C. Securities Law Claim.
The plaintiffs allege in Count One of the Amended Complaint that all of the defendants, save for Altman and his law firm, have committed fraud in violation of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5.
To state a claim under Section 10(b) and Rule 10b-5, the plaintiffs "must allege that, in connection with the purchase or sale of securities, each defendant, acting with scienter, made a material false representation, or omitted to disclose material information, or engaged in a scheme to defraud, and that plaintiff[s'] reliance upon defendant[s'] action caused plaintiff[s'] injury." In re Blech Sec. Litig., 961 F. Supp. 569, 580 (S.D.N.Y. 1997) (citing Bloor v. Carro, Spanbock Londin, Rodman & Fass, 754 F.2d 57, 61 (2d Cir. 1985)).
CEPA and Gevers contend that the Amended Complaint fails to satisfy two of the elements of the claim in that: 1) the alleged fraudulent acts did not take place "in connection with" the purchase or sale of securities and that 2) to the extent that the plaintiffs relied upon any statement or omission made by, or attributable to, CEPA or Gevers, no such statement caused them any injury for which the federal securities laws provide relief.
As to the first contention, CEPA and Gevers assert that the nature of the scheme alleged in the Amended Complaint actually precludes a finding that fraudulent acts "in connection with" the purchase or sale of securities are at issue here. As CEPA states, the plaintiffs have alleged "that the conspirators never intended to provide a note for the Fund and that no note was ever obtained." CEPA Mem. at 15. Thus, since the presence of a security in the form of a "prime bank note" was always illusory, the scheme did not actually involve securities and therefore cannot be characterized as a "securities fraud." In other words, the plaintiffs "apparently fell for a confidence game which could just as easily have involved non-existent diamonds or non-existent real estate." CEPA Reply Mem. at 19.
As CEPA and Gevers assert, a complaint that alleges no more than theft does not state a claim under the federal securities law merely because non-existent securities were used as the bait to effect the theft. See, e.g., Pross v. Katz, 784 F.2d 455, 459 (2d Cir. 1986). However, because our Court of Appeals admonishes that the "in connection with" requirement should be read in a flexible, not in a technical or reflexive, manner, In re Ames Dept. Stores Stock Litig., 991 F.2d 953, 962 (2d Cir. 1993), a Rule 10b-5 claim may be maintained even where a purchase was induced, but the existence of the security at issue was merely purported, not actual. The recent decision in SEC v. Bremont, 954 F. Supp. 726 (S.D.N.Y. 1997) is particularly instructive. Similar to the fraud alleged here, Bremont involved a scheme to induce investors to participate in transactions involving "prime bank instruments" or "PBI's." The defendants proposed that, for a fee, they would obtain purchase orders from banks for PBIs. They would then use investor funds to purchase PBIs from other banks and sell these-- at a considerable mark-up-- to the banks from which they had obtained purchase orders, thereby fulfilling the purchase orders and reaping substantial profits for the investors. In bringing suit against the defendants, the SEC contended that the scheme was blatantly fraudulent because PBIs, and the market for them, simply do not exist. One of the defendants moved to dismiss the Rule 10b-5 claim by asserting that no subject matter jurisdiction existed as to the claim. As do CEPA and Gevers, he argued that a scheme involving a non-existent security was not a scheme "in connection with" the purchase or sale of securities.
The court squarely rejected this argument upon the authority of Superintendent of Insurance v. Bankers Life & Casualty Co., 404 U.S. 6, 10, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971), in which the Supreme Court admonished that the broad reach of Section 10(b) and Rule 10b-5 prohibits all fraudulent schemes in connection with the purchase or sale of securities. 954 F. Supp. at 732. On the face of its complaint, the court continued, "the SEC has demonstrated the likelihood that defendants took large fees, essentially brokerage commissions, for setting up deals for non-existent securities," a scheme which, the court concluded, "clearly satisfies Rule 10b-5's 'in connection with' language,":
Making substantial misrepresentations as to the value of a worthless but technically extant security is a paradigmatic form of securities fraud. Extending the protection of the securities laws to the victims of schemes so fraudulent that the underlying paper does not exist logically follows, as fraudsters would have a perverse incentive to magnify their deceptive conduct. Other courts have reached the same conclusion. See [SEC v.] Lauer, 52 F.3d [667, 670 (7th Cir. 1995)] ("It would be a considerable paradox if the worse the securities fraud, the less applicable the securities laws."); Mishkin v. Peat, Marwick, Mitchell & Co., 744 F. Supp. 531, 553 n. 10 (S.D.N.Y. 1990) (fact that securities do not exist "does not remove an action from the operation of the federal securities laws.").
Id.; see also SEC v. Gallard, 1997 U.S. Dist. LEXIS 19677, 1997 WL 767570 at *2-*3 (S.D.N.Y. Dec. 10, 1997) (scheme involving non-existent "prime bank instruments" was actionable under federal securities laws).
Here, as in Bremont, that the Note is alleged to have existed nowhere but in the minds of the defendants does not remove this case from the purview of Rule 10b-5. A fraud in connection with the purchase or sale of a fraudulent security is no less actionable for its fictitious quality.
CEPA and Gevers next argue that, even if it is sufficient for the purpose of stating a claim that the plaintiffs were led to believe that they were investing in securities, no claim is stated as to CEPA and Gevers because no act is alleged by which they induced the Trustees' initial decision in November 1993 to purchase the Note. CEPA contends that its "alleged statements were made after plaintiffs had handed their money to Pellegrin (an alleged "fraudster"), and after the seizure by DSB. Plaintiffs thus did not rely on CEPA's statements in making their investment and CEPA's statements did not cause either the transaction or plaintiffs' loss within the meaning of Section 10 or Rule 10b-5." CEPA Reply Mem. at 14 (emphasis in original). Similarly, Gevers argues that, since he "first became involved in this debacle after certain other defendants are alleged to have fraudulently induced plaintiffs to part with $ 9.3 million,. . . it is impossible to fathom any basis for alleging that [he] 'caused' plaintiffs' loss." Gevers Mem. at 12 (emphasis in original).
However, the Trusteees' initial decision to devote Fund assets to the purchase of the Note is not the sole relevant act for determining the scope of reliance in this case. Instead, it is consistent with the purpose of Rule 10b-5 to view reliance in light of the alleged continuing scheme to mislead the plaintiffs. In Perez-Rubio v. Wyckoff, 718 F. Supp. 217 (S.D.N.Y. 1989), the plaintiffs alleged that they had been defrauded by a complex scheme pursuant to which they had been induced to place funds in certain off-shore corporations formed to shield the plaintiffs from U.S. taxes. Although the defendants represented that they would invest the funds placed with the corporations in legitimate securities, they actually used them to make loans to a brokerage firm, which maintained its seat on the New York Stock Exchange by listing the funds as part of its equity in order to satisfy the Exchange's firm capital requirements. The defendants concealed these loans by providing the plaintiffs with fictitious account statements that represented that their funds were being conservatively invested. Indeed, the defendants were able to maintain their deception for more than six years. The defendants, like CEPA and Gevers, asserted that statements made in connection with the cover-up could not have been relied upon in connection with the plaintiffs' initial investment decision and, therefore, could not have been the cause of any alleged loss suffered by them.
The court disagreed. Instead, it held that the defendants' concealment of their scheme to divert the plaintiffs' funds over the course of six years had the effect of impeding the plaintiffs from recalling those funds. And herein lay reliance and causation of loss:
The Court can properly infer that if Ossorio had disclosed his scheme to use plaintiffs' funds for the benefit of himself and Drysdale, plaintiffs would never have permitted the securities transactions set forth above. Furthermore, plaintiffs have alleged that defendants were involved directly in the process by which the funds were diverted. The damage plaintiffs complain of must be considered a foreseeable consequence of the alleged fraud.
718 F. Supp. at 239 (citations omitted).
The plaintiffs in this case contend that, if not for the alleged misrepresentations of the defendants, including those attributed to Gevers and CEPA, they would not have been possessed for well over a year of the false belief that their $ 9.3 million was in the process of being applied to the purchase of the Note. Consequently, but for their reliance upon these alleged misrepresentations, they would have recalled their investment. The Amended Complaint clearly alleges that the fraudulent activity undertaken by the defendants after the Trustees' initial decision to invest consisted of much more than a cover-up. On the contrary, the Amended Complaint details a series of misappropriations of the Funds' assets after they had been placed with CEPA, purportedly to purchase the Note. In accord with Perez-Rubio, therefore, I find that these contentions adequately set forth a claim of reliance.
Contrary to the argument of CEPA and Gevers, Mills v. Polar Molecular Corp., supra, in no way suggests that Perez-Rubio should be rejected. In Mills, the plaintiffs signed employment contracts with the defendants. These contracts provided that, as part of their compensation, the plaintiffs would receive unregistered shares of company stock that would be registered "at the earliest opportunity." 12 F.3d at 1173. Upon signing the contracts, the plaintiffs began to work for the defendants, but the shares were never registered. In seeking to sustain a Rule 10b-5 claim, one of the plaintiffs, Miles, alleged that a fraudulent promise to immediately register the shares had been made to him by one of the defendants 18 months after he had signed his employment contract. The court held that this statement could not be relied upon for the assertion of a securities fraud claim because "obviously, [it] could not have induced Miles to sign the contract." Id. at 1175. At the time the statement was made, Miles had been irrevocably defrauded of 18 months of his labor. This is clearly different from the situation here, where the plaintiffs have alleged that statements made over the course of many months after the initial decision to invest in the Note induced them to maintain that investment, on which the defendants purported to pay them interest, and prevented them from seeking to recover their assets.
In sum, the atypicality of the securities fraud set forth in the Amended Complaint is by no means a bar to the application of Rule 10b-5. On the contrary, more than three decades ago--long before fraud on the market cases and cases involving complex derivative securities became common in securities fraud litigation--our Court of Appeals plainly declared that "novel or atypical methods [of fraud] should not provide immunity from the securities laws." A.T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2d Cir. 1967).
Further, while the fraud set forth in the Amended Complaint may be atypical now, it may not be viewed as such in the near future. As the court noted in Bremont, fraud involving purported transactions in so-called prime bank instruments "has become rife in recent years." 954 F. Supp. at 728. In consideration of this, the federal securities laws, as has happened in the past, should be applied to meet a challenge posed by the ingenuity of the practitioners of fraud. See D. Langevoort, Rule 10b-5 as an Adaptive Organism, 61 Fordham L. Rev. S7 (1993)(noting that the terms of Rule 10b-5 "are sufficiently indistinct that a cunning operator cannot confidently" escape its grasp through "new schemes and tactics"). I therefore hold that Count One of the Amended Complaint states a claim as to CEPA and Gevers.
D. RICO Claim.
Counts Two and Three of the Amended Complaint assert claims for violations of RICO and for conspiracy to violate RICO. CEPA and Gevers have moved, again pursuant to Rule 12(b)(6), to have these claims dismissed as to them. As will be seen, however, their attacks upon the RICO counts consist largely of arguments already rejected above in other contexts.
The components of a proper claim under RICO are as follows:
1) that the defendant 2) through the commission of two or more acts 3) constituting a 'pattern' 4) of 'racketeering activity' 5) directly or indirectly invests in, or maintains an interest in, 6) an 'enterprise' 7) the activities of which affect interstate or foreign commerce.
DeFalco v. Dirie, 923 F. Supp. 473, 476 (S.D.N.Y. 1996) (citing Moss v. Morgan Stanley, 719 F.2d 5, 17 (2d Cir. 1983), cert. denied, 465 U.S. 1025 (1984)). Where, as here, allegations of fraud serve as the basis of a RICO claim, those allegations must meet the pleading requirements of Rule 9(b). Pahmer v. Greenberg, 926 F. Supp. 287, 300 (E.D.N.Y. 1996), aff'd., 123 F.3d 717 (2d Cir. 1997). I have already determined that the Amended Complaint satisfies Rule 9(b).
The Amended Complaint alleges that the H&P Defendants, the Infinity Defendants, Stovin-Bradford, D'Souza, Gevers and CEPA formed an enterprise within the meaning of 18 U.S.C. § 1961(4), P 125, and that this enterprise engaged in a pattern of racketeering activity as defined 18 U.S.C. § 1961(5). P 127. Further, the Amended Complaint alleges the existence of numerous predicate acts of fraud, including several committed by Gevers. CEPA and Gevers' primary attack upon the RICO claims is that this alleged conspiracy is too limited in scope and of too short a duration to satisfy the so-called "continuity" requirement of RICO. This requires that the plaintiff in a RICO action allege that the conspiratorial enterprise has engaged in either
an "open-ended" pattern of racketeering activity (i.e., past criminal conduct coupled with a threat of future criminal conduct) or a "closed-ended" pattern of racketeering activity (i.e., past criminal conduct extending over a substantial period of time).