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Wert v. Cohn

United States District Court, N.D. Illinois, Eastern Division

September 1, 2017

LAWRENCE J. WERT, RICHARD D. KINCAID, and JAMES O. MYERS, individually and derivatively on behalf of Ditto Holdings, Inc. Plaintiffs,
v.
STUART COHN, ZVI FEINER, DAVID JONATHAN ROSENBERG, and AVI FOX, Defendants.

          MEMORANDUM OPINION AND ORDER

          MATTHEW F. KENNELLY, DISTRICT JUDGE

         Lawrence Wert, Richard Kincaid, and James Myers, all shareholders of Ditto Holdings, have sued members of Ditto Holdings' board of directors and its general counsel in connection with alleged mismanagement, fraud, and concealment of the company's finances and operations. Plaintiffs allege that they invested additional funds and retained their initial investments in Ditto based on defendants' misrepresentations and omissions regarding the company's financial condition. Plaintiffs also allege that defendants knew or should have known that directors Joseph and Avi Fox were engaged in practices that constituted financial mismanagement of Ditto, breach of fiduciary duty, and corporate waste.

         Specifically, Myers has sued Cohn under sections 10(b) and 20(a) of the Securities Exchange Act and Securities and Exchange Commission (SEC) Rule 10b-5 for fraud in connection with Myers's purchase of shares of Ditto stock (Count 1 of the amended complaint). Plaintiffs have brought additional state law claims against defendants for corporate waste (Count 2), breach of fiduciary duty (Count 3), fraudulent misrepresentation (Count 4), fraudulent concealment (Count 5), and negligent misrepresentation (Count 6). Lastly, plaintiffs have sued Cohn for legal malpractice (Count 7). Plaintiffs bring the corporate waste claim solely on a derivative basis, the breach of fiduciary duty, negligent misrepresentation, and legal malpractice claims both individually and on a derivative basis, and the fraudulent misrepresentation and concealment claims solely on an individual basis.

         Defendants Stuart Cohn, Zvi Feiner, David Rosenberg, and Avi Fox each have moved to dismiss plaintiffs' amended complaint on numerous grounds. For the reasons stated below, the Court denies defendants' motions to dismiss, except for with respect to the derivative claims in Counts 2, 3, 6, and 7, which are dismissed with leave to amend.

         Background

         The Court takes the following factual allegations from plaintiffs' amended complaint. Plaintiffs are shareholders of Ditto Holdings, Inc. Ditto (later renamed SoVesTech, Inc.) is a Delaware corporation that owns 100% of Ditto Trade, Inc. (previously FB Securities Corp.), a securities broker-dealer registered with the SEC.

         Defendants are current or past officers or directors of Ditto. Cohn was Ditto's general counsel from its incorporation in 2010 until at least January 2016. He also was the company's original secretary. Avi Fox was one of the original members of Ditto's board of directors, along with his brother Joseph Fox, who is not named as a defendant in this lawsuit. In addition to serving as Ditto's chief compliance officer, Rosenberg became a member of the board in 2012. It is unclear if he has since left the board and when. Feiner has been a member of the board since 2013. It is also unclear if and when Feiner has left the board.

         In July 2013, Paul Simons joined Ditto's board. Upon review of Ditto's records in preparation for an investor meeting, Simons became aware of a number of expenditures, transactions, and accounting irregularities that raised concerns about corporate mismanagement. Simons outlined his concerns in a September 2013 letter to his fellow board members. He enumerated the following suspect transactions between the period of January 2012 through July 2013:

• payments of approximately $170, 000 to Joseph Fox's son, Jorden Fox, for rent, legal expenses, and the production of "Savaged the Movie";
• other payments to Joseph Fox and other Fox family members with no indicated or apparent business purpose;
• charges and cash withdrawals of almost $46, 000 at various Las Vegas resorts and casinos for which Ditto did not have an apparent business purpose; and
• payments totaling $15, 000 to a company owned by Cohn's son.

         Simons's letter also raised concerns about Joseph Fox's 2013 sale of his own shares of stock at prices different from the price offered by Ditto, the company's failure to file tax returns since its incorporation, and the lack of appropriate internal controls or systems to record transactions.

         Simons was removed from the board shortly after he sent the letter. Ultimately, the board of directors approved the use of company funds to sue him for defamation. Feiner replaced Simons on the board. Also in September 2013, the Financial Industry Regulatory Authority (FINRA) opened an investigation into the issues raised in Simons's letter. Ditto retained an outside law firm, Goldberg Kohn, to investigate the allegations in Simons's letter. Goldberg Kohn issued its final report to Ditto in January 2014.

         Joseph Fox told Goldberg Kohn during its investigation that the payments to his family members were either advances under his employment agreement[1] or were draws against a line of credit extended to him by Ditto in consideration of his personal guaranty of investor loans and stock purchases. Goldberg Kohn accepted this explanation for the payments. Nonetheless, the Goldberg Kohn report concluded that Ditto had been operating on an "ad hoc undisciplined, nontransparent basis." Am. Compl. ¶ 70 (quoting Ex. B, at 6-8). The report further stated, "we do not condone operating a business in the manner in which it has been run to date, " and it made several recommendations to help Ditto establish and comply with good corporate practices. Id. ¶ 71 (quoting Ex. B, at 8).

         A February 2, 2014 email, signed by Rosenberg and Feiner and approved by Cohn, notified shareholders of the board's receipt of the Goldberg Kohn report. A copy of the report was not attached to the email. The email stated that the report "does not find any dishonest business practices, nor did it find any misappropriation or misuse of company funds." Id. ¶ 73 (quoting Ex. C). The email did not mention the report's condemnation of Ditto's lack of discipline and transparency. The email also assured investors-falsely, plaintiffs allege-that Ditto had already adopted many of the improvements and controls recommended in the report. Additionally, the February 2014 email included as an attachment a cash flow statement for 2010 through 2013, which the email characterized as containing details from Ditto's consolidated income statement. The consolidated income statement itself was not attached to the email. Plaintiffs allege that the omitted consolidated income statement would have revealed information about losses that "likely would have caused concern for shareholders and given them significant pause before investing further in the company." Id. ¶ 78.

         Plaintiff Myers became interested in investing in Ditto at the end of 2014. On or about January 20, 2015, Myers met with representatives of Ditto in their Chicago office to discuss his potential investment. During this meeting, Myers asked Joseph Fox and Cohn to provide him with a summary of the concerns raised by Simons and Ditto's planned response to those concerns. Cohn also brought up the Goldberg Kohn report. Joseph Fox told Myers the report was not available but said he would be happy to answer questions about it. Myers contends that he was intentionally and falsely "led to believe by statements of Joseph and Cohn" that the Goldberg Kohn report provided no support for Simons's allegations of "financial malfeasance." Id. ¶ 105. Myers alleges that he was further misled during the meeting on whether Ditto had implemented any of the Goldberg Kohn report's recommendations. Acting in reliance upon these misrepresentations and omissions, Myers says, he purchased $25, 000 worth of Ditto stock in February 2015. He made additional purchases in March and April 2015.

         Myers alleges that did not begin to become aware of Ditto's problems until he obtained and read the Goldberg Kohn report in July 2015. At that time, Myers says, he realized that he had been misled about Ditto's operation and its true financial condition. When he later obtained a copy of a 2012-2014 audit of Ditto, Myers says that he came to understand the extent to which information about Ditto's finances had been misrepresented and concealed from him prior to his decision to invest.

         Plaintiffs allege that Ditto's persistent recordkeeping failures, defendants' issuance and approval of misleading emails to shareholders, and their failure to respond to calls for reform, among other failings, served to conceal and actively misrepresent the state of Ditto's operations and finances through 2015. For example, plaintiffs contend that defendants approved another intentionally misleading email from Joseph Fox to shareholders on September 16, 2015. Joseph Fox sent this September 2015 email shortly after the SEC issued orders finding that Joseph and Ditto had violated the Securities Act by selling securities without having filed a registration statement. According to plaintiffs, the email was misleading in its characterization of both the seriousness and the scope of the SEC's findings.

         Concerned about Ditto's apparent misappropriation of shareholder funds, near the end of 2015, Wert hired an attorney to review Ditto and draft a letter detailing its ongoing problems and demanding significant changes to its structure and business operations. Plaintiffs allege that Ditto did nothing in response. Less than a month later, Joseph Fox informed shareholders that he was shutting down Ditto Trade, Ditto's subsidiary, because it was insolvent.

         At present, Ditto's applications for patents on its proprietary trading technology are the only remaining assets of any value. Due to inaction on the defendants' part, however, the U.S. Patent and Trademark Office has since classified the most valuable of these patents as abandoned. Plaintiffs allege that Ditto stock is currently "worthless." Id. ¶ 143.

         Discussion

         The Court will begin by addressing defendants' challenges to Count 1, the sole claim under federal law, before moving on to the state law claims (Counts 2 through 7).

         A. Rule 10b-5 securities fraud claim (Count 1)

         Cohn seeks dismissal of Count 1, Myers's claim under SEC Rule 10b-5. Cohn argues that Count 1 fails to state a claim and that it is time-barred.

         1. Failure to state a claim

         On a motion to dismiss for failure to state a claim, the Court accepts the factual allegations in the amended complaint as true and draws reasonable inferences in favor of the plaintiff. Alamo v. Bliss, 864 F.3d 541, 548-49 (7th Cir. 2017). A claim is plausible on its face and thus survives a motion to dismiss "when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged." Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009). Where the plaintiff alleges fraud, as in this case, Federal Rule of Civil Procedure 9(b) requires the plaintiff to "state with particularity the circumstances constituting fraud." Gandhi v. Sitara Capital Mgmt., LLC, 721 F.3d 865, 869 (7th Cir. 2013) (quoting Fed.R.Civ.P. 9(b)). The level of particularity required depends on the facts of the case; typically, however, Rule 9(b) requires a description of the "who, what, when, where, and how" of the fraud. AnchorBank, FSB v. Hofer, 649 F.3d 610, 615 (7th Cir. 2011) (quoting Pirelli Armstrong Tire Corp. Retiree Medical Benefits Tr. v. Walgreen Co., 631 F.3d 436, 441-42 (7th Cir. 2011)). In addition, the Private Securities Litigation Reform Act (PSLRA) requires a securities fraud complaint to "specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed" and "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." ABN AMRO, Inc. v. Capital Int'l Ltd., 595 F.Supp.2d 805, 834 (N.D. Ill. 2008) (quoting 15 U.S.C. § 78u-4(b)(1)-(2)).

         Rule 10b-5 makes it unlawful, in connection with the purchase or sale of a security, "[t]o make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." 17 C.F.R. § 240.10b-5. To state a Rule 10b-5 claim, 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." Amgen Inc. v. Conn. Retirement Plans & Tr. Funds, 568 U.S. 455, 460-61 (2013). For mere silence to be actionable under Rule 10b-5, the defendant must be under an affirmative duty to disclose. Chiarella v. United States, 445 ...


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