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July 17, 2002


The opinion of the court was delivered by: Robert L. Carter, District Judge.



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.

In reliance on the misrepresentations described above, on or about May 11, 2000, ITIS entered into a Convertible Preferred Stock Purchase Agreement ("Stock Purchase Agreement") with Cootes Drive, inserted in lieu of Southridge as a signatory at the last minute.*fn1

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 attorney's fees.


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 ยง 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.) ...

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