Plaintiff, Harold Fox, a limited partner in Prudent Resources Oil and Gas Program (Program), a New York limited partnership, brings this action against defendant Prudent Resources Trust (Prudent), a New York business trust which is a general partner in the Program, and various named individuals also instrumental in running the Program, alleging acts of securities fraud, corporate mismanagement and breach of fiduciary duty. Specifically, Fox' complaint alleges violations of § 10 (b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), more particularly, Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder; § 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q (a); various sections of the Investment Company and Investment Advisors Acts, 15 U.S.C. § 80a-1 et seq.; and the applicable provisions of Pennsylvania corporation law. Federal jurisdiction is predicated upon § 27 of the 1934 Act, 15 U.S.C. § 78aa; §§ 17 and 22 of the 1933 Act, 15 U.S.C. §§ 77q and 77v; § 44 of the Investment Company Act, 15 U.S.C. § 80a-43, and diversity of citizenship.
Defendants Prudent Resources Trust, Milton G. Gershenson, Simon Kaplan, Abraham Sanders and the Estate of Benjamin Rosenberg (sometimes hereinafter collectively referred to as Prudent) have filed a motion to dismiss for failure to state a claim on which relief can be granted. F.R.C.P. 12(b) (6). Defendant Harold Seth Leader has joined in that motion. An answer was filed on behalf of the Estate of I. Theodore Leader, Bruce G. Leader, and BGL Oil Company. Thereafter, Bruce G. Leader and BGL Oil Company moved to dismiss and for summary judgment for lack of jurisdiction and improper venue. That motion is denied for reasons stated from the bench at oral argument. Before the court is Prudent's (and by joinder, Harold Seth Leader's) motion to dismiss.
On a motion to dismiss, of course, all well pleaded facts in the complaint must be accepted and the complaint must be viewed in the light most favorable to the plaintiff. The complaint may not be dismissed unless it appears certain that the plaintiff would not be entitled to relief under any state of facts which could be proven in support of his claim, e.g., Frederick Hart & Co. v. Recordgraph Corp., 169 F.2d 580 (3d Cir. 1948); Melo-Sonics Corp. v. Cropp, 342 F.2d 856 (3d Cir. 1965). Read in this light, the complaint alleges the following: The Program was instituted in late January 1969, with Prudent becoming its general partner on April 30, 1969. Soon afterward, Prudent and the Program, by means of a written prospectus placed in interstate commerce, invited the general public to purchase shares in the newly created limited partnership. The prospectus informed the public that the Program would be a partnership lasting for ten years and that management and control of the business would reside exclusively with Prudent, the Program's only general partner. The investments made by the limited partners would be used to finance the acquisition of oil and gas company leases and royalties therein, and for the acquisition of acreage on which the Program would test for and ultimately drill and develop oil wells. The prospectus stated further that Prudent would not charge the Program for indirect costs or administrative expenses and that each limited partner would have an undivided interest in the Program's properties proportionate to the capital investments made. It also contained assurances that the Program would not buy property from the trustees, officers, or employees of Prudent; that if Prudent sold property to the Program it would sell only "oil and gas" leases or producing properties and that it would not profit on the transaction, receiving in return only its cost plus reimbursement for direct expenses; and that Prudent was obligated to deal fairly and in good faith with its limited partners and all investment decisions would be made consistent with these duties, rather than with Prudent's self-interest.
Relying on the representations in the prospectus, Fox bought ten limited partnership units at a price of $5,000 per unit for a total investment of $50,000. Altogether, as a result of the public offering, 636 limited partnership units were sold by the Program and Prudent to 150 individuals for a total of $3,180,000.
The complaint further alleges that, despite the terms of the prospectus, even while the offer to the public remained outstanding, Prudent and the other defendants embarked upon a course of self-dealing which operated as a fraud on the prospective limited partners. Plaintiff also alleges that Prudent profited handsomely from the sale of properties to the Program, despite the prohibition against this in the prospectus; that Prudent also charged indirect costs and administrative expenses to the Program; that Prudent knowingly purchased properties from officers, trustees and employees of the Program, blatant acts of self-dealing in flat contravention of the guarantees of the prospectus; that this course of conduct which began in April 1969 continued until well into 1972, and resulted in the enrichment of the general partner and certain named individuals, and the simultaneous attrition in worth of the investment of plaintiff and the other limited partners; and that the defendants concealed their actions from the limited partners by means of a series of misleading communications describing the Program's investments.
In offering their 12(b) motion to dismiss, Prudent and the individual defendants contend that the actions complained of, even if true, do not constitute violations of Rule 10b-5 or § 17(a) of the 1933 Act; that Prudent is neither an investment company nor advisor under the provisions of the Investment Company or Investment Advisors Acts and that, barring these bases of federal jurisdiction, this action should be consigned to state court because there is no diversity of citizenship between the parties on which to premise federal jurisdiction, 28 U.S.C. § 1332. Movants also argue that while the complaint alleges fraud, the allegations of fraud have not been set forth with the particularity required by F.R.C.P. 9(b). These contentions will be considered seriatim.
I. 10b-5 Claims.
The gravamen of the complaint is that Prudent's conduct has violated SEC Rule 10b-5,
a provision which in the past ten years has risen "from obscurity to the highest place in policing 'securities fraud. '" 1 Bromberg, Securities Law: Fraud, Sec. 1.1, p. 5 (1973). The linchpin of a 10b-5 violation is fraud "in connection with the purchase or sale" of a security, and Fox has stated two claims under 10b-5: one arising from fraud alleged "in connection with" Fox' purchase of his limited partnership units; the other arising from fraud alleged "in connection with" the purchase of various securities by the Program, presumably on behalf of all the partners. Because, as will become evident, the two 10b-5 claims are not co-extensive, they will be analyzed separately.
A. Purchase of Limited Partnership Units by Fox.
In this claim, Fox alleges that he purchased his limited partnership units in the Program as a result of misrepresentations in the prospectus through which the public offering was made. Read liberally, the complaint alleges that defendants had already begun to engage in transactions which constituted self-dealing while the prospectus was still being considered by the public. At the very least, the complaint alleges that defendants' plan to enrich themselves at the expense of the enterprise was already formulated at the time the partnership units were being offered to the public through the prospectus.
In my view, these facts, if proven, would constitute a 10b-5 violation. It is alleged that defendants, for the purpose of inducing investors to purchase shares in their business, intentionally misrepresented material facts concerning the way the Program would be operated. Whereas the prospectus pictured the embryonic enterprise as being run for the benefit of all investors, and made guarantees to that effect, plaintiff charges that actually plans were afoot to run it as a vehicle to enrich a privileged few "inside" investors at the expense of the limited partners. A misleading prospectus can play a part in a scheme which violates Rule 10b-5, see, e.g., Green v. Wolf Corp., 406 F.2d 291 (2d Cir. 1968), whenever the misrepresentation is "of a sort that would cause reasonable investors to rely thereon, and, in connection therewith, so relying, cause them to purchase or sell a corporation's securities." Gottlieb v. Sandia American Corp., 452 F.2d 510, 516 (3d Cir. 1971), quoting SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 860 (2d Cir. 1968). The assurances in the prospectus that the Program would not purchase property from its trustees or employees would be "material," List v. Fashion Park, Inc., 340 F.2d 457, 462 (2d Cir. 1965), to an investor of any experience, because the liquid and readily negotiable nature of the assets of investment trust companies have traditionally "offered many opportunities for exploitation by unscrupulous management." L. Loss, Securities Regulation, vol. 1, p. 146 (2 ed. 1961). The basic purpose of 10b-5 -- to safeguard investors by policing devices inimical to "the climate of fair dealing" -- dictates the conclusion that these allegations state a claim under Rule 10b-5.
Defendants' argument that no 10b-5 claim is stated relies almost exclusively on Lester v. Preco Industries, Inc., 282 F. Supp. 459 (S.D.N.Y. 1965). In that case, the court considered the question "whether allegations of evil intent, purportedly entertained when the registration statement was filed but not carried out until a subsequent time, are sufficient to convert what would otherwise be a stockholders derivative suit into a suit for violation of the 1934 Act." 282 F. Supp. at 462. In concluding that a federal claim was not stated, the court stated:
"If such a complaint sets forth a cause of action under the Security Laws, by merely adding the allegation that defendants intended so to spend money at the time of a registration statement, any stockholders of any corporation who are unhappy about any expenditure of corporate funds can obtain federal jurisdiction over their complaint by merely alleging that any given expenditure was not fully disclosed in the last registration statement on file for that company." 282 F. Supp. at 464. (On Motion to Reargue)
The Lester ruling is not persuasive in this case. Lester reflects a judicial view of 10b-5 which has since been discredited. The court was strongly influenced by Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir.), cert. denied, 343 U.S. 956, 96 L. Ed. 1356, 72 S. Ct. 1051 (1952), and what has been described as Birnbaum's "extraordinary restraint" that 10b-5 is not aimed at " 'fraudulent mismanagement of corporate affairs. '" Bromberg, supra, at 84.15. But "little of the Birnbaum rationale -- of excluding fiduciary breach from the scope of 10b-5 -- survived the decisions of the 1960's. . . ." Bromberg, supra, at 84.18. Rule 10b-5 projects into the realm of more general corporate management to reach " all fraudulent schemes in connection with the purchase or sale of securities, whether . . a garden variety type of fraud, or . . a unique form of deception." A. T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2d Cir. 1967). Where 10b-5 properly extends, it will be applied regardless of any cause of action that may exist under state law. Popkin v. Bishop, 464 F.2d 714 (2d Cir. 1972); cf. Superintendent of Insurance v. Banker's Life and Casualty Co., 404 U.S. 6, 30 L. Ed. 2d 128, 92 S. Ct. 165 (1971). To deny that plaintiffs have stated a cause of action under Rule 10b-5, defendants must take the position that they may concoct a plan to defraud investors, issue a prospectus to attract investment to that plan and thereafter carry out their fraudulent scheme and yet avoid 10b-5 liability so long as they waited until the public offer was complete before breaching the promises made in the prospectus. So stated, this view of Rule 10b-5 falls of its own weight.
Of course, plaintiff has the heavy burden of showing either that transactions which were in violation of the prospectus occurred while the prospectus was before the public, or if self-dealing took place only after the public offering was complete, that defendants intended to defraud their purchasers at the time they issued the prospectus, but problems of proof concerning the merits of the case cannot effect the result at this point. Fox' allegations of fraud in connection with the purchase of his share in the limited partnership state a claim under 10b-5 satisfying federal jurisdiction.
B. The Purchase of Securities by the Program.
Fox also alleges that 10b-5 was violated because of defendants' fraud and misrepresentation "in connection with" the securities purchased and sold by the Program between 1969 and 1972. Presumably, this claim is concerned with the purchase and sales made by the Program from trustees or officers of the Program, purchases which constituted self-dealing and breaches of fiduciary duty and which caused the attrition of Fox' investment.
At first blush, this second 10b-5 count appears to be superfluous. The fraudulent activities allegedly committed by defendants are identical to those outlined in the first 10b-5 claim; only the " purchase or sale" on which the claim hinges differs. Further reflection, however, confirms the need for this second count from Fox' standpoint. Ultimate success on the merits of the first count requires proof of either fraudulent transactions or fraudulent intent contemporaneous with the release of the prospectus. If Fox cannot sustain this burden of proof, or if it becomes evident that defendants realized the possibilities for self-enrichment only after the sale of the limited partnership shares was complete, a 10b-5 action premised on Fox' original purchase of shares as a result of the prospectus could not be sustained. In such case, Fox seeks to insure that grounds for a 10b-5 action will exist even for late blossoming fraud by focusing on the "purchase or sale" of securities by the partnership. In this regard, he can achieve only partial success. The thrust of this claim is directed at the purchase and sale of securities by the Program, rather than at purchase of the interest in Program by Fox. He seeks to recover only as the indirect victim of a fraudulent scheme. However, the so-called "purchaser-seller" rule, coined in Birnbaum, supra, which holds that 10b-5 protects only defrauded purchasers or sellers of securities, retains vitality in this circuit with respect to a private action for damages.
In Landy v. FDIC, 486 F.2d 139 (3d Cir. 1973), cert. denied, 416 U.S. 960, 94 S. Ct. 1979, 40 L. Ed. 2d 312 (1974), shareholders of a bank brought a 10b-5 action to recover damages for losses resulting from the fraudulent use of bank funds and sale of the bank's securities by the bank's president. Although $200 million worth of securities were involved and the damage suffered by plaintiff shareholders was arguendo clear, the court refused to permit an action for damages, stating:
"When Congress enacted § 10(b), it did not contemplate the protection of every person injured by a fraudulent scheme in connection with the purchase or sale of securities . . . . [Plaintiffs here] did not engage in any market transaction with the defendants by which they sustained their losses. Were we to extend the provisions of § 10(b) beyond the buyer-seller relationship . . . [it] would establish a new and amorphous body of rights and obligations heretofore unrecognized in federal jurisdiction." 486 F.2d at 157-58.