The opinion of the court was delivered by: PAUL E. PLUNKETT
The Plaintiffs in this action are lenders claiming that they were fraudulently induced to make loans to two corporations, Marine Capital Group, Ltd. (Marine) and Dreamstreet Holsteins, Inc. (Dreamstreet), by means of misleading financial statements and information provided by Defendants Hartford Computer Group (Hartford) and its officer, Paul Graffia. Some of these misrepresentations related to the finances of a third company in which both Dreamstreet and Marine were shareholders, Hera Resources, Inc. (Hera). The amended complaint (Complaint) asserts claims under both RICO and the common law. The Court has jurisdiction both by reason of the RICO claim under 28 U.S.C. § 1331 and 18 U.S.C. § 1964(c) and by reason of diversity of citizenship under 28 U.S.C. § 1332.
Hartford and Graffia have moved to dismiss the Complaint, contending that (a) the Plaintiffs have failed to show the "pattern of racketeering activity" required for RICO liability; (b) the fraud claims are not alleged with the particularity required by Rule 9(b), Fed. R. Civ. P.; (c) the Defendants had no reason to know of certain alleged misrepresentations; (d) the alleged fraud did not cause the Plaintiffs' losses; and (e) the plaintiffs have not stated a claim for negligent misrepresentation.
According to the Complaint, Marine was a start-up company in the business of manufacturing floating fiberglass-reinforced docks, while Dreamstreet was in the business of selling investment syndications in Holstein dairy cattle and embryos. While it would be hard to imagine two more diverse businesses, Dreamstreet was a stockholder of Marine, and both businesses had investments in Hera, which was purportedly in the business of developing a natural gas lease in Colorado.
Marine needed money. In order to get it, Marine and Dreamstreet jointly entered into three loan transactions with the Plaintiffs. In May of 1987, they executed a promissory note to Hartford in the amount of $ 947,676.80. Hartford, through Graffia, resold the note in June to Plaintiff CIT Group/Equipment Financing, Inc. (CIT), receiving a broker's commission from CIT. Complaint P 5. In October of 1987, Dreamstreet and Marine again entered into a joint loan transaction with Hartford in the amount of $ 947,634, which Hartford, through Graffia, brokered to Plaintiff A.I. Credit Corp. (AI) in April of 1988. Hartford again received a commission from the lender, AI. (Compl. at P 17). In March of 1988, they entered into a third joint loan transaction with Plaintiff Mitsubishi Electronics America, Inc. (MELA) in the amount of $ 487,322.20. Again, Hartford, through Graffia, received a broker's commission from MELA. (Compl. at P 16.)
In November of 1989, Dreamstreet and Marine notified the lenders that their loans were in default. Marine filed a bankruptcy petition and Dreamstreet dissolved. After liquidating their collateral, Dreamstreet and Marine still owed $ 389,591.85 to CIT, $ 578,795.38 to AI and $ 240,341.38 to MELA. (Compl. at PP 20-22.) The Plaintiffs contend that Hartford and Graffia are liable to them because they participated in Dreamstreet and Marine's fraudulent scheme to induce them to make the loans.
I. Misrepresentation of Dreamstreet's Business and Assets
On or about February 27, 1987, Dreamstreet's auditors, Defendants Edwards, Williams, McManus, Ricciardelli, and Coffey, P.C., and Richard Frasier (all of whom have been dismissed from this suit), "acting in concert with Ralston, Graffia and [Hartford]," (Compl. at P 26), prepared and issued the audited financial statements of Dreamstreet for the fiscal years ending October 31, 1985 and October 31, 1986, (Compl. Ex. A), intending that they would be used to solicit loans from lenders such as the Plaintiffs.
The audit letter accompanying the financial statements stated that they fairly presented Dreamstreet's financial position in accordance with generally accepted accounting principles. (Compl. at P 27.)
This was false, because the 1986 statements misrepresented the value of certain assets including the value of Dreamstreet's "cattle notes receivable." They also failed to disclose that Dreamstreet's primary business was the investment syndication of Holstein dairy cattle and embryos, that its income derived almost exclusively from the sale of such syndications, that the Tax Reform Act of 1986 had eliminated the tax advantages of such syndications, and that many of the makers of notes given in connection with the purchase of interests in such syndications had defaulted or would soon default. A properly prepared audit would have raised significant doubt about Dreamstreet's ability to continue in business; these financial statements did not. (Compl. at PP 28-29. ) The Complaint alleges that Dreamstreet's auditors were aware that the financial statements were false and misleading, Compl. at P 30, but makes no such allegation as to Hartford or Graffia.
II. Inflation of the Value of Hera
Dreamstreet acquired a 20% interest in Marine on or about February 27, 1987, and agreed to provide loan guarantees to Marine of up to $ 2,000,000. Marine owned 28% percent of Hera's capital stock. Hera was in the business of developing a lease of natural gas reserves in Gunnison, Colorado known as the "Gunnison Lease." In May 1987, Dreamstreet and Hera entered into a joint venture agreement in which Hera agreed to sell Dreamstreet 50,000,000,000 cubic feet of natural gas from the Gunnison Lease and Dreamstreet agreed to execute a promissory note payable to Hera in the amount of $ 50,000,000. Dreamstreet also received an option to purchase 20% of the stock of Hera at a nominal price. (Compl. PP 31-34.)
Dreamstreet created a shell corporation, Dreamstreet Resources, Inc., to carry out the transaction. Dreamstreet Resources purchased 50,000,000,000 cubic feet of natural gas from Hera in exchange for a series of promissory notes in the face amount of $ 50,000,000. This "sale" of natural gas permitted Hera to increase the value of the Gunnison lease on its financial statement from the amount it originally paid for it, approximately $ 280,000, to the value of the lease's "proven reserves," a figure approximately one hundred times that amount. (Compl. PP 35-37.) By causing its shell subsidiary, Dreamstreet Resources, to carry out the transaction, Dreamstreet avoided having to include the $ 50,000,000 promissory notes on its financial statements, but could include in its assets the value of its 20% interest in Hera. Included in Hera's assets, of course, was the $ 50,000,000 receivable from Dreamstreet Resources.
On July 21, 1987, with the knowledge that they would be submitted to lenders on behalf of Dreamstreet and Marine, Graffia prepared the financial statements for Hera for the fiscal year ended June 30, 1987. (Compl. Ex. B.) The balance sheet listed as the company's greatest asset the $ 50,000,000 receivable from Dreamstreet Resources. These statements did not comply with generally accepted accounting standards and principles because they did not disclose the affiliation between Hera and Dreamstreet Resources, that the sale was a sham, and that on the date of the supposed transaction Dreamstreet Resources had not yet been incorporated. The financial statement misrepresented that Graffia was licensed as a C.P.A. by the state of Illinois and failed to disclose that Graffia was not a disinterested auditor, since he was engaged in brokering loans for Hera's shareholders, Dreamstreet and Marine. Graffia knew that Hera's 1987 financial statement and audit letter were false and materially misleading. (Compl. at PP 38-41.)
The false and misleading information contained in Hera's 1987 financial statement was incorporated in Marine's financial statement for the fiscal year ending June 30, 1987, prepared on or about August 14, 1987. The statement of assets listed the value of Marine's 28.57% investment in Hera at approximately $ 5.7 million, based on cost adjusted for undistributed earnings, but in a footnote gave the value of Hera's total assets as approximately $ 64 million and its net worth as approximately $ 48.3 million, following Hera's financial statement. (Compl. Ex. C.) Marine's financial statement also failed to disclose that Marine's investment in Hera was a related party transaction, that Hera's sale of gas was a sham, and that the financial statements relied upon information provided by Graffia, who was neither a C.P.A. nor a disinterested auditor. Had generally accepted accounting practices been followed, the financial statement would have disclosed a substantial doubt as to Marine's ability to continue in business. (Compl. PP 42-45).
In October 1987, Dreamstreet exercised its option to purchase 20% of Hera's stock. Dreamstreet's financial statement, prepared February 29, 1988 for the fiscal year ending October 31, 1987, Complaint Exh. D, also included the misleading information regarding Hera. Dreamstreet's 20% share of Hera was valued at approximately $ 9 million. A footnote to Dreamstreet's financial statement repeated Hera's balance sheet figures from Hera's 1987 financial statements. The 1987 statements again failed to disclose the weaknesses in Dreamstreet's position and business prospects. Had generally accepted accounting practices been followed, the financial statement would have disclosed a substantial doubt as to Dreamstreet's ability to continue in business. (Compl. PP 48-51.)
On August 15, 1989, Graffia prepared and issued audited financial statements for Hera as of June 30, 1988 and June 30, 1989. (Compl. Ex. E.) These had the same shortcomings as Hera's 1987 financial statement, and were likewise false and materially misleading, although the fifty million dollar receivable was marked down substantially. (Compl. at PP 53-56.)
III. Hartford and Graffia's Brokering Activities
In March of 1987, Hartford and Graffia, acting as loan brokers, solicited CIT on behalf of Dreamstreet and Marine and mailed it a copy of the 1986 Dreamstreet financial statements. Hartford and Graffia represented to CIT that Dreamstreet and Marine were borrowers with strong financial positions that met the creditworthiness standards of CIT. Relying on these representations, CIT purchased from Hartford the joint promissory note made by Dreamstreet and Marine. (Compl. PP 58-60.) After the purchase, Hartford and Graffia furnished CIT with copies of the 1987 financial statements for Hera, Dreamstreet and Marine, and Hera's 1988 and 1989 financial statements. CIT relied on these documents in determining that the borrowers were not in default. (Compl. P 61.) The Plaintiffs declare on information and belief that in August 1987 Graffia and Hartford similarly solicited and induced Multibank Leasing Corporation (which is not a party to this suit) to purchase from Hartford a repayment agreement executed by Dreamstreet and Marine in favor of Hartford, relying on these same financial statements. (Compl. PP 62-65.)
In February 1988, Graffia and Hartford approached MELA seeking a joint loan to Dreamstreet and Marine. Graffia and Hartford provided MELA with copies of the 1986 and 1987 Dreamstreet and Marine financial statements and the 1987 Hera financial statement. In reliance upon these documents, MELA made a loan to Dreamstreet and Marine in March 1988. Subsequently Graffia and Hartford provided MELA with the 1988 and 1989 Hera financial statements.
In February 1988, Graffia and Hartford approached AI and requested that it purchase a promissory note executed by Dreamstreet and Marine. As before, they "represented that Dreamstreet and Marine Capital were borrowers with strong financial positions that met the creditworthy [sic] standards required by [AI]." Al was provided with the 1986 and 1987 financial statements of both companies, and the 1987 Hera financial statement. AI purchased the promissory note, and thereafter Hartford and Graffia provided it with copies of the 1988 and 1989 Hera financial statements and audit letter. (Compl. at PP 70-73.)
The Complaint consists of nine counts. Counts I and II allege that Graffia and Hartford were brokers representing the Plaintiffs and owed them a duty of disclosure regarding the creditworthiness of Dreamstreet and Marine. Count I alleges this duty was breached fraudulently, Count II that it was breached negligently. Counts III and IV are directed at Graffia alone; they allege that he breached his professional duty as an accountant in preparing Hera's financial statements by making either fraudulent and knowing misrepresentations (Count III) or negligent misrepresentations (Count IV), knowing that they would be used to solicit loans from the plaintiffs and that the Plaintiffs would rely upon them. Counts V and VI assert claims against Dreamstreet and Marine's accountants, who have been dismissed from this suit. Count VII is a claim of fraud against the estate of John Ralston. Count VIII is a fraud claim directed against all Defendants.
Count IX is that familiar travelling companion of fraud suits, a civil RICO claim. The Plaintiffs allege that Dreamstreet and Marine constituted an association-in-fact RICO "enterprise" that engaged in a pattern of racketeering activity by using the mails to send copies of the false and misleading financial statements of Dreamstreet, Marine and Hera to the Plaintiffs, thus committing mail fraud. Hartford and Graffia's liability is predicated on their being associated with the enterprise and conducting or ...