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In re Refco Capital Markets

August 28, 2008


The opinion of the court was delivered by: Gerard E. Lynch, District Judge


On September 13, 2007, this Court dismissed the securities fraud complaint in the putative class action, In re Refco Capital Markets, Ltd. Brokerage Customer Securities Litigation, No. 06 Civ. 643, 2007 WL 2694469, at *12-13 (S.D.N.Y. Sept. 13, 2007) (hereinafter "RCM I"), for failure to allege deceptive conduct, but granted Lead Plaintiffs leave to replead as to certain defendants. Thereafter, two groups of plaintiffs brought individual actions based on allegations substantially similar to those advanced by Lead Plaintiffs in the putative class action. See VR Global Partners, L.P. et al. v. Bennett et al., No. 07 Civ. 8686 (GEL) (S.D.N.Y. filed Oct. 9, 2007); Capital Mgmt. Select Fund Ltd. et al. v. Bennett et al., No. 07 Civ. 8688 (GEL) (S.D.N.Y. filed Oct. 9, 2007). On November 20, 2007, the Court consolidated all three actions for pretrial purposes. Lead Plaintiffs in due course filed a Second Amended Complaint in the putative class action.

This opinion addresses fifteen motions to dismiss filed in the consolidated actions by various former corporate officers of Refco,*fn1 Refco's auditor Grant Thornton LLP, and a group of defendants affiliated with Thomas H. Lee Partners, L.P. (the "THL Defendants"), who collectively owned a majority interest in Refco at all times relevant to the pending actions. Because plaintiffs lack standing to assert their claims for securities fraud and, in any event, fail to allege deceptive conduct, the motions to dismiss will be granted in their entirety, and plaintiffs' request for leave to replead will be denied with prejudice.


The initial discussion of background facts will be brief, as the facts are fully set forth in the Court's prior opinion in RCM I. Detailed discussions of relevant factual allegations will be reserved for the legal analyses that require them.

I. The Parties

Plaintiffs in the consolidated actions are all former customers of Refco Capital Markets, Ltd. ("RCM"), a Refco subsidiary that operated as a securities brokerage firm. In the putative class action, Lead Plaintiffs Global Management Worldwide Limited, Arbat Equity Arbitrage Fund Limited, and Russian Investors Securities Limited are "commonly controlled investment funds" who represent a prospective class of RCM customers who "placed securities with or held securities at" RCM (and/or its sister company Refco Securities, LLC ("RSL")) at any time from October 17, 2000, to October 17, 2005, and elected to contribute the proceeds of their claims to the Refco Private Action Trust (collectively, the "Class Plaintiffs").*fn2 (P. Mem. 9; Class Compl. ¶¶ 2, 34-38.*fn3 ) In the VR Global action, plaintiffs VR Global Partners, L.P., Paton Holdings, Ltd., VR Capital Group Ltd., and VR Argentina Recovery Fund, Ltd. (collectively, the "VR Plaintiffs") describe themselves as "one of the top-ranked emerging markets funds in the world, achieving a 43% annual compound return for its investors, net of fees, over its six year existence prior to the Refco debacle." (VR Compl. ¶ 81.) Plaintiffs in the Capital Management Action, Capital Management Select Fund Ltd., Investment & Development Finance Corporation, and IDC Financial S.A., are offshore investment funds incorporated in the Bahamas, British Virgin Islands, and Panama respectively (collectively, the "Capital Plaintiffs"). (Capital Compl. ¶¶ 31-33.)

Various former corporate officers of Refco and/or RCM are named as defendants in the consolidated actions (collectively, the "Officer Defendants").*fn4 Defendant Grant Thornton LLP, RCM's auditor, is sued only in the VR Global action. Grant Thornton provided auditing services in connection with RCM's financial statements for the fiscal years ending in February 2003, 2004, and 2005, and issued unqualified audit opinion letters for each of those fiscal years. (VR Compl. ¶ 78.) The THL Defendants are entities or individuals affiliated with defendant Thomas H. Lee Partners, L.P., a private equity firm.*fn5 (Class Compl. ¶¶ 54-62; VR Compl. ¶¶ 69-77; Capital Compl. ¶¶ 51-59.) In August 2004, one year prior to Refco's initial public offering ("IPO"), the THL Defendants purchased a 57% equity stake in Refco for approximately $507 million. (Class Compl. ¶ 56; VR Compl. ¶ 71; Capital Compl. ¶ 53.) After the IPO, the THL Defendants continued to hold a dominant 43% interest in Refco. (Class Compl. ¶ 62; VR Compl. ¶ 77; Capital Compl. ¶ 59.)

II. The Alleged Scheme

As noted in RCM I, the fraud alleged in the RCM customer actions is distinct from the fraudulent scheme alleged in the Refco shareholders' class action and related cases, see, e.g., In re Refco, Inc. Secs. Litig., 503 F. Supp. 2d 611, 618-20 (S.D.N.Y. 2007); Thomas H. Lee Equity Fund V, L.P. v. Grant Thornton LLP, No. 07 Civ. 8663, 2008 WL 3166536, at *1-2 (S.D.N.Y. Aug. 6, 2008), which involved the purported manipulation of Refco's financial condition through a "round-robin fraud" designed to erase a massive uncollectible receivable from Refco's books at the end of each financial reporting period, RCM I, 2007 WL 2694469, at *1, *4. Plaintiffs in the pending actions allege a separate scheme in which RCM allegedly sold customer assets without authorization and improperly used the proceeds to make loans and fund the business operations of other Refco affiliates.*fn6 (Class Compl. ¶ 5; VR Compl. ¶ 5; Capital Compl. ¶ 4.)

In particular, plaintiffs allege that they each opened non-discretionary trading accounts at RCM, which meant that any transactions made by RCM on their behalf required their advance approval. (Class Compl. ¶ 4; VR Compl. ¶ 4; Capital Compl. ¶ 3.) According to plaintiffs, RCM routinely sold, hypothecated, or pledged their securities without their authorization in violation of their customer agreements with RCM and in contravention of oral representations made by Refco representatives that RCM would hold their securities for safekeeping. (See Class Compl. ¶¶ 8, 10; VR Compl. ¶¶ 8,10; Capital Compl. ¶¶ 7, 9.) Plaintiffs contend that they were misled by RCM's monthly account statements and trade confirmations, which purportedly failed to disclose RCM's sales of their securities. (Class Compl. ¶ 11; VR Compl. ¶¶ 11, 105; Capital Compl. ¶ 10.) Plaintiffs also allege that RCM owed them a fiduciary duty and that its unauthorized sale of their assets breached that duty. (Class Compl. ¶ 9; VR Compl. ¶ 9; Capital Compl. ¶ 8.)

On October 10, 2005, just two months after its IPO, Refco disclosed that it had discovered a receivable in the amount of $430 million due from an entity controlled by Refco's CEO, Philip R. Bennett. As a result, the company announced that its financial statements for the preceding four years could no longer be relied upon. On October 17, 2005, Refco and many of its subsidiaries, including RCM, filed for bankruptcy protection under Chapter 11 of Title 11 of the United States Code. (Class Comp. ¶¶ 152-54; VR Compl. ¶¶ 236-38; Capital Compl. ¶¶ 155-57.)

Following Refco's disclosure of the $430 million receivable, many RCM customers, including plaintiffs, attempted to "withdraw securities and funds that they entrusted to RCM." (Class Compl. ¶ 153; VR Compl. ¶ 237; Capital Compl. ¶ 156.) Refco responded by imposing a moratorium on all withdrawals from RCM customer accounts. (Class Compl. ¶ 153; VR Compl. ¶¶ 237-38; Capital Compl. ¶ 156.) In bankruptcy proceedings, RCM acknowledged that it owes its customers approximately $4.16 billion, but has only $1.905 billion in assets. (Class Compl. ¶¶ 156-57; VR Compl. ¶¶ 240-41; Capital Compl. ¶¶ 159-60.) RCM also disclosed that "the majority of RCM's customer property had been transferred to other Refco entities . . . through a series of intercompany 'loans.'" (Class Compl. ¶ 156; VR Compl. ¶ 240; Capital Compl. ¶ 159.) As a result of RCM's allegedly deceptive conduct, plaintiffs purportedly suffered hundreds of millions of dollars in losses. (See Class Compl. ¶ 28; VR Compl. ¶ 28; Capital Compl. ¶ 25.)

III. Claims

All of the complaints allege that defendants violated §§ 10(b) and 20(a) of the Securities Exchange Act of 1934. 15 U.S.C. §§ 78j(b), 78t(a). Specifically, Count I of all complaints asserts claims under § 10(b) and Rule 10b-5(a) and (c) against the Officer Defendants and the THL Defendants. 17 C.F.R. § 240.10b-5. Count I of the VR Complaint also pleads claims against Grant Thornton LLP for alleged violations of Rule 10b-5(a)-(c). Id. Count II of all complaints sues the Officer Defendants for purported violations of § 10(b) and Rule 10b-16. Id. § 240.10b-16. Finally, Count III of all complaints alleges § 20(a) control liability claims against both the Officer Defendants and the THL Defendants.


I. Motion to Dismiss Standard

Under the notice pleading standard set forth in Rule 8(a) of the Federal Rules of Civil Procedure, complaints must include "a short and plain statement of the claim showing that the pleader is entitled to relief." Fed. R. Civ. P. 8(a)(2). The Supreme Court reconsidered the standard for motions to dismiss in Bell Atlantic Corp. v. Twombly, 127 S.Ct. 1955 (2007), in the wake of which courts are to apply "a flexible 'plausibility standard,' which obliges a pleader to amplify a claim with some factual allegations in those contexts where such amplification is needed to render the claim plausible." Iqbal v. Hasty, 490 F.3d 143, 157-58 (2d Cir. 2007) (emphasis in original). Under this standard, a complaint may be dismissed where it fails to plead "enough facts to state a claim to relief that is plausible on its face." Twombly, 127 S.Ct. at 1974. "[A] plaintiff's obligation to provide the grounds of his entitlement to relief requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do." Id. at 1964-65 (internal quotation marks and alteration omitted). In order to state a claim, the "factual allegations must be enough to raise a right to relief above the speculative level." Id. at 1965. Where a plaintiff "ha[s] not nudged [its] claims across the line from conceivable to plausible, [its] complaint must be dismissed." Id. at 1974.

When deciding a 12(b)(6) motion, the Court must take as true the facts as alleged in the complaint and draw all reasonable inferences in the plaintiff's favor. ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 98 (2d Cir. 2007). "General, conclusory allegations need not be credited, however, when they are belied by more specific allegations of the complaint." Hirsch v. Arthur Andersen & Co., 72 F.3d 1085, 1092 (2d Cir. 1995).

In addition, where a complaint alleges fraud, Rule 9(b) provides that "a party must state with particularity the circumstances constituting fraud or mistake." Fed. R. Civ. P. 9(b). The pleading must be sufficiently particular to serve the three goals of Rule 9(b), which are (1) to provide a defendant with fair notice of the claims against him or her; (2) to protect a defendant from harm to reputation or goodwill by unfounded allegations of fraud; and (3) to reduce the number of "strike suits." DiVittorio v. Equidyne Extractive Indus., 822 F.2d 1242, 1247 (2d Cir. 1987). Accordingly, where the fraud is based on alleged misrepresentations, the complaint must "specify the statements it claims were false or misleading, give particulars as to the respect in which plaintiff contends the statements were fraudulent, state when and where the statements were made, and identify those responsible for the statements." Suez Equity Investors, L.P. v. Toronto-Dominion Bank, 250 F.3d 87, 95 (2d Cir. 2001), quoting Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir. 1989). A plaintiff pleading fraud based on deceptive conduct "must specify what deceptive or manipulative acts were performed, which defendants performed them, when the acts were performed, and the effect the scheme had on investors in the securities at issue." In re Parmalat Secs. Litig., 383 F. Supp. 2d 616, 622 (S.D.N.Y. 2006).

II. Rule 10b-5 Claims

A. Standing

A plaintiff's standing to sue is necessarily the first inquiry, as "standing is at heart 'a jurisdictional prerequisite to a federal court's deliberations.'" Thompson v. County of Franklin, 15 F.3d 245, 248 (2d Cir. 1998), quoting Hodel v. Irving, 481 U.S. 704, 711 (1987). Although § 10(b) and Rule 10b-5 do not expressly provide for private rights of action,*fn7 courts since 1946 have sustained the existence of this right. See Kardon v. National Gypsum Co., 69 F. Supp. 512, 514 (E.D. Pa. 1946); see also Superintendent of Ins. v. Bankers Life & Cas. Co., 404 U.S. 6, 13 n.9 (1971); Ontario Pub. Serv. Employees Union Pension Trust Fund v. Nortel Networks, Inc., 369 F.3d 27, 30-31 (2d Cir. 2004). Subsequent caselaw read an "actual purchaser or seller" standing limitation into claims brought under § 10(b) and Rule 10b-5, see Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952), and the Birnbaum rule was adopted by the Supreme Court as a bright-line rule in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). Exhaustively analyzing the policy arguments for and against the Birnbaum rule, the Court concluded that, on balance, retaining the rule, in its "straightforward application," was an appropriate and desirable limitation on the private right of action under § 10(b) and Rule 10b-5. Id. at 755. The Court specifically rejected a "shifting and highly fact-oriented disposition of the issue of who may bring a damages claim for violation of Rule 10b-5" and stated that such an approach would not be "a satisfactory basis for a rule of liability imposed on the conduct of business transactions." Id. The "purchaser or seller" standing rule of Blue Chip Stamps has since been reaffirmed hundreds of times. See, e.g., Ontario, 369 F.3d at 31-32.

Plaintiffs contend that RCM's sales of their securities, which allegedly occurred without their knowledge or authorization, nevertheless sufficed to make them "actual . . . sellers of securities" for purposes of satisfying the Birnbaum rule. Blue Chip Stamps, 421 U.S. at 731. (P. Mem. 43.) To support this contention, plaintiffs cite the Second Circuit's decision in Caiola v. Citibank, N.A., 295 F.3d 312 (2d Cir. 2002), which held that an equity investor had standing to bring a Rule 10b-5 claim against Citibank when he alleged that Citibank executed physical trades for his account without his authorization.*fn8 Id. at 323. The Court of Appeals remarked that "it is well-settled that claims under Rule 10b-5 arise when brokers purchase or sell securities on their clients' behalf without specific authorization," and cited cases brought under Rule 10b-5 for unauthorized trading, "which occurs when a broker intentionally places trades without obtaining the customer's approval," and churning, "which depend on a broker's liability for excessive trading." Id. at 323-24, citing, inter alia, Securities Inv. Prot. Corp. v. Vigman, 803 F.2d 1513, 1519 (9th Cir. 1986) (unauthorized trading claim under Rule 10b-5), and Armstrong v. McAlpin, 699 F.2d 79, 91 (2d Cir. 1983) (observing that "[c]hurning, in and of itself, may be a deceptive and manipulative device under section 10(b)"). Relying heavily on Caiola, plaintiffs contend that RCM's unauthorized sale of their securities likewise made them "sellers of securities" for purposes of satisfying the Birnbaum rule. Blue Chip Stamps, 421 U.S. at 731.

As defendants point out, however, the Court of Appeals expressly noted that the "key fact" in its decision was that the complaint alleged that the broker's transactions, though unauthorized, "were made on [plaintiff's] behalf." Id. at 324 (emphasis added). Indeed, the unauthorized trading and churning cases cited in Caiola all involve transactions undertaken by the broker for the customer's account. In contrast, all three complaints in the pending actions specifically allege that RCM sold plaintiffs' securities without authorization for RCM's own benefit by "us[ing] the proceeds to finance Refco'sdaily operations, trading losses and significant acquisitions."*fn9 (Class Compl. ¶ 5; VR Compl. ¶ 5; Capital Compl. ¶ 4.)

Although plaintiffs acknowledge that RCM sold their securities for its own benefit, they argue that it would be an anomalous result to allow a customer to bring a Rule 10b-5 claim where a broker makes unauthorized trades for the customer's benefit, but to deny standing where the broker makes unauthorized trades for the broker's own benefit - "[i]n both cases, the customer has been defrauded and injured through the unauthorized purchase and sale of the customer's securities." (P. Sur-reply Mem. 7 n.19.) In adopting the Birnbaum rule, however, the Supreme Court itself recognized that the bright-line purchaser-seller requirement, strictly applied, would exclude certain classes of potential plaintiffs who may have legitimate claims of injury from Rule 10b-5 violations. See Blue Chip Stamps, 421 U.S. at 739. This Court has similarly noted that "proper application of the [purchaser-seller rule] for standing to sue will undoubtedly prevent some otherwise meritorious claims from surviving motions to dismiss." MBIA Ins. Corp. v. Spiegel Holdings, Inc., No. 03 Civ. 10097, 2004 WL 1944452, at *6 (S.D.N.Y. Aug. 31, 2004).

Plaintiffs' own theory of the fraudulent scheme, moreover, necessarily defeats their claim of standing. Each of the complaints specifically alleges that plaintiffs' securities were first "stolen" by RCM, and then sold for the benefit of RCM and other Refco affiliates. (Class Compl. ¶¶ 4-5; VR Compl. ¶¶ 4-5; Capital Compl. ¶¶ 3-4; see P. Mem. 10 ("Plaintiffs' securities were stolen from [their] accounts.").) In contrast to cases of unauthorized trading and churning, then, which involve the unwitting purchase or sale of securities by a customer (effectuated by the broker on the customer's behalf), plaintiffs' allegations here establish only a theft and subsequent sale of customer securities by RCM for its own benefit. (See Grant Thornton Reply Mem. 3.) Such allegations simply do not demonstrate that plaintiffs themselves were "actual . . . sellers of securities" under the Birnbaum rule. Blue Chip Stamps, 421 U.S. at 731.*fn10

In sum, even assuming arguendo that some or all of the defendants violated ยง 10(b) and Rule 10b-5, in the absence of any allegation that plaintiffs themselves were "actual purchasers [or] sellers of securities," Blue Chip Stamps, 421 U.S. at 730, plaintiffs lack standing to seek a private remedy for those violations. ...

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