Opinion
June 1, 2000
OPINION AND ORDER
Plaintiffs Manufacturers Life Insurance Company (U.S.A.) and Manufacturers Life Insurance Company (collectively, "plaintiff" or "Manulife") bring this action against defendant Donaldson, Lufkin Jenrette Securities Corporation ("defendant" or "DLJ"), alleging securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j (b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder (Count I), as well as common law fraud (Count II), negligent misrepresentation (Count III), and fraudulent concealment (Count IV). Now pending is defendant's motion to dismiss, pursuant to Fed.R.Civ.P. 12(b)(6), for failure to state a claim. Following an oral argument held on May 4, 2000 and our review of the motion papers, for the reasons set forth below, we grant defendant's motion and dismiss plaintiff's complaint.
BACKGROUND
This action arises out of plaintiff's purchase of mortgagebacked securities, pursuant to two 1997 private placement offerings underwritten by DLJ. See Compl. ¶¶ 5-11. The securities represented interests in approximately 3,500 mortgage loans, roughly 200 of which were later discovered to have been fraudulently obtained, that is, based on falsely inflated appraisals. See id. ¶ 12; Def.'s Mem. at 1. As a result of the fraud, the value of the securities plaintiff had purchased decreased. See Compl. ¶ 15. While plaintiff does not claim that defendant participated in the underlying fraud, it alleges that DLJ made materially false statements or non-disclosures in accompanying sales literature and that plaintiff was fraudulently induced into purchasing the securities. See id. ¶¶ 16-17.
The Court takes judicial notice, pursuant to Fed.R.Evid. 201, of a newspaper article appearing in the Asbury Park Press on July 29, 1997, first describing a property-flipping scheme in Asbury Park, New Jersey by which residential properties were purchased and resold in a short time period in order to fraudulently drive up prices. See Jonathan Rosenberg Aff. ("Rosenberg Aff."), dated September 10, 1999, Ex. A (attached to Complaint). Mortgage loans were extended on the basis of the inflated values as well as on false appraisals and other documents. Roughly 200 of these loans, representing an aggregate balance of $21 million, were in the two securitized mortgage pools, $250 million in the aggregate, that DLJ underwrote. See Def.'s Mem. at 8. Plaintiff's complaint attaches four newspaper articles describing the scheme, none of which mentions DLJ. See Rosenberg Aff. Ex. A.
Specifically, plaintiff identifies three statements and nondisclosures, alleged to be fraudulent, that DLJ made in two Private Placement Memoranda ("PPMs") that it prepared, dated January 17, 1997 and March 7, 1997. See Rosenberg Aff. Exs. D E; Compl. ¶ 16. First, plaintiff notes DLJ's representation, based on its due diligence review, that the underlying mortgage loans were "well underwritten" and that the underlying appraisals were "in good order and well documented." Compl. ¶ 16(a). In fact, some of the loans were discovered in June 1997 to have been based on fraudulently inflated valuations. See id. Plaintiff concludes that DLJ knowingly or recklessly misrepresented the quality of the loans and appraisals in early 1997 and thereby induced plaintiff to purchase the securities. See id. ¶ 17.
Although plaintiff couches its complaint with such terms as "for example" and "inter alia," see, e.g., Compl. ¶¶ 16 (a)-(d), we only consider the statements and omissions specifically identified in plaintiff's submissions, in accordance with the requirement under Fed.R.Civ.P. 9(b) of pleading fraud with specificity, discussed infra. We decline to infer from the allegation of some misrepresentations the existence of others. Moreover, at the oral argument held on May 4, 2000 (the "oral argument"), plaintiff's counsel only discussed those alleged misstatements specifically mentioned in the complaint.
Second, plaintiff points out that the PPMs prepared by DLJ failed to disclose that the principal officer of the firm that originated and pooled the mortgage loans, Robert C. Walsh of Walsh Securities, Inc. ("Walsh" and "Walsh Securities," respectively), had previously managed the mortgage operations of a savings and loan that failed due to poorly underwritten loans. See Compl. ¶ 16(b). Instead, the PPMs allegedly describe Walsh' s past experience in mortgage operations in positive terms. See Pl.'s Mem. at 5 (citing Rosenberg Aff. Ex. D. at 20, 40, 45). Plaintiff claims that if it had known about Walsh's involvement with the failed savings and loan, it would not have purchased the securities. Compl. ¶ 17.
Third, plaintiff claims that DLJ misrepresented the financial ability of Walsh Securities to repurchase the mortgage loans, as it would be required to do in the event that any of the loans were found to be in breach of representations and warranties in the PPMs. See Compl. 16(c). Yet in December 1997, after the fraud had unraveled, when Walsh Securities became obligated to repurchase the defective loans, it was only able to repurchase approximately 9% of those loans. See Def.'s Mem. at 8. Once again, plaintiff claims it was fraudulently induced into the transaction, partly on the basis of this particular misrepresentation. See Compl. ¶ 17.
DLJ disputes having misrepresented Walsh Securities' financial ability, pointing to cautionary language in the PPMs which specifically raises the possibility that the Seller, Walsh Securities, would "not have sufficient assets with which to satisfy its repurchase obligations." Def.'s Mem. at 14 (quoting Rosenberg Aff. Exs. D at 21 and E at 21). However, drawing all inferences in plaintiff's favor, as we must, see infra, we do not consider the effect of such cautionary language in deciding this motion.
In their complaint, plaintiffs identify a fourth alleged misrepresentation in the PPMs, closely related to the third, namely that the mortgage loans would be "serviced in a manner intended to result in a faster exercise of remedies, including foreclosure, in the event delinquencies and defaults occur." Compl. ¶ 16(d). According to plaintiffs, the loans were not actually serviced in that manner. See id. Nevertheless, plaintiffs do not strongly argue this fourth point in their brief, see Pl.'s Mem. at n. 1, and thus we do not further address it herein. It would not, in any event, affect our ultimate disposition of the present motion, as it is plead with the same defects as the three primary allegations.
DLJ is also alleged to have acted deceptively after the 1997 sales were consummated. Plaintiff claims that defendant fraudulently concealed material information, namely that the securities had declined in value and continued to decline. See id. ¶ 16. Supposedly, while DLJ had placed the securities on its "restricted list," it continued to provide plaintiff with "current `bid' prices," i.e., the price at which DLJ purportedly offered to purchase the securities. Id. Although plaintiff does not specify any dates as to the communication of bid prices or DLJ's designation of the securities as "restricted," plaintiff avers that it discovered the adverse designation in April 1998, at which point the value of the securities had significantly declined. Id.
Having discovered the decrease in value of the securities, plaintiff demanded in September 1998 that DLJ repurchase the securities at the original purchase price. See id. ¶ 19. DLJ has declined to do so, see id., and plaintiff filed this lawsuit in March 1999.
DISCUSSION
1. Fed.R.Civ.P. 12(b)(6) Standard
Dismissal of a complaint pursuant to Fed.R.Civ.P. 12(b)(6) is warranted if "it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." See Cooper v. Parsky, 140 F.3d 433, 440 (2d Cir. 1998) (quoting Conley v. Gibson, 355 U.S. 41, 45-46 (1957)). In ruling on a Rule 12(b)(6) motion, a court is required "merely to assess the legal feasibility of the complaint, not to assay the weight of the evidence which might be offered in support thereof."Geisler v. Petrocelli, 616 F.2d 636, 639 (2d Cir. 1980). Further, a court must accept all factual allegations in the complaint as true, and draw all inferences in the plaintiff's favor. See Sheppard v. Beerman, 18 F.3d 147, 150 (2d Cir. 1994), cert. denied, 513 U.S. 816 (1994). However, while the pleading standard is a liberal one, bald assertions and conclusory allegations are insufficient to defeat a motion to dismiss. See Cooper, 140 F.3d at 440.
2. Pleading Securities Fraud
Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder "prohibit fraudulent activities in connection with the purchase or sale of securities." Press v. Chemical Investment Services Corp., 166 F.3d 529, 534 (2d Cir. 1999). To state a cause of action under Rule 10b-5, a plaintiff must allege that,
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 Inc. Secs. Litig., 9 F.3d 259, 264 (2d Cir. 1993))
In order to plead scienter, the element most strongly challenged in the present motion, see Def.'s Mem. at 15-21, a plaintiff must "state with particularity facts giving rise to a strong inference" of defendant's fraudulent intent. 15 U.S.C. § 78u-4 (b)(2). In a securities fraud claim, the requisite state of mind is knowing misconduct or an intent "to deceive, manipulate, or defraud," Press, 166 F.3d at 538 (quoting Securities and Exchange Com'n v. First Jersey Sec., Inc., 101 F.3d 1450, 1467 (2d Cir. 1996)). To plead such intent, a plaintiff may 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 (quoting Shields v. Citytrust Bancorp., Inc., 25 F.3d 1124, 1128 (2d Cir. 1994)). The level of recklessness required in a securities fraud case, however, is conduct "involving not merely simple, or even inexcusable negligence," but rather "an extreme departure from the standards of ordinary care." Sundstrand Corp. v. Sun Chem. Corp. 553 F.2d 1033, 1045 (7th Cir.), cert. denied, 434 U.S. 875 (1977); see also Ernst Ernst v. Hochfelder, 425 U.S. 185, 194 n. 12 (1976) ("[i]n certain areas of the law recklessness is considered to be a form of intentional conduct for purposes of imposing liability for some act")
3. Securities Fraud Claim
Plaintiff has failed to state a claim for relief under Rule 10b-5 because they have not adequately pled scienter. Although they allege, in conclusory terms, that DLJ acted knowingly or recklessly, see Compl. ¶ 17; Pl.'s Mem. in Opp'n at 4-7, they offer insufficient facts on which to base their allegations.
The Complaint
Plaintiff's effort to plead scienter may be viewed from several perspectives. On one reading of the Complaint, plaintiff seems to ask the Court to infer defendant's knowledge, at the time the PPMs were disseminated, from the later unraveling of the fraud. Both in their Complaint and their opposition brief, plaintiff merely sets out what DLJ said in the PPMs, or failed to say, and why the statements were false. See Compl. ¶¶ 16(a)-(d); Pl.'s Mem. at 10-11. As subsequent events would prove, the three statements at issue were false: (1) some of the underlying mortgage loans were in fact not well underwritten and not based on valid appraisals; (2) Walsh had had some negative past experience in mortgage operations, particularly given his history with the failed savings and loan association; and (3) Walsh Securities did not have the financial ability to meet its repurchase obligations under the terms of the sales. Yet, to say that because the statements or omissions proved in hindsight to be false, does not even suggest that DLJ knew them to be false at the time of their making. We decline to infer DLJ's culpability in the fraud, ipso facto, from the later discovery of the fraud itself and, accordingly, reject any suggestion of "fraud by hindsight." Denny v. Barber, 576 F.2d 465, 470 (2d Cir. 1978)
On a different, yet equally unpersuasive, reading of its papers, plaintiff alleges that DLJ was negligent in performing its due diligence review. Plaintiff contends that had DLJ properly done its work as an underwriter and thoroughly reviewed relevant materials, it would have realized (1) that some of the underlying loans were inflated, (2) that Walsh had a negative history in mortgage loan operations, and (3) that Walsh Securities did not have the financial abilities it claimed. See Pl.'s Mem. at 11-12. In other words, plaintiff claims that DLJ should have known the statements in the PPMs to be false, even at the time of their making. Plaintiff's argument fails, however, as it amounts to nothing more than a claim that DLJ performed its due diligence negligently, and it is well-established that negligence is insufficient to establish fraudulent intent, Ernst Ernst, 425 U.S. at 210. In addition, there is no allegation by plaintiff that DLJ's due diligence was such an "extreme departure from the standards of ordinary care," so as to constitute the level of recklessness required for securities fraud. Sundstrand Corp., 553 F.2d at 1045; compare Pl.'s Mem. (suggesting that DLJ may have "recklessly employed inadequate statistical sampling methods to conduct its review of the mortgage loans"). Oral Argument
There is even a third reading of plaintiff's papers, pursuant to which plaintiff would have us infer scienter from the fact that DLJ performed an adequate due diligence review. The argument is that because DLJ reviewed relevant materials as part of its due diligence, as the underwriter claims, it must have known, actually knew, or consciously disregarded the falsity of the statements and non-disclosures in the PPMs. See Pl.'s Mem. at 11-13. Plaintiff does not point to any specific information DLJ may have discovered in the course of due diligence, only to the fact that it conducted due diligence.
A potential question presented by this last theory is whether the mere fact that an underwriter conducted due diligence is the type of circumstantial evidence, at the pleading stage, that can give rise to a "strong inference" that the underwriter acted knowingly or recklessly. We have found no authority to suggest its sufficiency. Moreover, we conclude that pleading the mere fact of due diligence cannot meet the scienter requirement. See also In Re WRT Energy Securities Litigation, 1997 Wl 576023, at *14 (S.D.N Y Sept. 15, 1997) (finding that "plaintiffs' allegations of access, standing alone, do not constitute evidence of conscious misbehavior or recklessness"). We can discern no basis to find that Congress intended the performance of such a routine part of a securities transaction to satisfy so stringent a pleading requirement.
At the oral argument held on May 4, plaintiff was asked to elucidate its allegations of recklessness and to differentiate them from allegations of mere negligence. Tr. 11. Plaintiff made three primary arguments in response. We find each unpersuasive.
"Tr." refers to the transcript of the May 4 oral argument.
Plaintiff first argued that Walsh's involvement with Carteret Savings Bank ("Carteret"), and its subsequent failure, were publicly known facts that could have been readily discovered as the local New Jersey news media did subsequently. Tr. 11-13. Accordingly, plaintiff asks us to infer that DLJ was reckless in failing to discover and disclose this aspect of Walsh's business history. We can draw no such inference, however. Again plaintiff has simply alleged a claim of arguable negligence and pointed to no facts from which to draw a strong inference of recklessness.
Plaintiff's second argument, regarding the underlying mortgage loans, particularly those based in New Jersey. is that DLJ recklessly ignored numerous "red flags." Tr. 13. Specifically, plaintiff points to the facts that (a) the loans were "subprime," that is, of higher risk than more conventional mortgages, Tr. 13; (b) Walsh Securities had been a relative newcomer to the securitization business, Tr. 13; and (c) a disproportionate amount of the loans were from the state of New Jersey, and many were clustered in a particular part of the state, Tr. 14-16. These facts, plaintiff argues, should have heightened DLJ's due diligence investigation and led the underwriter to more closely scrutinize the New Jersey loans; DLJ was allegedly reckless for failing to do so. Tr. 15-16. In contrast, we find nothing in plaintiff's proffered "red flags" from which we can infer that defendant acted with fraudulent intent. At most, plaintiff asserts a claim for negligence.
Moreover, plaintiff was itself a sophisticated investor, able to participate in private placement transactions such as the one at issue by virtue of that sophistication. Tr. 22. It apparently had access to much the same information as DLJ and knowledge of the risks involved in the offering. Tr. 25; see Rosenberg Aff. Ex. D at iv.
As DLJ points out in its submissions, the PPMs contained the following language, in all capital letters, which invited investors to conduct an independent investigation of the underlying securities:
IT IS EXPECTED THAT INVESTORS INTERESTED IN PARTICIPATING IN THIS PRIVATE PLACEMENT WILL CONDUCT AN INDEPENDENT INVESTIGATION OF THE RISKS POSED BY AN INVESTMENT IN THE CERTIFICATES. OFFICERS OF THE DEPOSITOR WILL BE AVAILABLE TO ANSWER QUESTIONS CONCERNING THE TRUST FUND AND WILL, UPON REQUEST, MAKE AVAILABLE SUCH OTHER INFORMATION AS INVESTORS MAY REASONABLY REQUEST.
Rosenberg Aff. Ex. D at iv.
Plaintiff's third argument regards DLJ's conduct after the transactions had been consummated. It posits that DLJ's quoting of bid prices, months after the securities' decline in value, suggests that the underwriter knew the wrongfulness of its actions at the time of the offerings and was attempting to cover them up. Tr. 17-19. Plaintiff claims that we may infer from defendant's subsequent conduct its fraudulent intent earlier. We will separately address,infra, plaintiff's substantive claim of fraud as to the quoting of bid prices. However, at this stage, we reject plaintiff's use of this claim as evidence of defendant's scienter at the earlier times. Based on pled facts and logic, the sought after inference is simply not a reasonable one.
In sum, plaintiff has failed to sufficiently plead scienter, despite our generous reading of its complaint and the additional opportunity to develop its theory at oral argument. Plaintiff has simply failed to allege facts from which we can infer that DLJ acted recklessly at the time it made the allegedly false statements in the PPMs. Accordingly, plaintiff's securities fraud claim under Rule 10b-5 is dismissed.
4. Common Law Claims
Since this Court's jurisdiction is based on 28 U.S.C. § 1332, in addition to § 1331, see Compl. ¶ 1, we must also consider plaintiff's state law claims, despite our disposition of the federal securities law claim. For the following reasons, these claims are also lacking and warrant dismissal.
First, plaintiff's common law fraud claim (Count II) is based entirely on the same alleged misrepresentations and omissions in the PPMs as is its federal claim, see Compl. ¶¶ 27-32. As the same elements, including scienter, must be pled and proved, it is deficient for precisely the same reasons that its federal claim fails. See Scone Investments, L.P. v. American Third Market Corp., No. 97 Civ. 3802, 1998 WL 205338, at *10 (S.D.N.Y. Apr. 28, 1998)
Pursuant to Fed.R.Civ.P. 9(b), a plaintiff must establish the defendant's fraudulent intent whether his fraud claim arises under federal securities law or state law. See San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 812 (2d Cir. 1996)
Second, plaintiff's claim of negligent misrepresentation (Count III), with regard to the statements and omissions in the PPMs, see Compl. ¶¶ 33-38, also fails, as private enforcement of such a claim is barred by New York's Martin Act. See N.Y. Gen. Bus. Law, art. 23-A § 352, et seq. It is well-settled in this district that plaintiff's claim of negligent misrepresentation, which arises out of the sale of securities, is barred by the Martin Act, and accordingly, the claim must be dismissed. See Noz v. Value Investing Partners, Inc., No. 98 Civ. 6977, 1999 WL 387400, at *2 (S.D.N.Y. June 14, 1999) ("A claim for negligent misrepresentation with regard to the sale of securities, which does not require intentional deceit, is covered by [the] Act . . . and can only be asserted by the Attorney General, not private litigants.");Bibeault v. Advanced Health Corporation, No. 97 Civ. 6026, 1999 WL 301691, at *10 (S.D.N.Y. May 12, 1999); Independent Order of Foresters v. Donaldson, Lufkin Jenrette, Inc., 919 F. Supp. 149, 153 (S.D.N.Y. 1996).
Third, plaintiff's fraudulent concealment claim, based on the allegation that DLJ continued to quote current bid prices even though the securities had been designated as restricted, is also inadequately pled and must be dismissed. This pleading does not meet the requirement of Fed.R.Civ.P. 9(b) that "circumstances constituting fraud . . . be stated with particularity." Neither the complaint nor the opposition brief states when the bid prices were communicated, who communicated them, when the securities were placed on the restricted list, or other facts that might satisfy the particularity requirement. See Compl. ¶¶ 18, 40-42; Pl.'s Mem. at 24-25. Moreover, plaintiff has neglected, yet again, to sufficiently allege that DLJ acted with scienter in not disclosing the securities' adverse designation. See id.
Accordingly, plaintiff's state law claims of fraud (Count II), negligent misrepresentation (Count III), and fraudulent concealment (Count IV) are dismissed.
5. Leave to Replead
Although plaintiff has not requested leave to amend its pleadings, we raise the issue, sua sponte, given the nature of this decision. We are well aware of the directive of Chill v. General Electric Co., that "[l]eave to amend should be freely granted, especially where dismissal of the complaint [is] based on Rule 9(b)," 101 F.3d 263, 271 (2d Cir. 1996) (quoting Acito v. IMCERA Group, Inc., 47 F.3d 47, 55 (2d Cir. 1995). We are equally cognizant of the teaching that "[l]eave may be denied so long as there is a good reason for it, such as futility, bad faith or undue delay." Chill, 101 F.3d at 271-72. Here we conclude that "any amendment would be futile because [plaintiff has] not, and could not, plead the elements of a securities fraud claim." Koehler v. The Bank of Bermuda (New York) Ltd., 209 F.3d 130, 138 (2d Cir. 2000)
We further note that at no stage of this litigation, neither after DLJ made its motion, nor even after oral argument, has plaintiff requested leave to replead. Having analyzed plaintiff's papers under several different theories and having granted plaintiff the opportunity to further develop its allegations at oral argument, we did not at any point detect any facts that plaintiff wished, but had failed, to plead in its complaint. Thus, we dismiss its claims without leave to replead.
CONCLUSION
For the foregoing reasons, defendant's motion to dismiss pursuant to Fed.R.Civ.P. 12(b)(6) is granted as to all of plaintiff's claims, and the complaint is dismissed without leave to replead.
IT IS SO ORDERED.
DATED: New York, New York May 31, 2000
NAOMI REICE BUCHWALD UNITED STATES DISTRICT JUDGE