Zohar CDO 2003-1, Ltd. et al v. Patriarch Partners, LLC et al
Filing
105
OPINION AND ORDER: re: 53 MOTION to Dismiss filed by Patriarch Partners XV, LLC, Patriarch Partners XIV, LLC, ARK Investment Partners II, L.P., For the foregoing reasons, Defendants' motion to dismiss is granted. Consistent with the Joint Sti pulation and Order dated December 15, 2017, Zohar and the Third Party Defendants should respond to Defendants' Third Party Complaint by January 12, 2018. Separately, Defendants shall provide an explanation as to why this Court should retain juri sdiction over their claims in the Third Party Complaint and why their third-party claims qualify as an impleader action under Rule 14 by no later than January 26, 2018. The Clerk of Court is directed to terminate all pending motions on the docket. SO ORDERED. (Signed by Judge William H. Pauley, III on 12/29/2017) (ama)
UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
ZOHAR CDO 2003-1, LTD., et al.,
Plaintiffs,
-againstPATRIARCH PARTNERS, LLC, et al.,
Defendants.
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17cv307
OPINION & ORDER
WILLIAM H. PAULEY III, United States District Judge:
Defendants Patriarch Partners, LLC, Patriarch Partners VIII, LLC, Patriarch
Partners XIV, LLC, Patriarch Partners XV, LLC (together, “Patriarch”), Octaluna LLC, Octaluna
II LLC, Octaluna III LLC (together, “Octaluna”), Ark II CLO 2001-1, LLC, Ark Investment
Partners II, L.P. (together, “Ark”), and Lynn Tilton (“Tilton”) move to dismiss Plaintiffs Zohar
CDO 2003-1, Ltd. (“Zohar I”), Zohar II 2005-1 Ltd. (“Zohar II”), and Zohar III, Ltd.’s (“Zohar
III”) (together, “Zohar”) complaint.
Zohar asserts a dozen claims against Defendants predicated on a massive
racketeering conspiracy involving the investment and management of Zohar’s assets. The
remedies that Zohar seeks through its common law claims include compensatory damages,
declaratory relief, an accounting, and restitution. But all such relief is eclipsed by Zohar’s
request for treble damages under the Racketeering Influenced and Corrupt Organizations
(“RICO”) Act, 18 U.S.C. § 1964(c). Defendants seek dismissal of this action in its entirety, both
for failure to state a claim under Rule 12(b)(6) and lack of subject matter jurisdiction under Rule
12(b)(1). For the reasons that follow, Defendants’ motion to dismiss is granted.
BACKGROUND
This civil RICO action arises from an alleged fraudulent investment scheme
orchestrated by Tilton and her firms. At bottom, Zohar alleges that Defendants engaged in a
wide-ranging conspiracy to enrich themselves by pillaging Zohar’s funds and impairing its
assets, ultimately rendering it unable to repay investors. Over the course of five years,
Defendants created three special purpose vehicles—Zohar I, Zohar II, and Zohar III—that raised
and invested more than $2.5 billion dollars in an assortment of distressed companies. Imbued
with the authority to act on Zohar’s behalf, Defendants made virtually every investment
decision—they chose the companies to whom Zohar would lend, monitored the collateral
underlying the loans, and provided the companies with consulting and management services.
But instead of acting in Zohar’s interest—to maximize repayment to noteholders—Defendants
exploited their fiduciary status to expropriate Zohar’s equity in its portfolio companies, pay
themselves dividends, and deceive Zohar and its investors into paying exorbitant fees by
misreporting the value of Zohar’s collateral.
Because Zohar’s complaint (the “Complaint”) focuses on the predicate acts
alleged in support of its civil RICO claim, the threshold issue in Defendants’ motion to dismiss is
whether the alleged scheme is actionable as fraud in the purchase or sale of securities. Indeed, if
any one of the predicate acts involves the purchase or sale of securities, the entire claim is
foreclosed by the securities fraud bar codified in the RICO statute. Resolving this question
requires a more detailed recitation of the Complaint’s allegations, which are presumed true on a
motion to dismiss.
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I.
Zohar’s Creation and Purpose
Zohar—three special purpose vehicles created by Tilton—raised over $2.5 billion
dollars 1 from the sale of collateralized loan obligations (“CLOs”), which are essentially
investment notes backed by a pool of loans. Zohar used the offering proceeds to make loans to
dozens of distressed companies with the aim of rehabilitating their businesses and maximizing
profits. (Complaint (“Compl.”), ECF No. 1, ¶¶ 40–41.) Zohar loaned money under various
arrangements. Some involved standard repayment of principal and interest while others included
equity investments in portfolio companies. The latter arrangement—obtaining equity in
exchange for a loan—was of paramount importance to Zohar because it offset losses arising from
a defaulted loan and offered enormous upside if a portfolio company turned profitable. (Compl.
¶ 41.)
II.
Defendants’ Roles
Tilton’s role in the CLO transactions extended well beyond creating Zohar. She
and her investment companies—namely, Patriarch—assumed a panoply of roles in overseeing
Zohar’s investments. Patriarch’s chief task was to manage Zohar’s collateral. (Compl. ¶¶ 30–
31.) As collateral manager, Patriarch selected loans and other investments making up the
collateral pool. (Compl. ¶ 28.) Patriarch also assigned some of its affiliates to oversee Zohar’s
assets—Patriarch Partners Agency Services collected and processed loan payments, and
Patriarch Partners Management Group provided management and consulting services to the
portfolio companies. (Compl. ¶ 37.)
1
Zohar I raised approximately $530 million after launching in November 2003; Zohar II raised
approximately $1 billion after launching in January 2005; and Zohar III raised approximately $1 billion after
launching in April 2007. All of the Zohar funds are exempted companies registered in the Cayman Islands.
(Compl. ¶¶ 9–11, 29.)
3
Tilton’s other entities played pivotal roles in perpetrating the fraudulent scheme.
Ark assumed debt or equity positions in portfolio companies alongside Zohar, and Octaluna held
preference share rights or interests in Zohar’s assets. (Compl. ¶ 38.) As the conspiracy
unfolded, Ark and Octaluna were instrumental in expropriating and obscuring Zohar’s ownership
interests in portfolio companies.
Despite the amalgam of entities involved, Tilton exercised unchecked authority
and control over all of them as sole director or managing member. As a practical matter, Tilton
made virtually every single investment decision for Zohar. (Compl. ¶¶ 12–20, 37–38.)
III.
Collateral Management
As with most secured transactions, the parties’ activities were governed by a key
set of operative documents: the (i) Indenture governed the rights and obligations of the Zohar
Fund vis-à-vis the noteholders, credit enhancer, and controlling party; and (ii) the Collateral
Administration Agreement memorialized an agreement between Zohar, Patriarch, and a national
bank, as collateral administrator, to provide administrative services concerning the collateral.
(See Compl. ¶ 31; see, e.g., Declaration of Akiva Shapiro in Support of Motion to Dismiss
(“Shapiro Decl.”), ECF No. 55, Exs. 1, 3.)
A third document—the Collateral Management Agreement—enumerated
Patriarch’s duties, responsibilities, and privileges as collateral manager. (Compl. ¶¶ 31–33.)
Chief among Patriarch’s duties was the covenant “not [to] take any action which [it] knows or
should be reasonably expected to know in accordance with prevailing market practices [that]
would . . . adversely affect the interests” of the noteholders. (Compl. ¶ 33 (internal citation
omitted).) And like all investment advisors, Patriarch owed a number of implied fiduciary duties
to Zohar, including the duties of care and loyalty. (Compl. ¶ 34.)
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One of Patriarch’s most important duties as collateral manager was to report
Zohar’s financial condition and performance through monthly reports and quarterly note
valuation reports (“Monthly Reports”) to stakeholders, including rating agencies and Zohar’s
noteholders. (Compl. ¶ 36.) The purpose of these communications, prepared by the collateral
administrator, was to apprise noteholders about the condition of the collateral underlying the
CLOs. (Compl. ¶¶ 36, 56.)
To ascertain this information, Patriarch performed an Overcollateralization Test
(“OC Test”), which was designed to calculate the ratio between the outstanding amounts due on
the loans in Zohar’s portfolio and the principal balances on the senior notes. (Compl. ¶ 56.) The
OC Test results were a barometer of Zohar’s ability to collect sufficient amounts on outstanding
loans to meet its obligations to senior noteholders. (Compl. ¶ 56.) Thus, a passing OC Test
signaled that the value of the underlying collateral exceeded the balance of the outstanding senior
notes, and could be used to satisfy those notes if one of Zohar’s loans defaulted. Conversely, a
failing OC Test triggered a number of consequences designed to conserve funds, such as
suspending payments to certain classes of noteholders and reducing the collateral management
fee. (Compl. ¶¶ 56–57.) The OC Test results constituted a key component of the Monthly
Reports.
As a collateral manager, Patriarch charged a fee to select and monitor the
collateral, and replace any deficient assets. Under the operative Indenture agreements, Patriarch
charged a senior management fee and a subordinated management fee, each calculated as 1% of
the outstanding principal amount of assets held by Zohar. (Compl. ¶ 57.) Thus, Patriarch
received a 2% management fee, which could be halved if the OC Test produced failing results.
(Compl. ¶ 57.) A severe failure of the OC Test, which the Indenture categorized as an “Event of
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Default,” resulted in even more devastating consequences to Patriarch—the controlling parties 2
were entitled to terminate Patriarch and step in to control Zohar’s assets, thus jeopardizing
Patriarch’s lucrative position to collect “hundreds of millions of dollars in management fees and
preference share distributions.” (Compl. ¶¶ 57, 65–66.)
Beginning in 2009, Zohar alleges that the OC Test should have produced failing
results in view of the “significant deterioration” of the loans in its portfolio. (Compl. ¶ 58.)
Rather than reporting those dismal results, Patriarch and Tilton manipulated the OC Test to yield
passing results in the Monthly Reports. (Compl. ¶ 58.) Patriarch inflated the value of the
collateral in two ways. First, based on Tilton’s subjective and biased judgment, Patriarch
routinely misclassified certain portfolio companies as posing a low credit risk when, in reality,
many were on the verge of default. (Compl. ¶¶ 59–60.)
Second, Patriarch fraudulently valued Zohar’s debt at par even though Zohar had
previously purchased the debt at a significant discount. (Compl. ¶ 63.) For example, Zohar once
purchased a portfolio company’s debt originally valued at $29 million for only $5.3 million,
reflecting an 82% discount. (Compl. ¶ 64.) But when calculating the OC Test, Patriarch valued
the company’s debt at the full $29 million while also rating the distressed company as a low
credit risk. (Compl. ¶ 64.) Patriarch also gave that company a more favorable credit risk rating
after restructuring its loans despite the company’s inability to make interest payments.
Unsurprisingly, that company defaulted seven months after restructuring its debt. (Compl. ¶ 64.)
Zohar alleges that Patriarch manipulated the results of the OC Test to facilitate the
payment of more than $700 million in fees over the life of the Zohar funds and to preserve its
2
Such parties include MBIA, the Credit Enhancer and Controlling Party for Zohar I and Zohar II, and a
group of investors holding at least 25% of the aggregate outstanding amount of Class A-1 notes designated as the
Controlling Class for Zohar III. (See Compl. ¶¶ 39, 66; Akiva Decl. Ex. 7.)
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position as collateral manager. (Compl. ¶ 65.) To that end, a successful OC Test kept other
stakeholders—namely the Controlling Party and Controlling Class—at bay.
IV.
Equity Interests and Equity Distributions
The second component of Defendants’ alleged scheme involved misappropriating
Zohar’s equity in its portfolio companies to reap the benefits of equity ownership, such as
receiving “tens of millions of dollars or more” in dividend and equity distributions.
(Compl. ¶ 50.) Because of their fiduciary position, Defendants played both sides of Zohar’s
investment decisions—they selected the company which Zohar invested in and then installed
Tilton as the company’s officer or director to facilitate the exchange of equity for Defendants’
benefit.
Capitalizing on a ploy rife with self-dealing, Defendants executed their equity
misappropriation scheme in four different ways. First, Defendants used Zohar’s funds to obtain
equity positions in their name. (Compl. ¶ 49.) In other words, instead of giving Zohar the equity
it should have received in exchange for its loan, Defendants took a slice of the equity for
themselves “without making any contributions, or with only disproportionate or minimal
contributions.” (Compl. ¶ 49.)
Second, as their equity holdings grew, Defendants siphoned dividends and other
distributions that the companies made to their shareholders instead of re-directing those funds to
Zohar “for ultimate distribution to the Zohar Funds’ noteholders.” (Compl. ¶ 50.) As a result,
Defendants reaped an unearned profit estimated in the tens of millions of dollars. (Compl. ¶ 50.)
Third, in some instances, Defendants simply re-assigned Zohar’s equity holdings
to themselves. By way of example, in 2009, Patriarch reported that Zohar owned 100% of a
certain portfolio company. Three years later, however, after the company was sold for $199
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million, Zohar was left empty-handed. To justify this outcome, Patriarch disavowed its previous
representations that Zohar ever had an interest in the company and maintained that Defendants
were its rightful owners all along. (Compl. ¶ 51.)
Finally, Defendants stole voting and other rights associated with Zohar’s equity
interests. (Compl. ¶ 52.) Although they kept the equity in Zohar’s name, Defendants essentially
deprived Zohar of its ability to control its companies by agreeing to contract provisions, on
Zohar’s behalf, that gave Defendants “control over the Zohar Funds’ assets without any apparent
benefit provided to the Zohar Funds.” (Compl. ¶ 70.) For example, Defendants required Zohar
to obtain the consent of Patriarch Partners Agency Services—Zohar’s agent under its loan
agreements—before making any loan assignments, a condition that effectively robbed Zohar of
the ability to unilaterally sell its loans. (Compl. ¶ 70.) Patriarch also amended dozens of loan
agreements between Zohar and its portfolio companies which had adverse consequences for
Zohar, like subordinating its loans to Ark’s loans and reducing the interest that borrowers paid on
Zohar’s loans. (Compl. ¶ 73.)
Beginning in September 2015, Tilton executed a series of legal documents
transferring Zohar’s voting and other rights in its equity to Tilton’s entities. These valuable
rights were transferred by way of irrevocable proxies or amendments to the LLC or stockholder
agreements. Thus, Zohar was forced to relinquish a bevy of rights normally conferred through
ownership—the right to change directors or managing members, the right to effect a sale of a
company, or the right to veto another party’s attempt to exercise equity rights. (Compl. ¶ 74.)
In November 2015, Tilton entered into another round of amendments depriving
Zohar of its ability to declare an event of default against a portfolio company, and instead
conferred that privilege on herself and her companies. (Compl. ¶ 75.) And in February 2016,
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Tilton, by way of amendments to the operative agreements, conferred discretion on Ark to make
revolving credit loans and reduced commitment fees that portfolio companies were obligated to
pay Zohar. (Compl. ¶ 76.)
After resigning its post as collateral manager in February 2016, Patriarch
aggressively laid claim to Zohar’s assets. Rather than stealing equity outright, Patriarch began
obscuring and concealing the true extent of Zohar’s ownership in its companies. When the
replacement collateral manager requested Zohar’s books and records, Patriarch produced an
incomplete set of documents that muddled Zohar’s claim over its assets. When the replacement
collateral manager confronted Patriarch about these issues, Patriarch continued to obfuscate
Zohar’s equity holdings. And once the replacement collateral manager commenced a lawsuit to
obtain the relevant books and records, Patriarch and Tilton steadfastly maintained that they
owned the companies, further clouding Zohar’s title. (Compl. ¶¶ 81–83.)
V.
SEC Enforcement Action
In March 2015, the Securities and Exchange Commission (the “SEC”)
commenced an enforcement action against Tilton and Patriarch, alleging violations of the
Investment Advisers Act (“IAA”). In essence, the SEC’s action presaged many of the
allegations in this action, but focused principally on the “categorization” issue—namely,
Patriarch’s misrepresentations concerning the value and quality of Zohar’s collateral. Under the
SEC’s theory of liability, although Defendants were required to provide “valuation
categorizations of [Zohar’s] assets and financial statements purportedly reflecting the financial
position of each” of Zohar’s funds, they instead “directed that nearly all valuations of these
assets be reported as unchanged from their valuations at the time the assets were originated.” (In
re Lynn Tilton, et al., Order Instituting Administrative and Cease-and-Desist Proceedings
9
Pursuant to Sections 203(e), 203(f), and 203(k) of the Investment Advisers Act of 1940, and
Section 9(b) of the Investment Company Act of 1940, and Notice of Hearing, Release No. 4053,
dated Mar. 30, 2015 (“SEC Order”), at ¶¶ 3–4.) By miscategorizing Zohar’s investments,
flouting the categorization methodology set forth in Zohar’s governing documents, and
misleading investors, the SEC alleges that Defendants reaped “almost $200 million” in
management fees and retained their control over Zohar’s activities. (SEC Order at ¶ 6.)
DISCUSSION
I.
Standard
On a motion to dismiss, a court must take “factual allegations [in the complaint]
to be true and draw[ ] all reasonable inferences in the plaintiff’s favor.” Harris v. Mills, 572 F.3d
66, 71 (2d Cir. 2009) (citation omitted). To state a legally sufficient claim, the complaint must
allege “enough facts to state a claim for relief that is plausible on its face.” Bell Atl. Corp. v.
Twombly, 550 U.S. 554, 570 (2007). “A claim has facial plausibility when the plaintiff pleads
factual content that allows the court to draw the reasonable inference that the defendant is liable
for the misconduct alleged.” Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (citation omitted). A
pleading that offers only “labels and conclusions or a formulaic recitation of the elements of a
cause of action will not do.” Iqbal, 556 U.S. at 678 (citing Twombly, 550 U.S. at 555). If the
plaintiff “ha[s] not nudged [his] claims across the line from conceivable to plausible, [the]
complaint must be dismissed.” 3 Twombly, 550 U.S. at 570.
3
Defendants bring their motion to dismiss under both Rule 12(b)(1) and Rule 12(b)(6), but do not specify
which rule applies to Zohar’s RICO claim. (See Def. Memo. of Law in Support of Motion to Dismiss (“Mot.”),
ECF No. 54, at 9.) Notwithstanding that, the “standards for dismissal under Rule 12(b)(6) and 12(b)(1) are
substantively identical.” Porghavami v. Aerolinea Principal Chile S.A., 2015 WL 1206493, at *2 (S.D.N.Y. Mar.
17, 2015) (internal citations, quotation marks, and alterations omitted). “In deciding both types of motions, the
Court must accept all factual allegations in the complaint as true, and draw inferences from those allegations in the
light most favorable to the plaintiff.” Kacocha v. Nestle Purina Petcare Co., 2016 WL 4367991, at *3 (S.D.N.Y.
Aug. 12, 2016). “The only substantive difference is that the party invoking the jurisdiction of the court has the
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In determining the sufficiency of a complaint, a court may consider the factual
allegations in the complaint, “documents attached to the complaint as an exhibit or incorporated
in it by reference, . . . matters of which judicial notice may be taken, [and] documents either in
plaintiffs’ possession or of which the plaintiffs had knowledge and relied on in bringing suit.”
Brass v. Am. Film Techs., Inc., 987 F.2d 142, 150 (2d Cir. 1993).
II.
RICO Claim
A. The RICO Amendment
This motion hinges on whether Zohar may assert a civil RICO claim against
Defendants notwithstanding Section 107 of the Private Securities Litigation Reform Act—
dubbed the “RICO Amendment”—which bars any RICO action predicated on the purchase or
sale of securities. Specifically, the RICO Amendment provides that:
Any person injured in his business or property by reason of a
violation of section 1962 of [the RICO statute] may sue therefor in
any appropriate United States district court and shall recover
threefold damages he sustains and the cost of the suit . . . 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.
18 U.S.C. § 1964(c). Prior to the RICO Amendment, a plaintiff “could allege a private civil
RICO claim for securities laws violations sounding in fraud because ‘fraud in the sale of
securities’ was listed as a predicate offense.” In re Enron Corp. Sec., Derivatives & ERISA
Litig., 284 F. Supp. 2d 511, 618 (S.D. Tex. 2003) (internal citation omitted). But that created a
perverse incentive in which plaintiffs “regularly elevated fraud to RICO violations because
RICO offered the potential bonanza of recovering treble damages.” Bald Eagle Area Sch. Dist.
v. Keystone Fin., Inc., 189 F.3d 321, 327 (3d Cir. 1999). The bar was therefore designed to
burden of proof in a 12(b)(1) motion, in contrast to a 12(b)(6) motion, in which the defendant has the burden of
proof.” Porghavami, 2015 WL 1206493, at *2.
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“eliminat[e] the so-called ‘treble damage blunderbuss of RICO’ in securities fraud cases,”
Mathews v. Kidder, Peabody & Co., Inc., 161 F.3d 156, 164 (3d Cir. 1998), and prevent
“litigants from using artful pleading to boot-strap securities fraud cases into RICO cases.”
MLSMK Inv. Co. v. JPMorgan Chase & Co., 651 F.3d 268, 274 (2d Cir. 2011) (internal citation
omitted); Thomas H. Lee Equity Fund V, L.P. v. Mayer Brown, Rowe & Maw LLP, 612 F.
Supp. 2d 267, 281 (S.D.N.Y. 2009).
The scope of the RICO Amendment is broad. It bars any claim that is actionable
as fraud in the purchase or sale of securities, even in situations where a plaintiff lacks standing or
is otherwise precluded from asserting a valid claim under the securities laws. By its very terms,
the RICO Amendment bars claims based on conduct that “would have been actionable” under 18
U.S.C. 1964(c) in the purchase or sale of securities “even when the plaintiff, himself, cannot
bring a cause of action under the securities laws.” Thomas H. Lee Equity Fund, 612 F. Supp. 2d
at 283.
Thus, a plaintiff may not circumvent the RICO Amendment’s reach on the basis
that the alleged conduct—like aiding and abetting another party’s securities fraud—is not
formally recognized by the securities laws. If that were so, “plaintiffs would then have the
incentive to present only those facts that, if taken as true . . . , would not form the basis of a
securities-fraud claim,” and “reap the benefits of a RICO claim complete with the threat of treble
damages by merely failing to state a cause of action for securities fraud against a particular
defendant while relying on others’ securities fraud to establish a RICO claim.” Fezzani v. Bear,
Stearns & Co., 2005 WL 500377, at *4 (S.D.N.Y. Mar. 2, 2005). Put differently, if the alleged
conduct could form the basis of a securities fraud claim against any party—be it against, or on
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behalf of, the plaintiff, defendants or a non-party—it may not be fashioned as a civil RICO
claim.
To best define what constitutes conduct actionable as fraud in the purchase or sale
of securities, courts have consulted an obvious source in Section 10(b) of the Securities
Exchange Act of 1934, which—while not identical to the language of the RICO Amendment—
covers a broad range of securities fraud. Compare 18 U.S.C. § 1964(c) (“conduct . . . actionable
as fraud in the purchase or sale of securities”), with 15 U.S.C. § 78j (barring use of a deceptive
device “in connection with the purchase or sale of any security”). Thus, “[t]o determine whether
an alleged predicate act in a civil RICO claim is in connection with the purchase or sale of
securities and is therefore barred by [the RICO Amendment], the Court must focus its analysis
on whether the conduct pled as the predicate offenses is ‘actionable’ as securities fraud.” Ling v.
Deutsche Bank AG, 2005 WL 1244689, at *3 (S.D.N.Y. May 26, 2005).
Section 10(b) makes it unlawful for any person to employ a deceptive device “in
connection with the purchase or sale of any security.” 15 U.S.C. § 78j. But even that phrase—
“in connection with the purchase or sale”—has invoked a great deal of discussion among courts
grappling with when a fraud alleged by a plaintiff could relate to, arise out of, or bear some
nexus to the purchase or sale of a security, “especially so in a transaction . . . where there are
obviously non-securities components.” Ling, 2005 WL 1244689, at *3.
The Supreme Court in SEC v. Zandford, 535 U.S. 813 (2002), clarified the
contours of the phrase “in connection with the purchase or sale,” first directing courts to construe
Section 10(b)’s language “not technically and restrictively, but flexibly to effectuate its remedial
purposes.” 535 U.S. at 825. At the same time, however, the Court warned that “the statute must
not be construed so broadly as to convert every common-law fraud that happens to involve
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securities into a violation of § 10(b).” Zandford, 535 U.S. at 820 (citing Marine Bank v. Weaver,
455 U.S. 551, 556 (1982)). In Zandford, the Court determined that a stockbroker’s unauthorized
use of proceeds arising from stock sales in his client’s account constituted a fraud under Section
10(b) because the “scheme to defraud and the sale of securities coincide[d].” Zandford, 535 U.S.
at 822. Even though the respondent in Zandford characterized his scheme as a simple theft of
cash in an investment account, the Court concluded that the “securities sales and respondent’s
fraudulent practices were not independent events”—in other words, “each sale was made to
further respondent’s fraudulent scheme” without his client’s knowledge or permission, thus
amounting to a violation of the securities laws. Zandford, 535 U.S. at 820–21.
Three years after Zandford, the Supreme Court opined further on what it means
for certain deceptive conduct to be “in connection with” a securities transaction. In analyzing the
Securities Litigation Uniform Standards Act, the Court reiterated that the “fraud alleged [must]
‘coincide’ with a securities transaction—whether by the plaintiff or by someone else.” Merrill
Lynch, Pierce, Fenner & Smith Inc. v. Dabit (“Dabit II”), 547 U.S. 71, 85 (2006). Consistent
with Zandford’s broad mandate, the “requisite showing . . . is deception in connection with the
purchase or sale of any security, not deception of an identifiable purchaser or seller.” Dabit II,
547 U.S. at 85. Thus, a fraud “‘coincid[ing]’ with a securities transaction—whether by the
plaintiff or by someone else,” runs afoul of the securities laws. Dabit II, 547 U.S. at 85
B. RICO Predicate Acts
Zohar’s complaint broadly alleges three discrete categories of misconduct—
misrepresenting collateral value in Monthly Reports, expropriating and obscuring Zohar’s equity
interests, and converting equity distributions intended for Zohar. The first category pertains to
Defendants’ attempts to inflate the quality of Zohar’s collateral to preserve a continuous stream
14
of “hundreds of millions of dollars in management fees and preference share distributions to
which they were not entitled and would not have otherwise received,” and to “prevent[ ] the
Controlling Party from gaining control over the Zohar Funds’ Collateral.” (Compl. ¶ 65.) The
latter two categories relate to each other—Defendants denied Zohar “the proper benefit of their
equity investments, either by attempting to abscond with the equity investments themselves, by
improperly diverting the benefit of those equity holdings for their own use, or by outright
stealing the distributions on the equity.” (Compl. ¶ 41.)
“In determining whether misrepresentations coincided with the purchase or sale of
securities, courts consider the allegedly fraudulent scheme as a whole.” Levinson v. PSCC
Servs., Inc., 2009 WL 5184363, at *7 (D. Conn. Dec. 23, 2009); see also Stechler v. Sidley,
Austin Brown & Wood, LLP, 382 F. Supp. 2d 580, 597–98 (S.D.N.Y. 2005) (considering tax
strategy as a whole to ascertain whether it involved purchase and sale of securities). If even “one
predicate act alleges breaches of duty coincident with securities transactions then the whole
scheme is subject to the [RICO Amendment].” Ling, 2005 WL 1244689, at *4. Thus, this Court
must analyze each category of alleged misconduct in turn to assess whether the RICO
Amendment bars Zohar’s RICO claim.
i. OC Test Manipulation and Monthly Report Misrepresentations
Defendants contend that the allegations regarding Patriarch’s manipulation of the
OC Test are fatal to Zohar’s RICO claim because they relate to the purchase or sale of CLOs.
According to Defendants, Zohar’s sale of CLOs and Defendants’ misrepresentations regarding
the OC Test results constitute securities fraud. To bolster this argument, Defendants assert that
the Complaint imports many of the allegations from the SEC’s enforcement action, which
involved miscategorizing loan performance, manipulating OC Test results, and misleading
15
investors. Defendants argue that Zohar’s pleading “expressly relies on the same fraud
allegations made by the SEC . . . so, of course, it could have been actionable as securities fraud.”
(Mot. at 12.) And despite the SEC’s decision to bring a claim under the IAA—instead of Section
10(b) of the Exchange Act—Defendants contend that the IAA “expressly regulates conduct that
‘relate[s] to the purchase and sale of securities,’ including the issuance of ‘reports’ to investors
on which they rely in making investment decisions.” (Defendants’ Reply in Support of Motion
to Dismiss (“Reply”), ECF No. 60, at 3–4 (internal alteration and citation omitted).) Thus,
Defendants claim that because the SEC and investors “could have brought a securities fraud
action based on the conduct alleged in the Complaint, the RICO claim is barred.” (Reply at 3
(emphasis original).)
Defendants are correct that the RICO Amendment extends to allegations
supporting any claim brought by any person, but the claim must involve an actionable fraud in
the purchase or sale of securities. Equally true is that a civil RICO claim derived from the same
allegations as an SEC enforcement action is vulnerable to dismissal under the RICO Amendment
since the SEC is the regulatory agency principally tasked with rooting out securities fraud. Bald
Eagle, 189 F.3d at 328 (SEC’s complaint alleged the same scheme which “is at the heart of this
RICO action”); Eagletech Comm’cns Inc. v. Citigroup, Inc., 2008 WL 3166533, at *14 (S.D.
Fla. June 27, 2008) (“[T]he predicate acts are actionable as securities fraud and may be
prosecuted by the SEC.”). But the simple fact of a parallel SEC action predicated on the same
subject matter as this action, by itself, is insufficient to invoke the RICO Amendment if the
claims in the former action do not involve a fraud in the purchase or sale of securities.
Here, Defendants seek to apply the patina of an SEC enforcement action to
Zohar’s claims and argue that the SEC’s prosecution of an IAA claim is tantamount to securities
16
fraud. But that overlooks the substance of the SEC’s claims, which allege that Tilton and
Patriarch’s misrepresentations to investors about the value of Zohar’s assets and their decision to
enter into fundamentally conflicted positions to enrich themselves violated their fiduciary duties.
Obviously, securities are involved here because Zohar’s existence arises from the sale of CLOs,
but the “incidental involvement of securities do[es] not implicate the anti-fraud provisions of the
federal securities laws.” Dabit v. Merrill Lynch, Pierce, Fenner & Smith, Inc. (“Dabit I”), 395
F.3d 25, 37 (2d Cir. 2005), rev’d on other grounds, 547 U.S. 71 (2006). The SEC Order makes
no reference to the purchase or sale of a security, nor does it allege that Defendants’ breach of
fiduciary duty coincided with Zohar’s sale, or its investors’ purchase, of the CLOs.
Turning to Zohar’s allegations in this action, this Court concludes that
Defendants’ decision to manipulate the OC Test and issue false Monthly Reports do not coincide
with the purchase or sale of securities. Rather, the Complaint depicts a situation in which this
particular aspect of the fraud was perpetrated to retain Defendants’ ability to collect management
fees in their capacity as collateral manager. (Compl. ¶ 56.) Defendants’ misrepresentations in
the Monthly Reports bear an attenuated nexus to the purchase or sale of Zohar’s notes because
such reports were issued only to investors who had purchased the CLOs long ago. And there is
no indication from the face of the Complaint that the OC Test results or the Monthly Reports
were disseminated in connection with the purchase or sale of a CLO, or had any bearing on an
investor’s decision to purchase the notes. 4 Rather, the terms of the Indenture contemplate
4
Defendants reference investor testimony from the SEC enforcement action regarding the purchase and sale
of CLOs and their decision to invest in Zohar. (Mot. at 12 n.7.) While this Court may consider materials external to
the pleadings, there is a limit. “A complaint that alleges facts related to or gathered during a separate litigation does
not open the door to consideration, on a motion to dismiss, of any and all documents filed in connection with that
litigation.” Goel v. Bunge, Ltd., 820 F.3d 554, 560 (2d Cir. 2016). Thus, “a court may take judicial notice of a
document filed in another court not for the truth of the matters asserted in the other litigation but rather to establish
the fact of such litigation and related filings.” Global Network Commc’ns, Inc. v. City of N.Y., 458 F.3d 150, 157
(2d Cir. 2006). To consider detailed testimony from an SEC proceeding involving related claims would “permit the
17
disclosure of the OC Test results and Monthly Reports to existing investors after they have
purchased the notes. (See Shapiro Decl., Ex. 1, § 10.13.)
In “look[ing] beyond the face of the complaint to analyze the substance of the
allegations made,” the OC Test allegations fall outside the ambit of the RICO Amendment.
Dabit I, 395 F.3d at 34. Zohar sets forth a series of detailed allegations to make out what appears
to be a veritable scheme to defraud, but that scheme existed independent of the securities
transactions. The OC Test and Monthly Report allegations, like those referenced in the SEC
action, appear more akin to a scenario that Zanford exempted from the scope of a securities fraud
claim: “after a lawful transaction had been consummated, a broker decided to steal the proceeds
and did so.” Zandford, 535 U.S. at 820.
Applied here, the purchase and sale of Zohar’s CLOs in 2003, 2005, and 2007
were entirely lawful transactions. Nothing in the Complaint suggests that Defendants “secretly
intend[ed] from the very beginning to keep the proceeds” of the note offerings. Zandford, 535
U.S. at 824; Wharf (Holdings) Ltd. v. United Int’l Holdings, Inc., 532 U.S. 588, 596–97 (2001).
Rather, the fraud appears to have arisen “well after the creation of the Zohar Funds,” since “2009
at the very latest, [when] the OC Test under the Zohar Funds’ Indentures should have been
failing due to significant deterioration in the Funds’ loan portfolios.” (Pl. Memo. of Law in
Opposition to Motion to Dismiss (“Opp.”), ECF No. 58, at 10; Compl. ¶ 58.) The incentive to
fraudulently inflate collateral value appears only to have arisen when things went awry—with
the collateral underperforming and in danger of failing the OC Test, Defendants were in danger
of losing their fees and control over Zohar’s assets. But that fraud occurred separate and apart
from the sale of Zohar’s CLOs. See Leykin v. AT&T Corp., 423 F. Supp. 2d 229, 242 (S.D.N.Y.
improper transformation of the Rule 12(b)(6) inquiry into a summary-judgment proceeding—one featuring a
bespoke factual record, tailor-made to suit the needs of defendants.” Goel, 820 F.3d at 560.
18
2006) (“[A]n otherwise legitimate stock transaction that is antecedent, but not integral, to the
alleged fraud does not meet the ‘in connection with’ requirement.”).
Defendants nevertheless attempt to burnish the purported link between the CLO
transactions and the OC Test allegations by citing investor testimony from the SEC action that
the decision to purchase, sell, or hold the notes would have changed if the collateral were
categorized accurately. (Mot. at 12 n.7, 13 n.9.) Plaintiffs counter that the notes did “not trade
in a public market 5 and the [Monthly] Reports are disseminated only to existing investors, unlike
reports filed with the SEC by corporate issuers of publicly traded securities.” (Opp. at 11
(internal quotation marks omitted).) Thus, Plaintiffs argue, it is “rank speculation that some
theoretical investor in the Zohar Funds’ notes may have made some investment decision based
on misrepresentations” in the Monthly Reports. (Opp. at 11–12.)
At this juncture in the litigation, the Complaint sheds no light on whether there
was a market for the CLOs, or the type of information prospective purchasers possessed (if any),
during the period in which Defendants issued false Monthly Reports. Nor does the Complaint
suggest that the original investors purchased or sold CLOs in a secondary market after
Defendants’ scheme to defraud had been hatched. Even if CLOs were traded during the life of
Zohar’s funds, “incidental purchases and sales” of the notes, without more, would “not implicate
the anti-fraud provisions of the federal securities laws.” SEC v. Northshore Asset Mgmt., 2008
WL 1968299, at *7 (S.D.N.Y. May 5, 2008). These apparent omissions may be the kind of artful
pleading that the RICO Amendment is designed to bar. But the Complaint is otherwise
5
Though a public market for the notes is not required to establish a Section 10(b) claim, the Complaint
makes no reference to whether there was any market for the notes, let alone disclosures of information from which
potential buyers in that market could have based their decision to purchase the security. See Superintendent of Ins.
of N.Y. v. Bankers Life & Cas. Co., 404 U.S. 6, 12 (1971) (rejecting argument that Section 10(b) applied only to
fraudulent transactions in the context of a securities exchange, instead reading the statute “flexibly” to “bar
deceptive devices and contrivances in the purchase or sale of securities whether conducted in the organized markets
or face to face.”).
19
sufficiently detailed that discovery on such issues would be appropriate assuming the rest of the
alleged scheme is not barred by the RICO Amendment. (See Hearing Tr. dated Apr. 4, 2017,
ECF No. 63, at 24:21–25 (“If at some point further down the road there is discovery taken and
they are able to show that, in fact, there were investors who were out there who were actually
engaging in a purchase or sale based upon this false information, then they can come back to you
with that evidence.”).)
ii. Misappropriation of Equity and Equity Distributions
Because the Complaint alleges a single, ongoing fraudulent scheme, all of
Defendants’ alleged acts must be considered together. Levinson, 2009 WL 5184363, at *7.
(See, e.g., Compl. ¶ 176 (“Defendants “engage[d] in a common scheme of fraudulent
misrepresentations, self-dealing, breaches of trust and fiduciary duty, and outright theft or
attempted theft for [a] common purpose.”).) While the OC Test and Monthly Report allegations
escape the RICO bar, the allegations relating to Defendants’ theft of Zohar’s equity interests and
distributions are fatal to the RICO claim. 6
Zohar characterizes the alleged scheme as a “classic example of a case of postinvestment looting and the concealment thereof that is not actionable under the securities laws,”
but that overlooks the granular mechanics of executing the fraud. (Opp. at 12 (internal quotation
marks omitted).) While the sale of the CLO notes may have been incidental to the fraudulent
scheme, other securities—namely portfolio company equity—were acquired in connection with
the underlying fraud. Indeed, as Zohar alleges, one of Tilton’s key objectives in managing the
6
This set of allegations concerning Zohar’s equity does not appear to have been a part of the SEC’s case.
(See Plaintiffs’ Ltr. dated Sept. 29, 2017, ECF No. 72, at 1 (“[T]he SEC decision has no relevance to this case. It
does not even address, let alone undermine, the core of the Zohar Funds’ allegations.”); see also Zohar II 2005-1,
Ltd. v. FSAR Holdings, Inc., No. 12946-VCS (Del. Ch. Ct. Nov. 30, 2017), slip op. at 93 (“Insofar as [the SEC
administrative law judge’s] Initial Decision considered whether the Zohar Funds own equity in their portfolio
companies, that issue—equity ownership—was not case-dispositive.”).)
20
funds was “loan-to-own or [] own-to-loan” because, according to her, “the only way to get
beyond the face value of the loan is to have that equity upside.” (Compl. ¶ 46.) Despite Tilton’s
apparent confusion over her own investment strategy, Zohar’s aim was not only to extend loans
to repay its noteholders, but to secure interests in portfolio companies whose equity could later
be monetized at a substantial profit.
Zohar authorized Defendants to loan and invest its funds in portfolio companies,
knowing full well that Defendants were bound by express and implied fiduciary duties to utilize
the money in Zohar’s interests. Zohar was “sometimes provided with equity interests in the
company in recognition of the distressed nature of loans,” or in “connection with restructurings
of existing loans to Portfolio Companies.” (Compl. ¶¶ 43–45, 49.) That equity came in the form
of common stock, preferred stock, or LLC membership interests. (Compl. ¶¶ 43–45.) As a
result, Zohar (along with Defendants) at one point in 2007 held a majority interest in 23 portfolio
companies, including 100% in seven of those companies. (Compl. ¶ 46.) And in 2009, Patriarch
boasted equity ownership by Zohar in 43 portfolio companies, of which 14 were completely
owned by Zohar. (Compl. ¶ 46.)
But instead of using Zohar’s funds to transfer all equity interests to Zohar,
Defendants often misused the money to acquire equity for themselves. This is a clear example in
which a breach of fiduciary duty and a securities transaction coincide. Tilton and Patriarch,
authorized to act on Zohar’s behalf, were bound to express and implied fiduciary duties. Most
sacred of those duties is the duty of loyalty—Zohar trusted Tilton and Patriarch to invest its
funds for its benefit and entirely in its own interests. Defendants ignored that duty, instead
entering into many transactions involving the extension of a loan and the transfer of equity that
were “made to further [Defendants’] fraudulent scheme; each [transaction] was deceptive
21
because it was neither authorized by, nor disclosed to” Zohar. Zandford, 535 U.S. at 820–21.
Put another way, Defendants were “only able to carry out [their] fraudulent scheme . . . because
[Zohar and the noteholders] trusted [them] to make transactions in their best interest.” Zandford,
535 U.S. at 822. And these equity transactions, tendered as common stock, preferred stock, and
LLC membership interests, 7 were governed by the federal securities laws. Nelson v. Stahl, 173
F. Supp. 2d 153, 164 (S.D.N.Y. 2001) (“[S]tock, whether in a publicly held company or [ ] in a
closely held corporation, constitutes a security governed by the federal securities laws.”); Reves
v. Ernst & Young, 494 U.S. 56, 62 (1990) (“[C]ommon stock is the quintessence of a security.”);
Sobek v. Quattrochi, 2004 WL 2809989, at *4 (S.D.N.Y. Dec. 8, 2004).
The purchase of stock was integral to the scheme to defraud since, without it,
Defendants would have lacked the position to claim dividends and exercise control over the
portfolio companies. Seippel v. Jenkens & Gilchrist, P.C., 341 F. Supp. 2d 363, 374 (S.D.N.Y.
2004) (“[S]ale of that stock was an integral part of the scheme, as without it there would have
been no gain” for the tax fraud.); Levinson, 2009 WL 5184363, at *7. Defendants, in essence,
“accepted and deposited [Zohar’s] monies as payment for securities with no intent to deliver
them” to Zohar. Instituto De Prevision Militar v. Merrill Lynch, 546 F.3d 1340, 1349 (11th Cir.
2008). Thus, after claiming Zohar’s equity for themselves, Defendants “absconded with
[dividend payments] rather than allowing them to properly be paid to the Zohar Funds’ trustee
for ultimate distribution to the Zohar Funds’ noteholders.” (Compl. ¶ 50.)
7
This Court recognizes that “membership interests in LLCs resist categorical classification . . . [and a] caseby-case analysis into the economic realities of the underlying transactions is required.” United States v. Leonard,
529 F.3d 83, 89 (2d Cir. 2008). Defendants’ purported investment strategy—loaning to own with the expectation
that rehabilitating a distressed company would maximize their equity—suggests that at least some of the LLC
membership interests Defendants obtained would qualify as a security under the Supreme Court’s test in SEC v.
W.J. Howey Co., 328 U.S. 293 (1946) (an investment of money into a common enterprise with the expectation of
profits derived from the efforts of others).
22
The two cases cited by Zohar in support of its view that Defendants engaged in
post-investment looting are unpersuasive. In Mezzonen S.A. v. Wright, 1999 WL 1037866
(S.D.N.Y. Nov. 16, 1999)—a case decided well before Zandford—the court found that postinvestment activity involving the issuance of “fraudulent earnings and activities reports, false
valuations, and money transfers” to prevent investors from withdrawing their investment was not
actionable as a claim under the securities laws. While the Mezzonen defendants sought
dismissal under the RICO Amendment by advancing what was in essence a holder claim, the
court found that the securities laws “do [ ] not afford relief to those who forego . . . a sale and
instead merely hold in reliance of a nondisclosure or misrepresentation.” Mezzonen, 1999 WL
1037866, at *4 (internal citations omitted). While certain allegations here may fall into that
category of exempted conduct, there was clearly another component to Defendants’ overarching
scheme that involved activity forming the basis for an actionable claim under the securities laws.
Here, the post-investment looting involved the purchase and sale of securities.
Moreover, Mezzonen’s rationale underscores just how dated and unavailing it is
today, in view of the Second Circuit’s decisive holding that the RICO Amendment “bars civil
RICO claims alleging predicate acts of securities fraud, even where a plaintiff cannot itself
pursue a securities fraud action against the defendant.” MLSMK, 651 F.3d at 277; see also
Thomas H. Lee Equity Fund, 612 F. Supp. 2d at 283. Mezzonen held, in part, that the plaintiff
could not “base a securities fraud claim on Defendants’ post-investment conduct.” 1999 WL
1037866, at *5. Even the single transaction that the Mezzonen defendants offered as evidence of
actionable securities fraud was rejected on the basis that it “did not involve [the plaintiff]
Mezzonen as a purchaser or seller of the debentures.” Mezzonen, 1999 WL 1037866, at *5.
23
Today, however, a single securities transaction that coincides with the fraudulent scheme can be
the death knell of a RICO claim.
Further, Zohar cites Leykin, for the proposition that “an otherwise legitimate
stock transaction that is antecedent, but not integral, to the alleged fraud does not meet the ‘in
connection with’ requirement.” Leykin, 423 F. Supp. at 242. That may hold true for Zohar’s
CLO note offerings to its investors, which this Court has already concluded were legitimate
stock transactions antecedent to Defendants’ fraud. But the other predicate acts giving rise to
Zohar’s RICO claim existed part and parcel of the purchase or sale of securities—the acquisition
of equity (in the form of common stock, preferred stock, or LLC interests) in portfolio
companies.
Zohar takes pains to avoid using the term “securities” in the Complaint, and to the
extent securities are involved, paints a picture in which they are tangentially involved in the
scheme to defraud. But taking Zohar at its word is tantamount to crediting a “surgical
presentation” of the claims and “undermine[s] the congressional intent behind the RICO
Amendment,” which is to strike artful pleadings that attempt to mask any actionable securities
fraud claim as wire or mail fraud. Bald Eagle, 189 F.3d at 329–30; Burton v. Ken–Crest Servs.,
Inc., 127 F. Supp. 2d 673, 677 (E.D. Pa. 2001) (“Plaintiff cannot magically revive his claim by
picking out discreet details of his allegations and then claiming that they are not actionable as
securities fraud.”). Much of the Complaint alleges a complex scheme to abscond with millions
of dollars in fees, obfuscate title to assets, or simply loot the assets of a portfolio company, which
all appear, at least superficially, like non-securities conduct. But this Court cannot ignore
allegations that an integral component of that scheme to loot included pillaging portfolio
companies of their equity, re-directing Zohar’s equity interests for Defendants’ benefit, and
24
diverting the equity distributions into Defendants’ coffers—all actions coinciding with the
purchase or sale of securities. See Gilmore v. Gilmore, 2011 WL 3874880, at *6 (S.D.N.Y.
Sept. 1, 2011) (“Plaintiff’s over-arching theory of this case is that [Defendants] engaged in
various plots to loot Covington and other family corporations. That conduct counts as a single
scheme, and the securities aspects of the fraud must be aggregated with the non-securities
aspects.”); Hollinger Int’l, Inc. v. Hollinger Inc., 2004 WL 2278545, at *8–9 (N.D. Ill. Oct. 8,
2004) (while predicate acts of “fraudulently convert[ing] $380.6 million in assets from the
Company . . . and [taking] inflated and unearned management fees,” were not “per se violations
of securities law, they were an integral part of Defendants’ scheme to loot” and coincided with
shareholders’ purchase and sale of securities).
Accordingly, because this aspect of Defendants’ scheme runs headlong into the
heart of the RICO Amendment, Zohar’s civil RICO claim is dismissed.
III.
Remaining Causes of Action
This Court’s subject matter jurisdiction arises principally from federal question
jurisdiction under 28 U.S.C. § 1331 and the RICO statute under 18 U.S.C. §§ 1964, 1965.
(Compl. ¶ 22.) While the Complaint also alleges that subject matter jurisdiction exists under the
parties’ diversity of citizenship, 28 U.S.C. § 1332, Zohar has conceded that no such basis exists.
(Opp. at 25 (“Plaintiffs concede there is no diversity jurisdiction on the present pleading.”).)
With the RICO claim dismissed, this Court must consider whether it is
appropriate to exercise supplemental jurisdiction over the remaining 11 common law claims. 8
While a district court may, “at its discretion, exercise supplemental jurisdiction over state law
8
The other causes of action seek remedies pertaining to three counts for declaratory judgment, an
accounting, breach of contract, conversion, breach of fiduciary duty, aiding and abetting breach of fiduciary duty,
faithless servant, and unjust enrichment.
25
claims even where it has dismissed all claims over which it had original jurisdiction, see 28
U.S.C. § 1367(c)(3), it cannot exercise supplemental jurisdiction unless there is first a proper
basis for original jurisdiction.” Nowak v. Ironworkers Local 6 Pension Fund, 81 F.3d 1182,
1187 (2d Cir. 1996).
“In most circumstances, it makes little practical difference whether the district
court labels its dismissal of an action as one for lack of subject matter jurisdiction under Rule
12(b)(1) or for failure to state a claim under Rule 12(b)(6).” Nowak, 81 F.3d at 1188. But
because “a court must have original jurisdiction in order to exercise supplemental jurisdiction, a
dismissal pursuant to Rule 12(b)(1) precludes a district court from exercising supplemental
jurisdiction over related state claims.” Nowak, 81 F.3d at 1188. Whether a “federal court
possesses federal-question subject matter jurisdiction and whether a plaintiff can state a claim for
relief under a federal statute are two questions that are easily, and often, confused.” Carlson v.
Principal Fin. Grp., 320 F.3d 301, 305–06 (2d Cir. 2003). In federal question cases, like this one,
the “very statute that creates the cause of action often confers jurisdiction as well—that is, the
claim ‘arises under’ the same federal law that gives the plaintiff a cause of action.” Nowak, 81
F.3d at 1187.
Adding to the confusion, Defendants’ motion seeks dismissal under both Rules
12(b)(1) and 12(b)(6), but does not appear to distinguish which of Zohar’s claims should be
dismissed under one or both of the rules. (See Mot. at 9; Defendants’ Notice of Motion, ECF
No. 53, at 1.) In their Answer, however—filed during the pendency of the motion to dismiss—
Defendants specify that the “RICO claim should be dismissed under Federal Rule of Civil
Procedure 12(b)(6) for failure to state a cognizable claim.” (Answer, Counterclaims, and ThirdParty Complaint (“Third Party Compl.”), ECF No. 79, ¶ 26.)
26
Nevertheless, the “jurisdictional inquiry is rather straightforward and depends
entirely upon the allegations in the complaint: where the complaint is so drawn as to seek
recovery directly under the Constitution or laws of the United States, the federal court, but for
two possible exceptions 9 . . . must entertain the suit.” Carlson, 320 F.3d at 306 (citing Bell v.
Hood, 327 U.S. 678, 681–82 (1946)) (internal quotation marks and alterations omitted). Indeed,
this Court need only ask whether the “complaint is drawn so as to seek recovery under federal
law or the Constitution. If so, then [the court must] assume or find a sufficient basis for
jurisdiction, and reserve further scrutiny for an inquiry on the merits.” Nowak, 81 F.3d at 1189.
And standing under RICO, in particular, “for purposes of a motion to dismiss, is not a
jurisdictional concept, but instead is analyzed as a merits issue under” Rule 12(b)(6).
Brookhaven Town Conservative Committee v. Walsh, 2016 WL 1171583, at *4 (E.D.N.Y. Mar.
23, 2016); Alphas Co. of N.Y. Inc. v. Hunts Point Terminal Produce Cooperative, Inc., 2017 WL
1929506, at *3 (S.D.N.Y. May 9, 2017) (“Supreme Court clarified that standing under a statute
is not in fact a standing issue that implicates subject matter jurisdiction but rather the issue of
whether a particular plaintiff has a cause of action under the statute.”) (citation omitted).
Here, Zohar clearly seeks relief under the federal RICO statute. (Compl. ¶¶ 22,
219–220.) While Defendants raise a threshold argument in their motion to dismiss—whether the
RICO Amendment forecloses the RICO claim as a matter of law—that is an attack on the
sufficiency of the RICO-specific allegations in Zohar’s complaint. See Crawford & Sons, Ltd.
9
The two exceptions do not apply here. They arise “where the alleged claim under the Constitution or
federal statutes clearly appears to be immaterial and made solely for the purpose of obtaining jurisdiction or where
such a claim is wholly insubstantial and frivolous.” Bell, 327 U.S. 682–83. While Zohar’s RICO claim is the only
basis on which federal subject matter jurisdiction exists (absent diversity of citizenship), it is neither “immaterial”
nor “wholly insubstantial and frivolous.” Rather, the Complaint specifically and thoroughly alleges a number of
predicate acts to support Zohar’s theory of liability under RICO. And though this Court has concluded that some of
those predicate acts run afoul of the RICO Amendment, such a determination does not render the claim immaterial,
insubstantial, or frivolous.
27
Profit Sharing Plan v. Besser, 216 F.R.D. 228, 233 (E.D.N.Y. 2003). In other words, the
“jurisdictional question (whether [Zohar’s] claim ‘arose under’ [RICO]) and the question on the
merits (whether [Zohar] stated a claim upon which relief could be granted) were inextricably
bound together, and required the court to make a substantial inquiry into the statute’s
applicability.” Nowak, 81 F.3d at 1190. Thus, this Court was vested with subject matter
jurisdiction to evaluate the merits of the RICO claim. It examined the sufficiency of the
allegations in the Complaint to determine that Zohar’s claim was foreclosed by the RICO
Amendment. Therefore, this Court’s dismissal of the RICO claim is founded on Zohar’s failure
to state a claim under Rule 12(b)(6).
Because this Court had original jurisdiction over the RICO claim, it may now
consider, in its discretion, whether to exercise supplemental jurisdiction over the remaining
common law claims. Under 28 U.S.C. § 1367(a), district courts have “supplemental jurisdiction
over all other claims that are so related to claims in the action within such original jurisdiction
that they form part of the same case or controversy under Article III of the United States
Constitution.” Claims “form a part of the same case or controversy” if they “derive from a
common nucleus of operative fact.” Briarpatch Ltd., L.P. v. Phoenix Pictures, Inc., 373 F.3d
296, 308 (2d Cir. 2004). Here, Zohar’s common law claims and RICO claim arise from a
common nucleus of operative facts regarding Defendants’ wide-ranging, ongoing scheme to
deceive investors and pilfer Zohar’s assets.
Where Section 1367(a) is satisfied, however, the “discretion to decline
supplemental jurisdiction is available only if founded upon an enumerated category of subsection
1367(c).” Itar–Tass Russian News Agency v. Russian Kurier, Inc., 140 F.3d 442, 448 (2d Cir.
1998). In this case, section 1367(c)(3) applies—this Court “dismissed all claims over which it
28
has original jurisdiction.” Even so, “where at least one of the subsection 1367(c) factors is
applicable,” a court should also determine whether exercising supplemental jurisdiction would
promote economy, convenience, fairness, and comity. Jones v. Ford Motor Credit Co., 358 F.3d
205, 214 (2d Cir. 2004).
In “the usual case [where] all federal-law claims are eliminated before trial, the
balance of factors to be considered . . . will point toward declining to exercise jurisdiction over
the remaining state-law claims.” Valencia ex rel. Franco v. Lee, 316 F.3d 299, 305 (2d Cir.
2003). Several of the discretionary factors here militate against exercising supplemental
jurisdiction. Despite the torrent of letters the parties filed during the pendency of the motion to
dismiss—and the unhelpful rhetoric undergirding each of them—this case is in the early stages
of litigation. Discovery has not begun in earnest, and Defendants’ Answer to the Complaint was
recently filed. Certilman v. Becker, 807 F. Supp. 307, 310 (S.D.N.Y. 1992) (declining to
exercise jurisdiction where “the complaint was amended to omit all federal-law claims before the
parties engaged in any discovery”); Torre v. Town of Tioga, 2015 WL 1524421, at *2 (N.D.N.Y.
Apr. 2, 2015) (remand action to state court is “appropriate [ ] where discovery had not even
begun”).
Dismissal at this stage would not amount to a waste of this Court’s resources or
inconvenience the parties in bringing their claims in state court. In re Methyl Tertiary Butyl
Ether (MTBE) Prods. Liab. Litig., 613 F. Supp. 2d 437, 445 (S.D.N.Y. 2009) (“Because no
judicial resources have been invested in these matters, the interest of economy and convenience
in retaining supplemental jurisdiction are modest.”); Cedar Swamp Holdings, Inc. v. Zaman, 487
F. Supp. 2d 444, 453 n.63 (S.D.N.Y. 2007) (“[A]t early stages in the proceedings, [there is] little
to be gained by way of judicial economy from retaining jurisdiction.”). Further, while federal
29
courts are equipped to examine common law claims such as breach of contract and breach of
fiduciary duty, comity dictates that these causes of action are predominantly issues of state law
better suited for resolution in state court.
Finally, it would not be unfair to any of the parties if this Court declined
supplemental jurisdiction. During the pendency of the motion to dismiss, Zohar apparently filed
a “new, and entirely duplicative, omnibus action in Delaware involving 11 of the same portfolio
companies that [Zohar] long ago put at issue here,” (the “November 2017 Delaware Action”) and
designated that action as “related” to a case Zohar filed in November 2016 before the Delaware
Chancery Court regarding Zohar’s control over three other portfolio companies (the “November
2016 Delaware Action”). 10 (Defendants’ Ltr. dated Nov. 16, 2017 (“Def. Nov. 16 Ltr.”), ECF
No. 78, at 2.) Defendants characterize the move as “blatant forum shopping” that seeks
“verbatim the relief” sought in this action. (Def. Nov. 16 Ltr. at 1, 2.) Thus, to prevent the
“procedural gamesmanship” that Zohar has ostensibly engaged in, Defendants withdrew their
initial request for this Court to decline supplemental jurisdiction so that “the issues already raised
in this case concerning ownership and control of all of these portfolio companies can be litigated
and resolved here.” (Compare Mot. at 1, 25 n.20, with Def. Nov. 16 Ltr., at 1.)
But the simple fact that Zohar filed an action in Delaware Chancery Court similar
to the one here does not militate in favor of this Court’s exercise of supplemental jurisdiction. If
anything, permitting the state law claims here to proceed in a Delaware state court would uphold
values of comity and fairness. The Delaware Chancery Court seems best positioned to
adjudicate the remaining state law claims since an action predating this case—the November
10
On November 30, 2017, the Delaware court issued an omnibus decision addressing Zohar’s claims in the
November 2016 Delaware Action. (See Plaintiffs’ Ltr. dated Dec. 2, 2017 (“Plaintiffs’ Dec. 2 Ltr.”), ECF No. 97, at
1.) But the counterclaims asserted by Defendants remain under review in that action. (See Plaintiffs’ Dec. 2 Ltr. at
4.)
30
2016 Delaware Action—already raised issues pertaining to Zohar’s ownership and control over
three portfolio companies, 11 and the latest November 2017 Delaware Action implicates
“purported ownership and control of 11 of the portfolio companies.” (Def. Nov. 16 Ltr. at 2.)
The Delaware court is an ideal forum to resolve these equity-related questions because
Defendants filed counterclaims in the November 2016 Delaware Action concerning “the equity
ownership of several other companies—including companies that are the subject of Plaintiffs’
[November 2017 Delaware Action] complaint and Defendants’ new state-court complaints” in
three other states. (Plaintiffs’ Dec. 2 Ltr. at 4.) There is substantial overlap between the factual
and legal questions invoked by each of the parties’ claims in the November 2016 and November
2017 Delaware Actions. And all such claims are pending before the same judge in the Delaware
Chancery Court, who is eminently qualified to resolve them.
Also relevant here, and worth noting, is the irony behind Defendants’ contention
that Zohar has engaged in “gamesmanship” when, a few days before Zohar filed the November
2017 Delaware Action, Defendants filed three separate state court actions in Michigan, Arizona,
and California, respectively, seeking declaratory relief concerning their ownership and control of
certain assets. That they would stymie Zohar’s efforts to litigate these corporate control cases
elsewhere, yet at the same time file their own claims in far-flung state forums, underscores this
Court’s determination that absent a valid RICO claim, the remaining common law claims should
be resolved by state courts.
11
Defendants also claim that their counterclaims in the November 2016 Delaware Action, “although
expressly addressing only the ownership of those three portfolio companies, broadly implicate all of the companies
because of the overlapping legal and factual issues with regard to [Tilton’s] ownership of the many other portfolio
companies now directly at issue” in this action. (Mot. at 7 n.4.) That simply validates this Court’s view that all of
Zohar and Defendants’ claims should be heard by a Delaware court that is, by now, well-versed with the facts and
the relevant state law.
31
Supplemental jurisdiction “is a doctrine of discretion, not of plaintiff’s right. Its
justification lies in considerations of judicial economy, convenience, and fairness to litigants; if
these are not present a federal court should hesitate to exercise jurisdiction over state claims.”
United Mine Workers v. Gibbs, 383 U.S. 715, 726 (1966); Gilmore v. Gilmore, 2011 WL
5517832, at *2 (S.D.N.Y. Nov. 10, 2011). In accord with that principle, this Court finds that
interests of economy, convenience, comity, and fairness weigh against exercising supplemental
jurisdiction over the remaining claims.
IV.
Defendants’ Third Party Complaint
On November 22, 2017, Defendants answered the Complaint, filed counterclaims
against Zohar, and filed third-party claims against MBIA, U.S. Bank, Alvarez & Marsal Zohar
Management, and the Zohar III Controlling Class 12 (the “Third Party Complaint”). (Third Party
Compl. ¶¶ 1–23.) The Third Party Complaint was filed during the pendency of Defendants’
motion to dismiss. Through their prolix pleading, Defendants fire off 22 causes of action that are
similar to Zohar’s claims. That is, Defendants generally allege that MBIA, U.S. Bank, Alvarez
& Marsal Zohar Management, and Zohar III Controlling Class (“Third Party Defendants”)
orchestrated a wide-ranging fraud to rob Tilton of her control and equity in portfolio companies.
Defendants claim that this Court has original jurisdiction under 28 U.S.C. § 1331,
through the RICO claim, and 12 U.S.C. § 632, through the Edge Act, which confers federal
jurisdiction in cases where one of the parties—here, U.S. Bank—is a federally chartered
corporation engaged in international banking. (Third Party Compl. ¶ 24–26.) They also claim
that supplemental jurisdiction over any state law claims, counterclaims, and third-party claims is
proper under 28 U.S.C. § 1367(a).
12
The Zohar III Controlling Class consists of a group of four noteholders who collectively own a majority of
Zohar III’s Class A notes. (Third Party Compl., ¶ 22.)
32
Zohar and the Third Party Defendants have yet to answer the Third Party
Complaint. 13 But before they do, a few observations about this Court’s jurisdiction over the
third-party claims and the propriety of impleading these claims are in order. There is a question,
especially in view of this Court’s dismissal of the original action, of whether there is an
independent basis for federal jurisdiction or whether the Third Party Complaint may properly be
considered under Federal Rule of Civil Procedure 14.
“Federal courts are courts of limited jurisdiction.” Kokkonen v. Guardian Life
Ins. Co. of Am., 511 U.S. 375, 377 (1994). “In the Second Circuit, it is clear that the jurisdiction
of the district court over the claims of the plaintiffs is not enhanced by third party complaints.”
Arrow Fin. Servs., LLC v. Massil, 2009 WL 348553, at *2 (E.D.N.Y. Feb. 11, 2009) (citing In re
Agent Orange Prod. Liab. Litig., 635 F.2d 987, 990 n.6 (2d Cir. 1980)) (internal quotation marks
and alterations omitted).
More importantly, it is unclear whether Defendants can establish an independent
basis for jurisdiction by asserting counterclaims or third-party claims arising under federal law.
Holmes Grp. Inc. v. Vornado Air Circ. Sys., Inc., 535 U.S. 826, 831 (2002) (“It follows that a
counterclaim—which appears as part of the defendant’s answer, not as part of the plaintiff’s
complaint—cannot serve as the basis for ‘arising under’ jurisdiction.”). The Third Party
Complaint asserts two federal statutes from which Defendants’ counterclaims and third-party
claims arise—RICO and the Edge Act. Because this Court has dismissed the RICO claim,
Defendants may not rely on the RICO statute to create an independent jurisdictional basis for
their own claims. Defendants’ reliance on the Edge Act is also unavailing. “Under the wellpleaded complaint rule, federal question jurisdiction exists only if [a] plaintiff’s statement of his
13
By joint stipulation, the Third Party Defendants shall file a response to the Third Party Complaint by
January 12, 2018. (ECF No. 100.)
33
own cause of action shows that it is based on federal law.” Romano v. Kazacos, 609 F.3d 512,
518 (2d Cir. 2010). It thus follows that “a defendant may not evade this rule by raising a federal
question in its responsive pleadings.” Calabro v. Aniqa Halal Live Poultry Corp., 650 F.3d 163,
166 (2d Cir. 2011).
Taking RICO and the Edge Act out of the jurisdictional equation, it appears that
the remaining basis from which this Court may retain jurisdiction over the Third Party Complaint
is under 28 U.S.C. § 1367(a). But it is unclear why exercising supplemental jurisdiction over the
third-party claims is appropriate or fair if this Court has already declined to consider Zohar’s
non-federal claims.
Separately, “whether a court has subject matter jurisdiction over a third-party . . .
cause of action is distinct from an assessment of the propriety and merits of an impleader action”
under Federal Rule of Civil Procedure 14. Bank of India v. Trendi Sportswear, Inc., 239 F.3d
428, 438 (2d Cir. 2000). Thus, jurisdictional questions aside, Rule 14 provides that a defending
party may serve a summons and complaint on a non-party who “is or may be liable to it for all or
part of the claim against it.” Fed. R. Civ. P. 14(a)(1). A third party claim may be asserted when
the third party’s liability is somehow dependent on the outcome of the main action or when the
third party is secondarily liable to the defendant. See Falcone v. MarineMax, Inc., 659 F. Supp.
2d 394, 401–02 (E.D.N.Y. 2009) (emphasis added). The “purpose of Rule 14 is to avoid two
separate actions which should be tried together; to save the time and cost of duplicating
evidence; to obtain consistent results; and to do away with the serious handicap to a defendant of
a time difference between a judgment against him and a judgment in his favor against a thirdparty.” Horsehead Corp. v. Shinski, 2010 WL 1781596, at *3 (N.D.N.Y. Apr. 30, 2010). A
“third-party claim is not permissible simply because it arises out of the same nucleus of facts as
34
the main claim.” Prudential Ins. Co. of Am. v. BMC Indus., Inc., 113 F.R.D. 100, 102 (S.D.N.Y.
1986).
Even if Defendants could establish a basis for supplemental jurisdiction under 28
U.S.C. § 1367, it is not entirely clear whether Defendants’ claims against the Third Party
Defendants, though related to Zohar’s allegations, actually are dependent on the outcome of the
original action or allege that the Third Party Defendants are secondarily liable to Defendants.
See Siemens Westinghouse Power Corp. v. Dick Corp., 299 F. Supp. 2d 242, 248 (S.D.N.Y.
2004) (“The crucial characteristic of a Rule 14 claim is that defendant is attempting to transfer to
the third-party defendant the liability asserted against him by the original plaintiff. In other
words, the outcome of the third-party claim must be contingent on the outcome of the main
claim[.]”). Here, while the Third Party Complaint’s allegations encompass largely the same cast
of characters and investment activities, Defendants appear to seek relief based on the Third Party
Defendants’ conduct impeding Tilton’s efforts to manage her portfolio companies, depriving her
of control over those assets, and orchestrating sham auctions to sell off Zohar’s collateral. These
seem to be the type of allegations that Tilton could have asserted in an independent action
against the Third Party Defendants, and appear to contravene the rule that a third-party complaint
“cannot be used to bring in other matters that may have some relationship to the case.” Doucette
v. Vibe Records, Inc., 233 F.R.D. 117, 120 (E.D.N.Y. 2005).
Accordingly, based on this Court’s initial observations, Defendants are directed to
explain why this Court should exercise jurisdiction over the Third Party Complaint and why the
claims therein qualify for an impleader action under Rule 14.
35
CONCLUSION
For the foregoing reasons, Defendants’ motion to dismiss is granted. Consistent
with the Joint Stipulation and Order dated December 15, 2017, Zohar and the Third Party
Defendants should respond to Defendants’ Third Party Complaint by January 12, 2018.
Separately, Defendants shall provide an explanation as to why this Court should retain
jurisdiction over their claims in the Third Party Complaint and why their third-party claims
qualify as an impleader action under Rule 14 by no later than January 26, 2018.
The Clerk of Court is directed to terminate all pending motions on the docket.
Dated: December 29, 2017
New York, New York
36
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