CHASE v. MERSON et al

Filing 107

DECISION AND ORDER ON DEFENDANTS DON PATCH'S, KEITH ROY'S, ARTHUR MERSON'S, AND ENDEAVOR PROJECT CONSULTANTS LLC'S MOTIONS TO DISMISS - granting in part and reserving ruling in part on 83 Motion to Dismiss, 104 Motion to Dismiss and 105 Motion to Dismiss. By JUDGE D. BROCK HORNBY. (mnw)

UNITED STATES DISTRICT COURT
DISTRICT OF MAINE
JOHN F. CHASE,
PLAINTIFF
V.

ARTHUR MERSON,

ET AL.,

DEFENDANTS

)
)
)
)
)
)
)
)
)

CIVIL NO. 2:18-CV-165-DBH

DECISION AND ORDER ON DEFENDANTS DON PATCH’S, KEITH ROY’S,
ARTHUR MERSON’S, AND ENDEAVOR PROJECT CONSULTANTS LLC’S
MOTIONS TO DISMISS
In securities cases, the Private Securities Litigation Reform Act of 1995
(PSLRA) pre-empts civil relief for fraud that the Racketeer Influenced and
Corrupt Organizations Act (RICO) previously made available. As a result, a court
confronted with a motion to dismiss a RICO fraud claim because of the PSLRA
must parse the would-be RICO claim to determine whether it is covered by the
PSLRA. The First Circuit calls this “a sort of reverse Rule 12(b)(6) inquiry: we
ask whether the conduct in question would be ‘actionable as fraud in the
purchase or sale of securities,’ in which case a RICO count based on such fraud
as a predicate act is not actionable.” Calderon Serra v. Banco Santander Puerto
Rico, 747 F.3d 1, 4 (1st Cir. 2014). One challenge in identifying PSLRA-covered
securities claims involves applying the Supreme Court’s definition1 of the term
“investment contracts,” one of the investment devices governed by federal

1

It appears in SEC v. W.J. Howey Company, 328 U.S. 293 (1946).

securities laws.

The challenge is compounded in cases like this, where the

promised investment opportunity is so blatantly fraudulent that there is no real
benchmark against which to measure whether it is RICO fraud or a PSLRA
investment.2
The plaintiff filed this federal lawsuit alleging RICO violations, breach of
contract, fraudulent inducement, negligent misrepresentation, unfair trade
practices, and conversion against a number of defendants. Compl. ¶¶ 87-151
(ECF No. 1).

Several of the principal defendants he accuses of fraud have

defaulted. I previously granted two defendants’ 12(b)(6) motions to dismiss.3
Feb. 6, 2019 Dec. & Order on Cloutier Defs.’ Mot. to Dismiss (ECF No. 84). Now,
another defendant, Donald Patch, has moved to dismiss the RICO claims
because of the PSLRA. Def. Patch’s Mot. to Dismiss at 1 (ECF No. 83). Patch
argues that without those federal claims this court lacks subject matter
jurisdiction. Id. Other defendants have joined his argument. See Def. Roy’s
Mot. to Dismiss at 1 (ECF No. 104); Merson Defs.’ Mem. of Law on Subject Matter
Jurisdiction at 7 (ECF No. 105).

The United States Court of Appeals for the Seventh Circuit confronted this issue in SEC v.
Lauer, 52 F.3d 667 (7th Cir. 1995). It stated:
The case is surprisingly novel, involving as it does a degree of fraud so complete
and barefaced that it ordinarily would be dealt with under the mail or wire fraud
statutes or other criminal statutes not specialized to the securities market—
indeed a fraud so thoroughgoing, pure, and barefaced as to raise the question
whether it can be considered to have involved “securities” at all.
Id. at 669. But it went on to rule that “[i]t would be a considerable paradox if the worse the
securities fraud, the less applicable the securities laws,” and that “it is the representations made
by the promoters, not their actual conduct, that determine whether an interest is an investment
contract (or other security).” Id. at 670.
3 The plaintiff had charged them only with breach of contract, and I ruled that he had shown no
contractual provision they had breached. See Feb. 6, 2019 Dec. & Order on Cloutier Defs.’ Mot.
to Dismiss at 2 (ECF No. 84).
2

2

After full briefing, I GRANT the motions to dismiss the RICO claims.

I

reserve decision on the motions to dismiss the remaining state law claims until
I determine whether the plaintiff can maintain federal jurisdiction based upon
diversity of citizenship.4
SUMMARY OF COMPLAINT ALLEGATIONS5
The plaintiff says that the defendants fraudulently induced him to
participate in an investment opportunity.
unbelievable.

The promised return was literally

Specifically, for every $250,000 he invested, he would receive

approximately $10,000,000 in 7 to 12 days. Compl. ¶ 18. The route to this
fortune was through so-called monetized6 Standby Letters of Credit (SBLC).7 The
He says that he is prepared “to amend” his filings “to invoke jurisdiction on the basis of diversity
of citizenship.” Pl.’s Opp’n to Def. Roy’s Mot. to Dismiss (ECF No. 106).
5 Like Lauer, note 2 supra, I focus on the promoters’ alleged representations.
6 Variations of this term appear in the SBLC Issuance and Delivery Agreement (ECF No. 1-2) and
the Irrevocable 17.5% Success Fee Participation Agreement (ECF No. 1-1), both of which the
plaintiff signed.
7 This fraud is not unique to Maine and Florida. See, e.g., SEC v. Cooper, 142 F. Supp. 3d 301,
308 (D.N.J. 2015) (“The purported investments involved the purchase of bank instruments,
including ‘standby letters of credit’ (‘SBLCs’) and ‘bank guarantees’, from major international
banks. The instruments were to be ‘monetized’ or ‘traded’ on a ‘platform’ generating astronomical
profits from complex and secretive transactions.”) (internal citations omitted). These SBLC
schemes appear to be akin to so-called Prime Bank or High Yield schemes. See, e.g., SEC v.
Milan Group, Inc., 962 F. Supp. 2d 182, 194 (D.D.C. 2013) (testimony by an expert that the
“defining characteristic … is the promise of a disproportionate return without risk or with low
risk from a source which is obscure or unable to be ascertained objectively.”) The Milan court
further explained that:
“[S]ome of the instruments . . . such as standby letters of credit and bank
guarantees are not traded.” Standby letters of credit are a “promise to honor a
timely presentation of documents that comply with the terms and conditions of
the undertaking,” thereby assuring performance or payment.
“They are
specialized promises that only run to the named beneficiary, are not transferable
unless they expressly so state and then only with the consent of their issuer,” and
they expire on a date certain agreed to by the parties. Most critically, [expert
testimony] is absolutely clear that:
4

[Standby Letters of Credit] are not investments, they do not pay
interest, they are not discounted, they are not traded or bought
and sold, there is no market in which they are traded or could be
traded even were they freely transferable and freely drawable
(which is most unlikely) because each must be evaluated
individually and in light of its terms and the transactions which [it]
3

plaintiff entered into an SBLC Issuance and Delivery Agreement. See Compl. Ex.
2 (ECF No. 1-2.) It told him to wire his $250,000 to a Florida lawyer’s trust
account, Compl. Ex. 2; that an undisclosed private entity would then apply for
a $100 million standby letter of credit from Credit Suisse AG, id. at 2; and that
upon proof of its issuance the undisclosed entity would then pay the Florida
lawyer’s trust account $10 million for the plaintiff, calculated as 25% of the $100
million, “less fees to participants,” id. The plaintiff also signed an Irrevocable
17.5% Success Fee Participation Agreement, Compl. Ex. 1 (ECF No. 1-1), by
which he agreed to pay 17.5% of any profits he received to various consultants.
The plaintiff then sent $500,000 (two $250,000 transactions) to the Florida
lawyer’s trust account. Compl. ¶ 49.

After many months and unsuccessful

demands, he has received nothing in return. He has learned that the lawyer’s
trust account has been depleted, that at least one other investor fell for the ruse
to the tune of $1.25 million, also with nothing to show for his investment, and
that the Florida lawyer whose trust account was used has since been disbarred.
See Compl. Ex. 3 at 3-4 (ECF No. 1-3).
ANALYSIS
The PSLRA preempts civil RICO claims for fraud in securities transactions.
I cannot improve on the United States Court of Appeals for the Third Circuit’s
useful and succinct description of the interaction between the two statutes:

support[s]. While [Standby Letters of Credit] are used to assure
performance, banks do not issue them unless there is a dependable
means of reimbursement and their issuance is treated like a loan.)
Id. at 195.
4

Prior to 1995, a private plaintiff could assert a civil
RICO claim for securities law violations sounding in ‘garden
variety’ fraud. Inasmuch as ‘fraud in the sale of securities’
was a predicate offense in both criminal and civil RICO
actions, plaintiffs regularly elevated fraud to RICO violations
because RICO offered the potential bonanza of recovering
treble damages. However, in 1995, Congress enacted the
Private Securities Litigation Reform Act (“PSLRA”). The
PSLRA amended RICO by narrowing the kind of conduct that
could qualify as a predicate act. Section 107 of the PSLRA
(known as the “RICO Amendment”) amended 18 U.S.C.
§ 1964(c), to provide in relevant part as follows:
Any person injured in his business or property by
reason of a violation of section 1962 of this chapter may sue
therefor in any appropriate United States District Court and
shall recover threefold the damages he sustains and the cost
of the suit, including a reasonable attorney’s fee, 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 [RICO’s prohibited
activities section].”

Bald Eagle Area Sch. Dist. v. Keystone Fin., Inc., 189 F.3d 321, 327 (3rd Cir.
1999) (emphasis in original; internal citations omitted). The “RICO Amendment,”
as quoted in italics, remains in effect.
So the issue I confront on the motions to dismiss is whether the RICO
counts in the plaintiff’s Complaint8 “rely upon any conduct that would have been
actionable as fraud in the purchase or sale of securities.” Id. Perhaps the closest
appellate case to this one is a 1995 Seventh Circuit decision. In SEC v. Lauer,
52 F.3d 667 (7th Cir. 1995), certain defendants and entities promoted a
“program [that] purported to invest in ‘Prime Bank Instruments,’ a nonexistent
high-yield security,” “promising an annual return of 60 percent on the minimum
investment, which was $10 million.” Id. at 669. Investors were solicited to

There are two RICO counts: a substantive RICO count (Count I) against three defendants, only
one of whom (Merson) has not defaulted, and a RICO conspiracy count (Count II) against two
defendants, Roy and Patch, who are alleged to have furthered the scheme asserted in Count I.
Compl. ¶¶ 87-112.

8

5

“invest $10 million (or more) with Konex, which would use the money to buy
Prime Bank Instruments.” Id. at 670. The Seventh Circuit rejected the argument
that the scheme was not the sale of securities even though “Prime Bank
Instruments do not exist.” Id. It said: “A central purpose of the securities laws
is to protect investors and would-be investors in the securities markets against
misrepresentations.

An elementary form of such misrepresentation is

misrepresenting an interest as a security when it is nothing of the kind. . . . The
effect [of what the promoter told the investor] was to represent [the investor’s]
interest as being an investment contract. It was nothing of the kind. It was the
perilous deposit of money with a fraud.” Id. at 670-71.
As in Lauer, the fraud element is clearly satisfied here. Was the fraud
practiced on this plaintiff “in the sale or purchase of securities”? Certainly, the
alleged transaction was not the typical stock sale or purchase.

But federal

securities laws include “investment contracts” (the type of security in Lauer)
under the rubric “securities.” 15 U.S.C. §§ 77b(a)(1) (Securities Act of 1933);
78c(a)(10) (Securities Exchange Act of 1934). The federal statutes do not define
that term, which came from state securities law decisions that predated the
federal statute, see Louis Loss, Joel Seligman, & Troy Paredes, Securities
Regulation (5th ed. 2018), at 1059 n. 121. But in 1946, the Supreme Court
defined it in SEC v. W.J. Howey Company, 328 U.S. 293 (1946).
According to Howey, there are three elements: “The test is whether the
scheme involves [1] an investment of money in [2] a common enterprise with
[3] profits to come solely from the efforts of others.” Id. at 301. As the Supreme
Court later described it in 1985, the determinative factor was that “looking at
6

the economic realities, the transaction ‘involve[d] an investment of money in a
common enterprise with profits to come solely from the efforts of others,’”
distinguishing it from circumstances where “the economic realities of the
transaction showed that the purchasers had parted with their money not for the
purpose of reaping profits from the efforts of others, but for the purpose of
purchasing a commodity for personal consumption.” Landreth Timber Co. v.
Landreth, 471 U.S. 681, 689 (1985); see also id. at 690-91 (distinguishing United
Housing Foundation, Inc. v. Forman, 421 U.S. 837, 858 (1975)9). Moreover, the
Supreme Court has said that “Congress’ purpose in enacting the securities laws
was to regulate investments, in whatever form they are made and by whatever
name they are called.” Reves v. Ernst & Young, 494 U.S. 56, 61 (1990) (emphasis
in original).10

In United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), the Supreme Court said:
“What distinguishes a security transaction—and what is absent here—is an investment where
one parts with his money in the hope of receiving profits from the efforts of others, and not where
he purchases a commodity for personal consumption or living quarters for personal use.” Id. at
858. In this case, Chase invested his money on a promise of extraordinary profits, not to
purchase something for his personal use or consumption.
10 I recognize that letters of credit themselves are not securities. See, e.g., Leslie v. Minson, 679
F. Supp. 280, 287 (S.D.N.Y. 1988). But the defendants here were not selling letters of credit
(although the Complaint sometimes loosely suggests that). See, e.g., Compl. ¶ 24 (“a great
opportunity to invest in standby letters of credit”). The Complaint’s more detailed allegations
make clear that Chase understood the defendants were offering him participation in a scheme
(not completely defined) where some other, undisclosed, entity would invest in standby letters of
credit, “monetize” them, and return some of the profits to him. See, e.g., id. ¶ 42: “An undisclosed
private entity was to procure the standby letters of credit and within ten business days after its
‘validation’ pay, through Ochoa and Stellar Enterprises, $10,000,000 to Mr. Chase.” See also id.
¶ 46 (plaintiff gets only confirmation of transmission of documents to Wells Fargo, N.A.). See
also Compl. Ex. 2 (the SBLC Issuance and Delivery Agreement he signed); Compl. ¶ 72 (his
description of the parallel investment by another investor and the Florida Referee’s finding in the
Florida lawyer’s disbarment proceeding that the SBLCs were to “be monetized, leveraged and
multiplied”).
9

7

Here, the plaintiff essentially concedes that the first and third Howey
elements are satisfied.11 The parties focus their dispute instead on the second
element—whether this chimerical investment was in “a common enterprise.”
Since Howey, the circuits have divided on whether that common enterprise
element requires a relationship by which investors pool their funds or other
assets (called a horizontal approach), or only a relationship between the investor
and the promoter (the vertical approach) and— if the latter—whether the test for
vertical commonality is “broad” (satisfied if an investor depends on the
promoter’s expertise for any profits) or “narrow” (satisfied only if the investor’s
profits and the promoter’s profits are “interwoven,” or interdependent). The Loss
securities law treatise describes the three approaches and the Circuits that
follow them. Louis Loss, Joel Seligman, & Troy Paredes, Securities Regulation
(5th ed. 2018), at 1076-77.12

The First Circuit has held “that a showing of

horizontal commonality—the pooling of assets from multiple investors in such a
manner that all share in the profits and risks of the enterprise—satisfies the
test.” SEC v. SG Ltd., 265 F.3d 42, 50 (1st Cir. 2001). But it explicitly reserved
judgment on whether a vertical approach is also satisfactory: “[W]e take no view
as to whether vertical commonality, in either of its iterations, also may suffice to

11 “The transaction at issue here meets the first, and perhaps third, prong of the Howey test—it
was an investment of money, perhaps with the expectation of profits to be derived solely from
the efforts of the promoter or a third party.” Pl.’s Opp’n to Def,’s Mot. to Dismiss at 3 (ECF No.
91). Even if the plaintiff did not concede them, they clearly are satisfied. The plaintiff says he
invested $500,000, and he had no role in how the investment return would be produced, relying
solely on the promised efforts of certain of the defendants. As the Complaint says, “Defendant
Hearld was to manage the transaction by procuring issuance of the standby letters of credit.
Funds were to be deposited and disbursed through his attorney, Defendant Ochoa.” Compl. ¶ 21.
12 According to the treatise, the Third, Sixth and Seventh Circuits adopt the horizontal approach;
the Fifth and Eleventh adopt the broad vertical approach; and the Ninth adopts the narrow
vertical approach.

8

satisfy the ‘common enterprise’ requirement.” Id. at 50 n.2. The Loss treatise
favors the “narrow” vertical approach.

Louis Loss, Joel Seligman, & Troy

Paredes, Securities Regulation (5th ed. 2018), at 1076-77 (“The Ninth Circuit’s
[narrow vertical] approach is the preferable one. It [embraces] common
enterprises both of a horizontal and of a vertical type whenever some form of
profit sharing can be shown.”) (emphasis in original).
There are intimations of horizontal commonality in the allegations here.
Chase says that he “was victimized by a scheme that Defendants have
perpetrated against others. Public records indicate that Mr. Chase is one of
multiple victims who have been targeted by the Defendants’ standby letter of
credit scheme.” Compl. ¶ 23. One of the fraudulent documents he includes in
his Complaint says that in the transaction, fees are paid to other “participants”
(an undefined term), reducing $25 million to the $10 Million Chase says he was
promised.

Compl. Ex. 2.

The plaintiff says that one of the defendants

“acknowledges that a number of investors in the standby letter of credit scheme
have not received their funds,” Compl. ¶ 85, and that the significant amount of
money that went into the Florida lawyer’s trust account “would seem to suggest
investments from other victims of the standby letter of credit scheme.” Id. ¶ 86.
The Complaint’s introductory paragraphs say that the “scheme to defraud Mr.
Chase is part of a wider pattern and practice by Defendants that they have
carried out on a nationwide scale.” Id. at 2; see also ¶¶ 62-63 (“part of a larger
scheme,” “fraudulently inducing others to invest in purported standby letter of
credit transactions”). Paragraph 19 alleges that two of the defendants told the
plaintiff that “they had participated in such transactions numerous times before
9

and had never lost money.” Id. ¶ 19. One defendant “expressed confidence
about the deal and stated that he was willing to put up some of his own land to
secure the deal for Mr. Chase.” Id. ¶ 27; see also id. ¶ 35.13
Nevertheless, it is true, as the plaintiff argues, that “Defendants never
claimed to be pooling Mr. Chase’s money with that of other investors in such a
manner that all would share in the profits and risks of the enterprise.” Pl.’s
Opp’n to Def.’s Mot. to Dismiss at 4 (ECF No. 91); Pl.’s Opp’n to Def. Roy’s Mot.
to Dismiss at 2 (ECF No. 106). Although I think it is a close call given all the
other attributes of this investment transaction, I will assume that the First
Circuit, under SG Ltd, would find that horizontal commonality was not
satisfied.14
I conclude, however, that the representations Chase says the defendants
made satisfy both the broad and narrow vertical tests. As to the broad vertical
test, Chase certainly depended on the promoters’ expected expertise for any
profits. For the narrow vertical test, Chase’s profits and the profits of some
defendants were directly related in the Irrevocable 17.5% Success Fee
Participation Agreement, Compl. ¶¶ 32-36, and in the $15 million in “fees to
participants” that the SBLC Issuance and Delivery Agreement provided for upon

The defendants point out that Chase was told to transfer his money to the Florida lawyer’s
trust account as further evidence of pooling. See Reply at 5 (ECF No. 95). But nothing in the
Complaint shows that Chase should have interpreted that vehicle as a pooling arrangement with
other investors.
14 In Lauer, the defendant argued there was no horizontal commonality because he was the only
investor. The Seventh Circuit did not make a final ruling on whether horizontal commonality
was satisfied, because the issue was raised on preliminary injunction and only the probability
standard was in play. The Seventh Circuit did state that “it is the character of the investment
vehicle, not the presence of multiple investors, that determines whether there is an investment
contract.” Id. at 670.
13

10

the success of the transaction, Compl. Ex. 2.15 If horizontal commonality is
missing, I conclude that the First Circuit would approve at least the narrow
vertical test as the Loss treatise has recommended.16

In the language of

Landreth Timber Co., Chase was not purchasing a commodity for personal
consumption; he parted with his money to reap profits from the efforts of others.
The scheme he invested in fits within Congress’s purpose in enacting the
securities laws as described by Reves: “to regulate investments, in whatever form
they are made and by whatever name they are called.”17 494 U.S. at 61 (emphasis
in original).
In the end, like the Howey Court, I conclude that “all the elements of a
profit-seeking business venture are present here.

The investors provide the

capital and share in the earnings and profits; the promoters manage, control and
operate the enterprise. It follows that the arrangements whereby the investors’
interests are made manifest involve investment contracts, regardless of the legal
terminology in which such contracts are clothed.” W.J. Howey Co., 328 U.S. at
300.

15 It may also be reflected in the allegation that “the Conspiracy Defendants stood to share in the
proceeds of funds invested in this fraudulent scheme,” Compl. ¶ 104, although it is possible that
allegation means only that the defendants would share in the profits of the fraud they practiced
upon the plaintiff.
16 That is, it will recognize common enterprises of both a horizontal and vertical type whenever
some form of profit sharing can be shown.
17 The Loss treatise criticizes the horizontal requirement based primarily upon Landreth Timber
Co. It states: “By analogy to the Supreme Court’s holding that the sale of 100 percent of the stock
in a business to one investor is a security, the sale of an investment contract to a single investor,
at least in some instances, also should be a security.” Louis Loss, Joel Seligman and Troy
Paredes, Securities Regulation (5th ed. 2014), at 1071.

11

CONCLUSION
I GRANT IN PART the motions to dismiss. I DISMISS the RICO claims, Counts
I and II, in their entirety. I RESERVE RULING on the state law claims until I see
whether the plaintiff is able to assert diversity jurisdiction successfully. The
plaintiff shall file a motion to amend his complaint by June 4, 2019, and the
defendants shall respond by June 25, 2019.
I note the dismissed Cloutier defendants’ concern about what effect
dismissing the RICO claims has on my earlier substantive ruling in their favor
and on their deferred claim for attorney fees. I will address that issue once I
determine subject matter jurisdiction in connection with the plaintiff’s motion to
amend his complaint.
SO ORDERED.
DATED THIS 21ST DAY OF MAY, 2019
/S/ D. BROCK HORNBY
D. BROCK HORNBY
UNITED STATES DISTRICT JUDGE

12