The opinion of the court was delivered by: SWEET
Defendant Warren Essner "Essner") has brought this motion to dismiss the complaint of the plaintiff Securities and Exchange Commission ("SEC") pursuant to Fed.R.Civ.P. 12(b)(1) and 12(b)(6) relying upon the Second Circuit's recent decision in Chemical Bank v. Arthur Andersen & Co., 726 F.2d 930 (2d Cir.), cert. denied, 469 U.S. 884, 105 S. Ct. 253, 83 L. Ed. 2d 190 (1984). The motion is granted.
The SEC brought this action against Essner arising out of his participation in a fraud which resulted in the collapse of Drysdale Government Securities, Inc. ("DGSI"), and losses to investors of about $290 million. The allegations in the complaint, described below, are accepted as true for the purposes of deciding this motion to dismiss. Miree v. DeKalb, 433 U.S. 25, 27, 97 S. Ct. 2490, 53 L. Ed. 2d 557 (1977).
Drysdale Securities Corporation ("DSC"), a broker-dealer registered with the SEC and regulated by the New York Stock Exchange, operated a business in U.S. Government obligations including United States treasury bonds, notes and bills. From December 1979 to February 1982, DSC's government securities business was conducted by David Heuwetter. This operation was taken over by DGSI, a newly formed corporation, as of January 31, 1982, and was continued by DGSI under Heuwetter's direction until May 17, 1982 when DGSI defaulted on payments of over $160 million in accrued coupon interest obligations. (Complaint at P P 31-32).
This default occurred as a consequence of DGSI's repurchase and reverse repurchase agreements in what is called the "repo" market in U.S. Government obligations.
(Complaint at P 42). In its repurchase agreements, DGSI loaned U.S. government obligations to third parties in return for cash. These agreements provided that DGSI would repay the cash, with interest, at a specified date and that the third parties would return the same or similar U.S. government obligations. Ownership of the U.S. government obligations did not change, and the owners remained entitled to all coupon interest which accrued during the term of the agreements (Complaint at P P 34-39).
In its reverse repurchase agreements, DGSI borrowed U.S. government obligations from third parties and loaned cash in return. DGSI was obligated to return the same or similar U.S. government obligations at a specified date, and the third party was required to repay the cash, with interest, to DGSI. Again, ownership of the U.S. government obligations did not change, and the owner remained entitled to coupon interest which accrued during the term of the agreements. (Complaint at P 39). See generally SEC v. Miller, 495 F. Supp. 465 (S.D.N.Y. 1980).
DGSI followed the earlier practice of DSG, generating working capital for its government securities business by taking advantage of prevailing pricing practices in the government securities market. At that time, the purchaser of government security in a reverse repo transaction did not pay the seller accrued coupon interest as part of the purchase price but remitted it when the coupon matured. In contrast, the purchaser of a government security in the cash or outright market was required to pay the accrued interest as part of the purchase price (Complaint at P 39). This disparity enabled DGSI to obtain securities through reverse repos, sell them to dealers in the outright market, and immediately realize the accrued interest. Using this strategy, DGSI had use of the interest until the coupon payment dates. However, once the securities were sold outright, DSGI had to purchase securities in the cash market in order to redeliver them to the reverse repo sellers at the close of the transaction. (Complaint P P 37-39, 53).
DGSI carried out these operations on a massive scale, its daily cash transactions amounted to over $100 million (Complaint P 53), and DGSI's ability to carry out commitments to its trading partners depended on continually opening new reverse repo positions and selling the government securities thus acquired. (Complaint P P 42, 51, 53). When its reverse repo partners cut back on the open positions maintained with DGSI (Complaint P 55), the firm collapsed.
In January 1982, Essner, an audit partner at the accounting firm of Arthur Andersen & Co., was retained by DSC to assist in the spin-off of its government securities business (Complaint at P P 26, 43). Essner proposed a plan, which DSC implemented, to transfer DSC's government securities business to DGSI. (Complaint at P 43). At the request of DSC's chairman of the board, Essner drafted a letter for distribution to various government securities dealers and banks, announcing DGSI's formation and representing its capital as $20.8 million. (Complaint P P 44, 65). In fact, DGSI inherited from DSC its positions in government securities carrying with them a deficit of approximately $190 million. (Complaint at 40, 43, 52, 65).
To give DGSI greater credibility, Essner prepared, on behalf of Arthur Andersen, a certified statement of DGSI's subordinated debt and equity, accompanied by an unqualified audit opinion representing that the examination of DGSI's subordinated debt and equity had been made in accordance with generally accepted auditing standards. (Complaint at P P 45-48). In addition to repeating the representation that DGSI had capital of $20.8 million, the report materially misstated the net fair value of significant operating assets and liabilities which ostensibly had been transferred to DGSI in exchange for preferred stock. (Complaint at P P 48, 65). The report, issued on February 22, 1982, and dated February 1, did not disclose that $15.8 million of DGSI's capital was in fact loaned indirectly to it by DSC, and that on February 1, after DGSI opened for business, it transferrred at least $12 million of these funds back to DSC. (Complaint at P P 49, 65(c)(3)). Essner knew that DGSI would use these documents to induce securities dealers and banks to engage in government securities transactions. (Complaint at P 50).
The SEC alleges that Essner's acts constitute violations of § 17(a) of the Securities Act, 15 U.S.C. § 77q(a) and Section 10(b) of the Exchange, 15 U.S.C. § 78j(b), and Rule 10b-5, 17 C.F.R. § 250.10b-5, promulgated thereunder. These provisions make it unlawful to engage in fraudulent conduct "in connection with the purchase or sale of a security."
The issue that must be resolved here, in light of Chemical Bank, supra, is whether Essner's alleged misrepresentations with respect to the Government securities involved in the repo and reverse repo transactions, are "in connection with" the purchase or sale of a security. If ...