The opinion of the court was delivered by: Judge Blanche M. Manning
This is a case about alleged fraud in the sale and transfer of securities. After this court granted the defendants' motion to dismiss the Corrected Amended Complaint ("CAC") in part and allowed the plaintiffs to replead, the plaintiffs filed a Second Amended Complaint ("SAC"). The plaintiffs, Carl Greer and Thomas Floyd, allege that they purchased stock in a company called Pixelon, Inc. on the advice of defendants Keith Daubenspeck and Dwight Badger, two officers at defendant Advanced Equities, Inc. ("AEI"). According to the SAC, the defendants induced Greer and Floyd to invest money through AEI "knowing all the while that Pixelon management was crooked and its financials fraudulent."
As in the CAC, the SAC includes three counts under federal securities laws: Count III alleges a violation under Section 12(a)(2) of the Securities Act of 1933 and Counts IV and V allege violations under Section 10(b) of the Securities Exchange Act of 1934. The remaining three counts allege state law claims for breach of contract, breach of fiduciary duty, and common law fraud. Again, the defendants have moved to dismiss the federal securities law counts on the ground that they are not pleaded with sufficient particularity. The defendants further move to dismiss the state law claims on the ground that the court should decline to exercise supplemental jurisdiction given the failure of the federal claims. For the reasons stated below, the motion to dismiss is granted.
The plaintiffs' well-pled allegations are accepted as true. In the fall of 1999, the defendants' salesman, Paul Wilkowski, contacted the plaintiffs to become AEI's customers. Daubenspeck, Badger, and AEI ultimately advised the plaintiffs on investment opportunities and they relied on this advice to invest a total of $4,083,345 in several opportunities, including Pixelon, Inc.
Wilkowski told the plaintiffs that Pixelon was an up-and-coming company and its founder, David Stanley, had developed a special technology that would be the first to provide "TV-quality internet broadcasts." According to the plaintiffs, Wilkowski also told them that AEI was "significantly involved with Pixelon" and they planned to have several AEI members on Pixelon's board. In addition, Daubenspeck, Badger and Wilkowski told the plaintiffs that AEI had worked with Pixelon for several months and had access to the company's books and records. Daubenspeck and Badger told Greer that they invested in Pixelon, and they urged Greer and Floyd to do the same.
On August 25, 1999, AEI issued an Amended and Restated Private Placement Memorandum ("Placement Memorandum") to solicit investors to purchase Pixelon Series A Preferred Stock. The Placement Memorandum stated that the offering was intended to raise $20,650,000, which would finance Pixelon's operations through approximately June 1, 2000. The original offering, however, only raised $18,172,000. (SAC ¶ 48.) The Placement Memorandum also stated that they would launch Pixelon in October 1999 with a concert that would cost $7,000,000. In addition, the Placement Memorandum restated Stanley's role within Pixelon and in developing its technology. The plaintiffs later discovered that Stanley was a convicted embezzler and fugitive. Moreover, in May 2000, Pixelon admitted that its technology was merely an adaptation of a common Windows Media Player program.
Before that, however, on October 22, 1999, Greer purchased 1,080,000 shares of Pixelon Series A Preferred Stock for $1,890,000 and Floyd purchased 30,000 shares of Pixelon Series A Preferred Stock for $52,500. The plaintiffs allege that neither Greer nor Floyd knew about Pixelon's technology or Stanley's criminal history.
Later, in November 1999, Wilkowski approached Greer for more money. He asked Greer to consider lending Pixelon an additional $1,000,000, but Greer refused. A few days later, Wilkowski told Floyd that Stanley was going to be terminated.
On December 9, 1999, AEI issued a Supplement to the Placement Memorandum. In the Supplement, AEI requested an additional $21,500,000 to fund its operations through June 1, 2000. The Supplement revealed that: Pixelon's capitalization had changed; the launch event cost over $15 million instead of $7 million as initially stated; there were nine previously undisclosed material contracts; Stanley was terminated for mismanagement and had been awarded additional shares of stock than the amount disclosed in the Placement Memorandum; Pixelon was involved in litigation with various employees and several executives had resigned; and Pixelon borrowed an additional $3.55 million from investors in October and November 1999.
In December 1999, Greer and Floyd met with defendants about their investment in Pixelon. They told defendants that the Supplement's disclosures concerned them, and after Daubenspeck and Badger acknowledged plaintiffs' concerns, they promised to find ways to make Greer and Floyd whole. In September 2000, while the defendants indicated that they could not give the plaintiffs their money back, they proposed a consulting agreement that would allow the plaintiffs to recoup their money. According to the plaintiffs, in addition to compensating them for their initial investment, defendants' consulting agreement included the transfer of certain securities and equity interests to the plaintiffs in consideration for their not filing suit against the defendants. The plaintiffs allege that in addition to the fraudulent representations and omissions made to them to induce them to make their initial investment in Pixelon, the defendants did not perform their obligations under the consulting agreement.
Additional allegations will be discussed in the order as necessary.
Rule 12(b)(6) permits a motion to dismiss a complaint for failure to state a claim upon which relief can be granted. To state such a claim, the complaint need only contain a "short and plain statement of the claim showing that the pleader is entitled to relief." Fed. R. Civ. P. 8(a)(2). On a motion to dismiss under Fed. R. Civ. P. 12(b)(6), the court accepts the allegations in the complaint as true, viewing all facts, as well as any inferences reasonably drawn therefrom, in the light most favorable to the plaintiff. See Marshall-Mosby v. Corporate Receivables, Inc., 205 F.3d 323, 326 (7th Cir. 2000).
The Seventh Circuit has recently synthesized the relevant Supreme Court caselaw as follows:
So, what do we take away from Twombly, Erickson, and Iqbal? First, a plaintiff must provide notice to defendants of her claims. Second, courts must accept a plaintiff's factual allegations as true, but some factual allegations will be so sketchy or implausible that they fail to provide sufficient notice to defendants of the plaintiff's claim. Third, in considering the plaintiff's factual allegations, courts should not accept as adequate abstract recitations of the elements of a cause of action or conclusory legal statements.
Moreover, the Brooks court stated that the "plausibility requirement applies across the board, not just to antitrust cases." Id. However, the court should also take into consideration the complexity of the case when addressing whether a complaint alleges sufficient facts. See Limestone Dev. Corp. v. Village of Lemont, Ill., 520 F.3d 797, 803 (7th Cir. 2008) (amount of factual allegations required to state a plausible claim "will depend on the type of case" and "[i]n a complex antitrust or RICO case a fuller set of factual allegations than found in the sample complaints in the civil rules' Appendix of Forms may be necessary"). To be facially plausible, a plaintiff must plead factual content that "allows the court to draw the reasonable inference that the defendant is liable." Ashcroft v. Iqbal, 129 S.Ct. 1937, 1949 (2009).
Prior to beginning its analysis of the defendants' arguments, the court addresses several general arguments made by the defendants as to why the plaintiffs' SAC is deficient. Two of the defendants' bases for dismissal (that certain of the allegations are not material and that the plaintiffs have failed to plead loss causation with respect to the Rule 10b-5 claim) are set forth in footnote number 2 of their opening memorandum. In their reply brief, the defendants fault the plaintiffs for having failed to address these arguments and contend that the plaintiffs have forfeited their right to address them. See Reply at 5-6, Dkt. #51. However, arguments raised only in footnotes are forfeited. United States v. White, 879 F.2d 1509, 1513 (7th Cir. 1989)("[B]y failing to raise this issue other than by a passing reference in a footnote, [the defendant] has waived it."). As such, the court will not address these two arguments.
In addition, the defendants take issue with the assertions of a conspiracy, which were made for the first time in the plaintiffs' response to the motion to dismiss the SAC. The court addresses this argument in Section III.A.2. of this order.
Finally, the defendants argue that the plaintiffs' allegations that the defendants "knew of," or "should have known" that their representations were false or that they "condoned" unlawful conduct are too conclusory to credit. See Iqbal, 129 S.Ct. at 1951 ("It is the conclusory nature of respondent's allegations, rather than their extravagantly fanciful nature, that disentitles them to the presumption of truth."). The court agrees that the plaintiffs' allegations in this regard are not sufficiently supported by facts. The court addresses this issue in more detail under its discussion of scienter in Section III.B. of this order.
A. Count III--Section 12(a)(2) of the Securities Act of 1933, 15 U.S.C. § 77l
Section 12(a)(2) of the Securities Act of 1933, 15 U.S.C. § 77l, creates liability for any person who "offers or sells a security . . . by the use of any means or instruments of transportation or communication in interstate commerce or of the mails, [or] 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, in the light of the circumstances under which they were made, not misleading. . . ." The plaintiffs allege the defendants made numerous misleading statements and omitted numerous material facts in the Placement Memorandum and through oral communications when they offered and sold Pixelon Series A Preferred Stock. (SAC at 148-156).
1. Does Rule 9(b) apply to the 12(a)(2) claim?
As noted above, the defendants first argue that the plaintiffs have failed to plead the fraud alleged in the § 12(a)(2) claim with particularity as required under Fed. R. Civ. P. 9(b). The plaintiffs do not deny that Rule 9(b) applies to the § 12(a)(2) challenge; instead, they assert that their allegations meet the Rule 9(b) standard for specificity as related to the fraud allegations.
While not directly raised by the parties, the court notes that whether § 12(a)(2) claims are governed by Rule 9(b)'s specificity requirements is not a settled issue. While some courts have concluded that Rule 9(b)'s particularity requirement applies to § 12(a)(2) claims, other courts have rejected that conclusion on the ground that § 12(a)(2) imposes strict liability for misstatements in a prospectus or registration statement. Because neither fraud nor scienter is an element of a § 12(a)(2) claim, some courts have concluded that a plaintiff should not be required to plead what it need not prove. See, e.g., Brian Murray & Donald J. Wallace, You Shouldn't Be Required to Plead More Than You Have to Prove, 53 Baylor L. Rev. 783 (2001)("Baylor Law Review Article"), and cases cited therein. See also In Re Ulta Salon, Cosmetics & Fragrance, Inc. Securities Litigation, 604 F. Supp. 2d 1188, 1193 (N.D. Ill. 2009)("Such a 'pleading standard which requires a party to plead particular facts to support a cause of action that does not include fraud or mistake as an element comports neither with Supreme Court precedent nor with the liberal system of 'notice pleading' embodied in the Federal Rules of Civil Procedure.'")(citation omitted).
The Seventh Circuit has not spoken directly on the issue although its decision in Sears v. Liken, 912 F.2d 889 (7th Cir. 1990), has been construed, including by this court in its order on the defendants' motion to dismiss the Corrected Amended Complaint in the instant case, as affirming dismissal of a § 12(a)(2) claim because of the plaintiffs' failure to plead the claim with particularity under Rule 9(b). Some authority questions this interpretation of the Sears case. See Baylor Law Review Article at 795-98 ("The court offered no justification for why Securities Act claims should be subject to Rule 9(b) nor did it state that the plaintiffs had alleged fraud in the Securities Act claims."). See also In Re Ulta Salon Securities Litig., 604 F. Supp. 2d at 1993 (stating that the Seventh Circuit in Sears "was not asked to and did not determine that Rule 9(b) applies to § 11 and 12 claims even if those claims 'sound in fraud.'").
Regardless of how one interprets the holding of Sears, the court concludes that the allegations supporting the plaintiffs' § 12(a)(2) claim in this case are subject to the heightened pleading standard of Rule 9(b). As an initial matter, Rule 9(b) applies to all allegations of fraud, not just claims of fraud. Fed. R. Civ. P. 9(b)("In alleging fraud or mistake, a party must state with particularity the circumstances constituting fraud or mistake."). See also Borsellino v. Goldman Sachs Group, Inc., 477 F.3d 502, 507 (7th Cir. 2007)("Rule 9(b) applies to 'averments of fraud,' not claims of fraud, so whether the rule applies will depend on the plaintiffs' factual allegations").*fn1 Moreover, "because Rule 9(b) only excises deficient averments of fraud from a complaint (and does not provide an independent basis for dismissal), failure to satisfy Rule 9(b) does not necessarily sound a death knell." Siegel v. Shell Oil Co., 480 F. Supp.2d 1034, 1040 (N.D. Ill. 2007). Nevertheless, "if, while the [applicable] statute or common law doctrine doesn't require proof of fraud, only a fraudulent violation is charged, failure to comply with Rule 9(b) requires dismissal of the entire charge." Kennedy v. Venrock Assocs., 348 F.3d 584, 593 (7th Cir. 2003)(citations omitted).
Although § 12(a)(2) does not require allegations of fraud, the plaintiffs' allegations with respect to their § 12(a)(2) claim are in fact all based on alleged fraud. Specifically, the plaintiffs ...