalf of Global's other directors. This court agrees with those finding that the signing of a fraudulent SEC filing raises a sufficient inference of control, see. e.g., In re Livent Inc. Securities Litigation, 78 F. Supp.2d at 221-22; Jacobs v.Coopers Lybrand. L.L.P., 97 Civ. 3374, 1999 WL 101772, at *17 (S.D.N.Y. Mar. 1, 1999), an inference which is strengthened by Mortman's explicit authority to amend these documents.
The allegations regarding Keizer's control of Global's operations are as follows: Keizer was the Vice President, Secretary, and General Counsel of Global; he had the authority to represent Global in significant matters as evidenced by his solicitation of capital funding for the corporation, his involvement in negotiating the August financing and Lock-Up Agreement, the fact that he signed the Certificates of Designation for the Series 10 and Series 11 Preferred Stock, and the fact that he was listed as the contact person on several of the Disclosure Documents filed with the SEC; and he owned "a significant number of shares" of Global stock. Despite defendants' arguments to the contrary, these allegations amount to more than a simple statement of Keizer's corporate position. Because the Court finds that from these facts that it is possible to infer that Keizer possessed the power to control the primary violator and the wrongful acts at issue here, the control person claim against Keizer in the Kernaghan action will not be dismissed.
3. Common Law Fraud
The fourth claim in the Kernaghan action alleges a violation of common law fraud. The elements of a fraud claim under New York law are as follows: (1) defendant made a material misstatement, (2) the defendant intended to defraud the plaintiff thereby, (3) the plaintiff reasonably relied upon the representation, and (4) the plaintiff suffered damage as a result of such reliance. Bridgestone/Firestone. Inc. v. Recovery Credit Servs., Inc., 98 F.3d 13, 19 (2d Cir. 1996). Relying on Mann v. Levy, 776 F. Supp. 808 (S.D.N.Y. 1991), Mortman and Keizer contend that plaintiffs' claim fails for the lack of a misstatement or representation. In Mann the court dismissed the fraud claim as to one of the defendants when the allegations against him involved only the preparation of financial statements which were neither false nor misleading. See id. at 812. As discussed above, plaintiffs have adequately specified misrepresentations or omissions attributable to each defendant to avoid dismissal of their claims at this stage in the proceedings. Finally, because the Court has found that plaintiffs' allegations regarding scienter in connection with the federal securities law claims are sufficient to avoid dismissal, these allegations are also sufficient to state a claim for common law fraud.
By briefing the common law claims under New York law, the parties have consented to its application as the law of the forum state. See American Fuel Corp. v. Utah Energy Development Co., 122 F.3d 130, 134 (2d Cir. 1997).
B. Dismissal of Mortman from the JNC action
Mortman argues that the third claim in the JNC action — the claim for control person liability under Section 20(a) of the Exchange Act — should be dismissed as against him because plaintiff has alleged no more than Mortman's status as an officer and director of Global which is insufficient to state a control person claim under federal securities law.
The requirements for a claim of control person liability under Section 20(a) are set forth above. JNC alleges that "Mortman in his capacity as president, chief operating officer, and a director of [Global] at the time of the wrongful acts complained of, had the power and authority to cause [Global] to engage in these acts," and further alleges that Mortman was, at all relevant times, a "principal and controlling shareholder" of Global. While these allegations, by themselves, are simply contentions as to status, JNC further alleges that "Mortman directed [Global) to make the misrepresentations set forth above, with full knowledge that these representations were false at the time they were made." Because plaintiff has thus alleged that Mortman possessed actual control over the transactions in question, JNC's third claim will not be dismissed as against Mortman.
C. Dismissal of Muller from the Kernaghan and JNC Actions
Muller argues that certain of the claims in the Kernaghan and JNC actions should be dismissed as against him pursuant to Rules 9(b), 12(b)(6), and 12(c), Fed.R.Civ.Pro.
Due to the pending bankruptcy proceeding, JNC has agreed to voluntarily dismiss its seventh and eighth claims — claims asserting fraudulent conveyance — without prejudice to repleading in the event Global emerges from bankruptcy.
The sixth claim in the Kernaghan action, which seeks an injunction requiring Muller, as an officer of Global, to compel the conversion of Global's convertible securities into common stock, is dismissed as moot. Muller resigned as a director of Global in July 1999, and accordingly is incapable of directing the activities of Global, which, in any event, is in the midst of bankruptcy proceedings.
1. Violations of Section 10(b)
Muller asserts that the second claim of the Kernaghan action and the first claim in the JNC action should be dismissed against him for failure to state a claim for federal securities fraud under Section 10(b) as a matter of law, and because these claims fail to satisfy the pleading requirements of Rule 9(b), Fed.R.Civ.Pro. A fraud claim under Section 10(b) must meet the requirements of Rule 9(b), Fed.R.Civ.P., that a plaintiff
(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent.Stevelman, 174 F.3d at 84 (internal quotation omitted).
The elements of a claim for securities fraud under Section 10(b) are set forth above. Muller relies solely on Gurary v. Winehouse, 190 F.3d 37, to argue that plaintiffs' allegations are insufficient because the purported misrepresentations are in a future tense and therefore are statements of intention or of a promissory nature. The failure to carry out a promise made in connection with a securities transaction does constitute fraud, however, if "when the promise was made, the defendants secretly intended not to perform or knew tha[t] he could not perform."Id. at 44 (internal quotation omitted). The plaintiffs in these actions have alleged that Muller promised that Global would honor its conversion obligations despite his contemporaneous knowledge that Global secretly did not intend to honor such commitments. Thus, plaintiffs have stated a claim for securities fraud.
Turning to Muller's argument as to the pleading requirements under Rule 9(b), the Court finds that plaintiffs' allegations in both the Kernaghan and JNC actions are sufficient to state a claim under Section 10(b) and Rule 10b-5 of the Exchange Act.
a. The Kernaghan Amended Complaint
The Kernaghan plaintiffs allege two primary bases for Muller's liability: (1) Muller's representations that Global would honor plaintiffs' conversion rights despite his secret intention never to honor these obligations, and (2) Muller's material false representations in the subscription agreements wherein Muller failed to disclose Global's numerous defaults and threatened lawsuits against the company despite his actual knowledge of these facts. The allegations as set forth in the amended complaint are sufficiently pleaded as they specify the statements, the speaker, where and when the statements were made, and explain why the statements were fraudulent. The allegations are also sufficient to meet the scienter requirement in that they describe strong circumstantial evidence of conscious misbehavior or recklessness.
Muller argues, however, that the Kernaghan plaintiffs' failure to allege sufficiently loss causation is fatal to this claim. Indeed, a sufficient allegation of loss causation is required of any claim under Section 10(b). Weiss v. Wittcoff, 966 F.2d 109, 111 (2d Cir. 1992). Loss causation is causation in the traditional "proximate cause" sense: "the allegedly unlawful conduct caused the economic harm." AUSA Life Insurance Co. v. Ernest and Young, 206 F.3d 202, 209 (2d Cir. 2000). Thus, whether loss causation has been alleged turns on the following question: "was the damage complained of a foreseeable result of the plaintiff's reliance on the fraudulent misrepresentation?" Weiss, 966 F.2d at 111. See also Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1992) (in the context of securities fraud, the element of loss causation requires the plaintiff to prove "that the damage suffered was a foreseeable consequence of the misrepresentation."). The loss causation requirement may be met where the complaint alleges that the plaintiffs' loss was a proximate result of reliance on the defendant's misrepresentations, even where those misrepresentations are as to future actions. Weiss, 966 F.2d at 111.
Muller argues that the Kernaghan plaintiffs' damages are alleged to have resulted from Global's failure to convert plaintiffs' holdings into common stock, and not from Muller's alleged misrepresentations regarding undisclosed defaults. While it may be true that the alleged financial loss is most directly attributable to Global's failure to honor the plaintiffs' conversion notices, such a characterization of the causation issue offers an incomplete picture of the events described by plaintiffs. Plaintiffs allege that it was in reliance on Muller's false representations as to Global's present financial condition and intention to honor the Subscription Agreements that plaintiffs entered into the various agreements which included the agreement to lock-up their conversion rights as to the Series 6 preferred shares and the purchase of additional debentures. In the series of events as alleged by the plaintiffs, Muller's misrepresentations were "a substantial factor in the sequence of responsible causation", First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994) (internal quotation omitted), and a foreseeable consequence of the misrepresentations given the context in which they were made. Cf. AUSA Life Insurance Co. v. Ernest and Young, 206 F.3d 202, 212-13 (2d Cir. 2000) (discussing Continental Ins. Co. v. Mercadante, 225 N.Y.S. 488 (1st Dep't 1927)). Because, on the facts alleged by plaintiffs, "there [is] a reasonable probability that the fraud actually accomplished the result it was intended to bring about," id. at 213 (internal quotation omitted), the Court finds that the Kernaghan plaintiffs have adequately pleaded loss causation.
b. The JNC Amended Complaint
JNC's claim for securities fraud is essentially that Muller induced JNC to refrain from converting debentures — that were at the time freely convertible into registered shares of Global common stock — and to give these debentures up in exchange for preferred stock that was valueless. Muller is alleged to have accomplished this fraud by making fraudulent statements in a series of telephone conversations in September and October of 1998 that included the following misrepresentations: that Global would honor the Series 12 Agreement; that Global would take the steps necessary to register the shares of Global common stock JNC would receive upon conversion of the Series 12 shares; and that the Series 12 Agreement was necessary to prevent NASDAQ from delisting Global. JNC alleges that Muller's actions following the execution of the Series 12 Agreement reveal that Muller never had any intention of honoring his contractual obligations:
within a month of entering into the new agreement, Global failed to take the steps necessary to ensure that it would have sufficient registered, authorized, and unissued shares of common stock to issue upon JNC's notice of conversion. Further, JNC alleges that Global, Muller, and counsel for Global engaged in a charade of pretending to comply with their contractual obligations so as to postpone JNC's discovery of the alleged fraud. These facts provide the level of specificity required by Rule 9(b) and, as strong circumstantial evidence of conscious misbehavior or recklessness, are sufficient to support the element of scienter at this stage of the litigation.
Muller asserts that the fact that JNC acknowledges in its pleadings that Global ultimately provided JNC with a draft of the required registration supplement "undermines Muller's alleged fraudulent intent when he represented that Global would take steps to register common shares for JNC." The Series 6 Agreement required Global to file with the SEC a supplement to the registration statement by November 6, 1998 and a new registration statement by November 18, 1998. Neither was filed, and on November 24, counsel for JNC sent Muller a letter notifying him of Global's defaults. No statement was ever filed by Global, although a draft of the supplemental statement — a single page in length — was provided to JNC on November 30. Under these circumstances, Muller's argument that the complaint's description of the draft conclusively establishes his lack of fraudulent intent cannot succeed. Contrary to Muller's assertion, JNC has alleged more than "fraud by hindsight".
2. Common Law Fraud Claims
Muller asserts that the claims for common law fraud — the fourth claim in both the Kernaghan action and the JNC actions — should be dismissed as against him. The requirements for fraud under New York law are set forth above. Additionally, in order to avoid converting every breach of contract action into a fraud claim, a fraud claim may only proceed alongside a breach of contract claim where the plaintiff (1) demonstrates a legal duty separate from the duty to perform under the contract, (2) demonstrates a fraudulent misrepresentation collateral or extraneous to the contract, or (3) seeks special damages that are caused by the misrepresentation and unrecoverable as contract damages. Bridgestone/Firestone, Inc., 98 F.3d at 20. Muller argues that the common law fraud claims must be dismissed because they are basically attempts to replead contract claims. The Amended Complaints in these actions assert claims for breach of contract against Global arising from Global's failure to convert the debentures to common stock in accordance with the parties' written agreements. Muller argues that plaintiffs have established none of the additional factors necessary in order for a common law fraud claim to proceed alongside the breach of contract claim.
a. Misrepresentations Collateral to the Contract
The Kernaghan plaintiffs assert that their fraud claim is distinct from its contract claim because Muller made fraudulent misrepresentations collateral to the principal obligations and promises of the contract. Where a party is "induced to enter into's transaction because a defendant misrepresented material facts" the plaintiff may state a claim for fraud "even though the same circumstances also give rise to the plaintiff's breach of contract claim." First Bank of the Americas v. Motor Car Funding, 690 N.Y.S.2d 17, 21 (1st Dep't 1999). See also New York Univ. v. Continental Ins. Co., 639 N.Y.S.2d 283, 287-88 (N Y 1995); Deerfield Communications Corp. v. Cheesebrough-Ponds, 510 N.Y.S.2d 88, 89 (N.Y. 1986). Such a collateral misrepresentation is one that asserts "present facts rather than a future intent to perform" under the contract. Rays Trading (H.K.) Co. Ltd. v. Judy-Philippine, Inc., No. 98 Civ. 0170, 1998 WL 355422, at *3 (S.D.N.Y. July 2, 1998).
The Kernaghan plaintiffs argue that Muller made fraudulent misrepresentations collateral to his contractual obligations by falsely stating in the Lock-Up and Series 10 and 11 Agreements that other than a single civil suit brought by a financial advisor and certain sales tax enforcement actions, Global was not in default on any other contractual or financial obligations, that there were no material claims threatened or contemplated against it, and that there were no actions, investigations, or other proceedings pending or threatened. These misrepresentations were of present facts regarding Global's overall financial condition which were collateral to the principal contractual terms regarding plaintiffs' provision of financing in exchange for certain convertible preferred stock. The Kernaghan plaintiffs have, therefore, stated a claim for fraud. Given this conclusion, the Court need not reach the alternative bases for the fraud claim pressed by the Kernaghan plaintiffs.
In defense of its fraud claim, JNC points to Muller's statements that Global would honor its obligations under the Series 12 Agreement and argues that they are "collateral" since those statements induced JNC to forego its rights under a previously existing agreement. JNC asserts further that they provide a basis for its fraud claim because it has alleged that Muller never intended to fulfill those express contractual obligations. JNC's reliance on Kelly v. MD Buyline. Inc., 2 F. Supp.2d 420 (S.D.N.Y. 1998), for the proposition that a representation is collateral if it induces a party to give up existing rights, is misplaced. In Kelly, the alleged misrepresentation did not occur in connection with the contract at issue, nor did it amount to an assurance of defendant's intent to comply with its legal obligations under that contract. Id. at 435. In other words, the oral representation that formed the basis of the fraud claim in Kelly was not incorporated into the underlying contractual agreement between the parties. Here, the misrepresentations to which JNC points — Muller's statements that Global would honor its obligations under the Series 12 Agreement — are, by definition, representations incorporated into the contract at issue.
Further, JNC's allegation that Muller never intended to fulfill its contractual obligations is insufficient to create a claim for fraud.
An action for fraud cannot exist when the fraud claim arises out of the same facts as a breach of contract claim with the sole additional allegation that the defendant never intended to fulfill its express contractual obligations.Turnbull v. Kling, 1999 WL 672561, at *4 (S.D.N.Y. Aug. 26, 1999) (internal quotation omitted). Because "[i]t is well settled under New York law that a contract action cannot be converted to one for fraud merely by alleging that the contracting party did not intend to meet its contractual obligations," International Cabletel Inc. v. Le Groupe Videotron Ltee, 978 F. Supp. 483, 486 (S.D.N.Y. 1997) (internal quotations omitted), JNC cannot sustain its fraud claim on this ground.
Muller's statement that Global would be delisted from NASDAQ if the convertible preferred debt purchased by JNC was not exchanged for equity cannot be characterized as a misrepresentation of present fact.
b. Legal Duty Distinct from the Contract
JNC next argues that, as a holder of Global's convertible debentures, it was owed a fiduciary duty by Muller that is distinct from any contractual duty. Under New York law, a debenture holder is not owed a fiduciary duty by the issuing corporation. See Metropolitan Life Ins. Co. v. RJR Nabisco Inc., 716 F. Supp. 1504, 1524-25 (S.D.N.Y. 1989). See also Page Mill Asset Management v. Credit Suisse First Boston Corp., 2000 WL 335557, at *11 (S.D.N.Y. 2000); Geren v. Quantum Chemical Corp., 832 F. Supp. 728, 738 n. 5 (S.D.N.Y. 1993), aff'd, 99 F.3d 401 (2d Cir. 1995).
Alternatively, JNC argues that it was owed a duty of good faith and fair dealing. Having explicitly recognized that, to the extent this duty exists, it arises under the Series 12 Agreement, and is implied in every contract governed by New York law, JNC cannot argue that such a duty qualifies as a legal duty separate from the duty to perform under the contract. See New York Univ., 639 N.Y.S.2d at 289.
Creditors, including bondholders, may be owed a fiduciary duty, however, once the corporation is insolvent. See, e.g., Credit Agricole Indosuez v. Rossiyskiy Kredit Bank, 697 N.Y.s.2d 273, 274 (1st Dep't 1999), rev'd in Part on other grounds, 2000 WL 330341, 2000 N.Y. Slip Op. 03310 (N.Y. Mar 30, 2000). If a corporation is insolvent, the "officers and directors thereof, [are] to be considered as though trustees of the property for the corporate-beneficiaries" Clarkson Co. Ltd. v. Shaheen, 660 F.2d 506, 512 (2d Cir. 1981) (internal quotation omitted). See also In re STN Enterprises, 779 F.2d 901, 904 (2d Cir. 1985);Metropolitan Life Insurance Co. v. RJR Nabisco. Inc., 716 F. Supp. 1504, 1524 n. 33 (S.D.N.Y. 1989). The Second Circuit has rejected the contention that under New York law, a corporation's fiduciary duty to creditors arises only when liquidation is "imminent and foreseeable," emphasizing New York policy to preserve the assets of insolvent corporations for the creditors. Clarkson Co. Ltd., 660 F.2d at 512.
While JNC has explicitly alleged that Global is presently insolvent, allegations which would support the argument that Global was insolvent at the time of Muller's misrepresentations are implicit at best. Indeed, to support the argument that Global was insolvent at the time of Muller's misrepresentations, JNC cites to facts alleged in the Amended Complaint of theKernaghan action rather than to its own pleadings. Nevertheless, taking the allegations in the light most favorable to the plaintiff, as this Court is required to do when considering a motion to dismiss, JNC has pointed to defaults by Global on contractual and other financial obligations which could amount to Global's insolvency at the time of Muller's misrepresentations. Such insolvency — by creating a fiduciary duty between Muller and Global's creditors — would establish a legal duty separate from the duty to perform under the contract sufficient to sustain JNC's claim for common law fraud.
3. JNC's Claim for Negligent Misrepresentation
Muller argues that the claim for negligent misrepresentation — the fifth cause of action in the JNC action — must be dismissed. A statement may be the basis for a claim for negligent misrepresentation where there is
"carelessness in imparting words upon which others were expected to rely and upon which they did act or failed to act to their damage, but such information is not actionable unless expressed directly, with knowledge or notice that it will be acted upon, to one to whom the author is bound by some relation of duty, arising out of contract or otherwise, to act with care if he acts at all."AUSA Life Ins. Co., 206 F.3d at 208 (quoting White v. Guarente, 401 N.Y.S.2d 474, 478 (1977)). As a general matter, promises of future conduct are not actionable as negligent misrepresentations under New York law. See Murray v. Xerox Corp., 811 F.2d 118, 123 (2d Cir. 1987). An exception to this rule recognizes a claim for negligent misrepresentation with regard to a promise of future conduct when there is a special relationship between the parties.See American Protein Corp. v. AB Volvo, 844 F.2d 56, 63-64 (2d Cir. 1988); Durante Bros. Sons. Inc. v. Flushing Nat'l Bank, 755 F.2d 239, 252-53 (2d Cir. 1985).
Muller argues that JNC's claim for negligent misrepresentation must fail as it is based on alleged promises of future conduct regarding JNC's rights to convert the Series 12 Preferred Stock to Global common stock at a time that no fiduciary relationship existed between Muller and JNC. As discussed above, however, a fiduciary duty may have in fact existed between Global's officers and directors and the company's creditors if Global was insolvent at the time the misrepresentations were made. Therefore, because JNC may ultimately be able to prove a set of facts that would support a negligent misrepresentation claim even as to promises of future conduct, this claim will not be dismissed at this time.
D. Stay of the Kernaghan and LJNC Actions
Muller asserts that in light of Global's September 24, 1999 filing of a Chapter 7 bankruptcy proceeding and the accompanying stay of these proceedings against Global, both of these actions should be stayed — at least as to him. Muller concedes that, because a stay pursuant to Section 362(a) of the Bankruptcy Code is limited to the debtor and does not encompass non-bankrupt codefendants, he is not entitled to such a stay as a matter of course. Muller nevertheless argues that the stay should be granted due to the "unusual circumstances" he contends are present: the unitary interest of Muller and Global and the possibility that, if plaintiffs prevail, this litigation could have a significant impact on the pending bankruptcy proceeding and on the debtor's estate.
Muller asserts that there is a unitary interest between himself and Global because the claims against him arise out of statements he allegedly made towards raising financing for Global in his capacity as the company's Chairman and Chief Executive Officer. Muller believes that Global is obliged to indemnify him for any liability arising from his efforts to raise capital for Global and that Global's assets — namely its directors and officers' liability insurance — will thereby be affected in the event that plaintiffs prevail in these actions.
Section 362 of the Bankruptcy Code provides that the filing of a petition in bankruptcy automatically stays certain actions directed against the debtor or against the debtor's property. 11 U.S.C. § 362(a). The automatic stay provisions promote two principal purposes of the Bankruptcy Code. First, the automatic stay "provides the debtor with `a breathing spell from his creditors.'" Teachers Ins. Annuity Ass'n of America v. Butler, 803 F.2d 61, 64 (2d Cir. 1986) (quoting legislative history); In re Petrusch, 667 F.2d 297, 299 (2d Cir. 1981) (same). In addition, the automatic stay allows the bankruptcy court to centralize all disputes concerning property of the debtor's estate in the bankruptcy court so that reorganization can proceed efficiently, unimpeded by uncoordinated proceedings in other arenas. The Bankruptcy Code thus
provide[s] for centralized jurisdiction and administration of the debtor, its estate and its reorganization in the Bankruptcy Court, and [this policy] is effectuated by Sections 362 and 105 of the Code.In re Ionosphere Clubs Inc., 922 F.2d 984, 989 (2d Cir. 1990).
Although the plain language of Section 362 limits the extension of an automatic stay to a proceeding against the debtor, "under specific circumstances non-debtors may be protected by the automatic stay . . . if it contributes to the debtor's efforts to achieve rehabilitation." Teachers Ins., 803 F.2d at 65. For example, where
The Second Circuit has expressly declined "to define under what circumstances, if any, a bankruptcy court may properly exercise § 105 jurisdiction to issue a stay with respect to non-bankrupt co-defendants." Teachers Ins., 803 F.2d at 65.
a debtor and a nondebtor are so bound by statute or contract that the liability of the nondebtor is imputed to the debtor by operation of law, then the Congressional intent to provide relief to debtors would be frustrated by permitting indirectly what is expressly prohibited in the Code.In re Metal Center. Inc., 31 B.R. 458, 462 (Bankr. D. Conn. 1983). Such reasoning has been largely approved by the Fourth Circuit, which has held that in "unusual situations" — including where
there is such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor
— a court is empowered to extend the automatic stay to non-debtor co-defendants. A.H. Robins Co.. Inc. v. Piccinin, 788 F.2d 994, 999 (4th Cir. 1986). In contrast,
in situations where a codefendant is independently liable as, for example, where the debtor and another are joint tort feasors or where the nondebtor's liability rests upon his own breach of a duty, then the protection afforded a debtor under the automatic stay would clearly not extend to such nondebtor.In re Metal Center, Inc., 31 B.R. at 462. This limitation on the "unusual situation" exception has been adopted in this district,see, e.g., CAE Indus. Ltd. v. Aerospace Holdings Co., 116 B.R. 31, 32 (S.D.N.Y. 1990); Matter of Johns-Manville Corp., 26 B.R. 405, 411 (Bankr. S.D.N.Y. 1983), and by numerous other courts. Because the claims against Muller are not derivative of his status as Chairman and Chief Executive Officer of Global, but rather are premised upon Muller's own conduct, including an alleged breach of his fiduciary duty and misrepresentations made by Muller himself, a stay is not warranted on these grounds.
Neither does the existence of Muller's potential claim for indemnification from Global rise to the level of unusual circumstances necessary for an extension of the stay. The underlying purpose behind embracing non-debtor officers and directors within the stay provided by Section 362(a)(1) is to suspend actions that pose a serious threat to a corporate debtor's reorganization efforts. See, e.g., Gray v. Hirsch, 230 B.R. 239, 243 (S.D.N.Y. 1999); In re United Health Care Org., 210 B.R. 228, 234 (S.D.N.Y. 1997); In re Continental Airlines, 177 B.R. 475, 479 (D. Del. 1993). Here, Global is undergoing a liquidation under Chapter 7; there are no reorganization efforts that might be jeopardized by allowing the present litigation to proceed, even if the claims here ultimately result in an indemnification demand on Global. See In re First Central Financial Corp., 238 B.R. 9, 20 (Bankr. E.D.N.Y. 1999).
JNC asserts that for Muller's indemnification claim to even merit consideration, the company's indemnification obligation would have to be absolute. See In re Wolf Financial Group, Inc., 1994 WL 913278, at *4 (Bankr. S.D.N.Y. Dec. 15, 1994). Because the Court concludes that even if available, Global's obligation to indemnify Muller is insufficient to justify an expansion of the stay to encompass Muller, the Court need not determine whether such indemnification is unavailable in any event.
The existence of Global's directors' and officers' insurance policy does not change this result. Despite the existence of this insurance policy, and the potential for a claim by Muller against it, such a claim would not damage the estate in a Chapter 7 liquidation. At most, it would lessen the overall pro rata distribution to creditors. See id. In any event, Muller's contention that the outcome of these actions may be potentially detrimental to Global's estate is insufficient to stay these proceedings against Muller.
Finally, Muller's argument, devoid of any legal authority, that Global's absence in these actions may prejudice his ability to obtain corporate documents does not justify a stay of these actions. Any difficulty that arises during discovery may be brought to the attention of this Court when it is ripe for consideration.
CONCLUSION
For the reasons stated, the motion to stay the actions as to Muller is denied. The motions to dismiss are denied with the following exception: the sixth claim in the Kernaghan action is dismissed against Muller as moot.
SO ORDERED:
Dated: New York, New York May 17, 2000
COPIES SENT TO:
Hillary Richard Andrew J. Goodman BRUNE RICHARD BRESLER GOODMAN UNTERMAN 26 Broadway 521 Fifth Avenue, 28th Floor New York, N Y 10004 New York, N Y 10175
George Zimmerman Eric Rieder SKADDEN ARPS SLATE MEAGHER FLOM ROBINSON SILVERMAN PEARCE Four Times Square ARONSOHN BERMAN New York, N Y 10036 1290 Avenue of the Americas New York, N Y 10104