GFL Advantage Fund v. Colkitt

• Decision Date: 16 November 2001
• Docket Number: No. 00-2428,00-2428
• Citation: 272 F.3d 189
• Parties: (3rd Cir. 2001) GFL ADVANTAGE FUND, LTD., A BRITISH VIRGIN ISLANDS CORPORATION, v. DOUGLAS R. COLKITT DOUGLAS COLKITT APPELLANT
• Court: U.S. Court of Appeals — Third Circuit

Page 189

272 F.3d 189 (3rd Cir. 2001)

GFL ADVANTAGE FUND, LTD., A BRITISH VIRGIN ISLANDS CORPORATION, v. DOUGLAS R. COLKITT

DOUGLAS COLKITT APPELLANT

No. 00-2428

UNITED STATES COURT OF APPEALS FOR THE THIRD CIRCUIT

Argued October 9, 2001

Filed November 16, 2001

On Appeal from the United States District Court for the Middle District of Pennsylvania (No. 4:CV-97-0526) District Judge: Honorable James F. McClure, Jr. [Copyrighted Material Omitted]

[Copyrighted Material Omitted]

[Copyrighted Material Omitted] Peter S. Russ (argued), Gregory J. Krock, Buchanan Ingersoll, One Oxford Centre, 20th Floor 301 Grant Street Pittsburgh, PA 15219-1410, for Appellee.

Peter Konolige, Marcy L. Colkitt & Associates, P.C., 983 The Woods, Suite 618 Old Eagle School Road Wayne, PA 19087, and James P. Kimmel, Jr. (argued), P.O. Box 1139 Kennett Square, PA 19348, for Appellant.

Before: Scirica, Greenberg and Cowen, Circuit Judges

OPINION OF THE COURT

Greenberg, Circuit Judge

This matter comes on before this court on defendant Douglas R. Colkitt's appeal from the district court's order for summary judgment in favor of plaintiff GFL Advantage Fund, Ltd. against Colkitt entered on April 25, 2000, and on appeal from an order entered on July 17, 2000, denying reconsideration of the April 25 order. For the reasons stated herein, we will affirm the orders of the district court.

I. BACKGROUND

A. FACTUAL HISTORY

Douglas Colkitt, who earned both his medical degree and MBA from the University of Pennsylvania in 1979, is the founder and majority shareholder of two small capitalization medical services businesses -- EquiMed, Inc. ("EquiMed") and National Medical Financial Services Corporation ("National Medical"). As of February 1996, Colkitt held 20,783,633 (73%) of EquiMed's 28,589,717 outstanding shares of common stock, and as of May 1996, he owned 2.8 million (38%) of National Medical's 7,426,844 outstanding shares of common stock. See GFL Advantage Fund, Ltd. v. Colkitt, No. 4:CV-97-0526, Memorandum and Order at 4 (M.D. Pa. July 17, 2000).

Beginning in 1996, Colkitt sought financing to pursue various business ventures unrelated to EquiMed and National Medical. After unsuccessfully attempting to secure financing from traditional commercial lending institutions, Colkitt contacted alternative lenders that might be willing to structure "convertible or exchange transactions," whereby Colkitt would be able immediately to convert his vast stockholdings into cash. In particular, Colkitt endeavored to borrow money by pledging his common stock as collateral and providing the lender with the right to convert or exchange the debt for the shares pledged by Colkitt.

In the spring of 1996, Colkitt's broker identified GFL Advantage Fund, Ltd. ("GFL") as a possible lender, and on May 24, 1996, Colkitt obtained a loan of $3,000,000 from GFL. Under the terms of the note ("National Medical note"), GFL had the right after 30 days of the date of the note to exchange up to $1.5 million of its outstanding principal for shares of National Medical stock held by Colkitt at an exchange rate of 82% of the average market price. GFL could exchange the remainder of the unpaid balance for shares of National Medical 60 days after the date of the note. The average market price was computed by taking the average of the stock's closing prices for the five days immediately prior to the exchange request. In essence, the note gave GFL the right to require Colkitt to repay the loan with National Medical stock valued at a discount of 18% of the five-day average closing price, thus giving GFL an immediate paper profit as it would receive stock with a premium value to repay a debt of a lesser amount.

Several months later on August 5, 1996, Colkitt entered into a similar transaction with GFL for a $10,000,000 loan. The structure of the second note ("EquiMed note") was akin to that of the National Medical note, except the parties agreed that GFL could convert the debt into shares of Colkitt's other business, EquiMed, Inc., at an exchange rate of 83% of the average market price. In addition, GFL could convert up to $5 million of the outstanding principal after 60 days of the date of the note and could convert the balance of the principal 30 days thereafter.

Nearly four months after issuing the initial $3,000,000 loan to Colkitt, GFL made its first of six exchange demands for National Medical stock. On September 13, 1996, GFL exchanged $250,000 of debt for 34,130 shares of National Medical stock at the average market price of $9.20 and an exchange or conversion price of $7.32. On September 19, 1996, GFL exchanged $135,000 of loan principal for 18,726 shares at an average market price of $9.075 and a conversion price of $7.21. On October 10, 1996, GFL converted $257,000 of debt into 47,081 shares at an average closing price of $6.925 and a conversion price of $5.46. On December 5, 1996, GFL exchanged $100,000 of unpaid principal for 14,845 shares at an average market price of $8.725 and an exchange price of $6.74. On December 19, 1996, GFL converted $200,000 of debt into 34,588 shares at an average market price of $7.525 and a conversion price of $5.78. Finally, on January 7, 1997, GFL demanded an exchange of $545,000 of loan principal for 100,223 shares, but the request was withdrawn after Colkitt dishonored GFL's earlier exchange demand for EquiMed stock.

GFL waited until November 1996, more than 3 months after the date of the EquiMed note, before making its first exchange demand for EquiMed shares. On November 27, 1996, GFL demanded that Colkitt convert $560,000 in outstanding principal into EquiMed stock. With a five-day average closing price of $4.50, GFL received 150,555 shares of EquiMed at an exchange rate price of $3.72. GFL's next exchange demand for EquiMed stock occurred on January 3, 1997, when GFL sought to convert $1,430,000 in unpaid principal, but Colkitt dishonored the request.

Unknown to Colkitt at the time, and on the same day in September 1996 as GFL's first exchange demand for National Medical stock, GFL began short selling National Medical stock. As we have explained:

Short selling is accomplished by selling stock which the investor does not yet own; normally this is done by borrowing shares from a broker at an agreed upon fee or rate of interest.... The short seller is obligated, however, to buy an equivalent number of shares in order to return the borrowed shares.... Herein lies the short seller's potential for profit: if the price of stock declines after the short sale, he does not need all the funds to make this covering purchase; the short seller then pockets the difference. On the other hand, there is no limit to the short seller's potential loss: if the price of the stock rises, so too does the short seller's loss, and since there is no cap to a stock's price, there is no limitation on the short seller's risk.

Zlotnick v. Tie Communications, 836 F.2d 818, 820 (3d Cir. 1988). See also 17 C.F.R. S 240.3b-3 (defining short sale as "any sale of a security which the seller does not own or any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller"); Black's Law Dictionary 1339 (7th ed. 1999) (defining short sale as the "sale of a security that the seller does not own or has not contracted for at the time of sale, and that the seller must borrow to make delivery"). In other words, short sellers are betting that the stock price will decline between the time they sell the borrowed stock and the time they must "cover," i.e., purchase replacement shares to repay the borrowed stock. Short selling, which is closely regulated, see, e.g., 17 C.F.R. S 240.10a-1, is a legitimate trading strategy for stocks that traders believe are overvalued.

GFL's first short sale of National Medical stock occurred on September 13, 1996, when it sold 32,500 shares at a price of $10.00 per share. On September 16, 1996, GFL sold short 15,000 shares of National Medical at $9.13 per share. On September 17, 1996, GFL sold short 5,000 shares at $9.25 per share. On October 11, 1996, GFL sold short 3,000 shares at $8.25 per share. Finally, on October 14, 1996, GFL sold short 7,000 shares of National Medical at $8.25 per share. GFL sold short a total of 62,500 shares of National Medical stock over a one-month period.

GFL also sold EquiMed shares short. On November 8, 1996, GFL sold short a total of 18,400 shares of EquiMed -- 10,000 shares at $5.50 per share and 8,400 shares at $5.48 per share. On November 11, 1996, GFL sold short 32,500 shares at $5.38 per share. On November 12, 1996, GFL sold short 16,000 shares at $5.25 per share. On November 14, 1996, GFL sold short 8,500 shares at $5.25 per share. Finally, on November 22, 1996, GFL sold short 3,300 shares of EquiMed stock at $5.00 per share. Over this two-week period in November 1996, GFL sold short a total of 78,700 shares of EquiMed stock.

GFL explains that it engaged in short sales of National Medical and EquiMed stock as a hedging strategy against "delivery risk." Under the terms of the notes, the exchange price was based on the average closing price during the five trading days preceding the exchange request. Consequently, the exchange price was locked in on the date of the exchange request, thus shifting onto GFL the risk that the stock's price would drop more than the 17% or 18% discount. In other words, "if the stock price dropped more than the agreed-upon discount before GFL was able to sell the exchanged shares, GFL would be in a loss position." Br. of Appellee at 7. GFL claims it sold short to protect itself in the event that the price of the stock declined further after GFL made the exchange request but before GFL was able to sell the shares.

The theory of Colkitt's case, however, is that GFL sold National Medical and EquiMed shares short in an effort to depress the prices of the stocks. Indeed, Colkitt contends that the market price of National Medical...