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December 12, 1995

MYRON SHAIN, individually and on behalf of all others similarly situated, Plaintiffs, against DUFF & PHELPS CREDIT RATING COMPANY, Defendant.

The opinion of the court was delivered by: PECK


 TO THE HONORABLE WHITMAN KNAPP, United States District Judge:

 This purported class action is another of the proceedings arising from the alleged "Ponzi scheme" involving the securities of Towers Financial Corporation ("Towers"). The background facts about Towers and its alleged Ponzi scheme are more fully described in this Court's Report and Recommendation dated September 20, 1995 in In Re Towers Financial Corporation Noteholders Litigation, 93 Civ. 0810 (WK) (AJP), 1995 WL 571888 (S.D.N.Y. Sept. 20, 1995), familiarity with which is assumed. *fn1" The present action is related to In re Towers but not consolidated into that action.

 Plaintiff Myron Shain, who purchased $ 200,000 of Towers Notes brought this action on behalf of himself and an alleged class of similarly situated purchasers, against defendant Duff & Phelps Credit Rating Company ("Duff & Phelps"), a securities rating service. (Amended Complaint [hereafter, "complaint" or "Cplt."] PP 5, 6, 24.) Shain's complaint asserts federal securities law claims against Duff & Phelps for alleged violations of Sections 12(1) & 12(2) of the Securities Act of 1933, and also asserts three pendent state law claims. Presently before the Court is Duff & Phelps' motion to dismiss Shain's complaint for failure to state a claim upon which relief can be granted and for failure to plead fraud with particularity, pursuant to Rules 12(b) and 9(b) of the Federal Rules of Civil Procedure.

 For the reasons set forth below, I recommend that the Court dismiss the federal Securities law claims with prejudice and the state law claims without prejudice.


 On a motion to dismiss, the Court must accept the well-pleaded allegations in the complaint as true. E.g., In re Towers, 1995 WL 571888 at *1, citing Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989). Accordingly, this opinion will summarize Shain's complaint, without resorting to the phrase "plaintiff alleges."

 Towers was engaged in a far-reaching "Ponzi scheme" designed to deceive purchasers of Towers Notes into believing Towers was a healthy and growing concern when it was failing on a massive scale and kept afloat only through using cash from subsequent Note offerings to make the interest payments on earlier Notes. (Cplt. PP 10-11, 15-22.)

 On or about March 10, 1992 and August 24, 1992, Shain purchased $ 200,000 of the more than $ 215 million of Notes issued by Towers pursuant to five "private placement" Offering Memoranda. (Cplt. PP 5, 19.)

 "The Duff & Phelps [proposed] Class is defined as all persons who purchased Notes from February 15, 1989 to the present ('Class Period') by or through broker-dealers Cooper Davis, located in Chicago, Illinois, and East-West Capital, located in Southfield, Michigan. (Cooper-Davis and East-West Capital are referred to as the 'Class Brokers')." (Cplt. P 7.) There are at least 80 members of the proposed class, who purchased over $ 17 million of Towers Notes. (Cplt. P 9.)

 The gist of Shain's complaint is that "Duff & Phelps actively foisted a uniform and consistent set of misrepresentations and omissions on the Duff & Phelps Class via the Class Brokers who reiterated them to, or relied on them for, the Class." (Cplt. P 11.)

 Beginning in or about July 1990, "in an effort to lend additional credibility and respectability to its operations, Towers hired Duff & Phelps to rate the Towers Bonds." (Cplt. P 25.) Towers paid "substantial sums" to Duff & Phelps, "ostensibly for the investigatory and other 'due diligence' activities by Duff & Phelps that were a supposed precondition of a Duff & Phelps bond rating." (Id.) The relationship between Towers and Duff & Phelps, however, soon became "symbiotic":

Towers paid Duff & Phelps fees and Duff & Phelps helped Towers promote itself to the investment community with Duff & Phelps' rating of the Bonds, the favorable "shadow rating" *fn2" of Towers, and other representations made to the Class Brokers.


 The Towers Notes "were distributed via broker dealers." (Cplt. P 26.) As part of Towers' efforts to market the Notes, beginning in or about June 1990, the broker-dealers began to communicate with Towers to learn more about Towers and to verify information regarding Towers' operations and financial background. (Id.) Towers referred the Class Brokers to Duff & Phelps, which Towers said "would provide independent verification and corroboration regarding the creditworthiness of Towers and its Notes, and confirm the positive statements Towers had made in its public SEC filings and otherwise." (Id.)

 Duff & Phelps represented to the Class Brokers that it "had conducted extensive due diligence investigations prior to assigning ratings to the Towers Bonds and it was continuing to monitor the performance of the Bonds and Towers." (Cplt. P 28.) Duff & Phelps' "actions in convincing the Class Brokers that their customers should buy the Notes were facilitated by Duff & Phelps' use of what Duff & Phelps termed a 'shadow rating' of Towers' company operations." (Cplt. P 29.) While it "is not known [to plaintiff] at this time whether Duff & Phelps received direct cash payments or other monetary incentives for preparing and disseminating the shadow rating," Duff & Phelps did "reap substantial monetary, pecuniary and reputational benefits" as a result of its overall relationship with Towers. (Id.)

 Between June 1990 and February 1993, "Mark Tuttle, Ernest Elsner and other employees and agents of Duff & Phelps" met in person and by telephone with the two Class Brokers, Cooper Davis and East-West Capital. (Cplt. P 31.) During these meetings, Duff & Phelps represented that:

(1) its relationship with Towers gave it "unique insight into Towers' operations and performance";
(2) "it was performing and/or had performed exhaustive ongoing review of all aspects of Towers finances, operations and management";
(3) "it could assure the Class Brokers and their clients of the solid worth, integrity, stability and safety of the Notes";
(4) "its investigation of Towers showed that Towers' public representations ...

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