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INTERNET LAW LIBRARY v. SOUTHRIDGE CAPITAL MAN.
July 17, 2002
INTERNET LAW LIBRARY, INC. AND HUNTER M.A. CARR, PLAINTIFFS
SOUTHRIDGE CAPITAL MANAGEMENT, LLC; STEVE HICKS; DAN PICKETT; CHRISTY CONSTABILE; THOMSON KERNAGHAN & CO., LTD.; AND COOTES DRIVE, LLC, DEFENDANTS. COOTES DRIVE LLC, PLAINTIFF V. INTERNET LAW LIBRARY, INC., DEFENDANT. BILL U. BREWER, MARC CALDWELL, ET AL. PLAINTIFFS V. SOUTHRIDGE CAPITAL MANAGEMENT LLC; STEPHEN HICKS; DANIEL PICKETT; CHRISTY CONSTABILE; THOMSON KERNAGHAN & CO., LTD.; TK HOLDINGS, INC.; AND MARK VALENTINE, DEFENDANTS.
The opinion of the court was delivered by: Robert L. Carter, District Judge.
Formerly known as Internet Law Library, Inc., plaintiff ITIS
Inc. ("ITIS") and its CEO, Hunter Carr, along with several
of its shareholders, bring this action against defendants
Southridge Capital Management LLC ("Southridge"), Stephen Hicks,
Daniel Pickett, Christy Constabile, Thomson Kernaghan & Co.,
Ltd. ("Thomson Kernaghan"), Mark Valentine, TK Holdings, Inc.
("TK"), and Cootes Drive LLC ("Cootes Drive") alleging their
involvement in a scheme to defraud plaintiffs and to manipulate
downward the price of ITIS stock in violation of federal and
state laws. Defendants now move to dismiss the Amended
Consolidated Complaint with prejudice pursuant to Rule 12(b)(6),
F.R.Civ.P. for failure to state a claim and Rule 9(b),
F.R.Civ.P. and the Private Securities Litigation Reform Act of 1995
("PSLRA") for failure to plead fraud with sufficient
particularity. For the reasons set forth below, defendants'
motion is granted in part and denied in part.
This action is the by-product of the consolidation of several
related actions — Internet Law Library, Inc., et al. v.
Southridge Capital Management, LLC, et al., 01 Civ. 6600(RLC)
and Brewer, et al. v. Southridge Capital Management LLC, et
al., 02 Civ. 0138(RLC), both transferred from the Southern
District of Texas, and Cootes Drive LLC v. Internet Law
Library, Inc., 01 Civ. 0877(RLC), originally filed in this
court. ITIS, a Delaware corporation owning subsidiaries that
operate Internet sites specializing in legal and other types of
research and litigation support services, is a publicly-traded
company whose stock trades on the NASDAQ over-the-counter
bulletin board. In March, 2000, ITIS was in the process of
seeking out capital in fulfillment of its business plan and, to
that end, CEO Carr was referred to defendant Southridge.
Negotiations between Carr, acting on behalf of ITIS, and Hicks,
Pickett, and Constabile, acting on behalf of Southridge and
later Cootes Drive, ensued throughout March and April, 2000.
During these negotiations, plaintiffs allege that defendants
Hicks, Pickett, and Constabile made a number of
misrepresentations, including that capital of up to $28 million,
as needed by ITIS, consisting of a $3 million convertible
preferred stock purchase and a $25 million equity line
agreement, would be provided to ITIS, that defendants would
refrain from selling ITIS stock for a year after the closing
because they had a long-term investment interest in ITIS, that
they would not manipulate ITIS stock with the intention of
depressing its price, that they would not engage in the
short-selling of ITIS stock, that Southridge was an accredited
investor able to satisfy its funding commitment, that ITIS stock
was being acquired for investment purposes and not for
distribution or resale, that the stock of other companies funded
by entities affiliated with the defendants had appreciated, and
that defendants were not the subject of any active lawsuits.
Throughout the negotiations, Carr, according to plaintiffs,
continually inquired of Southridge and its agents about concerns
regarding short-selling and stock manipulation and was
repeatedly assured by Hicks, Pickett, and Constabile that no
person associated with Southridge or its agents was engaged in
short sales or manipulating ITIS stock, that no person would
engage in such activities in the future, and that no sales would
take place for a year after any closing. On the eve of the close
of negotiations, however, defendants insisted that the
no-short-sale period be reduced to six months.
Pursuant to the terms of the Stock Purchase Agreement, ITIS
submitted registration statements to the Securities and Exchange
Commission to enable common shares to be issued to Cootes Drive
upon conversion. Some time before the second registration
statement became effective, defendant Thomson Kernaghan, acting
for itself and on behalf of the defendants, allegedly sold ITIS
stock short and otherwise manipulated the stock, despite
representations that it would not do so. Specifically, the
Amended Consolidated Complaint alleges that on July 18, 2000,
Thomson Kernaghan sold 1,500 shares of ITIS stock short; on July
19, 2000, it sold 5,000 shares short; on July 27, 2000, it sold
10,000 shares short; on October 5, 2000, it closed 19,306 shares
short; on October 6, 2000, it closed 29,306 shares short; and on
October 10, 2000, it closed 61,806 shares short. A similar
pattern of short sales continued until Thomson Kernaghan's short
position had increased to nearly a million and a half shares by
January 19, 2001 and back down to 876,894 shares by February 2,
2001, three days before Cootes Drive filed suit against ITIS in
this court for breach of contract and fraud.
In general, plaintiffs allege that this short-selling activity
was part of a larger strategy that defendants have repeatedly
employed to manipulate the stock price of companies in which
they have invested. According to plaintiffs, defendants Hicks,
Pickett, and Valentine are seasoned practitioners of "death
spiral" funding schemes in which they provide financing to a
target company and proceed to aggressively short-sell its stock
in the hope that such short sales will drive down its price.
This price drop, in turn, enables the defendants to obtain more
shares of common stock upon conversion by virtue of an
arrangement known as a "toxic convertible" that allows the
company's preferred stock to be converted at a discount to the
present market value of the common stock issuable upon
conversion. Defendants then use the additional shares obtained
upon conversion to cover their short positions, profiting
handsomely from the difference between the price at which the
stock was sold short and at which it was converted. There are
even times, according to plaintiffs, when defendants need not
cover at all, typically when they have succeeded in driving down
the stock price of the target company practically to zero.
Moreover, the defendants use the stock from the conversion to
push the stock price still lower, hence the characterization
"death spiral." Plaintiffs have listed over 25 other companies
in their Amended Consolidated Complaint that they believe have
been the victims of toxic convertible or similar financing
schemes orchestrated by defendants.
Plaintiffs allege that ITIS was the victim of one such toxic
convertible financing scheme at the hands of Hicks, Pickett,
Valentine, and Southridge or entities associated with them.
After holding a short position that had ballooned to almost a
million and a half shares by January 19, 2001, the Amended
Consolidated Complaint alleges that Thomson Kernaghan set out to
cover its short position, despite knowing or having reason to
know that the Stock Purchase Agreement was being materially
breached by such action, by issuing conversion notices to ITIS,
requesting that ITIS issue shares to Cootes Drive, with Thomson
Kernaghan acting as an agent for Cootes Drive. In all, Thomson
Kernaghan sent ITIS 12 notices of conversion and succeeded in
converting 129.02 shares of preferred stock into 3,137,907
shares of common stock. The Amended Consolidated Complaint
further alleges, on information and belief, that Thomson
Kernaghan, acting on behalf of itself and other defendants and
with their involvement and knowledge, made use of a multitude of
manipulative techniques including, without limitation, "painting
the tape," "hitting the bids," and "dumping" large amounts of
ITIS stock on the market, with an eye towards artificially
affecting the price of ITIS stock, in violation of federal laws
and regulations. The daily trading volume in ITIS stock
mushroomed from 15,000 shares a day before the closing to an
average of 365,157 in the period between September 29, 2000 and
October 27, 2000.
As a result of such manipulation, plaintiffs allege that they
have been damaged, that the price of ITIS stock was artificially
depressed to the detriment of ITIS and its shareholders, both
those present in this suit and elsewhere. The toxic convertible
financing scheme, they allege, has been successful in running
the price of ITIS stock into the ground, from a high of almost
$7 to approximately 18 cents. Additionally, on account of
defendants' manipulation of ITIS stock and the resulting price
drop in the stock, Cootes Drive was excused from funding the $25
million equity line since the Stock Purchase Agreement
conditioned funding on the stock of ITIS trading above a $1.50,
further damaging plaintiffs. Accordingly, plaintiffs seek, among
other things, the rescission of all agreements between ITIS and
the defendants, declaratory relief excusing ITIS from honoring
any future conversion notices by the defendants, damages of $200
million representing the decline in ITIS's market value caused
by defendants' stock manipulation, damages of $100 million
representing the decline in ITIS stock owned by Carr, damages
for each of the individual plaintiffs equal to his/her losses in
ITIS stock, an accounting for and disgorgement of all profits
made by defendants in transactions involving ITIS stock, and
When ruling on a motion to dismiss pursuant to Rule 12(b)(6),
F.R.Civ.P., the allegations in the complaint are accepted as
true and all inferences are drawn in the plaintiffs favor.
Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184, 188 (2d
Cir. 1998). The court's function on such a motion is not to
weigh the evidence but simply to determine whether the complaint
is legally sufficient. Goldman v. Belden, 754 F.2d 1059, 1067
(2d Cir. 1985). In view of these guidelines, dismissal of a
complaint for failure to state a claim is warranted only if "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). In making this determination, a court is
permitted to look to documents that are incorporated into the
complaint by reference, Sabratek Corp. v. Keyser, No. 99 Civ.
8589, 2000 WL 423529, at *2 (S.D.N.Y. Apr. 19, 2000) (Baer, J.),
or documents on which the plaintiff relied in making his claims
or of which he had notice. See Cortec Industries, Inc. v. Sum
Holding L.P., 949 F.2d 42, 48 (2d Cir. 1991).
(1) Rule 9(b), F.R.Civ.P.
Allegations of fraud are subject to heightened pleading
requirements under the Federal Rules of Civil Procedure. These
requirements dictate that "the circumstances constituting fraud
. . . shall be stated with particularity." Rule 9(b),
F.R.Civ.P. To meet this high standard, fraud claims must specify: 1) the
statements alleged by the plaintiff to be fraudulent, 2)
the speaker of those statements, 3) where and when the
statements were made, and 4) the reasons for plaintiffs belief
that the statements were fraudulent. Shields v. Citytrust
Bancorp, Inc., 25 F.3d 1124, 1128 (2d Cir. 1994); see also
Acito v. IMCERA Group, Inc., 47 F.3d 47, 51 (2d Cir. 1995).
Rule 9(b), F.R.Civ.P. is, as such, in place to furnish a
defendant with fair notice of the claims against him, to
safeguard his reputation from improvident allegations of
wrongdoing, and to protect him from the commencement of a strike
suit. Shields, 25 F.3d at 1128.
Defendants argue that the first claim for relief in the
Amended Consolidated Complaint, alleging misrepresentation in
violation of § 10(b) and Rule 10b-5 of the federal securities
laws, must be dismissed because it fails, as a threshold matter,
to identify the speaker of the statements mentioned therein,
when and where the statements were made, and why they were
fraudulent in nature. (Defs.' Mem. of Law in Supp. of Mot. to
Dismiss at 1112.) ...