189 F. 3d 321 - Bald Eagle Area School District

Bald Eagle Area School District and South Butler County School District filed a putative class action complaint asserting, inter alia, four claims against Keystone Financial, Inc., Mid-State Bank & Trust Co., and certain named individuals under the Racketeer Influenced Corrupt Organizations Act ("RICO"), 18 U. S. C. S 1962, by which they sought to recover approximately $70 million that they lost as a result of a Ponzi scheme. The District Court, concluded that S 107 of the Private Securities Litigation Reform Act of 1995 ("PSLRA") amended RICO so as to preclude the School Districts' civil RICO action, and dismissed the complaint under Fed. R. Civ. P. 12(b)(6). For the reasons that follow, we will affirm.

Various school districts, municipalities and other governmental units were purported victims of a Ponzi scheme1 run by John Gardner Black through his companies: Devon Capital Management2 ("Devon") and Financial Management Services, Inc.3 ("FMS") (hereinafter collectively referred to as "Devon."). The various local government units appointed Devon to act as their investment advisor for the proceeds of bonds, loans and other revenues. On September 26, 1997, the Securities and Exchange Commission obtained a freeze of all assets under the control of Devon. The original SEC action has been closed and a number of the investors have received only a small fraction of their original investments. Certain of the investors then began an involuntary bankruptcy action against Black, Devon and FMS and that action has halted any other litigation in which Black, Devon and FMS were named as defendants.

Bald Eagle Area School District and South Butler County School District (hereinafter "School Districts") were among Black's clients. From 1990 to 1997, they retained Devon as their investment advisor for the investment of proceeds from bonds sold to finance school construction. The School Districts entered into a series of Investment Advisory Agreements with Devon pursuant to which Devon would invest bond proceeds on their behalf and distribute funds as they were needed to pay construction costs. The Investment Advisory Agreements gave Devon discretion to invest in securities authorized by law but provided that Devon would not take possession of, or act as custodian for, the cash, securities or other assets of the School Districts. Instead, the Investment Advisory Agreements provided for Devon's appointment of a custodian for the accounts in which the School Districts' assets were held. Pursuant to the Investment Advisory Agreements, Devon entered into a Custodian Agreement with Mid-State Bank & Trust Co. Under the Custodian Agreement, Mid-State was to maintain custody of the School Districts' assets, which were at all times to be 100% secured by collateral. Chief among Mid-States' duties under the Custodian Agreement was implementation of securities investment decisions made by Devon as the School Districts' investment advisor. Essentially, Mid-State acted as the intermediary which processed the securities trades that were directed by Devon. Its specific obligations under the Custodian Agreement included receiving funds for investment from Devon's clients, executing securities transactions with these funds based on instructions from Devon, executing further purchases and sales of securities held in the custodial accounts based on instructions from Devon; collecting and crediting all payments received on the securities, including dividends, interest, or principal payments; and providing monthly account statements of the assets held in each custodial account.

From 1990 through 1993, the relationship between Devon and the School Districts was lucrative. However, starting in 1993, in response to competitive pressures in the marketplace, Devon sought ways to get a better return on the funds entrusted to it. One way Devon attempted to earn better returns was by purchasing riskier investments, including volatile derivative securities.

To facilitate the purchase of the riskier investments, Devon directed Mid-State beginning in mid-1994 to invest a portion of the clients' funds in Collateralized Investment Agreements ("CIAs") issued by FMS.4 The CIAs had varying fixed income returns, but they all required that FMS maintain collateral equal to 100% of the principal amount invested. Each CIA had a fixed maturity date and a demand element permitting the School Districts to request repayment before the maturity date. FMS pooled the funds from the sale of the CIAs, invested them in risky securities and used those securities as collateral for the CIAs.

Pursuant to Devon's instructions, Mid-State sold securities in Devon's client accounts and purchased CIAs issued by FMS. Following the placement of the CIAs in client accounts, Mid-State continued to provide monthly account statements for Devon clients as required by the Custodian Agreement. The statements reported the transactions in the accounts, including deposits, withdrawals and interest earned. The CIAs were reported in the statements as cash equivalents with current value equal to the principal amount owed by FMS.

However, FMS began to suffer large trading losses in the risky derivative investments in its collateral account. Other losses resulted from Black's misuse of assets held as CIA collateral and his transfer of CIA collateral to other Devon advisory clients for less than full value. By early 1995, the collateral in the FMS accounts was approximately $56 million less than FMS' liabilities under the CIAs. Nevertheless, pursuant to Devon's instructions, FMS continued to sell and repurchase its CIAs at face value. Consequently, Devon permitted its clients to redeem their CIAs at full price even though the value of the underlying collateral had plummeted, while at the same time Devon (through instructions to Mid-State) helped fund these redemptions with new sales of CIAs at full face value. In the aggregate, between June 1994 and September 1997, Mid- State, at Devon's direction, purchased and sold hundreds of millions of dollars of CIAs for the account of Devon clients for whom Mid-State had custodial accounts. These transactions were all for the face value of the CIAs regardless of the value of the securities in FMS' CIA collateral accounts. The purchases and sales between FMS and Devon's clients continued until the SEC revealed on September 26, 1997, that the Devon CIA investment program was a securities fraud.

Thereafter, the SEC commenced a civil action against Black, Devon and FMS alleging that they had perpetrated a massive Ponzi scheme through the purchase and sale of the CIA securities in violation of S 10(b) of the Securities Exchange Act of 1934, SEC Rule 10b-5, and other provisions of federal securities law. The SEC alleged that Devon continued to accept new funds from investment advisory clients for purchases of CIAs without disclosing that, as a result of the shortfall in the collateral for the funds already invested in those securities, any new funds invested would immediately diminish in value by as much as 45 percent. The SEC further alleged that the Devon advisory clients who had invested in the CIA program had suffered a combined loss of their principal investment of approximately $71 million. On December 12, 1997, the District Court issued an injunction against Black, Devon and FMS barring future violations of securities law including S 10(b), and Rule 10b-5.

On May 27, 1998, the School Districts filed this putative class action asserting four RICO claims, and seeking to recover the $70 million lost as a result of the Ponzi scheme. Counts 1 through 3 assert claims for violations of 18 U.S.C. S 1962(c).5 The predicate acts are alleged to consist of wire, mail and bank fraud. Count 4 asserts a claim for conspiracy to violate S 1962(c). In addition, the complaint asserts six state law claims. The complaint named Mid- State, Keystone Financial, Inc., (Mid-State's corporate parent); William H. Bogel, Senior VP and Director of Trust Department at Mid-State; Nancy F. Fogel, VP, Trust Officer and Head of Operations for Mid-State; Robert Leech, Director of Trust Services for Keystone; and Robert R. Magill, VP and Head of Trust Operations for Keystone (hereinafter collectively referred to as "Mid-State") as defendants.6

The Ponzi scheme is the foundation of this complaint. The School Districts allege that Mid-State knowingly participated in, and furthered, the Ponzi scheme through numerous acts of mail, wire and bank fraud. The School Districts' theory is that Mid-State's role in the Ponzi scheme was essential to the scheme's existence and continuation. Mid-State accepted deposits into custodian accounts and those funds were exchanged for CIAs, by which FMS promised to repay the funds with earnings. Bald Eagle and South Butler allege not only that Mid-State acted as a "back office" for Devon and FMS, but also that the Ponzi scheme could not have operated without Mid-State's participation. That argument is based upon the assertion that the putative class members' funds could be held only in custodian accounts and had to be fully secured. Plaintiffs also allege that although Mid-State was well aware of the shortfalls in the FMS collateral accounts, Mid-State seized upon the volatility of the investments as a means of recovering the losses in hope of limiting its own liability. Plaintiffs further allege that, at the same time, Mid-State took affirmative steps to conceal the scheme by knowingly preparing trust statements which falsely inflated the market values of the investments despite knowing that the collateral was grossly insufficient. The School Districts contend that whenever funds were requested by Devon clients, Mid-State paid out the full amount requested even though there was insufficient collateral to pay all putative class members and other clients.

The School Districts also allege that Mid-State gave a false explanation to the FDIC and other bank regulators to explain the collateral shortfall, and that Mid-State received a cash flow projection from Black which indicated that FMS would be in full balance by November of 1998. However, according to plaintiffs, Mid-State knew that Black's projection required, among other things, the receipt of an additional $330 million of custodian funds between March 1996 and November 1998 -- i.e., Mid-State knew that in order for FMS to be in full balance as projected by Black, the Ponzi scheme needed to be continued.

On August 10, 1998, Mid-State moved to dismiss the School Districts' civil RICO claims under Fed. R. Civ. P. 9(b) and 12(b)(6). Mid-State asserted that (1) the civil RICO action was barred by S 107 of the PSLRA; (2) the complaint was not supported by adequate averments of fraud as required by Fed. R. Civ. P. 9(b); (3) the alleged predicate acts were not the proximate cause of the School Districts' injuries; and (4) the complaint failed to satisfy other required elements for civil RICO claims. On February 9, 1999, the District Court held that S 107 of the PSLRA barred the School Districts' civil RICO claims, and granted Mid-State's motion to dismiss. The court did not discuss the other grounds for dismissal advanced by Mid-State, and the District Court declined to exercise supplemental jurisdiction over the School Districts' state law claims. This appeal followed.7

Prior to 1995, a private plaintiff could assert a civil RICO claim for securities law violations sounding in "garden variety" fraud.. See Sedima S.P.R.L. v. Imrex Co., Inc., 473 U. S. 479, 504-505 (1985)(Marshall, J., dissenting). Inasmuch as "fraud in the sale of securities" was a predicate offense in both criminal and civil RICO actions, Id. at 504, plaintiffs regularly elevated fraud to RICO violations because RICO offered the potential bonanza of recovering treble damages. However, in 1995, Congress enacted the Private Securities Litigation Reform Act ("PSLRA"), Pub.L. No. 104-67, 109 Stat. 737 (1995). The PSLRA amended RICO by narrowing the kind of conduct that could qualify as a predicate act. Section 107 of the PSLRA (known as the "RICO Amendment") amended 18 U.S.C. S 1964(c), to provide in relevant part as follows:

Any person injured in his business or property by reason of a violation of section 1962 of this chapter may sue therefor in any appropriate United States District Court and shall recover threefold the damages he sustains and the cost of the suit, including a reasonable attorney's fee, except that no person may rely upon any conduct that would have been actionable as fraud in the purchase or sale of securities to establish a violation of section 1962.

18 U.S.C. S 1964(c)(emphasis added).

The Conference Committee Report accompanying S 107 states that the amendment was intended not simply "to eliminate securities fraud as a predicate offense in a civil RICO action," but also to prevent a plaintiff from "plead[ing] other specified offenses, such as mail or wire fraud, as predicate acts under civil RICO if such offenses are based on conduct that would have been actionable as securities fraud." H. R. Conf. Rep. No. 104-369, at 47 (1995).

We recently held that S 107 eliminated "any conduct actionable as fraud in the purchase or sale of securities" as a predicate act for a private cause of action under RICO. Mathews v. Kidder, Peabody & Co., Inc., 161 F.3d 156, 157 (3d Cir. 1998).8 We stated that the legislative history shows that Congress enacted the RICO Amendment "to address a significant number of frivolous actions based on alleged securities law violations." Id. at 164 (quoting 141 Cong. Rec. H2771 (daily ed. Mar. 7, 1995)(statement of Rep. Cox)). The "focus" of the Amendment was on "completely eliminating the so-called `treble damage blunderbuss of RICO' in securities fraud cases." Id. (quoting 141 Cong. Rec. H2771).

Here, careful examination of the School Districts' complaint discloses the District Court correctly concluded that the School Districts' Civil RICO Action is barred by S 107. In the SEC's civil action against Black, Devon and FMS, the SEC has alleged that a massive Ponzi scheme was perpetrated through the purchase and sale of CIAs in violation of the securities laws including S 10(b) of the Securities Exchange Act of 1934, and SEC Rule 10b-5 and other provisions of the securities law. SEC Complaint, App. at 523-39. That same Ponzi scheme is at the heart of this RICO action. Plaintiff's allegations include the following: P 3. Bald Eagle and South Butler bring this class action under . . . [RICO] . . . to recover their losses caused by [Mid-States'] participation in an elaborate, but carefully concealed municipal fraud of immense magnitude, that ultimately became nothing more than an old-fashioned Ponzi Scheme. . . .

P 4. The Ponzi scheme was revealed publicly on September 26, 1997, when the Securities and Exchange Commission ("SEC") commenced a civil enforcement action . . . against . . . [Black, Devon and FMS] . . . . As detailed in the SEC's enforcement action, Black illegally perpetrated such a scheme upon . . . [the School Districts and other class members] . . . causing them to lose approximately $70,000,000. However, Black could not conduct this scheme alone, and, in fact, [Mid-State] joined and participated in such scheme through multiple acts of bank, mail and wire fraud, . . . .

Plaintiffs allege that Mid-State joined, assisted and participated in Black's Ponzi scheme:

P 5. [A]lthough Black's Ponzi scheme was first revealed publicly in September 1997, [Mid-State] discovered it years before the SEC uncovered it. Rather than reveal the scheme, and put a stop to it, however, [Mid-State] joined in the scheme and enabled it to continue in the hope that Black could recover his massive losses and, more importantly, thereby avoid any claims against [Mid-State](emphasis in original) . . . .

P 94. [Mid-State] ignored [its] obligations to class members because [it] became embroiled in, and participated in, a Ponzi scheme that depended upon the unauthorized pooling of class members' funds, the investment of those funds in risky, impermissible investment, the fraudulent reporting of market values, and the infusion of more money to keep the scheme going. . . .

P 95. [B]ecause neither Devon nor FMS were licensed as a broker or dealer in securities, Black used Mid- State . . . as the "back office" for Devon. In this capacity, Mid-State . . . essentially acted as the intermediar[y] which processed the securities trades that were directed by Black. . . .

P 126. [Mid-State], whose role[ ], inter alia, custodian and "back office," [was] essential to Black's Ponzi scheme, had by now knowingly joined the scheme as participant[ ]. . . .

P 133. Because bond proceeds and certain other funds of school districts and other governmental units can only be deposited with custodian banks, such as[Mid- State], it was impossible for Black to continue his Ponzi scheme, once disclosed and fully understood, without the knowing participation and assistance of [Mid- State]. Rather than stop this fraud, however, and fearing that [Mid-State] would be liable for tens of millions of dollars of past losses, and that individual Defendants' jobs and careers were in jeopardy, [Mid- State] elected not to reveal the Ponzi scheme, but rather, to join, assist, and continue it.These few excerpts demonstrate, in the School Districts' own words, that Mid-State's "role in the Ponzi scheme was essential to its existence and continuation." Appellants' Br. at 8. The School Districts allege that Black's Ponzi scheme was securities fraud. We, like the District Court, must accept these allegations as true for purposes of a motion to dismiss under Rule 12(b)(6)9 University of Maryland v. Peak, Marwick, Main & Co., 996 F.2d 1534, 1537-38 (3d Cir. 1993). Therefore, the alleged conduct is "conduct that would have been actionable as fraud in the purchase and sale of securities," S 107 PSLRA, and it cannot constitute predicate acts of a RICO violation. Accordingly, it is clear that the RICO action is barred by S 107.

The School Districts attempt to avoid the unavoidable by arguing here, as they did before the District Court, that the challenged conduct "does constitute bank fraud, wire fraud and mail fraud, but does not constitute securities fraud." Appellants' Br. at 11-12 (emphasis in original). However, they also concede that some of the conduct alleged as predicate offenses of mail, wire, and bank fraud does constitute securities fraud. See Reply Br. at 28 ("The District Court correctly stated that `the issue before me appears to be whether the RICO amendment bars an action where only some of the predicate acts would have been actionable as [securities] fraud.") Plaintiffs assert that if only some of the conduct alleged is securities fraud, then "obviously some other portion of [Mid-State's] conduct is not actionable as securities fraud." Id. And, it is this "other portion" of Mid-State's conduct which the School Districts argue constitutes the predicate offenses of mail, wire and bank fraud.

The School Districts submit that the "other portion" of the conduct consists of "obtaining deposits of funds, failing to maintain collateral, failing to maintain custody of funds, paying out more funds to withdrawing clients than the fair value of their account, providing false trust statements (after deposits are obtained), and lying to bank regulators." School Districts' Br. At 12 (emphasis in original).

The School Districts' position ignores two significant and intertwined facts. First, as noted earlier, the RICO Amendment removed securities fraud as a predicate offense in a civil RICO action. Section 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. S 78j(b),10 and SEC Rule 10b-5, 17 C.F.R. S 240.10b-5,11 are directed at fraud "in connection with the purchase or sale" of securities. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 733 (1975) (emphasis added). The School Districts' position ignores the reality that the same set of facts can support convictions for mail fraud, wire fraud, bank fraud and securities fraud without giving rise to any multiplicity problems. See United States v. Faulhaber, 929 F.2d 16 (1st Cir. 1991) and United States v. Reed, 639 F.2d 896 (2d Cir. 1981). Each of those offenses requires proof of a fact which the others do not. See Blockburger v. United States, 284 U. S. 299 (1932). Consequently, a plaintiff cannot avoid the RICO Amendment's bar by pleading mail fraud, wire fraud and bank fraud as predicate offenses in a civil RICO action if the conduct giving rise to those predicate offenses amounts to securities fraud. Allowing such surgical presentation of the cause of action here would undermine the congressional intent behind the RICO Amendment. Second, the contention that the conduct alleged as predicate offenses was not in connection with the purchase or sale of securities completely ignores the hard reality that the conduct was an integral part of Black's securities fraud Ponzi scheme. A Ponzi scheme is ongoing, and it continues only so long as new investors can be lured into it so that the early investors can be paid a return on their "investment." Consequently, conduct undertaken to keep a securities fraud Ponzi scheme alive is conduct undertaken in connection with the purchase and sale of securities. For example, the CIAs purchased by the School Districts were worth significantly less than their purchase price because of the shortfall in the collateral in the funds already under management. However, it is alleged that Mid-State either misrepresented, or failed to disclose, the collateral shortfall in account statements it prepared. This misrepresentation/omission, induced new investments. Such conduct may well constitute wire, mail or bank fraud, but it was also undertaken in connection with the purchase of a security. Thus, it cannot support a civil RICO claim after enactment of the PSLRA.

The District Court held that the RICO Amendment barred the School Districts' civil RICO action because the conduct underlying the RICO claims is "intrinsically connected to, and dependent upon conduct which would be actionable under Federal securities law." Dist. Ct. Op. at 13. But, the proper focus of the analysis is on whether the conduct pled as predicate offenses is "actionable" as securities fraud -- not on whether the conduct is "intrinsically connected to, and dependent upon" conduct actionable as securities fraud. Because the District Court appeared to center its attention on whether the conduct alleged as predicate offenses was connected to and dependent upon securities fraud, rather than on whether the conduct was actionable as securities fraud, the School Districts argue that the District Court gave an "overly expansive" reading to the RICO Amendment. Appellants' Br. at 11. However, on a close reading of the District Court's opinion, it is clear that the District Court's analysis was properly focused on whether the conduct was actionable as securities fraud. The tenor of the opinion demonstrates that the District Court found the conduct alleged as predicate acts was so closely connected to and dependent upon conduct undertaken in connection with the purchase or sale of securities that it was actionable as securities fraud. Consequently, we find no merit in the School Districts' argument that the District Court's reading of the RICO Amendment was overly expansive.

For the above reasons, we will affirm the decision of the District Court.