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Small v. Arch Capital Group

September 20, 2006


The opinion of the court was delivered by: John F. Keenan, United States District Judge



Defendants Arch Capital Group Ltd. ("Arch"), American Independent Insurance Holding Company ("AIIHC"), Joseph King ("King") and William B. Lockhorn ("Lockhorn") (collectively the "Arch Defendants") move to dismiss Plaintiffs' Second Amended Complaint ("SAC") under Rules 12(b)(1), 12(b)(6), and 9(b) of the Federal Rules of Civil Procedure. Defendants TDH Capital Partners) and TDH III, L.P. (collectively, "TDH") move to dismiss Counts III through V of the SAC insofar as those counts purport to state claims against them. For the reasons that follow, the Court grants the Arch Defendants' motion and dismisses the SAC with prejudice.


On March 24, 2005, the Court granted the Arch Defendants' motions to dismiss Plaintiffs' First Amended Complaint. Small v. Arch Capital Group, Ltd., No. 03 Civ. 5604(JFK), 2005 WL 696903 (S.D.N.Y. Mar. 24, 2005). The Court determined that Plaintiffs had not adequately pleaded scienter with respect to their claim arising under Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"). The Court declined to exercise supplemental jurisdiction over the remaining state law claims. These dismissals were without prejudice. After Plaintiffs missed a Court-imposed deadline to file a second amended complaint because of a technical defect, the Court closed the case. The Court granted Plaintiffs' motion to vacate the judgment and allowed them to file a corrected complaint. Small v. Arch Capital Group, Ltd., No. 03 Civ. 5604(JFK), 2005 WL 2584158 (S.D.N.Y. Oct. 12, 2005). Plaintiffs timely filed the SAC.

Weighing in at seventy-eight pages, the SAC is even heftier than the First Amended Complaint. Although the SAC contains many of the same allegations that appeared in the First Amended Complaint, it contains some significant additions. For the sake of clarity, the Court will restate the entire factual background here rather than asking the reader to ping-pong between this Opinion and the one dismissing the First Amended Complaint.


On this Rule 12(b)(6) motion, the Court derives the facts from the SAC, all documents incorporated therein by reference, and other "integral" documents. See Int'l Audiotext Network, Inc. v. Am. Tel. & Tel. Co., 62 F.3d 69, 72 (2d Cir. 1995). The Court accepts Plaintiffs' factual allegations as true and draws all reasonable inferences in Plaintiffs' favor. See Chambers v. Time Warner, Inc., 282 F.3d 147, 152 (2d Cir. 2002).

A. The Parties

The Small and Wilstein Plaintiffs (collectively, the "Stockholder Plaintiffs") are disenchanted former stockholders of Defendant AIIHC, which functioned as a holding company for its subsidiary, American Independent Insurance Company ("AIICO"). (SAC ¶ 1.) Prior to February 28, 2001, the Stockholder Plaintiffs (along with BCI Holdings, Inc.) owned all of AIIHC's issued and outstanding stock. (SAC ¶ 1.)*fn1 Plaintiff Gitterman provided legal and business services to AIIHC and AIICO and served as a director of those companies from January 1995 to February 28, 2001. (SAC ¶ 1, 25.)

Defendant Arch is a Bermuda company. (SAC ¶ 26.) AIIHC is a Pennsylvania company that allegedly has been a subsidiary of Arch since February 28, 2001. (SAC ¶ 27.) The TDH entities are former AIIHC creditors. (SAC ¶¶ 3, 43.) King became a director of AIIHC and AIICO. (SAC ¶ 30.) Lockhorn has been president and CEO of AIICO since 1996. (SAC ¶ 31.)

B. The Lederman Fraud and its Aftermath

During the 1990's, AIICO lost millions of dollars in a fraud allegedly spearheaded by non-party Charles M. Lederman ("Lederman"). In essence, Lederman used reinsurance treaties with, and referral arrangements involving, companies that he controlled to divert funds belonging to AIICO into those companies and into his own pocket. (SAC ¶¶ 8, 35-42.) From 1995 to 2000, AIICO tried to survive as a family-owned business. AIIHC and AIICO obtained additional capital by selling stock to the Wilstein Plaintiffs and their children, and borrowing funds from TDH in exchange for interest-bearing debt obligations and warrants to purchase AIIHC shares. (SAC ¶ 43.) In 1996, AIIHC turned to Risk Capital Reinsurance Company ("Risk Reinsurance"), the wholly owned subsidiary of Risk Capital Holdings, Inc. ("Risk Capital") --- Arch's predecessor in interest -- for both reinsurance and additional financial support. (SAC ¶¶ 44-45.) By 2000, Risk Reinsurance had provided approximately $12.1 million in contingent debt financing to AIIHC in return for warrants to purchase AIIHC stock. (SAC ¶¶ 48, 51-52.) Risk Reinsurance also provided substantial reinsurance capacity to AIICO, replacing AIICO's prior reinsurers. (SAC ¶ 48.)

On May 5, 2000, Risk Capital sold the reinsurance operations of Risk Reinsurance and changed names from Risk Capital to Arch Capital Group, Ltd. (SAC ¶ 56.) In September 2000, defendant Arch was formed as a Bermuda public limited company to serve as a holding company. (SAC ¶ 57.) On November 8, 2000, the name of Arch Capital Group, Ltd. (formerly Risk Capital) was changed to Arch Capital Group (U.S.), Inc., which then became a wholly-owned subsidiary of defendant Arch. Risk Capital's shareholders became Arch shareholders. (SAC ¶ 58.)

C. The Lawsuits and D&O Claim

Lederman's alleged fraudulent activity resulted in several lawsuits. In 1997, AIICO commenced an action against Lederman and several others ("Lederman") in the United States District Court for the Eastern District of Pennsylvania. (SAC ¶ 8.) In Lederman, AIICO primarily alleged RICO violations and fraud, and sought damages of approximately $6.1 million, potentially subject to trebling. (Agmt., Sched. 6.11.)*fn2 William F. Kuntz ("Kuntz") of Seward & Kissel LLP was lead counsel to AIICO in Lederman. (SAC ¶¶ 59-60.) In August 2000, Judge Robert F. Kelly, the assigned district judge, denied most of the defendants' motions for summary judgment. On May 30, 2001, Judge Kelly administratively closed Lederman and placed it on the suspense docket. (SAC ¶ 9.)

Aside from Lederman, AIICO commenced two other actions in Pennsylvania (the "State Lawsuits") arising out of Lederman's allegedly fraudulent actions. (SAC ¶ 59.) Kuntz eventually came to represent AIICO in these lawsuits as well, having replaced the original counsel. (SAC ¶ 60.) In September 2000, however, Small and AIICO replaced Kuntz as lead counsel for the State Lawsuits with M. Mark Mendel ("Mendel"). Kuntz remained lead counsel for Lederman and played a supporting role to Mendel for the State Lawsuits. (SAC ¶ 62.)

In connection with the successful defense of Small against counterclaims in one of the State Lawsuits, AIIHC submitted a claim to its directors and officers liability insurance carrier (the "D&O Claim"). This carrier was an affiliate or subsidiary of American International Group ("AIG"). AIIHC sought approximately $460,000 in attorneys' fees from AIG. (SAC ¶ 64.)

D. The Reorganization Agreement

1. Negotiations

In October 2000, AIIHC began negotiating with Vesta Insurance Group, Inc. ("Vesta"), which was interested in acquiring AIIHC. (SAC ¶ 65.) AIIHC also negotiated with Arch. (SAC ¶ 68.) Plaintiffs allege that Arch threatened to hire away key AIIHC employees and to sue for breach of contract if AIIHC did not agree to an acquisition by Arch. (SAC ¶¶ 71-72.) Plaintiffs also allege that Arch threatened to hire AIICO's president, Lockhorn, whose presence was an essential component of any transaction with Vesta. (SAC ¶ 71.) On November 14, 2000, Arch presented AIIHC with a "take it or leave it" term sheet detailing Arch's proposal to acquire AIIHC. Despite a better offer from Vesta, AIIHC executed the Arch term sheet. (SAC ¶¶ 69, 74.) On December 31, 2000, the Stockholder Plaintiffs, Arch, AIIHC and the TDH Defendants entered into a Reorganization Agreement (the "Agreement") (SAC ¶ 79.) This Agreement closed on February 28, 2001. (SAC ¶ 88.)

2. Relevant Agreement Provisions

By its terms, the Agreement "sets forth the entire understanding of the parties ... regarding the subject matter hereof," with "[a]ny previous agreements or understandings between the parties ... regarding the subject matter hereof, and any amendments thereto" being "merged into and superseded by" the Agreement. (Agmt. § 17.5.) In the instant context, three provisions in the Agreement are of primary importance.

a. Definition of "Lawsuits"

The parties spend a good deal of time debating the meaning of the term "lawsuit." The Agreement provides:

"Lawsuits" shall mean the State Lawsuits together with the Lederman Lawsuits and any other lawsuits or other actions which may arise out of or be in relation to or in connection with such lawsuits, whether or not involving the same claims or facts based on similar claims. (Agmt. § 1.) Plaintiffs contend that this definition embraces the D&O Claim. (SAC ¶¶ 78, 86.) The Arch Defendants disagree. (Arch Def. Mem. of Law at 12-13.)

b. Allocation of Lawsuit Proceeds

The Agreement provides that any proceeds or property derived from any of the so-called Lawsuits "shall immediately be paid over to [AIIHC] (and not to Lewis Small or any other Person)." (Agmt. § 4.1.) The parties agreed that AIIHC would distribute the proceeds in the following order of priority:

(a) FIRST, [AIIHC] to cover any and all unpaid fees and expenses incurred in connection with the Lawsuits ... and any expenses paid by [AIIHC] pursuant to clause (iv) of Section 9.10 hereof [the $500,000 commitment, which is discussed infra]; (b) SECOND, in the event that [AIIHC] receives [proceeds] in excess of amounts allocated ... pursuant to clause (a) above, Frederick Gitterman pursuant to [a] letter agreement ...; (Agmt. § 4.1(a)-(b).) Any remaining balance after payments to AIIHC and Gitterman would be shared among the Stockholder Plaintiffs, BCI, the AIICO Voting Trust and TDH. (SAC ¶ 4; Agmt. §§ 4.1, 4.2, Ex. A, F.)

c. Administration of Lawsuits

Perhaps the most important section of the Agreement for the purposes of the instant motions is Section 9.10. The Court ...

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