The opinion of the court was delivered by: P. Kevin Castel, District Judge
The plaintiffs allege that they were misled into investing in a commercial real-estate financing fund that collapsed when the national real estate market entered a downturn. The plaintiffs -- whose individual losses are alleged to range from approximately $31,000 to $265,000 -- claim that they were inadequately apprised of the risks attendant upon making loans to subprime commercial real estate borrowers. When borrower defaults accumulated, the investors lost their principal and stopped receiving payments on a promised 8% percent return.
The plaintiffs allege violations of section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, and allege that certain defendants are liable as control persons under section 20(a) of the 1934 Act, 15 U.S.C. § 78t. They also assert common-law claims of fraud and breach of contract.*fn1 The defendants move to dismiss the Second Amended Complaint (the "Complaint") for failure to state a claim pursuant to Rule 12(b)(6), Fed. R. Civ. P., and for failure to plead fraud with the particularity required by Rule 9(b), Fed. R. Civ. P., and the Private Securities Litigation Reform Act of 1995, 15 U.S.C. § 78u-4(b)(1) ("PSLRA"). For the reasons explained below, the motions to dismiss are granted. The motion for sanctions brought by an accountant and his firm, both of which are defendants, is denied without prejudice.
The facts as described in this section are drawn from the allegations set forth in the Complaint, and are assumed as true for purposes of this motion. ECA, Local 134 IBEW Joint Pension Trust of Chicago v. JP Morgan Chase Co., 553 F.3d 187, 193 (2d Cir. 2009). All reasonable inferences are drawn in favor of the plaintiffs as nonmovants.
Defendant Gaffken & Barriger Fund (the "Fund") was organized in or about January 1998. (Compl. ¶ 9.) The Fund originally pursued a strategy of trading in micro-cap equities. (Compl. ¶ 35.) In or about 2004, the Fund shifted its focus toward loans to subprime commercial borrowers, and it became increasingly leveraged as a result. (Compl. ¶¶ 35, 39.) As part of this new approach, the Fund engaged in a strategy that it described as asset-based lending: it anticipated borrower defaults, and then hoped to recoup interest and principal while the borrower underwent foreclosure and bankruptcy. (Compl. ¶ 37.) According to the Complaint, the Fund's post-2004 strategy posed materially different risks from its original micro-cap investment strategy and was contrary to the safe and conservative investment approach promised by the defendants. (Compl. ¶ 38.)
The change of investment philosophy was disclosed to the Fund's investors. In a letter dated October 29, 2004, the Fund announced its new emphasis on a leverage-intensive strategy, stating that it hoped to enhance investor returns "while maintaining a conservative posture." (Compl. ¶ 41; Ex. 5.) The letter was signed by defendant Lloyd V. Barriger, the Fund's managing director. (Compl. ¶¶ 9, 41.) In a letter dated January 31, 2005, Barriger further explained the strategy to accrue leverage in anticipation of bringing a higher return to the Fund, and offered a hypothetical investment scenario to illustrate how the Fund would profit from its strategy. (Compl. ¶ 43.)
In July 2005, Barriger wrote to the Fund's investors, asking that they respond to what he described as a "poll." (Compl. ¶ 45.) His letter stated that the Fund's "investment policy had changed, going from chiefly stocks to primarily real estate mortgages. And always our guiding principle was to make the best return for you without taking undue risks." (Compl. ¶ 45; emphasis omitted.) He stated "that many regard our Fund as more of a fixed income investment," and that "the hard-money lending business" entails "certain costs" and "certain times when there is no current return." (Compl. ¶ 45; emphasis omitted.) "Consequently, the use of leverage which can greatly increase the return in good times can conversely sabotage the return in tough times when real estate is not as readily saleable." (Compl. ¶ 45.) These downsides "would not be so apparent to one without experience." (Compl. ¶ 45.) Barriger asked investors for feedback as to whether they "want a more modest, predictable, steady, consistent return" of about 8% or whether they preferred "more risk and less consistency and aim for higher returns." (Compl. ¶ 45.)
A September 2005 letter reported on the responses: "The great majority of you indicated that you were happy to leave the Fund exactly as it is; some of you expressed a proclivity toward safety of principal and consistency of return." (Compl. ¶ 47.) Barriger stated that he would "infuse some capital personally" and pay investors an 8% annual return, payable by monthly check. (Compl. ¶ 47.)
Annexed to the September letter was a proposed amendment to the Fund's LLC Agreement. (Compl. ¶ 49.) The Complaint does not allege in meaningful detail how the Fund is structured and organized, but a review of the Fund's 1998 Private Placement Memorandum ("PPM") indicates that investors purchased membership interests in the Fund's limited liability company upon execution and delivery of the Fund's subscription agreement. (Compl. Ex. 1 at 2, 4.) Investors also were asked to execute a copy of the Fund's LLC Agreement, which denoted them as "investor members" of the Fund, as distinguished from the Fund's managing member, G&B Partners, Inc. (Compl. Ex. 3 at 34-35.) Thus, an investor in the Fund would become an "investor member" of the LLC. The 2005 amendment altered the Fund's purpose from "investing, holding and trading in securities" and other financial instruments to "investing, holding and trading in real estate, real estate loans, real estate securities, other securities and other financial instruments." (Compl. ¶ 51.)
In the months after September 2005, Barriger continued to issue enthusiastic statements about the Fund's future. In April 2006, he described the Fund's progress on receiving a line of credit for $15 million. (Compl. ¶ 62.) The credit line was deemed the product of "a great deal of investigation of our assets and our methods of doing business" by the lender, Textron Financial. (Compl. ¶ 65.) According to the Complaint, the line of credit was contingent on an undisclosed "fraud guaranty" in Textron's favor, executed by Barriger and Andrew McKean. (Compl. ¶ 66.) The lending agreement between the Fund and Textron states that Barriger and McKean "each executed and delivered" to Textron a fraud guaranty "with respect to the transactions contemplated by the Loan Agreement," but the contents of the guaranty are not alleged in the Complaint or annexed as an exhibit. (Compl. Ex. 14 at 1 ¶B.) A September 2006 letter from Barriger stated that investment capital exceeded $18.5 million and that Fund management expected to extend $50 million in loans in 2007. (Compl. ¶ 67.) In December 2006, the Fund reported that it was "more solid financially, and more on-track to attain its purposes" than at any time since its formation. (Compl. ¶ 83.)
Beginning in early 2007, however, the condition of the commercial real estate market began to deteriorate, and the Fund's holdings suffered. As an example, the Complaint cites undisclosed promissory notes worth approximately $2.25 million that the Fund acquired on the Platinum Properties of Central Florida, Inc., including $1.15 million that the Fund acquired after Platinum Properties had gone into default. (Compl. ¶¶69-81.) Barriger's communications to Fund investors remained upbeat in tone, however, and noted that problems in sub-prime mortgages were centered on individual homeowner and consumer debt, in contrast with the commercial loans pursued by the Fund. (Compl. ¶ 85.) In an April 2007 letter, Barriger stated that as a "commercial property bridge lender," the Fund was "in a different business" than the residential mortgages subject to "a great deal of negative news recently." (Compl. ¶ 89.)
According to the Complaint, the Fund's borrowing base began to plummet in 2007, and the Fund experienced an undisclosed event of default on its credit line from Textron in April 2007, which was not disclosed. (Compl. ¶¶ 86-87.) Barriger and McKean asserted in a letter of October 2007 that "positive progress continues to be made in a number of key areas," and reiterated that "we personally guaranteed the principal a floor minimum return of 8%." (Compl. ¶¶ 95-96.) A few months later, however, the Fund announced that its fortunes were taking a turn for the worse. On December 31, 2007, Barriger described the Fund as "in a batten-down-the-hatches mode" as a result of "significant challenges" in the "entire real estate sector and the banking world." (Compl. ¶ 101.) It continued to make monthly 8% payments to investors. (Compl. ¶ 101.)
A letter of March 14, 2008 announced to the plaintiffs, "for the first time," that some or all of their investment principal had been lost, and that the value of each capital account was recorded as "undetermined 0." (Compl. ¶ 109.) All investor withdrawals from the Fund were frozen on or about March 28, and on May 30, the Fund announced that collateral securing the Fund's loans "was inadequate to recover the principal." (Compl. ¶¶ 110-11.) In July 2008, the Fund announced that its portfolio showed no sign of recovery, that "most of the Fund's borrowers had very poor credit ratings at the time the loans were granted," and that any recovery by investors was indefinitely postponed, with the ultimate ceiling on recovery likely to be capped at 60 percent. (Compl. ¶ 112.)
In addition to bringing claims against the Fund and Barriger, the plaintiffs have asserted claims against various entities and individuals affiliated with the Fund's operation. G&B Partners Inc. ("G&B") was the Fund's managing member and sole common shareholder. (Compl. ¶ 10.) Barriger Capital LLC ("Barriger Capital") was the Fund's loan servicer. (Compl. ¶ 12.) It received a $30,000 monthly fee from the Fund. (Compl. ¶ 12.) Barriger and Barriger, Inc. ("B&B") is a registered broker-dealer. (Compl. ¶ 14.) Linda Barriger was the principal shareholder, director and officer of G&B and a principal of B&B. (Compl. ¶ 15.) Andrew McKean was the president, CEO and part owner of Barriger Capital and vice president of the Fund. (Compl. ¶ 17.) McKean is now deceased, and the Estate of Andrew McKean stands in his shoes. (Compl. ¶ 17.) Defendant Campus Capital, which owned 50 percent of Barriger Capital, was, in turn, owned by Lloyd Barriger, Linda Barriger and defendant Irwin Gitlin. (Compl. ¶¶ 13, 19.) Defendant Irwin Gitlin was a principal of defendant Gitlin Associates LLC ("Gitlin Associates"), an accounting firm that provided certain services to the Fund. (Compl. ¶¶ 18-19.) Defendant Gitlin Associates was responsible for preparing and issuing to each plaintiff an annual Schedule K-1 for tax reporting purposes. (Compl. ¶ 18.) Finally, defendant John Doe is the unknown individual or entity that acted as the Fund's auditors. (Compl. ¶ 20.)*fn2
The plaintiffs are all investors in the Fund. Plaintiff Lloyd Heller first invested in the Fund in 1998. (Compl. ¶ 136.) In subsequent years, he increased his holdings in the Fund, until they totaled more than $265,000. (Compl. ¶¶ 136-42.)
Plaintiff Martha Graham had a brokerage account at B&B, with Barriger acting as her main stockbroker and financial adviser. (Compl. ¶ 144.) In June 2007, she met with Barriger to discuss investing $30,000 in the Fund. (Compl. ¶ 147.) Barriger told Graham that he does not permit small investors into the Fund, but that he would make an exception for Graham. (Compl. ¶¶ 146, 148.)
Plaintiff Paula Manzolillo maintained a brokerage account with B&B and retained Barriger as her principal adviser. (Compl. ¶ 154.) She invested mainly in stocks and municipal bonds, with her portfolio worth approximately $12,000-15,000. (Compl. ¶ 154.) In 2001, she approached Barriger for advice on how to invest $43,621, at which point Barriger solicited her to invest in the Fund and volunteered to waive the Fund's $60,000 minimum investment requirement. (Compl. ¶ 154.) According to the Complaint, Manzolillo told Barriger that she wanted to invest for retirement, and Barriger told her that the Fund would serve this purpose and allow for withdrawal of funds at any time. (Compl. ¶¶ 155-56.) She agreed to invest in the Fund, and after the 2005 reorganization, added further to her investment. (Compl. ¶¶ 157-58.) By the end of 2007, she had nearly $207,000 in the Fund. (Compl. ¶ 159.)
Plaintiff Maria Grimaldi had a brokerage account at B&B, and retained Barriger as her stockbroker and financial adviser. (Compl. ¶ 162.) During the Fund's 2005 reorganization, she purchased approximately $31,200 worth of preferred interests in the Fund. (Compl. ¶ 165.) Barriger told her that the Fund held real estate and mortgages that were fully collateralized by the borrowers' real property. (Compl. ¶¶ 166.) He stated that the Fund's income exceeded the 8% distribution to investors, but that it placed its earnings in reserves. (Compl. ¶ 166.) Barriger also told Grimaldi that the Fund loaned only to local businesses secured by local real property, and that the Fund was managed to have enough liquidity for investors to withdraw funds at any time. (Compl. ¶¶ 168-69.) By the end of 2007, Grimaldi had invested nearly $36,000 in the Fund. (Compl. ¶ 175.)
Plaintiff Carl Mills is the sole trustee and beneficiary of the Creamton Maple Trust. (Compl. ¶ 177.) According to the Complaint, Mills was persuaded to invest in the Fund because of Barriger's representations that the Fund was highly liquid and comparable to a money-market or savings account with higher returns. (Compl. ¶ 185.) He invested his life savings of $30,000 in the Fund through his trust. (Compl. ¶ 186.) After the 2005 reorganization, Mills reinvested his 8% return into the Fund. (Compl. ¶ 194.) Mills asserts that he was reassured by Barriger's 2007 representation that the Fund was not negatively affected by the nationwide drop in real estate values. (Compl. ¶ 196.) In December 2007, Mills invested another $11,000 in the Fund. (Compl. ¶¶ 198.) At the end of 2007, Mills had more than $40,000 invested in the Fund. (Compl. ¶ 201.)
This action was commenced on October 31, 2008, and accepted by Judge Conner as related to Owens v. Gaffken & Barriger Fund LLC, et al., 08 Civ. 8414 (S.D.N.Y.). An Amended Complaint was filed on February 24, 2009, and a Second Amended Complaint was filed on April 27, 2009. On March 24, 2009, Judge Conner issued an Opinion and Order denying the plaintiffs' motion to appoint a receiver to take control of the Fund. (Docket # 34.) Following Judge Conner's death, this matter and the related Owens case were reassigned to me. (Docket # 75.)
Four motions to dismiss are now pending. They were filed, respectively, by Gitlin & Associates and Irwin Gitlin; G&B and Lloyd Barriger; the Fund; and Linda Barriger, B&B and Barriger Capital. (Docket # 37, 44, 47, 50.) All defendants join the motion to dismiss filed by the Fund. Additionally, Gitlin & Associates and Irwin Gitlin seek sanctions against the plaintiffs pursuant to Rule 11 and 15 U.S.C. § 78u-4(c).
STANDARD ON A MOTION TO DISMISS
A motion to dismiss a securities fraud claim is evaluated under the PSLRA and Rules 9(b) and 12(b)(6). To survive a motion to dismiss under Rule 12(b)(6), "a complaint must plead 'enough facts to state a claim to relief that is plausible on its face.'" ECA, Local 134, 553 F.3d at 196 (quoting Ruotolo v. City of New York, 514 F.3d 184, 188 (2d Cir. 2008)). "A pleading that offers 'labels and conclusions' or 'a formulaic recitation of the elements of a cause of action will not do.'" Ashcroft v. Iqbal, 129 S.Ct. 1937, 1949 (2009) (quoting Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 555 (2007)). "A claim has facial plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged. The plausibility standard is not akin to a 'probability requirement,' but it asks for more than a sheer possibility that a defendant has acted unlawfully." Id. (citations omitted). When a complaint's allegations are "merely consistent" with liability, it falls short of alleging a plausible claim for relief. Id. A complaint's legal conclusions are not afforded the presumption of truth. Id. at 1949-50. Only nonconclusory factual allegations are to be accepted as true. South Cherry Street, LLC v. Hennessee Group LLC, 573 F.3d 98, 100 (2d Cir. 2009).
In a securities fraud case, however, the plaintiff "must do more" than satisfy Rule 12(b)(6). Id. at 110. The PSLRA has "imposed heightened pleading requirements and a loss causation requirement upon 'any private action' arising from the Securities Exchange Act." Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S.Ct. 761, 773 (2008) (quoting 15 U.S.C. § 78u-4(b)). "Any complaint alleging securities fraud must satisfy the heightened pleading requirements of the PSLRA and Fed. R. Civ. P. 9(b) by stating with particularity the circumstances constituting fraud." ECA, Local 134, 553 F.3d at 196 (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 321 (2007)). This pleading threshold gives a defendant notice of the plaintiff's claim, safeguards a defendant's reputation and protects against strike suits. See ATSI Communications, Inc. v. Shaar Funds, 493 F.3d 87, 99 (2d Cir. 2007). "A securities fraud complaint based on misstatements must (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." Id. at 99 (citing Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir. 2000)).
The PSLRA requires a complaint to "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, 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)(B). Allegations of fraud may be "too speculative even on a motion to dismiss," particularly when premised on "'distorted inferences and speculations.'"
ATSI, 493 F.3d at 104 (quoting Segal v. Gordon, 467 F.2d 602, 606, 608 (2d Cir. 1972)). "The [PSLRA] insists that securities fraud complaints 'specify' each misleading statement; that they set forth the facts 'on which [a] belief' that a statement is misleading was 'formed'; and that they 'state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.'" Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 345 (2005) (quoting 15 U.S.C. § 78u-4(b)(1), (2)). To plead fraud under the PSLRA, plaintiffs "must do more than say that the statements... were false and misleading; they must demonstrate with specificity why and how that is so." Rombach v. Chang, 355 F.3d 164, 174 (2d Cir. 2004).
The PSLRA also "requires plaintiffs to state with particularity... the facts evidencing scienter, i.e., the defendant's intention to 'deceive, manipulate, or defraud.'" Tellabs, 551 U.S. at 313 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976)). To qualify as "strong," the "inference of scienter must be more than merely plausible or reasonable -- it must be cogent and at least as compelling as any opposing inference of nonfraudulent intent." Id. at 314.
In considering a motion to dismiss, a court may consider documents annexed to the complaint or incorporated in the complaint by reference without converting the motion to dismiss into a motion for summary judgment. Rombach, 355 F.3d at 169 (citing Kramer v. Time Warner Inc., 937 F.2d 767, 773 (2d Cir. 1991)).
I. The Plaintiffs' Claims Under Section 10(b) and Rule 10b-5 are Dismissed
1. The Complaint Fails to Allege Fraud with Particularity
Section 10(b) of the 1934 Act makes it unlawful to "use or employ, in connection with the purchase or sale of any security... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe...." 15 U.S.C. § 78j(b). "The SEC rule implementing the statute, Rule 10b-5, prohibits 'mak[ing] any untrue statement of a material fact or [omitting] to state a material fact necessary in order to make the statements made, in light of the circumstance under which they were made, not misleading.'" ECA, Local 134, 553 F.3d at 197 (alterations in original) (quoting Rule 10b-5). As Judge Cote has observed, "[s]section 10(b) of the Exchange Act is designed to protect investors by serving as a 'catchall provision' which creates a cause of action for manipulative practices by defendants acting in bad faith." In re Openwave Systems Securities Litigation, 528 F. Supp. 2d 236, 249 (S.D.N.Y. 2007) (citing Ernst & Ernst, 425 U.S. at 206). The PSLRA also requires, with respect to allegations of false statements or omissions, that the Complaint specify the statements alleged to have been misleading, the reasons for the belief that the statements were misleading and, if the allegation is made upon information and belief, the Complaint must state, with particularity, the facts upon which the belief is formed. ATSI, 493 F.3d at 99.
"Statements that are opinions or predictions are not per se inactionable under the securities laws. Statements regarding projections of future performance may be actionable under Section 10(b) or Rule 10b-5 if they are worded as guarantees or are supported by specific statements of fact...." In re Int'l Business Machines Corporate Securities Litigation, 163 F.3d 102, 107 (2d Cir. 1998) (emphasis added) (citations omitted) ("IBM"); see also Novak, 216 F.3d at 315 ("Here, the complaint alleges that the defendants did more than just offer rosy predictions; the defendants stated that the inventory situation was 'in good shape' or 'under control' while they allegedly knew that the contrary was true.").
The defendants argue that the Complaint fails to allege with particularity that the Fund's statements and omissions amounted to acts of fraud. In opposition to the motions to dismiss, the plaintiffs contend that there were three distinct but overlapping phases during which the defendants engaged in securities fraud. I will separately address each of these phases. I note at the outset that the plaintiffs' theories of liability share a common impediment: a failure to reconcile the Complaint's allegations with the Fund's disclosures about the risks and instabilities ...