Maldonado v. Dominguez

• Decision Date: 16 November 1997
• Docket Number: No. 97-1345,97-1345
• Citation: 137 F.3d 1
• Parties: Fed. Sec. L. Rep. P 90,159, 40 Fed.R.Serv.3d 134 Miguel MALDONADO, et al., Plaintiffs--Appellants, v. Ramon DOMINGUEZ, et al., Defendants--Appellees. . Heard
• Court: U.S. Court of Appeals — First Circuit

Page 1

137 F.3d 1

Fed. Sec. L. Rep. P 90,159, 40 Fed.R.Serv.3d 134

Miguel MALDONADO, et al., Plaintiffs--Appellants, v. Ramon DOMINGUEZ, et al., Defendants--Appellees.

No. 97-1345.

United States Court of Appeals First Circuit.

Heard Nov. 16, 1997.

Decided Feb. 27, 1998.

Hilda Surillo-Pena, with whom Jaime Sifre-Rodrguez, Luis A. Melendez-Albizu and Sanchez-Betances & Sifre, Hato Rey, PR, were on brief, for appellants.

Jorge Perez-Daz, with whom Pietrantoni Mendez & Alvarez, San Juan, PR, was on brief, for Dean Witter Reynolds, Inc.

Amanda Acevedo-Rhodes, with whom Luz Ivette Rivera and Luz Ivette Rivera & Asociados, Hato Rey, PR, were on brief, for appellee Ramn Domnguez.

Before TORRUELLA, Chief Judge, CYR, Senior Circuit Judge, and DiCLERICO, ^* District Judge.

TORRUELLA, Chief Judge.

Plaintiffs invested in and became directors of a corporation called the Puerto Rico International Bank ("PRIBANK"), which was designed to create huge profits for its investor-directors by leveraging its collateral with low interest loans in order to purchase higher interest mortgage obligations. When PRIBANK failed, the plaintiffs brought this suit, claiming that the investment bankers marketing the PRIBANK stock defrauded them by failing to mention the possibility that PRIBANK's securities would be "called" in the event of an interest rate adjustment. The investors filed this suit under sections 12(2) and 17(a) of the Securities Act of 1933, 15 U.S.C. §§ 77l, 77q, as well as section 10(b) of the Securities Act of 1934, 15 U.S.C. § 78j, and Rule 10(b)(5) of the Securities and Exchange Commission ("SEC") promulgated thereunder. The district court dismissed all of these claims on a motion to dismiss. We affirm.

BACKGROUND

In addressing a 12(b)(6) motion, we must accept all well-pleaded facts as true and accord the plaintiff the benefit of all reasonable inferences. See LeBlanc v. Great Am. Ins. Co., 6 F.3d 836, 841 (1st Cir.1993). The following recitation of this case's background reflects this standard.

Plaintiffs Miguel Maldonado, et al.--important clients of Dean Witter Reynolds, Inc. of Puerto Rico ("Dean Witter")--received mailed invitations to a meeting at an exclusive San Juan club where they would be presented with a select investment opportunity. At the August 30, 1993 meeting, Ramn Domnguez, Senior Vice-President and Sales Manager of Dean Witter, made a presentation regarding the formation of PRIBANK, a new corporation. He explained PRIBANK's investment philosophy, and stated that individual investors' participation would be limited to ten blocks of $350,000, with an additional $1.5 million coming from himself and Antonio Luis Rosado--Vice President of Santander National Bank, and president-to-be of PRIBANK. Each investor would become a director of the corporation. According to Domnguez, PRIBANK was a virtually risk-free investment which was projected to return 176% of the investors' principal in only two years.

PRIBANK's strategy was relatively simple. PRIBANK would use $5 million of collateral to open margin accounts of almost $300 million with various brokerage houses. PRIBANK would be permitted to leverage itself through these brokerage houses for 60 times its capital because it had the credit of Dean Witter to back it up and because funds provided to PRIBANK on its margin accounts were not allowed to be used for the purchase of credit risk assets. In other words, PRIBANK would be seen by the brokerage houses as a safe entity because its investments would be low risk and its credit with Dean Witter was trusted.

The money in PRIBANK's margin accounts would be used to purchase Real Estate Mortgage Investment Conduits ("REMICs") and Collateralized Mortgage Obligations ("CMOs"), effectively making PRIBANK the lender for numerous home mortgages. These REMICs and CMOs would pay interest to PRIBANK at a higher rate than PRIBANK was required to pay to the brokerage houses for the money in its margin accounts. The difference between the low interest rate PRIBANK would be paying and the higher interest rate PRIBANK would be collecting--the "spread"--would be PRIBANK's profit. Since PRIBANK was able to borrow approximately 60 times more than its collateral, a spread of only 1 percent would have resulted in huge profits for PRIBANK's investors.

A further property of PRIBANK's investment structure made it unique. PRIBANK would only purchase investments called "floaters," which would be re-priced and adjusted for prevailing interest rates every thirty days. Every thirty days, PRIBANK would collect interest on these investments. PRIBANK planned to carefully structure its investments so that each month, on the same day that interest payments were due to the brokerage houses, PRIBANK would also collect interest on its investments. Domnguez labelled this as "matching."

This would give PRIBANK an advantage over normal financial institutions which purchased floating REMICS and CMOs without this perfect matching. Normal financial institutions have mismatched inventories, and have to keep reserves on hand to account for withdrawals and to pay obligations when they come due. The higher interest rates these institutions make on their loans barely make up for the potential interest lost on the money sitting in their reserves at any given time. However, due to its perfect matching, PRIBANK would not be required to keep any significant reserves on hand, and could invest all of its money every month, enabling it to take full advantage of the spread in interest rates. Therein lay the key to PRIBANK's philosophy, and eventually to its downfall.

Domnguez explained that PRIBANK's goal was to make money based upon the interest rate spread, and yet insulate itself from any changes in interest rates. Whether rates went up or down, the spread would always remain. What Domnguez failed to explain to the investors was that PRIBANK was not a risk-free, or even a low-risk investment. Instead, PRIBANK would be engaged in highly leveraged margin trading, and, like any margin trader, PRIBANK's investments could be subject to "margin calls." That is, if interest rates went up, the value of REMICs and CMOs (and other loan obligations) would go down, and brokerage houses could require investors to put up more collateral to cover the paper loss. Margin calls do not necessarily occur on the same day that investments are adjusted and repriced--at the 30-day mark in PRIBANK's case--but can occur at any time after the value of the investments falls. PRIBANK, which was designed to profit by having no reserves, would not be able to cover any margin calls. Therefore, any significant hike in interest rates could bankrupt PRIBANK, and its investors would lose their investments.

This significant risk was not disclosed to investors at the August 30, 1993 meeting. Instead, investors were told that fluctuating interest rates would pose no threat to PRIBANK's profitability. The investors believed that Domnguez and Rosado had struck upon a scheme whereby they could make huge profits for little or no risk. They invested $350,000 each in exchange for a 5.5% share of PRIBANK and a seat on the board. Domnguez and Rosado made commissions on this $3.5 million of investments. PRIBANK began operations in January 1994.

On February 4, 1994, the Federal Reserve increased interest rates by 1/4 point. This increase was the first of several increases which were to occur in future weeks. Brokerage houses soon began to make margin calls. To meet the margin calls, PRIBANK was required to sell investments before their agreed-upon settlement dates, resulting in significant penalties. As one margin call was being paid off, another loan would be called, and PRIBANK would scramble to sell another investment, incurring more penalties, and draining PRIBANK's original $5 million collateral.

In the midst of this collapse, on February 23, 1994, PRIBANK held a meeting of the board. At the meeting, Domnguez presented a picture of a smoothly-running operation, pointing out promising investments that PRIBANK was looking into and failing to mention the fact that PRIBANK was already experiencing margin calls and sustaining losses. Soon after this meeting, PRIBANK lost its remaining assets and its stock became worthless.

The present suit was brought before the District Court of Puerto Rico under the Securities Act of 1933, 15 U.S.C. § 77a (the "1933 Act" or "Securities Act"), and the Securities Act of 1934, 15 U.S.C. § 78a (the "1934 Act" or "Exchange Act"). Plaintiffs allege that fraudulent statements and omissions were made by Domnguez and Rosado, and further allege vicarious liability on the part of Dean Witter. The district court dismissed all claims on Rule 12(b)(6) motions. This appeal followed.

On appeal, plaintiffs make a number of claims. First, they argue that, to the extent that the district court converted any of the Rule 12(b)(6) motions into motions for summary judgment under Rule 56(c), plaintiffs received inadequate notice and opportunity to submit evidence. At issue is both whether such a conversion actually occurred and whether a conversion would have been appropriate at that stage of the case.

Plaintiffs next claim that the district court erred in finding that there is no implied private cause of action under section 17(a) of the 1933 Act. Plaintiffs urge this court to recognize such a cause of action.

Plaintiffs further contend that the district court erred in concluding that PRIBANK stock was privately offered. The character of PRIBANK's offering became material to the case when, shortly after this complaint was filed, the Supreme Court decided Gustafson v. Alloyd Co., 513 U.S. 561, 577-78, 115 S.Ct. 1061, 1070-71, 131 L.Ed.2d 1 (1995), holding that section 12(2) of the 1933 Act did not apply to private offerings.

Next, plaintiffs argue that their claim under section 10(b) of the 1934 Act--and Rule 10b-5 of the Securities and Exchange Commission promulgated...