Faced with a "battle of allegations" of "sinister intent and financial motive…that might serve well as the plot of an opera," District Judge Michael Baylson (E.D. Pa.) recently held, in denying motions to dismiss counterclaims and third-party claims, that Section 10(b) and Rule 10b-5 extend to "a manipulative scheme by an officer of a corporation to gain control [of] the stock’s float, artificially inflate its share price through fraud on the market, and reap substantial gains by selling off his shares while causing the corporation and its other shareholders to suffer losses." Advanced Multilevel Concepts v. Edward Bukstel, 2013 WL 200749 *1 (E.D. Pa. Jan. 25, 2013)

Acknowledging that he was presented with a "novel situation" and a "unique question," Baylson concluded that the "Supreme Court’s broad holdings" with respect to the "in connection with" and "reliance" elements of federal securities fraud claims would permit a company and its CEO to assert such claims against a third party and the plaintiff entities he allegedly controlled for "misrepresentations which induced other investors, in the general market, to buy and then sell off [the company's] stock." Id. at *11.

Baylson’s description of the alleged machinations of the players as an opera plot brings to mind the observation by poet W.H. Auden that "[n]o opera plot can be sensible, for in sensible situations people do not sing." Here, the cast includes third-party defendant Jehu Hand, the former general counsel of defendant and counter-plaintiff VitaminSpice Inc.; QualSec, a public company, into which VitaminSpice LLC was merged and the name of which was then changed to VitaminSpice Inc.; plaintiffs Able Direct Marketing Inc. and Esthetics World Inc., which were noteholders of QualSec and became VitaminSpice shareholders upon the reverse merger; and defendant and counter-plaintiff Edward Bukstel, the founder and CEO of VitaminSpice.

‘Novel’ Claims

The claims asserted by the plaintiffs against the company and its CEO are somewhat unusual, i.e., the CEO initiated a systematic effort to prevent plaintiffs from selling their shares while, at the same time, he issued "backdated" shares to his "confederates" for no consideration to the company and enabled those confederates to sell into the market and "thereby reap illicit gains at the expense of Plaintiff[s] and the investing public." Id. at *3. However, Baylson’s decision addresses the "novel" third-party claims and counterclaims by Bukstel and VitaminSpice.

In those claims, Bukstel and VitaminSpice allege that Hand, whose brother Learned Hand (apparently no joke) owned QualSec, "invented fake identities and addresses for directors in [plaintiffs], issued a fake Corporate Resolution of the QualSec Board [to the transfer agent], and withheld information about his true control over those companies from Bukstel and VitaminSpice." Id. at *12. They further allege that Hand made misrepresentations to the transfer agent that VitaminSpice had not been a shell company, thus allowing its shares to be freely traded. Thereafter, Hand allegedly advised the VitaminSpice board that because VitaminSpice had been a shell company, the restricted shares issued in connection with the reverse merger could not be traded, under SEC Rule 144(i), until one year after the initial form 10 was filed. In this manner, Hand allegedly was able to control the float of VitaminSpice’s stock.

Claiming reliance on Hand’s omissions in consummating the reverse merger, Bukstel and VitaminSpice next allege that "both parties suffered losses (the company, to its share price and market value, and Bukstel, to his holdings in VitaminSpice) when Hand used his position of control over 17 percent of VitaminSpice’s shares to consummate a pump-and-dump scheme." Id. VitaminSpice and Bukstel claim that "Hand could and did manipulate the price of VitaminSpice stock by giving the false impression of an active market and artificially inflating the price thereof" and "the drop in the price of VitaminSpice stock was caused by the winding down of the price manipulation and pump-and-dump scheme engaged in by Hand." Id.

Thus, the third-party claims and counterclaims are based on allegations that Hand (1) failed to disclose his control over plaintiffs to achieve the reverse merger (Count II), (2) made false statements to the transfer agent to secure free trading shares (Count I), (3) engaged in "pump-and-dump" schemes during which neither VitaminSpice nor Bukstel bought or sold shares (Count III) and (4) obtained control of the "float" of VitaminSpice’s securities in order to make those unlawful stock sales (Count IV).

Motion to Dismiss

In their motion to dismiss, Hand and plaintiffs challenged the sufficiency of the allegations for each of the elements under Section 10(b) and Rule 10b-5, but focused upon reliance, the "in connection with" requirement and loss causation. They pointed to the allegation of only a single purchase of VitaminSpice shares by Bukstel, on Sept. 28, 2009, and argued that Bukstel cannot base reliance on events which occurred after that purchase, and that Bukstel admittedly had no knowledge of certain misstatements by Hand occurring prior to Bukstel’s purchase. Hand and plaintiffs also argued that any representation made by Hand to the transfer agent, even if false, was not made "in connection with" the purchase or sale of a security by the company or Bukstel. With respect to loss causation, Hand and plaintiffs argued that any diminution in the stock price of VitaminSpice was not a harm to the company, but only to its investors.

Baylson rejected each of these arguments. Although most of the statements allegedly made by Hand to secure free-trading shares were made to and relied upon by the transfer agent, the court found that the essence of Count I is that Hand perpetrated a broad scheme, on behalf of himself and plaintiffs, to gain control of VitaminSpice’s stock price by making fraudulent misrepresentations to the transfer agent, to investors in the general market, to members of the Board of Directors, and to Bukstel, which allegedly caused significant harm to defendants.

Agreeing that the allegations presented a "novel situation," Baylson stated he could not necessarily conclude that "it would be legally impossible for Defendants to satisfy a jury that this scheme entitles them to relief." Id. at *10. Although Baylson cites Bell Atlantic v. Twombly, 550 U.S. 544, 570 (2007) (a complaint must "state a claim to relief that is plausible on its face") and Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (the threshold test for facial plausibility is satisfied if "the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged"), his stated rationale, legal impossibility, is at odds with the Supreme Court’s directives. Implausible does not equal impossible.

In denying the motion to dismiss Count II, alleging misrepresentations and omissions by Hand with respect to his control over the plaintiff companies, the court cited Bukstel’s single market purchase of VitaminSpice stock in September 2009 and overcame arguments that Bukstel had disavowed prior-to-purchase knowledge of those misrepresentations, which also had been made only to the transfer agent, by reasoning that "reliance can be assumed when an individual withholds material information," citing to Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 153-54 (1978) ("if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance.") Id. at *11. However, Baylson does not refer to any allegations that Hand or plaintiffs owed any such duty to Bukstel.

‘Connection’ and ‘Reliance’

The court also rejected the challenge to Count III, alleging that Hand made misrepresentations in press releases that inflated the price of VitaminSpice shares ("pump") and then sold millions of shares that he controlled ("dump") causing the market price to plummet. Recognizing that "an issue is whether the ‘connection’ and ‘reliance’ elements of a Section 10(b)…action can be satisfied when entities other than the plaintiffs [here, Bukstel and VitaminSpice] are the ones who executed the purchases or sales of securities in reliance upon the defendant’s [Hand and plaintiffs] misrepresentation," the court explained that "[t]his case is unique, because the company and its CEO are countersuing a third-party (Hand) for misrepresentation which induced other investors, in the general market, to buy and then sell off its stock." Id. at *11.

The broad focus of Count IV was that Hand committed securities fraud "through his control over the float of VitaminSpice’s stock and his unlawful participation in stock sales." Id. at *12. Baylson asked "can the ‘connection’ and ‘reliance’ elements of a Section 10(b)…action be satisfied when the securities transactions at issue were performed by parties other than the plaintiffs (e.g., by investors in the general market), but nonetheless caused harm to plaintiffs?" Id. Finding no specific authority either way, Baylson answered in the affirmative, relying upon United States v. O’Hagan, 521 U.S. 642 (1997) ("in connection with" element is satisfied when an individual uses confidential information to purchase securities "even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information" because the defendant "deceives the source of the information and simultaneously harms members of the investing public.") and Superintendent of Ins. v. Bankers Life & Cas., 400 U.S. 6 (1971) (fraud "in connection with" a purchase or sale has an expansive meaning and occurs as long as there is "an injury as a result of deceptive practices touching [the purchase] or sale of securities.") Baylson reasoned that the "in connection with" and "reliance" elements "should not be read so narrowly as to preclude novel securities fraud actions that are consistent with the purposes of Section 10(b)." Id. at *11.

The Supreme Court in SEC v. Zandford, 535 U.S. 813, 825 (2002) pointed to its decisions in O’Hagan and Bankers Life in holding that a complaint which "describes a fraudulent scheme in which securities transactions and breaches of fiduciary duty coincide" are "’in connection with’ securities sales within the meaning of §10(b)" and that "it is enough that the fraud alleged ‘coincide’ with a securities transaction—whether by the plaintiff or by someone else" in Merrill Lynch v. Dabit, 547 U.S. 71, 85 (2006) (interpreting Securities Litigation Uniform Standards Act). Here, Hand’s alleged misrepresentations to the transfer agent and, through press releases, to the public were claimed to have enabled his pump-and-dump schemes and thus "coincided" with those transactions for "in connection with" purposes.

Damages and Loss Causation

Whether Bukstel and VitaminSpice suffered actionable damages as a consequence is a more challenging issue. Baylson posits that Bukstel suffered losses "when his share price plummeted after the pump-and-dump schemes were carried through" and that VitaminSpice "arguably" suffered losses "when its share price collapsed and market reputation fell." Id. at *11. However, Bukstel’s sole market purchase of VitaminSpice’s stock was alleged to have occurred in September 2009, months before Hand is alleged to have commenced his first pump-and-dump scheme and, VitaminSpice made no purchases or sales of its own stock. Is it plausible, therefore, under Twombly and Iqbal, that either Bukstel or VitaminSpice suffered actual economic loss?

Baylson observed that defendants’ claims describe "a pump-and-dump scheme orchestrated by Hand, which caused VitaminSpice’s share price to soar and then plummet when investors in the market made trades based on his misrepresentations, and which caused losses to general investors as well as to Defendants who had earlier purchased and/or issued those securities," and stated that "[t]hese factors may also satisfy the requirements of [] loss causation," citing his decision in In re Cigna Securities Litigation, 2005 WL 3536212 (Dec. 23, 2005 E.D. Pa.).

In Cigna, Baylson concluded that the loss causation standard in the U.S. Court of Appeals for the Third Circuit as enunciated in Semerenko v. Cendant, 223 F.3d 165, 185 (3d Cir. 2000) was consistent with the Supreme Court’s then recent decision in Dura Pharmaceuticals v. Broudo, 544 U.S. 336, 346 (2005) and held that "a plaintiff in an action under §10(b) and Rule 10b-5 must prove that he or she suffered an actual economical loss" and "must also establish that the alleged misrepresentations proximately caused the decline in the security’s value to satisfy the element of loss causation." Cigna, at *6. Query whether Bukstel and VitaminSpice met this standard?

Sarah S. Gold is a partner and Richard L. Spinogatti is a senior counsel at Proskauer Rose.