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Schentag v. Nebgen

United States District Court, S.D. New York

June 21, 2018

JEROME SCHENTAG, individually and derivatively on behalf of TheraBrake, Inc. Plaintiff,


          GREGORY H. WOODS, United States District Judge

         Plaintiff Jerome Schentag, an inventor and holder of numerous medical patents, sought to develop and commercialize his inventions. Seduced by Defendant Georg Nebgen's promise of investment capital that would enable Plaintiff to accomplish his goal, Plaintiff agreed to the transfer of his intellectual property to a Swiss entity that would be formed by Nebgen. In the resulting integrated transaction, Nebgen formed two Swiss limited liability companies, of which Plaintiff became a shareholder. TheraBrake, the New York corporation holding Plaintiff's intellectual property, transferred its rights in that property to one of the Swiss companies in exchange for a promissory note. After the transaction was consummated, things began to disintegrate. Plaintiff discovered that Nebgen's statements that investors were standing by to invest were false. No payment was made on the promissory note. The Individual Defendants refused to pay for incurred liabilities. A lien was asserted against the assets of the Swiss holding company. And Plaintiff was removed as president of TheraBrake.

         Plaintiff filed this action, asserting securities fraud claims under the Securities and Exchange Act of 1934 and violations of various provisions of the Securities Act of 1933. Plaintiff also brings claims under state law. Defendants have moved to dismiss the complaint in its entirety. Because Plaintiff fails to plead that he acquired his shares of the Swiss LLCs, or that TheraBrake acquired the promissory note, in domestic transactions, Defendants' motion to dismiss the federal securities claims is granted. Plaintiff's breach of fiduciary duties claim survives, but the remainder of Plaintiff's state law claims are dismissed.

         I. BACKGROUND

         A. Factual Background[1]

         Plaintiff Jerome Schentag is a professor of pharmaceutical sciences and pharmacy at the University of Buffalo School of Pharmacy. Compl. (ECF No. 2) ¶ 3. He is also an inventor and holds numerous pharmaceutical patents. Id. Among those inventions are pharmaceutical drugs and devices used to treat and monitor diabetes, obesity, and other related diseases. Id. ¶ 30. Through TheraBrake, Inc., a Delaware corporation formed on April 8, 2011, Plaintiff and Defendant Joseph M. Fayad continued their research, development, and commercialization of patents and other intellectual property held by them. Id. ¶ 5. From the time TheraBrake was formed until November 1, 2014, Plaintiff and Fayad each held fifty percent of the corporation's shares. Id. ¶ 6.

         Defendant Georg Nebgen held himself out to be the co-founder and managing general partner of NGN Capital, a venture capital firm with offices in Manhattan. Id. ¶ 12. On several occasions during 2010, 2011, and 2012, Plaintiff discussed his inventions with Nebgen at NGN's Manhattan office. Id. ¶ 30.

         On January 8, 2013, Plaintiff met with Nebgen in San Francisco, California. Id. ¶ 31. During that meeting, Nebgen informed Plaintiff that he was no longer with NGN Capital and had begun operating his own business, Vivant Holdings. Id. Plaintiff shared with Nebgen his desire to commercially exploit his and other patents. Id. ¶ 32. Nebgen told Plaintiff that he was a successful investment banker, had closed several venture capital deals, and had access to investors willing to invest the capital required to have the existing patents issued worldwide. Id. These investors, according to Nebgen, also had money to invest in the continued research and development of the patented inventions. Id. Nebgen explained to Plaintiff that before Nebgen could secure these investments, Plaintiff would need to transfer his patents and other intellectual property to an entity that Nebgen would create. Id. ¶ 33. Nebgen recommended that the entity be formed in Switzerland so that investors could enjoy substantial personal tax benefits. Id.

         At some point after the San Francisco meeting, Plaintiff and Nebgen met again in New York City to further discuss the proposed venture. Id. ¶ 34. The two also discussed the proposal by telephone and electronic communication. Id. During those conversations, Nebgen continued to represent to Plaintiff that he had access to investors willing to come on board. Id.

         The following year, in September 2014, Nebgen informed Plaintiff that he had investors interested in investing in the development and marketing of the pharmaceutical products. Id. ¶ 35. In return for securing the capital, Nebgen demanded 33% of the shares of TheraBrake. Id. On November 1, 2014, because of Nebgen's representations regarding his investors, he was granted the requested shares. Id. As of that date, Plaintiff, Nebgen, and Fayad each have held 33% of the TheraBrake shares. Id. ¶ 18.

         Throughout 2014 and 2015, Nebgen continued to insist on the importance of forming a Swiss entity before his investors would contribute to their venture. Id. ¶ 36. Based on these statements, Plaintiff, Nebgen, and Fayad agreed upon the integrated transaction at the heart of this case. Id. ¶ 37. As part of that agreement, on September 16, 2015, Nebgen formed Volant Holdings GmbH (“Holdings”) as a Swiss limited liability company. Id. ¶ 20. Holdings' principal place of business is in Feusisberg, Canton Schwyz, Switzerland. Id. Holdings was formed to be the holder of the intellectual property that TheraBrake agreed to transfer to it. Id. ¶¶ 24, 37. Nebgen also represented that Holdings would pay for all costs associated with the research and development of the intellectual property, as well as any legal expenses incurred to protect the intellectual property. Id. ¶ 45.

         On October 15, 2015, Plaintiff, Nebgen, and Fayad executed several written agreements to consummate the agreed-upon transaction. Id. ¶ 21. Among those documents were an Asset Purchase Agreement (“APA”) and a Patent Assignment. Id. Pursuant to the APA, Holdings agreed to pay a total sum of $566, 510 as well as certain other liabilities described in Section 1.2 of the APA (“Assumed Liabilities”), as consideration for the transfer of the intellectual property. Id. ¶ 53. Payment of the $566, 510 was to be made in the form of a promissory note payable by Holdings to TheraBrake (the “Note”). Id. Holdings issued the Note on October 15, 2015. Id. ¶ 43.[2] The patent assignments were subsequently recorded in the United States Patent and Trademark Office. Id. ¶ 21.

         Two weeks after the contracts were executed, on October 30, 2015, Nebgen organized Volant Pharma AG (“Pharma”) as a Swiss limited liability company with its principal place of business in Feusisberg, Canton Schwyz, Switzerland. Id. ¶ 22. Pharma was intended to be the operating company and was formed to license the intellectual property acquired from TheraBrake and, along with Holdings, to pay for all research and development and legal fees and costs associated with protecting the intellectual property. Id. ¶ 24. Pharma was also intended to be the entity pursuing investment capital. Id. When Nebgen formed Holdings and Pharma, he appointed himself the chairman of the board and chief executive officer of each entity. Id. ¶ 10. He was the sole director of each entity and failed to explain to Plaintiff the significance of this fact. Id. ¶¶ 38, 48.

         As a result of the integrated transaction, Nebgen holds 31% of the shares of Holdings and 20% of the shares of Pharma. Id. ¶ 8. Plaintiff and Fayad each hold 31% of the shares of Holdings and 28% of the shares of Pharma. Id. ¶¶ 2, 18. To pay for his shares in Holdings, Plaintiff sent $7, 602 from his New York bank account via wire transfer to an account at Zuricher Kantonalbank in Zurich, Switzerland. Id. ¶ 39. He also wire-transferred $14, 678 on October 14, 2015 and $13, 798 on December 23, 2016 to the Swiss account to pay for his shares in Pharma. Id. Plaintiff also paid for Fayad's shares in Pharma by sending $7, 500 from his New York account to Fayad's Bank of America account in New York on October 21, 2015. Id. ¶¶ 19, 40.

         On October 23, 2015, Defendant Parviz Ghahramani was hired as the Chief Operating Officer of Holdings and Pharma. Id. ¶ 42. Ghahramani holds 8% of the shares of both Holdings and Pharma. Id. ¶ 15. From late October 2015, Holdings and Pharma have conducted business out of Ghahramani's New Jersey office. Id. ¶ 16. Nebgen has also held meetings in New York City for Holdings and Pharma business since that date. Id. ¶ 25.

         Following the October 2015 transaction, Nebgen continued to state that he had investors who were ready to invest in Holdings and Pharma. Id. ¶ 46. During monthly meetings with Plaintiff and Ghahramani between October 2015 and July 2017, Nebgen gave allegedly false reports regarding the status of investor solicitations. Id. This was done, according to Plaintiff, to induce Plaintiff to continue his research and development in connection with the intellectual property. Id.

         Recently, Nebgen told Plaintiff that he never intended for Plaintiff to become a shareholder of Pharma. Id. ¶ 56. Nebgen also demanded that Plaintiff re-subscribe for his Pharma shares. Id. ¶ 57. Plaintiff refused, arguing that Nebgen was “changing the deal.” Id. ¶ 58. Subsequently, Nebgen and Fayad informed Plaintiff that he was no longer an officer of TheraBrake. Id.[3]

         Holdings has not paid on the promissory note. Id. ¶¶ 52, 54. Plaintiff alleges that Nebgen, Ghahramani, and Fayad “have caused” Holdings not to make the payments due. Id. ¶ 52. Plaintiff further alleges that Nebgen's statements regarding the availability of ready and willing investors, the necessity of transferring the intellectual property to a Swiss entity because of those investors, and that Holdings and Pharma would pay any research and development and legal costs “have all turned out to be false and were knowingly false when made.” Id. ¶ 47.

         The complaint alleges a scheme in which Defendants “continuously” misrepresented the status of investor negotiations to secure Plaintiff's investment and credit from third parties. Id. ¶ 90. According to the complaint, Nebgen induced Plaintiff and TheraBrake to transfer their intellectual property to Holdings and enticed Plaintiff to purchase shares in Holdings. Id. ¶¶ 48, 50. Plaintiff also alleges that Nebgen used Holdings to strip Plaintiff of his intellectual property by promising consideration without any intent of actually paying. Id. ¶ 55. It was because of the allegedly false statements that Plaintiff purchased shares of Holdings and Pharma and that TheraBrake purchased the promissory note. Id. ¶ 49.

         The complaint also documents various expenses that have been incurred as a result of the integrated transaction, expenses which various of the Individual Defendants refuse to pay. The Individual Defendants retained counsel on behalf of Pharma and Holdings to prosecute and protect the acquired patents. Id. ¶ 87. Defendants have not paid for those legal services, and counsel has asserted a lien for $472, 539 on the assets of Holdings. Id. ¶¶ 87, 90. Nebgen and Ghahramani also retained Swiss counsel to prepare the documents necessary to effectuate the transfer of the intellectual property. Id. ¶ 88. Nebgen and Ghahramani refuse to pay for those services, a total sum in excess of $90, 000. Id. Nebgen and Ghahramani also retained Swiss counsel to draft the transactional documents associated with the licensing of intellectual property to an affiliated entity. Id. ¶ 89. They have refused to pay for those legal services, valued at over $96, 000. Id.

         Plaintiff asserts that it would be futile to move the Board of Directors of TheraBrake to bring claims on its own behalf; Nebgen and Fayad have the controlling votes. Id. ¶ 59.

         B. Procedural History

         Plaintiff commenced this action on November 9, 2017. ECF No. 1. In a joint letter filed on January 26, 2018, Defendants advised the Court of their intent to move to dismiss the complaint. ECF No. 26. On January 31, 2018, Defendants filed an answer, stating that they were not providing a substantive response to the complaint at that time because of the anticipated motion to dismiss. ECF No. 28. Nebgen, Ghahramani, and Fayad filed counterclaims against Plaintiff. Id. On February 9, 2018, Defendants filed their motion to dismiss the complaint. ECF No. 33. On February 23, 2018, Plaintiff answered the counterclaims. ECF No. 38. After several extensions of time, Plaintiff filed his opposition to the motion to dismiss on March 26, 2018. ECF No. 50. Defendants replied on April 11, 2018. ECF No. 51.


         A. Rule 12(b)(6)

         To survive a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), “a complaint must allege sufficient facts, taken as true, to state a plausible claim for relief.” Johnson v., Inc., 711 F.3d 271, 275 (2d Cir. 2013) (citing Bell Atl. Corp. v. Twombly, 550 U.S. 544, 555-56 (2007)). To determine plausibility, courts follow a “two-pronged approach.” Ashcroft v. Iqbal, 556 U.S. 662, 679 (2009). “First, although a court must accept as true all of the allegations contained in a complaint, that tenet is inapplicable to legal conclusions, and threadbare recitals of the elements of a cause of action, supported by mere conclusory statements, do not suffice.” Harris v. Mills, 572 F.3d 66, 72 (2d Cir. 2009) (alterations and internal quotation marks omitted) (quoting Iqbal, 556 U.S. at 678). Second, a court determines “whether the ‘well-pleaded factual allegations, ' assumed to be true, ‘plausibly give rise to an entitlement to relief.'” Hayden v. Paterson, 594 F.3d 150, 161 (2d Cir. 2010) (quoting Iqbal, 556 U.S. at 679). Determining whether a complaint states a plausible claim is a “context-specific task that requires the reviewing court to draw on its judicial experience and common sense.” Iqbal, 556 U.S. at 679.

         Claims sounding in fraud are subject to the heightened pleading requirements of Federal Rule of Civil Procedure 9(b). Ganino v. Citizens Utils. Co., 228 F.3d 154, 168 (2d Cir. 2000). Rule 9(b) requires that the complaint “state with particularity the circumstances constituting fraud.” Fed.R.Civ.P. 9(b). To satisfy that requirement, the complaint 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.” ATSI Commc'ns, Inc. v. Shaar Fund, Ltd., 493 F.3d 87, 99 (2d Cir. 2007) (citing Novak v. Kasaks, 216 F.3d 300, 306 (2d Cir. 2000)).

         In resolving a motion to dismiss under Rule 12(b)(6), courts generally may not consider materials extrinsic to the complaint. Fed.R.Civ.P. 12(d). However, that rule is not absolute. In addition to the facts alleged in the complaint, courts “may consider any written instrument attached to the complaint, statements or documents incorporated into the complaint by reference, legally required public disclosure documents filed with the SEC, and documents possessed by or known to the plaintiff and upon which it relied in bringing the suit.” ATSI, 493 F.3d at 98. Courts may also consider “matters of which judicial notice may be taken.” Goel v. Bunge, Ltd., 820 F.3d 554, 559 (2d Cir. 2016) (citation omitted).


         A. Federal Claims

         Defendants move to dismiss the federal securities claims on two grounds: (1) the Note and Plaintiff's shares in Holdings and Pharma do not constitute securities; and (2) even if those interests were securities, the complaint fails to plead a domestic transaction.

         1. The Shares and Promissory Note as “Securities”

         Plaintiff brings claims under Section 10(b) of the Securities and Exchange Act of 1934 and Sections 5(a) and (b)(2), 12(a) and (b), and 15(a) of the Securities Act of 1933. Section 10(b) of the Securities Exchange 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 [Securities and Exchange] Commission may prescribe.” 15 U.S.C. § 78j(b) (emphasis added). Thus, to state a claim under Section 10(b) for fraudulent misrepresentations, a plaintiff must allege “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” GAMCO Investors, Inc. v. Vivendi Universal, S.A., 838 F.3d 214, 217 (2d Cir. 2016) (quoting Halliburton Co. v. Erica P. John Fund, Inc., 134 S.Ct. 2398, 2407 (2014)).

         Section 5 of the Securities Act requires that “a security” be registered with the SEC prior to its sale. 15 U.S.C. § 77e(a); see SEC v. Cavanagh, 445 F.3d 105, 111 (2d Cir. 2006). To state a cause of action under Section 5, a plaintiff must show “(1) lack of a registration statement as to the subject securities; (2) the offer or sale of the securities; and (3) the use of interstate transportation or communication and the mails in connection with the offer or sale.” Cavanagh, 445 F.3d at 111 n.13 (quoting Eur. & Overseas Commodity Traders, S.A. v. Banque Paribas London, 147 F.3d 118, 124 n.4 (2d Cir. 1998)).

         Section 12 of the Securities Act imposes liability on “[a]ny person who . . . offers or sells a security in violation of section [5]” of the Act or “offers or sells a security . . . by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements . . . not misleading.” 15 U.S.C. § 77l(a) (emphasis added); see In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 359 (2d Cir. 2010) (“Section 12(a)(2) provides . . . redress where the securities at issue were sold using prospectuses or oral communications that contain material misstatements or omissions” (emphasis added)). Section 15(a) of the Securities Act imposes liability on a person who controls another person liable under Section 11 or Section 12. See 15 U.S.C. § 77o(a). To establish a claim under this section, a plaintiff must prove “a ‘primary violation' of the statute ‘and control of the primary violator by defendants.'” In re MF Global Holdings Limited Sec. Litig., 982 F.Supp.2d 277, 308 (S.D.N.Y. 2013) (quoting In re Lehman Bros. Mortg.-Backed Sec. Litig., 650 F.3d 167, 185 (2d Cir. 2011)).

         Thus, to avoid dismissal of his federal claims, Plaintiff must plead the threshold issue: that the shares and promissory note at issue are “securities” within the meaning of the 1933 and 1934 Acts. See OSRecovery, Inc. v. One Groupe Int'l, Inc., 354 F.Supp.2d 357, 369 (S.D.N.Y. 2005) (“A preliminary issue is whether the scheme involved ‘securities, ' as that term is defined by the Securities Act of 1933 . . . and the Securities and Exchange Act of 1934 . . . .”).

         a. Plaintiff's Shares in Holdings and Pharma

         In determining whether LLC membership interests are “securities” under the federal acts, courts generally apply the Supreme Court's test enunciated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to determine whether the interests constitute an “investment contract.” See, e.g., Uni-World Capital L.P. v. Preferred Fragrance, Inc., No. 13-cv-7204 (PAE), 2014 WL 3900565, at *7 (S.D.N.Y. Aug. 8, 2014) (“LLC membership interests are not ‘securities' unless they meet the definition of an ‘investment contract' . . . .” (quoting Automated Teller Mach. Advantage LC v. Moore, No. 08-cv-3340 (RMB), 2009 WL 2431513, at *4 (S.D.N.Y. Aug. 6, 2009))); Keith v. Black Diamond Advisors, Inc., 48 F.Supp.2d 326, 332 (S.D.N.Y. 1999) (noting that the plaintiff's LLC membership interests were not “securities” unless they satisfied the Howey criteria). The Howey test is met when a plaintiff alleges “[i] an investment of money [ii] in a common enterprise [iii] with profits to come solely from the efforts of others.” Automated Teller, 2009 WL 2431513, at *4 (alterations in original) (quoting Endico v. Fonte, 485 F.Supp.2d 411, 412 (S.D.N.Y. 2007)); see also Howey, 328 U.S. at 301 (“The test is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others”).

         The key consideration is “whether, under all the circumstances, the scheme was being promoted primarily as an investment or as a means whereby participants could pool their own activities, their money and the promoter's contribution in a meaningful way.” United States v. Leonard, 529 F.3d 83, 88 (2d Cir. 2008) (quoting SEC v. Aqua-Sonic Prods. Corp., 687 F.2d 577, 582 (2d Cir. 1982)). Therefore, the Howey test is not satisfied if, “at the time of investment, the investor possesses a ‘reasonable expectation of significant investor control.'” Uni-World Capital, 2014 WL 3900565, at *7 (quoting Automated Teller, 2009 WL 2431513, at *4). In making this determination, a court must conduct a “‘case-by-case analysis' into the ‘economic realities' of the underlying transaction.” Leonard, 529 F.3d at 89 (quoting Reves v. Ernst & Young, 494 U.S. 56, 62 (1990)). “The question is whether an investor, as a result of the investment agreement itself or the factual circumstances that surround it, is left unable to exercise meaningful control over his investment.” Id. at 91 (quoting Robinson v. Glynn, 349 F.3d 166, 170 (4th Cir. 2003)).

         Here, Plaintiff not only alleges but emphasizes that Nebgen recommended the transfer of the intellectual property to the Swiss LLCs in order to attract investors. Repeatedly, the complaint alleges that Nebgen consistently represented to Plaintiff that formation of a Swiss entity was a necessary predicate to obtaining the anticipated investment. In fact, Plaintiff alleges that he purchased the LLC interests because Nebgen assured him that investors were ready and willing to contribute. See Compl. ¶¶ 46-50. These allegations suggest that, at the time Plaintiff purchased his interests, he did so with the expectation of significant passive investment in the companies.

         Nevertheless, the complaint also explains that Holdings and Pharma were created “as part of” the parties' agreement to commercially exploit the relevant patents and other intellectual property. See Id. ¶¶ 21, 23. Thus, the complaint dually suggests that the Swiss LLCs were formed with the expectation that their shareholders would actively control the companies. The Asset Purchase Agreement executed by Nebgen and Plaintiff also lends support to the latter expectation.[4]The Agreement provides for the transfer of “all assets” of TheraBrake, including all of TheraBrake's records, books, mailing lists, study materials, inventory, and “all intellectual property rights.” Affirmation of Joseph M. Fayad (ECF No. 35) (“Fayad Aff.”), Ex. 2 § 1.1. The Agreement also contains a non-compete clause. See Id. § 6.4. These provisions suggest that all of TheraBrake's assets were transferred to Holdings so that the parties, through Holdings, could continue TheraBrake's work to commercially exploit the intellectual property. Although none of the assets were transferred to Pharma, the complaint describes Pharma as the entity designed to be the “operating company”; Pharma was established for the dual purpose of licensing the intellectual property and obtaining investor capital. See Compl. ¶ 24. The complaint itself creates a question as to whether the expectation, at the time Plaintiff purchased the LLC interests, was that shareholders would be passive investors or have an active role in controlling the companies that were to capitalize on Plaintiff's inventions.

         In light of these competing allegations, the Court cannot determine at this stage whether Plaintiff's membership interests in the Swiss LLCs are investment contracts and, thereby, securities under the federal securities acts.[5] Instead, the question of “[w]hether or not [Plaintiff's] membership interests are ultimately determined to be investment contracts is more appropriately addressed in a summary judgment motion.” Automated Teller, 2009 WL 2431513, at *4 (citation omitted); see also Uni-World Capital, 2014 WL 3900565, at *8 (denying motion to dismiss when court was unable to conclude based on the pleadings that “significant investor control” was expected at the time of the relevant transaction).[6]

         b. Promissory Note

         In determining whether a promissory note is a security under the 1933 and 1934 Acts, “[c]ourts begin with the presumption that notes with terms exceeding nine months are securities.” United States v. Bergstein, No. 16-cr-746 (PKC), 2018 WL 2417845, at *3 (S.D.N.Y. May 29, 2018) (citing Reves, 494 U.S. at 65 n.3, 70-71). This presumption is rebuttable upon a showing that the note either falls into or resembles categories of notes that have been judicially deemed not to constitute securities. See Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808, 811 (2d Cir. 1994); Reves, 494 U.S. at 65. Such notes include

the note delivered in consumer financing, the note secured by a mortgage on a home, the short-term note secured by a lien on a small business or some of its assets, the note evidencing a “character loan” to a bank customer, short-term notes secured by an assignment of accounts receivable, . . . a note which simply formalizes an open-account debt incurred in the ordinary course ...

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