United States District Court, Southern District of New York
April 26, 1990
BORDEN, INC., ET AL., PLAINTIFFS,
SPOOR BEHRINS CAMPBELL & YOUNG, INC., ET AL., DEFENDANTS.
The opinion of the court was delivered by: William C. Conner, District Judge:
OPINION AND ORDER
This securities action is presently before the Court on the
motion of defendants First Interstate Bank, Ltd. and First
Interstate Services, Inc. to dismiss the complaint as against
them for failure to state a claim upon which relief may be
granted pursuant to Fed.R.Civ.P. 12(b)(6). For the following
reasons, defendants' motion is denied.
The complaint in this action alleges, inter alia, various
fraudulent and corrupt practices in connection with the sale of
securities in violation of Section 10(b) of the Securities
Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and
Rule 10b-5 of the Securities and Exchange Commission. The
complaint identifies as the primary violator of that statute
and rule, Spoor Behrins Campbell & Young, Inc. ("SBCY"), a firm
of investment advisors. The complaint also identifies the
moving defendants as successive parent corporations and sole
stockholders of SBCY during the relevant time periods,
asserting "controlling person" liability pursuant to Section
20(a) of the Exchange Act, 15 U.S.C. § 78t(a). The complaint
further alleges that the moving defendants lent money to some
class members and that they knew that SBCY received fees from
some of the partnerships in which class members invested.
I. Motion to Dismiss Standard
A motion to dismiss for failure to state a claim tests only
the sufficiency of a complaint, see Scheuer v. Rhodes,
416 U.S. 232, 236, 94 S.Ct. 1683, 1686, 40 L.Ed.2d 90 (1974), and should
not be granted "unless it appears beyond a doubt that the
plaintiff can prove no set of facts in support of his claim
which would entitle him to relief." Conley v. Gibson,
355 U.S. 41, 45-46, 78 S.Ct. 99, 102-103, 2 L.Ed.2d 80 (1957); Anderson
v. Coughlin, 700 F.2d 37, 40 (2d Cir. 1983). A court must
accept as true the allegations of the complaint and draw all
reasonable inferences in favor of the plaintiff. See Scheuer,
416 U.S. at 236, 94 S.Ct. at 1686. Viewing plaintiff's
complaint in such favorable light, the Court denies defendants'
motion to dismiss.
II. Sufficiency of the Allegation of "Controlling Person"
Liability under Section 20(a) of the Exchange Act
Section 20(a) of the Exchange Act, 15 U.S.C. § 78t(a),
[e]very person who, directly or indirectly,
controls any person liable under any provision of
[the Exchange Act] or of any rule or regulation
thereunder shall also be liable jointly and
severally with and to the same extent as such
controlled person to any person to whom such
controlled person is liable, unless the
controlling person acted in good faith and did not
directly induce the act or acts constituting the
violation or cause of action.
The purpose of this provision is to impose secondary liability
on one who controls a violator of the securities laws, and who
fails to show that he acted in "good faith." Defendants argue
that plaintiffs have failed to plead sufficiently the necessary
elements of scienter and culpable participation to establish a
prima facie claim of controlling person liability. Plaintiffs
first refute the necessity of pleading these elements and,
alternatively, maintain that they have satisfied those
requirements if they do exist. For the following reasons, the
Court agrees with plaintiffs that neither scienter nor culpable
participation must be pleaded to state a claim for controlling
person liability. Stating such a claim in the Second Circuit
requires the pleading only of control status, i.e., that the
controlling person directly or indirectly held the power to
exercise control over the primary violator.
This question was resolved authoritatively in this Circuit by
Marbury Management, Inc. v. Kohn, 629 F.2d 705, 716 (2d Cir.),
cert. denied, 449 U.S. 1011, 101 S.Ct. 566, 66 L.Ed.2d 469
(1980), which held that in controlling person liability cases,
once control status is established, it becomes the defendant's
burden to prove that he acted in good faith. On the basis of
this Second Circuit Court ruling, four district court decisions
have explicitly rejected the argument defendants now advance.
The most recent decision, In re Citisource, Inc. Secur.
Litigation, 694 F. Supp. 1069, 1076 (S.D.N.Y. 1988),
crystallized the impact of Marbury Management that "the burden
is on the defendant to show that he is not culpable, rather
than on the plaintiff to show that the defendant is culpable"
and rejected the alleged controlling party's claim that
scienter is a necessary pleading element of Section 20(a)
Another case which rejected defendants' proposition is
Terra Resources I v. Burgin, 664 F. Supp. 82 (S.D.N.Y. 1987), in
which Judge Sweet's response, later quoted with approval by
Judge Goettel in Citisource, was as follows:
[I]t would seem imprudent to construct a pleading
requirement that demands that plaintiffs
anticipate and negate an alleged controlling
person's good faith defense by pleading detailed
facts to show the controller's culpability.
Id., 694 F. Supp. at 1077. The ruling in Terra Resources was
further based on the reasoning that the imposition of exacting
scienter pleading requirements would run contrary to the
settled rules of pleading with respect to affirmative defenses,
especially in light of "this Circuit's practice of reading the
`controlling person' provisions expansively." Id., 664 F. Supp.
Yet another case rejecting a stringent pleading requirement
is Polycast Technology Corp. v. Uniroyal, [Current]
Fed.Sec.L.Rep. (CCH) ¶ 94,005, 1988 WL 96586 (S.D.N.Y. 1988).
Judge Walker's opinion that "a plaintiff need not plead
scienter when alleging controlling person liability" fully
accords with the above cases.
Lastly and also squarely on point, Savino v. E.F. Hutton &
Co., 507 F. Supp. 1225, 1243 (S.D.N.Y. 1981), ruled that in view
of Marbury Management's statement that a prima facie Section
20(a) case requires only proof of control by status, it is
evident that a plaintiff need only allege control by status in
order to state a Section 20(a) claim. In that case, Judge Ward
explained the evolutionary process by which the Second Circuit
has reached conformity with the weight of controlling person
liability cases from other circuits. The Savino opinion
recognizes that in the past, some courts "viewed the good faith
component to be a part of the plaintiff's case under Section
20(a), and hence refused to impose liability unless plaintiff
showed that the alleged controlling person exercised actual
control over the controlled person in relation to the
transaction in question. . . . [namely], the absence of good
faith." Id. at 1242-43. The court concluded that,
Today, however, it is fairly well agreed that
proof of "control by status," as distinct from
"actual control," is all that is required to make
out prima facie case under Section 20(a). It has
been said that proof of control by status creates a
presumption of "control" within the meaning of
Section 20(a), which presumption can be rebutted if
the alleged controlling person proves an absence of
actual control. See Comment, supra, 15 Cal.W.L.Rev.
at 161. In the Court's view, the Court of Appeals
for this Circuit adopted precisely this view with
its recent decision in Marbury Management, Inc. v.
Kohn, 629 F.2d 705 (2d Cir.), cert. denied, 
U.S. , 101 S.Ct. 566, 66 L.Ed.2d 469 (1980).
Id. at 1243.*fn1
Another case, Drobbin v. Nicolet Instrument Corp.,
631 F. Supp. 860, 885 (S.D.N.Y. 1986), held on a substantive motion
that in accordance with Marbury Management, scienter is not an
element of controlling person liability unless the defendant
invokes the "good faith" defense: "[t]o the extent that there
is any scienter requirement for such liability, it arises only
in the context of that statutory defense."
Defendants' reliance on a separate line of authorities is
misplaced. Neither Lanza v. Drexel & Co., 479 F.2d 1277 (2d
Cir. 1973), nor Gordon v. Burr, 506 F.2d 1080 (2d Cir. 1974),
discuss pleading requirements but interpret the substantive
elements of proof needed to recover on the merits after a good
faith and lack of scienter defense has been duly presented. The
Lanza decision concerns culpable participation in the context
of what a plaintiff must ultimately prove after all elements of
the case have been duly presented for adjudication. Lanza, 479
F.2d at 1280. Gordon too is an appellate decision based upon a
lower court determination rendered after a non-jury trial on
the merits. Gordon 506 F.2d at
1081 Insofar as the cases might be construed more broadly, they
are superseded by the more recent Marbury Management
Another case cited by defendants, Index Fund, Inc. v.
Hagopian, 609 F. Supp. 499 (S.D.N.Y. 1985), is equally
inapposite. This case, decided expressly on summary judgment,
discussed what a plaintiff in a controlling person liability
action must show to prevail on the merits after a good faith
defense has been presented, not what a plaintiff must allege to
state a claim. Id. at 506.
Defendants do, however, point to a line of cases which appear
to support their position that section 20(a) imposes strict
pleading requirements. While these cases address the pleadings,
they misconstrue the applicable caselaw by applying
Lanza and Gordon's substantive rules instead of those set forth
in Marbury Management. See e.g., Friedman v. Arizona World
Nurseries Ltd., 730 F. Supp. 521, 534 (S.D.N.Y. 1990)
(dismissing complaint because no scienter or culpable
participation alleged); Hemming v. Alfin Fragrances, Inc.,
690 F. Supp. 239, 245 (S.D.N.Y. 1988) (denying motion to dismiss
because facts inferred culpable participation); Harrison v.
Enventure Capital Group, Inc., 666 F. Supp. 473, 478 (W.D.N Y
1987) (dismissing complaint for insufficient allegations to
satisfy "this Circuit's culpable participation standard");
O'Connor & Assocs. v. Dean Witter Reynolds, Inc., 529 F. Supp. 1179
(S.D.N.Y. 1981) (dismissing complaint against alleged
controlling person because it asserted "no facts as to
knowledge or reckless disregard of the facts"). Nothing in
these opinions suggests that the courts or the parties
considered Marbury Management's significance for pleading
purposes or recognized that knowledge and culpability issues
are affirmative defenses, rather than elements of a prima facie
Comparing the Citisource, Terra Resources, Polycast, and
Savino decisions with defendants' suggested authorities, it is
clear that the former are better reasoned and give proper
attention to the Marbury Management decision. See Polycast
Technology, supra, at ¶ 94,005 (noting the divided decisions of
this Court, Judge Walker concluded that a prima facie case did
not require pleading of scienter or "good faith"). This Court
concludes that in this Circuit, "good faith" and lack of
scienter is recognized as an affirmative defense under Section
20(a) and that a plaintiff therefore need allege only control
status to make out such a claim.
This pleading determination does not conflict with the
statute's aim to hold liable only those controlling persons
"who are in some meaningful sense culpable participants in the
fraud perpetrated by controlled persons." See Lanza, 479 F.2d
at 1299; 78 Cong.Rec. 8668, 8669 (1934) (Memorandum of Sen.
Fletcher) ("The mere existence of control is not made a basis
for liability unless that control is effectively exercised to
bring about the action upon which liability is based.").
Defendants simply bear the burden of proving that, despite
their sole stock ownership, they were not culpable participants
in the alleged fraudulent scheme of SBCY.
III. Control Status
Plaintiffs allege control person liability on the basis of
defendants' (i) successive sole stock ownership of SBCY; (ii)
loans to individual investors; and (iii) knowledge that SBCY
was deriving income from some recommended ventures. Defendants
maintain that these grounds, considered individually or
collectively, do not suffice to show control by status.
While there is no statutory definition of "control," the SEC
has defined "control" as "the possession, directly or
indirectly, of the power to direct or cause the direction of
the management and policies of a person, whether through the
ownership of voting securities, by contract, or otherwise."
17 C.F.R. § 240.12(b)-2(f). Congress deliberately did not define
"control," see H.R.
Rep. No. 1383, 73rd Cong., 2d Sess. 26 (1934), to allow courts
to decide issues of control status on a case-by-case basis.
See Rochez Bros. v. Rhoades, 527 F.2d 880, 890 n. 19 (3d Cir.
1975). Plaintiffs' allegation that defendants were sole
shareholders of SBCY clearly meets this standard. Defendants'
positions strongly suggest that they had the potential power to
influence and direct the activities of SBCY. Giving plaintiffs
the benefit of all reasonable inferences, as a court must on a
motion to dismiss, plaintiffs have sufficiently stated control
status and therefore, a Section 20 claim.
For the above-stated reasons, defendants' motion to dismiss
for failure to state a claim upon which relief may be granted