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Attorney misbehavior has prompted a federal judge to dismiss a suit claiming that an equity group preyed on an Internet company by lending it money and then driving its stock into the ground. In the so-called death spiral financing case, Internet Law Library v. Southridge Capital Management, 01 Civ. 6600, Southern District Judge Robert L. Carter said Tuesday that the “harsh” sanction of dismissal was warranted because plaintiffs’ lawyers showed “repeated and flagrant disregard for the court’s orders” when they attempted an end-run around restrictions on discovery with broad-ranging subpoenas. The attorneys — James W. Christian and Gary Jewell of Christian, Smith & Jewell in Houston; John O’Quinn of O’Quinn, Laminack & Pirtle of Houston; and O’Quinn’s local counsel, Maryann Peronti of New York’s Koerner Silberberg & Weiner — indicated they would appeal the ruling. Internet Law Library specializes in legal research and litigation support services. In order to survive and finance an expansion of its business in 2000, it reached an agreement to obtain $28 million in financing through Southridge Capital Management and an off-shore entity, Cootes Drive LLC. The financing agreement called for a $25 million equity line and a $3 million preferred stock purchase that gave Cootes Drive the right to convert preferred stock to common stock. Internet Law Library, now ITIS, claimed that Southridge, Cootes and their agents promised to refrain from selling ITIS stock for one year after the closing of the agreement, and also pledged not to manipulate the stock to depress its price. But Southridge, the lawsuit claimed, proceeded to do just that. The suit charged that Cootes Drive broker Thomas Kernaghan began aggressively short selling the stock, driving down the price and putting Cootes in a position to exercise a “reset” provision in the agreement converting 139 preferred shares for 3,137,907 shares of ITIS common stock. Even worse, from the position of ITIS and company chairman Hunter M.A. Carr, was that the decline in stock price from a high of $7 per share to a low of about 18 cents per share excused Cootes Drive from its obligation to fund the $25 million equity line of credit. The suit sought $300 million in damages, disgorgement of profits and attorney fees. ITIS also claimed that Southridge and its principals and agents were experienced practitioners of the scheme and had used similar tactics on dozens of companies nationwide, using death spiral financing with so-called “toxic convertibles,” and immediate, aggressive short selling. Christian released a statement Wednesday arguing that Southridge and other firms wrecked hundreds of companies in what “we believe to be the largest commercial fraud in U.S. history.” But Cootes Drive and Southridge claimed they stood to gain little from the depression of the stock price. Cootes Drive counter-sued charging securities fraud, and it sought an order forcing the company to complete its stock conversion. Perrie W. Weiner, head of Piper Rudnick’s securities group in Los Angeles and co-counsel for Southridge with Los Angeles attorney Michael S. Rosenblum, said the suit was only one of several he has handled for Southridge and the cases “either settle or are voluntarily dismissed.” “These are companies where no one else will provide financing. They are high risk investments and they go in with their eyes open knowing exactly what the terms are,” Weiner said. “In each case, the allegations are groundless and meritless. “If there was short selling, and that’s a big if, it would not be market manipulation,” he said. Nonetheless, Carter rejected the defendant’s motions to dismiss the case last July. Taking the allegations as true for the purposes of the motion, he said the “economics involved, despite their assertions to the contrary, gave defendants an incentive to manipulate ITIS stock.” DISCOVERY DISPUTE With the case still alive, the parties moved to the discovery dispute that led Carter to order the dismissal sanction Tuesday. In September, the defendants asked the judge for a protective order for all document production. The reason, they claim, was that the plaintiffs were using discovery to look for new plaintiffs. For their part, the plaintiffs claimed their document requests were intended to show that Southridge and others had engaged in a pattern of market manipulation. “Taking into account plaintiffs’ and defendants’ arguments, the court placed its trust in plaintiffs’ sense of restraint and denied the protective order,” Carter said in his ruling. “The court indicated that any information gained in discovery was not to be used to identify new clients or initiate new litigation but that it could be used to ‘locate additional witnesses or join new parties on a showing of good cause.’ “ The plaintiffs’ attorneys, Carter said, then proceeded to request “every manner of discovery from defendants and nonparties with regard to all companies that bore resemblance to the way in which ITIS was financed or its stock was sold,” serving subpoenas to the National Association of Securities Dealers and the National Securities Clearinghouse Corporation on trading in ATSI Communications and several funds that ATSI had sued in a unrelated lawsuit before Southern District Judge Lewis Kaplan. Before Kaplan, Carter said, Peronti “misrepresented” that the subpoenas were issued with the permission of Carter. Kaplan barred the plaintiffs from using the subpoenaed information in the ATSI case, and sent Peronti back to Carter, who quashed the subpoenas at a June 9, 2003, conference and ordered Peronti and lead plaintiffs’ lawyer Gary M. Jewell of Christian, Smith & Jewell in Houston not to make “any other efforts in this regard,” or face dismissal of the case. ACTING IN ‘BAD FAITH’ But the next day, Carter said, the plaintiffs’ lawyers notified the defense they would be “serving a subpoena on the NASD seeking every short sale made since March 30, 1999, irrespective of the identity of the stock or the trader.” Carter quashed the subpoenas immediately. And when the plaintiffs argued that his phrase “in this regard” was vague, Carter said: “The issue of nonparty trading records was never raised and in making this unsupported claim to this court as well as to Kaplan, plaintiffs all but fatally jeopardize their credibility. “In issuing the ATSI subpoenas, plaintiffs not only violated and misrepresented the court’s ruling to Kaplan, but they also attempted to violated the discovery stay mandated by the PSLRA (Private Securities Litigation Reform Act) in the ATSI case,” the judge said. “On its own, plaintiffs’ abuse of the subpoena power would justify severe sanctions,” he said, adding that in making the argument about the vagueness of his order, “Plaintiffs seem to believe that by playing innocent, they can escape their duty to be a responsible litigant. “Based on their disregard for the court’s order and discovery rules in the past, the court can only conclude that their behavior with regard to the latest subpoena was willful and in bad faith, just as it was with the ATSI subpoenas,” he said. Noting the “harshness of dismissal,” Carter said he considered other sanctions would be ineffective “considering the circumstances of plaintiffs’ transgressions.” Christian called the sanction “inappropriate” in a statement. “As officers of the court we respect the order of any federal judge, including the order of Judge Robert L. Carter,” he said. “However we feel this sanction is inappropriate for the conduct alleged. We intend, respectfully, to pursue all legal and equitable remedies available to us. All legal pursuits have victories and defeats. This recent ruling will not deter our team of lawyers from pursuing legally and equitably justice for our clients.”

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