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VOGEL v. SANDS BROS. & CO.

January 4, 2001

ROBERT VOGEL, SAM VOGEL, DR. JOHN MCCRACKEN, JOHN MAZARRA AND ALAN B. WERNER, PLAINTIFFS,
v.
SANDS BROS. & CO., LTD., DEFENDANT.



The opinion of the court was delivered by: Barrington D. Parker, Jr., District Judge.

  MEMORANDUM DECISION AND ORDER

By Memorandum Decision and Order dated March 30, 1999, this Court dismissed the original complaint (the "Complaint") filed by lead plaintiff David Schnell on behalf of a purported class of public investors in NAL Financial Group, Inc. ("NALF"). See Schnell v. Conseco, 43 F. Supp.2d 438 (S.D.N.Y. 1999). The Complaint alleged violations of the Racketeer Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. § 1961, et seq., against Conseco, Inc. ("Conseco"), and violations of § 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder by the Securities Exchange Commission (the "SEC"), 17 C.F.R. § 240.10b-5, against Sands Brothers & Co., Ltd. ("Sands").

The RICO claim against Conseco was dismissed with prejudice because plaintiff failed to adequately allege a scheme to defraud, a pattern of racketeering activity or causation. The § 10(b) and Rule 10b-5 claims were dismissed against Sands without prejudice because the Complaint failed to satisfy the heightened pleading standards set forth under the Private Securities Litigation Reform Act (the "PSLRA"), 15 U.S.C. § 78u-4(b) for alleging misrepresentations and omissions, and because it failed to adequately allege scienter. This Court granted leave to amend the Complaint against Sands.

On April 29, 1999, lead plaintiffs Robert Vogel, Sam Vogel, Dr. John McCracken, John Mazarra and Alan B. Werner,*fn1 on behalf of the same purported class of investors of NALF, filed an amended complaint (the "Amended Complaint") against Sands. The Amended Complaint again alleges violations of § 10(b) of the Exchange Act and Rule 10b-5.*fn2 Before this Court is defendant's motion to dismiss under Fed. R.Civ.P. 12(b)(6) and 9(b). For the reasons stated below, defendant's motion is granted.

BACKGROUND

Many of the facts relevant to this dispute are set forth in this Court's prior decision, with which familiarity is assumed. See Schnell, 43 F. Supp.2d at 438. For purposes of deciding this motion, the Court is obligated to construe the pleadings in favor of the plaintiffs, and must accept as true all factual allegations made in the Amended Complaint. See Cooper v. Parsky, 140 F.3d 433, 440 (2d Cir. 1998); Serrano v. 900 5th Avenue Corp., 4 F. Supp.2d 315, 316 (S.D.N.Y. 1998). All reasonable inferences must be made in plaintiffs' favor. In re Blech Securities Litigation, 961 F. Supp. 569, 579 (S.D.N Y 1997) (citing Hernandez v. Coughlin, 18 F.3d 133, 136 (2d Cir.), cert. denied, 513 U.S. 836, 115 S.Ct. 117, 130 L.Ed.2d 63 (1994)). The following facts are construed accordingly.

Conseco is an Indiana based financial services holding company, engaged in the development, marketing and administration of annuity, supplemental health and individual life insurance products. Sands is an investment banking firm, a broker and dealer in securities registered with the SEC, a member firm of the New York Stock Exchange and of the National Association of Securities Dealers ("NASD"). Conseco is alleged to be Sands' most valued client, and certain executive officers of Conseco are claimed to share a long-lasting relationship with Sands' co-founders, Martin and Steven Sands, spanning over fourteen years.

NALF is a Delaware corporation founded in 1991. It is engaged in the purchase and servicing of automobile loan and lease contracts. One year after becoming a public company on November 30, 1994, NALF began securitizing its loan portfolios whereby it would periodically sell an asset pool of various loan contracts to a trust. In turn, the trust would pay NALF with proceeds raised by issuing securities to investors in the form of notes and certificates backed by the assets of the trust. NALF collected payments due on the loan contracts, receiving an annual servicing fee equal to 3% of the principal of the outstanding loans.

The collections of interest and principal on the loan contracts were used to pay interest and principal due on the securities issued by the trust. Any payments in excess of those needed to service the securities and to pay other fees and expenses of the trust were deposited into a reserve account to the extent necessary to maintain a prescribed operating level. Any remaining cash was paid directly to NALF. The gains on the sale of the loan contracts under this securitization program enabled NALF to record significantly increased revenues in each of the quarters during which a securitization was completed.

NALF's stock price remained steady throughout most of 1996, peaking at over $16 per share. From late 1996, however, NALF's stock started to decline, particularly after a February 1997 announcement of reserve deficiencies deemed to be attributable to weak underwriting guidelines in the loan contracts from December 1995 through March 1996. On March 23, 1998, NALF filed for protection pursuant to Chapter 11 of the bankruptcy laws. No claims are asserted in this action against NALF.

The gravamen of the Amended Complaint revolves around plaintiffs' theory that Conseco devised and successfully implemented a scheme to take control over NALF at the expense of its public investors. Specifically, plaintiffs allege that Conseco intended to, and did, make a nominal investment in below-market convertible debt securities of NALF. Plaintiffs allege that the purpose of these investments was to obtain effective control over NALF through "arrangements" made with its corporate insiders and controlling shareholders, to permit those insiders and controlling shareholders to cash out their investments at a profit by artificially inflating the value of NALF's stock, and to cause NALF to conduct quarterly securitizations until its financial statements were in a position to support a public offering. Plaintiffs further allege that Conseco improperly schemed to use the proceeds of the public offering to continue the securitization program until the conversion date of the debt securities, to artificially depress the stock price of NALF after the offering to permit Conseco to convert the debt securities at a market discount, and finally to force NALF into a pre-packaged bankruptcy reorganization. See Amended Complaint at ¶ 4.

According to plaintiffs, Sands helped further Conseco's scheme by making material misrepresentations and omissions about NALF's business, and by using its market-making ability to manipulate NALF's stock prices in ways favorable to Conseco's purported scheme.

Plaintiffs support their theory with the following factual allegations made in the Amended Complaint. Sometime in 1995, one of the major shareholders of NALF, Howard Appel ("Appel"), allegedly began to seek outside financing for NALF through his relationships with brokerage and investment banking firms. Appel, a former stockbroker who had been permanently barred by the NASD in 1991 from becoming affiliated with any member of the NASD, allegedly offered NALF warrants as a "reward" for introducing the company to brokerage and banking institutions.

Sands began making a market in the stock of NALF in December 1995, allegedly around the time Appel began implementing his "reward" plan. On January 29, 1996, Sands entered into an investment banking agreement with NALF (the "Investment Banking Agreement") pursuant to which Sands introduced Conseco — its most valued and long-standing client — to NALF.

On April 23, 1996, Conseco, through two of its subsidiaries, acquired $10M in convertible debentures of NALF with a life span of eighteen months, expiring in October 1997 (the "Convertible Bonds"). At Conseco's option, the debentures were convertible into NALF common stock at the lesser of $12.00 per share or 80% of the market price of the stock on the date of conversion. In addition, Conseco received warrants to purchase 515,000 shares of NALF (the "Conseco Warrants") at an exercise price which was reduceable in the event a subsequent public offering of NALF priced shares lower than the originally agreed-upon exercise price of the Conseco Warrants. Plaintiffs allege that the market conversion feature of the Convertible Bonds and the price protection mechanism of the Conseco Warrants provided Conseco an incentive to artificially depress the stock price of NALF.

The Investment Banking Agreement was amended in April 1996 to provide for compensation to Sands for acting as NALF's investment banker in connection with the Convertible Bonds. Under the amendment, Sands received $550,000 in cash, as well as warrants to purchase 160,000 shares of NALF (the "Sands Warrants") — which also included a price protection mechanism — as its placement fee. Sands allegedly distributed the warrants to its individual brokers soon thereafter. According to the Amended Complaint, the cash portion of Sands' fee was "unusually high," while the warrant portion of the compensation was an "unusual form" of compensation. Amended Complaint at ¶ 35. Moreover, Sands' purported distribution of warrants to individual brokers was labeled an "unusual compensation arrangement" by plaintiffs. Id.

In addition, plaintiffs allege three other general problems associated with the issuance of the Convertible Bonds. First, plaintiffs contend that under NASD rules, NALF was required to — but did not — obtain shareholder approval for the issuance of the Convertible Bonds. According to plaintiffs, NASD rules provide that shareholder approval is required for the placement of below-market conversion rate securities if such securities are convertible into 20% or more of the issuer's outstanding shares of common stock before their issuance. Since the combination of the Convertible Bonds and the Conseco Warrants allegedly conferred beneficial ownership of 20.1% of the outstanding shares of NALF before their issuance, NALF's failure to obtain approval was, according to plaintiffs, a violation of NASD rules.*fn3

Second, because NALF relied upon the private placement exemption, § 4(2) of the Securities Act of 1933, to exempt the placement of the Convertible Bonds from the Act's registration requirements, plaintiffs contend that NALF should have filed, but failed to file, a Form D with the SEC.

Third, Robert Bartolini, Chairman of the Board and Chief Executive Officer of NALF, allegedly failed to receive the proper authorization from NALF's board of directors to sign the purchase agreement governing the sale of the Convertible Bonds from NALF to Conseco. Plaintiffs contend that these failures by NALF in connection with the issuance of the Convertible Bonds support the existence ...


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