The opinion of the court was delivered by: SWEET
Plaintiffs Noah and Clara Troyer ("the Troyers") seek in an Amended Complaint to recover alleged losses resulting from their investment in certain discretionary securities trading accounts. The defendants are one individual, Joseph Karcagi ("Karcagi"), and three brokerage houses, namely First Columbus Corporation ("First Columbus"), Jones & Co. ("Jones"), and Prescott, Ball & Turban ("Prescott") (collectively the "company defendants"), with which Karcagi was associated.
The Troyers claim that defendants have violated Section 10 of the Securities Exchange Act of 1934, 15 U.S.C. § 78j ("the 1934 Act"), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, and Section 12 of the Securities Act of 1933, 15 U.S.C. § 77L ("the 1933 Act"). Defendants have moved, pursuant to Rules 12(b)(6) and 9(b) of the Federal Rules of Civil Procedure, to dismiss the Troyers' claims.
For the reasons stated below, the motions pursuant to Rule 12(b)(6) are denied and the motions pursuant to Rule 9(b), granted in part and denied in part.
The Amended Complaint alleges that the Troyers were unsophisticated in securities transactions, but had substantial assets to invest; that in September of 1972 defendant Karcagi induced them to open cash and margin securities trading accounts with his employer, defendant First Columbus, and to grant Karcagi complete discretion to manage the funds in these accounts ("the discretionary accounts"); and that the Troyers' initial and subsequent deposits of cash and securities into the discretionary accounts totalled over $ 100,000 by the end of 1973. It is further alleged that Karcagi represented: (i) that he would invest these funds in the Troyers' best interests, (ii) that the investments had been profitable and (iii) that the portfolio was of great value; and that all of these representations were false because Karcagi intended to manage the discretionary accounts for his own benefit and because the Troyers' portfolio declined, rather than increased, in value. It is further alleged that Karcagi failed to disclose to the Troyers that in his management of the discretionary accounts he engaged in self-dealing by: (i) buying "new issues" of stock for the Troyers' accounts in transactions where his employer, First Columbus, acted as a dealer or market-maker, (ii) using the accounts to make a market in certain securities and (iii) selling certain securities from the accounts when he anticipated that the price of those securities would soon rise; and that as a result of this alleged undisclosed self-dealing, the value of the Troyers' accounts was substantially reduced as of the end of 1973.
It is further alleged that in December, 1973, Karcagi left First Columbus and entered the employ of defendant Jones; that in July of 1976 Karcagi again changed employers, this time becoming employed by defendant Prescott; that each time Karcagi changed jobs he induced the Troyers to close their discretionary accounts with Karcagi's previous employer and to open discretionary accounts with his new employer; and that Karcagi continued to misrepresent that his management of the Troyers' accounts had been profitable. The Amended Complaint finally alleges that in November of 1977 the Troyers closed their accounts with Prescott, and that by that time approximately 75% Of their total investment had been lost.
The Amended Complaint survives defendants' motions to dismiss pursuant to Rule 12(b)(6), Fed.R.Civ.P., because it contains allegations of a material misrepresentation or omission by Karcagi in connection with the purchase or sale of a security. See Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480 (1977). Material misrepresentations and omissions by Karcagi are alleged here, namely: (i) the misrepresentation of Karcagi's intent to manage the discretionary accounts in the Troyers' best interests; (ii) the misrepresentation that Karcagi's management of the accounts had been profitable; (iii) the misrepresentation that the Troyers' portfolio was of great value; and (iv) the omissions occurring when Karcagi failed to disclose his self-dealing.
These misrepresentations and omissions were in connection with the purchase or sale of a security, because the misrepresentations and omissions allegedly induced the Troyers to invest in the discretionary accounts, which accounts are here determined to be securities.
The discretionary accounts were "investment contracts," and therefore, "securities,"
because these accounts had the three characteristics necessary to create an investment contract pursuant to the test announced in SEC v. W. J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100, 90 L. Ed. 1244 (1946).
Two of the three prongs of the Howey test are satisfied because the Troyers allegedly invested money and were led to expect profits solely from the efforts of Karcagi as their investment manager. It is less clear whether the other prong of the Howey test "common enterprise" is adequately alleged, because it does not appear from the Amended Complaint that any investors other than the Troyers opened discretionary accounts under Karcagi's management.
The defendants have interpreted "common enterprise" to require a pooling of the monies of various investors; that is, they see a requirement of "horizontal commonality." The Troyers, on the other hand, assert that a one-to-one relationship between an investor and an investment manager, that is "vertical commonality," is sufficient to create a common enterprise.
In this District vertical commonality has been held sufficient to satisfy the Howey test when the alleged investment contract is a discretionary account for trading in commodities futures. See Johnson v. Arthur Espey, Shearson, Hammill & Co., 341 F. Supp. 764 (S.D.N.Y.1972); Berman v. Orimex Trading, Inc., 291 F. Supp. 701 (S.D.N.Y.1968); and Maheu v. Reynolds & Co., 282 F. Supp. 423 (S.D.N.Y.1967). No compelling reason has been advanced for the proposition that discretionary commodities accounts and discretionary securities accounts differ with respect to the interpretation of the Howey test, nor is a different result required by the division of authority in other Circuits.
The vertical commonality alleged here is therefore sufficient to satisfy the common enterprise component of the Howey test.
The Amended Complaint also pleads facts sufficient to satisfy the "purchaser-seller" or "in connection with" requirement of an action under Rule 10b-5. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975). A purchase can occur whenever an investor takes action that "represent(s) a new decision by (him) to invest." Fischer v. New York Stock Exchange, 408 F. Supp. 745, 755 (S.D.N.Y.1976) (plaintiffs' agreement to extend loans they had previously made held to be the purchase of an investment contract). In the case at bar, there are various actions alleged which can be said to represent a new decision to invest in a discretionary account, and hence a purchase of an investment contract, by the Troyers. More specifically, as to the original discretionary accounts with First Columbus, the allegation of an initial deposit of funds to open those accounts constitutes a sufficient allegation of the purchase of an investment contract, as do each of the allegations of subsequent deposits of new funds. In addition, the allegation is sufficiently made that each time the Troyers opened new discretionary accounts with a new brokerage house (i. e., after Karcagi moved to Jones and to Prescott), this amounted to the purchase of a new investment contract.
To satisfy the "in connection with" requirement, however, more than a purchase is required. That is, there must be a causal connection between a defendant's misstatements or omissions and the plaintiff's purchase. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 860 (2d Cir. 1968). There can be no such causal connection where the misstatement or omission occurred after the purchase. See duPont v. Wyly, 61 F.R.D. 615, 625 (D.Del.1973). Hence, where it is alleged that a misrepresentation or omission by Karcagi induced the "mere retention" of the discretionary accounts by the Troyers, no claim under Rule 10b-5 can be asserted in connection with the purchase of the investment contracts governing the funds already in these accounts. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 95 S. Ct. 1917, 44 L. Ed. 2d 539 (1975); Clinton Hudson & Sons v. Lehigh Valley Cooperative Farms, Inc., 73 F.R.D. 420, 425-26 (E.D.Pa.1977), Aff'd 586 F.2d 834 (3d Cir. 1978); Ingenito v. Bermec Corporation, 376 F. Supp. 1154, 1174 (S.D.N.Y.1974). On the other hand, where it is alleged that a misrepresentation or omission occurred before one of the purchases of a discretionary account, as defined above, and that this fraud induced the purchase, a Rule 10b-5 claim upon which relief can be granted against Karcagi is stated.
Defendants' motions pursuant to Rule 12(b)(6) Fed.R.Civ.P. are, therefore, denied as to the Rule 10b-5 claim against Karcagi.
As an alternative to the investment contract claim just discussed, the Troyers assert a Rule 10b-5 cause of action against Karcagi based upon fraud in connection with purchases or sales of the underlying securities traded by Karcagi in the discretionary accounts. The Rule 10b-5 claim for Karcagi's alleged omissions relating to his self-dealing in the transactions listed in Exhibit "B" to the Amended Complaint is sufficiently alleged, but the allegations as to misrepresentations and omissions relating to Karcagi's performance or intentions as the Troyers' investment manager do not adequately state a Rule 10b-5 claim. This distinction obtains because of the nature of the "in connection with" requirement.
The alleged misrepresentations concerning Karcagi's investment performance and his intentions affected the investors' confidence in a person selected by them to be their fiduciary rather than influencing their decision to purchase or sell particular securities. The purpose of Rule 10b-5, I. e., to promote "the maintenance of free and open securities markets nurtured in a climate of fair dealing" is not therefore sufficiently served. Niederhoffer, Cross & Zeckhauser, Inc. v. Telstat Systems, 436 F. Supp. 180, 184 (S.D.N.Y.1977), Quoting Herpich v. Wallace, 430 F.2d 792, 808 (5th Cir. 1970). See Wilson v. First Houston Investment Corp., 566 F.2d 1235 (5th Cir. 1978), holding that no Rule 10b-5 claim exists where an investment manager represents that he will utilize computer analysis to guide investments on his client's behalf, but then never employs such analysis. See also Sacks v. Reynolds Securities, Inc., 434 F. Supp. 37 (D.D.C.1977), holding that the "in connection with" requirement was not satisfied where the defendant brokerage house delayed in complying with instructions to transfer various accounts to another brokerage house. See generally Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 97 S. Ct. 1292, 51 L. Ed. 2d 480 (1977). Hence, under the Troyers' alternative theory of fraud in connection with purchases or sales of the underlying securities traded by Karcagi in the discretionary accounts, a Rule 10b-5 cause of action is adequately alleged as to instances of the purchase or sale of securities under circumstances where Karcagi failed to disclose self-interest, but not as to other purchases or sales where Karcagi induced the Troyers to grant him the discretion to make the purchases or sales by generalized representations.
The defendants have also moved for dismissal of the Rule 10b-5 claim under Rule 9(b) of the Federal Rules of Civil Procedure, which requires that "the circumstances constituting fraud" must be "stated with particularity."
This means that the Troyers must state the time, place and content of Karcagi's alleged misrepresentations. See 2A J. Moore, Federal Practice P 9.03 at 1927 (2d ed. 1975); Todd v. Oppenheimer & Co., 78 F.R.D. 415, 419-21 (S.D.N.Y.1978); Anspach v. Bestline Products, Inc., 382 F. Supp. 1083, 1091 (N.D.Cal.1974), Citing Walling v. Beverly Enterprises, 476 F.2d 393, 397 (9th Cir. 1973). The nature of Karcagi's alleged omissions must also be particularly stated.
The pleading of Karcagi's alleged failure to disclose his self-interest in the transactions listed in Exhibit "B" to the Amended Complaint is sufficiently particular in that the transactions and the nature of Karcagi's self-interest in them are identified. As to the alleged misrepresentations of the profitability of Karcagi's management of the discretionary accounts and his intentions to invest in the Troyers' best interests, the misrepresentations are identified as to who made them (i. e. Karcagi), and why they were false. However, the Amended Complaint does not state when or where Karcagi made these alleged misrepresentations. The failure to specify the time at which the alleged misrepresentations were made flaws the Amended Complaint, for two reasons. First, as set forth above, misrepresentations occurring before a purchase or sale of securities can be in connection with that transaction, while a misrepresentation occurring after the transaction cannot be. Second, as set forth below, the secondary liability of the company defendants may depend on which one of them employed Karcagi at the time a misrepresentation was made by him.
In sum, as a result of the lack of particularity as to time and place, the claims based on misrepresentations, as presently pleaded, fail to give the defendants "fair notice of what (the Troyers') claim is and the grounds upon which it rests." Denny v. Barber, 576 F.2d 465, 469 (2d Cir. 1978). The Rule 10b-5 claims against Karcagi which are based on misrepresentations are, therefore, dismissed for failure to comply with ...