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.
The complaint, filed on November 30, 1989, alleges that Frank
J. Livoti, a member of the defendant law firm of Livoti,
O'Grady and O'Hare, whose offices are located
in Mineola, New York, misrepresented material facts to induce
his clients Marcia and David Singer, residents of Westchester
and New York counties respectively, to "purchase" a promissory
note ("Note") from Frank G. Nocito, also Livoti's client. The
Note, dated June 23, 1986, was payable to Marcia Singer in the
principal amount of $350,000. It carried interest payable at
maturity at the annual rate of ten (10) percent and was due
December 23, 1986, six months after its issuance. To secure
payment, Hickory Ridge Associates, Ltd., a corporation of which
Nocito was the principal, executed and delivered a mortgage on
real property at Armonk, New York that Nocito was engaged in
developing. On maturity of the Note, a Refinanced Note due in
six months was issued.
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.
Taken as a whole, the complaint alleges reckless or deceptive
connection with the "purchas[e] from Nocito for $350,000 [of]
Nocito's promissory note[.]" Plaintiffs' Complaint at ¶ 11.
Specifically, plaintiffs claim that defendants misrepresented
Nocito's experience and credentials; advised against recording
the mortgage, thereby depriving plaintiffs of any effective
security interest; urged plaintiffs to refinance the Note for
three additional months, even though doing so meant cancelling
the original obligation, accruing interest already due, and
accepting a new three-month note ("Refinanced Note") in the
higher principal amount of $367,500; and failed to discover or
deliberately concealed material facts relating to the property
offered as security for the Note and Refinanced Note. With
respect to this last issue — the adequacy of Nocito's
collateral — plaintiffs assert that defendants knew or should
have known about prior mortgages containing prohibitions
against subsequent mortgage loans, delinquent indebtedness to
prior mortgage-holders, mechanics' and tax liens totalling more
than one million dollars, outstanding debts to Livoti and his
law firm for past professional services, and Nocito's loss of
title to three of the Hickory Ridge properties (lots 9, 24 and
25) that had been included in the original appraisal and
pledged as security for the Refinanced Note.
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
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
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,
By contrast, the language of § 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 ...