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ABF CAPITAL MGMT. v. ASKIN CAPITAL MGMT.

January 22, 1997

ABF CAPITAL MANAGEMENT, et al., Plaintiffs, against ASKIN CAPITAL MANAGEMENT, L.P., KIDDER, PEABODY & CO., INC., BEAR STEARNS & CO., INC. and DONALDSON, LUFKIN & JENRETTE SECURITIES CORP., Defendants.


The opinion of the court was delivered by: SWEET

 Sweet, D.J.

 In this action alleging violations of the Racketeer Influenced and Corrupt Organizations statute ("RICO") and state law fraud, breach of fiduciary duty, negligent misrepresentation and unjust enrichment claims, defendants Askin Capital Management, L.P. ("ACM"), Kidder Peabody & Co. Incorporated ("Kidder"), Bear, Stearns & Co. Inc. ("Bear Stearns"), and Donaldson, Lufkin & Jenrette Securtities Corporation ("DLJ") (collectively, "Defendants") have moved, pursuant to Rule 12(b)(6) and Rule 9(b), Fed. R. Civ. P., to dismiss the complaint against them for lack of standing, failure to state a claim and failure to plead fraud with particularity.

 For the reasons set forth below, Defendants' motions will be granted in part and denied in part.

 Parties

 The Plaintiffs are thirty-eight shareholders and/or limited partners in Granite Partners, L.P. ("Granite Partners"), a limited partnership registered in the State of Delaware, Granite Corporation ("Granite Corp."), incorporated in the Cayman Islands, and/or Quartz Hedge Funds ("Quartz"), also incorporated in the Cayman Islands (collectively, the "Funds"). Complaint P 9. The Funds are not parties to this action. Among the Plaintiffs are retirement plans governed by ERISA, corporations, investment partnerships, and individuals. Id.

 At all relevant times, Defendant ACM, a Delaware limited partnership with a principal place of business in New York, was a registered investment adviser. Non-party David J. Askin ("Askin") was the Chief Executive Officer of ACM. In January 1993, Askin formed ACM. Complaint P 13. At that time, ACM became the investment advisor to Granite Partners and Granite Corp.; at all times thereafter, ACM was the sole general partner of Granite Partners and the investment advisor to each of the Funds. Id. at PP 13-14.

 Kidder Peabody, Bear Stearns and DLJ (collectively, the "Brokers" or "Broker Defendants"), all Delaware Corporations with principal places of business in New York, are broker-dealers.

 Background

 I. Factual Allegations

 On a motion to dismiss under Rule 9(b) or Rule 12(b)(6), the facts alleged in the complaint are presumed to be true, and all factual inferences are drawn in the plaintiff's favor. Mills v. Polar Molecular Corp., 12 F.3d 1170, 1174 (2d Cir. 1993). Accordingly, the facts presented here are drawn from the allegations of Plaintiff's complaint (the "Complaint") and do not constitute findings of fact by the court.

 This action arises from the collapse in early 1994 of three "hedge funds" managed by ACM: Granite Partners, Granite Corp. and Quartz (the "Funds"). Compl. P 1. The Funds made leveraged investments in the volatile mortgage-backed securities market. Id. Each Plaintiff purchased an interest in one or more of the Funds; the earliest such transaction occurred in September 1990, and the latest occurred in March 1994. Compl. P 9. Several of the Plaintiffs acquired additional interests in the Funds after their initial investment. Id. In the aggregate, Plaintiffs allege that they lost approximately $ 230 million that they invested in the Funds. Id. at PP 1, 9.

 ACM (and, before ACM's creation, Askin) actively marketed interests in the Funds. In documents disseminated to each of the Plaintiffs, ACM described an investment strategy that purportedly could "achieve its investment objective of earning high absolute levels of return regardless of whether the bond market moves up, down or stays the same." Id. at PP 29, 30, 31, 35, 36. ACM targeted in particular investors who desired "low and manageable levels of risk," in part by promising that ACM would "meet[] its investment objectives without speculating on the future direction of interest rates." Id. at PP 31, 33, 36, 40. Rather, ACM promised to invest "in a balanced or hedged portfolio of CMOs [collateralized mortgage obligations] . . . with the security of high quality, low risk investments" that traded in an active market. Id. at PP 29, 34, 36. The ACM-created portfolios supposedly would be diversified and "hedged so as to maintain a relatively constant portfolio value, even through large interest rate swings." Id. at P 29, 36. In a document used by ACM to solicit purchases of interests in the Funds, ACM made the following representations to the Plaintiffs:

 
What is [the] risk exposure by investing in CMOs and their derivatives? Very little when investing through [ACM]. While the high yielding instruments in which we invest individually have market risk (e.g., exposure to prepayment), when combined in a risk-balanced, market-neutral portfolio, these government and government agency guaranteed instruments (or Aaa and Aa rated) have low risk (e.g., low volatility).

 Id. at P 37.

 ACM also provided detailed descriptions of the methodology it would use to make investment decisions. For example, ACM stated that it would employ "its proprietary analytic models" to evaluate each security under consideration over a variety of prepayment and interest rate scenarios. Id. at P 40. ACM represented that its investment analysis was not a one-time procedure, but an active and ongoing process "designed to assure that [ACM] can always have its portfolio structured with the most appropriate securities for achieving its investment goal." Id. at P 38. Written materials disseminated by ACM set forth a "structured five-step process" of computer-driven quantitative analysis that would enable ACM to identify and acquire "high yield bonds that, when combined with other select CMOs, [would] form a hedged, lower-risk portfolio." Id. at P 40.

 ACM's written materials also spoke about leverage and liquidity. As to the latter, ACM represented that it would purchase securities that traded in active markets and otherwise insure that the Funds never would become "distressed" or "forced" sellers of securities, but would maintain at all times an ability to "wait it out until conditions improve." Id. at PP 34, 43. Although ACM made various representations about the specific leverage ratios it would maintain for each of the Funds, ACM was consistent in its promise to keep borrowings conservative. Id. at 44.

 ACM and Askin allegedly issued these statements continuously from September 1991 to March 1994. The Plaintiffs, who invested their money through ACM throughout that period, each received and relied upon the allegedly fraudulent documents in purchasing and retaining their shares in the Funds. Compl. PP 21, 41.

 The Complaint alleges that each of the above-referenced representations was false and that ACM knew that each was false at the time that the statements were issued. The securities primarily trafficked in by ACM did not have "low risk" and "low volatility." Rather, ACM purchased mass quantities of esoteric securities that it and the Brokers referred to as "toxic" or "nuclear waste." Id. at PP 47, 48, 50, 57, 58, 59, 65, 66, 67, 68, 69, 73, 74. Neither did ACM create market-neutral, diversified, balanced, or hedged portfolios. At all times, ACM maintained dramatically tilted portfolios that were uniquely susceptible to rises in interest rates. Id. at PP 46, 48, 67, 71, 72-76. ACM did not employ a formalized, five-step process of analysis utilizing proprietary, computerized analytical models; it did not have any models, and it traded based predominantly on Askin's "gut" feelings or in response to pressure from the Brokers. Id. at PP 103-108. ACM created a highly illiquid portfolio, thus putting the Funds at risk of becoming a "forced" seller, which ACM in fact became in 1994. Id. at PP 50, 119, 120. Finally, ACM did not keep the Funds' leverage within reasonable ranges; it borrowed excessively, and on atypical terms, from the Brokers, and engaged in massive forward transactions. Id. at PP 46, 51, 94-98, 109-20.

 ACM (and Askin) allegedly steered the bulk of the Funds' business to the three defendant Brokers. Due in large part to their trading with ACM, the Brokers collectively garnered over 40% of the CMO market by early 1994. Id. at PP 53-54. At that time, moreover, approximately 65% of the securities in the Funds' portfolios had been created and sold by the Brokers. Id. at P 56. The Brokers made millions of dollars as a result of their dealings with ACM; in 1993, for example, the Brokers, in the aggregate, earned approximately $ 140 billion dollars from CMO offerings. Id. at P 53. Largely as a result of trades with ACM, the Brokers enjoyed continually increasing shares of -- and profits from -- the lucrative CMO market. Id. at P 54.

 ACM was allegedly a vitally important customer of the Brokers. Using excessive leverage, ACM was able to employ the Plaintiffs' money to buy and sell billions of dollars worth of high-risk, volatile CMO securities during 1993 and 1994. Id. at P 55. Most importantly, ACM was willing to purchase the most volatile tranches of any given CMO offering. This was allegedly crucial from the Brokers' perspective, as these tranches -- also known as the "deal drivers" -- had to be sold as a precondition to the pricing and selling of the remainder of each particular CMO offering and were the source of virtually all of the trading profit made by the Brokers on such offerings. Id. at P 57. ACM's pronounced role in this market is evidenced by the allegations that the Brokers' issuance of CMOs dropped by approximately 90% after ACM's demise. Id. at P 59.

 Plaintiffs allege that the Brokers knew that ACM had promised to purchase only "high quality," "low risk," freely-tradeable securities for the Funds' portfolios and to hedge and balance those portfolios so that they were immune to changes in interest rates. Id. at PP 47, 67, 68, 69, 71, 72, 73, 74. The Brokers also allegedly knew that the securities they sold to ACM did not fit within the parameters of ACM's investment discretion and were inappropriate for the Funds. Id. at PP 47, 48, 67-75. Among other things, these securities were highly volatile and could not be modeled or hedged effectively. Id. at PP 50, 67-75, 96, 102, 105. Knowing that ACM had created dramatically bullish (i.e., not neutral) portfolios, the Brokers allegedly continued to sell additional bullish securities to ACM. Id. at PP 48, 67-76, 77, 93, 102.

 The Brokers knew that ACM did not possess the analytic models or other tools necessary to understand or hedge esoteric CMO securities. Id. at PP 49, 96, 105-08. Knowing this, the Brokers not only continued to sell such securities to the Funds, but also misrepresented to ACM the essential characteristics of a given security in order to convince ACM that the security would be appropriate for the portfolios. Id. at PP 49, 78, 93. The Brokers also were aware that ACM had promised to keep leverage low and liquidity high. Id. at PP 68, 72, 94-98, 112, 119, 120. In order to ensure that ACM had a continuing source of money with which to purchase their high-risk, deal-driving tranches, each of the Brokers extended unusually favorable borrowing terms to ACM and induced ACM to purchase securities for forward settlement, which the Brokers knew would result (and which did result) in ACM becoming over-leveraged and illiquid. Id. at PP 50, 51, 94-97, 112-18. These conditions, in turn, rendered the Funds unable to meet margin calls issued by each of the Brokers in March 1994. Complaint PP 131-41. The Brokers also allegedly helped ACM to report artificially-inflated performance results by providing inflated performance marks to ACM. Complaint PP 121-30. Plaintiffs concede that the specific marks set forth in paragraph 130 as examples of inflated marks are inaccurate. However, there are allegations, including excerpts from Broker telephone conversations, that indicate the Brokers "re-evaluated" their initial marks upward in negotiations with ACM. Complaint P 127. These inflated marks were then allegedly passed on to Plaintiffs in monthly "flash" and "final" reports mailed to investors.

 Plaintiffs also allege that the relationship between the Brokers and ACM was symbiotic in nature. Plaintiffs allege that a Kidder salesman who covered the ACM account stated: "We are in bed with [ACM]." Complaint P 65. In the same conversation, Kidder's representative admitted: (1) Kidder's knowledge that the securities it sold to ACM were "nuclear waste"; and (2) that Kidder's salespeople could earn commissions from the sale of such "nuclear waste" to ACM that were as much as 128 times the amount that could be earned from selling less risky securities to ACM. Id.

 II. The Bankruptcy Proceedings and the Primavera Action

 On or about April 8, 1994, the Funds filed petitions under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York. The bankruptcy proceedings are before the Honorable Stuart M. Bernstein. In September 1995, Primavera Familienstiftung ("Primavera"), a Liechtenstein foundation and alleged stockholder in Granite Corp., filed a purported class action complaint in this Court, styled Primavera Familienstiftung v. Askin, No. 95 Civ. 8905. The complaint in that action, as amended, named David Askin, ACM, Geoffrey Bradshaw-Mack, Kidder Peabody, Bear Stearns, and DLJ as defendants and asserted claims for, inter alia, violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, common law fraud, negligent misrepresentation, breach of fiduciary obligations, third party beneficiary breach of contract, and violations of Article 9 of the New York Commercial Code. On December 21, 1995, the appointed trustee in bankruptcy, Harrison Goldin, sought a preliminary injunction to prevent Primavera from continuing to prosecute its action.

 By Opinion dated April 9, 1996, the Bankruptcy Court granted in part and denied in part the trustee's motion. In re Granite Partners, L.P., 194 Bankr. 318 (Bankr. S.D.N.Y. 1996). Specifically, the Bankruptcy Court determined that Primavera's fraudulent inducement claims were direct and belonged to shareholders. Id. at 327. However, the Bankruptcy Court enjoined Primavera from prosecuting its breach of fiduciary duty claims on the ground that only the trustee had standing to sue insiders for injuries to a corporation or limited partnership arising from breach of fiduciary duty. Id. at 327-28.

 This Court subsequently dismissed all of the claims in the second amended complaint in Primavera, granting plaintiff leave to replead the section 10(b) and fraud claims, which had been dismissed for failure to plead fraud with particularity, and to replead the breach of fiduciary duty claim at such time as the bankruptcy court's injunction was dissolved. See Primavera Familienstiftung v. Askin, 1996 U.S. Dist. LEXIS 12683, 1996 WL 494904 (S.D.N.Y. Aug. 30, 1996); Primavera Familienstiftung v. Askin, 1996 U.S. Dist. LEXIS 14845, 1996 WL 580917 (S.D.N.Y. Oct. 9, 1996).

 III. Prior Proceedings In This Action

 Plaintiffs originally filed this action in New York State Supreme Court on March 27, 1996. Defendants removed the case to this Court on April 24, 1996.

 In their Complaint, Plaintiffs asserted seven claims: (1) common law fraud against ACM; (2) aiding and abetting fraud against the Broker Defendants; (3) breach of fiduciary duty against ACM; (4) aiding and abetting breach of fiduciary duty against the Broker Defendants; (5) negligent misrepresentation against ACM; (6) unjust enrichment against all defendants; and (7) violations of the RICO statute, 28 U.S.C. ยง 1962, against all defendants.

 Defendants filed the instant motions on June 3, 1996. Oral argument was heard on September 24, 1996, at which time the motions were deemed fully submitted.

 Discussion

 I. Legal Standards

 A. Rule 12(b)(6)

 Rule 12(b)(6) imposes a substantial burden of proof upon the moving party. A court may not dismiss a complaint unless the movant demonstrates "beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." H.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 229, 249-50, 106 L. Ed. 2d 195, 109 S. Ct. 2893 (1989); Hishon v. King & Spalding, 467 U.S. 69, 73, 81 L. Ed. 2d 59, 104 S. Ct. 2229 (1984); Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957).

 B. Rule 9(b)

 Federal Rule of Civil Procedure 9(b) requires that in all allegations of fraud, the circumstances constituting the fraud must be stated with particularity. See Shields v. Citytrust Bankcorp, Inc., 25 F.3d 1124, 1127 (2d Cir. 1994); In re Time Warner, Inc. Secs. Litig., 9 F.3d 259, 265 (2d Cir. 1993); Shemtob v. Shearson, Hammill & Co., 448 F.2d 442, 444-45 (2d Cir. 1971). The pleading must be sufficiently particular to serve the three goals of Rule 9(b) which are (1) to provide a defendant with fair notice of the claims against it; (2) to protect a defendant from harm to his reputation or goodwill by unfounded allegations of fraud; and (3) to reduce the number of strike suits. See DiVittorio v. Equidyne Extractive Indus., Inc., 822 F.2d 1242, 1247 (2d Cir. 1987); O'Brien v. Price Waterhouse, 740 F. Supp. 276, 279 (S.D.N.Y. 1990), aff'd, 936 F.2d 674 (2d Cir. 1991).

 The Court of Appeals has required that allegations of fraud adequately specify the statements made that were false or misleading, give particulars as to the respect in which it is contended that the statements were fraudulent, and state the time and place the statements were made and the identity of the person who made them. See McLaughlin v. Anderson, 962 F.2d 187, 191 (2d Cir. 1992); Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989).

 The pleading must give notice to each opposing party of its alleged misconduct. Thus, a claim may not rely upon blanket references to acts or omissions by all of the defendants, for each defendant named in the complaint is entitled to be apprised of the circumstances surrounding the fraudulent conduct with which he individually stands charged. Jacobson v. Peat, Marwick, Mitchell & Co., 445 F. Supp. 518, 522 n.7 (S.D.N.Y. 1977). This requirement facilitates the preparation of an adequate defense while protecting a party's reputation from groundless accusations. See de Atucha v. Hunt, 128 F.R.D. 187, 189 (S.D.N.Y. 1989), aff'd, 979 F.2d 846 (2d Cir. 1992); Posner v. Coopers & Lybrand, 92 F.R.D. 765, 768 (S.D.N.Y. 1981), aff'd, 697 F.2d 296 (2d Cir. 1982). It also serves to prevent abuse of process and gratuitous disruption of normal business activity. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 740-41, 44 L. Ed. 2d 539, 95 S. Ct. 1917 (1975).

 Not all elements of a fraud claim need be pleaded with equal particularity. Rule 9(b) provides that "malice, intent, knowledge, and other condition of mind of a person may be averred generally." See Shields, 25 F.3d at 1128. The Court of Appeals has held that "allegations of scienter . . . are not subjected to the more exacting consideration applied to the other components of fraud." Breard v. Sachnoff & Weaver, Ltd., 941 F.2d 142, 143 (2d Cir. 1991) (quoting Ouaknine v. MacFarlane, 897 F.2d 75, 81 (2d Cir. 1991)). All that is required under Rule 9(b) is that there exist a "minimal factual basis for . . . conclusory allegations of scienter." Cohen v. Koenig, 25 F.3d 1168, 1173 (2d Cir. 1994) (quoting Connecticut Nat'l Bank v. Fluor Corp., 808 F.2d 957, 962 (2d Cir. 1987)). "In fact, conclusory allegations of scienter are sufficient 'if supported by facts giving rise to a "strong inference" of fraudulent intent.'" IUE AFL-CIO Pension Fund v. Herrmann, 9 F.3d 1049, 1057 (2d Cir. 1993) (quoting Ouaknine, 897 F.2d at 80). There are two methods of pleading that may give rise to such an inference. A plaintiff may either (1) identify circumstances indicating conscious or reckless behavior by the defendants, or (2) allege facts showing both a motive for committing fraud and a clear opportunity for doing so. Shields, 25 F.3d at 1128; Cosmas, 886 F.2d at 13.

 II. The RICO Claim Will Be Dismissed

 Plaintiffs assert as their Seventh Claim for Relief that the Dealers and ACM participated in a fraudulent RICO scheme. Plaintiffs allege:

 Complaint P 179.

 As part of the 1995 Private Securities Litigation Reform Act (the "Reform Act"), Congress amended RICO to remove securities fraud claims as RICO predicate acts. Section 1964(c) of Title 18, United States Code, now provides that:

 
Any person injured in his business or property by reason of a violation of section 1962 of this chapter may sue therefor . . . except that no person may rely upon any conduct that would have been actionable as fraud in the purchase or ...

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