Chase Manhattan Bank, NA v. Fidata Corp.

• Decision Date: 02 December 1988
• Docket Number: No. 87 Civ. 4844(PNL).,87 Civ. 4844(PNL).
• Citation: 700 F. Supp. 1252
• Parties: The CHASE MANHATTAN BANK, N.A., Plaintiff, v. FIDATA CORPORATION, et al., Defendants. FIDATA CORPORATION, et al., Counterclaim Plaintiffs, v. The CHASE MANHATTAN BANK, N.A., Counterclaim Defendant.
• Court: U.S. District Court — Southern District of New York

700 F. Supp. 1252

The CHASE MANHATTAN BANK, N.A., Plaintiff, v. FIDATA CORPORATION, et al., Defendants.

FIDATA CORPORATION, et al., Counterclaim Plaintiffs, v. The CHASE MANHATTAN BANK, N.A., Counterclaim Defendant.

No. 87 Civ. 4844(PNL).

United States District Court, S.D. New York.

December 2, 1988.

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Shereff, Friedman, Hoffman & Goodman, New York City (Barry L. Katz, of counsel), for counterclaim plaintiffs.

Kent T. Stauffer, The Chase Manhattan Bank, N.A., Litigation Div., Milbank, Tweed, Hadley & McCloy, New York City (Russel E. Brooks, of counsel), for counterclaim defendant The Chase Manhattan Bank, N.A.

OPINION AND ORDER

LEVAL, District Judge.

Counterclaim-defendant, the Chase Manhattan Bank, N.A., moves under Fed.R. Civ.P. Rules 9(b) and 12(b)(6), to dismiss the counterclaims for failure to plead fraud with particularity and failure to state a claim upon which relief can be granted. Counterclaim-plaintiffs, Fidata, FTC and FSMI, move under Fed.R.Civ.P. Rule 15(a) to amend the counterclaims.

BACKGROUND

The counterclaim-plaintiffs are Fidata — a banking organization incorporated under the laws of Delaware, its affiliate FTC—a New York trust company engaged in the business of providing securities clearance services in the government and municipal obligations market, and FSMI—a wholly-owned subsidiary of Fidata. They are referred to collectively as "FTC." Counterclaim-defendant Chase is a national banking organization organized under the laws of the United States, 12 U.S.C. § 27.

The counterclaim centers upon the trading activities in government securities of ESM, a financial institution placed in bankruptcy after its fraudulent conduct was revealed in March 1985. ESM engaged in a specialized form of borrowing known as a "repo" or "term repo." This is a transaction having the economics of a loan collateralized by pledge of a government security, presented in the form of a purchase (by the lender) of the government security with an agreement that the seller (borrower) will repurchase the security (repay the loan) at a specified time and price. Apparently, as explained more fully below, ESM was defrauding its lenders by double hypothecation of the government security it used in repo transactions. ESM is not named in this action. From 1981 through March 4, 1985, FTC operated as a clearing bank for ESM. Prior to 1984, Chase also provided clearing services for ESM.

FTC filed counterclaims against Chase on October 26, 1987 as part of its amended answer. The counterclaims asserted claims under the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78a et seq., the Racketeer Influenced Corrupt Organization Act, 18 U.S.C. § 1961 et seq., and state law. Subsequently, FTC filed amended counterclaims which add a claim for breach of warranty under § 8-306 of the New York Uniform Commercial Code and charge a somewhat different theory of recovery for securities and common law fraud.¹

The amended counterclaims allege that in the period commencing prior to 1982 and continuing through March 4, 1985, ESM engaged in a massive scheme to defraud in the repo market involving double hypothecation. ESM engaged in transactions known in the trade as "reverse repos" which were term repos seen from the perspective of the lender. ESM would loan funds against collateral of a government security and the borrower's agreement to repurchase the security. ESM held the pledged securities at one of its clearing banks. ESM then used the securities it received in reverse repo transactions as collateral for its borrowings under term repo agreements.² Delivery of the security to the lender, or "contra" party under its term repo borrowing would be accomplished by a book entry rather than by physical delivery. ESM represented to the contra parties that the securities would be placed in a segregated account. But, rather than place these hypothecated securities in a segregated account, ESM maintained them in its clearance account. It then used them a second time as collateral for loans it obtained from its clearing bank.

From 1981 through March 4, 1985, FTC operated as a clearing bank for ESM. In that period, ESM obtained loans from FTC using as collateral the securities already hypothecated to repo lenders. FTC extended credit to ESM on virtually a daily basis under a General Clearance, Draft Receivable Financing and Security Agreement dated September 18, 1981. By March 4, 1985, ESM was indebted to FTC in an amount in excess of $38 million for advances made under the Clearance Agreement and FTC held approximately $50 million of U.S. government and other securities.

Chase also provided clearing services to ESM from 1981 to 1983. As with FTC, ESM borrowed substantial sums from Chase using securities as collateral which it had already pledged to repo lenders. The counterclaim alleges that Chase knew that ESM's business consisted primarily of repos and reverse repos; that, following the collapse of Drysdale Government Securities, Inc. in 1982, Chase became wary of doing business with government securities dealers; and that, as a result, Chase audited ESM to determine whether it was solvent and operating in a legal manner. FTC alleges no later than the spring or early summer of 1983 Chase knew that the securities used as collateral for the loans from Chase were also pledged to repo participants and that ESM's lenders expected the securities pledged to them to be segregated and held free of any other lien.

In the spring of 1983, Chase also requested audited financial statements from ESM's parent corporation, ESM Group, Inc.; although ESM did not provide audited financial statements to Chase, it did provide unaudited financial statements.

In June 1983, Chase agreed to allow ESM to unwind its position with Chase without disclosing ESM's wrongful practices. Rather then the usual 30 days, Chase gave ESM 90 to 120 days to unwind the transactions in its clearing account at Chase. FTC alleges that Chase not only failed to disclose its knowledge of ESM's fraudulent activities, but also agreed to keep secret its real reasons for terminating ESM. Specifically, on July 1, 1983, Chase sent ESM a letter stating that Chase had "decided to discontinue this clearing service at this time." An internal Chase memorandum recording a conversation with Alan Novick, President of ESM, and appended to the original counterclaims (but not to the amended counterclaims) states: "We informed Alan that our current GNMA processing procedure needed to be revamped for better management and accounting control. To further explain our position, we pointed out the fact that his borrowing patterns and the use of customer's securities as collateral were not what we would consider a normal clearing transaction.... Handle in very low key, fashion as not to create rumors on the street (concern of A. Novick)." When Chase finally closed out ESM's account, it delivered the securities to the General Clearance Account at FTC without disclosing ESM's fraudulent activities to FTC.

The counterclaims allege that Chase decided to terminate its relationship with ESM because, had ESM's fraud become known, Chase's claim to the securities collateralizing its loans would have been challenged by the prior pledgers. Had Chase disclosed to FTC its true reason for terminating ESM, and not given ESM special consideration enabling it to stay in business, ESM would have been unable to perpetrate its fraud on FTC.

The counterclaims further allege that after Chase terminated its relationship with ESM and through 1985, Chase had actual knowledge that FTC cleared for ESM and that FTC relied on securities pledged by ESM as collateral for loans by FTC. Until the time of ESM's collapse, Chase acted as agent for ESM repo lenders without informing them or FTC that their securities would not be placed in a segregated account. From 1974 to 1981, Chase provided loans to FSMI (then known as Bradford Securities Processing Services, Inc.) collateralized in part by securities maintained by ESM in accounts at Bradford. Moreover, in May 1982, Chase agreed to provide overnight financing to ESM for government securities held by FTC. FTC alleges that Chase knew of ESM's false representations to FTC and that Chase had a duty to disclose to FTC by virtue of its business relationship with FTC, its business with FTC as agent for customers of ESM, and its knowledge of FTC's reliance on ESM.

Upon these facts, FTC predicates counterclaims for primary violations of, aiding and abetting, and conspiracy to violate section 10(b) of the Exchange Act, 15 U.S.C. § 78j, and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, violations of the Racketeer Influenced Corrupt Organizations Act ("RICO"), 18 U.S.C. § 1962(a), (c), (d), and common law fraud, recklessness, gross negligence, common law negligence, and breach of warranty under N.Y.U.C.C. §§ 8-306(2), (3), (4).

Chase moves to dismiss under Fed.R. Civ.P. 9(b) and 12(b)(6). It argues that plaintiff has failed to allege any actionable misrepresentation and that its alleged failure to disclose was not compelled by any duty and was too remote to serve as a basis for secondary liability. For these reasons, it contends that the action must be dismissed under Fed.R.Civ.P. 9(b) for failure to plead fraud with particularity and under Fed.R.Civ.P. 12(b)(6) for failure to state a claim upon which relief can be granted.

DISCUSSION

On a motion to dismiss under 12(b)(6), the court must accept all of plaintiff's well-pleaded allegations and all reasonable inferences therefrom. Hishon v. King & Spalding, 467 U.S. 69, 73, 104 S.Ct. 2229, 2232, 81 L.Ed.2d 59 (1984); Yoder v. Orthomolecular Nutrition Institute, Inc., 751 F.2d 555, 558 (2d Cir.1985). A complaint must not be dismissed unless it appears beyond doubt that the plaintiff can prove no set of facts in support of its claim which would entitle him to relief. Conley v....