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June 12, 1990


The opinion of the court was delivered by: Brieant, Chief Judge.


This case involves allegations of federal securities fraud on the part of an attorney who helped to arrange financing for a real estate development that later failed. The Court has jurisdiction under Section 22 of the Securities Act of 1933, 15 U.S.C. § 77v (1987), Section 27 of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa (1987), 28 U.S.C. § 1331 (1980) and the principles of pendent jurisdiction.

By motion heard and fully submitted on April 4, 1990, defendants move to dismiss the complaint pursuant to Fed.R.Civ.P. 12(b)(1) and 12(b)(6) on the ground that the short-term promissory note at issue in this lawsuit is not a "security" within the meaning of the federal securities laws and therefore the pendent state claims should be dismissed. The parties have submitted affidavits addressing several specific issues relevant to these motions, but have submitted no Local Rule 3(g) statements. The Court assumes for purposes of these motions that the allegations contained in the complaint, as amplified by the affidavits, are substantially true.

Plaintiffs claim that the discussions leading up to the "purchase" of the Note began in June of 1986 when Livoti, representing Nocito, phoned his client, David Singer, to ask if Singer would be willing to make a loan in connection with the development of a residential real estate subdivision in Armonk, New York. During that conversation, Livoti allegedly stated (1) that Nocito was an experienced builder, (2) that the project had excellent prospects, and (3) that the loan would be safe. A few days later, Livoti provided Singer with an independent appraisal, dated November 14, 1984, describing the property known as Hickory Ridge to consist of eighteen (18) building sites (including lots 9, 24, 25) with an aggregate market value, if sold over three years, of $3,285,000.*fn1

A few days after receiving the appraisal, David Singer met Livoti and Nocito at a restaurant in the Stouffer's Hotel in White Plains, New York. During that meeting, Nocito, not sued here, allegedly stated that he planned to build luxury homes for sale in the million-dollar range, had developed other similar projects successfully, had a lot of his own money invested in this latest project, and wanted Singer "to make a loan to the project with the opportunity to make an equity investment in the project." Plaintiffs' Complaint at ¶ 10(d). Plaintiffs describe this last representation as the "'carrot'" of an equity interest, arguing that "the loan was to be a prelude to an equity investment in the project . . . so the plaintiffs sought profit, not only in the form of interest, . . . but also as future equity participation." Plaintiffs' Memorandum In Opposition at 3 n. 2, 15.*fn2 David Singer's affidavit, however, distinguishes between the loan and the offer of equity participation. Singer states:

  Nocito asked me to loan $350,000 to finance the
  development of luxury homes being built by his
  company, Hickory Ridge Associates, Ltd. in Armonk,
  New York. He also offered me the opportunity to
  become an equity participant in the project.

Affidavit of David Singer (March 21, 1990) at 1-2. Singer does not assert, nor can he, that the Note or Refinanced Note (Exh. C to Saretsky Aff.) included a right to equity participation above and beyond the payment of fixed, market-rate interest at 10%. Nor does he claim that, as partial consideration for the loan, Nocito offered him an oral or written option to invest in equity on specific terms at some future date. Rather, the parties seem to have understood from the outset that the loan and the invitation to make an equity investment were separate and independent transactions. Thus, insofar as the complaint seeks to state a federal securities claim, it does so based on a conclusion of the pleader that the Note, on its own terms, qualifies as a "security" and not because of some vague, inarticulable equity investment or prelude thereto.

To prevail at trial, plaintiffs need not prove that these misrepresentations or omissions were deliberate. It is well settled that reckless conduct may give rise to liability under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The Supreme Court in Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976), reserved decision on the question of whether recklessness satisfies the scienter requirement of Section 10(b) and Rule 10b-5, but the circuit courts have been unanimous in holding that recklessness provides an adequate basis for liability. See generally Jennings & Marsh, Securities Regulation (Foundation Press 1987) at 955-957 (citing cases); Decker v. Massey-Ferguson, Ltd., 681 F.2d 111 (2d Cir. 1982); Rolf v. Blyth, Eastman, Dillon & Co., 570 F.2d 38 (2d Cir. 1978), cert. denied 439 U.S. 1039, 99 S.Ct. 642, 58 L.Ed.2d 698. "Reckless conduct [under Section 10(b) and Rule 10b-5] may be defined as . . . highly unreasonable [conduct], involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it." Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033 (7th Cir. 1977), cert. denied 434 U.S. 875, 98 S.Ct. 225, 54 L.Ed.2d 155 (1977). The recklessness standard comes "closer to being a lesser form of intent than merely a greater degree of ordinary negligence." Sanders v. John Nuveen & Co., 554 F.2d 790 (7th Cir. 1977). Applying this standard, this Court might well conclude that plaintiffs' claims more nearly resemble allegations of negligence than of fraud. But the record in this case is not yet complete, and it would be premature for the Court to decide at this time whether defendants are entitled to summary judgment on the issue of scienter.

Instead, defendants' motion to dismiss confronts this Court only with the antecedent question of whether the Note and the Refinanced Note are "securities" within the meaning of Section 3(a)(10) of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78c(a)(10). Defendants' motion to dismiss relies on alternative grounds, citing Fed.R.Civ.P. 12(b)(1) and 12(b)(6), but the Court notes at the outset that the objection to subject matter jurisdiction lacks merit. Frivolous claims interposed solely for the purpose of manufacturing jurisdiction may be dismissed on jurisdictional grounds, but jurisdiction "is not defeated . . . by the possibility that . . . averments might fail to state a cause of action on which petitioners could actually recover." Bell v. Hood, 327 U.S. 678, 682, 66 S.Ct. 773, 776, 90 L.Ed. 939 (1946). Plaintiffs here will secure the relief sought in their complaint only if they can establish that the Securities Exchange Act of 1934 applies to this short-term promissory note under the particular totality of circumstances of the case. A resolution by this Court of whether, upon the facts pleaded, the federal statute was violated to the extent of giving rise to a private action for damages must be regarded as an adjudication on the merits, binding in any subsequent litigation between the parties, as contrasted with a dismissal for want of subject matter jurisdiction, which has no preclusive effect. We therefore decline to dismiss plaintiffs' complaint under Rule 12(b)(1). See Bell v. Hood, supra.

One further preliminary issue requires discussion. Plaintiffs frame their federal securities allegations not only in terms of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 but also in terms of Section 17(a) of the Securities Act of 1933. In their brief, they concede that "[i]nasmuch as [their] 10b-5 claim is virtually identical to their claim under Section 17(a) of the Securities Act of 1933, the dismissal of the Section 17(a) claim will not effect [sic] this action." Plaintiffs' Memorandum in Opposition at 31. This concession, proceeding as it does from an assumption that Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Act are coextensive, has a familiar ring in this circuit.

Faced with considerable doubt that Section 17(a) of the 1933 Act confers an implied private right of action, our Court of Appeals occasionally has downplayed the importance of the whole issue by suggesting that a private right of action under Section 17(a) of the 1933 Act merely would replicate the private right of action already provided by Section 10(b) of the 1934 Act. In Globus v. Law Research Service, Inc., 418 F.2d 1276, 1283-84 (2d Cir. 1969), cert. denied, 397 U.S. 913, 90 S.Ct. 913, 25 L.Ed.2d 93 (1970), the Court of Appeals left open whether Section 17(a) of the 1933 Act created a private right of action, noting Judge Friendly's remark concurring in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 867 (2d Cir. 1968), cert. denied, 394 U.S. 976, 89 S.Ct. 1454, 22 L.Ed.2d 756 (1969), that denying a private right of action under Section 17(a) makes little difference once it has been established that an aggrieved buyer may sue under Section 10(b) of the 1934 Act. Later, in Kirshner v. United States, 603 F.2d 234 (2d Cir. 1978), the Court of Appeals reversed a district court decision denying a private right of action under Section 17(a) of the 1933 Act, but minimized the significance of its holding by suggesting that Section 17(a) and Section 10(b) are coextensive. Most recently, in Yoder v. Orthomolecular Nutrition Institute, Inc., 751 F.2d 555, 559 n. 3 (2d Cir. 1985), the court questioned its holding in Kirshner, and observed once again that "[h]ere, as in so many instances, § 10(b) of the Securities Exchange Act and Rule 10b-5 afford plaintiff the same relief as would § 17(a) of the Securities Act."

We are not persuaded that Section 17(a) of the 1933 Act and Section 10(b) of the 1934 Act are congruent provisions. As the Fifth Circuit has suggested, "the main reason for the somewhat awkward development of the law under § 17(a) of the 1933 Act is the fact that it has traditionally lived in the shadow of another area of securities law: Rule 10b-5 . . . When the judiciary recognized a private cause of action under Rule 10b-5 shortly after its promulgation, cases that might have fit a § 17(a) cause of action were instead decided under Rule 10b-5." Landry v. All American Assurance Co., 688 F.2d 381, 386 (5th Cir. 1982). After the Supreme Court held that liability under Section 10(b) and Rule 10b-5 requires proof of scienter, see Ernst & Ernst v. Hochfelder, supra, the trial courts quite naturally assumed that the same analysis would apply to claims under Section 17(a) of the 1933 Act. But it does not, for in Aaron v. SEC, 446 U.S. 680, 100 S.Ct. 1945, 64 L.Ed.2d 611 (1980), the Supreme Court held that the elements of a claim under Section 10(b) of the 1934 Act differ from those under Section 17(a) of the 1933 Act. In Aaron the Court adhered to Ernst & Ernst insofar as concerned proof of scienter in an SEC civil injunction proceeding under Section 10(b) and Rule 10b-5 of the 1934 Act, but concluded that the elements of proof under Section 17(a) are quite different. As the Court wrote,

    The language of § 17(a) strongly suggests that
  Congress contemplated a scienter requirement under
  § 17(a)(1), but not under § 17(a)(2) or § 17(a)(3).

  The language of § 17(a)(1), which makes it unlawful
  "to employ any device, scheme, or artifice to
  defraud," plainly evinces an intent on the part of
  Congress to proscribe only knowing or intentional
  misconduct . . .
    By contrast, the language of ยง 17(a)(2), which
  prohibits any person from obtaining money or
  property "by means of any untrue statement of a
  material fact," is devoid of any ...

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