The opinion of the court was delivered by: Jed S. Rakoff, U.S.D.J.
Plaintiff Barron Partners, LP ("Barron") brings suit against corporate defendants Lab123, Inc. ("Lab123"), Biosafe Laboratories, Inc. and Biosafe Medical Technologies, Inc. (collectively, "Biosafe") and individual defendants Henry A. Warner, Kent B. Connally, Robert Trumpy, and Jeremy J. Warner,*fn1 alleging, in essence, that defendants fraudulently induced Barron to invest in a new public entity, Lab123, by means of various misrepresentations and that the investment proved worthless. On this basis, the Amended Complaint ("Am. Compl.") asserts eleven causes of action: (1) securities fraud in violation of Section 10(b) of the Securities Exchange Act of 1934 ("1934 Act"), 15 U.S.C. § 78j(b); (2) "control person" liability (against the individual defendants only) in violation of Section 20(a) of the 1934 Act, 15 U.S.C. § 78t(a); (3) fraud; (4) negligent misrepresentation; (5) breach of contract against Lab123; (6) breach of contract against Biosafe and Lab123; (7) unjust enrichment; (8) conversion; (9) violation of the Illinois Consumer Fraud and Deceptive Business Practices Act; (10) violation of the Illinois Securities Law of 1953; and (11) fraud in the inducement. Defendants move under Federal Rule of Civil Procedure 12(b)(6) to dismiss all counts for failure to state a claim, and move under Rule 12(b)(2) to dismiss individual defendants Jeremy Warner and Kent Connally for want of personal jurisdiction.
The allegations relevant to the motion brought under Rule 12(b)(6) are as follows.*fn2 In early 2006, Barron, a private investment fund, began investigating a potential investment in Biosafe. See Am. Compl. ¶¶ 52-53. On June 2, 2006, plaintiff sent Biosafe a letter of intent ("LOI") in which it proposed to pay $2 million for 3.774 million shares of stock in an as-yet-unformed public company (eventually, Lab123). See Declaration of Henry Warner dated Apr. 30, 2008 ("Warner Decl."), Ex. 11 (the LOI). The LOI stated that Barron would have an exclusive due diligence period until July 30, 3006, during which time it would "be given reasonable access to the Company's facilities, management personnel, customers and its financial and legal records." Id.
In August, 2006, as part of the due diligence process, defendants completed plaintiff's Questionnaire. Am. Compl. ¶ 54. According to the Amended Complaint, defendants' responses to the Questionnaire contained numerous misrepresentations. Id. ¶¶ 54-67. Among other things, defendants' responses represented that Lab123 had the exclusive rights to market and sell in retail, internet, and disease management channels select Biosafe customer health diagnostic tests, including five tests covered by a licensing agreement between Biosafe and Lab123 that became effective as of September 7, 2006.
Id. ¶ 55-56. According to the Amended Complaint, this representation was false and misleading because (1) Biosafe had already granted the same exclusive rights to market and sell at least some of the five tests to other companies, including Johnson & Johnson and Biosafe subsidiaries Rapid Response and The Ultimate Health Club, Inc. ("Ultimate Health"); (2) Henry Warner, who controlled Biosafe, had already arranged for one of his sons, Chris Warner, to sell one of the tests through various websites; and (3) certain of the defendants sold one of the tests to Kellogg Company without remitting the proceeds to Lab123. Id. ¶ 57.
Defendants' responses to the Questionnaire also made reference to certain financial statements defendants had previously forwarded to plaintiff. Am. Compl. ¶¶ 64-65. According to the Amended Complaint, these financial statements also contained numerous misrepresentations. For example, a financial statement sent to plaintiff by defendant Henry Warner materially overstated Biosafe's 2005 revenue for the five relevant health diagnostic tests, the projected 2006 returns for these five tests, and the anticipated returns for the tests for 2007-2009. Id. ¶¶ 64, 68. Additionally, a statement sent to plaintiff by defendant Trumpy, Biosafe's CFO, stated that the five tests at issue had actual revenue of more than $1 million during the period January to June 2006, when in reality they had revenue of approximately $100,000. Id. ¶ 73.
Further still, the defendants' responses to the Questionnaire stated that "the key advantage that the Lab123's retail and internet sales have over other sales channel [sic] is that the sales are very profitable with a gross margin that could approach 70-80%." Am. Compl. ¶ 61. According to the Amended Complaint, this representation grossly overstated the gross margin and potential profitability. Id.
The Amended Complaint further alleges that, quite aside from the aforementioned misrepresentations made, directly or by reference, in defendants' responses to the Questionnaire, defendants made numerous other false and fraudulent misrepresentations in the period before plaintiff invested in Lab123. A few examples suffice:
First, in emails to plaintiff dated July 31, 2006 and August 7, 2006, respectively, Henry Warner falsely represented that Kellogg had placed an order with Biosafe for 500,000 cholesterol tests to be delivered in the fourth quarter of 2006. However, Kellogg had placed no order at the time, and when Kellogg finally did place the order in November 2006, Biosafe did not remit any of the sale proceeds to Lab123. Am. Compl. ¶¶ 82-83.
Second, in an August 2006 email from Henry Warner, defendants falsely misrepresented that Biosafe and Lab123 were completely separate and would operate independently of one another. Instead, according to the Amended Complaint, Henry Warner always intended that at least three of the five Lab123 Board Members would be controlled by him. Id. ¶ 86, 88, 105.
Third, a "Director & Officer Form," submitted to plaintiff in August 2006 by the individual defendants stated that Biosafe and Banc Street Acquisitions were the only two entities of which Henry Warner had been a director (as well as majority shareholder, founder, etc.). Id. ¶¶ 98, 100. However, this was false because Warner had been a director of, among other companies, Ultimate Health and Rapid Response. Id. ¶ 99. Plaintiff states that but for defendants' failure to disclose this fact, it would have investigated Ultimate Health and would have discovered that Biosafe had already granted to Ultimate Health some of the "exclusive" rights granted to Lab123.
After the completion of the due diligence process, Barron and Lab123 entered into a convertible preferred Stock Purchase Agreement ("SPA") whereby Barron agreed to purchase 3,774,000 shares of common stock of Lab123 for $2 million. Am. Compl. ¶ 102, Declaration of David S. Rich, Esq. dated May 23, 2008 ("Rich Decl."), Ex. B (the SPA). The SPA provided that Barron was able to bear the financial risks associated with the investment and that it had been given "full access to such records of the Company and [its] subsidiaries and to the officers of the Company . . . as it has deemed necessary or appropriate to conduct its due diligence investigation." Rich Decl., Ex. B § 5.4. It also provided that Barron was capable of evaluating the risks and merits of an investment by virtue of its experience as an investor and its "knowledge, experience, and sophistication in financial and business matters" and that Barron was capable of bearing the entire loss of its investment in the company. Id. The SPA also provided that Barron understood that the investment "involve[d] a high degree of risk," id. § 5.8, and further provided that Barron was an accredited investor as that term is defined in Rule 501 of Regulation D of the Securities Act of 1933, had experience in making investments of the kind described in the Agreement, was able to protect its own interests, and was able to afford a loss of its entire investment. Id. § 5.5.
The SPA also provided that Barron had been furnished with all materials relating to the business of the Company, had been afforded the opportunity to ask questions of the Company "and ha[d] received complete and satisfactory answers to any such inquiries." Id. § 5.7. Additionally, the SPA contained a standard merger clause, which stated: "This Agreement (together with the Schedule, Exhibits, Warrants and documents referred to herein) constitute [sic] the entire agreement of the parties and supersede [sic] all prior agreements and undertakings, both written and oral, between the parties, or any of them, with respect to the subject matter hereof." Id. § 11.4.
Given the breadth of the forgoing disclaimers, it is not surprising that the SPA included several warranties, of which the broadest read that "no . . . document furnished or to be furnished to the Investor pursuant to this Agreement contains or will contain any untrue statement of a material fact, or omits or will omit to state a material fact necessary to make the statements contained herein or therein not misleading." Id. § 4.15. The Amended Complaint, as noted, alleges that numerous of the documents previously furnished to plaintiff contained false material statements. Additionally, with respect to documents "to be furnished," the Amended Complaint alleges that after the SPA was executed, defendants continued to supply fraudulent financial statements to Barron. Am. Compl. ¶¶ 102-03. Among other things, Lab123 filed with the SEC a revised form SB-2 on November 22, 2006 that, plaintiff alleges, included the false statement that "[r]evenue is recognized upon shipment of products. Sales discounts and allowances are recorded at the time product sales are recognized and are offset against sales revenue." Id. ¶ 106. The Amended Complaint alleges that this statement was false because Lab123 actually used a pay-on-scan system, whereby revenue was only recognized when a store actually sold the relevant product to a retail customer. Id. ¶ 106.
Against this background, the Court turns first to defendant's motion to dismiss all claims for failure to state a claim. See Fed. R. Civ. P. 12(b)(6). As to the counts that sound in fraud or misrepresentation, to wit, Count 1 for violation of Section 10b of the 1934 Act, Count 2 for violation of Section 20(a) of the 1934 Act, Count 3 for common law fraud, Count 4 for negligent misrepresentation, Count 10 for violation of the Illinois Securities Law of 1953, and Count 11 for fraud in the inducement, defendants seek dismissal principally on the ground that, as a matter of law, plaintiff cannot establish reasonable reliance on the alleged false statements. Specifically, defendants emphasize the holding in Emergent Capital Inv. Management, LLC v. Stonepath Group, Inc., 343 F.3d 189 (2d Cir. 2003), that: where ... a party has been put on notice of the existence of material facts which have not been documented and he nevertheless proceeds with a transaction without securing the available documentation or inserting appropriate language in the agreement for his protection, ...