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August 16, 2000


The opinion of the court was delivered by: Marrero, District Judge.


This action was commenced in the Southern District of Texas in May 1993 and later that year transferred to this Court, where the underlying transaction remains governed by Texas law. During its seven-year odyssey to date, the case has passed through the dockets of five federal judges, four of them in this District. Yet, as described below, largely on account of the parties' own pretrial motion practice, the litigation remains no further along than a motion to dismiss the complaint, which itself is now in its third version.*fn1 Now before the Court is defendant's fourth such motion. In the mean-time, a number of people who played critical roles in events dating to 1989 which gave rise to the lawsuit have died or are no longer associated with the parties and consequently not readily available to testify.

This Court hopes to cut short any further pretrial skirmishing in this action, even if it may ruin its prospects to rank alongside Jarndyce and Jarndyce in the legends of legal intricacy and longevity. It is time for the parties to bring their encounter out in the open before a jury. For the reasons described below, defendant's motions are granted in part and denied in part. The parties are directed to proceed forthwith with completion of pretrial discovery in contemplation of advancing to a trial on the merits of the remaining issues within no longer than 60 days.


A. The Parties and Jurisdiction

Plaintiff National Western Life Insurance Co. ("National Western") is a Texas-based corporation incorporated in Colorado. Defendant Merrill Lynch, Pierce, Fenner & Smith, Inc. ("Merrill Lynch"), is a Delaware corporation whose principal place of business is in New York. The action was originally filed in the Southern District of Texas in May 1993 and transferred to this court in October 1993 pursuant to 28 U.S.C. § 1404(a). The Court has diversity jurisdiction over this dispute pursuant to 28 U.S.C. § 1332.

B. The Transaction

The Property, located in a Manhattan building known as "401 East 89th Street", was converted into a cooperative unit pursuant to an Offering Plan filed in August 1988 with the Attorney General of the State of New York. According to the Plan, the building would be converted to a two-unit condominium, with the first unit consisting of the ground floor commercial space and the garage, and the other unit comprising the Property with its 198 residential apartments. The Plan specified that the conversion of the Property to cooperative ownership would occur pursuant to a non-eviction plan, which would allow non-purchasing tenants then residing in rent-regulated apartments to remain in occupancy on lease terms and rents calculated in accordance with state law.

On January 25, 1989, Gracie Associates, the owner of the Property and sponsor of the Offering Plan (the "Sponsor"), transferred title to the residential portion of the building to a Cooperative Corporation controlled by the Sponsor (this transaction is here referred to as the "Conversion Closing" and the corporation as the "Cooperative"). The Cooperative allocated its shares proportionately among the Property's 198 apartments. Shares of the Cooperative corresponding to the apartments were offered for sale by the Sponsor. At the time of Conversion Closing, 61 units had been sold. Of the remaining unsold apartments, 48 were vacant, and the remaining 89 were occupied by rent-stabilized tenants. Thus, the Sponsor remained obligated for the monthly maintenance charges pertaining to 137 apartments, in full with respect to the vacant units and, as regards the occupied apartments, in effect for the difference between each apartment's actual maintenance charge and the amount of stabilized rent the Sponsor collected from the tenant. Contemporaneous with the Conversion Closing on January 25, 1989, the Cooperative obtained a loan from CorEast Savings Bank ("CorEast") for $12 million plus interest. CorEast, through a Participation and Servicing Agreement on January 26, 1989, sold 100% of its interest in the loan to Merrill Lynch Mortgage Capital, Inc. ("ML Mortgage") and remained as the loan servicing bank. On March 1, 1989, ML Mortgage and its affiliate, defendant Merrill Lynch, entered into an agreement whereby the latter purchased from ML Mortgage a 25% sub-participation interest in the CorEast loan. On the following day, Merrill Lynch assigned its rights under the Sub-Participation Agreement to National Western in exchange for National Western's payment of $2,816,215 (the "Transaction").

In November and December of 1990, the Cooperative defaulted on its monthly payments on the CorEast loan, and then made only partial payments on the loan in February, March, and April 1991. On February 27, 1991, the Sponsor was forced involuntarily into Chapter 11 Bankruptcy proceedings, although this fact allegedly was not known to National Western at the time. National Western contends it learned that the Cooperative defaulted on its obligations under the CorEast loan "in or about July or August 1991" (Compl. ¶ 70). In May 1993, National Western instituted this action in the Southern District of Texas, which granted Merrill Lynch's motion to transfer the case to the Southern District of New York in August 1993. National Western's second amended complaint, on which this action is based, was filed in this Court in October 1993.

C. The Transaction Documents

The Offering Summary, which the Complaint states was provided to National Western in connection with the Transaction, contains a "Summary of Terms" and an extensive description of the finances of CorEast. It notes that the security for the mortgage loan was a first lien only on the condominium unit comprised of the 198-unit residential portion of the Property, which is the cooperative owned by "401 East 89th Street Owners, Inc." The Summary also lists the Sponsor as "Gracie Associates", and gives an address for it at "c/o D.B.G. Property Corp./Arrandale Management Corp./Aegis Planning, Inc." in Manhattan. According to the Offering Summary, the Appraised Value of the Property was $41,135,000, based on the Future Sellout Value of the Cooperative as determined by "an appraisal performed by Wm A. White/Tishman East, Inc. on January 24, 1989." On the basis of this Appraised Value, the Loan-to-Value Ratio was represented to be 29.17%.

The Offering Summary also informed prospective purchasers that the Appraisal was available on request. The Complaint, however, alleges that National Western was provided and relied on "all or portions" of the Appraisal. National Western does not explicitly specify which, if any, parts of the Appraisal it actually received. But the Complaint cites the Appraisal as the source of a representation that the fair market value of the Property as rental was $20 million.

D. National Western's Claims

National Western claims that Merrill Lynch knowingly or recklessly provided or withheld erroneous and misleading information about the financial condition of the Sponsor and about the value of the Property in order to induce National Western to participate in the Transaction, and that National Western relied to its detriment on the information it was given. Specifically, National Western's allegations rest on two forms of material omissions or representations. The first claim centers on the financial condition of the Sponsor. National Western asserts that the Offering Summary purposefully omitted essential facts about the finances of the Sponsor and suggested through the omission that the financial condition of the Sponsor was irrelevant. The second claim relates to the fair market value of the Property. National Western maintains that the Offering Summary misrepresented the value of the investment by miscalculating the future sellout value and by reflecting that figure while omitting disclosure of the rental value. Finally, National Western contends that the rental value set forth in the Appraisal was false and misleading in material ways. On these grounds, National Western claims that Merrill Lynch's representations and omissions constituted (1) violations of the Texas Securities Act, (2) common law fraud, (3) negligent misrepresentation and (4) breach of fiduciary duty. Merrill Lynch has moved under Rule 12(b)(6) of the Federal Rules of Civil Procedure to dismiss the allegations of fraud, securities violations and negligent misrepresentation, and for summary judgment under Rule 56 with regard to the breach of fiduciary duty claim.



A. Standard of Review

On a motion pursuant to Fed.R.Civ.P. 12(b)(6) to dismiss a complaint for failure to state a claim upon which relief can be granted, the court must "tak[e] as true all allegations in the complaint, and draw[] all reasonable inferences therefrom in the [plaintiff's] favor." Koppel v. 4987 Corp., 167 F.3d 125, 130 (2d Cir. 1999) (quotations omitted); accord Scheuer v. Rhodes, 416 U.S. 232, 236, 94 S.Ct. 1683, 40 L.Ed.2d 90 (1974). A court must not dismiss the complaint "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Conley v. Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 2 L.Ed.2d 80 (1957) (citations omitted).

In addition to facts stated in the complaint, under Rule 10(c), "[a] copy of any written instrument which is an exhibit to a pleading is a part thereof for all purposes." Fed.R.Civ.P. 10(c). While the Court normally looks to allegations in the complaint in deciding a motion to dismiss, it may also consider authentic documents that plaintiffs rely upon in bringing suit. "[T]he complaint is deemed to include any written instrument attached to it as an exhibit or any statements or documents incorporated in it by reference." Cortec Indus., Inc. v. Sum Holding, LP, 949 F.2d 42 (2d Cir. 1991). Otherwise, when matters outside the pleading are presented to and not excluded by the Court, the motion may be treated as one for summary judgment pursuant to Rule 56. See Fed.R.Civ.P. 12(b)(6).

B. Documents Before the Court

Here, a threshold issue has arisen as to what papers are properly before the Court on this motion. The Complaint acknowledges that in connection with its purchase of an interest in the Property, National Western was provided "a document entitled Offering Summary and all or portions of an appraisal incorporated therein." (Compl. ¶ 23). However, neither document is attached to the Complaint as an exhibit or specifically incorporated in it by reference. See Cosmas v. Hassett, 886 F.2d 8, 13 (2d Cir. 1989) (citing Goldman v. Belden, 754 F.2d 1059, 1066 (2d Cir. 1985) for the proposition that limited quotation of a document not otherwise attached or relied upon does not constitute incorporation by reference). National Western also alleges that in deciding to purchase the sub-participation interest from Merrill Lynch, it "reasonably relied on the representations contained in both the Offering Summary and the appraisal incorporated therein." (Id. ¶ 24, emphasis added) The Complaint does not explicitly specify the particular pages or sections of the Appraisal National Western concedes it received and relied upon, constituting one of the factual issues which renders the action difficult to dispose of entirely by way of a motion to dismiss, as Merrill Lynch persistently has endeavored to do.

In order to fill that gap, Merrill Lynch submitted, along with its papers supporting the present motion, copies of the Offering Summary and the entire Appraisal, as well as other materials outside the pleadings.*fn2 It argues that because National Western's claims rely upon these documents, Merrill Lynch may offer them and properly place them before the court without converting its Rule 12(b)(6) motion to dismiss into a motion for summary judgment under Rule 56. In support of this proposition Merrill Lynch cites Cortec Indus., 949 F.2d at 48.

In response, National Western distinguishes Cortec Industries, arguing that the case applies only when plaintiff, as the foundation for the cause of action as stated in the complaint, actually has reviewed and relied upon the entire documents defendant places before the court on the motion to dismiss. Thus National Western contends that, without converting Merrill Lynch's motion into one for summary judgement, there is no basis for assuming that National Western, at the time its action accrued, saw portions of the Appraisal which are nowhere specified in the Complaint as constituting the source of the representations which gave rise to its claim. Merrill Lynch replies in supplemental correspondence that in fact its original motion was framed in the alternative, either as one to dismiss pursuant to Rule 12(b)(6) or for summary judgment, thereby apparently inviting the Court to exercise discretion under Rule 12(b)(6) to convert the entire motion into one for summary judgment.

The pleadings and cat-and-mouse motion practice in this case thus demonstrate some of the hallmarks of epochal litigation in the making. First are plaintiff fraud claims deftly crafted and shielded with seemingly meticulous imprecision, to that extent prompting defendant to pursue the pleadings — with some justification, as the Court here concludes — as though a moving target, a complaint still in search for a cause of action. Second is a defense apparently intent on pushing the envelope of the Rule 12(b) dismissal motion to the limits of its elasticity, prodding daringly beyond the pleadings right up to the border of summary judgment standards under Rule 56. And third are two litigants both endowed with institutional fortitude and fortunes to feed litigation, as well as counsel consummately skilled in the pretrial art of dodging their pleadings' bullets.

The Court believes it would not serve the interests of justice and efficient management of this case to treat Merrill Lynch's motion as one for summary judgment at this juncture of these proceedings. To do so inevitably would invite further delays and extend the ultimate resolution of the merits of a dispute that already has been excessively prolonged. Accordingly, declining to engage the parties' pre-trial sparring, the Court does not base any part of its determination on any of the documents outside the pleadings placed before the Court by Merrill Lynch beyond those National Western itself employed in bringing this lawsuit.

Accepting, as the Court must, the factual allegations in the Complaint as true and resolving doubts and drawing reasonable inferences in plaintiff's favor, the Court concludes that because National Western acknowledges it was provided a copy of the Offering Summary and because it refers to and relied upon that document as containing the representations and omissions upon which this action is founded, the Offering Summary in its entirety, under the doctrine of Cortec Industries, is before the Court for the purposes of this motion.

The question of how much of the Appraisal is properly before the Court presents greater difficulties, for National Western admits that it received "all or portions" of the document, thus conceding that at least some portions of the Appraisal on which the Complaint is grounded may be properly before the Court. The remaining question at this point is whether, for the purposes of this motion, a reasonable determination may be made as to which portions of the Appraisal National Western's allegations actually refer to and rest upon as the source of the allegedly fraudulent information, and thus may be properly placed before the Court. Again drawing reasonable doubts and inferences in plaintiff's favor, the Court divides the issue into two components, corresponding to the two distinct theories and particular instances of actionable conduct alleged in the Complaint. Following this approach, the portions of the Appraisal setting forth information with regard to the scope of the financial obligations assumed by Sponsor and owed to the Cooperative are not before the Court. By National Western's own contradictory admissions evident in the Complaint, however, the Court will deem some portions of the Appraisal that relate to the fair market value of the Property as part of the record of this motion. These matters are described in more detail below. On the basis of the record so constructed, the Court proceeds to examine the sufficiency of the Complaint as to each of the legal theories and factual grounds upon which it is founded and challenged.

C. Dismissal for Failure to State a Claim

1. Texas Securities Act

The Texas Securities Act, Article 581-33(A)(2), provides that:

A person who offers or sells a security . . . by means of an untrue statement of a material fact or an omission to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, is liable to the person buying the security from him. . . . However, a person is not liable if he sustains the burden of proof that either (a) the buyer knew of the untruth or omission or (b) he (the offeror or seller) did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

Thus, the statutory elements critical to a determination about violation of the Act are the truth or falsity, actual knowledge and materiality of the representation or omission alleged to be false or misleading. The relevant inquiry for a claim narrows to "whether [defendant's] representations, taken together and in context, would have misled a reasonable investor about the nature of the investment." I. Meyer Pincus & Assocs., P.C. v. Oppenheimer & Co., Inc., 936 F.2d 759, 761 (2d Cir. 1991). Unlike the prima facie standards applicable to common law fraud, under the Texas statute there is no requirement that plaintiff claim justifiable reliance on the representation or omission; it is enough that a false or misleading statement was made about a material fact. See Haralson v. EF Hutton, 919 F.2d 1014 (5th Cir. 1990); Wood v. Combustion Engineering, Inc., 643 F.2d 339 (5th Cir. 1981).

a. Sponsor's Financial Condition

Actual Knowledge/Falsity

National Western's first claim of fraud rests on Merrill Lynch's alleged failure to provide information about the financial condition and obligations of the Sponsor to the Cooperative, an omission National Western asserts was material in inducing it to enter into the Transaction. To some extent, a claim resting on failure to provide information compounds the difficulty of deciding whether and to what extent, based on the pleadings, plaintiff had actual knowledge of the facts omitted that constitute the particular instances of fraud.

Under article 581-33 A(2) of the Act, the relevant knowledge of the untruth or omission applies alternatively to the two parties to a securities transaction. It covers knowledge either by the buyer or by the seller. As applied by the Fifth Circuit, actual knowledge that would bar recovery requires that plaintiff know "of" the misleading statement or omission upon which the securities fraud claim is grounded. See Haralson, 919 F.2d at 1032. Unless plaintiff actually knows that a representation is false, or that existing information has been withheld, an action under the statute is not foreclosed. "And knowing that a false statement or omission has been made is not the same as knowing the true fact that was misrepresented or omitted." Id. The Court in Haralson, noting that the concept of plaintiff's constructive knowledge has no place in actions under the Texas statute, further elaborated: "We do not suggest that a purchaser has any duty to find out the truth under [article 581-33 A(2)]. Indeed, a purchaser who is actually ignorant that a seller's representation is inaccurate or incomplete may recover though the full truth is apparent from material in her possession." Id. at n. 10.

Applying these standards to guide resolution of the controversy here, the Court cannot find, solely on the basis of the pleadings, that National Western had actual knowledge of the omissions or representations relating to the financials of the Sponsor.

National Western alleges that the Offering Summary was misleading in that it failed to disclose: (1) that the Offering Plan was a non-eviction plan; (2) the practical and legal significance of that fact; (3) that the Sponsor would be required to pay indefinitely the monthly maintenance charges assessed on the 89 rent-stabilized apartments "regardless of the amount of rent received from the tenants and on the 48 vacant apartments until, if ever, those apartments were sold, whether or not such apartments remained vacant and regardless of the amount of any rent the Sponsor might collect"; and (4) the financial statements and cash flow projections of the Sponsor, while making available detailed documents about CorEast, thereby creating a false and misleading impression that only the financial condition of the servicing bank was material. (Compl. ¶ 36) According to National Western, by virtue of the obligations the Sponsor incurred to support indefinitely the maintenance charges corresponding to 69% of the apartments, the financial condition of the Sponsor was a fact material to an investor's decision whether to purchase an interest in the loan on the Property, and Merrill Lynch's failure to disclose that the Sponsor lacked the resources to sustain that commitment constituted a material omission.

Merrill Lynch argues that the Offering Summary provided information sufficient to alert a reasonable investor that the Sponsor was a single-purpose entity created in connection with the conversion of the Property into a cooperative and therefore was dependent on sales of apartments in order to pay the Cooperative loan and maintenance charges. Merrill Lynch also asserts that the Appraisal offers additional details disclosing that the conversion occurred pursuant to a non-eviction plan and explaining related effects, as well as providing information and assumptions about the extent of the Sponsor's financial obligations to the Cooperative. For the purposes of this motion, because constructive knowledge of the truth of Merrill Lynch's representations or omissions cannot be attributed to National Western, which has alleged it may not have been provided the full Appraisal, the Court looks only to the information contained in the Offering Summary. On this point the Offering Summary merely identifies the Sponsor as "Gracie Associates, c/o D.B.G. Property Corp/Arrandale Management Corp./Aegis Planning, Inc.," with an address at 850 Third Avenue, New York, New York.*fn3 It further states that 61 units had been sold as of January 26, 1989, leaving at least 48 units (24%) vacant and available for sale and 89 units (45%) occupied by tenants, the shares corresponding to these units therefore retained by the Sponsor.

The Court finds that beyond what is disclosed in the Offering Summary, the Complaint does not otherwise acknowledge awareness by National Western of information about Sponsor's financial statements and net worth, or about the materiality and importance of that information to the National Western's decision to invest, sufficient to introduce into the record here the full scope of all factual notice contained in the Appraisal regarding the Sponsor's obligations. As to this claim, it would not be productive or dispositive to assume National Western's receipt and actual knowledge of all facts set forth in the Appraisal relevant to this issue. As the Court reads the theory of the Complaint, even if National Western had seen the entire Appraisal, it would still not have possessed alleged material documentation not set forth in either the Offering Summary or in the Appraisal. That information pertained to the actual identity, cash flow and net worth statements of the Sponsor, supported with the same or comparable level of detail as National Western asserts it was provided with respect to CorEast. Neither party has claimed that this material was ever prepared or provided. National Western could not be held to have known of the omission of documents that in fact never existed.

Nonetheless Merrill Lynch contends that whatever material National Western was provided did contain sufficient information about the Sponsor and its financial significance to the transaction to have placed a reasonable investor on "inquiry notice" as early as March 1989 to undertake further investigation that may have disclosed the representations or omissions claimed to be false or misleading. The Court disagrees. At the time of National Western's investment, because the financial statements and net worth of the Sponsor presumably were not part of the Transaction documents, as regards this claim there were no suspicious circumstances suggestive of knowing misrepresentation or fraud misconduct. See Marks v. CDW Computer Centers, Inc., 122 F.3d 363, 368 (7th Cir. 1997). Moreover, National Western had no affirmative duty to undertake an inquiry in order to ascertain whether the information provided to it was inaccurate or incomplete. For the purposes of the Texas statute it is enough that plaintiff offer sufficient evidence that the representations or omissions were made by defendant, that they were false or misleading and that plaintiff did not know "of" the misstatements. See Haralson, 919 F.2d at 1032. See also Hill York Corp., 448 F.2d at 695-96 ("The availability of information elsewhere does not excuse misleading or incomplete statements."). Even were National Western ...

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