The opinion of the court was delivered by: John G. Koeltl, District Judge
This action involves allegations of securities fraud based on the inability of certain funds to redeem participants' investments after the market for managed portfolios of sub-prime automobile finance loans deteriorated. The plaintiffs, a variety of investment companies who are alleged to have invested in two different funds managed by the defendants, brought this action to recover money they allegedly lost as a result of representations the defendants made about the liquidity of their investments.
The plaintiffs assert a federal claim for securities fraud under Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, a controlling person liability claim under Section 20(b) of the Act, 15 U.S.C. § 78t, and state law claims for fraud and gross negligence. The defendants have moved to dismiss the entire Amended Complaint pursuant to Federal Rule of Civil Procedure 12(b)(6) for failure to state a claim upon which relief can be granted and, pursuant to Federal Rule of Civil Procedure 12(b)(1), for lack of subject matter jurisdiction over the state law claims or, in the alternative, dismissal of the state claims for failure to state a claim. The motion is granted in part and denied in part for the reasons discussed below.
On a motion to dismiss pursuant to Federal Rule of Civil Procedure 12(b)(6), the allegations in the Complaint are accepted as true. Grandon v. Merrill Lynch & Co., 147 F.3d 184, 188 (2d Cir. 1998). In deciding a motion to dismiss, all reasonable inferences must be drawn in the plaintiffs' favor. Gant v. Wallingford Bd. of Educ., 69 F.3d 669, 673 (2d Cir. 1995); Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989). The Court's function on a motion to dismiss is "not to weigh the evidence that might be presented at trial but merely to determine whether the complaint itself is legally sufficient." Goldman v. Belden, 754 F.2d 1059, 1067 (2d Cir. 1985). The Court should not dismiss the complaint if the plaintiff has stated "enough facts to state a claim to relief that is plausible on its face." Twombly v. Bell Atlantic Corp., 127 S.Ct. 1955, 1974 (2007); see also Iqbal v. Hasty, 490 F.3d 143, 157-58 (2d Cir. 2007).
While the Court should construe the factual allegations in the light most favorable to the plaintiff, the Court is not required to accept legal conclusions asserted in the Complaint. See Smith v. Local 819 I.B.T. Pension Plan, 291 F.3d 236, 240 (2d Cir. 2002); Barile v. City of Hartford, 386 F. Supp. 2d 53, 54 (D. Conn. 2005).
In deciding a motion to dismiss pursuant to Rule 12(b)(6), the Court may consider documents that are referenced in the Complaint, documents that the plaintiffs relied on in bringing suit and that are either in the plaintiffs' possession or that the plaintiffs knew of when bringing suit, or matters of which judicial notice may be taken. Chambers v. Time Warner, Inc., 282 F.3d 147, 153 (2d Cir. 2002); see also Taylor v. Vermont Dep't of Educ., 313 F.3d 768, 776 (2d Cir. 2002); Kramer v. Time Warner, Inc., 937 F.2d 767, 773 (2d Cir. 1991); Brass v. Am. Film Techs., Inc., 987 F.2d 142, 150 (2d Cir. 1993); Cortec Indus., Inc. v. Sum Holding L.P., 949 F.2d 42, 47-48 (2d Cir. 1991); VTech Holdings Ltd. v. Lucent Techs., Inc., 172 F. Supp. 2d 435, 437 (S.D.N.Y. 2001).
For the purposes of this motion to dismiss, the allegations in the Amended Complaint are accepted as true and certain documents referenced in the Amended Complaint are also considered.*fn1 The following summary of the background facts is drawn from those documents.
The plaintiffs, Edison Fund, Fairfax Fund, Essex Fund, Nucleus Fund, Oxford Fund, Santa Barbara II Fund, Shakti Fund, and Sagitarius Fund, are all limited liability investment companies organized and operating in the Grand Cayman Islands. (Am. Compl. ¶¶ 15-22.) The defendants include several companies alleged to be involved in the management or offering of two funds whose investment strategies focused on managed portfolios of insured sub-prime automobile finance loans. (See id. ¶¶ 23-27.)
The defendant Centrix Funds, LLC, is a Delaware multi-series limited liability company. The Centrix Loan Participation Fund ("Non-Leveraged Fund") and the Centrix Leveraged Loan Participation Fund ("Leveraged Fund") are separate series of Centrix Funds (collectively, "the Funds"). (Id. ¶ 25.)
The defendant Centrix Capital Management, LLC ("Centrix Capital") is a Colorado Limited Liability Company. The defendant Clark Gates is the President of Centrix Capital, which is the managing member of both the Leveraged Fund and the NonLeveraged Fund. (Id. ¶¶ 26--27.)
The defendant Cogent Investment Strategies Fund, Ltd., a Cayman Islands company, sponsors the Centrix Leveraged Loan Participation Portfolio (the "Portfolio") and is managed by the defendant Cogent Asset Management, LLC. (Id. ¶¶ 23--24.) The Portfolio was formed to invest in limited liability company interests of the Leveraged Fund. (Id. ¶ 64.)
Commencing in April 2004, Centrix Funds offered and sold securities in the form of "interests" in the Non-Leveraged Fund at a minimum purchase price of $1 million pursuant to a Confidential Offering Memorandum ("Non-Leveraged COM").*fn2 (Id. ¶ 33.) The Amended Complaint alleges that, in the Confidential Offering Memorandum and other documents, the defendants represented that the Non-Leveraged Fund's investment objective was to achieve a targeted annual return of eight percent by investing in a managed portfolio of insured sub-prime automobile finance loans. (Id. ¶ 35.) Sub-prime loans are loans provided to borrowers with weak credit histories or reduced payment capacity and which therefore have higher interest rates and higher delinquency rates than other loans. (See National Credit Union Association ("NCUA") Letter No. 04-CU-13, Affadavit of Arthur S. Linker dated March 30, 2007("Linker Aff."), Ex. E.) The defendants also represented that the portfolio management program had been viewed favorably by banks and credit unions, that there had historically been an active secondary market of financial institutions that buy and sell loans, and that Centrix Financial had generally been able to arrange sales of loan portfolios to meet the liquidity requirements of its customers. (Am. Compl. ¶ 35.)
Between July 2004 and May 2005, the plaintiffs invested a total of $77,750,000 in the Non-Leveraged Fund. (Id. ¶¶ 34, 60.)
In August 2005, one or more of the defendants offered voting, redeemable, participating shares of Class C of the Portfolio to the plaintiffs through a Private Placement Memorandum and Confidential Offering Memorandum with a stated minimum investment of $2.5 million. (Id. ¶¶ 63--64.) According to these offering materials, the Portfolio was formed to invest in the Leveraged Fund, which had as its investment objective providing a targeted return by indirectly investing on a leveraged basis in a managed portfolio of insured sub-prime automobile finance loans. (Id. ¶¶ 68.) According to the Amended Complaint, these offering materials, like the ones for the Non-Leveraged Fund discussed above, represented that Centrix Financial had generally been able to arrange sales of loan portfolios to meet the liquidity requirement of customers and that the plaintiffs' investments would be redeemed upon request in accordance with the terms of the offering memoranda. (Id. ¶ 68.) The Leveraged Fund managers also represented to the plaintiffs that this fund would "indirectly invest, on a leveraged basis" in the loans and that, until they could do so, they would maintain any investments in liquid vehicles such as money market funds and bank deposits. (Id. ¶ 70.)
Plaintiffs Edison Fund, Fairfax Fund, and Oxford Fund collectively invested approximately $13 million in the Leveraged Fund in August 2005. Oxford Fund's investment was transferred from its initial investment in the Non-Leveraged Fund. (Id. ¶ 66.)
Each of the plaintiffs directed KBC Financial or BNP Paribas, to purchase ownership interests in the Leveraged Fund or the Non-Leveraged Fund on its behalf. (Id. ¶ 32.)
In November 2001, the NCUA issued a letter urging due diligence review of "alternative financing" arrangements through third party providers such as subprime lending. (Linker Aff., Ex. D; Am. Compl. ¶ 41.) The letter also noted that such arrangements can lead to "growth, improved profitability, and strong member relationships." (Id.) In September 2004, the NCUA published a letter to federally insured credit unions addressing "safety and soundness concerns" about higher risk lending activities, including sub-prime lending. The letter advised credit unions to engage in on-going monitoring and analysis of these higher risk activities and their potential impact on the lender's financial performance. (Linker Aff., Ex. E; Am. Compl. ¶ 42.)
In June 2005, the NCUA published a risk alert letter to credit unions warning them of its concerns because of a "sharp increase in the number of credit unions engaged in outsourced, indirect, subprime automobile lending." (NCUA Risk Alert No. 05-Risk-01, dated June 2005, Linker Aff., Ex. F.) The risk alert provided more detailed guidance on how to analyze the risk associated with these practices and it outlined sound business practices and minimum due diligence requirements that credit unions should follow to engage in sub-prime lending through third-party vendors. (Id.)
In November 2005, the plaintiffs sought to redeem certain of their investments in the Leveraged and Non-Leveraged Funds. Centrix Capital announced by way of a memorandum dated November 21, 2005 and signed by Gates that it could not meet the large number of redemption requests on a timely basis and that it would liquidate the fund as of December 31, 2005 because of "unforeseen circumstances largely beyond the control of Centrix Capital Management, LLC," including "a change in credit union compliance guidelines set by the [NCUA]." (Decl. of Lance Gotthoffer dated May 8, 2007 ("Gotthoffer Decl"), Ex. E; Am. Compl. ¶ 80.)
The plaintiffs allege that the defendants knew or should have known about the NCUA's concerns about credit union involvement in sub-prime lending prior to the issuance of the first Non-Leveraged COM in April 2004. Further, because of the NCUA's risk alert of June 2005, the plaintiffs allege that the defendants knew or should have known that by June 2005 the secondary market was dead, but that the defendants did not disclose those concerns to the plaintiffs until after they had invested in the Leveraged Fund. (Am. Compl. ¶¶ 43-44, 55.)
On December 6, 2005, the defendants delivered to the plaintiffs a memorandum from Centrix Financial LLC, the parent of Centrix Capital, explaining the NCUA's risk alert letter of June 2005 and appending a copy of the risk alert itself. (Id. ¶ 84; Gotthoffer Decl., Ex. I.) The memorandum also explained that over 100 credit unions had already been examined by the NCUA and that Centrix Financial expected those credit unions to be in compliance and to resume funding the Centrix program in January 2006. (Id.)
A New York Post article published December 20, 2005 reported that Centrix Capital was limiting customer withdrawals from its Portfolio to keep institutional investors from "fleeing the fund after it was hit with hundreds of millions of dollars in client redemptions." The article said that Centrix's assets had gone from $700 million to $442 million because of the withdrawals, and that Centrix had to ration withdrawals because it did not "have liquidity in these [underlying sub-prime] loans." (Roddy Boyd, Hedge Clips Clients-Fund Cuts Withdrawals, New York Post, Dec. 20, 2005, at 37, Linker Aff., Ex. H.) The article also reported that the fund should get its principal back because the underlying loans are insured, and that the fund had dropped 1.03% in August 2005 but was up 4.8% so far for the year. (Id.)
Gates sent a letter to the plaintiffs' representative on December 27, 2005 offering the plaintiffs the option of transferring their money into a new fund that had redemption gates. The plaintiffs rejected the proposal. (Am. Compl. ¶ 86.)
All of the plaintiffs except Oxford Fund and Nucleus Fund sold their interests in the Funds in December 2005, incurring a total loss of approximately $20 million. Plaintiffs Oxford Fund and Nucleus Fund continue to hold positions in the Funds, but at a significant loss in value. (Id. ¶ 93.)
The plaintiffs' first claim is for violations of Section 10(b) of the Securities Exchange Act of 1934, 18 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5. To state a claim pursuant to Section 10(b) and Rule 10b-5, the plaintiffs must sufficiently allege that "in connection with the purchase or sale of securities, the defendant[s], acting with scienter, made a false material representation or omitted to disclose material information and that the plaintiff[s'] reliance on defendant's action caused [the plaintiff] injury." AIG Global Sec. Lending Corp. v. Banc of America Sec., LLC, 01 Civ. 11448, 2005 WL 2385854, at *8 (S.D.N.Y. Sept. 26, 2005) (quoting Rothman v. Gregor, 220 F.3d 81, 89 (2d Cir. 2000)).
The defendants argue that the plaintiffs have failed to meet these pleading requirements with respect to the NonLeveraged and the Leveraged Fund in several respects, each of which will be addressed in turn.
The defendants argue that the Complaint does not plead the alleged fraudulent statements with sufficient particularity. Securities fraud claims are subject to the heightened pleading requirements of both Federal Rule of Civil Procedure 9(b) and the Private Securities Litigation Reform Act of 1995 ("PSLRA"), 15 U.S.C. § 78u-4(b).
Rule 9(b) requires that the Complaint "(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent." ATSI Communications, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007). The PSLRA similarly requires that the Complaint "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading," and it adds the requirement that "if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1); see also ATSI Communications, 493 F.3d at 99.
First, the defendants argue that the plaintiffs do not allege with particularity any facts sufficient to show that the Non-Leveraged COMs contained material misrepresentations or omissions. The plaintiffs' allegations of material misrepresentation with regard to the Non-Leveraged Fund center around four statements in the Non-Leveraged offering materials that:
(a) [This fund would invest in a portfolio of insured special automobile loans by] directly funding Loans and by purchasing ...