LaSalle Nat. Bank v. Duff & Phelps Credit Rating Co.

Citation951 F.Supp. 1071
Decision Date26 November 1996
Docket NumberNo. 93 Civ. 4692 (WK) (AJP).,93 Civ. 4692 (WK) (AJP).
PartiesLaSALLE NATIONAL BANK, et al., Plaintiffs, v. DUFF & PHELPS CREDIT RATING CO. and Shawmut Bank Connecticut, N.A., Defendants.
CourtUnited States District Courts. 2nd Circuit. United States District Courts. 2nd Circuit. Southern District of New York

Alan R. Glickman, Schulte Roth & Zabel, New York City, for Plaintiffs.

Douglas M. Kraus, Skadden, Arps, Slate, Meagher & Flom, New York City, for Defendants.

MEMORANDUM AND ORDER

WHITMAN KNAPP, Senior District Judge.

Before us is an action brought by twenty-six institutional investors (plaintiffs), who purchased approximately $200 million of bonds offered by subsidiaries of Towers Financial Corporation in connection with its Ponzi scheme, against Duff & Phelps Credit Rating Co. ("defendant"), and Shawmut Bank Connecticut N.A. Defendant Duff & Phelps moved to dismiss plaintiffs' complaint. On June 19, 1996, Magistrate Judge Andrew J. Peck issued a Report and Recommendation recommending that we grant defendant's motion to dismiss plaintiffs' claim for aiding and abetting violation of the Racketeering Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. §§ 1962(c) and 1964(c), but deny as to the remaining claims.

Plaintiffs object to Judge Peck's recommendation that the RICO claim be dismissed; defendant objects to the recommendation that its motion to dismiss be denied as to the other claims. After listening to, and fully considering, the arguments advanced by both parties in support of their opposition to parts of Judge Peck's Report and Recommendation, and having subjected the arguments to de novo review, we are persuaded that Judge Peck reached the correct conclusions, with one slight variance.

With respect to plaintiffs' claim for common-law negligent misrepresentation, Judge Peck held that New York law should apply as opposed to Illinois law. However, he further concluded that plaintiffs' claim would survive defendant's motion to dismiss under either state's law for negligent misrepresentation. Finding this conclusion accurate, we reserve resolution on the choice of law question for future proceedings. See, e.g., Seldon v. Rabinowitz (S.D.N.Y.1989) 706 F.Supp. 13, 14 ("the choice of law issue ... need not be addressed because the Court concludes that the resolution of this motion would be the same under the law of either state").

Accordingly, we adopt Judge Peck's Report and Recommendation with the above noted modification as to the choice of law question, and grant defendant's motion to dismiss the claim for aiding and abetting violation of RICO, but deny its motion to dismiss the remaining claims.

SO ORDERED.

REPORT AND RECOMMENDATION

PECK, United States Magistrate Judge.

TO THE HONORABLE WHITMAN KNAPP, United States District Judge:

This is one of several actions pending in this Court arising out of the alleged Ponzi scheme involving Towers Financial Corporation. This particular action is brought by twenty-six institutional investors who purchased approximately $200 million of Bonds offered by Towers' Healthcare Subsidiaries. The defendants are Duff & Phelps Credit Rating Co., who rated the Bonds, and Shawmut Bank Connecticut N.A., the Bond Indenture Trustee. In summary, the complaint alleges that Duff & Phelps participated in Towers' Ponzi scheme by assigning the inflated rating of "AA" (or "AA+") to the Bonds. (Cplt. ¶¶ 9-10.) The complaint asserts four causes of action against Duff & Phelps: (1) violations of Section 10(b) of the Securities and Exchange Act of 1934, 15 U.S.C. § 78j(b) (1988), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5 (1994); (2) aiding and abetting violation of the Racketeering Influenced and Corrupt Organizations Act ("RICO"), 18 U.S.C. § 1964(c); (3) common law fraud; and (4) negligent misrepresentation.

Presently before the Court is Duff & Phelps' motion to dismiss the complaint pursuant to Fed.R.Civ.P. 12(b)(6). For the reasons set forth below, I recommend that Duff & Phelps' motion to dismiss be granted as to plaintiffs' RICO claim but denied as to the remaining claims.

FACTS

The various cases involved in the Towers litigation are more fully described in numerous prior decisions of this Court, three of which are particularly relevant to this decision and familiarity with which is assumed:

In re Towers Financial Corp. Noteholders Litigation, 93 Civ. 0810 (S.D.N.Y. May 30, 1996) (Report and Recommendation to grant Duff & Phelps' motion to dismiss the Noteholders complaint against it);

Lasalle National Bank v. Duff & Phelps Credit Rating Co., 93 Civ. 4692, 1996 WL 393212 (S.D.N.Y. March 11, 1996) (Report and Recommendation to deny Shawmut's motion to dismiss without prejudice to renewal after the close of discovery) (affirmed by Judge Knapp by Order dated April 9, 1996); and

In re Towers Financial Corp. Noteholders Litigation, 93 Civ. 0810, 1995 WL 571888 (S.D.N.Y. Sept. 20, 1995) (describing the allegations of the related Noteholder litigation; defined terms from this Report and Recommendation are used herein).

On a motion to dismiss, the Court must accept the well-pleaded allegations in the complaint as true. In re Towers, 1995 WL 571888 at *1 (citing Cosmas v. Hassett, 886 F.2d 8, 11 (2d Cir.1989)). This opinion will summarize the facts in the First Amended Complaint (the "complaint" or "Cplt.") as to Duff & Phelps without resort to the phrase "plaintiffs allege" before each statement from the complaint.

The Parties

The plaintiffs are LaSalle National Bank and 25 other institutional investors who purchased approximately $200 million in principal amount of Bonds issued by Towers' Healthcare Subsidiaries. (Cplt. ¶¶ 1, 12-37.)1

Defendant Duff & Phelps, a securities rating agency, rated the Bonds. (Cplt. ¶¶ 1, 5; Cplt. Ex. A at 16, 74.) Duff & Phelps is an Illinois corporation with its principal place of business in Chicago, Illinois. (Cplt. ¶ 39.) Defendant Shawmut served as the Indenture Trustee for the Bonds. (Cplt. ¶¶ 7-8, 38, 45.)

Although not named as a defendant, Towers Financial Corporation and its subsidiaries figure prominently in this action. Towers' principal place of business was New York City. (Cplt. ¶ 41.) Towers was engaged in acquiring and collecting healthcare receivables. (Id.) Towers issued the Bonds in question through five subsidiaries, Towers Healthcare Receivables Funding Corporations ("THRFC") I-V (collectively, the "Healthcare Subsidiaries" or the "Funding Corporations"). (Cplt. ¶¶ 3, 5, 44.) The combined amount of Bonds issued by the five Funding Corporations was $199,450,000.2

Towers' Receivables Program: How It Was Supposed to Work

The legal relationships among the respective Funding Corporations, Towers and the Providers were described in the Private Placement Memoranda ("Offering Memoranda") and were controlled by: (1) the Indentures between the Funding Corporations and Shawmut, (2) the Servicing Agreements between Towers and the Funding Corporations, and (3) the Healthcare Purchase Contracts between Towers and the Providers. (Cplt. ¶ 45.) Attached to the Complaint as Exhibits A, B, and C, respectively, are the Offering Memorandum, Indenture (with the Healthcare Purchase Contract attached as an exhibit), and Servicing Agreement for THRFC V. The provisions of the Offering Memoranda, Indentures, Healthcare Purchase Contracts, and Servicing Agreements are essentially the same for each of the five Bond issues. (Cplt. ¶ 45.)

Towers' Healthcare Subsidiaries were to use the proceeds of the Bond sales to purchase "Qualified Healthcare Receivables," using a closed, "lockbox" system to insure that funds were properly collected and disbursed. (Cplt. ¶¶ 48-51.) Shawmut was to establish the accounts through which the money flowed; Duff & Phelps and Shawmut were to receive certain reports from Towers and the Healthcare Subsidiaries to insure proper operation of the "closed" system. (Cplt. ¶¶ 52-60.) The Indenture also set forth a number of limitations on the quality and diversity of receivables that the Healthcare Subsidiaries could purchase. (Cplt. ¶ 61.) These restrictions included: (1) a Provider Concentration Limitation; (2) an Aging Limitation; and (3) a Collateral Coverage Ratio. (Id.)

Towers' Receivables Program: How It Actually Worked

While the program was supposed to work as described above, the actual practice was very different:

Instead of carrying out the program as it had been structured, Towers and the Funding Corporations engaged in a massive fraud, diverting many millions of dollars for their own purposes and acquiring non-conforming receivables by varying the actual operations of the program from the provisions of the form Healthcare Purchase Contracts, the Servicing Agreements and the Indentures from the outset in material ways, including, among other things, the following:

a. inadequate documentation was presented by Towers, as servicer, to Shawmut, ...

b. rather than sending their checks directly into the Lockbox Accounts, private Third Party Obligors were permitted to make payments to Providers ... — thereby allowing further diversion of funds by Towers and, later, by the Providers themselves;

c. Towers and the Funding Corporations engaged in impermissible transfers of receivables among the five Funding Corporations, diverted Bondholder proceeds by improperly "upstreaming" money from the Funding Corporations directly to Towers for purposes other than the purchase of receivables, and violated the Aging Limitation, the Collateral Coverage Ratio, and the Provider Concentration Limitation; and

d. many of the Healthcare Purchase Contracts are in a form inconsistent with the form required by the Indentures....

(Cplt. ¶ 70.) "[M]ost or all of the foregoing breaches of the Servicing Agreements and the Indentures ... were or should have been discovered by Duff & Phelps, had Duff & Phelps properly conducted the due diligence and ongoing review and oversight it claimed it would conduct." (Cplt. ¶ 71.)

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