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Internet Law Library Inc.’s allegation that it was the victim of “death spiral financing” by defendants who it claims have a long history of stock manipulation, states a claim under federal securities laws and will not be dismissed, a federal judge in New York has ruled. Judge Robert L. Carter for the Southern District of New York rejected motions to dismiss brought by Southridge Capital Management and Cootes Drive LLC, which deny their agents violated a promise to refrain from short-selling shares of Internet Law Library immediately after agreeing to provide $28 million in financing. Internet Law Library, now known as ITIS Inc., owns Internet sites specializing in legal research and litigation support services. The company claims that, in spring 2000, it negotiated with Southridge for capital of up to $28 million, consisting of a $25 million equity line agreement and a $3 million convertible preferred stock purchase that ultimately triggered the lawsuit, Internet Law Library v. Southridge Capital Management, 01 Civ. 6600. The company alleged that Southridge and its agents, Steve Hicks, Dan Pickett and Christy Constabile, promised to refrain from selling ITIS stock for one year after the closing, and also promised not to manipulate the stock to depress its price. ITIS Chief Executive Hunter M.A. Carr repeatedly asked Southridge and its agents about his concern on short-selling, and was told several times that Southridge would not engage in the practice. Carr claimed he relied on these representations when he signed the stock purchase agreement on May 11, 2000, with Cootes Drive, a company that replaced Southridge as a signatory at the last minute. Shortly after ITIS submitted registration statements to regulators allowing Cootes Drive to be issued common stock upon conversion, the company charges, Thomas Kernaghan, acting for the defendants, began to sell ITIS stock short with abandon. The short-selling, ITIS alleged, was designed to drive down the share price and enable the defendants to buy more shares of the stock upon the conversion of the preferred shares to common stock. The additional shares obtained at conversion, ITIS charged, were used by the defendants to cover their short positions and allow them to make a profit from the difference between the price at which the stock was sold short and the price at which it was converted. Through this scheme, ITIS said, Kernaghan was able to convert 139 shares of preferred stock into 3,137, 907 shares of common stock for Cootes Drive. And under the terms of the agreement, the resulting drop in the stock price from a high of $7 per share to about 18 cents per share allowed Cootes Drive to be excused from its obligation to fund the $25 million equity line of credit. ITIS’ lawsuit, one of several cases consolidated before Carter, seeks rescission of its agreement with Cootes Drive and $300 million in damages, disgorgement of all profits and attorney fees. The defendants moved to dismiss on several grounds, including a claim that ITIS’ complaint lacked specificity and that ITIS had failed to allege facts demonstrating that any of the defendant’s statements were false. Judge Carter disagreed. “Plaintiffs have alleged that defendants are accomplished practitioners of death spiral convertible schemes,” he said. “Plaintiffs have described in some detail the typical pattern such financing schemes follow, making reference to how defendants manipulate the stock of the target company, using short sales and toxic convertible arrangements to turn a large profit while driving the price of the company’s stock lower and lower.” Moreover, the judge said, ITIS listed a series of companies “which they believe to be the casualties of a long history of stock manipulation and fraud committed by defendants and of which defendants had knowledge.” The defendants claimed they did not stand to gain from the downward manipulation of the stock, in part because they had warrant to purchase hundreds of thousands of shares at an exercise price of $3.56 a share, and stood to gain from an upturn in the share price. But Carter, accepting ITIS allegations as true for purposes of the motion, said the “economics involved, despite their assertions to the contrary, gave defendants an incentive to manipulate ITIS stock.” Carter then granted a motion to dismiss by the individual defendants under Section 20(a) of the Securities Exchange Act of 1934, which provides that “any person who, directly or indirectly, controls another person liable for a securities violation can himself be held jointly and severally liable.” Carter said the complaint had failed to sufficiently plead such “control person liability” because the allegations about control were “predominantly conclusory in nature.” Nonetheless, he gave ITIS the opportunity to replead the claim. The judge went on to dismiss three claims, with prejudice, based on violations of Texas securities laws and another claim alleging civil conspiracy. All told, the judge allowed to remain in the action claims for misrepresentation under the federal securities laws, stock manipulation, common law fraud, and breach of contract. Representing ITIS were Carl S. Koerner and Maryann Peronti of Koerner Silberberg & Weiner in New York; Gary M. Jewell of Christian Wukoson Smith & Jewell in Houston; and W. Shawn Staples of O’Quinn, Laminack & Pirtle, also in Houston. Caryn G. Mazin of San Francisco’s Brobeck, Phleger & Harrison represented Cootes Drive, Southridge Capital Management and the individual defendants.

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