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SCHOLES v. STONE

March 25, 1992

STEVEN S. SCHOLES, as Receiver for D & S Trading Group, Ltd., Analytic Trading Systems, Inc., Analytic Trading Systems, Inc., and Market Systems, Inc., and on behalf of a class, and JOHN LAVINKA and PAMELA LAVINKA, individually and on behalf of all persons similarly situated, Plaintiffs,
v.
STONE, McGUIRE AND BENJAMIN, HOWARD L. STONE, MICHAEL L. SIEGEL, ROSENTHAL AND SCHANFIELD, P.C., WILLIAM P. ROSENTHAL, and LESLIE J. WEISS, Defendants.


ALESIA


The opinion of the court was delivered by: JAMES H. ALESIA

In this case, defendants Stone, McGuire & Benjamin ("SMB"), Howard L. Stone ("Stone"), a partner of SMB, Michael L. Siegel ("Siegel"), a non-equity partner of SMB, Rosenthal & Schanfield, P.C. ("R&S"), William P. Rosenthal ("Rosenthal"), a senior shareholder of R&S, and Leslie J. Weiss ("Weiss"), an attorney employed by R&S have filed separate motions to dismiss plaintiffs' complaint. *fn1" In addition, SMB filed a separate motion for sanctions pursuant to Rule 11 of the Federal Rules of Civil Procedure against Gary L. Prior ("Prior") and his client, the Receiver, Steven S. Scholes ("Scholes"). For the reasons outlined below, the court denies SMB's motion to dismiss and motion for sanctions. In addition, the court grants R&S' motion to dismiss Count VII, but denies the motion with respect to Counts V, VI, VIII and IX.

 I. BACKGROUND

 This action is brought by Scholes, not individually but solely as Receiver ("Receiver") for D&S Trading Group, Ltd.("D&S"), Analytic Trading Systems, Inc., Analytic Trading Service, Inc., and Market Systems, Inc., and by John and Pamela LaVinka, individually and on behalf of a putative class of investors in D&S, Analytic Trading Systems, Inc. and Analytic Trading Service, Inc., (collectively "plaintiffs"), against defendants SMB, Stone, Siegel, R&S, Rosenthal and Weiss. *fn2" This action arises out of certain fraudulent schemes perpetrated by Michael S. Douglas ("Douglas"), for which Douglas pleaded guilty and is currently incarcerated. Plaintiffs assert civil causes of action against the attorneys who allegedly assisted Douglas in carrying out his illegal schemes.

 Plaintiffs' complaint, as amended, consists of nine counts. Plaintiffs have asserted claims for legal malpractice-negligence against SMB (Count I) and R&S (Count V), and breach of fiduciary duty against SMB (Count II) and R&S (Count VI). In addition, the putative class has alleged claims for violations of Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78aa ("Exchange Act") and Rule 10b-5 promulgated thereunder against SMB (Count III) and R&S (Count VIII), violations of Section 12(2) of the Securities Act of 1933, 15 U.S.C. § 77v ("Securities Act") by R&S (Count VII), and common law fraud against SMB (Count IV) and R&S (Count IX).

 Defendants SMB, Stone, and Siegel (collectively "SMB") have moved to dismiss the complaint pursuant to Federal Rule of Civil Procedure 12(b)(6). Similarly, defendants R&S, Rosenthal, and Weiss (collectively "R&S") have moved to dismiss the amendment to the complaint pursuant to Federal Rules of Civil Procedure 12(b)(6) and 9(b), and for lack of supplemental jurisdiction.

 II. PROCEDURAL HISTORY

 Before the court addresses the objections of SMB and the arguments of R&S, a clarification of the procedural posture of this case is in order. Initially, on or about December 12, 1990, plaintiffs filed a four-count complaint against defendants SMB, Stone and Siegel alleging attorney malpractice-negligence (Count I), breach of fiduciary duty (Count II), violation of Section 10(b) of the Exchange Act (Count III), and common law fraud (Count IV). In response, the SMB defendants filed a motion to dismiss. This motion to dismiss was referred to Magistrate Judge Weisberg for a Report and Recommendation.

 Thereafter, on April 25, 1991, this court granted plaintiffs' emergency motion to amend their complaint to add R&S, Rosenthal, and Weiss as party defendants. This pleading was styled "Amendment to Complaint" and asserted five additional counts against the R&S defendants. Not surprisingly, R&S moved to dismiss the amendment to the complaint based on grounds similar to those raised by SMB.

 After plaintiffs filed their amendment to complaint, Magistrate Judge Weisberg filed his report dated June 27, 1991, recommending that SMB's motion to dismiss all four counts be denied. On May 21, 1991, before the Magistrate Judge issued his report, this court enlarged the referral to Magistrate Judge Weisberg to include R&S' subsequently filed motion to dismiss. However, on June 27, 1991, Magistrate Judge Weisberg issued his report without addressing R&S' motion to dismiss.

 To further compound the confusion, the referral to Magistrate Judge Weisberg was transferred by order of the executive committee on October 10, 1991 to Magistrate Judge Pallmeyer. *fn3" Due to the similar causes of action and underlying facts regarding both defendants, and in order to foster a legally consistent determination, the referral to Magistrate Judge Pallmeyer was withdrawn by this court on February 11, 1992.

 Unfortunately, this does not end the procedural morass. To further complicate matters, after the motions to dismiss were apparently fully briefed, all parties submitted supplemental briefs. As an initial matter, on July 25, 1991, this court granted plaintiffs leave to file a surreply memorandum in opposition to R&S' motion to dismiss. Thereafter, in a letter to Magistrate Judge Weisberg dated September 13, 1991, R&S cited as supplemental authority the Fourth Circuit's recent decision in Schatz v. Rosenberg, 943 F.2d 485 (4th Cir. 1991). Not surprisingly, on September 27, 1991, SMB messengered a similar letter to this judge also referring to the Schatz decision.

 This did not end the supplemental briefing. On January 3, 1992, R&S cited as supplemental authority the recent Illinois Supreme Court decision of Collins v. Reynard, 1991 Ill. LEXIS 104 (Oct. 31, 1991), and argued that based on Collins, plaintiffs are precluded from maintaining a claim for attorney malpractice under a tort theory of negligence (Count V) and breach of fiduciary duty (Count VI). In turn, plaintiffs responded to R&S' citation to Collins with their own letter to Magistrate Judge Pallmeyer dated January 16, 1992. On January 23, 1992, Magistrate Judge Pallmeyer granted R&S leave to file a reply in support of their position on the Collins case on or before February 6, 1992. Plaintiffs were also granted leave to file a surreply memorandum on or before February 13, 1992. Both plaintiffs and R&S filed timely briefs on this point.

 In sum, after considering Magistrate Judge Weisberg's Report and Recommendation (as it relates to SMB), SMB's objections, plaintiffs' response, and the parties' underlying briefs, we adopt the report and deny SMB's motion to dismiss. Similarly, after having carefully considered the numerous briefs filed by both R&S and plaintiffs, we grant R&S' motion to dismiss Count VII and deny R&S' motion to dismiss Counts V, VI, VII and IX. Against this backdrop, we now address SMB's objections to the report. Thereafter, we consider R&S' arguments.

 III. FACTS

 The standards to be applied in deciding a motion to dismiss are straightforward and beyond dispute. "Unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief," we will not dismiss the complaint. See Conley v. Gibson, 355 U.S. 41, 45-46, 2 L. Ed. 2d 80, 78 S. Ct. 99 (1957). Furthermore, in ruling on the defendants' motions to dismiss, the court accepts all well-pleaded allegations of plaintiffs' complaint as true and views these allegations in the light most favorable to plaintiffs. Bethlehem Steel Corp. v. Bush, 918 F.2d 1323, 1326 (7th Cir. 1990). Guided by these standards, we now address the facts as set forth in plaintiffs' amendment to the complaint. *fn4"

 On or about March 4, 1988, the Illinois Securities Department ("the ISD") began investigating Douglas and D&S for selling unregistered securities. On that same date, Douglas retained Weiss (who was not yet employed by R&S) to represent Douglas and D&S in connection with the ISD investigation. Even before she was officially retained by Douglas, Weiss was aware of Douglas' past criminal history and lack of income. Shortly after she began her representation of Douglas and D&S, Weiss learned of further wrongdoing by Douglas including, but not limited to, his distributing misleading offering materials to actual and potential investors which contained material misrepresentations and omissions. These misrepresentations included affirmative statements that substantial profits were made by Douglas, and his partner Lawrence L. Schroeder, Jr. ("Schroeder"), at a time when they were both in jail, and that Douglas personally guaranteed the investments.

 These were not the only misrepresentations of which Weiss was aware. Weiss also learned in March, 1988 that Douglas failed to disclose his criminal activities in the D&S offering materials. In light of these discoveries, Weiss recommended in early March, 1988, that Douglas make a "rescission offer" to all D&S investors who were Illinois residents. To this end, Weiss drafted the documents used by Douglas to implement the rescission offer. These documents did not contain the facts that Douglas was a convicted felon and that the original offering materials used to induce the original investments in D&S were fraudulent. Rather, the D&S investors were lead to believe that the reason for the rescission offer was the fact that the interests in D&S were not registered. Copies of the rescission offer were mailed to all D&S investors who were Illinois residents. The rescission offer was made in or about April, 1988. All Illinois investors responding to the rescission offer rejected it.

 The ISD was not the only governmental entity investigating D&S. In or about April or May, 1988, Wisconsin and federal government securities officials began investigating D&S. As a result, Weiss' representation of D&S was enlarged to include these new investigations and she recommended in or about April, 1988, that Douglas make a rescission offer to all D&S Wisconsin investors. Once again, Weiss drafted the documents used to implement the Wisconsin rescission offer which, like the Illinois rescission offer documents, failed to include Douglas' criminal history and failed to state that the original D&S offering materials were fraudulent. Instead, the Wisconsin D&S investors were falsely lead to believe that the only material fact which necessitated the rescission offer was D&S' failure to register its interests. Copies of the rescission offer were mailed to all D&S investors who were Wisconsin residents. All the Wisconsin investors who responded rejected the offer. In or about late April, 1988, Weiss became employed as an attorney at R&S.

 Weiss was aware of additional fraudulent conduct on Douglas' part. Weiss drafted Douglas' affidavit which falsely stated that no one other than Douglas solicited investors for D&S. Weiss prepared the affidavit based on information obtained from Douglas. Weiss knew that the Douglas affidavit was tendered to the ISD on or about March 28, 1988, in connection with its ongoing investigation. The affidavit was false in that Douglas was not the only individual soliciting investors for D&S. Schroeder was also soliciting investors.

 To further exacerbate matters, Douglas' lies about D&S caused Weiss to send a letter on or about April 11, 1988 to the State of Wisconsin which contained materially false representations. The letter falsely stated that Douglas was the only person soliciting Wisconsin residents to invest in D&S. The April 11, 1988 letter also falsely represented that Schroeder, Patrick Grady and John Hunter were not representatives of D&S. On or about April 11, 1988, Douglas admitted to Weiss that he had lied to her about Schroeder's involvement. Consequently, Weiss corrected her letter submitted to the Wisconsin authorities. The complaint alleges that Weiss did not withdraw or correct the affidavit submitted to the ISD.

 Douglas also lied to Weiss about the formation of D&S. Douglas told Weiss that an attorney drafted the D&S partnership agreement and filed a certificate of limited partnership on behalf of D&S. Obviously not taking Douglas at his word, Weiss spoke with that attorney on or about April 5, 1988. During this conversation, the attorney denied drafting the D&S partnership agreement or submitting any certificate of limited partnership to the Illinois Secretary of State. In addition, the attorney also told Weiss that Douglas had been previously advised that the D&S documentation was not legal. Weiss relayed Douglas' false story about the other attorney's involvement to the ISD. However, even though she knew Douglas' version of events was incorrect, Weiss never corrected the information sent to the ISD.

 Weiss' knowledge of Douglas' illegal activity continued. By no later than April 11, 1988, Weiss knew that Douglas was trading securities on behalf of one or more other persons. She also knew that it was illegal for Douglas, or any other company of which he was an officer or director, to trade on behalf of any other person or otherwise deal in securities. In late April, 1988, Weiss told Douglas that she would no longer represent him in matters other than the pending ISD and Wisconsin investigations. She said that she curtailed her representation of Douglas because he was not being honest with her. Notwithstanding her assertions, Weiss continued doing corporate, securities, and transactional work for Douglas and his entities after April, 1988.

 In mid-May, 1988, Weiss recommended that Douglas retain SMB as co-counsel to represent Douglas and D&S. She apparently made this recommendation because she knew of Douglas' criminal activity in relation to the sale of D&S' securities.

 Throughout the period that D&S was in business, Douglas diverted approximately $ 2,000,000 in funds that D&S had obtained from investors to satisfy his own personal expenses. Moreover, in classic pyramid scheme fashion, Douglas was taking the monies supplied by new investors and giving those funds to earlier investors with the false representation that the distributions were trading profits. In actuality, Douglas was losing money, not making profits, as he claimed. The bottom line result of Douglas' activity was that D&S did not have enough money to satisfy its then anticipated obligations under the Illinois and Wisconsin rescission offers which were still outstanding.

 The accumulation of Douglas' activities resulted in a meeting on or about June 1, 1988, in which Weiss, Douglas, and attorneys from SMB agreed that, due to D&S' legal problems, D&S should be liquidated and the investors' money returned. At that time, Douglas informed his attorneys that he intended to "stay in business." Before returning the investors' money, however, Douglas met with Weiss and attorneys from R&S to obtain advice on how he could continue to raise money from investors to continue trading. In or about late September 1988, Douglas sent checks to all D&S investors in amounts purporting to represent the investors' principal plus trading profits. Unfortunately for the investors, there were no trading profits.

 Instead, the money to fund the liquidation came from another Douglas entity, AT Systems, which was a new trading partnership engaged in activities similar to D&S. Douglas created Analytic Trading Systems, Inc. in August, 1988 to be the general partner of AT Systems. Douglas was the corporation's original president and registered agent. Weiss and R&S knew that AT Systems could not lawfully engage in the sale of securities if Douglas continued as president, owner, and registered agent of Analytic Trading Systems, Inc. Nevertheless, in September, 1988, Weiss and R&S began restructuring Analytic Trading Systems, Inc. and AT Systems with the purpose and objective of making AT Systems viable as a vehicle for the sale of securities.

 To further this end, Weiss and R&S advised Douglas that he could not be officially associated with AT Systems without having to disclose his criminal record. Therefore, Weiss and R&S advised Douglas to distance himself from AT Systems. To achieve this objective, Douglas, Weiss and R&S decided to install Robert Minervino ("Minervino") as president and sole shareholder of Analytic Trading Systems, Inc. and Norman Rothenbaum, an R&S attorney, as registered agent. Minervino had been hired by Douglas from a temporary employment agency and was performing clerical work for Douglas. Minervino continued to perform clerical work even after he became Analytic Trading Systems, Inc.'s president. Weiss and R&S knew that Minervino was unqualified to act as the president and that he had not paid anything for his stock in the company. Weiss and R&S also knew that Douglas was still running AT Systems and Analytic Trading Systems, Inc. In fact, these attorneys continued to consult Douglas, not Minervino, on decisions and matters relating to AT Systems.

 During this time, AT Systems was funded with money from new investors as well as monies previously invested by others in D&S. At no time were the securities of AT Systems registered with the Securities & Exchange Commission ("SEC"). Equally telling, the securities of AT Systems were not registered under the laws of the states in which they were being offered for sale.

 In connection with the sale of interests in AT Systems, Douglas prepared and mailed or delivered promotional materials to potential investors. These promotional materials made numerous fraudulent misrepresentations and omissions of material fact including, but not limited to, failure to disclose Douglas' criminal activities and convictions, failure to disclose the state and federal investigations of D&S, and failure to disclose in the promotional materials that the AT Systems securities were not registered. The AT Systems promotional material was relied upon by persons who invested in AT Systems.

 Thereafter, the complaint alleges that in or about March, 1989, due to perceived problems of Douglas' association with AT Systems, Weiss and R&S advised Douglas to form a new entity. Douglas, Weiss and R&S then created Analytic Trading Service, Inc. Analytic Trading Service, Inc. was to be the general partner of yet another new trading partnership, AT Service. R&S and Weiss performed the legal services in connection with the creation of this new trading partnership. *fn5" Once again, Douglas appointed Minervino and later Sharon Hidaka ("Hidaka"), as president and sole shareholder of AT Service. Hidaka was a client of R&S. As was the practice with AT Systems and Analytic Trading Systems, Inc., R&S continued to consult Douglas, not Minervino nor Hidaka on decisions and matters relating to AT Service.

 Weiss and R&S knew that Douglas planned to recruit new investors and salespersons for AT Service in an illegal manner. These new investors and salespersons were recruited by concealing his criminal record, the state and federal investigations, and Douglas' inability to deal lawfully in securities. Nevertheless, Weiss and R&S prepared National Futures Association registration applications for some investors, including the LaVinkas, without disclosing to them what R&S knew about Douglas and the entities. For example, the securities of AT Service were not registered with the SEC nor under the laws of the states in which they ...


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