Jensen et al v. Thompson et al

Filing 37

MEMORANDUM OPINION AND ORDER granting in part and denying in part #26 Motion to Dismiss; granting in part and denying in part #28 Motion to Dismiss. Signed by U.S. District Judge Lawrence L. Piersol on 3/22/18. (SLW)

UNITED STATES DISTRICT COURT
DISTRICT OF SOUTH DAKOTA
SOUTHERN DIVISION

WADE K. JENSEN, as trustee ofthe DeAima W. *

Jensen Living Trust dated January 26, 2012, and
any amendments thereto; DAN KENSINGER;
RAYMOND SHERMAN,trustee ofthe Raymond
Sherman Trust, and any amendments thereto;

*
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Case No: I7-CV-4014-LLP

STEVEN STOKESBARY; STEVE MEYER;
*
GRANT SHUMAKER;THOMAS KENNY;TOM *
JACOBSON;ELISABETH NOEL,as trustee of
*

the Elisabeth J. Noel Trust, and any amendments

*

thereto; SARAH POWELL;RYAN MEIS; and
MATTHEW JOHNSON,

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*

MEMORANDUM OPINION AND
ORDER ON DEFENDANTS'

MOTIONS TO DISMISS, DOC.26
Plaintiffs,

&28

vs.

WAYNE THOMPSON; MICHAEL HURLBURT; *
DANIEL RISSING; DANIEL NEWELL,
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*

Defendants.

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*

Pending before the Court is Defendants Wayne Thompson, Michael Hurlburt, and Daniel
Rissing's(Management Defendants) Motion to Dismiss, Doc. 26, pursuant to Rules 12(b)(1) and
12(b)(6) of the Federal Rules of Civil Procedure. In their motion. Management Defendants ask
that the federal security claims be dismissed for several reasons, including: I) the claims are
barred by the statute of limitations; 2) the complaint fails to meet the heightened pleading

standards required under the Private Securities Litigation Reform Act(PSLRA)and Rule 9(b) of
the Federal Rules of Civil Procedure; and 3) the complaint fails to raise a strong inference of
scienter, show materiality of the alleged misrepresentations or omissions, or adequately allege
reliance or loss causation. Additionally, Management Defendants ask that the state law claims be
dismissed as they I) necessarily rely on supplemental jurisdiction, which would be lacking
should the motion to dismiss the federal securities claims be granted, and 2) are also

inadequately pled as they do not meet the standards of Rule 9(b). Management Defendants also

assert that South Dakota law does recognize claims for "Fraud in Relation to a Contract" and that

they did not contract with the Plaintiffs, a necessary requirement ofthe cause of action for Fraud
in Relation to Contract under S.D. Code § 53-4-5. Finally, Management Defendants argue that
the claim for Breach of State-Law Fiduciary Duty is a derivative action and the necessary

procedural prerequisites for bringing a derivative action in federal court have not been met. For
the following reasons. Management Defendants' motion is granted in part and denied in part.
Also pending before the Court is Defendant Daniel Newell's Motion to Dismiss, Doc. 28.
With the exception of Count I, Plaintiffs complaint alleges all of the same causes of action
against Defendant Newell. Similarly, for the reasons below. Defendant Newell's motion is
granted in part and denied in part.
BACKGROUND

Accepting Plaintiffs' allegations as true and giving Plaintiffs the benefit of all reasonable
inferences, the Court lays out the following facts in accordance with the pleadings. See Frey v.

City of Herculaneum, 44 F.3d 667, 671 (8th Cir. 1995)(providing the standard for granting a
motion to dismiss under Rule 12(b)(6)). Plaintiffs—eleven physicians and one widow of a

deceased physician—allege they were defrauded by Defendants, who are managers and/or
directors of non-party Progressive Acute Care, LLC (PAC), when Defendants solicited the
Physicians' investment in PAC by misrepresenting or omitting material information regarding
historical and projected financial performance of the investment. PAC was founded in 2008
under the laws of the state of South Carolina and engages in the for-profit acquisition and

management of rural hospitals. PAC is managed by three individuals, the Management
Defendants—Thompson as Chief Financial Officer, Hurlburt as Chief Operating Offieer, and

Rissing as Chief Executive Officer. Each of the Management Defendants also sits on PAC's
Board of Directors along with Defendant Newell. Newell is a licensed CPA and was a member
ofPAC's Audit Committee at all times during the relevant period.

In 2009, PAC acquired and began operating three rural hospitals in central Louisiana,

thanks in part to the investments of Plaintiffs and others. Sometime around late 2012 to early
2013, Management Defendants suggested that PAC purchase a fourth hospital—Dauterive
Hospital (Dauterive). Defendants solicited additional capital from the Plaintiffs for this
investment through a private placement memorandum (PPM) and in-person meetings. An inperson meeting took place in Dakota Dunes, South Dakota in February of 2013, where

Management Defendants "walked [Plaintiffs] through key parts of the PPM. Defendant Newell
was evidently not present at this meeting. In April 2013, Plaintiffs were presented with the PPM
itself, which also contains a Due Diligence Report, dated February 8, 2013, which purportedly
discussed the historical performance of Dauterive. The PPM contained a table which purports to
"[set] forth the summary historical financial information" of Dauterive for the fiscal years ended
December 31, 2011 and 2012. Doc. 32-1 at 75. The PPM states that the information "was derived

fi-om Dauterive Hospital's internal unaudited financial statements which were prepared by the
seller and are not reflective or in accordance with generally accepted accounting principles
(GAAP)". Id. "Therefore," the PPM advised, "this unaudited historical financial information
may differ materially and completely from GAAP and may be substantially incomplete for your

purposes in evaluating Dauterive Hospital's financial results." Id. According to the provided
information, Dauterive's net income with interest, taxes, depreciation, and amortization

(EBITDA)was $3.72 million in 2011 and $2,434 million in 2012. Id.
The next seetion of the PPM is entitled "Projected Pro Forma Financial Information" and
contains a summary of a four year projection for fiscal years 2013-2016. Id. at 76. The

projections were prepared "based solely upon our analysis and on the assumptions...listed
related to revenues, expenses, and other factors." Id. The PPM states that its authors had not

"verified or confirmed the reasonableness of the assumptions contained in the projections" and
lists a total of eleven assumptions the financial projects are based on. Id. The projected EBITDA
for 2013 was $4,131 million, $9,169 million in 2014, $9,625 million in 2015, and $8,122 million
in 2016. Id. at 77. Finally, the PPM contains a lengthy description of risk factors associated with

the acquisition, including risks that accompany running a business in the healthcare industry,

government regulations and taxes that may impact the business, problems with deriving financial
projections from unaudited information prepared by the seller, and the fact that PAC's
accounting department had yet to operate in a company as large as PAC would become after the
potential Dauterive acquisition. Id. at 84-119.

Plaintiffs state in their complaint that Plaintiffs agreed to invest the $3 million in equity
required for PAC to complete the Dauterive acquisition following the February 2013 in-person
meeting in Dakota Dunes. The final version of the PPM was dated April 8, 2013 and stated that

the signed participation agreement and check had to be returned by April 22, 2013. The signed
participation agreements that were dated all had dates after April 8, 2013. In return for their

investment, they received a number of Series B Preferred Units in proportion to their existing
equity ownership of PAC. It is uncontested that these Series B Preferred Units and their
exchange fall under the Securities Exchange Act of 1934. Plaintiffs also approved the

Management Defendants obtaining financing for the remainder ofthe $15 million purchase price
with bank debt. Plaintiffs were also promised that each of the Management Defendants would

enter into a $1 million personal guarantee for the bank loan. Plaintiffs maintain these guarantees
were illusory.

PAC formally agreed to purchase Dauterive in May 2013. Following the Dauterive
acquisition, the PAC Board of Directors increased the Management Defendants' compensation to

$400,000 annually, along with short-term incentive compensation of up to 100% of the base
salary. Management Defendants were also entitled to 25% of the cash distributions if the 3-year
average EBITDA fell between $0-$3.39 million and could obtain as much as 40% of cash
distributions with an EBITDA of$19.1 million or more.

Plaintiffs "received little information regarding PAC's financial health outside of an
annual investors update and/or PowerPoint presentation from the Management Defendants" but

by early 2014, PAC began defaulting on its bank loans. Dauterive's cash flow from operations
sunk to -$4.7 million in 2014 and -$6.1 million in 2015, a far cry from the projected EBITDA of
$6 million as provided by the PPM. Though PAC's other three hospitals continued to remain

profitable. Plaintiffs received information in the spring of 2016 that PAC would potentially need
to file for bankruptcy.

On May 18, 2016, some of the Plaintiffs met with "some or all of the Management
Defendants" and PAC's legal counsel in Dakota Dunes. Multiple Plaintiffs were unable to attend
the meeting other than by proxy, which was entrusted to Management Defendant Hurlburt.
Hurlburt informed the Plaintiffs "that the 'perfect storm' of factors had hit PAC and left the

company insolvent." Management Defendants briefly summarized PAC's financial state, advised
the Plaintiffs that were present that PAC was defaulting on payments due, and informed them

that a group of emergency-room physicians had obtained a $1.2 million judgment against PAC,
making time of the essence because PAC could not currently pay thatjudgment.

Management Defendants called for a vote, with Defendant Hurlburt casting the proxy
votes for each absent member. Feeling under pressure and ill-prepared to discuss the company's

financial situation due to a lack of prior information. Plaintiffs authorized the filing of the

bankruptcy. It was through the Bankruptcy process that Plaintiffs came to discover documents
which they assert would have drastically altered their decision to invest in Dauterive: 1) a PAC
Board internal memorandum dated January 9, 2013 in which the seller's projection of 2013

EBITDA for Dauterive was a $50,000 loss; and 2) an audit report from the accounting firm
Crowe Horwath LLP which the Defendants received in April just days before releasing the
finalized PPM to Plaintiffs which was harshly critical of PAC's internal financial controls.
Further, Plaintiffs allege that Defendants were told by a PAC employee in December 2012 that
they would not be able to obtain their projected savings related to benefits at Dauterive, which
were presumably part of the assumptions made in PAC's calculations of projected fiiture

EBITDAs. In light of this information. Plaintiffs allege Defendants' projections were materially
misleading because they failed to disclose material facts. Plaintiffs allege that they relied on
these material misrepresentations in deciding to invest in PAC, which ultimately resulted in a
total loss oftheir investment.

Plaintiffs now seek damages for violations of securities laws, fraudulent and negligent
misrepresentations and omissions, and breaches of fiduciary duty. Specifically, Plaintiffs allege
that Defendants Wayne Thompson, Michael Hurlburt, and Daniel Kissing (Management

Defendants) violated § 10(b) of the Securities Exchange Act (SEA) and Rule IOb-5. Further,
Plaintiffs allege that all Defendants, Defendant Daniel Newell and the Management Defendants:

I) violated § 20(a) of the SEA; 2)engaged in deceit in contravention to S.D. Code § 20-10-1; 3)
committed actual fraud in relation to contract in violation of S.D. Code § 53-4-5; 4) committed
constructive fraud in relation to contract under S.D. Code § 53-4-6; 5) engaged in common law
fraud; 6) made negligent misrepresentations; and 7) breached their state law fiduciary duties.
DISCUSSION

I.

Rule 12(b)

As a preliminary matter, the Court must address the Plaintiffs' assertion that the Court
must not consider the documents attached to Defendants' briefs in support of their respective
motions to dismiss. Management Defendants attached numerous documents to their
Memorandum in Support of Their Motion to Dismiss including: 1) the Private Placement

Memorandum (PPM) dated April 8, 2013 which itself contains multiple appendices, such as the
"Dauterive Due Diligence Report"(DDR)dated February 8, 2013; 2) a table purporting to point

out cautionary language provided to Plaintiffs in the PPM and the DDR; 3) a 2013 Monthly

Budget Report updated January 9, 2013; 4) an April 5, 2013 letter from Crowe Horwath LLP

reporting the results of an audit of financial statements of PAC; 5) a PAC "Annual Investor
Update" for fiscal year 2013 dated January 20, 2014; 6) a PAC Investor Update: 2013 Final
Audit, dated July 2014; and 7) Subscription Agreements signed by the Plaintiffs to purchase
Series B preferred Units of PAC to fund the Dauterive acquisition. Defendant Newell attached
also attached a copies of the PPM, 2013 Budget Report, Crowe Horwath Letter, and July 2014
Investor Update.

In response. Plaintiffs submitted by declaration portions of the "PAC Offering Packet"
which includes "Consent Minutes Approving Transaction and Second Amended and Related
Operating Agreement," an "Exercise Notice and Subscription Agreement," and what appears to
be a more complete version of the PPM and its appendices. Stating that they would not "admit
the authenticity of the edited documents Defendants attached to their briefs. Plaintiffs argue that
considering the documents presented by Management Defendants would be inappropriate
because they improperly contradict the complaint, are facially incomplete, and have not been
tested in discovery. Management Defendants assert that the Court can "incorporate and consider
the documents referenced by Plaintiffs in their Complaint" and that "[b]y the Plaintiffs' own

pleading they 'opened the door' to consideration of the Investor Updates." Management
Defendants also argue that because they are not relying on the Investor Updates for the truth of
their contents, they are not using the documents to contradict statements made in the complaint,

but to provide evidence that the Plaintiffs received information that would have caused the
statute of limitations to run. Further, and in light ofPlaintiffs' challenge to the authenticity of the
documents. Management Defendants attached the full and complete versions of the Investor
Updates to their reply memorandum.
"If, on a motion asserting the defense numbered (6)... matters outside the pleading are

presented to and not excluded by the court, the motion shall be treated as one for summary
judgment... and all parties shall be given reasonable opportunity to present all material made

pertinent to such a motion by Rule 56." Fed. R. Civ.P. 12(b). However, the Court is "not strictly
limited to the four comers ofthe complaint" in adjudicating a Rule 12(b) motion. Dittmer Prop.,
L.P. V. Fed. Deposit Ins. Corp., 708 F.3d 1011, 1021 (8th Cir. 2013). In addressing a motion to

dismiss, "[t]he court may consider the pleadings themselves, materials embraced by the

pleadings, exhibits attached to the pleadings, and matters of public record" without converting

the motion into a motion for summary judgment. Porous Media Corp. v. Pall Corp., 186 F.3d

1077, 1079 (8th Cir. 1999); see also Mills v. City of Grand Forks, 614 F.3d 495, 498 (8th Cir.

2010), niig V. Union Elec. Co., 652 F.3d 971, 976 (8th Cir. 2011). As the documents attached to
Management Defendants' memorandum are not matters of public record, the court must
determine if the materials are embraced by the pleadings themselves. Matters embraced by the

pleadings include "matters incorporated by reference or integral to the claim" as well as "exhibits
attached to the complaint whose authenticity is unquestioned." Miller v. Redwood Toxicology
Lab, Inc., 688 F.3d 928, 931 n. 3 (8th Cir. 2011)(quoting 5B Charles Alan Wright & Arthur R.
Miller, Federal Practice and Procedure § 1357 (3d ed. 2004). "Most courts ... view 'matters

outside the pleadings' as including any written or oral evidence in support of or in opposition to
the pleading that provides some substantiation for and does not merely reiterate what is said in

the pleadings." Gibb v. Scott, 958 F.2d 814, 816 (8th Cir. 1992) (quoting Wright & Miller,
Federal Practice and Procedure § 1366). Therefore, for Management Defendants' documents to
be considered on this motion to dismiss without converting the matter into a motion for summary

judgment, the documents must be incorporated by reference or integral to the claim, cannot be
offered either in support of or opposition to what is said in the pleadings, and their authenticity
must remain unquestioned.

Case law provides for a few specific examples of documents considered on a motion to
dismiss that meet these requirements. For example, a contract upon which a claim rests is a

document necessarily embraced by the pleadings. See Gorog v. Best Buy Co., 760 F.3d 787(8th

Cir. 2014). However, that contract must be specifically alleged, undisputed, and the sole basis of
the complaint. See BJC Health Sys. v. Columbia Cas. Co., 348 F.3d 685 (8th Cir. 2003). SEC

filings have also been considered documents necessarily embraced by the pleadings when those
filings are required by law and are not offered for the truth ofthe document's contents. Compare
Florida State Bd. ofAdmin, v. Green Tree, 270 F.3d 645, 661 (8th Cir. 2001) with Kushner v.
Beverly Enters., Inc., 317 F.3d 820(8th Cir. 2003).

The crux of Plaintiffs' complaint is that Management Defendants fraudulently solicited

capital from the Plaintiffs to invest in a hospital. The complaint alleges that this was done
"through a private placement memorandum (the 'PPM') and in-person meetings." Doc.l, para. 4.
Because Plaintiffs have submitted a complete copy ofthe PPM within the exhibit attached to the
declaration in opposition to Defendants' motion to dismiss, the authenticity of which

Management Defendants did not dispute in their reply, the Court may consider this document as
its contents are alleged in the complaint. However, the Court notes that Plaintiffs' complaint
alleges it was both the PPM and information presented in in-person meetings that led the
Plaintiffs to invest in the hospital. The Court will also consider the Subscription Agreements
attached as Exhibit G to Management Defendants memorandum, as they are the agreements

Plaintiffs allege they were fraudulently induced to enter into. See Gorog, 760 F.3d 787 (a
contract upon which a claim rests is a document necessarily embraced by the pleadings).

Plaintiffs also allege that, following the acquisition of that hospital. Plaintiffs "received
little information regarding PAC's financial health outside of an annual investors update and/or
PowerPoint presentation from the Management Defendants." Id. at para. 62. Management
Defendants argue that by pleading this. Plaintiffs "opened the door" to consideration of the

Investor Updates. Management Defendants also assert that consideration of the Investor Updates
is proper because they are not submitted for their truth, but instead "to evidence that the

Plaintiffs received information relating to the financial health ofPAC in January and July 2014,
and coupled with PAC's earlier bank loan default and the 'whopping projections' made in the
PPM, would have caused a reasonable investor to conduct an investigation that would have
discovered the alleged violation."

The Court may consider "documents whose contents are alleged in a complaint and
whose authenticity no party questions." Kushner, 317 F.3d at 831-32. Contrary to Management
Defendants' assertions. Plaintiffs do not "open the door" to the consideration of documents on a
motion to dismiss by merely pleading the existence of outside information. Plaintiffs' complaint
does not state what specific documents were received by Plaintiffs following their investment,
other than that there was an annual investor update. Indeed, Management Defendants have

attached numerous investor updates to their memorandum, not just one. See BJC Health Sys.,
348 F.3d 685 (requiring a document be specifically alleged, undisputed, and the sole basis of the
complaint in order to be considered on a motion to dismiss). Further, Management Defendants
stated reasoning for attaching the documents is exactly what is impermissible at the motion to
dismiss stage—^to contradict the assertion on the face of the complaint that the action is not
barred by the statute of limitations. See Porous Media Corp., 186 F.3d at 1079 ("the court...may
consider some materials that are part of the public record or do not contradict the complaint");
see also Illig v. Union v. Elec. Co., 652 F.3d 971, 976 (8th Cir. 2011)("A court may dismiss a

claim under Rule 12(b)(6) as barred by the statute of limitations ifthe complaint itself establishes
that the claim is time-barred."). As laid out below, regardless of whether or not the Court
considered the documents, which it does not, the question of when the statute of limitations

began to run is a factual question that cannot be resolved on this motion to dismiss.'
II.

Statute of Limitations

Plaintiffs have brought an action for fraud under § 10(b) of the Securities Exchange Act
of 1934 (SEA). A complaint alleging private securities fraud is timely if filed "not later than the
earlier of—

"(1)2 years after the discovery of the facts constituting the violation"; or

"(2)5 years after such violation." 28 U.S.C. § 1658(b).
The complaint in this case was filed on February 10, 2017, and no one has called into doubt that
it was filed within five years of the alleged violation. Therefore, the critical date for timeliness

purposes is February 10, 2015—^two years before this complaint was filed. In construing this
limitations statute for the first time, the Supreme Court in Merck & Co., Inc. v. Reynolds, 559

U.S. 633(2010)held that "a cause of action accrues (1) when the plaintiff did in fact discover, or

(2) when a reasonably diligent plaintiff would have discovered, 'the facts constituting the
violation'—^whichever comes first." Merck, 559 U.S. at 637. "[T]he 'facts constituting the
violation' include the fact of scienter, 'a mental state embracing intent to deceive, manipulate, or

defraud." Id. (quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194, n. 12 (1976)). Applying
this standard, the complaint is timely.
Plaintiffs contend that the issue of whether they were on notice is a factual question that

should not be resolved on a 12(b)(6) motion.^ Indeed, the Court recognizes that

'The question still remains as to whether or not it is permissible for this court to consider Exhibits B and C attached
to Management Defendants' memorandum. However, because the Court did not find it pertinent to review those
documents in order to resolve whether the motion to dismiss should be granted, the question of whether relying on
those documents is permissible need not be addressed. Further, the Court did not rely on any of the documents
attached to Defendant Newell's memorandum.

^ Although Management Defendants claim to move the Court to dismiss this aetion pursuant to Rules 12(b)(1) and,
12(b)(6) of the Federal Rules of Civil Procedure, the Court construes the motion as one to dismiss pursuant to Rule
12(b)(6) only. Bar by statute of limitation is an affirmative defense which the defendant must plead and prove, not a
bar to jurisdiction which the plaintiff has the burden to establish. Compare John R. Sand & Gravel Co. v. United
States, 552 U.S. 130 (2008) ("the law typically treats a limitations defense as an affirmative defense that the
defendant must raise ... and that is subject to rules of forfeiture and waiver"), with Osborn v. United States, 918
F.2d 724, 730 (8th Cir. 1990)("The party seeking to establish jurisdiction has the burden of proof that jurisdiction
exists."). Because none of the other reasons for dismissal set forth in Management Defendants' motion are
jurisdictional in nature, the Court applies the standard of review required by Rule 12(b)(6).

[b]ar by a statute of limitation is typically an affirmative defense, which the
defendant must plead and prove. See John R. Sand & Gravel Co. v. United States,
552 U.S. 130 (2008); Fed. R. Civ. P. 8(c). A defendant does not render a
complaint defective by pleading an affirmative defense, Gomez v. Toledo, 446
U.S. 635, 640 (1980), and therefore the possible existence of a statute of
limitations defense is not ordinarily a ground for 12(b)(6) dismissal unless the
complaint itself establishes the defense. See Varner v. Peterson Farmers, 371
F.3d 1011, 1017-18 (8th Cir. 2004)(dismissal proper because complaint ruled out
tolling of statute of limitations).
Jessie v. Potter, 516 F.3d 709, 713 n.2 (8th Cir. 2008); see also Cohen v. Northwestern Growth

Corp., 385 F. Supp. 2d 935, 945(D.S.D. 2005)("the issue of whether a plaintiff was on[]notice
is 'often inappropriate for resolution on a motion to dismiss under Rule 12(b)(6)'").
Nevertheless, a motion to dismiss may be granted "in the unusual case in which a plaintiff
includes allegations that show on the face of the complaint that there is some insuperable bar to
relief." Frey,44 F.3d at 671 (quotation marks and citations omitted).

Management Defendants claim Plaintiffs received sufficient information through their

annual investor updates to put them on notice ofthe alleged seeurities violations by no later than
July 2014. Relying on Ritchey v. Homer,244 F.3d 635 (8th Cir. 2001) and Great Rivers Coop. v.
Farmland Indus., Inc., 120 F.3d 893 (8th Cir. 1997), Management Defendants argue that the

investor updates contained sufficient information "to trigger Plaintiffs' responsibility to inquire
further...yet they failed to exercise reasonable diligence by not seeking more information." In

response. Plaintiffs assert that the "inquiry notice" standard required in Ritchey and Great Rivers
was rejected by the Supreme Court in Merck & Co. v. Reynolds, 559 U.S. 633 (2010) and by the
Eighth Circuit in Zarecor v. Morgan Keegan & Co., 801 F.3d 882 (8th Cir. 2015); therefore.
Plaintiffs argue. Management Defendants cannot show that Plaintiffs had actual notice of the
alleged fraud before February 10, 2015.

The complaint is timely if it was filed "not later than two years after the discovery ofthe
facts constituting the violation." 28 U.S.C. § 1658(b). As explained in depth in Merck, the term

"discovery" as used in the statute "encompasses not only those facts the plaintiff actually knew,
but also those facts a reasonably diligent plaintiff would have known." Merck, 559 U.S. at 648.

In Merck, the term "inquiry notice" was used "to refer to the point at which a plaintiff possesses

a quantum of information sufficiently suggestive of wrongdoing that he should conduct a further
inquiry." Id. at 650 (international citations omitted). The Court also noted that the Eighth Circuit
used the term in a "roughly similar" way. Id. at 650-51 (citing Great Rivers, 120 F.3d at 896
10

("Inquiry notice exists when the victim is aware of facts that would lead a reasonable person to
investigation and consequently acquire actual knowledge ofthe defendant's misrepresentations."
(emphasis added))). The Court, disagreed, saying:
If the term "inquiry notice" refers to the point where the facts would lead a
reasonably diligent plaintiff to investigate further, that point is not necessarily the
point at which the plaintiff would already have discovered facts showing scienter
or other "facts constituting the violation." But the statute says that the plaintiffs
claim accrues only after the "discovery" of those latter facts. Nothing in the text
suggests that the limitations period can sometimes begin before "discovery can
take place.... Because the statute contains no indication that the limitations
period should occur at some earlier moment before "discovery," when a plaintiff
would have begun investigation, we cannot accept Merck's argument.

Id. at 651. Therefore, in concluding that the "discovery" of facts that put a plaintiff on "inquiry

notice" was not sufficient to begin the running ofthe limitations period, the Court concluded:
[T]he limitations period in § 1658(b)(1) begins to run once the plaintiff did
discover or a reasonably diligent plaintiff would have "discovered" the facts
constituting the violation"—^whichever comes first. In determining the time at
which "discovery" of those "facts" occurred, terms such as "inquiry notice" and
"storm warnings" may be useful to the extent that they identify a time when the
facts would have prompted a reasonably diligent plaintiff to begin investigating.
But the limitations period does not begin to run until the plaintiff thereafter
discovers or a reasonably diligent plaintiff would have discovered "the facts
constituting the violation," including scienter—irrespective of whether the actual
plaintiff undertook a reasonably diligent investigation.
Id. at 653.

Since the Merck decision, the Eighth Circuit has twice discussed the issue of inquiry
notice and the statute of limitations in securities fraud cases. See generally W. Va. Pipe Trades

Health & Welfare Fund v. Medtronic, Inc., 845 F.3d 384, 389-91 (8th Cir. 2016) and Zarecor,
801 F.3d at 886-87; see also Barnes v. Oldner, 359 F.Supp.3d 926, 933-35 (E.D. Ark. 2017).

Management Defendants suggest that ^ost-Merck case law is consistent with prc-Merck case
law. This is clearly not the case. Both Great Rivers and Ritchey concluded that the statute of
limitations began when the duty to exercise due diligence was triggered, i.e., when the plaintiffs

had inquiry notice. See Great Rivers, 120 F.3d at 896-99 (concluding that the statute of
limitations began running shortly after information was printed in an article because the

knowledge ofthat information would have triggered the duty to exercise due diligence which, in
turn, would have resulted in actual notice); Ritchey, 244 F.3d at 638—41 (finding that the effect of

the prior relationship with defendant on whether plaintiffs had sufficient facts beyond a level of
11

mere suspicion to reach a point which the victims would be incited to investigate was a factual
question that could not be resolved on summary judgment). Merck and the Eighth Circuit's postMerck case law adamantly state that inquiry notice is not enough—^the statute of limitations does
not begin to run at the point at which the duty to exercise due diligence was triggered. Instead,
the statute of limitations begins at the point at which, having exercised due diligence, a

reasonable plaintiff would have discovered the facts constituting the cause of action.

Specifically, and contrary to Management Defendants' analysis, the Zarecor court provided:
The limitations period does not begin to run when a plaintiff is put merely on
"inquiry notice," or when there are "storm warnings," such that "the facts would
have prompted a reasonably diligent plaintiff to begin investigation." Instead, the
statute of limitations is triggered when the reasonably diligent plaintiff would
have discovered "the facts constituting the violation" after an appropriate
investigation."

Indeed, the Eighth Circuit found the claims in Zarecor to be time-barred, but it did not do so by

relying on the inquiry notice standard. The mutual funds at issue had begun to decline and a class
action complaint had been filed by the end of2007. While the court determined that a reasonably

diligent plaintiff would have began investigating at this time, the court found it unnecessary to
determine when exactly a reasonably diligent plaintiff would have then discovered "the facts
constituting the violation" under the federal discovery rule because, by July of 2009, the
Zarecors themselves had filed a statement of claim in arbitration alleging misrepresentation,

suggesting they had indeed actually discovered the facts constituting the violation more than two
years before their federal claim was filed in November of2011.
Thus, fraud is deemed to be "discovered" not only when the plaintiff actually knows
those facts constituting fi-aud, but also when a reasonably diligent plaintiff would have known the
facts constituting fraud. This, of course, requires the discovery of the facts constituting the
violation, and one of those facts, in the case of fraud, is scienter—"a mental state embracing
intent to deceive, manipulate, or defraud." Merck, 599 U.S. at 637, 648^9. Therefore, fi-aud is
not "discovered" until facts—including those which would prove that a defendant made a
material misstatement with an intent to deceive, not merely innocently or negligently—are

actually known by the plaintiff or would have been known by a reasonably diligent plaintiff. Id.
It is not enough for a plaintiff to know of an incorrect prediction about a firm's future earnings.
See id. at 650. Instead, there must be facts suggesting that a reasonably diligent plaintiff would
have known someone had deliberately lied or withheld information in their representation about
12

that firm's future earnings. See id. This is particularly important in federal securities cases due to
the heightened pleading standards required for the scienter element of § 10(b). See 15 U.S.C. §
78u^(b)(2). To adequately plead scienter, plaintiffs must "state with partieularity facts giving
rise to a strong inference that the defendant acted with the required state of mind." Id. A "strong
inference" is "more than merely plausible or reasonable—it must be cogent and at least as

compelling as any opposing inference of nonfraudulent intent." W. Va. Pipe Trades, 845 F.3d at
390 (quoting Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 313 (2007)). In W. Va.

Pipe Trades, the court found the appellants did not discover or with reasonable diligence would
not have discovered facts constituting the deceptive act as well as an intent to deceive when

articles published found that corporate-sponsored research studies had over-emphasized
favorable reported results because the articles themselves attributed the problems with the studies
to be due to the nature of corporate-sponsored research, not to fraud. It wasn't until the Senate
Finance Committee released its finding that the appellee company had intentionally edited
studies to omit unfavorable results that appellants were charged with having discovered "facts
constituting the violation."

For the cause of action at hand to be timely, this Court must examine the facts known or
what facts should have been known to a reasonably diligent plaintiff before February 10, 2015,

two years before the complaint in this case was filed. Management Defendants assert that, even
if Plaintiffs had not actually discovered the alleged misrepresentations and omissions, a
"reasonable investor" would have conducted an investigation and discovered the facts

constituting the violation by, "at the latest, July 2014." Management Defendants argue that the

complaint itself establishes that within 12 months of the Dauterive acquisition, PAC had
defaulted on its bank loans, and widely missed its projected earnings. However, "[a]n incorrect

prediction about a firm's future earnings, by itself, does not automatically tell us whether the
speajker deliberately lied or just made an innocent (and therefore nonactionable) error." Merck,
559 U.S. at 650. Nevertheless, Management Defendants argue that after seeing the large

discrepancy between the predicted earnings and the actual earnings, a reasonable investor would
have begun an investigation via a simple request for information to PAC, which would have led
to the discovery ofthe internal memorandum and Crowe Horwath Audit report.

Similar to the facts presented in Rifchey, Plaintiffs have pled that they were involved in a

prior relationship with Management Defendants through their prior investments in PAC. The
13

extent of this prior relationship and its impact on the trust Plaintiffs had in Management

Defendants raises a factual issue inappropriate for resolution on a motion to dismiss. See Ritchey,
244 F.3d at 638-41 (finding that the effect of the prior relationship with defendant on whether
plaintiffs had sufficient facts beyond a level of mere suspicion to reach a point which the victims
would be incited to investigate was a factual question that could not be resolved on summary
judgment). Further, the PPM went to great lengths to lay out all of the risk factors involved in
investing in Dauterive. "It is well settled that financial performance, standing alone, does not

necessarily suggest fraud at the time of the sale, but could also be explained by poor
management, general market conditions, or other events unrelated to fraud, creating a jury
question on[]notice." Gray v. First Winthrop Corp., 82 F.3d 877, 881 (9th Cir. 1996). See also
La Grasta v. First Union Securities, Inc., 358 F.3d 840, 847 (2004)("There may be numerous
reasons, other than fraud, for a stock to decline (even steeply) in price."); LaSalle v. Medco

Research, Inc., 54 F.3d 443, 446 (7th Cir. 1995)(declining to find that a big drop in price is
notice per se of the possibility of securities fraud in light of other circumstances, such as the
stock's history of volatility).
Plaintiffs complaint alleges that they were not aware of an intent to deceive until after

the bankruptcy proceedings began in 2016, when they received copies of an internal
memorandum and audit. Predictions about future earnings that turn out to be incorrect are alone

not enough to plead scienter—"'a mental state embracing intent to deceive, manipulate, or
defraud." Merck, 599 U.S. at 637(quoting Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194, n. 12

(1976)). It cannot be said, as a matter of law, "[ajccepting Plaintiffs' allegations as true and
giving Plaintiffs the benefit of all reasonable inferences," that the discrepancy between the
projected and the real EBITDA, by itself, was enough to give the Plaintiffs notice of the "facts

constituting the violation," including scienter, nor that a reasonably prudent plaintiff, in light of
the circumstances, would have conducted an investigation leading to discovery of such facts
before April of 2015. Cohen, 385 F.Supp.2d at 946 (citing Frey, 44 F.3d at 671 (providing the
standard for a motion to dismiss)). Therefore, the complaint is timely.
in.

Federal Securities Claims

a. Section 10(b) and Rule IOb-5
1. Heightened Pleading Standards

14

Section 10(b) ofthe Securities Exchange Act makes it unlawful for any person to "use or
employ, in connection with the purchase or sale of any security... any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as the
Commission may prescribe as necessary or appropriate in the public interest or for the protection
of investors." 15 U.S.C. § 78j(b). "SEC Rule lOb-5 implements this provision by making it
unlawful to, among other things,'make any untrue statement of a material fact or to omit to state
a material fact necessary in order to make the statements made, in light of the circumstances
under which they were made, not misleading.'" Matrixx Initiatives, Inc. v. Siracusano, 563 U.S.

27, 37 (2011)(quoting 17 CFR § 240.10b-5(b)). A cause of action for private securities fraud
based on violations of § 10(b) and Rule lOb-5 requires: "(1) a material misrepresentation or

omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or
omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or
omission;(5) economic loss; and (6) loss causation." Stoneridge Inv. Partners, LLC v. ScientificAtlanta, 552 U.S. 148, 157 (2008). Congress, in the Private Securities Litigation Reform Act
(PSLRA), enacted two heightened pleading requirements for § 10(b) private securities fraud

cases. See 15 U.S.C. § 78u-4(b)(2)("Rule 9(b)"). "The first requires that the complaint specify
each false statement or misleading omission and explain why the [false statement or] omission
was misleading." In re Navarre Corp. Sec. Litig., 299 F.3d 735, 741^2(8th Cir. 2002)(quoting
Florida State Bd. ofAdmin, v. Green Tree Fin. Corp., 270 F.3d 645, 654 (8th Cir. 2001)). The
second requires that "the complaint state 'with particularity' facts giving rise to a 'strong
inference' that the defendant acted with the scienter required for the cause of action." Id.

(quoting Green Tree, 270 F.3d at 654). The purpose of these heightened standards "was
generally to eliminate abuse securities litigation and particularly to put an end to the practice of

pleading 'fraud by hindsight.'" Id. at 742 (citing In re Vantive Corp. Sec. Litig., 283 F.3d 1079,
1092 (9th Cir. 2002)). Further, "it ensures that a defendant is given sufficient notice of the
allegations against him to permit the preparation of an effective defense." Fames v. Gateway
2000, Inc., 122 F.3d 539, 549(8th Cir. 1997).

"Although the Court must assume all factual allegations in the complaint are true in

deciding a motion to dismiss under Rule 12(b)(6), 'under the Reform Act we disregard 'catchall' or 'blanket' assertions that do not live up to the particularity requirements of the statute."
Cohen, 385 F. Supp. 2d at 947(quoting Green Tree, 270 F.3d at 660).

15

A complaint subject to Rule 9(b) "must identify who, what, where, when, and
how." It must "specify the time, place, and content of the defendant's false
representations, as well as the details ofthe defendant's fraudulent acts, including
when the acts occurred, who engaged in them, and what was obtained as a result."

Streambend Properties II, LLC v. Ivy Tower Minneapolis, LLC, 781 F.3d 1003, 1013 (8th Cir.

2015)(internal citations omitted)(quoting

v. Hypoguard USA, Inc., 559 F.3d 818, 822(8th

Cir. 2009)).

Management Defendants argue that the eomplaint fails to meet the heightened pleading

requirements of the PSLRA in three ways: by 1) failing to identify the speaker and the recipient
of the fraud by impermissibly engaging in group pleading; 2) failing to explain how the
statements were materially misleading; and 3) failing to allege the element of scienter with
particularity.
i. Group Pleading

"Simply alleging that defendants made a particular statement at a given time, without

providing further particulars about who made the statement or when, and then showing in
hindsight that the statement is false misses the PSLRA pleading requirement." In re Navarre

Corp., 299 F.3d at 743. Further, vaguely attributing fraudulent representations and conduct to
multiple defendants, generally, in a group pleading fashion, does not satisfy Rule 9(b). See
Streambend Properties II, 781 F.3d at 1013. Instead, "[wjhere multiple defendants are asked to

respond to allegations of fraud, the complaint should inform each defendant of the nature of his
alleged participation in the fraud." Id. (eiting Trooien v. Mansour, 608 F.3d 1020, 1030 (8th Cir.
2010)).

In essence. Plaintiffs' complaint pleads three fraudulent acts of Management Defendants:

1) the April 8, 2013 PPM represented that Dauterive's "historical financial information" showed
an EBITDA gain of $2,434 million; 2) the April 8, 2013 PPM represented that Dauterive's "full

year" EBITDA estimate was $6,559 million and that PAC's net income would be over $4 million
in 2013 and $9 million in 2014; and 3) the April 8, 2013 PPM stated that "management ha[d]

identified a number of ways to enhance internal controls." The complaint alleges that each

defendant "was responsible for the content of the PPM and ultimately ratified and approved the
statements made therein" and also "met in person with the physicians ... to discuss the potential

Dauterive acquisition." Doc. 1 at 8-9. Further, the complaint states that "[ejach of the
Defendants was personally involved in drafting and/or approving the PPM, including the false
16

and misleading statements." Id. at 10. Management Defendants allegedly walked the Physicians

through the key parts of the PPM and the Management Due Diligence Report at an in-person
meeting in Dakota Dunes, South Dakota, held in February 2013. M at 11.

Beyond these general allegations, Plaintiffs allege that Defendant Hurlburt "told the

Physicians that a return of three-to-four times their investment was assured, and that he was
expecting a return of ten times their investment." Id. at 10. Plaintiffs assert that Defendant
Thompson was specifically approached by a PAC employee and warned that PAC would be
unable to achieve the projected EBITDA. Id. at 5. Finally, Page 4 of the Due Diligence Report
contained a recommendation "[o]n behalf of the PAC executive leadership team" specifically
attributed to Defendants Hurlburt, Rissing, and Thompson, which encouraged the acquisition of

Dauterive Hospital. Id. at 13; Doc. 32-1 at 125. The remaining pages of the Due Diligence

Report also appear to be written from the perspective on the Management Defendants through
the repeated use ofthe word "we"throughout the document.

'"Where multiple defendants are asked to respond to allegations of fraud, the complaint
should inform each defendant of the nature of his alleged participation in the fraud.'"

StreambendProperties II, 781 F.3d at 1013 {citmg DiVittorio v. Equidyne Extractive Indus., Inc.,
822 F.2d 1242, 1247 (2d Cir. 1987)). The Fifth Circuit provides further guidance as to what is

required to inform each defendant of their particular conduct in the "context of corporate
documents:

[Cjorporate officers may not be held responsible for unattributed corporate
statements solely on the basis of their titles, even if their general level of day-today involvement in the corporation's affairs is pleaded. However, corporate
documents that have no stated author or statements within documents not

attributed to any individual may be charged to one or more corporate officers

provided specific factual allegations link the individual to the statement at issue.
Such specific facts tying a corporate officer to a statement would include a
signature on the document or particular factual allegations explaining the
individual's involvement in the formulation of either the entire document, or that

specific portion of the document, containing the statement. Various unattributed
statements within documents may be charged to different individuals, and specific
facts may tie more than one individual to the same statement.

Southland Sec. Corp. v. INSpire Ins. Solutions, Inc., 365 F.3d 353, 365 (2004). Nevertheless,

where it is generally pleaded that the individual defendants "each controlled the contents of and
participated in writing" the corporate documents, such "conclusory allegation[s]" fail to meet the

17

specificity required by the PSLRA when they fail to specify "which portions or statements within
these documents are assignable to each individual defendant." Id.

The Court finds Plaintiffs have pleaded the allegedly fraudulent acts with sufficient

particularity to warn each defendant as to his involvement in the acts. While the general
allegations that Defendants were involved in the formulation of the PPM alone would be
insufficient, Plaintiffs have plead sufficient facts tying each individual Management Defendant
to the authorship of the PPM and therefore the authorship of the allegedly fraudulent
information.

ii. Materiality

The complaint must not only allege that false statements or omissions were made, but
also why those statements would have been false or misleading at the time in which it is alleged
they were made. See In re Navarre Corp., 299 F.3d at 743 (citing In re Vantive Corp., 283 F.3d
at 1086. This requires Plaintiffs to plead "the existence of any facts or further particularities fhat,
if true, demonstrate that defendants had access to, or knowledge of, information contradicting

their public statements when they were made." Id. at 742. Further, the Court notes "that § 10(b)
and Rule 10b-5(b) do not create an affirmative duty to disclose any and all material information.
Disclosure is required under these provisions only when necessary 'to make... statements
made, in the light of the circumstances under which they were made, not misleading.'" Matrixx
Initiatives, Inc. v. Siracusano, 563 U.S. 27, 44(2011)(citing 17 C.F.R. § 240.10b-5(b)).

Plaintiffs plead three fraudulent acts of Defendants: 1) representing that Dauterive's
"historical financial information" showed an EBITDA gain of $2,434 million; 2) representing

that.Dauterive's "full year" EBITDA estimate was $6,559 million and that PAC's net income
would be over $4 million in 2013 and $9 million in 2014; and 3) representing that "management

ha[d] identified a number of ways to enhance internal controls." Plaintiffs allege that all ofthese
statements were misleading because Defendants knew of information contradicting those
representations. Indeed, Plaintiffs allege the existence oftwo documents which Defendants were
aware of that should have been disclosed in order to render the representations made to investors

not misleading: 1) a PAC Board internal memorandum dated January 9, 2013 in which the

seller's projection of 2013 EBITDA for Dauterive was a $50,000 loss; and 2) an audit report
from the accounting firm Crowe Horwath LLP which the Defendants received in April just days
before releasing the finalized PPM to Plaintiffs which was harshly critical of PAC's internal
18

financial controls. Further, Plaintiffs allege that Defendant Thompson was told by a PAC
employee in December 2012 that they would not be able to obtain their projected savings related
to benefits at Dauterive, which were presumably part of the assumptions made in PAC's

ealculations of projected future EBITDAs. Plaintiffs therefore adequately plead the existence of
facts that, "if true, demonstrate that the defendants had aecess to, or knowledge of, information
contradieting their public statements when they were made." See In re Navarre Corp., 299 F.3d
at 742.

To present an aetionable elaim for securities fraud, it is not enough to allege
misstatements. Instead, "the alleged misstatements must be material." In re AMDOCS Ltd. Sec.

Litig. V. AMDOCS Ltd., 390 F.3d 542, 547(8th Cir. 2004)(eiting Parnes v. Gateway 2000, Inc.,

122 F.3d 539, 546 (8th Cir. 1997)). Generally, materiality is a question of fact reserved for the
jury. Id. However, where a court finds that "no reasonable investor could have been swayed by

the alleged misrepresentation," alleged misrepresentations are immaterial as a matter of law and
the eomplaint may be properly dismissed. Id. (citing Fames, 122 F.3d at 546); see also In re

Control Data Corp. Sec. Litig, 933 F.2d 616, 6321 (8th Cir. 1991)("The trier offact is uniquely
competent to determine materiality, as that inquiry requires delicate assessments of inferences a
reasonable investor would draw from a given set of facts."). On the other hand, where a court

finds that the "allegations suffice to 'raise a reasonable expectation that discovery will reveal
evidenee' satisfying the materiality requirement" the court will "draw the reasonable inference
that the defendant is liable for the misconduct," and the complaint will survive a motion to

dismiss. See Matrixx Initiatives, 563 U.S. at 46 (citing Bell Atlantic Corp. v. Twombly, 550 U.S.

544, 556(2007); Ashcroft v. Iqbal, 556 U.S. 662,678(2009)).

A misrepresentation or omission is material if there is "a substantial likelihood
that the disclosure of the omitted fact would have been viewed by the reasonable

investor as having significantly altered the 'total mix' of information made
available." Alleged misrepresentations can be immaterial as a matter of law if
they: 1) are of such common knowledge that a reasonable investor can be
presumed to understand them; 2)present or conceal such insignificant data that, in
the total mix of information, it simply would not matter; 3) are so vague and of
such obvious hyperbole that no reasonable investor would rely upon them; or 4)
are accompanied by sufficient cautionary statements.

In re AMDOCS Ltd. Sec. Litig., 390 F.3d at 548 (internal eitations omitted). The "bespeaks

eaution doctrine" provides that "cautionary language whieh relates directly to that which the

19

Plaintiffs claim to have been misled, if sufficient, renders the alleged misrepresentation or
omission immaterial as a matter of law." Id. (citing Parnes at 548).
The Court cannot agree with Management Defendants' argument that, as a matter oflaw,
the PPM contained suffieient cautionary language so as to render any alleged misrepresentations
immaterial because the Court cannot agree that "no reasonable investor would have been swayed
by the alleged misrepresentation." See id. at 547; see also Parnes, 122 F.3d at 548 (Dismissal
should only be granted under the bespeaks caution doctrine where "the documents containing
defendants' challenged statements include enough cautionary language or risk disclosure that

reasonable minds could not disagree that the challenged statements were not misleading.")
Plaintiffs contend that PAC's representations of Dauterive's "historical financial information"
were misleading because Defendants asserted 1) the EBITDA figure came from "financial
statements which were prepared by [the seller]"; 2)that Dauterive was currently "generating well

in excess of $3M in EBITDA"; and 3) that Dauterive should "maintain" a positive EBITDA.
Plaintiffs allege they were not informed, though Defendants were, of the manipulations made to
the numbers actually provided by the seller, though Defendants did disclose other later

adjustments made to the already manipulated figure. Further, Plaintiffs maintain that because the
full-year EBITDA projections relied on these "historical" numbers, the full-year projections were
misleading for the same reasons. To make these statements non-misleading. Plaintiffs argue.

Management Defendants should have disclosed the seller's projected EBITDA number, as well
as the manipulations made to that number that resulted in an EBITDA nearly 25 times higher
than the seller's. Finally, Plaintiffs argue that, although Plaintiffs stated that "financial reporting
and internal controls may not perform as anticipated" it was materially misleading to suggest that

"management ha[d] identified a number of ways to enhance internal controls that are not yet in
place" because Management Defendants did not inform Plaintiffs of weaknesses uncovered in a
third-party audit.

Management Defendants argue that all of these statements are forward-looking and

accompanied by sufficient cautionary language that speaks directly to the Plaintiffs' claim.
Therefore, Management Defendants argue that, as a matter of law, these statements did not affect
the "total mix" of information the document provided investors. See Yellen v. Hake, 437

F.Supp.2d 941, 968(S.D. Iowa 2006)(citing Parnes, 122 F.3d at 548). Indeed, the PPM included
a "Special Note Regarding Forward-Looking Statements" which warned that those forward
20

looking statements were "based upon estimates and assumptions made by [PAC's] management
that, although believed to be reasonable, are subject to numerous factors, risks and

uncertainties." Doc. 32-1 at 54. However, the note was intended to help identify "those
statements that are based upon management's current plans and expectations as opposed to
historical and current facts." Id. Some of Plaintiffs' claims, on the other hand, rely on the
argument that Management Defendants engaged in fraudulent misrepresentation by presenting
certain information as "historical fact" when it was actually based on "one-time paper
adjustments" and "accounting magic." Doc. 31 at 25 (citing In re Vivendi, S.A. Sec. Litig., 838
F.3d 223, 247-51 (2d Cir. 2016)). While Management Defendants may have made clear that
investing in Dauterive, especially in light of its size compared to PAC's past investments, as well

as uncertainty in the legislature as far as the continued sustainability ofthe Affordable Care Act,
Medicare, Medicaid, and other government spending, it cannot be said as a matter of law at this

stage in the pleadings that sufficient cautionary language was used to offset the material
misrepresentations alleged here.
ill. Scienter

Generally, the issue of whether a particular intent existed is a question of fact for the jury.
In re K-tel Intern., Inc. Sec. Litig., 300 F.3d at 894. However, under the PSLRA "inferences of
scienter do not survive if they are merely reasonable ... Rather, inferences of scienter survive a
motion to dismiss only if they are both reasonable and 'strong' inferences." Green Tree, 270
F.3d at 660. Nevertheless, the PSLRA "did not alter the substantive nature of the scienter

requirement." Kushner, 317 F.3d at 828. "Specifically, scienter may be demonstrated by severe
recklessness involving 'highly unreasonable omissions or misrepresentations' amounting to 'an

extreme departure from the standards of ordinary care, and that present a danger of misleading
buyers or sellers which is either known to the defendant or is so obvious that the defendant must
have been aware of it.'" Id. (citing K & S P'ship v. Cont'l Bank, N.A., 952 F.2d 971, 978 (8th
Cir. 1991) (internal quotations omitted), cert, denied, 505 U.S. 1205, 112 S.Ct. 2993, 120
L.Ed.2d 870 (1992)). "Recklessness, then, may be shown where unreasonable statements are
made and the danger of misleading investors is so obvious that the defendant must have been
aware of it." Id. "'Securities fraud claims typically have sufficed to state a claim based on
recklessness when they have specifically alleged defendants' knowledge of facts or access to

21

information contradicting their public statements.'" Id. (citing Novak v. Kansas, 216 F.3d 300,
308(2d Cir. 2000)).

Management Defendants argue that Plaintiffs have failed to establish a strong inference

of scienter because Plaintiffs' allegations "are cast against Defendants as a group—^with no
showing of what any individual Defendant thought at any time" and improperly rely on a broad
motive argument. "[M]otive and opportunity are generally relevant to a fraud case, and a

showing of unusual or heightened motive will often form an important part of a complaint that
meets the Reform Act standard." Green Tree, 270 F.3d at 660. Indeed, Plaintiffs have failed to

establish a motive by failing to plead anything beyond a general desire to make the company
appear attractive to potential buyers and to increase their personal compensation. See Kushner,
317 F.3d at 830 (citing Green Tree, 270 F.3d at 661) ("Pleading the simple fact 'that a
defendant's compensation depends on corporate value or earnings does not, by itself, establish

motive to fraudulently misrepresent corporate value or earnings.'"); In re K-tel Intern., Inc. Sec.
Litig., 300 F.3d at 894 (Noting that a general desire to make a company appear attractive to
%

potential buyers is insufficient to establish motive, but "where an individual defendant will
benefit to an unusual degree, based upon the magnitude of a compensation package tied to
earnings and the time of an overstatement of earnings, motive is sufficiently pled."); Horizon
Asset Management Inc. v. H & R Block, Inc., 580 F.3d 755, 766 (8th Cir. 2009)(noting that the

8th Circuit has found that bonuses as high as $630,000 and $355,000 paid to a corporate officer
under a performance plan are not so unusual as to establish a motive).
Nevertheless, "[t]he absence of a motive allegation, though relevant, is not dispositive."
Matrixx Initiatives, 563 U.S. at 48 (citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S.
308, 325 (2007)); see also In re K-tel Intern., Inc. Sec. Litig., 300 F.3d at 894 (citing Green Tree,

270 F.3d at 660) ("Without a showing of motive or opportunity 'other allegations tending to
show scienter would have to be particularly strong in order to meet the Reform Act standard.'").
This Court has already established that Plaintiffs have not engaged in group pleading, and have

specifically alleged how each Management Defendant had access to information which would
render statements attributed to them materially misleading. See In re Patterson Companies, Inc.

Sec. Litig, 479 F. Supp. 2d at 1032 ("A classic fact pattern of recklessness depicts defendants

publishing statements 'when they knew or had access to information suggesting that their public
statements were materially inaccurate.'"). Therefore, Plaintiffs' allegations, "taken collectively,"
22

if true, give rise to a "cogent and compelling" inference that Management Defendants elected not

to disclose the reports of adverse findings which may have significantly altered the total mix of
information available to investors. See Tellabs, 551 U.S. at 326 (noting that factual allegations
are viewed "holistically" and "collectively" rather than "in isolation").
2. Reliance

"Reliance by the plaintiff upon the defendant's deceptive acts is an essential element of
the § 10(b) private cause of action." Stoneridge Investment Partners, LLC v. Scientific-Atlanta,
Inc., 552 U.S. 148, 159 (2008). "This is because proof of reliance ensures that there is a proper
'connection between a defendant's misrepresentation and a plaintiffs injury.'" Erica P. John
Fund., Inc. v. Halliburton Co., 563 U.S. 804, 810 (2011). "The traditional (and most direct) way
a plaintiff can demonstrate reliance is by showing that he was aware of a company's statement
and engaged in a relevant transaction... based on that specific misrepresentation. In that

situation, the plaintiff plainly would have relied on the company's deceptive conduct."Id.
Management Defendants argue that Plaintiffs have failed to adequately plead reliance by

improperly relying on a presumption of reliance that does not apply to the allegations at hand and
by alleging that they agreed to invest in the Dauterive acquisition in February 2013, before the
PPM was provided to the Plaintiffs. Plaintiffs state that they are indeed entitled to a presumption
of reliance because their allegations are primarily of omissions. Further, Plaintiffs argue that the

misrepresentations made at the in-person meeting in February 2013 were the very same made in
the PPM in April 2013 and, therefore, they were relying on the same misrepresentations made by
Management Defendants:

Where the failure to disclose information is the principal fraud, "positive proof of

reliance is not a prerequisite to recovery." Affiliate Ute Citizens v. United States, 406 U.S. 128,
153-54. "All that is necessary is that the facts withheld be material in the sense that a reasonable
investor might have considered them important in the making ofthis decision. This obligation to
disclose and this withholding of a material fact establish the requisite element of causation in

fact." Id. The relaxed requirement in cases of nondisclosure recognizes "the difficulty of proving
reliance on the negative." Vervaecke v. Chiles, Heider & Co., 578 F.2d 713, 717(8th Cir. 1978)
(quoting The Reliance Requirement in Private Actions Under SEC Rule 10b—5, 88 Harv. L.
Rev. 584, 590(1975)[hereinafter The Reliance Requirement]). However,"[wjhere the securities
fraud at issue closely resembles the tort of deceit, the plaintiff encounters no special difficulty in
23

attempting to demonstrate reliance. The lack of any barrier to proof permits the private action
adequately to serve its [compensatory and deterrent purposes] purposes." The Reliance
Requirement, 88 Harv. L. Rev. at 589. Thus, where affirmative misrepresentation eases are

involved, there is no need to presume reliance as causation may be tested directly.
While Plaintiffs attempt to characterize this case as one involving primarily
nondisclosure, the Court has carefully examined the pleadings and does not view it as such. See
generally Vervaecke, 578 F.2d at 717-18 (dismissing Plaintiff's characterization of the case as
involving primarily nondisclosure after examination of the pleadings). Plaintiffs argue that the
complaint alleges Management Defendants made the following materially false statements: 1)
that the 2012 EBITDA was $2,434 million, when it was less than $100,000; 2) that the 2012
EBITDA of$ 2.434 million was "derived from Dauterive Hospital's internal unaudited financial
statements which were prepared by the seller"; and 3) that, as of February 2013, Dauterive was

"generating well in excess of $3M in EBIDTA currently." Doc. 31 at 16. Then Plaintiffs argue
that the complaint alleges "Defendants omitted the following material information necessary to
make disclosed information not misleading:" 1)that at least $1.4 million of the 2012 EBITDA of

$2,434 actually consisted of"additions" made by Defendant Thompson to the seller's numbers;
2)that the seller's own projection for the full year following acquisition for Dauterive was a loss

of nearly $50,000, in contrast to Defendants' projection of $6,559 million; 3) that Defendants
based their flill-year-following-acquisition estimate on the $2,434 million 2012 EBITDA which
was misrepresented as based on the seller's own financial statements; 4) that Defendant
Thompson was told that the number he projected for savings relating to benefits was
unattainable; and 5)that days before the PPM was issued, PAC's independent auditors issued an
audit report finding material weakness in PAC's internal controls. Doc. 31 at 16-17.
Despite this presentation. Plaintiffs complaint may be better summarized as alleging
Management Defendants made affirmative misrepresentations that the sellers of Dauterive

hospital provided that the 2012 EBITDA was $2,434, that Dauterive was currently generating in
excess of $3 million EBITDA, that Dauterive would generate $6,559 million in the year
following the acquisition, and that PAC had identified ways to correct deficiencies in PAC's
internal controls. The facts that Defendant Thompson had been approached by an employee, that
PAC's independent auditors had issued an audit report, and that additions had been made to the
seller's real projections are more accurately characterized as factual allegations that render

24

Defendants' affirmative representations inaccurate or, at the very least, that Defendants had
access to information which contradicted their own projections. Therefore, the "thrust of what

[Plaintiffs] actually pleaded was the use of fraudulent raisstatement and omission within the four
corners of an offering prospective which mislead" the Plaintiffs to invest in PAC in order to fund
the Dauterive acquisition. See Vervaecke, 578 F.2d at 718.
Since this is not a case where the Court may presume reliance. Plaintiffs must

affirmatively plead facts which show Plaintiffs relied on the alleged misrepresentations when

deciding to invest. See Halliburton, 563 U.S. at 810 (2011). Plaintiffs have done so. Although

Plaintiffs explicitly allege that "[f]ollowing the February 2013 in-person meeting in Dakota
Dunes, the Physicians agreed to invest the $3 million ofequity required for PAC to complete the
Dauterive acquisition," Doc. 1 at 20, Plaintiffs also allege that the same material was presented

in the in-person meeting in February 2013 as was presented in the April 2013 PPM. Further,
Plaintiffs did not actually sign the subscription agreements and invest until after the PPM was

presented to them. Therefore, Plaintiffs have still sufficiently pleaded reliance with respect to the
allegations that Management Defendants misrepresented the historical and projected EBITDA
numbers and the quality ofthe internal controls. Plaintiffs have established that they were "aware
of a company's statement and engaged in a relevant transaction... based on that specific
misrepresentation." See Halliburton, 563 U.S. at 810.
3. Loss Causation

A private cause of action for securities fraud is not intended to "provide investors with
broad insurance against market losses, but to protect them against those economic losses that

misrepresentations actually cause." Dura Pharmaceuticals, Inc., v. Broudo, 544 U.S. 336, 344

(2005). Therefore, a cause of action for private securities fraud based on violations of § 10(b)
and Rule lOb-5 requires Plaintiffs show that Management Defendants' misrepresentations
"caused the loss for which the plaintiff seeks to recover." 15 U.S.C. § 78u-4(b)(4). "Loss
causation in a securities fraud case is analogous to the common law's requirement of proximate

causation." McAdams v. McCord, 584 F.3d 1111, 1114 (8th Cir. 2009) (citing Schaaf v.

Residential Funding Corp., 517 F.3d 544, 550 (8th Cir. 2008)). "The plaintiff must show 'that
the loss was foreseeable and that the loss was caused by the materialization of the concealed

risk.'" Schaaf, 517 F.3d at 550(emphasis in original).

25

Loss causation, unlike the elements of material misrepresentation and scienter, is not
subject to the heightened pleading standards of the PSLRA. Instead, the pleading of loss
causation is subject only to Rule 8(a)(2)'s requirement of a short and plain statement of the
claim. Dura Pharmaceuticals, 544 U.S. at 346. Management Defendants argue that Plaintiffs
have failed even this "simple test" by using "threadbare, conclusory statements" which fail to

show how the alleged misrepresentations, and not other market factors, caused the loss of their
investment.

Plaintiffs' complaint alleges that, relying on Management Defendants' representations of
Dauterive's historical performance, as well as Dauterive's predicted performance. Plaintiffs

agreed to invest the additional capital into PAC which would fund the Dauterive acquisition.
Plaintiffs also allege that those representations were inaccurate and based on undisclosed

additions to the seller's true projections. One ofthose projections was a $50,000 loss in the year
following the acquisition. Finally, Plaintiffs allege that the acquisition did indeed result in
financial woes, and that it was Dauterive, and not any ofthe other hospital's owned by PAC,that

was the driving force behind PAC's bankruptcy filing. Plaintiffs have thus alleged "enough facts

to raise a reasonable expectation that discovery will reveal evidence of loss causation." In re St.
Jude Medical, Inc. Sec. Litig., 836 F. Supp. 2d 878, 908(D. Minn. 2011). Thus, the Court finds

Plaintiffs have sufficiently pleaded loss causation by showing that the loss was foreseeable—in
fact, had been foreseen by the sellers themselves—and that the loss was caused by the
materialization of the misrepresentations—namely, that the EBITDA of Dauterive was in fact

much lower than Management Defendants represented. Therefore, Management Defendants
motion to dismiss with respect to Count 1 is denied,
b. Section 20(a)

Under Section 20(a) of the Securities Exchange Act, "[ejvery person who, directly or

indirectly, controls any person liable" under Section 10(b) and Rule lOb-5 "shall also be liable
jointly and severally with and to the same extent as such controlled person is liable." 15 U.S.C.
§ 78t. In short, the statute generally subjects to liability "those who, subject to certain defenses,

'directly or indirectly' control a primary violator of the federal securities laws." Lustgraaf v.
Behrens, 619 F.3d 867, 873 (8th Cir. 2010). The Eighth Circuit has construed the statute
liberally, "requiring only some indirect means of discipline or influence short of actual direction
to hold a 'controlling person' liable." Id. (citing Farley v. Henson, 11 F.3d 827, 836 (8th Cir.
26

1993)). A plaintiffs prima facie case requires: "(1) that a primary violator violated the federal
securities laws; (2) that the alleged control person actually exercised control over the general
operations of the primary violator; and (3)that the alleged control person possessed—but did not
necessarily exercise—^the power to determine the specific acts or omissions upon which the
underlying violation is predicated." Id. (internal quotations omitted). "If a plaintiff satisfies the

prima facie burden, the burden shifts to the defendant to show that it 'acted in good faith and did
not directly or indirectly induce the act or acts constituting the violation or cause of action.'" Id.
at 874(quoting 15 U.S.C. § 78t(a)).
i.

Management Defendants

Management Defendants' sole argument as to why Plaintiffs have not stated a claim for a
violation of Section 20(a) is because it is a derivative claim which requires an underlying

violation of the SEA. As this Court explained above, however, Plaintiffs have sufficiently stated
a claim for a violation of Section 10(b) and Rule lOb-5. Therefore, Plaintiffs have successfully
alleged a claim for a violation of Section 20(a) with regard to Management Defendants and the
Motion to Dismiss with respect to the federal securities law claims is denied.
ii.

Defendant Newell

To the extent Defendant Newell argues that Count II should be dismissed against him

because Plaintiffs did not properly plead a primary violation of the Securities Exchange Act,
Defendant's Newell's motion is similarly denied. However, Defendant Newell also argues that
Count II should be dismissed as to him because Plaintiffs have failed to plead that Defendant

Newell could have or actually did exercise control over the Management Defendants. The Court
agrees.

SEC regulations define control as "the possession, direct or indirect, of the power to
direct or cause the direction of the management and policies of a person, whether through the

ownership of voting securities, by contract, or otherwise. 17 C.F.R. § 230.405. However, the
mere ability to control is not enough. Unless the controlling person was "actively participating

in the decisionmaking process of the [primary violator], no controlling liability can be imposed."
Lustgraaf, 619 F.3d at 875 (quoting Aldridge v. A.T. Cross Corp., 284 F.3d 72, 85 (1st Cir.

2002). The complaint generally alleges that Defendant Newell "had the power and authority to
cause the Management Defendants and/or PAC to engage in the wrongful conduct identified"

given his "influential position on PAC's Board of Directors and the Audit Committee." While
27

the question of whether an individual is a controlling person is "an intensely factual question,
involving scrutiny of the defendant's participation in the day-to-day affairs of the corporation
and the defendant's power to control corporate actions," Cumming v. Paramount Partners, LP,
715 F.Supp.2d 880, 907 (D. Minn. 2010), pleading titles and status as a significant beneficial
owner alone fails to demonstrate actual control. See Beaver Cnty Employees'Retirement Fund v.
Tile Shop Holdings, Inc., 94 F.Supp.Sd 1035, 1055(D. Minn. 2015)(holding that plaintiffs failed
to plead defendants actually exercised control where their titles, status as beneficial owners, and
signatures on registration documents were the only facts presented). Plaintiffs have failed to
allege facts to suggest that Defendant Newell, or even the Audit Committee more generally, had
the ability to control day-to-day operations of PAC or the Management Defendants, much less

any facts that may plausibly be read to state that Defendant Newell exercised such control.
Therefore, with regard to Defendant Newell, Count II is dismissed.
IV.

State Law Fraud Claims

Counts III - VI of Plaintiffs' complaint alleges violations ofthe law ofthe State of South

Dakota: 1) deceit under S.D.C.L. § 20-10-1; 2)actual fraud in relation to contract under S.D.C.L.
§ 53-4-5; 3) constructive fraud in relation to contract under S.D.C.L. § 53-4-6; and 4) common
law fraud. Defendants argue that Plaintiffs have actually pleaded only two state law claims for

fraud, as opposed to the four claims enumerated in the complaint: (1) a tort action seeking
damages, and (2) a contract action seeking rescission. Defendants argue that the claims sounding
in tort and in contract be dismissed as they 1) necessarily rely on supplemental jurisdiction,

which would be lacking should the motion to dismiss the federal securities claims be granted;
and 2) are also inadequately pled as they do not meet the standards of Rule 9(b) and do not
adequately plead reliance.

The Court already found above that Plaintiffs have not engaged in group pleading and
have therefore pleaded with sufficient particularity to meet the requirements of the PSLRA with
respect to Management Defendants. This finding also applies to Plaintiffs' state law claims. The
Court also found that Plaintiffs sufficiently pleaded federal securities law violations, therefore
Plaintiffs may rely on supplemental jurisdiction for their state law claims. Thus, Management
Defendants' Motion to Dismiss Counts III-VII on the grounds of failure to plead with

particularity and lack of jurisdiction is denied. See United Mine Workers ofAmerica v. Gibbs,
383 U.S. 715, 725 (1966)(A federal court may retain jurisdiction of a state law claim where it
28

has jurisdiction of a federal claim and the state and federal claims derive from a common nucleus

of operative fact.). The Court also denies Management Defendants' Motion to Dismiss with

respeet to Count VIII on the grounds of lack of supplemental jurisdiction. Similarly, the Court

denies Defendant Newell's Motion to Dismiss regarding Counts III-VIII on the grounds of lack
of supplemental jurisdietion. However, because Defendant Newell was not alleged to have
committed a primary violation of the Securities Exchange Act, the Court has not yet examined
whether Plaintiffs have pleaded with sufficient particularity to meet the requirements of the
PSLRA with respect to Defendant Newell and thus takes care to do so in the analysis of the state
law claims below.
a. Deceit and Common Law Fraud

With respect to Counts III and VI, claims for deceit under SDCL § 20-10-1 and for
common law fraud, the Court disagrees with Defendants' contention that they are one and the
same. Though "[t]he elements for common law fraud and statutory deceit are essentially identieal
under South Dakota law," they are nevertheless two distinct causes of action. See Stockmen's
Livestock Market, Inc. v. Norwest Bank ofSioux City, 135 F.3d 1236, 1243 (1998). The essential
elements ofeommon law fraud under South Dakota law are:

That a representation was made as a statement of fact, which was untrue and
known to be untrue by the party making it, or else recklessly made; that it was
made with intent to deceive and for the purpose of inducing the other party to act
upon it; and that he or she did in fact rely on it and was induced thereby to act to
his or her injury or damage.
Id (quoting M/v.Sittner, 474 N.W.2d 897, 900(S.D. 1991)). SDCL § 12-10-1, which governs

actions for deceit, provides: "One who willfully deceives another, with intent to induce him to
alter his position to his injury or risk, is liable for any damage which he thereby suffers." The
following acts come within the meaning of deceit:

1) The suggestion, as a fact, of that which is not true, by one who does not
believe it to be true;

2) The assertion, as a fact, or that which is not true, by one who has no
reasonable ground for believing it to be true;
3) The suppression of a fact by one who is bound to disclose it, or who gives
information of other facts which are likely to mislead for want of
communication ofthat fact; or

4) A promise made without any intention of performing.

SDCL § 20-10-3. The statutory elements of deceit are not only similar to those of the common
law cause of action for fraud under South Dakota law, but also to the elements of a federal law
29

claim for private securities fraud under Rule lOb-5 and § 10(b) of the Securities Exchange Act.
Thus, consistent with its findings above, the Court concludes that Plaintiffs have adequately

pleaded state law violations of deceit and common law fraud under South Dakota law as to
Management Defendants.

In analyzing the state law claims of deceit and common law fraud against Defendant
Newell, the Court notes that, under South Dakota law,"every participant in a fraud and each one

who assists another in the perpetration of the fraud is liable to the injured party." Cohen, 385 F.
Supp. 2d at 954 (quoting Tucekv. Mueller, 511 N.W.2d 832, 837(S.D. 1994)). Plaintiffs allege
that Defendant Newell participated in the fraud by "review[ing], approv[ing], and/or author[ing]
the PPM and Due Diligence Report. Thus, Plaintiffs have pleaded facts suggesting Defendant

Newell, at the very least, assisted another in the perpetration of a fraud and Defendant Newell's

Motion to Dismiss with respect to Counts 111 and VI is denied.^
b. Actual Fraud in Relation to Contract

With respect to Counts IV and V,the claims sounding in contract. Defendants argue that
South Dakota does not recognize claims for "Fraud in Relation to Contract" and, if such claims
do exist, that Defendants did not contract with Plaintiffs, a necessary element of such claims.

South Dakota law provides for rescission of a written contract when the consent of a contracting
party was "given by mistake or obtained through duress, fraud, or undue influence." SDCL § 5311-2. Fraud can be either actual or constructive. See SDCL § 53-4-5 and § 53-4-6. South Dakota

law also allows a defrauded plaintiff to bring a tort action or a contract action based on the same
facts. See Stabler v. First State Bank ofRoscoe, 865 N.W.2d 466, 474—75 (S.D. 2015) (citing

SDCL 20-10-1 (Tort) and SDCL 53-4-5 (Contract)). The plaintiff"may affirm the contract and

bring a tort action for deceit seeking monetary damages, or he may repudiate the contract and
bring a contract action for rescission or revision." Id. at 475 (quoting Ashoff v. Mobil Oil Corp.,
261 N.W.2d 120, 123 (S.D. 1977)). The plaintiff may pursue both of these alternative remedies
"so long as no double recovery is awarded." Id. (quoting Ripple v. Wold, 549 N.W.2d 673, 674-

' Court notes, however, that should it have taken Plaintiffs' complaint literally when Plaintiffs stated that they
The
agreed to invest after the February 2013 meeting, the statements within the PPM cannot be shown to be material nor
can Plaintiffs show reliance on such statements. At this stage, the Court does not take such a literal interpretation

and instead reads the complaint together as a whole. However, should such a literal interpretation be proven true,
Defendant Newell likely faces little exposure to liability, as his only apparent connection to the allegedly fraudulent
statements is through the PPM.
30

75 (S.D. 1996)). The Eighth Circuit explained this election of remedies in Pa. Nat'I Mut. Cas.
Ins. Co. V. City ofPine Bluff, 354 F.3d 945 (8th Cir. 2004):

Designed to prevent double recovery for a single injury, the election-of-remedies
rule applies when a party possesses two appropriate but inconsistent remedies and
deliberately pursues one remedy to the other's exclusion. The rule does not
prohibit assertion of multiple causes of action, nor does it preclude pursuit of
consistent remedies, even to final adjudication, so long as the plaintiff receives
but one satisfaction.

Id. at 950-51 (citations omitted). Therefore, Plaintiffs may properly pursue both a contract and
tort action for the facts at issue here, so long as the complaint states a plausible claim for relief in
both actions.

SDCL § 53-4-5 defines actual fraud in relation to contract and § 53-4-6 defines
constructive fraud in relation to contract. Both provisions describe circumstances which make
the contract voidable. See Schmidt v. Wildcat Cave, Inc., 261 N.W.2d 114, 116-17 (S.D. 1977).
SDCL § 53-4-5 provides:

Actual fraud in relation to contracts consists of any ofthe following acts committed by a

party to the contract, or with his connivance, with intent to deceive another party thereto
or to induce him to enter into the contract:

(1) The suggestion as a fact ofthat which is not true by one who does not believe it to be
true;

(2) The positive assertion, in a manner not warranted by the information of the person
making it, ofthat which is not true, though he believe it to be true;
(3) The suppression ofthat which is true by one having knowledge or belief ofthe fact;
(4) A promise made without any intention of performing it; or
(5) Any other act fitted to deceive.
Actual fraud is always a question offact.
SDCL § 53-4-6 provides:
Constructive fraud consists:

(1) In any breach of duty which, without any actually fraudulent intent, gains an
advantage to the person in fault or anyone claiming under him, by misleading another
to his prejudice or to the prejudice of anyone claiming under him; or
(2) In any such act or omission as the law specially declares to be fraudulent, without
respect to actual fi-aud.

"Although actual fi-aud may be the basis of tort actions and contract actions, constructive fraud is
the basis only for actions for the avoidance of contracts." Schmidt, 261 N.W.2d at 117. This is so
because constructive fraud requires no fraudulent intent, which is inconsistent with the intent
required for deceit under SDCL 20-10 and the common law. Id. s

31

Defendants argue that a reseission claim cannot be brought against a defendant who is not

a party to the contract and, because Plaintiffs have not identified a contract between them and
Defendants, Plaintiffs' contract actions for fraud should be dismissed. Plaintiffs argue that SDCL

§ 53-4-5 expressly permits claims to be brought against non-contract parties who aid in the fraud

by defining actual fraud in relation to contract as fraudulent "acts committed by a party to the
contract, or with his connivance." Doc. 31 at 56 (citing SDCL § 53-4-5) (emphasis added)).
Plaintiffs assert that the South Dakota Supreme Court construed this language to permit claims

against a company that was party to a contract, as well as its officers in Brevet Int'l, Inc. v. Great

Plains Luggage Co., 604 N.W.2d 268 (S.D. 2000). Defendants respond saying Brevet does not
stand for such" a proposition and that the language in the statute merely protects against a

contracting party circumventing liability by having a non-contracting party commit fraud for
him. Doc. 34 at 33. The Court agrees with Defendants.
In Brevet, Brevet International, Inc. contracted with Great Plains Luggage Company to

provide management consulting services in order to resolve Great Plains' manufacturing
problems. Id. at 269. After their relationship turned sour. Brevet initiated a suit against Great
Plains and its three principal officers, directors, and shareholders in their individual capacity
alleging breach of contract and fraud. Id. at 269-70. Great Plains and the individual defendants,
in addition to filing counterclaims, moved for partial summary judgment with respect to the
breach of contract claim (against the individual defendants), and the fraud claim (against all

defendants). Id. at 270. The trial court granted the defendants' motion for partial summary
judgment and Brevet appealed, arguing genuine issues of material fact existed so as to preclude
the granting of partial summary judgment on the fraud claim and that the trial court improperly
refused to pierce the corporate veil in order to hold the individual defendants personally liable.
Id. at 271.

Brevet argued that one of Great Plains' principal officers made a false representation in
their initial negotiations. Id. at 272. Great Plains argued the statement was true, or in the

alternative, he believed it to be true. Id. Because a statement, even if believed to be true, may still
constitute fraud ifthe declarant does not have sufficient information to support his statement, and
because other issues of fact were still outstanding, the South Dakota Supreme Court found the

claim could not be properly disposed of by summary judgment. Id. Nevertheless, the South

Dakota Supreme Court found the lower court had properly dismissed all claims against the
32

individual defendants because Brevet had not met its burden of showing the corporation's
separate legal existence had been used to "defeat public convenience, justify wrong, protect
fraud, or defend crime" so as to justify piercing the corporate veil. Id. at 273-74. The court did
not, as Plaintiffs claim, dismiss only the breach of contract claim against the individual
defendants. Instead, it dismissed all claims against the individual defendants because they could
not be held personally liable.

Only parties to a contract have rights in contract. Mahan v. Avera St. Luke's, 621 N.W.2d
150, 154 (S.D. 2001). The very definition of actual fraud expressly provides that it can be
committed only by parties of a contract. See Clausen v. National Geographic Soc., 664 F. Supp.

2d 1038, 1052-53 (D.N.D. 2009) (interpreting North Dakota's nearly identical actual fraud

statute). Similarly, SDCL § 53-11-2, the statute providing for the remedy of rescission, provides
that a party to a contract may rescind "[i]f consent of the party rescinding...was given

by...fraud...by or with the connivance of the party as to whom he rescinds." There are no
allegations which would, if proved, support a claim of actual or constructive fraud which would
provide for rescission of the contract because no contract existed between Plaintiffs and
Defendants. Because Plaintiffs have not alleged the connivance of the contracting party, PAC,

nor alleged that the PAC's separate legal existence had been used to "defeat public convenience,

justify wrong, protect fraud, or defend crime" so as to justify piercing the corporate veil.
Plaintiffs have not alleged facts sufficient to support a claim of actual or constructive fraud under

SDCL § 53-4-5 or § 53-4-6. Therefore, Counts IV and V ofthe complaint are dismissed as to all
defendants.

c. Negligent Misrepresentation

Count Vll ofthe complaint alleges all Defendants engaged in negligent misrepresentation
in their solicitation of additional funds for the Dauterive acquisition. As stated above. Defendants

argue that Count Vn should be dismissed as it does not meet the standards of Rule 9(b) and does
not adequately plead reliance. The South Dakota Supreme Court has cited with approval the tort
of negligent misrepresentation as it is described in the Restatement (Second) of Torts. See
O'Danielv. StroudNA,604 F. Supp. 2d 1260, 1263 (D.S.D. 2008).

The tort of negligent misrepresentation occurs when in the course of a business or

any other transaction in which an individual has a pecuniary interest, he or she
supplies false information for the guidance of others in their business transactions.

33

without exercising reasonable care in obtaining or communicating the
information.

Meyer v. Santema, 559 N.W.2d 251, 254 (S.D. 1997) (quoting Pickering v. Pickering, 434

N.W.2d 758, 762 (S.D. 1989)(emphasis omitted) (citing Restatement (Second) of Torts § 552
(1977))).

A party seeking relief for the tort of negligent misrepresentation must prove
knowledge, or its equivalent, that the information is desired for a serious purpose;
that he to whom it is given intends to rely and act upon it; that, if false or
erroneous, he will... be injured in person or property. Finally, the relationship of
the parties, arising out of contract or otherwise, must be such that in good morals
and good conscience the one has the right to rely upon the other for information
and the other giving the information owes a duty to give it with care.

Id. (internal quotations omitted)(citing Rumpza v. Larsen, 551 N.W.2d 810, 814(S.D. 1996)).
With respect to Management Defendants, Plaintiffs have pleaded sufficient facts
demonstrating alleged misrepresentations attributed to each of the Management Defendants,

made despite their alleged knowledge of facts to the contrary of their assertions and that
Management Defendants owed Plaintiffs a duty of care due to Plaintiffs' membership in PAC.
Plaintiffs allege that Defendant Newell participated in the fraud by "review[ing], approv[ing],

and/or author[ing] the PPM and Due Diligence Report. Plaintiffs further pleaded that they relied
on those statements in deciding.to provide additional funds to support the Dauterive acquisition.
Therefore, Plaintiffs have properly pleaded facts sufficient to support a plausible claim for relief

for negligent misrepresentation against all Defendants and Defendants' Motions to Dismiss
Count VII are denied.

V.

State Law Fiduciary Duty Claim

Plaintiffs' final claim is that all Defendants owed Plaintiffs fiduciary duties pursuant to

PAC's Operating Agreement and South Carolina law and that Defendants breached those
fiduciary duties in two ways: 1) by making the false and misleading statements as alleged above
in order to induce them to provide capital to fund the Dauterive acquisition; and 2) by soliciting

their proxies and convincing them to vote in favor of filing for bankruptcy protection without
providing "even the most basic information relevant to that filing" nor "a reasonable period of
time to consider the filing." "Fiduciary duties of directors and shareholders are governed by the
state of incorporation," in this case South Carolina. Trooien v. Mansour, 608 F.3d 1020, 1032

(8th Cir. 2010)(citing Dunning v. Bush, 536 F.3d 879, 886 (8th Cir. 2008)). Defendants do not
34

contest that they owe Plaintiffs fidueiary duties under S.C. Code Ann. § 33-44-409. However,
Defendants argue that Plaintiffs have again failed to comply with the Rule 9(b) pleading
standards which are required for breaeh of fidueiary duty claims sounding in fraud and that
Defendants did not breaeh their fiduciary duties. Further, Defendants assert that dismissal is
appropriate because Plaintiffs' breach of fiduciary duty claim regarding the bankruptcy vote "is
merely a derivative action disguised as a direct action." Assuming Rule 9(b) does apply to breach
of fiduciary claims involving fraud, the Court has already found that the heightened standards of
the Private Securities Litigation Reform Act (PSLRA) and Rule 9(b) pleading standards have

been met. Because this is the only reason Management Defendants provide as to why the breach
of fiduciary duty claim with regard to the alleged misrepresentations prior to the Dauterive

acquisition, the Court denies Management Defendants' motion to dismiss with regard to that

specific claim. Similarly, because Plaintiffs have pleaded a plausible claim for fraud or
misrepresentation against Defendant Newell, the allegation for breach of fiduciary duty with

regard to alleged misrepresentations prior to the Dauterive acquisition survives Defendant
Newell's motion to dismiss. The Court thus moves forward to address whether Plaintiffs have

adequately pleaded facts which would give rise to a plausible claim for relief for breach of
fiduciary duty with regard to the solicitation oftheir votes in favor offiling for bankruptcy.
"To establish a claim for breach of fiduciary duty, the plaintiff must prove: 1) the

existence of a fiduciary duty, 2) a breach of that duty owed to the plaintiff by the defendant, and

3) damages proximately resulting from the wrongful conduct of the defendant." RFT
Management Co., L.L.C. v. Tinsley & Adams L.L.P., 732 S.E.2d 166, 173 (S.C. 2012). Under
South Carolina law, a manager of a manager-managed LLC owes statutory duties of care,

loyalty, and good faith and fair dealing not only to the company, but also to the company's other
members. See generally S.C. Code. Ann. § 33-44-409. As such, S.C. Code Ann. § 33-44-410
allows a member of an LLC to maintain an action against the company or another member or

manager for legal or equitable relief to enforce that member's rights under the operating

agreement and under South Carolina law. That member, however, can only pursue that member's
claim against the company or another member or manager. See Hite v. Thomas & Howard Co.,
409 S.E.2d 340, 342(1991)(citations omitted), overruled on other grounds by Huntley v. Young,

462 S.E.2d 860, 861 (1995)("A shareholder may maintain an individual action only if his loss is

separate and distinct from that of the corporation. A shareholder's suit is derivative if the
35

gravamen of his complaint is an injury to the corporation and not the individual interest of the

shareholder."); Todd v. Zaldo, 403 S.E.2d 666, 668 (S.C. Ct. App. 1991) ("If an individual
shareholder has suffered a particular loss due to mismanagement of a corporation then the
stockholder may bring an action for his loss since it is his personal asset. But, this loss must be
personal and not a loss of the corporation."). To assert a claim on behalf of the company, the
member must instead pursue a derivative claim pursuant to S.C. Code Ann. 33-44-1101.

Plaintiffs allege that Defendants breached their fiduciary duties to Plaintiffs by failing to
provide basic information relevant to that filing and failing to give Plaintiffs a reasonable period
of time to consider the filing. Plaintiffs allege that Defendants failed to advise Plaintiffs that

authorizing the filing would require Plaintiffs to relinquish rights Plaintiffs held as members of
PAC,including their right to bring derivative claims against Defendants. Finally, Plaintiffs allege
that this breach caused a direct injury to the Plaintiffs by resulting in a loss of their entire PAC

investment. The Court notes, however, that Plaintiffs only allege that Management Defendants
were involved in the meetings and solicitation of votes regarding the bankruptcy filing. There is
no mention ofDefendant Newell's involvement.

Defendants argue that this is merely a derivative claim disguised as a direct claim.
Defendants also argue that, though South Carolina courts have not directly considered whether a
member's right to make an informed decision to vote on a company decision to file for

bankruptcy gives rise to a direct or derivative claim, case law supports the notion that Plaintiffs'
claim is a derivative one. The Court agrees.

In understanding the underlying reasons for requiring a derivative action, one may better
understand the circumstances in which a member suffers a distinct injury from that of the LLC

itself. The South Carolina Court of Appeals discussed the underlying reasons for the general rule
that shareholders must file derivative actions for losses suffered by a corporation in Brown v.

Stewart, 557 S.E.2d 676(S.C. Ct. App. 2001). Those reasons include:
1) it prevents a multiplicity of lawsuits by shareholders; 2) it protects corporate
creditors by putting the proceeds of the recovery back in the corporations; 3) it
protects the interests of all shareholders by increasing the value of their shares,
instead of allowing a recovery by one shareholder to prejudice the rights of others
not a party to the suit; and 4)it adequately compensates the injured shareholder by
increasing the value of his shares.

36

Id. at 685.(citing Thomas v. Dickson, 301 S.E.2d 49, 51 (Ga. 1983)). Those same reasons apply
equally to the general rule that members must file derivative actions for losses suffered by a
manager-managed LLC.

Plaintiffs' loss of their entire investment in FAG is not unique to Plaintiffs.alone. Instead,
it is a loss suffered by all members ofPAC as a result ofthe bankruptcy filing and as such cannot
be remedied in a direct action. Therefore, to bring a claim for breach offiduciary duty for failure
to inform the members of the consequences of their vote to file for bankruptcy. Plaintiffs must
follow the procedural requirements of Rule 23.1 of the Federal Rules of Civil Procedure and
state with particularity the efforts made, if any, by Plaintiffs to obtain the action they desire.

Plaintiffs have not done so here. Thus, Plaintiffs have failed to state a plausible claim for relief
and Defendants' motions to dismiss are granted with respect to the breach of fiduciary duty
claim regarding the bankruptcy filing.
CONCLUSION

Given the extent of the filings, much of which is not in the public domain, the Court
probably should have converted these motions to dismiss into motions for summary judgment.
However, there would have been no discovery at all. Nevertheless, there does not appear to be a
need for extensive discovery in this case as the facts are pretty well-known. The Court

anticipates setting a limited time for discovery and what is to be made of the facts will be for a
jury to decide.

It appears that the actual investment loss to the Plaintiffs is slightly in excess of a million
dollars. By the time this case goes through discovery, further motion practice, trial, and a likely

appeal, the parties will leave having spent more than that in fees and expenses. In addition to
that, there is always the unknown of what a jury might do. The Court says all ofthis even though
this will be an interesting case for the Court to try to a jury, as the issues are interesting and the

parties are well-represented. However, given the above considerations, the Court recommends,
but does not order, early mediation. Judge Duffy, the Magistrate Judge for this Court, has had

great success in mediation and, of course, private mediators are available. Accordingly,
IT IS ORDERED

1. Management Defendant's Motion to Dismiss, Doc. 26, is:
a. GRANTED with respect to Counts IV and V;

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b. GRANTED with respect to Count VIII to the extent it pertains to a failure to
inform prior to the bankruptcy filing;
c. DENIED with respect to Counts I, II, III, VI, and VII.

d. DENIED with respect to Count VIII to the extent it pertains to the alleged
misrepresentations leading to the investment funding the acquisition of
Dauterive.

2. Defendant Newell's Motion to Dismiss, Doc. 28, is

a. GRANTED with respect to Counts II, IV, and V;

b. GRANTED with respect to Count VIII to the extent it pertains to a failure to
inform prior to the bankruptcy filing;
c. DENIED with respect to Counts III, VI, and VII;

d. DENIED with respect to Count VIII to the extent it pertains to the alleged
misrepresentations leading to the investment funding the acquisition of
Dauterive.

Dated this 22nd day of March,2018.
BY THE COURT:

awrence L. Piersol

ATTEST:
MATTHEW W. THELEN,CLERK

BY:

United States District Judge

[l>t|fAPl^
DEPUTY

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