Morse v. Weingarten

• Decision Date: 13 November 1991
• Docket Number: No. 91 Civ. 3893(MEL).,91 Civ. 3893(MEL).
• Citation: 777 F. Supp. 312
• Parties: Sidney MORSE, Plaintiff, v. Robert WEINGARTEN, American Express Co., Shearson Lehman Brothers, Inc., and Michael R. Milken, Defendants.
• Court: U.S. District Court — Southern District of New York

777 F. Supp. 312

Sidney MORSE, Plaintiff, v. Robert WEINGARTEN, American Express Co., Shearson Lehman Brothers, Inc., and Michael R. Milken, Defendants.

No. 91 Civ. 3893(MEL).

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

November 13, 1991.

Wechsler, Skirnick, Harwood, Halebian & Feffer, New York City, for plaintiff (Stuart D. Wechsler and Daniella Quitt, of counsel).

Paul, Weiss, Rifkind, Wharton & Garrison, New York City, for defendant Michael R. Milken (Colleen McMahon and Beth Friedman Levine, of counsel).

LASKER, District Judge.

Defendant Michael Milken moves under Rules 12(b) and 9(b), Fed.R.Civ.P., to dismiss all claims against him in this securities fraud class action suit, and under Rule 12(f) to strike portions of the complaint.¹

For the reasons discussed below, the motion to dismiss and the motion to strike are granted.

I.

Plaintiffs are shareholders who bought stock in the now-bankrupt First Capital Holdings Corp. ("First Capital") between March 31, 1989 and May 31, 1991.

Their complaint alleges: 1) that Milken either caused or helped defendant Robert Weingarten to establish First Capital, a financial services and insurance holding company that derived much of its revenue from its investment portfolio; 2) that Milken, in his capacity as "junk bond chief" (Morse's term) of the brokerage firm Drexel Burnham Lambert, underwrote First Capital's financing through offerings of junk bonds; 3) that "Drexel/Milken" exercised control over First Capital's investment portfolio and caused it to invest heavily in junk bonds issued by other clients of Milken and Drexel; 4) that First Capital issued statements, including annual reports and reports filed with the Securities and Exchange Commission (SEC), which contained misrepresentations or misleading omissions indicating that its financial condition was sound and that its effective portfolio management reduced the risk normally associated with junk bonds despite the fact that the value of its junk bond portfolio was deteriorating rapidly; 5) that defendants knew or were recklessly indifferent to the falseness of their representations or the misleading nature of their omissions; 6) that plaintiffs bought stock from March 31, 1989 through May 31, 1991 in reliance on those misrepresentations or misleading omissions; and 7) that First Capital collapsed, filing for bankruptcy on May 30, 1991² and thereby injuring plaintiffs.

Morse alleges that Milken's participation in these events was part of a broader attempt by him to operate a scheme, which Morse calls a "Daisy Chain," by which Milken would both arrange financing for various entities with high-risk, high yield "junk bonds" and cause the same entities to invest in junk bonds of other Milken clients, all in an attempt to create an artificially inflated market for financial products created by Drexel and Milken.

As part of the alleged scheme, Morse claims, Drexel and Milken knowingly "made materially false and misleading statements ... to prospective purchasers or sellers in order to induce the purchase or sale of high-yield securities," Compl. at ¶ 61, and induced sales of high-yield securities by advising "certain prospective purchasers and sellers that their participation in the Drexel Daisy Chain would increase the price of high-yield securities." Compl. at ¶ 62. The complaint also alleges that Drexel and Milken "purchased and sold high-yield securities while in possession of material information, not generally available to the public, obtained from their relationships with the issuers and purchasers...." Compl. at ¶ 63.

Finally, Morse asserts:

Milken played an ongoing dominant role in the operation of the Daisy Chain. Pursuant thereto, he materially aided and abetted the other defendants in the wrongdoing herein alleged. Drexel/Milken further exercised substantial discretion and investment authority over First Capital's junk securities portfolio which he exercised without regard to First Capital's stated investment goals and further engaged in numerous unsuitable and unnecessary transactions. Defendants' statements to the contrary acted as a fraud upon plaintiff ...

Compl. at ¶ 64.

II.

According to Morse, the facts alleged constitute violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, 15 U.S.C. §§ 78j(b) and 78t(a) (1988), Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5, and common law fraud and negligent misrepresentation.

Milken argues that the claims against him must be dismissed pursuant to Fed. R.Civ.P. 12(b)(6) for failure to state a claim upon which relief can be granted and pursuant to Fed.R.Civ.P. 9(b) for failure to plead the circumstances constituting fraud with particularity. He also maintains that portions of the complaint should be stricken pursuant to Fed.R.Civ.P. 12(f).

Under Rule 12(b), the required inquiry is simply whether Morse has alleged facts that, if true, would constitute a violation of securities laws or applicable common law. Because Morse alleges fraud, his claims must also comply with Rule 9(b), which provides: "In all averments of fraud or mistake, the circumstances constituting fraud or mistake shall be stated with particularity. Malice, intent, knowledge, and other condition of mind of a person may be averred generally." Construing Rule 9(b), the Court of Appeals for this Circuit has recently held that "while Rule 9(b) permits scienter to be demonstrated by inference, this `must not be mistaken for license to base claims of fraud on speculation and conclusory allegations.' An ample factual basis must be supplied to support the charges." O'Brien v. National Property Analysts Partners, 936 F.2d 674, 676 (2d Cir.1991) (quoting Wexner v. First Manhattan Co., 902 F.2d 169, 172 (2d Cir. 1990)).

A. Section 10(b)

Morse argues that his allegations support recovery against Milken for primary violations of § 10(b), for aiding and abetting primary violations by other defendants, for "control person" liability pursuant to § 20(a), and for conspiring with other defendants to commit violations.

1. Primary Violation

Section 10(b) states that it is unlawful for any person "to use or employ, in connection with the purchase or sale of any security ..., any manipulative or deceptive device or contrivance...." 15 U.S.C. § 78j(b) (1988).

Typically, to state a claim for a primary violation of § 10(b) and Rule 10b-5 a plaintiff must allege that "in connection with the purchase or sale of securities, the defendant, acting with scienter, made a false material representation or omitted to disclose material information and that plaintiff's reliance on defendant's actions caused him injury." Bloor v. Carro, Spanbock, Londin, Rodman & Fass, 754 F.2d 57, 61 (2d Cir.1985).

Milken correctly observes that all of the representations or misleading omissions upon which Morse alleges he relied were contained in statements issued by First Capital, not by Milken, and that Morse has not alleged that Milken had any direct responsibility for preparing or distributing those representations. The complaint's sole allegations of any representations by Milken are that Milken engaged in various deceptive practices to encourage sales of high-risk securities of client companies. The complaint also alleges, in a conclusory fashion, that Milken exercised control over First Capital's investment portfolio. However, Morse has not alleged that plaintiffs were injured by investing in securities about which Milken made misleading statements or omissions. Morse merely alleges that other defendants knew of but denied or omitted to reveal Milken's mismanagement of First Capital's investments and that "defendants' statements to the contrary acted as a fraud upon plaintiff...." Compl. ¶ 64.³

Morse argues that acts other than statements made directly to investors can and, in this case, did constitute a "manipulative or deceptive device or contrivance" within § 10(b)'s meaning. He claims that Milken's alleged self-interested creation of an artificially inflated junk bond market in which he caused First Capital to invest was inconsistent with the company's best interests, injured plaintiffs and violated § 10(b).

Morse is correct that unusual methods to defraud investors have been held actionable under Section 10(b). See Competitive Associates, Inc. v. Laventhol, Krekstein, Horwath & Horwath, 516 F.2d 811, 815 (2d Cir.1975) ("Section 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involved a garden type variety of fraud, or present a unique form of deception") (emphasis in original).

However, Morse has failed to identify even an atypical scheme by which Milken defrauded plaintiffs. Plaintiffs complain they were duped into purchasing First Capital stock. They have identified specific misleading statements issued by First Capital upon which they relied, but have complained of no conduct by Milken beyond his alleged maintenance of his "Daisy Chain." The complaint falls short of stating a primary violation of § 10(b) by Milken as to these plaintiffs because its allegations do not establish that Milken's conduct was "in connection with" plaintiffs' purchase of First Capital stock or that his actions caused plaintiffs' injuries within the meaning of § 10(b).

Both the "in connection with" requirement and the causation requirement under § 10(b) concern the nexus between a defendant's behavior and the sale or purchase by which plaintiffs incurred actionable harm. The Court of Appeals for this Circuit has ruled that a plaintiff alleging a broad-based scheme to defraud must "demonstrate causation in fact by showing that defendant's allegedly fraudulent activities were actually responsible for plaintiff's injuries," Bloor, 754 F.2d at 61, and "must assert that the 10(b) violations caused the claimed economic loss. This required causal connection may not be supplied by `but for' allegations." Id. (...