Beck v. Cantor, Fitzgerald & Co., Inc., 84 C 10557.

• Decision Date: 19 November 1985
• Docket Number: No. 84 C 10557.,84 C 10557.
• Court: U.S. District Court — Northern District of Illinois
• Parties: Dennis BECK for himself and all others similarly situated, Plaintiffs, v. CANTOR, FITZGERALD & CO., INC., et al., Defendants.

621 F. Supp. 1547

Dennis BECK for himself and all others similarly situated, Plaintiffs, v. CANTOR, FITZGERALD & CO., INC., et al., Defendants.

No. 84 C 10557.

United States District Court, N.D. Illinois, E.D.

November 19, 1985.

COPYRIGHT MATERIAL OMITTED

Arthur Grebow, Edward Gartenberg, Antin, Stern, Litz & Grebow, Los Angeles, Cal., Michael Connelly, Edward Ruberry, John Mustes, Connelly, Ruberry & Mustes, Chicago, Ill., for plaintiffs.

Stephen A. Marshall, Martin J. Schwartz, Rubin, Baum, Levin, Constant & Friedman, New York City, Roger Harris, Mitchell Bryan, Altheimer & Gray, Donald Egan, Francis X. Grossi, Jr., Patrick J. Lamb, Katten, Muchin, Zavis, Pearl & Galler, Roger L. Longtin, Schuyler, Roche & Zwirner, Chicago, Ill., for defendants.

MEMORANDUM OPINION AND ORDER

ROVNER, District Judge.

Presently pending before this Court are the various motions of the defendants, Xonics, Inc. ("Xonics") and the individual Xonics defendants, Cantor, Fitzgerald & Co., Inc. ("Cantor, Fitzgerald") and Larry Friend, and Laventhol & Horwath ("Laventhol"), to dismiss plaintiff Richard Beck's First Amended Complaint for failure to state a claim upon which relief may be granted, pursuant to Fed.R.Civ.P. 12(b)(6), for failure to plead fraud with particularity, pursuant to Fed.R.Civ.P. 9(b), and for lack of pendent jurisdiction if the federal claims are dismissed. Defendant Laventhol has also moved to strike the allegations in paragraph 37 and the two paragraphs numbered 44, pursuant to Fed.R. Civ.P. 12(f), and for sanctions, pursuant to Fed.R.Civ.P. 11. Finally, after briefing was complete plaintiff moved for leave to file a surreply brief. These motions are granted in part and denied in part.

This case is a securities class action arising out of the sale through Cantor, Fitzgerald, a registered broker-dealer, of certain stock of Xonics to plaintiff Beck. The case involves an $8.8 million private placement by Cantor, Fitzgerald of 2 million shares of Xonics common stock to approximately 93 investors. Laventhol is the certified public accounting firm which audited Xonics' March 31, 1983 year-end financial statements. Although the allegations of the complaint are many and varied, the gist of the fraudulent scheme alleged is that the defendants induced Beck and the plaintiff class, which has yet to be certified, to purchase Xonics stock in February, 1983 with the representation that, although the stock being sold was then restricted and thus was not freely tradeable, the stock would be registered automatically with the Securities and Exchange Commission ("SEC") within four to five months and could then be resold at a substantial profit. Plaintiff alleges that the defendants concealed the fact that SEC registration was neither "automatic" nor "guaranteed" and that they would and did submit a proposed registration statement to the SEC which was not in accordance with generally accepted accounting principles and was, therefore, rejected.

Plaintiff seeks relief against all defendants for violation of Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder, and Sections 12(2) and 17(a) of the Securities Act of 1933 ("Securities Act"), 15 U.S.C. §§ 77l(2) and 77q(a), in Count I; for violation of the Racketeering Influenced and Corrupt Organizations Act of 1976 ("RICO"), 18 U.S.C. §§ 1961, et seq., in Count II; for common law fraud and negligence in Counts III and IV; for breach of fiduciary duty in Count V; and for civil conspiracy to violate the securities laws in Count VI.

Facts¹

In February, 1983, Xonics agreed with Cantor, Fitzgerald to place two million shares of Xonics stock through Cantor, Fitzgerald for sale to Accredited Investors as defined in Rule 501(a) of Regulation D of the Exchange Act. The stock was offered to plaintiff Beck in February, 1983. Xonics and Cantor represented to plaintiff orally and in writing that the stock was not registered under the Securities Act and could not be traded until registered with the SEC. Xonics and Cantor, Fitzgerald also represented that Xonics would file a registration statement with the SEC by late June or early July, 1983 and that approval by the SEC was "automatic" and "guaranteed." Plaintiff purchased 9,000 shares of Xonics stock on February 19, 1983 for $39,600.

During Xonics' fiscal year 1983, which began on April 1, 1982, Xonics spent substantial sums to improve certain of its existing product lines. Xonics treated some of these product enhancement costs as additions to capital in its third quarter report filed with the SEC and capitalized a total of $1.5 million of product enhancement costs in its Annual Report on Form 10-K. These costs should have been treated as expenses, and the capitalization of the product enhancement costs was not in accordance with generally accepted accounting principles. The effect of Xonics' accounting treatment was that Xonics reported a net income of $136,000 for fiscal year 1983 rather than a loss of approximately $1.3 million. Xonics capitalized certain of its product enhancement costs because Xonics' officers and directors wanted to reflect a positive net income and maintain or increase the market price of Xonics stock.

In connection with the sale of stock, Cantor, Fitzgerald and Xonics directors and officers distributed to plaintiff and other members of the class unaudited quarterly financial statements for the last three quarters of fiscal year 1983. Each defendant participated in the preparation and distribution of the financial reports, which were distributed, in part, through the United States mails.

Laventhol and the other defendants knew of Xonics' reasons for capitalizing the product enhancement costs, knew that the capitalization was not in accordance with generally accepted accounting principles, and knew that the various financial statements prepared during fiscal year 1983 did not fairly present Xonics' financial conditions. Subsequent to the February, 1983 sale of stock, Laventhol conspired with the other defendants to submit an S-1 Registration Statement to the SEC knowing or recklessly disregarding the fact that the fiscal year 1983 annual statements were not prepared in accordance with generally accepted accounting principles. When the defendants submitted the Registration Statement, they knew that there was a substantial likelihood that the SEC would prevent the Registration Statement from becoming effective.

At some time prior to November 10, 1983, the SEC informed Xonics that Xonics' treatment of its product enhancement costs as expenses rather than as additions to capital was not in accordance with generally accepted accounting principles and that Xonics' financial statements during fiscal year 1983 and the first quarter of fiscal year 1984 did not fairly present its financial position. To resolve its dispute with the SEC, Xonics announced on November 10, 1983 that it was restating its fiscal year 1983 financial statements as well as those for the first quarter of fiscal 1984. The effect of the restatement for fiscal 1983 was to change the reported net income of approximately $136,000 to a net loss of approximately $1.3 million. The effect of the change in the fiscal 1984 first quarter report was to increase the net loss by $800,000. On February 17, 1984, the same day that Beck instituted this lawsuit in the United States District Court for the Central District of California, Xonics filed its Chapter 11 petition for bankruptcy, which is now pending in the United States Bankruptcy Court for the Northern District of Illinois.

Plaintiff claims that these accounting practices were fraudulent and improper because the initially reported net figures created a falsely optimistic view of Xonics' performance and financial condition. Plaintiff further claims that when he and other class members purchased Xonics stock, they relied on the representations contained in the financial statements even though one of the financial statements, the fiscal year 1983 Report in Form 10-K, was not yet prepared when the Xonics stock was purchased.

On December 6, 1984, this case was transferred to this Court from the Central District of California after Judge Richard Gadbois granted Xonics' motion to transfer. The instant motions were filed shortly thereafter but not fully briefed until the summer of 1985.

Discussion

I. Rule 9(b) Motions

After reviewing the First Amended Complaint and all of the voluminous briefs filed by the parties, this Court agrees with the defendants that the First Amended Complaint fails to plead fraud with specificity as required by Rule 9(b). However, this Court is not convinced that plaintiff is not capable of stating a fraud claim at least against some of the defendants with sufficient particularity. Thus, plaintiff is granted leave to file a Second Amended Complaint within 30 days to cure this and other defects as set forth in this Opinion.

Because it is not the function of this Court to educate plaintiff's attorneys as to how to plead fraud with particularity, and because defendants have already pointed out the many deficiencies of the plaintiff's First Amended Complaint in this respect, this Court will not elaborate on those deficiencies except to note the following:

1) plaintiff has not identified the persons who made the alleged oral and written misrepresentations, the persons to whom the representations were made, the content of those misrepresentations, and where or when such misrepresentations were made, see, e.g., Rudolph v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 100 F.R.D. 807 (N.D.Ill.1984); Barr Co. v. Safeco Insurance Co. of America, 583 F.Supp. 248 (N.D.Ill.1984);

2) plaintiff has not adequately distinguished among the many defendants who are alleged to have participated in the fraud, see, e.g., Kennedy v. Nicastro, 503 F.Supp. 1116, 1122 (N.D.Ill.1980); Lincoln National Bank v. Lampe, 414 F.Supp. 1270,

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