United States District Court, Southern District of New York
November 13, 1991
SIDNEY MORSE, PLAINTIFF,
ROBERT WEINGARTEN, AMERICAN EXPRESS CO., SHEARSON LEHMAN BROTHERS, INC., AND MICHAEL R. MILKEN, DEFENDANTS.
The opinion of the court was delivered by: Lasker, District Judge.
Defendant Michael Milken moves under Rules 12(b) and 9(b),
Fed.R.Civ.P., to dismiss all claims against him in this
securities fraud class action suit, and under Rule 12(f) to
strike portions of the complaint.*fn1
For the reasons discussed below, the motion to dismiss and
the motion to strike are granted.
Plaintiffs are shareholders who bought stock in the
now-bankrupt First Capital Holdings Corp. ("First Capital")
between March 31, 1989 and May 31, 1991.
Their complaint alleges: 1) that Milken either caused or
helped defendant Robert Weingarten to establish First Capital,
a financial services and insurance holding company that derived
much of its revenue from its investment portfolio; 2) that
Milken, in his capacity as "junk bond chief" (Morse's term) of
the brokerage firm Drexel Burnham Lambert, underwrote First
Capital's financing through offerings of junk bonds; 3) that
"Drexel/Milken" exercised control over First Capital's
investment portfolio and caused it to invest heavily in junk
bonds issued by other clients of Milken and Drexel; 4) that
First Capital issued statements, including annual reports and
reports filed with the Securities and Exchange Commission
(SEC), which contained misrepresentations or misleading
omissions indicating that its financial condition was sound and
that its effective portfolio management reduced the risk
normally associated with junk bonds despite the fact that the
value of its junk bond portfolio was deteriorating rapidly; 5)
that defendants knew or were recklessly indifferent to the
falseness of their representations or the misleading nature of
their omissions; 6) that plaintiffs bought stock from March 31,
1989 through May 31, 1991 in reliance on those
misrepresentations or misleading omissions; and 7) that First
Capital collapsed, filing for bankruptcy on May 30, 1991*fn2
and thereby injuring plaintiffs.
Morse alleges that Milken's participation in these events was
part of a broader attempt by him to operate a scheme, which
Morse calls a "Daisy Chain," by which Milken would both arrange
financing for various entities with high-risk, high yield "junk
bonds" and cause the same entities to invest in junk bonds of
other Milken clients, all in an attempt to create an
artificially inflated market for financial products created by
Drexel and Milken.
As part of the alleged scheme, Morse claims, Drexel and
Milken knowingly "made materially false and misleading
statements . . . to prospective purchasers or sellers in order
to induce the purchase or sale of high-yield securities,"
Compl. at ¶ 61, and induced sales of high-yield securities by
advising "certain prospective purchasers and sellers that their
participation in the Drexel Daisy Chain would increase the
price of high-yield securities." Compl. at ¶ 62. The complaint
also alleges that Drexel and Milken "purchased and sold
high-yield securities while in possession of material
information, not generally available to the public, obtained
from their relationships with the issuers and purchasers. . .
." Compl. at ¶ 63.
Finally, Morse asserts:
Milken played an ongoing dominant role in the
operation of the Daisy Chain. Pursuant thereto, he
materially aided and abetted the other defendants
in the wrongdoing herein alleged. Drexel/Milken
further exercised substantial discretion and
investment authority over [First Capital's] junk
securities portfolio which he exercised without
regard to [First Capital's] stated investment
and further engaged in numerous unsuitable and
unnecessary transactions. Defendants' statements
to the contrary acted as a fraud upon plaintiff .
Compl. at ¶ 64.
According to Morse, the facts alleged constitute violations
of Sections 10(b) and 20(a) of the Securities Exchange Act of
1934, 15 U.S.C. § 78j(b) and 78t(a) (1988), Rule 10b-5
promulgated thereunder, 17 C.F.R. § 240.10b-5, and common law
fraud and negligent misrepresentation.
Milken argues that the claims against him must be dismissed
pursuant to Fed.R.Civ.P. 12(b)(6) for failure to state a claim
upon which relief can be granted and pursuant to Fed.R.Civ.P.
9(b) for failure to plead the circumstances constituting fraud
with particularity. He also maintains that portions of the
complaint should be stricken pursuant to Fed.R.Civ.P. 12(f).
Under Rule 12(b), the required inquiry is simply whether
Morse has alleged facts that, if true, would constitute a
violation of securities laws or applicable common law. Because
Morse alleges fraud, his claims must also comply with Rule
9(b), which provides: "In all averments of fraud or mistake,
the circumstances constituting fraud or mistake shall be stated
with particularity. Malice, intent, knowledge, and other
condition of mind of a person may be averred generally."
Construing Rule 9(b), the Court of Appeals for this Circuit has
recently held that "while Rule 9(b) permits scienter to be
demonstrated by inference, this `must not be mistaken for
license to base claims of fraud on speculation and conclusory
allegations.' An ample factual basis must be supplied to
support the charges." O'Brien v. National Property Analysts
Partners, 936 F.2d 674, 676 (2d Cir. 1991) (quoting Wexner v.
First Manhattan Co., 902 F.2d 169, 172 (2d Cir. 1990)).
A. Section 10(b)
Morse argues that his allegations support recovery against
Milken for primary violations of § 10(b), for aiding and
abetting primary violations by other defendants, for "control
person" liability pursuant to § 20(a), and for conspiring with
other defendants to commit violations.
1. Primary Violation
Section 10(b) states that it is unlawful for any person "[t]o
use or employ, in connection with the purchase or sale of any
security . . ., any manipulative or deceptive device or
contrivance. . . ." 15 U.S.C. § 78j(b) (1988).
Typically, to state a claim for a primary violation of §
10(b) and Rule 10b-5 a plaintiff must allege that "in
connection with the purchase or sale of securities, the
defendant, acting with scienter, made a false material
representation or omitted to disclose material information and
that plaintiff's reliance on defendant's actions caused him
injury." Bloor v. Carro, Spanbock, Londin, Rodman & Fass,
754 F.2d 57, 61 (2d Cir. 1985).
Milken correctly observes that all of the representations or
misleading omissions upon which Morse alleges he relied were
contained in statements issued by First Capital, not by Milken,
and that Morse has not alleged that Milken had any direct
responsibility for preparing or distributing those
representations. The complaint's sole allegations of any
representations by Milken are that Milken engaged in various
deceptive practices to encourage sales of high-risk securities
of client companies. The complaint also alleges, in a
conclusory fashion, that Milken exercised control over First
Capital's investment portfolio. However, Morse has not alleged
that plaintiffs were injured by investing in securities about
which Milken made misleading statements or omissions. Morse
merely alleges that other defendants knew of but denied or
omitted to reveal Milken's mismanagement of First Capital's
investments and that "[d]efendants' statements to the contrary
acted as a fraud upon plaintiff. . . ." Compl. ¶ 64.*fn3
Morse argues that acts other than statements made directly to
investors can and, in this case, did constitute a "manipulative
or deceptive device or contrivance" within § 10(b)'s meaning.
He claims that Milken's alleged self-interested creation of an
artificially inflated junk bond market in which he caused First
Capital to invest was inconsistent with the company's best
interests, injured plaintiffs and violated § 10(b).
Morse is correct that unusual methods to defraud investors
have been held actionable under Section 10(b). See Competitive
Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath,
516 F.2d 811, 815 (2d Cir. 1975) ("[Section] 10(b) and Rule
10b-5 prohibit all fraudulent schemes in connection with the
purchase or sale of securities, whether the artifices employed
involved a garden type variety of fraud, or present a unique
form of deception") (emphasis in original).
However, Morse has failed to identify even an atypical scheme
by which Milken defrauded plaintiffs. Plaintiffs complain they
were duped into purchasing First Capital stock. They have
identified specific misleading statements issued by First
Capital upon which they relied, but have complained of no
conduct by Milken beyond his alleged maintenance of his "Daisy
Chain." The complaint falls short of stating a primary
violation of § 10(b) by Milken as to these plaintiffs because
its allegations do not establish that Milken's conduct was "in
connection with" plaintiffs' purchase of First Capital stock or
that his actions caused plaintiffs' injuries within the meaning
of § 10(b).
Both the "in connection with" requirement and the causation
requirement under § 10(b) concern the nexus between a
defendant's behavior and the sale or purchase by which
plaintiffs incurred actionable harm. The Court of Appeals for
this Circuit has ruled that a plaintiff alleging a broad-based
scheme to defraud must "demonstrate causation in fact by
showing that defendant's allegedly fraudulent activities were
actually responsible for plaintiff's injuries," Bloor, 754 F.2d
at 61, and "must assert that the 10(b) violations caused the
claimed economic loss. This required causal connection may not
be supplied by `but for' allegations." Id. (citations omitted).
In the present case, the allegations of Milken's deception
are insufficiently connected to plaintiffs' injury to meet the
requirements of Bloor. The harm alleged was directly caused by
the corporation's statements, with which Milken is not alleged
to have been involved. The complaint provides no factual
assertions that support an inference of or establish that
plaintiffs directly relied on Milken's actions as they decided
to invest in First Capital or that he intended to deceive them
as opposed to First Capital itself. The allegedly misleading
statements identified in the complaint maintained that careful
portfolio management could minimize the exposure associated
with First Capital's high risk (junk bond) investments and that
expected high returns justified the investments. While these
allegedly deceptive statements, all of which were made by First
Capital only, may not have been possible without the existence
of an apparently vibrant junk bond market created by Milken,
that background fact is precisely the type of "but for" causal
factor that Bloor instructs is not sufficient to support
recovery under § 10(b).
It is true that in some "in connection with" cases, the
phrase has been contrued quite broadly. See, e.g.,
of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 12-13,
92 S.Ct. 165, 169, 30 L.Ed.2d 128 (1971) (connection sufficient
where deceptive practices "touch" sale of securities).
Nevertheless where the "transactional nexus" between a
defendant's conduct and a plaintiff's purchase or sale of
securities is not established, the claim is not viable. See In
re Financial Corp. of America Shareholder Litigation,
796 F.2d 1126, 1129-30 (9th Cir. 1986) (insufficient "transactional
nexus" where defendant accounting firm recommended accounting
method subsequently ruled unacceptable by SEC for asset
purchase by plaintiff client). Judged by this rule Milken's
alleged actions were simply not "in connection with"
plaintiffs' purchase of First Capital securities, as that
phrase is used in § 10(b) of the Act.
Accordingly, Morse's claim against Milken for a primary
violation of § 10(b) does not satisfy Rule 12(b) and is
2. Aider and Abettor Liability
To state a cause of action for aiding and abetting the
alleged securities fraud, Morse must allege the following:
(1) the existence of a securities law violation by
the primary (as opposed to the aiding and
(2) "knowledge" of this violation on the part of
the aider and abettor; and
(3) "substantial assistance" by the aider and
abettor in the achievement of the primary
IIT, International Invest. Trust v. Cornfeld, 619 F.2d 909, 922
(2d Cir. 1980). Milken argues that the complaint does not
sufficiently allege any of these elements as to him.
To begin with Milken contends that the complaint merely
alleges corporate mismanagement (in First Capital's failure to
establish adequate reserves or invest more prudently) rather
than fraud. The argument is not persuasive. The complaint
plainly and repeatedly alleges that the defendants caused First
Capital to issue statements that its sophisticated management
practices adequately safeguarded against the kind of loss
eventually suffered by the company and its shareholders when in
fact defendants knew that no adequate protections were in
place, and that these representations induced plaintiffs to
invest detrimentally in First Capital. That allegation states
a cause of action for fraud against the primary actors, who
were principal owners and officers of First Capital.
Milken argues next that the complaint contains no allegation
that Milken knew that First Capital was inducing investors to
purchase its shares by disseminating the allegedly misleading
statements. While Morse's brief now states that "Milken and
Weingarten are alleged to have intentionally misrepresented
[First Capital's] financial condition . . .", as discussed
above there is no allegation in the complaint that Milken made
or participated in misrepresentations directly to plaintiffs,
nor is there any other allegation which supports the
proposition that Milken knew of fraudulent misrepresentations
made by others. Accordingly, despite the provision of
Fed.R.Civ.P. 9(b) stating that "Malice, intent, knowledge and
other condition of mind of a person may be averred generally,"
Morse's pleadings as to Milken's knowledge are insufficient
under Rules 9(b) and 12(b).
Milken also challenges the sufficiency of Morse's claim that
Milken substantially assisted the primary actors in their
scheme to defraud plaintiffs. Milken's argument presents a
close question, particularly under Rule 9(b), although Morse
does provide at least a conclusory allegation that Milken's
manipulation of the junk bond market facilitated the primary
actors' misconduct. In light of the above conclusion that Morse
has not alleged Milken's knowledge of First Capital's
misrepresentations and misleading omissions, no more definite
resolution of the substantial assistance question is necessary.
Because of Morse's failure adequately to allege Milken's
knowledge of the primary violations, Morse's claim that Milken
aided and abetted others' violation of the securities laws is
dismissed pursuant to Rules 9(b) and 12(b).
3. Control Person Liability
Section 20(a) of the Securities Exchange Act provides, "Every
person who, directly or indirectly, controls any person liable
under any provision of this chapter . . . shall also be jointly
and severally liable 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 or indirectly induce the act or acts
constituting the violation or cause of action." 15 U.S.C. § 78t(a).
As with claims of liability for aiding and abetting a
securities law violation, to assert a "control person" claim
pursuant to § 20(a) plaintiffs must allege the existence of a
primary violation and defendant's knowledge of that violation.
See Bernstein v. Crazy Eddie, Inc., 702 F. Supp. 962, 979
(E.D.N.Y. 1988), vacated in part on other grounds sub nom. In
re Crazy Eddie Securities Litigation, 714 F. Supp. 1285
(E.D.N.Y. 1989). Plaintiffs also "must plead that the defendant
had `the power to exercise control over the primary violator,
based on a special relationship such as agency or stock
ownership.'" Id. (quoting Index Fund, Inc. v. Hagopian,
609 F. Supp. 499, 506 (S.D.N.Y. 1985)).
As discussed above, Morse has not made the requisite
allegation of Milken's knowledge pursuant to Rule 12(b).
Moreover, Morse has not alleged sufficiently that Milken
enjoyed any power whatsoever over First Capital's actions. The
complaint does make the conclusory statement that Milken
exercised control over First Capital's investments in
furtherance of his "Daisy Chain," but does not identify any
position or title that Milken held at First Capital, nor does
it identify any meetings which he attended or conversations
which he had with any of the company's officers. Even allowing
for the leniency of our pleading rules, Morse's allegations are
Accordingly, Morse's claim of Milken's control person
liability is dismissed pursuant to Rule 12(b).
To state a claim of conspiracy, the complaint must allege "an
agreement between two or more persons to accomplish an unlawful
purpose, their intentional participation in the furtherance of
the plan or purpose, and the resulting damage." First Federal
Savings & Loan Ass'n v. Oppenheim, Appel, Dixon & Co.,
629 F. Supp. 427, 443 (S.D.N.Y. 1986).
We have searched the complaint for allegations of conspiracy
between Milken and the principal actors and have found only the
vague statement, "Each of the defendants is liable as a direct
participant in, as a co-conspirator and as an aider and abettor
of the wrongs complained of herein." Compl. at ¶ 70.*fn4 This
allegation is totally inadequate because the complaint does not
anywhere identify any conspiratorial agreement involving
One cannot agree to what one does not know. Because Morse has
not alleged Milken's knowledge of primary violations, it
follows that Milken has not sufficiently been alleged to have
joined into a conspiracy to accomplish those violations.
Although plaintiffs contend that their claims of an agreement
between Milken and Weingarten to further the "Daisy Chain" by
causing First Capital to invest in high risk bonds state a
conspiracy claim, it remains the case that such a conspiracy,
if it did exist, would have as its victims First Capital itself
(through its investment in overvalued Milken products) and
perhaps more broadly all investors in high risk securities
which allegedly were overvalued as a result of Milken's efforts
to inflate the market for such securities. The plaintiffs in
this suit, however, were harmed not by investing in Milken
products but by investing in First Capital stock.
Accordingly, Morse's claim that Milken conspired to violate
the securities laws is dismissed pursuant to Rule 12(b).
B. Fraud and Negligent Misrepresentation
Morse's second and third causes of action are for common law
fraud and negligent misrepresentation under New York law.
To state a claim for common law fraud in New York, a
plaintiff must allege 1) the defendant's misrepresentation or
omission of a material fact, 2) the defendant's intent to
deceive plaintiff, 3) justifiable reliance upon the
misrepresentation by the defrauded party, and 4) that the
plaintiff's injury was caused by the defendant's
misrepresentation or omission. See Idrees v. American
University of Caribbean, 546 F. Supp. 1342, 1346 (S.D.N Y
1982); Jo Ann Homes at Bellmore, Inc. v. Dworetz, 25 N.Y.2d
112, 302 N.Y.S.2d 799, 803, 250 N.E.2d 214, 218 (1969). Because
these elements are substantially identical to those governing §
10(b), the identical analysis applies here, and accordingly
Morse has failed to allege facts which if proven would support
his common law fraud claim. That claim is dismissed.
Since Morse has not made allegations which tie Milken to any
misrepresentations or omissions which were made, his claim of
negligent misrepresentation is dismissed.*fn5
C. Motions to Strike
Milken moves pursuant to Rule 12(f) to strike references in
the complaint to his criminal conviction and income level.
Rule 12(f) authorizes the striking of "any redundant,
immaterial, impertinent, or scandalous matter." Such motions
are left to the court's discretion. See Payne v. Howard, 75
F.R.D. 465, 467 (D.D.C. 1977).
The complaint's reference to Milken's criminal conviction and
his income level are immaterial and impertinent to this case,
and may be "scandalous." Neither Milken's income nor the
outcome of his celebrated criminal prosecution bears remotely
on the merits of this case. Reference to those matters serves
no purpose except to inflame the reader. Although courts have
commented that motions to strike pursuant to Rule 12(f) "are
not favored" and should be denied "especially if the presence
of the material does not prejudice the moving party,"
Schramm v. Krischell, 84 F.R.D. 294, 299 (D.Conn. 1979), here
there is no reason to allow those references to remain in the
Milken's motion is granted pursuant to Rule 12(b) as well as
9(b) and all claims against him are dismissed. His motion to
strike is granted.
It is so ordered.