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BECK v. CANTOR

November 19, 1985

DENNIS BECK FOR HIMSELF AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFFS,
v.
CANTOR, FITZGERALD & CO., INC., ET AL., DEFENDANTS.



The opinion of the court was delivered by: Rovner, District Judge.

  MEMORANDUM OPINION AND ORDER

Presently pending before this Court are the various motions of the defendants, Xonics, Inc. ("Xonics") and the individual Xonics defendants, Cantor, Fitzgerald & Co., Inc. ("Cantor, Fitzgerald") and Larry Friend, and Laventhol & Horwath ("Laventhol"), to dismiss plaintiff Richard Beck's First Amended Complaint for failure to state a claim upon which relief may be granted, pursuant to Fed.R.Civ.P. 12(b)(6), for failure to plead fraud with particularity, pursuant to Fed.R.Civ.P. 9(b), and for lack of pendent jurisdiction if the federal claims are dismissed. Defendant Laventhol has also moved to strike the allegations in paragraph 37 and the two paragraphs numbered 44, pursuant to Fed.R. Civ.P. 12(f), and for sanctions, pursuant to Fed.R.Civ.P. 11. Finally, after briefing was complete plaintiff moved for leave to file a surreply brief. These motions are granted in part and denied in part.

This case is a securities class action arising out of the sale through Cantor, Fitzgerald, a registered broker-dealer, of certain stock of Xonics to plaintiff Beck. The case involves an $8.8 million private placement by Cantor, Fitzgerald of 2 million shares of Xonics common stock to approximately 93 investors. Laventhol is the certified public accounting firm which audited Xonics' March 31, 1983 year-end financial statements. Although the allegations of the complaint are many and varied, the gist of the fraudulent scheme alleged is that the defendants induced Beck and the plaintiff class, which has yet to be certified, to purchase Xonics stock in February, 1983 with the representation that, although the stock being sold was then restricted and thus was not freely tradeable, the stock would be registered automatically with the Securities and Exchange Commission ("SEC") within four to five months and could then be resold at a substantial profit. Plaintiff alleges that the defendants concealed the fact that SEC registration was neither "automatic" nor "guaranteed" and that they would and did submit a proposed registration statement to the SEC which was not in accordance with generally accepted accounting principles and was, therefore, rejected.

Plaintiff seeks relief against all defendants for violation of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, and Sections 12(2) and 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. § 77l (2) and 77q(a), in Count I; for violation of the Racketeering Influenced and Corrupt Organizations Act of 1976 ("RICO"), 18 U.S.C. § 1961, et seq., in Count II; for common law fraud and negligence in Counts III and IV; for breach of fiduciary duty in Count V; and for civil conspiracy to violate the securities laws in Count VI.

Facts*fn1

In February, 1983, Xonics agreed with Cantor, Fitzgerald to place two million shares of Xonics stock through Cantor, Fitzgerald for sale to Accredited Investors as defined in Rule 501(a) of Regulation D of the Exchange Act. The stock was offered to plaintiff Beck in February, 1983. Xonics and Cantor represented to plaintiff orally and in writing that the stock was not registered under the Securities Act and could not be traded until registered with the SEC. Xonics and Cantor, Fitzgerald also represented that Xonics would file a registration statement with the SEC by late June or early July, 1983 and that approval by the SEC was "automatic" and "guaranteed." Plaintiff purchased 9,000 shares of Xonics stock on February 19, 1983 for $39,600.

During Xonics' fiscal year 1983, which began on April 1, 1982, Xonics spent substantial sums to improve certain of its existing product lines. Xonics treated some of these product enhancement costs as additions to capital in its third quarter report filed with the SEC and capitalized a total of $1.5 million of product enhancement costs in its Annual Report on Form 10-K. These costs should have been treated as expenses, and the capitalization of the product enhancement costs was not in accordance with generally accepted accounting principles. The effect of Xonics' accounting treatment was that Xonics reported a net income of $136,000 for fiscal year 1983 rather than a loss of approximately $1.3 million. Xonics capitalized certain of its product enhancement costs because Xonics' officers and directors wanted to reflect a positive net income and maintain or increase the market price of Xonics stock.

In connection with the sale of stock, Cantor, Fitzgerald and Xonics directors and officers distributed to plaintiff and other members of the class unaudited quarterly financial statements for the last three quarters of fiscal year 1983. Each defendant participated in the preparation and distribution of the financial reports, which were distributed, in part, through the United States mails.

Laventhol and the other defendants knew of Xonics' reasons for capitalizing the product enhancement costs, knew that the capitalization was not in accordance with generally accepted accounting principles, and knew that the various financial statements prepared during fiscal year 1983 did not fairly present Xonics' financial conditions. Subsequent to the February, 1983 sale of stock, Laventhol conspired with the other defendants to submit an S-1 Registration Statement to the SEC knowing or recklessly disregarding the fact that the fiscal year 1983 annual statements were not prepared in accordance with generally accepted accounting principles. When the defendants submitted the Registration Statement, they knew that there was a substantial likelihood that the SEC would prevent the Registration Statement from becoming effective.

Plaintiff claims that these accounting practices were fraudulent and improper because the initially reported net figures created a falsely optimistic view of Xonics' performance and financial condition. Plaintiff further claims that when he and other class members purchased Xonics stock, they relied on the representations contained in the financial statements even though one of the financial statements, the fiscal year 1983 Report in Form 10-K, was not yet prepared when the Xonics stock was purchased.

On December 6, 1984, this case was transferred to this Court from the Central District of California after Judge Richard Gadbois granted Xonics' motion to transfer. The instant motions were filed shortly thereafter but not fully briefed until the summer of 1985.

Discussion

I. Rule 9(b) Motions

After reviewing the First Amended Complaint and all of the voluminous briefs filed by the parties, this Court agrees with the defendants that the First Amended Complaint fails to plead fraud with specificity as required by Rule 9(b). However, this Court is not convinced that plaintiff is not capable of stating a fraud claim at least against some of the defendants with sufficient particularity. Thus, plaintiff is granted leave to file a Second Amended Complaint within 30 days to cure this and other defects as set forth in this Opinion.

Because it is not the function of this Court to educate plaintiff's attorneys as to how to plead fraud with particularity, and because defendants have already pointed out the many deficiencies of the plaintiff's First Amended Complaint in this respect, this Court will not elaborate on those deficiencies except to note the following:

  1) plaintiff has not identified the persons who
  made the alleged oral and written
  misrepresentations, the persons to whom the
  representations were made, the content of those
  misrepresentations, and where or when such
  misrepresentations were made, see, e.g., Rudolph v.
  Merrill Lynch, Pierce, Fenner & Smith, Inc., 100
  F.R.D. 807 (N.D.Ill. 1984); Barr Co. v. Safeco
  Insurance Co. of America, 583 F. Supp. 248 (N.D.Ill.
  1984);
  2) plaintiff has not adequately distinguished
  among the many defendants who are alleged to have
  participated in the fraud, see, e.g., Kennedy v.
  Nicastro, 503 F. Supp. 1116, 1122 (N.D.Ill. 1980);
  Lincoln National Bank v. Lampe, 414 F. Supp. 1270,
  1278 (N.D.Ill. 1976);
  3) plaintiff has not alleged that each defendant
  violated the wire or mail fraud statutes at least
  twice, nor has he alleged with specificity the
  time, place, and manner of such violations, so as
  to plead a RICO claim with particularity, see,
  e.g., Haroco, Inc. v. American National Bank,
  747 F.2d 384, 405 (7th Cir. 1984), aff'd, ___ U.S. ___,
  105 S.Ct. 3291 [87 L.Ed.2d 437] (1985); UNR
  Industries, Inc. v. Continental Insurance Inc., No.
  83 A 2523, slip op. (N.D.Ill. April 9, 1985) (Hart,
  J.);
  4) plaintiff's allegations which are pleaded on
  information and belief contain no facts to
  support the foundation for the belief, see, e.g.,
  Duane v. Altenburg, 297 F.2d 515,

  518 (7th Cir. 1962); D & G Enterprises v.
  Continental Illinois National Bank and Trust Co.,
  574 F. Supp. 263, 267 (N.D.Ill. 1983);
  5) plaintiff has failed to allege in his
  complaint the basis for imposing individual
  liability against defendant Friend; and
  6) plaintiff has failed to support his general
  charge of civil conspiracy to commit securities
  fraud, to which the specific pleading
  requirements of Rule 9(b) apply, with any factual
  allegations of the specific parties engaged in
  the alleged conspiracy, its time and place, and
  the substance of the conspiracy, see, e.g., Koch v.
  Scheider, 550 F. Supp. 846 (N.D.Ill. 1982); In re
  Commonwealth Oil/Tesoro Petroleum Securities
  Litigation, 484 F. Supp. 253, 269 (W.D.Tex. 1979).

This list is not meant to be exhaustive; it merely serves to highlight some of the glaring inadequacies of the First Amended Complaint.

Plaintiff attempts to justify the factual inadequacies in three ways, none of which have any merit. First, plaintiff argues that the requirements of Rule 9(b) must be relaxed because of his allegations of a conspiracy to defraud. But plaintiff cannot circumvent the requirements of Rule 9(b) by pleading conclusory allegations of such a conspiracy or scheme to defraud. Decker v. Massey-Ferguson, 681 F.2d 111, 119 (2d Cir. 1982); Adair v. Hunt International Resources Corp., 526 F. Supp. 736, 744-45 (N.D.Ill. 1981).*fn2

Second, plaintiff offers new facts in his briefs to supply the factual allegations which are missing from the First Amended Complaint. Aside from the fact that many of these new facts are based on nothing more than plaintiff's understanding and thus constitute nothing more than pure speculation as to what the facts really are (see, e.g., Plaintiff's Responsive Brief at 6, 7, 27-29, 30, 43-44), plaintiff ignores that it is the First Amended Complaint which is at issue, not his briefs. "The requirements of Rule 9(b) must be fulfilled in the complaint itself. . . . not . . . in memoranda of points and authorities. . . ." Arroyo v. Wheat, 591 F. Supp. 141, 144 (D.Nev. 1984) (citation omitted).

Third, plaintiff attempts to justify his failure to plead fraud with particularity by the long discredited argument that he needs discovery to flush out the details of his claim. As courts throughout this District and nation have held, plaintiff may not use discovery to provide facts he presently does not have to plead fraud with specificity. This Court is mindful of Justice Rehnquist's often quoted admonition that a securities law complaint "which by objective standards may have very little chance of success at trial has a settlement value to the plaintiff out of proportion to its prospects of success at trial so long as he may prevent the suit from being resolved against him by dismissal or summary judgment." Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 740, 95 S.Ct. 1917, 1927, 44 L.Ed.2d 539 (1975). He further observed that such "strike suits" allow those with baseless claims to abuse the liberal federal discovery provisions, "with the right to do so representing an in terrorem increment of the settlement value" of the alleged fraud claim. Id. at 740-41, 95 S.Ct. at 1927-28.*fn3

Plaintiff professes a concern that "merely amending the complaint to allege further details which have already been identified [in his responsive brief] and prior filings such as plaintiff's own Declaration may unnecessarily delay and increase the cost of this litigation." (Plaintiff's Surreply Brief at 22.) Although this concern has merit, and is indeed shared by this Court, it is a concern that plaintiff could have avoided by pleading fraud with sufficient particularity in the first place, thereby avoiding the necessity of briefing on motions to dismiss and of repleading his complaint. Indeed, plaintiff could have and should have withdrawn his First Amended Complaint and offered a Second Amended Complaint once the defendants' motions specifying his Rule 9(b) deficiencies were filed. That course of action would have spared his own client the legal fees associated with defending a complaint which plaintiff implicitly acknowledges to be deficient by repeatedly offering to place his new factual assertions contained in his briefs or Declaration in a new complaint; it would have spared the defendants the legal fees they expended in briefing the motions to dismiss; and it would have spared this Court the considerable time and effort required to read voluminous briefs and numerous cases and to prepare this Opinion. Given all that has transpired, it is late in the day for plaintiff's professed concern about the cost of this litigation to be taken seriously.

Nonetheless, the Court itself seriously is concerned that this pattern not be repeated. Accordingly, if plaintiff's Second Amended Complaint fails to plead facts demonstrating fraud with particularity, this Court will not only dismiss that pleading with prejudice, but it will impose sanctions under Rule 11 as well.*fn4

II. Securities Claims

1. Section 10 of the Exchange Act and ...


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