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BROWN v. E.F. HUTTON GROUP

March 8, 1990

KAY N. BROWN, ET AL., PLAINTIFFS,
v.
THE E.F. HUTTON GROUP, ET AL., DEFENDANTS.



The opinion of the court was delivered by: Walker, Circuit Judge:[fn1]

OPINION AND ORDER

Plaintiff investors charge defendants with fraudulent conduct in connection with the sale of interests in an oil and gas limited partnership. Defendants have moved to dismiss the amended complaint for failure to state a claim pursuant to Fed.R.Civ.P. ("Rule") 12(b)(6) and for failure to plead fraud with particularity pursuant to Rule 9(b), or in the alternative, for summary judgment pursuant to Rule 56(b). For the reasons discussed below, defendants' motions for summary judgment and for dismissal pursuant to Rule 9(b) are granted, the amended complaint is dismissed, and plaintiffs are given leave to replead in conformity with this opinion.

I. BACKGROUND

Plaintiffs are investors in the Hutton/Indian Wells 1983 Energy Income Fund, Ltd. ("Partnership"), a limited partnership designed to produce income through the purchase and management of producing oil and gas properties. The Partnership has failed to produce any real profits, and plaintiffs have brought suit against the corporate parties allegedly responsible for organizing and promoting the Partnership and selling interests therein. Defendants include Hutton Energy Services II, Inc. ("Hutton Energy"), one of the co-general partners, E.F. Hutton & Co., Inc. ("EFH & Co."), The E.F. Hutton Group ("Hutton"), parent of Hutton Energy and EFH & Co., Shearson Lehman Hutton, Inc. ("Shearson")*fn2, recent acquiror of Hutton and its subsidiaries (collectively, the "Hutton defendants"), as well as the Partnership, Indian Wells Production Company ("IWPC"), the other co-general partner, and Indian Wells Oil Co. ("IWOC"), parent of IWPC (collectively, the "Indian Wells defendants").

In their amended complaint plaintiffs allege two violations of § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"). Count one, asserted against Hutton only, alleges sale of "unsuitable" securities; count two, against all defendants, alleges fraud in the sale of securities. Plaintiffs also assert claims of common law fraud against all defendants and breach of fiduciary duty against Hutton. They assert that as a result of defendants' wrongful conduct plaintiffs' investments are now worthless, and consequently demand judgment in the amount of their investments, plus interest, consequential damages and costs. Additionally, plaintiffs claim they are entitled to an award of punitive damages against Hutton under the common law fraud count. The Hutton and Indian Wells defendants have separately moved to dismiss the amended complaint, or in the alternative, for summary judgment.*fn3

The Partnership was allegedly organized and promoted by Hutton Energy, IWPC and IWOC, and was designed to acquire and operate previously developed oil and gas properties. Amended Complaint at ¶¶ 5, 30. Partnership units were marketed and sold by Hutton through EFH & Co. and its account executives, who disseminated information to potential investors. Id. at ¶¶ 5, 11-12. Plaintiffs purchased their interests during the latter part of 1983 through Hutton account executives, after having had conversations with the brokers about their investment objectives and the Partnership. Id. at ¶¶ 4, 17. Plaintiffs allegedly conveyed to the account executives their interest in low-risk securities providing either income or capital appreciation. Id. at ¶ 4. The brokers allegedly told them that there was "low" risk or "no" risk. Id. In making their investment decisions, plaintiffs were provided with the written offering materials for the Partnership, including the Prospectus, a Supplement describing some of the initial acquisitions of producing properties made by the Partnership, and a Brochure highlighting certain aspects of the Partnership. Id. at ¶¶ 16, 17.

The goal of the Partnership, as represented by the account executives and in the offering materials, was the provision of regular cash distributions to the investors. That goal has never been realized, and plaintiffs to date have received either zero or minimal returns, and their investments are allegedly worthless. Id. at ¶¶ 27, 35, 38. Defendants, however, have had use of the money and have earned some return from it, via sales commissions to Hutton and EFH & Co. and management fees and other expenses to Hutton Energy, IWPC and IWOC. Id. at ¶¶ 29, 31; Plaintiffs' Brief at 5-6.

Plaintiffs' claims of fraud are based upon allegations that the written offering materials contained material misrepresentations and omissions of which defendants were aware or were reckless in not being aware. They allege that the materials represented that the investment would generate a steady income stream and was low risk, when in fact it was extremely risky, and indeed there was a virtual certainty that the investors would never recover anything more than their original investments. Id. at ¶ 18. Plaintiffs allege that the Partnership was "fatally flawed" because of the prevailing industry conditions: a clear downward trend in oil and gas prices and excessively high operating costs. Id. at ¶¶ 18, 20. Allegedly, oil and gas prices would have had to rise about 33 percent — to their historical highs of several years earlier — in order for the Partnership to produce the hoped-for profits, and because prices had been dropping for two years and there was no indication of a change in that trend, the chance that the 33 percent rise would occur was practically zero. Id.

To support their claim that the offering materials represented the Partnership as low-risk and conservative plaintiffs point to statements in the Brochure that the Partnership featured "Regular Cash Distributions," "No Exploration Risk," and "Low Minimum Investment;" that the investment was one which "has been carefully structured to offer benefits that meet the needs of an income-oriented investor." Id. at ¶ 16.

They also point to as misleading representations in the Prospectus that the limited partners would receive an annual cash distribution of 15 percent of their investment; that the Partnership would reduce distributions to the general partners up to 50 percent in order to increase distributions to the limited partners to ensure them of receiving their 15 percent return per year; and that the Partnership was obligated, if asked, to repurchase up to $500,000 in units each year. Id. at ¶¶ 16, 18. Plaintiffs claim that these representations were designed to lull investors into a false sense of security and were misleading because investors would get these benefits only if enough money was available to trigger them, which would occur only in the unlikely event of a 33 percent oil and gas price rise.

Generally, they allege that the written materials are misleading and fraudulent because they either understate, obscure or omit discussion of the real risks of the investment. Defendants, of course, assert that none of these or any other statements are misleading and that there are no material omissions in the offering materials.

Plaintiffs assert that defendants either knew, or were reckless in not knowing, of the "fact" that the Partnership never had any realistic chance of producing profits and was in fact doomed to failure. They base this allegation on defendants' alleged knowledge of the industry and prior experience with similar oil and gas partnerships. Id. at ¶¶ 20, 38. Hutton in particular had previously offered two oil and gas limited partnerships involving the acquisition of producing oil and gas properties. Id. at ¶ 38. Also, they cite defendants' own due diligence investigation into the planned operations of the Partnership as a basis of knowledge. Id. at ¶ 20.

Despite their supposed knowledge and expertise, defendants proceeded to distribute materials that were allegedly designed to lure investors looking for conservative investments and omitted mention of both the specific "fatal flaw" and the exceedingly speculative nature of the investment generally. Id. at ¶¶ 9, 15. Indeed, they assert that Hutton specifically targeted the Partnership to the elderly on fixed incomes and other unsophisticated investors who would be more easily fooled by the misrepresentations and omissions. Id. at ¶ 43. Plaintiffs actually allege an entire scheme to defraud investors of their money. Id. at ¶¶ 29, 36, 39, 40.

II. DISCUSSION

Defendants have moved to dismiss the amended complaint for failure to state a claim and for failure to plead fraud with particularity, and in the alternative have moved for summary judgment. The Court believes that on a motion to dismiss it could not consider the written offering materials submitted by defendants' as exhibits in support of their motions.*fn4 For convenience the Court will assess plaintiffs' claims from the standpoint of summary judgment, always mindful, of course, that it can dismiss a claim as legally insufficient on the basis of the pleadings. Rule 9(b) also stands as an independent requirement of particularity addressed to the face of the pleadings.

In considering whether a claim is legally sufficient the Court must read the complaint very generously, taking the facts alleged as true and resolving all factual doubts in favor of the pleader. Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 101-02, 2 L.Ed.2d 80 (1957). See also, Connecticut Nat'l Bank v. Fluor Corp., 808 F.2d 957, 962 (2d Cir. 1987), citing, Yoder v. Orthomolecular Nutrition Institute, 751 F.2d 555, 558 (2d Cir. 1985). In considering a motion for summary judgment the Court must decide whether there are genuine issues of material fact requiring a trial, or whether one side is entitled to judgment as a matter of law. Fed.R.Civ.P. 56(c). A genuine issue exists if "a reasonable jury could return a verdict for the nonmoving party." Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248, 106 S.Ct. 2505, 2510, 91 L.Ed.2d 202 (1986). On a motion for summary judgment the Court must look beyond the face of the complaint, considering all pleadings, memoranda, affidavits and other materials submitted by the parties. Fed.R.Civ.P. 56(c).

A. Section 10(b) Claims

To state a claim for fraud under Section 10(b) plaintiffs must allege (1) material misstatements or omissions, (2) indicating an intent to deceive or defraud ("scienter"), (3) in connection with the sale or purchase of any security, (4) upon which the plaintiffs reasonably relied to their detriment. See Luce v. Edelstein, 802 F.2d 49, 55 (2d ...


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