United States District Court, Western District of Pennsylvania
May 22, 1991
MARVIN J. FOX, ON BEHALF OF HIMSELF AND ALL OTHERS SIMILARLY SITUATED, PLAINTIFFS,
EQUIMARK CORPORATION, ALAN S. FELLHEIMER, JUDITH E. FELLHEIMER, CLAIRE W. GARGALLI, MICHAEL E. JEHLE, AND ROBERT C. PAYMENT, DEFENDANTS.
The opinion of the court was delivered by: Cohill, Chief Judge.
Plaintiffs, purchasers of Equimark Corporation stock, brought
this class action against Equimark and a number of corporate
officers, charging them with securities fraud. Presently before
the Court are Motions to Dismiss filed by all defendants.
Because plaintiffs have failed to comply with the requirements
for pleading fraud, we will dismiss their amended complaint,
with leave to file a second amended complaint.
Plaintiffs claim status as purchasers of Equimark stock
during the proposed class period, September 12, 1987 to
September 12, 1990. They seek to represent all purchasers of
Equimark stock during that period.
Defendants are Equimark, a Delaware corporation with
corporate offices in Pittsburgh, and the following persons,
whom the plaintiffs claim held these positions as corporate
officers during the class period: Alan S. Fellheimer, Chairman
of the Board and Chief Executive Officer of Equimark; Judith E.
Fellheimer (wife of Alan Fellheimer), President and Executive
Vice President of Equimark and Chairman of the Board of
Equimanagement, Inc., an Equimark subsidiary; Claire W.
Gargalli, Chief Operating Officer of Equimark, a director of
Equimark, and an officer of various Equimark subsidiaries;
Michael E. Jehle, Chief Financial Officer, Secretary, and an
Executive Vice President of Equimark; Robert C. Payment, Senior
Vice President and Controller of Equimark. Complaint ¶¶ 5-10.
In Count I, plaintiffs charge defendants with securities
fraud in violation of Sections 10(b) and 20(a) of the
Securities Exchange Act, 15 U.S.C. § 78j(b) and 78t(a), and
Rule 10b-5 promulgated thereunder, 17 C.F.R. 240.10b-5.
Complaint ¶ 60. Count II is a state-law claim for negligent
Plaintiffs charge that throughout the class period,
defendants made false and misleading statements by portraying
Equimark as a thriving corporation that was well prepared for
a downturn in the economy, when in fact loan loss reserves were
not adequate to withstand the loan losses that began in 1990.
The following excerpts from the consolidated amended class
action complaint are representative of plaintiffs' allegations:
18. . . . During [the expansion period beginning
in 1987], Equimark disregarded the need for and,
therefore, lacked adequate management policies,
procedures and controls to assure that its
acquisitions would be profitable and that its
consequential loan portfolio would be comprised of
economically sound, well-secured credits. In
connection therewith, and unbeknownst to the
investing public, Equimark's subsidiaries, both
old and newly-acquired, made increasingly
imprudent loans and investments which were not
economically justifiable and which greatly
increased Equimark's profitability for incurring
losses thereon as a result of default.
19. Throughout the Class Period, in public
pronouncements at Equimark's annual meeting of
shareholders, in filings with the SEC, in Annual
and Quarterly Reports, and statements and releases
disseminated to the investment community,
defendants portrayed the Company in glowing terms,
with great prospects for future growth and
earnings. . . .
21. Throughout the Class Period, however, as part
of the scheme alleged herein, defendants
misrepresented and concealed the deterioration of
the quality of Equimark's loan portfolio,
concealed and misrepresented the likelihood of
in non-performing assets, concealed the failure to
set appropriate loan loss reserve levels on loans
experiencing problems, concealed the failure to
timely charge-off assets on which substantial
losses were virtually certain in light of the
facts known or available to them and misstated
34. On July 26, 1988, in a press release,
Defendants Alan and Judith Fellheimer announced
that they "have access to a capital pool of a
half-billion dollars — and if the deal's right,
more." This announcement was intended to convey to
the market that Equimark management and its
subsidiary EquiManagement, Inc. had unique skills
and great success in turning around troubled
35. In a press release issued on October 17, 1988,
Defendant Equimark announced its consolidated net
income for the third quarter of 1988. Equimark
announced that its earnings were "a record high
for a quarterly period and an increase of . . .
38.1 percent over consolidated net income . . . in
the third quarter of 1987." In announcing these
record earnings, defendants induced the market and
the public into believing that Equimark's
provisions for possible loan losses remained under
control and a small percentage of the total loans
38. In its Annual Report for 1988, . . .
[Equimark] stated that the reserve at December 31,
1988 was considered adequate to absorb future
credit losses of Equimark. The 1988 Annual Report
created the false impression that the financial
quality of Equimark was extremely strong, and that
any problems in the portfolio were adequately
reserved. The annual report was materially
misleading for the reasons set forth above, and by
reason of the failure to disclose that increases
in charge-offs, loan loss provision and
nonperforming assets were virtually certain.
46. The 1989 Third Quarter Report which was filed
with the SEC and disseminated to the investing
public on or about November 6, 1989, stated that
reserves for loan losses at September 30, 1989 was
$40.908 million, or 1.47% of loans outstanding.
This compared with reserves at December 31, 1988
of $36.617 million, or 1.50% of loans. Defendants
[a]s the result of effective ongoing loan
reviews, Equimark has been able to recognize the
signs of a weakening economy and has detected
the early symptoms of credit and collection
48. Equimark continued to portray the financial
condition and future prospects of Equimark and its
subsidiaries in a falsely optimistic manner in its
Form 10-K filed with the SEC for year ending
December 31, 1989.
A softening of the commercial real-estate market
in the Northeast (and, to a lesser degree, in
Western Pennsylvania) was felt through an
increase in non-performing loans, particularly
at Liberty. As a result of ongoing loan reviews,
however, we recognized the early symptoms of
collection problems and acted more quickly than
many of our peers to implement strategies and
recovery procedures and tighten credit
With solid primary capital protection plus our
proven expertise in loan workouts, both Equibank
and Liberty Bank are well-positioned to ride out
the softening economy in our region and achieve
growth during the eventual recovery.
49. Equimark's 1989 Annual Report stated that
consolidated reserves for possible loan losses
totaled $41.955 million, or 1.48% of loans
outstanding at December 31, 1989. The Report
[t]he adequacy of the reserve for possible loan
losses is evaluated on a quarterly
basis by senior management. The evaluation is
based on internal loan reviews, delinquency
trends, changes in the composition and levels of
various loan categories, historical loss
experience and current economic conditions.
Management considers the reserve at December 31,
1989 to be adequate to provide for future credit
losses inherent in the present loan portfolio.
50. In a press release dated April 17, 1990,
Equimark reported its financial results for the
first quarter of that year. Equimark announced
that it had suffered a consolidated net loss of
$15,447,000 or $1.38 per common share for the
quarter ended March 31, 1990. The corporation's
provision for possible loan losses was $24,526,000
in the first quarter of 1990 as compared to
$6,715,000 in the first quarter of 1989. As a
percentage of average loans outstanding, the total
provision for possible loan losses was 3.52% in
the first quarter of 1990 and 1.07% in the first
quarter of 1989. Despite these figures, Defendant
Alan Fellheimer emphasized in the press release
that Equimark's financial position at March 31,
1990 remained strong and reiterated that the first
quarter loss represented a temporary setback in
Equimark's five year record of financial
Plaintiffs allege that a press release dated July 19, 1990
reported further losses "equal to a net loss per common share
of $1.38," or $2.74 per share for the first six months of 1990.
Plaintiffs allege that Equimark increased its loan loss
provision in the second quarter of 1990 to $27,151,000. In
August, plaintiffs allege, Equimark reported that its loan loss
provision had increased to $54.121 million, or 2.18% of loans
outstanding. In September, 1990, "Equimark announced that it
would not pay the quarterly dividend on the common stock."
Complaint at ¶¶ 52-54.
The statements made by defendants concerning the
Company's reserves for loan losses, as set forth
herein in paragraphs 25 through 53, were
materially false and misleading at the time they
were made due to the fact that the reserves for
loan losses were not adequate at the time they
were reported, and were known by the defendants to
Complaint at ¶ 56.
On a motion to dismiss, the burden of showing that the
complaint is insufficient falls on the moving party.
Johnsrud v. Carter, 620 F.2d 29, 33 (3d Cir. 1980). In general,
"a complaint will not be dismissed for failure to state a claim
unless it appears beyond doubt that the plaintiff can prove no
set of facts in support of his claim which would entitle him to
relief." Id. But Federal Rule of Civil Procedure 9(b) adds a
special pleading requirement that plaintiffs here must comply
with to withstand a motion to dismiss. Rule 9(b) requires that
"[i]n 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." This requirement
applies to allegations of securities fraud. Recchion v.
Westinghouse Electric Corp., 606 F. Supp. 889, 894 (W.D.Pa.
The particularity requirement of Rule 9(b) has three
purposes: "(1) to place the defendants on notice and enable
them to prepare meaningful responses; (2) to preclude the use
of a groundless fraud claim as a pretext to discovering a wrong
or as a `strike suit'; and (3) to safeguard defendants from
frivolous charges which might damage their reputations."
New England Data Services, Inc. v. Becher, 829 F.2d 286, 289
(1st Cir. 1987) (citations omitted). Accord, Seville Indus.
Mach. Corp. v. Southmost Mach. Corp., 742 F.2d 786, 791 (3d
Cir. 1984), cert. denied, 469 U.S. 1211, 105 S.Ct. 1179, 84
L.Ed.2d 327 (1985).
Courts often relax the requirement of Rule 9(b) when
knowledge of the fraud is particularly within the control of
the defendant since a strict application prior to discovery
"may permit sophisticated defrauders to successfully conceal
the details of their fraud." Christidis v. First Pennsylvania
Mortgage Trust, 717 F.2d 96, 99-100 (3d Cir. 1983). "[F]ocusing
[Rule 9(b)'s] `particularity' language `is too narrow an
approach and fails to take account of the general simplicity
and flexibility contemplated by the rules.'" Id. at 100.
Thus, courts must strike a balance between avoiding overly
strict pleading requirements and preventing unfounded "strike"
suits. But "even under a nonrestrictive application of the
rule, . . . [pleaders'] allegations must be accompanied by a
statement of the facts upon which the allegations are based."
Craftmatic Securities Litigation v. Kraftsow, 890 F.2d 628, 645
(3d Cir. 1989).
In their complaint, plaintiffs allege that during the class
period Equimark made "increasingly imprudent loans" and kept a
loan loss reserve that was too low. Plaintiffs allege that
defendants committed securities fraud under § 10(b) and Rule
10b-5 by making overly optimistic projections and not revealing
Equimark's true loan situation to the investing public. In
addition, plaintiffs allege fraud in that Equimark represented
that its management had special and unique skills for managing
problem loans and weathering hard economic times. We must
decide whether these allegations are sufficient under Rule 9(b)
to constitute a proper pleading of securities fraud.
In DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990), the
Court of Appeals for the Seventh Circuit explored the
requirements of 9(b) in a securities fraud case brought against
the accounting firm for a financially distressed bank.
Investors in Continental Illinois Bank lost most of the value
of their stock when the bank lost large amounts of money in the
1980's. Among the resulting litigation was an action against
Ernst & Young, an accounting firm, for securities fraud. The
court described the facts as follows:
Continental got into trouble when risky loans did
not pay off. During the early 1980s Continental
identified ever-larger volumes of nonperforming
loans and established reserves. Almost every
financial report announced a higher reserve than
its predecessor. The gist of the DiLeos' complaint
is that Continental did not increase its reserves
fast enough. The central allegation of the
complaint . . . is that before the class members
bought their stock [the accounting firm] `became
aware that a substantial amount of the receivables
reported in Continental's financial statements
were likely to be uncollectible.' Id. at 626.
The appellate court upheld the dismissal of the complaint
because it did not "give examples of problem loans that [the
firm] should have caught, or explain how it did or should have
recognized that the provisions for reserves established by
Continental's loan officers were inaccurate." Id. Although the
complaint quoted figures from an annual report and alleged that
the figures materially understated bad loans and non-performing
loans, the court found the allegations insufficient because
plaintiffs had failed to provide "a single concrete example."
Id. at 626-27.
The court noted that "[s]ecurities laws do not guarantee
sound business practices and do not protect investors against
reverses." Id. at 627. To allege securities fraud successfully,
investors must "distinguish their situation from that of many
others who are adversely affected by business reverses." Id.
The story in this complaint is familiar in
securities litigation. At one time the firm bathes
itself in a favorable light. Later the firm
discloses that things are less rosy. The plaintiff
contends that the difference must be attributable
to fraud. `Must be' is the critical phrase, for
the complaint offers no information other than the
differences between the two statements of the
firm's condition. Because only a fraction of
financial deteriorations reflects fraud,
plaintiffs may not proffer the different financial
statements and rest. Investors must point to some
facts suggesting that the difference is
attributable to fraud. . . . Rule 9(b) required
the district court to dismiss the complaint, which
discloses none of the circumstances that might
separate fraud from the benefit of hindsight.
Id. at 627-28.
The allegations made in the instant case resemble the
allegations found insufficient in DiLeo. According to the
complaint, Equimark put forth glowing reports of its financial
condition and prospects for future growth up until April of
1990. It told investors, through press releases, annual
reports, and other documents, that its loan loss reserves were
adequate, its assets sound, and its management particularly
capable of "turning around" troubled banks and managing
troublesome loans. Then, starting with an April 17, 1990 press
release, Equimark began announcing a series of net losses in
profits and increases in its loan loss reserves. Plaintiffs
allege that the earlier reports were false and misleading in
that the loan loss reserves were not adequate at the time and
that Equimark knew the reserves to be inadequate.
However, plaintiffs do not specify how Equimark knew the
reserves to be inadequate or why it should have increased its
reserves earlier. Like the plaintiffs in DiLeo, plaintiffs here
present descriptions of the situations before and after the
financial reverses and allege that the difference must be due
to fraud. Plaintiff's allegations are insufficient since they
give no "facts suggesting that the difference is attributable
to fraud." DiLeo, 901 F.2d at 627. Their allegations amount to
no more than speculation that fraud may have been committed. "A
complaint alleging fraud should be filed only after a fraud is
reasonably believed to have occurred; it should serve to seek
redress for a wrong, not to find one." Clinton, Hudson & Sons
v. LeHigh Valley Co-op. Farms, 73 F.R.D. 420, 424 (E.D.Pa.
1977) (quoting Segal v. Gordon, 467 F.2d 602, 607-08 (2d Cir.
1972), affd, 586 F.2d 834 (3d Cir. 1978) (emphasis in
Perhaps the strongest indication that fraud was committed is
that the press release announcing the first reversal in
Equimark's fortunes came less than three weeks after the March
29 release of Equimark's 1989 annual report, in which Equimark
declared that it had "acted more quickly than many of [its]
peers" to deal with "the early symptoms of collection
problems," and was "well-positioned to ride out the softening
economy in our region." Complaint ¶ 48.
The inference of fraud which plaintiffs wish us to draw from
the timing of these statements is insufficient to comply with
the demands of Rule 9(b). First, although the annual report was
released on March 29, 1990, it no doubt purported to describe
the corporation's financial condition as of December 31, 1989.
It takes time for a company to compile its end-of-year data,
write the accompanying text, send the information to the
printer, proofread the printer's galleys, and print the final
copies. Even if Equimark officials had realized on March 29 the
full extent of its collection problems so far that year, they
still could have believed that Equimark was still
"well-positioned" to absorb the setback, or at least that that
was an accurate statement as of December 31, 1989. In fact,
Equimark's 1990 First Quarter Report filed May 11, 1990, while
reporting a loss and an increase in reserves, still maintained
that the corporation was "positioned to ride out the soft
Pennsylvania and regional economy." Complaint ¶ 51.
In any event, the mere implication of fraud made from the
timing of public statements is not enough to meet 9(b)'s
particularity requirement for pleading fraud.
For any bad loan the time comes when the debtor's
failure is so plain that the loan is written down
or written off. No matter when a bank does this,
someone may say that it should have acted sooner.
If all that is involved is a dispute about the
timing of the writeoff, based on estimates of the
probability that a particular debtor will pay, we
do not have fraud; we may not even have
negligence. Recklessness or fraud in making loans
is not the same as fraud in discovering and
revealing that the portfolio has turned sour.
DiLeo, 901 F.2d at 624. See also, Driscoll v. Landmark Bank
for Savings, 758 F. Supp. 48 (D.Mass. 1991) ("the inference one
may draw from the timing of the public statements and releases
is not sufficient, without additional supporting facts and
to withstand the strict requirements of Rule 9(b).").
Plaintiffs' allegations of fraud can be grouped into two
categories. The first category, relating to loan loss reserves,
includes allegations that Equimark made material
misrepresentations and omissions as to the adequacy of loss
reserves, the quality of their loan portfolio, and the dollar
amount of non-performing loans. The second category covers
those allegations that Equimark represented that its management
had special and unique skills for managing problem loans and
weathering an economic recession.
We turn initially to the first category of allegations. Under
applicable law, plaintiffs' complaint fails to set forth
sufficient facts supporting a claim of fraud as to bad debt
reserves to survive a motion for dismissal under 9(b). In
Christidis v. First Pennsylvania Mortgage Trust, 717 F.2d 96
(3d Cir. 1983), the plaintiffs alleged fraud on the ground that
the defendant had understated reserves it should have accrued
for bad debts.
[The complaint's] defect is the complete absence
of any disclosure of the manner in which, in
establishing reserves for bad debts in the
financial statements relied upon, the defendants
knowingly departed from reasonable accounting
practices. Those reserves were estimates or
predictions of the likely collection or
liquidation experience of the Trust in the future.
They could be fraudulent only if, when they were
established, the responsible parties knew or
should have known that they were derived in a
manner inconsistent with reasonable accounting
practices. What those practices are and how they
were departed from is nowhere set forth.
Id. at 100.
To the extent plaintiffs here allege fraud due to Equimark's
failure to disclose that loan loss reserves were inadequate or
that the quality of the asset base was poor, the complaint is
inadequate under the Christidis standard because it fails to
explain the manner in which reserves were improperly
established or falsely disclosed. Failure to predict the
severity of future economic downturns is not necessarily fraud.
As for the second category of allegations — relating to
claims of special and unique management skills — plaintiffs
have likewise failed to plead sufficient facts. In Santa Fe v.
Green, 430 U.S. 462, 476, 97 S.Ct. 1292, 1302, 51 L.Ed.2d 480
(1977), the United States Supreme Court drew a distinction
between allegations of misrepresentation and deception
actionable under securities fraud laws, and allegations of
"transactions which constitute no more than internal corporate
mismanagement." 430 U.S. at 479, 97 S.Ct. at 1304.
Construing Santa Fe, the United States Court of Appeals for
the Third Circuit has warned that "we must be alert to ensure
that the purpose of Santa Fe is not undermined by `artful legal
draftsmanship;' claims essentially grounded on corporate
mismanagement are not cognizable under federal law."
Craftmatic, 890 F.2d at 638-39. It would contravene the
holdings of Santa Fe and Craftmatic to allow plaintiffs to
convert allegations of mismanagement into a fraud claim simply
by inserting the words "defendants failed to disclose that . .
." before the claimed mismanagement. "The `crucial difference'
is whether there was misrepresentation or omission in the flow
of material information. . . . Where the incremental value of
disclosure is solely to place potential investors on notice
that management is culpable of a breach of faith or
incompetence, the failure to disclose does not violate the
securities acts." Id. at 639-40.
Defendants argue that this lawsuit is an example "of what has
become an epidemic of lawsuits against banks and financial
institutions as a result of the downturn currently afflicting
banking, real estate, and the economy as a whole." Defendants'
Brief at 1. They submit that the majority of courts considering
similar lawsuits against financial institutions arising out of
this downturn have dismissed them for lack of specificity in
pleading fraud. While plaintiffs point to two district court
opinions denying motions to dismiss similar to the instant
motion (Zinberg v. Washington
Bancorp, Civ. No. 88-5194 (D.N.J. April 24, 1989); In re
Midlantic Shareholder Litigation, 758 F. Supp. 226 (D.N.J.
1990)), it appears that the weight of better reasoned authority
lies in favor of dismissal on the facts in this case. See,
e.g., Gollomp v. MNC Fin., Inc., 756 F. Supp. 228 (D.Md. 1991);
Abrahamson v. Western Savings & Loan Assoc., Civ. No. 88-1677,
1989 WL 259994 (D.Ariz. July 3, 1989); Salit v. Centerbank,
767 F. Supp. 429 (D.Conn. 1990); Akerman v. Bankworcester Corp.,
751 F. Supp. 11 (D.Mass. 1990); Dubowski v. Dominion Bankshares
Corp., 763 F. Supp. 169 (W.D.Va. 1991); Wilkes v. Heritage
Bancorp., 767 F. Supp. 1166 (D.Mass. 1991); Driscoll v. Landmark
Bank for Savings, 758 F. Supp. 48 (D.Mass. 1991); Haft v.
Eastland Fin. Corp., 755 F. Supp. 1123 (D.R.I. 1991).
Because we find that plaintiffs have not pled sufficient
facts to make out a viable primary claim for securities fraud,
we must also dismiss the related aiding and abetting, control
person, and conspiracy claims. In addition, this Court will
decline to exercise its discretion to entertain the pendent
state law claim for negligent misrepresentation. United Mine
Workers v. Gibbs, 383 U.S. 715, 86 S.Ct. 1130, 16 L.Ed.2d 218
Amendment of Complaint
Plaintiffs request that in the event the complaint is
dismissed, plaintiffs be granted leave to file an amended
complaint curing any defects. Defendants argue that granting
such leave would be inappropriate because plaintiffs have
already filed one amended complaint. Defendants also argue that
an attempt to amend the complaint would be futile since
plaintiffs have admitted in discovery that they know of no
facts suggesting that defendants committed fraud.
Since the prior amendment was made for the purpose of merging
the allegations of several complaints that had been
consolidated, and was filed before the motions to dismiss,
plaintiffs will be granted leave to amend the complaint in a
manner consistent with this Opinion. That is, plaintiffs must
include facts sufficient to show that the financial losses
complained of were the result of fraud.
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