Opinion
CIVIL ACTION NO. 3:00-CV-382
June 19, 2003
MEMORANDUM OPINION
This matter is before the court on motion of Defendants, Kring and Brown, L.L.P. and Shefsky and Froelich, LTD., to dismiss the consolidated third amended complaint pursuant to Fed.R.Civ.P. 12(b)(6). (DN 70, 71)
Background
The plaintiffs in this action are investors who purchased stock in Pixelon, Inc. ("Pixelon") through a private offering between August 9, 1999 and April 19, 2000. Pixelon's business involved the development of broadcast technology and programming for the Internet. The plaintiffs allege that they were misled as to the real identity of Pixelon's president and founder Michael Fenne, and as to the true nature and extent of Pixelon's technology in violation of Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5.
Plaintiffs assert claims against numerous other defendantss. However, because of pending settlement negotiations between the plaintiffs and these defendants, we address only the claims against Shefsky and Kring.
Plaintiffs complaint is based on statements contained in three offering documents: (1) the August 25, 1999 Private Placement Memorandum (PPM); (2) the December 9, 1999 Supplement to the PPM ("December Supplement"); and (3) the March 5, 2000 Information for Shareholders of Pixelon ("March 2002 Supplement).
Kring and Brown("Kring") is the law firm that provided outside counsel to Pixelon until September 9, 1999. Shefsky and Froelich ("Shefsky"), another outside law firm representing Pixelon, was brought in to assist with some due diligence and the remaining drafting of the offering documents. The plaintiffs allege that both Kring and Shefsky were involved in the preparation of the PPM issued by Pixelon. Shefsky also allegedly drafted the December Supplement. There is no allegation that either firm had any involvement in the March 2000 supplement. Kring and Shefsky are not mentioned in these documents, nor are any statements attributed to them.
The PPM consists of a 47 pages describing in detail Pixelon's business and the risks associated with the investment. The PPM also contains other information about the investment such as the dividend plan, the dilution of ownership by management, a plan of distribution, and restrictions on transferring the stock. The plaintiffs maintain that the PPM contained false and incomplete information about the background of company president, Michael Fenne and about the extent of Pixelon's technology.
The PPM contained a one paragraph biographical summary of Fenne. This paragraph does not reveal that Fenne had been convicted of several felonies in Virginia under the name of David Stanley, and was concealing his true identity. Fenne. Plaintiffs admit that Fenne hid his background, by refusing to provide a social security number and falsely completing a questionnaire. Pixelon's own management did not discover Fenne's background until months after the PPM and Fenne's termination. The earliest Pixelon knew about Fenne's true identify was early December 1999. There is no allegation that either Shefsky or Kring was aware of Fenne's true identity.
The plaintiffs also allege that the PPM failed to disclose that the "proprietary" and revolutionary technology that Pixelon claimed to own and have developed was an elaborate hoax. The technology in question was based on open source code and other commercially available technology. As well, plaintiffs allege Pixelon had applied for fewer patents than it claimed.
Following the issuance of the PPM, Pixelon held a major music concert event called iBash to launch its network in October of 1999. The event cost Pixelon $16.2 million, most of the proceeds raised from the offering. The purpose of iBash was to feature Pixelon technology by broadcasting the event over the Pixelon Network. However, the transmission of the launch event was a failure, and the broadcast of iBash never occured. As a result of the failure of iBash, Fenne was terminated as Pixelon's president. After his termination, Pixelon management learned of his true identity.
On December 9, 1999, Pixelon issued the December Suplement drafted by Shefsky. The supplement divulged the cost of iBash, and the terms of a proposed severance agreement with Fenne. It also clarified that Pixelon had not applied for a patent for the playback software. Investors were offered to right to rescind their purchases based upon this information. Plaintiffs complain that Feeen's background and the reasons for terminating him were not explained.
Plainiffs assert that Kring and Shefsky's involvement in preparing of the offering documents violated Section 10(b) of the Securities and Exchange Act of 1934 and SEC Rule 10b-5. Plaintiffs allege that Kring and Shefsky should have performed a background check to verify the general biographical information provided by Fenne was correct. They further allege that Kring and Shefsky should have included an inspection or independent study of Pixelon's technology as part of the due diligence process.
Standard of Review
Under Fed.R.Civ.P. 12(b)(6), a court may dismiss a complaint with prejudice if it fails to state a claim upon which relief can be granted. When a motion to dismiss is made, the court must take the allegations of the complaint as true and grant dismissal only when it is beyond doubt that the plaintiffs can prove no set of facts entitling them to relief. Conley v. Gibson, 355 U.S. 41, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957).
Legal Analysis
To state a claim of securities fraud under Section 10(b) or Rule 10b-5, a plaintiff must prove:
A defendant's misstatement or omission of material fact;
connection with the purchase or sale of securities;
scienter by the defendant;
justifiable reliance on the misstatement or omission by the plaintiff; and
proximately caused damages.
In re Comshare, Inc. 183 F.3d 542, 548 (6th Cir. 1999).
In this case, the complaint does not allege that any statement made directly by defendants Kring or Shefsky violates 10(b) or Rule 10b-5. Instead, the plaintiffs seek to impose liability on these law firms by virtue of their involvement in preparing the offering documents.
In Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164, 191 (1994), the United States Supreme Court held that a person could no longer be liable for "aiding or abetting" a violation of 10(b) or Rule 10b-5. Those provisions prohibit only the "making of a material misstatement, omission, or manipulative act." However, the Court observed that secondary actors are not always free from liability under the Act. They may be held liable as primary violators if all the requirements for primary liability are met, including "a material misstatement (or omission) on which a purchaser or seller of securities relies." Central Bank, 511 U.S. at 191.
The Sixth Circuit has not yet discussed the Central Bank case, or whether outside professionals must themselves make a false or misleading statement for primary liability to attach. There is a split of authority among the circuits that have considered the issue. The Second, Tenth, and Eleventh Circuits appear to have taken the position that professionals must themselves make a false or misleading statement in order to impose liability. Wright v. Ernst Young LLP, 152 F.3d 169, 175-76 (2nd Cir. 1998); Anixter v. Home-Stake Production, 77 F.3d 1215, 1226 (10th Cir. 1996); Ziemba v. Cascade International, Inc., 256 F.3d 1194, 1205 (11th Cir. 2001). This approach has been characterized as the "bright line" test. In contrast, the Ninth Circuit has held that an outside professional can be held liable based on "significant" or "substantial" assistance to the representations of others. In re: Software Toolworks, 50 F.3d 615 (9th Cir. 1994). This approach has been characterized as the "substantial participation" test.
Were we to adopt the "bright line" approach of the Second, Tenth, and Eleventh Circuits, we would find that plaintiffs have not stated a claim against defendants Kring and Shefsky because they did not actually make any of the statements themselves. We reach the same result if we apply the "substantial participation" test of the Ninth Circuit because even were we to determine that Kring and Shefsky were substantial participants, plaintiffs have failed to allege they had the required mental state.
Under Fed.R.Civ.P. 9(b), "in all averments of fraud or mistake, the circumstances constitution fraud or mistake shall be stated with particularity." The Private Securities Litigation Reform Act ("PSLRA"), 15 U.S.C. § 78, heightened the pleading requirements for securities fraud cases beyond the requirements of Rule 9(b). Under the PSLRA, the complaint must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2). The plaintiffs are required to plead facts which indicate "a mental state embracing intent to deceive, manipulate or defraud." Bovee v. Coopers Lybrand C.P.A., 272 F.3d 356, 362-362 (6th Cir. 2001).
The Sixth Circuit has held that this mental state is recklessness, and a plaintiffs may survive a motion to dismiss only by pleading facts which give rise to a strong inference of recklessness. Id. "Recklessness" has been defined as "highly unreasonable conduct which is an extreme departure from the standards of ordinary care. While the danger need not be known, it must at least be so obvious that any reasonable man would have known of it." Id. Although under Fed.R.Civ.P. 12(b)(6), all inferences are to be drawn in plaintiffs' favor, "inferences of scienter do not survive if they are merely reasonable." Helwig v. Vencor, 251 F.3d 540, 551 (6th Cir. 2001). Inferences of scienter survive a motion to dismiss only if they are both reasonable and "strong" inferences. Id.
The complaint does not allege that Kring or Shefsky knew that any of the misstatements objected to by the plaintiff were false. From the facts it appears that Fenne duped everyone, even the directors of Pixelon. Plaintiffs argue that Kring and Shefsky should have known that the statements were false because Fenne refused to provide his social security number. They also allege that they should have questioned Pixelon's technology when eCommercial, a California Internet company, failed to follow through with an equity investment in Pixelon. The remainder of the plaintiffs' proof consists of evidence that came to light after the PPM was issued.
Plaintiffs seek to impose a duty on Kring and Shefsky to independently investigate Fenne's true identity and the extent of Pixelon's technology, even though they had no reason to suspect that things were not as they seemed. We can find no case law imposing a duty to investigate on law firms, absent some reason to know that they were making a misstatement. The standard clearly set forth by the courts is recklessness. Absent proof that Kring and Shefsky know, or with reasonable dilegence should have know that the statements they were making were false, plaintiffs have failed to allege that they acted with the requisite scienter. Therefore, plaintiffs' complaint against Kring and Shefsky must be dismissed for failure to state a claim.
For the reasons set forth above, the motion of defendants, Kring and Brown and Shefsky and Froelich to dismiss Plaintiff's Consolidated Third Amended Complaint (DN 70, 71) against them will be granted by separate order.