In Re Granite Partners, L.P.
MEMORANDUM DECISION AND ORDER SUBORDINATING INVESTORS’ CLAIMS UNDER
BACKGROUND
The background to these three eases is described in this Court’s decision in
Goldin v. Primavera Familienstiftung (In re Granite Partners, L.P.),
A. The Proofs of Claim
Seventy four investors filed proofs of claim (or interest) in these cases. The chapter 11 trustee, Harrison J. Goldin (the “Trustee”), objects to the claims, or alternatively, seeks to subordinate them under
Before answering the question, I must first consider who, among the many claimants, has asserted the type of post-investment fraud claim at issue. At the outset, and except for the UIC, Primavera and Looser, all of the other investors have either defaulted on the motion, or withdrawn their objections. Most of the claims assert fraud in some conclusory fashion. Some claimants filed only the official claim form; others annexed brief explanatory statements or documents, or both, but even these still allege fraud in the inducement. 4 None purport to assert a fraudulent retention claim.
B. The District Court Complaints
Primavera and the UIC have also filed district court complaints in which they allege
1. The Primavera Complaint
In its third amended complaint, dated November 8, 1996 (“Third Am. Compl.”), Primavera charges federal securities fraud and common law fraud against the Brokers and the debtors’ insiders. 5 Primavera did not name the debtors as parties because of the automatic stay, but the complaint includes a section devoted exclusively to their liability, and aptly titled, “Liability of the Granite Funds.” The allegations in this section are limited to claims of fraudulent inducement. The section alleges misrepresentations in the “private placement memoranda and other marketing materials” relating to the debtors’ investment strategy, (Third Am. Compl. ¶¶ 27-28), the use of sophisticated computer models, (id. at ¶ 29), and the leverage ratios and hedging strategy. (Id. at ¶ 30.) Primavera avers that it (and the members of the uncertified class it purports to represent) relied on these misrepresentations, (id. at ¶ 32), but does not say how. Nevertheless, the alleged misrepresentations relate to the marketing of the securities, and do not allege any post-investment fraud (other than the failure to perform in accordance with the pre-investment misrepresentations). Accordingly, the part of the complaint that Primavera expressly devoted to an exposition of the debtors’ liability alleges only inducement claims.
Parsing the allegations asserted against the debtors’ insiders leads to the same conclusion. In the first claim, based on section 10(b) of the Securities Exchange Act of 1934 (the “1934 Act”) and Rule 10b-5 promulgated thereunder, 6 Primavera alleges that the defendants made misrepresentations “to induce the plaintiff and the members of the class to purchase securities issued by the Granite Funds.” (Third Am. Compl. at ¶ 117.) Further, “[h]ad the plaintiff and the members of the class known of the material adverse information not disclosed by the defendants’, or been aware of the truth, they would not have purchased the Granite Funds securities.” (Id. at ¶ 121.) These are fraudulent inducement, and not fraudulent retention, claims. Similarly, in its third claim based on common law fraud, Primavera alleges that the debtors’ insiders made material misrepresentations with the intent of inducing the plaintiffs and members of the class to purchase securities issued by the debtors. (Id. at ¶ 132) (emphasis added.) As is apparent from a cursory reading of the Primavera complaint, the allegations against the debtors and their insiders raise pure inducement claims, and hence, must be subordinated pursuant to 510(b).
2. The UIC Compliant
This leaves the UIC, whose complaint in
ABF Capital
has already been the subject of a thorough decision by Judge Sweet. The complaint alleges,
inter alia,
that David Asian and Askin Capital Management, L.P. (“ACM”), two of the debtors’ insiders,
7
continually issued false statements between September 1991 and March 1994, and that the plaintiffs relied on these false statements in purchasing and
retaining
their interests.
ABF Capital,
The Brokers moved to dismiss the UIC’s aiding and abetting claim. In their motion,
First, Judge Sweet ruled that the misrepresentations regarding the debtors’ performance stated a fraudulent maintenance claim. The plaintiffs alleged that the debtors’ insiders, aided and abetted by the brokers, passed inflated marks on to the plaintiffs, and in reliance upon the false statements regarding performance, the plaintiffs retained their interests in the debtors. Id. Second, the allegations of a continuing concealment of the inducing fraud also stated a fraudulent maintenance claim:
Moreover, the fraudulent maintenance claim is not predicated exclusively on the existence of post-investment statements, but on ACM’s failure to disclose the falsity of the statements that initially induced the Plaintiffs’ investments. ACM, which had a direct relationship with the Plaintiffs, clearly has an affirmative duty to disclose such information, and its failure to do so constitutes a primary fraud upon which an aiding and abetting claim can be based. Thus the primary fraudulent maintenance claim is adequately pleaded.
Id.
The question for this Court is whether
DISCUSSION
A. Introduction
Any discussion of
According to Professors Slain and Kripke, both investors and creditors accept the risk of enterprise insolvency but to a different degree. Id. This stems from their dissimilar expectations. Even if the business prospers, the creditor anticipates no more than the repayment of his fixed debt. Further, the shareholder’s investment provides an equity cushion for the repayment of the claim. Id. The investors, on the other hand, share the profits to the exclusion of the creditors. The shareholder’s enhanced risk of insolvency represents the flipside of his unique right to participate in the profits. The allocation of the risk, as between the investor and the creditor, is reflected in the absolute priority rule, and should not be reallocated. Id. at 286-87.
In contrast, investors alone bear the risk of illegality in the issuance of securities. Moreover, no basis exists to shift any portion to creditors who are not offered the stock. Id. at 288. The authors analogized the situation to the principal debtor who defrauds its surety. While the surety has rights against the principal debtor, it may not withdraw from its undertaking, and thereby shift the risk of the principal debtor’s fraud to creditors who relied on the undertaking. Id. For the same reason, a shareholder’s fraud claim cannot be treated equally with the claims of general creditors. This improperly reallocates this risk to the latter class that has’ relied on the equity cushion in extending credit to the debtor. See Id. 8
We are only incidentally concerned with the precise predicate of a disaffected stockholder’s efforts to recapture his investment from the corporation. For present purposes it suffices to say that when the basis of the stockholder’s disaffection is either the issuer’s failure to comply with registration requirements or the issuer’s material misrepresentations, one or more state or federal claims may be made. Our purpose is to consider the impact of such claims on the distribution of the corporation’s assets in bankruptcy and the development of a plan of reorganization under Chapter X.
Slain & Kripke at 267.
B. The Pre-Code Cases
The Slain & Kripke analysis figured in the post-1973 cases decided under the former bankruptcy act. In the seminal case,
In re Stirling Homex Corp.,
The Court assumed, for purpose of analysis, that the defrauded stockholders were creditors within the meaning of the Bankruptcy Act. Id. at 212. Nevertheless, equitable principles required subordination of their claims. ‘Where the debtor corporation is insolvent and is about to undergo complete liquidation, the equities favor the conventional general creditors rather than the allegedly defrauded stockholders.” Id. at 213. Those who extend credit do so in reliance upon the equity cushion provided by the shareholders’ investment and the absolute priority rule. Id. at 213-14. When the corporation is solvent, the relative priorities between creditors and shareholders are without significance. But
[w]hen a corporation becomes bankrupt, the temptation to lay aside the garb of a stockholder, on one pretense or another, and to assume the role of a creditor, is very strong, and all attempts of that kind should be viewed with suspicion.
Id.
at 213 (quoting
Newton Nat’l Bank v. Newbegin,
The Court turned for additional support to the Slain & Kripke analysis of risk allocation. Thus, while both creditors and investors assume the risk of insolvency, “only the investors should be forced to bear the risk of illegality in the issuance of the stock.”
The shareholders never received the additional 300,000 shares. As a result, they filed fraud claims in the subsequent bankruptcy of THC Financial Corporation (“THCF”), THC’s wholly-owned subsidiary. The shareholders contended that after the merger, THC and THCF conspired to suppress FCC’s earnings and prevent them from receiving their additional shares. Id. The shareholders conceded that any claim against THC for fraud in the issuance of the stock would have to be subordinated. Id. at 786. They sought to distinguish their fraud claim, characterizing it as one against the issuer’s subsidiary for an independent tort. Id.
The Ninth Circuit rejected the distinction, concluding that “the policy considerations that led us to subordinate the stockholder’s claim in U.S. Financial apply with equal force.” Id. The shareholders in both cases bargained for equity-type profits and equity-type risks when they purchased the stock, including the risk of fraud. Id. Without subordination, the THC shareholders would stand in front of the THC creditors in the line for THC’s asset, the equity in THCF. Id. Further, although the shareholders characterized their claim as one for “interference with contractual relations,” “inducement of breach of contract” and/or “conspiracy to defraud”, their claim is essentially that of defrauded shareholders, and not victims of an independent tort. Id. at 787.
The Court reached this conclusion reasoning that the post merger conduct did not give rise to a separate tort, and related back to THC’s fraud in the issuance of the stock. First, the shareholders’ amended proof of claim stated that THCF and THC acted pursuant to a continuing scheme devised before and executed after the merger. Id. at 787 n. 5. Second, the fraudulent misrepresentations of THC and subsequent conduct of THCF did riot create two separate causes of action. Id. But even if they did, the absolute priority rule still required subordination of the claims against THCF. Id. at 787.
C. The Bankruptcy Code
In the present matter, the Trustee, Kidder and DLJ seek to subordinate the investors’ fraudulent retention claims under section § 10(b). In particular, the. parties dispute whether a claim that post-investment fraud induced an investor to hold on to and not sell his investment is a claim “arising from the purchase or sale” of a security of the debtor. As always, “[tjhough we may not end with the words in construing a disputed statute, one certainly begins there.” Felix Frankfurter, Some Reflections on the Reading of Statutes, 47 Colum. L.Rev. 527, 535 (1947).
The first principle of statutory construction is that a statute clear and unambiguous on its face should be enforced according to its terms. 2A Norman J. Singer,
Sutherland Statutory Construction
§ 45.02, at 5 (5th ed.1992 rev.)
(“Sutherland”); see Patterson v. Shumate,
Initially, the phrase “arising from the purchase or sale” ’is ambiguous, at least with respect to fraudulent maintenance claims. Something “arises” from a source when it originates from that source.
Webster’s New International Dictionary
117 (unabridged ed.1976);
Black’s Law Dictionary
108 (6th ed.1990). The phrase “arising from” signifies some causal connection.
Cf. Black’s Law Dictionary
108 (defining “arises out of”). A literal reading implies that the injury must flow from the actual purchase or sale; a broader reading suggests that the purchase or sale must be part of the causal link although the injury may flow from a subsequent event. Since the fraudulent maintenance claim cannot exist without the initial purchase, the purchase is a causal link. Reasonably well-informed persons could interpret
The legislative history provides some guidance to its meaning. In enacting
While these statements are helpful, they are not dispositive. Neither Congress, in enacting
D. Other Federal Statutes
In searching for Congress’s intent, a court may also look to similar language in unrelated statutes that apply to similar persons, things or relationships. 2B
Sutherland
§ 53.03, at 233. The use of similar language strongly indicates that the two statutes should be interpreted
pari passu,
particularly where they share the same raison d’etre.
Northcross v. Board of Educ.,
Any person injured in his business or property by reason of a violation of section 1962 of this chapter may sue ... except that no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of section 1962____
(Emphasis added.) The legislative history spells out Congress’s purpose in unambiguous terms. It sought to eliminate fraud in the purchase or sale of securities as a predicate act for civil RICO actions (as well as related claims of wire and mail fraud) S.Rep. No. 104-98,
The RICO amendment is highly instructive in construing
While conceding that their fraudulent maintenance claims are based on conduct that would be actionable as fraud in the purchase or sale of a security, the UIC nevertheless contend that they do not arise from the purchase and sale of the debtors’ securities within the meaning of
The UIC’s first point ignores their own argument. If Judge Sweet’s conclusion is dicta, this is only because the UIC conceded that the RICO amendments, if applicable, barred all of their claims, and instead, argued that the amendment should not be applied retroactively. 10 But more to the point, the UIC ultimately agrees with Judge Sweet’s analysis and his conclusion:
In short, Congress gave every indication of its intent to eliminate all forms of seeurities-related fraud — whether related to an “inducement” or a “retention,” whether arising under federal securities law or common law — as viable sources of RICO treble damages.
Id. at 11; see also id. at 8.
This brings us to the UIC’s second point: even though the RICO amendment and
The parties have engaged in a lively debate regarding whether “in connection with,” as used in section 10(b) and Rule 10b-5, is broader than “arising from,” as used in
In any event, the RICO amendment provides the better analogy.
While Rule 10b-5 was also intended to close a loophole,
Blue Chip Stamps v. Manor,
E. The UIC’s Claims
While the two components of the UIC’s fraudulent maintenance claims require separate consideration, I conclude that both arise from a purchase or sale of the debtors’ securities within the meaning of
The claim that the debtors continued to conceal their initial, inducing fraud involves the more straightforward analysis, and also disposes of the threshold argument that post-investment conduct cannot give rise to a
The second component of the fraudulent retention claim arguably raises a more difficult question. The UIC charges that the debtors misrepresented their performance through the use of managers’ marks, and issued false operating reports which induced the UIC to hold on to their investments. Unlike the continuing concealment claim, the investor need not assert that he is a defrauded purchaser. Nevertheless,
Second, a fraudulent retention claim involves a risk that only the investors should shoulder. In essence, the claim involves the wrongful manipulation of the information needed to make an investment decision. The UIC charge that the debtors’ wrongfully deprived them of the opportunity to profit from their investment (or minimize their losses) by supplying misinformation which affected their decision to sell. Just as the opportunity to sell or hold belongs exclusively to the investors, the risk of illegal deprivation of that opportunity should too. In this regard, there is no good reason to distinguish between allocating the risks of fraud in the purchase of a security and post-investment fraud that adversely affects the ability to sell (or hold) the investment; both are investment risks that the investors have assumed. 11
Finally, the two cases upon which the UIC rely are distinguishable, and in any event, not persuasive. In In
re Amarex, Inc., 78
B.R. 605 (W.D.Okla.1987),
rev’g,
The bankruptcy court subordinated all of the claims under 510(b), adopting a “but for” test. The limited partners had asserted that the common law claims should not be subordinated because they were not claims relating to the purchase or sale of a security. The bankruptcy court disagreed, stating that “[t]hese plaintiffs would have no claims against the debtor but for their purchase of the securities, and had the purchase not occurred they would not have the pendent common law claims.”
In re Amarex,
On appeal, the district court reversed. The limited partners conceded that their federal securities law claims had to be subordinated under
The second case,
In re Angeles Corp.,
The court next addressed the question of subordination under 510(b). 17 Relying on the district court opinion in Amarex, the court held that the claims alleging fraud, mismanagement or breach of fiduciary duty were not claims “arising from the purchase or sale” of the limited partnership interest because they were based on wrongful conduct that occurred subsequent to the purchase of the security. Hence, they could not be subordinated under 510(b). Id. at 926-27.
I do not share the UIC’s view that either of these cases is particularly compelling. First, neither court had the benefit of Judge Sweet’s analysis of the 1995 RICO amendment or its application to the very complaint now before me. Second, I disagree with
Amarex
to the extent it implies, and
a fortiori,
with
Angeles
which holds, that a derivative injury to an entity can give rise to an investor’s claim that is not subject to subordination under
This is simply another way of describing insolvency. Yet under the absolute priority rule, the creditors stand ahead of the investors on the receiving line; the enterprise cannot distribute profits until it satisfies its creditors’ claims. Twenty years ago, in
Stirling Homex,
CONCLUSION
The Trustee’s motion to subordinate the investors’ fraudulent inducement and fraudulent retention claims is granted. The parties shall contact chambers to schedule a conference to discuss any remaining issues raised
SO ORDERED.
Notes
.
(b) For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock.
. The UIC represent approximately 50% of the investors that filed claims. The committee itself has no independent standing, but for convenience, this decision refers simply to the UIC even though the reference to each of its members may be more accurate.
. Additional investors, John G. Polk, Lionel N. Sterling and Whitehead Institute for Biomedical Research, also filed objections to the motions. These objections have since been withdrawn.
. For example, Primavera filed a proof of claim in the Granite Corp. case in the amount of $1 million, and Looser filed a proof of claim in the Quartz case in the amount of $1.4 million. Both claimants attached nearly identical addenda stating that the “Debtor ... through ACM, Askin and Bradshaw-Mack, made false representations of material fact to Claimant’s agent ... with the intent to deceive Claimant, which representations were relied upon by Claimant in his decision to invest in the Debtor ... and Claimant has been damaged thereby____ ” (Trustee’s Motion to Expunge and Disallow, and/or to Subordinate and Classify Investor Claims, dated Dec. 16, 1996); Ex. B-9 (Primavera Proof of Claim, dated Jan. 3, 1995); Ex. D-6 (Hubert Looser Proof of Claim, dated Jan. 3, 1995).
. Primavera's second amended complaint, which was the subject of the Granite decision, was dismissed by District Judge Sweet with leave to replead some of the fraud claims.
See Primavera,
. Primavera could not allege a fraudulent retention claim under section 10(b) of the 1934 Act or Rule 10b-5.
Blue Chip Stamps v. Manor Drug Stores,
. ACM was also the debtors’ investment advisor.
. Two months after the publication of the article, the Commission on the Bankruptcy Laws of the
. The relevant provision in the House bill, H.R. 8200, is proposed
. It is far from clear that Judge Sweet's ruling regarding the fraudulent maintenance claim is dicta. According to the UIC, the members never asserted that their fraudulent maintenance claim could’ support RICO liability.
UIC Supp. Br.
at 4. In fact, shortly before Judge Sweet’s January 1997 decision, they implied that they held no such claim. When the Trustee objected to the allowance of all of the investors' claims, counsel for the UIC opposed the Trustee’s discovery. They argued that the investors' claims were subordinated under
The UIC’s position obviously “evolved,” and Judge Sweet considered the fraudulent maintenance claim at some length throughout the
ABF Capital
opinion. Thus, if, as the UIC imply, they limited their concession (regarding the reach of the RICO amendment) to the inducement claim, Judge Sweet had to consider whether the allegations of post-investment fraud described conduct "actionable as fraud in the purchase or sale of securities” before deciding if the RICO amendments also barred the fraudulent maintenance claim.
See Rowe v. Marietta Corp.,
. Moreover, the contrary conclusion can lead to an anomalous result. By holding on to their investment in the face of post-investment misinformation, the UIC purport to assert a non-
. The Partnerships filed their own chapter 11 cases more than one year after the Amarex filing.
. The claims were filed before the Partnerships filed their own cases.
. It appears that the limited partners also asserted direct contract claims against Amarex. These relate to Amarex’s failure to advance interest payments due on the production and subscription loans of the limited partners and its liability to the limited partners under the various partnership agreements. Id. at 606.
. Neither the bankruptcy court nor the district court discussed why
. The courts conclusion appears to be incorrect. In support of the exception to the general rule, the court cited two general partnership cases,
Prince v. Harting,
The exception had nothing to do with the matter before the Angeles court. The claimants were limited partners in limited partnerships. Under California law, any action for mismanagement of the partnership or breach of fiduciary duty by a third party must be brought directly by the partnership, or derivatively by the limited partners. See Cal.Corp.Code § 15702 (West 1997).
. The
Angeles
decision does not explain why
. In addition, the
Amarex
district court apparently read